Solutions Manual for Intermediate Accounting 11th Edition by David Spiceland, Mark Nelson, Wayne Tho by kriswilliams

SOLUTION MANUAL

Intermediate Accounting, 11e (Spiceland) Chapter 1 Environment and Theoretical Structure of Financial Accounting 1) The primary function of financial accounting is to provide relevant financial information to parties external to business enterprises. Answer: TRUE Difficulty: 1 Easy Topic: Environment of financial accounting and reporting Learning Objective: 01-01 Describe the function and primary focus of financial accounting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking

2) Accrual accounting attempts to measure revenues and expenses that occurred during accounting periods so they equal net operating cash flow. Answer: FALSE Difficulty: 1 Easy Topic: Cash versus accrual accounting Learning Objective: 01-02 Explain the difference between cash and accrual accounting. Blooms: Understand AACSB: Reflective Thinking AICPA: FN Measurement

3) The FASB is currently the public-sector organization responsible for setting accounting standards in the United States. Answer: FALSE Difficulty: 1 Easy Topic: Development of accounting and reporting standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

4) The FASB's due process invites various interested parties to indicate their opinions about whether financial accounting standards should be changed. Answer: TRUE Difficulty: 1 Easy Topic: GAAP―Standard-setting process Learning Objective: 01-04 Explain why establishing accounting standards is characterized as a political process. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

5) Accounting for stock-based compensation is an area in which the FASB has received little political interference. Answer: FALSE Difficulty: 1 Easy

Topic: GAAP―Standard-setting process Learning Objective: 01-04 Explain why establishing accounting standards is characterized as a political process. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

6) The Public Reform and Investor Protection Act of 2002 (Sarbanes-Oxley) changed the entity responsible for setting standards for auditing public companies in the United States. Answer: TRUE Difficulty: 1 Easy Topic: Encouraging high-quality financial reporting Learning Objective: 01-05 Explain factors that encourage high-quality financial reporting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

7) A rules-based approach to standard-setting stresses professional judgment as opposed to following a list of rules. Answer: FALSE Difficulty: 1 Easy Topic: Encouraging high-quality financial reporting Learning Objective: 01-05 Explain factors that encourage high-quality financial reporting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking

8) Under federal securities laws, the SEC has the authority to set accounting standards in the United States. Answer: TRUE Difficulty: 1 Easy Topic: Development of accounting and reporting standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

9) The primary responsibility for properly applying GAAP when communicating with investors and creditors through financial statements lies with a firm's auditors. Answer: FALSE Difficulty: 1 Easy Topic: Encouraging high-quality financial reporting Learning Objective: 01-05 Explain factors that encourage high-quality financial reporting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking

Answer: TRUE Difficulty: 1 Easy Topic: Encouraging high-quality financial reporting Learning Objective: 01-05 Explain factors that encourage high-quality financial reporting. Blooms: Understand AACSB: Reflective Thinking AICPA: BB Critical thinking

11) The purpose of the conceptual framework is to provide a structure and framework for a consistent set of GAAP. Answer: TRUE Difficulty: 1 Easy Topic: Conceptual framework―Purpose Learning Objective: 01-06 Explain the purpose of the conceptual framework. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking

12) In the United States, the conceptual framework indicates GAAP when a more specific accounting standard does not apply. Answer: FALSE Difficulty: 1 Easy Topic: Conceptual framework―Purpose Learning Objective: 01-06 Explain the purpose of the conceptual framework. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking

13) Materiality can be affected by the dollar amount of an item, the nature of the item, or both. Answer: TRUE Difficulty: 1 Easy Topic: Concepts―Qualitative characteristics Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

14) According to the FASB's Statements of Financial Accounting Concepts, conservatism is a desired qualitative characteristic of accounting information. Answer: FALSE Difficulty: 1 Easy Topic: Concepts―Qualitative characteristics Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking

AICPA: BB Critical thinking AICPA: FN Measurement

15) Equity is a residual amount representing the owner's interest in the assets of the business. Answer: TRUE Difficulty: 1 Easy Topic: Concepts―Elements of financial statements Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

16) Revenues are inflows of assets or settlements of liabilities from activities that constitute the entity's ongoing operations. Answer: TRUE Difficulty: 1 Easy Topic: Concepts―Elements of financial statements Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

17) Gains or losses result, respectively, from the disposition of business assets for greater than, or less than, their book values. Answer: TRUE Difficulty: 1 Easy Topic: Concepts―Elements of financial statements Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

18) Comprehensive income is another term for net income. Answer: FALSE Difficulty: 1 Easy Topic: Concepts―Elements of financial statements Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

Answer: FALSE Difficulty: 1 Easy Topic: Concepts―Qualitative characteristics Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

20) The monetary unit assumption requires that items in financial statements be measured in a particular monetary unit. Answer: TRUE Difficulty: 1 Easy Topic: GAAP―Underlying assumptions Learning Objective: 01-08 Describe the four basic assumptions underlying GAAP. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

21) The periodicity assumption requires that present value calculations take into account the number of compounding periods in each year. Answer: FALSE Difficulty: 1 Easy Topic: GAAP―Underlying assumptions Learning Objective: 01-08 Describe the four basic assumptions underlying GAAP. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

22) Determining fair value by calculating the present value of future cash flows is a level 1 type of input. Answer: FALSE Difficulty: 1 Easy Topic: Concepts―Recognition - Measurement - Disclosure Learning Objective: 01-09 Describe the recognition, measurement, and disclosure concepts that guide accounting practice. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

23) The FASB's framework for measuring fair value doesn't change the situations in which fair value is used under current GAAP. Answer: TRUE Difficulty: 1 Easy Topic: Concepts―Recognition - Measurement - Disclosure Learning Objective: 01-09 Describe the recognition, measurement, and disclosure concepts that guide accounting practice.

Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

24) The revenue/expense approach emphasizes determining the appropriate amounts of revenue and expense in each reporting period. Answer: TRUE Difficulty: 1 Easy Topic: Evolving GAAP Learning Objective: 01-10 Contrast a revenue/expense approach and an asset/liability approach to accounting standard setting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

25) The asset/liability approach emphasizes matching to determine what assets and liabilities should be reflected on the balance sheet. Answer: FALSE Difficulty: 1 Easy Topic: Evolving GAAP Learning Objective: 01-10 Contrast a revenue/expense approach and an asset/liability approach to accounting standard setting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

26) In IFRS, the conceptual framework indicates appropriate accounting when a more specific accounting standard does not apply. Answer: TRUE Difficulty: 1 Easy Topic: International Financial Reporting Standards Learning Objective: 01-11 Discuss the primary differences between U.S. GAAP and IFRS with respect to the development of accounting standards and the conceptual framework underlying accounting standards. Blooms: Remember AACSB: Diversity AICPA: BB Global

27) Political pressure never affects the IFRS standard-setting process. Answer: FALSE Difficulty: 1 Easy Topic: International Financial Reporting Standards Learning Objective: 01-11 Discuss the primary differences between U.S. GAAP and IFRS with respect to the development of accounting standards and the conceptual framework underlying accounting standards. Blooms: Remember AACSB: Diversity AICPA: BB Global AICPA: BB Legal

A) Granting credit. B) Capital budgeting. C) Selecting stocks. D) Mergers and acquisitions. Answer: B Difficulty: 1 Easy Topic: Environment of financial accounting and reporting Learning Objective: 01-01 Describe the function and primary focus of financial accounting. Blooms: Understand AACSB: Reflective Thinking AICPA: BB Resource management

29) The primary focus for financial accounting information is to provide information useful for: a. b. c. d.

Investing decisions Yes Yes No No

Credit decisions Yes No Yes No

A) Option a. B) Option b. C) Option c. D) Option d. Answer: A Difficulty: 1 Easy Topic: Environment of financial accounting and reporting Learning Objective: 01-01 Describe the function and primary focus of financial accounting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Resource management AICPA: FN Risk analysis

30) Which of the following groups is not among the external users for whom financial statements are prepared? A) Customers. B) Suppliers. C) Employees. D) Customers, suppliers, and employees are all external users of financial statements. Answer: D Difficulty: 1 Easy Topic: Environment of financial accounting and reporting Learning Objective: 01-01 Describe the function and primary focus of financial accounting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking

AICPA: FN Risk analysis

31) Which of the following is not true about net operating cash flow? A) It is the difference between cash receipts and cash disbursements from providing goods and services. B) It is a measure used in accrual accounting and is recognized as the best predictor of future operating cash flows. C) Over short periods, it may not be indicative of long-run cash-generating ability. D) It is easy to understand and all information required to measure it is factual. Answer: B Difficulty: 2 Medium Topic: Cash versus accrual accounting Learning Objective: 01-02 Explain the difference between cash and accrual accounting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

32) Which of the following groups is not among financial intermediaries? A) Mutual fund managers. B) Financial analysts. C) CPAs. D) Credit rating organizations. Answer: C Difficulty: 2 Medium Topic: Environment of financial accounting and reporting Learning Objective: 01-01 Describe the function and primary focus of financial accounting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

33) Which of the following was the first private-sector entity that set accounting standards in the United States? A) Accounting Principles Board. B) Committee on Accounting Procedure. C) Financial Accounting Standards Board. D) AICPA. Answer: B Difficulty: 2 Medium Topic: Development of accounting and reporting standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

publicly listed on a stock exchange? A) FASB B) IASB C) GASB D) EITF Answer: C Difficulty: 1 Easy Topic: Development of accounting and reporting standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

35) Porite Company recognizes revenue in the period in which it records an asset for the related account receivable, rather than in the period in which the account receivable is collected in cash. Porite's practice is an example of: A) Cash basis accounting. B) Accrual accounting. C) The matching principle. D) Economic entity. Answer: B Difficulty: 1 Easy Topic: Cash versus accrual accounting Learning Objective: 01-02 Explain the difference between cash and accrual accounting. Blooms: Evaluate AACSB: Analytical Thinking AICPA: FN Measurement

36) Which of the following is not a potential benefit of accrual accounting, compared to cashbasis accounting? A) Timeliness. B) Better reflecting economic activity. C) Periodicity. D) Better matching of revenues and expenses. Answer: C Difficulty: 1 Easy Topic: Cash versus accrual accounting Learning Objective: 01-02 Explain the difference between cash and accrual accounting. Blooms: Understand AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

37) In a recent annual report, Apple Computer reported the following in one of its disclosure notes: "Warranty Expense: The Company provides currently for the estimated cost for product warranties at the time the related revenue is recognized." This note exemplifies Apple's use of: A) Conservatism. 9 Copyright ©2021 McGraw-Hill

B) Matching. C) Revenue recognition. D) Economic entity. Answer: B Difficulty: 2 Medium Topic: Concepts―Recognition - Measurement - Disclosure Learning Objective: 01-09 Describe the recognition, measurement, and disclosure concepts that guide accounting practice. Blooms: Evaluate AACSB: Analytical Thinking AICPA: BB Critical thinking

38) GAAP is an abbreviation for: A) Generally authorized accounting procedures. B) Generally applied accounting procedures. C) Generally accepted auditing practices. D) Generally accepted accounting principles. Answer: D Difficulty: 1 Easy Topic: Development of accounting and reporting standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

39) The FASB issues accounting standards in the form of: A) Accounting Research Bulletins. B) Accounting Standards Updates. C) Financial Accounting Standards. D) Financial Technical Bulletins. Answer: B Difficulty: 1 Easy Topic: Development of accounting and reporting standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

40) Pronouncements issued by the Committee on Accounting Procedures: A) Dealt with specific accounting and reporting problems. B) Were based on exposure drafts and public comment letters. C) Originated from congressional studies and SEC directives. D) Were the outcome of research studies and a theoretical framework. Answer: A Difficulty: 1 Easy Topic: Development of accounting and reporting standards

Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

41) The FASB's standard-setting process includes, in the correct order: A) Exposure draft, research, discussion paper, Accounting Standards Update. B) Research, exposure draft, discussion paper, Accounting Standards Update. C) Research, discussion paper, exposure draft, Accounting Standards Update. D) Discussion paper, research, exposure draft, Accounting Standards Update. Answer: C Difficulty: 1 Easy Topic: GAAP―Standard-setting process Learning Objective: 01-04 Explain why establishing accounting standards is characterized as a political process. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

42) Which of the following is not a provision of the Public Company Accounting Reform and Investor Protection Act of 2002 (Sarbanes-Oxley)? The Act: A) Changed the entity responsible for setting auditing standards. B) Increased corporate executive responsibility for financial statements. C) Limited nonaudit services that can be performed by auditors for audit clients. D) Changed the entity responsible for setting accounting standards. Answer: D Difficulty: 1 Easy Topic: Encouraging high-quality financial reporting Learning Objective: 01-05 Explain factors that encourage high-quality financial reporting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

43) CPAs are licensed by: A) The AICPA. B) The SEC. C) The federal government. D) State governments. Answer: D Difficulty: 1 Easy Topic: Encouraging high-quality financial reporting Learning Objective: 01-05 Explain factors that encourage high-quality financial reporting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

B) IRS. C) SEC. D) AICPA. Answer: C Difficulty: 1 Easy Topic: Development of accounting and reporting standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

45) When a registrant company submits its annual filing to the SEC, it uses: A) Form 10-A. B) Form 10-K. C) Form 10-Q. D) Form S-1. Answer: B Difficulty: 1 Easy Topic: Development of accounting and reporting standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

46) The most likely important flaw leading to the demise of the APB was the perceived lack of: A) Confidence. B) Competence. C) Independence. D) Importance. Answer: C Difficulty: 2 Medium Topic: Development of accounting and reporting standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking

47) Accounting standard-setting has been characterized as: A) A political process. B) Using the scientific method. C) Pure deductive reasoning. D) Pure inductive reasoning. Answer: A Difficulty: 1 Easy Topic: GAAP―Standard-setting process

Learning Objective: 01-04 Explain why establishing accounting standards is characterized as a political process. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking

48) The International Accounting Standards Board: A) Was the predecessor to the IASC. B) Can overrule the FASB when their policies disagree. C) Promotes the use of high-quality, understandable global accounting standards. D) Has its headquarters in Geneva. Answer: C Difficulty: 1 Easy Topic: Development of accounting and reporting standards; International Financial Reporting Standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards.; 01-11 Discuss the primary differences between U.S. GAAP and IFRS with respect to the development of accounting standards and the conceptual framework underlying accounting standards. Blooms: Remember AACSB: Reflective Thinking AACSB: Diversity AICPA: BB Global AICPA: BB Legal

49) Which of the following is not a provision of the Public Company Accounting Reform and Investor Protection Act of 2002? A) Corporate executive accountability. B) Auditor rotation. C) Retention of work papers. D) All of these answer choices are correct. Answer: D Difficulty: 1 Easy Topic: Encouraging high-quality financial reporting Learning Objective: 01-05 Explain factors that encourage high-quality financial reporting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Legal

50) The primary professional organization for those accountants working in industry is the: A) AAA. B) AICPA. C) IIA. D) IMA. Answer: D Difficulty: 1 Easy Topic: Encouraging high-quality financial reporting Learning Objective: 01-05 Explain factors that encourage high-quality financial reporting. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking

51) Regarding convergence of accounting standards, the FASB and IASB: A) Have agreed to combine their organizations to form the BUSYB. B) Have achieved full convergence with respect to financial instruments. C) Do not intend to work together to achieve convergence where possible. D) Are not likely to achieve full convergence of accounting standards in the near future. Answer: D Difficulty: 1 Easy Topic: Development of accounting and reporting standards; International Financial Reporting Standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards.; 01-11 Discuss the primary differences between U.S. GAAP and IFRS with respect to the development of accounting standards and the conceptual framework underlying accounting standards. Blooms: Remember AACSB: Diversity AICPA: BB Global

52) Which of the following is not a concern regarding IFRS adoption by the U.S.? A) Need for the U.S. to have strong influence on the standard-setting process and ensure that standards meet U.S. needs. B) Geographic dispersion of standard setters make it unlikely that boards can interact to achieve consensus. C) The high costs to companies of converting to IFRS. D) The fact that many laws, regulations and private contracts reference U.S. GAAP. Answer: B Difficulty: 1 Easy Topic: Development of accounting and reporting standards Learning Objective: 01-03 Define generally accepted accounting principles (GAAP) and discuss the historical development of accounting standards, including convergence between U.S. and international standards. Blooms: Remember AACSB: Diversity AICPA: BB Global

53) The most political issue in the FASB's most recent deliberations and amendments to GAAP on stock options was: A) The negative effects on earnings of companies in the tech industry if they had to recognize expenses associated with stock compensation. B) The negative effects on assets of recognizing stock options in equity. C) The disclosure of stock compensation expense in the notes. D) Accounting for stock options that have not yet been granted to employees. Answer: A Difficulty: 3 Hard Topic: GAAP―Standard-setting process Learning Objective: 01-04 Explain why establishing accounting standards is characterized as a political process. Blooms: Understand AACSB: Reflective Thinking AICPA: BB Critical thinking

54) An important historical reason for the FASB reversing its positions when political pressures occur is: A) The cost of gathering data was prohibitive. B) The difficulties in measurement were too great. C) Companies withdraw financial support for the FASB. D) The SEC did not support the FASB position. Answer: D Difficulty: 2 Medium Topic: GAAP―Standard-setting process Learning Objective: 01-04 Explain why establishing accounting standards is characterized as a political process. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking

55) The most recent example of the political process at work in standard-setting is the heated debate that occurred on the issue of: A) Creation of the FASB. B) Accounting for stock compensation. C) Establishing the SEC. D) Accounting for fair values. Answer: D Difficulty: 2 Medium Topic: GAAP―Standard-setting process Learning Objective: 01-04 Explain why establishing accounting standards is characterized as a political process. Blooms: Understand AACSB: Reflective Thinking AICPA: BB Critical thinking

56) Independent auditors express an opinion on the: A) Fairness of financial statements. B) Accuracy of financial statements. C) Soundness of a company's future. D) Quality of a company's management. Answer: A Difficulty: 2 Medium Topic: Encouraging high-quality financial reporting Learning Objective: 01-05 Explain factors that encourage high-quality financial reporting. Blooms: Remember AACSB: Reflective Thinking AICPA: FN Reporting

57) The possibility that the capital markets' focus on periodic profits may tempt a company's management to bend or even break accounting rules to inflate reported net income is an example of: A) An ethical dilemma. B) An accounting theory issue. C) A technical accounting issue. 15 Copyright ©2021 McGraw-Hill

D) An auditor's responsibility to inform the SEC. Answer: A Difficulty: 2 Medium Topic: Encouraging high-quality financial reporting Learning Objective: 01-05 Explain factors that encourage high-quality financial reporting. Blooms: Evaluate AACSB: Analytical Thinking AACSB: Ethics AICPA: BB Resource management AICPA: FN Risk analysis

58) One of the elements that many believe distinguishes a profession from other occupations is the acceptance of responsibility by its members for the interests of those it serves, which is often articulated in: A) Its conceptual framework. B) Its code of ethics. C) Federal laws. D) State laws. Answer: B Difficulty: 2 Medium Topic: Encouraging high-quality financial reporting Learning Objective: 01-05 Explain factors that encourage high-quality financial reporting. Blooms: Remember AACSB: Ethics AICPA: BB Critical thinking

59) SFAC 8 of the conceptual framework focuses on: A) Objective and qualitative characteristics. B) Presentation and disclosure. C) Recognition and measurement. D) Elements of financial statements. Answer: A Difficulty: 1 Easy Topic: Conceptual framework―Purpose Learning Objective: 01-06 Explain the purpose of the conceptual framework. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

60) The FASB's conceptual framework's qualitative characteristics of accounting information include: A) Historical cost. B) Realization. C) Faithful representation. D) Full disclosure. Answer: C 16 Copyright ©2021 McGraw-Hill

Difficulty: 1 Easy Topic: Concepts―Recognition - Measurement - Disclosure Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

61) The FASB's conceptual framework's qualitative characteristics of accounting information include: A) Full disclosure. B) Relevance. C) Going concern. D) Historical cost. Answer: B Difficulty: 1 Easy Topic: Concepts―Recognition - Measurement - Disclosure Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

62) The conceptual framework's qualitative characteristic of relevance includes: A) Predictive value. B) Verifiability. C) Completeness. D) Neutrality. Answer: A Difficulty: 1 Easy Topic: Concepts―Recognition - Measurement - Disclosure Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

63) The conceptual framework's qualitative characteristic of faithful representation includes: A) Predictive value. B) Neutrality. C) Confirmatory value. D) Timeliness. Answer: B Difficulty: 1 Easy Topic: Concepts―Recognition - Measurement - Disclosure Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the

elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

64) SFAC No.5 focuses on: A) Objectives of financial reporting. B) Qualitative characteristics of accounting information. C) Recognition and measurement concepts in accounting. D) Elements of financial statements. Answer: C Difficulty: 2 Medium Topic: Conceptual framework―Purpose Learning Objective: 01-06 Explain the purpose of the conceptual framework. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

65) The main issue in the debate over accounting for employee stock options was: A) Which employees should receive options. B) The amount of compensation expense that a company should recognize. C) How many options should be granted to key executives. D) The tax consequences of employee stock options. Answer: B Difficulty: 2 Medium Topic: GAAP―Standard-setting process Learning Objective: 01-04 Explain why establishing accounting standards is characterized as a political process. Blooms: Understand AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

66) Confirmatory value is central to the concept of “earnings quality” because A) It helps investors predict a company’s future earnings. B) It allows investors to verify or change their prior assessments of a company’s performance. C) It helps investors predict a company’s future cash flows. D) It allows investors to compare the performance of a company over time. Answer: B Difficulty: 1 Easy Topic: Concepts―Qualitative characteristics Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Bloom's: Understand AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

A) Is the same as its net income. B) Is greater than its net income. C) Is less than its net income. D) Could be greater than or less than net income. Answer: D Difficulty: 1 Easy Topic: Concepts―Elements of financial statements Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Understand AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

68) Net income equals: A) Assets minus liabilities. B) Revenues minus cost of goods sold. C) Revenues minus expenses. D) Cash receipts minus cash payments. Answer: C Difficulty: 1 Easy Topic: Concepts―Elements of financial statements Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: FN Measurement

69) Enhancing qualitative characteristics of accounting information include each of the following except: A) Timeliness. B) Materiality. C) Comparability. D) Verifiability. Answer: B Difficulty: 1 Easy Topic: Concepts―Qualitative characteristics Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

70) The enhancing qualitative characteristic of understandability means that information should be understood by: A) Those who are experts in the interpretation of financial information. B) Those who have a reasonable understanding of business and economic activities. 19 Copyright ©2021 McGraw-Hill

C) Financial analysts. D) CPAs. Answer: B Difficulty: 1 Easy Topic: Concepts―Qualitative characteristics Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

71) Fundamental qualitative characteristics of accounting information are: A) Relevance and comparability. B) Comparability and consistency. C) Faithful representation and relevance. D) Neutrality and consistency. Answer: C Difficulty: 1 Easy Topic: Concepts―Qualitative characteristics Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

72) Enhancing qualitative characteristics of accounting information include: A) Relevance and comparability. B) Comparability and timeliness. C) Understandability and relevance. D) Neutrality and consistency. Answer: B Difficulty: 1 Easy Topic: Concepts―Qualitative characteristics Learning Objective: 01-07 Identify the objective and qualitative characteristics of financial reporting information, and the elements of financial statements. Blooms: Remember AACSB: Reflective Thinking AICPA: BB Critical thinking AICPA: FN Measurement

73) Gains are: A) Inflows from selling a product or service to a customer. B) Increases in equity resulting from transfers of assets to the company from owners. C) Increases in equity from peripheral transactions of an entity. D) None of these answer choices are correct. 20 Copyright ©2021 McGraw-Hill

The title documents are available in full on the following links

Title: Solutions Manual for Intermediate Accounting 11th Edition by David Spiceland, Mark Nelson, Wayne Thomas & Jennifer Winchel Link I: https://mega.nz/file/IHkDCSKB#-aWxvME6A53-9QALxOygm72KALqWij8GtJqFWgdOm9w

Chapter 1 Environment and Theoretical Structure of Financial Accounting Question 1–1 Financial accounting is concerned with providing relevant financial information about various kinds of organizations to different types of external users. The primary focus of financial accounting is on the financial information provided by profitoriented companies to their present and potential investors and creditors.

Question 1–2 Resources are efficiently allocated if they are given to enterprises that will use them to provide goods and services desired by society and not to enterprises that will waste them. The capital markets are the mechanism that fosters this efficient allocation of resources.

Question 1–3 Two extremely important variables that must be considered in any investment decision are the expected rate of return and the uncertainty or risk of that expected return.

Question 1–4 In the long run, a company will be able to provide investors and creditors with a rate of return only if it can generate a profit. That is, it must be able to use the resources provided to it to generate cash receipts from selling a product or service that exceed the cash disbursements necessary to provide that product or service.

Question 1–5 The primary objective of financial accounting is to provide investors and creditors with information that will help them make investment and credit decisions.

Question 1–6 Net operating cash flows are the difference between cash receipts and cash disbursements during a period of time from transactions related to providing goods and services to customers. Net operating cash flows may not be a good indicator of future cash flows because, by ignoring uncompleted transactions, they may not match the accomplishments and sacrifices of the period.

Question 1–7 GAAP (generally accepted accounting principles) are a dynamic set of both broad and specific guidelines that a company should follow in measuring and reporting the information in their financial statements and related notes. It is important that all companies follow GAAP so that investors can compare financial information across companies to make their resource allocation decisions.

Question 1–8 In 1934, Congress created the SEC and gave it the job of setting accounting and reporting standards for companies whose securities are publicly traded. The SEC has retained the power, but has relied on private sector bodies to create the standards. The current private sector body responsible for setting accounting standards is the FASB.

Question 1–9 Auditors are independent, professional accountants who examine financial statements to express an opinion. The opinion reflects the auditors‘ assessment of the statements' fairness, which is determined by the extent to which they are prepared in compliance with GAAP. The auditor adds credibility to the financial statements, which increases the confidence of capital market participants relying on that information.

Question 1–10 Key provisions included in the text are:  Creation of the Public Company Accounting Oversight Board  Regulate types of non-audit audit services  Require lead audit partner rotation every 5 year  Corporate executive accountability  Addresses conflicts of interest for security analysts  Internal control reporting and auditor opinion about controls

Question 1–11 New accounting standards, or changes in standards, can have significant differential effects on companies, investors and creditors, and other interest groups by causing redistribution of wealth. There also is the possibility that standards could harm the economy as a whole by causing companies to change their behavior.

Question 1–12 The FASB undertakes a series of elaborate information gathering steps before issuing an accounting standard to determine consensus as to the preferred method of accounting, as well as to anticipate adverse economic consequences.

Question 1–13 The purpose of the conceptual framework is to guide the Board in developing accounting standards by providing an underlying foundation and basic reasoning on which to consider merits of alternatives. The framework does not prescribe GAAP.

Question 1–14 Relevance and faithful representation are the primary qualitative characteristics that make information decision-useful. Relevant information will possess predictive and/or confirmatory value. Faithful representation is the extent to which there is agreement between a measure or description and the phenomenon it purports to represent.

Question 1–15 The components of relevant information are predictive value, confirmatory value and materiality. The components of faithful representation are completeness, neutrality, and freedom from error.

Question 1–16 The benefit from providing accounting information is increased decision usefulness. If the information is relevant and possesses faithful representation, it will improve the decisions made by investors and creditors. However, there are costs to providing information that include costs to gather, process, and disseminate that information. There also are costs to users in interpreting the information as well as possible adverse economic consequences that could result from disclosing information. Information should not be provided unless the benefits exceed the costs.

Question 1–17 Information is material if it is deemed to have an effect on a decision made by a user. The threshold for materiality will depend principally on the relative dollar amount of the transaction being considered. One consequence of materiality is that GAAP need not be followed in measuring and reporting a transaction if that transaction is not material. The threshold for materiality has been left to subjective judgment.

Question 1–18 1.

Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. 2. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions. 3. Equity is the residual interest in the assets of any entity that remains after deducting its liabilities. 4. Investments by owners are increases in equity resulting from transfers of resources, usually cash, to a company in exchange for ownership interest. 5. Distributions to owners are decreases in equity resulting from transfers to owners. 6. Revenues are inflows of assets or settlements of liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity‘s ongoing major or central operations. 7. Expenses are outflows or other using up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity‘s ongoing major or central operations. 8. Gains are defined as increases in equity from peripheral or incidental transactions of an entity. 9. Losses represent decreases in equity arising from peripheral or incidental transactions of an entity. 10. Comprehensive income is defined as the change in equity of an entity during a period from nonowner transactions.

Question 1–19 The four basic assumptions underlying GAAP are (1) the economic entity assumption, (2) the going concern assumption, (3) the periodicity assumption, and (4) the monetary unit assumption.

Question 1–20 The going concern assumption means that, in the absence of information to the contrary, it is anticipated that a business entity will continue to operate indefinitely. This assumption is important to many broad and specific accounting principles such as the historical cost principle.

Question 1–21 The periodicity assumption relates to needs of external users to receive timely financial information. This assumption requires that the economic life of a company be divided into artificial periods for financial reporting. Companies usually report to external users at least once a year.

Question 1–22 Four accounting practices, often referred to as principles, that guide accounting practice are (1) revenue recognition, (2) expense recognition, (3) mixed-attribute measurement (including historical cost), and (4) full disclosure.

Question 1–23 Two advantages to basing valuation on historical cost are (1) historical cost provides important cash flow information since it represents the cash or cash equivalent paid for an asset or received in exchange for the assumption of a liability, and (2) historical cost valuation is the result of an exchange transaction between two independent parties and the agreed upon exchange value is, therefore, objective and possesses a high degree of verifiability.

Question 1–24 Companies recognize revenue when goods or services are transferred to customers. However, no revenue is recognized if it isn‘t probable that the seller will collect the amounts it‘s entitled to receive. The amount of revenue recognized is the amount the company expects to be entitled to receive in exchange for those goods or services. Revenue is recognized at a point in time or over a period of time, depending on when goods or services are transferred to customers. So, revenue for the sale of most goods is recognized upon delivery, but revenue for services like renting apartments or lending money is recognized over time as those services are provided.

. Question 1–25 The four different approaches to implementing expense recognition are: 1. Recognizing an expense based on an exact cause-and-effect relationship between a revenue and expense event. Cost of goods sold is an example of an expense recognized by this approach. 2. Recognizing an expense by identifying the expense with the revenues recognized in a specific time period. Office salaries are an example of an expense recognized by this approach. 3. Recognizing an expense by a systematic and rational allocation to specific time periods. Depreciation is an example of an expense recognized by this approach. 4. Recognizing expenses in the period incurred, without regard to related revenues. Advertising is an example of an expense recognized by this approach.

Question 1–26 In addition to the financial statement elements arrayed in the basic financial statements, information is disclosed by means of parenthetical or modifying comments, notes, and supplemental schedules and tables.

Question 1–27 GAAP prioritizes the inputs companies should use when determining fair value. The highest and most desirable inputs, Level 1, are quoted market prices in active markets for identical assets or liabilities. Level 2 inputs are other than quoted prices that are observable, including quoted prices for similar assets or liabilities in active or inactive markets and inputs that are derived principally from observable related market data. Level 3 inputs, the least desirable, are inputs that reflect the entity‘s own assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances.

Question 1–28 Common measurement attributes are historical cost, net realizable value, current cost, present value, and fair value.

Answers to Questions (concluded) Question 1–29 Under the revenue/expense approach, revenues and expenses are considered primary, and assets, liabilities, and equities are secondary in the sense of being recognized at the time and amount necessary to achieve proper revenue and expense recognition. Under the asset/liability approach, assets and liabilities are considered primary, and revenues and expenses are secondary in the sense of being recognized at the time and amount necessary to allow recognition and measurement of assets and liabilities as required by their definitions.

Question 1–30 Under IFRS, the conceptual framework provides guidance to accounting standard setters but also provides GAAP when more specific accounting standards do not provide guidance.

Question 1–31 The International Accounting Standards Board (IASB) is responsible for determining IFRS. The IASB is funded by the IFRS Foundation. .

Complete Solution Manual for Intermediate Accounting, 11th Edition

BRIEF EXERCISES Brief Exercise 1–1 Revenues ($340,000 + 60,000) Expenses: Rent ($40,000  2) Salaries Utilities ($50,000 + 2,000) Net income

$400,000 (20,000) (120,000) (52,000) $208,000

Brief Exercise 1–2 (1) Liabilities (2) Assets (3) Revenues (4) Losses

Brief Exercise 1–3 1. The periodicity assumption 2. The economic entity assumption 3. Revenue recognition 4. Expense recognition

Brief Exercise 1–4 1. Expense recognition 2. The historical cost (original transaction value) principle 3. The economic entity assumption

Brief Exercise 1–5 1. Disagree 2. Agree 3. Disagree 4. Agree

— — — —

The full disclosure principle The periodicity assumption Expense recognition Revenue recognition

Brief Exercise 1–6 1. Obtains funding for the IFRS standard setting process: IFRS Foundation 2. Determines IFRS: International Accounting Standards Board (IASB) 3. Oversees the IFRS Foundation: Monitoring Board 4. Provides input about the standard setting agenda: IFRS Advisory Council. 5. Provides implementation guidance about relatively narrow issues: IFRS Interpretations Committee.

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EXERCISES Exercise 1–1 Requirement 1 Perez Associates Operating Cash Flow Cash collected Cash disbursements: Salaries Utilities Purchase of insurance policy Net operating cash flow

Year 1 $160,000

Year 2 $190,000

(90,000) (30,000) (60,000) $(20,000)

(100,000) (40,000) -0$ 50,000

Requirement 2 Perez Associates Income Statements Revenues Expenses: Salaries Utilities Insurance Net Income

Year 1 $170,000

Year 2 $220,000

(90,000) (35,000) (20,000) $ 25,000

(100,000) (35,000) (20,000) $ 65,000

Requirement 3 Year 1: Amount billed to clients Less: Cash collected Ending accounts receivable

$170,000 (160,000) $ 10,000

Year 2: Beginning accounts receivable Plus: Amounts billed to clients

$ 10,000 220,000 $230,000 (190,000) $ 40,000

Less: Cash collected Ending accounts receivable

Exercise 1– 12 Requirement 1

Revenues Expenses: Rent ($80,000  2) Salaries Utilities Advertising Net Income

Year 2 $350,000

Year 3 $450,000

(40,000) (140,000) (30,000) (25,000) $115,000

(40,000) (160,000) (40,000) (20,000)* $190,000

Requirement 2 Amount owed at the end of year one Advertising costs incurred in year two Amount paid in year two Liability at the end of year two Less cash paid in year three Advertising expense in year three

$ 5,000 25,000 30,000 (15,000) 15,000 (35,000) $20,000*

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 1–3 Requirement 1 FASB ASC 820: ―Fair Value Measurements‖ Requirement 2 The specific citation that describes the information that companies must disclose about the use of fair value to measure assets and liabilities for recurring measurements is FASB ASC 820–10–50: ―Fair Value Measurements -Overall-Disclosures.‖

Exercise 1– 14 The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1. The topic number for business combinations: FASB ASC 805: ―Business Combinations.‖ 2. The topic number for related-party disclosures: FASB ASC 850: ―Related Party Disclosures.‖ 3. The topic, subtopic, and section number for the initial measurement of internal-use software: FASB ASC 350–40–30: ―Intangibles–Goodwill and Other– Internal–Use Software– Initial Measurement.‖ 4. The topic, subtopic, and section number for the subsequent measurement of asset retirement obligations: FASB ASC 410– 20–35: ―Asset Retirement and Environmental Obligations–Asset Retirement Obligations–Subsequent Measurement.‖ 5. The topic, subtopic, and section number for the recognition of stock compensation: FASB ASC 718– 10–25: ―Compensation– Stock Compensation–Overall– Recognition.‖

Exercise 1–5 Organization 1. Securities and Exchange Commission 2. Financial Executives International 3. American Institute of Certified Public Accountants 4. Institute of Management Accountants 5. Association of Investment Management and Research

Group Users Preparers Auditors Preparers Users

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 1–6 1. Liability 2. Distribution to owners 3. Revenue 4. Assets, liabilities and equity 5. Comprehensive income 6. Gain 7. Loss 8. Equity 9. Asset 10. Net income 11. Investment by owner 12. Expense

Exercise 1–7 List A o

1. Predictive value

2. Relevance

g a j

3. Timeliness 4. Distribution to owners 5. Confirmatory value

6. Understandability

n 7. Gain f 8. Faithful representation k 9. Comprehensive income p 10. Materiality c 11. Comparability m 12. Neutrality l d

13. Recognition 14. Consistency

b i

15. Cost effectiveness 16. Verifiability

List B a. Decreases in equity resulting from transfers to owners. b. Requires consideration of the costs and value of information. c. Important for making interfirm comparisons. d. Applying the same accounting practices over time. e. Users understand the information in the context of the decision being made. f. Agreement between a measure and the phenomenon it purports to represent. g. Information is available prior to the decision. h. Pertinent to the decision at hand. i. Implies consensus among different measurers. j. Information confirms expectations. k. The change in equity from nonowner transactions. l. The process of admitting information into financial statements. m. The absence of bias. n. Increases in equity from peripheral or incidental transactions of an entity. o. Information is useful in predicting the future. p. Concerns the relative size of an item and its effect on decisions.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 1–8 1. Materiality 2. Neutrality 3. Consistency 4. Timeliness 5. Predictive value and/or confirmatory value 6. Faithful representation 7. Comparability (Consistency) 8. Cost effectiveness

Exercise 1–9 List A d

1. Expense recognition

g e i

2. 3. 4.

h c

5. 6.

a f

8. 9.

List B

a. The enterprise is separate from its owners and other entities. Periodicity assumption b. A common denominator is the dollar. Historical cost principle c. The entity will continue indefinitely. Materiality d. Record expenses in the period the related revenue is recognized. Revenue recognition e. The original transaction value upon acquisition. Going concern assumption f. All information that could affect decisions should be reported. Monetary unit assumption g. The life of an enterprise can be divided into artificial time periods. Economic entity assumption h. Criteria usually satisfied for products at point of sale. Full-disclosure principle i. Concerns the relative size of an item and its effect on decisions.

Exercise 1–10 1. The economic entity assumption 2. The periodicity assumption 3. Expense recognition (also the going concern assumption) 4. The historical cost (original transaction value) principle 5. Revenue recognition 6. The going concern assumption 7. Materiality

Exercise 1–11 1. The historical cost (original transaction value) principle 2. The periodicity assumption 3. Revenue recognition 4. The economic entity assumption 5. Expense recognition; materiality 6. The full disclosure principle

Exercise 1–12 — — — — — — —

Monetary unit assumption Full disclosure principle Expense recognition Historical cost (original transaction value) principle Revenue recognition Materiality Periodicity assumption

1. Disagree

—

2. Disagree 3. Disagree 4. Agree

— — —

5. Agree 6. Disagree

— —

This is a violation of the historical cost (original transaction value) principle. This is a violation of the economic entity assumption. This is a violation of appropriate revenue recognition. The company is conforming to appropriate expense recognition. The company is conforming to the full disclosure principle. This is a violation of the periodicity assumption.

1. Disagree 2. Disagree 3. Agree 4. Disagree 5. Agree 6. Agree 7. Disagree

Exercise 1–13

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 1–14 Statement 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

d. h. g. e. c. a. i. j. f. b.

Concept Monetary unit assumption Full-disclosure principle Expense recognition Historical cost principle Periodicity assumption Economic entity assumption Cost effectiveness Materiality Conservatism Going concern assumption

Exercise 1–15 1. 2. 3. 4. 5. 6.

b d c d b b

DECISION MAKERS’ PERSPECTIVE CASES Judgment Case 1–1 Requirement 1 The SEC has more authority than the FASB with respect to standard setting. In the 1934 Securities Act, Congress gave the SEC the job of setting accounting and reporting standards for companies whose securities are publicly traded. However, the SEC, a government-appointed body, always has accomplished the task of setting accounting standards by relying on the private sector, currently the FASB. It is important to understand that the SEC retains the power to set standards. If the SEC does not agree with a particular standard promulgated by the private sector, it can, and has in the past, required a change in the standard. Requirement 2 1. SEC employees may not have the expertise necessary to set accounting standards. 2. By relying on a private sector body to set standards, the cost of setting accounting standards is not borne by taxpayers. 3. By relying on a private sector body to set standards, standards may gain greater acceptance than if dictated by a public (government) body. 4. The SEC now has a buffer group between itself and concerned constituents. The SEC avoids criticism if a mistake is made by the FASB.

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Research Case 1–2 Requirement 1 The 1933 Act has two basic objectives: 1. To require that investors be provided with material information concerning securities offered for public sale; and 2. To prevent misrepresentation, deceit, and other fraud in the sale of securities. Requirement 2

Each of the following can be searched in EDGAR: company name, ticker symbol, standard industrial classification (SIC) code, taxpayer ID number.

Research Case 1–3 Requirement 1 7 - As of the time this book was printed, the FASB had seven members. Requirement 2 1 - As of the time this book was printed, the FASB had 1 academic member, Christine Botosan. By custom the FASB has had an academic member as one of the seven members of the Board. Requirement 3 The mission of the Financial Accounting Standards Board is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.

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Research Case 1–4 Requirement 1 14 - The IASB has 14 Board members. Requirement 2 London, United Kingdom Requirement 3 The IASB is committed to developing, in the public interest, a single set of highquality, understandable, and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements. In addition, the IASB cooperates with national accounting standard-setters to achieve convergence in accounting standards around the world.

Research Case 1-5 The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. Requirement 1 The part of the citation title associated with the sixth and seventh digits: a. ASC 505-10-50: Disclosure b. ASC 310-10-35: Subsequent Measurement c. ASC 730-10-25: Recognition d. ASC 330-10-45: Other Presentation Matters e. ASC 805-10-30: Initial Measurement f. ASC 320-10-45: Other Presentation Matters g. ASC 606-10-25: Recognition h. ASC 710-10-30: Initial Measurement i. ASC 718-10-35: Subsequent Measurement j. ASC 360-10-50: Disclosure Requirement 2 Yes, the Codification associates the sixth and seventh digits of a citation with the same categories, regardless of the account or transaction in Question. That approach makes it more efficient to find content relevant to each of the categories.

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Judgment Case 1–6 Disagree. Wolf has been paid, so collectability is not a concern. However, Wolf performs its rental service over time, and at the beginning of the period has not yet fulfilled its obligation to its renters to provide rent services. Under accrual accounting, revenue should be recognized over the rental period, not at the beginning of the period.

Real World Case 1–7 Requirement 1 a. Total net revenues b. Total operating expenses c. Net income (earnings) d. Total assets e. Total stockholders' equity

= = = = =

$ 16,383 million $ 5,559 million $ 351 million $ 13,679 million $ 3,316 million

Requirement 2 The balance sheet reports 371 million shares of common stock issued and outstanding as of February 1, 2020. Requirement 3 Yes, GAP Inc. presents more than one year of data, The presentation of more than one year facilitates the ability of investors and creditors to compare the profitability of the company over time. This, in turn, provides important information for predicting future results.

Judgment Case 1–8 Requirement 1 The two primary qualitative characteristics of accounting information are relevance and faithful representation. Requirement 2 No, GAAP does not routinely require disclosure of forecasts. The qualities of relevance and faithful representation often can conflict, requiring a trade-off between them. A forecast of a financial variable may possess a high degree of relevance to investors and creditors. However, a forecast necessarily contains subjectivity in the estimation of future events. Since a forecast is involved, information could be more easily biased and may contain material errors. Therefore, generally accepted accounting principles do not require companies to provide forecasts of financial variables.

Judgment Case 1–9 Requirement 1 The cost effectiveness constraint governs whether the FASB should require companies to provide additional financial information. Requirement 2 The cost effectiveness constraint is discussed in Concepts Statement No. 8. Requirement 3 The costs could include (1) increased information-gathering, processing and dissemination costs to the companies affected, (2) increased interpreting costs to users, and (3) adverse economic consequences to the companies, their investors, creditors, employees, other interest groups as well as to society as a whole.

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Communication Case 1–10 In the long run, a company will be able to provide investors with a return only if it can generate a profit. That is, it must be able to use the resources provided by investors and creditors to generate cash receipts from selling a product or service that exceed the cash disbursements necessary to provide that product or service. If this excess cash can be generated, the marketplace is implicitly saying that society‘s resources have been efficiently allocated. The marketplace is assigning a value to the product or service that exceeds the value assigned to the resources used to produce that product or service. Pollution costs to society should be borne by the company/individual causing the costs to be incurred. If they are, and the pollutioncausing company can still generate a profit, then society‘s resources are still being allocated efficiently. From this perspective, it appears that information on pollution costs is relevant information to financial statement users. However, even though this information might be relevant, it would not possess faithful representation. For example, how could we objectively measure the costs to society of dumping hazardous waste into a river? Fish and other river-life will die, drinking water will contain more pollutants, and the river will be a less desirable place for recreation. Some of these costs can be quantified (estimated), but others can‘t. It is important that each student actively participate in the process of arriving at a solution. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction.

Communication Case 1–11 Suggested Grading Concepts and Grading Scheme: Content (70%) 30 Briefly outlines the standard setting process. Role of FASB, SEC. The process. 20 Explains the meaning of economic consequences. 20 Discusses the need to balance accounting considerations and economic consequences. 70 points Writing (30%) 6 Terminology and tone appropriate to the audience of a business journal. 12 Organization permits ease of understanding. Introduction that states purpose. Paragraphs that separate main points. 12 English Sentences grammatically clear and well organized, concise. Word selection. Spelling. Grammar and punctuation. 30 points

Complete Solution Manual for Intermediate Accounting, 11th Edition

Communication Case 1–12 Requirement 1 Pro-convergence arguments include: 1. U.S. financial markets would be more attractive to companies with uniform accounting standards. 2. More comparable financial statements are easier for users. 3. Less costly information systems to prepare financial statements for multinational companies. 4. Cooperation with the rest of the world is good. Cooperating on accounting standards could facilitate progress on other political dimensions. 5. Preference for principles-based reporting under IFRS. 6. One common set of standards makes it easier for employers to obtain accountants from other countries or to locate accounting operations in other parts of the world. 7. Balancing of political interests (which could temper effect of U.S. political environment). Requirement 2 Anti-convergence arguments include: 1. Regulatory requirements (like Sarbanes-Oxley) are more important than accounting standards for discouraging use of U.S. capital markets. 2. Actual comparability depends on regulatory enforcement and how IFRS is applied in particular countries; could make financial statements seem more comparable than they really are. 3. For local companies, transition to IFRS would be expensive. 4. May be difficult to cooperate with the rest of the world when standards don‘t favor U.S. interests. How will U.S. Congress react when the French are pressuring the IASB to obtain accounting favorable to them? 5. Rules-based U.S. regime has developed because companies and their auditors want protection against litigation and regulators. If switch for IFRS, companies and their auditors will want implementation guidance that preserves the rules. 6. IASB is more vulnerable to political pressure from various governments like the EU. Solutions Manual, Chapter 2 2–29 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Ethics Case 1–13 Requirement 1 Company executives. It is the responsibility of management to apply GAAP appropriately. Requirement 2 No. While auditors are paid by the company, they must be an independent party to help ensure that management has in fact appropriately applied GAAP in preparing the company’s financial statements. Requirement 3 Yes. Some feel that it is impossible for an auditor to give an independent opinion on a company‘s financial statements because the auditors‘ fees for performing the audit are paid by the company. In addition to the audit fee, some perceive independence is further impaired when the auditors are paid to provide additional services to the company. Requirement 4 The standard audit arrangement can jeopardize independence by leaving auditors vulnerable to the following pressures: 1. Pressure from management to bias the audit opinion by threatening to withhold audit fee payment, to hire another audit firm, or to assign tax preparation work to another audit firm. 2. Pressure from management to bias the audit opinion by providing an expensive gift or an outright bribe to the auditor. Auditors should refuse all but nominal gifts from their clients. 3. Pressure to bias the audit opinion in favor of the client because the auditor, or family member, has a financial interest in the client beyond the audit fee. The interest could be in the form of an investment or a loan to or from the client. 4. Pressure to bias the audit opinion in favor of the client because the auditor, or family member, has current or future employment or is in a position of influence with the client. 5. An unfavorable opinion may provoke a lawsuit by investors and other injured parties against both the company and the auditors. Fear of litigation may prompt the auditors to give a favorable or clean opinion, when misleading information exists in the financial statements.

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Continuing Cases Target Case Requirement 1 a. Total revenues = $77,130 million b. Income from current operations = $ 3,269 million c. Net income or net loss = $ 3,281 million d. Total assets = $42,779 million e. Total equity = $11,833 million Requirement 2 Target‘s basic earnings per share was $6.42. Requirement 3 Target‘s fiscal year end is February 1, 2020. The accounting profession and the SEC encourage companies to adopt a fiscal year that corresponds to a natural business year, ending when a company‘s business cycle is at its lowest point. December 31 is in the hectic holiday shopping season at a time when stores are processing Christmas returns and offering after-holiday and New Year‘s sales, so it clearly is not at a low point in the business cycle. February 1 occurs after the holiday shopping season concludes, so it makes sense for Target to use that date as its fiscal year end. Requirement 4 a. Target‘s auditor is Ernst & Young LLP. b. Target received a ―clean‖ (unmodified) audit opinion. Specifically: ―In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Corporation at February 1, 2020 and February 2, 2019, and the results of its operations and its cash flows for each of the three years in the period ended February 1, 2020, in conformity with U.S. generally accepted accounting principles.‖ c. Target‘s audit report includes 2 critical audit matters: (1) Target‘s use of the retail inventory accounting method, and (2) Target‘s use of vendor income receivables.

Air France–KLM Case Requirement 1 a. Total revenues = b. Income from current operations = c. Net income (Group part) = d. Total assets = e. Total equity =

€ 27,189 million € 1,141 million € 290 million € 30,735 million € 2,299 million

Requirement 2 AF‘s basic earnings per share was € 0.64.

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Chapter 2 Review of the Accounting Process QUESTIONS FOR REVIEW OF KEY TOPICS

Question 2– 34 External events involve an exchange transaction between the company and a separate economic entity. For every external transaction, the company is receiving something in exchange for something else. Internal events do not involve an exchange transaction but do affect the financial position of the company. Examples of external events are the purchase of inventory, a sale to a customer, and the borrowing of cash from a bank. Examples of internal events include the recording of depreciation expense, the expiration of prepaid rent, and the accrual of salary expense.

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Question 2–2 According to the accounting equation, there is equality between the total economic resources of an entity, its assets, and the claims to those resources, liabilities, and equity. This implies that, since resources must always equal claims, the net effect of any transaction cannot affect one side of the accounting equation differently than the other side.

Question 2– 36 The purpose of a journal is to capture, in chronological order, the dual effect of a transaction in storage areas called accounts. A general ledger is an organized collection of accounts. The purpose is to keep track of the increases, decreases, and balances in each account.

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Question 2– 38 Permanent accounts represent the financial position of a company—assets, liabilities and owners' equity—at a particular point in time. Temporary accounts represent the changes in shareholders‘ equity, the retained earnings component of equity for a corporation, caused by revenue, expense, gain, loss, and dividend transactions. It would be cumbersome and less informative to record revenue/expense, gain/loss, and dividend transactions directly into the permanent retained earnings account. Recording these transactions in temporary accounts facilitates the preparation of the financial statements.

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Question 2–5 Assets are increased by debits and decreased by credits. Liabilities and equity accounts are increased by credits and decreased by debits.

Question 2– 40 Revenues and gains are increased with credits and decreased with debits.

Expenses, losses, and dividends are increased with debits (thus causing owners‘ equity to decrease) and decreased with credits (thus causing owners‘ equity to increase).

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Question 2–7 The first step in the accounting processing cycle is to identify external transactions affecting the accounting equation. Source documents, such as sales invoices, bills from suppliers, and cash register tapes, help to identify the transactions and then provide the information necessary to process the transaction.

Question 2– 42 Transaction analysis is the process of reviewing the source documents to determine the dual effect on the accounting equation and the specific elements involved.

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Question 2–44 After transactions are recorded in a journal, the debits and credits must be transferred to the appropriate general ledger accounts. This transfer is called posting.

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Question 2–10 In Transaction 1 we record the purchase of $20,000 of inventory on account. In Transaction 2 we record a credit sale of $30,000 and the corresponding cost of goods sold of $18,000.

Question 2–46 An unadjusted trial balance is a list of the general ledger accounts and their balances at a time before any end-of-period adjusting entries have been recorded. An adjusted trial balance is prepared after adjusting entries have been recorded and posted to the accounts.

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Question 2–12 We use adjusting entries to record the effect on financial position of internal events, those that do not involve an exchange transaction with another entity. We record them at the end of any period when financial statements are prepared to properly reflect financial position and results of operations according to the accrual accounting model, that is, to update accounts to their proper balances before we report those balances in the financial statements.

Question 2–48 Closing entries transfer the balances in the temporary owners‘ equity accounts (revenues, expenses, gains, losses, dividends) to a permanent owners‘ equity account, retained earnings for a corporation. This occurs only at the end of a reporting period in order to reduce the temporary accounts to zero before beginning the next reporting year.

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Question 2–50 Prepaid expenses represent assets recorded when a cash disbursement creates benefits that extend beyond the current reporting period. Examples are supplies on hand at the end of a period, prepaid rent, and prepaid insurance.

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Question 2–15 The adjusting entry required when deferred revenues are recognized is a debit to the deferred revenue liability and a credit to revenue.

Question 2–52 Accrued liabilities are recorded when an expense has been incurred that will not be paid until a subsequent reporting period. The adjusting entry needed to record an accrued liability is a debit to an expense and a credit to a liability.

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Question 2–17 Income statement—The purpose of the income statement is to summarize the profit-generating activities of a company during a particular period of time. It is a ―change statement‖ that reports the changes in shareholders‘ (owners‘) equity that occurred during the period as a result of revenues, expenses, gains, and losses. Statement of comprehensive income—The statement of comprehensive income extends the income statement to report changes in shareholders‘ equity during the reporting period that were not a result of transactions with owners. This statement includes net income and also other comprehensive income items. Balance sheet—The purpose of the balance sheet is to present the financial position of a company at a particular point in time. It is an organized list of assets, liabilities, and permanent shareholders‘ equity accounts. Statement of cash flows—The purpose of the statement of cash flows is to disclose the events that caused cash to change during the period. Statement of shareholders’ equity—The purpose of the statement of shareholders‘ equity is to disclose the sources of the changes in the various shareholders‘ equity accounts that occurred during the period. This statement includes changes resulting from investments by owners, distributions to owners, net income, and other comprehensive income.

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Question 2–18 A worksheet provides a way to organize the accounting information needed to prepare adjusting and closing entries and the financial statements. This error would result in an overstatement of revenue and thus net income and thus retained earnings, and an understatement of liabilities.

Question 2–19 Reversing entries are recorded at the beginning of a reporting period. They reverse the effects of some of the adjusting entries recorded at the end of the previous reporting period. This simplifies the journal entries recorded during the new period by allowing cash payments or cash receipts to be entered directly into the expense or revenue account without regard to the accrual recorded at the end of the previous period.

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Question 2–20 The purpose of special journals is to record, in chronological order, the dual effect of repetitive types of transactions, such as cash receipts, cash disbursements, credit sales, and credit purchases. Special journals simplify the recording process in the following ways: (1) journalizing the effects of a particular transaction is made more efficient through the use of specifically designed formats; (2) individual transactions are not posted to the general ledger accounts, but are accumulated in the special journals and a summary posting is made on a periodic basis; and (3) the responsibility for recording journal entries for the repetitive types of transactions is placed on individuals who have specialized training in handling them.

Answers to Questions (concluded)

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Question 2–21 The general ledger is a collection of control accounts representing assets, liabilities, and permanent and temporary shareholders‘ equity accounts. The subsidiary ledger contains a group of subsidiary accounts associated with a particular general ledger control account. For example, there will be a subsidiary ledger for accounts receivable that will keep track of the increases and decreases in the account receivable balance for each of the company‘s customers purchasing goods or services on credit. At any point in time, the balance in the accounts receivable control account should equal the sum of the balances in the accounts receivable subsidiary ledger accounts.

BRIEF EXERCISES

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Brief Exercise 2-1 + Stockholders’ Equity

Assets

Liabilities

(a)

+$50,000

(b)

+$35,000

(c)

−$10,000

(d)

−$5,000

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Brief Exercise 2-2

Dual Effect

1. Issue 10,000 shares of common stock in exchange for $32,000 in cash.

Assets increase

Stockholders’ equity increases

2. Purchase land for $19,000. A note payable is signed for the full amount.

Assets increase

Liabilities increase

3. Purchase equipment for $8,000 cash.

One asset (equipment) increases and another asset (cash) decreases

4. Hire three employees for $2,000 per month. Salaries are not paid until the end of the month.

No effect on the accounting equation

5. Receive cash of $12,000 in rental fees for the current month.

Assets increase

Stockholders’ equity increases

6. Purchase office supplies for $2,000 on account.

Assets increase

Liabilities increase

Pay employees $6,000 for the first month‘s salaries.

Assets decrease

Stockholders’ equity decreases

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Brief Exercise 2-3

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(1)

Debit

Equipment Cash (Purchase equipment with cash)

23,400

Credit 23,400

(2)

Cash

6,800 Service Revenue (Provide services for cash)

6,800

(3) Rent Expense Cash (Pay current month’s rent)

1,300 1,300

(4) Supplies 1,000 Accounts Payable (Purchase office supplies on account)

1,000

(5) Salaries Expense Cash (Pay current month’s salaries)

2,100 2,100

Brief Exercise 2-4 (1)

Debit

Advertising Expense Cash (Pay advertising for current month)

700

Credit 700

(2) Supplies Accounts Payable (Purchase supplies on account)

1,300 1,300

(3) Cash

2,900 Service Revenue (Provide services for cash)

2,900

(4) Salaries Expense Cash (Pay salaries for current month)

900 900

(5) Accounts Receivable Service Revenue (Provide services on account)

1,000 1,000

(6) Utilities Expense Cash (Pay utilities for current month)

300 300

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Brief Exercise 2-5 (1)

Debit

Cash

21,000 Common Stock (Issue common stock)

Credit 21,000

(2) Cash

9,000 Notes Payable (Obtain bank loan)

9,000

(3) Equipment Cash (Purchase equipment for cash)

25,000 25,000

(4) Advertising Expense 1,100 Cash (Purchase advertising for current month)

1,100

(5) Accounts Receivable Service Revenue (Provide services on account)

18,000 18,000

(6) Cash

13,000 Accounts Receivable (Receive cash on account)

13,000

(7) Salaries Expense Cash (Pay salaries for current month)

6,000 6,000

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Brief Exercise 2-6

(1) (4) (6)

Cash 5,000 15,000 9,000 (2) 8,000 3,000 (3) 4,000 1,000 (5) 7,000 (7) 12,000

Transaction (8) is not posted to the Cash T-account because a purchase on account does not involve cash.

Brief Exercise 2–7 Assets

Liabilities + Paid-in Capital + Retained Earnings

165,000

(inventory)

–

40,000

(cash)

+ 200,000(accounts receivable)

+ 200,000 (revenue)

–

120,000

(inventory)

–

180,000

(cash)

–

180,000

(accounts receivable)

–

145,000

(cash)

+ 165,000 (accounts payable) –

40,000 (expense)

120,000 (expense)

– 145,000 (accounts payable)

Brief Exercise 2–8 1. 2. 3.

4. 5.

Inventory ............................................................................ Accounts payable ........................................................... Salaries expense.................................................................. Cash .............................................................................. Accounts receivable ............................................................ Sales revenue ................................................................. Cost of goods sold .............................................................. Inventory........................................................................ Cash ................................................................................... Accounts receivable ...................................................... Accounts payable ............................................................... Cash ...............................................................................

165,000 165,000 40,000 40,000 200,000 200,000 120,000 120,000 180,000 180,000 145,000 145,000

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Brief Exercise 2–9 BALANCE SHEET ACCOUNTS Cash Accounts receivable 6/1 Bal. 4.

6/30 Bal.

65,000 180,000

43,000 200,000

6/30 Bal.

63,000

6/1 Bal. 40,000

145,000

60,000

Inventory 6/1 Bal.

165,000

6/30 Bal.

45,000

Accounts payable

180,000

6/1 Bal. 120,000

145,000

6/30 Bal.

22,000 165,000

42,000

INCOME STATEMENT ACCOUNTS Sales revenue

Cost of goods sold

6/1 Bal.

200,000

6/30 Bal.

6/1 Bal. 3.

0 120,000

6/30 Bal. 120,000

Salaries expense 6/1 Bal.

40,000

6/30 Bal.

40,000

Brief Exercise 2–10 1. 2. 3.

Prepaid insurance................................................................ Cash .............................................................................. Notes receivable ................................................................ Cash .............................................................................. Equipment ......................................................................... Cash ..............................................................................

12,000 12,000 10,000 10,000 60,000 60,000

Brief Exercise 2–11 1. 2. 3.

Insurance expense ($12,000 x 3/12) ..................................... Prepaid insurance .......................................................... Interest receivable ($10,000 x 6% x 6/12) ............................ Interest revenue .............................................................. Depreciation expense .......................................................... Accumulated depreciation ..............................................

3,000 3,000 300 300 12,000 12,000

Brief Exercise 2–12

1. 2. 3. Net effect

Higher (lower) $ 3,000 (300) 12,000 $14,700

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Brief Exercise 2–13 1. 2. 3. 4.

Deferred service revenue .................................................... Service revenue............................................................... Advertising expense ($2,000 x 1/2) ...................................... Prepaid advertising ......................................................... Salaries expense .................................................................. Salaries payable .............................................................. Interest expense ($60,000 x 8% x 4/12) ................................ Interest payable ...............................................................

4,000 4,000 1,000 1,000 16,000 16,000 1,600 1,600

Brief Exercise 2–14 Assets 1. 2. 3. 4. Net effect

Liabilities $ 4,000

$1,000

(16,000) (1,600) $(13,600)

Shareholders‘ Equity $(4,000) 1,000 16,000 1,600 $14,600

Brief Exercise 2–15 1. 2. 3. 4.

Interest receivable ............................................................... Interest revenue ($50,000 x 6% x 9/12) ...........................

2,250

Rent expense ($12,000 x 3/12)............................................. Prepaid rent .................................................................... Supplies expense ($3,000 + $5,000 – $4,200) ...................... Supplies .......................................................................... Salaries expense .................................................................. Salaries payable ..............................................................

3,000

2,250 3,000 3,800 3,800 6,000 6,000

Brief Exercise 2–16

BOWLER CORPORATION Income Statement For the Year Ended December 31, 2024 Sales revenue .............................................

$325,000

Cost of goods sold ......................................

168,000

Gross profit ................................................

157,000

Operating expenses: Salaries expense .......................................

$45,000

Rent expense ............................................

20,000

Depreciation expense ...............................

30,000

Miscellaneous expense .............................

12,000

Total operating expenses .............

107,000

Net income .................................................

$ 50,000

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Brief Exercise 2–17

BOWLER CORPORATION Balance Sheet At December 31, 2024 Assets Current assets: Cash ........................................................ Accounts receivable ................................ Inventory ................................................. Total current assets ............................. Property and equipment: Equipment ............................................... Less: Accumulated depreciation .............. Total assets ......................................

$ 5,000 10,000 16,000 31,000

$100,000 (40,000)

60,000 $91,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable .................................... Salaries payable ....................................... Total current liabilities ....................... Shareholders‘ equity: Common stock ........................................ Retained earnings .................................... Total shareholders‘ equity .................. Total liabilities and shareholders‘ equity

$20,000 12,000 32,000

$50,000 9,000 59,000 $91,000

Brief Exercise 2–18

Sales revenue.............................................................................. Retained earnings...................................................................

850,000

815,000

Retained earnings ....................................................................... Dividends...............................................................................

12,000

850,000

580,000 180,000 40,000 15,000

12,000

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Brief Exercise 2-19

Accrual-Basis Revenue Recognition

Cash-Basis Revenue Recognition

1. August 16.

June 12.

2. January 27.

February 2.

3. April 2.

April 2.

4. Revenue is recognized as each magazine is delivered.

July 1.

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Brief Exercise 2-20

Accrual-Basis Expense Recognition

Cash-Basis Expense Recognition

1. August 16.

September 2.

2. January 27.

January 6.

3. One month‘s worth of insurance expense is recognized each month.

January 1.

4. February 4.

February 23.

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Brief Exercise 2–21 Revenue

$428,000*

Expenses: Salaries Utilities Advertising Net Income

(240,000) (33,000)** (12,000) $143,000

Explanation: *$420,000 cash received plus $8,000 increase ($60,000 – $52,000) in amount due from customers: Cash .................................................................................. Accounts receivable (increase in account)............................ Service revenue (to balance)............................................

420,000 8,000 428,000

** $35,000 cash paid less $2,000 decrease in amount owed to utility company: Utilities expense (to balance) .............................................. Utilities payable (decrease in account) ................................. Cash ...............................................................................

33,000 2,000 35,000

EXERCISES Exercise 2–1 Assets

Liabilities + Paid-in Capital + Retained Earnings

300,000

(cash)

+ 300,000 (common stock)

– +

10,000 40,000

(cash) (equipment)

+ 30,000 (notes payable)

90,000

(inventory)

+ 90,000 (accounts payable)

+ –

120,000 70,000

(accounts receivable) (inventory)

+ –

120,000 70,000

(revenue) (expense)

–

5,000

(cash)

–

5,000

(expense)

– +

6,000 6,000

(cash) (prepaid insurance)

–

70,000

(cash)

+ –

55,000 55,000

(cash) (accounts receivable)

–

1,000

(accumulated depreciation)

–

1,000

(expense)

– 70,000 (accounts payable)

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Exercise 2–2 1.

Cash .................................................................................... Common stock ................................................................

300,000

Equipment ........................................................................... Notes payable ................................................................. Cash ...............................................................................

40,000

Inventory............................................................................. Accounts payable ............................................................

90,000

Accounts receivable............................................................. Sales revenue .................................................................. Cost of goods sold ............................................................... Inventory ........................................................................

120,000

Rent expense ....................................................................... Cash................................................................................

5,000

Prepaid insurance ................................................................ Cash................................................................................

6,000

Accounts payable ................................................................ Cash................................................................................

70,000

Cash .................................................................................... Accounts receivable ........................................................

55,000

Depreciation expense........................................................... Accumulated depreciation ...............................................

1,000

300,000

30,000 10,000

90,000

120,000 70,000 70,000

5,000

6,000

70,000

55,000

1,000

Exercise 2–3

BALANCE SHEET ACCOUNTS Cash

3/1 Bal. 1. 8.

0 300,000 55,000

3/31 Bal.

264,000

10,000 5,000 6,000 70,000

Accounts receivable

2. 5. 6. 7.

3/1 Bal. 4.

0 120,000

3/31 Bal.

65,000

Inventory 3/1 Bal. 3.

0 90,000

3/31 Bal.

20,000

70,000

55,000

Prepaid insurance

Equipment

3/1 Bal. 6.

0 6,000

3/31 Bal.

6,000

Accumulated depreciation

3/1 Bal. 2.

0 40,000

0 1,000

3/1 Bal. 9.

3/31 Bal.

40,000

1,000

3/31 Bal.

Accounts payable

70,000

Notes payable

0 90,000

3/1 Bal. 3.

0 30,000

3/1 Bal. 2.

20,000

3/31 Bal.

30,000

3/31 Bal.

Common stock 0 300,000

3/1 Bal. 1.

300,000

3/31 Bal.

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Exercise 2–3 (concluded) INCOME STATEMENT ACCOUNTS Sales revenue

Cost of goods sold

0 120,000

3/1 Bal. 4.

0 70,000

120,000

3/31 Bal.

70,000

Rent expense

Depreciation expense

3/1 Bal. 5.

0 5,000

3/1 Bal. 9.

0 1,000

3/31 Bal.

5,000

3/31 Bal.

1,000

Account Title Cash Accounts receivable Inventory Prepaid insurance Equipment Accumulated depreciation Accounts payable Notes payable Common stock Sales revenue Cost of goods sold Rent expense Depreciation expense Totals

Debits $264,000 65,000 20,000 6,000 40,000

Credits

70,000 5,000 _ 1,000 $471,000

1,000 20,000 30,000 300,000 120,000

$471,000

Exercise 2–92 1.

10.

Cash ............................................................................... Common stock ............................................................

500,000

Office equipment............................................................ Cash ............................................................................ Notes payable .............................................................

100,000

Inventory........................................................................ Accounts payable ........................................................

200,000

Accounts receivable ....................................................... Sales revenue............................................................... Cost of goods sold .......................................................... Inventory.....................................................................

280,000

Rent expense .................................................................. Cash ............................................................................

6,000

Prepaid insurance ........................................................... Cash ............................................................................

3,000

Accounts payable ........................................................... Cash ............................................................................

120,000

Cash ............................................................................... Accounts receivable ....................................................

55,000

Dividends ....................................................................... Cash ............................................................................

5,000

Cash ............................................................................... Deferred service revenue .............................................

2,000

500,000

40,000 60,000

200,000

280,000 140,000 140,000

6,000

3,000

120,000

55,000

5,000

2,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 2–5

List A 1. Source documents

2. Transaction analysis

3. Journal

4. Posting

5. Unadjusted trial balance e. Determine the dual effect on the accounting equation. 6. Adjusting entries f. List of accounts and their balances before recording adjusting entries. 7. Adjusted trial balance g. List of accounts and their balances after recording closing entries. 8. Financial statements h. List of accounts and their balances after recording adjusting entries. 9. Closing entries 10. Post-closing trial balance i. Transferring balances from the journal to the ledger. j. Used to identify and process external transactions.

b h c d g

List B a. Record of the dual effect of a transaction in debit/credit form. b. Updates to account balances recorded at the end of a reporting period. c. Primary means of disseminating information to external decision makers. d. To zero out the temporary accounts.

Exercise 2–94 Increase (I) or

Decrease (D)

Account

Inventory

Depreciation expense

Accounts payable

Prepaid rent

Sales revenue

Common stock

Salaries payable

Cost of goods sold

Utilities expense

10.

Equipment

11.

Accounts receivable

12.

Utilities payable

13.

Rent expense

14.

Interest expense

15.

Interest revenue

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Exercise 2–7

Example: Purchased inventory for cash 1. Paid a cash dividend.

Account(s) Account(s) Debited Credited 3 5 19 5

Paid rent for the next three months.

Sold goods to customers on account.

4, 16

9, 3

Purchased inventory on account.

Purchased supplies for cash.

Issued common stock in exchange for cash.

Collected cash from customers for goods sold in 3.

Borrowed cash from a bank and signed a note.

Paid salaries for the month of October.

10.

Received cash for advance payment from customer.

Exercise 2–96 1. Insurance expense ($12,000 × 6/36) ....................................... Prepaid insurance .............................................................

2,000

Depreciation expense ............................................................ Accumulated depreciation ...............................................

15,000

Salaries expense.................................................................... Salaries payable................................................................

18,000

4. Interest expense ($200,000 × 12% × 2/12) ............................. Interest payable ................................................................

4,000

5. Deferred rent revenue ........................................................... Rent revenue (1/3 × $3,000) ..............................................

1,000

2,000

15,000

18,000

4,000

1,000

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Exercise 2–9 1. Interest receivable ($90,000 x 8% x 3/12) .............................. Interest revenue................................................................

1,800

2. Rent expense ($6,000 x 2/3) .................................................. Prepaid rent......................................................................

4,000

3. Deferred rent revenue ($12,000 x 5/12).................................. Rent revenue ($12,000 x 5/12)...........................................

5,000

Depreciation expense............................................................ Accumulated depreciation ................................................

4,500

Salaries expense .................................................................. Salaries payable ...............................................................

8,000

6. Supplies expense ($2,000 + $6,500 – $3,250) ....................... Supplies ...........................................................................

5,250

1,800

4,000

5,000

4,500

8,000

5,250

Exercise 2–98 1. $7,200 represents nine months of interest on a $120,000 note, or 75% of annual interest. $7,200 ÷ 0.75 = $9,600 annual interest $9,600 ÷ $120,000 = 8% interest rate Or, $7,200 ÷ $120,000 = .06 nine-month rate To annualize the nine-month rate: .06 x 12/9 = .08 or 8%

2. $60,000 ÷ 12 months = $5,000 rent per month $35,000 ÷ $5,000 = 7 months expired. The rent was paid on June 1, seven months ago.

3. $500 represents two months (November and December) accrued interest, or $250 per month. $250 x 12 months = $3,000 annual interest Principal x 6% = $3,000 Principal = $3,000 ÷ .06 = $50,000 note

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 2–11 1. Prepaid insurance ................................................................ 2,500 Insurance expense ............................................................ (Five months remaining, July 1 through December 1, $500/month × 5)

2,500

2. Prepaid advertising .............................................................. 3,200 Advertising expense ......................................................... (Four months remaining, July 1 through November 1, $800/month × 4)

3,200

3. Rent revenue ........................................................................ 12,000 Deferred rent revenue....................................................... 12,000 (Six months remaining, July 1 through December 31, $2,000/month × 6) 4.

Supplies ............................................................................... Supplies expense.............................................................. (Supplies remaining = $7,200 – $4,100 = $3,100)

3,100

5. Delivery revenue ................................................................. 1,200 Deferred delivery revenue ................................................ (Remaining delivery services owed = $3,000 – $1,800 = $1,200)

3,100

1,200

Exercise 2–12 Requirement 1

BLUEBOY CHEESE CORPORATION Income Statement For the Year Ended December 31, 2024 Sales revenue ............................................. Cost of goods sold ...................................... Gross profit ................................................ Operating expenses: Salaries expense ....................................... Rent expense ............................................ Depreciation expense .............................. Advertising expense ................................. Total operating expenses ............. Operating income ....................................... Other expense: Interest expense ....................................... Net income .................................................

$800,000 480,000 320,000

$120,000 30,000 60,000 5,000 215,000 105,000 4,000 $101,000

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Exercise 2–12 (continued)

BLUEBOY CHEESE CORPORATION Balance Sheet At December 31, 2024 Assets Current assets: Cash ........................................................ Accounts receivable ................................ Inventory.................................................. Prepaid rent ............................................. Total current assets .............................

$ 21,000 300,000 50,000 10,000 381,000

Property and equipment: Office equipment ..................................... $600,000 Less: Accumulated depreciation ............... (250,000) Total assets ...................................... Liabilities and Shareholders' Equity Current liabilities: Accounts payable .................................... Salaries payable ....................................... Interest payable ....................................... Notes payable .......................................... Total current liabilities ....................... Shareholders‘ equity: Common stock ........................................ Retained earnings .................................... Total shareholders‘ equity .................. Total liabilities and shareholders‘ equity

350,000 $731,000

$ 60,000 8,000 2,000 60,000 130,000

$400,000 201,000* 601,000 $731,000

*Beginning balance of $100,000 plus net income of $101,000.

Exercise 2–12 (concluded) Requirement 2 December 31, 2024 Sales revenue.............................................................................. Retained earnings ................................................................ Retained earnings ....................................................................... Cost of goods sold ............................................................... Salaries expense .................................................................. Rent expense ....................................................................... Depreciation expense .......................................................... Interest expense................................................................... Advertising expense ............................................................

800,000 800,000 699,000 480,000 120,000 30,000 60,000 4,000 5,000

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Exercise 2–13

December 31, 2024 Sales revenue ............................................................................. Interest revenue .......................................................................... Retained earnings................................................................ Retained earnings ....................................................................... Cost of goods sold .............................................................. Salaries expense.................................................................. Rent expense....................................................................... Depreciation expense .......................................................... Interest expense .................................................................. Insurance expense ...............................................................

750,000 3,000 753,000 576,000 420,000 100,000 15,000 30,000 5,000 6,000

Exercise 2–14

December 31, 2024 Sales revenue.............................................................................. Interest revenue .......................................................................... Gain on sale of investments ....................................................... Retained earnings ................................................................ Retained earnings ....................................................................... Cost of goods sold ............................................................... Salaries expense .................................................................. Insurance expense ............................................................... Interest expense................................................................... Advertising expense ............................................................ Income tax expense ............................................................. Depreciation expense .........................................................

492,000 6,000 8,000 506,000 440,000 284,000 80,000 12,000 4,000 10,000 30,000 20,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 2–15 Requirement 1 Supplies 11/30 Balance 1,500 Expense Purchased ? 12/31 Balance

2,000

3,000

Cost of supplies purchased = $3,000 + $2,000 – $1,500 = $3,500

Requirement 2 Prepaid insurance 11/30 Balance 6,000 Expense 12/31 Balance

4,500

Insurance expense for December = $6,000 – $4,500 = $1,500

December 31, 2024 Insurance expense ...................................................................... Prepaid insurance................................................................

1,500 1,500

Exercise 2–15 (concluded) Requirement 3

Salaries paid 10,000

Salaries Payable 10,000 11/30 Balance ? Accrued salaries

15,000 12/31 Balance

Accrued salaries for December = $15,000

December 31, 2024 Salaries expense ......................................................................... Salaries payable .....................................................................

15,000 15,000

Requirement 4 Deferred rent revenue 2,000 11/30 Balance Recognized for Dec. 1,000 1,000 12/31 Balance Rent revenue recognized each month = $3,000 x 1/3 = $1,000

December 31, 2024 Deferred rent revenue ................................................................. Rent revenue ..........................................................................

1,000 1,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 2–16 Requirement 1 2024 Feb. 1

Cash .................................................. Notes payable ................................

April 1

July 17

Nov. 1

Debit 12,000

Credit 12,000

Prepaid insurance .............................. Cash ...............................................

3,600

Supplies ............................................ Accounts payable ...........................

2,800

Notes receivable ................................ Cash ...............................................

6,000

3,600

2,800

6,000

Requirement 2 2024 Dec. 31 Interest expense ($12,000 x 10% x 11/12) Interest payable ..............................

Debit 1,100

Dec. 31 Insurance expense ($3,600 x 9/24) ........ Prepaid insurance ..........................

1,350

Dec. 31 Supplies expense ($2,800 – $1,250) ....... Supplies .......................................

1,550

Dec. 31 Interest receivable ............................. Interest revenue ($6,000 x 8% x 2/12) .

Credit 1,100

1,350

1,550

Exercise 2–17 Unadjusted net income

$30,000

Adjustments: a. Only $2,000 in insurance should be expensed

+ 4,000

b. Sales revenue overstated

– 1,000

c. Supplies expense overstated

750

d. Interest expense understated ($20,000 x 12% x 3/12)

–

600

Adjusted net income

$33,150

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 2–18

S&J Lawn Service Company Income Statement For the Year Ended December 31, 2024 Service revenue (1)...................................... Operating expenses: Salaries expense ....................................... Supplies expense (2) ................................. Rent expense ........................................... Insurance expense (3) ............................... Miscellaneous expense (4) ....................... Depreciation expense .............................. Total operating expenses ............. Operating income ....................................... Other expense: Interest expense (5) ................................... Net income .................................................

$315,000

$180,000 24,500 12,000 4,000 21,000 10,000 251,500 63,500 1,500 $ 62,000

(1) $320,000 cash collected less $5,000 decrease in accounts receivable. Cash .................................................................................. Accounts receivable (decrease in account) ...................... Service revenue (to balance)............................................

320,000 5,000 315,000

(2) $25,000 cash paid for the purchase of supplies less $500 increase in supplies. Supplies expense (to balance) ............................................. Supplies (increase in account).............................................. Cash ...............................................................................

24,500 500 25,000

Exercise 2–18 (concluded) (3) $6,000 cash paid for insurance less $2,000 ending balance in prepaid insurance. Insurance expense (to balance) ........................................... Prepaid insurance (increase in account)............................... Cash ..............................................................................

4,000 2,000 6,000

(4) $20,000 cash paid for miscellaneous expenses plus increase in accrued liabilities. Miscellaneous expense (to balance) ................................... Accrued liabilities (increase in account) ......................... Cash ..............................................................................

21,000 1,000 20,000

(5) $100,000 x 6% x 3/12 = $1,500 Interest expense ................................................................ Interest payable ..............................................................

1,500 1,500

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 2–19 Cash basis income ($545,000 – $412,000)

$133,000

Add: Increase in prepaid insurance ($6,000 – $4,500)

1,500

Deduct: Depreciation expense

(22,000)

Decrease in accounts receivable ($62,000 – $55,000)

(7,000)

Decrease in prepaid rent ($9,200 – $8,200)

(1,000)

Increase in deferred service revenue ($11,000 – $9,200)

(1,800)

Increase in accrued liabilities ($15,600 – $12,200)

(3,400)

Accrual basis net income

$ 99,300

Exercise 2–20 Requirement 1 Wolkstein Drug Company Worksheet December 31, 2024 Account Title Cash Accounts receivable Prepaid rent Inventory Equipment Accumulated depreciation Accounts payable Salaries payable Common stock Retained earnings Sales revenue Cost of goods sold Salaries expense Rent expense Depreciation expense Utilities expense Advertising expense

Unadjusted Trial Balance Dr. Cr. 20,000 35,000 5,000 50,000 100,000 30,000 25,000 0 100,000 29,000 323,000 180,000 71,000 30,000 0 12,000 4,000

Adjusting Entries Dr.

Cr.

(1) 10,000 (2) 4,000

(2) 4,000 (1) 10,000

Adjusted Trial Balance Dr. Cr. 20,000 35,000 5,000 50,000 100,000 40,000 25,000 4,000 100,000 29,000 323,000 180,000 75,000 30,000 10,000 12,000 4,000

Net Income Totals

507,000

14,000

521,000

Income Statement Dr.

Cr.

Balance Sheet Dr. 20,000 35,000 5,000 50,000 100,000

Cr.

40,000 25,000 4,000 100,000 29,000 323,000 180,000 75,000 30,000 10,000 12,000 4,000 311,000 12,000

323,000

210,000

198,000 12,000

323,000

210,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 2–20 (continued) Requirement 2 WOLKSTEIN DRUG COMPANY Income Statement For the Year Ended December 31, 2024 Sales revenue ............................................. Cost of goods sold ...................................... Gross profit ................................................ Operating expenses: Salaries expense ....................................... Rent expense ............................................ Depreciation expense .............................. Utilities expense ...................................... Advertising expense ................................. Total operating expenses ............. Net income .................................................

$323,000 180,000 143,000 $75,000 30,000 10,000 12,000 4,000 131,000 $ 12,000

Exercise 2–20 (concluded) WOLKSTEIN DRUG COMPANY Balance Sheet At December 31, 2024 Assets Current assets: Cash ........................................................... Accounts receivable ................................... Inventory .................................................... Prepaid rent ................................................ Total current assets ................................. Property and equipment: Equipment .................................................. Less: Accumulated depreciation.................. Total assets .........................................

$ 20,000 35,000 50,000 5,000 110,000

$100,000 (40,000)

60,000 $170,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable ....................................... Salaries payable .......................................... Total current liabilities ............................ Shareholders‘ equity: Common stock ............................................ Retained earnings ....................................... Total shareholders‘ equity ....................... Total liabilities and shareholders‘ equity

$ 25,000 4,000 29,000

$100,000 41,000* 141,000 $170,000

*Beginning balance of $29,000 plus net income of $12,000.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 2–21 Requirement 1 June 30 - adjusting entry Salaries expense ($10,000 x 3/5)................................................. Salaries payable .....................................................................

6,000

July 1 - reversing entry Salaries payable.......................................................................... Salaries expense.....................................................................

6,000

July 2 – payment of salaries Salaries expense ......................................................................... Cash ......................................................................................

10,000

6,000

10,000

Requirement 2 June 30 - adjusting entry Salaries expense ......................................................................... Salaries payable .....................................................................

6,000

July 2 - payment of salaries Salaries expense ......................................................................... Salaries payable.......................................................................... Cash ......................................................................................

4,000 6,000

6,000

10,000

Exercise 2– 116 Requirement 1 The accountant would reverse adjusting entry 1, the accrual of interest receivable, and entry 5, the accrual of salaries payable. Requirement 2 1. Interest receivable ($90,000 x 8% x 3/12) .............................. Interest revenue ................................................................ 5. Salaries expense ................................................................... Salaries payable................................................................

1,800 1,800 8,000 8,000

Requirement 3 1. Interest revenue .................................................................... Interest receivable ............................................................ 5. Salaries payable ................................................................... Salaries expense ...............................................................

1,800 1,800 8,000 8,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 2–23

Transaction Purchased inventory on account.

Journal PJ

Collected an account receivable.

Borrowed $20,000 and signed a note.

Recorded depreciation expense.

Purchased equipment for cash.

Sold inventory for cash. (the sale only, not the cost of the inventory)

Sold inventory on credit. (the sale only, not the cost of the inventory)

Recorded accrued salaries payable.

Paid employee salaries.

10.

Sold equipment for cash.

11.

Sold equipment on credit.

12.

Paid a cash dividend to shareholders.

13.

Issued common stock in exchange for cash.

14.

Paid accounts payable.

Exercise 2– 118 Transaction

Journal

Paid interest on a loan.

Recorded depreciation expense.

Purchased office equipment for cash.

Purchased inventory on account.

Sold inventory on credit.

(the sale only, not the cost of the inventory)

Sold inventory for cash.

(the sale only, not the cost of the inventory)

Paid rent.

Recorded accrued interest payable.

Paid advertising bill.

10.

Sold a factory building in exchange for a note receivable.

11.

Collected cash from customers on account.

12.

Paid employee salaries.

13.

Collected interest on the note receivable.

Complete Solution Manual for Intermediate Accounting, 11th Edition

PROBLEMS Problem 2–1 Requirement 1 2024 Jan. 1 Jan. 2 Jan. 4 Jan. 10 Jan. 10 Jan. 15 Jan. 20 Jan. 22 Jan. 22 Jan. 24 Jan. 26 Jan. 28 Jan. 30

Cash .................................................... Common stock ................................

Debit 100,000

Credit 100,000

Inventory ............................................ Accounts payable ............................

35,000

Prepaid insurance ................................ Cash ................................................

2,400

Accounts receivable ............................ Sales revenue ..................................

12,000

Cost of goods sold .............................. Inventory ........................................

7,000

Cash .................................................... Notes payable .................................

30,000

Salaries expense .................................. Cash ................................................

6,000

Cash .................................................... Sales revenue ..................................

10,000

Cost of goods sold .............................. Inventory ........................................

6,000

Accounts payable ................................ Cash ................................................

15,000

Cash .................................................... Accounts receivable ........................

6,000

Utilities expense ................................. Cash ................................................

1,000

Prepaid rent ........................................ Rent expense ....................................... Cash .................................................

2,000 2,000

35,000 2,400 12,000 7,000 30,000 6,000 10,000 6,000 15,000 6,000 1,000

4,000

Problem 2–1 (continued) Requirement 2

BALANCE SHEET ACCOUNTS Cash Accounts receivable

1/1 Bal.

1/1 1/15 1/22 1/26

1/31 Bal.

0 100,000 30,000 10,000 6,000

2,400 6,000 15,000 1,000 4,000

1/4

1/10

0 12,000

1/31 Bal.

6,000

1/24 1/28 1/30

117,600

1/2

1/31 Bal.

0 35,000

Prepaid insurance

1/4

0 2,400

1/31 Bal.

2,400

1/1 Bal.

7,000 6,000

1/10 1/22

22,000 Prepaid rent

1/30

0 2,000

1/31 Bal.

2,000

1/1 Bal.

Accounts payable

1/24

Notes payable 0 30,000

1/26

1/20

Inventory 1/1 Bal.

6,000

15,000

0 35,000

1/1 Bal.

20,000

1/31 Bal.

1/2

Common stock 1/1 Bal. 1/15

30,000 1/31 Bal.

0 100,000

1/1 Bal.

100,000

1/31 Bal.

1/1

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–1 (continued) INCOME STATEMENT ACCOUNTS Sales revenue 0 12,000 10,000

Cost of goods sold 1/1 Bal.

1/1 Bal.

1/10

1/22

0 7,000 6,000

22,000 1/31 Bal. 1/31 Bal. 13,000

Salaries expense

Rent expense 1/1 Bal.

1/20

0 6,000

1/30

0 2,000

1/31 Bal.

6,000

1/31 Bal.

2,000

1/1 Bal.

Utilities expense

1/28

0 1,000

1/31 Bal.

1,000

1/1 Bal.

Problem 2–1 (concluded) Requirement 3 Account Title Cash

Debits

Credits

$117,600

Accounts receivable

6,000

Inventory

22,000

Prepaid insurance

2,400

Prepaid rent

2,000

Accounts payable

$ 20,000

Notes payable

30,000

Common stock

100,000

Sales revenue

22,000

Cost of goods sold

13,000

Salaries expense

6,000

Utilities expense

1,000

Rent expense

2,000

Totals

$172,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–2 Requirement 2 2024 Jan. 1 Jan. 1

Cash ................................................... Sales revenue ..................................

Debit 3,500

3,500

Cost of goods sold .............................. Inventory ........................................

2,000

Equipment .......................................... Accounts payable ............................

5,500

Advertising expense ........................... Accounts payable ............................

150

Accounts receivable ............................ Sales revenue ..................................

5,000

Cost of goods sold .............................. Inventory …………………………..

2,800

Jan. 10 Inventory ............................................ Accounts payable ............................

9,500

Jan. 2 Jan. 4 Jan. 8 Jan. 8

Jan. 13

Credit

2,000 5,500 150 5,000 2,800

9,500

Equipment .......................................... Cash ................................................

800

Jan. 16 Accounts payable ............................... Cash ................................................

5,500

Jan. 18

Cash ................................................... Accounts receivable ........................

4,000

Jan. 20 Rent expense ...................................... Cash .................................................

800

Jan. 30 Salaries expense ................................. Cash ................................................

3,000

Jan. 31 Dividends ........................................... Cash ................................................

1,000

800 5,500 4,000 800 3,000 1,000

Problem 2–2 (continued) Requirements 1 and 3 BALANCE SHEET ACCOUNTS Cash Accounts receivable 1/1 Bal. 1/1 1/18

1/31 Bal.

5,000 3,500 4,000

1/1 Bal.

800 5,500 800 3,000 1,000

1/13

1/8

2,000 5,000

1/31 Bal.

3,000

1/20 1/30 1/31

1,400

1/10

1/31 Bal.

5,000 9,500

9,700

Equipment 1/1 Bal.

2,000 2,800

1/18

1/16

Inventory 1/1 Bal.

4,000

1/1

1/2

1/8

1/13

11,000 5,500 800

1/31 Bal. 17,300

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–2 (continued) Accumulated depreciation 3,500

Accounts payable

1/1 Bal. 1/16

3,500 1/31 Bal. Common stock 10,000

5,500

3,000 5,500 150 9,500

1/1 Bal.

12,650

1/31 Bal.

1/2 1/4 1/10

Retained Earnings 1/1 Bal.

6,500

1/1 Bal.

10,000 1/31 Bal.

6,500

1/31 Bal.

Dividends

1/31

0 1,000

1/31 Bal.

1,000

1/1 Bal.

Problem 2–2 (continued) INCOME STATEMENT ACCOUNTS Sales revenue 0 3,500 5,000

Cost of goods sold 1/1 Bal.

1/1 Bal.

1/1

1/8

8,500 1/31 Bal. 1/31 Bal.

Rent expense

0 2,000 2,800 4,800

Salaries expense 1/1 Bal.

1/20

0 800

1/30

0 3,000

1/31 Bal.

800

1/31 Bal.

3,000

1/1 Bal.

Advertising expense

1/4

0 150

1/31 Bal.

150

1/1 Bal.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–2 (concluded) Requirement 4

Account Title Cash Accounts receivable Inventory Equipment Accumulated depreciation Accounts payable Common stock Retained earnings Dividends Sales revenue Cost of goods sold Salaries expense Rent expense Advertising expense Totals

Debits $ 1,400 3,000 9,700 17,300

Credits

$ 3,500 12,650 10,000 6,500 1,000 8,500 4,800 3,000 800 150 $41,150

$41,150

Problem 2–3 1.

Depreciation expense ............................................................ Accumulated depreciation ................................................

10,000

Salaries expense.................................................................... Salaries payable................................................................

1,500

Interest expense ($50,000 x 12% x 3/12)................................ Interest payable ................................................................

1,500

Interest receivable ($20,000 x 8% x 10/12)............................. Interest revenue ................................................................

1,333

Insurance expense ($6,000 x 9/12) ......................................... Prepaid insurance ............................................................

4,500

Supplies expense ($1,500 – $800) ......................................... Supplies ...........................................................................

700

No adjusting entry needed; not revenue until January 2025

Rent expense......................................................................... Prepaid rent .....................................................................

10,000

1,500

1,333

4,500

700

1,000 1,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–4 Requirements 1 and 2 BALANCE SHEET ACCOUNTS Cash Accounts receivable 40,000

Bal.

30,000

Bal.

12/31 Bal.

30,000

12/31 Bal. 40,000

Prepaid rent __________________________________________________________________________

2,000

Bal.

1,000 12/31 Bal.

1,000 Prepaid insurance

Supplies

__________________________________________________________________________

Bal.

6,000

Bal.

4,500 12/31 Bal.

___________________________________________________________________________

1,500

700 12/31 Bal.

Inventory

800 Notes receivable

___________________________________________________________________________________________

Bal.

60,000

Bal.

20,000

12/31 Bal.

60,000

12/31 Bal. 20,000

Office equipment

Interest receivable

__________________________________________________________________________

___________________________________________________________________________

Bal.

80,000

Bal. 4.

12/31 Bal.

80,000

0 1,333

12/31 Bal. 1,333

Problem 2–4 (continued) Accumulated depreciation 30,000 10,000

Accounts payable Bal.

31,000

Bal.

31,000

12/31 Bal.

40,000 12/31 Bal. Salaries payable

Notes payable

_______________________________________________________

______________________________________________________

Bal.

1,500

1,500 12/31 Bal.

50,000

Bal.

50,000

12/31 Bal.

Interest payable

Deferred sales revenue

______________________________________________________________

Bal.

2,000

Bal.

1,500

1,500 12/31 Bal.

2,000

12/31 Bal.

Common stock

Retained earnings

_______________________________________________________

______________________________________________________

60,000

Bal.

28,500

Bal.

60,000 12/31 Bal.

28,500

12/31 Bal.

Dividends _______________________________________________________

Bal.

4,000

12/31 Bal.

4,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–4 (continued) INCOME STATEMENT ACCOUNTS Sales revenue

Interest revenue

______________________________________________________________

_______________________________________________________________

146,000

Bal.

146,000 12/31 Bal. Cost of goods sold 70,000

70,000

4. 12/31 Bal.

Salaries expense Bal.

18,900 1,500

12/31 Bal. 20,400

Rent expense

Depreciation expense

__________________________________________________________________________

___________________________________________________________________________

Bal.

11,000 1,000

12/31 Bal.

12,000

12/31 Bal. 10,000

Bal.

1,333

___________________________________________________________________________

2. 12/31 Bal.

Bal.

1,333

__________________________________________________________________________

Bal.

0 10,000

Interest expense

Supplies expense

__________________________________________________________________________

___________________________________________________________________________

Bal.

1,100 700

1,500

12/31 Bal.

1,500

12/31 Bal. 1,800

Insurance expense

Advertising expense

__________________________________________________________________________

___________________________________________________________________________

3,000

Bal.

0 4,500

12/31 Bal.

4,500

12/31 Bal. 3,000

Bal.

Problem 2–4 (continued) Requirement 3

Account Title Cash Accounts receivable Supplies Inventory Notes receivable Interest receivable Prepaid rent Prepaid insurance Office equipment Accumulated depreciation Accounts payable Salaries payable Notes payable Interest payable Deferred sales revenue Common stock Retained earnings Dividends Sales revenue Interest revenue Cost of goods sold Salaries expense Rent expense Depreciation expense Interest expense Supplies expense Insurance expense Advertising expense Totals

Debits $ 30,000 40,000 800 60,000 20,000 1,333 1,000 1,500 80,000

Credits

$ 40,000 31,000 1,500 50,000 1,500 2,000 60,000 28,500 4,000 146,000 1,333 70,000 20,400 12,000 10,000 1,500 1,800 4,500 3,000 $361,833

$361,833

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–4 (continued) Requirement 4 PASTINA COMPANY Income Statement For the Year Ended December 31, 2024 Sales revenue ............................................ Cost of goods sold ..................................... Gross profit ............................................... Operating expenses: Salaries expense ..................................... Rent expense .......................................... Depreciation expense ............................. Supplies expense .................................... Insurance expense ................................. Advertising expense ............................... Total operating expenses ................ Operating income Other income (expense): Interest revenue .................................... Interest expense ..................................... Net income ................................................

$146,000 70,000 76,000

$20,400 12,000 10,000 1,800 4,500 3,000 51,700 24,300 1,333 (1,500)

(167) $ 24,133

Problem 2–4 (continued)

PASTINA COMPANY Statement of Shareholders' Equity For the Year Ended December 31, 2024

Balance at January 1, 2024 Issue of common stock

Common Stock $60,000

Retained Earnings $28,500

Total Shareholders’ Equity $ 88,500 -0-

-0-

Net income for 2024

24,133

Less: Dividends

(4,000)

$48,633

$108,633

Balance at December 31, 2024

$60,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–4 (continued) PASTINA COMPANY Balance Sheet At December 31, 2024 Assets Current assets: Cash .......................................................... Accounts receivable .................................. Supplies ..................................................... Inventory ................................................... Notes receivable ........................................ Interest receivable ..................................... Prepaid rent ............................................... Prepaid insurance ...................................... Total current assets ................................ Office equipment ......................................... Less: Accumulated depreciation ……………

$ 30,000 40,000 800 60,000 20,000 1,333 1,000 1,500 154,633 $80,000 40,000

Total assets ..........................................

40,000 $194,633

Liabilities and Shareholders' Equity Current liabilities Accounts payable ....................................... Salaries payable .......................................... Interest payable .......................................... Deferred sales revenue ............................... Total current liabilities ............................ Notes Payable Total liabilities ........................................ Shareholders‘ equity: Common stock ........................................... Retained earnings ....................................... Total shareholders‘ equity .......................

$ 31,000 1,500 1,500 2,000 36,000 50,000 86,000

$60,000 48,633 108,633

Total liabilities and shareholders‘ equity

$194,633

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–4 (continued) Requirement 5 December 31, 2024 Sales revenue ............................................................................. Interest revenue .......................................................................... Retained earnings ..................................................................

146,000 1,333 147,333

Retained earnings ....................................................................... Cost of goods sold ................................................................. Salaries expense..................................................................... Rent expense.......................................................................... Depreciation expense ............................................................. Interest expense ..................................................................... Supplies expense ................................................................... Insurance expense .................................................................. Advertising expense...............................................................

123,200

Retained earnings ....................................................................... Dividends ..............................................................................

4,000

70,000 20,400 12,000 10,000 1,500 1,800 4,500 3,000

4,000

Problem 2–4 (continued) Sales revenue

Interest revenue

_______________________________________________________

______________________________________________________

146,000 Closing

Bal.

146,000

Bal.

1,333

Closing

0 12/31 Bal.

12/31 Bal.

Cost of goods sold

Salaries expense

_______________________________________________________

______________________________________________________

70,000

Bal.

18,900 1,500

Bal. 4.

70,000 12/31 Bal.

20,400

Closing

12/31 Bal.

Rent expense

Bal.

12/31 Bal.

0 10, 000

12,000

Depreciation expense

11,000 1,000

Bal.

Closing

10,000

Closing

12/31 Bal.

Closing

Interest expense

Supplies expense

_______________________________________________________

______________________________________________________

Bal. 3.

0 1,500 1,500

12/31 Bal.

Bal.

1,100

700 1,800

Closing 12/31 Bal.

Closing

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–4 (continued) Insurance expense Bal.

0 4,500

3,000

Bal.

4,500 12/31 Bal.

Advertising expense

3,000

Closing

12/31 Bal.

Retained earnings

Cl. exp Cl. Div

123,200 4,000

Dividends

28,500 Bal. 147,333 Cl. rev

48,633

Closing

12/31 Bal.

Bal.

4,000 4,000

12/31 Bal.

Closing

Problem 2–4 (concluded) Requirement 6 Account Title Cash Accounts receivable Supplies Inventory Notes receivable Interest receivable Prepaid rent Prepaid insurance Office equipment Accumulated depreciation Accounts payable Salaries payable Notes payable Interest payable Deferred sales revenue Common stock Retained earnings Totals

Debits $ 30,000 40,000 800 60,000 20,000 1,333 1,000 1,500 80,000

$234,633

Credits

$ 40,000 31,000 1,500 50,000 1,500 2,000 60,000 48,633 $234,633

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–5 Rent expense .............................................................................. Prepaid rent ...........................................................................

800

Supplies expense ........................................................................ Supplies .................................................................................

700

Interest receivable ..................................................................... Interest revenue .....................................................................

1,500

Depreciation expense ................................................................. Accumulated depreciation......................................................

6,500

Salaries expense ......................................................................... Salaries payable .....................................................................

6,200

Interest expense ......................................................................... Interest payable......................................................................

2,500

Deferred rent revenue ................................................................ Rent revenue..........................................................................

2,000

800

700

1,500

6,500

6,200

2,500

2,000

Problem 2–6 Requirement 2 a.

Cash ..................................................................................... Accounts receivable ............................................................. Service revenue ................................................................

70,000 30,000

Cash ..................................................................................... Accounts receivable .........................................................

27,300

Cash ..................................................................................... Common stock .................................................................

10,000

d. Salaries expense ................................................................... Salaries payable ................................................................... Cash .................................................................................

41,000 9,000

Miscellaneous expense.......................................................... Cash .................................................................................

24,000

f. Equipment ............................................................................ Cash .................................................................................

15,000

2,500

Dividends ............................................................................ Cash .................................................................................

100,000

27,300

10,000

50,000

24,000

15,000

2,500

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–6 (continued) Requirements 1 and 3 BALANCE SHEET ACCOUNTS Cash Accounts receivable 30,000 70,000

1/1 Bal.

27,300 10,000

b. c.

12/31 Bal.

1/1 Bal. 15,000

50,000 24,000

15,000 2,500

30,000

27,300

e. g.

45,800

12/31 Bal. 17,700

Equipment 1/1 Bal.

20,000 15,000

12/31 Bal. 35,000 Accumulated depreciation 6,000

Salaries payable

1/1 Bal.

d. 6,000

12/31 Bal.

Common stock

9,000

1/1 Bal.

12/31 Bal.

9,000

Retained earnings

40,500 10,000

1/1 Bal.

50,500

12/31 Bal.

9,500

1/1 Bal.

9,500

12/31 Bal.

Problem 2–6 (continued) Dividends

0 2,500

12/31 Bal.

2,500

1/1 Bal.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–6 (continued) INCOME STATEMENT ACCOUNTS Service revenue

Miscellaneous expense

__________________________________________________________________________

0 100, 000

1/1 Bal.

___________________________________________________________________________

1/1 Bal.

24,000

100,000 12/31 Bal. 12/31 Bal. 24,000 Salaries expense __________________________________________________________________________

1/1 Bal.

41,000

12/31 Bal.

41,000

Requirement 4

Account Title Cash Accounts receivable Equipment Accumulated depreciation Salaries payable Common stock Retained earnings Dividends Service revenue Salaries expense Miscellaneous expense Totals

Debits $ 45,800 17,700 35,000

Credits

6,000 -050,500 9,500

2,500 100,000 41,000 24,000 $166,000

$166,000

Problem 2–6 (continued) Requirement 5

Salaries expense ......................................................................... Salaries payable .....................................................................

1,000

Depreciation expense.................................................................. Accumulated depreciation ......................................................

2,000

1,000

2,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–6 (continued) BALANCE SHEET ACCOUNTS Cash Accounts receivable ______________________________________________________________

30,000 70,000

1/1 Bal.

27,300 10,000

b. c.

12/31 Bal.

_______________________________________________________________

1/1 Bal. 15,000

50,000 24,000

15,000 2,500

30,000

27,300

e. g.

45,800

12/31 Bal. 17,700

Equipment

20,000 15,000

12/31 Bal.

35,000

1/1 Bal.

Accumulated depreciation 6,000 2,000

Adjusting

8,000

12/31 Bal.

Salaries payable

1/1 Bal.

Common stock

9,000

9,000 1,000

Adjusting

1,000

12/31 Bal.

1/1 Bal.

Retained earnings

40,500 10,000

1/1 Bal.

50,500

12/31 Bal.

9,500

1/1 Bal.

9,500

12/31 Bal.

Problem 2–6 (continued) Dividends

0 2,500

12/31 Bal.

2,500

1/1 Bal.

INCOME STATEMENT ACCOUNTS Service revenue

Miscellaneous expense

______________________________________________________________

1/1 Bal.

100, 000

1/1 Bal.

0 24,000

100,000 12/31 Bal. 12/31 Bal. 24,000

Depreciation expense _______________________________________________________

1/1 Bal.

Adjusting

2,000

12/31 Bal.

2,000

Salaries expense _______________________________________________________

1/1 Bal.

Adjusting

41,000 1,000

12/31 Bal.

42,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–6 (continued) Requirement 6

Account Title Cash Accounts receivable Equipment Accumulated depreciation Salaries payable Common stock Retained earnings Dividends Service revenue Salaries expense Miscellaneous expense Depreciation expense Totals

Debits $ 45,800 17,700 35,000

Credits

8,000 1,000 50,500 9,500

2,500 100,000 42,000 24,000 2,000 $169,000

$169,000

Requirement 7

KARLIN COMPANY Income Statement For the Year Ended December 31, 2024 Service revenue .......................................... Operating expenses: Salaries expense..................................... Miscellaneous expense .......................... Depreciation expense ............................ Total operating expenses ..........

$100,000

$42,000 24,000 2,000 68,000

Net income .................................................

$ 32,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–6 (continued) KARLIN COMPANY Balance Sheet At December 31, 2024 Assets Current assets: Cash .......................................................... Accounts receivable .................................. Total current assets ................................ Property and equipment: Equipment ................................................. Less: Accumulated depreciation................. Total assets ...........................................

$45,800 17,700 63,500

$35,000 (8,000)

27,000 $90,500

Liabilities and Shareholders' Equity Current liabilities: Salaries payable ......................................... Total current liabilities .......................... Shareholders‘ equity: Common stock .......................................... Retained earnings ...................................... Total shareholders‘ equity ..................... Total liabilities and shareholders‘ equity

$ 1,000 1,000

$50,500 39,000* 89,500 $90,500

*Beginning balance of $9,500 plus net income of $32,000 less dividends of $2,500.

Problem 2–6 (continued) Requirement 8 December 31, 2024 Service revenue .......................................................................... Retained earnings...................................................................

100,000 100,000

Retained earnings ....................................................................... Salaries expense ..................................................................... Miscellaneous expense ........................................................... Depreciation expense .............................................................

68,000

Retained earnings ....................................................................... Dividends...............................................................................

2,500

42,000 24,000 2,000

2,500

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–6 (continued) BALANCE SHEET ACCOUNTS Cash Accounts receivable _______________________________________________________

30,000 70,000

1/1 Bal.

27,300 10,000

b. c.

______________________________________________________

1/1 Bal. 15,000

50,000 24,000

15,000 2,500

30,000

27,300

e. g.

12/31 Bal. 45,800

12/31 Bal. 17,700

Equipment __________________________________________________________________________

20,000 15,000

12/31 Bal.

35,000

1/1 Bal.

Accumulated depreciation

Salaries payable

______________________________________________________________

_______________________________________________________________

6,000 2,000

Adjusting

8,000

12/31 Bal.

1/1 Bal.

Common stock

1,000

12/31 Bal.

___________________________________________________________________________

1/1 Bal.

c. Cl. exp Cl. div

50,500

Adjusting

1/1 Bal.

Retained earnings

__________________________________________________________________________

40,500 10,000

9,000

9,000 1,000

12/31 Bal.

9,500 100,000

1/1 Bal.

39,000

12/31 Bal.

Cl. rev

68,000 2,500

Problem 2–6 (continued) Dividends 1/1 Bal.

0 2,500 2,500

12/31 Bal.

Closing

0 INCOME STATEMENT ACCOUNTS Service revenue

Miscellaneous expenses

______________________________________________________________

1/1 Bal.

100,000 Closing

1/1 Bal.

24, 000 24,000

100,000 0 12/31 Bal.

12/31 Bal.

Closing

Depreciation expense ______________________________________________________________

1/1 Bal. Adjusting

0 2,000 2,000

12/31 Bal.

Closing

0 Salaries expense

_______________________________________________________

1/1 Bal.

41,000

Adjusting

1,000

42,000

Closing

Complete Solution Manual for Intermediate Accounting, 11th Edition 12/31 Bal.

Problem 2–6 (concluded) Requirement 9 Account Title Cash Accounts receivable Equipment Accumulated depreciation Salaries payable Common stock Retained earnings Totals

Debits $45,800 17,700 35,000

$98,500

Credits

$ 8,000 1,000 50,500 39,000 $98,500

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–7 Requirement 1 a.

Interest receivable ................................................................ Interest revenue ($10,000 x 12% x 1/2)............................. b. Depreciation expense ($30,000 x 1/5).................................... Accumulated depreciation ................................................ c. Deferred rent revenue ........................................................... Rent revenue ($6,000 x 2/6).............................................. d. Insurance expense ................................................................ Prepaid insurance ($2,400 x 9/24) ..................................... e. Interest expense ($20,000 x 12% x 3/12) ............................... Interest payable ................................................................ f. Supplies expense ($1,800 – $700)......................................... Supplies ...........................................................................

600 600 6,000 6,000 2,000 2,000 900 900 600 600 1,100 1,100

Requirement 2 Income overstated (understated) Adjustments to revenues: Understatement of interest revenue Understatement of rent revenue

$ (600) (2,000)

Adjustments to expenses: Understatement of insurance expense Understatement of depreciation expense Understatement of interest expense Understatement of supplies expense Overstatement of net income

900 6,000 600 1,100 $6,000

Problem 2–8 1. Depreciation expense ($75,000 ÷ 10 years) ........................... Accumulated depreciation ................................................

7,500

2. Salaries expense ($4,500 – $3,000) ....................................... Salaries payable................................................................

1,500

3. Interest expense ($30,000 x 10% x 4/12)................................ Interest payable ................................................................

1,000

Supplies expense................................................................... Supplies ...........................................................................

1,500

Rent Expense ........................................................................ Prepaid rent ......................................................................

13,000

7,500

1,500

1,000

1,500

13,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–9 Requirements 1 and 2 a. Depreciation expense ($50,000 ÷ 50 years)........................... Accumulated depreciation—buildings..............................

1,000

b. Depreciation expense ($100,000 x 10%)............................... Accumulated depreciation—office equipment ..................

10,000

Insurance expense................................................................. Prepaid insurance ............................................................

1,000

d. Salaries expense ................................................................... Salaries payable ...............................................................

1,500

6,300

Deferred rent revenue ........................................................... Rent revenue ....................................................................

1,000

10,000

1,000

1,500

6,300

Problem 2–9 (continued) BALANCE SHEET ACCOUNTS Cash Accounts receivable __________________________________________________________________________

__________________________________________________________________________

9,000

Bal.

8,000

Bal.

12/31 Bal.

8,000

12/31 Bal. 9,000

Prepaid insurance __________________________________________________________________________

3,000

Bal.

1,000 Adjusting 12/31 Bal.

2,000 Land

Buildings

___________________________________________________________________________________________

Bal.

___________________________________________________________________________________________

200,000

Bal.

12/31 Bal. 200,000

12/31 Bal. 50,000

Office equipment

Accumulated depreciation—buildings

___________________________________________________________________________________________

Bal.

50,000

___________________________________________________________________________________________

100,000

12/31 Bal. 100,000

20,000

Bal.

1,000

Adjusting

21,000 12/31 Bal.

Accumulated depreciation—office equip. ___________________________________________________________________________________________

40,000

Accounts payable ___________________________________________________________________________________________

Bal.

35,050

Bal.

35,050

12/31 Bal.

10,000 Adjusting 50,000 12/31 Bal.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–9 (continued) Salaries payable

Deferred rent revenue

___________________________________________________________________________________________

0 Bal. 1,500 Adjusting Adjusting 6,300

7,500

Bal.

1,500 12/31 Bal.

1,200

12/31 Bal.

Common stock 200,000

Retained earnings Bal.

56,450

Bal.

200,000 12/31 Bal.

56,450

12/31 Bal.

INCOME STATEMENT ACCOUNTS Service revenue

Interest revenue

___________________________________________________________________________________________

90,000

Bal.

90,000 12/31 Bal. Rent revenue __________________________________________________________________________

3,000

Bal.

3,000

12/31 Bal.

Salaries expense ___________________________________________________________________________

0 Bal. 6,300 Adjusting

Bal.

37,000 Adjusting 1,500

6,300 12/31 Bal.

12/31 Bal. 38,500

Depreciation expense _____________________________________________________________________________________________________________________

Adjusting

0 1,000 10,000

12/31 Bal.

11,000

Bal. Adjusting

Problem 2–9 (continued) Insurance expense __________________________________________________________________________

Bal. Adjusting

1,000

12/31 Bal.

1,000

Utilities expense __________________________________________________________________________

Bal.

30,000

12/31 Bal. 30,000

Maintenance expense ______________________________________________________________

Bal.

15,000

12/31 Bal.

15,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–9 (continued) Requirement 3

Account Title Cash Accounts receivable Prepaid insurance Land Buildings Accumulated depreciation—buildings Office equipment Accumulated depreciation—office equipment Accounts payable Salaries payable Deferred rent revenue Common stock Retained earnings Service revenue Interest revenue Rent revenue Salaries expense Depreciation expense Insurance expense Utilities expense Maintenance expense Totals

Debits $ 8,000 9,000 2,000 200,000 50,000

Credits

$ 21,000 100,000 50,000 35,050 1,500 1,200 200,000 56,450 90,000 3,000 6,300 38,500 11,000 1,000 30,000 15,000 $464,500

$464,500

Problem 2–9 (continued) Requirement 4 December 31, 2024 Service revenue .......................................................................... Interest revenue ......................................................................... Rent revenue .............................................................................. Retained earnings................................................................... Retained earnings ....................................................................... Salaries expense ..................................................................... Depreciation expense ............................................................. Insurance expense ................................................................. Utilities expense .................................................................... Maintenance expense ............................................................

90,000 3,000 6,300 99,300 95,500 38,500 11,000 1,000 30,000 15,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–9 (concluded) Requirement 5 Account Title Cash Accounts receivable Prepaid insurance Land Buildings Accumulated depreciation—buildings Office equipment Accumulated depreciation—office equipment Accounts payable Salaries payable Deferred rent revenue Common stock Retained earnings Totals

Debits $ 8,000 9,000 2,000 200,000 50,000

Credits

$ 21,000 100,000

$369,000

50,000 35,050 1,500 1,200 200,000 60,250 $369,000

Problem 2–10 Computations: Sales revenue Sales revenue during 2024 = $320,000 + $22,000 = $342,000 Cost of goods sold

Cash paid

Accounts payable 0 1/1 Balance 220,000 ? Purchases 30,000 12/31 Balance

Purchases during 2024 = $220,000 + $30,000 = $250,000

1/1 Balance Purchases

Inventory 0 250,000

Cost of goods sold

12/31 Balance 50,000 Cost of goods sold during 2024 = $250,000 – $50,000 = $200,000 Rent expense and prepaid rent Prepaid rent = $ 3,000 x 2/3 = $2,000 Rent expense during 2024 = $14,000 – $2,000 = $12,000 Depreciation expense Depreciation during 2024

= $30,000 x 10% = $3,000

Interest expense Interest accrued during 2024 = $40,000 x 12% x 9/12 = $3,600 Salaries expense Cash paid plus accrued salaries = $80,000 + $5,000 = $85,000 2–166 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–10 (continued) McGUIRE CORPORATION Income Statement For the Year Ended December 31, 2024 Sales revenue ................................................. Cost of goods sold .......................................... Gross profit .................................................... Operating expenses: Salaries expense ........................................... Rent expense ................................................ Depreciation expense ................................... Miscellaneous expense ................................. Total operating expenses ............... Operating income ........................................... Other expense: Interest expense .......................................... Net income .....................................................

$342,000 200,000 142,000

$85,000 12,000 3,000 10,000 110,000 32,000 3,600 $ 28,400

Problem 2–10 (concluded) McGUIRE CORPORATION Balance Sheet At December 31, 2024 Assets Current assets: Cash .......................................................... Accounts receivable .................................. Prepaid rent ............................................... Inventory ................................................... Total current assets ................................. Office equipment ......................................... Less: Accumulated depreciation ................. Total assets ...........................................

$ 56,000 (1) 22,000 2,000 50,000 130,000 $30,000 (3,000)

27,000 $157,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable ...................................... Salaries payable ......................................... Notes payable ............................................ Interest payable ......................................... Total current liabilities ............................ Shareholders‘ equity: Common stock .......................................... Retained earnings ...................................... Total shareholders‘ equity ....................... Total liabilities and shareholders‘ equity

$ 30,000 5,000 40,000 3,600 78,600

$50,000 28,400 78,400 $157,000

(1) $410,000 – $354,000 = $56,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–11 Requirement 1 a. Sales revenue Accounts receivable 11/30 Balance 10,000 80,000 Cash collections Sales revenue ? 12/31 Balance

3,000

Sales revenue during December = $3,000 + $80,000 – $10,000 = $73,000 b.

Cost of goods sold Accounts payable 12,000 11/30 Balance Cash paid 60,000 ? Purchases 15,000 12/31 Balance

Purchases during December = $15,000 + $60,000 – $12,000 = $63,000 11/30 Balance Purchases

Inventory 7,000 63,000 ? Cost of goods sold

12/31 Balance

6,000

Cost of goods sold during December = $7,000 + $63,000 – $6,000 = $64,000

Problem 2–11 (concluded) c.

Insurance expense

Prepaid insurance 11/30 Balance 5,000 Cash payment 5,000 ? Insurance expense 12/31 Balance

7,500

Insurance expense during December = $5,000 + $5,000 – $7,500 = $2,500 d.

Salaries expense

Salaries payable 5,000 11/30 Balance Cash payments 10,000 ? Salaries expense 3,000 12/31 Balance Salaries expense during December = $3,000 + $10,000 – $5,000 = $8,000 Requirement 2 Accounts receivable.................................................................... Sales revenue .........................................................................

73,000

Cost of goods sold ...................................................................... Inventory................................................................................

64,000

73,000

64,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–12 Requirement 1 Computations: Sales revenue: Cash collected from customers Add: Increase in accounts receivable Sales revenue Interest revenue: Cash received Add: Amount accrued at the end of 2024 ($50,000 x .08 x 9/12) Deduct: Amount accrued at the end of 2023 Interest revenue Cost of goods sold: Cash paid for inventory Add: Increase in accounts payable Purchases during 2024 Add: Decrease in inventory Cost of goods sold Insurance expense: Cash paid Add: Prepaid insurance expired during 2024 Deduct: Prepaid insurance on 12/31/2024 ($6,000 x 4/12) Insurance expense Salaries expense: Cash paid Add: Increase in salaries payable Salaries expense

$675,000 30,000 $705,000

$4,000 3,000 (c) (3,000) $4,000

$390,000 12,000 402,000 18,000 $420,000

$6,000 2,500 (2,000) (a) $6,500

$210,000 4,000 $214,000

Problem 2–12 (continued) Interest expense: Amount accrued at the end of 2024 ($100,000 x .06 x 2/12)

$1,000 (d)

Rent expense: Amount paid Add: Prepaid rent on 12/31/2023 expired during 2024 Deduct: Prepaid rent on 12/31/2024 ($24,000 x 6/12) Rent expense Depreciation expense: Increase in accumulated depreciation

$24,000 11,000 (12,000) (b) $23,000 $10,000

Zambrano Wholesale Corporation Income statement For the Year Ended December 31, 2024 Sales revenue Cost of goods sold Gross profit Operating expenses: Insurance expense Salaries expense Rent expense Depreciation expense Total operating expenses Operating income Other income (expense): Interest revenue Interest expense Net income

$705,000 420,000 285,000 $ 6,500 214,000 23,000 10,000 253,500 31,500 4,000 (1,000)

3,000 $34,500

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 2–12 (concluded) Requirement 2 a. Prepaid insurance

$ 2,000

b. Prepaid rent

12,000

c. Interest receivable

3,000

d. Interest payable

1,000

Problem 2–13 Excalibur Corporation Worksheet December 31, 2024 Account Title Cash Accounts receivable Supplies Prepaid rent Inventory Office equipment Accumulated depreciation Accounts payable Salaries payable Notes payable (long-term) Interest payable Common stock Retained earnings Dividends Sales revenue Cost of goods sold Interest expense Salaries expense Rent expense Supplies expense Utilities expense Depreciation expense

Unadjusted Trial Balance Dr. Cr. 23,300 32,500 2,000 14,000 65,000 75,000 10,000 26,100 3,000 30,000 0 80,000 22,050 6,000 180,000 95,000 0 32,350 0 0 6,000 0

Adjusting Entries Dr. Cr.

(4) 1,500 (5) 13,000

(1) 7,500 (2) 1,500 (3) 1,000

(3) 1,000 (2) 1,500 (5) 13,000 (4) 1,500 (1) 7,500

Adjusted Trial Balance Dr. Cr. 23,300 32,500 500 1,000 65,000 75,000 17,500 26,100 4,500 30,000 1,000 80,000 22,050 6,000 180,000 95,000 1,000 33,850 13,000 1,500 6,000 7,500

Net Income Totals

351,150

24,500

361,150

Income Statement Dr. Cr.

Balance Sheet Dr. Cr. 23,300 32,500 500 1,000 65,000 75,000 17,500 26,100 4,500 30,000 1,000 80,000 22,050 6,000

180,000 95,000 1,000 33,850 13,000 1,500 6,000 7,500 157,850 22,150 180,000

180,000

203,300

181,150 22,150

180,000

203,300

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–13 (continued) EXCALIBUR CORPORATION Income Statement For the Year Ended December 31, 2024 Sales revenue ............................................. Cost of goods sold ...................................... Gross profit ............................................ Operating expenses: Salaries expense ....................................... Rent expense ............................................ Supplies expense ..................................... Utilities expense ...................................... Depreciation expense ............................... Total operating expenses ........... Operating income ....................................... Other expense: Interest expense ....................................... Net income .................................................

$180,000 95,000 85,000

$33,850 13,000 1,500 6,000 7,500 61,850 23,150 1,000 $ 22,150

Problem 2–13 (continued) EXCALIBUR CORPORATION Statement of Shareholders' Equity For the Year Ended December 31, 2024

Balance at January 1, 2024

Issue of common stock

Common Stock $80,000

Retained Earnings $22,050

-0-

Total Shareholders’ Equity $102,050

-0-

Net income for 2024

22,150

Less: Dividends

(6,000)

$38,200

$118,200

Balance at December 31, 2024

$80,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 2–13 (continued) EXCALIBUR CORPORATION Balance Sheet At December 31, 2024 Assets Current assets: Cash ............................................................ Accounts receivable .................................... Supplies ....................................................... Prepaid rent .................................................. Inventory ..................................................... Total current assets ................................... Office equipment ........................................... Less: Accumulated depreciation .................. Total assets .............................................

$ 23,300 32,500 500 1,000 65,000 122,300 $75,000 (17,500)

57,500 $179,800

Liabilities and Shareholders' Equity Liabilities: Accounts payable ........................................ Salaries payable ........................................... Notes payable (long-term) ............................ Interest payable ........................................... Total liabilities .......................................... Shareholders‘ equity: Common stock ............................................ Retained earnings ........................................ Total shareholders‘ equity ......................... Total liabilities and shareholders‘ equity

$ 26,100 4,500 30,000 1,000 61,600

$80,000 38,200 118,200 $179,800

Problem 2–13 (concluded) December 31, 2024 Sales revenue.............................................................................. Retained earnings...................................................................

180,000 180,000

Retained earnings ....................................................................... Cost of goods sold.................................................................. Interest expense...................................................................... Salaries expense ..................................................................... Rent expense .......................................................................... Supplies expense ................................................................... Utilities expense..................................................................... Depreciation expense .............................................................

157,850

Retained earnings ....................................................................... Dividends...............................................................................

6,000

95,000 1,000 33,850 13,000 1,500 6,000 7,500

6,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

DECISION MAKERS’ PERSPECTIVE CASES

Analysis Case 2–1 Requirement 1 1. Prepayments occur when cash flow precedes either expense or revenue recognition Accruals occur when cash flow comes after either expense or revenue recognition

Requirement 2 1. The appropriate adjusting entry for a prepaid expense is a debit to expense and a credit to the prepaid asset. 2. The appropriate adjusting entry for a deferred revenue is a debit to the deferred revenue liability and a credit to revenue. 3. Failure to record an adjusting entry for a prepaid expense will cause assets to be overstated and shareholders‘ equity to be overstated. 4. Failure to record an adjusting entry for deferred revenue will cause liabilities to be overstated and shareholders‘ equity to be understated.

Requirement 3 1. The appropriate adjusting entry for accrued liabilities is a debit to expense and a credit to a liability. 2. The appropriate adjusting entry for accrued receivables is a debit to a receivable and a credit to revenue. 3. Failure to record an adjusting entry for an accrued liability will cause liabilities to be understated and shareholders‘ equity to be overstated. 4. Failure to record an adjusting entry for accrued receivables will cause assets to be understated and shareholders‘ equity to be understated.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Judgment Case 2–2 Requirement 1 Cash basis net income Add:

$26,000

1. Unexpired (prepaid insurance) ($12,000 x 8/12)

8,000

2. Increase in accounts receivable ($6,500 – $5,000)

1,500

5. Increase in inventories ($35,000 – $32,000)

3,000

Deduct: 3. Increase in salaries payable ($8,200 – $7,200) 4. Increase in utilities payable ($1,200 – $900) 6. Increase in amount owed to suppliers Accrual basis net income

(1,000) (300) (4,000) $33,200

Requirement 2 Assets would be higher by $12,500 (=$8,000 + $1,500 + $3,000) and liabilities would also be higher by $5,300 (=$1,000 + $300 + $4,000). The difference, $7,200, is the difference between cash and accrual income. Therefore, equity would be higher by $7,200.

Communication Case 2–3

Memorandum To: From: Date: RE:

Mr. Sean Pitt Your Name Current Date Usefulness of accrual based financial statements

Ms. Davis requested that I follow up with you regarding your application for a bank loan. In particular, she asked that I provide an explanation of why the bank requests accrual based financial statements for loan requests such as yours. Cash basis accounting produces a measure of performance called net operating cash flow. This measure is the difference between cash receipts and cash disbursements during a reporting period from transactions related to providing goods and services to customers. On the other hand, the accrual accounting model measures an entity‘s accomplishments (revenues) and resource sacrifices (expenses) during the period, regardless of when cash is received or paid. In most cases, the accrual accounting model provides a better measure of performance because it attempts to measure the accomplishments and sacrifices that occurred during the year, which may not correspond to cash inflows and outflows. Adjusting entries, for the most part, are conversions from cash to accrual. Prepayments and accruals occur when cash flow precedes or follows expense or revenue recognition. Please let me know if I can provide any additional information.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Target Case Requirement 1 ($ in millions) Assets = Liabilities + Shareholders‘ Equity $42,779 = $30,946a + $11,833 a

Total liabilities are computed as current liabilities ($14,487) + noncurrent liabilities ($16,459).

Requirement 2 (a)($ in millions) Cash ........................................................................................... Sales Revenue........................................................................ (b)($ in millions) Cost of goods sold ...................................................................... Inventory ............................................................................... (c)($ in millions) Inventory.................................................................................... Accounts payable...................................................................

77,130 77,130

54,864 54,864 54,359a 54,359

Beginning inventory + Purchases – Cost of goods sold = Ending inventory $9,497 + Purchases – $54,864 = $8,992 Purchases = $54,359 a

Requirement 3 Note 9, ―Other Current Assets,‖ reports Prepaid expenses of $154 million and $157 million for the years ended February 1, 2020, and February 2, 2019, respectively. Assuming this pertains to prepaid insurance, insurance expense must have exceeded the amount paid for insurance coverage, because the balance decreased during the year. We can visualize the change with a T account: Prepaid Insurance

Beginning balance 157 50 Insurance expense Cash paid for insurance

Ending balance 154 Cash paid for insurance must have been $47 million. Prior to the adjusting entry, the balance in prepaid insurance would have been $157 + $47 = $204. The adjusting entry to record expired insurance coverage and reduce the unexpired coverage to $154 would be: ($ in millions)

Insurance expense....................................................................... Prepaid insurance ...................................................................

50 50

The appropriate adjusting entry for a prepaid expense is a debit to expense and a credit to the prepaid asset. Failure to record an adjusting entry for a prepaid expense will cause expenses to be understated and thus net income to be overstated. In the balance sheet, assets and shareholders‘ equity (retained earnings) would be overstated.

Requirement 4 ($ in millions) (a) $416 = $6,433 – $6,017 (b) Change in retained earnings = Net income – $2,865 Net income = $416 + $2,865 = $3,281 (as shown in the income statement also)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Air France–KLM Case Requirement 1 (€ in millions) Assets = Liabilities + Shareholders‘ Equity $30,735 = $28,436 + $2,299

Requirement 2 (a)(€ in millions) Cash ........................................................................................... Deferred revenue ...................................................................

27,188

(b) Deferred revenue ........................................................................ Sales revenue .........................................................................

27,188

Requirement 3 (a)(€ in millions) Prepaid aircraft fuel .................................................................... Cash ......................................................................................

5,511

(b) Aircraft fuel expense .................................................................. Prepaid aircraft fuel ...............................................................

5,511

Requirement 4 (€ in millions)

Equipment.................................................................................. Cash ......................................................................................

3,372 3,372

CHAPTER 3 THE BALANCE SHEET AND FINANCIAL DISCLOSURES QUESTIONS FOR REVIEW OF KEY TOPICS

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 3–1 The purpose of the balance sheet, also known as the statement of financial position, is to present the financial position of the company on a particular date. Unlike the income statement, which is a change statement that reports events occurring during a period of time, the balance sheet is a statement that presents an organized list of assets, liabilities, and shareholders‘ equity at a point in time. It is a freeze-frame or snapshot picture of financial position at the end of a particular day marking the end of an accounting period.

Question 3– 188 The balance sheet does not portray the market value of the entity (number of common stock shares outstanding multiplied by price per share) for a number of reasons. Most assets are not reported at fair value, but instead are measured according to historical cost. Also, there are certain resources, such as trained employees, an experienced management team, and a good reputation, that are not recorded as assets at all. Therefore, the assets of a company minus its liabilities, as shown in the balance sheet, will not be representative of the company‘s market value.

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Question 3–3 Current assets include cash and other assets that are reasonably expected to be converted to cash or consumed within one year from the balance sheet date, or within the normal operating cycle of the business if the operating cycle is longer than one year. The typical asset categories classified as current assets include: — Cash and cash equivalents — Short-term investments — Accounts receivable — Inventory — Prepaid expenses

Question 3– 190 Current liabilities are those obligations that are expected to be satisfied through the use of current assets or the creation of other current liabilities. So, this classification will include all liabilities that are scheduled to be liquidated within one year of the balance sheet date (or operating cycle, if longer), except those that management intends to refinance on a long-term basis. The typical liability categories classified as current liabilities include: — Accounts payable — Deferred revenue — Short-term notes payable — Accrued liabilities — Current maturities of long-term debt or long-term leases

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Question 3– 192 The operating cycle for a typical manufacturing company refers to the period of time required to convert cash to raw materials, raw materials to a finished product, finished product to receivables, and then finally receivables back to cash.

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Question 3–6 Investments in equity securities are classified as current if the company‘s management (1) intends to liquidate the investment within one year from the balance sheet date (or operating cycle, if longer), and (2) has the ability to do so, that is, the investment is marketable. If either of these criteria does not hold, the investment is classified as long-term.

Question 3– 194 The common characteristics that these assets have in common are that they are tangible, longlived assets used in the operations of the business. They usually are the primary revenue-generating assets of the business. These assets include land, buildings, equipment, machinery, furniture, and other assets used in the operations of the business, as well as natural resources, such as mineral mines, timber tracts, and oil wells.

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Question 3–8 Property, plant, and equipment and intangible assets each represent assets that are long-lived and are used in the operations of the business. The difference is that property, plant, and equipment represent physical assets, while intangible assets lack physical substance. Generally, intangible assets represent the ownership of an exclusive right, such as a patent, copyright, or franchise.

Question 3– 196 A note payable of $100,000 due in five years would be classified as a long-term liability. A $100,000 note due in five annual installments of $20,000 each would be classified as a $20,000 current liability—current maturities of long-term debt—and an $80,000 long-term liability.

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Question 3–10 Paid-in capital consists of amounts invested by shareholders in the corporation. Retained earnings equals net income less dividends distributed to shareholders from the inception of the corporation.

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Question 3–11 Disclosure notes provide additional detail concerning specific financial statement items. Included are such data as the fair values of financial instruments and off-balance-sheet risk associated with financial instruments and details of pension plans, leases, debt, and assets. Common to all companies‘ disclosures are certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions. However, many notes are designed to fit the disclosure needs of the particular reporting company. In fact, any explanation that helps investors and creditors make decisions should be included.

Question 3–14 The disclosure of the company‘s significant accounting policies is extremely important to external users in terms of their ability to compare financial information across companies. It is critical to a financial analyst involved in assessing future cash flows of two retail companies to know that one company uses FIFO and the other uses LIFO in recognizing inventory and cost of goods sold.

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Question 3–13 A subsequent event is an event that occurs after the date of the financial statements but prior to the date on which the statements are actually issued or ―available to be issued.‖ It may help to clarify a previously existing situation or it may represent a new event not directly affecting financial position at the end of the reporting period.

Question 3–14 The discussion provides management‘s views on significant events, trends, and uncertainties pertaining to the company‘s (a) operations, (b) liquidity, and (c) capital resources. Certainly, the Management Discussion and Analysis section may be slanted toward management‘s biased perspective and therefore can lack objectivity. However, management can offer an informed insight that might not be available elsewhere, so if the reader maintains awareness of the information‘s source, it can offer a unique view of the situation.

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Question 3–15 A proxy statement must be reported each year to all shareholders. It is usually reported at the same time as the annual report. The statement invites shareholders to the shareholders‘ meeting to elect board members and to vote on issues before the shareholders. It also permits shareholders to vote using an enclosed proxy card. The proxy statement also provides for more disclosures on compensation to directors and executives, and in particular, stock options granted to executives.

Question 3–16 The three primary types of sustainability disclosures include environmental, social, and governance. Shareholders use these disclosures to undersand the company‘s ability to sustain its current operations, which helps in understanding financial performance, resource efficiency, and operating risks. Stakeholders (creditors, employees, suppliers, governments, and the community from which the business draws its resources) use these disclosures to better understand their unique relationship with the company and the impact of the company on society in general.

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Question 3–17 1.

Depending on the circumstances, the auditor of a public company will issue a (an): Unqualified opinion—The auditors are satisfied that the financial statements ―present fairly‖ the financial position, results of operations, and cash flows and are ―prepared in conformity with generally accepted accounting principles.‖ Qualified opinion—This contains an exception to the standard unqualified opinion, but not of sufficient seriousness to invalidate the financial statements as a whole. Examples of exceptions are (a) unconformity with generally accepted accounting principles, (b) inadequate disclosures, and (c) a limitation or restriction of the scope of the examination. Adverse opinion—This is necessary when the exceptions (a) and (b) above are so serious that a qualified opinion is not justified. Adverse opinions are rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report. Disclaimer—An auditor will disclaim an opinion if item (c) above applies and, therefore, insufficient information has been gathered to express an opinion.

Question 3–16 Working capital is the difference between current assets and current liabilities. The current ratio is computed by dividing current assets by current liabilities. The acid-test ratio (or quick ratio) is computed by dividing quick assets (cash and cash equivalents, short-term investments, and accounts receivable) by current liabilities.

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Question 3–19 Debt to equity ratio

Total liabilities Shareholders' equity

Times interest earned ratio

Net income + Interest + Taxes Interest

Question 3–20 IAS No.1, revised, ―Presentation of Financial Statements,‖ provides authoritative guidance for balance sheet presentation under IFRS.

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Question 3–21 Differences in balance sheet presentation between U.S. GAAP and IFRS include: 1. International standards specify a minimum list of items to be presented in the balance sheet. U.S. GAAP has no minimum requirements. 2. IAS No. 1, revised, changed the title of the balance sheet to statement of financial position, although companies are not required to use that title. Some U.S. companies use the statement of financial position title as well. 3. Under U.S. GAAP, we present current assets and liabilities before long-term assets and liabilities. IAS No. 1 doesn‘t prescribe the format of the balance sheet, but balance sheets prepared using IFRS often report long-term items first.

Question 3–20 An operating segment is a component of a public entity: 1. That engages in business activities from which it may recognize revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same public entity). 2. Whose operating results are regularly reviewed by the public entity's chief operating decisionmaker to make decisions about resources to be allocated to the segment, and to assess its performance. 3. For which discrete financial information is available. Only segments of material size (10% or more of total company revenues, assets, or net income) must be disclosed. However, a company must account for at least 75% of consolidated revenue through segment disclosures.

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Answers to Questions (concluded)

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Question 3–23 1. 2. 3. 4.

For areas determined to be reportable operating segments, the following disclosures are required: General information about the operating segment. Information about reported segment profit or loss, including certain revenues and expenses included in reported segment profit or loss, segment assets, and the basis of measurement. Reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items to corresponding enterprise amounts. Interim period information.

Question 3–24 U.S. GAAP requires public companies to report information about reported segment profit or loss, including certain revenues and expenses included in reported segment profit or loss, segment assets, and the basis of measurement. The international standard on segment reporting, IFRS No. 8, requires that companies also disclose the total liabilities of its reportable segments.

BRIEF EXERCISES Brief Exercise 3–1 (a) Current (b) Current (c) Long-term (d) Current (e) Long-term (f) Long-term

Brief Exercise 3–2 Current assets: $16,000 + $11,000 + $25,000 = $52,000 Current liabilities: $14,000 + $9,000 + $1,000 = $24,000

Brief Exercise 3–3 Assets:

minus Liabilities

$ 52,000 current assets 80,000 equipment (net) $132,000 total assets $ 24,000 current liabilities 30,000 notes payable $ 54,000 total liabilities

Complete Solution Manual for Intermediate Accounting, 11th Edition Shareholders‘ equity

$78,000 (total assets $132,000 – total liab. $54,000) (50,000) common stock $28,000 retained earnings

Brief Exerci se 3–4

K AND J NURSERY, INC. Balance Sheet At December 31, 2024 Assets Current assets: Cash ................................................................. Accounts receivable ......................................... Inventory .......................................................... Total current assets ...................................... Long-term assets: Equipment ........................................................ Less: Accumulated depreciation ........................ Net property, plant, and equipment .............. Total assets ...............................................

$ 16,000 11,000 25,000 52,000 $140,000 (60,000) 80,000 $132,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable ............................................. Salaries payable ................................................ Interest payable ................................................ Total current liabilities ................................ Long-term liabilities: Notes payable ................................................... Total liabilities ............................................... Shareholders’ equity: Common stock ................................................. Retained earnings* ........................................... Total shareholders‘ equity ........................... Total liabilities and shareholders‘ equity

$ 14,000 9,000 1,000 24,000 30,000 54,000

$50,000 28,000 78,000 $132,000

*$28,000 is the amount needed to cause total assets to equal total liabilities and shareholders‘ equity. This is calculated in BE 3–3.

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Brief Exercise 3–5 CULVER CITY LIGHTING, INC. Balance Sheet At December 31, 2024 Assets Current assets: Cash .................................................................. Accounts receivable .......................................... Inventory .......................................................... Prepaid insurance .............................................. Total current assets ......................................

$ 55,000 39,000 45,000 15,000 154,000

Property, plant, and equipment: Equipment ............................................................. $100,000 Less: Accumulated depreciation ............................ (34,000) Net property, plant, and equipment ..............

66,000

Intangible assets: Patent (net) ..................................................... Total assets ................................................

40,000 $260,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable .............................................. Interest payable.................................................. Total current liabilities .................................

$ 12,000 2,000 14,000

Long-term liabilities: Notes payable ................................................... Total liabilities ............................................... Shareholders’ equity: Common stock .................................................. Retained earnings ............................................. Total shareholders‘ equity ............................ Total liabilities and shareholders‘ equity

100,000 114,000 $70,000 76,000 146,000 $260,000

Brief Exercise 3–6 1. 2. 3.

The $30,000 should be classified as a long-term asset, under the investments classification. The next year‘s installment, $10,000, should be classified as a current liability, current maturities of long-term debt. The remaining $90,000 is classified in long-term liabilities. Two-thirds of the deferred revenue, $40,000, should be classified as a current liability. The remaining $20,000 is classified as a long-term liability.

Brief Exercise 3–7 Current assets – Cash and cash equivalents – Accounts receivable = Inventory $235,000 – $40,000 – $120,000 = $75,000 Total assets – Current assets = Property, plant, and equipment (net) $400,000 – $235,000 = $165,000 Total assets – Accounts payable – Notes payable – Common stock = Retained earnings $400,000 – $32,000 – $50,000 – $100,000 = $218,000

Brief Exercise 3–8 (1) (2) (3) (4) (5) (6)

A B B A B A

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Brief Exercise 3–9 (1) (2) (3) (4) (5)

B C A C B

Brief Exercise 3–10 (a)

Current assets  Current liabilities ($55,000 + $39,000 + $45,000 + $15,000)  ($12,000 + $2,000) $154,000  $14,000 = 11.00

(b) (Cash + Short-term investments + Accounts receivable)  Current liabilities ($55,000 + $0 + $39,000)  $14,000 = 6.71 (c) Total liabilities  Shareholders‘ equity $14,000 Current liabilities + $100,000 Long-term liabilities = $114,000 $70,000 Common stock + $76,000 Retained earnings = $146,000 $114,000  $146,000 = 0.78

Brief Exercise 3–11 Paying accounts payable reduces both current assets and current liabilities. If the current ratio before the payment was above 1.0, the transaction would cause the current ratio to increase. However, if the current ratio before the transaction was less than 1.0, the current ratio would decrease.

Brief Exercise 3–12 Acid-test ratio = (Cash + Short-term investments + A/R)  Current liabilities 1.5 = ($20,000 + $0 + $40,000)  Current liabilities 1.5 × Current liabilities = $60,000 Current liabilities = $60,000  1.5 Current liabilities = $40,000 Current ratio = Current assets  Current liabilities 2.0 = Current assets  $40,000 Current assets = $40,000 × 2.0 Current assets = $80,000 $80,000 – $20,000(cash) – $40,000(A/R) = $20,000 inventory

Complete Solution Manual for Intermediate Accounting, 11th Edition

EXERCISES Exercise 3–1 1. Total current assets Current liabilities = $44,000 + $15,000 + $1,000 (interest payable) = $60,000 Since the current ratio is 1.5:1, Current assets = 1.5 × $60,000 = $90,000 2. Short-term investments $90,000 – $5,000 – $20,000 – $60,000 = $5,000 3. Retained earnings Current assets + Long-term assets = Current liabilities + Long-term liabilities + Paid-in capital + Retained earnings (RE) $90,000 + $120,000 = $60,000 + $30,000 (notes payable) + $100,000 + RE RE = $20,000

Exercise 3–2 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18.

c e -a b f e e h b a d c e a g c a e

Equipment Accounts payable Allowance for uncollectible accounts Land (held for investment) Notes payable (due in 5 years) Deferred revenue (for the next 12 months) Notes payable (due in 6 months) Accumulated amount of net income less dividends Investment in XYZ Corp. (long-term) Inventory Patent Land (used in operations) Accrued liabilities (due in 6 months) Prepaid rent (for the next 9 months) Common stock Building (used in operations) Cash Income taxes payable

Exercise 3–3 1. 2. 3. 4.

e d -c a

Interest payable (due in 3 months) Franchise Accumulated depreciation Prepaid insurance (for next 6 months)

10. 11. 12. 13.

a c c e

Supplies Machinery Land (used in operations) Deferred revenue (for next

f Bonds payable (due in 10 years) e Current maturities of long-term debt e Notes payable (due in 3 months) b Long-term receivables a Unrestricted cash

14. 15. 16. 17. 18.

d g b a e

Copyrights Common stock Land (held for speculation) Cash equivalents Salaries payable

4 months)

5. 6. 7. 8. 9.

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Exercise 3–4 JACKSON CORPORATION Balance Sheet At December 31, 2024 Assets Current assets: Cash .................................................................. Investment in equity securities........................... Accounts receivable .......................................... Inventory .......................................................... Prepaid rent ....................................................... Total current assets ......................................

$ 40,000 10,000 34,000 75,000 16,000 175,000

Property, plant, and equipment: Machinery.............................................................. $145,000 Less: Accumulated depreciation ............................ (11,000) Net property, plant, and equipment ..............

134,000

Intangible assets: Patent (net) ..................................................... Total assets ................................................

83,000 $392,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable .............................................. Salaries payable ................................................ Income taxes payable ........................................ Total current liabilities .................................

$ 8,000 4,000 32,000 44,000

Long-term liabilities: Bonds payable .................................................. Total liabilities ...............................................

200,000 244,000

Shareholders’ equity: Common stock .................................................. Retained earnings ............................................. Total shareholders‘ equity ............................ Total liabilities and shareholders‘ equity

$100,000 48,000 148,000 $392,000

VALLEY PUMP CORPORATION Balance Sheet At December 31, 2024 Assets Current assets:

Exercise 3–5

Complete Solution Manual for Intermediate Accounting, 11th Edition Cash ................................................................. Investment in equity securities ......................... Accounts receivable .......................................... Less: Allowance for uncollectible accounts....... Net accounts receivable ................................ Inventory .......................................................... Prepaid expenses .............................................. Total current assets ...................................... Investments: Investment in equity securities ......................... Land ................................................................. Total investments ........................................ Property, plant, and equipment: Land ................................................................. Buildings .......................................................... Equipment ........................................................ Less: Accumulated depreciation—buildings ..... Less: Accumulated depreciation—equipment ... Net property, plant, and equipment ..............

$ 25,000 22,000 $56,000 (5,000) 51,000 81,000 32,000 211,000

22,000 20,000 42,000

100,000 300,000 75,000 475,000 (100,000) (25,000)

Intangible assets: Copyright (net) .................................................. Total assets ...............................................

350,000

12,000 $615,000

Exercise 3–5 (continued)

Liabilities and Shareholders' Equity Current liabilities: Accounts payable ............................................. Interest payable ................................................

$ 65,000 10,000

Deferred revenue .............................................. Notes payable (current) ..................................... Notes payable (current maturities of long-term debt) ................................................................. Total current liabilities ................................

20,000 100,000 50,000 245,000

Long-term liabilities: Notes payable (long-term) ................................. Total liabilities ............................................ Shareholders’ equity: Common stock ................................................. Retained earnings ............................................. Total shareholders‘ equity ........................... Total liabilities and shareholders‘ equity ...

100,000 345,000 $200,000 70,000 270,000 $615,000

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Exercise 3–6 Current assets: Cash Accounts receivable Less: Allowance for uncollectible accounts Notes receivable Interest receivable Investment in debt securities Raw materials Work in process Finished goods Prepaid rent (one-half of $60,000) Total current assets

$ 20,000 130,000 (13,000) 100,000 3,000 32,000 24,000 42,000 89,000 30,000

Current liabilities: Deferred revenue (one half of $36,000) Accounts payable Interest payable Total current liabilities

18,000 180,000 5,000

Working capital

$457,000

(203,000) $254,000

Exercise 3–7 LOS GATOS CORPORATION Balance Sheet At December 31, 2024 Assets Current assets: Cash ....................................................................... Accounts receivable ................................................ Less: Allowance for uncollectible accounts............. Net accounts receivable..................................... Inventory ................................................................ Total current assets ...........................................

$ 20,000 $ 60,000 ( 5,000)

55,000 55,000 130,000

Investments: Notes receivable ..................................................... Property, plant, and equipment: Machinery .............................................................. Less: Accumulated depreciation ............................. Net property, plant, and equipment ...................

20,000

190,000 (70,000) 120,000

Intangible assets: Franchise (net) .......................................................

30,000

Other assets: Restricted cash Total assets .................................................... Liabilities and Shareholders' Equity Current liabilities: Accounts payable ................................................... Interest payable ...................................................... Notes payable ......................................................... Total current liabilities ...................................... Long-term liabilities: Bonds payable ........................................................ Total liabilities ................................................. Shareholders’ equity: Common stock (no par value; 100,000 shares authorized; 50,000 shares issued and outstanding) Retained earnings ................................................... Total shareholders‘ equity .................................

20,000 $320,000

$ 50,000 5,000 50,000 105,000 110,000 215,000

$ 70,000 35,000 105,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Total liabilities and shareholders‘ equity ........

$320,000

Exercise 3–8

CONE CORPORATION Balance Sheet (Partial) At December 31, 2024 Assets Current assets: Investment in equity securities ......................... Prepaid rent ......................................................

$ 40,000 12,000

Long-term investments: Investment in equity securities .........................

40,000

Other assets: Prepaid rent (1) ................................................. Restricted cash ..................................................

12,000 50,000

Liabilities and Shareholders' Equity Current liabilities: Interest payable ................................................ Notes payable (current maturities of long-term debt)

$ 12,000 20,000

Long-term liabilities: Notes payable (long-term) .................................

180,000

(1) Note: In practice, companies often report all prepaid expenses as current

assets.

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KORVER SUPPLY COMPANY Balance Sheet At December 31, 2024 Assets Current assets:

Exercise 3–9 See calculations below the balance sheet.

Cash .................................................................. Accounts receivable .......................................... Inventory .......................................................... Total current assets ...................................... Property, plant, and equipment: Furniture and fixtures ........................................ Less: Accumulated depreciation ....................... Net property, plant, and equipment .............. Total assets ................................................

$168,000 320,000 250,000 738,000 $300,000 (170,000) 130,000 $868,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable .............................................. Interest payable ................................................. Notes payable ................................................... Total current liabilities .................................

$180,000 6,000 200,000 386,000

482,000 $868,000

$100,000 382,000

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Exercise 3–9 (concluded) Beginning balance in cash + Cash collected from customers – Cash paid to suppliers – Cash paid for operating expenses – Cash paid for interest Ending cash balance

$120,000 780,000 (560,000) (160,000) (12,000) $168,000

Beginning balance in accounts receivable + Credit sales – Cash collected from customers Ending balance in accounts receivable

$300,000 800,000 (780,000) $320,000

Beginning balance in inventory + Purchases – Cost of merchandise sold Ending balance in inventory

$200,000 550,000 (500,000) $250,000

Beginning balance in furniture and fixtures, net – Depreciation for the year Ending balance in furniture and fixtures, net

$150,000 (20,000) $130,000

Beginning balance in accounts payable + Purchases on account – Cash paid to suppliers Ending balance in accounts payable

$190,000 550,000 (560,000) $180,000

Beginning balance in retained earnings + Sales revenue – Cost of goods sold – Operating expenses – Depreciation expense – Interest expense Ending balance in retained earnings

$274,000 800,000 (500,000) (160,000) (20,000) (12,000) $382,000

Accrued interest on notes ($200,000 x 6% x 6/12)

$6,000

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Exercise 3–10 1. Inventory costing method 2. Information on related-party transactions 3. Composition of property, plant, and equipment 4. Depreciation method 5. Subsequent event information 6. Measurement basis for certain financial instruments 7. Important merger occurring after year-end 8. Composition of receivables

A B B A B A B B

Exercise 3–11 1.

4. 5.

When related-party transactions occur, companies must disclose the nature of the relationship, provide a description of the transaction, and report the dollar amounts of the transactions and any amounts due from or to related parties. When an event that has a material effect on the company‘s financial position occurs after the fiscal year-end, but before the financial statements actually are issued, the event is disclosed in a subsequent event disclosure note. The choice of the straight-line method to determine depreciation typically is disclosed in the company‘s summary of significant accounting policies disclosure note. This information would be included in a disclosure note describing the company‘s debt. The choice of the FIFO method to determine value inventory typically is disclosed in the company‘s summary of significant accounting policies disclosure note.

Exercise 3–12 1. 2. 3. 4. 5. 6. 7. 8.

(B) in a separate disclosure note. (A) in the summary of significant policies note. (C) on the face of the balance sheet. (B) in a separate disclosure note. (B) in a separate disclosure note. (A) in the summary of significant policies note. (C) on the face of the balance sheet. (B) in a separate disclosure note.

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Exercise 3–13 1. Topic number that provides guidance on information contained in the notes to the financial statements: ASC Topic 235: ―Notes to the Financial Statements.‖ 2. The topic, subtopic, and section number that describes the information that companies must disclose in the accounting policies note: ASC 235–10–50: ―Notes to Financial Statements–Overall–Disclosure–What to Disclose.‖

3. Disclosure of accounting policies should identify and describe the accounting principles the company follows and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, the disclosure encompasses important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods. In particular, it encompasses those accounting principles and methods that involve any of the following: a. A selection from existing acceptable alternatives. b. Principles and methods peculiar to the industry in which the entity operates, even if such principles and methods are predominantly followed in that industry. c. Unusual or innovative applications of GAAP.

Exercise 3–14 6. The topic, subtopic, and section number that determines the balance sheet classification for a note payable due in six months that was used to purchase a building: FASB ASC 210–10–45–9: ―Notes to Financial Statements–Overall–Other Presentation Matters–Other Liabilities.‖

Other liabilities whose regular and ordinary liquidation is expected to occur within a relatively short period of time, usually 12 months, are also generally included, such as the following: a. Short-term debts arising from the acquisition of capital assets. b. Serial maturities of long-term obligations. c. Amounts required to be expended within one year under sinking fund provisions. d. Agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons. Loans accompanied by pledge of life insurance policies would be classified as current liabilities if, by their terms or by intent, they are to be repaid within 12 months. The pledging of life insurance policies does not affect the classification of the asset any more than does the pledging of receivables, inventories, real estate, or other assets as collateral for a short-term loan. However, when a loan on a life insurance policy is obtained from the insurance entity with the intent that it will not be paid but will be liquidated by deduction from the proceeds of the policy upon maturity or cancellation, the obligation shall be excluded from current liabilities.

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Exercise 3–14 (continued)

7. The topic, subtopic, and section number that determines which assets may be excluded from current assets: FASB ASC 210–10–45–4: ―Notes to Financial Statements–Overall–Other Presentation Matters.‖

The concept of the nature of current assets contemplates the exclusion from that classification of such resources as the following: a. Cash and claims to cash that are restricted as to withdrawal or use for other than current operations, are designated for expenditure in the acquisition or construction of long-term assets, or are segregated for the liquidation of long-term debts. Even though not actually set aside in special accounts, funds that are clearly to be used in the near future for the liquidation of long-term debts, payments to sinking funds, or for similar purposes shall also, under this concept, be excluded from current assets. However, if such funds are considered to offset maturing debt that has properly been set up as a current liability, they may be included within the current asset classification. b. Investments in securities (whether marketable or not) or advances that have been made for the purposes of control, affiliation, or other continuing business advantage. c. Receivables arising from unusual transactions (such as the sale of capital assets, or loans or advances to affiliates, officers, or employees) that are not expected to be collected within 12 months. d. Cash surrender value of life insurance policies. e. Land and other natural resources. f. Depreciable assets. g. Long-term prepayments that are fairly chargeable to the operations of several years, or deferred charges such as bonus payments under a longterm lease, costs of rearrangement of factory layout or removal to a new location. 7–244 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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Exercise 3–14 (continued) 8. The topic, subtopic, and section number that determines whether a note receivable from a related party would be included in the balance sheet with notes receivable from customers: FASB ASC 850–10–50–2: ―Related Party Disclosures–Overall–Disclosure.‖ Notes or accounts receivable from officers, employees, or affiliated entities must be shown separately and not included under a general heading such as notes receivable or accounts receivable.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 3–14 (concluded) 9. The topic, subtopic, and section number determines what items are nonrecognized subsequent events that require a disclosure in the notes to the financial statements: FASB ASC 855–10–55–2: ―Subsequent Events–Overall–Implementation Guidance and Illustrations–Nonrecognized Subsequent Events.‖

The following are examples of nonrecognized subsequent events addressed in paragraph 855–10–55–2: a. Sale of a bond or capital stock issued after the balance sheet date but before financial statements are issued or are available to be issued. b. A business combination that occurs after the balance sheet date but before financial statements are issued or are available to be. c. Settlement of litigation when the event giving rise to the claim took place after the balance sheet date but before financial statements are issued or are available to be issued. d. Loss of plant or inventories as a result of fire or natural disaster that occurred after the balance sheet date but before financial statements are issued or are available to be issued. e. Losses on receivables resulting from conditions (such as a customer‘s major casualty) arising after the balance sheet date but before financial statements are issued or are available to be issued. f. Changes in the fair value of assets or liabilities (financial or nonfinancial) or foreign exchange rates after the balance sheet date but before financial statements are issued or are available to be issued. g. Entering into significant commitments or contingent liabilities, for example, by issuing significant guarantees after the balance sheet date but before financial statements are issued or are available to be issued.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 3–15 List A d

1. Balance sheet

k 6. m 7. l

e 10. i 11. n 12. c 13. f 14.

List B

a. Will be satisfied through the use of current assets. Liquidity b. Items expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer. Current assets c. The statements are presented fairly in conformity with GAAP. Operating cycle d. An organized array of assets, liabilities, and equity. Current liabilities e. Important to a user in comparing financial information across companies. Cash equivalent f. Scope limitation or a departure from GAAP. Intangible asset g. Recorded when an expense is incurred but not yet paid. Working capital h. Refers to the ability of a company to convert its assets to cash to pay its current obligations. Accrued liabilities i. Occurs after the fiscal year-end but before the statements are issued. Summary of significant j. Period of time from payment of cash to accounting policies collection of cash. Subsequent events k. One-month U.S. treasury bill. Sustainability disclosures l. Current assets minus current liabilities. Unqualified opinion m. Lacks physical substance Qualified opinion n. Information about environmental, social and governance factors related to company operations.

Exercise 3–16 1. Current ratio 2. Acid-test ratio 3. Debt to equity ratio 4. Times interest earned ratio

[$200 + $150 + $200 + $350] ÷ $400 = 2.25 [$200 + $150 + $200] ÷ $400 = 1.375 [$400 + $350] ÷ [$750 + $400] = 0.65 [$160 + $40 + $100] ÷ $40 = 7.5 times

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 3–17 Requirement 1 a. Current ratio b. Acid-test ratio c. Debt to equity ratio d. Times interest earned ratio

$8,857 ÷ $8,060 = 1.10 [$2,229 + $0 + $1,149] ÷ $8,060 = 0.42 [$8,060 + $4,052] ÷ $3,479= 3.48 [$1,541 + $64 + $452] ÷ $64 = 32.14 times

Requirement 2 Best Buy‘s current ratio is well below the industry average (but above 1) and its debt to equity ratio is well above the industry average. Both of these ratios relative to the industry are indications of the company‘s higher risk. However, the company‘s acid-test ratio is slightly above the industry average and its times interest eaerned ratio is well above the industry average. Overall, Best Buy seems capable of meeting the debt obligations.

Exercise 3–16 a. Acid-test ratio = Quick assets ÷ Current liabilities = Quick assets = Current assets – Inventory Quick assets = Current assets – $840,000

1.20

Current assets ÷ Current liabilities = Current assets – $840,000 ÷ Current liabilities = $840,000 ÷ Current liabilities = Current liabilities = $800,000 Current assets ÷ $800,000 = 2.25 Current assets = $1,800,000

2.25 1.20 1.05

b. Debt to equity ratio = Total liabilities ’ Shareholders‘ equity = 1.8 Total liabilities + Shareholders' equity = Total assets Total liabilities + Shareholders' equity = $2,800,000 Let x equal shareholders' equity 1.8 x + x = $2,800,000 x = $1,000,000 = Shareholders' equity c. Long-term assets = Total assets – Current assets Long-term assets = $2,800,000 – $1,800,000 = $1,000,000 d. Long-term liabilities = Total assets – Current liabilities – Shareholders' equity Long-term liabilities = $2,800,000 – $800,000 – $1,000,000 = $1,000,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 3–19 1. Debt to equity ratio = Total liabilities ’ Shareholders‘ equity = 1.4 Total liabilities ÷ $2,500,000 = 1.4 Shareholders‘ equity × 1.4 = Total liabilities $2,500,000 × 1.4 = $3,500,000 = Total liabilities Total liabilities + Equity = Total assets $3,500,000 + $2,500,000 = $6,000,000 = Total assets Total assets – Long-term assets = Current assets $6,000,000 – $2,400,000 = $3,600,000 = Current assets Current ratio = Current assets ÷ Current liabilities 2.0 = $3,600,000 ÷ Current liabilities Current liabilities = $3,600,000  2 = $1,800,000 2. Total assets = Total liabilities + Shareholders‘ equity Total assets = Current liabilities + Long-term liabilities + Shareholders‘ equity $6,000,000 = $1,800,000 + Long-term liabilities + $2,500,000 Long-term liabilities = $1,700,000 3. Current assets = Cash + Accounts receivable + Prepaid expenses $3,600,000 = $1,300,000 + Accounts receivable + $360,000 Accounts receivable = $1,940,000 4. Acid-test ratio = Quick assets ÷ Current liabilities Quick assets = Cash + Accounts receivable Quick assets = $1,300,000 + $1,940,000 = $3,240,000 Acid-test ratio = $3,240,000 ÷ $1,800,000 = 1.8

Exercise 3–20 Current Acid-test Debt to Action Ratio Ratio Equity Ratio 1. Issuance of long-term bonds 2. Issuance of short-term notes 3. Payment of accounts payable 4. Purchase of inventory on account 5. Purchase of inventory for cash 6. Purchase of equipment with a 4-year note 7. Repayment of long-term notes payable 8. Issuance of common stock 9. Payment for advertising expense 10. Purchase of short-term investment for cash 11. Reclassification of long-term notes-payable to current notes payable

I I D I N N D I D N

I I D D D N D I D N

I I D I N I D D I N

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 3–21 Requirement 1 The pharmaceuticals, plastics, and farm equipment segments are reportable. Only segments representing 10% or more of total company revenues, assets, or net income must be reported. The electronics segment does not meet this criterion.

Requirement 2 a. b. c. d.

For segments determined to be reportable, the following disclosures are required: General information about the operating segment. Information about reported segment profit or loss, including certain revenues and expenses included in reported segment profit or loss, segment assets, and the basis of measurement. Reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items to corresponding enterprise amounts. Interim period information.

Exercise 3–22 In addition to revenues, profit or loss, and assets, IFRS also require the disclosure of total liabilities for each of the reportable segments.

Problems Problem 3–1 Name of Company Balance Sheet At [date] Assets Current assets: Cash Short-term investments Accounts receivable Less: Allowance for uncollectible accounts Interest receivable Inventory Prepaid expenses Total current assets Investments: Land (held for speculation) Long-term equity investments Notes receivable Total investments Property, plant, and equipment: Land (in use) Buildings Equipment Less: Accumulated depreciation—buildings Less: Accumulated depreciation—equipment Net property, plant, and equipment Intangible assets: Patent (net) Copyright (net) Total intangible assets Total assets Liabilities and Shareholders' Equity Current liabilities: Accounts payable Interest payable Income taxes payable Salaries payable Notes payable 7–256 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition Total current liabilities

Long-term liabilities: Bonds payable Total liabilities Shareholders’ equity: Common stock Additional paid-in capital Retained earnings Total shareholders‘ equity Total liabilities and shareholders‘ equity

Problem 3–2 Requirement 1 Inventory: Current assets – Cash and cash equivalents – Short-term investments – Accounts receivable – Prepaid expenses = Inventory $1,594,927 – $239,186 – $353,700 – $504,944 – $83,259 = $413,838 Total assets: Total liabilities + (Common stock + Retained earnings) = Total assets $956,140 + $370,627 + $1,000,000 = $2,326,767 Equipment (net): Total assets – Current assets – Long-term receivables = Property and equipment $2,326,767 – $1,594,927 – $110,800 = $621,040 Accounts payable: Total current liabilities – Notes payable (current) – Accrued liabilities – Other current liabilities = Accounts payable $693,564 – $31,116 – $421,772 – $181,604 = $59,072 Long-term debt: Total liabilities – Current liabilities = Long-term debt $956,140 – $693,564 = $262,576

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 3–2 (concluded) Requirement 2 TRIDENT CORPORATION Balance Sheet At December 31, 2024 Assets ($ in thousands)

Current assets: Cash and cash equivalents ........................... Short-term investments ................................ Accounts receivable .................................... Inventory ..................................................... Prepaid expenses ......................................... Total current assets .................................

$ 239,186 353,700 504,944 413,838 83,259 1,594,927

Investments: Long-term receivables .................................

110,800

Property, plant, and equipment: Equipment (net) ........................................... Total assets ..........................................

621,040 $2,326,767

Liabilities and Shareholders' Equity Current liabilities: Notes payable ................................................ Accounts payable ......................................... Accrued liabilities ........................................ Other current liabilities ................................. Total current liabilities ............................

31,116 59,072 421,772 181,604 693,564

Long-term liabilities: Long-term debt ............................................. Total liabilities ..........................................

262,576 956,140

Shareholders’ equity Common stock ............................................. Retained earnings ......................................... Total shareholders‘ equity ........................

370,627 1,000,000 1,370,627

Complete Solution Manual for Intermediate Accounting, 11th Edition Total liabilities and shareholders‘ equity

$2,326,767

Problem 3–3

Complete Solution Manual for Intermediate Accounting, 11th Edition ALMWAY CORPORATION Balance Sheet At December 31, 2024 Assets Current assets: Cash and cash equivalents .................................................... Restricted cash ...................................................................... Investment in equity securities ............................................ Accounts receivable .............................................................. Less: Allowance for uncollectible accounts ........................... Net accounts receivable ................................................... Inventory ............................................................................. Prepaid insurance ................................................................. Total current assets ........................................................ Investments: Investment in equity securities ............................................. Land held for sale ................................................................

$ 7,000 23,000 80,000 $ 68,000 ( 8,000) 60,000 200,000 9,000 379,000 30,000 25,000

Total investments ........................................................... Property, plant, and equipment: Land .................................................................................... Buildings ............................................................................. Equipment ........................................................................... Less: Accumulated depreciation—buildings ......................... Less: Accumulated depreciation—equipment ....................... Net property, plant, and equipment ................................

55,000 65,000 420,000 110,000 595,000 (100,000) (60,000) 435,000

Intangible assets: Patent (net) .......................................................................... Other assets: Restricted cash ...................................................................... Total assets ....................................................................

10,000 15,000 $894,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable ................................................................. Interest payable Notes payable (current) ........................................................ Notes payable (current maturities of long-term debt) ............ Total current liabilities ................................................... Long-term liabilities: Notes payable (long-term)..................................................... Bonds payable ...................................................................... Total long-term liabilities ............................................... Total liabilities ............................................................... Shareholders’ equity: Common stock (no par value; 500,000 shares authorized; 100,000 shares issued and outstanding) ........... Retained earnings ................................................................. Total shareholders‘ equity .............................................. Total liabilities and shareholders‘ equity ..................... Solutions Manual, Chapter 7

$ 75,000 20,000 30,000 10,000 135,000 $ 90,000 240,000 330,000 465,000

300,000 129,000 429,000 $894,000 7–263

Complete Solution Manual for Intermediate Accounting, 11th Edition WEISMULLER PUBLISHING COMPANY Balance Sheet At December 31, 2024 Assets Current assets: Cash and cash equivalents (1) .............................................. Investment in equity securities ............................................. Accounts receivable ............................................................. Less: Allowance for uncollectible accounts .......................... Net accounts receivable .................................................. Inventory ............................................................................. Prepaid expenses (2)............................................................. Total current assets .......................................................

$ 160,000 (16,000)

Property, plant, and equipment: Equipment ........................................................................... Less: Accumulated depreciation ........................................... Net property, plant, and equipment ................................

320,000 (110,000)

$ 95,000 110,000

144,000 285,000 88,000 722,000

210,000

Other assets: Prepaid expenses Total assets ................................................................

60,000 $992,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable ................................................................ Interest payable ................................................................... Deferred revenue ................................................................. Income taxes payable .......................................................... Notes payable (current) ....................................................... Notes payable (current maturities of long-term debt) ........... Total current liabilities ..................................................

$ 60,000 20,000 80,000 30,000 40,000 20,000 250,000

Long-term liabilities: Notes payable (long-term) ................................................... Total liabilities .............................................................

140,000 390,000

Shareholders’ equity: Common stock (no par value; 800,000 shares authorized; 400,000 shares issued and outstanding) .......... Retained earnings ................................................................ Total shareholders‘ equity ............................................. Total liabilities and shareholders‘ equity ....................

$ 400,000 202,000 602,000 $992,000

(1) Includes $30,000 in U.S. treasury bills. (2) Excludes $60,000 in prepaid rent for the second year on the building lease. Solutions Manual, Chapter 7 7–265 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Problem 3–5

EXCELL COMPANY Balance Sheet At June 30, 2024 Assets Current assets: Cash and cash equivalents (1) .............................................. Short-term investments ........................................................ Accounts receivable (net of allowance for uncollectible accounts of $15,000) ......................................................... Interest receivable ................................................................ Prepaid expenses ................................................................. Total current assets ........................................................ Investments: Notes receivable .................................................................. Land held for sale ................................................................ Property, plant, and equipment: Land .................................................................................... Buildings ............................................................................. Equipment ........................................................................... Less: Accumulated depreciation—buildings ......................... Less: Accumulated depreciation—equipment ....................... Net property, plant, and equipment ................................ Total assets ................................................................

$ 101,000 47,000 210,000 5,000 32,000 395,000 $ 65,000 25,000 50,000 320,000 265,000 635,000 (160,000) (120,000) 355,000 $ 840,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable ................................................................. Accrued liabilities ................................................................ Notes payable (current) ........................................................ Notes payable (current maturities of long-term debt) ............ Total current liabilities ................................................... L ong-term liabilities: Notes payable (long-term) ................................................... Mortgage payable ................................................................ Total long-term liabilities .............................................. Total liabilities .............................................................. Shareholders’ equity: Common stock (no par value; 500,000 shares authorized; 200,000 shares issued and outstanding) ........... Retained earnings ................................................................ Total shareholders‘ equity ............................................. Total liabilities and shareholders‘ equity .....................

90,000

$ 173,000 45,000 50,000 10,000 278,000 $ 50,000 240,000 290,000 568,000

100,000 172,000 272,000 $ 840,000

(1) Includes $18,000 in U.S. treasury bills. 7–266 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition

VOSBURGH ELECTRONICS CORPORATION Balance Sheet At December 31, 2024 Assets Current assets: Cash and cash equivalents (1)........................................ Short-term investments (2) ............................................ Accounts receivable ...................................................... Less: Allowance for uncollectible accounts ................... Net accounts receivable ........................................... Receivables from employees ........................................ Interest receivable ........................................................ Notes receivable ............................................................ Inventory ...................................................................... Prepaid expenses .......................................................... Total current assets ................................................. Investments: Long-term investments .................................................. Notes receivable ........................................................... Total investments ....................................................

117,000 132,000

$ 123,000 (8,000) 115,000 40,000 12,000 50,000 215,000 16,000 697,000

35,000 200,000 235,000

Property, plant, and equipment: Land ............................................................................. Buildings ...................................................................... Equipment ....................................................................

280,000 1,550,000 637,000 2,467,000 Less: Accumulated depreciation—buildings ................. (620,000) Less: Accumulated depreciation—equipment....................... (210,000) Net property, plant, and equipment ......................... 1,637,000

Intangible assets: Patent (net) ................................................................... Franchise (net) .............................................................. Total intangible assets ............................................ Total assets ..........................................................

152,000 40,000 192,000 $ 2,761,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 3–6 (continued)

Liabilities and Shareholders' Equity Current liabilities: Accounts payable .......................................................... Dividends payable ........................................................ Interest payable ............................................................. Income taxes payable .................................................... Deferred revenue (3)...................................................... Total current liabilities ............................................ Long-term liabilities: Notes payable ............................................................... Deferred revenue (3)...................................................... Total long-term liabilities ....................................... Total liabilities ....................................................... Shareholders’ equity: Common stock (no par value; 1,000,000 shares authorized; 500,000 shares issued and outstanding) .... Retained earnings ......................................................... Total shareholders‘ equity ....................................... Total liabilities and shareholders‘ equity ..............

$ 189,000 10,000 16,000 40,000 48,000 303,000

$ 300,000 12,000 312,000 615,000

2,000,000 146,000 2,146,000 $ 2,761,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 3–6 (concluded) (1) $67,000 + $50,000 in treasury bills considered a cash equivalent. (2) $182,000 – $50,000 in treasury bills considered a cash equivalent. (3) $60,000 in deferred revenue, 80%, $48,000, current and 20%, $12,000, long-term. Requirement 2 a. The allowance for uncollectible accounts. b. Original cost by major category along with the accumulated depreciation and method used to compute depreciation. c. Number of shares of authorized, issued, and outstanding shares. d. Information about the types of securities and the accounting method used to value those securities. e. The policy used to determine highly liquid investments. f. The cost method used. g. Payment terms, interest rates, and collateral pledged as security for the debt. e. Cash equivalents a. Accounts receivable f. Inventory d. Investments b. Property, plant and equipment g. Notes payable c. Common stock

HUBBARD CORPORATION Balance Sheet At December 31, 2024

Problem 3–7

Complete Solution Manual for Intermediate Accounting, 11th Edition Assets Current assets: Cash ..................................................................................... Investment in equity securities ............................................. Accounts receivable (net) ..................................................... Inventory ............................................................................. Total current assets ........................................................ Investments: Investment in equity securities .............................................. Land held for sale ................................................................ Total investments ........................................................... Property, plant, and equipment: Land (1) ............................................................................... Buildings ............................................................................. Machinery ............................................................................ Less: Accumulated depreciation ........................................... Net property, plant, and equipment ................................

60,000 20,000 120,000 160,000 360,000

40,000 50,000 90,000

130,000 750,000 280,000 1,160,000 (255,000) 905,000

Intangible assets: Patent (net) .......................................................................... Total assets .................................................................

100,000 $1,455,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable ................................................................. Notes payable (current maturities of long-term debt) ............ Total current liabilities ...................................................

$ 215,000 25,000 240,000

Long-term liabilities: Notes payable (long-term) .................................................... Total liabilities ..............................................................

475,000 715,000

Shareholders’ equity: Common stock (no par value; 100,000 shares authorized; 100,000 shares issued and outstanding) ........... $ 430,000 Retained earnings (2) ........................................................... 310,000 Total shareholders‘ equity .............................................. 740,000 Total liabilities and shareholders‘ equity ..................................................... $1,455,000

(1) $250,000 – $50,000 in land held for sale – $70,000 increase in land. (2) $380,000 – $70,000 increase in land.

Problem 3–8 Solve for missing amounts: Total liabilities = 120% of total shareholders‘ equity Current liabilities + Long-term liabilities = Total liabilities $12,300 + $5,500 + $200 = $18,000 Total liabilities  Shareholders‘ equity = 1.2 $18,000  Shareholders‘ equity = 1.2 $18,000

 1.2 = Shareholders‘ equity = $15,000

Beginning retained earnings + Net income – Dividends = Ending retained earnings

$4,000

+ $1,560 –

$560

$5,000

Shareholders‘ equity – Retained earnings = Common stock $15,000 – $5,000 = $10,000 Total liabilities + Shareholders‘ equity = Total assets $18,000 + $15,000 = $33,000 Total assets – all other assets = Patent (net) $33,000 – $27,600 = $5,400

Complete Solution Manual for Intermediate Accounting, 11th Edition

SANDERSON MANUFACTURING COMPANY Balance Sheet At December 31, 2024 ($ in 000s, except share data) Assets Current assets: Cash ............................................................................. Investments .................................................................. Accounts receivable....................................................... Less: Allowance for uncollectible accounts.................... Net accounts receivable............................................ Inventories: Raw materials and work in process ............................ Finished goods ........................................................... Prepaid expenses .......................................................... Total current assets ................................................. Property, plant, and equipment: Equipment .................................................................... Less: Accumulated depreciation .................................... Net property, plant, and equipment .........................

$ 1,250 3,000 $ 3,500 (400) 3,100 2,250 6,000

8,250 1,200 16,800

15,000 (4,200) 10,800

Intangible assets: Patent (net) ................................................................. Total assets ..........................................................

5,400 $ 33,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable .......................................................... Interest payable.............................................................. Deferred revenue .......................................................... Notes payable (current maturities of long-term debt) ..... Total current liabilities ............................................

$ 5,200 300 1,500 1,000 8,000

Long-term liabilities: Deferred revenue .......................................................... Notes payable (long-term) ............................................ Bonds payable .............................................................. Total long-term liabilities ....................................... Total liabilities ....................................................... Shareholders’ equity: Common stock (no par, 400,000 shares authorized,........ 250,000 shares issued and outstanding) Retained earnings ......................................................... aalpstehra7reholders‘ equity ....................................... Solutions ManuaTl,oCt h

$ 1,500 3,000 5,500 10,000 18,000

10,000 5,000 15,000

Total liabilities and shareholders‘ equity

$ 33,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 3–9

HHD, INC. Balance Sheet At December 31, 2024 Assets Current assets: Cash Investment in equity securities Accounts receivable (net) Inventory Prepaid insurance Total current assets

Investments: Investment in equity securities

Property, plant, and equipment: Land Buildings Equipment Less: Accumulated depreciation—buildings Less: Accumulated depreciation—equipment Net property, plant, and equipment Intangible assets: Patent (net) Copyright (net) Total intangible assets Total assets

150,000 90,000 200,000 225,000 25,000 690,000 410,000

800,000 1,500,000 500,000 2,800,000 (600,000) (200,000) 2,000,000 110,000 90,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable Notes payable (current) Income taxes payable Total current liabilities Long-term liabilities: Notes payable (long-term) $ 90,000 Bonds payable 1,100,000 Total long-term liabilities Total liabilities Shareholders’ equity: Common stock (no par, 500,000 shares authorized, 200,000 shares issued and outstanding) 1,000,000 Retained earnings 800,000 Total shareholders‘ equity Total liabilities and shareholders‘ equity

200,000 $ 3,300,000

100,000 150,000 60,000 310,000

1,190,000 1,500,000

1,800,000 $ 3,300,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 3–10 MELODY LANE MUSIC COMPANY Balance Sheet At December 31, 2024 Assets

(1) Cash receipts of $560,000 less cash disbursements of $393,000.

Current assets: Cash (1) ............................................................ Inventory .......................................................... Prepaid rent ....................................................... Total current assets ......................................

$167,000 100,000 3,000 270,000

(2) $20,000 owed to suppliers + $1,000 owed to utility company.

Property, plant, and equipment: Equipment ......................................................... Less: Accumulated depreciation ....................... Net property, plant, and equipment .............. Total assets ................................................

(3) Net income for the year.

Liabilities and Shareholders' Equity Current liabilities: Accounts payable (2) ........................................ Interest payable ................................................. Notes payable ............................................... Total current liabilities .................................

$ 21,000 9,000 100,000 130,000

Shareholders’ equity: Common stock (no par, 100,000 shares authorized, 20,000 shares issued and outstanding) ...................................................... Retained earnings (3) ........................................ Total shareholders‘ equity ............................ Total liabilities and shareholders‘ equity ...

176,000 $306,000

$ 40,000 (4,000) 36,000 $306,000

$100,000 76,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

DECISION MAKERS’ PERSPECTIVE CASES Analysis Case 3–1 Requirement 1 Identify the factors that determine whether an asset or liability should be classified as current or long term in a balance sheet (check all that apply): X Nature of the asset or liability. Amount of the asset or liability. Whether the asset or liability is reported at historical cost or fair value. X Management‘s intent for the asset or liability. X The company‘s length of operating cycle. The length of time for which the asset or liability has been held.

Requirement 2 For each of the items below, determine whether it would be reported as current or long-term. Assume the company‘s operating cycle is less than one year. Current Long-term Current Long-term Current Long-term Current Long-term Current Long-term Current Long-term

Cash held for normal operations. Cash restricted to pay long-term debt. Receivables expected to be collected within the next year. Receivables not expected to be collected within the next year. Investments management intends to sell within the next year. Investments management intends to hold for more than one year. Prepaid rent that will expire within one year. Prepaid rent that will not expire within one year. Notes payable that are due within one year. Notes payable that are due in more than one year. Deferred revenue for goods and services management intends to provide to customers within the next year. Deferred revenue for goods and services management intends to provide to customers in more than one year.

IFRS Case 3–2 The following are differences between Vodafone‘s balance sheet and a typical U.S. company balance sheet (check all that apply): X Vodafone lists long-term assets before current assets. X Vodafone lists equities before liabilities. Vodafone lists liabilities in order of amount. X Vodafone lists long-term liabilities before current liabilities. Vodafone‘s total assets do not equal total liabilities plus total equities. X Vodafone‘s current assets are listed in reverse order of liquidity.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Judgment Case 3–3 For each asset and liability, determine whether it is correctly classified. If it is not, select the correct classification. Cash Accounts receivable (net) Notes Receivable of $50,000 Interest Receivable of $3,000 Inventory Investments Land Equipment (net) Prepaid expenses Patent (net) Accounts payable Salaries payable Notes payable of $20,000 Notes payable of $80,000 Bonds payable Interest payable

Correct Correct Long-term Investment Correct Correct Long-term Investment Long-term Investment Property, Plant, and Equipment Current Asset Intangible Asset Correct Correct Current Liability Correct Correct Current Liability

Judgment Case 3– 284 Determine which of the listed disclosure notes would most likely be used to provide additional information about one of the items shown on the face of the balance sheet (choose all that apply): X

1. Disclosure of various debt instruments including payment terms, interest rates, maturity dates, and any collateral pledged as security. 2. Disclosure of earnings per share for income from continuing operations and for discontinued operations.

Disclosure of original cost by major category, along with the accumulated depreciation and the method used to compute depreciation.

4. Disclosure of types of investments and valuation method used. 5. Disclosure of the criteria for recognizing revenue from providing goods and services to customers and the provisions for sales returns and discounts.

6. Disclosure of the allowance for uncollectible accounts and the procedure used by management to estimate that amount.

7. Disclosure of par value, if any, and the number of shares authorized, issued, and outstanding. 8. Disclosure of the amount spent on research and development to design new products and improve existing services.

9. Disclosure of the cost method used to report unsold merchandise at the end of the year. 10. Disclosure of significant noncash investing and financing activities.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Real World Case 3–5 Requirement 1 Yes

Requirement 2 a. Total assets b. Current assets c. Current liabilities d. Total equity e. Retained earnings f. Inventory Requirement 3

= $ 236,495 million = $ 61,806 million = $ 77,790 million = $ 81,552 million = $ 83,943 million = $ 44,435 million

Walmart‘s largest current asset is inventory. Walmart‘s largest current liability is accounts payable.

Requirement 4 Current ratio = Current assets divided by Current liabilities Current ratio = $61,806 ÷ $77,790 = 0.79 Requirement 5 a. b.

Yes. LIFO. The company values inventory at the lower of cost or market determined primarily by the retail method of accounting, using the last-in, first-out (LIFO) method for U.S. inventory and the first-in, first-out (FIFO) method for foreign operations. At the time the service is performed.

Judgment Case 3– 286 Should these events be disclosed with the 2024 financial statements? 1.

Yes. This is a significant event occurring after the end of the fiscal year but prior to the issuance of the financial statements. Details of the merger should be disclosed in a note to the financial statements. Yes. This is a significant event occurring after the end of the fiscal year but prior to the issuance of the financial statements. Details of the issuance of the new debt should be described in a note to the financial statements. Yes. This is a significant event occurring after the end of the fiscal year but prior to the issuance of the financial statements. The event should be described in a note to the financial statements along with the amount of uninsured damage.

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Real World Case 3–7 1. $3.5 billion 2. $4.9 billion 3. $3.0 billion 4. Yes 5. $500 million

Judgment Case 3– 288 Requirement 1 Comparative income for the first year of operations resulting from the two alternative financing choices is illustrated below.

DEBT versus EQUITY Comparative Income for Two Financing Alternatives

Income before interest and taxes Less: Interest Income before taxes Less: Income taxes Net Income

Alternative 1 $5,000,000 -05,000,000 (1,250,000)** $3,750,000

Alternative 2 $5,000,000 (1,600,000)* 3,400,000 (850,000)** $2,550,000

* 8% × $20,000,000. ** 25% × Income before taxes. Requirement 2 Alternative 1 is expected to generate a higher net income. There is no interest expense because there is no debt financing.

Requirement 3 Return on shareholders‘ investment is expected to be higher for Alternative 2.

(Net income ÷ investment)

$3,750,000

$2,550,000 = 8.5%

= 7.5% $50,000,000

$30,000,000

Alternative 2 generated a higher return for each dollar invested by shareholders. This was made possible because the corporation was able to generate income on borrowed funds at a higher rate than the cost of the debt. This represents financial leverage.

Requirement 4 Alternative 2 results in a riskier capital structure. The debt in Alternative 2 requires fixed payments of interest and principal to be made. The company's income before interest and income taxes could drop to zero under Alternative 1 and the company would still be solvent (i.e., able to pay its debts). Under Alternative 2, however, if income before interest and taxes drops below the 7–288 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition required interest payments of $1,600,000, the company could become insolvent and eventually go bankrupt.

Analysis Case 3–9 Requirement 1 Yes. The balance sheet includes: Current assets; Property and equipment, Operating lease assets; Other noncurrent assets; and liability classifications: Current liabilities; Long-term debt and other borrowings; Noncurrent operating lease liabilities; Deferred income taxes; and Other noncurrent liabilities.

Requirement 2 No. The company does not have any investments (other than cash equivalents) that are expected to be converted to cash in the next year or operating cycle.

Requirement 3 Accrued and other current liabilities. This account includes wages and benefits, gift card liability, taxes payable, dividends payable, rent accruals, and interest payable that are expected to be paid within the next year.

Requirement 4 Straight-line.

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Analysis Case 3–10 1. Business 2. (a) Medical Devices, (b) Medical Devices, (c) Diagnostics. 3. Established Pharmaceuticals 4. 64.3% [= 1 – ($11,398/$31,904)] 5. China

Communication Case 3–11 IBM manufactures and sells personal and mainframe computers. The computers included as current assets in the balance sheet for the company represent the cost of inventory available for sale. In addition, IBM uses computers in its operations. The cost of these computers is included in the property, plant, and equipment category in the balance sheet. Investments in equity securities could be classified as either current or long-term assets depending on the intent of management. If management intends to sell the securities in one year from the balance sheet date (or operating cycle, if longer), they are classified as current assets. If management intends to hold the securities beyond that time period, they are classified as long-term assets.

Communication Case 3–12 The critical Question that student groups should address is whether the cost of the egg-producing flock should be classified as inventory or as property, plant, and equipment. There is no right or wrong answer. The process of developing the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole. Solutions should address the following issues:

1. The definitions of inventory and property, plant, and equipment. The definition of inventory according to GAAP [FASB ASC Master Glossary] is ―goods awaiting sale, goods in the course of production, and goods to be consumed directly in production.‖ The chickens certainly represent goods awaiting sale, since they will eventually be sold to soup companies. However, they also represent property, plant, and equipment, since they are used in the production of product—the eggs.

2. The definition of a current asset. GAAP [FASB ASC Master Glossary and FASB ASC 210–10–45–1 through 4: ―Balance Sheet–Overall–Other Presentation Matters–General–Classification of Current Assets‖] provides the following definition of a current asset:

―Current assets is used to designate cash and other assets or resources commonly identified as those which are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.‖ GAAP [FASB ASC 210–10–45–3] also states that a one-year time period is to be used where there are several operating cycles occurring within a year. In this case, it could be argued that the operating cycle is two years, since the chickens are not sold until after the laying life and, therefore, the cost of the flock should be classified as a current asset. However, if the chickens are considered productive assets, then the concept of an operating cycle is not relevant. According to this argument, the chickens should be classified as a long-term asset, that is, a producing asset, and not a saleable asset. It appears that the primary benefits of the chickens come from the sale of eggs, not the sale of the chickens themselves.

3. Regardless of the classification of the cost of the chickens, the cost capitalized when the chickens begin to lay eggs must be depreciated down to an estimated salvage value at the end of the egg-laying life. This is necessary to properly match expenses with revenues. (Industry practice is to classify the costs of the egg-producing flock as inventory in the current asset section of the balance sheet, but to depreciate the inventory down to estimated salvage value.) It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group 7–292 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction.

Communication Case 3–13 The objectives of this case are to motivate students to obtain hands-on familiarity with an actual annual report and to apply the techniques learned in the chapter. You may wish to provide students with multiple copies of the same annual reports and compare responses. Another approach is to divide the class into teams who evaluate reports from a group perspective.

Ethics Case 3–14 Discussion should include these elements.

Facts: The impact of following the controller's suggestions would be to obscure financial information by aggregating the financial data of geographic operations and investments. Aggregation of data potentially hides the risks associated with North African operations where political instability is especially high. Aggregation also conceals how much profit the company generates in a zero-tax country (tax haven). GAAP suggests that reportable segments are those for whom financial data are available and whose results are regularly reviewed by company management in assessing performance. The data for Libya, Egypt, France, and Cayman Islands are available and most likely reviewed for performance purposes by the controller and higher management levels.

Ethical Dilemma: Should you, as staff accountant, challenge the controller's combination of geographic areas or follow the controller's suggestion to obscure financial information by aggregating the financial data?

Who is affected? You, as a staff accountant Controller and other managers Other employees Shareholders Potential shareholders Creditors Financial analysts Auditors Tax authorities Who benefits and who is injured: Company management may benefit from aggregating the data by attracting more investors to their company and obtaining more loans from creditors than would be the case with more complete disclosure regarding the operations in Libya and Egypt. Injured parties include current and future investors and creditors with economic, social, and political concerns. Investors potentially benefit through additional tax savings by the company structuring transactions through the Cayman Islands. However, when a company does not pay its ―fair‖ share of taxes in France and the United States, some feel that those countries and their citizens are at a disadvantage. Those countries, their social programs, and the welfare of their citizens would have benefited from those additional tax dollars.

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Target Case ($ in millions) Requirement 1 Consolidated Statements of Financial Position. Requirement 2 a. $ 12,902. b. $29,877. c. $ 42,779. d. $ 14,487. e. $ 16,459. f. $30,946. g. $ 11,833. Requirement 3 Inventory; Accounts payable. Requirement 4 Current ratio = $12,902/$14,487 = 0.89. Debt ratio = $30,946/$11,833 = 2.62. Requirement 5 Target‘s current ratio is less than the industry average, and this indicates worse liquidity compared to the industry. Target‘s debt ratio is more than the industry average, and this indicates worse solvency compared to the industry.

Air France–KLM Case (€ in millions) Requirement 1 a. Assets are listed before liabilities and equity. b. Liabilities are listed after equity. c. Current assets are listed after long-term assets. d. Current liabilities are listed after long-term liabilities.

Requirement 2 a. €8,539. b. €22,196. c. €30,735. d. €12,649. e. €15,787. f. €28,436. g. €2,299. Requirement 3 Cash; Deferred revenue. Requirement 4 Current ratio = €8,539/€12,649 = 0.68. Debt ratio = €28,436/€2,299 = 12.37. Requirement 5 AF‘s current ratio is less than the industry average, and this indicates worse liquidity compared to the industry. AF‘s debt ratio is more than the industry average, and this indicates worse solvency compared to the industry.

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Chapter 4 The Income Statement, Comprehensive Income, and the Statement of Cash Flows

QUESTIONS FOR REVIEW OF KEY TOPICS

Question 4– 298 The income statement is a change statement that reports transactions—revenues, expenses, gains, and losses—that cause owners‘ equity to change during a specified reporting period.

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Question 4–2 Income from continuing operations includes the revenue, expense, gain, and loss transactions that are more likely to continue in future periods. It is important to segregate the income effects of these items because they are the most important transactions in terms of predicting future cash flows.

Question 4– 300 Operating income includes revenues and expenses and gains and losses that are directly related to the principal revenue generating activities of the company. Nonoperating income includes items that are not directly related to these activities.

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Question 4–4 The single-step format first lists all revenues and gains included in income from continuing operations to arrive at total revenues and gains. All expenses and losses are then grouped and subtotaled, subtracted from revenues and gains to arrive at income from continuing operations. The multiple-step format reports a series (multiple) of intermediate totals such as gross profit, operating income, and income before taxes. Very often income statements adopt variations of these formats, falling somewhere in between the two extremes.

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Question 4–5 The term earnings quality refers to the ability of reported earnings (income) to predict a company‘s future earnings. After all, an income statement simply reports on events that already have occurred. The relevance of any historical-based financial statement hinges on its predictive value.

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Question 4–6 Restructuring costs include costs associated with shutdown or relocation of facilities or downsizing of operations. They are reported as an operating expense in the income statement.

Question 4–5 The process of intraperiod tax allocation separately reports tax expense or tax benefit with income from continuing operations and with income from discontinued operations. Just as income from discontinued operations, by definition, won‘t continue to future periods, neither will the tax consequences associated with those operations continue. By allocating the portion of taxes between continuing and discontinued operations, investors and others can better predict a company‘s future after-tax performance.

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Question 4–8 The net-of-tax income effects of a discontinued operation must be disclosed separately in the income statement, below income from continuing operations. The income effects include income (loss) from operations and gain (loss) on disposal. The gain or loss on disposal must be disclosed either on the face of the statement or in a disclosure note. If the component is held for sale but not sold by the end of the reporting period, the income effects will include income (loss) from operations and an impairment loss if the fair value less costs to sell is less than the book value of the component‘s assets. The income (loss) from operations of the component is reported separately in discontinued operations on prior income statements presented for comparative purposes.

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Question 4–9 A change in accounting principle refers to a change from one acceptable accounting method to another. The various approaches chosen by the FASB to require implementation by companies include: 1. Retrospective approach. The new standard is applied to all periods presented in the financial statements. That is, we restate prior period financial statements as if the new accounting method had been used in those prior periods. We revise the balance of each account affected to make those statements appear as if the newly adopted accounting method had been applied all along. 2. Modified retrospective approach. The new standard is applied to the adoption period only. Prior period financial statements are not restated. The cumulative effect of the change on prior periods' net income is shown as an adjustment to the beginning balance of retained earnings in the adoption period. 3. Prospective approach. This approach requires neither a modification of prior period financial statements nor an adjustment to account balances. Instead, the change is simply implemented in the current period and all future periods.

Question 4–10 A change in accounting estimate is accounted for in the year of the change and in subsequent periods; prior years‘ financial statements are not restated. A disclosure note should justify that the change is preferable and should describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported.

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Question 4– 312 Prior period adjustments are accounted for by restating prior years‘ financial statements when those statements are presented again for comparison purposes. The beginning of period retained earnings is increased or decreased on the statement of shareholders‘ equity as of the beginning of the earliest period presented.

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Question 4–12 Earnings per share (EPS) is the amount of income achieved during a period for each share of common stock outstanding. If there are different components of income reported below continuing operations, their effects on earnings per share must be disclosed. If a period contains discontinued operations, EPS data must be reported separately for income from continuing operations, discontinued operations, and net income.

Question 4– 314 Comprehensive income is the total change in equity for a reporting period other than from transactions with owners. Reporting comprehensive income can be accomplished with a continuous statement of comprehensive income that includes an income statement and other comprehensive income items or in two statements, an income statement and a separate statement of comprehensive income.

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Question 4–14 The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise during a period. Similar to the income statement, it is a change statement, summarizing the transactions that caused cash to change during a particular period of time.

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Question 4–15 The three categories of cash flows reported on the statement of cash flows are:

1. Operating activities—Inflows and outflows of cash related to the transactions entering into the determination of net income from operations. 2. Investing activities—Involve the acquisition and sale of (1) long-term assets used in the business and (2) nonoperating investment assets. 3. Financing activities—Involve cash inflows and outflows from transactions with creditors (excluding trade payables) and owners.

Question 4–16 Noncash investing and financing activities are transactions that do not increase or decrease cash but are important investing and financing activities. An example would be the acquisition of property, plant, and equipment (an investing activity) by issuing either long-term debt or equity securities (a financing activity) to the seller. These activities are reported either on the face of the statement of cash flows or in a disclosure note.

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Question 4–17 The direct method of reporting cash flows from operating activities presents the cash effect of each operating activity directly in the statement of cash flows. The indirect method of reporting cash flows from operating activities is derived indirectly, by starting with reported net income and adding and subtracting items to convert that amount to a cash basis.

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Question 4–18 U.S. GAAP designates cash outflows for interest payments and cash inflows from interest and dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows. IFRS allows more flexibility. Companies can report interest and dividends paid as either operating or financing cash flows and interest and dividends received as either operating or investing cash flows. Interest and dividend payments usually are reported as financing activities. Interest and dividends received normally are classified as investing activities.

Question 4–19

Receivables turnover ratio

Net sales Average accounts receivable (net)

Inventory turnover ratio

Cost of goods sold Average inventory

Asset turnover ratio

Net sales Average total assets

Activity ratios are designed to provide information about a company‘s effectiveness in managing assets. Activity or turnover of certain assets measures the frequency with which those assets are replaced. The greater the number of times an asset turns over, the less cash a company must devote to that asset, and the more cash it can commit to other purposes.

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Question 4–20

Profit margin on sales

Net income Net sales

Return on assets

Net income Average total assets

Return on equity

Net income Average shareholders' equity

A fundamental element of an analyst‘s task is to develop an understanding of a firm‘s profitability. Profitability ratios provide information about a company‘s ability to earn an adequate return relative to sales or resources devoted to operations. Resources devoted to operations can be defined as total assets or only those assets provided by owners, depending on the evaluation objective.

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Question 4–21 Return on equity

Profit margin

Asset turnover

Equity multiplier

Net income Avg. total equity

Net income Total sales

Total sales Avg. total assets

Avg. total assets Avg. total equity

The DuPont framework shows return on equity as being driven by profit margin (reflecting a company‘s ability to earn income from sales), asset turnover (reflecting a company‘s effectiveness in using assets to generate sales), and the equity multiplier (reflecting the extent to which a company has used debt to finance its assets).

Answers to Questions (concluded)

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Question 4–22 Current interim reporting requirements and existing practice generally view interim reports as integral parts of annual statements. However, the discrete approach is applied to some items. Most revenues and expenses are recognized in interim periods as they are provided or incurred. However, if an expenditure clearly benefits more than just the period in which it is incurred, the expense should be spread among the periods benefited. Examples include annual repair expenses, property tax expense, and advertising expenses incurred in one quarter that clearly benefit later quarters. These are assigned to each quarter through the use of accruals and deferrals. On the other hand, major events such as discontinued operations and unusual items should be reported separately in the interim period in which they occur.

Question 4–23 U.S. GAAP views interim reports as an integral part of the annual report, so amounts that affect multiple interim periods are accrued or deferred and then charged to each of the periods they affect. IFRS takes much more of a discrete-period approach than does U.S. GAAP, such that costs for repairs, property taxes, advertising, etc., that do not meet the definition of an asset at the end of an interim period are expensed entirely in the period in which they occur.

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BRIEF EXERCISES Brief Exercise 4–1

PACIFIC SCIENTIFIC CORPORATION Income Statement For the Year Ended December 31, 2024 ($ in millions)

Revenues and gains: Sales revenue ................................................... Gain on sale of investments ............................. Total revenues and gains .............................. Expenses and losses: Cost of goods sold ........................................... Selling expense ................................................ General and administrative expense ................. Interest expense ................................................ Total expenses and losses ............................. Income before income taxes ............................... Income tax expense* .......................................... Net income .........................................................

$2,106 45 2,151

$1,240 126 105 40 1,511 640 160 $ 480

* $640 × 25% = $160

Brief Exercise 4–2 (a)

Sales revenue Less: Cost of goods sold Gross profit Less: Selling expense General and administrative expense Operating income

$2,106 (1,240) 866 (126) (105) $ 635

(b)

Gain on sale of investments Interest expense Nonoperating income

$45 (40) $5

Brief Exercise 4–3

PACIFIC SCIENTIFIC CORPORATION Income Statement For the Year Ended December 31, 2024 ($ in millions)

Sales revenue ..................................................... Cost of goods sold .............................................. Gross profit ........................................................ Operating expenses: Selling expense ................................................ General and administrative expense ................. Total operating expenses .............................. Operating income ............................................... Other income (expense): Gain on sale of investments ............................. Interest expense ............................................... Total other income, net ................................ Income before income taxes ............................... Income tax expense* .......................................... Net income .........................................................

$2,106 1,240 866

$126 105 231 635

45 (40) 5 640 160 $ 480

*$640 × 25%

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Brief Exercise 4–4 (a)

Sales revenue Less: Cost of goods sold General and administrative expense Restructuring costs Selling expense Operating income

$300,000 (160,000) (40,000) (50,000) (25,000) $ 25,000

(b)

Operating income Add: Interest revenue Deduct: Loss on sale of investments Income before income taxes

$25,000 4,000 (22,000) $ 7,000

Income before income taxes Income tax expense (25%) Net income

$ 7,000 (1,750) $ 5,250

(c)

Brief Exercise 4–5

WHITE AND SONS, INC. Partial Income Statement For the Year Ended December 31, 2024 Income from continuing operations before income taxes ... Income tax expense* ......................................................... Income from continuing operations ................................... Loss on discontinued operations (net of $100,000 tax benefit)........................................................................... Net income ........................................................................ Earnings per share: Income from continuing operations.................................... Loss on discontinued operations ....................................... Net income ........................................................................

$ 800,000 200,000 600,000 (300,000) $ 300,000

$ 6.00 (3.00) $ 3.00

*$800,000 × 25% Note: Restructuring costs, interest revenue, and loss on sale of investments are included in income from continuing operations before income taxes.

Brief Exercise 4–6

REVOLUTIONARY INDUSTRIES Partial Income Statement For the Year Ended December 31, 2024 Income from continuing operations before income taxes ... $ 12,000,000 Income tax expense* ............................................................. 3,000,000 7–332 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition Income from continuing operations ................................... Discontinued operations: Income from operations of discontinued component (including gain on disposal of $2,000,000)** ......................... Income tax expense*** ................................................... Income from discontinued operations ............................... Net income ........................................................................

$ 9,000,000

6,000,000 1,500,000 4,500,000 $ 13,500,000

* $12,000,000 × 25% ** Income from operations of discontinued component, before tax: Income from operations Gain on sale of assets Income from operations of discontinued component, before tax

$ 4,000,000 2,000,000 ($9 million less $7 million)

$ 6,000,000

*** $6,000,000 × 25%

Brief Exercise 4–7

CALIFORNIA MICROTECH CORPORATION Partial Income Statement For the Year Ended December 31, 2024 Income from continuing operations before income taxes ... Income tax expense* ......................................................... Income from continuing operations ................................... Discontinued operations: Loss from operations of discontinued component (including gain on disposal of $2,000,000)** ......................... Income tax benefit***..................................................... Loss on discontinued operations ....................................... Net income ........................................................................

$ 5,800,000 1,450,000 $ 4,350,000

(1,600,000) 400,000 (1,200,000) $ 3,150,000

* $5,800,000 × 25% ** Loss from operations of discontinued component, before tax: Loss from operations Gain on sale of assets Loss from operations of discontinued component, before tax

$(3,600,000) 2,000,000 ($10 million less $8 million)

$(1,600,000)

*** $1,600,000 × 25%

Brief Exercise 4–8

CALIFORNIA MICROTECH CORPORATION Partial Income Statement For the Year Ended December 31, 2024 Income from continuing operations before income taxes ... Income tax expense* ......................................................... Income from continuing operations ................................... Discontinued operations: Loss from operations of discontinued component** ....... Income tax benefit***..................................................... Loss on discontinued operations ....................................... Net income ........................................................................

$ 5,800,000 1,450,000 $ 4,350,000 (3,600,000) 900,000 (2,700,000) $ 1,650,000

* $5,800,000 × 25% ** Includes only the loss from operations. There is no impairment loss because the fair value of segment assets ($10 million) is greater than their book value ($8 million). *** $3,600,000 × 25%

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Brief Exercise 4–9

CALIFORNIA MICROTECH CORPORATION Partial Income Statement For the Year Ended December 31, 2024 Income from continuing operations before income taxes ... Income tax expense* ......................................................... Income from continuing operations ................................... Discontinued operations: Loss from operations of discontinued component (including impairment loss of $1,000,000) ** ......................... Income tax benefit*** .................................................... Loss on discontinued operations ....................................... Net income ........................................................................

$ 5,800,000 1,450,000 $ 4,350,000

(4,600,000) 1,150,000 (3,450,000) $ 900,000

* $5,800,000 × 25% ** Loss from operations of discontinued component: Loss from operations Impairment loss ($8 million book value less $7 million net fair value) Loss from operations of discontinued component, before tax

$(3,600,000) $(1,000,000)

$(4,600,000)

*** $4,600,000 × 25%

Brief Exercise 4–10

ATLANTIC BEVERAGE COMPANY Statement of Comprehensive Income For the Year Ended December 31, 2024 Net income ......................................................... Other comprehensive income, net of tax: Loss on derivatives ......................................... Gain on debt securities .................................... Total other comprehensive income (loss) .... Comprehensive income ......................................

$650,000 $(45,000)* 30,000 ** (15,000) $635,000

* $60,000 – ($60,000 × 25%) ** $40,000 – ($40,000 × 25%)

Brief Exercise 4–11 Cash flows from operating activities: Cash received from customers Cash received for interest Cash paid for interest Cash paid for operating expenses Net cash flows from operating activities

$ 660,000 12,000 (18,000) (440,000) $214,000

Only these four cash flow transactions relate to operating activities. The others are investing and financing activities.

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Brief Exercise 4–12 Cash flows from investing activities: Collection of notes receivable Sale of land Purchase of equipment Net cash flows from investing activities

$100,000 40,000 (120,000)

Cash flows from financing activities: Issuance of common stock Dividends paid to shareholders Net cash flows from financing activities

$200,000 (30,000)

$20,000

$170,000

Brief Exercise 4–13 Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation expense Changes in operating assets and liabilities: Increase in prepaid rent Increase in salaries payable Increase in income taxes payable Net cash inflows from operating activities

$45,000 80,000 (60,000) 15,000 12,000 $92,000

Brief Exercise 4–14 Under IFRS, interest received and interest paid usually are classified as investing and financing cash flows, respectively, not operating cash flows as with U.S. GAAP. The revised cash flow categories usually would appear as follows:

Cash flows from operating activities: Cash received from customers Cash paid for operating expenses Net cash flows from operating activities

$ 660,000 (440,000) $220,000

Cash flows from investing activities: Collection of notes receivable Sale of land Interest on notes receivable Purchase of equipment Net cash flows from investing activities

$100,000 40,000 12,000 (120,000)

Cash flows from financing activities: Issuance of common stock Dividends paid to shareholders Interest on notes payable Net cash flows from financing activities

$200,000 (30,000) (18,000)

$32,000

$152,000

Brief Exercise 4–15 Receivables turnover ratio

Net sales Average accounts receivable (net)

Receivables turnover ratio

$600,000 [$100,000 + 120,000] ÷ 2

5.45 times

Inventory turnover ratio

Cost of goods sold Average inventory

Inventory turnover ratio

$400,000* [$80,000 + 60,000] ÷ 2

5.71 times

*$600,000 – $200,000

Brief Exercise 4–16

Complete Solution Manual for Intermediate Accounting, 11th Edition Profit margin

Return on assets

Return on equity

Net income Net sales

$65,000 $420,000

15.48%

Net income Average total assets

$65,000 $800,000

8.125%

Net income Average shareholders‘ equity

$65,000 $522,500*

12.44%

Shareholders‘ equity, beginning of period Add: Net income Deduct: Dividends Shareholders‘ equity, end of period

$500,000 65,000 (20,000) $545,000

*Average shareholders‘ equity = ($500,000 + $545,000)  2 = $522,500

Brief Exercise 4–17 Return on

Profit

Asset turnover

× Equity multiplier

equity

margin

Net income Avg. total equity

= Net income Net sales

Return on equity

Net income Average shareholders‘ equity

$65,000 $522,500

12.44%

Net income Net sales

$65,000 $420,000

Profit margin

Asset turnover

Net sales Avg. total assets

15.48%

Net sales Average total assets

$420,000 $800,000

0.525 times

Avg. total assets Avg. total equity

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Equity multiplier

Average total assets Average shareholders‘ equity

$800,000 $522,500

1.53

Check: ROE = 15.48% profit margin × 0.525 asset turnover × 1.53 equity multiplier = 12.43% (difference due to rounding)

Brief Exercise 4–18 Inventory turnover ratio = Cost of goods sold  Average inventory 6.0 = ×  $75,000 Cost of goods sold Net sales $600,000

= $75,000 × 6.0 = $450,000

– Cost of goods sold = Gross profit – $450,000 = $150,000

EXERCISES Exercise 4–1 Operating revenues: Sales revenue

$12,500,000

Total operating revenues Less operating expenses: Cost of goods sold Selling expense General and administrative expense Research and development expense

$12,500,000 $6,200,000 620,000 1,520,000 1,200,000

Total operating expenses Operating income

9,540,000 $2,960,000

Note: Interest revenue, loss on sale of investments, and interest expense are all nonoperating items and would be reported in the income statement as ―Other income (expense)‖ below operating income. Income tax expense is a line item in the income statement shown after nonoperating income (expense).

Exercise 4–2 Requirement 1

GREEN STAR CORPORATION Income Statement For the Year Ended December 31, 2024 Revenues and gains: Sales revenue ................................................... Interest revenue ............................................... Gain on sale of investments .............................

$1,300,000 30,000 50,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Total revenues and gains .............................. Expenses and losses: Cost of goods sold ........................................... Selling expense ................................................ General and administrative expense ................. Interest expense ................................................ Total expenses and losses ............................. Income before income taxes ............................... Income tax expense ............................................ Net income .........................................................

1,380,000

$720,000 160,000 75,000 40,000 995,000 385,000 130,000 $ 255,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 4–2 (concluded) Requirement 2

GREEN STAR CORPORATION Income Statement For the Year Ended December 31, 2024 Sales revenue ..................................................... Cost of goods sold .............................................. Gross profit ........................................................ Operating expenses: Selling expense ................................................ General and administrative expense ................. Total operating expenses .............................. Operating income ............................................... Other income (expense): Interest revenue ............................................... Gain on sale of investments ............................. Interest expense ............................................... Total other income, net ................................ Income before income taxes ............................... Income tax expense ............................................ Net income .........................................................

$1,300,000 720,000 580,000

$160,000 75,000 235,000 345,000

30,000 50,000 (40,000) 40,000 385,000 130,000 $ 255,000

Exercise 4–3 Requirement 1

GENERAL LIGHTING CORPORATION Income Statement For the Year Ended December 31, 2024 Revenues and gains: Sales revenue.................................................... Interest revenue ................................................ Total revenues and gains .............................. Expenses and losses: Cost of goods sold ........................................... Selling expense ................................................ General and administrative expense ................. Interest expense ................................................ Loss on sale of investments ............................. Loss on inventory write-down .......................... Total expenses and losses ............................. Income before income taxes ............................... Income tax expense * ......................................... Net income .........................................................

$2,350,000 80,000 2,430,000

$1,200,300 300,000 150,000 90,000 22,500 200,000 1,962,800 467,200 116,800 $ 350,400

* $467,200 × 25%

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 4–3 (concluded) Requirement 2 GENERAL LIGHTING CORPORATION Income Statement For the Year Ended December 31, 2024 Sales revenue ..................................................... Cost of goods sold .............................................. Gross profit ........................................................ Operating expenses: Selling expense ................................................ General and administrative expense ................ Loss on inventory write-down .......................... Total operating expenses .............................. Operating income ............................................... Other income (expense): Interest revenue ............................................... Loss on sale of investments ............................. Interest expense ............................................... Total other income, net ................................ Income before income taxes ............................... Income tax expense *.......................................... Net income .........................................................

$2,350,000 1,200,300 1,149,700

$300,000 150,000 200,000 650,000 499,700

80,000 (22,500) (90,000) (32,500) 467,200 116,800 $350,400

* $467,200 × 25%

Exercise 4–4 LINDOR CORPORATION Statement of Comprehensive Income Solutions Manual, Chapter 7 7–347 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

For the Year Ended December 31, 2024 Sales revenue ..................................................... Cost of goods sold .............................................. Gross profit ........................................................

$2,300,000 1,400,000 900,000

Operating expenses: Selling and administrative expense................... Operating income ...............................................

420,000 480,000

Other income (expense): Interest expense ................................................. Income before income taxes................................ Income tax expense*........................................... Net income Other comprehensive income, net of tax: Gain on debt securities** .................................... Comprehensive income ......................................

(40,000) 440,000 110,000 330,000 60,000 $ 390,000

* $440,000 × 25% ** $80,000 – ($80,000 × 25%)

Exercise 4–5

AXEL CORPORATION Income Statement For the Year Ended December 31, 2024 Sales revenue ..................................................... Cost of goods sold .............................................. Gross profit ........................................................

$ 592,000 325,000 267,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Operating expenses: Selling expense ................................................ Administrative expense ................................... Restructuring costs .......................................... Total operating expenses .............................. Operating income ............................................... Other income (expense): Interest revenue ............................................... Interest expense ............................................... Gain on sale of investments ............................ Total other income, net ............................... Income before income taxes................................ Income tax expense* .......................................... Net income .........................................................

$67,000 87,000 55,000 209,000 58,000

32,000 (16,000) 86,000 102,000 160,000 40,000 $120,000

* $160,000 × 25%

Exercise 4–6

CHANCE COMPANY Partial Income Statement For the Year Ended December 31, 2024 Income from continuing operations ................................... Discontinued operations: Loss from operations of discontinued component (including loss on disposal of $400,000) * .............................. Income tax benefit**....................................................... Loss on discontinued operations ....................................... Net income ........................................................................

$ 550,000

(520,000) 130,000 (390,000) $ 160,000

Earnings per share: Income from continuing operations ................................... Loss on discontinued operations ....................................... Net income ........................................................................

$ 5.50 (3.90) $ 1.60

* Loss from operations of discontinued component, before tax: Loss from operations Loss on sale of assets Loss from operations of discontinued component, before tax

$(120,000) (400,000) ($600,000 less $1 million)

$(520,000)

** $520,000 × 25%

Exercise 4–7

ESQUIRE COMIC BOOK COMPANY Partial Income Statement For the Year Ended December 31, 2024 Income from continuing operations* .................................. Discontinued operations: Income from operations of discontinued component (including loss on disposal of $340,000)** ............................. Income tax expense*** ................................................... Income on discontinued operations .................................... Net income..........................................................................

$690,000

160,000 40,000 120,000 $810,000

* Income from continuing operations: Income before considering additional items

$1,000,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Decrease in income due to restructuring costs Income from continuing operations before income taxes Income tax expense (25%) Income from continuing operations

(80,000) 920,000 (230,000) $ 690,000

** Income from operations of discontinued component, before tax: Income from operations Loss on sale of assets Income from operations of discontinued component, before tax

$ 500,000 (340,000) $ 160,000

*** $160,000 × 25%

Exercise 4–8 Requirement 1 KANDON ENTERPRISES, INC. Partial Income Statement For the Year Ended December 31, 2024 Income from continuing operations ................................... Discontinued operations: Loss from operations of discontinued component (including impairment loss of $40,000)* .............................. Income tax benefit** ....................................................... Loss on discontinued operations ....................................... Net income ........................................................................

$ 400,000

(180,000) 45,000 (135,000) $ 265,000

* Loss from operations of discontinued component, before tax: Loss from operations Impairment loss ($240,000 – $200,000) Loss from operations of discontinued component, before tax

$(140,000) (40,000) $(180,000)

** $180,000 × 25%

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 4–8 (concluded) Requirement 2 KANDON ENTERPRISES, INC. Partial Income Statement For the Year Ended December 31, 2024 Income from continuing operations ................................... Discontinued operations: Loss from operations of discontinued component*.......... Income tax benefit** ....................................................... Loss on discontinued operations ....................................... Net income ........................................................................

$ 400,000 (140,000) 35,000 (105,000) $ 295,000

*Includes only the operating loss during the year. There is no impairment loss. ** $140,000 × 25%

Exercise 4–9 Pretax income from continuing operations Income tax expense Income from continuing operations Less: Net income Loss from discontinued operations

$14,000,000 (3,500,000) 10,500,000 7,200,000 $ 3,300,000

$3,300,000  75%* = $4,400,000 = Pretax loss from discontinued operations. *1 – tax rate of 25% = 75% Pretax income of division Add: Pretax loss from discontinued operations Impairment loss

$4,000,000 4,400,000 $8,400,000

Fair value of division‘s assets

$11,000,000

Add: Impairment loss Book value of division‘s assets

8,400,000 $19,400,000

Exercise 4–10 Earnings per share: Income from continuing operations Loss on discontinued operations Net income

$5.00 (1.60) $3.40

Exercise 4–11

THE MASSOUD CONSULTING GROUP Statement of Comprehensive Income For the Year Ended December 31, 2024 Net income ......................................................... Other comprehensive income, net of tax: Foreign currency translation adjustment* ........ Loss on debt securities** ................................. Total other comprehensive income ............... Comprehensive income ......................................

$1,354,000 $180,000 (60,000) 120,000 $1,474,000

* $240,000 – ($240,000 × 25%) ** $80,000 – ($80,000 × 25%)

Exercise 4–12 1. 2. 3. 4.

b a a c

Purchase of equipment for cash. Payment of employee salaries. Collection of cash from customers. Cash proceeds from notes payable.

Complete Solution Manual for Intermediate Accounting, 11th Edition 5. 6. 7. 8. 9. 10. 11.

b c_ b a_ d c_ c_

Purchase of common stock of another corporation for cash. Issuance of common stock for cash. Sale of equipment for cash. Payment of interest on notes payable. Issuance of bonds payable in exchange for land and building. Payment of cash dividends to shareholders. Payment of principal on notes payable.

Exercise 4–13 Bluebonnet Bakers Statement of Cash Flows For the Year Ended December 31, 2024 Cash flows from operating activities: Cash received from customers $ 380,000 Cash received for interest 6,000 Cash paid for merchandise (160,000) Cash paid for interest (5,000) Cash paid for salaries (90,000) Net cash flows from operating activities Cash flows from investing activities: Collection of notes receivable Sale of investments Purchase of equipment Net cash flows from investing activities

$131,000

50,000 30,000 (85,000) (5,000)

Cash flows from financing activities: Issuance of notes payable 100,000 Payment of notes payable (25,000) Dividends paid to shareholders (20,000) Net cash flows from financing activities

55,000

Net increase in cash

181,000

Cash and cash equivalents, January 1

17,000

Cash and cash equivalents, December 31

$ 198,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 4–14 Cash collected for interest, considered an operating cash flow by U.S. GAAP, could be classified as either an operating cash flow or an investing cash flow according to International Financial Reporting Standards. Cash paid for interest, considered an operating cash flow by U.S. GAAP, could be classified as either an operating cash flow or a financing cash flow according to International Financing Reporting Standards. Cash collected for dividends, considered an operating cash flow by U.S. GAAP, could be classified as either an operating cash flow or an investing cash flow according to International Financial Reporting Standards. Accordingly, the statement of cash flows prepared according to IFRS could be the same as under U.S. GAAP (E4–13) or could be presented as follows:

BLUEBONNET BAKERS Statement of Cash Flows For the Year Ended December 31, 2024 Cash flows from operating activities: Cash received from customers $ 380,000 Cash paid for merchandise (160,000) Cash paid for salaries (90,000) Net cash flows from operating activities Cash flows from investing activities: Collection of notes receivable Interest on notes receivable Sale of investments Purchase of equipment Net cash flows from investing activities

50,000 6,000 30,000 (85,000)

Cash flows from financing activities: Issuance of notes payable Payment of notes payable Interest on notes payable Dividends paid to shareholders Net cash flows from financing activities

100,000 (25,000) (5,000) (20,000)

$130,000

1,000

50,000

Net increase in cash

181,000

Cash and cash equivalents, January 1

17,000

Cash and cash equivalents, December 31

$ 198,000

Exercise 4–358 Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation expense Changes in operating assets and liabilities: Increase in accounts receivable Decrease in inventory Decrease in prepaid insurance Decrease in salaries payable Increase in interest payable Net cash flows from operating activities

$17,300 7,800 (4,000) 5,500 1,200 (2,700) 800 $25,900

Exercise 4–16 Requirement 1 Operating 1. 2. 3. 4. 5. 6. 7. 8. 9.

Investing $(10,000)

Financing $300,000 

$(10,000)

$300,000

  $ (5,000) (6,000) (70,000) 55,000  $(26,000)

$264,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 4–16 (concluded) Requirement 2

WAINWRIGHT CORPORATION Statement of Cash Flows For the Month Ended March 31, 2024 Cash flows from operating activities: Cash received from customers Cash paid for rent Cash paid for insurance Cash paid for merchandise Net cash flows from operating activities

$ 55,000 (5,000) (6,000) (70,000)

Cash flows from investing activities: Purchase of equipment Net cash flows from investing activities

(10,000)

Cash flows from financing activities: Issuance of common stock Net cash flows from financing activities Net increase in cash Cash and cash equivalents, March 1 Cash and cash equivalents, March 31

$ (26,000)

(10,000)

300,000 300,000 264,000 40,000 $ 304,000

Noncash investing and financing activities: Acquired $40,000 of equipment by paying cash and issuing a note as follows: Cost of equipment $40,000 Cash paid 10,000 Note issued $30,000

Exercise 4–360 Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation and amortization expense Changes in operating assets and liabilities: Decrease in accounts receivable Increase in inventory Increase in prepaid expenses Increase in salaries payable Decrease in income taxes payable Net cash flows from operating activities

$624,000 87,000 22,000 (9,200) (8,500) 10,000 (14,000) $711,300

Exercise 4–18 Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation expense Changes in operating assets and liabilities: Increase in accounts receivable Decrease in inventory Decrease in prepaid expenses Decrease in salaries payable Increase in income taxes payable Net cash flows from operating activities

$1,250,000 140,000 (152,000) 108,000 62,000 (30,000) 44,000 $1,422,000

Exercise 4–19 Consistent with U.S. GAAP, international standards also require a statement of cash flows. Consistent with U.S. GAAP, cash flows are classified as operating, investing, or financing. However, the U.S. standard designates cash outflows for interest payments and cash inflows from

Complete Solution Manual for Intermediate Accounting, 11th Edition interest and dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows. IAS No. 7, on the other hand, allows more flexibility. Companies can report interest and dividends paid as either operating or financing cash flows and interest and dividends received as either operating or investing cash flows. Interest and dividend payments usually are reported as financing activities. Interest and dividends received normally are classified as investing activities.

Exercise 4–19 (concluded) Accordingly, the statement of cash flows prepared according to IFRS mostly likely would be presented as follows (differences from U.S. GAAP in italics):

BRONCO METALS Statement of Cash Flows For the Year Ended December 31, 2024 Cash flows from operating activities: Collections from customers Purchase of inventory Payment of operating expenses Net cash flows from operating activities Cash flows from investing activities: Interest on notes receivable Dividends received from investments Collection of notes receivable Purchase of equipment Net cash flows from investing activities

$ 353,000 (186,000) (67,000) $100,000

4,000 2,400 100,000 (154,000) (47,600)

Cash flows from financing activities: Payment of interest on notes payable (8,000) Issuance of common stock 200,000 Dividends paid to shareholders (40,000) Net cash flows from financing activities 152,000 Net increase in cash 204,400 Cash and cash equivalents, January 1 Cash and cash equivalents, December 31

28,600 $233,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Statement of Cash Flows For the Year Ended December 31, 2024 ($ in thousands)

Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation expense Changes in operating assets and liabilities: Decrease in accounts receivable Increase in inventory Increase in prepaid insurance Decrease in accounts payable Decrease in accrued liabilities Increase in income taxes payable Net cash flows from operating activities Cash flows from investing activities: Purchase of equipment Net cash flows from investing activities Cash flows from financing activities: Issuance of common stock Issuance of notes payable Dividends paid to shareholders (1) Net cash flows from financing activities Net increase in cash Cash, January 1 Cash, December 31

$ 900 240 80 (40) (30) (60) (100) 50 $1,040

(300) (300)

100 200 (940) (640) 100 200 $ 300

(1) Retained earnings, beginning + Net income – Dividends Retained earnings, ending

$540 900 ? $500

? = $940

Exercise 4–21 The T-account analysis of the transactions related to operating cash flows is shown below. To derive the cash flows, the beginning and ending balances in the related assets and liabilities are inserted, together with the revenue and expense amounts from the income statements. In each balance sheet account, the remaining (plug) figure is the other half of the cash increases or decreases. Cash Flows (Operating) (a.) 7,080 (b.) 130 (c.) 3,460 (d.) 1,900 (e.) 550 Sales Revenue

Accounts Receivable 1/1 830 (a.) 7,080 7,000 <-----------> 7,000 12/31 750

Prepaid Insurance 20 (b.) 130 100 < ---------- > 12/31 50

Insurance Expense

1/1

Accounts Payable (c.) 3,460 1/1

100

Inventory 360 1/1 600 3,400 <-----------> 3,400 12/31 300 12/31 640

3,360 <----------->

Cost of Goods Sold 3,360

Accrued liabilities General and admin. expense (d.) 1,900 1/1 400 1,800 <-----------> 1,800 12/31 300 Income Taxes Payable Income Tax Expense (e.) 550 1/1 150 600 <-----------> 600 12/31 200

Based on the information in the T-accounts above, the operating activities section of the SCF for Tiger Enterprises would be as shown next.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 4–21 (concluded) TIGER ENTERPRISES Statement of Cash Flows For the Year Ended December 31, 2024 ($ in thousands) Cash flows from operating activities: Cash received from customers (a) $ 7,080 Cash paid for insurance (b) (130) Cash paid for merchandise (c) (3,460) Cash paid for general and administrative exp. (d) (1,900) Cash paid for income taxes (e) (550) Net cash flows from operating activities

$ 1,040

Exercise 4–22 1. FASB ASC 260: ―Earnings Per Share.‖ 2. The specific citation that describes the additional information for earnings per share that must be included in the notes to the financial statements is FASB ASC 260–10–50–1: ―Earnings Per Share–Overall–Disclosure.‖

For each period for which an income statement is presented, an entity discloses all of the following: a. A reconciliation of the numerators and the denominators of the basic and diluted per-share computations for income from continuing operations. The reconciliation includes the individual income and share amount effects of all securities that affect earnings per share (EPS). Example 2 (see paragraph 260–10–55–51) illustrates that disclosure. (See paragraph 260–10–45–3.) An entity is encouraged to refer to pertinent information about securities included in the EPS computations that is provided elsewhere in the financial statements as prescribed by Subtopic 505-10. b. The effect that has been given to preferred dividends in arriving at income available to common stockholders in computing basic EPS. Solutions Manual, Chapter 7 7–365 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

c. Securities (including those issuable pursuant to contingent stock agreements) that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because to do so would have been antidilutive for the period(s) presented. Full disclosure of the terms and conditions of these securities is required even if a security is not included in diluted EPS in the current period.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 4–22 (concluded) 3. The specific eight-digit Codification citation (XXX-XX-XX-X) that requires disclosure of transactions affecting the number of common shares outstanding that occur after the most recent reporting period but before the financial statements are issued is FASB ASC 260–10–50–2: ―Earnings Per Share–Overall–Disclosure.‖ For the latest period for which an income statement is presented, an entity must provide a description of any transaction that occurs after the end of the most recent period but before issuance of the financial statements that would have changed materially the number of common shares or potential common shares outstanding at the end of the period if the transaction had occurred before the end of the period. Examples of those transactions include the issuance or acquisition of common shares; the issuance of warrants, options, or convertible securities; the resolution of a contingency pursuant to a contingent stock agreement; and the conversion or exercise of potential common shares outstanding at the end of the period into common shares.

Exercise 4–23 The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is:

The calculation of the weighted average number of shares for basic earnings per share purposes: FASB ASC 260–10–55–2: ―Earnings per Share–Overall–Implementation Guidance and Illustration–Computing a Weighted Average.‖ The weighted-average number of shares is an arithmetical mean average of shares outstanding and assumed to be outstanding for EPS computations. The most precise average would be the sum of the shares determined on a daily basis divided by the number of days in the period. Less-precise averaging methods may be used, however, as long as they produce reasonable results. Methods that introduce artificial weighting, such as the Rule of 78 method, are not acceptable for computing a weighted-average number of shares for EPS computations.

Exercise 4–23 (continued) 2.

The alternative formats permissible for reporting comprehensive income: FASB ASC 220–10–45–1: ―Comprehensive Income–Overall–Other Presentation Items– Reporting Comprehensive Income.‖

1A. An entity reporting comprehensive income in a single continuous financial statement shall present its components in two sections, net income and other comprehensive income. If applicable, an entity shall present the following in that financial statement: a. A total amount for net income together with the components that make up net income. b. A total amount for other comprehensive income together with the components that make up other comprehensive income. As indicated in paragraph 220–10–15–3, an entity that has no items of other comprehensive income in any period presented is not required to report comprehensive income. c. Total comprehensive income. 1B. An entity reporting comprehensive income in two separate but consecutive statements shall present the following: a. Components of and the total for net income in the statement of net income b. Components of and the total for other comprehensive income as well as a total for comprehensive income in the statement of other comprehensive income, which shall be presented immediately after the statement of net income. A reporting entity may begin the second statement with net income. 1C. An entity shall present, either in a single continuous statement of comprehensive income or in a statement of net income and statement of other comprehensive income, all items that meet the definition of comprehensive income for the period in which those items are recognized. Components 7–368 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition included in other comprehensive income shall be classified based on their nature.

Exercise 4–23 (concluded) 3.

The classifications of cash flows required in the statement of cash flows: FASB ASC 230–10–45–10: ―Statement of Cash Flows–Overall–Other Presentation Matters– Form and Content.‖ A statement of cash flows shall classify cash receipts and cash payments as resulting from investing, financing, or operating activities.

Complete Solution Manual for Intermediate Accounting, 11th Edition List A

List B

f 1. Intraperiod tax allocation g 2. Comprehensive income

a. An other comprehensive income item. b. Starts with net income and works backwards to convert to cash. c. Reports the cash effects of each operating activity directly on the statement. d. Correction of a material error of a prior period. e. Related to the external financing of the company. f. Associates tax with income statement item. g. Total nonowner change in equity. h. Related to the transactions entering into the determination of net income. i. Related to the acquisition and disposition of long-term assets. j. Required disclosure for publicly traded corporation. k. A component of an entity. l. Directly related to principal revenuegenerating activities.

a 3. Unrealized gain on debt securities l 4. Operating income k 5. A discontinued operation j

6. Earnings per share

d 7. Prior period adjustment e 8. Financing activities h 9. Operating activities (SCF) i 10. Investing activities c 11. Direct method b 12. Indirect method

Exercise 4–25 Requirement 1 Inventory turnover ratio

Cost of goods sold Average inventory

$1,840,000 [$690,000 + 630,000] ÷ 2

2.79 times

By itself, this one ratio provides very little information. In general, the higher the inventory turnover, the lower the investment must be for a given level of sales. It indicates how well inventory levels are managed and the quality of inventory, including the existence of obsolete or overpriced inventory. However, to evaluate the adequacy of this ratio it should be compared with some norm such as the industry average. That indicates whether inventory management practices are in line with the competition. It‘s just one piece in the puzzle, though. Other points of reference should be considered. For instance, a high turnover can be achieved by maintaining too low inventory levels and restocking only when absolutely necessary. This can be costly in terms of stockout costs. The ratio also can be useful when assessing the current ratio. The more liquid inventory is, the lower the norm should be against which the current ratio should be compared.

Exercise 4–26 Requirement 1 Turnover ratios for Anderson Medical Supply Company for 2024:

Inventory turnover ratio

Receivables turnover ratio

Average collection period

Asset turnover ratio

$4,800,000 [$900,000 + 700,000] ÷ 2

6 times

$8,000,000 [$700,000 + 500,000] ÷ 2

13.33 times

365 13.33

27.4 days

$8,000,000 [$4,300,000 + 3,700,000] ÷ 2

2 times

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 2 The company turns its inventory over 6 times per year compared to the industry average of 5 times per year. The asset turnover ratio also is slightly better than the industry average (2 times per year versus 1.8 times). These ratios indicate that Anderson is able to generate more sales per dollar invested in inventory and in total assets than the industry averages. However, Anderson takes slightly longer to collect its accounts receivable (27.4 days compared to the industry average of 25 days).

Exercise 4–27 Requirement 1 a. Profit margin on sales b. Return on assets c. Return on equity

$180 ÷ $5,200 = 3.5% $180 ÷ [($1,900 + 1,700) ÷ 2] = 10% $180 ÷ [($550 + 500) ÷ 2] = 34.3%

Requirement 2 Retained earnings beginning of period Add: Net income Less: Retained earnings end of period Dividends paid

$100,000 180,000 280,000 150,000 $130,000

Exercise 4–28 Requirement 1 a. Profit margin on sales b. Asset turnover c. Equity multiplier d. Return on equity

$180 ÷ $5,200 = 3.46% $5,200 ÷ [($1,900 + 1,700) ÷ 2] = 2.89 [($1,900 + 1,700) ÷ 2] ÷ [($550 + 500) ÷ 2] = 3.43 $180 ÷ [($550 + 500) ÷ 2] = 34.3%

Profit margin × Asset turnover × Equity multiplier = ROE 3.46% × 2.89 × 3.43 = 34.3%

Exercise 4–29 First Cumulative income before taxes $50,000 Estimated annual effective tax rate 22% 11,000 Less: Income tax reported earlier -0Tax expense to be reported $11,000

Quarter Second Third $90,000 $190,000 25% 24% 22,500 45,600 11,000 22,500 $11,500 $ 23,100

Exercise 4–30 Incentive compensation Depreciation expense Gain on sale

$300 million ÷ 4 = $75 million $60 million ÷ 4 = $15 million $23 million

Exercise 4–31 Quarters Ending March 31 June 30 Sept. 30 Advertising $200,000 $200,000 $200,000 Property tax 87,500 87,500 87,500 Equipment repairs 65,000 65,000 65,000 Research and development -096,000 0

Dec. 31 $200,000 87,500 65,000 0

Note: this solution assumes that advertising, property tax, and equipment repairs are viewed as benefitting all periods following the one in which the expenditure is made, but that the R&D consulting fee only benefits the periods in which it occurred.

Complete Solution Manual for Intermediate Accounting, 11th Edition March 31 Advertising $800,000 Property tax 350,000 Equipment repairs 260,000 Research and development -0-

June 30 $ -0-0-096,000

Sept. 30 $ -0-0-0-0-

Dec. 31 $ -0-0-0-0-

PROBLEMS Problem 4–1 REED COMPANY Comparative Income Statements For the Years Ended December 31 Sales revenue ....................................................... [1] Cost of goods sold ............................................... [2] Gross profit ........................................................

2024 $4,000,000 2,570,000 1,430,000

Operating expenses: Administrative expense ...................................... [3] Selling expense .................................................. [4] Loss on building (fire damage) .......................... Loss on inventory write-down ........................... Total operating expenses ............................... Operating income ...............................................

750,000 340,000 50,000 35,000 1,175,000 255,000

Other income (expense): Interest revenue ................................................. Interest expense ................................................. Total other income, net ................................. Income from continuing operations before income taxes .................................................. Income tax expense ............................................ Income from continuing operations...................... Discontinued operations: Income (loss) from operations of discontinued component (including loss on disposal of $48,000 in 2024) .............................................. Income tax benefit (expense)............................. Income (loss) on discontinued operations ............. [5] Net income ......................................................... Earnings per share: Income from continuing operations ........................... Discontinued operations ............................................ Net income ................................................................

[6] [7]

[8] [9]

2023 $3,000,000 1,680,000 1,320,000 635,000 282,000 --917,000 403,000

150,000 (200,000) (50,000)

140,000 (200,000) (60,000)

205,000 51,250 153,750

343,000 85,750 257,250

(8,000) 2,000 (6,000) $ 147,750

120,000 (30,000) 90,000 $ 347,250

$ 0.51 (0.02) $ 0.49

$ 0.86 0.30 $ 1.16

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 4–1 (concluded) [1]

$4,400,000 – 400,000 (sales from discontinued operation)

[2]

$2,860,000 – 290,000 (cost of goods sold from discontinued operations)

[3]

$800,000 – 50,000 (administrative expenses from discontinued operations)

[4]

$360,000 – 20,000 (selling expenses from discontinued operations)

[5] Loss in 2024: Income from operations Loss on sale of assets Loss before tax benefit Tax benefit (25% × $8,000) Loss on discontinued operations, net of tax benefit

$ 40,000 (48,000) (8,000) 2,000 $ (6,000)

[6]

$3,500,000 – 500,000 (sales from discontinued operation)

[7]

$2,000,000 – 320,000 (cost of goods sold from discontinued operations)

[8]

$675,000 – 40,000 (administrative expenses from discontinued operations)

[9]

$302,000 – 20,000 (selling expenses from discontinued operations)

Problem 4–2 Requirement 1 JACKSON HOLDING COMPANY Comparative Income Statements (in part) For the Years Ended December 31 2024 Income from continuing operations before income taxes [1] ........................................ $2,200,000 Income tax expense ........................................ 550,000 Income from continuing operations ................ 1,650,000 Discontinued operations:

2023 $700,000 175,000 525,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Income from operations of discontinued component (including gain on disposal of $600,000 in 2024) [2] ...................................... Income tax expense ...................................... Income from discontinued operations ............ Net Income ....................................................

1,000,000 (250,000) 750,000 $2,400,000

300,000 (75,000) 225,000 $750,000

[1]

Income from continuing operations before income taxes: 2024 2023 Unadjusted $2,600,000 $1,000,000 Less: Income from discontinued operations 400,000 300,000 Adjusted $2,200,000 $ 700,000 [2]

Income from discontinued operations:

Income from operations Gain on disposal Total

2024 $ 400,000 600,000 $1,000,000

2023 $300,000 $300,000

Problem 4–2 (concluded) Requirement 2 The 2024 income from discontinued operations would include only the income from operations of $400,000. Net of $100,000 income tax expense, the income from discontinued operations would be presented as $300,000. Since no impairment loss is indicated ($5,000,000 – 4,400,000 = $600,000 anticipated gain), none is included. The anticipated gain on disposal is not recognized until it is realized, presumably in the following year.

Requirement 3 The 2024 income from discontinued operations would include the income from operations of $400,000 as well as an impairment loss of $500,000 ($4,400,000 book value of assets less $3,900,000 fair value). The net amount to report would be a loss on discontinued operations of $100,000 ($400,000 income from operations less $500,000 impairment loss). Net of $25,000 income tax benefit, the loss from discontinued operations would be presented as $(75,000).

Problem 4–3 OLIVO CORPORATION Partial Income Statement For the Year Ended December 31, 2024 Income from continuing operations before income taxes .......................................... Income tax expense ................................... Income from continuing operations............ Discontinued operations: Loss from operations of discontinued component (including loss on disposal of $300,000) ............................................... Income tax benefit .................................. Loss on discontinued operations ............... Net income ................................................

[1] $1,300,000 325,000 975,000

$(140,000) 35,000 [2]

(105,000) $ 870,000

[1] Income from continuing operations before taxes: 7–380 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition Unadjusted Add: Gain from sale of factory Adjusted

$1,200,000 100,000 $1,300,000

[2] Loss on discontinued operations: Income from operations Deduct: Loss on sale of assets Loss before tax Tax benefit (25% × $140,000) Loss on discontinued operations

$ 160,000 (300,000) (140,000) 35,000 $(105,000)

Problem 4–4 1. Restructuring is an example of an event that is material and unusual. Restructuring costs should be included in income from continuing operations but reported on a separate line. The item is reported gross, not net of tax as with discontinued operations. 2. The income from the discontinued operation should be presented, net of tax, in the income statement below income from continuing operations. Also, earnings per share for income from continuing operations, for the income from the discontinued operation, and for net income should be disclosed.

3. The correction of the error should be treated as a prior period adjustment to beginning retained earnings, not as an adjustment to current year's cost of goods sold. In addition, the 2023 financial statements should be restated to reflect the correction, and a disclosure note is required that communicates the impact of the error on 2023 income.

Problem 4–5 ALEXIAN SYSTEMS, INC. Income Statement For the Year Ended December 31, 2024 ($ in millions except per share data) Sales revenue ................................................................ Cost of goods sold ......................................................... Gross profit ...................................................................

$425 [1] 235 190

Operating expenses: Selling and administrative expense ............................. Restructuring costs ..................................................... Total operating expenses .......................................... Operating income ..........................................................

[2] $128 26

Other income: Interest revenue .......................................................... Gain on sale of investments ........................................ Total other income ................................................... Income from continuing operations before income taxes ............................................................... Income tax expense ....................................................... Income from continuing operations ................................ Discontinued operations: Income from operations of discontinued component (including gain on disposal of $30) ....... Income tax expense ..................................................... Income on discontinued operations ................................ Net income .................................................................... Earnings per share: Income from continuing operations ................................ Discontinued operations ................................................ Net income ....................................................................

154 36

4 6 10 46 11.5 34.5

[3]

120 (30) 90 $124.5 $ 1.73 4.50 $ 6.23

[1] $245 – $10 (prior period adjustment) [2] $154 – $26 (restructuring costs) [3] 25% × $46 Note: The difference in net income of $7.5 million ($124.5 million compared to $117 million on the original income statement) is the effect of the inventory error of $10 million, less the 25% tax effect.

Problem 4–6 REMBRANDT PAINT COMPANY Income Statement For the Year Ended December 31, 2024 ($ in thousands, except per share amounts) Sales revenue ..................................................... Cost of goods sold ..............................................

$18,000 10,500

Complete Solution Manual for Intermediate Accounting, 11th Edition Gross profit ........................................................ Operating expenses: Selling and administrative expense ................. Restructuring costs .......................................... Operating income ............................................... Other income (expense): Interest revenue Interest expense Other income, net ........................................ Income from continuing operations before income taxes ................................................... Income tax expense ............................................ Income from continuing operations .................... Discontinued operations: Income from operations of discontinued component (including gain on disposal of $2,000) ......................................................... Income tax expense ......................................... Income on discontinued operations .................... Net income ......................................................... Earnings per share: Income from continuing operations .................... Income on discontinued operations .................... Net income .........................................................

7,500 $2,500 800

3,300 4,200

100 (300) (200) 4,000 1,000 3,000

400 (100) 300 $ 3,300

$6.00 0.60 $6.60

Problem 4–7 Requirement 1 SCHEMBRI MANUFACTURING CORPORATION Statement of Comprehensive Income For the Year Ended December 31, 2024 ($ in thousands) Sales revenue ............................................................... Cost of goods sold ........................................................ Gross profit .................................................................. Operating expenses: Selling expense ......................................................... General and administrative expense .......................... Restructuring costs .................................................... Total operating expenses ...................................... Operating income ......................................................... Other income (expense): Loss on sales of investments ........................................ Interest expense ............................................................ Interest revenue ............................................................ Other income, net ...................................................... Income from continuing operations before income taxes Income tax expense ...................................................... Income from continuing operations ............................. Discontinued operations: Income from operations of discontinued component (including gain on disposal of $1,400) ..................... Income tax expense ................................................... Income on discontinued operations .............................. Net income .................................................................. Other comprehensive income, net of tax: Gain on debt securities ..................................................... Foreign currency translation adjustment ................... Total other comprehensive income ....................... Comprehensive income ...............................................

$15,300 6,200 9,100 $1,300 800 1,200 3,300 5,800 (220) (180) 40 (360) 5,440 1,360 4,080

840 (210) 630 4,710 240 (180) 60 $ 4,770

Problem 4–7 (concluded)

Complete Solution Manual for Intermediate Accounting, 11th Edition Earnings per share:* Income from continuing operations Discontinued operations Net income

$3.40 0.53 $3.93

*Weighted-average shares = 1,000,000 + (400,000÷2) = 1,200,000

Note: The depreciation expense error is a prior period adjustment (to retained earnings) and is not reported in the income statement. Requirement 2 SCHEMBRI MANUFACTURING CORPORATION Statement of Comprehensive Income For the Year Ended December 31, 2024 ($ in 000s)

Net income .................................................................... Other comprehensive income, net of tax: Gain on debt securities ................................................. Foreign currency translation adjustment ...................... Total other comprehensive income .......................... Comprehensive income .................................................

$4,710 $240 (180) 60 $4,770

Problem 4–8 DUKE COMPANY Statement of Comprehensive Income For the Year Ended December 31, 2024 Sales revenue ............................................................... Cost of goods sold ........................................................ Gross profit .................................................................. Operating expenses: General and administrative expense .......................... Selling expense ........................................................ Restructuring costs .................................................... Loss on inventory write-down ................................... Total operating expenses ........................................ Operating income ......................................................... Other income (expense): Interest expense ........................................................ Income before income taxes.......................................... Income tax expense ...................................................... Net income ................................................................. Other comprehensive income, net of tax: Foreign currency translation adjustment……………… Gain on debt securities ............................................... Total other comprehensive income (loss) ............... Comprehensive income ................................................

$15,000,000 9,000,000 6,000,000

$1,000,000 500,000 300,000 400,000 2,200,000 3,800,000

(700,000) 3,100,000 775,000 2,325,000 (150,000) 135,000 (15,000) $ 2,310,000

Note: The depreciation expense error is a prior period adjustment and is not reported in the income statement.

Problem 4–9 Requirement 1 DIVERSIFIED PORTFOLIO CORPORATION Statement of Cash Flows For the Year Ended December 31, 2024 7–386 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition Cash flows from operating activities: Cash received from customers (1) Cash paid for operating expenses (2) Cash paid for income taxes (3) Net cash flows from operating activities

$880,000 (660,000) (55,000)

Cash flows from investing activities: Sale of investments Net cash flows from investing activities

50,000

Cash flows from financing activities: Issuance of common stock Dividends paid to shareholders Net cash flows from financing activities Increase in cash Cash and cash equivalents, January 1 Cash and cash equivalents, December 31

$165,000

50,000

100,000 (80,000) 20,000 235,000 70,000 $305,000

(1) $900,000 in service revenue less $20,000 increase in accounts receivable. (2) $700,000 in operating expenses less $30,000 in depreciation less $10,000 increase

in accounts payable. (3) $50,000 in income tax expense plus $5,000 decrease in income taxes payable.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 4–9 (concluded) Requirement 2 DIVERSIFIED PORTFOLIO CORPORATION Statement of Cash Flows For the Year Ended December 31, 2024 Cash flows from operating activities: Net income $150,000 Adjustments for noncash effects: Depreciation expense 30,000 Changes in operating assets and liabilities: Increase in accounts receivable (20,000) Increase in accrued liabilities 10,000 Decrease in income taxes payable (5,000) Net cash flows from operating activities $165,000

Problem 4–10 Requirement 1 2023 Cash: 2023 Cash + Net increase in cash = 2024 Cash 2023 Cash + $86 = $145 2023 Cash = $59 2024 A/R: 2023 A/R + Cr. Sales – Cash collections = 2024 A/R $84 + $80 – $71 = $93 2023 Inventory: 2023 A/P + Purchases – Cash paid = 2024 A/P $30 + Purchases – $30 = $40 Therefore, Purchases = $40 2023 Inventory + Purchases – 2024 Inventory = Cost of goods sold Solutions Manual, Chapter 7 7–389 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

2023 Inventory + $40 2023 Inventory = $52

–

$60

$32

2023 Accumulated depreciation: 2024 accumulated depreciation less 2024 depreciation = 2023 accumulated depreciation $65 – $10 = $55

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 4–10 (continued) 2023 Total assets: $59 + $84 + $52 + $50 + $150 – $55 = $340 2024 Total assets: $145 + $93 + $60 + $150 – $65 = $383 2023 Income taxes payable: 2023 Inc. taxes payable + Inc. tax expense – Income taxes paid = 2024 Inc. taxes payable 2023 Inc. taxes payable =2024 Inc. taxes payable + Taxes paid – Inc. tax expense 2023 Inc. taxes payable = $22 + $9 – $7 = $24 2024 Retained earnings: 2023 R/E + Net income – Dividends = 2024 R/E $47 + $28 – $3 = $72 2023 Total liabilities and shareholders’ equity: $30 + $9 + $24 + $230 + $47 = $340 2024 Total liabilities and shareholders’ equity: $40 + $9 + $22 + $240 + $72 = $383

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 4–10 (concluded) Requirement 2 GRANDVIEW CORPORATION Statement of Cash Flows For the Year Ended December 31, 2024 ($ in millions)

Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation expense Gain on sale of investments Changes in operating assets and liabilities: Increase in accounts receivable1 Increase in inventory2 Increase in accounts payable3 Decrease in income taxes payable4 Net cash flows from operating activities

1 2 3 4

$ 28 10 (15) (9) (8) 10 (2) $14

$93 – 84 $60 – 52 $40 – 30 $22 – 24

Problem 4–11 SANTANA INDUSTRIES Statement of Cash Flows For the Year Ended December 31, 2024 ($ in thousands) Cash flows from operating activities: Net income Adjustments for noncash effects:

$ 4,800

Complete Solution Manual for Intermediate Accounting, 11th Edition Depreciation expense Changes in operating assets and liabilities: Increase in accounts receivable Increase in inventory Decrease in prepaid rent Increase in accounts payable Increase in interest payable Increase in deferred revenue Decrease in income taxes payable Net cash flows from operating activities

1,600 (300) (1,000) 150 300 100 200 (250) $5,600

Cash flows from investing activities: Purchase of equipment Sale of equipment Net cash flows from investing activities

(4,000) 500

Cash flows from financing activities: Issuance of notes payable Dividends paid to shareholders Net cash flows from financing activities

5,000 (1,000)

(3,500)

4,000

Net increase in cash

6,100

Cash, January 1 Cash, December 31

2,200 $8,300

Problem 4–12 1. Inventory turnover ratio 2. Average days in inventory 3. Receivables turnover ratio 4. Average collection period 5. Asset turnover ratio 6. Profit margin on sales 7. Return on assets or:

$6,300 ÷ [($800 + 600) ÷ 2] = 9.0 365 ÷ 9.0 = 40.56 days $9,000 ÷ [($600 + 400) ÷ 2] = 18.0 365 ÷ 18.0 = 20.28 days $9,000 ÷ [($4,000 + 3,600) ÷ 2] = 2.37 $300 ÷ $9,000 = 3.33% $300 ÷ [($4,000 + 3,600) ÷ 2] = 7.89% 3.33% × 2.37 times = 7.89%

8. Return on equity $300 ÷ [($1,500 + 1,350) ÷ 2] = 21.1% 9. Equity multiplier [($4,000 + 3,600) ÷ 2] ÷ [($1,500 + 1,350) ÷ 2] = 2.67 10. Return on equity 3.33% × 2.37 × 2.67 = 21.1% (using the Dupont framework)

Problem 4–13 Requirement 1 =

Net sales Accounts receivable

J&J

$82,059 $14,481

= 5.67 times

Pfizer

$51,750 $8,724

= 5.93 times

Receivables turnover

Average collection period =

365 Receivables turnover

J&J

365 5.67

= 64 days

Pfizer

365 5.93

= 62 days

On average, Pfizer collects its receivables in 2 days less than J&J.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 4–13 (continued) Inventory turnover

Cost of goods sold Inventory

J&J

$27,556 $9,020

= 3.05 times

Pfizer

$10,219 $8,283

= 1.23 times

Average days in inventory =

365 Inventory turnover

J&J

365 3.05

= 120 days

Pfizer

365 1.23

= 297 days

On average, J&J sells its inventory more than twice as fast as Pfizer.

Requirement 2 Rate of return on assets

Net income Total assets

J&J

$15,119 $157,728

9.6%

Pfizer

$16,298 $167,489

9.7%

The return on assets indicates a company's overall profitability, ignoring specific sources of financing. In this regard, J&J‘s profitability is slightly less than that of Pfizer.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 4–13 (continued) Requirement 3 Profitability can be achieved by a high profit margin, high turnover, or a combination of the two. Rate of return on assets =Profit margin on sales Net income Net sales

J&J



Net sales Total assets

$15,119 $82,059



$82,059 $157,728

18.42%



0.520 times

= Pfizer

 Asset turnover

9.6% =

$16,298 $51,750



31.49%



$51,750 $167,489 0.309 times

9.7%

No, the combinations of profit margin and asset turnover are not similar. Pfizer‘s profit margin is higher than that of J&J, while J&J‘s turnover is higher than that of Pfizeras. These differences combine to produce similar return on assets.

Problem 4–13 (concluded) Requirement 4 Rate of return on equity

Net income Shareholders‘ equity

J&J

$15,119 $59,471

= 25.4%

Pfizer

$16,298 $63,447

= 25.7%

Pfizer provides a slightly higher return to shareholders.

Requirement 5 Equity multiplier = shareholders‘ equity

Total Assets Shareholders‘ equity

J&J

$157,728 $59,471

= 2.65

Pfizer

$167,489 $63,447

= 2.64

The two companies have virtually identical equity multipliers, indicating that they are using leverage to the same extent to earn a return on equity that is higher than their return on assets.

Problem 4–14

Complete Solution Manual for Intermediate Accounting, 11th Edition CADUX CANDY COMPANY Balance Sheet At December 31, 2024 Assets Current assets: Cash Accounts receivable (net) Inventory Total current assets Property, plant, and equipment (net) Total assets

$ 10 20 30 60 140 $200

Liabilities and Shareholders’ Equity Current liabilities Long-term liabilities Shareholders‘ equity Total liabilities and shareholders' equity

$ 30 70 100 $200

a. Times interest earned ratio = (Net income + Interest + Taxes) ÷ Interest = 17 (Net income + $2 + 12) ÷ $2 = 17 Net income + $14 = 17 × $2 Net income = $20 b. Return on assets = Net income ÷ Total assets = 10% Total assets = $20 ÷ 10% = $200 c. Profit margin on sales = Net income ÷ Net sales = 5% Net sales = $20 ÷ 5% = $400 d. Gross profit margin = Gross profit ÷ Net sales = 40% Gross profit = $400 × 40% = $160 Cost of goods sold = Net sales – Gross profit = $400 – 160 = $240 e. Inventory turnover ratio = Cost of goods sold ÷ Inventory = 8 Inventory = $240 ÷ 8 = $30 f. Receivables turnover ratio = Net sales ÷ Accounts receivable = 20 Accounts receivable = $400 ÷ 20 = $20

g. Current ratio = Current assets ÷ Current liabilities = 2.0 Acid-test ratio = Quick assets ÷ Current liabilities = 1.0 Current assets ÷ 2 = Current liabilities Quick assets ÷ 1 = Current liabilities Current assets ÷ 2 = Quick assets ÷ 1 Current assets = 2 × Quick assets Cash + Accts. rec. + Inventory = 2 × (Cash + Accounts receivable) Cash + $20 + 30 = (2 × Cash) + (2 × $20) Cash + $50 = Cash + Cash + $40 Cash = $10 h. Acid-test ratio = (Cash + Accounts receivable) ÷ Current liabilities = 1.0 Current liabilities = ($10 + 20) ÷ 1.0 = $30 i. Noncurrent assets = Total assets – Current assets = $200 – ($10 + 20 + 30) = $140 j. Return on equity = Net income ’ Shareholders‘ equity = 20% Shareholders‘ equity = $20 ’ 20% = $100 k. Debt to equity ratio = Total liabilities ’ Shareholders‘ equity = 1.0 Total liabilities = $100  1.0 = $100 Long-term liabilities = Total liabilities – Current liabilities = $100 – 30 = $70

Problem 4–15 Requirement 1 Net income Total assets

Rate of return on assets

Metropolitan

$ 593.8 = $4,021.5

14.8%

Republic

$ 424.6 = $4,008.0

10.6%

The return on assets indicates a company's overall profitability, ignoring specific sources of financing. In this regard, Metropolitan‘s profitability exceeds that of Republic. 7–402 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 2 Profitability can be achieved by a high profit margin, high turnover, or a combination of the two. Rate of return on assets

Metropolitan = = Republic = =

= Profit margin on sales

Asset turnover

= Net income Net sales

Net sales Total assets

$ 593.8 $5,698.0

$5,698.0 $4,021.5

10.421%

1.417 times =

$ 424.6 $7,768.2

$7,768.2 $4,008.0

5.466%

1.938 times =

14.8%

10.6%

Republic‘s profit margin is much less than that of Metropolitan, but partially makes up for it with a higher turnover.

Problem 4–15(continued) Requirement 3 Rate of return on equity

Net income Shareholders‘ equity

Metropolitan

$593.8 $144.9 + 2,476.9 – 904.7

= 34.6%

Republic

$424.6 $335.0 + 1,601.9 – 964.1

= 43.6%

Republic provides a greater return to common shareholders.

Requirement 4 Equity multiplier

Total assets Shareholders‘ equity

Metropolitan

$4,021.5 $144.9 + 2,476.9 – 904.7

= 2.34

Republic

$4,008.0 $335.0 + 1,601.9 – 964.1

= 4.12

When the return on equity is greater than the return on assets, management is using debt funds to enhance the earnings for stockholders. Both firms do this. Republic‘s higher leverage has been used to provide a higher return to shareholders than Metropolitan, even though its return on assets is less. Republic increased its return to shareholders 4.12 times (43.6% ÷ 10.6%) the return on assets. Metropolitan increased its return to shareholders 2.34 times (34.6% ÷ 14.8%) the return on assets.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 4–15 (continued) Requirement 5 Current ratio

Current assets Current liabilities

Metropolitan

$1,203.0 $1,280.2

= 0.94

Republic

$1,478.7 $1,787.1

= 0.83

Quick assets Current liabilities

Acid-test ratio

Metropolitan

$1,203.0 – 466.4 – 134.6 $1,280.2

= 0.47

Republic

$1,478.7 – 635.2 – 476.7 $1,787.1

= 0.21

The current ratios of the two firms are comparable and within the range of the rule-of-thumb standard of 1 to 1. The more robust acid-test ratio reveals that Metropolitan is more liquid than Republic.

Problem 4–15 (concluded) Requirement 6 Receivables turnover ratio

Net sales Accounts receivable

Metropolitan

$5,698.0 = 13.5 times $422.7

Republic

$7,768.2 = 23.9 times $325.0

Inventory turnover ratio

Cost of goods sold Inventory

Metropolitan

$2,909.0 = 6.2 times $466.4

Republic

$4,481.7 = 7.1 times $635.2

Republic‘s receivables turnover is more rapid than Metropolitan‘s, perhaps suggesting that its relative liquidity is not as bad as its acid-test ratio indicated.

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 7 Times interest earned ratio

Net income plus interest plus taxes Interest

Metropolitan

$593.8 + 56.8 + 394.7 $56.8

= 18.4 times

Republic

$424.6 + 46.6 + 276.1 $46.6

= 16.0 times

Both firms provide an adequate margin of safety.

Problem 4–16 Branson Electronics Company Income Statement Sales revenue Cost of goods sold Gross profit Advertising expense1 Other operating expenses2 Income before income taxes Income tax expense3 Net income

$180,000 35,000 145,000 (12,500) (57,000) 75,500 (18,875) $ 56,625

1$50,000 ÷ 4 = $12,500 2$48,000 + [59,000 – 50,000] 3$75,500 × 25%

DECISION MAKERS’ PERSPECTIVE CASES Analysis Case 4–1 Requirement 1 Multiple-step

Requirement 2 Income tax expense ÷ Income before taxes $3,473 ÷ $14,715 = 23.6% = Approximate income tax rate

Requirement 3 $11,242 ÷ $110,225 = 10.2%

Complete Solution Manual for Intermediate Accounting, 11th Edition

Research Case 4–2 1. The accounting standards topic number that addresses exit or disposal cost obligations is FASB ASC 420: ―Exit or Disposal Cost Obligations.‖ 2. The specific citation that addresses the initial measurement of these obligations is FASB ASC 420–10–30–1: ―Exit or Disposal Cost Obligations–Overall–Initial Measurement.‖ 3. A liability for a cost associated with an exit or disposal activity is measured initially at its fair value in the period in which the liability is incurred. 4. The specific citation that describes the disclosure requirements for exit or disposal obligations is FASB ASC 420–10–50–1: ―Exit or Disposal Cost Obligations–Overall–Disclosure.‖

5. All of the following information is disclosed in notes to financial statements that include the period in which an exit or disposal activity is initiated and any subsequent period until the activity is completed: a. A description of the exit or disposal activity, including the facts and circumstances leading to the expected activity and the expected completion date. b. For each major type of cost associated with the activity (for example, one-time employee termination benefits, contract termination costs, and other associated costs), both of the following are disclosed: 1. The total amount expected to be incurred in connection with the activity, the amount incurred in the period, and the cumulative amount incurred to date. 2. A reconciliation of the beginning and ending liability balances showing separately the changes during the period attributable to costs incurred and charged to expense, costs paid or otherwise settled, and any adjustments to the liability with an explanation of the reason(s) why. c. The line item(s) in the income statement in which the costs are aggregated. d. For each reportable segment, as defined in Subtopic 280-10, the total amount of costs expected to be incurred in connection with the activity, the amount Solutions Manual, Chapter 7 7–409 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

incurred in the period, and the cumulative amount incurred to date, net of any adjustments to the liability with an explanation of the reason(s) why. e. If a liability for a cost associated with the activity is not recognized because fair value cannot be reasonably estimated, that fact and the reasons why.

Judgment Case 4–3

Situation 1. 2. 3. 4. 5. 6. 7.

Treatment (a–g) a. b. e. f. a. d. c.

Financial Statement Presentation (CO, BC, or RE) CO RE CO CO CO BC RE

Judgment Case 4–4 1. The loss is not unusual. It is included in income from continuing operations along with other nonoperating items. 2. The sale of the financing component is treated as income from discontinued operation. The gain or loss from the sale of the assets along with income or loss generated by the component is presented below income from continuing operations. 3. A change in depreciation method is treated as a change in accounting estimate achieved by a change in accounting principle. Changes in estimates are accounted for prospectively and reported as part of income from continuing operations. The remaining book value is depreciated, using the new method, over the remaining useful life.

4. This event usually is either included in cost of goods sold or presented as a line item included in income from continuing operations. 5. The correction of an error is treated as a prior period adjustment. The effect of the correction is not reported in the income statement, but as an adjustment to retained earnings. Prior years‘ financial statements are restated to correct the error. 7–410 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition 6. This event requires no unusual treatment. The lipstick line does not qualify as a component of an entity requiring treatment as a discontinued operation. The loss on sale of the assets of the product line is included in income from continuing operations.

Judgment Case 4–5 Requirements 1 and 2 1. a. As a component of operating income. 2. b. As a nonoperating income item. 3. d. As an other comprehensive income item. 4. b. As a nonoperating income item. 5. c. As a discontinued operation. 6. a. As a component of operating income. 7. e. As an adjustment to retained earnings.

Net of tax No No Yes No Yes No Yes

Real Word Case 4–6 1. Non-GAAP earnings are typically higher. This is true for Cisco. 2. Share-based compensation expense 3. Non-GAAP is more likely to be used for internal budgeting 4. Significant asset impairments and restructurings

Integrating Case 4–7

Indicate which of the following are deficiencies in presentation of the statements (check all that apply):

The asset section of the balance sheet should be classified by separating current assets and long-term assets. X Accounts receivable should be shown net of the allowance for uncollectible accounts. Inventory should be shown as a long-term asset. X Investments should be split into their current ($57,000) and long-term ($21,000) amounts. A disclosure note should describe net adjustments to property and equipment for increases and decreases in fair value. X The liability and shareholders' equity section of the balance sheet should be classified into (1) current liabilities, (2) long-term liabilities, and (3) shareholders' equity. X Notes payable should be separated into its current ($140,000) and long-term ($60,000) amounts. Common stock and retained earnings should be combined into a single PaidIn Capital account. X For common stock, the number of shares authorized, issued, and outstanding should be disclosed. X Earnings per share disclosure is required in the income statement. The loss on discontinued operations should be excluded from the income statement. X Income tax expense is typically shown separate from other expenses with a preceding subtotal for income before taxes from continuing opertions.

Real World Case 4–8 a. The company uses the multiple-step format to present its income statements. b. Yes. $67.2 million. Restructuring costs include employee severance and termination benefits plus other costs associated with the shutdown or relocation of facilities or downsizing of operations. They are reported as a separate line in the income statement because of their unusual nature. This way of reporting, combined with note disclosure, provides financial statements users with information to help them decide if these costs are part of permanent earnings or if they are transitory. c. Yes. $31.6 million. An asset impairment occurs when an asset‘s value is impaired. 7–412 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition

d. $9.4 million. This amount includes interest income ($34.4) less interest expense ($17.6) and other expense ($7.4). e. Two consecutive statements. The company could have chosen to present the information in the two statements in a single, continuous statement of comprehensive income. f. The company reported the following other comprehensive income items: a. Foreign currency translation adjustments. b. Gains (losses) on cash flow hedges. c. Net gain (losses) on defined benefit plans. According to U.S. GAAP, additional other comprehensive income items include unrealized holding gains or losses on debt investments that are classified as available for sale. g. $369.5 million. This amount equals net income ($384.3) plus other comprehensive loss (−$14.8).

Analysis Case 4–9

Return on equity Shareholders‘ equity Debt to equity ratio Total liabilities Total assets

= Net income ’ Shareholders‘ equity = 14% = $21 million ÷ 14% = $150 million = Total liabilities ’ Shareholders‘ equity = 2 = $150 million × 2 = $300 million = Total liabilities + Shareholders‘ equity = $300 million + $150 million = $450 million

Integrating Case 4–10

Balance Sheet Assets Cash Accounts receivable (net) Inventory Prepaid expenses and other current assets Current assets Property, plant, and equipment (net) Liabilities and Shareholders’ Equity Accounts payable Short-term notes Current liabilities Bonds payable Shareholders‘ equity

$ 15,000 12,000 30,000 3,000 60,000 140,000 $200,000

given (e) (d) (i) (h) (j) (b)

$ 25,000 5,000 30,000 20,000 150,000 $200,000

(g) given (f) (l) (k) (b)

$300,000 (180,000) 120,000 (96,000) (2,000) (7,000) $ 15,000

(a) (c) (c) (o) (m) (n) given

Income Statement Net sales Cost of goods sold Gross profit Operating expenses Interest expense Income tax expense Net income

Complete Solution Manual for Intermediate Accounting, 11th Edition

Case 4–10 (concluded) Calculations ($ in 000s): a. Profit margin on sales = Net income ÷ Net sales = 5% Net sales = $15 ÷ 5% = $300 b. Return on assets = Net income ÷ Total assets = 7.5% Total assets = $15 ÷ 7.5% = $200 c. Gross profit margin = Gross profit ÷ Sales = 40% Gross profit = $300 × 40% = $120 Cost of goods sold = Net sales – Gross profit = $300 – 120 = $180 d. Inventory turnover ratio = Cost of goods sold ÷ Inventory = 6 Inventory = $180 ÷ 6 = $30 e. Receivables turnover ratio = Net sales ÷ Accounts receivable = 25 Accounts receivable = $300 ÷ 25 = $12 f. Acid-test ratio = Cash + AR + ST Investments ÷ Current liabilities = .9 Current liabilities = ($15 + 12 + 0) ÷ .9 = $30 g. Accounts payable = Current liabilities – Short-term notes = $30 – 5 = $25 h. Current ratio = Current assets ÷ Current liabilities = 2 Current assets = $30 × 2 = $60 i. Prepaid expenses and other current assets = Current assets – (Cash + AR + Inventory) = $60 – (15 + 12 + 30) = $3 j. Property, plant, and equipment = Total assets – Current assets = $200 – 60 = $140 k. Return on equity = Net income ’ Shareholders‘ equity =10% Shareholders‘ equity = $15 ’ 10% = $150 l. Debt to equity ratio = Total liabilities ’ Shareholders‘ equity = 1/3 Total liabilities = $150 × 1/3 = $50 Bonds payable = Total liabilities – Current liabilities = $50 – 30 = $20 m. Interest expense = 8% × (Short-term notes + Bonds ) Interest expense = 8% × ($5 + 20) = $2 n Times interest earned ratio = (Net income + Interest +Taxes) ÷ Interest = 12 Times interest earned ratio = ($15 + 2 + Taxes) ÷ 2 = 12 Times interest earned ratio = ($15 + 2 + Taxes) = $24 Tax expense = $24 – (15 + 2) = $7 o. Operating expenses = (Net sales – Cost of goods sold – Interest expense – Income tax expense) – Net income = ($300 – 180 – 2 – 7) – 15 = $96

Ethics Case 4–11 It would be nice to think that management makes all accounting choices in the best interest of fair and consistent financial reporting. Unfortunately, other motives influence the choices among accounting methods and whether to change methods. It has been suggested that the effect of choices on management compensation, on existing debt agreements, and on union negotiations each can affect management‘s selection of accounting methods.1 For instance, research has suggested that managers of companies with bonus plans are more likely to choose accounting methods that maximize their bonuses (often those that increase net income). 2 Other research has indicated that the existence and nature of debt agreements and other aspects of a firm‘s capital structure can influence accounting choices.3 Whether a company is forbidden from paying dividends if retained earnings fall below a certain level, for example, can affect the choice of accounting methods. Choices made are not always those that tend to increase income. As you will learn in Chapter 8, many companies use the LIFO inventory method because it reduces income and therefore reduces the amount of income taxes that must be paid currently. Also, some very large and visible companies might be reluctant to report high income that might render them vulnerable to union demands, government regulations, or higher taxes. 4

Communications Case 4–12 Answers to the Questions will, of course, vary because students will research financial statements of different companies. No specific standards dictate how income from continuing operations must be displayed, so companies have considerable latitude in how they present the components of income from continuing operations. This flexibility has resulted in a considerable variety of income statement presentations. However, we can identify two general approaches, the single-step and the multiplestep formats that might be considered the two extremes, with the income statements of most companies falling somewhere in between. The presentation of discontinued operations, however, is mandated, and students should be able to easily identify them.

1Watts, R.L., and J.L. Zimmerman, ―Towards a Positive Theory of the Determination of Accounting Standards,‖ The

Accounting Review, January 1978, and ―Positive Accounting Theory: A Ten Year Perspective,‖ The Accounting Review, January 1990. 2For example, see Healy, P.M., ―The Effect of Bonus Schemes on Accounting Decisions,‖ Journal of Accounting and Economics, April 1985, and Dhaliwal, D., G. Salamon, and E. Smith, ―The Effect of Owner Versus Management Control on the Choice of Accounting Methods,‖ Journal of Accounting and Economics, July 1982. 3Bowen, R.M., E.W. Noreen, and J.M. Lacy, ―Determinants of the Corporate Decision to Capitalize Interest,‖ Journal of Accounting and Economics,‖ August 1981. 4This ―political cost‖ motive is suggested by Watts, R.L.. and J.L. Zimmerman, ― ―Positive Accounting Theory: A TenYear Perspective,‖ The Accounting Review, January 1990, and Zmijewski, M., and R. Hagerman, ―An Income Strategy Approach to the Positive Theory of Accounting Standard Setting/Choice,‖ Journal of Accounting and Economics, August 1981. 7–416

Intermediate Accounting, 11/e

Complete Solution Manual for Intermediate Accounting, 11th Edition

Communications Case 4–13 Requirement 1 The term earnings quality refers to the ability of reported earnings (income) to predict a company‘s future earnings. After all, an income statement simply reports on events that already have occurred. The relevance of any historical-based financial statement hinges on its predictive value.

Requirement 2 To enhance predictive value, analysts try to separate a company‘s transitory earnings effects from its permanent earnings. Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future, or that are likely to have a different impact on earnings in the future.

Requirement 3 An often-debated contention is that, within GAAP, managers have the power, to a limited degree, to manipulate reported company income. And the manipulation is not always in the direction of higher income. Many believe that manipulating income reduces earnings quality because it can mask permanent earnings.

Requirement 4 You would consider the size of the gain in relation to net income, the size of the company‘s investment portfolio, and the frequency of gains and losses from the sale of investment securities in past years. The main objective is to determine the likelihood of this type of gain occurring again in the future.

Communications Case 4–14 This case encourages students to obtain hands-on familiarity with an actual annual report and library sources of industry data. They also must apply the techniques learned in the chapter. You may wish to provide students with multiple copies of the same annual reports and compare responses. Another approach is to divide the class into teams who evaluate reports from a group perspective.

Target Case ($ in millions) Requirement 1 Consolidated Statements of Operations. Requirement 2 a. $77,130. b. $54,864. c. $4,190. Solutions Manual, Chapter 7 7–417 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

d. $3,269. e. $3,281. Requirement 3 Yes. Pension and other benefit liabilities, and currency translation adjustment and cash flow hedges. Requirement 4 Indirect method, showing a reconciliation from net earnings to operating cash flows. Requirement 5 Operating cash flows from continuing operations ($7,099) are higher than net earnings from continuing operations ($3,269). The largest item in the reconciliation of the two amounts is depreciation and amortization, which is an expense that decreases net earnings but has no effect on operating cash flows. Requirement 6 The largest investing cash flow is the outflow from expenditures for property and equipment ($3,027). The largest financing cash flow is the outflow from reductions of long-term debt ($2,069).

Air France–KLM Case (€ in millions) Requirement 1 (a) €27,188 (b) €5,511 (c) €2,628 Requirement 2 €2,987. This amount is listed as an addition to net income under operating activities. Requirement 3 Interest expense is listed as cost of financial debt. Interest revenue is listed as income from cash and cash equivalents. Requirement 4 Interest paid and interest received are included under operating activities. Under IFRS, interest paid could also be included under financing, and interest received could be included under investing. 7–418 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 5 Dividends received are included under investing activities, and dividends paid are included under financing activities. Under IFRS, dividends received could be included under operating.

CHAPTER 5 TIME VALUE OF MONEY CONCEPTS QUESTIONS FOR REVIEW OF KEY TOPICS

Question 5– 420 Interest is the amount of money paid or received in excess of the amount borrowed or lent.

Complete Solution Manual for Intermediate Accounting, 11th Edition Question 5–2 Compound interest includes interest not only on the original invested amount but also on the accumulated interest from previous periods.

Question 5– 422 If interest is compounded more frequently than once a year, the effective rate or yield will be higher than the annual stated rate.

Complete Solution Manual for Intermediate Accounting, 11th Edition Question 5–4 The three items of information necessary to compute the future value of a single amount are the original invested amount, the interest rate (i), and the number of compounding periods (n).

Question 5– 424 The present value of a single amount is the amount of money today that is equivalent to a given amount to be received or paid in the future, after removing the time value of money.

Complete Solution Manual for Intermediate Accounting, 11th Edition Question 5–6 Monetary assets and monetary liabilities represent cash or fixed claims/commitments to receive/pay cash in the future and are valued at the present value of these fixed cash flows. All other assets and liabilities are nonmonetary.

Question 5– 426 An annuity is a series of cash flows received or paid in equal amounts over a period of time.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 5– 428 An ordinary annuity exists when the cash flows occur at the end of each period. In an annuity due the cash flows occur at the beginning of each period.

Complete Solution Manual for Intermediate Accounting, 11th Edition Question 5–9 Table 2 lists the present value of $1 factors for various time periods and interest rates. The factors in Table 4 are simply the summation of the individual PV of $1 factors from Table 2.

Question 5– 430 Present Value

? Today

End of Year 1

End of Year 2

End of Year 3

End of Year 4

$200

n = 4, i = 10%

Complete Solution Manual for Intermediate Accounting, 11th Edition Question 5–11 Present Value

End of Today Year 1

End of Year 2

End of Year 3

$200

End of Year 4

n = 4, i = 10%

Answers to Questions (concluded)

Complete Solution Manual for Intermediate Accounting, 11th Edition Question 5–12

A deferred annuity exists when the first cash flow occurs more than one period after the date the agreement begins.

Question 5–13

The formula for computing present value of an ordinary annuity incorporating the ordinary annuity factors from Table 4 is: PVA = Annuity amount x Ordinary annuity factor Solving for the annuity amount,

PVA Annuity amount = Ordinary annuity factor The annuity factor can be obtained from Table 4 at the intersection of the 8% column and 5 periods row.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 5–14 Annuity amount

$500 3.99271

Annuity amount

$125.23

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 5–15

Companies frequently acquire the use of assets by leasing rather than purchasing them. Leases usually require the payment of fixed amounts at regular intervals over the life of the lease. Certain leases are treated in a manner similar to an installment sale by the lessor and an installment purchase by the lessee. In other words, the lessor records a receivable and the lessee records a liability for the several installment payments. For the lessee, this requires that the leased asset and corresponding lease liability be valued at the present value of the lease payments.

Complete Solution Manual for Intermediate Accounting, 11th Edition

BRIEF EXERCISES Brief Exercise 5–1 You should choose the second investment opportunity. More rapid compounding has the effect of increasing the actual rate, which is called the effective rate, at which money grows per year. For the second opportunity, there are four, three-month periods paying interest at 2% (onequarter of the annual rate). $10,000 invested will grow to $10,824 ($10,000 x 1.0824*). The effective annual interest rate, often referred to as the annual yield, is 8.24% ($824 ÷ $10,000), compared to just 8% for the first opportunity.

* Future value of $1: n = 4, i = 2% (from Table 1)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 5–2 Investment Interest rate Compounding amount (a) $10,000 4% Annually (b) 10,000 6 Annually (c) 10,000 8 Annually a $10,000 × Future value of $1; n = 4; i = 4% b $10,000 × Future value of $1; n = 4; i = 6% c $10,000 × Future value of $1; n = 4; i = 8%

Period invested 4 years 4 years 4 years

Future Value $11,698.59 a 12,624.77 b 13,604.89 c

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 5–3 Investment Interest rate Compounding amount (a) $25,000 6% Annually (b) 25,000 6 Annually (c) 25,000 6 Annually a $25,000 × Future value of $1; n = 3; i = 6% b $25,000 × Future value of $1; n = 4; i = 6% c $25,000 × Future value of $1; n = 5; i = 6%

Period invested 3 years 4 years 5 years

Future Value $ 29,775.40 a 31,561.92 b 33,455.64 c

Brief Exercise 5–4 The husband will not have enough accumulated to take the trip. investment of $23,153 is $347 short of $23,500.

The future value of his

FV = $20,000 (1.15763* ) = $23,153 * Future value of $1: n = 3, i = 5% (from Table 1)

Brief Exercise 5–5 FV factor =

$26,600 = 1.33* $20,000

* Future value of $1: n = 3, i = ? (from Table 1, i = approximately 10%)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 5-6 Payment Interest rate Compounding amount (a) $50,000 5% Annually (b) 50,000 7 Annually (c) 50,000 9 Annually a $50,000 × Present value of $1; n = 3; i = 5% b $50,000 × Present value of $1; n = 3; i = 7% c $50,000 × Present value of $1; n = 3; i = 9%

Period due 3 years 3 years 3 years

+$50,000 Present payment Value today a $ 43,191.88 $ 93,191.88 40,814.89 b 90,814.89 38,609.17 c 88,609.17

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 5-7 Payment Interest amount rate Compounding (a) $250,000 7% Annually (b) 250,000 7 Annually (c) 250,000 7 Annually a $250,000 × Present value of $1; n = 2; i = 7% b $250,000 × Present value of $1; n = 3; i = 7% c $250,000 × Present value of $1; n = 4; i = 7%

Period due 2 years 3 years 4 years

Present Value $ 218,359.68 a 204,074.47 b 190,723.80 c

Brief Exercise 5–8 You would be willing to invest no more than $12,673 in this opportunity.

PV = $16,000 (0.79209* ) = $12,673 * Present value of $1: n = 4, i = 6% (from Table 2)

Brief Exercise 5–9 PV factor

= $13,200 = 0.825* $16,000

* Present value of $1: n = 4, i = ? (from Table 2, i = approximately 5%)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 5-10 Annuity Annual Interest Period Future value payment Rate compounded invested of annuity (a) $40,000 3% Annually 5 years $ 212,365.43 a (b) 40,000 6 Annually 5 years 225,483.72 b (c) 40,000 9 Annually 5 years 239,388.42 c a $40,000 × Future value of ordinary annuity; n = 5; i = 3% b $40,000 × Future value of ordinary annuity; n = 5; i = 6% c $40,000 × Future value of ordinary annuity; n = 5; i = 9%

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 5-11 Annuity Annual Interest Period payment Rate compounded invested (a) $3,000 8% Annually 2 years (b) 3,000 8 Annually 3 years (c) 3,000 8 Annually 4 years a $3,000 × Future value of ordinary annuity; n = 2; i = 8% b $3,000 × Future value of ordinary annuity; n = 3; i = 8% c $3,000 × Future value of ordinary annuity; n = 4; i = 8%

Future value of annuity $ 6,240.00 a 9,739.20 b 13,518.34 c

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 5–12 Interest is paid for 12 periods at 1% (one-quarter of the annual rate).

FVA

= $500 (12.6825* )

= $6,341

* Future value of an ordinary annuity of $1: n = 12, i = 1% (from Table 3)

Brief Exercise 5–13 Interest is paid for 12 periods at 1% (one-quarter of the annual rate).

FVAD

= $500 (12.8093* )

= $6,405

* Future value of an annuity due of $1: n = 12, i = 1% (from Table 5)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 5-14 Annuity Annual Interest Period Payment Rate compounded invested (a) $150,000 8% Annually 6 years (b) 150,000 10 Annually 6 years (c) 150,000 12 Annually 6 years a $150,000 × Present value of ordinary annuity; n = 6; i = 8% b $150,000 × Present value of ordinary annuity; n = 6; i = 10% c $150,000 × Present value of ordinary annuity; n = 6; i = 12%

Present value of annuity $ 693,431.95 a 653,289.10 b 616,711.10 c

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 5-15 Annuity Annual Interest Period Payment Rate compounded invested (a) $200,000 7% Annually 3 years (b) 200,000 7 Annually 4 years (c) 200,000 7 Annually 5 years a $200,000 × Present value of ordinary annuity; n = 3; i = 7% b $200,000 × Present value of ordinary annuity; n = 4; i = 7% c $200,000 × Present value of ordinary annuity; n = 5; i = 7%

Present value of annuity $ 524,863.21 a 677,442.25 b 820,039.49 c

Brief Exercise 5–16 PVA

= $10,000 (4.10020* )

= $41,002

* Present value of an ordinary annuity of $1: n =5, i = 7% (from Table 4)

The following time diagram depicts this situation: Today PVA

End of year 1 $10,000

End of year 2 $10,000

End of year 3 $10,000

End of year 4 $10,000

End of year 5 $10,000

End of year 6

$41,002

Brief Exercise 5–17 PVAD

= $10,000 (4.38721*)

= $43,872

* Present value of an annuity due of $1: n = 5, i = 7% (from Table 6)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 5–18 PVA = $10,000 x 4.10020* = $41,002 * Present value of an ordinary annuity of $1: n = 5, i = 7% (from Table 4) PV = $41,002 x 0.87344* = * Present value of $1: n = 2, i = 7% (from Table 2)

$35,813

This time diagram helps visualize the situation:

Today

End of year 1

PVA n=5 PV n=2

End of year 2

End of year 3 $10,000

End of year 4 $10,000

End of year 5 $10,000

End of year 6 $10,000

End of year 7 $10,000

End of year 6 $10,000

End of year 7 $10,000

$41,002 4.10020 $35,813 .87344

Or alternatively: PVAD = $10,000 x 4.38721* = $43,872 * Present value of an annuity due of $1: n = 5, i = 7% (from Table 4) PV = $43,872 x 0.81630* = * Present value of $1: n = 3, i = 7% (from Table 2)

$35,813

This time diagram helps visualize the situation:

Today

End of year 1

PVAD n=5 PV n=3

End of year 2

End of year 3 $10,000

End of year 4 $10,000

End of year 5 $10,000

$43,872 4.38721 $35,813 .81630

Brief Exercise 5–19 Annuity

$100,000

= $14,903 = Payment

6.71008* * Present value of an ordinary annuity of $1: n = 10, i = 8% (from Table 4)

Brief Exercise 5–20 PV = $6,000,0001 (12.40904* ) + $100,000,000 (0.13137** ) PV = $74,454,240 + $13,137,000 = $87,591,240 = price of the bonds 1

$100,000,000 x 6% = $6,000,000

* Present value of an ordinary annuity of $1: n = 30, i = 7% (from Table 4) ** Present value of $1: n = 30, i = 7% (from Table 2)

Brief Exercise 5–21 PVAD = $55,000 (7.24689* ) = $398,579 = Liability * Present value of an annuity due of $1: n = 10, i = 8% (from Table 6)

Complete Solution Manual for Intermediate Accounting, 11th Edition

EXERCISES Exercise 5–1 1. FV = $15,000 (2.01220* ) = $30,183 * Future value of $1: n = 12, i = 6% (from Table 1)

2. FV = $20,000 (2.15892* ) = $43,178 * Future value of $1: n = 10, i = 8% (from Table 1)

3. FV = $30,000 (9.64629* ) = $289,389 * Future value of $1: n = 20, i = 12% (from Table 1)

4. FV = $50,000 (1.60103* ) = $80,052 * Future value of $1: n = 12, i = 4% (from Table 1)

Exercise 5–2 Investment Interest amount rate Compounding Jerry $13,000 12% Quarterly Elaine 16,000 6 Semiannually George 23,000 8 Annually Kramer 19,000 10 Annually a $13,000 × Future value of $1; n = 24; i = 3% b $16,000 × Future value of $1; n = 12; i = 3% c $23,000 × Future value of $1; n = 6; i = 8% d $19,000 × Future value of $1; n = 6; i = 10%

Period invested 6 years 6 years 6 years 6 years

Future Value $26,426.32a 22,812.17b 36,498.11c 33,659.66d

George will have the greatest investment accumulation.

Exercise 5–3 Accumulated investment by retirement (age 65)

Person

Age

Initial investment

Alec

$11,000

$28,531.17a

Daniel

$11,000

$74,002.50b

William

$11,000

$191,943.42c

Stephen

$11,000

$497,851.81d

$11,000 × Future value of $1; n = 10; i = 10% $11,000 × Future value of $1; n = 20; i = 10% c $11,000 × Future value of $1; n = 30; i = 10% d $11,000 × Future value of $1; n = 40; i = 10% b

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 5–4 1. PV = $20,000 (0.50835* ) = $10,167 * Present value of $1: n = 10, i = 7% (from Table 2)

2. PV = $14,000 (0.39711* ) = $5,560 * Present value of $1: n = 12, i = 8% (from Table 2)

3. PV = $25,000 (0.10367* ) = $2,592 * Present value of $1: n = 20, i = 12% (from Table 2)

4. PV = $40,000 (0.46651* ) = $18,660 * Present value of $1: n = 8, i = 10% (from Table 2)

Exercise 5–5

Contract Discount amount rate Compounding Derek $600,000 9% Annually Isabel 640,000 9 Annually Meredith 500,000 9 Annually George 500,000 9 Annually a $600,000 × Present value of $1; n = 2; i = 9% b $640,000 × Present value of $1; n = 3; i = 9% c $500,000 × Present value of $1; n = 0; i = 9% d $500,000 × Present value of $1; n = 1; i = 9%

Period invested 2 years 3 years Today 1 year

Present Value $505,008.00a 494,197.43b 500,000.00c 458,715.60d

Derek is being paid the most in present value terms.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 5–6

Purchase Discount amount rate Compounding Store 1 $3,500 9% Annually Store 2 3,700 9 Annually a $3,500 × Present value of $1; n = 0; i = 9% b $3,700 × present value of $1; n = 1; i = 9%

Period due Today One year

Present Value $3,500.00a 3,394.50b

Complete Solution Manual for Intermediate Accounting, 11th Edition Ray and Rachel should buy their ovens from Store 2.

Exercise 5–7 1.

PV = $40,000 (0.62092* ) = $24,837

* Present value of $1: n = 5, i = 10% (from Table 2)

$36,289 $65,000

0.55829*

* Present value of $1: n = 10, i = ? (from Table 2, i = approximately 6%)

$15,884 $40,000

0.3971*

* Present value of $1: n = ?, i = 8% (from Table 2, n = approximately 12 years)

$46,651 = $100,000

0.46651*

* Present value of $1: n = 8, i = ? (from Table 2, i = approximately 10%)

FV = $15,376 (3.86968* ) = $59,500

* Future value of $1: n = 20, i = 7% (from Table 1)

Exercise 5–8 PV = $85,000 (0.82645* ) = $70,248 = Note/revenue * Present value of $1: n = 2, i = 10% (from Table 2)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 5–9

Present Total Payment value of present in one Discount payment in Payment value (or year rate Compounding one year today total cost)d a Option 1 $ 0 11% Annually $ 0 $150,000 $150,000.00 Option 2 82,500 11 Annually 74,324.32b 75,000 149,324.32 c Option 3 172,500 11 Annually 155,405.41 0 155,405.41 a $0 × Present value of $1; n = 1; i = 11% b $82,500 × present value of $1; n = 1; i = 11% c $172,500 × present value of $1; n = 1; i = 11% d Total present value (or total cost) = present value of payment in one year + payment today Option 2‘s cost has the lowest present value.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 5–10 List A e

1. Interest

m 2. Monetary asset j 3. Compound interest i 4. Simple interest k 5. Annuity l 6. Present value of a single amount c 7. Annuity due d 8. Future value of a single amount a 9. Ordinary annuity b 10. Effective rate or yield h 11. Nonmonetary asset g 12. Time value of money f 13. Monetary liability

List B a. First cash flow occurs one period after agreement begins. b. The rate at which money will actually grow during a year. c. First cash flow occurs on the first day of the agreement. d. The amount of money that a dollar will grow to. e. Amount of money paid/received in excess of amount borrowed/lent. f. Obligation to pay a sum of cash, the amount of which is fixed. g. Money can be invested today and grow to a larger amount. h. No fixed dollar amount attached. i. Computed by multiplying an invested amount by the interest rate. j. Interest calculated on invested amount plus accumulated interest. k. A series of equal-sized cash flows. l. Amount of money required today that is equivalent to a given future amount. m. Claim to receive a fixed amount of money.

Exercise 5– 474

Complete Solution Manual for Intermediate Accounting, 11th Edition

Annuity Annual Interest Period payment Rate compounded invested $2,000 13% Annually 30 years a $2,000 × Future value of annuity; n = 30; i = 13%

Future value of annuity $586,398.43a

Exercise 5–12 1.

FVA

= $200,000 (4.7793* )

= $955,900

* Future value of an ordinary annuity of $1: n = 4, i = 12% (from Table 3)

FVAD = $200,000 (5.3528* )

= $1,070,600

* Future value of an annuity due of $1: n = 4, i = 12% (from Table 5)

3. First deposit: Second deposit Third deposit Fourth deposit

Deposit $200,000 200,000 200,000 200,000 Total

x x x x

FV of $1 i=3% FV 1.60471 = $ 320,900 1.42576 = 285,200 1.26677 = 253,400 1.12551 = 225,100 $1,084,600

n 16 12 8 4

$200,000 x 4 = $800,000

Exercise 5– 476

Complete Solution Manual for Intermediate Accounting, 11th Edition

Annuity Annual Interest Period Payment Rate compounded invested Option 1 $35,000 12% Annually Today Option 2 4,000 12% Quarterly 3 years a $35,000 × Present value of annuity; n = 0; i = 12% b $4,000 × Present value of annuity; n = 12; i = 3%

Present value of annuity $35,000.00a 39,816.02b

Since the present value of payments ($39,816.02) is more than the cost today ($35,000), Denzel should choose option 1.

Exercise 5–14 1.

PVA

= $5,000 (3.60478* )

= $18,024

* Present value of an ordinary annuity of $1: n = 5, i = 12% (from Table 4)

PVAD = $5,000 (4.03735* )

= $20,187

* Present value of an annuity due of $1: n = 5, i =12% (from Table 6)

3. Payment

PV of $1 i = 3%

First payment:

$5,000

0.88849 =

$ 4,442

Second payment

5,000

0.78941 =

3,947

Third payment

5,000

0.70138 =

3,507

Fourth payment

5,000

0.62317 =

3,116

Fifth payment

5,000

0.55368 =

2,768

Total

$17,780

Exercise 5– 478 1. Choose the option with the highest present value. (1) PV = $64,000 (2) PV = $20,000 + $8,000 (4.91732* ) * Present value of an ordinary annuity of $1: n = 6, i = 6% (from Table 4)

PV = $20,000 + $39,339 = $59,339 (3) PV = $13,000 (4.91732* ) = $63,925 * Present value of an ordinary annuity of $1: n = 6, i = 6% (from Table 4)

Alex should choose option (1).

2. FVA = $100,000 (13.8164* ) = $1,381,640 * Future value of an ordinary annuity of $1: n = 10, i = 7% (from Table 3)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 5–16 PVA = $5,000 x 4.35526* = $21,776 * Present value of an ordinary annuity of $1: n = 6, i = 10% (from Table 4) PV = $21,776 x 0.82645* = $17,997 * Present value of $1: n = 2, i = 10% (from Table 2)

Or alternatively: From Table 4, PVA factor, n = 8, i = 10% – PVA factor, n = 2, i = 10%

= PV factor for deferred annuity PV

= =

5.33493 1.73554 =

3.59939

= $5,000 x 3.59939 = $17,997

Exercise 5– 480 Requirement 1 PV = $100,000 (0.68058* ) = $68,058 * Present value of $1: n = 5, i = 8% (from Table 2)

Requirement 2 Annuity amount = $100,000 5.8666* Annuity amount

= $17,046

* Future value of an ordinary annuity of $1: n = 5, i = 8% (from Table 3)

Requirement 3 Annuity amount = $100,000 6.3359* Annuity amount = $15,783 * Future value of an annuity due of $1: n = 5, i = 8% (from Table 5)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 5–18 1.

PVA = $3,000 (3.99271* ) = $11,978 * Present value of an ordinary annuity of $1: n = 5, i = 8% (from Table 4)

$242,980 = $75,000

3.23973*

* Present value of an ordinary annuity of $1: n = 4, i = ? (from Table 4, I = approximately 9%)

$161,214 = $20,000

8.0607*

* Present value of an ordinary annuity of $1: n = ?, i = 9% (from Table 4, n = approximately 15 years)

$500,000 = $80,518

6.20979*

* Present value of an ordinary annuity of $1: n = 8, i = ? (from Table 4, i = approximately 6%)

$250,000 = 3.16987*

$78,868

* Present value of an ordinary annuity of $1: n = 4, i = 10% (from Table 4)

Exercise 5–19 Annuity =

$12,000

= $734 = Payment

16.35143* * Present value of an ordinary annuity of $1: n = 20, i = 2% (from Table 4) 5 years x 4 quarters = 20 periods 8% ÷ 4 quarters = 2%

Exercise 5–20 PV

0.90573*

1,200

$1,200 = $1,325 0.90573* * Present value of $1: n = 5, i = 2% (from Table 2)

PVA =

14.99203*

$1,325

annuity amount

PVA =

$1,325

= 14.99203*

$88

Payment

* Present value of an ordinary annuity of $1: n = 18, i = 2% (from Table 4)

Exercise 5–21 To determine the price of the bonds, we calculate the present value of the 40-period annuity (40 semiannual interest payments of $12 million) and the lump-sum payment of $300 million paid at maturity using the semiannual market rate of interest of 5%. In equation form,

PV = $12,000,0001 (17.15909* ) + $300,000,000 (0.14205** ) PV = $205,909,080 + $42,615,000 = $248,524,080 = price of the bonds 1

$300,000,000 x 4 % = $12,000,000

* Present value of an ordinary annuity of $1: n = 40, i = 5% (from Table 4) ** Present value of $1: n = 40, i = 5% (from Table 2)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 5–22 Requirement 1 To determine the price of the bonds, we calculate the present value of the 30period annuity (30 semiannual interest payments of $6 million) and the lump-sum payment of $200 million paid at maturity using the semiannual market rate of interest of 2.5%. In equation form, PV = $6,000,0001 (20.93029* ) + $200,000,000 (0.47674) PV = $125,581,740 + $95,348,000 = $220,929,740 = price of the bonds 1

$200,000,000 x 3 % = $6,000,000

* Present value of an ordinary annuity of $1: n = 30, i = 2.5% (from Table 4) ** Present value of $1: n = 30, i = 2.5% (from Table 2)

Requirement 2 $220,929,740 x 2.5% = $5,523,244 Because the bonds were outstanding only for six months of the year, Single reports only one-half year‘s interest in 2024.

Exercise 5–23 Purchase price $20,000 – $5,000 down payment = $15,000 balance to pay in 30 months. Annuity = $15,000

÷ 22.39646* = $670 = Monthly payment

* Present value of an ordinary annuity of $1: n = 30, i = 2% (from Table 4)

Exercise 5–24 PVA factor = $100,000 = 7.46938* $13,388 * Present value of an ordinary annuity of $1: n = 20, i = ? (from Table 4, i = approximately 12%)

Exercise 5–25 Requirement 1 PVA = $400,000 (10.59401* ) = $4,237,604 = Liability * Present value of an ordinary annuity of $1: n = 20, i = 7% (from Table 4)

Requirement 2 PVAD = $400,000 (11.33560* ) = $4,534,240 = Liability * Present value of an annuity due of $1: n = 20, i = 7% (from Table 6)

Exercise 5–26 PVA factor = $2,293,984 = 11.46992* $200,000 * Present value of an ordinary annuity of $1: n = 20, i = ? (from Table 4, i = 6%)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 5–27 The Excel function is used to answer each Question.1. =-FV(.0725, 18, 0, 25000) = $88,123.44 2. = -PV(.085, 3, 0, 200000) = $156,581.62 3. =-FV(.0975/4, 4*4, 5000, 0, 0) = $96,428.45 4. = -PV(.065/12, 6*12, 800, 0, 0) = $47,590.92 5. =-FV(.045/2, 12*2, 20000, 0, 1) = $641,463.40 6. = -PV(.05/12, 3*12, 2500, 0, 1) = $83,761.81

PROBLEMS Problem 5–1 Choose the option with the lowest present value of cash outflows, net of the present value of any cash inflows (Cash outflows are shown as negative amounts; cash inflows as positive amounts).

Machine A: PV = – $48,000 – $1,000 (6.71008* ) + $5,000 (0.46319** ) * Present value of an ordinary annuity of $1: n = 10, i = 8% (from Table 4) ** Present value of $1: n = 10, i = 8% (from Table 2)

PV = – $48,000 – $6,710 + $2,316 PV = – $52,394

Machine B: PV = – $40,000 – $4,000 (0.79383) – $5,000 (0.63017) – $6,000 (0.54027) PV of $1: i = 8% (from Table 2)

n=3

n=6

n=8

PV = – $40,000 – $3,175 – $3,151 – $3,242 PV = – $49,568 Esquire should purchase machine B.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 5–2 1. PV = $10,000 + $8,000 (3.79079* ) = $40,326 = Equipment * Present value of an ordinary annuity of $1: n = 5, i = 10% (from Table 4)

2. $400,000 = Annuity amount x 5.9753* * Future value of an annuity due of $1: n = 5, i = 6% (from Table 5)

Annuity amount = $400,000 5.9753 Annuity amount = $66,942 = Required annual deposit

3. PVAD = $120,000 (9.36492* ) = $1,123,790 = Lease liability * Present value of an annuity due of $1: n = 20, i = 10% (from Table 6)

Problem 5–5 Choose the option with the lowest present value of cash payments. 1. PV = $1,000,000

2. PV = $420,000 + $80,000 (6.71008* ) = $956,806 * Present value of an ordinary annuity of $1: n = 10, i = 8% (from Table 4)

3. PV = PVAD = $135,000 (7.24689* ) = $978,330 * Present value of an annuity due of $1: n = 10, i = 8% (from Table 6)

4. PV = $1,500,000 (0.68058* ) = $1,020,870 * Present value of $1: n = 5, i = 8% (from Table 2)

Hard Hat should choose option 2.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 5–4 The restaurant should be purchased if the present value of the future cash flows discounted at a 10% rate is greater than $800,000. PV = $80,000 (4.35526* ) + $70,000 (0.51316**) + $60,000 (.46651**) n=7

n=8

+ $50,000 (0.42410**) + $40,000 (0.38554**) + $700,000 (0.38554**) n=9 *

n = 10

Present value of an ordinary annuity of $1: n = 6, i = 10% (from Table 4)

** Present value of $1: i = 10% (from Table 2)

PV = $718,838 < $800,000

Since the PV is less than $800,000, No, the restaurant should not be purchased.

Problem 5–5 The maximum amount that should be paid for the store is the present value of the estimated cash flows. Years 1–5: PVA = $70,000 x 3.99271* = $279,490 * Present value of an ordinary annuity of $1: n = 5, i = 8% (from Table 4) Years 6–10: PVA = $70,000 x 3.79079* = $265,355 * Present value of an ordinary annuity of $1: n = 5, i = 10% (from Table 4) PV = $265,355 x 0.68058* = * Present value of $1: n = 5, i = 8% (from Table 2)

$180,595

Years 11–20: PVA = $70,000 x 5.65022* = $395,515 * Present value of an ordinary annuity of $1: n = 10, i = 12% (from Table 4) PV = $395,515 x 0.62092* = * Present value of $1: n = 5, i = 10% (from Table 2)

$245,583

PV = $245,583 x 0.68058* = * Present value of $1: n = 5, i = 8% (from Table 2)

$167,139

End of Year 20: PV = $400,000 x 0.32197* x .62092 x 0.68058 = * Present value of $1: n = 10, i = 12% (from Table 2)

$54,424

Total PV = $279,490 + $180,595 + $167,139 + $54,424 = $681,648 The maximum purchase price is $681,648.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 5–6 1. PV of $1 factor = $30,000 = 0.5000* $60,000 * Present value of $1: n = ?, i = 8% (from Table 2, n = approximately 9 years)

2. Annuity factor =

PVA Annuity amount

Annuity factor = $28,700 = 4.1000* $7,000 * Present value of an ordinary annuity of $1: n = 5, i = ? (from Table 4, i = approximately 7%)

3. Annuity amount =

PVA Annuity factor

Annuity amount = $10,000 = 6.41766*

$1,558

Payment

* Present value of an ordinary annuity of $1: n = 10, i = 9% (from Table 4)

Problem 5– 492

Requirement 1 Present value of payments 4–6: PVA = $40,000 x 2.48685* = $99,474 * Present value of an ordinary annuity of $1: n = 3, i = 10% (from Table 4) PV = $99,474 x 0.75131* = * Present value $1: n = 3, i = 10% (from Table 2)

$74,736

Present value of all payments: $ 62,171

(PV of payments 1–3: $25,000

2.48685* )

74,736 (PV of payments 4–6 calculated above) $136,907 The note payable and corresponding building should be recorded at $136,907. Or alternatively:

PV = $25,000 (2.48685* ) + $40,000 (1.86841** ) = $136,907 * Present value of an ordinary annuity of $1: n = 3, i = 10% (from Table 4) From Table 4, PVA factor, n = 6, i = 10% – PVA factor, n = 3, i = 10%

= 4.35526 = 2.48685

= PV factor for deferred annuity

= 1.86841**

Requirement 2 $136,907 x 10% = $13,691 = Interest in 2024

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 5–8 Choose the alternative with the highest present value. Alternative 1: PV = $180,000 Alternative 2: PV = PVAD = $16,000 (11.33560* ) = $181,370 * Present value of an annuity due of $1: n = 20, i = 7% (from Table 6)

Alternative 3: PVAD factor, n = 10, i = 7%

= 7.51523

PVAD = $50,000 x 7.51523* = $375,762 * Present value of an annuity due of $1: n = 10, i = 7% (from PVAD of $1) PV = $375,762 x 0.50835* = * Present value of $1: n = 10, i = 7% (from PV of $1)

$191,019

Shuai should choose alternative 3. Or, alternatively (for 3):

PV = $50,000 (3.82037* )

From PVA of $1 (Table 4), PVA factor, n = 19, i = 7% – PVA factor, n = 9, i =7%

= 10.33560 = 6.51523

= PV factor for deferred annuity

$191,019

3.82037*

or, From PVAD of $1 (Table 6), PVAD factor, n = 20, i = 7% — PVAD factor, n = 10, i = 7%

= 11.33560 = 7.51523

= PV factor for deferred annuity

3.82037*

Problem 5– 494 PV = $20,000 (3.79079* ) + $100,000 (0.62092** ) = $137,908 * Present value of an ordinary annuity of $1: n = 5, i = 10% (from Table 4) ** Present value of $1: n = 5, i = 10% (from Table 2)

The note payable and corresponding merchandise should be recorded at $137,908.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 5–10 Requirement 1 Annuity amount =

PVA Annuity factor

Annuity amount = $250,000 = $78,868 = Payment 3.16987* * Present value of an ordinary annuity of $1: n = 4, i = 10% (from Table 4)

Requirement 2 Annuity amount =

PVA Annuity factor

Annuity amount = $250,000 = $62,614 = Payment 3.99271* * Present value of an ordinary annuity of $1: n = 5, i = 8% (from Table 4)

Requirement 3 Annuity factor =

PVA Annuity amount

Annuity factor = $250,000 = 4.86845* $51,351 * Present value of an ordinary annuity of $1: n = ?, i = 10% (from Table 4, n = approximately 7 payments)

Requirement 4 Annuity factor =

PVA Annuity amount

Annuity factor = $250,000 = 2.40184* $104,087 * Present value of an ordinary annuity of $1: n = 3, i = ? (from Table 4, i = approximately 12%)

Problem 5–11 Requirement 1 PVAD = Annuity amount x Annuity factor Solutions Manual, Chapter 7 7–495 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Annuity amount =

PVAD Annuity factor

Annuity amount = $800,000 7.24689* * Present value of an annuity due of $1: n = 10, i = 8% (from Table 6)

Annuity amount = $110,392 = Lease payment Requirement 2 Annuity amount = $800,000 6.71008* * Present value of an ordinary annuity of $1: n = 10, i = 8% (from Table 4)

Annuity amount = $119,224 = Lease payment Requirement 3 PVAD = (Annuity amount x Annuity factor) + PV of residual Annuity amount =

PVAD – PV of residual Annuity factor

PV of residual = $50,000

0.46319*

$23,160

* Present value of $1: n = 10, i = 8% (from Table 2)

Annuity amount = $800,000 – $23,160 7.24689* * Present value of an annuity due of $1: n = 10, i = 8% (from Table 6)

Annuity amount = $107,196 = Lease payment

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 5–12 Requirement 1 PVA = Annuity amount x Annuity factor Annuity amount =

PVA Annuity factor

Annuity amount = $800,000 7.36009* * Present value of an ordinary annuity of $1: n = 10, i = 6% (from Table 4)

Annuity amount = $108,694 = Lease payment Requirement 2 Annuity amount = $800,000 15.32380* * Present value of an annuity due of $1: n = 20, i = 3% (from Table 6)

Annuity amount = $52,206 = Lease payment Requirement 3 Annuity amount = $800,000 44.9550* * Present value of an ordinary annuity of $1: n = 60, i = 1% (given)

Annuity amount = $17,796 = Lease payment

Problem 5–13 Choose the option with the lowest present value of cash outflows, net of the present value of any cash inflows. (Cash outflows are shown as negative amounts; cash inflows as positive amounts)

1. Buy option: PV = – $160,000 – $5,000 (5.65022* ) + $10,000 (0.32197** ) * Present value of an ordinary annuity of $1: n = 10, i = 12% (from Table 4) ** Present value of $1: n = 10, i = 12% (from Table 2)

PV = – $160,000 – $28,251 + $3,220 PV = – $185,031 `

2. Lease option: PVAD = – $25,000 (6.32825* ) = – $158,206 * Present value of an annuity due of $1: n = 10, i = 12% (from Table 6)

Kiddy Toy should lease the machine.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 5–14 Requirement 1 Tinkers: PVAD = $20,000 x 7.98187* = * Present value of annuity due of $1: n = 15, i = 11%

$159,637

PV = $159,637 x 0.73119* * Present value of $1: n = 3, i = 11%

$116,725

Evers: PVAD = $25,000 x 7.98187* = * Present value of an annuity due of $1: n = 15, i = 11%

$199,547

PV = $199,547 x 0.65873* * Present value of $1: n = 4, i = 11%

$131,447

Chance: PVAD = $30,000 x 7.98187* = * Present value of an annuity due of $1: n = 15, i = 11%

$239,456

PV = $239,456 x 0.59345* * Present value of $1: n = 5, i = 11%

$142,105

Problem 5–14 (concluded) Requirement 2 Present value of pension obligations as of December 31, 2027: Employee

Tinkers Evers Chance

PVAD from Requirement 1 12/31/2027 $159,637 12/31/2028 199,547 12/31/2029 239,456

PV of $1 factor,

PV as of 12/31/2027

i = 11% n=0, 1.00000

$159,637

n=1, 0.90090

179,772

n=2, 0.81162

194,347

Total present value, 12/31/2027

$533,756

Amount of annual contribution beginning 12/31/2024: FVAD = Annuity amount x Annuity factor Annuity amount =

FVAD Annuity factor

Annuity amount = $533,756 = 3.7097*

$143,881

* Future value of an annuity due of $1: n = 3, i = 11%

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 5–15 Bond liability: PV = $4,000,0001 (18.40158* ) + $100,000,000 (0.17193** ) PV = $73,606,320 + $17,193,000 = $90,799,320 = Initial bond liability 1

$100,000,000 x 4 % = $4,000,000 * Present value of an ordinary annuity of $1: n = 40, i = 4.5% (from Table 4) ** Present value of $1: n = 40, i = 4.5% (from Table 2)

Lease liability: Lease A: PVAD = $200,000 (9.36492* ) = $1,872,984 = Liability * Present value of an annuity due of $1: n = 20, i = 10% (from Table 6)

Lease B: PVAD = $220,000 x 8.82371* = $1,941,216 * Present value of an annuity due of $1: n = 17, i = 10% (from Table 6) PV = $1,941,216 x 0.75131* = $1,458,455 * Present value of $1: n = 3, i = 10% (from Table 2) Or, alternatively for Lease B: PVA = $220,000 x 8.02155* = $1,764,741 * Present value of an ordinary annuity of $1: n = 17, i = 10% (from Table 4) PV = $1,764,741 x 0.82645** = $1,458,470 (difference due to rounding) **Present value of $1: n = 2, i = 10% (from Table 2) Or, alternatively for Lease B:

PV = $220,000 (6.62938* )

$1,458,464 (difference due to rounding)

From Table 4, PVA factor, n = 19, i = 10% – PVA factor, n = 2, i = 10%

= =

8.36492 1.73554

= PV factor for deferred annuity

6.62938*

The company‘s balance sheet would include a liability for bonds of $90,799,320 and a liability for leases of $3,331,439 ($1,872,984 + $1,458,455).

DECISION MAKERS’ PERSPECTIVE Analysis Case 5–1 The effective interest rate can be determined by solving for the unknown present value of an ordinary annuity of $1 factor for ten periods:

PV of an ordinary annuity of $1 factor = $2,330,716 ÷ $200,000 = 11.65358* In row 25 of Table 4, the value of 11.65358 is in the 7% column. So, 7% is the approximate effective interest rate. A financial calculator or Excel will produce the same result. * Present value of an ordinary annuity $1: n = 25, i = ? (from Table 4, i = approximately 7%) Your memo to Sara would be:

Send

To: Sara Cc: John Subject: Legal settlement

Hi Sara, The settlement was determined by calculating the present value of lost future income ($200,000 per year) discounted at a rate that is expected to approximate the time value of money. In this case, the discount rate, i, apparently is 7% and the number of periods, n, is 25 (the number of years to John‘s retirement). John‘s settlement was calculated as follows:

$200,000 annuity amount

11.65358*

$2,330,716

* Present value of an ordinary annuity of $1: n = 25, i = 7% (from Table 4)

Note: In the actual case, John‘s present salary was increased by 3% per year to reflect future salary increases.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Analysis Case 5–2 The manager should choose the alternative with the highest present value. Requirement 1 PV = $50,000 Requirement 2 PV = PVAD = $10,000 (5.21236* ) = $52,124 * Present value of an annuity due of $1: n = 6, i = 6% (from Table 6)

Requirement 3 PVA = $22,000 x 2.67301* = $58,806 * Present value of an ordinary annuity of $1: n = 3, i = 6% (from Table 4) PV = $58,806 x 0.89000* = * Present value of $1: n = 2, i = 6% (from Table 2)

$52,337

The manager should choose alternative 3. Or, alternatively (for 3):

PV = $22,000 (2.37897* )

= $52,337

From Table 4, PVA factor, n = 5, i = 6% – PVA factor, n = 2, i = 6%

= 4.21236 = 1.83339

= PV factor for deferred annuity

= 2.37897*

or, from Table 6, PVAD factor, n = 6, i = 6% – PVAD factor, n = 3, i = 6%

= 5.21236 = 2.83339

= PV factor for deferred annuity due

= 2.37897*

Judgment Case 5–3 Requirement 1 Purchase price of new machine Sales price of old machine Incremental cash outflow required

$150,000 (100,000) $ 50,000

Requirement 2 The new machine should be purchased if the present value of the savings in operating costs of $8,000 ($18,000 – $10,000) plus the present value of the salvage value of the new machine exceeds $50,000.

PV = ($8,000 x 3.99271* ) + ($25,000 x 0.68058** ) PV = $31,942 + $17,015 PV = $48,957 * Present value of an ordinary annuity of $1: n = 5, i = 8% (from Table 4) ** Present value of $1: n = 5, i = 8% (from Table 2)

The new machine should not be purchased.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Real World Case 5–4 Requirement 1 The maturity value (face amount) can be determined by dividing the present value by the present value of $1 factor for 5 semiannual periods (middle of 2017 – beginning of 2020) at the semiannual rate of 1.5%:

PV of $1 factor = $ 69 ÷ 0.92826* = $74 * Present value of $1: n = 5, i = 1.5% (from Table 2) So, $74 million is the maturity value (face amount) to be paid in 2.5 years. Of that amount, $74 – $69 = $5 million will represent interest at 1.5% for 5 semiannual periods.

Requirement 2 Using a 1.5% effective semiannual rate and 40 periods: PV = $1,000 (0.55126* ) = $551.26 * Present value of $1: n = 40, i = 1.5% (from Table 2) The issue price of one, $1,000 maturity-value bond was $551.

Real World Case 5–5 Requirement 1 The effective interest rate can be determined by solving for the unknown present value of an ordinary annuity of $1 factor for ten periods:

PV of an ordinary annuity of $1 factor = $627 ÷ $75 = 8.36*

In row 10 of Table 4, the value of 8.32 is in the 3.5% column. So, 3.5% is the approximate effective interest rate. A financial calculator or Excel will produce the same result.

* Present value of an ordinary annuity $1: n = 10, i = ? (from Table 4, i = approximately 3.5%)

Requirement 2 The effective interest rate can be determined by solving for the unknown present value of an annuity due $1 factor for 10 periods:

PV of an annuity due of $1 factor = $627 ÷ $75 = 8.36* * Present value of an annuity due of $1: n = 10, i = ? (from Table 6, i = approximately 4%) In row 10 of Table 6, the value of 8.43533 is in the 4% column. So, 4% is the approximate effective interest rate. A financial calculator or Excel will produce the same result.

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Communication Case 5–6 Suggested Grading Concepts and Grading Scheme: Content (65%) 25 Explanation of the method used (present value) to compare the two contracts. 30

Presentation of the calculations. 49ers PV = $6,989,065 Cowboys PV = $6,492,710

Correct conclusion.

65 points Writing (35%) 5 Proper letter format. 6

Terminology and tone appropriate to the audience of a player's agent.

Organization permits ease of understanding. Introduction that states purpose. Paragraphs that separate main points.

English Sentences grammatically clear and well organized, concise. Word selection. Spelling. Grammar and punctuation.

35 points

Ethics Case 5–7 The ethical issue is that the 21% return implies an annual return of 21% on an investment and misrepresents the fund‘s performance to all current and future stakeholders. Interest rates are usually assumed to represent an annual rate, unless otherwise stated. Interested investors may assume that the return for $100 would be $21 per year, not $21 over two years. The Upward Investment Company ad should explain that the 21% rate represented appreciation over two years.

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Target Case Requirement 1

Note 17: ―Leases‖ reports the following: Future Minimum Lease Payments

2018 2019 2020 2021 2022 After 2022 Total lease payments Less: Interest Present value of future minimum capital lease payments

(millions) Operating Finance Leases Leases $ 284 $121 278 127 274 127 270 125 261 120 1,838 1,270 $3,205 $1,890 730 520 $2,475 $1,370

The note indicates that the present value of lease payments was $2,475 million for operating leases and $1,370 million for finance leases on February 1, 2020. Those are the present value of the total lease payments of $3,205 million and $1,890 million. The difference for each type of lease represents what will be reported as interest expense over the term of the leases. Requirement 2

The weighted average discount rates reported by Target are 3.71% for operating leases and 4.23% for finance leases. Requirement 3

Target reports its lease liabilities for the present value.

Air France/KLM Case Requirement 1

Note 29.2 Description of the actuarial assumptions and related sensitivities (in part) Discount rates used to determine the actuarial present value of the projected benefit obligations. The discount rates for the different geographical areas are thus determined based on the duration of each plan, taking into account the average trend in interest rates on investment grade bonds, observed on the main available indices. In some countries, where the market in this type of bond is not sufficiently broad, the discount rate is determined with reference to government bonds. Most of the Group‘s benefit obligations are located in the Euro zone, where the discount rates used are as follows: As of December 31 Euro zone - Duration 10 to 15 years Euro zone - Duration 15 years and more

2019 0.70% to 0.75% 1.15%

2018 1.45% 1.85%

Requirement 2

Note 29.2 Description of the actuarial assumptions and related sensitivities (in part) Sensitivity to changes in the discount rate (in € millions) for the year ended December 31, 2019

for the year ended December 31, 2018

100 bp increase in the discount rate

(2,120)

(1,754)

100 bp decrease in the discount rate

2,803

2,284

If the rate used had been 1% higher, the pension obligation would have been €2,120 million less in 2019. If the rate used had been 1% lower, the pension obligation would have been €2,803 million higher in 2019. 7–510 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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Chapter 6 Revenue Recognition QUESTIONS FOR REVIEW OF KEY TOPICS Question 6–1 The five key steps in applying the core revenue recognition principle are: 1. Identify the contract with a customer. 2. Identify the performance obligation(s) in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations. 5. Recognize revenue when (or as) each performance obligation is satisfied.

Question 6–2 A performance obligation is satisfied at a single point in time when control is transferred to the buyer at a single point in time. This often occurs at delivery. Five key indicators are used to decide whether control of a good or service has passed from the seller to the buyer. The customer is more likely to control a good or service if the customer has: 1. 2. 3. 4. 5.

An obligation to pay the seller. Legal title to the asset. Physical possession of the asset. Assumed the risks and rewards of ownership. Accepted the asset.

Management should evaluate these indicators individually and in combination to decide whether control has been transferred.

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Question 6–3 A performance obligation is satisfied over time if at least one of the following three criteria is met:

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Question 6–4 Services typically qualify for revenue recognition over time because the customer consumes the benefit of the seller‘s work as it is performed. However, for convenience, even if the service qualifies for recognition of revenue over time, the seller might wait to recognize revenue until the service has been completed because it is more convenient to account for it that way. For example, if a service is delivered over days or even weeks, the seller might just wait to recognize revenue until delivery is complete rather than bothering with a more precise recognition of revenue over time. This departure from GAAP is appropriate only if the amount of revenue recognized under the departure is not materially different from the amount of revenue that would be recognized if revenue was recognized over time.

Question 6– 516 Sellers account for a promise to provide a good or service as a performance obligation if the good or service is distinct from other goods and services in the contract. The idea is to separate contracts into parts that can be viewed on a standalone basis. That way the financial statements can better reflect the timing of the transfer of separate goods and services and the profit earned on each one. Performance obligations that are not distinct are combined and treated as a single performance obligation. A performance obligation is distinct if it is both: 1. Capable of being distinct. The customer could use the good or service on its own or in combination with other goods and services it could obtain elsewhere, and 2. Separately identifiable from other goods or services in the contract. The good or service is not highly interrelated with other goods and services in the contract.

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. Question 6–6 If an arrangement has multiple performance obligations, the seller allocates the transaction price in proportion to the stand-alone selling prices of the goods or services underlying those performance obligations. If the seller can‘t observe actual stand-alone selling prices, the seller should estimate them.

Question 6– 518

A contract specifies the legal rights and obligations of the seller and the customer. For a contract to exist for purposes of revenue recognition, it must:

1. Have commercial substance, affecting the risk, timing or amount of the seller‘s future cash flows, 2. Be approved by both the seller and the customer, indicating commitment to fulfilling their obligations, 3. Specify the seller and customer‘s rights regarding the goods or services to be transferred, and 4. Specify payment terms. 5. Be probable that the seller will collect the amount it is entitled to receive. We normally think of a contract as being specified in a written document, but contracts can be oral rather than written. Contracts also can be implicit based on the typical business practices that a company follows. The key is that, implicitly or explicitly, the arrangement be substantive and specify the legal rights and obligations of a seller and a customer.

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Question 6–8 Under U.S. GAAP, ―probable‖ is defined as ―likely to occur‖ or as ―reasonably be expected or believed on the basis of available evidence or logic but is neither certain nor proved,‖ which implies a relatively high likelihood of occurrence. Under IFRS ―probable‖ is defined as a likelihood that is greater than 50%, which is lower than the definition in U.S. GAAP. Therefore, some contracts might not meet this threshold under U.S. GAAP that do meet it under IFRS.

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Question If a seller 6–11 grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation only if the option provides a material right to the customer that the customer would not receive without entering into the contract. If the option provides a material right, the customer in effect pays the seller in advance for future goods or services, and the seller recognizes revenue when those future goods or services are transferred or when the option expires.

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Question 6–10 Variable consideration is included in the contract‘s transaction price when the seller believes it is probable that it won‘t have to reverse (adjust downward) a significant amount of revenue in the future because of a change in that variable consideration. The seller estimates the variable consideration as either the expected value or the most likely amount to be received, and includes that amount in the contract‘s transaction price.

Question 6–11 A seller is constrained to recognize only the amount of revenue for which the seller believes it is probable that a significant amount of revenue won‘t have to be reversed (adjusted downward) in the future because of a change in that variable consideration. Indicators that variable consideration should be constrained include limited other evidence on which to base an estimate, dependence of the variable consideration on factors outside the seller‘s control, and a long delay between when the estimate must be made and when the uncertainty is resolved.

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Question 6–12 A right to return merchandise is not a performance obligation. Rather, it represents a potential failure to satisfy the original performance obligation. We view a right of return as a particular type of variable consideration. A seller usually can estimate the returns that will result for a given volume of sales based on past experience. Accordingly, the seller usually recognizes revenue upon delivery, but then reduces revenue by the estimated returns. The seller reports net sales revenue in the income statement, and also reports a refund liability in the balance sheet for any additional amounts it expects to refund to customers who make returns. However, if the seller lacks sufficient information to be able to accurately estimate returns, the constraint on variable consideration applies, and the seller should recognize revenue only to the extent it is probable that a significant revenue reversal will not occur later if the estimate of returns changes. The seller might instead postpone recognizing any revenue until the uncertainty about returns is resolved.

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Question 6–13

A principal has primary responsibility for delivering a product or service and obtains control of the goods or services before they are transferred to the customer. A principal recognizes as revenue the amount received from a customer. An agent doesn‘t primarily deliver goods or services, but acts as a facilitator that earns a commission for helping sellers to transact with buyers, and recognizes as revenue only the commission it receives for facilitating the sale.

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Question 6–14 In general, the ―time value of money‖ refers to the fact that money to be received in the future is less valuable than the same amount of money received now. If you have the money now, you can invest it to earn a return so the money can grow to a larger amount in the future. If payment occurs either before or after delivery, conceptually the arrangement includes a financing component. Prepayments include an element of interest expense (the seller is borrowing from the buyer between payment and delivery), while receivables include an element of interest revenue (the buyer is borrowing from the seller between payment and delivery). When delivery and payment occur relatively near each other, the financing component is not significant and can be ignored. As a practical matter, sellers can assume the financing component is not significant if the period between delivery and payment is less than a year.

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Question 6–15 If a seller purchases distinct goods or services from their customer and pays more than fair value for those goods or services, the excess payments are viewed as a refund of part of the price of the goods and services that the customer purchased from the seller. The excess payments are subtracted from the amount the seller is entitled to receive from the customer when calculating the transaction price of the sale to the customer.

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Question 6–16 1. Adjusted market assessment approach: Under this approach, the seller estimates what it could sell the product or services for in the market in which it normally sells products. The seller likely would consider prices charged by competitors for similar products. 2. Expected cost plus margin approach: Under this approach, the seller estimates its costs of satisfying the performance obligation and then adds an appropriate profit margin to determine the revenue it would anticipate receiving for satisfying the performance obligation. 3. Residual approach: Under this approach, the seller subtracts from the total transaction price the sum of the known or estimated stand-alone selling prices of the other performance obligations that are included in the contract to arrive at an estimate of an unknown or highly uncertain stand-alone selling price.

Answers to Questions (continued) Question 6–17 For licenses of symbolic intellectual property (IP), like trademarks, logos, brand names and franchise rights, sellers recognize revenue over time, because the license provides the customer with the right of access to the seller‘s IP with the understanding that the seller will undertake ongoing activities during the license period that benefit the customer. For licenses of functional IP, sellers typically recognize revenue at the point in time that the customer can first use the IP. Functional IP has significant standalone functionality that is not affected by the seller‘s ongoing activity. Examples include software, drug formulas, and media content. However, even for functional IP, sometimes sellers have to recognize revenue over time, because the seller is expected to change the functionality over the license period and the customer is required to use the updated version. In that case, even though the license involves functional IP, we view the license as transferring a right of access, and revenue must be recognized over the license period.

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Question 6–18 In franchise arrangements, the franchisor typically has multiple performance obligations. The franchisor grants to the franchisee a right to sell the franchisor‘s products and services and use its name for a specified period of time. The franchisor also usually provides initial start-up services (such as identifying locations, remodeling or constructing facilities, and selling equipment and training to the franchisee). The franchisor also may provide ongoing products and services (such as franchise-branded products and advertising and administrative services). So, a franchise involves a license to use the franchisor‘s intellectual property, but also involves initial sales of products and services as well as ongoing sales of products and services.

Answers to Questions (continued)

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Question 6–19 A bill-and-hold arrangement exists when a customer purchases goods but requests that the seller retain physical possession until a later date. The key indicator of whether control has passed from the seller to the customer for bill-and-hold arrangements is whether the customer has control of the asset. Since the customer doesn‘t have physical possession of the goods in a bill-and-hold arrangement, the customer isn‘t normally viewed as controlling the goods. However, if the customer goods are specifically identified as the customer‘s, and are ready for physical transfer, and the seller can‘t use the goods or sell them to another customer, then revenue would be recognized despite the customer not having taken physical possession of the goods.

Question 6–20 Under U.S. GAAP, intellectual property (IP) is categorized as either functional or symbolic, and symbolic IP is viewed as providing an access right that requires revenue recognition over time. IFRS does not require revenue recognition over time for symbolic IP if the seller is not affecting the usefulness of the IP to the customer during the license period.

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Question 6–21 Sometimes a company arranges for another company to sell its product under consignment. The ―consignor‖ physically transfers the goods to the other company (the consignee), but the consignor retains legal title. If the consignee can‘t find a buyer within an agreed-upon time, the consignee returns the goods to the consignor. However, if a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor. Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record revenue (and related costs) until the consignee sells the goods and title passes to the eventual customer.

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Question 6–22 Sometimes companies receive non-refundable prepayments from customers for some future good or service. That is what occurs when a company sells a gift card. The seller does not recognize revenue at the time the gift card is sold to the customer. Instead, the seller records a deferred revenue liability in anticipation of recording revenue when the gift card is redeemed. If the gift card isn‘t redeemed, the seller recognizes revenue when it expires or when, based on past experience, the seller has concluded that customers will not redeem it.

Question 6– 542Bad debt expense must be reported clearly either on its own line in the income statement or in the notes to the financial statements.

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Question 6–24 If the customer makes payment to the seller before the seller has satisfied performance obligations, the seller records a contract liability. If the seller satisfies a performance obligation before the customer has paid for it, the seller records either a contract asset or a receivable. The seller recognizes an accounts receivable if the seller has an unconditional right to receive payment, which is the case if only the passage of time is required before the payment is due. If instead the seller satisfies a performance obligation but its right to payment depends on something other than the passage of time (for example, the seller satisfying other performance obligations), the seller recognizes a contract asset.

Question 6– 544If a long-term contract qualifies for revenue recognition over time, the seller recognizes a portion

of the project‘s expected revenues and costs to each period in which construction occurs, according to the percentage of the project completed to date. If the contract does not qualify for revenue recognition over time, the seller recognizes revenue and costs when the project is complete.

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Question 6–26 The billings on construction contract account is a contra account to the construction in progress asset. At the end of each reporting period, the balances in these two accounts are compared. If the net amount is a debit, it is reported in the balance sheet as a contract asset. Conversely, if the net amount is a credit, it is reported as a contract liability.

Question 6– 546 An estimated loss on a long-term contract must be fully recognized in the first period the loss becomes evident, regardless of the revenue recognition method used.

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BRIEF EXERCISES Brief Exercise 6–1 In 2024 Apache has transferred the land, and the construction company has an obligation to pay Apache. Apache‘s performance obligation has been satisfied, and revenue and a related account receivable of $3,000,000 can be recognized.

Under accrual accounting, revenue is recorded when goods or services are transferred to customers (2024), not necessarily when cash changes hands in future periods.

Brief Exercise 6–2 A performance obligation is satisfied over time if at least one of the following three criteria is met:

1. The customer consumes the benefit of the seller‘s work as it is performed, 2. The customer controls the asset as it is created, or 3. The seller is creating an asset that has no alternative use to the seller, and the seller can receive payment for its progress even if the customer cancels the contract. Under Estate‘s construction agreement with CyberB, if for any reason Estate can‘t complete construction, CyberB would own the partially completed building. Therefore, criterion 2 is satisfied, and revenue should be recognized as the building is being constructed.

Brief Exercise 6–3 This contract qualifies for revenue recognition over time, because the performance obligation (to provide technology consulting services upon request) is consumed by the customer as the seller‘s work is performed. Therefore, Varga should recognize revenue of $4,000 ($6,000 × 8/12 months) in 2024. Journal entries (not required): May 1, 2024 Cash Deferred revenue

6,000

December 31, 2024 adjusting entry Deferred revenue 4,000 Service revenue ($6,000 x 8/12)

6,000

4,000

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Brief Exercise 6–4 Based on relative stand-alone selling prices, the software comprises 70% of the total fair values ($70,000 ÷ [$30,000 + $70,000]), and the technical support comprises 30% ($30,000 ÷ [$30,000 + $70,000]). Therefore, Sarjit would recognize $56,000 (equal to $80,000  70%) in revenue when the software is delivered and defer the remaining $24,000 (equal to $80,000  30%) to be recognized evenly over the next six months as the technical support service is provided.

$80,000 Transaction Price 70%

30%

$56,000

$24,000

Software

Technical Support Service

The journal entry is recorded as follows:

Cash 80,000 Sales revenue (for software) Deferred revenue (for tech support)

56,000 24,000

Brief Exercise 6–5 $0. Under U.S. GAAP, ―probable‖ is defined as ―likely to occur‖ or as ―reasonably expected or believed on the basis of available evidence or logic but is neither certain nor proved,‖ which implies a relatively high likelihood of occurrence. Therefore, this contract would not qualify for revenue recognition under U.S. GAAP.

Brief Exercise 6–6 $100,000. Under IFRS ―probable‖ is defined as a likelihood that is greater than 50%. Therefore, this contract would qualify for revenue recognition under IFRS. (However, Tulane also would recognize a large bad debt expense associated with the contract, given concern that it might not be paid.)

Brief Exercise 6–7 Number of performance obligations in the contract: 1. Access to eLean services is one performance obligation. Registration on the website is not a performance obligation, but rather is part of the activity eLean must provide to satisfy its performance obligation of providing access to eLean‘s on-line services. The $50 payment is an upfront payment that is part of the total transaction price associated with the service, and the monthly payments are the other component.

Brief Exercise 6–8 Number of performance obligations in the contract: 1. We need to consider three aspects of the vacuum contract: delivery of the vacuum, the one-year quality-assurance warranty, and the option to purchase the three-year extended warranty. Delivery of the vacuum cleaner is a performance obligation. The one-year warranty that is included as part of the purchase (the quality-assurance warranty) is not a performance obligation, but rather is part of the obligation to deliver a vacuum of appropriate quality. The option to purchase a three-year extended warranty is not a performance obligation within the contract to purchase a vacuum, because customers can purchase that warranty for the same amount at other times, so the opportunity to buy it at the same time that they buy the vacuum does not present a material right.

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Brief Exercise 6–9 Number of performance obligations in the contract: 2. We need to consider three aspects of the vacuum contract: delivery of the vacuum, the one-year quality-assurance warranty, and the option to purchase the three-year extended warranty. Delivery of the vacuum cleaner is a performance obligation. The one-year warranty that is included as part of the purchase (the quality-assurance warranty) is not a performance obligation, but rather it is part of the obligation to deliver a vacuum of appropriate quality. The option to purchase the extended warranty, though, is a performance obligation within the contract to purchase a vacuum. Customers can purchase that warranty at a 20% discount if they do so when they buy the vacuum, so the opportunity to buy the extended warranty constitutes a material right. Also, the option is capable of being distinct, as it could be sold or provided separately, and it is separately identifiable, as the vacuum could be sold without the option to purchase an extended warranty, so the option is distinct, and qualifies as a performance obligation.

Brief Exercise 6–10 Number of performance obligations in the contract: 2. In addition to the subscription, the renewal option is a performance obligation because it provides a material right that allows the customer to renew at a better price than could be obtained without the right. The renewed protection is capable of being distinct, as it could be sold or provided separately, and it is separately identifiable, as the customer can use the renewed protection on its own. Therefore, the renewed protection is distinct, and qualifies as a performance obligation.

Brief Exercise 6-11 Number of performance obligations in the contract: 1. The separate goods and services that Precision Equipment has agreed to provide (equipment, customized software package, and consulting services) might be capable of being distinct, but they are not separately identifiable. In the context of the contract, the goods and services are highly dependent on and interrelated with each other. The contractor‘s role is to integrate and customize them to create one automated assembly line.

Brief Exercise 6-12 Number of performance obligations in the contract: 1. Lego enters into a contract to design and construct a specific building. Each smaller component of the construction contract, though capable of being distinct, is not separately identifiable because each component is highly interrelated with each other, and providing them to the customer requires the seller to integrate the components into a combined item (garage).

Brief Exercise 6-13 Number of performance obligations in the contract: 1. A right of return is not a performance obligation. Instead, the right of return represents a potential failure to satisfy the original performance obligation to deliver goods to the customer. Because the total amount of cash received from the customer depends on the amount of returns, a right of return is a type of variable consideration. Aria should estimate sales returns and reduce revenue by that amount in order to arrive at ―net revenue,‖ which would be the transaction price (the amount to be recorded as revenue on the seller‘s books). The total net revenue in this situation is $280,233: Revenue Sales returns Net revenue

$288,900 8,667 $280,233

($90 × 3,210 units) ($288,900 × 3%)

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Brief Exercise 6–14 The expected value would be calculated as follows: Possible Amounts Probabilities Expected Amounts $35,000 ($25,000 fixed fee + $10,000 bonus) × 50% = $17,500 $25,000 ($25,000 fixed fee + $0 bonus) × 50% = 12,500 Expected contract price at inception $30,000 Or, alternatively: $25,000 + ($10,000 × 50%) = $30,000

Brief Exercise 6-15 When a contract includes variable consideration, sellers are constrained to recognize only the amount of revenue they believe is probable that they won‘t have to reverse (adjust downward) in the future if the variable consideration changes. In this case, factors outside the seller‘s control (stock market volatility) make the seller‘s estimate of variable consideration very uncertain, so the amount of revenue that Continental will recognize during the year is limited to the fixed annual management fee, which is $1.5 million (1% of the client‘s $150 million total assets under management). Therefore, Continental would use $1.5 million as its estimate of the transaction price. Any performance bonus earned by Continental will be recognized as revenue if and when it is earned.

Brief Exercise 6–16 Finerly should recognize $0 of revenue upon delivery to distributors. Given the uncertainty about estimated returns, Finerly can‘t argue that it is probable that it won‘t have to reverse (adjust downward) a significant amount of revenue in the future because of a change in returns. Therefore, Finerly won‘t recognize revenue until it either can better estimate returns or sales to end consumers occur. Essentially, because Finerly can‘t estimate returns, it treats this transaction as if it is placing those goods on consignment with independent distributors.

Brief Exercise 6–17 Amazon will recognize revenue of $150, its commission on the sale. In this transaction, Amazon never has primary responsibility for delivering a product or service, and it is not vulnerable to risks associated with holding inventory or delivering the product or service. Therefore, Amazon serves as an agent, and will only recognize revenue on the transaction equal to the amount of the commission it receives.

Brief Exercise 6–18 If payment occurs after delivery, conceptually the arrangement includes a financing component. When the financing component is deemed to be significant, receivables, like those of Wooten, we include an element of interest revenue (the buyer is borrowing from the seller between payment and delivery). So, to determine the component of the $10,000 that represents sales, we must remove the interest component: Sales revenue = present value of the amount to be paid on December 31, 2024 = $10,000 × 0.92593¥ = $9,259 ¥ Present value of $1: n = 1, i = 8% (Table 2)

Brief Exercise 6–19 Deferred revenue = amount received up front = $8,000

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Brief Exercise 6–20 If a seller is purchasing distinct goods or services from a customer at the fair value of those goods or services, we account for that purchase as a separate transaction. Otherwise, excess payments by the seller are treated as a refund of the customer‘s purchase. If the payments are made (or are expected to be made) at the time of the original sale, the transaction price of the customer‘s purchase is reduced immediately by the refund. If payment is not expected at the time of the sale, revenue is recorded based on the full transaction price, and any subsequent payment by the seller above fair value results in a reduction of the transaction price at that time. There is no indication that Lewis‘ payment to AdCo for $10,000, which is $2,500 more than the fair value of those services ($7,500), was expected at the time of the original sale. Therefore, the original sale would be recorded based on the full transaction price of $60,000. The overpayment of $2,500 reduces the $60,000 transaction price of the goods sold by Lewis to AdCo at the time the $10,000 is paid, resulting in a downward adjustment of revenue of $2,500 at that time and net revenue over the period of $60,000 – $2,500 = $57,500.

Brief Exercise 6–21 Under the adjusted market assessment approach, O‘Hara would base its estimate of the standalone selling price of the club-fitting services on the prices charged by other vendors for those services, adjusted as necessary. Because O‘Hara typically charges 10% more than what other vendors charge, O‘Hara would estimate the stand-alone selling price of the club-fitting service to be $110 × 110% = $121.

Brief Exercise 6–22 Under the expected cost plus margin approach, O‘Hara would base its estimate of the standalone selling price of the club-fitting service on the $60 cost it incurs to provide the services, plus its normal margin of $60 × 30% = $18. Therefore, O‘Hara would estimate the stand-alone selling price of the club-fitting services to be $60 + $18 = $78.

Brief Exercise 6–23 Under the residual approach, O‘Hara would base its estimate of the stand-alone selling price of the club-fitting services on the total selling price of the contract ($1,500) minus the observable stand-alone selling price of clubs ($1,400). Therefore, O‘Hara would estimate the stand-alone selling price of the club-fitting services to be $1,500 – $1,400 = $100.

Brief Exercise 6–24 The software is functional intellectual property and the license transfers a right of use, since Saar‘s activities during the license period (which for this software does not have an end date) will not affect the value of the software to Kim. Therefore, Saar can recognize the entire $100,000 upon transfer of the right. However, the SAAR Associates name is symbolic intellectual property, so the license to use the Saar name is an access right, with Saar‘s ongoing activity affecting the benefit that Kim receives, so Saar should recognize revenue as that access is consumed over 36 months. Since Kim uses the Saar name for four months in 2024 (September through December), Saar should recognize revenue of 4 ÷ 36 = 1/9 of $90,000, or $10,000, for that access right in 2024. In total, Saar recognizes revenue of $100,000 + $10,000 = $110,000 in 2024.

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Brief Exercise 6–25 $110,000. The software is functional intellectual property and the license transfers a right of use, since Saar‘s activities during the license period (which for this software does not have an end date) will not affect the value of the software to Kim. Therefore, Saar can recognize the entire $100,000 upon transfer of the right. However, the Saar Associates name is symbolic intellectual property, so the license to use the Saar name is an access right, with Saar‘s ongoing activity affecting the benefit that Kim receives, so Saar should recognize revenue as that access is consumed over 36 months. Under U.S. GAAP it is not relevant that Saar will not provide any services with respect to the access right over the license period – it only matters that the license is classified as involving symbolic intellectual property. Since Kim uses the Saar name for four months in 2024 (September through December), Saar should recognize revenue of 4 ÷ 36 = 1/9 of $90,000, or $10,000, for that access right in 2024. In total, Saar recognizes revenue of $100,000 + $10,000 = $110,000 in 2024.

Brief Exercise 6–26 $190,000. The software is functional intellectual property and the license transfers a right of use, since Saar‘s activities during the license period (which for this software does not have an end date) will not affect the value of the software to Kim. Therefore, Saar can recognize the entire $100,000 upon transfer of the right. The Saar Associates name would be classified as symbolic intellectual property under U.S. GAAP, but under IFRS the focus is on whether the seller provides benefit to the customer over the license period. Given that is not the case, Saar would view this license as conveying a right of use, and could recognize $90,000 of revenue for the license to use the Saar Associates name at the start of the license. In total, Saar recognizes revenue of $100,000 + $90,000 = $190,000 in 2024.

Brief Exercise 6–27 Because Carlos had completed training and was open for business on August 1, 2024, TopChop apparently has satisfied its performance obligation with respect to the initial training, equipment and furnishings, so it would recognize $50,000 of revenue in 2024. In addition, since Carlos was a franchisee for the last six months of 2024, TopChop should recognize 6 ÷ 12 = 50% of a yearly fee of $30,000, or $15,000. In total, TopChop recognizes revenue from Carlos of $50,000 + $15,000 = $65,000 in 2024.

Brief Exercise 6–28 $0. Prior to delivery, Dowell maintains control of the inventory and should not recognize revenue.

Brief Exercise 6–29 $250, equal to revenue for the sale of one painting. Kerianne has a consignment arrangement with Holmstrom, so should not recognize transfer of paintings to Holmstrom as sales. Kerianne would recognize Holmstrom‘s commission of $250 × 20% = $50 as an expense.

Brief Exercise 6–30 GoodBuy should not recognize revenue when it sells the $1,000,000 of gift cards, because it has not yet satisfied its performance obligation to deliver goods upon redemption of the cards. GoodBuy should recognize revenue of $840,000 for redemptions, as well as $30,000 for gift cards that it estimates will never be redeemed, totaling $870,000.

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Brief Exercise 6–31 Contract asset: $0. Contract liability: $2,000. Accounts receivable: $0. Holt has a contract liability, deferred revenue, of $2,000. It never has a contract asset because it hasn‘t satisfied a performance obligation for which payment depends on something other than the passage of time. It does not have an accounts receivable for the $3,000 until it delivers the furniture to Ramirez.

Brief Exercise 6–32 For long-term contracts, we view a company as having a contract asset if CIP > Billings, so Cady has a contract asset for the first construction job of $6,000 (equal to $20,000 CIP less $14,000 billings). For long-term contracts, we view a company as having a contract liability if Billings > CIP, so Cady has a contract liability for the second construction job of $2,000 (equal to $5,000 billings less $3,000 CIP).

Brief Exercise 6–33 Total estimated cost to complete = $6 million + $9 million = $15 million % of completion = $6 million  $15 million = 40% First year revenue = $20,000,000 x 40% = $8,000,000 First year gross profit = $8,000,000 – $6,000,000 = $2,000,000 Note: We can also determine first year gross profit as follows: Total estimated gross profit ($20 million – $15 million) = multiplied by the % of completion Gross profit recognized the first year

$5,000,000 40% $2,000,000

Brief Exercise 6–34 Assets: Accounts receivable ($7 million – $5 million) CIP ($6 million + $2 million*) in excess of billings ($7 million)

$2,000,000 1,000,000

* First year gross profit = $8,000,000 – $6,000,000 = $2,000,000

Brief Exercise 6–35 No revenue or gross profit recognized until project completed in year 2. Year 2 revenue Less: Costs in year 1 Costs in year 2 Year 2 gross profit

$20,000,000 (6,000,000) (10,000,000) $ 4,000,000

Brief Exercise 6–36 The anticipated loss of $3 million ($30 million contract price less total estimated costs of $33 million) must be recognized in the first year applying either method.

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EXERCISES Exercise 6–1 The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. Requirement 1 Regarding the five steps used to apply the revenue recognition principle, the appropriate citation is: FASB ASC 606–10–05–04: ―Revenue from Contracts with Customers–Overall–Overview and Background–General.‖

Requirement 2 Regarding indicators that control has passed from the seller to the buyer, such that it is appropriate to recognize revenue at a point in time, the appropriate citation is: FASB ASC 606–10–25–30: ―Revenue from Contracts with Customers–Overall––Recognition– Performance Obligations Satisfied at a Point in Time.‖

Requirement 3 Regarding circumstances under which sellers can recognize revenue over time, the appropriate citation is: FASB ASC 606–10–25–27: ―Revenue from Contracts with Customers–Overall––Recognition– Performance Obligations Satisfied Over Time.‖

Exercise 6– 562 Requirement 1 Ski West should recognize revenue over the ski season. Ski West fulfills its performance obligation over time as it delivers the service to its pass holders by providing access to its ski lifts.

Requirement 2 November 6, 2024 To record the cash collection. Cash ........................................................................................... Deferred revenue....................................................................

450 450

December 31, 2024 To recognize revenue earned in December (no revenue earned in November, as season starts on December 1). Deferred revenue ($450 x 1/5) ..................................................... 90 Service revenue...................................................................... 90

Requirement 3 $90 is included in revenue in Ski West‘s 2024 income statement. The $360 remaining balance in deferred revenue is included in the current liability section of Ski West‘s 2024 balance sheet.

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Exercise 6–3 VP first must identify each performance obligation‘s share of the sum of the stand-alone selling prices of all performance obligations:

TV:

$1,700 $1,700 + $100 + $200

= 85%

Remote:

$100 $1,700 + $100 + $200 $200

= 5%

Installation:

= 10%

$1,700 + $100 + $200 100% VP would allocate the total selling price of the package ($1,900) based on stand-alone selling prices, as follows:

TV:

$1,900

85% =

$1,615

Remote:

$1,900

5% =

Installation:

$1,900

10% =

190 $1,900

$1,900 Transaction Price TV package 85%

$1,615 TV

$95 Remote

10%

$190 Installation

Exercise 6– 564 The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. Requirement 1 Regarding the basis upon which a contract‘s transaction price allocated to its performance obligations, the appropriate citation is: FASB ASC 606–10–32–29: ―Revenue from Contracts with Customers–Overall–Measurement– Allocating the Transaction Price to Performance Obligations.‖

Requirement 2 Regarding indicators that a promised good or service is separately identifiable, the appropriate citation is: FASB ASC 606–10–25–21: ―Revenue from Contracts with Customers–Overall–Recognition– Identifying Performance Obligations—Distinct Goods or Services.‖

Requirement 3 Regarding circumstances under which an option is viewed as a performance obligation, the appropriate citation is: FASB ASC 606–10–55–42: ―Revenue from Contracts with Customers–Overall– Implementation Guidance and Illustrations–Customer Options for Additional Goods or Services.‖

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Exercise 6-5 Requirement 1 Number of performance obligations in the contract: 2. Delivery of gold is one performance obligation. The additional insurance for replacement of gold bars is a second performance obligation. The insurance service is capable of being distinct because the bank could choose to receive similar services from another insurance provider, and it is separately identifiable, as it is not highly interrelated with the other performance obligation of delivering gold, and the seller‘s role is not to integrate and customize them to create one service or product. So, the insurance qualifies as a performance obligation. The receipt of cash prior to delivery is not a performance obligation, but rather gives rise to deferred revenue associated with performance obligations to be satisfied in the future.

Requirement 2 Value of the gold bars: $1,440/unit 100 units =

$144,000

Stand-alone selling price of the insurance: $60  100 units =

6,000

Total of stand-alone prices

$150,000

Gold Examiner first identifies each performance obligation‘s share of the sum of the stand-alone selling prices of all deliverables:

Gold bars delivered: Insurance:

$144,000 $144,000 + $6,000 $6,000

= 96% = 4%

$144,000 + $6,000 100%

Exercise 6-5 (concluded) Gold Examiner then allocates the total selling price based on stand-alone selling prices, as follows:

$147,000 Transaction Price Gold bars 96%

$141,120 Gold bars

$5,880 Insurance for

delivered

replacement of gold bars

Entry on March 1, 2024:

Cash Deferred revenue Deferred revenue – insurance

147,000 141,120 5,880

Requirement 3 Entry on March 30, 2024:

Deferred revenue Sales revenue

141,120 141,120

Gold Examiner recognizes only the portion of revenue associated with passing of the legal title. The revenue associated with insurance coverage will be earned only when that performance obligation is satisfied.

Requirement 4 Entry on April 1, 2024:

Deferred revenue – insurance Service revenue

5,880 5,880

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Exercise 6–6 Requirement 1 Number of performance obligations in the contract: 2. The delivery of SunBoots is one performance obligation. The option for discount on additional future purchases is a second performance obligation because it provides a material right to the customer that the customer would not receive without the purchase of SunBoots. That material right to receive a discount is both capable of being distinct, as it could be sold or provided separately, and it is separately identifiable, as it is not highly interrelated with the other performance obligation of delivering SunBoots, and the seller‘s role is not to integrate and customize them to create one product. So, the discount option represented by the coupon is distinct and qualifies as a performance obligation.

Requirement 2 If Clarks can‘t estimate the stand-alone selling price of SunBoots, it will use the residual method to calculate that price as the amount of the total transaction price minus the value of the discount.

Cash (1,000 x $70) 70,000 Sales revenue (to balance) Deferred revenue – coupons (discount option)

64,000 6,000*

*(1,000 pairs  $100 average purchase price × 30% discount  20% of customers estimated to redeem coupon)

Exercise 6–7 Requirement 1 The amount of revenue Manhattan Today should recognize upon receipt of the subscription fee: $0. Even though Manhattan Today received payments from customers for an annual subscription, payment of the subscription activity does not transfer goods or services to customers. Therefore, the annual fee is viewed as a prepayment for future delivery of goods or services and would be recognized as deferred revenue – subscription (a liability) when received. Later, when newspapers are delivered, deferred revenue – subscription will be reduced and revenue recognized.

Requirement 2 Number of performance obligations in the contract: 2. Delivery of newspapers for one year is one performance obligation. The option to receive a 40% discount on a carriage ride qualifies as a second performance obligation. First, it is an option that conveys a material right to the recipient (as opposed to just a general marketing offer). Second, it is both capable of being distinct, as it could be sold or provided separately, and it is separately identifiable, as it is not highly interrelated with the other performance obligation of delivering newspapers, so the discount, as represented by the coupon, is distinct and qualifies as a performance obligation. The seller‘s role is not to integrate and customize them to create one product. The seller will record deferred revenue – coupons for that performance obligation and recognize revenue when either the coupons are exercised or Manhattan Today estimates that they will not be redeemed.

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 6–7 (concluded) Requirement 3 Value of the coupon: 40% discount  $125 carriage fee =

$ 50

Estimated redemption

 30%

Stand-alone selling price of coupon

$ 15

Stand-alone selling price of a normal subscription

135

Total of stand-alone prices

$150

Manhattan Today must identify each performance obligation‘s share of the sum of the standalone selling prices of all deliverables:

$15 $15 + $135

Coupon:

$135

Subscription:

= 10% = 90%

$15 + $135 100% Manhattan Today allocates the total selling price based on stand-alone selling prices, as follows:

$130

90%

Transaction Price New subscription

10%

$117

$13

Delivery of subscription newspapers

Discount on

Upon receiving the fee for 10 new subscriptions, the journal entry should be:

Cash ($130  10) 1,300 Deferred subscription revenue ($117  10) Deferred revenue – coupons ($13  10)

1,170 130

Exercise 6-8 Requirement 1 Number of performance obligations in the contract: 2. Delivery of keyboards is one performance obligation. The option to receive a special discount is a second performance obligation, as it provides a material right that the customer would not receive had it not bought the keyboards. In this particular instance, the customer has the right to receive a 25% discount for any purchases in the next six months, which is a 20% discount in addition to the normal 5% discount offered to other customers. The option to receive the discount, represented by the coupon, is both capable of being distinct, as it could be sold or provided separately, and it is separately identifiable, as it is not highly interrelated with the other performance obligation of delivering keyboards, and the seller‘s role is not to integrate and customize them to create one product. So, it is distinct and qualifies as a performance obligation.

Requirement 2 When two or more performance obligations are associated with a single transaction price, the transaction price must be allocated to the performance obligations on the basis of respective standalone selling prices (estimated if not directly available). Meta‘s estimated stand-alone selling price of the discount option is: Value of the discount coupon: (25% discount – 5% normal discount)  $20,000 = $ 4,000  50% Estimated redemption Stand-alone selling price of discount coupon: $ 2,000 Stand-alone selling price of the keyboards: $19.60  5,000 keyboards = Total of stand-alone prices

98,000 $100,000

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Exercise 6–8 (continued) Meta first must identify each performance obligation‘s share of the sum of the stand-alone selling prices of all deliverables:

$2,000 $2,000 + $98,000

Discount:

$98,000

Keyboards:

= 2% = 98%

$2,000 + $98,000 100% Meta then allocates the total selling price based on stand-alone selling prices, as follows:

$95,000 Transaction Price Keyboards 98%

$93,100 Delivery of

$1,900 Discount on

keyboards

future purchases

The journal entry to record the sale is:

Cash Deferred revenue Deferred revenue – coupons

95,000 93,100 1,900

The deferred revenue for the keyboards will become recognized as revenue on June 1st. The deferred revenue for the option to exercise the discount coupon is recognized when the coupon either is exercised or expires in six months.

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 6-8 (concluded) Requirement 3 All customers are eligible for a 5% discount on all sales. Therefore, the 5% discount option issued to Bionics, Inc. does not give any material right to the customer, so it is not a performance obligation in the contract, and Meta would account for both (a) the delivery of keyboards and (b) the 5% coupon as a single performance obligation.

Cash Deferred revenue

95,000 95,000

Exercise 6–9 Requirement 1 The expected value would be calculated as follows: Possible Amounts

Probabilities

$70,000 ($50,000 fixed fee + $20,000 bonus) × 20% = $50,000 ($50,000 fixed fee + $0 bonus) × 80% = Expected contract price at inception

Expected Amounts $14,000 40,000 $54,000

Or, alternatively: $50,000 + ($20,000 × 20%) = $54,000

Requirement 2 The most likely amount is the flat fee of $50,000, because there is a greater chance of not qualifying for the bonus than of qualifying for the bonus, so that is the transaction price.

Requirement 3 Because Thomas is very uncertain of its estimate, Thomas can‘t argue that it is probable that it won‘t have to reverse (adjust downward) a significant amount of revenue in the future because of a change in returns. Therefore, Thomas would not include the bonus estimate in the transaction price, and the transaction price would be the flat fee of $50,000.

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Exercise 6-10 Requirement 1 During the July 1 – July 15 period, Rocky estimates a less than 50% chance it will earn the bonus, so using the ―most likely amount‖ approach, it assumes no bonus, and estimates its revenue as $1,000 per day × 10 days = $10,000

Accounts receivable Service revenue ($1,000 × 10 days)

10,000 10,000

Requirement 2 During the July 16 – July 31 period, Rocky earns guide revenue of another 15 days × $1,000 per day = $15,000. In addition, because Rocky estimates a greater than 50% chance it will earn the bonus, using the ―most likely amount‖ approach, it estimates a bonus receivable of $100 per day × (10 days + 15 days) = $2,500.

Accounts receivable ($1,000 ×15 days) Bonus receivable ($100 × 25 days) Service revenue (to balance)

15,000 2,500 17,500

Requirement 3 On August 5, Rocky learns that it won‘t receive a bonus, and receives only the $25,000 balance in accounts receivable. Rocky must reduce its bonus receivable to zero and record the offsetting adjustment in revenue.

Cash ($1,000 × 25 days) Accounts receivable

25,000

Service revenue ($100 × 25 days) Bonus receivable

2,500

25,000

2,500

Exercise 6-11 Requirement 1 Rocky‘s normal guide revenue is 10 days × $1,000 per day = $10,000. Rocky also estimates that there is a 30% chance it will earn the bonus, so its estimate of the expected value of the bonus revenue earned to date is:

Possible Amounts $1,000 ($100 bonus × 10 days) $0 ($0 bonus × 10 days) Expected bonus as of July 15

Probabilities Expected Amounts × 30% = $300 × 70% = -0$300

Or, alternatively: $100 × 10 days × 30% = $300.

Rocky‘s July 15 journal entry would be: Accounts receivable ($1,000 ×10 days) Bonus receivable ($100 × 30% × 10 days) Service revenue

10,000 300 10,300

Requirement 2 During the July 16 – July 31 period, Rocky earns another 15 days × $1,000/day = $15,000 of its normal guiding revenue. In addition, because Rocky now believes there is an 80% chance it will earn the bonus, its estimate of the expected value of the bonus revenue earned to date (based on all 25 days guided during July) is:

Possible Amounts

Probabilities Expected Amounts

$2,500 ($100 bonus × 25 days) $0 ($0 bonus × 25 days) Expected bonus as of July 31

× 80% = × 20% =

$2,000 -0$2,000

Or, alternatively: $100 × 25 days × 80% = $2,000.

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 6-11 (concluded) With $300 of bonus receivable and revenue already recognized, Rocky must recognize an additional $2,000 – $300 = $1,700 of bonus receivable and bonus revenue. Rocky‘s July 31 journal entry would be:

Accounts receivable ($1,000 × 15 days) Bonus receivable ([$100 × 80% × 25 days] –

15,000 1,700

$300)

Service revenue (to balance)

16,700

Requirement 3 On August 5, Rocky learns that it won‘t receive a bonus, and receives only the $25,000 balance in accounts receivable. Rocky also must reduce its bonus receivable to zero and record the offsetting adjustment in revenue.

Cash ($1,000 × 25) Accounts receivable

25,000

Service revenue ($100 × 80% × 25 days) Bonus receivable

2,000

25,000

2,000

Exercise 6–12 Requirement 1 If payment occurs after delivery, conceptually the arrangement includes a financing component (the buyer is borrowing from the seller between payment and delivery). Therefore, when the financing component is deemed to be significant, the seller must account for interest revenue. To determine the component of the $40,000 that represents sales revenue, we must remove the interest component: January 1, 2024:

Notes receivable (given) 40,000 Discount on notes receivable (to balance) Sales revenue (calculated below)

2,963 37,037

Revenue = present value of the amount to be paid on December 31, 2024 = $40,000 × 0.92593¥ = $37,037 ¥ Present value of $1: n = 1, i = 8% (Table 2) Requirement 2 December 31, 2024:

Cash (given) 40,000 Discount on notes receivable (from requirement 1) 2,963 Notes receivable (given) 40,000 Interest revenue (to balance) 2,963

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 6-12 (concluded) Requirement 3 January 1, 2024:

Notes receivable (given) 40,000 Discount on notes receivable (to balance) Sales revenue (calculated below)

5,706 34,294

Revenue = present value of the amount to be paid on December 31, 2025 = $40,000 × 0.85734¥ = $34,294 ¥ Present value of $1: n = 2, i = 8% (Table 2) Requirement 4 If the financing component is deemed to be insignificant, we can ignore the interest component: January 1, 2024:

Notes receivable (given) Sales revenue (to balance)

40,000 40,000

Exercise 6–13 Requirement 1 January 1, 2024:

If payment occurs before delivery, conceptually the arrangement includes a financing component (the seller is borrowing from the buyer between payment and delivery). Therefore, when the financing component is deemed to be significant, the seller must account for interest expense. However, at the time the prepayment occurs, the entire amount received is viewed as deferred revenue: Cash (calculated below) Deferred revenue (to balance)

37,037 37,037

Deferred revenue = amount received on January 1, 2024= present value of the fair value of the goods to be delivered on December 31, 2024 = $40,000 × 0.92593¥ = $37,037 ¥ Present value of $1: n = 1, i = 8% (Table 2) Requirement 2 December 31, 2024:

Interest expense ($37,037 × 8% ) Deferred revenue (from requirement 1) Sales revenue (given)

2,963 37,037 40,000

Requirement 3 January 1, 2024:

Cash (calculated below) Deferred revenue (to balance)

34,294 34,294

Deferred revenue = amount received on January 1, 2024 = present value of the fair value of the goods to be delivered on December 31, 2025 = $40,000 × 0.85734¥ = $34,294 ¥ Present value of $1: n = 2, i = 8% (Table 2) 7–580 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 6-13 (concluded) Requirement 4 If the financing component is deemed to be insignificant, we can ignore the interest component: January 1, 2024:

Cash (from requirement 1) Deferred revenue (to balance)

37,037 37,037

Exercise 6–14 Requirement 1 Record revenue upon sale:

Accounts receivable Sales revenue

150,000 150,000

Requirement 2 Because the advertising services have a fair value ($5,000) that is less than the amount paid by Furtastic to Willett ($12,000), the remaining amount ($7,000) is viewed as a refund, reducing revenue by that amount.

Advertising expense Sales revenue Cash

5,000 7,000 12,000

Requirement 3 Record receipt of cash:

Cash Accounts receivable

150,000 150,000

Requirement 4 It is probable that Willett will pay Furtastic, so the relatively low likelihood of bad debts does not affect Furtastic‘s recognition of revenue on the Willet sale. If Furtastic had considered it less than probable that it would collect its receivable from Willet, it would not have a contract on June 1 for purposes of revenue recognition, and would not recognize revenue until payment actually occurred on June 30.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 6–15 Requirement 1 Under the adjusted market assessment approach, VP would base its estimate of the stand-alone selling price of the installation service on the prices charged by other vendors for that service, adjusted as necessary. Given that the other vendors are similar to VP, no adjustment is necessary. Therefore, VP would estimate the stand-alone selling price of the installation service to be $150, the amount charged by competitors for that service.

Requirement 2 Under the expected cost plus margin approach, VP would base its estimate of the stand-alone selling price of the installation service on the $100 cost it incurs to provide the service, plus its normal margin of 40% × $100 = $40. Therefore, VP would estimate the stand-alone selling price of the installation service to be $100 + $40 = $140.

Requirement 3 Under the residual approach, VP would base its estimate of the stand-alone selling price of the installation service on the total selling price of the package ($1,900) less the observable stand-alone selling prices of the TV ($1,750) and universal remote ($100). Therefore, VP would estimate the stand-alone selling price of the installation service to be $1,900 – ($1,750 + $100) = $50.

Exercise 6– 584 The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. Requirement 1 Regarding the alternative approaches that can be used to estimate variable consideration, the appropriate citation is: FASB ASC 606–10–32–08: ―Revenue from Contracts with Customers–Overall–Measurement– Variable Consideration.‖

Requirement 2 Regarding the alternative approaches that can be used to estimate the stand-alone selling price of performance obligations that are not sold separately, the appropriate citation is: FASB ASC 606–10–32–34: ―Revenue from Contracts with Customers–Overall–Measurement– Allocation Based on Standalone Selling Prices.‖

Requirement 3 Regarding the timing of revenue recognition with respect to licenses, the appropriate citation is: FASB ASC 606–10–55–60: ―Revenue from Contracts with Customers–Overall– Implementation Guidance and Illustrations–Determining the Nature of the Entity‘s Promise.‖

Requirement 4 Regarding indicators for assessing whether a seller is a principal, the appropriate citation is: FASB ASC 606–10–55–39: ―Revenue from Contracts with Customers–Overall– Implementation Guidance and Illustrations–Principal versus Agent Considerations.‖

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 6–17 Requirement 1 Total amount of franchise agreement

$600,000

Less: stand-alone selling price of training

(15,000)

Less: stand-alone selling price of building and equip.

(450,000)

Stand-alone selling price of five-year right

$135,000

Requirement 2 As of July 1, 2024, Monitor has not fulfilled any of its performance obligations, so the entire $600,000 franchise fee is recorded as deferred revenue.

Cash Notes receivable Deferred revenue

75,000 525,000 600,000

Requirement 3 On September 1, 2024, Monitor has satisfied its performance obligations with respect to training and certifying Perkins and delivering an equipped Monitor Muffler building. Therefore, Monitor should recognize revenue of $15,000 + $450,000 = $465,000 on that date. In addition, by December 31, 2024, Monitor should recognize 4 months of revenue (September – December) associated with the five-year right it granted to Perkins, so Monitor should recognize revenue of $135,000 × (4 ÷ (5 × 12)) = $9,000 associated with that right. Total revenue recognized for the year ended December 31, 2024, is $465,000 + $9,000 = $474,000.

Exercise 6– 586 The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. Requirement 1 Regarding disclosures that are required with respect to performance obligations that the seller is committed to satisfying but that are not yet satisfied, the appropriate citation is: FASB ASC 606–10–50–12: ―Revenue from Contracts with Customers–Overall–Disclosure– Performance Obligations.‖

Requirement 2 Regarding disclosures that are required with respect to uncollectible accounts receivable, also called impairment losses on receivables, the appropriate citation is: FASB ASC 606–10–50–4: ―Revenue from Contracts with Customers–Overall–Disclosure– Contracts with Customers.‖

Requirement 3 Regarding disclosures that are required with respect to contract assets and contract liabilities, the appropriate citation is: FASB ASC 606–10–50–10: ―Revenue from Contracts with Customers–Overall–Disclosure– Contract Balances.‖

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 6–19 Requirement 1 Contract price Actual costs to date Estimated costs to complete Total estimated costs Gross profit (estimated in 2024)

2024 $2,000,000 300,000 1,200,000 1,500,000 $ 500,000

2025 $2,000,000 1,875,000 -01,875,000 $ 125,000

Revenue recognition: 2024:

$ 300,000 = 20% × $2,000,000 = $400,000 $1,500,000

2025: $2,000,000 – $400,000 = $1,600,000 Gross profit recognition: 2024: $400,000 – $300,000 = $100,000 2025: $1,600,000 – $1,575,000 = $25,000 Note: We also can calculate gross profit directly using the percentage of completion: 2024:

$ 300,000 = 20% × $500,000 = $100,000 $1,500,000

2025:

$125,000 – $100,000 = $25,000

Requirement 2 2024: $0 (contract not yet completed) 2025: $2,000,000 – $1,875,000 = $125,000 Solutions Manual, Chapter 7 7–587 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Exercise 6–19 (concluded) Requirement 3

Balance Sheet At December 31, 2024 Current assets: Accounts receivable CIP ($400,000*) in excess of billings ($380,000)

$ 130,000 20,000

* Costs ($300,000) + profit ($100,000) Requirement 4

Balance Sheet At December 31, 2024 Current assets: Accounts receivable

$ 130,000

Current liabilities: Billings ($380,000) in excess of CIP ($300,000)

$ 80,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 6–20 Requirement 1 ($ in millions)

Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2026)

2024 $220 40 120 160 $ 60

2025 $220 120 60 180 $ 40

2026 $220 170 -0170 $ 50

Revenue recognition: 2024:

$40 = 25% × $220 = $55 $160

2025:

$120 = (66.67% × $220) – $55 = $91.67 $180

2026:

$220 – ($55 + $91.67) = $73.33

Gross profit (loss) recognition: 2024: $55 – $40 = $15 2025: $91.67 – $80 = $11.67 2026: $73.33 – $50 = $23.33 Note: We also can calculate gross profit directly using the percentage of completion: 2024:

$40 = 25% × $60 = $15 $160

2025:

$120

= 66.67% × $40 = $26.67 – $15 = $11.67 $180 2026:

$220 – $170 – ($15 + $11.67) = $23.33

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 6–20 (concluded) Requirement 2 Year

Revenue recognized -0-0$220

2024 2025 2026

Gross profit (loss) recognized -0-0$50

Requirement 3 2025 Revenue recognition: $120 = (60% × $220) – $55 = $77 $200

2025 Gross profit (loss) recognition: $77 – $80 = $(3) loss Note: Also can calculate gross profit directly using the percentage of completion: $120 = 60% × $20* = $12 – $15 = $(3) loss $200 *$220 – ($40 + $80 + $80) = $20

Exercise 6–21 Requirement 1 Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2026)

2024 $8,000,000 2,000,000 4,000,000 6,000,000

2025 $8,000,000 4,500,000 3,600,000 8,100,000

2026 $8,000,000 8,300,000 -08,300,000

$2,000,000

$ (100,000)

$ (300,000)

Revenue recognition: 2024: $2,000,000 = 33.3333% × $8,000,000 = $2,666,667 $6,000,000 2025: $4,500,000 = (55.5556% × $8,000,000) – $2,666,667 = $1,777,778 $8,100,000 2026: $8,000,000 – ($2,666,667 + $1,777,778) = $3,555,555

Gross profit (loss) recognition: 2024: $2,666,667 – $2,000,000 = $666,667 2025: $(100,000) – $666,667 = $(766,667) 2026: $(300,000) – $(100,000) = $(200,000)

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 6–21 (continued) Requirement 2 Construction in progress Cash, Materials, etc. To record construction costs Accounts receivable Billings on construction contract To record progress billings

2,500,000 2,750,000 2,500,000 2,750,000

Cash Accounts receivable To record cash collections

2,250,000 2,475,000 2,250,000 2,475,000

Construction in progress Cost of construction Revenue from long-term contracts To record gross profit

666,667 2,000,000 2,666,667

Cost of construction (1) Revenue from long-term contracts Construction in progress To record expected loss

(1)

2024 2025 2,000,000 2,500,000 2,000,000 2,500,000

2,544,445 1,777,778 766,667

Revenue recognized in 2025 $1,777,778 Plus: Loss recognized in 2025 (from previous page) 766,667 Cost of construction, 2025 $2,544,445

Exercise 6–21 (concluded) Requirement 3 2024

2025

Balance Sheet Current assets: Accounts receivable CIP ($2,666,667*) in excess of billings ($2,500,000) Current liabilities: Billings ($5,250,000) in excess of CIP ($4,400,000**)

$250,000 $525,000 166,667

$850,000

* Costs ($2,000,000) + profit ($666,667) ** Costs ($2,000,000 + $2,500,000) – loss ($100,000 = $766,667 – $666,667)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 6–22 Requirement 1 Year 2024 2025 2026 Total

Revenue recognized -0-0$8,000,000 $8,000,000

Gross profit (loss) recognized -0$(100,000) (200,000) $(300,000)

Requirement 2

2024

2025

Construction in progress Cash, Materials, etc. To record construction costs

2,000,000 2,500,000 2,000,000 2,500,000

Accounts receivable Billings on construction contract To record progress billings

2,500,000 2,750,000 2,500,000 2,750,000

Cash Accounts receivable To record cash collections

2,250,000 2,475,000 2,250,000 2,475,000

Loss on long-term contract Construction in progress To record expected loss

100,000 100,000

Exercise 6–22 (concluded) Requirement 3

Balance Sheet Current assets: Accounts receivable

2024

2025

$250,000

$525,000

Current liabilities: Billings ($2,500,000) in excess of CIP ($2,000,000)

$500,000

Billings ($5,250,000) in excess of CIP ($4,400,000*)

$850,000

* Costs ($2,000,000 + $2,500,000) – loss ($100,000)

Note: Billings in excess of CIP is a contract liability, similar to deferred profit.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 6–23 SUMMARY Gr. Profit Recognized Over Time Situation 1 2 3 4 5 6

2024 $166,667 $166,667 $166,667 $125,000 $125,000 $(100,000)

2025 $233,333 $(66,667) $(266,667) $375,000 $(125,000) $(100,000)

2026 $100,000 $100,000 $(100,000) $0 $200,000 $(100,000)

Gr. Profit Recognized Upon Completion 2024 2025 2026 $0 $0 $500,000 $0 $0 $200,000 $0 $(100,000) $(100,000) $0 $0 $500,000 $0 $0 $200,000 $(100,000) $(100,000) $(100,000)

Situation 1 - Revenue Recognized Over Time

Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2026)

2024

2025

2026

$5,000,000 1,500,000 3,000,000 4,500,000

$5,000,000 3,600,000 900,000 4,500,000

$5,000,000 4,500,000 -04,500,000

$ 500,000

Gross profit (loss) recognized: 2024: Revenue =

$1,500,000 = 33.3333% × $5,000,000 = $1,666,667 $4,500,000

Gross Profit = 1,666,667 – $1,500,000 = $166,667 Note: We can calculate gross profit directly as $1,500,000 = 33.3333% × $500,000 = $166,667 $4,500,000 Solutions Manual, Chapter 7 7–597 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

2025: Revenue =

$3,600,000 = 80.0% × $5,000,000 = $4,000,000 – $1,666,667 $4,500,000 = $2,333,333

Gross Profit = 2,333,333 – $2,100,000 = $233,333

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 6–23 (continued) Note: We can calculate gross profit directly as: $3,600,000 = 80.0% × $500,000 = $400,000 – $166,667 = $233,333 $4,500,000 2026: Revenue = $5,000,000 – $4,000,000 = $1,000,000 Gross Profit = $1,000,000 – $900,000 = $100,000

Situation 1 - Revenue Recognized Upon Completion Year 2024 2025 2026 Total gross profit

Gross profit recognized -0-0$500,000 $500,000

Situation 2 - Revenue Recognized Over Time

Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2026)

2024 $5,000,000 1,500,000 3,000,000 4,500,000

2025 $5,000,000 2,400,000 2,400,000 4,800,000

2026 $5,000,000 4,800,000 -04,800,000

$ 500,000

$ 200,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 6–23 (continued) Gross profit (loss) recognized: 2024: Revenue =

$1,500,000 = 33.3333% × $5,000,000 = $1,666,667 $4,500,000

Gross Profit = $1,666,667 – $1,500,000 = $166,667 Note: We can calculate gross profit directly as $1,500,000 = 33.3333% × $500,000 = $166,667 $4,500,000 2025: Revenue =

$2,400,000 = 50.0% × $5,000,000 = $2,500,000 – $1,666,667 $4,800,000 = $833,333

Gross Profit = $833,333 – $900,000 = $(66,667)

Note: We can calculate gross profit directly as: $2,400,000 = 50.0% × $200,000 = $100,000 – $166,667 = $(66,667) $4,800,000 2026: Revenue = $5,000,000 – $2,500,000 = $2,500,000 Solutions Manual, Chapter 7 7–601 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Gross Profit = $2,500,000 – $2,400,000 = $100,000 Situation 2 - Revenue Recognized Upon Completion Year 2024 2025 2026 Total gross profit

Gross profit recognized -0-0$200,000 $200,000

Exercise 6–23 (continued) Situation 3 - Revenue Recognized Over Time

Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2026)

2024 $5,000,000 1,500,000 3,000,000 4,500,000

2025 $5,000,000 3,600,000 1,500,000 5,100,000

2026 $5,000,000 5,200,000 -05,200,000

$ 500,000

$ (100,000)

$ (200,000)

Gross profit (loss) recognized:

2024: Revenue =

$1,500,000 = 33.3333% × $5,000,000 = $1,666,667 $4,500,000

Gross Profit = $1,666,667 – $1,500,000 = $166,667 Note: can calculate gross profit directly as $1,500,000 = 33.3333% × $500,000 = $166,667 7–602 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition $4,500,000

2025: Overall loss of $5,000,000 – $5,100,000 = $(100,000) Gross profit = $(100,000) – $166,667 = $(266,667)

2026: Overall loss of $5,000,000 – $5,200,000 = $(200,000) Gross profit = $(200,000) – $(100,000) = $(100,000)

Exercise 6–23 (continued) Situation 3 - Revenue Recognized Upon Completion Year 2024 2025 2026 Total project loss

Gross profit (loss) recognized -0$(100,000) (100,000) $(200,000)

Situation 4 - Revenue Recognized Over Time

Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2026)

2024 $5,000,000 500,000 3,500,000 4,000,000

2025 $5,000,000 3,500,000 875,000 4,375,000

2026 $5,000,000 4,500,000 -04,500,000

$1,000,000

$ 625,000

$ 500,000

Gross profit (loss) recognized: 2024: Revenue =

$ 500,000 = 12.5% × $5,000,000 = $625,000 $4,000,000

Gross Profit = $625,000 – $500,000 = $125,000 Note: can calculate gross profit directly as $500,000 7–604 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition = 12.5% × $1,000,000 = $125,000 $4,000,000

Exercise 6–23 (continued) 2025: Revenue =

$3,500,000 = 80% × $5,000,000 = $4,000,000 – $625,000 $4,375,000 = $3,375,000

Gross Profit = $3,375,000 – $3,000,000 = $375,000 Note: can calculate gross profit directly as $3,500,000 = 80.0% × $625,000 = $500,000 – $125,000 = $375,000 $4,375,000 2026: Revenue = $5,000,000 – $4,000,000 = $1,000,000 Gross Profit = $1,000,000 – $1,000,000 = $ - 0 –

Situation 4 - Revenue Recognized Upon Completion Year 2024 2025 2026 Total gross profit

Gross profit recognized -0-0$500,000 $500,000

Situation 5 - Revenue Recognized Over Time

Contract price Actual costs to date

2024 $5,000,000 500,000

2025 $5,000,000 3,500,000

2026 $5,000,000 4,800,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2026)

3,500,000 4,000,000

1,500,000 5,000,000

-04,800,000

$1,000,000

$ 200,000

-0-

Exercise 6–23 (continued) Gross profit (loss) recognized: 2024: Revenue =

$ 500,000 = 12.5% × $5,000,000 = $625,000 $4,000,000

Gross Profit = $625,000 – $500,000 = $125,000 Note: can calculate gross profit directly as $500,000 = 12.5% × $1,000,000 = $125,000 $4,000,000 2025:

$0 – $125,000 = $(125,000)

2026:

$200,000 – 0 = $200,000

Situation 5 - Revenue Recognized Upon Completion Year 2024 2025 2026 Total gross profit

Gross profit recognized -0-0$200,000 $200,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 6–23 (concluded) Situation 6 - Revenue Recognized Over Time

Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2026)

2024 $5,000,000 500,000 4,600,000 5,100,000

2025 $5,000,000 3,500,000 1,700,000 5,200,000

2026 $5,000,000 5,300,000 -05,300,000

$ (100,000)

$ (200,000)

$ (300,000)

Gross profit (loss) recognized: 2024: $(100,000) 2025: $(200,000) – $(100,000) = $(100,000) 2026: $(300,000) – $(200,000) = $(100,000)

Situation 6 - Revenue Recognized Upon Completion Year 2024 2025 2026 Total project loss

Gross profit (loss) recognized $(100,000) (100,000) (100,000) $(300,000)

Exercise 6–24 Requirement 1 Construction in progress = Costs incurred + Profit recognized $100,000

$20,000

Actual costs incurred in 2024 = $80,000 Requirement 2 Billings = Cash collections + Accounts receivable

$94,000 =

$30,000

Cash collections in 2024 = $64,000 Requirement 3 Let A = Actual cost incurred + Estimated cost to complete Actual cost incurred × (Contract price – A) = Profit recognized A $80,000 ($1,600,000 – A) = $20,000 A $128,000,000,000 – $80,000A = $20,000A $100,000A = $128,000,000,000 A = $1,280,000 Estimated cost to complete = $1,280,000 – $80,000 = $1,200,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 6–24 (concluded) Requirement 4 $80,000 = 6.25% $1,280,000

Alternatively, Requirement 4 can be answered as follows: Contract price Less: Total estimated cost Estimated gross profit

$1,600,000 1,280,000 $ 320,000

Proportion of gross profit recognized to date: $20,000 = 6.25% $320,000

PROBLEMS Problem 6-1 Requirement 1 a. Number of performance obligations in the contract: 2. The unlimited access to facilities for one year is one performance obligation. Because the discount voucher provides a material right to the customer (a 25% discount for yoga classes rather than a 10% discount) and that right is not one the Solutions Manual, Chapter 7 7–611 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

customer would receive had it not bought the one-year new membership, the option to buy yoga classes at a discount is a second performance obligation. The discount voucher is capable of being distinct because it could be sold or provided separately, and it is separately identifiable, as it is not highly interrelated with the other performance obligation of providing access to Fit & Slim‘s facilities, and the seller‘s role is not to integrate and customize them to create one product or service. So, the discount coupon qualifies as a performance obligation. b. To allocate the contract price to the performance obligations, we should first consider that Fit & Slim would offer a 10% discount on the yoga classes to all customers as part of its normal promotion strategy. So, a 25% discount provides a customer with an incremental value of 15% (25% – 10%). Thus, the estimated stand-alone selling price of the voucher provided by Fit & Slim is $30 ($500 initial price of the classes  15% incremental discount  40% likelihood of exercising the option). F&S‘s estimated stand-alone selling price of the discount option is: Value of the yoga discount voucher: (25% discount – 10% normal discount)  $500 = $ 75  40% Estimated redemption Stand-alone selling price of yoga discount voucher: $ 30 Stand-alone selling price of new gym membership: Total of stand-alone prices

720 $750

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 6-1 (continued) F&S must identify each performance obligation‘s share of the sum of the stand-alone selling prices of all deliverables:

$30 $30 + $720

Yoga discount voucher:

$720

Facilities access:

= 4% = 96%

$30 + $720 100% F&S then allocates the total selling price based on stand-alone selling prices, as follows:

$700 Transaction Price New membership 96% $672 Access to facilities

4% $28 Discount on yoga classes

The journal entry to record the sale is:

Cash Deferred revenue Deferred revenue – coupons

700 672 28

Problem 6-1 (concluded) Requirement 2 a. Number of performance obligations in the contract: 1. The access to the gym for 50 visits is one performance obligation. The option to pay $15 for additional visits does not constitute a material right because it requires the same fee as would normally be paid by nonmembers. Therefore, it is not a performance obligation in the contract. (Note: It could be argued that the coupon book actually includes 50 performance obligations – one for each visit to the gym. That would end up producing a very similar accounting outcome, as the $500 cost of the book would be allocated to the 50 visits with revenue recognized for each visit.) b. Since the option to visit on additional days is not a performance obligation, F&S should not allocate any of the contract price to the option. Therefore, the entire $500 payment is allocated to the 50 visits associated with the coupon book (―coupons‖). c.

Cash

500 Deferred revenue – coupons

500

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 6–2 Requirement 1 Number of performance obligations in the contract: 2. Delivery of a Protab computer is one performance obligation. The option to purchase a Probook at a 50% discount is a second performance obligation because it provides a material right to the customer that the customer would not receive had it not bought the Protab. The option, represented by the coupon, is capable of being distinct because it could be sold or provided separately, and it is separately identifiable, as it is not highly interrelated with the other performance obligation of delivering a Protab computer, and the seller‘s role is not to integrate and customize them to create one product. So, the discount coupon qualifies as a performance obligation. The 6-month quality assurance warranty is not a performance obligation. It is not sold separately and is simply a cost to assure that the product is of good quality. The seller will estimate and recognize an expense and related contingent warranty liability in the period of sale. Accounting for warranties is covered in Chapter 13. The coupon providing an option to purchase an extended warranty does not provide a material right to the customer because the extended warranty costs the same whether or not it is purchased along with the Protab. Therefore, that option does not constitute a performance obligation within the contract to purchase a Protab package.

Problem 6-2 (continued) Requirement 2 Allocation of purchase price to performance obligations:

Performance obligation:

Stand-alone selling price of the performance obligation:

Percentage of the sum of the stand-alone selling prices of the performance obligations:

Allocation of total transaction price to each performance obligation:

Protab tablet

$76,000,0001

95%3

$74,100,0005

Option to purchase a Probook

4,000,0002

5%4

3,900,0006

Total

$80,000,000

100.00%

$78,000,000

$76,000,000 = $760/unit × 100,000 units.

$4,000,000 = 50% discount × $400 normal Probook price × 100,000 discount coupons issued × 20% probability of redemption. 3

95% = $76,000,000 ÷ $80,000,000

5% = $4,000,000 ÷ $80,000,000

$74,100,000 = 95.00% × ($780 × 100,000 units)

$3,900,000 = 5.00% × ($780 × 100,000 units)

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 6-2 (concluded) Requirement 3 Creative then allocates the total selling price based on stand-alone selling prices, as follows:

$78,000,000 Transaction Price Protab package 95% $74,100,000 Protab computers

5% $3,900,000 Probook discount

The journal entry to record the sale is: Cash ($780 × 100,000 units) Sales revenue Deferred revenue – coupons

78,000,000 74,100,000 3,900,000

Problem 6–3 Requirement 1 Number of performance obligations in the contract: 3. Delivery of a Protab computer is one performance obligation. The option to purchase a Probook at a 50% discount is a second performance obligation because it provides a material right to the customer that the customer would not receive had it not bought the Protab. The option, represented by the coupon, is capable of being distinct because it could be sold or provided separately, and it is separately identifiable, as it is not highly interrelated with the other performance obligations in the contract, so the discount coupon qualifies as a performance obligation. The 6-month quality assurance warranty is not a performance obligation. It is not sold separately and is simply a cost to assure that the product is of good quality. The seller will estimate and recognize an expense and related contingent warranty liability in the period of sale. Accounting for warranties is covered in Chapter 13. The option to purchase the extended warranty provides a material right to the customer, as the extended warranty costs less when purchased with the coupon that was included in the Protab Package ($50) than it does when purchased separately ($75), so it is a third performance obligation. The option is capable of being distinct because it could be sold or provided separately, and it is separately identifiable, as it is not highly interrelated with the other performance obligations in the contract, and the seller‘s role is not to integrate and customize them to create one product or service. So, the discount option qualifies as a performance obligation.

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 6-3 (continued) Requirement 2 Allocation of purchase price to performance obligations:

Performance obligation:

Stand-alone selling price of the performance obligation:

Percentage of the sum of the stand-alone selling prices of the performance obligations (to two decimal places):

Allocation of total transaction price to each performance obligation:

$76,000,0001

93.83%4

$73,187,4007

Option to purchase Probook

4,000,0002

4.94%5

3,853,2008

Option to purchase extended warranty

1,000,0003

1.23%6

959,4009

100.00%

$78,000,000

Protab tablet

Total 1

$81,000,000

$76,000,000 = $760/unit × 100,000 units.

$4,000,000 = 50% discount × $400 normal Probook price × 100,000 discount coupons issued × 20% probability of redemption. 3

$1,000,000 = ($75 price of warranty sold separately minus $50 price of warranty sold at time of software purchase) × 100,000 units sold × 40% probability of exercise of option. 4

93.83% = $76,000,000 ÷ $81,000,000

4.94% = $4,000,000 ÷ $81,000,000

1.23% = $1,000,000 ÷ $81,000,000

$73,187,400 = 93.83% × ($780 × 100,000 units)

$3,853,200 = 4.94% × ($780 × 100,000 units)

$959,400 = 1.23% × ($780 × 100,000 units)

Problem 6-3 (concluded) Requirement 3 Creative then allocates the total selling price based on stand-alone selling prices, as follows:

$78,000,000

93.83%

$73,187,400 Protab computers

Transaction Price Protab Package 4.94%

1.23%

$3,853,200 Probook discount

$959,400 Extended warranty

The journal entry to record the sale is: Cash ($780 × 100,000 units) Sales revenue Deferred revenue – coupons Deferred revenue – extended warranties

78,000,000 73,187,400 3,853,200 959,400

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 6-4 Requirement 1 The delivery of Supply Club‘s normal products is one performance obligation. The promise to redeem loyalty points for discounts on purchases represents a material right to customers that they would not receive had they not bought Supply Club‘s products, so that the discount provided upon redemption of loyalty points represents a second performance obligation. The loyalty program provides customers with a discount option on future purchases. That option is capable of being distinct because it could be sold or provided separately, and it is separately identifiable, as it is not highly interrelated with the other performance obligation of delivering products under normal sales agreements (the customer can redeem loyalty points for future purchases). Therefore, the promise to redeem loyalty points qualifies as a performance obligation. Because there are two performance obligations associated with a single transaction price ($135,000), the transaction price must be allocated between the two performance obligations on the basis of stand-alone prices. Supply Club‘s estimated stand-alone selling price of the loyalty points is: Value of the loyalty points: 125,000 points  $0.20 discount per point = $ 25,000 Estimated redemption  60% Stand-alone selling price of loyalty points: $ 15,000 Stand-alone selling price of purchased products:

135,000

Total of stand-alone prices

$150,000

Supply Club must identify each performance obligation‘s share of the sum of the stand-alone selling prices of all deliverables:

Loyalty points:

Purchased products:

$15,000 $15,000 + $135,000 $135,000

= 10%

= 90%

$15,000 + $135,000 100%

Problem 6-4 (continued) Supply Club then allocates the total selling price based on stand-alone selling prices, as follows:

$135,000 Transaction Price Loyalty program 10%

90% $121,500 Purchased products

$13,500 Loyalty points discount

The journal entry to record July sales would be: Cash ($135,000 × 80%) Accounts receivable ($135,000 × 20%) Sales revenue

108,000 27,000 121,500

Deferred revenue – loyalty points

13,500

Requirement 2 Cash ($60,000 × 75% × 80%)* Accounts receivable ($60,000 × 25% × 80%)* Deferred revenue – loyalty points** Sales revenue (to balance)

36,000 12,000 10,800 58,800

Sales are discounted by 20% when points are redeemed, so only 80% of each dollar sold is received. 75% of sales are for cash, and 25% are on credit.

Supply Club expected that 60% of the 125,000 awarded points would eventually be redeemed. 60% × 125,000 = 75,000. Therefore, the 60,000 August redemptions constitute 60,000 ÷ 75,000 = 80% of total redemptions expected. Because Supply Club assigned $13,500 of deferred revenue to the July loyalty points, Supply Club should recognize revenue of $13,500 × 80% = $10,800.

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 6-4 (concluded)

When deferred revenue associated with the loyalty points was first recognized, a total of $13,500 was assigned to the points, given an expectation that 75,000 points would be redeemed. Therefore, each redeemed point results in recognition of $13,500/75,000 or $0.18/point. When 60,000 points are redeemed, they reduce the cash collected (now or in the future) by 20%. Thus, total cash collected will be $60,000 x 80% = $48,000. 75%, or $36,000, is collected immediately, and another $12,000 is collected when the receivable is collected. Thus, total revenue recognized upon sale is $36,000 (associated with cash sales) + $12,000 (associated with A/R) + $10,800 (deferred revenue associated with loyalty point redemption), totaling $58,800.

Problem 6–5 Requirement 1 The contract requires 6 payments of $20,000, plus or minus $10,000 at the end of the contract. So the contract will provide either [(6  $20,000) + $10,000] = $130,000, or [(6  $20,000) – $10,000] = $110,000. Revis would estimate the expected value of the transaction price as follows:

Possible Prices $130,000 ([$20,000  6] + $10,000) $110,000 ([$20,000  6] – $10,000)

Probability

Expected Consideration

80% 20%

$104,000 22,000

Expected value of contract price at inception

$126,000

Each month Revis will recognize $21,000 (equal to $126,000 ÷ 6) of revenue, recording the following journal entry:

Cash Bonus receivable Service revenue

20,000 1,000 21,000

Requirement 2 After six months the bonus receivable will have accumulated to $6,000 (equal to 6  $1,000). If Revis receives the bonus, it will record the following entry:

Cash Bonus receivable Service revenue

10,000 6,000 4,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 6-5 (concluded) Requirement 3 If Revis pays the penalty, it will record the following entry:

Service revenue Bonus receivable Cash

16,000 6,000 10,000

Problem 6–6 Requirement 1 Cash Deferred revenue

80,000 80,000

Because Super Rise believes that unexpected delays are likely and that it will not earn the $40,000 bonus, Super Rise is not likely to receive the bonus. Thus, the $40,000 is not included in the transaction price, and only the fixed payment of $80,000 is recognized as deferred revenue.

Requirement 2 Deferred revenue ($80,000 ÷ 10) Bonus receivable ($40,000 ÷ 10) Service revenue

8,000 4,000 12,000

Super Rise recognizes revenue of $12,000 associated in the month of January. Because Super Rise believes it is likely to receive the bonus, it will estimate the transaction price to be $120,000 (equal to $80,000 fixed payment + $40,000 bonus), and will recognize 1/10 of that amount each month.

Requirement 3 Deferred revenue ($80,000 ÷ 10) Bonus receivable [($40,000 ÷ 10) × 5] Service revenue

8,000 20,000 28,000

Super Rise recognizes revenue of $8,000 in each month, including May, based on the original transaction of $80,000 (equal to $80,000 ÷ 10 months). However, no bonus receivable had been recognized prior to May because unexpected delays were considered likely and thus no bonus was expected. In May, Super Rise concludes it is likely to receive the bonus, so it will revise the transaction price to $120,000 (equal to $80,000 fixed payment + $40,000 contingent bonus). This means Super Rise must record additional revenue of $20,000 to adjust revenue to the appropriate amount [($40,000 bonus receivable ÷ 10 months) × 5 months], and recognize a receivable for that amount.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 6–7 Requirement 1 Cash Deferred revenue

80,000 80,000

Because Super Rise has high uncertainty about its bonus estimate, it can‘t argue that it is probable that it won‘t have to reverse (adjust downward) a significant amount of revenue in the future because of a change in its estimate. Therefore, the $40,000 is not included in the transaction price, and only the fixed payment of $80,000 is recognized as deferred revenue.

Requirement 2 Deferred revenue ($80,000 ÷ 10) Bonus receivable [($40,000 ÷ 10) × 5] Service revenue

8,000 20,000 28,000

Super Rise recognizes revenue of $8,000 in the month of May based on the original transaction of $80,000 (equal to $80,000 ÷ 10 months). In addition, now that Super Rise can make an accurate estimate, it can argue that it is probable that it won‘t have to reverse (adjust downward) a significant amount of revenue in the future because of a change in its estimate. Therefore, Super Rise will revise the transaction price to $120,000 (equal to $80,000 fixed payment + $40,000 contingent bonus). This means Super Rise must record additional revenue of $20,000 to adjust revenue to the appropriate amount [($40,000 bonus receivable ÷ 10 months) × 5 months], and recognize a receivable for that amount.

Problem 6-8 Requirement 1 At the contract‘s inception, Velocity calculates the transaction price to be the expected value of the two possible eventual prices:

Possible Prices

Probabilities

80% $500,000 ([$60,000  8] + $20,000) $460,000 ([$60,000  8] – $20,000) 20% Expected value at contract inception:

Expected Consideration $400,000 92,000 $492,000

Because its consulting services are provided evenly over the eight months, Velocity will recognize revenue of $61,500 (equal to $492,000 ÷ 8 months). Because Velocity is guaranteed to receive only $60,000 per month ($1,500 less than the revenue recognized), it will recognize a bonus receivable of $1,500 in each month to reflect the expected value of the bonus amount to be received at the end of the contract. Therefore, Velocity‘s journal entry to record the revenue each month for the first four months is as follows:

Cash Bonus receivable Service revenue

60,000 1,500 61,500

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 6–8 (continued) Requirement 2 By the end of the fourth month, the bonus receivable account would have a balance of $6,000 (equal to 4  $1,500), equal to half of the expected value of the bonus of $12,000 (equal to $492,000 – [8  $60,000]). At the start of the fifth month, the estimated likelihood of receiving the bonus is revised so the estimated transaction price decreases:

Possible Prices

Expected Probabilities Consideration

60% $300,000 $500,000 ([$60,000  8] + $20,000) 40% 184,000 $460,000 ([$60,000  8] – $20,000) Transaction price at start of fifth month: $484,000 So, after four months, the bonus receivable account should have a balance of $2,000, which is half of the new expected value of the bonus of $4,000 (equal to $484,000 – [8  $60,000]). Because the bonus receivable account was increased to $6,000 in the first four months, an adjustment of $4,000 is needed to reduce the bonus receivable down to $2,000:

Service revenue Bonus receivable

4,000 4,000

This entry reduces the bonus receivable from $6,000 to $2,000, with the offsetting debit being a reduction in revenue. Over the remaining four months, the bonus receivable will increase by $500 each month, accumulating to $4,000 by the end of the contract.

Problem 6–8 (concluded) Requirement 3 Because services are provided evenly over the eight months, Velocity would recognize revenue of $60,500 (equal to $484,000 ÷ 8 months) in each of months five through eight. Because Velocity received $60,000 per month ($500 less than the revenue recognized), Velocity would recognize a bonus receivable of $500 each month to reflect the additional service revenue in excess of its unconditional right to $60,000. The journal entry would be:

Cash Bonus receivable Service revenue

60,000 500 60,500

Requirement 4 At the end of contract, Velocity learns that it will receive the bonus of $20,000. It already has recognized revenue of $4,000 associated with the bonus. Therefore, when Velocity receives the cash bonus, it will recognize additional revenue of $16,000.

Cash Bonus receivable Service revenue

20,000 4,000 16,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 6-9 Requirement 1 The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. Regarding accounting for sales-based royalties from licenses, the appropriate citation is: FASB ASC 606–10–55–65: ―Revenue from Contracts with Customers–Overall– Implementation Guidance and Illustrations–Sales-Based or Usage-Based Royalties.‖

That citation requires that both of the following two events have occurred: 1. The sales that utilize the intellectual property have occurred. 2. The performance obligation to which the royalty has been allocated has been satisfied. Therefore, Tran can‘t recognize revenue for sales-based royalties on the Lyon license until sales have actually occurred. Requirement 2 If Tran accounts for the Lyon license of functional intellectual property as a right of use that is conveyed on April 1, 2024, Tran can recognize revenue of $500,000 on that date, because that is the date upon which Tran transfers to Lyon the right to use its intellectual property. The journal entry would be:

Cash License revenue

500,000 500,000

Requirement 3 Tran recognizes revenue for sales-based royalties in the period in which uncertainty is resolved. Tran is due $1,000,000 of royalties on Lyon‘s sales in 2024, so it should recognize revenue in that amount. The journal entry would be:

Cash License revenue

1,000,000 1,000,000

Problem 6–9 (concluded) Requirement 4 If Tran accounts for the Lyon license of symbolic intellectual property as an access right for the period from April 1, 2024, through March 31, 2029, Tran cannot recognize any revenue on April 1, 2024, because it fulfills its performance obligation over the access period and no time has yet passed. Instead, Tran must recognize deferred revenue of $500,000. The journal entry would be:

Cash Deferred revenue

500,000 500,000

As of December 31, 2024, Tran has partially fulfilled its performance obligation to provide access to its symbolic intellectual property. Given that the access right covers a five-year period (from April 1, 2024, through March 31, 2029), and Tran provided access for nine months of 2024 (from April 1, 2024, through December 31, 2024), Tran has provided 15% [equal to 9 ÷ (5 × 12)] of the access right during 2024, and should recognize 15% × $500,000 = $75,000 of revenue. Tran also should recognize revenue for the $1,000,000 of royalties arising from Lyon‘s sales in 2024. So, total revenue recognized in 2024 is $75,000 + $1,000,000 = $1,075,000. The journal entry would be:

Cash Deferred revenue License revenue

1,000,000 75,000 1,075,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 6–10 Requirement 1 Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2026)

2024 $10,000,000 2,400,000 5,600,000 8,000,000

2025 $10,000,000 6,000,000 2,000,000 8,000,000

2026 $10,000,000 8,200,000 -08,200,000

$ 2,000,000

$ 1,800,000

Revenue recognition: 2024: $2,400,000 = 30.0% × $10,000,000 = $3,000,000 $8,000,000 2025: $6,000,000 = 75.0% × $10,000,000 – $3,000,000 = $4,500,000 $8,000,000 2026: $10,000,000 – $7,500,000 = $2,500,000

Gross profit (loss) recognition: 2024: $3,000,000 – $2,400,000 = $600,000 2025: $4,500,000 – $3,600,000 = $900,000 2026: $2,500,000 – $2,200,000 = $300,000

Note: Also can calculate gross profit directly using the percentage of completion: 2024: $2,400,000 = 30.0% × $2,000,000 = $600,000 $8,000,000 2025: $6,000,000 Solutions Manual, Chapter 7 7–633 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

= 75.0% × $2,000,000 = $1,500,000 – $600,000 = $900,000 $8,000,000 2026: $1,800,000 – $1,500,000 = $300,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 6–10 (continued) Requirement 2 2024

2025

2026

Construction in progress Cash, materials, etc. To record construction costs

2,400,000 3,600,000 2,200,000 2,400,000 3,600,000 2,200,000

Accounts receivable Billings on construction contract To record progress billings

2,000,000 4,000,000 4,000,000 2,000,000 4,000,000 4,000,000

Cash Accounts receivable To record cash collections

1,800,000 3,600,000 4,600,000 1,800,000 3,600,000 4,600,000

Construction in progress (gross profit) Cost of construction (cost incurred) Revenue from long-term contracts To record gross profit

600,000

900,000

300,000

2,400,000

3,600,000

2,200,000

3,000,000

4,500,000

2,500,000

Problem 6–10 (continued) Requirement 3 Balance Sheet Current assets: Accounts receivable Construction in progress Less: Billings CIP in excess of billings

2024

2025

$ 200,000

$600,000

$3,000,000 (2,000,000)

$7,500,000 (6,000,000) 1,000,000

1,500,000

Note: Construction in progress in excess of billings is a contract asset; Billings in excess of construction in progress is a contract liability.

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 6–10 (continued) Requirement 4 Costs incurred during the year Estimated costs to complete as of year-end Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (actual in 2026)

2024 $2,400,000

2025 $3,800,000

2026 $3,200,000

5,600,000

3,100,000

2024 $10,000,000 2,400,000 5,600,000 8,000,000

2025 $10,000,000 6,200,000 3,100,000 9,300,000

2026 $10,000,000 9,400,000 -09,400,000

$ 2,000,000

$ 700,000

$ 600,000

Revenue recognition: 2024: $2,400,000 = 30.0% × $10,000,000 = $3,000,000 $8,000,000 2025: $6,200,000 = 66.6667% × $10,000,000 – $3,000,000 = $3,666,667 $9,300,000 2026: $10,000,000 – $6,666,667 = $3,333,333 Gross profit (loss) recognition: 2024: $3,000,000 – $2,400,000 = $600,000 2025: $3,666,667 – $3,800,000 = $(133,333) 2026: $3,333,333 – $3,200,000 = $133,333

Problem 6–10 (continued) Note: Also can calculate gross profit directly using the percentage of completion: 2024: $2,400,000 = 30.0% × $2,000,000 = $600,000 $8,000,000 2025: $6,200,000 = 66.6667% × $700,000 = $466,667 – $600,000 = $(133,333) $9,300,000 2026:

$600,000 – $466,667 = $133,333

Requirement 5 Costs incurred during the year Estimated costs to complete as of year-end Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2026)

2024 $2,400,000

2025 $3,800,000

2026 $3,900,000

5,600,000

4,100,000

2024 $10,000,000 2,400,000 5,600,000 8,000,000

2025 $10,000,000 6,200,000 4,100,000 10,300,000

2026 $10,000,000 10,100,000 -010,100,000

$ 2,000,000

$ (300,000)

$ (100,000)

Revenue recognition: 2024: $2,400,000 = 30.0% × $10,000,000 = $3,000,000 $8,000,000 2025: $6,200,000 = 60.19417% × $10,000,000 – $3,000,000 = $3,019,417 $10,300,000 2026: $10,000,000 – $6,019,417 = $3,980,583 7–638 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 6–10 (concluded) Gross profit (loss) recognition: 2024: $3,000,000 – $2,400,000 = $600,000 2025: $(300,000) – $600,000 = $(900,000) 2026: $(100,000) – $(300,000) = $200,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 6–11 Requirement 1 Year 2024 2025 2026 Total

Revenue recognized -0-0$10,000,000 $10,000,000

Gross profit recognized -0-0$1,800,000 $1,800,000

Requirement 2

Construction in progress Cash, materials, etc. To record construction costs

2024 2025 2026 2,400,000 3,600,000 2,200,000 2,400,000 3,600,000 2,200,000

Accounts receivable Billings on construction contract To record progress billings

2,000,000 4,000,000 4,000,000 2,000,000 4,000,000 4,000,000

Cash Accounts receivable To record cash collections

1,800,000 3,600,000 4,600,000 1,800,000 3,600,000 4,600,000

Construction in progress (gross profit) Cost of construction (costs incurred) Revenue from long-term contracts (contract price) To record gross profit

1,800,000 8,200,000 10,000,000

Problem 6–11 (concluded) Requirement 3 Balance Sheet Current assets: Accounts receivable Construction in progress Less: Billings CIP in excess of billings

2024

2025

$ 200,000

$ 600,000

$2,400,000 (2,000,000)

$6,000,000 (6,000,000) 400,000

-0-

Note: Construction in progress in excess of billings is a contract asset. Requirement 4 Costs incurred during the year Estimated costs to complete as of year-end Year 2024 2025 2026 Total

2024 $2,400,000

2025 $3,800,000

2026 $3,200,000

5,600,000

3,100,000

Revenue recognized -0-0$10,000,000 $10,000,000

Gross profit recognized -0-0$600,000 $600,000

2024 $2,400,000

2025 $3,800,000

2026 $3,900,000

5,600,000

4,100,000

Requirement 5 Costs incurred during the year Estimated costs to complete as of year-end Year 2024 2025 2026 Total

Revenue recognized -0-0$10,000,000 $10,000,000

Gross profit (loss) recognized -0$(300,000) 200,000 $(100,000)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 6–12 Requirement 1 Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit (loss) (actual in 2026)

2024 $4,000,000 350,000 3,150,000 3,500,000

2025 $4,000,000 2,500,000 1,700,000 4,200,000

2026 $4,000,000 4,250,000 -04,250,000

$ 500,000

$ (200,000)

$ (250,000)

Year 2024 2025 2026 Total project loss

Gross profit (loss) recognized -0$(200,000) (50,000) $(250,000)

Requirement 2 Gross profit (loss) recognition: 2024:

Revenue: (10% × $4,000,000) – $350,000 cost = $50,000

2025:

$(200,000) – $50,000 = $(250,000)

2026:

$(250,000) – $(200,000) = $(50,000)

Requirement 3 Balance Sheet

2024

Current assets: CIP ($2,300,000*) in excess of billings ($2,170,000) Current liabilities: Billings ($720,000) in excess of CIP ($400,000)

2025

$ 130,000

$ 320,000

*Cumulative costs ($2,500,000) less cumulative loss recognized ($200,000) = $2,300,000 Solutions Manual, Chapter 7

7–643

Problem 6–13 Requirement 1 Recognizing revenue upon completion of long-term construction contracts is equivalent to recognizing revenue at the point in time at which delivery occurs. Recognizing revenue over time requires assigning a share of the project‘s expected revenues and costs to each construction period. The share is estimated based on the project's costs incurred each period as a percentage of the project's total estimated costs.

Requirement 2 Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit

2024 $20,000,000 4,000,000 12,000,000 16,000,000 $ 4,000,000

2026 $20,000,000 13,500,000 4,500,000 18,000,000 $ 2,000,000

Revenue recognition: If revenue is recognized upon project completion, Citation would not report any revenue in the 2024 or 2025 income statements.

Gross profit recognition: If revenue is recognized upon project completion, Citation would not report gross profit until the project is completed. Citation would have to report an overall gross loss on the contract in whatever period it first revises the estimates to determine that an overall loss will eventually occur. Citation never estimates the Altamont contract will earn a gross loss, so never has to recognize one.

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 6–13 (continued) c. Balance Sheet At December 31, 2024 Current assets: Accounts receivable CIP ($4,000,000*) in excess of billings ($2,000,000)

$ 200,000 2,000,000

* If revenue is recognized upon project completion, this account would only include costs of $4,000,000 Requirement 3 Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit a.

2024 $20,000,000 4,000,000 12,000,000 16,000,000 $ 4,000,000

2025 $20,000,000 13,500,000 4,500,000 18,000,000 $ 2,000,000

Revenue recognition:

2024: $ 4,000,000 Revenue:

= 25% × $20,000,000 = $5,000,000 $16,000,000

2025: $13,500,000 Revenue:

= 75% × $20,000,000 = $15,000,000 $18,000,000

Less: 2024 revenue

5,000,000

2025 revenue

$10,000,000

Gross profit recognition:

2024: Gross Profit: $5,000,000 – $4,000,000 = $1,000,000 2025: Gross Profit: $10,000,000 – $9,500,000 = $500,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 6–13 (continued) c. Balance Sheet At December 31, 2024 Current assets: Accounts receivable CIP ($5,000,000*) in excess of billings ($2,000,000)

$ 200,000 3,000,000

* Costs ($4,000,000) + profit ($1,000,000) Requirement 4 Contract price Actual costs to date Estimated costs to complete Total estimated costs Estimated gross profit

2024 $20,000,000 4,000,000 12,000,000 16,000,000 $ 4,000,000

2025 $20,000,000 13,500,000 9,000,000 22,500,000 ($ 2,500,000)

a. Revenue recognition: Total revenue recognized to date = (percentage complete)(total revenue) = ($13,500,000 ÷ $22,500,000) x ($20,000,000) = (60%) x ($20,000,000) = $12,000,000 Revenue recognized in 2025 = total – revenue recognized in prior periods = $12,000,000 – $5,000,000 = $7,000,000 b.

Gross profit recognition: 2025: Overall loss of ($2,500,000) – previously recognized gross profit of $1,000,000 = $(3,500,000).

Problem 6–13 (continued) c. Balance Sheet At December 31, 2025 Current assets: Accounts receivable

$ 1,600,000

Current liabilities: Billings ($12,000,000) in excess of CIP ($11,000,000*)

1,000,000

* 2024 costs ($4,000,000) + 2024 profit ($1,000,000) + 2025 costs ($9,500,000) – 2025 loss ($3,500,000) Requirement 5 Citation should recognize revenue at the time of delivery, when the homes are completed and title is transferred to the buyer. Recognizing revenue over time is not appropriate in this case, because the criteria for revenue recognition over time are not met. Specifically, the customers are not consuming the benefit of the seller‘s work as it is performed (criterion 1 in Illustration 5-5), the customer does not control the asset as it is created (criterion 2), and the homes have an alternative use to the seller and seller does not have the right to receive payment for progress to date (criterion 3). Until completion of the home, transfer of title does not occur and the full sales price is not received, so control of the homes has not passed from Citation to the buyers.

Requirement 6 Income statement: Sales revenue (3 x $600,000) Cost of goods sold (3 x $450,000) Gross profit Balance sheet: Current assets: Inventory (work in process) Current liabilities: Customer deposits (or deferred revenue) *$600,000 x 10% = $60,000 x 5 = $300,000

$1,800,000 1,350,000 $ 450,000

$2,700,000 $ 300,000*

ECISION MAKERS’ PERSPECTIVE CASES Research Case 6–1 (Note: This case requires the student to reference a journal article.) 7–648 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition

1. Abuse 1. Cutoff manipulation

2. Deferring too much or too little revenue 3. Bill-and-hold sale 4. Right-of-return sale

Explanation The company either closes its books early (so some current-year revenue is postponed until next year) or leaves the books open too long (so some next-year revenue is included in the current year). The company has an arrangement under which revenue should be deferred, but it doesn‘t defer the revenue. Or, a company could defer too much revenue to shift income into future periods. The company records sales even though it hasn‘t yet delivered the goods to the customer. The company sells to distributors or other customers and can‘t estimate returns with sufficient accuracy due to the nature of the selling relationship.

Manipulating estimates of percentage complete in order to manipulate gross profit recognition.

These abuses tended to increase income (75% of the time), consistent with management generally having an incentive to increase income.

Yes, auditors tended to require adjustment (56% of the time), consistent with auditors being concerned about income-increasing earnings management.

Judgment Case 6–2 Level 1: Kerry obtained the access code for Level I on December 1, meaning that Kerry has obtained the control of the right to use the software for Level I on that date. On December 1 Cutler should recognize $50 of revenue for Level I. Level II: Tom passed the Level I test on December 10 and Kerry purchased access to Level II on the same day. However, Kerry received the access code for Level II on December 20, so control over the Level II software was not transferred to Kerry until December 20. Cutler should recognize $30 of revenue for Level II on December 20.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Judgment Case 6-3 Scenario 1: Recognize revenue over time. The terms of the contract and all the related facts and circumstances indicate that Star controls the room as it is built. Crown is entitled to receive payments throughout the contract as evidenced by the required progress payments (with no refund of payment for any work performed to date) and by the requirement to pay for any partially completed work in the event of contract termination. Consequently, Crown‘s performance obligation is to provide Star with construction services, and Crown would recognize revenue over time throughout the construction process. Scenario 2: Recognize revenue upon contract completion. The terms of the contract and all the related facts and circumstances indicate that Star does not obtain control of the gym until it is delivered. If the contract is terminated prior to completion, Crown retains the equipment, suggesting that Crown retains control of the equipment throughout the job. Consequently, Crown‘s performance obligation is to provide Star with a completed gym, and Crown would recognize revenue upon contract completion. Scenario 3: Recognize revenue over time. The terms of the contract and all the related facts and circumstances indicate that Coco has the ability to direct the use of, and receive the benefit from, the consulting services as they are performed. The restaurant has an unconditional obligation to pay throughout the contract as evidenced by the nonrefundable progress payments, and the right to a report regardless of contract termination. Also, the report has no alternate use to CostDriver. Therefore, the CostDriver Company‘s performance obligation is to provide the restaurant with services continuously during the three months of the contract, and CostDriver should recognize revenue over the life of the contract. Scenario 4: Recognize revenue upon contract completion. The terms of the contract and all the related facts and circumstances indicate that Edwards, the customer, obtains control of the apartment upon completion of the contract. Edwards obtains title and physical possession of the apartment only on completion of the contract. Consequently, Tower‘s performance obligation is to provide the customer with a completed apartment, and Tower should not recognize revenue until delivery of the apartment.

Real World Case 6–4 1. Verizon: Output-based. Verizon recognizes revenue recognizes revenue either as the customer consumes the service or as time passes. 2. Lockheed Martin: Input-based. Lockheed Martin recognizes revenue over time according to a cost-to-cost ratio, comparing costs incurred to date to the estimated total cost necessary to complete its performance obligation. 3. TriNet: Output-based. TriNet recognizes revenue over time according to its provision of payroll processing services.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Research Case 6–5 Requirement 1 FASB ASC 606–10–55–42: ―Revenue from Contracts with Customers–Overall– Implementation Guidance and Illustrations–Customer Options for Additional Goods or Services.‖

Requirement 2 FASB ASC 606–10–32–31: ―Revenue from Contracts with Customers–Overall–Measurement– Allocation Based on Standalone Selling Prices.‖

Requirement 3 FASB ASC 606–10–32–34: ―Revenue from Contracts with Customers–Overall–Measurement– Allocation Based on Standalone Selling Prices.‖

Requirement 4 FASB ASC 606–10–25–23: ―Revenue from Contracts with Customers–Overall–Recognition– Satisfaction of Performance Obligations.‖

Judgment Case 6-6 No, the license and R&D development services are not separate performance obligations. The license granted by Pfizer is for functional intellectual property, so you might be tempted to recognize revenue upon the date of transfer. However, the license is not a performance obligation, because it is not separately identifiable. The only way to exploit the license is by utilizing ongoing R&D services from Pfizer. The license does not provide utility on its own or together with other goods or services that HealthPro has received previously from Pfizer or that are available from other entities. Rather, the license requires Pfizer‘s R&D services and proprietary expertise to be valuable. Therefore, Pfizer would combine the license with the R&D services to HealthPro and account for them as a single performance obligation, with revenue recognized over time as Pfizer provides R&D services.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Judgment Case 6-7 When other parties are involved in providing goods or services to a seller‘s customer, the seller must determine whether its performance obligation is to provide the goods or services, making the seller a principal, or the seller arranges for another party to provide those goods or services, making the seller an agent. That determination affects whether the seller recognizes revenue in the amount of consideration received in exchange for those goods or services (if principal) or in the amount of any fee or commission received in exchange for arranging for the other party to provide the goods or services (if agent).

Requirement 1 AuctionCo is a principal because it obtained control of the used bicycle before the bicycle was sold. Therefore, AuctionCo should recognize revenue of $300 at the time of the sale to the customer.

Requirement 2 AuctionCo is an agent because it never controlled the product before it was sold. Therefore, AuctionCo should recognize revenue for the commission fees of $100 received upon sending $200 to the original owner at the time of the sale to the customer.

Requirement 3 If AuctionCo must pay the bicycle owner the $200 price regardless of whether the bicycle is sold, then AuctionCo would appear to have purchased the bicycle and should be treated as a principal. Therefore, AuctionCo should recognize revenue of $300 at the time of the sale to the customer.

Real World Case 6–8 Requirements 1 and 2 Excerpt from Expedia’s 2019 Annual Report: Merchant Hotel. Our travelers pay us for merchant hotel transactions prior to departing on their trip, generally when they book the reservation. We record the payment in deferred merchant bookings until the stayed night occurs, at which point we recognize the revenue, net of amounts paid to suppliers, as this is when our performance obligation is satisfied. In certain nonrefundable, nonchangeable transactions where we have no significant post booking services (primarily opaque hotel offerings), we record revenue when the traveler completes the transaction on our website, less a reserve for chargebacks and cancellations based on historical experience. Payments to suppliers are generally due within 30 days of check-in or stay.

Excerpt from Booking Holding’s (Priceline) 2019 Annual Report: Merchant revenues include travel reservation commissions and transaction net revenues (i.e., the amount charged to travelers less the amount owed to travel service providers) in connection with the Company's merchant reservations services; credit card processing rebates and customer processing fees; and ancillary fees, including travel-related insurance revenues and certain GDS reservation booking fees. … Under the previous revenue recognition standard, revenues from Priceline's Name Your Own Price® transactions were presented on a gross basis with the amount remitted to the travel service providers reported as cost of revenues. Under the current revenue recognition standard, Name Your Own Price® revenues are reported on a net basis with the amount remitted to the travel service providers recorded as an offset in merchant revenues. Therefore, for periods beginning after December 31, 2017, the Company no longer presents "Cost of revenues" or "Gross profit" in its Consolidated Statements of Operations. Total revenues reported in 2019 and 2018 are comparable to gross profit reported in previous years.

Complete Solution Manual for Intermediate Accounting, 11th Edition Case 6–8 (continued)

Requirement 3 a) Expedia‘s ―merchant hotel‖ revenues: This is reported net: ―we recognize the revenue, net of amounts paid to suppliers, as this is when our performance obligation is satisfied ...‖ b) Priceline‘s ―‗Name Your Own Price®‘ services‖: This is reported net: ―Under the current revenue recognition standard, Name Your Own Price® revenues are reported on a net basis with the amount remitted to the travel service providers recorded as an offset in merchant revenues.‖ c) Priceline‘s ―Merchant revenues‖: This is reported net: ―Merchant revenues include travel reservation commissions and transaction net revenues (i.e., the amount charged to travelers less the amount owed to travel service providers) in connection with the Company's merchant reservations services; credit card processing rebates and customer processing fees; and ancillary fees.‖ Requirement 4 This was reported gross: Under the previous revenue recognition standard, revenues from priceline's Name Your Own Price® transactions were presented on a gross basis with the amount remitted to the travel service providers reported as cost of revenues. Effect of change from gross to net presentation: Revenue: lower Cost of revenues: lower Net income: no change 7–658 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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Research Case 6–9 Requirement 1 FASB ASC 606–10–55–36: ―Revenue from Contracts with Customers–Overall– Implementation Guidance and Illustrations–Principal versus Agent Considerations.‖

Requirement 2 FASB ASC 606–10–55–39: ―Revenue from Contracts with Customers–Overall– Implementation Guidance and Illustrations–Principal versus Agent Considerations.‖ The Codification lists the following indicators that the entity is a principal: 1. The entity is primarily responsible for fulfilling the contract. 2. The entity has inventory risk before or after the goods have been ordered by a customer, during shipping, or on return. 3. The entity has discretion in establishing prices for the goods or services.

Requirements 3 and 4 Yes. Alphabet‘s 2017 10K states: ―For ads placed on Google Network Members‘ properties, we evaluate whether we are the principal (i.e., report revenues on a gross basis) or agent (i.e., report revenues on a net basis). Generally, we report advertising revenues for ads placed on Google Network Members‘ properties on a gross basis, that is, the amounts billed to our customers are recorded as revenues, and amounts paid to Google Network Members are recorded as cost of revenues. Where we are the principal, we control the advertising inventory before it is transferred to our customers. Our control is evidenced by our sole ability to monetize the advertising inventory before it is transferred to our customers, and is further supported by us being primarily responsible to our customers and having a level of discretion in establishing pricing. ‖ That is consistent with the indicators listed above, so Alphabet‘s reasoning appears appropriate.

Real World Case 6–10 Requirement 1 a) Is Deere & Company accounting appropriately for revenue on contracts with interest free periods of less than one year? Yes. Sellers can assume the financing component is not significant if the period between delivery and payment is less than a year. b) Is Deere & Company accounting appropriately for revenue on contracts with interest free periods of greater than one year? Yes. If the period between delivery and payment is greater than a year, sellers must assess whether the financing component is significant, and in this case Deere must have concluded that it is significant.

Requirement 2 a) Total receivable at time of sale: Same b) Sales revenue at time of sale: Higher c)

Interest revenue at time of sale: Same

d) Interest revenue in period after sale: Lower e)

Cash received upon collection of the receivable: Same

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Real World Case 6–11 1. eBay: Adjusted market assessment approach 2. Oracle: Residual approach 3. Lockheed Martin: Expected cost plus margin approach 4. EMCOR: Adjusted market assessment approach 5. EMCOR: Expected cost plus margin approach

Trueblood Accounting Case 6–12 A solution and extensive discussion materials can be obtained from the Deloitte Foundation.

Trueblood Accounting Case 6–13 A solution and extensive discussion materials can be obtained from the Deloitte Foundation.

Trueblood Accounting Case 6–14 A solution and extensive discussion materials can be obtained from the Deloitte Foundation.

Trueblood Accounting Case 6–15 A solution and extensive discussion materials can be obtained from the Deloitte Foundation.

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Communication Case 6–16 The critical Question that student groups should address is how to account for punches in the punch card and the option to possibly receive a free ice cream cone that it provides. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole. The preferred solution should include the idea that the sale of an ice cream cone to a person who has a card involves two performance obligations: 1. Providing the ice cream cone 2. Eventually providing an additional ice cream cone, if and when a customer reaches 10 punches on a card and redeems the card for the free cone. Students should recognize that each punch on the punch card contributes to an option to receive a future ice cream cone. That option is capable of being distinct because it could be sold or provided separate from selling a cone, and it is separately identifiable, as it is not highly interrelated with selling a cone (for example, cones certainly could be sold without offering the punch card program, and in fact that is how Jerry‘s currently does business). Therefore, each punch on the punch card is distinct from the cone that is sold at the same time, and each punch qualifies as a performance obligation. Students also should recognize that not all cards will be redeemed for ice cream cones. Some may be lost, and some may never fill up with the required 10 punches. Therefore, Jerry must estimate the chance that a punch results in a future ice cream cone. He likely would come up with some estimate. For example, he might conclude that half of all punches end up unused, such that a punch on average leads to Jerry providing 1/20 of a free future cone. In that case, the revenue for each cone should be allocated to the two performance obligations based on their stand-alone selling prices, and a journal entry is recorded upon sale of a cone as follows: Cash

xxx Sales Revenue Deferred revenue

xxx xxx

Case 6–16 (concluded) In the future, when a card is redeemed, the deferred revenue account would be reduced and revenue recognized for deferred revenue related to ten punches. Sales of ice cream cones to people who do not have cards have only a single performance obligation – to deliver the ice cream cone – and so can be accounted for in the same manner as they were previously. Other solutions that are likely to emerge:

1. Treat providing the occasional free cone as a cost of doing business and don‘t view provision of that cone as a separate performance obligation. The idea here is that the deferral of revenue associated with the free cones is timeconsuming and is not likely to provide a material amount of additional information to financial statement users. This approach would be an immaterial departure from GAAP. 2. Ignore revenue recognition and instead accrue an estimated cost. This solution views the free ice cream cone as a promotional expense. The estimated cost of the free cone should be expensed as the 10 required cones are sold. A corresponding liability is recorded which should increase to an amount equal to the cost of the free cone. When the free cone is awarded, the liability and inventory are reduced. This approach ignores the idea that there is a revenuerecognition aspect to the promise of free cones, so is not correct. It‘s important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction.

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Communication Case 6–17 Suggested Grading Concepts and Grading Scheme: Content (70%) 25

Income differences.  Revenue recognition over time recognizes gross profit during construction based on an estimate of percent complete.  If a project doesn‘t qualify for revenue recognition over time, no gross profit is recognized until project completion.  Estimated losses are fully recognized in the first period an overall loss is anticipated. Balance sheet differences.  The two approaches are similar. However, for profitable projects, the construction in progress account during construction will have a higher balance when revenue is recognized over time due to the inclusion of gross profit. According to generally accepted accounting principles, revenue should be recognized over time if: 1. The customer consumes the benefit of the seller‘s work as it is performed,

2. The customer controls the asset as it is created, or 3. The seller is creating an asset that has no alternative use to the seller, and the seller can receive payment for its progress even if the customer cancels the contract. The second and third of these situations likely apply to Willingham‘s construction contracts, so those contracts probably require revenue recognition over time. 70 points Writing (30%) 6 12

Terminology and tone appropriate to the audience of a company controller. Organization permits ease of understanding.  Introduction that states purpose.  Paragraphs that separate main points. English  Sentences grammatically clear and well organized, concise.  Word selection.  Spelling.  Grammar and punctuation.

30 points

Ethics Case 6–18 Discussion should include these elements.

Facts: Horizon Corporation, a computer manufacturer, reported profits from 2019 through 2022, but reported a $20 million loss in 2023 due to increased competition. The chief financial officer (CFO) circulated a memo suggesting the shipment of computers to J.B. Sales, Inc., in 2024 with a subsequent return of the merchandise to Horizon in 2025. Horizon would record a sale for the computers in 2024 and avoid an inventory write-off that would place the company in a loss position for that year. The CFO is clearly asking Jim Fielding to recognize revenue in 2024 that he knows will be reversed as a sales return in 2025.

Ethical Dilemma: Is Jim's obligation to challenge the memo of the CFO and provide useful information to users of the financial statements greater than the obligation to prevent a company loss in 2024 that may lead to bankruptcy?

Who is affected? Jim Fielding CFO and other managers Other employees Shareholders Potential shareholders Creditors Auditors

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Target Case Requirement 1 Target reports Sales revenue of $78,112 million for the 2019 fiscal year, which ended February 1, 2020. Requirement 2 Recording revenue at the point of sale indicates that Target records revenue at the point in time that customers receive goods or services. That is the point in time that Target has fulfilled its performance obligation to deliver goods to customers. Requirement 3 Target‘s Note 2 indicates: ―Sales are recognized net of expected returns, which we estimate using historical return patterns and our expectation of future returns.‖ Therefore, estimated returns reduce revenue and net income. Those estimates will be adjusted to reflect actual returns over time. Requirement 4 When a gift card is sold, Target does not recognize revenue. Instead, it recognizes a deferred revenue liability rather than revenue, because it has not yet delivered goods or services to a customer. Target will reduce the deferred revenue liability and recognize revenue either when the gift card is redeemed or when, based on historical experience, Target judges it to be ―broken‖, meaning that Target does not believe the gift card will ever be redeemed. Requirement 5 Target indicates that ―We receive consideration for a variety of vendor-sponsored programs, such as volume rebates, markdown allowances, promotions, and advertising allowances and for our compliance programs, referred to as ‗vendor income.‘ Substantially all vendor income is recorded as a reduction of cost of sales.‖ Thus, vendor income is really a refund of some of the amount that Target is paying for goods or services. Vendor income reduces Target’s costs, and so does not affect Target’s revenue. Likewise, because Target‘s cost is the same as the vendor‘s revenue, these refunds serve to reduce vendors’ revenue. Solutions Manual, Chapter 7 7–667 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Air France–KLM Case Requirement 1 a. AF‘s balance sheet indicates current deferred revenue on ticket sales of €3,289 million as of December 31, 2019. b. The journal entry would be: Deferred revenue Sales revenue

3,289 3,289

c. Yes, this seems consistent with U.S. GAAP. A liability for deferred revenue is recognized when tickets are purchased, and then the deferred revenue is reduced and revenue is recognized when the transportation service is provided. Requirement 2 The journal entry would be: Contra revenue Refund liability

50,000 50,000

Requirement 3 a. Yes. From note 4.7: ―Miles are considered as separate elements of a sale of a ticket with multiple elements and one part of the price of the initial sale of the ticket is allocated to these Miles and deferred until the Group‘s commitments relating to these Miles have been met. The deferred amount due in relation to the acquisition of Miles by members is estimated:  according to the fair value of the Miles, defined as the amount for which the benefits could be sold separately  after taking into account the redemption rate, corresponding to the probability that the Miles will be used by members, using a statistical method.‖ b. Per the balance sheet, AF has a liability for ―Frequent flyer programs‖ of €848 million.

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Air France—KLM Case (concluded) c. Yes. AF‘s approach is consistent with IFRS 15, in that the transaction price for airfare is allocated to the performance obligations of (1) providing the airfare and (2) providing future airfare or other goods and services upon redemption of miles. The revenue associated with AF miles is deferred and recognized separately from the revenue associated with the flights that customers use to earn the miles.

CHAPTER 7 CASH AND RECEIVABLES QUESTIONS FOR REVIEW OF KEY TOPICS

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Question 7–1 Cash equivalents usually include negotiable instruments as well as highly liquid investments that have a maturity date no longer than three months from date of purchase.

Question 7– 672

Internal control procedures involving accounting functions are intended to improve the accuracy and reliability of accounting information and to safeguard the company‘s assets. The separation of duties means that employees involved in recordkeeping should not also have physical responsibility for assets.

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Question 7–3 Management must document the company‘s internal controls and assess their adequacy. The auditors must provide an opinion on management‘s assessment. The Public Company Accounting Oversight Board‘s Auditing Standard No. 5, which supersedes Auditing Standard No. 2, further requires the auditor to express its own opinion on whether the company has maintained effective internal control over financial reporting.

Question 7– 674

Yes, restricted cash is included in the reconciliation of cash balances on the statement of cash flows. Restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period cash balances.

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Question 7– 676

A compensating balance is an amount of cash a depositor (debtor) must leave on deposit in an account at a bank (creditor) as security for a loan or a commitment to lend. The classification and disclosure of a compensating balance depends on the nature of the restriction and the classification of the related debt. If the restriction is legally binding, then the cash will be classified as either current or noncurrent (investments and funds or other assets) depending on the classification of the related debt. In either case, note disclosure is appropriate. If the compensating balance arrangement is informal and no contractual agreement restricts the use of cash, note disclosure of the arrangement including amounts involved is appropriate, and the compensating balance can be included in the cash and cash equivalents category of current assets.

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Question 7–6 Yes, IFRS and U.S. GAAP differ in how bank overdrafts are treated. Under IFRS, overdrafts can be offset against other cash accounts. Under U.S. GAAP, overdrafts must be treated as liabilities.

Question 7– 678

Trade discounts are reductions below a list price and are used to establish a final price for a transaction. The reduced price is the starting point for initial valuation of the transaction. A cash discount is a reduction, not in the selling price of a good or service, but in the amount to be paid by a credit customer if the receivable is paid within a specified period of time.

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Question 7–8 The gross method of accounting for cash discounts initially records accounts receivable at their gross value, without reducing them for sales discounts, and then reduces sales revenue for discounts taken. The net method initially records accounts receivable at their net value, having already reduced them for sales discounts, and then, if collection does not occur in the discount period, increases sales revenue for discounts not taken.

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Question 7–9 Companies must estimate sales returns and reduce revenue to account for them. For convenience, companies typically account for returns as they occur during the period, reducing revenue and refunding cash as well as reducing cost of goods sold and increasing inventory for the returned items. Then, at the end of the accounting period, they make an adjusting entry that debits sales returns, an account that is contra to sales revenue, and credits a refund liability for the amount expected to be refunded when products are returned. A similar adjusting entry reduces cost of goods sold for estimated returns and recognizes an asset for the right to receive inventory that will be returned.

Question 7–10 Each period companies estimate the amount of accounts receivable that will be collected, and adjust an allowance for uncollectible accounts (contra to accounts receivable) to show net accounts receivable at that carrying value. The corresponding entry to that adjustment is bad debt expense. So, for example, if additional accounts are expected to prove uncollectible, the allowance is credited (increasing it) and a corresponding debit increases bad debt expense for the period. If uncollectible accounts are immaterial, any bad debts that do arise can be written off as bad debt expense at the time they prove uncollectible.

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Question 7–11 CECL stands for ―Current Expected Credit Loss‖. The CECL model allows a company to apply any method that reasonably captures its expectation of credit losses, so that the resulting carrying value of net accounts receivable reflects the cash the company expects to collect. That estimate should consider all receivables and be based on all relevant information, including historical experience, current conditions, and reasonable and supportable forecasts.

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Question 7–12

The CARES Act included a provision that enabled banks and some other financial institutions to avoid adopting the CECL model between March 27, 2020 and December 31, 2020.

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Question 7–13 ECL stands for ―Expected Credit Loss‖. Unless a receivable‘s credit quality has deteriorated significantly, the ECL model reports a ―12-month ECL,‖ which bases expected credit losses only on defaults that could occur within the next twelve months. On the other hand, if a receivable‘s credit quality has deteriorated significantly, the creditor instead reports the ―lifetime ECL,‖ which also includes credit losses expected to occur from defaults after twelve months, as is done for all receivables under the CECL model used in U.S. GAAP. Because of this difference, it is likely that accruals for credit losses under ECL will be lower, and occur later, than under CECL.

Question 7– 688

The balance sheet approach to estimating expected credit losses determines the appropriate carrying value for accounts receivable at the end of the period and records an adjustment to the allowance for uncollectible accounts and bad debt expense to reflect the appropriate carrying value of accounts receivable. The income statement approach to estimating expected credit losses adjusts the allowance for uncollectible accounts and bad debt expense by a percentage of the current period‘s credit sales.

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Question 7–15 A company has to separately disclose trade receivables and receivables from related parties under U.S. GAAP, but not under IFRS.

Question 7– 690

The assignment of all accounts receivable in general as collateral for debt requires no special accounting treatment other than note disclosure of the agreement.

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Question 7–17 The accounting treatment of receivables factored with recourse depends on whether certain criteria are met. If the criteria are met, the factoring is accounted for as a sale. If they are not met, the factoring is accounted for as a loan. In addition, note disclosure may be required. Accounts receivable factored without recourse are accounted for as the sale of an asset. The difference between the book value and the fair value of proceeds received is recognized as a gain or a loss.

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Question 7–18 U.S. GAAP focuses on whether control of assets has shifted from the transferor to the transferee. In contrast, IFRS focuses on whether the company has transferred ―substantially all of the risks and rewards of ownership,‖ as well as whether the company has transferred control. Under IFRS: 1. If the company transfers substantially all of the risks and rewards of ownership, the transfer is treated as a sale. 2. If the company retains substantially all of the risks and rewards of ownership, the transfer is treated as a secured borrowing. 3. If neither conditions 1 or 2 hold, the company accounts for the transaction as a sale if it has transferred control, and as a secured borrowing if it has retained control.

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Question 7–19 When a note is discounted, a financial institution, usually a bank, accepts the note and gives the seller cash equal to the maturity value of the note reduced by a discount. The discount is computed by applying a discount rate to the maturity value and represents the financing fee the bank charges for the transaction. The four-step process used to account for a discounted note receivable is as follows: 1. Accrue any interest revenue earned since the last payment date (or date of the note). 2. Compute the maturity value. 3. Subtract the discount the bank requires (discount rate times maturity value times the remaining length of time from date of discounting to maturity date) from the maturity value to compute the proceeds to be received from the bank (maturity value less discount). 4. Compute the difference between the proceeds and the book value of the note and related interest receivable. The treatment of the difference will depend on whether the discounting is accounted for as a sale or as a loan. If it‘s a sale, the difference is recorded as a loss or gain on the sale; if it‘s a loan, the difference is viewed as interest expense or interest revenue.

Question 7–20 A company‘s investment in receivables is influenced by several related variables, to include the level of sales, the nature of the product or service, and credit and collection policies. The receivables turnover and average collection period ratios are designed to monitor receivables.

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Question 7–21 The items necessary to adjust the bank balance might include deposits outstanding (including undeposited cash), outstanding checks, and any bank errors discovered during the reconciliation process. The items necessary to adjust the book balance might include collections made by the bank on the company‘s behalf, service and other charges made by the bank, NSF (nonsufficient funds) check charges, and any company errors discovered during the reconciliation process.

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Question 7–22 A petty cash fund is established by transferring a specified amount of cash from the company‘s general checking account to an employee designated as the petty cash custodian. The fund is replenished by writing a check to the petty cash custodian for the sum of the bills paid with petty cash. The appropriate expense accounts are recorded from petty cash vouchers at the time the fund is replenished.

Question 7–23 When a creditor‘s investment in a receivable results in a credit loss due to a troubled debt restructuring, the receivable is remeasured as the present value of currently expected cash flows (principal and accrued interest) discounted at the loan‘s original effective rate. That value is compared to the carrying value of the receivable (including any interest receivable). The credit loss is the difference between those two amounts.

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Question 7–24 The CARES Act allowed banks and other lenders to suspend accounting for loan modifications as Troubled Debt Restructurings if the loans were past due because of COVID-19-related business problems.

BRIEF EXERCISES Brief Exercise 7–1 The company could improve its internal control procedure for cash receipts by segregating the duties of recordkeeping and the handling of cash. Jim Seymour, responsible for recordkeeping, should not also be responsible for depositing customer checks.

Brief Exercise 7–2 Under IFRS the cash balance would be $245,000, because Cutler could offset the two accounts. Under U.S. GAAP the balance would be $250,000, because Cutler could not offset the two accounts. The $5,000 overdraft would be reported as a liability under GAAP.

Brief Exercise 7–3 All of these items would be included as cash and cash equivalents except the U.S. Treasury bills that mature in six months, which would be included in the current asset section of the balance sheet as short-term investments.

Brief Exercise 7–4 Income before tax in 2025 will be reduced by $2,500, the amount of the cash discounts. $25,000 × 10 = $250,000 × 1% = $2,500

Brief Exercise 7–5 Income before tax in 2024 will be reduced by $2,500, the anticipated amount of cash discounts. $25,000 × 10 = $250,000 × 1% = $2,500

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Brief Exercise 7–6 Estimated returns = $10,600,000 × 8% = Less: Actual returns Remaining estimated returns

$848,000 (720,000) $128,000

Sales returns ............................................................................... Refund liability .....................................................................

128,000

Inventory—estimated returns .................................................... Cost of goods sold ($128,000 × 60%) ...................................

76,800

128,000 76,800

Brief Exercise 7–7 Estimated returns = $10,600,000 × 8% = Less: Actual returns Remaining estimated returns

$848,000 (720,000) $128,000

Sales returns ............................................................................... Refund liability ......................................................................

128,000

Inventory—estimated returns .................................................... Cost of goods sold ($128,000 × 60%) ...................................

76,800

128,000 76,800

Note; the answer to BE 7-7 is the same as the answer to BE 7-6. A refund liability is recognized regardless of whether a receivable is outstanding.

Brief Exercise 7–8 Singletary cannot combine the two types of receivables under U.S. GAAP, as the director is a related party. Under IFRS a combined presentation would be allowed.

Brief Exercise 7–9

Bad debt expense (to balance)..................................................... Allowance for uncollectible accounts ($300,000 × 6%) ..........

18,000 18,000

Brief Exercise 7–10 Allowance for uncollectible accounts: Beginning balance Adjustment: Ending balance ($600,000 × 10%)

$12,000 48,000 $60,000

Bad debt expense (to balance)..................................................... Allowance for uncollectible accounts (calculated above) ........

48,000 48,000

Brief Exercise 7–11 Allowance for uncollectible accounts: Beginning balance Adjustment: Ending balance ($600,000 × 10%)

$(12,000) 72,000 $60,000

Bad debt expense (to balance)..................................................... Allowance for uncollectible accounts (calculated above) ........

72,000 72,000

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Brief Exercise 7–12 Age Group Amount % Uncollectible Not yet due $60,000 × 5% 1-30 days past due 15,000 × 10% 31-60 days past due 10,000 × 20% More than 60 days past due 5,000 × 30% Total $90,000

Total = $3,000 = 1,500 = 2,000 = 1,500 $8,000

Brief Exercise 7–13 (1) Bad debt expense = $1,500,000 × 2% = $30,000 (2) Allowance for uncollectible accounts: Beginning balance Add: Bad debt expense Deduct: Write-offs Ending balance

$25,000 30,000 (16,000) $39,000

Brief Exercise 7–14 (1) Allowance for uncollectible accounts: Beginning balance Deduct: Write-offs Required allowance Bad debt expense

$25,000 (16,000) (33,400)* $24,400

(2) Required allowance = $334,000** × 10% = $33,400* Accounts receivable: Beginning balance Add: Credit sales Deduct: Cash collections Write-offs Ending balance

$ 300,000 1,500,000 (1,450,000) (16,000) $ 334,000**

Brief Exercise 7–15 Allowance for uncollectible accounts: Beginning balance Add: Bad debt expense

$30,000 40,000

Deduct: Required allowance Write-offs

(38,000) $32,000

Brief Exercise 7–16 Credit sales Deduct: Cash collections Write-offs Year-end balance in A/R Beginning balance in A/R *Allowance for uncollectible accounts: Beginning balance Add: Bad debt expense Deduct: Required allowance Write-offs

$8,200,000 (7,950,000) (32,000)* (2,000,000) $1,782,000 $30,000 40,000 (38,000) $32,000

Brief Exercise 7–17 2024 interest revenue: $20,000 × 6% × 1/12 = $100 2025 interest revenue: $20,000 × 6% × 2/12 = $200

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Brief Exercise 7–18 Sales revenue = present value of the note receivable = $120,000 × 0.71299¥ = $85,559 ¥ Present value of $1: n = 5, i = 7% (Table 2)

Brief Exercise 7–19 Assets decrease by $7,000: Cash increases by $100,000 × 85% = Receivable from factor increases by ($11,000 – $3,000 fee) Accounts receivable decrease Net decrease in assets

$ 85,000 8,000 (100,000) $ (7,000)

Liabilities would not change as a result of this transaction. Income before income taxes decreases by $7,000 (the loss on sales of receivables) The journal entry to record the transaction is as follows:

Cash (85% × $100,000).............................................................. Loss on sale of receivables (to balance) ...................................... Receivable from factor ($11,000 fair value – $3,000 fee) ........... Accounts receivable (balance sold) ........................................

85,000 7,000 8,000 100,000

Brief Exercise 7–20 Logitech would account for the transfer as a secured borrowing. The receivables remain on the company‘s books and a liability is recorded for the amount borrowed plus the bank‘s fee.

Brief Exercise 7–21 Under IFRS Huling would treat this transaction as a secured borrowing, because it retains substantially all of the risks and rewards of ownership. Under U.S. GAAP Huling would treat this transaction as a sale, because it has transferred control. Note, however, that in practice we would Solutions Manual, Chapter 7 7–707 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

typically expect for the entity that has the risks and rewards of ownership to also have control over the assets, so we would expect these criteria to usually lead to the same accounting.

Brief Exercise 7–22

$30,000 450 30,450 (406) $30,044

Face amount Interest to maturity ($30,000 × 6% × 3/12) Maturity value Discount ($30,450 × 8% × 2/12) Cash proceeds

Brief Exercise 7–23 Receivables turnover =

$320,000 = 5.33 times $60,000*

($50,000 + $70,000)  2 = $60,000* Average collection period

365 5.33

= 68 days

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Brief Exercise 7–24 Balance per books $22,340 Add: Error in recording cash receipt ($550 – $500) 50 Deduct: NSF checks (1,500) Service charges (45) Corrected cash balance $20,845

Brief Exercise 7–25 Balance per bank statement Add: Deposits outstanding Deduct: Checks outstanding Corrected cash balance

$47,582 2,500 (7,224) $42,858

Brief Exercise 7–26 $100,000. Thaler would recognize a loss equal to the difference between the $1 million receivable and the $900,000 fair value of consideration received from Einhorn.

EXERCISES Exercise 7–1 Requirement 1 Cash and cash equivalents includes: a. Balance in checking account Balance in savings account b. Undeposited customer checks c. Currency and coins on hand f. U.S. treasury bills with 2-month maturity Total Requirement 2

$13,500 22,100 5,200 580 15,000 $56,380

d. The $400,000 savings account will be used for future plant expansion and therefore should be classified as a noncurrent asset, either in other assets or investments. e. The $20,000 in the checking account is a compensating balance for a longterm loan and should be classified as a noncurrent asset, either in other assets or investments. f. The $20,000 in 7-month treasury bills should be classified as a current asset along with other temporary investments.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–2 Requirement 1 Cash and cash equivalents includes: Cash in bank—checking account U.S. treasury bills Cash on hand Undeposited customer checks Total Requirement 2

$22,500 5,000 1,350 1,840 $30,690

The $10,000 in 6-month treasury bills should be classified as a current asset along with other temporary investments.

Exercise 7– 712

The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is:

1. Accounts receivables from related parties should be shown separately from trade receivables: Appears as ACS 310–10–45: ―Receivables—Overall—Other Presentation Matters—Receivables from Officers, Employees or Affiliates,‖ and under ASC 850–10–50: "Related Party Disclosures—Overall—Disclosure". Also appears as ACS 210–10–S99: ―Balance Sheet—Overall—SEC Materials. 2. Definition of Cash Equivalents: FASB ACS 230–10–45: ―Statement of Cash Flows—Overall—Other Presentation Matters—Cash and Cash Equivalents.‖ 3. Notes exchanged for cash are valued at the cash proceeds: FASB ACS 310–10–30: ―Receivables—Overall—Initial Measurement.‖ 4. The two conditions that must be met to accrue a loss on an account receivable: FASB ASC 310–10–35: "Receivables—Overall—Subsequent Measurement."

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–4 Requirement 1: U.S. GAAP Current Assets: Cash

$175,000

Current Liabilities: Bank overdrafts

$ 15,000

Requirement 2: IFRS Current Assets: Cash

$160,000

(No current liabilities with respect to overdrafts.)

Exercise 7–5 Requirement 1 Sales price = 100 units × $600 = $60,000 × 70% = $42,000 November 17, 2024 Accounts receivable.................................................................... Sales revenue .........................................................................

42,000

November 26, 2024 Cash (98% × $42,000) ................................................................ Sales discounts (2% × $42,000) .................................................. Accounts receivable ...............................................................

41,160 840

42,000

Requirement 2 November 17, 2024 Accounts receivable.................................................................... Sales revenue .........................................................................

42,000

December 15, 2024 Cash ........................................................................................... Accounts receivable ...............................................................

42,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–5 (concluded) Requirement 3 Requirement 1, using the net method: November 17, 2024 Accounts receivable ................................................................... Sales revenue (98% × $42,000)..............................................

41,160

November 26, 2024 Cash ........................................................................................... Accounts receivable ...............................................................

41,160

Requirement 2, using the net method: November 17, 2024 Accounts receivable ................................................................... Sales revenue (98% × $42,000)..............................................

December 15, 2024 Cash ........................................................................................... Accounts receivable ............................................................... Sales discounts forfeited ........................................................

41,160 41,160

42,000 41,160 840

Exercise 7– 716

Requirement 1 Sales price = 1,000 units × $50 = $50,000 July 15, 2024 Accounts receivable.................................................................... Sales revenue .........................................................................

50,000

July 23, 2024 Cash (98% × $50,000) ................................................................ Sales discounts (2% × $50,000) .................................................. Accounts receivable ...............................................................

49,000 1,000

50,000

Requirement 2

July 15, 2024 Accounts receivable.................................................................... Sales revenue .........................................................................

50,000

Aug. 15, 2024 Cash ........................................................................................... Accounts receivable ...............................................................

50,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–7 Requirement 1

July 15, 2024 Accounts receivable ................................................................... Sales revenue (98% × $50,000)..............................................

49,000

July 23, 2024 Cash ........................................................................................... Accounts receivable ...............................................................

49,000

Requirement 2 July 15, 2024 Accounts receivable ................................................................... Sales revenue (98% × $50,000)..............................................

August 15, 2024 Cash ........................................................................................... Accounts receivable ............................................................... Sales discounts forfeited ........................................................

49,000 49,000

50,000 49,000 1,000

Exercise 7– 718 Requirement 1 Estimated returns of 2024 sales= 4% × $11,500,000 = $460,000 Less: Actual returns of 2024 sales (200,000) Remaining estimated returns of 2024 sales $260,000

250,000

Inventory ................................................................................... Inventory – estimated returns ($250,000 × 65%) ...................

162,500

(b) Record the actual sales returns of merchandise sold during 2024: Sales returns ($450,000 - $250,000)............................................ 200,000 Accounts receivable ...............................................................

200,000

Inventory ................................................................................... Cost of goods sold ($200,000 × 65%) ....................................

130,000

(c)Adjust balance to equal the estimated sales returns at December 31, 2024: Sales returns ............................................................................... 210,000 Refund liability ..................................................................... 210,000 Inventory—estimated returns ..................................................... Cost of goods sold ($210,000 × 65%) ....................................

136,500 136,500

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–8 (concluded) Requirement 2 Beginning balance in refund liability Less: Actual returns of pre- 2024 sales Plug: adjustment needed: Ending balance in refund liability (equal to amount estimated for remaining returns of 2024 sales)

$300,000 (250,000) $210,000 $260,000

Note: By the end of 2024, all pre-2024 refunds have expired. Therefore, the adjustments of $210,000 can be viewed as having two parts: (1) reversing the remaining $50,000 of pre-2024 refunds that did not occur, and (2) recognizing the remaining $260,000 of future refunds of 2024 sales that are estimated to occur in 2025.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–9 Requirement 1 Estimated returns of 2024 sales = 4% × $11,500,000 = Less: Actual returns of 2024 sales Remaining estimated returns of 2024 sales

$460,000 (200,000) $260,000

(a)Record the actual sales returns of merchandise sold prior to 2024: Refund liability .......................................................................... 250,000 Accounts receivable ............................................................... Inventory ................................................................................... 162,500 Inventory – estimated returns ($250,000 × 65%) ...................

250,000

(b) Record the actual sales returns of merchandise sold during 2024: Sales returns ($450,000 - $250,000) ........................................... 200,000 Accounts receivable ............................................................... Inventory ................................................................................... 130,000 Cost of goods sold ($200,000 × 65%) ...................................

200,000

162,500

130,000

(c)Adjust balance to equal the estimated sales returns at December 31, 2024: Sales returns ............................................................................... 260,000 Refund liability ..................................................................... 260,000 Inventory—estimated returns .................................................... 169,000 Cost of goods sold ($260,000 × 65%) ................................... 169,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 7–9 (concluded) Requirement 2 Beginning balance in refund liability Less: Actual returns of pre-2024 sales Add: Remaining estimated returns of 2024 sales Ending balance in refund liability

$300,000 (250,000) 260,000 $310,000

Note: with no expiration of returns, can also view the refund liability account as calculated as follows: Beginning balance in refund liability Add: Estimated returns of 2024 sales Less: Actual returns of pre-2024 sales Less: Actual returns of 2024 sales Ending balance in refund liability

$300,000 460,000 (250,000) (200,000) $310,000

Exercise 7–10 Requirement 1

The specific citation that specifies these disclosure policies is FASB ACS 310–10– 50–2: ―Receivables—Overall—Disclosure—Accounting Policies for Loans and Trade Receivables.‖ Requirement 2

FASB ACS 310–10–50–2 reads as follows: ―The summary of significant accounting policies shall include the following: a.

The basis for accounting for loans and trade receivables

b. The method used in determining the lower of cost or fair value of nonmortgage loans held for sale (that is, aggregate or individual asset basis) c. The classification and method of accounting for interest-only strips, loans, other receivables, or retained interests in securitizations that can be contractually prepaid or otherwise settled in a way that the holder would not recover substantially all of its recorded investment d. The method for recognizing interest income on loan and trade receivables, including a statement about the entity‘s policy for treatment of related fees and costs, including the method of amortizing net deferred fees or costs.‖

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–11 Requirement 1 Allowance for uncollectible accounts (to record write-offs)10,000 Accounts receivable (to balance)............................................

10,000

Requirement 2 Allowance for uncollectible accounts Balance, beginning of year $ 0 16,000 Add: Bad debt expense Less: Accounts receivable written off (10,000) Balance, end of year (($250,000 – $210,000 – $10,000) × 20%) $ 6,000

Bad debt expense (to balance) .................................................... Allowance for uncollectible accounts (calculated above)........

16,000 16,000

Exercise 7– 726 Requirement 12/31/20231 balance in allowance for uncollectible accounts = $30,000 = 12/31/2023 balance in gross accounts receivable × 10%, so 12/31/2023 balance in gross accounts receivable = $30,000 ÷ 10% = $300,000 Requirement 2 Allowance for uncollectible accounts: Beginning balance Adjustment: Ending balance ($500,000 × 10%)

$(55,000) 105,000 $ 50,000

Bad debt expense (to balance) .......................................................... 105,000 Allowance for uncollectible accounts (calculated above) ............. 105,000

Requirement 3 Allowance for uncollectible accounts Balance, beginning of year Less : Accounts receivable written off Pre-adjustment end-of-year balance

$ 30,000 85,000 $(55,000)

Requirement 4 $85,000 — the amount of accounts receivable written off.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–13 Requirement 1 Bad debt expense = $67,500 (1.5% × $4,500,000) Requirement 2 Allowance for uncollectible accounts Balance, beginning of year $42,000 Add: Bad debt expense for 2024 (1.5% × $4,500,000) 67,500 (69,500) Less: Accounts receivable written off End-of-year balance $40,000 Requirement 3 $69,500 — the amount of accounts receivable written off.

Exercise 7– 728 Requirement 1

Age Group Amount % Uncollectible Total Not yet due $180,000 × 10% = $18,000 1-45 days past due 25,000 × 20% = 5,000 More than 45 days past due 10,000 × 30% = 3,000 Total $215,000 $26,000

Requirement 2 Allowance for uncollectible accounts: Beginning balance Adjustment: Ending balance

$(45,000) 71,000 $ 26,000

Bad debt expense (to balance)..................................................... Allowance for uncollectible accounts (calculated above) ........

71,000 71,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–15 Requirement 1 Age Group Amount % Uncollectible Not yet due $400,000 × 8% 1-30 days past due 50,000 × 15% 31-90 days past due 40,000 × 30% More than 90 days past due 30,000 × 50% Total $520,000

= = = =

Total $32,000 7,500 12,000 15,000 $66,500

Requirement 2 Allowance for uncollectible accounts: Beginning balance Adjustment: Ending balance

$22,000 44,500 $66,500

Bad debt expense (to balance) .................................................... Allowance for uncollectible accounts (calculated above)........

44,500 44,500

Requirement 3 Gross accounts receivable Less: Allowance for uncollectible accounts Net accounts receivable

$520,000 66,500 $453,500

Exercise 7– 730 To record1the write-off of receivables: Requirement Allowance for uncollectible accounts.......................................... Accounts receivable ...............................................................

21,000 21,000

To reinstate an account previously written off and to record the collection: Accounts receivable.................................................................... Allowance for uncollectible accounts .....................................

1,200

Cash ........................................................................................... Accounts receivable ...............................................................

1,200

Allowance for uncollectible accounts: Balance, beginning of year Deduct: Receivables written off Add: Collection of receivable previously written off Balance, before adjusting entry for 2024 bad debts

$32,000 (21,000) 1,200 12,200

Required allowance: 10% × $625,000 Bad debt expense

(62,500) $50,300

To record bad debt expense for the year: Bad debt expense........................................................................ Allowance for uncollectible accounts .....................................

50,300 50,300

Requirement 2 Current assets: Accounts receivable, net of $62,500 allowance for uncollectible accounts

$562,500

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–17 Using the direct write-off method, bad debt expense is equal to actual write-offs. Collections of previously written-off receivables are recorded as revenue.

Allowance for uncollectible accounts: Balance, beginning of year Deduct: Receivables written off Add: Collection of receivables previously written off Less: End of year balance Bad debt expense for the year 2024

$17,280 (17,100) 2,200 (22,410) $20,030

Allowance 17,280 2,200 20,030

Beginning balance Reinstated Bad debt expense (plug)

22,410

Ending balance

Write-offs 17,100

Exercise 7– 732 Allowance

Allowance for uncollectible accounts:

28.8

Balance, beginning of year Add: Bad debt expense Less: End of year balance Write-offs during the year

$28.8 25.9 (33.2) $ 21.5* plug #1

25.9 writeoffs 21.5

33.2

Accounts receivable analysis: Balance, beginning of year

$ 1,708.5

($1,679.7 + $28.8)

Add: Credit sales Less: Write-offs* Less: Balance, end of year

Gross A/R 1,708.5

17,626.6 (21.5) (1,648.3)

17,626.6

collections 17,665.3

($1,615.1 + $33.2)

Cash collections

21.5

$17,665.3 plug #2

1,648.3

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–19 Requirement 1

June 30, 2024 Notes receivable ......................................................................... Sales revenue ......................................................................... December 31, 2024 Interest receivable ......................................................................

30,000 30,000

900

Interest revenue ($30,000 × 6% × 6/12) .................................. March 31, 2025 Cash [$30,000 + ($30,000 × 6% × 9/12)]..................................... Interest revenue ($30,000 × 6% × 3/12) .................................. Interest receivable (accrued at December 31) ......................... Notes receivable ...................................................................

900

31,350 450 900 30,000

Requirement 2 2024 income before income taxes would be understated by $900 2025 income before income taxes would be overstated by $900.

Exercise 7– 734 Requirement 1 June 30, 2024 Notes receivable (face amount) ................................................... Discount on notes receivable (to balance)............................... Sales revenue (difference) ......................................................

30,000 1,800 28,200

December 31, 2024 Discount on notes receivable ..................................................... Interest revenue ($1,800 × 6/9) ...............................................

1,200

March 31, 2025 Discount on notes receivable ..................................................... Interest revenue ($1,800 × 3/9) ...............................................

600

Cash .......................................................................................... Notes receivable (face amount) ..............................................

1,200

600 30,000 30,000

Requirement 2 $ 1,800 ÷ $28,200 = 6.383% 12/9 x

interest for 9 months sales price rate for 9 months to annualize the rate

effective interest rate

8.511%

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–21 Requirement 1 Sales revenue = present value of the note receivable = $515,000 × 0.79383¥ = $408,822 ¥ Present value of $1: n = 3, i = 8% (Table 2) Requirement 2 January 1, 2024 Note receivable .............................................................. 515,000 Discount on notes receivable .................................... Sales revenue*.......................................................... To record the sale of goods in exchange for a three-year note receivable. December 31, 2024 Discount on notes receivable .......................................... Interest revenue ($408,822 × 8%)............................... To record interest revenue in 2024.

106,178 408,822

32,706

December 31, 2025 Discount on notes receivable .......................................... 35,322 Interest revenue (($408,822 + $32,706) × 8%) ................ To record interest revenue in 2025. December 31, 2026 Discount on notes receivable ............................................ 38,150 Interest revenue (($408,822+32,706+35,322) × 8%) ........ Cash ................................................................................ 515,000 Notes receivable ....................................................... To record interest revenue in 2026 and collection of the note.

32,706

35,322

38,150 515,000

* $515,000 × Present value of $1; n = 3, i = 8% Note: the debit to Discount on notes receivable of $38,150 is necessary to reduce the discount to zero. It differs from $38,148, which equals ($408,822 + $32,706 + $35,322) × 8%, due to rounding.

Exercise 7– 736 Requirement 1 Book (carrying) value of stock Plus gain on sale of stock = Note receivable

$16,000 6,000 $22,000

Interest reported for the year

$ 2,200 = 10% rate

Divided by value of note $ 22,000 Requirement 2 To record sale of stock in exchange for note receivable: January 1, 2024 Notes receivable ......................................................................... Investments ............................................................................ Gain on sale of investments....................................................

22,000 16,000 6,000

To accrue interest on note receivable for twelve months: December 31, 2024 Interest receivable....................................................................... Interest revenue ($22,000 × 10%)...........................................

2,200 2,200

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–23

Cash (difference)........................................................................ Finance charge expense (1.8% × $600,000)................................ Notes payable .......................................................................

439,200 10,800 450,000

Exercise 7–24

Cash (90% × $60,000)................................................................ Loss on sale of receivables (to balance) ...................................... Receivable from factor ($5,000 fair value – [2% × $60,000]) ..... Accounts receivable (balance sold) ........................................

54,000 2,200 3,800 60,000

Exercise 7–25 Cash ([90% – 2%] × $60,000) .................................................... Loss on sale of receivables (to balance) ...................................... Receivable from factor ($5,000 fair value) ................................. Recourse liability .................................................................. Accounts receivable (balance sold) ........................................

52,800 5,200 5,000 3,000 60,000

Exercise 7–26 Mountain High retains significant risks and rewards and therefore must treat the transfer as a secured borrowing. The accounts receivable stay on the balance sheet of Mountain High, and they must record a liability. Cash ([90% – 2%] × $60,000) .................................................... Finance charge expense (2% × $60,000)..................................... Liability ................................................................................

52,800 1,200 54,000

Exercise 7– 738 Step 1: Accrue interest earned. February 28, 2024 Interest receivable....................................................................... Interest revenue ($15,000 × 10% × 2/12).................................

250 250

Step 2: Add interest to maturity to calculate maturity value. Step 3: Deduct discount to calculate cash proceeds. $15,000 750 15,750 (630) $15,120

Face amount Interest to maturity ($15,000 × 10% × 6/12) Maturity value Discount ($15,750 × 12% × 4/12) Cash proceeds

Step 4: Record a loss for the difference between the cash proceeds and the note‘s book value. February 28, 2024 Cash (proceeds determined above) .............................................. Loss on sale of notes receivable (difference) ............................... Notes receivable (face amount) .............................................. Interest receivable (accrued interest determined above) ..........

15,120 130 15,000 250

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–28 List A

List B

c 1. j 2. g 3. h 4. i 5. l 6. d 7. k 8. a 9. m 10. b 11. e 12.

Internal control a. Restriction on cash. Trade discount b. Cash discount not taken is sales revenue. Cash equivalents c. Includes separation of duties. Allowance for uncollectibles d. Bad debt expense a % of credit sales. Cash discount e. Recognizes bad debts as they occur. Balance sheet approach f. Sale of receivables to a financial institution. Income statement approach g. Include highly liquid investments. Net method h. Estimate of bad debts. Compensating balance i. Reduction in amount paid by credit customer. Discounting j. Reduction below list price. Gross method k. Cash discount not taken is sales discount forfeited. Direct write-off method l. Bad debt expense determined by estimating realizable value. f 13. Factoring m. Sale of note receivable to a financial institution.

Exercise 7– 740

Requirement 1 March 17, 2024 Allowance for uncollectible accounts.......................................... Accounts receivable ...............................................................

1,700

March 30, 2024 Notes receivable ......................................................................... Cash.......................................................................................

20,000

1,700

20,000

Step 1: Accrue interest earned for two months on note receivable. May 30, 2024 Interest receivable....................................................................... Interest revenue ($20,000 × 7% × 2/12)...................................

233 233

Step 2: Add interest to maturity to calculate maturity value. Step 3: Deduct discount to calculate cash proceeds.

$20,000 1,400 21,400 (1,427) $19,973

Face amount Interest to maturity ($20,000 × 7%) Maturity value Discount ($21,400 × 8% × 10/12) Cash proceeds

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–29 (continued) Step 4: Record a loss for the difference between the cash proceeds and the note‘s book value. May 30, 2024 Cash (proceeds determined above) ............................................. Loss on sale of notes receivable (difference) .............................. Interest receivable (from adjusting entry) ............................... Notes receivable (face amount) ..............................................

19,973 260 233 20,000

June 30, 2024 Accounts receivable ................................................................... Sales revenue .........................................................................

12,000

July 8, 2024 Cash ($12,000 × 98%)................................................................ Sales discounts ($12,000 × 2%) .................................................. Accounts receivable ...............................................................

11,760 240

August 31, 2024 Notes receivable (face amount)................................................... Discount on notes receivable ($6,000 × 8% × 6/12) ................ Investments (book value) ....................................................... Gain on sale of investments (difference) ................................

12,000

6,000 240 5,000 760

Exercise 7–29 (concluded) Requirement 2 To accrue interest earned on note receivable: December 31, 2024 Discount on notes receivable ...................................................... Interest revenue ($6,000 × 8% × 4/12).....................................

160 160

To accrue bad debt expense: Allowance 12,000 Beginning balance 3,700 Bad debt expense (plug) Write-offs 1,700 14,000 Ending balance ($700,000 × 2%)

December 31, 2024 Bad debt expense........................................................................ Allowance for uncollectible accounts .....................................

3,700 3,700

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–30 Q4 (ended 6/30/2020): Average receivables balance: ($32,011 + $22,699) / 2 = $27,355 Receivables turnover =

$38,033 $27,355

Average collection period

91 = 65.47 days 1.390

= 1.390 times

Q3 (ended 3/31/2020): Average receivables balance: ($22,699 + $23,525) / 2 = $23,112 = 1.515 times

Receivables turnover =

$35,021 $23,112

Average collection period

91 = 60.07 days 1.515

Exercise 7–33 Average collection period

= 365 ÷ Accounts receivable turnover = 50 days

Accounts receivable turnover

= 365 ÷ 50 = 7.3

Average accounts receivable

= ($400,000 + $300,000) ÷ 2 = $350,000

Accounts receivable turnover 7.3

= Net sales ÷ Average accounts receivable = Net sales ÷ $350,000

Net sales = 7.3 × $350,000

= $2,555,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–32 To establish the petty cash fund:

October 2, 2024 Petty Cash .................................................................... Cash (checking account) ..........................................

200 200

To replenish the petty cash fund:

October 31, 2024 Office supplies expense ................................................ Advertising expense ..................................................... Postage expense ........................................................... Miscellaneous expense ................................................. Cash (checking account) ..........................................

76 48 20 19 163

Exercise 7–33 September 30, 2024 To replenish the petty cash fund Delivery expense ......................................................... 16 Office supplies expense ............................................... 19 Receivables from employees........................................ 25 Postage expense........................................................... 32 Cash (checking account) .........................................

Exercise 7–34 Balance per books Deduct: Deposits outstanding Add: Checks outstanding Deduct: Bank service charges Balance per bank Step 1:

Bank Balance to Corrected Balance

Balance per bank statement Add: Deposits outstanding Deduct: Checks outstanding Corrected cash balance Step 2:

$23,820 (2,340) 1,890 (38) $23,332

$23,332 2,340 (1,890) $23,782

Book Balance to Corrected Balance

Balance per books Deduct: Service charges Corrected cash balance

$23,820 (38) $23,782

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–35 Requirement 1 Step 1: Bank Balance to Corrected Balance Balance per bank statement Add: Deposits outstanding Deduct: Checks outstanding Add: Bank error in recording check Corrected cash balance

$38,018 6,300 (8,420) 270 $36,168

Step 2: Book Balance to Corrected Balance Balance per books Add: Error in recording cash receipt ($2,000 – $200) Deduct: Service charges NSF checks Monthly payment on note Corrected cash balance

$38,918 1,800 (30) (1,200) (3,320) $36,168

Exercise 7–35 (concluded) Requirement 2 To correct error in recording cash receipt from credit customer: Cash ............................................................................ Accounts receivable ................................................

1,800 1,800

To record credits to cash revealed by the bank reconciliation: Miscellaneous expense (bank service charges)............. Accounts receivable (NSF checks)............................... Interest expense ........................................................... Notes payable .............................................................. Cash........................................................................

30 1,200 320 3,000 4,550

Note: Each of the adjustments to the book balance required journal entries. adjustments to the bank balance require entries.

None of the

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–36 ANALYSIS Previous Value:

Accrued 2024 interest (10% × $12,000,000) Principal Carrying amount of the receivable

$ 1,200,000 12,000,000 $13,200,000

New Value:

Interest $1 million x 1.73554 * = x 0.82645 ** = Principal $11 million Present value of the receivable

$1,735,540 9,090,950

Loss: * present value of an ordinary annuity of $1: n = 2, i =10% (from Table 4) ** present value of $1: n = 2, i =10% (from Table 2)

(10,826,490) $ 2,373,510

JOURNAL ENTRIES January 1, 2024 2,373,510 Bad debt expense (to balance) ................................... ............. Interest receivable (account balance)..................... ............. Allowance for uncollectible accounts ($12,000,000 – $10,826,490)

1,200,000 1,173,510

December 31, 2024 Cash (required by new agreement) ............................ ............. Allowance for uncollectible accounts (to balance) ......... 82,649 Interest revenue (10% × $10,826,490)................... .............

1,082,649

December 31, 2025 Cash (required by new agreement) ............................ ............. Allowance for uncollectible accounts (to balance) ......... 90,861 Interest revenue (10% × [$10,826,490 + $82,649]) .............

1,000,000

1,000,000 1,090,861*

Cash (required by new agreement) ............................ ............. 11,000,000 Allowance for uncollectible accounts (to balance) ..... 1,000,000 Notes receivable (balance) .................................... ............. * rounded to amortize the note to $11,000,000 (per schedule below)

12,000,000

Exercise 7–36 (concluded) Amortization Schedule – Not required Cash Interest by agreement

1 2

1,000,000 1,000,000 2,000,000

Effective Increase in Interest Balance 10% × Outstanding Balance Discount Reduction .10 (10,826,490) = 1,082,649 .10 (10,909,139) = 1,090,861*

2,173,510

82,649 90,861 173,510

Outstanding Balance

10,826,490 10,909,139 11,000,000

* rounded

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 7–37 Requirement 1 1. January 2 Cash Service Revenue (Provide services for cash)

Debit 35,100

Credit 35,100

2. January 6 Accounts Receivable Service Revenue (Provide services on account)

Debit 72,400

3. January 15 Allowance for Uncollectible Accounts Accounts Receivable (Write off uncollectible accounts)

Debit 1,000

4. January 20 Salaries Expense Cash (Pay for salaries)

Debit 31,400

5. January 22 Cash Accounts Receivable (Receive cash on account)

Debit 70,000

6. January 25 Accounts Payable Cash (Pay cash on account)

Debit 5,500

7. January 30 Utilities Expense Cash (Pay for utilities)

Debit 13,700

Credit 72,400

Credit 1,000

Credit 31,400

Credit 70,000

Credit 5,500

Credit 13,700

Exercise 7–37 (continued) Requirement 2 8. January 31 Debit Credit Bad Debt Expense 1,100 Allowance for Uncollectible Accounts 1,100 (Adjust uncollectible accounts) ($1,100 = ($5,000×20%)+($10,000a×5%)−$400b) a $10,000 =$13,600+$72,400−$70,000−$1,000−$5,000 b $400 = $1,400−$1,000 9. January 31 Supplies Expense Supplies (Adjust supplies) ($1,800 = $2,500−$700)

Debit 1,800

10. January 31 Interest Receivable Interest Revenue (Adjust interest revenue) ($100 = $20,000×6%×1/12)

Debit 100

11. January 31 Salaries Expense Salaries Payable (Adjust salaries payable)

Debit 33,500

Credit 1,800

Credit 100

Credit 33,500

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 7–37 (continued) Requirement 3 3D Family Fireworks Adjusted Trial Balance January 31, 2024 Accounts Cash Accounts Receivable Interest Receivable Supplies Notes Receivable Land Allowance for Uncollectible Accounts Accounts Payable Salaries Payable Common Stock Retained Earnings Service Revenue Interest Revenue Supplies Expense Salaries Expense Utilities Expense Bad Debt Expense Totals

Debit $ 78,400 15,000 100 700 20,000 77,000

Credit

1,800 64,900 13,700 1,100 $272,700

1,500 1,700 33,500 96,000 32,400 107,500 100

$272,700

Exercise 7–37 (continued) Requirement 3 (continued) Ending Accounts Balance Cash 78,400 Accounts Receivable 15,000 Interest Receivable 100 Supplies 700 Notes Receivable 20,000 Land 77,000 Allowance for Uncollectible 1,500 Accounts Accounts Payable 1,700 Salaries Payable 33,500 Common Stock 96,000 Retained Earnings 32,400 Service Revenue 107,500 Interest Revenue 100 Supplies Expense 1,800 Salaries Expense 64,900 Utilities Expense 13,700 Bad Debt Expense 1,100

= = = = = = =

Beginning balance in bold, entries during January in blue, and adjusting entries in red. 23,900+35,100+70,000−31,400−5,500−13,700 13,600+72,400−1,000−70,000 100 2,500−1,800 20,000 77,000 1,400−1,000+1,100

= = = = = = = = = =

7,200−5,500 33,500 96,000 32,400 35,100+72,400 100 1,800 31,400+33,500 13,700 1,100

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 7–37 (continued) Requirement 4 3D Family Fireworks Income Statement For the year ended January 31, 2024 Revenues: Service revenue $107,500 Interest revenue 100 Total revenues 107,600 Expenses: Supplies expense 1,800 Salaries expense 64,900 Utilities expense 13,700 Bad debt expense 1,100 Total expenses 81,500 Net income

$ 26,100

Exercise 7–37 (continued) Requirement 5 3D Family Fireworks Balance Sheet January 31, 2024 Assets Liabilities Cash $ 78,400 Accounts payable $ 1,700 Accounts receivable $15,000 Salaries payable 33,500 Less: Allowance for Total current liabilities 35,200 uncollectible accounts (1,500) 13,500 Interest receivable 100 Supplies 700 Total current assets 92,700 Stockholders’ Equity Common stock 96,000 Notes receivable 20,000 Retained earnings 58,500 * Land 77,000 Total stockholders’ equity 154,500 Total liabilities and Total assets $189,700 stockholders’ equity $189,700 * Retained earnings = Beginning retained earnings + Net income − Dividends = $32,400 + $26,100 − $0 = $58,500 Requirement 6 12. January 31, 2024 Service Revenue Interest Revenue Retained Earnings (Close revenue accounts) 13. January 31, 2024 Retained Earnings Supplies expense Salaries expense Utilities expense Bad debt expense (Close expense accounts)

Debit 107,500 100

Credit

107,600

Debit 81,500

Credit 1,800 64,900 13,700 1,100

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 7–37 (concluded) Requirement 7 (a) The receivables turnover ratio is: Receivables Turnover Ratio

Net credit sales Average accounts receivable

$72,400 ($13,600 - $1,400 + $15,000 - $1,500) / 2

5.6

A ratio of 5.6 suggests that credit sales are about five times the average balance of accounts receivable. Companies allow customers to purchase goods and services on account to boost revenues, but these credit sales also create a risk of the customer not paying, so a higher receivables turnover ratio typically is preferred. Compared to the industry average receivables turnover ratio of 4.2., 3D Family Fireworks is collecting cash more efficiently from customers on credit sales. (b) The ratio at the end of January is: Allowance for Uncollectible Accounts Accounts receivable

$1,500 =

= 10% $15,000

In comparison, the ratio at the beginning of January was 10.3% (= $1,400 / $13,600). The allowance is lower in relation to accounts receivable at the end of the month indicating the company expects an improvement in cash collections from customers on credit sales.

PROBLEMS Problem 7–1 Requirement 1 Monthly bad debt expense accrual summary. Bad debt expense (3% × $2,620,000).......................................... Allowance for uncollectible accounts .....................................

78,600 78,600

To record year 2024 accounts receivable write-offs: Allowance for uncollectible accounts.......................................... Accounts receivable ...............................................................

68,000 68,000

Requirement 2 Bad debt expense ....................................................................... Allowance for uncollectible accounts (below) ........................

4,300 4,300

Year-end required allowance for uncollectible accounts: Summary Age Group 0–60 days 61–90 days 91–120 days Over 120 days Totals

Amount $430,000 98,000 60,000 55,000 $643,000

Percent Uncollectible 4% 15% 25% 40%

Estimated Allowance $17,200 14,700 15,000 22,000 $68,900

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–1 (concluded) Allowance for uncollectible accounts: Beginning balance Add: Monthly bad debt accruals Deduct: Write-offs Balance before year-end adjustment Required allowance (determined above) Required year-end increase in allowance Requirement 3 Bad debt expense for 2024: Monthly accruals Year-end adjustment Total

$54,000 78,600 (68,000) 64,600 68,900 $ 4,300

$78,600 4,300 $82,900

Balance sheet: Current assets: Accounts receivable, net of $68,900 allowance for uncollectible accounts

$574,100

Problem 7–2 Requirement 1 (a) Net amount of accounts receivable written off or reinstated. Accounts Receivable (gross) ($ in millions)

Beg. B al. 12,371 + 85= 12,456 Sales

92,154 91,868 Collections 164 Write off

End. Bal. 12,484 + 94 = 12,578 Because the plug is a credit, there must have been a writeoff of accounts receivable of $164.

(b) Increase or decrease in bad debt expense Allowance for Uncollectible Accounts ($ in millions)

85 Beg. Bal. 173 Bad debt expens e 164 Write off of bad de bts 94

End. Bal.

A credit plug implies a debit to bad debt expense of $173, adjusting upward the level of the allowance of uncollectible accounts. Note that this differs by $5 from the $178 listed as the provision for doubtful accounts on the statement of cash flows. The difference might be explained by the $178 including provisions for financing receivables.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–2 (concluded) (c) The approximate percentage used to estimate bad debts assuming Dell used the income statement approach $173 ÷ $92,154 = 0.188% Requirement 2 (a) ($ in millions) Current assets: Receivables

2020

2019

$12,578

$12,456

(b) Bad debt expense would be equal to actual receivables written off or

reinstated; in this case the reinstatement of $164 million.

Problem 7–3 Requirement 1 ($ in millions)

Accounts receivable, net Add: Allowances Accounts receivable, gross Requirement 2

2020

2019

$2,749 214 $2,963

$4,272 30 $4,302

Accounts Receivable (net) ($ in millions)

Beg. Bal. S W

C E W

End. Bal. Accounts Receivable (net) ($ in millions)

Beg. Bal.

4,272 1,239 E = 284

End. Bal. 2,749 If A/R decreased by $1,239, Collections must have exceeded Sales by that amount, shown as a credit. Solving for Bad debt expense (E) yields an estimate of $284.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–3 (continued) Requirement 3 Allowance for Uncollectible Accounts ($ in millions)

Beg. Bal. W E End. Bal.

Allowance for Uncollectible Accounts ($ in millions)

Beg. Bal.

284

Bad Debt Expense

214

End. Bal.

W = 100

Nike had $100 of bad debt write-offs during 2020.

Problem 7–3 (concluded) Requirement 4 Accounts Receivable (gross) ($ in millions)

Beg. Bal. Sales

4,302 37,403 38,642 Collections 100 Write-offs

End. Bal.

2,963

Nike collected $38,642 of accounts receivable during 2020. Requirement 5 Accounts Receivable (net) ($ in millions)

Beg. Bal. Sales

4,272 37,403

Write-offs

100

End. Bal.

2,749

284 Bad debts expense 38,642 Collections 100 Write-offs

Once again we see that Nike collected $38,642 of accounts receivable during 2020. Note that write-offs cancel when reconciling net accounts receivable, because the journal entry to recognize write-offs debits the Allowance for uncollectible accounts and credits Accounts receivable. However, we have to make sure to include the credit to Bad debt expense, as that increases the Allowance for uncollectible accounts and therefore decreases Net accounts receivable.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–4 Requirement 1 To record accounts receivable written off during the year 2024: Allowance for uncollectible accounts ......................................... Accounts receivable ...............................................................

35,000 35,000

To record collection of account receivable previously written off: Accounts receivable ................................................................... Allowance for uncollectible accounts.....................................

3,000

Cash ........................................................................................... Accounts receivable ...............................................................

3,000

Requirement 2 (a) December 31, 2024 Bad debt expense (3% × $1,750,000) ......................................... Allowance for uncollectible accounts.....................................

52,500 52,500

(b) December 31, 2024 Bad debt expense ....................................................................... Allowance for uncollectible accounts (below) ........................

36,700 36,700

Problem 7–4 (continued) Accounts receivable analysis: Beginning balance Add: Credit sales Less: Write-offs Less: Cash collections Ending balance

$ 462,000 1,750,000 (35,000) (1,830,000) $ 347,000

$347,000 × 10% = $34,700 = Required allowance for uncollectible accounts Allowance for uncollectible accounts analysis: Beginning balance Add: Collection of receivable previously written off Less: Write-offs Balance before adjustment Required allowance (determined above) Bad debt expense adjustment

$30,000 3,000 (35,000) (2,000) debit balance 34,700 $36,700

(c) December 31, 2024 Bad debt expense........................................................................ Allowance for uncollectible accounts (below) ........................

37,047 37,047

Required allowance:

Age Group 0–60 days 61–90 days 91–120 days Over 120 days Totals

Amount $225,550 69,400 34,700 17,350 $347,000

Percent Uncollectible 4% 15% 25% 40%

Estimated Allowance $ 9,022 10,410 8,675 6,940 $35,047

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–4 (concluded) Allowance for uncollectible accounts analysis: Beginning balance Add: Collection of receivable previously written off Less: Write-offs Balance before adjustment Required allowance Bad debt expense adjustment Requirement 3 Accounts receivable – Year-end allowance

$30,000 3,000 (35,000) (2,000) debit balance 35,047 $37,047

(a)

$347,000

–

[($2,000) + $52,500]

= $296,500

(b)

$347,000

–

$34,700

= $312,300

(c)

$347,000

–

$35,047

= $311,953

Problem 7–5 Requirement 1 ($ in thousands)

Accounts receivable, net Add: Allowances Accounts receivable, gross Requirement 2

2016 $458,900 131,100 $590,000

2015 $440,000 86,700 $526,700

Allowance for Uncollectible Accounts ($ in thousands)

77,600

Beg. Bal.

Write-offs 145,700 191,000 122,900

Bad Debt Expense End. Bal.

Avon had $145,700 thousand of bad debt write-offs during 2016. Requirement 3 ($ in thousands)

Allowance for Sales Returns 9,100

Beg. Bal.

Actual returns 187,000 186,100 8,200

Estimated Sales Returns End. Bal.

Avon had $186,100 thousand of estimated sales returns during 2016. Gross sales for the year equal net sales of $5,578,800 + estimated sales returns of $186,100 = $5,764,900 thousand.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–5 (concluded) Requirement 4 Accounts Receivable ($ in thousands)

Beg. Bal. Sales

526,700 5,764,900

End. Bal.

590,000

5,368,900 Collections 145,700 Write-offs 187,000 Sales returns

Avon had $5,368,900 thousand of cash collected from customers during 2016.

Problem 7–6 Requirement 1 Total face value of notes = $300,000 + $150,000 + $200,000 = Balance sheet carrying value = Difference is the remaining discount on note 3

$650,000 645,000 $ 5,000

Note 3 is a 6-month note, with three months remaining. Therefore, $5,000 represents one-half of the total discount of $10,000. $10,000 ÷ $200,000 = 5% × 12/6 = 10% discount rate. Requirement 2 Total accrued interest receivable $16,000 Less: Interest accrued on note 1: $300,000 × 10% × 4/12 = (10,000) Interest accrued on note 2 $ 6,000 $6,000 ÷ $150,000 = 4% × 12/6 = 8% R equirement 3 Note 1 Note 2 Note 3 ($200,000 × 10% × 3/12) Total interest revenue

$10,000 6,000 5,000 $21,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–7 Requirement 1 Alternative a: To record the borrowing of $500,000 and signing of a promissory note: July 1, 2024 Cash ................................................................................................ 500,000 Notes payable ........................................................................

500,000

Alternative b: To record the transfer of receivables: July 1, 2024 Cash ($550,000 × 98%).............................................................. Loss on sale of receivables (2% × $550,000) .............................. Accounts receivable ...............................................................

539,000 11,000 550,000

Requirement 2 Alternative a: July, 2024 Cash (80% × $780,000).............................................................. Accounts receivable ...............................................................

624,000

July 31, 2024 Interest expense ($500,000 × 12% × 1/12)................................... Notes payable............................................................................. Cash ......................................................................................

5,000 500,000

624,000

505,000

Problem 7–7 (concluded) Alternative b: $550,000 of accounts receivable are now held by the bank, and presumably the bank has collected 0.8 × $550,000 = $440,000 during July. Lonergan still holds accounts receivable of ($780,000 – $550,000 = $230,000), so should have collected 0.8 × $230,000 = $184,000 during July. July 31, 2024 Cash [80% × ($780,000 – $550,000)] .............................................. 184,000 Accounts receivable ...............................................................

Requirement 3 Alternative a. –

Alternative b. –

184,000

Note disclosure is required for the assignment of accounts receivable as collateral for the $500,000 note. No disclosure is required since the transfer of receivables was made without recourse.

Problem 7–8

Cash (90% × $800,000) .............................................................. 720,000 Loss on sale of receivables (to balance) ...................................... 52,000 Receivable from factor ($60,000 fair value – [4% × $800,000])28,000 Accounts receivable (balance sold)......................................... 800,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–9 WALKEN COMPANY Balance Sheet December 31, 2024 Current Assets Casha Accounts receivable (net)b

€35,000 60,000

Walken would net the €40,000 and (€5000) cash balances, yielding a balance of €35,000. a

Net accounts receivable would be affected as follows: Beginning balance: € 25,000 Credit sales 85,000 Cash collections (30,000) Receivables factored with Reliable (20,000) Receivables factored with Dependablec -0Total €60,000

The receivables factored with Dependable don‘t qualify for sales treatment, as substantially all risks and rewards of ownership are retained by Walken. c

Problem 7–10 Requirement 1 February 28, 2024 Notes receivable ......................................................................... Sales revenue .........................................................................

March 31, 2024 Notes receivable (face amount) ................................................... Discount on notes receivable ($8,000 × 10%)......................... Sales revenue (difference) ......................................................

10,000 10,000

8,000 800 7,200

April 3, 2024 Accounts receivable.................................................................... Sales revenue .........................................................................

7,000

April 11, 2024 Cash (98% × $7,000) .................................................................. Sales discounts (2% × $7,000) .................................................... Accounts receivable ...............................................................

6,860 140

April 17, 2024 Sales returns ............................................................................... Accounts receivable ...............................................................

5,000

Inventory .................................................................................... Cost of goods sold..................................................................

7,000

5,000 3,200 3,200

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–10 (continued) April 30, 2024 Cash (99% × $50,000) ................................................................ Loss on sale of receivables (1% × $50,000) ................................ Accounts receivable ...............................................................

49,500 500 50,000

To accrue interest on note receivable for four months: June 30, 2024 Interest receivable ...................................................................... Interest revenue ($10,000 × 10% × 4/12).................................

333 333

To record discounting of note receivable: June 30, 2024 Cash (proceeds determined below) ............................................. Loss on sale of notes receivable (to balance) .............................. Interest receivable (from adjusting entry) ............................... Notes receivable (face amount) ..............................................

$10,000 583 10,583 (317) $10,266

10,266 67 333 10,000

Face amount Interest to maturity ($10,000 × 10% × 7/12) Maturity value Discount ($10,583 × 12% × 3/12) Cash proceeds

September 30, 2024 — NO ENTRY REQUIRED

Problem 7–10 (concluded) Requirement 2 To accrue nine months‘ interest on the Maddox Co. note receivable: Discount on notes receivable ...................................................... Interest revenue ($8,000 × 10% × 9/12)...................................

600 600

Requirement 3 Date February 28 March 31 April 3 April 11 April 17 April 17 April 30 June 30 June 30 December 31 Total effect

Income increase (decrease) $10,000 7,200 7,000 (140) (5,000) 3,200 (500) 333 (67) 600 $22,626

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–11

Note

Note Face Value

Date of Note

Interest Rate

Date Discounted

Discount Rate

Proceeds Received

$50,000

3-31-24

6-30-24

10%

$50,350 (1)

50,000

3-31-24

9-30-24

10%

51,675 (2)

50,000

3-31-24

9-30-24

12%

51,410 (3)

80,000

6-30-24

10-31-24

10%

81,027 (4)

80,000

6-30-24

10-31-24

12%

80,752 (5)

80,000

6-30-24

11-30-24

10%

81,713 (6)

(1) $50,000 3,000 53,000 (2,650) $50,350

Face amount Interest to maturity ($50,000 × 8% × 9/12) Maturity value Discount ($53,000 × 10% × 6/12) Cash proceeds

$50,000 3,000 53,000 (1,325) $51,675

Face amount Interest to maturity ($50,000 × 8% × 9/12) Maturity value Discount ($53,000 × 10% × 3/12) Cash proceeds

(2)

Problem 7–11 (concluded) (3) $50,000 3,000 53,000 (1,590) $51,410

Face amount Interest to maturity ($50,000 × 8% × 9/12) Maturity value Discount ($53,000 × 12% × 3/12) Cash proceeds

$80,000 2,400 82,400 (1,373) $81,027

Face amount Interest to maturity ($80,000 × 6% × 6/12) Maturity value Discount ($82,400 × 10% × 2/12) Cash proceeds

$80,000 2,400 82,400 (1,648) $80,752

Face amount Interest to maturity ($80,000 × 6% × 6/12) Maturity value Discount ($82,400 × 12% × 2/12) Cash proceeds

$80,000 2,400 82,400 (687) $81,713

Face amount Interest to maturity ($80,000 × 6% × 6/12) Maturity value Discount ($82,400 × 10% × 1/12) Cash proceeds

(4)

(5)

(6)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–12 Requirement 1 In addition to sales revenue of $1,340,000, the 2024 income statement will include (1) interest revenue, (2) bad debt expense, and (3) loss on sale of note receivable. Interest revenue $200,000 note: $200,000 × 6% × 3/12 = $60,000 note: $ 60,000 × 8%(1) × 10/12 = Total interest revenue

$3,000 4,000 $7,000

(1)

The interest rate on the $60,000 note can be determined as follows: Interest receivable in 12/31/2024 balance sheet = $6,800 Less: Interest on $200,000 note: $200,000 × 6% × 6/12 = (6,000) Interest on $60,000 note $ 800 $800 represents interest for two months (November and December of 2024) or $400 per month. Annual interest is $400 × 12 = $4,800. $4,800  $60,000 = 8% interest rate. Bad debt expense

Analysis of accounts receivable Beginning accounts receivable ($218,000 + $24,000) Add: Credit sales Less: Cash collections Less: Write-offs Ending accounts receivable

$ 242,000 1,340,000 (1,280,000) (22,000) $ 280,000

Analysis of allowance for uncollectible accounts Beginning allowance Add: Bad debt expense Less: Write-offs Ending allowance(2)

$24,000 ? (22,000) $28,000

Therefore, bad debt expense is $26,000 ($24,000 – $22,000 – $28,000) (2)

$280,000 × 10% = $28,000

Problem 7–12 (concluded) Loss on sale of notes receivable

Interest accrued on the $200,000 note for nine months (6/30/2024 to 3/31/2025): $200,000 × 6% × 9/12 = $9,000 Calculation of cash proceeds received from discounting note: $200,000 12,000 212,000 (4,240) $207,760

Face amount Interest to maturity ($200,000 × 6%) Maturity value Discount ($212,000 × 8% × 3/12) Cash proceeds

Carrying value of note $209,000 ($200,000 + $9,000 interest receivable) Less: Cash proceeds (207,760) Loss on sale of notes receivable $ 1,240 Requirement 2 Accounts receivable, net of $28,000 allowance for uncollectible accounts

$252,000

Requirement 3 Accounts receivable turnover ratio: $1,340,000 ------------$235,000(3) (3)

= 5.7 times

($218,000 + $252,000)  2 = $235,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–13 Requirement 1 Computation of balance per books: Balance per bank statement Add: Deposits outstanding Deduct: Checks outstanding Error in recording rent check Add: Automatic mortgage payment Add: Bank service charges Deduct: Deposit credit to company‘s account in error Add: NSF check charge Balance per books

Step 1:

(875.00) 85.00 $13,542.87

Bank Balance to Corrected Balance

Balance per bank statement Add: Deposits outstanding Deduct: Bank error—deposit incorrectly credited to company account Checks outstanding Corrected cash balance Step 2:

$14,632.12 575.00 (1,320.25) (18.00) 450.00 14.00

$14,632.12 575.00

(875.00) (1,320.25) $13,011.87

Book Balance to Corrected Balance

Balance per books Add: Error in recording rent check Deduct: Automatic payment on note Service charges NSF checks Corrected cash balance

$13,542.87 18.00 (450.00) (14.00) (85.00) $13,011.87

Problem 7–13 (concluded) Requirement 2 To correct error in recording cash disbursement for rent:

Cash ............................................................................ Rent expense ...........................................................

18 18

To record credits to cash revealed by the bank reconciliation:

Interest expense ........................................................... Notes payable .............................................................. Miscellaneous expense (bank service charges) ............. Accounts receivable (NSF checks)............................... Cash........................................................................

350 100 14 85 549

Requirement 3 Checking account balance Petty cash U.S. treasury bills Total cash and cash equivalents

$13,011.87 200.00 5,000.00 $18,211.87

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–14 Requirement 1 Step 1:

Bank Balance to Corrected Balance

Balance per bank statement Add: Deposits outstanding Deduct: Bank error—deposit incorrectly credited to company account Outstanding checks Corrected cash balance Step 2:

$3,851 2,150 (1)

(1,300) (831) (2) $3,870

Book Balance to Corrected Balance

Balance per books Deduct: Error in recording check #411 Service charges NSF checks Corrected book balance

$4,422

(1) Receipts Less: December receipts deposited: Bank deposits $43,000 Less: Deposit error (1,300) Less: Prior month‘s deposits outstanding (1,200) Deposits outstanding, Dec. 31

$42,650

(2) Dec. disbursements Error in recording check #411 Less: December checks cleared: $41,918 Total checks cleared Prior month's checks: #363 $123 #380 56 #381 86 #382 340 (605) December checks outstanding Add: check # 365 Total checks outstanding, Dec. 31

$41,853 90

(90) (22) (440) $3,870

40,500 $ 2,150

(41,313) 630 201 $ 831

Problem 7–14 (concluded) Requirement 2 To record credits to cash revealed by the bank reconciliation:

Advertising expense .................................................... Miscellaneous expense (bank service charges)............. Accounts receivable (NSF checks)............................... Cash........................................................................

90 22 440 552

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 7–15 Requirement 1

($ in millions) Land.......................................................................... Loss on troubled debt restructuring............................ Notes receivable ................................................... Interest receivable .................................................

16 6 20 2

Requirement 2

ANALYSIS Previous Value: Accrued 2023 interest (10% × $20,000,000) Principal Carrying amount of the receivable New Value: Interest $1 million x 3.16987 * = Principal $15 million x 0.68301 ** = Present value of the receivable Loss:

$ 2,000,000 20,000,000 $22,000,000 $ 3,169,870 10,245,150 (13,415,020) $ 8,584,980

Present value of an ordinary annuity of $1: n = 4, i = 10% (from Table 4) ** Present value of $1: n = 4, i = 10% (from Table 2)

JOURNAL ENTRIES January 1, 2024 8,584,980 Bad debt expense (to balance) ................................... ................... Interest receivable (10% × $20,000,000) ............... ................... Allowance for uncollectible accounts ($20,000,000 – $13,415,020)

2,000,000 6,584,980

December 31, 2024 Cash (required by new agreement)……………………….............. Allowance for uncollectible accounts (to balance) ...............341,502 Interest revenue (10% × $13,415,020)................... ...................

1,341,502

1,000,000

December 31, 2025 1,000,000 Cash (required by new agreement)……………………….............. Allowance for uncollectible accounts (to balance) .................. 375,652 Interest revenue (10% × $13,756,522)................... ...................

1,375,652

Problem 7–15 (continued) December 31, 2026 Cash (required by new agreement)............................. Allowance for uncollectible accounts (to balance)413,217 Interest revenue (10% × $14,132,174) ...................

December 31, 2027 Cash (required by new agreement)............................. Allowance for uncollectible accounts (to balance)454,609 Interest revenue (10% × $14,545,391) ...................

1,000,000 1,413,217

1,000,000 1,454,609*

Cash (required by new agreement)............................. 15,000,000 Allowance for uncollectible accounts (to balance)5,000,000 Notes receivable (balance) .................................... * rounded to amortize the note to $15,000,000 (per schedule below)

20,000,000

Amortization Schedule – Not required Cash Interest by agreement

1 2 3 4

1,000,000 1,000,000 1,000,000 1,000,000 4,000,000

Effective Interest 10% × Outstanding Balance .10(13,415,020) = 1,341,502 .10(13,756,522) = 1,375,652 .10(14,132,174) = 1,413,217 .10(14,545,391) = 1,454,609*

5,584,980

Increase in Balance Discount Reduction

341,502 375,652 413,217 454,609 1,584,980

Outstanding Balance

13,415,020 13,756,522 14,132,174 14,545,391 15,000,000

* rounded

Complete Solution Manual for Intermediate Accounting, 11th Edition

DECISION MAKERS’ PERSPECTIVE CASES Judgment Case 7–1 1. No, there is not a weakness. John must submit supporting documentation as well as a list of accounts and amounts to be charged to replenish the petty cash fund and must obtain approval before replenishing the fund. Surprise counts of the fund also ensure that the fund is being maintained on an imprest basis, that is, to ensure that cash and/or receipts equal $200 at all times. 2. Yes, there is a weakness. The internal control system for disbursements does not contain sufficient separation of duties. Dean Leiser approves the vouchers, signs the checks, maintains the disbursement records, and reconciles the bank account. There should be at least one other person involved in these activities to ensure accuracy and to safeguard cash from expropriation. 3. Yes, there is a weakness. The internal control system for receipts does not contain sufficient separation of duties. Fran Jones has physical control of the deposits and also maintains the subsidiary ledger for accounts receivable. These duties should be separated. In addition, the company should require that customers pay their bills via check and that cash not be used.

Judgment Case 7–2 Requirement 1 a. Yes, Hogan should account for the sales discounts at the date of sale using the net method by recording accounts receivable and sales revenue at the amount of sales less the sales discounts available. Revenues should be recorded at the amount the seller is entitled to receive. Under the net method, the sale is recorded at an amount that represents that amount, as the seller anticipates that the buyer will take the sales discount. b. Yes, sales revenues should be increased by the amount of sales discounts forfeited when customers do not take the sales discounts. That has the effect of also increasing net income.

Requirement 2 Yes, trade discounts affect the amount recorded as sales revenue. The amount recorded as sales revenues and accounts receivable is net of trade discounts and represents the price of the asset sold. The trade discount is simply a way of specifying the transaction price.

Requirement 3 Yes, to account for the accounts receivable factored on August 1, 2024, Hogan should decrease accounts receivable by the amount of the accounts receivable factored, increase cash by the amount received from the factor, and record a loss. Factoring of accounts receivable without recourse is equivalent to a sale. The difference between the cash received and the carrying amount of the receivables is a loss.

Requirement 4 Hogan should report the face amount of the interest-bearing notes receivable and the related interest receivable for the period from October 1 through December 31 on its balance sheet as current assets. Both assets are due on September 30, 2025, which is less than one year from the date of the balance sheet.

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Real World Case 7–3 Requirement 3 a. Balance in the allowance for doubtful accounts: 2019: $0 2018: $0 b.

2019 2018

Accounts receivable, net $2,075,380 985,854

Allowance for doubtful accounts $0 0

Yes, the $0 balance is surprising, because Toughbuilt has a significant amount of accounts receivable and the balance more than doubled during 2019 with no change in the allowance. c. The direct writeoff method is consistent with a $0 balance in the allowance for doubtful accounts. That method is not GAAP, but it could be justified if the amount of bad debt is not material

Real World Case 7–3 (concluded) Requirement 4 a. Balance in the Reserve for sales returns and allowances: 2019: $13,000 2018: $13,000 b. Accounts receivable, net 2019 2018 Change

$2,075,380 985,854 $1,089,526

Reserve for sales returns and allowances $13,000 13,000 $ 0

Yes, the comparison is of concern, because Toughbuilt‘s balance in net accounts receivable more than doubled but there was no change in the reserve. We would assume those would move at least somewhat in parallel. Requirement 5 a.

Secured borrowing.

With recourse.

$125,645, listed under Current Liabilities.

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Real World Case 7–4 Answers will, of course, vary depending on the year. The following were reported in Cisco‘s financial statements for the year ended July 27, 2019 ($ in millions):

2019 Net sales: $51,904 2019 net accounts receivable: $5,491 (allowance, $136) 2018 net accounts receivable: $5,554 (allowance, $129) Provision for receivables (bad debt expense) from cash flow statement: $40 Requirement 3 a.

Net trade accounts receivable + Allowance for doubtful accounts = Gross accounts receivable $5,491 + $136 = $ 5,627

b. The statement of cash flows indicates bad debt expense (provision for receivables) of $40 c. Allowance for Uncollectible Accounts

129

Beg. Bal.

Bad Debt Expense

136

End. Bal.

Write-offs 33

Case 7–4 (concluded) d.

Cash collected from customers can be calculated based on either gross accounts receivable of net accounts receivable. Gross Accounts Receivable

Beg. Bal. 5,554 + 129 = 5,683 Sales

51,904

51,927 Collections 33 Write-offs

End. Bal. 5,491 + 136 = 5,627 Net Accounts Receivable

Beg. Bal.

5,554

Sales

51,904

51,927 Collections 40 Bad Debt Expe nse

End. Bal.

5,491

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Integrating Case 7–5 McLaughlin's underestimation of bad debts is treated as a change in accounting estimate. Changes in estimates are accounted for prospectively. When a company revises a previous estimate, prior financial statements are not restated. Instead, the company merely incorporates the new estimate in any related accounting determinations from then on. In this case, bad debt expense for 2025 will be higher than it would have been had the underestimation not occurred. A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for 2025.

Real World Case 7–6 Requirement 1 Yes, Sanofi-Aventis has recently engaged in factoring and/or securitizing its receivables. We know this because note D.10 states, ―Some Sanofi subsidiaries have assigned receivables to factoring companies or banks without recourse. The amount of receivables derecognized was €214 million as of December 31, 2019…‖ Requirement 2 a. Reduce. Accounts receivable would be reduced in the period of change, as Sanofi-Aventis would collect outstanding receivables and immediately securitize new receivables. b. Increase. Cash flow from operations would be increased in the period of change, as Sanofi-Aventis would show cash inflows both from collecting outstanding receivables and from immediately securitizing new receivables. c. Stabilize at low level. Accounts receivable would be stable at a relatively low level, as Sanofi-Aventis would immediately securitize new receivables. d. Stabilize at same level. Cash flow from operations would return to approximately its former level, as Sanofi-Aventis would show cash inflows only from immediately securitizing new receivables. Requirement 3 Yes. The answers to requirement 3 highlight that decisions to increase or decrease the extent of securitization create one-time changes in receivables and cash flows in the period in which the company transitions to the new level. For example, increasing securitization will boost cash flow in the period of change. However, the increased cash flow is only temporary—in future periods cash flow will revert to former levels unless the company increases the extent of securitization yet further.

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Research Case 7–7 Requirement 1 FASB ASC 860–10–40–05: ―Transfers and Servicing—Overall—Derecognition— Criteria for a Sale of Financial Assets.‖ The transferor is determined to have surrendered control over the receivables if and only if all of the following conditions are met:

a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors—even in bankruptcy or other receivership. b. Each transferee has the right to pledge or exchange the assets it received. c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that the transferor repurchase or redeem them before their maturity or (2) the ability to cause the transferee to return specific assets. (These criteria were included in Statement of Financial Accounting Standards No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" subsequently modified by SFAS No. 166, ―Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140.‖ (The above conditions can be found in paragraph 9 of the standard.)

Requirement 2 Cash (90% × $400,000) ................................................................... 360,000 Loss on sale of receivables (to balance) ...................................... 31,000 Receivable from factor ($25,000 fair value – [4% × $400,000])9,000 Accounts receivable (balance sold) ........................................

400,000

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Case 7–7 (concluded)

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 3 FASB ACS 860–10–40–24: ―Transfers and Servicing—Overall—Derecognition – Effective Control Through Both a Right and an Obligation (previously paragraph 47 of SFAS No. 140) lists the following conditions: a. The assets to be repurchased or redeemed are the same or substantially the same as those transferred. b. The agreement is to repurchase or redeem them before maturity, at a fixed or determinable price. c. The agreement is entered into concurrently with the transfer.

Analysis Case 7–8 Requirement 1 Pilgrim’s Pride

Tyson Receivables turnover

$42,405 ($2,173 + $1,723) ’ 2

21.77 times

$11,409 ($741 + $562) ’ 2

17.51 times

Average collection period

365 21.77

16.77 days

365 17.51

20.85 days

The receivable turnover ratios are reasonably close to each other, but Tyson is turning over their receivables more quickly. All else equal, this indicates that Tyson is managing its receivables more effectively.

Requirement 2 The objective of this requirement is to motivate students to obtain hands-on familiarity with actual annual reports and to apply the techniques learned in the chapter. You may wish to provide students with multiple copies of the same annual reports and compare responses. Another approach is to divide the class into teams who evaluate reports from a group perspective.

Trueblood Accounting Case 7-9 A solution and extensive discussion materials can be obtained from the Deloitte Foundation.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Communication Case 7–10 Suggested Grading Concepts and Grading Scheme: Content (70%) 40 Explains the difference between the allowance method and the direct write-off method. Direct write-off is more objective. Direct write-off has potential to violate the matching principle. 15

Even if uncollectibles are fairly stable, when significant variations do occur, profit will be overstated in one period and understated in another period.

Even if uncollectibles remain constant, the direct write-off method will result in an overstatement of accounts receivable in the balance sheet.

70 points Writing (30%) 6 Terminology and tone appropriate to the audience of a company president. 12

Organization permits ease of understanding. Introduction that states purpose. Paragraphs that separate main points.

English Sentences grammatically clear and well organized, concise. Word selection. Spelling. Grammar and punctuation.

30 points

Ethics Case 7–11 Requirement 1 Required allowance Revised allowance Increase in income before taxes of proposed change

$180,000 135,000 $ 45,000

Requirement 2 Discussion should include these elements.

Ethical Dilemma: You, as the assistant controller, have a responsibility to follow GAAP and make a reasonably accurate estimate of the amount of receivables that will be collected. Is your responsibility to fairly present Stanton Industries‘ financial statements to external users greater than your obligation to improve the financial position of your employer?

Alternative actions and consequences include: 1. Refuse to comply with the controller‘s request to change the aging category of the large account. Positive consequences: a. Preservation of your honesty and integrity. b. Fair presentation of receivables. Negative consequences: a. Possible loss of your job. b. Lower net income for Stanton Industries. c. A devalued stock price for Stanton Industries. 2. Comply with the controller's suggestion to report the allowance for uncollectible accounts at $135,000. Positive consequences: a. Retention of your job. b. A more favorable net income for Stanton Industries. c. A more favorable position with unknowing creditors, financial analysts, current investors, and future investors. Negative consequences: a. Endure guilt feelings. b. A lack of trust in you by other managers and employees. c. Possible litigation from investors and creditors.

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Case 7–11 (concluded) 3. Report the controller‘s suggestion to a higher level of management, the audit committee, or the auditors. If one of these parties corrects the controller and compels fair reporting of the allowance account, the consequences would be the same as in alternative 1 when you refuse to make the adjustment. Your job may still be in jeopardy due to the fact that management may consider whistle blowing as indicative of employee disloyalty. If the reportee parties agree with the controller and report the incorrect amount of $135,000, the consequences will be similar to those for the second alternative in 2, except that you run an even greater risk of losing your job. 4. Refuse to comply with the controller‘s request and resign as assistant controller. If you report the controller‘s suggestion to higher management, the audit committee, or the auditor, the positive and negative considerations are the same as for alternative 3. If you do not report the controller‘s request, then the consequences are the same as for alternative 2. In either case, your job is not an issue since you have already resigned.

Target Case Requirement 1 From note 7: ―Cash equivalents include highly liquid investments with an original maturity of three months or less from the time of purchase. Cash equivalents also include amounts due from third-party financial institutions for credit and debit card transactions. These receivables typically settle in five days or less.‖ Requirement 2 Cash and cash equivalents, including short-term investments of $1,810 million, was $2,577 million as of February 1, 2020. Requirement 3 From note 2: ―Generally, guests may return national brand merchandise within 90 days of purchase and owned and exclusive brands within one year of purchase. Sales are recognized net of expected returns, which we estimate using historical return patterns and our expectation of future returns.‖ Requirement 4 Target does not show any accounts receivable in its balance sheet. Per note 2, the receivables associated with the Target Credit Card and Target MasterCard are owned by TD Bank. However, per note 7 Target has receivables from third-party financial institutions of $441 million, and per note 9, Target has amounts due from vendors of $464 million.

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Air France–KLM Case Requirement 1 AF indicates the following: ―4.11 Valuation of trade receivables and non-current financial assets: Trade receivables, loans and other non - current financial assets are considered to be assets issued by the Group and are initially recorded at fair value. They are subsequently valued using the amortized cost method. Regarding the impairment of trade receivables, the Group has chosen the simplified method approach in that the automated customer invoicing and settlement processes for the Passenger and Cargo businesses significantly limit the credit risk.‖ This approach is consistent with U.S. GAAP. The receivables are recorded initially at their fair value (their value when the sales transaction occurs). If they are discounted for the time value of money, the amount of any discount is amortized to interest revenue over the life of the receivable. And by using the ―simplified method‖ to record impairments, AF is using an approach consistent with CECL, rather than the ECL approach that requires identification of significant increases in credit risk with respect to credit losses expected to occur from defaults after twelve months. Requirement 2 Valuation allowance for trade accounts receivable

―Use of allowance‖ (bad-debt writeoffs)

Reclassification

155 39

Beg. balance ―Charge to allowance‖ (Bad debt expense)

173

End. balance

Air France–KLM Case (concluded) Requirement 3 AF has bank overdrafts of €4 as of December 31, 2019. Under IFRS, those overdrafts would be netted against AF‘s total cash and cash equivalents of €3,711 if the overdrafts are payable on demand and are part of the AF‘s normal cash management process. Given that AF shows a cash balance of €3,715 on the balance sheet, it is apparent that they do not net overdrafts with cash. Instead, the overdrafts must be shown as a current liability, consistent with U.S. GAAP and suggesting that the overdrafts don‘t meet IFRS‘s requirements for netting against the cash balance.

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Chapter 8 Inventories: Measurement QUESTIONS FOR REVIEW OF KEY TOPICS

Question 8– 808 Inventory for a manufacturing company consists of (1) raw materials, (2) work in process, and (3) finished goods. Raw materials represent the cost, primarily purchase price plus freight charges, of goods purchased from suppliers that will become part of the finished product. Work-in-process inventory represents the products that are not yet complete in the manufacturing process. The cost of work in process includes the cost of raw materials used in production, the cost of labor that can be directly traced to the goods in process, and an allocated portion of other manufacturing costs, called manufacturing overhead. When the manufacturing process is completed, these costs that have been accumulated in work in process are transferred to finished goods.

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Question 8–2 Beginning inventory plus net purchases for the period equals cost of goods available for sale. The main difference between a perpetual and a periodic system is that the periodic system allocates cost of goods available for sale to ending inventory and cost of goods sold only at the end of the period. The perpetual system accomplishes this allocation by decreasing inventory and increasing cost of goods sold each time goods are sold. The perpetual inventory system is used by nearly all major companies.

Question 8– 810 Perpetual System

Periodic System

(1) Purchase of merchandise

debit inventory

debit purchases

(2) Sale of merchandise

debit cost of goods sold; credit inventory

no entry

(3) Return of merchandise

credit inventory

credit purchase returns

(4) Payment of freight

debit inventory

debit freight-in

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Question 8– 812 Inventory shipped f.o.b. shipping point is included in the inventory of the purchaser when the merchandise is given to the delivery company. Depot Corporation records the purchase in 2024 and includes the shipment in its ending inventory. Boxcar Company records the sale in 2024. Inventory shipped f.o.b. destination is included in the inventory of the seller until it reaches the purchaser‘s location. Boxcar would include the merchandise in its 2024 ending inventory and the sale/purchase would be recorded in 2025.

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Question 8–5 A consignment is an arrangement under which goods are physically transferred to another company (the consignee), but the transferor (consignor) retains legal title. If the consignee can‘t find a buyer, the goods are returned to the consignor. Goods held on consignment are included in the inventory of the consignor until sold by the consignee.

Question 8– 814 Under the gross method, we record the purchase for the full (or gross) amount of the inventory‘s cost. Purchase discounts taken are a reduction of inventory at the time the invoice is paid. Under the net method, we record the purchase of inventory for its full amount minus (or net of) the possible discount on that amount. The presumption by the purchaser under the net method is that inventory should be recorded for its cost, and because the purchaser expects to pay the invoice within the discount period, the discount should be subtracted at the time of the purchase to reflect the inventory‘s expected cost.

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Question 8–7 1. Beginning inventory — 2. Purchases — 3. Ending inventory — 4. Purchase returns — 5. Freight-in —

increase increase decrease decrease increase

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Question 8–8 Four methods of assigning cost to ending inventory and cost of goods sold are (1) specific identification, (2) first-in, first-out (FIFO), (3) last-in, first-out (LIFO), and (4) average cost. The specific identification method requires each unit sold during the period or each unit on hand at the end of the period to be traced through the system and matched with its actual cost. First-in, first-out (FIFO) assumes that units sold are the first units purchased. The last-in, first-out (LIFO) method assumes that the units sold are the most recent units purchased. The average cost method assumes that cost of goods sold and ending inventory consist of a mixture of all the goods available for sale. The average unit cost applied to goods sold or ending inventory is an average unit cost weighted by the number of units acquired at the various unit prices.

Question 8–9 When costs are declining, LIFO will result in a lower cost of goods sold and higher net income than FIFO. This is because LIFO will include in cost of goods sold the most recently purchased lower-cost merchandise. LIFO also will provide a higher ending inventory in the balance sheet when costs are declining because the inventory has units purchased at an earlier date, when costs were higher.

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Question 8–10 Proponents of LIFO argue that it provides a better match of revenues and expenses because cost of goods sold includes the costs of the most recent purchases. These are matched with sales that reflect a current selling price. On the other hand, inventory costs in the balance sheet generally are out of date because they are derived from old purchase transactions. It is conceivable that a company‘s LIFO inventory balance could be based on unit costs actually incurred several years earlier. When inventory quantity declines during a period, then these out-of-date inventory layers will be liquidated and cost of goods sold will match noncurrent costs with current selling prices.

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Question 8–11 Many companies choose the LIFO inventory method to reduce income taxes in periods when prices are rising. In periods of rising prices, LIFO results in a higher cost of goods sold and therefore a lower net income than the other methods. The companies‘ income tax returns will report lower taxable incomes using LIFO and lower taxes will be paid currently. If a company uses LIFO to measure its taxable income, IRS regulations require that LIFO also be used to measure income reported to investors and creditors.

Question 8– 822 The gross profit, inventory turnover, and average days in inventory ratios are designed to monitor inventories. The gross profit ratio is calculated by dividing gross profit (net sales minus cost of goods sold) by net sales. Inventory turnover is calculated by dividing cost of goods sold by average inventory, and we compute average days in inventory by dividing the number of days in the period by the inventory turnover ratio.

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Question 8–13 A LIFO inventory pool groups inventory units into pools based on physical similarities of the individual units. The average cost for all of a pool‘s beginning inventory and for all of a pool‘s purchases during the period is used instead of individual unit costs. If the quantity of ending inventory for the pool increases, then ending inventory will consist of the beginning inventory plus a layer added during the period at the average acquisition cost for the pool.

Question 8– 824 The dollar-value LIFO method has important advantages. First, it simplifies the recordkeeping procedures compared to unit LIFO because no information is needed about unit flows. Second, it minimizes the probability of the liquidation of LIFO inventory layers, even more so than the use of pools alone, through the aggregation of many types of inventory into larger pools. In addition, firms that do not replace units sold with new units of the same kind can use the method.

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Answers to Questions (concluded)

Question 8–15 After determining ending inventory at year-end cost, the following steps remain: 1. Convert ending inventory valued at year-end cost to base year cost. 2. Identify the layers in ending inventory with the years they were created. 3. Convert each layer‘s base year cost measurement to layer year cost measurement using the layer year‘s cost index and then sum the layers.

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BRIEF EXERCISES Question 8–16 The primary difference between U.S. GAAP and IFRS in the methods allowed to value inventory is that IFRS does not allow the use of the LIFO method.

Brief Exercise 8–1 Beginning inventory Plus: Purchases Less: Cost of goods sold Ending inventory

$186,000 945,000 (982,000) $149,000

Brief Exercise 8–2 To record the purchase of inventory on account. Inventory............................................................ 845,000 Accounts payable......................................... 845,000

To record sales on account and cost of goods sold. Accounts receivable ......................................... 1,420,000 Sales revenue ............................................... 1,420,000 Cost of goods sold .............................................. 902,000 Inventory ..................................................... 902,000

Brief Exercise 8–3 To record the purchase of inventory on account. Purchases............................................................ 845,000 Accounts payable ......................................... 845,000

To record sales on account. Accounts receivable .......................................... 1,420,000 Sales revenue ............................................... 1,420,000

Brief Exercise 8–4 Both shipments should be included in inventory. The goods shipped to a customer f.o.b. destination did not arrive at the customer‘s location until after the fiscal year-end. They belong to Kryoton until they arrive at the customer‘s location. Title to the goods shipped from a supplier to Kryoton on December 30, f.o.b. shipping point, changed hands on December 30.

Brief Exercise 8–5 $140,000 (= $200,000 − $60,000)

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Brief Exercise 8–6 To record the purchase of inventory on account. Inventory............................................................ 100,000 Accounts payable......................................... 100,000

To record freight-in. Inventory.......................................................... Cash ............................................................

5,000 5,000

Brief Exercise 8–7 To record the purchase of inventory on account. Purchases ........................................................... 100,000 Accounts payable......................................... 100,000

To record freight-in. Freight-in ......................................................... Cash ............................................................

5,000 5,000

Brief Exercise 8–8 To record the purchase of inventory on account. Inventory ............................................................ 250,000 Accounts payable ......................................... 250,000

To record purchase return. Accounts payable.................................................. 20,000 Inventory...................................................... 20,000

Brief Exercise 8–9 To record the purchase of inventory on account. Purchases............................................................ 250,000 Accounts payable ......................................... 250,000

To record purchase return. Accounts payable.................................................. 20,000 Purchase returns ........................................... 20,000

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Brief Exercise 8–10 Purchase price = 10 units × $25,000 = $250,000 December 28, 2024 Inventory............................................................ 250,000 Accounts payable......................................... 250,000

January 6, 2025 Accounts payable ............................................. 250,000 Cash (99% × $250,000) ............................... 247,500 Inventory (1% × $250,000) .......................... 2,500

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Brief Exercise 8– 834 December 28, 2024 Inventory (99% × $250,000) ............................... 247,500 Accounts payable ........................................ 247,500

January 6, 2025 Accounts payable................................................ 247,500 Cash............................................................. 247,500

Brief Exercise 8–11 First-in, first-out (FIFO) Cost of goods sold: Date of Sale January 10 January 25 Total

Cost of Units Sold

Units Sold 125 (from Beg. Inv.) 75 (from Beg. Inv.) 25 (from 1/8 purchase) 225

Ending inventory: Date of Purchase Units January 8 75 January 19 200 Total

Unit Cost $28 30

$25 25 28

Total Cost $3,125 1,875 700 $5,700

Total Cost $2,100 6,000 $8,100

Brief Exercise 8–12 (concluded) Average cost Date

Purchased

Beginning inventory

200 @ $25 =

$5,000

January 8

100 @ $28 =

$2,800

Sold

Balance 200 @ $25

$5,000

125 @ $26 = $3,250 175 @ $26

$4,550

$7,800

Available

= $26/unit 300 units

January 10 January 19 Available

200 @ $30 =

$6,000

$10,550 = $28.133/unit 375 units 100 @ $28.133 = $2,813 275 @ $28.133

January 25 Total cost of goods sold

$7,737 Ending inventory

= $6,063

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 8–13 Cost of goods available for sale: Beginning inventory (200 × $25) Purchases: 100 × $28 200 × $30 Cost of goods available (500 units)

$ 5,000 $2,800 6,000

8,800 $13,800

First-in, first-out (FIFO) Cost of goods available for sale (500 units) Less: Ending inventory (determined below) Cost of goods sold

$13,800 (8,100) $ 5,700

Cost of ending inventory: Date of purchase January 8 January 19 Total

Units 75 200

Unit cost $28 30

Total cost $2,100 6,000 $8,100

Average cost Cost of goods available for sale (500 units) Less: Ending inventory (determined below) Cost of goods sold

$13,800 (7,590) $ 6,210 *

Cost of ending inventory: $13,800 Weighted-average unit cost =

= $27.60 500 units

275 units × $27.60 = $7,590 * Alternatively, could be determined by multiplying the units sold by the average cost: 225 units × $27.60 = $6,210

Brief Exercise 8–14 Cost of goods available for sale: Beginning inventory (20,000 × $25) Purchases: 80,000 × $30 Cost of goods available (100,000 units) Less: Ending inventory (15,000 units) Cost of goods sold

500,000

2,400,000 2,900,000 375,000* $2,525,000

*15,000 units × $25 each = $375,000

Brief Exercise 8–15 64,000 units were sold. Cost of goods sold without year-end purchase: Units purchased during the year: 60,000 × $18 Plus units from beginning inventory: 4,000 × $15 Cost of goods sold

$1,080,000 60,000 1,140,000

Cost of goods sold with year-end purchase: 64,000 units × $18 Difference

1,152,000 $ 12,000

Under LIFO, cost of goods sold would be $12,000 higher and income before income taxes $12,000 lower if the year-end purchase is made. If FIFO were used instead of LIFO, the year-end purchase would have no effect on income before income taxes. FIFO cost of goods sold with or without the purchase would consist of the 10,000 units from beginning inventory and 54,000 units purchased during the year at $18: 10,000 units × $15 Plus: 54,000 units × $18 Cost of goods sold

$ 150,000 972,000 $1,122,000

Brief Exercise 8–16 Units liquidated Difference in cost ($30 – $25) Before-tax LIFO liquidation profit

5,000 × $5 $25,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Tax effect ($25,000 × 25%) LIFO liquidation profit

(6,250) $18,750

Brief Exercise 8–17

Cost of goods sold ................................................ 15,000 LIFO reserve ($75,000 − $60,000)............... 15,000

The LIFO reserve has increased from $60,000 to $75,000. Inventory is reduced with the use of the LIFO reserve, a contra account to inventory. Thus, an increase of the LIFO reserve is a credit in the adjusting entry.

Brief Exercise 8–18

LIFO reserve ($60,000 − $45,000) ....................... 15,000 Cost of goods sold ....................................... 15,000

The LIFO reserve has decreased from $60,000 to $45,000. Inventory is reduced with the use of the LIFO reserve, a contra account to inventory. Thus, a decrease of the LIFO reserve is a debit in the adjusting entry.

Brief Exercise 8–19 Cost of goods sold for the year ended August 31, 2020, would have been $100 million lower had Walgreens used FIFO for its LIFO inventory. The LIFO reserve increased in 2020 by $100 million, from $3,200 million to $3,300 million. An increase in the LIFO reserve has the effect of increasing cost of goods sold when converting from FIFO to LIFO. So, to convert in the opposite direction from LIFO to FIFO, we would subtract the increase in the LIFO reserve from the LIFO amount of cost of goods sold to calculate FIFO cost of goods sold. Cost of goods sold as reported (LIFO) Decrease to convert to FIFO Cost of goods sold (FIFO)

$111,520 million (100) million $111,420 million

Brief Exercise 8–20 Gross profit ratio = (sales revenue – cost of goods sold) / sales revenue Gross profit ratio = ($560,000 − $320,000) / $560,000 = 42.86% Inventory turnover ratio = cost of goods sold / average inventory Average inventory = ($60,000 + 48,000)  2 = $54,000 Inventory turnover ratio = $320,000 / $54,000 = 5.93

Brief Exercise 8–21 Date

Ending Inventory at Base Year Cost

1/1/2024

$1,400,000

Inventory Layers at Base Year Cost

Inventory Layers Converted to Cost

Inventory DVL Cost

= $1,400,000

$1,400,000 (base)

$1,400,000 × 1.00 = $1,400,000

$1,400,000

= $1,600,000

$1,400,000 (base) 200,000 (2024)

$1,400,000 × 1.00 = $1,400,000 200,000 × 1.04 = 208,000

$1,608,000

1.00

12/31/2024 $1,664,000 1.04

Complete Solution Manual for Intermediate Accounting, 11th Edition

EXERCISES Exercise 8–1 1.

To record the purchase of inventory on account and the payment of freight charges. Inventory.......................................................... Accounts payable.........................................

5,000

Inventory.......................................................... Cash ............................................................

300

5,000

300

To record purchase returns. Accounts payable ............................................. Inventory .....................................................

600 600

To record cash sales and cost of goods sold. Cash ................................................................. Sales revenue ...............................................

5,200

Cost of goods sold ............................................ Inventory .....................................................

2,800

5,200

2,800

Exercise 8– 842 1.

To record the purchase of inventory on account and the payment of freight charges. Purchases.......................................................... Accounts payable .........................................

5,000

Freight-in.......................................................... Cash.............................................................

300 300

To record purchase returns. Accounts payable ............................................. Purchase returns ...........................................

5,000

600 600

To record cash sales. Cash ....................................................................... 5,200 Sales revenue ...............................................

5,200

NO ENTRY IS MADE FOR THE COST OF GOODS SOLD.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–3 Beginning inventory Plus net purchases: Purchases Less: Purchase discounts Less: Purchases returns Plus: Freight-in Cost of goods available for sale Less: Ending inventory Cost of goods sold

$ 32,000 $240,000 (6,000) (10,000) 17,000

241,000 273,000 (40,000) $233,000

Exercise 8– 844 PERPETUAL SYSTEM

PERIODIC SYSTEM ($ in 000s)

Purchases Inventory Accounts payable

155

Freight Inventory Cash

Returns Accounts payable Inventory

Sales Accounts receivable Sales revenue

250

Cost of goods sold Inventory End of period No entry

155

Purchases Accounts payable

Freight-in Cash

Accounts payable Purchase returns

Accounts receivable Sales revenue

250

250 148

155

250

No entry 148 Cost of goods sold (below) Inventory (ending) Purchase returns Inventory (beginning) Purchases Freight-in Cost of goods sold: Beginning inventory Purchases Less: Returns Plus: Freight-in Net purchases Cost of goods available Less: Ending inventory Cost of goods sold

148 30 12 25 155 10 $25 $155 (12) 10 153 178 (30) $148

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–5 Beginning inventory Cost of goods sold Ending inventory Cost of goods available for sale Purchases (gross) Purchase discounts Purchase returns Freight-in

2024 275 (1) 627 249 (2) 876 630 18 24 13

2025 249 (3) 621 225 846 (4) 610 (5) 15 30 32

2026 225 584 (6) 216 800 585 12 (7) 14 16

Net purchases = Purchases (gross) – Purchase returns – Purchase discounts + Freight-in Beginning inventory + Net purchases = Cost of goods available for sale Cost of goods available for sale – Ending inventory = Cost of goods sold 2024: (1) Cost of goods available for sale – Net purchases = Beginning inventory 876 – (630 – 18 – 24 + 13) = 275 = Beginning inventory (2) Cost of goods available for sale – Cost of goods sold = Ending inventory 876 – 627 = 249 = Ending inventory 2025: (3) 2025 beginning inventory = 2024 ending inventory = 249 (4) Cost of goods sold + Ending inventory = Cost of goods available for sale 621 + 225 = 846 = Cost of goods available for sale (5) Cost of goods available for sale – Beginning inventory = Net purchases 846 – 249 = 597 = Net purchases Net purchases + Purchases discounts + Purchase returns – Freight-in = Purchases (gross) 597 + 15 + 30 – 32 = 610 = Purchases (gross) 2026: (6) Cost of goods available for sale – Ending inventory = Cost of goods sold 800 – 216 = 584 = Cost of goods sold

Exercise 8–5 (concluded) (7) Cost of goods available for sale – Beginning inventory = Net purchases 800 – 225 = 575 = Net purchases Purchases (gross) – Purchase returns + Freight-in – Net purchases = Purchase discounts 585 – 14 + 16 – 575 = 12 = Purchase discounts

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–6 Inventory balance before additional transactions Add: 2. Goods shipped to Kwik f.o.b. shipping point on December 28 3. Goods shipped to customer f.o.b. destination on December 27 Correct inventory balance

$165,000 17,000 22,000 $204,000

Exercise 8–7 Inventory balance before additional transactions Add: 4. Merchandise on consignment with Juniper Corp. Deduct: 1. Merchandise shipped to Almond f.o.b. destination on December 26 2. Merchandise held on consignment from the Hardgrove Company Correct inventory balance

$210,000 15,000 (30,000) (14,000) $181,000

Exercise 8–8 1. 2. 3. 4. 5. 6. 7.

Excluded Included Included Excluded Included Excluded Included

Exercise 8–11 Requirement 1 Purchase price = 1,000 units × $50 = $50,000 July 15, 2024 Inventory .............................................................. 50,000 Accounts payable ......................................... 50,000

July 23, 2024 Accounts payable ............................................. Cash (98% × $50,000).................................. Inventory (2% × $50,000) ............................

50,000 49,000 1,000

Requirement 2 August 15, 2024 Accounts payable.................................................. 50,000 Cash............................................................. 50,000

Requirement 3 The July 15 entry would include a debit to the Purchases account instead of to Inventory, and the July 23 entry would include a credit to the Purchase Discounts account instead of to Inventory.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–10 Requirement 1 July 15, 2024 Inventory (98% × $50,000)................................... 49,000 Accounts payable ........................................ 49,000

July 23, 2024 Accounts payable ................................................. 49,000 Cash ............................................................ 49,000

Requirement 2 August 15, 2024 Accounts payable ............................................. Purchase discounts lost..................................... Cash ............................................................

49,000 1,000 50,000

Requirement 3 The July 15 entry would include a debit to the Purchases account instead of to Inventory.

Exercise 8–11 Requirement 1 Purchases: $500 × 70% = $350 per unit. 100 units × $350 = $35,000 November 17, 2024 Inventory .............................................................. 35,000 Accounts payable ......................................... 35,000

November 26, 2024 Accounts payable ............................................. Inventory (2% × $35,000) ............................ Cash (98% × $35,000)..................................

35,000 700 34,300

Requirement 2 December 15, 2024 Accounts payable.................................................. 35,000 Cash............................................................. 35,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–11 (concluded) Requirement 3 Requirement 1: November 17, 2024 Inventory (98% × $35,000)................................... 34,300 Accounts payable......................................... 34,300

November 26, 2024 Accounts payable ................................................. 34,300 Cash ............................................................ 34,300

Requirement 2: December 15, 2024 Accounts payable ............................................. Purchase discounts lost (2% × $35,000) ........... Cash ............................................................

34,300 700 35,000

Exercise 8–12 The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: Define the meaning of cost as it applies to the initial measurement of inventory. FASB ASC 330–10–30–1: ―Inventory–Overall–Initial Measurement.‖ The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. It is understood to mean acquisition and production cost, and its determination involves many considerations. 5. Indicate the circumstances when it is appropriate to initially measure agricultural inventory at fair value. FASB ASC 905–330–30–1: ―Agriculture–Inventory–Initial Measurement.‖

Exceptional cases exist in which it is not practicable to determine an appropriate cost basis for products. A market basis is acceptable if the products meet all of the following criteria: 

a. They have immediate marketability at quoted market prices that cannot be influenced by the producer.



b. They have characteristics of unit interchangeability.



c. They have relatively insignificant costs of disposal.

The accounting basis of those kinds of inventories shall be their realizable value, calculated on the basis of quoted market prices less estimated direct costs of disposal. An example is freshly dressed meats produced in meat packing operations.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–12 (concluded) 6.

What is a major objective of accounting for inventory? FASB ASC 330–10–10–1: ―Inventory–Overall–Objectives.‖ A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.

Are abnormal freight charges included in the cost of inventory? FASB ASC 330–10–30–7: ―Inventory–Overall–Initial Measurement.‖ Unallocated overheads shall be recognized as an expense in the period in which they are incurred. Other items such as abnormal freight, handling costs, and amounts of wasted materials (spoilage) require treatment as current period charges rather than as a portion of the inventory cost.

Exercise 8–13 Cost of goods available for sale: Beginning inventory (2,000 × $5.30) Purchases: 8,000 × $5.50 $44,000 6,000 × $5.60 33,600 4,000 × $5.80 23,200 Cost of goods available (20,000 units)

$10,600

100,800 $111,400

First-in, first-out (FIFO) Cost of goods available for sale (20,000 units) Less: Ending inventory (determined below) Cost of goods sold

$111,400 (40,000) $ 71,400

Cost of ending inventory: Date of purchase August 18 August 28

Units 3,000 4,000 Total

Unit cost $5.60 $5.80

Total cost $16,800 23,200 $40,000

Last-in, first-out (LIFO) Cost of goods available for sale (20,000 units) Less: Ending inventory (determined below) Cost of goods sold

$111,400 (38,100) $ 73,300

Cost of ending inventory: Date of purchase Beg. Inv. August 8

Units 2,000 5,000 Total

Unit cost $5.30 5.50

Total cost $10,600 27,500 $38,100

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–13 (concluded) Average cost Cost of goods available for sale (20,000 units) Less: Ending inventory (determined below) Cost of goods sold

$111,400 (38,990) $72,410 *

Cost of ending inventory: $111,400 Weighted-average unit cost =

= $5.57 20,000 units

7,000 units × $5.57 = $38,990 * Alternatively, could be determined by multiplying the units sold by the average cost: 13,000 units × $5.57 = $72,410

Exercise 8–14 First-in, first-out (FIFO) Cost of goods sold: Date of Sale Aug. 14 Aug. 25 Total

Units Sold 2,000 (from Beg. Inv.) 4,000 (from 8/8 purchase) 4,000 (from 8/8 purchase) 3,000 (from 8/18 purchase) 13,000

Cost of Units Sold $5.30 5.50 5.50 5.60

Total Cost $10,600 22,000 22,000 16,800 $71,400

Ending inventory = (3,000 units × $5.60) + (4,000 units × $5.80) = $40,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–14 (concluded) Average cost Date

Purchased

Beginning inventory

2,000 @ $5.30 =

August 8

8,000 @ $5.50 = $44,000

Available

Sold

Balance

$10,600

2,000 @ $5.30

$10,600

6,000 @ $5.46 =

$32,760 4,000 @ $5.46

$21,840

7,000 @ $5.544 =

$38,808 3,000 @ $5.544

$16,632

$54,600 = $5.46/unit 10,000 units

August 14 August 18 Available

6,000 @ $5.60 =

$33,600

$55,440 = $5.544/unit 10,000 units

August 25 August 28

4,000 @ $5.80 =

$23,200

Ending inventory = $39,832 Total cost of goods sold = $71,568

Exercise 8–15 Last-in, first-out (LIFO) Date

Purchased

Sold

Beginning inventory

2,000 @ $5.30 =

August 8

8,000 @ $5.50 = $44,000

$10,600

6,000 @ $ 5.50 =

August 14 August 18

6,000 @ $5.60 =

$ 5,500 $33,600

$23,200

Total cost of goods sold

2,000 @ $5.30

$10,600

2,000 @ $5.30 8,000 @ $5.50

$54,600

2,000 @ $5.30 2,000 @ $5.50

$21,600

2,000 @ $5.30 2,000 @ $5.50 6,000 @ $5.60 1,000 @ $5.50 = 6,000 @ $5.60 =

4,000 @ $5.80 =

$33,000

$33,600

August 25 August 28

Balance

2,000 @ $5.30 1,000 @ $5.50 2,000 @ $5.30 1,000 @ $5.50 4,000 @ $5.80

$55,200

$16,100

$39,300 Ending inventory

$72,100

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–16 Requirement 1 LIFO will result in the highest cost of goods sold figure because both the cost of merchandise and the quantity of merchandise rose during the period. FIFO will result in the highest ending inventory balance for the same reasons.

Requirement 2 Cost of goods available for sale: Beginning inventory (600 × $80) Purchases: 1,000 × $ 95 $95,000 800 × $100 80,000 Cost of goods available (2,400 units)

$ 48,000

175,000 $223,000

First-in, first-out (FIFO) Cost of goods available for sale (2,400 units) Less: Ending inventory (below) Cost of goods sold

$223,000 (80,000) $143,000

Cost of ending inventory: Date of purchase January 21

Units 800

Unit cost $100

Total cost $80,000

Last-in, first-out (LIFO) Cost of goods available for sale (2,400 units) Less: Ending inventory (below) Cost of goods sold

$223,000 (67,000) $156,000

Cost of ending inventory: Date of purchase Beg. Inv. January 15 Total

Units 600 200

Unit cost $80 95

Total cost $48,000 19,000 $67,000

Exercise 8–16 (concluded) Requirement 3 FIFO will result in the highest cost of goods sold figure because the cost of merchandise declined and the quantity of merchandise rose during the period. LIFO will result in the highest ending inventory balance for the same reasons.

Cost of goods available for sale: Beginning inventory (600 × $80) Purchases: 1,000 × $70 $70,000 800 × $65 52,000 Cost of goods available (2,400 units)

$ 48,000

122,000 $170,000

First-in, first-out (FIFO) Cost of goods available for sale (2,400 units) Less: Ending inventory (below) Cost of goods sold

$170,000 (52,000) $118,000

Cost of ending inventory: Date of purchase January 21

Units 800

Unit cost $65

Total cost $52,000

Last-in, first-out (LIFO) Cost of goods available for sale (2,400 units) Less: Ending inventory (below) Cost of goods sold

$170,000 (62,000) $108,000

Cost of ending inventory: Date of purchase Beg. Inv. January 15 Total

Units 600 200

Unit cost $80 70

Total cost $48,000 14,000 $62,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–17 Requirement 1 Cost of goods available for sale: Beginning inventory (5,000 × $10.00) Purchases: 3,000 × $10.40 $31,200 8,000 × $10.75 86,000

$ 50,000

117,200

Cost of goods available (16,000 units)

$167,200

Cost of goods available for sale (16,000 units) Less: Ending inventory (below) Cost of goods sold

$167,200 (73,150) $ 94,050*

Cost of ending inventory: $167,200 Weighted-average unit cost =

= $10.45 16,000 units

7,000 units × $10.45 = $73,150 * Alternatively, could be determined by multiplying the units sold by the average cost: 9,000 units × $10.45 = $94,050

Exercise 8–17 (concluded) Requirement 2 Date

Purchased

Beginning inventory

5,000 @ $10.00 =

$50,000

September 7

3,000 @ $10.40 =

$31,200

Available

$81,200

Sold

Balance 5,000 @ $10.00

$50,000

4,000 @ $10.15 =

$40,600 4,000 @ $10.15

$40,600

5,000 @ $10.55 =

$52,750 7,000 @ $10.55

$73,850 Ending inventory

= $10.15/unit 8,000 units

September 10 September 25

8,000 @ $10.75 =

Available

$126,600

$86,000

= $10.55/unit 12,000 units

September 29 Total cost of goods sold

$93,350

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–18 Requirement 1 FIFO cost of goods sold: 10,000 units @ $5.00 + 10,000 units @ $6.00 (determined below)

= $50,000 = 60,000 $110,000

Requirement 2 LIFO cost of goods sold: 20,000 units @ $6.00 (determined below)

= $120,000

Calculations to determine cost per unit of year 2024 purchases: Cost of goods sold = Weighted-average cost per unit Number of units sold $115,000 = $5.75 per unit 20,000 units $5.75 × 40,000 units = $230,000 = Cost of goods available for sale $230,000 – 50,000 (beginning inventory) = $180,000 = Cost of purchases $180,000 = $6 = Cost per unit of year 2024 purchases 30,000 units purchased Cost of goods available for sale: Beginning inventory (10,000 × $5.00) Purchases (30,000 × $6.00) Cost of goods available (40,000 units)

$ 50,000 180,000 $230,000

Exercise 8–19 Requirement 1 First-in, first-out (FIFO) Cost of goods sold: Date of Sale Apr. 30 Sep. 9 Total

Units Sold 20,000 (from Beg. Inv.) 30,000 (from 2/12 purchase) 40,000 (from 2/12 purchase) 30,000 (from 7/22 purchase) 120,000

Cost of Units Sold $12.20 12.50 12.50 12.80

Total Cost $ 244,000 375,000 500,000 384,000 $1,503,000

Ending inventory = (20,000 units × $12.80) + (40,000 units × $13.20) = $784,000 Note that Telnex would achieve the same result if it used FIFO on a periodic basis rather than a perpetual basis. Its 120,000 units sold consist of the beginning inventory of 20,000 units, all 70,000 units purchased on 2/12, and 30,000 units purchased on 7/22. Telnex‘s numbers would be the same because, regardless of whether we view FIFO inventory on a perpetual or periodic basis, we always view the oldest units on hand as those that are the first to be sold.

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 2 Last-in, first-out (LIFO) Cost of goods available for sale: Beginning inventory (20,000 × $11.70) Purchases: 70,000 × $12.50 $875,000 50,000 × $12.80 640,000 40,000 × $13.20 528,000 Cost of goods available (180,000 units)

$ 234,000

2,043,000 $2,277,000

Cost of goods available for sale (180,000 units) Less: Ending inventory (determined below) Cost of goods sold

$2,277,000 (734,000) $1,543,000

Cost of ending inventory: Date of purchase Beg. Inv. Feb. 12

Units 20,000 40,000 Total

Unit cost $11.70 12.50

Total cost $234,000 500,000 $734,000

Requirement 3 LIFO Reserve Perpetual FIFO (Required 1) Less: Periodic LIFO(Required 2) LIFO Reserve

$ 784,000 (734,000) $ 50,000

Requirement 4 Cost of goods sold ................................................ 40,000 LIFO reserve ($50,000 − $10,000)............... 40,000

Exercise 8–20 Requirement 1 Average Cost Date

Purchased

Sold

Balance

Beginning inventory

80,000 @ $4.25 =

$340,000

80,000 @ $4.25 = $340,000

Feb. 14

120,000 @ $4.50 =

$540,000

200,000 @ $4.40 = $880,000

$880,000

Available

= $4.40/unit 200,000 units

150,000 @ $4.40 = $660,000

Mar. 5 Aug. 27

50,000 @ $4.80 =

Available

$460,000

$240,000

50,000 @ $4.40 = $220,000 100,000 @ $4.60 = $460,000

= $4.60/unit 100,000 units 60,000 @ $4.60 =

Sep. 12 Nov. 15

70,000 @ $4.90 =

$276,000 40,000 @ $4.60 =

$343,000

$184,000

110,000 @ $4.7909 = $527,000 Ending inventory

$527,000 = $4.7909/unit 100,000 units Total cost of goods sold = $936,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 2 Last-in, first-out (LIFO) Cost of goods available for sale: Beginning inventory (80,000 × $4.00) Purchases: 120,000 × $4.50 $540,000 50,000 × $4.80 240,000 70,000 × $4.90 343,000 Cost of goods available (320,000 units)

$ 320,000

1,123,000 $1,443,000

Cost of goods available for sale (320,000 units) Less: Ending inventory (determined below) Cost of goods sold

$1,443,000 (455,000) $ 988,000

Cost of ending inventory: Date of purchase Beg. Inv. Feb. 14

Units 80,000 30,000

Unit cost $4.00 $4.50

Total cost $320,000 $135,000 $455,000

Requirement 3 LIFO Reserve Perpetual average (Required 1) Less: Periodic LIFO(Required 2) LIFO Reserve

$ 527,000 (455,000) $ 72,000

Requirement 4 Cost of goods sold ................................................ 52,000 LIFO reserve ($72,000 − $20,000)............... 52,000

Exercise 8–21 Requirement 1

September 30, 2019 LIFO reserve ($1,534 − $1,512)........................ Cost of goods sold........................................

($ in millions) 22 22

Requirement 2 $174,451 + $22 = $174,473 million cost of goods sold under FIFO. Cost of goods sold is provided as $174,451 (million) on a LIFO basis. To convert LIFO to FIFO, the adjustment in Requirement 1 converting FIFO to LIFO is reversed and cost of goods sold is thereby increased by $22.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–22 Requirement 1 Cost of goods sold: 50,000 units × $8.50 = 4,000 units × $7.00 =

$425,000 28,000 $453,000

Requirement 2 When inventory quantity declines during a reporting period, liquidation of LIFO inventory layers carried at different costs prevailing in prior years results in noncurrent costs being matched with current selling prices. If the resulting effect on income is material, it must be disclosed. In this case, the effect of the LIFO layer liquidation is to increase income (ignoring taxes) by $6,000 [4,000 units liquidated × $1.50 ($8.50 current year cost per unit – $7 LIFO layer cost per unit)].

Exercise 8–23 Units liquidated Units liquidated multiplied by the difference between their current cost and acquisition cost: 8,000 × ($12 – $9) = 2,000 × ($12 – $8) = Before-tax LIFO liquidation profit

10,000

$24,000 8,000 $32,000

When inventory quantity declines during a reporting period, liquidation of LIFO inventory layers carried at different costs that prevailed in prior years results in noncurrent costs being matched with current selling prices. If the resulting effect on income is material, it must be disclosed. In this case, the effect of the LIFO layer liquidation is to decrease cost of goods sold and thereby to increase income before income taxes by $32,000.

Exercise 8–24 Requirement 1 The specific citation that describes the disclosure requirements that must be made by publicly traded companies for a LIFO liquidation is FASB ASC 330–10–S99–3: ―Inventory–Overall–SEC Materials–LIFO Liquidations.‖

Requirement 2 When a company using LIFO liquidates a substantial portion of its inventory, the company must disclose the affect on income had the inventory liquidation not taken place. Such disclosure would be required in order to make the financial statements not misleading. Disclosure may be made either in a footnote or parenthetically on the face of the income statement.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–25 ($ in millions)

LOWE’S

HOME DEPOT Gross profit ratio

= 37,572 = 34.09% 110,225

22,943 72,148

= 31.80%

Inventory turnover

= 72,653 = 5.11 times 14,228

49,205 12,870

= 3.82 times

Average days in inventory

365 3.82

= 96 days

365 5.11

= 71 days

The gross profit ratios for the two companies are similar and both exceed the industry average of 27.25%. On average, Lowe‘s turns over its inventory 25 days slower than does Home Depot and both companies turn over their inventories faster than the industry average. This is not surprising, since Home Depot and Lowe‘s lead the market in size of stores and merchandise available, making it more difficult for smaller retailers to sell merchandise as quickly as these two companies.

Exercise 8–26 Date 1/1/2024

Ending Inventory at Base Year Cost

Inventory Layers at Base Year Cost

$660,000 = $660,000 1.00

$660,000 (base)

$660,000 × 1.00 = $660,000

$660,000

$660,000 (base) 3,462 (2024)

$660,000 × 1.00 = $660,000 3,462 × 1.04 = 3,600

663,600

$660,000 (base) 3,462 (2024) 40,242 (2025)

$660,000 × 1.00 = $660,000 3,462 × 1.04 = 3,600 40,242 × 1.08 = 43,461

707,061

12/31/2024 $690,000 = $663,462 1.04 12/31/2025 $760,000 = $703,704 1.08

Inventory Layers Converted to Cost

Inventory DVL Cost

Exercise 8– 872 Date

Ending Inventory at Base Year Cost

12/31/2024 $200,000 = $200,000 1.00

Inventory Layers at Base Year Cost $200,000 (base)

Inventory Layers Converted to Cost

Inventory DVL Cost

$200,000 × 1.00 = $200,000

$200,000

$200,000 × 1.00 = $200,000 20,000 × 1.05 = 21,000

$221,000

$200,000 × 1.00 = $200,000 20,000 × 1.05 = 21,000 40,000 × 1.15 = 46,000

$267,000

$200,000 × 1.00 = $200,000 20,000 × 1.05 = 21,000 30,000 × 1.15 = 34,500

$255,500

12/31/2025 $231,000 = $220,000

Index = 1.05

Index $200,000 (base) 20,000 (2025) 12/31/2026 $299,000 = $260,000

Index = 1.15

Index $200,000 (base) 20,000 (2025) 40,000 (2026) 12/31/2027 $300,000 = $250,000

Index = 1.20

Index $200,000 (base) 20,000 (2025) 30,000 (2026)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–28 Set the base year, 1/1/2024, equal to 1.00. Cost index in layer year:

264 ÷ 240 = 1.10

Date

Ending Inventory at Base Year Cost

Inventory Layers at Base Year Cost

1/1/2024

$720,000

Inventory Layers Converted to Cost

Inventory DVL Cost

= $720,000

$720,000 (base)

$720,000 × 1.00 = $720,000

$720,000

= $800,000

$720,000 (base) 80,000 (2024)

$720,000 × 1.00 = $720,000 80,000 × 1.10 = 88,000

$808,000

1.00 12/31/2024 $880,000 1.10

Exercise 8– 874 List A i 1. l 2.

Perpetual inventory system Periodic inventory system

3. F.o.b. shipping point

4. Gross method

5. Net method

6. Cost index

7. F.o.b. destination

8. FIFO

9. LIFO

b 10. Consignment j 11. Average cost d 12. IRS conformity rule

List B a. Legal title passes when goods are delivered to common carrier. b. Goods are transferred to another company but title remains with transferor. c. Purchases are recorded for the full cost of the inventory. d. If LIFO is used for taxes, it must be used for financial reporting. e. Assumes items sold are those acquired first. f. Assumes items sold are those acquired last. g. Purchases are recorded for the full cost of the inventory less any possible discount. h. Used to convert ending inventory at yearend cost to base year cost. i. Continuously records changes in inventory. j. Items sold come from a mixture of goods acquired during the period. k. Legal title passes when goods arrive at location. l. Adjusts inventory at the end of the period.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–30 Requirement 1 a. Inventory Accounts Payable (Purchased inventory on account) b. Accounts Receivable Sales Revenue (Sold inventory on account) Cost of Goods Sold Inventory (Record cost of inventory sold) c. Cash Accounts Receivable (Received cash on account) d. Inventory Cash (Paid freight on inventory received) e. Accounts Payable Inventory Cash (Paid cash on account) f. Rent Expense Cash (Paid rent) g. Salaries Expense Cash (Paid salaries)

Debit 330,000

Credit 330,000

Debit 570,000

Credit 570,000

310,000 310,000 Debit 540,000

Credit 540,000

Debit 24,000

Credit 24,000

Debit 325,000

Credit 5,000 320,000

Debit 42,000

Credit 42,000

Debit 150,000

Credit 150,000

Requirement 2 Debit (a) December 31 Supplies Expense Supplies (Record supplies used) ($17,000 = $25,000 − $8,000)

17,000 17,000

Debit (b) December 31 Interest Expense Interest Payable (Record interest expense not yet paid) ($1,000 = $20,000 × 5%)

Credit

1,000 1,000

Debit (c) December 31 Income Tax Expense Income Taxes Payable (Record income taxes not yet paid)

Credit

18,000 18,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Requirement 3 Displays Incorporated Adjusted Trial Balance December 31, 2024 Accounts Cash Accounts Receivable Supplies Inventory Land Accounts Payable Interest Payable Income Taxes Payable Notes Payable Common Stock Retained Earnings Sales Revenue Cost of Goods Sold Rent Expense Salaries Expense Supplies Expense Interest Expense Income Tax Expense Totals

Debit $ 26,000 49,000 8,000 99,000 227,000

Credit

$ 23,000 1,000 18,000 20,000 186,000 129,000 570,000 310,000 42,000 150,000 17,000 1,000 18,000 $947,000

$947,000

Requirement 3 (continued) Accounts Cash Accounts Receivable Supplies Inventory Land Accounts Payable Interest Payable Income Taxes Payable Notes Payable Common Stock Retained Earnings Sales Revenue Cost of Goods Sold Rent Expense Salaries Expense Supplies Expense Interest Expense Income Tax Expense

Ending Beginning balance in bold, entries during January in blue, Balance and adjusting entries in red. $ 26,000 = 22,000+540,000−24,000−320,000−42,000−150,000 49,000 = 19,000+570,000−540,000 8,000 = 25,000−17,000 99,000 = 60,000+330,000−310,000+24,000−5,000 227,000 = 227,000 23,000 = 18,000+330,000−325,000 1,000 = 1,000 18,000 = 18,000 20,000 = 20,000 186,000 = 186,000 129,000 = 129,000 570,000 = 570,000 310,000 = 310,000 42,000 = 42,000 150,000 = 150,000 17,000 = 17,000 1,000 = 1,000 18,000 = 18,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 4 Displays Incorporated Income Statement For the year ended December 31, 2024 Sales revenue $570,000 Cost of goods sold 310,000 Gross profit $260,000 Rent expense Salaries expense Supplies expense Total operating expenses Operating income

42,000 150,000 17,000 209,000 51,000

Interest expense Income before taxes

1,000 50,000

Income tax expense Net income

18,000 $ 32,000

Requirement 5

Assets Cash Accounts receivable Supplies Inventory Total current assets Land

Total assets *

Displays Incorporated Balance Sheet December 31, 2024 Liabilities $ 26,000 Accounts payable 49,000 Income taxes payable 8,000 Interest payable 99,000 Notes payable 182,000 Total liabilities 227,000

$409,000

Stockholders’ Equity Common stock Retained earnings Total stockholders‘ equity Total liabilities and stockholders‘ equity

$ 23,000 18,000 1,000 20,000 62,000

186,000 161,000 * 347,000 $409,000

Retained earnings = Beginning retained earnings + Net income − Dividends = $129,000 + $32,000 − $0 = $161,000

Requirement 6 December 31, 2024 Sales Revenue Retained Earnings (Close revenue accounts)

Debit 570,000

Retained Earnings Cost of Goods Sold Rent Expense Salaries Expense Supplies Expense Interest Expense Income Tax Expense (Close expense accounts)

538,000

Credit 570,000

310,000 42,000 150,000 17,000 1,000 18,000

Requirement 7 (a) The LIFO reserve is: Internal records (FIFO) $99,000 External reporting (LIFO) 85,000 LIFO reserve $14,000 (b)

Step 1:

$99,000 / 1.10 = $90,000 ending inventory at base year cost

Step 2: $60,000 beginning inventory 30,000 new layer in 2024 $90,000 ending inventory at base year cost Step 3:

$60,000 × 1.00 = $60,000 30,000 × 1.10 = $33,000 $93,000 ending inventory using dollar-value LIFO

(c) Indicate whether each of the ratios below generally would be higher or lower when reporting inventory using LIFO (or dollar-value LIFO) instead of FIFO in periods of rising inventory costs and stable inventory quantities. 1. Inventory turnover ratio – higher under LIFO 2. Average days in inventory – lower under LIFO 3. Gross profit ratio – lower under LIFO

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 8–31 Requirement 1 January 2 Debit Notes Receivable 20,000 Cash (Accepted 6% note receivable due in six months) January 5 Debit Inventory 385,000 Accounts Payable (Purchased inventory on account) January 8 Debit Accounts Payable 11,000 Inventory (Returned 100 units of inventory; $110 × 100 units) January 15 Debit Accounts Receivable 429,000 Sales Revenue (Sold inventory on account) Cost of Goods Sold 360,000 Inventory (Recorded cost of inventory sold) ($360,000 = [$100×300 units]+[$110×3,000 units]) January 17 Debit Sales Returns 26,000 Accounts Receivable (Customer returned inventory; $130 × 200 units) Inventory 22,000 Cost of Goods Sold (Customer returned inventory; $110 × 200 units) January 20 Debit Cash 379,980 Sales Discounts (($130 × 2,700) × 2%) 7,020 Accounts Receivable ($36,000 + ($130 × 2,700)) (Received cash from customers on account) January 21 Debit Allowance for Uncollectible Accounts 4,000 Accounts Receivable (Wrote off uncollectible accounts) ($40,000 − $36,000) January 24 Debit Accounts Payable 361,000 Cash (Paid cash on account; $110 × 3,100 units) + $20,000)

Credit 20,000 Credit 385,000 Credit 11,000 Credit 429,000 360,000

Credit 26,000

22,000 Credit

387,000 Credit 4,000

Credit 361,000

January 28 Salaries Expense Cash (Paid salaries for the current period) January 29 Utilities Expense Cash (Paid utilities for the current period) January 30 Dividends Cash (Paid dividends)

Requirement 2 January 31 Bad Debt Expense Allowance for Uncollectible Accounts (Estimated uncollectible accounts) ($4,200 = ($52,000 × 10%) − $1,000) January 31 Interest Receivable Interest Revenue (Record interest receivable) ($20,000 × 6% × 1/12 = $100) January 31 Interest Expense Interest Payable (Record interest payable) ($36,000 × 8% × 1/12 = $240) January 31 Income Tax Expense Income Taxes Payable (Record income taxes payable) January 31 Depreciation Expense Accumulated Depreciation (Record depreciation)

Debit 28,000

Credit 28,000

Debit 10,000

Credit 10,000

Debit 3,000

Credit 3,000

Debit 4,200

Credit 4,200

Debit 100

Credit 100

Debit 240

Credit 240

Debit 5,000

Credit 5,000

Debit 2,000

Credit 2,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 3 Tripley Company Adjusted Trial Balance January 31, 2024 Accounts Cash Accounts Receivable Allowance for Uncollectible Accounts Interest Receivable Notes Receivable Inventory Building Accumulated Depreciation Land Accounts Payable Interest Payable Income Taxes Payable Notes Payable Common Stock Retained Earnings Dividends Sales Revenue Sales Returns Sales Discounts Interest Revenue Cost of Goods Sold Salaries Expense Utilities Expense Bad debt Expense Depreciation Expense Interest Expense Income Tax Expense Totals

Debit $ 27,980 52,000

Credit

5,200

100 20,000 66,000 70,000 12,000 200,000 33,000 240 5,000 36,000 100,000 239,000 3,000 429,000 26,000 7,020 100 338,000 28,000 10,000 4,200 2,000 240 5,000 $859,540

$859,540

Requirement 884

Tripley Company Income Statement For the year ended January 31, 2024 Sales revenue $429,000 Less: Sales returns (26,000) Sales discounts (7,020) Net sales revenue $395,980 Cost of goods sold 338,000 Gross profit 57,980 Operating expenses: Salaries expense 28,000 Utilities expense 10,000 Bad debt expense 4,200 Depreciation expense 2,000 44,200 Operating income 13,780 Other income (expenses): 100 Interest revenue Interest expense (240) (140) Income before taxes 13,640 Income tax expense 5,000 Net income $ 8,640

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 5 Tripley Company Balance Sheet January 31, 2024 Assets Liabilities Cash $ 27,980 Accounts payable Accounts receivable 52,000 Interest payable Less: Allowance for Income taxes payable uncollectible accounts (5,200) 46,800 Interest receivable 100 Total current liabilities Notes receivable 20,000 Notes payable Inventory 66,000 Total liabilities Total current assets 160,880 Property, plant, and equipment: Stockholders’ Equity 70,000 Building Common stock Less: Accumulated depreciation (12,000) Retained earnings Land 200,000 Total stockholders‘ equity Total liabilities and Total assets $418,880 stockholders‘ equity *

$ 33,000 240 5,000 38,240 36,000 74,240

100,000 244,640 * 344,640 $418,880

Retained earnings = Beginning retained earnings + Net income − Dividends = $239,000 + $8,640 − $3,000 = $244,640

Requirement January 31 886 Sales revenue Interest revenue Retained Earnings (Close temporary credit accounts) January 31 Retained Earnings Sales returns Sales discounts Cost of goods sold Salaries expense Utilities expense Bad debt expense Depreciation expense Interest expense Income tax expense Dividends (Close temporary debit accounts)

Debit 429,000 100

Credit

429,100 Debit 423,460

Credit 26,000 7,020 338,000 28,000 10,000 4,200 2,000 240 5,000 3,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 7 (a) The inventory turnover ratio is: Inventory Turnover Ratio

Cost of Goods Sold Average Inventory

$338,000 = ($30,000 + $66,000)/2

7.0

A ratio of 7.0 suggests that the average inventory balance is sold 7.0 times over the period. Typically, a higher ratio is good. The industry average inventory turnover ratio is lower at 4.5, so the company is selling its inventory more quickly than the average company in the same industry.

(b) The gross profit ratio is: Gross Profit Ratio

(Net Sales − Cost of Goods Sold) = Net Sales

($395,980 − $338,000) $395,980

14.6%

A gross profit ratio of 14.6% suggests that for every $1 of sales, the company spends $0.854 on inventory ($1.00 − $0.146), resulting in a gross profit of $0.146. The industry average gross profit ratio is higher at 33%, so the company is less profitable per dollar of sales than the average company in the same industry. (c) Based on the inventory turnover ratio and the gross profit ratio, the company‘s business strategy appears to be selling a high volume of less profitable items. In general, lower priced items sell more frequently.

PROBLEMS Problem 8–1 Requirement 1 a. To record the purchase of inventory on account and the payment of freight charges. October 12 Inventory (98% × $22,000)............................... Accounts payable ........................................ Inventory .......................................................... Cash.............................................................

21,560 500 500

To record payment of accounts payable. October 31 Accounts payable ............................................. Purchase discounts lost ..................................... Cash.............................................................

21,560

21,560 440 22,000

To record sales on account. During October Accounts receivable.......................................... Sales revenue ............................................... Cost of goods sold ............................................ Inventory......................................................

28,000 28,000 18,000 18,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

No entry is needed for item d.

Problem 8–1 (continued) Requirement 2 a. To record the purchase of inventory on account and the payment of freight charges. October 12 Purchases (98% × $22,000) .............................. Accounts payable ........................................ Freight-in.......................................................... Cash.............................................................

21,560 21,560 500 500

To record payment of accounts payable. October 31 Accounts payable ............................................. Interest expense ................................................ Cash.............................................................

21,560 440 22,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 8–1 (concluded) c.

To record sales on account. During October Accounts receivable ............................................. 28,000 Sales revenue ............................................... 28,000 No entry is made for the cost of goods sold.

Cost of goods sold: Beginning inventory Plus net purchases: Purchases $21,560 Plus: Freight-in 500 Cost of goods available for sale Less: Ending inventory Cost of goods sold

$15,000

22,060 37,060 (19,060) $18,000

Adjusting entry: October 31 Cost of goods sold (above*) ............................. Inventory (ending)............................................ Inventory (beginning) .................................. Purchases..................................................... Freight-in.....................................................

18,000 19,060 15,000 21,560 500

If Autumn considers the purchase discount lost of $440 on October 31 to be an increase in cost of goods sold, then the Purchase Discounts Lost account would be debited on October 31 and credited (closed) in this year-end adjusting entry, increasing cost of goods sold to $18,440 ($18,000 + $440).

Problem 8–2 1. The transaction is not correctly accounted for. Inventory held on consignment by another company should be included in the inventory of the consignor. Rasul should include this merchandise in its 2024 ending inventory. 2. The transaction is not correctly accounted for. Legal title to merchandise shipped f.o.b. shipping point changes hands when the goods are shipped. Rasul should record the purchase and corresponding account payable in 2024 and include the merchandise in its 2024 ending inventory. 3. The transaction is not correctly accounted for. Since the merchandise was shipped f.o.b. destination and did not arrive at the customer's location until 2025, it should be included in Rasul‘s 2024 ending inventory. The sale should be recorded in 2025. 4. The transaction is correctly accounted for. Merchandise held on consignment from another company belongs to the consignor and should be excluded from the inventory of the consignee. 5. The transaction is correctly accounted for. Since the merchandise was shipped f.o.b. destination and did not arrive at Rasul‘s location until 2025, it should not be included in Rasul‘s 2024 ending inventory. The purchase is correctly recorded in 2025.

Problem 8–3 Inventory $1,250,000

Initial amounts Adjustments - increase (decrease): (155,000) 1. 2. (22,000) 3. NONE 4. 210,000 5. 25,000 6. 2,000 7. (5,300) Total adjustments 54,700 Adjusted amounts $1,304,700

Accounts Payable $1,000,000

Sales $9,000,000

(155,000) NONE NONE NONE 25,000 2,000 (5,300) (133,300) $ 866,700

NONE NONE 40,000 NONE NONE NONE NONE 40,000 $9,040,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 8–4 Requirement 1 Even though specific dates for purchases and sales of inventory are not given, amounts for ending inventory and cost of goods sold under FIFO are the same using calculations under a periodic or perpetual inventory system. Therefore, we can calculate perpetual FIFO as follows: Beginning inventory (10,000 × $8.00) Net purchases: Purchases (50,000* units × $10.00) $500,000 Less: Purchase returns (1,000 units × $10.50) (10,500) Less: Purchase discounts (9,800) ($490,000 × 2%) Plus: Freight-in (50,000 units × $0.50) 25,000 Cost of goods available (59,000 units) Less: Ending inventory (below) Cost of goods sold (45,000 units)

$ 80,000

504,700 584,700 (144,200) $440,500

* The 5,000 units purchased on December 28 are not included. The merchandise was shipped f.o.b. destination and did not arrive at Jillet‘s warehouse until the following year. Cost of ending inventory: Date of purchase During the year

Units 14,000

Unit cost Total cost 10.30** $144,200

**($10 × 98%) + $0.50 per unit freight-in charge = $10.30 per unit Requirement 2 Sales (45,000 units × $18.00) $810,000 Less: Cost of goods sold (above) $440,500 Other operating expenses 150,000 (590,500) Income before income taxes $219,500 Requirement 3 Cost of ending inventory under LIFO (periodic inventory system):

Date of purchase Beg. Inv. During the year Total

Units 10,000 4,000 14,000

Unit cost Total cost $ 8.00 $ 80,000 10.30*** 41,200 $121,200

***($10 × 98%) + $0.50 per unit freight-in charges = $10.30 LIFO Reserve Perpetual FIFO (Required 1) Less: Periodic LIFO(above) LIFO Reserve

$ 144,200 (121,200) $ 23,000

Cost of goods sold .................................................. 8,000 LIFO reserve ($23,000 − $15,000) ...............

8,000

Requirement 4 Sales (45,000 units × $18.00) Less: Cost of goods sold**** Other operating expenses Income before income taxes

$810,000 $448,500 150,000

(598,500) $211,500

**** $440,500 (Required 2 using FIFO) + $8,000 (Required 3 LIFO reserve adjustment) = $448,500.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 8–5 Cost of goods available for sale for periodic system: Beginning inventory (6,000 × $8.00) Purchases: 5,000 × $ 9.00 $45,000 6,000 × $10.00 60,000 Cost of goods available (17,000 units)

$ 48,000

105,000 $153,000

1. FIFO, periodic system Cost of goods available for sale (17,000 units) Less: Ending inventory (determined below) Cost of goods sold

$153,000 (78,000) $ 75,000

Cost of ending inventory: Date of purchase Jan. 10 Jan. 18 Totals

Units 2,000 6,000 8,000

Unit cost $ 9.00 10.00

Total cost $18,000 60,000 $78,000

Alternatively, cost of goods sold can be determined by adding the cost of the 6,000 units in beginning inventory ($48,000) and the 3,000 units from the January 10 purchase ($27,000) = $75,000.

Problem 8–5 (continued) 2. LIFO, periodic system Cost of goods available for sale (17,000 units) Less: Ending inventory (determined below) Cost of goods sold

$153,000 (66,000) $ 87,000

Cost of ending inventory: Date of purchase Beg. Inv. Jan. 10 Totals

Units 6,000 2,000 8,000

Unit cost $8.00 9.00

Total cost $48,000 18,000 $66,000

Alternatively, cost of goods sold can be determined by adding the cost of the 6,000 units from the January 18 purchase ($60,000) and the 3,000 units from the January 10 purchase ($27,000) = $87,000.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 8–5 (continued) 3. FIFO, perpetual system Date Beginning inventory

Purchased 6,000 @ $8.00 =

3,000 @ $8.00 = 5,000 @ $9.00 =

2,000 @ $8.00 =

6,000 @ $10.00 =

6,000 @ $8.00

$48,000

$24,000 3,000 @ $8.00

$24,000

3,000 @ $8.00 5,000 @ $9.00

$69,000

$16,000 1,000 @ $8.00 5,000 @ $9.00

$53,000

$45,000

January 12 January 18

Balance

$48,000

January 5 January 10

Sold

$60,000

1,000 @ $8.00 5,000 @ $9.00 6,000 @ $10.00 1,000 @ $8.00 = 3,000 @ $9.00 =

January 20

Total cost of goods sold

$ 8,000 2,000 @ $9.00 $27,000 6,000 @ $10.00

$113,000

$78,000 Ending inventory

$75,000

4. Average cost, periodic system Cost of goods available for sale (17,000 units) Less: Ending inventory (below) Cost of goods sold

$153,000 (72,000) $ 81,000

Cost of ending inventory: $153,000 Weighted-average unit cost =

= $9.00 17,000 units

8,000 units × $9.00 = $72,000 Alternatively, cost of goods sold could be determined by multiplying the units sold by the average cost: 9,000 units × $9.00 = $81,000.

Problem 8–5 (concluded) 5. Average cost, perpetual system Date Beginning inventory

Purchased 6,000 @ $8.00 =

Available

5,000 @ $9.00 =

Balance

$48,000

January 5 January 10

Sold

6,000 @ $8.00

$48,000

3,000 @ $8.00 =

$24,000 3,000 @ $8.00

$24,000

2,000 @ $8.625 =

$17,250 6,000 @ $8.625

$51,750

$45,000

$69,000 = $8.625/unit 8,000 units

January 12 January 18

Available

6,000 @ $10.00 =

$60,000

$111,750 = $9.3125/unit 12,000 units

4,000 @ $9.3125 = $37,250 8,000 @ $9.3125

January 20

Total cost of goods sold

$74,500 Ending inventory

= $78,500

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 8–6 Requirement 1 Cost of goods available for sale for periodic system: Purchases: 5,000 × $4.00 12,000 × $4.50 17,000 × $5.00 Cost of goods available (34,000 units)

$20,000 54,000 85,000 $159,000

a. FIFO Cost of goods available for sale (34,000 units) Less: Ending inventory (determined below) Cost of goods sold

$159,000 (70,000) $ 89,000

Cost of ending inventory: Date of purchase March 22

Units 14,000

Unit cost $5.00

Total cost $70,000

b. LIFO Cost of goods available for sale (34,000 units) Less: Ending inventory (determined below) Cost of goods sold

$159,000 (60,500) $ 98,500

Cost of ending inventory: Date of purchase Jan. 7 Feb. 16 Totals

Units 5,000 9,000 14,000

Unit cost $4.00 4.50

Total cost $20,000 40,500 $60,500

Problem 8–6 (concluded) c. Average cost Cost of goods available for sale (34,000 units) Less: Ending inventory (below) Cost of goods sold

$159,000 (65,471) $ 93,529*

Cost of ending inventory: $159,000 Weighted-average unit cost =

= $4.6765 34,000 units

14,000 units × $4.6765 = $65,471 * Alternatively, could be determined by multiplying the units sold by the average cost: 20,000 units × $4.6765 = $93,530 (rounding) Gross Profit ratio: FIFO:

$51,000* ÷ $140,000** = 36%

LIFO:

$41,500* ÷ $140,000** = 30%

Average: $46,471* ÷ $140,000** = 33% *Sales less cost of goods sold **20,000 units × $7 sales price = sales Requirement 2 In situations when costs are rising, LIFO results in a higher cost of goods sold and, therefore, a lower gross profit ratio than FIFO. The gross profit ratio using the average cost method falls between that of FIFO and LIFO.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 8–7 Requirement 1 Beginning inventory ($60,000 + $60,000 + $63,000) Purchases: 211 $63,000 212 63,000 213 64,500 214 66,000 215 69,000 216 70,500 217 72,000 218 72,300 219 75,000 Cost of goods available Ending inventory: 213 $64,500 216 70,500 219 75,000 Cost of goods sold Requirement 2

$183,000

615,300 798,300

(210,000) $588,300

Cost of goods available for sale Less: Ending inventory (below) Cost of goods sold

$798,300 (219,300) $579,000

Cost of ending inventory (3 autos): Car ID 219 218 217 Total

Cost $ 75,000 72,300 72,000 $219,300

Problem 8–7 (concluded) Requirement 3 Cost of goods available for sale Less: Ending inventory (below) Cost of goods sold

$798,300 (183,000) $615,300

Cost of ending inventory (3 autos): Car ID 203 207 210 Total

Cost $ 60,000 60,000 63,000 $183,000

Requirement 4 Cost of goods available for sale (12 units) Less: Ending inventory (below) Cost of goods sold

$798,300 (199,575) $598,725*

Cost of ending inventory: $798,300 Weighted-average unit cost =

= $66,525 12 units

3 units × $66,525 = $199,575 * Alternatively, could be determined by multiplying the units sold by the average cost: 9 units × $66,525 = $598,725

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 8–8 Requirement 1 The note indicates that if the company had used FIFO, inventory would have been higher by $2,086 million and $2,009 million at the end of 2019 and 2018, respectively. The increase in the difference between LIFO and FIFO means there was a increase in the LIFO reserve in 2019. The increase in the LIFO reserve increased cost of goods sold by $77 million under LIFO. Therefore, we reverse this and subtract this amount from LIFO cost of goods sold to determine FIFO cost of goods sold of $36,553 million ($36,630 million − $77 million). Requirement 2 Because cost of goods sold would have been lower by $77 million if FIFO had been used, income before taxes under FIFO would have been higher by $77 million. Requirement 3 The information might be useful to a financial analyst interested in comparing Caterpillar‘s performance with another company using the FIFO inventory method exclusively.

Problem 8– 904 Beginning Requirement 1 inventory Purchases: 30,000 units @ $25 Cost of goods available for sale Less: Ending inventory (below) Cost of goods sold

$ 450,000 750,000 1,200,000 (250,000) $ 950,000

Cost of ending inventory: Date of purchase Units Unit cost Total cost Beg. Inv. 10,000 $15 $150,000 Beg. Inv. 5,000 20 100,000 Totals 15,000 $250,000 Requirement 2 Cost of goods sold assuming all units purchased at the year 2024 price: 40,000 units × $25.00 = $1,000,000 Less: LIFO cost of goods sold (950,000) LIFO liquidation profit before tax 50,000 Multiplied by 1 – 0.25 × 0.75 LIFO liquidation profit $ 37,500 Requirement 3 $50,000* × 25% = $12,500 * ($25 − $20) × 10,000 units = $50,000 additional reported for cost of goods sold.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 8–10 Requirement 1 Cost of goods sold: 2024: 1,000 × $16 = $ 16,000 10,000 × $18 = 180,000 11,000 $196,000 2025:

1,500 × $16 = $ 24,000 13,000 × $18 = 234,000 14,500 $258,000

2026:

1,000 × $12 = $ 12,000 12,000 × $18 = 216,000 13,000 $228,000

Requirement 2 LIFO liquidation before-tax profit or loss: 2024: 1,000 units × $2 ($18 – $16) = 2025: 1,500 units × $2 ($18 – $16) = 2026: 1,000 units × $6 ($18 – $12) =

$2,000 profit $3,000 profit $6,000 profit

Requirement 3 Disclosure note: During fiscal 2026, 2025, and 2024, inventory quantities in certain LIFO layers were reduced. These reductions resulted in a liquidation of LIFO inventory quantities carried at lower costs prevailing in prior years as compared with the cost of fiscal 2026, 2025, and 2024 purchases. As a result, cost of goods sold decreased by $6,000, $3,000, and $2,000 in fiscal 2026, 2025, and 2024, respectively, and net income increased by approximately $4,500, $2,250, and $1,500, respectively.

Problem 8– 906 Sales (27,000 $54,000,000 Requirement 1 units × $2,000) Less: Cost of goods sold (27,000 units × $1,000) (27,000,000) Gross profit $27,000,000 Gross profit ratio = $27,000,000  $54,000,000 = 50% Requirement 2 Sales (27,000 units × $2,000) Less: Cost of goods sold* Gross profit $29,000,000

$54,000,000 (25,000,000)

Gross profit ratio = $29,000,000  $54,000,000 = 53.7%

*Cost of goods sold: 15,000 units × $1,000 = 6,000 units × $ 900 = 4,000 units × $ 800 = 2,000 units × $ 700 = 27,000 units

$15,000,000 5,400,000 3,200,000 1,400,000 $25,000,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 8–11 (concluded) Requirement 3 The gross profit and gross profit ratio are higher applying the requirement 2 assumption of 15,000 units purchased because of the LIFO liquidation profit that results. When inventory quantity declines during a reporting period, LIFO inventory layers carried at costs prevailing in prior years are ―liquidated‖ or assumed sold in the cost of goods sold calculation. This results in noncurrent costs being matched with current selling prices. If the company had purchased at least 27,000 units during 2025, there would be no LIFO liquidation. The profit difference ($2,000,000 in this case), if material, must be disclosed in a note. The difference can be arrived at by comparing the current replacement cost of $1,000 with each inventory layer from prior years that was included in this year‘s cost of goods sold, as follows: 6,000 units × $100 ($1,000 – $900) 4,000 units × $200 ($1,000 – $800) 2,000 units × $300 ($1,000 – $700) Total LIFO liquidation profit

Requirement 4 Sales (27,000 units × $2,000) Cost of goods sold: 5,000 units × $700 4,000 units × $800 6,000 units × $900 12,000 units × $1,000 27,000 units

$ 600,000 800,000 600,000 $2,000,000

$54,000,000 $ 3,500,000 3,200,000 5,400,000 12,000,000 24,100,000 Gross profit

=$29,900,000

Gross profit ratio = $29,900,000  $54,000,000 = 55.4% If only 15,000 units are purchased, cost of goods sold, gross profit, and the gross profit ratio would be exactly the same as when 28,000 units are purchased.

Requirement 5 The number of units purchased has no effect on FIFO cost of goods sold. When applying the first-in, first-out approach, beginning inventory costs are included in cost of goods sold first, regardless of the quantities of inventory purchased in the new reporting period.

Problem 8–12 Requirement 1 Allowance for uncollectible accounts Balance, beginning of year Add: Bad debt expense for 2024 Less: End-of-year balance

$7 8 (10)

Accounts receivable written off Requirement 2 Accounts receivable analysis:

Balance, beginning of year ($583 + 7) Add: Credit sales Less: write-offs (from Requirement 1) Less: Balance end of year ($703 + 10) Cash collections Requirement 3

$ 590 6,255 (5) (713) $6,127

Cost of goods sold for 2024 would have been $130 million lower had Inverness used the average cost method for its entire inventory. While beginning inventory would have been $350 million higher, ending inventory also would have been higher by $480 million. An increase in beginning inventory causes an increase in cost of goods sold, but an increase in ending inventory causes a decrease in cost of goods sold. Purchases for the year are the same regardless of the inventory valuation method used. Therefore, cost of goods sold would have been $5,060 ($5,190 – 130).

Requirement 4 $6,255 = ($703 + $583)/2

9.73 times

b. Inventory turnover ratio

$5,190 ($880 + $808)/2

6.15 times

c. Gross profit ratio

= ($6,255– $5,190) $6,255

17%

a. Receivables turnover ratio

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 8–12 (concluded) Requirement 5 If inventory costs are increasing, when inventory quantity declines during a period, liquidation of LIFO inventory layers carried at lower costs prevailing in prior year‘s results in noncurrent costs being matched with current selling prices. The ―income‖ generated by this liquidation is known as LIFO liquidation profit. The liquidation caused 2024 cost of goods sold to be lower by $8 million [$6 million  (1 – 0.25)]

Problem 8–13 Date

Ending Inventory at Base Year Cost

1/1/2024

$400,000

Inventory Layers at Base Year Cost

Ending Inventory DVL Cost

Inventory Layers Converted to Cost

= $400,000

$400,000 (base)

$400,000 × 1.00 =

$400,000

= $420,000

$400,000 (base) $20,000 (2024)

$400,000 × 1.00 = $20,000 × 1.05 =

$400,000 21,000

421,000

$400,000 (base) $20,000 (2024) $15,000 (2025)

$400,000 × 1.00 = $20,000 × 1.05 = $15,000 × 1.12 =

$400,000 $21,000 $16,800

437,800

$400,000 (base) $20,000 (2024) $5,000 (2025)

$400,000 × 1.00 = $20,000 × 1.05 = $5,000 × 1.12 =

$400,000 $21,000 $5,600

426,600

1.00 12/31/2024 $441,000 1.05 12/31/2025 $487,200 = $435,000 1.12

12/31/2026 $510,000 = $425,000 1.20

Problem 8–14 Date

Ending Inventory at Base Year Cost

1/1/2024

$150,000

Inventory Layers at Base Year Cost

Inventory Layers Converted to Cost

Ending Inventory DVL Cost

= $150,000

$150,000 (base)

$150,000 × 1.00 =

$150,000

= $185,185

$150,000 (base) $35,185 (2024)

$150,000 × 1.00 = $35,185 × 1.08 =

$150,000 $38,000

188,000

$150,000 (base) $35,185 (2024) $24,815 (2025)

$150,000 × 1.00 = $35,185 × 1.08 = $24,815 × 1.17 =

$150,000 $38,000 $29,034

217,034

$150,000 (base) $35,185 (2024) $21,815 (2025)

$150,000 × 1.00 = $35,185 × 1.08 = $21,815 × 1.17 =

$150,000 $38,000 $25,524

213,524

$150,000 (base) $35,185 (2024) $21,815 (2025) $1,000 (2027)

$150,000 $35,185 $21,815 $1,000

$150,000 $38,000 $25,524 $1,100

214,624

1.00 12/31/2024 $200,000 1.08 12/31/2025 $245,700 = $210,000 1.17

12/31/2026 $235,980 = $207,000 1.14

12/31/2027 $228,800 = $208,000 1.10

× 1.00 = × 1.08 = × 1.17 = × 1.10 =

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 8–15 Date

Ending Inventory at Base Year Cost

1/1/2024

$260,000

Inventory Layers at Base Year Cost

Inventory Layers Converted to Cost

Ending Inventory DVL Cost

= $260,000

$260,000 (base)

$260,000 × 1.00 =

$260,000

= $333,333

$260,000 (base) 73,333 (2024)

$260,000 × 1.00 = 73,333 × 1.02 =

$260,000 74,800

334,800

$260,000 (base) 70,189 (2024)

$260,000 × 1.00 = $70,189 × 1.02 =

$260,000 71,593

331,593

$260,000 (base) $70,189 (2024) $43,643 (2026)

$260,000 × 1.00 = $70,189 × 1.02 = $43,643 × 1.07 =

$260,000 $71,593 $46,698

378,291

$260,000 (base) $70,189 (2024) $43,643 (2026) $17,077 (2027)

$260,000 $70,189 $43,643 $17,077

$260,000 $71,593 $46,698 $18,785

397,076

1.00 12/31/2024 $340,000 1.02 12/31/2025 $350,000 = $330,189 1.06 12/31/2026 $400,000 = $373,832 1.07

12/31/2027 $430,000 = $390,909 1.10

× 1.00 = × 1.02 = × 1.07 = × 1.10 =

Problem 8–16 Date

Ending Inventory at Base Year Cost

1/1/2024

$84,000

Inventory Layers at Base Year Cost

Ending Inventory DVL Cost

Inventory Layers Converted to Cost

= $84,000

$84,000 (base)

$84,000

× 1.00 =

$84,000

= $96,000

$84,000 (base) $12,000 2024)

$84,000 $12,000

× 1.00 = × 1.05 =

$84,000 $12,600

96,600

$84,000 (base) $12,000 (2024) $24,000 (2025)

$84,000 $12,000 $24,000

× 1.00 = × 1.05 = × 1.14 =

$84,000 $12,600 $27,360

123,960

$84,000 (base) $12,000 (2024) $24,000 (2025) $5,000 (2026)

$84,000 $12,000 $24,000 $5,000

× 1.00 = × 1.05 = × 1.14 = × 1.20 =

$84,000 $12,600 $27,360 $6,000

129,960

$84,000 (base) $12,000 (2024) $24,000 (2025) $5,000 (2026) $3,000 (2027)

$84,000 × 1.00 = $12,000 × 1.05 = $24,000 × 1.14 = $5,000 × 1.20 = $3,000(3) × 1.25 =

$84,000 $12,600 $27,360 $6,000 $3,750(2)

133,710

1.00 12/31/2024 $100,800 1.05 12/31/2025 $136,800 = $120,000 1.14

12/31/2026 $150,000 = $125,000 1.20 (1)

12/31/2027 $160,000(5) = $128,000(4) 1.25

(1) $150,000  $125,000 = 1.20 (2026 cost index) (2) $133,710 – $129,960 = $3,750 (3) $3,750  1.25 = $3,000 (4) $125,000 + $3,000 = $128,000 (2027 inventory at base-year cost) (5) $128,000 × 1.25 = $160,000 (2027 inventory at year-end costs)

Complete Solution Manual for Intermediate Accounting, 11th Edition

DECISION MAKERS’ PERSPECTIVES CASES

Judgment Case 8–1 Requirement 1 Identifying items that should be included in inventory is difficult due to goods in transit, goods on consignment, and sales returns. Goods in transit. Inventory shipped f.o.b. shipping point is included in the purchaser‘s inventory as soon as the merchandise is shipped. On the other hand, inventory shipped f.o.b. destination is included in the purchaser‘s inventory only after it reaches the purchaser‘s location. Goods on consignment. Goods held on consignment are included in the inventory of the consignor until sold by the consignee. Sales returns. When the right of return exists, a seller must be able to estimate those returns. As a result, a company includes in inventory the cost of merchandise it anticipates will be returned.

Requirement 2 In addition to the direct acquisition costs such as the price paid, the following additional costs would be included in inventory for sale: transportation cost to obtain inventory and cost of unloading, unpacking, and preparing inventory for sale. Transportation cost to ship inventory sold to customers is an expense (either cost of goods sold or selling expense). Advertising expense is reported separately from inventory.

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Judgment Case 8–2 Requirement 1 Without purchase of the additional units: Sales (35,000 @ $60) Cost of goods sold (35,000 × $30) Gross profit

$2,100,000 (1,050,000) $1,050,000

Due Jim Lester ($1,050,000 × 20%) = $210,000 With purchase of the additional units: Sales Cost of goods sold: 20,000 × $40 $800,000 15,000 × $30 450,000 Gross profit

$2,100,000

(1,250,000) $ 850,000

Due Jim Lester ($850,000 × 20%) = $170,000

Real World Case 8–3 Requirement 1 Yes. The LIFO conformity rule permits LIFO users to present disclosures that report, in a note, the difference between inventories valued using LIFO and inventory valued as if another method had been used. Wolverine's note provides this information for FIFO.

Requirement 2 December 28, 2019 Ending Beginning Inventory Inventory ($ in millions)

Inventory as stated Increase from LIFO to FIFO inventory FIFO inventory balances

$348.2 11.4 $359.6

$317.6 11.8 $329.4

Requirement 3 Cost of goods sold for the fiscal year ended December 30, 2019, would have been $0.4 million higher had Wolverine used FIFO for its entire inventory. The decrease in the LIFO reserve ($11.8 million – $11.4 million) decreased cost of goods sold by $0.4 million, and to reverse this and convert back to FIFO, the effect is the opposite whereby cost of goods sold is increased by $0.4 million. Therefore, cost of goods sold under FIFO would have been $1,350.3 million ($1,349.9 million under LIFO + $0.4 million decrease in LIFO reserve). The higher amount of cost of goods sold under FIFO means that gross profit would have been lower by $0.4 million. Gross profit under FIFO would have been $923.4 million ($923.8 under LIFO − $0.4 million decrease in LIFO reserve).

Requirement 4 When inventory quantities decline during a period, then out-of-date inventory layers are liquidated and cost of goods sold will partially match noncurrent costs with current selling prices. This occurrence is known as a LIFO liquidation. If costs have been increasing (decreasing), LIFO liquidations produce lower (higher) cost of goods sold and therefore higher (lower) gross profit. Because the company reports the liquidation decreased cost of goods sold, we know that inventory costs must have been increasing over time.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Analysis Case 8–4

(Note to instructor: Amounts are based on annual reports filed December 2019)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Requirement 1

Complete Solution Manual for Intermediate Accounting, 11th Edition ($ in millions) Gross profit ratio

Gross profit Net sales

= =

Coca-Cola $22,647 $37,266

PepsiCo $37,029 $67,161

60.8%

55.1%

Complete Solution Manual for Intermediate Accounting, 11th Edition

Inventory turnover ratio

Coca-Cola Cost of goods sold $14,619 = Average inventory = ($3,379+$3,071)/2

PepsiCo $30,132 ($3,128+$3,338)/2

9.32 times

4.53 times

365 Average days = = in inventory Inventory turnover ratio =

365 4.53

365 9.32

80.6 days

39.2 days

Requirement 2 As indicated by the higher gross profit ratio, Coca-Cola is able to generate more profit selling its inventory (beverages) than PepsiCo is selling its inventory (beverages and snack foods). PepsiCo turns over (or sells) its inventory much faster, which likely reflects the shorter shelf-life of snack foods compared to beverages.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Analysis Case 8–5 Requirement 1 ($ in millions)

KOHL’S

DILLARDS

Gross profit ratio

$6,745 = 35.72% $18,885

$1,968 $6,204

Inventory turnover

$12,140 = 3.46 times $3,506

$4,236 = 2.83 times $1,496. 5

Average days in inventory

365 3.46

= 105 days

365 2.83

= 31.72%

= 129 days

Kohl‘s has a more favorable gross profit ratio and a more favorable inventory turnover ratio (average days in inventory is 14 days less than Dillards‘).

Research Case 8–6 Requirement 1 The FASB‘s codification citation that provides guidance for determining whether an arrangement involving the sale of inventory is in substance a financing arrangement is FASB ASC 470–40–05–2: ―Debt–Product Financing Arrangements–Overview and Background.‖

Requirement 2 The FASB‘s codification citation that addresses the recognition of a product financing arrangement is FASB ASC 470–40–25–1: ―Debt–Product Financing Arrangements–Recognition.‖

Requirement 3 The appropriate accounting treatment for this type of arrangement is for the sponsor to record a liability at the time the proceeds are received from the other entity. The sponsor does not record the transaction as a sale and does not remove the product from its inventory. The cost of the repurchase amount in excess of the originally recorded liability represents financing and holding costs. These costs are accounted for in accordance with the sponsor‘s accounting policies applicable to other financing and holding costs. Notice that this is an example of ―substance (a loan) over form (a sale).‖

Requirement 4 Journal entry to record the ―sale‖ (cash receipt):

Cash ................................................................... 160,000 Liability—product financing arrangement .... 160,000

Journal entry to record the repurchase:

Liability—product financing arrangement ....... 160,000 Holding and financing costs* ........................... 4,000 Cash............................................................. 164,000

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Research Case 8–6 (concluded) *The treatment of these costs depends on the accounting policies of the sponsor. For example, if these costs normally are expensed as period costs, then the debit in this case would be to an expense account (or accounts).

Communication Case 8–7 Suggested Grading Concepts and Grading Scheme: Content (70%) 20 Describes the differential effect on ending inventory and cost of goods sold of using FIFO versus LIFO when Prices are increasing. Prices are decreasing. 25 Discusses the various motivating factors that might influence the choice of inventory method. The actual physical flow of product. The better match of expenses with revenues provided by LIFO. The effect on the balance sheet. The effect on reported income and income taxes. The cost of implementation of LIFO. 10 Discusses briefly the methods available to simplify LIFO. 15 Discusses the IRS conformity rule with respect to LIFO and the relaxation of the rule that allows a a company using LIFO to present supplemental non-LIFO disclosures. 70 points Writing (30%) 6 Terminology and tone appropriate to the audience of a company president. 12

Organization permits ease of understanding. Introduction that states purpose. Paragraphs that separate main points. English Sentences grammatically clear and well organized, concise. Word selection. Spelling. Grammar and punctuation.

30 points

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Communication Case 8–8 LIFO produces a higher cost of goods sold, lower taxable income, and therefore lower income taxes currently payable than FIFO only in periods when the costs of the company‘s products are rising. When costs are decreasing, LIFO results in lower cost of goods sold, higher taxable income, and a higher current tax liability than FIFO. In the case of the electronics client, you would explain this to the intern concluding that the costs of the client's products must be decreasing, as frequently occurs in this industry.

Communication Case 8–7 The dollar-value LIFO inventory estimation technique begins with the determination of the current year‘s ending inventory valued in terms of year-end costs. It is not necessary for a company using DVL to track the cost of purchases during the year. All that is needed is to take the physical quantities of goods on hand at the end of the year and apply year-end costs. The next step is to convert the ending inventory from year-end costs to base year costs. This usually is accomplished by dividing the ending inventory at year-end costs by the year‘s cost index. The cost index reflects the change in cost from a base year to the current year. The ending inventory has been deflated for cost changes from the base year to the end of the current year. The next step in the procedure is to identify the layers in ending inventory with the years they were created by comparing ending inventory at base year cost to the beginning inventory at base year cost. Applying the LIFO concept, if inventory has increased, ending inventory at base year cost consists of the beginning inventory layer plus a current year layer. The final step converts the layers identified to cost by multiplying the layers at base year cost by the layer‘s cost index. The costs are totaled to obtain ending inventory at DVL cost.

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Target Case Requirement 1 Target uses LIFO. More specifically, the company uses the LIFO retail inventory method to account for the majority of its inventory and the related cost of sales. Under this method, inventory is stated at cost using the LIFO method as determined by applying a cost-to-retail ratio to each merchandise grouping's ending retail value. The LIFO retail inventory method is covered in chapter 9. Requirement 2 The cost of inventory includes - the amount Target pays to its suppliers to acquire inventory - freight costs incurred in connection with the delivery of product to its distribution centers and stores - import costs, reduced by vendor income and cash discounts. Requirement 3 ($ in millions) Gross profit ratio =

Inventory turnover =

$22,266 = 28.9% $77,130 $54,864 = 5.93 times $9,244.5*

*($8,992 + $9,497) ÷ 2 Target‘s gross profit ratio indicates that the company is more profitable than the industry average. Its inventory turnover ratio indicates the company sells its inventory less frequently.

Air France–KLM Case Per note 4.17, AF uses the weighted-average method to value its inventory. Under IFRS, the FIFO (first-in, first-out) method also can be used. However, the LIFO (last-in, first-out) method, which can be used under U.S. GAAP in addition to the average cost method and the FIFO method, is prohibited under IFRS.

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Chapter 9 Inventories: Additional Issues QUESTIONS FOR REVIEW OF KEY TOPICS

Question 9–1 To avoid reporting inventory at an amount greater than the benefits it can provide, the lower of cost or net realizable value (LCNRV) approach to valuing inventory was developed for companies that use FIFO, average cost, or any method other than LIFO and the retail inventory method. Net realizable value (NRV) is the estimated selling price reduced by any costs of completion, disposal, and transportation. For companies that use the LIFO or retail inventory method, the lower of cost or market (LCM) approach is used. Market equals replacement cost, except that market should not (a) be greater than NRV (ceiling) or (b) be less than NRV minus an approximately normal profit margin (floor). Both LCNRV and LCM result in the recognition of losses when the value of inventory declines below its cost, rather than in the period in which the goods are ultimately sold.

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Question 9–2 The LCNRV and LCM determination can be made based on individual inventory items, on categories of inventory, or on the entire inventory.

Question 9–1 When NRV is below cost, companies are required to write down inventory to the lower NRV. These write-downs usually are included as part of cost of goods sold because they are a natural consequence of holding inventory and therefore part of the inventory‘s normal cost. However, when a write-down is substantial and unusual, the write-down should be recorded in a separate loss account instead. That loss must be expressly disclosed in the financial statements. This could be accomplished with a disclosure note alone or also by reporting the loss as a separate line in the income statement, usually among operating expenses.

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Question 9–4 The gross profit method estimates cost of goods sold, which is then subtracted from cost of goods available for sale to obtain an estimate of ending inventory. The estimate of cost of goods sold is found by multiplying sales by the historical ratio of cost to selling prices. The cost percentage is the complement of the gross profit ratio (1 – GP%).

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Question 9–5 The key to obtaining accurate estimates when using the gross profit method is the reliability of the cost percentage. If the cost percentage is too low, cost of goods sold will be understated and ending inventory overstated. Cost percentages usually are based on relationships of past years, which aren‘t necessarily representative of the current relationship. Failure to consider theft or spoilage also could cause an overstatement of ending inventory.

Question 9–6 The retail inventory method first determines the amount of ending inventory at retail by subtracting sales for the period from goods available for sale at retail. Ending inventory at retail is then converted to cost by multiplying it by the cost-toretail percentage.

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Question 9–7 The main difference between the gross profit method and the retail inventory method is in the determination of the cost percentage used to convert sales at selling prices to sales at cost. The retail inventory method uses a cost percentage, called the cost-to-retail percentage, which is based on a current relationship between cost and selling price. The gross profit method relies on past data to reflect the current cost percentage.

Question 9–6 Initial markup—Original amount of markup from cost to selling price. Additional markup—Increase in selling price subsequent to initial markup. Markup cancellation —Elimination of an additional markup. Markdown—Reduction in selling price below the original selling price. Markdown cancellation —Elimination of a markdown.

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Question 9–9 When using the retail method to estimate average cost, the cost-to-retail percentage is determined by dividing total cost of goods available for sale by total goods available for sale at retail. By including beginning inventory in the calculation of the cost-to-retail percentage, the percentage reflects the average cost/retail relationship for all inventories, not just the portion acquired in the current period.

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Question 9–10 The lower of cost or market (LCM) retail variation combined with the average cost method is called the conventional retail method. The LCM rule is incorporated into the retail inventory estimation procedure by excluding markdowns from the calculation of the cost-to-retail percentage.

Question 9–11 When applying LIFO, if inventory increases during the year, none of the beginning inventory is assumed sold. Ending inventory includes the beginning inventory plus the current year‘s layer. To determine layers, we compare ending inventory at retail to beginning inventory at retail and assume that no more than one inventory layer is added if inventory increases. Each layer carries its own cost-toretail percentage that is used to convert each layer from retail to cost.

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Question 9–12 For calculating the cost-to-retail percentage, freight-in adds to the cost amount, purchase returns decrease the cost and retail amounts, and purchase discounts decrease the cost amount. Normal spoilage is deducted from goods available for sale at retail after the calculation of the cost-to-retail percentage. Net sales also are subtracted from goods available for sale at retail. Net sales, for purposes of applying the retail inventory method, include sales returns but exclude sales discounts and employee discounts.

Question 9–11 The dollar-value LIFO retail method eliminates the stable price assumption of regular retail LIFO. In effect, it combines dollar-value LIFO (Chapter 8) with LIFO retail. Before comparing beginning and ending inventory at retail prices, ending inventory is deflated to base year retail using the current year‘s retail price index. After identifying the layers in ending inventory with the years they were created, in addition to converting retail prices to cost using the cost-to-retail percentage, the dollar-value LIFO method requires that each layer first be converted from base year retail to layer year retail using the year‘s retail price index.

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Question 9–14 Changes in inventory methods, other than a change to the LIFO method, are reported retrospectively. This means reporting all previous periods‘ financial statements as if the new inventory method had been used in all prior periods.

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Question 9–15 When a company changes to the LIFO inventory method from any other method, it usually is impossible to calculate the income effect on prior years. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. As a result, a company changing to LIFO usually does not report the change retrospectively. Instead, the LIFO method simply is used from that point on. The base year inventory for all future LIFO determinations is the beginning inventory in the year the LIFO method is adopted.

Question 9–16 If a material inventory error is discovered in an accounting period subsequent to the period in which the error is made, any previous years‘ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. And, of course, any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders‘ equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on income from continuing operations, net income, and earnings per share.

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Answers to Questions (concluded)

Question 9– 954 2022: Cost of goods sold Net income Ending retained earnings 2023: Net purchases Cost of goods sold Net income Ending retained earnings

overstated understated understated no effect understated overstated correct

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Question 9–18 When applying the lower of cost or net realizable value (LCNRV) rule for valuing inventory according to IFRS, if circumstances reveal that an inventory write-down is no longer appropriate, it must be reversed. Reversals are not permitted under U.S. GAAP. Also, under U.S. GAAP, the LCNRV rule can be applied to individual items, inventory categories, or the entire inventory. Using the international standard, the assessment usually is applied to individual items, although using inventory categories is allowed under certain circumstances.

Question 9– 956 Purchase commitments are contracts that obligate the company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates. These agreements are entered into primarily to secure the acquisition of needed inventory and to protect against increases in purchase price.

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Question 9–20 Purchases made pursuant to a purchase commitment are recorded at the lower of contract price or market price on the date the contract is executed. A loss is recognized if the market price is less than the contract price. For purchase commitments outstanding at year-end, a loss is recognized if the market price at yearend is less than the contract price.

BRIEF EXERCISES Brief Exercise 9–1 NRV = $30 – 4 = $26 Cost = $20 Because the cost of $20 is lower than the NRV of $26, the unit value is $20.

Brief Exercise 9–2 (1)

(2)

Product

Cost

NRV (*)

Per Unit Inventory Value [Lower of (1) and (2)]

$50

$64

$50

* Selling price less costs to sell.

Product 1 (1,000 units) Product 2 (1,000 units) Cost Inventory value

Cost $50,000 34,000 $84,000

Lower of Cost or NRV $50,000 32,000 $82,000

Before-tax income will be lower by $2,000, the amount of the required inventory write-down.

Brief Exercise 9–3 Replacement cost = $18 Ceiling = $30 – $4 = $26 12–958 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition Floor = $26 – ($30 × 30%) = $17 Because replacement cost is between the ceiling and floor, Market = $18. Cost = $20 Because the market of $18 is lower than the cost of $20, the unit value is $18.

Brief Exercise 9–4 (1)

(2)

Product

Cost

Market (*)

Per Unit Inventory Value [Lower of (1) or (2)]

$50

$54

$50

Replacement cost NRV (ceiling) Product 1 $48 $70 − $6 = $64 Product 2 $26 $36 − $4 = $32 * Market is the middle amount for each product

NRV – NPM (Floor) $64 − $10 = $54 $32 − $8 = $24

Lower of cost or market is $50 per unit for Product 1 and $26 per unit for product 2.

Product 1 (1,000 units) Product 2 (1,000 units) Cost Inventory value

Lower of Cost Cost or Market $50,000 $50,000 34,000 26,000 $84,000 $76,000

Before-tax income will be lower by $8,000, the amount of the required inventory write-down ($84,000 − $76,000).

Brief Exercise 9–7

Beginning inventory (from records) Plus: Net purchases (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit of 30% Estimated cost of goods sold Estimated cost of inventory destroyed

$220,000 400,000 620,000 $600,000 (180,000) (420,000) $200,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 9–6 Beginning inventory (from records) Plus: Net purchases (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit Estimated cost of goods sold Estimated cost of inventory lost

$150,000 450,000 600,000 $700,000 ( ? ) ( ? ) $ 75,000

Estimated cost of goods sold = $600,000 – $75,000 = $525,000* Estimated gross profit = $700,000 – $525,000* = $175,000 $175,000  $700,000 = 25% gross profit ratio

Brief Exercise 9–7

Cost $ 300,000 861,000 22,000

Beginning inventory Plus: Net purchases Freight-in Net markups Less: Net markdowns Goods available for sale

1,183,000

Retail $ 450,000 1,210,000 48,000 (18,000) 1,690,000

$1,183,000 Cost-to-retail percentage:

= 70% $1,690,000

Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (70% × $490,000) Estimated cost of goods sold

(1,200,000) $ 490,000 (343,000) $ 840,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 9–8

Beginning inventory Plus: Net purchases Freight-in Net markups Less: Net markdowns Goods available for sale (excluding beg. Inventory) Goods available for sale (including beg. Inventory)

Cost $ 300,000 861,000 22,000

883,000 1,183,000

Retail $ 450,000 1,210,000 48,000 (18,000) 1,240,000 1,690,000

$883,000 Cost-to-retail percentage:

= 71.21% $1,240,000

Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost: Retail Cost Beginning inventory $ 450,000 $ 300,000 Current period‘s layer 40,000 × 71.21 % = 28,484 $328,484 (328,484) Total $ 490,000 $ 854,516 Estimated cost of goods sold

(1,200,000) $ 490,000

Brief Exercise 9– 964 Cost $ 300,000 861,000 22,000

Beginning inventory Plus: Net purchases Freight-in Net markups Goods available for sale

Retail $ 450,000 1,210,000 48,000 1,708,000

$1,183,000 Cost-to-retail percentage:

= 69.26% $1,708,000

Less: Net markdowns Goods available for sale 1,183,000 Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (69.26% × $490,000) (339,374) Estimated cost of goods sold $ 843,626

(18,000) 1,690,000 (1,200,000) $ 490,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 9–10

Cost $220,000 640,000 17,800

Beginning inventory Plus: Purchases Freight-in Plus: Net markups

Retail $ 400,000 1,180,000 16,000 1,596,000

$877,800 Cost-to-retail percentage:

= 55% $1,596,000

Less: Net markdowns Goods available for sale Less: Normal spoilage Less: Net sales Sales Employee discounts

877,800 $1,300,000 15,000

Estimated ending inventory at retail Estimated ending inventory at cost (55% × $272,000) (149,600) Estimated cost of goods sold $728,200

(6,000) 1,590,000 (3,000) (1,315,000) $ 272,000

Brief Exercise 9– 966 Cost $ 40,800 155,440

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory)

155,440 196,240

Retail $ 68,000 270,000 6,000 (8,000) 268,000 336,000

$40,800 Base layer cost-to-retail percentage:

= 60% $68,000 $155,440

2024 layer cost-to-retail percentage:

= 58% $268,000

Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (calculated below) Estimated cost of goods sold

Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

(250,000) $ 86,000 (50,451) $145,789

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$68,000 (base) 16,314 (2024)

x 1.00 × 60% = x 1.02 × 58% =

$86,000 $86,000 (above)

= $84,314 1.02

Total ending inventory at dollar-value LIFO retail cost ......................

$40,800 9,651 $50,451

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 9–12

Cost $ 50,451 168,000

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory)

168,000 218,451

Retail $ 86,000 301,000 3,000 (4,000) 300,000 386,000

$155,440 2024 layer cost-to-retail percentage:

= 58% $268,000 $168,000

2025 layer cost-to-retail percentage:

= 56% $300,000

Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (calculated below) Estimated cost of goods sold

Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

(280,000) $106,000 (59,762) $158,689

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$68,000 (base) 16,314 (2024) 15,686 (2025)

x 1.00 × 60%* = x 1.02 × 58% = x 1.06 × 56% =

$106,000 $106,000 (above)

= $100,000 1.06

Total ending inventory at dollar-value LIFO retail cost ......................

$40,800 9,651 9,311 $59,762

Brief Exercise 9– 968 Hopyard applies the FIFO cost method retrospectively; that is, to all prior periods as if it always had used that method. In other words, all financial statement amounts for individual periods that are included for comparison with the current financial statements are revised for period-specific effects of the change. Then, the cumulative effects of the new method on periods prior to those presented are reflected in the reported balances of the assets and liabilities affected as of the beginning of the first period reported and a corresponding adjustment is made to the opening balance of retained earnings for that period. The effect of the change on each line item affected should be disclosed for each period reported as well as any adjustment for periods prior to those reported. Also, the nature of and justification for the change should be described in the disclosure notes, as well as the cumulative effect of the change on retained earnings or other components of equity as of the beginning of the earliest period presented. 2024 cost of goods sold is $7,000 higher than it would have been if Hopyard had not switched to FIFO. This is because beginning inventory is $18,000 higher ($145,000 – $127,000) and ending inventory is $11,000 higher ($162,000 – $151,000). An increase in beginning inventory causes an increase in cost of goods sold, but an increase in ending inventory causes a decrease in cost of goods sold. Purchases for 2024 are the same regardless of the inventory valuation method used.

Brief Exercise 9–14 When a company changes to the LIFO inventory method from any other method, it usually is impossible to calculate the income effect on prior years. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. As a result, a company changing to LIFO usually does not report the change retrospectively. Instead, the LIFO method simply is used from that point on. The base year inventory for all future LIFO determinations is the beginning inventory in the year the LIFO method is adopted, $150,000 in this case. A disclosure note is needed to explain (a) the nature of and justification for the change, (b) the effect of the change on current year‘s income and earnings per share, and (c) why retrospective application was impracticable.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 9–15 The 2022 error caused 2022 net income to be overstated, but since 2022 ending inventory is 2023 beginning inventory, 2023 net income was understated by the same amount. So, the income statement was misstated for 2022 and 2023, but the balance sheet (retained earnings) was incorrect only for 2022. After that, no account balances are incorrect due to the 2022 error. Analysis of 2022 ending inventory error effects: U = Understated O = Overstated 2022 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income



Retained earnings

  O  U

2023 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold

Revenues Less: cost of goods sold Less: other expenses Net income

Retained earnings



O U corrected

Brief Exercise 9–15 (concluded) However, the 2023 error has not yet self-corrected. Both retained earnings and inventory still are overstated as a result of the second error. Analysis of 2023 ending inventory error effects: U = Understated O = Overstated 2023 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income

O U

U O

 Retained earnings

Retained earnings on January 1, 2024, in this case, would be overstated by $500,000 (ignoring income taxes).

Brief Exercise 9–16 The financial statements that were incorrect as a result of both errors (effect of one error in 2022 and effect of two errors in 2023) would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income from continuing operations, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A ―prior period adjustment‖ to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s income from continuing operations, net income, and earnings per share.

Complete Solution Manual for Intermediate Accounting, 11th Edition

EXERCISES Exercise 9–1 (1)

(2)

Product

Cost

NRV (*)

Per Unit Inventory Value [Lower of (1) and (2)]

$20

$34

$20

* Selling price less costs to sell. Product 1 2 3

NRV per unit $40 –$6 = $34 $120 – $40 = $80 $70 – $10 = $60

Exercise 9–4

(1)

(2)

Product

Cost

NRV (*)

Per Unit Inventory Value [Lower of (1) and (2)]

$ 40

$ 52

$ 40

100

112

100

* Selling price less costs to sell. Costs to sell = 10% of selling price and 5% of cost. Product A B C D E

Selling price $ 60 100 80 130 30

Cost $ 40 80 40 100 20

NRV per unit $60 – (10% × $60) – (5% × $40) = $52 $100 – (10% × $100) – (5% × $80) = $86 $80 – (10% × $80) – (5% × $40) = $70 $130 – (10% × $130) – (5% × $100) = $112 $30 – (10% × $30) – (5% × $20) = $26

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–3 Requirement 1 (1)

(2)

Product

Cost

NRV

Inventory Value [Lower of (1) and (2)]

101

$120,000

$100,000

102

90,000

110,000

90,000

103

60,000

50,000

30,000 $300,000

50,000

30,000 $270,000

104

The inventory value is $270,000.

Requirement 2 Write-down of inventory: $300,000 – $270,000 = $30,000 Cost of Goods Sold Inventory

30,000 30,000

If the write-down of inventory was considered substantial and unusual, the debit would have been to a Loss on inventory write-down account.

Exercise 9–4 (1)

(2) Ceiling

(3) Floor

(4)

(5)

Cost

Per Unit Inventory Value [Lower of (4) and (5)]

$29

$20

Product

NRV (*)

NRV – NP (**)

$18

$34

$29

Market [Middle value of (1), (2) & (3)]

* Selling price less selling costs. ** NRV less normal profit. Product 1 2 3

NRV per unit $40 –$6 = $34 $120 – $40 = $80 $70 – $10 = $60

NRV – NP per unit $34 –$5 = $29 $80 –$30 = $50 $60 –$12 = $48

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–5 (1)

(2) Ceiling

(3) Floor

(4)

(5)

Market [Middle value of (1), (2) & (3)]

Cost

Per Unit Inventory Value [Lower of (4) and (5)]

Product

NRV (*)

NRV – NP (**)

$35

$52

$34

$35

$40

$35

112

100

* Selling price less selling costs. Selling costs = 10% of selling price and 5% of cost. ** NRV less normal profit. Profit = 30% of selling price. Product A B C D

Selling price $60 100 80 130

Cost $40 80 40 100

NRV – NP per unit $52 – (30% × $60) = $34 $86 – (30% × $100) = $56 $70 – (30% × $80) = $46 $112 – (30% × $130) = $73 $26 – (30% × $30) = $17

Exercise 9– 976 Requirement 1 (1)

(2)

(3)

Ceiling

Floor

(4)

(5)

Product

NRV

NRV – NP*

Market [Middle value of (1), (2) & (3)]

Cost

Inventory Value [Lower of (4) and (5)]

101

$100,000

$70,000

$100,000

$120,000

$100,000

102

85,000

110,000

87,500

90,000

87,500

103

40,000

50,000

35,000

40,000

60,000

40,000

104

28,000

50,000

42,500

42,500 Totals

30,000 $300,000

30,000 $257,500

The inventory value is $257,500. *NP = 25% of total cost Product Total cost 101 $120,000 102 $90,000 103 $60,000 104 $30,000

NRV – NP $100,000 – (25% × $120,000) = $70,000 $110,000 – (25% × $90,000) = $87,500 $50,000 – (25% × $60,000) = $35,000 $50,000 – (25% × $30,000) = $42,500

Requirement 2 Write-down of inventory: $300,000 – 257,500 = $42,500 Cost of Goods Sold Inventory

42,500 42,500

If the write-down of inventory was considered unusual, the debit would have been to a separate Loss account.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–7 The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 8. Measurement of ending inventory using lower of cost or net realizable value (LCNRV) and lower of cost or market (LCM): FASB ASC 330–10–35: ―Inventory–Overall–Subsequent Measurement.‖

9. Measurement of the ceiling for purposes of using the lower of cost or market (LCM) rule: FASB ASC 330–10–35–4: ―Inventory–Overall–Subsequent Measurement.‖ As a general guide, utility is indicated primarily by the current cost of replacement of the goods as they would be obtained by purchase or reproduction. In applying the rule, however, judgment must always be exercised and no loss shall be recognized unless the evidence indicates clearly that a loss has been sustained. There are therefore exceptions to such a standard. Replacement or reproduction prices would not be appropriate as a measure of utility when the estimated sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so determined more appropriately measures utility.

10. Measurement of the floor for purposes of using the lower of cost or market (LCM) rule: FASB ASC 330–10–35–5: ―Inventory–Overall–Subsequent Measurement.‖ Furthermore, when the evidence indicates that cost will be recovered with an approximately normal profit upon sale in the ordinary course of business, no loss shall be recognized even though replacement or reproduction costs are lower. This might be true, for example, in the case of production under firm sales contracts at fixed prices, or when a reasonable volume of future orders is assured at stable selling prices.

Exercise 9– 978 Beginning inventory (from records) Plus: Net purchases (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit of 25% Estimated cost of goods sold Estimated cost of inventory destroyed

$140,000 370,000 510,000 $550,000 (137,500) (412,500) $ 97,500

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–9 Beginning inventory (from records) Plus: Net purchases (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit of 35% Estimated cost of goods sold Estimated ending inventory

$100,000 140,000 240,000 $220,000 (77,000) (143,000)

97,000

Less: Value of usable damaged goods Estimated loss from fire

(12,000) $ 85,000

Exercise 9–10 Merchandise inventory, January 1, 2024 Purchases Freight-in Cost of goods available for sale Less: Cost of goods sold: Sales Less: Estimated gross profit of 20% Estimated loss from fire

$1,900,000 5,800,000 400,000 8,100,000 $8,200,000 (1,640,000)

(6,560,000) $1,540,000

Exercise 9–11 Requirement 1 Beginning inventory (from records) Plus: Net purchases ($110,000 – $4,000) Freight-in (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales ($180,000 – $5,000) Less: Estimated gross profit of 40% Estimated cost of goods sold Estimated cost of inventory before theft Less: Stolen inventory Estimated ending inventory

$ 58,500 106,000 3,000 167,500 $175,000 (70,000) (105,000) 62,500 (8,000) $ 54,500

Requirement 2 Beginning inventory (from records) Plus: Net purchases ($110,000 – $4,000) Freight-in (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales ($180,000 – $5,000) Less: Estimated gross profit of 37.5%* Estimated cost of goods sold Estimated cost of inventory before theft Less: Stolen inventory Estimated ending inventory

$ 58,500 106,000 3,000 167,500 $175,000 (65,625) (109,375) 58,125 (8,000) $ 50,125

*Mark-up as a % of cost  (1 + Mark-up as a % of cost) = Gross profit as a % of sales. 60%  160% = 37.5%

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–12 Beginning inventory + Net purchases – Ending inventory = Cost of goods sold $27,000 + $31,000 – $28,000 = $30,000 = Cost of goods sold Cost of goods sold Cost percentage = Net sales $30,000 Cost percentage =

= 60% $50,000

Exercise 9–13

Cost $35,000 19,120

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale

54,120

Retail $50,000 31,600 1,200 (800) 82,000

$54,120 Cost-to-retail percentage:

= 66% $82,000

Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (66% × $50,000) Estimated cost of goods sold

(32,000) $50,000 (33,000) $21,120

Exercise 9– 982 Cost $190,000 600,000 8,000

Beginning inventory Plus: Purchases Freight-in Net markups

Retail $ 280,000 840,000 20,000 1,140,000

$798,000 Cost-to-retail percentage:

= 70% $1,140,000

Less: Net markdowns Goods available for sale Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (70% × $336,000) Estimated cost of goods sold

798,000

(4,000) 1,136,000 (800,000) $ 336,000

(235,200) $562,800

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–15

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beg. inventory) Goods available for sale (including beg. inventory)

Cost $160,000 607,760

607,760 767,760

Retail $ 280,000 840,000 20,000 (4,000) 856,000 1,136,000

$607,760 Cost-to-retail percentage:

= 71% $856,000

Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost: Cost Retail Beginning inventory $280,000 $160,000 Current period‘s layer 56,000 × 71% = 39,760 Total $336,000 $199,760 Estimated cost of goods sold

(800,000) $ 336,000

(199,760) $568,000

Exercise 9– 984 Cost $ 12,000 102,600 3,480 (4,000)

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups

Retail $ 20,000 165,000 (7,000) 6,000 184,000

$114,080 Cost-to-retail percentage:

= 62% $184,000

Less: Net markdowns Goods available for sale Less: Normal spoilage Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (62% × $24,800) Estimated cost of goods sold

114,080

(3,000) 181,000 (4,200) (152,000) $ 24,800

(15,376) $ 98,704

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–17 Requirement 1 Cost $ 40,000 207,000 14,488 (4,000)

Retail $ 60,000 400,000

Less: Net markdowns Goods available for sale 257,488 Less: Less: Normal breakage Less: Net sales: Sales $280,000 Employee discounts 1,800 Estimated ending inventory at retail Estimated ending inventory at cost (56% × $168,500) (94,360) Estimated cost of goods sold $163,128

(3,500) 456,300

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups

(6,000) 5,800 459,800

$257,488 Cost-to-retail percentage:

= 56% $459,800

(6,000)

(281,800) $168,500

Requirement 2 Net markdowns are included in the cost-to-retail percentage: $257,488 Cost-to-retail percentage:

= 56.43% $456,300

Exercise 9– 986 Net purchases: Using LIFO, the beginning inventory is excluded from the calculation of the cost-toretail percentage: Cost of goods available (excluding beg. inventory) Cost-to-retail percentage = Goods available at retail (excluding beg. inventory) $10,500 50% =

, and × = $21,000. x

Net purchases at retail equals $21,000 less markups plus markdowns. Net purchases at retail = $21,000 – 4,000 + 1,000 = $18,000 Net sales: The cost-to-retail percentage can be calculated as follows: Cost Retail $21,000.00 $ 35,000 10,500.00 18,000 4,000 (1,000) 31,500.00 56,000

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale $31,500 Cost-to-retail percentage:

= 56.25% $56,000

Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (56.25% × ?) =

(

? ?

)

$17,437.50

Estimated ending inventory at retail is: $17,437.50 = $31,000 .5625

Complete Solution Manual for Intermediate Accounting, 11th Edition Net sales = $56,000 – 31,000 = $25,000

Exercise 9–19 Cost $ 71,280 112,500

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory)

112,500 183,780

Retail $132,000 255,000 6,000 (11,000) 250,000 382,000

$71,280 Base year cost-to-retail percentage:

= 54% $132,000 $112,500

2024 cost-to-retail percentage:

= 45% $250,000

Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (below) Estimated cost of goods sold

Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

(232,000) $150,000 (77,004) $106,776

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$132,000 (base) 12,231 (2024)

x 1.00 × 54% = x 1.04 × 45% =

$150,000 $150,000 (above)

= $144,231 1.04

Total ending inventory at dollar-value LIFO retail cost ......................

$71,280 5,724 $77,004

Exercise 9– 988

Requirement 1 $15,000 Cost-to-retail percentage =

= 80% $18,750

Requirement 2 2024 Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$25,000 $25,000 (given)

= $20,000 1.25

$18,750 (base) × 1.00 × 80% = 1,250 (2024) × 1.25 × 82% =

Total ending inventory at dollar-value LIFO retail cost .............

$15,000 1,281 $16,281

2025 $28,600 $28,600 (given)

= $22,000 1.30

$18,750 (base) × 1.00 × 80% = 1,250 (2024) × 1.25 × 82% = 2,000 (2025) × 1.30 × 85% =

Total ending inventory at dollar-value LIFO retail cost .............

$15,000 1,281 2,210 $18,491

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–21

Cost $160,000 350,200

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory)

350,200 510,200

Retail $250,000 510,000 7,000 (2,000) 515,000 765,000

$160,000 Base layer cost-to-retail percentage:

= 64% $250,000 $350,200

2024 layer cost-to-retail percentage:

= 68% $515,000

Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (calculated below) Estimated cost of goods sold

Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

Step 2 Inventory Layers at Base Year Retail Prices

(380,000) $385,000 (234,800) $275,400

Step 3 Inventory Layers Converted to Cost

$385,000 $385,000 (above)

= $350,000 1.10

$250,000 (base) 100,000 (2024)

x 1.00 × 64% = x 1.10 × 68% =

Total ending inventory at dollar-value LIFO retail cost ......................

$160,000 74,800 $234,800

Exercise 9– 990

Cost-to-retail percentage, 1/1/2024: $21,000 = 75% $28,000 Cost-to-retail percentage, 12/31/2024: $33,600 = $30,000 = Ending inventory at base year retail 1.12 $30,000 – $28,000 = $2,000 = LIFO layer added during 2024 at base year retail $2,000 × 1.12 = $2,240 = LIFO layer added at current year retail $22,792 – $21,000 = $1,792 = LIFO layer added at current year cost $1,792 = 80% = Cost-to-retail percentage for the year 2024 layer $2,240

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–22 (concluded) 2025 ending inventory: Cost $22,792 60,000 $82,792

Beginning inventory Plus: Net purchases Goods available for sale (including beginning inventory)

Retail $ 33,600 88,400 122,000

$60,000 Cost-to-retail percentage:

= 67.87% $88,400

Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (below)

Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

(80,000) $ 42,000 $26,864

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$28,000 (base) 2,000 (2024) 5,000 (2025)

x 1.00 × 75.00% = x 1.12 × 80.00% = x 1.20 × 67.87% =

$42,000 $42,000 (above)

= $35,000 1.20

Total ending inventory at dollar-value LIFO retail cost ..................

$21,000 1,792 4,072 $26,864

Exercise 9–23 Requirement 1 To record the change: ..... Retained earnings ............................................. Inventory ($32 million – $23.8 million)........

($ in millions) 8.2 8.2

Requirement 2 CPS applies the average cost method retrospectively; that is, to all prior periods as if it always had used that method. In other words, all financial statement amounts for individual periods that are included for comparison with the current financial statements are revised for period-specific effects of the change. Then, the cumulative effects of the new method on periods prior to those presented are reflected in the reported balances of the assets and liabilities affected as of the beginning of the first period reported and a corresponding adjustment is made to the opening balance of retained earnings for that period. Let‘s say CPS reports 2022– 2024 comparative statements of shareholders‘ equity. The $8.2 million adjustment above is due to differences prior to the 2024 change. The portion of that amount due to differences prior to 2022 is subtracted from the opening balance of retained earnings for 2022. The effect of the change on each line item affected should be disclosed for each period reported as well as any adjustment for periods prior to those reported. Also, the nature of and justification for the change should be described in the disclosure notes, as well as the cumulative effect of the change on retained earnings or other components of equity as of the beginning of the earliest period presented.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–24 Requirement 1 Retained earnings ............................................................................... Inventory ($83,000 – $78,000) .......................................................

5,000 5,000

Requirement 2 Effect on cost of goods sold: Decrease in beginning inventory ($78,000 – $71,000)

- $7,000

Decrease in ending inventory ($83,000 – $78,000) Decrease in cost of goods sold

+ 5,000 $2,000

Cost of goods sold for 2023 would be $2,000 lower in the revised income statement.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–25 Requirement 1 The 2022 error caused 2022 net income to be understated, but since 2022 ending inventory is 2023 beginning inventory, 2023 net income was overstated by the same amount. So, the income statement was misstated for 2022 and 2023, but the balance sheet (retained earnings) was incorrect only for 2022. After that, no account balances are incorrect due to the 2022 error. Analysis of 2022 ending inventory effects: U = Understated O = Overstated 2022 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income

  U  O

O U

 Retained earnings

2023 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income

U O

 U

Retained earnings

corrected

Exercise 9–25 (concluded) However, the 2023 error has not yet self-corrected. Both retained earnings and inventory still are overstated as a result of the second error. Analysis of 2023 ending inventory error effects: U = Understated O = Overstated 2023 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income

O U

U O

 Retained earnings

Requirement 2 Retained earnings (overstatement of 2023 income) .................................. 150,000 Inventory (overstatement of 2024 beginning inventory)..................

150,000

Requirement 3

The financial statements that were incorrect as a result of both errors (effect of one error in 2022 and effect of two errors in 2023) would be retrospectively restated to report the correct inventory amount, cost of goods sold, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A ―prior period adjustment‖ to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s income from continuing operations, net income, and earnings per share.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–26 U = understated O = overstated NE = no effect

1. Overstatement of ending inventory 2. Overstatement of purchases 3. Understatement of beginning inventory 4. Freight-in charges are understated 5. Understatement of ending inventory 6. Understatement of purchases 7. Overstatement of beginning inventory 8. Understatement of purchases + understatement of ending inventory by the same amount

Cost of Goods Sold U O U U O U O

Net Income O U O O U O U

Retained Earnings O U O O U O U

Exercise 9–29 1.

To include the $4 million in year 2024 purchases and increase retained earnings to what it would have been if 2023 cost of goods sold had not included the $4 million purchases: Analysis: 2023 Beginning inventory Purchases Less: Ending inventory Cost of goods sold Revenues Less: Cost of goods sold Less: Other expenses Net income  Retained earnings

2024 Beginning inventory Purchases

U = Understated O = Overstated

U U ($ in millions)

Purchases .................................................................... Retained earnings ...................................................

4 4

The 2023 financial statements that were incorrect as a result of the errors would be retrospectively restated to reflect the correct cost of goods sold, (income tax expense if taxes are considered), income from operations, net income, and retained earnings when those statements are reported again for comparative purposes in the 2024 annual report.

A ―prior period adjustment‖ to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s income from continuing operations, net income, and earnings per share.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–28 Requirement 1 The $42,000 should have been charged to purchases instead of advertising expense. This error caused 2023 net purchases and thus cost of goods sold to be understated and advertising expense to be overstated by $42,000. The understatement of ending inventory for the $30,000 in merchandise held on consignment caused 2023 cost of goods sold to be overstated. Analysis:

U = Understated O = Overstated

2023 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold

U by U by U by

42,000 30,000 12,000

Revenues Less: cost of goods sold Less: other expenses Net income

U by O by U by

12,000 42,000 30,000

U by

30,000

 Retained earnings Requirement 2

Inventory (understatement of 2024 beginning inventory) Retained earnings (understatement of 2023 income)

30,000 30,000

Requirement 3

The 2023 financial statements that were incorrect as a result of the two errors would be retrospectively restated to report the correct inventory amount, cost of goods sold, advertising expense, income from continuing operations, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A ―prior period adjustment‖ to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s income from continuing operations, net income, and earnings per share.

Exercise 9–29 List A

List B

e 1. Gross profit ratio

a. Reduction in selling price below the original selling price. i 2. Cost-to-retail percentage b. Beginning inventory is not included in the calculation of the cost-to-retail percentage. l 3. Additional markup c. Deducted in the retail column after the calculation of the cost-to-retail percentage. a 4. Markdown d. Requires base year retail to be converted to layer year retail and then to cost. k 5. Net markup e. Gross profit divided by net sales. b 6. Retail method, f. Material inventory FIFO & LIFO error discovered in a subsequent year. j 7. Conventional retail g. Must be added to sales if sales are method recorded net of discounts. n 8. Change from LIFO h. Deducted in the retail column to arrive at goods available for sale at retail. d 9. Dollar-value LIFO retail i. Divide cost of goods available for sale by goods available at retail. c 10. Normal spoilage j. Average cost, lower of cost or market. f 11. Requires retrospective k. Added to the retail column to arrive at goods restatement available for sale. g 12. Employee discounts l. Increase in selling price subsequent to initial markup. h 13. Net markdowns m. Selling price less estimated selling costs. m 14. Net realizable value n. Accounting change requiring retrospective treatment.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–30 Requirement 1 If market price at year-end is less than contract price for outstanding purchase commitments, a loss is recorded for the difference. December 31, 2024 Estimated loss on purchase commitment ($60,000 – $56,000) 4,000 Estimated liability on purchase commitment 4,000

Requirement 2 If market price on purchase date declines from year-end price, the purchase is recorded at market price. March 21, 2025 Inventory.............................................................. 54,000 Loss on purchase commitment ($56,000 – $54,000) 2,000 Estimated liability on purchase commitment .... 4,000 Cash ............................................................ 60,000

Exercise 9–31 If market price is less than the contract price, the purchase is recorded at the market price. June 15, 2024 Purchases (market price)................................... Loss on purchase commitment (difference) ....... Cash.............................................................

85,000 15,000 100,000

If market price at year-end is less than contract price for outstanding purchase commitments, a loss is recorded for the difference. June 30, 2024 Estimated loss on purchase commitment ($150,000 – $140,000)10,000 Estimated liability on purchase commitment 10,000

If market price on purchase date declines from year-end price, the purchase is recorded at market price. August 20, 2024 Purchases (market price) ..................................... 120,000 Loss on purchase commitment ($140,000 – $120,000) 20,000 Estimated liability on purchase commitment ......... 10,000 Cash ............................................................ 150,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9–32 Requirement 1 January 3 Debit Inventory 126,000 Accounts payable (Purchase inventory on account) January 8 Debit Inventory 143,000 Accounts payable (Purchase inventory on account) January 12 Debit Inventory 161,000 Accounts payable (Purchase inventory on account) January 15 Debit Accounts payable 11,500 Inventory (Return defective inventory) ($11,500 = $115×100 units) January 19 Debit Accounts receivable 600,000 Sales revenue (Sell inventory on account) Cost of goods sold 437,000 Inventory (Record cost of inventory sold) ($437,000 = [$100×300 units]+[$105×1,200 units]+ [$110×1,300 units]+[$115×1,200 units]) January 22 Debit Cash 580,000 Accounts receivable (Receive cash on account) January 24 Debit Accounts payable 410,000 Cash (Pay cash on account)

Credit 126,000 Credit 143,000 Credit 161,000 Credit 11,500

Credit 600,000

437,000

Credit 580,000 Credit 410,000

Exercise 9-32 (continued) Requirement 1004 (concluded) January 27 Allowance for uncollectible accounts Accounts receivable (Write off uncollectible accounts) January 31 Salaries expense Cash (Pay salaries for the current period)

Debit 2,500

Credit 2,500

Debit 128,000

Requirement 2 (a) January 31 Debit Cost of goods sold 1,500 Inventory (Adjust inventory for net realizable value) ($1,500 = ($115−$100)×100 units (b) January 31 Debit Bad debt expense 3,000 Allowance for uncollectible accounts (Adjust uncollectible accounts) $3,000 = ($4,000×40%)+($50,000a×4%)−$600b a $50,000 balance for 4% estimated uncollectible= $36,500+$600,000−$580,000−$2,500−$4,000 b $600 = $3,100 beginning−$2,500 written off= balance before adjustment (c) January 31 Debit Interest expense 200 Interest payable (Accrue interest expense) ($200 = $30,000 × 8% × 1/12) (d) January 31 Debit Income tax expense 12,300 Income taxes payable (Accrue income taxes)

Credit 128,000

Credit 1,500

Credit 3,000

Credit 200

Credit 12,300

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9-32 (continued) Requirement 3 Big Blast Fireworks Adjusted Trial Balance January 31, 2024 Accounts Debit Cash $ 63,900 Accounts receivable 54,000 Inventory 10,000 Land 61,600 Allowance for uncollectible accounts Accounts payable Interest payable Income taxes payable Notes payable Common stock Retained earnings Sales revenue Cost of goods sold 438,500 Salaries expense 128,000 Bad Debt expense 3,000 Interest expense 200 Income tax expense 12,300 Totals $771,500

Credit

3,600 40,900 200 12,300 30,000 56,000 28,500 600,000

$771,500

Exercise 9-32 (continued) Requirement 3 (concluded) Accounts Cash Accounts Receivable Inventory Land Allowance for Uncollectible Accounts Accounts Payable Interest Payable Income Taxes Payable Notes Payable Common Stock Retained Earnings Sales Revenue Cost of Goods Sold Salaries Expense Bad Debt Expense Interest Expense Income Tax Expense

Ending Balance $ 63,900 54,000 10,000 61,600 3,600

= = = = =

Beginning balance in bold, entries during January in blue, and adjusting entries in red. 21,900+580,000−410,000−128,000 36,500+600,000−580,000−2,500 30,000+126,000+143,000+161,000−437,000−11,500−1,500 61,600 3,100−2,500+3,000

40,900 200 12,300 30,000 56,000 28,500 600,000 438,500 128,000 3,000 200 12,300

= = = = = = = = = = = =

32,400+126,000+143,000+161,000−410,000−11,500 200 12,300 30,000 56,000 28,500 600,000 437,000+1,500 128,000 3,000 200 12,300

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 9-32 (continued) Requirement 4 Big Blast Fireworks Income Statement For the year ended January 31, 2024 Sales revenue $600,000 Cost of goods sold 438,500 Gross profit $161,500 Operating expenses: Salaries expense Bad debt expense Total operating expenses Operating income Interest expense Income before taxes Income tax expense Net income

128,000 3,000 131,000 30,500 200 30,300 12,300 $ 18,000

Requirement 5 Big Blast Fireworks Balance Sheet January 31, 2024 Assets Cash Accounts receivable Less: Allowance for uncollectible accounts

$ 63,900 54,000

(3,600) Inventory Total current assets Land

50,400 10,000 124,300 61,600

Liabilities Accounts payable Interest payable Income taxes payable

$ 40,900 200 12,300

Total current liabilities

53,400

Notes payable Total liabilities Stockholders’ Equity Common stock Retained earnings

Total stockholders‘ equity Total liabilities and Total assets $185,900 stockholders‘ equity * Retained earnings = Beginning retained earnings + Net income − Dividends = $28,500 + $18,000 − $0 = $46,500

30,000 83,400 56,000 46,500

102,500 $185,900

Exercise 9-32 (continued) Requirement 6 January 31, 2024 Sales revenue Retained earnings (Close revenue accounts)

Debit 600,000

Retained earnings Cost of goods sold Salaries expense Bad debt expense Interest expense Income tax expense (Close expense accounts)

582,000

Credit 600,000

438,500 128,000 3,000 200 12,300

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 9-32 (concluded) Requirement 7 (a) The inventory turnover ratio is: Inventory Turnover Ratio

$438,500

Cost of Goods Sold =

Average Inventory

($30,000 + $10,000)/2

21.9

A ratio of 21.9 suggests that the average inventory balance is sold 21.9 times over the period. Typically, a higher ratio is good. Therefore, Big Blast Fireworks appears to be managing its inventory more efficiently than the average company in the same industry.

(b) The gross profit ratio is: Gross Profit Ratio

(Sales − Cost of Goods Sold) ($600,000 − $438,500) = Sales $600,000

= 26.9%

A ratio of 26.9% suggests that for every $1 of sales, the company spends just over $0.73 on inventory ($1.00 − $0.269), resulting in a gross profit of almost $0.27 per dollar of sales. The industry average gross profit ratio, however, is higher at 33%, so Big Blast Fireworks is less profitable per dollar of sales than the average company in the same industry. (c) Based on the inventory turnover ratio and the gross profit ratio, Big Blast Fireworks‘ business strategy appears to be selling a higher volume of less expensive items. In general, lower priced items sell more frequently.

PROBLEMS Problem 9–1 Requirement 1

(1)

(2)

Product (units)

Cost

NRV*

Inventory Value [Lower of (1) or (2)]

A (1,000)

$10,000

$13,600

$10,000

B (800)

12,000

12,240

12,000

C (600)

1,800

4,080

1,800

D (200)

1,400

1,020

E (600)

8,400

6,630

$33,600

$37,570

$31,450

Inventory carrying value would be $31,450. * Selling price less costs to sell. Costs to sell = 15% of selling price Product A B C D E

Selling price NRV per unit $16 $16 – (15% × $16) = $13.60 18 $18 – (15% × $18) = $15.30 8 $ 8 – (15% × $8) = $ 6.80 6 $ 6 – (15% × $6) = $ 5.10 13 $13 – (15% × $13) = $11.05

Requirement 2 Inventory carrying value would be $33,600. This amount is the lower of aggregate inventory cost ($33,600) and aggregate inventory net realizable value ($37,570).

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 3 No entry required. There is no loss from inventory write-down because the LCNRV is already recorded, at cost.

Problem 9–2 Requirement 1 Lower of cost or NRV (c) (b) (a) By By Individual Product By Total Products Type Inventory

Cost

Net Realizable Value

500

$ 550

Saws

2,000

1,800

Screwdrivers Total tools

600 $3,100

780 $3,130

600

Paint products: 1-gallon cans

$3,000

$2,500

2,500

Paint brushes Total paint

400 $3,400

450 $2,950

400

Total

$6,500

$6,080

$5,800

Product Tools: Hammers

500

$3,100

2,950 $6,050

$6,080

Requirement 2 (a) Individual products = $6,500 – 5,800 = $700 Cost of goods sold 700 Inventory 700 (b) Product Categories = $6,500 – 6,050 = $450 Cost of goods sold 450 Inventory 450 (c) Total inventory = $6,500 – 6,080 = $420 Cost of goods sold 420 Inventory 420

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 9–3 Requirement 1 (1)

(2)

(3)

Ceiling

Floor

(4)

(5)

Cost

Inventory Value [Lower of (4) or (5)]

$10,000

8,800

12,000

8,800

2,160

1,800

1,020

540

800

1,400

800

6,630

3,510

6,630

8,400

6,630

$30,390

$33,600

$28,030

Market

Product (units)

NRV*

A (1,000)

$12,000

$13,600

B (800)

8,800

12,240

6,480

C (600)

1,200

4,080

D (200)

800

E (600)

7,200

[Middle value NRV – of (1), (2) & (3)] NP** $7,200 $12,000

Totals

Inventory carrying value would be $28,030. * Selling price less costs to sell. Costs to sell = 15% of selling price ** NRV less normal profit. Profit = 40% of the selling price. Product A B C D E

Selling price $16 18 8 6 13

NRV per unit $16 – (15% × $16) = $13.60 $18 – (15% × $18) = $15.30 $ 8 – (15% × $8) = $ 6.80 $ 6 – (15% × $6) = $ 5.10 $13 – (15% × $13) = $11.05

NRV – NP per unit $13.60 – (40% × $16) = $7.20 $15.30 – (40% × $18) = $8.10 $ 6.80 – (40% × $ 8) = $3.60 $ 5.10 – (40% × $ 6) = $2.70 $11.05 – (40% × $13) = $5.85

Requirement 2 Inventory carrying value would be $30,390, the lower of aggregate inventory cost ($33,600) and aggregate inventory market ($30,390).

Requirement 3 The amount of the loss from inventory write-down is $3,210 ($33,600 – 30,390).

Cost of goods sold

3,210

Inventory

3,210

Problem 9–2 Requirement 1

Product

Lower of cost or market (a) (b) (c) By By Individual Product By Total Products Type Inventory

Cost

Market

Furniture: Chairs

$1,250

$1,550

$1,250

Desks

730

580

1,680 $3,660

1,840 $3,970

1,680

Accessories: Rugs

$2,400

$1,920

1,920

Lamps Total accessories

660 $3,060

540 $2,460

540

Total

$6,720

$6,430

$5,970

Tables Total furniture

$3,660

2,460 $6,120

$6,430

Requirement 2 (a) Individual products Cost of goods sold 750 Inventory 750 ($6,720 – 5,970 = $750) (b) Product Categories Cost of goods sold 600 Inventory 600 ($6,720 – 6,120 = $600) (c) Total inventory Cost of goods sold 290 Inventory 290 ($6,720 – 6,430 = $290)

Complete Solution Manual for Intermediate Accounting, 11th Edition

P roblem 9–5 R equirement 1 Fruit Toppings

Marshmallow Toppings

Chocolate Topping

80% $200,000 $160,000

70% $55,000 $38,500

65% $20,000 $13,000

Beginning inventory Plus: Net purchases Cost of goods available for sale

$ 20,000 150,000 170,000

$ 7,000 36,000 43,000

$ 3,000 12,000 15,000

Less: Estimate of cost of goods sold

160,000

38,500

13,000

Estimate of cost of inventory lost

$ 10,000

$ 4,500

$ 2,000

Estimate of cost of goods sold: Cost percentage × Net sales

Requirement 2 The two main factors that could cause the estimates of the inventory lost to be over- or understated are:

1. The historical cost percentages used may not be representative of the current relationship between cost and selling price. 2. Theft or spoilage losses may not be appropriately considered in the cost percentage.

Problem 9–6 1. Average cost Cost $ 90,000 355,000 9,000 (7,000)

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Net markdowns Abnormal spoilage Goods available for sale

(4,800) 442,200

Retail $180,000 580,000 (11,000) 16,000 (12,000) (8,000) 745,000

$442,200 Cost-to-retail percentage:

= 59.36%

$745,000 Less: Normal spoilage Less: Net sales Sales 540,000 Sales returns (10,000) Employee discounts 4,000 Estimated ending inventory at retail Estimated ending inventory at cost (59.36% × $208,000) (123,469) Estimated cost of goods sold $318,731

(3,000)

(534,000) $208,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 9–6 (concluded) 2. Conventional Cost $ 90,000 355,000 9,000 (7,000)

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Abnormal spoilage

(4,800)

Retail $180,000 580,000 (11,000) 16,000 (8,000) 757,000

$442,200 Cost-to-retail percentage:

= 58.41%

$757,000 Less: Net markdowns Goods available for sale 442,200 Less: Normal spoilage Less: Net sales: 540,000 Sales Sales returns (10,000) Employee discounts 4,000 Estimated ending inventory at retail Estimated ending inventory at cost (58.41% × $208,000) (121,493) Estimated cost of goods sold $320,707

(12,000) 745,000 (3,000)

(534,000) $208,000

Problem 9–7 Requirement 1 Employee discounts must be accounted for in the calculation of net sales. Sales if no employee discount = $250,000 / 0.80 = $312,500 Employee discount = $312,500 – $250,000 = $62,500

Cost $ 100,000 1,387,500 10,000

Beginning inventory Plus: Purchases Freight-in Plus: Net markups

Retail $ 150,000 2,000,000 300,000 2,450,000

$1,497,500 Cost-to-retail percentage:

= 61.12% $2,450,000

Less: Net markdowns Goods available for sale Less: Less: Normal shrinkage Less: Net sales Sales to customers Sales to employees Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost (61.12% × $222,500)

Estimated cost of goods sold

1,497,500

(150,000) 2,300,000 (15,000)

$1,750,000 250,000 62,500

(2,062,500) $ 222,500 (135,992) $1,361,508

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 9–7 (concluded) Requirement 2

Beginning inventory Plus: Purchases Freight-in Plus: Net markups Less: Net markdowns Goods available for sale (excluding beginning

Cost $ 100,000 1,387,500 10,000

Retail $ 150,000 2,000,000

1,397,500

300,000 (150,000) 2,150,000

1,497,500

2,300,000

inventory)

Goods available for sale (including beginning inventory) $1,397,500 Cost-to-retail percentage:

= 65% $2,150,000

Less: Less: Normal shrinkage (15,000) Less: Net sales Sales to customers $1,750,000 Sales to employees 250,000 Employee discounts (2,062,500) 62,500 Estimated ending inventory at retail $ 222,500 Estimated ending inventory at cost: Retail Cost $100,000 Beginning inventory $150,000 Current period‘s layer 72,500 × 65% = 47,125 Total $222,500 $147,125 (147,125) $1,350,375 Estimated cost of goods sold

Problem 9– 1020 Requirement 1 Cost $ 20,000 100,151 5,100 (2,100)

Retail $ 30,000 146,495

Less: Net markdowns Goods available for sale $123,151 Less: Normal spoilage Less: Net sales $140,000 Sales Sales returns (4,270) Estimated ending inventory at retail Estimated ending inventory at cost (70% × $34,900) (24,430) Estimated cost of goods sold $ 98,721

(800) 175,130 (4,500)

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups ($2,500 – 265)

(2,800) 2,235 175,930

$123,151 Cost-to-retail percentage:

= 70% $175,930

(135,730) $ 34,900

Requirement 2 The difference between the inventory estimate per retail method and the amount per physical count may be due to:

1. Theft losses. 2. Spoilage or breakage above normal. 3. Differences in cost-to-retail percentage for purchases during the month, beginning inventory, and ending inventory. 4. Markups on goods available for sale inconsistent between cost of goods sold and ending inventory. 5. A wide variety of merchandise with varying cost-to-retail percentages. 6. Incorrect reporting of markdowns, additional markups, or cancellations.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 9–9 Cost $ 80 671 30 (1)

($ in 000s)

Beginning inventory Purchases Freight-in on purchases Purchase returns Net markups Net markdowns Goods available for sale

$780

Cost-to-retail percentages: Average cost ratio: $780 ÷ $1,125 = Conventional cost ratio: $780 ÷ ($1,125 + 8) =

.6933 .6884

Deduct: Net sales Ending inventory: At retail (sales price) Average cost Conventional

Retail $ 125 1,006 (2) 4 (8) 1,125

(916) $ 209 ($209 × .6933) ($209 × .6884)

$144.90 $143.88

Note that the lower of average cost and net realizable value cost-to-retail percentage is approximated by excluding net markdowns.

Problem 9– 1022 ($ in 000s)

Cost $ 80 671 30

Beginning inventory Plus: Net purchases Freight-in Net markups Less: Purchase returns Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory)

(1) 700 780

Retail $ 125 1,006 4 (2) (8) 1,000 1,125

$80 Base layer cost-to-retail percentage:

= 64% $125 $700

2024 layer cost-to-retail percentage:

= 70% $1,000

Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (calculated below) Estimated cost of goods sold

Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

(916) $ 209 (130) $650

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$125 (base) 65 (2024)

x 1.00 × 64% = x 1.10 × 70% =

$209 $209 (above)

= $190 1.10

Total ending inventory at dollar-value LIFO retail cost ......................

$ 80 50 $130

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 9–11 Employee discounts must be accounted for in the calculation of net sales. 2024: Sales if no employee discount = $2,400 / 0.80 = $3,000 Employee discount = $3,000 – $2,400 = $600 Cost Retail Beginning inventory $ 28,000 $ 40,000 Plus: Net purchases 85,000 108,000 Freight-in 2,000 Net markups 10,000 Less: Net markdowns (2,000) Goods available for sale (excluding beginning inventory) 87,000 116,000 Goods available for sale (including beginning inventory) 115,000 156,000 Base layer cost-to-retail percentage: $28,000 = 70% $40,000 2024 layer cost-to-retail percentage: $ 87,000 = 75% $116,000 Less: Net sales Net sales to customers $100,000 Sales to employees 2,400 Employee discounts 600 (103,000) Estimated ending inventory at current year retail prices $ 53,000 Estimated ending inventory at cost (below) (35,950) Estimated cost of goods sold $ 79,050

Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$40,000 (base) 10,000 (2024)

x 1.00 × 70% x 1.06 × 75%

$53,000 $53,000 (above)

= $50,000 1.06

Total ending inventory at dollar-value LIFO retail cost ............

= =

$28,000 7,950 $35,950

Problem 9–11 (concluded) 2025: Sales if no employee discount = $4,000 / 0.80 = $5,000 Employee discount = $5,000 – $4,000 = $1,000 Cost $ 35,950 90,000 2,500

Beginning inventory Plus: Net purchases Freight-in Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory)

92,500 128,450

Retail $ 53,000 114,000 8,000 (2,200) 119,800 172,800

2025 layer cost-to-retail percentage: $ 92,500 = 77.21% $119,800 Less: Net sales Net sales to customers $104,000 Sales to employees 4,000 Employee discounts 1,000 Estimated ending inventory at current year retail prices Estimated ending inventory at cost (below) Estimated cost of goods sold

Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

(109,000) $ 63,800 (42,744) $ 85,706

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$40,000 (base) 10,000 (2024) 8,000 (2025)

x 1.00 × 70% = x 1.06 × 75% = x 1.10 × 77.21% =

$63,800 $63,800 (above)

= $58,000 1.10

Total ending inventory at dollar-value LIFO retail cost ............

$28,000 7,950 6,794 $42,744

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Problem 9–12 Requirement 1 Conventional retail method, December 31, 2022 Cost $ 27,500 282,000 26,500 (6,500) (5,000)

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Purchase discounts Plus: Net markups

Retail $ 45,000 490,000 (10,000) 25,000 550,000

$324,500 Cost-to-retail percentage:

= 59% $550,000

Less: Net markdowns Goods available for sale $324,500 Less: Net sales Sales $492,000 Sales returns (5,000) Employee discounts 3,000 Estimated ending inventory at retail Estimated ending inventory at cost (59% × $50,000) $ 29,500

(10,000) 540,000

490,000) $ 50,000

Problem 9–12 (continued) Requirement 2 LIFO retail method, December 31, 2022 Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Purchase discounts Plus: Net markups Less: Net markdowns Goods available for sale (excluding beg. inventory) Goods available for sale (including beg. inventory)

Cost $ 27,500 282,000 26,500 (6,500) (5,000)

297,000 $324,500

Retail $ 45,000 490,000 (10,000) 25,000 (10,000) 495,000 540,000

$297,000 Cost-to-retail percentage:

= 60% $495,000

Less: Net sales Sales $492,000 Sales returns (5,000) Employee discounts 3,000 Estimated ending inventory at retail Estimated ending inventory at cost: Retail Cost Beginning inventory $45,000 $27,500 Current period‘s layer 5,000 × 60% = 3,000 Total $50,000 $30,500

(490,000) $ 50,000

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Problem 9–12 (concluded) Requirement 3 Dollar-value LIFO retail method, December 31, 2023 and 2024 2023

Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$56,100 $56,100

= $55,000

1.02

$50,000 (base)^ x 1.00 × 61%* = $30,500 5,000 (2023) x 1.02 × 62% = 3,162

Total ending inventory at dollar-value LIFO retail cost ................... $33,662 ^ The $50,000 base comes from the 2022 ending inventory at retail (see Requirement 2) * $30,500 / $50,000 = 61%

2024

$48,300 $48,300

= $46,000

$46,000 (base)

x 1.00 × 61% = $28,060

1.05 Total ending inventory at dollar-value LIFO retail cost .................. $28,060

Problem 9–13 Requirement 1 Dollar-value LIFO retail method Employee discounts must be accounted for in the calculation of net sales. 2024: Sales if no employee discount = $14,000 / 0.70 = $20,000 Employee discount = $20,000 – $14,000 = $6,000 Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Net markdowns Goods available for sale (excluding beg. inventory) Goods available for sale (including beg. inventory)

Cost $ 90,000 478,000 6,960 (2,500)

482,460 572,460

Retail $150,000 730,000 (3,500) 8,500 (4,000) 731,000 881,000

$90,000 = 60%

Base layer cost-to-retail percentage:

$150,000 $482,460 = 66%

2024 layer cost-to-retail percentage:

$731,000 Less: Normal spoilage Less: Net sales Net sales to customers $650,000 Sales to employees 14,000 Employee discounts 6,000 Estimated ending inventory at retail (123,990) Estimated ending inventory at cost (below) $448,470 Estimated cost of goods sold

(5,000)

(670,000) $206,000

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Problem 9–13 (continued)

2024 Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$150,000 (base) 50,000 (2024)

x 1.00 × 60% x 1.03 × 66%

$206,000 $206,000 (above)

= $200,000 1.03

Total ending inventory at dollar-value LIFO retail cost ............

= =

$ 90,000 33,990 $123,990

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Problem 9–13 (continued) 2025: Sales if no employee discount = $17,500 / 0.70 = $25,000 Employee discount = $25,000 – $17,500 = $7,500 Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Net markdowns Goods available for sale (excluding beg. inventory) Goods available for sale (including beg. inventory)

Cost $123,990 511,000 8,000 (2,200)

516,800 640,790

Retail $206,000 760,000 (4,000) 10,000 (6,000) 760,000 966,000

$90,000 = 60%

Base layer cost-to-retail percentage:

$150,000 $482,460 = 66%

2024 layer cost-to-retail percentage:

$731,000 $516,800 = 68%

2025 layer cost-to-retail percentage:

$760,000 Less: Normal spoilage Less: Net sales Net sales to customers $680,000 Sales to employees 17,500 Employee discounts 7,500 Estimated ending inventory at retail (152,822) Estimated ending inventory at cost (below) Estimated cost of goods sold $487,968

(6,600)

(705,000) $254,400

Problem 9–13 (continued)

2025 Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$254,400 $254,400 (above)

= $240,000 1.06

$150,000 (base) 50,000 (2024) 40,000 (2025)

x 1.00 × 60% x 1.03 × 66% x 1.06 × 68%

Total ending inventory at dollar-value LIFO retail cost ............

= = =

$ 90,000 33,990 28,832 $152,822

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Problem 9–13 (continued) Requirement 2 Average cost retail Employee discounts must be accounted for in the calculation of net sales. 2024: Sales if no employee discount = $14,000 / 0.70 = $20,000 Employee discount = $20,000 – $14,000 = $6,000 Cost $ 90,000 478,000 6,960 (2,500)

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Net markdowns Goods available for sale

572,460

Retail $150,000 730,000 (3,500) 8,500 (4,000) 881,000

$572,460 Cost-to-retail percentage:

= 64.98% $881,000

Less: Normal spoilage Less: Net sales Net sales to customers $650,000 Sales to employees 14,000 Employee discounts 6,000 Estimated ending inventory at retail Estimated ending inventory at cost (64.98% × $206,000) (133,859) Estimated cost of goods sold $438,601

(5,000)

(670,000) $206,000

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Problem 9–13 (concluded) Requirement 3 Conventional retail Employee discounts must be accounted for in the calculation of net sales. 2024: Sales if no employee discount = $14,000 / 0.70 = $20,000 Employee discount = $20,000 – $14,000 = $6,000 Cost $ 90,000 478,000 6,960 (2,500)

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups

572,460

Retail $150,000 730,000 (3,500) 8,500 885,000

$572,460 Cost-to-retail percentage:

= 64.68% $885,000

Less: Markdowns Goods available for sale Less: Less: Normal spoilage Less: Net sales Net sales to customers $650,000 Sales to employees 14,000 Employee discounts 6,000 Estimated ending inventory at retail Estimated ending inventory at cost (64.68% × $206,000) (133,241) Estimated cost of goods sold $439,219

(4,000) 881,000 (5,000)

(670,000) $206,000

Problem 9– 1036 Requirement 1

Retained earnings ............................................................................... Inventory ($150,000 – 130,000) .....................................................

20,000 20,000

Requirement 2

FIFO method cost of goods sold: $530,000

Cost of goods available for sale Less ending inventory: 5,000 units @ $40 2,000 units @ $36

$200,000 72,000

Cost of goods sold

(272,000) $258,000

Average cost method cost of goods sold: Beginning inventory (5,000 units) Purchases: 5,000 units @ $36 5,000 units @ $40

$130,000 $180,000 200,000

Cost of goods available for sale (15,000 units) Less ending inventory (below) Cost of goods sold

380,000 510,000 (238,000) $272,000

Cost of ending inventory: $510,000 Weighted average unit cost =

= $34

15,000 units 7,000 units × $34 = $238,000 The effect of the change for the year 2024 is a $14,000 increase in cost of goods sold ($272,000 – 258,000) resulting in a $14,000 decrease in income before taxes and an $10,500 decrease in income after tax [$14,000 × (1 – 0.25)].

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Problem 9–15 Requirement 1 Analysis: 2022 Beginning inventory Plus: Net purchases Less: Ending inventory Cost of goods sold Revenues Less: Cost of goods sold Less: Other expenses Net income

U-6,000 O-6,000 O-6,000 U-6,000

U = Understated O = Overstated 2023 Beginning inventory Plus: Net purchases Less: Ending inventory Cost of goods sold

Revenues Less: Cost of goods sold U-18,000 Less: Other expenses Net income O-18,000

 Retained earnings

U-6,000 U-3,000 O-9,000 U-18,000

 U-6,000

Retained earnings

O-12,000

Requirement 2 Retained earnings ............................................. Inventory ..................................................... Purchases.....................................................

12,000 9,000 3,000

Requirement 3 The financial statements that were incorrect as a result of both errors (effect of one error in 2022 and effect of three errors in 2023) would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income, and retained earnings when those statements are reported again for comparative purposes in the 2024 annual report. A ―prior period adjustment‖ to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s income from continuing operations, net income, and earnings per share.

Problem 9– 1038 December 31, Requirement 1 2024, inventory, based on a physical count Add:

Merchandise shipped FOB shipping point in 2024 Merchandise shipped FOB shipping point in 2024 Correct ending inventory

U = Understated O = Overstated

Analysis: 2024 Beginning inventory Plus: Net purchases Less: Ending inventory Cost of goods sold Revenues Less: Cost of goods sold Less: Other expenses Net income  Retained earnings

$450,000 20,000 80,000 $550,000

U – 130,000 ($50,000 + 80,000) U – 100,000 U – 30,000 U – 30,000 O – 30,000 O – 30,000

Requirement 2 Retained earningsa ............................................ 30,000 Inventoryb......................................................... 100,000 Purchasesc .................................................... 50,000 d Accounts payable ........................................ 80,000

See calculation in Requirement 1. Correction for inventory from the second purchase ($20,000) and third purchase ($80,000) not being included in the physical count in 2024. c Correction for first purchase ($50,000) being recorded in 2025 instead of 2024. d Correction for third purchase on account ($80,000) not being recorded in 2024. Note: For items c. and d., the Purchases account in 2024 would be closed to zero under a periodic inventory system, so the Purchases account should have no balance in 2025 for these two purchases. b

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Problem 9–17 Requirement 1 Unadjusted balance Item: 2. 3. 6. 7. Adjusted balance

Accounts Accounts Sales Purchases paya ble receivable revenue $620,000 $210,000 $225,000 (27,000) (25,000)

(27,000) (25,000)

18,000 $586,000

18,000 $176,000

$840,000

(40,000)

$185,000

$800,000

Requirement 2 Beginning balance Close beginning inventory Close purchases (from requirement 1) Unadjusted ending inventory Item: 1. 4. 6. 7. Adjusted balance

Ending Inventory $ 414,000* (414,000)

Cost of Goods Sold $ 0 414,000 586,000 (326,000)

326,000 (32,000) 36,000** 22,000 18,000 $ 370,000

32,000 (36,000) (22,000) (18,000) $ 630,000

* $352,000 + 62,000 for the prior period adjustment in item 5. ** 1,000 units – 100 units = 900 units × $40 = $36,000 Alternatively: Beginning inventory ($352,000 + 62,000) Plus: Purchases (from requirement 1) Less: Ending inventory Cost of goods sold

$414,000 586,000 (370,000) $630,000

Problem 9–17 (concluded) Requirement 3 The 2023 financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income, and retained earnings when those statements are reported again for comparative purposes in the 2024 annual report. A ―prior period adjustment‖ to 2024 beginning retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on 2023 income from continuing operations, net income, and earnings per share. An understatement of ending inventory causes cost of goods sold to be overstated. Therefore, 2023 before-tax income was understated by $62,000.

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Problem 9–18 Requirement 1 a. $10.50 If market price is equal to or greater than the contract price, the purchase is recorded at cost. Purchases ($10.00 × 10,000 units) ...................... 100,000 Cash ............................................................ 100,000

b. $9.50 If market price is less than the contract price, the purchase is recorded at the market price. Purchases ($9.50 × 10,000 units) .......................... 95,000 Loss on purchase commitment (difference) ...... 5,000 Cash ............................................................ 100,000

Requirement 2 a. $12.50 No entry is required. Market price is greater than contract price. b. $10.30 If market price at year-end is less than contract price for outstanding purchase commitments, a loss is recorded for the difference. December 31, 2024 Estimated loss on purchase commitment [($11.00 × 20,000 units) – ($10.30 × 20,000 units)] Estimated liability on purchase commitment

14,000 14,000

Problem 9–18 (concluded) Requirement 3 a. $11.50 If market price on purchase date has not declined from year-end price, the purchase is recorded at the year-end market price. Purchases ($10.30 × 20,000 units) .................... 206,000 Estimated liability on purchase commitment..... 14,000 Cash ($11.00 × 20,000 units)........................ 220,000

b. $10.00 If market price on purchase date declines from year-end price, the purchase is recorded at market price. Purchases ($10.00 × 20,000 units) .................... 200,000 Loss on purchase commitment ($220,000 – 200,000 – 14,000)* ..................... 6,000 Estimated liability on purchase commitment..... 14,000 Cash ($11.00 × 20,000 units)........................ 220,000 * or, ($10.30 – 10.00) × 20,000 units = $6,000

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DECISION MAKERS’ PERSPECTIVES CASES Judgment Case 9–1 1. Hudson should account for the warehousing costs related to its wholesale inventories as part of inventory. All reasonable and necessary costs of preparing inventory for sale should be recorded as inventory cost. This approach results in proper matching of the warehousing costs with revenue when the wholesale inventories are sold. 2. a. The lower of cost or market (LCM) rule produces a more realistic estimate of future cash flows to be realized from assets, which is consistent with the principle of conservatism, and recognizes (matches) the anticipated loss in the income statement in the period in which the price decline occurs. b. Hudson‘s wholesale inventories should be reported in the balance sheet at market. 3. Hudson‘s freight-in costs should be included only in the cost amounts to determine the cost-to-retail percentage. Hudson‘s net markups should be included only in the retail amounts to determine the cost-to-retail-percentage. Hudson‘s net markdowns should not be deducted from the retail amounts to determine the cost-to-retail percentage. 4. By not deducting net markdowns from the retail amounts to determine the cost-to-retail percentage, Hudson produces a lower cost-to-retail percentage than would result if net markdowns were deducted. By applying this lower percentage to ending inventory at retail, the inventory is reported at an amount below cost, which approximates lower of average cost or market.

Integrating Case 9–2 Requirement 1 YORK CO. Schedule of Cost of Goods Sold For the Year Ended December 31, 2024 Beginning inventory Add: Purchases Less: Purchase discounts Add: Freight-in Goods available for sale Less: Ending inventory Cost of goods sold

$ 53,900 380,600 (18,000) 5,000 421,500 (176,000) (1) $245,500

YORK CO. Supporting Schedule of Ending Inventory December 31, 2024 Inventory at cost (FIFO): Units Purchases, quarter ended, June 30, 2,000 Purchases, quarter ended, September 30 12,000 Purchases, quarter ended, December 31 8,000 22,000 Inventory at net realizable value: 22,000 units @ $8 = $176,000 (1) Requirement 2

Cost per unit $7.90 8.25 8.20

Total cost $ 15,800 99,000 65,600 $180,400

Inventory should be valued at the lower of cost or net realizable value. In this situation, because inventory valued at net realizable value ($176,000) is lower than inventory valued at cost ($180,400), inventory should be reported in the financial statements at net realizable value.

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Analysis Case 9–3 1. Retrospective. We report most voluntary changes in accounting principles retrospectively. 2. Yes. All previous periods‘ financial statements changed as if the new method were used in those periods. For each year in the comparative statements reported, we revise the balance of each account affected so that those statements appear as if the newly adopted accounting method had been applied all along. Then we create a journal entry to adjust all account balances affected as of the date of the change. 3. Comparability. GAAP require retrospective application to enhance comparability of the statements from year to year. The revised statements are made to appear as if the newly adopted accounting method (average cost method in this case) had been applied in all previous years.

Real World Case 9–4 Requirement 1 Both FIFO and LIFO. Inventories are valued using the retail first-in, first-out method for goods in stores and the first-in, first-out cost method for goods in distribution centers. For pharmacy department inventories, cost is determined using the dollar-value LIFO retail method.

Requirement 2 The company uses the Producer Price Index in applying the dollar-value LIFO retail method to its pharmacy department inventories.

Requirement 3 The disclosure note states that the current cost of inventories exceeded the LIFO cost for pharmacy department inventories by approximately $52.8 million at January 28, 2017, and $47.5 million at January 30, 2016. Assuming that the current cost of inventory approximates FIFO values, this means that inventory values would have been higher by these amounts if FIFO had been used. Therefore, cost of goods sold for the year ended January 28, 2017, would have been lower, and pretax income would be higher by $5.3 million ($52.8 million – $47.5 million) if Fred‘s had used FIFO to value its pharmacy department inventory instead of LIFO.

Requirement 4 ($ in thousands) Inventory turnover =

$1,615,162 = 4.80 times $336,270*

*($340,730 + 331,809) ÷ 2

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Case 9–4 (concluded) Requirement 5 For changes not involving LIFO or changes from the LIFO method to another, the event is accounted for as a normal change in accounting principle. In general, we use the retrospective approach to account for voluntary changes in accounting principles. This means revising all previous periods‘ financial statements as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. More specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we make an adjustment to the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders‘ equity (or statements of retained earnings if they‘re presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change.

Analysis Case 9–5 Requirement 1 The effect of the error would be an overstatement of pretax income by $665,000 ($3,265,000 – 2,600,000). By correcting this error, bonuses will be negatively affected because a lower ending inventory results in higher cost of goods sold and lower income.

Requirement 2 Decrease. By correcting this error, bonuses will be reduced because a lower ending inventory results in higher cost of goods sold and lower income.

Requirement 3 It will be reported as a prior period adjustment in 2025 to the beginning retained earnings balance for the year beginning January 1, 2025. Financial statements for the year ending December 31, 2024, will be retrospectively restated to reflect the correct inventory amount, cost of goods sold, income from continuing operations, net income, and retained earnings.

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Analysis Case 9–6

Requirement 1 Date Transaction Aug. 22 Purchase Oct. 29 Purchase

Number of units 30 80 110

Unit cost $600 640

Ending Inventory $18,000 51,200 $69,200

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Date Transaction Jan. 1 Beginning inventory Mar. 8 Purchase Aug. 22 Purchase

Number of units 150 120 70 340*

Unit cost $540 570 600

Cost of Goods Sold $ 81,000 68,400 42,000 $191,400

* First 340 units purchased are assumed sold

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 2 Date Oct. 29

Transaction Purchase

Number of units 50

Unit cost $640

Ending Inventory $32,000

Date Jan. 1 Mar. 8 Aug. 22 Oct. 29

Transaction Beginning inventory Purchase Purchase Purchase

Number of units 150 120 100 30 400*

Unit cost $540 570 600 640

Cost of Goods Sold $ 81,000 68,400 60,000 19,200 $228,600

Complete Solution Manual for Intermediate Accounting, 11th Edition * First 400 units purchased are assumed sold

Requirements 3 and 4

Complete Solution Manual for Intermediate Accounting, 11th Edition 2024

2025

(a) ending inventory

Overstatement

No Effect

Complete Solution Manual for Intermediate Accounting, 11th Edition (b) retained earnings

Overstatement

No Effect

Understatement

Overstatement

Complete Solution Manual for Intermediate Accounting, 11th Edition (d) net income

Overstatement

Understatement

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Communication Case 9–7 Sometimes circumstances arise after (or subsequent to) the purchase or production of inventory that indicate the company will have to sell its inventory for less than its cost. This might happen because of inventory damage, physical deterioration, obsolescence, changes in price levels, or any situation that lessens demand for the inventory. Consider, for example, the value of unsold electronics inventory when the next generation comes out, or the leftover clothing inventory at the end of the selling season. Usually, the only way these items can be sold is at deeply discounted prices (well-below their purchase cost). GAAP requires that companies evaluate their unsold inventory at the end of each reporting period (for reasons mentioned above). When the expected benefit of unsold inventory is estimated to have fallen below its cost, companies must depart from the cost basis of reporting ending inventory; an adjusting entry is needed to reduce the reported amount of inventory and to reduce net income for the period. This end-ofperiod adjusting entry is known as an inventory write-down.

Communication Case 9–8 Suggested Grading Concepts and Grading Scheme: Content (70%) 30 Describes the method. Determining ending inventory at retail. Multiply ending inventory at retail by the cost percentage. Markups and markdowns. 10

Discusses the conditions that may distort results. Possible inaccurate cost percentage. Does not explicitly consider theft, breakage, etc.

Describes the advantages of using the method when compared to other methods. Avoids physical inventory count. Acceptable for financial reporting and income taxes. Can explicitly incorporate cost flow methods, taxes, and an approximation of lower of average cost and net realizable value.

70 points Writing (30%) 6 Terminology and tone appropriate to the audience of a company president. 12 Organization permits ease of understanding. Introduction that states purpose. Paragraphs that separate main points. 12

English Sentences grammatically clear and well organized, concise. Word selection. Spelling. Grammar and punctuation.

30 points

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Communication Case 9–9 Requirement 1 Change in Inventory Method During 2024, the Company changed the method of valuing its inventories from the first-in, firstout (FIFO) method, to the last-in, first-out (LIFO) method, determined by the retail method. To estimate the effects of changing retail prices on inventories, the Company utilizes internally developed price indexes. The impact of the change was to decrease 2024 net income by $13.2 million and to decrease earnings per share by $0.132. Management has determined that retrospective application of the change is impracticable because the cumulative effect of the change on prior years was not determinable. The Company believes that the change to the LIFO method provides a more consistent matching of merchandise costs with sales revenue and also provides a more comparable basis of accounting with competitors. Note: Because cost of goods sold would have been $22 million lower if the change had not been made, income before tax would have been $22 million higher, and net income would have been $13.2 million higher ($22 million multiplied by 60% [1 – 0.40]).

Requirement 2 It usually is impracticable to calculate the cumulative effect of a change to LIFO. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. Accounting records usually are inadequate for a company to create the appropriate LIFO inventory layers. That‘s why a change to LIFO usually can‘t be applied retrospectively.

Target Case Requirement 1 The LIFO provision is calculated based on internally measured retail price indices.

Requirement 2 The use of RIM will result in inventory being valued at the lower of cost or market because permanent markdowns are taken as a reduction of the retail value of inventory

Requirement 3 Activity under this program is included in sales and cost of sales in the Consolidated Statements of Operations (income statement), but the merchandise received under the program is not included in inventory in Target‘s Consolidated Statements of Financial Position (balance sheet) because of the virtually simultaneous purchase and sale of this inventory. Solutions Manual, Chapter 12 12–1065 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Air France-KLM Case No. Both U.S. GAAP and IFRS require inventory to be valued at the lower of cost and net realizable value.

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Chapter 10 Property, Plant, and Equipment and Intangible Assets: Acquisition QUESTIONS FOR REVIEW OF KEY TOPICS

Question 10– 1068 The difference between tangible and intangible long-lived, revenue-producing assets is that intangible assets lack physical substance and they primarily refer to the ownership of rights.

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Question 10–2 The cost of property, plant, and equipment and intangible assets includes the purchase price (less any discounts received from the seller); transportation costs paid by the buyer to transport the asset to the location in which it will be used; expenditures for installation, testing, and legal fees to establish title; and any other costs of bringing the asset to its condition and location for use.

Question 10– 1070 The cost of a developed natural resource includes the acquisition costs for the use of land, the exploration and development costs incurred before production begins, and the restoration costs incurred during or at the end of extraction.

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Question 10–4 Purchased intangibles are valued at their original cost to include the purchase price and all other necessary costs to bring the asset to condition and location for use. Research and development costs incurred to internally develop an intangible asset are expensed in the period incurred. Filing and legal costs for both purchased and developed intangibles are capitalized.

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Question 10–5 Goodwill represents the unique value of the company as a whole over and above all identifiable tangible and intangible assets. This value results from a company‘s clientele and reputation, its trained employees and management team, its unique business location, and any other unique features of the company that can‘t be associated with a specific asset. Because goodwill can‘t be separated from a company, it is not possible for a buyer to acquire it without also acquiring the whole company or a substantial portion of it. Goodwill will appear as an asset in a balance sheet only when it was paid for in connection with the acquisition of another company. The capitalized cost of goodwill equals the acquisition consideration exchanged for the acquired company less the fair value of the net assets acquired. The fair value of the net assets equals the fair value of all identifiable tangible and intangible assets less the fair value of any liabilities of the acquired company assumed by the buyer.

Question 10–6 A lump-sum purchase price generally is allocated based on the relative fair values of the individual assets. The relative fair value percentages are multiplied by the lump-sum purchase price to arrive at the initial valuation of each of the separate assets.

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Question 10–7 Assets acquired in exchange for deferred payment contracts are valued at their fair value or the present value of payments using a realistic interest rate. Theoretically, both alternatives should lead to the same valuation.

Question 10–6 Assets acquired through the issuance of equity securities are valued at the fair value of the securities if known. If not known, the fair value of the assets received is used.

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Question 10–9 Donated assets are valued at their fair values.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 10–10 Revenue. The rationale is that the company receiving the donation is performing a service for the donor in exchange for the asset donated.

Question 10–11 The basic principle used to value assets acquired in a nonmonetary exchange is to use the fair value of asset(s) given up plus (minus) monetary consideration—cash— paid (received).

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Question 10–12 The two exceptions are (1) when fair value is not determinable and (2) when the exchange lacks commercial substance resulting in a gain.

Question 10–11 GAAP requires the capitalization of interest incurred during the construction of assets for a company‘s own use as well as for assets constructed for sale or lease. Assets qualifying for capitalization exclude inventories that are routinely manufactured in large quantities on a repetitive basis and assets that are in use or ready for their intended purpose. Only assets that are constructed as discrete projects qualify for interest capitalization.

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Question 10–14 Average accumulated expenditures for a period is an approximation of the average amount of debt the company would have had outstanding if it borrowed all of the funds necessary for construction. If construction expenditures are incurred equally throughout the period, the average accumulated expenditures for the period can be estimated by adding the accumulated expenditures at the beginning of the period to the accumulated expenditures at the end of the period and dividing by two. If expenditures on the project are unequal throughout the period, individual expenditures, perhaps expenditures grouped by month, should be weighted by the amount of time outstanding until the end of the construction period or the end of the company‘s fiscal year, whichever comes first.

Question 10–15 Applying the specific interest method, the interest rate on any constructionrelated debt is used up to the amount of the construction debt and any excess average accumulated expenditures is multiplied by a weighted-average interest rate of all other debt. The weighted-average method multiplies average accumulated expenditures by the weighted-average interest rate of all debt, including any construction-related debt.

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Question 10–16 GAAP defines research and development as follows: Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about a significant improvement to an existing product or process. Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use.

Question 10–15 GAAP specifically excludes from current R&D expense the cost of property, plant, and equipment and intangible assets that have ―alternative future uses‖ beyond the current R&D project. However, the depreciation or amortization of these assets will be included as R&D expenses in the future periods the assets are used for R&D activities. If the asset has no alternative future use, its cost is expensed as R&D immediately.

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Question 10– 1090 GAAP requires the capitalization of software development costs incurred after technological feasibility is established. Technological feasibility is established ―when the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements.‖ Costs incurred after technological feasibility but before the product is available for general release to customers are capitalized as an intangible asset. These costs include coding and testing costs and the production of product masters. Costs incurred after commercial production begins usually are not R&D expenditures.

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Question 10–19 The cost of developed technology is capitalized and expensed over its expected useful life. Developed technology relates to those projects that have reached technological feasibility. The cost of in-process R&D is capitalized and treated as an indefinite life intangible asset and not amortized. If the R&D project is completed successfully, we switch to the way we account for developed technology and amortize the capitalized amount over the estimated period the product or process developed will provide benefits. If the project instead is abandoned, we expense the entire balance immediately. After the acquisition of in-process R&D, research and development costs incurred to complete the project are expensed as incurred, consistent with the treatment of any other R&D not acquired in an acquisition.

Question 10– 1092Under U.S. GAAP, donated assets are recorded as revenue. However, IAS No. 20 requires that government grants be recognized in income over the periods necessary to match them on a systematic basis with the related costs that they are intended to compensate. For example, for grants related to assets, companies can either (1) deduct the amount of the grant in determining the initial cost of the asset, or (2) record the grant as a liability, deferred income, in the balance sheet and recognize it in the income statement systematically over the asset‘s useful life.

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Answers to Questions (concluded)

Question 10– 1094 Other than software development costs incurred after technological feasibility has been established, U.S. GAAP requires all research and development expenditures to be expensed in the period incurred. IAS No. 38 draws a distinction between research activities and development activities. Research expenditures are expensed in the period incurred. However, development expenditures that meet specified criteria are capitalized as an intangible asset.

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Question 10–22 Capitalization of software development costs is similar under U.S. GAAP and IFRS.

Question 10– 1096 The successful efforts method allows companies to capitalize only exploration costs resulting in successful wells. The full-cost method allows companies to capitalize all exploration costs incurred within a geographical area.

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BRIEF EXERCISES Brief Exercise 10–1 Capitalized cost of the equipment: Purchase price Freight Installation Testing Total capitalized cost

$35,000 1,500 3,000 2,000 $41,500

Note: Personal property taxes on the equipment for the period after acquisition are not part of acquisition cost. They are expensed in the period incurred.

Brief Exercise 10–2 Capitalized cost of land: Purchase price Broker‘s commission Title insurance Miscellaneous closing costs Demolition of old building Total capitalized cost

$600,000 30,000 3,000 6,000 18,000 $657,000

All of the expenditures, including the costs to demolish the old building, are included in the initial cost of the land.

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Brief Exercise 10–3 Cost of land and building: Purchase price Broker‘s commission Title insurance Miscellaneous closing costs Total capitalized cost

$600,000 30,000 3,000 6,000 $639,000

The total must be allocated to the land and building based on their relative fair values:

Percent of Total Fair Value Asset Land Building

Fair Value $420,000 280,000 $700,000

60% 40 100%

Initial Valuation (Percent × $639,000)

$383,400 255,600 $639,000

Brief Exercise 10–4 Cost of silver mine: Acquisition, exploration, and development Restoration costs Total capitalized cost †

$5,600,000 429,675 † $6,029,675

$500,000 × 20% = $100,000 550,000 × 45% = 247,500 650,000 × 35% = 227,500 $575,000 × .74726* = $429,675

*Present value of $1, n = 5, i = 6% (from Table 2)

Brief Exercise 10–5 After one year, the liability will increase to $455,456. ($429,675† + ($429,675 × 6%) = $455,456) †

$500,000 × 20% = $100,000 550,000 × 45% = 247,500 650,000 × 35% = 227,500 $575,000 × .74726* = $429,675

*Present value of $1, n = 5, i = 6% (from Table 2)

Actual restoration costs Less: Asset retirement liability Loss on retirement

$596,000 (575,000) $ (21,000)

Brief Exercise 10–6 Purchase price Legal fees Total capitalized cost

$1,200,000 20,000 $1,220,000

The costs of advertising and employee training would be expensed immediately.

Brief Exercise 10–7 Only the legal fees of $20,000 would be capitalized. The costs of internal development are recorded as research and development expense. Advertising and employee training would be expensed immediately as well.

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Brief Exercise 10–8 Calculation of goodwill: Fair value of consideration given Less fair value of identifiable net assets acquired: Book value of assets $8,300,000 Plus: Excess of fair value over book value of intangible assets 2,500,000 Goodwill

$14,000,000

(10,800,000) $ 3,200,000

Brief Exercise 10–9 The initial value of equipment and note will be the present value of the note payment: PV = $60,000 (0.85734* ) = $51,440 * Present value of $1: n = 2, i = 8% (from Table 2)

Interest expense for July 1 to December 31, 2024: $51,440 × 8% × 6/12 = $2,058

Brief Exercise 10–10 The initial value of the franchise and note will be the fair value (cash price) of the franchise = $356,000. The implicit interest rate in the agreement is determined as: $356,000 (present value) = $400,000 (face amount) × PV factor* * Present value of $1: n = 2, i = ?% (from Table 2)

PV factor = $356,000/$400,000 = 0.89 (PV factor for n = 2, i = 6%) Interest expense for September 30 to December 31, 2024: $356,000 × 6% × 3/12 = $5,340

Brief Exercise 10–11 The cost of the patent equals the fair value of the stock given in exchange: 50,000 × $22 = $1,100,000

Brief Exercise 10–12 Net sales ÷ Average PP&E = Fixed-asset turnover ratio Huebert:

$1,850 ÷ ($220 + $210) / 2 = 8.60

Winslow:

$5,120 ÷ ($680 + $650) / 2 = 7.70

Because Huebert has a higher ratio, we would conclude that it more efficiently generates sales with its fixed assets.

Brief Exercise 10–13 Average PP&E for 2024 = ($740,000 + 940,000) ÷ 2 = $840,000 Net sales ÷ Average PP&E = Fixed-asset turnover ratio ? ÷ $840,000 = 3.25 Average PP&E × Fixed-asset turnover ratio = Net sales $840,000

3.25

= $2,730,000

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Brief Exercise 10– 1104 1. Pickup trucks = Fair value of equipment given, plus cash paid $17,000 + $8,000 = $25,000 2. Gain or loss to recognize on the exchange: Fair value of equipment given up .................... $17,000 Less: Book value of equipment Original cost of equipment ........................... $65,000 Accumulated depreciation ............................ (45,000) (20,000) Loss on exchange of assets.............................. $ (3,000) Journal entry (not required): Pickup trucks―new (determined above) .......... Accumulated depreciation (account balance) ... Loss on exchange of assets (determined above) Equipment—old (account balance) ............... Cash ............................................................

25,000 45,000 3,000 65,000 8,000

Brief Exercise 10–15 1. Pickup trucks = Fair value of equipment given, plus cash paid $24,000 + $8,000 = $32,000 2. Gain or loss to recognize on the exchange: Fair value of equipment given up .................... $24,000 Less: Book value of equipment Original cost of equipment ........................... $65,000 Accumulated depreciation ............................ (45,000) (20,000) Gain on exchange of assets ............................. $ 4,000

Journal entry (not required): Pickup trucks―new (determined above) .......... Accumulated depreciation (account balance) ... Equipment―old (account balance)...............

32,000 45,000 65,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Cash ............................................................ Gain on exchange of assets (determined above)

8,000 4,000

Brief Exercise 10– 1106 1. Pickup trucks = Book value of equipment given, plus cash paid $20,000 + $8,000 = $28,000 2. Gain or loss to recognize on the exchange: Fair value of equipment given up .................... $24,000 Less: Book value of equipment Original cost of equipment ........................... $65,000 Accumulated depreciation ............................ (45,000) (20,000) Gain on exchange of assets $ 4,000 There is a gain on the exchange of assets, but no gain is recognized because the exchange lacks commercial substance and no cash was received. Journal entry (not required): Pickup trucks―new (determined above) .......... Accumulated depreciation (account balance) ... Equipment―old (account balance)............... Cash ............................................................

28,000 45,000 65,000 8,000

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Brief Exercise 10–17 Average accumulated expenditures: January 1 March 31 June 30

$500,000 × 12/12 600,000 × 9/12 400,000 × 6/12 600,000 × 2/12

October 30

= $ 500,000

= = =

450,000 200,000 100,000 $1,250,000

Interest capitalized: $1,250,000 – 700,000 (construction loan) × 7% = $49,000 $ 550,000 × 6.75%* = 37,125 $86,125 = Interest capitalized * Weighted-average rate of all other debt: $3,000,000 5,000,000 $8,000,000 $540,000

× 8% = $240,000 ×

6% =

300,000 $540,000

= 6. 75% weighted average

$8,000,000

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Brief Exercise 10–18 Average accumulated expenditures: January 1 March 31 June 30

$500,000 × 12/12 600,000 × 9/12 400,000 × 6/12 600,000 × 2/12

October 30

= $ 500,000

= = =

450,000 200,000 100,000 $1,250,000

Interest capitalized: $1,250,000

6.77%* = $84,625

* Weighted-average rate of all other debt: $ 700,000 3,000,000 5,000,000 $8,700,000 $589,000

× × ×

7% = 8% = 6% =

$ 49,000 240,000 300,000 $589,000

= 6.77% weighted average

$8,700,000

Brief Exercise 10–19 Research and development: Salaries Depreciation on R & D facilities and equipment Utilities and other direct costs Payment to another company Total R & D expense

$220,000 125,000 66,000 120,000 $531,000

Note: The patent filing and related legal costs and the costs of adapting the product to a particular customer‘s needs are not included as research and development expense.

Brief Exercise 10–20

The software costs to be capitalized include those made after technological feasibility = $500,000 ($800,000 − $300,000).

Brief Exercise 10–21 The software costs to be capitalized include those incurred after application development = $125,000 ($150,000 − $25,000).

Brief Exercise 10–22 The software costs to be capitalized include the cost of the arrangement plus all implementation costs = $50,000 ($35,000 + $15,000). Costs related to preliminary planning ($5,000) or post-implementation operation ($10,000) are not capitalized but are expensed as incurred.

Brief Exercise 10–23 Research and development: Internal projects Payment to acquire R&D from a third party Total R & D expense

$620,000 75,000 $695,000

Note: The costs of an R&D project to be sold under contract would be included as part of inventory. The in-process R&D associated with the acquisition would be recorded as an indefinitelife intangible asset.

Brief Exercise 10–24 Start-up costs: Market appraisal Consulting fees Advertising Traveling to train employees Total start-up expense

$ 50,000 72,000 47,000 31,000 $200,000

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EXERCISES Exercise 10–1 Capitalized cost of land: Purchase price Demolition of old building Less: Sale of materials Legal fees for title investigation Total cost of land

$60,000 $4,000 (2,000)

2,000 2,000 $64,000

Capitalized cost of building: Construction costs Architect's fees Interest on construction loan Total cost of building

$500,000 12,000 5,000 $517,000

Note: Property taxes on the land for the period after acquisition are not part of acquisition cost. They are expensed in the period incurred.

Exercise 10–2 To record the purchase of equipment. Equipment ($45,000 + $2,200 + $700 + $1,000) Accounts payable ......................................... Cash.............................................................

48,900 47,200 1,700

To record prepaid insurance for the equipment. Prepaid insurance ............................................. Cash.............................................................

900 900

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Exercise 10–3 Requirement 1 Cost of land and building: Purchase price Title insurance Legal fees State transfer fees Total cost

$4,000,000 16,000 5,000 4,000 $4,025,000

Note: The pro-rated property taxes for the period after acquisition are not included in the initial valuation of the land and building. They are recorded instead as prepaid taxes and expensed over the related period. The total is allocated to the land and building based on their relative fair values:

Percent of Total Fair Value Asset Land Building

Assets: Land Building Land improvements: Parking lot Landscaping

Fair Value $3,300,000 1,100,000 $4,400,000

75% 25 100%

Initial Valuation (Percent × $4,025,000)

$3,018,750 1,006,250 $4,025,000

$3,018,750 $1,006,250 $ 82,000 40,000 $122,000

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Exercise 10–3 (concluded) Requirement 2 Cost of land: Purchase price

$4,000,000

Title insurance Legal fees State transfer fees Demolition of old building Less: Sale of materials Clearing and grading costs Total cost of land Land improvements: Parking lot Landscaping

16,000 5,000 4,000 $250,000 (6,000)

244,000 86,000 $4,355,000 $ 82,000 40,000 $122,000

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Exercise 10–4 Requirement 1 Cost of copper mine: Mining site $1,000,000 Development costs 600,000 † Restoration costs 303,939 $1,903,939 †

$300,000 × 25% = 400,000 × 40% = 600,000 × 35% =

Present value of Restoration costs

$ 75,000 160,000 210,000 $445,000 × .68301* $303,939

= Asset retirement liability *Present value of $1, n = 4, i = 10% (from Table 2)

Requirement 2 Copper mine (determined above) ...................... 1,903,939 Cash ($1,000,000 + $600,000) ..................... 1,600,000 Asset retirement liability (determined above) ......................... 303,939 Equipment (cost) ................................................ 120,000 Cash ............................................................ 120,000

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Exercise 10–5 Patent ($200,000 + $10,000) ............................ 210,000 Franchise*........................................................ 300,000 Equipment ....................................................... 400,000 Copyright ......................................................... 25,000 Cash ............................................................ 935,000

*The ongoing expense each month of operating as a franchise would be expensed as incurred. Exercise 10–6 Calculation of goodwill: Fair value of consideration given Less: Fair value of identifiable net assets acquired: Fair value of identifiable assets acquired $23,000,000 Less: Fair value of liabilities assumed (9,500,000) Goodwill

$17,000,000

(13,500,000) $ 3,500,000

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Exercise 10–7 Requirement 1 Calculation of goodwill: Fair value of consideration given $11,000,000 Less: Fair value of identifiable net assets acquired: Fair value of assets $11,700,000* Less: Fair value of liabilities (1,700,000) 10,000,000 Goodwill $ 1,000,000

Complete Solution Manual for Intermediate Accounting, 11th Edition * $1,100,000 + $1,500,000 + $7,900,000 +$1,200,000 = $11,700,000

Requirement 2 Accounts receivable ......................................... 1,100,000 Land ................................................................. 1,500,000 Equipment ........................................................ 7,900,000 Patent ............................................................... 1,200,000 Goodwill .......................................................... 1,000,000 Accounts payable......................................... 1,700,000 Cash ............................................................ 11,000,000

Exercise 10–8

Percent of Total Fair Value Asset Land ................. Building A ....... Building B ....... Totals

Fair Value $ 300,000 450,000 250,000 $1,000,000

30% 45 25 100%

Initial Valuation (Percent × $900,000)

$270,000 405,000 225,000 $900,000

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Exercise 10–9 Requirement 1 Tractor ($5,000 cash + $18,783† present value of note) 23,783 Discount on notes payable (difference) ............ 6,217 Cash............................................................. 5,000 Notes payable (face amount) ........................ 25,000 †

Present value of note payment:

PV = $25,000 (.75131* ) = $18,783 * Present value of $1: n = 3, i = 10% (from Table 2)

Requirement 2 2024: Interest expense ($18,783 × 10%) = 2025: Interest expense [($18,783 + $1,878) × 10%] =

$1,878 2,066

Requirement 3 2024: $25,000 – ($6,217 – $1,878) = 2025: $25,000 – ($6,217 – $1,878 – $2,066) =

$20,661 22,727

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Exercise 10–10 Land: Purchase price Demolition and removal of old building Clearing and grading Closing costs Total cost of land Building: Architect‘s fees Construction costs Total cost of building Equipment: Purchase price Freight charges Special platforms and wire installation Cost of trial runs Total cost of equipment Land improvements: Landscaping Sprinkler system

$1,200,000 80,000 150,000 42,000 $1,472,000

50,000 3,250,000 $3,300,000

$860,000 32,000 12,000 7,000 $911,000

$45,000 5,000 $50,000

Fork lifts:

PV = $16,000 + $70,000 (.93458* ) =

$81,421

* Present value of $1: n = 1, i = 7% (from Table 2) Prepaid insurance:

$24,000

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Exercise 10– 1130 Requirement 1 To record the acquisition of land in exchange for common stock. February 1, 2024 Land ................................................................... 900,000 Common stock (50,000 shares × $18)........... 900,000

To record the acquisition of a building through purchase and donation. November 2, 2024 Building ........................................................... 6,000,000 Cash ............................................................ 4,000,000 Revenue – donation of asset (difference) ...... 2,000,000

Requirement 2 As with U.S. GAAP, the building would be valued at fair value. However, the amount donated ($2,000,000) would not be recorded as revenue. Instead, IFRS requires that government grants be recognized in income over the periods necessary to match them on a systematic basis with the related costs that they are intended to compensate. For grants related to assets, companies can either (1) deduct the amount of the grant in determining the initial cost of the asset, or (2) record the grant as a liability, deferred income, in the balance sheet and recognize it in the income statement systematically over the asset‘s useful life.

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Exercise 10–12 Requirement 1 IFRS requires that government grants be recognized in income over the periods necessary to match them on a systematic basis with the related costs that they are intended to compensate. For grants related to assets, companies can either (1) deduct the amount of the grant in determining the initial cost of the asset, or (2) record the grant as a liability, deferred income, in the balance sheet and recognize it in the income statement systematically over the asset‘s useful life.

Requirement 2 Alternative 1: A correcting entry is necessary to eliminate the revenue recognized and reduce the cost of the equipment:

Revenue ........................................................... 2,000,000 Equipment ................................................... 2,000,000

Alternative 2: A correcting entry is necessary to eliminate the revenue recognized and record deferred income.

Revenue ........................................................... 2,000,000 Deferred income .......................................... 2,000,000

Exercise 10– 1132 Requirement 1 ($ in thousands) Average PP&E for 2020 = ($1,674 + $1,404) ÷ 2 = $1,539 Net sales ÷ Average PP&E = Fixed-asset turnover ratio $10,918 ÷ $1,539 = 7.1 times

Requirement 2 The fixed-asset turnover ratio indicates the level of sales generated by the company‘s investment in property, plant, and equipment. Nvidia is able to generate $7.1 in sales for every $1 invested in property, plant, and equipment.

Exercise 10–14

260,000 Equipment—new ($200,000 FV given + $60,000 cash paid) Accumulated depreciation (account balance) ...... 220,000 Equipment—old (account balance)............... 400,000 Cash ............................................................. 60,000 Gain on exchange of assets ($200,000 FV – $180,000 BV) 20,000

Exercise 10–15

230,000 Equipment—new ($170,000 FV given + $60,000 cash paid) 10,000 Loss on exchange of assets ($170,000 FV – $180,000 BV) Accumulated depreciation (remove account balance) 220,000 Equipment—old (remove account balance) .. 400,000 Cash ............................................................. 60,000

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Exercise 10–16 Requirement 1 Fair value of land + Cash given = Fair value of equipment $150,000 + $10,000 = $160,000 Requirement 2 160,000 Equipment―new ($150,000 FV given+ $10,000 cash paid) Land―old (remove account balance)........... 120,000 Cash ............................................................. 10,000 Gain on exchange of assets ($150,000 FV – $120,000 BV) 30,000

Exercise 10–17 Requirement 1 Fair value of land given – Cash received = Fair value of equipment $150,000 – $10,000 = $140,000 Requirement 2 Equipment―new ($150,000 FV given – $10,000 cash received)140,000 Cash ..................................................................... 10,000 Land―old (remove account balance) ........... 120,000 Gain on exchange of assets ($150,000 FV – $120,000 BV) 30,000

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Exercise 10–18 Requirement 1 Fair value of old land + Cash given = Fair value of new land $72,000 + $14,000 = $86,000 Requirement 2 Exchange has commercial substance. Cash paid. Land—new ($72,000 FV given + $14,000 paid) 86,000 Land—old (remove account balance) ........... 30,000 Cash ............................................................. 14,000 Gain on exchange of assets ($72,000 FV – $30,000 BV)

42,000

Requirement 3 Exchange lacks commercial substance. Cash paid. Land—new ($30,000 BV given + $14,000 paid) Land—old (remove account balance) ........... Cash .............................................................

44,000 30,000 14,000

Requirement 4 Exchange lacks commercial substance. Cash received. Land—new (see below) .................................... Cash ................................................................. Land—old (remove account balance) ........... Gain on exchange of assets (see below)........

26,250 9,000 30,000 5,250

Complete Solution Manual for Intermediate Accounting, 11th Edition Gain recognized = (fair value given – book value given) × (cash received ÷ total fair value

received) = ($72,000 – $30,000) × ($9,000 ÷ $72,000a) = $5,250

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In normal business transactions, the fair value received will equal the fair value given.

Land―new = $30,000 BV given – $9,000 cash received + $5,250 gain recognized

Exercise 10–19 1. To record the purchase of equipment on account. Equipment ($25,000 × 98%) ................................. 24,500 Accounts payable ......................................... 24,500

2. To record the acquisition of equipment in exchange for a note. Equipment (determined below) ............................. 24,545 Discount on notes payable (difference) ................... 2,455 Notes payable (face amount) ........................ 27,000

PV = $27,000 (0.90909* ) = $24,545 * Present value of $1: n=1, i=10% (from Table 2)

3. To record the exchange of old equipment for new equipment. 24,500 Equipment—new ($2,500 FV given + $22,000 cash paid) 3,500 Loss on exchange of assets ($2,500 FV – $6,000 BV) Accumulated depreciation ...................................... 8,000 14,000 Equipment—old (remove account balance) .. Cash ............................................................. 22,000

4. To record the acquisition of equipment by the issuance of stock. Equipment ............................................................ 24,000 Common stock ............................................. 24,000

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Exercise 10–20 1. The basic principle for recording nonmonetary transactions at fair value. FASB ASC 845–10–30–1: ―Nonmonetary Transactions–Overall–Initial Measurement–Basic Principle.‖

In general, the accounting for nonmonetary transactions should be based on the fair values of the assets (or services) involved, which is the same basis as that used in monetary transactions. Thus, the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered to obtain it, and a gain or loss shall be recognized on the exchange. The fair value of the asset received shall be used to measure the cost if it is more clearly evident than the fair value of the asset surrendered. Similarly, a nonmonetary asset received in a nonreciprocal transfer shall be recorded at the fair value of the asset received. A transfer of a nonmonetary asset to a stockholder or to another entity in a nonreciprocal transfer shall be recorded at the fair value of the asset transferred and a gain or loss shall be recognized on the disposition of the asset. 2. Modifications of the principle for recording nonmonetary transactions when fair value is not determinable or the exchange lacks commercial substance. FASB ASC 845–10–30–3: ―Nonmonetary Transactions–Overall–Initial Measurement– Modifications of the Basic Principle.‖

A nonmonetary exchange shall be measured based on the recorded amount (after reduction, if appropriate, for an indicated impairment of value as discussed in paragraph 360-10-40-4) of the nonmonetary asset(s) relinquished, and not on the fair values of the exchanged assets, if any of the following conditions apply: a. The fair value of neither the asset(s) received nor the asset(s) relinquished is determinable within reasonable limits. b. The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange.

c. The transaction lacks commercial substance (see the following paragraph).

3. The concept of commercial substance. FASB ASC 845–10–30–4: ―Nonmonetary Transactions–Overall–Initial Measurement–Commercial Substance.‖

A nonmonetary exchange has commercial substance if the entity's future cash flows are expected to significantly change as a result of the exchange. The entity's future cash flows are expected to significantly change if either of the following criteria is met: a. The configuration (risk, timing, and amount) of the future cash flows of the asset(s) received differs significantly from the configuration of the future cash flows of the asset(s) transferred. The configuration of future cash flows is composed of the risk, timing, and amount of the cash flows. A change in any one of those elements would be a change in configuration. b. The entity-specific value of the asset(s) received differs from the entity-specific value of the asset(s) transferred, and the difference is significant in relation to the fair values of the assets exchanged. An entity-specific value (referred to as an entity-specific measurement in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements) is different from a fair value measurement. As described in paragraph 24(b) of Concepts Statement No. 7, an entity-specific value attempts to capture the value of an asset or liability in the context of a particular entity. For example, an entity computing an entityspecific value of an asset would use its expectations about its use of that asset rather than the use assumed by marketplace participants. If it is determined that the transaction has commercial substance, the exchange would be measured at fair value, rather than at the entity-specific value. A qualitative assessment will, in some cases, be conclusive in determining that the estimated cash flows of the entity are expected to significantly change as a result of the exchange. 4. The required disclosures for nonmonetary transactions. FASB ASC 845–10–50–1: ―Nonmonetary Transactions–Overall–Disclosure.‖

An entity that engages in one or more nonmonetary transactions during a period shall disclose in financial statements for the period all of the following: 12–1142 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition a. The nature of the transactions b. The basis of accounting for the assets transferred c. Gains or losses recognized on transfers.

Exercise 10–21 1. The disclosure requirements in the notes to the financial statements for depreciation on property, plant, and equipment: FASB ASC 360–10–50–1: ―Property, Plant, and Equipment–Overall–Disclosure.‖

Because of the significant effects on financial position and results of operations of the depreciation method or methods used, all of the following disclosures shall be made in the financial statements or in notes thereto: a. Depreciation expense for the period. b. Balances of major classes of depreciable assets, by nature or function, at the balance sheet date. c. Accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date. d. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets.

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Exercise 10–21 (continued) 2. The criteria for determining commercial substance in a nonmonetary exchange: FASB ASC 845–10–30–4: ―Nonmonetary Transactions–Overall–Initial Measurement.‖

Exercise 10–21 (continued) 3. The disclosure requirements for interest capitalization: FASB ASC 835–20–50–1: ―Interest Capitalization–Overall–Disclosure.‖

An entity shall disclose the following information with respect to interest cost in the financial statements or related notes: a. For an accounting period in which no interest cost is capitalized, the amount of interest cost incurred and charged to expense during the period b. For an accounting period in which some interest cost is capitalized, the total amount of interest cost incurred during the period and the amount thereof that has been capitalized.

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Exercise 10–21 (concluded) 4. The elements of costs to be included as R&D activities: FASB ASC 730–10–25–2: ―Research & Development–Overall–Recognition.‖

Elements of costs shall be identified with research and development activities as follows: a. Materials, equipment, and facilities. The costs of materials (whether from the entity's normal inventory or acquired specially for research and development activities) and equipment or facilities that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed. The cost of such materials consumed in research and development activities and the depreciation of such equipment or facilities used in those activities are research and development costs. However, the costs of materials, equipment, or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred. b. Personnel. Salaries, wages, and other related costs of personnel engaged in research and development activities shall be included in research and development costs. c. Intangible assets purchased from others. The costs of intangible assets that are purchased from others for use in research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be accounted for in accordance with Topic 350. The amortization of those intangible assets used in research and development activities is a research and development cost. However, the costs of intangibles that are purchased from others for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred. d. Contract services. The costs of services performed by others in connection with the research and development activities of an entity, including research and development conducted by others in behalf of the entity, shall be included in research and development costs. e. Indirect costs. Research and development costs shall include a reasonable allocation of indirect costs. However, general and administrative costs that are not clearly related to research and development activities shall not be included as research and development costs.

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Exercise 10–22 Average accumulated expenditures: $6,000,000 = $3,000,000 2 Interest capitalized: $3,000,000 – 1,500,000 (construction loan) × 10% = $150,000 $1,500,000 × 7%* = 105,000 $255,000 = interest capitalized * Weighted-average rate of all other debt: $2,000,000 4,000,000 $6,000,000 $420,000

× ×

9% = $180,000 6% = 240,000 $420,000

= 7%

$6,000,000

Exercise 10–23 Average accumulated expenditures for 2024: January 1 March 1 July 31 September 30 December 31

$500,000 × 12/12 600,000 × 10/12 480,000 × 5/12 600,000 × 3/12 300,000 × 0/12

= $ 500,000 = 500,000 = 200,000 = 150,000 = -0$1,350,000

Interest capitalized: $1,350,000 × 8% = $108,000

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Exercise 10– 1152 Average accumulated expenditures for 2024: January 1, 2024 March 31, 2024 June 30, 2024 September 30, 2024 December 31, 2024

$ 600,000 × 12/12 = $ 600,000 1,200,000 × 9/12 = 900,000 800,000 × 6/12 = 400,000 600,000 × 3/12 = 150,000 400,000 × 0/12 = -0$2,050,000

Interest capitalized: $2,050,000 – 1,500,000 (construction loan) $ 550,000

× 8.0% =$120,000 × 10.5%* = 57,750 $177,750 = interest capitalized

* Weighted-average rate of all other debt: $5,000,000 × 12% = 3,000,000 × 8% = $8,000,000

$600,000 240,000 $840,000

$840,000 = 10.5% $8,000,000

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Exercise 10–25 Average accumulated expenditures for 2024: July 1, 2024 September 30, 2024 November 30, 2024

$ 400,000 × 6/6 = 600,000 × 3/6 = 600,000 × 1/6 = $1,600,000

$400,000 300,000 100,000 $800,000

Interest capitalized in 2024: $800,000 × 4.8%* × 6/12 = $19,200 * Weighted-average rate of all debt: $ 2,000,000 × 8% = 8,000,000 × 4% = $10,000,000

$160,000 320,000 $480,000

$480,000 = 4.8% $10,000,000 Average accumulated expenditures for 2025: January 1, 2025 ($1,600,000 + $19,200) January 30, 2025

$1,619,200 × 3/3 = $1,619,200 540,000 × 2/3 = 360,000 $1,979,200

Interest capitalized in 2025: $1,979,200 × 4.8%* × 3/12 = $23,750

Exercise 10– 1154 To expense R&D costs incorrectly capitalized. Research and development expense (below) ..... 3,180,000 Patent........................................................... 3,180,000

Research and development expenditures: Basic research to develop the technology Engineering design work Development of a prototype Testing and modification of the prototype Total

$2,000,000 680,000 300,000 200,000 $3,180,000

To capitalize cost of equipment incorrectly capitalized as patent. Equipment ............................................................ 60,000 Patent........................................................... 60,000

To record depreciation on equipment used in R&D projects. Research and development expense ...................... 10,000 Accumulated depreciation—equipment ........ 10,000

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Exercise 10–27 Research and development expense: Salaries and wages for lab research Materials used in R&D projects Fees paid to third parties for R&D projects Depreciation on R&D equipment Total

400,000 200,000 320,000 120,000 $1,040,000

The patent filing and legal costs are capitalized as the cost of the patent. The salaries, wages, and supplies for R&D performed for another company are included as inventory and expensed as cost of goods sold either when revenue is recognized at the completion of the contract or as revenue is recognized over the life of the contract based on the percentage complete.

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Exercise 10–28 Requirement 1 According to U.S. GAAP, the following costs would be expensed as R&D: Research for new formulas Development of a new formula Total

$2,425,000 1,600,000 $4,025,000

The legal and filing fees are capitalized as an intangible asset.

Requirement 2 According to IFRS, only the $2,425,000 in research costs would be expensed as R&D. Both the development costs incurred after feasibility is established and the legal and filing fees are capitalized as intangible assets.

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Exercise 10–29 Requirement 1 NXS should expense only the research expenditures:

Salaries and wages for basic research Materials used in basic research Other costs incurred for basic research Total

$3,450,000 330,000 1,220,000 $5,000,000

Requirement 2 Both the development costs incurred after feasibility is established and the legal and filing fees are capitalized as intangible assets and amortized.

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Exercise 10–30 List A f 1.

List B

Property, plant, and and equipment Land improvements

a. Exclusive right to display a word, a symbol, or an emblem. d 2. b. Exclusive right to benefit from a creative work. i 3. Capitalize c. Assets that represent rights. g 4. Average accumulated d. Costs of establishing parking lots, driveways, expenditures and private roads. h 5. Revenue e. Purchase price less fair value of net identifiable assets. j 6. Nonmonetary exchange f. Assets such as land, buildings, and machinery. k 7. Natural resources g. Approximation of average amount of debt if all construction funds were borrowed. c 8. Intangible assets h. Account credited when assets are donated to a corporation. b 9. Copyright i. Term meaning to record the cost as an asset. a 10. Trademark j. Basic principle is to value assets acquired using fair value of assets given other than cash. e 11. Goodwill k. Assets such as oil and gas deposits, timber tracks, and mineral deposits.

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Exercise 10–31

.................................................................... Research and development expense .................. 4,000,000 Software development costs.............................. 2,000,000 Cash............................................................. 6,000,000

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Exercise 10–32

2024: ................................................................ Research and development expense .................. 2,200,000 Cash............................................................. 2,200,000

2025: ................................................................ Research and development expense .................. 800,000 Software development costs ............................. 400,000 Cash............................................................. 1,200,000

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Exercise 10–33 Organization cost expense ($12,000 + $3,000) . Start-up expenses ............................................ Patent ($20,000 + $2,000) ................................ Equipment........................................................ Cash ............................................................

15,000 40,000 22,000 30,000 107,000

Exercise 10–34 Requirement 1 Oil wells ............................................................. 450,000 Cash............................................................. 450,000

Requirement 2 Oil wells ($50,000 + $60,000 + $80,000).......... 190,000 Exploration expense ......................................... 260,000 450,000 Cash.............................................................

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PROBLEMS Problem 10–1 1. To record the acquisition of land and building. Land (determined below) ........................................ Building (determined below) ............................ Cash.............................................................

62,500 37,500 100,000

Percent of Total Fair Value Asset Land Building Totals

Fair Value $ 75,000 45,000 $120,000

62.5% 37.5 100.0%

Initial Valuation (Percent × $100,000)

$ 62,500 37,500 $100,000

2. To record the acquisition of equipment for cash and a note. Equipment (determined below) ......................... Discount on notes payable (difference) ............. Notes payable (face amount) ........................

37,037 2,963 40,000

Present value of note payments: PV = $40,000 (0.92593* ) = $37,037 * Present value of $1: n = 1, i=8% (from Table 2)

3. To record the acquisition of a truck by donation. Truck ...................................................................... 2,500 Revenue—donation of asset .........................

2,500

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Problem 10–1 (concluded) 4. To record organization costs. Organization cost expense ................................ Cash ............................................................

3,000 3,000

5. To record the purchase of equipment. Equipment ($15,000 + $500)............................ Cash ............................................................

15,500 15,500

6. To record the acquisition of office equipment by the issuance of common stock. Equipment........................................................ Common stock.............................................

5,500 5,500

7. To record the acquisition of land in exchange for cash and a note. Land................................................................. Cash ............................................................ Notes payable ..............................................

20,000 2,000 18,000

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Problem 10–2 Requirement 1 BLACKSTONE CORPORATION Land Account (Site Number 11) As of September 30, 2025 Acquisition cost $600,000 Real estate broker‘s commission 36,000 Legal fees 6,000 Title insurance 18,000 Cost of razing existing building 75,000 Balance, September 30, 2025 $735,000 Requirement 2 BLACKSTONE CORPORATION Capitalized Cost of Office Building As of September 30, 2025 Contract cost (fixed-price) Plans, specifications, and blueprints Architects‘ fees for design and supervision Capitalized interest for 2024: $900,000 × 14% × 10/12 Capitalized interest for 2025: $1,200,000 × 14% × 9/12 Total capitalized cost, September 30, 2025

$3,000,000 12,000 95,000 105,000 126,000 $3,338,000

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Problem 10–3 PELL CORPORATION Analysis of Changes in Plant Assets For the Year Ended December 31, 2024

Land Land improvements Building

Balance 12/31/2023 $ 350,000 180,000 1,500,000

Equipment Automobiles Totals

1,158,000 150,000 $3,338,000

Increase $438,000 [1] 17,000 19,000 [3] 287,000 [2] $761,000

Explanation of Amounts: [1] Cost of land acquired 11/1/2024: Pell stock exchanged (10,000 shares × $38) Legal fees and title insurance Razing existing building [2]

[3]

Balance 12/31/2024 $ 788,000 180,000

Decrease

Cost of equipment purchased 1/2/2024: Invoice cost Installation cost Cost recorded for small storage building 12/31/2024: Fair value of automobile given Cash paid

1,536,000 1,445,000 132,000 $4,081,000

$18,000 $18,000

$380,000 23,000 35,000 $438,000 $260,000 27,000 $287,000 $

3,750 15,250 $ 19,000

Problem 10–4 To reclassify various expenditures incorrectly charged to the intangible asset account. Organization cost expense ................................ Prepaid insurance ............................................. Copyright ......................................................... Research and development expense .................. Patent ($3,000 + $12,000)................................. Franchise .......................................................... Advertising expense ......................................... Intangible asset ............................................

7,000 6,000 20,000 40,000 15,000 40,000 16,000 144,000

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Problem 10–5 1. To expense R&D costs. Research and development expense ...................... 12,000 Cash............................................................. 12,000

2. To expense legal fees for unsuccessful defense of patent. Legal fees expense .................................................. 7,500 Cash.............................................................

7,500

3. To capitalize the cost of equipment. Equipment (cash price) ..................................... Discount on notes payable (difference) ............. Cash (amount paid) ...................................... Notes payable (face amount) ........................

23,000 1,000 6,000 18,000

4. To capitalize cost of the sprinkler system. Building (sprinkler system) ................................... 28,000 Cash............................................................. 28,000

5. To capitalize legal fees for successful defense of patent. Patent ................................................................... 12,000 Cash............................................................. 12,000

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Problem 10–5 (concluded) 6. To record the exchange of old equipment for new equipment. Equipment—new ($2,000 FV given* + $8,000 cash paid) Accumulated depreciation ($7,400 cost – $3,000 BV) Loss on exchange of assets ($2,000 FV* – $3,000 BV) Equipment—old (remove account balance) .. Cash .............................................................

10,000 4,400 1,000 7,400 8,000

*Fair value of old equipment (Fair value of new equipment – Cash given): $10,000 – $8,000 = $2,000

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Problem 10–6 Southern Company: Cash ................................................................... 140,000 Building—new ($1,400,000 FV given – $140,000 cash received)1,260,000 Accumulated depreciation (remove account balance) 1,200,000 Building—old (remove account balance) ..... 2,000,000 Gain on exchange of assets ($1,400,000 FV– $800,000 BV)

600,000

Eastern Company: The fair value of Eastern‘s building is $1,260,000 ($1,400,000 fair value of Southern‘s building less $140,000 cash given).

Building—new ($1,260,000 FV given + $140,000 cash paid) Accumulated depreciation (remove account balance) 650,000 Building—old (account balance).................. 1,600,000 Cash ............................................................. 140,000 Gain on exchange of assets ($1,260,000 FV – $950,000 BV)

1,400,000

310,000

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Problem 10–7 Robers: Cash ................................................................. 5,000 Equipment―new ($75,000 FV given – $5,000 cash received) 70,000 Accumulated depreciation (remove account balance) 55,000 Equipment―old (remove account balance).. 120,000 Gain on exchange of assets ($75,000 FV – $65,000 BV) 10,000

Phifer: Equipment―new ($70,000 FV given + $5,000 cash paid) 75,000 Accumulated depreciation (remove account balance) 63,000 Loss on exchange of assets ($70,000 FV – $77,000 BV) 7,000 Equipment―old (remove account balance).. 140,000 Cash ............................................................. 5,000

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Problem 10–8 Case A. Requirement 1 Gain or loss to recognize on the exchange: Fair value of tractor given up .......................... $9,000 Less: Book value of tractor Original cost of tractor .................................... $28,000 Accumulated depreciation ........................... (16,000) (12,000) Loss on exchange of assets ............................. $(3,000)

Fair value of old tractor + cash given = Initial value of new tractor $9,000 + $20,000 = $29,000 Journal entry (not required): Tractor―new ($9,000 FV given + $20,000 cash paid) Accumulated depreciation (remove account balance) Loss on exchange of assets ($9,000 FV – $12,000 BV) Tractor―old (remove account balance) ....... Cash ............................................................

29,000 16,000 3,000 28,000 20,000

Requirement 2 Gain or loss to recognize on the exchange: Fair value of tractor given up .......................... $14,000 Less: Book value of tractor Original cost of tractor ................................. $28,000 Accumulated depreciation ........................... (16,000) (12,000) Gain on exchange of assets ............................. $ 2,000

Fair value of old tractor + cash given = Initial value of new tractor $14,000 + $20,000 = $34,000 Journal entry (not required): Tractor―new ($14,000 FV given + $20,000 cash paid) 34,000 Accumulated depreciation—old asset (remove account balance)16,000 Solutions Manual, Chapter 12 12–1185 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Tractor―old (remove account balance)........ 28,000 Cash ............................................................ 20,000 Gain on exchange of assets ($14,000 FV – $12,000 BV).

2,000

Case B. Requirement 1 Fair value of land given up ............................. $700,000 Less: Book value of land Original cost of land ................................. (500,000) Gain on exchange of assets ............................. $200,000 Fair value of old land + cash given = Initial value of new land $700,000 + $50,000 = $750,000 Journal entry (not required): Land―new ($700,000 FV given + $50,000 cash paid) 750,000 Land―old (remove account balance) ........... 500,000 Cash ............................................................ 50,000 Gain on exchange of assets ($700,000 FV – $500,000 BV) 200,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 10–8 (continued) Requirement 2 Fair value of land given up ............................. Less: Book value of land Original cost of land .................................... Loss on exchange of assets

$ 400,000 (500,000) $(100,000)

Fair value of old land + cash given = Initial value of new land $400,000 + $50,000 = $450,000 Journal entry (not required): Land―new ($400,000 + $50,000)...................... 450,000 Loss on exchange of asset ($400,000 FV – $500,000 BV) 100,000 Land―old (remove account balance)........... 500,000 Cash ............................................................ 50,000

Requirement 3 Fair value of land given up ............................. Less: Book value of land Original cost of land ................................ Gain on exchange of assets

$700,000 (500,000) $200,000

There is a gain on the exchange of assets, but no gain is recognized because the exchange lacks commercial substance and no cash was received. Book value of old land + cash given = Initial value of new land $500,000 + $50,000 = $550,000 Journal entry (not required): Land―new ($500,000 FV given + $50,000 cash paid) Cash ............................................................ Land―old (account balance) .......................

550,000 50,000 500,000

Problem 10–8 (concluded) Requirement 4 Fair value of land given up ............................. Less: Book value of land Original cost of land .................................... Loss on exchange of assets

$400,000 (500,000) $(100,000)

There is a loss on the exchange of assets. Even though the exchange lacks commercial substance, the loss is recognized. Fair value of old land + cash given = Initial value of new land $400,000 + $50,000 = $450,000 Journal entry (not required): Land―new ($400,000 + $50,000) ...................... 450,000 Loss on exchange of asset ($400,000 FV – $500,000 BV) 100,000 Land―old (remove account balance) ........... 500,000 Cash ............................................................ 50,000

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Problem 10–9 Requirement 1 2024: Expenditures for 2024: January 1, 2024 March 1, 2024 June 30, 2024 October 1, 2024

$1,000,000 × 12/12 = 600,000 × 10/12 = 800,000 × 6/12 = 600,000 × 3/12 =

Accumulated expenditures (before interest) $3,000,000 Average accumulated expenditures -

$1,000,000 500,000 400,000 150,000

$2,050,000

Interest capitalized: $2,050,000 × 10% = $205,000 = Interest capitalized in 2024

2025: January 1, 2025 ($3,000,000 + 205,000)

January 31, 2025 April 30, 2025 August 31, 2025

$3,205,000 × 270,000 × 585,000 × 900,000 ×

9/9 = 8/9 = 5/9 = 1/9 =

Accumulated expenditures (before interest) $4,960,000 Average accumulated expenditures -

$3,205,000 240,000 325,000 100,000

$3,870,000

Interest capitalized: $3,870,000 - 3,000,000 (construction loan) × 10.0% × 9/12 = $ 870,000 × 7.2%* × 9/12 = Interest capitalized in 2025

$225,000 46,980 $271,980

* Weighted-average rate of all other debt: $ 4,000,000 × 6% = 6,000,000 × 8% = $10,000,000

$240,000 480,000 $720,000

$720,000 = 7.2% $10,000,000

Problem 10–9 (concluded) Requirement 2 Accumulated expenditures 9/30/2025 before interest capitalization (above) 2025 interest capitalized (above) Total cost of building Requirement 3 2024 $3,000,000 × 10% = 4,000,000 × 6% = 6,000,000 × 8% = Total interest incurred Less: Interest capitalized 2024 interest expense

$4,960,000 271,980 $5,231,980

$ 300,000 240,000 480,000 1,020,000 (205,000) $ 815,000

2025 Total interest incurred Less: Interest capitalized 2025 interest expense

$1,020,000 (271,980) $ 748,020

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Problem 10–10 Requirement 1 2024 Expenditures for 2024 January 1, 2024 March 1, 2024 June 30, 2024 October 1, 2024

$1,000,000 × 12/12 600,000 × 10/12 800,000 × 6/12 600,000 × 3/12

Accumulated expenditures (before interest) $3,000,000 Average accumulated expenditures -

= = = =

$1,000,000 500,000 400,000 150,000

$2,050,000

Interest capitalized: $2,050,000 × 7.85%* = $160,925 = Interest capitalized in 2024 * Weighted-average rate of all debt: $ 3,000,000 × 10% = $ 300,000 4,000,000 × 6% = 240,000 6,000,000 × 8% = 480,000 $13,000,000 $1,020,000

$1,020,000 = 7.85% (rounded) $13,000,000

2025: January 1, 2025 ($3,000,000 + $160,925)

January 31, 2025 April 30, 2025 August 31, 2025

$3,160,925 × 270,000 × 585,000 × 900,000 ×

Accumulated expenditures (before interest) $4,915,925 Average accumulated expenditures -

9/9 8/9 5/9 1/9

= = = =

$3,160,925 240,000 325,000 100,000

$3,825,925

Interest capitalized: $3,825,925 × 7.85% × 9/12 = $225,251 = Interest capitalized in 2025

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Problem 10–10 (concluded) Requirement 2 Accumulated expenditures 9/30/2025, before interest capitalization (above) 2025 interest capitalized (above) Total cost of building Requirement 3 2024: $3,000,000 × 10% = 4,000,000 × 6% = 6,000,000 × 8% = Total interest incurred Less: Interest capitalized 2024 interest expense

$4,915,925 225,251 $5,141,176

$ 300,000 240,000 480,000 1,020,000 (160,925) $ 859,075

2025: Total interest incurred Less: Interest capitalized 2025 interest expense

$1,020,000 (225,251) $ 794,749

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Problem 10–11 To capitalize the cost of equipment to be used on future projects incorrectly charged to R&D expense. Equipment .......................................................... 400,000 Research and development expense ............. 400,000

To record depreciation on equipment used in R&D projects. $400,000 ÷ 5 years = $80,000 Research and development expense ...................... 80,000 Accumulated depreciation............................ 80,000

To capitalize filing and legal fees for patent incorrectly charged to R&D expense. Patent ................................................................... 40,000 Research and development expense ............. 40,000

To reclassify the expenditures made for quality control during commercial production. Inventory* ............................................................ 20,000 Research and development expense ............. 20,000

*Quality control costs would either be treated as manufacturing overhead and included in the cost of inventory (as in this journal entry), or expensed in the period incurred.

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Problem 10–12 Requirement 1 Land Purchase price (determined below) Closing costs Removal of old building Clearing and grading

Purchase price of land: Cash paid Value of note† †

$714,404 20,000 70,000 50,000 $854,404 $200,000 514,404 $714,404

Present value of note payment:

PV = $600,000 × 0.85734* = $514,404

*Present value of $1: n = 2, i = 8% (from Table 2) Land improvements Parking lot and landscaping

$285,000

Building Construction expenditures: May 1 July 30 September 1 October 1 Total expenditures Interest capitalized (determined below) Total cost of building

$1,200,000 1,500,000 900,000 1,800,000 5,400,000 141,072 $5,541,072

Problem 10–12 (concluded) Average accumulated expenditures: March 28, 2024* $734,404 × April 30, 2024* 120,000 × May 1, 2024 1,200,000 × July 30, 2024 1,500,000 × September 1, 2024 900,000 × October 1, 2024 1,800,000 ×

7/7 = $ 734,404 6/7 = 102,857 6/7 = 1,028,571 3/7 = 642,857 2/7 = 257,143 1/7 = 257,143 $3,022,975

Interest capitalized: $3,022,975 × 8% × 7/12 =

$141,072

* According to ASC 835-20-15-8, ―If activities are undertaken for the purpose of developing land for a particular use, the expenditures to acquire the land qualify for interest capitalization while those activities are in progress. The interest cost capitalized on those expenditures is a cost of acquiring the asset that results from those activities. If the resulting asset is a structure, such as a plant or a shopping center, interest capitalized on the land expenditures is part of the acquisition cost of the structure.‖ The amount on March 28 includes the immediate payment of cash for the land ($200,000), present value of the note ($514,404), and closing costs ($20,000). The amount on April 30 includes removal of the old building ($70,000) and clearing and grading of the land ($50,000).

Equipment and furniture and fixtures

Equipment Furniture & fixtures Totals

Fair Value $455,000 245,000 $700,000

Percent of Total Fair Value 65% 35% 100%

Initial valuation: Equipment $390,000 Furniture & fixtures 210,000 Requirement 2 Interest expense: Note issued to purchase land and building, $514,404 × 8% × 9/12 = Construction loan, $3,000,000 × 8% × 8/12 Long-term note, $5,250,000 × 8% Total Less: Interest capitalized (determined above)

Initial Valuation % × $600,000 $390,000 210,000 $600,000

$ 30,864 160,000 420,000 610,864 (141,072)

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$469,792

DECISION MAKERS’ PERSPECTIVES CASES Judgment Case 10–1 Requirement 1 All costs necessary to bring the land to its condition for use should be capitalized as the cost of the land. This should include the following costs:

Purchase price.  Title insurance.  Escrow fees.  Delinquent property taxes.  Cost of removing old building.  Cost of grading and other land preparation costs. Requirement 2 

Assets acquired in exchange for deferred payment contracts are valued at their fair value or the present value of payments using a realistic interest rate.

Requirement 3 In general, property, plant, and equipment and intangible assets received in exchange for other nonmonetary assets should be valued at the fair value of the nonmonetary assets given up plus (minus) monetary consideration given (received). There are certain exceptions when the assets received are valued at the book value of the nonmonetary assets given up plus (minus) monetary consideration given (received). The new equipment acquired by exchanging older, similar equipment generally would be valued at the fair value of the old equipment plus (minus) any cash given (received). However, if fair value cannot be determined or if the exchange lacks commercial substance, then the new equipment would be valued at the book value of the old equipment plus (minus) any cash given (received).

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Research Case 10–2 Requirement 1 (a) Accounting for asset retirement obligations is specified in FASB ASC 410–20 ―Asset Retirement Obligations.‖ (b) Section 410–20–25 outlines recognition criteria. (c) Section 410–20–25–4 requires that an entity shall recognize the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate of fair value can be made. (d) Section 410–20–25–5 explains that upon initial recognition of a liability for an asset retirement obligation, an entity shall capitalize an asset retirement cost by increasing the carrying amount of the related long-lived asset by the same amount as the liability.

Requirement 2 The cost of the copper mine is $24,513,419, determined as follows:

Mining site $15,000,000 Development costs 6,000,000 Restoration costs 3,513,419 † $24,513,419 †

$3 million × 20% 4 million × 30% 5 million × 25% 6 million × 25%

= $ 600,000 = 1,200,000 = 1,250,000 = 1,500,000 $4,550,000 × 0.77218* = $3,513,419

*Present value of $1, n = 3, i = 9%

Case 10–2 (continued) Requirement 3 Copper mine (determined above) ...................... 24,513,419 Cash ($15,000,000 + $6,000,000)................. 21,000,000 Asset retirement liability (determined above) ...................... 3,513,419

Requirement 4 $3,513,419 × 9% = $316,208 × 6/12 = $158,104 (a) The measurement of accretion expense is described in FASB ASC 410–20–35–5. (b) The classification of accretion expense in the income statement is addressed in FASB ASC 410–20–45–1.

Requirement 5 If the actual restoration costs are more (less) than the recorded liability at the retirement date, a loss (gain) on retirement of the obligation is recognized for the difference. Asset retirement liability (maturity amount) ...... 4,550,000 Loss (difference) ................................................. 150,000 Cash ............................................................ 4,700,000

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Case 10–2 (concluded) Requirement 6 An entity shall disclose the following information about its asset retirement obligations: a. b. c.

A general description of the asset retirement obligations and the associated long-lived assets. The fair value of assets that are legally restricted for purposes of settling asset retirement obligations. A reconciliation of the beginning and ending aggregate carrying amount (book value) of asset retirement obligations showing separately the changes attributable to (1) liabilities incurred in the current period, (2) liabilities settled in the current period, (3) accretion expense (interest expense), and (4) revisions in estimated cash flows, whenever there is a significant change in one or more of those four components during the reporting period.

If the fair value of an asset retirement obligation cannot be reasonably estimated, that fact and the reasons therefore shall be disclosed. These disclosure requirements can be found at FASB ASC 410–20–50–1.

Real World Case 10–3 ($ in thousands) Property and equipment, beginning of the year Add: Additions Less: Property and equipment, end of the year Decrease in property and equipment Decrease in property and equipment Less: Depreciation Decrease in property and equipment, excluding depreciation Sale price of property and equipment Less: Decrease in property and equipment, excluding depreciation Gain on the sale of property and equipment

$ 31,091 2,019 (31,614) $ 1,496 $1,496 1,139 $ 357 $377 357 $ 20

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Analysis Case 10–4 Requirement 1 The fixed-asset turnover ratio is computed by dividing net sales by average fixed assets. A ratio of 2.94 for Darden Restaurants indicates that the company is able to generate approximately $2.94 in net sales for each dollar invested in fixed assets (property, plant, and equipment). This ratio is less than the industry average of 4.0, so Darden‘s fixed-asset turnover ratio is less favorable than the industry average.

Requirement 2 ($ in thousands) Book value of PP&E, beginning of the year Add: Purchases during the year Deduct: Depreciation for the year Book value of PP&E, end of the year

$2,552.6 454.1 (249.8) $2,756.9

Average PP&E for 2017 = ($2,552.6+2,756.9) ÷ 2 = $2,654.75 Turnover ratio = Net sales ÷ Average PP&E 2.94 = Net sales ÷ $2,654.75 Net sales = $7,805 (approximately)

Judgment Case 10–5 Requirement 1 The cost of a self-constructed asset includes:  Identifiable materials  Labor for construction  Portion of the company's manufacturing overhead costs.

Requirement 2 The treatment of manufacturing overhead cost and its allocation between construction projects and normal production is a difficult issue. One alternative is to include only the incremental overhead costs in the total cost of construction. That is, only those additional costs that are incurred because of the decision to construct the asset should be added to the cost of the asset. This would exclude such indirect costs as depreciation and the salaries of supervisors that would be incurred whether or not the construction project is undertaken. If, however, a new construction supervisor were hired specifically to work on the project, then that salary would be included in asset cost. A second alternative is to assign overhead on the same basis that is used for the regular manufacturing process. For example, all overhead costs might be allocated both to production and to self-constructed assets based on the relative amount of labor hours incurred. This is known as the full-cost approach and is the generally accepted method used to determine the cost of a selfconstructed asset.

Requirement 3 Generally accepted accounting principles provide specific guidelines for the treatment of interest costs incurred during construction. These guidelines pertain to the construction of assets for a company‘s own use as well as for assets constructed for sale or lease. Assets qualifying for capitalization exclude inventories that are routinely manufactured in large quantities on a repetitive basis and assets that are in use or ready for their intended purpose. Only assets that are constructed as discrete projects qualify for interest capitalization. The construction of equipment by the Chilton Company appears to qualify for interest capitalization. The cost of the equipment would include interest if, during the construction period, interest costs were actually being incurred.

Requirement 4 The capitalization period for a self-constructed asset starts when (1) expenditures (materials, labor, and overhead) have been made and (2) interest cost is being incurred. The interest cost incurred does not have to pertain to specific borrowings related to the construction project. The capitalization period ends either when the asset is substantially complete and ready for use or when interest costs are no longer incurred.

Real World Case 10–6 1. Property and equipment, net = $2,375 2. Property and equipment, gross = $4,176 3. Goodwill = $25,134 4. Goodwill for Tableau acquisition = $10,806 5. Intangible assets acquired through business acquisitions, net = $4,724 6. Customer relationships, net = $2,364 12–1206 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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Judgment Case 10–7 Requirement 1 Balance sheet – The initial costs of research equipment used on both Trouver and future research projects would be capitalized and shown as equipment (less accumulated depreciation) in the balance sheet. Income statement – An appropriate method of depreciation should be used. Depreciation on capitalized research equipment should be reported as a research and development expense.

Requirement 2 a. Research and development costs usually are expensed in the period incurred and may not be matched with revenues they help to produce in future periods. b. This accounting treatment is justified by the high degree of uncertainty regarding the amount and timing of future benefits. A direct relationship between research and development costs and future revenues generally cannot be demonstrated.

Requirement 3 Corporate headquarters‘ costs allocated to research and development would be classified as general and administrative expenses in the period incurred, because they are not clearly related to research and development activities.

Requirement 4 The legal expenses incurred in successfully defending the patent should be capitalized as part of the cost of the intangible asset, patent.

Ethics Case 10–8 Requirement 1 $30 million

Requirement 2 $6 million (= $30 million / 5 years = $6 million per year)

Ethical Dilemma: No. The controller‘s responsibility is to follow GAAP by expensing the equipment purchase, regardless of the company‘s need for new financing.

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IFRS Case 10–9 Research expenditures – expensed Development expenditures – capitalized Yes. Development expenditures are expensed in the United States (other than software). a.

U.S. GAAP requires that both research and development expenditures be expensed in the period incurred. The only exception is the capitalization of certain computer software development costs.

Judgment Case 10–10 Requirement 1 Elegant was not correct in its treatment of the software development costs. Generally accepted accounting principles require companies to expense costs incurred to develop computer software to be sold, leased, or otherwise marketed as R&D costs until technological feasibility of the product or process has been established. Only those costs incurred after technological feasibility has been attained and before the product is available for general release to customers can be capitalized.

Requirement 2 Elegant was not correct in its treatment of the software development costs for internal use. We account for the costs incurred to develop computer software to be used internally in a similar manner to that developed for sale to customers. Costs incurred during the preliminary project stage are expensed as R&D. After the application development stage is reached (for example, at the coding stage or installation stage), we capitalize any further costs.

Requirement 3 Elegant would capitalize the full cost of purchased software.

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Communication Case 10–11 Requirement 1 A company undertakes an R&D project because it believes the project will eventually provide benefits that exceed the current expenditures. Unfortunately, though, it‘s difficult to predict which individual research and development projects will ultimately provide benefits. In fact, only one in ten actually reach commercial production. Moreover, even for those projects that pan out, a direct relationship between research and development costs and specific future revenue is difficult to establish. In other words, even if R&D costs do lead to future benefits, it‘s difficult to objectively determine the size of the benefits and in which periods the costs should be expensed if they are capitalized. These are the issues that prompted the FASB to require immediate expensing.

Requirement 2 Possible reasons include:

1. The larger a firm is, the more likely it is to prefer income-reducing accounting methods (e.g., expense R&D). This is particularly true in politically sensitive industries where excessive profits could trigger intervention into a firm‘s activities by government, unions, and other special interest groups. 2. Large firms may tend to have more R&D activities occurring simultaneously, creating a portfolio effect. That is, the number of successful R&D projects relative to total projects may be fairly stable from year to year in large firms. There may be much more variability in smaller firms creating larger variability in income if R&D is expensed. 3. Earnings-based management compensation schemes may be more prevalent in smaller R&D companies, thus creating a preference for accounting methods that can be more easily manipulated (e.g., capitalize R&D). 4. Smaller companies may be more dependent on debt financing. Debt covenants (contractual limitations on debt) could create a preference for accounting methods that can be more easily manipulated (e.g., capitalize R&D).

Communication Case 10–12 Both views, expense and capitalize, can and often are convincingly defended. The process of developing and synthesizing the arguments will likely be more beneficial than just acceptance of the standard. Each student should benefit from participating in the process, interacting first with his or her partner, and then witnessing or participating in a debate on the issue. It is important that each student actively participate in the process of arriving at a consensus argument. Domination by one individual should be discouraged. Arguments supporting the expense view should include the reasons cited by the FASB in FASB ASC 730–10–05. Arguments supporting the capitalize view should include reference to violations to the matching principle for successful R&D projects.

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Communication Case 10–13 Suggested Grading Concepts and Grading Scheme: Content (70%) 20 Defines research and development according to FASB ASC 730. 30

Explains the conceptual reasons for the conclusion reached by the FASB on accounting for R&D. High degree of uncertainty regarding the amount and timing of future benefits. Lack of direct relationship between R&D costs and future revenues.

Describes the treatment of equipment costs. $200,000 should be expensed as R&D. $300,000 should be capitalized and depreciated.

70 points Writing (30%) 6 Terminology and tone appropriate to the audience of a company president. 12

Organization permits ease of understanding. Introduction that states purpose. Paragraphs that separate main points.

English Sentences grammatically clear and well organized, concise. Word selection. Spelling. Grammar and punctuation.

30 points

Target Case Requirement 1 Property and equipment, net = $26,283 million. In its balance sheet, Target lists property and equipment and other noncurrent assets. The largest category of property and equipment is buildings and improvements. Other categories include land, fixtures and equipment, computer hardware and software, and construction-in-process.

Requirement 2 The statement of cash flows reports that $3,027 million was spent in the year ended February 1, 2020, on expenditures for property and equipment. This is an decrease compared to $3,516 million spent in the previous year.

Requirement 3 Advertising costs. Generally retail merchandising companies like Target do not invest significant amounts in research and development. Target attempts to sell products of other companies rather than manufacture its own products for sale. Instead, retail merchandising companies are likely to spend significant amounts on advertising (see Note 5). Similar to research and development, advertising is expensed as incurred (as the advertising occurs). It is difficult to determine whether current advertising benefits future periods. In addition, a direct relationship between current advertising and specific future revenue is difficult to establish.

Requirement 4 The fixed-asset turnover ratio is computed by dividing net sales (revenues) by average fixed assets (normally property and equipment, net of accumulated depreciation). Using 2020 data, the ratio for Target is ($ in millions) $77,130 = 2.98 $25,908* *Average plant and equipment for 2018 = ($26,283 + $25,533) ÷ 2 = $25,908. The ratio is intended to measure a company's effectiveness in managing property, plant, and equipment. It indicates the level of sales generated by the company's investment in these assets. Like any ratio, it is but one piece of a larger puzzle and should not be interpreted in isolation.

Requirement 5 Yes. Target reports goodwill and other intangible assets of $686 million for the year ended February 1, 2020.

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Air France–KLM Case Requirement 1 From Note 4.13: IT development costs are capitalized. IT development costs are amortized over their useful lives.

Requirement 2 IFRS requires development expenditures to be expensed in the period incurred. X IFRS requires research expenditures to be expensed in the period incurred. X Except for software development costs incurred after technological feasibility has been established, U.S. GAAP requires all research and development expenditures to be expensed in the period incurred. Requirement 3 Both U.S. GAAP and IFRS require that donated assets be valued at their fair values. For government grants, though, the way that value is recorded is different under the two sets of standards. Unlike U.S. GAAP, donated assets are not recorded as revenue under IFRS. Instead, government grants must be recognized in income over the periods necessary to match them on a systematic basis with the related costs that they are intended to compensate. For grants related to assets, two alternatives are allowed: 1. Deduct the amount of the grant in determining the initial cost of the asset. 2. Record the grant as a liability, deferred income, in the balance sheet and recognize it in the income statement systematically over the asset‘s useful life.

Chapter 11 Property, Plant, and Equipment and Intangible Assets: Utilization and Disposition QUESTIONS FOR REVIEW OF KEY TOPICS

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Question 11–1 The terms depreciation, depletion, and amortization all refer to the process of allocating the cost of property, plant, and equipment and finite-life intangible assets to periods of use. The only difference between the terms is that they refer to different types of these long-lived assets; depreciation for plant and equipment, depletion for natural resources, and amortization for intangibles.

Question 11– 1218 The term depreciation often is confused with a decline in value or worth of an asset. Depreciation is not measured as a decline in value from one period to the next. Instead, it involves the distribution of the cost of an asset, less any anticipated residual value, over the asset's estimated service life in a systematic and rational manner that attempts to match revenues with the use of the asset.

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Question 11–3 The process of cost allocation for plant and equipment and finite-life intangible assets requires that three factors be established at the time the asset is put into use. These factors are: 1. Service (useful) life—The estimated use that the company expects to receive from the asset. 2. Allocation base—The cost of the asset expected to be consumed during its service life. 3. Allocation method—The pattern in which the allocation base is expected to be consumed.

Question 11– 1220 Physical life provides the upper bound for service life. Physical life will vary according to the purpose for which the asset is acquired and the environment in which it is operated. Service life may be less than physical life for several reasons. For example, the expected rate of technological changes may shorten service life. Management intent also may shorten the period of an asset‘s usefulness below its physical life. For instance, a company may have a policy of using its delivery trucks for a three-year period before trading the trucks for new models.

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Question 11– 1222

The total amount of depreciation to be recorded during an asset‘s service life is called its depreciable base. This amount is the difference between the initial value of the asset at its acquisition (its cost) and its residual value. Residual or salvage value is the amount the company expects to receive for the asset at the end of its service life less any anticipated disposal costs.

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Question 11–6 Activity-based allocation methods estimate service life in terms of some measure of productivity. Periodic depreciation or depletion is then determined based on the actual productivity generated by the asset during the period. Time-based allocation methods estimate service life in years. Periodic depreciation or amortization is then determined based on the passage of time.

Question 11– 1224 The straight-line depreciation method allocates an equal amount of depreciable base to each year of an asset‘s service life. Accelerated depreciation methods allocate higher portions of depreciable base to the early years of the asset‘s life and lower amounts of depreciable base to later years. Total depreciation is the same by either approach.

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Question 11–8 Conceptually, the use of activity-based depreciation methods would provide a better relation between revenues and expenses. Clearly, the productivity of a plant asset is more closely associated with the benefits provided by that asset than the mere passage of time. However, activity-based methods quite often are either infeasible or too costly to use. For example, buildings do not have an identifiable measure of productivity. For assets such as equipment, there may be an identifiable measure of productivity, such as hours or units produced, but it is more costly to determine the amount each period than it is to simply measure the passage of time. For these reasons, most companies use time-based depreciation methods.

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Question 11–9 Companies might use the straight-line method because they consider that the benefits derived from the majority of plant assets are realized approximately evenly over these assets‘ service lives. It also is the easiest method to understand and apply. The effect on net income also could explain why so many companies prefer the straight-line method to the accelerated methods. Straight line produces a higher net income in the early years of an asset‘s life. Net income can affect bonuses paid to management or debt agreements with lenders. Income taxes are not a factor in determining the depreciation method because a company is not required to use the same depreciation method for both financial reporting and income tax purposes.

Question 10–10 Property, plant, and equipment may be disposed of by sale or retirement or abandonment. When an item of property, plant, and equipment is sold, a gain or loss is recognized for the difference between the consideration received and the asset‘s book value. Retirements and abandonments are handled in a similar fashion. The only difference is that there will be no monetary consideration received so there will be a loss if the asset is not fully depreciated. A loss is recorded for the remaining book value of the asset.

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Question 11–11 The group approach to aggregation is applied to a collection of depreciable assets that share similar service lives and other attributes. For example, group depreciation could be used for fleets of vehicles or collections of equipment. The composite approach to aggregation is applied to dissimilar operating assets, such as all of the depreciable assets in one manufacturing plant. Individual assets in the composite may have diverse service lives. Both approaches are similar in that they involve applying a single straight-line rate based on the average service lives of the assets in the group or composite.

Question 1230– 12 The allocation of the cost of a natural resource to periods of use is called depletion. The process otherwise is identical to depreciation. The activity-based unitsof-production method is the predominant method used to calculate depletion, not the time-based straight-line method.

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Question 1232– 12 The amortization of finite-life intangible assets is based on the same concepts as depreciation and depletion. The capitalized cost of an intangible asset that has a finite useful life must be allocated to the periods the company expects the asset to contribute to its revenue-generating activities. Intangibles, though, generally have no residual values, so the amortizable base is simply cost. Also, intangibles possess no physical life to provide an upper bound to service life. However, most intangibles have a legal or contractual life that limits useful life. Intangible assets that have indefinite useful lives, including goodwill, are not amortized.

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Question 11–14 A company can calculate depreciation based on the actual number of days or months the asset was used during the year. A common simplifying convention is to record one-half of a full year‘s expense in the years of acquisition and disposal. This is known as the half-year convention. The modified half-year convention records a full year‘s expense when the asset is acquired in the first half of the year or sold in the second half. No expense is recorded when the asset is acquired in the second half of the year or sold in the first half.

Question 1234– 12 A change in the service life of plant and equipment and finite-life intangible assets is accounted for as a change in an estimate. The change is accounted for prospectively by simply depreciating the remaining depreciable base of the asset (book value at date of change less estimated residual value) over the revised remaining service life.

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Question 11–16 A change in depreciation method is accounted for prospectively by simply depreciating the remaining depreciable base of the asset (book value at date of change less estimated residual value) over the remaining service life using the new depreciation method, exactly as we would account for a change in estimate. One difference is that most changes in estimate do not require a company to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justification as to why the new method is preferable. A disclosure note reports the effect of the change on net income and earnings per share along with clear justification for changing depreciation methods.

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Question 11–17 If a material error is discovered in an accounting period subsequent to the period in which the error is made, previous years‘ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. Any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders‘ equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary items, and earnings per share.

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Question 11–18 Impairment of the value of property, plant, and equipment and intangible assets results when there has been a significant decline in value below book value. For property, plant, and equipment and intangible assets with finite useful lives, GAAP requires an entity to perform a recoverability test to determine if the undiscounted sum of estimated future cash flows from an asset is less than the asset‘s book value. If there is indication of an impairment, then the loss is measured and recognized as the amount by which the book value exceeds the fair value of the asset or group of assets when the fair value is readily determinable. If fair value is not determinable, it must be estimated. One method of estimating fair value is to compute the present value of estimated future cash flows from the asset or group of assets. For intangible assets with indefinite useful lives, if fair value is less than book value, an impairment loss is recognized for the difference. For goodwill, an impairment loss is indicated if the fair value of the reporting unit is less than its book value. For property, plant, and equipment and intangible assets held for sale, an impairment loss is recognized for the amount by which fair value is less than book value.

Question 11–19 Repairs and maintenance are expenditures made to maintain a given level of benefits provided by the asset and do not increase future benefits. Expenditures for these activities should be expensed in the period incurred. Additions involve adding a new major component to an existing asset. These expenditures usually are capitalized. Improvements are expenditures for the replacement of a major component of plant and equipment. The costs of improvements usually are capitalized. Rearrangements are expenditures to restructure plant and equipment without addition, replacement, or improvement. The objective is to create a new capability for the asset and not necessarily to extend useful life. The costs of material rearrangements should be capitalized if they clearly increase future benefits.

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Answers to Questions (concluded)

Question 11– 1242 IFRS allows a company to value property, plant, and equipment (PP&E) and intangible assets subsequent to initial valuation at (1) cost less accumulated depreciation/amortization or (2) fair value (revaluation). If a company chooses revaluation, all assets within a class of PP&E must be revalued on a regular basis. U.S. GAAP prohibits revaluation.

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Question 11–21 Under U.S. GAAP, an impairment loss for property, plant, and equipment and finite-life intangible assets is measured as the difference between book value and fair value. Under IFRS, an impairment loss is measured as the amount by which the recoverable amount is less than book value. The recoverable amount is the higher of the asset‘s fair value less costs to sell and value-in-use (present value of estimated future cash flows).

Question 11– 1244 Under U.S. GAAP, an impairment loss for goodwill is indicated if the fair value of a reporting unit is less than its book value. A reporting unit is an operating segment of a company or a component of an operating segment for which discrete financial information is available and segment management regularly reviews the operating results of that component. If goodwill is tested for impairment at the same time as other assets of the reporting unit, the other assets must be tested first and any impairment loss and asset write-down is recorded prior to testing goodwill. Under IFRS, the measurement of an impairment loss for goodwill is determined by comparing the recoverable amount of the cash-generating unit to book value. A cash-generating unit is the lowest level at which goodwill is monitored by management, which cannot be lower than a segment. If the recoverable amount is less, reduce goodwill first, then other assets. The recoverable amount is the higher of fair value less costs to sell and value-in-use (present value of estimated future cash flows).

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Question 11–23 Under IFRS, litigation costs to successfully defend an intangible right are expensed, except in rare situations when the expenditure increases future benefits.

BRIEF EXERCISES Brief Exercise 11–1 No. Depreciation is a process of cost allocation, not valuation. Koeplin should not record depreciation of $18,000 for year one of the equipment‘s life. Instead, it should distribute the cost of the asset, less any anticipated residual value, over the estimated service life in a systematic and rational manner that attempts to match revenues with the use of the asset, not the periodic decline in its value.

Brief Exercise 11–2 1. Straight-line: $30,000 – $2,000 = $7,000 per year 4 years 2. Double-declining balance: Straight-line rate is 25% (1 ÷ 4 years) × 2

= 50% DDB rate

2024 2025

= $15,000 = $ 7,500

$30,000 × 50% ($30,000 – $15,000) × 50%

3. Units-of-production: $30,000 – $2,000 = $2.80 per hour depreciation rate 10,000 hours 2024 2025

2,200 hours × $2.80 = $6,160 3,000 hours × $2.80 = $8,400

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Brief Exercise 11–3 1. Straight-line: $30,000 – $2,000 = $7,000 per year 4 years 2024 2025

$7,000 × 9/12 $7,000 × 12/12

= =

$5,250 $7,000

2. Double-declining balance: Straight-line rate is 25% (1 ÷ 4 years) × 2

= 50% DDB rate

2024

$30,000 × 50% × 9/12

= $11,250

2025

($30,000 – $11,250) × 50%

= $ 9,375

3. Units-of-production: $30,000 – $2,000 = $2.80 per hour depreciation rate 10,000 hours 2024 2025

2,200 hours × $2.80 = $6,160 3,000 hours × $2.80 = $8,400

Because the units-of-production method is not based on when the asset was acquired, but rather based on hours used, the calculation of depreciation each year is not affected by whether the equipment was purchased at the beginning of the year or during the year.

Brief Exercise 11–4 1. January 1: Sum-of-the-digits is ([4 (4 + 1)] ÷ 2) = 10 2024 2025

$28,000 × 4/10 $28,000 × 3/10

= $11,200 = $ 8,400

2. March 31: Sum-of-the-digits is ([4 (4 + 1)] ÷ 2) = 10 2024

$28,000 × 4/10 × 9/12

$8,400

2025

$28,000 × 4/10 × 3/12 + $28,000 × 3/10 × 9/12

= =

$2,800 $6,300 $9,100

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Brief Exercise 11–5 Selling price (cash received) Less: Book value of equipment Original cost Accumulated depreciation Gain on sale of equipment

$16,000 $80,000 (71,000)

(9,000) $ 7,000

Journal entry (not required): Cash ................................................................. 16,000 Accumulated depreciation (account balance) ... 71,000 Gain on sale of equipment (selling price – book value) Equipment (account balance) ....................... 80,000

7,000

Brief Exercise 11–6 (1) Cash ................................................................. 3,000 Accumulated depreciation—tractor (account balance) 26,000 Loss on sale of tractor (selling price – book value) 1,000 Tractor (account balance) ............................. 30,000

(2) Cash ................................................................. 10,000 Accumulated depreciation—tractor (account balance) 26,000 Tractor (account balance)............................. 30,000 Gain on sale of tractor (selling price – book value) 6,000

Notice that no matter how much the asset is sold for, the same amounts are removed from the books for the account balance of the asset and its accumulated depreciation.

Brief Exercise 11–7 (1) To record the sale of the patent. July 15, 2024 Cash ................................................................... 750,000 Patent (account balance)............................... 120,000 Gain on sale of patent (selling price – book value) 630,000

Selling price (cash received) Less: Book value of patent

$750,000 (120,000)

Gain on sale of patent

$630,000

(2) To record the sale of equipment. July 15, 2024 Cash ................................................................... 325,000 Accumulated depreciation – equipment (account balance) 150,000 Loss on sale of equipment (selling price – book value) 75,000 Equipment (account balance) ...................... 550,000 Selling price (cash received) Less: Book value of equipment Original cost Accumulated depreciation

Loss on sale of equipment

$325,000 $550,000 (150,000)

(400,000)

$(75,000)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 11–8 Assets held for sale are reported at the lower of book value or fair value. The building will be reported in the balance sheet for its lower book value of $800,000, and the equipment will be reported in the balance sheet for its lower fair value of $200,000. A loss is reported when fair value is less than book value. The equipment will result in a loss of $40,000 ($200,000 fair value − $240,000 book value). No gain is recognized on the building until sold.

Brief Exercise 11–9 (1) Annual depreciation will equal the group rate multiplied by the original cost of the group: $425,000 × 18% = $76,500 (2) Since depreciation records are not kept on an individual asset basis, dispositions are recorded under the assumption that the book value of the disposed item exactly equals any proceeds received and no gain or loss is recorded. Any actual gain or loss is implicitly included in the accumulated depreciation account. Journal entry (not required): Cash ................................................................. Accumulated depreciation (difference) ............ Equipment (account balance) .......................

35,000 7,000 42,000

Brief Exercise 11–10 $8,250,000 Depletion per foot

= $2.75 per foot 3,000,000 cubic feet

Year 1 depletion Year 2 depletion

= $2.75 × 700,000 feet = $2.75 × 800,000 feet

= $1,925,000 = $2,200,000

Brief Exercise 11–11 Expenses for the year include: Amortization of the patent † Amortization of the developed technology* Total

= =

$400,000 300,000 $700,000

Goodwill is not amortized. A trademark is not amortized. †

Amortization of the patent: ($4,000,000  5) × 6/12

$400,000

*Amortization of the developed technology: ($3,000,000  5) × 6/12 = $300,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 11–12 (1) .................................................................... Research and development expense .................. 4,000,000 Software development costs ............................. 2,000,000 Cash ............................................................ 6,000,000

(2) (1) Percentage-of-revenue method: $3,000,000 = 30% × $2,000,000 = $600,000 $10,000,000 (2) Straight-line method: 1/5 or 20% × $2,000,000 = $400,000. The percentage-of-revenue method is used since it produces the greater amortization, $600,000.

(3)

Software development costs Less: Amortization to date Net amount reported in balance sheet

$2,000,000 (600,000) $1,400,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 11–13 (1) 2024:................................................................ Research and development expense .................. 2,200,000 Cash ............................................................ 2,200,000

2025:................................................................ Research and development expense .................... 800,000 Software development costs ............................... 300,000 Cash ............................................................ 1,100,000

(2) (1) Percentage-of-revenue method: $1,000,000 = 20% × $300,000 = $60,000 $5,000,000 (2) Straight-line method: 1/4 or 25% × $300,000 × 8/12 = $50,000. The percentage-of-revenue method is used since it produces the greater amount of amortization, $60,000.

Brief Exercise 11–14 Calculation of annual depreciation after the estimate change: $9,000,000 $320,000 × 2 years

Cost Previous annual depreciation ($8 million ÷ 25 years) (640,000) Less: Depreciation to date (2022–2023) 8,360,000 Undepreciated cost (500,000) Less: Revised residual value 7,860,000 Revised depreciable base  18 Estimated remaining life – 18 years (20 – 2) $ 436,667 2024 depreciation

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 11–15 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company‘s knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Robotics reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the double-declining-balance method from now on. The undepreciated cost remaining at the time of the change would be depreciated DDB over the remaining service life. A disclosure note should justify that the change is preferable and should describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported.

Asset‘s cost Less: Accumulated depreciation to date* Undepreciated cost, Jan. 1, 2024

$9,000,000 (640,000) $8,360,000 × 2/23 †

Double-declining balance depreciation for 2024

$ 726,957

*$8,000,000 ÷ 25 = $320,000 × 2 years = $640,000 †

Remaining life is 23 years. Twice the straight-line rate is 2/23.

Brief Exercise 11–14 (1) If a material error is discovered in an accounting period subsequent to the period in which the error is made, previous years‘ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. Any account balances that are incorrect as a result of the error are corrected by a journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders‘ equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income from continuing operations, and earnings per share. In this case, depreciation of $32,000 should have been $320,000 ($8,000,000  25 years). Therefore, 2022 income before tax is overstated by $288,000 ($320,000 – 32,000) and accumulated depreciation is understated by the same amount. The following journal entry is needed in 2024 to correct the error (ignoring income tax): Retained earnings ............................................... 288,000 Accumulated depreciation ........................... 288,000 (2) Depreciation for 2024 would be $320,000.

Brief Exercise 11–17 Recoverability test: Because the undiscounted sum of future cash flows of $28 million exceeds book value of $26.5 million, there is no impairment loss to measure.

Brief Exercise 11–18 Recoverability test: Because the undiscounted sum of future cash flows of $24 million is less than book value of $26.5 million, there is an impairment loss. Measurement: The impairment loss is calculated as follows:

Fair value Book value Impairment loss

$21.0 million 26.5 million $(5.5) million

Brief Exercise 11–19

Complete Solution Manual for Intermediate Accounting, 11th Edition Under IFRS, the impairment loss is the difference between book value and the recoverable amount. The recoverable amount is $22 million, the higher of the value-in-use of $22 million (present value of estimated future cash flows) and the $21 million fair value less costs to sell.

Recoverable amount Book value Impairment loss

$22.0 million 26.5 million $(4.5) million

Brief Exercise 11–20 Fair value of SCC Less: Book value of SCC Impairment loss

$40 million 42 million $(2) million

Brief Exercise 11–21 Because SCC‘s fair value of $44 million is greater than the book value of SCC‘s net assets of $42 million, there is no impairment loss indicated.

Brief Exercise 11–22 Under IFRS, the impairment loss is the difference between book value and the recoverable amount of the cash-generating unit. The recoverable amount is $41 million, the higher of the $41 million value-in-use (present value of estimated future cash flows) and the $40 million fair value less costs to sell.

Recoverable amount Book value Impairment loss

$41 million 42 million $(1) million

Brief Exercise 11–23 Annual maintenance on equipment, $5,400—This is an example of normal repairs and maintenance. Future benefits are not increased; therefore, the expenditure should be expensed in the period incurred. Remodeling of offices, $22,000—This is an example of an improvement. The cost of the remodeling should be capitalized and depreciated, either by (1) substitution, (2) direct capitalization of the cost, or (3) a reduction of accumulated depreciation. Rearrangement of the shipping and receiving area, $35,000—This is an example of a rearrangement. Because the rearrangement increased productivity, the cost should be capitalized and depreciated. Addition of a security system, $25,000—This is an example of an addition. The cost of the security system should be capitalized and depreciated.

Complete Solution Manual for Intermediate Accounting, 11th Edition

EXERCISES Exercise 11–1 1. Straight-line: $33,000 – $3,000 = $6,000 per year 5 years 2. Double-declining balance: Straight-line rate of 20% (1 ÷ 5 years) × 2 = 40% DDB rate.

Year 2024 2025 2026 2027 2028 Total

Book Value Beginning of Year X $33,000 19,800 11,880 7,128 4,277

Depreciation Rate per Year = 40% 40% 40% 40%

Depreciation $ 13,200 7,920 4,752 2,851 1,277* $30,000

Book Value End of Year $19,800 11,880 7,128 4,277 3,000

* Amount necessary to reduce book value to residual value

Exercise 11–1 (concluded)

3. Units-of-production: $33,000 – $3,000 = $0.30 per mile depreciation rate 100,000 miles

Year 2024 2025 2026 2027 2028 Totals

Actual Miles Driven X 22,000 24,000 15,000 20,000 21,000 102,000

Depreciation Rate per Mile = $0.30 0.30 0.30 0.30

Depreciation $ 6,600 7,200 4,500 6,000 5,700* $30,000

Book Value End of Year $26,400 19,200 14,700 8,700 3,000

* Amount necessary to reduce book value to residual value

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–2 1. Straight-line: $115,000 – $5,000 = $11,000 per year 10 years 2. Double-declining balance: Straight-line rate is 10% (1 ÷ 10 years) × 2

= 20% DDB rate

2024 2025

= $23,000 = $18,400

$115,000 × 20% ($115,000 – $23,000) × 20%

3. Units-of-production: $115,000 – $5,000 = $0.50 per unit depreciation rate 220,000 units 2024 2025

30,000 units × $0.50 = $15,000 25,000 units × $0.50 = $12,500

Exercise 11–11 1. Straight-line: $115,000 – $5,000 = $11,000 per year 10 years 2024 2025

$11,000 × 3/12 $11,000 × 12/12

= =

$ 2,750 $11,000

2. Double-declining balance: Straight-line rate is 10% (1 ÷ 10 years) × 2

= 20% DDB rate

2024 2025

= =

$115,000 × 20% × 3/12 ($115,000 – $5,750) × 20%

$ 5,750 $21,850

3. Units-of-production: $115,000 – $5,000 = $0.50 per unit depreciation rate 220,000 units 2024 2025

10,000 units × $0.50 = $ 5,000 25,000 units × $0.50 = $12,500

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–4 1. Sum-of-the-years’ digits: Sum-of-the-digits is ([10 (10 + 1)] ÷ 2) = 55 2024 2025

$110,000 × 10/55 $110,000 × 9/55

= $20,000 = $18,000

2. One hundred fifty percent declining balance: Straight-line rate is 10% (1 ÷ 10 years) × 1.5

= 15% rate

2024 2025

= $17,250 = $14,663

$115,000 × 15% ($115,000 – 17,250) × 15%

3. Sum-of-the-years’ digits: Sum-of-the-digits is {[10 (10 + 1)]/2} = 55 2024

$110,000 × 10/55 × 3/12

= $ 5,000

2025

$110,000 × 10/55 × 9/12 + $110,000 × 9/55 × 3/12

= $15,000 = 4,500 $19,500

One hundred fifty percent declining balance: Straight-line rate is 10% (1 ÷ 10 years) × 1.5

= 15% rate

2024

$115,000 × 15% × 3/12

$ 4,313

2025

($115,000 – $4,313) × 15%

$16,603

Exercise 11–11 Building depreciation: $5,000,000 – $200,000 = $160,000 per year 30 years Building addition depreciation: Remaining service life from June 30, 2024, is 27.5 years. $1,650,000 = $60,000 per year 27.5 years 2024 $60,000 × 6/12 = $30,000 2025 $60,000 × 12/12 = $60,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–6 Asset A: Straight-line rate is 20% (1 ÷ 5 years) × 2 = 40% DDB rate $24,000 = $60,000 = Book value at the beginning of year 2 0.40 Cost – (Cost × 40%) = $60,000 60% × Cost = $60,000 Cost = $100,000 Asset B: ($40,000 – residual) × 1/8 = $4,500 ($40,000 – residual) = $36,000 Residual =

$4,000

Asset C: $65,000 – $5,000 = $6,000 Life Life = 10 years Asset D: $230,000 – $10,000 = $220,000 depreciable base $220,000 ÷ 10 years = $22,000 per year Method used is straight line. Asset E: Straight-line rate is 12.5% (1 ÷ 8 years) × 2

= 25% rate

Year 1 $200,000 × 25% Year 2 ($200,000 – $50,000) × 25% =

= $50,000 $37,500

Exercise 11–11 Requirement 1 Building depreciation: $8,000,000* – $800,000** = $240,000 per year 30 years *$12,000,000 total × 2/3 for building cost **$8,000,000 × 10% 2024: $240,000 × 9/12 = $180,000 2025: $240,000 Furniture and fixtures depreciation: 1/10 or 10% (the straight-line rate) × 2

= 20% DDB rate

2024: $1,200,000 × 20% × 9/12 2025: ($1,200,000 – $180,000) × 20%

= $180,000 = $204,000

Office equipment depreciation: 1/5 or 20% (the straight-line rate) × 2

= 40% DDB rate

2024: $700,000 × 40% × 9/12 2025: ($700,000 – $210,000) × 40%

= $210,000 = $196,000

Requirement 2 Book values on December 31, 2025: Land $4,000,000 (1/3 of purchase price; no depreciation) Building $7,580,000 (= $8,000,000 − $180,000 − $240,000) Furniture and fixtures $816,000 (= $1,200,000 − $180,000 − $204,000) Office equipment $294,000 (= $700,000 − $210,000 − $196,000)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–8 Requirement 1 U.S. GAAP: 2024: 2025:

$120,000  8 = $15,000 × 6/12 $120,000  8 =

= $ 7,500 $15,000

Equipment: $100,000  8 = $12,500 × 6/12 =

$6,250

Requirement 2 IFRS: 2024:

Drill: $ 20,000  4 = $5,000 × 6/12 Total 2025:

2,500 $8,750

Equipment: $100,000  8 = $12,500 Drill: $ 20,000  4 = 5,000 Total $17,500

Exercise 11–11 Requirement 1 Depreciation for 2024: $240,000  6 = $40,000 × 9/12 = $30,000

Requirement 2 ($ in thousands) Equipment Accumulated depreciation Book value

Before Revaluation $240,000 × 30,000 × $210,000 ×

After Revaluation 220/210 = $251,429 220/210 = 31,429 220/210 = $220,000

Equipment ($251,429 – $240,000) Accumulated depreciation ($31,429 – $30,000) Revaluation surplus–OCI ($220,000 – $210,000)

11,429 1,429 10,000

Requirement 3 Depreciation for 2025: $220,000  5.25 years = $41,905

Requirement 4

Equipment Accumulated depreciation Book value

Before After Revaluation Revaluation $240,000 × 195/210 = $222,857 30,000 × 195/210 = 27,857 $210,000 × 195/210 = $195,000

Revaluation expense* ($210,000 – $195,000)15,000 Accumulated depreciation ($30,000 – $27,857) Equipment ($240,000 – $222,857)

2,143 17,143

*If a revaluation surplus account relating to the same asset had existed, that account would have been debited up to the amount of its balance before debiting revaluation expense.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–10 Requirement 1 * Depreciation per unit = ($400,000 – $50,000) ÷ 700,000 units = $0.50. Accumulated depreciation 2022-2024 = 340,000 units × $0.50 = $170,000. Selling price (cash received) Less: Book value of equipment Original cost Accumulated depreciation*

$ 210,000 $400,000 (170,000)

Loss on sale of equipment Requirement 2

(230,000)

$ (20,000)

Cash ................................................................... 210,000 Accumulated depreciation—equipment (account balance) 170,000* Loss on sale of equipment (selling price – book value) 20,000 Equipment (account balance) ....................... 400,000

Requirement 3 Selling price (cash received) Less book value of equipment: Original cost Accumulated depreciation Gain on sale of equipment Requirement 4

$ 245,000 $400,000 (170,000)

(230,000) $ 15,000

Cash ................................................................... 245,000 Accumulated depreciation—equipment (account balance) 170,000* Equipment (account balance) ....................... 400,000 Gain on sale of equipment (selling price – book value) 15,000

Exercise 11–11 Depreciation = ($126,000 − $30,000) ÷ 8 years = $12,000/year or $1,000/month Requirement 1 To update depreciation in 2024; 2 months of service to date of disposal. Depreciation expense .............................................. 2,000 Accumulated depreciation ............................

2,000

Requirement 2 Selling price (cash received) Less: Book value of equipment: Original cost Accumulated depreciation* Loss on sale of equipment

$ 58,000 $126,000 ( 56,000)

(70,000) $(12,000)

* July 1, 2019 to March 1, 2024 = 6 months (2019) + 48 months (2020-2023) + 2 months (2024) = 56 months Total accumulated depreciation = 56 months × $1,000 = $56,000.

To record the sale of the truck. Cash ................................................................ 58,000 Loss on sale of truck (selling price – book value) 12,000 Accumulated Depreciation (account balance) ... 56,000 126,000 Truck (account balance) ...............................

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 11–11 (continued) Requirement 3 Selling price (cash received) Less: Book value of equipment Original cost Accumulated depreciation Gain on sale of equipment

$ 80,000 $126,000 (56,000)

(70,000) $ 10,000

To record the sale of the truck. Cash ..................................................................... 80,000 Accumulated Depreciation (account balance) ....... 56,000 Truck (account balance) ............................... 126,000 Gain on sale of truck (selling price – book value) 10,000

Exercise 11–12 Requirement 1 Selling price (cash received) Less: Book value of equipment Original cost Accumulated depreciation Loss on sale of equipment

$170,000 $800,000 (562,500)*

237,500 $ (67,500)

*Annual depreciation = ($800,000 – $50,000) / 5 years = $150,000/year 2020 2021 2022 2023 2024 Total

$150,000 × 1/2 =

$ 75,000 150,000 150,000 150,000 $150,000 × 1/4 = 37,500 $562,500

Cash ................................................................... 170,000 Accumulated depreciation—equipment (above) 562,500 Loss on sale of equipment (selling price – book value) 67,500 Equipment (balance) ................................... 800,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–12 (concluded) Requirement 2 Cash ................................................................. 170,000 Accumulated depreciation—equipment (below) 675,584 Gain on sale (selling price – book value)...... 45,584 Equipment (balance) .................................... 800,000

Accumulated depreciation: 2020

$800,000 × 2/5 × 6/12 =

$160,000

2021

$640,000 × 2/5 =

256,000

2022

$384,000 × 2/5 =

153,600

2023

$230,400 × 2/5 =

92,160

2024

$138,240 × 2/5 × 3/12 = Total

Selling price (cash received) Less book value of equipment: Original cost Accumulated depreciation

Gain on sale of equipment

13,824 $675,584 $170,000 $ 800,000 (675,584)

124,416

$ 45,584

Exercise 11– 1276 Requirement 1 Straight-line depreciation: $260,000 – $20,000 = $40,000 per year 6 years 2022 2023 2024

$40,000 × 3/12

= $40,000 = $40,000 = $10,000 $90,000

Book value as of March 31, 2024 = $260,000 − $90,000 = $170,000 Requirement 2 The equipment would be reported for the lower of book value ($170,000) or fair value ($150,000). In this case, the fair value of $150,000 is lower. The entry to record the loss is (not required): Loss on asset held for sale Accumulated depreciation Equipment

20,000 90,000 110,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–14 Requirement 1

Asset Stoves Refrigerators Dishwashers Totals

Cost $15,000 10,000 8,000 $33,000

Residual Value $3,000 1,000 500 $4,500

Depreciable Base $12,000 9,000 7,500 $28,500

Estimated Life(yrs.) 6 5 4

Depreciation per Year (straight line) $2,000 1,800 1,875 $5,675

$5,675 Group depreciation rate =

= 17.2% (rounded) $33,000

Group life

$28,500 = 5.02 years (rounded) $5,675

Requirement 2 To record the purchase of new refrigerators. Refrigerators .................................................... Cash ............................................................

2,700 2,700

To record the sale of old refrigerators. Cash ................................................................. Accumulated depreciation (difference) ............. Refrigerators................................................

200 1,300 1,500

Exercise 11– 1278

Requirement 1 Capitalized cost of the equipment: Purchase price $154,000 Freight charges 2,000 Installation charges 4,000 Capitalized cost $160,000 Straight-line rate of 12.5% (1 ÷ 8 years) × 2 = 25% DDB rate.

Year 2024 2025 2026 2027 2028 2029 2030 2031 Total

Book Value Depreciation Beginning × Rate per Year = of Year $160,000 25% 120,000 25% 90,000 25% 67,500 25% 50,625 * 45,625 * 40,625 * 35,625 *

Depreciation $ 40,000 30,000 22,500 16,875 5,000 5,000 5,000 5,000 $129,375

Book Value End of Year $120,000 90,000 67,500 50,625 45,625 40,625 35,625 30,625

* Switch to straight line in 2028: ($50,625 – $30,625) / 4 years = $5,000 / year Requirement 2 Prospectively. Generally accepted accounting principles allow a company to change from one depreciation method to another if the company can justify the change. For example, new information might become available to suggest that a different depreciation method would better represent the pattern of the asset‘s consumption relative to revenue production. We account for these changes prospectively.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–16 Requirement 1 $4,500,000 Depletion per ton

= $5.00 per ton 900,000 tons

2024 depletion Requirement 2

= $5.00 × 240,000 tons

= $1,200,000

Yes. Depletion is part of product cost and is included in the cost of the inventory of copper, just as the depreciation on manufacturing equipment is included in inventory cost. The depletion is then included in cost of goods sold in the income statement when the copper is sold.

Exercise 11–17 Timber tract: $3,200,000 – $600,000 = $0.52 per board foot 5,000,000 board feet 500,000 × $0.52 = $260,000 depletion Logging roads: $240,000  5,000,000 board feet = $0.048 per board foot 500,000 × $0.048 = $24,000 depreciation

Exercise 11–18 Requirement 1 Cost of copper mine: Mining site $1,000,000 Development costs 600,000 † Restoration costs 303,939 $1,903,939 †

$300,000 × 25% = 400,000 × 40% = 600,000 × 35% =

$ 75,000 160,000 210,000 $445,000 × .68301* = $303,939

*Present value of $1, n = 4, i = 10% (Table 2)

Depletion: $1,903,939 Depletion per pound =

= $0.1904 per pound 10,000,000 pounds

2024 depletion 2025 depletion

= $0.1904 × 1,600,000 pounds = $304,640 = $0.1904 × 3,000,000 pounds = $571,200

Depreciation: $120,000 – 20,000 Depreciation per pound =

= $0.01 per pound 10,000,000 pounds

2024 depreciation = $0.01 × 1,600,000 pounds = $16,000 2025 depreciation = $0.01 × 3,000,000 pounds = $30,000 Requirement 2 Depletion of natural resources and depreciation of assets used in the extraction of natural resources are part of product cost and are included in the cost of the inventory of copper, just as the depreciation on manufacturing equipment is included in inventory cost. The depletion and depreciation are then included in cost of goods sold in the income statement when the copper is sold.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–19 Requirement 1 a. To record the purchase of a patent. January 1, 2022 Patent ................................................................. 700,000 Cash ............................................................ 700,000

To record amortization on the patent. December 31, 2022 and 2023 Amortization expense ($700,000 ÷ 10 years) ........ 70,000 Patent........................................................... 70,000

b. To record the purchase of a franchise. 2024 Franchise ............................................................ 500,000 Cash ............................................................ 500,000

c. To record research and development expenses. 2024 Research and development expense .................... 380,000 Cash ............................................................ 380,000

Exercise 11–19 (concluded) 2024 Year-end adjusting entries Patent: To record amortization on the patent after change in useful life. December 31, 2024 Amortization expense (determined below) .......... 112,000 Patent........................................................... 112,000

Calculation of annual amortization after the estimate change: ($ in thousands) $700 $70 × 2 years

( 140 ) 560 ÷ 5 $112

Cost Previous annual amortization ($700 ÷ 10 years) Less: Amortization to date (2022–2023) Unamortized cost (balance in the patent account) Estimated remaining life New annual amortization

Franchise: To record amortization of franchise. December 31, 2024 Amortization expense ($500,000 ÷ 10 years) ........ 50,000 Franchise...................................................... 50,000

Requirement 2 Intangible assets: Patent Franchise Total intangibles

$448,000 [1] 450,000 [2] $898,000

[1] $560,000 – 112,000 [2] $500,000 – 50,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–20 To record the purchase of the patent. January 2, 2024 Patent ................................................................. 500,000 Cash ............................................................ 500,000

To record amortization of the patent for the year 2024. Amortization expense ($500,000 ÷ 8 years) .......... 62,500 Patent........................................................... 62,500

To record amortization of the patent for the year 2025. Amortization expense ($500,000 ÷ 8 years) .......... 62,500 Patent........................................................... 62,500

To record costs of successfully defending the patent infringement suit. January, 2026 Patent ................................................................... 45,000 Cash ............................................................ 45,000

Exercise 11–20 (concluded) To record amortization of the patent for the year 2026. Amortization expense (determined below) ............ 70,000 Patent........................................................... 70,000

Calculation of revised annual amortization: ($ in thousands) $500 Cost $62.5 Previous annual amortization ($500 ÷ 8 years) × 2 years ( 125) Less: Amortization to date (2024–2025) 375 Unamortized cost (balance in the patent account) 45 Add: Legal fees of successful defense 420 New unamortized cost ÷ 6 Estimated remaining life (8 years – 2 years) $ 70 New annual amortization

Exercise 11–21 Adjustment of amortization expense to reflect change in useful life. .................................................................... Amortization expense (determined below) ........ Patent...........................................................

($ in millions) 2.5 2.5

Calculation of annual amortization after the estimate change: $ in millions) $9 Cost $1 Previous annual amortization ($9 ÷ 9 years) × 4 years ( 4) Less: Amortization to date (2020–2023) 5 Unamortized cost (balance in the patent account) ÷ 2 Estimated remaining life (6 years – 4 years) $2.5 New annual amortization

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–22 Requirement 1 2024 amortization: $1,200,000 ÷ 10 = $120,000 × 6/12 = $60,000

Requirement 2 Franchise ($1,180,000 – [$1,200,000 – $60,000])…… Revaluation surplus–OCI…………………….

40,000 40,000

Requirement 3 2025 amortization: $1,180,000 ÷ 9.5 = $124,211

Exercise 11– 1286 Requirement 1 Depreciation expense (determined below) ............... 3,088 Accumulated depreciation—computer..........

3,088

Calculation of annual depreciation after the estimate change: $40,000 $7,200 × 2 years

(14,400) 25,600 ( 900) 24,700 ÷8 $ 3,088

Cost Previous annual depreciation ($36,000 ÷ 5 years) Less: Depreciation to date (2022–2023) Undepreciated cost Less: Revised residual value Revised depreciable base Estimated remaining life (10 years – 2 years) New annual depreciation

Requirement 2 Depreciation expense (determined below) ............... 3,600 Accumulated depreciation—computer..........

3,600

Calculation of annual depreciation after the estimate change: $40,000 $16,000 9,600 (25,600) 14,400 × 2/8 $ 3,600

Cost Previous depreciation: 2022 – ($40,000 × 20% × 2) 2023 – ($24,000 × 20% × 2) Less: Depreciation to date (2022–2023) Undepreciated cost Estimated remaining life – 8 years 2024 depreciation

Exercise 11–24 DDB depreciation 2022: $1,500,000 × 2/10 = 2023: ($1,500,000 – $300,000) × 2/10 =

$300,000 $240,000

Complete Solution Manual for Intermediate Accounting, 11th Edition $540,000 $1,500,000 ( 540,000) 960,000 ( 300,000) 660,000 ÷ 8 yrs. $ 82,500

Cost Less: Depreciation to date, DDB (2022–2023) Undepreciated cost as of 1/1/2024 Less: Residual value Depreciable base Remaining life (10 years – 2 years) New annual depreciation

Adjusting entry (2024 depreciation): ................................................................................................................................................................................................................................

Depreciation expense (calculated above) .............. 82,500 Accumulated depreciation............................ 82,500

Exercise 11– 1288 Requirement 1 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company‘s knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Clinton reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change would be depreciated straight line over the remaining useful life. A disclosure note should justify that the change is preferable and should describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Requirement 2

Asset‘s cost

$2,560,000

Less: Accumulated depreciation to date (given) (1,801,000) Undepreciated cost, Jan. 1, 2024

$ 759,000

Less: Estimated residual value

(160,000)

To be depreciated over remaining 3 years

$ 599,000 ÷ 3 years

Annual straight-line depreciation 2024–2026

$ 199,667 (rounded)

Journal entry: Depreciation expense (calculated above) ................... Accumulated depreciation ....................................

199,667 199,667

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–26 Requirement 1 Analysis: Correct (Should Have Been Recorded) 2021 Equipment Cash

350,000

2021 Expense Accum. deprec.

70,000

2022 Expense Accum. deprec.

70,000

2023 Expense Accum. deprec.

70,000

Incorrect (As Recorded)

350,000

Expense Cash

350,000 350,000

Depreciation entry omitted 70,000 Depreciation entry omitted 70,000 Depreciation entry omitted 70,000

Over the three-year period, depreciation expense was understated by $210,000, but other expenses were overstated by $350,000. This means that net income over the three-year period from 2021 through 2023 is understated by $140,000, which means retained earnings is understated by $140,000 by the end of 2023.

Requirement 2 To correct incorrect accounts in 2024 (before adjusting entries) Equipment .................................................................... 350,000 Accumulated depreciation ($70,000 × 3 years).......... Retained earnings ($350,000 – $210,000) .................

210,000 140,000

Requirement 3 Correcting entry in 2026: Assuming the equipment had been disposed of, no correcting entry would be required because, after five years, the accounts would show appropriate balances.

Exercise 11– 1290 Recoverability Requirement 1 test: Because the undiscounted sum of future cash flows of $4.0 million is less than book value of $6.5 million, there is an impairment loss. Measurement: The impairment loss is calculated as follows:

Fair value Book value Impairment loss

$ 3.5 million 6.5 million $(3.0) million

Requirement 2 Book value = $3.5 million* * ($6.5 million − $3.0 million impairment loss; this amount equals the assets‘ fair value)

Requirement 3 Because the undiscounted sum of future cash flows of $6.8 million exceeds book value of $6.5 million, there is no impairment loss. The reported amount of the assets remains at their book value of $6.5 million.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–28 Requirement 1 IFRS requires an impairment loss to be recognized when an asset‘s book value exceeds the higher of the asset‘s value-in-use (present value of estimated future cash flows) and fair value less costs to sell. In this case, value-in-use and fair value less costs to sell are the same, $3.5 million. Because book value ($6.5 million) exceeds this amount, a loss is indicated. The loss is the difference between book value and the recoverable amount, which also is the higher of the asset‘s value-in-use (present value of estimated future cash flows) and fair value less costs to sell. Therefore, the amount of impairment loss is the same as under U.S. GAAP, $3 million. Recoverable amount Book value Impairment loss

$ 3.5 million (6.5) million $(3.0) million

Requirement 2 An impairment loss also is indicated because book value ($6.5 million) exceeds fair value less costs to sell/value-in-use ($5 million). The amount of impairment loss is $1.5 million.

Recoverable amount Book value Impairment loss

$ 5.0 million (6.5) million $(1.5) million

Under U.S. GAAP, because the undiscounted sum of future cash flows of $6.8 million exceeds book value of $6.5 million, there is no impairment loss.

Exercise 11– 1292 IFRS requires Requirement 1 an impairment loss to be recognized when an asset‘s book value exceeds the higher of the asset‘s value-in-use (present value of estimated future cash flows) and fair value less costs to sell. In this case, value-in-use of £150 million is higher. Because the value-in-use amount is less than book value (£220 million), a loss is indicated. The loss is the difference between book value and the recoverable amount, which also is the higher of the asset‘s value-in-use (present value of estimated future cash flows) and fair value less costs to sell. The amount of impairment loss is £70 million. Recoverable amount Book value Impairment loss

£150 million 220 million £ (70) million

Requirement 2 U.S. GAAP requires an impairment loss to be recognized when an asset‘s book value exceeds the undiscounted sum of estimated future cash flows. In this case, a loss is indicated because the undiscounted sum of estimated future cash flows of £210 million is less than the book value of £220 million. The loss is the difference between fair value and book value, or $75 million in this case.

Fair value Book value Impairment loss

£145 million 220 million £ (75) million

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–30 Requirement 1 Recoverability test: An impairment loss is indicated because the estimated undiscounted sum of future cash flows of $15 million is less than the book value of $18.3 million. Measurement: The amount of the loss to be reported is calculated using the estimated fair value rather than the undiscounted future cash flows:

Fair value Book value Impairment loss Requirement 2

$11.0 million 18.3 million $ (7.3) million

($ in millions) Loss on impairment ...................................................... Accumulated depreciation ............................................ Plant assets ...............................................................

7.3 14.2 21.5

Requirement 3 Recoverability test: An impairment loss is indicated because the estimated undiscounted sum of future cash flows of $12 million is less than the book value of $18.3 million. Measurement: The amount of the loss to be reported is calculated using the estimated fair value rather than the undiscounted future cash flows:

Fair value $11.0 million Book value ............................................. 18.3 million Impairment loss $ (7.3) million Requirement 4 Recoverability test: Because the estimated undiscounted sum of future cash flows of $19 million exceeds the book value of $18.3 million, no impairment loss is indicated.

Exercise 11–31 Requirement 1 Measurement of impairment loss: Fair value of Centerpoint, Inc. Book value of Centerpoint, Inc. Impairment loss

$220 million 250 million $(30) million

Requirement 2 Goodwill = $20 million* * ($50 million − $30 million impairment loss)

Requirement 3 Because the fair value of the reporting unit, $270 million, exceeds book value, $250 million, there is no impairment loss. The reported amount of goodwill remains at $50 million.

Exercise 11–32 Under IFRS, the impairment loss is the difference between book value and the recoverable amount of the cash-generating unit. The recoverable amount is $225 million, the higher of the $225 million value-in-use (present value of estimated future cash flows) and the $220 million fair value less costs to sell.

Recoverable amount Book value Impairment loss

$225 million 250 million $ (25) million

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–33 Requirement 1 Calculation of goodwill: Consideration exchanged Less fair value of identifiable net assets: Assets Less: Liabilities assumed Goodwill Requirement 2 Measurement of impairment loss: Fair value of Harman, Inc. Book value of Harman, Inc. (including goodwill) Impairment loss

$420 million $512 million (150) million

(362) million $ 58 million

$ 400 million 410 million $ (10) million

Requirement 3 Entry to record the impairment loss: Loss on impairment of goodwill ................................... Goodwill ..................................................................

($ in millions) 10 10

Exercise 11–34 Requirement 1 The Codification topic number that provides guidance on accounting for the impairment of long-lived assets is FASB ASC Topic Number 360: ―Property, Plant, and Equipment.‖

Requirement 2 The specific citation that discusses the disclosures required in the notes to the financial statements for the impairment of long-lived assets classified as held and used is FASB ASC 360–10– 50–2: ―Property, Plant, and Equipment–Overall–Disclosure–Impairment or Disposal of Long-Lived Assets.‖

Requirement 3 All of the following information shall be disclosed in the notes to financial statements that include the period in which an impairment loss is recognized: a. A description of the impaired long-lived asset (asset group) and the facts and circumstances leading to the impairment b. If not separately presented on the face of the statement, the amount of the impairment loss and the caption in the income statement or the statement of activities that includes that loss c. The method or methods for determining fair value (whether based on a quoted market price, prices for similar assets, or another valuation technique) d. If applicable, the segment in which the impaired long-lived asset (asset group) is reported under Topic 280.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–35 The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 5. Depreciation involves a systematic and rational allocation of cost rather than a process of valuation: FASB ASC 360–10–35–4: ―Property, Plant, and Equipment–Overall– Subsequent Measurement–Depreciation.‖ The cost of a productive facility is one of the costs of the services it renders during its useful economic life. Generally accepted accounting principles (GAAP) require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility. This procedure is known as depreciation accounting, a system of accounting that aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation. 6. The calculation of an impairment loss for property, plant, and equipment: FASB ASC 360–10–35–17: ―Property, Plant, and Equipment–Overall– Subsequent Measurement.‖ An impairment loss shall be recognized only if the carrying amount (book value) of a long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group). That assessment shall be based on the carrying amount of the asset (asset group) at the date it is tested for recoverability, whether in use or under development. An impairment loss shall be measured as the amount by which the carrying amount of a long-lived asset (asset group) exceeds its fair value.

Exercise 11–35 (concluded) 7. Accounting for a change in depreciation method: FASB ASC 250–10–45–18: ―Accounting Changes and Error Correction–Overall– Other Presentation Matters–Change in Accounting Estimates.‖ Distinguishing between a change in an accounting principle and a change in an accounting estimate is sometimes difficult. In some cases, a change in accounting estimate is effected by a change in accounting principle. One example of this type of change is a change in method of depreciation, amortization, or depletion for longlived, nonfinancial assets (hereinafter referred to as depreciation method). The new depreciation method is adopted in partial or complete recognition of a change in the estimated future benefits inherent in the asset, the pattern of consumption of those benefits, or the information available to the entity about those benefits. The effect of the change in accounting principle, or the method of applying it, may be inseparable from the effect of the change in accounting estimate. Changes of that type often are related to the continuing process of obtaining additional information and revising estimates and, therefore, shall be considered changes in estimates for purposes of applying this Subtopic. 8. Goodwill should not be amortized: FASB ASC 350–20–35–1: ―Intangibles–Goodwill and Other–Goodwill– Subsequent Measurement–Overall Accounting for Goodwill.‖ Goodwill shall not be amortized. Instead, goodwill shall be tested for impairment at a level of reporting referred to as a reporting unit.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–36 1. To record the replacement of the heating system. Accumulated depreciation—building.................. 250,000 Cash ............................................................ 250,000

2. To record the addition to the building. Building ............................................................. 750,000 Cash ............................................................ 750,000

3. To expense annual maintenance costs. Maintenance expense ....................................... Cash ............................................................

14,000 14,000

4. To capitalize rearrangement costs. Equipment ............................................................ 50,000 Cash ............................................................ 50,000

Exercise 11–37 Requirement 1 2022 amortization: $6,000,000  10 = $600,000 × 3/12 = $150,000 2023 amortization: $6,000,000  10 = $600,000

Requirement 2 Patent…………….. Cash………..….

500,000 500,000

Requirement 3 Calculation of revised annual amortization: $6,000,000 Cost ( 750,000) Less: Amortization to date (above) 5,250,000 Unamortized cost (balance in the patent account) 500,000 Add: Successful defense of patent 5,750,000 New unamortized cost ÷ 8 3/4 Estimated remaining life (10 years – 1 1/4 years) $ 657,143 New annual amortization

Requirement 4 Requirement 1: 2022 amortization: $6,000,000  10 = $600,000 × 3/12 = $150,000 2023 amortization: $6,000,000  10 = $600,000 Requirement 2: Litigation expense… Cash……………

500,000 500,000

Requirement 3: 2024 amortization: $6,000,000  10 = $600,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–38 List A

List B

g 1. Depreciation d 2. Service life f 3. Depreciable base e 4.

k 5. h 6.

a 7. j 8. b 9.

a. Cost allocation for natural resource. b. Accounted for prospectively. c. When there has been a significant decline in value. Activity-based method d. The amount of use expected from plant and equipment and finite-life intangible assets. Time-based method e. Estimates service life in units of output. Double-declining balance f. Cost less residual value. g. Cost allocation for plant and equipment. h. Does not subtract residual value from cost. Depletion i. Accounted for the same way as a change in estimate. Amortization j. Cost allocation for an intangible asset. Change in useful life k. Estimates service life in years.

i 10. Change in depreciation method c 11. Write-down of asset

Exercise 11–37 Requirement 1 To record the acquisition of small tools. 2022 Small tools .............................................................. 8,000 Cash.............................................................

8,000

To record additional small tool acquisitions. 2024 Small tools .............................................................. 2,500 Cash.............................................................

2,500

To record the sale/depreciation of small tools. 2024 Cash ................................................................ Depreciation expense (difference)..................... Small tools ...................................................

250 1,750 2,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 11–39 (concluded) Requirement 2 To record the acquisition of small tools. 2022 Small tools ...................................................... Cash ............................................................

8,000 8,000

To record the replacement/depreciation of small tools. 2024 Depreciation expense ...................................... Cash ............................................................

2,500 2,500

To record the sale of small tools. 2024 Cash ................................................................ Depreciation expense ...................................

250 250

Exercise 11–40 Requirement 1 January 1 Equipment Cash (Purchase equipment for cash)

Debit 19,500

Credit 19,500

January 4 Accounts Payable Cash (Pay cash on account)

Debit 9,500

January 8 Inventory Accounts Payable (Purchase inventory on account)

Debit 82,900

January 15 Cash Accounts Receivable (Receive cash on account)

Debit 22,000

January 19 Salaries Expense Cash (Pay for salaries)

Debit 29,800

January 28 Utilities Expense Cash (Pay for utilities)

Debit 16,500

January 30 Accounts Receivable Sales Revenue (Sell inventory on account) Cost of Goods Sold Inventory (Record cost of inventory sold)

Debit 220,000

Credit 9,500

Credit 82,900 Credit 22,000

Credit 29,800

Credit 16,500 Credit 220,000

115,000 115,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 11-40 (continued) Requirement 2 (a) January 31 Depreciation Expense Accumulated Depreciation (Record depreciation) ($300 = [$19,500−$1,500] / 60 months)

Debit 300

300

(b) January 31 Bad Debt Expense Allowance for Uncollectible Accounts (Adjust uncollectible accounts)

Debit 5,900

Debit 50

(d) January 31 Salaries Expense Salaries Payable (Adjust salaries payable)

Debit 32,600

(e) January 31 Income Tax Expense Income Taxes Payable (Accrue income taxes)

Credit

Credit 5,900

Credit 50

Credit 32,600

Debit 9,000

Credit 9,000

Exercise 11-40 (continued) Requirement 3 TNT Fireworks Adjusted Trial Balance January 31, 2024 Accounts Debit Cash $ 5,400 Accounts Receivable 223,000 Interest Receivable 50 Inventory 4,200 Notes Receivable 12,000 Land 155,000 Equipment 19,500 Allowance for Uncollectible Accounts Accumulated Depreciation Accounts Payable Salaries Payable Income Taxes Payable Common Stock Retained Earnings Sales Revenue Interest Revenue 115,000 Cost of Goods Sold Salaries Expense 62,400 Utilities Expense 16,500 Bad Debt Expense 5,900 Depreciation Expense 300 Income Tax Expense 9,000 Totals $628,250

Credit

8,100 300 88,200 32,600 9,000 220,000 50,000 220,000 50

$628,250

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 11-40 (continued) Requirement 3 (continued) Accounts

Ending Balance Cash 5,400 Accounts Receivable 223,000 Interest Receivable 50 Inventory 4,200 Notes Receivable 12,000 Land 155,000 Equipment 19,500 Allowance for Uncollectible Accounts 8,100 Accumulated Depreciation 300 Accounts Payable 88,200 Salaries Payable 32,600 Income Taxes Payable 9,000 Common Stock 220,000 Retained Earnings 50,000 Sales Revenue 220,000 Interest Revenue 50 Cost of Goods Sold 115,000 Salaries Expense 62,400 Utilities Expense 16,500 Bad Debt Expense 5,900 Depreciation Expense 300 Income Tax Expense 9,000

Beginning balance in bold, entries during January in blue, and adjusting entries in red. = 58,700−19,500−9,500+22,000−29,800−16,500 = 25,000−22,000+220,000 = 50 = 36,300+82,900−115,000 = 12,000 = 155,000 = 19,500 = 2,200+5,900 = 300 = 14,800−9,500+82,900 = 32,600 = 9,000 = 220,000 = 50,000 = 220,000 = 50 = 115,000 = 29,800+32,600 = 16,500 = 5,900 = 300 = 9,000

Exercise 11-40 (continued) Requirement 1308 TNT Fireworks Income Statement For the month ended January 31, 2024 Sales revenue $220,000 Cost of goods sold 115,000 Gross profit $105,000 Salaries expense Utilities expense Bad debt expense Depreciation expense Total operating expenses Operating income

62,400 16,500 5,900 300 85,100 19,900

Interest revenue Income before taxes

50 19,950

Income tax expense Net income

9,000 $ 10,950

Requirement 5 TNT Fireworks Balance Sheet January 31, 2024 Liabilities Current liabilities: $ 5,400 Accounts payable Salaries payable 214,900 Income taxes payable

Assets Current assets: Cash Accounts receivable 223,000 Less: Allowance for (8,100) uncollectible accounts Interest receivable Inventory Total current assets

50 4,200 224,550

Total current liabilities

Long-term assets: Notes receivable Land Equipment Less: Accumulated depreciation

12,000 155,000 19,500 (300)

Stockholders’ Equity Common stock Retained earnings Total stockholders‘ equity Total liabilities and stockholders‘ equity

Total assets *

$410,750

88,200 32,600 9,000 129,800

220,000 60,950 * 280,950 $410,750

Retained earnings = Beginning retained earnings + Net income − Dividends = $50,000 + $10,950 − $0

Complete Solution Manual for Intermediate Accounting, 11th Edition = $60,950

Exercise 11-40 (continued) Requirement 1310 January 31, 2024 Sales Revenue Interest Revenue Retained Earnings (Close revenue accounts)

Debit 220,000 50

Retained Earnings Cost of goods sold Salaries expense Utilities expense Bad debt expense Depreciation expense Income tax expense (Close expense accounts)

209,100

Credit

220,050

115,000 62,400 16,500 5,900 300 9,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 11-40 (concluded) Requirement 7 (a) The return on assets ratio is: Return on Assets Ratio

Net income Average total assets

$10,950 = ($284,800 + $410,750) / 2

3.1%

Compared to the industry average of 2%, TNT Fireworks is more profitable than other companies in the same industry. Note these are monthly, rather than annual, return on asset calculations. A consistent monthly return on assets of 1% results in a 12% return on assets for the entire year. (b) The profit margin is: Profit Margin

Net income

Net sales

$10,950

5.0%

$220,000

Compared to the industry average profit margin of 4%, TNT Fireworks is more efficient at converting sales to profit than other companies in the same industry. (c) The asset turnover ratio is: Asset Turnover Ratio

Net sales Average total assets

$220,000 = ($284,800 + $410,750) / 2

0.63 times

Compared to the industry average asset turnover of 0.5 times per month, TNT Fireworks is also more efficient at producing revenues with its assets.

Exercise 11–41 Requirement 1 Jan. 1 to Dec. 31 Inventory Accounts payable (Purchased inventory on account) Jan. 1 to Dec. 31 Accounts receivable Sales revenue (Revenue from sales on accounts) Cost of goods sold Inventory (Cost of inventory from sales on account) Jan. 1 to Dec. 31 Cash Accounts receivable (Received cash from customers on account) Jan. 1 to Dec. 31 Accounts payable Cash (Paid cash on account) Jan. 1 to Dec. 31 Salaries expense Utilities expense Cash (Paid for salaries and utilities) April 1 Equipment Notes payable Cash (Purchased equipment with note) ($95,000 + $3,200 + $3,800) June 30 Patent Cash (Purchased patent) October 1 Depreciation expense Accumulated depreciation (Update depreciation for the current year) Cash Accumulated depreciation Equipment Gain on sale of equipment (Sold equipment)

Debit 325,800

Credit 325,800

Debit 567,200

Credit 567,200

342,600 342,600 Debit 558,700

Credit 558,700

Debit 328,500

Credit 328,500

Debit 94,700 52,700

Credit

147,400 Debit 102,000

Credit 95,000 7,000

Debit 40,000

Credit 40,000

Debit 8,500

Credit 8,500

30,200 45,900 60,700 15,400

Complete Solution Manual for Intermediate Accounting, 11th Edition November 15 Equipment Cash (Capitalization of improvements to equipment)

Debit 54,100

Requirement 2 December 31 Debit Depreciation expense 6,900 Accumulated deprecation (Record depreciation) ($6,900 = (($102,000 − $10,000) ÷ 10 years) × 9/12) December 31 Debit Depreciation expense 21,500 Accumulated deprecation (Record depreciation) December 31 Debit Amortization expense 1,000 Patent (Record amortization) ($1,000 = $40,000 ÷ 20 years × 6/12) December 31 Debit Interest expense 5,700 Interest payable (Record interest payable) ($95,000 × 8% × 9/12) December 31 Debit Loss on impairment 14,300 Accumulated depreciation 40,300 Equipment (Record impairment) (($65,400 − $40,300) − $10,800) December 31 Debit Income tax expense 12,600 Income taxes payable (Record income taxes payable)

Credit 54,100

Credit 6,900

Credit 21,500 Credit 1,000

Credit 5,700 Credit

54,600 Credit 12,600

Requirement 3 Parts Unlimited Adjusted Trial Balance December 31, 2024 Accounts Cash Accounts receivable Inventory Land Equipment Patent Accumulated depreciation Accounts payable Interest payable Income taxes payable Notes payable Common stock Retained earnings Sales revenue Gain on sale of equipment Cost of goods sold Salaries expense Utilities expense Depreciation expense Amortization expense Loss on impairment Interest expense Income tax expense Totals

Debit $ 174,300 20,900 21,000 340,000 388,300 39,000

Credit

$ 122,700 12,100 5,700 12,600 95,000 520,000 193,300 567,200 15,400 342,600 94,700 52,700 36,900 1,000 14,300 5,700 12,600 $1,544,000

$1,544,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 4 Parts Unlimited Income Statement For the year ended January 31, 2024 Sales revenue $567,200 Cost of goods sold 342,600 Gross profit 224,600 Operating expenses: Salaries expense $94,700 Utilities expense 52,700 Depreciation expense 36,900 Amortization expense 1,000 Loss on impairment 14,300 199,600 25,000 Gain on sale of equipment 15,400 Operating income 40,400 Interest expense 5,700 Income before taxes 34,700 Income tax expense 12,600 Net income $ 22,100

Requirement 5

Assets Cash Accounts receivable Inventory Total current assets Property, plant, and equipment Equipment Less: Accumulated depreciation Land Intangible assets Patent Total assets *

Parts Unlimited Balance Sheet December 31, 2024 Liabilities $174,300 Accounts payable $ 12,100 20,900 Interest payable 5,700 21,000 Income taxes payable 12,600 216,200 Notes payable 95,000 Total liabilities 125,400 388,300 Stockholders’ Equity (122,700) 340,000 Common stock 520,000 Retained earnings 215,400 * 39,000 Total stockholders‘ equity 735,400 $860,800

Total liabilities and stockholders‘ equity

$860,800

Retained earnings = Beginning retained earnings + Net income – Dividends = $193,300 + $22,100 − 0 = $215,400

Requirement 6 December 31 Sales revenue Gain on sale of equipment Retained Earnings (Close temporary credit accounts) December 31 Retained Earnings Cost of goods sold Salaries expense Utilities expense Depreciation expense Amortization expense Loss on impairment Interest expense Income tax expense (Close temporary debit accounts)

Debit 567,200 15,400

Credit

582,600 Debit 560,500

Credit 342,600 94,700 52,700 36,900 1,000 14,300 5,700 12,600

Complete Solution Manual for Intermediate Accounting, 11th Edition Requirement 7 (a) The fixed asset turnover ratio is: Fixed Asset Turnover Ratio

Net Sales Average Fixed Assets

$567,200 = $1.01 ($515,500 + $605,600)/2

A ratio of 1.01 suggests that the company is able to generate $1.01 in sales for every $1 invested in fixed assets. Typically, a higher ratio is good. Therefore, the company appears to be managing its fixed assets more efficiently than the average company in the same industry.

(b) Units-of-production depreciation: Depreciation = per unit

($102,000 − $10,000) 20,000 units

$4.60 per unit

Units-of-production depreciation = $4.6 × 2,000 units = $9,200 Straight-line depreciation is $6,900. Depreciation expense under units-of-production is higher by $2,300 (= $9,200 − $6,900), so net income and total assets in 2024 would have been lower by $2,300 (ignoring tax effects).

(c) The costs of internally developed patents are recorded as research and development expense in the period incurred. The cost of an externally purchased patent is capitalized and then amortized over the remaining life of the patent. The difference for 2024 is calculated as: Internal development – Research and development expense External patent – Amortization expense* Additional expense for 2024

$40,000 1,000 $39,000

*$1,000 = $40,000 ÷ 20 years × 6/12. The remaining $39,000 of the capitalized patent cost is amortized over the remaining 19.5 years of the patent. The amount of the expense for the internally developed patent is higher by $39,000, so net income and total assets in 2024 would have been lower by $39,000 (ignoring tax effects).

PROBLEMS Problem 11–1 Requirement 1 Determine useful life: $200,000 depreciable base = 20-year useful life $10,000 annual depreciation Determine age of assets: $40,000 accumulated depreciation = 4 years old $10,000 annual depreciation Double-declining balance in 4th year of life: Year 1 (2021) $200,000 × 10% = $20,000 Year 2 (2022) 180,000 × 10% = 18,000 Year 3 (2023) 162,000 × 10% = 16,200 Year 4 (2024) 145,800 × 10% = 14,580 Requirement 2 Depreciation expense (below) ................................. Accumulated depreciation .............................. $200,000 30,000 $170,000

20,000 20,000

Cost Depreciation to date, SL 3 years (2021–2023) Undepreciated cost as of 1/1/2024

Seventeen-year remaining life, or 1/17 × 2 = 2/17 × $170,000 = $20,000 A disclosure note reports the effect of the change on net income and earnings per share along with clear justification for changing depreciation methods.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–2 Requirement 1 CORD COMPANY Analysis of Changes in Plant Assets For the Year Ending December 31, 2024

Land Land improvements Buildings Equipment Automobiles and trucks Leasehold improvements

Balance 12/31/2023 $ 175,000 -1,500,000 1,125,000 172,000 216,000 $3,188,000

Increase $ 312,500 [1] 192,000 937,500 [1] 385,000 [2] 12,500 -$1,839,500

Decrease $ ---17,000 24,000 -$41,000

Balance 12/31/2024 $ 487,500 192,000 2,437,500 1,493,000 160,500 216,000 $4,986,500

Explanations of Amounts: [1]

Plant facility acquired from King 1/6/2024—allocation to Land and Building: Fair value—25,000 shares of Cord common stock at $50 per share fair value $1,250,000 Allocation in proportion to appraised values at date of exchange: % of Amount Total Land $187,500 25 Building 562,500 75 $750,000 100 Land Building

[2]

$1,250,000 × 25% = $1,250,000 × 75% =

Equipment purchased 7/1/2024: Invoice cost Delivery cost Installation cost Total acquisition cost

$ 312,500 937,500 $1,250,000

$325,000 10,000 50,000 $385,000

Problem 11–2 (continued) Requirement 2 CORD COMPANY Depreciation and Amortization Expense For the Year Ended December 31, 2024 Land Improvements: Cost Straight-line rate (1 ÷ 12 years) Annual depreciation Depreciation on land improvements for 2024: (3/25 to 12/31/2024)

B uildings: Book value, 1/1/2024 ($1,500,000 – $328,900) Building acquired 1/6/2024 Total amount subject to depreciation 150% declining balance rate:

$192,000 x 8 1/3% 16,000 × 3/4

$ 12,000

$1,171,100 937,500 2,108,600

(1 ÷ 25 years = 4% × 1.5)

× 6%

$ 126,516

E quipment: Balance, 1/1/2024 Straight-line rate (1 ÷ 10 years)

$1,125,000 × 10%

112,500

Purchased on 7/1/2024 Depreciation for one-half year Depreciation on equipment for 2024 Automobiles and trucks: Book value, 1/1/2024 ($172,000 – $100,325) Deduct 1/1/2024 book value of truck sold on 9/30 ($9,100 + $2,650 depr. taken for 9 months) Amount subject to depreciation at 1/1/2024 200% declining balance rate: (1 ÷ 5 years = 20% × 2)

Automobile purchased 9/30/2024 Depreciation for 2024 (40% × 3/12) Truck sold on 9/30/2024 – depreciation (given) Depreciation on automobiles and trucks

385,000 × 5%

19,250 $ 131,750

$71,675 (11,750) 59,925 × 40% 12,500 × 10%

23,970 1,250 2,650 $ 27,870

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–2 (concluded) Leasehold improvements: Book value, 1/1/2024 ($216,000 – $108,000) $108,000 Amortization period (1/1/2024 to 12/31/2028) ÷ 5 years Amortization of leasehold improvements for 2024 $ 21,600 Total depreciation and amortization expense for 2024 $319,736 Note: the amortization period was originally over the shorter of the asset life (8 years) or the lease (6 years). Three years have passed. The lease will end in 2030 but the life will end in 2028. The new amortization period is thus 5 years.

Problem 11– 1322 PELL CORPORATION Depreciation For the Year Ended December 31, 2024 Land improvements:* Cost Straight-line rate (1 ÷ 15 years)

Building: Book value 12/31/2023 ($1,500,000 – $350,000) 150% declining balance rate:

$1,150,000

180,000 × 6 2/3%

(1 ÷ 20 years = 5% × 1.5)

× 7.5%

Building donated on 3/31/2024 150% declining balance rate:

$17,000

(1 ÷ 20 years = 5% × 1.5 × 9/12)

× 5.625%

Total depreciation on buildings Equipment: Balance, 12/31/2023 Straight-line rate (1 ÷ 10 years) Purchased 1/2/2024 Depreciation Total depreciation on equipment Automobiles: Activity-based (38,000 miles × $0.50): Total depreciation for 2024

$1,158,000 × 10% 287,000 × 10%

$ 12,000

$ 86,250

956 $87,206

$115,800 28,700 $144,500 $ 19,000 $262,706

*The repaving of the parking lots is considered a repair that doesn‘t provide future benefits beyond those originally anticipated.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–4 1. Depreciation for 2022 and 2023. December 31, 2022 Depreciation expense ($48,000 ÷ 8 years × 9/12) Accumulated depreciation—equipment........

December 31, 2023 Depreciation expense ($48,000 ÷ 8 years) ........ Accumulated depreciation—equipment........

4,500 4,500

6,000 6,000

2. The year 2024 expenditure. [Any capitalized amounts are recorded using Alternative 2—capitalization of new cost]. January 4, 2024 Repair and maintenance expense ...................... Equipment........................................................ Cash ............................................................

2,000 10,350 12,350

3. Depreciation for the year 2024. December 31, 2024 Depreciation expense (determined below) ........ Accumulated depreciation—equipment........

5,800 5,800

Calculation of annual depreciation after the estimate change: $ 48,000 (10,500) 37,500 10,350 47,850 ÷ 8 1/4 $ 5,800

Cost Less: Depreciation to date ($4,500 + 6,000) Undepreciated cost Add: Asset addition New depreciable base Estimated remaining life (10 years – 1 3/4 years) New annual depreciation

Problem 11– 1324 (1) $65,000 Allocation in proportion to appraised values at date of exchange: % of Amount Total Land $ 72,000 8 Building 828,000 92 $900,000 100 Land $812,500 × 8% = Building $812,500 × 92% =

$ 65,000 747,500 $812,500

(2) $747,500 [From (1)] (3)

50 years

$747,500 – $47,500 $14,000 annual depreciation

(4)

$ 14,000

Same as prior year, since method used is straight line.

(5)

$ 85,400

(6)

None

3,000 shares × $25 per share = $75,000 Plus demolition of old building 10,400 $85,400 No depreciation before use.

(7)

$ 16,000

Fair value [given in item e].

(8)

$ 3,200

$16,000 × 20% (2 × Straight-line rate of 10%).

(9)

$ 2,560

($16,000 – 3,200) × 20%.

(10) $ 99,000 (11)

$ 9,000

(12) $

750

(13) $ 30,840

Total cost of $110,000 – $11,000 in normal repairs. ($99,000 –$9,000) × 1/10. ($99,000 – $9,000) × 1/10 × 1/12. PVAD = $4,000 (7.71008 * ) * Present value of an annuity due of $1: n = 11, i = 8% (from Table 6)

(14) $ 2,056

$30,840 15 years

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–6 Requirement 1 Building: $500,000 = $20,000 per year × 9/12 = $15,000 25 years Equipment: $240,000 – (10% × $240,000) = $27,000 per year × 9/12 = $20,250 8 years Vehicles: $160,000 × 25% (2 × straight-line rate of 12.5%) = $40,000 × 9/12 = $30,000 Requirement 2 (a) June 29, 2025 Depreciation expense (determined below) ........ Accumulated depreciation—equipment........

5,625 5,625

$100,000 – (10% × $100,000) = $11,250 × 6/12 = $5,625 8 years

Problem 11–6 (concluded) (b) June 29, 2025 Cash ................................................................. Accumulated depreciation—equipment (below) Loss on sale of equipment (difference).............. Equipment....................................................

80,000 14,063 5,937 100,000

Accumulated depreciation on equipment sold: 2024 depreciation = $11,250 × 9/12 = 2025 depreciation = $11,250 × 6/12 Total Requirement 3 Building:

$ 8,438 5,625 $14,063

$500,000 = $20,000 25 years Equipment: $140,000 – (10% × $140,000) = $15,750 8 years Vehicles: ($160,000 – $30,000) × 25% (2 × straight-line rate of 12.5%, calculated as 1 ÷ 8 years) = $32,500

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–7 Requirement 1 Cost of mineral mine: Purchase price Development costs

$1,600,000 600,000 $2,200,000

Depletion: $2,200,000 – $100,000 Depletion per ton =

= $5.25 per ton 400,000 tons

2024 depletion

= $5.25 × 50,000 tons = $262,500

2025 depletion: Revised depletion rate =

($2,200,000 – $262,500) – $100,000 = $4.20 487,500 – 50,000 tons

2025 depletion

= $4.20 × 80,000 tons = $336,000

Depreciation: Structures: $150,000 Depreciation per ton =

= $0.375 per ton 400,000 tons

2024 depreciation

= $0.375 × 50,000 tons = $18,750

2025 depreciation: Revised depreciation rate =

$150,000 – $18,750 = $0.30 per ton 487,500 – 50,000 tons

2025 depreciation

= $0.30 × 80,000 tons = $24,000

Problem 11–7 (continued) Equipment: $80,000 – $4,000 Depreciation per ton =

= $0.19 per ton 400,000 tons

2024 depreciation

= $0.19

2025 depreciation: Revised depreciation rate =

× 50,000 tons = $9,500 ($80,000 – $9,500) – $4,000 = $0.152 per ton 487,500 – 50,000 tons

2025 depreciation = $0.152 × 80,000 tons = $12,160 Requirement 2 Mineral mine: $2,200,000 Cost Less accumulated depletion: $262,500 2024 depletion 2025 depletion 336,000 598,500 Book value, 12/31/2025 $1,601,500 Structures: Cost Less accumulated depreciation: 2024 depreciation 2025 depreciation Book value, 12/31/2025 Equipment: Cost Less accumulated depreciation: 2024 depreciation 2025 depreciation Book value, 12/31/2025

$150,000 $18,750 24,000

42,750 $107,250 $80,000

$ 9,500 12,160

21,660 $58,340

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–7 (concluded) Requirement 3 Depletion of natural resources and depreciation of assets used in the extraction of natural resources are part of product cost and are included in the cost of the inventory of the mineral, just as the depreciation on manufacturing equipment is included in inventory cost. The depletion and depreciation are then included in cost of goods sold in the income statement when the mineral is sold. In 2024, since all of the ore was sold, all of 2024‘s depletion and depreciation is included in cost of goods sold. In 2025, since not all of the extracted ore was sold, a portion of both 2025‘s depletion and depreciation remains in inventory.

Problem 11–8 Requirement 1 Calculation of goodwill: Consideration exchanged Less: Fair value of net identifiable assets Goodwill acquired

$2,000,000 1,700,000 $ 300,000

Goodwill is not amortized. To record amortization of patent. Amortization expense ($80,000 ÷ 8 years × 6/12) Patent...........................................................

5,000 5,000

To record amortization of franchise. Amortization expense ($200,000 ÷ 10 years × 3/12) Franchise......................................................

5,000 5,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–8 (concluded) Requirement 2 Intangible assets: Goodwill Patent Franchise Total intangibles

$300,000 [1] 75,000 [2] 195,000 [3] $570,000

[1] $300,000 [2] $ 80,000 – $5,000 [3] $200,000 – $5,000

Problem 11–9 Requirement 1 Machine 101: $70,000 – $7,000 = $6,300 per year × 3 years =

$18,900

= $9,000 per year × 1.5 years =

13,500

= $3,000 per year × 4/12

1,000

10 years Machine 102: $80,000 – $8,000 8 years Machine 103: $30,000 – $3,000 =

9 years Accumulated depreciation, 12/31/2023

$33,400

Requirement 2 To record depreciation on machine 102 up to the date of sale. March 31, 2024 Depreciation expense ($9,000 per year × 3/12) .. Accumulated depreciation—equipment ........

2,250 2,250

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–9 (continued) Requirement 3 Selling price (cash received) Less: Book value of machine 102: Original cost Accumulated depreciation* Loss on sale of equipment (machine 102)

$ 52,500 $80,000 ( 15,750)

(64,250) $(11,750)

*Accumulated depreciation: Depreciation through 12/31/2023 $13,500 Depreciation from 1/1/2024 to 3/31/2024 ($9,000 × 3/12) 2,250 $15,750 Requirement 4 To record sale of equipment (machine 102). March 31, 2024 Cash ..................................................................... 52,500 Accumulated depreciation—equipment ($13,500 + $2,250)15,750 Loss on sale of equipment (determined in requirement 3) 11,750 Equipment ................................................... 80,000

Problem 11–9 (concluded) Requirement 5 Building: Useful life of the building: $200,000 = $40,000 in depreciation per year 5 years (2019–2023)

$840,000 – $40,000 = 20-year useful life $40,000 To record depreciation on the building. Depreciation expense [($840,000 – $40,000) ÷ 20 years] Accumulated depreciation—building ...........

40,000 40,000

To record depreciation on the equipment. Depreciation expense (determined below) ............. 15,775 Accumulated depreciation—equipment ........ 15,775

Equipment: Machine 103 (determined in requirement 1) Machine 101: Cost Less: Accumulated depreciation Book value, 12/31/2023 Revised remaining life (7 years – 3 years)

$ 3,000 $ 70,000 (18,900) 51,100 ÷ 4 years

12,775 $15,775

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–10 a. This is a change in estimate.

No entry is needed to record the change. 2024 Journal entry: Depreciation expense (determined below) .......... 370,000 Accumulated depreciation ........................... 370,000

Calculation of annual depreciation after the estimate change: $10,000,000

$250,000 × 3 yrs

Cost Previous depreciation ($10,000,000 ÷ 40 years) (750,000) Less: Depreciation to date (2021–2023) 9,250,000 Undepreciated cost ÷ 25 yrs. Estimated remaining life (25 years: 2024–2048) $ 370,000 New annual depreciation

A disclosure note should describe the effect of a change in estimate on income from continuing operations, net income, and related per-share amounts for the current period.

Problem 11–10 (concluded) b. This is a change in accounting principle that is accounted for as a change in estimate. Depreciation expense (below) ................................... 66,000 Accumulated depreciation ...................... 66,000 $330,000 Cost (132,000) Less: Depreciation to date, straight-line ($33,000 × 4 years) Undepreciated cost as of 1/1/2024 0 Less: Residual value 198,000 Depreciable base × 2/6 Double-declining-balance rate (1/6 remaining years × 2) $ 66,000 New annual depreciation

198,000

A disclosure note reports the effect of the change on net income and earnings per share along with clear justification for changing depreciation methods.

c. This is a change in accounting principle accounted for as a change in estimate. Because the change will be effective only for assets placed in service after the date of change, depreciation schedules do not require revision because the change does not affect assets depreciated in prior periods. A disclosure note still is required to provide justification for the change and to report the effect of the change on current year‘s income.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–11 Requirement 1 Analysis: Correct (Should Have Been Recorded)

Incorrect (As Recorded)

2022 Equipment Maintenance expense Cash

1,900,000 100,000

2022 Depreciation expense Accum. deprec.

475,000 [1]

Depreciation expense 500,000 [2] 475,000 Accum. deprec. 500,000

2023 Depreciation expense Accum. deprec.

356,250 [3]

Depreciation expense 375,000 [4] 356,250 Accum. deprec. 375,000

Equipment

2,000,000 Cash

2,000,000

[1] $1,900,000 × 25% (2 times the straight-line rate of 12.5%) [2] $2,000,000 × 25% [3] ($1,900,000 – 475,000) × 25% [4] ($2,000,000 – 500,000 ) × 25% During the two-year period, depreciation expense was overstated by $43,750, but other expenses were understated by $100,000, so net income during the period was overstated by $56,250, which means retained earnings is currently overstated by that amount. During the two-year period, accumulated depreciation was overstated, and continues to be overstated by $43,750. To correct incorrect accounts Retained earnings ............................................................ Accumulated depreciation ...................................................... Equipment ..................................................................

56,250 43,750 100,000

Problem 11–11 (concluded) Requirement 2 This is a change in accounting principle accounted for as a change in estimate. No entry is needed to record the change. 2024 Journal entry: Depreciation expense (determined below)................................ Accumulated depreciation ..................................................

178,125 178,125

A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, the Collins Corporation reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight line over the remaining useful life. Asset‘s cost (after correction)

$1,900,000

Less: Accumulated depreciation to date ($475,000 + $356,250) (831,250) Undepreciated cost, Jan. 1, 2024 Less: Estimated residual value To be depreciated over remaining 6 years

1,068,750 (0) 1,068,750 ÷ 6

Annual straight-line depreciation 2024–2029

years

$ 178,125

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–12 Requirement 1 Plant and equipment: Depreciation to date: $150 million  10 years = $15 million per year × 3 years = $45 million Book value: $150 million – $45 million = $105 million Patent: Amortization to date: $40 million  5 years = $8 million per year × 3 years = $24 million Book value: $40 million – $24 million = $16 million Requirement 2 Property, plant, and equipment and finite-life intangible assets are tested for impairment only when events or changes in circumstances indicate book value may not be recoverable.

Requirement 3 A qualitative assessment of goodwill impairment is required at least annually to determine if quantitative measurement is necessary. Alternatively, a company may proceed directly to performance of the quantitative goodwill impairment test.

Requirement 4 Plant and equipment: Recoverability test: An impairment loss is indicated because the $80 million undiscounted sum of future cash flows is less than the $105 million book value of the assets. Measurement: The amount of the impairment loss to be reported is calculated using the fair value rather than the undiscounted future cash flows:

Fair value Book value Impairment loss

$ 60 million (105) million $ (45) million

Patent: Recoverability test: There is no impairment loss because the undiscounted sum of future cash flows, $20 million, exceeds the book value of $16 million.

Goodwill: Measurement of impairment loss: Fair value of Ellison Technology‘s net assets Book value of Ellison Technology‘s net assets (including goodwill) Impairment loss

$450 million 470 million $ (20) million

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–13 Requirement 1 Hecala‘s cost of the mineral mine is $13,721,871, determined as follows:

Mining site $10,000,000 Development costs 3,200,000 Restoration costs 521,871 † $13,721,871 †

$600,000 × 30% = 700,000 × 30% = 800,000 × 40% =

$180,000 210,000 320,000 $710,000 × .73503* = $521,871

*Present value of $1, n = 4, i = 8%

Requirement 2 Depletion: $13,721,871  800,000 tons = $17.1523 per ton 120,000 tons × $17.1523 = $2,058,276 Depreciation of equipment: $140,000 – $10,000 = $.1625 per ton 800,000 tons 120,000 tons × $.1625 = $19,500 Depreciation of structures: $68,000  800,000 tons = $.085 per ton 120,000 tons × $.085 = $10,200

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–13 (continued) Requirement 3 2024 accretion expense: $521,871 × 0.08 × 8/12 = $27,833

Requirement 4 Depletion of natural resources and depreciation of assets used in the extraction of natural resources are part of product cost and therefore are included in the cost of the inventory of the mineral, just as the depreciation on manufacturing equipment is included in inventory cost. The depletion and depreciation are then included in cost of goods sold in the income statement when the mineral is sold.

Requirement 5 A change in the service life of plant and equipment and finite-life intangible assets is accounted for as a change in an estimate. The change is accounted for prospectively by simply depreciating/depleting the remaining depreciable/depletable base of the asset (book value at date of change less estimated residual value) over the revised remaining service life (tons of ore in this case). 2025 Depletion: Original cost Less: 2024 depletion Remaining depletable cost  Revised estimate of tons remaining (1,000,000 – 120,000) Depletion rate × Tons extracted 2025 depletion

$13,721,871 (2,058,276) $11,663,595 880,000 tons 13.2541 per ton 150,000 tons $ 1,988,115

Problem 11–13 (concluded) 2025 Depreciation of equipment: Original cost Less: 2024 depreciation Less: residual value Remaining depreciable cost  Revised estimate of tons remaining (1,000,000 – 120,000) Depreciation rate × Tons extracted 2025 depreciation

$140,000 (19,500) $120,500 (10,000) $110,500 880,000 tons $0.1256 per ton 150,000 tons $18,840

2025 Depreciation of structures: Original cost Less: 2024 depreciation Remaining depreciable cost  Revised estimate of tons remaining (1,000,000 – 120,000) Depreciation rate × Tons extracted 2025 depreciation

$ 68,000 (10,200) $ 57,800 880,000 tons $ 0.0657 per ton 150,000 tons $ 9,855

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 11–14 Requirement 1

Depreciation Depreciation × Rate per = MACRS Bonus Total Basis for Year Depreciation Depreciation Depreciation MACRS MACRS $20,000* 2024 20.00% $ 4,000 $30,000** $34,000 2025 32.00% 6,400 0 6,400 2026 19.20% 3,840 0 3,840 2027 11.52% 2,304 0 2,304 2028 11.52% 2,304 0 2,304 2029 5.76% 1,152 0 1,152 Total 100.00% $20,000 $30,000 $50,000 * Book value after bonus depreciation = $50,000 – ($50,000 × 60%) = $20,000. ** Bonus depreciation = $50,000 × 60% = $30,000.

Requirement 2

Year 2024 2025 2026 2027 2028 2029 Total

Depreciable Base × $50,000 50,000 50,000 50,000 50,000 50,000

Depreciate Rate 1/5 × 3/4 1/5 1/5 1/5 1/5 1/5 × 1/4

Depreciation $ 7,500 10,000 10,000 10,000 10,000 2,500 $50,000

Requirement 3 Only in 2024 is tax depreciation ($34,000) greater than financial reporting depreciation ($7,500).

DECISION MAKERS’ PERSPECTIVES CASES

Complete Solution Manual for Intermediate Accounting, 11th Edition

Judgment Case 11–1 Requirement 1 a. The capitalized cost for the computer includes all costs reasonable and necessary to prepare it for its intended use. Examples of such costs are the purchase price, delivery, installation, testing, and setup. b. The objective of depreciation accounting is to allocate the depreciable base of an asset over its estimated useful life in a systematic and rational manner. This process matches the depreciable base of the asset with revenues generated from its use. Depreciable base is the capitalized cost less its estimated residual value.

Requirement 2 The rationale for using accelerated depreciation methods is based on the assumption that an asset is more productive in the earlier years of its estimated service life. Therefore, larger depreciation charges in the earlier years would be matched against the larger revenues generated in the earlier years. An accelerated depreciation method also would be appropriate when benefits derived from the asset are approximately equal over the asset‘s life, but repair and maintenance costs increase significantly in later years. The early years record higher depreciation expense and lower repairs and maintenance expense, while the later years have lower depreciation and higher repairs and maintenance.

Integrating Case 11–2 Requirement 1 a. ($ in millions) Inventory (understatement of 2025 beginning inventory) ............ 10 Retained earnings (understatement of 2024 income)............... 10 Note: The 2023 error requires no adjustment because it has self-corrected by 2025. b. Retained earnings (2023–2024 patent amortization).................... Patent [($18 million ÷ 6 years) × 2]........................................

2025 adjusting entry: Patent amortization expense ($18 million ÷ 6 years) ................. Patent ...................................................................................

c. 2025 adjusting entry: Depreciation expense (below) .................................................... Accumulated depreciation ....................................................

4 4

($ in millions) 2023 depreciation 2024 depreciation Accumulated depreciation $30 (18) 12 ( 0) 12 ÷ 3 yrs. $ 4

SYD $10 ($30 × 5/15) 8 ($30 × 4/15) $18

Cost Less: Depreciation to date, SYD (above) Undepreciated cost as of 1/1/2025 Less: Residual value Depreciable base Remaining life (5 years – 2 years) New annual depreciation

Complete Solution Manual for Intermediate Accounting, 11th Edition

Case 11–2 (concluded) Requirement 2

2023 2023 inventory Patent amortization Depreciation

2024

2023 inventory 2024 inventory Patent amortization Depreciation

Shareholders’ Equity

Net Income

Expenses

$640 $330 $310 (12) (12) (3) (3) no adjustments to prior years

$210 (12) (3)

$150 12 3

$625

$330

$295

$195

$165

$820

$400

$420

$230

$175

10 (6)

12 10 (3)

(12) (10) 3

$249

$156

Assets

Liabilities

10 (6)

no adjustments to prior years

$824

$400

$424

Judgment Case 11–3 Requirement 1 A change from the double-declining-balance method of depreciation to the straight-line method for previously recorded assets as a result of new information related to production patterns is a change in accounting principle that is accounted for as a change in estimate. Both the doubledeclining-balance method and the straight-line method are generally accepted. A change in accounting principle that is accounted for as a change in estimate is accounted for using a prospective approach.

Requirement 2 A change in the expected service life of an asset arising because of more experience with the asset is a change in accounting estimate. A change in accounting estimate occurs because future events and their effects cannot be perceived with certainty. Estimates are an inherent part of the accounting process. A change in accounting estimate is accounted for using a prospective approach.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Research Case 11–4 Requirement 1 FASB ASC 360–10–35–17: ―Property, Plant and Equipment–Overall–Subsequent Measurement–Impairment or Disposal of Long-Lived Assets,‖ discusses measurement of an impairment loss for property, plant, and equipment.

Requirement 2 FASB ASC 360–10–35–21: ―Property, Plant and Equipment–Overall–Subsequent Measurement–Impairment or Disposal of Long-Lived Assets,‖ discusses when to test property, plant, and equipment for impairment. Property, plant, and equipment are tested for impairment whenever events or changes in circumstances indicate book value may not be recoverable.

Requirement 3 FASB ASC 360–10–35–20: ―Property, Plant and Equipment–Overall–Other Presentation Matters–Long-Lived Assets Classified as Held for Sale,‖ lists explains the new cost basis of impaired property, plant, and equipment and that later recovery of an impairment loss is prohibited.

Requirement 4 FASB ASC 350–30–35–14: ―Intangibles-Goodwill and Other–General Intangibles Other Than Goodwill–Subsequent Measurement–Recognition and Measurement of an Impairment Loss,‖ discusses recognition and measurement of impairment losses for intangible assets that are subject to amortization. An intangible asset that is subject to amortization shall be reviewed for impairment in accordance with the Impairment or Disposal of Long-Lived Assets Subsections of Subtopic 36010 by applying the recognition and measurement provisions in paragraphs 360-10-35-17 through 3535. In accordance with the Impairment or Disposal of Long–Lived Assets Subsections of Subtopic 360-10, an impairment loss shall be recognized if the carrying amount of an intangible asset is not recoverable and its carrying amount exceeds its fair value. After an impairment loss is recognized, the adjusted carrying amount of the intangible asset shall be its new accounting basis. Subsequent reversal of a previously recognized impairment loss is prohibited.

Case 11–4 (concluded) Requirement 5 FASB ASC 350–30–35–18: ―Intangibles-Goodwill and Other–General Intangibles Other Than Goodwill–Subsequent Measurement–Recognition and Measurement of an Impairment Loss,‖ provides the requirement that intangible assets not subject to amortization be tested for impairment at least annually. An intangible asset that is not subject to amortization shall be tested for impairment annually and more frequently if events or changes in circumstances indicate that it is more likely than not that the asset is impaired. See also 350–30–35–18A-F:

Complete Solution Manual for Intermediate Accounting, 11th Edition

Ethics Case 11–5 Requirement 1 2024 expense using CEO's approach: $42,000,000 $4,200,000 × 2 years

( 8,400,000) 33,600,000 ÷3 $11,200,000

Cost Previous annual depreciation ($42,000,000 ÷ 10 years) Less: Depreciation to date (2022–2023) Book value Estimated remaining life (2024–2026) New annual depreciation

2024 income would include only depreciation expense of $11,200,000. 2024 expense using controller's approach: $42,000,000 $4,200,000 × 2 years

( 8,400,000) 33,600,000 (12,900,000) 20,700,000 ÷3 $ 6,900,000

Cost Previous annual depreciation ($42,000,000 ÷ 10 years) Less: Depreciation to date (2022–2023) Book value Less: Write-down New depreciable base Estimated remaining life (2024–2026) New annual depreciation

2024 income would include depreciation expense of $6,900,000 and an asset write-down of $12,900,000 for a total income reduction of $19,800,000. Using the controller's approach, 2024's before tax income would be lower by $8,600,000 ($19,800,000 – $11,200,000).

Case 11–5 (concluded) Requirement 2 GAAP is more likely to require the CFO’s approach. GAAP provides guidance for recording impairment losses on partial write-downs of property, plant, and equipment and intangible assets remaining in use. Assets should be written down if there has been a significant impairment of value such as in decreased product demand and full recovery of book value through use or resale is not expected. Although the decision and computation to record an impairment loss often is very subjective and difficult to measure, the controller is able to estimate an equipment impairment of $12,900,000, presumably using the best information available. The simple revision in service life approach is clearly an effort to enhance net income on the part of the CEO.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Ethics Case 11–6

1. Yes.

Complete Solution Manual for Intermediate Accounting, 11th Edition Depreciation is affected by management‘s choice of depreciation method (such as straight-line, double-declining-balance, or activity-based) and by management‘s estimate of the asset‘s useful service life and residual value. Depreciation expense is reported as an expense in the income statement. Accumulated Depreciation is reported as a contra asset in the balance sheet.

Complete Solution Manual for Intermediate Accounting, 11th Edition 2.

(a) Straight-line.

Complete Solution Manual for Intermediate Accounting, 11th Edition A company could increase earnings by changing from double-declining-balance to straight-line in the early years of an asset‘s life. Double-declining-balance depreciation will be higher than straight-line depreciation in earlier years, but lower in later years. Since expenses decrease net income, the higher depreciation expense under double-declining-balance will result in lower reported net income.

(b) Longer service life.

Complete Solution Manual for Intermediate Accounting, 11th Edition A company could increase earnings by lengthening the estimated service lives of depreciable assets. A longer service life reduces the amount of depreciation in each particular year, resulting in higher reported net income.

Complete Solution Manual for Intermediate Accounting, 11th Edition A company could increase earnings by increasing the estimated residual value of depreciable assets. A larger residual value results in a lower depreciable cost of the asset and therefore less depreciation expense being recorded each year. Lower depreciation expense, in turn, results in higher reported net income.

Complete Solution Manual for Intermediate Accounting, 11th Edition 3. Yes.

Many amounts reported in financial statements are based on estimates by management, and these estimates are a crucial part of the information set used by investors and creditors to make decisions. To the extent that these estimates are materially misstated by management, financial reporting provides misleading information.

Complete Solution Manual for Intermediate Accounting, 11th Edition

4. No.

Complete Solution Manual for Intermediate Accounting, 11th Edition Even though Wall Street analysts place extensive pressure on companies to meet earnings expectations, management and the company‘s auditors have a legal and ethical responsibility to fairly report all estimates, including those for depreciation. A successful defense for misreporting financial performance cannot include pressure from external decision makers.

Judgment Case 11–7 Transaction

Disposition

Transaction is correctly recorded as repairs and maintenance expense.

Transaction is incorrectly recorded. The amount should be capitalized as part of the cost of the plant.

Transaction is incorrectly recorded. The amount should be capitalized either as part of the cost of the plant or as a reduction in the accumulated depreciation of the plant.

Transaction is correctly recorded as repairs and maintenance expense.

Transaction is incorrectly recorded. The amount should be capitalized as equipment.

Transaction is correctly recorded as repairs and maintenance expense.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Real World Case 11–8 Requirement 1 ($ in millions)

Property, plant and equipment (Cost): Balance, beginning of 2019 Add: Acquisitions during 2019 Less: Balance end of 2019 Dispositions during 2019

$12,754 618 (13,285) $ 87

Property, plant, and equipment (Accumulated depreciation): Balance, beginning of 2019 Add: Depreciation for 2019 Less: Balance end of 2019 Accumulated depreciation of 2019 dispositions

$ 7,796 635 (8,357) $ 74

Gain (loss) on 2019 dispositions: Cost of dispositions Less: Accumulated depreciation of dispositions Book value of dispositions

$ 87 (74) $ 13

Proceeds from dispositions Less: Book value of dispositions Loss on 2019 dispositions Requirement 2 2019 depreciable assets:

$ 0 (13) $ 13

Property, plant, and equipment Less: Land Cost of depreciable assets

$13,285 (263) $13,022

Assuming that Amgen uses the straight-line depreciation method, $13,022 ÷ $635 (2019 depreciation) = 20.5 years. The approximate average service life of Amgen‘s depreciable assets is 20.5 years.

Real World Case 11–9 The following was taken from the company‘s 2020 financial statements. Your results could differ if the company changes any of its policies in years after 2020. 1. The company's depreciation and depletion policies, disclosed in Note 1. Summary of Significant Account Policies, are as follows: Depreciation and depletion of all capitalized costs of proved crude oil and natural gas producing properties, except mineral interests, are expensed using the unit-of-production method, generally by individual field, as the proved developed reserves are produced. Depletion expenses for capitalized costs of proved mineral interests are recognized using the unit-of-production method by individual field as the related proved reserves are produced. Impairments of capitalized costs of unproved mineral interests are expensed. The capitalized costs of all other plant and equipment are depreciated or amortized over their estimated useful lives. In general, the declining-balance method is used to depreciate plant and equipment in the United States; the straight-line method is generally used to depreciate international plant and equipment and to amortize all capitalized leased assets. 2. Expenditures for maintenance (including those for planned major maintenance projects), repairs and minor renewals to maintain facilities in operating condition are generally expensed as incurred. Major replacements and renewals are capitalized.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Communication Case 11–10 There is no necessarily correct answer to the Question. The support made for the answer given is more important than the answer itself. Materiality is the critical consideration. Information is material if it can have an effect on a decision made by users. One consequence of materiality is that GAAP needs to be followed only if an item is material. The threshold for materiality will depend principally on the relative dollar amount of the transaction. In this case, is the $70,000 material? Net-of-tax income would be $49,000 higher if the expenditures were capitalized instead of expensed [$70,000 × (1 – .30)]. This represents a 4.45% increase in income ($49,000 ÷ $1,100,000). The effect on the balance sheet is small. Shareholders' equity would be higher by $49,000 if the expenditures were capitalized. This represents an increase of less than one-half of one percent. Would these differences have an effect on decision makers? There is no single answer to this Question. The FASB has been reluctant to establish any quantitative materiality guidelines. The threshold for materiality has been left to subjective judgment of the company preparing the financial statement and its auditors.

Communication Case 11–11 The terms depreciation, depletion, and amortization all refer to the same process of allocating the cost of property and equipment and finite-life intangible assets to the periods benefited by their use. However, each term is applied to a different type of long-lived asset; depreciation is used for plant and equipment, depletion for natural resources, and amortization for intangibles. There are differences in determining the factors necessary to calculate depreciation, depletion, and amortization but the concepts involved are the same. The service life of plant and equipment and natural resources is limited to physical life, while the service life of intangible assets is limited to the asset‘s legal or contractual life, or 40 years, whichever is shorter. The majority of companies use straight-line depreciation and straight-line amortization. Natural resources usually are depleted using the units-of-production method.

Communication Case 11–12 Suggested Grading Concepts and Grading Scheme: Content (70%) 50 Explains the concept of depreciation as a process of cost allocation, not valuation. Rational match versus market fluctuations. Numerical example. 10

Purpose of the balance sheet is to provide information about financial position, not to directly measure company value.

Purpose of the income statement is to provide cash flow information, not to directly measure the change in company value. 70 points Writing (30%) 6 Terminology and tone appropriate to the audience of a company president. 12

Organization permits ease of understanding. Introduction that states purpose. Paragraphs that separate main points.

English Sentences grammatically clear and well organized, concise. Word selection. Spelling. Grammar and punctuation.

30 points

Complete Solution Manual for Intermediate Accounting, 11th Edition

Target Case Requirement 1 Estimated Useful Lives Buildings and improvements Fixtures and equipment

Life (Years) 8-39 2-15

Computer hardware and software

2-7

Land does not have a definite life so it has no estimated useful life and is not depreciated.

Requirement 2 Property and equipment is depreciated using the straight-line method over estimated useful lives or lease terms if shorter. For income tax purposes, accelerated depreciation methods are generally used. Straight-line depreciation is simple to use and allocates the cost of assets evenly over their useful lives. Accelerated depreciation allocates more cost to earlier years, resulting in lower income and therefore lower taxes owed.

Requirement 3 Repair and maintenance costs are expensed as incurred. Requirement 4 Long-lived assets are reviewed for impairment when events or changes in circumstances, such as a decision to relocate or close a store or make significant software changes, indicate that the asset's carrying value may not be recoverable. For asset groups classified as held for sale, the carrying value is compared to the fair value less cost to sell. Target estimates fair value by obtaining market appraisals, valuations from third party brokers, or other valuation techniques. For 2019, impairments of $23 million related to store closures and supply chain changes. Requirement 5 No. For the year ended February 1, 2020, Target did not report any impairments on intangible assets.

Air France–KLM Case Requirement 1 (€ in millions) December 31, 2019

Before Revaluation

Flight equipment

€20,880

Accumulated depreciation Book value

After Revaluation × 14,000/11,334 = €25,791

9,546

× 14,000/11,334 =

11,791

€11,334

× 14,000/11,334 =

€14,000

The entry to revalue the flight equipment and the accumulated depreciation accounts (and thus the book value) is: Flight equipment (€25,791 – 20,880)

4,911

Accumulated depreciation (€11,791 – 9,546)

2,245

Revaluation surplus—OCI (€14,000 – 11,334)

2,666

Requirement 2 Under U.S. GAAP, property, plant, and equipment is valued at cost less accumulated depreciation. U.S. GAAP prohibits using the revalued amount.

Requirement 3 IFRS requires that each component of an item of property, plant, and equipment must be depreciated separately if its cost is significant in relation to the total cost of the item. AF uses this approach with its flight equipment. Note 4.14 states, ―Any major airframes and engine overhaul (excluding parts with limited useful lives) are treated as a separate asset component with the cost capitalized and depreciated over the period between the date of acquisition and the next major overhaul.‖ In the United States, component depreciation is allowed but is not often used in practice.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Air France-KLM Case (concluded) Requirement 4 Per Note 4.16, fixed assets are tested when there is an indication of impairment. This approach is similar to U.S. GAAP. However, under IFRS, assets must be assessed for indicators of impairment at the end of each reporting period. Requirement 5 In Note 4.16, AF states that the company deems the recoverable value of the asset to be the higher of market value less cost of disposal and its value in use. The later is determined according to the discounted future cash flow method. While not stated, AF then compares the recoverable amount to book value. If recoverable amount is less, an impairment loss is recognized for the difference. Under U.S. GAAP, the measurement of an impairment loss is a two-step process. Step one, recoverability, requires an impairment loss to be recognized only when the undiscounted sum of the asset’s estimated future cash flows is less than its book value. If a loss is required, step two measures the loss as the difference between book value and fair value of the asset.

Requirement 6 Revaluation expense Other intangible assets (€1,031* – €500)

(€ in millions) 531 531

*€1,811–€780

CHAPTER 12 Investments QUESTIONS FOR REVIEW OF KEY TOPICS

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–1 Debt investments are classified as ―held-to-maturity,‖ ―trading,‖ or ―available-forsale‖ securities.

Question 12– Increases and decreases in the market value between the time a debt security is 1382 acquired and the day it matures to a prearranged maturity value are ignored for a security classified as ―held-to-maturity.‖ These changes aren‘t important if sale before maturity isn‘t an alternative, which is the case if an investor has the ―positive intent and ability‖ to hold the security to maturity.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–3 GAAP distinguishes between three levels of inputs to fair value determination, with level 1 being readily observable fair values (for example, from a securities exchange), level-2 inputs are other observable amounts (for example, quoted values for similar items, or important inputs like interest rates), and level-3 inputs are unobservable, like the company‘s own assumptions. GAAP requires disclosure of the amount of fair values based on each of these three classes of inputs.

Question 12– For debt investments to be held for an unspecified period of time, fair value 1384 information is more relevant than for investments to be held to maturity. Changes in fair values are less relevant if the investment is to be held to maturity because sale at that fair value is not an option. The investor receives the same contracted interest payments for the period held to maturity and the stated principal at maturity, regardless of movements in market values. However, when the investment is of unspecified length, changes in fair values indicate management‘s success in deciding when to acquire the investment and when to sell it, as well as the propriety of investing in fixed-rate or variable-rate securities and long-term or short-term securities.

Complete Solution Manual for Intermediate Accounting, 11th Edition .

Question 12– The way unrealized holding gains and losses are reported in the financial 1386 statements depends on whether the debt investments are classified as ―securities available-for-sale‖ or as ―trading securities.‖ Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not included in the determination of income for the period. Rather, they are reported as a separate component of shareholders’ equity, as part of other comprehensive income (OCI). (Available-for-sale securities for which the investor has chosen the fair value option are treated like trading securities.)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–6 Comprehensive income is a more expansive view of the change in shareholders‘ equity than traditional net income. It encompasses all changes in equity from nonowner transactions. The part of comprehensive income other than net income is called ―other comprehensive income.‖ Other comprehensive income includes net unrealized holding gains (losses) on AFS investments.

Question 12– Unrealized holding gains or losses on trading securities are reported in the income 1388 statement as if they actually had been realized. Trading securities are actively managed in a trading account with the express intent of profiting from short-term market price changes. So, any gains and losses that result from holding securities during market price changes are suitable measures of success or lack of success in achieving that goal. On the other hand, unrealized holding gains or losses on securities available-forsale are not reported in the income statement. By definition, these securities are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are less relevant performance measures to be included in earnings.

Complete Solution Manual for Intermediate Accounting, 11th Edition .

Question 12–8 When acquired, debt securities are assigned to one of the three reporting classifications: held-to-maturity, trading, or available-for-sale. The appropriateness of the classification is reassessed at each reporting date. A reclassification should be accounted for as though the security had been sold and immediately reacquired at its fair value. Any unrealized holding gain or loss should be accounted for in a manner consistent with the classification into which the security is being transferred. Specifically, when a security is transferred: 1. Into the trading category, any unrealized holding gain or loss should be recognized in earnings of the reclassification period. 2. Into the available-for-sale category, any unrealized holding gain or loss should be recorded in other comprehensive income, which will then increase accumulated other comprehensive income in shareholders‘ equity. 3. Into the held-to-maturity category, any unrealized holding gain or loss should be amortized over the remaining time to maturity. In the case of Western Die-Casting‘s investment in the LGB Heating Equipment bonds, the investment is being transferred to the held to maturity category, so any unrealized holding gain or loss should be amortized over the remaining time to maturity.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–9 Yes. Although a company is not required to report individual amounts for the three categories of investments—held-to-maturity, available-for-sale, or trading—on the face of the balance sheet, that information should be presented in the disclosure notes. The following also should be disclosed for each year presented: aggregate fair value, gross realized and unrealized holding gains, gross realized and unrealized holding losses, the change in net unrealized holding gains and losses, and amortized cost basis by major security type. Information about the level of the fair value hierarchy upon which fair values are based should be provided, and more disclosure is necessary with respect to amounts based on level 3 of the fair value hierarchy.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–10 Under IFRS No. 9, investments in debt securities are classified either as amortized cost (accounted for like HTM investments in U.S. GAAP), fair value through other comprehensive income (―FVOCI‖, accounted for like AFS investments) and fair value through profit or loss (―FVPL‖, accounted for like trading securities).

Question 12–11

Complete Solution Manual for Intermediate Accounting, 11th Edition Under IFRS No. 9, investments in equity securities are classified as either fair value through profit and loss (―FVPL‖, accounted for like trading securities) or fair value through other comprehensive income (―FVOCI‖, accounted for like AFS investments). If the equity investment is held for trading, it must be classified as FVPL, but otherwise the company can irrevocably elect to classify it as FVOCI.

Question 12–12 When a company elects the fair value option for held-to-maturity or available-forsale investments, it accounts for the investment the same way it would account for a trading security. Specifically, it shows the investment at fair value in the balance sheet and includes unrealized gains and losses in net income.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–13 U.S. GAAP allows companies complete discretion in electing the fair value option when an investment is made. The only constraint is that the election is irrevocable. IFRS allows companies to elect the fair value option only in specific circumstances, for example, when electing the fair value option for an asset or liability allows a company to avoid the ―accounting mismatch‖ that occurs when some parts of a fair value risk-hedging arrangement are accounted for at fair value and others are not.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–14 The equity method is used when an investor can‘t control but can ―significantly influence‖ the investee. For example, if effective control is absent, the investor still might be able to exercise significant influence over the operating and financial policies of the investee if the investor owns a large percentage of the outstanding shares relative to other shareholders. By voting those shares as a block, the investor often can sway decisions in the direction desired. We presume, in the absence of evidence to the contrary, that the investor exercises significant influence over the investee when it owns between 20% and 50% of the investee's voting shares.

Question 12–15 The equity method, like consolidation, views the investor and investee as a special type of single entity. By the equity method, though, the investor doesn‘t include separate financial statement items of the investee on an item-by-item basis as in consolidation. Rather, by the equity method, the investor reports its equity interest in the investee as a single investment account. That single investment account is periodically adjusted to reflect the effects of consolidation, without actually consolidating financial statements.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–16 The investor should account for dividends from the investee as a reduction in the investment account. Since investment revenue is recognized when net income is recognized by the investee, it would be inappropriate to again recognize revenue when that income is distributed as dividends. Rather, the dividend distribution is considered to be a reduction of the investee’s net assets, indicating that the investor‘s ownership interest in those net assets declines proportionately.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–17 The equity method attempts to approximate the effects of accounting for the purchase of the investee as a consolidation. Consolidated financial statements report acquired identifiable net assets at their fair values as of the date the investor acquired the investee. The accounting in the consolidated financial statements subsequent to the acquisition date is based on those fair values. So, if Finest had consolidated its acquisition of Penner, Penner‘s depreciable assets would have been put on Finest‘s balance sheet in their respective asset accounts at their fair value on the date of acquisition and then depreciated over 10 years. Under the equity method, Finest‘s investment in Penner is shown in a single investment account. Therefore, for the equity method to approximate consolidation, it would reduce both investment revenue (as if depreciation expense were being recognized) and the investment (as if the book value of the asset were being reduced) by the negative income effect of the ―extra depreciation‖ the higher fair value would cause. This would equal 40% × $12 million ÷ 10 years = $480,000 each year for 10 years.

Question 12–18 The investment account was decreased by $40,000 (40% × $100,000). increased by the same amount. There is no effect in the income statement.

Cash

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–19 When it becomes necessary to change from the equity method to another method, no adjustment is made to the carrying amount of the investment. The equity method is simply discontinued and the new method is applied from then on. The investment account balance when the equity method is discontinued would serve as the new cost basis for writing the investment up or down to fair value in the next set of financial statements.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–20 IFRS require that accounting policies of investees be adjusted to correspond to those of the investor when applying the equity method. U.S. GAAP has no such requirement. Also, IFRS does not provide the fair value option for most investments that qualify for the equity method. U.S. GAAP provides the fair value option for all investments that qualify for the equity method.

Question 12– When a company elects the fair value option for a significant-influence investment, 1408 the company carries the investment at fair value in the balance sheet and includes unrealized gains and losses in earnings in the period in which they occur. The investment is shown on its own line in the balance sheet as a significant-influence investment, or is combined with equity method investments with the amount at fair value shown parenthetically.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–22 A financial instrument is defined as one of the following: (1) cash, (2) evidence of an ownership interest in an entity, (3) a contract that (a) imposes on one entity an obligation to deliver cash or another financial instrument and (b) conveys to a second entity a right to receive cash or another financial instrument, or (4) a contract that (a) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms and (b) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms. Accounts payable, bank loans, and investments in securities are examples.

Question 12– These instruments ―derive‖ their values or contractually required cash flows from 1410 some other security or index.

Complete Solution Manual for Intermediate Accounting, 11th Edition .

Question 12– Since this money won‘t be used within the upcoming operating cycle, it is a 1412 noncurrent asset. It should be reported as part of investments.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–25 For a whole life insurance policy, part of each premium payment the company makes is not used by the insurance company to pay for life insurance coverage, but rather is invested on behalf of the insured company in a fixed-income investment. This investment can be exchanged for a determinable amount of money while the insured person is still alive. A company accounts for the cash surrender value by increasing it each year for a portion of the premium paid, and reporting the balance of the account in the investments section of the balance sheet.

Question 12– For HTM investments, unrealized gains and losses are ignored. However, 1414 companies do apply the CECL model to account for credit losses. Therefore, if the drop in fair value was due to worsening financial conditions of the investee, it is likely that the investor would need to recognize credit losses due to a reduced expectation that it would receive all future interest and principal payments associated with the HTM investment.

Complete Solution Manual for Intermediate Accounting, 11th Edition Answers to Questions (concluded)

Question 12–27 For AFS investments, the investment account is required to be reported at fair value and unrealized gains and losses to adjust the investment account to fair value are recorded through other comprehensive income (OCI). However, companies do apply the CECL model to account for credit losses. If fair value is less than amortized cost, there is some impairment of the investment. At this point, we need to consider what the investor intends to do with the investment. If the investor intends to sell the investment, or thinks it will be more likely than not that it will be required to sell the investment prior to recovering the impairment, it is required to recognize the entire accumulated unrealized loss in net income and write down the investment to fair value in the balance sheet. Otherwise, the investor considers whether credit losses exist. If there are no credit losses, the investor continues recognizing unrealized losses in OCI as normal for AFS investments. On the other hand, if there are some credit losses, the investor recognizes those losses in net income and increases an allowance for credit losses (contra to the AFS investment account) in the balance sheet. Any noncredit losses are recognized in OCI as normal for AFS investments.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Question 12–28 U.S. GAAP and IFRS differ somewhat. Under IFRS No. 9, impairments are recognized under the expected credit loss (ECL) model, and measured either as the 12-month expected credit loss (if the credit risk on the investment has increased significantly) or the lifetime expected credit loss (if the credit risk on the investment has not increased significantly. Changes in the ECL are reflected in earnings, and impairments can be recovered in earnings if estimates of credit losses are reduced. If the investment is accounted for at amortized cost, the offsetting entry is to an allowance for impairment losses that reduces the carrying value of the investment. However, if the investment is accounted for at FVOCI, the offsetting entry is to OCI, and any accumulated amounts in AOCI are reclassified upon sale or maturity of the investment.

BRIEF Exercises

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 12–1 (a) Investment in bonds (face amount) ....................... Discount on bond investment (difference)......... Cash (price of bonds) .........................................

720,000

Cash (1.5% × $720,000)......................................... Discount on bond investment (difference) ............ Interest revenue (2% × $600,000) ......................

10,800 1,200

120,000 600,000

(b) 12,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 12–2

Because S&L Financial is purchasing the bonds for purposes of earning profits on short-term differences in price, those bonds would be classified as trading securities. For trading securities, gains and losses from changes in fair values are recognized in net income in the periods in which they occur.

Complete Solution Manual for Intermediate Accounting, 11th Edition 2024 change in fair value: $875,000 – $873,000 = unrealized holding loss of $2,000 included in 2024 net income.

2025 change in fair value: $880,000 – $873,000 = unrealized holding gain of $7,000 included in 2025 net income.

Complete Solution Manual for Intermediate Accounting, 11th Edition Note: The total gain recognized over the life of the investment is $7,000 – $2,000 = $5,000, which equals the sale price of $880,000 – the initial cost of $875,000 = $5,000.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 12–3 2024 December 31 Loss on investments (unrealized, NI) ........................ 2,000 Fair value adjustment (TS) ($875,000 – $873,000) .............. 2025

2,000

January 3 Step 1: Adjust to fair value on date of sale:

Balance on December 31, 2024 ± Adjustment needed to update fair value Balance needed on January 3, 2025 ($880,000 − $875,000)

Fair Value Adjustment $(2,000) ? $ 5,000

Fair Value Adjustment 12/31/2024 Change needed

2,000 7,000

1/3/2025

5,000

Fair value adjustment ($873,000 – $880,000)....................7,000 Gain on investments (unrealized, NI) ........ ...................

7,000

Step 2: Record the sale transaction: Cash (selling price) ........................................................... 880,000 Investment in bonds (account balance) ......................................... 875,000 Fair value adjustment (account balance) ........ ................... 5,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 12–4

S&L Financial classifies the bonds as available-for-sale investments. For AFS investments, gains and losses from changes in fair values are recognized in other comprehensive income in the periods in which they occur, and recognized in net income only in the period in which they are realized.

Complete Solution Manual for Intermediate Accounting, 11th Edition 2024: no sale, so no effect on 2024 net income.

2025: $880,000 sales price – $875,000 initial cost = gain of $5,000 included in 2025 net income.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Brief Exercise 12–5 2024 December 31 Loss on investments (unrealized, OCI) ..................... 2,000 Fair value adjustment ($875,000 – $873,000) . ................... 2025

2,000

January 3: Three journal entries: 1. Adjust to fair value on date of sale:

Balance on December 31, 2024 ± Adjustment needed to update fair value Balance needed on January 3, 2025 ($880,000 − $875,000)

Fair Value Adjustment $(2,000) ? $ 5,000

Fair Value Adjustment 12/31/2024 Change needed

2,000 7,000

1/3/2025

5,000

Fair value adjustment (amount necessary to reach balance of $5,000) 7,000 Gain on investments (unrealized, OCI) (to balance) ........

7,000

2. Reverse previous fair value adjustments: Reclassification adjustment (OCI) (to balance) ..............5,000 Fair value adjustment (account balance) ....... ...................

5,000

3. Record the sale transaction: Cash (selling price) ........................................................... 880,000 Investment in bonds (account balance) ......................................... 875,000 Gain on investments (NI) (to balance) ......... ................... 5,000

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Brief Exercise 12–6

Because S&L Financial elected the fair value option for their investment, unrealized holding gains and losses from changes in fair values are recognized in net income in the periods in which they occur.

Complete Solution Manual for Intermediate Accounting, 11th Edition 2024

Change in fair value: $875,000 – $873,000 = unrealized holding loss of $2,000 included in 2024 net income.

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Change in fair value: $880,000 – $873,000 = unrealized holding gain of $7,000 included in 2025 net income.

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Brief Exercise 12–7 AFS securities are reported at fair value, so in the December 31, 2025 balance sheet the Microsoft bonds will be reported at $600,000. Change needed in the fair value adjustment to report the bonds at that fair value:

Date December 31,2024 Change needed: December 31,2025

Amortized Cost $510,000

Fair Value $610,000

520,000

600,000

Fair Value Adjustment $100,000 ? 80,000

Fair Value Adjustment 100,000 20,000 80,000 December 31, 2025 Loss on investments (unrealized, OCI) (to balance)................... 20,000 Fair value adjustment (amount necessary to reach balance of $80,000)

20,000

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Brief Exercise 12–8 Fowler would account for the bonds at fair value through other comprehensive income (FVOCI), because the bonds‘ cash flows consist of only interest and principal, and Fowler‘s business model with respect to the bonds is to both collect contractual cash flows and to hold the investment for sale at a gain. Therefore, Fowler would report the bonds in the balance sheet as an investment of $80,000 and include the $5,000 increase in fair value as a gain in other comprehensive income. Fowler would report $0 gain or loss in 2024 net income.

Brief Exercise 12– 1446

Fowler would account for the bonds at amortized cost, because its cash flows consist of only interest and principal and Fowler‘s business model with respect to the bonds is to hold the bonds until maturity. Therefore, Fowler would report the bonds in the balance sheet as an investment of $75,000, and would not include the $5,000 increase in fair value in either OCI or net income. Therefore, Fowler would report $0 gain or loss in 2024 net income.

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Brief Exercise 12–10 Given that the size of Adams‘ investment is not sufficient for it to exercise significant influence over FedEx, Adams would account for this equity investment as fair value through net income. That would require that the investment be carried at its fair value of $4,000,000 (equal to 40,000 shares × $100/share).

Brief Exercise 12– 1448

Turner‘s cash increased by $500,000 (10% × $5 million). It also reports $500,000 as dividend revenue in the income statement. Since Turner holds only 10% of ICA stock, it‘s assumed that it does not have significant influence over the company. An investor should account for dividends from an investment not accounted for by the equity method as dividend revenue.

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Brief Exercise 12– 1450

Turner‘s cash increased by $2 million (40% × $5 million). Its investment account declined by the same amount. There is no effect in the income statement. Since Turner owns 40% of ICA stock, it is presumed that Turner has significant influence over the operating and financial policies of the investee. As such, Turner should account for its investment in ICA under the equity method of accounting. An investor should account for dividends from an equity method investee as a reduction in its investment account. Since investment revenue is recognized as the investee recognizes net income, it would be inappropriate to again recognize revenue when net income is distributed as dividends. Instead, the dividend distribution is considered to be a reduction of the investee‘s net assets, reflecting the fact that the investor‘s ownership interest in those net assets declined proportionately.

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Brief Exercise 12–13 With the equity method we attempt to approximate the effects of accounting for the purchase of the investee as a consolidation. Consolidated financial statements report acquired identifiable net assets at their fair values. Both investment revenue and the investment would be reduced by the negative income effect of the ―extra depreciation‖ the higher fair value would cause. This would equal (30% × $50 million) ÷ 15 years = $1 million each year for 15 years.

Brief Exercise 12– 1452

Kim doesn‘t need to amortize any of the $2 million difference, because the entire difference relates to land, which does not depreciate. Kim would increase its investment for its percentage share of Phelps‘ net income and decrease it for its percentage share of Phelps‘ dividends. Therefore, at December 31, 2024, Phelps’ investment would be carried at $10 + [30% × ($1.00 – $0.50)] = $10.15 million.

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Brief Exercise 12–15 When a change to the equity method is appropriate, Pioneer’s investment account would not change. The previous method is discontinued and the balance in the investment account at the date of the change (including any unrealized holding gains or losses that occurred prior to the date the investment qualifies for the equity method) is used as the starting balance for applying the equity method. A disclosure note also should describe the change. Instead, the equity method would start as if the investment had been purchased in the current year for $44 million.

Yes, the answer would be the same if Pioneer changes from the equity method in that Pioneer’s investment account would not change. The equity method is discontinued, and the new method is applied from then on. If the equity method had been used prior to the change in accounting principle, the balance of $56 million in the investment account when the equity method is discontinued would serve as the new cost basis for writing the investment up or down to fair value in the next set of financial statements. There also would be no revision of prior years, but the change should be described in a disclosure note.

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Brief Exercise 12– Given Turner‘s election of the fair value option, it would account for this 1456 investment similar to an investment accounted for using the fair value through net income approach, for the percentage of ownership of the investee, while still preserving its classification as a significant influence investment and showing it as a noncurrent asset in the balance sheet. 2024 January 2 Investment in equity affiliate.............................10,000,000 Cash ............................................................................... 10,000,000 December 30 Cash (40% × $500,000) .................................................... 200,000 Investment revenue ............................................................. 200,000 December 31 Fair value adjustment ($11.5M – $10M) ................... 1,500,000 Gain on investment (unrealized, NI) ................................ 1,500,000 Note: A different approach to reach the same outcome would be for Turner to use equity method accounting throughout the year, and then at the end of the year make whatever adjustment to fair value is necessary to adjust the investment account to fair value. Under that approach, Turner would recognize 40% of ICA‘s $750,000 income ($300,000) as investment income, it would not recognize investment income associated with ICA‘s dividend, and would instead, reduce its investment account by its share of the dividend distribution. After these adjustments, it would end up with an investment account containing $10,100,000 ($10,000,000 + $300,000 – $200,000). Turner then would need to make a fair value adjustment of $1,400,000 ($11,500,000 – $10,100,000) to its ICA investment. So, the total amount of income recognized would be $1,700,000 ($300,000 investment income + $1,400,000 unrealized gain). Note that this alternative produces the same total amount of investment income as is produced above, $1,700,000 ($200,000 investment revenue + $1,500,000 unrealized gain).

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Brief Exercise 12–17 LED would reduce the carrying value of the investment using an allowance for credit losses contra account and would record a $200,000 credit loss as follows: Credit loss expense .......................................... Allowance for credit losses ..........................

200,000 200,000

In the income statement, the $200,000 credit loss is a reduction toward net income. No noncredit loss would be recognized for an HTM investment.

Brief Exercise 12– 1458

LED believes it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is not relevant. LED must recognize the entire impairment by writing down the carrying value of the investment and recognizing a loss in net income. LED reduces the carrying value of the LED investment by crediting the account(s) used to reflect carrying value. In this exercise, a discount on bond investment account was not evident as part of the accounting for the carrying value, but the journal entry required to write down the investment may use such an account. Since there is already a fair value adjustment for this investment, the balance in that account will be removed with a corresponding amount to reverse the existing effect in accumulated other comprehensive income. LED reclassifies previously recognized unrealized losses of $100,000 and records the impairment of $450,000 as follows: Fair value adjustment...................................... Reclassification adjustment (OCI) .............

100,000

Loss on impairment (NI) ............................... Discount on bond investment ......................

450,000

100,000

450,000

In the income statement, $450,000 will be shown as an impairment loss. A $100,000 reclassification adjustment will increase OCI. Therefore, the net effect on comprehensive income during the current period will be a decrease of $350,000.

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Brief Exercise 12–19 LED does not intend to sell the investment, and it does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is relevant. LED must recognize in net income the $200,000 credit loss component of the impairment, and must increase the total unrealized loss and the fair value adjustment on the AFS investment by $150,000 from the $100,000 recorded previously so that the total unrealized loss and fair value adjustment to date will be $250,000. LED records the following entries: Credit loss expense ........................................... Allowance for credit losses ...........................

200,000

Loss on investments (unrealized, OCI) .......... Fair value adjustment ..................................

150,000

200,000

150,000

LED would include the credit loss as a $200,000 reduction of net income. The $150,000 unrealized loss would decrease OCI. Therefore, the net effect on comprehensive income during the current period will be a decrease of $350,000.

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Brief Exercise 12–20 Wickum would have recorded a journal entry previously that recognized the impairment in earnings and recognized an offsetting allowance for credit losses that reduced the carrying value of the investment: Loss on impairment (NI) ................................... Allowance for credit losses.............................

500,000 500,000

If impairment is recognized in one period and the investment value increases in another period, the credit loss is reduced. This means there is a recovery of a prior credit loss. Upon recovery of $300,000 of fair value, Wickum would reverse by that amount the impairment previously recorded: Allowance for credit losses .............................. Loss on impairment (NI) .............................

300,000 300,000

Brief Exercise 12–21 Wickum would have recorded a journal entry previously that recognized the impairment in earnings and recognized an offsetting amount in OCI, creating a ―Reserve for credit losses‖ that sits in AOCI: Loss on impairment (NI) ................................... Reserve for credit losses (OCI) ......................

500,000 500,000

If impairment is recognized in one period and the investment value increases in another period, the credit loss is reduced. This means there is a recovery of a prior credit loss. Upon recovery of $300,000 of fair value, Wickum would reverse by that amount the impairment previously recorded: Reserve for credit losses (OCI) .......................... Loss on impairment (NI) .............................

300,000 300,000

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Exercises

Exercise 12– 1464 Requirement 1

Investment in bonds (face amount) ....................... Discount on bond investment (difference)......... Cash (price of bonds) .........................................

($ in millions)

240.0 40.0 200.0

Requirement 2 Cash (3% × $240 million)....................................... Discount on bond investment (difference) ............ Interest revenue (4% × $200) ............................

7.2 0.8 8.0

Requirement 3 Tanner-UNF reports its investment in the December 31, 2024, balance sheet at its amortized cost—that is, its book value: Investment in bonds ........................................... Less: Discount on bond investment ($40 – $0.8 million) Amortized cost ...............................................

$240.0 39.2 $200.8

If sale before maturity isn‘t an alternative, increases and decreases in the fair value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant. For this reason, if an investor has the ―positive intent and ability‖ to hold the securities to maturity, investments in debt securities are classified as ―held-to-maturity‖ and reported at amortized cost rather than fair value in the balance sheet. Requirement 4 Cash (proceeds from sale) ...................... ………… Discount on bond investment (balance, determined above) Loss on investments (to balance) .......................... Investment in bonds (face amount)....................

($ in millions)

190.0 39.2 10.8 240.0

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Exercise 12–2 Requirement 1 Investment in bonds (face amount) ....................... Premium on bond investment (difference) ............ Cash (price of bonds) .........................................

($ in millions)

240.0 40.0 280.0

Requirement 2 Cash (3% × $240 million)....................................... Premium on bond investment (difference) ........ Interest revenue (2% × $280) ............................

7.2 1.6 5.6

Requirement 3 Mills reports its investment in the December 31, 2024, balance sheet at its amortized cost—that is, its book value: Investment in bonds ........................................... Plus: Premium on bond investment ($40 – $1.6 million) Amortized cost ...............................................

$240.0 38.4 $278.4

If sale before maturity isn‘t an alternative, increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant. For this reason, if an investor has the ―positive intent and ability‖ to hold the securities to maturity, investments in debt securities are classified as ―held-to-maturity‖ and reported at amortized cost rather than fair value in the balance sheet. Requirement 4 Cash (proceeds from sale) ...................................... Premium on bond investment (balance, determined above) Investment in bonds (face amount).................... Gain on investments (to balance) ......................

($ in millions)

290.0 38.4 240.0 11.6

Exercise 12– 1466

November 1 Cash............................................................... Interest revenue ..........................................

($ in millions)

2.4 2.4

December 1 Investment in bonds ...................................... Cash ...........................................................

30.0

December 31 Investment in bonds ...................................... Cash ...........................................................

8.9

30.0

8.9

December 31 Adjusting entries: Accrue interest for Convenience, Inc. bonds: Interest receivable ..................................... Interest revenue ($48 million × 10% × 2/12)

0.8

Accrue interest for Facsimile Enterprises bonds: Interest receivable ...................................... Interest revenue ($30 million × 12% × 1/12)

0.3 0.3

0.8

Note: Securities held-to-maturity are not adjusted to fair value.

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Exercise 12–4 Requirement 1 The specific citation that specifies the circumstances and conditions under which it is appropriate to account for investments as held-to-maturity is FASB ASC 320–10–25– 4: ―Investments—Debt and Equity Securities—Overall—Recognition —Circumstances Not Consistent with Held-to-Maturity Classification.‖ Requirement 2 FASB ASC 320–10–25–4 reads as follows: ―An entity shall not classify a debt security as held-to-maturity if the entity has the intent to hold the security for only an indefinite period. Consequently, a debt security shall not, for example, be classified as held-to-maturity if the entity anticipates that the security would be available to be sold in response to any of the following circumstances: a. Changes in market interest rates and related changes in the security's prepayment risk b. Needs for liquidity (for example, due to the withdrawal of deposits, increased demand for loans, surrender of insurance policies, or payment of insurance claims) c. Changes in the availability of and the yield on alternative investments d. Changes in funding sources and terms e. Changes in foreign currency risk.‖

Exercise 12– 1468 Requirement 1

($ in millions)

Investment in bonds (face amount) ....................... Discount on bond investment (difference)......... Cash (price of bonds) .........................................

240.0 40.0 200.0

Requirement 2 Cash (3% × $240 million)....................................... Discount on bond investment (difference) ............ Interest revenue (4% × $200) ................................

7.2 0.8 8.0

Requirement 3 The amortized cost of the bonds is $240 – ($40 – $0.8) = $200.8. Therefore, to adjust to fair value of $210, Tanner-UNF would need a fair value adjustment of $210 – $200.8 = $9.2. Fair Value Adjustment Balance on 7/1/2024 $ 0 ± Adjustment needed to update fair value ? Balance needed on 12/31/2021 ($210 – $200.8) $9.2 Fair Value Adjustment 7/1/2024

Change needed

9.2 9.2

12/31/2024

Tanner-UNF would record the following journal entry: Fair value adjustment ......................................... Gain on investments (unrealized, NI) (to balance)

9.2 9.2

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–5 (concluded) Requirement 4 1) Update the fair value adjustment: Need to move from a fair value adjustment of $9.2 to ($10.8):

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 1/2/2025 ($200.8 − $190) Fair Value Adjustment 12/31/2024

Fair Value Adjustment $ 9.2 ? $(10.8)

9.2

Change needed

20.0

1/2/2025

10.8

Loss on investments (unrealized, NI) (to balance) ........................ Fair value adjustment .............................................................

20.0 20.0

2) Record the sale transaction: Cash (proceeds from sale) ...................................... Fair value adjustment (account balance) ................ Discount on bond investment (account balance) .... Investment in bonds (account balance) ...............

190.0 10.8 39.2 240.0

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Exercise 12–6 Requirement 1

($ in millions)

Investment in bonds (face amount) ....................... Premium on bond investment (difference) ............ Cash (price of bonds) .........................................

240.0 40.0 280.0

Requirement 2 7.2

Cash (3% × $240 million)....................................... Premium on bond investment (difference) ........ Interest revenue (2% × $280) ............................

1.6 5.6

Requirement 3 The amortized cost of the bonds is $240 + ($40 – $1.6) = $278.4. Therefore, to adjust to fair value of $270, Tanner-UNF would need a fair value adjustment of $270 – $278.4 = ($8.4). Fair Value Adjustment Balance on 7/1/2024 $ 0 ± Adjustment needed to update fair value ? Balance needed on 12/31/2024 ($270 – $278.4) $(8.4) Fair Value Adjustment 7/1/2024

Change needed 12/31/2024

8.4 8.4

Mills would record the following journal entry: Loss on investments (unrealized, NI) (to balance) Fair value adjustment .....................................

8.4 8.4

Exercise 12–6 (concluded) Requirement 4

($ in millions)

1) Update the fair value adjustment: Need to move from a fair value adjustment from ($8.4) to $11.6:

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 1/2/2025 ($290 – $278.4) Fair Value Adjustment 12/31/2024 Change needed 1/2/2025

Fair Value Adjustment $(8.4) ? $11.6

8.4 20.0 11.6

Fair value adjustment................................................................. Gain on investments (unrealized, NI) (to balance) ....................

20.0 20.0

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2) Record the sale transaction: Cash (proceeds from sale) ...................................... Premium on bond investment (balance, determined above) Investment in bonds (face amount).................... Fair value adjustment (account balance).........

290.0 38.4 240.0 11.6

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Exercise 12–7 Requirement 1 2024 December 17 Investment in bonds .............................................. 350,000 Cash .................................................................................... 350,000 December 28 Cash.......................................................................... 2,000 Interest revenue.......................................... ...................

2,000

December 31 Need to move from a fair value adjustment of $0 to $50,000:

Balance on 12/17/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($400,000 − $350,000) Fair Value Adjustment 12/17/2024

Change needed

50,000 50,000

12/31/2024

Fair value adjustment .............................................. 50,000 Gain on investments (unrealized, NI) ($400,000 – $350,000)

Fair Value Adjustment $ 0 ? $50,000

50,000

Exercise 12–7 (continued) 2025 January 5 1) Update the fair value adjustment: Need to move from a fair value adjustment of $50,000 to $45,000:

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 1/5/2025 ($395,000 − $350,000) Fair Value Adjustment 12/31/2024

50,000

Change needed 1/5/2025

Fair Value Adjustment $50,000 ? $45,000

5,000 45,000

Loss on investments (unrealized, NI) ($395,000 – $400,000) . Fair value adjustment ................................. ...................

5,000 5,000

2) Record the sale transaction: Cash (selling price) ........................................................... 395,000 Fair value adjustment (account balance) ........ ................... 45,000 Investment in bonds (account balance) ......................................... 350,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–7 (concluded) Requirement 2 Balance Sheet December 31, 2024 Current Assets Investment in bonds ................................ ..........

$ 400,000

Income Statement: Interest revenue ....................................... .................... Gain on investments (from adjusting entry) ............... 50,000

2,000

Exercise 12– 1478

The specific citation for each of the following items is: 1. Unrealized holding gains for trading securities should be included in earnings: FASB ASC 320–10–35–1a: ―Investments—Debt and Equity Securities— Overall—Subsequent Measurement—General.‖ 2. Under the equity method, the investor accounts for its share of the earnings or losses of the investee in the periods they are reported by the investee in its financial statements: FASB ASC 323–10–35–4: ―Investments—Equity Method and Joint Ventures—Overall—Subsequent Measurement—The Equity Method— Overall Guidance.‖ 3. Transfers of securities between categories shall be accounted for at fair value: FASB ASC 320–10–35–10: ―Investments—Debt Securities—Overall— Subsequent Measurement—Transfers of Securities Between Categories.‖ 4. Disclosures for available-for-sale securities should include total losses for securities that have net losses included in accumulated other comprehensive income: FASB ASC 320–10–50–2: ―Investments—Debt Securities—Overall— Disclosure—Securities Classified as Available for Sale.‖

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Exercise 12–9 Requirement 1 Need to move from a fair value adjustment of $0 to ($25,000): Fair Value Adjustment $ 0 ?

Balance on 1/1/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($20,000 long term − $45,000 short term)

$(25,000)

Fair Value Adjustment 1/1/2024

Change needed

25,000

12/31/2024

25,000

Loss on investments (unrealized, OCI) (to balance) Fair value adjustment

25,000 25,000

Requirement 2 None. Accumulated net holding gains and losses for securities available-forsale are reported as a component of shareholders‘ equity (in accumulated other comprehensive income), and changes in the balance are reported as other comprehensive income or loss in the statement of comprehensive income rather than as part of net income. This statement can be reported either (a) as a combined statement of comprehensive income that includes net income and other comprehensive income, or (b) as a separate statement of comprehensive income.

Exercise 12– 1480 Requirement 1

($ in millions)

Investment in bonds (face amount) ....................... Discount on bond investment (difference)......... Cash (price of bonds) .........................................

240.0 40.0 200.0

Requirement 2 Cash (3% × $240 million)....................................... Discount on bond investment (difference) ............ Interest revenue (4% × $200) ................................

7.2 0.8 8.0

Requirement 3 The amortized cost of the bonds is $240 – ($40 – $0.8) = $200.8. Therefore, to adjust to fair value of $210, Tanner-UNF would need a fair value adjustment of $210 – $200.8 = $9.2. Fair Value Adjustment Balance on 7/1/2024 $ 0 ± Adjustment needed to update fair value ? Balance needed on 12/31/2024 ($210 – $200.8) $9.2 Fair Value Adjustment 7/1/2024 Change needed 12/31/2024

0 9.2 9.2

Tanner-UNF would record the following journal entry: Fair value adjustment ......................................... Gain on investments (unrealized, OCI) (to balance)

9.2 9.2

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Exercise 12–10 (continued) Requirement 4 1) Update the fair value adjustment: Need to move from a fair value adjustment from $9.2 to ($10.8):

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 1/2/2025 ($200.8 − $190) Fair Value Adjustment 12/31/2024

Fair Value Adjustment $ 9.2 ? $(10.8)

9.2

Change needed

20.0

1/2/2025

10.8

Loss on investments (unrealized, OCI) (to balance) ..................... Fair value adjustment ............................................................

20.0 20.0

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Exercise 12–10 (concluded) 2) Record any reclassification adjustment Need to move from a fair value adjustment from ($10.8) to $0:

Balance on 1/2/2025: ± Reclassification adjustment Balance needed to close fair value adjustment Fair Value Adjustment

Fair Value Adjustment $(10.8) ? $ 0

10.8

1/2/2025 Change needed

10.8

1/2/2025

Fair value adjustment..................................................... Reclassification adjustment (OCI) (to balance)............

10.8 10.8

3) Record the sale transaction: Cash (proceeds from sale) ...................................... Loss on investments (NI) (to balance) ................. Discount on bond investment (account balance) .... Investment in bonds (account balance) ...............

190.0 10.8 39.2 240.0

Note: The loss of $10.8 included in NI equals the difference between the proceeds ($190 million) and the carrying value of the investment ($240.0 – $39.2 = $200.8). It also equals the amount of unrealized gain that had accumulated in AOCI and was removed from AOCI with the reclassification adjustment.

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Exercise 12–11 Requirement 1

($ in millions)

Investment in bonds (face amount) ....................... Premium on bond investment (difference) ............ Cash (price of bonds) .........................................

240.0 40.0 280.0

Requirement 2 7.2

Cash (3% × $240 million)....................................... Premium on bond investment (difference) ........ Interest revenue (2% × $280) ............................

1.6 5.6

Requirement 3 The amortized cost of the bonds is $240 + ($40 – $1.6) = $278.4. Investment in bonds ........................................... Plus: Premium on bond investment ($40 – $1.6 million)

$240.0 38.4

Amortized cost

$278.4

Therefore, to adjust to fair value of $270, Tanner-UNF would need a fair value adjustment of $270 – $278.4 = ($8.4). Fair Value Adjustment Balance on 7/1/2024 $ 0 ± Adjustment needed to update fair value ? Balance needed on 12/31/2024 ($270 – $278.4) $(8.4) Fair Value Adjustment 7/1/2024

Change needed

8.4

12/31/2024

8.4

Mills would record the following journal entry: Loss on investments (unrealized, OCI) (to balance) Fair value adjustment .....................................

8.4 8.4

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Exercise 12–11 (continued) Requirement 4 1) Update the fair value adjustment: Need to move from a fair value adjustment from ($8.4) to $11.6:

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 1/2/2025 ($290 – $278.4) Fair Value Adjustment 12/31/2024

Fair Value Adjustment $(8.4) ? $11.6

8.4

Change needed

20.0

1/2/2025

11.6

Fair value adjustment ................................................................ Gain on investments (unrealized, OCI) (to balance) .................

20 20

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Exercise 12–11 (concluded) 2) Record any reclassification adjustment: Need to move from a fair value adjustment of ($11.6) to $0:

Balance on 1/2/2025: ± Reclassification adjustment Balance needed to close fair value adjustment Fair Value Adjustment 1/2/2025

11.6

Change needed 1/2/2025

Fair Value Adjustment $11.6 ? $ 0

11.6 0

Reclassification adjustment (OCI) (to balance)................ Fair value adjustment .............................................................

11.6 11.6

3) Record the sale transaction: Cash (proceeds from sale) ...................................... Premium on bond investment (balance, determined above) Investment in bonds (face amount).................... Gain on investments (NI) (to balance)...............

290.0 38.4 240.0 11.6

Note: The gain included in NI equals the difference between the proceeds ($290 million) and the carrying value of the investment ($278.4 million). It also equals the amount of unrealized gain that had accumulated in AOCI and was removed from AOCI with the reclassification adjustment.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–12 Requirement 1 a. July 1, 2024: Purchase of the Jackson bonds Investment in bonds ............................................................ 1,000,000 Cash........................................................................... 1,000,000 b. December 31, 2024: Recognition of interest revenue Cash ............................................................................. Interest revenue ($1,000,000 × 5% × ½ year) ..................

25,000 25,000

c. December 31, 2024: Year-end adjusting entries Need to move from a fair value adjustment of $0 to $200,000:

Balance on 7/1/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($1,200,000 − $1,000,000) Fair Value Adjustment 7/1/2024 Change needed

0 200,000

12/31/2024

200,000

Fair value adjustment..................................................... Gain on investments (unrealized, OCI) (to balance) .....

Fair Value Adjustment $ 0 ? $200,000

200,000 200,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–12 (continued) d. June 30, 2025: Recognition of interest revenue Cash ............................................................................. Interest revenue ($1,000,000 × 5% × ½ year) ..................

25,000 25,000

e. July 1, 2025: Any entries necessary upon sale of the Jackson bonds 1) Update the fair value adjustment: Need to move from a fair value adjustment of $200,000 to ($100,000):

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 7/1/2025 ($900,000 − $1,000,000) Fair Value Adjustment 12/31/2024

Fair Value Adjustment $200,000 ? $(100,000)

200,000

Change needed

300,000

7/1/2025

100,000

Loss on investments (unrealized, OCI) (to balance) .............................. 300,000 Fair value adjustment ................................................ 300,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–12 (concluded) 2) Record any reclassification adjustment: Need to move from a fair value adjustment of ($100,000) to $0: Fair Value Adjustment $(100,000) ? $ 0

Balance on 7/1/2025: ± Reclassification adjustment Balance needed to close fair value adjustment Fair Value Adjustment 7/1/2025

100,000

Change needed

100,000

7/1/2025

Fair value adjustment .................................................... Reclassification adjustment (OCI) (to balance).............

100,000 100,000

3) Record the sale transaction: Cash........................................................................................... Loss on investments (NI) (to balance) .......................................... Investment in bonds (amortized cost).…………………………

900,000 100,000 1,000,000

Requirement 2 2024 Net Income

$25,000

OCI

$200,000

Comprehensive Income

$225,000

2025

Total

$25,000 – $100,000 = $(75,000) $(300,000) + $100,000 = $(200,000)

$25,000 + $(75,000) = $(50,000)

$(275,000)

$200,000 + $(200,000) = $0 $225,000 + $(275,000) = $(50,000)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–13 Requirement 1 Securities ―held-to-maturity‖ are debt securities that an investor has the ―positive intent and ability‖ to hold to maturity. Actively traded investments in debt acquired principally for the purpose of selling them in the near term are classified as ―trading securities.‖ The IBM bonds are classified as ―available-for-sale‖ since all investments in debt securities that don‘t fit the definitions of the other reporting categories are classified this way. Investments in securities available-for-sale are reported at fair value, and holding gains or losses are not included in the determination of income for the period. Instead, they are reported as other comprehensive income or loss in the statement of comprehensive income. This statement can be reported either (a) as a combined statement of comprehensive income that includes net income and other comprehensive income, or (b) as a separate statement of comprehensive income. Accumulated net holding gains and losses for securities available-for-sale are reported as a separate component of shareholders‘ equity in the balance sheet. Requirement 2 Need to move from a fair value adjustment of $0 to ($20,000):

Balance on 2/18/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($580,000 − $600,000) Fair Value Adjustment 2/18/2024

Fair Value Adjustment $ 0 ? $(20,000)

Change needed

20,000

12/31/2024

20,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–13 (concluded)

December 31, 2024 Loss on investments (unrealized, OCI) (to balance) ............. Fair value adjustment ................................................

20,000 20,000

Requirement 3 Need to move from a fair value adjustment from ($20,000) to $10,000:

Balance on 1/1/2025: ± Reclassification adjustment Balance needed on 12/31/2025 ($610,000 − $600,000) Fair Value Adjustment 1/1/2025

Fair Value Adjustment $(20,000) ? $ 10,000

20,000

Change needed

30,000

12/31/2025

10,000

Fair value adjustment .................................................... Gain on investments (unrealized, OCI) (to balance) .....

30,000 30,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–14 1. Investments reported as current assets. Security A $ 910,000 Security B 100,000 Security C 780,000 Security E 490,000 Total $2,280,000 2. Investments reported as noncurrent assets. Security D $ 915,000 Security F 615,000 $1,530,000 3. Unrealized gain (or loss) recognized in net income. Trading Securities: Cost Security

A B

Totals

Fair value

$ 900,000$ 910,000 105,000 100,000 $1,005,000$1,010,000

Unrealized gain (loss) $10,000 (5,000) $ 5,000

4. Unrealized gain (or loss) in AOCI in shareholders’ equity. Securities Available-for-Sale: Cost Security Totals

C D

Fair value

$ 700,000$ 780,000 900,000 915,000 $1,600,000$1,695,000

Unrealized gain (loss) $80,000 15,000 $95,000

Exercise 12–15 Requirement 1 Purchase .............................................($ in millions)

Investment in equity securities ............................................... 50 Cash .......................................................... ...........................

Net income ...............................................................

No entry Dividends .................................................................

No entry (none were declared) Adjusting entry ........................................................

Need to move from a fair value adjustment of $0 to ($15 million):

Balance on 3/31/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($35 − $50) Fair Value Adjustment 3/31/2024

Fair Value Adjustment $ 0 ? $(15)

Change needed

12/31/2024

Loss on investments (unrealized, NI) (to balance) ........................ Fair value adjustment ($35 – $50 million) ...... ...........................

15 15

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–15 (concluded) Requirement 2 1) Update the fair value adjustment: Need to move from a fair value adjustment of ($15.0) to ($20.0):

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 1/20/2025 ($50 − $30) Fair Value Adjustment 12/31/2024 Change needed

15 5

1/20/2025

Loss on investments (unrealized, NI) (to balance) ........................ Fair value adjustment ............................................................

Fair Value Adjustment $(15) ? $(20)

5 5

Note: The loss included in NI equals the difference between the proceeds ($30 million) and the carrying value of the investment ($35 million). An additional $15 million was recognized in net income as an unrealized loss in 2024, when fair value decreased from $50 million to $35 million.

2) Record the sale transaction: Cash (proceeds from sale) ...................................... Fair value adjustment (account balance) ................ Investment in equity securities (face amount)....

30 20 50

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–16 Requirement 1 Purchase ............................................ ($ in millions)

Investment in equity securities ............................................... 90 Cash .......................................................... ...........................

Net income ...............................................................

No entry Dividends ................................................................. Cash (5% × $60 million) ....................................................................... 3

Dividend revenue ....................................... ...........................

Adjusting entry........................................................

Need to move from a fair value adjustment of $0 to $8 million:

Balance on 1/2/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($98 − $90) Fair Value Adjustment 1/2/2024 Change needed

0 8

12/31/2024

Fair value adjustment ($98 – $90 million)......................................... 8 Gain on investments (unrealized, NI) (to balance) ....................

Fair Value Adjustment $0 ? $8

Exercise 12–16 (concluded) Requirement 2 1) Update the fair value adjustment: Need to move from a fair value adjustment of $8 to $20:

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 1/2/2025 ($110 − $90) Fair Value Adjustment 12/31/2024

Change needed

1/2/2025

Fair Value Adjustment $ 8 ? $20

Fair value adjustment................................................................. Gain on investments (unrealized, NI) (to balance) ...................

12.0 12.0

Note: The gain included in NI equals the difference between the proceeds ($110 million) and the carrying value of the investment ($98 million). An additional $8 million was recognized in net income as an unrealized gain in 2024, when fair value increased from $90 million to $98 million. 2) Record the sale transaction: Cash (proceeds from sale) ...................................... Investment in equity securities ...................... Fair value adjustment (account balance).............

110.0 90.0 20.0

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–17 Requirement 1 Need to move from a fair value adjustment of $(145,000) to ($170,000):

Balance on 1/1/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($1,175,000 – $1,345,000) Fair Value Adjustment 1/1/2024 Change needed

145,000 25,000

12/31/2024

170,000

Loss on investments (unrealized, NI) (to balance) ................... Fair value adjustment ............................. ......................

Fair Value Adjustment $(145,000) ? $(170,000)

25,000 25,000

Exercise 12–17 (continued) Requirement 2 Need to move from a fair value adjustment from ($145,000) to ($70,000):

Balance on 1/1/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024($1,275,000 – $1,345,000) Fair Value Adjustment 1/1/2024 Change needed 12/31/2024

Fair Value Adjustment $(145,000) ? $(70,000)

145,000 75,000 70,000

Fair value adjustment .................................................... Gain on investments (unrealized, NI) (to balance) ........

75,000 75,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–17 (concluded) Requirement 3 Need to move from a fair value adjustment from ($145,000) to $30,000:

Balance on 1/1/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($1,375,000 – $1,345,000) Fair Value Adjustment 1/1/2024

Fair Value Adjustment $(145,000) ? $ 30,000

145,000

Change needed

175,000

12/31/2024

30,000

Fair value adjustment..................................................... Gain on investments (unrealized, NI) (to balance) ........

175,000 175,000

Exercise 12–18 Requirement 1 The sale of the A Corporation shares increased Harlon‘s pretax earnings by $1 million. In prior periods Harlon would have recorded losses corresponding to the decline in the fair value of those securities from $20 to $14 million, and established a fair value adjustment with a credit balance of $6 million to reduce the carrying value from cost of $20 million to fair value of $14 million. The journal entries to record the sale would be: June 1, 2025 1) Update the fair value adjustment: Need to move from a fair value adjustment of ($6) to ($5):

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 6/1/2025 ($15 − $20) Fair Value Adjustment 12/31/2024 Change needed 6/1/2025

Fair Value Adjustment $(6) ? $(5)

6 1 5

Fair value adjustment................................................................. Gain on investments (unrealized, NI) (to balance) ...................

1 1

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–18 (concluded) 2) Record the sale transaction: ................................................ ($ in millions) Cash………………………………………………….. Fair value adjustment (account balance)………………….. Investment in equity securities (cost)………….

15 5 20

December 31, 2025: Update the fair value adjustment: The purchase of C Corporation shares would require recognizing any postpurchase unrealized gains or losses in 2025 earnings. The fair value of the C Corporation shares declined by $1, so Harlon needs to move from a fair value adjustment of 0 at purchase to ($1) as of 12/31/2025:

Balance on 9/12/2025 ± Adjustment needed to update fair value Balance needed on 12/31/2025 ($14 − $15) Fair Value Adjustment 9/12/2025 Change needed

0 1

12/31/2025

Fair Value Adjustment $ 0 ? $(1)

Loss on investments (unrealized, NI) (to balance) ....................... Fair value adjustment .............................................................

1 1

Total effect on 2025 pretax earnings: gain of $1 + loss of ($1) = $0.

Requirement 2 Harlon‘s equity investment portfolio should be reported in its 2025 balance sheet at its fair value of $101 million. .

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–19 Requirement 1 The investment would be accounted for at fair value through net income: Purchase...................................................................

Investment in equity securities .............................. 480,000 Cash ......................................................... ...................

480,000

Net income ...............................................................

No entry Dividends ................................................................. Cash (20% × 400,000 shares × $0.25 per share).................. 20,000

Dividend revenue...................................... ...................

20,000

Adjusting entry ........................................................

Need to move from a fair value adjustment of $0 to $25,000:

Balance at purchase ± Adjustment needed to update fair value Balance needed at year end ($505,000 – $480,000) Fair Value Adjustment 1/2/2024 Change needed

0 25,000

12/31/2024

25,000

Fair value adjustment ...................................................... 25,000 Gain on investments (unrealized, NI) (to balance) ....................

Fair Value Adjustment $ 0 ? $25,000

25,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–19 (concluded) Requirement 2 The investment would be accounted for using the equity method: Purchase ..................................................................

Investment in equity affiliate................................. 480,000 Cash ......................................................... ...................

480,000

Net income ............................................................... Investment in equity affiliate (20% × $250,000)............ 50,000

Investment revenue ................................... ...................

50,000

Dividends ................................................................. Cash (20% × 400,000 shares × $0.25 per share) .................. 20,000

Investment in equity affiliate .................... ...................

20,000

Adjusting entry........................................................

No entry

Exercise 12–20 Purchase .............................................($ in millions)

Investment in equity affiliate ............................................. 56 Cash .......................................................... ....................... Net income ............................................................... Investment in equity affiliate (30% × $40 million) ....................

Investment revenue .................................... .......................

56 12 12

Dividends ................................................................. Cash (30% × 8 million shares × $1.25 per share) ...............................3

Investment in equity affiliate...................... .......................

Adjusting entry ........................................................

No entry

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12– Requirement 1: Error discovered before the books are adjusted or closed in 1520 2024. The journal entry the company made is: Cash............................................................... Investment in equity affiliate......................

100,000 100,000

The journal entry the company should have made is: Cash............................................................... Investment in equity affiliate...................... Gain on investments ($100,000 – $75,000).. ...

100,000 75,000 25,000

Therefore, to get from what was done to what should have been done, the following entry is needed: Investment in equity affiliate (to balance)…...... Gain on investments ($100,000 – $75,000).. ...

25,000 25,000

Requirement 2: Error not discovered until early 2025. Investment in equity affiliate (to balance)......... Retained earnings ($100,000 – $75,000).........

25,000 25,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–22 Purchase ............................................ ($ in millions)

Investment in equity affiliate ......................................... 68 Cash .......................................................... ................... Net income ............................................................... Investment in equity affiliate (25% × $40 million) ................

Investment revenue .................................... ...................

68 10 10

Dividends ................................................................. Cash (4 million shares × $1 per share) ........................................... 4

Investment in equity affiliate...................... ................... Depreciation Adjustment ........................................

‡

Investment revenue ($8 million [calculation below ] ÷ 8 years).. Investment in equity affiliate ..................... ...................

1 1

‡

Calculations: Investee Identifiable Net Assets



Cost

Identifiable................... Net Assets... Difference PurchasedAttributed to:





$68

 Fair value:

$224* × 25% = $56

 Book value:

Goodwill:$12

$192 × 25% = $48

Undervaluation of assets: $8

*[$192 + $32] = $224 Adjusting entry

No entry to adjust for changes in fair value as this investment is accounted for under the equity method.

Exercise 12–23 Requirement 1 Purchase .............................................($ in millions)

Investment in equity affiliate ....................................... 300 Cash .......................................................... ...................

300

Net income ............................................................... Investment in equity affiliate (20% × $150 million) .................

30 30

Investment revenue .................................... ................... Dividends ................................................................. Cash (20% × $30 million) ............................................................ 6

Investment in equity affiliate...................... ................... Adjustment for depreciation ...................................

‡

Investment revenue ($10 million [calculation below ] ÷ 10 years) Investment in equity affiliate...................... ...................

1 1

‡

calculation: Investee Identifiable Net Assets



Cost Fair value:

Book value:

Identifiable ................... Net Assets.. Difference PurchasedAttributed to:



$300



.... Goodwill: $120

$900 × 20% = $180

Undervaluation

$800 × 20% = $160 of buildings ($10) and land ($10):

$20

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–23 (concluded) Requirement 2 a. Investment in Lake Construction shares ($ in millions)

Cost Share of net income

300 30 6 Dividends 1 Depreciation adjustment

Balance

323

b. As net investment revenue in the income statement. $30 million (share of net income) – $1 million (depreciation adjustment) = $29 million net investment revenue c. Among investing activities in the statement of cash flows. $300 million outflow [Cash dividends received ($6 million) also are reported—as part of operating activities. If Cameron reports cash flows using the indirect method, the operating activities section of its statement of cash flows would include an adjustment of ($23 million) to get from the net income figure that includes $29 million of revenue to a cash flow number that should only include $6 million of cash flow.]

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–24 Requirement 1 Purchase .............................................($ in millions)

Investment in equity affiliate ....................................... 100.00 Cash .......................................................... ...................

100.00

Net income ............................................................... Investment in equity affiliate (25% × $32 million) ...................

8.00 8.00

Investment revenue .................................... ................... Dividends ................................................................. Cash (25% × $24 million)............................................................. 6.00

Investment in equity affiliate...................... ...................

6.00

Amortization of differential .................................... ‡

Investment revenue (calculation below ) .................................. 6.75 Investment in equity affiliate...................... ...................

6.75

‡

calculation: Investee Identifiable Net Assets



Cost

Identifiable ................... Net Assets.. Difference PurchasedAttributed to:

............................... 

$100

.... Goodwill: $12.5 Fair value:

Book value:

$350 × 25% = $87.5

Total Undervaluation

$32.5

$220 × 25% = $55 inventory ($20 × 25% = $5), buildings ($80 × 25% = $20), and equipment ($30 × 25% = $7.5)

Calculation of 2024 amortization of differential: Inventory (all sold in latter half of 2024, so entire differential expensed): Buildings ($20 ÷ 10 year remaining life × 0.5 year): Equipment ($7.5 ÷ 5 year remaining life × 0.5 year): Total:

$5.00 1.00 0.75 $6.75

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–24 (concluded) Requirement 2 a.

Investment in VB shares ($ in millions)

Cost Share of net income

100 8 6 Dividends 6.75 Amortization of differentials

Balance

95.25

b. As net investment revenue or loss in the income statement. $8 million (share of net income) – $6.75 million (adjustment for amortization purchase price differential) = $1.25 million net investment revenue

c. Among investing activities in the statement of cash flows. $100 million outflow [Cash dividends received ($6 million) also are reported as part of operating activities. If Gupta reports cash flows using the indirect method, the operating activities section of its statement of cash flows would include an add back of $4.75 million to get from the net income figure that includes $1.25 million of income to a cash flow number that should include $6 million of cash flow.]

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–25 Requirement 1 Held to maturity at fair value Electing the fair value option for held-to-maturity securities requires accounting for those investments the same way Tanner-UNF would account for trading securities. The securities would be shown at fair value in Tanner-UNF‘s balance sheet and unrealized gains and losses would be included in Tanner-UNF‘s net income in the periods in which they arise. Requirement 2 Investment in bonds (face amount) ....................... Discount on bond investment (difference)......... Cash (price of bonds) ......................................... Requirement 3 Cash (3% × $240 million)....................................... Discount on bond investment (difference) ............ Interest revenue (4% × $200)................................

($ in millions)

240.0 40.0 200.0 7.2 0.8 8.0

Requirement 4 The amortized cost of the bonds is $240 – ($40 – $0.8) = $200.8. Therefore, to adjust to fair value of $210, Tanner-UNF would need a fair value adjustment of $210 – $200.8 = $9.2. Fair Value Adjustment Balance on 7/1/2024 $ 0 ± Adjustment needed to update fair value ? Balance needed on 12/31/2024 ($210 – $200.8) $9.2 Fair Value Adjustment 7/1/2024

Change needed

9.2

12/31/2024

9.2

Tanner-UNF would record the following journal entry: Fair value adjustment ......................................... Gain on investments (unrealized, NI) (to balance)

9.2 9.2

Exercise 12–25 (concluded) Requirement 5 Tanner-UNF reports its investment in the December 31, 2024, balance sheet at fair value of $210 million. Requirement 6 1) Update the fair value adjustment: Need to move from a fair value adjustment of $9.2 to ($10.8):

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 1/2/2025 ($190.0 – $200.8) Fair Value Adjustment 12/31/2024 Change needed 1/2/2025

Fair Value Adjustment $ 9.2 ? $(10.8)

9.2 20 10.8

Loss on investments (unrealized, NI) (to balance) ........................ Fair value adjustment ............................................................

20.0 20.0

Note: the loss equals the difference between the proceeds ($190 million) and the carrying value of the investment ($210 million).

Complete Solution Manual for Intermediate Accounting, 11th Edition

2) Record the sale transaction: ($ in millions)

Cash (proceeds from sale) ...................................... Fair value adjustment (account balance) ................ Discount on bond investment (account balance) .... Investment in bonds (account balance) ...............

190.0 10.8 39.2 240.0

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–26 Requirement 1 a. July 1, 2024: Purchase Jackson bonds These are available for sale securities but when electing the fair value option Colah must account for the bonds with unrealized gains and losses recognized each period in net income and report the bond investment at fair value on the balance sheet. Investment in bonds ............................................................ 1,000,000 Cash........................................................................... 1,000,000 b. December 31, 2024: Recognize interest revenue Cash ............................................................................. Interest revenue ($1,000,000 × 5% × ½ year) ..................

25,000 25,000

c. December 31, 2024: Year-end adjusting entries Need to move from a fair value adjustment of $0 to $200,000:

Balance on 7/1/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($1,200,000 − $1,000,000) Fair Value Adjustment 7/1/2024 Change needed

0 200,000

12/31/2024

200,000

Fair value adjustment .................................................... Gain on investments (unrealized, NI) (to balance) ........

Fair Value Adjustment $ 0 ? $200,000

200,000 200,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–26 (continued) d. June 30, 2025: Recognize interest revenue Cash ............................................................................. Interest revenue ($1,000,000 × 5% × ½ year) ..................

25,000 25,000

e. July 1, 2025: Any entries necessary upon sale of the Jackson bonds 1)

Update the fair value adjustment: Need to move from a fair value adjustment of $200,000 to ($100,000):

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 7/1/2025 ($1,000,000 – $900,000) Fair Value Adjustment 12/31/2024

Fair Value Adjustment $ 200,000 ? $(100,000)

200,000

Change needed

300,000

7/1/2025

100,000

Loss on investments (unrealized, NI) (to balance) ............. 300,000 Fair value adjustment ...............................................

300,000

Note: The loss equals the difference between the proceeds ($900,000) and the carrying value of the investment ($1.2 million). 2)

Record the sale transaction: Cash.............................................................................. 900,000 Fair value adjustment .................................................... 100,000 Investment in bonds (amortized cost) ............................ 1,000,000

Exercise 12–26 (concluded) Requirement 2 2024

2025

Total

Net Income

$25,000 + $200,000 = $225,000

$25,000 – $300,000 = $(275,000)

$225,000 + ($275,000) = $(50,000)

OCI

-0-

$(275,000)

$225,000 + $(275,000) = $(50,000)

Comprehensive Income

$225,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–27 Requirement 1 Significant influence investment at fair value Electing the fair value option for significant influence investments requires the securities to be shown at fair value in the balance sheet and unrealized gains and losses to be included in net income in the periods in which they arise. However, the investments will still be classified as significant influence investments and shown either on the same line of the balance sheet as equity method investments (but with the amount at fair value indicated parenthetically) or on a separate line of the balance sheet. Requirement 2 (Prepared in the manner of equity investments that do not have significant influence.) Purchase .............................................($ in millions)

Investment in equity affiliate ............................................. 56 Cash .......................................................... .......................

Net income ...............................................................

No entry. Dividends ................................................................. Cash (30% × 8 million shares × $1.25 per share) ...............................3

Dividend revenue ....................................... .......................

Adjusting entry ........................................................

Need to move from a fair value adjustment of $0 to ($4) million:

Balance at purchase ± Adjustment needed to update fair value Balance needed at year end ($52 million – $56 million)

Fair Value Adjustment $ 0 ? $(4)

Complete Solution Manual for Intermediate Accounting, 11th Edition

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–27 (concluded) Fair Value Adjustment 1/1/2024

Change needed

12/31/2024

Complete Solution Manual for Intermediate Accounting, 11th Edition

Florists would make the following journal entry:

Complete Solution Manual for Intermediate Accounting, 11th Edition

Loss on investments (unrealized, NI) to balance) ........................ Fair value adjustment ................................. .......................

4 4

Note: A different approach to reach the same outcome would be for Florists to use equity method accounting throughout the year, and then at the end of the year make whatever adjustment to fair value is necessary to adjust the investment account to fair value. Under that approach, Florists would recognize 30% of Nursery‘s $40 million of income ($12 million) as investment income, it would not recognize investment income associated with Nursery‘s dividend, and would end up with an investment account containing $65 ($56 million + $12 million – $3 million). The company would need to make a fair value adjustment of $13 million ($65 million – $52 million). So the total amount of loss recognized would be $1 million ($12 million investment income – $13 million unrealized loss). Note that this alternative produces the same total amount of investment loss as is produced above: $1 million ($3 million dividend (investment revenue) – $4 million unrealized loss). Requirement 3 The effect on net income before taxes is a loss of $1 million ($3 million dividend (investment revenue) – $4 million unrealized loss).

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–28 Requirement 1 Insurance expense (difference)......................................... 64,000 Cash surrender value of life insurance ($27,000 – $21,000) ... Cash (2024 premium) .................................... ...................

6,000 70,000

Requirement 2 Cash (death benefit) ................................................. 4,000,000 Cash surrender value of life insurance (account balance) Gain on life insurance settlement (to balance) ...........

27,000 3,973,000

Exercise 12– 1552 Requirement 1

Insurance expense (difference) ................................22,900 Cash surrender value of life insurance ($4,600 – $2,500) Cash (premium)............................................ ............

2,100 25,000

Requirement 2 Cash (death benefit) ..................................................250,000 Cash surrender value of life insurance (account balance) Gain on life insurance settlement (to balance) ...........

16,000 234,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–30 Requirement 1 For HTM investments, it is not relevant that Bloom believes it is more likely than not it will have to sell the investment before fair value recovers. Also for HTM investments, noncredit losses also are not relevant. Bloom must recognize credit losses toward net income as follows: Credit loss expense ......................................... Allowance for credit losses.............................

250,000 250,000

In the income statement, the $250,000 will be shown as a credit loss expense. Requirement 2 Because it is not relevant that Bloom believes it is more likely than not it will have to sell the investment before fair value recovers, the answer for requirement 2 is the same as that given for requirement 1. Bloom must recognize credit losses toward net income as follows: Credit loss expense ......................................... Allowance for credit losses.............................

250,000 250,000

In the income statement, the $250,000 will be shown as a credit loss expense.

Exercise 12– 1554

Requirement 1: Assuming Bloom has not previously recorded a $100,000 loss Scenario 1: Bloom believes it is more likely than not it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is not relevant. Bloom must recognize the entire impairment in earnings. Bloom makes the following entry: Loss on impairment (NI) .................................. Discount on bond investment .........................

400,000 400,000

In the income statement, the entire $400,000 will be shown as an impairment loss which will reduce net income. There is no effect on OCI, and the net effect is a $400,000 decrease in comprehensive income. Scenario 2: Bloom does not plan to sell the investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is relevant. Bloom must recognize the $250,000 of credit losses in earnings, and the other $150,000 as a reduction of OCI. Bloom makes the following entries: Credit loss expense ......................................... Allowance for credit losses.............................

250,000

Loss on investments (unrealized, OCI) ............. Fair value adjustment .....................................

150,000

250,000

150,000

In the income statement, $250,000 will be shown as a credit loss which will decrease net income. OCI will decrease by $150,000, and the net effect is a $400,000 decrease in comprehensive income.

Complete Solution Manual for Intermediate Accounting, 11th Edition Exercise 12–31 (continued) Requirement 2: Assuming Bloom has previously recorded a $100,000 unrealized loss Scenario 1: Bloom believes it is more likely than not it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is not relevant. Bloom must recognize the entire impairment in net income. Bloom makes the following entry: Loss on impairment (NI) .................................. Discount on bond investment .........................

400,000 400,000

At December 31, 2024, Bloom must reclassify out of OCI the loss that was recorded in the prior year 2023. Bloom would reverse that 2023 entry: Fair value adjustment ......................................... Reclassification adjustment (OCI) .................

100,000 100,000

In the income statement, $400,000 will be shown as a loss on impairment which will decrease net income. OCI will increase by $100,000, and the net effect is a $300,000 decrease in comprehensive income.

Note: The total effect of the decline in fair value is $400,000 of which $300,000 is recognized in comprehensive income in year 2024, and $100,000 was recognized in comprehensive income in the prior year of 2023 when Bloom would have made the following entry for the unrealized loss at December 31, 2023: Loss on investments (unrealized, OCI) ............. Fair value adjustment .....................................

100,000 100,000

Exercise 12–31 (concluded) Scenario 2: Bloom does not plan to sell the investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is relevant. Bloom must recognize the $250,000 of credit losses in net income. Bloom also should recognize in OCI an additional $50,000 of unrealized losses on its AFS investment, as that loss has increased from $100,000 to $150,000: Credit loss expense ............................................ Allowance for credit losses.............................

250,000

Loss on investments (unrealized, OCI) ............. Fair value adjustment .....................................

50,000

250,000

50,000

In the income statement, $250,000 will be shown as a credit loss expense which will decrease net income. OCI will be decreased by $50,000, and the net effect is a $300,000 decrease in comprehensive income. Note: Of the total $400,000 decline in fair value since the investment was purchased, $100,000 of decrease in OCI and comprehensive income occurred in 2023, when the $100,000 unrealized loss was recognized.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Exercise 12–32 Requirement 1 Under IFRS No. 9, if there has not been a significant increase in credit risk, only 12-month credit losses are recognized as impairments: Loss on impairment (NI) .................................. Allowance for credit losses.............................

750,000 750,000

Requirement 2 Under IFRS No. 9, if there has been a significant increase in credit risk, lifetime credit losses are recognized as impairments: Loss on impairment (NI) (€750,000 + €450,000) ... Allowance for credit losses.............................

1,200,000 1,200,000

Requirement 3 Under IFRS No. 9, credit losses are eligible for reversal if they recover. In this case, because no significant increase in credit risk has occurred, only 12-month credit losses have been recognized as impairments, totaling €750,000. Now 12-month credit losses total €650,000, so the allowance should be reduced by €100,000: Allowance for credit losses ................................ Loss on impairment (NI) ..............................

100,000 100,000

Problems

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–1 Requirement 1 Investment in bonds (face amount) ....................... Discount on bond investment (difference)......... Cash (price of bonds) .........................................

($ in millions)

80.00 14.00 66.00

Requirement 2 Cash (4% × $80 million) ........................................ Discount on bond investment (difference) ............ Interest revenue (5% × $66)..................................

3.20 0.10

Requirement 3 Cash (4% × $80 million) ........................................ Discount on bond investment (difference) ............ Interest revenue (5% × [$66 + $0.1]) ....................

3.20 0.11

3.30

3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2024, balance sheet at its amortized cost; that is, its book value: Investment in bonds .......................................................... $80.00 Less: Discount on bond investment ($14 – $0.10 – $0.11 million) 13.79 Amortized cost .............................................................. $66.21 Increases and decreases in the fair value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant if sale before maturity isn‘t an alternative. For this reason, if an investor has the positive intent and ability to hold the securities to maturity, investments in debt securities are classified as held-to-maturity and reported at amortized cost rather than fair value in the balance sheet.

Problem 12–1 (concluded) Requirement 5 Fuzzy Monkey‘s 2024 statement of cash flows would be affected as follows: Operating activities cash flows: Cash flow from interest received of $3.2 + $3.2 = $6.4 inflow. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + $3.31 = $6.61 included in net income, so would have to include an adjustment of $6.4 – $6.61 = ($0.21) to get from net income to cash flow from operating activities.) Investing activities cash flows: Cash flow from purchase of investments = $66 outflow.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–2 Requirement 1 Investment in bonds (face amount)........................ Discount on bond investment (difference)......... Cash (price of bonds) .........................................

($ in millions)

80.00 14.00 66.00

Requirement 2 Cash (4% × $80 million) ........................................ Discount on bond investment (difference) ............ Interest revenue (5% × $66)..................................

3.20 0.10

Requirement 3 Cash (4% × $80 million) ........................................ Discount on bond investment (difference) ............ Interest revenue (5% × [$66 + $0.1]) ....................

3.20 0.11

3.30

3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2024, balance sheet at its fair value, $70 million. For investments in trading securities, changes in market values, and thus market returns, provide an indication of management‘s success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in long-term or short-term securities. To do this, we first need to determine the investment‘s amortized cost (or book value) at the end of the year: Investment in bonds .......................................................... Less: Discount on bond investment ($14 – $0.10 – $0.11 million) Amortized cost ..............................................................

$80.00 13.79 $66.21

Thus, Fuzzy Monkey needs to move from a fair value adjustment of $0 to $3.79 in order to reflect a fair value of $70 million:

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–2 (concluded)

Balance on 1/1/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($70 – $66.21) Fair Value Adjustment 1/1/2024

Change needed

3.79

12/31/2024

3.79

Fair Value Adjustment $ 0 ? $3.79

Fair value adjustment (calculated above) ......................... 3.79 Gain on investments (unrealized, NI) (to balance) .....

3.79

Because these are trading securities, the unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey‘s 2024 income statement. Requirement 5 Fuzzy Monkey‘s 2024 statement of cash flows would be affected as follows: Operating activities cash flows: Cash flow from interest received of $3.2 + $3.2 = $6.4 inflow. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + $3.31 = $6.61 and an unrealized holding gain of $3.79 included in net income, totaling $10.4, so would have to include an adjustment of $6.4 – $10.4 = ($4.0) to get from net income to cash flow from operating activities.) Fuzzy Monkey would also be likely to treat the cash flow from purchase of trading securities as an operating activities $66 cash outflow.

Problem 12–3 Requirement 1 Investment in bonds (face amount)........................ Discount on bond investment (difference)......... Cash (price of bonds) .........................................

($ in millions)

80.00 14.00 66.00

Requirement 2 Cash (4% × $80 million) ........................................ Discount on bond investment (difference) ............ Interest revenue (5% × $66) ..................................

3.20 0.10

Requirement 3 Cash (4% × $80 million) ........................................ Discount on bond investment (difference) ............ Interest revenue (5% × [$66 + $0.1]).....................

3.20 0.11

3.30

3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2024, balance sheet at its fair value, $70 million. For investments in securities available-for-sale, changes in market values, and thus market returns, provide an indication of management‘s success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in long-term or short-term securities. To do this, we first need to determine the investment‘s amortized cost (or book value) at the end of the year: Investment in bonds .......................................................... Less: Discount on bond investment ($14 – $0.10 – $0.11 million) Amortized cost ..............................................................

$80.00 13.79 $66.21

Thus, Fuzzy Monkey needs to move from a fair value adjustment of $0 to $3.79 in order to reflect a fair value of $70 million:

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–3 (concluded)

Balance on 1/1/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($70 – $66.21) Fair Value Adjustment 1/1/2024

Change needed

3.79

12/31/2024

3.79

Fair Value Adjustment $ 0 ? $3.79

Fair value adjustment (calculated above).......................... 3.79 Gain on investments (unrealized, OCI) (to balance) ..

3.79

Because these are securities available for sale, the unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey‘s 2024 other comprehensive income. They only would be recognized in net income in the period in which they are sold. Requirement 5 Fuzzy Monkey‘s 2024 statement of cash flows would be affected as follows: Operating activities cash flows: Cash flow from interest received of $3.2 + $3.2 = $6.4 inflow. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + $3.31 = $6.61 included in net income, so would have to include an adjustment of $6.4 – $6.61 = ($0.21) to get from net income to cash flow from operating activities.) Investing activities cash flows: Cash flow from purchase of investments = $66 outflow.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–4 Note: Because Fuzzy Monkey elected the fair value option, these investments will be accounted for similar to trading securities with regard to recognizing unrealized gains or losses on the investment in net income. Therefore, the answers to Requirements 1– 3 are the same as for any type of investment in debt securities, and the answer to Requirement 4 follows that for trading securities in Problem 12–2. Requirement 1 Investment in bonds (face amount)........................ Discount on bond investment (difference)......... Cash (price of bonds) .........................................

($ in millions)

80.00 14.00 66.00

Requirement 2 Cash (4% × $80 million) ........................................ Discount on bond investment (difference) ............ Interest revenue (5% × $66)..................................

3.20 0.10

Requirement 3 Cash (4% × $80 million) ........................................ Discount on bond investment (difference) ............ Interest revenue (5% × [$66 + $0.10]) ..................

3.20 0.11

3.30

3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2024, balance sheet at its fair value, $70 million. To determine the journal entry that Fuzzy Monkey must make, we first need to determine the investment‘s amortized cost (or book value) at the end of the year: Investment in bonds .......................................................... Less: Discount on bond investment ($14 – $0.10 – $0.11 million) Amortized cost ..............................................................

$80.00 13.79 $66.21

Thus, Fuzzy Monkey needs to move from a fair value adjustment of $0 to $3.79 in order to reflect a fair value of $70 million:

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–4 (continued)

Balance on 1/1/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ($70 – $66.21) Fair Value Adjustment 1/1/2024

Change needed

3.79

12/31/2024

3.79

Fair value adjustment (calculated above) ......................... 3.79 Gain on investments (unrealized, NI) (to balance) .....

Fair Value Adjustment $ 0 ? $3.79

3.79

The unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey‘s 2024 income statement.

Requirement 5 Fuzzy Monkey‘s 2024 statement of cash flows would be affected as follows: Operating activities cash flows: Cash flow from interest received of $3.2 + $3.2 = $6.4 inflow. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have included in net income interest revenue of $3.30 + $3.31 = $6.61 and an unrealized holding gain of $3.79, totaling $10.4, so would have to include an adjustment of $6.4 – $10.4 = ($4.0) to get from net income to the correct operating activities cash flow.) If Fuzzy Monkey anticipates holding these investments for a sufficiently long period, which seems likely given that it didn‘t classify them as trading securities to begin with, it would report this $66 cash outflow as an investing activities cash flow. Note that if Fuzzy Monkey had instead anticipated holding the securities for a short period of time, it might treat the cash outflow as an operating activities cash flow, similar to how it would treat cash flows associated with a trading security.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Investing activities cash flows: Cash flow from purchase of investments = $66 outflow

Complete Solution Manual for Intermediate Accounting, 11th Edition

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–4 (concluded) Requirement 6 The answers to requirements 1–5 would not differ if the investment qualified for treatment as a held-to-maturity investment, because Fuzzy Monkey‘s choice of the fair value option still requires accounting for the investment at fair value and recognizing unrealized gains or losses in net income.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–5 Requirement 1 2024 March 31 for Distribution Transformer bonds Investment in bonds ....................................... 400,000 Cash........................................................... ............

400,000

September 1 for American Instruments bonds Investment in bonds ....................................... 900,000 Cash........................................................... ............

900,000

September 30 for Distribution Transformer bonds Cash................................................................. 16,000 Interest revenue ($400,000 × 8% × 6/12) ........ ............

16,000

October 2 for Distribution Transformer bonds 1)

Update the fair value adjustment for Distribution Transformer bonds

Need to move from a fair value adjustment of $0 to $25,000:

Balance on 3/31/2024 ± Adjustment needed to update fair value Balance needed on 10/2/2024 ($425,000 – $400,000) Fair Value Adjustment 3/31/2024

Change needed

25,000

10/2/2024

25,000

Fair Value Adjustment $ 0 ? $25,000

Fair value adjustment................................................................. Gain on investments (unrealized, NI) (to balance) ...................

25,000 25,000

Note: The gain included in NI equals the difference between the proceeds ($425,000) and the carrying value of the investment ($400,000).

Problem 12–5 (continued) 2)

Record the sale transaction for Distribution Transformer bonds Cash (proceeds)........................................................425,000 Investment in bonds (cost) .......................... ............ Fair value adjustment (account balance) ........ ............

400,000 25,000

November 1 for M&D bonds Investment in bonds ....................................... 1,400,000 Cash........................................................... ............

1,400,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–5 (continued) December 31 Adjusting entries: Accrue interest for American Instruments bonds Interest receivable ............................................ 30,000 Interest revenue ($900,000 × 10% × 4/12) ........ ............

30,000

Accrue interest for M&D bonds Interest receivable ............................................ 14,000 Interest revenue ($1,400,000 × 6% × 2/12) ....... ............

14,000

Prepare fair value adjustment for remaining investments Accumulated Unrealized Trading Securities Investments CostFair ValueGain (Loss) M & D Corporation bonds ............$1,400,000$1,460,000$60,000 American Instruments bonds ........ 900,000 850,000 (50,000) Totals—Dec. 31, 2024 ...............$2,300,000$2,310,000$10,000* Need to move from a fair value adjustment of $0 to $10,000:

Balance on 1/1/2021 ± Adjustment needed to update fair value Balance needed on 12/31/2024 Fair Value Adjustment 1/1/2024

Change needed

10,000

12/31/2024

10,000

Fair value adjustment (calculated above) ............... 10,000 Gain on investments (unrealized, NI) ........ ............

Fair Value Adjustment $ 0 ? $10,000

10,000

Problem 12–5 (concluded) Requirement 2 Income statement: Interest revenue ($16,000 + $30,000 + $14,000) .. Gain on investments ($25,000 + $10,000)......... Net Income...................................................

$ 60,000 35,000 $ 95,000

Statement of comprehensive income: Net income ................................................. Other comprehensive income Comprehensive income................................

$95,000

Balance sheet: Current Assets Interest receivable ......................................

$95,000 0

44,000

Investment in bonds ................................... $2,300,000 Plus: Fair value adjustment ........................ 10,000$2,310,000 Shareholders’ Equity Retained Earnings ...................................... .......

$95,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–6 Requirement 1 2024 March 31 for Distribution Transformer bonds Investment in bonds ....................................... 400,000 Cash........................................................... ............

400,000

September 1 for American Instruments bonds Investment in bonds ....................................... 900,000 Cash........................................................... ............

900,000

September 30 for Distribution Transformer bonds Cash................................................................. 16,000 Interest revenue ($400,000 × 8% × 6/12) ........ ............

16,000

October 2 for Distribution Transformer bonds 1) Update the fair value adjustment for Distribution Transformer bonds Need to move from a fair value adjustment from $0 to $25,000:

Initial balance ± Adjustment needed to update fair value Balance needed on 10/2/2024 ($425,000 – $400,000) Fair Value Adjustment Initial

Change needed

25,000

10/2/2024

25,000

Fair Value Adjustment $ 0 ? $25,000

Fair value adjustment ................................................................ Gain on investments (unrealized, OCI) (to balance) .................

25,000 25,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–6 (continued) 2) Record any reclassification adjustment for Distribution Transformer bonds Need to move from a fair value adjustment from $25,000 to $0:

Balance on 10/2/2024: ± Reclassification adjustment Balance needed to close fair value adjustment Fair Value Adjustment 10/2/2024

25,000

Change needed 10/2/2024

Fair Value Adjustment $25,000 ? $ 0

25,000 0

Reclassification adjustment (OCI) (to balance)................ 25,000 Fair value adjustment ............................................................. 3)

25,000

Record the sale transaction for Distribution Transformer bonds Cash............................................................... 425,000 Investment in bonds .................................. ............ Gain on investments (NI) .......................... ............

400,000 25,000

Note: The gain included in NI equals the difference between the proceeds ($425,000) and the carrying value of the investment ($400,000). It also equals the amount of unrealized gain that had accumulated in AOCI and was removed from AOCI with the reclassification adjustment. November 1 for M&D bonds Investment in bonds ....................................... 1,400,000 Cash........................................................... ............

1,400,000

Problem 12–6 (continued) December 31 Adjusting entries: Accrue interest for American Instruments bonds Interest receivable ............................................ 30,000 Interest revenue ($900,000 × 10% × 4/12) ........ ............

30,000

Accrue interest for M&D bonds Interest receivable ............................................ 14,000 Interest revenue ($1,400,000 × 6% × 2/12) ....... ............

14,000

Prepare fair value adjustment for remaining investments Accumulated Unrealized Available-for-Sale Securities CostFair ValueGain (Loss) M & D Corporation bonds ............$1,400,000$1,460,000$60,000 American Instruments bonds ........ 900,000 850,000 (50,000) Totals—Dec. 31, 2024 ...............$2,300,000$2,310,000$10,000* Need to move from a fair value adjustment of $0 to $10,000 for the portfolio:

Balance on 1/1/2024 ± Adjustment needed to update fair value * Balance needed on 12/31/2024 Fair Value Adjustment 1/1/2024

Change needed

10,000

12/31/2024

10,000

Fair value adjustment (calculated above) ................10,000 Gain on investments (unrealized, OCI) ..... ............

Fair Value Adjustment $ 0 ? $10,000

10,000

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–6 (concluded) Requirement 2 Income statement: Interest revenue ($16,000 + $30,000 + $14,000)) Gain on investments ..................................... Net income ............................................. Statement of comprehensive income: Net income ................................................. Other comprehensive income: Gain on investments ($25,000 + $10,000)$ 35,000 Reclassification adjustment (25,000) Comprehensive income................................ Balance sheet: Current Assets Interest receivable ......................................

$ 60,000 25,000 $ 85,000

$ 85,000

10,000 $ 95,000

44,000

Noncurrent Assets Investment in bonds ................................... $2,300,000 Plus: Fair value adjustment ........................ 10,000$2,310,000 Shareholders’ Equity Retained Earnings ...................................... Accumulated other comprehensive income

85,000 10,000

Problem 12–7 Requirement 1 2024 March 31 for Distribution Transformer stock Investment in equity securities ....................... 400,000 Cash........................................................... ............

400,000

September 1 for American Instruments stock Investment in equity securities ....................... 900,000 Cash........................................................... ............

900,000

September 30 for Distribution Transformer stock Cash................................................................. 16,000 Dividend revenue ....................................... ............

16,000

October 2 for Distribution Transformer stock 1)

Update the fair value adjustment for Distribution Transformer stock Need to move from a fair value adjustment of $0 to $25,000:

Balance on 3/31/2024 ± Adjustment needed to update fair value Balance needed on 10/2/2024 ($425,000 – $400,000) Fair Value Adjustment 3/31/2024

Change needed

25,000

10/2/2024

25,000

Fair Value Adjustment $ 0 ? $25,000

Fair value adjustment ...................................................... 25,000 Gain on investments (unrealized, NI) (to balance) .....

25,000

Note: The gain included in NI equals the difference between the proceeds ($425,000) and the carrying value of the investment ($400,000).

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–7 (continued) Record the sale transaction for Distribution Transformer stock Cash (proceeds) ....................................................... 425,000 Investment in equity securities (cost) .......... ............ Fair value adjustment (account balance) .... ............

400,000 25,000

November 1 for M&D stock Investment in equity securities ....................... 1,400,000 Cash........................................................... ............

1,400,000

December 31 Adjusting entry: Prepare fair value adjustment for remaining investments Accumulated Unrealized Equity Securities CostFair ValueGain (Loss) M & D Corporation stock .............$1,400,000$1,460,000$60,000 American Instruments stock.......... 900,000 850,000 (50,000) Totals—Dec. 31, 2024 ...............$2,300,000$2,310,000$10,000* *Need to move from a fair value adjustment of $0 to $10,000:

Balance on 1/1/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 Fair Value Adjustment 1/1/2024

Change needed

10,000

12/31/2024

10,000

Fair value adjustment (calculated above) ............... 10,000 Gain on investments (unrealized, NI) ........ ............

Fair Value Adjustment $ 0 ? $10,000

10,000

Problem 12–7 (concluded) Requirement 2 Income statement: Dividend revenue ................................................ Gain on investments (unrealized) ................. Gain on investments (sold) ........................... Net Income...................................................

$16,000 10,000 25,000 $51,000

Statement of comprehensive income: Net income ................................................. Other comprehensive income....................... Comprehensive income................................

$51,000 0 $51,000

Balance sheet: Noncurrent Assets Investments in equity securities .................. $2,300,000 Plus: Fair value adjustment ........................ 10,000$2,310,000 Shareholders’ Equity Retained Earnings ...................................... .......

$51,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–8 Requirement 1

2024 December 12 for FF&G bonds ....... ($ in millions) Investment in bonds ................................................................ 12.0 Cash........................................................... ............................

12.0

December 13 for Ferry Intercommunications stock Investment in equity securities ................................................ 22.0 Cash........................................................... ............................

22.0

December 15 for FF&G bonds 1) Update the fair value adjustment for FF&G bonds Need to move from a fair value adjustment of $0 to $0.1 million:

Balance on 12/12/2024 ± Adjustment needed to update fair value Balance needed on 12/15/2024 ($12.1 – $12.0) Fair Value Adjustment 12/12/2024

Change needed

0.1

12/15/2024

0.1

Fair Value Adjustment $0 ? $0.1 million

Fair value adjustment .............................................................................. 0.1 Gain on investments (unrealized, NI) (to balance) ...................

0.1

Note: The gain included in NI equals the difference between the proceeds ($12.1 million) and the carrying value of the investment ($12.0 million).

Problem 12–8 (continued) 2)

Record the sale transaction for FF&G bonds Cash........................................................................................ 12.1 Investment in bonds .................................. ............................ Fair value adjustment (account balance) ........ ............................

12.0 0.1

December 22 for U.S. treasury bills and bonds Investment in bonds .............................................................. 121.0 Cash........................................................... ............................

121.0

December 23 for Ferry Intercommunications stock 1)

Update the fair value adjustment for Ferry Intercommunications stock Need to move from a fair value adjustment of $0 to ($1.0) million:

Balance on 12/13/2024 ± Adjustment needed to update fair value Balance needed on 12/23/2024 ($10.0 – $11.0) Fair Value Adjustment 12/13/2024

Fair Value Adjustment $ 0 ? ($1.0)

Change needed

1.0

12/23/2024

1.0

Loss on investments (unrealized, NI) (to balance) ........................ Fair value adjustment ............................................................

1.0 1.0

Note: The loss included in NI equals the difference between the proceeds ($10.0 million) and the carrying value of the investment ($11.0 million).

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–8 (continued) 2) Record the sale transaction for Ferry Intercommunications stock Cash........................................................................................ 10.0 Fair value adjustment (account balance)........................................... .. 1.0 Investment in equity securities .................. ............................

11.0

December 26 for U.S. Treasury bills 1)

Update the fair value adjustment for U.S. Treasury bills Need to move from a fair value adjustment of $0 to $1.0 million:

Balance on 12/22/2024 ± Adjustment needed to update fair value Balance needed on 12/26/2024 ($57.5 – 56) Fair Value Adjustment 12/22/2024

Change needed

1.5

12/26/2024

1.5

Fair value adjustment................................................................. Gain on investments (unrealized, NI) (to balance) ...................

Fair Value Adjustment $ 0 ? $1.5

1.5 1.5

Note: The gain included in NI equals the difference between the proceeds ($57.5 million) and the carrying value of the investment ($56.0 million).

Problem 12–8 (continued) 2)

Record the sale transaction for U.S. Treasury bills Cash (selling price)............................................................................... 57.5 Fair value adjustment (account balance) ........ ............................ Investment in bonds (account balance) .......... ............................

1.5 56.0

December 27 for U.S. Treasury bonds 1)

Update the fair value adjustment for U.S. Treasury bonds Need to move from a fair value adjustment of $0 to ($2) million:

Balance on 12/22/2024 ± Adjustment needed to update fair value Balance needed on 12/27/2024 ($63.0 – $65.0) Fair Value Adjustment 12/22/2024 Change needed

0 2.0

12/27/2024

2.0

Fair Value Adjustment $0 ? $(2)

Loss on investments (unrealized, NI) (to balance) ........................ Fair value adjustment ............................................................

2.0 2.0

Note: The loss included in NI equals the difference between the proceeds ($63.0 million) and the carrying value of the investment ($65.0 million). 2)

Record the sale transaction for U.S. Treasury bonds Cash (selling price)............................................................................... 63 Fair value adjustment (account balance) ............................................ 2 Investment in bonds (account balance) .......... ............................

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–8 (continued) December 28 for Ferry Intercommunications Cash.......................................................................................... 0.2 Dividend revenue ....................................... ............................

0.2

December 31 .............................................................................

Adjusting entry: Prepare fair value adjustment for Ferry Intercommunications (in millions) December 13 Cost of 2 million shares $ 22.0 December 23 Sale of 1 million shares, original cost (11.0) December 31 Cost of remaining 1 million shares $ 11.0 December 31 Fair value (1m shares × $10 per share December 31 Cost (from above) December 31 Fair value adjustment required

$ 10.0 (11.0) $( 1.0)

Loss on investments (unrealized, NI) ........................................ 1.0 Fair value adjustment ................................. ............................

1.0

Requirement 2 ....................................................... ($ in millions)

Balance sheet: Current Assets Investments in equity securities Less: Fair value adjustment

$ 11.0 ( 1.0)

$ 10.0

Problem 12–8 (continued) Income statement: Other revenue (expenses): Interest revenue (11 months) Dividend revenue (December) Total interest and dividend revenue Gain(loss) on investments:......................... Gain on investments (11 months) Loss on investments (11 months) FF&G bonds Ferry Intercommunications U.S. Treasury bills U.S. Treasury bonds Net loss on investments Total other revenue(expenses)

$ 5.0 0.2 $ 5.2 $ 8.0 (11.0) 0.1 (2.0) 1.5 (2.0) (5.4) $(0.2)

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–8 (concluded) Requirement 3

2025 January 2 1) Update the fair value adjustment for Ferry Intercommunications: Need to move from a fair value adjustment of ($1.0) to ($0.8) million:

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 1/2/2025 ($10.2 – $11.0) Fair Value Adjustment 12/31/2024 Change needed 1/2/2025

Fair Value Adjustment $ (1) ? $(0.8)

1.0 0.2 0.8

Fair value adjustment................................................................. Gain on investments (unrealized, NI) (to balance) ....................

0.2 0.2

Note: The gain included in NI equals the difference between the proceeds ($10.2 million) and the carrying value of the investment ($10 million). 2)

Record the sale transaction for Ferry Intercommunications: ....................................................... ($ in millions) Cash (selling price) .............................................................................. 10.2 Fair value adjustment (account balance) .............................................0.8 Investment in equity securities (account balance) .......................

January 5 for Warehouse Designs bonds Investment in bonds ................................................................ 34.0 Cash........................................................... ............................

11.0

34.0

Problem 12–9 2024 ($ in millions) October 18 for Millwork Ventures stock Investment in equity securities ................................................ 58.0 Cash........................................................... ............................

58.0

October 31 for Kansas Abstractors bonds Cash.......................................................................................... 1.5 Interest revenue.......................................... ............................

1.5

November 1 for Holistic Entertainment bonds Investment in bonds ................................................................ 18.0 Cash........................................................... ............................

18.0

November 1 for Kansas Abstractors bonds 1)

Update the fair value adjustment for Kansas Abstractors bonds: Need to move from a fair value adjustment of $0 to ($2) million:

Balance on 5/1/2024 ± Adjustment needed to update fair value Balance needed on 11/1/2024 ($28 – $30) Fair Value Adjustment 5/1/2024

Fair Value Adjustment $ 0 ? $(2.0)

Change needed

2.0

11/1/2024

2.0

Loss on investments (unrealized, NI) (to balance) ........................ Fair value adjustment ............................................................

2.0 2.0

Note: The loss included in NI equals the difference between the proceeds ($28 million) and the carrying value of the investment ($30 million). 12–1596 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–9 (continued) Record the sale transaction for Kansas Abstractors bonds: Cash........................................................................................ 28.0 Fair value adjustment (account balance)........................................... .. 2.0 Investment in bonds (TS) .......................... ............................

30.0

December 1 for Household Plastics bonds Investment in bonds ................................................................ 60.0 Cash........................................................... ............................

60.0

December 20 for U.S. Treasury bonds Investment bonds ...................................................................... 5.6 Cash........................................................... ............................

5.6

December 21 for NXS Corporation stock Investment in equity securities ................................................ 44.0 Cash........................................................... ............................

44.0

December 23 for U.S. Treasury bonds Update the fair value adjustment for U.S. Treasury bonds: Need to move from a fair value adjustment of $0 to $0.1 million:

Balance on 12/20/2024 ± Adjustment needed to update fair value Balance needed on 12/23/2024 ($5.7 – $5.6) Fair Value Adjustment 12/20/2024

Change needed

0.1

12/23/2024

0.1

Fair Value Adjustment $ 0 ? $0.1

Problem 12–9 (continued) Fair value adjustment................................................................. Gain on investments (unrealized, NI) (to balance) ...................

0.1 0.1

Note: The gain included in NI equals the difference between the proceeds ($5.7 million) and the carrying value of the investment ($5.6 million). 2)

Record the sale transaction for U.S. Treasury bonds: Cash.......................................................................................... 5.7 Investment bonds ...................................... ............................ Fair value adjustment (account balance) ........ ............................

5.6 0.1

.......................................................($ in millions)

December 29 for Millwork Ventures stock Cash.......................................................................................... 3.0 Dividend revenue .................................... ............................

3.0

December 31 Adjusting entries: Accrue interest for Holistic Entertainment bonds: Interest receivable ($18 million × 10% × 2/12) ................................... 0.3 Interest revenue Accrue interest for Household Plastics bonds Interest receivable ($60 million × 12% × 1/12) .................................... 0.6 Interest revenue ...................................... ............................

0.3

0.6

Prepare fair value adjustment for remaining investments (in millions) Accumulated Unrealized Investments in Securities CostFair ValueGain (Loss) Millwork Ventures stock $ 58.0 $ 55.0 $(3.0) NXS Corporation stock 44.0 46.0 2.0 Totals—Dec. 31, 2024 $102.0 $101.0 $(1.0)* Note: For held-to-maturity investments, there are no adjustments to fair value.

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–9 (continued) Need to move from a fair value adjustment of $0 to $(1.0 million) for the portfolio:

Balance on 10/18/2024 ± Adjustment needed to update fair value *Balance needed on 12/31/2024 Fair Value Adjustment 10/18/2024

Fair Value Adjustment $ 0 ? $(1)

Change needed

12/31/2024

Loss on investments (unrealized, NI) (to balance) ......................... Fair value adjustment ............................. ............................

1 1

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–9 (concluded) 2025 January 7 for NXS Corporation stock 1)

Update the fair value adjustment: Need to move from a fair value adjustment from $2 to $(1 million):

Balance on 12/31/2024 ± Adjustment needed to update fair value Balance needed on 1/7/2025 ($43.3 – $44 fair value) Fair Value Adjustment 12/31/2024

Fair Value Adjustment $ 2.0 ? $ (0.7)

Change needed

2.7

1/7/2025

0.7

Loss on investments (unrealized, NI) (to balance) ........................ Fair value adjustment ............................................................ 2)

2.7 2.7

Record the sale transaction: Cash........................................................................ 43.3 Fair value adjustment ................................................ 0.7 Investment in equity securities ................... ............

Note: Because accounted for as fair value through net income, all gain or loss has already been recognized in NI as unrealized gains and losses, so no additional gain or loss is recognized in the transaction recording the sale.

Problem 12–10 Requirement 1 Purchase .................................... ($ in millions) Investment in equity affiliate ................................................ 324 Cash .......................................................... ............................

324

Net income ............................................................ Investment in equity affiliate (30% × $160 million) ........................ Investment revenue .................................... ............................

48 48

Dividends............................................................... Cash (10 million shares × $2 per share) ................................................ 20 Investment in equity affiliate...................... ............................

Depreciation adjustment .................................. Investment revenue ([30% × $80 million] ÷ 6 years) ........................ Investment in equity affiliate...................... ............................

4 4

Adjusting entry ............................................ No entry to recognize changes in the fair value of the Lavery investment, as Runyan is accounting for its investment under the equity method.

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–10 (concluded) Requirement 2 Purchase .................................... ($ in millions) Investment in equity securities .............................................. 324 Cash .......................................................... ............................

324

Net income.................................................... No entry Dividends...................................................... Cash (10 million shares × $2 per share) ................................................ 20 Dividend revenue ....................................... ............................

Adjusting entry ............................................ Need to move from a fair value adjustment from $0 to ($14 million):

Balance on 1/4/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ([10 × $31] – $324 ) Fair Value Adjustment 1/4/21

Fair Value Adjustment $ 0 ? $ (14)

Change needed

12/31/2024

Loss on investments (unrealized, NI) (to balance) ........................ Fair value adjustment ...........................................................

14 14

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–11 Note: The answer to P12-11 is the same as the answer to Requirement 2 of P12-10. Purchase .................................... ($ in millions) Investment in equity securities .............................................. 324 Cash .......................................................... ............................

324

Adjusting entry ............................................ Need to move from a fair value adjustment from $0 to ($14 million):

Balance on 1/4/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ([10 × $31] – $324) Fair Value Adjustment 1/4/24

Fair Value Adjustment $ 0 ? $ (14)

Change needed

12/31/2024

Loss on investments (unrealized, NI) (to balance) ........................ Fair value adjustment .............................................................

14 14

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–12 Requirement 1 Note: The journal entries for Requirement 1 of P12-12 are the same as the answer to Requirement 2 of P12-10 and the same as the answer to P12-11. Purchase .................................... ($ in millions) Investment in equity securities .............................................. 324 Cash .......................................................... ............................

324

Adjusting entry Need to move from a fair value adjustment from $0 to ($14 million):

Balance on 1/4/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 ([10 × $31] – $324) Fair Value Adjustment 1/4/2024

Fair Value Adjustment $ 0 ? $ (14)

Change needed

12/31/2024

Loss on investments (unrealized, NI) (to balance) ........................ Fair value adjustment .............................................................

14 14

Problem 12–12 (continued) Because Runyan is accounting for the Lavery investment under the fair value option, the unrealized holding loss would be included in 2024 net income. Therefore, the total effect on net income would be $20 of dividend – $14 of unrealized holding loss, or $6. The investment would be shown in the balance sheet at its fair value of $310. Requirement 2 Purchase .................................... ($ in millions) Investment in in equity affiliate ............................................ 324 Cash .......................................................... ............................

324

Net income ............................................................ Investment in in equity affiliate (30% × $160 million) .................... Investment revenue .................................... ............................

48 48

Depreciation adjustment .................................. Investment revenue ([30% × $80 million] ÷ 6 years) ......................... Investment in equity affiliate...................... ............................

4 4

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–12 (concluded) Note: After the preceding journal entries are recorded, the balance in the Lavery Labeling investment account would be: Investment in Equity Affiliate ($ in millions)

Cost Share of net income

324

Balance

348

20 Dividends 4 Depreciation adjustment

At December 31, 2024, the fair value of that investment is $310 (= 10 million shares × $31/share), implying need for the following adjusting entry to adjust the $348 carrying value of the investment to fair value [$310 – $348 = ($38)]: Loss on investments (unrealized, NI) ...................................... 38 Fair value adjustment ................................. ............................

Because Runyan is accounting for the Lavery investment under the fair value option, the unrealized holding loss would be included in 2024 net income. Therefore, the total effect on net income would be $48 million for Runyan‘s share of Lavery net income minus $4 million of depreciation adjustment and minus the $38 million unrealized holding loss, yielding a total of $6 million of income. The investment would be shown in the balance sheet at its fair value of $310 million. Note that the net income effect and the carrying value in the balance sheet are the same in requirements 1 and 2.

Problem 12–13 Requirement 1 Purchase .................................... ($ in millions) Investment in equity affiliate ................................................ 400.0 Cash .......................................................... ............................

400.0

Net income.................................................... Investment in equity affiliate (40% × $140 million) ........................ Investment revenue .................................... ............................

56.0 56.0

Dividends...................................................... Cash (40% × $30 million) .................................................................... 12.0 Investment in equity affiliate...................... ............................

12.0

Inventory adjustment .................................. Investment revenue ($5 million × 40%: all sold in 2024).................... Investment in equity affiliate...................... ............................

2.0 2.0

Depreciation adjustment ............................. ‡ Investment revenue ([$20 million × 40%] ÷ 16 years) ..................... Investment in equity affiliate...................... ............................

0.5 0.5

‡

Calculations: Investee Identifiable Net Assets



Identifiable ............. Net Assets Difference PurchasedAttributed to:

Cost

 ....................... 

$400

Goodwill:$80 [plug] $800* × 40% =$320

Fair value: inventory

(5) × 40%

Undervaluation of inventory:$2

plant facilities

(20) × 40%

Book value:

$775

Undervaluation

... of plant: $8 × 40% = $310 .................

* $775 + $5 + $20

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–13 (concluded) Requirement 2 Investment Revenue ($ in millions) 56.0 Share of net income Inventory 2.0 Depreciation 0.5 Balance

53.5

Requirement 3 Investment in Equity Affiliate ($ in millions)

Cost 400.0 Share of net income 56.0 12.0 Dividends 2.0 Inventory 0.5 Depreciation Balance

441.5

Requirement 4 $400 million cash outflow in investing activities to purchase investment $12 million cash inflow in operating activities for dividends received Note: If Northwest uses the indirect method to report its cash flows from operating activities, it would need an adjustment of ($41.5) to get from the $53.5 included as investment revenue in net income to the $12 of cash actually received in dividends and needing to be shown in cash flow from operating activities.

Problem 12–14 Requirement 1 Miller‘s management should decide whether it has the ability to exercise significant influence over operating and financial policies of the Marlon Company. Ability to exercise significant influence is presumed for investments of 20 percent or more of voting stock and presumed not to exist for investments of less than 20 percent, other things being equal. Evidence to the contrary should be considered, including participation on the board of directors, technological dependency, material intercompany transactions, or interchange of managerial personnel. Requirement 2 a.

Income statement:

($ in millions)

Investment revenue ($12 million × 1/6) Patent amortization adjustment ($4 million* ÷ 10)

$2.0 (0.4)

*([$24 million] × 1/6])

$1.6 b.

Balance sheet:

Investment in equity affiliate ($19 million + $2 million – $1 million – $0.4 million)

$19.6*

*Investment in Equity Affiliate ($ in millions)

Cost 19.0 Share of net income 2.0 1.0 Dividends ($6 million × 1/6) 0.4 Amortization adjustment Balance

19.6

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–14 (concluded) c. Statement of cash flows: $19 million cash outflow in investing activities for purchase of investment $1 million cash inflow in operating activities for dividends received

Note: If Marlon uses the indirect method to report its cash flows from operating activities, it would need an adjustment of ($0.6) to get from the $1.6 included as investment revenue in net income to the $1 of cash actually received in dividends and needing to be shown in cash flows from operating activities.

Problem 12–15 Item

Reporting Category

F_ 1. 35% of the nonvoting preferred stock T. Trading securities of American Aircraft Company. M. Held-to-maturity M_ 2. Treasury bills to be held-to-maturity. A. Available-for-sale M_ 3. Two-year note receivable from affiliate. F. FV through NI N_ 4. Accounts receivable. E. Equity method M_ 5. Treasury bond maturing in one week. C. Consolidation F_ 6. Common stock held in an investment N. None of these account for immediate resale. T_ 7. Bonds acquired to profit from short-term differences in price. E_ 8. 35% of the voting common stock of Computer Storage Devices Company. C_ 9. 90% of the voting common stock of Affiliated Peripherals, Inc. A_10. Corporate bonds of Primary Smelting Company to be sold if interest rates fall 1/2%. F _11. 25% of the voting common stock of Smith Foundries Corporation: 51% family-owned by Smith family; fair value readily determinable. E_12. 17% of the voting common stock of Shipping Barrels Corporation: Investor‘s CEO on the board of directors of Shipping Barrels Corporation.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–16 Requirement 1 Bond Fair Value at 1/1/2024: Interest [($150,000 × 6%) ÷ 2] × 14.21240 * = Principal $150,000 x 0.50257 ** = Present value of the receivable

$ 63,956 75,386 $139,342

* Present value of an ordinary annuity of $1: n = 20, i = 3.5% (= 7% ÷ 2) (from Table 4) ** Present value of $1: n = 20, i = 3.5% (= 7% ÷ 2) (from Table 2)

January 1, 2024 Investment in bonds (face amount) ....................... Discount on bond investment (difference)......... Cash (price of bonds) .........................................

150,000 10,658 139,342

Requirement 2 January 1, 2024 Investment in bonds (face amount) ....................... Discount on bond investment (difference)......... Cash (price of bonds) .........................................

150,000 10,658 139,342

June 30, 2024 Cash [($150,000 × 6%) ÷ 2].................................... Discount on bond investment (difference) ............ Interest revenue [($150,000 – $10,658) × 7%] ÷ 2

4,500 377

December 31, 2024 Cash (6% ÷ 2 × $150,000) ...................................... Discount on bond investment (difference) ............ Interest revenue [{$150,000 – ($10,658 – $377)} × 7%] ÷ 2

4,500 390

4,877

4,890

Note: For held-to-maturity investments, there are no adjustments to fair value.

Problem 12–16 (continued) Requirement 3 January 1, 2024 Investment in bonds (face amount) ....................... Discount on bond investment (difference)......... Cash (price of bonds) .........................................

150,000 10,658 139,342

June 30, 2024 Cash ($150,000 × 6%) ÷ 2 .................................... Discount on bond investment (difference) ............ Interest revenue [($150,000 – $10,658) × 7%] ÷ 2

4,500 377 4,877

Bond Fair Value at June 30, 2024: Interest [($150,000 × 6%) ÷ 2] × 13.13394 * = $ 59,103 Principal $150,000 × 0.47464 ** = 71,196 Present value of the receivable $130,299 *Present value of an ordinary annuity of $1: n = 19, i = 4% (= 8% ÷ 2) (from Table 4) **Present value of $1: n = 19, i = 4% (= 8% ÷ 2) (from Table 2)

January 1 initial cost Increase from discount amortization June 30 amortized initial cost

$139,342 377 $139,719

Comparing the amortized initial cost with the fair value of the bonds on that date provides the amount needed to adjust the investment to its fair value. June 30 amortized initial cost June 30 fair value Fair value adjustment needed

$139,719 130,299 $ 9,420

Complete Solution Manual for Intermediate Accounting, 11th Edition Problem 12–16 (continued) Need to move from a fair value adjustment from $0 to ($9,420):

Balance on 1/1/2024 ± Adjustment needed to update fair value Balance needed on 6/30/2024 Fair Value Adjustment 1/1/2024

Fair Value Adjustment $ 0 ? $(9,420)

Change needed

9,420

6/30/2024

9,420

Loss on investments (unrealized, NI) ............................. 9,420 Fair value adjustment .............................................................. 9,420

December 31, 2024 Cash ($150,000 × 6%) ÷ 2 .................................... Discount on bond investment (difference) ............ Interest revenue [{$150,000 – ($10,658 – $377)} × 7%] ÷ 2

4,500 390 4,890

Bond Fair Value at December 31, 2024: Interest [($150,000 × 6%) ÷ 2] × 12.15999 * = $ 54,720 Principal $150,000 × 0.45280 ** = 67,920 Present value of the receivable $122,640 *Present value of an ordinary annuity of $1: n = 18, i = 4.5% (= 9% ÷ 2) (from Table 4) **Present value of $1: n = 18, i = 4.5% (= 9% ÷ 2) (from Table 2)

Problem 12–16 (concluded) June 30 amortized initial cost Increase from discount amortization Dec. 31 amortized initial cost

$139,719 390 $140,109

Comparing the amortized initial cost with the fair value of the bonds on that date provides the amount needed to adjust the investment to its fair value. Dec. 31 amortized initial cost Dec. 31 fair value Fair value adjustment balance needed: debit/(credit)

$140,109 122,640 $ (17,469)

Need to move from a fair value adjustment from ($9,420) to ($17,469):

Balance on 6/30/2024 ± Adjustment needed to update fair value Balance needed on 12/31/2024 Fair Value Adjustment 6/30/2024 Change needed

9,420 8,049

12/31/2024

17,469

Fair Value Adjustment $ ( 9,420) ? $(17,469)

Loss on investments (unrealized, NI) ............................. 8,049 Fair value adjustment .............................................................. 8,049

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–17 Requirement 1 The Donald Company bonds include only interest and principal, so Feherty‘s business purpose is relevant for the purpose of classification and reporting. Ten bonds are to be held to collect contractual cash flows over the life of the debt, so they would be accounted for at amortized cost. The remaining bonds would be accounted for at fair value through other comprehensive income (FVOCI), as Feherty is holding those bonds both to collect contractual cash flows and for sale. The Watson company stock would be accounted for at fair value through OCI (FVOCI) because that is what Feherty elected. Feherty can make that irrevocable election, but otherwise, because it does not qualify for the equity method, would account for the Watson equity investment as FVPL. Requirement 2 The Donald Company bonds would be reported as follows: a) 5 bonds are accounted for at amortized cost and were not sold. No unrealized gain or loss would be recognized in OCI or net income. Effect: $0 in net income $0 in other comprehensive income $0 in comprehensive income b) 5 of the amortized cost bonds were sold at a price of $1,040 per bond, yielding a realized gain on sale of 5 × ($1,040 – $1,000) = $200. Effect: $200 in net income $ 0 in other comprehensive income $200 in comprehensive income c) 30 bonds are accounted for at FVOCI and were not sold. Unrealized gains of 30 × ($1,040 – $1,000) = $1,200. Effect: $ 0 in net income $1,200 in other comprehensive income $1,200 in comprehensive income

Problem 12–17 (concluded) d) 10 of the FVOCI bonds were sold at a price of $1,040 per bond, yielding a realized gain on sale of 10 × ($1,040 – $1,000) = $400. Effect: $400 in net income $ 0 in other comprehensive income $400 in comprehensive income

e) The Watson Company common stock investment is accounted for at FVOCI. Unrealized gain of $5,000 ($30,000 – $25,000). Effect: $ 0 in net income $5,000 in other comprehensive income $5,000 in comprehensive income Summary of effects: Net income: Realized gain on 5 bonds sold that were at amortized cost: Realized gain on 10 bonds sold that were at FVOCI: Total effect on net income ..............................

$ 200 400 $ 600

Other comprehensive income (OCI): Unrealized gain on 30 bonds retained that are at FVOCI: Unrealized gain on Watson equity accounted for at FVOCI: Total effect on other comprehensive income ..

$1,200 5,000 $6,200

Comprehensive income = Net income + OCI =

$6,800

Complete Solution Manual for Intermediate Accounting, 11th Edition

Problem 12–18 Bee Company Investment 2024: Stewart must recognize the $240,000 of credit losses in net income. The other $260,000 is ignored. Credit loss expense (NI) .................................... Allowance for credit losses.............................

240,000 240,000

2025: The credit loss is reduced from $240,000 to $140,000, so Stewart must recognize a $100,000 recovery of credit loss in 2025: Allowance for credit losses ................................ Credit loss expense (NI) .................................

100,000 100,000

Oliver Corporation Investment 2024: Stewart accounts for the Oliver investment as a trading security, so impairment accounting is not relevant. Stewart continues to recognize in net income any unrealized gains and losses associated with fair value changes. Given that the bonds already have a negative fair value adjustment of $200,000, and need a negative fair value adjustment of $300,000 to adjust from amortized cost of $2,500,000 to fair value of $2,200,000, Stewart must recognize additional unrealized losses of $100,000 for 2024. Loss on investments (unrealized, NI) ..................... Fair value adjustment ......................................... 100,000

100,000

2025: Fair value increased to $2,700,000 during 2025, so Stewart needs to have a positive fair value adjustment of $200,000 in the balance sheet to adjust from amortized cost of $2,500,000 to fair value of $2,700,000. Therefore, Stewart must recognize an unrealized gain of $500,000 for 2025, moving the fair value adjustment from a negative $300,000 to a positive $200,000. Note that this is not a recovery of the impairment, but just normal ongoing accounting for a TS investment. Fair value adjustment ......................................... Gain on investments (unrealized, NI) ............ 500,000

500,000

Problem 12–18 (concluded) Jones, Inc Investment 2024: Stewart does not plan to sell the Jones investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is relevant. Stewart must recognize the $225,000 of credit losses in net income, as follows: Credit loss expense (NI) ................................... Allowance for credit losses.............................

225,000 225,000

Stewart also must recognize a total of $575,000 of unrealized losses. Given that it already has an unrealized loss of $400,000, it can recognize an additional $175,000 of unrealized loss as a reduction of OCI: Loss on investments (unrealized, OCI) ............. Fair value adjustment .....................................

175,000 175,000

2025: Fair value has increased to $2,875,000, with the $625,000 difference between cost and fair value consisting of $125,000 of credit losses and $500,000 of noncredit losses. Stewart therefore should account for a $100,000 recovery of credit loss ($225,000 – $125,000) as well as a $75,000 unrealized gain associated with the noncredit loss portion of that difference ($575,000 – $500,000): Allowance for credit losses .............................. Credit loss expense (NI) .................................

100,000

Fair value adjustment ......................................... Gain on investments (unrealized, OCI) ..........

75,000

100,000

75,000

Complete Solution Manual for Intermediate Accounting, 11th Edition

DECISION MAKERS’ PERSPECTIVES Cases Research Case 12–1 Requirement 1 FASB ASC 320–10–25–01c: ―Investments–Overall–Recognition–Classification of Debt Securities–Held-to-Maturity Securities.‖ ―Investments in debt securities shall be classified as held-to-maturity only if the reporting entity has the positive intent and ability to hold those securities to maturity.‖ Requirement 2 FASB ASC 320–10–35–01c: ―Investments–Overall–Debt and Equity Securities– Held-to-Maturity Securities.‖ ―Investments in debt securities classified as held to maturity shall be measured subsequently at amortized cost in the statement of financial position.‖ Requirement 3 FASB ASC 320–10–25–01a: ―Investments–Overall–Recognition–Classification of Debt Securities–Trading Securities.‖ ―If a security is acquired with the intent of selling it within hours or days, the security shall be classified as trading.‖ Requirement 4 FASB ASC 320–10–35–01a: ―Investments–Overall–Debt and Equity Securities– Trading Securities.‖ ―Unrealized holding gains and losses for trading securities shall be included in earnings.‖ Requirement 5 FASB ASC 320–10–25–01b: ―Investments–Overall–Recognition–Classification of Debt Securities–Available-for-Sale Securities.‖ ―Investments in debt securities not classified as trading securities or as heldto-maturity securities shall be classified as available-for-sale securities.‖

Case 12–1 (concluded) Requirement 6 FASB ASC 320–10–35–01b: ―Investments–Overall–Debt and Equity Securities– Available-for-Sale Securities.‖ ―Unrealized holding gains and losses for available-for-sale securities (including those classified as current assets) shall be excluded from earnings and reported in other comprehensive income until realized…‖

Complete Solution Manual for Intermediate Accounting, 11th Edition

Real World Case 12–2 Requirement 1 July 28, 2018

July 27, 2019

Fair Value Adjustment, AFS Investments 503 ($37,009 fair value  $37,512 cost) Increase during 2019 573

($21,660 fair value  $21,590 cost)

Given the T-account above, the fair value adjustment change during 2019 was an increase of $573 million. Requirement 2 Intel would record the following entry to account for unrealized holding gains and losses associated with its AFS investments: Fair value adjustment............................................. Gain on investments (unrealized, OCI)...........

560 560

The effect of that journal entry would be to debit (increase) the T-account of the fair value adjustment. Requirement 3 Cisco would record the following entry to make its reclassification adjustment: Fair value adjustment ............................................ Reclassification adjustment (OCI) ..................

13 13

The fair value adjustment is debited (increased) by $13 because reclassification is removing unrealized losses from the fair value adjustment and from OCI. The effect of that journal entry would be to debit (increase) the T-account of the fair value adjustment.

Case 12–2 (concluded) Requirement 4 After considering these adjustments, the T-account appears as follows: Fair Value Adjustment, AFS Investments July 28, 2018 503 (($37,009 fair value  $37,512 cost) Net unrealized holding gain 560 Reclassification adjustments 13 July 27, 2019

($21,660 fair value  $21,590 cost)

These two entries reconcile the T-account completely.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Real World Case 12–3 Requirement 1 Fair value adjustment ($3,987 + 1,057)........................... 5,044 Gain on investments (unrealized, OCI) (to balance) ........

5,044

Requirement 2 Fair value adjustment.................................. .................... 4 Reclassification adjustment (OCI) (to balance) ................

Real World Case 12–4 Requirement 1 Note 4 lists a total fair value of $13,644 (equal to $9,470 + 4,174) million of available-for-sale investments. GM‘s 2019 balance sheet lists $4,174 million of investments as current assets. It indicates that available-for-sale debt securities of $9,470 million were included in cash equivalents. Requirement 2 In Note 2 (significant accounting policies), GM describes its policy regarding accounting for its AFS investments: Accounting for unrealized gains and losses (both temporary and OTT): ―Marketable Debt Securities We classify marketable debt securities as either available-for-sale or trading. Various factors, including turnover of holdings and investment guidelines, are considered in determining the classification of securities. Available-for-sale debt securities are recorded at fair value with unrealized gains and losses recorded net of related income taxes in Accumulated other comprehensive loss until realized. ― Requirement 3 Yes. Investments accounted for using the equity method are described in Note 8, ―Equity in Net Assets of Nonconsolidated Affiliates.‖ The company has ongoing joint ventures and other equity-method investments with Automotive China and others. Requirement 4 As indicated in the income statement and in Note 8, equity income recognized by GM during 2019 was $1,268 million.

Complete Solution Manual for Intermediate Accounting, 11th Edition

International Case 12–5 Requirement 1 Satisfied by going to https://www.iasplus.com/en/standards/ias/ias28-2011. Requirement 2 Renault‘s decision appears appropriate, as the company has significant influence, but not control. Significant influence is indicated by a greater-than20% equity stake and seats on the Nissan board. Lack of control is indicated by Renault not owning a majority of voting rights or board seats and not having full rights to use assets or the obligations with respect to liabilities. Requirement 3 It is appropriate that Renault makes adjustments that take into account the fair value of Nissan‘s assets and liabilities at the time Renault invested in Nissan. For example, if the fair value of Nissan‘s fixed assets was greater than the book value of those assets on the date of Renault‘s purchase, Renault would need to recognize additional depreciation over the life of those assets when applying the equity method. This is consistent with IFRS and also with U.S. GAAP. Requirement 4 Renault‘s harmonization adjustments are required by IFRS, which requires that, ―if the associate uses accounting policies that differ from those of the investor, the associate's financial statements should be adjusted to reflect the investor's accounting policies for the purpose of applying the equity method.‖ [IAS 28(2011).33, IAS 28(2011).34]. U.S. GAAP has no such requirement.

International Case 12–6 P. 179 of the 2019 Annual Report includes the following note: Investments in other companies are measured at fair value. Equity investments for which there is no quoted market price in an active market and there is insufficient financial information in order to determine fair value may be measured at cost as an estimate of fair value, as permitted by IFRS 9 - Financial Instruments (―IFRS 9‖). The Group may irrevocably elect to present subsequent changes in the investment‘s fair value in Other comprehensive income (―OCI‖) upon the initial recognition of an equity investment that is not held to sell. This election is made on an investment-by-investment basis. Thus, FCA carries some equity investments as available-for-sale investments. Prior to ASU 2016-1, U.S. GAAP allowed classification of equity investments as AFS securities if those investments were not held for trading, but ASU 2016-1 requires equity investments to be accounted for at fair value through net income unless the investor can exert significant influence over the activities of the investee. Therefore, FCA‘s approach is not consistent with current U.S. GAAP.

Trueblood Accounting Case 12–7 A solution and extensive discussion materials can be obtained from the Deloitte Foundation.

Complete Solution Manual for Intermediate Accounting, 11th Edition

Communication Case 12–8 Answers to the Questions will, of course, vary because students will access the financial statements of different companies. Although a company is not required to report individual amounts for the three categories of investments—held-to-maturity, available-for-sale, or trading—on the face of the balance sheet, that information should be presented in the disclosure notes. If securities available-for-sale are held, there may be accumulated unrealized gains or losses reported in AOCI in the shareholders‘ equity section of the balance sheet. Investments in securities available-for-sale are reported at fair value, and holding gains or losses are not included in the determination of income for the period. Instead, they are reported as a separate component of shareholders‘ equity. Unlike the treatment of securities available-for-sale, unrealized holding gains and losses are included in income for trading securities. There may also be gains or losses from the sale of investments during the year. There also will likely be interest revenue in the income statement. The statement of cash flows will report acquisitions or disposals of available for sale investments as investing activities. Acquisitions and disposals of trading securities typically are shown as operating activities. Interest revenue is an operating activity.

Communication Case 12–9 Requirement 1 The note that describes an investment in securities ―available-for-sale‖ may be headed by any one of a variety of captions or subsumed within another disclosure note. Likewise, the caption by which the investments are reported in the balance sheet can be reported separately as one of several asset titles or included within another asset caption. Requirement 2 Investments in securities available-for-sale will be reported as current or noncurrent assets depending on the intent of management regarding the timing of their eventual sale. Requirement 3 Realized gains or losses are reported in the income statement if any of these securities were sold during any year reported. Requirements 4 and 5 Investments in securities available-for-sale are reported at fair value. Unrealized holding gains and losses from retaining securities during periods of price change are not included in the determination of net income for the period. Rather, they are accumulated and reported as accumulated other comprehensive income, a separate component of shareholders‘ equity. This means an unrealized holding gain would increase shareholders‘ equity and an unrealized holding loss would decrease shareholders‘ equity. The amounts of unrealized gains and losses will be shown on a combined statement of comprehensive income that includes net income and other comprehensive income, or as a separate statement of comprehensive income, or summarized in the statement and detailed in the notes to the financial statements. By definition, securities available-for-sale are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are not considered relevant performance measures to be included in earnings.

Complete Solution Manual for Intermediate Accounting, 11th Edition Case 12–9 (concluded) Requirement 6 Cash outflows from acquiring these investments or inflows from selling them are reported as investing activities in the company‘s comparative statements of cash flows unless trading securities are included in the operating activities section. Whether they are specifically identifiable depends on the degree of detail the company uses in reporting its cash flows. Information on investing activities assists investors and creditors by indicating the direction the company is directing its funds.

Continuing Cases Target Case Requirement 1 a. Per Note 1, CVS classifies these investments as available-for-sale securities. b. The total of CVS’s investments on 12/31/2019 is $19,687 million, which is shown on the balance sheet as a current asset of $2,373 and a noncurrent asset of $17,314. c. The total of CVS’s available-for-sale investments on 12/31/2019 is $16,922 million, consisting of $15,898 amortized cost and $1,024 total fair-value adjustment. d. Per Note 4, of the total of $16,922 million of available-for-sale investments on 12/31/2019, $1,785 are categorized as Level 1, $15,088 are categorized as Level 2, and $49 are categorized as Level 3.

Requirement 2 a. CVS’s income would increase by CVS’s percentage share of Heartland’s income. b. CVS’s ―investment in Heartland‖ asset would increase by CVS’s percentage share of Heartland’s income.

Air France-KLM Case Requirement 1 a. Per note 23 (―Other financial assets‖), the balance of debt investments accounted for at FVPL is €411 (including ―Cash secured‖ portion) as of December 31, 2019, equal to €73 current marketable securities, €38 noncurrent marketable securities, and €300 current cash secured. b. Per note 23 (―Other financial assets‖), €373 of the balance is classified as current, and €38 is classified as noncurrent. c. Per note 36.4 (―Valuation methods for financial assets and liabilities at their fair value‖), €19 of the €411 balance is estimated using level 1 inputs, and the other €392 is estimated using level 2 inputs. Requirement 2 a. Per note 23 (―Other financial assets‖), the balance of equity investments accounted for as FVPL or FVOCI is €433 as of December 31, 2019, including €360 accounted for as FVPL and €73 accounted for as FVOCI. b. Per note 23 (―Other financial assets‖), the €360 accounted for as FVPL is current, and the €73 accounted for as FVOCI is noncurrent. c. Per note 36.4 (―Valuation methods for financial assets and liabilities at their fair value‖), €432 of the €433 is estimated using level 1 inputs, and €1 of the €433 is estimated using level 2 inputs.

Air France-KLM Case (concluded) Requirement 3 a. Per note 4.3 (―Consolidation principles‖), ―In accordance with IAS 28 ―Investments in Associates and Joint Ventures‖, companies in which the Group has the ability to exercise significant influence on financial and operating policy decisions are also accounted for using the equity method. The ability to exercise significant influence is presumed to exist when the Group holds more than 20 per cent of the voting rights.‖ b. Per note 4.3 (―Consolidation principles‖), ―In accordance with IFRS 11 ―Joint arrangements‖, the Group applies the equity method to partnerships over which it exercises control jointly with one or more partners (joint-venture).‖ c. Per note 21 (―Equity affiliates‖) and the balance sheet, the carrying value of AF‘s equity-method investments on its December 31, 2019, balance sheet is €307 million. d. Per note 21 (―Equity affiliates‖) and the income statement, AF‘s equitymethod investments increased its net income from continuing operations by €23 during 2019.

Chapter 13 Current Liabilities and Contingencies QUESTIONS FOR REVIEW OF KEY TOPICS

Question 13– 1637A liability involves the past, the present, and the future. It is a present responsibility, to sacrifice assets in the future, caused by a transaction or other event that already has happened. Specifically, ―Elements of Financial Statements,‖ Statement of Financial Accounting Concepts No. 6, par. 36, describes three essential characteristics: Liabilities– 1. are probable, future sacrifices of economic benefits 2. that arise from present obligations (to transfer assets or provide services) to other entities 3. that result from past transactions or events.

Question 13–2 Liabilities traditionally are classified as either current liabilities or long-term liabilities in a classified balance sheet. Current liabilities are those expected to be satisfied with current assets or by the creation of other current liabilities. Usually, but with exceptions, current liabilities are obligations payable within one year or within the firm's operating cycle, whichever is longer.

Question 13– 1639In concept, liabilities should be reported at their present values; that is, the valuation amount is the present value of all future cash payments resulting from the debt, usually principal and/or interest payments. In this case, the amount would be determined as the present value of $100,000, discounted for three months at an appropriate rate of interest for a debt of this type. This is proper because of the time value of money. In practice, liabilities ordinarily are reported at their maturity amounts if payable within one year because the relatively short time period makes the interest or time value component immaterial. FASB ASC 835–30–15–3: ―Interest–Imputation of Interest–Scope and Scope Exceptions‖ specifically exempts from present value valuation all liabilities arising in connection with suppliers in the normal course of business and due within a year.

Question 13– 1641Lines of credit permit a company to borrow cash from a bank up to a prearranged limit at a predetermined, usually floating, rate of interest. The interest rate often is based on current rates of the prime London interbank borrowing, certificates of deposit, bankers‘ acceptance, or other standard rates. Lines of credit usually must be available to support the issuance of commercial paper. Lines of credit can be noncommitted or committed. A noncommitted line of credit allows the company to borrow without having to follow formal loan procedures and paperwork at the time of the loan and is less formal, usually without a commitment fee. Sometimes a compensating balance is required to be on deposit with the bank as compensation for the service. A committed line of credit is more formal. It usually requires a commitment fee in the neighborhood of 1/4 of one percent of the unused balance during the availability period. Sometimes compensating balances also are required.

Question 13–5 Noninterest-bearing notes do, of course entail interest, but the interest is deducted (or discounted) from the face amount to determine the cash proceeds made available to the borrower at the outset and included in the amount paid at maturity. In fact, the effective interest rate is higher than the stated discount rate because the discount rate is applied to the face value, but the cash borrowed is less than the face value.

Question 13– 1643Commercial paper represents loans from other corporations. It refers to unsecured notes sold in minimum denominations of $25,000 with maturities ranging from 1 to 270 days. The firm would be required to file a registration statement with the SEC if the maturity is beyond 270 days. The name ―commercial paper‖ implies that a paper certificate is issued to the lender to represent the obligation. But, increasingly, no paper is created because the entire transaction is computerized. Recording the issuance and payment of commercial paper is the same as for notes payable. The interest rate usually is lower than in a bank loan because commercial paper (a) typically is issued by large, sound companies (b) directly to the lender, and (c) normally is backed by a line of credit with a bank.

Question 13–7 This is an example of an accrued expense—an expense incurred during the current period, but not yet paid. The expense and related liability should be recorded as follows: Salaries expense Salaries payable

5,000 5,000

This achieves a proper matching of this expense with the revenues it helps generate, and recognizes that a liability has been created by the employee earning wages for which she has not yet been paid.

Question 13–8 An employer should accrue an expense and the related liability for employees' compensation for future absences, like vacation pay, if the obligation meets each of four conditions: (1) the obligation is attributable to employees' services already performed, (2) the paid absence can be taken in a later year—the benefit vests (will be compensated even if employment is terminated) or the benefit can be accumulated over time, (3) the payment is probable, and (4) the amount can be reasonably estimated. Customary practice should be considered when deciding whether an obligation exists. For instance, whether the rights to paid absences have been earned by services already rendered sometimes depends on customary policy for the absence in Question. An example is whether compensation for upcoming sabbatical leave should be accrued. Is it granted only to perform research beneficial to the employer? Or, is it customary that sabbatical leave is intended to provide unrestrained compensation for past service? Similar concerns also influence whether unused rights to the paid absences can be carried forward or expire. Although holiday time, military leave, maternity leave, and jury time typically do not accumulate if unused, if it is customary practice that one can be carried forward, a liability is accrued if it‘s probable employees will be compensated in a future year. Similarly, sick pay is specifically excluded from mandatory accrual, according to GAAP regarding compensated absences, because future absence depends on future illness, which usually is not a certainty. But, if company policy or custom is that employees are paid for unused sick days or are allowed to be paid for a certain number of days taken as sick days, even when their absence is not due to illness, a liability for unused sick pay should be recorded.

Question 13–9 When a company collects cash from a customer as a refundable deposit or as an advance payment for products or services, a liability is created obligating the firm to return the deposit or to supply the products or services. When the amount is to be returned to the customer in cash, it is a refundable deposit. When the amount will be applied to the purchase price when goods are delivered or services provided (gift certificates, magazine subscriptions, layaway deposits, special order deposits, and airline tickets), it is a customer advance.

Question 13– 1649 Gift cards are a particular form of advance collection of revenues. When the payment is received, the seller debits cash and credits a deferred revenue liability. Later, deferred revenue is reduced and revenue recognized either when the customer redeems the gift card or when the probability of redemption is viewed as remote, based on an expiration date or the company‘s experience.

Question 13– Examples 1650 of amounts collected for third parties that represent liabilities until remitted are sales taxes, and payroll-related deductions such as federal and state income taxes, social security taxes, employee insurance, employee contributions to retirement plans, and union dues.

Question 13– 1651 The requirement to classify currently maturing debt as a current liability includes debt that is callable, or due on demand, by the creditor in the upcoming year, even if the debt is not expected to be called.

Question 13– Short-term 1652 obligations can be reported as noncurrent liabilities if the company (a) intends to refinance on a long-term basis and (b) demonstrates the ability to do so by a refinancing agreement or by actual financing.

Question 13– 1653 Under U.S. GAAP, ability to finance must be demonstrated by securing financing prior to the date the balance sheet is issued. Under IFRS, ability to finance must be demonstrated by securing financing prior to the balance sheet date (which typically is a couple of months earlier than the date of issuance).

Question 13–15 A loss contingency is an existing situation or set of circumstances involving potential loss that will be resolved when some future event occurs or doesn‘t occur. Examples: (1) a possible repair to a product under warranty, (2) a possible uncollectible receivable, (3) being the defendant in a lawsuit.

Question 13– 1656The likelihood that the future event(s) will confirm the incurrence of the liability must be categorized as: PROBABLE—the confirming event is likely to occur. REASONABLY POSSIBLE—the chance the confirming event will occur is more than remote but less than likely. REMOTE—the chance the confirming event will occur is slight.

Question 13– 1657A liability should be accrued if it is both probable that the confirming event will occur and the amount can be at least reasonably estimated.

Question 13– 1658Under U.S. GAAP, the term ―contingent liability‖ is used to refer generally to contingent losses, regardless of probability. Under IFRS, a contingent liability refers only to those contingencies that are not recognized in the financial statements; the term ―provision‖ is used to refer to those that are accrued as liabilities because they are probable and reasonably estimable.

Answers to Questions (concluded)

Question 13–19 If one or both of the accrual criteria is not met, but there is at least a reasonable possibility that an obligation exists (the loss will occur), a disclosure note should describe the contingency. The note also should provide an estimate of the possible loss or range of loss, if possible. If an estimate cannot be made, a statement to that effect should be included.

Question 13– 1661

Manufacturers‘ product warranties—these inevitably involve expenditures, and reasonably accurate estimates of the total liability for a period usually are possible, based on prior experience.

Question 13– The 1662 contingent liability for warranties and guarantees usually is accrued. The estimated warranty (guarantee) liability is credited and warranty (guarantee) expense is debited in the reporting period in which the product under warranty is sold. An extended warranty provides warranty protection beyond the manufacturer‘s original warranty. A manufacturer‘s warranty is offered as an integral part of the product package. By contrast, an extended warranty is priced and sold separately from the warranted product and is identified as a separate performance obligation. As such, it constitutes a separate sales transaction and is recorded as such.

Question 13– 1663 Several weeks usually pass between the end of a company‘s fiscal year and the date the financial statements for that year actually are issued. Any enlightening events occurring during this period should be used to assess the nature of a loss contingency existing at the report date. Since a liability should be accrued if it is both probable that the confirming event will occur and the amount can be at least reasonably estimated, the contingency should be accrued.

Question 13–23 When a contingency comes into existence only after the year-end, a liability cannot be accrued because none existed at the end of the year. Yet, if the loss is probable and can be reasonably estimated, the contingency should be described in a disclosure note. The note should include the effect of the loss on key accounting numbers affected. Furthermore, even events other than contingencies that occur after the year-end but before the financial statements are issued must be disclosed in a ―subsequent events‖ disclosure note if they have a material effect on the company‘s financial position (i.e., an issuance of debt or equity securities, a business combination, or discontinued operations).

Question 13– 1666In U.S. GAAP, the low end of the range is accrued as a liability, and the rest of the range is disclosed. In IFRS, the mid-point of the range is accrued.

Question 13– 1667In IFRS, present values must be used to measure a liability whenever the time value of money is material. That requirement does not exist for U.S. GAAP.

Question 13– 1668When an assessment is probable, reporting the possible obligation would be warranted if an unfavorable settlement is at least reasonably possible. This means an estimated loss and contingent liability would be accrued if (a) an unfavorable outcome is probable and (b) the amount can be reasonably estimated. Otherwise, note disclosure would be appropriate. So, when the assessment is unasserted as yet, a twostep process is involved in deciding how it should be reported: 1. Is the assessment probable? If it is not, no disclosure is warranted. 2. If the assessment is probable, evaluate (a) the likelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated to determine whether it should be accrued, disclosed only, or neither.

Question 13–27 You should not accrue your gain. A gain contingency should not be accrued. This conservative treatment is consistent with the general inclination of accounting practice to anticipate losses, but to recognize gains only at their realization. Though gain contingencies are not recorded in the accounts, they should be disclosed in notes to the financial statements. Attention should be paid that the disclosure note not give "misleading implications as to the likelihood of realization."

Question 13–28 You should accrue your gain. Under IFRS, a gain contingency is accrued if it is virtually certain to occur, as is the case with respect to this gain.

BRIEF EXERCISES

Brief Exercise 13–1 Cash .............................................................. Notes payable .............................................

60,000,000

Interest expense ($60,000,000 × 12% × 3/12)........ Interest payable .........................................

1,800,000

60,000,000 1,800,000

Brief Exercise 13–2 Cash (difference) ........................................................ Discount on notes payable ($60,000,000 × 12% × 9/12) . Notes payable (face amount) ...................................

54,600,000 5,400,000 60,000,000

Interest expense ($60,000,000 × 12% × 3/12) ................. Discount on notes payable ..................................

1,800,000 1,800,000

Brief Exercise 13–3 a. December 31 $100,000 × 12% × 6/12 = $6,000 b. September 30 $100,000 × 12% × 3/12 = $3,000

Brief Exercise 13–4 Cash (difference) ........................................................ Discount on notes payable ($12,000,000 × 9% × 9/12).... Notes payable (face amount) ...................................

11,190,000 810,000

Interest expense ...................................................... Discount on notes payable .........................................

810,000

Notes payable (face amount)....................................... Cash.....................................................................

12,000,000

810,000

12,000,000

Brief Exercise 13–5 Cash (difference) ........................................................ Discount on notes payable ($10,000,000 × 6% × 9/12).... Notes payable (face amount) ................................... Effective interest rate: Discount ($10,000,000 × 6% × 9/12) Cash proceeds Interest rate for 9 months

$ 450,000 ÷ $9,550,000 4.712% x

Annual effective rate

9,550,000 450,000 10,000,000

12/9 6.3%

Brief Exercise 13–6 December 12 Cash..................................................................... Deferred revenue .............................................

24,000

January 16 Cash..................................................................... Deferred revenue ................................................. Sales revenue ...................................................

216,000 24,000

24,000

240,000

Brief Exercise 13–7

In 2024 Lizzie would recognize $11,500 of revenue ($4,000 + $3,000 + $2,500 + $2,000). In 2025 Lizzie would recognize the remainder of $6,500 ($18,000 – $11,500), either because gift cards were redeemed (the $1,000 in January and the $500 in February) or because they are viewed as expired.

Brief Exercise 13–8 Accounts receivable ............................................. Sales revenue .................................................. Sales taxes payable ([6% + 1.5%] × $600,000) ......

645,000 600,000 45,000

Brief Exercise 13–9 1. Current liability—The requirement to classify currently maturing debt as a current liability includes debt that is callable, or due on demand, by the creditor in the upcoming year even if the debt is not expected to be called. 2 Long-term liability—The current liability classification includes (a) situations in which the creditor has the right to demand payment because an existing violation of a provision of the debt agreement makes it callable and (b) situations in which debt is not yet callable, but will be callable within the year if an existing violation is not corrected within a specified grace period— unless it's probable the violation will be corrected within the grace period. In this case, the existing violation is expected to be corrected within six months.

Brief Exercise 13–10

Under U.S. GAAP, the debt would be classified as long-term for both completion dates, as what is key is that the refinancing be completed before the financial statements are issued.

Brief Exercise 13– 1692

Under IFRS, the debt would be classified as long-term if the refinancing was completed on December 15, 2024, but not if completed on January 15, 2025, because for IFRS what is key is that the refinancing be completed by the balance sheet date.

Brief Exercise 13–12 This is a loss contingency and the estimated warranty liability is credited and warranty expense is debited in the period in which the products under warranty are sold. Das will report a liability of $130,000: Warranty Liability 150,000

Warranty expense (1% × $15,000,000)

130,000

Balance

Actual expenditures 20,000

Brief Exercise 13– 1696

This is a loss contingency and should be accrued because it is both probable that the confirming event will occur and the amount can be at least reasonably estimated. Goo Goo should report a $5.5 million loss in its income statement and a $5.5 million liability in its balance sheet.

Brief Exercise 13– Skill should disclose the $12 million gain contingency in a note, but not accrue 1697 it. Gain contingencies are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized.

Brief Exercise 13–15 Bell should disclose the $10 million loss contingency in a note, but not accrue it. A liability should be accrued if it is both probable that the confirming event will occur and the amount can be at least reasonably estimated. If one or both of these criteria is not met (as in this case), but there is at least a reasonable possibility that the loss will occur, a disclosure note should describe the contingency.

Brief Exercise 13–16 Only the situation (3) cost should be accrued. A liability should be accrued for a loss contingency if it is both probable that the confirming event will occur and the amount can be at least reasonably estimated. If one or both of these criteria is not met, but there is at least a reasonable possibility that the loss will occur, a disclosure note should describe the contingency. Both criteria are met only for the warranty costs.

Brief Exercise 13–17 Under U.S. GAAP, no liability would be recognized, because a 51% chance is less than the level of probability typically associated with ―probable‖ in the United States. A liability would be accrued under IFRS, as 51% is clearly ―more likely than not.‖ If a liability were accrued under U.S. GAAP, it would be for $10 million, the low end of the range, but under IFRS it would be for $15 million, the midpoint of the range.

Brief Exercise 13–18 No disclosure is required because, although an investigation is ongoing, no claim has yet been asserted, and an assessment is not probable. Even if an unfavorable outcome is thought to be probable in the event of an assessment and the amount is estimable, disclosure is not required unless it is probable that an unasserted claim will be asserted.

EXERCISES

Exercise 13–1 Requirement 1 Cash ...................................................................16,000,000 Notes payable ............................................. 16,000,000 Requirement 2 Interest expense ($16,000,000 × 12% × 2/12)........ Interest payable ..........................................

320,000 320,000

Requirement 3 Interest expense ($16,000,000 × 12% × 7/12)........ Interest payable (from adjusting entry) ............... Notes payable (face amount) ............................. Cash (total) ..................................................

1,120,000 320,000 16,000,000 17,440,000

Exercise 13–2 1.

Interest rate

Fiscal year-end

12%

December 31

$400 million × 12% × 6/12 = $24 million Interest rate Fiscal year-end 10%

September 30

$400 million × 10% × 3/12 = $10 million Interest rate Fiscal year-end 9%

October 31 4 $400 million × 9% × /12 = $12 million

Interest rate

Fiscal year-end

January 31

$400 million × 6% × 7/12 = $14 million

Exercise 13–3 2024 Jan. 13 No entry is made for a line of credit until a loan actually is made. It would be described in a disclosure note. Feb. 1 Cash ........................................................................ 5,000,000 Notes payable ...................................................... 5,000,000 May 1 Interest expense ($5,000,000 × 10% × 3/12) ................... 125,000 Notes payable (face amount)....................................... 5,000,000 Cash ($5,000,000 + $125,000)................................... 5,125,000 Dec. 1 Cash (difference) ........................................................ 9,325,000 9 Discount on notes payable ($10,000,000 × 9% × /12).... 675,000 Notes payable (face amount) ................................... 10,000,000 Dec. 31 The effective interest rate is 9.6515% ($675,000 ÷ $9,325,000) × 12/9. So, properly, interest should be recorded at that rate times the outstanding balance times one-twelfth of a year: Interest expense ($9,325,000 × 9.6515% × 1/12) ............. Discount on notes payable ..................................

75,000 75,000

However the same results are achieved if interest is recorded at the discount rate times the maturity amount times one-twelfth of a year: Interest expense ($10,000,000 × 9% × 1/12) ................... Discount on notes payable ..................................

75,000 75,000

Exercise 13–3 (concluded) 2025 Sept. 1 Interest expense ($10,000,000 × 9% × 8/12)* ................. Discount on notes payable .................................. Notes payable (balance) ............................................. Cash (maturity amount)............................................

600,000 600,000 10,000,000 10,000,000

* or, ($9,325,000 × 9.6515% × 8/12) = $600,000

Exercise 13–4 Salaries expense (increases salaries expense to $410,000) ............. 6,000 Liability—compensated future absences .................... 6,000* * ($404,000 – 4,000] = $400,000 non-vacation salaries × 1/40 = 10,000 vacation pay earned (4,000) vacation pay taken = $ 6,000 vacation pay carried over

Exercise 13– 1713 Requirement 1 Salaries expense (700 × $900) .......................................... Liability—compensated future absences ............

630,000 630,000

Requirement 2 Liability—compensated future absences ................. Salaries expense ($31 million + [5% × $630,000]) ........... Cash (total) ..........................................................

630,000 31,031,500 31,661,500

Exercise 13– 1714 Requirement 1

Cash .......................................................................... Deferred gift card revenue ....................................

5,200

Cash ($2,100 + 84 – 1,300) ............................................ Deferred gift card revenue ......................................... Sales revenue ......................................................... Sales taxes payable (4% × $2,100) ............................

884 1,300

5,200

2,100 84

Requirement 2 Gift cards sold $5,200 Gift cards redeemed (1,300) Deferred gift card revenue liability as of December 31 $3,900 Requirement 3 The sales tax liability is a current liability because it is payable in January. The liability for gift cards is part current and part noncurrent because of the following calculation: Gift cards sold $5,200 × 80% Current liability $4,160 Gift cards redeemed (1,300) Current liability at December 31 $2,860 Noncurrent liability at December 31 ($5,200 × 20%) Total liability for gift cards $3,900

1,040

Exercise 13– 1715 Requirement 1 Received Deposits Cash ................................................................ Liability—refundable deposits ....................

850,000

Deposits Returned Liability—refundable deposits ........................ Cash.............................................................

790,000

Deposits Forfeited Liability—refundable deposits ........................ Revenue—sale of containers........................

35,000

Cost of goods sold ........................................... Inventory of containers ............................... Requirement 2 Liability for Refundable Deposits Balance on January 1 Deposits received Deposits returned Deposits forfeited Balance on December 31

850,000

790,000

35,000 35,000 35,000

$530,000 850,000 (790,000) (35,000) $555,000

Exercise 13– 1716 Requirement 1

Cash..................................................................... Deferred revenue .............................................

7,500 7,500

Requirement 2 Cash..................................................................... Liability—refundable deposits ........................

25,500 25,500

Requirement 3 Accounts receivable ............................................. Sales revenue .................................................. Sales taxes payable ([5% + 2%] × $800,000).........

856,000 800,000 56,000

Exercise 13–9 Requirement 1 The entire $10,000 sold in January will be recognized as revenue during 2024. $6,000 because of gift card redemption; $4,000 because of gift card breakage. Requirement 2 January Gift Card Sales Cash ................................................................ Deferred gift card revenue ...........................

10,000

Redemption of January Gift Cards Deferred gift card revenue .............................. Revenue—gift cards ....................................

6,000

Breakage (expiration) of January Gift Cards Deferred gift card revenue .............................. Revenue—gift cards ....................................

4,000

10,000

6,000

4,000

Requirement 3 Of the $16,000 sold in March, $4,000 will be recognized as revenue because of gift card redemption. The remaining $12,000 of sales are not recognized as revenue in 2024 because gift cards sold in March of 2024 won‘t start expiring until January 2025. Requirement 4 The only liability at 12/31/2024 would be the $12,000 of unexpired March gift cards (see answer to requirement 3).

Exercise 13–10 The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1.

If it is only reasonably possible that a contingent loss will occur, the contingent loss should be disclosed:

FASB ASC 450–20–50–3: ―Contingencies–Loss Contingencies–Disclosure– Unrecognized Contingencies.‖ 2.

Criteria allowing short-term liabilities expected to be refinanced to be classified as long-term liabilities: FASB ASC 470–10–45–14: ―Debt–Overall–Other Presentation Matters–Intent and Ability to Refinance on a Long-Term Basis.‖

Accounting for separately priced extended warranty contracts: FASB ASC 606–10–55–31: ―Revenue from Contracts with Customers–Overall– Implementation Guidance and Illustrations–Warranties.‖

The criteria to determine if an employer must accrue a liability for vacation pay. FASB ASC 710–10–25–1:―Compensation–General–Overall–Recognition– Compensated Absences.‖

Exercise 13– Normally, short-term debt (payable within a year) is classified as current liabilities. 1721 However, when such debt is to be refinanced on a long-term basis, it may be included with long-term liabilities. The narrative indicates that Marriott has both (1) the intent and (2) the ability ("existing long-term credit facilities") to refinance on a long-term basis. Thus, Marriott reported the debt as long-term liabilities.

Exercise 13–12 Requirement 1 Normally, IFRS requires that short-term debt (payable within a year) be classified as current liabilities. However, when such debt is to be refinanced on a long-term basis, it may be included with long-term liabilities. The narrative indicates that Marriott has both (1) the intent and (2) the ability ("existing long-term credit facilities") to refinance on a long-term basis. Thus, Marriott reported the debt as longterm liabilities. Requirement 2 IFRS requires that the refinancing capability be in place as of the balance sheet date. Therefore, given that the refinancing was not arranged until after year-end, IFRS would require that the debt be classified as a current liability.

Exercise 13– 1723

1. Current liability: $10 million Noncurrent liability: $0 The requirement to classify currently maturing debt as a current liability includes debt that is callable by the creditor in the upcoming year—even if the debt is not expected to be called. 2. Current liability: $14 million Noncurrent liability: $0 The debt is due within one year, so should be classified as a current liability. If the debt was not due within one year, we would have to be concerned about the violation of the debt covenant. The current liability classification includes (a) situations in which the creditor has the right to demand payment because an existing violation of a provision of the debt agreement makes it callable and (b) situations in which debt is not yet callable, but will be callable within the year if an existing violation is not corrected within a specified grace period—unless it's probable the violation will be corrected within the grace period. In this case, the existing violation is expected to be corrected within six months, so if the debt were due far enough in the future to be normally classified as a noncurrent liability, it would still merit that noncurrent classification. 3. Current liability: $7 million Noncurrent liability: $0 The debt should be reported as a current liability because it is payable in the upcoming year and will not be refinanced with long-term obligations.

Exercise 13–14 Requirement 1 Guidelines for determining when an expense and liability should be accrued for a contingent loss: FASB ASC 450–20–25–2: ―Contingencies–Loss Contingencies–Recognition– General Rule.‖ Requirement 2 Specifically, the guidelines are that an estimated loss from a loss contingency be accrued by a charge to income if both of the following conditions are met: a.

Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

The amount of loss can be reasonably estimated.

Exercise 13– 1726 Yes, this is a loss contingency. There may be a future sacrifice of economic benefits (cost of satisfying the warranty) due to an existing circumstance (the warranted awnings have been sold) that depends on an uncertain future event (customer claims). The liability is probable because product warranties inevitably entail costs. A reasonably accurate estimate of the total liability for a period is possible based on prior experience. So, the contingent liability for the warranty is accrued. The estimated warranty liability is credited and warranty expense is debited in 2024, the period in which the products under warranty are sold. Requirement 2 2024 Sales Accounts receivable ........................................... Sales revenue..................................................

5,000,000

Accrued liability and expense Warranty expense (3% × $5,000,000)....................... Warranty liability ..........................................

150,000

Actual expenditures Warranty liability .............................................. Cash ...............................................................

37,500

5,000,000

150,000

37,500

Requirement 3 Liability at December 31, 2024: $112,500 Warranty Liability 150,000

Expense 3% of sales

112,500

Balance

Actual expenditures 37,500

Exercise 13– 1727

Requirement 1 Requirement 1 No, this is not a loss contingency. An extended warranty is priced and sold separately from the warranted product and therefore essentially constitutes a separate sales transaction. Since the earning process for an extended warranty continues during the contract period, revenue should be recognized over the same period. Revenue from separately priced extended warranty contracts are deferred as a liability at the time of sale, and recognized over the contract period on a straight-line basis. Requirement 2 During the year Cash.................................................................... Deferred revenue—extended warranties ......... December 31 (adjusting entry) Deferred revenue—extended warranties ............ extended warranties* .....................

412,000 412,000

82,400 Revenue— 82,400

*$412,000 × 20% = $82,400.

Exercise 13– 1728 This loss contingency should be accrued. This is a loss contingency. A liability is accrued if it is both probable that the confirming event will occur and the amount can be at least reasonably estimated. If one or both of these criteria is not met, but there is at least a reasonable possibility that the loss will occur, a disclosure note should describe the contingency. In this case, a liability is accrued since both of these criteria are met. Requirement 2 Loss to report: $2 million Requirement 3 Liability to report: $2 million Requirement 4 Loss—product recall .................................................................2,000,000 Liability—product recall......................................... 2,000,000 A disclosure note also is appropriate.

Exercise 13– 1729

Requirement 1 this is a loss contingency. Some loss contingencies don‘t involve liabilities Requirement Yes, 1 at all. Some contingencies when resolved cause a noncash asset to be impaired, so accruing it means reducing the related asset rather than recording a liability. The most common loss contingency of this type is an uncollectible receivable, as described in this situation. Requirement 2 Bad debt expense: 3% × $2,400,000 = $72,000 Requirement 3 Bad debt expense (3% × $2,400,000) ............................... Allowance for uncollectible accounts ..................

72,000 72,000

Requirement 4 Allowance for uncollectible accounts: Beginning of 2024 Write off of bad debts* Credit balance before accrual Year-end accrual (Req. 3) End of 2024

$75,000 (73,000) 2,000 72,000 $74,000

* Allowance for uncollectible accounts....................... Accounts receivable ........................................ Net accounts receivable: Accounts receivable Less: Allowance for uncollectible accounts Net accounts receivable

73,000 73,000

$490,000 (74,000) $416,000

Exercise 13–19 Scenario 1 No disclosure is required because an FDA claim is as yet unasserted, and an assessment is not probable. Scenario 2 No disclosure is required because an FDA claim is as yet unasserted, and an assessment is not probable. Even if an unfavorable outcome is thought to be probable in the event of an assessment and the amount is estimable, disclosure is not required unless an unasserted claim is probable. Scenario 3 A disclosure note is required because an FDA claim is as yet unasserted, but an assessment is probable. Since an unfavorable outcome is not thought to be probable in the event of an assessment, no accrual is needed, but since an unfavorable outcome is thought to be reasonably possible in the event of an assessment, disclosure in a footnote is required. Keep in mind, though, that in practice, disclosure of an unasserted claim is rare. Such disclosure would alert the other party, the FDA in this case, of a potential point of contention that may otherwise not surface. The outcome of litigation and any resulting loss are highly uncertain, making difficult the determination of their possibility of occurrence. Scenario 4 Accrual of the loss is required because an FDA claim is as yet unasserted, but an assessment is probable. Since an unfavorable outcome also is thought to be probable in the event of an assessment, accrual is needed. Keep in mind, though, that in practice, accrual of an unasserted claim is rare. Such disclosure could alert the other party, the FDA in this case, of a potential point of contention that may otherwise not surface. Accrual could be offered in court as an admission of responsibility. A loss usually is not recorded until after the ultimate settlement has been reached or negotiations for settlement are substantially completed.

Exercise 13– 1731 Requirement 1

Warranty expense ([4% × $2,000,000] – $30,800) ........... Estimated warranty liability ................................

49,200 49,200

Disclosure note indicated: Yes Requirement 2 Bad debt expense (2% × $2,000,000) ............................... Allowance for uncollectible accounts ..................

40,000 40,000

Disclosure note indicated: Yes Requirement 3 This is a loss contingency. Classical can use the information occurring after the end of the year and before the financial statements are issued to determine appropriate disclosure. Loss—litigation ......................................................... 1,500,000 Liability—litigation ............................................. 1,500,000 Disclosure note indicated: Yes Requirement 4 This is a gain contingency. Gain contingencies are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. Disclosure note indicated: Yes Requirement 5 Loss—product recall................................................... Liability—product recall.........................................

500,000 500,000

Disclosure note indicated: Yes

Exercise 13–20 (concluded) Requirement 6 Promotional expense ([60% × $25 × 10,000] – $105,000) .. Estimated premium liability ...................................

45,000 45,000

Disclosure note indicated: Yes Feedback: Because the rebate is offered as a promotion rather than provided as part of a sales transaction, it really is a ―coupon‖ as discussed in the Additional Consideration Box in the text section for product warranties and guarantees. An expense and liability is recorded for the estimated amount that will be paid in the future. If the rebate instead was offered as part of a sale transaction, it would be accounted for as variable consideration as discussed in Chapter 6. In that case, rather than debiting an expense, revenue associated with the sale would be reduced, and a liability recorded for the estimated amount that will be paid in the future.

Exercise 13–21 Requirement 1 Asset: $0 Liability: $0 Erismus would not recognize a liability, as U.S. GAAP defines ―probable‖ to be a likelihood of substantially more than ―more likely than not‖. Rather, Erismus would view the loss as reasonably possible and provide disclosure in a note. Requirement 2 Asset: $0 Liability: $2,000,000 Erismus would recognize a liability of $2,000,000, as it is probable Erismus will lose in court, and U.S. GAAP requires accrual of the low end of a range of equally likely outcomes. There will also be note disclosure of the lawsuit. Requirement 3 Asset: $0 Liability: $5,000,000 Erismus would recognize a liability of $5,000,000, as it is probable that it will lose the case. Under U.S. GAAP companies typically do not discount litigation claims for the time value of money. There will also be note disclosure of the lawsuit. Requirement 4 Asset: $0 Liability: $0 This is a gain contingency. Gain contingencies are not accrued under U.S. GAAP. A disclosure note is appropriate if the amount is deemed material.

Exercise 13–21 (concluded) Requirement 5 Asset: $0 Liability: $0 This is a gain contingency. Gain contingencies are not accrued under U.S. GAAP. A disclosure note is appropriate if the amount is deemed material.

Exercise 13–22 Requirement 1 Asset: $0 Liability: $1,000,000 Erismus would recognize a liability of $1,000,000, as IFRS defines ―probable‖ as ―more likely than not‖ (> 50%), and it is more likely than not to lose in court. Requirement 2 Asset: $0 Liability: $3,000,000 Erismus would recognize a liability of $3,000,000, as it is more likely than not to lose in court, and IFRS requires that they take the midpoint of the range of equally likely outcomes. There will also be note disclosure of the lawsuit. Requirement 3 Asset: $0 Liability: $3,500,000 Erismus would recognize a liability of $3,500,000, as it is more likely than not to lose in court, and IFRS requires that they take the present value of future outcomes if time-value-of-money effects are material. There will also be note disclosure of the lawsuit. Requirement 4 Asset: $0 Liability: $0 This is a gain contingency. Gain contingencies are accrued under IFRS when the gain is virtually certain and reasonably estimable. Because this gain is only probable, the gain would not be recognized. Instead, the gain should be recognized only when realized. A disclosure note is appropriate.

Exercise 13–22 (concluded) Requirement 5 Asset: $500,000 Liability: $0 This is a gain contingency. Gain contingencies are accrued under IFRS when the gain is virtually certain and reasonably estimable. Erismus would recognize a gain of $500,000, recorded at present value if the time value of money is material.

Exercise 13–23 Item C_ 1. Commercial paper. D_ 2. Noncommitted line of credit. C_ 3. Customer advances. C_ 4. Estimated quality assurance warranty cost.

Reporting Method N. C. L. D.

Not reported Current liability Long-term liability Disclosure note only C_ 5. Accounts payable. A. Asset C_ 6. Long-term bonds that will be callable by the creditor in the upcoming year unless an existing violation is not corrected (there is a reasonable possibility the violation will be corrected within the grace period). C_ 7. Note due March 3, 2025. C_ 8. Interest accrued on note, Dec. 31, 2024. L_ 9. Short-term bank loan to be paid with proceeds of sale of common stock. D_ 10. A determinable gain that is contingent on a future event that appears extremely likely to occur in three months. C_ 11. Unasserted assessment of taxes owed on prior-year income that probably will be asserted, in which case there would probably be a loss in six months. N_ 12. Unasserted assessment of taxes owed on prior-year income with a reasonable possibility of being asserted, in which case there would probably be a loss in 13 months. C_ 13. A determinable loss from a past event that is contingent on a future event that appears extremely likely to occur in three months. L_ 14. Note payable due April 4, 2027. C_ 15. Long-term bonds callable by the creditor in the upcoming year that are not expected to be called.

Exercise 13– 1742 Requirement 1

Accrued liability and expense Warranty expense (3% × $3,600,000) ............................................... 108,000 Warranty liability ............................................................. 108,000 Actual expenditures (summary entry) Warranty liability ...................................................................... 88,000 Cash .................................................................................

88,000

Requirement 2 Actual expenditures (summary entry) Warranty liability ($50,000 – $23,000)..................................... Loss on product warranty ([3% – 2%] × $2,500,000) ................. Cash .................................................................................

27,000 25,000 52,000*

*(3% × $2,500,000) – $23,000 = $52,000)

Exercise 13– 1. This is a change in estimate. 1743 To revise the liability on the basis of the new estimate: Liability—litigation ($1,000,000 – 600,000).................. Gain—litigation ....................................................

400,000 400,000

2. A disclosure note should describe the effect of a change in estimate on income from continuing operations, net income, and related per-share amounts for the current period.

Exercise 13– 1744

1. Yes, the note describes a loss contingency. 2. DuPont considers the liability probable and the amount is reasonably estimable, so DuPont would accrue the contingency.

3. To accrue this amount of liability in a single journal entry, DuPont would record the following entry: ($ in millions)

Loss—environmental claims ............................................ Liability—environmental claims ............................

77 77

In practice this liability would be accrued in multiple entries, increasing when DuPont recognized additional liability and decreasing either when DuPont paid off parts of the liability or revised downward its estimate of remediation and restoration costs.

Exercise 13– 1745

Salaries expense (total amount earned) ........................ Withholding taxes payable (federal income tax) ... Social security taxes payable ($500,000 × 6.2%).. Medicare taxes payable ($500,000 × 1.45%)......... Salaries payable (net pay) ..................................

500,000

Payroll tax expense (total) ..................................... 68,250 Social security taxes payable (employer‘s matching amount) Medicare taxes payable (employer‘s matching amount) Federal unemployment tax payable ($500,000 × 0.6%) State unemployment tax payable ($500,000 × 5.4%)

100,000 31,000 7,250 361,750 31,000 7,250 3,000 27,000

PROBLEMS

Problem 13–1 Requirement 1 Blanton Plastics Cash ....................................................................... 14,000,000 Notes payable ...................................................... 14,000,000 L & T Bank Notes receivable...................................................... 14,000,000 Cash ................................................................... 14,000,000 Requirement 2 Adjusting entries (December 31, 2024) Blanton Plastics Interest expense ($14,000,000 × 12% × 3/12)................. Interest payable ...................................................

420,000

L & T Bank Interest receivable ................................................... Interest revenue ($14,000,000 × 12% × 3/12) .............

420,000

Maturity (January 31, 2025) Blanton Plastics 140,000 Interest expense ($14,000,000 × 12% × 1/12)................. Interest payable (from adjusting entry) ........................ 420,000 Notes payable (face amount) ...................................... 14,000,000 Cash (total) ........................................................... 14,560,000 L & T Bank Cash (total)............................................................... 14,560,000 140,000 Interest revenue ($14,000,000 × 12% × 1/12)............... Interest receivable (from adjusting entry) ................. 420,000 Notes receivable (face amount) .............................. 14,000,000

Problem 13–1 (concluded) Requirement 3 a. Issuance of note (October 1, 2024) Cash (difference) ................................................................... 13,440,000 Discount on notes payable ($14,000,000 × 12% × 4/12) 560,000 Notes payable (face amount) ....................................... 14,000,000 Adjusting entry (December 31, 2024) Interest expense ($14,000,000 × 12% × 3/12)................. 420,000 Discount on notes payable ...................................

420,000

Maturity (January 31, 2025) Interest expense ($14,000,000 × 12% × 1/12)................. Discount on notes payable ...................................

140,000

Notes payable (face amount)............................................... 14,000,000 Cash ................................................................... 14,000,000

b. Effective interest rate: Discount ($14,000,000 × 12% × 4/12) $ 560,000 Cash proceeds ÷ $13,440,000 Interest rate for four months 4.1666% x 12/4 Annual effective rate

12.5%

Problem 13–2 Requirement 1 2024 a.

No entry is made for a line of credit until a loan actually is made. It would be described in a disclosure note.

Cash .................................................................. 12,000,000 Notes payable ............................................... 12,000,000

Cash................................................................... Liability—refundable deposits .....................

2,600

Accounts receivable (total) .................................. Sales revenue (given)...................................... Sales taxes payable ([3% + 3%] × $4,100,000) ...

4,346,000

Interest expense ($12,000,000 × 10% × 3/12)............ Interest payable ............................................

300,000

2,600 4,100,000 246,000 300,000

2025 f.

Cash .................................................................. 10,000,000 10,000,000 Bonds payable............................................... 200,000 Interest expense ($12,000,000 × 10% × 2/12)............ Interest payable (from adjusting entry) ................... 300,000 Notes payable (face amount) ................................. 12,000,000 Cash ($12,000,000 + $500,000) .......................... 12,500,000

Liability—refundable deposits .......................... Cash..............................................................

1,300 1,300

Problem 13–2 (concluded) Requirement 2 CURRENT LIABILITIES: Accounts payable $ 252,000 Current portion of notes payable 2,000,000* Liability—refundable deposits 2,600 Sales taxes payable 246,000 Interest payable 300,000 Total current liabilities $2,800,600 LONG-TERM LIABILITIES: Notes payable to be refinanced on a long-term basis

$10,000,000*

* Notes payable to be refinanced on a long-term basis: The intent of management is to refinance all $12,000,000 of notes payable by issuing long term bonds payable, but the actual refinancing demonstrates the ability only for $10,000,000, evidenced by the issuance of bonds in February 2025 before the repayment of the entire amount of the 10% note due in March 2025.

Problem 13–3 Requirement 1 a. Current liability: $40 million Noncurrent liability: $0 The requirement to classify currently maturing debt as a current liability includes debt that is callable by the creditor in the upcoming year—even if the debt is not expected to be called. So, the entire $40 million debt is a current liability. b. Current liability: $1 million Noncurrent liability: $5 million $5 million can be reported as long term, but $1 million must be reported as a current liability. Short-term obligations that are expected to be refinanced with long-term obligations can be reported as noncurrent liabilities only if the firm (a) intends to refinance on a long-term basis and (b) actually has demonstrated the ability to do so. Ability to refinance on a long-term basis can be demonstrated by either an existing refinancing agreement or by actual financing prior to the issuance of the financial statements. The refinancing agreement in this case limits the ability to refinance to $5 million of the notes. In the absence of other evidence of ability to refinance, the remaining $1 million cannot be reported as long term. c. Current liability: $20 million Noncurrent liability: $0 The entire $20 million maturity amount should be reported as a current liability because that amount is payable in the upcoming year and it will not be refinanced with long-term obligations.

Problem 13–3 (continued) d. Current liability: $0 Noncurrent liability: $12 million The entire $12 million loan should be reported as a long-term liability because that amount is payable in 2030 and it will not be refinanced with long-term obligations. The current liability classification includes (a) situations in which the creditor has the right to demand payment because an existing violation of a provision of the debt agreement makes it callable and (b) situations in which debt is not yet callable, but will be callable within the year if an existing violation is not corrected within a specified grace period—unless it's probable the violation will be corrected within the grace period. Here, the existing violation is expected to be corrected within six months (actually three months in this case). Requirement 2 Liability section of classified balance sheet: December 31, 2024 ($ in millions) Current Liabilities Accounts payable and accruals 10% notes payable, due May 2025 Current portion of long-term debt: 11% bonds payable, due October 31, 2035, redeemable on October 31, 2025 12% bonds payable, due September 30, 2025 Total Current Liabilities Long-Term Debt Currently maturing debt classified as long-term: 10% notes payable, due May 2025 (Note X) 9% loan payable, due October 2030 Total Long-Term Liabilities Total Liabilities

$ 22 1

$40 20

60 83

5 12 17 $100

Problem 13–3 (concluded) Note disclosure: NOTE X: CURRENTLY MATURING DEBT CLASSIFIED AS LONG-TERM

The Company intends to refinance $6 million of 10% notes that mature in May of 2025. In March, 2025, the Company negotiated a line of credit with a commercial bank for up to $5 million available for use any time during 2025. Any borrowings will mature two years from the date of borrowing. Accordingly, $5 million was reclassified to long-term liabilities.

Problem 13– 1754 Requirement 1 a. Interest expense ($600,000 × 10% × 5/12)..................... Interest payable ...............................................

25,000 25,000

b. No adjusting entry since interest has been paid up to December 31. $950,000 can be reported as a noncurrent liability, because (a) intent and (b) ability to refinance has been demonstrated for that amount. c. Accounts receivable (to eliminate the credit balance) .. Deferred revenue .............................................

18,000

d. Deferred revenue (2/12 × $30,000) ........................... Revenue .........................................................

5,000

18,000 5,000

Requirement 2 CURRENT LIABILITIES: Accounts payable Current portion of long-term debt250,000 Accrued interest payable Deferred revenue Deferred rent revenue 10% notes payable, due July 31, 2025 Total current liabilities LONG-TERM LIABILITIES: Currently maturing debt classified as long-term: Mortgage note payable to be refinanced on a long-term basis

$ 35,000 25,000 18,000 25,000 600,000 $953,000

$950,000

Problem 13–5 Requirement 1 B = .10 ($150,000 – B – T), where

B = the bonus T = income tax

T = .30 ($150,000 – B) Requirement 2 Since income tax (T) is a component of both equations, we can combine the two and then solve for the remaining unknown amount (B): Substitute value of T for T:

B = .10 [ $150,000 – B – .30 ($150,000 – B)] Reduce the right-hand side of the equation to one known and one unknown value:

B = .10 ( $150,000 – B – $45,000 + .30B) B = .10 ( $105,000 – .70B) B = $10,500 – .07B Add .07B to both sides

1.07B = $10,500 Divide both sides by 1.07

B = $9,813 Requirement 3 Bonus compensation expense ............................ Bonus compensation payable .........................

9,813 9,813

Requirement 4 The approach is the same in any case: (1) express the bonus formula as one or more algebraic equation(s), (2) use algebra to solve for the amount of the bonus. For example, the bonus might specify that the bonus is 10% of the division‘s income before tax, but after the bonus itself: B = .10 ($150,000 – B) B = $15,000 – .10B 1.10B = $15,000 B = $13,636

Problem 13– a. This is a loss contingency. Eastern can use the information occurring after the end 1756 of the year in determining appropriate disclosure. It is unlikely that Eastern would choose to accrue the $122 million loss because the judgment will be appealed and that outcome is uncertain. A disclosure note is appropriate: Note X: Contingency In a lawsuit resulting from a dispute with a supplier, a judgment was rendered against Eastern Manufacturing Corporation in the amount of $107 million plus interest, a total of $122 million at February 3, 2025. Eastern plans to appeal the judgment. While management and legal counsel are presently unable to predict the outcome or to estimate the amount of any liability the company may have with respect to this lawsuit, it is not expected that this matter will have a material adverse effect on the company. b. This is a loss contingency. Eastern can use the information occurring after the end of the year in determining appropriate disclosure. Eastern should accrue the $140 million loss because the ultimate outcome appears settled and the loss is probable. Loss—litigation ......................................... Liability—litigation................................ A disclosure note also is appropriate:

140,000,000 140,000,000

Notes: Litigation In November 2023, the State of Nevada filed suit against the Company, seeking civil penalties and injunctive relief for violations of environmental laws regulating hazardous waste. On January 12, 2025, the Company announced that it had reached a settlement with state authorities on this matter. Based upon discussions with legal counsel, the Company has accrued and charged to operations in 2024, $140 million to cover the anticipated cost of all violations. The Company believes that the ultimate settlement of this claim will not have a material adverse effect on the Company's financial position.

Problem 13–6 (concluded) c. This is a gain contingency. Gain contingencies are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. Though gain contingencies are not recorded in the accounts, they should be disclosed in notes to the financial statements. Note X: Contingency Eastern is the plaintiff in a pending lawsuit filed against United Steel for damages due to lost profits from rejected contracts and for unpaid receivables. The case is in final appeal. No amount has been accrued in the financial statements for possible collection of any claims in this litigation. d. No disclosure is required because the claim is as yet unasserted (no lawsuit has been filed), and it is not probable that a claim will be asserted in the future. Even if an unfavorable outcome is thought to be probable in the event a lawsuit is filed, and even if the amount of losses that could result from the lawsuit is estimable, disclosure is not required unless an unasserted claim is probable.

Problem 13–7 Requirement 1 Item (a): Because the loss is probable and can be reasonably estimated, HW would be required to accrue a liability under both U.S. GAAP and IFRS, but the amount of the liability would differ between the two. Under U.S. GAAP, the liability would be for $5,000,000, the low end of the range, while under IFRS the liability would be for $7,500,000, the midpoint of the range. Item (b): Under IFRS, present values would be used, so the relevant midpoint of the range that would be accrued as a liability would be $5,500,000. Under U.S. GAAP, present values would not be used given the uncertain timing of cash flows, so HW would still use the lower end of the undiscounted range, or $5,000,000. Item (c): This item is only probable according to IFRS‘s use of the term, so it would only be accrued as a liability under IFRS, for the midpoint of the range ($6,000,000). Item (d): This item would be classified as long-term under U.S. GAAP, but short-term under IFRS, given that the financing was obtained prior to financial statement issuance but not before the balance sheet date. Requirement 2 Total liabilities under U.S. GAAP equal $5,000,000 + $5,000,000 + $0 + $10,000,000 = $20,000,000. Total liabilities under IFRS equal $7,500,000 + $5,500,000 + $6,000,000 + $10,000,000 = $29,000,000. In this case, U.S. GAAP provides the lower total liabilities.

Problem 13–8 Requirement 1 By the traditional approach, Heinrich would accrue the more-likely-than-not (more than 50%) amount, $30 million: Loss—product recall Liability—product recall

30,000,000 30,000,000

Requirement 2 Heinrich would record a contingent liability (and loss) of $27,619,020, calculated as follows: $40,000,000 × 20% = $ 8,000,000 30,000,000 × 50% = 15,000,000 20,000,000 × 30% = 6,000,000 $29,000,000 × .95238* Liability at end of 2024 $27,619,020 *Present value of $1, n = 1, i = 5% (from Table 2)

Requirement 3 Loss—product recall Liability—product recall

27,619,020 27,619,020

Requirement 4 The difference between $29,000,000 and the initial value of the liability of $27,619,020 represents interest expense, which Heinrich will accrue during 2025 as follows: Interest expense Liability—product recall

1,380,980 1,380,980

Problem 13–8 (concluded) Requirement 5 Interest increases the liability to $29 million at the end of 2025. Since there is a difference between the actual costs, $31 million, and the $29 million liability, Heinrich will record an additional loss. Liability—product recall Loss—product recall Cash

29,000,000 2,000,000 31,000,000

Problem 13–9 Case 1 Disclosure note Only. When a contingency comes into existence after the year-end, a liability cannot be accrued because it didn‘t exist at the end of the year. However, if the loss is probable and can be estimated, the situation should be described in a disclosure note. Case 2 Disclosure note Only. Since an unasserted claim or assessment is probable, the likelihood of an unfavorable outcome and the feasibility of estimating a dollar amount should be considered in deciding whether and how to report the possible loss. An estimated loss and contingent liability cannot be accrued since an unfavorable outcome is only reasonably possible even though the amount can be reasonably estimated. Case 3 Accrual and Disclosure Note. When the cause of a loss contingency occurs before the year-end, a clarifying event before financial statements are issued can be used to determine how the contingency is reported. Even though the loss was not probable at year-end, it becomes so before financial statements are issued. The situation also should be described in a disclosure note. Case 4 No Disclosure. Even though the cause of the contingency occurred before year-end, Lincoln is unaware of the loss contingency when the financial statements are issued.

Problem 13–10 Requirement 1 Portion of the notes payable not refinanced on a long-term basis through the stock sale .................

$3,000,000

Liability for the payment of employee‘s medical bills ... Total to report among current liabilities......................

75,000 $3,075,000

Normally, short-term debt (payable within a year) is classified as current liabilities. However, when such debt is to be refinanced on a long-term basis, it may be included with long-term liabilities. The narrative indicates that Rushing refinanced $9 million of the notes payable on a long-term basis. Thus, Rushing should report that amount among long-term liabilities. The remaining $3 million was a current liability at Dec. 31. The $75,000 payment of the employee‘s medical bills is a loss contingency as of Dec. 31. Rushing can use the information occurring after the end of the year and before the financial statements are issued (the settlement) to determine appropriate disclosure. That information confirms that payment was probable (certain) and the amount can be at least reasonably estimated (known). A disclosure note also is appropriate.

Requirement 2 Portion of the notes payable refinanced on a long-term basis through the stock sale ................. Total to report among long-term liabilities ..........

$9,000,000 $9,000,000

Problem 13–10 (concluded) Requirement 3 If the settlement agreement had occurred on March 15, 2025, instead, the $75,000 payment of the employee‘s medical bills would not have been accrued as either a current or long-term liability because that payment had not been determined to be probable as of the publication of the financial statements.

Requirement 4 If the work-site injury had occurred on January 3, 2025, instead, the $75,000 payment of the employee‘s medical bills would not have been accrued as either a current or long-term liability because the cause of the liability had not occurred as of Dec. 31, 2024. Thus, the liability did not exist as of that date.

Problem 13–11 j_ g h

List A 1. Face amount × Interest rate × Time 2. Payable with current assets 3. Short-term debt to be refinanced with common stock

4. Present value of interest plus present value of principal d 5. Noninterest-bearing a 6. Noncommitted line of credit b_ 7. Pledged accounts receivable c_ 8. Reclassification of debt f_ 9. Purchased by other corporations e_ 10. Expenses not yet paid l_ 11. Liability until refunded k_ 12. Liability until satisfy performance obligation

a. b. c.

d. e. f. g. h. i. j. k. l.

List B Informal agreement Secured loan Refinancing prior to the issuance of the financial statements Accounts payable Accrued liabilities Commercial paper Current liabilities Long-term liability Usual valuation of liabilities Interest on debt Customer advances Customer deposits

Problem 13–12 Requirement 1 The requirement to classify currently maturing debt as a current liability includes debt that is callable by the creditor in the upcoming year—even if the debt is not expected to be called. So, the entire $90 million debt is a current liability. Requirement 2 The entire $30 million loan should be reported as a long-term liability because that amount is payable in 2027. The current liability classification includes (a) situations in which the creditor has the right to demand payment because an existing violation of a provision of the debt agreement makes it callable and (b) situations in which debt is not yet callable, but will be callable within the year if an existing violation is not corrected within a specified grace period—unless it's probable the violation will be corrected within the grace period. Here, the existing violation is expected to be corrected within six months (actually six weeks in this case). Requirement 3 The intent of management is to refinance all $45,000,000 of the 7% notes, but the refinancing agreement demonstrates the ability only for $40,000,000. $40 million can be reported as long term, but $5 million must be reported as a current liability. Shortterm obligations that are expected to be refinanced with long-term obligations can be reported as noncurrent liabilities only if the firm (a) intends to refinance on a longterm basis and (b) actually has demonstrated the ability to do so. Ability to refinance on a long-term basis can be demonstrated by either an existing refinancing agreement or by actual financing prior to the issuance of the financial statements. The refinancing agreement in this case limits the ability to refinance to $40 million of the notes. In the absence of other evidence of ability to refinance, the remaining $5 million cannot be reported as long term. Requirement 4 The lawsuit resulting from a dispute with a food caterer should not be accrued. The suit is in appeal and it is not deemed probable that that Transit will lose the appeal. Note disclosure is required.

Problem 13–12 (continued) Requirement 5 December 31, 2024 ($ in millions)

Current Liabilities Accounts payable and accruals 6.5 % bonds payable, maturing on July 31, 2030, callable July 31, 2025 Current portion of 7% notes payable, due May 2025 Total Current Liabilities Long-Term Debt 8% loan payable, due to bank on October 31, 2030 Currently maturing debt classified as long-term: 7% notes payable, due May 2025 (Note X) Total Long-Term Liabilities Total Liabilities

$ 43 90 5 138 30 40 70 $208

Problem 13–12 (continued) Requirement 6

NOTE X: CALLABLE DEBT CLASSIFIED AS CURRENT

Transit has outstanding 6.5% bonds with a face amount of $90 million. The bonds mature on July 31, 2030. Bondholders have the option of calling (demanding payment on) the bonds on July 31, 2025, at a redemption price of $90 million. Market conditions are such that the call option is not expected to be exercised. The Company is required to report debt that is callable by the creditor in the upcoming year even if the debt is not expected to be called as current. Accordingly, the $90 million of 6.5% bonds is reported as a current liability.

NOTE X: LOAN IN VIOLATION OF DEBT COVENANT

A $30 million 8% bank loan is payable on October 31, 2030. The bank has the right to demand payment after any fiscal year-end in which the Company‘s ratio of current assets to current liabilities falls below a contractual minimum of 1.9 to 1 and remains so for six months. That ratio was 1.75 on December 31, 2024, due primarily to an intentional temporary decline in parts inventories. Normal inventory levels will be reestablished during the sixth week of 2025. Accordingly, the loan is reported as a long-term liability in the balance sheet.

Problem 13–12 (concluded)

NOTE X: CURRENTLY MATURING DEBT CLASSIFIED AS LONG-TERM

The Company intends to refinance $45 million of 7% notes that mature in May of 2025. In February 2025, the Company negotiated a line of credit with a commercial bank for up to $40 million any time during 2025. Any borrowings will mature two years from the date of borrowing. Accordingly, $40 million was reclassified to long-term liabilities.

NOTE X: LAWSUIT

The Company is involved in a lawsuit resulting from a dispute with a food caterer. On February 13, 2025, judgment was rendered against the Company in the amount of $53 million plus interest, a total of $54 million. The Company plans to appeal the judgment and is unable to predict its outcome, though it is not expected to have a material adverse effect on the company.

Problem 13–13 Salaries expense (total amount earned) ............................ Withholding taxes payable (federal income tax) .......... Withholding taxes payable (local income tax)............. Social security taxes payable ($2,000,000 × 6.2%) ...... Medicare taxes payable ($2,000,000 × 1.45%)............. Medical insurance payable ($42,000 × 20%) .............. Life insurance payable ($9,000 × 20%) ......................... Retirement plan payable (employees‘ investment) ........ Salaries payable (net pay) .........................................

2,000,000 400,000 53,000 124,000 29,000 8,400 1,800 84,000 1,299,800

Payroll tax expense (total) .......................................... 153,000 Social security taxes payable (employer‘s matching amount) Medicare taxes payable (employer‘s matching amount).

124,000 29,000

Salaries expense (fringe benefits) ................................. Medical insurance payable ($42,000 × 80%) .............. Life insurance payable ($9,000 × 80%) ......................... Retirement plan payable (matching amount) .................

33,600 7,200 84,000

124,800

ECISION MAKERS’ ERSPECTIVES CASES

Research Case 13–1 [Note: This case encourages the student to reference authoritative pronouncements.]

The relevant authoritative literature can be found in the FASB‘s codification at ASC 470–10–45–15: ―Debt–Overall–Other Presentation Matters–Intent and Ability to Refinance on a Long-Term Basis.‖ The $2,000,000 of commercial paper liquidated in November 2024 would be classified as a current liability in Cheshire's balance sheet at September 30, 2024. The essence of a current liability is that its payment requires the use of current assets or the creation of other current liabilities. If a liability is liquidated after the year-end with current assets, it is reported as a current liability as of the end of the reporting period—even if the current assets are later replenished by proceeds of a long-term obligation before the issuance of the financial statements. The $3,000,000 of commercial paper liquidated in January 2025 but refinanced by the long-term debt offering in December 2024 would be excluded from current liabilities in the balance sheet at the end of September 2024. It should be noted that the existence of a financing agreement at the date of issuance of the financial statements rather than a completed financing at that date would not change these classifications.

Analysis Case 13–2 Requirement 1 Current ratio

Current assets Current liabilities

$1,879 $1,473

1.28 Industry average = 1.5

The current ratio is one of the most widely used ratios. It is intended as a measure of short-term solvency and is determined by dividing current assets by current liabilities. Comparing assets that either are cash or will be converted to cash in the near term, with those liabilities that must be satisfied in the near term, provides a useful measure of a company‘s liquidity. A ratio of 1 to 1 or higher often is considered a rule-of-thumb standard, but like other ratios, acceptability should be evaluated in the context of the industry in which the company operates and other specific circumstances. IGF‘s current ratio is slightly less than the industry average, which, on the surface, might indicate a liquidity problem. Keep in mind, though, that industry averages are only one indication of adequacy and that the current ratio is but one indication of liquidity.

Case 13–2 (concluded) Requirement 2 Acid-test ratio (or quick ratio)

Quick assets Current liabilities

$48 + $347 + $358 $1,473

0.51 Industry average = 0.80

The acid-test or quick ratio attempts to adjust for the implicit assumption of the current ratio that all current assets are equally liquid. This ratio is similar to the current ratio, but is based on a more conservative measure of assets available to pay current liabilities. Specifically, the numerator, quick assets, includes only cash and cash equivalents, short-term investments, and accounts receivable. By eliminating current assets such as inventories and prepaid expenses that are less readily convertible into cash, the acid-test ratio provides a more rigorous indication of a company's short-term solvency than does the current ratio. Once again, IGF‘s ratio is less than that of the industry as a whole. Is this confirmation that liquidity is an issue for IGF? Perhaps; perhaps not. It does, though, raise a red flag that suggests caution when assessing other areas. It‘s important to remember that each ratio is but one piece of the puzzle. For example, profitability is probably the best long-run indication of liquidity. Also, management may be very efficient in managing current assets so that some current assets—receivables or inventory—are more liquid than they otherwise would be and more readily available to satisfy liabilities.

IFRS Case 13–3 Under IFRS, the $70 million environmental contingency would be accrued and included in Fizer’s liabilities. The associated loss would be reported in the income statement. Accounting for contingencies is covered under IAS No. 37, ―Provisions, Contingent Liabilities, and Contingent Assets.‖ U.S. GAAP‘s specific guidance on contingencies can be found in the FASB‘s Codification Research System at the FASB website (www.fasb.org) at FASB ASC 450–20–25–2: ―Contingencies– Loss Contingencies–Recognition–General Rule.‖ A difference in accounting relates to determining the existence of a loss contingency. We accrue a loss contingency under U.S. GAAP if it‘s both probable and can be reasonably estimated. IFRS is similar, but the threshold is ―more likely than not.‖ This is anything higher than 50%, a lower threshold than ―probable.‖ Under IFRS, Fizer’s bonds would have been reported as a current liability in Fizer‘s balance sheet rather than as long-term debt. Under U.S. GAAP, liabilities payable within the coming year are classified as long-term liabilities if refinancing is completed before the date of issuance of the financial statements, which occurred in this case. Under IFRS, refinancing must be completed before the balance sheet date. Fizer would have reported the long-term contingency in its 2024 financial statements at its present value rather than the face amount. The reason the cash flows were not discounted is that their timing is uncertain, and according to U.S. GAAP discounting of cash flows is allowed if the timing of cash flows is certain. Under IFRS, present value of the estimated cash flows is reported when the effect of time value of money is material.

Real World Case 13–4 Requirement 1 A liability is accrued if it is both probable that a loss will occur and the amount can be at least reasonably estimated. Most consumer products are accompanied by a warranty or guarantee. Warranties and guarantees are loss contingencies for which the conditions for accrual almost always are met. Microsoft has determined that it‘s probable that over $1 billion will be needed to satisfy warranty obligations for its existing Xboxes. If Microsoft had known or believed the obligation was this large when the products were sold, the expense would have been recorded then. In this case, though, undependability of the products wasn‘t known until the current year. So, when that determination was made (the $1 billion estimate), the criteria were met for the first time and the expense was accrued. Requirement 2 When the announcement was made, analyst Richard Doherty stated that either a high number of Xbox 360s will fail or the company is being overly conservative in its warranty estimate. If the estimate of future repairs turns out to be overly conservative, Microsoft will eventually need to eliminate the liability with a corresponding gain. The result will be an increase in future earnings that is unrelated to the future period‘s operations, something analysts should be alert to.

Real World Case 13–5 Requirement 1 In accordance with GAAP, when a contingency exists as of the end of a fiscal year, in assessing whether a loss is probable and measurable and therefore should be recorded in its financial statements, Honda is required to take into consideration all information up to and including the date of issuance of its financial statements and, if appropriate, accrue the loss contingency as of the date of the financial statements. Honda‘s financial results for fiscal 2020 are considered to be issued upon the filing of its Form 10-K with the SEC, which occurred on June 22, 2020. Subsequent to the end of the 2020 reporting year, the company and the plaintiffs agreed to a settlement on June 22, 2020. As a result of that settlement, Honda should include the $85 million settlement payment obligation in its financial statements for the fiscal year ended March 31, 2020. Requirement 2 ($ in millions)

Loss—litigation··········································································· Liability—litigation······························································

85 85

Requirement 3 If the settlement occurred after the June 22 financial statement date, the company still should accrue a liability if a loss is probable and can be estimated. Since it hadn‘t accrued a liability prior to the settlement, apparently management had not considered a loss both probable and reasonably estimable. In that case, note disclosure is appropriate.

Research Case 13–6 Requirement 1 Guidance on accounting for contingent losses: FASB ASC 450–20–25–2: ―Contingencies–Loss Contingencies–Recognition– General Rule‖

Guidelines for determining when an expense and liability should be accrued versus only disclosed in the notes: FASB ASC 450–20–50–3: ―Contingencies–Loss Contingencies–Disclosure– Unrecognized Contingencies.‖ A liability is accrued if it is both probable that a loss will occur and the amount can be at least reasonably estimated. If one or both of these criteria is not met, but there is at least a reasonable possibility that the loss will occur, a disclosure note should describe the nature of the contingency. It also should provide an estimate of the possible loss or range of loss, if possible. If an estimate cannot be made, a statement to that effect is needed. Often such disclosure notes provide only a very general description of contingencies for losses that were not accrued in the financial statements, reducing the usefulness of the information to investors and creditors. Requirements 2 through 5 These requirements are individualized by student selection.

Judgment Case 13–7 Yes, Valleck should accrue both the $190,000 compliance cost and the $205,000 penalty because an agreement has been reached making the loss probable and the amount at least reasonably estimable. These are the two conditions that require accrual of a loss contingency. Valleck can use the information from the February negotiations (occurring after the end of the year) in determining appropriate disclosure. The cause for the suit existed at the end of the year. The disclosure note should also indicate that an accrual was made. This can be accomplished by adding the following sentence to the end of the note: ....... Both of the above amounts have been fully accrued as of December 31, 2024.

Real World Case 13–8 Requirement 1 Per AU Optronics‘ (Form 20-F, filed 3/27/2020): Where there is a continuous range of possible outcomes, with each point in the range as likely as any other, what amount is accrued as the estimate of the obligation? ―Where there is a continuous range of possible outcomes, and each point in that range is as likely as any other, we use the mid-point of the range to measure and recognize the provision.‖ Under U.S. GAAP, the amount at the low end of the range would be accrued, and higher amounts would be disclosed.

Requirement 2 B Communications LTD (Form 20-F, filed 4/23/2020): With respect to legal claims, at what probability level would B Communications accrue a liability for a possible litigation loss? Legal claims Contingent liabilities are accounted for according to IAS 37 and its related provisions. Accordingly, the claims are classified by likelihood of realization of the exposure to risk, as follows: A. More likely than not—more than 50% probability; B. Possible—probability higher than unlikely and less than 50%; or C. Unlikely—probability of 10% or less. Thus, B Communications would accrue a provision for a contingent liability at any probability greater than 50 percent. Under U.S. GAAP, accrual would occur when the liability is viewed as ―probable,‖ which is a higher probability threshold than ―more likely than not.‖

Trueblood Accounting Case 13–9 [Note: This case encourages the student to reference authoritative pronouncements.]

A solution and extensive discussion materials accompany each case in the Deloitte Foundation‘s Trueblood Case Study Series. These are available to instructors at: www.deloitte.com/us/truebloodcases. Relevant discussion in the FASB codification can be found at FASB ASC 450: ―Contingencies.‖

Trueblood Accounting Case 13–10 [Note: This case encourages the student to reference authoritative pronouncements.]

Trueblood Accounting Case 13–1783 [Note: This case encourages the student to reference authoritative pronouncements.]

Communication Case 13–12 Assumptions students make will determine the correct answer to some classifications. Depending on the assumptions made, different views can be convincingly defended. The process of developing and synthesizing the arguments will likely be more beneficial than any single solution. Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. A significant benefit of this case is forcing students‘ consideration of why liabilities currently due are sometimes classified as long term. It also requires them to carefully consider the profession‘s definition of current liabilities. Arguments likely will include the following: a. Commercial paper If it‘s assumed that early April is prior to the actual issuance of the financial statements, then $12 million can be reported as long term, but $3 million must be reported as a current liability. Short-term obligations that are expected to be refinanced with long-term obligations can be reported as noncurrent liabilities only if the firm (a) intends to refinance on a long-term basis and (b) actually has demonstrated the ability to do so. Ability to refinance on a long-term basis can be demonstrated by either an existing refinancing agreement or by actual financing prior to the issuance of the financial statements. The refinancing agreement in this case limits the ability to refinance to $12 million of the notes. In the absence of other evidence of ability to refinance, the remaining $3 million cannot be reported as long term. If it‘s assumed that early April is after the actual issuance of the financial statements, the ability to refinance has not been demonstrated, and all would be reported as short term. b. 11% notes The debt should be reported as a current liability because it is payable in the upcoming year and will not be refinanced with long-term obligations. The fact that the company has available for sale investments does not change the requirement that the company repay the notes in the coming year.

Case 13–12 (concluded) c. 10% notes Short-term obligations that are expected to be refinanced with long-term obligations can be reported as noncurrent liabilities only if the firm (a) intends to refinance on a long-term basis and (b) actually has demonstrated the ability to do so. Ability to refinance on a long-term basis can be demonstrated by either an existing refinancing agreement or by actual financing prior to the issuance of the financial statements. Management‘s ability to refinance at least some of the notes on a long-term basis was demonstrated by the issuance of new bonds prior to the issuance of the financial statements. No mention is made of the proceeds of the new bonds or whether they were used to pay off the maturing notes. If it‘s assumed the intent was to refinance the notes, then the notes would be classified as noncurrent to the extent of the proceeds of the bonds. d. Bonds If it‘s assumed that March 15 is prior to the actual issuance of the financial statements, the bonds can be reported as noncurrent liabilities. The firm (a) intends to refinance on a long-term basis with common stock, and (b) actually has demonstrated the ability to do so by a refinancing agreement prior to the issuance of the financial statements. Refinancing with either debt or equity serves this purpose.

Communication Case 13–13 Memorandum: To: From: Re:

Mitch Riley Your Name Accounting for contingencies

Below is a brief overview of my initial thoughts on how Western should account for the four contingencies in Question. 1. The labor disputes constitute a loss contingency. Though a loss is probable, the amount of loss is not reasonably estimable. Therefore, the loss should not be accrued, but a disclosure note is appropriate: Note X: Contingency During 2024, the Company experienced labor disputes at three of its plants. The Company hopes an agreement will soon be reached. However negotiations between the Company and the unions have not produced an acceptable settlement and, as a result, strikes are ongoing at these facilities. 2. The A. J. Conner matter is a gain contingency. Gain contingencies are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. Though gain contingencies are not recorded in the accounts, they should be disclosed in notes to the financial statements. Note X: Contingency In accordance with a 2022 contractual agreement with A.J. Conner Company, the Company is entitled to $37 million for certain fees and expense reimbursements. The bankruptcy court has ordered A.J. Conner to pay the Company $23 million immediately upon consummation of a proposed merger with Garner Holding Group.

Case 13–13 (concluded) 3. The contingency for warranties should be accrued. During the period Western would make the following journal entries: Warranty expense (2% × $2,100 million) Warranty liability ........

42,000,000

Warranty liability............. Cash (and other costs of warranty fulfillment)

40,000,000 40,000,000

42,000,000

Thus, the liability at December 31, 2024, would be $39 million + 42 million – 40 million = $41 million. 4. The Crump Holdings lawsuit is a loss contingency. Even though the lawsuit occurred in 2025, the cause for the action occurred in 2024. Only a disclosure note is needed because an unfavorable outcome is reasonably possible, but not probable. Also, the amount is not reasonably estimable. Note X: Contingency Crump Holdings filed suit in January 2025 against the Company seeking $88 million, as an adjustment to the purchase price in connection with the Company's sale of its textile business in 2024. Crump alleges that the Company misstated the assets and liabilities used to calculate the purchase price for the division. The Company has answered the complaint and intends to vigorously defend the lawsuit. Management believes that the final resolution of the case will not have a material adverse effect on the Company's financial position.

We can discuss these further in our meeting later today.

Communication Case 13–14 Suggested Grading Concepts and Grading Scheme: Content (80% ) 20 Identifies the situation as a change in estimate. The liability was originally (appropriately) estimated as $750,000. The final settlement indicates the estimate should be revised. 40

Describes the journal entry related to the change in amounts. The liability must be reduced (a debit). A gain should be recorded (a credit). The amount of the gain should be $275,000 ($750,000 – 475,000).

Indicates that additional disclosure is necessary. Bonus (4) Provides detail regarding the disclosure note. A disclosure note should describe the effect of a change in estimate on key items. The effect on income before extraordinary items, net income, and related per share amounts for the current period should be indicated. 80–84 points Writing (20%) 5 Terminology and tone appropriate to the audience of a vice president. 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English. Word selection. Spelling. Grammar. 20 points

Communication Case 13– 1790 Suggested Grading Concepts and Grading Scheme: Content (80% ) 30 Warranty for awnings (5 each; maximum of 30 for this part) Change in estimate. Change is effected prospectively only. No prior financial statements are adjusted. Will affect the adjusting entry for warranty expense in 2024 [Warranty expense and Estimated warranty liability (2% × $4,000,000)]. 30 Clean air lawsuit (5 each; maximum of 30 for this part) Change in estimate. Change is effected prospectively only. No prior financial statements are adjusted. will require a revision of the previously recorded liability [Loss—Litigation and Liability—Litigation increased by $150,000 ($350,000 – 200,000)]. 20 Indicates that additional disclosure is necessary for both. Bonus (4) Provides detail regarding the disclosure note. A disclosure note should describe the effect of a change in estimate on key items. The effect on income before extraordinary items, net income, and related per-share amounts for the current period should be indicated. 80–84 points Writing (20%) 5 Terminology and tone appropriate to the audience of division managers. 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English Word selection. Spelling. Grammar. 20 points 13–1790 Intermediate Accounting, 11/e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Ethics Case 13–16 Discussion should include these elements. Liabilities had been recorded previously. When a high degree of uncertainty exists concerning the collection of receivables, revenue should not be recorded at the time of sale. Instead, deferred revenue— a liability—should be recorded. With the high degree of uncertainty surrounding ―sales‖ of Outdoors R Us, it would be very hard to justify recording sales revenue when memberships are signed. Ethical Dilemma: How does a doubtful justification for a change in reporting methods compare with the perceived need to maintain profits? Who is affected? Rice Sun Other managers? The company‘s auditor Shareholders Potential shareholders The employees The creditors

Ethics Case 13–17 Discussion should include these elements. Warranty estimate The cost of product warranties (or product guarantees) cannot be predicted with certainty. However, to match expenses and revenues, we estimate the cost. The estimated warranty liability is credited and warranty expense is debited in the reporting period in which the product under warranty is sold. In this case, the estimate is probably ―softer‖ than normal because the company is new and has little experience in these estimates. However, Craig presumably made the estimates on the basis of the best information available. The current effort to change the estimate clearly is motivated by the desire to ―window dress‖ performance. Ethical Dilemma: Is Craig‘s obligation to challenge the Questionable change in estimates greater than the obligation to the financial interests of his employer and bosses? Who is affected? Craig President, controller, and other managers Shareholders Potential shareholders The employees The creditors The company‘s auditors

DATA ANALYTICS CASE Your Tableau analysis should produce the following bar chart:

Data Analytics Case (concluded) Data Analytics Case (concluded) Requirement 1 Other things being equal, which company appears to have the better liquidity position in terms of their ability to pay short-term debts as they come due as measured by the current ratio? In 2021, Discount Goods has the better liquidity position in terms of their ability to pay short-term debts as they come due as measured by the current ratio. Requirement 2 Which company appears to offer the better liquidity position in terms of their ability to pay short-term debts as they come due as measured by the acid-test or quick ratio? In 2021, Discount Goods has the better liquidity position in terms of their ability to pay short-term debts as they come due as measured by the acid-test or quick ratio. Requirement 3 Other things being equal, which company appears to have the better liquidity position in terms of ability of the firm's current liabilities to be covered using its cash and cash equivalents as measured by the cash ratio? In 2021, Discount Goods has the better liquidity position in terms of the ability of the firm‘s current liabilities to be covered using its cash and cash equivalents as measured by the cash ratio. Requirement 4 Which company appears to offer the better security for its current obligation creditors as measured by the current liabilities to net worth ratio? In 2021, Big Store offers better security for its current obligation creditors as measured by the current liabilities to net worth ratio.

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TARGET CASE Requirement 1 a. The three components of current liabilities are:

($ in millions)

Current Liabilities: Accounts payable Accrued and other current liabilities Current portion of LT debt & other borrowings Total current liabilities b.

2/1/2020

2/2/2019

$ 9,920 4,406 161

$ 9,761 4,201 1,052

$14,487

$15,014

Current assets are not sufficient to cover current liabilities in either fiscal year: Current assets 2/1/2020 Current assets 2/2/2019 Current ratio 2/1/2020 Current ratio 2/2/2019

$12,902 $12,519 $12,902 ’ $14,487= 0.89 $12,519 ’ $15,014= 0.83

The current ratio at 2/1/2020 is higher than in the prior year.

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Target Case (continued) Requirement 2 d. February 1, 2020: $935 million February 2, 2019: 840 million Increase: $ 95 million e. The liability will be affected as follows: i. The liability will increase for sales of gift cards, because that will increase deferred revenue with a journal entry of the form: Cash

xxx Deferred revenue, gift cards

ii.

The liability will decrease when gift cards are redeemed, because the deferred revenue associated with the gift card can now be recognized. Deferred revenue, gift cards Revenue

iii.

xxx xxx

The liability will decrease for an increase in estimated breakage, because it is anticipated that fewer gift cards will be redeemed. The offset will be to revenue, because at the point the gift card is concluded to not be redeemed, Target has satisfied its performance obligation (refer to Chapter 6 for further discussion of revenue recognition with respect to gift cards). Deferred revenue, gift cards Revenue

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xxx

xxx xxx

Target Case (concluded) Requirement 3 Target states that ―We are exposed to claims and litigation arising in the ordinary course of business and use various methods to resolve these matters in a manner that we believe serves the best interest of our shareholders and other constituents. When a loss is probable, we record an accrual based on the reasonably estimable loss or range of loss. When no point of loss is more likely than another, we record the lowest amount in the estimated range of loss and, if material, disclose the estimated range of loss. We do not record liabilities for reasonably possible loss contingencies, but do disclose a range of reasonably possible losses if they are material and we are able to estimate such a range. If we cannot provide a range of reasonably possible losses, we explain the factors that prevent us from determining such a range. Historically, adjustments to our estimates have not been material. We believe the recorded reserves in our consolidated financial statements are adequate in light of the probable and estimable liabilities. We do not believe that any of these identified claims or litigation will be material to our results of operations, cash flows, or financial condition.‖ So, Target is making reasonable estimates based on their view of probable outcomes. Target does not believe it is probable it would be found liable if these cases were litigated, which could be the case either because Target does not believe it is probable the cases would be litigated or it does not believe it is probable that it would be found liable should the cases be litigated. This approach appears appropriate, given that Target should only accrue amounts that are probable and reasonably estimable.

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Air France–KLM Case Requirement 1 AF-KLM receives payment for flight services in advance of delivery of those services. Upon receipt of payment, AF-KLM records a liability, deferred revenue, and only when the services later are delivered does it reduce that liability and record revenue. Yes, transactions of this type would be handled similarly under U.S. GAAP. Requirement 2 Yes, it is different. Under both U.S. GAAP and IFRS, liabilities associated with a past event are recorded when the obligation is probable and the amount of the obligation can be reliably estimated. However, IFRS defines ―probable‖ as ―more likely than not,‖ which is a lower threshold than is typically applied under U.S. GAAP, so it is more likely to recognize a liability under IFRS than it would under U.S. GAAP. Also, under IFRS, it is more likely to discount the liability (recording it at present value) than it would under U.S. GAAP, so, given that a liability is recognized, the amount of liability that is recognized may be lower under IFRS than under U.S. GAAP. Requirement 3 a. Yes, the total beginning balances (totaling €4,162 million, consisting of €3,657 million noncurrent and €505 million current) and ending balances (totaling €4,464, million consisting of €3,750 million noncurrent and €714 million current) of provisions and retirement benefits shown in Note 30 for fiscal 2019 tie to the balance sheet. In total, AF-KLM’s ―Other provisions‖ current and noncurrent liabilities increased by €302 million during fiscal 2019.

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Air France Case (concluded) b. Journal entries for the following changes in the litigation provision that occurred during fiscal 2019: i.

New provision Provision expense Litigation provision

32 32

This journal entry captures AF-KLM establishing an additional liability for future litigation-related expenditures. ii.

Use of provision Litigation provision Cash

9 9

This journal entry captures AF-KLM paying down an existing liability with cash. iii.

Reversal of unnecessary provision Litigation provision Reversal of litigation provision

5 5

This journal entry captures AF-KLM reducing its litigation provision and increase income to adjust downward a prior estimate of litigation cost. c. AF-KLM‘s treatment of litigation provision under IFRS is consistent with how these items would be treated under U.S. GAAP.

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Air France Case (concluded) Requirement 4 Under IFRS, ―contingent liabilities‖ are disclosed and not accrued as a liability in the balance sheet or recognized as an expense in the income statement. These are amounts that relate to prior events and either are possible future obligations or are present obligations but either are not probable or not reliably estimated. Under U.S. GAAP, these contingencies would be treated the same way. However, U.S. GAAP uses the term ―contingent liability‖ to refer to the entire set of what IFRS refers to as contingencies and provisions.

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Chapter 14 Bonds and Long-Term Notes

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16–95

QUESTIONS FOR REVIEW OF KEY TOPICS

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16–97

Question 14–1 Periodic interest is calculated as the effective interest rate times the amount of the debt outstanding during the period. This same principle applies to the flip side of the transaction, that is, the creditor‘s receivable or investment. The approach also is the same regardless of the specific form of the debt, that is, whether in the form of notes, bonds, leases, pensions, or other debt instruments.

16–1

Question 14–2 Long-term liabilities are appropriately reported at their present values. The present value of a liability is the present value of its related cash flows—specifically the present value of the face amount of the debt instrument, if any, plus the present value of stated interest payments, if any. Both should be discounted to present value at the effective (market) rate of interest at issuance.

16–2

Question 14– 100Bonds and notes are very similar. Both typically obligate the issuing corporation to repay a stated amount (e.g., the principal, par value, face amount, or maturity value) at a specified maturity date. In return for the use of the money borrowed, the company also agrees to pay interest to the lender between the issue date and maturity. The periodic interest is a stated percentage of face amount. In concept, bonds and notes are accounted for in precisely the same way. Normally a company will borrow cash from a bank or other financial institution by signing a promissory note. Corporations, especially medium- and large- sized firms, often choose to borrow cash by issuing bonds and instead of borrowing from a lending institution, it borrows from the public. A bond issue, in effect, breaks down a large debt into manageable parts ($1,000 units), which makes it more attractive to individual and corporate investors. Also, bonds typically have longer maturities than notes. The most common form of corporate debt is bonds.

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Question 14–4 All of the specific promises made to bondholders are described in a bond indenture. This formal agreement will specify the bond issue‘s face amount, the stated interest rate, the method of paying interest (whether the bonds are registered bonds or coupon bonds), whether the bonds are backed by a lien on specified assets, and whether they are subordinated to other debt. The bond indenture also might provide for redemption through a call feature, by serial payments, through sinking fund provisions, or by conversion. It also will specify the trustee (usually a commercial bank or other financial institution) appointed by the issuing firm to represent the rights of the bondholders. The bond indenture serves as a contract between the company and the bondholder(s). If the company fails to live up to the terms of the bond indenture, the trustee may bring legal action against the company on behalf of the bondholders.

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Question 14– 104for Brandon to sell its bonds that pay only 11.5% stated interest in a In order 12.25% market, the bonds would have to be priced at a discount from face amount. The discount would be the amount that causes the bond issue to be priced to yield the market rate. In other words, an investor paying that price would earn an effective rate of return on the investment equal to the 12.25% market rate.

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Question 14– 105 The price will be the present value of the periodic cash interest payments (face amount times stated rate) plus the present value of the principal payable at maturity. Both interest and principal are discounted to present value at the market rate of interest for securities of similar risk and maturity.

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16–106

16–107

Question 14–7 In a strict sense, it‘s true that zero-coupon bonds pay no interest. ―Zeros‖ offer a return in the form of a ―deep discount‖ from the face amount. Still, interest accrues at the effective rate times the outstanding balance, but no interest is paid periodically. So, interest on zero-coupon bonds is determined and reported in precisely the same manner as on interest-paying bonds. Under the concept of accrual accounting, the periodic effective interest is unaffected by when the cash actually is paid. Corporations can deduct for tax purposes the annual interest expense, but without cash outflow until the bonds mature.

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Question 14–8 When bonds are issued at a premium, the debt declines each period because the effective interest each period is less than the cash interest paid. The ―overpayments‖ each period reduce the balance owed. This is precisely the opposite of when debt is sold at a discount. In that case, the effective interest each period is more than the cash paid, and the ―underpayment‖ of interest adds to the amount owed.

16–8

16–9

16–111

Question 14–9 By the effective interest method, interest expense is recorded each period as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period). This simply is an application of the accrual concept, consistent with accruing all expenses as they are incurred. The difference between the interest expense and the interest paid increases (or decreases) the existing bond liability and is reflected as ―amortization‖ of the discount (or premium). An exception to the conceptually appropriate method of determining interest for bond issues is the straight-line method. Companies are allowed to determine interest indirectly by allocating a discount or a premium equally to each period over the term to maturity if doing so produces results that are not materially different from the effective interest method. The firm‘s decision should be guided by whether the straight-line method would tend to mislead investors and creditors in the particular circumstance. The straight-line method results in a constant dollar amount of interest expense each period. By the straight-line method, the amount of the discount to be reduced periodically is calculated, and the effective interest is the ―plug‖ figure. By the effective interest method, the dollar amounts of interest vary over the term to maturity because the percentage rate of interest remains constant but is applied to a changing debt balance. The ―straight-line method‖ is not an alternative method of determining interest in a conceptual sense but is an application of the materiality concept.

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Answers to Questions (continued)

16–113

Question 14–10 For either publicly or privately issued debt securities, the issuing company will incur costs in connection with issuing bonds or notes, such as legal and accounting fees and printing costs, in addition to registration and underwriting fees. We reduce the related debt liability by combining debt issue costs with any discount (add to) or premium (subtract from). The combined valuation account is reported in the balance sheet as a direct deduction from the liability. This approach has the appeal of reflecting the effect debt issue costs have on the effective interest rate. Debt issue costs reduce the net cash the company receives from the sale of the financial instrument. A lower net amount is borrowed at the same cost, increasing the effective interest rate. The actual increase in the effective interest rate is reflected in the interest expense if the issue cost is allowed to reduce the premium (or increase the discount) on the debt. This approach is consistent with IFRS and with the treatment of issue costs when shares of stock are sold. Share issue costs are recorded as a reduction in the amount credited to stock accounts (see Chapter 18).

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16–115

Question 14–11 When the stated interest rate is not indicative of the market rate at the time a note is negotiated, the value of the asset (cash or noncash) or service exchanged for the note establishes the market rate. This rate is the implicit rate of interest. If the value of the asset (or service) is not readily determinable, the implicit rate may not be apparent. In that case an appropriate rate should be ―imputed‖ as the rate that would be expected in a similar transaction, under similar circumstances. The economic essence of a transaction should prevail over its outward appearance. The accountant should look beyond the form of this transaction and record its substance. The amount actually paid for the asset is the present value of the cash flows called for by the loan agreement, discounted at the ―imputed‖ market rate. Both the asset acquired, and the liability used to purchase it should be recorded at the real cost.

16–11

Question 14– 117

16–117

16–118

Question 14– 119When notes are paid in installments, rather than a single amount at maturity, installment payments typically are equal amounts each period. Each payment will include both an amount representing interest and an amount representing a reduction of the outstanding balance (principal reduction). The installment amount is calculated by dividing the amount of the loan by the appropriate discount factor for the present value of an annuity. Determining periodic interest is the same as for a note whose principal is paid at maturity—effective interest rate times the outstanding principal. But the periodic cash payments are larger and there is no lump-sum payment at maturity.

16–119

Question 14– 120For all long-term borrowings, disclosure should include (a) the fair values, (b) the aggregate amounts maturing, and (c) sinking fund requirements (if any) for each of the next five years.

16–120

Question 14– 121Regardless of the method used to retire debt prior to its scheduled maturity date, the gain or loss on the transaction is simply the difference between the book value of the debt at that time and the cash paid to retire it. To record the extinguishment, the account balances pertinent to the debt are removed from the books. Cash is credited for the amount paid (the call price or market price). The difference between the book value and the reacquisition price is the gain or loss.

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Question 14– 122 The entire issue price of convertible bonds is recorded as debt, precisely the same way, in fact, as for nonconvertible bonds. Thus, Air Supply will record no equity and $6,060,000 ($6 million at 101) as a liability when the bonds are issued.

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16–124

Question 14– 125GAAP requires that the entire issue price of convertible bonds be recorded as debt, precisely the same way, in fact, as for nonconvertible bonds. On the other hand, the issue price of bonds with detachable warrants is allocated between the two different securities on the basis of their market values. The difference is based on the relative separability of the debt and equity features of the two securities. In the case of convertible bonds, the two features of the security, the debt and the conversion option, are physically inseparable—the option cannot be exercised without surrendering the debt. But the debt and equity features of bonds with detachable warrants can be separated. Unlike a conversion feature, warrants can be separated from the bonds and can be exercised independently or traded in the market separately from bonds. In substance, two different securities—the bonds and the warrants—are sold as a "package" for a single issue price.

16–125

Question 14– 126Additional consideration a company provides to induce conversion of convertible debt should be recorded as an expense of the period. It is measured at the fair value of that consideration. This might be cash paid, the market price of stock warrants given, or the market value of additional shares issued due to modifying the conversion ratio.

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Question 14– 127Rising interest rates, other factors remaining the same, cause prices of fixed-rate securities to fall. For the investor in these securities, the price decline represents a loss; but for Cordova Tools, the borrower, the decline in the value of the liability is a gain. If Cordova has elected the fair value option for the bonds, it will report the gain on change in the fair value of the bonds in net income if the entire change is due to the change in general interest rates. But any change in the fair value caused by a change in the credit risk associated with the securities is reported as other comprehensive income in the statement of comprehensive income.

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16–128

Question 14–19 Under International Financial Reporting Standards, unlike U.S. GAAP, convertible debt is divided into its liability and equity elements. If a company prepares its financial statements according to IFRS, it accounts for convertible bonds it issues for $12.5 million by separating the $12.5 million into two parts. Effectively, the company is selling two securities— (1) bonds and (2) an option to convert to stock—for one package price. The bonds represent a liability; the option is shareholders‘ equity. It would record the fair value of the bonds as the liability and the remaining difference between the fair value of the convertible bonds, $12.5 million, and the fair value of the bonds as equity. If the fair value of the bonds cannot be determined from an active trading market, that value can be calculated as the present value of the bonds‘ cash flows, using the market rate of interest

16–19

Question 14–20 All bonds sell at their price plus any interest that has accrued since the last interest date to simplify the process of paying and recording interest. The buyer is asked to pay the seller accrued interest for any time that has elapsed since the last interest date in addition to the price of the bonds so that when a full six months‘ interest is paid at the next interest date, the net interest paid/received will be correct for the time the bonds have been held by the investor.

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Question 14– 131By definition, a troubled debt restructuring involves some concessions on the part of the creditor (lender) that would not have otherwise been considered if not for the financial difficulties of the debtor. A creditor may feel it can minimize losses by restructuring a debt agreement, rather than forcing liquidation. A troubled debt restructuring takes one of two forms, with the second further categorized for accounting purposes: 1. The debt may be settled at the time of the restructuring, or 2. The debt may be continued, but with modified terms. a. Under the modified terms, total cash to be paid is less than the book value of the debt. b. Under the modified terms, total cash to be paid exceeds the book value of the debt.

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Answers to Questions (concluded)

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16–133

Question 14–22 Pratt has a gain of $2 million (the difference between the book value of the debt and the fair value of the property transferred). Pratt also must adjust the book value of the land to its fair value prior to recording its exchange for the debt. Pratt would need to change the recorded amount for the property specified in the exchange agreement from $2 million to the $3 million fair value. This produces a ―gain on disposition of assets‖ of $1 million. So, Pratt would report two items on its income statement in connection with the troubled debt restructuring: (1) a $2 million gain on troubled debt restructuring and (2) a ―gain on disposition of assets‖ of $1 million.

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Question 14– 135 (a) When the total future cash payments are less than the book value of the debt, the difference is recorded as a gain to the debtor at the date of restructure. No interest is recorded thereafter. All subsequent cash payments produce reductions of principal. (b) When the total future cash payments exceed the book value of the debt, no reduction of the existing debt is necessary, and no entry is required at the time of the debt restructuring. The accounting objective is to determine the new (lower) effective interest rate and to record interest expense for the remaining term of the loan at that new, lower rate.

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BRIEF EXERCISES

16–136

Brief Exercise 14– 137

$30,000,000 x 6% face amount

annual rate

6/12 fraction of the annual period

$900,000 cash interest

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Brief Exercise 14– 138 Interest $2,000,000 ¥ Principal $80,000,000 Present value (price) of the bonds

x x

23.11477* = 0.30656** =

$46,229,540 24,524,800 $70,754,340

¥ [5 ÷ 2] % × $80,000,000 * Present value of an ordinary annuity of $1: n = 40, i = 3%. (Table 4) ** Present value of $1: n = 40, i = 3%. (Table 2)

16–138

Brief Exercise 14– 139

The price will be the present value of the periodic cash interest payments (face amount times stated rate) plus the present value of the principal payable at maturity. Both interest and principal are discounted to present value at the market rate of interest for securities of similar risk and maturity. When the stated rate and the market rate are the same, the bonds will sell at face value, $75 million in this instance. Interest $2,250,000 ¥ Principal $75,000,000 Present value (price) of the bonds

x x

19.60044* = 0.41199** =

$44,100,990 30,899,250 $75,000,240

¥ [6÷2] % × $75,000,000 * present value of an ordinary annuity of $1: n=30, i=3%. (Table 4) ** present value of $1: n=30, i=3%. (Table 2) Note: The result differs from $75,000,000 only because the present value factors in any present value table are rounded. Because the stated rate and the market rate are the same, the true present value is $75,000,000.

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Brief Exercise 14– 140 Interest $2,500,000 ¥ Principal $100,000,000 Present value (price) of the bonds

x x

27.35548* = 0.45289** =

$ 68,388,700 45,289,000 $113,677,700

¥ [5 ÷ 2] % × $100,000,000 * Present value of an ordinary annuity of $1: n = 40, i = 2%. (Table 4) ** Present value of $1: n = 40, i = 2%. (Table 2)

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16–141

16–142

Brief Exercise 14– 143

Interest will be the effective rate times the outstanding (book value) balance: 4% × $82,218,695 = $3,288,748

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Brief Exercise 14–6 Interest will be the effective rate times the outstanding (book value) balance: June 30 Interest expense (2% × $69,057,776) .............................. 1,381,156 Discount on bonds payable (difference) ................. 181,156 Cash (1.5% × $80,000,000) ...................................... 1,200,000 December 31 Interest expense (2% × [$69,057,776 + $181,156]) ........ 1,384,779 Discount on bonds payable (difference) ................. 184,779 Cash (1.5% × $80,000,000)...................................... 1,200,000 Interest expense for the year: $1,381,156 + $1,384,779 = $2,765,935

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Brief Exercise 14–7 Interest will be a plug figure: $80,000,000 – $69,057,776 = $10,942,224 discount $10,942,224 ÷ 40 semiannual periods = $273,556 reduction each period June 30 Interest expense (to balance) ........................................... 1,473,556 Discount on bonds payable (difference) ................. 273,556 Cash (1.5% × $80,000,000) ...................................... 1,200,000 December 31 Interest expense (to balance) ........................................... 1,473,556 Discount on bonds payable (difference) ................. 273,556 Cash (1.5% × $80,000,000) ...................................... 1,200,000 Interest expense for the year: $1,473,556 + $1,473,556 = $2,947,112

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Brief Exercise 14–8 Interest will be the effective rate times the outstanding balance: June 30 Cash (1.5% × $80,000,000).......................................... 1,200,000 Discount on investment in bonds (difference)............ 181,156 Interest revenue (2% × $69,057,776)........................... December 31 Cash (1.5% × $80,000,000).......................................... Discount on investment in bonds (difference)............ Interest revenue (2% × [$69,057,776 + $181,156]) .....

16–8

1,381,156

1,200,000 184,779 1,384,779

Brief Exercise 14– 149 December 31, 2024

Nantucket Ferry (Borrower) Interest expense .......................................................... Cash (6%  $14,000,000) ............................................

840,000 840,000

BankOne (Lender) Cash (6%  $14,000,000)................................................ Interest revenue......................................................

840,000 840,000

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Brief Exercise 14– 150

Interest $6,000¥ x 2.72325 * = Principal $300,000 x 0.86384 ** = Present value (price) of the note

$ 16,340 259,152 $275,492

2% × $300,000

Present value of an ordinary annuity of $1: n = 3, i = 5%. (Table 4)

** Present value of $1: n = 3, i = 5%. (Table 2)

Equipment (price determined above) ................................ Discount on notes payable (difference).......................... Notes payable (face amount)......................................

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275,492 24,508 300,000

Brief Exercise 14– 151 $300,000 ÷ 2.72325 =

$110,162

amount of loan

installment payment

(from Table 4) n = 3, i = 5%

Helpful, but not required: Cash Payment

1 2 3

110,162 110,162 110,162

Effective Interest 5% × Outstanding Balance .05 (300,000) = .05 (204,838) = .05 (104,918) =

15,000 10,242 5,246

Decrease in Balance Balance Reduction

95,162 99,920 104,918*

Outstanding Balance

300,000 204,838 104,918 0

* rounded

Interest expense (5% × ($300,000 – [$110,162 – 5% × $300,000])) Notes payable (difference)............................................. Cash (payment determined above).................................

10,242 99,920 110,162

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Brief Exercise 14–12 ($ in millions)

Bonds payable (face amount) ..................................... Loss on early extinguishment (to balance) ................. Discount on bonds payable (given) ....................... Cash ($60,000,000 × 102%) .....................................

60.0 3.2 2.0 61.2

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Brief Exercise 14–13 The issue price of bonds with detachable warrants is allocated between the two different securities on the basis of their market values. ($ in millions)

Cash (102% × $60 million) .................................................... Discount on bonds payable (difference)............................... Bonds payable (face amount)............................................ Equity—stock warrants ($5 × 10 warrants × 60,000 bonds).....................................

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61.2 1.8 60.0 3.0

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Brief Exercise 14–14 GAAP requires that the entire issue price of convertible bonds be recorded as debt, precisely the same way, in fact, as for nonconvertible bonds. ($ in millions)

Cash (102% × $60 million) .................................................... Premium on bonds payable (difference) ........................... Convertible bonds payable (face amount).........................

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61.2 1.2 60.0

Brief Exercise 14–15 AI will report a gain when adjusting the bonds to fair value. A decrease in the fair value of a liability is a gain, just the opposite of a decrease in the value of an asset. If the change in fair value is attributable to a change in the interest rate, the rate increased. This is because as interest rates rise, the value of a fixed rate instrument— like bonds—falls, as occurred with AI‘s bonds. AI will report the gain on the change in the fair value of the bonds in net income if the entire change is due to the change in general interest rates. But any change in the fair value caused by a change in the credit risk associated with the securities is reported as other comprehensive income in the statement of comprehensive income. The change in the fair value caused by a change in the credit risk would be reflected as a portion of the change in the market rate of interest, the risk premium portion added to the risk-free portion. Credit risk is the risk that the investor in the bonds will not receive the promised interest and maturity amounts at the times they are due. Companies can assume that any change in fair value that exceeds the amount caused by a change in the general (risk-free) interest rate to be the result of credit risk changes.

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EXERCISES

16–158

Exercise 14–1 Bonds are priced to yield the market rate, 10% in this case. When this rate is used to price the bonds, we get the prices shown below. Presumably, the market rate changed since the underwriters priced two of the bond issues. The DD Corp. bonds are appropriately priced to yield the market rate of interest. The GG Corp. bonds are slightly underpriced at the stated price of $91 million and, therefore, are the most attractive. The BB Corp. bonds are slightly overpriced at the price of $109 million and are the least attractive. BB Corp. bonds: Interest $5,500,000 ¥ x 17.15909 * = $ 94,374,995 0.14205 ** = Principal $100,000,000 x 14,205,000 Present value (price) of the bonds $108,579,995 ¥ [11 ÷2] % × $100,000,000 * Present value of an ordinary annuity of $1: n = 40, i = 5 % (Table 4) ** Present value of $1: n = 40, i = 5% (Table 2)

DD Corp. bonds: Interest $5,000,000 ¥ Principal $100,000,000 Present value (price) of the bonds

x x

17.15909 * = 0.14205 ** =

$ 85,795,450 14,205,000 $100,000,450

Note: The result differs from $100,000,000 only because the present value factors in any present value table are rounded. Because the stated rate and the market rate are the same, the true present value is $100,000,000. ¥ [10 ÷ 2] % × $100,000,000 * Present value of an ordinary annuity of $1: n = 40, i = 5% (Table 4) ** Present value of $1: n = 40, i = 5% (Table 2)

GG Corp. bonds: Interest $4,500,000 ¥ Principal $100,000,000 Present value (price) of the bonds

x x

17.15909 * = 0.14205 ** =

$77,215,905 14,205,000 $91,420,905

¥ [9÷ 2] % × $100,000,000 * Present value of an ordinary annuity of $1: n = 40, i = 5% (Table 4) ** Present value of $1: n = 40, i = 5% (Table 2)

16–159

Exercise 14–2 1. Maturity 10 years

Interest paid annually $100,000 ¥

Stated rate 10%

Interest x Principal $1,000,000 x Present value (price) of the bonds

Effective (market) rate 12% 5.65022 * = $565,022

0.32197 ** =

321,970 $886,992

10% × $1,000,000

Present value of an ordinary annuity of $1: n = 10, i = 12% (Table 4)

** Present value of $1: n = 10, i = 12% (Table 2)

2. Maturity 10 years

Interest paid semiannually $50,000 ¥

Stated rate 10%

Interest x Principal $1,000,000 x Present value (price) of the bonds

Effective (market) rate 12% 11.46992 * = $573,496

0.31180 ** =

5% × $1,000,000

Present value of an ordinary annuity of $1: n = 20, i = 6% (Table 4)

311,800 $885,296

** Present value of $1: n = 20, i = 6% (Table 2)

3. Maturity 10 years

Interest paid semiannually $60,000 ¥

Stated rate 12%

Interest x Principal $1,000,000 x Present value (price) of the bonds

Effective (market) rate 10% 12.46221 * = $ 747,733

0.37689 ** =

376,890 $1,124,623

¥ 6% × $1,000,000 * Present value of an ordinary annuity of $1: n = 20, i = 5% (Table 4) ** Present value of $1: n = 20, i = 5% (Table 2)

16–160

Exercise 14–2 (concluded) 4. Maturity 20 years

Interest paid semiannually $60,000 ¥

Stated rate 12%

Interest x Principal $1,000,000 x Present value (price) of the bonds

Effective (market) rate 10% 17.15909 * = $1,029,545

0.14205 ** =

6% × $1,000,000

Present value of an ordinary annuity of $1: n = 40, i = 5% (Table 4)

142,050 $1,171,595

** Present value of $1: n = 40, i = 5% (Table 2)

5. Maturity 20 years

Interest paid semiannually $60,000 ¥

Stated rate 12%

Interest x Principal $1,000,000 x Present value (price) of the bonds

Effective (market) rate 12% 15.04630 * = $902,778

0.09722 **

97,220 $999,998

actually, $1,000,000 if PV table factors were not rounded ¥ 6% × $1,000,000 * Present value of an ordinary annuity of $1: n = 40, i = 6% (Table 4) ** Present value of $1: n = 40, i = 6% (Table 2)

16–161

Exercise 14– 1621. Price of the bonds on January 1, 2024 Interest $4,000,000¥ x Principal $80,000,000 x Present value (price) of the bonds

11.46992 * = 0.31180 ** =

$45,879,680 24,944,000 $70,823,680

¥ 5% × $80,000,000 * Present value of an ordinary annuity of $1: n = 20, i = 6% (Table 4) ** Present value of $1: n = 20, i = 6% (Table 2)

2. January 1, 2024 Cash (price determined above) ..................................... 70,823,680 Discount on bonds payable (difference)..................... 9,176,320 Bonds payable (face amount) ................................. 80,000,000 3. June 30, 2024 Interest expense (6% × $70,823,680) .............................. Discount on bonds payable (difference) ................. Cash (5% × $80,000,000) ........................................ Partial amortization schedule (not required)

Cash Payment 5% × Face Amount

1 4,000,000 2 4,000,000

4,249,421 249,421 4,000,000

Effective Interest 6% × Outstanding Balance

Increase in Outstanding Balance Balance Discount Reduction

.06(70,823,680) = 4,249,421 .06(71,073,101) = 4,264,386

70,823,680 71,073,101 71,337,487

249,421 264,386

4. December 31, 2024 Interest expense (6% × [$70,823,680 + $249,421]) ......... Discount on bonds payable (difference) ................. Cash (5% × $80,000,000) ........................................

16–162

4,264,386 264,386 4,000,000

Exercise 14–4 1. January 1, 2024 Interest $4,000,000¥ x 11.46992 * Principal $80,000,000 x 0.31180 ** Present value (price) of the bonds

= =

$45,879,680 24,944,000 $70,823,680

5% × $80,000,000

Present value of an ordinary annuity of $1: n = 20, i = 6% (Table 4)

** Present value of $1: n = 20, i = 6% (Table 2)

Investment in bonds (face amount) ............................ 80,000,000 9,176,320 Discount on investment in bonds (difference) ........ Cash (price determined above) .................................. 70,823,680 2. June 30, 2024 Cash (5% × $80,000,000) ............................................ Discount on investment in bonds (difference)............. Interest revenue (6% × $70,823,680) ..........................

4,000,000 249,421 4,249,421

3. December 31, 2024 Cash (5% × $80,000,000) ............................................ Discount on investment in bonds (difference)............ Interest revenue (6% × [$70,823,680 + $249,421]) .....

4,000,000 264,386 4,264,386

16–163

Exercise 14– 1641. Liability on December 31, 2024 Bonds payable (face amount) ..................................... Less: discount ......................................................... Initial balance, January 1,2024................................ June 30, 2024 discount amortization ....................... Dec. 31, 2024 discount amortization ....................... December 31, 2024 net liability ..............................

$320,000,000 36,705,280 283,294,720 997,683* 1,057,544** $285,349,947

2. Interest expense for year ended December 31, 2024 June 30, 2024 interest expense ................................ Dec. 31, 2024 interest expense ................................ Interest expense for 2024 ........................................

$16,997,683* 17,057,544** $34,055,227

3. Statement of cash flows for year ended December 31, 2024 Myriad would report the cash inflow of $283,294,720*** from the sale of the bonds as a cash inflow from financing activities in its statement of cash flows. The $32,000,000 ($16,000,000* + $16,000,000**) cash interest paid is cash outflow from operating activities because interest is an income statement (operating) item.

16–164

Exercise 14–5 (concluded) Calculations: January 1, 2024*** Cash (price given)............................................................... 283,294,720 Discount on bonds payable (difference)..................... 36,705,280 Bonds payable (face amount) ................................. 320,000,000 June 30, 2024* Interest expense (6% × $283,294,720) ............................ 16,997,683 Discount on bonds payable (difference) ................. 997,683 Cash (5% × $320,000,000)....................................... 16,000,000 December 31, 2024** Interest expense (6% × [$283,294,720 + $997,683]) ....... 17,057,544 Discount on bonds payable (difference) ................. 1,057,544 Cash (5% × $320,000,000)....................................... 16,000,000

16–165

Exercise 14– 1661. June 30, 2024 Cash (price given) ...................................................... Bonds payable (face amount) ................................. Premium on bonds payable (difference) ................. 2. December 31, 2024

967,707

Interest expense (6% × $967,707) ................................... Premium on bonds payable (difference) .................... Cash (6.5% × $900,000) .......................................... 3. June 30, 2025

58,062 438

Interest expense (6% × [$967,707 – $438]) ..................... Premium on bonds payable (difference) .................... Cash (6.5% × $900,000) ..........................................

58,036 464

16–166

900,000 67,707

58,500

Exercise 14– 1671. Price of the bonds on January 1, 2024 Interest $7,500,000¥ x 13.76483 * = Principal $150,000,000 x 0.17411 ** = Present value (price) of the bonds

$103,236,225 26,116,500 $129,352,725

5% × $150,000,000

Present value of an ordinary annuity of $1: n = 30, i = 6% (Table 4)

** Present value of $1: n = 30, i = 6% (Table 2)

2. January 1, 2024 Cash (price determined above) .............................. Discount on bonds payable (difference).............. Bonds payable (face amount) ..........................

129,352,725 20,647,275 150,000,000

3. June 30, 2024 Interest expense ($7,500,000 + $688,243)....................... Discount on bonds payable ($20,647,275 ÷ 30) ....... Cash (5% × $150,000,000).......................................

8,188,243 688,243 7,500,000

4. December 31, 2031 Interest expense ($7,500,000 + $688,243)....................... 8,188,243 Discount on bonds payable ($20,647,275 ÷ 30) ....... 688,243 Cash (5% × $150,000,000)....................................... 7,500,000 [Using the straight-line method, each interest entry is the same.]

16–167

Exercise 14– 1681. January 1, 2024 Interest $7,500,000¥ x 13.76483 * = Principal $150,000,000 x 0.17411 ** = Present value (price) of the bonds

$103,236,225 26,116,500 $129,352,725

5% × $150,000,000

Present value of an ordinary annuity of $1: n = 30, i = 6% (Table 4)

** Present value of $1: n = 30, i = 6% (Table 2)

Investment in bonds (face amount) ........................ Discount on investment in bonds (difference) .... Cash (price determined above) ..............................

150,000,000 20,647,275 129,352,725

2. June 30, 2024 Cash (5% × $150,000,000) .......................................... Discount on investment in bonds ($20,647,275 ÷ 30).. Interest revenue ($7,500,000 + $688,243) ...................

7,500,000 688,243 8,188,243

3. December 31, 2031 Cash (5% × $150,000,000)...................................................... 7,500,000 Discount on investment in bonds ($20,647,275 ÷ 30).. 688,243 Interest revenue ($7,500,000 + $688,243) ................... 8,188,243 [Using the straight-line method, each interest entry is the same.]

16–168

Exercise 14– 169 1. Price of the bonds on January 1, 2024 Interest $18,000¥ x 6.87396 * = Principal $600,000 x 0.75941 ** = Present value (price) of the bonds

$123,731 455,646 $579,377

¥ 3% × $600,000 * Present value of an ordinary annuity of $1: n = 8, i = 3.5% (Table 4) ** Present value of $1: n = 8, i = 3.5% (Table 2)

2. January 1, 2024 Cash (price determined above) ......................... Discount on bonds payable (difference)......... Bonds payable (face amount) ..................... 3. Amortization schedule Cash Payment 3% × Face Amount

1 2 3 4 5 6 7 8

18,000 18,000 18,000 18,000 18,000 18,000 18,000 18,000 144,000 *rounded

579,377 20,623 600,000

Effective Increase in Outstanding Interest Balance Balance 3.5% × Outstanding Balance Discount Reduction

.035 (579,377)

.035 (581,655)

.035 (584,013)

.035 (586,453)

.035 (588,979)

.035 (591,593)

.035 (594,299)

.035 (597,099)

20,278 20,358 20,440 20,526 20,614 20,706 20,800 20,901*

2,278 2,358 2,440 2,526 2,614 2,706 2,800 2,901

164,623

20,623

579,377 581,655 584,013 586,453 588,979 591,593 594,299 597,099 600,000

16–169

Exercise 14–9 (concluded) 4. June 30, 2024 Interest expense (3.5% × $579,377) ................... Discount on bonds payable (difference) ..... Cash (3% × $600,000)................................. December 31, 2024** Interest expense (3.5% × [$579,377 + $2,278]) .. Discount on bonds payable (difference) ..... Cash (3% × $600,000)................................. 5. Liability on December 31, 2024

20,278 2,278 18,000 20,358 2,358 18,000

Bonds payable (face amount) ..................................... Less: discount ......................................................... Initial balance, January 1,2024................................ June 30, 2024 discount amortization .................... Dec. 31, 2024 discount amortization .................... December 31, 2024 book value ...............................

$600,000 (20,623) 579,377 2,278 2,358 $584,013

6. Interest expense for year ended December 31, 2024 June 30, 2024 interest expense ................................ Dec. 31, 2024 interest expense ................................ Interest expense for 2024 ........................................ 7 . December 31, 2027 Interest expense (3.5% × $597,099) ................... Discount on bonds payable (difference) ..... Cash (3% × $600,000).................................

$20,278 20,358 $40,636 20,901* 2,901 18,000

* rounded value from amortization schedule

Bonds payable ................................................... Cash .......................................................

16–170

600,000 600,000

Exercise 14–10 1. Price of the bonds on January 1, 2024 Interest $22,500¥ x 6.46321 * = Principal $500,000 x 0.67684 ** = Present value (price) of the bonds

$145,422 338,420 $483,842

¥ 4.5% × $500,000 * Present value of an ordinary annuity of $1: n = 8, i = 5% (Table 4) ** Present value of $1: n = 8, i = 5% (Table 2)

2. January 1, 2024 Cash (price determined above) ......................... Discount on bonds payable (difference)......... Bonds payable (face amount) ..................... 3. Amortization schedule

Cash Payment 4.5% × Face Amount

1 2 3 4 5 6 7 8

22,500 22,500 22,500 22,500 22,500 22,500 22,500 22,500 180,000

Effective Interest 5% × Outstanding Balance

.05 (483,842)

.05 (485,534)

.05 (487,311)

.05 (489,177)

.05 (491,136)

.05 (493,193)

.05 (495,353)

.05 (497,621)

483,842 16,158 500,000

Increase in Outstanding Balance Balance Discount Reduction

24,192 24,277 24,366 24,459 24,557 24,660 24,768 24,879*

1,692 1,777 1,866 1,959 2,057 2,160 2,268 2,379

196,158

16,158

483,842 485,534 487,311 489,177 491,136 493,193 495,353 497,621 500,000

* rounded.

16–171

Exercise 14–10 (concluded) 4. June 30, 2024 Interest expense (5% × $483,842) ...................... Discount on bonds payable (difference) ..... Cash (4.5% × $500,000) .............................. 5. December 31, 2027 Interest expense (5% × $497,621) ...................... Discount on bonds payable (difference) ..... Cash (4.5% × $500,000) ..............................

24,192 1,692 22,500

24,879* 2,379 22,500

* rounded value from amortization schedule

Bonds payable ................................................... Cash .......................................................

16–172

500,000 500,000

Exercise 14– 173

1. February 1, 2024 Cash (price given) .......................................... Discount on bonds payable (difference)......... Bonds payable (face amount) ..................... 2. July 31, 2024

731,364 68,636

Interest expense (5% × $731,364) ...................... Discount on bonds payable (difference) ..... Cash (4.5% × $800,000) .............................. 3. December 31, 2024

36,568

Interest expense (5/6 × 5% × [$731,364 + $568]) Discount on bonds payable (difference) ..... Interest payable (5/6 × 4.5% × $800,000) ...... 4. January 31, 2025

30,497

Interest expense (1/6 × 5% × [$731,364 + $568]) Interest payable (from adjusting entry)............. Discount on bonds payable (difference) ..... Cash (4.5% × $800,000) ..............................

6,100* 30,000

800,000

568 36,000

497 30,000

100 36,000

* rounded

16–173

Exercise 14– 1741. March 1, 2024 Cash (price given) .......................................... Discount on bonds payable (difference)......... Bonds payable (face amount) .....................

294,000 6,000 300,000

2. August 31, 2024 Interest expense ($21,000 + $150)...................... Discount on bonds payable ($6,000 ÷ 40)... Cash (7% × $300,000).................................

21,150 150 21,000

3. December 31, 2024 Interest expense (4/6 × $21,150) ......................... Discount on bonds payable (4/6 × $150)..... Interest payable (4/6 × $21,000) ..................

14,100 100 14,000

4. February 28, 2025 Interest expense (2/6 × $21,150) ......................... Interest payable (4/6 × $21,000)...................... Discount on bonds payable (2/6 × $150)..... Cash (7% × $300,000) ................................

16–174

7,050 14,000 50 21,000

Exercise 14– 1751. January 1, 2024 Cash (price given) ................................................. Discount on bonds payable (difference)................ Bonds payable (face amount) ............................

739,813,200 60,186,800 800,000,000

2. June 30, 2024 Interest expense (6% × $739,813,200) ...................... Discount on bonds payable (difference) ............ Cash (5.5% × $800,000,000) ...............................

44,388,792 388,792 44,000,000

3. December 31, 2024 Interest expense (6% × [$739,813,200 + $388,792]) . Discount on bonds payable (difference) ............ Cash (5.5% × $800,000,000) ...............................

44,412,120 412,120 44,000,000

4. December 31, 2024 Federal will report the bonds among its liabilities in the December 31, 2024, balance sheet at $740,614,112: Balance Jan. 1 $739,813,200 June 30 increase 388,792 Dec. 31 increase 412,120 $740,614,112

16–175

Exercise 14– 176 1. National Equipment Transfer Corporation Cash (priced at par) ........................................ Bonds payable (face amount) ..................... IgWig

200,000,000

Cash (99% × $350 million) .............................. Discount on notes payable (difference).......... Notes payable (face amount) ......................

346,500,000 3,500,000

200,000,000

350,000,000

2. National Equipment Transfer Corporation

16–176

Interest expense ................................................ Cash ([7.46% ÷ 2] × $200 million) ................ IgWig

7,460,000

Interest expense ([6.56% ÷ 2] × $346,500,000).. Discount on notes payable (difference) ...... Cash ([6.46% ÷ 2] × $350 million) ................

11,365,200

7,460,000

60,200 11,305,000

Exercise 14– 177 The 2024 interest expense is overstated by the extra interest recorded in February. Similarly, retained earnings is overstated by the same amount because 2023 interest expense was understated when the accrued interest was not recorded. To correct the error: Retained earnings ......................................................... Interest expense ($73,200 – $12,200*).......................

61,000 61,000

*$73,200 × 1/6

2024 adjusting entry: Interest expense (5/6 × $73,200) ................................. Discount on bonds payable (5/6 × $1,200) .............. Interest payable (5/6 × $72,000) ..............................

ENTRIES THAT SHOULD HAVE BEEN RECORDED: December 31, 2023 adjusting entry: Interest expense (5/6 × $73,200) .......................................... Discount on bonds payable (5/6 × $1,200) ....................... Interest payable (5/6 × $72,000) ...................................... February 1,2024: Interest expense (1/6 × $73,200) .......................................... Interest payable (5/6 × $72,000)........................................... Discount on bonds payable (1/6 × $1,200) ....................... Cash (given) ...................................................................

61,000 1,000 60,000

12,200 60,000 200 72,000

16–177

Exercise 14– 178 Requirement 1

The error caused both 2022 net income and 2023 net income to be overstated, so retained earnings is overstated by a total of $85,000. Also, the notes payable would be understated by the same amount. Remember, the entry to record interest is: Interest expense ............................................................................. Notes payable (difference)....................................................... Cash..................................................................................

xxx xxx xxx

So, if interest expense is understated, the reduction in the note will be too much, causing the balance in that account to be understated. Requirement 2 Retained earnings (overstatement of 2022–2023 income) .....................85,000 Notes payable (understatement determined above) ...................

85,000

Requirement 3 The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct interest amounts, income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A ―prior period adjustment‖ to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s net income, income before discontinued operations, and earnings per share.

16–178

16–179

Exercise 14–17 Requirement 1 $24,000¥ x Interest Principal $600,000 x Present value of the note

2.40183 * = 0.71178 ** =

$ 57,644 427,068 $484,712

¥ 4% × $600,000 * Present value of an ordinary annuity of $1: n = 3, i = 12% (Table 4) ** Present value of $1: n = 3, i = 12% (Table 2)

Equipment (price determined above) ...................................... Discount on notes payable (difference)................................ Notes payable (face amount) ............................................

484,712 115,288 600,000

Requirement 2 Cash Payment 4% × Face Amount

1 2 3

24,000 24,000 24,000

72,000 * rounded.–

Effective Interest 12% × Outstanding Balance .12 (484,712) .12 (518,877)

= =

.12 (557,142)

Increase in Outstanding Balance Balance Discount Reduction

58,165 62,265 66,858*

34,165 38,265 42,858

187,288

115,288

Requirement 3 Interest expense (market rate × outstanding balance) ................ Discount on notes payable (difference) ............................ Cash (stated rate × face amount)..........................................

16–180

484,712 518,877 557,142 600,000

58,165 34,165 24,000

Interest expense (market rate × outstanding balance) ................ Discount on notes payable (difference) ............................ Cash (stated rate × face amount)..........................................

62,265

Interest expense (market rate × outstanding balance) .................. Discount on notes payable (difference) ............................ Cash (stated rate × face amount)..........................................

66,858

Notes payable ................................................................... Cash ..............................................................................

600,000

38,265 24,000 42,858 24,000 600,000 Intermediate Accounting, 11/e

Exercise 14–18 Requirement 1 Interest $24,000¥ x Principal $600,000 x Present value of the note

2.40183 * = 0.71178 ** =

$ 57,644 427,068 $484,712

4% × $600,000

Present value of an ordinary annuity of $1: n = 3, i = 12% (Table 4)

** Present value of $1: n = 3, i = 12% (Table 2)

Notes receivable (face amount) ............................................ Discount on notes receivable (difference) ........................ Sales revenue (price determined above) ..............................

600,000

Cost of goods sold ............................................................ Inventory (cost of construction) .........................................

400,000

115,288 484,712

400,000

Requirement 2

Cash Payment 4% × Face Amount

1 2 3

24,000 24,000 24,000 72,000

Effective Interest 12% × Outstanding Balance .12 (484,712)

.12 (518,877)

.12 (557,142)

Increase in Outstanding Balance Balance Discount Reduction

58,165 62,265 66,858*

34,165 38,265 42,858

187,288

115,288

484,712 518,877 557,142 600,000

* rounded.

16–181

Exercise 14–18 (concluded) Requirement 3 Cash (stated rate × face amount) ............................................. Discount on notes receivable (difference) ............................ Interest revenue (market rate × outstanding balance).............

16–182

24,000 34,165 58,165

Cash (stated rate × face amount) ............................................. Discount on notes receivable (difference) ............................ Interest revenue (market rate × outstanding balance).............

24,000 38,265

24,000 42,858

Cash.................................................................................. Notes receivable ............................................................

600,000

62,265

66,858

600,000

Exercise 14–19 1. January 1, 2024 Notes receivable .....................................................................8,000,000 Cash ................................................................................. 8,000,000 2. Amortization schedule $8,000,000 amount of loan

Cash Payment

Dec.31

2024 2025 2026

2,992,881 2,992,881 2,992,881 8,978,643

÷ 2.67301

(from Table 4) n = 3, i = 6%

$2,992,881 installment payment

Effective Decrease in Outstanding Interest Balance Balance 6% × Outstanding Balance Balance Reduction .06 (8,000,000) =

480,000 .06 (5,487,119) = 329,227 .06 (2,823,465) = 169,416*

2,512,881 2,663,654 2,823,465

978,643

8,000,000

8,000,000 5,487,119 2,823,465 0

* rounded.

3. December 31, 2024 Cash (payment determined above) ................................................... 2,992,881 Notes receivable (difference) ........................................... 2,512,881 Interest revenue (6% × outstanding balance) ........................... 480,000 4. December 31, 2026 Cash (payment determined above) ................................................... 2,992,881 Notes receivable (difference) ........................................... 2,823,465

16–183

Interest revenue (6% × outstanding balance)

16–184

169,416

Exercise 14–20 1. January 1, 2024 Equipment ..........................................................................4,000,000 Notes payable ................................................................ 4,000,000 2. Amortization schedule $4,000,000 amount of loan

Cash Payment

Dec.31

2024 2025 2026 2027

÷ 3.16987 (from Table 4) n = 4, i = 10%

$1,261,881 installment payment

Effective Decrease in Outstanding Interest Balance Balance 10% × Outstanding Balance Balance Reduction

1,261,881 1,261,881 1,261,881 1,261,881

.10 (4,000,000) = 400,000 .10 (3,138,119) = 313,812 .10 (2,190,050) = 219,005 .10 (1,147,174) = 114,707*

861,881 948,069 1,042,876 1,147,174

5,047,524

1,047,524

4,000,000

4,000,000 3,138,119 2,190,050 1,147,174 0

* rounded.

3. December 31, 2024 Interest expense (10% × outstanding balance) ............................. Notes payable (difference)................................................... Cash (payment determined above) .......................................

400,000 861,881 1,261,881

4. December 31, 2026 Interest expense (10% × outstanding balance) ............................. 219,005 Notes payable (difference)................................................... 1,042,876 Cash (payment determined above) ....................................... 1,261,881

16–185

Exercise 14– 186

1. November 1, 2024 Inventory ...................................................................... 24,000,000 Notes payable ......................................................... 24,000,000

2. November 30, 2024 Interest expense (1% × outstanding balance) .............................. 240,000 Notes payable (difference)................................................... 1,892,370 Cash (payment determined below) ....................................... 2,132,370 Calculation of installment payment: $24,000,000 ÷ 11.25508 = $2,132,370 amount of loan

(from Table 4) n = 12, i = 1%

installment payment

3. December 31, 2024 November (1% × $24,000,000) December (1% × [$24,000,000 – $1,892,370]) 2021 interest expense

$240,000 221,076 $461,076

Journal entry (not required): Interest expense (1% × [$24,000,000 – $1,892,370]).................. 221,076 Notes payable (difference)................................................... 1,911,294 Cash (payment determined above) ....................................... 2,132,370

Exercise 14–22 The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is:

16–186

Disclosure requirements for maturities of long-term debt: FASB ASC 470–10–50–1: ―Debt–Overall–Disclosure–Disclosure of Long-Term Obligations‖

How to estimate the value of a note when a note having no ready market and no interest rate is exchanged for a noncash asset without a readily available fair value: FASB ASC 835–30–25–11: ―Interest–Imputation of Interest–Recognition–Note exchanged for property, goods, or services‖

3. When the straight-line method can be used as an alternative to the interest method of determining interest: FASB ASC 835–30–55–2: ―Interest–Imputation of Interest–Implementation Guidance and Illustrations–Application of the Interest Method‖

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Exercise 14–23 Bonds payable (face amount) ..................................... Loss on early extinguishment (to balance) ................. Discount on bonds payable (given) ....................... Cash ($90,000,000 × 102%) .....................................

90,000,000 4,800,000 3,000,000 91,800,000

16–23

Exercise 14– 189 Gless (Issuer) Cash (101% × $12 million) .......................................... Convertible bonds payable (face amount)............... Premium on bonds payable (difference) ................. Century (Investor) Investment in convertible bonds (10% × $12 million) . Premium on investment in bonds (difference)............. Cash (101% × $1.2 million) ..................................... Requirement 2 Gless (Issuer) Interest expense ($540,000 – $6,000).............................. Premium on bonds payable ($120,000 ÷ 20)............... Cash (4.5% × $12,000,000) ......................................

12,120,000 12,000,000 120,000

1,200,000 12,000 1,212,000

534,000 6,000 540,000

Century (Investor) Cash (4.5% × $1,200,000) ........................................... 54,000 Premium on investment in bonds ($12,000 ÷ 20).... Interest revenue ($54,000 – $600)............................... [Using the straight-line method, each interest entry is the same.] Requirement 3 Gless (Issuer) Convertible bonds payable (10% of the account balance) Premium on bonds payable (($120,000 – [$6,000 × 11*]) × 10%)........................ Common stock (to balance) ...................................

600 53,400

1,200,000 5,400 1,205,400

Century (Investor) Investment in common stock ...................................... 1,205,400 Investment in convertible bonds (account balance) . 1,200,000 Premium on investment in bonds ($12,000 – [$600 × 11*]) 5,400 * Semi-annual interest; June 30, 2026 was the 11th payment.

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Exercise 14– 190

Under US GAAP, the entire issue price of convertible debt is recorded as debt: Requirement 1 Cash (101% × $12 million) ............................................... 12,120,000 Convertible bonds payable (face amount) .................. 12,000,000 Premium on bonds payable (difference) .................... 120,000 Under IFRS, convertible debt is divided into its liability and equity elements. We achieve separation by measuring the fair value of a similar liability that does not have an associated equity component. In the exercise, we know that bonds similar in all respects, except that they are nonconvertible, currently are selling at 99 (99% of face amount), so the liability-first separation gives us the following entry: Cash (101% × $12 million)............................................... Convertible bonds payable (99% × $12 million).......... Equity—conversion option (to balance)........................

12,120,000 11,880,000* 240,000

* Note that the discount on the bonds ($12 million – [99% × $12 million] = $120,000) is combined with the face amount, and the net amount is recorded as bonds payable. This is the ―net method.‖ By the gross method, the entry would be: Cash (101% × $12 million)............................................... 12,120,000 Discount on bonds payable ($12 million – [99% × $12 million]) 120,000 Convertible bonds payable (face amount) .................. 12,000,000 Equity—conversion option (to balance)........................ 240,000

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Exercise 14– 191 Cash (given) ............................................................. Convertible bonds payable (face amount)............... Premium on bonds payable (to balance).................

40,800,000 40,000,000 800,000

Requirement 2 Interest expense ($1,200,000 – $40,000)......................... Premium on bonds payable ($800,000 ÷ 20)............... Cash (3% × $40,000,000) ........................................

1,160,000 40,000 1,200,000

Requirement 3 Interest expense ($1,200,000 – $40,000)......................... Premium on bonds payable ($800,000 ÷ 20)............... Cash (3% × $40,000,000) ........................................

1,160,000 40,000

Convertible bonds payable (account balance) ............. Premium on bonds payable ($800,000 – [$40,000 × 5]) Common stock (to balance) ...................................

40,000,000 600,000

1,200,000

40,600,000

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Exercise 14–27 Requirement 1 Under U.S. GAAP, the entire issue price of convertible debt is recorded as debt: Cash (given)..................................................................... Convertible bonds payable (face amount)..................... Premium on bonds payable (to balance).......................

40,800,000 40,000,000 800,000

Under IFRS, convertible debt is divided into its liability and equity elements. We achieve separation by measuring the fair value of a similar liability that does not have an associated equity component. In the exercise, we know that bonds similar in all respects, except that they are nonconvertible, currently are selling at 99 (99% of face amount), so the liability-first separation gives us the following entry: Cash (given)..................................................................... Convertible bonds payable (99% × $40 million) ............ Equity—conversion option (to balance) ..........................

40,800,000 39,600,000* 1,200,000

* Note that the discount on the bonds ($40 million – [99% × $40 million] = $400,000) is combined with the face amount, and the net amount is recorded as bonds payable. This is the ―net method.‖ By the gross method, the entry would be: Cash (given) ........................................................................... Discount on bonds payable ($40 million – [99% × $40 million])... Convertible bonds payable (face amount) ........................... Equity—conversion option (to balance) .............................

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40,800,000 400,000 40,000,000 1,200,000

Exercise 14–27 (concluded) Requirement 2 Interest expense ($1,200,000 + $20,000)......................... Convertible bonds payable* ($400,000 ÷ 20) ........ Cash (3% × $40,000,000) .......................................

1,220,000 20,000 1,200,000

* When the net method is used, the discount (or premium) is amortized directly to the bonds account.

Requirement 3 Interest expense ($1,200,000 + $20,000)......................... Convertible bonds payable* ($400,000 ÷ 20) ........ Cash (3% × $40,000,000) .......................................

1,220,000

Convertible bonds payable (account balance*)............

39,700,000 1,200,000

Equity—conversion option (account balance)..................

Common stock (to balance).....................................

20,000 1,200,000

40,900,000

* $39,600,000 Initial balance + 100,000 ($20,000 × 5) Amortization for 5 periods (2 1/2 years) $39,700,000 Balance at conversion

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Exercise 14–28 Requirement 1 ($ in millions)

Perez (Issuer) Cash (104% × $30 million) .................................................... Discount on bonds payable (difference)............................... Bonds payable (face amount)............................................ Equity—stock warrants ($8 × 20 warrants × [$30,000,000 ÷ $1,000] bonds) .............. Interstate (Investor) Investment in stock warrants ($4.8 million × 20%)................ Investment in bonds (20% × $30 million).............................. Discount on investment in bonds (difference) .................. Cash (104% × $30 million × 20%).......................................

31.2 3.6 30.0 4.8

0.96 6.00 0.72 6.24

Requirement 2 ($ in millions)

Perez (Issuer) Cash (20% × 30,000 bonds × 20 warrants × $60) ....................... Equity—stock warrants ($4.8 million × 20%)........................ Common stock (to balance)..............................................

Interstate (Investor) Investment in common stock (to balance)............................ Investment in stock warrants ($4.8 million × 20%) ............ Cash (20% × 30,000 × 20 warrants × $60).............................

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7.20 0.96 8.16

8.16 0.96 7.20

Exercise 14–29 Requirement 1 On January 1, 2024, the book value of the bonds was the initial issue price, $739,813,200. The liability, though, was increased when Federal recorded interest during 2024: June 30, 2024 Interest expense (6% × $739,813,200) ...................... Discount on bonds payable (difference) ............ Cash (5.5% × $800,000,000) ............................... December 31, 2024

44,388,792

Interest expense (6% × [$739,813,200 + $388,792]) . Discount on bonds payable (difference) ............ Cash (5.5% × $800,000,000) ...............................

44,412,120

388,792 44,000,000

412,120 44,000,000

Reducing the discount increases the book value of the bonds: Jan.1, 2024, book value Increase from discount amortization ($388,792 + $412,120) December 31, 2024, book value (amortized initial amount)

$739,813,200 800,912 $740,614,112

Comparing the amortized initial amount on December 31, 2024, with the fair value on that date provides the fair value adjustment balance needed: December 31, 2024, book value (amortized initial amount) December 31, 2024, fair value Fair value adjustment balance needed: debit/(credit)

$740,614,112 730,000,000 $ 10,614,112

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Exercise 14–29 (continued) Because none of the change is due to the change in general interest rates, Federal can assume that the entire change in fair value is caused by a change in the general (riskfree) interest rate to be the result of credit risk. Any change in the fair value caused by a change in the credit risk associated with the securities is reported as other comprehensive income (OCI) in the statement of comprehensive income. Credit risk is the risk that the investor in the bonds will not receive the promised interest and maturity amounts at the times they are due. Federal records the $10,614,112 as a gain in 2024 as other comprehensive income (OCI): December 31, 2024 Fair value adjustment 10,614,112 Gain on bonds payable (unrealized, OCI) 10,614,112 Note: A decrease in the value of an asset is a loss; a decrease in the value of a liability is a gain.

In the balance sheet, the bonds are reported among long-term liabilities at their $730,000,000 fair value: Bonds payable Less: Discount on bonds payable December 31, 2024, book value (amortized initial amount)

$800,000,000 59,385,888 740,614,112

Less: Fair value adjustment

10,614,112

December 31, 2024, fair value

$730,000,000

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Exercise 14–29 (continued) Requirement 2 If the fair value on December 31, 2025, is $736,000,000 a year later, Federal needs to compare that amount with the amortized initial measurement on that date. That amount was increased when Federal recorded interest during 2025: June 30, 2025 Interest expense (6% × [$739,813,200 + $388,792 + $412,120]) 44,436,847 Discount on bonds payable (difference) ................... 436,847 Cash (5.5% × $800,000,000)....................................... 44,000,000 December 31, 2025 Interest expense (6% × [$739,813,200 + $388,792 + $412,120 + $436,847]) 44,463,058 Discount on bonds payable (difference) ................... 463,058 Cash (5.5% × $800,000,000)....................................... 44,000,000 Reducing the discount increases the book value of the bonds: December 31, 2024, book value (amortized initial amount)

$740,614,112

Increase from discount amortization ($436,847 + $463,058)

899,905

December 31, 2025, book value (amortized initial amount)

$741,514,017

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Exercise 14–29 (continued) Comparing the amortized initial amount on December 31, 2025, with the fair value on that date provides the fair value adjustment balance needed: December 31, 2025, book value (amortized initial amount) December 31, 2025, fair value Fair value adjustment balance needed: debit/(credit) Less: Fair value adjustment debit/(credit), balance 1/1/2025 Change in fair value adjustment, 12/31/2025

$741,514,017 (736,000,000) 5,514,017 10,614,112 $ (5,100,095)

Because one-half of the change is due to the change in general interest rates, Federal can assume that the remaining change in fair value is the result of credit risk. Any change in the fair value caused by a change in the credit risk associated with the securities is reported as other comprehensive income (OCI) in the statement of comprehensive income. Credit risk is the risk that the investor in the bonds will not receive the promised interest and maturity amounts at the times they are due. Federal records $2,550,047 as a loss as OCI in the 2025 statement of comprehensive income: December 31, 2025 Loss on bonds payable (unrealized, NI) 2,550,048* Loss on bonds payable (unrealized, OCI) 2,550,047** Fair value adjustment 5,100,095 Note: An increase in the value of an asset is a gain; an increase in the value of a liability is a loss. *rounded up from $2,550,047.50 **rounded down from $2,550,047.50

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Exercise 14–29 (concluded) In the balance sheet, the bonds are reported among long-term liabilities at their $736,000,000 fair value: Bonds payable Less: Discount on bonds payable December 31, 2025, book value (amortized initial amount)

$800,000,000 (58,485,983) 741,514,017

Less: Fair value adjustment

(5,514,017)

December 31, 2025, fair value

$736,000,000

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Exercise 14–30 Requirement 1 June 30, 2024 Interest expense (5% × $184 million) Discount on bonds payable (difference) Cash (4% × $200 million) Requirement 2 December 31, 2024 Interest expense (5% × [$184 million + $1.2 million]) Discount on bonds payable (difference) Cash (4% × $200 million)

9,200,000 1,200,000 8,000,000

9,260,000 1,260,000 8,000,000

Requirement 3 The interest entries increased the book value from $184,000,000 to $186,460,000:

16–200

$200,000,000 16,000,000 $184,000,000

Face amount Less: Discount Book value on January 1

$200,000,000 13,540,000 $186,460,000

Face amount Less: Discount ($16,000,000 – $1,200,000 – $1,260,000) Book value on December 31

Exercise 14–30 (concluded Rapid will report the loss from the change in the fair value of the bonds in net income if the entire change is due to the change in general interest rates. But any change in the fair value caused by a change in the credit risk associated with the securities is reported as other comprehensive income (OCI) in the statement of comprehensive income. Credit risk is the risk that the investor in the bonds will not receive the promised interest and maturity amounts at the times they are due. Companies can assume that any change in fair value that exceeds the amount caused by a change in the general (risk-free) interest rate to be the result of credit risk changes, $540,000 in this instance. To increase the book value to $188,000,000, Rapid needed the following entry: Loss on bonds payable (unrealized, NI) Loss on bonds payable (unrealized, OCI) Fair value adjustment ($188,000,000 – $186,460,000)

1,000,000 540,000 1,540,000

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Exercise 14–31 Requirement 1 If the bonds are not traded on a market exchange, their fair value is not readily observable. As a result, the next most preferable way to determine fair value is to calculate the fair value as the present value of the remaining cash flows discounted at the current interest rate. On December 31, 18 of the original 20 payments remain. If the current interest rate is 9% (4.5% semi-annually), as we‘re assuming now, that present value would be $751,360:

Interest

Present Values $32,000¥ × 12.15999* = $389,120

Principal

$800,000

0.45280† =

Present value of the bonds

362,240 $751,360

¥ (8% / 2) × $800,000

* Present value of an ordinary annuity of $1: n = 18, i = 4.5%. (Table 4) † Present value of $1: n = 18, i = 4.5%. (Table 2)

Requirement 2 June 30, 2024 Interest expense (5% × $700,302) Discount on bonds payable (difference) Cash (4% × $800,000) Requirement 3 December 31, 2024 Interest expense (5% × [$700,302 + $3,015]) Discount on bonds payable (difference) Cash (4% × $800,000)

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35,015 3,015 32,000

35,166 3,166 32,000

Exercise 14–31 (concluded) Requirement 4 The interest entries increased the book value from $700,302 to $706,483: $700,302 3,015 3,166 $706,483

January 1 book value June 30 increase December 31 increase December 31, 2024, book value

Essence will report the loss from the increase in the fair value of the bonds in net income because the entire change is due to the change in general interest rates. If any change in the fair value had been caused by a change in the credit risk associated with the securities, that portion would have been reported as other comprehensive income (OCI) in the statement of comprehensive income. Credit risk is the risk that the investor in the bonds will not receive the promised interest and maturity amounts at the times they are due. Companies can assume that any change in fair value that exceeds the amount caused by a change in the general (risk-free) interest rate to be the result of credit risk changes, none in this instance. To increase the book value to $751,360, Essence needs the following entry: Loss on bonds payable (unrealized, NI) Fair value adjustment ($751,360 – $706,483)

44,877 44,877

Balances: Bonds payable, Dec. 31 Less: Discount on bonds payable Book value, Dec. 31, 2024 (amortized initial cost) Fair value adjustment Fair value for balance sheet

$800,000 (93,517) 706,483 44,877 $751,360

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Exercise 14–32 Requirement 1 $100 million x face amount

12% annual rate

2/12 fraction of the annual period

$2 million accrued interest

Requirement 2 ($ in millions)

Cash ($99 million plus accrued interest) ................................... Discount on bonds payable ($100 million – $99 million) ........ Bonds payable (face amount) ........................................... Interest payable (accrued interest determined above) ............

16–204

101 1 100 2

16–205

16–206

16–207

16–208

16–209

16–210

Exercise 14–33 Land ($450,000 – $325,000) ........................................ Gain on disposition of assets ...............................

125,000

Notes payable (face amount)...................................... Interest payable (11% × $600,000) ............................. Gain on troubled debt restructuring (difference)..... Land (fair value) ....................................................

600,000 66,000

125,000

216,000 450,000

16–33

Exercise 14– 212 Analysis:

Book value: Future payments: Gain to debtor

$12 million + $1.2 million = $13,200,000 ($1 million × 2) + $11 million = 13,000,000 $ 200,000

1. January 1, 2024 Interest payable (10% × $12,000,000) ......................... 1,200,000 Notes payable ($13 million – $12 million)* .............. 1,000,000 Gain on troubled debt restructuring ..................... 200,000 * Establishes a balance in the note account equal to the total cash payments under the new agreement. 2. December 31, 2025 Notes payable ......................................................... Cash (revised ―interest‖ amount) ............................... Note:

1,000,000 1,000,000

No interest should be recorded after the restructuring. All subsequent cash payments result in reductions of principal.

3. December 31, 2026

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Notes payable ......................................................... Cash (revised ―interest‖ amount) ...............................

1,000,000

Notes payable ......................................................... Cash (revised principal amount) ................................

11,000,000

1,000,000

11,000,000

Exercise 14– Analysis: Book value: 213 Future payments: Interest

$240,000 + (10% × $240,000) = ($11,555 × 3) + $240,000 = $ 10,665

$ 264,000 (274,665)

The discount rate that ―equates‖ the present value of the debt ($264,000) and its future value ($274,665) is the effective rate of interest: $264,000 ÷ $274,665 = .961 – the Table 2 value for n = 2, i = ? In row 2 of Table 2, the value 0.961 is in the 2% column. So, this is the new effective interest rate. A financial calculator will produce the same rate.

1. January 1, 2024 No entry needed. 2. December 31, 2024 Interest expense (2% × $264,000)............................... 5,280 Interest payable ................................................... 5,280 [Unpaid interest is accrued at the effective rate times the book value of the debt.] 3. December 31, 2025 Interest expense (2% × [$264,000 + $5,280])................ Interest payable ...................................................

5,385* 5,385

*rounded

Notes payable (balance) ............................................ Interest payable ($24,000 + $5,280 + $5,385) ............... Cash ([$11,555 × 3] + $240,000)...............................

240,000 34,665 274,665

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Exercise 14– 214 Requirement 2

The specific citation that specifies the accounting treatment of legal fees and other direct costs incurred by a creditor to effect a troubled debt restructuring is FASB ASC 310–40–25–1: ―Receivables–Troubled Debt Restructurings by Creditors – Recognition–Legal Fees.‖ Requirement 3 Legal fees and other direct costs incurred by a creditor to effect a troubled debt restructuring shall be included in expense when incurred.

16–214

Exercise 14– 215 Requirement 1 Jan. 1 Cash ..................................................................... Notes payable ................................................... Jan. 1 Bonds payable (face amount)................................ Loss on early extinguishment (to balance) ............ Discount on bonds payable (account balance)... Cash (call price)................................................

100,000 100,000 120,000 10,000 30,000 100,000

Jan. 4 Cash ..................................................................... Accounts receivable ........................................

31,000

Jan. 10 Accounts payable.................................................. Cash................................................................

11,000

Jan. 15 Salaries expense ................................................... Cash................................................................

28,900

Jan. 30 Cash ..................................................................... Accounts receivable.............................................. Sales revenue ..................................................

65,000 130,000

Cost of goods sold ................................................ Inventory ........................................................ Jan. 31 Interest expense .................................................... Notes payable ....................................................... Cash................................................................ ($583 = $100,000 × 7% × 1/12)

31,000

11,000

28,900

195,000 112,500 112,500

583 1,397 1,980

16–215

Exercise 14-37 (continued) Requirement 2 (a) Jan. 31 Depreciation expense............................................ Accumulated depreciation............................... ($800 = [$120,000 − $24,000] / 120 months)

800 800

(b) Jan. 31 2,300 Bad debt expense .................................................. Allowance for uncollectible accounts ............. ($2,300 = [$3,000×50%] +[$130,000a×2%] −$1,800) a $130,000 = $34,000 −$31,000 +$130,000 −$3,000

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(c) Jan. 31 Salaries expense ................................................... Salaries payable ..............................................

26,100

(d) Jan. 31 Income tax expense .............................................. Income tax payable .........................................

5,000

2,300

26,100

5,000

Exercise 14-37 (continued) Requirement 3 Freedom Fireworks Adjusted Trial Balance January 31, 2024 Accounts Debit Cash $155,320 Accounts receivable 133,000 Allowance for uncollectible accounts 39,500 Inventory Land 67,300 Buildings 120,000 Accumulated depreciation Accounts payable Salaries payable Income tax payable Notes payable Common stock Retained earnings Sales revenue Cost of goods sold 112,500 Salaries expense 55,000 Bad debt expense 2,300 Depreciation expense 800 Loss on early extinguishment 10,000 Interest expense 583 Income tax expense 5,000 Totals $701,303

Credit

$ 4,100

10,400 6,700 26,100 5,000 98,603 200,000 155,400 195,000

$701,303

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Exercise 14-37 (continued) Accounts Cash Accounts receivable Allow for uncoll accts Inventory Land Buildings Accumulated depreciation Accounts payable Salaries payable Income tax payable Notes payable Bonds payable Discount on bonds payable Common stock Retained earnings Sales revenue Cost of goods sold Salaries expense Bad debt expense Depreciation expense Interest expense Loss on early extinguishment Income tax expense

16–218

Ending Beginning balance in bold, entries during Balance January in blue, and adjusting entries in red. $155,320 = 101,200 +100,000 −100,000 + 31,000 − 11,000 −28,900 + 65,000 − 1,980 133,000 = 34,000 − 31,000 + 130,000 4,100 = 1,800 + 2,300 39,500 67,300 120,000 10,400

= = = =

152,000 − 112,500 67,300 120,000 9,600 + 800

6,700 26,100 5,000 98,603 0 0

= = = = = =

17,700 − 11,000 26,100 5,000 100,000 − 1,397 120,000 − 120,000 30,000 − 30,000

200,000 155,400 195,000 112,500 55,000 2,300 800 583 10,000

= = = = = = = = =

200,000 155,400 195,000 112,500 28,900 + 26,100 2,300 800 583 10,000

5,000 = 5,000

Exercise 14-37 (continued) Requirement 4 Freedom Fireworks Multiple-Step Income Statement For the month ended January 31, 2024 Sales revenue Cost of goods sold Gross profit Salaries expense Bad debt expense Depreciation expense Total operating expenses Operating income Loss on early extinguishment Interest expense Income before taxes Income tax expense Net income

$195,000 112,500 $82,500 55,000 2,300 800 (58,100) 24,400 (10,000) (583) 13,817 (5,000) $ 8,817

16–219

Exercise 14-37 (continued) Requirement 5 Freedom Fireworks Classified Balance Sheet January 31, 2024 Assets

Liabilities

$ 155,320

Accounts payable

Accounts receivable $133,000 Less: Allowance for uncollectible accounts (4,100) 128,900 Inventory 39,500 Total current assets 323,720

Salaries payable

26,100

Income tax payable Notes payable, current Total current liabilities Notes payable, longterm Total liabilities

5,000 17,411 55,211

Cash

6,700

81,192 136,403

Land 67,300 Shareholders’ Equity Buildings 120,000 Common stock 200,000 Less: Accumulated Depreciation (10,400) Retained earnings 164,217 * Total shareholders‘ equity 364,217 Total liabilities and Total assets $500,620 shareholders‘ equity $500,620 *

16–220

Retained earnings = Beginning retained earnings + Net income − Dividends = $155,400 + $8,817 − $0 = $164,217

Exercise 14-37 (concluded) Requirement 6 January 31, 2024 Sales revenue Retained earnings (Close revenue accounts)

Debit 195,000

Retained earnings Cost of goods sold Salaries expense Bad debt expense Depreciation expense Loss on early extinguishment Interest expense Income tax expense (Close expense accounts)

186,183

Requirement 7 (a) The debt to equity ratio is: Debt to Total Liabilities = Equity Ratio Stockholders‘ Equity

Credit 195,000

112,500 55,000 2,300 800 10,000 583 5,000

$136,403 $364,217

0.37

Freedom Fireworks is less leveraged than the industry average. Freedom Fireworks has a lower proportion of liabilities in relation to shareholders‘ equity than the industry average of 1.0. (b) The times interest earned ratio is: $8,817 +$583 Times Net Income +Interest Interest +$5,000 = Expense + Tax Expense = = 24.7 Earned Ratio Interest Expense $583 Compared to the industry average of 20 times, Freedom Fireworks is somewhat more able to meet interest payments than other companies in the same industry. (c) Based on the debt to equity ratio and the times interest earned ratio, ratio, Freedom Fireworks would more likely receive a lower interest rate than the average borrowing rate in the industry. Freedom Fireworks carries less debt than the industry average and is better able to meet interest payments than the average company in the industry.

16–221

Exercise 14–38 a. for debt by FASB ASC 405-20/470-50. Note payable Gain on extinguishment of debt

210,000 210,000

b. for grants to not-for-profit organizations by FASB ASC 958-605. Note payable Grant revenue

210,000 210,000

c. for grants to business organizations by IFRS—IAS20. Note payable Other income

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210,000 210,000

Exercise 14–39 Note payable ($210,000 x 1.01 x 1.01) Cash

214,221 214,221

Explanation: Accrued interest had been recorded with debits to interest expense and credits to the note payable: Interest expense ($210,000 x .01) Note payable

2,100

Interest expense ([$210,000 + $2,100] x .01) Note payable

2,121

2,100

2,121

16–223

PROBLEMS

16–224

Problem 14–1 Requirement 1 Interest $2,500,000¥ × 15.04630 * = 0.09722 ** = Principal $50,000,000 × Present value (price) of the bond s

$37,615,750 4,861,000 $42,476,750

¥ 5% × $50,000,000 * Present value of an ordinary annuity of $1: n = 40, i = 6% (Table 4) ** Present value of $1: n = 40, i = 6% (Table 2)

Cash (price determined above) ..................................... Discount on bonds payable (difference)..................... Bonds payable (face amount) .................................

Requirement 2 Interest $2,500,000 × 18.40158 * = 0.17193 ** = Principal $50,000,000 × Present value (price) of the bonds *

42,476,750 7,523,250 50,000,000

$46,003,950 8,596,500 $54,600,450

Present value of an ordinary annuity of $1: n = 40, i = 4.5% (Table 4)

** Present value of $1: n = 40, i = 4.5% (Table 2)

Cash (price determined above) ..................................... Premium on bonds (difference) .............................. Bonds payable (face amount) ................................. Requirement 3 Investment in bonds (face amount) ................................ Premium on investment in bonds ........................... Cash (price calculated above) ...................................

54,600,450 4,600,450 50,000,000

50,000,000 4,600,450 54,600,450

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Problem 14–2 1. Liabilities on September 30, 2024 Bonds payable (face amount) ..................................... Less: discount ......................................................... Initial balance, January 1, 2024............................... June 30, 2024, discount amortization ...................... Sept. 30, 2024, discount amortization ..................... Sept. 30, 2024, net bonds payable ...........................

$160,000,000 20,000,000 140,000,000 400,000* 212,000** $140,612,000

Interest payable ** ..................................................

$4,000,000

2. Interest expense for year ended September 30, 2024 June 30, 2024, interest expense ............................... September 30, 2024, interest expense ..................... Interest expense for fiscal 2024...............................

$ 8,400,000* 4,212,000** $12,612,000

3. Statement of cash flows for year ended September 30, 2024 Baddour would report the cash inflow of $140,000,000*** from the sale of the bonds as a cash flow from financing activities in its statement of cash flows. The $8,000,000* cash interest paid is a cash outflow from operating activities because interest is an income statement (operating) item.

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Problem 14–2 (concluded) Calculations: January 1, 2024*** Cash (price: given).............................................................. 140,000,000 Discount on bonds payable (difference)..................... 20,000,000 Bonds payable (face amount) ................................. 160,000,000 June 30, 2024* Interest expense (6% × $140,000,000) ............................ 8,400,000 Discount on bonds payable (difference) ................. 400,000 Cash (5% × $160,000,000)....................................... 8,000,000 September 30, 2024** Interest expense (6% × [$140,000,000 + $400,000] × 3/6) 4,212,000 Discount on bonds payable (difference) ................. 212,000 Interest payable (5% × $160,000,000 × 3/6)............... 4,000,000

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Problem 14–3 Requirement 1 Cash Payment 4.5% × Face Amount

1 2 3 4 5 6 7 8

4,500 4,500 4,500 4,500 4,500 4,500 4,500 4,500

Effective Interest 5% × Outstanding Balance .05 (96,768) .05 (97,106) .05 (97,461) .05 (97,834) .05 (98,226) .05 (98,637) .05 (99,069) .05 (99,522)

Increase in Balance

Outstanding Balance

= 4,838 = 4,855 = 4,873 = 4,892 = 4,911 = 4,932 = 4,953 = 4,978*

338 355 373 392 411 432 453 478

96,768 97,106 97,461 97,834 98,226 98,637 99,069 99,522 100,000

39,232

3,232

36,000 * rounded.

Requirement 2

Cash Payment 4.5% × Face Amount

1 2 3 4 5 6 7 8

4,500 4,500 4,500 4,500 4,500 4,500 4,500 4,500 36,000

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Recorded Interest Cash plus Discount Reduction (4,500 + 404) (4,500 + 404) (4,500 + 404) (4,500 + 404) (4,500 + 404) (4,500 + 404) (4,500 + 404) (4,500 + 404)

= = = = = = = =

Increase in Balance $3,232 ÷ 8

4,904 4,904 4,904 4,904 4,904 4,904 4,904 4,904

404 404 404 404 404 404 404 404

39,232

3,232

Outstanding Balance

96,768 97,172 97,576 97,980 98,384 98,788 99,192 99,596 100,000

Problem 14–3 (continued) Requirement 3 (effective interest) Interest expense (5% × $98,226)..................................... Discount on bonds payable (difference) ................. Cash (4.5% × $100,000) .......................................... (straight-line) Interest expense ($4,500 + $404) .................................... Discount on bonds payable ($3,232 ÷ 8) ................ Cash (4.5% × $100,000) ..........................................

4,911 411 4,500 4,904 404 4,500

Requirement 4 By the straight-line method, a company determines interest indirectly by allocating a discount or a premium equally to each period over the term to maturity. This is allowed if doing so produces results that are not materially different from the interest method. The decision should be guided by whether the straight-line method would tend to mislead investors and creditors in the particular circumstance. Allocating the discount or premium equally over the life of the bonds by the straight-line method results in an unchanging dollar amount of interest each period. By the straight-line method, the amount of the discount to be reduced periodically is calculated, and the effective interest is the ―plug‖ figure. Unchanging dollar amounts like these are not produced when the effective interest approach is used. By that approach, the dollar amounts of interest vary over the term to maturity because the percentage rate of interest remains constant but is applied to a changing debt balance. Remember that the ―straight-line method,‖ is not an alternative method of determining interest in a conceptual sense but is an application of the materiality concept. The appropriate application of GAAP, the effective interest method, is bypassed as a practical expediency in situations when doing so has no ―material‖ effect on the results.

16–229

Problem 14–3 (concluded) Requirement 5 The amortization schedule in requirement 1 gives us the present value, which represents fair value since the market rate still is 10%. The outstanding debt balance after the June 30, 2026, interest payment (line 5) is the present value at that time ($98,637) of the remaining payments. Since $10,000 face amount of the bonds is 10% of the entire issue, we take 10% of the table amount to arrive at $9,864. This can be confirmed by calculating the present value: Interest $450¥ x 2.72325 * = Principal $10,000 x 0.86384 ** = Present value (price) of the bonds

$1,225 8,638 $9,863 (rounded)

4.5% × $10,000

Present value of an ordinary annuity of $1: n = 3, i = 5% (Table 4)

** Present value of $1: n = 3, i = 5% (Table 2)

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Problem 14–4 Requirement 1 $8,000,000 (outstanding balance at maturity) Requirement 2 $6,627,273 (initial balance at issuance date) Requirement 3 20 years (40 semiannual periods) Requirement 4 At the effective interest rate (By the alternative straight-line approach, interest would be the same amount each period.) Requirement 5 8% [($320,000 ÷ $8,000,000) × 2] Requirement 6 10% [($331,364 ÷ $6,627,273) × 2] Requirement 7 $12,800,000 ($320,000 × 40) Requirement 8 $14,172,727 ($12,800,000* + [$8,000,000 – $6,627,273]) (Total cash interest plus the discount)

*$320,000 × 40

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Problem 14–5 Requirement 1 Interest $3,600,000¥ x 6.46321 * = $23,267,556 0.67684 ** = 54,147,200 Principal $80,000,000 x Present value (price) of the bonds $77,414,756 ¥ * **

4.5% × $80,000,000 Present value of an ordinary annuity of $1: n = 8, i = 5% (Table 4) Present value of $1: n = 8, i = 5% (Table 2)

Requirement 2 (a) Sanyal

Cash Payment 4.5% × Face Amount

1 2 3 4 5 6 7 8

3,600,000 3,600,000 3,600,000 3,600,000 3,600,000 3,600,000 3,600,000 3,600,000 28,800,000

Effective Interest 5% × Outstanding Balance

.05 (77,414,756) = .05 (77,685,494) = .05 (77,969,769) = .05 (78,268,257) = .05 (78,581,670) = .05 (78,910,754) = .05 (79,256,292) = .05 (79,619,107) =

Increase in Outstanding Balance Balance Discount Reduction

3,870,738 3,884,275 3,898,488 3,913,413 3,929,084 3,945,538 3,962,815 3,980,893*

270,738 284,275 298,488 313,413 329,084 345,538 362,815 380,893

31,385,244

2,585,244

77,414,756 77,685,494 77,969,769 78,268,257 78,581,670 78,910,754 79,256,292 79,619,107 80,000,000

* rounded.

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Problem 14–5 (continued) (b) Barnwell

Cash Payment 4.5% × Face Amount

1 2 3 4 5 6 7 8

3,600 3,600 3,600 3,600 3,600 3,600 3,600 3,600 28,800

Effective Interest 5% × Outstanding Balance

Increase in Outstanding Balance Balance Discount Reduction

.05 (77,415) = 3,871 .05 (77,686) = 3,884 .05 (77,970) = 3,899 .05 (78,269) = 3,913 .05 (78,582) = 3,929 .05 (78,911) = 3,946 .05 (79,257) = 3,963 .05 (79,620) = 3,980 *

31,385

77,415 77,686 77,970 78,269 78,582 78,911 79,257 79,620 80,000

271 284 299 313 329 346 363 380 2,585

*rounded

Requirement 3 February 1, 2024 (Sanyal) Cash (price determined above) ................................ Discount on bonds payable (difference)................ Bonds payable (face amount) ............................ February 1, 2024 (Barnwell) Investment in bonds (face amount) ....................... Discount on investment in bonds (difference) ... Cash (price paid) ...............................................

77,414,756 2,585,244 80,000,000

80,000 2,585 77,415

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Problem 14–5 (continued) Requirement 4 July 31, 2024 (Sanyal) Interest expense (from schedule) .............................. Discount on bonds payable (from schedule) ...... Cash (from schedule) ........................................ July 31, 2024 (Barnwell) Cash (from schedule)............................................. Discount on investment in bonds (from schedule) . Interest revenue (from schedule) ........................... December 31, 2024 (Sanyal) Interest expense (5/6 × $3,884,275) ........................... Discount on bonds payable (5/6 × $284,275)...... Interest payable (5/6 × $3,600,000) ..................... December 31, 2024 (Barnwell) Interest receivable (5/6 × $3,600)........................... Discount on investment in bonds (5/6 × $284) ...... Interest revenue (5/6 × $3,884) ..............................

January 31, 2025 (Sanyal) Interest expense (1/6 × $3,884,275) ........................... Interest payable (from adjusting entry above) ............ Discount on bonds payable (1/6 × $284,275)...... Cash (stated rate × face amount)........................... January 31, 2025 (Barnwell) Cash (stated rate × face amount) .............................. Discount on investment in bonds (1/6 × $284) ...... Interest receivable (from adjusting entry above) ... Interest revenue (1/6 × $3,884) ..............................

16–234

3,870,738 270,738 3,600,000

3,600 271 3,871

3,236,896 236,896 3,000,000

3,000 237 3,237

647,379 3,000,000 47,379 3,600,000

3,600 47 3,000 647

Problem 14–5 (concluded) July 31, 2025 (Sanyal) Interest expense (from schedule) .............................. Discount on bonds payable (from schedule) ...... Cash (from schedule) ........................................

3,898,488

July 31, 2025 (Barnwell) Cash (from schedule)............................................. Discount on investment in bonds (from schedule). Interest revenue (from schedule) ...........................

3,600 299

December 31, 2025 (Sanyal) Interest expense (5/6 × $3,913,413) ........................... Discount on bonds payable (5/6 × $313,413)...... Interest payable (5/6 × $3,600,000) ..................... December 31, 2025 (Barnwell) Interest receivable (5/6 × $3,600)........................... Discount on investment in bonds (5/6 × $313) ...... Interest revenue (5/6 × $3,913)..............................

January 31, 2026 (Sanyal) Interest expense (1/6 × $3,913,413) ........................... Interest payable (from adjusting entry above)............ Discount on bonds payable (1/6 × $313,413)...... Cash (stated rate × face amount)........................... January 31, 2026 (Barnwell) Cash (stated rate × face amount) .............................. Discount on investment in bonds (1/6 × $313) ...... Interest receivable (from adjusting entry above) ... Interest revenue (1/6 × $3,913)..............................

298,488 3,600,000

3,899

3,261,177 261,177 3,000,000

3,000 261 3,261

652,236* 3,000,000 52,236* 3,600,000

3,600 52 3,000 652

*rounded

16–235

Problem 14–6 Requirement 1 April 1, 2024 (Western) 29,600,000 Cash ($29,300,000 + [1/12 × 12% × $30,000,000])....... Discount on bonds payable ($30 million – $29.3 million) 700,000 Bonds payable (face amount) ............................ 30,000,000 1 Interest payable ( /12 × 12% × $30,000,000) ........ 300,000 April 1, 2024 (Stillworth) Investment in bonds (face amount) ....................... Interest receivable (1/12 × 12% × $30,000) .............. Discount on investment in bonds ($30,000 – $29,300) Cash ($29,300 + [1/12 × 12% × $30,000])...............

30,000 300 700 29,600

Alternative: Some accountants prefer to credit (debit) interest expense (revenue), rather than interest payable (receivable), when bonds are sold (purchased). April 1, 2024 (Western) Cash ($29,300,000 + [1/12 × 12% × $30,000,000]) ............ 29,600,000 Discount on bonds payable ($30 million – $29.3 million) 700,000 Bonds payable (face amount) .................................. 30,000,000 1 300,000 Interest expense ( /12 × 12% × $30,000,000).............. April 1, 2024 (Stillworth) Investment in bonds (face amount) ............................. Interest revenue (1/12 × 12% × $30,000)........................... Discount on investment in bonds ($30,000 – $29,300) Cash ($29,300 + [1/12 × 12% × $30,000]).....................

30,000 300 700 29,600

If the alternate entries are used, entries at the next interest date would simply require a debit (credit) to interest expense (revenue) for the full interest. The interest accounts would then reflect the same net debit of five months' interest.

16–236

Problem 14–6 (continued) Requirement 2 The original maturity of the bonds was three years, or 36 months. But since the bonds weren‘t sold until one month after they were dated, they are outstanding for only 35 months. Straight-line amortization, then, is $700,000 ÷ 35 months = $20,000 per month for Western (and $700 ÷ 35 months = $20 per month for Stillworth‘s investment). August 31, 2024 (Western) Interest expense ($1,800,000 + $100,000 – $300,000) . Interest payable (accrued interest from above) ............. Discount on bonds payable ($20,000 × 5 months) Cash ($30,000,000 × 12% × 6/12) ..........................

1,600,000 300,000 100,000 1,800,000

August 31, 2024 (Stillworth) Cash ($30,000 × 12% × 6/12) .................................... Discount on investment in bonds ($20 × 5 months) Interest receivable (accrued interest from above).... Interest revenue ($1,800 + $100 – $300)..................

1,800 100 300 1,600

If alternate method of recording accrued interest is used: August 31, 2024 (Western) Interest expense ($1,800,000 + $100,000) ................... Discount on bonds payable ($20,000 × 5 months) Cash ($30,000,000 × 12% × 6/12) .......................... August 31, 2024 (Stillworth) Cash ($30,000 × 12% × 6/12) .................................... Discount on investment in bonds ($20 × 5 months) Interest revenue ($1,800 + $100) .............................

1,900,000 100,000 1,800,000

1,800 100 1,900

16–237

Problem 14–6 (continued) December 31, 2024 (Western) Interest expense ($1,200,000 + $80,000) ................... Discount on bonds payable ($20,000 × 4 months) Interest payable ($30,000,000 × 12% × 4/12) ........

1,280,000

December 31, 2024 (Stillworth) Interest receivable ($30,000 × 12% × 4/12) .............. Discount on investment in bonds ($20 × 4 months) Interest revenue ($1,200 + $80).............................

1,200 80

February 28, 2025 (Western) Interest expense ($1,800,000 + $40,000 – $1,200,000) Interest payable (from adjusting entry) ................... Discount on bonds payable ($20,000 × 2 months) Cash ($30,000,000 × 12% × 6/12) ........................ February 28, 2025 (Stillworth) Cash ($30,000 × 12% × 6/12)................................... Discount on investment in bonds ($20 × 2 months) Interest receivable (from adjusting entry) ............ Interest revenue ($1,800 + $40 – $1,200) ............. August 31, 2025 (Western) Interest expense ($1,800,000 + $120,000) ................ Discount on bonds payable ($20,000 × 6 months) Cash ($30,000,000 × 12% × 6/12) ........................ August 31, 2025 (Stillworth) Cash ($30,000 × 12% × 6/12) .................................. Discount on investment in bonds ($20 × 6 months) Interest revenue ($1,800 + $120)........................... December 31, 2025 (Western) Interest expense ($1,200,000 + $80,000) ................... Discount on bonds payable ($20,000 × 4 months) Interest payable ($30,000,000 × 12% × 4/12) ........

16–238

80,000 1,200,000

1,280

640,000 1,200,000 40,000 1,800,000 1,800 40 1,200 640

1,920,000 120,000 1,800,000 1,800 120 1,920 1,280,000 80,000 1,200,000

Problem 14–6 (continued) December 31, 2025 (Stillworth) Interest receivable ($30,000 × 12% × 4/12) .............. Discount on investment in bonds ($20 × 4 months) Interest revenue ($1,200 + $80) ............................ February 28, 2026 (Western) Interest expense ($1,800,000 + $40,000 – $1,200,000) Interest payable (from adjusting entry) ................... Discount on bonds payable ($20,000 × 2 months) Cash ($30,000,000 × 12% × 6/12) ........................ February 28, 2026 (Stillworth) Cash ($30,000 × 12% × 6/12)................................... Discount on investment in bonds ($20 × 2 months) Interest receivable (from adjusting entry) ............ Interest revenue ($1,800 + $40 – $1,200) ............. August 31, 2026 (Western) Interest expense ($1,800,000 + $120,000) ................ Discount on bonds payable ($20,000 × 6 months) Cash ($30,000,000 × 12% × 6/12) ........................ August 31, 2026 (Stillworth) Cash ($30,000 × 12% × 6/12) .................................. Discount on investment in bonds ($20 × 6 months) Interest revenue ($1,800 + $120) .......................... December 31, 2026 (Western) Interest expense ($1,200,000 + $80,000)................... Discount on bonds payable ($20,000 × 4 months) Interest payable ($30,000,000 × 12% × 4/12) ........ December 31, 2026 (Stillworth) Interest receivable ($30,000 × 12% × 4/12) .............. Discount on investment in bonds ($20 × 4 months) Interest revenue ($1,200 + $80) ............................

1,200 80 1,280

640,000 1,200,000 40,000 1,800,000

1,800 40 1,200 640

1,920,000 120,000 1,800,000 1,800 120 1,920

1,280,000 80,000 1,200,000 1,200 80 1,280

16–239

Problem 14–6 (concluded) February 28, 2027 (Western) Interest expense ($1,800,000 + $40,000 – $1,200,000) Interest payable (from adjusting entry) ................... Discount on bonds payable ($20,000 × 2 months) Cash ($30,000,000 × 12% × 6/12) ........................ Bonds payable ................................................... Cash .............................................................. February 28, 2027 (Stillworth) Cash ($30,000 × 12% × 6/12)................................... Discount on investment in bonds ($20 × 2 months) Interest receivable (from adjusting entry) ............ Interest revenue ($1,800 + $40 – $1,200) ............. Cash .................................................................. Investment in bonds ......................................

16–240

640,000 1,200,000 40,000 1,800,000 30,000,000 30,000,000

1,800 40 1,200 640 30,000 30,000

Problem 14–7 Requirement 1 Interest $16,000,000¥ x 17.15909 * = x 0.14205 ** = Principal $400,000,000 Present value (price) of the bonds

$274,545,440 56,820,000 $331,365,440

¥ 4% × $400,000,000 * Present value of an ordinary annuity of $1: n = 40, i = 5% (Table 4) ** Present value of $1: n = 40, i = 5% (Table 2)

Requirement 2 (a) Cash (price determined above) ................................ Discount on bonds payable (difference)................ Bonds payable (face amount) ............................ (b) Investment in bonds (face amount) ....................... Discount on investment in bonds (difference) ... Cash (0.1% × $331,365,440) ............................... Requirement 3 (a) Interest expense (5% × $331,365,440) ...................... Discount on bonds payable (difference) ............ Cash (4% × $400,000,000).................................. (b) Cash (4% × $400,000) ........................................... Discount on investment in bonds (difference)....... Interest revenue (5% × $331,365) ......................... Requirement 4 (a) Interest expense (5% × [$331,365,440 + $568,272]) . Discount on bonds payable (difference) ............ Cash (4% × $400,000,000).................................. (b) Cash (4% × $400,000) ........................................... Discount on investment in bonds (difference)....... Interest revenue (5% × [$331,365 + $568])...........

331,365,440 68,634,560 400,000,000 400,000 68,635 331,365

16,568,272 568,272 16,000,000 16,000 568 16,568

16,596,686 596,686 16,000,000 16,000 597 16,597

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Problem 14–8 1. Interest expense for year ended December 31, 2024 Dec. 31, 2024, interest expense (calculated below 1) 2. Liabilities on December 31, 2024

$4,422

Bonds payable (face amount) ..................................... Less: Discount 2...................................................... Initial balance, November 1,2024 ........................... Dec. 31, 2024, discount amortization 3.................... Balance, December 31,2024................................

$500,000 (57,785) 442,215 255 $442,470

Interest payable 4 ....................................................

$4,167

3. Interest expense for year ended December 31, 2025 April 30, 2025, interest expense 5 ........................... Oct. 31, 2025, interest expense 6 ............................. Dec. 31, 2025, interest expense 7 ............................ Interest expense for2025 ..................................... Or, using the amortization schedule below: $13,266 × 4/6 + $13,289 + $13,313 × 2/6 = $26,571

$ 8,844 13,289 4,438 $26,571

4. Liabilities on December 31, 2025 Balance, December 31, 2024(from req. 2 above) .... April 30, 2025, discount amortization 8................... Oct. 31, 2025, discount amortization 9 .................... Dec. 31, 2025, discount amortization 10 .................. Balance, December 31,2025................................

$442,470 511 789 271 $444,041

Interest payable 11...................................................

$4,167

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Problem 14–8 (concluded) Calculations: November 1, 2024 Cash (price: given) ......................................... Discount on bonds payable (difference)......... Bonds payable (face amount) ..................... Partial amortization schedule (not required) Cash Payment

Effective Interest

442,215 57,785 2 500,000 Increase in Outstanding Balance Balance

442,215 442,981 443,770 444,583

1 12,500 .03 (442,215) = 13,266 766 2 12,500 .03 (442,981) = 13,289 789 3 12,500 .03 (443,770) = 13,313 813 December 31, 2024 Interest expense (3% × $442,215 × 2/6).............. 4,4221 Discount on bonds payable (difference) ..... 255 3 4,167 4 Interest payable (2.5% × $500,000 × 2/6) ...... April 30, 2025 8,844 5 Interest expense (3% × $442,215 × 4/6).............. Interest payable (from adjusting entry above).... 4,167 Discount on bonds payable (difference) ..... 511 8 Cash (stated rate × face amount) ................... 12,500 October 31, 2025 Interest expense (3% × [$442,215 + $255 + $511]) 13,289 6 Discount on bonds payable (difference) ...... 789 9 Cash (stated rate × face amount) ................... 12,500 December 31, 2025 Interest expense (3% × [$442,215 + $255 + $511 + $789] × 2/6) 4,438 7 Discount on bonds payable (difference) ..... 271 10 Interest payable (2.5% × $500,000 × 2/6) ...... 4,167 11

16–243

Problem 14–9 Requirement 1 Cash (price given) ................................................. Discount on bonds payable (difference)................ Bonds payable (face amount) ............................

5,795,518 12,204,482 18,000,000

Requirement 2 The discount rate that ―equates‖ the present value of the debt ($5,795,518) and its future value ($18,000,000) is the effective rate of interest: $5,795,518 ÷ $18,000,000 = 0.32197—the Table 2 value for n = 10, i = ? In row 10 of Table 2, the value 0.32197 is in the 12% column. So, this is the effective interest rate. A financial calculator will produce the same rate.

Requirement 3 Interest expense (12% × $5,795,518) ........................ Discount on bonds payable ............................

695,462 695,462

Requirement 4 Interest expense (12% × [$5,795,518 + $695,462]) ... Discount on bonds payable ............................

778,918 778,918

Requirement 5 Bonds payable.................................................... Cash ..............................................................

16–244

18,000,000 18,000,000

Problem 14–10 Requirement 1 Land ........................................................................... Notes payable (face amount)...................................... Interest expense (12% × $600,000) ................................. Cash (12% × $600,000)............................................... Requirement 2 Office equipment (price given) ...................................... Discount on notes payable (difference).......................... Notes payable (face amount)......................................

600,000 600,000 72,000 72,000 94,643 5,357 100,000

The discount rate that ―equates‖ the present value of the debt ($94,643) and its future value ($100,000 + $6,000) is the effective rate of interest: $94,643 ÷ $106,000 = 0.8929—the Table 2 value for n = 1, i = ? In row 1 of Table 2, the value 0.8929 is in the 12% column. So, this is the effective interest rate. A financial calculator will produce the same rate.

PROOF: Interest $6,000¥ x 0.89286 * = Principal $100,000 x 0.89286 ** = Present value (price) of the note

$ 5,357 89,286 $94,643

¥ 6% × $100,000 * Present value of an ordinary annuity of $1: n = 1, i = 12% (Table 4) ** Present value of $1: n = 1, i = 12% (Table 2)

Interest expense (12% × $94,643)................................... Discount on notes payable (determined above) ........... Cash (6% × $100,000) ................................................

11,357 5,357 6,000

16–245

Problem 14–10 (concluded)

16–246

Not required, but recorded at the same date (may be combined with interest entry): Notes payable (face amount).......................................... Cash........................................................................

100,000 100,000

Requirement 3 $1,000,000 x 2.40183 = installment (from Table 4)present payments n = 3, i = 12% value

$2,401,830

Building (implicit price) ................................................. Notes payable (present value determined above) ............

2,401,830

Interest expense (12% × $2,401,830)............................... Notes payable (difference)............................................. Cash (given) .............................................................

288,220 711,780

2,401,830

1,000,000

16–247

Problem 14– 248 Interest 1 $6,000 x 3.79079 * = Requirement Principal $150,000 x 0.62092 ** = Present value (price) of the note *

$ 22,745 93,138 $115,883

Present value of an ordinary annuity of $1: n = 5, i = 10% (Table 4)

** Present value of $1: n = 5, i = 10% (Table 2)

Equipment (fair value)................................................... Discount on notes payable (difference).......................... Notes payable (face amount)......................................

115,883 34,117 150,000

Requirement 2 December 31, 2024 Interest expense (10% × $115,883)...................................... Discount on notes payable (difference)...................... Cash (given) .............................................................

11,588 5,588 6,000

Requirement 3 December 31, 2025 Interest expense (10% × [$115,883 + $5,588])..................... Discount on notes payable (difference)...................... Cash (given) .............................................................

16–248

12,147 6,147 6,000

Problem 14–12 Requirement 1 $6,074,700 present value

$2,000,000 =

3.03735

installment payment

present value table amount

This is the Table 4 value for n = 4, i = ? In row 4 of Table 4, the number 3.03735 is in the 12% column. So, 12% is the implicit interest rate. Requirement 2 Equipment (fair value) .................................................. Notes payable (present value).....................................

6,074,700 6,074,700

Requirement 3 Interest expense (12% × outstanding balance) ..................... Notes payable (difference)............................................. Cash (given) .............................................................

728,964 1,271,036 2,000,000

Requirement 4 Interest expense (12% × [$6,074,700 – $1,271,036])........... Notes payable (difference)............................................. Cash (given) .............................................................

576,440 1,423,560 2,000,000

Requirement 5 $2,000,000

x 3.10245 =

$6,204,900

installment payment

(from Table 4) n = 4, i = 11%

present value

Equipment .................................................................. Notes payable .........................................................

6,204,900 6,204,900

16–249

Problem 14– 250 Requirement 1 Interest $5,000¥ x 3.16987 * = Principal $100,000 x 0.68301 ** = Present value (price) of the note

$15,849 68,301 $84,150

¥ 5% × $100,000 * Present value of an ordinary annuity of $1: n = 4, i = 10% (Table 4) ** Present value of $1: n = 4, i = 10% (Table 2)

Equipment (price determined above) ................................ Discount on notes payable (difference).......................... Notes payable (face amount)......................................

84,150 15,850 100,000

Requirement 2

Cash Dec.31 Payment

2024 2025 2026 2027

5,000 5,000 5,000 5,000 20,000

Effective Interest

Increase in Balance

Outstanding Balance

8,415 .10 (87,565) = 8,757 .10 (91,322) = 9,132 .10 (95,454) = 9,546*

3,415 3,757 4,132 4,546

84,150 87,565 91,322 95,454 100,000

35,850

15,850

.10 (84,150) =

* rounded

Requirement 3 Interest expense (market rate × outstanding balance) .......... Discount on notes payable (difference)...................... Cash (stated rate × face amount) ...................................

16–250

9,132 4,132 5,000

Problem 14–13 (concluded) Requirement 4 $84,150 amount of loan

3.16987 =

$26,547

(from Table 4) n = 4, i = 10%

installment payment

Requirement 5 Cash Dec. 31 Payment

2024 2025 2026 2027

26,547 26,547 26,547 26,547

106,188 * rounded

Effective Interest 10% × Outstanding Balance .10 (84,150) = .10 (66,018) = .10 (46,073) = .10 (24,133) =

Decrease in Balance Balance Reduction

8,415 6,602 4,607 2,414*

18,132 19,945 21,940 24,133

22,038

84,150

Outstanding Balance

84,150 66,018 46,073 24,133 0

Requirement 6 Interest expense (market rate × outstanding balance) .......... Notes payable (difference)............................................. Cash (payment determined above).................................

4,607 21,940 26,547

16–251

Problem 14–14 Bonds payable (face amount)......................................... Loss on early extinguishment (to balance)..................... Discount on bonds payable (7/10 × [$800,000 – $770,000]) .................................. Cash (given) .............................................................

16–252

800,000 11,000 21,000 790,000

16–253

Problem 14–15 Requirement 1 Interest expense (7% × $19,000,000)................................... Discount on bonds payable (difference)..................... Cash (6% × $20,000,000) ............................................

1,330,000 130,000 1,200,000

Requirement 2 Bonds payable (face amount)......................................... Loss on early extinguishment (to balance)..................... Discount on bonds payable ($1,000,000 – $130,000) ... Cash (redemption price) ..............................................

16–254

20,000,000 1,270,000 870,000 20,400,000

Problem 14– 255 1. Issuance of the bonds. Cash ($385,000 – $1,500).......................................................... Discount and debt issue costs ([$400,000 – $385,000] + $1,500) . Bonds payable (face amount) ............................................... 2. December 31, 2024 Interest expense ($20,000 + $825)................................................... Discount and debt issue costs ($16,500 ÷ 20)....................... Cash (5% × $400,000) .......................................................... 3. June 30, 2025 Interest expense ($20,000 + $825)................................................... Discount and debt issue costs ($16,500 ÷ 20)....................... Cash (5% × $400,000) ..........................................................

383,500 16,500 400,000

20,825 825 20,000

4. Call of the bonds Bonds payable (face amount)................................................... 400,000 Loss on early extinguishment (to balance)............................... 9,850 Discount and debt issue costs (9/10 × [$400,000 – $385,000 + $1,500]) 14,850 Cash (given) ....................................................................... 395,000

16–255

Problem 14-17 U.S. GAAP and IFRS now treat transaction costs (called debt issue costs under U.S. GAAP) similarly and reduce the recorded amount of the debt, as well as the net cash the issuing company receives from the sale of the bonds. A lower [net] amount is borrowed at the same cost, increasing the effective interest rate. Since the recorded amount of the debt is reduced by the transaction costs, the higher rate will be reflected in a higher recorded interest expense.

1. Issuance of the bonds Cash ($385,000 – $1,500)................................................ Bonds payable......................................................... 2. December 31, 2024 Interest expense ($20,000 + $825) ....................................... Bonds payable ([$400,000 – $383,500] ÷ 20) ................ Cash (5% × $400,000) ................................................ 3. June 30, 2025 Interest expense ($20,000 + $825) ....................................... Bonds payable ([$400,000 – $383,500] ÷ 20) ................ Cash (5% × $400,000) ................................................ 4. Call of the bonds Bonds payable ($383,500 + 825 + $825) .......................... Loss on early extinguishment (to balance)..................... Cash (given) .............................................................

383,500 383,500 20,825 825 20,000 20,825 825 20,000 385,150 9,850 395,000

*Notice that the discount is combined with the face amount of the bonds. This is the ―net method‖ that is the preferred method under IFRS.

16–256

Problem 14–18 Requirement 1 Bonds payable (face amount)......................................... Premium on bonds (20/40 × $6,000,000) .......................... Gain on early extinguishment (to balance)................. Cash ($20,000,000 × 102%)......................................... Requirement 2 Bonds payable (face amount)......................................... Premium on bonds (10/40 × $6,000,000) .......................... Gain on early extinguishment (to balance)................. Cash (given) .............................................................

16–18

20,000,000 3,000,000 2,600,000 20,400,000

10,000,000 1,500,000 1,000,000 10,500,000

Problem 14– 258

Requirement 1

($ i n m i l l i o n s)

Convertible Bonds—2011 issue Cash (97.5% × $200 million) ...................................................... Discount on bonds payable (difference).................................... Convertible bonds payable (face amount).............................. Bonds with Warrants—2015 issue Cash (102% × $50 million) ......................................................... Discount on bonds payable (difference).................................... Bonds payable (face amount)................................................. Equity—stock warrants (given)............................................

195 5 200

51 3 50 4

Requirement 2 ($ in millions)

Convertible bonds payable (90% × $200 million) ...................... Discount on bonds payable (90%x $2 million) ....................... Common stock (to balance) ..................................................

180.0

Convertible bonds payable (10% × $200 million) ....................... Loss on early extinguishment (to balance) ................................ Discount on bonds payable (10% × $2 million) ..................... Cash (101% × 10% × $200 million) ..........................................

20.0 0.4

1.8 178.2

0.2 20.2

Requirement 3 ($ in millions)

Convertible bonds payable (90% × $200 million) ....................... Conversion expense* (90% × 200,000 bonds × $150) .................. Discount on bonds payable (90% × $2 million) ...................... Common stock (to balance) .................................................. Cash (90% × 200,000 bonds × $150) ........................................

180.0 27.0 1.8 178.2 27.0

* When additional consideration is provided to induce conversion, the fair value of that consideration is considered an expense incurred to bring about the conversion.

16–258

Problem 14–19 (concluded) Requirement 4 ($ in millions)

Convertible bonds payable (90% × $200 million) ....................... Conversion expense* (90% × [200,000 × (45 – 40) shares] × $32).. Discount on bonds payable (90% × $2 million) ...................... Common stock (to balance) ..................................................

180.0 28.8 1.8 207.0

* When additional consideration is provided to induce conversion, the fair value of that consideration is considered an expense incurred to bring about the conversion.

Requirement 5 ($ in millions)

Cash (40% × 50,000 × 40 warrants × $25) ..................................... Equity—stock warrants (40% × $4 million) ............................... Common stock (to balance)...................................................

20.0 1.6

21.6

16–259

Problem 14– 260 List A j_ 1. Effective rate times balance h_ 2. Promises made to bondholders o_ 3. Present value of interest plus present value of principal m_ 4. Call feature l_ 5. Debt issue costs b_ 6. Market rate higher than stated rate d_ 7. Coupon bonds k_ 8. Convertible bonds e_ 9. Market rate less than stated rate n_10. Stated rate times face amount f_ 11. Registered bonds g_12. Debenture bond i_ 13. Mortgage bond a_ 14. Materiality concept c_ 15. Subordinated debenture

16–260

a. b. c. d. e. f. g. h. i. j. k. l. m. n. o.

List B Straight-line method Discount Liquidation payments after other claims satisfied Name of owner not registered Premium Checks are mailed directly No specific assets pledged Bond indenture Backed by a lien Interest expense May become stock Legal, accounting, printing Protection against falling rates Periodic cash payments Bond price

Problem 14–21 Requirement 1 Interest $32,000 × 17.15909* = $549,091 Principal $800,000 × 0.14205 ** = 113,640 $662,731 4% × $800,000 = $32,000 * Present value of an ordinary annuity of $1: n = 40, i = 5% (Table 4) ** Present value of $1: n = 40, i = 5% (Table 2)

January 1 Cash Discount on bonds payable Bonds payable

662,731 137,269

Requirement 2 June 30 Interest expense (5% × $662,731) Discount on bonds payable (difference) Cash (4% × $800,000)

33,137

Requirement 3 December 31 Interest expense (5% × [$662,731 + $1,137]) Discount on bonds payable (difference) Cash (4% × $800,000)

33,193

800,000

1,137 32,000

1,193 32,000

Requirement 4 The interest entries increased the book value from $662,731 to $665,061. To increase the book value to $668,000, NFB needed the following entry: Loss on bonds payable (unrealized, OCI) Fair value adjustment ($668,000 – $665,061)

2,939 2,939

16–261

Problem 14– 262 Requirement 1 On January 1, the book value of the bonds was the initial issue price, $331,364. The liability, though, was increased by three months‘ interest that has accrued for the quarter but has not been paid. This is recorded in an adjusting entry in preparation for the quarterly financials: Interest expense (5% × $331,364 × 3/6) ..................... Discount on bonds payable (difference) .............. Accrued interest payable (4% × $400,000 × 3/6) ....

8,284 284 8,000

Note: None of the interest will be paid until June 30.

Reducing the discount increases the book value of the bonds: January 1 book value and fair value Increase from discount amortization Increase from accrued interest payable* March 31 book value (amortized initial amount)

$331,364 284 8,000 $339,648

*Interest payable is considered part of the book value of the bonds.

Comparing the amortized initial amount on March 31, 2024, with the fair value on that date provides the fair value adjustment balance needed: March 31 book value (amortized initial amount) March 31 fair value Fair value adjustment balance needed: debit/(credit)

$339,648 350,000 $ (10,352)

Appling assumes the change in fair value is due to a change in the credit risk associated with the bonds because general interest rates did not change and would record the $10,352 loss as other comprehensive income in the 2024 first quarter statement of comprehensive income: Loss on bonds payable (unrealized, OCI) ................. 10,352 Fair value adjustment........................................ 10,352 Note: An increase in the value of an asset is a gain; an increase in the value of a liability is a loss.

Appling‘s first quarter comprehensive income will be decreased by: Interest expense (in net income) Loss on bonds payable (unrealized, OCI) Decrease in comprehensive income

$ 8,284 10,352 $18,636

Note: Remember that comprehensive income includes net income and other comprehensive income.

16–262

Problem 14–22 (continued) Requirement 2 If the fair value on June 30 is $340,000, Appling needs to compare that amount with the amortized initial measurement on that date. That amount was increased when Appling recorded interest on June 30: Interest expense (5% × $331,364* × 3/6).................... Accrued interest payable (balance) ......................... Discount on bonds payable (difference) .............. Cash (4% × $400,000) ..........................................

8,284 8,000 284 16,000

* Because interest is compounded semiannually on bonds, this amount is not increased by the discount amortization until June 30.

March 31 book value (amortized initial amount) Increase from discount amortization Decrease from payment of accrued interest payable* June 30 book value (amortized initial amount)

$339,648 284 (8,000) $331,932

*Interest payable is considered part of the book value of the bonds.

Comparing the amortized initial amount on June 30 with the fair value on that date provides the fair value adjustment balance needed: June 30 book value (amortized initial amount) June 30 fair value Fair value adjustment balance needed: debit/(credit) Less: Current fair value adjustment balance debit/(credit) Change in fair value adjustment

$331,932 340,000 (8,068) (10,352) $ 2,284

Appling would record the $2,284 gain as OCI in the 2024 second quarter statement of comprehensive income: Fair value adjustment............................................ Gain on bonds payable (unrealized, OCI) ............

2,284 2,284

Appling‘s second quarter comprehensive income will be decreased by: Interest expense (in net income) Gain on bonds payable (unrealized, OCI) Decrease in comprehensive income

$8,284 (2,284) $6,000

Note: Remember that comprehensive income includes net income and other comprehensive income.

16–263

Problem 14–22 (continued) Requirement 3 If the fair value on September 30 is $335,000, Appling needs to compare that amount with the amortized initial measurement on that date. That amount, though, has increased by three months‘ interest that has accrued for the quarter but has not been paid. This is recorded in an adjusting entry in preparation for the quarterly financials: Interest expense (5% × [$331,364 + $284 + $284] × 3/6) Discount on bonds payable (difference) .............. Accrued interest payable (8% × $400,000 × 1/4)…..

8,298 298 8,000

June 30 book value (amortized initial amount) Increase from discount amortization Increase from accrued interest payable* September 30 book value (amortized initial amount)

$331,932 298 8,000 $340,230

*Interest payable is considered part of the book value of the bonds.

September 30 book value (amortized initial amount) September 30 fair value Fair value adjustment balance needed: debit/(credit) Less: Current fair value adjustment balance debit/(credit) Change in fair value adjustment

$340,230 335,000 5,230 (8,068) $(13,298)

Appling would record the $13,298 gain as OCI in the 2024 third quarter statement of comprehensive income: Fair value adjustment............................................ Gain on bonds payable (unrealized, OCI) .............

13,298 13,298

Appling‘s third quarter comprehensive income will be decreased by: Interest expense (in net income) Gain on bonds payable (unrealized, OCI) Increase in comprehensive income

16–264

$ 8,298 (13,298) $ 5,000

We are ignoring income tax in this problem but note that gains–OCI and losses– OCI are reported in the statement of comprehensive income net of tax.

16–265

Problem 14–22 (continued) Requirement 4 If the fair value on December 31 is $342,000, Appling needs to compare that amount with the amortized initial measurement on that date. That amount was increased when Appling recorded interest on December 31: Interest expense (5% × [$331,364 + $284 + $284] × 3/6) Accrued interest payable (balance)........................... Discount on bonds payable (difference).............. Cash (4% × $400,000) .........................................

8,298 8,000 298 16,000

September 30 book value (amortized initial amount) Increase from discount amortization Decrease from payment of accrued interest payable* December 31 book value (amortized initial amount)

$340,230 298 (8,000) $332,528

*Interest payable is considered part of the book value of the bonds.

December 31 book value (amortized initial amount) December 31 fair value Fair value adjustment balance needed: debit/(credit) Less: Current fair value adjustment debit/(credit) Change in fair value adjustment

$332,528 342,000 (9,472) 5,230 $(14,702)

Appling would record the $14,702 loss as OCI in the 2024 statement of comprehensive income: Loss on bonds payable (unrealized, OCI)................... Fair value adjustment .......................................

16–266

14,702 14,702

Problem 14–22 (continued) Appling‘s 2024 statement of comprehensive income will include the interest expense for all four quarters as well as the gains and losses (OCI) from adjusting to fair value: Interest expense, 1st quarter Interest expense, 2nd quarter Interest expense, 3rd quarter Interest expense, 4th quarter Loss–OCI, 1st quarter Gain–OCI, 2nd quarter Gain–OCI, 3rd quarter Loss–OCI, 4th quarter Decrease in 2024 comprehensive income

$ 8,284 8,284 8,298 8,298 10,352 (2,284) (13,298) 14,702 $42,636

We are ignoring income tax in this problem but note that gains–OCI and losses– OCI are reported in the statement of comprehensive income net of tax. The same result can be reached by comparing fair values at the beginning and end of the year and including semiannual interest amounts rather than quarter-by-quarter: If the fair value on December 31 is $342,000, Appling needs to compare that amount with the amortized initial measurement on that date. The liability, though, was increased when Appling recorded interest on June 30 and December 31: Interest expense (5% × $331,364)..............................................16,568 Discount on bonds payable (difference) ...................... 568 Cash (4% × $400,000).................................................. 16,000 Interest expense (5% × [$331,364 + $568]) ...............................16,597 Discount on bonds payable (difference) ...................... 597 Cash (4% × $400,000).................................................. 16,000 January 1 book value Increase from discount amortization ($568 + $597) December 31 book value (amortized initial amount) December 31 fair value Fair value adjustment balance needed: debit/(credit)

$331,364 1,165 332,529 342,000 $ (9,471)

16–267

Problem 14–22 (concluded) Appling would record the $9,471 loss as OCI in the 2024 statement of comprehensive income: Loss on bonds payable (unrealized, OCI)............................ Fair value adjustment................................................

9,471 9,471

Appling‘s 2024 statement of comprehensive income will include the interest expense for June 30 and December 31 as well as the loss–OCI from adjusting to fair value: Interest expense, June 30 Interest expense, December 31 Loss on bonds payable (unrealized, OCI) Decrease in 2024 comprehensive income

$16,568 16,597 9,471 $42,636

We are ignoring income tax in this problem but note that gains–OCI and losses– OCI are reported in the statement of comprehensive income net of tax.

16–268

Problem 14–23 Requirement 1 2024 July 1 Investment in bonds (face amount) ................................ Discount on investment in bonds (difference)............ Cash (price paid) .......................................................

16,000,000

Oct. 1 Investment in bonds (face amount) ................................ Premium on investment in bonds ............................... Interest receivable ($30,000,000 × 12% × 4/12)................ Cash ($31,160,000 + $1,200,000) .................................

30,000,000 1,160,000 1,200,000

Dec. 1 Cash (6% × $30,000,000) ................................................ Premium on investment in bonds*.............................. Interest receivable (from October entry) ......................... Interest revenue (to balance) ...........................................

300,000 15,700,000

32,360,000 1,800,000 20,000 1,200,000 580,000

* 10 years: (June–September) = 116 months $1,160,000 ÷ 116 months = $10,000 / month $10,000 × 2 months = $20,000

Dec. 31 Accrued interest Bracecourt Interest receivable ($16,000,000 × 10% × 6/12)................. Discount on investment in bonds * ............................. Interest revenue (to balance) ...........................................

800,000 7,500 807,500

* 20 years = 240 months $300,000 ÷ 240 months = $1,250 / month $1,250 × 6 months = $7,500

Framm Interest receivable ($30,000,000 × 12% × 1/12)................. Premium on investment in bonds ($10,000 × 1 month) Interest revenue (to balance) ...........................................

300,000 10,000 290,000

16–269

Problem 14–23 (continued) 2025 Jan. 1 Cash (10% × $16,000,000 × 6/12)...................................... 800,000 Interest receivable (from adjusting entry)..................... 800,000 June 1 Cash (12% × $30,000,000 × 6/12)...................................... 1,800,000 Premium on investment in bonds ($10,000 × 5 months) 50,000 Interest receivable (from adjusting entry) ....................... 300,000 Interest revenue (to balance) ........................................... 1,450,000 July 1 Cash (10% × $16,000,000 × 6/12) ..................................... 800,000 Discount on investment in bonds ($1,250 × 6 months) .... 7,500 Interest revenue (to balance) ........................................... 807,500 Sept. 1 450,000 Interest receivable (12% × $15,000,000 × 3/12)................. Premium on investment in bonds ($10,000 × 3 months × 15/30) 15,000 Interest revenue (difference)............................................ 435,000 Cash ([101% × $15,000,000] + $450,000) .......................... Loss on sale of investments ** ................................... Investment in bonds (face amount) ............................ Premium on investment in bonds * ........................ Interest receivable (12% × $15,000,000 × 3/12) .............

15,600,000 375,000 15,000,000 525,000 450,000

* ([$1,160,000 – $20,000 – $10,000 – $50,000] × 15/30) – $15,000 = $525,000, or [$1,160,000 × 105/116 × 15/30] = $525,000

** [$15,000,000 + $525,000] – [101% × $15,000,000]) = $375,000

16–270

Problem 14–23 (continued) Dec. 1 Cash (12% × $15,000,000 × 6/12) ...................................... Premium on investment* .............................................. Interest revenue (to balance) ........................................... * ($10,000 × 6 months × 15/30) Dec. 31 Accrued interest Bracecourt Interest receivable (10% × $16,000,000 × 6/12) ................. Discount on investment in bonds ($1,250 × 6 months) .... Interest revenue (to balance) ........................................... Framm Interest receivable ($15,000,000 × 12% × 1/12)................. Premium on investment ($10,000 × 1 month × 15/30).... Interest revenue (to balance) ........................................... 2026 Jan. 1 Cash (10% × $16,000,000 × 6/12) ...................................... Interest receivable (from adjusting entry).....................

900,000 30,000 870,000

800,000 7,500 807,500

150,000 5,000 145,000

800,000 800,000

16–271

Problem 14–23 (continued) Feb. 28 Interest receivable (12% × $15,000,000 × 2/12)................. Premium on investment ($10,000 × 2 months × 15/30)... Interest revenue (difference)............................................ Cash ([102% × $15,000,000] + $150,000 + $300,000) .......... Loss on sale of investments ** ................................... Investment in bonds (face amount) ............................ Premium on investment in bonds * ........................ Interest receivable (12% × $15,000,000 × 3/12) .............

300,000 10,000 290,000 15,750,000 195,000 15,000,000 495,000 450,000

* $1,160,000 – $20,000 – $10,000 – $50,000 – $15,000 – $525,000 – $30,000 – $5,000 – $10,000 = $495,000, or [$1,160,000 × 99/116 × 15/30] = $495,000

** [$15,000,000 + $495,000] – [102% × $15,000,000]) = $195,000 Dec. 31 Accrued interest Interest receivable (10% × $16,000,000 × 6/12) ................. Discount on investment in bonds ($1,250 × 6 months) .... Interest revenue (to balance) ...........................................

16–272

800,000 7,500 807,500

Problem 14–23 (concluded) Requirement 2 2024 Interest revenue—Dec. 1 Interest revenue—Dec. 31 Interest revenue—Dec. 31 Increase in pretax earnings 2025 Interest revenue—June 1 Interest revenue—July 1 Interest revenue—Sept. 1 Loss on sale of investments Interest revenue—Dec. 1 Interest revenue—Dec. 31 Interest revenue—Dec. 31 Increase in pretax earnings 2026 Interest revenue—Feb. 28 Loss on sale of investments Interest revenue—Dec. 31 Increase in pretax earnings

580,000 807,500 290,000 $1,677,500

$1,450,000 807,500 435,000 (375,000) 870,000 807,500 145,000 $4,140,000

$290,000 (195,000) 807,500 $902,500

16–273

Problem 14–24 1. Liabilities on September 30, 2024 Bonds payable (face amount) ..................................... Less: discount ......................................................... Initial balance, March 1, 2024................................. June 30, 2024 discount amortization ....................... Sept. 30, 2024 discount amortization ...................... Sept. 30, 2024 net bonds payable ............................

$160,000,000 20,000,000 140,000,000 156,667 (1) 122,200 (2) $140,278,867

Interest payable ......................................................

$4,000,000 (3)

2. Interest expense for year ended September 30, 2024 June 30, 2024 interest expense ................................ September 30, 2024 interest expense ...................... Interest expense for fiscal 2024...............................

$5,490,000 (4) 4,122,200 (5) $9,612,200

3. Statement of cash flows for year ended September 30, 2024 Baddour would report the cash inflow of $140,000,000(6) from the sale of the bonds as a cash flow from financing activities in its statement of cash flows. The accrued interest portion of the cash receipt was paid on June 30 and is part of the cash outflow from operating activities (below). The $8,000,000 cash interest paid (7) is cash outflow from operating activities because interest is an income statement (operating) item.

16–274

Problem 14-24 (concluded) Calculations: March 1, 2024 Cash ($140(6) million plus accrued interest) ....................... 142,666,667 Discount on bonds payable (difference)..................... 20,000,000 Bonds payable (face amount) ................................. 160,000,000 Interest payable ($160 million × 10% × 2/12)............ 2,666,667 June 30, 2024 5,490,000(4) Interest expense (6% × $137,250,000 × 4/6) ................... Interest payable (balance) ......................................... 2,666,667 Discount on bonds payable (difference) ................. 156,667 (1) Cash (5% × $160,000,000)....................................... 8,000,000 (7) September 30, 2024 Interest expense (6% × [$137,250,000 + $156,667] × 3/6) 4,122,200 (5) Discount on bonds payable (difference) ................. 122,200 (2) Interest payable (5% × $160,000,000 × 3/6) .............. 4,000,000 (3)

16–275

Problem 14–25 Requirement 1 ($ in millions) Land ........................................................................... Gain on disposition of assets .................................. Notes payable ............................................................. Interest payable........................................................... Land ....................................................................... Gain on troubled debt restructuring.........................

3 3 20 2 16 6

Requirement 2 Analysis:

Book value: $20 million + $2 million = $22,000,000 Future payments: ($1 million × 4) + $15 million = 19,000,000 Gain to debtor $ 3,000,000 ($ in millions) (a) January 1, 2024 Interest payable........................................................... 2 Notes payable * .......................................................... 1 Gain on troubled debt restructuring......................... 3 * establishes a balance in the note account equal to the total cash payments under the new agreement ($20 million – $1 million = $19 million)

(b) December 31, 2024, 2025, 2026, and 2027 revised ―interest‖ payments Notes payable ............................................................. 1 Cash ....................................................................... 1 Note: No interest expense should be recorded after the restructuring. All subsequent cash payments result in reductions of principal.

(c) December 31, 2027 revised principal payment Notes payable ............................................................. Cash ..................................................................................

16–276

15 15

Problem 14–25 (continued) Requirement 3 Analysis:

Book value: Future payments: Interest

$20,000,000 + $2,000,000 = 27,775,000 $ 5,775,000

$22,000,000

Calculation of the new effective interest rate:

• $22,000,000 ÷ $27,775,000 = 0.79208—the Table 2 value for n = 4, i = ? • In row 4 of Table 2, the number 0.79209 is in the 6% column. So, this is the new effective interest rate. (a) January 1, 2024 [Since the total future cash payments are not less than the book value of the debt, no reduction of the existing debt is necessary, and no entry is required at the time of the debt restructuring.] Amortization Schedule (not required)

Dec.31

2024 2025 2026 2027

Cash Payment

Effective Interest 6% × Outstanding Balance

0 0 0 0

.06 (22,000,000) = 1,320,000

5,775,000

.06 (23,320,000) = 1,399,200 .06 (24,719,200) = 1,483,152 .06 (26,202,352) = 1,572,648*

Increase in Balance

Outstanding Balance

1,320,000 1,399,200 1,483,152 1,572,648

22,000,000 23,320,000 24,719,200 26,202,352 27,775,000

5,775,000

* rounded

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Problem 14–25 (concluded)

(b) December 31, 2024 Interest expense ................................................. Interest payable ..............................................

1,320,000

December 31, 2025 Interest expense ................................................. Interest payable ..............................................

1,399,200

December 31, 2026 Interest expense ................................................. Interest payable ..............................................

1,483,152

December 31, 2027 Interest expense ................................................. Interest payable ..............................................

1,572,648

(c) December 31, 2027 revised payment Interest payable ($2,000,000 + 4 years‘ interest above) Notes payable .................................................... Cash...............................................................

7,775,000 20,000,000

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1,320,000

1,399,200

1,483,152

1,572,648

27,775,000

DECISION MAKERS’ PERSPECTIVE Real World Case 14–1 Requirement 1 ($ in millions) Cash (price given) ...................................................... Discount on notes (difference)................................... Notes payable (face amount) ..................................

968 832 1,800

Requirement 2 ($ in millions) Fiscal Year-end 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Cash 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Interest Expense 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149 0.03149

(968) (998) (1,030) (1,062) (1,096) (1,130) (1,166) (1,203) (1,240) (1,280) (1,320) (1,361) (1,404) (1,449) (1,494) (1,541) (1,590) (1,640) (1,691) (1,745)

= = = = = = = = = = = = = = = = = = = =

30 31 32 33 35 36 37 38 39 40 42 43 44 46 47 49 50 52 53 55

Increase Outstanding in Balance Balance 968 30 998 31 1,030 32 1,062 33 1,096 35 1,130 36 1,166 37 1,203 38 1,240 39 1,280 40 1,320 42 1,361 43 1,404 44 1,449 46 1,494 47 1,541 49 1,590 50 1,640 52 1,691 53 1,745 55 1,800

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Case 14–1 (continued) Requirement 3 In a strict sense, zero-coupon debt pays no interest. ―Zeros‖ offer a return in the form of a ―deep discount‖ from the face amount. In fact, though, interest accrues at the effective rate (3.149% in this case) times the outstanding balance ($968 million during 1998), even though no interest is paid periodically. Interest on zero-coupon debt is determined and reported in precisely the same manner as on interest-paying debt. Under the concept of accrual accounting, the periodic effective interest is unaffected by when the cash actually is paid. Corporations can even deduct for tax purposes the annual interest expense. So, for 1998, HP Inc.‘s earnings were reduced by $30 million (.03149 × $968) and increased by the tax savings from being able to deduct the $30 million. If the tax rate was 35%, that savings would have been 35% × $30, or $10.5 million, and the net decrease in earnings would have been $19.5 million ($30 – $10.5). Requirement 4 From the amortization schedule, we can see that the book value of the debt at the end of 2002 was $1,130 million. Requirement 5 The journal entry HP Inc. used to record the early extinguishment of debt in 2002, assuming the purchase was made at the end of the year was: Notes payable (given) ............................................................ 257 Discount (calculated below) ................................................. Gain on the early extinguishment of debt (to balance) ........ Cash (given).......................................................................

96 34 127

Calculations: $257 ÷ $1,800 = 14.28% of notes were repurchased 14.28% × $1,130 (from schedule) = $161 million of notes repurchased $257 – $161 = $96 million discount on notes repurchased

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Case 14–1 (concluded) Requirement 6 The journal entry HP Inc. used to record the extinguishment of debt at its 2017 maturity would be: Notes payable .................................................... 1,800 Cash .............................................................. 1,800

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Analysis Case 14–2 Requirement 1 Higher. The notice is being placed by the four underwriters listed at the bottom of the notice. The purpose is to announce the sale of the bonds described. Actually, the sale by Craft Foods already has occurred at this point. The underwriters resell the securities to the investing public. These are 10-year bonds. The stated rate of interest is 7.75%, but the bonds are priced to yield a higher rate, which accounts for the fact they are offered at a discount, 99.57% of face value. In practice, debt securities rarely are priced at a premium in their initial offering. The reason is primarily a marketing consideration. It‘s psychologically more palatable for a security salesperson to approach a customer with an issue that is offered at a discount from its face value and that provides a return greater than its stated rate than one that is priced above its face value and provides a return less than its stated rate. Requirement 2 The accounting considerations for Craft Foods are to recognize the liability and related debt issue costs, as well as to record interest expense semiannually over the 10-year term to maturity at the effective rate of interest. The bonds were issued at their selling price: $750,000,000 × 99.57 = $746,775,000 (Bonds payable at face, discount of $3,225,000). Craft Foods also recorded the debt issue costs by combining them with the discount on the debt. The combined valuation account was reported in the balance sheet as a direct deduction from the liability and then amortized over the life of the debt (probably straight line). Because the sale by Craft Foods to the underwriters occurred on an interest date, there was no accrued interest. Any accrued interest would have been recorded as interest payable to be paid at the first interest date as part of the first semiannual interest payment. Issuance of the bonds Cash ([$750,000,000 × 99.57] – $75,000) ..................................... 746,700,000 Discount and debt issue costs ($3,225,000 + $75,000) ................ 3,300,000 Bonds payable (face amount)....................................... 750,000,000

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Judgment Case 14–3 Obviously, no rational lender will lend money without interest. The zero-interest loan described actually does implicitly bear interest. The amount and rate of interest can be inferred from either the market rate of interest at the time for this type of transaction or from the fair value of the asset being sold. The case information provides no information about either, other than that the stated price of the asset is higher than prices for this model Mr. Wilde had seen elsewhere. Requirement 1 If we knew that the market rate of interest at the time for this type of transaction is 8%, we would assume that‘s the effective interest rate and could calculate the price of the equipment as follows: $17,000

x 10.57534

installment payment

(from Table 4) n = 12, i = 2.0%

$179,781 actual price

Both the asset acquired, and the liability used to purchase it should be recorded at the real cost, $179,781.

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Case 14–3 (concluded) Requirement 2 If we know the cash price of the equipment is $185,430, then we could calculate the effective rate of interest as follows: The discount rate that ―equates‖ the present value of the debt ($185,430) and the installment payments ($17,000) is the effective rate of interest: $185,430 ÷ $17,000 = 10.9076: the Table 4 value for n = 12, i = ? In row 12 of Table 4, the value 10.90751 is in the 1.5% column. Since payments are quarterly, this equates to a 1.5 × 4 = 6% annual rate. So, 6% is the effective interest rate. A financial calculator will produce the same rate. In any case, Mr. Wilde will not avoid interest charges with this offer. Interest expense must be recorded at the effective rate, 8% in our first scenario, and 6% in the second.

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Judgment Case 14–4 Requirement 1 Although not specifically discussed in the chapter, concepts studied in this and other chapters provide the logic for addressing the situation described. The company's accountant is incorrect in valuing the note at $200,000. The note should be valued at the present value of the receivable using the prevailing market rate and the difference between the present value and the cash given is regarded as an addition to the cost of products purchased during the contract term. In this case, the note would be valued at $136,602, computed as follows: PV = $200,000 × .68301 PV of $1: n = 4, i = 10% (from Table 2)

PV = $136,602 The journal entry to record the initial transaction is as follows:

Notes receivable (above)................................ Prepaid inventory (difference) ....................... Cash...........................................................

136,602 63,398 200,000

Requirement 2 Interest revenue is recognized over the four-year life of the note using the effective interest rate of 10%. Accrued interest will increase the receivable valuation to $200,000. Prepaid inventory is credited, and inventory is debited as inventory is purchased, thus increasing the cost of inventory from the prices paid to market value. The journal entry to record the receipt of 25,000 inventory units is as follows:

Inventory (market value: $26.60 × 25,000) ........... Prepaid inventory (difference) ................... Cash...........................................................

665,000 15,000 650,000

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Judgment Case 14–5 Requirement 1 The debt to equity ratio is computed by dividing total liabilities by total shareholders' equity. The ratio summarizes the capital structure of the company as a mix between the resources provided by creditors and those provided by owners. For example, a ratio of 2.0 means that twice as many resources (assets) have been provided by creditors as those provided by owners. Debt to equity ratio

Total liabilities Shareholders' equity

$2,414 $2,931

0.82 Industry average = 1.0

Requirement 2 In general, debt increases risk. Debt places owners in a subordinate position relative to creditors because the claims of creditors must be satisfied first in case of liquidation. In addition, debt requires payment, usually on specific dates. Failure to pay debt interest and principal on a timely basis may result in default and perhaps even bankruptcy. Other things being equal, the higher the debt to equity ratio, the higher the risk. The type of risk this ratio measures is called default risk because it presumably indicates the likelihood a company will default on its obligations. AGF‘s debt to equity ratio is not particularly high—in fact, it‘s less than the 1.0 industry average. Other things being equal, AGF appears to have lower default risk than others in its industry.

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Case 14–5 (continued)

Requirement 3 Debt also can be used to enhance the return to shareholders. This concept is known as leverage. If a company earns a return on borrowed funds in excess of the cost of borrowing the funds, shareholders are provided with a total return greater than what could have been earned with equity funds alone. This desirable situation is called ―favorable financial leverage.‖ Unfortunately, leverage is not always favorable. Sometimes the cost of borrowing the funds exceeds the returns they generate. This illustrates the typical risk-return tradeoff faced by shareholders. AGF has experienced favorable leverage, as demonstrated by calculating and comparing the return on assets and the return on shareholders‘ equity for 2024: Rate of return on assets

Rate of return on shareholders' equity

Net income Average total assets

$487 [$5,345 + $4,684] ÷ 2

9.7%

Net income Average shareholders' equity

$487 [$2,931 + $2,671] ÷ 2

17.4%

The debt to equity ratio is not particularly high, but the debt the company does have has been used to shareholders‘ advantage. The return on equity is greater than the return on assets. In fact, it may be that debt is being underutilized by AGF. More debt might increase the potential for return, but the price would be higher risk. This is a fundamental tradeoff faced by virtually all firms when trying to settle on the optimal capital structure.

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Case 14–5 (concluded) Requirement 4 Creditors generally demand interest payments as compensation for the use of their capital. Failure to pay interest as scheduled may cause several adverse consequences, including bankruptcy. Therefore, another way to measure a company's ability to pay its obligations is by comparing interest payments with cash flow generated from operations. The times interest earned ratio does this by dividing income before subtracting interest expense or income tax expense by interest expense. Times interest earned =

Net income + interest + taxes Interest

$487 + $54 + $316 $54

15.9 times Industry average = 5.1 times

Two points about this ratio are important. First, because interest is deductible for income tax purposes, income before interest and taxes is a better indication of a company's ability to pay interest than is income after interest and taxes (i.e., net income). Second, income before interest and taxes is a rough approximation for cash flow generated from operations. The primary concern of decision makers is, of course, the cash available to make interest payments. In fact, this ratio often is computed by dividing cash flow generated from operations by interest payments. Requirement 5 AGF appears to have higher interest coverage than others in its industry. AGF‘s fixed charges are covered over 15 times, far exceeding the industry norm. The interest coverage ratio seems to indicate an ample safety cushion for creditors, particularly when considered in conjunction with their debt-equity ratio. There seems also to be considerable room for additional borrowing in the event the firm wanted to increase its leverage in an attempt to further enhance the return to shareholders.

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Real World Case 14–6 Requirement 1 The following is from Macy‘s annual report: February 1,

February 2,

2020

2019

($ in millions)

Total current liabilities Long-term debt Long-Term Lease Liabilities Deferred income taxes Other noncurrent liabilities Total liabilities

$ 5,750 3,621 2,918 1,169 1,337 $14,795

$ 5,232 4,708 -1,238 1,580 $12,758

Total debt has increased by about 16%. Requirement 2 Total debt Shareholders‘ equity

$14,795 6,377

$12,758 6,436

Total debt Shareholders‘ equity

$14,795 $6,377

$12,758 $6,436

2.32

1.98

Ratio

The debt to equity ratio in 2020 is about 17% higher than in 2019.

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Case 14–6 (concluded) Requirement 3 The vast majority is in the form of notes.

Requirement 4 No discernable pattern. From Note 6: Financing: Aggregate required payments of maturities of long-term debt for the next five fiscal years are as follows: Dollars in Millions

2021

2022

2023

2024

2025

Required payments

$453

$ ---

$850

$622

$24

After a $453 million payment in 2021, none is payable in 2022. Then a dramatic increase in 2023, followed by an erratic decrease over the next two years.

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Analysis Case 14–7 Requirement 1 No gain or loss. Earnings are not affected by conversion under the book value method. Requirement 2 Loss. A gain or loss is recorded, and thus earnings are affected by conversion if the market value method is used assuming the market value differs from the book value of the convertible bonds. In this case, the $6 million fair value of the common stock is higher than the book value of the bonds because the book value would be some amount less than the face amount of. A loss would be recorded for the difference, reducing earnings. Requirement 3 Discount. The 7% bonds were issued at a discount (less than face amount). We know this because the stated rate was less than the prevailing or market rate for bonds of similar risk and maturity at the time the bonds were issued. Thus, the bonds would have to be sold at a discount for them to yield 8%. Requirement 4 Higher. The amount of interest expense would be higher in the second year of the term to maturity than in the first year of the life of the bond issue. That‘s because the 8% effective interest rate is applied to an increasing bond book value, and results in higher interest expense in each successive year Requirement 5 Loss. We determine gain or loss on early extinguishment of debt by comparing the book value of the bonds at the date of extinguishment with the purchase price. If more is paid than the book value, a loss results. If less is paid than the book value, a gain results. In this case, a loss results. The bonds were issued at a discount so the book value of the bonds at the date of extinguishment must be less than the face amount. Thus, the reacquisition price is more than the book value.

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Requirement 1 Explanation: Arguments Supporting View 1: 1. Those who favor accounting for convertible debt as entirely a liability until it is either converted or repaid argue that a convertible bond offers the holder two mutually exclusive choices. The holder cannot both redeem the bond for cash at maturity and convert it into common stock. They contend that the accounting before conversion or other settlement should reflect only the issuer's current position as a borrower and the holder's current position as a creditor. Until the conversion option is exercised, the bondholder is entitled to receive, and the enterprise is obligated to pay, only the periodic interest payments. If the option has not been exercised at the date the bonds mature, the issuer is obligated to pay the face amount, not to issue stock to the holder. Advocates of accounting for convertible debt according to its governing characteristics argue that a convertible bond is a single instrument, not two. To account for it as two instruments would not be representationally faithful.

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Case 14–8 (continued) 2. Supporters of the first alternative generally also are concerned about the ability to measure reliably the components of convertible debt because neither is separately traded. They conclude that because the market does not determine a separate value for the conversion option, any value attributed to it would be subjective. The original pronouncement cited "the uncertain duration of the right to obtain the stock and the uncertainty as to the future value of the stock obtainable upon conversion" as factors further complicating valuation of the conversion option. Supporters of that view argue that factors other than the conversion feature typically affect the pricing of convertible debt and therefore may complicate an attempt to allocate the proceeds from issuance between the straight debt and the conversion feature. For example, convertible bonds generally have covenants that are less restrictive than those for nonconvertible bonds on matters such as issuing more debt, maintaining specified financial ratios, paying large dividends on common stock, and establishing sinking funds. Less restrictive covenants may result in some reduction in market value and a corresponding increase in yield, which would complicate valuing the debt component of a convertible bond by comparing it with nonconvertible bonds with similar terms issued by enterprises with comparable credit ratings. Moreover, no cash payment from holder to issuer is required when a convertible bond is converted; the bond itself represents the consideration received by the issuing enterprise for the stock into which the bond is converted. Thus, the price paid by the holder upon conversion effectively depends on the market price of the bond at the time of conversion. Those who would account for convertible debt as entirely a liability argue that the absence of a fixed cash price for which a bondholder obtains an equity interest complicates an attempt to value the straight debt and conversion feature components.

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Case 14–8 (concluded) Requirement 2 Explanation: Arguments Supporting View 2: Those who favor separate recognition of the liability and equity components of convertible debt argue that to ignore the existence of the conversion feature in recognizing the issuance of the bond results in overstating the liability and understating the interest expense. The effect of the conversion feature is to lower the rate for otherwise comparable straight debt. Supporters of separate accounting contend that accounting for convertible debt as entirely a liability impairs comparability between enterprises. If convertible debt is reported as entirely a liability, an enterprise with a relatively high credit rating that issues nonconvertible debt appears to have a higher cost of borrowing than a company with a lower credit rating that issues convertible debt because inclusion of the conversion feature lowers the nominal interest rate significantly. Those who support separate recognition of the liability and equity components of convertible debt argue that accounting for a convertible bond as if it were entirely a debt instrument fails to recognize and display appropriately the obligation to issue stock, that is, the option embedded in convertible debt. The conversion feature has essentially the same economic value as the call on stock represented by a separately traded call option or warrant. The fact that the conversion feature cannot be sold separately does not justify ignoring its existence.

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Research Case 14–9 Requirement 1 ($ in millions) Cash (proceeds given in Note 10).................................. Discount on bonds payable ($125.0 – $117.2) ............ Bonds payable (given in Note 10) ...................... Equity—conversion option (given in Note 10)…

118.3 7.8 125.0 1.1

Requirement 2 In a strict sense, zero-coupon debt pays no interest. ―Zeros‖ offer a return in the form of a ―deep discount‖ from the face amount. In fact, though, interest accrues at the effective rate (1.85% in this case) times the outstanding balance ($118.3 – 1.1 = $117.2 million) during the first fiscal year), even though no interest is paid periodically. Interest on zero-coupon debt is determined and reported in precisely the same manner as on interest-paying debt. Under the concept of accrual accounting, the periodic effective interest is unaffected by when the cash actually is paid. Corporations can even deduct for tax purposes the annual interest expense. So, for the first year, MGC recorded interest expense of $2.17 million (.0185 × $117.2 = $2,168). Amortization schedule (not required): Year

Cash

1 2 3

0 0 0

Interest Expense 0.0185 (117,200) = 0.0185 (119,368) = 0.0185 (121,576) =

2,168 2,208 2,249

Increase in Balance 2,168 2,208 2,249

Outstanding Balance 117,200 119,368 121,576 123,825

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Research Case 14–9 (concluded) Requirement 3 FASB ASC 470–20–25–22: ―Debt–Debt with Conversion and Other Options– Recognition– Liability and Equity Components.‖ This is the codification of FASB Staff Position (FSP 14–1): Liability and Equity Components 25-22 The liability and equity components of a convertible debt instrument within the scope of the Cash Conversion Subsections shall be accounted for separately. Recognition of a convertible debt instrument within the scope of the Cash Conversion Subsections is not addressed by paragraph 470-20-25-12. 25-23 The issuer of a convertible debt instrument within the scope of the Cash Conversion Subsections shall do both of the following:  a.

First, determine the book value of the liability component in accordance with the guidance in paragraph 470-20-30-27.  b. Second, determine the book value of the equity component represented by the embedded conversion option in accordance with the guidance in paragraph 470-20-30-28. MGC‘s note states that ―Because the convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the notes.‖ As indicated in the ―Where We‘re Headed‖ box in the chapter, a pre-Codification FASB Staff Position (FSP 14–1; codified as FASB ASC 470–20–25–22) indicates that for a limited subset of convertible securities not within the scope of current GAAP—those that could possibly be settled in cash rather than shares—companies must divide the proceeds from convertible securities into its two components and record the fair value of the debt as a liability and the conversion option in an equity account. As an aside, international standards already require that convertible debt be divided into its liability and equity elements.

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Communication Case 14–10 The critical Question that student groups should address is the valuation of the note receivable. In this case, there is a correct answer. The note should be valued at the present value of $300,000 using the appropriate market rate of interest. The difference between present value and the $300,000 should be accounted for by Pastel as prepaid advertising. Interest revenue over the life of the note will be recognized using the effective rate. As advertising services are provided by the radio station, advertising expense is debited, and prepaid advertising credited. It is important that each student actively participate in the process of arriving at a solution. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction.

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Communication Case 14–11 Suggested Grading Concepts and Grading Scheme: Content (80%) 20 Convertible bonds Entire proceeds of the bond issue should be allocated to the debt and the related premium or discount accounts. 20 Bonds with detachable warrants Proceeds should be allocated between debt and warrants. Basis of allocation is their relative fair values. Relative values are usually determined by the price at which the respective instruments are traded in the open market. Portion of the proceeds assigned to the warrants should be accounted for as equity. 20 Reasons why all the proceeds of convertible bonds should be allocated to the debt The option is inseparable from the debt: no way to retain one right while selling the other. The valuation presents practical problems: would be subjective. 20 Arguments that accounting for convertible debt should be the same as for debt issued with detachable stock purchase warrants Convertible debt has features of both debt and shareholders‘ equity, and separate recognition should be given to the fundamental elements at the time of issuance. Difficulties in separating the relative values of the features are not insurmountable. Bonus (5) Other relevant arguments not mentioned above 80–85 points Writing (20%) 5 Terminology and tone appropriate to the audience (CFO). 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English. Word selection. Spelling. Grammar. 20 points

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You may wish to suggest to your students that they consult the FASB 1990 Discussion Memorandum, “Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both,” which sets forth the most common arguments on the issues in this case. Or, you may prefer that they think for themselves and approach the issue from scratch. There is no right or wrong answer. Both views can and often are convincingly defended. The process of developing and synthesizing the arguments likely will be more beneficial than any single solution. Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Arguments brought out in the FASB DM include the following: Arguments Supporting View 1: 1. Those who favor accounting for convertible debt as entirely a liability until it is either converted or repaid argue that a convertible bond offers the holder two mutually exclusive choices. The holder cannot both redeem the bond for cash at maturity and convert it into common stock. They contend that the accounting before conversion or other settlement should reflect only the issuer's current position as a borrower and the holder's current position as a creditor. Until the conversion option is exercised, the bondholder is entitled to receive, and the enterprise is obligated to pay, only the periodic interest payments. If the option has not been exercised at the date the bonds mature, the issuer is obligated to pay the face amount, not to issue stock to the holder. Advocates of accounting for convertible debt according to its governing characteristics argue that a convertible bond is a single instrument, not two. To account for it as two instruments would not be representationally faithful. 2. Supporters of the first alternative generally also are concerned about the ability to measure reliably the components of convertible debt because neither is separately traded. They conclude that because the market does not determine a separate value for the conversion option, any value attributed to it would be subjective. The original pronouncement cited "the uncertain duration of the right to obtain the stock and the uncertainty as to the future value of the stock obtainable upon conversion" as factors further complicating valuation of the conversion option. 3. Supporters of that view argue that factors other than the conversion feature typically affect the pricing of convertible debt and therefore may complicate an attempt to allocate the proceeds from issuance between the straight debt and the conversion feature. For example, convertible bonds generally have covenants that are less restrictive than those for nonconvertible bonds on matters such as issuing more debt, maintaining specified financial ratios, paying large dividends on common stock, and establishing sinking funds. Less restrictive covenants may result in some reduction in market value and a corresponding increase in yield, which would complicate valuing the debt component of a convertible bond by comparing it with nonconvertible bonds with similar terms issued by enterprises with comparable credit ratings. 4. Moreover, no cash payment from holder to issuer is required when a convertible bond is converted; the bond itself represents the consideration received by the issuing enterprise for the stock into which the bond is converted. Thus, the price paid by the holder upon conversion effectively depends on the market price of the bond at the time of conversion. Those who would account for convertible debt as entirely a liability argue that the absence of a fixed cash price for which a bondholder obtains an equity interest complicates an attempt to value the straight debt and conversion feature components.

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Arguments Supporting View 2: 1. Those who favor separate recognition of the liability and equity components of convertible debt argue that to ignore the existence of the conversion feature in recognizing the issuance of the bond results in overstating the liability and understating the interest expense. The effect of the conversion feature is to lower the rate for otherwise comparable straight debt. 2. The higher interest expense recognized if the components are separately recognized than if all of the proceeds of issuance are recorded as a liability reflects the fact that an enterprise that issues debt at less than its face amount pays an effective interest rate that is higher than the coupon rate. The lower reported interest expense that results if the convertible debt is accounted for as entirely a liability leads those who support separate accounting to argue that failure to attribute a portion of the proceeds to the conversion option, thereby overstating the amount of the enterprise's liability, does not faithfully represent the economics of the transaction between the enterprise and the bondholder. 3. Supporters of separate accounting contend that accounting for convertible debt as entirely a liability impairs comparability between enterprises. If convertible debt is reported as entirely a liability, an enterprise with a relatively high credit rating that issues nonconvertible debt appears to have a higher cost of borrowing than a company with a lower credit rating that issues convertible debt because inclusion of the conversion feature lowers the nominal interest rate significantly. 4. Those who support separate recognition of the liability and equity components of convertible debt point to the different values assigned by the market to convertible and nonconvertible debt with like terms as evidence of the inherent value of the conversion feature. They argue that accounting for a convertible bond as if it were entirely a debt instrument fails to recognize and display appropriately the obligation to issue stock, that is, the option embedded in convertible debt. The conversion feature has essentially the same economic value as the call on stock represented by a separately traded call option or warrant. The fact that the conversion feature cannot be sold separately does not justify ignoring its existence. 5. In the 21 years since the original pronouncement, Opinion 14, was issued (to the date of this literature), the idea that many financial instruments may be broken down into more fundamental components, which then may be traded separately, has been embraced by the Wall Street community. The cash flows from instruments that have generally not been thought of as containing different components, such as government bonds, have been unbundled and recombined. Those who support separate accounting for the fundamental components of convertible debt argue that separate accounting would be consistent with the current economic environment. They contend that it is neither necessary nor appropriate to wait until the components of a financial instrument like convertible debt, which so obviously has both liability and equity characteristics, are physically separated to give accounting recognition to the existence of the separate components.

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Ethics Case 14–12 Discussion should include these elements. Facts: Inducing a bond conversion is a common method of indirectly issuing stock, though typically not for the purpose of enhancing profits. Reported performance will increase. Company managers stand to benefit from the change. Ethical Dilemma: Should Hunt Manufacturing enter into these transactions primarily for ―window dressing‖ rather than for economic reasons? Who is affected? Meyer Barr Other managers Bondholders Hunt‘s auditors Shareholders Potential shareholders The employees Other creditors

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DAT TARGET CASE Requirement 1 We compute the debt to equity ratio by dividing a company‘s total liabilities by total shareholders' equity. The ratio summarizes the capital structure of the company as a mix between the resources provided by creditors and those provided by owners. For instance, a ratio of 2.0 means that twice as many resources (assets) have been provided by lenders as those provided by owners. Debt to equity ratio

Total liabilities Shareholders' equity

$14,487 + $16,459 $11,833

2.62 Industry = 1.95

Generally, debt increases risk. Debt places owners in a subordinate position relative to creditors because the claims of creditors must be satisfied first in case of liquidation. Moreover, debt requires payment, usually on specific dates. Failure to pay debt interest and principal on a timely basis may result in default and perhaps even bankruptcy. So, other things being equal, the higher the debt to equity ratio, the higher the risk. The type of risk this ratio measures is called default risk because it essentially indicates the likelihood a company will default on its obligations. Target‘s debt to equity ratio is somewhat higher than the industry sector average. On the other hand, debt also can be an advantage. It can be used to enhance the return to shareholders. This concept is known as leverage. When the return on borrowed funds is in excess of the cost of borrowing the funds, shareholders are provided with a total return greater than what could have been earned with equity funds. (This, in fact, is the case for Target whose return on equity for 2020 is 28%, far in excess of its return on assets of 8%.)

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Target Case (concluded) Requirement 2 Lenders demand interest payments as compensation for the use of their capital. Inability to pay interest as scheduled may cause several adverse consequences, including bankruptcy. Thus, another way to measure a company's ability to pay its obligations is by comparing interest payments with cash flow available to pay those obligations. The times interest earned ratio does this by dividing income before subtracting interest expense or income tax expense by interest expense. Times interest earned

Net income + interest + taxes Interest

$3,281 + $477 + $921 $477

9.8 times Industry = 6.5 times

Note a couple of points about this ratio. First, because interest is deductible for income tax purposes, income before interest and taxes is a better indication of a company's ability to pay interest than is income after interest and taxes (i.e., net income). Second, income before interest and taxes is a rough approximation for cash flow generated from operations. The primary concern of decision makers is, of course, the cash available to make interest payments. In fact, this ratio often is computed by dividing cash flow generated from operations by interest payments. Target‘s fixed charges are covered almost 10 times, quite a bit higher than the industry norm. The interest coverage ratio seems to indicate an ample safety cushion for creditors.

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Air France-KLM Case Requirement 1 From Note 31.3 OCEANE, we see that in March 2019, Air France issued convertible bonds maturing in 7 years. The conversion option allows for conversion and/or exchange at any time into new or existing Air France-KLM shares. 27,901,785 bonds were issued. Each bond has a nominal value of €17.92, so the nominal value of the bonds was €500 million. ―Upon issue of this convertible debt, Air France-KLM recorded a debt of €446 million, corresponding to the present value of future payments of interest and face amount discounted at the rate of a similar bond without a conversion option.‖ The option value was evaluated by deducting this debt value from the total nominal amount (i.e., €500 million) and was recorded in equity in keeping with IFRS. Under IFRS, convertible debt is divided into its liability and equity elements. We achieve separation by measuring the fair value of a similar liability that does not have an associated equity component. Air France determined the effective interest rate that bonds similar in all respects, except that they are nonconvertible, would sell for. Using that rate as the discount rate, AF determined the present value of future payments of interest and principal (nominal) discounted at the rate of a similar bond without a conversion option to be €446 million. The liability-first separation gives us the following entry:

Cash (amount given) Convertible bonds payable (similar bond

(€ in millions) 500 446 54

value without a conversion option, amount given)

Equity—conversion option (to balance) Requirement 2

Under U.S. GAAP, the entire issue price of convertible debt is recorded as debt: Cash (given) Convertible bonds payable (face amount) 16–304

500 500 Intermediate Accounting, 11/e

Air France (concluded) Requirement 3

If AF had elected the FVO for all of its debt measured at amortized cost, the fair value adjustment account would have a December 31, 2019, debit balance of €68 million, the difference between the €1,586+ €541 + €1,955 = €4,082 million net book value and the €1,659 + €489 + €2,002 = €4,150 million fair value.

Chapter 15 Leases QUESTIONS FOR REVIEW OF KEY TOPICS

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Question 15306When a lessee returns a leased asset at the end of the lease term little effort or cost is required. For example, when a company no longer needs a building it‘s leased, the company simply moves out. Likewise, after renting a car for the week, the renter simply returns the car to the rental company. On the other hand, selling an asset that‘s been previously purchased usually isn't that easy. Some unique assets might not have an available market in which used items can be easily sold. Selling an asset also might require substantial costs. For instance, many realtors charge up to 6% to sell a home or office building.

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Question 15-2 Regardless of the legal form of the agreement, a lease is accounted for as either a rental agreement or a purchase/sale accompanied by debt financing depending on the substance of the leasing arrangement. Finance leases are agreements that are formulated outwardly as leases, but that are in essence installment purchases. Professional judgment is needed to differentiate between leases that represent ―rental agreements‖ and those that in essence are ―installment purchases/sales.‖ The FASB provides guidance for distinguishing between the two fundamental types of leases.

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Question 15308Periodic interest expense is calculated by the lessee as the effective interest rate times the amount of the outstanding lease payable during the period. This same principle applies to the flip side of the transaction, i.e., the lessor‘s lease receivable (net investment). The approach is the same regardless of the specific form of the debt – that is, whether in the form of notes, bonds, leases, pensions, or other debt instruments.

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Question 15310Finance leases and installment notes are very similar. The fundamental nature of the transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease. In return for providing financing, the borrower (lessee) pays interest over the maturity (lease term). Conceptually, finance leases and installment notes are accounted for in precisely the same way.

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Question 15-5 The criteria are: (1) the agreement specifies that ownership of the asset transfers to the lessee, (2) the agreement contains a purchase option that is reasonably certain to be exercised, (3) the lease term is equal to the major part of the expected economic life of the asset, (4) the present value of the lease payments is equal to or greater than substantially all of the fair value of the leased asset, or (5) the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

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Question 15312The lease is a finance lease to Seminole because the present value of the lease payments ($5.2 million) is greater than substantially all of the fair value of the asset ($5.2 million / $5.6 million = 93%). Furthermore, it is a sales-type lease to Lukawitz for the same reason and, because the present value of the lease payments exceeds the lessor‘s cost, it‘s a sales-type lease with a selling profit.

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Question 15-7 When accounting for a finance/sales-type lease, as lease payments are made over the term of the lease, the lessee records interest expense and the lessor records interest revenue at the effective interest rate. The lessee also records amortization expense on its right-of-use asset over the term of the lease. Because the lessor removes the asset from its books at the beginning of the lease, it would not record depreciation.

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Question 15-8 Sometimes, the lessor earns an immediate profit from the lease transaction in addition to the interest revenue earned over the term of the lease. Usually, the lessor in this type of agreement is a manufacturer or a merchandiser that is using the lease as a means of ―selling‖ its product. In addition to interest revenue earned over the lease term, the lessor receives a profit on the ―sale‖ of the asset. This selling profit exists when the fair value of the asset, usually the present value of the lease payments, or ―selling price,‖ exceeds the cost or carrying value of the asset transferred to the lessee. We account for this type of lease the same as for others except for recognizing the profit at the beginning of the lease. Most companies when recording this profit will record a credit to sales revenue for the present value of the lease payments, or ―selling price,‖ and a debit to cost of goods sold for the cost or carrying value of the asset transferred to the lessee in place of the profit.

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Question 15-9 Even when the risks and rewards of ownership are not transferred to the lessee, the lessee acquires the right to use the asset and will record a right-of-use asset and lease liability for the present value of the payments (just as in a finance lease).

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Question 15-10 In an operating lease, the lessor records no lease receivable and does not remove from its balance sheet the asset being leased. So, it records no asset, or anything that affects the balance sheet other than accumulated depreciation on the asset that stays on the books because it‘s an operating lease.

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Question 15-11 When accounting for an operating lease, both the lessee and lessor report total lease expense (lessee) and lease revenue (lessor) on a straight-line basis. The lessor, having recorded no entry affecting its balance sheet at the beginning of the lease, simply records lease payments as lease revenue on a straight-line basis. The lessor continues to record depreciation on the asset being leased, which the lessor continues to report on its balance sheet in an operating lease. The lessee reports its total lease expense on a straight-line basis over the term of the lease. This is accomplished by determining interest the normal way (at the effective interest rate) and then ―plugging‖ the right-of-use asset amortization at whatever amount is needed to cause interest plus amortization to equal the straightline lease payment amount. Those two components (interest and amortization) comprise a single lease expense amount reported in the income statement.

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Question 15-12 The right to use a leased asset can provide the lessee with a significant benefit. The lessee reports this benefit as a right-of-use asset in its balance sheet. Similarly, the obligation to make the lease payments can be a significant liability that the lessee also reports in its balance sheet.

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Question 15-13 In a finance lease, the lessee records more expense and the lessor records more revenue early in the life of the lease. This ―front loading‖ of lease expense and revenue occurs due to the fact that interest is higher initially than it is in the later stages of a lease (constant interest rate times a declining lease balance), while amortization expense for the lessee‘s right-of-use asset remains the same straight-line amount each period. This ―front loading‖ is avoided in an operating lease because both the lessee and lessor report total lease expense (lessee) and interest revenue (lessor) on a straight-line basis. The lessee reports its total lease expense on a straight-line basis over the term of the lease. This is accomplished by determining interest the normal way (at the effective interest rate) and then ―plugging‖ the right-of-use asset amortization at whatever amount is needed for interest plus amortization to equal the straight-line lease payment. The lessor, having recorded no entry affecting its balance sheet at the beginning of the lease, simply records lease payments as lease revenue on a straightline basis. (The lessor continues to record depreciation on the asset that it does not remove from its records in an operating lease.)

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Question 15-14 The lessor’s discount rate is the effective interest rate the lease payments provide the lessor over and above the ―price‖ at which the right to use the asset is ―sold‖ under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the lease payments.

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In its calculations, the lessee uses same rate the lessor uses if it is known to the lessee. This is the rate implicit in the lease agreement. In other words, it‘s the desired rate of return the lessor has in mind when deciding the size of the lease payments, the rate the lessor charges the lessee. If that rate is unknown to the lessee, the lessee uses its own incremental borrowing rate, which is the rate that the lessee would have to pay to borrow over a similar term the funds needed to purchase an asset of a similar value to the right-of-use asset. ―Incremental‖ refers to the fact that lending institutions tend to view debt as being increasingly risky as the level of debt increases. Thus, additional (i.e., incremental) debt is likely to be loaned at a higher interest rate than existing debt, other things being equal.

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Question 15-15 When a lessee has a short-term lease it‘s acceptable to use a short-cut approach and forego recording the right-of-use asset and the lease payable. The lessee simply recognizes lease payments as expense over the lease term.

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Answers to Questions (continued)

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Question 15-16 Contingent rentals are not included in lease payments but are reported in disclosure notes by both the lessor and lessee. This is because they are not determinable at the beginning of the lease. They are included as components of income when (and if) the payments occur. Two exceptions to excluding variable payments are:  When apparent ―variable‖ payments actually are fixed payments in disguise, these in-substance fixed payments are considered as part of the lease payments.  When the variation in the lease payments depends on an index or a rate, the Consumer Price Index or current market rate of interest, for example. However, changes in payments due to changes in the index or rate affect the lease liability and right-of-use asset only when the lease liability is remeasured for some other reasons (for instance, due to a change in the lease term).

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Question 15-17 A purchase option is a provision in a lease contract that gives the lessee the option to purchase the leased property at a specified exercise price. If that price is sufficiently lower than the expected fair value of the property when the option becomes exercisable that the exercise of the option appears reasonably certain at the beginning of the lease, then transfer of ownership is expected and the lease would be considered a finance lease. Also, the exercise price would be part of the lease payments for both the lessee and lessor, influencing the amount recorded as a right-of-use asset, lease liability, and lease receivable. Furthermore, the lease term would be considered ended at the time the option becomes exercisable.

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Answers to Questions (continued)

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Question 15-18 Sometimes the actual term of a lease is not obvious. In these situations, we need to decide whether the lessee is ―reasonably certain‖ to exercise any renewal, purchase, or termination options. If so, both the lessee and lessor adjust the lease term accordingly. Otherwise, they use the contractual lease term.

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Question 15-19 The lease term will be 8 years. The lease term for both the lessee and the lessor is the contractual lease term modified by any renewal or termination options for which exercise is ―reasonably certain‖. The first three-year renewal option can be exercised for one-half the original and usual rate, which implies that the lessee is ―reasonably certain‖ to extend the original lease term to 8 years.

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Answers to Questions (continued)

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Question 15-20 Several situations cause us to remeasure a lease liability (and right-of-use asset). In each case, we compare the remeasured liability with its current balance to see the adjustment needed, calculating the new amount as the present value of the remaining lease payments: Present value of remaining payments Liability balance (current) Increase in balance

$xxx xxx $xxx

Situations requiring remeasurement of the lease liability are when there is a change in the assessment of:  the lease term.  whether exercise of a purchase or termination option is reasonably certain.  any cash payment due to a guaranteed residual value.  whether a variable payment is now a fixed payment. or, when there is a modification of the terms of the lease not accounted for as a new lease. We reassess (a) the lease term or (b) whether exercise of a purchase or termination option is reasonably certain only when some new event, like a leasehold improvement, triggers a reassessment. In those two situations, as well as when there‘s a modification of the terms of the lease, the discount rate used in the present value calculation is updated from the rate used at the beginning of the lease to the rate current at remeasurement.

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Answers to Questions (continued)

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Question 15-21 If a cash payment under a lessee-guaranteed residual value is predicted (because the lessee-guaranteed residual value exceeds the estimate of the actual residual value), the present value of that payment is added to the present value of the lease payments that the lessee records as both a right-of-use asset and a lease liability. Similarly, in addition to the present value of the residual value (residual asset), the expected cash payment also adds to the amount that the lessor records as a lease receivable (as part of its net investment in the lease).

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Question 15-22 If a purchase option is reasonably certain to be exercised, the exercise price is included as a component of lease payments. A lessee-guaranteed residual value is not included as a component of lease payments unless the amount guaranteed exceeds the estimated fair value at the end of the lease. In that case, though, the excess lesseeguaranteed residual value is treated precisely the same way that the reasonably certain exercise price is treated. The expectation that the option price will be paid effectively adds an additional cash flow to the lease. The same is true for the expectation that a cash payment will be made due to a lessee-guaranteed residual value. Those additional payments are included as components of lease payments. They therefore are included in the computation of the amount to be capitalized (as an asset and liability) by the lessee and a lease receivable by the lessor. But, a residual value not guaranteed by the lessee is ignored by the lessee, but still is expected to be received by the lessor, thus influencing the size of the lease payments and becoming part of the lease receivable (as a residual asset).

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Question 15-23 Repairs, maintenance, hazard insurance, and property taxes are costs often associated with owning and operating an asset. Often, for convenience, a lease contract will specify that the lessor is to pay some or all of these costs, but in reality these additional costs are embedded in the periodic payments made by the lessee. The accounting Question is whether to include these costs as separate components of the lease contract (to be expensed by the lessee) or, instead, include them in the payments to be capitalized as part of the right-of-use asset. The determining factor is whether the charge represents a transfer of a good or service to the lessee. If so, it qualifies as a ―nonlease component‖ of the payment and is separated from the lease payments and expensed. As a practical expedient, the lessee is given the option to elect to include nonlease components in the amounts to be capitalized, except for insurance and property taxes, which always must be excluded. For example, a lessee could elect to treat maintenance cost, not as maintenance expense, but instead treat it as part of the lease expense. In that case, the right-of-use asset and lease liability would be measured as the present value of payments that include the maintenance amount.

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Question 15-24 The incremental costs (those that would not have been incurred had the lease agreement not occurred) of consummating a completed lease transaction incurred by the lessor that are associated directly with originating a lease and are essential to acquire that lease are referred to as initial direct costs. They include legal fees, evaluating the prospective lessee's financial condition, commissions, and preparing and processing lease documents.

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Question 15352Initial direct costs paid by the lessee are added to the right-of-use asset. If incurred by the lessor, treatment depends on the classification of the lease. In a sales-type lease that includes selling profit, initial direct costs are expensed in the period of ―sale‖ – that is, at the beginning of the lease. This treatment assumes that, in a sales-type lease, the primary reason for incurring these costs is to facilitate the sale of the leased asset and thus is a selling expense. In a sales-type lease with no selling profit, initial direct costs are deferred and included in the lease receivable. The nature of the lease motivates this treatment. The only revenue a sales-type lease with no selling profit generates for the lessor is interest revenue, which is recognized over the lease term. So, initial direct costs are recorded proportionally over the term of the lease. Increasing the receivable causes the implicit rate (the interest rate that causes the present value of the lease payments to equal the receivable) to be lower. Determining interest revenue at this lower rate accomplishes the purpose of reducing interest revenue each period by a portion of the prepaid expense In an operating lease, initial direct costs are expensed over the lease term on a straight line basis, as is the lease revenue.

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Question 15353Extensive disclosure requirements for lessees and lessors are designed to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases.

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Question 15354We can find authoritative guidance for accounting for leases under IFRS in ―Leases,‖ International Financial Reporting Standard No. 16, IASB.

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Question 15355Yes. A finance lease under IFRS might be classified as an operating lease under U.S. GAAP. The classification criteria are the same for lessors. But, while lessees classify leases as operating or finance leases under U. S. GAAP, lessees classify all leases as finance leases under IFRS No. 16.

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Question 15-29 Sale leaseback accounting is permitted only when the sale portion qualifies as a sale under the revenue recognition guidelines. If the leaseback qualifies as a finance lease, no sale has occurred. So, the only way to have a sale leaseback is to have a sale (accounted for as such), followed by an operating lease. If it‘s not a sale, we account for the transaction as a loan from the buyer to the seller.

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Question 15-30 No. If a seller-lessee sells an asset that‘s subject to a leaseback for a major part of the remaining economic life, the transaction would be accounted for as a loan rather than a sale-leaseback.

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BRIEF EXERCISES

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Brief Exercise 15364

The present value of the lease payments is greater than ―substantially all‖ of the

fair value of the asset ($20.6 / $22.4 = 92%). The criteria indicate it is a sales-type lease to Corinth. Furthermore, it‘s a sales-type lease with a selling profit because the present value of the lease payments ($20.6 million) exceeds the lessor‘s cost ($16 million).

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Brief Exercise 15365

The lease is a finance lease to Athens because the present value of the lease

payments is greater than ―substantially all‖ of the fair value of the asset ($20.6 ÷ $22.4 = 92%). None of the other classification criteria is met.

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Brief Exercise 15366The amount of interest expense the lessee would record in conjunction with the second quarterly payment on October 1 is $2,892: Initial balance, July 1 (given)................................... Reduction for first payment, July 1 ......................... Balance ..............................................................

$150,000 (5,376) $144,624

Interest expense October 1: 2% x $144,624 = $2,892 Journal entries (not required): July 1 Right-of-use asset (given).................................... Lease payable ................................................ Lease payable ................................................... Cash (lease payment)......................................... Oct. 1 Interest expense (2% x [$150,000 – $5,376]) ............. Lease payable (difference).................................... Cash (lease payment).........................................

150,000 150,000 5,376 5,376

2,892 2,484 5,376

The amount of interest revenue the lessor would record in conjunction with the second quarterly payment on October 1 also is $2,892, determined in the same manner.

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Brief Exercise 15367The lease liability in the balance sheet will be $113,731: Initial balance, January 1 (calculated below)............. Reduction for first payment, January 1............... December 31, net liability ....................................... $26,269 x 5.32948 

$140,000 (26,269) $113,731

$140,000 (rounded)

 present value of an annuity due of $1: n=6, i=5%

The interest payable on the lease liability in the balance sheet will be $5,687: Interest expense (5% x [$140,000 – $26,269]) ............. Interest payable ...................................................

5,687 5,687

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Brief Exercise 15370The lessee‘s income statement will report a decrease of $29,020 as calculated below: January 1 interest expense.......................................... Dec. 31, interest expense (5% x [$140,000* – $26,269]) Interest expense for the year ......................................

Amortization expense ($140,000* ÷ 6 years) ............... Total expenses related to the lease ...........................

23,333** $29,020

$26,269 x 5.32948 

0 5,687 $ 5,687

$140,000* (rounded)

 present value of an annuity due of $1: n=6, i=5%

** Amortization expense ($140,000* ÷ 6 years) .... Right-of-use asset ....................................

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23,333

Brief Exercise 15371The lessor‘s income statement will report an increase of $20,687 as calculated below: January 1 interest revenue .......................................... Dec. 31, interest revenue (5% x [$140,000* – $26,269]) Interest revenue for the year.......................................

Sales revenue ............................................................ Cost of goods sold .................................................... Income effect .........................................................

140,000 (125,000) $ 20,687

$26,269 x 5.32948 

0 5,687 $ 5,687

$140,000* (rounded)

 present value of an annuity due of $1: n=6, i=5%

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Brief Exercise 15÷ 16.67846** $100,000 372 fair value

$5,996 lease payments

** present value of an annuity due of $1: n=20, i=2%

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Brief Exercise 15373Because none of the classification criteria is met, this is an operating lease. Accordingly, LTT will record a right-of-use asset and lease liability for the present value of the twenty-eight $25,000 payments. Interest expense will be determined each quarter as the effective interest rate (lessor‘s implicit rate) times the declining liability balance. Because it‘s an operating lease, amortization of the right-of-use asset is a ―plug‖ figure each period to cause the total of interest and amortization to be $25,000 each quarter. That total lease expense will reduce LTT‘s earnings by $100,000 each year.

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Brief Exercise 15374Because none of the five classification criteria is met, this is an operating lease. Accordingly, Lakeside will record lease revenue for each of the four $25,000 payments, increasing its earnings by $100,000 each year. In addition, Lakeside, as owner of the asset, will record depreciation. Assuming straight-line depreciation of the $2 million cost over the 25-year life, that‘s $80,000 depreciation expense each year. So, earnings are increased by a net $20,000 ($100,000 – $80,000). Lease revenue

$100,000

Depreciation expense

(80,000)

Increase Lakeside‘s earnings

$ 20,000

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Brief Exercise 15375

A lease that has a lease term (including options to terminate or renew that are reasonably certain) of twelve months or less is considered a ―short-term lease.‖ A lessee that has a short-term lease has the option to not record the right-ofuse asset and the liability to make lease payments and instead to simply record lease expense for the amount of each lease payment. King Cone‘s earnings will be reduced by the $10,000 per month lease expense, $80,000 for the eight-month term, ignoring taxes. Journal entries (not required): Beginning of lease No entry End of each of 8 months Lease expense .................................................... Cash (lease payment).........................................

10,000 10,000

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Brief Exercise 15-11 The lease term consists of ten years plus two renewal years, or 12 years, because the expensive installation now means that Java Hut is reasonably certain to exercise two of its one-year renewal options.

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Brief Exercise 15–12

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If the amounts of future lease payments are uncertain due to contingencies or otherwise, we don’t consider them as part of the lease payments. There are two exceptions to not including variable payments when recording the lease. One is when apparent ―variable‖ payments actually are fixed payments in disguise. These in-substance fixed payments are considered to be part of the lease payments. Another exception is when variable lease payments depend on an index or a rate, the Consumer Price Index or current market rate of interest for instance. If the amounts of future lease payments vary solely when an index or rate changes, the amount of the payments based on the index or rate at the beginning of the lease are initially included in the calculation of the right-of-use asset and liability. However, changes in the payments do not influence the right-of-use asset and liability unless those amounts are remeasured for another reason. Other than those two exceptions, though, variable lease payments, like those in this situation, are not included. The additional $4,000 is excluded, even though Espinoza estimates a 60% probability of meeting the target revenue amount. So, the amount recorded as the right-of-use asset and lease liability should be: $10,000 x 3.54595 

$35,460* (rounded)

 present value of an ordinary annuity of $1: n=4, i=5%

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Brief Exercise 15-13 A purchase option is a provision in a lease contract that gives the lessee the option of purchasing the leased property at a specified exercise price. If that price is sufficiently lower than the expected fair value of the property when the option becomes exercisable that the exercise of the option appears ―reasonably certain‖ at the beginning of the lease, transfer of ownership is expected, and the lease would be considered a finance lease. The exercise price would be part of the lease payments for both the lessee and lessor, influencing the amount recorded as a right-of-use asset, lease liability, and lease receivable. Furthermore, the lease term would be considered as ending at the time the option becomes exercisable. Amount to be recovered (fair value)

$600,000

Less: Present value of the exercise price ($100,000 x 0.74726*) (74,726) Amount to be recovered through periodic lease payments

$525,274

Lease payments at the beginning of each of the next 5 years: ($525,274 ÷ 4.46511**)

$117,640

* present value of $1: n=5, i=6% ** present value of an annuity due of $1: n=5, i=6%

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Brief Exercise 15-14 Amount to be recovered (fair value)

$700,000

Less: Present value of the residual value ($100,000 x 0.82270*) (82,270) Amount to be recovered through periodic lease payments

$617,730

Lease payments at the end of each of the next 4 years:

$174,207

($617,730 ÷ 3.54595**)

* present value of $1: n=4, i=5% ** present value of an ordinary annuity of $1: n=4, i=5%

When the lessor gets a lease asset back at the end of the lease term, the value of the asset itself, which at the beginning of the lease is estimated as the residual value, will provide another source of recovery of the lessor‘s investment. That reduces the amount needed from lessee payments.

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Brief Exercise 15–15 If a cash payment under a lessee-guaranteed residual value is predicted, the present value of that payment is added to the present value of the lease payments the lessee records as both a right-of-use asset and a lease liability. Likewise, it also adds to the amount that the lessor records as a lease receivable. Garcia guarantees a cash payment of $1,000 to make up the difference of the $36,000 total guarantee to the lessor and the guaranteed residual value estimate of $35,000 for the asset to be returned to the lessor. Amount to be added to the right-of-use asset and lease liability: ($36,000 – $35,000 = $1,000) x 0.82270** = $823 ** Present value of $1: n = 4, i = 5%

16–389

Brief Exercise 15-16 In a sales-type lease that includes selling profit, initial direct costs are expensed in the period of ―sale‖ – that is, at the beginning of the lease. This assumes that in a sales-type lease the primary reason for incurring these costs is to enable the sale of the leased asset. The lessor‘s earnings will be increased by $91,868 as calculated below: January 1 interest revenue .......................................... Dec. 31, interest revenue (8% x [$600,000* – $139,142]) Interest revenue for the year....................................... Sales revenue ............................................................ Cost of goods sold .................................................... Selling profit....................................................... Selling expense (initial direct cost) ......................... Increase in earnings .............................................. Journal entries (not required): Beginning of the Lease, January 1 Lease receivable (fair value)............................................ Cost of goods sold (lessor‘s cost)..................................... Sales revenue (fair value) ............................................ Equipment (lessor‘s cost).............................................

0 36,869 $ 36,869 $ 600,000 (530,000) 70,000 (15,000) $ 91,869

600,000 530,000 600,000 530,000

Selling expense ............................................................. Cash (initial direct costs) ...............................................

15,000

Cash (lease payment)........................................................ Lease receivable........................................................ December 31 Interest receivable ......................................................... Interest revenue (8% x [$600,000 – $139,142) ................

139,142

16–16

15,000

139,142 36,869 36,869

Brief Exercise 15391Yes. The first criterion for an arrangement to constitute a lease is: Do we have an identified asset? There is no type of identifier for the equipment, such as a model number or serial number. But that‘s okay because the lease accounting guidance says that an asset needn‘t be explicitly stated in the contract if it‘s ―implicitly‖ stated as long as there‘s enough information to recognize the physically distinct asset that is the subject of the lease. Although the equipment used to fulfill the contract is not explicitly identified, it is implicitly identified as a result of the contractual requirements.

16–391

Brief Exercise 15392 No. At first glance, we might say the first requirement is not met because there is no model number or serial number. But the agreement specifies “Able's newest server model” which is enough information to recognize the physically distinct equipment that is the subject of the contract. So, we have an identified asset. What about criterion 2: The lessee must have the right to control the use of the identified asset? Even though M. T. Bin has “access to the equipment and the ability to direct its use,” M. T. Bin doesn’t have the right to control the use of the identified asset because Able can replace or reconfigure the equipment if Able finds it's financially advantageous to do so (substantive substitution right). Since it’s not a lease, we account for the arrangement as a service contract. We simply record each payment as an expense.

16–392

Brief Exercise 15393 Jasperse is receiving two separate benefits in the lease contract (1) the right to use equipment and (2) maintenance on that equipment. So, payments specified in the lease contract contain a separate lease component (use of equipment for $75,000) and a nonlease component (maintenance of $5,000). The payment for insurance does not transfer to the lessee a separate good or service. Payments for insurance and property taxes are specifically identified in the lease standard as part of the lease payments (to be capitalized) rather than nonlease components (to be expensed separately) if they are fixed amounts in the lease contract. (If the payments will be billed separately, they are separate components of the lease and not included in the lease payments.) So, the right-of-use asset and lease liability (and the lessor‘s lease receivable) would be measured as the present value of the $70,000 lease payments rather than $75,000. At the beginning of the lease, Jasperse records a right-of-use asset and lease liability for the present value of the ten $70,000 lease payments. For the first payment of $75,000, $5,000 is recorded as maintenance expense and the remaining $70,000 reduces the lease liability. So, Jasperse will record a right-of-use asset of $442,978. Journal entries (not required): January 1 Right-of-use asset ([$75,000 – $5,000] x 6.32825**)……….. Lease payable (present value of lease payments)…………

442,978 442,978

** present value of an annuity due of $1: n=10, i=12%

Lease payable (payment less nonlease component)............... Maintenance expense (2024 fee) ........................................... Cash (annual payment) .................................................

70,000 5,000 75,000

EXERCISES

16–393

Exercise 15-1 Situation 1 Since none of the criteria is met, this is an operating lease to the lessee:

Lessee’s Application of Classification Criteria Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option?

3 Does the lease term constitute the major part of the expected economic life of the asset? 4

NO {Lease term 4 yrs. ; useful life 6 yrs.}

Is the present value of the lease payments greater than or equal to substantially all of the fair value of the asset?

NO {$37,2331 ; $44,000} present fair value value $10,000 x 3.72325*= $37,233 * present value of an annuity due of $1: n=4, i=5% 1

16–394

Is the asset of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

Exercise 15-1 (continued) Situation 2 Since at least one (two in this case: #2 and #3) classification criterion is met, this is a finance lease. Lessee’s Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee?

2 Does the agreement contain a bargain purchase option?

YES

3 Does the lease term constitute the major part of the expected economic life of the asset? 4

YES {Lease term 4 yrs. ; useful life 5 yrs.}

Is the present value of the lease payments greater than or equal to substantially all of the fair value of the asset?

NO {$34,6511 ; $45,000} present fair value value

$10,000 x 3.46511*= $34,651 * present value of an ordinary annuity of $1: n=4, i=6% 1

Is the asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

16–395

Exercise 15-1 (continued) Situation 3 Since at least one (#4 in this case) classification criterion is met, this is a finance lease. Lessee’s Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee?

2 Does the agreement contain a bargain purchase option?

3 Does the lease term constitute the major part of the expected economic life of the asset? 4

NO {Lease term 4 yrs. ; useful life 6 yrs.}

Is the present value of the lease payments greater than or equal to substantially all of the fair value of the asset?

YES {$37,2331 ; $41,000} present fair value value $10,000 x 3.72325*= $37,233 * present value of an annuity due of $1: n=4, i=5% 1

16–396

Is the asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

Exercise 15-1 (concluded) Situation 4 Since at least one (#4 in this case) classification criterion is met, this is a finance lease.

Lessee’s Application of Classification Criteria Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option?

3 Does the lease term constitute the major part of the expected economic life of the asset? 4

NO {Lease term 4 yrs.; useful life 6 yrs.}

Is the present value of the lease payments greater than or equal to substantially all of the fair value of the asset?

YES {$34,6511 ; $38,000} present fair value value

$10,000 x 3.46511*= $34,651 * present value of an ordinary annuity of $1: n=4, i=6% 1

Is the asset of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

16–397

Exercise 15-2 Requirement 1 January 1, 2024 Right-of-use asset .................................................. 4,000,000 Lease payable ................................................ 4,000,000 Requirement 2 $4,000,000

÷ 3.16987**

present value

$1,261,881 lease payment

** present value of an ordinary annuity of $1: n=4, i=10%

Lease Amortization Schedule Lease Payments

Effective Interest 10% x Outstanding Balance

Decrease in Balance

Outstanding Balance

4,000,000 2024

1,261,881

.10 (4,000,000) =

400,000

861,881

3,138,119

2025

1,261,881

.10 (3,138,119) =

313,812

948,069

2,190,050

2026

1,261,881

.10 (2,190,050) =

219,005

1,042,876

1,147,174

2027

1,261,881

.10 (1,147,174) =

114,707*

1,147,174

1,047,524

4,000,000

5,047,524

* adjusted for rounding of other numbers in the schedule

16–398

Exercise 15-2 (concluded) Requirement 3

December 31, 2024

Interest expense (10% x outstanding balance) .......... Lease payable (difference).................................... Cash (payment determined above)........................ Amortization expense ($4 million ÷ 4 years) .... Right-of-use asset .........................................

Requirement 4

400,000 861,881 1,261,881 1,000,000 1,000,000

December 31, 2026

Interest expense (10% x outstanding balance) .......... Lease payable (difference).................................... Cash (payment determined above)........................

219,005 1,042,876

Amortization expense ($4 million ÷ 4 years) .... Right-of-use asset .........................................

1,000,000 1,000,000

1,261,881

16–399

Exercise 15-3 1. Calculation of the present value of lease payments $562,907 x 5.32948 

$3,000,000 (rounded)

 present value of an annuity due of $1: n=6, i=5%

2. Liability on December 31, 2024 Initial balance, June 30, 2024.................................. June 30, 2024 reduction .......................................... Dec. 31, 2024 reduction .......................................... December 31, 2024 net liability .............................. Right-of-Use Asset on December 31, 2024 Initial balance, June 30, 2024.................................. Dec. 31, 2024 reduction .......................................... December 31, 2024 ...........................................

$3,000,000 (562,907)* (441,052)** $1,996,041 $3,000,000 (500,000)** $2,500,000

3. Expenses for year ended December 31, 2024 June 30, 2024 interest expense ................................ Dec. 31, 2024 interest expense ................................ Interest expense for 2024 ........................................

$ 0* 121,855** $121,855

Amortization expense for 2024 ............................... Total expenses ......................................................

500,000 $621,855

16–400

Exercise 15-3 (concluded) Calculations: June 30, 2024* Right-of-use asset (calculated in req. 1) .......................... Lease payable (calculated in req. 1)............................. Lease payable .............................................................. Cash (lease payment)..................................................

December 31, 2024** Interest expense (5% x [$3 million – $562,907]) .............. Lease payable (difference) ............................................. Cash (lease payment).................................................. Amortization expense ($3 million ÷ 3 years x ½ year).. Right-of-use asset .....................................................

3,000,000 3,000,000 562,907 562,907

121,855 441,052 562,907 500,000 500,000

16–401

Exercise 15-4 1. Receivable on December 31, 2024 $562,907 x 5.32948 

$3,000,000 (rounded)

 present value of an annuity due of $1: n=6, i=5%

Initial balance, June 30, 2024............

Net Receivable $3,000,000

June 30, 2024 reduction ....................

(562,907)*

Dec. 31, 2024 reduction ....................

(441,052)**

December 31, 2024 net receivable ....

$1,996,041

The receivable replaces the $3,000,000 equipment on the balance sheet. 2. Interest revenue for year ended December 31, 2024 June 30, 2024 interest revenue ................................ Dec. 31, 2024 interest revenue ................................ Interest revenue for 2024 ........................................

16–402

$ 0* 121,855** $121,855

Exercise 15-4 (concluded) Calculations: June 30, 2024 Lease receivable (present value calculated above)............ Equipment (lessor‘s cost) ........................................... Cash (lease payment)...................................................... Lease receivable*......................................................

December 31, 2024 Cash (lease payment)...................................................... Lease receivable (difference)** .................................. Interest revenue (5% x [$3,000,000 – $562,907]) .........

3,000,000 3,000,000 562,907 562,907

562,907 441,052 121,855

16–403

Exercise 15-5

1. Calculation of the present value of lease payments (―selling price‖) $562,907 x 5.32948 

$3,000,000 (rounded)

 present value of an annuity due of $1: n=6, i=5%

2. Lease receivable on December 31, 2024 Receivable Initial balance, June 30, 2024 ................ $3,000,000 June 30, 2024 reduction .................... (562,907)* Dec. 31, 2024 reduction ...................... (441,052)** December 31, 2024 receivable .............. $1,996,041 The receivable replaces the $2,500,000 equipment on the balance sheet. 3. Amounts reported in income statement for year ended December 31, 2024 June 30, 2024 interest revenue ................................ Dec. 31, 2024 interest revenue ................................ Interest revenue for 2024 ........................................

$ 0* 121,855** $121,855

Sales revenue* .......................................................... $3,000,000 Cost of goods sold*.................................................... (2,500,000) Selling profit .......................................................... 500,000 Total effect on net income from lease ........................................ $621,855

16–404

Exercise 15-5 (concluded) Calculations: June 30, 2024* Lease receivable (present value calculated above)............ Cost of goods sold (lessor‘s cost) ..................................... Sales revenue (present value calculated above) ............ Equipment (lessor‘s cost) ........................................... Cash (lease payment) .................................................... Lease receivable........................................................

December 31, 2024** Cash (lease payment)...................................................... Lease receivable (difference)...................................... Interest revenue (5% x [$3,000,000 – $562,907]) .........

3,000,000 2,500,000 3,000,000 2,500,000 562,907 562,907

562,907 441,052 121,855

16–405

Exercise 15-6 Present Value of Lease Payments: ($15,000 x 7.47199*) = $112,080 lease present payments value * present value of an annuity due of $1: n=8, i=2% [i = 2% (8% ÷ 4) because the lease calls for quarterly payments]

Lease Amortization Schedule Lease Payments

Effective Interest 2% x Outstanding Balance

Decrease in Balance

Outstanding Balance

112,080 1

15,000

97,080

15,000

.02 (97,080) = 1,942

13,058

84,022

15,000

.02 (84,022) = 1,680

13,320

70,702

15,000

.02 (70,702) = 1,414

13,586

57,116

15,000

.02 (57,116) = 1,142

13,858

43,258

15,000

.02 (43,258) =

865

14,135

29,123

15,000

.02 (29,123) =

582

14,418

14,705

.02 (14,705) =

295*

14,705

7,920

112,080

8 15,000 120,000

* adjusted for rounding of other numbers in the schedule

16–406

Exercise 15-6 (concluded) January 1, 2024 Right-of-use asset (calculated above)..................... Lease payable (calculated above) ....................... Lease payable ................................................... Cash (lease payment).........................................

112,080 112,080 15,000 15,000

April 1, 2024 Interest expense (2% x [$112,080 – $15,000])........... Lease payable (difference).................................... Cash (lease payment).........................................

1,942 13,058

July 1, 2024 Interest expense (2% x $84,022: from schedule)........ Lease payable (difference).................................... Cash (lease payment).........................................

1,680 13,320

October 1, 2024 Interest expense (2% x $70,702: from schedule)........ Lease payable (difference).................................... Cash (lease payment).........................................

1,414 13,586

December 31, 2024 Interest expense (2% x $57,116: from schedule)........ Interest payable .............................................

1,142

Amortization expense ($112,080 ÷ 2 years) ............. Right-of-use asset .......................................... January 1, 2025 Interest payable (from adjusting entry) ...................... Lease payable (difference).................................... Cash (lease payment).........................................

15,000

1,142 56,040 56,040

1,142 13,858 15,000

16–407

16–408

Exercise 15-7 Present Value of Lease Payments: ($15,000 x 7.47199*) = $112,080 lease present payments value * present value of an annuity due of $1: n=8, i=2% [i = 2% (8% ÷ 4) because the lease calls for quarterly payments]

16–409

Lease Amortization Schedule Lease Payments

Effective Interest 2% x Outstanding Balance

Decrease in Balance

Outstanding Balance

112,080 1

15,000

97,080

15,000

.02 (97,080) = 1,942

13,058

84,022

15,000

.02 (84,022) = 1,680

13,320

70,702

15,000

.02 (70,702) = 1,414

13,586

57,116

15,000

.02 (57,116) = 1,142

13,858

43,258

15,000

.02 (43,258) =

865

14,135

29,123

15,000

.02 (29,123) =

582

14,418

14,705

.02 (14,705) =

295*

14,705

7,920

112,080

8 15,000 120,000

* adjusted for rounding of other numbers in the schedule

January 1, 2024 Lease receivable (fair value)................................. Equipment (lessor‘s cost).................................. Cash (lease payment)............................................. Lease receivable ............................................

112,080 112,080 15,000 15,000

No depreciation

16–410

Exercise 15-7 (concluded) April 1, 2024 Cash (lease payment)............................................. Lease receivable (difference) ........................... Interest revenue (2% x [$112,080 – $15,000]).......

15,000 13,058 1,942

No depreciation

July 1, 2024 Cash (lease payment)............................................. Lease receivable (difference) ............................ Interest revenue (2% x $84,022: from schedule) ...

15,000 13,320 1,680

No depreciation

October 1, 2024 Cash (lease payment)............................................. Lease receivable (difference) ............................ Interest revenue (2% x $70,702: from schedule) ...

15,000 13,586 1,414

No depreciation

December 31, 2024 Interest receivable ............................................. Interest revenue (2% x $57,116: from schedule) ...

1,142 1,142

No depreciation January 1, 2025 Cash (lease payment)............................................. Lease receivable (difference) ............................ Interest receivable (from adjusting entry)............

15,000 13,858 1,142

16–411

Exercise 15412 Requirement 1 Lessor’s Calculation of Lease Payments Amount to be recovered (fair value)

$112,080

Lease payments at the beginning of each of eight quarters:

($112,080 ÷ 7.47199**) $15,000 ** present value of an annuity due of $1: n=8, i=2%

Requirement 2 January 1, 2024 Lease receivable (fair value / present value) ............ Cost of goods sold (lessor‘s cost).......................... Sales revenue (fair value / present value) ............. Equipment (lessor‘s cost).................................. Cash (lease payment)............................................. Lease receivable ............................................

April 1, 2024 Cash (lease payment)............................................. Lease receivable (difference) ............................ Interest revenue (2% x [$112,080 – $15,000]).......

16–412

112,080 85,000 112,080 85,000 15,000 15,000

15,000 13,058 1,942

Exercise 15-9 Situation 1 (a)

$600,000

÷ 6.53705** =

$91,785

fair lease value payments ** present value of an annuity due of $1: n=10, i=11%

(b)

$91,785

x 6.53705** =

$600,000

(rounded)

lease right-of-use asset/ payments lease payable ** present value of an annuity due of $1: n=10, i=11%

Situation 2 (a)

$980,000

÷ 9.95011** =

$98,491

fair lease value payments ** present value of an annuity due of $1: n=20, i=9%

(b)

$98,491

x 9.95011** =

$980,000

(rounded)

lease right-of-use asset/ payments lease payable ** present value of an annuity due of $1: n=20, i=9%

Situation 3 (a)

$185,000

÷ 3.40183** =

$54,382

fair lease value payments ** present value of an annuity due of $1: n=4, i=12%

(b)

$54,382

x 3.40183** =

$185,000

lease right-of-use asset/ payments lease payable ** present value of an annuity due of $1: n=4, i=12%

16–413

Exercise 15Situation 1 414 (a)

$600,000

÷ 5.88923** =

$101,881

fair lease value payments ** present value of an ordinary annuity of $1: n=10, i=11%

(b)

$101,881

x 5.88923** =

lease payments

$600,000* right-of-use asset/ lease payable

* rounded ** present value of an ordinary annuity of $1: n=10, i=11%

Situation 2 (a)

$980,000

÷ 9.12855** =

$107,355

fair lease value payments ** present value of an ordinary annuity of $1: n=20, i=9%

(b)

$107,355

x 9.12855** =

$980,000‡

lease right-of-use asset/ payments lease payable ** present value of an ordinary annuity of $1: n=20, i=9% ‡ rounded for convenience

Situation 3 (a)

$185,000

÷ 3.03735** =

fair value

$60,908 lease payments

** present value of an ordinary annuity of $1: n=4, i=12%

(b)

$60,908

x 3.03735** =

$185,000‡

lease right-of-use asset/ payments lease payable ** present value of an ordinary annuity of $1: n=4, i=12% ‡ rounded for convenience

16–414

Exercise 15–11 Present Value of Lease Payments: ($15,000 x 16.67846*) = $250,177 contract payments

present value

* Present value of an annuity due of $1: n = 20, i = 2% [i = 2% (8% ÷ 4) because the contract calls for quarterly payments]

March 31, 2024 Interest expense (2% x [$250,177 – $15,000])........... Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($250,177 ÷ 20 quarters)....... Right-of-use asset ..........................................

250,177 250,177 15,000 15,000

4,704 10,296 15,000 12,509 12,509

16–415

Exercise 15–11 (concluded) Requirement 2 January 1, 2024 Lease receivable (present value of lease payments)............. 250,177 Cost of goods sold ...................................................... 200,000 250,177 Sales revenue (present value of lease payments) ............. Equipment (carrying value) ....................................... 200,000 Cash (lease payment).................................................... Lease receivable ................................................... March 31, 2024 Cash (lease payment).................................................... Lease receivable (difference) ................................... Interest revenue (2% x [$250,177 – $15,000])...............

16–416

15,000 15,000

15,000 10,296 4,704

Exercise 15-12 Requirement 1 Income Statement: Interest expense (10% x [($25,000 x 6.33493) – $25,000]) Amortization expense ($158,373 ÷ 9 years) Decrease in earnings (pretax)

$13,337 17,597 $30,934

 present value of an annuity due of $1: n=9, i=10%

Requirement 2 Balance Sheet: Lease payable Initial balance ($25,000 x 6.33493) Jan. 1, 2024 reduction (first lease payment) Dec. 31, 2024 reduction ($25,000 – 10% x [$158,373 – $25,000]) End-of-year balance Right-of-Use Asset Initial balance Amortization for the year ($158,373 ÷ 9 years) End-of-year balance

$158,373 (25,000) (11,663) $121,710 $158,373 (17,597)** $140,776

16–417

Exercise 15-12 (concluded) Journal entries (not required): January 1, 2024 Right-of-use asset .............................................. Lease payable ($25,000 x 6.33493) ..................

158,373 158,373

 present value of an annuity due of $1: n=9, i=10%

Lease payable (first payment; no interest)................ Cash (lease payment).........................................

December 31, 2024 Interest expense (10% x [$158,373 – $25,000]) ......... Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($158,373 ÷ 9 years) ............. Right-of-use asset ..........................................

16–418

25,000 25,000

13,337 11,663 25,000 17,597 17.597

Exercise 15-13 Requirement 1 Income Statement: Interest (10% x [$158,373* – $25,000])......................... Amortization for the year ($25,000 – $13,337) Lease expense; decrease in earnings (pretax) .......

$13,337 11,663 $25,000

* $25,000 x 6.33493  = $158,373  present value of an annuity due of $1: n=9, i=10%

In an operating lease, the lessee determines interest the normal way (at the effective interest rate) and then “plugs” the right-of-use asset amortization at the amount that is needed for interest plus amortization to equal the straight-line lease payment. The lessee reports that amount as a single lease expense in the income statement. Although ASC 842 doesn’t specify this decomposition, the lessee must (a) calculate the interest component in order to determine the reduction of the lease payable over the lease term and (b) calculate the amortization component in order to determine the reduction in the balance of the right-of-use asset over the lease term. For convenience, we determine and record these two "components", and then combine them for purposes of reporting.

Requirement 2 Balance Sheet: Lease Payable Initial balance ($25,000 x 6.33493) Jan. 1, 2024 reduction (first lease payment) Dec. 31, 2024 reduction ($25,000 – 10% x [$158,373 – $25,000]) End-of-year balance Right-of-Use Asset Initial balance ($25,000 x 6.33493) Amortization for the year ($25,000 – 10% x [$158,373 – $25,000]) End-of-year balance

$158,373 (25,000) (11,663) $121,710 $158,373 (11,663) $146,710

 present value of an annuity due of $1: n=9, i=10%

16–419

Exercise 15-13 (concluded) Journal entries (not required): January 1, 2024 Right-of-use asset .............................................. Lease payable ($25,000 x 6.33493) ..................

158,373 158,373

 present value of an annuity due of $1: n=9, i=10%

Lease payable (difference).................................... Cash (lease payment)......................................... December 31, 2024 Interest expense (10% x [$158,373 – $25,000]) ......... Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($25,000 – $13,337) .............. Right-of-use asset ..........................................

16–420

25,000 25,000

13,337* 11,663 25,000 11,663 11,663

Exercise 15-14 Requirement 1 Income Statement: Lease revenue (straight-line amount) ........................... Depreciation ($180,000 ÷ 13 years) ................................. Increase in earnings (pretax) ..............................

$25,000 (13,846) $11,154

In an operating lease, the lessor records lease revenue on a straight-line basis. The lessor, having recorded no entry affecting its balance sheet at the beginning of the lease, simply records lease payments as lease revenue on a straight-line basis and records depreciation on the asset it doesn’t remove from its records.

Requirement 2 Assets: Restaurant equipment (cost) ..................................... Accumulated depreciation ($180,000 ÷ 13 years) ..... Equipment balance (net)

$180,000 (13,846) $166,154

Liabilities: Deferred lease revenue............................................

$ 25,000

16–421

Exercise 15-14 (concluded) Journal entries (not required): January 1, 2024 [No entry to record receivable or to derecognize asset] Cash (lease payment).................................................. Deferred lease revenue .......................................... December 31, 2024 Deferred lease revenue............................................ Lease revenue ..........................................................

25,000 25,000 25,000 25,000

Cash (second lease payment)........................................ Deferred lease revenue ..........................................

25,000

Depreciation expense ($180,000 ÷ 13 years) .................... Accumulated depreciation– equipment .............

13,846

16–422

25,000 13,846

Exercise 15-15 Requirement 1 The price at which the lessor is ―selling‖ the asset being leased is the present value of the lease payments: $52,538 x 5.32948 

$280,000 (rounded)

 present value of an annuity due of $1: n=6, i=5%

Requirement 2 The lessor‘s income statement will report an increase of $61,373 as calculated below: January 1, interest revenue ...................................... $ 0 Dec. 31, interest revenue (5% x [$280,000 – $52,538]) 11,373 Interest revenue for the year....................................

$11,373

Sales revenue ............................................................ Cost of goods sold .................................................... Selling profit .......................................................... Income statement increase .......................................

50,000 $61,373

280,000 (230,000)

Journal entry (not required): Beginning of lease Lease receivable (present value) ..................................... Cost of goods sold (lessor‘s cost) ................................... Sales revenue (present value)...................................... Equipment (lessor‘s cost) ...........................................

280,000 230,000

End of fiscal year Interest receivable ........................................................ Interest revenue (5% x [$280,000 – $52,538])...........

11,373

280,000 230,000

11,373

16–423

Exercise 15-16 Present Value of Lease Payments: ($15,000 x 7.47199*) = $112,080 lease present payments value * present value of an annuity due of $1: n=8, i=2% [i = 2% (8% ÷ 4) because the lease calls for quarterly payments]

January 1, 2024 Right-of-use asset (present value calculated above) .. Lease payable (present value calculated above) .... Lease payable .................................................... Cash (lease payment)......................................... March 31, 2024 Interest expense (2% x [$112,080 – $15,000]) ........... Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($15,000 – $1,942) ................ Right-of-use asset ..........................................

112,080 112,080 15,000 15,000

1,942 13,058 15,000 13,058 13,058

In an operating lease, the lessee determines interest the normal way (at the effective interest rate) and then “plugs” the right-of-use asset amortization at the amount needed for interest plus amortization to equal the straight-line lease payment. The lessee reports that amount as a single lease expense in the income statement. Although ASC 842 doesn’t specify this decomposition, the lessee must (a) calculate the interest component in order to determine the reduction of the lease payable over the lease term and (b) calculate the amortization component in order to determine the reduction in the balance of the right-of-use asset over the lease term. For convenience, we determine and record these two "components", and then combine them for purposes of reporting. 16–424

Exercise 15-16 (concluded) June 30, 2024 Interest expense (2% x [$112,080 – $15,000 – $13,058]) Lease payable (difference).................................... Cash (lease payment).........................................

1,681 13,319 15,000

Amortization expense ($15,000 – $1,681)................ Right-of-use asset ..........................................

13,319 13,319

September 30, 2024 Interest expense (2% x [$112,080 – $15,000 – $13,058 – $13,319]) Lease payable (difference).................................... Cash (lease payment).........................................

1,414 13,586 15,000

Amortization expense ($15,000 – $1,414)................ Right-of-use asset ..........................................

13,586 13,586

December 31, 2024 Interest expense (2% x [$112,080 – $15,000 – $13,058 – $13,319 – $13,586]) Lease payable (difference) ...................................... Cash (lease payment) ............................................

1,142 13,858 15,000

Amortization expense ($15,000 – $1,142)..................... Right-of-use asset ..........................................

13,858 13,858

16–425

Exercise 15-17 (a) Nath-Langstrom Services, Inc. (Lessee) January 1, 2024 Right-of-use asset .......................................... Lease payable ($10,000 x 3.80773) .............

38,077 38,077

 present value of an ordinary annuity of $1: n=4, i=2%

June 30, 2024 Interest expense (2% x $38,077) ........................... Lease payable (difference)................................ Cash (lease payment).................................... Amortization expense ($10,000 – $762) .............. Right-of-use asset .....................................

762 9,238 10,000 9,238 9,238

Note: In an operating lease, the lessee determines interest the normal way (at the

effective interest rate) and then “plugs” the right-of-use asset amortization at the amount needed for interest plus amortization to equal the straight-line lease payment. The lessee reports that amount as a single lease expense in the income statement. Although ASC 842 doesn’t specify this decomposition, the lessee must (a) calculate the interest component in order to determine the reduction of the lease payable over the lease term and (b) calculate the amortization component in order to determine the reduction in the balance of the right-ofuse asset over the lease term. For convenience, we determine and record these two "components", and then combine them for purposes of reporting.

16–426

Exercise 15-17 (concluded) December 31, 2024 Interest expense (2% x [$38,077 – $9,238]) .......... Lease payable (difference)................................ Cash (lease payment).................................... Amortization expense ($10,000 – $577) .............. Right-of-use asset .....................................

577 9,423 10,000 9,423 9,423

16–427

(b) ComputerWorld Leasing (Lessor) June 30, 2024 Cash............................................... Lease revenue............................. Depreciation expense ($90,000 ÷ 10 semi-annual periods) Accumulated depreciation .......... December 31, 2024 Cash............................................... Lease revenue............................. Depreciation expense ($90,000 ÷ 10 semi-annual periods) Accumulated depreciation ..........

16–428

10,000 10,000 9,000 9,000 10,000 10,000 9,000 9,000

Exercise 15-18 A lease that has a maximum possible lease term (including options to terminate or renew that are reasonably certain) of twelve months or less is considered a ―short-term lease.‖ A lessee that has a short-term lease has the option to not record a right-of-use asset or lease payable and simply record lease payments as periodic expense. January 1, 2024 No entry to record a right-of-use asset and liability Lease expense .................................................... Cash (lease payment).........................................

15,000 15,000

February 1, 2024 Lease expense .................................................... Cash (lease payment).........................................

15,000

March 1, 2024 Lease expense .................................................... Cash (lease payment).........................................

15,000

April 1, 2024 Lease expense .................................................... Cash (lease payment).........................................

15,000

Note: These payments technically could be recorded as prepaid expenses at the beginning of each month. Then, at the end of each month, we would need to credit prepaid lease expense and debit lease expense.

16–18

Exercise 15–19 The lease term will be five years. The lease term for both the lessee and the lessor is the contractual lease term modified by any renewal or termination options for which exercise of the options is reasonably certain. The $45,000 penalty for failure to exercise the three-year renewal option implies that it is reasonably certain the original lease term will be extended to five years (20 quarters).

Present Value of Lease Payments: ($15,000 x 16.67846*) = $250,177 contract payments

present value

* Present value of an annuity due of $1: n = 20, i = 2% [i = 2% (8% ÷ 4) because the contract calls for quarterly payments]

January 1, 2024 Right-of-use asset (PV calculated above)................ Lease payable (PV calculated above) .................. Lease payable .................................................... Cash (lease payment)......................................... March 31, 2024 Interest expense (2% x [$250,177 – $15,000]) ........... Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($250,177 ÷ 20 quarters) ....... Right-of-use asset ..........................................

250,177 250,177 15,000 15,000

4,704 10,296 15,000 12,509 12,509

16–19

Exercise 15431 Requirement 1

If the amounts of future lease payments depend on an index or a rate, the Consumer Price Index for instance, the payments are included in calculating the present value of lease payments, but without trying to forecast the future payments. That is, the payments indicated at the beginning of the lease are the amounts used. Wetick records the transaction based on current lease payments: $300,000  4.79079* = $1,437,237 Lessee‘s cost

Lease payments

*Present value of an annuity due of $1: n = 6, i = 10%.

Beginning of the Lease (January 1, 2024) Right-of-use asset (present value of lease payments) ................ Lease payable (present value of lease payments) ..................

1,437,237

Lease payable ...................................................... Cash (initial payment)..........................................

300,000

1,437,237 300,000

Requirement 2 December 31, 2024 At the end of one year, the CPI is 124, so the amount of the current payment and the remaining five payments is adjusted to be $310,000 ($300,000 × 124 ÷ 120). The right-of-use asset and liability are not adjusted to reflect the higher future payments. A lessee should adjust the right-of-use asset and lease liability for the present value of the payment increase only if and when the lessee remeasures the lease liability for reasons other than a change in the index (for example, because of a term extension or a revision to the base rent). Lease expense (payment adjustment for CPI increase) Interest expense (10%  [$1,437,237 – $300,000]) Lease payable (difference)................................ Cash (new payment)......................................

10,000 113,724 186,276

Amortization expense ($1,437,237 ÷ 6 years) ..... Right-of-use asset .....................................

239,540

310,000

239,540

16–431

Exercise 15432 When apparent ―variable‖ payments actually are in-substance fixed payments we include these fixed payments in disguise as part of the lessee‘s lease payments. Because QuickStream, the lessee, is required to make payments each year that are at least 3 percent more than the previous year, regardless of changes in the CPI, those payments are considered in-substance fixed payments. At the beginning of the lease, then, QuickStream measures the right-of-use asset and lease payable at $1,397,091, the present value of those payments: Year

In-Substance Fixed Payments

Present Value factor*

Present Value

$300,000

0.90909

$ 272,727

309,000

0.82645

255,373

318,270

0.75131

239,119

327,818

0.68301

223,903

337,653

0.62092

209,656

347,782

0.56447

196,313 $1,397,091

*Present value of $1: n = 1, 2, 3, 4, 5, 6

i = 10%.

Beginning of the Lease (January 1, 2024) Right-of-use asset (present value of lease payments) ........... 1,397,091 Lease payable (present value of lease payments) ........... 1,397,091

16–432

Exercise 15433 Requirement 1 Because Taco King is required to make quarterly payments based on minimum sales revenue of $400,000, lease payments are in-substance fixed payments of $12,000 ($400,000 × 3%) and are the basis for measurement of the right-of-use asset and lessee‘s lease liability. January 1, 2024 Right-of-use asset .............................................. Lease payable ($12,000 x 33.16303)………….

397,956 397,956

 present value of an annuity due of $1: n=40, i=1%

Lease payable .................................................... Cash ($400,000 × 3%).....................................

12,000 12,000

Requirement 2 Quarterly variable lease payments based on sales over $400,000 per quarter are recognized only as incurred: April 1, 2024 Interest expense (1% x [$397,956 – $12,000])........... Lease expense ([$660,000 – $400,000] × 3%)])..... …. Lease payable (difference).................................... Cash ($660,000 × 3%)..................................... Amortization expense ($397,956 ÷ 40 quarters)....... Right-of-use asset........................................

3,860 7,800 8,140 19,800 9,949 9,949

16–433

Exercise 15434

The lease term will be 6 years. The lease term is the contractual lease term modified by any renewal or termination options for which exercise of the options is ―reasonably certain.‖

Requirement 1 January 1, 2024 Right-of-use asset .............................................. Lease payable ($10,000 x 5.07569 ) .................

50,757 50,757

 present value of an ordinary annuity of $1: n=6, i=5%

Requirement 2 December 31, 2024 Interest expense (5% x $50,757)................................ Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($10,000 – $2,538) ................ Right-of-use asset ..........................................

2,538 7,462 10,000 7,462 7,462

16–434

Exercise 15435

Situation 1 (a) Lessor’s Calculation of the Periodic Lease Payments: Amount to be recovered (fair value)

$50,000

Lease payments at the beginning of each of the next 4 years: ($50,000 ÷ 3.48685**) = $14,340 ** present value of an annuity due of $1: n=4, i=10%

(b) Lessee’s Calculation of the Right-of-Use Asset and Lease Liability: $14,340 lease payments

x 3.48685** =

$50,000 right-of-use asset/ lease payable

** present value of an annuity due of $1: n=4, i=10%

16–435

Exercise 15-24 (continued) Situation 2 (a) Lessor’s Calculation of the Periodic Lease Payments: Amount to be recovered (fair value)

$350,000

Less: Present value of the residual value ($50,000 x 0.48166*)

(24,083)

Amount to be recovered through periodic lease payments

$325,917

Lease payments at the beginning of each of the next 7 years: ($325,917 ÷ 5.23054**)

$62,310

* present value of $1: n=7, i=11% ** present value of an annuity due of $1: n=7, i=11%

From the lessor‘s perspective, even if a residual value is not guaranteed, the lessor still expects to receive it. So, the lessor will view the residual asset as contributing to amount needed to recover its investment causing the lessee‘s lease payments to be less than otherwise.

(b) Lessee’s Calculation of the Right-of-Use Asset and Lease Liability: $62,310

x 5.23054** =

$325,917

lease right-of-use asset/ payments lease payable ** present value of an annuity due of $1: n=7, i=11%

16–436

Exercise 15-24 (continued) Situation 3 (a) Lessor’s Calculation of the Periodic Lease Payments: Amount to be recovered (fair value)

$75,000

Less: Present value of the residual value ($7,000 x 0.64993*)

(4,550)

Amount to be recovered through periodic lease payments

$70,450

Lease payments at the beginning of each of the next 5 years:

$16,617

($70,450 ÷ 4.23972**)

* present value of $1: n=5, i=9% ** present value of an annuity due of $1: n=5, i=9%

From the lessor‘s perspective, even if a residual value is not guaranteed, the lessor still expects to receive it. So, the lessor will view the residual asset as contributing to the amount needed to recover its investment causing the lessee‘s lease payments to be less than otherwise. (b) Lessee’s Calculation of the Right-of-Use Asset and Lease Liability: $16,617 lease payments

x 4.23972** =

$70,450 right-of-use asset/ lease payable

** present value of an annuity due of $1: n=5, i=9%

16–437

Exercise 15-24 (concluded) Situation 4 (a) Lessor’s Calculation of the Periodic Lease Payments: Amount to be recovered (fair value) Less: Present value of the excess guaranteed residual value ([$50,000 – $45,000] x 0.40388*)

$465,000 (2,019)

Less: Present value of the residual value ($45,000 x 0.40388*) (18,175) Amount to be recovered through periodic lease payments $444,806 Lease payments at the beginning of each of the next 8 years:

($444,806 ÷ 5.56376**)

$79,947

* present value of $1: n=8, i=12% ** present value of an annuity due of $1: n=8, i=12%

(b) Lessee’s Calculation of the Right-of-Use Asset and Lease Liability: Present value of periodic lease payments ($79,947  5.56376**) Plus: Present value of an estimated cash payment under a residual value guarantee ($5,000†  0.40388*) Present value of expected total lease payments

$444,806 2,019 $446,825

* present value of $1: n=8, i=12% ** present value of an annuity due of $1: n=8, i=12% †

$50,000 guaranteed residual value minus $45,000 expected residual value

16–438

Exercise 15-25 Requirement 1 Income Statement: Interest revenue (10% x [$180,000 – $25,000]) ..............

$15,500

Requirement 2 Balance Sheet: Lease Receivable Initial balance ([$25,000 x 6.33493] + PV of the residual value) .. $180,000 January 1....................................................................... (25,000) December 31 ($25,000 – [10% x ($180,000 – $25,000)]) ............ (9,500) End-of-year balance ............................................................... $145,500 $180,000 asset under lease no longer in balance sheet

16–439

Exercise 15-25 (concluded) Journal entries (not required): Beginning of lease Lease receivable ($25,000 x 6.33493 + PV of the residual value ($50,995 x 0.42410) 180,000 Equipment (lessor‘s cost: net investment in the lease). 180,000 Cash (lease payment)............................................. Lease receivable ...........................................

25,000 25,000

 present value of an annuity due of $1: n=9, i=10%  present value of $1: n=9, i=10%

Note: Both (a) the present value of the lease payments, $158,373, and (b) the present value of the residual value (i.e., the residual asset) are included in the lease receivable because the two amounts combine to allow the lessor to recover its $180,000 net investment. The description of the lease provided us with the amount of the residual value the lessor used in its calculation of the lease payments, but we can calculate it from other information given: $180,000 – $158,373 = $21,627. $21,627 ÷ 0.42410  = $50,995.  present value of $1, n = 9, i = 10%

End of fiscal year Cash (lease payment)............................................. Lease receivable (difference) ............................ Interest revenue (10% x [$180,000 – $25,000]).....

16–440

25,000 9,500 15,500

Exercise 15441

Situation

A. The lessor‘s: 1. Lease payments1

$700,000 $700,000$800,000$800,000

2. Gross investment in the lease2 700,000 750,000808,000860,000 3. Net investment in the lease3 548,592 547,137590,574580,609 (Lease receivable) B. The lessee‘s: 4. Lease payments4 $700,000 $700,000$800,000$810,000 5. Right-of-use asset5 548,592 523,054586,842560,415 6. Lease payable6 548,592 523,054586,842560,415 1 ($100,000 x number of fixed payments) *; for situation 4: ($100,000 x 8). 2 Lease payments plus guaranteed residual value plus unguaranteed residual value; for situation 4: ($800,000 + $0 + $60,000). 3 Present value of gross investment (discounted at lessor‘s rate); for situation 4: ($100,000 x 5.56376) + ($60,000 x 0.40388). 4 ($100,000 x number of fixed payments) + excess lessee-guaranteed residual value*; for situation 4: ($100,000 x 8) + ($60,000 – $50,000). 5 Present value of lease payments + present value of excess lessee-guaranteed residual value* (discounted at lessor‘s rate); should not exceed fair value; for situation 4: ($100,000 x 5.56376) + ($10,000 x 0.40388). 6 Present value of lease payments + present value of excess lessee-guaranteed residual value* (discounted at lessor‘s rate); should not exceed fair value; for situation 4: ($100,000 x 5.56376) + ($10,000 x 0.40388). * Also would include any exercise price or termination penalty for options whose exercise is deemed reasonably certain + variable lease payments only if (a) deemed in-substance fixed payments or (b) based on an index or rate.

16–441

Exercise 15-27 Lessee’s Calculation of the Right-of-Use Asset and Lease Liability: $354,595 Present value of periodic lease payments ($100,000  3.54595*) Plus: Present value of an estimated cash payment under a 16,454 residual value guarantee ($20,000†  0.82270**) Present value of expected lease payments $371,049 * present value of $1: n=4, i=5% ** present value of an ordinary annuity of $1: n=4, i=5% † $70,000 guaranteed residual value minus $50,000 expected residual value

If a cash payment under a lessee-guaranteed residual value is predicted, the present value of that payment is added to the present value of the lease payments that the lessee records as both a right-of-use asset and a lease liability and, if a sales-type lease, that the lessor records as a lease receivable. Beginning of the Lease (January 1, 2024) Lessee Right-of-use asset .................................................. Lease payable (calculated above) ............................ December 31, 2024 Amortization expense ($371,049 ÷ 4 years)................. Right-of-use asset ............................................... Interest expense (5% x 371,049)................................. Lease payable (difference: from schedule) .................... Cash (annual payment) ...........................................

16–442

371,049 371,049

92,762 92,762 18,552 81,448 100,000

Exercise 15-28 Situation 1 Amount to be recovered (fair value)

$60,000

Less: Present value of the exercise price ($10,000 x 0.56743*)

(5,674)

Amount to be recovered through periodic lease payments

$54,326

Lease payments at the beginning of each of the next 5 years:

$13,456

($54,326 ÷ 4.03735**) =

* present value of $1: n=5, i=12% ** present value of an annuity due of $1: n=5, i=12%

Situation 2 Amount to be recovered (fair value)

$420,000

Less: Present value of the exercise price ($0 x 0.59345*)

(0) see note

Amount to be recovered through periodic lease payments

$420,000

Lease payments at the beginning of each of the next 5 years:

$102,378

($420,000 ÷ 4.10245**) =

* present value of $1: n=5, i=11% ** present value of an annuity due of $1: n=5, i=11% Note: Since the option is not ―reasonably certain‖ to be exercised, the exercise price is not considered a lease payment.

16–28

Exercise 15444 Situation 3 Amount to be recovered (fair value)

$185,000

Less: Present value of the exercise price ($22,000 x 0.77218*)

(16,988)

Amount to be recovered through periodic lease payments

$168,012

Lease payments at the beginning of each of the next 3 years:

$60,894

($168,012 ÷ 2.75911**) =

* present value of $1: n=3, i=9% ** present value of an annuity due of $1: n=3, i=9% Note: Since the purchase option is ―reasonably certain‖ to be exercised, the lease term ends for accounting purposes when the option becomes exercisable.

16–444

Exercise 15-29 Requirement 1 Note: Because exercise of the option appears at the beginning of the lease to be reasonably certain, payment of the option price ($45,000) is expected to occur when the option becomes exercisable (at the end of the third year). Present value of annual lease payments ($36,000 x 2.69005**)

$ 96,842

Plus: Present value of the exercise price ($45,000 x 0.71178*)

32,030

Present value of lease payments

$128,872

* present value of $1: n=3, i=12% ** present value of an annuity due of $1: n=3, i=12%

Requirement 2

Lease Amortization Schedule Payments

Effective Interest 12% x Outstanding Balance

Decrease in Balance

Outstanding Balance

128,872 1/1/24

36,000

92,872

12/31/24 36,000

.12 (92,872) = 11,145

24,855

68,017

12/31/25 36,000

.12 (68,017) =

8,162

27,838

40,179

12/31/26 45,000

.12 (40,179) =

4,821

40,179

24,128

128,872

153,000

16–445

Exercise 15-29 (concluded) Requirement 3 January 1, 2024 Right-of-use asset (calculated above)...................... Lease payable (calculated above) ........................ Lease payable .................................................... Cash (annual payment)........................................

December 31, 2024 Amortization expense ($128,872 ÷ 6 years*) ............ Right-of-use asset ........................................... Interest expense (12% x [$128,872 – $36,000]) .......... Lease payable (difference: from schedule) ................ Cash (annual payment)........................................

December 31, 2025 Amortization expense ($128,872 ÷ 6 years*) ............ Right-of-use asset ........................................... Interest expense (12% x $68,017: from schedule) ....... Lease payable (difference: from schedule) ................ Cash (annual payment)........................................ December 31, 2026 Amortization expense ($128,872 ÷ 6 years*) ............ Right-of-use asset ........................................... Interest expense (12% x $40,179: from schedule) ....... Lease payable (difference: from schedule) ................ Cash (option price).............................................

128,872 128,872 36,000 36,000

21,479 21,479 11,145 24,855 36,000

21,479 21,479 8,162 27,838 36,000

21,479 21,479 4,821 40,179 45,000

* Because title passes with the expected exercise of the option, amortization is for the entire six-year useful life of the asset. The amortization entry will be recorded for three years after the completion of the lease term.

16–446

Exercise 15-30 Requirement 1 Amount to be recovered (fair value)

$30,900

Less: Present value of the exercise price ($12,000 x 0.75131*)

(9,016)

Amount to be recovered through periodic lease payments

$21,884

Lease payments at the beginning each of three years: ($21,884 ÷ 2.73554**)

$8,000

* present value of $1: n=3, i=10% ** present value of an annuity due of $1: n=3, i=10%

Requirement 2

Lease Amortization Schedule Effective Payments Interest 10% x Outstanding Balance

Decrease in Balance

Outstanding Balance

30,900 1/1/24

8,000

22,900

12/31/24

8,000

.10 (22,900) = 2,290

5,710

17,190

12/31/25

8,000

.10 (17,190) = 1,719

6,281

10,909

12/31/26

12,000

.10 (10,909) = 1,091

10,909

36,000

5,100

30,900

16–447

Exercise 15-30 (concluded) Requirement 3 January 1, 2024 Lease receivable (PV of lease payments + PV of exercise price)…… Equipment (lessor‘s cost)............................................. Cash (lease payment)........................................................ Lease receivable........................................................

December 31, 2024 Cash (lease payment)........................................................ Lease receivable (difference) ....................................... Interest revenue (10% x [$30,900 – $8,000])...................... December 31, 2025 Cash (lease payment)........................................................ Lease receivable........................................................ Interest revenue (10% x $17,190: from schedule)............... December 30, 2026 Cash (exercise price) ........................................................ Lease receivable (account balance) ............................... Interest revenue (10% x $10,909: from schedule) ...............

16–448

30,900 30,900 8,000 8,000

8,000 5,710 2,290

8,000 6,281 1,719

12,000 10,909 1,091

Exercise 15-31 Does the contract explicitly or implicitly identify an asset to be used to fulfill the contract? No. Two key criteria must be met for an arrangement to constitute a lease: 1. There must be an identified asset, and 2. The lessee must have the right to control the use of the identified asset. The asset is identified because the contract explicitly specifies 45-foot slips for four boats which will be identified per boat, although the actual location of the slips is not identified. Although Warren Marina has agreed to provide a specific level of capacity within its marina, it has the unilateral right to relocate Lucky Fisher Fleet‘s boats for its own benefit and can do so without significant cost to accommodate more customers and thus provide economic benefit to Warren Marina. This is a substantive substitution right. Therefore, this agreement constitutes a service contract, not a lease. March 1, 2024 Prepaid expense ........................... 16,000 Cash……………………….

16,000

16–31

Exercise 15-32 Two key criteria must be met for an arrangement to constitute a lease: 1. There must be an identified asset, and 2. The lessee must have the right to control the use of the identified asset. The slips are identified in the contract even though the actual location of the slips is not identified. Now that we have determined that there is an identified asset, we check Criterion 2: Does Lucky Fisher Fleet have the right to control the use of the asset? What that means under the lease accounting guidance is that the customer can derive substantially all of the potential economic benefits from using the asset and direct the use of the asset throughout the contract term. In this situation Lucky Fisher Fleet (a) has sole use of the slips throughout the three-year period, indicating that it has the right to obtain substantially all the economic benefits from use of the slips and (b) ―can modify the slips with fenders, docklines, and equipment needed to conduct its fishing business.‖ Another consideration for this second criterion is whether Warren has the right to substitute alternative slips during the period of use and could benefit economically from such a substitution. If so, the lessee can‘t control the use of the identified asset. The agreement specifically prevents Warren from doing this. So, yes; this criterion is met. Both requirements are met: (1) There is an identified asset, and (2) the lessee has the right to control the use of the identified asset. We have a lease, and the lessee records a right-of-use asset and lease liability for the present value of the three lease payments. March 1, 2024 Right-of-use asset ($16,000 x 2.85941*)……………….. Lease payable (present value of lease payments)……

45,751 45,751

* present value of an annuity due of $1: n=3, i=5%

Lease payable……………………………………… Cash……………………………………………

16–450

16,000 16,000

Exercise 15-33 January 1, 2024 Brand Services (Lessee) Right-of-use asset ([$55,000 – $5,000] x 6.32825**)……….. Lease payable (present value of lease payments)…………

316,412 316,412

* present value of $1: n=10, i=12% ** present value of an annuity due of $1: n=10, i=12%

Lease payable (payment less maintenance costs).................. Maintenance expense (2024 fee) ........................................... Cash (annual payment) .................................................

50,000 5,000 55,000

Note: The maintenance payment could be recorded as a prepaid expense at the beginning of the period. Then, at December 31, we would need to credit prepaid maintenance expense and debit maintenance expense.

NRC Credit (Lessor) Lease receivable ([$55,000 – $5,000] x 6.32825**) ............. Equipment (lessor‘s cost)............................................. Cash (annual payment) ..................................................... Maintenance fee payable [or cash] ............................ Lease receivable .......................................................

316,412 316,412 55,000 5,000 50,000

16–33

Exercise 15-33 (concluded) Requirement 2 December 31, 2024 Brand Services (Lessee) Interest expense (12% x [$316,412 – $50,000]) ...................... Lease payable (difference)............................................... Prepaid maintenance expense (2025 fee)............................. Cash (lease payment).................................................... Amortization expense ($316,412 ÷ 10 years) ........................ Right-of-use asset .....................................................

NRC Credit (Lessor) Cash (lease payment)........................................................ Lease receivable (difference) ....................................... Maintenance fee payable [or cash] ............................ Interest revenue (12% x [$316,412 – $50,000])..................

16–34

31,969 18,031 5,000 55,000 31,641 31,641

55,000 18,031 5,000 31,969

Exercise 15453In a sales-type lease with no selling profit, initial direct costs are deferred and expensed over the lease term. This can be accomplished by not recording the ―prepaid expense‖ separately, but including it in the lease receivable (net investment). Increasing the receivable causes the implicit rate (the effective interest rate that causes the present value of the lease payments to equal the receivable) to be lower. Determining interest revenue at this lower rate accomplishes the purpose of reducing interest revenue each period by a portion of the prepaid expense. 1. January 1, 2024 Lease receivable (fair value / present value) ....................... 500,000 Equipment (lessor‘s cost)............................................. 500,000 Lease receivable ........................................................... Cash (initial direct costs) ...............................................

4,242 4,242

184,330 Cash (lease payment)........................................................ Lease receivable........................................................ 184,330 2. Effective rate of interest revenue: The initial direct costs increase the net investment (lease receivable): $500,000 + $4,242. The new effective rate is the discount rate that equates the net investment and the future lease payments: $504,242 ÷

? **

= $184,330

lessor‘s lease net investment payments ** present value of an annuity due of $1: n = 3, I = ?%

Rearranging algebraically: $504,242 ÷ $184,330 = 2.73554. When you consult the present value table for an annuity due, you search row 3 (n=3) for this value and find it in the 10% column. So the new effective interest rate is 10%. The net investment is amortized at the new rate. 3. December 31, 2024 Interest receivable ......................................................... Interest revenue (10% x [$500,000 + $4,242 – $184,330]) .....

31,991 31,991

16–453

Exercise 15454 In a sales-type lease that includes selling profit, initial direct costs are expensed in the period of ―sale‖ – that is, at the beginning of the lease. This assumes that in a sales-type lease the primary reason for incurring these costs is to enable the sale of the leased asset. Requirement 1 Beginning of the Lease, January 1, 2024 Lease receivable (fair value)............................................ Cost of goods sold (lessor‘s cost)..................................... Sales revenue (fair value) ............................................ Equipment (lessor‘s cost).............................................

300,000 265,000 300,000 265,000

Selling expense ............................................................. Cash (initial direct costs) ...............................................

7,500

Cash (lease payment)........................................................ Lease receivable........................................................

69,571

7,500

69,571

Requirement 2 December 31, 2024 Interest receivable ......................................................... Interest revenue (8% x [$300,000 – $69,571]).................

16–454

18,434 18,434

Exercise 15455 January 1, 2024 Deferred initial direct cost ............................................ Cash..........................................................................

2,400

January 1, 2024, 2025, 2026 Cash.............................................................................. Deferred lease revenue .............................................

137,000

December 31, 2024, 2025, 2026 Deferred lease revenue ................................................. Lease revenue ...........................................................

137,000

2,400

137,000

Lease expense ($2,400 ÷ 3 years) ..................................... Deferred initial direct cost.........................................

800

Depreciation expense ($800,000 ÷ 8 years) ....................... Accumulated depreciation.........................................

100,000

800

100,000

16–455

Exercise 15456

List A

List B

j_ 1. Effective rate times balance

a. PV of purchase option exercise price.

k_ 2. Revenue recognition issues

b. Lessor‘s net investment.

c_ 3. Lease payments plus

c. Lessor‘s gross investment.

residual value

d. Operating lease.

l_ 4. Periodic lease payments plus excess e. Depreciable assets. lessee-guaranteed residual value b_ 5. PV of lease payments plus PV of residual value

f. Component of lease payments. g. Nonlease payments. h. Amortization longer than lease term.

n_ 6. Initial direct costs

i. Disclosure only.

d_ 7. Rent revenue

j. Interest expense.

m_8. Purchase option

k. Control passed to lessee.

e_ 9. Leasehold improvements

l. Lessee‘s lease payments.

f_10. Cash expected to satisfy

m. Might shorten lease term.

residual value guarantee

n. Sales-type lease selling expense.

g_11. Payments expensed by the lessee a_12. Deducted in lessor‘s computation of lease payments h_13. Title transfers to lessee i_14. Contingent rentals .

16–456

Exercise 15457 Requirement 1

The specific citation that describes the guidelines for determining when the lessee should reassess the term of the lease is FASB ASC 842–10–35–14. Requirement 2 A lessee shall reassess the lease term if any of the following occur:

a) There is a significant event or a significant change in circumstances that is within the control of the lessee that directly affects whether the lessee is reasonably certain to exercise or not to exercise an option to extend or terminate the lease or to purchase the underlying asset. b) There is an event that is written into the contract that obliges the lessee to exercise (or not to exercise) an option to extend or terminate the lease. c) The lessee elects to exercise an option even though the entity had previously determined that the lessee was not reasonably certain to do so. d) The lessee elects not to exercise an option even though the entity had previously determined that the lessee was reasonably certain to do so.

16–457

Exercise 15458 The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1.

Definition of initial direct costs: FASB ASC 842–10–20: ―Leases–Overall–Glossary.‖ Also found in Master Glossary.

2. When a modification to a contract is reported as a separate contract (that is, separate from the original contract): FASB ASC 842–10–25–8: ―Leases–Recognition–Lease Modifications. 3.

The disclosures required in the notes to the financial statements for a lessor. FASB ASC 842–30–50: ―Leases–Lessors–Disclosure.‖

Classification criteria for when a lessee classifies a lease as a finance lease and a lessor classifies a lease as a sales-type lease. FASB ASC 840–10–25–2: "Leases–Overall–Recognition–Lease Classification Criteria‖

16–458

Exercise 15459 Requirement 1

The lessee reports operating lease rent payments, both the interest and liability portions, entirely as operating expenses, but reports the interest portion of financing lease rent payments as a cash outflow from operating activities and the principal portion as a cash outflow from financing activities. ($ in millions)

Lease expense…………………… Cash………………………

1,829 1,829

Requirement 2 ($ in millions)

Interest expense………………… Lease payable………………….. Cash……………………..

336 409 745

16–459

Exercise 15460 Requirement 1 Transfer of ownership indicates that the leaseback arrangement would qualify as a finance lease, instead of an operating lease. So, the transaction does not qualify for sale-leaseback accounting. We view the transaction, not as a sale, but as a loan by the finance company to the Signal for the $770,000 ―sale‖ price. The asset remains on the lessee‘s books. The ―lease‖ payments are considered to be repayment of the loan. Present value of periodic payments* ($102,771 x 7.49236**) $770,000* * rounded ** present value of an annuity due of $1: n=13, i=11%

January 1, 2024 Cash (given) ................................................................... Note payable ............................................................. Note payable ................................................................ Cash..........................................................................

770,000 770,000 102,771 102,771

Requirement 2 December 31, 2024 Interest expense (11% x [$770,000 – $102,771]) .................... Interest payable ........................................................ Depreciation expense ($600,000 ÷ 15 years*).................... Accumulated depreciation.........................................

73,395 73,395 40,000 40,000

* The airplane is depreciated over its remaining useful life rather than the lease (loan) term because there is no sale or lease. The title remains with the lessee.

16–460

Exercise 15461Requirement 1 January 1, 2024 Cash (given) ................................................................... Accumulated depreciation (cost – book value) .................. Building (original cost) ................................................ Gain on sale-leaseback (difference) ............................. Right-of-use asset .............................................. Lease payable ($100,000 x 7.16073 ) ...............

800,000 350,000 1,000,000 150,000 716,073 716,073

 present value of an ordinary annuity of $1: n=12, i=9%

Requirement 2 December 31, 2024 Interest expense (9% x $716,073).............................. Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($100,000 – $64,447)............ Right-of-use asset ..........................................

64,447 35,553 100,000 35,553 35,553

In an operating lease, the lessee determines interest the normal way (at the effective interest rate) and then “plugs” the right-of-use asset amortization at the amount that is needed for interest plus amortization to equal the straight-line lease payment. The lessee reports that amount as a single lease expense in the income statement. Although ASC 842 doesn‘t specify this decomposition, the lessee must (a) calculate the interest component in order to determine the reduction of the lease payable over the lease term and (b) calculate the amortization component in order to determine the reduction in the balance of the right-of-use asset over the lease term. For convenience, we determine and record these two "components" and then combine them for reporting purposes.

PROBLEMS

16–461

Problem 15-1 Calculation of interest expense for the year ended December 31, 2024 Bonds payable

$ 91,421

[1]

Notes payable

49,500

[2]

Finance lease

9,947

[3]

Total interest expense

$150,868

[1] $1,828,418 x 10% x ½ = $91,421

Interest

$90,000¥

Principal $2,000,000

x 17.15909 * x

0.14205 **

Present value (price) of the note

= $1,544,318

284,100 $1,828,418

¥ 9% x ½ x $2,000,000 * present value of an ordinary annuity of $1: n=40, i=5% ** present value of $1: n=40, i=5%

16–462

Problem 15-1 (concluded) [2] June 30: $500,000 x 10% x ½ = Dec. 31: ($500,000 – [$60,000 – $25,000 – $25,000]) x 10% x ½ = 2024 interest Relevant journal entries: December 31, 2023 (adjusting entry) Interest expense ($500,000 x 10% x ½)…… Interest payable…………………….

$25,000 24,500 $49,500

25,000 25,000

June 30, 2024 Interest expense ($500,000 x 10% x ½)….. Interest payable (from adjusting entry)…… Note payable (difference)…………………. Cash (annual payment)…………………

25,000 25,000 10,000 60,000

December 31, 2024 Interest expense ([$500,000 – $10,000] x 10% x ½).. 24,500 Interest payable…………………………. 24,500

[3]

10% x $99,474 ($139,474* – $40,000) = $9,947 * $40,000 x 3.48685** lease payment

$139,474 present value

** present value of an annuity due of $1: n=4, i=10%

16–463

Problem 15[Note: This problem is the lease equivalent of Problem 14-12, which deals with a parallel situation 464 in which the machine was acquired with an installment note.] 1. Effective rate of interest implicit in the agreement $6,074,700

present value

$2,000,000 = lease payment

3.03735 present value table amount

This is the ordinary annuity present value table amount for n = 4, i = ? In row 4 of the present value of an ordinary annuity table, the number 3.03735 is in the 12% column. So, 12% is the implicit interest rate. 2. Beginning of the lease Right-of-use asset ........................................................ Lease payable (present value).......................................

6,074,700

3. December 31, 2024 Interest expense (12% x $6,074,700) ...................................... Lease payable (difference)............................................... Cash (lease payment)....................................................

728,964 1,271,036

6,074,700

2,000,000

4. December 31, 2025 Interest expense (12% x [$6,074,700 – $1,271,036]) .............. Lease payable (difference)............................................... Cash (lease payment)....................................................

576,440 1,423,560 2,000,000

5. Beginning of the lease $2,000,000 x 3.10245** lease payment

$6,204,900 present value

** present value of an ordinary annuity of $1: n=4, i=11%

Right-of-use asset ........................................................ Lease payable ...........................................................

16–464

6,204,900 6,204,900

Problem 15-3 1. Majestic’s lease payable at the beginning of the lease $167,298: [$187,298 – $20,000] (present value of lease payments or initial lease balance minus first payment) 2. Right-of-use asset $187,298 (present value of lease payments; initial lease balance) 3. Lease term in years 20 years: 2024 to 2043 4. Effective annual interest rate 10%: ($16,730 ÷ $167,298) 5. Total of lease payments $400,000: [$20,000 x 20 years] 6. Total effective interest expense over the term of the lease $212,702: [$400,000 – $187,298]

16–465

Problem 15-4 Requirement 1 Finance lease to lessee;

Sales-type lease to lessor.

Since the present value of lease payments (same for both the lessor and the lessee) is the same value (100%) as the fair value of the asset at the beginning date, they exceed ―substantially all‖ of the fair value of the asset, and the substantially all fair value criterion is met. Calculation of the Present Value of Lease Payments Present value of periodic lease payments $130,516 x 15.32380**

$2,000,000 (rounded)

** present value of an annuity due of $1: n=20, i=3%

The lease term criterion is met also because the lease term is the entire estimated economic life of the asset.

Requirement 2 Mid-South Urologists Group (Lessee) January 1, 2024 Right-of-use asset (calculated above)................................ Lease payable (calculated above) .................................. Lease payable .............................................................. Cash (lease payment).................................................... April 1, 2024 Interest expense (3% x [$2 million – $130,516])..................... Lease payable (difference)............................................... Cash (lease payment).................................................... 16–466

2,000,000 2,000,000 130,516 130,516 56,085 74,431 130,516 Intermediate Accounting, 11/e

Problem 15-4 (concluded) Physicians’ Leasing (Lessor) January 1, 2024 Lease receivable (present value calculated above) ......... Equipment (lessor‘s cost)....................................... Cash (lease payment).................................................. Lease receivable ................................................. April 1, 2024 Cash (lease payment).................................................. Lease receivable (difference) ................................. Interest revenue (3% x [$2 million – $130,516]) .........

Requirement 3 Rand Medical (Lessor) January 1, 2024 Lease receivable (present value calculated above) ......... Cost of goods sold (lessor‘s cost)..................................... Sales revenue (present value calculated above) ................ Equipment (lessor‘s cost)............................................. Cash (lease payment)........................................................ Lease receivable ....................................................... April 1, 2024 Cash (lease payment)........................................................ Lease receivable (difference) ....................................... Interest revenue (3% x [$2 million – $130,516]) ................

2,000,000 2,000,000 130,516 130,516

130,516 74,431 56,085

2,000,000 1,700,000 2,000,000 1,700,000 130,516 130,516

130,516 74,431 56,085

16–467

Problem 15-5 Requirement 1 Beginning of the Lease (January 1, 2024) Right-of-use asset ($100,000 + [$80,000 x 2.72325*) .. Lease payable (present value of lease payments)...........

317,860 317,860

.....................

Lease payable……………………………….. ....... Cash (advance payment).....................................

100,000 100,000

* present value of an ordinary annuity of $1: n=3, i=5%

Leasehold improvements……………………………….. 180,000 Cash ............................................................... 180,000 Second Lease Payment (December 31, 2024) Interest expense (5%  [$317,860 – $100,000]).... Lease payable (difference)................................ Cash (1st lease payment).................................

10,893 69,107

Amortization expense ($113,333 – $10,893).... Right-of-use asset (to balance)......................

102,440

80,000 102,440

 ($100,000 + [$80,000 x 3]) ÷ 3 = $113,333 straight-line lease expense Note: For some operating leases, the asset and liability will be the same at any point during the life of the lease. If there are uneven payments (advance payment, first payment at the commencement of the lease, scheduled payment increases, or scheduled payment decreases), the lease leveling effect will be reflected in the right-of-use asset.

Depreciation expense ($180,000 ÷ 3 years) .................. Accumulated depreciation – leasehold improvement

60,000 60,000

Third Lease Payment (December 31, 2025) Interest expense (5%  [$317,860 – $100,000 – $69,107]) Lease payable (difference)................................ Cash (2nd lease payment) ................................

7,438 72,562

Amortization expense ($113,333 – $7,438)...... Right-of-use asset (to balance)......................

105,895

Depreciation expense ($180,000 ÷ 3 years) .................. Accumulated depreciation – leasehold improvement

60,000

16–468

80,000 105,895

60,000 Intermediate Accounting, 11/e

Problem 15-5 (concluded) Fourth Lease Payment (December 31, 2026) Interest expense (5%  [$317,860 – $100,000 – $69,107 – $72,562]) 3,810 Lease payable (difference)................................ 76,190 rd Cash (3 lease payment) ................................ 80,000 Amortization expense ($113,333 – $3,810)...... Right-of-use asset ......................................

109,523

Depreciation expense ($180,000 ÷ 3 years) .................. Accumulated depreciation – leasehold improvement

60,000

109,523

60,000

16–469

Problem 15-6 1. Lease term in years 20 years: 2024 to 2043 2. Asset’s residual value expected at the end of the lease term $35,000: Even if not guaranteed, the residual value is expected by the lessor. 3. Effective annual interest rate 10%: ($17,250 ÷ $172,501) 4. Total of lease payments – United $435,000: [$20,000 x 20 years] + $35,000: Even if not guaranteed, the residual value is expected by the lessor. 5. Total of lease payments – NIC $400,000: $20,000 x 20 years 6. United’s net investment in the lease at the beginning of the lease $172,501: [$192,501 – $20,000] (present value of lease payments [periodic payments plus residual value], or initial lease balance minus first payment). Remember, we include the residual asset (PV of residual value) in the Lease receivable along with the PV of the periodic lease payments. 7. Total effective interest revenue over the term of the lease $242,499: [$435,000 – $192,501] 8. Right-of-use asset $187,298 (present value of NIC‘s lease payments; $20,000 x 9.36492*) *present value of annuity due; n=20, i=10%

16–470

Problem 15-7 Requirement 1 The lease term should be reassessed only when there is a significant event or change in circumstances, within the control of the lessee, that the lessee‘s economic incentive to exercise any options to extend or terminate the lease has changed. That is the case here. At the end of the second year, Rick‘s had made significant improvements to the asset whose cost could be recovered only if it exercises the extension option, making it ―reasonably certain‖ that Rick‘s will exercise the option to extend the lease having considered the relevant economic factors. So, the lessee would re-assess the lease term, so the revised term is now a total of nine years with seven years remaining. Rick‘s should remeasure the lease payable as the present value of the remaining seven lease payments. The discount rate for the new term is the incremental borrowing rate of the lessee using market interest rates at the time of the reassessment, 6% in this instance, rather than the rate used at the beginning of the lease. Here are the entries: Entries for first two years (not required) January 1, 2024 Right-of-use asset .............................................. Lease payable ($10,000 x 5.07569 ) .................

50,757 50,757

 present value of an ordinary annuity of $1: n=6, i=5%

December 31, 2024 Interest expense (5% x $50,757)................................ Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($10,000 – $2,538)................ Right-of-use asset ..........................................

2,538 7,462 10,000 7,462 7,462

16–471

statement.

16–472

Problem 15-7 (concluded) December 31, 2025 Interest expense (5% x [$50,757 – $7,462])............... Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($10,000 – $2,165)................ Right-of-use asset .......................................... January 1, 2026 Reassessment: Right-of-use asset .............................................. Lease payable (increase in balance*) ...........

2,165 7,835 10,000 7,835 7,835

20,364 20,364

* PV of remaining 7 payments, discounted at 6% ($10,000 x 5.58238) Liability balance after 2 years ($50,757 – $7,462 – $7,835) Increase in balance

$55,824 35,460 $20,364

Also, lessees are required to reassess the classification of a lease when there is a change in the lease term (or a change in the assessment of a lessee option to purchase the underlying asset). Because, with the assumed renewal, the lease term is for the entire useful life of the asset, it would be considered a finance lease rather than an operating lease as previously classified. As a result, we had an operating lease for two years, and now have a seven-year finance lease. So, amortization of the right-of-use asset will be a straight-line allocation of the balance in that account at this point ([$50,757 – $7,462 – $7,835] + $20,364) = $55,824 over the next seven years. December 31, 2026 Interest expense (6% x $55,824)................................ Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($55,824 ÷ 7 years) ............... Right-of-use asset ..........................................

3,349 6,651 10,000 7,975 7,975

Requirement 2 A lessor is never required to reassess the lease term.

16–473

Problem 15-8 Situation 1 A. The lessor‘s: 1. Lease payments1

$40,000

$40,000$40,000$33,000

40,000 34,437

44,00044,00037,000 37,07237,07229,319

4. Lease payments4

$40,000

$40,000$40,000$33,000

5. Right-of-use asset5 6. Lease payable6

34,437 34,437

34,43734,43729,319 34,43734,43729,319

2. Gross investment in the lease2 3. Net investment in the lease3 B. The lessee‘s:

($10,000 x number of fixed payments) + exercise price or termination penalty for options whose exercise is deemed reasonably certain* + ; for situations 1 to -3: ($10,000 x 4); for situation 4: ($10,000 x 3) + $3,000.

2 Lease payments (from 1) plus guaranteed residual value plus unguaranteed residual value; for situation 3: ($10,000 x 4) + ($2,000 + $2,000). 3 Present value of gross investment; for situations 2 and 3: ($10,000 x 3.44371) + ($4,000 x 0.65873); for situation 4: ($10,000 x 2.71252) + ($3,000 x 0.73119). 4 ($10,000 x number of payments) + excess lessee-guaranteed residual value*; for situation 3: ($10,000 x 4) + $0. 5 Present value of lease payments; for situations 1 to 3: ($10,000 x 3.44371); for situation 4: ($10,000 x 2.71252) + ($3,000 x 0.73119). 6 Present value of lease payments; for situations 1 to 3: ($10,000 x 3.44371); for situation 4: ($10,000 x 2.71252) + ($3,000 x 0.73119). * Also would include any variable lease payments only if (a) deemed in-substance fixed payments or (b) based on an index or rate.

16–474

Problem 15-9 Requirement 1 Note: Because exercise of the option appears at the beginning of the lease to be reasonably certain, payment of the option price ($6,000) is expected to occur when the option becomes exercisable (at the end of the eighth quarter). Also, the lease contract specifies that the BPO becomes exercisable before the designated lease term ends. Since a BPO is expected to be exercised, the lease term ends for accounting purposes when the option becomes exercisable (after two years of the three-year lease term).

Present value of quarterly lease payments ($3,000 x 7.23028**)

$21,691

Plus: Present value of the BPO price ($6,000 x 0.78941*) Present value of lease payments

4,736 $26,427

present value of $1: n=8, i=3%

** present value of an annuity due of $1: n=8, i=3%

―Selling price‖ minus Truck‘s cost equals Selling profit

$26,427 (25,000) $ 1,427

16–475

Problem 15-9 (continued) Not required in the problem, but helpful to see that the present value calculation is precisely the reverse of the lessor’s calculation of quarterly payments: Amount to be recovered (fair value)

$26,427

Less: Present value of the BPO price ($6,000 x 0.78941*)

(4,736)

Amount to be recovered through quarterly lease payments

$21,691

Lease payments at the beginning each of the next eight quarters:

$3,000

($21,691 ÷ 7.23028**)

* present value of $1: n=8, i=3% ** present value of an annuity due of $1: n=8, i=3%

Requirement 2 September 30, 2024 Anything Grows (Lessee) Right-of-use asset ......................................................... Lease payable (present value of lease payments) .............. Lease payable .............................................................. Cash (lease payment)....................................................

16–476

26,427 26,427 3,000 3,000

Mid-South Auto Leasing (Lessor) Lease receivable (calculated above) .................................. Cost of goods sold (lessor‘s cost)..................................... Sales revenue (calculated above)................................... Equipment (lessor‘s cost)............................................. Cash (lease payment)........................................................ Lease receivable........................................................

26,427 25,000 26,427 25,000 3,000 3,000

16–477

Problem 15-9 (continued) Requirement 3 Since both use the same discount rate, the amortization schedule for the lessee and lessor is the same:

Lease Amortization Schedule Date

Payments

9/30/24 9/30/24 3,000 12/31/24 3,000 3/31/25 3,000 6/30/25 3,000 9/30/25 3,000 12/31/25 3,000 3/31/26 3,000 6/30/26 3,000 9/29/26 6,000 30,000

Effective Interest 3% x Outstanding Balance

.03 (23,427) = .03 (21,130) = .03 (18,764) = .03 (16,327) = .03 (13,817) = .03 (11,232) = .03 (8,569) = .03 (5,826) =

703 634 563 490 415 337 257 174* 3,573

Decrease in Balance

Outstanding Balance

26,427 23,427 21,130 18,764 16,327 13,817 11,232 8,569 5,826 0

3,000 2,297 2,366 2,437 2,510 2,585 2,663 2,743 5,826 26,427

* adjusted for rounding of other numbers in the schedule

16–478

Problem 15-9 (continued) Requirement 4 December 31, 2024 Anything Grows (Lessee) Amortization expense ([$26,427 ÷ 4 years*] x 1/4 year) ........ Right-of-use asset ..................................................... Interest expense (3% x [$26,427 – $3,000]: from schedule) ... Lease payable (difference: from schedule) .......................... Cash (lease payment)....................................................

Mid-South Auto Leasing (Lessor) Cash (lease payment)........................................................ Lease receivable (difference : from schedule) ................. Interest revenue (3% x [$26,427 – $3,000]) .......................

1,652 1,652 703 2,297 3,000

3,000 2,297 703

* Because title passes with the expected exercise of the BPO, depreciation is over the full 4-year useful life.

16–479

Problem 15-9 (concluded) Requirement 5 September 29, 2026 Anything Grows (Lessee) Amortization expense ([$26,427 ÷ 4 years*] x 1/4 year) ........ Right-of-use asset ..................................................... Interest expense (3% x $5,826 : from schedule) ...................... Lease payable (difference: from schedule) .......................... Cash (BPO price).........................................................

Mid-South Auto Leasing (Lessor) Cash (BPO price)............................................................. Lease receivable (difference: from schedule) .................. Interest revenue (3% x $5,826: from schedule)...................

1,652 1,652 174 5,826 6,000

6,000 5,826 174

* Because title passes with the expected exercise of the BPO, amortization is over the full 4-year useful life.

16–480

Problem 15–10 Requirement 1 January 1, 2024 Operating lease: no entry December 31, 2024 Cash (lease payment)............................................. Lease revenue .......................................................

8,000 8,000

Requirement 2 January 1, 2025 Operating lease: no entry The lease term now is expected to be four years, three years remaining after the first year. It still is considered an operating lease. Lease revenue continues to be $8,000 per year, but now for three remaining years rather than five years.

Requirement 3 December 31, 2025 Cash (lease payment)............................................. Lease revenue .......................................................

8,000 8,000

16–481

Problem 15–11 Requirement 1 The lease term will be five years. The lease term for both the lessee and the lessor is the contractual lease term modified by any renewal or termination options the lessee is reasonably certain to exercise. The three-year renewal option can be exercised for significantly less than the original rate, which implies that lessee is reasonably certain to extend the original lease term to five years. Present Value of Lease Payments: $15,000 x 7.47199* = $112,080 ** 8,000 x 10.78685 = $86,295 x 0.85349*** = 73,652 $185,732 Because the 12 quarter annuity doesn‘t begin for 8 quarters, $86,295 is its PV at that future time, and we need to multiply by .85349 to find its PV now. * Present value of an annuity due of $1: n = 8, i = 2% **Present value of an annuity due of $1: n = 12, i = 2% ***Present value of $1: n = 8, i = 2% [i = 2% (8% ÷ 4) because the lease calls for quarterly payments.]

January 1, 2024 Right-of-use asset .................................................... Lease payable (present value calculated above) .... Lease payable .................................................... Cash (lease payment)......................................... March 31, 2024 Interest expense (2% x [$185,732 – $15,000]) ........... Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($185,732 ÷ 20 quarters) ....... Right-of-use asset ..........................................

16–482

185,732 185,732 15,000 15,000 3,415 11,585 15,000 9,287 9,287

Problem 15–11 (concluded) Requirement 2 Amortization Schedule: Cash Payments

Effective Interest

15,000

.02 (170,732)

15,000

.02 (159,147)

15,000

Decrease in Balance

Balance 185,732

15,000

170,732

3,415

11,585

159,147

3,183

11,817

147,330

.02 (147,330)

2,947

12,053

135,276

15,000

.02 (135,276)

2,706

12,294

122,982

15,000

.02 (122,982)

2,460

12,540

110,441

15,000

.02 (110,441)

2,209

12,791

97,650

15,000

.02

(97,650)

1,953

13,047

84,603

8,000

.02

(84,603)

1,692

6,308

78,295

8,000

.02

(78,295)

1,566

6,434

71,861

8,000

.02

(71,861)

1,437

6,563

65,298

8,000

.02

(65,298)

1,306

6,694

58,604

8,000

.02

(58,604)

1,172

6,828

51,776

8,000

.02

(51,776)

1,036

6,964

44,812

8,000

.02

(44,812)

896

7,104

37,708

8,000

.02

(37,708)

754

7,246

30,462

8,000

.02

(30,462)

609

7,391

23,072

8,000

.02

(23,072)

461

7,539

15,533

8,000

.02

(15,533)

311

7,689

7,844

8,000

.02

(7,844)

156

7,844

16–483

Problem 15–12 Requirement 1 January 1, 2024 Present Value of Lease Payments for Lessee Present value of periodic lease payments ($200,000 x 3.54595**)

$709,190

Plus: Present value of the excess lessee-guaranteed residual value ($40,000 x 0.82270*)

32,908

Present value of lease payments

$742,098

* present value of $1: n = 4, i = 5% ** present value of an ordinary annuity of $1: n = 4, i = 5%

If a lessee-guaranteed residual value exceeds the estimate of the actual residual value, that excess is considered an additional cash payment and is added to the present value of the lease payments the lessee records as both a right-of-use asset and a lease liability. Karrier (Lessee) Right-of-use asset (calculated above)………….. Lease payable (calculated above)………….

16–484

742,098 742,098

Problem 15–12 (continued) Lease Receivable for Lessor Present value of periodic lease payments ($200,000 x 3.54595**)

$709,190

Plus: Present value of the residual value ($300,000 x 0.82270*)

246,810

Plus: Present value of the excess lessee-guaranteed residual value ($40,000 x 0.82270*) Present value of lease payments

32,908 $988,908

* present value of $1: n = 4, i = 5% ** present value of an ordinary annuity of $1: n = 4, i = 5%

The lessor includes both guaranteed and unguaranteed residual value (at PV) in its lease receivable because it expects to receive that value whether it‘s guaranteed or not. Also, if a guaranteed residual value exceeds the estimate of the actual residual value, that excess (at PV) is considered an additional cash payment and also is included in the lessor‘s lease receivable. For its sales revenue, the lessor includes a residual value only if it‘s guaranteed, as it is here, because the lessor is assured of receiving the residual value either in cash or in the value of the asset returned. In that case, the present value of the residual value (the residual asset) is added to the present value of cash receipts that the lessor records as sales revenue. [Note that if the residual value is not guaranteed, we would not include its present value in either sales or cost of goods sold because there would be less certainty that the unguaranteed portion of the asset has been sold. Also, note that the selling profit would be the same either way (guaranteed or not); only the amounts of sales revenue and cost of goods sold would differ.] If a guaranteed residual value exceeds the estimate of the actual residual value, that excess (at PV) is considered an additional cash payment and also is included in both the lessor‘s lease receivable and sales revenue.

16–485

Problem 15–12 (concluded) Ghosh (Lessor) Lease receivable (calculated above) .................................. Cost of goods sold ($956,000) ...................................... Sales revenue ($988,908) .......................................... Equipment ................................................................ December 31, 2024 Karrier (Lessee) Interest expense (5% x $742,098) ........................................... Lease payable (difference)............................................... Cash (lease payment).................................................... Amortization expense ($742,098 ÷ 4 years) .......................... Right-of-use asset ..................................................... Ghosh (Lessor) Cash (lease payment)........................................................ Lease receivable (difference) ....................................... Interest revenue (5% x $988,908).......................................

988,908 956,000 988,908 956,000

37,105 162,895 200,000 185,525 185,525 200,000 150,555 49,445

Note: The situation described, in which the lessee-guaranteed residual value exceeds the estimate of the actual residual value, is unusual in practice. However, the requirement to account for it in this way serves as a deterrent to lessees and lessors who might be inclined to manipulate reported numbers by reducing lease payments while creating an excess lessee-guaranteed residual value to compensate for the reduced lease payments.

16–486

Problem 15–13 Present Value of Lease Payments: ($14,547 x 16.67846**) = lease payments

$242,622 present value

** Present value of an annuity due of $1: n = 20, i = 2% [i = 2% (8% ÷ 4) because the contract calls for quarterly payments]

Requirement 1 January 1, 2024 Right-of-use asset (PV calculated above)................ Lease payable (PV calculated above) .................. Lease payable .................................................... Cash (lease payment)......................................... March 31, 2024 Interest expense (2% x [$242,622 – $14,547])........... Lease payable (difference).................................... Cash (lease payment)......................................... Amortization expense ($242,622 ÷ 20 quarters)....... Right-of-use asset ..........................................

242,622 242,622 14,547 14,547

4,562 9,985 14,547 12,131 12,131

16–487

Problem 15-13 (concluded) Requirement 2 January 1, 2024 Lease receivable ([$14,547 x 16.67846**] + [$25,823 x 0.67297*]) Cost of goods sold ($200,000 – $17,378) .................................. Sales revenue ($260,000 – $17,378) ...................................... Equipment (carrying value) ..................................................

260,000 182,622 242,622 200,000

* Present value of $1: n = 20, i = 2% ** Present value of an annuity due of $1: n = 20, i = 2% Residual asset calculated as the present value (n = 20, i = 2%) of the anticipated fair value at the end of the lease term: $25,823 x 0.67297 = $17,378.

Note: Both (a) the present value of the lease payments, $242,662, and (b) the present value of the residual value are included in the lease receivable because the two amounts combine to allow the lessor to recover its $260,000 net investment. But for its sales revenue, the lessor includes a residual value only if it’s guaranteed because the lessor would be assured of receiving the residual value either in cash or in the value of the asset returned. Since the residual value is not guaranteed, we would not include its present value in either sales or cost of goods sold (subtract from both) because there would is less certainty that the unguaranteed portion of the asset has been sold.

Cash (lease payment).................................................... Lease receivable ................................................... March 31, 2024 Cash (lease payment).................................................... Lease receivable (difference) ................................... Interest revenue (2% x [$260,000 – $14,547])...............

16–488

14,547 14,547

14,547 9,638 4,909

Problem 15-14 Quality receives two separate benefits in the lease contract – the right to use equipment and maintenance on that equipment. So, payments specified in the lease contract contain a separate lease component (use of equipment for $51,000) and a nonlease component (maintenance service of $5,000). There also is a fixed payment for hazard insurance that does not transfer to the lessee a separate good or service. Payments for hazard insurance and property taxes are specifically identified in the lease accounting guidance as part of the lease payments (to be capitalized) rather than nonlease components (to be expensed separately). Thus, the right-of-use asset and lease liability (and the lessor‘s lease receivable) would be measured as the present value of the $51,000 lease payments, not $56,000. At the beginning of the lease, Quality records a right-of-use asset and lease liability for the present value of the ten $51,000 lease payments. For the first payment of $56,000, $5,000 is recorded as maintenance expense and the remaining $51,000 reduces the lease liability. January 1, 2024 Quality Services (Lessee) Right-of-use asset ([$56,000 – $5,000] x 6.32825**)……... Lease payable (present value of lease payments)……….

322,741 322,741

* present value of $1: n=10, i=12% ** present value of an annuity due of $1: n=10, i=12%

51,000 5,000 56,000

Note: The maintenance payment could be recorded as a prepaid expense at the beginning of the period. Then, at the December 31, we would need to credit prepaid maintenance expense and debit maintenance expense.

16–489

Problem 15–14 (concluded) Lesco Leasing (Lessor) Lease receivable ([$56,000 – $5,000] x 6.32825**) ............. Equipment (lessor‘s cost)............................................. Cash (annual payment) ..................................................... Maintenance fee payable [or cash] ............................ Lease receivable .......................................................

322,741 322,741 56,000 5,000 51,000

Requirement 2 December 31, 2024 Quality Services (Lessee) Interest expense (12% x [$322,741 – $51,000]) ...................... Lease payable (difference)............................................... Prepaid maintenance expense (2025 fee)............................. Cash (lease payment).................................................... Amortization expense ($322,741 ÷ 10 years) ........................ Right-of-use asset ..................................................... Lesco Leasing (Lessor) Cash (lease payment)........................................................ Lease receivable (difference) ....................................... Maintenance fee payable [or cash] ............................ Interest revenue (12% x [$322,741 – $51,000])..................

16–490

32,609 18,391 5,000 56,000 32,274 32,274

56,000 18,391 5,000 32,609

Problem 15-15 Requirement 1 January 1 Cash.............................................................................. Deferred lease revenue * ........................................... Deferred initial direct cost ............................................ Cash.......................................................................... December 31 Deferred lease revenue ................................................. Lease revenue ........................................................... Lease expense ($2,062 ÷ 3 years) ..................................... Deferred initial direct cost.........................................

20,873 20,873 2,062 2,062

20,873 20,873 687 687

Depreciation expense ($100,000 ÷ 6 years) ....................... 16,667 Accumulated depreciation......................................... 16,667 * Alternatively, Lease revenue. Either way, an adjusting entry is needed at the end of the reporting period to assure that the recognized portion of the payment is recorded in Lease revenue and the deferred portion in Deferred lease revenue

16–491

Problem 15-15 (continued) Requirement 2 In a sales-type lease with no selling profit, initial direct costs are deferred and expensed over the lease term. This can be accomplished by not recording the ―prepaid expense‖ separately, but including it in the lease receivable (net investment). Increasing the receivable causes the implicit rate (the effective interest rate that causes the present value of the lease payments to equal the receivable) to be lower. Determining interest revenue at this lower rate accomplishes the purpose of reducing interest revenue each period by a portion of the prepaid expense. January 1 Proof that new implicit rate is 9% (not required): $102,062 ÷ 4.88965** = $20,873 lessor‘s lease net investment payments ** present value of an annuity due of $1: n=6, i=9%

January 1 Lease receivable (fair value / present value) ....................... Equipment (lessor‘s cost).............................................

100,000 100,000

Lease receivable ........................................................... Cash (initial direct costs)...............................................

2,062

Cash (lease payment)........................................................ Lease receivable........................................................

20,873

December 31 Interest receivable ......................................................... Interest revenue (9% x [$100,000 + $2,062 – $20,873]) ....

16–492

2,062

20,873

7,307 7,307

Problem 15-15 (concluded) Requirement 3 January 1 Lease receivable (fair value / present value) ....................... Cost of goods sold (lessor‘s cost)..................................... Sales revenue (fair value / present value) ........................ Equipment (lessor‘s cost).............................................

100,000 85,000 100,000 85,000

Selling expense ............................................................. Cash (initial direct costs) ...............................................

2,062

Cash (lease payment)........................................................ Lease receivable........................................................

20,873

December 31 Interest receivable ......................................................... Interest revenue (10% x [$100,000 – $20,873]) ...............

2,062

20,873

7,913 7,913

16–493

Problem 15-16 Requirement 1 Branson Construction (Lessee) Interest expense (10% x [$936,492* – $100,000]) .................. Lease payable (difference)............................................... Cash (lease payment)....................................................

83,649 16,351 100,000

* $100,000 x 9.36492 ** present value of an annuity due of $1: n=20, i=10%

Maintenance expense ............................................................ Cash (2025 expenses as incurred) ...................................

3,000

Amortization expense ($936,492 ÷ 20 years) ........................ Right-of-use asset .....................................................

46,825

Branif Leasing (Lessor) Cash (lease payment)........................................................ Lease receivable (difference) ....................................... Interest revenue (10% x [$936,492* – $100,000]) ..............

3,000

46,825

100,000 16,351 83,649

* $100,000 x 9.36492 ** present value of an annuity due of $1: n=20, i=10%

16–494

Problem 15-16 (continued) Requirement 2 Branson Construction (Lessee) Interest expense (10% x [$936,492* – $100,000]) .................. Lease payable (to balance) .............................................. Maintenance expense (annual fee)***................................... Cash (lease payment)....................................................

83,649 16,351 3,000 103,000

* $100,000 x 9.36492 ** present value of an annuity due of $1: n=20, i=10%

Amortization expense ($936,492 ÷ 20 years) ........................ Right-of-use asset .....................................................

46,825 46,825

*** This debit to maintenance expense is the net effect of (a) expensing the current year‘s costs that were prepaid with the first lease payment the last day of 2024 and (b) prepaying next year‘s expense with the 2025 payment: Maintenance expense (2025 costs).............................................. Prepaid maintenance expense (paid in 2024) ..........................

3,000

Interest expense (10% x [$936,492 – $100,000]) ........................ Lease payable (difference).......................................................... Prepaid maintenance expense (2026 costs) ................................. Cash (lease payment) .............................................................

83,649 16,351 3,000

Branif Leasing (Lessor) Cash (lease payment)........................................................ Lease receivable (to balance)....................................... Maintenance fee payable [or cash] ............................ Interest revenue (10% x [$936,492* – $100,000])..............

3,000

103,000

103,000 16,351 3,000 83,649

* $100,000 x 9.36492 ** present value of an annuity due of $1: n=20, i=10%

16–495

Problem 15-16 (concluded) Requirement 3 Branson Construction (Lessee) Interest expense (10% x [$964,587* – $103,000]) .................. Lease payable (to balance) .............................................. Cash (lease payment)....................................................

86,159 16,841 103,000

* $103,000 x 9.36492 ** present value of an annuity due of $1: n=20, i=10%

Whether to include costs as separate components of the lease contract (to be expensed by the lessee) or, instead, included in the payments to be capitalized as part of the right-of-use asset depends on whether the charge represents a transfer of a good or service to the lessee. If so, it qualifies as a ―nonlease component‖ of the payment and is separated from the lease payments and expensed. That was the case for maintenance costs, but not for insurance costs. In fact, ASC 842 specifically excludes insurance and taxes from costs that can be expensed. So, in this case, the entire $103,000 is capitalized. Amortization expense ($964,587 ÷ 20 years) ........................ Right-of-use asset ..................................................... Branif Leasing (Lessor) Cash (lease payment)........................................................ Lease receivable (to balance)....................................... Interest revenue (10% x [$964,587* – $103,000]) ..............

16–496

48,229 48,229 103,000 16,841 86,159

Problem 15-17 Requirement 1 Since at least one (exactly one in this case) criterion is met, this is a finance lease to the lessee: Lessee’s Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers NO to the lessee? 2 Does the agreement contain a bargain purchase option? 3 Does the lease term constitute the major part of the expected economic life of the asset? 4 Is the present value of the lease payments greater than or equal to substantially all of the fair value of the asset?

NO YES {lease term 4 yrs. ; useful life 5 yrs.}

JUDGMENT: 88% {$39,564a ; $45,114 } present value

5 Is the asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

fair value

a ([$11,000 – $1,000] x 3.53129* + ($6,000 x 0.70843**) = $39,564 ** present value of an annuity due of $1: n=4, i=9% * present value of $1: n=4, i=9% Note: The lessee uses its incremental borrowing rate (9%) because it is unaware of the lessor‘s implicit rate (10%)

Requirement 2 Present value of lessee‘s periodic payments (not including residual value): ([$11,000 – $1,000] x 3.53129 **) = $35,313 ** present value of an annuity due of $1: n=4, i=9%

16–497

Problem 15-17 (continued) Requirement 3 Since at least one classification criterion is met, this is a sales-type lease to the lessor.

Lessor’s Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option? 3 Does the lease term constitute the major part of the expected economic life of the asset? 4 Is the present value of the lease payments greater than or equal to substantially all of the fair value of the asset?

5 Is the asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

NO YES {lease term 4 yrs. ; useful life 5 yrs.}

JUDGMENT: 86% {$38,967a ; $45,114 } present value

fair value

a ([$11,000 – $1,000] x 3.48685* + ($6,000 x 0.68301**) = $38,967 ** present value of an annuity due of $1: n=4, i=10% * present value of $1: n=4, i=10%

16–3

Problem 15-17 (continued) Requirement 4 Lessor’s Calculation of Lease Payments Amount to be recovered (fair value)

$45,114

Less: Present value of the residual value ($15,000 x 0.68301*)

(10,245)

Amount to be recovered through periodic lease payments

$34,869 

 Lease payments at the beginning ($34,869 ÷ 3.48685**) of each of the next four years: Plus: Maintenance costs Lease payments including maintenance costs

$10,000 1,000 $11,000

* present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10%

16–4

Problem 15-17 (continued) Requirement 500

Lessor’s Calculation of the Sales Revenue Present value of periodic payments ([$11,000 – $1,000] x 3.48685**) $34,869 Plus: Present value of the lessee-guaranteed residual value ($6,000*** x 0.68301*) 4,098 Sales revenue $38,967 * **

present value of $1: n=4, i=10% present value of an annuity due of $1: n=4, i=10%

Or, equivalently: Fair value Minus: Present value of the unguaranteed residual value ($9,000*** x 0.68301*) Sales revenue

$45,114 6,147 $38,967

* This is the unguaranteed residual value: $15,000 – $6,000

Since the ―selling price‖ (present value of the lease receivable) exceeds the lessor‘s book value, the asset is being ―sold‖ at a profit, making this a sales-type lease: Sales revenue Minus Cost of goods sold equals Selling profit

$38,967 (Calculated above) (33,853) ($40,000 – [$9,000* x 0.68301]) $ 5,114

* This is the unguaranteed residual value: $15,000 – $6,000. Alternatively, since the fair

value exceeds the lessor‘s book value, the selling profit can also be calculated as:

16–500

Fair value minus Book value equals Selling profit

$45,114 (40,000) $ 5,114

For the portion of the residual value that is guaranteed, the lessor is assured of receiving the residual value either in cash or in the value of the asset returned, so the present value of that guaranteed amount is added to the present value of cash receipts that the lessor records as sales revenue. For the portion of the residual value that is not guaranteed, we would not include its present value in either sales or cost of goods sold (subtract from both) because there would is less certainty that the unguaranteed portion of the asset has been sold.

16–501

Problem 15-17 (continued) Requirement 6 December 31, 2024 Yard Art Landscaping (Lessee) Right-of-use asset (calculated in requirement 2) ................. Lease payable (calculated requirement 2) ....................... Lease payable (payment less maintenance costs).................. Prepaid maintenance expense (2025 fee)............................. Cash (lease payment).................................................... Branch Motors (Lessor) Lease receivable (to balance)........................................... Cost of goods sold ($40,000 – [$9,000a x 0.68301]) ............ Sales revenue ($45,114 – [$9,000a x 0.68301])................ Equipment (lessor‘s cost)............................................. Cash (lease payment)........................................................ Maintenance fee payable [or prepaid maintenance expense*]... Lease receivable (payment less maintenance costs) ..........

35,313 35,313 10,000 1,000 11,000

45,114 33,853 38,967 40,000 11,000 1,000 10,000

a This is the unguaranteed residual value: $15,000 – $6,000. * If paid previously.

16–502

Problem 15-17 (continued) Requirement 7 Lessee’s Amortization Schedule Dec. 31

2024 2025 2026 2027

Payments

10,000 10,000 10,000 10,000 40,000

Effective Interest 9% x Outstanding Balance

.09 (25,313) = 2,278 .09 (17,591) = 1,583 .09 (9,174) =

826 4,687

Decrease in Balance

10,000 7,722 8,417 9,174 35,313

Outstanding Balance

35,313 25,313 17,591 9,174 0

Requirement 8 Lessor’s Amortization Schedule Dec. 31

2024 2025 2026 2027 2028

Payments

10,000 10,000 10,000 10,000 15,000 55,000

Effective Interest 10% x Outstanding Balance

.10 (35,114) = 3,511 .10 (28,625) = 2,863 .10 (21,488) = 2,149 .10 (13,637) = 1,363*

9,886

Decrease in Balance

10,000 6,489 7,137 7,851 13,637 45,114

Outstanding Balance

45,114 35,114 28,625 21,488 13,637 0

* adjusted for rounding of other numbers in the schedule

16–503

Problem 15-17 (continued) Requirement 9 December 31, 2025 Yard Art Landscaping (Lessee) Maintenance expense (2025 fee) ........................................... Prepaid maintenance expense (paid in 2024) ..................

1,000 1,000

Interest expense (9% x [$35,313 – $10,000]) .......................... Lease payable (difference)............................................... Prepaid maintenance expense (2026 fee)............................. Cash (lease payment)....................................................

2,278 7,722 1,000

Amortization expense ($35,313 ÷ 4 years) ........................ Right-of-use asset .....................................................

8,828

Branch Motors (Lessor) Cash (lease payment)........................................................ Maintenance fee payable [or prepaid maintenance*]....... Lease receivable (payment less maintenance costs) .......... Interest revenue (10% x [$45,114 – $10,000])....................

11,000

8,828

11,000 1,000 6,489 3,511

* If paid previously.

16–504

Problem 15-17 (continued) Requirement 10 December 31, 2027 Yard Art Landscaping (Lessee) Maintenance expense (2027 fee) ........................................... Prepaid maintenance expense (paid in 2026) ..................

1,000 1,000

Interest expense (9% x $9,174: from schedule)....................... Lease payable (difference: from schedule) .......................... Prepaid maintenance expense (2028 fee)............................. Cash (lease payment)....................................................

826 9,174 1,000

Amortization expense ($35,313 ÷ 4 years) ........................ Right-of-use asset .....................................................

8,828

Branch Motors (Lessor) Cash (lease payment)........................................................ Maintenance fee payable [or prepaid maintenance expense*] Lease receivable (payment less maintenance costs) .......... Interest revenue (10% x $21,488: from schedule)...............

11,000

8,828

11,000 1,000 7,851 2,149

* If paid previously.

16–505

Problem 15-17 (concluded) Requirement 11 December 31, 2028 Yard Art Landscaping (Lessee) Maintenance expense (2028 fee) ........................................... Prepaid maintenance expense (paid in 2027) ..................

1,000 1,000

Amortization expense ($35,313 ÷ 4 years) ........................ Right-of-use asset .....................................................

8,828

Loss on residual value guarantee ($6,000 – $4,000).......... Cash (annual payment plus $6,000 – $4,000).....................

2,000

Branch Motors (Lessor) Equipment (actual residual value) ...................................... Cash ($6,000 – $4,000)..................................................... Loss on leased assets ($15,000 – $6,000) .......................... Lease receivable (account balance) ............................... Interest revenue (10% x $13,637: from schedule) ...............

16–506

8,828

2,000

4,000 2,000 9,000 13,637 1,363

Problem 15-18 Requirement 1

Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option? 3 Does the lease term constitute the major part of the expected economic life of the asset? 4 Is the present value of the lease payments greater than or equal to substantially all of the fair value of the asset?

NO YES {lease term 8 yrs. ; useful life 8 yrs.}

YES {$645,526a ; $645,526} present value

5 Is the asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

fair value

a $110,000 x 5.86842** = $645,526 ** present value of an annuity due of $1: n=8, i=10%

The implicit rate (10%) is known by the lessee. So, both parties‘ calculations should be made using a 10% discount rate:

16–507

Problem 15-18 (continued) (a) Since at least one (two in this case) classification criterion are met, this is a finance lease to the lessor (Lahiri Leasing). Since the fair value is the lessor‘s cost, there is no selling profit, in this sales-type lease. (b) Since at least one (two in this case) criteria are met, this is a finance lease to the lessee. Red Baron records the present value of lease payments as a right-of-use asset and a lease payable.

Requirement 2 January 1, 2024 Red Baron Flying Club (Lessee) Right-of-use asset (calculated above)................................ Lease payable (calculated above) .................................. Lease payable ............................................................... Cash (lease payment).................................................... Lahiri Leasing (Lessor) Lease receivable (calculated above) .................................. Equipment (lessor‘s cost).............................................

645,526 645,526 110,000 110,000

645,526 645,526

Lease receivable ........................................................... Cash (initial direct costs) ...............................................

18,099

Cash (lease payment)........................................................ Lease receivable........................................................

110,000

16–508

18,099

110,000

Problem 15-18 (continued) Requirement 3

Lease Amortization Schedule Effective Payments Interest 10% x Outstanding Balance

Decrease in Balance

Outstanding Balance

645,526 110,000

110,000

535,526

12/31/24

110,000 .10 (535,526) = 53,553

56,447

479,079

12/31/25

110,000 .10 (479,079) = 47,908

62,092

416,987

12/31/26

110,000 .10 (416,987) = 41,699

68,301

348,686

12/31/27

110,000 .10 (348,686) = 34,869

75,131

273,555

12/31/28

110,000 .10 (273,555 = 27,356

82,644

190,911

12/31/29

110,000 .10 (190,911) = 19,089*

90,911

100,000

12/31/30

110,000 .10 (100,000) = 10,000

100,000

880,000

645,526

1/1/24

234,474

* adjusted for rounding of other numbers in the schedule

16–509

Problem 15-18 (continued)

16–510

Requirement 4 With the initial direct costs, the lease payments are the same, but the net investment is higher: $645,526 + $18,099 = $663,625. The new effective rate is the discount rate that equates the net investment and the future lease payments: $663,625 ÷

?**

= $110,000

lessor‘s lease investment payments ** present value of an annuity due of $1: n=8, i=?

Rearranging algebraically, we find that the present value table value is $663,625 ÷ $110,000 = 6.03295. When you consult the present value table, you search row 8 (n=8) for this value and find it in the 9% column. So, the effective interest rate has declined from 10% to 9%. The net investment is amortized at the 9% rate.

16–511

Problem 15-18 (continued) Requirement 5

Lease Amortization Schedule Decrease in Balance

Outstanding Balance

110,000

663,625 553,625

12/31/24

110,000 .09 (553,625) = 49,826

60,174

493,451

12/31/25

110,000 .09 (493,451) = 44,411

65,589

427,862

12/31/26

110,000 .09 (427,862) = 38,508

71,492

356,370

12/31/27

110,000 .09 (356,370) = 32,073

77,927

278,443

12/31/28

110,000 .09 (278,443) = 25,060

84,940

193,503

12/31/29

110,000 .09 (193,503) = 17,415

92,585

100,918

12/31/30

110,000 .09 (100,918) = 9,082*

100,918

880,000

663,625

Payments

1/1/24

Effective Interest 9% x Outstanding Balance

216,375

* adjusted for rounding of other numbers in the schedule

16–512

Problem 15-18 (concluded) Requirement 6 December 31, 2024 Red Baron Flying Club (Lessee) Interest expense (10% x [$645,526 – $110,000]).................... Lease payable (difference)............................................... Cash (lease payment).................................................... Amortization expense ($645,526 ÷ 8 years) ...................... Right-of-use asset .....................................................

Lahiri Leasing (Lessor) Cash (lease payment)........................................................ Lease receivable (difference) ....................................... Interest revenue (9% x [$663,625 – $110,000])..................

53,553 56,447 110,000 80,691 80,691

110,000 60,174 49,826

Requirement 7 December 31, 2030 Red Baron Flying Club (Lessee) Interest expense (10% x $100,000: from schedule) ................. Lease payable (difference)............................................... Cash (lease payment).................................................... Amortization expense ($645,526 ÷ 8 years) ...................... Right-of-use asset .....................................................

10,000 100,000 110,000 80,691 80,691

110,000 100,918 9,082

16–513

Problem 15-19 Requirement 1

NO YES {lease term 8 yrs. ; useful life 8 yrs.}

YES {$645,526a ; $645,526} present value

5 Is the asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

fair value

a $110,000 x 5.86842** = $645,526 ** present value of an annuity due of $1: n=8, i=10%

The implicit rate (10%) is known by the lessee. So, both parties‘ calculations should be made using a 10% discount rate:

16–514

Problem 15-19 (continued) (a) Since at least one (two in this case) classification criterion are met, this is a finance lease to the lessor (Lahiri Leasing). Since the fair value exceeds the lessor‘s book value, the plane was ―sold‖ at a profit, making this a sales-type lease with a selling profit: Fair value minus Book value equals Selling profit

$645,526 (400,000) $245,526

(b) Since at least one (two in this case) criterion is met, this is a finance lease to the lessee. Red Baron records the present value of lease payments as a right-of-use asset and a lease payable. Requirement 2 January 1, 2024 Red Baron Flying Club (Lessee) Right-of-use asset (calculated above)................................ Lease payable (calculated above) .................................. Lease payable ............................................................... Cash (lease payment).................................................... Lahiri Leasing (Lessor) Lease receivable (calculated above) .................................. Cost of goods sold (lessor‘s cost)..................................... Sales revenue (calculated above)................................... Equipment (lessor‘s cost).............................................

645,526 645,526 110,000 110,000

645,526 400,000 645,526 400,000

Selling expense ............................................................. Cash (initial direct costs) ...............................................

18,099

Cash (lease payment)........................................................ Lease receivable........................................................

110,000

18,099

110,000

16–515

Problem 15-19 (continued) Requirement 3

Lease Amortization Schedule Payments

1/1/24 12/31/24 12/31/25 12/31/26 12/31/27 12/31/28 12/31/29 12/31/30

110,000 110,000 110,000 110,000 110,000 110,000 110,000 110,000 880,000

Effective Interest 10% x Outstanding Balance

.10 (535,526) = 53,553 .10 (479,079) = 47,908 .10 (416,987) = 41,699 .10 (348,686) = 34,869 .10 (273,555) = 27,356 .10 (190,911) = 19,089* .10 (100,000) = 10,000

234,474

Decrease in Balance

110,000 56,447 62,092 68,301 75,131 82,644 90,911 100,000 645,526

Outstanding Balance

645,526 535,526 479,079 416,987 348,686 273,555 190,911 100,000 0

* adjusted for rounding of other numbers in the schedule

16–516

Requirement 4 December 31, 2024 Red Baron Flying Club (Lessee) Interest expense (10% x [$645,526 – $110,000]).................... Lease payable (difference)............................................... Cash (lease payment).................................................... Amortization expense ($645,526 ÷ 8 years) ...................... Right-of-use asset ..................................................... Lahiri Leasing (Lessor) Cash (lease payment)........................................................ Lease receivable (difference) ....................................... Interest revenue (10% x [$645,526 – $110,000])................

53,553 56,447 110,000 80,691 80,691

110,000 56,447 53,553

16–517

Problem 15-19 (concluded) Requirement 5 December 31, 2030 Red Baron Flying Club (Lessee) Interest expense (10% x $100,000: from schedule) ................. Lease payable (difference)............................................... Cash (lease payment).................................................... Amortization expense ($645,526 ÷ 8 years) ...................... Right-of-use asset .....................................................

16–518

10,000 100,000 110,000 80,691 80,691

110,000 100,000 10,000

Problem 15-20 Requirement 1 Lessor’s Calculation of Lease payments Amount to be recovered (fair value)

$365,760

Less: Present value of the residual value ($25,000 x 0.68301*)

(17,075)

Amount to be recovered through periodic lease payments Lease payments at the beginning of each of four years:

$348,685 

 ($348,685 ÷ 3.48685**)

$100,000

* present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10%

Requirement 2 The lessor‘s implicit rate (10%) is known by the lessee. calculations should be made using a 10% discount rate:

So, both parties‘

16–519

Problem 15-20 (continued) Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee?

2 Does the agreement contain a bargain purchase option?

3 Does the lease term constitute the major part of the expected economic life of the asset?

NO {lease term 4 yrs. ; useful life 6 yrs.}

4 Is the present value of the lease payments greater than or equal to substantially all of the fair value of the asset?

YES {$365,760b ; $365,760} present fair value value

b See calculation below.

5 Is the asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

b Present Value of Lease Payments

Present value of periodic lease payments ($100,000 x 3.48685**)

Plus: Present value of the lessee-guaranteed residual value ($25,000 x 0.68301*) Present value of lease payments

$348,685 17,075 $365,760

* present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10%

16–520

Problem 15-20 (continued) (a) By Western Soya Co. (the lessee) Since at least one criterion is met, this is a finance lease to the lessee. Western Soya records the present value of lease payments as a right-of-use asset and a lease payable. (b) By Rhone-Metro (the lessor) Because at least one criterion is met, this is a sales-type to the lessee. Since the fair value equals the lessor‘s book value, there is no selling profit.

16–521

Problem 15-20 (continued) Requirement 3 Western Soya Co. (Lessee) Present Value of Lease Payments Present value of periodic lease payments ($100,000* x 3.48685**) = $348,685 ** present value of an annuity due of $1: n=4, i=10% * The lessee views the residual value as a lease payment only if a cash payment is predicted due to a lessee-guaranteed residual value that is higher than the residual value expected.

Western Soya Co. (Lessee) Right-of-use asset (calculated above)................................ Lease payable (calculated above) .................................. Lease payable ............................................................... Cash (lease payment).................................................... Rhone-Metro (Lessor) Lease receivable (calculated above) .................................. Equipment (lessor‘s cost).............................................

348,685 348,685 100,000 100,000

365,760* 365,760

* See lessor‘s calculation of the present value of payments (that include the residual value in Requirement 2 above.

Cash (lease payment)........................................................ Lease receivable........................................................

16–522

100,000 100,000

Problem 15-20 (continued) Requirement 4 Both (a) the present value of the lease payments and (b) the present value of the unguaranteed residual value combine to allow the lessor to recover its $365,760 investment and are recorded as the lease receivable at the beginning of the lease. The lessor includes the $25,000 residual value in its amortization schedule, along with the lease payments:

Lease Amortization Schedule Dec. Payments 31

Effective Interest 10% x Outstanding Balance

Decrease in Balance

2024

Outstanding Balance

365,760

2024 100,000

100,000

265,760

2025 100,000

.10 (265,760) = 26,576

73,424

192,336

2026 100,000

.10 (192,336) = 19,234

80,766

111,570

2027 100,000

.10 (111,570) = 11,157

88,843

22,727

2028

.10 (22,727) =

2,273

22,727

59,240

365,760

25,000 425,000

16–523

Problem 15-20 (continued) The lessee, though, views the residual value as a lease payment only if a cash payment is predicted due to a lessee-guaranteed residual value. That‘s not the case here:

Lease Amortization Schedule Dec. Payments 31

Effective Interest 10% x Outstanding Balance

Decrease in Balance

2024

Outstanding Balance

348,685

2024 100,000

100,000

248,685

2025 100,000

.10 (248,685) = 24,869

75,131

173,554

2026 100,000

.10 (173,554) = 17,355

82,645

90,909

2027 100,000

.10 (90,909) =

9,091

90,909

51,315

348,685

400,000

Requirement 5 December 31, 2025 Western Soya Co. (Lessee) Interest expense (10% x [$348,685 – $100,000]) .................... Lease payable (difference)............................................... Cash (lease payment).................................................... Amortization expense ($348,685 ÷ 4 years) .......................... Right-of-use asset ..................................................... Rhone-Metro (Lessor) Cash (lease payment)........................................................ Lease receivable (difference) ....................................... Interest revenue (10% x [$365,760 – $100,000]) ................

16–524

24,869 75,131 100,000 87,171 87,171

100,000 73,424 26,576

Problem 15-20 (concluded) Requirement 6 December 31, 2028 Western Soya Club (Lessee) Amortization expense ($348,685 ÷ 4 years) .......................... Right-of-use asset ..................................................... Loss on residual value guarantee ($25,000 – $1,500) ......... Cash ($25,000 – $1,500) ...............................................

Rhone-Metro (Lessor) Equipment (actual residual value) ...................................... Cash ($25,000 – $1,500) ................................................... Lease receivable (account balance) ............................... Interest revenue (10% x $22,727: from schedule)...............

87,171 87,171 23,500 23,500

1,500 23,500 22,727 2,273

16–525

Problem 15-21 Requirement 1 Lessor’s Calculation of Lease payments Amount to be recovered (fair value) Less: Present value of the residual value ($25,000 x 0.68301*) Amount to be recovered through periodic lease payments  Lease payments at the beginning ($348,685 ÷ 3.48685**) of each of four years: Plus: Maintenance costs Lease payments including nonlease components

$365,760 (17,075) $348,685  $100,000 4,000 $104,000

* present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10%

16–526

Problem 15-21 (continued) Requirement 2 The lessee is aware of the lessor‘s implicit rate (10%). calculations should be made using a 10% discount rate:

So, both parties‘

Application of Classification Criteria 1

Does the agreement specify that ownership of the asset transfers to the lessee? 2 Does the agreement contain a bargain purchase option? 3 Does the lease term constitute the major part of the expected economic life of the asset?

4 Is the present value of the lease payments greater than or equal to substantially all of the fair value of the asset?

NO NO NO {lease term 4 yrs. ; useful life 6 yrs.}

YES {$348,685a ; $365,760} present fair value value

a See calculation below.

5 Is the asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

16–527

a Present Value of Lease Payments

Present value of periodic lease payments excluding nonlease payments of $4,000 ($100,000* x 3.48685**)

$348,685

** present value of an annuity due of $1: n=4, i=10% * Since the residual value is not guaranteed, it is excluded from both the lessor‘s and the lessee‘s lease payments and therefore does not affect the fair value criterion.

16–528

Problem 15-21 (continued) (a) by Western Soya Co. (the lessee) Since at least one criterion is met, this is a finance lease to the lessee. Western Soya records the present value of lease payments as a right-of-use asset and a lease payable. (b) by Rhone-Metro (the lessor) Since the fair value exceeds the lessor‘s book value, this a sales-type lease with a selling profit: Fair value minus Book value equals Selling profit

$365,760 (300,000) $ 65,760

16–529

Problem 15-21 (continued) Requirement 530 December 31, 2024 Western Soya Co. (Lessee) Right-of-use asset (calculated above)................................ Lease payable (calculated above) .................................. Lease payable ............................................................... Prepaid maintenance expense (2025 expense) .................. Cash (lease payment).................................................... Rhone-Metro (Lessor) Lease receivable (fair value)............................................ Cost of goods sold ($300,000 – [$25,000 x 0.68301]) ............ Sales revenue ($365,760 – [$25,000 x 0.68301]).............. Equipment (lessor‘s cost)............................................. Cash (lease payment)........................................................ Maintenance fee payable........................................... Lease receivable........................................................

16–530

348,685 348,685 100,000 4,000 104,000

365,760 282,925 348,685 300,000 104,000 4,000 100,000

Problem 15-21 (continued) Requirement 4 Lessee (unguaranteed residual value excluded): Lease Amortization Schedule Dec. Payments 31

2024 2025 2026 2027

100,000 100,000 100,000 100,000 400,000

Effective Interest 10% x Outstanding Balance

.10 (248,685) = 24,869 .10 (173,554) = 17,355 .10 (90,909) =

9,091 51,315

Decrease in Balance

100,000 75,131 82,645 90,909 348,685

Outstanding Balance

348,685 248,685 173,554 90,909 0

Lessor (unguaranteed residual value included): Lease Amortization Schedule Dec. Payments 31

2024 2024 2025 2026 2027 2028

100,000 100,000 100,000 100,000 25,000 425,000

Effective Interest 10% x Outstanding Balance

.10 (265,760) = 26,576 .10 (192,336) = 19,234 .10 (111,570) = 11,157 .10 (22,727) =

2,273 59,240

Decrease in Balance

100,000 73,424 80,766 88,843 22,727 365,760

Outstanding Balance

365,760 265,760 192,336 111,570 22,727 0

16–531

Problem 15-21 (continued) Requirement 532 December 31, 2025 Western Soya Co. (Lessee) Amortization expense ($348,685 ÷ 4 years) .......................... Right-of-use asset .....................................................

87,171 87,171

Maintenance expense (2025 expenses) ............................. Prepaid maintenance expense (paid in 2024) ................

4,000

Interest expense (10% x [$348,685 – $100,000]) .................... Lease payable (difference)............................................... Prepaid maintenance expense (2026 expenses)................. Cash (lease payment)....................................................

24,869 75,131 4,000

Rhone-Metro (Lessor) Cash (lease payment)........................................................ Maintenance fee payable........................................... Lease receivable (difference) ....................................... Interest revenue (10% x [$365,760 – $100,000]) ................

16–532

4,000

104,000

104,000 4,000 73,424 26,576

Problem 15-21 (concluded) Requirement 6 December 31, 2028 Western Soya Co. (Lessee) Maintenance expense (2028 expenses) ............................. Prepaid maintenance expense (paid in 2027) ................ Amortization expense ([$348,685] ÷ 4 years) ....................... Right-of-use asset .....................................................

Rhone-Metro (Lessor) Equipment (actual residual value) ...................................... Loss on leased assets ($25,000 – $1,500) .......................... Lease receivable (account balance) ............................... Interest revenue (10% x $22,727: from schedule)...............

4,000 4,000 87,171 87,17

1,500 23,500 22,727 2,273

16–533

Problem 15-22 Requirement 1 Lessor’s Calculation of Lease payments Amount to be recovered (fair value)

$365,760

Less: Present value of the BPO price ($10,000 x 0.75131*) Amount to be recovered through periodic lease payments

(7,513) $358,247

Lease payments at the beginning ($358,247 ÷ 2.73554**) of each of three years: Plus: Maintenance costs Lease payments including maintenance costs

$130,960 4,000 $134,960

* present value of $1: n=3, i=10% ** present value of an annuity due of $1: n=3, i=10%

Requirement 2 The lessee is aware of the lessor‘s implicit rate (10%). calculations should be made using a 10% discount rate:

16–534

So, both parties‘

Problem 15-22 (continued) Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee?

2 Does the agreement contain a bargain purchase option?

YES

3 Does the lease term constitute the major part of the expected economic life of the asset? 4 Is the present value of the lease payments greater than or equal to substantially all of the fair value of the asset?

NO {lease term 3 yrsa. ; useful life 6 yrs.}

YES {$365,760b ; $365,760} present value

Is the asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

fair value

a The lease term is considered to end at the date a BPO becomes exercisable. b See calculation below.

Present Value of Lease Payments Present value of periodic lease payments excluding maintenance costs of $4,000 ($130,960 x 2.73554**)

$358,247***

Plus: Present value of the BPO price ($10,000 x 0.75131*)

7,513

Present value of lease payments

$365,760

* present value of $1: n=3, i=10% ** present value of an annuity due of $1: n=3, i=10% *** rounded

Note: The BPO price is included in both the lessor‘s and the lessee‘s lease payments. Also, the lease term ends for accounting purposes after 3 years, when the BPO becomes exercisable. Solutions Manual, Chapter 16 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

16–535

Problem 15-22 (continued) (a) by Western Soya Co. (the lessee) Since at least one (two in this case) classification criterion is met, this is a finance lease to the lessee. Western Soya records the present value of lease payments as a right-of-use asset and a lease payable. (b) by Rhone-Metro (the lessor) Since the fair value exceeds the lessor‘s book value, this is a sales-type lease with a selling profit: Fair value minus Book value equals Selling profit

$365,760 (300,000) $ 65,760

Requirement 3 December 31, 2024 Western Soya Co. (Lessee) Right-of-use asset (calculated above)................................ Lease payable (calculated above) .................................. Lease payable ............................................................... Prepaid maintenance expense (2025 costs) ...................... Cash (lease payment).................................................... Rhone-Metro (Lessor) Lease receivable (present value of lease payments).............. Cost of goods sold (lessor‘s cost)..................................... Sales revenue (present value of lease payments) .............. Equipment (lessor‘s cost)............................................. Cash (lease payment)........................................................ Maintenance fee payable........................................... Lease receivable........................................................

16–536

365,760 365,760 130,960 4,000 134,960

365,760 300,000 365,760 300,000 134,960 4,000 130,960

Problem 15-22 (continued) Requirement 4 Lessee and lessor (BPO included): Since both use the same discount rate and since the bargain purchase option is included as an additional payment for both, the same amortization schedule applies to both the lessee and lessor. The lease term ends for accounting purposes after 3 lease payments, because the BPO becomes exercisable before the fourth:

Lease Amortization Schedule Dec. Payments 31

Effective Interest 10% x Outstanding Balance

Decrease in Balance

2024

Outstanding Balance

365,760

2024 130,960

130,960

234,800

2025 130,960

.10 (234,800) = 23,480

107,480

127,320

2026 130,960

.10 (127,320) = 12,732

118,228

9,092

2027

.10

908*

9,092

37,120

365,760

10,000 402,880

(9,092) =

* adjusted for rounding of other numbers in the schedule

16–537

Problem 15-22 (continued) Requirement 5 December 31, 2025 Western Soya Co. (Lessee) Amortization expense ($365,760 ÷ 6 years*) ........................ Right-of-use asset .....................................................

60,960 60,960

Maintenance expense (2025 maintenance costs)................. Prepaid maintenance expense (paid in 2024)................

4,000

Interest expense (10% x [$365,760 – $130,960]) .................... Lease payable (to balance) .............................................. Prepaid maintenance expense (2026 maintenance costs) .... Cash (lease payment)....................................................

23,480 107,480 4,000

Rhone-Metro (Lessor) Cash (lease payment)........................................................ Maintenance fee payable........................................... Lease receivable (to balance)....................................... Interest revenue (10% x [$365,760 – $130,960]) ................

4,000

134,960

134,960 4,000 107,480 23,480

* If ownership transfers (a) by contract or (b) by the expected exercise of a bargain

purchase option, the asset should be depreciated over the asset's useful life. This reflects the fact that the lessee anticipates using the leased asset for its full useful life. In this case, the equipment is expected to be useful for 6 years.

16–538

Problem 15-22 (concluded) Requirement 6 December 31, 2027 Western Soya Club (Lessee) Amortization expense ($365,760 ÷ 6 years) .......................... Right-of-use asset .....................................................

60,960 60,960

Interest expense (10% x $9,092: from schedule[rounded])..... Lease payable (from schedule) ......................................... Cash (BPO price).........................................................

908 9,092

Maintenance expense (2027 costs) .................................. Prepaid maintenance expense (paid in 2026)................

4,000

Equipment ................................................................... Right-of-use asset ($365,760 – [$60,960 x 3]) ................

182,880

Rhone-Metro (Lessor) Cash (BPO price)............................................................. Lease receivable (difference) ....................................... Interest revenue (10% x $9,092: from schedule[rounded]) . Cash (assuming maintenance costs continue to be paid by lessor) Maintenance fee payable (maintenance) ...................

10,000

4,000

182,880

10,000 9,092 908 4,000 4,000

16–539

Problem 15–23 Requirement 1 January 1, 2024 Present Value of Lease payments Present value of periodic lease payments ($300,000 x 3.54595**)

$1,063,785

Plus: Present value of the excess lessee-guaranteed residual value ($60,000 x 0.82270*) Present value of lease payments

49,362 $1,113,147

* Present value of $1: n = 4, i = 5% ** present value of an ordinary annuity of $1: n = 4, i = 5%

If a lessee-guaranteed residual value exceeds the estimate of the actual residual value, that excess is added to the present value of the lease payments the lessee records as both a right-of-use asset and a lease liability. The present value of the estimated amount payable also is added, along with the present value of the residual value itself (the residual asset), to the lessor‘s present value of lease payments for its lease receivable. Nguyen (Lessee) Right-of-use asset (calculated above)................................ Lease payable (calculated above) ..................................

1,113,147

Nevels (Lessor) Lease receivable ($1,113,147+ [$150,000 x 0.82270]).......... Equipment (lessor‘s cost])............................................

1,236,552

16–540

1,113,147

1,236,552

Problem 15–23 (concluded) Requirement 2 December 31, 2024 Nguyen (Lessee) Interest expense (5% x $1,113,147)........................................ Lease payable (difference)............................................... Cash (lease payment).................................................... Amortization expense ($1,113,147 ÷ 4) ................................ Right-of-use asset .....................................................

Nevels (Lessor) Cash (lease payment) ....................................................... Lease receivable (difference)....................................... Interest revenue (5% x $1,236,552) ...................................

55,658 244,342 300,000 278,287 278,287

300,000 238,173 61,827

Note: The situation described, in which the lessee-guaranteed residual value exceeds the estimate of the actual residual value, is unusual in practice. However, the requirement to account for it in this way serves as a deterrent to lessees and lessors who might be inclined to manipulate reported numbers by reducing lease payments while creating an excess lesseeguaranteed residual value to compensate for the reduced lease payments.

16–541

Problem 15–24 Requirement 1 $7,000  .86384*** = $ 6,047 $6,000  .90703** = 5,442 $5,000  .95238* = 4,762 Present value of lease payments $16,251 * Present value of $1: n = 1, i = 5%. ** Present value of $1: n = 2, i = 5%. *** Present value of $1: n = 3, i = 5%.

Beginning of the Lease (January 1, 2024) Right-of-use asset ………………………….. Lease payable (present value of lease payments)..

16,251 16,251

Requirement 2 First Lease Payment (December 31, 2024) Interest expense (5%  $16,251) ....................... Lease payable (difference)................................ Cash (1st lease payment)................................. Amortization expense ($6,000 – $813) .............. Right-of-use asset ......................................

813 4,187 5,000 5,187 5,187

* You might view this as the following with accrued lease incorporated into the right-of-use asset:

Amortization expense ($6,000 – $813)......................... Accrued lease payable ($6,000 – $5,000)................... Right-of-use asset ..................................................

5,187 1,000 4,187

Requirement 3 Second Lease Payment (December 31, 2025) Interest expense [5%  ($16,251 – $4,187)]......... Lease payable (difference)................................ Cash (2nd lease payment) ................................ Amortization expense ($6,000 – $603) .............. Right-of-use asset ...................................... 16–542

603 5,397 6,000 5,397 5,397 Intermediate Accounting, 11/e

Problem 15–24 (concluded) Requirement 4 Third Lease Payment (December 31, 2026) Interest expense [5%  ($16,251 – $4,187 – $5,397)]…. Lease payable (difference)................................ Cash (3rd lease payment) ................................ Amortization expense ($6,000 – $333) ........... Right-of-use asset ......................................

333 6,667 7,000 5,667 5,667

* You might view this as the following with accrued lease incorporated into the right-of-use asset:

Amortization expense ($6,000 – $333)......................... Accrued lease payable ($6,000 – $7,000) ...................... Right-of-use asset ..................................................

5,667 1,000 6,667

16–543

Problem 15–25 Requirement 1 $5,000  .86384*** = $ 4,319 $6,000  .90703** = 5,442 $7,000  .95238* = 6,667 Present value of lease payments $16,428 * Present value of $1: n = 1, i = 5%. ** Present value of $1: n = 2, i = 5%. *** Present value of $1: n = 3, i = 5%.

Beginning of the Lease (January 1, 2024) Right-of-use asset ……………………………. Lease payable (present value of lease payments).…

16,428 16,428

Requirement 2 First Lease Payment (December 31, 2024) Interest expense (5%  $16,428) ....................... Lease payable (difference)................................ Cash (1st lease payment)................................. Amortization expense ($6,000 – $821) .............. Right-of-use asset*.....................................

821 6,179 7,000 5,179 5,179

Requirement 3 Second Lease Payment (December 31, 2025) Interest expense [5%  ($16,428 – $6,179)]......... Lease payable (difference)................................ Cash (2nd lease payment) ................................ Amortization expense ($6,000 – $512) .............. Right-of-use asset ......................................

512 5,488 6,000 5,488 5,488

* You might view this as the following with prepaid lease incorporated into the right-of-use asset:

Amortization expense ($6,000 – $821)........................ Prepaid lease ($6,000 – $7,000)..................................... Right-of-use asset .................................................. 16–544

5,179 1,000 6,179 Intermediate Accounting, 11/e

Problem 15–25 (concluded) Requirement 4 Third Lease Payment (December 31, 2026) Interest expense [5%  (16,428 – $6,179 – $5,488)]….. Lease payable (difference)................................ Cash (3rd lease payment) ................................ Amortization expense ($6,000 – $238) .............. Right-of-use asset ......................................

238 4,762 5,000 5,762 5,762

* You might view this as the following with prepaid lease incorporated into the right-of-use asset: Amortization expense ($6,000 – $238)........................ 5,762 Prepaid lease ($6,000 – $5,000) ................................ 1,000

Right-of-use asset ..................................................

4,762

16–545

Problem 15–26 Requirement 1 Modification of the Lease (January 1, 2026) Worcester Construction, the lessee, will adjust its right-of-use asset and lease payable for the present value of the remaining lease payments. Worcester Construction (Lessee) Right-of-use asset (increase in balance) .......................... 324,440 Lease payable (increase in balance) .................... 324,440

* PV of remaining 3 payments, discounted at 9% current rate Liability balance on January 1, 2026 (see Schedule below) Increase in balance $200,000  2.53129* = $506,258 Lease Payments

$506,258 181,818 $324,440

Present value

*Present value of an ordinary annuity of $1: n = 3, i = 9%.

Note: At the beginning of 2026, the last payment made was on Dec. 31, 2025, so the next payment is due Dec. 31, 2026, one year from then. The modification adds two more payments, Dec. 31, 2027 and 2028. Thus, at the beginning of 2026, we have three payments beginning a year later. This constitutes an ordinary annuity.

Lease Amortization Schedule Payments

2024 2024 2025 2026

200,000 200,000 200,000 200,000

Effective Interest 10% x Outstanding Balance

.10 (497,370) = 49,737 .10 (347,107) = 34,711 .10 (181,818) = 18,182*

Decrease in Balance

Outstanding Balance

200,000 150,263 165,289 181,818

697,370 497,370 347,107 181,818 0

* adjusted for rounding of other numbers in the schedule

16–546

Problem 15–26 (continued) Requirement 2 Modification of the Lease (January 1, 2026)

Waltham LeaseCorp, the lessor, previously viewed its operating lease as simply renting the asset to the lessee and thus recorded lease revenue of $200,000 each year on a straight-line basis while depreciating the asset over the first two years. Now, it‘s a sales-type lease, so Waltham records a lease receivable for the present value of the remaining lease payments (discounted at the current interest rate) and derecognizes the equipment (and related accumulated depreciation). Waltham LeaseCorp (Lessor) Deferred sales revenue (balance from Dec. 31, 2025) .................. 200,000* Sales revenue ...................................................... 200,000 *Treating the lease as an operating lease prior to the modification, Waltham recorded the cash receipt on December 31, 2025, this way: Cash Deferred sales revenue

200,000 200,000

That deferred revenue becomes sales revenue in 2026.

Lease receivable (PV of 3 remaining lease payments from req. 1) ... 506,258 Accumulated depreciation ([$958,158  6 years] x 2 years)…… 319,386 Cost of goods sold ($958,158 – $319,386).................................638,772 Sales revenue (PV of 3 remaining lease payments) ......... 506,258 Equipment (account balance) .................................... 958,158

Loss $132,514

Because the present value of the 3 remaining lease payments is less than the carrying amount of the equipment, Waltham also recognizes a selling loss for the difference: Sales revenue of $506,258 minus cost of goods sold of $638,772 equals a $132,514 loss on leased assets.

16–547

Problem 15–26 (concluded) Requirement 3 Worcester Construction previously viewed this as an operating lease and thus determined amortization as the amount needed to report lease expense (interest plus amortization) on a straight-line basis. Now, it‘s a finance lease, so Worcester accounts for the modified lease in the same manner as any other finance lease, recording interest at the now current interest rate of 9% and amortizing the balance in the right-of-use asset over the remaining four years on a straight-line basis: Worcester Construction (Lessee) Interest expense (9%  $506,258) ............................... Lease payable (difference).......................................... Cash (lease payment)...............................................

45,563 154,437

Amortization expense ($706,258  4 years) ................. Right-of-use asset ................................................

176,565

200,000 176,565

*The balance in ROU Asset before the modification was $697,370 – $150,263 – $165,289 = $381,818. Now, the modification adds $324,440 to the ROU Asset: $381,818 + $324,440 = $706,258.

Requirement 4 Waltham LeaseCorp accounts for the modified lease in the same manner as any other sales-type lease, recording interest at the now current interest rate of 9%. Waltham LeaseCorp (Lessor) Cash (lease payment)................................................. Lease receivable................................................. Interest revenue (9%  $506,259)..........................

16–548

200,000 154,437 45,563

Problem 15-27 1. Calculation of the present value of lease payments $391,548 x 15.32380

$6,000,000 (rounded)

 present value of an annuity due of $1: n=20, i=3%

2. Liability on December 31, 2024 Initial balance, September 30, 2024 ........................ Sept. 30, 2024 reduction ...................................... Dec. 31, 2024 reduction ....................................... December 31, 2024 net liability ..............................

$6,000,000 (391,548)* (223,294)** $5,385,158

The current and noncurrent portions of the liability would be reported separately.

Asset on December 31, 2024 Initial balance, September 30, 2024 ........................ Right-of-use asset on Dec. 31, 2024........................ December 31, 2024 ...........................................

$6,000,000 (300,000)** $5,700,000

3. Expenses for year ended December 31, 2024 Sept. 30, 2024 interest expense ............................... Dec. 31, 2024 interest expense ................................ Interest expense for 2024 ........................................

$ 0* 168,254** $168,254

Amortization expense for 2024 ............................... Total expenses ......................................................

300,000 $468,254

16–549

Problem 15-27 (concluded) 4. Statement of cash flows for year ended December 31, 2024 Werner would report the $6,000,000* investment in the protein analyzer and its financing with a finance lease as a significant noncash investing and financing activity in the disclosure notes to the financial statements. The $783,096 ($391,548 x 2) cash lease payments are divided into the interest portion and the principal portion. The interest portion, $168,254**, is reported as cash outflows from operating activities. The principal portion, $391,548 + $223,294**, is reported as cash outflows from financing activities. Note: By the indirect method of reporting cash flows from operating activities, we would add back to net income the $300,000 amortization expense since it didn‘t actually reduce cash. The $168,254 interest expense that reduced net income actually did reduce cash [the interest portion of the $783,096 ($391,548 x 2) cash lease payments], so for it, no adjustment to net income is necessary. Calculations: September 30, 2024* Right-of-use asset (calculated in req. 1) .......................... 6,000,000 Lease payable (calculated in req. 1)............................. 6,000,000 Lease payable .............................................................. Cash (lease payment).................................................. December 31, 2024** Interest expense (3% x [$6 million – $391,548]) .............. Lease payable (difference) ............................................. Cash (lease payment).................................................. Amortization expense ($6 million ÷ 5 years x ¼ year) ..... Right-of-use asset .....................................................

16–550

391,548 391,548

168,254 223,294 391,548 300,000 300,000

Problem 15-28 1. Receivable on December 31, 2024 Calculation of the present value of lease payments $391,548 x 15.32380 = $6,000,000 (rounded)  present value of an annuity due of $1: n=20, i=3%

Receivable Initial balance, September 30, 2024 .. $6,000,000 Sept. 30, 2024 reduction ................... (391,548)* Dec. 31, 2024 reduction ....................... (223,294)** December 31, 2024 receivable .............. $5,385,158 The receivable replaces the $6,000,000 machine in the balance sheet. 2. Interest revenue for year ended December 31, 2024 Sept. 30, 2024 interest revenue ............................... Dec. 31, 2024 interest revenue ................................ Interest revenue for 2024 ........................................ 3. Statement of cash flows for year ended December 31, 2024

$ 0* 168,254** $168,254

Abbott would report the $6,000,000* sales-type lease of the protein analyzer as a significant noncash investing activity (acquiring one asset and disposing of another) in the disclosure notes to the financial statements. In a sales-type lease, we assume the lessor is actually selling its product, an operating activity. Thus, both the interest portion, $168,254**, and the principal portion, $391,548 + $223,294**, are reported as cash inflows from operating activities. Note: By the indirect method of reporting cash flows from operating activities, the $168,254 interest revenue that increased net income actually did increase cash [the interest portion of the $783,096 ($391,548 x 2) cash lease payments], so no adjustment to net income is necessary.

16–551

Problem 15-28 (concluded) Calculations: September 30, 2024* Lease receivable (present value calculated above)............ Equipment (lessor‘s cost) ........................................... Cash (lease payment)...................................................... Lease receivable........................................................

16–552

6,000,000 6,000,000 391,548 391,548

391,548 223,294 168,254

Problem 15-29 1. Calculation of the present value of lease payments (―selling price‖) $391,548 x 15.32380

$6,000,000 (rounded)

 present value of an annuity due of $1: n=20, i=3%

2. Receivable on December 31, 2024 Receivable Initial balance, September 30, 2024 .. $6,000,000 Sept. 30, 2024 reduction ................... (391,548)* Dec. 31, 2024 reduction ....................... (223,294)** December 31, 2024 net receivable ........ $5,385,158 The receivable replaces the $5,000,000 machine in the balance sheet. * First payment has zero interest. ** $6,000,000 minus first payment $391,548 = $5,608,542 $5,608,542 x .03 = $168,254 interest $391,548 payment minus $168,254 interest = $223,294 reduction of receivable 3. Income effect for year ended December 31, 2024 Sept. 30, 2024 interest revenue ............................... Dec. 31, 2024 interest revenue ................................ Interest revenue for 2024 ........................................

0* 168,254** $ 168,254

Sales revenue* .......................................................... Cost of goods sold*................................................... Income effect .........................................................

6,000,000 (5,000,000) $1,168,254

16–553

Problem 15-29 (continued) 4. Statement of cash flows for year ended December 31, 2024 NutraLabs would report the $6,000,000* sales-type lease of the protein analyzer as a significant noncash activity in the disclosure notes to the financial statements. The $783,096 ($391,548 x 2) cash lease payments are considered to be cash flows from operating activities. In a sales-type lease, we assume the lessor is actually selling its product, an operating activity. Thus, both the interest portion, $168,254**, and the principal portion, $391,548 + $223,294**, are reported as cash inflows from operating activities. Note: By the indirect method of reporting cash flows from operating activities, the $1,000,000 (Sales revenue: $6,000,000 – Cost of goods sold: $5,000,000) selling profit must be deducted from net income because it is included in net income but won‘t increase cash flows until the lease payments are collected over the next five years. This addition, however, occurs automatically as we make the usual adjustments for the change in receivables (to adjust sales to cash received from customers) and for the change in inventory (to adjust cost of goods sold to cash paid to suppliers). The $168,254 interest revenue that increased net income actually did increase cash [the interest portion of the $783,096 ($391,548 x 2) cash lease payments], so for it, no adjustment to net income is necessary. The principal portion, $391,548 + $223,294, must be added because it is not otherwise included in net income. This, too, though, occurs automatically as we make the usual adjustments for the change in receivables (to adjust sales to cash received from customers). Noncash adjustments to convert net income to cash flows from operating activities: Increase in lease receivable...................................... Decrease in inventory of equipment ......................... Decrease in lease receivable, Sept. 30 ...................... Decrease in lease receivable, Dec. 31.......................

16–554

($6,000,000) 5,000,000 391,548 223,294

Problem 15-29 (concluded) Calculations: September 30, 2024* Lease receivable (present value calculated above)............ Cost of goods sold (lessor‘s cost) ................................... Sales revenue (present value calculated above) ............ Equipment (lessor‘s cost) ........................................... Cash (lease payment)...................................................... Lease receivable........................................................

6,000,000 5,000,000 6,000,000 5,000,000 391,548 391,548

391,548 223,294 168,254

16–555

Problem 15-30 Requirement 1 Present value of periodic lease payments ($88,492 x 5.65022**)

$500,000*

* rounded ** present value of an ordinary annuity of $1: n=10, i=12%

January 1, 2024 Cash ............................................................................. Notes payable (loan) ..................................................

500,000 500,000

Note: Because the title transfers to the lessee, this transaction is considered a loan.

December 31, 2024 Interest expense (12% x $500,000) ......................................... Notes payable (difference)............................................... Cash (lease payment).................................................... Depreciation expense ($1,000,000 ÷ 30 years*) ................. Accumulated depreciation.........................................

60,000 28,492 88,492 33,333 33,333

* The building is depreciated over its original useful life.

16–556

Problem 15-30 (continued) Requirement 2 BALANCE SHEET

Assets: Building.............................................................. Less: Accumulated depreciation ($600,000 + $33,333)

$1,000,000 (633,333) $ 366,667

Liabilities: Current: Notes payable ($88,492 – {12% x [$500,000 – $28,492]})

$31,911

Noncurrent: Notes payable ($500,000 – $28,492 – $31,911) .........

$439,597

INCOME STATEMENT

Interest expense .................................................. Depreciation expense ..........................................

$60,000 33,333 $93,333

Portion of Amortization Schedule – not required, but verifies several amounts: Note Amortization Schedule Date 1/1/24 12/31/24 12/31/25

Payments

88,492 88,492

~ ~

Effective Interest 12% x Outstanding Balance .12 (500,000) = 60,000 .12 (471,508) = 56,581

~ ~

Decrease in Balance

Outstanding Balance

28,492 31,911

500,000 471,508 439,597

~ ~

16–557

DECISION MAKERS’ PERSPECTIVE CASES

16–558

Research Case 15-1 Requirement 1 After the first full year under the warehouse lease, the balance in Dowell‘s lease payable is $30,816,422. This is the balance after reductions from the first five quarterly lease payments as shown in this amortization schedule. (The first payment was on December 31 of the previous year, the beginning of the lease.) Lease Amortization Schedule Payments

Effective Interest 2% x Outstanding Balance

D D2,398,303 M2,398,303 .02 (37,601,697) = 2,398,303 .02 (35,955,428) = 2,398,303 .02 (34,276,234) = 2,398,303 .02 (32,563,456) = 2,398,303 .02 (30,816,422) = 2,398,303 .02 (29,034,448) = 2,398,303 .02 (27,216,835) = 2,398,303 .02 (25,362,869) = 2,398,303 .02 (23,471,823) = 2,398,303 .02 (21,542,957) = 2,398,303 .02 (19,575,514) = 2,398,303 .02 (17,568,722) = 2,398,303 .02 (15,521,794) = 2,398,303 .02 (13,433,927) = 2,398,303 .02 (11,304,303) = 2,398,303 .02 (9,132,086) = 2,398,303 .02 (6,916,425) = 2,398,303 .02 (4,656,450) = 2,398,303 .02 (2,351,276) =

752,034 719,109 685,525 651,269 616,328 580,689 544,337 507,257 469,436 430,859 391,510 351,374 310,436 268,679 226,086 182,642 138,328 93,129 47,027*

Decrease in Balance

Outstanding Balance

2,398,303 1,646,269 1,679,194 1,712,778 1,747,034 1,781,975 1,817,614 1,853,966 1,891,046 1,928,867 1,967,444 2,006,793 2,046,929 2,087,867 2,129,624 2,172,217 2,215,661 2,259,975 2,305,174 2,351,276

40,000,000 37,601,697 35,955,428 34,276,234 32,563,456 30,816,422 29,034,448 27,216,835 25,362,869 23,471,823 21,542,957 19,575,514 17,568,722 15,521,794 13,433,927 11,304,303 9,132,086 6,916,425 4,656,450 2,351,276 0

* rounded

16–559

Case 15-1 (continued) Requirement 2 After the first full year under the warehouse lease, the book value of Dowell‘s leased warehouses is $32,000,000: $40,000,000 ÷ 5 years $ 8,000,000

Leased warehouses, PV of lease payments Life of lease Accumulated amortization after one year

$40,000,000 (8,000,000) $32,000,000

Leased warehouses, PV of lease payments Accumulated amortization after one year Book value after one year

Requirement 3 The specific citation that specifies the guidelines for derecognition of finance leases is FASB ASC 842–20–40: ―Derecognition General > Lease Termination.‖ Accounting for lessees is described in paragraphs 40–1, 2, 3 840–20–40–3: If the nature of a sublease is such that the original lessee is relieved of the primary obligation under the original lease, the transaction should be considered a termination of the original lease agreement. Because Dowell‘s proposed sublease is a termination of a finance lease before the expiration of the lease term, it falls under Par. 40–1: 40–1 A termination of a finance lease before the expiration of the lease term is accounted for by the lessee by removing the asset and obligation, with gain or loss recognized for the difference.

16–560

Case 15-1 (concluded) Requirement 4 In accordance with FASB ASC 842–20–40–1, the asset and obligation representing the original lease would be removed from the accounts and a loss would be recognized for the difference. The journal entry Dowell would record in connection with the sublease is: Lease payable (balance after 4 quarters; from req. 1) .. Loss on sublease (to balance) ................................ Right-of-use asset (balance: PV of lease payments)..

30,816,422 1,183,578 32,000,000

16–561

Analysis Case 15-2 Requirement 1 The noncancelable lease is a finance lease if it meets at least one of the following criteria. 1. The lease transfers ownership of the property to the lessee at the end of the lease term. 2. The lease contains a purchase option that the lessee is reasonably certain to exercise. 3. The lease term is equal to the major part of the estimated economic life of the leased property. 4. The present value of the lease payments, including guaranteed residual value, and excluding maintenance costs, equals or exceeds substantially all of the fair value of the leased property. 5. the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. Criteria 1., 3., and 5. are not met. Criterion 2 is met only if the purchase option is viewed as a bargain purchase option. But, because $290,000 is not sufficiently less than $300,000 that exercise of the option is reasonably certain to occur, criterion 2 is not met. There is no bargain purchase option. Criterion 4 is met only if the present value of the lease payments (not including the maintenance costs) is greater than substantially all of the fair value of the vans. VIP (Lessee): Present value of lease payments, assuming the purchase option is not a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Fair value of vans

$1,260,000

$1,046,055 ÷ $1,260,000 = 83% 83% is not substantially all of the fair value of the vans. Criterion 4 is not met. In this case, it is an operating lease to VIP, the lessee.

16–562

Case 15-2 (continued) Interstate (Lessor): Present value of lease payments, assuming the purchase option is not a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Residual value ($300,000 x 0.68301) 204,903 Total $1,250,958 Note: Even if not guaranteed, the residual value is expected by the lessor. $1,250,958 ÷ $1,260,000 = 99% 99% is substantially all of the fair value of the vans, so criterion 4 is met. And, since Interstate‘s cost, $1,050,000, was less than its ―selling price,‖ this is a sales-type lease with a selling profit. Requirement 2 Criteria 1., 3., and 5. are not met. Criterion 2 is met only if the purchase option is viewed as a bargain purchase option. Because $290,000 is sufficiently less than $400,000, the exercise of the option is reasonably certain to occur, and criterion 2 is met. There is a bargain purchase option. Criterion 4 is met only if the present value of the lease payments (not including the maintenance costs) is greater than substantially all of the fair value of the vans. The present value is calculated as follows:

16–563

Case 15-2 (continued) VIP (Lessee): Present value of lease payments, assuming a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Bargain purchase price ($290,000 x 0.68301) 198,073 Total $1,244,128 Fair value of vans $1,260,000 $1,244,128 ÷ $1,260,000 = 99% 99% is substantially all of the fair value of the vans. In this case, it is a finance lease to the lessee. Interstate (Lessor): Present value of lease payments, assuming a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Bargain purchase price ($290,000 x 0.68301) 198,073 Total $1,244,128 Fair value of vans $1,260,000 $1,244,128 ÷ $1,260,000 = 99% 99% is substantially all of the fair value of the vans. And, since Interstate‘s cost, $1,050,000, was less than its ―selling price,‖ this is a sales-type lease with a selling profit.

16–564

Case 15-2 (concluded) Requirement 3 VIP would record the following on December 31, 2024: Interest expense ([$1,100,000 – $300,000] x 10%)................. Lease payable ............................................................... Cash.......................................................................... Maintenance expense .................................................... Cash..........................................................................

80,000 220,000 300,000 1,000 1,000

Because a BPO is assumed, VIP would have the vans for 7 years: Amortization expense ([$1,100,000 – $50,000] ÷ 7 yrs.)…..… Right-of-use asset ....................................................

150,000 150,000

Note: If a BPO is not assumed, VIP would have the vans for 4 years: Amortization expense ($1,100,000 ÷ 4 yrs.)……………….. Right-of-use asset ....................................................

275,000 275,000

16–565

IFRS Case 15-3 Requirement 1 Because SDI wants to avoid income statement effects that would disrupt its attempts to ―smooth‖ income over time, other things equal, management would prefer leases to be classified as operating leases. With a finance lease, the lessee records more expense and the lessor records more revenue early in the life of the lease. This ―front loading‖ of lease expense/revenue occurs due to the fact that interest is higher initially than it is in the later stages of a lease, while amortization expense for the right-of-use asset remains the same each period. Operating leases avoid front loading. When accounting for an operating lease, the lessee records its total lease expense on a straight-line basis over the term of the lease. This is accomplished by recording interest the normal way (at the effective interest rate) and then ―plugging‖ the right-of-use asset amortization at whatever amount is needed to cause interest plus amortization to equal the straight-line lease payment amount. Those two components (interest and amortization) comprise a single lease expense amount reported in the income statement. This treatment would be consistent with SDI‘s attempts to ―smooth‖ income over time. A related benefit is that straight line expense recognition makes net income higher in the early years of the lease than if expense is front loaded. Requirement 2 SDI‘s meeting its reporting objective would be more difficult under IFRS. Following IFRS No. 16, all leases are accounted for as finance leases by the lessee (one-model approach). Only lessors apply the classification criteria to distinguish between finance and operating leases. So, even for leases that qualify under U.S. GAAP (two-model approach) as operating leases, the lessee amortizes the right-of-use asset on a straightline basis rather than ―plugging‖ that amount to cause the total of interest and amortization to be a straight-line amount. This means that those leases under IFRS will have a front-loaded expense profile (because interest expense is more at the beginning than at the end).

16–566

Real World Case 15-4 Requirement 1 When finance leases are first recorded, both assets and liabilities increase by the present value of lease payments. In later years, though, the amounts differ. Right-ofuse assets are reduced by amortization. Lease liabilities are reduced by the principal portion of lease payments. (The same is true for operating leases unless lease payments occur at the end each lease period and coincide with the end of a reporting period. In that case, the amortization amounts will be the same as the principal portion of lease payments.) Requirement 2 ($ in millions)

Interest expense (given) .......................... Lease payable (Jul. 31, 2019 current obligation; paid during following year: given) .................... Cash (lease payment: to balance) .........

331 439 770

 Leasing can allow a firm to conserve assets.  Leasing can preserve the ability to borrow under lines of credit.  Leasing can provide an interest rate lower than the incremental borrowing rate.  Leasing may avoid violating restrictive loan agreements that prohibit the issuance of additional debt securities.  Leasing can lessen the risk of obsolescence.  Leasing allows 100% financing at fixed interest rates as compared with 70% to 90% financing when assets are purchased.

16–567

Real World Case 15–5 Requirement 1 The structure of leases is shifting from operating leases to finance leases. We know this because the operating lease payments over the next five years and thereafter are declining each year while finance lease payments over the next five years and thereafter are increasing each year.

Requirement 2 Interest expense (operating cash flow from finance leases) Lease payable (financing cash flow from finance leases) .. Cash (to balance)........................................................

336 409

Requirement 3 Amortization expense (amortization of ROU assets) ...... Right-of-use asset .....................................................

611

16–568

745

611

Analysis Case 15–6 Requirement 1 Modification of the Lease (December 31, 2020) Anthony‘s Ristorante, the lessee, will adjust its right-of-use asset and lease payable for the difference between the present value of the new lease payments and the existing balance. Anthony’s Ristorante (Lessee) Right-of-use asset (increase in balance) .......................... 113,748 Lease payable (increase in balance) .................... 113,748 *PV of new payments, discounted at 6% current rate $202,911 ** Liability (PV of remaining 2 payments, discounted at 8% original rate) 89,163 $113,748 Increase in balance * PV of new payments, discounted at 6% current rate December 31: New payments PV at Dec. 31, 2020 2020 2021 $0 $ 0 2022 $0 0 1 2023 $150,000 .83962 125,943 1 2024 $ 50,000 .79209 39,605 1 2025 $ 50,000 .74726 37,363 $202,911 1

Present value of $1: n = 3,4,5, i =6%.

** Liability (PV of remaining 2 payments, discounted at 8% original rate) 2 $50,000  1.78326 = $89,163 Lease Payments

Present value

Present value of an ordinary annuity of $1: n = 2, i =8%.

16–569

Requirement 2 Modification of the Lease (December 31, 2020) Fauci Properties, the lessor, previously viewed its operating lease as simply renting the asset to the lessee and thus recorded lease revenue of $50,000 each year on a straight-line basis while depreciating the asset over the first 18 years. Now, it qualifies as a sales-type lease, so Fauci could record a lease receivable for the present value of the new lease payments (discounted at the current interest rate) and derecognize the asset (and related accumulated depreciation). However, Fauci chose the option under the CARES Act to not reclassify the lease from an operating lease to a sales-type lease. So, it will make no entry for the modification of the lease.

16–570

Case 15–6 (concluded) Requirement 3 Anthony‘s Ristorante previously viewed this as an operating lease and thus recorded amortization so as to report lease expense (interest plus amortization) on a straight-line basis. Now, it‘s a finance lease, so Anthony‘s could account for the modified lease in the same manner as any other finance lease, recording interest at the now current interest rate of 6% and amortizing the balance in the right-of-use asset over the remaining five years on a straight-line basis. However, Anthony‘s chose the option under the CARES Act to not reclassify the lease from an operating lease to a finance lease. So, it will continue to record amortization so as to report lease expense (interest plus amortization) on a straight-line basis. Anthony’s Ristorante (Lessee) Interest expense (6%  $202,911)*.............................. Interest payable .................................................. Amortization expense ($50,000 – $12,175) .................. Right-of-use asset ................................................

12,175 12,175 37,825 37,825

*The 2021 lease payment is deferred, but interest accrues on the liability, nonetheless.

Requirement 4 Fauci Properties, the lessor, previously viewed its operating lease as simply renting the asset to the lessee and thus recorded lease revenue of $50,000 each year on a straight-line basis while depreciating the asset over the first 18 years. Now, it qualifies as a sales-type lease, so Fauci could record a lease receivable for the present value of the new lease payments (discounted at the current interest rate) and derecognize the asset (and related accumulated depreciation). However, Fauci chose the option under the CARES Act to not reclassify the lease from an operating lease to a sales-type lease. So, it will continue to record lease revenue of $50,000 each year on a straight-line basis: Fauci Properties (Lessor) Lease revenue receivable ....................................... Lease revenue* ..................................................

50,000 50,000

*The 2021 lease payment is deferred, but Fauci continues to record lease revenue of $50,000 each Solutions Manual, Chapter 16 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

16–571

year on a straight-line basis, nonetheless.

16–572

Real World Case 15–7 Requirement 1 The lessee reports operating lease rent payments, both the interest and liability portions, entirely as operating expenses, but reports the interest portion of financing lease rent payments as a cash outflow from operating activities and the principal portion as a cash outflow from financing activities. Requirement 2 Lease expense…………………… Cash………………………

($ in millions)

2,608 2,608

Requirement 3 Interest expense…………………. Lease payable…………………… Cash………………………

14 84 98

Requirement 4 No. FedEx did not pay the amounts indicated in addition to incurring lease liabilities for the right-of-use assets for finance leases. The amounts indicated are for non-cash leases. Transactions that do not increase or decrease cash, but that result in significant investing and financing activities such as leases, must be reported on a SCF or in related disclosures. Requirement 5 Right-of-use assets………………. Lease payable…………….

($ in millions)

1,915 1,915

16–573

Communication Case 15-8 Suggested Grading Concepts and Grading Scheme: Content (80%) 40

Sale leaseback accounting (10 each; maximum 40). Sale leaseback accounting permitted only when sale portion qualifies as a sale under the revenue recognition guidelines. Then record gain or loss on sale. If leaseback qualifies as a finance lease, no sale has occurred. So, leaseback would be an operating lease.

If it‘s not a sale, (10 each; maximum 40). Since General Tools would retain the right to essentially all of the remaining use of the equipment, it‘s not a sale. Account for the transaction as a loan from the buyer to the seller. Note receivable for seller-lessor. Note payable for buyer-lessee. Thus, no gain.

80 points Writing (20%) 5 Terminology and tone appropriate to the audience (CFO). 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English Word selection. Spelling. Grammar. 20 points

16–574

Ethics Case 15-9 Discussion should include these elements: Leasehold improvement depreciation period There may be some degree of latitude associated with uncertainty concerning the life of the leasehold improvements. However, trade publications indicate 25 years probably is out of range. The suggestion to use 25 years clearly is motivated by the desire to ―window dress‖ performance. Ethical Dilemma: How does a doubtful justification for the estimated life of leasehold improvements compare with the perceived need to increase reported profits? Who is affected? Person Keene Other managers Shareholders Potential shareholders Employees Creditors The company‘s auditors

16–575

Target Case Requirement 1 When Target recorded its finance lease at inception, both assets and liabilities increased by the present value of lease payments. In later years, though, the amounts differ. Right-of-use assets are reduced by amortization. Lease liabilities are reduced by the principal portion of lease payments. (The same is true for operating leases unless lease payments occur at the end each lease period and coincide with the end of a reporting period. In that case, the amortization amounts will be the same as the principal portion of lease payments.) Requirement 2 Finance lease assets, net Add back: accumulated amortization Finance lease assets, before amortization Requirement 3 Operating lease assets (from SCF)…. Operating lease liability……..

16–576

($ in millions)

$1,180 441 $1,621 ($ in millions)

464 464

Air France/KLM Case Requirement 1 In Note 4.15: Lease contracts, AF states that ―leases are recorded in the balance sheet and lead to the recognition of: - an asset representing a right of use of the asset leased during the lease term of the contract and - a liability related to the payment obligation. Yes. This policy is generally consistent with U.S. GAAP, ASC 842. Requirement 2 Under IFRS 16, the lessee makes no distinction between a finance lease and an operating lease. All leases are accounted for as finance leases by the lessee (onemodel approach). Only lessors apply the classification criteria to distinguish between finance and operating leases. Thus, even for leases that qualify under U.S. GAAP (two-model approach) as operating leases, the lessee amortizes the right-of-use asset on a straight-line basis rather than ―plugging‖ that amount to cause the total of interest and amortization to be a straight-line amount. For all leases (with lease terms of more than 12 months and amounts of $5,000 or more) companies will report both right-ofuse assets and lease liabilities. And, unlike under U.S. GAAP, companies will report both interest expense and amortization expense the same way for all leases.

16–577

Chapter 16 Accounting for Income Taxes QUESTIONS FOR REVIEW OF KEY TOPICS

16–578

Question 16–1 Income tax expense is comprised of both the current and the deferred tax consequences of events and transactions already recognized. Specifically, the $12.3 million expense includes (a) the $7.9 million income tax that is payable currently and (b) the change in the deferred tax liability (or asset). Apparently, in the situation described, temporary differences required a $4.4 million increase in deferred tax liabilities or the valuation allowance, a $4.4 million decrease in deferred tax assets, or some combination of those changes.

16–579

Question 16–2 Temporary differences between the reported amount of an asset or liability in the financial statements and its tax basis are primarily caused by revenues, expenses, gains, and losses being included in taxable income in a year earlier or later than the year in which they are recognized for financial reporting purpose, although there are other, less common, events that can cause these temporary differences. Some temporary differences create deferred tax liabilities because they result in taxable amounts in some future year(s) when the related assets are recovered or the related liabilities are settled (when the temporary differences reverse). An example is the receivable created when installment sale gross profit is recognized for financial reporting purposes. When this asset is recovered, taxable amounts are produced because the installment sale gross profit is then recognized for tax purposes. Some temporary differences create deferred tax assets because they result in deductible amounts in some future year(s) when the related assets are recovered or the related liabilities are settled (when the temporary differences reverse). An example is the liability created when estimated warranty expense is recognized for financial reporting purposes. When this liability is settled, deductible amounts are produced because the warranty cost is then deducted for tax purposes. The deferred tax liability or asset each year is the tax rate times the temporary difference between the financial statement carrying amount (book value) of the receivable or liability and its tax basis.

16–580

16–581

Question 16– 582 Future deductible amounts mean that taxable income will be decreased relative to pretax accounting income in one or more future years. Two examples are (a) estimated expenses that are recognized on income statements when incurred, but deducted on tax returns in later years when actually paid and (b) revenues that are taxed when collected, but are recognized on income statements in later years when actually earned. These situations have favorable tax consequences that are recognized as deferred tax assets.

16–582

Question 16–4 Deferred tax assets are recognized for all deductible temporary differences and operating loss carryforwards. However, a deferred tax asset is then reduced by a valuation allowance if it is ―more likely than not‖ that some portion or the entire deferred tax asset will not be realized. The decision as to whether a valuation allowance is needed should be based on the weight of all available evidence.

16–583

Question 16– 584 Nontemporary or ―permanent‖ differences are caused by transactions and events that under existing tax law will be removed from accounting income when calculating taxable income and are therefore not included in taxes payable. Some provisions of the tax laws exempt certain revenues from taxation and prohibit the deduction of certain expenses. Provisions of the tax laws, in some other instances, dictate that the amount of a revenue that is taxable or expense that is deductible permanently differs from the amount reported in the income statement. Permanent differences are disregarded when determining both the tax payable currently and the deferred tax effect. Therefore, they don‘t affect tax expense.

16–584

16–585

Question 16–6 Examples of nontemporary or ―permanent‖ differences are: • Interest received from investments in governmental bonds issued by state and municipal governments (not taxable) • Investment expenses incurred to obtain tax-exempt income (not tax deductible) • Life insurance proceeds upon the death of an insured executive (not taxable) • Premiums paid for life insurance policies (not tax deductible) • Compensation expense pertaining to some employee stock option plans (not tax deductible) • Expenses due to violations of the law (not tax deductible) • Portion of dividends received from U.S. corporations that is not taxable due to the ―dividends received deduction‖ • Difference in tax paid on foreign income permanently reinvested in the foreign country and the amount that would have been paid if taxed at U.S. rates. • Tax deduction for depletion of natural resources (percentage depletion) that permanently exceeds the income statement depletion expense (cost depletion)

16–586

Question 16–7 A deferred tax liability (or asset) is based on enacted tax rates and laws. Hudson should use the 35% rate, the currently enacted tax rate that will be effective in the year(s) the temporary difference reverses. Calculations are not based on anticipated legislation that would alter the company‘s tax rate.

16–587

16–588

Question 16–8 When a change in a tax law or rate occurs, a deferred tax liability or asset must be adjusted to reflect the amount to be paid or recovered in the future. If a deferred tax liability was established with the expectation that the future taxable amount would be taxed at 21%, then that deferred tax liability now would be decreased to reflect that the same future taxable amount will be taxed at 21% instead of 35%. Tax rate changes automatically are accounted for in steps 2-4 of the four-step process used to calculate tax expense, namely: (2) calculating the desired balance in a deferred tax asset or liability each period, (3) comparing that amount with any previously existing balance, and adjusting the account for the debit or credit change necessary to reach the desired ending balance, and (4) plugging the amount for tax expense, by netting the tax payable (step 1) and any changes in the deferred tax accounts (step 3) such that the effect is reflected in operating income in the year the change in the tax law or rate is enacted.

16–589

Question 16–9 The income tax benefit of a net operating loss carryforward is recognized for accounting purposes in the year the operating loss occurs. The net after-tax operating loss reflects the future tax savings that the loss carryforward is expected to create. A net operating loss carryforward creates future deductible amounts, so a deferred tax asset is recognized for a net operating loss carryforward. The deferred tax asset is then reduced by a valuation allowance if it is ―more likely than not‖ that some portion or all of the deferred tax asset will not be realized due to insufficient taxable income expected in the carryforward years.

16–590

16–591

Question 16– 592 Deferred tax assets and deferred tax liabilities are classified as noncurrent. So long as they are associated with the same taxable component of a company and the same tax jurisdiction, they are offset and reported as a net noncurrent amount reported as either an asset—if deferred tax assets exceed deferred tax liabilities—or as a liability—if deferred tax liabilities exceed deferred tax assets. However, sometimes a single company can have multiple components that report tax returns separately, and can pay tax in multiple jurisdictions. Deferred tax assets and liabilities that are associated with different taxable components or different tax jurisdictions are not offset on the balance sheet.

16–592

Question 16–11 Regarding deferred tax amounts reported in the balance sheet, disclosure notes should indicate (a) the total of all deferred tax liabilities, (b) the total of all deferred tax assets, (c) the total valuation allowance recognized for deferred tax assets, (d) the net change in the valuation allowance, and (e) the approximate tax effect of each type of temporary difference (and carryforward).

16–593

Question 16– 594 Pertaining to the income tax expense reported in the income statement, disclosure notes should indicate (a) the current portion of the tax expense (or tax benefit), (b) the deferred portion of the tax expense (or tax benefit), with separate disclosure of amounts attributable to (c) the portion that does not include the effect of the following separately disclosed amounts, (d) operating loss carryforwards, (e) adjustments due to changes in tax laws or rates, (f) adjustments to the beginning-of-the-year valuation allowance due to revised estimates, and (g) investment tax credits. A reconciliation of the effective and statutory tax rates also is required.

16–594

Answers to Questions (concluded)

16–595

Question 16– 596Step 1: For an uncertain tax benefit to be recognized in a company‘s financial statements, the identified tax position must have a "more-likely-than-not" likelihood— a more than 50 percent chance—of being sustained on examination. The concept of "being sustained" means being capable of making it through the final level of appeal or litigation on the tax position's technical merits, assuming the examining jurisdictions have full knowledge of all facts and circumstances. Step 2: Once a company concludes that a particular tax position has a "more likely than not" chance of being sustained, it should measure the dollar amount of benefit to recognize as the largest benefit that cumulatively is greater than 50 percent likely to be sustained.

16–596

Question 16– 597 Intraperiod tax allocation means the total income tax obligation for a reporting period is allocated among the income statement items that gave rise to the income tax. The following items should be reported net of their respective income tax effects: • Income (or loss) from continuing operations • Discontinued operations

16–597

Question 16– 598 Despite the similar approaches for accounting for taxation under IAS No. 12, ―Income Tax,‖ and U.S. GAAP, differences in reported amounts for deferred taxes are among the most frequent between the two reporting approaches. The reason is that a great many of the nontax differences between IFRS and U.S. GAAP affect deferred taxes as well.

16–598

Question 16– 599 The CARES Act included two provisions affecting accounting for the tax effects of NOLs that arose in tax years beginning after December 31, 2017 and before January 1, 2021: 1) Is suspended the 80% limitation on utilization of NOLs. 2) It allowed carryback of the NOLs to offset taxable income generated in the previous five years.

16–599

Question 16– 600 By allowing NOL carrybacks to prior years, the CARES Act enabled some companies to obtain an immediate tax refund rather than waiting for carryforwards to offset future taxable income. Also, because companies could carryback to years in which the federal tax rate was 35%, companies could recover more tax than they could if they carried forward to years in which the federal tax rate was 21%.

16–600

BRIEF EXERCISES

16–601

Brief Exercise 16–1 Since taxable income is less than pretax accounting income, a future taxable amount will occur when the temporary difference reverses. This means a deferred tax liability should be recorded to reflect the future tax consequences of the temporary difference:

Step 1: Tax payable: $1.75 Step 2: DTL end. bal: $0.75 Step 3: DTL change: $0.75 Step 4: Tax exp. plug: $2.5

Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax liability ([$10 – $7] × 25% – $0) Income tax payable ($7 × 25%)

16–602

Deferred Tax Liability 0 0.75 0.75

($ in millions)

2.5 0.75 1.75

16–603

16–604

16–605

16–606

16–607

16–608

Brief Exercise 16–2 Since tax depreciation to date has been $100,000 more than depreciation for financial reporting purposes, there will be fewer tax deductions for depreciation in the future, and future taxable amounts will be higher as the temporary difference reverses. This means a deferred tax liability should be reported to reflect the future tax consequences of the temporary difference. At this point, that amount is $100,000 times 25%, or $25,000. If the balance of the deferred tax liability was $20,000 last year, we need an increase of $5,000. The entry to record income taxes is:

Step 1: Tax payable: $1,000,000 Step 2: DTL end. bal: $25,000 Step 3: DTL change: $5,000 Step 4: Tax exp plug: $1,005,000 Journal entry: Income tax expense (to balance) Deferred tax liability ($25,000 – $20,000) Income tax payable ($4,000,000 × 25%)

Deferred Tax Liability 20,000 5,000 25,000 1,005,000 5,000 1,000,000

16–609

16–610

Brief Exercise 16–3 Since 100% of the tax deduction for this equipment was taken in the year of purchase, the entire book value of $600,000 is a temporary difference. There will be no tax deductions for depreciation in the future, and future taxable amounts will be higher as the temporary difference reverses. A deferred tax liability should be reported to reflect the future tax consequences of that temporary difference. At this point, that amount is $600,000 times 25%, or $150,000. If the balance was $175,000 last year, we need a decrease of $25,000. The entry to record income taxes is:

Step 1: Tax payable: $2,500,000 Step 2: DTL end. bal: $150,000 Step 3: DTL change: $(25,000) Step 4: Tax exp plug: $2,475,000

Journal entry: Income tax expense (to balance) Deferred tax liability ($150,000 – $175,000) Income tax payable ($4,000,000 × 25%)

Deferred Tax Liability 175,000 25,000 150,000

2,475,000 25,000 2,500,000

16–611

16–612

Brief Exercise 16– 613

Since taxable income is $2 million more than pretax accounting income, a future deductible amount will occur when the temporary difference reverses. This means a deferred tax asset should be recorded to reflect the future tax savings from the temporary difference equal to $2 million times 25%, or $0.5 million.

Step 1: Tax payable: $3 Step 2: DTA end bal: $0.5 Step 3: DTA change: $0.5 Step 4: Tax exp plug: $2.5 Journal entry: Income tax expense (to balance) Deferred tax asset ([$12 – $10] × 25% – $0) Income tax payable ($12 × 25%)

Deferred Tax Asset 0 0.5 0.5 ($ in millions)

2.5 0.5

3.0

16–613

Brief Exercise 16–5 Since 100% of the revenue was taxed in the year collected, the $50 million of deferred revenue in 2024 is a temporary difference. Already taxed, this amount will not be taxed in the future, so future taxable amounts will be lower as the temporary difference reverses. A deferred tax asset should be reported to reflect the future tax consequences of that temporary difference. At this point, that amount is $50 million times 25%, or $12.5 million.

Step 1: Tax payable: $45 Step 2: DTA end bal: $12.5 Step 3: DTA change: $12.5 Step 4: Tax exp plug: $32.5

Deferred Tax Asset 0 12.5 12.5

The balance of the deferred tax asset was $0 at the beginning of the year, so we need an increase of $12.5 million. The entry to record income taxes is: Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset ([$50 × 25%] – $0) Income tax payable ($180 × 25%)

16–614

($ in millions)

32.5 12.5 45.0

Brief Exercise 16– 615

Since 100% of the revenue was taxed in the year collected, the $40 million of deferred revenue in 2025 is a temporary difference. Already taxed, this amount will not be taxed in the future, and future taxable amounts will be lower as the temporary difference reverses. A deferred tax asset should be reported to reflect the future tax consequences of that temporary difference. At this point, that amount is $40 million times 25%, or $10 million.

Step 1: Tax payable: $50 Step 2: DTA end. bal: $10 Step 3: DTA change: $(2.5) Step 4: Tax exp plug: $52.5

Deferred Tax Asset 12.5 2.5 10

The balance of the deferred tax asset was $12.5 million at the beginning of the year, so we need a decrease of $2.5 million. The entry to record income taxes is: Journal entry at the end of 2025 Income tax expense (to balance) Deferred tax asset ([$40 × 25%] – $12.5) Income tax payable ($200 × 25%)

($ in millions)

52.5 2.5 50.0

16–615

16–616

Brief Exercise 16– 617 Step 1: Tax payable: $15 Step 2: DTA end bal: $4 Val allow end bal: $3 Step 3: DTA change: $4 Val allow change: $3 Step 4: Tax exp plug: $14

Journal entry at the end of the year: Income tax expense (to balance) Deferred tax asset ([$16 × 25%] – $0) Income tax payable ($60 × 25%) Income tax expense Valuation allowance (3/4 × $4)

Valuation Allowance 0

Deferred Tax Asset 0 4

3 3

($ in millions)

11 4 15 3 3

16–617

Note: these two entries could be combined into one entry: Income tax expense (to balance) Deferred tax asset ([$16 × 25%] – $0) Income tax payable ($60 × 25%) Valuation allowance (3/4 × $4)

16–618

14 4 15 3

16–619

Brief Exercise 16–8 No, the fact that Uber has such a high valuation allowance suggests that it is not more likely than not that it will be able to realize most of its tax benefits. That would be the case if management feels taxable income will not be sufficient in future years to permit gaining the benefit of reducing taxable income by the future deductible amounts.

16–8

Brief Exercise 16– 621

Since the cumulative temporary difference between pretax accounting income and taxable income as of the end of 2024 is $40 million and it is a future taxable amount, a deferred tax liability should be reported to reflect the future tax consequences of the temporary difference. That amount is $40 million times 25%, or $10 million. (The $16 million temporary difference shown for the current year already is included in the $40 million cumulative difference as of the end of 2024.)

16–621

Brief Exercise 16– 622 Pretax accounting income Permanent difference: Governmental bond interest Temporary difference: Depreciation

Current year $ 900,000

Future taxable amount

(20,000) (120,000)*

Taxable income (tax return)

$ 760,000

Enacted tax rate Tax payable currently Deferred tax liability

25% $ 190,000

$120,000

25% $ 30,000

Deferred Tax Liability 0 30,000

Step 1: Tax payable: $190,000 Step 2: DTL end. bal: $30,000 Step 3: DTL change: $30,000 Step 4: Tax exp plug: $220,000 Journal entry: Income tax expense (to balance) Deferred tax liability ([$120,000 × 25%] – $0) Income tax payable (determined above)

* Tax depreciation: $800,000 × 40% Straight-line depreciation: $800,000 ÷ 4 years Difference the first year

16–622

30,000 220,000 30,000 190,000

$320,000 (200,000) $120,000

Brief Exercise 16– 623

($ in 000s) Current Future Year Deductible 2024 Amounts* 2025 2026 2027

Pretax accounting income Temporary difference: Warranty expense

291 9

(3)

Taxable income (tax return) Enacted tax rate Tax payable currently Deferred tax asset

300 25% 75

25%

20%

Step 1: Tax payable: $75 Step 2: DTA end. bal: $1.95 Step 3: DTA change: $1.95 Step 4: Tax exp plug: $73.05 Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset (determined above) Income tax payable ($300 × 25%)

Total

(0.75) + (0.6) + (0.6) =

(1.95)

Deferred Tax Asset 0 1.95 1.95

73.05 1.95 75.00

16–623

*The warranty expense is only deductible on a tax return if an actual warranty payment is made in the taxable year. Thus, the $9 expense in current accounting income will give rise to a future deductible amount for tax purposes as the payments are made.

16–624

16–625

Brief Exercise 16–12 Superior should change its deferred tax liability in 2024 by reducing it $5.5 million: ($ in millions)

Deferred tax liability 12/31/2023 Deferred tax liability 12/31/2024 Reduction needed to achieve desired balance

16–626

$8.0 ($20 future taxable amt. × 40%) (2.5) ($10 future taxable amt. × 25%) $5.5

Brief Exercise 16– 627

LossCo‘s NOL is carried forward. Journal entry Deferred tax asset ($25 million × 25%) Income tax expense (to balance)

6,250,000 6,250,000

16–627

16–628

Brief Exercise 16–14 NOL carrybacks are not allowed for most companies, except for property and casualty insurance companies as well as some farm-related businesses. Here, we are told that LossCo is one of those businesses, and that it carries back an NOL. Because the net operating loss is less than the previous two years taxable income, LossCo cannot get back all taxes paid those two years. It can reduce taxable income from two years ago by $15 million (to zero) and last year‘s taxable income by $10 million and get a refund of $6.25 million of the taxes paid those years. Journal entry Receivable—income tax refund ($25 million × 25%) Income tax expense (to balance)

16–14

6,250,000 6,250,000

Brief Exercise 16– 630

Taxable income reflects the benefit of the interest being tax-free, so the tax currently payable is $55 million × 25% or $13.75 million. But, since it‘s more likely than not that the interest isn‘t tax-free, that benefit can‘t be recognized in the tax expense. So, First Bank would record tax expense as if the interest is fully taxable, income tax payable that reflects none of it being taxable, and a liability for uncertain tax positions that represents the potential obligation to pay the additional taxes if the tax-free status is not ultimately upheld: ($ in millions) Income tax expense (to balance) 15.00 Income tax payable ($55 × 25%) 13.75 Liability—uncertain tax positions ($5 × 25%) 1.25 The $1.25 million represents the tax benefit not recognized in the income statement, but potentially due if the deduction is not upheld. Because the ultimate outcome probably won‘t be known within the upcoming year, the Liability—uncertain tax positions likely will be reported as a long-term liability.

16–630

Brief Exercise 16– 631 Intraperiod tax allocation means the total income tax obligation for a reporting period is allocated among the income statement items that gave rise to the income tax. The following items should be reported net of their respective income tax effects: • Income (or loss) from ordinary, continuing operations. • Discontinued operations. Southeast Airlines had income from continuing operations of $55 million before the income from discontinued operations of $10 million. Since the company‘s tax rate is 25%, the amount of income tax expense that Southeast should report as part of income from continuing operations is $55 million × 25%, or $13.75 million. The income from discontinued operations should be reported net of its tax expense: $10 million less 25% of $10 million (or $2.50 million), which nets to $7.50 million. So, the total income tax obligation of $16.25 million ($65 million × 25%) is allocated between the income statement items that gave rise to the income tax: ($ in millions)

Income from continuing operations before tax Income tax expense Income from continuing operations Income from discontinued operations, net of income tax expense of $2.50 Net income

$55.00 13.75 $41.25 7.50 $48.75

16–631

Brief Exercise 16– 632 Hwang would carryback its $50,000 NOL to 2017 and realize an immediate refund of the taxes it paid in 2017 (which were taxed at a rate of 40%). Journal entry Receivable—income tax refund ($50,000 × 40%) Income tax expense (to balance)

16–632

20,000 20,000

Brief Exercise 16– 633 The valuation allowance would have a balance of $0. Because Krand would be able to carry its NOL back to prior profitable years, it would realize an immediate tax refund rather than recognizing a deferred tax asset. With no deferred tax asset, it would not need to recognize a valuation allowance.

16–633

EXERCISES

16–634

Exercise 16–1 Requirement 1 Since taxable income is less than pretax accounting income in the amount of $150,000 ($400,000 – $250,000), a future taxable amount will occur when the temporary difference of $150,000 reverses. This means a deferred tax liability of $150,000 times the tax rate of 25% (= $37,500) should be recorded to reflect the future tax consequences of the temporary difference.

Deferred Tax Liability

Step 1: Tax payable: $62,500 Step 2: DTL end. bal: $37,500 Step 3: DTL change: $37,500 Step 4: Tax exp. plug: $100,000

0 37,500 37,500

Income tax expense (to balance) 100,000 Deferred tax liability ([$400,000 – $250,000] × 25% – $0) 37,500 Income tax payable ($250,000 × 25%) 62,500

As a result, net income is $300,000: Pretax accounting income Income tax expense Net income

$400,000 (100,000) $300,000

Requirement 2 In its balance sheet, Alvis will report the $37,500 deferred tax liability among long-term liabilities and the $62,500 income tax payable as a current liability.

16–635

16–636

Exercise 16–2 Requirement 1 ($ in millions) Current Future Year Taxable 2024 Amount [total]

Pretax accounting income Temporary difference: Depreciation ($30 – $20) – ($28 – $12) =

Taxable income (tax return)

Enacted tax rate Tax payable currently Deferred tax liability

25% 11

(6)

16 ($28 – $12)

25% 4

Deferred Tax Liability 2.5* 1.5 4.0

Step 1: Tax payable: $11 Step 2: DTL end bal: $4 Step 3: DTL change: $1.5 Step 4: Tax exp plug: $12.5

* ($3 0 – $2 0)

× 25% Note: Alternatively, steps 2 and 3 can be completed from a balance sheet perspective by examining book-tax differences: ($ in millions)

Accounting book value Tax basis Tax rate Deferred tax liability:

12/31/2023 $30 20 $10

12/31/2024 $28 12 $16

25%

_ 25%

$2.5 +

1.5 =

16–637

Exercise 16–2 (concluded) Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

12.5 1.5 11.0

Requirement 2 ($ in millions) Pretax income Income tax expense Net income $37.5

16–638

$50.0 (12.5)

Exercise 16–3 Requirement 1 ($ in millions) Current Future Year Taxable 2024 Amount [total]

Pretax accounting income Temporary difference: Depreciation ($30 – $28)

Taxable income (tax return)

Enacted tax rate Tax payable currently Deferred tax liability

25% 13

25% 7

Deferred Tax Liability 7.5* 0.5 7.0

Step 1: Tax payable: $13 Step 2: DTL end. bal: $7 Step 3: DTL change: $(0.5) Step 4: Tax exp plug: $12.5

* $30 × 25%

Note: Alternatively, steps 2 and 3 can be completed from a balance sheet perspective by examining book-tax differences: ($ in millions)

Accounting book value Tax basis Tax rate Deferred tax liability:

12/31/2023 $30 0 $30

12/31/2024 $28 0 $28

25%

_ 25%

$7.5 + (0.5) =

16–639

Exercise 16–3 (concluded) Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

12.5 0.5 13.0

Requirement 2 ($ in millions) Pretax income Income tax expense Net income $37.5

16–640

$50.0 (12.5)

Exercise 16–4 ($ in millions)

Cost Accounting book value $80 Tax basis 80 Temporary book-tax difference: Tax rate Deferred tax liability:

December 31 2025 2026

2024 (20) (25)

$60 55

(20) (33)

$40 22

(20) (15)

2027

$20 7

(20) ( 7)

$0 0

$18

$13

25%

_ 25%

25%

$1.25

$4.5

$3.25

16–641

16–642

Exercise 16–5 ($ in millions)

Cost Accounting book value $80 Tax basis 80 Temporary book-tax difference: Tax rate Deferred tax liability:

December 31 2025 2026

2024 (20) (80)

$60 0

(20) (0)

$40 0

(20) (0)

$20 0

2027 (20) ( 0)

$0 0

$60

$40

$20

25%

_ 25%

25%

$15

$10

16–643

Exercise 16–6

16–644

Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset ([$300,000 × 25%] − $0) Income tax payable (given)

875,000 75,000 950,000

16–645

16–646

16–647

Exercise 16–7

16–648

Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset ([$2 million × 25%] – $435,000) Income tax payable ($75 million × 25%)

Step 1: Tax payable: $18,750,000 Step 2: DTA end bal: $500,000* Step 3: DTA change: $65,000 Step 4: Tax exp plug: $18,685,000

18,685,000 65,000 18,750,000

Deferred Tax Asset 435,000 65,000 500,000*

*$2 million × 25%

16–649

Exercise 16–8

16–8

1. Accrual of loss contingency; tax deductible when paid.

2. Newspaper subscriptions: taxable when received; recognized for financial reporting when the performance obligation is satisfied.

3. Prepaid rent; tax deductible when paid.

4. Accrued bond interest expense; tax deductible when paid.

5. Prepaid insurance; tax deductible when paid.

6. Unrealized loss from recording investments at fair value (tax deductible when investments are sold).

7. Warranty expense; estimated for financial reporting when products are sold; deducted for tax purposes when paid.

8. Advance rent receipts on an operating lease (as the lessor); taxable when received.

9. Straight-line depreciation for financial reporting; accelerated depreciation for tax purposes.

10. Accrued expense for employee vacation days not yet taken; tax deductible when employee takes vacation in future.

Exercise 16– 651 1.

Liability—loss contingency

Deferred subscription revenue

Prepaid rent

Interest payable

Prepaid insurance

Fair Value Adjustment (unrealized loss, OCI)

Warranty liability

Deferred rent revenue

Accumulated depreciation

10.

Liability—compensated future absences

16–651

Exercise 16– ($ in thousands) 652

Situation 2 3 $216 $196 25% 25% $ 54 $ 49

a. Taxable income Tax rate Current income tax payable

1 $84 25% $21

b. Future deductible amounts Tax rate Deferred tax asset— bal. Beginning of the year: c. Change in deferred tax asset:

$16 25% $4 2 $2

$0 25% $0 0 $0

$20 25% $5 9 $(4)

$20 25% $5 4 $1

d. Future taxable amounts Tax rate Deferred tax liability— bal. Beginning of the year: e. Change in deferred tax liability:

$0 25% $0 0 $0

$16 25% $4 8 $(4)

$16 25% $4 2 $2

$28 25% $7 0 $7

f. Income tax payable currently Deferred tax asset decrease (increase): Deferred tax liability increase (decrease): Income tax expense

$21 (2) 0 $19

$54 0 (4) $50

$49 4 2 $55

$65 (1) 7 $71

16–652

4 $260 25% $65

Exercise 16– 653

($ millions) PRETAX ACCOUNTING INCOME

1 2 3 4 5 6 7 8 $100 $100 $100 $100 $100 $100 $100 $100

Temporary differences: Income statement first:

Revenue Expense

(20)

(15) 20

(15) (15) 20 20

Tax return first:

Revenue Expense TAXABLE INCOME

$120

5 (20) (10) (10) $80 $120 $ 80 $105 $135 $ 95 $100

16–653

Exercise 16–12 Requirement 1 Current Year 2024

($ in millions) Future Deductible Amounts

(64)

Temporary difference: Taxable income Enacted tax rate Tax payable currently Deferred tax asset

Step 1: Tax payable: $45 Step 2: DTA end. bal: $16 Step 3: DTA change: $(9) Step 4: Tax exp plug: $54

Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset (determined above) Income tax payable (determined above)

16–654

180 25% 45

25% (16) Deferred Tax Asset 25 9 16

54 9 45

Exercise 16–12 (concluded) Requirement 2 Step 1: Tax payable: $45 Step 2: DTA end. bal: $16 Val allow end bal: $12 Step 3: DTA change: $(9) Val allow change: $12 Step 4: Tax exp plug: $54

Valuation Allowance

Deferred Tax Asset

25 9

12 12

16 ($ in millions)

Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset (determined above) Income tax payable (determined above) Income tax expense Valuation allowance (3/4 × $16)

54 9 45 12 12

One-fourth of the deferred tax asset will be realized, which means three-fourths of the deferred tax asset will not be realized, so three-fourths of the deferred tax asset will be recognized in a valuation allowance. Of course, these two entries can be combined, as follows: Income tax expense (to balance) Deferred tax asset (determined above) Income tax payable (determined above) Valuation allowance (3/4 × $16)

66 9 45 12

16–655

Exercise 16–13 Requirement 1 ($ in millions) Current Future Year Deductible 2024 Amounts

Temporary difference: Taxable income Enacted tax rate Tax payable currently Deferred tax asset Step 1: Tax payable: $45 Step 2: DTA end. bal: $16 Val allow end bal: $0 Step 3: DTA change: $(9) Val allow change: $(10) Step 4: Tax exp plug: $44

16–656

(64) 180 25% 45

25% (16)

Valuation Allowance 10

Deferred Tax Asset 25 9

10 0

Journal entries at the end of 2024 Income tax expense (to balance) Deferred tax asset (determined above) Income tax payable (determined above) Valuation allowance Income tax expense (to balance)

54 9 45 10 10

Since it is more likely than not that the deferred tax asset will be realized, there is no need for a valuation allowance and the account is removed. Of course, these two entries can be combined, as follows Income tax expense (to balance) Valuation allowance Deferred tax asset (determined above) Income tax payable (determined above)

44 10 9 45

16–657

Exercise 16–13 (concluded) Requirement 2 Step 1: Tax payable: $45 Step 2: DTA end. bal: $16 Val allow end bal: $12 Step 3: DTA change: $(9) Val allow change: $2 Step 4: Tax exp plug: $56

Valuation Allowance 10

Deferred Tax Asset 25 9

2 12

Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset (determined above) Income tax payable (determined above)

($ in millions)

Income tax expense (to balance) Valuation allowance ([3/4 × $16] – $10)

54 9 45

One-fourth of the deferred tax asset will be realized, which means three-fourths of the deferred tax asset will not be realized, so three-fourths of the $16 deferred tax asset balance will be recognized in a valuation allowance. Since there is already a balance in the valuation at the beginning of the year, the adjusting entry includes the amount necessary to achieve the required balance of three-fourths of $16. Of course, these two entries can be combined, as follows: Income tax expense (to balance) Deferred tax asset (determined above) Income tax payable (determined above) Valuation allowance ([3/4 × $16] – $10)

16–658

56 9 45 2

Exercise 16–14 Requirement 1 The specific citation that specifies how a firm should determine whether a valuation allowance for deferred tax assets is needed is FASB ASC 740–10–30–17: ―Income Taxes–Overall–Initial Measurement–Establishment of a Valuation Allowance for Deferred Tax Assets.‖ Requirement 2 Specifically, the guidelines are: 740–10–30-17: All available evidence, both positive and negative, is considered to determine whether, based on the weight of that evidence, a valuation allowance for deferred tax assets is needed. Information about an entity's current financial position and its results of operations for the current and preceding years ordinarily is readily available. That historical information is supplemented by all currently available information about future years. Sometimes, however, historical information may not be available (for example, start-up operations) or it may not be as relevant (for example, if there has been a significant, recent change in circumstances) and special attention is required.

16–14

Exercise 16–15 Requirement 1 ($ in thousands) Current Year 2024

Pretax accounting income Permanent difference: Governmental bond interest Temporary difference: Depreciation

300

Taxable income (income tax return)

250

Enacted tax rate Tax payable currently Deferred tax liability

25% 62.5

Future Taxable Amounts

(40) (10)

25% 2.5 Deferred Tax Liability 0 2.5 2.5

Step 1: Tax payable: $62.5 Step 2: DTL end. bal: $2.5 Step 3: DTL change: $2.5 Step 4: Tax exp plug: $65

Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

65 2.5 62.5

Requirement 2 ($ in thousands) Pretax accounting income Income tax expense Net income $235

$300 (65)

16–15

Exercise 16– 661 ($ in thousands)

Requirement 1

Current Year 2024

Pretax accounting income Permanent difference: Governmental bond interest Temporary differences: Depreciation Warranty expense

978

Taxable income (income tax return)

904

Enacted tax rate Tax payable currently Deferred tax liability Deferred tax asset

25% 226

Step 1: Tax payable: $226 Step 2: DTA end. bal: $4 DTL end. bal: $22 Step 3: DTA change: $4 DTL change: $14.5 Step 4: Tax exp plug: $236.5

Future Taxable Amounts

Future Deductible Amounts

(32) (58) 16

88 (16)

25%

22 (4) Deferred Tax Liability 7.5

Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset (determined above) Deferred tax liability (determined above) Income tax payable (determined above)

Deferred Tax Asset 0 4

14.5 22

236.5 4.0 14.5 226.0

16–661

Exercise 16–16 (concluded) Requirement 2 ($ in thousands) Pretax accounting income Income tax expense Net income $741.5

16–662

$978.0 (236.5)

Exercise 16–17 Requirement 1 ($ in millions) Current Year 2024

Pretax accounting income Temporary difference: Warranty expense

Taxable income (tax return) Enacted tax rate Tax payable currently Deferred tax asset

20 25% 5

2025

(2)

Future Deductible Amounts 2026 2027

2028

(1)

(2)

(1)

Total

20% 20% 20% 15% (0.4)+(0.2)+(0.2)+(0.3) = (1.1)

Deferred Tax Asset 0 1.1

Step 1: Tax payable: $5 Step 2: DTA end bal: $1.1 Step 3: DTA change: $1.1 Step 4: Tax exp plug: $3.9

Journal entry at the end of 2024

1.1

Income tax expense (to balance) Deferred tax asset (determined above) Income tax payable (determined above)

3.9 1.1 5.0

Requirement 2 ($ in millions) Pretax accounting income Income tax expense Net income $10.1

$14.0 (3.9)

16–663

Exercise 16–18 Requirement 1 ($ in millions) Current Future Year Taxable 2024 Amounts 2025 2026 2027 2028

Pretax accounting income Temporary difference: Advance rent payment Taxable income (income tax return) Enacted tax rate Tax payable currently Deferred tax liability

32 (8) 24 25% 6

Step 1: Tax payable: $6 Step 2: DTL end. bal: $2 Step 3: DTL change: $2 Step 4: Tax exp plug: $8 Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

16–664

Future Taxable Amounts [total]

25% 2 Deferred Tax Liability 0 2 2 8 2 6

Exercise 16–18 (continued) Requirement 2 ($ in millions) Current Year 2025

Pretax accounting income Temporary difference: Advance rent payment Taxable income (income tax return) Enacted tax rate Tax payable currently Deferred tax liability

Future Future Taxable Taxable Amounts Amounts [total] 2026 2027 2028

50 2

52 25% 13

Step 1: Tax payable: $13 Step 2: DTL end. bal: $1.5 Step 3: DTL change: $0.5 Step 4: Tax exp plug: $12.5 Journal entry at the end of 2025 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

25% 1.5 Deferred Tax Liability 2 0.5 1.5

12.5 0.5 13.0

16–665

Exercise 16–18 (continued) Requirement 3 ($ in millions) Current Year 2025

Pretax accounting income Temporary difference: Advance rent payment

Taxable income (income tax return) Enacted tax rate Tax payable currently Deferred tax liability

52 25% 13

Step 1: Tax payable: $13 Step 2: DTL end. bal: $0.9 Step 3: DTL change: $1.1 Step 4: Tax exp plug: $11.9 Journal entry at the end of 2025 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

16–666

Future Taxable Amounts 2026 2027 2028

Future Taxable Amounts [total]

15% 0.9 Deferred Tax Liability 2 1.1 0.9 11.9 1.1 13.0

Exercise 16–18 (concluded) Requirement 4 Without the change, income tax expense in 2025 [requirement 2] is $12.5 million. However, when the tax rate changes to 15%, the deferred tax liability must be reduced to reflect the fact that future taxable amounts will be taxed at a lower rate than the rate assumed when the liability was recorded in 2024. The adjustment is the future taxable amount, $6 million, multiplied by the rate change, 25% – 15%, or $0.6 million. The adjustment is to be reflected in operating income in the year of the change. Application of the asset/liability approach automatically accomplishes that goal. The income tax expense with the change in 2025 [requirement 3] is $11.9 million ($12.5 – $0.6 million).

16–667

Exercise 16–19 A deferred tax liability is established using the currently enacted tax rate for the year(s) a temporary difference is expected to reverse. In this case that rate was 25%. The change in the tax law in 2025 constitutes a change in estimate. The deferred tax liability is simply revised to reflect the new rate. ($ in millions)

Income tax expense (to balance)............................................... Deferred tax liability ($20 million × [25% – 15%])...................... Income tax payable ($30 million × 25%)................................

5.5 2.0 7.5

Because the tax rate change reduces tax expense by $2 million, it will increase net income by $2 million.

16–668

16–669

Exercise 16–20 A deferred tax asset is established using the currently enacted tax rate for the year(s) a temporary difference is expected to reverse. In this case that rate was 25%. The change in the tax law in 2025 constitutes a change in estimate. The deferred tax asset is simply revised to reflect the new rate. ($ in millions)

Income tax expense (to balance)............................................... Deferred tax asset ($20 million × [25% – 15%]) ...................... Income tax payable ($30 million × 25%)................................

9.5 2.0 7.5

Because the tax rate change increases tax expense by $2 million, it will decrease net income by $2 million.

16–670

Exercise 16–21

16–671

Income tax expense (to balance)............................................... 20,000 Deferred tax asset ($12,000 × 25%)........................................... 3,000 Deferred tax liability (($60,000 + $17,000) × 25%).................. 19,250 Income tax payable ($15,000 × 25%) .................................... 3,750

16–672

16–673

16–674

Exercise 16–22 Requirement 1 ($ in millions)

Income tax expense (to balance)............................................... Deferred tax asset ($25 million × 25%) ..................................... Deferred tax liability (($30 million + $50 million) × 25%) ........ Income tax payable ($145 million × 25%) ..............................

50.0 6.25 20.00 36.25

Requirement 2 ($ in millions) Pretax accounting income Income tax expense Net income $150

$200 (50)

16–675

Exercise 16–23 Requirement 1 ($ in thousands) Current Year 2024

Net operating loss Loss carryforward Enacted tax rate Tax payable Deferred tax asset

Future Deductible Amounts

(360) 360 0 25% 0

(360) 25% (90) Deferred Tax Asset 0 90 90

Step 1: Tax payable: $0 Step 2: DTA end. bal: $90 Step 3: DTA change: $90 Step 4: Tax exp (benefit) plug: $(90)

Journal entry at the end of 2024 Deferred tax asset (determined above) Income tax expense (to balance)

90 90

Since the weight of available evidence suggests that future taxable income will be sufficient to benefit from future deductible amounts from the net operating loss carryforward, no valuation allowance is needed.

16–676

Exercise 16–23 (concluded) Requirement 2 ($ in thousands) Operating loss before income taxes Income tax benefit Net loss

$(360) 90 $(270)

16–677

Exercise 16– 678 Requirement 1 ($ in thousands) Current Year 2025

Pretax accounting and taxable income NOL carryforward (using 80% of $200) Enacted tax rate Tax payable Deferred tax asset

Future Deductible Amounts

200 (160) 40 25% 10

(200) 25% (50) Deferred Tax Asset

Step 1: Tax payable: $10 Step 2: DTA end. bal: $50 Step 3: DTA change: $(40) Step 4: Tax exp (benefit) plug: $50

Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset (determined above) Income tax payable ($40 million × 25%)...................................

90 40 50

50 40 10

Requirement 2 ($ in thousands) Operating income before income taxes Income tax expense Net income

16–678

$200 50 $150

Exercise 16–25 Requirement 1 NOL carrybacks are not allowed for most companies, except for property and casualty insurance companies as well as some farm-related businesses. Wynn is one of those businesses. ($ in thousands) Prior Years

Current Year

2022

2024

2023

Net operating loss Loss carryback

(80) (20)

Enacted tax rate Tax payable (receivable)

25% 30% (20) (6)

Journal entry at the end of 2024 Receivable—Income tax refund ($20 + $6) Income tax expense (to balance)

(100) 100 0 25% 0

26 26

Requirement 2 ($ in thousands)

Operating loss before income taxes Income tax benefit Net loss

$(100) 26 $( 74)

16–679

Exercise 16– 680 Requirement 1 are not allowed for most companies, except for property and NOL carrybacks casualty insurance companies as well as some farm-related businesses. Wynn is one of those businesses. ($ in thousands) Prior Years 2022 2023

Net operating loss Loss carryback Loss carryforward Enacted tax rate Tax payable (receivable) Deferred tax asset

(80)

25% (20)

Step 1: Tax payable(receivable): $(38) Step 2: DTA end. bal: $5 Step 3: DTA change: $5 Step 4: Tax exp(benefit) plug: $(43) Receivable—Income tax refund ($20 + $18) Deferred tax asset (determined above) Income tax expense (to balance)

16–680

(60)

30% (18)

Current Year 2024

Future Deductible Amounts [total]

(160) 140 20 0 25% 0

(20) 25% (5)

Deferred Tax Asset 0 5 5 38 5 43

Journal entr

Exercise 16–26 (concluded) Requirement 2 ($ in thousands)

Operating loss before income taxes Income tax benefit: Tax refund from NOL carryback Tax savings from NOL carryforward Net loss

$(160) $38 5

43 $(117)

16–681

Exercise 16–27 L 1.

Advance payments on insurance; tax deductible when paid.

A 2.

Estimated warranty costs; tax deductible when paid.

A 3.

Rent revenue collected in advance; cash basis for tax purposes.

N 4.

Interest received from investments in municipal governmental bonds.

L 5.

Prepaid expenses; tax deductible when paid.

A 6.

Net operating loss carryforward.

N 7.

Net operating loss carryback.

L 8.

Straight-line depreciation for financial reporting; MACRS for tax purposes.

A 9.

Organization costs expensed when incurred; tax deductible over 15 years.

N 10.

Life insurance proceeds received upon the death of the company president.

16–682

Exercise 16–28 ($ in millions)

Related Balance Sheet Account

Liability—Warranty expense Depreciable assets Receivable—Installment sales Deferred rent revenue

Future Taxable (Deductible) Amounts

(16) 120 20 (24)

Tax Rate x 25% x 25% x 25% x 25%

Deferred Tax (Asset) Liability

(4) 30 5 (6)

16–683

Net deferred tax liability

16–684

16–685

Exercise 16–29 Requirement 1 ($ in thousands) Current Year 2024

Pretax accounting income Permanent difference: Governmental bond interest Temporary difference: Installment sales Taxable income (tax return) Enacted tax rate Tax payable currently Deferred tax liability

Future Taxable Amounts 2025 2026 2027

810 (10) (600)

140

260

200

200 20% 40

20%

25%

Step 1: Tax payable: $40 Step 2: DTL end. bal: $143 Step 3: DTL change: $143 Step 4: Tax exp plug: $183 Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

+ 65 + 50 =

143

Deferred Tax Liability 0 143 143 183 143 40

Requirement 2 ($ in thousands)

16–686

Pretax accounting income Income tax expense Net income

$ 810 (183) $ 627

16–687

Exercise 16–30 Requirement 1 ($ in thousands) Current Year 2024

Pretax accounting income Permanent difference: Governmental bond interest Temporary differences: Installment sales

(10) (600)

Deferred tax asset Taxable income (tax return) Enacted tax rate Tax payable currently

Journ al entry at the end of 2024

140 260 20% 25% 28 65

25% 50

(20) 20% (4)

(16) 25% (4)

(24) 25% (6)

143

(14)

260 20% 52

Step 1: Tax payable: $52

Step 2: DTA end. bal: $14 DTL end. bal: $143 Step 3: DTA change: $14 DTL change: $143 Step 4: Tax exp plug: $181 Income tax expense (to balance) 181 Deferred tax asset (determined above) 14 Deferred tax liability (determined above) Income tax payable (determined above)

16–688

Deferred Tax Liab. Asset

810

Deferred tax liability Warranty expense

Future Taxable (Deductible) Amounts 2025 2026 2027

Deferred Tax Liability

Deferred Tax Asset

0 14

143 143

143 52

Exercise 16–30 (concluded) Requirement 2 ($ in thousands) Pretax accounting income Income tax expense Net income $629

$810 (181)

16–689

Exercise 16–31 Requirement 1

16–690

If all of Lange‘s deferred tax assets and liabilities are in the same tax jurisdiction, they would be offset and shown as a single noncurrent deferred tax asset or liability. In Lange‘s case, it would show a net noncurrent deferred tax asset of $50,000 ($500,000 deferred tax assets – $450,000 deferred tax liabilities). Requirement 2

16–691

If the deferred tax effects of Lange‘s pension plans and unrealized gains on investments occurred in a different tax jurisdiction from Lange‘s other deferred tax effects, the deferred tax effects associated with each jurisdiction would be offset separately. Lange would show a net noncurrent deferred tax asset of $100,000 ($200,000 inventory – $100,000 PP&E) and a net noncurrent deferred tax liability of $50,000 ($350,000 unrealized gains – $300,000 pension plans).

16–692

Exercise 16–32 List A No deferred tax consequences a. Originates, then reverses b. Revise deferred tax amounts c. Operating loss d. Future tax effect of prepaid expenses tax deductible when paid e. Loss carryback f.

g e h l a

1. 2. 3. 4. 5.

b j

7. Future tax effect of estimated warranty expense 8. Valuation allowance

g. h.

9. Phased-in change in rates

i 10. Balance sheet presentation k 11. Individual tax consequences of financial statement components d 12. Income tax expense

j. k. l.

List B Deferred tax liability Deferred tax asset 2 years Current and deferred tax consequence combined Temporary difference Specific tax rates times amounts reversing each year Permanent differences When enacted tax rate changes Net deferred tax asset or liability ―More likely than not‖ test Intraperiod tax allocation Negative taxable income

16–693

16–694

Exercise 16–33 Requirement 1 Probability table: Amount of the tax benefit that management expects to sustain Percentage likelihood that the tax position will be sustained at this level Cumulative probability that the tax position will be sustained

$10

10% 20% 25% 20% 25% 10% 30% 55% 75% 100%

$6 million is the amount of tax benefit that would be recognized in the financial statements; it represents the largest amount of benefit that is more than 50 percent likely to be the end result. Requirement 2 Delta would record tax expense as if there is a $6 million tax credit, income tax payable that reflects the entire $10 million credit, and a liability that represents the potential obligation to pay the additional taxes if the deduction is not ultimately upheld: ($ in millions)

Income tax expense ([$84 × 25%] – $6* tax credit) Income tax payable ([$84 × 25%] – $10 tax credit) Liability—uncertain tax positions ($10 – $6*)

15 11 4

*Largest amount of tax credit that has a higher than 50% likelihood of being sustained upon examination.

The Liability–uncertain tax positions represents the eventual additional tax payment for the $4 million not included in the current income tax payable. The timing of the potential payment depends on the resolution of the uncertainty in the tax position. It likely will be reported as a long-term liability because that resolution probably will not be made within the coming year.

16–695

Exercise 16–34 Income Statement For the fiscal year ended March 31, 2024 ($ in millions)

Sales revenue Cost of goods sold Gross profit Operating expenses Income from continuing operations before income taxes Income tax expense Income before discontinued operations Loss from discontinued operations (net of $21 income tax benefit) Net income

$830 (350) 480 (180) 300 (75) 225 (63) $162

Exercise 16–35 The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1. The specific items to which income tax expense is allocated for intraperiod tax allocation: FASB ASC 740–20–45–2: ―Income Taxes–Intraperiod Tax Allocation–Other Presentation Matters–General.‖ 2.

The tax rate used to calculate deferred tax assets and liabilities: FASB ASC 740–10–30–8: ―Income Taxes–Overall–General–Applicable Tax Rate Used to Measure Deferred Taxes.‖

3. Required disclosures in the notes to financial statements for the components of income tax expense: FASB ASC 740–10–50–9: ―Income Taxes–Overall–Disclosure–Income Statement Related Disclosures.‖

16–696

Exercise 16–36 Requirement 1 ($ in thousands) Current Year 2020

Prior Years 2016 2017

Net operating loss Loss carryback

(100) (80)

Enacted tax rate Tax payable (receivable)

35% 35% (35) (28)

Journal entry at the end of 2024 Receivable—Income tax refund ($35 + $28) Income tax expense (to balance)

(180) 180 0 21% 0

63 63

Requirement 2 ($ in thousands)

Operating loss before income taxes Income tax benefit Net loss

$(180) 63 $(117)

16–697

Exercise 16–37 Requirement 1 ($ in thousands) Prior Years 2016 2017

Net operating loss Loss carryback Loss carryforward

(100)

Enacted tax rate Tax payable (receivable) Deferred tax asset

35% (35)

Step 1: Tax payable(receivable): $(42) Step 2: DTA end. bal: $12.6 Step 3: DTA change: $12.6 Step 4: Tax exp(benefit) plug: $(54.6) Journal entry at the end of 2024 Receivable—Income tax refund ($35 + $7) Deferred tax asset (determined above) Income tax expense (to balance)

(20)

35% (7)

Current Year 2020

Future Deductible Amounts [total]

(180) 120 60 0 21% 0

(60) 21% (12.6)

Deferred Tax Asset 0 12.6 12.6

42.0 12.6 54.6

Requirement 2 ($ in thousands)

Operating loss before income taxes Income tax benefit Net loss

16–698

$(180.0) 54.6 $(125.4)

PROBLEMS

16–699

16–700

Problem 16–1 RELATED ASSET—CUMULATIVE BALANCE (NOT REQUIRED) ($ in thousands)

Collections of 2023 2024 2025 2026

Service Revenue

Previous Current Year Year

$750 710 716

$40 12 20

$738 690 700

Service Revenue Receivable Balance $40 12 20 16

16–701

Problem 16–1 (continued) Requirement 1 ($ in thousands) Current Year 2024

Pretax accounting income Temporary difference: 2023 services 2024 services

Future Taxable Amount

260 (40)

40 (12)

Taxable income (income tax return)

288

Enacted tax rate Tax payable currently Deferred tax liability

25% 72

25% 3

Deferred Tax Liability 10* 7 3

Step 1: Tax payable: $72 Step 2: DTL end. bal: $3 Step 3: DTL change: $(7) Step 4: Tax exp plug: $65

*$40 × 25% Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

16–702

65 7 72

Problem 16–1 (continued) Requirement 2

($ in thousands) Current Year 2025

Pretax accounting income Temporary difference: 2024 services 2025 services

Future Taxable Amount

228 (12)

12 (20)

Taxable income (income tax return)

220

Enacted tax rate Tax payable currently Deferred tax liability

25% 55

Step 1: Tax payable: $55 Step 2: DTL end. bal: $5 Step 3: DTL change: $2 Step 4: Tax exp plug: $57 Journal entry at the end of 2025 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

25% 5 Deferred Tax Liability 3 2 5 57 2 55

16–703

Problem 16–1 (concluded) Requirement 3 ($ in thousands) Current Year 2026

Pretax accounting income Temporary difference: 2025 services 2026 services Taxable income (income tax return)

Future Taxable Amount

200 (20)

Enacted tax rate Tax payable currently Deferred tax liability Step 1: Tax payable: $51 Step 2: DTL end. bal: $4 Step 3: DTL change: $(1) Step 4: Tax exp plug: $50

20 (16) 204

25% 51

25% 4 Deferred Tax Liability 5 1 4

Journal entry at the end of 2026 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

50 1

16–704

Intermediate Accounting, 11/e

Problem 16–1 (concluded) Note: Alternatively, we can take a balance sheet perspective and focus on book-tax differences for the Service Revenue Receivable (A/R) account, as follows: ($ in millions)

A/R Book basis A/R Tax basis Difference Tax rate Deferred tax liability (change)

2023 $40 0 $40 5% $10

2024 $12 0 $12 25% $(7)

2025 $20 0 $20 25% $2

2026 $16 0 $16 25% $(1)

This table indicates that the deferred tax liability required a debit of $7 in 2024 to reduce it from $10 to $3, a credit of $2 in 2025 to increase it from $3 to $5, and a debit of $1 in 2026 to reduce it from $5 to $4.

Deferred Tax Liability 12/31/2023 balance 10 2024 adjustment 7 3 12/31/2024 balance 2 2025 adjustment 12/31/2025 balance 5 2026 adjustment 1 4 12/31/2026 balance

16–705

Problem 16–2 Requirement 1 A liability for deferred subscription revenue is created when subscriptions are received (debit: cash; credit: deferred subscription revenue). For tax purposes, no such liability is recorded. Instead, subscriptions are included in income when received. This causes a temporary difference between the financial statement carrying amount of the subscription liability and its tax basis.

Requirement 2

2024

Deferred subscription revenue: Beginning balance $0 Pretax accounting income (250) Taxable income 290 Accounting book value $ 40 Tax basis 0 Cumulative temporary difference $ 40

($ in 000‘s) December 31 2025

2026

$ 40 (240) 220 $ 20 0

$ 20 (230) 260 $ 50 0

$ 20

$ 50

Requirement 3 TEMPORARY DIFFERENCE

$ 40

$ 20

$ 50

Tax rate DEFERRED TAX ASSET

x 25%

$ 10

$ 5

$ 12.5

16–706

Problem 16–3 Requirement 1 ($ in millions) Current Year 2024

Pretax accounting income Temporary difference: Lot sales Taxable income (tax return) Enacted tax rate Tax payable currently Deferred tax liability

Future Taxable Amounts 2025 2026 2027

Future Taxable Amounts [total]

16 (12)

4 25% 1

Step 1: Tax payable: $1 Step 2: DTL end. bal: $3 Step 3: DTL change: $3 Step 4: Tax exp plug: $4 Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

25% 3 Deferred Tax Liability 0 3 3 4 3 1

16–707

Problem 16–3 (continued) Requirement 2 ($ in millions) Current Year 2025

Pretax accounting income Temporary difference: Lot sales

Taxable income (tax return) Enacted tax rate Tax payable currently Deferred tax liability

24 25% 6.0

Future Taxable Amounts 2026 2027

Future Taxable Amounts [total]

20% 1.6 Deferred Tax Liability

Step 1: Tax payable: $6.0 Step 2: DTL end. bal: $1.6 Step 3: DTL change: $(1.4) Step 4: Tax exp plug: $4.6

Journal entry at the end of 2025 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

16–708

3 1.4 1.6

4.6 1.4 6.0

Problem 16–3 (concluded) Requirement 3 The balance in the deferred tax liability account at the end of 2025 would have been $2 million if the new tax rate had not been enacted: Future taxable amounts Previous tax rate Deferred tax liability

$8 million 25% $2 million

The effect of the change is included in income tax expense, because income tax expense is less than it would have been if the rate had not changed.

16–709

Problem 16–4 Pretax accounting income Depreciation for tax Taxable Income Tax rate Tax payable

Straight-line Tax depreciation Temporary differences: 2024 2025 2026 2027

Cumulative difference Tax rate Year-end DTL balance

16–710

2024

2025

2026

2027

$60,000 (39,600) $20,400 30% $ 6,120

$80,000 (52,800) $27,200 30% $ 8,160

$70,000 (18,000) $52,000 40% $20,800

$70,000 ( 9,600) $60,400 40% $24,160

Cumulative Temporary Difference

2024 30,000 (39,600)

2025 30,000 (52,800)

2026 30,000 (18,000)

2027 30,000 (9,600)

(9,600)

(22,800) (22,800)

12,000 12,000 12,000

20,400 20,400 20,400 20,400

0 9,600 32,400 20,400 0

2024 $ 9,600 30% $ 2,880

2025 $32,400 40% $12,960

2026 $20,400 40% $ 8,160

2027 $ 0 40% $ 0

Problem 16–4 (continued) 2024 Step 1: Tax payable: $6,120 Step 2: DTL end. bal: $2,880 Step 3: DTL change: $2,880 Step 4: Tax exp plug: $9,000 Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

Deferred Tax Liability 0 2,880 2,880

9,000 2,880 6,120

2025 Step 1: Tax payable: $ 8,160 Step 2: DTL end. bal: $12,960 Step 3: DTL change: $10,080 Step 4: Tax exp plug: $18,240 Journal entry at the end of 2025 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

Deferred Tax Liability 2,880 10,080 12,960

18,240 10,080 8,160

16–711

Problem 16–4 (concluded) 2026 Step 1: Tax payable: $20,800 Step 2: DTL end. bal: $ 8,160 Step 3: DTL change: $ (4,800) Step 4: Tax exp plug: $16,000 Journal entry at the end of 2026 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

2027 Step 1: Tax payable: $24,160 Step 2: DTL end. bal: $0 Step 3: DTL change: $(8,160) Step 4: Tax exp plug: $16,000 Journal entry at the end of 2027 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

16–712

Deferred Tax Liability 12,960 4,800 8,160

16,000 4,800 20,800

Deferred Tax Liability 8,160 8,160 0

16,000 8,160 24,160

Problem 16–5 Pretax accounting income Installment sale

2024

2025

2026

2027

$350,000 (50,000)

$270,000 20,000

$340,000 25,000

$380,000 5,000

Governmental bond interest Taxable income Tax rate Income tax payable

Temporary difference: 2024 2025 2026 2027

Cumulative difference Tax rate Year-end balance

(15,000) $300,000 $290,000 $350,000 $385,000 40% 40% 25% 25% $120,000 $116,000 $ 87,500 $ 96,250

Cumulative Temporary Difference

2024

2025

2026

2027

(50,000)

20,000 20,000

25,000 25,000 25,000

5,000 = 5,000 = 5,000 = 5,000 =

2024 $50,000 40% $20,000

2025 $30,000 25% $ 7,500

2026 2027 $ 5,000 $ 0 25% 25% $ 1,250 $ 0

0 50,000 30,000 5,000 0

16–713

Problem 16–5 (continued)

2024 Step 1: Tax payable: $120,000 Step 2: DTL end. bal: $ 20,000 Step 3: DTL change: $ 20,000 Step 4: Tax exp plug: $140,000 Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

2025 Step 1: Tax payable: $116,000 Step 2: DTL end. bal: $ 7,500 Step 3: DTL change: $(12,500) Step 4: Tax exp plug: $103,500 Journal entry at the end of 2025 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

16–714

Deferred Tax Liability 0 20,000 20,000

140,000 20,000 120,000

Deferred Tax Liability 20,000 12,500 7,500

103,500 12,500 116,000

Problem 16–5 (concluded)

2026 Step 1: Tax payable: $87,500 Step 2: DTL end. bal: $ 1,250 Step 3: DTL change: $(6,250) Step 4: Tax exp plug: $81,250

Deferred Tax Liability 7,500 6,250 1,250

Journal entry at the end of 2026 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

81,250 6,250

2027 Step 1: Tax payable: $96,250 Step 2: DTL end. bal: $0 Step 3: DTL change: $(1,250) Step 4: Tax exp plug: $95,000

Deferred Tax Liability 1,250 1,250 0

Journal entry at the end of 2027 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

95,000 1,250

87,500

96,250

16–715

Problem 16–6 Requirement 1 ($ in millions)

Income tax expense (to balance) Deferred tax asset ($5 million × 25%) Deferred tax liability ([$30 million + $12 million] × 25%) Income tax payable ($8 million × 25%)

11.25 1.25 10.5 2

Requirement 2 ($ in millions)

Pretax accounting income Temporary differences: Depreciation Prepaid insurance Loss contingency Taxable income (income tax return) Enacted tax rate Tax payable currently Deferred tax liability Deferred tax asset

Step 1: Tax payable: $2 Step 2: DTA end. bal: $1 DTL end. bal: $9 Step 3: DTA change: $1 DTL change: $9 Step 4: Tax exp plug: $10

16–716

Current Year 2024

Future Taxable (Deductible) Amounts 2025 2026 2027

Deferred Tax Liab. Asset

45 (30) (12) 5

30* 12

8 25% 2

25%

20%

6 (1)

(5)

Deferred Tax Liability 0

9 (1) Deferred Tax Asset 0 1

9 9

Problem 16–6 (concluded) Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset (determined above) Deferred tax liability (determined above) Income tax payable (determined above)

10 1 9 2

*The $60 million excess tax depreciation will not occur until 2025. Since this schedule is for 2024, the only depreciation difference to schedule is the $30 million. The information given in the problem from the PricewaterhouseCoopers‘ Comperio database states that the FIFO pattern is intended. Thus, it is assumed that the $30 million difference will reverse the first year the difference begins reversing. If future originations were considered in the reversal pattern, the deferred tax liability related to depreciation would be $3 million, rather than $9 million:

Depreciation

2025 2026 2027 (30) (60) 50 40 25% 20% 20% (15) + 10 + 8 =

16–717

Problem 16–7 Requirement 1 Current Year 2024 ($ in millions)

Pretax accounting income Permanent difference: Federal fine not deductible Temporary differences: Installment sales Depreciation Warranties Paid future absences Loss contingency

(3) (15) 1 7 (2)

Taxable income (tax return)

Enacted tax rate Tax payable currently Deferred tax liability Deferred tax asset

Future Taxable (Deductible) Amounts 2025 2026

Future Deductible Amounts [total]

76 2 3.5 8 (3) (4)

25% 16.5

Step 1: Tax payable: $16.5 Step 2: DTA end. bal: $2.5 DTL end. bal: $7.0 Step 3: DTA change: $1.5 DTL change: $4.5 Step 4: Tax exp plug: $19.5 Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset (determined above) Deferred tax liability (determined above) Income tax payable (determined above)

16–718

Future Taxable Amounts [total]

3.5 13

7 21 (3) (7)

(3)

28 25%

(10) 25%

7.0 (2.5) Deferred Tax Liability 2.5

Deferred Tax Asset 1.0 1.5

4.5 7.0

2.5

19.5 1.5 4.5 16.5

Problem 16–7 (concluded) Requirement 2 ($ in millions)

Income before income tax Income tax expense Net income

$76.0 (19.5) $56.5

Requirement 3 Net noncurrent deferred tax liability ($7.0 – $2.5)

$4.5

16–719

16–720

Problem 16–8 Requirement 1 a. Casualty insurance expense: Temporary difference (originating in 2024, reversing in 2025) b. Life insurance premiums: Permanent difference (recognized as an income statement expense, but is not tax-deductible in any year) c. Subscriptions: Temporary difference (originating in each year and reversing in the following year) d. Unrealized loss on trading securities: Temporary difference (originating in 2024, reversing in 2025) e. Loss contingency: Temporary difference (originating in 2023, reversing in 2024)

16–721

Problem 16–8 (continued) Requirement 2 ($ in millions)

Current Year 2024

Pretax accounting income Permanent difference: Life insurance premiums Temporary differences: Casualty insurance expense Subscriptions—2023 (reversing)* Subscriptions—2024 ($33 – [$25 – $10])* Unrealized loss Loss contingency (reversing)

128

Taxable income (income tax return)

116

Enacted tax rate Tax payable currently Deferred tax liability Deferred tax asset

Step 1: Tax payable: $29 Step 2: DTA end. bal: $8 DTL end. bal: $7.5 Step 3: DTA change: $4 DTL change: $7.5 Step 4: Tax exp plug: $32.5

Future Taxable Amounts [2025]

Future Deductible Amounts [2025]

2 (30) (10) 18 14 (6)

25% 29

30 (18) (14)

30 25%

(32) 25%

7.5 (8) Deferred Tax Liability 0

Deferred Tax Asset 4 4

7.5 7.5

* Temporary difference for subscriptions: 2023 2024 2025

Recognized in current yr. (reported on income statement) Collected in prior yr., recognized in current yr. (reversing difference) Collected in current yr., recognized in following yr. (originating difference) Collected in current yr. (reported on tax return)

16–722

$25 $33 (10) (18) $10 18 20 $33 $35

Problem 16–8 (continued) Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax asset (determined above) Deferred tax liability (determined above) Income tax payable (determined above)

32.5 4.0 7.5 29.0

Requirement 3 Net noncurrent deferred tax asset ($8.0 asset – $7.5 liability]

$0.5 million

16–723

Problem 16–8 (continued) Requirement 4 ($ in millions) Current Year 2025

Pretax accounting income Permanent difference: Life insurance premiums Temporary differences: Casualty insurance (reversing) Subscriptions—2024 (reversing)* Subscriptions—2025 ($35 – [$33 – $18])* Unrealized loss (reversing)

180

Taxable income (income tax return)

200

Enacted tax rate Tax payable currently Deferred tax liability Deferred tax asset

Step 1: Tax payable: $50 Step 2: DTA end. bal: $5 DTL end. bal: $0 Step 3: DTA change: $(3) DTL change: $(7.5) Step 4: Tax exp plug: $45.5

Future Taxable Amounts [2026]

Future Deductible Amounts [2026]

2 30 (18) 20 (14)

(20)

25% 50

0 25%

(20) 25%

0 (5) Deferred Tax Liability 7.5

Deferred Tax Asset 8 3

7.5 0

* Temporary difference for subscriptions: Earned in current yr. (reported on income statement) Collected in prior yr., earned in current yr. (reversing difference) Collected in current yr., earned in following yr. (originating difference) Collected in current yr. (reported on tax return)

2023

16–4

Intermediate Accounting, 11/e

$10

2024 2025 $25 $33 (10) (18) 18 20 $33 $35

Problem 16–8 (continued) Journal entry at the end of 2025 Income tax expense (to balance) Deferred tax liability (determined above) Deferred tax asset (determined above) Income tax payable (determined above)

45.5 7.5 3 50

Requirement 5 Noncurrent deferred tax asset

$5 million

16–725

Problem 16–8 (continued) Requirement 726

($ in millions) Current Year 2025

180

Taxable income (income tax return)

200

Enacted tax rate Tax payable currently Deferred tax liability Deferred tax asset

Step 1: Tax payable: $50 Step 2: DTA end. bal: $3 DTL end. bal: $0 Step 3: DTA change: $(5) DTL change: $(7.5) Step 4: Tax exp plug: $47.5

Future Taxable Amounts [2026]

2 30 (18) 20 (14)

25% 50

(20)

0 15%

(20) 15%

0 (3)

Deferred Tax Liability 7.5

Deferred Tax Asset 8 5

7.5 0

* Temporary difference for subscriptions:

Earned in current yr. (reported on income statement) Collected in prior yr., earned in current yr. (reversing difference) Collected in current yr., earned in following yr. (originating difference) Collected in current yr. (reported on tax return)

16–726

Future Deductible Amounts [2026]

3 2023 2024

2025

$25 (10) 18 $33

$33 (18) 20 $35

$10

Problem 16–8 (concluded) Journal entry at the end of 2025 Income tax expense (to balance) Deferred tax liability (determined above) Deferred tax asset (determined above) Income tax payable (determined above)

47.5 7.5 5 50

16–727

Problem 16–9 Requirement 1 ($ in millions)

Temporary Differences Net accounts receivable Prepaid insurance Prepaid advertising Investment in equity securities Buildings and equipment (net) Deferred subscription revenue Liability—compensated future absences Totals Tax rate Deferred tax liability Deferred tax asset

Future Taxable Amounts

Future Deductible Amounts (2)

20 6 4 80

110 25% 27.5

(14) (594) (610) 25% (152.5)

Requirement 2 Step 1: Tax payable: $30 Step 2: DTA end. bal: $152.5 DTL end. bal: $27.5 Step 3: DTA change: $(3.75) DTL change: $2.5 Step 4: Tax exp plug: $36.25

Deferred Tax Liability

25.0

Deferred Tax Asset

156.25 3.75

2.5 27.5

152.50

Requirement 3 Taxable income times tax rate equals income tax payable $120 million × 25% = $30 million

16–728

Problem 16–9 (concluded) Requirement 4 Income tax expense (to balance) Deferred tax asset (determined above) Deferred tax liability (determined above) Income tax payable (determined above)

36.25 3.75 2.50 30.00

16–729

Problem 16–10 Requirement 1 Current Year 2024

Future Deductible Amounts [total]

($ in millions)

Accounting loss Permanent difference: Federal fine not deductible Temporary differences: Loss contingency Taxable loss Loss carryforward Enacted tax rate Tax payable (refundable) Deferred tax asset

(137) 5 12 (120) 120 0 25% 0

(12) (120) (132) 25% (33) Deferred Tax Asset 0 33 33

Step 1: Tax payable: $0 Step 2: DTA end. bal: $33 Step 3: DTA change: $33 Step 4: Tax exp (benefit) plug: $(33)

Journal entry at the end of 2024 Deferred tax asset (determined above) Income tax expense (to balance)

16–730

33 33

Problem 16–10 (concluded) Requirement 2 ($ in millions)

Operating loss before income taxes Income tax benefit: Tax savings from NOL carryforward Net loss

$(137) 33 $(104)

Requirement 3 ($ in millions) Current Year 2025

Pretax accounting income Temporary differences: Loss contingency NOL carryforward Taxable income (income tax return) Enacted tax rate Tax payable Deferred tax asset

Future Deductible Amounts

160 (12) (118.4)* 29.6 25% 7.4

0 25% 0.4

* The amount of NOL carryforward that can be used in any one year is limited to 80% of taxable income, or ($160 – 12) × 80% = $118.4.

Step 1: Tax payable: $7.4 Step 2: DTA end. bal: $0.4 Step 3: DTA change: $(32.6) Step 4: Tax exp plug: $40 Income tax expense (to balance) Deferred tax asset (determined above) Income tax payable (determined above)

Deferred Tax Asset 33 32.6 0.4

Jou

40 32.6 7.4

16–731

Problem 16–11 Requirement 1 NOL carrybacks are not allowed for most companies, except for property and casualty insurance companies as well as some farm-related businesses. Here, we are told that Fore is one of those businesses, and that it elects an NOL carryback option.

($ in millions)

Accounting loss Permanent difference: Federal fine not deductible Temporary differences: Loss contingency Taxable loss NOL carryback NOL carryforward Enacted tax rate Tax payable (refundable) Deferred tax asset Step 1: Tax payable (receivable): $(28) Step 2: DTA end. bal: $5 Step 3: DTA change: $5 Step 4: Tax exp (benefit) plug: $33

16–732

Prior Years 2022 2023

Current Year 2024

Future Deductible Amounts [total]

(137) 5

(80)

25% (20)

(32)

25% (8)

12 (120) 112 8 0 25% 0

(12)

(8) (20) 25% (5) Deferred Tax Asset 0 5 5

Journal entry at the end of 2024 Receivable—Income tax refund ($20 + $8) Deferred tax asset (determined above) Income tax expense (to balance)

28 5 33

16–733

Problem 16–11 (concluded) Requirement 2 ($ in millions)

Operating loss before income taxes Income tax benefit: Tax refund from NOL carryback Tax savings from NOL carryforward Net loss

$(137) $28 5

33 $(104)

Requirement 3 ($ in millions) Current Year 2025

Pretax accounting income Temporary differences: Loss contingency NOL carryforward Taxable income (income tax return) Enacted tax rate Tax payable Deferred tax asset

Step 1: Tax payable: $35 Step 2: DTA end. bal: $0 Step 3: DTA change: $(5) Step 4: Tax exp plug: $40 Journal entry at the end of 2025 Income tax expense (to balance) Deferred tax asset (determined above) Income tax payable (determined above)

16–734

Future Deductible Amounts

160 (12) (8) 140 25% 35

0 25% 0 Deferred Tax Asset 5 5 0

40 5 35

Problem 16–12 CPS TRANSPORTATION Income Tax Expense and Net Income For the Year Ended December 31, 2024 Requirement 1 ($ in thousands)

Current 2024

Pretax accounting income Temporary difference: Depreciation

900

Taxable income (income tax return) Enacted tax rate Tax payable currently Deferred tax liability

840 25% 210

(60)

Future Taxable Amounts 2025 2026 2027

Total

25% 22.5 Deferred Tax Liability 7.5 15.0 22.5

Step 1: Tax payable: $210 Step 2: DTL end. bal: $22.5 Step 3: DTL change: $15 Step 4: Tax exp plug: $225 Journal entry at the end of 2024 Income tax expense (to balance) Deferred tax liability (determined above) Income tax payable (determined above)

225 15 210

Calculation of 2024 Net Income Income before income tax Income tax expense Net income

$ 900 (225) $ 675

16–735

Problem 16–12 (continued) Requirement 2 CPS TRANSPORTATION Calculation of Interest Expense For the Year Ended December 31, 2024 Lease obligation Jan. 1 – Dec. 31: ($73,667* × 10%)

$ 7,367

* The balance at Dec. 31, 2024, would be $73,667. The entries at the end of 2023 and beginning of 2024 were:

2023 adjusting entry: Interest expense (10% × $76,061) ......... Interest payable (on Jan. 1, 2024) .....

7,606

Jan. 1, 2024: Interest payable (10% × $76,061).......... Lease liability (to balance)................... Cash (annual payment)......................

7,606 2,394

7,606

10,000

Bonds payable July 1 – Dec. 31: ($731,367 (calculation below) × 10% × ½) Calculation of bond price: Interest $ 36,000 ¥ Principal $800,000 Present value (price) of the bonds

× ×

36,568 $43,935

17.15909 * = 0.14205 ** =

$617,727 113,640 $731,367

¥ [9÷2] % × $800,000 * Present value of an ordinary annuity of $1: n = 40, i = 5% (from Table 4) ** Present value of $1: n = 40, i = 5% (from Table 2)

Entry to record interest: Interest expense (5% × $731,367)................................... Discount on bonds payable (difference)..................... Cash (4.5% × $800,000)..............................................

16–736

36,568 568 36,000

Problem 16–12 (concluded) Requirement 3 CPS TRANSPORTATION Long-Term Liabilities Section of Balance Sheet December 31, 2024 Long-term liabilities: Lease liability—14 payments of $10,000 due annually on January 1 Less: current portion ($10,000 – $7,367)

$73,667 (2,633)

$ 71,034

9% bonds payable due June 30, 2044, less unamortized discount of $68,065

731,935

Deferred tax liability Total long-term liabilities

22,500 $825,469

16–737

Problem 16–13 Requirement 1 In the tax return, taxable income is reduced by the $16 million interest, reducing taxes currently payable by the entire tax benefit: $16 million × 25% = $4 million. Requirement 2 In the financial statements, none of the tax benefit is recognized because it is not ―more likely than not‖ that Tru‘s position that the interest is not taxable could be sustained upon examination. Thus, Tru should record a $16 million × 25% = $4 million liability for the potential additional tax. This represents the potential payment to the taxing authorities in the event the tax position is ultimately not upheld. It likely will be reported as a long-term liability because that determination probably will not be made within the coming year. Requirement 3 (a) The tax benefit from the tax treatment of the plot sales is the ability to defer paying the tax. Tru is reducing taxable income by the entire $60 million, effectively deferring the $60 million × 25% = $15 million tax. (b) How much of that deferral can Tru show as a deferred tax liability (DTL) as opposed to a liability associated with an uncertain tax position? It is ―more likely than not‖ that Tru‘s position could be sustained upon examination, so Tru needs to determine the largest amount that has a greater than 50% likelihood of sustainability. As shown below, that amount is $40 million, so Tru will recognize a DTL for $40 million × 25% = $10 million. Amount Qualifying for Installment Sales Treatment $60 50 40 30 20

Percentage Likelihood of Tax Treatment Being Sustained 20% 20% 20% 20% 20%

Cumulative Likelihood of Tax Treatment Being Sustained 20% 40% 60% 80% 100%

(c) The other $5 million is shown as a liability associated with an uncertain tax position. The timing of the payment of that liability depends on the resolution of the uncertainty in the tax position. It likely will be reported as a long-term liability because that resolution probably will not be made within the coming year. 16–738

Problem 16–13 (continued) Requirement 4 ($ in millions) Current Year 2024

Accounting income Permanent difference: Interest income Temporary difference: Plot sales

$88

Taxable income Enacted tax rate Tax payable currently Deferred tax liability

12 25% 3

Future Taxable Amounts 2025 2026

Future Taxable Amounts [total]

(16) (60)

25% 15 Deferred Tax Liability 0 15 15

Step 1: Tax payable: $3 Step 2: DTL end. bal: $15 Step 3: DTL change: $15 Step 4: Tax exp plug: $18 Journal entry at the end of 2024 Income tax expense (to balance) 18 Deferred tax liability (determined above) Income tax payable (determined above)

15 3

16–739

Problem 16–13 (continued) Requirement 5

Step 1: Tax payable: $3 Step 2: DTL end. bal: $10 Proj tax liab: $9 Step 3: DTL change: $10 Proj tax liab change: $9 Step 4: Tax exp plug: $22

Deferred Tax Liability 0

Liability—uncertain tax positions 0 9

10 10

Journal entry at the end of 2024 Income tax expense (to balance) Income tax payable (determined in req. 4) Deferred tax liability ($40 × 25%) Liability—uncertain tax positions ($4 + $5, calculated below) Projected additional tax for interest: Projected additional tax for installment income:

22 3 10 9

$16 × 25% = $4 $20* × 25% = $5

*$60 installment sales less $40, the largest amount with greater than 50% likelihood of sustainability.

16–740

Problem 16–13 (concluded) Now consider what happens later, when uncertainty about the tax position is resolved. Interest income (permanent difference): What if it is completely disallowed? (worst case)

Liability—uncertain tax positions Cash (or income tax payable)

4 4

What if it is completely upheld? (best case) Liability—uncertain tax positions Income tax expense

4 4

Installment income (temporary difference): What if it is completely disallowed? (worst case) Liability—uncertain tax positions Deferred tax liability (removing it, because tax paid)

5 10 15

Cash (or income tax payable)

What if it is completely upheld? (best case) Liability—Projected additional tax Deferred tax liability (setting up additional DTL, because Requirement 1

5 5

16–741

Problem 16–14 Requirement 1 ($ in millions) Current Future Year Deductible 2020 Amounts

Net operating loss NOL carryforward Taxable income Enacted tax rate Tax payable currently Deferred tax asset

Step 1: Tax payable: $0 Step 2: DTA end. bal: $126 Val allow end bal: $126 Step 3: DTA change: $126 Val allow change: 126 Step 4: Tax expense (benefit) plug: $0

16–742

(600) 600 0 21% 0

(600) 21% (126)

Valuation Allowance 0

Deferred Tax Asset 0 126

126 126

126

Journal entry at the end of 2020 Deferred tax asset (determined above) Valuation allowance

126 126

Calculation of net income (loss): Operating loss before income taxes Income tax benefit Net loss

$(600) 0 $(600)

Requirement 2

($ in millions)

Net Operating Loss NOL carryback NOL carryforward Taxable income Enacted tax rate Tax payable (refundable) Deferred tax asset

Step 1: Tax refund rec.: $140 Step 2: DTA end. bal: $44 Val allow end bal: $44 Step 3: DTA change: $44 Val allow change: 44 Step 4: Tax expense (benefit) plug: $(140)

Current Year 2020

Prior Years 2016 2017

Future Deductible Amounts [total]

(600) 400 200 0 21% 0

(300) (100)

35% 35% (105) (35)

(200) 21% (44)

Valuation Allowance 0

Deferred Tax Asset 0 44

44 44

16–743

Journal entry at the end of 2020 Receivable—Income tax refund ($105 + $35) Deferred tax asset (determined above) Valuation allowance Income tax expense (benefit) Calculation of net income (loss): Operating loss before income taxes Income tax benefit Net loss

16–744

140 44 44 140

$(600) 140 $(460)

DECISION MAKERS’ PERSPECTIVE CASES Real World Case 16–1 Requirement 1 The journal entry that summarizes the entries Buckle used to record income taxes associated with continuing operations in the fiscal year ended February 1, 2020 can be reconstructed from the information provided in the note: ($ in thousands)

Income tax expense Net deferred taxes Income tax payable

33,278 1,986 35,264

Requirement 2 Buckle‘s net deferred income tax asset increased by $1,986 thousand during the fiscal year ended February 1, 2020, from $5,830 on February 2, 2019 to $7,816 on February 1, 2020. Yes, that change reconciles with the summary journal entry. Requirement 3 Buckle‘s Consolidated Statement of Income indicates a provision for income taxes of $33,278 thousand for the fiscal year ended February 1, 2020. Yes, that change reconciles with the summary journal entry. Requirement 4 From Buckle‘s Consolidated Statement of Income, we can calculate an effective tax rate of $33,278 ÷ $137,707 = 24.17% for the fiscal year ended February 1, 2020. Per note G, a state income tax effect of 3.2% was the biggest factor causing Buckle‘s effective tax rate to deviate from the statutory rate of 21%.

16–745

Real World Case 16–2 Requirement 1 The journal entry that summarizes the entries Francesca‘s used to record income taxes associated with continuing operations in the fiscal year ended February 1, 2020 can be reconstructed from the information provided in the note: ($ in thousands)

Income tax expense Income tax payable

125 125

Requirement 2 ($ in thousands)

Income tax expense Deferred tax assets ($79,078  20,902) Deferred tax liabilities ($54,501  3,785) Valuation allowance ($24,577  17,117) Income tax payable

125 58,176 50,716 7,460 125

Requirement 3 From Francesca‘s‘ Consolidated Statement of Income, we can calculate an effective tax rate of $125 ÷ (24,895) = (0.5)% for the fiscal year ended February 1, 2020. Per note 6, a valuation allowance effect of 29% was the biggest factor causing Francesca‘s‘ effective tax rate to deviate from the statutory rate of 21%. The valuation allowance completely offset the increase in net deferred tax assets that occurred during the fiscal year, such that Francesca‘s was not able to record a large income tax benefit associated with its net loss for the period.

16–746

Case 16–2 (concluded) Requirement 4 If Francesca‘s had not increased its valuation allowance by $7,460, it would have recorded the following summary journal entry for the fiscal year ended February 1, 2020: ($ in thousands)

Deferred tax assets ($79,078  20,902) Deferred tax liabilities ($54,501  3,785) Income tax payable Income tax benefit (to balance)

58,176 50,716 125 7,335

That indicates an income tax expense (benefit) of $(7,335), a net loss of $(24,895)  (7,335) = $17,560, and an effective tax rate of $(7,335) ÷ (24,895) = 29.5% for the fiscal year ended February 1, 2020. With no change in valuation allowance, Francesca‘s recognizes a tax benefit that serves to offset some of its loss when calculating net loss for the fiscal year.

16–747

Analysis Case 16–3 Requirement 1 The journal entry that summarizes the entries Walmart used to record income taxes associated with continuing operations in the fiscal year ended January 31, 2020 can be reconstructed from the information provided in the note: ($ in millions)

Income tax expense Net deferred taxes Income tax payable (to balance)

4,915 329 4,586

Requirement 2 No, the net deferred tax liability decreased by $210 million (= $4,290 – $4,500), which would imply a debit of $210 million, which differs by $539 million from the credit to net deferred taxes of $329 million shown in the answer to requirement 1. That difference can be explained by the fact that the journal entry summarized in the answer to Requirement 1 relates only to continuing operations. Other events also could affect the deferred tax asset, liability and valuation allowance accounts, and so cause the actual change in net deferred taxes to not reconcile with the change associated with only continuing operations. Walmart doesn‘t show any discontinued operations, but the difference could be caused by other comprehensive income items.

16–3

Analysis Case 16–4 1. Kroger's February 1, 2020 income statement reports the income tax expense for the year as $469 million. The current portion is $454 + $70 = $524 million. The deferred portion of the expense is $50 + $5 = $55. A summary journal entry that records Kroger‘s tax expense from continuing operations for the fiscal year ended February 1, 2020 is: Income tax expense Deferred tax assets/liabilities Income tax payable

469 55 524

2. Kroger has a $1,466 million total deferred tax liability for the fiscal year ended February 1, 2020, and $1,562 for the prior fiscal year. The change between years was to decrease the deferred tax liability by $ 96 million. That is $41 million greater than the debit change identified in Kroger‘s summary of tax expense from continuing operations. Kroger doesn‘t show any discontinued operations, but the difference could be caused by other comprehensive income items.

16–4

Analysis Case 16– 1. 750Ford shows a net deferred tax asset of $11,373 million. 2. Ford shows a valuation allowance of $843 million. It indicates that it is ―primarily related to deferred tax assets in various non-U.S. operations.‖ Apparently Ford believes it is more likely than not that it will not be able to generate sufficient income soon enough in those tax jurisdictions to be able to use the tax deductions that are provided by its deferred tax assets in those tax jurisdictions. 3. Ford indicates that it has operating loss carryforwards of $4.3 billion, resulting in a deferred tax asset of $1.7 billion. Because (NOL carryforward) × tax rate = deferred tax asset, we know that $4.3 × tax rate = 1.7, so the effective tax rate used to calculate the deferred tax asset = 1.7 ÷ 4.3 = 40%.

16–750

16–751

16–752

Judgment Case 16–6 Requirement 1 Decrease, by $520 – $374 = $146 million. Requirement 2 $6,631 – $146 = $6,485 million. CVS would debit the valuation allowance by $146 million to reduce it, which would require an offsetting credit that reduces tax expense by the same amount. Lower tax expense would produce higher net income. Requirement 3 More profitable. CVS would need to indicate that it would be producing more future taxable income, such that it would have sufficient taxable income to realize an additional $146 million of deferred tax assets.

16–753

16–754

Integrating Case 16–7 Requirement 1 Because postretirement costs aren‘t tax deductible until paid to, or on behalf of, employees, accruing compensation expense produces temporary differences that create future deductible amounts. These have favorable tax consequences that are recognized as deferred tax assets. The deferred tax assets represent the future tax benefit from the reversal of the temporary difference between the financial statement carrying amount of the postretirement benefit liability and its tax basis. Requirement 2 Unlike most temporary differences, the temporary difference for postretirement benefits is related to an estimated liability—postretirement benefit liability—that already is a discounted amount. The postretirement benefit liability is the discounted present value of estimated future postretirement benefits. Perhaps the appropriate objection to discounting is inconsistency; some amounts are discounted, some are not.

16–755

16–756

16–757

16–758

16–759

16–760

16–761

16–762

Integrating Case 16–8 a. This is a correction of an error. To correct the error: Prepaid insurance ($35,000 ÷ 5 yrs × 3 yrs: 2024–2026) .......... Deferred Tax Liability ($21,000 × 25%) .......................... Retained earnings* ..............................................................

21,000 5,250 15,750

*($35,000 – [$35,000 ÷ 5 years × 2 years: 2022–2023]) less $5,250 tax

2024 adjusting entry: Insurance expense ($35,000 ÷ 5 years) .................................... Prepaid insurance .........................................................

7,000 7,000

The financial statements that were incorrect as a result of the error would be retrospectively restated to report the prepaid insurance acquired and reflect the correct amount of insurance expense when those statements are reported again for comparative purposes in the current annual report. A ―prior period adjustment‖ to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s net income and earnings per share. b. This is a correction of an error. To correct the error: Retained earnings (net effect) ................................................... Receivable-Income tax refund ($25,000 × 25%) .................... Inventory ...............................................................................

18,750 6,250 25,000

The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct inventory amounts, cost of goods sold, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A ―prior period adjustment‖ to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s net income and earnings per share.

16–763

Case 16–8 (continued) c. This is a change in accounting principle and is reported retrospectively. To record the change: Inventory (given)................................................................ Deferred tax liability ($960,000 × 25%) ........................... Retained earnings (net effect) ..............................................

960,000 240,000 720,000

Most changes in accounting principle are accounted for retrospectively. Prior years' financial statements are recast to reflect the use of the new accounting method. The company should increase retained earnings to the balance it would have had if the FIFO method had been used previously; that is, by the cumulative net income difference between the LIFO and FIFO methods. Simultaneously, inventory is increased to the balance it would have had if the FIFO method had always been used. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. For financial reporting purposes, but not for tax, the company is retrospectively increasing pretax accounting income, but not taxable income. This creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. When that happens, taxable income will be higher than pretax accounting income. When taxable income will be higher than pretax accounting income as a temporary difference reverses, we have a ―future taxable amount‖ and record a deferred tax liability.

16–764

Case 16–8 (continued) d. This is a correction of an error. To correct the error: Retained earnings (net effect) ................................................... Receivable-Income tax refund ($15,500 × 25%) .................. Compensation expense .......................................................

11,625 3,875 15,500

The 2023 financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct compensation expense, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A ―prior period adjustment‖ to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s net income and earnings per share. e. This is a change in estimate resulting from a change in accounting principle and is accounted for prospectively. No entry is needed to record the change 2024 adjusting entry: Depreciation expense (calculated below) ................................ Accumulated depreciation ...........................................

57,600 57,600

A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, Williams-Santana reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight-line over the remaining useful life. Undepreciated cost, Jan. 1, 2024 (given) Estimated residual value To be depreciated over remaining 8 years Annual straight-line depreciation 2024–2031

$460,800 (0) $460,800 8 $ 57,600

years

16–765

Case 16–8 (concluded) f. This is a correction of an error. To correct the error: Equipment (cost) ................................................................ 1,000,000 Accumulated depreciation ([$1,000,000 ÷ 10] × 3 years) .... 300,000 Deferred tax liability ([$1,000,000 – $300,000] × 25%) ...... 175,000 Retained earnings 525,000 ($1,000,000 – [$100,000 × 3 years]) less $175,000 tax........... 2024 adjusting entry: Depreciation expense ($1,000,000 ÷ 10) .........................................100,000 Accumulated depreciation............................................. 100,000 The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct depreciation, assets, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A ―prior period adjustment‖ to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s net income and earnings per share.

16–766

Research Case 16–9 Requirement 3 Yes. Specific deductions are listed that are deductible from ―total income‖ to arrive at ―taxable income.‖ On the 2019 Form 1120 these are items 12 (compensation of officers) through 29 (net operating loss deduction). Each of these items is a deduction that might not also be included among expenses in the income statement. In addition, the amounts for the items might be different on the two statements. No. A ―net operating loss deduction‖ only would be reported if a company reported a net operating loss in a previous period that was not ―carried back‖ to a prior period if the company was entitled to a carryback, and the loss hasn‘t yet been deducted as a net operating loss carryforward. The deduction reduces taxable income and therefore tax payable.

16–767

Analysis Case 16–10 Requirement 1 Macy‘s debt to equity ratio for the year ended February 1, 2020, was 2.32, calculated as ($21,172 – $6,377) ÷ 6,377. Requirement 2 To exclude deferred tax liabilities, we would reduce the numerator by the deferred tax: ($21,172 – $6,377) – $1,169. Reducing liabilities would necessitate also increasing equity to keep everything in balance: $6,377 + $1,169. The reasoning behind adjusting both amounts is that we are in effect reversing the effect of recording the deferred tax liability over time which was: Income tax expense (reduces income and therefore equity [retained earnings]) 1,169 Deferred tax liability (increases liabilities) 1,169 So, the revised ratio would be: ($21,172 – $6,377 – $1,169) ÷ ($6,377 + $1,169) = 1.81 This is a 22% reduction in the ratio. Requirement 3 Argument for excluding deferred tax liabilities from debt to equity ratio: In many cases the deferred tax liability account remains the same (or continually grows larger), so this liability does not require payment, and therefore does not increase risk.

16–768

16–769

Research Case 16–11 [Note: This case encourages the student to reference authoritative pronouncements.]

1. No, Perkins does not have authoritative support. ACS 740–10–30–8: ―Income Taxes–Overall–Initial Measurement–Applicable Tax Rate Used to Measure Deferred Taxes‖ states the following: ―Deferred taxes shall not be accounted for on a discounted basis.‖ 2. Yes, Perkins has authoritative support. ACS 740–10–30–18: ―Income Taxes– Overall–Initial Measurement– Establishment of a Valuation Allowance for Deferred Tax Assets‖ states the following: ―The following four possible sources of taxable income may be available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards: a. Future reversals of existing taxable temporary differences‖ 3. No, Perkins does not have authoritative support. ACS 740–10–45–4: ―Income Taxes–Overall–Other Presentation Matters–Deferred Tax Accounts‖ states the following: ―In a classified statement of financial position, an entity shall classify deferred tax liabilities and assets as noncurrent amounts.‖ 4. No, Perkins does not have authoritative support. ACS 740–10–50–15A: ―Income Taxes–Overall–Other Presentation Matters–Unrecognized Tax Benefit Related Disclosures‖ states the following: ―Public entities shall disclose both of the following at the end of each annual reporting period presented: a. A tabular reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of the period, which shall include at a minimum: 1. The gross amounts of the increases and decreases in unrecognized tax benefits as a result of tax positions taken during a prior period 2. The gross amounts of increases and decreases in unrecognized tax benefits as a result of tax positions taken during the current period 3. The amounts of decreases in the unrecognized tax benefits relating to settlements with taxing authorities 4. Reductions to unrecognized tax benefits as a result of a lapse of the applicable statute of limitations.‖

16–770

Judgment Case 16–12 Requirement 1 ($ in millions, except per share amounts)

RUSSELL-JAMES CORPORATION Income Statement For the year ended December 31, 2024 Sales revenue Cost of goods sold Gross profit Selling and administrative expenses Income from continuing operations before income taxes Income tax expense Income from continuing operations Discontinued operations: Loss from operations of cosmetics division (net of $25 income tax benefit) Gain from disposal of cosmetics division (net of $4 income tax expense) Net income

Per share of common stock (100 million shares): Income from continuing operations Loss from operations of cosmetics division, net of tax Gain from disposal of cosmetics division, net of tax Net income

$300 90 210 (50) 160 40 120

$(75) 12

(63) $ 57

$1.20 (.75) .12 $0.57

16–771

Case 16–12 (concluded) Requirement 2 Income tax on income from continuing operations Tax benefit on loss from cosmetics division Tax on gain from disposal of cosmetics division

$40` (25) 4

Income taxes (total, unallocated)

$19

16–772

16–773

Real World Case 16–13 Requirement 1 ($ in millions)

Receivable-Income tax refund Income tax benefit

1,100 1,100

Requirement 2 (Amount of NOL carryback) × 35% = $1,100, so $1.1 billion ÷ 35% = Amount of NOL carryback = $3,143.

Requirement 3 ($ in millions)

Deferred tax asset ($3,143 × 21%) Income tax benefit

660 660

Requirement 4 From answers to requirements 1 and 3, answer is $440 million. Note, can also calculate as ((35%  21%) ÷ 35%) × $1,100 million = $440 million.

16–774

Trueblood Case 16–14 A solution and extensive discussion materials accompany each case in the Deloitte & Touche Trueblood Case Study Series. These are available to instructors at: www.deloitte.com/us/truebloodcases.

16–775

Trueblood Case 16–15 A solution and extensive discussion materials accompany each case in the Deloitte & Touche Trueblood Case Study Series. These are available to instructors at: www.deloitte.com/us/truebloodcases.

16–776

16–777

Communication Case 16–16 To: From: Date: Re:

Mr. Randy Patey <your name> November 15, 2020 Accounting for income taxes

Below is a brief overview of accounting for income taxes and its application to our situation. The objectives of accounting for income taxes are to recognize the amount of taxes payable (or refundable) for the current year and deferred tax liabilities and assets for the estimated future tax consequences of temporary differences and carryforwards. Temporary differences are differences between the tax basis of assets or liabilities and their reported amounts in the financial statements that will result in taxable or deductible amounts in future years. The reported amount in the financial statements for our building is $5,600,000, which is its $6,000,000 cost reduced by two years‘ straight-line depreciation of $200,000 per year ($6,000,000 ÷ 30 years). The tax basis is $5,200,000, so there is a $400,000 temporary difference. The deferred tax liability is that amount times the tax rate when the future taxable amounts are taxable. That rate is the currently enacted rate, 40%, even though it‘s likely that rate might change. Note that, if the change from a 40% rate to a 25% rate is enacted prior to 12/31/2020, the 25% rate will be used for this calculation. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance to reflect the net asset amount that is ―more likely than not‖ to be realized. Nontemporary or ―permanent‖ differences are caused by transactions and events that under existing tax law will never affect taxable income or taxes payable. Some provisions of the tax laws exempt certain revenues from taxation and prohibit the deduction of certain expenses. One such deduction is the insurance premium we pay each year on the CEO‘s life insurance policy. Nontemporary or ―permanent‖ differences are not included when determining both the tax payable currently and the deferred tax effect of book-tax differences. Please let me know if you have any Questions or concerns. 16–778

Ethics Case 16–17 Requirement 1 ($ in millions)

Deferred tax assets ($10 million × 25%)) Income tax benefit (to balance)

2.5 2.5

Maryton‘s net loss would be ($10 million)  (2.5 million) = ($7.5 million)

Requirement 2 ($ in millions)

Deferred tax assets ($10 million × 25%)) 2.5 Valuation allowance (to balance) Maryton‘s net loss would be ($10 million)  (0) = ($10 million)

2.5

Requirement 3 If Smith argues that it is more likely than not that Maryton will return to sufficient profitability for it to be able to realize the benefits that will arise from deferred tax asset associated with its NOL, Maryton can avoid recording a valuation allowance. That will reduce Maryton‘s net loss, and also will avoid sending the signal to stakeholders that Maryton‘s management does not believe it is more likely than not that it will return to profitability.

16–779

Case 16–17 (concluded) Requirement 4 Yes, Smith faces an ethical dilemma. If Smith avoids recording the valuation allowance and shows a lower net loss, thereby portraying Maryton‘s current and future profitability more favorably, the following stakeholders could benefit: 1. Smith and the rest of Maryton‘s management (stay employed, higher compensation). 2. Maryton‘s current shareholders (prop up share price) 3. Maryton‘s employees (maintain access to capital and keep business running). If Smith records the valuation allowance and shows a higher net loss, thereby portraying Maryton‘s current and future profitability less favorably, the following stakeholders could benefit: 1. Smith (avoids potential allegations of inaccurate accounting). 2. Maryton‘s lendors (need to know Maryton‘s performance, possibly triggering debt covenants). 3. Maryton‘s prospective shareholders (benefit from neutral reporting to consider whether to invest). 4. Maryton‘s current shareholders (benefit from neutral reporting and possibly sell shares) 5. Maryton‘s employees (seeing true performance, can consider whether want to find employment elsewhere).

Target Case 1. Target's February 1, 2020 income statement reports the income tax expense for the year as $921 million. The current portion is $743 million. The deferred portion is = $178. A summary journal entry that records Target‘s tax expense from continuing operations for the fiscal year ended February 1, 2020 is:

16–780

Income tax expense Deferred tax assets/liabilities Income tax payable

921 178 743

2. Target‘s net deferred tax liability increased from $960 to $1,114, which is an increase of $154. The journal entry in the answer to requirement 1 indicates a credit of $178, which would increase the net deferred tax liability, so it only differs by $24. That difference could be caused by discontinued operations, acquisitions or dispositions that changed the deferred tax balances, or deferred taxes associated with other comprehensive income items. Target has both discontinued operations and other comprehensive income items, which could account for the difference. 3. The effect of the tax rate change is to reduce tax expense and increase net income by $36 million. 4. Target‘s liability for unrecognized tax benefits is $160 million as of February 1, 2020. Were Target to prevail and receive $50 million more of tax benefits than it thought it would receive, it would reduce the liability by $50 million and show an offsetting reduction of tax expense of $50 million: Liability for unrecognized tax benefits Income tax expense

50 50

That would increase net income in the period in which the liability for unrecognized tax benefits was reduced.

17–781

Air France–KLM Case Requirement 1 AF reported a €523 million noncurrent deferred tax asset, and a €142 million noncurrent deferred tax liability, totaling a €381 million net noncurrent deferred tax asset at December 31, 2019.

Requirement 2 This policy is not consistent with U.S. GAAP, which requires that measurement be based on tax rates and laws that are enacted at the balance sheet date. Using ―substantively enacted‖ is not permissible in U.S. GAAP.

Requirement 3 This policy is not consistent with U.S. GAAP, which requires that all deferred tax assets be recorded and then reduced by a valuation allowance when it is deemed ―more likely than not‖ (the definition of probable under IFRS) that some or all of the benefits will not be realized due to insufficient taxable income to absorb the future deductible amounts and realize the tax savings.

Chapter 17 Pensions and Other Postretirement Benefits

17–782

QUESTIONS FOR REVIEW OF KEY TOPICS

17–783

Question 17–1 Pension plans are arrangements designed to provide income to individuals during their retirement years. Funds are set aside during an employee‘s working years so that the accumulated funds plus earnings from investing those funds are available to replace wages at retirement. An individual has a pension fund when she or he periodically invests in stocks, bonds, CDs, or other securities for the purpose of saving for retirement. When an employer establishes a pension plan, the employer provides some or all of the periodic contributions to the retirement fund.

17–784

The motivation for corporations to establish pension plans comes from several sources. Pension plans provide employees with a degree of retirement security. They may fulfill a moral obligation many employers feel toward employees. Pension plans often enhance productivity, reduce turnover, satisfy union demands, and allow employers to compete in the labor market.

17–785

Question 17–2 A qualified pension plan gains important tax advantages. The employer is permitted an immediate tax deduction for amounts paid into the pension fund. Conversely, the benefits to employees are not taxed until retirement benefits are received. Also, earnings on the funds set aside by the employer accumulate tax-free. For a pension plan to be qualified for special tax treatment, these general requirements must be met: 1. It must cover at least 70% of employees. 2. It cannot discriminate in favor of highly compensated employees. 3. It must be funded in advance of retirement through contributions to an irrevocable trust fund. 4. Benefits must ―vest‖ after a specified period of service, commonly five years. 5. It complies with specific restrictions on the timing and amount of contributions and benefits.

17–786

17–787

17–788

Question 17–3 This is a noncontributory plan because the corporation makes all contributions. When employees make contributions to the plan in addition to employer contributions, it‘s called a ―contributory‖ plan. This is a defined contribution plan because it promises fixed annual contributions to a pension fund, without further commitment regarding benefit amounts at retirement.

17–3

Question 17– 790The vested benefit obligation is the pension benefit obligation that is not contingent upon an employee's continuing service.

17–790

Question 17– 791The accumulated benefit obligation is the discounted present value of retirement benefits calculated by applying the pension formula with no attempt to forecast what salaries will be when the formula actually is applied. The projected benefit obligation is the present value of those benefits when the actuary includes projected salaries in the pension formula.

17–791

Question 17– 792The projected benefit obligation can change due to periodic service cost, accrued interest, revised estimates, plan amendments, and the payment of benefits.

17–792

Question 17– 793The balance of the plan assets can change due to investment returns, employer contributions, and the payment of benefits.

17–793

17–794

Question 17–8 The pension expense reported on the income statement is a composite of periodic changes that occur in both the pension obligation and the plan assets. These include service cost, interest cost, return on the plan assets, and the amortization of prior service cost and of net gains or losses. The service cost component of pension expense is reported in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the non-service cost components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

17–8

Question 17– The service 796 cost in connection with a pension plan is the present value of benefits attributed by the pension formula to employee service during the period, projecting future salary levels (i.e., the projected benefits approach).

17–796

Question 17– 797 The interest cost is the projected benefit obligation outstanding at the beginning of the period multiplied by the actuary's interest (discount) rate. This is the ―interest expense‖ that accrues on the PBO and is included as a component of pension expense rather than being separately reported.

17–797

Question 17– GAAP798 specifies that the actual return be included in the determination of pension expense. However, the actual return is adjusted for any difference between actual and expected return, meaning that the expected return is really the amount reflected in the calculation of pension expense. This ―investment revenue‖ is deducted as a component of pension expense rather than being separately reported. The difference between actual and expected return on plan assets is combined with gains and losses from other sources for possible future amortization to pension expense.

17–798

17–799

Question 17–12 Prior service cost is the obligation (present value of benefits) due to giving credit to employees for years of service provided before either the date of an amendment to (or initiation of) a pension plan. Prior service cost is recognized as other comprehensive income as incurred and then as a component of accumulated other comprehensive income in the company‘s balance sheet. The account is allocated (amortized) to pension expense over the service period of affected employees. The straight-line method allocates an equal amount of the prior service cost to each year. The service method recognizes the cost each year in proportion to the fraction of the total remaining ―service years‖ worked in each of these years. In the income statement the amortization of prior service cost is included with the other (non-service cost) components of pension expense.

17–800

Question 17–13 Gains or losses related to pension plan assets represent the difference between the return on investments and what the return had been expected to be. They are recognized as other comprehensive income as incurred and then as a component of accumulated other comprehensive income in the company‘s balance sheet: either a net loss–AOCI or a net gain–AOCI depending on whether cumulative losses have exceeded gains, or vice versa. The account is amortized to pension expense only if the net loss–AOCI or net gain–AOCI exceeds a defined threshold. Specifically, a portion of the excess is included in pension expense only if it exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is higher. The amount that should be included is the excess divided by the average remaining service period of active employees expected to receive benefits under the plan. Gains or losses related to the pension obligation are treated the same way. In fact, gains and losses from both sources are combined to determine the net gains or net losses referred to above.

17–801

17–802

Question 17– 803A company‘s PBO is not reported among liabilities in the balance sheet. Similarly, the plan assets a company sets aside to pay those benefits are not reported among assets in the balance sheet. However, firms report the net difference between those two amounts, referred to as the ―funded status‖ of the plan, as either a net pension liability (if underfunded) or a net pension asset (if overfunded).

17–803

Question 17– 804The two components of pension expense that may reduce pension expense are the return on plan assets (always) and the amortization of a net gain–AOCI (amortizing a net loss–AOCI increases the expense).

17–804

Question 17– 805The components of pension expense that involve delayed recognition are the prior service cost and gains and losses.

17–805

Question 17– 806The excess of the actual return on plan assets over the expected return is considered a gain. It does, in fact, decrease the employer‘s pension cost, but not immediately the pension expense. It is reported as other comprehensive income as it occurs, grouped with other gains and losses to create a net gain–AOCI or net loss– AOCI account, and then amortized as a component of pension expense only if the net gain–AOCI or net loss–AOCI exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is higher.

17–806

17–807

Question 17–18 The cash contribution is debited to the pension asset. It adds to plan assets, thereby reducing an underfunded status (PBO > assets) or increasing an overfunded status (assets > PBO). So, if the plan is underfunded so that a net pension liability exists, the liability is reduced. Otherwise, if the plan is overfunded so that a net pension asset exists, the asset is increased.

17–808

17–809

Question 17–19 TFC Inc. revises its estimate of future salary levels causing its PBO estimate to increase by the $3 million. The $3 million is considered a loss and is reported in the statement of comprehensive income rather than being reported as part of traditional net income as would occur if included as part of pension expense. It then becomes part of accumulated other comprehensive income in the balance sheet as part of the net loss– AOCI or net gain–AOCI. A portion of that balance might possibly be amortized to pension expense if the net loss–AOCI or net gain–AOCI exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is higher.

17–810

17–811

17–812

Question 17–20 The difference between the employer‘s obligation (PBO) and the resources available to satisfy that obligation (plan assets) is the funded status of the pension plan. Firms must report the net difference between those two amounts, referred to as the ―funded status‖ of the plan, in the balance sheet. It‘s reported as a net pension asset if the plan assets exceed the PBO or as a net pension liability if the PBO exceeds the plan assets.

17–813

17–814

17–815

Question 17–21 The expected postretirement benefit obligation (EPBO) is the actuary's estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants. When a plan is pay-related, future compensation levels are implicitly assumed. The accumulated postretirement benefit obligation (APBO) measures the obligation existing at a particular date, rather than the total amount expected to be earned by plan participants. The APBO is conceptually similar to a pension plan‘s projected benefit obligation. The EPBO has no counterpart in pension accounting.

17–816

Question 17–22 The cost of benefits is ―attributed‖ to the years during which those benefits are assumed to be earned by employees. The attribution period spans each year of service from the employee‘s date of hire to the employee‘s ―full eligibility date,‖ which is the date the employee has performed all the service necessary to have earned all the retiree benefits estimated to be received by that employee. The approach assigns an equal fraction of the EPBO to each of those years. The attribution period does not include any years of service beyond the full eligibility date, even if the employee is expected to work after that date.

17–817

17–818

Question 17–23 The service cost for pensions reflects additional benefits employees earn from an additional year‘s service, whereas the service cost for retiree health care plans is simply an allocation to the current year of a portion of a fixed total cost.

17–819

17–820

Question 17–24 The attribution period spans each year of service from the employee‘s date of hire to the employee‘s ―full eligibility date,‖ 30 years in this case. The APBO is $10,000, which represents the portion of the EPBO earned after 15 years of the 30-year attribution period: $20,000 x 15/30 = $10,000.

17–821

Answers to Questions (concluded)

17–822

Question 17–25 Mid-South Logistics prepares its financial statements according to U.S. GAAP. Under U.S. GAAP, prior service cost is included among OCI items in the statement of comprehensive income and thus subsequently becomes part of AOCI where it is amortized over the average remaining service period. On the other hand, under IAS No. 19, prior service cost (called past service cost under IFRS) is combined with service cost and reported within the income statement, in the period in which it arises, rather than as a component of other comprehensive income as it is under U.S. GAAP, so it never is amortized to expense. Since Mid-South Logistics is amortizing a portion of the amount, U.S. GAAP is indicated.

17–823

Question 17–26 Under both U.S. GAAP and IFRS we report gains and losses among OCI items in the statement of comprehensive income; thus, they subsequently become part of AOCI. But, under IFRS the gains and losses are not subsequently amortized to expense and recycled or reclassified from other comprehensive income as is required under U.S. GAAP (when the accumulated net gain or net loss exceeds the 10% threshold). A second difference pertains to the make-up of the gain or loss on plan assets. This amount under U.S. GAAP is the difference in the actual and expected returns, where the expected return is different from company to company and usually different from the interest rate used to determine the interest cost. Under IFRS, though, we use the same rate (the rate for high-grade corporate bonds) for both the interest cost on the defined benefit obligation and the interest income on the plan assets. In fact, under IFRS, we multiply that rate times the net difference between the defined benefit obligation and plan assets and report the net interest cost/income.

17–824

BRIEF EXERCISES

17–825

Brief Exercise 17–1 ($ in millions)

Beginning of the year PBO Service cost Interest cost Loss (gain) on PBO Less: Retiree benefits End of the year PBO

$80 10 4 0 (6) $88

🠞 (5% x $80)

17–1

Brief Exercise 17– 827

($ in millions)

Beginning of the year PBO $80 Service cost 10 Service cost Interest cost 4 Interest cost Loss (gain) on PBO Loss (gain) on PBO 0 Less: Retiree benefits End of the year PBO

? 🠞 (5% 4 x $80) 🠞 (5% x $80) 0 (6) $85

Service cost = $85 – $80 – $4 + $6 = $7 million

17–827

Brief Exercise 17– 828

Beginning of the year PBO

Less: Retiree benefits End of the year PBO

($ in millions)

$80

(?) $85

Retiree benefits = $85 – $80 – $4 – $10 = $9 million

17–828

Brief Exercise 17– 829

($ in millions)

Beginning of the year PBO $80 Service cost 10 Service cost Interest cost 4 Interest cost Loss (gain) on PBO Loss (gain) on PBO 0 Less: Retiree benefits End of the year PBO

10 🠞 (5% 4 x $80) 🠞 (5% x $80)

? (6) $85

Gain = $85 – $80 – $10 – $4 + $6 = $3 million

17–829

Brief Exercise 17– 830 Plan assets Beginning of the year Actual return Cash contributions Less: Retiree benefits End of the year

17–830

($ in millions)

$80 4 🠞 (5% x $80) 7 (6) $85

17–831

17–832

Brief Exercise 17–6 ($ in millions)

Plan assets Beginning of the year $80 Actual return 4 🠞 (5% x $80) Cash contributions 7 Less: Retiree benefits (?) End of the year $83 Retiree benefits = $83 – $80 – $4 – $7 = $8 million

17–833

Brief Exercise 17–7 ($ in millions)

Plan assets Beginning of the year Actual return Cash contributions Less: Retiree benefits End of the year

$100

🠞 (? % x $100)

7 (6) $104

Return on assets = $104 – $100 – $7 + $6 = $3 million Rate of return on assets = $3 million ÷ $100 million = 3%

17–834

Brief Exercise 17–8 The difference between an employer‘s obligation (PBO) and the resources available to satisfy that obligation (plan assets) is the funded status of the pension plan. The employer must report the net difference between those two amounts, referred to as the ―funded status‖ of the plan in the balance sheet. It‘s reported as a net pension liability if the PBO exceeds the plan assets or a net pension asset if the plan assets exceed the PBO. In the situation described, JDS would report a net pension liability of $15 million: ($ in millions)

PBO Plan assets Net pension liability

$40 25 $15

If the plan assets are $45 million, JDS would report a net pension asset of $5 million: ($ in millions)

Plan assets PBO Net pension asset

17–8

$45 40 $ 5

Brief Exercise 17– ($ in millions) 836 Service cost $10 Interest cost (5% x $80) 4 Expected return on the plan assets ($5 actual, less $1 gain) (4) Amortization of prior service cost 0 Amortization of net loss (gain) 0 Pension expense

$10

Note: When reported in the income statement, the service cost will be reported separately from the other (non-service cost) components of pension expense.

17–836

Brief Exercise 17– 837

($ in millions) Service cost $10 Interest cost 4 Expected return on the plan assets ($4 actual, plus $2 loss) (6) Amortization of prior service cost 2* Amortization of net loss (gain) 0 Pension expense $10 * $20 ÷ 10 years = $2 Note: When reported in the income statement, the service cost will be reported separately from the other (non-service cost) components of pension expense.

17–837

Brief Exercise 17– 838

Gains or losses should not be part of pension expense unless and until total net gains or losses exceed a defined threshold. Specifically, a portion of the excess is included in pension expense only if it exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is larger. The amount that should be included is the excess divided by the average remaining service period of active employees expected to receive benefits under the plan. Amortization of net gains is deducted from pension expense; amortization of a net loss is added to pension expense. Pension expense in this instance is decreased by a $2 million amortization of the net gain: ($ in millions)

Net gain Less: 10% corridor (threshold)* Excess Service period Amortization

$30 (10) $20 ÷ 10 $2

* 10% times either the PBO ($80) or plan assets ($100), whichever is larger.

17–838

Brief Exercise 17– 839

The net pension liability, which is the difference between the PBO and plan assets, increases by the combination of the service cost, interest cost, and the expected return ($70 + $50 – $55 million) as is reflected in the following entry. To Record Pension Expense

($ in millions)

Pension expense (total) ...........................

Plan assets ($55 expected return on assets)

PBO ($70 + $50).................................

120

Amortization of prior service cost—OCI

Note: When reported in the income statement, the service cost will be reported separately from the other (non-service cost) components of pension expense. The net pension liability (PBO minus plan assets) is affected only by the three components of pension expense that change either the PBO or plan assets. The pension expense also includes the $2 million of prior service cost amortization but, unlike the other three components, this amortization amount affects neither the PBO nor the plan assets and therefore doesn‘t change the net pension liability. However, the prior service cost (an accumulated other comprehensive income account) is reduced by $2 million. This reduction is reported as other comprehensive income in the statement of comprehensive income.

17–839

Brief Exercise 17– 840

Pension gains and losses (either from changing assumptions regarding the PBO or the return on assets being higher or lower than expected) are deferred and not immediately included in pension expense and net income. They are, however, reported as other comprehensive income in the period they occur. Accordingly, these gains and losses are reported in Major‘s statement of comprehensive income as a gain of $4 million and a loss of $1 million. Here are the entries: ($ in millions)

Loss—OCI (loss from actual return falling short of expected) Plan assets.............................................................

PBO .......................................................................... Gain—OCI (gain from change in assumption)................

The net pension liability in the balance sheet declines by the $3 million net effect of the loss and the gain: ($ in millions)

PBO

$4 

Less: Plan assets

(1) 

Net pension liability

$ 3 

 The Net loss—AOCI in the balance sheet increases by the current $1 million Loss—OCI and deceases by the current $4 million Gain—OCI, a net reduction of $3 million. ($ in millions)

Plus: Loss—OCI

Less: Gain—OCI

(4)

Decrease in Net loss—AOCI

17–840

$(3)

Brief Exercise 17– APBO 841

Service Cost

2024

$50,000 x 6/30 = $10,000

$50,000 x 1/30 = $1,667

2025

$54,000 x 7/30 = $12,600

$54,000 x 1/30 = $1,800

30-year attribution period (age 25–55).

17–841

Brief Exercise 17– 842 ($ in millions) Beginning of 2024 APBO

$25

Service cost

Interest cost

Gain on APBO

(1)

Less: Retiree benefits

(3)

End of 2024 APBO

17–842

🠞 (8% x $25)

$30

EXERCISES

17–843

Exercise 17–1 Events I

1. Interest cost.

2. Amortization of prior service cost.

3. A decrease in the average life expectancy of employees.

4. An increase in the average life expectancy of employees.

5. A plan amendment that increases benefits is made retroactive to prior years.

17–844

6. An increase in the actuary‘s assumed discount rate.

7. Cash contributions to the pension fund by the employer.

8. Benefits are paid to retired employees.

9. Service cost.

10. Return on plan assets during the year lower than expected.

11. Return on plan assets during the year higher than expected.

Exercise 17–2 ($ in millions)

Beginning of 2024

$30

Service cost

Interest cost

Loss (gain) on PBO

Less: Retiree benefits

(4)

End of 2024

🠞 (10% x $30)

$41

17–845

Exercise 17–3 I

Events 1. Interest cost.

2. Amortization of prior service cost—AOCI.

3. Excess of the expected return on plan assets over the actual return.

4. Expected return on plan assets.

5. A plan amendment that increases benefits is made retroactive to prior years.

17–846

6. Actuary‘s estimate of the PBO is increased.

7. Cash contributions to the pension fund by the employer.

8. Benefits are paid to retired employees.

9. Service cost.

10. Excess of the actual return on plan assets over the expected return.

11. Amortization of net loss—AOCI.

12. Amortization of net gain—AOCI.

Exercise 17–4 Requirement 1 ($ in millions) Pension expense (total) ............................................................14 Plan assets (expected return on assets) ......................................... 4 PBO ($10 service cost + $6 interest cost)......................... 16

Amortization of net loss—OCI (current amortization)* ..

Requirement 2 ($ in millions)

Pension expense (total) ................................................. 10 Plan assets (expected return on assets) ............................... 4 Amortization of net gain—OCI (current amortization)* .... 2 PBO ($10 service cost + $6 interest cost).........................

Requirement 3 ($ in millions)

Pension expense (total) ................................................. 17 Plan assets (expected return on assets) ............................... 4 PBO ($10 service cost + $6 interest cost)......................... 16 Amortization of net loss—OCI (current amortization)* . 2 Amortization of prior service cost—OCI (current amortization)* 3 The amortization amounts are reported as other comprehensive income in the statement of comprehensive income. * Because Prior service cost—AOCI and Net loss—AOCI have debit balances, we amortize them with a credit. We amortize a Net gain—AOCI (credit balance) with a debit. After the amortization amounts are reported as OCI in this year‘s statement of comprehensive income, the respective AOCI amounts in the balance sheet are reduced.

Note: When reported in the income statement, the service cost will be reported separately from the other (non-service cost) components of pension expense.

17–847

17–848

Exercise 17–5 ($ in millions)

Plan assets Beginning of the year Actual return Cash contributions Less: Retiree benefits End of the year

$600 48 100 (11) $737

17–5

Exercise 17– 850

PBO: Beginning of the year

($ in millions)

$360

Service cost ? Interest cost 36 🠞 (10% x $360) Loss (gain) on PBO 0 Less: Retiree benefits (54) End of the year $465 Service cost = $465 – $360 – $36 + $54 = $123 million

17–850

Exercise 17– 851

Plan assets Beginning of the year Actual return

($ in millions)

$700 77

🠞 (11% x $700)

Cash contributions ? Less: Retiree benefits (66) End of the year $750 Cash contributions = $750 – $700 – $77 + $66 = $39 million

17–851

Exercise 17– 852

($ in 000s) Service cost $112 Interest cost (6% x $850) 51 Expected return on the plan assets ($99 actual, less $9 gain*) (90) Amortization of prior service cost 8 Amortization of net loss 1

Pension expense

$ 82

* (11% x $900) – (10% x $900) The service cost component of pension expense ($112,000) is reported in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense ($30,000 [gain]) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

17–852

Exercise 17– Under IFRS the various components of pension expense Sterling 853 Properties would separately report service cost (including past service cost), net interest cost/income, and remeasurement gains and losses: ($ in 000s) Income statement: Service cost—2024 $112 Past service cost 80 Service cost (reported in income statement)$192 Net interest income* (6%** x [$900 – $850]) $ (3) Statement of comprehensive income: Remeasurement gain–OCI ([11% – 6%] x $900])$ (45) Net pension cost (not separately reported) $144 * Because plan assets exceed the DBO, we have net interest income rather than net interest cost ** This solution assumes that the 6% interest rate is also the interest rate for high-quality corporate bonds, which is the rate prescribed for determining the net interest cost/income. Note: Using IFRS, there would be no prior service cost in AOCI and no amortization of the net loss.

17–853

Exercise 17– 854 Requirement 1

($ in millions) Service cost $20 Interest cost 12 Expected return on the plan assets ($9 actual, less $1 gain) Pension expense

(8)

$24

Requirement 2 (a) Pension expense (calculated above) Plan assets (expected return on plan assets) PBO ($20 service cost + $12 interest cost)

24 8

(b)

Plan assets Cash (contribution)

PBO Plan assets (given)

(c)

The service cost component of pension expense ($20M) is reported in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (nonservice cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense ($4M) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

17–854

The following entry also would be required for actual return in excess of the expected return, although it does not affect the pension expense or the plan asset funding:

17–855

Plan assets

17–856

Gain—OCI

17–857

17–858

17–859

Exercise 17–11 Requirement 1 ($ in 000s) Service cost $310 Interest cost (7% x $2,300) 161 Expected return on the plan assets ($216 actual, plus $24 loss*) Amortization of prior service cost 25 Amortization of net gain (6) Pension expense * (10% x $2,400) – (9% x $2,400)

(240)

$250

Requirement 2 (a) Pension expense (calculated above) 250 Plan assets (expected return on assets) 240 Amortization of net gain—OCI (current amortization)* 6 Amortization of prior service cost—OCI (current amortization)* PBO ($310 service cost + $161 interest cost) (b) (c) (d)

Loss—OCI ($216 actual return on assets – $240 expected return) Plan assets

Plan assets Cash (contribution)

245

PBO Plan assets (retiree payments)

270

25 471

24 245 270

The amortization amounts are reported as other comprehensive income in the statement of comprehensive income. The service cost component of pension expense ($310,000) is reported in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense ($60,000 [gain]) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

* Because Prior service cost—AOCI has a debit balance, we amortize it with a credit. We amortize a Net gain—AOCI (credit balance) with a debit. After the two amortization amounts are reported as 17–860

OCI in this year‘s statement of comprehensive income, the respective AOCI amounts in the balance sheet are reduced.

17–861

Exercise 17–12 Requirement 1

1.2% x service years x final year‘s salary = 1.2% x 20 x $270,000 = $64,800

Requirement 2 The present value of the retirement annuity at the end of 2049 is $64,800 x 9.10791* = $590,193 * Present value of an ordinary annuity of $1: n = 15, i = 7% (from Table 4)

Requirement 3 The PBO is the present value of the retirement benefits at the end of 2024: $590,193 x .18425* = $108,743 *

Present value of $1: n = 25, i = 7 % (from Table 2)

Requirement 4 1.2% x 20 x $80,000 = $19,200 $19,200 x 9.10791* = $174,872 $174,872 x .18425** = $32,220 * Present value of an ordinary annuity of $1: n = 15, i = 7% (from Table 4) ** Present value of $1: n = 25, i = 7% (from Table 2)

Requirement 5 1.2% x 21 x $270,000 = $68,040 $68,040 x 9.10791* = $619,702 $619,702 x .19715** = $122,174 * Present value of an ordinary annuity of $1: n = 15, i = 7% (from Table 4) ** Present value of $1: n = 24, i = 7% (from Table 2)

17–862

Exercise 17–12 (concluded) Requirement 6 PBO at the end of 2025 PBO at the end of 2024 Change in PBO

$122,174 (108,743) $ 13,431

Less: Interest cost ($108,743 x 7%) Service cost

(7,612) $ 5,819

The change due to service cost can be verified as follows ($1 difference due to rounding): (1.2% x 1 yr. x $270,000) x 9.10791 x 0.19715 = $5,818 annual retirement benefits from 2025 service

to discount to 2049 *

to discount to 2025 **

* Present value of an ordinary annuity of $1: n = 15, i = 7% (from Table 4) ** Present value of $1: n = 24, i = 7% (from Table 2)

17–863

Exercise 17–13 Requirement 1 ($ in 000s)

Net loss or gain Less: 10% corridor (threshold)* Excess Service period Amortization

Case 1

Case 2

Case 3

$320 – 331 none ÷ 12 none

$330 270 $ 60 15 $ 4

$260 170 $ 90 10 $ 9

* 10% times either the PBO or plan assets (beginning of the year), whichever is larger. Case 1

3,310 or 2,800: choose 3,310

Case 2

2,670 or 2,700: choose 2,700

Case 3

1,700 or 1,550: choose 1,700

Requirement 2 ($ in 000s)

Case 1

Case 2

Case 3

January 1, 2024, net loss or (gain) 2024 loss (gain) on plan assets 2024 amortization 2024 loss (gain) on PBO January 1, 2025

$320 (11) 0 (23) $286

$(330) (8) 4 16 $(318)

$260 2 (9) (265) $( 12)

Note: The balance in this account is recognized as part of accumulated other comprehensive income in the balance sheet.

17–864

Exercise 17–14 In the balance sheet, Liabilities increase by $274 million:  The PBO increases by $374 (service cost and interest cost); plan assets increase by $100 (expected return on assets plus the gain due to the actual return exceeding expectations). When those two accounts are reported in the balance sheet by netting the two together (PBO less plan assets), the net pension liability (underfunded plan) will increase by $274 million. Shareholders’ equity decreases by $274 million: Retained earnings:  Retained earnings decreases by the reduction of earnings by the $294 million expense. Accumulated other comprehensive income:  The prior service cost—AOCI (a negative shareholders‘ equity account) decreases by the $8 million amortization.  The net loss—AOCI (a negative shareholders‘ equity account) decreases by the $2 million amortization and by the $10 million gain—OCI. Retained earnings Prior service cost—AOCI Net loss—AOCI Shareholders‘ equity

$(294) 8 12 $ 274

Journal entries (not required): To record expense ($ in 000s) Pension expense (given) 294 Plan assets (expected return on assets) 90 Amortization of prior service cost—OCI (current amortization) 8 Amortization of net loss—OCI (current amortization) 2 PBO ($224 service cost + $150 interest cost) 374

17–865

To record gain on assets........................... Plan assets .............................................. Gain—OCI (actual return exceeded expected return)

17–866

10 10

Exercise 17–15

17–867

Balance, Jan. 1, 2024 Service cost Interest cost, 5% Expected return on assets Adjust for: Loss on assets

PBO

Plan Assets

Prior Service Cost –AOCI

Net Loss –AOCI

(800)

600

114

Pension Expense

Cash

Net Pension (Liability ) / Asset

(200)

(84)

(40)

(48)

48 (6)

(6)

Amortization:

Prior service cost

(6)

Amortization:

Net loss Gain on PBO Prior service cost Cash funding Retiree benefits Bal., Dec. 31, 2024

17–868

0 12

(0)

(12)

68 50

(50)

(862)

660

(68)

108

(202)

Exercise 17–16 Requirement 1 ($ in millions)

Pension expense (calculated below) 88* Plan assets (expected return on assets) 40 Amortization of net loss—OCI (current amortization)** 2 Amortization of prior service cost—OCI (current amortization)** 4 PBO ($80 service cost + $42 interest cost) 122

* Service cost Interest cost Expected return on the plan assets ($32 actual, plus $8 loss) Amortization of prior service cost Amortization of net loss Pension expense Computation of net loss amortization: Net loss—AOCI (previous losses exceeded previous gains) 10% of $600 PBO (greater than $400 plan assets) Amount to be amortized Amortization

$ 80 42 (40) 4 2 $ 88 $ 80 (60) $ 20 ÷ 10 years $ 2

The amortization amounts are reported as other comprehensive income in the statement of comprehensive income. The service cost component of pension expense ($80M) is reported in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (nonservice cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense ($8M) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

** Because Prior service cost—AOCI and Net loss—AOCI have debit balances, we amortize them with a credit. We would amortize a Net gain—AOCI (credit balance) with a debit. After the two Solutions Manual, Chapter 17 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

17–869

amortization amounts are reported as OCI in this year‘s statement of comprehensive income, the respective AOCI amounts in the balance sheet are reduced.

17–870

Exercise 17–16 (concluded) Note: At first glance, it may appear that the Prior service cost—AOCI and Net loss—AOCI are being amortized over different time periods since the balance in the PSC is $28 and the amortization is $4 and $28 ÷ 4 = 7. Actually, though, both the PSC and the net loss are amortized in 2024 using 10 years. Remember, the PSC arose 3 years ago, so 3 year‘s amortization would be 3 x $4 = $12. Added to the current balance of $28, we see the original PSC was $40. Amortizing that balance by 10 years (same as used to amortize the net loss) gives us the $4. (It‘s also possible that the average remaining service life three years ago could have been slightly different than now, since that number can change over time, but not by much.)

Requirement 2 ($ in millions)

Loss—OCI ($32 actual return on assets – $40 expected return) Plan assets

PBO Gain—OCI (from change in assumption regarding the PBO)

Requirement 3 ($ in millions)

Plan assets Cash (contribution)

90 90

Requirement 4 ($ in millions)

PBO Plan assets (retiree benefit payments)

38 38

17–871

Exercise 17–17 List A

List B

d_ 1. Future compensation levels estimated. a. Actual return exceeds expected f_

2. All funding provided by the employer. b. Net gain—AOCI

a_ 3. Credit to OCI and debit to plan assets. l_

4. Retirement benefits specified

c. Vested benefit obligation d. Projected benefit obligation e. Choice between PBO and ABO

by formula. e_ 5. Trade-off between relevance and representational faithfulness.

f. Noncontributory pension plan g. Accumulated benefit obligation h. Plan assets

b_ 6. Cumulative gains in excess of losses.

i. Interest cost

g_ 7. Current pay levels implicitly assumed. j. Delayed recognition in earnings i_

8. Created by the passage of time.

k. Defined contribution plan

c_ 9. Not contingent on future employment. l. Defined benefit plan k_ 10. Risk borne by employee.

m. Prior service cost

h_ 11. Increased by employer contributions.

n. Amortize net loss—AOCI

m_12. Caused by plan amendment. j_ 13. Loss on plan assets. n_ 14. Excess over 10% of plan assets or PBO.

17–17

Exercise 17–18 Requirement 1 A decrease in the discount rate from 7% to 6% increases the projected benefit obligation. The lower the discount rate in a present value calculation, the higher the present value. When the obligation increases, it is reported as a loss. Requirement 2 ($ in millions)

Loss—OCI (from change in discount rate) PBO

13 13

U.S. GAAP requires that actuarial gains and losses be included among OCI items in the statement of comprehensive income, thus subsequently become part of AOCI. Requirement 3 Reporting actuarial gains and losses among OCI items in the statement of comprehensive income also is required under IAS No. 19, referred to as remeasurement gains and losses. Under IAS No. 19 they are not subsequently amortized to expense and recycled or reclassified from other comprehensive income as is required under U.S. GAAP (if the net gain or net loss exceeds the 10% corridor threshold). So, the entry might be identical to the one in Requirement 2 except we call it a ―remeasurement‖ loss and the projected benefit obligation is called the defined benefit obligation (DBO): ($ in millions)

Remeasurement loss—OCI (from change in discount rate) DBO

17–18

13 13

Exercise 17– 874 Requirement 1

($ in millions)

Pension expense (calculated below) 67* Plan assets (expected return on assets) 45 Amortization of net gain—OCI (current amortization) ** 2 Amortization of prior service cost—OCI (current amortization) ** 8 PBO ($82 service cost + $24 interest cost) 106 * Service cost Interest cost Expected return on the plan assets ($40 actual, plus $5 loss) Amortization of prior service cost Amortization of net gain Pension expense

$ 82 24 (45) 8 (2) $ 67

** Because Prior service cost–AOCI has a debit balance, we amortize it with a credit. We amortize a Net gain–AOCI (credit balance) with a debit. After the two amortization amounts are reported as OCI in this year‘s statement of comprehensive income, the respective AOCI amounts in the balance sheet are reduced.

Computation of net gain amortization: Net gain—AOCI (previous gains exceeded previous losses) 10% of $500 plan assets (greater than $480 PBO) Amount to be amortized Amortization

$ 80 (50) $ 30 ÷ 15 years $ 2

Companies report the service cost component of pension expense ($82M) in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense (– $15M [gain]) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

17–874

Exercise 17–19 (continued) Requirement 2 Journal entries to record gains and losses ($ in millions)

PBO (given) ............................................. Gain—OCI (from change in assumption regarding the PBO)

Loss—OCI ($40 actual return on assets – $45 expected return) Plan assets...........................................

10 5

Requirement 3 ($ in millions)

Plan assets Cash (contribution)

PBO Plan assets (benefit payments)

70 40

Requirement 4 SHAREHOLDERS’ EQUITY: ACCUMULATED OTHER COMPREHENSIVE INCOME

(a)

Net Gain—AOCI 80 10

Jan. 1 balance New gain

Dec. 31 balance

New loss 5 Amortized in 2024 2

(b)

Prior Service Cost—AOCI

Jan. 1 balance

17–875

8 Dec. 31 balance

17–876

Amortized in 2024

Exercise 17–19 (concluded)

Requirement 5 The pension plan is overfunded. Beale will report a net pension asset of $34 million in its 2024 balance sheet:

Plan assets 2023 2024

$500 $570

– – –

PBO =

Net pension asset

$480 = $536 =

$20 $34

17–877

Exercise 17–20

17–878

PBO

Balance, Jan. 1, 2024 (480) (82) Service cost Interest cost, 5% (24) Expected return on assets Adjust for: Loss on assets

Plan Assets

Prior Service Cost –AOCI

Net Gain –AOCI

500

(80)

45 (5)

Pension Expense

Cash

Net Pension (Liability) / Asset

20 (82)

(24)

(45)

(5)

Amortization of:

Prior service cost Net gain Gain on PBO Cash funding Retiree benefits Balance, Dec. 31, 2024

(8) 2 10

8 (2)

(10)

70 40

(40)

(536)

570

(70)

(83)

17–879

17–880

Exercise 17–21 Requirement 1 ($ in millions)

Service cost Interest cost Expected return on the plan assets ($27 actual, less $3 gain) Amortization of prior service cost Amortization of net gain or net loss—AOCI Pension expense

$ 60 27 (24) 0* 0 $ 63

* Since the amendment was at the end of the year, there is no amortization of prior service cost in 2024.

Requirement 2 ($ in millions)

(a)

(b)

(c)

(d)

(e)

Pension expense (calculated above) Plan assets (expected return on assets) PBO ($60 service cost + $27 interest cost)

63 24

Plan assets Gain—OCI ($27 actual return on assets – $24 expected return)

Prior service cost—OCI (from 2024 amendment) PBO

Plan assets Cash (funding contribution)

PBO Plan assets (retiree benefits)

17–881

Companies report the service cost component of pension expense ($60M) in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense (– $3M [loss]) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

17–882

Exercise 17–22 Under U.S. GAAP, prior service cost is included among other comprehensive income items in the statement of comprehensive income and thus subsequently becomes part of accumulated other comprehensive income where it is amortized over the average remaining service period. Under IAS No. 19, past service cost (called prior service cost under U.S. GAAP) is expensed immediately as part of the service cost for the year. Requirement 1 Income statement: Service cost—2024 Past service cost Service cost

($ in millions)

$ 60 12 $ 72

Net interest cost (7.5% x [$360 – $240])

Other comprehensive income: Remeasurement gain—OCI ($27 – [7.5% x $240])

($ 9)

Net pension cost (not separately reported)

$ 72

17–883

Exercise 17–22 (concluded) Requirement 2 ($ in millions)

Service cost DBO (2024 service cost) DBO (past service cost)

Net interest cost (7.5% x [$360 – $240]) Plan assets (7.5% x $240: interest income) DBO (7.5% x $360: interest cost)

9 18

Plan assets (actual return in excess of 7.5%) Remeasurement gain—OCI ($27 – [7.5% x $240])

60 12

When Lacy adds its annual cash investment to its plan assets, the value of those plan assets increases by $60 million: To Record Funding Plan assets Cash (contribution to plan assets)

60 60

Lacy‘s retired employees were paid benefits of $37 million in 2024. Paying those benefits, of course, reduces the obligation to pay benefits (the DBO), and since the payments are made from the plan assets, that balance is reduced as well: To Record Payment of Benefits DBO Plan assets

17–884

37 37

Exercise 17– B 1. Change in actuarial assumptions for a defined benefit pension plan. 885 C

Determination that the accumulated benefits obligation under a pension plan exceeded the fair value of plan assets at the end of the previous year by $17,000. The only pension-related amount on the balance sheet was net pension liability of $30,000. Pension plan assets for a defined benefit pension plan achieving a rate of return in excess of the amount anticipated. Instituting a pension plan for the first time and adopting GAAP for employers‘ accounting for defined benefit pension and other postretirement plans.

17–885

Exercise 17– 886 Requirement 1

$72,000 EPBO 2024

Requirement 2 $72,000 x 2/[2+28] EPBO 2024

Requirement 3 $72,000 x EPBO 2024

Requirement 4 $76,320 x EPBO 2025

17–886

= $4,800

fraction earned

APBO 2024

1.06

= $76,320

to accrue interest

EPBO 2025

3/30

= $7,632

fraction earned

APBO 2025

Exercise 17– 887 Requirement 1 $50,000 x EPBO

3/25 fraction earned

= $6,000 APBO

Requirement 2 $6,000 (beginning APBO) x 6% = $360

Requirement 3 $53,000 x

1/25

EPBO 2024

attributed to 2024

= $2,120 service cost

Requirement 4 Postretirement benefit expense ($360 + $2,120)..... APBO............................................................

2,480 2,480

17–887

Exercise 17– 888 Requirement 1

22 years

Requirement 2

$44,000

Requirement 3 $44,000 x

?/22

= $20,000

EPBO

fraction earned

APBO

$44,000 x

10/22

= $20,000

EPBO

fraction earned

APBO

10 years before 2024: beginning of 2015 (or end of 2014) Requirement 4 $

17–888

1.10

= $44,000

EPBO beg.

interest multiple

EPBO end

$40,000 x

1.10

= $44,000

EPBO beg.

interest multiple

EPBO end

or, alternatively: x 9/22 $?

= $16,364

EPBO

fraction earned

APBO

$40,000 x

9/22

= $16,364

EPBO

fraction earned

APBO

Exercise 17–27 Requirement 1 ($ in 000s) Service cost Interest cost (7% x $700) Return on the plan assets (10% x $50) Amortization of prior service cost Amortization of net gain

$124 49 (5) 0 (1)

Postretirement benefit expense

$167

Requirement 2 ($ in 000s)

(a)

(b)

(c)

Postretirement benefit expense (calculated above) ................................ 167 Plan assets (expected return on assets) ........................................... 5 Amortization of net gain—OCI (current amortization)* ............... 1 APBO ($124 service cost + $49 interest cost) ..............................

173

Plan assets ..................................................................................... 185 Cash (contributions to fund) .....................................................

185

APBO ........................................................................................ Plan assets (retiree benefits) ....................................................

The amortization amount is reported as other comprehensive income on the statement of comprehensive income. Companies report the service cost component of postretirement benefit expense ($124,000) in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of postretirement benefit expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The nonservice cost components of postretirement benefit expense ($43,000) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

17–889

* We amortize a Net gain–AOCI (credit balance) with a debit.

17–890

Exercise 17– 891 Requirement 1 ($ in 000s)

$336 (280) $ 56 ÷ 14 $ 4

Net loss (previous losses exceeded previous gains) 10% of $2,800 ($2,800 is greater than $500) Excess at the beginning of the year Average remaining service years Amount amortized to 2024 expense

Requirement 2 ($ in 000s)

Postretirement benefit expense exclusive of net loss amortization Amortization of net loss Postretirement benefit expense

$212 4 $216

Requirement 3 ($ in 000s)

Net loss, beginning of 2024 2024 gain on plan assets ([10% – 9%] x $500) 2024 amortization 2024 loss on PBO Net loss, end of 2024

$336 (5) (4) 39 $366

17–891

Exercise 17– 892 ($ in millions)

Requirement 1 Service cost Interest cost Return on plan assets Amortization of prior service cost Postretirement benefit expense

$34 12 🠞 (8% x [$130 + $20]) (0) 1🠞($20 ÷ 20 yrs) $47

Requirement 2 ($ in millions)

Postretirement benefit expense (calculated above)........................ Amortization of prior service cost—OCI (amortization)* ....... APBO ($34 service cost + $12 interest cost)................................

47 1 46

The amortization amount is reported as other comprehensive income in the statement of comprehensive income. Companies report the service cost component of postretirement benefit expense ($34M) in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of postretirement benefit expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of postretirement benefit expense ($13M) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations. * Because Prior service cost—AOCI has a debit balance, we amortize it with a credit. After the amortization amount is reported as OCI in this year‘s statement of comprehensive income, the respective AOCI amount in the balance sheet is reduced.

17–892

Exercise 17– 893 Requirement 1 The ―negative‖ prior service cost is first offset against any existing prior service cost before it is amortized. ($ in 000s)

Prior service cost Reduction for amendment Negative prior service cost Service period to full eligibility Amortization

Requirement 2 Service cost Interest cost Return on plan assets Amortization of prior service cost Postretirement benefit expense

$ 50 (80) $(30) ÷ 15 years $ 2

$114 36 🠞 (8% x [$530 – $80]) (0) (2) 🠞 ([$50 – $80] ÷ 15 yrs) $148

17–893

Exercise 17– 894 Requirement 1 ($ in 000s) Year

Number of Employees Still Employed

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034

100 90 80 70 60 50 40 30 20 10

Fraction of Total Service Years 100/550 90/550 80/550 70/550 60/550 50/550 40/550 30/550 20/550 10/550

x x x x x x x x x x

Prior Service Cost

Amount Amortized

$110 110 110 110 110 110 110 110 110 110

= $ 20 = 18 = 16 = 14 = 12 = 10 = 8 = 6 = 4 = 2

_ Totals

550/550

550*

$110

Total Number of Service Years

Total Amount Amortized

Requirement 2 $110,000 ÷ 5.5 years* = $20,000/year * The average service life is the total estimated service years divided by the total number of employees in the group: 550 years ÷ 100 = 5.5 years total number of service years

17–894

total number of employees

average service years

Exercise 17– 895 Requirement 1

The specific citation that describes the guidelines is found in FASB ASC 715– 60–35: ―Compensation–Retirement Benefits–Defined Benefit Plans–Other Postretirement–Subsequent Measurement.‖ a. What is the objective for attributing expected postretirement benefit obligations to years of service: 715–60–35–61 b. When does the attribution period for expected postretirement benefits begin for an employee: 715–60–35–66 c. When does the attribution period for expected postretirement benefits end for an employee: 715–60–35–68 Requirement 2 Specifically, the guidelines are: Attribution 35-61 In the context of this Subtopic, attribution is the process of assigning the expected cost of benefits to periods of employee service. The general objective is to assign to each year of service the cost of benefits earned or assumed to have been earned in that year. 35-66 The beginning of the attribution period generally is the date of hire. However, if the plan's benefit formula grants credit only for service from a later date and that credited service period is not nominal in relation to employees' total years of service before their full eligibility dates, the expected postretirement benefit obligation is attributed from the beginning of that credited service period. 35-68 In all cases, the end of the attribution period shall be the full eligibility date. For postretirement benefit plans that are pay-related or that otherwise index benefits during employees' service periods to their retirement date, the full eligibility date and retirement date may be the same. The attribution period for those benefits will differ from the attribution period for a similarly defined pension benefit with a capped credited service period.

17–895

Exercise 17–33 The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1.

The disclosure required in the notes to the financial statements for plan assets: FASB ASC 715–20–50–1: ―Compensation-Retirement Benefits–Defined Benefit Plans-General–Disclosure–Disclosures by Public Entities.‖

Recognition of the net pension asset or net pension liability: FASB ASC 715–30–25–1: ―Compensation-Retirement Benefits–Defined Benefit Plans-Pension–Recognition–Recognition of Liabilities and Assets.‖

Disclosures required in the notes to the financial statements for pension cost for a defined contribution plan: FASB ASC 715–70–50–1: ―Compensation-Retirement Benefits–Defined Contribution Plans-Disclosure–General.‖

17–896

PROBLEMS

17–897

Problem 17– 898 date Requirementmeasurement 1  2024 (end)

2010 (beg.)

2044 (end)



15 years 20 years Service period

2062 (end) 18 years Retirement

Requirement 2 1.6% x 15 x $90,000 = $21,600

Requirement 3 The present value of the retirement annuity as of the retirement date (end of 2044) is: $21,600 x 10.05909* = $217,276 * Present value of an ordinary annuity of $1: n = 18, i = 7% (from Table 4)

The ABO is the present value of the retirement benefits at the end of 2024: $217,276 x .25842* = $56,148 * Present value of $1: n = 20, i = 7% (from Table 2)

Requirement 4 1.6% x 18 x $100,000 = $28,800 $28,800 x 10.05909* = $289,702 $289,702 x 0.31657** = $91,711 * Present value of an ordinary annuity of $1: n = 18, i = 7% (from Table 4) ** Present value of $1: n = 17, i = 7% (from Table 2)

17–898

Problem 17– 899 date Requirementmeasurement 1  2024 (end)

2010 (beg.)

2044 (end)

2062 (end)

 15 years 20 years Service period

18 years Retirement

Requirement 2 1.6% x 15 x $240,000 = $57,600

Requirement 3 The present value of the retirement annuity as of the retirement date (end of 2044) is: $57,600 x 10.05909* = $579,404 [This is the lump-sum equivalent of the retirement annuity as of the retirement date.] * Present value of an ordinary annuity of $1: n = 18, i = 7% (from Table 4)

The PBO is the present value of the retirement benefits at the end of 2024: $579,404 x .25842* = $149,730 * Present value of $1: n = 20, i = 7% (from Table 2)

Requirement 4 1.6% x 18 x $240,000 = $69,120 $69,120 x 10.05909* = $695,284 $695,284 x .31657** = $220,106 * Present value of an ordinary annuity of $1: n = 18, i = 7% (from Table 4) ** Present value of $1: n = 17, i = 7% (from Table 2)

17–899

Problem 17– 900 Requirement 11.6% x 14 x $240,000 = $53,760 $53,760 x 10.05909* = $540,777 $540,777 x .24151** = $130,603 * Present value of an ordinary annuity of $1: n = 18, i = 7% (from Table 4) ** Present value of $1: n = 21, i = 7% (from Table 2)

Requirement 2 1.6% x 1 x $240,000 = $3,840

Requirement 3 $3,840 x 10.05909* = $38,627 $38,627 x .25842** = $9,982 * Present value of an ordinary annuity of $1: n = 18, i = 7% (from Table 4) ** Present value of $1: n = 20, i = 7% (from Table 2)

Requirement 4 $130,603 x 7% = $9,142 Requirement 5 PBO at the beginning of 2024 (end of 2023) Service cost: Interest cost: $130,603 x 7% PBO at the end of 2024

$130,603 9,982 9,142 $149,727

Note: In requirement 3 of the previous problem this same amount is calculated without separately determining the service cost and interest elements (allowing for a $3 rounding adjustment).

17–900

Problem 17– 901 Requirement 1 PBO Without Amendment 1.6% x 15 yrs. x $240,000 = $57,600 $57,600 x 10.05909* = $579,404 $579,404 x .25842** = $149,730

PBO With Amendment 1.75% x 15 yrs. x $240,000 = $63,000 $63,000 x 10.05909* = $633,723 $633,723 x .25842** = $163,767 $14,037 Prior service cost

* Present value of an ordinary annuity of $1: n = 18, i = 7% (from Table 4) ** Present value of $1: n = 20, i = 7% (from Table 2) Alternative calculation: 1.75 – 1.6 =

0.15% x 15 yrs x $240,000 = $5,400 $5,400 x 10.05909* = $54,319 $54,319 x .25842** = $14,037

Requirement 2 $14,037 ÷ 20 years (expected remaining service) = $702 Requirement 3 1.75% x 1 x $240,000 = $4,200 $4,200 x 10.05909* = $42,248 $42,248 x .27651** = $11,682 * Present value of an ordinary annuity of $1: n = 18, i = 7% (from Table 4) ** Present value of $1: n = 19, i = 7% (from Table 2)

Requirement 4 $163,767 x 7% = $11,464 Requirement 5 Service cost (from req. 3) Interest cost (from req. 4) Return on the plan assets (10% x $150,000) Amortization of prior service cost (from req. 2) Pension expense

$11,682 11,464 (15,000) 702 $ 8,848

17–901

Problem 17–5 PBO With Previous Rate 1.6% x 15 yrs x $240,000 = $57,600 $57,600 x 10.059091 = $579,404 $579,404 x .258422 = $149,730

PBO With Revised Rate 1.6% x 15 yrs x $240,000 = $57,600 $57,600 x 9.371893 = $539,821 $539,821 x .214554 = $115,819 $33,911

Gain on PBO 1 Present value of an ordinary annuity of $1: n = 18, i = 7% (from Table 4) 2 Present value of $1: n = 20, i = 7% (from Table 2) 3 Present value of an ordinary annuity of $1: n = 18, i = 8% (from Table 4) 4 Present value of $1: n = 20, i = 8% (from Table 2)

17–902

Problem 17–6 1.

Projected Benefit Obligation Balance, January 1, 2024 Service cost Interest cost (6% x $0) Benefits paid Balance, December 31, 2024 Service cost Interest cost (6% x $150) Benefits paid Balance, December 31, 2025 Plan Assets Balance, January 1, 2024 Actual return on plan assets (10% x $0) Contributions, 2024 Benefits paid Balance, December 31, 2024 Actual return on plan assets (10% x $160) Contributions, 2025 Benefits paid Balance, December 31, 2025 Pension expense—2024 Service cost Interest cost (6% x $0) Expected return on the plan assets (10% x $0) Pension expense Pension Expense—2025 Service cost Interest cost (6% x $150) Expected return on the plan assets (10% x $160) Pension expense Net pension asset or net pension liability PBO Plan assets Net pension asset, Dec. 31, 2024 PBO Plan assets

($ in 000s)

0 150 0 (0) $150 200 9 (0) $359 $

0 0 160 (0) $160 16 170 (0) $346 $150 0 0 $150 $200 9 (16) $193 $150 160 $ 10 $359 346

17–903

Net pension liability, Dec. 31, 2025

17–904

$ 13

Problem 17–7 Requirement 1 ($ in 000s)

Net gain (previous gains exceeded previous losses)

$170

10% of $1,400 ($1,400 is greater than $1,100)

140

Excess at the beginning of the year

$ 30

Average remaining service period years Amount amortized to 2024 pension expense

15 $ 2

Requirement 2 Pension expense exclusive of net gain amortization Amortization of net gain Pension expense

$325 (2) $323

Requirement 3 Net gain—AOCI, beginning of 2024

$(170)

2024 loss on plan assets ([10% – 9%] x $1,100)

2024 amortization

2024 gain on PBO

(23)

Net gain—AOCI, end of 2024 (beg. of 2025)

$(180)

17–905

Problem 17–8

17–906

( )s indicate credits; debits otherwise ($ in millions)

Balance, Jan. 1, 2024

Service cost Interest cost, 10% Expected return on assets Adjust for: Loss on assets

PBO

(830) (74)

Plan Assets

Prior Service Cost –AOCI

Net Loss –AOCI

680

(83) 68 (7)

Pension Expense

Cash

Net Pension (Liability) / Asset

(150) (74)

(83)

(68)

(7)

Amortization of:

Prior service cost Net loss Loss on PBO Prior service cost Cash funding Retiree benefits Bal., Dec. 31, 2024

(5) (1) (13)

5 1

(40)

(13)

(40)

84 50

(50)

(990)

775

(84)

112

(215)

17–907

Problem 17–8 (concluded)

19–908

Calculations:

19–909

Interest cost = $830 x 10% = $83

19–910

Expected return on assets = $680 x 10% = $68

19–911

Amortization of net loss:

19–912

Net loss—AOCI

$93

19–913

Corridor: 10% x $830

19–914

Excess

$10

19–915

Avg. service life

19–916

÷ 10 years

2024 Amortization

Requirement 2 ($ in millions)

Pension expense (total) ............................................................ Plan assets (expected return on plan assets) ................................... PBO ($74 service cost + $83 interest cost) .................................. Amortization of prior service cost—OCI (2024 amortization). Amortization of net loss—OCI (2024 amortization)................

95 68 157 5 1

The amortization amounts are reported as other comprehensive income in the statement of comprehensive income. Companies report the service cost component of pension expense ($74M) in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense ($21M) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations. Requirement 3 Record gains and losses ($ in millions)

Loss—OCI ($61 actual return on assets less than $68 expected return) Plan assets...........................................

Loss—OCI (from change in assumption regarding the PBO) PBO ...................................................................................

Record new prior service cost Prior service cost—OCI (from new amendment to the PBO).......... PBO ...................................................................................

7 13 40 40

19–917

Problem 17–8 (concluded) Requirement 4 ($ in millions)

(a) Plan assets Cash (contribution to plan assets) (b) PBO Plan assets (retiree benefits)

19–918

84 84 50 50

Problem 17–9 Requirement 1 ($ in 000s) Pension expense Service cost $60 Interest cost (5% x $320) 16 Return on the plan assets (9% x $400) (36) Amortization of prior service cost 0 Amortization of net loss or gain 0 Pension expense $40

Requirement 2 Projected Benefit Obligation Balance, January 1 Service cost Interest cost Benefits paid Balance, December 31

$320 60 16 (44) $352

Requirement 3 Plan Assets Balance, January 1 Actual return on plan assets Contributions 2024 Benefits paid Balance, December 31

$400 36 120 (44) $512

19–919

Problem 17–9 (concluded) Requirement 4 Net Pension Asset or Net Pension Liability Plan assets PBO Net pension asset, Dec. 31, 2024

$512 (352) $160

Requirement 5 ($ in 000s)

(a) Pension expense (total) ............................................................ Plan assets (expected return on plan assets) ................................... PBO ($60 service cost + $16 interest cost) .................................. Amortization of prior service cost—OCI (2024 amortization)* Amortization of net loss—OCI (2024 amortization)* ..............

40 36 76 0 0

The amortization amounts are reported as other comprehensive income in the statement of comprehensive income. Companies report the service cost component of pension expense ($60,000) in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense (—$20,000 [gain]) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations. * Because Prior service cost—AOCI and Net loss—AOCI have debit balances, we amortize them with credits. We would amortize a Net gain—AOCI (credit balance) with a debit. After the two amortization amounts are reported as OCI in this year‘s statement of comprehensive income, the respective AOCI amounts in the balance sheet are reduced.

(b) (c)

19–920

Plan assets Cash (contribution to plan assets) PBO Plan assets (retiree benefits)

120 120 44 44

Problem 17–10 Requirement 1 ($ in millions)

Service cost Interest cost Expected return on the plan assets ($20 actual, plus $4 loss) Amortization of prior service cost Amortization of net gain or net loss—AOCI 0 Pension expense

$ 75 45 (24) 0* $ 96

* Since the amendment was at the end of the year, there is no amortization of prior service cost in 2024. Companies report the service cost component of pension expense ($75M) in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense ($21M) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

19–921

Problem 17–10 (continued) Requirement 2 ($ in millions)

(a) Pension expense (calculated above) Plan assets (expected return on assets: 8% x $300) PBO ($75 service cost + $45 interest cost)

96 24

(b) PBO Gain—OCI (change in assumption)

(b) Loss—OCI ($20 actual return – $24 expected return) Plan assets

(d) Plan assets Cash (funding contribution)

(e) PBO Plan assets (retiree benefits)

19–922

120

Problem 17–10 (concluded) Requirement 3 ($ in millions)

PBO balance, January 1 $480 Service cost 75 Interest cost 45 Gain from change in actuarial assumption (22) Prior service cost (new) 12 Benefits paid (36) PBO balance, December 31

$554

Plan assets balance, January 1 Actual return on plan assets Contributions 2024 Benefits paid Plan assets balance, December 31

$300 20 60 (36) $344

Because the plan is underfunded, Electronic Distribution will report a net pension liability: PBO balance, December 31 Plan assets balance, December 31 Net pension liability

$554 (344) $210

19–923

Problem 17–11 Requirement 1 ($ in millions)

Reported in income statement: Service cost—2024 Past service cost Service cost

$ 75 12 $ 87

Net interest cost (10% x [$480 – $300])

$ 18

Reported as OCI: $(22) Remeasurement gain from assumption change—OCI Remeasurement loss on plan assets—OCI ($20 – [10% x $300]) 10 Net pension cost (not separately reported)

19–924

(12) $ 93

Problem 17–11 (continued) Requirement 2 ($ in millions)

(a) Service cost DBO (Service cost—2024) DBO (past service cost)

(a) Net interest cost (10% x [$480 – $300]) Plan assets (10% x $300: interest income) DBO (10% x $480: interest cost)

18 30

(a) Remeasurement loss—OCI ($20 – [10% x $300]) Plan assets (actual return below 10%)

(a) DBO Remeasurement gain—OCI (given)

75 12

When Electronic adds its annual cash investment to its plan assets, the value of those plan assets increases by $60 million: (b) Plan assets Cash (contribution to plan assets)

60 60

Retired employees were paid benefits of $36 million in 2024. Paying those benefits, of course, reduces the obligation to pay benefits (the DBO), and since the payments are made from the plan assets, that balance is reduced as well: (c) DBO Plan assets

19–925

Problem 17–11 (concluded) Requirement 3 ($ in millions)

DBO balance, January 1 $480 Service cost 75 Interest cost (10% x $480) 48 Gain from change in actuarial assumption (22) Past service cost 12 Benefits paid (36) DBO balance, December 31

$557

Plan assets balance, January 1 Actual return on plan assets Contributions 2024 Benefits paid Plan assets balance, December 31

$300 20 60 (36) $344

Because the plan is underfunded, Electronic Distribution will report a net pension liability: DBO balance, December 31 Plan assets balance, December 31 Net pension liability

19–926

$557 (344) $213

Problem 17–12 Requirement 1

($ in millions)

Service cost (given) Interest on PBO (2024: 10% x $2,200*; 2025: 10% x $2,560*) Expected return (2024: 12% x $1,600; 2025: 12% x $1,940**) Amortization of prior service cost ($400 ÷ 10 years) Amortization of net gain *** Pension expense *PBO

2024 $520 220 (192) 40 (5) $583

2025 $570 256 (232.8) 40 none $633.2

**Plan Assets

Balance, 1-1-2024 Prior service cost Balance, 1-2-2024 Interest 10% Service cost Payments Balance, 12-31-2024 Interest 10% Service cost Payments Balance, 12-31-2025

$1,800 400 $2,200 220 520 (380) $2,560 256 570 (450) $2,936

Balance, 1-1-2024

$1,600

2024 contribution 540 2024 actual return 180 Payments (380) Balance, 12-31-2024 $1,940 2025 contribution 590 2025 actual return 210 Payments (450) Balance, 12-31-2025 $2,290

*** Net Gain—AOCI

2024 Net gain—AOCI at 1-1-2024 $230 10% of $1,800 ($1,800 is greater than $1,600): (180) Excess at the beginning of the year $ 50 Average remaining service period ÷ 10 years Amount amortized to 2024 pension expense $ 5 2025 Net gain—AOCI at 1-1-2024 $230 Loss in 2024 (actual return: $180 - expected return: $192) (12) Amortization in 2024 (calculated above) (5) Net gain—AOCI at 1-1-2025 $213 10% of $2,560 ($2,560 is greater than $1,940): (256) No excess at the beginning of the year none No amortization for 2025

19–927

Problem 17–12 (continued) Requirement 2 ($ in millions)

2024 Pension expense (total) ........................................................................... 583 Plan assets (expected return on plan assets) .............................................. 192 Amortization of net gain—OCI (2024 amortization)* ................. 5 PBO ($520 service cost + $220 interest cost)............................... Amortization of prior service cost—OCI (2024 amortization)*

740 40

2025 Pension expense (total) ........................................................................... 633.2 Plan assets (expected return on plan assets) .............................................. 232.8 PBO ($570 service cost + $256 interest cost)............................... 826.0 Amortization of prior service cost—OCI (2025 amortization)* 40.0 The amortization amounts are reported as other comprehensive income in the statement of comprehensive income. Companies report the service cost component of pension expense in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations. * Because Prior service cost—AOCI has a debit balance, we amortize it with a credit. We amortize a Net gain—AOCI (credit balance) with a debit. After the two amortization amounts are reported as OCI in this year‘s statement of comprehensive income, the respective AOCI amounts in the balance sheet are reduced.

19–928

Problem 17–12 (concluded) Requirement 3 ($ in millions)

2024 Loss—OCI ($180 actual return on assets less than $192 expected return) 12 Plan assets..........................................................................

Prior service cost—OCI (from new amendment to the PBO).......... PBO ...................................................................................

400

2025 Loss—OCI ($210 actual return on assets less than $232.8 expected) Plan assets..........................................................................

400

22.8 22.8

Requirement 4 ($ in millions)

(a) 2024 Plan assets Cash (contribution to plan assets)

540

(a) 2025 Plan assets Cash (contribution to plan assets)

590

(b) 2024 PBO Plan assets (benefit payments)

380

(b) 2025 PBO Plan assets (benefit payments)

450

540

590

380

450

19–929

Problem 17–13 Projected Benefit Obligation Balance on Jan. 1 $ 0 Prior service cost 2,000,000 Amortization of prior service cost

Plan Assets

Pension Expense

$ 0 2,000,000

Service cost Interest cost

250,000

$200,000 250,000

($2,000,000* x 9%)

180,000

($2,000,000 ÷ 10 years)

Return on plan assets Actual ($2,000,000** x 11%) Expected ($2,000,000** x 9%) Retirement payments Cash contribution Balance on Dec. 31

220,000 (180,000) (16,000) $2,414,000

(16,000) 250,000 $2,454,000

$450,000

Note: The $40,000 gain ($220,000 – $180,000), while not included in pension expense, is reported as a gain—OCI in the statement of comprehensive income; it is carried forward as part of accumulated other comprehensive income in the balance sheet to be combined with future gains and losses, which will be included in pension expense only if the net gain or net loss exceeds 10% of the higher of the PBO or plan assets. *

Since the plan was adopted at the beginning of the year, the prior service cost increased the PBO at that time.

** Since the prior service cost was funded at the beginning of the year, the plan assets were increased at that time.

19–930

Problem 17–14 1. Actual return on plan assets ($ in 000s)

Plan assets Beginning of 2024 Actual return Cash contributions Less: Retiree benefits End of 2024

$2,400

? 245 (270) $2,591

Actual return = $2,591 – $2,400 – $245 + $270 = $216

2. Loss or gain on plan assets Expected return Actual return Loss on plan assets 3. Service cost PBO: Beginning of 2024 Service cost Interest cost Loss (gain) on PBO Less: Retiree benefits End of 2024

$240 🠞 (10% x $2,400) (216) $ 24

$2,300

161 🠞 (7% x $2,300) 0 (270) $2,501

Service cost = $2,501 – $2,300 – $161 + $270 = $310

19–931

Problem 17–14 (concluded) 4. Pension expense ($ in 000s)

Service cost $310 Interest cost 161 🠞 (7% x $2,300) Expected return ($216 actual, plus $24 loss) (240) Amortization of: Prior service cost—AOCI 25 🠞 ($325 – $300) Net gain—AOCI (6) 🠞 ($330 – $300 – $24*) $250 Pension expense * 2024 loss on plan assets Companies report the service cost component of pension expense in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations. 5. Average remaining service life of active employees Net gain, Jan. 1 $330 10% of $2,400 240 Excess $ 90 Amount amortized ÷ 6 Average service period 15 years Note: If we use the Prior service cost–AOCI and its annual amortization to calculate average service period ($325 beginning balance / $25 amortization, we get 13 years. This points out a fundamental difference between the two types of ―amortization.‖ The average service period used to amortize PSC is the average remaining service period at the time the PSC originated (some unknown number of years prior to now). On the other hand, the average service period used to amortize the net gain is the average remaining service period as of the end of the current year, which can be, and in this case is, a different number. 19–932

Problem 17–15 ( )s indicate credits; debits otherwise ($ in 000s)

PBO

Plan Assets

Prior Service Cost –AOCI

Balance, Jan. 1, 2024

(4100) 4530

840

Service cost2 Interest cost, 7%1 Expected return on assets3 Adjust for: Loss on assets4

Net Loss –AOCI

477

Pension Expense

Cash

Net Pension (Liability) / Asset

430

(332)

332

(332)

(287)

287

(287)

(453)

453

453 (53)

(53)

Amortization of:

Prior service cost5 Net loss6 Gain on PBO Cash funding Retiree benefits

295

Bal., Dec. 31, 2024

(4380) 4975

(70) (2) 44

70 2

(44)

340

(340)

340

(295) 770

484

238

595

1 7% x $4,100 = $287 2 $4,380 – $4,100 – $287 + $44 + $295 = $332 3 10% x $4,530 = $453 (expected) 4 10% x $4,530 = $453 (expected) – $400 = $53 5 $840 ÷ 12 = $70 6 ($477 – $453) ÷ 12 = $2

19–933

19–934

Problem 17–16 Requirement 1 Calculation of pension expense: Service cost (given) Interest cost (given) Expected return on the plan assets ($15 actual, plus $5 loss) Amortization of prior service cost (given) Amortization of the net loss * Pension expense

($ in millions)

$48 24 (20) 4 1 $57

* Amortization of the net loss: Net loss—AOCI (previous losses exceeded previous gains) 10% of $300 ($300 is greater than $200): the ―corridor‖ (30) Excess at the beginning of the year $10 Average remaining service period  10 years Amount amortized to 2024 pension expense $1

$40

To record expense ($ in millions)

Pension expense (total) ............................................................ Plan assets (expected return on plan assets) ................................... PBO ($48 service cost + $24 interest cost) .................................. Amortization of prior service cost—OCI (2024 amortization)* Amortization of net loss—OCI (2024 amortization)* ..............

57 20 72 4 1

* Because Prior service cost—AOCI and Net loss—AOCI have debit balances, we amortize them with a credit. We would amortize a Net gain—AOCI (credit balance) with a debit. After the two amortization amounts are reported as OCI in this year‘s statement of comprehensive income, the respective AOCI amounts in the balance sheet are reduced.

Companies report the service cost component of pension expense in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (nonservice cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

19–935

Problem 17–16 (continued) To record funding and benefit payment ($ in millions)

Plan assets Cash (contribution to plan assets)

PBO Plan assets (benefit payments)

45 20

Requirement 2 To record gains and losses ($ in millions) Loss—OCI ($20 – $15 loss due to return on assets being less than expected) 5

Plan assets...........................................

5 2

PBO ........................................................ Gain—OCI ($2 gain on change of PBO assumption)

Requirement 3

($ in millions)

PBO

Plan Assets

Prior Service Cost –AOCI

Net Loss –AOCI

Bal., Jan. 1, 2024

(300)

200

Service cost Interest cost, 8% Expected return on assets Loss on assets Amortization of: Prior service cost–AOCI Net loss–AOCI

(48) (24)

Gain on PBO

( )s indicate credits; debits otherwise

(100) (48) (24) 20 (5)

5 (4) (1)

4 1

(2)

Retiree benefits

(20)

Bal., Dec. 31, 2024

(350)

240

19–936

Cash

48 24 (20)

20 (5)

Cash contributions

Pension Expense

(45)

Net Pension (Liability) / Asset

(110) Intermediate Accounting, 11/e

Problem 17–16 (continued) Requirement 4 Calculation of pension expense: Service cost (given) Interest cost (given) Expected return on the plan assets ($36 actual, less $12 gain) Amortization of prior service cost (given) Amortization of the net loss * Pension expense * Amortization of the net loss: Net loss—AOCI (previous losses exceeded previous gains) 10% of $350 ($350 is greater than $240): the ―corridor‖ (35) Excess at the beginning of the year $7 Average remaining service period  10 years Amount amortized to 2025 pension expense $ 0.7

($ in millions)

$38 28 (24) 4 0.7 $46.7

$42

To record expense ($ in millions)

Pension expense (total) ............................................................. Plan assets (expected return on plan assets) ................................... PBO ($38 service cost + $28 interest cost) .................................. Amortization of net loss—OCI (2025 amortization)* .............. Amortization of prior service cost—OCI (2025 amortization)*

46.7 24.0 66.0 0.7 4.0

* Because Prior service cost—AOCI and Net loss—AOCI have debit balances, we amortize them with credits. We would amortize a Net gain—AOCI (credit balance) with a debit. After the two amortization amounts are reported as OCI in this year‘s statement of comprehensive income, the respective AOCI amounts in the balance sheet are reduced.

We report the service cost component of pension expense in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

19–937

Problem 17–16 (continued) To record funding and benefit payments ($ in millions)

Plan assets ......................................................... Cash (contribution to plan assets) .........................

30.0

PBO ................................................................... Plan assets (benefit payments)............................

16.0

30.0

16.0

Requirement 5 To record gains and losses ($ in millions)

Loss—OCI ($5 loss on change of PBO assumption) PBO ....................................................

Plan assets .............................................. Gain—OCI ($36 actual return on assets exceeds $24 gain expected)

5 12

Requirement 6 SHAREHOLDERS’ EQUITY: ACCUMULATED OTHER COMPREHENSIVE INCOME

Net Loss—AOCI Balance, Jan. 1 New loss

42.0 5.0 12.0 0.7

Balance, Dec.31

34.3

New gain Amortized in 2025

Prior Service Cost–AOCI Balance, Jan. 1

28.0 4.0 Amortized in 2025

Balance, Dec.31

19–938

24.0

Problem 17–16 (concluded) Requirement 7

($ in millions)

PBO

Plan Assets

Prior Service Cost –AOCI

Bal., Jan. 1, 2025

(350)

240

Service cost Interest cost, 8% Expected return on assets Gain on assets Amortization of: Prior service cost–AOCI Net loss–AOCI Loss on PBO Cash contributions Retiree benefits

(38) (28)

30 (16)

Bal., Dec. 31, 2025

(405)

290

( )s indicate credits; debits otherwise

Net Loss –AOCI

Pension Expense

Cash

(110) 38 28 (24)

24 12

(38) (28) 24 12

(12) (4) (0.7) 5

(5)

4 0.7 (30)

34.3

Net Pension (Liability) / Asset

46.7

(5) 30

(115)

19–939

Problem 17–17 Requirement 1 To Record Pension Expense Deferred tax asset (25% x [$41 + $24 – $27]).............................. Pension expense ($41 + $24 – $27 + $4 + $1).............................. Plan assets (expected return on plan assets) ................................... PBO ($41 service cost + $24 interest cost) .................................. Amortization of prior service cost—OCI* (current amortization net of $1 tax benefit) .............................. Amortization of net loss—OCI*

($ in millions)

(current amortization net of $.25 tax benefit) ....................... Income tax expense (25% x $43) ..............................................

0.75 10.75

9.50 43.00 27.00 65.00 3.00

Although for financial reporting purposes the income is reduced now, only the actual contributions to the plan assets can be deducted for tax purposes. This creates a ―temporary difference‖ as described in Chapter 16. Remember, we already recorded the deferred tax asset for the net loss and the prior service cost, and amortizing a portion of those amounts now merely moves amounts to the income statement, not the tax return where a tax benefit would be realized. We do, however, need to record a deferred tax asset for the future deductible amounts created by the new amounts—service cost, interest cost, and return on assets. Also, because the annual tax expense should reflect both the current and deferred tax effects of what occurs each year, the 2024 tax expense is reduced by the $10.75 million eventual tax savings from the 2024 pension expense.

19–940

Problem 17–17 (continued) We report the service cost component of pension expense in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The nonservice cost components of pension expense are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations. Here is how the new gain and new loss would be recorded if we now include the tax implications: To Record New Gains and Losses Deferred tax asset (25% x $23).................. Loss—OCI ($23 loss, net of $5.75 tax benefit PBO .................................................... Plan assets .............................................. Gain—OCI ($3 gain, net of $0.75 tax expense) Deferred tax liability (25% x $3) ...........

($ in millions)

5.75 17.25 23.00 3.00 2.25 0.75

Global reported a $23 million loss in 2024 from revising an assumption used to calculate its PBO. That additional cost is recognized now on the statement of comprehensive income but won‘t be deducted until the pension benefits are paid in the future. This creates a future deductible amount and thus a deferred tax asset for 25% of the loss. In like manner, the $3 million gain creates a future taxable amount and thus a deferred tax liability for 25% of the gain. There are no tax effects of the funding and payment of benefits entries.

19–941

Problem 17–17 (continued) To Record Funding and Payment of Benefits Plan assets .............................................. Cash (contribution to plan assets)..............

($ in millions)

48 48

Earlier, when we recorded the pension expense, the book basis (financial statement carrying value) of the net pension liability increased relative to its tax basis (original value for tax purposes less amounts included to date on the tax return). That created a temporary difference and thus a deferred tax asset. This occurred also in previous years. Now, when $48 million cash is paid, that payment is deducted for tax purposes. This reduces our temporary difference and thus our deferred tax asset. As a portion of this asset is realized, income taxes payable is reduced as well: Income tax payable ................................. Deferred tax asset ($48 x 25%) ................

12 12

The payment for retiree benefits reduces both the obligation to make payments and the plan assets used to make the payment. There is no net tax effect of that transaction: PBO ........................................................ Plan assets (retiree benefits).......................

19–942

38 38

Problem 17–17 (concluded) Requirement 2 GLOBAL COMMUNICATIONS Statement of Comprehensive Income Year ended December 31, 2024 Net income $300.00 Other comprehensive income: Net unrealized holding gain on investments ($30, net of $7.5 tax) $ 22.50 Loss on pensions—PBO estimate ($23, net of $5.75 tax benefit) (17.25) Gain on pensions—return on plan assets ($3, net of $0.75 tax) 2.25 Reclassification: Amortization of net loss ($1, net of $0.25 tax) 0.75 Reclassification: Amortization of prior service cost ($4, net of $1 tax) 3.00 11.25 Comprehensive income $311.25

19–943

Problem 17–18 R equirement 1 Retirement Period 5 years

Attribution Period 26 years age 34 2001 (end)

age age 60 62 2027 2029 (end) (end)

age 67 2034 (end)

retirement  date hired

 ―full-eligibility‖ date

Requirement 2 Year End 2030 2031 2032 2033 2034

Expected Net Cost $4,000 4,400 2,300 2,500 2,800

PV of $1 n = 1–5, i = 6% x .94340 x .89000 x .83962 x .79209 x .74726

Present Value on Dec. 31, 2026 $ 3,774 3,916 1,931 1,980 2,092 $13,693

Requirement 3 $13,693 x .74726* = $10,232 *Present value of $1: n = 5, i = 6% (from Table 2)

19–944

Problem 17–18 (concluded) Requirement 4 $10,232 x 23 yrs*/26 yrs** = $9,051 * 2001-2024 ** Attribution period (2001–2027)

Requirement 5 $13,693 x .79209* = $10,846 (EPBO) * Present value of $1: n = 4, i = 6% (from Table 2)

$10,846 x 24 yrs*/26 yrs** = $10,012 * 2001–2025 ** attribution period (2001–2027)

Requirement 6 $13,693 x .79209* = $10,846 (EPBO) * Present value of $1: n = 4, i = 6% (from Table 2)

$10,846 x 1 yr/26 yrs = $417 Requirement 7 $9,051 (beginning APBO) x 6% = $543 Requirement 8 APBO at the beginning of 2025 (from req. 4) Service cost: (from req. 6) Interest cost: (from req. 7) APBO at the end of 2025 (agrees with req. 5*)

$ 9,051 417 543 $10,011

* $1 difference due to rounding.

19–945

Problem 17–19

2024 2025 2026 2027 2028 2029 2030 2031

EPBO

Fraction Earned

$18,000 19,800 1 21,780 23,958 26,354 28,989 31,888 35,077

1/8 2/8 3/8 4/8 5/8 6/8 7/8 8/8

Totals

APBO

Service Cost

$ 2,250 $ 2,250 4,950 2 2,475 3 8,168 2,723 11,979 2,995 16,471 3,294 21,742 3,624 27,902 3,986 35,077 4,385 $25,732

Interest Cost 10% $ 0 225 4 495 817 1,198 1,647 2,174 2,790

$ 2,250 2,700 5 3,218 3,812 4,492 5,271 6,160 7,175

$9,346

$35,078

Expense

1 $18,000 x 1.10 = $19,800 2 $19,800 x 2/8 = $4,950 3 $19,800 x 1/8 = $2,475 4 $2,250 (APBO) x 10% = $225 5 $2,475 + $225 = $2,700

19–946

Problem 17–20 Requirement 1 ($ in 000s)

APBO: Beginning of 2024

$460

Service cost ? Interest cost 23 🠞 (5% x $460) Loss (gain) on APBO 0 Less: Retiree benefits (52) End of 2024 $485 Service cost = $485 – $460 – $23 + $52 = $54 Requirement 2 ($ in 000s)

Service cost Interest cost Return on plan assets Amortization of: Prior service cost Net gain Postretirement benefit expense

$54 23 (0) 10 (1) $86

🠞 (5% x $460)

🠞 ($120 – $110) 🠞 ($50 – $49)

We report the service cost component of postretirement benefit expense ($54M) in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of postretirement benefit expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of postretirement benefit expense ($32M) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations. Requirement 3 ($ in 000s)

Accumulated postretirement benefit obligation Plan assets Net postretirement benefit liability

$485 (75) $410

19–947

Problem 17– 948 Requirement 1 The difference between an employer‘s obligation (PBO) and the resources available to satisfy that obligation (plan assets) is the funded status of the pension plan. The employer must report the net difference between those two amounts, referred to as the ―funded status‖ of the plan in the balance sheet. It‘s reported as a pension liability if the PBO exceeds the plan assets or a pension asset if the plan assets exceed the PBO. Clorox would report a pension liability of $121 million: ($ in millions)

PBO Plan assets Pension liability

$628 (507) $121

Requirement 2 Gains or losses should not be part of pension expense unless and until total net gains or losses exceed a defined threshold. Specifically, a portion of the excess is included in pension expense only if it exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is higher. The amount that should be included is the excess divided by the average remaining service period of active employees expected to receive benefits under the plan. Amortization of a net loss is added to pension expense. Pension expense in this instance does not include amortization of the net loss: ($ in millions)

Unrecognized net actuarial loss Less: 10% corridor (threshold)* Excess Service period Amortization

$240 (60) $180 ÷ ? $ 10

So, the average remaining service period is: $180 ÷ $10 = 18 years * 10% times either the PBO ($604) or plan assets ($485) at the beginning of the year, whichever is larger.

19–948

Problem 17–21 (continued) Requirement 3 Service cost Interest cost Expected return on plan assets Amortization of prior service cost Amortization of net loss (req. 2) Pension expense

($ in millions)

$ 1 20 (19) 0 10 $ 12

Requirement 4 The pension liability, which is the difference between the PBO and plan assets, increases by the combination of the service cost, interest cost, and the expected return as is reflected in the following entry. To Record Pension Expense Pension expense (calculated in Req. 3) ...................................... Plan assets (expected return on assets) ........................................ PBO (service cost $1 + interest cost $20).................................. Amortization of net loss—OCI (current amortization)...........

($ in millions)

12 19 21 10

Companies report the service cost component of pension expense ($1M) in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The nonservice cost components of pension expense ($11M) are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations. The PBO is affected only by the two components of pension expense that change the PBO. The net loss—AOCI would be reduced the $10M amortization which would be reported as other comprehensive income in the statement of comprehensive income. Solutions Manual, Chapter 19 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

19–949

Problem 17–21 (concluded) Pension gains and losses (either from changing assumptions regarding the PBO or the return on assets being higher or lower than expected) are deferred and not immediately included in pension expense and net income. They are, however, reported as other comprehensive income in the period they occur. Accordingly, the actuarial loss that increased the PBO and the gain from the actual return being more than the expected return are reported in Clorox‘s statement of comprehensive income as a loss of $43 million and a gain of $29 million (actual return – expected return: $48 – $19 = $29). Here are the entries: ($ in millions)

Loss—OCI (given) .................................... PBO............................................................. Plan assets ............................................... Gain—OCI ($48 – $19) .............................

19–950

43 43 29 29

DECISION MAKERS’ PERSPECTIVE CASES

19–951

Judgment Case 17–1 Requirement 1 Here is a graphical depiction of your estimated service and retirement periods: 2024

2063 40 years Service period

2083 20 years Retirement

Salary at retirement: $100,000 x 3.26204, or $100,000 x (1.03)40 = $326,204 1.5% x 40 x $326,204 = $195,722

The present value of the retirement annuity as of the retirement date (end of 2063) is: $195,722 x 11.46992* = $2,244,916 [This is the lump-sum equivalent of the retirement annuity as of the retirement date.] * Present value of an ordinary annuity of $1: n = 20, i = 6%

19–952

Case 17–1 (continued) Requirement 2 The value of your plan assets as of the anticipated retirement date is $1,872,981: A B C D End of Years to Year: Retirement Salary Contribution 2024 39 100,000 8,000 2025 38 103,000 8,240 2026 37 106,090 8,487 2027 36 109,273 8,742 2028 35 112,551 9,004 2029 34 115,927 9,274 2030 33 119,405 9,552 2031 32 122,987 9,839 2032 31 126,677 10,134 2033 30 130,477 10,438 2034 29 134,392 10,751 2035 28 138,423 11,074 2036 27 142,576 11,406 2037 26 146,853 11,748 2038 25 151,259 12,101 2039 24 155,797 12,464 2040 23 160,471 12,838 2041 22 165,285 13,223 2042 21 170,243 13,619 2043 20 175,351 14,028 2044 19 180,611 14,449 2045 18 186,029 14,882 2046 17 191,610 15,329 2047 16 197,359 15,789 2048 15 203,279 16,262 2049 14 209,378 16,750 2050 13 215,659 17,253 2051 12 222,129 17,770 2052 11 228,793 18,303 2053 10 235,657 18,853 2054 9 242,726 19,418 2055 8 250,008 20,001 2056 7 257,508 20,601 2057 6 265,234 21,219 2058 5 273,191 21,855 2059 4 281,386 22,511 2060 3 289,828 23,186 2061 2 298,523 23,882 2062 1 307,478 24,598 2063 0 316,703 25,336 Lump-sum equivalent of the retirement annuity as of the retirement date

E Future Value at Retirement 77,628 75,431 73,296 71,222 69,206 67,247 65,344 63,495 61,698 59,952 58,255 56,606 55,004 53,447 51,935 50,465 49,037 47,649 46,300 44,990 43,717 42,479 41,277 40,109 38,974 37,871 36,799 35,757 34,745 33,762 32,806 31,878 30,976 30,099 29,247 28,419 27,615 26,834 26,074 25,336 1,872,981

19–953

Case 17–1 (concluded) Your annual retirement pay assuming continuing investment of assets at 6% will be: $1,872,981 ÷ 11.46992 = $163,295 * Present value of an ordinary annuity of $1: n = 20, i = 6%

Requirement 3 Based on the calculations alone, the state‘s defined benefit plan offers the larger retirement annuity and, therefore, lump-sum equivalent of the retirement annuity.

Requirement 4 Be aware though that many other factors need to be considered. Other factors you should consider in making the choice would include each of the following except: a. Very often, defined contribution plans provide benefits only until you and/or your spouse dies with no benefits to other beneficiaries. b. Greater uncertainty is associated with defined contribution plans, in general. c. In a defined benefit plan, the employer is responsible for making up the difference when investment performance is less than expected. d. Defined benefit plans pay benefits from retirement to death. e. Assets accumulated under defined contribution plans are a fixed amount. Answer: a

19–954

Explanation: Plans vary in terms of the flexibility regarding how you can choose to receive distributions of your retirement assets. Very often, defined benefit plans provide benefits only until you and/or your spouse dies with no benefits to other beneficiaries; whereas, assets accumulated under defined contribution plans can be bequeathed to other beneficiaries. Also, greater uncertainty is associated with defined contribution plans, in general. The employee bears the risk of uncertain investment returns and, potentially, might settle for far less at retirement than at first expected. On the other hand, results may exceed expectations as well. Risk is reversed in a defined benefit plan. Because specific benefits are promised at retirement, the employer is responsible for making up the difference when investment performance is less than expected. Relatedly, uncertainty regarding mortality significantly affects the equation. Defined benefit plans pay benefits from retirement to death. Assets accumulated under defined contribution plans, however, are a fixed amount. How well that amount provides for retirement income depends on how many years you live after retirement.

19–955

Real World Case 17–2 Requirement 1 Microsoft‘s pension plan is a defined contribution plan in the form of a 401(k) plan. It is described in disclosure note 18: NOTE 18 — EMPLOYEE STOCK AND SAVINGS PLANS (in part) We have savings plans in the U.S. that qualify under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Eligible U.S. employees may contribute a portion of their salary into the savings plans, subject to certain limitations. We contribute fifty cents for each dollar a participant contributes into the plans, with a maximum employer contribution of 50% of the IRS contribution limit for the calendar year. Employer-funded retirement benefits for all plans were $1.0 billion, $877 million, and $807 million in fiscal years 2020, 2019, and 2018, respectively, and were expensed as contributed.

Requirement 2 Defined contribution plans promise defined periodic contributions to a pension fund, without further commitment regarding benefit amounts at retirement. Retirement benefits are entirely dependent upon how well investments perform. Thus, the employee bears the risk of uncertain investment returns. The employer is free of any further obligation.

19–956

Case 17–2 (concluded) Requirement 3 Microsoft matches contributions fifty cents for each dollar contributed. Also, both employee and employer contributions vest immediately. So, she is entitled to roll over $1,530: Employee contribution

$1,000

Microsoft match

500

Total invested

1,500

Value increase (2% x $1,500) Vested balance

30 $1,530

Requirement 4 Microsoft‘s plan is a 401(k) plan—named after the Tax Code section that specifies the conditions for the favorable tax treatment of these plans. 401(k) plans allow voluntary contributions by employees, which in Microsoft‘s case is fifty cents for each dollar matched up to a set percentage of salary per year. Microsoft simply records pension expense equal to the cash contribution. Summarized for the year, Microsoft recorded the following: ($ in millions)

Pension expense................................. Cash................................................

1,000 1,000

19–957

Real World Case 17–3 Requirement 1 FedEx sponsors postretirement benefits in the form of: a. defined contribution plans b. postretirement healthcare plans

c. defined benefit pension plans d. all of the above

Answer: d FedEx sponsors both defined benefit and defined contribution pension plans as well as a postretirement healthcare plan. These are described in disclosure note 13 (in part) for the years ended May 31, 2020 and 2019:

19–958

We sponsor programs that provide retirement benefits to most of our employees. These programs include defined benefit pension plans, defined contribution plans and postretirement healthcare plans.

19–959

Case 17–3 (continued) Requirement 2 FedEx reported a net pension liability in its 2020 balance sheet in the amount of $3,221 million. A pension plan is underfunded when the obligation (PBO) exceeds the resources available to satisfy that obligation (plan assets) and overfunded when the opposite is the case. The PBO exceeds plan assets in both years reported. Thus, a net pension liability is reported in the balance sheet both years, as FedEx‘s defined benefit plans are underfunded. The amounts of each are reported in the disclosure note as reproduced below. US Pension Plans 2020 2019

Postretirement Healthcare Plans 2020 2019

PBO/APBO at the end of year

$30,199 $26,554

$1,314 $1,221

Fair value of plan assets at the end of year

$26,978 $23,320

$—

Funded Status of the Plans

$(3,221) $(3,234)

$—

$(1,314) $(1,221)

Requirement 3 FedEx reported a net postretirement healthcare plans liability in its 2020 balance sheet in the amount of $1,314 million. The postretirement healthcare plan is not just underfunded; it is unfunded. Thus, the funded status reported as a liability is equal to the postretirement benefit obligation each year.

19–960

Case 17–3 (concluded) Requirement 4 FedEx reports several actuarial assumptions used to determine reported pension amounts. The discount rate and rate of increase in future compensation levels used to determine the projected benefit obligation on 2020 were 3.14% and 5.17%: Pension Plans

2020

2019

Discount rate Rate of increase in future compensation levels

3.14%

3.85%

5.17%

5.10%

Requirement 5 The reported decrease in the discount rate from 2019 to 2020 increased FedEx‘s projected benefit obligation. The lower the discount rate in a present value calculation, the higher the present value. Requirement 6 FedEx reported an increase in the rate of increase in future compensation levels. This increased FedEx‘s PBO. Higher compensation estimates in the pension formula result in higher estimates of retirement benefits and thus in the PV of those benefits.

19–961

Analysis Case 17–4 Requirement 1 The increase in a company‘s PBO attributable to making a plan amendment retroactive is referred to as the prior service cost. Requirement 2 Prior service cost adds to the cost of having a pension plan. Amending a pension plan typically is done with the idea that future operations will benefit from having done so. Thus, the cost is not recognized as pension expense entirely in the year the plan is amended, but is recognized as pension expense over the time that the employees who benefited from the retroactive amendment will work for the company in the future. In AM‘s case, that may be a relatively short time. Apparently, a motive for AM‘s amendment was the expectation that employees would retire early and take advantage of the limited time offer.

Requirement 3 The amendment increased AM‘s pension obligation (PBO). The net pension obligation reported as a liability in the balance sheet is the excess of the PBO over plan assets. AM‘s pension expense will be higher each year for as long as the prior service cost is amortized.

19–962

Analysis Case 17–5 Requirement 1 Normally, a company‘s net periodic pension cost represents an expense and therefore decreases earnings. Sometimes, though, circumstances cause this element of the income statement to actually increase reported earnings. This occurs when the ―expected return on assets,‖ a negative component of pension expense, is higher than the combined total of the other components. Consider the following disclosure adapted from a pension disclosure note in a previous annual report of Qwest Communications that indicated that ―the pension plan contributed‖ $87 million to reported earnings during the year: ($ in millions)

Service cost $ 170 Interest cost 601 Expected return on plan assets. (858) Net (credit) pension cost $ (87) The major contributor to this effect is the expected return on plan assets of over $858 million. We see another example in Office Depot‘s 2018 financial statements: ($ in millions)

Service cost Interest cost Expected return on plan assets. Net (credit) cost

$ 4 35 (43) $ (4)

19–963

Case 17–5 (concluded) Requirement 2 Companies must report the actuarial assumptions used to make estimates concerning pension plans, namely the discount rate, the average rate of compensation increase, and the expected long-term rate of return on plan assets. How might these estimates influence reported profits?  The expected long-term rate of return on assets directly affects the net pension expense. The higher the rate, the higher the ―expected return on assets,‖ a negative component of the net pension cost. The more aggressive a company is in estimating this return, the lower will be the expense and the higher reported profits will be.  The discount rate can affect profits, too. The higher the discount rate in a present value calculation, the lower the present value. A lower present value will decrease the service cost and interest cost components of the net pension cost and increase earnings.  The lower the rate of increase in future compensation levels, the lower will be the PBO, the service cost, and interest cost. So, the lower the rate of increase in future compensation levels, the higher earnings will be.

19–964

Analysis Case 17–6 Requirement 1 ($ in millions)

Net loss, February 2, 2019 Gain on plan assets [actual ($602) – expected $191] Amortization Loss on PBO Settlement charges Net loss, February 1, 2020

$1,109 (411) (29) 463 (45) $1,087*

* rounded

Requirement 2 Gains or losses should not be part of pension expense unless and until total net gains or losses exceed a defined threshold. Specifically, a portion of the excess is included in pension expense only if it exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is higher. The amount that should be included is the excess divided by the average remaining service period of active employees expected to receive benefits under the plan. Amortization of net gains is deducted from pension expense; amortization of a net loss is added to pension expense.

($ in millions)

Net loss, February 2, 2019 Less: 10% corridor (threshold)* Excess Service period Amortization (given)

$1,109 (302) $ 807

÷ $

Average service years = $807 ÷ $29 = 28 years * 10% times either the beginning-of-the-period PBO ($3,011) or plan assets ($3,018), whichever is larger

19–965

Case 17–6 (concluded) Requirement 3 Note 10 states the effect on the Accumulated postretirement benefit obligation of a 1% decrease in the healthcare cost trend is a decrease of $6M. Using that, we can determine that the balance would have been ($ in millions): $133 million reported balance – $6 million = $127 million.

19–966

Judgment Case 17–7 Requirement 1 Yes, it‘s true that the pension expense is calculated as if the balance sheet contained certain amounts it doesn‘t individually report, specifically the projected benefit obligation and the pension assets. The balance sheet does actually reflect these balances on a ―net‖ basis; that is, the funded status of the plan is reported as a net pension liability to the extent the PBO exceeds the pension assets or as a net pension asset if the pension assets exceed the PBO. Actually, even the pension expense falls short of reflecting all changes in the PBO and plan assets due to methods invented by the FASB to defer the effect of gains, losses, and the prior service cost.

Requirement 2 A small liability, $30,000, was reported in 2023 because the plan was underfunded by that amount—the PBO of $3,786 exceeded plan assets. This was not the case in 2024.

Requirement 3 A net pension asset, $405,000, was reported in 2024 because the plan was overfunded by that amount—the plan assets exceeded the PBO. This was not the case in 2023.

19–967

Case 17–7 (concluded) Requirement 4 Two of the other amounts reported in the disclosure note are reported in the balance sheet. The net gain and prior service cost are reported as components of accumulated other comprehensive income. This is a part of shareholders‘ equity.

Requirement 5 Gains and losses occur when either the PBO or the return on plan assets turns out to be different than expected. LGD‘s net gain indicates that cumulative previous gains of either type have exceeded cumulative previous losses of either type. The loss in 2024 indicates the PBO is higher than previously expected due to some unspecified change in an actuarial assumption. This loss, as well as any other loss or gain, is reported in the statement of comprehensive income as it occurs. A net gain or a net loss affects pension expense only if it exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is higher. That appears to be the case with LGD, and the amortized portion of the net gain is one component of the pension expense.

Requirement 6 As mentioned in the previous requirement, losses and gains are reported in the statement of comprehensive income as they occur. These amounts accumulate as a net gain or net loss in the balance sheet as part of accumulated other comprehensive income, one of the components of shareholders‘ equity.

19–968

Research Case 17-8 Requirement 1 The results students report will vary somewhat depending on the firms chosen. However, disclosures of changes in actuarial assumptions for benefit plans are quite similar. A recent disclosure for Kellogg Company follows: NOTE 11 NONPENSION POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS (in part)

The assumed U.S. health care cost trend rate is 5.25% for 2020, decreasing 0.25% annually to 4.5% by the year 2023 and remaining at that level thereafter. These trend rates reflect the Company‘s historical experience and management‘s expectations regarding future trends. A one percentage point change in assumed health care cost trend rates would have the following effects:

(millions)

One percentage

point increase

point decrease

Effect on total of service and interest cost components $3 $ (2) Effect on postretirement benefit obligation 77 (66)

19–969

Case 20-8 (concluded) Requirement 2 The specific citation that describes disclosure requirements for health care cost trends is FASB ASC 715–20–50–1: Compensation-Retirement Benefits–Defined Benefit Plans-General–Disclosure. m. The effect of a one-percentage-point increase and the effect of a one-percentagepoint decrease in the assumed health care cost trend rates on the aggregate of the service and interest cost components of net periodic postretirement health care benefit costs and the accumulated postretirement benefit obligation for health care benefits. Measuring the sensitivity of the accumulated postretirement benefit obligation and the combined service and interest cost components to a change in the assumed health care cost trend rates requires re-measuring the accumulated postretirement benefit obligation as of the beginning and end of the year. (For purposes of this disclosure, all other assumptions are held constant, and the effects are measured based on the substantive plan that is the basis for the accounting.)

19–970

Communication Case 17–9 First, this case has no right or wrong answer. The process of developing the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole. Solutions should consider the facts brought out in the solution to the previous case on which this one is based. Also, it is likely that some of the suggestions will be variations of the following alternatives: 1. The FASB ―funded status‖ approach as described in the text. 2. Individual recognition of the projected benefit obligation and the plan assets. 3. Recognition of the accumulated benefit obligation rather than the projected benefit obligation. 4. Alternatives 1, 2, or 3, but with no ―smoothing‖—deferral of gains, losses, or prior service cost. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, (b) clarifying or modifying ideas already expressed, or (c) suggesting an alternative direction.

19–971

Communication Case 17–10 Suggested Grading Concepts and Grading Scheme: Content (80%) 30 The net periodic pension expense measures this compensation and consists of the following five elements which can vary differently from changes in employment. (5 each; maximum of 25 for this part) The service cost component is the present value of the benefits earned by the employees during the current period. The interest cost component is the increase in the projected benefit obligation due to the passage of time. The return on plan assets reduces the pension expense. The actual return on plan assets component is the difference between the fair value of the plan assets at the beginning and the end of the period, adjusted for contributions and benefit payments. This amount is adjusted for any gain or loss, so it is the expected return that actually affects the calculation. Prior service cost is created when a pension plan is amended, and credit is given for employee service rendered in prior years. This retroactive credit is not recognized as pension expense entirely in the year the plan is amended, but is recognized in pension expense over the time that the employees who benefited from this credit work for the company. Gains and losses arise from changes in estimates concerning the amount of the projected benefit obligation or the return on the plan assets being different from expected. These are not included in pension expense as they occur. They are instead reported as other comprehensive income. The service cost component of pension expense is reported in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other (non-service cost) components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The non-service cost components of pension expense are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

19–972

Case 17–10 (concluded) 15 Gains and losses occur when the PBO or the return on plan assets turns out to be different than expected. (10 each; maximum of 20 for this part) Gains and losses are reported as they occur in the statement of comprehensive income, not as part of pension expense. They accumulate over time as a net gain or net loss, a component of accumulated other comprehensive income. A net gain or a net loss affects pension expense only if it exceeds 10% of the PBO, or 10% of plan assets, whichever is higher. When the corridor is exceeded, the excess is not charged to pension expense all at once. Instead, the amount that should be included is the excess divided by the average remaining service period of active employees expected to receive benefits under the plan. 20 PBO and ABO compared (10 each; maximum of 20 for this part) Both the accumulated benefit obligation and the projected benefit obligation represent the present value of the benefits attributed by the pension benefit formula to employee service rendered prior to a specific date. The accumulated benefit obligation is based on present salary levels and the projected benefit obligation is based on estimated future salary levels. 15 The projected benefit obligation in excess of plan assets: This is the funded status of the plan and is reported in the balance sheet as a pension liability (10 points) If the plan assets exceed the PBO, it would be reported as a pension asset. (5 points) 80 points Writing (20%) 5 Terminology and tone appropriate to the audience of assistant controllers. 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English Word selection. Spelling. Grammar. 20 points Solutions Manual, Chapter 19 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

19–973

Ethics Case 17–11 The CFO‘s apparent motivation for the change in the way contributions are handled is to have the company benefit from the earning power of the contributed funds for up to three months, prior to the funds being deposited for the benefit of the employees. Temporarily diverting 401(k) funds this way benefits the company at the expense of the employee. There is some Question as to whether the practice described is illegal. In practice, such cases are rarely prosecuted. Regardless of the legality, though, there is the ethical Question of whether the employer should earn dividends, interest, and so forth on funds deducted from employees‘ paychecks, prior to the funds being deposited to the employees‘ accounts.

19–974

Target Case In Note 23 ―Pension Plans‖, Target reported the following changes in its Projected Benefits Obligation, Plan Assets, and Pension Expense: Requirement 1 Change in Projected Benefit Obligation (millions) Benefit obligation at beginning of period Service cost Interest cost Actuarial (gain)/loss Participant contributions Benefits paid Benefit obligation at end of period

Qualified Plans 2019 2018 $3,905 $4,061 90 93 146 145 615 (167) 11 6 (275) (233) $4,492 $3,905

Note: Some projected benefit plans permit employees to contribute to their own plans in addition to the employer responsibility. Requirement 2 Change in Plan Assets (millions) Fair value of plan assets at beginning of period Actual return on plan assets Employer contributions Participant contributions Benefits paid Fair value of plan assets at end of period

2019 $3,915 729 50 11 (275) $4,430

2018 $4,107 (65) 100 6 (233) 3,915

19–975

Target Case (concluded) Requirement 3 Target‘s PBO is overfunded in fiscal year 2018, but underfunded in 2019: (millions) Fair value of plan assets at end of period Benefit obligation at end of period Funded/(underfunded) status

2019 $4,430 4,492 $ (62)

2018 $3,915 3,905 $ 10

Requirement 4 Net Pension Benefits Expense (millions)

2019

2018

2017

Service cost benefits earned during the period Interest cost on projected benefit obligation Expected return on assets Amortization of losses

$ 93 149 (248) 62

$ 95 146 (246) 82

$ 86 140 (250) 61

(11)

1 $ 46

4 $ 70

1 $ 27

Amortization of prior service cost

Settlement and special termination charges Total

Prior service cost amortization is determined using the straight-line method over the average remaining service period of team members expected to receive benefits under the plan.

19–976

Air France–KLM Case Requirement 1 Under IAS No. 19, prior service cost (called past service cost under IFRS) is combined with service cost as part of net periodic pension cost and reported within the income statement. AF reports this amount within ―Plan amendments and curtailments‖ as part of its Net periodic cost. Under U.S. GAAP, prior service cost is not expensed immediately, but is included among OCI items in the statement of comprehensive income and thus subsequently becomes part of AOCI where it is amortized to earnings over the average remaining service period.

Requirement 2 AF reports Pension assets and Pension liabilities separately on its balance sheet. Under U.S GAAP, a company‘s PBO is not reported separately among liabilities in the balance sheet. Similarly, the plan assets a company sets aside to pay those benefits are not separately reported among assets in the balance sheet. Instead, firms report the net difference between those two amounts, referred to as the ―funded status‖ of the plan. Most companies that follow IFRS also report only the net amount.

Requirement 3

As shown in Note 29.3 Evolution of commitments, For its NE operations, AF reported a net interest income (rather than net interest cost) for 2019 of €5 million, indicating that its plan assets exceeded its DBO. The high grade corporate bond rate is multiplied by the difference between those two amounts to determine the net interest cost or net interest income for the period.

19–977

19–978

Questions for Review of Key Topics

19–979

Question 18– 980The two primary sources of shareholders‘ equity are amounts invested by shareholders in the corporation and amounts earned by the corporation on behalf of its shareholders. Invested capital is reported as paid-in capital and earned capital is reported as retained earnings.

19–980

Question 18– 981The three primary ways a company can be organized are (1) a sole proprietorship, (2) a partnership, or (3) a corporation. Transactions are accounted for the same regardless of the form of business organization with the exception of the method of accounting for capital—the ownership interest in the company. Several capital accounts (as discussed in this chapter) are used to record changes in ownership interests for a corporation, rather than recording all changes in ownership interests in a single capital account for each owner, as we do for sole proprietorships and partnerships.

19–981

Question 18– 982In the eyes of the law, a corporation is a separate legal entity—separate and distinct from its owners. The owners are not personally liable for debts of the corporation. So, shareholders generally may not lose more than the amounts they invest when they purchase shares. This is perhaps the single most important advantage of corporate organization over a proprietorship or a partnership.

19–982

Question 18– 983―Not-for-profit‖ corporations such as churches, hospitals, universities, and charities, are not organized for profit and do not sell stock. Some not-for-profit corporations, such as the Federal Deposit Insurance Corporation (FDIC), are government owned.

19–983

Question 18– 984Corporations that are organized for profit may be publicly held or privately (or closely) held. The stock of publicly held corporations is available for purchase by the general public. Shares might be traded on organized national stock exchanges or available ―over-the-counter‖ from securities dealers. Privately held companies' shares are held by only a few individuals and are not available to the general public.

19–984

19–985

Question 18–6 Corporations are formed in accordance with the corporation laws of individual states. The Model Business Corporation Act serves as the guide to states in the development of their corporation statutes, presently as the model for the majority of states.

19–6

Question 18– 987The ownership rights held by common shareholders, unless specifically withheld by agreement with the shareholders, are:

a. The right to vote on policy issues. b. The right to share in profits when dividends are declared (in proportion to the percentage of shares owned by the shareholder). c. The right to share in the distribution of any assets remaining at liquidation after other claims are satisfied.

19–987

Question 18– 988The ―preemptive right‖ is the right to maintain one‘s percentage share of ownership when new shares are issued. When granted, each shareholder is offered the opportunity to buy the same percentage of any new shares issued as the percentage of shares he/she owns at the time. For reasons of practicality, the preemptive right usually is excluded.

19–988

Question 18– 989The typical rights of preferred shares usually include one or both of the following: a. A preference to a predesignated amount of dividends, that is, a stated dollar amount per share or percent of par value per share. This means that when the board of directors of a corporation declares dividends, preferred shareholders will receive the specified dividend prior to any dividends being paid to common shareholders. b. A preference over common shareholders in the distribution of assets in the event the corporation is dissolved.

19–989

Question 18– 990If preferred shares are noncumulative, dividends not declared in any given year need never be paid. However, if cumulative, when the specified dividend is not paid in a given year, the unpaid dividends accumulate and must be made up in a later dividend year before any dividends are paid on common shares. These unpaid dividends are called ―dividends in arrears.‖

19–990

19–991

Question 18–11 Par value was defined by early corporation laws as the amount of net assets not available for distribution to shareholders (as dividends or otherwise). However, now the concepts of ―par value‖ and ―legal capital‖ have been eliminated entirely from the Model Business Corporation Act. Most shares continue to bear arbitrarily designated par values, typically nominal amounts. Although many states already have adopted these provisions, most established corporations issued shares prior to changes in the state statutes. So, most companies still have par value shares outstanding and continue to issue previously authorized par value shares.

19–992

Question 18–12 Comprehensive income is a broader view of the change in shareholders‘ equity than traditional net income. It is the total nonowner change in equity for a reporting period. It encompasses all changes in equity except those caused by transactions with owners. Transactions between the corporation and its owners (shareholders) primarily include dividends and the sale or purchase of shares of the company‘s stock. Most nonowner changes (e. g., revenues and expenses) are reported in the income statement. The changes other than the ones that are part of net income are those reported as ―other comprehensive income.‖ Two attributes of other comprehensive income are reported: (1) components of comprehensive income created during the reporting period and (2) the comprehensive income accumulated over the current and prior periods. The components of comprehensive income created during the reporting period can be reported in either (a) an expanded version of the income statement or (b) a separate statement immediately following the income statement. Regardless of the choice a company makes, the presentation will report net income, other components of comprehensive income, and total comprehensive income. The second attribute—the comprehensive income accumulated over the current and prior periods— is reported as a separate component of shareholders‘ equity. This amount represents the cumulative sum of the changes in each component created during each reporting period throughout all prior years.

19–993

Question 18–13 Components of comprehensive income created during the reporting period can be reported in either (a) an expanded version of the income statement or (b) a separate statement immediately following the income statement. Regardless of the placement a company chooses, the presentation is similar. It will report net income, other components of comprehensive income, and total comprehensive income.

19–994

19–995

Question 18– 996The statement of shareholders‘ equity reports the transactions that cause changes in its shareholders‘ equity account balances. It shows the beginning and ending balances in primary shareholders‘ equity accounts and any changes that occur during the years reported. Typical reasons for changes are the sale of additional shares of stock, the acquisition of treasury stock, net income, and the declaration of dividends.

19–996

Question 18– 997The measurement objective is that the transaction should be recorded at fair value. This might be the fair value of the shares or of the noncash assets or services received, whichever evidence of fair value seems more clearly evident. This is consistent with the general practice of recording any noncash transaction at market value.

19–997

Question 18– 998The cash received usually is the sum of the separate market values of the separate securities. However, when the total selling price is not equal to the sum of the separate market prices, the total selling price is allocated in proportion to their relative market values.

19–998

Question 18– 999Share issue costs reduce the net cash proceeds from selling the shares and thus paid-in capital— excess of par. Paid-in capital—excess of par is credited for the excess of the proceeds over the par amount of the shares sold, and the issue costs are debited to that same account, thus reducing the account balance. Share issue costs are not subsequently amortized. While debt issue costs are similarly treated in that they reduce the proceeds from issuing debt, they differ in that debt issue costs are amortized to expense over the life of the debt. By doing so, debt issue costs change the effective rate of interest at which the debt is originally issued. The difference in accounting treatment often is justified by the presumption that share issue costs and debt issue costs are fundamentally different because a debt issue has a fixed maturity, but that selling shares represents a perpetual equity interest.

19–999

19–1000

Question 18–18 The same accounts that previously were increased when the shares were sold are decreased when the shares are retired. Specifically, common (or preferred) stock and paid-in capital—excess of par are reduced by the same amounts they were increased by when the shares were originally sold. If the cash paid to repurchase the shares differs from the amount originally paid in, accounting for the difference depends on whether the cash paid to repurchase the shares is less than or more than the price previously received when the shares were sold. When less cash is distributed to shareholders to retire shares than originally paid in, some of the original investment remains and is labeled paid-in capital—share repurchase. When more cash is distributed to shareholders to retire shares than originally was paid in for those shares, the additional amount is viewed as a dividend on the original investment, and thus a reduction of retained earnings (unless previous share repurchases have created a balance in paid-in capital—share repurchase, which would be reduced first).

19–18

Question 18–19 The purchase of treasury stock and its subsequent resale are considered to be a ―single transaction.‖ The purchase of treasury stock is perceived as a temporary reduction of shareholders' equity, to be reversed later when the treasury stock is resold, so the cost of acquiring the shares is ―temporarily‖ debited to the treasury stock account. Allocating the effects to specific shareholders‘ equity accounts is deferred until the shares are subsequently reissued.

19–19

Question 18– For a stock dividend of less than 25%, a "small" stock dividend, the fair value of the additional 1003 shares distributed is transferred from retained earnings to paid-in capital. The reduction in retained earnings is the same amount as if cash dividends were paid equal to the market value of the shares issued. The treatment is consistent with the belief that per share prices remain unchanged by stock dividends. This is not logical. If the value of each share were to remain the same when additional shares are distributed without compensation, the total value of the company would grow simply because additional stock certificates are distributed. Instead, the market price per share will decline in proportion to the increase in the number of shares distributed in a stock dividend.

19–1003

Answers to Questions (concluded)

19–1004

Question 18– The effect and maybe the motivation for the 2-for-1 stock split is to reduce the per share market 1005 price (by half). This will likely increase the stock‘s marketability by making it attractive to a larger number of potential investors. The appropriate accounting treatment of a stock split is to make no journal entry, which avoids the reclassification of ―earned‖ capital as ―invested‖ capital. However, if the stock distribution is referred to as a "stock split effected in the form of a stock dividend," and the per share par value of the shares is not changed, a journal entry is recorded that increases the common stock account by the par value of the additional shares. To avoid reducing retained earnings Brandon can reduce (debit) paid-in capital—excess of par to offset the credit to common stock, although it‘s permissible to debit retained earnings.

19–1005

Question 18– When a company decreases, rather than increases, its outstanding shares, a reverse stock split 1006 occurs. A 1-for-2 reverse stock split would cause one million $1 par shares to become one-half million $2 par shares. No journal entry would be recorded, so no account balances will change. But the market price per share would double, and the par amount per share would double.

19–1006

Question 18– You would be entitled to 3.2 shares (4% x 80 shares). Since cash in lieu of payments usually are 1007 made when shareholders are entitled to fractions of whole shares, you probably would receive 3 shares and cash equal to the market value of 1/5 of one share. Sometimes fractional share rights are issued for the partial shares, which would entitle you to a fractional share right for 1/5 of a share.

19–1007

Question 18– A quasi reorganization allows a company to (1) write down inflated asset values and (2) 1008 eliminate an accumulated deficit in retained earnings. The following steps are taken:

1. Assets and liabilities are revalued to reflect their fair values, with corresponding credits or debits to retained earnings. This may temporarily increase the deficit. 2. The debit balance in retained earnings is eliminated against additional paid-in capital. When additional paid-in capital is not sufficient to absorb the entire deficit, capital stock is debited. 3. Disclosure is provided to indicate the date the deficit was eliminated and when the new accumulation of earnings began.

BRIEF EXERCISES

19–1008

Brief Exercise 18– 1009

Two attributes of other comprehensive income are reported: (1) the components of comprehensive income created during the reporting period ($15 million in this instance) and (2) the comprehensive income accumulated over the current and prior periods ($50 million at the end of this year). The $50 million represents the cumulative sum of the changes in each component created during each reporting period throughout all prior years. Since this amount increased by $15 million, the balance must have been $35 million last year.

19–1009

Brief Exercise 18– 1010 Cash (8 million shares x $12 per share) ................................. Common stock (8 million shares x $1 par per share) ............. Paid-in capital—excess of par (remainder) ...................

19–1010

($ in millions)

96 8 88

19–1011

19–1012

Brief Exercise 18– 1013 Brown‘s paid-in capital—excess of par will increase by $860,000: 4,000 hours x $240 less $100,000 par. Journal entry (not required): Legal expense (4,000 hours x $240) ................................... Common stock (100,000 shares x $1 par per share)............... Paid-in capital—excess of par (remainder) ...................

960,000 100,000 860,000

19–1013

Brief Exercise 18– 1014

Hamilton‘s shareholders‘ equity will increase by $3,500,000 as a result of this transaction. Journal entry (not required): Inventory of motors (1,000 x $3,500) ......................................... 3,500,000 Common stock ........................................................... 3,500,000

19–1014

19–1015

Brief Exercise 18–5 Horton‘s total paid-in capital (common stock as well as paid-in capital in excess of par and paid-in capital from share repurchase) will decline by $17 million, the price paid to buy back the shares. Journal entry (not required): ($ in millions)

Common stock (2 million shares x $1 par).................................. Paid-in capital—excess of par (2 million shares x $9*) ............... Paid-in capital—share repurchase (difference) .................... Cash (2 million shares x $8.50 per share) ................................. * Paid-in capital—excess of par: $900 ÷ 100 million shares

2 18 3 17

19–5

Brief Exercise 18– 1017

Agee‘s total paid-in capital at the second buyback (common stock as well as paidin capital in excess of par and paid-in capital from share repurchase) will decline by $18 million because recording the transaction involves a $1 million reduction of retained earnings and an $18 million reduction in accounts comprising total paid-in capital. Journal entries (not required): First buyback ($ in millions) Common stock (1 million shares x $1 par).................................. 1 Paid-in capital—excess of par (1 million shares x $15*) ............ 15 Paid-in capital—share repurchase (difference) .................... 2 Cash (1 million shares x $14) ................................................. 14 * $16 – $1 par from original issue of stock Second buyback Common stock (1 million shares x $1 par).................................. Paid-in capital—excess of par (1 million shares x $15*) ............ Paid-in capital—share repurchase (balance from first buyback) .. Retained earnings (difference)................................................. Cash (1 million shares x $19) ................................................. * $16 – $1 par from original issue of stock

1 15 2 1 19

19–1017

Brief Exercise 18– 1018

Basu‘s retained earnings will decline by $2 million because the $67 million sale price is less than the sum of the cost of the treasury stock ($70 million) and paidin capital from the previous treasury stock sale ($1 million). Journal entries (not required): ($ in millions) Purchase of treasury stock Treasury stock (2 million shares x $70)...................................... 140 Cash.................................................................................. 140

First sale of treasury stock Cash (1 million shares x $71) ..................................................... Treasury stock (1 million shares x $70).................................. Paid-in capital—share repurchase (remainder) .................... Second sale of treasury stock Cash (1 million shares x $67) ..................................................... Paid-in capital—share repurchase (balance from first sale) ........ Retained earnings (remainder)................................................. Treasury stock (1 million shares x $70)..................................

19–1018

71 70 1

67 1 2 70

Brief Exercise 18– 1019

Cox‘s paid-in capital—share repurchase will increase by $7 million as determined in the following journal entry: ($ in millions)

Cash (1 million shares x $29) ..................................................... Paid-in capital—share repurchase (difference) .................... Treasury stock (1 million shares x $22*)................................ * 2 million shares x $20 =$40 million 1 million shares x $26 = 26 million 3 million shares $66 million $66 million ÷ 3 million shares = $22 average cost per share

29 7 22

19–1019

19–1020

19–1021

Brief Exercise 18– 1022

Cox‘s paid-in capital—share repurchase will increase by $9 million as determined in the following journal entry: ($ in millions)

Cash (1 million shares x $29) ..................................................... Paid-in capital—share repurchase (difference) .................... Treasury stock (1 million shares x $20*)................................ * 2 million shares x $20 =$40 million (first million at $20) 1 million shares x $26 = 26 million $66 million

19–1022

29 9 20

Brief Exercise 18– 1023

Declaration date Retained earnings ............................................................ Cash dividends payable (500 million shares x $0.66) ........

($ in millions)

330 330

Date of record no entry Payment date Cash dividends payable .................................................. Cash ............................................................................

330 330

19–1023

19–1024

Brief Exercise 18–11 MLS‘s common shareholders will receive dividends of $18 million as a result of the 2024 distribution. Preferred Common 2022 2023 2024

$20 million* 20 million** 32 million***

$ 0 0 18 million (remainder)

$24 million current preference (6% x $400 million), thus $4 million dividends in arrears. ** $24 million current preference (6% x $400 million), thus another $4 million dividends in arrears. *** $8 million dividends in arrears plus the $24 million current preference.

19–1025

19–1026

19–1027

19–1028

Brief Exercise 18–12 Declaration date Loss on investments ($37,000 – $35,000) ........................... Investment in equity securities* ...................................

2,000 2,000

* As an alternative to using a fair value adjustment account, we adjust for fair value directly to the investment account.

Retained earnings (1,000 shares at $35 per share) ..................... Property dividends payable ......................................... Payment date Property dividends payable ............................................. Investment in equity securities ....................................

35,000 35,000

19–1029

Brief Exercise 18–13 ($ in millions)

Retained earnings (3 million* shares at $25 per share).............. Common stock (3 million* shares at $1 par per share) ........ Paid-in capital—excess of par (remainder) ..................... * 5% x 60 million shares = 3 million shares

19–1030

75 3 72

19–1031

Brief Exercise 18–14 ($ in millions)

Paid-in capital—excess of par** …………………….. Common stock (60 million shares* x $1 par per share)….

60 60

**alternatively, retained earnings may be debited

* 100% x 60 million shares = 60 million shares If the per share par value of the shares is not to be changed, the stock distribution is referred to as a "stock split effected in the form of a stock dividend." In that case, the journal entry increases the common stock account by the par value of the additional shares. This prevents the increase in shares from reducing (by half in this case) the par per share. The par is $1 per share before and after the split.

19–1032

Brief Exercise 18–15

19–1033

If a stock split is not to be effected in the form of a stock dividend, no entry is recorded. Since the shares double, but the balance in the common stock account is not changed, the par per share is reduced, to $0.50 in this instance.

19–1034

19–1035

Brief Exercise 18–16 If Nestlé used U.S. GAAP:  Ordinary share capital would be common stock,  Share premium would be paid-in capital—excess of par, and  Translation reserve would be net gains (losses) from foreign currency translation—AOCI.

EXERCISES

19–1036

Exercise 18–1 Requirement 1 Comprehensive income is a more expansive view of the change in shareholders‘ equity than traditional net income. It is the total nonowner change in equity for a reporting period. In fact, it encompasses all changes in equity other than from transactions with owners. Transactions between the corporation and its shareholders primarily include dividends and the sale or purchase of shares of the company‘s stock. Most nonowner changes are reported in the income statement. The changes other than those that are part of net income are the ones reported as ―other comprehensive income.‖ Requirement 2 Two attributes of other comprehensive income are reported: (1) the components of comprehensive income created during the reporting period and (2) the comprehensive income accumulated over the current and prior periods. The second measure—the comprehensive income accumulated over the current and prior periods—is reported in the balance sheet as a separate component of shareholders‘ equity. This is what Kaufman reported in its balance sheet ($107 million in 2024). Be sure to realize this amount represents the cumulative sum of the changes in each component created during each reporting period (the disclosure note) throughout all prior years.

19–1037

Exercise 18–1 (concluded) Requirement 3 From the information Kaufman's financial statements provide, we can determine how the company calculated the $107 million accumulated other comprehensive income in 2024: ($ in millions) Accumulated other comprehensive income, 2023 $ 75 Change in net unrealized gains on investments 34 Change in ―other‖ (2) Accumulated other comprehensive income, 2024 $107

19–1038

Exercise 18–2 Requirement 1

The specific citation that describes the guidelines for presenting accumulated other comprehensive income on the statement of shareholders‘ equity is FASB ASC 220– 10–45–14: ―Income Statement–Reporting Comprehensive Income–Overall–Other Presentation Matters– Reporting Accumulated Other Comprehensive Income.‖ Requirement 2 The total of other comprehensive income for a period shall be transferred to a component of equity that is displayed separately from retained earnings and additional paid-in capital in a statement of financial position at the end of an accounting period. A descriptive title such as accumulated other comprehensive income shall be used for that component of equity. An entity shall present, on the face of the financial statements or as a separate disclosure in the notes, the changes in the accumulated balances for each component of other comprehensive income included in that separate component of equity, as required in FASB ASC paragraph 220-10-45-14A.

19–1039

19–1040

19–1041

19–1042

19–1043

19–1044

Exercise 18– 1045

Indicate by letter whether each of the items listed below most likely is reported in the income statement as Net Income (NI) or in the statement of comprehensive income as Other Comprehensive Income (OCI). Items OCI 1. NI 2. OCI 3. OCI 4. NI 5. OCI 6. NI 7. OCI 8. NI 9. OCI 10.

Increase in the fair value of available-for-sale (AFS) debt securities Gain on sale of land Loss on pension plan assets (actual return less than expected) Adjustment for foreign currency translation Increase in the fair value of investments in common stock securities Loss from revising an assumption related to a pension plan Loss on sale of patent Prior service cost in defined benefit pension plan Increase in the fair value of bonds outstanding due to change in general interest rates; fair value option Gain on postretirement plan assets (actual return more than expected)

19–1045

Exercise 18– 1046 Cash (3 million shares x $17.15 per share)............................. 51,450,000 Common stock (3 million shares x $.01 par per share) ....... 30,000 Paid-in capital—excess of par (remainder) ................... 51,420,000

19–1046

Exercise 18– February 12 1047 Cash (2 million shares x $9 per share)................................ Common stock (2 million shares x $1 par).................... Paid-in capital—excess of par (difference) .................. February 13 Legal expenses (40,000 shares x $9 per share) .................. Common stock (40,000 shares x $1 par)....................... Paid-in capital—excess of par (difference) ..................

18,000,000 2,000,000 16,000,000 360,000 40,000 320,000

Note: Because 2 million shares sold the previous day for $9 per share, it‘s reasonable to assume a $9 per share fair value.

February 13 Cash............................................................................ Common stock (80,000 shares x $1 par) ...................... Paid-in capital—excess of par, common* ............... Preferred stock (4,000 shares x $50 par)....................... Paid-in capital—excess of par, preferred**.............

945,000 80,000 640,000 200,000 25,000

* 80,000 shares x [$9 market value – $1 par] ** Since the value of the common shares is known ($720,000), the market value of the preferred ($225,000) is assumed from the total selling price ($945,000).

November 15 Property, plant, and equipment (cash value) .................. Common stock (380,000 shares at $1 par per share) ....... Paid-in capital—excess of par (difference) ................

3,688,000 380,000 3,308,000

19–1047

Exercise 18– 1048

Williams Industries must report the 20 million Class B shares among its longterm liabilities in its balance sheet, not as part of shareholders‘ equity. The ―triggering event,‖ the death of J.P Williams, is certain to occur even though its timing may not be. A share or other financial instrument is considered to be mandatorily redeemable if it embodies an unconditional obligation that requires the issuer to redeem the instrument with cash or other assets at a specified or determinable date or upon an event certain to occur. Events certain to occur include the death or termination of employment of an individual, since both events, like taxes, are inevitable. Because Williams has the right but not the obligation to repurchase the Class A shares if a change in ownership of the voting common shares changes, there is no unconditional obligation to repurchase the Class A shares. They are classified as equity.

19–1048

Exercise 18– 1049

($ in millions) Requirement 1 Cash ($424 million – $2 million) ............................................... 422 Common stock (15 million shares at $1 par per share) .............. 15 Paid-in capital—excess of par (difference) .......................... 407

Requirement 2 In recording the sale of shares above, the cost of services related to the sale reduced the net proceeds from selling the shares. Paid-in capital—excess of par is credited for the excess of the proceeds over the par amount of the shares sold, and the issue costs are debited to that same account, thus reducing the account balance. Share issue costs are not subsequently amortized. While debt issue costs are similarly treated in that they reduce the proceeds from issuing debt, they differ in that debt issue costs are amortized to expense over the life of the debt. By doing so, debt issue costs change the effective rate of interest at which the debt is originally issued. The difference in accounting treatment often is justified by the presumption that share issue costs and debt issue costs are fundamentally different because a debt issue has a fixed maturity, but that selling shares represents a perpetual equity interest. Furthering that view is the notion that debt issue costs are part of the expense of borrowing funds for a definite period of time. On the other hand, selling shares represents an equity interest that may be held for as long as the entity is in existence. Just as dividends paid on that capital investment are not an expense, neither are the share issue costs of obtaining that capital investment.

19–1049

Exercise 18– 1050 Requirement 1 The base amount of the preferred shares is $2,500,000 ÷ 100,000 shares = $25. The dividend preference is 6.785%. So, the dividends paid annually to a preferred shareholder owning 100 shares are: $25 x 100 shares x 6.785% = $169.625.

Requirement 2 If dividends are not paid in 2025 and 2026, but are paid in 2027, the shareholder will receive $169.625 x 3 = $508.875. The prior years‘ unpaid dividends are paid because the shares are cumulative. Otherwise, only the $169.625 current year dividend would be paid. When preferred shares are cumulative, this means that if the specified dividend is not paid in a given year, the unpaid dividends (called ―dividends in arrears‖) accumulate and must be made up in a later dividend year before any dividends are paid on common shares.

Requirement 3 If the investor chooses to convert the shares in 2025, the investor will receive $25 ÷ $30.31 x 100 shares = 82.48 shares of common stock for his/her 100 shares. This can be calculated also as 82,481 ÷ 100,000, or $0.8248 per share times 100 shares. The 0.48 fractional share likely would be paid in cash equal to the current market price per share times 0.48. Requirement 4 If Ozark chooses to redeem the shares on June 18, 2025, the investor will be paid $2,750 for his/her 100 shares: The redemption price is $27.50 ($25 x 110%), original 112% reduced by 2% because redemption would be two years after the initial redemption date. The total payment would be $27.50 x 100 shares, or $2,750.

19–1050

Exercise 18– AMTC 1051 Cash (7.5 million shares x $13.546).................... Common stock (7.5 million shares x $.001 par) Paid-in capital—excess of par (difference) ..... PSI Cash (9 million shares x $15.20)......................... Common stock (9 million shares x $.01 par) .. Paid-in capital—excess of par (difference) .....

101,595,000 7,500 101,587,500

136,800,000 90,000 136,710,000

19–1051

Exercise 18– 1. January 7, 2024 1052 ($ in millions)

Common stock (2 million shares x $1 par).................................. Paid-in capital—excess of par (2 million shares x $3*) ............... Retained earnings (difference)................................................. Cash (2 million shares x $5 per share)......................................

2 6 2 10

* Paid-in capital—excess of par: $300 ÷ 100 million shares 2. August 23, 2024 Common stock (4 million shares x $1 par).................................. Paid-in capital—excess of par (4 million shares x $3) ................. Paid-in capital—share repurchase (difference) .................... Cash (4 million shares x $3.50 per share) ................................. 3. July 25, 2025 Cash (3 million shares x $6 per share).......................................... Common stock (3 million shares x $1 par).............................. Paid-in capital—excess of par (difference) .............................

19–1052

4 12 2 14

18 3 15

Exercise 18– 1053 1. January 2, 2024 ($ in millions) Common stock (10 million shares x $1 par) ................................ 10 Paid-in capital—excess of par (10 million shares x $33*) ................. 330 Paid-in capital—share repurchase (difference) .................... 15 Cash (10 million shares x $32.50) ........................................... 325 * $34 – $1 par 2. March 3, 2024 Common stock (10 million shares x $1) ..................................... Paid-in capital—excess of par (10 million shares x $33*) ............ Paid-in capital—share repurchase (available balance)............... Retained earnings (remainder)................................................. Cash (10 million shares x $36) ............................................... * $34 – $1 par 3. August 13, 2024 Cash (1 million shares x $42) ..................................................... Common stock (1 million shares x $1)................................... Paid-in capital—excess of par (remainder) .......................... 4. December 15, 2024 Cash (2 million shares x $36)..................................................... Common stock (2 million shares x $1)................................... Paid-in capital—excess of par (remainder) ..........................

10 330 15 5 360

42 1 41 72 2 70

19–1053

Exercise 18– 1054

1. January 23, 2024 ($ in millions) Treasury stock (10 million shares x $20) .............................................. 200 Cash.................................................................................. 200 2. September 3, 2024 Cash (1 million shares x $21) ..................................................... 21 Treasury stock (1 million shares x $20).................................. 20 Paid-in capital—share repurchase (remainder) .................... 1 3. November 4, 2024 Cash (1 million shares x $18) ..................................................... 18 Paid-in capital—share repurchase (available balance from req. 2.) 1 Retained earnings (remainder)................................................. 1 Treasury stock (1 million shares x $20).................................. 20

19–1054

Exercise 18– 1. February 12, 2024 1055 ($ in millions)

Treasury stock (1 million shares x $13)...................................... Cash.................................................................................. 2. June 9, 2025 Treasury stock (2 million shares x $10)...................................... Cash.................................................................................. 3. May 25, 2026 Cash (2 million shares x $15) ..................................................... Paid-in capital—share repurchase (difference) .................... Treasury stock (2 million shares x $11*)................................ * 1 million shares x $13 =$13 million 2 million shares x $10 = 20 million 3 million shares $33 million $33 million ÷ 3 million shares = $11 average cost per share 4. May 25, 2026 Cash (2 million shares x $15) ..................................................... Paid-in capital—share repurchase (difference) .................... Treasury stock (FIFO cost*) ................................................ * 1 million shares x $13 =$13 million 1 million shares x $10 = 10 million $23 million

13 13 20 20 30 8 22

30 7 23

19–1055

Exercise 18– 1056 Requirement 1 Method A – Reacquired shares are treated as treasury stock. Although theoretically identical to retired shares, treasury shares are treated as issued, but not outstanding shares—at the same time both (a) issued and (b) not outstanding. This artificial status has provided companies an effective device to evade the superficial constraints imposed on par value shares. Treasury stock is reported as a reduction in total shareholders' equity, not associated with any specific shareholders‘ equity account. By either method, total shareholders‘ equity is the same. Retiring shares clearly is conceptually superior because it effectively restores the shares to the status of being authorized, but unissued, shares. Treated as treasury stock, the cost of acquiring the shares is debited to the treasury stock account. Recording the effects on specific shareholders‘ equity accounts is delayed until later when the shares are reissued. In the meantime, the shares assume the artificial status of being neither unissued nor outstanding.

Requirement 2 Method B – Reacquired shares are retired with their status restored to that of authorized but unissued shares. Reacquired shares that are retired have their status restored to that of authorized but unissued shares.

19–1056

Exercise 18– 1057

This is a change in accounting principle. ($ in millions)

Common stock ($1 par x 4 million shares retired) ........................ Paid-in capital—excess of par (average amount above par at which the retired shares originally sold*) ............................... Retained earnings (difference)................................................. Treasury stock (cost of the shares retired) ...............................

4 16 5 25

* $800 million ÷ 200 million shares = $4; $4 x 4 million shares retired

Miller-Li applies the new way of reporting reacquired shares retrospectively; that is, to all prior periods as if it always had used that method. In other words, all financial statement amounts for individual periods affected by the change and that are included for comparison with the current financial statements are revised. In each prior period reported, then, Miller-Li would reduce Common stock by $4 million, Paid-in capital—excess of par by $16 million, Retained earnings by $5 million, and Treasury stock by $25 million. The effect of the change on each line item affected should be disclosed for each period reported as well as any adjustment for periods prior to those reported. Also, the nature of and justification for the change should be described in the disclosure notes.

19–1057

19–1058

19–1059

19–1060

Exercise 18–16 Requirement 1 ($ in millions)

Treasury stock………………………………………….... Cash (112 million shares x $16)…………………………..

1,792 1,792

Requirement 2 ($ in millions)

Common stock (112 million shares x $.01)…………………. Paid-in capital—excess of par (112 million shares x $5.39).. Retained earnings (difference)………………………………….. Cash (112 million shares x $16)……………………………

1.12 603.68 1,187.20 1,792.00

Requirement 3 Ford is referring to the fact that stock options and stock awards increase the number of shares and thus decrease earnings per share, other things being equal. This effect would partially be offset by decreasing the number of shares through share repurchase.

19–1061

19–1062

19–1063

19–1064

19–1065

19–1066

19–1067

19–1068

Exercise 18–17 Requirement 1 Retirement of common shares Common stock (5 million shares x $1 par per share)..................... Paid-in capital—excess of par ($22 – $5 – $2) ......................... Retained earnings (given) ....................................................... Cash (given) .......................................................................

($ in millions)

5 15 2 22

Net income closed to retained earnings Income summary .......................................................................... Retained earnings (given) ...................................................

Declaration and payment of a cash dividend Retained earnings (given) ....................................................... Cash ............................................................................................

Declaration and distribution of a stock dividend Retained earnings (given) ....................................................... 20 Common stock ([105 – 5] x 4%) million shares at $1 par per share) Paid-in capital—excess of par (difference) ..........................

4 16

Requirement 2 BRENNER-JUDE CORPORATION Statement of Retained Earnings FOR THE YEAR ENDED DECEMBER 31, 2024 ($ in millions)

Balance at January 1

$ 90

Net income for the year

Deductions: Retirement of common stock Cash dividends of $.33 per share 4% stock dividend Balance at December 31

(2) (33) (20) $123

19–1069

Exercise 18–18 Requirement 1 Assuming the preferred stock is cumulative and nonparticipating: Preferred Common 2024 2025 2026

$ 8 million 20 million* 20 million**

$ 0 0 130 million (remainder)

$8 million dividends in arrears plus $12 million of the $16 million current preference. ** $4 million dividends in arrears plus the $16 million current preference. Requirement 2 Assuming the preferred stock is noncumulative and nonparticipating: Preferred Common 2024 2025 2026

19–1070

$ 8 million 16 million 16 million**

0 4 million (remainder) 134 million (remainder)

19–1071

Exercise 18–19 April 1, 2024 Retained earnings (300,000* shares at $30 per share) ............... 9,000,000 Common stock (300,000* shares at $1 par per share) ......... Paid-in capital—excess of par (remainder) ..................... * 10% x 3 million shares issued and outstanding

300,000 8,700,000

or, alternatively:

April 1, 2024 Retained earnings ..................................................................... 9,000,000 Common stock dividends distributable ........................ Paid-in capital—excess of par ..................................... June 1, 2024 Common stock dividends distributable................................. Common stock ............................................................

300,000 8,700,000

300,000 300,000

19–19

Exercise 18– 1073 Paid-in capital—excess of par** .......................................... 24,500 Common stock (24.5 million shares* x $.001 par per share)..

24,500

**alternatively, retained earnings may be debited

* 100% x 24.5 million shares = 24.5 million shares Requirement 2 If Hanmi‘s stock price had been $36 at the time of the split, its approximate value after the split (other things equal) would be $18. The same pie is sliced into twice as many pieces, so each piece is worth half as much.

19–1073

Exercise 18–21 Requirement 1 A stock dividend or stock split usually results in some shareholders being entitled to fractions of whole shares. For instance, if a company declares a 25% stock dividend, or equivalently a 5-for-4 stock split, a shareholder owning 10 shares would be entitled to 2 1/2 shares. Another shareholder with 15 shares would be entitled to 3 3/4 shares. Paying shareholders the cash equivalent of the fractional shares simplifies matters for both the corporation and shareholders. Requirement 2 ($ in millions)

Retained earnings (36 million* x $21 per share) ................................. 756 Common stock ([36 million* – 2 million] x $1 par) ................. Paid-in capital—excess of par ([36 million* – 2 million] x [$21 – $1 = $20 per share]) ............ Cash (2 million shares at $21 market price per share)..................

34 680 42

* 4% x 900 million shares = 36 million additional shares

19–21

Exercise 18– 1075 The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1. Requirements to disclose within the financial statements the pertinent rights and privileges of the various securities outstanding: FASB ASC 505–10–50–3: ―Equity–Overall–Disclosure–General.‖

Requirement to record a ―small‖ stock dividend at the fair value of the shares issued: FASB ASC 505–20–30–3: ―Equity–Stock Dividends and Stock Splits–Initial Measurement–Stock Dividend.‖ Another citation that describes what qualifies as a small stock dividend is FASB ASC 505–20–25–3. Notice, though, that this paragraph does not say fair value, so it can‘t be considered the ―best‖ answer.

3. Requirement to exclude from the determination of net income gains and losses on transactions in a company’s own stock: FASB ASC 505–10–25–2: ―Equity–Overall–Recognition–General‖

19–1075

Exercise 18–22 Requirement 1 a. March 3—declaration date Investment in equity securities* ...................................... Gain on investments ($720,000 – $700,000) ....................

20,000 20,000

* As an alternative to using a fair value adjustment account, we adjust for fair value directly to the investment account.

Retained earnings (240,000 shares at $3 per share) ................... Property dividends payable .........................................

720,000 720,000

March 15—date of record no entry March 31—payment date Property dividends payable ............................................. Investment in equity securities ....................................

720,000

b. May 3 Paid-in capital—excess of par, common* ........................ Common stock (25% x [364,000 – 4,000] shares at $1 par) ..

90,000

720,000

90,000

*alternatively, retained earnings may be debited. c. July 5 Retained earnings (9,000* x $11 per share)............................... Common stock (9,000* x $1 par) .................................... Paid-in capital—excess of par, common (difference)......

99,000 9,000 90,000

* 2% x [360,000 + 90,000 shares] = 9,000 additional shares

19–1076

Exercise 18–23 (continued) d. December 1—declaration date Retained earnings ............................................................ Cash dividends payable ($90,000 par x 8.8%) .................

7,920 7,920

December 20—date of record no entry December 28—payment date Cash dividends payable .................................................. Cash ............................................................................

7,920

e. December 1—declaration date Retained earnings ............................................................ Cash dividends payable (459,000* x $0.50) ....................

229,500

7,920

229,500

* 360,000 + 90,000 + 9,000 = 459,000 shares December 20—date of record no entry December 28—payment date Cash dividends payable .................................................. Cash ............................................................................

229,500 229,500

19–1077

Exercise 18–23 (concluded) Requirement 2 CONSOLIDATED PAPER, INC. [Shareholders’ Equity section] December 31, 2024 Paid-in capital: Preferred stock, 8.8%, 90,000 shares at $1 par Common stock, 463,0001 shares at $1 par Paid-in capital—excess of par, preferred Paid-in capital—excess of par, common Retained earnings Treasury stock, at cost; 4,000 common shares Total shareholders’ equity

90,000 463,000 1,437,000 2,574,000 2 9,488,580 3

(44,000) $14,008,580

1 364,000 + 90,000 + 9,000 = 463,000 shares 2 $2,574,000 – $90,000 + $90,000 = $2,574,000 3 $9,735,000 – $720,000 – $99,000 – $7,920 – $229,500 + $810,000 = $9,488,580

19–1078

Exercise 18– 1079 Requirement 1 The return on shareholders' equity is computed by dividing net income by average shareholders' equity. [$200 – $120]* ÷ ([$600 + $520] ÷ 2) = 14.29% * Increase in retained earnings, which equals net income since no dividends were paid.

Requirement 2 The ratio is a summary measure of profitability often used by investors and potential investors, particularly common shareholders. It measures the ability of company management to generate net income from the resources that owners provide. However, because shareholders‘ equity is a measure of the book value of equity, investors often relate earnings to the market value of equity, calculating the earningsprice ratio. Information available in the exercise is insufficient to do so.

19–1079

Exercise 18–25 Indicate by letter whether each of the terms or phrases listed below is more associated with financial statements prepared in accordance with U.S. GAAP (U) or International Financial Reporting Standards (I). Terms and phrases U 1. Common stock I 2. Preference shares U 3. Liabilities often listed before Equity in the balance sheet (statement of financial position) I 4. Asset revaluation reserve U 5. Accumulated other comprehensive income I 6. Share premium I 7. Equity often listed before Liabilities in the balance sheet (statement of financial position) I 8. Translation reserve I 9. Ordinary shares U 10. Paid-in capital—excess of par U 11. Net gains (losses) on investments—AOCI I 12. Investment revaluation reserve U 13. Preferred stock

19–1080

Exercise 18– 1081 Requirement 1 January 2 Cash…………………………………. Common stock…………………… Paid-in capital—excess of par……

Debit 40,000

Credit 2,000 38,000

January 9 Accounts receivable…………………. Service revenue…………………..

14,300

January 10 Supplies…………………………….. Accounts payable………………..

4,900

January 12 Treasury stock……………………… Cash……………………………..

18,000

January 15 Accounts payable………………….. Cash…………………………….

16,500

January 21 Cash………………………………... Service revenue…………………

49,100

January 22 Cash……………………………….. Accounts receivable……………

16,600

14,300

4,900

18,000

16,500

49,100

16,600

19–1081

Exercise 18–26 (continued) Requirement 1 (concluded)

January 29 Retained earnings……………………………. Dividends payable……………………….. ($3,300 = [10,000 + 2,000 − 1,000]×$0.30) January 30 Cash…………………………………………. Treasury stock…………………………… Paid-in capital—share repurchase………. ($10,800 = 600 shares repurchased ×$18.00) January 31 Salaries expense………………….………… Cash………………………….…………. Requirement 2 (a) January 31 Utilities expense………………………. Utilities payable……………………

Debit 6,200

(b) January 31 Supplies expense ....................................... 7,300 Supplies……………………………. ($7,300 = $7,500 + $4,900 − $5,100) (c) January 31 Depreciation expense ................................ 1,500 Accumulated depreciation………… ($1,500 = [$64,000 − $10,000] / 36 months) (d) January 31 Income tax expense ................................... 2,000 Income taxes payable………………

19–1082

Debit 3,300

Credit 3,300

12,000 10,800 1,200

42,000 42,000

Credit 6,200

7,300

1,500

2,000

Exercise 18–26 (continued) Requirement 3 Freedom Fireworks Adjusted Trial Balance January 31, 2024 Accounts Debit Cash $ 83,900 Accounts receivable 42,200 Supplies 5,100 Equipment 64,000 Accumulated depreciation Accounts payable Utilities payable Dividends payable Income taxes payable Common stock Paid-in capital—excess of par Paid-in capital—share repurchase Retained earnings 7,200 Treasury stock Service revenue 42,000 Salaries expense Utilities expense 6,200 Supplies expense 7,300 Depreciation expense 1,500 Income tax expense 2,000 Totals $261,400

Credit

$ 10,500 3,000 6,200 3,300 2,000 12,000 118,000 1,200 41,800 63,400

$261,400

19–1083

Exercise 18–26 (continued) Requirement 3 (continued) Accounts

ounts receivable plies ipment umulated depreciation ounts payable ities payable idends payable me taxes payable mmon stock -in capital—excess of par -in capital—share rchase ained earnings asury stock vice revenue ries expense ities expense plies expense reciation expense me tax expense

19–1084

Ending Beginning balance in bold, entries during Balance January in blue, and adjusting entries in red. 83,900 = 42,700 + 40,000 − 18,000 − 16,500 + 49,100 + 16,600 +12,000 − 42,000 42,200 = 44,500 + 14,300 − 16,600 5,100 = 7,500 + 4,900 − 7,300 64,000 = 64,000 10,500 = 9,000 + 1,500 3,000 = 14,600 + 4,900 − 16,500 6,200 = 6,200 3,300 = 3,300 2,000 = 2,000 12,000 = 10,000 + 2,000 118,000 = 80,000 + 38,000 1,200 = 0 + 1,200 41,800 7,200 63,400 42,000 6,200 7,300 1,500 2,000

= = = = = = = =

45,100 − 3,300 18,000 − 10,800 14,300 + 49,100 42,000 6,200 7,300 1,500 2,000

Exercise 18–26 (continued) Requirement 4 Freedom Fireworks Income Statement For the month ended January 31, 2024 Service revenue $63,400 Salaries expense Utilities expense Supplies expense Depreciation expense Income before taxes Income tax expense Net income

42,000 6,200 7,300 1,500 6,400 2,000 $ 4,400

19–1085

Exercise 18–26 (continued) Requirement 5

Assets Cash Accounts receivable Supplies Total current assets

Equipment Less: Accumulated depreciation Total assets

Freedom Fireworks Balance Sheet January 31, 2024 Liabilities $ 83,900 Accounts payable 42,200 Utilities payable 5,100 Dividends payable 131,200 Income taxes payable Total current liabilities Shareholders’ Equity Common stock Paid-in capital—excess of par Paid-in capital—share repurchase Retained earnings 64,000 Treasury stock (10,500) Total shareholders‘ equity

3,000 6,200 3,300 2,000 14,500

12,000 118,000 1,200 46,200 * (7,200) 170,200

$184,700

Total liabilities and shareholders‘ equity

$184,700

* Retained earnings = Beginning retained earnings + Net income − Dividends = $45,100 + $4,400 − $3,300 = $46,200

19–1086

Exercise 18–26 (continued) Requirement 6 January 31, 2024 Service revenue………………………. Retained earnings………………….

Debit 63,400

Retained earnings…………………….. Salaries expense…………………... Utilities expense…………………... Supplies expense………………….. Depreciation expense……………… Income tax expense………………..

59,000

Credit 63,400

42,000 6,200 7,300 1,500 2,000

19–1087

Exercise 18–26 (concluded) Requirement 7 (a) The return on equity is: Return on Equity Ratio

Net Income Average Shareholders‘ = Equity

$4,400 ($135,100 + $170,200) / 2

2.9%

Compared to the industry average of 2.5%, Freedom Fireworks is more profitable than other companies in the same industry. Note these are monthly, rather than annual, return on equity calculations. A consistent monthly return on equity of 2.5% results in a 30% annual return on equity.

(b) The number of common shares outstanding as of January 31, 2024 is 11,600. The company had 10,000 shares at the beginning of January, issued 2,000 additional shares on January 2, repurchased 1,000 shares on January 12, and reissued 600 shares on January 30. (11,600 = 10,000 + 2,000 − 1,000 + 600)

$4,400 (10,000 + 11,600) / 2

$ 0.41

Compared to an average earnings per share of $0.30 per month last year, earnings per share for January 2024 is better than last year‘s average earnings per share.

19–1088

Exercise 18–27 Requirement 1 Cash PSP Note payable Payroll Support Program Warrants

($ in billions) 1.8 1.7 0.1

Requirement 2 American‘s shareholders‘ equity increased at the time of the loan by $0.1 billion, the value of the warrants issued.

PROBLEMS

19–1089

Problem 18–1 PART A Jan. 9 ($ in millions) Cash (40 million shares x $20 per share) ................................................ 800

Common stock (40 million shares x $1 par) ............................ 40 Paid-in capital—excess of par (difference) ............................. 760 Mar. 11 Equipment (5,000 shares x $20 per share) ...................................... 100,000 Common stock (5,000 shares x $1 par) ............................... 5,000 Paid-in capital—excess of par (difference) ........................... 95,000 PART B Sept. 1 ($ in millions)

Common stock (2 million shares x $1 par).................................. Paid-in capital—excess of par

(2 million shares x $19) ...................................................................

38 10

Retained earnings (difference)................................................. Cash.................................................................................. Dec. 1

50 ($ in millions)

Cash...................................................................................... Common stock .................................................................. Paid-in capital—excess of par ..........................................

19–1090

26 1 25

Problem 18–2 Requirement 1 a. February 5, 2024 ($ in millions)

Retirement Common stock (6 million sh. x $1) Paid-in capital—excess of par

Treasury Stock 6

Treasury stock (6 million sh. x $10)60 Cash 60

42 Paid-in capital—share repurchase 1 Retained earnings (plug) 11 Cash 60 * Paid-in capital—excess of par: $1,680 ÷ 240 (6 million shares x $7*)

b. July 9, 2024 Cash (2 million sh. x $12) 24 Common stock (2 million sh. x $1) 2 Paid-in capital—excess of par 22

Cash (2 million sh. x $12) 24 Treasury stock (2 million sh. x $10) 20 Paid-in capital—share repurchase 4

c. November 14, 2026 Cash (2 million sh. x $7) 14 Common stock (2 million sh. x $1) 2 Paid-in capital—excess of par 12

Cash (2 million sh. x $7) 14 Paid-in cap.-sh. repurchase ($1+$4)5 Retained earnings (plug) 1 Treasury stock (2 million sh. x $10) 20

19–1091

Problem 18–2 (concluded) Requirement 2 Shareholders’ Equity

$ in millions

Retirement

Treasury Stock

Paid-in capital: Common stock, $1 par, ................................................ Paid-in capital—excess of par ...................................... Paid-in capital—share repurchase .................................

$ 238 1,672 * 0

$ 240 1,680 0

Retained earnings .......................................................

1,089 **

1,099 ***

$2,999

(20) $2,999

Less: Treasury stock, 2 million shares (at cost) .......... Total shareholders’ equity ........................................... * $1,680 – $42 + $22 + $12 ** $1,100 – $11 *** $1,100 – $1

or, alternatively: Paid-in capital: Common stock, $1 par, ................................................ Additional paid-in capital..............................................

$ 238 1,672 *

$ 240 1,680

Retained earnings .......................................................

1,089 **

1,099 ***

$2,999

(20) $2,999

Less: Treasury stock, 2 million shares (at cost) .......... Total shareholders’ equity ........................................... * $1,680 – $42 + $22 + $12 ** $1,100 – $11 *** $1,100 – $1

19–1092

Problem 18–3 Requirement 1 February 15, 2024 (a) Retired Common stock (300,000 shares x $1 par) ......................... Paid-in capital—excess of par (300,000 shares x $5)....... Retained earnings (difference)....................................... Cash (300,000 shares x $8) .......................................... (b) Accounted for as treasury stock Treasury stock (300,000 shares x $8)............................... Cash (300,000 shares x $8) .......................................... February 17, 2025 (a) Retired Common stock (300,000 shares x $1 par) ......................... Paid-in capital—excess of par (300,000 shares x $5)....... Paid-in capital—share repurchase (difference) .......... Cash (300,000 shares x $5.50)...................................... (b) Accounted for as treasury stock Treasury stock (300,000 shares x $5.50) .......................... Cash (300,000 shares x $5.50)......................................

300,000 1,500,000 600,000 2,400,000

2,400,000 2,400,000

300,000 1,500,000 150,000 1,650,000

1,650,000 1,650,000

19–1093

Problem 18–3 (concluded) November 9, 2026 (a) Retired Cash (200,000 shares x $7) .............................................. Common stock (200,000 shares x $1 par) ..................... Paid-in capital—excess of par (difference) ................

1,400,000 200,000 1,200,000

(b) Accounted for as treasury stock Cash (200,000 shares x $7).............................................. Retained earnings ....................................................... Treasury stock (200,000 shares x $8 FIFO cost) ............

1,400,000 200,000 1,600,000

Requirement 2 Shareholders’ Equity SHARES RETIRED TREASURY STOCK Paid-in capital: Common stock, $1 par, ...................................... Paid-in capital—excess of par............................. Paid-in capital—share repurchase .......................

6,000,000 30,000,000 0

130,900,000*

131,300,000**

$164,850,000

(2,450,000) $164,850,000

Retained earnings ............................................. Less: treasury stock, 400,000 shares (at cost) .. Total shareholders’ equity .................................

5,600,000 28,200,000 150,000

$86,500,000 – $600,000 + $14,000,000 + $15,000,000 + $16,000,000 $86,500,000 + $14,000,000 + $15,000,000 + $16,000,000 – $200,000

or, alternatively: Paid-in capital: Common stock, $1 par, ...................................... Additional paid-in capital ................................... Retained earnings ............................................. Less: treasury stock, 400,000 shares (at cost) .. Total shareholders’ equity .................................

19–1094

5,600,000 28,350,000

130,900,000*

131,300,000** (2,450,000) $164,850,000

$164,850,000

6,000,000 30,000,000

Problem 18–4 2024 Retained earnings ....................................................... Income summary ....................................................

160,500

2025 Income summary ........................................................ Retained earnings ...................................................

2,240,900

160,500

2,240,900

Common stock (110,000 shares at $1 par per share) ............ 110,000 Paid-in capital—excess of par (110,000 shares x $4*) ..... 440,000 Retained earnings (given) ............................................. 212,660 Cash (total)............................................................... * Paid-in capital—excess of par: $7,420 ÷ 1,855 = $4 Retained earnings (given) ............................................. Cash dividends payable .........................................

698,000

Cash dividends payable ............................................. Cash .......................................................................

698,000

2026 Income summary ........................................................ Retained earnings ...................................................

762,660

698,000

3,308,700 3,308,700

Retained earnings (given) ............................................. Common stock (34,900 shares at $1 par per share) ........ Paid-in capital—excess of par (difference) ................

242,000

Retained earnings ....................................................... Cash dividends payable ..........................................

889,950

Cash dividends payable ............................................. Cash .......................................................................

889,950

34,900 207,100

889,950

19–1095

19–1096

Problem 18–5 Requirement 1 2024 a. November 1—declaration date Retained earnings............................................................. 84,000,000 Cash dividends payable (105 million shares at $0.80/share) 84,000,000 November 15—date of record no entry December 1—payment date Cash dividends payable .................................................... 84,000,000 Cash ....................................................................... 84,000,000

2025 b. March 1—declaration date Investment in debt securities ....................................... Gain on investments ($1.6 million – $1.3 million) ........ Retained earnings ...................................................... Property dividends payable ...................................

300,000 300,000 1,600,000 1,600,000

March 13– date of record no entry April 5– payment date Property dividends payable ........................................ Investment in debt securities ..................................

1,600,000 1,600,000

c. July 12 Retained earnings (5,250,000* x $21 per share)................... 110,250,000 Common stock ([5,250,000* – 250,000] x $1 par) .... 5,000,000 Paid-in capital—excess of par ([5,250,000* – 250,000] x $20 per share) ................. 100,000,000 Cash (250,000 shares at $21 market price per share) ..... 5,250,000 * 5% x 105,000,000 shares = 5,250,000 additional shares

19–1097

Problem 18–5 (continued) d. November 1—declaration date Retained earnings.............................................................88,000,000 Cash dividends payable (110,000,000* x $0.80) ........... 88,000,000 * 105,000,000 + 5,000,000 = 110,000,000 shares November 15—date of record no entry December 1—payment date Cash dividends payable ....................................................88,000,000 Cash ....................................................................... 88,000,000 2026 e. January 15 Paid-in capital—excess of par** ......................................55,000,000 Common stock (55,000,000* shares at $1 par) ............. 55,000,000 **alternatively, retained earnings may be debited * 110,000,000 shares x 50% = 55,000,000 shares f. November 1—declaration date Retained earnings ..........................................................107,250,000 Cash dividends payable (165,000,000 * x $0 .65) ......... 107,250,000 * 105,000,000 + 5,000,000 + 55,000,000 = 165,000,000 shares November 15—date of record no entry December 1—payment date Cash dividends payable ..................................................107,250,000 Cash ....................................................................... 107,250,000

19–1098

Problem 18–5 (concluded) Requirement 2 BRANCH-RICKIE CORPORATION Statement of Shareholders’ Equity For the Years Ended Dec. 31, 2024, 2025, and 2026 ($ in 000s)

Jan. 1, 2024 Net income Cash dividends Dec. 31, 2024 Property dividends Common stock dividend Net income Cash dividends Dec. 31, 2025 3-for-2 split effected in the form of a stock dividend Net income Cash dividends Dec. 31, 2026

Common Stock

Additional Paid-in Capital

Retained Earnings

Total Shareholders‘ Equity

$105,000

$630,000

$ 970,000

$1,705,000

$630,000

330,000 (84,000) $1,216,000

330,000 (84,000) $1,951,000

(1,600)

(110,250) 395,000 (88,000) $1,411,150

(5,250) 395,000 (88,000) $2,251,150

455,000 (107,250) $1,758,900

455,000 (107,250) $2,598,900

$105,000

5,000

100,000

$110,000

$730,000

55,000

(55,000)

$165,000

$675,000

19–1099

Problem 18–6 Requirement 1 ($ in millions) 2024 Cash...................................................................................... 480 Preferred stock (1 million shares x $10 par per share) ............... 10 Paid-in capital—excess of par, preferred........................... 470

Cash...................................................................................... Common stock (7 million shares x $1 par per share)................. Paid-in capital—excess of par, common ..........................

Retained earnings ................................................................. Cash dividends payable, preferred ..................................

Cash dividends payable, preferred ....................................... Cash .................................................................................

Retained earnings ................................................................. Cash dividends payable, common ....................................

Cash dividends payable, common ........................................ Cash .................................................................................

Income summary .................................................................. Retained earnings .............................................................

290

2025 Common stock (3 million shares x $1 par).................................. Paid-in capital—excess of par (3 million shares x $9*).............. Retained earnings (given) ....................................................... Cash (total).........................................................................

($ in millions)

7 63

290

3 27 20 50

* [$495 million + $63 million] ÷ [55 million + 7 million shares] = $9 weighted average amount per share in excess of par

19–1100

Problem 18–6 (continued) ($ in millions)

Retained earnings ................................................................. Cash dividends payable, preferred ..................................

Cash dividends payable, preferred ....................................... Cash .................................................................................

Retained earnings ................................................................. Cash dividends payable, common ....................................

Cash dividends payable, common ........................................ Cash .................................................................................

Paid-in capital—excess of par, preferred .............................. Preferred stock ...........................................................................

Income summary .................................................................. Retained earnings .............................................................

380

($ in millions) 2026 Retained earnings ................................................................ 65 Common stock ................................................................. 6 Paid-in capital—excess of par, common ........................... 59

Retained earnings ................................................................. Cash dividends payable, preferred ..................................

Cash dividends payable, preferred ....................................... Cash .................................................................................

Retained earnings ................................................................. Cash dividends payable, common ....................................

Cash dividends payable, common ........................................ Cash .................................................................................

Income summary .................................................................. Retained earnings .............................................................

412

1 1 22 22 412

19–1101

Problem 18–6 (concluded) Requirement 2 ANACONDA INTERNATIONAL CORPORATION Balance Sheets at December 31 2026 2025 Shareholders’ Equity: Preferred stock Common stock Additional paid-in capital Retained earnings Total shareholders‘ equity

19–1102

15 65 1,055 2,814 $3,949

15 59 996 2,490 $3,560

Problem 18–7 Requirement 1 The statement of shareholders‘ equity explains why and how the various shareholders‘ equity items in the balance sheet change from period to period. The statement shows the beginning and ending balances in primary shareholders‘ equity accounts and any changes that occur during the years reported (usually three years). In this problem, the period is for one fiscal year. Typical reasons for changes are the sale of additional shares of stock, the buyback of stock, net income, and the declaration of dividends. Cisco accounts for its share repurchases as retired shares. The Statement of Equity reports the repurchase of common stock and yet has no column in the Statement of Equity for treasury stock. If the buybacks were viewed as the purchase of treasury shares, a Treasury Stock account would have been employed. Requirement 2 The price Cisco paid for the shares repurchased during the period shown was more than the average price at which Cisco had sold the shares previously. We know this because the Statement of Equity reports a reduction in retained earnings (increase in Accumulated Deficit in this case) resulting from that transaction. This occurs only when the cash paid exceeds the reduction in Common stock and Additional Paid-in capital as demonstrated by the journal entry in requirement 3. Requirement 3 ($ in millions)

Common stock (59,000,000 shares x $.001 par per share) .... Additional paid-in capital* (given) ............................. Retained earnings (given) .......................................... Cash (given: change in total shareholders’ equity) .......

0 561 2,058 2,619

*consisting of Paid-in capital—excess of par (shares x paid-in per share in excess of par when sold), and possibly Paid-in capital—share repurchase (if any balance remained from previous buybacks when the cash paid was less than the selling price.)

19–1103

Problem 18–7 (continued) Requirement 4 Comprehensive income is the total nonowner change in equity for a reporting period. It encompasses all changes in equity other than from transactions with owners. Transactions between the corporation and its owners primarily include dividends and the sale or purchase of shares of the company‘s stock. Most nonowner changes are reported in the income statement ($11,214 million earnings for Cisco). The changes other than those that are part of traditional net income are reported as ―Other comprehensive income‖: $273 million gain for Cisco. Other Comprehensive Income in the period consisted of (1) net income of $11,214 million and (2) other comprehensive income (OCI) of $273 million. OCI consists of some unreported combination of (1) net unrealized gain/loss on AFS investments in debt securities, (2) changes in pension and other postretirement benefits, (3) net unrealized gain/loss on derivative instruments, and/or (4) cumulative translation adjustment. Each of the last two items is considered other comprehensive income and not discussed in detail in this chapter. Here‘s a summary: For reporting purposes, investments in available-for-sale debt securities are reported at their fair values. The unrealized gains and losses from adjusting those securities up or down to fair value are not reported in the income statement, but instead are reported as a component of other comprehensive income in the balance sheet (described in Chapter 12). When a derivative designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in the Derivatives Appendix to the textbook).

19–1104

Problem 18–7 (concluded)

19–1105

As we noted in Chapter 17, gains and losses, and prior service cost for pensions and other postretirement benefit plans are not recognized currently in earnings. Instead, we report them as part of other comprehensive income. Adjustments from changes in foreign currency exchange rates when translating financial statements of foreign subsidiaries are discussed elsewhere in the accounting curriculum, and also are included in other comprehensive income rather than net income.

Requirement 5 The comprehensive income accumulated over the current and prior periods is reported as a separate component of shareholders‘ equity. In Cisco‘s case, this amount is accumulated other comprehensive loss of $519 million. This amount represents the cumulative sum of the changes in each component created during each reporting period throughout all prior years.

19–1106

Problem 18– 1107 Requirement 1

Cash ($385,000 – $1,500)....................................................... Common stock (30,000 shares at $1 par per share) ................ Paid-in capital—excess of par (remainder) .......................

383,500 30,000 353,500

Requirement 2 Retained earnings .............................................................. Cash dividends payable (30,000 shares x $2) ....................

60,000 60,000

Requirement 3 Cash dividends payable .................................................... Cash ..............................................................................

60,000 60,000

Requirement 4 Common stock (10% x $30,000) ........................................... Paid-in capital—excess of par (10% x $353,500)...................... Retained earnings (difference).............................................. Cash (given) ....................................................................

3,000 35,350 1,150 39,500

19–1107

Problem 18– 1108 Assumption A – noncumulative Preferred Current preference

$10 (10% x $100)

Remainder to common Allocation

Common

$140 $10

Total $150 (10) 140 (140) $ 0

$140

Assumption B – cumulative Preferred

Common Total $150

Dividends in arrears: -2023 -2024 Current preference

$10 (10% x $100) 10 (10% x $100) 10 (10% x $100)

Remainder to common Allocation

19–1108

$120 $30

(10) (10) (10) 120 (120) $ 0

$120

Problem 18– 1109 Transactions N N N

1. 2. 3.

D N D* I D N N D N

4. 5. 6. 7. 8. 9. 10. 11. 12.

13.

N(orD) 14. N 15. D

16.

Sale of common stock Purchase of treasury stock at a cost less than the original issue price Purchase of treasury stock at a cost greater than the original issue price Declaration of a property dividend Sale of treasury stock for more than cost Sale of treasury stock for less than cost Net income for the year Declaration of a cash dividend Payment of a previously declared cash dividend Issuance of convertible bonds for cash Declaration and distribution of a 5% stock dividend Retirement of common stock at a cost less than the original issue price Retirement of common stock at a cost greater than the original issue price A stock split effected in the form of a stock dividend A stock split in which the par value per share is reduced (not effected in the form of a stock dividend) A net loss for the year

* Shareholders‘ equity of the transacting company includes only common stock, paid-in capital—excess of par, and retained earnings at the time of each transaction. No Paid-in capital—share repurchase.

19–1109

Problem 18– 1110

A stock dividend is the distribution of additional shares of stock to current shareholders of the corporation. The investor receives no assets, only additional shares. Because each shareholder receives the same percentage increase in shares, an investor‘s proportional interest in (percentage ownership of) the investee corporation remains unchanged. So, when additional shares are received from a stock dividend, no journal entry is needed. The same investment is simply represented by a larger number of shares. Of course, the investment per share is now less, an effect that must be considered if a portion of the investment is sold. To record the investment Investment in equity securities ............................................. Cash (1.2 million shares x $44) ..............................................

($ in millions)

52.8 52.8

To record the sale of shares......................... Cash (200,000 shares x $46) ...................................................... Investment in equity securities (200,000 shares x $44) .......... Gain on investments (difference) .........................................

9.2 8.8 0.4

10% stock dividend There is no entry for the stock dividend, but a new investment per share must be calculated for use later when the shares are sold: $44 million* = $40 per share 1,000,000 shares x 1.10 * $52.8 – $8.8 = $44 To record the sale of shares Cash (100,000 shares x $43) ...................................................... Investment in equity securities (100,000 shares x $40) .......... Gain on investments (difference) .........................................

4.3 4.0 0.3

Note: If a financial reporting date falls between the acquisition and sale of shares, and the investment is adjusted to fair value on that date, the treatment of the stock dividend would be the same. That is, the new per share basis of the investment still would be the investment balance divided by the number of shares after the stock dividend. But the investment balance now would be its fair value on the last reporting date rather than its cost. 19–1110

Problem 18– 1111 Part A

Requirement 1 January 2 Cash (amount received) ............................................................... 30,000,000 Common stock ($1 par x 3,000,000 shares) .................... 3,000,000 Paid-in capital—excess of par, common (difference)... 27,000,000 January 2 Cash (amount received) ............................................................... 20,000,000 Preferred stock ($5 par x 1,000,000 shares)........................ 5,000,000 Paid-in capital—excess of par, preferred (difference) .. 15,000,000

Requirement 2 NICKLAUS CORPORATION Balance Sheet-Shareholders' Equity Section March 31, 2024 Shareholders' equity Preferred stock, $5 par, authorized 1,000,000 shares, issued and outstanding 1,000,000 shares Common stock, $1 par, authorized 5,000,000 shares, issued and outstanding 3,000,000 shares Paid-in capital—excess of par Retained earnings Total shareholders' equity

$ 5,000,000 3,000,000 42,000,000 1,000,000 $51,000,000

19–1111

Problem 18–12 (continued) Part B Requirement 1 June 30 Treasury stock ($12 x 200,000 shares) ......................................... 2,400,000 Cash..........................................................................

2,400,000

July 31 Cash ($15 x 50,000 shares) ................................................ 750,000 Treasury stock ($12 x 50,000 shares)............................. Paid-in capital—share repurchase [($15 – $12) x 50,000 shares]

600,000 150,000

September 30 Cash ($10 x 50,000 shares)................................................ Paid-in capital—share repurchase [($12 – $10) x 50,000 shares] .......................................... Treasury stock ($12 x 50,000 shares) .............................

600,000

19–1112

500,000 100,000

Problem 18–12 (continued) Requirement 2 NICKLAUS CORPORATION Balance Sheet - Shareholders' Equity Section September 30, 2024 Shareholders' equity Preferred stock, $5 par, authorized 1,000,000 shares, issued and outstanding 1,000,000 shares Common stock, $1 par, authorized 5,000,000 shares issued 3,000,000 shares, 2,900,0001 shares outstanding Paid-in capital—excess of par Paid-in capital—share repurchase2 Retained earnings3 Less: Treasury stock (at cost) Total shareholders' equity 1

3,000,000 – 200,000 + 50,000 + 50,000

$150,000 – $100,000

$1,000,000 + $3,000,000

$ 5,000,000 3,000,000 42,000,000 50,000 4,000,000 $54,050,000 (1,200,000) $52,850,000

19–1113

Problem 18–12 (continued) Part C Requirement 1 October 1 No entry November 1 Retained earnings ......................................................... 1 Cash dividends payable, common ($.05 x 5,800,000 ) .. Cash dividends payable, preferred ($.25 x 1,000,000)...

540,000 290,000 250,000

November 15 No entry December 1 Cash dividends payable, common ................................ Cash dividends payable, preferred ............................... Cash..........................................................................

290,000 250,000 540,000

Note: Dividends are not paid on treasury shares. Cash dividends are paid only on the 5,800,000 common shares outstanding. December 2 2 Retained earnings ($10 fair value x 58,000 shares ) 580,000 Common stock dividends distributable ($.50 par x 58,000 shares) 29,000 Paid-in capital—excess of par, common (difference) 551,000 December 28 Common stock dividends distributable ......................... 29,000 Common stock .......................................................... 29,000 1

(3,000,000 – 200,000 + 50,000 + 50,000) x 2 = 5,800,000 shares

1% x 5,800,000 shares

19–1114

Problem 18–12 (continued) Requirement 2 NICKLAUS CORPORATION Balance Sheet - Shareholders' Equity Section December 31, 2024 Shareholders' equity Preferred stock, $5 par, authorized 1,000,000 shares, issued and outstanding 1,000,000 shares Common stock, $.50 par, authorized 10,000,000 shares, issued 6,058,000 shares, and 5,858,0001 shares outstanding Paid-in capital—excess of par2 Paid-in capital—share repurchase Retained earnings3 Less: Treasury stock (at cost) Total shareholders' equity 1

5,900,000 + 59,000

$27,000,000 + $15,000,000 + $551,000

$4,000,000 – $540,000 – $580,000 + $2,500,000

$ 5,000,000 3,029,000 42,551,000 50,000 5,380,000 $56,010,000 (1,200,000) $54,810,000

19–1115

Problem 18–12 (concluded) Requirement 3 NICKLAUS CORPORATION Statement of Shareholders’ Equity for the Year Ended Dec. 31, 2024 ($ in 000s)

Preferred Common Stock Stock

–– Jan. 2, 2024 Issuance of preferred stock 5,000 Issuance of common stock Purchase of treasury stock Sale of treasury stock Net income Common cash dividends Preferred cash dividends Stock dividend Dec. 31, 2024

19–1116

5,000

––

3,000

Additional Paid-in Capital

––

Retained Earnings

––

Total Treasury ShareStock holders’ Equity

––

15,000

20,000

27,000

30,000

(2,400)

1,200 6,500

1,250 6,500

(290)

(290) (250) 0

551

(250) (580)

3,029

42,601

5,380

(1,200)

54,810

Problem 18–13 Requirement 1 To revalue assets: Retained earnings ................................................................. Inventory ........................................................................ Land ..................................................................................... Retained earnings..............................................................

105 105 5 5

To eliminate a portion of the deficit against available additional paid-in capital: Additional paid-in capital ..................................................... 60 Retained earnings.............................................................. 60 To eliminate the remainder of the deficit against common stock: Common stock .......................................................................... 240 Retained earnings.............................................................. 240

19–1117

Problem 18–13 (concluded)

Requirement 2 CHAMPION CHEMICAL CORPORATION Balance Sheet January 1, 2025 ASSETS Current Assets: Cash Receivables Inventory Total Current Assets Land Buildings and equipment (net) Total Assets

$ 20 40 125 185 45 90 $320

LIABILITIES AND STOCKHOLDERS’ EQUITY Liabilities Stockholders‘ Equity: Common stock (320 million shares at $.25 par) Additional paid-in capital Retained earnings (deficit) Total Stockholders‘ Equity Total Liabilities and Stockholders‘ Equity

$240 80 0 0 80 $320

DECISION MAKERS’ PERSPECTIVE CASES Real World Case 18–1 Requirement 1

19–1118

Assuming the shares are issued at the midpoint of the price range indicated, $14.50 per share, Dolby Laboratories would raise $14.50 x 27.5 million shares = $398.75 million before any underwriting discount and offering expenses Requirement 2 $ in millions

Cash (determined above) ......................................................... Common stock (27.5 million shares x $.01 par) ...................... Paid-in capital—excess of par (difference) .........................

398.750 0.275 398.475

19–1119

Analysis Case 18–2 SESSEL‘S DEPARTMENT STORES, INC. Statement of Shareholders’ Equity For the Years Ended December 31, 2025, 2024, and 2023 ($ in 000s) Common Additional PaidStock in Series A Series B Capital

Retained Earnings

Total Shareholders’ Equity

$19,178 13,494

$108,934 13,494

Preferred Stock

Dec. 31, 2022 Net income Issuance of common stock

$ –

$1,288

$ 88,468

814

1,300

89,282

558

112,148

Dec. 31, 2024 1,858 Net income Issuance of 57,700 6,592 1044 shares Conversion of Series B (6,592) preferred stock 322 Preferred dividends Dec. 31, 2025 $57,700 $ – $1,994

201,430

Dec. 31, 2023 Net income Issuance of common stock

826 32,672 12,126

123,254 12,126 112,706

44,798 32,2561

20,0025

248,086 32,256 84,398

6,5603

$227,992

(3,388)

$73,666

$361,352

1 [$73,666,000 – $44,798,000] + $3,388,000 = $32,256,000 2 320,000 shares x $.10 par = $32,000 3 $6,592,000 – $32,000 = $6,560,000 4 [$1,994,000 – $1,858,000] – $32,000 = $104,000 5 [$227,992,000 – $201,430,000] – $6,560,000 = $20,002,000 19–1120

Research Case 18–3 Requirement 1 Cisco reports accumulated other comprehensive income (loss in this instance) in its balance sheet as a component of shareholders‘ equity as follows: ($ in millions)

Shareholders' equity: Preferred stock Common stock and additional paid-in capital Accumulated deficit Accumulated other comprehensive loss Total shareholders' equity

2020

2019

$41,202 $40,266 (2,763) (5,903) (519) (792) $37,920 $33,571

Requirement 2 Comprehensive income is a more expansive view of the change in shareholders‘ equity than traditional net income. It‘s the total nonowner change in equity for a reporting period. That is, comprehensive income encompasses all changes in equity other than from transactions with owners. Transactions between the corporation and its shareholders primarily include dividends and the sale or purchase of shares of the company‘s stock. Most nonowner changes are reported in the income statement. The changes other than those that are part of traditional net income are the ones reported as ―other comprehensive income.‖ From the information Cisco's financial statements provide, we can determine how the company calculated the $519 million accumulated other comprehensive loss at the end of fiscal 2020: Accumulated Other Comprehensive Loss

Balance at July 27, 2019 Available-for-sale investments: Cash flow hedging instruments: Net change in cumulative translation adjustment and actuarial gains and losses, net of tax Other comprehensive income (loss) Balance at July 25, 2020

$(792) $315 8 (50) 273 $(519)

19–1121

19–1122

Case 18–3 (concluded) Requirement 3 Cisco relies on FASB ASC 220–10–45–1: ―Comprehensive Income–Overall–Other Presentation Matters–Reporting Comprehensive Income‖ when reporting comprehensive income. Cisco reports a separate statement of comprehensive income. 45–1 This Subtopic requires an entity to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements.

19–1123

Real World Case 18–4 Requirement 1 Nike could choose not to make any journal entry for the stock split. Alternatively, Nike chose to effect the split ―in the form of a stock dividend.‖ So, Nike accounted for the stock split by debiting paid-in capital —excess of par for the stated value per share multiplied by the shares distributed, in this case 1,200 million shares. Total shareholders' equity does not change. This prevents the stated value per share from changing. Nike then credited common stock for the same amount: Paid-in capital—excess of par* ................................................. 1,200,000 Common stock (1,200,000,000** shares at $0.001 stated value).. 1,200,000 * Alternatively, Nike could choose to debit retained earnings ** 1,200,000,000 shares x 100% = 1,200,000,000 shares

Requirement 2 Formally retiring shares restores the balances in both the Common stock account and Paid-in capital—excess of stated value to what those balances would have been if the shares never had been issued at all. Any net increase in assets resulting from the sale and subsequent repurchase is reflected as Paid-in capital—share repurchase. On the other hand, any net decrease in assets resulting from the sale and subsequent repurchase is reflected as a reduction in retained earnings: Retirement of stock Common stock (50 million shares x $0.001*)……… Paid-in capital—excess of stated value (50 million shares x $0.149*)………………………

Retained earnings (difference)……………………. Cash (50 million shares x $59)…………….

50,000 7,450,000 2,942,500,000 2,950,000,000

* $0.15 – $0.001 stated value

19–1124

Case 18–4 (concluded) Requirement 3 When a share repurchase is viewed as treasury stock, the cost of the treasury stock is simply reported as a reduction in total shareholders‘ equity. Nike would account for the purchase of the treasury stock by debiting treasury stock and crediting cash for the cost of the purchase: Purchase of treasury stock Treasury stock……………………………. Cash (50 million shares x $59)………..

2,950,000,000 2,950,000,000

The treasury stock should be presented separately in the shareholders' equity section of Nike‘s balance sheet as an unallocated reduction of shareholders' equity. These shares are considered issued but not part of common stock outstanding.

Requirement 4 Nike should account for the cash dividend on the declaration date by debiting retained earnings and crediting cash dividends payable for $0.20 per share multiplied by the number of shares outstanding. After the 2-for-1 stock split, Nike had 2,400 (= 1,200 x 2) million shares. Declaration date Retained earnings............................................................ 480,000,000 Cash dividends payable (2,400 million shares x $0.20). 480,000,000 On the payment date, Nike would debit the liability and credit cash: Payment date Cash dividends payable ................................................. 480,000,000 Cash ……………………………………………. 480,000,000

19–1125

Analysis Case 18–5 Requirement 1 When a company sells shares, it obtains the legal, promotional, and accounting services necessary to effect the sale. The cost of these services reduces the net proceeds from selling the shares. Paid-in capital—excess of par is credited for the excess of the proceeds over the par value of the shares sold. Thus, the effect of share issue costs is to reduce the amount credited to that account. This treatment differs from how debt issue costs are recorded. The costs associated with a debt issue are deducted from the proceeds of the debt thereby increasing the effective interest rate on the debt. These costs are amortized over the life of the debt. Requirement 2 IBR‘s shares sold for a total of $53.289 million (2,395,000 shares times $22.25 per share). Requirement 3 Since paid-in capital—excess of par is credited for the excess of the $50.2 million net proceeds over the par amount of the shares sold, the effect of share issue costs (underwriting discount and offering expenses) is to reduce the amount credited to that account. In particular, IBR would have recorded the following journal entry upon the issue of the shares. ($ in 000s)

Cash (given) ............................................................... Common stock ($.10 par x 2,395 shares)................... Paid-in capital—excess of par (difference) .............

50,200.0 239.5 49,960.5*

* This amount reflects the reduction for share issue costs (underwriting discount and offering expenses).

19–1126

Analysis Case 18–6 Requirement 1 The ratio is computed by dividing net income by average shareholders' equity. Rate of return on = shareholders’ equity

Net income Average shareholders‘ equity

$487 [$2,931 + $2,671] ÷ 2

17.4% NYSE average = 18.8%

The return on shareholders' equity is an important ratio for the owners of a company. It measures the ability of company management to generate net income from the resources that owners provide. AGF‘s return is comparable to other firms, although slightly less. Like most ratios, though, it should not be viewed in isolation. For example, when the return on shareholders‘ equity is greater than the return on assets, management is using debt funds to enhance the earnings for stockholders.

Requirement 2 The return on assets is a measure of a company's ability to use assets profitably, regardless of how the assets were financed. It is computed by dividing net income by average total assets. Rate of return on assets

Net income Average total assets

$487 [$5,345 + $4,684] ÷ 2

9.7%

AGF is in this enviable position and, therefore, has favorable financial leverage. We discussed financial leverage in Chapter 14. Solutions Manual, Chapter 19 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

19–1127

Case 18–6 (concluded) Requirement 3 Earnings per share, in its simplest form, is simply a firm‘s net income divided by the number of shares outstanding throughout the year. It expresses a firm‘s profitability on a per share basis. Earnings per share

Income available to common shareholders Average shares outstanding

$487 181

$2.69

Requirement 4 To complement the return on shareholders‘ equity ratio, analysts sometimes calculate the earnings-price ratio in order to relate earnings to the market value of equity. This ratio is the earnings per share divided by the market price per share: Earnings-price ratio

Earnings per share Market price per share

$2.69 $47

5.7%

The earnings-price ratio measures the return on the market value of common stock. Remember, shareholders‘ equity is a measure of the book value of equity. The market value of a share of stock (or of total shareholders‘ equity) usually is different from its book value. AGF‘s return on market value is somewhat higher than the average return for the stocks listed on the New York Stock Exchange in a comparable time period (5.4%). So, even though the return on book value is a little lower than

19–1128

average, a closer look at the return to market value shows AGF to be at least in line with its industry.

19–1129

Communication Case 18–7 This case encourages students to consider the larger Question of the factors that differentiate whether financial instruments qualify for recognition as liabilities or part of equity. It also requires them to carefully consider the profession‘s definitions of those elements. You may wish to suggest to your students that they consult FASB ASC 480: ―Distinguishing Liabilities from Equity‖ (previously SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity), and the FASB‘s Preliminary Views on phase two of that project, which set forth the most common arguments on the issues in this case. In IAS No. 32, ―Financial Instruments: Presentation,‖ the IFRS generally requires more preferred shares to be classified as debt than does U.S. GAAP. The standard provides additional perspective on the issue. Or, you may prefer that they think for themselves and approach the issue from scratch. There is no right or wrong answer. Both views can and often are convincingly defended. The process of developing and synthesizing the arguments likely will be more beneficial than any single solution. Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Arguments brought out in IAS 32 cited above include the following: Classification as Liability or Equity The fundamental principle of IAS 32 is that a financial instrument should be classified as either a financial liability or an equity instrument according to the substance of the contract, not its legal form. The enterprise must make the decision at the time the instrument is initially recognized. The classification is not subsequently changed based on changed circumstances. [IAS 32.15]

19–1130

Case 18–7 (continued) A financial instrument is an equity instrument only if (a) the instrument includes no contractual obligation to deliver cash or another financial asset to another entity and (b) if the instrument will or may be settled in the issuer's own equity instruments, it is either: a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. [IAS 32.16] Illustration – preference shares If an enterprise issues preference (preferred) shares that pay a fixed rate of dividend and that have a mandatory redemption feature at a future date, the substance is that they are a contractual obligation to deliver cash and, therefore, should be recognized as a liability. In contrast, normal preference shares do not have a fixed maturity, and the issuer does not have a contractual obligation to make any payment. Therefore, they are equity. [IAS 32.18] Arguments brought out in FASB documents cited above include the following: Basic Ownership Approach—The Board’s Preliminary View The underlying principle of the basic ownership approach is that claims against the entity‘s assets are liabilities (or assets) if they reduce (or enhance) the net assets available to the owners of the entity. Under the approach, an instrument would be classified as equity if it is a basic ownership instrument. A basic ownership instrument (1) is the most subordinated interest in an entity and (2) entitles the holder to a share of the entity‘s net assets after all higher priority claims have been satisfied. All other instruments, for example, all forward contracts, options, and convertible debt, would be classified as liabilities or assets. Instruments classified as liabilities or assets that have varying or uncertain settlement amounts would be measured at fair value with changes reported in income unless other generally accepted accounting principles apply. As a result, changes in an issuer‘s share price would affect income. Instruments or components with fixed payoffs at the settlement date would be accreted or amortized.

19–1131

Case 18–7 (concluded) Ownership-Settlement Approach Under the ownership-settlement approach, an entity would classify instruments based on the nature of their return and their settlement requirements (or lack thereof). The following three types of instruments would be classified as equity: 1. Basic ownership instruments 2. Other perpetual instruments (for example, preferred shares) 3. Indirect ownership instruments settled by issuing related basic ownership instruments. An indirect ownership instrument has the following characteristics: 1. It is not perpetual 2. Its terms link its value to the price of a basic ownership instrument and cause its fair value to change in the same direction as the fair value of that basic ownership instrument. 3. It does not include a contingent exercise provision based on either of the following factors: (a) A market price for anything other than the reporting entity‘s basic ownership instruments; or (b) A price index other than an index calculated or measured solely by reference to the reporting entity‘s own operations (for example, revenue of the reporting entity). If an instrument has one or more equity outcomes and one or more nonequity outcomes, it would be separated into an equity component and a nonequity component. Examples of instruments that would be separated are convertible debt and puttable stock. The nonequity component of a separated instrument would be initially measured at fair value and the difference between the fair value of the nonequity component and the transaction price of the instrument would be allocated to the equity component. All other instruments that are not equity instruments or are not separated are classified as assets or liabilities. Instruments or components with varying payoffs at the settlement date are measured at fair value through income unless other generally accepted accounting principles apply. Instruments or components with fixed payoffs at the settlement date are accreted or amortized.

19–1132

Ethics Case 18–8 Discussion should include these elements. Return on assets: Rate of return on assets is net income divided by assets. The lower the asset base, the higher the percentage return. A noncash transaction should be recorded at fair value. This should be the fair value of the consideration given or the asset (in this case) received. The asset has no readily available fair value because it is custom-made. The value of debt the Swiss firm is asking for probably provides a good indication of the fair value of the asset. Ethical Dilemma: Is the desire to boost return justification for Questionable accounting treatment of the transaction? Who is affected? Benson Sharp Other managers? The company‘s auditor, if any. This is a private company. Shareholders (probably few) The employees

19–1133

Target Case Requirement 1 Target‘s share repurchases are described in Note 20 ―Share Repurchase‖. 2019, these repurchases were reported this way: Share Repurchases (millions)

2019

Total number of shares purchased(a)

16.0

Average price paid per share

In fiscal

$95.07

This information combined with that in the Statements of Shareholders' Investment allow us to reconstruct the (summary) journal entry for these repurchases: ($ in millions)

Common stock (16.0 million shares x $.0833 par) .......................... 1 Retained earnings (given in statement of shareholders’ investment) 1,520 Cash (16.0 million shares x $95.07 per share)......................... 1,521

Requirement 2 Target accounts for share repurchases as retired shares. Target retires the shares it repurchases rather than labeling the repurchased shares as treasury stock. We know that because treasury stock is not an account reported in the company‘s financial statements. When shares are formally retired, we normally reduce the same accounts that previously were increased when the shares were sold, namely, common stock and paid-in capital—excess of par. Some companies, though, choose to debit retained earnings for the entire difference between the cash paid to repurchase shares and the par amount of those shares rather than allocate that difference in the prescribed way. Target Corporation is an example of a company that follows this approach. While this 19–1134

method lacks conceptual merit by itself, it‘s permitted by ASC 505-30-30-8, which states that ―a corporation can always capitalize or allocate retained earnings for such purposes.‖

19–1135

Air France–KLM Case Requirement 1 Air France–KLM lists five items in the shareholders‘ equity section of the balance sheet. If AF used U.S. GAAP, Issued capital would be Common stock, Reserves and retained earnings would be separated into retained earnings and one or more other accounts. The term ―reserves‖ is considered misleading and thus is discouraged under U.S. GAAP. For example, what would be called Investment revaluation reserve under IFRS might be called Net gains (losses) on investments— AOCI. What would be called Investment revaluation reserve under IFRS might be called Net gains (losses) foreign currency translation—AOCI. Often firms using IFRS will use the term Share premium for Paid-in capital— excess of par and Investment in own shares for Treasury stock. Note 28.5 indicates that the items that comprise ―Reserves and retained earnings‖ as reported in the balance sheet are: 1. Legal reserve, 2. Pension defined benefit reserves, 3. Derivatives reserves, 4. Equity instruments reserves, 5. Other reserves, 6. Net income (loss)—group share. If AF used U.S. GAAP, the first of those would not be listed as shareholders‘ equity. What AF called Pension defined benefit reserves might be called Postretirement benefit gains (losses)—AOCI. What AF called Derivatives reserves might be called Net gains (losses) on derivatives–AOCI. What AF called Equity instruments reserves under IFRS might be called Net gains (losses) on investments—AOCI. Other reserves might be Net gains (losses) foreign currency translation—AOCI. Net income (loss)—Group share is equivalent to retained earnings but not included as a component of ―reserves‖ under U.S. GAAP.

19–1136

AF Case (concluded) Requirement 2 The order of presentation of the components of the balance sheet usually is different between U.S. GAAP and IFRS. AF lists Non-current assets before current assets. Yes. This is the opposite order from what we see under U.S. GAAP.

Requirement 3 AF lists Non-current liabilities before current liabilities. Yes. This is the opposite order from what we see under U.S. GAAP.

Requirement 4 Within Total equity and liabilities, Shareholders’ equity is listed first. Yes. This is the opposite order from what we see under U.S. GAAP.

Chapter 19 Share-Based Compensation and Earnings per Share QUESTIONS FOR REVIEW OF KEY TOPICS

19–1137

Question 19–1 Restricted stock refers to shares actually awarded in the name of an employee, although the employer might retain physical possession of the shares. Typically, the employee has all rights of a shareholder, but the shares are subject to certain restrictions or forfeiture. Usually the employee is not free to sell the shares during the restriction period. Restricted shares usually are subject to forfeiture by the employee if employment is terminated between the date of grant and a specified vesting date. Restricted stock units (RSUs) are a more popular variation for which shares aren‘t actually issued when the RSUs are granted. After the recipient of RSUs satisfies the vesting requirement, the company distributes the shares. Thus, like restricted stock, the recipient benefits by the value of the shares at the end of the vesting period. Sometimes, RSUs are payable in cash, sometimes in shares, and sometimes a combination of both. Restrictions provide the employee an incentive to remain with the company. Compensation cost for either restricted stock awards or units is the fair value of the restricted stock at the grant date and is equal to the market price of unrestricted shares of the same stock. The fair value of shares awarded under a restricted stock award plan is accrued to compensation expense over the service period for which participants receive the shares. This usually is the period from the date of grant to when restrictions are lifted (the vesting date).

19–1138

Question 19–2 The fair value of a stock option is determined by employing a recognized option pricing model. The option pricing model should take into account the (1) exercise price of the option, (2) expected term of the option, (3) current market price of the stock, (4) expected dividends, (5) expected risk-free rate of return during the term of the option, and (6) expected volatility of the stock.

19–1139

19–1140

Question 19–3 A nonqualified plan offers favorable tax treatment to the employer, while an incentive plan offers favorable tax treatment to the employee. Under an incentive plan, the recipient pays no tax at the time of the grant or the exercise of the options. Instead, the tax on the difference between the option price and the market price at the exercise date is paid on the date any shares acquired are subsequently sold. The employer gets no tax deduction at all. The employee cannot delay paying tax under a nonqualified plan. The tax that could be deferred until the shares are sold under an incentive plan must be paid at the exercise date under a nonqualified plan. On the other hand, the employer is allowed to deduct the difference between the option price and the market price on the exercise date.

19–1141

Question 19–4 For performance-based options, initial estimates of compensation cost as well as subsequent revisions of that estimate consider the likelihood of both forfeitures and achieving performance targets. If it is probable that the performance target will be met, we recognize compensation over the vesting period at fair value. If achieving the target is not probable, no compensation is recorded. Probability is reassessed each period. If the award contains a market condition (e.g., a share option with an exercisability requirement based on the stock price reaching a specified level), then no special accounting is required. The fair value estimate of the share option already implicitly reflects market conditions due to the nature of share option pricing models. Thus, we recognize compensation expense regardless of when, if ever, the market condition is met.

19–1142

19–1143

Question 19–5 A firm has a simple capital structure if it has no potential common shares outstanding. These are securities that are not yet common stock, but might become common stock if exercised or converted. Thus, they could potentially dilute (meaning reduce) earnings per share. For a firm with a simple capital structure, EPS is simply earnings available to common shareholders divided by the weighted-average number of common shares outstanding.

19–1144

Question 19–6 There is a fundamental difference between the increase in shares caused by stock dividends and stock splits and an increase from selling new shares. When additional shares are sold, both the assets of the firm and shareholders‘ equity are increased by an additional investment by owners. On the other hand, stock dividends or stock splits merely increase the number of shares without affecting the firm‘s assets. As a consequence, the same ―pie‖ is divided into more pieces resulting in a larger number of less valuable shares. Shares outstanding prior to a stock dividend or stock split are retroactively restated to reflect the increase in shares, as if the distribution occurred at the beginning of the period. On the other hand, any new shares issued are ―timeweighted‖ by the fraction of the period they were outstanding and then added to the number of shares outstanding for the entire period.

19–1145

19–1146

Question 19– 1147The weighted-average number of shares for calculating EPS would be 104,500 determined as follows: 100,000 (1.05) – 1,200 (5/12) = shares stock treasury at Jan. 1 dividend shares adjustment

104,500 shares

The 1,200 shares retired are weighted by ( 5/12) to reflect the fact they were not outstanding the last five months of the year. Purchases of shares that occur after a stock dividend or split are not affected by the distribution.

19–1147

Question 19– 1148Preferred dividends are deducted from the numerator in the EPS fraction so that ―earnings available to common shareholders‖ will be divided by the weighted-average number of common shares. An exception would be when the preferred stock is noncumulative and no dividends were declared in the reporting period. Another time the deduction is not made is when the preferred stock is convertible and the calculation of diluted EPS assumes the preferred stock has been converted and therefore no dividends are paid.

19–1148

Question 19– 1149Basic EPS does not reflect the dilutive effect of potential common shares. On the other hand, diluted EPS incorporates the dilutive effect of all potential common shares, if the effect is not antidilutive.

19–1149

Question 19– 1150When calculating diluted EPS, we assume that the shares specified by stock options, warrants, and rights are issued at the exercise price and that the hypothetical proceeds are used to buy back as treasury stock as many of those shares as could be acquired at the average market price.

19–1150

19–1151

Question 19–11 The potentially dilutive effect of convertible bonds is reflected in diluted EPS calculations by assuming the bonds were converted into common stock. The conversion is assumed to have occurred at the beginning of the period, or at the time the convertible bonds were issued, if later. When conversion is assumed, the additional common shares that would have been issued upon conversion are added to the denominator of the EPS fraction. The numerator is increased by the after-tax interest that would have been avoided if the bonds had not been outstanding. This effect is reflected in diluted EPS calculations only if the effect is dilutive.

19–11

Question 19–12 The potentially dilutive effect of convertible preferred stock is reflected in diluted EPS calculations by assuming the preferred stock was converted into common stock. The conversion is assumed to have occurred at the beginning of the period, or at the time the convertible preferred stock was issued, if later. When conversion is assumed, the additional common shares that would have been issued upon conversion are added to the denominator of the EPS fraction. Since EPS are calculated as if the preferred shares had been converted into common shares, there would be no dividends on the preferred stock; so, earnings available to common shareholders are not decreased by the dividends that otherwise would have been distributed to preferred shareholders. If there are hypothetically no preferred stock outstanding, there would be no preferred dividends to be paid. Thus, all of net income would hypothetically be available to common shareholders. This effect is reflected in diluted EPS calculations only if the effect is dilutive.

19–12

Question 19– 1154The order in which convertible securities are included in the dilutive EPS calculation is determined by comparing the incremental effect of their conversion. They should be included in numerical order, beginning with the lowest incremental effect (that is, the most dilutive).

19–1154

19–1155

Question 19–14 For the treasury stock method, ―proceeds‖ include (1) the amount, if any, received from the hypothetical exercise of options or vesting of restricted stock and (2) the total compensation from the award that's not yet expensed.

19–1156

Question 19–15 Contingently issuable shares are considered outstanding in the computation of diluted EPS when they will later be issued upon the mere passage of time or because of conditions that currently are met. If this year‘s operating income was $2.2 million, the additional shares would be considered outstanding in the computation of diluted EPS by simply adding 50,000 additional shares to the denominator of the EPS fraction: Contingently issuable shares: no numerator adjustment ——————————— + 50,000 additional shares If conditions specified for issuance are not yet met, the additional shares are ignored in the calculation. This would be the case if this year‘s operating income had been $2 million.

19–1157

19–1158

Question 19–16 The calculation of diluted EPS assumes convertible bonds had been converted at the beginning of the year (unless they actually were issued later). If they actually had been converted, the actual conversion would cause an actual increase in shares at the conversion date. These additional shares would be time-weighted for the remainder of the year. The numerator would be higher because net income actually would be increased by the after-tax interest saved on the bonds for that period. But the calculation also would assume conversion for the period before the actual conversion date because they were potentially dilutive during that period. The shares assumed outstanding would be time-weighted for the fraction of the year before the conversion, and the numerator would be increased by the after-tax interest assumed saved on the bonds for the same period.

19–16

Question 19–17 EPS data (both basic and diluted for a complex capital structure) must be reported on the face of the income statement for income from continuing operations and net income. Per share numbers for discontinued operations also should be reported either on the face of the income statement or in related disclosure notes when discontinued operations are present.

19–17

Question 19– 1161Disclosure notes should include (a) a summary description of the rights and privileges of the company‘s various securities and (b) supplemental EPS data for transactions that occur after the balance sheet date that result in a material change to the number of shares outstanding at the balance sheet date, and (c) a reconciliation of the numerator and denominator used in the basic EPS computations to the numerator and the denominator used in the diluted EPS computations.

19–1161

Answers to Questions (concluded)

19–1162

Question 19–19 The fair value of stock options has two essential components: (1) intrinsic value and (2) time value. ―Intrinsic value‖ is the benefit the holder of an option would realize by exercising the option rather than buying the underlying stock directly. For example, an option that allows an employee to buy $13 stock for $8 has an intrinsic value of $5. ―Time value‖ exists so long as time remains before expiration because the market price of the underlying stock may yet rise and create additional intrinsic value.

19–1163

Question 19–20 The accounting treatment of SARs depends on whether the award is considered an equity instrument or a liability. If the employer can choose to settle in shares rather than cash, the award is considered to be equity. If the employee will receive cash or can choose to receive cash, the award is considered to be a liability. This is the case with the LTV plan. As a result, the amount of compensation and related liability is continually adjusted to reflect changes in the fair value of the SARs until the liability is finally settled. The expense each period is the percentage of the total liability earned to date by recipients of the SARs (based on the elapsed percentage of the service period), minus any amounts expensed in prior periods. Both compensation expense and the liability are adjusted each period until the SARs ultimately either are exercised or lapse. We use fundamentally the same accounting for restricted stock units (RSUs) payable in cash. RSUs give the recipient the right to receive a set number of shares of company stock after the vesting requirement is satisfied, or sometimes the recipient is given the cash equivalent of those shares instead. If the employee will receive cash or can elect to receive cash, as in the case of an SAR, we consider the award to be a liability. We determine its fair value at the grant date and recognize that amount as compensation expense over the vesting period. Like SARs payable in cash, we periodically adjust the liability (and corresponding compensation) based on the change in the stock‘s fair value until the liability is paid. We determine the periodic value of the liability (and compensation) as the actual fair value of the shares, rather than an estimated fair value as is necessary when valuing SARs.

19–1164

BRIEF EXERCISES

19–1165

19–1166

Brief Exercise 19–1 $ 6 x 8 million = $48 million

fair value per share shares granted total compensation

The $48 million total compensation is expensed equally over the three-year vesting period, reducing earnings by $16 million each year.

19–1167

19–1168

19–1169

Brief Exercise 19–2 $10 x 16 million = $160 million

fair value per share shares represented by RSUs shares granted total compensation represented by RSUs

The $160 million total compensation is expensed equally over the four-year vesting period, reducing earnings by $40 million each year.

19–1170

19–1171

Brief Exercise 19–3 $ 5 x 12 million = $60 million

fair value per option options granted total compensation

The $60 million total compensation is expensed equally over the three-year vesting period, reducing earnings by $20 million each year.

19–3

Brief Exercise 19–4 The company should adjust the cumulative amount of compensation expense recorded to date in the year the estimate changes. 2025 Compensation expense ([$60 x 95% x 2/3] – $20)................... Paid-in capital—stock options ...........................................

2026 Compensation expense ([$60 x 95% x 3/3] – $20 – $18)......... Paid-in capital—stock options ...........................................

Note that this approach is contrary to the usual way companies account for changes in estimates. For instance, assume a company acquires a three-year depreciable asset having no estimated residual value. The $60 million depreciable cost would be depreciated straight line at $20 million over the three-year useful life. If the estimated residual value changes after one year to 5% of cost, the new estimated depreciable cost of $57 would be reduced by the $20 million depreciation recorded the first year, and the remaining $37 million would be depreciated equally, $18.5 million per year, over the remaining two years.

19–4

Brief Exercise 19– 1174

19–1174

At January 1, 2024, the estimated value of the award is: $9 estimated fair value per option x 1 million options granted = $9 million total compensation ($ in millions)

Compensation expense ($9 million ÷ 3 years) ..................................... 3,000,000 Paid-in capital—stock option .............................................. 3,000,000 We adjust the cumulative amount of compensation expense recorded to date in the year a forfeiture occurs. 2 years of the 3-year vesting period have passed

December 31, 2025 Compensation expense ([$9M – (1% x $9M) x 2/3] – $3M)........... Paid-in capital—stock options

2,940,000 2,940,000

Not required: December 31, 2026 Compensation expense ([$9M – (1% x $9M) x 3/3] – $3M – $2,940,000) 2,970,000 Paid-in capital—stock options 2,970,000

19–1175

19–1176

19–1177

Brief Exercise 19–6 ($ in millions)

Cash ($17 exercise price x 12 million shares) ............................... 204 Paid-in capital—stock options (account balance)............ 60 Common stock (12 million shares at $1 par per share) .... 12 Paid-in capital—excess of par (remainder) .................. 252 Note: The market price at exercise is irrelevant.

19–1178

19–1179

19–1180

Brief Exercise 19–7 Paid-in capital—stock options (account balance)............ Paid-in capital—expiration of stock options ...........

60 60

19–1181

19–1182

Brief Exercise 19– 1183

The estimate of the total compensation would be: 100,000 options expected to vest

$6 = $600,000 fair estimated value total per option compensation

One-third of that amount, or $200,000, will be recorded in each of the three years.

19–1183

19–1184

19–1185

Brief Exercise 19–9 The new estimate of the total compensation would change to: 0 options expected to vest

$6 = fair value per option

$0 estimated total compensation

In that case, in 2025, Farmer would reverse the $200,000 expensed in 2024 because no compensation can be recognized for options that don‘t vest due to performance targets not being met, and that‘s the new expectation.

19–1186

Brief Exercise 19– 1187

In that case, in 2025, the revised estimate of the total compensation would change to $600,000: 100,000 options expected to vest

$6 = $600,000 fair estimated value total compensation

Farmer would reflect the cumulative effect on compensation in 2025 earnings and record compensation thereafter: 2025 Compensation expense ([$600,000 x 2/3] – $0) Paid-in capital—stock options ................

400,000 400,000

2026 Compensation expense ([$600,000 x 3/3] – $400,000) 200,000 Paid-in capital—stock options ................ 200,000

19–1187

19–1188

Brief Exercise 19–11

19–1189

19–1190

If an award contains a market condition such as the stock price reaching a specified level, then no special accounting is required. The fair value estimate of the share option ($6) already implicitly reflects market conditions due to the nature of share option pricing models. So, Farmer recognizes compensation expense regardless of when, if ever, the market condition is met. The estimate of the total compensation would be: 100,000 options expected to vest

$6 = $600,000 fair estimated value total per option compensation

One-third of that amount, or $200,000, will be recorded in each of the three years.

19–1191

Brief Exercise 19–12 (amounts in millions, except per share amount) net income

Earnings Per Share

$741 $741 ——————————————————————— = —— = $1.30 570 544 + 36 (10/12) – 6 (8/12) shares at Jan. 1

19–1192

new shares

shares retired

19–1193

Brief Exercise 19–13 (amounts in millions, except per share amount) net preferred income dividends

Earnings

$426 – $16 $410 Per Share —————————————————— = —— = $0.50 820 820 common shares

Since the preferred stock is cumulative, the 2024 dividends (8% x $200 million = $16 million) are deducted even though no dividends were declared. There are no potential common shares, so a single calculation of EPS is appropriate.

19–1194

Brief Exercise 19– 119524,000 shares – 20,000 shares* = 4,000 shares *Purchase of treasury shares

24,000 shares x $50 (exercise price) $1,200,000 ÷ $60 (average market price) 20,000 shares

19–1195

Brief Exercise 19–15 (amounts in thousands, except per share amounts)

Basic EPS net income

preferred dividends

$1,500 – $60 $1,440 ————————————————— = ——— 800 800

= $1.80

shares at Jan. 1

Diluted EPS net income

$1,500 ———————————————— = 800 + 200 shares at Jan. 1

$1,500 ——— 1,000

= $1.50

conversion* of preferred shares

* The preferred shares are considered converted when calculating diluted EPS. If

converted, there would be no preferred dividends.

19–1196

Brief Exercise 19– 1197 The total compensation for the award is $45 million ($5 market price per share x 9 million shares). Because the stock award vests over three years, it is expensed as $15 million each year for three years. At the end of 2024, the second year, $30 million has been expensed and $15 million remains unexpensed, so $15 million would be the assumed proceeds in an EPS calculation. If the market price averages $5, the $15 million will buy back 3 million shares and we would add to the denominator of diluted EPS 6 million common shares: No adjustment to the numerator 9 million – 3* million = 6 million *Assumed purchase of treasury shares $15 million

÷ $5 (average market price) 3 million shares

19–1197

EXERCISES

19–1198

Exercise 19–1 Requirement 1 $5 x 16 million = $80 million

fair value per share shares granted total compensation

Requirement 2 ($ in millions) December 31, 2024 Compensation expense ($80 million ÷ 2 years)... 40 40 Paid-in capital—restricted stock ................

December 31, 2025 Compensation expense ($80 million ÷ 2 years)... Paid-in capital—restricted stock ................ Paid-in capital—restricted stock .................... Common stock (16 million shares x $1 par) ..... Paid-in capital—excess of par (remainder) ...

40 40 80 16 64

19–1

Exercise 19– 1200 Requirement 1 $2.50 x 12 million = $30 million

fair value per share shares represented by RSUs granted total compensation

Requirement 2 no entry Requirement 3 ($ in millions)

Compensation expense ($30 million ÷ 3 years)... Paid-in capital—restricted stock ................

10 10

Requirement 4 Compensation expense ($30 million ÷ 3 years) ........ 10 Paid-in capital—restricted stock ................

Requirement 5 Compensation expense ($30 million ÷ 3 years) ........ 10 Paid-in capital—restricted stock ................

Requirement 6 Paid-in capital—restricted stock .................... Common stock (12 million shares x $1 par) ..... Paid-in capital—excess of par (remainder) ...

19–1200

30 12 18

Exercise 19– 1201 Requirement 1 shares = $32,827,963 $158.58 x 207,012 The $32,827,963 total compensation is expensed over the four-year vesting period, $8,206,991 each year. During 2020, the expense for RSUs granted is the appropriate portion of $8,206,991, depending on the date the RSUs were issued. For instance, if the RSUs were issued three months before the end of the year, the expense would be 3 /12 x $8,206,991 = $2,051,748. The expense is the full $8,206,991 in the year following the year in which the RSUs issued. Requirement 2 Paid-in capital—restricted stock (account balance of $200.84 x 154,449 shares) .........................

Common stock (154,449 shares at $0.10 par per share) ........ Paid-in capital—excess of par (remainder) ........................

31,019,537 15,445 31,004,092

19–1201

Exercise 19– 1202 Requirement 1 $22.50 x 4 million = $90 million

fair value per share shares granted total compensation

Requirement 2 no entry Requirement 3 ($ in millions)

Compensation expense ($90 million ÷ 3 years)... Paid-in capital—restricted stock ................

30 30

Requirement 4 $22.50 x 4 million x 90% = $81 million

19–1202

fair value per share shares granted 100% – 10% forfeiture rate total compensation after forfeiture

Exercise 19– 1203 Requirement At January11, 2024, the estimated value of the award is: $12 estimated fair value per share x 30 million RSUs granted = $360 million total compensation ($ in millions)

Compensation expense ($360 million ÷ 3 years) .......................... Paid-in capital—restricted stock ........................................

120 120

Requirement 2 We adjust the cumulative amount of compensation expense recorded to date in the year a forfeiture occurs. 2 years of the 3-year vesting period have passed

2025 Compensation expense ([$360 – (5% x $360) x 2/3] – $120).. Paid-in capital—restricted stock ........................................

108 108

All of the 3-year vesting period has passed

Requirement 3 2026 Compensation expense ([$360 – (5% x $360) x 3/3] – $120 – $108) Paid-in capital—restricted stock ........................................ Note:

114 114

As a practical expedient, companies can elect to account for forfeitures of stock options or restricted stock when they occur rather than estimating them. So rather than reduce in advance the amount to be recorded as compensation expense and paid-in capital, companies choosing this approach reduce those same accounts only if and when a forfeiture occurs. This election only applies to forfeitures related to turnover. For share-based plans with performance conditions, companies must assess the probability that such conditions will be achieved. A company must disclose its policy election for forfeitures (estimated or recorded as they occur).

19–1203

Exercise 19– 1204 Requirement $3 1 x 4 million = $12 million

fair value per option options granted total compensation

Requirement 2 no entry Requirement 3 ($ in millions)

Compensation expense ($12 million ÷ 2 years)... Paid-in capital—stock options ...................

6 6

Requirement 4 Compensation expense ($12 million ÷ 2 years)... Paid-in capital—stock options ...................

19–1204

6 6

Exercise 19– 1205 Requirement At January11, 2024, the estimated value of the award is: $ 3 estimated fair value per option x 25 million options granted = $75 million total compensation Requirement 2 ($ in millions)

Compensation expense ($75 million ÷ 3 years)............................ Paid-in capital—stock options ...........................................

25.0 25.0

Requirement 3 Adams-Meneke should adjust the cumulative amount of compensation expense recorded to date in the year the estimate changes. All of the 3-year vesting period has passed

2 years of the 3-year vesting period have passed

2025 Compensation expense ([$75 x 94% x 2/3] – $25) .................. Paid-in capital—stock options ...........................................

22.0

2026 Compensation expense ([$75 x 94% x 3/3] – $25 – $22) ........ Paid-in capital—stock options ...........................................

23.5

22.0

23.5

Note that this approach is contrary to the usual way companies account for changes in estimates. For instance, assume a company acquires a three-year depreciable asset having no estimated residual value. The $75 million depreciable cost would be depreciated straight-line at $25 million over the threeyear useful life. If the estimated residual value changes after one year to 6% of cost, the new estimated depreciable cost of $70.5 million would be reduced by the $25 million depreciation recorded the first year, and the remaining $45.5 million would be depreciated equally, $22.75 million per year, over the remaining two years.

19–1205

Exercise 19– 1206 Requirement At January11, 2024, the estimated value of the award is: $ 1 estimated fair value per option x 40 million options granted = $40 million total compensation Requirement 2 ($ in millions)

Compensation expense ($40 million ÷ 2 years)... Paid-in capital—stock options ..................

20 20

Requirement 3 Compensation expense ($40 million ÷ 2 years)... Paid-in capital—stock options ..................

20 20

Requirement 4 Cash ($8 exercise price x 30 million shares)........................ Paid-in capital—stock options (3/4 account balance of $40 million) ................................. Common stock (30 million shares at $1 par per share) .... Paid-in capital—excess of par (remainder) ..................

240 30 30 240

Note: The market price at exercise is irrelevant.

Requirement 5 Paid-in capital—stock options ($40 – $30 million) ......... Paid-in capital—expiration of stock options ...........

19–1206

10 10

Exercise 19– 1207 Requirement At January11, 2024, the total compensation is measured as: $ 3 fair value per option x 12 million options granted = $36 million total compensation Requirement 2 December 31, 2024, 2025, 2026 ($ in millions)

Compensation expense ($36 million ÷ 3 years)................ Paid-in capital—stock options ................................ Requirement 3 Cash ($11 exercise price x 12 million shares) ...................... Paid-in capital—stock options ($12 million x 3 years) ..... Common stock (12 million shares at $1 par per share) .... Paid-in capital—excess of par (to balance)..................

12 12

132 36 12 156

Note: The market price at exercise is irrelevant.

19–1207

19–1208

Exercise 19–10 Cash ($12 x 50,000 x 85%) Compensation expense ($12 x 50,000 x 15%) Common stock ($1 x 50,000) Paid-in capital—in excess of par ($11 x 50,000)

510,000 90,000 50,000 550,000

19–1209

Exercise 19–11

Employee share purchase plans allow employees to buy company stock under convenient or favorable terms. Most such plans are considered compensatory and require the fair value of any discount to be recorded as compensation expense. Microsoft‘s employee purchases during the year ending June 30, 2020, can be summarized as follows: ($ in millions) Cash (9 million x $142.22)

Compensation expense (fair value x 10%)* Common stock (9 million x $0.00000625) Paid-in capital—excess of par (to balance)

19–1210

1,279,980,000 142,220,000 56 1,422,199,944

* Employees pay 90% of the stock‘s value; the 10% difference is compensation expense. Fair value x 90% = $1,279,980,000. Therefore, fair value = $1,279,980,000÷ 90% or $1,422,200,000. Compensation expense is equal to $1,422,200,000 – $1,279,980,000 = $142,220,000

19–1211

Exercise 19–12 (amounts in thousands, except per share amount) net income

Earnings Per Share

$655 $655 ———————————————————————— = —— 1,029 900 (1.05) + 60 (8/12) (1.05) + 72 (7/12) shares at Jan. 1

new shares



19–1212

stock dividend adjustment

= $0.64

new shares



Exercise 19–13 1. EPS in 2024 (amounts in thousands, except per share amount) net income

Earnings Per Share

$400 $400 —————————————————————————— –––– = $2.00 202 – 6 (10/12) + 6 (2/12) + 24 (1/12) 200 shares at Jan. 1

treasury shares

treasury shares sold

new shares

2. EPS in 2025 (amounts in thousands, except per share amount) net income

Earnings Per Share

$400 $400 —————————————————————————— –––– = (202 – 6 + 6 + 24) x (2.00) 452 shares at Jan. 1

$0.88

stock split adjustment

3. 2024 EPS in the 2025 comparative financial statements (amounts in thousands, except per share amount) net income

Earnings Per Share

$400 $400 —————————————————————————— –––– = $1.00 200 x (2.00) 400 weighted-average shares as previously calculated

stock split adjustment

19–1213

19–1214

Exercise 19–14 (amounts in thousands, except per share amount) net income

preferred dividends

$2,000 – $50 ————————————————— = 800 (1.25) shares at Jan. 1

Earnings Per Share

$1,950 ———— 1,000

= $1.95

stock dividend adjustment

19–1215

19–1216

Exercise 19–15 (amounts in thousands, except per share amount) net loss

preferred dividends

– $114 – $76 – $190 —————————————————————— = —— 373 + 12 (7/12) 380

Net Loss Per Share

shares at Jan. 1 1

= ($0.50)

new shares

9.5% x $800 * = $76 *8,000 shares x $100 par = $800,000

19–15

Exercise 19–1218 (amounts in millions, except per share amount) net income

preferred dividends

Earnings Per Share

$150 – $27* —————————————————————— $0.65 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) shares at Jan. 1

treasury shares



stock dividend adjustment

$123 = ———

190

new shares



*9% x $100 x 3 million shares = $27 million preferred dividends

19–1218

Exercise 19– 1219 (amounts in millions, except per share amount) Basic EPS net income

preferred dividends

$150 – $27* $123 —————————————————————————— = —— = $0.65 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) 190 shares at Jan. 1

treasury shares



new shares

stock dividend adjustment



*9% x $100 x 3 million shares = $27 million preferred dividends Diluted EPS net income

preferred dividends

$150 – $27 $123 —————————————————————————— = —— = $0.63 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) + (30 – 24**) 196 shares at Jan. 1

treasury shares



stock dividend adjustment

new shares

assumed exercise of options



**Purchase of treasury stock

30 million shares x $56 (exercise price) $1,680 million ÷ $70 (average market price) 24 million shares

19–1219

Exercise 19–1220 (amounts in millions, except per share amount)

Basic EPS net income

preferred dividends

$150 – $27* $123 —————————————————————————— = —— = $0.62 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) + 30 (4/12) 200 shares at Jan. 1

treasury shares



new shares

stock dividend adjustment

actual exercise of options



*9% x $100 x 3 million shares = $27 million preferred dividends Diluted EPS net income

preferred dividends

$150 – $27 $123 ———————————————————————————— = —— = $0.60 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) + (30 – 24**) (8/12) + 30 (4/12) 204 shares at Jan. 1

treasury shares



stock dividend adjustment

new shares

assumed exercise of options

actual exercise of options



**Purchase of treasury stock

30 million shares x $56 (exercise price) $1,680 million ÷ $70 (average market price) 24 million shares

19–1220

Exercise 19– 1221

(amounts in millions, except per share amount)

Basic EPS net income

preferred dividends

$150 – $27* $123 ———————————————————————————— = — = $0.65 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) 190 shares at Jan. 1

treasury shares



new shares

stock dividend adjustment

 *9% x $100 x 3 million shares = $27 million preferred dividends

Diluted EPS net income

preferred dividends

after-tax interest savings

$150 – $27 + $4* – 25% ($4**) $126 ———————————————————————————— = — = $0.62 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) + (30 – 24***) + 6 202 shares at Jan. 1

treasury shares



stock dividend adjustment

new shares

assumed exercise conversion of options of bonds

 **8% x $50 million = $4 million interest

***Purchase of treasury stock

30 million shares x $56 (exercise price) $1,680 million ÷ $70 (average market price) 24 million shares

19–1221

Exercise 19– 1222 (amounts in thousands, except per share amount)

Basic EPS net income

$720 $720 ———————————————————— = —— = $8.47 80 + 15 (4/12) 85 shares at Jan. 1

new shares

Diluted EPS net income

$720 $720 ————————————————————— = —— = $8.09 80 + 15 (4/12) + (24 – 20*) 89 shares at Jan. 1

new shares

assumed exercise of options

*Purchase of treasury shares

24,000 x $37.50 $900,000 ÷ $45 20,000

19–1222

shares (exercise price) (average market price) shares

Exercise 19– (amounts 1223 in thousands, except per share amounts) Basic EPS net income

preferred dividends

$500 – 60* $440 ——————————————————————— = ——— = $4.40 100 100 shares at Jan. 1

Diluted EPS net income

preferred dividends

after-tax interest savings

$500 – 60* + 60* + $80** – 25% ($80) $560 ——————————————————————————— = —— = $3.46 100 + 32 + 30 162 shares at Jan. 1

conversion of preferred stock

conversion of bonds

* 12,000 shares x $5 ** $1,000,000 x 8%

Order of Entry: Note that we included in our calculation, the convertible security with the lowest ―incremental effect‖ ($60 ’ 32 = $1.87) before the one with the higher effect ($60 ’ 30 = $2.00). After including the conversion of the preferred stock only, EPS is $500 ÷ 132 = $3.79. The $2.00 incremental effect of the conversion of the bonds is less than that amount, so in this instance the order of entry was unimportant. But there are situations in which the incremental effect of the second convertible security is higher than the calculation prior to its inclusion. In those situations, including the second security is antidilutive. That‘s why we should include securities in the calculation in reverse order, beginning with the lowest incremental effect (most dilutive).

19–1223

Exercise 19– 1224 (amounts in thousands, except per share amounts) Basic EPS net income

Earnings Per Share

$120 —————————— 800

$120 ——— = $0.15 800

shares at Jan. 1

Diluted EPS net income

Earnings Per Share

$120 —————————— 800 + (54 – 18*)

$120 ——— = $0.14 836

shares shares at Jan. 1 assumed vested

Proceeds: $270,000 ÷ 3 $90,000 x 2 $180,000

($5 market price per share x 54,000 shares) years vesting period compensation expense per year expensed in 2023 and 2024

$ 90,000 unexpensed compensation at Dec. 31, 2024 *Assumed purchase of treasury shares $90,000 proceeds ÷ $5 (average market price) 18,000 shares

19–1224

Exercise 19– 1225

19–1225

Requirement 1

19–1226

x =

$5 18 million $90 million

fair value per share shares granted total compensation expense

The $90 million total compensation is expensed equally over the three-year vesting period, reducing earnings by $30 million each year. 2023 Compensation expense .................................................................. Paid-in capital—restricted stock ................................................

2024 Compensation expense .................................................................. Paid-in capital—restricted stock ................................................

19–1227

Requirement 2 The total compensation for the award is $90 million ($5 market price per share x 18 million shares). Because the stock award vests over three years, it is expensed as $30 million each year for three years. At the end of 2024, the second year, $60 million has been expensed and $30 million remains unexpensed, so $30 million would be the assumed proceeds in an EPS calculation. If the market price averages $5, the $30 million will buy back 6 million shares and we would add to the denominator of diluted EPS 12 million common shares: No adjustment to the numerator 18 million – 6* million = 12 million *Assumed purchase of treasury shares $30 million ÷ $5 (average market price) 6 million shares

19–1228

Exercise 19– 1229 (amounts in millions, except per share amounts)

Basic EPS net income

$148 $148 —————————————————————————— = ——— = $3.89 35 + 4 (9/12) 38 shares at Jan. 1

new shares

Diluted EPS net income

$148 $148 —————————————————————————— = ——— = $3.79 35 + 4 (9/12) +1 39 shares at Jan. 1

new shares

additional shares

Because the conditions are met for issuing 1 million shares, those shares are assumed issued for diluted EPS. Conditions for the other 1 million shares are not yet met, so as they are ignored.

19–1229

Exercise 19– 1230 (amounts in thousands, except per share amounts) Basic EPS net income

$2,000 $2,000 —————————————————————————— = ——— = $2.96 600 + 100 (9/12) 675 shares at Jan. 1

new shares

Diluted EPS net income

$2,000 $2,000 —————————————————————————— = ——— = $2.74 600 + 100 (9/12) + 4 x 10 + 15 730 shares at Jan. 1

new shares

contingent shares*

contingent shares**

Because the conditions currently are met (i.e., market price exceeds $48) for issuing 10,000 shares in each of the next four years, those shares are assumed issued for diluted EPS. ** The condition for the other 15,000 shares also is met (the controller is employed), so those shares are assumed issued for diluted EPS.

19–1230

Exercise 19– 1231 List A

List B

e_ 1. Subtract preferred dividends. a. Options exercised. m_2. Time-weighted by 5/12. b. Simple capital structure. a_ 3. Time-weighted shares assumed issued c. Basic EPS. plus time-weighted actual shares. d. Convertible preferred stock. i_ 4. Midyear event treated as if e. Earnings available to common it occurred at the beginning of the shareholders. reporting period. f. Antidilutive. l_ 5. Preferred dividends do not reduce g. Increased marketability. earnings. h. Discontinued operations. b_ 6. Single EPS presentation. i. Stock dividend. g_ 7. Stock split. j. Add after-tax interest to numerator. d_ 8. Potential common shares. k. Diluted EPS. f_ 9. Exercise price exceeds market price. l. Noncumulative, undeclared c_10. No dilution assumed. preferred dividends. j_11. Convertible bonds. m. Common shares retired at the beginning of August. _n_ 12. Contingently issuable shares. n. Include in diluted EPS when _k_ 13. Maximum potential dilution. conditions for issuance are met. _h_ 14. Shown between per share amounts for net income and for income from continuing operations.

19–1231

Exercise 19– Requirement 1 1232 The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. The appropriate accounting treatment for the situation is specified in FASB ASC 718–10–50–1: ―Compensation–Stock Compensation–Overall–Disclosure–General.‖ Requirement 2 Section 718–10–50–2c states that companies must disclose: For the most recent year for which an income statement is provided, both of the following: 1. The number and weighted-average exercise prices (or conversion ratios) for each of the following groups of share options: 1. Those outstanding at the beginning of the year 2. Those outstanding at the end of the year 3. Those exercisable or convertible at the end of the year 4. Those that during the year were: 1. Granted 2. Exercised or converted 3. Forfeited 4. Expired

19–1232

Exercise 19– 1233

The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1.

Stock options: FASB ASC 718–10–30: ―Compensation–Stock Compensation–Overall–Initial Measurement.‖

The measurement date for share-based payments classified as liabilities: FASB ASC 718–30–30–1: ―Compensation–Stock Compensation– Awards Classified as Liabilities– Initial Measurement–Public Entity.‖

3. The formula to calculate diluted earnings per share. FASB ASC 260–10–45–16: ―Earnings per Share–Overall–Other Presentation Matters– Computation of Diluted EPS.‖ 4.

The way stock dividends or stock splits in the current year affect the presentation of EPS on the income statement. FASB ASC 260–10–55–12: ―Earnings per Share–Overall–Implementation Guidance and Illustrations–Stock Dividends or Stock Splits.‖

19–1233

Exercise 19– 1234 Requirement 1

The SARs are considered to be equity because IE will settle in shares of IE stock at exercise. January 1, 2024 No entry Calculate total compensation expense: $ 3 estimated fair value per SAR x 24 million SARs granted = $72 million total compensation The total compensation is allocated to expense over the four-year service (vesting) period: 2024 – 2027 $72 million ÷ 4 years = $18 million per year Requirement 2 December 31, 2024, 2025, 2026, 2027 ($ in millions) Compensation expense ($72 million ÷ 4 years)… 18 Paid-in capital—SAR plan…………………. 18

Requirement 3 The total compensation is measured once — at the grant date — and is not remeasured subsequently. Requirement 4 June 6, 2029 Paid-in capital—SAR plan (account balance) .................... 72.00 Common stock ($1 par per share x [$96 million* ÷ $50]) 1.92 Paid-in capital—in excess of par (to balance)……. 70.08 *$50 – $46 = $4 appreciation per share times 24 million units = $96 million 19–1234

Exercise 19– 1235

Requirement 1 The SARs are considered to be a liability because employees can elect to receive cash at exercise. January 1, 2024 No entry Requirement 2 December 31, 2024 ($ in millions) Compensation expense ($4 x 24 million x 1/4)…………………………. 24 Liability—SAR plan ……………………………………….……. 24 December 31, 2025 Compensation expense ([$3 x 24 million x 2/4] – $24)…………….……. Liability—SAR plan ……………………………………………..

December 31, 2026 Compensation expense ([$4 x 24 million x 3/4] – $24 – $12)……….…… Liability—SAR plan………………………………………….…...

December 31, 2027 Liability—SAR plan ………………………………………………… Compensation expense ([$2.50 x 24 million x 4/4] – $24 – $12 – $36).

Requirement 3 December 31, 2028 Compensation expense ([$3 x 24 million x all] – $24 – $12 – $36 + $12). Liability—SAR plan ………………………………………..…….

12 12

Requirement 4 June 6, 2029 Compensation expense ([($50 – $46) x 24 million x all] – $24 – $12 – $36 + $12 – $12)…………………………………………….…….

Liability—SAR plan ……………………………………………… Liability—SAR plan (account balance)…………………………….…….. Cash………………………………………………………………..

24 96

19–1235

Exercise 19– 1236

Requirement 1 The RSUs are considered to be a liability because employees can elect to receive cash at exercise. January 1, 2024 No entry Requirement 2 December 31, 2024 Compensation expense ($8 x 50 million x 1/4)……………….……….. Liability—RSUs……………………………………….……….. December 31, 2025 Compensation expense ([$6 x 50 million x 2/4] – $100)……….………. Liability— RSUs……………………………………….………..

($ in millions)

100 100

50 50

December 31, 2026 Compensation expense ([$8 x 50 million x 3/4] – $100 – $50)…………………………………………………….….………..

Liability— RSUs………………………………………….……… . December 31, 2027 Liability— RSUs…………………………………………………….. Compensation expense ([$5 x 50 million x 4/4] – $100 – $50 – $150).. Requirement 3 December 31, 2028 Compensation expense ([$6 x 50 million x all] – $100 – $50 – $150 + $50)……. Liability— RSUs………………………………………………..… Requirement 4 June 6, 2029 Compensation expense ([$6.50 x 50 million x all] – $100 – $50 – $150 + $50 – $50) Liability— RSUs…………………………………………………… Liability— RSUs (account balance)……………………………………….. Cash…………………………………………………………………

19–1236

150 150

50 50

25 25 325 325

PROBLEMS

19–1237

Problem 19–1 Requirement 1 The measurement date always is the date of grant, January 1, 2024.

Requirement 2 $ 6 x 20 million = $120 million

estimated fair value per option options granted total compensation

The total compensation is to be allocated to expense over the three-year service (vesting) period: 2024–2026 $120 million ÷ 3 years = $40 million per year

2 years of the 3-year vesting period have passed

Requirement 3 Martinez should adjust the cumulative amount of compensation expense recorded to date in the year the forfeiture occurs. ($ in millions)

2025 Compensation expense ([$120 x 90% x 2/3] – $40)................. Paid-in capital—stock options ...........................................

32 32

2026 Compensation expense ([$120 x 90% x 3/3] – $40 – $32)....... Paid-in capital—stock options ...........................................

36 36

All of the 3-year vesting period has passed

19–1238

Problem 19–1 (concluded) Requirement 4 This approach is contrary to the usual way companies account for changes in estimates. For instance, assume a company acquires a three-year depreciable asset having no estimated residual value for $120 million. The $120 million depreciable cost would be depreciated straight line at $40 million over the threeyear useful life. If the estimated residual value changes after one year to 10% of cost, the new estimated depreciable cost of $108 million would be reduced by the $40 million depreciation recorded the first year, and the remaining $68 million would be depreciated equally, $34 million per year, over the remaining two years.

Requirement 5 ($ in millions)

Cash ($15 x 80% = $12 exercise price x 18 million shares) .... Paid-in capital—stock options (account balance of $108 million) Common stock (18 million shares at $1 par per share) .... Paid-in capital—excess of par (remainder) ..................

216 108 18 306

Note: The market price at exercise is irrelevant.

19–1239

Problem 19–2 Requirement 1 We treat each individual vesting date as a separate award and allocate the compensation cost for each of the four groups (tranches) evenly over its individual vesting (service) period: Vesting Date

Amount Vesting

Fair Value per Option

Dec. 31, 2024 Dec. 31, 2025 Dec. 31, 2026 Dec. 31, 2027

25% 25% 25% 25%

$3.50 $4.00 $4.50 $5.00

The compensation cost is allocated evenly over the appropriate vesting (service) period: ($ in 000s) Shares Vesting at: Dec. 31, 2024 Dec. 31, 2025 Dec. 31, 2026 Dec. 31, 2027

Compensation Expense in: 2024 2025 2026 2027 Total $350 200 150 125 $825

$200 150 125 $475

$150 125 $275

$ 350 (400,000 x 25% x $3.50) 400 (400,000 x 25% x $4.00) 450 (400,000 x 25% x $4.50) $125 500 (400,000 x 25% x $5.00) $125 $1,700

Also, a company must have expensed at least the amount vested by that date. The allocation here meets that constraint:  The $825,000 recognized in 2024 exceeds the $350,000 vested.  The $1,300,000 ($825,000 + $475,000) expensed by 2025 exceeds the $750,000 ($350,000 + $400,000) vested by the same time.  The $1,575,000 ($825,000 + $475,000 + $275,000) expensed by 2026 exceeds the $1,200,000 ($350,000 + $400,000 + $450,000) vested by the same time.

19–1240

Problem 19–2 (concluded) Requirement 2 Companies are allowed to use the straight-line method. The $1,700,000 total compensation cost is allocated equally to 2024, 2025, 2026, and 2027 at $425,000 per year. Also, a company must have expensed at least the amount vested by that date. The straight-line allocation meets that constraint:  The $425,000 expensed in 2024 exceeds the $350,000 vested.  The $850,000 ($425,000 + $425,000) expensed by 2025 exceeds the $750,000 ($350,000 + $400,000) vested by the same time.  The $1,275,000 ($425,000 + $425,000 + $425,000) expensed by 2026 exceeds the $1,200,000 ($350,000 + $400,000 + $450,000) vested by the same time.

19–1241

Problem 19–3 Requirement 1 We treat each individual vesting date as a separate award: Vesting Date Dec. 31, 2024 Dec. 31, 2025 Dec. 31, 2026 Dec. 31, 2027

Number Vesting 25% 25% 25% 25%

Fair Value per Option $4.50 $4.50 $4.50 $4.50

The compensation cost is allocated equally over the appropriate vesting (service) period: ($ in 000s) Shares Compensation Expense Recorded in: Vesting at: 2024 2025 2026 2027 Total Dec. 31, 2024 Dec. 31, 2025 Dec. 31, 2026 Dec. 31, 2027

$450 $ 450 (400,000 x 25% x $4.50) 225 $225 450 (400,000 x 25% x $4.50) 150 150 $150 450 (400,000 x 25% x $4.50) 112.5 112.5 112.5 $112.5 450 (400,000 x 25% x $4.50) $937.5 $487.5 $262.5 $112.5 $1,800

Also, a company must have expensed at least the amount vested by that date. The allocation here meets that constraint:  The $937,500 expensed in 2024 exceeds the $450,000 vested.  The $1,425,000 ($937,500 + $487,500) expensed by 2025 exceeds the $900,000 ($450,000 + $450,000) vested by the same time.  The $1,687,500 ($937,500 + $487,500 + $262,500) expensed by 2026 exceeds the $1,350,000 ($450,000 + $450,000 + $450,000) vested by the same time.

19–1242

Problem 19–3 (concluded) Requirement 2 Companies are allowed to use the straight-line method. The $1,800,000 total compensation cost is allocated equally to 2024, 2025, 2026, and 2027 at $450,000 per year. Notice that this approach is essentially the same as we use for options that vest all at one time at the end of the vesting period (cliff-vesting). Also, a company must have expensed at least the amount vested by that date. The straightline allocation meets that constraint:  The $450,000 expensed in 2024 equals the $450,000 vested.  The $900,000 ($450,000 + $450,000) expensed by 2025 equals the $900,000 ($450,000 + $450,000) vested by the same time.  The $1,350,000 ($450,000 + $450,000 + $450,000) expensed by 2026 equals the $1,350,000 ($450,000 + $450,000 + $450,000) vested by the same time.

19–1243

Problem 19–4 Using IFRS, the basic accounting would be the same as under U.S. GAAP, except there is no specific requirement that a company must have recognized at least the amount vested by that date. We treat each individual vesting date as a separate award: Vesting Amount Fair Value Date Vesting per Option Dec. 31, 2024 Dec. 31, 2025 Dec. 31, 2026 Dec. 31, 2027

25% 25% 25% 25%

$3.50 $4.00 $4.50 $5.00

The compensation cost is allocated equally over the appropriate vesting (service) period: ($ in 000s) Shares Vesting at: Dec. 31, 2024 Dec. 31, 2025 Dec. 31, 2026 Dec. 31, 2027

Compensation Expense Recorded in: 2024 2025 2026 2027 Total $350 200 150 125 $825

$200 150 125 $475

$150 125 $275

$ 350 (400,000 x 25% x $3.50) 400 (400,000 x 25% x $4.00) 450 (400,000 x 25% x $4.50) $125 500 (400,000 x 25% x $5.00) $125 $1,700

Under IFRS companies are not permitted to use the straight-line method.

19–1244

Problem 19–5 Requirement 1 At January 1, 2024, the estimated value of the award is: $ 2 estimated fair value per option x 40 million options granted = $80 million total compensation Requirement 2 ($ in millions)

Compensation expense ($80 million ÷ 2 years)... Paid-in capital—stock options ...................

Deferred tax asset ($40 million x 25%) .............. Tax expense ..............................................

Note: Since the plan does not qualify as an incentive plan, Walters will deduct the difference between the exercise price and the market price at the exercise date. Recall from Chapter 16 that this creates a temporary difference between accounting income (for which compensation expense is recorded currently) and taxable income (for which the tax deduction is taken later upon the exercise of the options). We assume the temporary difference is the cumulative amount expensed for the options, $40 million at this point. So, the deferred tax benefit is 25% x $40 million. Requirement 3 Compensation expense ($80 million ÷ 2 years)... Paid-in capital—stock options ...................

Deferred tax asset ($40 million x 25%) .............. Tax expense ..............................................

19–1245

Problem 19–5 (concluded) Requirement 4 ($ in millions) Cash ($8 exercise price x 40 million shares) ......................................320

Paid-in capital—stock options (account balance) ................ Common stock (40 million shares at $1 par per share) ......... Paid-in capital—excess of par (to balance) ........................

Income tax payable ([$12 – $8] x 40 million shares x 25%)...... Deferred tax asset (2 years x $10 million) ......................... Tax expense (remainder) ................................................

40 360

20 20

Requirement 5 Compensation expense ($80 million ÷ 2 years)..................... Paid-in capital—stock options .....................................

40 40

No deferred tax asset is recorded because an incentive plan does not provide the employer a tax deduction.

Requirement 6 Cash ($8 exercise price x 40 million shares)............................. Paid-in capital—stock options (account balance)................. Common stock (40 million shares at $1 par per share) ......... Paid-in capital—excess of par (to balance) ........................

320 80 40 360

No tax effect because an incentive plan does not provide the employer a tax deduction.

19–1246

Problem 19–6 Requirement 1 At January 1, 2024, the total compensation is measured as: $ 6 x 6 million = $36 million

fair value per option options granted total compensation

Requirement 2 Dec. 31, 2024, 2025, 2026 ($ in millions)

Compensation expense ($36 million ÷ 3 years)... Paid-in capital—stock options ...................

Deferred tax asset ($12 million x 25%) .............. Tax expense ..............................................

Note: Since the plan does not qualify as an incentive plan, JBL will deduct the difference between the exercise price and the market price at the exercise date. Recall from Chapter 16 that this creates a temporary difference between accounting income (for which compensation expense is recorded currently) and taxable income (for which the tax deduction is taken later upon the exercise of the options). Under GAAP, we assume the temporary difference is the cumulative amount expensed for the options, $12 million, $24 million, and $36 million at Dec. 31, 2024, 2025, and 2026, respectively. So, the deferred tax benefit is 25% of that amount each year.

Requirement 3 August 21, 2028 ($ in millions)

Cash ($22 exercise price x 6 million shares).................................. Paid-in capital—stock options (account balance)...................... Common stock (6 million shares at $1 par per share) ................ Paid-in capital—excess of par (to balance) ..............................

132.0 36.0

Income tax payable ([$27 – $22] x 6 million shares x 25%) .......... Tax expense (remainder) ......................................................... Deferred tax asset (3 years x $3 million)................................

7.5 1.5

6.0 162.0

9.0

19–1247

Problem 19–7 Requirement 1 No entry until the end of the reporting period, but compensation must be estimated at the grant date: 1 million

options expected to vest

$12

fair value per option

$12 million estimated total compensation

Requirement 2 December 31, 2024, 2025, 2026, 2027 Compensation expense ($12 million x ¼) ...... Paid-in capital—stock options ...................

($ in millions)

3 3

Requirement 3 If, after two years, LCI estimates that it is not probable that the performance goals will be met, then the new estimate of the total compensation would change to: 0 options expected to vest

$12 fair value per option

$0 estimated total compensation

In that case, LCI would reverse the $6 million expensed in 2024–2025 because no compensation can be recognized for options that don‘t vest due to performance targets not being met, and that‘s the new expectation. December 31, 2026 ($ in millions) Paid-in capital—stock options ....................... 6 Compensation expense .............................. 6 December 31, 2027 No entry

19–1248

Problem 19–8 1. Net loss per share for the year ended December 31, 2024: (amounts in millions, except per share amount) net loss

preferred dividends

Net Loss Per Share

– $140 – $1601 – $300 — ————————————————————————— = ——— = ($0.49) 600 (1.05) – 30 (8/12) (1.05) + 12 (4/12) 613 shares at Jan. 1



treasury shares stock dividend adjustment

new shares



2. Per share amount of income or loss from continuing operations for the year ended December 31, 2024: (amounts in millions, except per share amount)

operating income

Income from Continuing Operations Per Share

preferred dividends

$2602 – $1601 $100 ————————————————————————— = ——— = $0.16 600 (1.05) – 30 (8/12) (1.05) + 12 (4/12) 613 shares at Jan. 1



treasury shares stock dividend adjustment

new shares



1 20 million shares x $100 x 8% = $160 million 2 $400 – $140 = $260 million

19–1249

Problem 19–8 (concluded) 3. 2024 and 2023 comparative income statements: (amounts in millions, except per share amount)

2024

2023

Income from continuing operations

$0.16

$0.71

Loss from discontinued operations

(0.65)

Net

income (loss)

($0.49)

$0.71

Earnings (Loss) Per Common Share:

Note: The weighted-average

number of common shares in 2023 should be adjusted for the stock dividend in 2024 for the purpose of reporting 2023 EPS in subsequent years for comparative purposes:

net income

Earnings Per Share

$450 $450 ——————————— = ——— 600 (1.05) 630 shares at Jan. 1

19–1250

= $0.71

stock dividend adjustment

Problem 19– 1251 2022 net loss

Net Loss Per Share

– $160,500 —————————— 1,855,000

= ($0.09)

2023 net income

Earnings Per Share

$2,240,900 $2,240,900 ————————————————— = ——————— = $1.23 1,855,000 – 110,000 (3/12) 1,827,500 shares at Jan. 1

retired shares

2024 net income

Earnings Per Share

$3,308,700 $3,308,700 ————————————————— = ——————— = $1.86 1,745,000* x (1.02)** 1,779,900 shares at Jan. 1

stock dividend adjustment

1,855,000 – 110,000 = 1,745,000 shares ** This is a 2% stock dividend: 34,900 ÷ 1,745,000 = 2%. Alternatively, the additional 34,900 shares could be simply added to the 1,745,000 initial shares outstanding. *

19–1251

Problem 19– 1252 (amounts in millions, except per share amount)

2022 net income

preferred dividends

Earnings Per Share

$290 – $1 ————————————————— 55 + 9 (6/12) shares at Jan. 1

$289 = ——— 59.5

$4.86

new shares

2023 net income

preferred dividends

Earnings Per Share

$380 – $1 ————————————————— 64 (1.50) – 4 (9/12) (1.50) shares at Jan. 1

$379 = ——— 91.5

$4.14

retired shares



stock split adjustment



2024 net income

preferred dividends

Earnings Per Share

$412 – $2 ————————————————— 90 (1.10) + 3 (4/12) shares at Jan. 1

19–1252

stock dividend adjustment

$410 = ——— 100

= $4.10

new shares

Problem 19– 1253 (amounts in thousands, except per share amount) net income

preferred dividends

Earnings Per Share

$2,100 – $75 $2,025 ————————————————————————— = ——— 675 600 (1.04) + 60 (10/12) (1.04) – 2 (6/12) shares at Jan. 1

new shares



stock dividend adjustment

= $3.00

shares retired



19–1253

Problem 19– 1254 The options issued in 2023 are not considered when calculating 2024 EPS because the exercise price ($33) is not less than the 2024 average market price of $32. As a result, these options are antidilutive. The options issued in 2024 do not affect the calculation of 2024 EPS for two reasons related to their being issued at December 31. First, the exercise price ($32) is equal to the 2024 average market price of $32. While they are not antidilutive, neither are they dilutive. Second, even if the exercise price had been less than the market price, these options would be excluded. Options are assumed exercised at the beginning of the year or when granted, whichever is later—when granted, in this case. So, the fraction of the year the shares are assumed outstanding is 0/12, meaning no increase in the weighted-average shares. The options issued in 2022 are considered exercised for 8,000 shares when calculating 2024 EPS because the exercise price ($24) is less than the 2024 average market price of $32. Treasury shares are assumed repurchased at the average price for diluted EPS: 8,000 shares x $24 (exercise price) $192,000 ÷ $32 (average market price) 6,000 shares

19–1254

Problem 19–12 (concluded) (amounts in thousands, except per share amount)

Basic EPS net income

preferred dividends

$2,100 – $75 $2,025 —————————————————————————— = —— 600 (1.04) + 60 (10/12) (1.04) – 2 (6/12) 675 shares at Jan. 1



new shares stock dividend adjustment



= $3.00

shares retired

Diluted EPS net income

preferred dividends

$2,100 – $75 $2,025 —————————————————————————— = —— 600 (1.04) + 60 (10/12) (1.04) – 2 (6/12) + (8 – 6) 677 shares at Jan. 1

new shares



stock dividend Adjustment

shares retired

= $2.99

assumed exercise of options



19–1255

Problem 19–13 The options issued in 2023 are not considered when calculating 2024 EPS because the exercise price ($33) is not less than the 2024 average market price of $32. As a result, these options are antidilutive. The options issued in 2024 do not affect the calculation of 2024 EPS for two reasons related to their being issued at December 31. First, the exercise price ($32) is equal to the 2024 average market price of $32. While they are not antidilutive, neither are they dilutive. Second, even if the exercise price had been less than the market price, these options would be excluded. Options are assumed exercised at the beginning of the year or when granted, whichever is later—when granted, in this case. So, the fraction of the year the shares are assumed outstanding is 0/12, meaning no increase in the weighted-average shares. The options issued in 2022 are considered exercised for 8,000 shares when calculating 2024 EPS because the exercise price ($24) is less than the 2024 average market price of $32. Treasury shares are assumed repurchased at the average price for diluted EPS: 8,000 shares x $24 (exercise price) $192,000 ÷ $32 (average market price) 6,000 shares

19–1256

Problem 19–13 (concluded) (amounts in thousands, except per share amounts)

Basic EPS net income

preferred dividends

$2,100 – $75 $2,025 ——————————————————————————— = —— = $3.00 600 (1.04) + 60 (10/12) (1.04) – 2 (6/12) 675 shares at Jan. 1

new shares



stock dividend adjustment

shares retired



Diluted EPS net income

preferred dividends

after-tax interest savings

$2,100 – $75 + $64 – 25%($64)** $2,073 ———————————————————————————— = — = $2.86 600 (1.04) + 60(10/12) (1.04) – 2 (6/12) + (8 – 6) + 23* + 24** 724 shares at Jan. 1

new shares



stock dividend adjustment

shares retired

assumed exercise contingent conversion of options shares of bonds



* The contingently issuable shares are considered issued when calculating diluted EPS because the condition for issuance (Merrill net income > $500,000) currently is being met. ** The bonds are considered converted when calculating diluted EPS: 800 bonds x 30 shares = 24,000 shares upon conversion. Interest = $800,000 x 8% = $64,000.

19–1257

Problem 19–14 (amounts in millions, except per share amounts)

Basic EPS net income

preferred dividends

$520 – $120* $400 ——————————————————————— = ——— = $4.00 100 100 shares at Jan. 1

The incremental effect of the conversion of the preferred stock is: preferred dividends

+$120* ————————————— = $3.75 +32 conversion of preferred stock

The incremental effect of the conversion of the bonds is: after-tax interest savings

+ $72** – 25% ($72**) ————————————— = $4.00 + 13.5 conversion of bonds * 60 million shares x $2 ** $900 million x 8%

Order of Entry: We include in our calculation the convertible security with the lowest ―incremental effect‖ ($3.75) before the one with the higher effect ($4.00).

19–1258

Problem 19–14 (concluded) Diluted EPS (without conversion of bonds) net income

preferred dividends

$520 – $120* +$120* $520 ——————————————————————————— = —— = $3.94 100 +32 132 shares at Jan. 1

conversion of preferred stock

After including the conversion of the preferred stock only, EPS is $3.94. The $4.00 incremental effect of the conversion of the bonds is higher than that amount, so the second security is antidilutive. This is demonstrated by calculating EPS again after including the conversion of the bonds: Diluted EPS (with conversion of bonds) net income

preferred dividends

after-tax interest savings

$520 – $120* +$120* + $72** – 25% ($72**) $574 ——————————————————————————— = —— = $3.95 100 +32 + 13.5 145.5 shares at Jan. 1

conversion of preferred

conversion of bonds

So, we omit the convertible bonds from the calculation and diluted EPS is $3.94. That‘s why we should include securities in the calculation in reverse order, beginning with the lowest incremental effect (most dilutive). * 60 million shares x $2 ** $900 million x 8%

19–1259

Problem 19–15 Requirement 1 (amounts in thousands, except per share amount)

Basic EPS: net income

preferred dividends

$150 – $77 $73 ———————————————— = ——— = 40 40

$1.83

weighted-average shares

With conversion of preferred stock (Diluted EPS): net income

$150 $150 ———————————————— = ——— = 40 + 20 60 weighted-average shares

$2.50

conversion of preferred shares

Since the assumed conversion of the convertible preferred stock causes EPS to increase, it is antidilutive and therefore ignored when calculating EPS.

19–1260

Problem 19–15 (concluded) Requirement 2 Basic EPS: net income

$150 ————————— 40

= $3.75

weighted-average shares

With conversion of bonds: net income

after-tax interest savings

$150 + $32* – 25% ($32) $174 ———————————————— = ——— = 40 +5 45 weighted-average shares

$3.87

conversion of bonds

* 6.4% x $500 = $32

Since the assumed conversion of the convertible bonds causes EPS to increase, it is antidilutive and therefore ignored when calculating EPS. Requirement 3 Since the exercise price is less than average market price, the options are not antidilutive (that is, dilutive) and therefore assumed exercised when calculating diluted EPS. Requirement 4 Since the exercise price is higher than the average market price, the warrants are antidilutive and therefore ignored when calculating diluted EPS. Requirement 5 The 5,000 shares are added to the denominator when calculating diluted EPS since 2024 net income is higher than the conditional amount. Since only the denominator is increased, the effect is not antidilutive (that is, dilutive).

19–1261

Problem 19– 1262 (amounts in millions, except per share amounts)

Basic EPS net income

$560 $560 —————————————————————— = —— = $1.44 400 – 30 (4/12) 390 shares at Jan. 1

new shares

Diluted EPS after-tax* interest savings

net income

$560 + $24 – 25% ($24) $578 —————————————————————— = —— = $1.36 426 400 – 30 (4/12) + 36 shares at Jan. 1

new shares

conversion of bonds

*Interest on the bonds = $300 million x 8% = $24 million. If the bonds were not

outstanding, interest expense would have been $24 million lower, and tax expense would have been 25% x $24 million, or $6 million higher, a net after-tax savings of $18 million.

19–1262

Problem 19– 1263 (amounts in thousands, except per share amounts)

Basic EPS net income

preferred dividends

$650

– $40*

$610

—————————————————————————————————— = ——— = $1.37 440 + 16 (3/12) 444

shares at Jan. 1

new shares

Diluted EPS net income

preferred dividends

$650

– $40*

+ $40*

shares at Jan. 1

new shares

$650 ————————————————————————————————— = ——— = $1.33 440 + 16 (3/12) + (20 – 15**) + 40 489 assumed exercise of options

conversion of preferred shares

* 4,000 shares x $100 par x 10% = $40,000

**Assumed purchase of treasury shares

20,000 x $30 $600,000 ÷ $40 15,000

shares (exercise price) (average market price) shares

19–1263

Problem 19– 1264 (amounts in millions, except per share amounts) Basic EPS net income

preferred dividends

$1,476

– $60*

shares at Jan. 1

new shares

$1,416 ——————————————————————————————————————— = ——— = $2.27 600 + 72 (4/12) 624

Diluted EPS net income

preferred dividends

after-tax Interest savings

$1,476

– $60*

+ $128** – 25% ($128)

shares at Jan. 1

new shares

$1,512 ——————————————————————————————————————— = ——— = $2.09 600 + 72 (4/12) + (60 – 40)*** + 80 724 exercise of options

conversion of bonds

*Preferred dividends: 6% x $50 x 20 million shares = $60 million * 6.4% x $2,000 million = $128 million ***Computation of treasury shares: 60 million x $12 $720 million ÷ $18 40 million

19–1264

shares exercise price proceeds average share price treasury shares

Problem 19– 1265 Requirement 1

(amounts in millions, except per share amount)

2024 Basic EPS net income

$150 $150 —————————————————————————— = —— = $0.50 300 300 shares at Jan. 1

2024 Diluted EPS net income

$150 $150 —————————————————————————— = —— = $0.49 300 + (30 – 27.5*) + (15 – 11.25***) 306.25 shares at Jan. 1

assumed exercise of options

assumed vesting of restricted stock

* Reacquired shares for assumed exercise of stock options in 2024: 30 million options x $ 10 exercise price $300 million cash proceeds 30 unexpensed compensation** $330 million hypothetical proceeds ÷ $ 12 average market price 27.5 million shares assumed reacquired ** Calculation of proceeds from unexpensed compensation: 30 million shares x $3 = $90 million total compensation to be expensed $30 million per year over 3 years (2023–2025). The expense has been recorded in 2023 and 2024: 2023 Compensation expense Paid-in capital—stock options 2024 Compensation expense

($ in millions)

30 30 30

19–1265

Paid-in capital—stock options

19–1266

Problem 19–19 (continued) So, $30 million compensation (for 2025) remains unexpensed and is considered part of the hypothetical proceeds of the options. Restricted Stock Award Like stock options, restricted stock awards represent potential common shares and their dilutive effect is included in diluted EPS. In fact, they too are included using the treasury stock method. That is, the shares are added to the denominator and then reduced by the number of shares that can be bought back with the ―proceeds‖ at the average market price of the company‘s stock. Unlike stock options, though, the first component of the proceeds is absent. *** Reacquired shares for assumed vesting of restricted stock in 2024: $ 0 million cash proceeds 135 unexpensed compensation**** $135 million hypothetical proceeds ÷ $ 12 average market price 11.25 million shares assumed reacquired **** Calculation of proceeds from unexpensed compensation: 15 million shares x $12 = $180 million total compensation to be expensed $45 million per year over four years. The expense has been recorded in 2024: 2024 Compensation expense Paid-in capital—restricted stock

($ in millions)

45 45

So, $135 million compensation (for 2025–2027) remains unexpensed and is considered part of the hypothetical proceeds of the options.

19–1267

Problem 19–19 (continued) Requirement 2 (amounts in millions, except per share amount)

2025 Basic EPS net income

$160 $160 —————————————————————————— = —— = $.53 300 300 shares at Jan. 1

2025 Diluted EPS net income

$160 $160 —————————————————————————— = —— = $0.50 300 + (30 – 20*) + (15 – 6***) 319 shares at Jan. 1

assumed exercise of options

assumed vesting of restricted stock

* Reacquired shares for assumed exercise of stock options in 2025: 30 million options x $ 10 exercise price $300 million cash proceeds 0 unexpensed compensation** $300 million hypothetical proceeds ÷ $ 15 average market price in 2025 20 million shares assumed reacquired ** Calculation of proceeds from unexpensed compensation: 30 million shares x $3 = $90 million total compensation to be expensed $30 million per year over 3 years. The expense has been recorded in 2023, 2024, and 2025, so no unexpensed compensation remains.

19–1268

Problem 19–19 (concluded) Restricted Stock Award *** Reacquired shares for assumed vesting of restricted stock in 2025: $0 million cash proceeds 90 unexpensed compensation**** $90 million hypothetical proceeds ÷ $15 average market price 6 shares assumed reacquired **** Calculation of proceeds from unexpensed compensation: 15 million shares x $12 = $180 million total compensation to be expensed $45 million per year over four years. The expense has been recorded in 2024 and 2025: 2024 Compensation expense Paid-in capital—restricted stock 2025 Compensation expense Paid-in capital—restricted stock

($ in millions)

45 45 45 45

So, $90 million compensation (for 2026–2027) remains unexpensed and is considered part of the hypothetical proceeds of the options.

19–1269

DECISION MAKERS’ PERSPECTIVES CASES

19–1270

Real World Case 19–1 The shares are restricted in such a way as to provide some incentive to the recipient. Microsoft‘s restricted stock award plans are tied to continued employment. The shares are subject to forfeiture by the employee if employment is terminated within five years from the date of grant. These restrictions give the employee incentive to remain with the company until rights to the shares vest.

19–1271

Case 19–1 (continued) Compensation pertaining to pre-2020 grants: Outstanding all year: 147 x $78.49 = $11,538.0 Nonvested at beg. of year 65 x $75.35 = (4,897.8) Vested during fiscal 2020 9 x $90.30 = (812.7) Forfeited during fiscal 2020 $5,827.5 Outstanding all year ÷ 5 yrs $1,165.5 Expense during 2020 for outstanding restricted (nonvested) shares outstanding all year Vested in 2020: $4,897.8 x ½ yr* =

2,448.9 Expense during 2020 for vested shares

Forfeited in 2020: Granted in 2017 ($812.7 x 1/3 = $270.9): Expensed in 2017: $270.9 ÷ 5 yrs = $54.2 Expensed in 2018: 270.9 ÷ 5 yrs = 54.2 Expensed in 2019: 270.9 ÷ 5 yrs = 54.2 Granted in 2018 ($812.7 x 1/3 = $270.9): Expensed in 2018: $270.9 ÷ 5 yrs = 54.2 Expensed in 2019: 270.9 ÷ 5 yrs = 54.2 Granted in 2019 ($812.7 x 1/3 = $270.9): Expensed in 2019: $270.9 ÷ 5 yrs = 54.2 (325.2) Reversal in expense for forfeited shares** $3,289.2 2020 expense for awards prior to 2020

19–1272

Case 19–1 (concluded) $3,289.2

2020 grants and acquisitions: 53 x $140.49 ÷ 5 yrs x ½ yr =

2020 expense for awards prior to 2020

744.6 2020 expense for 2020 $4,033.8 Total 2020 expense

* vested evenly throughout the year ** expense is reduced in year of forfeiture for amount expensed in previous years

19–1273

Real World Case 19–2 Requirement 1 The note indicates that Best Buy does not include potentially dilutive shares of common stock when calculating EPS for the twelve months ended March 3, 2012. Securities, like stock options, restricted stock awards, or convertible bonds, while not being actual shares of common stock, may become common stock through their exercise, vesting, or conversion. As a result, they may dilute (reduce) earnings per share and therefore are called ―potentially dilutive shares‖ by Best Buy. Normally, diluted EPS incorporates the dilutive effect of all potential common shares. However, whenever a company reports a net loss, as Best Buy did, it reports a loss per share. In that situation, stock options or restricted stock that otherwise are dilutive will be antidilutive. The loss per share declines. This represents an increase in performance— not a dilution of performance. The potential common shares would be considered antidilutive, then, and not included in the calculation of the net loss per share.

19–1274

Case 19–2 (concluded) Requirement 2 Best Buy does not include potentially dilutive shares when calculating EPS for the twelve months ended March 3, 2012. Whenever a company reports a net loss, as Best Buy did, it reports a loss per share. In that situation, stock options or restricted stock that otherwise are dilutive will be antidilutive. The loss per share declines. This represents an increase in performance—not a dilution of performance. The potential common shares would be considered antidilutive, then, and not included in the calculation of the net loss per share. Best Buy‘s diluted EPS calculation was:  366.3 = $3.36, or $1,231  366.3 = $3.36.

If Best Buy had 40 million common equivalent shares and included them in the calculation, the diluted loss per share for the twelve months ended March 3, 2012, would have declined from ($3.36) to ($3.03): $1,231  [366.3 + 40].

19–1275

Analysis Case 19–3 Requirement 1 When calculating basic earnings per share, the numerator in the computation is the earnings available to common shareholders. This will be net income of $70 million reduced by dividends payable to preferred shareholders of $14 million (7% x $100 x 2 million shares). Since the preferred stock is cumulative we subtract preferred dividends even if not declared. Because unpaid dividends accumulate to be paid in a future year when (if) dividends are subsequently declared, the presumption is that, although the year‘s dividend preference isn‘t distributed this year, it eventually will be paid. (amounts in millions)

Basic EPS numerator net income

preferred dividends

$70

– $14*

$56

* $14 million (7% x $100 x 2 million shares)

19–1276

Case 19–3 (continued) Requirement 2 When calculating basic earnings per share, the denominator in the computation is the weighted-average number of common shares outstanding during 2024. Thus, the 8 million shares outstanding at January l, 2024, plus a portion of the shares sold will result in the weighted-average number of shares outstanding for calculating basic EPS. The 3 million common shares issued during 2024 must be included in computing the weighted-average number of shares outstanding. The 3 million shares will be weighted by one-third because they were outstanding only for the four months of 2024. The 1 million common shares issued upon the exercise of stock options also must be included in computing the weighted-average number of shares outstanding. The 1 million shares will be weighted one-half because they were outstanding only for the six months of 2024. (amounts in millions)

Basic EPS denominator 8 + 3 (4/12) shares at Jan. 1

new shares

+ 1 (6/12)

= 9.5

actual exercise of options

(amounts in millions, except per share amounts)

Basic EPS net income

preferred dividends

$70

– $14

$56

—————————————————————————————————————— = ——— 9.5 8 + 3 (4/12) + 1 (6/12)

shares at Jan. 1

new shares

= $5.89

actual exercise of options

19–1277

Case 19–3 (continued) Requirement 3 When calculating diluted earnings per share, the numerator in the computation is the earnings available to common shareholders. Proactive will not reduce net income by dividends payable to preferred shareholders because it will treat the convertible preferred stock as if the preferred shares were converted, unless assuming conversion increase earnings per share (be antidilutive). As long as the preferred stock is not antidilutive, Proactive would not reduce the numerator for the preferred dividends as it would do if the preferred shares were assumed outstanding, as in calculating basic EPS. The assumed conversion of options outstanding has no effect on the numerator for computing diluted EPS.

(amounts in millions)

Diluted EPS numerator net income

preferred dividends

$70

+ $0

$70

Requirement 4 When calculating diluted earnings per share, the denominator in the computation is the weighted-average number of common shares outstanding during 2024 plus the effect of any potentially dilutive common shares. Proactive will treat the convertible preferred stock as if the preferred shares were converted and 4 million common shares were outstanding, unless including these shares in the denominator would increase earnings per share (be antidilutive).

19–1278

Case 19–3 (continued) The shares from the options outstanding for only part of the reporting period are included in the denominator on a time-weighted basis, while the options outstanding for the entire reporting period are assumed converted at the beginning of the year. For the 1 million options outstanding on January 1, the denominator would include the appropriate incremental shares (determined by the treasury stock method). For the 1.5 million options granted during the year, the denominator would include the appropriate incremental shares (determined by the treasury stock method) times the appropriate time-weighting fraction for the period from the grant date to the end of the year. (They can‘t be assumed to have been exercised before they were granted.) Similarly, for the 1 million options actually exercised during the year, the weightedaverage shares should include (a) the appropriate incremental shares (determined by the treasury stock method) times the appropriate time-weighting fraction for the period prior to actual exercise and (b) the appropriate actual shares issued times the appropriate time-weighting fraction for the period after the exercise. (amounts in millions)

Diluted EPS denominator 8

+ 3 (4/12)

+ 1 (6/12)

shares new at Jan. 1 shares

+ 4 + (1 – 0.8)** + (2 – 1.5)**(6/12) = 13.95

actual exercise conversion of options of PS

exercise of options

**Computation of treasury shares: 1 million x $50 $50 million ÷ $60 0.8 million

shares exercise price proceeds average share price treasury shares

***Computation of treasury shares: 2 million x $50 $100 million ÷ $66.67 1.5 million

shares exercise price proceeds average share price treasury shares

19–1279

Case 19–3 (concluded) (amounts in millions, except per share amounts)

Diluted EPS net income

preferred dividends

$70

+ $0

$70

——————————————————————————————————————— = ——— = $5.02 8 + 3 (4/12) + 1 (6/12) + 4 + (1 – 0.8)** + (2 – 1.5)**(6/12) 13.95

shares new at Jan. 1 shares

19–1280

actual exercise conversion of options of PS

exercise of options

Analysis Case 19–4 Requirement 1 Earnings per share is a way to summarize the performance of business enterprises into a single number. It is simply earnings expressed on a per share basis. It does not imply anything about cash dividends. Whether some, all, or none of the earnings are distributed depends on the company‘s reinvestment strategy. A dividend payout ratio expresses the percentage of earnings that is distributed to shareholders as dividends. Requirement 2 When calculating earnings per share, shares outstanding prior to a stock split (or stock dividend) are retroactively restated to reflect the increase in shares. That is, it is treated as if the split occurred at the beginning of the year. EPS is likewise adjusted for a reverse stock split. When calculating earnings per share, shares outstanding prior to a reverse split are retroactively restated to reflect the decrease in shares (95% in this instance). That is, it is treated as if the June share decrease occurred at the beginning of the year. When reported again for comparison purposes in the comparative income statements, the year earlier figure also would be restated to reflect the reverse stock split. Otherwise we would be comparing apples and oranges. Requirement 3 If the number of shares changes, it‘s necessary to find the weighted-average of the shares outstanding during the period the earnings were generated. If shares are reacquired during a period, REC would reduce the weighted-average number of shares. The company time-weights the number of reacquired shares for the fraction of the year they were not outstanding, prior to subtracting from the number of shares outstanding during the period. The effect would be an increase in EPS.

19–1281

Judgment Case 19–5 Although net income declined during the period, a combination of events caused EPS to increase in spite of declining profits. Specifically, retiring the preferred shares increased earnings available to common shareholders; retiring common shares and retiring convertible debt each decreased the weighted-average number of common shares. The following calculations show the effect of these events: (amounts in millions, except per share amount)

2022 net income

preferred dividends

Basic EPS

$145 – $16* $129 ——————————————————— = —— 60 60

= $2.15

shares at Jan. 1

net income

preferred dividends

after-tax interest savings

$145 – $16* + $4 – 25% ($4) $132 ——————————————————— = —— 60 +9 69 shares at Jan. 1

Diluted EPS

= $1.91

conversion of bonds

* 8% x [$10 x 20 million] = $16

19–1282

Case 19–5 (concluded) 2023 net income

preferred dividends

Basic EPS

$134 – $12‡ $122 ——————————————————— = —— 60 – 12 (10/12) 50 shares at Jan. 1

retired shares

net income

preferred dividends

after-tax interest savings

$134 – $12‡ + $4 – 25% ($4) $125 ——————————————————— = —— 60 – 12 (10/12) +9 59 shares at Jan. 1

retired shares

= $2.44

Diluted EPS

= $2.12

conversion of bonds

2024 net income

Basic EPS

$95 $95 ——————————————————— = —— 48± – 12 (10/12) 38 shares at Jan. 1

retired shares

net income

Diluted EPS

$95 $95 ——————————————————— = —— 48 – 12 (10/12) 38 shares at Jan. 1

= $2.50

retired shares

‡ $16 – (6/12 x 8% x [$10 x 20 million x 1/2]): calculation reflects the retirement of half the shares on July 1 ± 60 – 12

19–1283

Analysis Case 19–6 Requirement 1 In its simplest form, earnings per share is merely a firm‘s net income divided by the number of shares outstanding throughout the year. Earnings per share =

Income available to common shareholders Weighted-average shares outstanding

$487 181

$2.69

Requirement 2 Price-earnings ratio

Market price per share Earnings per share

$47.00 $2.69

17.5 times

The ratio is a measure of the market's perception of the ―quality‖ of a company‘s earnings. It indicates the price multiple the capital market is willing to pay for the company‘s earnings. In a way, this ratio reflects the market‘s perceptions of the company‘s growth potential, stability, and relative risk in that the ratio relates these performance measures to the external judgment of the marketplace concerning the value of the firm. The calculation indicates that IGF‘s share price represents $17.50 for every dollar of earnings. In that regard, it measures the ―quality‖ of earnings in the sense that it represents the market‘s expectation of future earnings as indicated by current earnings. We should be aware, though, that a ratio might be low, not because earnings expectations are low, but because of abnormally elevated current earnings, or, the ratio might be high, not because earnings expectations are high, but because the company‘s current earnings are temporarily depressed.

19–1284

Case 19–6 (concluded) Requirement 3 The dividend payout ratio expresses the percentage of earnings that is distributed to shareholders as dividends. To calculate the ratio for IGF with the information provided, we must estimate dividends from analysis of the retained earnings account: Retained Earnings 2,428 487 Dividends ?

Net income

2,730 Dividends apparently were $185,000,000. Dividends per share, then, would be $185 ÷ 181 = $1.02 Dividend payout ratio

Cash dividends per share Earnings per share

$1.02 $2.69

37.9%

IGF paid cash dividends of $1.02 cents per share during the most recent year, almost 38% of earnings. The ratio provides an indication of the firm‘s reinvestment strategy. If the payout ratio is low, it suggests that the company retains a large portion of earnings for reinvestment purposes such as new facilities and current operations. Sometimes, though, the ratio just reflects managerial strategy regarding the mix of internal versus external financing. Investors who, for tax or other reasons, prefer current income over market price appreciation, or vice versa, are particularly interested in this ratio.

19–1285

Real World Case 19–7 Requirement 1 The price-earnings ratio is simply the market price per share divided by the earnings per share. For Kellogg, the ratio is: $62.23 ÷ $3.63 = 17 It purports to measure the market's perception of the ―quality‖ of a company‘s earnings by indicating the price multiple the securities market is willing to pay for the company‘s earnings. The P/E ratio reflects analysts‘ perceptions of the company‘s growth potential, stability, and relative risk by relating these performance measures to the external judgment of the marketplace in regard to the value of the company. Care is needed when evaluating price-earnings ratios. Like other ratios, it is best evaluated in the context of P/E ratios of earlier periods and other, similar companies. For example, the P/E ratio of General Mills, Kellogg‘s prime competitor, was 18 at the same time. Kellogg‘s slightly lower than General Mills and slightly lower than the average P/E ratio for all companies at the time, which was 22.

19–1286

Case 19–7 (concluded) Requirement 2 The dividend payout ratio expresses the percentage of earnings that is distributed to shareholders as dividends. The ratio is calculated by dividing dividends per common share by the earnings per share. For Kellogg‘s most recent 12 months, the ratio is: ($0.57 x 4) ÷ ($3.63) = 63% Relative to the average company, this payout percentage is quite high. It is higher even than that of General Mills, Kellogg‘s prime competitor. General Mills‘ payout ratio was 55% at the same time. Historically, both companies and the industry in general have relatively high dividend payouts. This ratio provides an indication of a firm‘s reinvestment strategy. A low payout percentage suggests that a company is retaining a large portion of earnings for reinvestment in new projects. Low ratios often are found in growth industries. High payouts, like those of General Mills and Kellogg, often are found in mature industries. Sometimes, the ratio is just an indication of management strategy related to the mix of internal versus external financing. A high ratio is preferred by investors who, for tax or other reasons, prefer current income to market price appreciation.

19–1287

Research Case 19–8 Requirement 1 The appropriate accounting treatment for the situation is specified in FASB ASC 718– 10–35: ―Compensation–Stock Compensation–Overall.‖ Section 718–10–35–15 states: Change in Classification Due to Change in Probable Settlement Outcome 35-15 An option or similar instrument that is classified as equity, but subsequently becomes a liability because the contingent cash settlement event is probable of occurring, shall be accounted for similar to a modification from an equity to liability award. That is, on the date the contingent event becomes probable of occurring (and therefore the award must be recognized as a liability), the entity recognizes a share-based liability equal to the portion of the award attributed to past performance (which reflects any provision for acceleration of vesting) multiplied by the award's fair value on that date. To the extent the liability equals or is less than the amount previously recognized in equity, the offsetting debit is a charge to equity. To the extent that the liability exceeds the amount previously recognized in equity, the excess is recognized as compensation cost. The total recognized compensation cost for an award with a contingent cash settlement feature shall at least equal the fair value of the award at the grant date. The guidance in this paragraph is applicable only for options or similar instruments issued as part of compensation arrangements. That is, the guidance included in this paragraph is not applicable, by analogy or otherwise, to instruments outside share-based payment arrangements. Requirement 2 National Paper should record a liability for the portion of the award attributed to past performance (2/5) multiplied by the award's fair value ($8 million) on the date cash payment becomes probable: Paid-in capital—SAR plan ($5 million x 2/5) Compensation expense (difference) Liability—SAR plan ($8 million x 2/5)

2.0 1.2 3.2

Previously recorded paid-in capital (appropriate for an equity award) is removed, with the difference recorded as compensation.

19–1288

Communication Case 19–9 Suggested Grading Concepts and Grading Scheme: Content (80%) 30 Measurement of compensation. Compensation cost should be measured at the date of grant. Fair value of the stock options. Estimated by employing a recognized option pricing model. Value per option times number of options. Can be adjusted for estimated forfeiture rate. No entry on grant date. 25 Determination of compensation expense. Expensed over the period of service for which the options are given, 2024–2029. Debit compensation expense. Credit paid-in capital—stock options. Not adjusted when the price of the underlying stock changes. 15 Effect of forfeiture before vesting. Reduce compensation expense in forfeiture period for the cumulative effect of the revised estimate. Revise compensation expense for remaining service period. 10 Effect of forfeiture after vesting. Paid-in capital—stock options become Paid-in capital—expiration of stock options. Compensation expense of previous periods cannot be reversed for vested options. Bonus (5) For unvested, nonqualifying options: Proceeds for TS method include unexpensed compensation. Bonus (5) Option pricing model considers: Exercise price of the option. Expected term of the option. Current market price of the stock. Expected dividends.

19–1289

Expected risk-free rate of return. Expected volatility of the stock. 80–85 points

19–1290

Case 19–9 (concluded) Writing (20%) 5 Terminology and tone appropriate to the audience of controller. 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English. Word selection. Spelling. Grammar. 20 points

19–1291

Communication Case 19–10 Suggested Grading Concepts and Grading Scheme: Content (80%) 60 Convertible securities are included in the computation. Of diluted earnings per share. By assuming they were converted, the ―ifconverted‖ method, as it‘s called. The denominator of the EPS fraction is increased by the additional common shares that would have been issued upon conversion. The numerator is increased by the interest (after-tax) or preferred dividends that would have been avoided. 20 Antidilutive securities. Antidilutive means EPS increases rather than decreases. Ignored when calculating earnings per share. Bonus (4) Provides detail regarding the tax effect calculation

for convertible bonds. Interest on bonds is tax deductible. Tax expense will increase by the tax rate times interest. 80–84 points Writing (20%) 5 Terminology and tone appropriate to the audience of division managers. 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English Word selection. Spelling. Grammar. 20 points 19–1292

Ethics Case 19–11 Discussion should include these elements: Facts: The choice of method will affect earnings. FIFO will increase reported net income. FIFO will cause an increase in taxes paid. Company managers stand to benefit from the change. The auditor risks negative consequences if the change is challenged. Ethical Dilemma: Is the auditor‘s obligation to challenge the Questionable change in methods greater than the obligation to the financial interests of the CPA firm and its client? Who is affected? You, the auditor Managers CPA firm (lost fees? reputation? legal action?) Shareholders Potential shareholders The employees The creditors [From research performed in this area, it is not clear that accounting changes that increase earnings without any real economic (cash flow) effect will have the desired effect of increasing share price. In fact, the preponderance of such research indicates that the market ―sees through‖ cosmetic accounting changes. Nevertheless, there is plenty of evidence, at least anecdotal, that managers attempt to fool the market. Some efforts to manage earnings may not be an attempt to affect share prices, but to avoid violating terms of contracts based on earnings or related balance sheet items. Some may be to favorably affect terms of compensation agreements.]

19–1293

Ethics Case 19–12 Discussion should include these elements. 1. Effect of share repurchase on EPS. Reducing the number of shares will increase earnings per share. That impact will be lessened, though, the closer to the end of the year the shares are bought due to the way the share reduction is ―time-weighted‖ for the fraction of the year they are not outstanding. 2. Ethical Dilemma: Apparently, a more productive use for available funds will be offered by Barber. How does a less-than-optimal use of company funds compare with the perceived need to maintain a record of increasing reported EPS? 3. Who is affected? Mashburn Lane Managers under the bonus plan Shareholders Potential shareholders Employees Creditors

19–1294

Target Case Requirement 1 Three types of awards are described in Note 21: Share-Based Compensation:  restricted stock units  performance share units  stock options Requirement 2 Based on the fair value of the awards granted, Target‘s primary form of share-based compensation for the year ended February 1,2020 was restricted stock units (RSUs). The fair values of the awards granted for restricted stock units were approximately $172.6 million (= 2,157 thousand RSUs x $80.01). The value of the performance share units granted was $125.6 million (= 1,447 thousand performance stock units x $86.81). No new stock options were issued. Requirement 3 Projections of future performance should be based primarily on continuing operations. Diluted EPS for continuing operations in the most recent three years were 2019: $6.34, 2018: $5.50, and 2017: $5.29. So, there is no clear indication of future direction, but these numbers suggest a likely increase. Requirement 4 Securities, like stock options or restricted stock awards, while not being common stock, may become common stock through their exercise or vesting. As a result, they may dilute (reduce) earnings per share and therefore are called ―potential common shares.‖ Diluted EPS incorporates the dilutive effect of all potential common shares. 4.7 (=515.6 – 510.9) million shares were included in diluted earnings per share but not basic earnings per share in 2019, due to share-based compensation awards.

Air France–KLM Case Requirement 1 €279 million ÷ 455,334,249 = €0.61 Requirement 2 It‘s the after-tax interest savings that would occur if Air France-KLM‘s convertible bonds were to be converted. The potentially dilutive effect of convertible bonds is reflected in diluted EPS calculations by assuming the bonds were converted into common stock. The conversion is assumed to have occurred at the beginning of the period, or at the time the convertible bonds were issued, if later. When conversion is assumed, the additional common shares that would have been issued upon conversion are added to the denominator of the EPS fraction. That‘s the 27,901,785 share increase in the shares used to calculate basic EPS to determine the shares used to calculate diluted EPS reported as ―OCEANE conversion.‖ [Elsewhere in the financial statements it‘s reported that ― On March 20, 2019, Air France-KLM issued 27,901,785 bonds convertible and/or exchangeable for new or existing Air France-KLM shares (Ou d'Echange En Actions Nouvelles ou Existantes - OCEANE) ... The conversion ratio is one share for one bond.‖] The numerator is increased by the after-tax interest that would have been avoided if the bonds really had not been outstanding. This is the €6 million ―Consequence of potential ordinary shares on net income.‖

Chapter 20

Accounting Changes and Error Corrections

QUESTIONS FOR REVIEW OF KEY TOPICS Question 20-1 Accounting changes are categorized as: 1. Changes in principle (when companies switch from one acceptable accounting method to another) 2. Changes in estimate (when new information causes companies to revise estimates made previously) 1–1296 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

3. Changes in reporting entity (the group of companies comprising the reporting entity changes)

Question 20-2 Accounting changes can be accounted for: 1. Retrospectively (prior years revised), 2. Modified retrospectively, (adoption period only revised), or 3. Prospectively (only current and future years affected).

Answers to Questions (continued)

Question 20-3 In general, we report voluntary changes in accounting principles retrospectively. This means revising all previous periods‘ financial statements presented in comparative statements as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. Specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we revise the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders‘ equity (or statements of retained earnings if they‘re presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change. In the first set of financial statements after the change, a disclosure note would describe the change and justify the new method as preferable. It also would describe the effects of the change on all items affected, including the fact that the retained earnings balance was revised in the statement of shareholders‘ equity.

. Question 20-4 Lynch should report its change in depreciation method as a change in estimate, rather than as a change in accounting principle. This is because a change in depreciation method is considered a change in accounting estimate reflected by a change in accounting principle. In other words, a change in the depreciation method is adopted to reflect a change in (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company‘s knowledge about those benefits. The effect of the change in depreciation method is inseparable from the effect of the change in accounting estimate. Such changes frequently are related to the ongoing process of obtaining new information and revising estimates and, accordingly, are actually changes in estimates not unlike changing the estimated useful life of a depreciable asset. Logically, the two events should be reported the same way. Accordingly, Lynch reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from then on. The undepreciated cost remaining at the time of the change would be depreciated straight line over the remaining useful life. A disclosure note should justify that the change is preferable and describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported.

Question 20-5 In general, we report voluntary changes in accounting principles retrospectively. This means Sugarbaker will revise all previous period‘s financial statements presented in comparative statements, including 2023, as if the average cost method always had been used. Sugarbaker will revise cost of goods sold for 2023 as well as any other income statement amounts affected by that revision, including income taxes and net income. Since the change affects income, retained earnings also changes. Sugarbaker reflects the cumulative prior year difference in cost of goods sold (after tax) as a difference in prior years‘ income and therefore in the balance in retained earnings. It also revises inventory in the balance sheet.

Answers to Questions (continued) The company also will revise deferred taxes. Income tax effect is reflected in the deferred income tax asset because retrospectively decreasing accounting income, but not taxable income, creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. When that happens, taxable income will become lower than accounting income—a future deductible amount, creating a deferred tax asset. Recall from Chapter 16 that in the meantime, the temporary difference is reflected in the deferred tax asset. Question 20-6 Voluntary changes in accounting principles usually are reported retrospectively. We don‘t report changes in depreciation method that way, though, because such changes are considered to be changes in estimate and thus reported prospectively. Also, it‘s not practicable to report some changes in principle retrospectively because insufficient information is available. Revising balances in prior years means knowing what those balances should be. For instance, suppose we‘re switching from the FIFO method of inventory costing to the LIFO method. Recall that LIFO inventory consists of ―layers‖ added in prior years at costs existing in those years. So, if FIFO has been used, the company probably hasn‘t kept track of those costs. Accounting records of prior years typically are inadequate to report the change retrospectively, so a company changing to LIFO usually reports the change prospectively. The beginning inventory in the year the LIFO method is adopted becomes the base year inventory for all future LIFO calculations. Another exception is when authoritative accounting literature requires prospective application for specific changes in accounting methods. For example, when there‘s a change from the equity method to another method of accounting for long-term investments, GAAP requires the prospective application of the new method. From Chapter 12, recall that if an investor's level of influence over an investee changes, it may be necessary to change from the equity method to another method. This might happen if a sale of shares causes the investor‘s ownership interest to fall from, say, 20% to 10%, resulting in the equity method no longer being appropriate. In such a case, we make no adjustment to the book value of the investment, but instead, simply discontinue the equity method and apply the new method from then on. The existing balance in the investment account when the equity method is discontinued serves as 1–1300 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the new ―cost‖ basis from then on.

Answers to Questions (continued) Question 20-7 Accounting records of prior years usually are inadequate to determine the cumulative income effect of the change for prior years when a company changes to the LIFO inventory method from another inventory method. For example, it would be necessary to make assumptions as to when specific LIFO inventory layers were created in years prior to the change. Accordingly, a company changing to LIFO generally does not revise the balance in retained earnings. Rather, the beginning inventory in the year the LIFO method is adopted becomes the base year inventory for all future LIFO calculations. A disclosure note would be included in the financial statements describing the nature of and justification for the change as well as an explanation as to why retrospective application was impracticable. Question 20-8 A change in estimate is accounted for prospectively. When a company revises an estimate, previous financial statements are not revised. Rather, the company simply incorporates the new estimate in any related accounting determinations from then on. The unamortized cost remaining after three years would be amortized over the new estimate of the remaining useful life. A disclosure note should describe the effect of a material change in estimate on income from continuing operations, net income, and related per share amounts for the current period. Question 20-9 When it‘s not possible to distinguish between a change in principle and a change in estimate, the change should be treated as a change in estimate. Question 20-10 The situations deemed to constitute a change in reporting entity are (1) presenting consolidated financial statements in place of statements of individual companies and (2) changing the specific companies that comprise the group for which consolidated or combined statements are prepared.

. Question 20-11 Ford reported the situation as a change in reporting entity. This means that Ford needed to recast all previous periods‘ financial statements as if the new reporting entity existed in those periods. In the first set of financial statements after the change, a disclosure note described the nature of the change and the reason it occurred. Also, the effect of the change and the impact of its correction on each financial statement line item and any per-share amounts affected for each prior period are presented. Question 20-12 When an error is discovered, previous years' financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. Any account balances that currently are incorrect as a result of the error should be corrected by a journal entry. Also, if retained earnings is one of the accounts whose balance is incorrect, the correction is reported net of tax as a prior period adjustment to the beginning balance in a statement of shareholders‘ equity (or statement of retained earnings if that‘s presented instead). A disclosure note is needed also to describe the nature of the error and the impact of its correction on each financial statement line item and any per-share amounts affected for each prior period presented. Question 20-13 If merchandise inventory is understated at the end of 2023, that year‘s cost of goods sold would be overstated, causing 2023 net income to be understated. Because 2023 ending inventory is 2024 beginning inventory, the opposite effect on net income would occur in 2024. The 2024 cost of goods sold would be understated, causing 2024 net income to be overstated by the same amount it was understated the year before. Question 20-14 The error would have caused the previous year‘s expenses to be overstated, and therefore its net income to be understated. Therefore, retained earnings would be understated as a result of the error. So, the correction to that account would be reported net of tax as a prior period adjustment (increase in this case) to the beginning retained earnings balance in the retained earnings column of the statement of shareholders‘ equity or in a separate statement of retained earnings. Solutions Manual, Chapter 1 1–1303 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answers to Questions (continued) Question 20-15 During the two-year period, insurance expense would have been overstated by $30,000, so net income during the period was understated by $30,000. This means beginning retained earnings is currently understated by that amount. During the twoyear period, prepaid insurance would have been understated, and continues to be understated by $30,000. So, a correcting entry would debit prepaid insurance and credit retained earnings. Also, the financial statements that were incorrect as a result of the error would be retrospectively restated to report the prepaid insurance acquired and reflect the correct amount of insurance expense when those statements are reported again for comparative purposes in the current annual report. A prior period adjustment to the beginning balance of retained earnings would be reported because retained earnings is one of the accounts incorrect as a result of the error. And, a disclosure note should describe the nature of the error and the impact of its correction on the line item affected in each year‘s financial statements as well as on each year‘s net income and earnings per share. Question 20-16 If the error in the previous Question is not discovered until the insurance coverage has expired, no correcting entry at all would be needed. By then, the sum of the omitted insurance expense amounts ($10,000 x 5 years) would equal the expense incorrectly recorded when the error occurred, so the retained earnings balance at the beginning of the year of discovery would be the same as if the error never had occurred. Also, the asset—prepaid insurance—would have expired so it also would not need to be recorded. Of course, any statements of prior years that were affected and are reported again in comparative statements still would be restated, and a disclosure note would describe the error and its effect on net income of the affected years reported. Question 20-17 When correcting errors in previously issued financial statements, IFRS (IAS No. 8) permits the effect of the error to be reported in the current period if it‘s not considered 1–1304 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

practicable to report it retrospectively. Retrospective application is required by U.S. GAAP with no practicability exception.

BRIEF EXERCISES Brief Exercise 20-1 To record the change: Retained earnings ...................................................................................... Inventory ($32 million – $23.8 million) ..................................

($ in millions)

8.2 8.2

B & B applies the average cost method retrospectively; that is, to all prior periods as if it always had used that method. In other words, all financial statement amounts for individual periods that are included for comparison with the current financial statements are revised for period-specific effects of the change. Then, the cumulative effects of the new method on periods prior to those presented are reflected in the reported balances of the assets and liabilities affected as of the beginning of the first period reported and a corresponding adjustment is made to the opening balance of retained earnings for that period. Let‘s say B & B reports comparative statements of shareholders‘ equity for 2022, 2023, and 2024. The $8.2 million adjustment above is due to differences prior to the 2024 change. The portion of that amount due to differences prior to 2022 is subtracted from the opening balance of retained earnings for 2022. The effect of the change on each line item affected should be disclosed for each period reported as well as any adjustment for periods prior to those reported. Also, the nature of and justification for the change should be described in the disclosure notes.

Brief Exercise 20-2 To record the change: Inventory ($47.6 million – $64 million) ...................................... Retained earnings .................................................................................

($ in millions)

16.4 16.4

Brief Exercise 20-3 When a company changes to the LIFO inventory method from another inventory method, accounting records of prior years often are inadequate to determine the cumulative income effect of the change for prior years. For instance, it would be necessary to make assumptions as to when specific LIFO inventory layers were created in years prior to the change. So, a company changing to LIFO generally does not revise the balance in retained earnings. This is the case for JJ Dishes. No entry is made. Instead, the beginning inventory in the year the LIFO method is adopted ($96 million for JJ) becomes the base year inventory for all future LIFO calculations. A disclosure note would be included in the financial statements describing the nature of and justification for the change as well as an explanation as to why retrospective application was impracticable.

Brief Exercise 201308 A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method is similar to changing the economic useful life of a depreciable asset, and therefore the two events should be reported the same way. Accordingly, Irwin reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from then on. The undepreciated cost remaining at the time of the change would be depreciated straight line over the remaining useful life. ($ in millions)

Asset‘s cost Accumulated depreciation to date (calculated below) Undepreciated cost, Jan. 1, 2024 Estimated residual value To be depreciated over remaining 7 years Annual straight-line depreciation 2024–2030

$35.0 (16.2) $18.8 (2.0) $16.8 ÷7 years $ 2.4

Calculation of SYD depreciation (10 + 9 + 8) x [$35 – $2] million) = $16.2 million 55* * n (n + 1)  2 = [10 (11)]  2 = 55

Adjusting entry (2024 depreciation): ($ in millions)

Depreciation expense (calculated above) ............................................ Accumulated depreciation...........................................................

2.4 2.4

Brief Exercise 20-5 A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method is similar to changing the economic useful life of a depreciable asset, and therefore the two events should be reported the same way. Accordingly, Irwin reports the change prospectively; previous financial statements are not revised. Instead, the undepreciated cost remaining at the time of the change would be depreciated by the sum-of-the-years‘-digits method over the remaining useful life. ($ in millions)

Asset‘s cost Accumulated depreciation to date (calculated below) Undepreciated cost, Jan. 1, 2024 Estimated residual value To be depreciated over remaining 7 years

$35.0 (9.9) $25.1 (2.0) $23.1

Calculation of straight-line depreciation to date ($35 – $2)  10 years = $3.3 x 3 years = $9.9 Adjusting entry (2024 depreciation): ($ in millions)

Depreciation expense (calculated below) ............................................ Accumulated depreciation...........................................................

5.78 5.78

Calculation of SYD depreciation 7 x $23.1 million = $5.775 million 28* * n (n + 1)  2 = [7 (8)]  2 = 28

Brief Exercise 201310 The fact that more royalty revenue was received in February than anticipated in December represents a change in estimate. No adjustments are made to any 2024 financial statements. Feenix would record the following entry at February 1, 2025, upon receiving the 2024 royalties (not required): Cash...................................................................................... Receivable—royalty revenue ............................................ Royalty revenue ...............................................................

36,500 36,000 500

Brief Exercise 20-7 The fact that claims were less than expected represents a change in estimate. As a result, no adjustments are made to any 2023 financial statements, and the 2024 warranty expense is unaffected by any previous estimates. 2024 warranty expense is $350,000 times 4%, or $14,000. Quapau would record the following entry to record the expense (not required): Accrued liability and expense Warranty expense (4% x $350,000) .....................................................14,000 Estimated warranty liability .............................................

14,000

Brief Exercise 201311 When an estimate is revised as new information comes to light, accounting for the change in estimate is quite straightforward. We do not recast prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from the beginning of the year of change and years forward. If the effect of the change in estimate is material, the effect on continuing operations, net income, and earnings per share must be disclosed in a note, along with the justification for the change.

($ in millions)

Amortization expense (determined below) .. Patent..................................................

5 5

Calculation of annual amortization after the estimate change: ($ in millions)

$18 $2 x 4 years

8 $10 ÷ 2 $ 5

Cost Previous annual amortization ($18 ÷ 9 years) Amortization to date (2020–2023) Unamortized cost (balance in the patent account) Estimated remaining life (6 years – 4 years used) New annual amortization

Brief Exercise 20To correct the error: 1312 Equipment ................................................................................ 65,000 Buildings ..........................................................................

65,000

Other step(s) that would be taken in connection with the error: When comparative balance sheets are reported that include 2023, the 2023 balance sheet would be restated to reflect the correction. A disclosure note should describe the error and the impact of its correction on each financial statement line item and any per-share amounts affected for each prior period presented. In this case, because the machine was purchased at the end of 2023, depreciation in 2023 is correct and net income for 2023 is not impacted by the error.

Brief Exercise 201313 Analysis: Correct (Should Have Been Recorded)

Incorrect (As Recorded)

2021 Equipment…… 350,000 Cash………… 350,000

Expense… 350,000 Cash... 350,000

2021 Expense………. 70,000 Accum. deprec. 70,000

depreciation entry omitted

2022 Expense………. 70,000 Accum. deprec. 70,000

depreciation entry omitted

2023 Expense………. 70,000 Accum. deprec. 70,000

depreciation entry omitted

During the three-year period, depreciation expense was understated by $210,000, but other expenses were overstated by $350,000, so net income during the period was understated by $140,000, which means retained earnings is currently understated by that amount. During the three-year period, accumulated depreciation was understated, and continues to be understated by $210,000.

To correct incorrect accounts Equipment ........................................................ Accumulated depreciation ($70,000 x 3 years) Retained earnings ($350,000 – $210,000) ......

350,000 210,000 140,000

Brief Exercise 201314 No correcting entry would be required because, after five years, the accounts would show appropriate balances.

Brief Exercise 20-12 Error a 1. 2023 Income Statement: Expenses understated, net income overstated. 2023 Balance Sheet: Liabilities understated, retained earnings overstated. The journal entry for the correction in 2024 is: ($ in millions)

Retained earnings ................................................................. 2 Salaries expense .............................................................. 2 2. The 2023 financial statements that were incorrect as a result of the error would be retrospectively restated to reflect the correct salaries expense, (income tax expense if taxes are considered), net income, and retained earnings when those statements are reported again for comparative purposes in the 2024 annual report. 3. Because retained earnings is one of the accounts incorrectly stated accounts, the correction to that account is reported as a prior period adjustment to the 2024 beginning retained earnings balance in the comparative statements of shareholders‘ equity. 4. Also, a disclosure note should describe the nature of the error and the impact of its correction on each financial statement line item and any per-share amounts affected for each prior period presented.

Brief Exercise 20-12 (concluded) Error b 1. To include the $3 million in year 2024 purchases and increase retained earnings to what it would have been if 2023 cost of goods sold had not included the $3 million purchases. Analysis: 2023 2024 Beginning inventory Beginning inventory Purchases Purchases U O Less: Ending inventory Less: Ending inventory Cost of goods sold Cost of goods sold O U Revenues Less: Cost of goods sold O Less: Other expenses U Net income  U Retained earnings

U = Understated O = Overstated

($ in millions)

Purchases ......................................................... Retained earnings .........................................

3 3

2. The 2023 financial statements that were incorrect as a result of the error would be retrospectively restated to reflect the correct cost of goods sold, (income tax expense if taxes are considered), net income, and retained earnings when those statements are reported again for comparative purposes in the 2024 annual report. 3. Because retained earnings is one of the accounts incorrectly stated, the correction to that account is reported net of tax as a prior period adjustment to the 2024 beginning retained earnings balance in the comparative statements of shareholders‘ equity. 4. Also, a disclosure note should describe the nature of the error and the impact of its correction on each financial statement line item and any per-share amounts affected for each prior period presented.

EXERCISES Exercise 20-1 Requirement 1 January 1, 2024

($ in millions)

Retained earnings........................................................................ Inventory (cumulative effect) * ................................................

* Cost of goods sold (FIFO) ..................................................... Cost of goods sold (average).................................................. Difference...........................................................................

2022 $38 52 $14

30 30 2023 $40 56 $16

Total

$30

Since the cost of goods available for sale each period is the sum of the cost of goods sold and the cost of goods unsold (inventory), a $30 million difference ($14 + $16) in cost of goods sold due to using FIFO rather than Average means there also is a $30 million difference in inventory. The cumulative prior year difference in cost of goods sold is reflected as a difference in prior years‘ income and, therefore, the balance in retained earnings.

Requirement 2

COMPARATIVE INCOME STATEMENTS ($ in millions)

Revenues Cost of goods sold (average) Operating expenses Net income

2024 $420 (62) (254) $104

2023 $390 (56) (250) $ 84

Exercise 20-1 (continued) Requirement 3 Calculations ($ in millions):

Revenues Cost of goods sold (FIFO) Operating expenses Net income Dividends Retained earnings, Jan. 1, 2022 Retained earnings, Jan. 1, 2023

2022 $380 (38) (242) 100 (20) 0 $ 80

Exercise 20-1 (concluded) Requirement 4 Calculations ($ in millions): 2022 cumulative effect for January 1, 2023 retained earnings restatement: FIFO Average Difference Revenues $380 $380 Cost of goods sold (38) (52) Operating expenses (242) (242) Net income $100 $ 86 $14 Comparative Statements of Shareholders’ Equity (not required)

Common Stock

Additional Paid-in Capital

Retained Earnings

Total Shareholders‘ Equity

($ in millions)

Jan. 1, 2023* Net income Dividends Jan. 1, 2024 Net income Dividends Jan. 1, 2025

66 84** (20) 130 104** (20) 214

* Decreased from $80 million to $66 million to reflect the effect of the $14 cumulative effect of the change in inventory methods prior to restated financial statements. **Calculations ($ in millions): 2023

2024

Revenues Cost of goods sold (average) Operating expenses Net income

$390 (56) (250) $ 84

$420 (62) (254) $104

Exercise 20-2 Requirement 1 Balance at January 1, 2024, using LIFO Prior to 2024, using FIFO: Inventory would have been higher by $60,000, so Cost of goods sold would have been lower by $60,000, so Pretax income would have been higher by: Less: Income tax at 25% Cumulative net income and thus retained earnings would have been higher by: Balance at January 1, 2024, using FIFO

$780,000

$60,000 (15,000) 45,000 $825,000

Requirement 2 January 1, 2024 Inventory (additional inventory if FIFO had been used) ..................... Retained earnings (additional net income if FIFO had been used).. Income tax payable (25% x $60,000).......................................

60,000 45,000 15,000

Exercise 201321

This is a change in accounting principle. ($ in millions)

Common stock ($1 par x 4 million shares retired) ........................ Paid-in capital—excess of par (average amount above par at which the retired shares originally sold: $800 million ................. ÷ 200 million shares = $4; $4 x 4 million shares retired) ..............

Retained earnings (difference)................................................. Treasury stock (cost of the shares retired) ...............................

16 5 25

UMC applies the new way of reporting reacquired shares retrospectively; that is, to all prior periods as if it always had used that method. In other words, all financial statement amounts for individual periods affected by the change and that are included for comparison with the current financial statements are revised. In each prior period reported, then, UMC would reduce Common stock by $4 million, Paid-in capital – excess of par by $16 million, Retained earnings by $5 million, and Treasury stock by $25 million. The effect of the change on each line item affected should be disclosed for each period reported as well as any adjustment for periods prior to those reported. Also, the nature of and justification for the change should be described in the disclosure notes.

Exercise 201322 Requirement 1 Prospectively. When a change to the equity method is appropriate, the previous method is discontinued and the balance in the investment account at the date of the change (including any unrealized holding gains or losses that occurred prior to the date the investment qualifies for the equity method) is used as the starting balance for applying the equity method. Any cost of acquiring additional shares is added to that balance, and going forward that balance is adjusted for the investor‘s portion of investee earnings and dividends. A disclosure note also should describe the change. Requirement 2 Prospectively. When a company changes from the equity method, no adjustment is made to the book value of the investment. Instead, the equity method is simply discontinued, the existing balance in the investment in equity affiliate account is transferred to an investment in equity securities account, and the new method is applied from then on. The balance in the investment in equity affiliate account when the equity method is discontinued would serve as the new ―cost‖ basis for writing the investment in equity securities account up or down to fair value in the next set of financial statements. There also would be no revision of prior years, but the change in accounting method and the balance sheet account classification should be described in a disclosure note.

Exercise 201323 Requirement 1

The specific citation that describes the guidelines for how to account for a change in percentage ownership which then mandates use of the equity method for investments in common stock is FASB ASC 323–10–35–33: ―Investments–Equity Method and Joint Ventures–Overall–Subsequent Measurement–Increase in Level of Ownership or Degree of Influence.‖

Requirement 2 35-33 An investment in common stock of an investee that was previously accounted for on other than the equity method may become qualified for use of the equity method by an increase in the level of ownership (that is, acquisition of additional voting stock by the investor, acquisition or retirement of voting stock by the investee, or other transactions). If an investment qualifies for use of the equity method (that is, falls within the scope of this Subtopic), the investor shall add the cost of acquiring the additional interest in the investee (if any) to the current basis of the investor‘s previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting.

Exercise 20-6 The FASB Accounting Standards Codification® represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1.

Reporting most changes in accounting principle: FASB ASC 250–10–45–5: ―Accounting Changes and Error Corrections – Overall–Other Presentation Matters–Change in Accounting Principle.‖

Disclosure requirements for a change in accounting principle: FASB ASC 250–10–50–1: ―Accounting Changes and Error Corrections – Overall–Disclosure–Change in Accounting Principle.‖

Illustration of the application of a retrospective change in the method of accounting for inventory: FASB ASC 250–10–55–3: ―Accounting Changes and Error Corrections – Overall– Implementation Guidance and Illustrations – Retrospective Application of a Change in Accounting Principle.‖

Exercise 201325 Requirement 1 ($ in millions)

Inventory (additional amount due to the new method: $14 million + $6 million) ....................................... Deferred income tax liability ($20 million x 25%) .......................... Retained earnings (difference) .......................................................

20 5 15

Retained earnings is increased by $15 million because the net income in years prior to 2024 would have been higher by that amount. Note: Notice that the income tax effect is reflected in the income tax payable account. The reason is that, unlike for other accounting method changes, the Internal Revenue Code requires that the inventory costing method used for tax purposes must be the same as that used for financial reporting. For that reason, the tax code allows a retrospective change in an inventory method, but then requires that taxes saved previously ($5 million in this case) from having used another inventory method must now be repaid. However, taxpayers are given up to six years to pay the tax due. As a result, this liability has both a current portion (payable within one year) and a noncurrent portion (payable after one year) but is not a deferred tax liability. Requirement 2 Income before income tax Income tax expense (25%) Net Income

2024 $20 (5) $15

2023 $16 (4) $12

Exercise 20-7 (continued) Requirement 3 Besides net income, which was reported in 2023 as $7.5 million ($10 million less tax) and now revised to $12 million, other amounts that would be revised to reflect accounting by the FIFO costing method are: Earnings per share Cost of goods sold Income tax expense (and income before income taxes) Inventory (and total assets) Income tax payable (and total liabilities) Retained earnings (and total shareholders‘ equity)

Exercise 20-7 (concluded) Requirement 4 In the retained earnings column of the comparative statements of shareholders‘ equity, the beginning balance of 2023 retained earnings is revised to include any portion of the cumulative income effect attributable to years prior to 2023. The adjusted balance is then followed by any increases or decreases to retained earnings during the year (net income, dividends, etc.) Retained earnings would be adjusted as follows (not required): Millington Supplies Statement of Shareholders’ Equity For the Years Ended Dec. 31, 2024 and 2023 ($ in millions)

Total Common Additional Retained Shareholders‘ Stock Paid-in Earnings Equity Capital Balance at Jan. 1, 2023 Net income Cash dividends Balance at Dec. 31, 2023 Net income Cash dividends Balance at Dec. 31, 2024

$22.5* 12.0 (2.0) 32.5 15.0 (2.0) $45.5

* $30 million, less 25% income tax.

Exercise 201328 Requirement 1 To record the change: Retained earnings (cost of goods sold higher; 2023 net income lower) Inventory (cost of goods sold higher; inventory lower)...............

($ in millions)

6 6

Requirement 2 Flay is unable to apply the LIFO cost method retrospectively. It does, however, have sufficient information to apply the new method prospectively beginning in 2023. So, the company reports numbers for years beginning in 2023 as if it had carried forward the 2022 ending balance in inventory (measured on the FIFO inventory costing basis) and then had begun applying LIFO as of January 1, 2023. A journal entry is needed to revise retained earnings and inventory to balances that would have resulted from using LIFO beginning in 2023 (Requirement 1). Information available doesn‘t allow recording and reporting the cumulative effects of the new method on periods prior to 2023. The effect of the change on each line item affected should be disclosed for each period reported. Also, the nature of and justification for the change should be described, as well as the reasons full retrospective application was impracticable. Requirement 3 ($ in millions)

Net income

2022 $82

2023 $78

2024 $80

FIFO

LIFO (revised)

LIFO

Exercise 20-9 Requirement 1 To record the change: Retained earnings ($23 million plus $7 million) .......................... Inventory (cost of goods sold higher; inventory lower)...............

($ in millions)

30 30

Requirement 2 If it is impracticable to revise all specific years reported, a change is applied retrospectively as of the earliest year practicable. Wolfgang has information that would allow it to revise all assets and liabilities on the basis of LIFO for 2023 in its comparative statements, but not for 2022. So, the company should report 2023 statement amounts (revised) and 2024 statement amounts (reported for the first time) based on LIFO, but not revise 2022 numbers. Then, it should revise reported account balances retrospectively as of the beginning of 2023 since that‘s the earliest date it‘s practicable to do so. A journal entry is needed at the beginning of 2024 to adjust retained earnings and inventory to balances that would have resulted from using LIFO all along. This is the cumulative income effect prior to 2023 ($23 million), plus the income effects of 2023 ($7 million). The effect of the change on each line item affected should be disclosed for each period reported. Also, the nature of and justification for the change should be described, as well as the reasons full retrospective application was impracticable. Requirement 3 ($ in millions)

Net income

2022 $92

2023 $87

FIFO No change

LIFO (revised) Reduced $7

2024 $90 LIFO No change

Exercise 201330 Requirement 1 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company‘s knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Kumas reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change would be depreciated straight line over the remaining useful life. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported.

Requirement 2 Adjusting entry (2024): Depreciation expense (calculated below) ......................... Accumulated depreciation ...................................... Asset‘s cost Accumulated depreciation to date (given) Undepreciated cost, Jan. 1, 2024 Estimated residual value To be depreciated over remaining 3 years Annual straight-line depreciation 2022-2024

199,667 199,667

$2,560,000 (1,801,000) $ 759,000 (160,000) $ 599,000 ÷ 3 years $ 199,667

Exercise 20-11 Requirement 1 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company‘s knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Canliss reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the SYD method from now on. The undepreciated cost remaining at the time of the change would be depreciated by the SYD method over the remaining useful life (three years). A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Requirement 2 Adjusting entry: Depreciation expense (calculated below) ......................... Accumulated depreciation ...................................... Asset‘s cost Accumulated depreciation to date ($160,000 x 2) To be depreciated over remaining 3 years 2024 SYD depreciation:

Not required: 2025 SYD depreciation:

2026 SYD depreciation:

240,000 240,000

$800,000 (320,000) $480,000

3 x $480,000 = $240,000 (3 + 2 + 1)

2 x $480,000 = $160,000 (3 + 2 + 1) 1

x $480,000 =

$80,000

(3 + 2 + 1)

Exercise 201333 Requirement 1 April 1, 2024 Cash...................................................................................... Receivable—royalty revenue ............................................ Royalty revenue ...............................................................

36,000 31,000 5,000

October 1, 2024 Cash.......................................................................................... 40,000 Royalty revenue ...............................................................

40,000

December 31, 2024 Receivable—royalty revenue ..................................................... 50,000 Royalty revenue ($500,000 x 10%).......................................

50,000

Requirement 2 The fact that more royalty revenue was received in April than anticipated in December represents a change in estimate. No adjustment is made to retained earnings or any other account balance in the 2023 financial statements.

Exercise 201334 This is a change Requirement 1 in estimate. To revise the liability on the basis of the new estimate: Liability—litigation ($1,000,000 – $600,000)................. litigation ....................................................

400,000 Gain— 400,000

Requirement 2 No. When a company revises a previous estimate, prior financial statements are not revised. No adjustment is made to existing accounts.

Requirement 3 Yes. A disclosure note should describe the effect of a material change in estimate on income from continuing operations, net income, and related per-share amounts for the current period.

Exercise 201335 Requirement 1 Accrued liability and expense Warranty expense (3% x $3,600,000) ................................................108,000 Warranty liability ............................................................. 108,000 Actual expenditures (summary entry) Warranty liability ...................................................................... 88,000 Cash (or salaries payable, parts and supplies, etc.) ...........

88,000

Requirement 2 Actual expenditures (summary entry) Warranty liability ($50,000 – $23,000) ................................................ 27,000 Loss on product warranty [(3% – 2%) x $2,500,000] ......................... 25,000 Cash (or salaries payable, parts and supplies, etc.) ...........

52,000*

*(3% x $2,500,000) – $23,000 = $52,000

Exercise 201336 Requirement A deferred1 tax liability is established using the currently enacted tax rate for the year(s) a temporary difference is expected to reverse. In this case that rate was 25%. The change in the tax law in 2025 constitutes a change in estimate. The deferred tax liability is simply revised to reflect the new rate:

($ in millions)

Income tax expense (to balance)............................................... Deferred tax liability ($20 million x [25% – 20%]) ...................... Income tax payable ($60 million x 25%) ................................

14 1 15

Requirement 2 No. When a company revises a previous estimate, prior financial statements are not revised. No adjustment is made to existing accounts.

Exercise 20-16 Requirement 1 This is a change in accounting estimate. Requirement 2 No. When an estimate is revised as new information comes to light, accounting for the change in estimate is quite straightforward. We do not recast prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from there on. Requirement 3 Yes. If the after-tax income effect of the change in estimate is material, the effect on income from continuing operations, net income, and earnings per share must be disclosed in a note, along with the justification for the change. Requirement 4 $800,000 $160,000 x 2 years

320,000 480,000

Cost Old annual depreciation ($800,000 ÷ 5 years) Depreciation to date (2022–2023) Book value

÷ 6 $ 80,000

New estimated remaining life (8 years – 2 years used) New annual depreciation

Exercise 20-17 Requirement 1 Depreciation expense (determined below)... Accumulated depreciation ..................

3,088 3,088

Calculation of annual depreciation after the estimate change: $40,000 Cost $7,200 Old annual depreciation ($36,000 ÷ 5 years) x 2 years 14,400 Depreciation to date (2022–2023) $25,600 Book value (900) Revised residual value $24,700 Revised depreciable base ÷8 Estimated remaining life (10 years – 2 years used) $ 3,088 New annual depreciation Requirement 2

Depreciation expense (determined below)... Accumulated depreciation...................

3,889 3,889

Calculation of annual depreciation after the estimate change: $40,000 $12,000 9,600 21,600 $18,400 (900) $17,500 x 8/36* $ 3,889

Cost Previous depreciation: 2022: ($36,000 x 5/15) 2023: ($36,000 x 4/15) Depreciation to date (2022–2023) Book value Revised residual value Revised depreciable base Estimated remaining life: 8 years 2024 depreciation * n (n + 1) ÷ 2 = 8 (9) ÷ 2 = 36

Exercise 20-18 EP E E

1. Change from declining balance depreciation to straight-line. 2. Change in the estimated useful life of office equipment. 3. Technological advance that renders worthless a patent with an unamortized cost of $45,000. PR 4. Change from determining lower of cost or net realizable value (LCNRV) for inventories by the individual item approach to the aggregate approach. PR 5. Change from LIFO inventory costing to weighted-average inventory costing. E 6. Settling a lawsuit for less than the amount accrued previously as a loss contingency. R 7. Including in the consolidated financial statements a subsidiary acquired several years earlier that was appropriately not included in previous years. N* 8. Change by a retail store from reporting warranty expense on a pay-asyou-go basis to estimating the expense in the period of sale. PR 9. A shift of certain manufacturing overhead costs to inventory that previously were expensed as incurred to more accurately measure cost of goods sold. (Either method is generally acceptable.) E 10. Pension plan assets for a defined benefit pension plan achieving a rate of return in excess of the amount anticipated. *Error correction: change from an unacceptable method to GAAP.

Exercise 20-19 Requirement 1 The 2022 error caused 2022 net income to be understated, but since 2022 ending inventory is 2023 beginning inventory, 2023 net income was overstated by the same amount. So, the income statement was misstated for 2022 and 2023, but the balance sheet (retained earnings) was incorrect only for 2022 with regard to this error. After that, no account balances are incorrect due to the 2022 error. Analysis: 2022 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income

U = Understated O = Overstated  

U  O

O U

 Retained earnings

2023 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income

U O

 U

Retained earnings

corrected

Exercise 20-19 (concluded) However, the 2023 error has not yet self-corrected. Both retained earnings and inventory still are overstated as a result of the second error. Analysis: 2023 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income

U = Understated O = Overstated

O U

U O

 Retained earnings

Requirement 2 Retained earnings (overstatement of 2023 income) ............................150,000 Inventory (overstatement of 2024 beginning inventory).............. 150,000 Requirement 3 Retrospectively. The financial statements that were incorrect as a result of both errors (effect of one error in 2022 and effect of two errors in 2023) would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A prior period adjustment to the balance of retained earnings would be reported, net of tax, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s affected line items, net income, and earnings per share. Solutions Manual, Chapter 1 1–1341 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Exercise 20-20 1. Error discovered before the books are adjusted or closed in 2024. Investment in equity securities ($100,000 – $80,000)........................20,000 Gain on investments..........................................................

20,000

2. Error not discovered until early 2025. Investment in equity securities ($100,000 – $80,000)........................20,000 Retained earnings..............................................................

20,000

Exercise 201343 Requirement 1

The error caused both 2022 net income and 2023 net income to be overstated, so retained earnings is overstated by a total of $85,000. Also, the note payable would be understated by the same amount. Remember, the entry to record interest is: Interest expense .............................................................................. Notes payable (difference)....................................................... Cash..................................................................................

xxx xxx xxx

So, if interest expense is understated, the reduction in the note will be too much, causing the balance in that account to be understated. Requirement 2 Retained earnings (overstatement of 2022–2023 income) .................... 85,000 Notes payable (understatement determined above) ...................

85,000

Requirement 3 Retrospectively. The financial statements that were incorrect as a result of the errors would be retrospectively restated to report the correct interest amounts, income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A prior period adjustment to the balance of retained earnings would be reported, net of tax, and a disclosure note should describe the nature of the error and the impact of its correction on each financial statement line item and any per-share amounts affected for each prior period presented.

Exercise 201344 The 2024 interest expense is overstated by the extra interest recorded in February. Similarly, retained earnings is overstated by the same amount because 2023 interest expense was understated when the accrued interest was not recorded. To correct the error: Retained earnings ......................................................... Interest expense (5/6 x $73,200) .............................

2024 adjusting entry: Interest expense (5/6 x $73,200) .............................. Discount on bonds payable (5/6 x $1,200) ........... Interest payable (5/6 x $72,000) ...........................

*ENTRIES THAT SHOULD HAVE BEEN RECORDED: 2023 adjusting entry: Interest expense (5/6 x $73,200) .............................. Discount on bonds payable (5/6 x $1,200) ........... Interest payable (5/6 x $72,000) ........................... February 1, 2024: Interest expense (1/6 x $73,200) .............................. Interest payable (5/6 x $72,000)............................... Discount on bonds payable (1/6 x $1,200) ........... Cash (given) ........................................................

61,000 61,000

61,000 1,000 60,000

12,200 60,000 200 72,000

Exercise 201345 Error a 2023 Income Statement: Balance Sheet:

Expenses understated, net income overstated. Liabilities understated, retained earnings overstated.

2024 Retained earnings ................................................................. Salaries expense ..............................................................

1,800 1,800

Error b 2023 Income Statement: Balance Sheet:

Revenue overstated, net income overstated. Liabilities understated, retained earnings overstated.

2024 Retained earnings ................................................................. Rent revenue ..................................................................... Deferred rent revenue .......................................................

90,000 45,000 45,000

Error c 2023 Income Statement: Balance Sheet:

Revenue understated, net income understated. Assets understated, retained earnings understated.

2024 Interest revenue .................................................................... Retained earnings..............................................................

8,000 8,000

Exercise 201346 U = understated O = overstated NE = no effect Cost of Goods Sold U

Net Income O

Retained Earnings O

2. Overstatement of purchases

3. Understatement of beginning inventory

4. Freight-in charges are understated

5. Understatement of ending inventory

6. Understatement of purchases

7. Overstatement of beginning inventory

8. Understatement of purchases and understatement of ending inventory, by the same amount

1. Overstatement of ending inventory

Exercise 20F 1. Change from expensing extraordinary repairs to capitalizing the 1347 C B C A B E D A C

expenditures. 2. Change in the residual value of machinery. 3. Change from FIFO inventory costing to LIFO inventory costing. 4. Change in the percentage used to determine warranty expense. 5. Change from LIFO inventory costing to FIFO inventory costing. 6. Change from reporting an investment by the equity method to another method due to a reduction in the percentage of shares owned. 7. Change in the composition of a group of firms reporting on a consolidated basis. 8. Change from sum-of-the-years‘-digits depreciation to straight-line depreciation. 9. Change from FIFO inventory costing to average inventory costing. 10. Change in actuarial assumptions for a defined benefit pension plan.

PROBLEMS Problem 20-1 Requirement 1 To record the change: Inventory ($155,000 – $120,000) ......................................................... 35,000 Deferred income tax liability ($35,000 x 25%) ..................... Retained earnings (net effect) .............................................

8,750 26,250

Note: Notice that the income tax effect is reflected in the income tax payable account. The reason is that an accounting method used for tax purposes cannot be changed retrospectively for prior years. The Internal Revenue Code requires that taxes saved previously ($8,750 in this case) from having used another inventory method must now be repaid. However, taxpayers are given up to six years to pay the tax due. As a result, this liability has both current (portion payable within one year) and noncurrent (payable after one year) aspects but is not a deferred tax liability. .

Requirement 2 COMPARATIVE INCOME STATEMENTS

Income from continuing operations Income tax expense (25%) Net income

2024 $525,000** (131,250) $393,750

2023 $399,000* (99,750) $299,250

Earnings per share: Earnings per common share

$3.94

$2.99

*$400,000

‡

less 1,000 = $399,000 if FIFO had been used ** 2024 is correct as differences were in prior period adjustment ‡

Calculation of decrease in 2023 pretax income: $160,000 – $124,000 = $36,000 increase in 2022 inventory is increase in 2023 beginning inventory $155,000 – $120,000 = (35,000) increase in 2023 ending inventory ↑ ↑ $ 1,000 increase in cost of goods sold/ FIFO average decrease in income 1–1348 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Problem 20-2 Requirement 1 Inventory (additional amount due to the new method) ................... Income tax payable ($39,000* x 25%) .................................. Retained earnings (difference) .............................................

39,000 9,750 29,250

* 2022 difference plus 2023 equals the cumulative difference

Note: Notice that the income tax effect is reflected in the income tax payable account. The reason is that, unlike for other accounting method changes, the Internal Revenue Code requires that the inventory costing method used for tax purposes must be the same as that used for financial reporting. For that reason, the tax code allows a retrospective change in an inventory method, but then requires that taxes saved previously ($9,750 in this case) from having used another inventory method must now be repaid. However, taxpayers are given up to six years to pay the tax due. As a result, this liability has both a current portion (payable within one year) and a noncurrent portion (payable after one year) but is not a deferred tax liability. .

Retained earnings is increased by $29,250 because the net income for 2022 and 2023 would have been higher by that amount, and net income accumulates as an increase in retained earnings. Requirement 2 Income before income taxes Income tax expense (25%) Net Income Earnings per share: (50,000 shares) *rounded

2024 $51,000 (12,750) $38,250

2023 $45,000 (11,250) $33,750

$0.77*

$0.68*

Problem 20-2 (concluded) Requirement 3 Coclin Company Statement of Shareholders’ Equity For the Years Ended Dec. 31, 2024 and 2023

Common Additional Retained Total Stock Paid-in Earnings Shareholders‘ Capital Equity Balance at Jan. 1, 2023* Net income** Cash dividends Balance at Dec. 31, 2023 Net income** Cash dividends Balance at Dec. 31, 2024

$50,000

$180,000 $ 67,500 33,750 (10,000) 50,000 180,000 91,250 38,250 (10,000) $50,000 $180,000 $119,500

$297,500 33,750 (10,000) 321,250 38,250 (10,000) $349,500

* Retained earnings at the beginning of 2023 is increased by $22,500 because the net income for 2022 would have been higher by that amount, and net income increases retained earnings. So, $45,000 + $22,500 = $67,500. ** from Requirement 1 above

Problem 20-3 1. This is a change in accounting principle to be recorded retrospectively.

($ in 000s)

Retained earnings ($3,550 – $3,140) ........................................ Inventory (reduction to Average method) ................................

410 410

Roberti will recast its financial statements to appear as if the average cost method always had been used. The FIFO method has a higher ending inventory and a lower cost of goods sold so net income under the FIFO method is higher than other methods. Thus, switching from FIFO to average cost will reduce retained earnings to the balance it would have had if the average method had been used previously; that is, by the cumulative income difference between the average and FIFO methods. Simultaneously, inventory is reduced to the balance it would have been if the average method had always been used. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. 2. This is a change in accounting principle that usually is reported prospectively.

No entry is needed to record the change.

When a company changes to the LIFO inventory method from another inventory method, it usually does not report the change retrospectively. Instead, the base year inventory for all future LIFO calculations is the beginning inventory in the year the LIFO method is adopted. A disclosure note should describe the nature of and justification for the change as well as an explanation of why retrospective application was impracticable.

Problem 20-3 (concluded) 3. This is a change in accounting principle to be partially recorded retrospectively. ($ in 000s)

Retained earnings ($750 – $540) ............................................. Inventory (decrease to LIFO for 2023 difference only)...............

210 210

In its comparative 2024–2023 financial statements, Roberti should report numbers for 2023 as if it had carried forward the 2022 ending balance in inventory (measured on the previous FIFO inventory costing basis) and then had begun applying LIFO as of January 1, 2023. There would be no adjustment to accounts for the cumulative income effect of not using LIFO prior to that.

Problem 20-4 Requirement 1 To record the change: Retained earnings (net effect)............................................................. 15,000 Deferred tax asset ($20,000 x 25%)...................................................... 5,000 Inventory ($150,000 – $130,000)...........................................

20,000

Note: For financial reporting purposes, but not for tax, the company is retrospectively decreasing accounting income, but not taxable income. This creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. When that happens, taxable income will be lower than accounting income. When taxable income will be lower than accounting income as a temporary difference reverses, we have a ―future deductible amount‖ and record a deferred tax asset. Requirement 2 Strawser-Morris will recast its financial statements to appear as if the average method always had been used. This will include reporting cost of goods sold in the income statement and inventory in the balance sheet for 2024 using the newly adopted average method.

Average cost method cost of goods sold: Beginning inventory (5,000 units) Purchases:

$130,000 $180,000 200,000

5,000 units @ $36 5,000 units @ $40

Cost of goods available for sale (15,000 units) Less: Ending inventory (below) Cost of goods sold

380,000 510,000 (238,000) $272,000

Cost of ending inventory: $510,000 Weighted-average unit cost =

= $34

15,000 units Inventory: 7,000 units x $34 = $238,000 1–1354 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Problem 20-5 Requirement 1 January 1, 2024 ($ in millions)

Inventory (additional inventory if FIFO had been used) ..................... Retained earnings (additional net income if FIFO had been used).. Income tax payable (25% x $20 million) .................................. * Prior to 2024, using FIFO: Inventory would have been higher by $20, so cost of goods sold would have been lower by $20, so pretax income would have been higher by: Less: Income tax at 25% Cumulative net income and thus retained earnings would have been higher by:

20 15* 5

$20 (5) $15

Notice that the income tax effect is reflected in the income tax payable account. The reason is that, unlike for other accounting method changes, the Internal Revenue Code requires that the inventory costing method used for tax purposes must be the same as that used for financial reporting. For that reason, the tax code allows a retrospective change in an inventory method, but then requires that taxes saved previously ($5 million in this case) from having used another inventory method must now be repaid. However, taxpayers are given up to six years to pay the tax due. As a result, this liability has both a current portion (payable within one year) and a noncurrent portion (payable after one year) but is not a deferred tax liability. Requirement 2 Net income, which was reported in 2023 as $28 million, would be revised to $30 million in the comparative income statements of 2024 and 2023. Net income in 2024 would simply be reported at $36 million, the amount resulting from using the new method (FIFO). The comparative income statements and balance sheets also would be recast to reflect the balances as if the FIFO method had been used in prior years.

Problem 20-5 (concluded) Requirement 3 Fantasy Fashions Statement of Shareholders’ Equity For the Years Ended Dec. 31, 2024 and 2023 ($ in millions)

Common Additional Retained Paid-in Earnings Stock Capital 1

Balance at Jan. 1, 2023

250

Net income (revised to FIFO) Cash dividends Balance at Dec. 31, 2023

30 (8) 272

Net income (using FIFO) Cash dividends Balance at Dec. 31, 2024

36 (8) 300

1 2

Total Shareholders‘ Equity

$240 million plus the difference in net income before 2023: $250 – $240 given

A disclosure note would describe the change and justify the new method as preferable. It also would describe the effects of the change on all items affected, including the fact that the January 1, 2023, balance in the statement of shareholders‘ equity was revised by $10 million due to the change from the LIFO to the FIFO method of accounting for inventories. If three-year comparative statements were provided, it would be the balance in retained earnings at the beginning of 2022 that would be revised for any portion of the cumulative income effect attributable to years prior to 2022. Retained earnings is revised for the earliest year reported in the comparative statements.

Problem 20-6 Requirement 1 A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method is similar to changing the economic useful life of a depreciable asset, and therefore the two events should be reported the same way. Accordingly, Faulkner reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from then on. The undepreciated cost remaining at the time of the change would be depreciated straight-line over the remaining useful life. Asset‘s cost Accumulated depreciation (SYD) to date (given) Undepreciated cost, Jan. 1, 2024 Estimated residual value To be depreciated over remaining 8 years Annual straight-line depreciation 2024–2031

$21,000 (6,909) $14,091 (1,000) $13,091 ÷ 8 years $ 1,636

Adjusting entry (2024 depreciation): Depreciation expense (calculated above) .....................................................1,636 Accumulated depreciation........................................................... 1,636 A disclosure note should justify that the change is preferable and describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported.

Problem 20-6 (concluded) Requirement 2 If Faulkner switched to sum-of-the-years‘ digits with eight years remaining, it reports the change prospectively; previous financial statements are not revised. Instead, the company employs the SYD method from then on. The undepreciated cost remaining at the time of the change would be depreciated by the SYD method over the remaining useful life. Asset‘s cost Accumulated depreciation (S-L) to date (given) Undepreciated cost, Jan. 1, 2024 Estimated residual value To be depreciated over remaining 8 years SYD depreciation 2024

$21,000 (4,000) $17,000 (1,000) $16,000 x 8 / 36* $ 3,556

* n (n + 1) ÷ 2 = 8 (9) ÷ 2 = 36

Adjusting entry (2024 depreciation): Depreciation expense (calculated above) ..................................................... 3,556 Accumulated depreciation........................................................... 3,556 A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported.

Problem 20-7 Requirement 1 Cost of mineral mine: Purchase price Development costs

$1,600,000 600,000 $2,200,000

Depletion: $2,200,000 – $100,000 Depletion per ton =

= $5.25 per ton 400,000 tons

2024 depletion

= $5.25 x 50,000 tons = $262,500

2025 depletion: Revised depletion rate =

($2,200,000 – $262,500) – $100,000 = $4.20 per ton 487,500 – 50,000 tons

2025 depletion

= $4.20 x 80,000 tons = $336,000

Depreciation: Structures: $150,000 Depreciation per ton =

= $0.375 per ton 400,000 tons

2024 depreciation

= $0.375 x 50,000 tons = $18,750

2025 depreciation: Revised depreciation rate =

$150,000 – $18,750 = $0.30 per ton 487,500 – 50,000 tons

2025 depreciation

= $0.30 x 80,000 tons = $24,000

Problem 20-7 (concluded) Equipment: $80,000 – $4,000 Depreciation per ton =

= $0.19 per ton 400,000 tons

2024 depreciation

= $0.19

2025 depreciation: Revised depreciation rate =

x 50,000 tons = $9,500 ($80,000 – $9,500) – $4,000 = $0.152 per ton 487,500 – 50,000 tons

2025 depreciation = $0.152 x 80,000 tons = $12,160 Requirement 2 Mineral mine: Cost Less accumulated depletion: 2024 depletion 2025 depletion Book value, 12/31/2025 Structures: Cost Less accumulated depreciation: 2024 depreciation 2025 depreciation Book value, 12/31/2025 Equipment: Cost Less accumulated depreciation: 2024 depreciation 2025 depreciation Book value, 12/31/2025

$2,200,000 $262,500 336,000

598,500 $1,601,500 $150,000

$18,750 24,000

42,750 $107,250 $80,000

$ 9,500 12,160

21,660 $58,340

Problem 20-8 a. This is a change in estimate.

No entry is needed to record the change 2024 adjusting entry: Warranty expense (2% x $4,000,000) ................................. Warranty liability ...................................................

80,000 80,000

If the effect is material, a disclosure note should describe the effect of a change in estimate on income from continuing operations, net income, and related per share amounts for the current period. b. This is a change in estimate.

No entry is needed to record the change 2024 adjusting entry: Depreciation expense (determined below) ..................... Accumulated depreciation ......................................

45,000 45,000

Calculation of annual depreciation after the estimate change: $1,000,000 Cost $25,000 Old depreciation ($1,000,000 ÷ 40 years) x 3 yrs. (75,000) Depreciation to date (2021-2023) $ 925,000 Undepreciated cost (700,000) New estimated salvage value $ 225,000 To be depreciated ÷ 5 Estimated remaining life (5 years: 2024–2028) $ 45,000 New annual depreciation A disclosure note should describe the effect of a change in estimate on income from continuing operations, net income, and related per share amounts for the current period. 1–1362 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Problem 20-8 (continued) c. This is a change in accounting principle that usually is reported prospectively. No entry is needed to record the change.

When a company changes to the LIFO inventory method from another inventory method, accounting records usually are insufficient to determine the cumulative income effect of the change necessary to retrospectively revise accounts. So, a company changing to LIFO usually reports the beginning inventory in the year the LIFO method is adopted ($690,000 in this case) as the base year inventory for all future LIFO calculations. The disclosure required is a note to the financial statements describing the nature of and justification for the change as well as an explanation as to why the retrospective application was impracticable. d. This is a change in accounting estimate resulting from a change in accounting principle. No entry is needed to record the change 2024 adjusting entry: Depreciation expense (determined below) ..................... Accumulated depreciation ......................................

24,000 24,000

Problem 20-8 (concluded) A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, the Hoffman Group reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight line over the remaining useful life. ($ in 000s)

$330 (162) $168 (0) $168 ÷ 7 $ 24

years

Calculation of SYD depreciation: (10 + 9 + 8) x $330,000) = $162,000 55 e. This is a change in estimate.

To revise the liability on the basis of the new estimate: Loss—litigation ................................................................... 150,000 Liability—litigation ($350,000 – $200,000)....................... 150,000 A disclosure note should describe the effect of a change in estimate on income from continuing operations, net income, and related per share amounts for the current period. f. This is a change in accounting principle accounted for prospectively. Because the change will be effective only for assets placed in service after the date of change, the change doesn‘t affect assets depreciated in prior periods. The nature of and justification for the change should be described in the disclosure notes. Also, the effect of the change on the current period‘s financial statements should be disclosed. 1–1364 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Problem 20-9 P P 1.By acquiring additional stock, Wagner increased its investment in Wise, Inc. from a 12% interest to 25% and changed its method of accounting for the investment to the equity method. N

Wagner instituted a postretirement benefit plan for its employees in 2024. Wagner did not previously have such a plan.

Wagner changed its method of depreciating computer equipment from the SYD method to the straight-line method.

Wagner determined that a liability insurance premium it both paid and expensed in 2023 covered the 2023–2025 period.

By selling shares in Launch Corp, Wagner decreased its investment in the company from a 23% interest to 15% and changed its method of accounting for the investment from the equity method to the fair value through net income method.

Due to an unexpected relocation, Wagner determined that its office building previously depreciated using a 45-year life should be depreciated using an 18-year life. 7.

Wagner offers a three-year warranty on the farming equipment it sells. Manufacturing efficiencies caused Wagner to reduce its expectation of warranty costs from 2% of sales to 1% of sales.

Wagner changed from LIFO to FIFO to account for its materials and work in process inventories.

P R 9. Wagner changed from FIFO to average cost to account for its equipment inventory. X

10.

Wagner sells extended service contracts on some of its equipment sold. Wagner performs services related to these contracts over several years, so in 2024 Wagner changed from recognizing revenue from these service contracts on a cash basis to the accrual basis.

Problem 20-10 Requirement 1 Analysis: 2022 Beginning inventory Plus: Net purchases Less: Ending inventory Cost of goods sold Revenues Less: Cost of goods sold Less: Other expenses Net income

  U-6,000 O-6,000

U-6,000 U-3,000 O-9,000 U-18,000

U-6,000

Revenues Less: Cost of goods sold U-18,000 Less: Other expenses Net income O-18,000

U-6,000

Retained earnings

O-6,000

 Retained earnings

U = Understated O = Overstated 2023 Beginning inventory Plus: Net purchases Less: Ending inventory Cost of goods sold

 O-12,000

Requirement 2

Retained earnings..................................... 12,000 Inventory ............................................ 9,000 Purchases ............................................ 3,000 Requirement 3 Retrospectively. The financial statements that were incorrect as a result of both errors (effect of one error in 2022 and effect of three errors in 2023) would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income, and retained earnings when those statements are reported again for comparative purposes in the 2024 annual report. A prior period adjustment to the balance of retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each financial statement line item and any per-share amounts affected for each prior period presented.

Problem 20Requirement 1 1367 Analysis: Correct (Should Have Been Recorded) 2022 Equipment Expense Cash

1,900,000 100,000

Incorrect (As Recorded) Equipment Cash

2,000,000 2,000,000

2,000,000

2022 Expense 475,000 [1] Accum. deprec. 475,000

Expense 500,000 [2] Accum. deprec. 500,000

2023 Expense 356,250 [3] Accum. deprec. 356,250

Expense 375,000 [4] Accum. deprec. 375,000

[1] $1,900,000 x 25% (2 times the straight-line rate of 12.5%) [2] $2,000,000 x 25% [3] ($1,900,000 – $475,000) x 25% [4] ($2,000,000 – $500,000) x 25% During the two-year period, depreciation expense was overstated by $43,750, but other expenses were understated by $100,000, so net income during the period was overstated by $56,250, which means retained earnings is currently overstated by that amount. During the two-year period, accumulated depreciation was overstated, and continues to be overstated by $43,750. To correct incorrect accounts Retained earnings ............................................... Accumulated depreciation .................................. Equipment ......................................................

56,250 43,750 100,000

Problem 20-11 (concluded) Requirement 2 This is a change in accounting estimate resulting from a change in accounting principle. No entry is needed to record the change 2024 adjusting entry: Depreciation expense (determined below) .............................178,125 Accumulated depreciation ...................................... 178,125 A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, the Collins Corporation reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight line over the remaining useful life. Asset‘s cost (after correction) Accumulated depreciation to date ($475,000 + $356,250) Undepreciated cost, Jan. 1, 2024 Estimated residual value To be depreciated over remaining 6 years Annual straight-line depreciation 2024–2029

$1,900,000 (831,250) $1,068,750 (0) $1,068,750 ÷ 6 $ 178,125

years

Problem 20-12 a. This is a correction of an error. To correct the error: Prepaid insurance ($35,000 ÷ 5 yrs. x 3 yrs.: 2024–2026) ........ Retained earnings* ..............................................................

21,000 21,000

*$35,000 – [$35,000 ÷ 5 years x 2 years: 2022–2023]

2024 adjusting entry: Insurance expense ($35,000 ÷ 5 years) .................................... Prepaid insurance .........................................................

7,000 7,000

The financial statements that were incorrect as a result of the error would be retrospectively restated to report the prepaid insurance acquired and reflect the correct amount of insurance expense when those statements are reported again for comparative purposes in the current annual report. A prior period adjustment to the balance of retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each financial statement line item and any per-share amounts affected for each prior period presented. b. This is a change in estimate. No entry is needed to record the change 2024 adjusting entry: Depreciation expense (determined below) ........................... Accumulated depreciation ............................................

15,000 15,000

C alculation of annual depreciation after the estimate change: $600,000 Cost $12,500 Old depreciation ([$600,000 – $100,000] ÷ 40 years) x 10 yrs (125,000) Depreciation to date (2014–2023) $475,000 Undepreciated cost (25,000) New estimated salvage value $450,000 To be depreciated ÷ 30 Estimated remaining life (40 years – 10 years used) $ 15,000 New annual depreciation

Problem 20-12 (continued) A disclosure note should describe the effect of a change in estimate on income from continuing operations, net income, and related per share amounts for the current period. c. This is a correction of an error.

To correct the error: Retained earnings ..................................................................... Inventory ...............................................................................

25,000 25,000

The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct inventory amounts, cost of goods sold, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A prior period adjustment to the balance of retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each financial statement line item and any per-share amounts affected for each prior period presented.

d. This is a change in accounting principle and is reported retrospectively.

To record the change: Inventory (given) ............................................................................. 960,000 Retained earnings ................................................................ 960,000

Problem 20-12 (continued) Most changes in accounting principle are accounted for retrospectively. Prior years' financial statements are recast to reflect the use of the new accounting method. The company should increase retained earnings to the balance it would have been if the FIFO method had been used previously; that is, by the cumulative income difference between the LIFO and FIFO methods. Simultaneously, inventory is increased to the balance it would have been if the FIFO method had always been used. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Given the information in the problem, the entry above is recorded at the end of 2024. But, because the change is reported retrospectively, the balance in both inventory and retained earnings for the end of 2023 (and any other prior years reported) also would be determined and reported as if the FIFO method had been used previously. e. This is a correction of an error.

To correct the error: Retained earnings .................................................................... Compensation expense .......................................................

15,500 15,500

The 2023 financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct compensation expense, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A prior period adjustment to the balance of the current period‘s retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each financial statement line item and any per-share amounts affected for each prior period presented.

Problem 20-12 (concluded) f. This is a change in estimate resulting from a change in accounting principle and is accounted for prospectively.

No entry is needed to record the change 2024 adjusting entry: Depreciation expense (calculated below) ................................ Accumulated depreciation ...........................................

57,600 57,600

A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, Williams-Santana reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight line over the remaining useful life. Undepreciated cost, Jan. 1, 2024 (given) Estimated residual value To be depreciated over remaining 8 years Annual straight-line depreciation 2024-2031 g . This is a change in estimate.

$460,800 (0) $460,800 ÷ 8 $ 57,600

years

No entry is needed to record the change 2024 adjusting entry: Warranty expense (0.75% x $4,000,000) ............................. Warranty liability .........................................................

30,000 30,000

If the effect is material, a disclosure note should describe the effect of a change in estimate on income from continuing operations, net income, and related per share amounts for the current period.

Problem 20-13 a. This is a correction of an error.

To correct the error: Prepaid insurance ($35,000 ÷ 5 yrs. x 3 yrs.: 2024–2026) ........ Income tax payable ($21,000 x 25%) ............................... Retained earnings* ..............................................................

21,000 5,250 15,750

*($35,000 – [$35,000 ÷ 5 years x 2 years: 2022–2023]) less $5,250 tax

2024 adjusting entry: Insurance expense ($35,000 ÷ 5 years) .................................... Prepaid insurance .........................................................

7,000 7,000

The financial statements that were incorrect as a result of the error would be retrospectively restated to report the prepaid insurance acquired and reflect the correct amount of insurance expense when those statements are reported again for comparative purposes in the current annual report. A prior period adjustment to the balance of retained earnings would be reported, net of tax, and a disclosure note should describe the nature of the error and the impact of its correction on each financial statement line item and any per-share amounts affected for each prior period presented.

Problem 20-13 (continued) b. This is a change in estimate.

No entry is needed to record the change 2024 adjusting entry: Depreciation expense (determined below) ........................... Accumulated depreciation ............................................

15,000 15,000

Calculation of annual depreciation after the change: $600,000 $12,500 x 10 yrs

(125,000) $475,000 (25,000) $450,000 ÷ 30 $ 15,000

Cost Old depreciation ([$600,000 – $100,000] ÷ 40 years) Depreciation to date (2014-2023) Undepreciated cost New estimated salvage value To be depreciated Estimated remaining life (40 years – 10 years used) New annual depreciation

Problem 20-13 (continued) A disclosure note should describe the effect of a material change in estimate on income from continuing operations, net income, and related per share amounts for the current period. c. This is a correction of an error. To correct the error: Retained earnings (net effect) ................................................... Refund—income tax ($25,000 x 25%) ................................ Inventory ...............................................................................

18,750 6,250 25,000

The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct inventory amounts, cost of goods sold, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A prior period adjustment to the balance of retained earnings would be reported, net of tax, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s affected line items, net income, and earnings per share.

Problem 20-13 (continued) d. This is a change in accounting principle and is reported retrospectively. To record the change: Inventory (given)................................................................ Income tax payable ($960,000 x 25%) ............................. Retained earnings (net effect) ..............................................

960,000 240,000 720,000

Most changes in accounting principle are accounted for retrospectively. Prior years' financial statements are recast to reflect the use of the new accounting method. The company should increase the beginning balance of retained earnings to the balance it would have been if the FIFO method had been used previously; that is, by the cumulative net income difference between the LIFO and FIFO methods, net of tax. Simultaneously, inventory is increased to the balance it would have been if the FIFO method had always been used. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Companies are required to repay the taxes saved by using LIFO in prior years within six years. As a result, this liability has both current (payable within one year) and noncurrent (payable after one year) aspects but is not a deferred tax liability. e. This is a correction of an error.

To correct the error: Retained earnings (net effect).................................................... Refund—income tax ($16,400 x 25%) ................................ Compensation expense .......................................................

12,300 4,100 16,400

The 2023 financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct compensation expense, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A prior period adjustment to the balance of retained earnings would be reported, net of tax, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s affected line items, net income, and earnings per share. 1–1376 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Problem 20-13 (concluded) f. This is a change in estimate resulting from a change in accounting principle and is accounted for prospectively.

57,600 57,600

A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, Williams-Santana reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight line over the remaining useful life. Undepreciated cost, Jan. 1, 2024 (given) Estimated residual value To be depreciated over remaining 8 years Annual straight-line depreciation 2024–2031 g . This is a change in estimate.

$460,800 (0) $460,800 ÷ 8 years $ 57,600

No entry is needed to record the change. 2024 adjusting entry: Warranty expense (0.75% x $4,000,000) ............................. Warranty liability .........................................................

30,000 30,000

If the effect is material, a disclosure note should describe the effect of a change in estimate on income from continuing operations, net income, and related per share amounts for the current period.

Problem 20-14 Requirement 1 a. Inventory (understatement of 2024 beginning inventory) ................ Retained earnings (understatement of 2023 income) .................

($ in millions)

10 10

Note: The 2022 error requires no adjustment because it has self-corrected by 2024.

b. Liability—litigation (original estimate) ......................................... Gain—litigation ($7 million – $4 million).................................. Cash (actual settlement) ...............................................................

7 3 4

c. Retained earnings (2022–2023 patent amortization) ....................... Patent ([$18 million ÷ 6 yrs.] x 2)................................................

2024 adjusting entry: Amortization expense ($18 million ÷ 6 years) .......................... Patent ..............................................................................

d. No entry to record the change 2024 adjusting entry: Depreciation expense (determined below) ................................ Accumulated depreciation ................................................

4 4

Calculation of annual depreciation after the change: $30 (18) $12 (0) $12 ÷ 3 yrs. $ 4

Cost Previous depreciation (calculated below*) Undepreciated cost Estimated residual value To be depreciated Estimated remaining life New annual depreciation

*SYD: 2022 depreciation 2023 depreciation Accumulated depreciation

$10 ($30 x 5/15) 8 ($30 x 4/15) $18

Problem 20-14 (concluded) Requirement 2 Assets

2022 2022 inventory Loss contingency Patent amortization Depreciation

2023 2022 inventory 2023 inventory Loss contingency Patent amortization Depreciation

$740 (12)

Shareholders’ Net Liabilities Equity Income

$330

$410 (12)

Expenses

$210 (12)

$150 12

(3)

no adjustments to prior years

(3)

no adjustments to prior years

$725

$330

$395

$195

$165

$820

$400

$420

$230 12 10

$175 (12) (10)

(3)

$249

$156

no adjustments to prior years

(6)

no adjustments to prior years

$824

$400

$424

Problem 20-15 1a. To correct the error: Equipment (cost) .................................................................. Accumulated depreciation ([$45,000 ÷ 5] x 2 years) ............ Retained earnings ($45,000 – [$9,000 x 2 years]) ....................

45,000 18,000 27,000

2024 adjusting entry:

Depreciation expense ($45,000 ÷ 5) ..................................... Accumulated depreciation...............................................

9,000 9,000

b. To reverse erroneous entry: Cash ................................................................................... Office supplies ...............................................................

17,000

To record correct entry: Tools .................................................................................. Cash ...............................................................................

17,000

Note: These entries can, of course, be combined.

c. To correct the error: Inventory ...................................................................................... Retained earnings ...................................................................

78,000

d. To correct the error: Retained earnings ([$12 x 2,000 shares] – $2,000)..................... Paid-in capital—excess of par.........................................

22,000

78,000

22,000

Note: A ―small‖ stock dividend (< 25%) requires that the market value of the additional shares be ―capitalized.‖

Problem 20-15 (continued) e. Should have been recorded: September 1, 2023, semiannual interest payment: Interest expense (6 mo.: Mar. 1-Aug. 31) .................................

156,000

Cash ............................................................................... December 31, 2023 adjusting entry: Interest expense (4 mo.: Sept.1-Dec. 31: 4/6 x $156,000) ............

156,000 104,000

Interest payable ............................................................... March 1, 2024, semiannual interest payment: Interest expense (2 mo.: Jan. – Feb.: 2/6 x $156,000)..................

Interest payable................................................................... Cash ...............................................................................

104,000

52,000 104,000 156,000

Incorrectly recorded: September 1, 2023, semiannual interest payment: Interest expense (6 mo.: Mar. 1-Aug. 31) .................................

156,000

Cash ...............................................................................

156,000

March 1, 2024, semiannual interest payment:

Interest expense .................................................................. Cash ............................................................................... To correct the error: Retained earnings (overstatement of 2023 income) ...................... Interest expense (overstatement of 2024 interest) ..................

156,000 156,000

104,000 104,000

Problem 20-15 (concluded) Annual adjusting entry: 2024 adjusting entry: Interest expense (4 mo.: Sept.1-Dec. 31: 4/6 x $156,000) ............ Interest payable (4/6 x $156,000)........................................

104,000

f. To correct the error: Prepaid insurance ($72,000 ÷ 3 yrs. x 2 years: 2024–2025) ........ Retained earnings ($72,000 – [$72,000 ÷ 3 years]) ..............

48,000

2024 adjusting entry: Insurance expense ($72,000 ÷ 3 years) .......................................

Prepaid insurance ...........................................................

104,000

48,000 24,000 24,000

Problem 20-16 a. Fair value adjustment ($220,000 – $180,000) ....................... Gain on investments (NI) .............................................

40,000

Investment in equity securities ($220,000 – $180,000) ......... Fair value adjustment (NI) ...........................................

40,000

b. Loss on investments (NI) ................................................. Fair value adjustment (calculated below) .......................

16,000

Fair value adjustment calculation: Investment balance, December 31, 2024, as reported Error adjustment Corrected investment balance, 12/31/2024 Fair value of investments, 12/31/2024 Fair value adjustment (credit) needed, 12/31/2024

40,000 40,000 16,000

$250,000 40,000 290,000 (274,000) $ 16,000

Loss–litigation ................................................................. Liability—litigation .....................................................

130,000

d. Cost of goods sold ........................................................... Inventory .....................................................................

132,000

e. Deferred tax asset (calculated below *) ................................ Income tax payable (calculated below **) ........................... Income tax expense (to balance) .....................................

29,200 23,000

130,000 132,000

52,200

Problem 20-16 (concluded) Future deductible amounts (not included in taxable income): Lawsuit expected to be settled in 2027 (c) Loss on investments (unrealized) (b) Total future deductible amounts Tax rate effective after 2024 * Deferred tax asset

Income tax payable: Taxable income (same as pretax accounting income before temporary differences), as reported Add: Gain on investments (realized) (a) Less: Inventory overstatement (d) Taxable income, as adjusted 2024 tax rate Income tax payable, as adjusted Income tax payable, as reported) **Adjustment to income tax payable

$130,000 16,000 $146,000 x 20% $ (29,200)

$1,280,000 40,000 (132,000) $1,188,000 25% $ 297,000 (320,000) $ (23,000)

Problem 20-17 Requirement 1 If GYI had recorded the purchase correctly, depreciation would have been $100,000 per year in the financial statements for 2021, 2022, and 2023. Deductions on the tax return would have been $142,900 + $244,900 + $174,900 = $562,700 over the same three-year period. Instead, as a result of erroneously recording the 2021 expenditure as an expense, the tax deduction was $1,000,000. As a result, GYI owes income taxes for the three previous years of 25% x ($1,000,000 – $562,700) = $109,325. In addition, because using straight-line depreciation in the income statement and MACRS on the tax return creates a temporary difference, GYI needs to record a deferred tax liability for the remaining seven years. After three years, the cumulative temporary difference (and thus the future deductible amount) is $262,700 as indicated in the table below. The deferred tax liability is the tax rate times that cumulative temporary difference, $65,675:

Year

MACRS Deductions

StraightLine Depreciation

2021 2022 2023

$142,900 244,900 174,900

$100,000 100,000 100,000

Cumulative Temporary Difference Difference

Deferred Tax Liability

$ 42,900 144,900 74,900

$10,725 46,950 65,675

$ 42,900 187,800 262,700

Correcting entry: Equipment (cost) ..................................................................................1,000,000 Accumulated depreciation (S-L depr: $100,000 x 3 years)……. 300,000 Deferred tax liability (25% x cumulative temporary difference). 65,675 Income tax payable (25% x [$1,000,000 – ($142,900 + $244,900 + $174,900)]) 109,325 Retained earnings ([$1,000,000 – $300,000] less 25% x [$1,000,000 – $300,000]) 525,000

Problem 20-17 (concluded) Requirement 2 Retrospectively. The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct depreciation, assets, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A prior period adjustment to the beginning balance of retained earnings of the first period restated would be reported, net of tax, and a disclosure note should describe the nature of the error and the impact of its correction on each year‘s affected line items, net income, and earnings per share. Requirement 3 Adjusting entry: Depreciation expense…………………………………………… Accumulated depreciation……………………………………

100,000 100,000

DECISION MAKERS’ PERSPECTIVES CASES Integrating Case 20-1 1. Webster's dollar-value LIFO inventory at December 31, 2025 and 2026, is calculated as follows: Year Inventory Divided Inventory Layers at by At Base At Base TimesInventory FIFO IndexYear CostYear Cost Indexat DVL 2024

$300,000 1.00$300,000$300,000

1.00$300,000

2025

$412,500 1.25$330,000$300,000 30,000

1.00$300,000 1.25 37,500 $337,500

2026

$585,000 1.50$390,000$300,000 30,000 60,000

1.00$300,000 1.2537,500 1.50 90,000 $427,500

2. Prospectively. When a company changes to the LIFO inventory method from another inventory method, accounting records usually are insufficient to determine the cumulative income effect of the change required to apply the new method retrospectively. So, a company changing to LIFO usually applies the change prospectively. The base year inventory for all future LIFO calculations is the beginning inventory in the year the LIFO method is adopted ($300,000 in this case). Disclosure required includes a note to the financial statements describing the nature of and justification for the change as well as an explanation of why retrospective application was impracticable.

Judgment Case 20-2 Requirement 1 The impact of the change was to decrease 2024 net income by $16.5 million and to decrease earnings per share by $0.17. Because cost of goods sold would have been $22 million lower if the change had not been made, income before tax would have been $22 million higher, and net income would have been $16.5 million higher ($22 million multiplied by 75% [1 – .25]). The note will be similar to the following: Change in Inventory Method During 2024, the Company changed the method of valuing its inventories from the first-in, first-out (FIFO) method, to the last-in, first-out (LIFO) method, determined by the retail method. To estimate the effects of changing retail prices on inventories, the Company utilizes internally developed price indexes. The impact of the change was to decrease 2024 net income by $16.5 million and to decrease earnings per share by $0.17. Management has determined that retrospective application of the change is impracticable because the cumulative effect of the change on prior years was not determinable. The Company believes that the change to the LIFO method provides a more consistent matching of merchandise costs with sales revenue and also provides a more comparable basis of accounting with competitors. Requirement 2 Prospectively. It usually is impracticable to calculate the cumulative effect of a change to LIFO. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. Accounting records usually are inadequate for a company to create the appropriate LIFO inventory layers. That‘s why a change to LIFO usually can‘t be applied retrospectively.

Analysis Case 20-3 Larry apparently is referring to the fact that because the company now believes the useful lives of the assets are longer than before, the depreciation calculated assuming the shorter 16-year life was overstated. Now, by not recalculating a lower depreciation for earlier years, the undepreciated cost to be allocated to future years is less than it would have been if depreciation been based on a 20-year life all along. The result is that depreciation following the change in estimate is less than it would have been had depreciation been based on 20 years all along. In other words, depreciation was ―too high‖ before the change and ―too low‖ after the change. Larry is right if we accept his premise that depreciation was, in fact, ―too high‖ before the change. That perspective enjoys the benefit of hindsight. When the original estimate was made, 16 years was considered the appropriate useful life. The accounting profession argues that as conditions change, estimates change, and that resulting inconsistencies are unavoidable. Therefore, changes in estimates are accounted for prospectively. When a company revises a previous estimate, prior financial statements are not revised. Instead, the company merely incorporates the new estimate in any related accounting determinations from then on. The result, however, is as Larry describes: the depreciation before the change is higher and the depreciation after the change is lower than it would have been if the new estimate had been used throughout.

Analysis Case 20-4 Requirement 1 DRS's change in depreciation method for computers represents a change in estimate resulting from a change in accounting principle. This is because a change in the depreciation method is adopted to reflect a change in (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company‘s knowledge about those benefits. Accordingly, the company reports the change prospectively; previous financial statements are not recast. Instead, the company simply employs the straight-line method from then on. The undepreciated cost remaining at the time of the change would be depreciated using the straight-line method over the remaining useful life The change in residual value for the office building is a change in accounting estimate. The company reports the change prospectively; previous financial statements are not recast. Instead, the company simply employs the new residual value estimate from then on. The undepreciated cost remaining at the time of the change would be reduced by the new estimate of residual value and the resulting amount would be depreciated over the remaining useful life of the building. DRS's change in the specific subsidiaries constituting the group of companies for which consolidated financial statements are presented is a change in reporting entity. A change in reporting entity is effected and disclosed by recasting all prior-period financial statements in accordance with the method of presenting the current financial statements of the new reporting entity. In the initial set of financial statements occurring after the change, the nature of and reason for the change must be disclosed by a note to the financial statements, but subsequent financial statements need not repeat the disclosures.

Case 20-4 (concluded) Requirement 2 Applying the same accounting principles from one reporting period to another enhances the comparability of accounting information across accounting periods. The FASB‘s conceptual framework describes comparability as one of the enhancing qualitative characteristics of financial reporting information in order to provide useful information that is relevant and faithfully represented. When accounting changes occur, the usefulness of the comparative financial statements is enhanced with retrospective application of those changes, especially when assessing trends. If a change in accounting principle occurs, the nature and effect of a change should be disclosed. Disclosure is desirable because of the presumption that an accounting principle once adopted will not change.

Judgment Case 20-5 Situation I 1. A change in the depreciable lives of fixed assets is a change in accounting estimate. 2. Prospectively. The change in estimate should be applied prospectively and thus reflected in the current period and in future periods. Unlike a change in accounting principle, the change in accounting estimate should not be applied retrospectively. This change in accounting estimate will affect the balance sheet in that the accumulated depreciation in the current and future years will increase at a different rate than previously reported, and this will also be reflected in depreciation expense in the income statement in the current and future years. 3. Yes. A note should disclose the effect of a material change in accounting estimate on income from continuing operations, net income, and related per share amounts for the current period. Situation II 1. The change from reporting the investment in Allen to using a consolidated financial statement basis is a change in reporting entity. 2. Retrospectively. A change in reporting entity is effected and disclosed by recasting all prior-period financial statements in accordance with the method of presenting the current financial statements of the new reporting entity. In the initial set of financial statements occurring after the change, the nature of and reason for the change must be disclosed by note, but subsequent financial statements need not repeat the disclosures.

Case 20-5 (concluded) 3. Yes. The financial statements of the period of the change in the reporting entity should describe by note disclosure the nature of the change and the reason for it. In addition, the effect of the change in income from continuing operations, net income, and related per share amounts should be disclosed for all periods presented. Financial statements of subsequent periods need not repeat the disclosures. Situation III 1. The change in the method of computing depreciation represents a change in estimate resulting from a change in accounting principle. This is because a change in the depreciation method is adopted to reflect a change in (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company‘s knowledge about those benefits. The effect of the change in depreciation method is inseparable from the effect of the change in accounting estimate. Such changes frequently are related to the ongoing process of obtaining new information and revising estimates and, accordingly, are actually changes in estimates not unlike changing the estimated useful life of a depreciable asset. Logically, the two events should be reported the same way. Accordingly, the company reports the change prospectively; previous financial statements are not recast. Instead, the company simply employs the straight-line method from then on. The undepreciated cost remaining at the time of the change would be depreciated straight-line over the remaining useful life. 2. Prospectively. The change should be reflected in the current period and in future periods. Unlike most changes in accounting principle, the change in accounting estimate should not be applied retrospectively. This change will affect the balance sheet in that the accumulated depreciation in the current and future years will increase at a different rate than previously reported, and this will also be reflected in depreciation expense in the income statement in the current and future years. 3. Yes. Additionally, a disclosure note should justify that the change is preferable and describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported.

Analysis Case 20-6 Despite the self-correcting feature of certain inventory errors, the errors cause the financial statements of the year of the error as well as the financial statements in the subsequent year to be incorrect. For example, an overstatement of ending inventory at the end of 2023 will correct itself in 2024 and retained earnings at the end of 2024 will be correct. However, cost of goods sold and net income will be incorrect in both years. In addition, inventory and retained earnings on the 2023 balance sheet will be incorrect. If a material inventory error is discovered in an accounting period subsequent to the period in which the error is made, previous years‘ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. And, of course, any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance of retained earnings, net of tax, in the statement of shareholders‘ equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on affected line items, net income, and earnings per share.

Analysis Case 20-7 Change from cash basis to the accrual basis a. Error correction. The change from cash basis recognition for service contract revenue to the accrual basis is a change from an unacceptable accounting principle to one that is generally accepted. b. Retrospectively. Ray should restate prior periods‘ financial statements and adjust retained earnings for the effect on January 1, 2024. Ray also should disclose the nature and details of the corrections in disclosure notes. Change from accelerated depreciation for all future acquisitions. a. The change from accelerated depreciation for all future acquisitions is a change in accounting principle. b. Prospectively. There is no retrospective application because the change was made only for equipment acquired after January 1, 2024. Ray should disclose the nature and justification for the change in depreciation methods in the disclosure notes to the 2024 financial statements, along with the effect of the change on current year‘s net income. Change from LIFO to FIFO a. Change in accounting principle. Ray‘s change from LIFO to FIFO is a change in accounting principle b. Retrospectively. This is a change for which Ray should recast prior periods‘ financial statements to appear as if FIFO had been used all along. It also should state the nature and justification for the change in inventory method along with the effects of the change presented on financial statement components for all periods presented.

Communication Case 20-8 For changes not involving LIFO or changes from the LIFO method to another, the event is accounted for as a normal change in accounting principle. In general, we report voluntary changes in accounting principles retrospectively. This means revising all previous period‘s financial statements presented as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. More specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we make an adjustment to the beginning balance of retained earnings, net of tax, for the earliest period reported in the comparative statements of shareholders‘ equity (or statements of retained earnings if they‘re presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change. The advantage of retrospective application is to enhance comparability of the statements from year to year. The recast statements appear as if the newly adopted accounting method had been applied in all previous years. Consistency and comparability suggest that accounting choices once made should be consistently followed from year to year. So, any change requires that the new method be justified as clearly more appropriate. In the first set of financial statements after the change, a disclosure note is needed to provide that justification. The footnote also should point out that comparative information has been revised and report any per share amounts affected for the current period and all prior periods presented. When a company changes to the LIFO inventory method from any other method, it usually is impracticable to calculate the cumulative effect of the change. Revising balances in prior years would require knowing what those balances should be. LIFO inventory, though, consists of ―layers‖ added in prior years at costs existing in those years. If another method has been used, the company probably hasn‘t kept a record of those costs. Accordingly, accounting records of prior years usually are inadequate to report the change retrospectively. Because of this difficulty, a company changing to LIFO usually does not report the change retrospectively. Instead, the base year inventory for all future LIFO calculations is the beginning inventory in the year the LIFO method is adopted. Then, the LIFO method is applied prospectively from that point on. The disclosure note must include an explanation as to why retrospective application was impracticable.

Communication Case 20-9 Suggested Grading Concepts and Grading Scheme: Content (80%) 20 Identifies the situation as a change in estimate. The liability was originally (appropriately) estimated as $750,000. The final settlement indicates the estimate should be revised. 40

Indicates that additional disclosure is necessary. Bonus (4) Provides detail regarding the disclosure note. A disclosure note should describe the effect of a change in estimate on key items. The effect on income from continuing operations, net income, and related per share amounts for the current period should be indicated. 80-84 points Writing (20%) 5 Terminology and tone appropriate to the audience of a Vice President. 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English. Word selection. Spelling. Grammar. 20 points

Ethics Case 20-10 Discussion should include these elements. How would the suggested actions contribute toward ―softening‖ the bad news? The choice of inventory method will affect earnings. FIFO will increase reported net income in a period of rising prices. However, FIFO also will cause an increase in taxes paid. Less obvious would be a change in LIFO pools. By drastically increasing the number of LIFO pools, the company may be able to cause some LIFO liquidations. If so, cost of goods sold would be forced to include much older, lower costs, thereby increasing net income. Changing estimates on depreciable lives, salvage values, pension assumptions, and others also can influence reported profits. Academic research performed in this area would indicate that accounting changes that merely increase reported earnings without any real economic (or cash flow) effect will not produce the desired effect of increasing share price. Most research suggests that the stock market ―sees through‖ purely cosmetic accounting changes. Quite a bit of evidence, though, at least anecdotal evidence, indicates that managers attempt to fool the market. Some efforts to manage earnings may not be an attempt to affect share prices, but to avoid violating terms of contracts based on earnings or related balance sheet items. Some may be to favorably affect terms of compensation agreements.

Case 20-10 (concluded) Ethical Dilemma: Is the auditor‘s obligation to challenge the Questionable change in methods greater than the obligation to the financial interests of the CPA firm and its client? Who is affected? You, the auditor Managers CPA firm (lost fees? reputation? legal action?) Shareholders Potential shareholders The employees The creditors Company managers, particularly the president, stand to benefit from the suggested actions. The auditor risks negative consequences if the changes occur and are challenged.

Ethics Case 20-11 Requirement 1 Bonuses will be negatively affected because if the error is corrected, a lower ending inventory results in higher cost of goods sold and lower pre-tax income. The effect of the error would be an overstatement of income by $665,000 ($3,265,000 – $2,600,000). Requirement 2 The error will be reported as a prior period adjustment to the beginning retained earnings balance, net of tax, for the year beginning July 1, 2024. Financial statements for the year ending June 30, 2024, will be restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings. Requirement 3 Ethical Dilemma: Should John recognize his obligation to disclose the inventory error to Danville shareholders, the local bank, auditors, and taxing authorities or remain quiet, enabling him and other company employees to receive originally computed year-end bonuses?

Target Case Requirement 1 Target reports its inventory under the retail inventory accounting method (RIM) using the last-in, first-out (LIFO) method. Inventory is stated at the lower of LIFO cost or market: 8. Inventory The vast majority of our inventory is accounted for under the retail inventory accounting method (RIM) using the last-in, first-out (LIFO) method. Inventory is stated at the lower of LIFO cost or market. Inventory cost includes the amount we pay to our suppliers to acquire inventory, freight costs incurred to deliver product to our distribution centers and stores, and import costs, reduced by vendor income and cash discounts. Distribution center operating costs, including compensation and benefits, are expensed in the period incurred. Inventory is also reduced for estimated losses related to shrink and markdowns. The LIFO provision is calculated based on inventory levels, markup rates, and internally measured retail price indices. Under RIM, inventory cost and the resulting gross margins are calculated by applying a cost-to-retail ratio to the inventory retail value. RIM is an averaging method that has been widely used in the retail industry due to its practicality. The use of RIM will result in inventory being valued at the lower of cost or market because permanent markdowns are taken as a reduction of the retail value of inventory.

Requirement 2 Retrospective approach. We report most voluntary changes in accounting principles retrospectively. This means Target would (1) revise all previous period‘s financial statements presented as if the new method always had been used. Target would (2) revise cost of goods sold as well as any other income statement amounts affected by that revision, including income taxes and net income. Since the change would affect net income, retained earnings also changes. Target would reflect the cumulative prior year difference in cost of goods sold (after tax) as a difference in prior years‘ net income and therefore in the balance in retained earnings. It also revises inventory in the balance sheet.

Target Case (concluded) Requirement 3 Prospective approach. It‘s not practicable to report some changes in principle retrospectively because insufficient information is available. Revising balances in prior years means knowing what those balances should be. One example is switching from the FIFO method of inventory costing to the LIFO method. Recall that LIFO inventory consists of ―layers‖ added in prior years at costs existing in those years. So, if FIFO has been used, Target probably hasn‘t kept track of those costs. Accounting records of prior years probably are inadequate to report the change retrospectively, so Target would report the change prospectively. The beginning inventory in the year the LIFO method is adopted would become the base year inventory for all future LIFO calculations.

Air France/KLM Case Requirement 1 The first of the two changes in Note 2 describes a change in principle. (Actually, both changes reported are changes in accounting principle.) In the first change described in Note 2: Restatement of Accounts 2018, Air France followed the retrospective approach, which is required for most changes in accounting principle. The change did not affect net income, but instead the way compensation to customers for delayed or cancelled flight is reported within the income statement, which was restated retrospectively. Requirement 2 Yes. This the same approach AF would follow if using U.S. GAAP. In fact, U.S. GAAP and International standards are largely converged with respect to accounting changes and error corrections. One remaining difference is that when correcting errors in previously issued financial statements, IFRS permits the effect of the error to be reported in the current period if it‘s not considered practicable to report it retrospectively as is required by U.S. GAAP.

Chapter 21 The Statement of Cash Flows Revisited

Questions for Review of Key Topics

Question 21–1 Every cash flow eventually affects the balance of one or more accounts in the balance sheet, and the cash flows related to income-producing activities also are represented in the income statement. The activities, though, are not necessarily reported in the balance sheet and income statement in the period the cash flows occur. This is because the income statement measures activities on an accrual basis rather than a cash basis. The statement of cash flows fills the information gap by reporting the cash flows directly and in the period the cash flows occur.

Question 21–2 The informational value of the presentation is enhanced if the cash flows are classified according to the nature of the activities that create the cash flows. The three primary classifications of cash flows are (1) cash flows from operating activities, (2) cash flows from investing activities, and (3) cash flows from financing activities. Categorizing each cash flow by source (operating, investing, or financing activities) is more informative than simply listing the various cash flows.

Question 21– 1408 No, an investment in Treasury bills need not always be classified as a cash equivalent. A guideline—not a rule—for cash equivalents is that these investments must have a maturity date not longer than three months from the date of purchase. However, flexibility is permitted, and each company must establish a policy regarding which short-term, highly liquid investments it classifies as cash equivalents. The designation must be consistent with the company's customary motivation for acquiring various investments and the policy should be described in disclosure notes.

Question 21– 1410 Transactions that involve merely transfers from cash to cash equivalents such as the purchase of a three-month Treasury bill, or from cash equivalents to cash such as the sale of a Treasury bill, should not be reported on the statement of cash flows. A dollar amount is simply transferred from one ―cash‖ account to another ―cash‖ account so that the total of cash and cash equivalents is not altered by such transactions. An exception is the sale of a cash equivalent at a gain or loss. In this case, the total of cash and cash equivalents actually increases or decreases. The increase or decrease is reported as a cash flow from operating activities.

Question 21–5 "Cash flows from operating activities" are both inflows and outflows of cash that result from the same activities that are reported on the income statement. However, the income statement reports the activities on an accrual basis (revenues earned during the reporting period, regardless of when cash is received, and the expenses incurred in generating those revenues, regardless of when cash is paid). Cash flows from operating activities, on the other hand, report those activities when the cash is exchanged (on a cash basis).

Question 21– 1412 The generalization that "cash flows from operating activities" report all the elements of the income statement on a cash basis is not strictly true for all elements of the income statement. No cash effects are reported for depreciation and amortization of assets, or for gains and losses from the sale of those assets. Cash outflows occur when assets are acquired, and cash inflows occur when the assets are sold. However, the acquisition and subsequent resale of noncurrent assets are classified as investing activities, rather than as operating activities.

Question 21–7 "Cash flows from investing activities" are both outflows and inflows of cash due to the acquisition and disposition of assets. This classification includes cash payments to acquire (1) property, plant, and equipment and other productive assets; (2) investments in securities; and (3) nontrade receivables. When these assets later are liquidated, any cash receipts from their disposition also are classified as investing activities. The four specific examples can come from any combination of these categories. Two exceptions are inventories and cash equivalents. The purchase and sale of inventories are not considered investing activities because inventories are purchased for the purpose of being sold as part of the company's primary operations and are classified as operating activities. The purchase and sale of assets classified as cash equivalents are not reported on the statement of cash flows unless the total of cash and cash equivalents changes from the sale of a cash equivalent at a gain or loss.

Question 21–8 The payment of cash dividends to shareholders is classified as a financing activity, but paying interest to creditors is classified as an operating activity. This is because "cash flows from operating activities" should reflect the cash effects of items that enter into the determination of net income. Interest expense is a determinant of net income. A dividend, on the other hand, is a distribution of net income and not an expense.

Question 21–9 A statement of cash flows reports transactions that cause an increase or a decrease in cash. However, some transactions that don‘t increase or decrease cash, but which result in significant investing and financing activities, must be reported in related disclosures. Entering a significant investing activity and a significant financing activity as two parts of a single transaction does not limit the value of reporting these activities. Examples of noncash transactions that would be reported: 1. Acquiring an asset by incurring a debt payable to the seller. 2. Acquiring an asset by entering into a lease agreement. 3. Converting debt into common stock or other equity securities. 4. Exchanging noncash assets or liabilities for other noncash assets or liabilities.

Question 21–10 The acquisition of a building purchased by issuing a mortgage note payable in addition to a cash down payment is an example of a transaction involving a significant investing and financing activity that is part cash and part noncash. The cash portion would be reported under the caption "cash flows from investing activities," and the noncash portion of the transaction would be reported as a "noncash investing and financing activity."

Question 21– 1419 Perhaps the most noteworthy item reported on an income statement is net income—the amount by which revenues exceed expenses. The most noteworthy item reported on a statement of cash flows is not the amount of net cash flows. In fact, this may be the least important number on the statement. The increase or decrease in cash can be seen easily on comparative balance sheets. The purpose of the statement of cash flows is not to report that cash increased or decreased by a certain amount, but why cash increased or decreased by that amount. The individual cash inflows and outflows provide that information.

Question 21– 1421 The spreadsheet entries shown in the two "changes" columns, which separate the beginning and ending balances, explain the increase or decrease in each account balance. Spreadsheet entries duplicate the actual journal entries used to record the transactions as they occurred during the year. Recording spreadsheet entries simultaneously identifies and classifies the activities to be reported on the statement of cash flows because in order for cash to increase or decrease, there must be a corresponding change in a noncash account. Thus, if we can identify the events and transactions that caused the change in each noncash account during the period, we will have identified all the operating, investing, and financing activities.

Question 21–13 If sales revenue is $200,000, this does not necessarily mean that $200,000 cash was received from customers. Amounts reported on the income statement usually do not represent the cash effects of the items reported. By referring to the beginning and ending balances in accounts receivable, we see whether cash received from customers was more or less than $200,000. If accounts receivable increased during the year, some of the sales revenue earned must not yet have been collected. On the other hand, if accounts receivable decreased during the year, more must have been collected than the sales revenue earned.

Question 21– 1423 When an asset is sold at a gain, the gain is not reported as a cash inflow from operating activities. A gain (or loss) is simply the difference between cash received in the sale of an asset and the book value of the asset—not a cash flow. The cash effect of the sale is reported as an investing activity. To report the gain as a cash flow from operating activities, in addition to reporting the entire cash flow from investing activities, would be to report the gain twice.

Question 21– 1425 When determining the amount of cash paid for income taxes, an increase in the deferred income tax liability account would indicate that less cash had been paid than the income tax expense reported. The difference represents the portion of the income tax expense whose payment is deferred to a later year. Notice that precisely the same analysis would apply for an increase in current income tax payable.

Question 21–16 When using the indirect method of determining net cash flows from operating activities, the net cash increase or decrease from operating activities is derived indirectly by starting with reported net income and "working backwards" to convert that amount to a cash basis. Amounts that were subtracted in determining net income, but which did not reduce cash, are added back to net income to reverse the effect of the amounts having been subtracted. Depreciation expense is one example. Depreciation expense is an allocation of previous cash expenditures, but does not reduce cash currently. Other examples of noncash reductions of net income that must be added back are amortization of other intangibles, depletion, and a loss on the sale of assets.

Question 21– 1427 When using the indirect method of determining net cash flows from operating activities, when components of net income increase or decrease cash, but by an amount different from that reported on the income statement, net income is adjusted for changes in the balances of related balance sheet accounts to convert the effects of those items to a cash basis. For components of net income that increase or decrease cash by an amount exactly the same as that reported on the income statement, no adjustment of net income is required.

Question 21– 1429 Either the direct method or the indirect method is permitted, but the FASB strongly encourages companies to report "cash flows from operating activities" by the direct method. The direct method reports specific operating cash receipts and operating cash payments, consistent with the primary objective of the statement of cash flows. This allows investors and creditors to gain additional insight into the specific sources of cash receipts and payments from operating activities. Users also can more easily interpret and understand the information presented because the direct method avoids the confusion caused by reporting noncash items and other reconciling adjustments under the caption "cash flows from operating activities.‖

Question 21– 1430 The direct and indirect methods are alternative approaches to deriving net cash flows from operating activities only. Regardless of which method is used for that purpose, the way cash flows from investing and financing activities are presented is precisely the same.

Question 21– 1431 We can find authoritative guidance for the statement of cash flows under IFRS in ―Cash Flow Statements,‖ International Accounting Standard No. 7, IASB.

Question 21– 1432 U.S. GAAP designates cash outflows for interest payments and cash inflows from interest and dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows. IFRS permits more flexibility. Companies can report interest and dividends paid as either operating or financing cash flows and interest and dividends received as either operating or investing cash flows. Interest and dividend payments typically are reported as financing activities. Interest and dividends received usually are classified as investing activities.

BRIEF EXERCISES Brief Exercise 21–1 Summary Entry Cash (received from customers)…………… Accounts receivable……………………. Sales revenue……………………………

($ in millions)

38 5 33

Brief Exercise 21–2 Summary Entry Cash (received from customers)….………. Accounts receivable………………………. Sales revenue…………………………..

($ in millions)

40 4 44

Brief Exercise 21–3 Summary Entry Cost of goods sold……………………….. Inventory………………………………… Accounts payable……………………. Cash (paid to suppliers of goods)…….

($ in millions)

25 6 5 26

Brief Exercise 21–4 Summary Entry

($ in millions)

Salaries expense…………….………. Salaries payable…………………. Cash (paid to employees)………..

17 3 14

Brief Exercise 21–5 ($ in millions)

Interest expense (10% x 1/2 x $380)……………… 19 Discount on bonds payable………………… Cash (paid to bondholders) (9% x 1/2 x $400)..

1 18

Agee would report the cash inflow of $380 million from the sale of the bonds as a cash inflow from financing activities in its statement of cash flows. The $18 million cash interest paid is a cash outflow from operating activities because interest is an income statement (operating) item.

Brief Exercise 21–6 ($ in millions)

Interest expense (10% x 1/2 x $380) ..........................19 Discount on bonds payable…………………. Cash (paid to bondholders) (9% x 1/2 x $400)…

1 18

Agee would report the cash inflow of $380 million from the sale of the bonds as a cash inflow from financing activities in its statement of cash flows. The $1 million amortization of the discount would be added back to net income because the interest expense ($19 million) was subtracted in calculating net income and yet the cash interest paid was only $18 million.

Brief Exercise 21–7 Merit would report the cash inflow of $41 million from the borrowing as a cash inflow from financing activities in its statement of cash flows. Each installment payment includes both an amount that represents interest and an amount that represents a reduction of principal. In its statement of cash flows, then, Merit reports the interest portion ($2,870,000 *) as a cash outflow from operating activities and the principal portion ($7,130,000*) as a cash outflow from financing activities.

*December 31, 2024 Interest expense (7% x outstanding balance)... Notes payable (difference) ......................... Cash (given).........................................

2,870,000 7,130,000 10,000,000

Brief Exercise 21–8 ($ in millions)

Cash ....................................................... Gain on sale of land (difference) ........... Land (cost) ..........................................

35 13 22

Morgan would report the cash inflow of $35 million from the sale as a cash inflow from investing activities in its statement of cash flows. The $13 million gain is not a cash flow and would not be reported when using the direct method. For that reason, when using the indirect method, the gain would be subtracted from net income (which includes the gain) to avoid double-counting it.

Brief Exercise 21–9 Cash Flows from Investing Activities: Proceeds from sale of marketable securities Proceeds from sale of land Purchase of equipment for cash Purchase of patent Net cash inflows from investing activities

$30 15 (25) (12) $8

Brief Exercise 21–10 Cash Flows from Financing Activities: Sale of common shares Purchase of treasury stock Net cash inflows from financing activities

$40 (21) $19

Brief Exercise 21–11 Net income $90 Adjustments for noncash effects: Depreciation expense Loss on sale of equipment Increase in accounts receivable Increase in accounts payable Increase in inventory Net cash flows from operating activities

3 2 (1) 4 (3) $95

Brief Exercise 21–12 Net income $60 Adjustments for noncash effects: Amortization expense Gain on sale of land Decrease in accounts receivable Decrease in accounts payable Decrease in inventory Net cash flows from operating activities

2 (1) 2 (5) 4 $62

EXERCISES

Exercise 21– Example F 1441

Sale of common stock

Sale of land

Purchase of treasury stock

Merchandise sales

Issuance of a long-term note payable

Purchase of merchandise

Repayment of a note payable

Employee salaries

Sale of equipment at a gain

10. Issuance of bonds

11. Acquisition of bonds of another corporation

12. Payment of semiannual interest on bonds payable

13. Payment of a cash dividend

14. Purchase of building

15. Collection of nontrade note receivable (principal amount)

16. Loan to another company

17. Retirement of common stock

18. Income taxes

19. Issuance of a short-term note payable

20. Sale of a copyright

Exercise 21– 1442 Requirement 1 ($ in millions)

Inventory Beginning balance 90 Goods purchased 303 Ending balance

300 Cost of goods sold

Accounts Payable

Cash paid

301

14 303

Beginning balance Goods purchased

Ending balance

Requirement 2 Summary Entry Cost of goods sold………………………… Inventory………………………………….. Accounts payable……………….……… Cash (paid to suppliers of goods)………

($ in millions)

300 3 2 301

Exercise 21– 1443 ($ in millions) Situation

Sales revenue

Accounts receivable

Cash received from customers

increase (decrease)

100

1. Summary Entry

100

2. Summary Entry

100

3. Summary Entry

-0-

100

Cash (received from customers)….. Sales revenue…………………..

100

Cash (received from customers)… Accounts receivable….……..…… Sales revenue…………………

(5)

100

95 5 100

105

Cash (received from customers).… Accounts receivable…………. Sales revenue…………………

105 5 100

Exercise 21– 1444 Sales Situation revenue

Accounts receivable

Cash received from customers

increase (decrease)

200

1. Summary Entry

200

2. Summary Entry

200

3. Summary Entry

-0-

200

Cash (received from customers)….. Sales revenue…………………..

200

190

Cash (received from customers)….. Accounts receivable………………. Sales revenue…………………..

(10)

200

190 10 200

210

Cash (received from customers)… Accounts receivable…………. Sales revenue…………………

210 10 200

Exercise 21– 1445 Cost of Situation

goods sold

Inventory increase (decrease)

Accounts payable increase (decrease)

Cash paid to suppliers

100

Cost of goods sold…………………… Cash (paid to suppliers of goods)....

1. Summary Entry

100

5. Summary Entry

100

100 3 103 97 100 3 97

Cost of goods sold……………….…… Accounts payable……………….… Cash (paid to suppliers of goods) …

4. Summary Entry

103

Cost of goods sold……………….…… Inventory……………….…….…… Cash (paid to suppliers of goods) …

3. Summary Entry

(3)

100

Cost of goods sold……………….…… Inventory……………………………… Cash (paid to suppliers of goods) …

2. Summary Entry

100

93 100 7 93

(7)

Cost of goods sold……………….…… Accounts payable………….……….…

107 100 7

Cash (paid to suppliers of goods)…

107

Exercise 21–5 (concluded) Situation

Cost of goods sold

100

9. Summary Entry

(3)

100

(3)

100 3 7 96

(7)

110 100 3 7 110

(7)

Cost of goods sold………….…….… Accounts payable………..……….… Inventory……………..……….… Cash (paid to suppliers of goods)..

8. Summary Entry

Cash paid to suppliers

Cost of goods sold……….………..… Inventory………………………….… Accounts payable…………..……..… Cash (paid to suppliers of goods)..

7. Summary Entry

Accounts payable increase (decrease)

Cost of goods sold……………….… Inventory……………………..….… Accounts payable………….…… Cash (paid to suppliers of goods).

6. Summary Entry

Inventory increase (decrease)

104 100 7 3 104

Cost of goods sold…………..……..… Inventory……………………….… Accounts payable……………….…

90 100 3 7

Cash (paid to suppliers of goods)…

Exercise 21–6 Situation

Cost of goods sold

200

5. Summary Entry

200

(6)

200 200

206 200 6 206

186 200 14 186

Cost of goods sold…….……….….… Inventory…….………………...….… Accounts payable…………...….… Cash (paid to suppliers of goods)...

4. Summary Entry

Cost of goods sold…….……….….… Accounts payable.. ….………...… Cash (paid to suppliers of goods)...

3. Summary Entry

Cash paid to suppliers

Cost of goods sold…….……….….… Inventory…….………………...….… Cash (paid to suppliers of goods)...

2. Summary Entry

Accounts payable increase (decrease)

Cost of goods sold…….……….….… Cash (paid to suppliers of goods)..

1. Summary Entry

Inventory increase (decrease)

192 200 6 14 192

(14)

Cost of goods sold…….……….….… Accounts payable.……………...….… Inventory…….……………...….…

208 200 14 6

Cash (paid to suppliers of goods)...

208

Exercise 21–7 Situation

Interest expense

Interest payable increase (decrease)

Unamortized discount increase (decrease)

Cash paid for interest

Interest expense.……………...….… Cash (paid to bondholders)……..

1. Summary Entry

4. Summary Entry

8 10 2 8

Interest expense.……………...….… Interest payable………..……...….… Cash (paid to bondholders) ……..

3. Summary Entry

(2)

Interest expense.……………...….… Interest payable…………...….… Cash (paid to bondholders) ……..

2. Summary Entry

12 10 2 12

(3)

Interest expense.……………...….… Discount on bonds payable.….… Cash (paid to bondholders) ……..

7 10 3 7

Exercise 21–7 (concluded)

Situation

Interest expense

Interest payable increase (decrease)

Unamortized discount increase (decrease)

Cash paid for interest

(3)

Interest expense.……………...….… Interest payable…………...….… Discount on bonds payable..…… Cash (paid to bondholders) ……..

5. Summary Entry

6 6. Summary Entry

(2)

10 2 3 5

(3)

Interest expense.……………...….… Interest payable.……………...….… Discount on bonds payable.….… Cash (paid to bondholders)……..

9 10 2 3 9

Exercise 21–8 Situation

Interest expense

Interest payable increase (decrease)

Unamortized discount increase (decrease)

Cash paid for interest

Interest expense.……………...….… Cash (paid to bondholders)…..…

1. Summary Entry

4. Summary Entry

(4)

16 20 4 16

(6)

Interest expense.……………...….… Discount on bonds payable.….… Cash (paid to bondholders)…..…

3. Summary Entry

Interest expense.……………...….… Interest payable…………...….… Cash (paid to bondholders) ….…

2. Summary Entry

14 20 6 14

(6)

Interest expense.……………...….… Interest payable.……………...….… Discount on bonds payable.….… Cash (paid to bondholders) ….…

18 20 4 6 18

Exercise 21–9 Situation

Income tax expense

5. Summary Entry

(3)

Cash paid for taxes

10 10 10

7 10 3 7

13 10 3 13

Income tax expense.……………...….… Deferred income tax liability...….… Cash (paid for income taxes)....….…

4. Summary Entry

Income tax expense.……………...….… Income tax payable.……………...….… Cash (paid for income taxes)....….…

3. Summary Entry

Income tax expense.……………...….… Income tax payable…………...….… Cash (paid for income taxes) ...….…

2. Summary Entry

Deferred tax liability increase (decrease)

Income tax expense.……………...….… Cash (paid for income taxes) ...….…

1. Summary Entry

Income tax payable increase (decrease)

8 10 2 8

(2)

Income tax expense.……………...….… Deferred income tax liability.........….…

12 10 2

Cash (paid for income taxes) ...….…

Exercise 21–9 (concluded)

Situation

Income tax expense

9. Summary Entry

(3)

10 3 2 5

(2)

9 10 2 3 9

(2)

Income tax expense.……………...….… Income tax payable.……………...….… Deferred income tax liability…….….… Cash (paid for income taxes) ...….…

8. Summary Entry

Cash paid for taxes

Income tax expense.……………...….… Deferred income tax liability….....….… Income tax payable…………...….… Cash (paid for income taxes) ...….…

7. Summary Entry

Deferred tax liability increase (decrease)

Income tax expense.……………...….… Income tax payable…………...….… Deferred income tax liability…….… Cash (paid for income taxes)…….…

6. Summary Entry

Income tax payable increase (decrease)

15 10 3 2 15

Income tax expense.……………...….… Income tax payable.……………...….… Deferred income tax liability…….… Cash (paid for income taxes) ...….…

11 10 3 2 11

Exercise 21–10

Situation

Income tax expense

5. Summary Entry

(3)

10 10

7 10 3 7

(2)

12 10 2 12

Income tax expense.……………...….… Income tax payable…………...….… Deferred income tax liability...….… Cash (paid for income taxes).........…

4. Summary Entry

Income tax expense.……………...….… Deferred income tax liability...…..……. Cash (paid for income taxes) .........…

3. Summary Entry

Cash paid for taxes

Income tax expense.……………...….… Income tax payable…………...….… Cash (paid for income taxes).........…

2. Summary Entry

Deferred tax liability increase (decrease)

Income tax expense.……………...….… Cash (paid for income taxes).........…

1. Summary Entry

Income tax payable increase (decrease)

5 10 3 2 5

(2)

Income tax expense.……………...….… Income tax payable……………....….… Deferred income tax liability….....….…

15 10 3 2

Cash (paid for income taxes).........…

Exercise 21–11 Most would report the cash inflow of $566,589,440 from the sale of the bonds as a cash inflow from financing activities in its statement of cash flows. *

The $64,000,000 cash interest paid ($32,000,000 + $32,000,000 ) is a cash outflow from operating activities because interest is an income statement (operating) item. If the direct method is used, interest paid is reported in the operating activities section. If the indirect method is used, interest paid must be separately disclosed. Therefore, interest paid is specifically reported regardless of which method is used for the operating activities section. June 30, 2024* Interest expense (6% x $566,589,440) .................. Discount on bonds payable (difference)......... Cash (5% x $640,000,000) .............................. December 31, 2024** Interest expense (6% x [$566,589,440 + $1,995,366]) Discount on bonds payable (difference)......... Cash (5% x $640,000,000) ..............................

33,995,366 1,995,366 32,000,000 34,115,088 2,115,088 32,000,000

Exercise 21– 1462 National would report the cash inflow of $4 million from the borrowing as a cash inflow from financing activities in its statement of cash flows. Each installment payment includes both an amount that represents interest and an amount that represents a reduction of principal. In its statement of cash flows, then, National reports the interest portion ($400,000*) as a cash outflow from operating activities and the principal portion ($861,881*) as a cash outflow from financing activities.

*December 31, 2024 Interest expense (10% x outstanding balance). Notes payable (difference) ........................ .. Cash (given)…..................................... ..

400,000 861,881 1,261,881

Exercise 21– 1463 Requirement 1 Cash Flows from Investing Activities: Proceeds from sale of land

$ 12

Purchase of investment

(160)

Net cash outflows from investing activities

$(148)

Requirement 2 Cash Flows from Financing Activities: Repayment of bonds

$(102)

Proceeds from the sale of treasury stock

Distribution of dividends

(40)

Net cash outflows from financing activities

$(120)

Exercise 21– 1464 Requirement 1 Cash Flows from Investing Activities: Proceeds from sale of equipment

Acquisition of building for cash

(7)

Purchase of marketable securities

(5)

Collection of note receivable

Net cash inflows from investing activities

Requirement 2 Cash Flows from Financing Activities: Repayment of long-term notes

$ (54)

Sale of common shares

176

Retirement of common shares

(122)

Issuance of short-term note payable for cash

Distribution of cash dividends

(30)

Net cash outflows from financing activities

$ (20)

Exercise 21– 1465 Neri would report the $3,000,000* investment in the commercial food processor and its financing with a finance lease as a significant noncash investing and financing activity in the disclosure notes to the financial statements. *

The $391,548 ($195,774 + $195,774 ) cash lease payments are divided into the interest portion and the principal portion. The interest portion, $84,127, is reported as cash outflows from operating activities. The principal portion, $195,774 + $111,647, is reported as cash outflows from financing activities. Note: By the indirect method of reporting cash flows from operating activities, Neri would add back to net income the $150,000 depreciation expense since depreciation didn‘t actually reduce cash. The $84,127 interest expense that reduced net income actually did reduce cash [the interest portion of the $391,548 ($195,774 x 2) cash lease payments], so for interest, no adjustment to net income is necessary.

Exercise 21–15 (concluded) Calculations: September 30, 2024* Right-of-use asset (calculated below)..................... Lease payable (calculated below)....................... Lease payable ................................................... Cash (rental payment)......................................

3,000,000 3,000,000 195,774 195,774

Note: $195,774 x 15.3238t = $3,000,000 t

Present value of an annuity due of $1: n = 20, i = 3% (from Table 6)

December 31, 2024** Interest expense (3% x [$3,000,000 – $195,774])........ Lease payable (difference) ...................................... Cash (lease payment)......................................... Amortization expense ($3,000,000  5 years x ¼ year). Right-of-use asset ..........................................

84,127 111,647 195,774 150,000 150,000

Exercise 21–16 Investing Activities: Clor-Proell would report the $600 million investment as a cash outflow among investing activities in its statement of cash flows. Operating Activities: By the direct method of reporting cash flows from operating activities, Clor-Proell would report the $12 million cash dividend as a cash inflow from operating activities. By the indirect method of reporting cash flows from operating activities, Clor-Proell would subtract from net income the $60 million investment revenue since it didn‘t actually provide cash but would add the $12 million cash dividend. Alternatively, the company might just subtract the $48 million difference.

Exercise 21–17 RECONCILIATION OF NET INCOME TO NET CASH FLOWS FROM OPERATING ACTIVITIES Net income $50,000 Adjustments for noncash effects: Depreciation expense

7,000

Amortization of patent

500

Changes in operating assets and liabilities: Increase in inventory

(1,500)

Decrease in salaries payable

(800)

Decrease in accounts receivable

2,000

Decrease in bond premium

(1,000)

Increase in accounts payable

4,000

Net cash flows from operating activities$60,200

Exercise 21– 1469 Net income closed to retained earnings Net income ............................................................................................. Retained earnings (given) ...............................................

($ in millions)

75 75

The operating activities summarized by this transaction are identified individually when we explain the changes in the components of net income. But including the entry on the spreadsheet is helpful in partially explaining the change in retained earnings. Cash dividend Retained earnings (given)................................................... Cash .......................................................................................................

25 25

This transaction identifies a $25 million cash outflow from financing activities.

Stock dividend Retained earnings (given)................................................... Common stock (1 million shares at $1 par per share) .................. Paid-in capital—excess of par (remainder) .......................

16 1 15

This transaction does not represent a significant investing or financing activity, but including the entry on the spreadsheet is helpful in partially explaining changes in the balances of the three accounts affected.

Exercise 21–18 (concluded) Property dividend Retained earnings (given)................................................... Short-term investments................................................................

12 12

This transaction identifies a $12 million financing activity (distribution of a property dividend to shareholders) which is a noncash transaction. The transaction also identifies that an investment asset has been distributed and must have been removed from the accounting records. This is a $12 million investing activity (disposition of an investment). It is not known whether there was a gain or loss on the investment prior to its distribution, so with no other information provided, we simply credit short-term investments. The transaction comprises a significant noncash investing and financing activity which is disclosed either on the face of the statement of cash flows beneath the statement, or in disclosure notes.

Sale of treasury shares Cash (difference)* ............................................................. Retained earnings (given) ................................................. Treasury stock (at cost, given) ........................................

43 10 53

*This transaction identifies a $43 million cash inflow from financing activities.

Exercise 21–19 Income Statement Sales Cost of goods sold Salaries expense Depreciation expense Insurance expense Loss on sale of land Income tax expense Net Income

a Summary Entry

b Summary Entry

c Summary Entry

d Summary Entry

e Summary Entry

$600a $360b 78c 18f 42d 12f 54e

(564) $ 36

Cash (received from customers)…... Accounts receivable……….…… Sales revenue…………….……..

612

Cost of goods sold………….……… Inventory…………………….…….. Accounts payable……………….…. Cash (paid to suppliers of goods).

360 24 36

Salaries expense……………………. Salaries payable………………… Cash (paid to employees)……….

Insurance expense…………………. Prepaid insurance………………. Cash (paid for insurance)……….

Income tax expense…………….….. Income tax payable…………….. Cash (paid for income taxes)……

12 600

420

12 66

18 24

12 42

f Depreciation expense and the loss on sale of land are noncash reductions in income.

Exercise 21–20 RECONCILIATION OF NET INCOME TO NET CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments for noncash effects:

$ 26

Depreciation expense

Depletion expense

Gain on sale of equipment Loss on sale of land

(25) 8

Changes in operating assets and liabilities: Increase in accounts receivable

(54)

Increase (decrease) in inventory

Increase in accounts payable

Increase in salaries payable

Decrease in prepaid insurance

Increase in interest payable

Increase in income tax payable

Net cash flows from operating activities

$ 7

Exercise 21–21 Requirement 1: a. Summary Entry

b. Summary Entry

c. Summary Entry

d. Summary Entry

e. Summary Entry

Cash (received from customers)…….. Accounts receivable……………… Sales revenue……………………...

311

Cost of goods sold…………………… Inventory…………………………….. Accounts payable……………………. Cash (paid to suppliers of goods)…

185 13 8

Salaries expense…………………….. Salaries payable…………………. Cash (paid to employees)………..

Insurance expense………………….. Prepaid insurance……………….. Cash (paid for insurance)………..

Income tax expense……………..…. Income tax payable…………….. Cash (paid for income taxes)……

6 305

206

5 36

9 10

20 2

Depreciation expense and the loss on sale of land are not cash outflows. Requirement 2: Cash Flows from Operating Activities: Cash received from customers $311 Cash paid to suppliers (206) Cash paid to employees (36) Cash paid for insurance (10) Cash paid for income taxes (2) 1–1474 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Net cash flows from operating activities

$ 57

Exercise 21–22 RECONCILIATION OF NET INCOME TO NET CASH FLOWS FROM OPERATING ACTIVITIES Net loss

$(5,000)

Adjustments for noncash effects: Depreciation expense

6,000

Amortization of patent

300

Changes in operating assets and liabilities: Increase in salaries payable

500

Decrease in accounts receivable

2,000

Increase in inventory

(2,300)

Decrease in discount on bonds Net cash flows from operating activities

200 $ 1,700

Exercise 21– 1477 Direct Method Cash Flows from Operating Activities: Cash received from customers

$672

Cash paid to suppliers

(234)

Cash paid to employees

(116)

Cash paid for interest

(15)

Cash paid for income taxes

(86)

Net cash flows from operating activities

$221

The depreciation expense, amortization expense, and loss on sale of land are not cash flows.

Exercise 21– 1478 Indirect Method Cash Flows from Operating Activities: Net income Adjustments for noncash effects: Depreciation expense Amortization expense Loss on sale of land Changes in operating assets and liabilities: Decrease in accounts receivable Decrease in inventory Increase in accounts payable Decrease in salaries payable Increase in interest payable Increase in income tax payable Net cash flows from operating activities

$ 91 90 5 3 12 10 6 (6) 5 5 $221

Exercise 21– 1479 Direct Method Cash Flows from Operating Activities: Cash received from customers Cash decrease from sale of cash equivalents Cash paid to suppliers Cash paid to employees Cash paid for interest Cash paid for income taxes Net cash flows from operating activities

$1,332 a (6)** (484)b (226)c (35)d (177)e $ 404

Exercise 21–25 (concluded) Calculations using summary entries: a. Summary Entry

b. Summary Entry

c. Summary Entry

d. Summary Entry

e. Summary Entry

Cash (received from customers)…… Accounts receivable……………. Sales revenue……………………

1,332

Cost of goods sold…………………. Inventory……………………….. Accounts payable………………. Cash (paid to suppliers of goods).

500

Salaries expense…………………… Salaries payable…………………… Cash (paid to employees)………

220 6

Interest expense…………………… Interest payable…………….….. Cash (paid for interest)…………

Income tax expense………………. Income tax payable…………… Cash (paid for income taxes)….

182

12 1,320

10 6 484

226

5 35

5 177

** If a cash equivalent investment is sold for either more or less than its acquisition cost, we have a cash flow. Suppose the cost of this investment classified as a cash equivalent had been, say, $15,000, and was sold for $9,000, $6,000 less than that cost. The sale constitutes both a $9,000 increase and a $15,000 decrease in cash and cash equivalents. The cash equivalent was already in the beginning balance in cash and cash equivalents in the balance sheet, so the change in cash is the loss only. The transaction in journal entry format: Cash .......................................................... 9,000 Loss on sale of cash equivalent ................. 6,000 Cash (cash equivalent investment) ....... 15,000 1–1480 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Depreciation expense and amortization expense are not cash flows.

Exercise 21–26 Indirect Method Cash Flows from Operating Activities: Net income

$182

Adjustments for noncash effects: Depreciation expense

180

Amortization expense

Changes in operating assets and liabilities: Decrease in accounts receivable

Decrease in inventory

Increase in accounts payable

Decrease in salaries payable

(6)

Increase in interest payable

Increase in income tax payable

Net cash flows from operating activities

$404

Exercise 21–27 RED, INC. Spreadsheet for the Statement of Cash Flows Dec.31 2023

Balance Sheet Assets: Cash 110 Accounts receivable 132 Prepaid insurance 3 Inventory 175 Buildings and equipment 350 Less: Accum. depreciation (240) 530 Liabilities: Accounts payable 100 Accrued liabilities 11 Notes payable 0 Bonds payable 0 Shareholders' Equity: Common stock Retained earnings Income Statement Revenues: Sales revenue Expenses: Cost of goods sold Depreciation expense Operating expenses Net income

400 19 530

Changes Debits

(1) (4) (2) (6) (7)

(2) (4)

46 4 110 230 171

(11)

(7)

180 50

(3)

13 5 (8) (10)

(9)

(2) (3) (4) (5)

Dec. 31 2024

Credits

1,400 50 447 103

50 160

24 178 7 285 400 (119) 775 87 6 50 160

(5)

103

400 72 775

(1)

2,000

2,000 1,400 50 447 103

Exercise 21–27 (continued)

Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Statement of Cash Flows Operating activities: Cash inflows: From customers Cash outflows: To suppliers of goods For operating expenses Net cash flows Investing activities: Purchase of equipment Sale of equipment Net cash flows Financing activities: Issuance of note payable Payment of dividends Issuance of bonds payable Net cash flows Net decrease in cash Totals

Changes Debits

(1)

Dec. 31 2024

Credits

1,954 (2) (4)

1,523 456 (25)

(6) (7)

230

9 (221)

(8)

50 (9)

(10)

(11)

160 160 (86)

86 4,888

4,888

Exercise 21–27 (concluded)

RED, INC. Statement of Cash Flows For year ended December 31, 2024 ($ in millions) Cash flows from operating activities: Cash inflows: From customers Cash outflows: To suppliers of goods For operating expenses Net cash flows from operating activities Cash flows from investing activities: Purchase of equipment Sale of equipment Net cash flows from investing activities Cash flows from financing activities: Issuance of note payable Issuance of bonds payable Payment of dividends Net cash flows from financing activities Net decrease in cash Cash balance, January 1 Cash balance, December 31

$1,954 (1,523) (456) $ (25)

(230) 9 (221)

50 160 (50) 160 (86) 110 $ 24

Exercise 21– 1488

$ in millions

Pension expense (given)…………………………………… Plan assets (expected return)……………………………….. PBO ($112 service cost + $51 interest cost)…………….. Amortization of net loss—OCI (given)……………… Amortization of prior service cost—OCI (given)…..

82 90

Plan assets…………………………………………………… Gain—OCI (given) ……………………………………...

Plan assets ($1,080 – $900 – $90 – $9)…………………….. Cash (paid to the pension trustee) ……………………….

163 1 8

Exercise 21– 1489

The specific citation that specifies the guidelines for cash equivalents is FASB ASC 230–10–20: ―Statement of Cash Flows–Overall–Glossary.‖ Specifically, the guidelines are: Cash Equivalents Cash equivalents are short-term, highly liquid investments that have both of the following characteristics: a. Readily convertible to known amounts of cash. b. So near their maturity that they present insignificant risk of changes in value because of changes in interest rates. Generally, only investments with original maturities of three months or less qualify under that definition. Original maturity means original maturity to the entity holding the investment. For example, both a three-month U.S. Treasury bill and a three-year Treasury note purchased three months from maturity qualify as cash equivalents. However, a Treasury note purchased three years ago does not become a cash equivalent when its remaining maturity is three months. Examples of items commonly considered to be cash equivalents are Treasury bills, commercial paper, money market funds, and federal funds sold (for an entity with banking operations).

Exercise 21– 1490 The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1.

Disclosure of interest and income taxes paid if the indirect method is used: FASB ASC 230–10–50–2: ―Statement of Cash Flows–Overall–Disclosure– Interest and Income Taxes Paid.‖

Primary objectives of a statement of cash flows: FASB ASC 230–10–10–1: ―Statement of Cash Flows–Overall–Objectives.‖

3. Disclosure of noncash investing and financing activities: FASB ASC 230–10–50–3: ―Statement of Cash Flows–Overall–Disclosure– Noncash Investing and Financing Activities.‖

Exercise 21– 1491 RED, INC. Spreadsheet for the Statement of Cash Flows Dec.31 2023

400 19 530

Changes Debits

(3) (4) (5) (8) (9)

(6) (7)

46 4 110 230 171

(13)

(9)

180 50

(2)

13 5 (10) (11)

(12)

Dec. 31 2024

Credits

(1)

50 160

103

24 178 7 285 400 (119) 775 87 6 50 160

400 72 775

Exercise 21–31 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Statement of Cash Flows Net income Adjustments for noncash effects: Depreciation expense Increase in accounts receivable Increase in prepaid insurance Increase in inventory Decrease in accounts payable Decrease in accrued expenses Net cash flows Investing activities: Purchase of equipment Sale of equipment Net cash flows Financing activities: Issuance of note payable Issuance of bonds payable Payment of dividends Net cash flows Net decrease in cash Totals

Dec. 31 2024

Changes Debits

Credits

(1)

103

(2)

50 (3) (4) (5) (6) (7)

46 4 110 13 5 (25)

(8) (9)

230

9 (221)

(10) (11)

50 160 (12)

(13)

50 160 (86)

86 1,087

1,087

Exercise 21–31 (concluded) RED, INC. Statement of Cash Flows For year ended December 31, 2024 ($ in millions) Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation expense Changes in operating assets and liabilities: Increase in accounts receivable Increase in prepaid insurance Increase in inventory Decrease in accounts payable Decrease in accrued liabilities Net cash flows from operating activities

$ 103 50 (46) (4) (110) (13) (5) $ (25)

Cash flows from investing activities: Purchase of equipment Sale of equipment Net cash flows from investing activities

(230) 9

Cash flows from financing activities: Issuance of note payable Issuance of bonds payable Payment of dividends Net cash flows from financing activities

50 160 (50)

(221)

160

Net decrease in cash

(86)

Cash balance, January 1 Cash balance, December 31

110 $ 24

Exercise 21–32 BALANCE SHEET ACCOUNTS Cash (Statement of Cash Flows) 86 Operating Activities: From customers

1,954

(1)

1,523 456

(2) (4)

To suppliers For expenses

230

(6)

Purchase of equipment

(9)

Payment of dividends

Investing Activities: Sale of equipment

(7)

Financing Activities: Issuance of notes Issuance of bonds

(8)

50 160

(10)

Accounts Receivable

Prepaid Insurance `

46 (1)

46 Inventory

4 (4)

Buildings and Equipment

110

(2) 110

(6) 230

Accumulated Depreciation 121

180

(7)

Accounts Payable 13

(7)

171

(3)

(2)

Exercise 21–32 (continued) Accrued Liabilities

(4)

Notes Payable

Bonds Payable

Retained Earnings

160 160

(8)

53 (10)

(9)

103

(5)

Common Stock 0

INCOME STATEMENT ACCOUNTS Sales

Cost of Goods Sold

2,000 2,000

1,400 (1)

Depreciation Expense

(2)

Operating Expenses

50 (3)

1,400

447 (4)

447

Net Income (Income Summary) 103

(5)

103

Exercise 21–32 (concluded) RED, INC. Statement of Cash Flows For year ended December 31, 2024 ($ in millions) Cash flows from operating activities: Cash inflows: From customers Cash outflows: To suppliers of goods For operating expenses Net cash flows from operating activities

$1,954 (1,523) (456) $ (25)

Cash flows from investing activities: Purchase of equipment Sale of equipment Net cash flows from investing activities

(230) 9

Cash flows from financing activities: Issuance of note payable Issuance of bonds payable Payment of dividends Net cash flows from financing activities

50 160 (50)

(221)

160

Net decrease in cash

(86)

Cash balance, January 1 Cash balance, December 31

110 $ 24

PROBLEMS Problem 21–1 Classifications +I Investing activity (cash inflow) –I Investing activity (cash outflow +F Financing activity (cash inflow) –F Financing activity (cash outflow) N Noncash investing and financing activity X Not reported as an investing and/or a financing activity Transactions Example +I 1. Sale of land. +F 2. Issuance of common stock for cash. –F 3. Purchase of treasury stock. N 4. Conversion of bonds payable to common stock. N 5. Lease of equipment. +I 6. Sale of patent. –I 7. Acquisition of building for cash. N 8. Issuance of common stock for land. +I 9. Collection of note receivable (principal amount). +F 10. Issuance of bonds. X 11. Issuance of stock dividend. N 12. Payment of property dividend. – F 13. Payment of cash dividends. +F 14. Issuance of short-term note payable for cash. +F 15. Issuance of long-term note payable for cash. –I 16. Purchase of marketable debt securities (―available for sale‖). – F 17. Payment of note payable. X 18. Cash payment for 5-year insurance policy. +I 19. Sale of equipment. N 20. Issuance of note payable for equipment. – I 21. Acquisition of common stock of another corporation. N 22. Repayment of long-term debt by issuing common stock. X 23. Payment of semiannual interest on bonds payable. – F 24. Retirement of preferred stock. – I 25. Loan to another company. X 26. Sale of inventory to customers. X 27. Purchase of marketable securities (cash equivalents). Solutions Manual, Chapter 1 1–1499 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Problem 21–2 WRIGHT COMPANY Spreadsheet for the Statement of Cash Flows Dec.31 2023

Balance Sheet Assets: Cash Accounts receivable Short-term investment Inventory Land Buildings and equipment Less: Accum. depreciation Liabilities: Accounts payable Salaries payable Interest payable Income tax payable Notes payable Bonds payable Shareholders' Equity: Common stock Paid-in capital-excess of par Retained earnings Income Statement Revenues: Sales revenue Expenses: Cost of goods sold Salaries expense Depreciation expense Interest expense Loss on sale of land Income tax expense

Changes Debits

30 75 15 70 60 400 (75) 575

(15)

35 5 3 12 30 100

(2)

200 100 90 575

(9) (2) (10)

(3) (7) (11)

12 (1)

(6)

(4)

25 5 150

7 3

(2) (3) (4) (5) (6) (7)

130 45 40 12 3 70

28 2 5 9 0 160

(12)

(13) (8)

50 26 80

250 126 135 715

(1)

380

3 30

42 73 40 75 50 550 (115) 715

(5)

(13) (14)

Dec. 31 2024

Credits

(130) (45) (40) (12) (3) (70)

Net income

(8)

Problem 21–2 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Statement of Cash Flows Operating activities: Cash inflows: From customers Cash outflows: To suppliers of goods To employees For interest For income taxes Net cash flows Investing activities: Sale of land Purchase of short-term investment Purchase of equipment Net cash flows Financing activities: Repayment of notes payable Sale of bonds payable Sale of common stock Payment of dividends Net cash flows

(1)

Credits

382 (2) (3) (5) (7)

142 48 10 73 109

(6)

7 (9) (10)

25 150 (168)

(12) (13)

(11)

(14)

60 76 71

Net increase in cash Totals

Dec. 31 2024

Changes Debits

(15) 1,175

1,175

Problem 21–2 (concluded) WRIGHT COMPANY Statement of Cash Flows For year ended December 31, 2024 (in $000) Cash flows from operating activities: Cash inflows: From customers Cash outflows: To suppliers of goods To employees For interest For income taxes Net cash flows from operating activities

$382 (142) (48) (10) (73) $109

Cash flows from investing activities: Sale of land Purchase of short-term investment Purchase of equipment Net cash flows from investing activities

7 (25) (150)

Cash flows from financing activities: Repayment of notes payable Sale of bonds payable Sale of common stock Payment of dividends Net cash flows from financing activities

(30) 60 76 (35)

(168)

Net increase in cash

Cash balance, January 1 Cash balance, December 31

30 $ 42

Problem 21–3 NATIONAL INTERCABLE COMPANY Spreadsheet for the Statement of Cash Flows Dec.31 2023

Balance Sheet Assets: Cash Accounts receivable Less: Allowance Prepaid insurance Inventory Long-term investment Land Buildings and equipment Less: Accum. depreciation Trademark Liabilities: Accounts payable Salaries payable Deferred tax liability Lease liability Bonds payable Less: Discount on bonds

Changes Debits

55 170 (6) 12 165 90 150 270 (75) 25 856

(18)

45 8 15 0 275 (25)

(4)

Shareholders' Equity: Common stock 290 Paid-in capital—excess of par 85 Preferred stock 0 Retained earnings 163 856

(1)

2 11 (8)

2 5

(3)

(10)

60 25 1

(1)

(4) (2)

(13) (10)

5 6 80 15

(6) (7)

(5)

15 5 X (13)

3 80

(9)

(15)

20 10 50 22

(11) (13) (14)

12 130

(15) (16) (17)

Dec. 31 2024

Credits

(12)

57 181 (8) 7 170 66 150 290 (85) 24 852 30 3 18 68 145 (22)

310 95 50 155 852

X Noncash investing and financing activity.

Problem 21–3 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Income Statement Revenues: Sales revenue Investment revenue Gain on sale of investments Expenses: Cost of goods sold Salaries expense Depreciation expense Amortization expense Bad debt expense Insurance expense Interest expense Loss on sale of building Income tax expense Net income

Changes Debits

Credits

(1) (2) (3)

320 15 5

Dec. 31 2024

320 15 5

(11)

125 55 25 1 7 13 30 42 20

(125) (55) (25) (1) (7) (13) (30) (42) (20)

(12)

(4) (5) (6) (7) (1) (8) (9) (10)

Problem 21–3 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Statement of Cash Flows Operating activities: Cash inflows: From customers From investment revenue Cash outflows: To suppliers of goods To employees For insurance For interest For income taxes Net cash flows Investing activities: Sale of long-term investment Sale of building Net cash flows Financing activities: Payment on lease liability Retirement of bonds payable Sale of common stock Sale of preferred stock Payment of dividends Net cash flows

(1) (2)

Credits

304 9 (4) (5) (8) (9) (11)

145 60 8 27 17 56

(3) (10)

35 3 38

(14)

12 130

(17)

(13)

(15) (16)

30 50 (92)

Net increase in cash Totals

Dec. 31 2024

Changes Debits

(18) 1,082

1,082

Problem 21–3 (concluded) NATIONAL INTERCABLE COMPANY Statement of Cash Flows For year ended December 31, 2024 ($ in millions) Cash flows from operating activities: Cash inflows: From customers From investment revenue Cash outflows: To suppliers of goods To employees For insurance expense For interest expense For income taxes Net cash flows from operating activities

$304 9 (145) (60) (8) (27) (17) $ 56

Cash flows from investing activities: Sale of long-term investment Sale of building Net cash flows from investing activities

35 3

Cash flows from financing activities: Payment on lease liability Retirement of bonds payable Sale of common stock Sale of preferred stock Payment of dividends Net cash flows from financing activities

(12) (130) 30 50 (30)

Net increase in cash Cash balance, January 1 Cash balance, December 31

(92) 2 55 $ 57

Noncash investing and financing activities: Acquired $80 million of equipment by 7-year lease. 1–1508 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Problem 21–4 DUX COMPANY Spreadsheet for the Statement of Cash Flows Dec.31 2023

Balance Sheet Assets: Cash Accounts receivable Less: Allowance Dividends receivable Inventory Long-term investment Land Buildings and equipment Less: Accum. depreciation Liabilities: Accounts payable Salaries payable Interest payable Income tax payable Notes payable Bonds payable Less: Discount on bonds

Changes Debits

20 50 (3) 2 50 10 40 250 (50) 369

(17)

20 5 2 8 0 70 (3)

(3)

Shareholders' Equity: Common stock 200 Paid-in capital—excess of par 20 Retained earnings 47

(1)

(3) (10) (11) (12) (7)

(4)

(8)

0 369

1 5 5 30 15 30

(7) (5)

(6)

X (11)

30 25 1

(14)

10 4

210 24

(9)

45 (8) 420

14 13 8

33 48 (4) 3 55 15 70 225 (25) 420 13 2 4 7 30 95 (2)

(14)

(16)

40 5

7 3

(6)

(14)

2 1

(13)

(15)

Less: Treasury stock

13 (1)

(2)

Dec. 31 2024

Credits

X Noncash investing and financing activity.

Problem 21–4 (continued)

Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Income Statement Revenues: Sales revenue Dividend revenue Expenses: Cost of goods sold Salaries expense Depreciation expense Bad debt expense Interest expense Loss on sale of building Income tax expense Net income Statement of Cash Flows

Changes Debits

(1) (2) (3) (4) (5) (1) (6) (7) (8) (9)

Dec. 31 2024

Credits

200 3

120 25 5 1 8 3 16 25

200 3 (120) (25) (5) (1) (8) (3) (16) 25

Operating activities:

Cash inflows: From customers From dividends received Cash outflows: To suppliers of goods To employees For interest For income taxes Net cash flows

(1) (2)

202 2 (3) (4) (6) (8)

132 28 5 17 22

Investing activities:

Sale of building Purchase of long-term investment Purchase of equipment Net cash flows

(7)

7 (10) (12)

5 15 (13)

Financing activities:

Sale of bonds payable Payment of dividends Purchase of treasury stock Net cash flows Net increase in cash Totals

(13)

25 (15) (16) (17) 584

13 8 13

4 13

584

Problem 21–4 (concluded)

DUX COMPANY Statement of Cash Flows For year ended December 31, 2024 ($ in 000s) Cash flows from operating activities: Cash inflows: From customers From dividends received Cash outflows: To suppliers of goods To employees For interest For income taxes Net cash flows from operating activities

$202 2 (132) (28) (5) (17) $22

Cash flows from investing activities: Sale of building Purchase of long-term investment Purchase of equipment Net cash flows from investing activities

7 (5) (15)

Cash flows from financing activities: Sale of bonds payable Payment of dividends Purchase of treasury stock Net cash flows from financing activities

25 (13) (8)

(13)

Net increase in cash

Cash balance, January 1 Cash balance, December 31

20 $33

Noncash investing and financing activities: Acquired $30,000 of land by issuing a 13%, 7-year note.

$30

Problem 21–5 METAGROBOLIZE INDUSTRIES Spreadsheet for the Statement of Cash Flows Dec.31 2023

Balance Sheet Assets: Cash 375 Accounts receivable 450 Inventory 525 Land 600 Building 900 Less: Accum. depreciation (270) Equipment 2,250 Less: Accum. depreciation (480) Patent 1,500 5,850 Liabilities: Accounts payable 450 Accrued expenses 225 Lease liability—land 0 Shareholders' Equity: Common stock 3,000 Paid-in capital—excess of par 675 Retained earnings 1,500

Changes Debits

(14) (1) (4) (2)

(11) (7)

205 150 375 150

900 270

(3)

(5)

30 300 315 300

(7) (6) (8)

(4) (9) (2)

X (2)

(12) (12) (12) (13)

225 450

Dec. 31 2024

Credits

(10)

300 75 150

750 300 130

150 75 975

3,150 750 1,800 6,880

5,850 Income Statement Revenues: Sales revenue Gain on sale of land Expenses: Cost of goods sold Depreciation expense—build. Depreciation expense—equip. Loss on sale of equipment Amortization expense

(1) 2,645 (3) (4) (5) (6) (7) (8)

600 30 315 15 300

580 600 900 675 900 (300) 2,850 (525) 1,200 6,880

2,645 90 (600) (30) (315) (15) (300)

Operating expenses Net income

(9) (10)

500 975

(500) 975

Problem 21–5 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Changes Debits

Dec. 31 2024

(1) 2,495 (4) (9)

675 425 1,395

(11) (3) (7)

900

165 15 (720)

Financing activities: Payment on lease liability Payment of dividends Net cash flows Net increase in cash Totals

Credits

(2) (13) (14) 8,155

20 450 205

(470) 205

8,155

X Noncash investing and financing activity.

Problem 21–5 (concluded) METAGROBOLIZE INDUSTRIES Statement of Cash Flows For year ended December 31, 2024 ($ in 000) Cash flows from operating activities: Cash inflows: From customers Cash outflows: To suppliers of goods For operating expenses Net cash flows from operating activities

$2,495 (675) (425) $1,395

Cash flows from investing activities: Purchase of equipment Sale of land Sale of equipment Net cash flows from investing activities

(900) 165 15

Cash flows from financing activities: Payment on lease liability Payment of dividends Net cash flows from financing activities

(20) (450)

(720)

(470)

Net increase in cash

205

Cash balance, January 1 Cash balance, December 31

375 $ 580

Noncash investing and financing activities: Land acquired by lease

$150

Problem 21–6 Requirement 1 a. Summary Entry

b. Summary Entry

c. Summary Entry

d. Summary Entry

e. Summary Entry

f. Summary Entry

Cash (received from customers)…… Accounts receivable……….……….. Sales revenue…………….………

155

Cost of goods sold………………….. Inventory…………………………… Accounts payable……………….. Cash (paid to suppliers of goods)..

90 6

Salaries expense……………….…… Salaries payable………………… Cash (paid to employees)……….

Interest expense……………………. Discount on bonds payable.......... Cash (paid for interest)…………

Insurance expense………………… Prepaid insurance……………… Cash (paid for insurance )……..

Income tax expense………………. Income tax payable…………… Cash (paid for income taxes)….

5 150

9 87

3 17

3 3

2 10

6 7

Depreciation expense, bad debt expense, the gain on sale of equipment, and the loss on sale of land are not cash outflows.

Problem 21–6 (concluded) Requirement 2 Cash Flows from Operating Activities: Cash received from customers Cash paid to suppliers Cash paid to employees Cash paid for interest Cash paid for insurance Cash paid for income taxes

$155 (87) (17) (3) (10) (7)

Net cash flows from operating activities

$ 31

Problem 21–7 Cash Flows from Operating Activities: Cash received from customers Cash increase from sale of cash equivalents Cash paid to suppliers Cash paid to employees Cash paid for interest Cash paid for insurance Cash paid for income taxes Net cash flows from operating activities a. Summary Entry

Cash (received from customers)……. Accounts receivable…………….. Sales revenue……………………

$316a 2b (114)c (34)d (11)e (16)f (52)g $ 91 316 6 310

b. The gain on sale of cash equivalents indicates that total cash increased as a result of converting cash in one form (say a $10 million treasury bill) to cash in another form (checking account)*: Summary Entry

Cash [checking account]…………………………. Gain on sale of cash equivalents… Cash [treasury bill]…………………………..

12 2 10

[*Any other example you think of that involves a gain on sale of cash equivalents would work as well.]

c. Summary Entry

d. Summary Entry

Cost of goods sold……….………….. Inventory……………………………. Accounts payable……….……….. Cash (paid to suppliers of goods)..

120 12

Salaries expense……………………. Salaries payable………………… Cash (paid to employees)……….

18 114

6 34

e. Summary Entry

Interest expense…………………… Discount on bonds payable….… Cash (paid for interest)…………

12 1 11

Problem 21–7 (concluded) f.

Summary Entry

g. Summary Entry

Insurance expense………………….. Prepaid insurance………………. Cash (paid for insurance)……….

Income tax expense……….……. Income tax payable…………. Cash (paid for income taxes)..

4 16

10 52

Depreciation expense, Amortization expense, the loss on sale of land, and the gain on sale of investment are neither cash inflows nor outflows.

Problem 21– 1526 Requirement 1

Direct Method Cash Flows from Operating Activities: Cash received from customers Cash paid to suppliers Cash paid to employees Cash paid for insurance Cash paid for interest Cash paid for income taxes

$692 (103) (111) (18) (40) (70)

Net cash flows from operating activities

$350

Requirement 2

Indirect Method Cash Flows from Operating Activities: Net income Adjustments for noncash effects: Depreciation expense Gain on sale of building Loss on sale of equipment Changes in operating assets and liabilities: Increase in accounts receivable Decrease in inventory Increase in accounts payable Increase in salaries payable Decrease in prepaid insurance Decrease in bond discount Increase in deferred tax liability Net cash flows from operating activities

$ 88 123 (11) 12 (108) 104 93 9 22 10 8 $350

Problem 21– 1527 Requirement 1 Direct Method Cash Flows from Operating Activities: Cash received from customers Cash paid to suppliers Cash paid to employees Cash paid for interest Cash paid for income taxes Gain on sale of cash equivalents Net cash flows from operating activities

$926 (384) (240) (35) (54) 4 $217

Requirement 2

Indirect Method Cash Flows from Operating Activities: Net income Adjustments for noncash effects: Depreciation expense Loss on sale of land

$ 40 190 12

Changes in operating assets and liabilities: Decrease in accounts receivable Increase in inventory Decrease in accounts payable Decrease in salaries payable Increase in interest payable Decrease in income tax payable Net cash flows from operating activities

26 (10) (24) (8) 5 (14) $217

Problem 21– 1528

1. Cash received from customers

$306

2. Cost of goods sold

$180

Increase

in salaries payable

4. Cash paid for depreciation

[Not reported—no cash effect] 5. Interest expense

$12

6. Cash paid for insurance

$12

7. Increase in income tax payable

8. Net income

$27

Problem 21– 1529

ARDUOUS COMPANY Spreadsheet for the Statement of Cash Flows Dec.31 2023

Balance Sheet Assets: Cash Accounts receivable Investment rev. receivable Inventory Prepaid insurance Long-term investment

81 194 4 200 8 125

Changes Debits

(21) (2) (4) (2) (13)

Land 150 Buildings and equipment 400 Less: Accum. depreciation (120) Patent 32 1,074 Liabilities: Accounts payable 65 Salaries payable 11 Interest payable 4 Income tax payable 14 Deferred tax liability 8 Notes payable 0 Lease liability 0 Bonds payable 275 Less: Discount (25) Shareholders' Equity: Common stock 410 Paid-in capital—excess of par 85 Preferred stock 0 Retained earnings 227

(14) (15) (10)

(5) (11)

0 1,074

(1)

(8)

2 5 6 25 46 82 35

X X

(10) (6)

(15) (16)

(20)

30 22 9

156 196 412 (97) 30 1,211

(9)

(11) X (15)

3 23 82

(9)

(17) (18)

20 10 75

430 95 75

(12)

242 (9) 1,211

7 60

109 190 6 205 4

50 6 8 12 11 23 75 215 (22)

(17) (17)

70 12 2

15 5

X (14)

(19)

Less: Treasury stock

(7)

(4)

Dec. 31 2024

Credits

Problem 21–11 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Income Statement Revenues: Sales revenue Investment revenue Gain on sale of treasury bills Expenses: Cost of goods sold Salaries expense Depreciation expense Amortization expense Insurance expense Interest expense Loss on sale of equipment Income tax expense Net income

Changes Debits

Credits

(1) (2) (3)

410 11 2

Dec. 31 2024

410 11 2

(11)

180 73 12 2 7 28 18 36

(180) (73) (12) (2) (7) (28) (18) (36)

(12)

(4) (5) (6) (7) (8) (9) (10)

X Noncash investing and financing activity.

Problem 21–11 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Statement of Cash Flows Operating activities: Cash inflows: From customers From investment revenue From sale of cash equivalents Cash outflows: To suppliers of goods To employees For insurance For interest For income taxes Net cash flows Investing activities: Sale of equipment Purchase of long-term investment Purchase of land Net cash flows Financing activities: Payment on lease liability Retirement of bonds payable Sale of preferred stock Payment of dividends Purchase of treasury stock Net cash flows

Changes Debits

(1) (2) (3)

Dec. 31 2024

414 3 2 (4) (5) (8) (9) (11)

200 78 3 21 35 82

(10)

17 (13) (14)

25 23 (31)

(15) (16) (18)

7 60

75 (19) (20)

22 9 (23)

Net increase in cash Totals

Credits

(21) 1,313

1,313

Problem 21–11 (concluded) ARDUOUS COMPANY Statement of Cash Flows For year ended December 31, 2024 ($ in millions) Cash flows from operating activities: Cash inflows: From customers From investment revenue From sale of cash equivalents Cash outflows: To suppliers of goods To employees For insurance For interest For income tax Net cash flows from operating activities Cash flows from investing activities: Sale of equipment Purchase of long-term investment Purchase of land Net cash flows from investing activities Cash flows from financing activities: Payment on lease liability Retirement of bonds payable Sale of preferred stock Payment of dividends Purchase of treasury stock Net cash flows from financing activities Net increase in cash Cash balance, January 1 Cash balance, December 31

$414 3 2 (200) (78) (3) (21) (35) $ 82 17 (25) (23) (31) (7) (60) 75 (22) (9) (23) 28 81 $109

Noncash investing and financing activities: Acquired $82 million building by 15-year lease. Acquired $46 million of land by issuing cash and a 15%, 4-year note as follows: Cost of land $46 Cash paid 23 1–1532 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Note issued

$23

Problem 21–12 Requirement 1 Retirement of common shares

($ in millions)

Common stock (5 million shares x $1 par per share)....................... Paid-in capital—excess of par ($22 – $5 – $2) ........................... Retained earnings (given) ......................................................... Cash (given)*........................................................................

5 15 2 22

*This transaction identifies a $22 million cash outflow from financing activities. Net income reconstruction entry for retained earnings Net income ....................................................................................................... Retained earnings (given) .......................................................

88 88

*The operating activities summarized by this transaction are identified individually when we explain the changes in the components of net income. But including the entry on the spreadsheet is helpful in partially explaining change in retained earnings. Declaration of a cash dividend Retained earnings (given) ......................................................... Cash..................................................................................................................

33 33

*This transaction identifies a $33 million cash outflow from financing activities.

Declaration of a stock dividend Retained earnings (given) ......................................................... Common stock ([105 – 5] x 4%) million shares at $1 par per share) Paid-in capital—excess of par (difference) ............................

20 4 16

*This transaction does not represent a significant investing or financing activity, but including the entry on the spreadsheet is helpful in partially explaining changes in the balances of the two accounts affected.

Problem 21–12 (concluded) Requirement 2

BRENNER-JUDE CORPORATION Statement of Retained Earnings FOR THE YEAR ENDED DECEMBER 31, 2024 ($ in millions)

Balance at January 1

$ 90

Net income for the year

Deductions: Retirement of common stock Cash dividends of $0.33 per share 4% stock dividend Balance at December 31

(2) (33) (20) $123

Problem 21–13 1. Cash collections from customers (direct method). 2. Payments for purchase of property, plant, and equipment. 3. Proceeds from sale of equipment. 4. Cash dividends paid. 5. Redemption of bonds payable.

Amount Category $145,0001 O $ 50,0002 $ 31,0003 $ 12,0004 $ 17,0005

I I F F

1 Summary Entry

Cash (received from customers)……………… Accounts receivable ($34,000 – $24,000)………………. Sales revenue (given)………………………………….

145,000 10,000 155,000

2Property, Plant, & Equipment

247 20

Beginning balance Acquired with B/P

Equipment sold

Purchased Ending balance

277

$277,000 + $40,000 – $247,000 – $20,000 = $50,000 3 Summary Entry

Cash (sale of equipment)…………………………. Accumulated depreciation (determined below)……………. P, P, & E (given)……………………………………………… Gain on sale of equipment (given)…………………….

31,000 22,000 40,000 13,000

Accumulated Depreciation

Equipment sold

167 33

Beginning balance Depreciation expense

178

Ending balance

$167,000 + $33,000 – $178,000 = $22,000

Problem 21–13 (concluded) Summary Entry Retained earnings (determined below)………….…………. Dividends payable ($8,000 – $5,000)………………… Cash (paid for dividends)………………………….………..

15,000 3,000 12,000

Retained Earnings

Dividends declared

91 28

Beginning balance Net income

104

Ending balance

$91,000 + $28,000 – $104,000 = $15,000

5 Summary Entry

Bonds payable (determined below)……………………………….. Cash.....................................................................

17,000 17,000

Bonds Payable

Bonds redeemed

46 20

Beginning balance Issued for P, P, & E

Ending balance

$46,000 + $20,000 – $49,000 = $17,000

Problem 21–14 SURMISE COMPANY Spreadsheet for the Statement of Cash Flows Dec.31 2023

Balance Sheet Assets: Cash 40 Accounts receivable 96 Less: Allowance (4) Prepaid expenses 5 Inventory 130 Long-term investment 40 Land 100 Buildings and equip. 300 Less: Accum. depreciation (120) Patent 17 604 Liabilities: Accounts payable 32 Accrued liabilities 10 Notes payable 0 Lease liability 0 Bonds payable 125 Shareholders' Equity: Common stock 50 Paid-in capital—excess of par 205 Retained earnings 182 604

Changes Debits

(16) (5) (3)

(10)

3 15 40

(11)

120

(8) (6)

(4)

(9)

(13)

9 60

X (11)

(14) (14) (15)

22 1

19 8 (12)

(11)

4 4 8

X (2)

(7)

Dec. 31 2024

Credits

(1)

35 120

10 40 50

36 92 (12) 8 145 80 100 420 (142) 16 743 13 2 35 111 65 60 245 212 743

X Noncash investing and financing activity.

Problem 21–14 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Statement of Cash Flows Operating activities: Net income Adjustments for noncash effects: Depreciation expense Bad debt expense Amortization expense Decrease in accounts receivable Increase in inventory Decrease in accounts payable Increase in prepaid expenses Decrease in accrued liabilities Net cash flows Investing activities: Purchase of long-term investment Net cash flows Financing activities: Payment on lease liability Issuance of note payable Retirement of bonds payable Sale of common stock Payment of dividends Net cash flows Net decrease in cash Totals

Changes Debits

(1)

(2)

22 8 1 4

(3) (4) (5)

Dec. 31 2024

Credits

(6) (7) (8) (9)

15 19 3 8 40

(10)

40 (40)

(12)

(14)

(16)

(11)

(13)

(15)

35 50 (4) (4)

4 468

468

Problem 21–14 (concluded) SURMISE COMPANY Statement of Cash Flows For year ended December 31, 2024 ($ in millions) Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation expense Bad debt expense Amortization expense Changes in operating assets and liabilities: Decrease in accounts receivable Increase in inventory Decrease in accounts payable Increase in prepaid expenses Decrease in accrued liabilities Net cash flows from operating activities

$ 50 22 8 1 4 (15) (19) (3) (8) $40

Cash flows from investing activities: Purchase of long-term investment Net cash flows from investing activities

(40)

Cash flows from financing activities: Payment of lease liability Issuance of note payable Retirement of bonds payable Sale of common stock Payment of dividends Net cash flows from financing activities

(9) 35 (60) 50 (20)

(40)

Net decrease in cash

(4)

Cash balance, January 1 Cash balance, December 31

40 $36

Noncash investing and financing activities: 1–1542 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Acquired use of buildings by lease

$120

Problem 21–15 Requirement 1 Digital would report the cash inflow of $28,329,472 from the sale of the bonds as a cash inflow from financing activities in its statement of cash flows. *

The $3,200,000 ($1,600,000 + $1,600,000 ) cash interest paid is a cash outflow from operating activities because interest is an income statement (operating) item. June 30, 2024* Interest expense (6% x $28,329,472) ..................... 1,699,768 Discount on bonds payable (difference)......... 99,768 Cash (5% x $32,000,000) ................................ 1,600,000 December 31, 2024** Interest expense (6% x [$28,329,472 + $99,768]) ... 1,705,754 Discount on bonds payable (difference)......... 105,754 Cash (5% x $32,000,000) ................................ 1,600,000 Note: By the indirect method of reporting cash flows from operating activities, we would add back to net income the $99,768 and $105,754 discount amortization since net income was reduced by interest expense each period, but cash decreased by only $1,600,000 each period.

Problem 21–15 (continued) Requirement 2 Calculation of the present value of lease payments $391,548 x 15.32380t

$6,000,000 (rounded)

t Present value of an annuity due of $1: n = 20, i = 3% (from Table 6)

Midsouth would report the $6,000,000* investment in the switching equipment and its financing with a lease as a significant noncash investing and financing activity in the disclosure notes to the financial statements. *

The $783,096 ($391,548 + $391,548 ) cash lease payments are divided into the interest portion and the principal portion. The interest portion, $168,254, from the December 31 payment, is reported as a cash outflow from operating activities. The principal portion, $614,842 ($391,548 + $223,294), is reported as a cash outflow from financing activities. Note: By the indirect method of reporting cash flows from operating activities, we would add back to net income the $300,000 amortization expense since it didn‘t actually reduce cash. The $168,254 interest expense that reduced net income actually did reduce cash [the interest portion of the $783,096 ($391,548 x 2) cash lease payments], so for it, no adjustment to net income is necessary. Calculations: September 30, 2024* Right-of-use asset (calculated above).............................. 6,000,000 Lease payable (calculated in above) ............................ 6,000,000 Lease payable .............................................................. Cash (lease payment)..................................................

391,548 391,548

December 31, 2024** Interest expense (3% x [$6 million – $391,548]) .............. Lease payable (difference) ............................................. Cash (lease payment)..................................................

168,254 223,294

Amortization expense ($6 million  5 years x ¼ year) ..... Right-of-use asset .....................................................

300,000

391,548

300,000

Problem 21–15 (continued) Requirement 3 In a sales-type lease in which the present value of lease receipts is more than the asset‘s cost, we assume the lessor is actually selling its product. Consistent with reporting sales of products under installment sales agreements rather than lease agreements, the lessor reports cash receipts from a sales-type lease as cash inflows from operating activities after initially reporting its acquisition of a lease receivable and derecognition of the leased asset as a supplemental noncash transaction in its cash flow disclosure note. So Digital would report the $6,000,000* lease of the switching equipment as a noncash transaction in the disclosure notes to the financial statements. *

The $783,096 ($391,548 + $391,548 cash inflow from operating activities.

) cash lease receipts are reported as a

Note: By the indirect method of reporting cash flows from operating activities, the $168,254 interest revenue that increased net income actually did increase cash. The remaining portion of the $783,096 ($391,548 x 2) cash lease payments], $783,096 minus $168,254 = $614,842, must be added to net income to cause operating activities to reflect the entire cash flow. Calculations: September 30, 2024* Lease receivable (PV of lease payments)......................... 6,000,000 Inventory of equipment (lessor‘s cost)........................ 6,000,000 Cash (rental payment)..................................................... Lease receivable........................................................ December 31, 2024** Cash (rental payment)..................................................... Lease receivable........................................................ Interest revenue (3% x [$6,000,000 – $391,548]) .........

391,548 391,548

391,548 223,294 168,254

Problem 21–15 (concluded) Requirement 4 MDS would report the $6,000,000* lease of the switching equipment as a noncash transaction in the disclosure notes to the financial statements. In a sales-type lease we assume the lessor is actually selling its product. Consistent with reporting sales of products under installment sales agreements rather than lease agreements, the lessor reports cash receipts from a sales-type *

lease as cash inflows from operating activities. So the $783,096 ($391,548 + **

$391,548 ) cash lease payments are considered to be cash flows from operating activities.

Note: By the indirect method of reporting cash flows from operating activities, the $168,254 interest revenue that increased net income actually did increase cash. The remaining portion of the $783,096 [($391,548 x 2) cash lease payments], $783,096 minus $168,254 = $614,842, must be added to net income to cause operating activities to reflect the entire cash flow. Calculations: September 30, 2024* Lease receivable (present value) ..................................... Cost of goods sold (lessor‘s cost .................................... Sales revenue (present value)...................................... Inventory of equipment (lessor‘s cost)........................ Cash (rental payment)..................................................... Lease receivable........................................................ December 31, 2024** Cash (rental payment)..................................................... Lease receivable........................................................ Interest revenue (3% x [$6,000,000 – $391,548]) .........

6,000,000 5,000,000 6,000,000 5,000,000 391,548 391,548

391,548 223,294 168,254

Problem 21–16 DUX COMPANY Spreadsheet for the Statement of Cash Flows Dec.31 2023

Changes Debits

20 50 (3) 2 50 10 40 250 (50) 369

(20)

20 5 2 8 0 70 (3)

(9)

Shareholders' Equity: Common stock 200 Paid-in capital—excess of par 20 Retained earnings 47

(6)

(8) (13) (14) (15) (4)

(10)

(12)

0 369

1 5 5 30 15 30

(4) (2)

(11)

X (14)

30 25 1

(17)

10 4

210 24

(1)

45 (8) 420

14 13 8

33 48 (4) 3 55 15 70 225 (25) 420 13 2 4 7 30 95 (2)

(17)

(19)

40 5

7 3

(3)

(17)

2 1

(16)

(18)

Less: Treasury stock

13 (5)

(7)

Dec. 31 2024

Credits

X Noncash investing and financing activity.

Problem 21–16 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Statement of Cash Flows Net income Adjustments for noncash effects: Depreciation expense Amortization of bond discount Loss on sale of building Decrease in accounts receivable Increase in allowance for uncoll. Increase in dividends receivable Increase in inventory Decrease in accounts payable Decrease in salaries payable Increase in interest payable Decrease in income tax payable Net cash flows Investing activities: Sale of building Purchase of long-term investment Purchase of equipment Net cash flows Financing activities: Sale of bonds payable Payment of dividends Purchase of treasury stock Net cash flows Net increase in cash Totals

Dec. 31 2024

Changes Debits

Credits

(1)

(2)

5 1 3 2 1

(3) (4) (5) (6)

(10)

1 5 7 3

(12)

(7) (8) (9)

(11)

2 22

(4)

7 (13) (15)

5 15 (13)

(16)

25 (18) (19)

(20) 216

13 8 13

4 13

216

Problem 21–16 (concluded) DUX COMPANY Statement of Cash Flows For year ended December 31, 2024 ($ in 000s) Cash flows from operating activities: Net income $25 Adjustments for noncash effects: Depreciation expense 5 Loss on sale of building 3 Changes in operating assets and liabilities: Amortization of bond discount 1 Decrease in accounts receivable 2 Increase in allowance for uncollectible accounts 1 Increase in dividends receivable (1) Increase in inventory (5) Decrease in accounts payable (7) Decrease in salaries payable (3) Increase in interest payable 2 Decrease in income tax payable (1) Net cash flows from operating activities

$22

Cash flows from investing activities: Sale of building Purchase of long-term investment Purchase of equipment Net cash flows from investing activities

7 (5) (15) (13)

Cash flows from financing activities: Sale of bonds payable Payment of dividends Purchase of treasury stock Net cash flows from financing activities

25 (13) (8) 4

Net increase in cash Cash balance, January 1 Cash balance, December 31

13 20 $33

Noncash investing and financing activities: Acquired $30,000 of land by issuing a 13%, 7-year note.

$30

Problem 21–17 METAGROBOLIZE INDUSTRIES Spreadsheet for the Statement of Cash Flows Dec.31 2023

Changes Debits

(15) (7) (8) (11)

(12) (5)

900 270

(2)

(3)

30 300 315 300

(5) (4) (6)

(9) (10) (11)

X (11)

(13) (13) (13) (14)

5,850

205 150 375 150

Credits

225 450

(1)

Dec. 31 2024

580 600 900 675 900 (300) 2,850 (525) 1,200 6,880

300 75 150

750 300 130

150 75 975

3,150 750 1,800 6,880

X Noncash investing and financing activity.

Problem 21–17 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Statement of Cash Flows Operating activities: Net income Adjustments for noncash effects: Gain on sale of land Depreciation expense—building Depreciation expense—equipment Loss on sale of equipment Amortization expense Increase in accounts receivable Increase in inventory Increase in accounts payable Increase in accrued expenses Net cash flows Investing activities: Purchase of equipment Sale of land Sale of equipment Net cash flows

Changes Debits

(1)

(3) (4) (5) (6)

(2)

(7)

150 375

30 315 15 300 (8)

(9) (10)

Dec. 31 2024

975

300 75 1,395 (12)

(2) (5)

900

165 15 (720)

Financing activities: Payment on lease liability Payment of dividends Net cash flows Net increase in cash Totals

Credits

(11) (14)

(15) 4,935

20 450 205

(470) 205

4,935

Problem 21–17 (concluded) METAGROBOLIZE INDUSTRIES Statement of Cash Flows For year ended December 31, 2024 ($ in 000s) Cash flows from operating activities: Net income Adjustments for noncash effects: Gain on sale of land Depreciation expense—building Depreciation expense—equipment Loss on sale of equipment Amortization expense Changes in operating assets and liabilities: Increase in accounts receivable Increase in inventory Increase in accounts payable Increase in accrued expenses Net cash flows from operating activities

$ 975 (90) 30 315 15 300 (150) (375) 300 75 $1,395

Cash flows from investing activities: Purchase of equipment Sale of land Sale of equipment Net cash flows from investing activities

(900) 165 15

Cash flows from financing activities: Payment on lease liability Payment of dividends Net cash flows from financing activities

(20) (450)

(720)

(470)

Net increase in cash

205

Cash balance, January 1 Cash balance, December 31

375 $ 580

Noncash investing and financing activities: Acquired land by lease

$150

Problem 21–18 ARDUOUS COMPANY Spreadsheet for the Statement of Cash Flows Dec.31 2023

Balance Sheet Assets: Cash 81 Accounts receivable 194 Investment revenue receivable 4 Inventory 200 Prepaid insurance 8 Long-term investment 125

Changes Debits

(24) (6) (9) (7) (16)

(17) (18) (15)

(11) (13)

0 1,074

(5)

(8)

2 5 6 25 46 82 35

X X

(15) (2)

(15) (19)

(23)

30 22 9

156 196 412 (97) 30 1,211

(12)

(14) X (18)

3 23 82

(4)

(20) (21)

20 10 75

430 95 75

(1)

242 (9) 1,211

7 60

109 190 6 205 4

50 6 8 12 11 23 75 215 (22)

(20) (20)

70 12 2

15 5

X (17)

(22)

Less: Treasury stock

(3)

(10)

Dec. 31 2024

Credits

Problem 21–18 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 2023

Statement of Cash Flows Operating activities: Net income Adjustments for noncash effects: Depreciation expense Amortization expense Amortization of discount Decrease in accounts receivable Increase in investment rev. rec. Equity method income Decrease in prepaid insurance Increase in inventory Decrease in accounts payable Decrease in salaries payable Increase in interest payable Decrease in tax payable Increase in deferred tax liability Loss on equipment damage Net cash flows Investing activities: Sale of equipment Purchase of LT investment Purchase of land Net cash flows Financing activities: Payment on lease liability Retirement of bonds payable Sale of preferred stock Payment of dividends Purchase of treasury stock Net cash flows Net increase in cash Totals

Dec. 31 2024

Changes Debits

Credits

(1)

(2)

12 2 3 4

(3) (4) (5)

(6) (7) (8)

(11)

5 15 5

(13)

(9) (10) (12) (14) (15)

2 6

4 3 18 82

(15)

17 (16) (17)

25 23 (31)

(15) (19) (21)

7 60

75 (22) (23)

(24) 588

22 9 28

(23) 28

588

Problem 21–18 (continued) Arduous Company Statement of Cash Flows For year ended December 31, 2024 ($ in millions) Cash flows from operating activities: Net income $67 Adjustments for noncash effects: Depreciation expense 12 Amortization expense 2 Loss on equipment 18 Changes in operating assets and liabilities: Amortization of bond discount 3 Decrease in accounts receivable 4 Increase in investment revenue receivable (2) Increase in investment due to equity method income (6) Decrease in prepaid insurance 4 Increase in inventory (5) Decrease in accounts payable (15) Decrease in salaries payable (5) Increase in interest payable 4 Decrease in income tax payable (2) Increase in deferred tax liability 3 Net cash flows from operating activities $ 82 Cash flows from investing activities: Sale of equipment 17 Purchase of long-term investment (25) Purchase of land (23) Net cash flows from investing activities (31) Cash flows from financing activities: Payment on lease liability (7) Retirement of bonds payable (60) Sale of preferred stock 75 Payment of dividends (22) Purchase of treasury stock (9) Net cash flows from financing activities (23) Net increase in cash Cash balance, January 1

28 81

Cash balance, December 31

$109

Problem 21–18 (concluded)

$46 23 $23

X Noncash investing and financing activity.

The following problems use the technique learned in Appendix 21–B.

Problem 21–19 BALANCE SHEET ACCOUNTS Cash (Statement of Cash Flows) 13 Operating Activities: From customers From dividends received

(1) 202 (2)

132 28 5 17

(3) (4) (6) (8)

To suppliers of goods To employees For interest For income taxes

Investing Activities: Sale of building

(7)

5 (10) Purchase of long-term investment 15 (12) Purchase of equipment

Financing Activities: Sale of bonds payable

(13)

13 (15) Payment of dividends 8 (16) Purchase of treasury stock

Accounts Receivable

Allowance for Uncollectible Accounts

2 2 Inventory

1 1 (1)

(1)

Dividends Receivable

5 (3)

1 (2)

Problem 21–19 (continued) Long-term Investments

Land

5 (10)

30 X (11)

Buildings and Equipment

Accumulated Depreciation

25 (12)

(7)

Accounts Payable

(7)

(5)

Salaries Payable

7 (3)

(4)

Interest Payable

Income Tax Payable

(6)

Notes Payable 30 30

(8)

1 Bonds Payable 25

(11) X

Discount on Bonds

(13)

Common Stock

1 1

10 (6)

(14)

Problem 21–19 (continued) Paid-in Capital

Retained Earnings

4 4

2 (14)

(14) (15)

14 13

(9)

Treasury Stock 8 (16)

X Noncash investing and financing activity.

Problem 21–19 (continued) INCOME STATEMENT ACCOUNTS Sales

Dividend Revenue

200 200

3 3

(1)

Cost of Goods Sold

Salaries Expense

120 (3)

120

Depreciation Expense

25 (4)

Interest Expense

1 (1)

Income Tax Expense

3 (7)

Net Income (Income Summary)

16 (8)

Loss on Sale of Building

8 (6)

Bad Debt Expense

5 (5)

(2)

25 (9)

Problem 21–19 (concluded) DUX COMPANY Statement of Cash Flows For year ended December 31, 2024 ($ in 000s) Cash flows from operating activities: Cash inflows: From customers From dividends received Cash outflows: To suppliers of goods To employees For interest For income taxes Net cash flows from operating activities

$202 2 (132) (28) (5) (17) $22

Cash flows from investing activities: Sale of building Purchase of long-term investment Purchase of equipment Net cash flows from investing activities

7 (5) (15)

Cash flows from financing activities: Sale of bonds payable Payment of dividends Purchase of treasury stock Net cash flows from financing activities

25 (13) (8)

(13)

Net increase in cash

Cash balance, January 1 Cash balance, December 31

20 $33

Noncash investing and financing activities: Acquired $30,000 of land by issuing a 13%, 7-year note.

$30

Problem 21–20 BALANCE SHEET ACCOUNTS Cash (Statement of Cash Flows) 205 Operating Activities: From customers

Investing Activities: Sale of land Sale of equipment

(1)

(3) (7)

2,495

165 15

675 425

(4) (9)

To suppliers For expenses

900

(11)

Purchase of equipment

20 450

(2)

Payment on lease Payment of dividends

Financing Activities: (13)

Accounts Receivable

(1)

Inventory

150

375

150

(4) 375

Building

Accumulated Depr.-Building

30 30

(5)

Land 75 X (2)

150

(3)

Equipment

Accumulated Depr.-Equipment

600 (11) 900

45 300

(7)

(7) 270

315

(6)

Problem 21–20 (continued) Patent

Accounts Payable

300 300

(8)

Accrued Liabilities

Lease Liability–Land

75 75

130 (9)

Common Stock 150 150

(4)

(2)

150

(2) X

Paid-in Capital 75

(12)

Retained Earnings 300 (12) 225

975

(10)

(13) 450

X Noncash investing and financing activity.

Problem 21–20 (continued) INCOME STATEMENT ACCOUNTS Sales

Gain on Sale of Land

2,645

2,645 (1)

Cost of Goods Sold

Depreciation Expense—Build.

600 (4)

600

Depreciation Expense—Equip.

30 (5)

315

Amortization Expense

(8)

Loss on Sale of Equipment

315 (6)

(3)

15 (7)

Operating Expenses

300

500

300

(9) 500

Net Income (Income Summary)

975 (10) 975

Problem 21–20 (concluded) METAGROBOLIZE INDUSTRIES Statement of Cash Flows For year ended December 31, 2024 ($ in 000s) Cash flows from operating activities: Cash inflows: From customers Cash outflows: To suppliers of goods For operating expenses Net cash flows from operating activities

$2,495 (675) (425) $1,395

Cash flows from investing activities: Purchase of equipment Sale of land Sale of equipment Net cash flows from investing activities

(900) 165 15

Cash flows from financing activities: Payment on lease liability Payment of dividends Net cash flows from financing activities

(20) (450)

(720)

(470)

Net increase in cash

205

Cash balance, January 1 Cash balance, December 31

375 $ 580

Noncash investing and financing activities: Land acquired by lease

$150

Problem 21–21 BALANCE SHEET ACCOUNTS Cash (Statement of Cash Flows) 28 Operating Activities: From customers From investment revenue From sale of cash equivalents

Investing Activities: Sale of equipment

Financing Activities: Sale of preferred stock

414 (2) 3 (3) 2 (1)

(11)

(18)

200 78 3 21 35

(4) (5) (8) (9) (10)

25 23

(13)

7 60 22 9

(15)

(14)

(16) (19) (20)

To suppliers of goods To employees For insurance For interest For income taxes

Purchase of long-term invest. Purchase of land

Payment on lease liability Retirement of bonds Payment of dividends Purch. of treasury stock

Accounts Receivable 4 4 (1)

Prepaid Insurance

Inventory

4 4 (8)

5 (4)

Problem 21–21 (continued) Investment Revenue Receivable

(2)

Long-term Investments

6 (13) 25 (2)

Land

Buildings and Equipment

46 X (14)

12 X (15)

Accumulated Depreciation

2 12 (6)

Accounts Payable

(7)

Salaries Payable

15 (4)

(11)

Patent

23 (11)

5 (5)

Interest Payable

Income Tax Payable

4 4 (9)

2 (10)

X Noncash investing and financing activity.

Problem 21–21 (continued) Deferred Tax Liability

Notes Payable

3 (10)

23 (14) X

Lease Liability

Bonds Payable

75 (15)

60 (15) X

(16)

Discount on Bonds

Common Stock

3 (9)

Paid-in Capital 10

10 (17)

(19)

67 (12)

(18)

Treasury Stock

15 30 22

(17)

Preferred Stock

Retained Earnings

(17)

9 (20)

X Noncash investing and financing activity.

Problem 21–21 (continued) INCOME STATEMENT ACCOUNTS Sales

Investment Revenue

410

410 (1)

Gain on Sale of Treasury Bills

Cost of Goods Sold

2 2 (3)

Salaries Expense

180 (4) 180

Depreciation Expense

73 (5)

(2)

12 (6)

Problem 21–21 (continued) Amortization Expense 2 (7)

Insurance Expense

Interest expense

7 (8)

(9)

Income Tax Expense

Loss on Sale of Equipment

36 (10)

(11)

Net Income (Income Summary) 67 (12)

Problem 21–21 (concluded) ARDUOUS COMPANY Statement of Cash Flows For year ended December 31, 2024 ($ in millions)

Cash flows from operating activities: Cash inflows: From customers $414 From investment revenue 3 From sale of cash equivalents 2 Cash outflows: To suppliers of goods (200) To employees (78) For insurance (3) For interest (21) For income taxes (35) Net cash flows from operating activities $ 82 Cash flows from investing activities: Sale of equipment 17 Purchase of long-term investment (25) Purchase of land (23) Net cash flows from investing activities (31) Cash flows from financing activities: Payment on lease liability (7) Retirement of bonds payable (60) Sale of preferred stock 75 Payment of dividends (22) Purchase of treasury stock (9) Net cash flows from financing activities (23) Net increase in cash 28 Cash balance, January 1 81 Cash balance, December 31 $109 Noncash investing and financing activities: Acquired $82 million building by 15-year lease. Acquired $46 million of land by issuing cash and a 15%, 4-year note as follows: Cost of land $46 Cash paid 23 Note issued $23

CASES

Analysis Case 21–1 You want your report to explain that operating results for the first half of the year demonstrate that it is possible for operating activities to simultaneously produce a positive net income and negative net cash flows. Net income was $5 million. Cash flow from operating activities for the period was negative $16 million. Generally accepted accounting principles permit us to report cash flows by either of two methods—the direct or the indirect approach as follows: ($ in millions)

[Direct Method] Cash flows from operating activities: Cash inflows: From customers ($75 – $20) Cash outflows: To suppliers of goods ($30 + $15 – $2) For other expenses ($35 – $7) Net cash flows from operating activities

$55 (43) (28) $(16)

Case 21–1 (concluded) [Indirect Method] Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation expense Changes in operating assets and liabilities: Increase in accounts receivable Increase in inventory Increase in accounts payable Increase in accrued liabilities Net cash flows from operating activities

$5 5 (20) (15) 2 7 $(16)

The reason for the apparent discrepancy between cash flows and net income is due to the way the two items are measured. Net income (or loss) is the result of combining the revenues recognized during the reporting period, regardless of when cash is received, and the expenses incurred in generating those revenues, regardless of when cash is paid. We refer to this as the ―accrual concept‖ of accounting. On the other hand, "cash flows from operating activities" are both inflows and outflows of cash that result from the same activities that are reported on the income statement. In other words, this classification of cash flows includes the elements of net income, but reported on a cash basis.

Judgment Case 21–2 DARING COMPANY Statement of Cash Flows For year ended December 31, 2024 ($ in 000s) Cash flows from operating activities: Cash inflows: From customers ($100 – $25) Cash outflows: To suppliers of goods ($50 + $20 – $10) For remaining expenses ($25 – $5) Net cash flows from operating activities

$75 (60) (20) $ (5)

Cash flows from investing activities: Purchase of depreciable assets (given) Cash flows from financing activities: Issuance of note payable Issuance of common stock Net cash flows from financing activities Net increase in cash Cash balance, January 1 Cash balance, December 31

(55) 45 20 65 5 0 $5

Your concerns are justified in the sense that cash flows are insufficient to cover existing interest charges, not to mention additional charges from new debt. In fact, the principal on the debt of $45,000 will come due shortly in addition to additional interest. Although net income is positive, cash flows from operating activities are negative. A difference between cash flows and net income can exist due to the way the two items are measured. Net income, measured on an accrual basis, is the difference between the revenues recognized during the reporting period, regardless of when cash is received, and the expenses incurred in generating those revenues, regardless of when cash is paid. Cash flows from operating activities are inflows and outflows of cash resulting from the same activities that are reported on the income statement.

Case 21–2 (concluded) On the other hand, the negative cash flow from operations is not reason, in and of itself, for rejecting the application. Profit is positive. The reason net income is measured on an accrual basis rather than a cash basis is that very often, net income is a better indication of performance, particularly long-term performance, than cash flow. However, many promising companies that have reported profits have failed due to cash shortages. Good business managers understand that bottom line net income has little to do with maintaining solvency. By being able to accurately predict the timing and amounts of cash flows, companies can remain afloat and also avoid financing charges caused by having to undertake emergency borrowing, as is the case here. The bottom line is that additional information is needed. One cause of the negative operating cash flows is the acquisition of a large amount of inventory that is unsold. If product demand is strong, this is favorable. Why are those inventories unsold? What is the projected growth rate in revenues? Another concern may be the rather high balance in accounts receivable. Cash collected from customers was only 75% of sales for the year. Is credit policy too lax? On the other hand, if the uncollected receivables arose primarily as a result of heavy year-end sales and are imminently collectible, the cash flow situation will benefit. Another practical consideration is the fact that the bank already has a $45,000 investment in this new company, an investment that likely will be lost if the company is denied the new funds it seeks.

Real World Case 21–3 Requirement 1 FedEx is expanding its business as evidenced by the increase in investing activities in 2020 over those activities in 2019 and 2018. In two of the three years it spent more than its cash flow provided by operating activities and borrowed relatively little of the amounts invested in capital expenditures which are productive assets that help maintain and expand operations. Requirement 2 No. But that‘s ok. External financing need not be sufficient to fund those investments because of the substantial internal financing provided by operating activities. Notice that dividends to shareholders are relatively small, so most funds from operating activities are being reinvested in the business. Requirement 3 The six activities listed under financing activities for the fiscal years ended May 31 are: ($ in millions): Financing Activities 2020 2019 2018 Principal payments on debt $ (2,548) $(1,436) $ (38) Proceeds from debt issuances 6,556 2,463 1,480 Proceeds from stock issuances 64 101 327 Dividends paid (679) (683) (535) Purchase of treasury stock (3) (1,480) (1,017) Other, net (9) (4) 10 Cash provided by financing activities $ 3,381 $(1,039) $ 227 The statement tells us that FedEx borrowed much more cash in all three years than it paid to retire debt. A relatively small amount of cash also was received from sale of stock. [Reference to FedEx‘s Statement of Changes in Common Stockholders‘

Investment tells us that stock was sold or granted under employee benefit plans rather than being sold to the public.]

Case 21–3 (concluded) Requirement 4 Companies are required to separately disclose cash payments for both interest and income taxes. When the direct method is used to report operating activities, those amounts automatically are shown. But when a company uses the indirect method, as FedEx does, supplemental disclosure is needed. Note 15 in the disclosure notes serves this purpose: Note 15: Supplemental Cash Flow Information Cash paid for interest expense and income taxes for the years ended May 31 was as follows: In millions

Interest (net of capitalized interest) Cash tax payments, net

2020 $ 639 36

2019 $ 617 371

2018 $ 524 189

Analysis Case 21–4 Requirement 1 Calculations: (a) Cash Beginning balance ? Net increase (from SCF) 183 Ending balance

360

Beginning cash + Net increase in cash = Ending cash Beginning cash + 183 = 360 Beginning cash = 360 – 183 Beginning cash = 177

(b) Accounts Receivable Beginning balance Sales (from IS)

252 240 213 Collected from customers (from SCF)

Ending balance

Ending accounts receivable = Beginning accounts receivable + Sales – Cash collections = 252 + 240 – 213

= 279

Case 21–4 (continued) (c) Accounts Payable 90 Cash paid to suppliers

Beginning balance Purchases

120

Ending balance

Beginning A/P + Purchases – Cash paid = Ending A/P 90 + Purchases – 90 = 120 Purchases + 90 – 90 = 120 Therefore, Purchases = 120 Inventory Beginning balance ? Purchases (from above) 120 96 Cost of goods sold (from IS) Ending balance

180

Beginning inventory + Purchases – Ending inventory = Cost of goods sold Beginning inventory + 120 – 180 = 96 Beginning inventory = 96 – 120 + 180 Beginning inventory = 156

Case 21–4 (continued) (d) Gain on sale of equipment was 45; cash received was 120; therefore, book value of equipment was 75. Since the cost of equipment sold was 150 (600 – 450), accumulated depreciation must have been 75. Summary Entry Cash (from SCF)…………………………………………… Accumulated depreciation (to balance)………………… P, P, & E (450 – 600)…………………………………. Gain on sale of equipment (from IS)……………….

120 75 150 45

Accumulated Depreciation

? 30

Beginning balance Depreciation expense

120

Ending balance

Equipment sold (from above) 75

Beginning accumulated depreciation + Depreciation expense – Accumulated depreciation on equipment sold = Ending accumulated depreciation Beginning accumulated depreciation + 30 – 75 = 120 Beginning accumulated depreciation = 120 – 30 + 75 = 165 (e) Income Tax Payable

? Cash paid (from SCF)

Beginning balance Income tax expense

Ending balance

Beg. IT payable + IT expense – IT paid = Ending IT payable Beg. IT payable = Ending IT payable + IT paid – IT expense Beg. IT payable = 66 + 27 – 21

= 72

Case 21–4 (continued) (f) Retained Earnings

Dividends declared

141 84

Beginning balance Net income

Ending balance

Ending R/E = Beginning R/E + Net income – Dividends = 141 + 84 –9 = 216 DISTINCTIVE INDUSTRIES Comparative Balance Sheets At December 31 2024

2023

Assets: Cash Accounts receivable (net) Inventory Property, plant, and equipment Less: Accumulated depreciation Total assets

$ 360 279 180 450 (120) $1,149

$ 177 252 156 600 (165) $1,020

Liabilities and shareholders’ equity: Accounts payable General and administrative expenses payable Income tax payable Common stock Retained earnings Total liabilities and shareholders‘ equity

$ 120 27 66 720 216 $ 1,149

$ 90 27 72 690 141 $1,020

Case 21–4 (concluded) Requirement 2 DISTINCTIVE INDUSTRIES Statement of Cash Flows For the Year Ended December 31, 2024 ($ in millions) Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation expense Gain on sale of equipment Changes in operating assets and liabilities: Increase in accounts receivable (net) * Increase in inventory ** Increase in accounts payable *** Decrease in income tax payable **** Net cash inflows from operating activities

$ 84 30 (45) (27) (24) 30 (6) $42

* $279 – $252 = $27 ** $180 – $156 = $24 *** $120 – $90 = $30 **** $66 – $72 = $(6)

Real World Case 21–5 Requirement 1 General Mills‘ statement of cash flows indicates an erratic pattern of net income over the most recent three years, decreasing by 17% in 2019 and increasing the next year by about the same amount: $ in millions Net income Increase (decrease) from previous year

2020

2019

2018

$2,110.8 18%

$1,786.2 (17)%

$2,163.0

On the other hand, the statement of cash flows reveals a less erratic pattern for operating cash flows, decreasing by only 1% in 2019 and increasing the next year by a much more sizeable 31%: Net cash provided by operating activities Increase (decrease) from previous year

$3,676.2 31%

$2,807.0 (1)%

$2,841.0

Requirement 2 To supplement their analysis of profitability, or to provide another perspective, many analysts like to look at "free cash flow." A popular way to measure this metric is cash flow from operations minus capital expenditures. Free cash flow is the cash left over after a company pays for its operating expenses and capital expenditures. It shows how efficient a company is at generating cash and whether a company might have enough cash, after funding operations and capital expenditures, to pay investors through dividends and share buybacks. $ in millions Net cash provided by operating activities Less: Capital expenditures (from SCF investing activities) Free cash flow Increase from previous year

2020

2019

2018

$3,676.2 (460.8)

$2,807.0 (537.6)

$2,841.0 (622.7)

$3,215.4 42%

$2,269.4 2%

$2,218.3

Case 21–5 (concluded) Requirement 3 Our calculations reveal a pattern similar to that of cash flow from operations, but showing a small increase in 2019 in place of a small decrease as well as a more pronounced increase in 2020, 42% rather than 31%: $ in millions Net cash provided by operating activities Increase (decrease) from previous year Net cash provided by operating activities Less: Capital expenditures (from SCF investing activities) Free cash flow Increase from previous year

2020

2019

2018

$3,676.2 31%

$2,807.0 (1)%

$2,841.0

$3,676.2 (460.8)

$2,807.0 (537.6)

$2,841.0 (622.7)

$3,215.4 42%

$2,269.4 2%

$2,218.3

This additional analysis suggests that General Mills‘ ability to maintain its dividend payouts is actually less worrisome than at first glance. This is another indication that astute analysts will not rely on single measurements, but will look at each situation from multiple perspectives.

Research Case 21–6 Requirement 1 The specific citation that specifies the classification of notes payable to suppliers is FASB ASC 230–10–45–17: ―Statement of Cash Flows–Overall–Other Presentation Matters–Cash Flows from Operating Activities.‖ Requirement 2 Yes. Accounting is the same for both short-term and long-term notes payable to suppliers.

Real World Case 21–7 Requirement 1 The lessee reports operating lease rent payments, both the interest and liability portions, entirely as operating expenses, but reports the interest portion of financing lease rent payments as a cash outflow from operating activities and the principal portion as a cash outflow from financing activities. Requirement 2 Lease expense…………………… Cash………………………

($ in millions)

1,829 1,829

Requirement 3 Interest expense………………… Lease payable…………………... Cash……………………..

336 409 745

Requirement 4 No. Microsoft did not pay the amounts indicated in addition to incurring lease liabilities for the right-of-use assets for finance leases or operating leases. The amounts indicated are for non-cash leases. Transactions that do not increase or decrease cash, but that result in significant investing and financing activities such as leases, must be reported on a SCF or in related disclosures. Requirement 5 Right-of-use assets……………….. Lease payable……………..

($ in millions)

3,677 3,677

IFRS Case 21–8 Requirement 1 BT‘s statement of cash flows, prepared in accordance with IFRS, classifies cash flows as arising from operating, investing, or financing activities. This classification is the same as cash flow statements prepared in accordance with U.S. GAAP. Requirement 2 BT reports interest received and dividends received as investing activities and interest paid as a financing activity. In its prior year statement, when it paid dividends, BT reported those dividends as a financing activity. IAS No. 7 allows flexibility, permitting companies to report (a) interest and dividends received as operating or investing and (b) interest paid as operating or financing, provided that they are classified consistently from period to period. BT‘s choice is typical of IFRS-based statements. U.S. GAAP designates (a) interest payments and interest received as operating cash flows and (b) dividend payments as financing cash flows and dividends received as operating cash flows.

Ethics Case 21–9 Discussion should include these elements. The apparent situation: There seems to be at least superficial evidence that income is being artificially propped up by management practices that might not be healthy for the company in the long run. Ben apparently suspects the motivation may be partly due to management compensation tied to reported profits. Ethical Dilemma: Does Ben have an obligation to challenge the Questionable practices? If his suspicions are confirmed, what action, if any, should he take?

Who is affected? Ben President, controller, and other managers Shareholders Potential shareholders The employees The creditors The company‘s auditors

Target Case Requirement 1 Cash provided by operating activities increased in fiscal 2019 over the previous year. Requirement 2 Cash provided by operating activities is more than net income in each year reported. Cash flows from operating activities are both inflows and outflows of cash that result from the same activities that are reported in the income statement. The income statement, however, reports the activities on an accrual basis. This means that the income statement reports revenues earned during the reporting period, regardless of when cash is received, and the expenses incurred in generating those revenues, regardless of when cash is paid. Cash flows from operating activities, on the other hand, reports those activities when the cash is exchanged (i.e., on a cash basis).

Requirement 3 Target's largest investing activity is its investment in property and equipment. Investing activities show large expenditures for property and equipment in each year reported.

Target Case (concluded) Requirement 4 Target is decreasing its long-term debt. Payments to reduce long-term debt far exceed cash borrowed with long-term debt in each of the three years reported.

Requirement 5 A statement of cash flows reports transactions that cause an increase or a decrease in cash. Nonetheless, some transactions that don‘t increase or decrease cash, but which result in significant investing and financing activities, must be reported in the statement or related disclosures. Engaging in a significant investing activity and a significant financing activity as two parts of a single transaction does not limit the value of reporting these activities. Examples of noncash transactions that would be reported: 1. Acquiring an asset by incurring a debt payable to the seller. 2. Acquiring an asset by entering into a lease agreement. 3. Converting debt into common stock or other equity securities. 4. Exchanging noncash assets or liabilities for other noncash assets or liabilities. In each of the three years, Target reported Leased assets obtained in exchange for new lease liabilities (both finance and operating leases)

Air France–KLM Case Requirement 1 AF‘s statement of cash flows, prepared in accordance with IFRS, classifies cash flows as arising from operating, investing, or financing activities.

Requirement 2 No. This classification is the same as cash flow statements prepared in accordance with U.S. GAAP.

Requirement 3

AF reports dividends received as investing activities. It reports dividends paid as a financing activity. Interest received and interest paid are reported as operating activities. IAS No. 7 allows flexibility, permitting companies to report (a) interest and dividends received as operating or investing and (b) interest paid as operating or financing, provided that they are classified consistently from period to period. U.S. GAAP designates (a) interest payments and interest received as operating cash flows and (b) dividend payments as financing cash flows and dividends received as operating cash flows. Requirement 4 Yes. U.S. GAAP designates dividends received as operating cash flows.

Appendix A Derivatives QUESTIONS FOR REVIEW OF KEY TOPICS

Question A–1 These instruments ―derive‖ their values or contractually required cash flows from some other security or index.

Question A–2 The FASB has taken the position that the income effects of the hedge instrument and the income effects of the item being hedged should be recognized at the same time.

Question A–3 If interest rates change, the change in the debt‘s fair value will be less than the change in the swap‘s fair value. The gain or loss on the $500,000 notional difference will not be offset by a corresponding loss or gain on debt. Any increase or decrease in income resulting from a hedging arrangement designated as a fair value hedge would be a result of differences such as this. As long as the derivative instrument is considered ―highly effective‖ in offsetting the changes in fair value of the debt, then hedge accounting may be used.

Question A–4 A futures contract is an agreement between a seller and a buyer that calls for the seller to deliver a certain commodity (such as wheat, silver, or Treasury bond) at a specific future date, at a predetermined price. Such contracts are actively traded on regulated futures exchanges. When the contract involves a financial instrument, such as a Treasury bill, commercial paper, or a CD, the contract is called a financial futures agreement.

Question A–5 An interest rate swap exchanges fixed interest payments for floating rate payments, or vice versa, without exchanging the underlying notional amount. The interest expense then reflects the rate(s) to which the interest has been swapped. If the interest rate swap is designated as a fair value hedge, the interest expense also reflects offsetting gains and losses on the fair value of the swap and the fair value of the hedged asset or liability.

Question A–6 All derivatives are reported on the balance sheet as either assets or liabilities at fair (or market) value. The rationale is that (a) derivatives create either rights or obligations that meet the FASB‘s definition of assets or liabilities and (b) fair value is the most meaningful measurement.

Question A–7 A gain or loss from a cash flow hedge is deferred as other comprehensive income until it can be recognized in earnings along with the earnings effect of the item being hedged. At that time, it will be reported in the income statement in the same line items as the income or expense from the item that was hedged.

EXERCISES

Exercise A–1 Indicate (by abbreviation) the type of hedge each activity described below would represent. Hedge Type FV Fair value hedge CF Cash flow hedge FC Foreign currency hedge N Would not qualify as a hedge Activity FV 1. An options contract to hedge possible future price changes of inventory. CF 2. A futures contract to hedge exposure to interest rate changes prior to replacing bank notes when they mature. CF 3. An interest rate swap to synthetically convert floating rate debt into fixed rate debt. FV 4. An interest rate swap to synthetically convert fixed rate debt into floating rate debt. FV 5. A futures contract to hedge possible future price changes of timber covered by a firm commitment to sell. CF 6. A futures contract to hedge possible future price changes of a forecasted sale of aluminum. FC 7. ExxonMobil‘s net investment in offshore drilling operations in Brazil. CF 8. An interest rate swap to synthetically convert floating rate interest on an available-for-sale debt investment into fixed rate interest. N 9. An interest rate swap to synthetically convert fixed rate interest on a heldto-maturity debt investment into floating rate interest. FV 10. An interest rate swap to synthetically convert fixed rate interest on an available-for-sale debt investment into floating rate interest.

Exercise A–2 Requirement 1 January 1 Fair value of interest rate swap Fair value of notes payable Fixed rate – swap Floating rate – swap Fixed interest receipts Floating interest payments Net interest receipts

March 31

June 30

September 30

11,394

9,565

$ 211,394 10% 6% $ 5,000 (4,000) $ 1,000

209,565 10% 6% 5,000 (3,000) 2,000

6,472

200,000 10% 10%

206,472 10% 8% 5,000 (5,000) 0

$ $

Note: This is a fair value hedge, swapping a fixed interest rate for a variable interest rate. Thus, if the variable rate is less than the fixed rate, cash will be collected in the net settlement. If the variable rate is more than the fixed rate, cash will be paid in the net settlement. In this exercise, the variable rate always is less than the fixed rate and thus the net settlement is only of cash receipts.

Exercise A–2 (continued) Requirement 2 January 1 Cash Notes payable To record the issuance of the note March 31 Interest expense ([10% x ¼] x $200,000) Cash To record interest on the note

200,000 200,000

5,000 5,000

Interest rate swap [asset] ($6,472 – $0) Interest expense To record change in fair value of the derivative

6,472

Interest expense Notes payable ($206,472 – $200,000) To record change in fair value of the note

6,472

June 30 Interest expense ([10% x ¼] x $200,000) Cash To record interest on the note

6,472

5,000 5,000

Cash ($5,000 – ([8% x ¼] x $200,000)) Interest expense To record the net cash settlement on the swap

1,000

Interest rate swap [asset] ($11,394 – $6,472) Interest expense To record change in fair value of the derivative

4,922

Interest expense Notes payable ($211,394 – $206,472) To record change in fair value of the note

4,922

1,000

4,922

Exercise A–2 (continued) Note: With the shortcut method, calculating the fair value of the note is unnecessary. The shortcut method assumes that the change in fair value of the note is the same as the change in the fair value of the hedging instrument. Requirement 2 (continued) September 30 Interest expense ([10% x ¼] x $200,000) Cash To record interest on the note

5,000 5,000

Cash ($5,000 – ([6% x ¼] x $200,000)) Interest expense To record the net cash settlement on the swap

2,000

Interest expense Interest rate swap [asset] ($9,565 - $11,394) To record change in fair value of the derivative

1,829

Notes payable ($209,565 – $211,394) Interest expense To record change in fair value of the note

1,829

2,000

1,829

Exercise A–2 (concluded) Requirement 3 March 31

June 30

$6,472

$11,394

$200,000

$206,472

$211,394

Fixed rate

10%

Floating rate

10%

Fixed interest receipts

$5,000

Floating payments

4,000

3,000

Net interest receipts (payments)

$1,000

$2,000

January 1 Fair value of interest rate swap Fair value of note payable

Note: With an interest rate swap-in-arrears, the rates are reset at the end of the period and paid at the end of the period when determining the net cash settlement. Thus, in this exercise, the cash receipts are moved forward one period.

Exercise A–2 (concluded) Journal entries – swap-in-arrears January 1 Cash Notes payable To record the issuance of the note March 31 Interest expense ([10% x ¼] x $200,000) Cash To record interest on the note

200,000 200,000

5,000 5,000

Cash ($5,000 – ([8% x ¼] x $200,000)) Interest expense To record the net cash settlement on the swap

1,000

Interest rate swap [asset] ($6,472 – $0) Interest expense To record change in fair value of the derivative

6,472

Interest expense Notes payable ($206,472 – $200,000) To record change in fair value of the note

6,472

June 30 Interest expense ([10% x ¼] x $200,000) Cash To record interest on the note

1,000

6,472

5,000 5,000

Cash ($5,000 – ([6% x ¼] x $200,000)) Interest expense To record the net cash settlement on the swap

2,000

Interest rate swap [asset] ($11,394 – $6,472) Interest expense To record change in fair value of the derivative

4,922

Interest expense Notes payable ($211,394 – $206,472)

4,922

2,000

4,922

To record change in fair value of the note

Exercise A–3 Requirement 1

Fair value of interest rate swap Fair value of note payable Fixed rate Floating rate Fixed receipts Floating payments Net interest receipts (payments)

June 30 $11,394 $220,000 10% 6% $5,000 ([10% x ¼] x $200,000) (4,000) ([8% x ¼] x $200,000) $1,000

Exercise A–3 (concluded) Requirement 2 Your entries would be the same whether there was or was not an additional rise in the fair value of the note (higher than that of the swap) on June 30 due to investors‘ perceptions that the creditworthiness of LLB was improving. When a note‘s fair value changes by an amount different from that of a designated hedge instrument for reasons unrelated to interest rates, we ignore those changes. We recognize only the fair value changes in the hedged item that we can attribute to the risk being hedged (interest rate risk in this case). The entries would be: June 30 Interest expense ([10% x ¼] x $200,000) Cash To record interest on the note

5,000 5,000

Cash ($5,000 – ([8% x ¼] x $200,000) Interest expense To record the net cash settlement on the swap

1,000

Interest rate swap [asset] ($11,394 – $6,472) Interest expense To record change in fair value of the derivative

4,922

Interest expense Notes payable ($211,394 – $206,472) To record change in fair value of the note due to interest

4,922

1,000

4,922

Exercise A–4 January 1 Cash Notes payable To record the issuance of the note March 31 Interest expense ([10% x ¼] x $200,000) Cash To record interest on the note Interest rate swap ($6,472 – $0) Interest expense To record change in fair value of the derivative

200,000 200,000

5,000 5,000 6,472 6,472

Interest expense 6,472 Notes payable ($206,472 – $200,000) To record change in fair value of the note due to interest rates. June 30 Interest expense ([8% x ¼] x $206,472) Notes payable (difference) Cash ([10% x ¼] x $200,000) To record interest on the note Cash ($5,000 – ([8% x ¼] x $200,000)) Interest rate swap ($11,394 – $6,472) Interest expense (interest on swap: [8% x ¼] x $6,472) Interest expense (change in fair value to balance) To record the net cash settlement, accrued interest on the swap, and change in fair value of the derivative

6,472

4,129 871 5,000

1,000 4,922

Interest expense 5,793 Notes payable ($211,394 – $206,472 + $871) To record change in fair value of the note due to interest rates

129 5,793

5,793

Exercise A–4 (concluded) September 30 Interest expense ([6% x ¼] x $211,394) Notes payable (difference) Cash ([10% x ¼] x $200,000) To record interest on the note Cash ($5,000 – ([6% x ¼] x $200,000)) Interest rate swap ($9,565 – $11,394) Interest expense (interest on swap: [6% x ¼] x $11,394) To record the net cash settlement, accrued interest on the swap, and change in fair value of the derivative

3,171 1,829 5,000

2,000 1,829 171

Note: Since there was no change in the interest rate from June 30 to September 30, there is no change in fair value of the hedging instrument or the hedged item related to changes in interest rates.

Exercise A–5 Requirement 1

Fair value of interest rate swap Fair value of note payable Fixed rate Floating rate Fixed receipts Floating payments Net interest receipts (payments)

June 30 $11,394 $220,000 10% 8% $5,000 ([10% x ¼] x $200,000) (4,000) ([8% x ¼] x $200,000) $1,000

Exercise A–5 (concluded) Requirement 2 Your entries would be the same whether there was or was not an additional rise in the fair value of the note (higher than that of the swap) on June 30 due to investors‘ perceptions that the creditworthiness of LLB was improving. When a note‘s fair value changes by an amount different from that of a designated hedge instrument for reasons unrelated to the hedged risk, we ignore those changes. We recognize only the fair value changes in the hedged item that we can attribute to the risk being hedged (interest rate risk in this case). The entries would be: June 30 Interest expense ([8% x ¼] x $206,472) Notes payable (difference) Cash ([10% x ¼] x $200,000) To record interest on the note Cash ($5,000 – ([8% x ¼] x $200,000)) Interest rate swap ($11,394 – $6,472) Interest expense (interest on swap [8% x ¼] x $6,472) Interest expense (change in fair value to balance) To record the net cash settlement, accrued interest on the swap, and change in fair value of the derivative

4,129 871 5,000

1,000 4,922

Interest expense 5,793 Notes payable ($211,394 – $206,472 + $871) To record change in fair value of the note due to interest rates

129 5,793

5,793

Exercise A–6 Requirement 1 1/1/24 Fair value of interest rate swap Fixed rate – swap Floating rate – swap Fixed interest payments Floating interest receipts Net interest receipts (payments)

6/30/24 0

4% 4% $ $

(20,901) $ 4% 3% (10,000) $ 10,000 0 $

12/31/24 17,925 4% 5% (10,000) 7,500 (2,500)

6/30/25 $

$ $

23,585 4% 5.5% (10,000) 12,500 2,500

Note: This is a fair value hedge on an investment security, swapping interest revenue based on a fixed interest rate for revenue and cash flows based on a variable interest rate. Thus, when hedging the fair value of a fixed income security, if the variable rate at the beginning of the settlement period (i.e., the rate at the end of the prior period) is less than the fixed rate, cash will be paid in the net settlement. If the variable rate is more than the fixed rate, cash will be received in the net settlement.

Exercise A–6 (continued) Requirement 2 1/1/2024 Investment in notes Cash To record the investment of the note 6/30/2024 Cash Interest revenue ([4% x ½] x 500,000) To record interest received on the note Interest revenue Interest rate swap [liability] ($20,901 – $0) To record change in fair value of the derivative

500,000 500,000

10,000 10,000 20,901 20,901

20,901 Investment in notes (same as swap adjustment) Interest revenue To record change in fair value of the investment – shortcut method 12/31/2024 Cash Interest revenue ([4% x ½] x 500,000) To record interest received on the note Interest revenue Cash ($10,000 – ([3% x ½] x $500,000)) To record the net cash settlement on the swap

20,901

10,000 10,000 2,500

Interest rate swap [asset] 38,826 Interest revenue To record the change in fair value of the derivative from a liability of $20,901 to an asset of $17,925. 38,826 Interest revenue Investment in notes (same as swap adjustment) To record change in fair value of the investment – shortcut method

2,500

38,826

Exercise A–6 (concluded) 6/30/2025 Cash Interest revenue ([4% x ½] x 500,000) To record interest received on the note

10,000

Cash ($10,000 – ([5% x ½] x $500,000) Interest revenue To record the net cash settlement on the swap

2,500

Interest rate swap [asset] ($23,585 – $17,925) Interest revenue To record the change in fair value of the derivative

5,660

10,000

2,500

5,660 Interest revenue Investment in notes (same as swap adjustment) To record change in fair value of the investment – shortcut method

5,660

Exercise A–7 Requirement 1 Fair value of futures contract Fair value of firm commitment

January 3 $ 0 0

March 31 $20,000 20,000

Receipts—futures contract Payment at spot rate Net cash receipts (payments)

April 30 $30,000 30,000 $630,000 600,000 $ 30,000

Requirement 2 January 3 Document the firm commitment to purchase iron ore and the futures contract to sell iron ore, but no formal entry. Futures contract is issued at the current/spot price; no cash is exchanged at the inception of the contract. March 31 Futures contract to sell iron ore [($63 – $61) × 10,000] Cost of goods sold To record the change in fair value of the futures contract.

20,000

Cost of goods sold Firm commitment to purchase iron ore To record the change in fair value of the firm commitment.

20,000

Exercise A–7 (concluded) April 30 Futures contract to sell iron ore [($61 – $60) × 10,000] Cost of goods sold To record the change in fair value of the futures contract.

10,000

Cost of goods sold Firm commitment to purchase iron ore To record the change in fair value of the firm commitment.

10,000

Cash Futures contract to sell iron ore To record the net settlement of the futures contract.

30,000

Inventory Firm commitment to purchase iron ore Cash To record the purchase of inventory.

600,000 30,000

10,000

30,000

630,000

Exercise A–8 Requirement 1 6/30/24 Futures Wheat Contract 3/31/24 Futures price – end of period (3/31) Futures price – beginning of period (1/1) Change in price per bushel Bushels hedged under contract Change in fair value – gain (loss) at 3/31

$6.77 6.73 $0.04 x 20,000 $ 800

6/30/24 Spot price at 6/30/24 (end of contract) Futures price – beginning of period (3/31) Change in price per bushel Bushels hedged under contract Change in fair value – gain (loss) at 6/30/24

$6.90 6.77 $0.13 x 20,000 $ 2,600

Cumulative change in fair value/expected cash flows – gain (loss) on contract

$3,400

Requirement 2 1/1/24 Document the hedging relationship and the futures contract, but there is no journal entry required because the futures contract has a fair value of zero at inception and no cash is exchanged. 3/31/24 Futures contract – wheat [($6.77 – $6.73) × 20,000] Other comprehensive income (OCI) – gain To record the change in fair value of the futures contract.

800 800

Exercise A–8 (concluded) 6/30/24 Futures contract – wheat [($6.90 – $6.73) × 20,000] Other comprehensive income (OCI) – gain To record the change in fair value of the futures contract.

2,600

Cash Futures contract – wheat To record the net settlement of the futures contract.

3,400

Inventory – wheat Cash To record the purchase of wheat inventory at the spot rate.

2,600

3,400

138,000 138,000

Requirement 3 9/30/24 Cost of goods sold (to balance) 134,600 Other comprehensive income (OCI) 3,400 Inventory – wheat 138,000 To record the utilization of the wheat inventory and reclassify the related hedge amounts deferred in OCI into earnings.

Exercise A–9 Requirement 1 Deliver ¥ and receive USD at contract rate (¥105/US $1) Pay USD and receive ¥ at spot rate (¥110/US $1) Net cash receipt (payment)

$476,190 (454,545) $ 21,645

Requirement 2 January 1 No formal entry required, since the forward rate equals the contract rate. March 31 Forward contract Other comprehensive income (OCI) – gain To record the change in the fair value of the derivative. June 30 Forward contract Other comprehensive income (OCI) – gain To record the change in the fair value of the derivative. Cash Forward contract To record the net cash settlement of the forward contract.

13,227 13,227

8,418 8,418

21,645 21,645

454,545 Cash Sales 454,545 To record ¥50,000,000 in cash sales at the spot rate of ¥110/US $1.00.

Other comprehensive income (OCI) 21,645 Sales 21,645 To transfer the gain on the hedge activity from OCI to earnings. 1–1642 Intermediate Accounting, 11e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Exercise A–10 Requirement 1 6/30/24 Receive floating interest ($300,000×6%×½) Pay fixed interest ($300,000×6%×½) Net cash receipt (payment)

$9,000 (9,000) $ 0

12/31/24 Receive floating interest ($300,000×5.5%×½) Pay fixed interest ($300,000×6%×½) Net cash receipt (payment)

$8,250 (9,000) $ ( 750)

Requirement 2 1/1/24 Cash Notes payable To record the debt. 6/30/24 Interest expense (6% × $300,000 × ½) Cash To record interest on the note. Other comprehensive income (OCI) – loss Interest rate swap [liability] To record the change in the fair value of the derivative.

300,000 300,000

9,000 9,000

3,459 3,459

At June 30, 2024, there is no cash exchanged for settlement of the interest rate swap, because the cash settlement is based on beginning-of-year rates (when both the fixed and floating rates were 6%). JPS does recognize a decrease in the fair value of the interest rate swap, related to the declining interest rates in the upcoming six months. This decrease in fair value is recognized in other comprehensive income.

Exercise A–10 (concluded) 12/31/24 Interest expense (5.5% × $300,000 × ½) Cash To record interest on the note. Interest expense Cash [(6% × $300,000 × ½) – $8,250] To record the net cash settlement on the swap. Interest rate swap [asset] Other comprehensive income (OCI) – gain To record the change in the fair value of the derivative from a liability of $3,459 to an asset of $5,510.

8,250 8,250

750 750

8,969 8,969

PROBLEMS

Problem A–1 Requirement 1 Avalanche meets all criteria for hedge accounting using the shortcut method. The shortcut method greatly simplifies the hedge effectiveness assessment for the interest rate swap by allowing Avalanche to assume that the hedging relationship is perfectly effective. As a result, the change in the fair value of the hedged item (debt) due to the interest rate risk being hedged is assumed to mirror the change in the fair value of the interest rate swap. In other words, if the fair value of the interest rate swap increases by $1,000, then the fair value of the debt attributable to interest rate risk is assumed to decrease by $1,000. Requirement 2 Fixed rate – swap Floating rate – swap

1/1/24

6/30/24

12/31/24

6/30/25

12/31/25

5% 5%

5% 6%

5% 4%

5% 3%

$2,500 (2,500) $ 0

$2,500 (3,000) $ (500)

$2,500 (2,000) $ 500

$2,500 (1,500) $1,000

Fixed receipts – swap Floating payments – swap Net receipts (payments)

Requirement 3 January 1, 2024 Cash Notes payable To record the issuance of the note

100,000 100,000

Problem A–1 (continued) June 30, 2024 Interest expense (8% × ½ × $100,000) Cash To record interest on the note

4,000 4,000

Interest expense (to balance) Interest rate swap [liability] (0 – $1,414) To record the change in fair value of the derivative

1,414

Notes payable (same as swap adjustment) Interest expense To record change in fair value of the note

1,414

December 31, 2024 Interest expense (8% × ½ × $100,000) Cash To record interest on the note Interest expense Cash ($2,500 fixed leg – [6% × ½ × $100,000]) To record the net cash settlement on the swap

1,414

4,000 4,000

500 500

Interest rate swap [asset] ($971 – [–1,414]) Interest expense (to balance) To record the change in fair value of the derivative from a liability of $1,414 to an asset of $971.

2,385

Interest expense (same as swap adjustment) Notes payable (to balance) To record change in fair value of the note due to interest

2,385

Problem A–1 (continued) Requirement 4 June 30, 2025 Interest expense (8% × ½ × $100,000) Cash To record interest on the note

4,000 4,000

Cash ($2,500 fixed leg – [4% × ½ × $100,000]) Interest expense To record the net cash settlement on the swap

500

Interest rate swap ($985 – 971) Interest expense (to balance) To record the change in fair value of the derivative

Notes payable (same as swap adjustment) Interest expense To record change in fair value of the note due to interest

December 31, 2025 Interest expense (8% × ½ × $100,000) Cash To record interest on the note

500

4,000 4,000

Cash ($2,500 fixed leg – [3% × ½ × $100,000]) Interest expense To record the net cash settlement on the swap

1,000

Interest expense (to balance) Interest rate swap (0 – $985) To record the change in fair value of the derivative

985

Notes payable (same as swap adjustment)

985

1,000

985

Interest expense To record change in fair value of the note due to interest Notes payable Cash To repay the loan

985

100,000 100,000

Problem A–1 (continued) Requirement 5 Swap Jan. 1, 2024 June 30, 2024 Balance

1,414 1,414

Note 100,000 1,414 98,586

Dec. 31, 2024

2,385

Balance

971

100,971

June 30, 2025

Balance

985

100,985 985

Dec. 31, 2025 Balance

985 100,000 0

Problem A–1 (concluded) Requirement 6 Income Statement  () Six-month period ending June 30, 2024 $(4,000) Interest expense – notes payable (1,414) Interest expense—loss on interest rate swap 1,414 Interest expense—gain on hedged note $(4,000) Net effect—same as effective rate on debt (SOFR + 3%) Six-month period ending December 31, 2024 $(4,000) Interest expense – notes payable (500) Interest expense – net cash settlement 2,385 Interest expense—gain on interest rate swap (2,385) Interest expense—loss on hedged note $(4,500) Net effect— same as effective rate on debt (SOFR + 3%) Six-month period ending June 30, 2025 $(4,000) Interest expense – notes payable 500 Interest expense – net cash settlement 14 Interest expense—gain on interest rate swap (14) Interest expense—loss on hedged note $(3,500) Net effect— same as effective rate on debt (SOFR + 3%) Six-month period ending December 31, 2025 $(4,000) Interest expense – notes payable 1,000 Interest expense – net cash settlement (985) Interest expense—loss on interest rate swap 985 Interest expense—gain on hedged note $(3,000) Net effect— same as effective rate on debt (SOFR + 3%)

Problem A–2 Requirement 1 6/30/24

12/31/24

6/30/25

12/31/25

A: Cumulative change in the fair value of interest rate swap B: Cumulative change in the fair value of debt due to changes in SOFR

$1,414

$ 971

$ 985

1,374

950

971

Effectiveness % (A ÷ B)

102.9%

102.2%

101.4%

n/a

Requirement 2 Fixed rate – swap Floating rate – swap

1/1/24

6/30/24

12/31/24

6/30/25

12/31/25

5% 5%

5% 6%

5% 4%

5% 3%

$2,500 (2,500) $ 0

$2,500 (3,000) $ (500)

$2,500 (2,000) $ 500

$2,500 (1,500) $1,000

Fixed receipts – swap Floating payments – swap Net receipts (payments)

Requirement 3 January 1, 2024 Cash Notes payable To record the issuance of the note

100,000 100,000

Problem A–2 (continued) June 30, 2024 Interest expense (8% × ½ × $100,000) Cash To record interest on the note

4,000 4,000

Interest expense (to balance) Interest rate swap [liability] (0 – $1,414) To record the change in fair value of the derivative

1,414

Notes payable (given) Interest expense To record change in fair value of the note

1,374

December 31, 2024 Interest expense (9% × ½ × [$100,000 - $1,374]) Notes payable (to balance) Cash To record interest on the note at the effective rate Interest rate swap [asset] ($971 – [-$1,414]) Interest expense (interest on swap: [6% × ½] x $1,414) Interest expense (change in fair value to balance) Cash ($2,500 fixed leg – [6% × ½] x $100,000) To record the net cash settlement, accrued interest on the swap, and change in fair value of the derivative from liability to asset

1,414

1,374

4,438 438 4,000

2,385 42

Interest expense 1,886 Notes payable ($950 – [-$1,374] - $438) To record change in fair value of the note due to interest rates

1,927 500

1,886

Problem A–2 (continued) Requirement 4 June 30, 2025 Interest expense (7% × ½ × [$100,000 + $950]) Notes payable (to balance) Cash To record interest on the note Cash ($2,500 fixed leg – [4% × ½] x $100,000) Interest rate swap ($985 – 971) Interest expense (interest on swap: [4% × ½] x $971) Interest expense (change in fair value to balance) To record the net cash settlement, accrued interest on the swap, and change in fair value of the derivative

3,533 467 4,000

500 14

Interest expense 488 Notes payable ($950 – $971 - $467) To record change in fair value of the note due to interest rates

19 495

488

December 31, 2025 Interest expense (6% × ½ × [$100,000 + $971]) Notes payable (to balance) Cash To record interest on the note Cash ($2,500 fixed leg – [3% × ½] x $100,000) Interest expense (interest on swap: [3% × ½] x $985) Interest rate swap ($0 – $985) To record the net cash settlement, accrued interest on the swap, and change in fair value of the derivative Notes payable Cash To repay the loan

3,029 971 4,000

1,000 15 985

100,000 100,000

Problem A–2 (continued) Requirement 5 Swap Jan. 1, 2024 June 30, 2024 Balance

1,414 1,414

Dec. 31, 2024

2,385

Balance

971

June 30, 2025

Balance

985

Balance

438 1,886 100,950 467

488 100,971

985

Dec. 31, 2025

Note 100,000 1,374 98,626

971 100,000 0

Problem A–2 (concluded) Requirement 6 Income Statement  () Six-month period ending June 30, 2024 $(4,000) Interest expense – effective rate (SOFR+3% = 8%) (1,414) Interest expense—loss on interest rate swap 1,374 Interest expense—gain on hedged note $(4,040) Net effect—hedge is highly but not perfectly effective Six-month period ending December 31, 2024 $(4,438) Interest expense – effective rate (SOFR+3% = 9%) (42) Interest expense—accrued interest on swap 1,927 Interest expense – gain on interest rate swap (1,886) Interest expense—loss on hedged note $(4,439) Net effect— hedge is highly but not perfectly effective Six-month period ending June 30, 2025 $(3,533) Interest expense – effective rate (SOFR+3% = 7%) 19 Interest expense – accrued interest on swap 495 Interest expense—gain on interest rate swap (488) Interest expense—loss on hedged note $(3,507) Net effect— hedge is highly but not perfectly effective Six-month period ending December 31, 2025 $(3,029) Interest expense – effective rate (SOFR+3% = 6%) 15 Interest expense—accrued interest on swap $(3,014) Net effect— hedge is highly but not perfectly effective

Problem A–3 Requirement 1 CMOS has an unrealized gain due to the increase in the value of the derivative (not necessarily the same amount). Because interest rates declined, the swap will enable CMOS to pay the lower floating rate (receive cash on the net settlement of interest). The value of the swap (an asset) represents the present value of expected future net cash receipts. That amount has increased, as has the swap‘s fair value, creating the unrealized gain. There is an offsetting loss on the bonds (a liability) because the fair value of the company‘s debt has increased. Because the loss on the bonds exactly offsets the gain on the swap, earnings will neither increase nor decrease due to the hedging arrangement.

Requirement 2 CMOS would have an unrealized loss due to the decrease in the value of the derivative. Because interest rates increased, the swap will cause CMOS to pay the higher floating rate (pay cash on the net settlement of interest). The value of the swap (an asset) represents the present value of expected future net cash receipts. That amount has decreased, as has the swap‘s fair value, creating the unrealized loss. There is an offsetting gain on the bonds (a liability) because the fair value of the company‘s debt has decreased. Because the gain on the bonds exactly offsets the loss on the swap, earnings will neither increase nor decrease due to the hedging arrangement.

Problem A-3 (continued) Requirement 3 The unrealized gain on the swap and loss on the bonds would not be affected. When a hedged debt‘s fair value changes by an amount different from that of a designated hedge instrument for reasons unrelated to the hedged risk (in this case, interest), we ignore those changes. We recognize only the fair value changes in the hedged item that we can attribute to interest rate risk in this case. Because the loss on the bonds exactly offsets the gain on the swap, earnings will neither increase nor decrease due to the hedging arrangement.

Requirement 4 There would be an unrealized gain due to the increase in the value of the derivative, and there is an unrealized loss on the bonds (a liability). However, the gain on the derivative would be $5,000 more than the loss on the bonds. Because the loss on the bonds is less than the gain on the swap, earnings will increase by $5,000 (ignoring taxes) due to the hedging arrangement. This effect results from the hedge not being perfectly effective. To the extent that a hedge is effective and the company applies hedge accounting, the earnings effect of a derivative will cancel out the earnings effect of the item being hedged. All ineffectiveness of a fair value hedge is recognized currently in earnings.

Problem A–3 (concluded) Requirement 5 There would be an unrealized loss due to a decrease in the value of the derivative, a liability to BIOS. Because interest rates declined, the swap would cause BIOS to receive a lower floating rate (and, perhaps, pay cash on the net settlement of interest). The value of the swap represents the present value of expected future net cash payments. Thus, in a pay-fixed, receive-variable swap, a decline in interest rates lowers those expected future cash receipts or increases the expected future payments This decreases the fair value of the swap, creating the unrealized loss. There would be an offsetting gain, though, on the bond investment because the fair value of the company‘s investment has increased. Because the gain on the bonds exactly offsets the loss on the swap, earnings will neither increase nor decrease due to the hedging arrangement.

DECISION MAKERS’ PERSPECTIVE CASES Real World Case A–1 Requirement 1 When Johnson & Johnson indicates that it expects that substantially all of the balance of deferred net gains on derivatives will be reclassified into earnings over the next 12 months as a result of transactions that are expected to occur over that period, it is saying that these as-yet-unrecognized net gains will be included in net income. A gain or loss from certain hedges is deferred as other comprehensive income until it can be recognized in earnings along with the earnings effect of the item being hedged. Requirement 2 A gain or loss from a ―fair value‖ hedge is recognized immediately in earnings along with the loss or gain on the hedged item that is attributable to the hedged risk. On the other hand, a gain or loss from a cash flow hedge is deferred in the manner described by Johnson & Johnson until it can be recognized in earnings along with the earnings effect of the item being hedged. The hedging transactions referred to by Johnson & Johnson could be related to foreign currency hedges that are used to hedge foreign currency exposure to a forecasted transaction. Those types of foreign currency hedges are treated as cash flow hedges.

Communication Case A–2 Depending on the assumptions made, different views can be convincingly defended. The process of developing and synthesizing the arguments likely will be more beneficial than any single solution. Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Hedging means taking an action that is expected to produce exposure to a particular type of risk that‘s precisely the opposite of an actual risk to which the company already is exposed. Under existing hedge accounting, if the contract meets specified hedging criteria, the income effects of the hedge instrument and the income effects of the item being hedged should be recognized at the same time. Arguments raised may focus on a variety of issues including: • Which hedges should qualify for special accounting? Hedges of risk of loss? Hedges that reduce the variability of outcomes? • Should treatment be different for fair value hedges and cash flow hedges? • Should only risk exposures arising from existing assets or liabilities qualify for special accounting? Should anticipated transactions be included also? • To what extent, if any, must there be correlation between the gains and losses on the hedge instrument and the item being hedged? • How should any deferred gain or loss be classified prior to recognition?

Target Case

Requirement 1 According to Note 16, Target entered into three swap agreements with varying notional amounts. However, all the swap agreements work the same way. Under the agreements, Target pays a floating rate equal to the 1-month LIBOR rate and received a fixed rate (an average of 2.5% and 2.9% annual rate, depending on the swap). That is, the agreement is a pay-floating, receive-fixed agreement. If the floating rate is higher than the fixed rate used to calculate the net settlement, Target will pay a net cash settlement. In contrast, if the floating rate is lower than the fixed rate used to calculate the net settlement, then Target will receive a net cash settlement. Requirement 2 Target has designated its interest rate swaps as fair value hedges. By entering into a swap by which it pays a floating rate and receives a fixed rate, it is effectively converting its debt into floating rate debt. Target would likely do this if it was concerned that interest rates were going to decline, which would cause the fair value of its existing fixed rate debt to increase. Requirement 3 Per Note 16, Target has a gain on the fair value of its interest rate swaps for the fiscal year ended February 1, 2020. This gain was recognized in interest expense. The hedging relationship was perfectly effective, and Target recognized an exactly offsetting loss on the fair value of its debt for the same period which was also recognized into interest expense. Requirement 4 According to Note 6, Target recorded a $137 million interest rate swap asset on its balance sheet in noncurrent assets. Per Note 15, it also has a corresponding increase to the carrying value of its debt of the same amount ($137 million) related to the interest rate swaps.

Air France/KLM Case Requirement 1 In Notes 36:1 and 36:2, AF lists the following risk exposures, along with the various derivative instruments to hedge its risk exposures: Commodity Risk—Jet Fuel Prices – oil price volatility is a risk for the industry, especially sharp increases that cannot be adjusted through ticket prices. AF hedges jet fuel prices with swap and option contracts based on crude oil, gas oil and jet fuel prices (cash flow hedges). Currency Risk—US Dollar Exposure – AF‘s revenues are generated in euros, but because of international activities, the principal exposure relates to US dollars, because of significant expenditures on items based in USD. AF hedges its foreign currency risk with exchange rate options and forward purchases and sales contracts that are designated as cash flow hedges for its operating flows and fair value hedges for the investment in flight equipment. Interest Rate Risk-debt – a portion of AF‘s debt is contracted at floating rates. AF/KLM use option and swap strategies to effectively convert a significant portion of floating rate debt to fixed rate debt.

Requirement 2 Air France/KLM recognizes $496 million of derivative instruments in the other assets section ($258 current; $238 noncurrent) of their balance sheet, and $261 million ($154 current; $107 non-current) as other liabilities.

GAAP COMPREHENSIVE CASE PART A: FINANCIAL STATEMENTS, INCOME MEASUREMENT, AND CURRENT ASSETS

Question A1 a. Total revenues = b. Income from current operations = c. Net income or net loss = d. Total assets = e. Total equity = Question A2

$77,130 million $ 3,269 million $ 3,281 million $42,779 million $11,833 million

Target‘s basic earnings per share was $6.42.

Question A3 Target‘s fiscal year end is February 1, 2020. The accounting profession and the SEC encourage companies to adopt a fiscal year that corresponds to a natural business year, ending when a company‘s business cycle is at its lowest point. December 31 is in the hectic holiday shopping season at a time when stores are processing Christmas returns and offering after-holiday and New Year‘s sales, so it clearly is not at a low point in the business cycle. February 1 occurs after the holiday shopping season concludes, so it makes sense for Target to use that date as its fiscal year end. Question A4 a. Target‘s auditor is Ernst & Young LLP. b. Target received a ―clean‖ (unmodified) audit opinion. Specifically: ―In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Corporation at February 1, 2020 and February 2, 2019, and the results of its operations and its cash flows for each of the three years in the period ended February 1, 2020, in conformity with U.S. generally accepted accounting principles.‖ c. Target‘s audit report includes 2 critical audit matters: (1) Target‘s use of the retail inventory accounting method, and (2) Target‘s use of vendor income receivables.

Question A1666 ($ in millions) Assets = Liabilities + Shareholders‘ Equity $42,779 = $30,946a + $11,833 a

Total liabilities are computed as current liabilities ($14,487) + noncurrent liabilities ($16,459).

Question A1667

(€ in millions)

(a) Cash ................................................................. Sales Revenue.............................................. (b) Cost of goods sold ............................................ Inventory ..................................................... (c) Inventory.......................................................... Cash ............................................................

77,130 77,130 54,864 54,864 54,359a 54,359

Beginning inventory + Purchases – Cost of goods sold = Ending inventory $9,497 + Purchases – $54,864 = $8,992 Purchases = $54,359 a

Question A1668

Note 9, ― Other Current Assets,‖ reports Prepaid expenses of $154 million and $157 million for the years ended February 1, 2020, and February 2, 2019, respectively. Assuming this pertains to prepaid insurance, insurance expense must have exceeded the amount paid for insurance coverage, because the balance decreased during the year. We can visualize the change with a T account: Prepaid Insurance

Beginning balance 157 50 Insurance expense Cash paid for insurance

50 50

Question ($ in millions) A1669 (a) $416 = $6,433 – $6,017 (b) Change in retained earnings = Net income – $2,865 Net income = $416 + $2,865 = $3,281 (as shown in the income statement also)

Question A9 Consolidated Statements of Financial Position.

Question A1672 a. $12,902. b. $29,877. c. $42,779. d. $14,487. e. $16,459. f. $30,946. g. $11,833.

Question A1673 Inventory; Accounts payable.

Question A1674 Current ratio = $12,902/$14,487 = 0.89. Debt ratio = $30,946/$11,833 = 2.62.

Question A1675 Target‘s current ratio is less than the industry average and this indicates worse liquidity compared to the industry. Target‘s debt ratio is more than the industry, and this indicates worse solvency compared to the industry.

Question A1676 Consolidated Statements of Operations.

Question A15 ($ in millions) a. $77,130. b. $54,864. c. $4,190. d. $3,269. e. $3,281.

Question A16 Yes. Pension and other benefit liabilities, and currency translation adjustment and cash flow hedges.

Question A1679 Indirect method, showing a reconciliation from net earnings to operating cash flows.

Question A1680 Operating cash flows from continuing operations ($7,099) are higher than net earnings from continuing operations ($3,269). The largest item in the reconciliation of the two amounts is depreciation and amortization, which is an expense that decreases net earnings but has no effect on operating cash flows.

Question A1681 The largest investing cash flow is the outflow from expenditures for property and equipment ($3,027). The largest financing cash flow is the outflow from reductions of long-term debt ($2,069).

Question A1682 Note 17: ―Leases‖ reports the following: Future Minimum Lease Payments

2018 2019 2020 2021 2022 After 2022 Total lease payments Less: Interest Present value of future minimum capital lease payments

(millions) Operating Finance Leases Leases $ 284 $121 278 127 274 127 270 125 261 120 1,838 1,270 $3,205 $1,890 730 520 $2,475 $1,370

Question A1683 The weighted average discount rates reported by Target are 3.71% for operating leases and 4.23% for finance leases

Question A1684 Target reports its lease liabilities for the present value.

Question A1685 Target reports Sales revenue of $ 78,112 million for the 2019 fiscal year, which ended February 1, 2020.

Question A1686 Recording revenue at the point of sale indicates that Target records revenue at the point in time that customers receive goods or services. That is the point in time that Target has fulfilled its performance obligation to deliver goods to customers.

Question A1687 Target‘s Note 2 indicates: ―Sales are recognized net of expected returns, which we estimate using historical return patterns and our expectation of future returns.‖ Therefore, estimated returns reduce revenue and net income. Those estimates will be adjusted to reflect actual returns over time.

Question A1688 When a gift card is sold, Target does not recognize revenue. Instead, it recognizes a deferred revenue liability rather than revenue, because it has not yet delivered goods or services to a customer. Target will reduce the deferred revenue liability and recognize revenue either when the gift card is redeemed or when, based on historical experience, Target judges it to be ―broken‖, meaning that Target does not believe the gift card will ever be redeemed.

Question A1689 Target indicates that ―We receive consideration for a variety of vendor-sponsored programs, such as volume rebates, markdown allowances, promotions, and advertising allowances and for our compliance programs, referred to as ‗vendor income.‘ Substantially all vendor income is recorded as a reduction of cost of sales.‖ Thus, vendor income is really a refund of some of the amount that Target is paying for goods or services. Vendor income reduces Target’s costs, and so does not affect Target’s revenue. Likewise, because Target‘s cost is the same as the vendor‘s revenue, these refunds serve to reduce vendors’ revenue.

Question A1690 From note 7: ―Cash equivalents include highly liquid investments with an original maturity of three months or less from the time of purchase. Cash equivalents also include amounts due from third-party financial institutions for credit and debit card transactions, which typically settle in five days or less.‖

Question A1691 Cash and cash equivalents, including short-term investments of $1,810 million, was $2,577 million as of February 1, 2020.

Question A1692 From note 2: ―Generally, guests may return national brand merchandise within 90 days of purchase and owned and exclusive brands within one year of purchase. Sales are recognized net of expected returns, which we estimate using historical return patterns and our expectation of future returns.‖

Question A1693 Target does not show any accounts receivable on its balance sheet. Per note 2, the receivables associated with the Target Credit Card and Target MasterCard are owned by TD Bank However, per note 7 Target has receivables from third-party financial institutions of $441 million, and per note 9, Target has amounts due from vendors of $464 million.

Question A1694 Target uses LIFO. More specifically, the company uses the LIFO retail inventory method to account for the majority of its inventory and the related cost of sales. Under this method, inventory is stated at cost using the LIFO method as determined by applying a cost-to-retail ratio to each merchandise grouping's ending retail value. The LIFO retail inventory method is covered in chapter 9.

Question A1695 The cost of inventory includes the amount Target pays to its suppliers to acquire inventory, freight costs incurred in connection with the delivery of product to its distribution centers and stores, and import costs, reduced by vendor income and cash discounts.

Question ($ in millions) A1696 Gross profit ratio =

$22,266 = 28.9%

$77,130 Inventory turnover =

$54,864 = 5.93 times

$9,244.5* *($8,992 + $9,497) ÷ 2 Target‘s gross profit ratio indicates that the company is more profitable than the industry average. Its inventory turnover ratio indicates the company sells its inventory less frequently.

Question The LIFO provision is calculated based on internally measured retail price indices. A1697

Question The use of RIM will result in inventory being valued at the lower of cost or market because A1698 permanent markdowns are taken as a reduction of the retail value of inventory.

Question Activity under this program is included in sales and cost of sales in the Consolidated A1699 Statements of Operations (income statement), but the merchandise received under the program is not included in inventory in Target‘s Consolidated Statements of Financial Position (balance sheet) because of the virtually simultaneous purchase and sale of this inventory.

PART B: PROPERTY, PLANT, AND EQUIPMENT AND INTANGIBLES

Question Property and equipment, net = $26,283million. In its balance sheet, Target lists property and B1700

equipment and other noncurrent assets. The largest category of property and equipment is buildings and improvements. Other categories include land, fixtures and equipment, computer hardware and software, and construction-in-process.

Question The statement of cash flows reports that $3,027 million was spent in the year ended February B1701 1, 2020, on expenditures for property and equipment. This is a decrease compared to $3,516 million spent in the previous year.

Question B1702 Advertising costs. Generally retail merchandising companies like Target do not invest significant amounts in research and development. Target attempts to sell products of other companies rather than manufacture its own products for sale. Instead, retail merchandising companies are likely to spend significant amounts on advertising (see Note 5). Similar to research and development, advertising is expensed as incurred (as the advertising occurs). It is difficult to determine whether current advertising benefits future periods. In addition, a direct relationship between current advertising and specific future revenue is difficult to establish.

Question The fixed-asset turnover ratio is computed by dividing net sales (revenues) by average fixed B1703 assets (normally property and equipment, net of accumulated depreciation). Using 2020 data, the ratio for Target is ($ in millions) $71,879 = 2.98 $24,838* *Average plant and equipment for 2020 = ($26,283 + $25,533) ÷ 2 = $25,908. The ratio is intended to measure a company's effectiveness in managing property, plant, and equipment. It indicates the level of sales generated by the company's investment in these assets. Like any ratio, it is but one piece of a larger puzzle and should not be interpreted in isolation.

Question B1704 Yes. Target reports goodwill and other intangible assets of $686 million for the year ended February 1, 2020.

Question B1705 Estimated Useful Lives Buildings and improvements Fixtures and equipment

Life (Years) 8-39 2-15

Computer hardware and software

2-7

Land does not have a definite life so it has no estimated useful life and is not depreciated.

Question B1706 Property and equipment is depreciated using the straight-line method over estimated useful lives or lease terms if shorter. For income tax purposes, accelerated depreciation methods are generally used. Straight-line depreciation is simple to use and allocates the cost of assets evenly over their useful lives. Accelerated depreciation allocates more cost to earlier years, resulting in lower income and therefore lower taxes owed.

Question B1707

Repair and maintenance costs are expensed as incurred.

Question B1708 Long-lived assets are reviewed for impairment when events or changes in circumstances, such as a decision to relocate or close a store or make significant software changes, indicate that the asset's carrying value may not be recoverable. For asset groups classified as held for sale, the carrying value is compared to the fair value less cost to sell. Target estimates fair value by obtaining market appraisals, valuations from third party brokers, or other valuation techniques. For 2019, impairments of $23 million related to store closures and supply chain changes.

Question B1709 No. For the year ended February 1, 2020, Target did not report any impairments on intangible assets.

PART C: INVESTMENTS

Question C1 a. Per Note 1, CVS classifies these investments as available-for-sale securities. b. The total of CVS’s investments on 12/31/2019 is $19,687 million, which is shown on the balance sheet as a current asset of $2,373 and a noncurrent asset of $17,314. c. The total of CVS’s available-for-sale investments on 12/31/2019 is $16,922 million, consisting of $15,898 amortized cost and $1,024 total fair-value adjustment. d. Per Note 4, of the total of $16,922 million of available-for-sale investments on 12/31/2019, $1,785 are categorized as Level 1, $15,088 are categorized as Level 2, and $49 are categorized as Level 3.

Question C2 c. CVS‘s income would increase by CVS‘s percentage share of Heartland‘s income. d. CVS‘s ―investment in Heartland‖ asset would increase by CVS‘s percentage share of Heartland‘s income.

PART D: LIABILITIES

Question D1 a.

The three components of current liabilities are:

($ in millions)

2/1/2020

Current Liabilities: Accounts payable Accrued and other current liabilities Current portion of LT debt & other borrowings Total current liabilities b.

2/2/2019

$ 9,920 4,406 161

$ 9,761 4,201 1,052

$14,487

$15,014

Current assets are not sufficient to cover current liabilities in either fiscal year: Current assets 2/1/2020 Current assets 2/2/2019 Current ratio 2/1/2020 Current ratio 2/2/2019

$12,902 $12,519 $12,902 ’ $14,487= 0.89 $12,519 ’ $15,014= 0.83

The current ratio at 2/1/2020 is higher than in the prior year.

Question D1714 a. February 1, 2020: $935 million February 2, 2019: 840 million Increase: $ 95 million b. The liability will be affected as follows: i. The liability will increase for sales of gift cards, because that will increase deferred revenue with a journal entry of the form: Cash

xxx Deferred revenue, gift cards

ii.

The liability will decrease when gift cards are redeemed, because the deferred revenue associated with the gift card can now be recognized. Deferred revenue, gift cards Revenue

iii.

xxx

xxx xxx

Question D1715 Target states that ―We are exposed to claims and litigation arising in the ordinary course of business and use various methods to resolve these matters in a manner that we believe serves the best interest of our shareholders and other constituents. When a loss is probable, we record an accrual based on the reasonably estimable loss or range of loss. When no point of loss is more likely than another, we record the lowest amount in the estimated range of loss and, if material, disclose the estimated range of loss. We do not record liabilities for reasonably possible loss contingencies, but do disclose a range of reasonably possible losses if they are material and we are able to estimate such a range. If we cannot provide a range of reasonably possible losses, we explain the factors that prevent us from determining such a range. Historically, adjustments to our estimates have not been material. We believe the recorded reserves in our consolidated financial statements are adequate in light of the probable and estimable liabilities. We do not believe that any of these identified claims or litigation will be material to our results of operations, cash flows, or financial condition.‖ So, Target is making reasonable estimates based on their view of probable outcomes. Target does not believe it is probable it would be found liable if these cases were litigated, which could be the case either because Target does not believe it is probable the cases would be litigated or it does not believe it is probable that it would be found liable should the cases be litigated. This approach appears appropriate, given that Target should only accrue amounts that are probable and reasonably estimable.

Question We compute the debt to equity ratio by dividing a company‘s total liabilities by total D1716 shareholders' equity. The ratio summarizes the capital structure of the company as a mix between the resources provided by creditors and those provided by owners. For instance, a ratio of 2.0 means that twice as many resources (assets) have been provided by lenders as those provided by owners.

Debt to equity ratio

Total liabilities Shareholders' equity

$14,487 + $16,459 $11,833

2. 62 Industry = 1.95

On the other hand, debt also can be an advantage. It can be used to enhance the return to shareholders. This concept is known as leverage. When the return on borrowed funds is in excess of the cost of borrowing the funds, shareholders are provided with a total return greater than what could have been earned with equity funds. (This, in fact, is the case for Target whose return on equity for 2020 is 28%, far in excess of its return on assets of 8%.)

Question D1717 Lenders demand interest payments as compensation for the use of their capital. Inability to pay interest as scheduled may cause several adverse consequences, including bankruptcy. Thus, another way to measure a company's ability to pay its obligations is by comparing interest payments with cash flow available to pay those obligations. The times interest earned ratio does this by dividing income before subtracting interest expense or income tax expense by interest expense.

Times interest earned

Net income + interest + taxes Interest

$3,281 + $477 + $921 $477

9.8 times Industry = 6.5 times

PART E: LEASES, INCOME TAXES, AND PENSIONS

Question E1 When Target recorded its finance lease at inception, both assets and liabilities increased by the present value of lease payments. In later years, though, the amounts differ. Right-of-use assets are reduced by amortization. Lease liabilities are reduced by the principal portion of lease payments. (The same is true for operating leases unless lease payments occur at the end each lease period and coincide with the end of a reporting period. In that case, the amortization amounts will be the same as the principal portion of lease payments.)

Requirement b Finance lease assets, net Add back: accumulated amortization Finance lease assets, before amortization Requirement c Operating lease assets (from SCF)…. Operating lease liability……..

($ in millions)

$1,180 441 $1,621 ($ in millions)

464 464

Question E2 Target's February 1, 2020 income statement reports the income tax expense for the year as $921 million. The current portion is $743 million. The deferred portion is = $178. A summary journal entry that records Target‘s tax expense from continuing operations for the fiscal year ended February 1, 2020 is: Income tax expense Deferred tax assets/liabilities Income tax payable

921 178 743

Question E3 Target‘s net deferred tax liability increased from $960 to $1,114, which is an increase of $154. The journal entry in the answer to requirement 1 indicates a credit of $178, which would increase the net deferred tax liability, so it only differs by $24. That difference could be caused by discontinued operations, acquisitions or dispositions that changed the deferred tax balances, or deferred Solutions Manual, Chapter 1 1–1719 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

taxes associated with other comprehensive income items. Target has both discontinued operations and other comprehensive income items, which could account for the difference. Question E4 The effect of accounting for the tax rate change is to reduce tax expense and increase net income by $36 million. Question E5 Target‘s liability for unrecognized tax benefits is $160 million as of February 1, 2020. Were Target to prevail and receive $50 million more of tax benefits than it thought it would receive, it would reduce the liability by $50 million and show an offsetting reduction of tax expense of $50 million: Liability for unrecognized tax benefits Income tax expense

50 50

That would increase net income in the period in which the liability for unrecognized tax benefits was reduced.

Question E6 In Note 23 ―Pension Plans‖, Target reported the following changes in its Projected Benefits Obligation, Plan Assets, and Pension Expense: Requirement 1 Change in Projected Benefit Obligation (millions) Benefit obligation at beginning of period Service cost Interest cost Actuarial (gain)/loss Participant contributions Benefits paid Benefit obligation at end of period

Qualified Plans 2019 2018 $3,905 $4,061 90 93 146 145 615 (167) 11 6 (275) (233) $4,492 $3,905

Note: Some projected benefit plans permit employees to contribute to their own plans in addition to the employer responsibility. Question E7 Change in Plan Assets (millions) Fair value of plan assets at beginning of period Actual return on plan assets Employer contributions Participant contributions Benefits paid Fair value of plan assets at end of period

2019 $3,915 729 50 11 (275) $4,430

2018 $4,107 (65) 100 6 (233) $3,915

Question E8 Target‘s PBO is overfunded in fiscal year 2018, but underfunded in 2019: (millions) Fair value of plan assets at end of period Benefit obligation at end of period Funded/(underfunded) status

2019 $4,430 4,492 $ (62)

2018 $3,915 3,905 $ 10

Question E9 Net Pension Benefits Expense (millions)

2019

2018

2017

Service cost benefits earned during the period Interest cost on projected benefit obligation Expected return on assets Amortization of losses

$ 93 149 (248) 62

$ 95 146 (246) 82

$ 86 140 (250) 61

(11)

1 $ 46

4 $ 70

1 $ 27

Amortization of prior service cost

Settlement and special termination charges Total

Prior service cost amortization is determined using the straight-line method over the average remaining service period of team members expected to receive benefits under the plan.

PART F: SHAREHOLDERS’ EQUITY AND ADDITIONAL FINANCIAL REPORTING ISSUES

Question F1 Target‘s share repurchases are described in Note 20 ―Share Repurchase‖. 2019, these repurchases were reported this way: Share Repurchases (millions)

2019

Total number of shares purchased(a)

16.0

Average price paid per share

In fiscal

$95.07

This information combined with that in the Statements of Shareholders' Investment allow us to reconstruct the (summary) journal entry for these repurchases: ($ in millions) Common stock (16.0 million shares x $.0833 par).......................................... 1 Retained earnings (given in statement of shareholders’ investment) ............. 1,520 Cash (16.0 million shares x $95.07 per share)......................................... 1,521

Question F2 Target accounts for share repurchases as retired shares. Target retires the shares it repurchases rather than labeling the repurchased shares as treasury stock. We know that because treasury stock is not an account reported in the company‘s financial statements. When shares are formally retired, we normally reduce the same accounts that previously were increased when the shares were sold, namely, common stock and paid-in capital—excess of par. Some companies, though, choose to debit retained earnings for the entire difference between the cash paid to repurchase shares and the par amount of those shares rather than allocate that difference in the prescribed way. Target Corporation is an example of a company that follows this approach. While this method lacks conceptual merit by itself, it‘s permitted by ASC 505-30-30-8, which states that ―a corporation can always capitalize or allocate retained earnings for such purposes.‖

Question F1727 Three types of awards are described in Note 21: Share-Based Compensation:  restricted stock units  performance share units  stock options

Question F1728 Based on the fair value of the awards granted, Target‘s primary form of share-based compensation for the year ended February 1, 2020, was restricted stock units (RSUs). The fair values of the awards granted for restricted stock units were approximately $172.6 million (= 2,157 thousand RSUs x $80.01). The value of the performance share units granted was $125.6 million (= 1,447 thousand). No new stock options were issued.

Question F1729 Projections of future performance should be based primarily on continuing operations. Diluted EPS for continuing operations in the most recent three years were 2019: $6.34, 2018: $5.50, and 2017: $5.29. So, there is no clear indication of future direction, but these numbers suggest a likely increase.

Question F1730 Securities, like stock options or restricted stock awards, while not being common stock, may become common stock through their exercise or vesting. As a result, they may dilute (reduce) earnings per share and therefore are called ―potential common shares.‖ Diluted EPS incorporates the dilutive effect of all potential common shares. 4.7 (=515.6 – 510.9) million shares were included in diluted earnings per share but not basic earnings per share in 2019, due to share-based compensation awards.

Question Target reports its inventory under the retail inventory accounting method (RIM) using the last-in, F1731 first-out (LIFO) method. Inventory is stated at the lower of LIFO cost or market: 8. Inventory The vast majority of our inventory is accounted for under the retail inventory accounting method (RIM) using the last-in, first-out (LIFO) method. Inventory is stated at the lower of LIFO cost or market. Inventory cost includes the amount we pay to our suppliers to acquire inventory, freight costs incurred to deliver product to our distribution centers and stores, and import costs, reduced by vendor income and cash discounts. Distribution center operating costs, including compensation and benefits, are expensed in the period incurred. Inventory is also reduced for estimated losses related to shrink and markdowns. The LIFO provision is calculated based on inventory levels, markup rates, and internally measured retail price indices. Under RIM, inventory cost and the resulting gross margins are calculated by applying a cost-to-retail ratio to the inventory retail value. RIM is an averaging method that has been widely used in the retail industry due to its practicality. The use of RIM will result in inventory being valued at the lower of cost or market because permanent markdowns are taken as a reduction of the retail value of inventory.

Question Retrospective approach. F1732

We report most voluntary changes in accounting principles retrospectively. This means Target would (1) revise all previous period‘s financial statements presented as if the new method always had been used. Target would (2) revise cost of goods sold as well as any other income statement amounts affected by that revision, including income taxes and net income. Since the change would affect net income, retained earnings also changes. Target would reflect the cumulative prior year difference in cost of goods sold (after tax) as a difference in prior years‘ net income and therefore in the balance in retained earnings. It also revises inventory in the balance sheet.

Question F1733 Prospective approach. It‘s not practicable to report some changes in principle retrospectively because insufficient information is available. Revising balances in prior years means knowing what those balances should be. One example is switching from the FIFO method of inventory costing to the LIFO method. Recall that LIFO inventory consists of ―layers‖ added in prior years at costs existing in those years. So, if FIFO has been used, Target probably hasn‘t kept track of those costs. Accounting records of prior years probably are inadequate to report the change retrospectively, so Target would report the change prospectively. The beginning inventory in the year the LIFO method is adopted would become the base year inventory for all future LIFO calculations.

Question F1734

Cash provided by operating activities increased in fiscal 2019 over the previous year.

Question F1735

Cash provided by operating activities is more than net income in each year reported. Cash flows from operating activities are both inflows and outflows of cash that result from the same activities that are reported in the income statement. The income statement, however, reports the activities on an accrual basis. This means that the income statement reports revenues earned during the reporting period, regardless of when cash is received, and the expenses incurred in generating those revenues, regardless of when cash is paid. Cash flows from operating activities, on the other hand, reports those activities when the cash is exchanged (i.e., on a cash basis).

Question Target's largest investing activity is its investment in property and equipment. Investing activities F1736 show large expenditures for property and equipment in each year reported.

Question F1737 Target is decreasing its long-term debt. Payments to reduce long-term debt far exceed cash borrowed with long-term debt in each of the three years reported.

Question F1738

A statement of cash flows reports transactions that cause an increase or a decrease in cash. Nonetheless, some transactions that don‘t increase or decrease cash, but which result in significant investing and financing activities, must be reported in the statement or related disclosures. Engaging in a significant investing activity and a significant financing activity as two parts of a single transaction does not limit the value of reporting these activities. Examples of noncash transactions that would be reported: 1. Acquiring an asset by incurring a debt payable to the seller. 2. Acquiring an asset by entering into a lease agreement. 3. Converting debt into common stock or other equity securities. 4. Exchanging noncash assets or liabilities for other noncash assets or liabilities. In each of the three years, Target reported Leased assets obtained in exchange for new lease liabilities (both finance and operating leases).

Question F1739 According to Note 16, Target entered into three swap agreements with varying notional amounts. However, all the swap agreements work the same way. Under the agreements, Target pays a floating rate equal to the 1-month LIBOR rate and received a fixed rate (an average of 2.5% and 2.9% annual rate, depending on the swap). That is, the agreement is a pay-floating, receive-fixed agreement. If the floating rate is higher than the fixed rate used to calculate the net settlement, Target will pay a net cash settlement. In contrast, if the floating rate is lower than the fixed rate used to calculate the net settlement, then Target will receive a net cash settlement.

Question F1740 Target has designated its interest rate swaps as fair value hedges. By entering into a swap by which it pays a floating rate and receives a fixed rate, it is effectively converting its debt into floating rate debt. Target would likely do this if it was concerned that interest rates were going to decline, which would cause the fair value of its existing fixed rate debt to increase.

Question F17 Per Note 16, Target has a gain on the fair value of its interest rate swaps for the fiscal year ended February 1, 2020. This gain was recognized in interest expense. The hedging relationship was perfectly effective, and Target recognized an exactly offsetting loss on the fair value of its debt for the same period which was also recognized into interest expense.

Question F1742 According to Note 6, Target recorded a $137 million interest rate swap asset on its balance sheet in noncurrent assets. Per Note 15, it also has a corresponding increase to the carrying value of its debt of the same amount ($137 million) related to the interest rate swaps.

IFRS COMPREHENSIVE CASE PART A: FINANCIAL STATEMENTS, INCOME MEASUREMENT, AND CURRENT ASSETS

Question A1 a. b. c. d. e.

Total revenues = Income from current operations = Net income (Group part) = Total assets = Total equity =

€ 27,189 million € 1,141 million € 290 million € 30,735 million € 2,299million

Question A1745

AF‘s basic earnings per share was 0.64.

Question (€ in millions) A1746 Assets = Liabilities + Shareholders‘ Equity $30,735 = $28,436 + $2,299

Question A1747

(€ in millions) (a) Cash ................................................................. Deferred revenue .........................................

27,188

(b) Deferred revenue .............................................. Sales revenue ...............................................

27,188

Question A5 (€ in millions) (a) Prepaid aircraft fuel .......................................... Cash ............................................................

5,511

(b) Aircraft fuel expense ........................................ Prepaid aircraft fuel .....................................

5,511

Question A1750 Equipment .............................................................. 3,372 Cash.............................................................

(€ in millions)

3,372

Question A1751 a. Assets are listed before liabilities and equity. b. Liabilities are listed after equity. c. Current assets are listed after long-term assets. d. Current liabilities are listed after long-term liabilities.

Question A1752 a. €8,539. b. €22,196. c. €30,735. d. €12,649. e. €15,787. f. €28,436. g. €2,299.

Question A1753 Cash; Deferred revenue.

Question A1754 Current ratio = $8,539/$12,649 = 0.68. Debt ratio = $28,436/$2,299 = 12.37.

Question A1755 AF‘s current ratio is less than the industry average, and this indicates worse liquidity compared to the industry. AF‘s debt ratio is more than the industry average, and this indicates worse solvency compared to the industry.

Question A1756 (€ in millions) (a) €27,188 (b) €5,511 (c) €2,628

Question A1757 (€ in millions) €2,987. This amount is listed as an addition to net income under operating activities.

Question A1758 Interest expense is listed as cost of financial debt. Interest revenue is listed as income from cash and cash equivalents.

Question A1759 Interest paid and interest received are included under operating activities. Under IFRS, interest paid could also be included under financing, and interest received could be included under investing.

Question A1760received are included under investing activities, and dividends paid are Dividends included under financing activities. Under IFRS, dividends received could be included under operating.

Question A1761 d. Note 29.2 Description of the actuarial assumptions and related sensitivities (in part) Discount rates used to determine the actuarial present value of the projected benefit obligations. The discount rates for the different geographical areas are thus determined based on the duration of each plan, taking into account the average trend in interest rates on investment grade bonds, observed on the main available indices. In some countries, where the market in this type of bond is sufficiently broad, the discount rate is determined with reference to government bonds. Most of the Group‘s benefit obligations are located in the Euro zone, where the discount rates used are as follows: As of December 31 Euro zone - Duration 10 to 15 years zone - Duration 15 years and more

2019 2018 0.70% to 0.75% 1.45% Euro 1.15% 1.85%

e. Note 29.2 Description of the actuarial assumptions and related sensitivities (in part)

Sensitivity to changes in the discount rate (in € millions) for the year ended December 31, 2019

for the year ended December 31, 2018

100 bp increase in the discount rate

(2,120)

(1,754)

100 bp decrease in the discount rate

2,803

2,284

If the rate used had been 1% higher, the pension obligation would have been €29120 million less in 2019. If the rate used had been 1% lower, the pension obligation would have been €2,803 million higher in 2019.

Question A1762 d. AF‘s balance sheet indicates current deferred revenue on ticket sales of €3,289 million as of December 31, 2019. e. The journal entry would be: Deferred revenue Sales revenue

3,289 3,289

f. Yes, this seems consistent with U.S. GAAP. A liability for deferred revenue is recognized when tickets are purchased, and then the deferred revenue is reduced and revenue is recognized when the transportation service is provided.

Question A1763 The journal entry would be: Contra revenue Refund liability

50,000 50,000

Question c. Yes, From note 4.7: ―Miles are considered as separate elements of a sale of a t A1764 icket with multiple elements and one part of the price of the initial sale of the t icket is allocated to these Miles and deferred until the Group‘s commitments r elating to these Miles have been met. The deferred amount due in relation to the acquisition of Miles by members is estimated: - According to the fair value of the ‗miles,‘ defined as the amount at which the benefits can be sold separately. - After taking into account the redemption rate, corresponding to the probability that the miles will be used by members, using a statistical method.‖ d. Per the balance sheet, AF has a liability for ―Frequent flyer programs‖ of €848 million. e. Yes, AF‘s approach is consistent with IFRS 15,in that the transaction price for airfare is allocated to the performance obligations of (1) providing the airfare and (2) providing future airfare or other goods and services upon redemption of miles. The revenue associated with AF miles is deferred and recognized separately from the revenue associated with the flights that customers use to earn the miles.

Question A1765 AF indicates the following: ―4.11 Valuation of trade receivables and non-current financial assets: Trade receivables, loans and other non-current financial assets are considered to be assets issued by the Group and are recorded at fair value. They are subsequently valued using the amortized cost method. Regarding the impairment of trade receivables, the Group has chosen the simplified method approach in that the automated customer invoicing and settlement processes for the Passenger and Cargo businesses significantly limit the credit risk.‖ This approach is consistent with U.S. GAAP. The receivables are recorded initially at their fair value (their value when the sales transaction occurs). If they are discounted for the time value of money, the amount of any discount is amortized to interest revenue over the life of the receivable. And, by using the ―simplified method‖ to record impairments, AF is using an approach consistent with CECL, rather than the ECL approach that requires identification of significant increases in credit risk with respect to credit losses expected to occur from defaults after twelve months.

Question A1766 Valuation allowance for trade accounts receivable

―Use of allowance‖ (bad-debt writeoffs)

Reclassification

155 39

Beg. balance ―Charge to allowance‖ (Bad debt expense)

173

End. balance

Question A1767

AF has bank overdrafts of €4 as of December 31, 2019. Under IFRS, those overdrafts would be netted against AF‘s total cash and cash equivalents of €3,711 if the overdrafts are payable on demand and are part of the AF‘s normal cash management process. Given that AF shows a cash balance of €3,715 on the balance sheet, it is apparent that they do not net overdrafts with cash. Instead, the overdrafts must be shown as a current liability, consistent with U.S. GAAP and suggesting that the overdrafts don‘t meet IFRS‘s requirements for netting against the cash balance.

Question Per note 4.17, AF uses the weighted-average method to value its inventory. Under IFRS, the A1768 FIFO (first-in, first-out) method also can be used. However, the LIFO (last-in, first-out) method, which can be used under U.S. GAAP in addition to the average cost method and the FIFO method, is prohibited under IFRS.

Question No. Both U.S. GAAP and IFRS require inventory to be valued at the lower of cost and net A1769 realizable value.

PART B: PROPERTY, PLANT, AND EQUIPMENT AND INTANGIBLES

Question From Note 4.13: B1770 IT development costs are capitalized. IT development costs are amortized over their useful lives.

Question B2 IFRS requires development expenditures to be expensed in the period incurred. X IFRS requires research expenditures to be expensed in the period incurred. X Except for software development costs incurred after technological feasibility has been established, U.S. GAAP requires all research and development expenditures to be expensed in the period incurred.

Question B1772 Both U.S. GAAP and IFRS require that donated assets be valued at their fair values. For government grants, though, the way that value is recorded is different under the two sets of standards. Unlike U.S. GAAP, donated assets are not recorded as revenue under IFRS. Instead, government grants must be recognized in income over the periods necessary to match them on a systematic basis with the related costs that they are intended to compensate. For grants related to assets, two alternatives are allowed: 1. Deduct the amount of the grant in determining the initial cost of the asset. 2. Record the grant as a liability, deferred income, in the balance sheet and recognize it in the income statement systematically over the asset‘s useful life.

Question B4 (€ in millions) December 31, 2019

Before Revaluation

Flight equipment

€20,880

× 14,000/11,334 =

€25,791

9,546

× 14,000/11,334 =

11,791

€11,334

× 14,000/11,334 =

€14,000

Accumulated depreciation Book value

After Revaluation

The entry to revalue the flight equipment and the accumulated depreciation accounts (and thus the book value) is: Flight equipment (€25,791 – 20,880)

4,911

Accumulated depreciation (€11,791 – 9,546)

2,245

Revaluation surplus—OCI (€14,000 – 11,334)

2,666

Question Under U.S. GAAP, property, plant, and equipment is valued at cost less accumulated B1775 depreciation. U.S. GAAP prohibits using the revalued amount.

Question B1776

IFRS requires that each component of an item of property, plant, and equipment must be depreciated separately if its cost is significant in relation to the total cost of the item. AF uses this approach with its flight equipment. Note 4.14 states, ―Any major airframes and engines overhauls (excluding parts with limited useful lives) are treated as a separate asset component with the cost capitalized and depreciated over the period between the date of acquisition and the next major overhaul.‖ In the United States, component depreciation is allowed but is not often used in practice.

Question B1777

Per Note 4.16, fixed assets are tested when there is an indication of impairment.

This approach is similar to U.S. GAAP. However, under IFRS, assets must be assessed for indicators of impairment at the end of each reporting period.

Question In Note 4.16, AF states that the company deems the recoverable value of the asset to be the B1778 higher of market value less cost of disposal and its value in use. The later is determined according to the discounted future cash flow method. While not stated, AF then compares the recoverable amount to book value. If recoverable amount is less, an impairment loss is recognized for the difference. Under U.S. GAAP, the measurement of an impairment loss is a two-step process. Step one, recoverability, requires an impairment loss to be recognized only when the undiscounted sum of the asset’s estimated future cash flows is less than its book value. If a loss is required, step two measures the loss as the difference between book value and fair value of the asset.

Question B1779 Revaluation expense

Other intangible assets (€1,031* – 500)

(€ in millions) 531

531

*€1,811–€780

PART C: INVESTMENTS

Question C1780 d. Per note 23 (―Other financial assets‖), the balance of debt investments accounted for at FVPL is €411 (including ―Cash secured‖ portion) as of December 31, 2019, equal to €73 current marketable securities, €38 noncurrent marketable securities, and €300 current cash secured. e. Per note 23 (―Other financial assets‖), €373 of the balance is classified as current, and €38 is classified as noncurrent. f. Per note 36.4 (―Valuation methods for financial assets and liabilities at their fair value‖), €19 of the €411 balance is estimated using level 1 inputs, and the other €392 is estimated using level 2 inputs

Question C2 a. Per note 23 (―Other financial assets‖), the balance of equity investments accounted for as FVPL or FVOCI is €433 as of December 31, 2019, including €360 accounted for as FVPL and €73 accounted for as FVOCI. b. Per note 23 (―Other financial assets‖), the €360 accounted for as FVPL is current, and the €73 accounted for as FVOCI is noncurrent. c. Per note 36.4 (―Valuation methods for financial assets and liabilities at their fair value‖), €432 of the €433 is estimated using level 1 inputs, and €1 of the €433 is estimated using level 2 inputs.

Question C1782 a. Per note 4.3 (―Consolidation principles‖), ―In accordance with IAS 28 ―Investments in Associates and Joint Ventures‖, companies in which the Group has the ability to exercise significant influence on financial and operating policy decisions are also accounted for using the equity method. The ability to exercise significant influence is presumed to exist when the Group holds more than 20 per cent of the voting rights.‖ b. Per note 4.3 (―Consolidation principles‖), ―In accordance with IFRS 11 ―Joint arrangements‖, the Group applies the equity method to partnerships over which it exercises control jointly with one or more partners (joint-venture).‖ c. Per note 21 (―Equity affiliates‖) and the balance sheet, the carrying value of AF‘s equity-method investments on its December 31, 2019, balance sheet is €307 million. d. Per note 21 (―Equity affiliates‖) and the income statement, AF‘s equitymethod investments increased its net income from continuing operations by €23 during 2019.

PART D: LIABILITIES

Question D1 AF-KLM receives payment for flight services in advance of delivery of those services. Upon receipt of payment, AF-KLM records a liability, deferred revenue, and only when the services later are delivered does it reduce that liability and record revenue. Yes, transactions of this type would be handled similarly under U.S. GAAP.

Question D2 Yes, it is different. Under both U.S. GAAP and IFRS, liabilities associated with a past event are recorded when the obligation is probable and the amount of the obligation can be reliably estimated. However, IFRS defines ―probable‖ as ―more likely than not,‖ which is a lower threshold than is typically applied under U.S. GAAP, so it is more likely to recognize a liability under IFRS than it would under U.S. GAAP. Also, under IFRS, it is more likely to discount the liability (recording it at present value) than it would under U.S. GAAP, so, given that a liability is recognized, the amount of liability that is recognized may be lower under IFRS than under U.S. GAAP.

Question D3 a. Yes, the total beginning balances (totaling €4,162 million, consisting of €3,657 million noncurrent and €505 million current) and ending balances (totaling €4,464, million consisting of €3,750 million noncurrent and €714 million current) of provisions and retirement benefits shown in Note 30 for fiscal 2019 tie to the balance sheet. In total, AF-KLM’s ―Other provisions‖ current and non-current liabilities increased by €302 million during fiscal 2019. b. Journal entries for the following changes in the litigation provision that occurred during fiscal 2019: i.

New provision Provision expense Litigation provision

32 32

This journal entry captures AF-KLM establishing an additional liability for future litigation-related expenditures. ii.

Use of provision Litigation provision Cash

9 9

This journal entry captures AF-KLM paying down an existing liability with cash. iii.

Reversal of unnecessary provision Litigation provision Reversal of litigation provision

5 5

This journal entry captures AF-KLM reducing its litigation provision and increase income to adjust downward a prior estimate of litigation cost.

c. AF-KLM‘s treatment of litigation provision under IFRS is consistent with how these items would be treated under U.S. GAAP.

Question D4 Under IFRS, ―contingent liabilities‖ are disclosed and not accrued as a liability in the balance sheet or recognized as an expense in the income statement. These are amounts that relate to prior events and either are possible future obligations or are present obligations but either are not probable or not reliably estimated. Under U.S. GAAP, these contingencies would be treated the same way. However, U.S. GAAP uses the term ―contingent liability‖ to refer to the entire set of what IFRS refers to as contingencies and provisions.

Question D5 From Note 31.3 OCEANE, we see that in March 2019, Air France issued convertible bonds maturing in 7 years. The conversion option allows for conversion and/or exchange at any time into new or existing Air France-KLM shares. 27,901,785 bonds were issued. Each bond has a nominal value of €17.92, so the nominal value of the bonds was €500 million. ―Upon issue of this convertible debt, Air France-KLM recorded a debt of €446 million, corresponding to the present value of future payments of interest and face amount discounted at the rate of a similar bond without a conversion option.‖ The option value was evaluated by deducting this debt value from the total nominal amount (i.e., €500 million) and was recorded in equity in keeping with IFRS. Under IFRS, convertible debt is divided into its liability and equity elements. We achieve separation by measuring the fair value of a similar liability that does not have an associated equity component. Air France determined the effective interest rate that bonds similar in all respects, except that they are nonconvertible, would sell for. Using that rate as the discount rate, AF determined the present value of future payments of interest and principal (nominal) discounted at the rate of a similar bond without a conversion option to be €446 million. The liability-first separation gives us the following entry: .............................................. (€ in millions) Cash (amount given) ................................. 500 Convertible bonds payable (similar bond value without a conversion option, amount given) 446 Equity—conversion option (to balance) 54 Under U.S. GAAP, the entire issue price of convertible debt is recorded as debt: Cash (given) ........................................ 500 Convertible bonds payable (face amount)

500

Question If AF had elected the FVO for all of its debt measured at amortized cost, the fair value D1791 adjustment account would have a December 31, 2019, debit balance of €68 million, the difference between the €1,586+ €541 + €1,955 = €4,082 million net book value and the €1,659 + €489 + €2,002 = €4,150 million fair value.

PART E: LEASES, INCOME TAXES, AND PENSIONS

Question In Note 4.15: Lease contracts, AF states that ―leases are recorded in the balance E1792 sheet and lead to the recognition of: - an asset representing a right of use of the asset leased during the lease term of the contract and - a liability related to the payment obligation. Yes. This policy is generally consistent with U.S. GAAP, , ASC 842.

Question E1793 Under IFRS 16, the lessee makes no distinction between a finance lease and an operating lease. All leases are accounted for as finance leases by the lessee (onemodel approach). Thus, even for leases that qualify under U.S. GAAP (two-model approach) as operating leases, the lessee amortizes the right-of-use asset on a straightline basis rather than ―plugging‖ that amount to cause the total of interest and amortization to be a straight-line amount. In the 2015 update to IFRS 17 the lessee makes no distinction between a finance lease and an operating lease. For all leases (with lease terms of more than 12 months and amounts of $5,000 or more) companies will report both right-of-use assets and lease liabilities. And, unlike under U.S. GAAP, companies will report both interest expense and amortization expense the same way for all leases.

Question E1794 AF reported a €523 million noncurrent deferred tax asset, and a €142 million noncurrent deferred tax liability, totaling a €381 million net noncurrent deferred tax asset at December 31, 2019.

Question E1795 This policy is not consistent with U.S. GAAP, which requires that measurement be based on tax rates and laws that are enacted at the balance sheet date. Using ―substantively enacted‖ is not permissible in U.S. GAAP.

Question E1796 This policy is not consistent with U.S. GAAP, which requires that all deferred tax assets be recorded and then reduced by a valuation allowance when it is deemed ―more likely than not‖ (the definition of probable under IFRS) that some or all of the benefits will not be realized due to insufficient taxable income to absorb the future deductible amounts and realize the tax savings.

Question E1797 Under IAS No. 19, prior service cost (called past service cost under IFRS) is combined with service cost as part of net periodic pension cost and reported within the income statement. AF reports this amount within ―Plan amendments and curtailments‖ as part of its Net periodic cost.

Under U.S. GAAP, prior service cost is not expensed immediately, but is included among OCI items in the statement of comprehensive income and thus subsequently becomes part of AOCI where it is amortized to earnings over the average remaining service period.

Question E7 AF reports Pension assets and Pension liabilities separately on its balance sheet. Under U.S GAAP, a company‘s PBO is not reported separately among liabilities in the balance sheet. Similarly, the plan assets a company sets aside to pay those benefits are not separately reported among assets in the balance sheet. Instead, firms report the net difference between those two amounts, referred to as the ―funded status‖ of the plan. Most companies that follow IFRS also report only the net amount.

Question E1801 As shown in Note 29.3 Evolution of commitments, For its NE operations, AF reported a net interest income (rather than net pension liability) for 2019 of €5 million, indicating that its plan assets exceeded its DBO. The high grade corporate bond rate is multiplied by the difference between those two amounts to determine the net interest cost or net interest income for the period.

PART F: SHAREHOLDERS’ EQUITY AND ADDITIONAL FINANCIAL REPORTING ISSUES

Question F1803Air France–KLM lists five items in the shareholders‘ equity section of the balance sheet. If AF used U.S. GAAP, Issued capital would be Common stock, Reserves and retained earnings would be separated into retained earnings and one or more other accounts. The term ―reserves‖ is considered misleading and thus is discouraged under U.S. GAAP. For example, what would be called Investment revaluation reserve under IFRS might be called Net gains (losses) on investments— AOCI. What would be called Investment revaluation reserve under IFRS might be called Net gains (losses) foreign currency translation—AOCI. Often firms using IFRS will use the term Share premium for Paid-in capital— excess of par and Investment in own shares for Treasury stock. Note 28.5 indicates that the items that comprise ―Reserves and retained earnings‖ as reported in the balance sheet are: 7. Legal reserve, 8. Pension defined benefit reserves, 9. Derivatives reserves, 10.Equity instruments reserves, 11.Other reserves, 12.Net income (loss)—group share. If AF used U.S. GAAP, the first of those would not be listed as shareholders‘ equity. What AF called Pension defined benefit reserves might be called Postretirement benefit gains (losses)—AOCI. What AF called Derivatives reserves might be called Net gains (losses) on derivatives–AOCI. What AF called Equity instruments reserves under IFRS might be called Net gains (losses) on investments—AOCI. Other reserves might be Net gains (losses) foreign currency translation—AOCI. Net income (loss)—Group share is equivalent to retained earnings but not included as a component of ―reserves‖ under U.S. GAAP.

Question F1804 The order of presentation of the components of the balance sheet usually is different between U.S. GAAP and IFRS. AF lists Non-current assets before current assets. Yes. This is the opposite order from what we see under U.S. GAAP.

Question AF lists Non-current liabilities before current liabilities. F1805 Yes. This is the opposite order from what we see under U.S. GAAP.

Question Within Total equity and liabilities, Shareholders’ equity is listed first. F1806 Yes. This is the opposite order from what we see under U.S. GAAP.

Question Required F1807 1. €279 million ’ 455,334,249 = €0.61 Required 2. It‘s the after-tax interest savings that would occur if Air France-KLM‘s convertible bonds were to be converted. The potentially dilutive effect of convertible bonds is reflected in diluted EPS calculations by assuming the bonds were converted into common stock. The conversion is assumed to have occurred at the beginning of the period, or at the time the convertible bonds were issued, if later. When conversion is assumed, the additional common shares that would have been issued upon conversion are added to the denominator of the EPS fraction. That‘s the 27,901,785 share increase in the shares used to calculate basic EPS to determine the shares used to calculate diluted EPS reported as ―OCEANE conversion.‖ [Elsewhere in the financial statements it‘s reported that ― On March 20, 2019, Air France-KLM issued 27,901,785 bonds convertible and/or exchangeable for new or existing Air France-KLM shares (Ou d'Echange En Actions Nouvelles ou Existantes - OCEANE) ... The conversion ratio is one share for one bond.‖] The numerator is increased by the after-tax interest that would have been avoided if the bonds really had not been outstanding. This is the €6 million ―Consequence of potential ordinary shares on net income.‖

Question F1808 The first of the two changes in Note 2 describes a change in principle. (Actually, both changes reported are changes in accounting principle.) In the first change described in Note 2: Restatement of Accounts 2018, Air France followed the retrospective approach, which is required for most changes in accounting principle. The change did not affect net income, but instead the way compensation to customers for delayed or cancelled flight is reported within the income statement, which was restated retrospectively.

Question F1809 Yes. This the same approach AF would follow if using U.S. GAAP. In fact, U.S. GAAP and International standards are largely converged with respect to accounting changes and error corrections. One remaining difference is that when correcting errors in previously issued financial statements, IFRS permits the effect of the error to be reported in the current period if it‘s not considered practicable to report it retrospectively as is required by U.S. GAAP.

Question F1810 AF‘s statement of cash flows, prepared in accordance with IFRS, classifies cash flows as arising from operating, investing, or financing activities.

Question F1811 No. This classification is the same as cash flow statements prepared in accordance with U.S. GAAP.

Question F1812 Yes. U.S. GAAP designates dividends received as operating cash flows.

Question AF reports dividends received as investing activities. It reports dividends paid as a financing F1813 activity. Interest received and interest paid are reported as operating activities. IAS No. 7 allows flexibility, permitting companies to report (a) interest and dividends received as operating or investing and (b) interest paid as operating or financing, provided that they are classified consistently from period to period. U.S. GAAP designates (a) interest payments and interest received as operating cash flows and (b) dividend payments as financing cash flows and dividends received as operating cash flows.

Question F1814 In Notes 36:1 and 36:2, AF lists the following risk exposures, along with the various derivative instruments to hedge its risk exposures: Commodity Risk—Jet Fuel Prices – oil price volatility is a risk for the industry, especially sharp increases that cannot be adjusted through ticket prices. AF hedges jet fuel prices with swap and option contracts based on crude oil, gas oil and jet fuel prices (cash flow hedges). Currency Risk—US Dollar Exposure – AF‘s revenues are generated in euros, but because of international activities, the principal exposure relates to US dollars, because of significant expenditures on items based in USD. AF hedges its foreign currency risk with exchange rate options and forward purchases and sales contracts that are designated as cash flow hedges for its operating flows and fair value hedges for the investment in flight equipment. Interest Rate Risk-debt – a portion of AF‘s debt is contracted at floating rates. AF/KLM use option and swap strategies to effectively convert a significant portion of floating rate debt to fixed rate debt.

Question F13 Air France/KLM recognizes $496 million of derivative instruments in the other assets section ($258 current; $238 noncurrent) of their balance sheet, and $261 million ($154 current; $107 non-current) as other liabilities.