Solution manual intermediate accounting 9e by nicolai ch03

Q3-10 The five alternatives for measuring valuing assets are: historical cost, current cost to replace, current market value in orderly liquidation, net realizable value in due course of

CHAPTER 3

THE BALANCE SHEET AND STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

CONTENT ANALYSIS OF EXERCISES AND PROBLEMS

E3-1 Current Assets Partial balance sheet preparation from listed

E3-6 Balance Sheet Preparation from accounts listed in random

order Calculation of debt ratio

15-20

E3-7 Balance Sheet Preparation from accounts listed in

alphabetical order Calculation of working capital and current ratio

15-20

E3-8 Balance Sheet Calculations Calculate missing information,

given amounts of selected balance sheet elements 15-25 E3-9 Balance Sheet Calculations Calculate missing information,

given amounts of selected balance sheet elements

15-25

E3-10 Corrections Preparation of a properly classified balance sheet

from one prepared erroneously

10-15

E3-11 Changes in Stockholders' Equity Stock issuance, income

earned, dividends paid Statement of changes in stockholders' equity

10-15

E3-12 Changes in Stockholders' Equity Stock issuance, income

earned, dividends paid Statement of changes in stockholders' equity

10-15

P3-1 Balance Sheet Matching various accounts with major

P3-2 Balance Sheet Format preparation, no amounts 20-40

P3-3 Balance Sheet Preparation from accounts listed in

alphabetical order Identification of possible disclosures

Computation of working capital and current ratio

30-45

P3-4 Balance Sheet Preparation from accounts listed in random

order

20-40

P3-5 Balance Sheet Preparation from alphabetical adjusted trial

balance Calculation of debt ratio

20-30

P3-6 Balance Sheet Preparation from accounts listed in random

order Notes Calculation of current ratio, liquid assets, and separable assets

45-60

P3-7 Comprehensive Preparation of balance sheet from accounts

listed in alphabetical order Notes Statement of changes in stockholders' equity Calculation of debt ratio and discussion

75-90

P3-8 Corrections Preparation of a properly classified balance sheet

from one prepared incorrectly, using account breakdowns 30-45 P3-9 Corrections Preparation of a properly classified balance sheet

from one prepared incorrectly, using additional available information

30-45

P3-10 Balance Sheet Calculations Calculate missing information,

given amounts of selected balance sheet elements

20-30

P3-11 Errors Identification of balance sheet errors Preparation of a

properly classified balance sheet from one prepared erroneously

30-45

P3-12 (AICPA adapted) Complex Balance Sheet Preparation of

corrected balance sheet from unaudited balance sheet and additional information

45-60

P3-13 Changes in Stockholders' Equity Stock issuance, treasury stock,

paid dividends, donation, earned income Statement of changes in stockholders' equity

10-15

P3-14 Balance Sheet Disclosures Questions relating to the review of

The Coca-Cola Company balance sheet disclosures in Appendix A

20-40

ANSWERS TO QUESTIONS

Q3-1 The major financial statements of a company are:

1 A balance sheet, which summarizes the company's financial position at the end

of the accounting period

2 An income statement, which summarizes the results of operations of the

company for the accounting period

3 A statement of cash flows, which summarizes the cash inflows and cash

outflows of a company for the accounting period

Many companies also include a statement of changes in stockholders' equity, which summarizes the changes in each item of a company's stockholders' equity for the accounting period, as a fourth major financial statement

Q3-2 The financial position of a company includes its economic resources (i.e., assets),

economic obligations (i.e., liabilities), and equity, and their relationships to each other

at a moment in time

Q3-3 One purpose of a company's balance sheet is to provide information about its

liquidity, financial flexibility, and operating capability A second purpose of the balance sheet is to provide a basis for evaluating the company's income-producing performance during a period

Q3-4 Liquidity refers to how quickly an asset of a company can be converted into cash or

a liability paid Financial flexibility refers to the ability of a company to use its financial resources to adapt to change Operating capability refers to the ability of a

company to maintain a given physical level of operations

Q3-5 Financial capital is the monetary value of the net assets contributed by stockholders

and the value of the increase in net assets resulting from earnings retained by the corporation (cumulative income in excess of cumulative dividends) Capital

maintenance refers to maintaining the stockholders' equity of the corporation in order to provide a return of investment Information about the maintenance of a corporation's capital is important in assessing the adequacy of a corporation's

profitability and its ability to provide a return on investment

Q3-6 Recognition is the process of formally recording and reporting an element in the

financial statements It includes depiction of an element in both words and numbers, with the amount included in the totals

Q3-7 An asset is a probable future economic benefit obtained or controlled by a

company as a result of a past transaction or event To be considered an asset, an economic resource must have three characteristics First, the resource must singly, or

in combination with other resources, have the capacity to contribute directly or indirectly to the company's future net cash inflows Second, the company must be able to obtain the future benefit and control others' access to it Third, the

transaction or event giving the company the right to or control over the benefit must

Q3-8 A liability is a probable future sacrifice of economic benefits arising from a present

-obligation of a company to transfer assets or provide services to other entities in the

future as a result of a past transaction or event An obligation of a company must

have three characteristics to be considered a liability First, it must entail a

responsibility to another entity or entities that will be settled by a sacrifice involving

the transfer of assets, providing services, or other use of assets at a specified or

determinable date, on occurrence of a specified event, or on demand Second, the

responsibility must obligate the company in a way that it has little or no discretion to

avoid the future sacrifice Third, the transaction or other event obligating the

company must have occurred

Q3-9 Stockholders' equity is the residual interest in the assets of a corporation that remains

after deducting its liabilities

Q3-10 The five alternatives for measuring (valuing) assets are: historical cost, current cost to

replace, current market value in orderly liquidation, net realizable value in due

course of business, and present value of future cash flows The latter four alternatives

are ways of measuring the fair value of an asset Historical cost is the valuation

method usually used in a company's balance sheet

Q3-11 A company's balance sheet is divided into three major sections each with the

Current assets may include five items: (1) cash (and cash equivalents), (2) temporary

investments in marketable securities, (3) receivables, (4) inventories, and (5) prepaid

items

Current liabilities are obligations whose liquidation is expected to require the use of

existing resources properly classified as current assets, or the creation of other current

liabilities within one year or the normal operating cycle, whichever is longer

Q3-12 (continued)

Examples of current liabilities are accounts payable, taxes payable, unearned rent, salaries payable, estimated liabilities for warranties, and the current portion of long-term debt

Q3-13 A company's operating cycle is the average time taken by the company to spend

cash for inventory, process and sell the inventory, and collect the receivables,

converting them back into cash

Working capital of a company relates primarily to the financial resources utilized in its operating cycle

Working capital is computed by subtracting current liabilities from current assets Q3-14 a If management expects to hold investments for more than one year or the

operating cycle, whichever is longer, these investments are classified as term Long-term investments include:

long-1 Noncurrent investments in available-for-sale debt and equity securities

2 Investments in held-to-maturity debt securities

3 Investments in noncurrent notes receivable of unaffiliated companies and long-term advances to unconsolidated affiliated companies

4 Financial instruments (such as options to buy stock) that are noncurrent

5 Investments in property and equipment being held for use in future operations

6 Special funds established for long-term purposes, such as the retirement of bonds or the acquisition of equipment

7 Miscellaneous investments, such as the cash surrender value of life insurance

b All tangible assets used in the operations of a company are classified as property, plant, and equipment They include:

Q3-14 (continued)

-c Economic resources that are used in the operations of the business but that have

no physical existence are classified as intangible assets They include:

expected to create current liabilities within one year or the normal operating cycle (whichever is longer) are classified as long-term liabilities They include:

1 Bonds payable

2 Long-term notes payable

3 Capital lease contract obligations

4 Mortgages payable

5 Pension obligations

6 Obligations under noncurrent financial instruments

b Other liabilities are miscellaneous liabilities not meeting the definition of either a

current or long-term liability They include:

1 Deferred income taxes payable

2 Obligations of a segment of the company that is being discontinued

3 Long-term advances from customers Q3-16 A bond is a written promise to pay a specified interest rate and to repay a specific

amount (its face value) at some future maturity date

Bonds payable may be disclosed on a company's balance sheet as follows:

Long-term liabilities 10% bonds payable outstanding, due

$ 85,000 Q3-17 a Capital stock are the shares of stock that a corporation is authorized to issue as

evidence of ownership in that corporation There are two types of capital stock, preferred stock and common stock Preferred stock has a preference over common stock as to dividends Common stock carries the right to vote at the annual stockholders' meeting and to share in residual profits

b Additional paid-in capital represents the amount paid to the corporation by

stockholders in excess of the par value of the stock issued

c Treasury stock is the capital stock of a corporation that has been issued but

reacquired by the corporation

Q3-17 (continued)

d Retained earnings is the amount of corporate earnings that has not been distributed to stockholders as dividends

e Deficit is the term used to describe a negative retained earnings balance

f Accumulated other comprehensive income is the other comprehensive

income [from items such as unrealized increases (gains)or decreases (losses) in the market value of investments in available-for-sale securities] that a

corporation has accumulated to date

Q3-18 Investments by owners are increases in the equity of a company resulting from

transfers of something valuable to the company from other entities in order to obtain

or increase ownership interests Distributions to owners are decreases in the equity of

a company caused by transferring assets, rendering services, or incurring liabilities to owners Many companies report these items in a statement of changes in

stockholders' equity

Q3-19 Examples of accounting policies that are disclosed in the notes accompanying a

company's financial statements include:

1 Basis for consolidation

2 Depreciation and amortization methods

3 Inventory pricing method

4 Method for recognition of profits on long-term contracts

5 Revenue recognition method for franchise and leasing operations

6 Methods of foreign currency translation

The disclosure of accounting policies is important because it enables the external users of financial statements to see:

1 What method is employed by the company among existing acceptable

alternatives

2 Whether any method peculiar to the industry is used by the company

3 Whether there are any unusual or innovative applications of generally accepted accounting principles

Q3-20 Financial instruments include such items as notes payable and receivable, contracts

for loan commitments, collateralized mortgages, interest rate swaps, and put and call options on stocks A company is also required to disclose the fair value of all its financial instruments (both assets and liabilities), whether recognized or not on the balance sheet, as well as all significant concentrations of credit risk due to its

financial instruments A company is required to disclose information such as the types

of derivative financial instruments it holds, its objectives in holding the instruments, and its strategies for achieving these objectives The description must indicate the company's risk management policy in regard to each type of instrument

Q3-21 A loss contingency is a condition, situation, or circumstance that exists for a company

-on its balance sheet date involving uncertainty as to possible losses that it may incur if

some future event occurs

The following criteria are required for a company to accrue a contingent liability:

1 It is probable that a liability has been incurred (or an asset impaired), and

2 The amount of the loss can be reasonably estimated

If either of these criteria is not met, a company discloses a contingent liability in a

note accompanying its financial statements

Q3-22 Usually a time lag of several weeks or months exists between the end of a company's

accounting period and the date of the issuance of its annual report During this time,

it is possible for significant business events and transactions to occur, which, if not

disclosed in the company's annual report, would cause this report to be misleading

When subsequent events occur that provide additional evidence concerning

conditions that existed on the balance sheet date and significantly affect the

estimates the company used in the preparation of its financial statements, an

adjustment is made to the financial statements Subsequent events that provide

evidence concerning conditions that did not exist on the balance sheet date but

occurred after that date are disclosed in the form of a note, in pro-forma ("as if")

statements, or in an explanatory paragraph in the audit report, depending on the

materiality of the financial impact

Q3-23 For related-party transactions, a company must disclose (1) the nature of the

relationship involved, (2) a description of the transactions, (3) the dollar amount of

the transactions, and (4) any amounts due to or from the related parties on the

balance sheet date

Q3-24 Comparative financial statements provide current as well as past financial

information about a company Such information enables a trend to be drawn of the

company's activities, thus yielding useful insights into the prediction of the company's

future performance

Q3-25 In an audit the certified public accountant is responsible for making an examination

of the accounting system, records, and reports of a company in accordance with

generally accepted auditing standards and, based on this examination, expressing

an opinion as to the fairness of the company's financial statements and

accompanying notes in accordance with generally accepted accounting

principles The opinion, or auditor's report, usually provides external users with

additional confidence that the reported financial statements and notes are a fair

presentation of the company's financial resources, obligations, and activities

Q3-26 The SEC "integrated" disclosures that most regulated companies include in their

annual reports are:

(1) Comparative financial statements These include comparative balance sheets

for two years and comparative income statements and statements of cash flows for three years

Q3-26 (continued)

(2) Selected financial data These include (for a five-year period) net sales or operating revenues, income (loss) from continuing operations and related earnings per share, total assets, long-term obligations and redeemable stock, and cash dividends declared per share

(3) Management's discussion and analysis This involves a discussion and analysis of the company's financial condition, changes in financial condition, and results of operations It includes, at a minimum, specific information about short-term and long-term liquidity and capital resources, a narrative discussion of the impact of inflation on sales and on income from continuing operations, explanations of material changes in financial statement items between years, and known events and uncertainties expected to impact future operations (4) Common stock market prices and dividends Information included here

consists of the principal trading markets for the company's common stock, the high and low market prices for each quarter in the last two years, the

approximate number of stockholders, the dividends paid in the last two years, and any dividend restrictions

Q3-27 Under International Accounting Standards, on a company's balance sheet long-term

assets are listed first followed by current assets Then, capital and reserves are listed, followed by long-term liabilities Current liabilities are listed last

Q3-28 The report form of the balance sheet takes a vertical format in which the asset

accounts are listed first and the liability and stockholders' equity accounts are listed in sequential order directly below the assets In the account form, the balance sheet is organized in a horizontal fashion, with the asset accounts listed on the left-hand side and liabilities and stockholders' equity accounts listed on the right-hand side

Q3-29 Additional information not included in the accounts reported on a company's

financial statements can be disclosed by the following alternative methods

1 Notes are used to describe narrative information and to provide additional

monetary amounts (and sometimes supplemental schedules)

a Retained earnings statement

b Itemization of long-term liabilities

3 Parenthetical notations are used to explain such items as the method of valuation

or of determining the ending inventory, or to cross-reference certain related asset and liability accounts Examples include:

Q3-29 (continued)

-3 (continued)

a Lower of cost or market method of valuing inventories

b The FIFO method of valuing ending inventory

c Cross-referencing a bond sinking fund to the related bonds payable Q3-30 When preparing and writing financial reporting notes, the accountant should (1)

specify what data are to be disclosed (by reference to related generally accepted

accounting principles), (2) outline the desired format, (3) use short sentences, (4) use

terminology understandable to the non-accountant, and (5) be concise but

complete

ANSWERS TO CASES

C3-1

There are several alternative valuation methods other than historical cost that a company

could use to measure the value of an asset First, the current cost of an asset might be

measured in terms of the amount of cash (or equivalent) that would be required on the

date of the balance sheet to obtain the same asset Methods for obtaining the current

cost of an asset include quoted market prices, the use of specific price indexes, and the

use of appraisals Inventories, which include goods held for resale in the normal course of

business, or in the case of a manufacturing company, raw materials and goods in process

inventories, are listed at their market value (current cost) when that value is lower than

cost

Second, the current market value of an asset might be measured in terms of the amount

of cash (or equivalent) that could be obtained on the date of the balance sheet by

selling the asset, in its present condition, in an orderly liquidation A current market value

would be determined by obtaining a quoted market price for the sale of an asset of

similar kind and condition Short-term marketable securities are listed at their current

market (fair) value

Third, the value of an asset might be determined by measuring its net realizable value This

method values the asset at the amount of cash (or equivalent) into which the asset is

expected to be converted in the ordinary operations of the company, less any expected

conversion costs It is based upon expected future sales proceeds of the asset and is

sometimes referred to as expected exit value Both accounts receivable and notes

receivable are listed at their estimated collectible amounts (net realizable values)

A fourth alternative valuation method is present value The present value of an asset is the

net amount of discounted future cash inflows less the discounted future cash outflows

relating to the asset The estimated cash flows used to determine present value are similar

to those used to determine net realizable value with the exception that in the present

value approach consideration is given to the time value of money Long-term investments

(i.e., bonds) may be listed at their present value, depending on the type of investment

C3-2

Contingent liabilities are conditions that exist on a company's balance sheet date

involving uncertainty as to possible losses that the company may incur should some future event occur Two types of disclosures are generally made relating to contingent liabilities:

1 An estimated loss is accrued (reported) if it is probable that a liability has been

incurred and the amount of the loss can be reasonably estimated

2 If either of the above conditions is not met, the company discloses the loss

contingency in the notes to its financial statements

The disclosure of contingent liabilities is important in providing external users with additional information which may help them in predicting the use of financial resources by the

company in the future

Subsequent events are significant business events or transactions that occur between a company's balance sheet date and the date of issuance of its annual report There are two different types of subsequent events:

1 Those that provide additional evidence concerning conditions that existed on the balance sheet date and significantly affect the estimates the company used in the preparation of the financial statements For these subsequent events, an adjustment

is made to the financial statements

2 Those that provide evidence concerning conditions that did not exist on the

company's balance sheet date, but instead occurred after that date For these, disclosure is in the form of a note, pro-forma ("as if") statements, or in an explanatory paragraph of the audit report

Since a company's annual report is not issued for some time after the close of the year, disclosure of subsequent events is necessary for a set of fair, more informative, and

complete financial statements The failure to report subsequent events may cause its financial statements to be misleading

C3-3 (CMA adopted solution)

Note to Instructor: This case is slightly more advanced than the text explanation, but is useful for class discussion

1 The major classes of information that must be included in both the annual report to

shareholders and Form 10-K filed with the SEC are:

audited financial statements

five-year summary of selected financial data

management's discussion and analysis of financial condition and results of operations market data disclosure for common stock and related security holder matters

C3-3 (continued)

-2 a Incorporation by reference permits the corporation to cross-reference schedules from

other documents Information from the proxy or corporate annual report may be

substituted by reference for various sections of the 10-K to avoid repetition of already

available data

b The integrated disclosure system reduces management's efforts in filing annual

reports with the SEC because the SEC is asking for essentially the same information as

is already provided on the uniform financial statements or other documents Thus,

repetition of already available data is avoided, and the time and cost to file reports

are reduced

c The SEC's principal reasons for making the changes in the annual reporting process

are to improve disclosure to investors and other users of financial information and to

achieve a single disclosure system at a reduced cost

d Potential problems the integrated disclosure system could have on the annual

reporting process from the aspect of financial information are that:

Information overload in the annual report could cause users greater difficulty in

understanding and analyzing the report

The quality of disclosure may decline as there may be less control over how data

are presented

C3-4

To: President

From: Accountant

I am writing in response to your question concerning the recording of property, plant, and

equipment at the current appraised cost Although this method would increase our

reported 2004 earnings, it is not appropriate

According to GAAP, property, plant, and equipment is measured and recorded at the

exchange price (historical cost) minus any accumulated depreciation Consequently,

reporting it at current cost would violate this historical cost concept In addition, by using

current cost and showing a gain in this year, we would be reducing comparability, not

only between our own financial statements of past years, but also between our financial

statements and those of other companies that follow GAAP This would create an ethical

issue because we would appear to have higher earnings than a company using GAAP,

which might put us at an unfair advantage regarding the market price of our stock and

our ability to sell stock and borrow money

Furthermore, because we are using a method which is not in compliance with GAAP, our

auditor would be required to disclose this in the auditor's report If the difference between

using historical cost and current cost were material enough, it may prevent the auditor

from giving us an unqualified opinion Such a result would greatly harm our reputation to

external users

C3-4 (continued)

Although our goal is ultimately to increase the value of our company's stock and satisfy the investment requirements of our stockholders, using a method which is not GAAP to manipulate our asset values and earnings is unethical in that it is unfair to (justice criterion), violates the rights of (rights criterion), and does not optimize the satisfaction (utility

criterion) of our various stakeholders (e.g., current and potential investors, creditors,

suppliers, community, etc) Therefore, it will be more beneficial to our company in the long run if we report our property, plant, and equipment at historical cost in accordance with GAAP, even though it results in lower earnings, than to ignore GAAP and mislead our external users

C3-5

Historical cost is the method primarily used to measure the "value" of the various assets reported on the balance sheet of a company In general, each asset is recorded at the exchange price of the transaction in which the asset is obtained Usually this exchange price is then reported in the entity's balance sheet until another exchange has taken place Certain modifications to this general rule are made for specific assets The

valuation and reporting of specific assets are discussed below

Cash is reported at its monetary value Temporary investments in marketable securities are reported at their market (fair) value (current market value) Receivables are reported

at their estimated collectible amounts (net realizable values) Inventories are reported at their cost or market value (current cost), whichever is lower Finally, prepaid items are reported at their historical cost, less any amortized amount

Long-term investments can be reported in several ways They may be listed at their market (fair) value, historical cost, book value, or present value, depending on the type of investment Property, plant, and equipment, on the other hand, are measured and reported at their historical cost adjusted for depreciation, with the exception of land which is listed at its historical cost Property, plant, and equipment that has been impaired

is reported at its lower fair value In addition, a capital lease is initially recorded as an asset at the present value of the future lease payments and is amortized in a manner similar to other legally owned assets of the company Intangible assets with a finite useful life are reported on the balance sheet at their book values Intangible assets that have been impaired are reported at their lower fair value

The "value" of the $1,100,000 total assets is determined by summing the "values" reported for the individual assets Thus, the $1,100,000 total assets reported in the balance sheet does not represent the total current value of the company's assets

With respect to the common stock, the $1,000,000 total value of the outstanding common stock will ordinarily not agree with the total "value" of the assets reported on the balance sheet for several reasons First, as discussed above, the amount reported for total assets does not reflect the current values of the individual assets Second, the company may hold economic resources that are valuable but are not reported on the balance sheet because they do not meet the definition of an asset Finally, the accounting equation states that the total of the assets is equal to the sum of the liabilities and stockholders' equity; that is, assets are not only financed by common stockholders, but by creditors and

C3-6 (AICPA adapted solution)

-Note to Instructor: The answer to this case also involves a discussion of the impact on

earnings, discussed in Chapter 4

1 Valuation of assets is a significant issue because of its effect on the statement of financial

position and the statement of earnings The valuation method used affects the

measurement of total assets and the timing and amount of periodic net earnings This

relationship between asset valuation and measurement of net earnings is referred to as

"articulation" between these two financial statements

2 Historical-cost valuation reports assets at their acquisition cost (net of depreciation,

depletion, or amortization, if applicable) and is the total of exchange prices to obtain an

asset and render it suitable for use Such valuation is measured by the cash or cash

equivalent sacrificed in exchange for the asset There is an inherent assumption that a

stable monetary unit exists

Because acquisition cost is the vital measurement, that amount for limited life assets is

allocated on a reasonable basis to future periods as expense or as a factor in the cost of

goods sold (if inventory) It is, therefore, the actual past purchase price that affects the

future period's measurement of net earnings under the matching concept Because of

this emphasis on matching each period's revenue and expense, the earnings statement

emerges as the primary financial statement based on a transactions approach and the

statement of financial position becomes partly a statement of un-allocated past costs for

nonmonetary assets

Concerning allocation to the earnings statement under historical-cost valuation, gains are

normally recognized in the period they are realized through sale or use Unrealized gains

are not considered Unrealized losses, theoretically, should be treated the same as

unrealized gains; nevertheless, conventional accounting practice permits recognition of

some unrealized losses This inconsistent treatment is justified under the doctrine of

conservatism

Historical cost adjusted to reflect general price-level changes is a valuation method that

uses the historical cost (previously discussed) of nonmonetary assets and applies a general

price-level index to reflect changes in the standard unit of purchasing power, the dollar,

so that the information reported is not biased by changes in the ability of the dollar to

command goods and services In this way, information reported in successive periods

(time-series data) would be expressed in terms of a constant unit of measure

Nonmonetary assets are, therefore, stated in terms of the units of general purchasing

power as of the date of the statement These adjusted amounts do not measure any form

of "current value" except by coincidence

Monetary assets (cash, accounts receivable, etc.) are fixed claims to units of purchasing

power that are the same as the units of dollars Nonetheless, holding net monetary assets

(monetary assets in excess of monetary liabilities) during a period of rising prices causes a

general price-level loss because these assets represent a fixed claim to reduced

purchasing power A general price-level gain occurs by holding net monetary assets

during periods of falling prices (or by being a net debtor in periods of rising prices) These

general price-level losses and gains would be shown on a company's earnings statement

They reflect, in part, the stewardship of management during a period of changing price

levels

C3-6 (continued)

2 (continued)

Discounted-cash-flow valuation is one method that yields a "current-value" measurement Under this approach, assets are reported at the present value of their estimated future net cash inflows Thus, it is considered a future exchange price It reflects the notion that assets represent future service potential (economic benefits) and an attempt should be made to measure this potential (benefit) for reporting

When using the discounted-cash-flow approach, net earnings would be equal to the discounted amount of stockholders' equity at the beginning of the period multiplied by the rate used to discount the future net cash flow This reflects the amount that could be paid out to stockholders and still leave the business as "well off" at the end of the period as

it was at the beginning of the period

Market-price valuation yields a different "current-value" measurement Under this

approach, assets are reported at their present realizable sales prices at the date of the statement of financial position These selling prices should be market selling prices of similar assets under conditions of orderly sales, rather than liquidation selling prices under conditions of forced sales Use of current market selling prices is an indicator of present cash equivalents of the assets and reflects existing market alternatives; such use does not assume that these assets will necessarily be sold at those prices

When using the market-price approach, net earnings would equal net assets (assets minus liabilities) at the end of the period plus capital withdrawals and dividends, less capital additions and net assets at the beginning of the period Net earnings are, therefore, based on the valuation of the company's assets (and liabilities) because these assets generate such earnings Net earning are not based on a transactions approach and, therefore, do not include arbitrary cost allocations to an accounting period

Replacement-cost valuation yields another, and different "current-value" measurement Under this approach, assets are reported at the market price quoted to acquire them (replacement in kind) Current replacement cost, which may be approximated by using a specific price index or by appraisals, reflects supply and demand for the specific asset(s) in question Replacement-cost valuation can be based upon either replacement in kind or replacement or equivalent services or benefits

When using the replacement-cost approach, net earnings include earnings computed by the transactions approach and gains or losses from holding assets (and liabilities) whose purchase prices rise or fall The earnings statement thus contains some unrealized items (from a conventional viewpoint) Part of the traditionally determined net earnings would, under replacement-cost accounting, be reclassified as holding gains or losses The

earnings statement would show earnings from operations by deducting from current revenue the cost to replace the goods and services consumed in generating that

revenue, plus holding gains or less holding losses resulting from changes in the

replacement cost of the resources (and obligations) held

C3-7

-1 A description of all significant accounting policies of a company must be included as an

integral part of its financial statements Generally, the disclosures should encompass a

discussion of the principles relating to revenue recognition and asset allocation,

particularly when these principles and methods involve (1) a selection from existing

acceptable alternatives, (2) principles and methods peculiar to the industry in which the

company operates, and (3) unusual or innovative applications of generally accepted

accounting principles Examples cited include, among others, those policies related to

the basis for consolidation, depreciation methods, amortization of intangibles, inventory

pricing, recognition of profits on long-term contracts, and revenue recognition from

franchise and leasing operations

2 a The consolidated financial statements include the accounts of the company and all

subsidiaries except where control is temporary and does not rest with the company

b Marketable securities that are highly liquid and have maturities of three months or less

at the date of purchase are classified as cash equivalents

c Inventories are valued at the lower of cost or market In general, cost is determined

on the basis of average cost or first-in, first-out (FIFO) methods

d Property, plant, and equipment are stated at cost and are depreciated principally

by the straight-line method over the estimated useful lives of the assets

e Trademarks and other intangible assets are stated on the basis of cost and are

amortized, principally on a straight-line basis, over the estimated future periods to be

benefitted (not exceeding 40 years) Trademarks and other intangible assets are

periodically reviewed for impairment to ensure they are appropriately valued

Accumulated amortization was approximately $285 million at December 31, 2001

f The company expenses production costs of print, radio, and television

advertisements as of the first date the advertisements take place Advertising costs

of approximately $52 million were included in prepaid expenses and other assets and

noncurrent other assets at December 31, 2001

C3-8

Note to Instructor: This case does not have a definitive answer From a financial reporting perspective, GAAP is identified and summarized From an ethical perspective, various issues are raised for discussion purposes

From a financial reporting perspective, this is considered a subsequent event If a

subsequent event occurs that provides additional evidence about conditions that existed

on the balance sheet date and significantly affects an estimate used in preparing the financial statements, an adjustment is made to them If the subsequent event occurred after the balance sheet date, an adjustment is not made Instead, the information is disclosed in a note, pro forma statements, or an explanatory paragraph in the audit report, depending on its materiality Thus, if there is sufficient evidence that some or all of Travis Company's $50,000 account receivable will not be collected and the uncollectibility existed at the end of 2004, then recognition of a loss and a writedown of the accounts receivable should be made in Davenport's 2004 financial statements If there is sufficient evidence of the uncollectibility but it did not occur until 2005, then a note (or other)

disclosure is appropriate

From an ethical perspective there are several primary stakeholders, including the creditors and stockholders of Davenport Corporation, the creditors and stockholders of Travis Corporation, Jim Davenport, and Ted Travis If the loss and writedown are recognized, this will decrease Davenport Corporation's income and working capital which may have an adverse affect on Davenport's ability to provide a return to stockholders and pay

creditors It may also affect users' perceptions of Jim Davenport's ability to manage the company Recognition of the loss by Davenport may also provide "corroborating"

evidence of Travis Corporation's financial difficulty, which may adversely affect its

creditors, stockholders, and president Disclosure in the notes (or elsewhere) may have similar, but less significant effects From an ethical perspective, the critical questions are what, if any, reporting of the financial difficulty of Travis in Davenport's annual report is fair and just, and whether the reporting would respect the rights of stakeholders?

The questions that are important from financial reporting and ethical perspectives in this situation are how reliable is the newspaper report, what is meant by financial difficulty, and when did the financial difficulty of Travis occur Additional information must be

gathered concerning each of these questions For instance, there are times when

newspaper reports misstate the facts What is the source of the newspaper report; can it

be corroborated? In regard to financial difficulty, how is this defined and how serious is it? Financial difficulty may mean that sales or income have decreased, but cash flows are sufficient to pay creditors And, if there is serious financial difficulty, was this in existence at the end of 2004 or did some significant event occur in early 2005 to cause it? There are three alternative courses of action from financial reporting and ethical perspectives: (1) recognize the loss, (2) disclose the financial difficulty in a note (or other means) to the financial statements, or (3) not report anything in regard to Travis The action to select will depend on the answers to the preceding questions If there is sufficient evidence that Travis Company is in serious enough financial difficulty to jeopardize the collection of its receivable and the difficulty existed at the end of 2004, then from financial and ethical perspectives, it is appropriate for Davenport Company to recognize a loss and writedown the receivable

C3-9

-Note to Instructor: This case does not have a definitive answer From a financial reporting

perspective, GAAP is identified and summarized From an ethical perspective, various

issues are raised for discussion purposes

From a financial reporting perspective, the note receivable from the president is the result

of a related party transaction of Spaedy Company For this transaction, GAAP requires

disclosures of the nature of the relationship involved, a description of the transaction, the

dollar amount, and the amount due from the president GAAP does not specify where (or

how) on the balance sheet the receivable from a related party should be classified The

note could be classified as a current asset if it is expected to be collected in 2005, or as a

noncurrent asset if it is expected to be collected later than 2005

From an ethical perspective, where this note is classified and how it is reported may have

an impact on the rights of, and fairness to, the various stakeholders These stakeholders

include the creditors, stockholders, and president of Spaedy Company If the note is

classified as a current asset in the usual manner (which would increase the working capital

and current ratio) as suggested by the president, this might reflect positively on

perceptions of the president's management However, since there is no specified due

date, there is considerable uncertainty that it will be collected in 2005 Without additional

evidence (say, from the board of directors) that the note will be collected in 2005, a

normal current asset classification would misrepresent the liquidity of and risk associated

with the company This would violate the rights of and be unfair to creditors who might

expect the proceeds from the collection to be available for payments to them, as well as

the stockholders who might perceive there is less risk of investment in the company

because of its higher current ratio and working capital Even if it was determined that

repayment by the president is likely to occur in 2005, so that the note is classified as a

current asset, for full disclosure the note should not be reported as a routine note

receivable Rather, it should be labeled something like "note receivable from officer" so

that users can make whatever adjustments they feel are appropriate to the current ratio

and working capital If additional evidence does not support a likely payment in 2005,

then a noncurrent classification with a similar title is appropriate for the note receivable

From: Assistant Accountant

I have researched the issue of how to report the $100,000 note payable (that is due on March 6, 2005) on the Tyler Corporation's December 31, 2004 balance sheet Recall that the company issued common stock for $80,000 on January 5, 2005 and intends to use the proceeds (plus $20,000 cash it already has on hand) to repay the note payable on March

6 This situation falls under the category of a "short-term obligation expected to be

refinanced." According to the FASB Current Text, par B05.113 (FASB Original

Pronouncements, FAS 6, par 9-11), a company excludes a short-term obligation from its current liabilities if it intends to refinance the obligation on a long-term basis and it has the ability to do so The company can demonstrate its ability to refinance the short-term obligation by issuing equity securities after the date of its balance sheet but before the date that the balance sheet is issued B05.114 (FAS 6, par 12) goes on to state that the amount of the short-term obligation that is excluded from current liabilities shall not

exceed the proceeds of the equity securities issued Footnote 9 of B05.113 (FAS 6, par 11, footnote 2) also states that the amount of the short-term obligation excluded from current liabilities (because of the issuance of equity securities) is not included in owners' equity Finally, B05.118 (FAS 6, par 15) indicates that the company must include a general

description of the equity securities issued in the refinancing

The Tyler Corporation intends to refinance the $100,000 note payable on a long-term basis and has demonstrated its ability to do so by issuing its common stock for $80,000

Therefore, based on the preceding generally accepted accounting principles, I

recommend that Tyler Corporation report $20,000 of the note payable as a current liability and $80,000 as a long-term liability My reasoning in regard to the amounts is that only the portion of the short-term obligation that is equal to the proceeds ($80,000) may be

excluded from current liabilities My reasoning as to the classification of the $80,000 as a long-term liability is that the excluded amount should not be reported as stockholders' equity because the common stock had not yet been issued on the balance sheet date I also recommend that Tyler Corporation include a note to its financial statements which indicates that $80,000 of the $100,000 note payable is to be refinanced by the issuance of 2,000 shares of the company's $10 par common stock after the balance sheet date

ANSWERS TO MULTIPLE CHOICE

-SOLUTIONS TO EXERCISES

E3-1

JENKINS COMPANY Current Asset Section of Balance Sheet

Balance Sheet December 31, 2004

Cost Accumulated Depreciation Value Book

*Includes office building with cost and accumulated depreciation of

$50,000 and $15,000, respectively, and factory building with cost

and accumulated depreciation of $120,000 and $36,000, respectively

-E3-3

GRAF CORPORATION Stockholders' Equity Section of

Balance Sheet December 31, 2004 Contributed Capital

Accumulated Other Comprehensive Income 8,200

+The unrealized decrease is a negative (although not strictly a contra-

account) component of Accumulated Other Comprehensive Income

*Although the letter is checked, the Deficit account is not a contra-account

to retained earnings Instead, it is the title given to a negative retained

D

B A√

accumulated other comprehensive income to arrive at total stockholders' equity

*Although the letter is checked, the Deficit account is not a contra-account to

retained earnings Instead, it is the title given to a negative retained earnings

balance

E3-6

Balance Sheet December 31, 2004

Assets Current Assets

Sinking fund to retire bonds payable 5,000

Property, Plant, and Equipment

Less: Accumulated depreciation (21,000) 36,400

Less: Accumulated depreciation (9,700) 19,000

Total property, plant, and equipment 67,600 Intangible Assets

Liabilities Current Liabilities

Bonds payable (due 2014) $ 23,000

Premium on bonds payable 1,400 $24,400

-E3-6 (continued)

1 (continued)

Stockholders' Equity Contributed Capital

Total Liabilities and Stockholders' Equity $118,100

2 Debt ratio = Total liabilities Total assets

43.4% = $51,300 $118,100

E3-7

Balance Sheet December 31, 2004

Assets Current Assets

Property, Plant, and Equipment

Less: Accumulated depreciation (53,000) 91,000

Less: Accumulated depreciation (35,100) 37,300

E3-7 (continued)

1 (continued)

Liabilities Current Liabilities

Less: Discount on bonds payable (6,900)

Stockholders' Equity Contributed Capital

Additional paid-in capital on preferred stock 11,500

Additional paid-in capital on common stock 24,000

Accumulated Other Comprehensive Income

Unrealized increase in value of marketable securities 1,100

Total Liabilities and Stockholders' Equity $238,700

2 Working capital = Current assets - Current liabilities

$32,100 = $66,900 - $34,800 Current ratio = Current assets Current liabilities

1.92 = $66,900 $34,800

-E3-8

Note to Instructor: The solution is shown in a balance sheet format The answers are

lettered (a) through (l)

DAWSON COMPANY Balance Sheet December 31

Additional paid-in capital 15,000 15,000(k)

Total contributed capital $ 35,000(c) $ 35,000(g)

Accumulated other comprehensive income 6,900 7,000

Total stockholders' equity $ 91,900(f) $102,000(l)

Total liabilities & stockholders' equity $142,200 $149,200

E3-9

Note to Instructor: The solution is shown in a balance sheet format The answers are numbered (1) through (14)

FERMER COMPANY Balance Sheet December 31

Capital stock, $10 par $ 17,000(6)b $ 18,000(12)c

Additional paid-in capital 34,000(7)b 36,000 Total contributed capital $ 51,000 $ 54,000(9)

Accumulated other comprehensive income 4,800 5,000 Total stockholders' equity $ 96,700(1) $100,700 Total liabilities & stockholders' equity $134,800 $140,700

aWorking capital = Current assets - Current liabilities;

2004: $9,900 = $19,100 - $9,200(2); 2005: $10,200 = $20,000(8) - $9,800

bContributed capital = Common stock(x) + Additional paid-in capital(2x)

$51,000 = x + 2x; $51,000 = 3x; x = $17,000, 2x = $34,000

c$17,000 + (100 shares x $10 par)

-E3-10

STEVENS COMPANY Balance Sheet December 31, 2004

Assets Current Assets

Plant and Equipment

Less: Accumulated depreciation (9,200) 26,400

Intangible Assets

Liabilities Current Liabilities

Less: Discount on bonds payable (1,000)

(continued on next page)

E3-10 (continued)

Stockholders' Equity Contributed Capital

Total contributed capital and retained earnings $46,600

Total Liabilities and Stockholders' Equity $68,100