solution manual for financial reporting financial statement analysis and valuation a strategic perspective 7th edition wahlen baginski bradshaw

Fair value/relevant and reliable: Marketable equity securities, commodities, andfinancial assets traded in liquid markets Fair value/relevant but less reliable: Real estate valuations ba

CHAPTER 2

ASSET AND LIABILITY VALUATION AND INCOME MEASUREMENT

Solutions to Questions, Exercises, and Problems, and Teaching Notes to Cases

2.1 Asset Valuation and Income Recognition The important part of the question is that

it focuses on net income (as opposed to comprehensive income) Changes in the

valuation of assets generally result in an increase in shareholders’ equity (tomaintain the balance of the accounting equation), which is accomplished throughassociated effects captured as part of net income For example, sales generate cash

or receivables, which increase both assets and net income Similarly, recognition ofdepreciation expense decreases both assets and net income However, certainchanges in asset valuations result in corresponding amounts being temporarily held

as part of “accumulated other comprehensive income” on the balance sheet (inshareholders’ equity) Such changes would be part of Approach 2 as shown inExhibit 2.4 and discussed in the text In these situations, asset valuations do nothave to relate to the recognition of net income (although such asset valuations relate

to comprehensive income).

2.2 Reliability versus Relevance Reliability is an attribute of accounting information

that relates to the degree of verifiability or representational faithfulness of thereported amounts; reliable asset valuations are supported by source documents,liquid market prices, or other credible evidence There is limited room forsubjectivity in these valuations For example, reporting assets at acquisition costprovides management with fewer opportunities to bias the valuation compared tousing current replacement costs or fair value inputs Relevance describesaccounting information that is timely and has the capacity to affect a user’sdecisions based on the information; relevant asset valuations incorporate allavailable information, including the acquisition cost and subsequent developments.Relevant asset valuations may or may not be subjective; the existence ofsubjectivity in an asset valuation does not necessarily mean the valuation will not bereliable

Examples:

Historical cost/reliable and relevant: accounts receivable, fixed assets, and other

assets with values that remain relatively stable

Historical cost/reliable but less relevant: LIFO inventory layers, acquired

research and development and other intangible assets, and real estate that hasappreciated

Fair value/relevant and reliable: Marketable equity securities, commodities, and

financial assets traded in liquid markets

Fair value/relevant but less reliable: Real estate valuations based on comparable

analysis, internally generated intangible asset valuations, and pension plan assetsinvested in illiquid investments

2.3 Income Flows versus Cash Flows The analysis below demonstrates that the change

in cash for the five years as a whole is $117,000 Subtracting the $100,000 cashcontribution by the owners equals $17,000, which equals the amount of net incomefor the five years and the balance in retained earnings at the end of five years Notethat the cash outflow to purchase the machine occurs at the beginning of the firstyear, whereas depreciation on the machine occurs throughout the five years, and theremaining book value of the machine of $20,000 affects computation of the gain onsale at the end of five years Thus, the statement about the equivalence of cashflows and earnings holds for this example and in general

Cash Contributed by Owners + $ 100,000 + $ 100,000

Purchase of Machine for Cash – 100,000 + $ 100,000

2.4 Measurement of Acquisition Cost Acquisition cost is $240,500 ($250,000 invoice

price – $15,000 cash discount + $4,000 for the title + $1,500 to paint company’sname on the truck) The license fee of $800 and the insurance of $2,500 are notcosts to prepare the truck for its intended use, but costs to operate the truck duringits first year Therefore, these latter two costs are prepayments that becomeexpenses of the first year

2.5 Measurement of a Monetary Asset.

Balance, January 1, 2009: $10 million x 9.81815 (Part a.) $ 98,181,500Interest for 2009: 08 x $98,181,500 7,854,520Less Cash Received (10,000,000)Balance, December 31, 2009 (Part b.) $ 96,036,020Interest for 2010: 08 x $96,036,020 7,682,882

Less Cash Received (10,000,000)Balance, December 31, 2010 (Part c.) $ 93,718,902

2.6 Fair Value Measurements.

a.The stocks are Level 1 assets, assuming they are for public companies for whichthe prices of each share are available via closing quotes from one of the majorexchanges

b Bonds are also likely Level 1 assets if they are publicly traded; however, if theyare privately placed issues, they would be Level 2 assets because their valueswould be determined by reliable inputs such as market interest rates and yieldcurves

c.Real estate is more likely comprised of Level 2 assets, given ready availability ofreal estate valuation data

d Timber investments are either Level 2 or Level 3 assets depending on theavailability of directly applicable current and future timber prices

e.Private equity funds are typically invested in young privately held start-upcompanies, and due to the illiquidity of such investments and difficulty inobtaining directly comparable asset prices, these would likely be Level 3 assets

f Illiquid asset-backed securities are, by definition, illiquid, and although variousmodels exist for valuing manufactured securities (such as mortgage-backedsecurities), the inputs are generally well-placed guesses, making such assetsLevel 3

2.7 Computation of Income Tax Expense.

a Taxes Currently Payable $ 50,000Plus Decrease in Deferred Tax Assets: $42,900 – $38,700 4,200Plus Increase in Deferred Tax Liabilities: $34,200 – $28,600 5,600Income Tax Expense $ 59,800

b Taxes Currently Payable $ 50,000Plus Decrease in Deferred Tax Assets: $42,900 – $38,700 4,200Less Decrease in Deferred Tax Liability: $58,600 – $47,100 (11,500)Income Tax Expense $ 42,700

c In both Part a and Part b., the value of the deferred tax asset decreased, whichmeans that the company utilized deferred tax assets to decrease taxes owedrelative to the amount expensed However, the difference lies in the change inthe deferred tax liability In Part a., the deferred tax liability increased, whichoccurs when the firm has larger deductions (lower income) on its tax returnrelative to amounts expensed (amounts recognized in income) Theadvantageous treatment of these amounts leads to lower current cash outflowsfor taxes than amounts recognized as income tax expense For Part b., the

situation is reversed In Part b., the decrease in the deferred tax liability meansthat previous timing differences likely reversed, leading to higher cashpayments required for current income tax payments relative to amountsrecognized as income tax expense.

2.8 Computation of Income Tax Expense.

a Taxes Currently Payable $ 35,000Less Increase in Deferred Tax Assets:

Beginning of Year: $24,600 – $6,400 = $ 18,200End of Year: $27,200 – $7,200 = 20,000 (1,800)Less Decrease in Deferred Tax Liabilities: $18,900 – $16,300 (2,600)Income Tax Expense $ 30,600

b Taxes Currently Payable $ 35,000Less Increase in Deferred Tax Assets:

Beginning of Year: $24,600 – $6,400 = $ 18,200End of Year: $27,200 – $4,800 = 22,400 (4,200)Less Decrease in Deferred Tax Liabilities: $18,900 – $16,300 (2,600)Income Tax Expense $ 28,200

2.9 Effect of Valuation Method for Nonmonetary Asset on Balance Sheet and

Cash 180,000Land 100,000Gain on Sale of Land 80,000

b Valuation of the land at current market value but including unrealized gains andlosses in accumulated other comprehensive income until sale of land:

Assets = Liabilities + CC Shareholders' Equity AOCI RE

Land +50,000

Unrealized ing Gain or Loss—OCI +50,000

Hold-Land 50,000Unrealized Holding Gain or Loss—OCI 50,000

2010

Assets = Liabilities + CC Shareholders' Equity AOCI RE

Land –30,000

Unrealized ing Gain or Loss—OCI –30,000

Hold-Unrealized Holding Gain or Loss—OCI 30,000Land 30,000

Hold-Gain on Sale

of Land +80,000

Cash 180,000Unrealized Holding Gain or Loss—OCI 20,000Land 120,000Gain on Sale of Land 80,000

c.Valuation of the land at current market value and including market value changeseach year in net income:

Assets = Liabilities + CC Shareholders' Equity AOCI RE

Land +50,000

Gain on Fair Market Value

of Land +50,000

Land 50,000Gain on Fair Market Value of Land 50,000

2010

Assets = Liabilities + CC Shareholders' Equity AOCI RE

Land –30,000

Loss on Fair Market Value

d Net income over sufficiently long time periods equals cash inflows minus cashoutflows, other than cash transactions with owners Walmart acquired the land

in 2009 for $100,000 and sold it for $180,000 in 2011 Thus, the total effect onnet income through the realization of the increase in the value of the landbought and sold is $80,000 The three different methods of asset valuation andincome measurement recognize this $80,000 in different patterns over time, butthe total is the same

2.10 Effect of Valuation Method for Monetary Asset on Balance Sheet and Income

b$7,478 = 08 x ($180,000 – $86,539) plus an additional $1 due to rounding

b Valuation of the note at the present value of future cash flows, adjusting the note

to fair value upon changes in market interest rates and including unrealizedgains and losses in net income (Approach 3)

Receivable –1,699c

Cash 100,939Interest Revenue 14,400aNote Receivable 86,539

a$14,400 = 08 x $180,000Loss on Note Receivable 1,699cNote Receivable 1,699

d$9,177 = 10 x $91,762 plus an additional $1 due to rounding

c Over sufficiently long time periods, net income equals cash inflows minus cashoutflows, other than cash transactions with owners WMT receives $101,878 net

in cash from purchasing the land for $100,000 and selling it for $201,878($100,939 x 2) Problem 2.9 indicates that net income across 2009 to 2011includes the $80,000 change in market value of the land as of the time of sale onDecember 31, 2011 The $21,878 difference between the cash received of

$201,878 and the market value of the land on December 31, 2011, of $180,000 is

income for 2012 and 2013 The valuation method in Part a uses the 8 percentinterest rate applicable to this note on December 31, 2011, both to value the noteand to recognize interest revenue for both years (acquisition cost valuation of theasset, Approach 1 for income recognition) The valuation method in Part b usesthe market interest rate for this note each year (8 percent for 2012 and 10 percentfor 2013) to value the note and to recognize interest revenue and holding gainsand losses (fair value for the asset, Approach 3 for income recognition) Thesetwo methods report the same total income but in a different pattern over time.

2.11 Effect of Valuation Method for Nonmonetary Asset on Balance Sheet and

Depreciation Expense 25,000Accumulated Depreciation 25,000

(3)

Assets = Liabilities + CC Shareholders' Equity AOCI RE

Impairment Loss 15,000Equipment 15,000

Depreciation Expense 20,000Accumulated Depreciation 20,000

b Assume that PCU accounts for the equipment using current market valuesadjusted for depreciation and impairment losses

Assets = Liabilities + CC Shareholders' Equity AOCI RE

Impairment Loss 15,000Equipment 15,000

(5)

Assets = Liabilities + CC Shareholders' Equity AOCI RE

Equipment +8,000

Gain on Change in Equipment Fair Value +8,000

Equipment 8,000Gain on Change in Equipment Fair Value 8,000

Depreciation Expense 24,000Accumulated Depreciation 24,000

(7)

Assets = Liabilities + CC Shareholders' Equity AOCI RE

Equipment +2,000

Gain on Change in Equipment Fair Value +2,000

Equipment 2,000Gain on Change in Equipment Fair Value 2,000

c Total expenses over sufficiently long time periods equal cash outflows, other thancash transactions with owners The negative $74,000 total net cash outflow forthe equipment reflects the cash outflow to acquire the equipment of $100,000offset by the cash inflow to sell the equipment for $26,000 When thedepreciation expense, gain, and loss accounts under the retained earnings columnare summed, the total also is negative $74,000, which is the amount that reducedincome related to the purchase, use, and disposition of the equipment.

2.12 Effect of Valuation Method for Monetary Asset on Balance Sheet and Income

Cash 5,000Note Receivable 40,000Sales 45,000Cost of Goods Sold 30,000

e$555 = 04 x $13,859 plus an additional $1 due to rounding

f$13,859 = $14,414 – $555

b Assume that Alfa Romeo values this note receivable at fair value each year.

a$1,600 = 04 x $40,000

b$12,814 = $14,414 – $1,600

Assets = Liabilities + CC Shareholders' Equity AOCI RE

Note Receivable –384

Loss on Decline in Fair Value of Note Receivable –384c

Loss on Decline in Fair Value of Note Receivable 384cNote Receivable 384

Loss on Decline in Fair Value of Note Receivable 382fNote Receivable 382

f$382 = $13,346 – ($26,802 – $13,074)

g$1,068 = 08 x $13,346

h$13,346 = $14,414 – $1,068

c Total expenses over sufficiently long time periods equal cash inflows minus cashoutflows, other than cash transactions with owners The $18,242 balance inretained earnings equals the cash inflows of $48,242 ($5,000 + $14,414 + $14,414+ $14,414) minus cash outflows of $30,000 for the cost of the automobile

d In Part a., the balance sheet suffers at the end of 2010 and 2011 because the notereceivable is overvalued The overvaluation is due to the market interest rate that

Alfa Romeo ought to be realizing on the note being higher than what the company

is actually realizing Thus, the note is worth less than its adjusted acquisition cost(that is, the initial present value minus payments) In Part b., however, the fairvaluation of the note receivable on the balance sheet results in volatility of the

“loss” and “interest revenue” line items, reflecting the fair value adjustments

2.13 Deferred Tax Assets.

a Biosante Pharmaceuticals discloses that the amount of the net operating losscarryforwards at the end of 2008 is $62,542,000 This amount reflects theaccumulated total of taxable losses (as opposed to taxable income) that Biosantehas reported on its tax returns (possibly offset by taxable income, but this seemsunlikely) In future years, Biosante could offset up to $62,542,000 of taxableincome with the tax loss carryforwards, for which the company did not receiveany tax benefit at the time they were reported The amount of the deferred taxasset for these net operating loss carryforwards is $23,609,594 This is theincome tax “shield” available due to the $62,542,000 tax loss carryfowards

The link between these two amounts is that the deferred tax asset represents thetax effect of the tax loss carryforwards Generally, this text uses 35–40 percent

as the tax effect of income and deductions You can back into the rate that wasassumed by Biosante $23,609,594/$62,542,000 = 37.75% Intuitively, for eachdollar of taxable income the company might report in the future (up to

$62,542,000), it would be able to save $0.3775 in tax because it would offsetthat dollar of taxable income with a dollar of its tax loss carryforwards