Questions For Review of Key Topics: The Income Statement and Statement of Cash Flows

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Chapter 4
The Income Statement and Statement of Cash Flows
QUESTIONS FOR REVIEW OF KEY TOPICS

Question 4-1
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.
Question 4-2
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 separate
statement or by including the information in either the income statement or the statement of changes
in shareholders equity.
Question 4-3
Income from continuing operations includes the revenue, expense, gain and loss transactions
that will probably 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 4-4
Operating income includes revenues and expenses 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.
Question 4-5
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.
Question 4-6
The term earnings quality refers to the ability of reported earnings (income) to predict a
companys 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.
Question 4-7
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.
Solutions Manual, Vol.1, Chapter 4
The McGraw-Hill Companies, Inc., 2007

4-1
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Answers to Questions (continued)

Question 4-8
The process of intraperiod tax allocation matches tax expense or tax benefit with each major
component of income, specifically continuing operations and any item reported below continuing
operations. The process is necessary to achieve the desired result of separating the total income
effects of continuing operations from the two separately reported items - discontinued operations and
extraordinary items, and also to show the after-tax effect of each of those two components.
Question 4-9
A component of an entity comprises operations and cash flows that can be clearly
distinguished, operationally and for financial reporting purposes.
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
components assets. The income (loss) from operations of the component is reported separately in
discontinued operations on prior income statements presented for comparative purposes.
Question 4-10
Extraordinary items are material gains and losses that are both unusual in nature and infrequent
in occurrence, taking into account the environment in which the entity operates.
Question 4-11
Extraordinary gains and losses are presented, net of tax, in the income statement below
discontinued operations, if any.

4-2
Intermediate Accounting, 4/e
Answers to Questions (continued)

Question 4-12
GAAP permit alternative treatments for similar transactions. Common examples are the choice
among FIFO, LIFO, and average cost for the measurement of inventory and the choice among
alternative revenue recognition methods. A change in accounting principle occurs when a company
changes from one generally accepted treatment to another.
In general, we report voluntary changes in accounting principles retrospectively. 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. 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 theyre 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.
An exception is a change in depreciation, amortization, or depletion method. These changes
are accounted for as a change in estimate, rather than as a change in accounting principle. Changes
in estimates are accounted for prospectively. The remaining book value is depreciated, amortized, or
depleted, using the new method, over the remaining useful life.
Question 4-13
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 and extraordinary items, EPS data must be reported separately for income from
continuing operations and net income. Per share amounts for discontinued operations and
extraordinary items would be disclosed on the face of the income statement.
Question 4-14
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 describe the effect of a change on any financial statement line items and per
share amounts affected for all periods reported.

4-3
Answers to Questions (concluded)

Question 4-15
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 (or the statement of
retained earnings) in the year the error is discovered.
Question 4-16
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.
Question 4-17
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
and owners.
Question 4-18
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). These activities are reported either in a separate schedule or in a
note.
Question 4-19
The direct method of reporting cash flows from operating activities presents the cash effect of
each operating activity directly on 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.

4-4
BRIEF EXERCISES
Brief Exercise 4-1
OREILLY BEVERAGE COMPANY
Statement of Comprehensive Income
For the Year Ended December 31, 2006
Net income ........................................................
Other comprehensive income (loss):
Unrealized gains on investment securities
net of tax ......................................................
Deferred loss on derivatives, net of tax ...........
Total other comprehensive loss .........................
Comprehensive income .....................................
$650,000
$ 24,000
(36,000)
(12,000)
$638,000

4-5
Brief Exercise 4-2

PACIFIC SCIENTIFIC CORPORATION
Income Statement
($ in millions)
Revenues and gains:

Sales ...............................................................
Gain on sale of investments ............................
Total revenues and gains .............................
$2,106
45
2,151
Expenses and losses:

Cost of goods sold ..........................................
Selling .............................................................
General and administrative ..............................
Interest.............................................................
Income tax expense* .......................................
Total expenses and losses ............................
Net income ........................................................
$1,240
126
105
35
258
1,764
$ 387
*$2,151 (1,240 + 126 + 105 + 35) = $645 x 40% = $258
Brief Exercise 4-3

(a)
Sales revenue
$2,106
Less: Cost of goods sold
(1,240)
Gross profit
866
Less: Selling expenses
(126)
General and administrative expenses
(105)
Operating income
$ 635
(b)
Gain on sale of investments

Interest expense
Nonoperating income

4-6
45
(35)
$10
Brief Exercise 4-4
PACIFIC SCIENTIFIC CORPORATION

Income Statement
($ in millions)
Sales revenue .....................................................

Cost of goods sold .............................................
Gross profit .......................................................
Operating expenses:
Selling .............................................................
General and administrative ..............................
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
(35)
10
645
258
$ 387
*$645 x 40%

4-7
Brief Exercise 4-5

(a)
Sales revenue
Less: Cost of goods sold
General and administrative expenses
Restructuring costs
Selling expenses
Operating income
(b)
Operating income
Add: Interest revenue
Deduct: Loss on sale of investments
Income before income taxes and
Extraordinary item
Income tax expense (40%)
Income before extraordinary item
$25,000
4,000
(22,000)
Income before extraordinary item

Extraordinary item:
Loss from flood damage, net of $20,000
tax benefit
Net loss
$ 4,200
(c)

4-8
$300,000
(160,000)
(40,000)
(50,000)
(25,000)
$ 25,000
7,000
(2,800)
$ 4,200
(30,000)
(25,800)
Brief Exercise 4-6

WHITE AND SONS, INC.
Partial Income Statement
Income before income taxes and extraordinary item..........
Income tax expense* ........................................................
Income before extraordinary item .....................................
Extraordinary item:
Loss from earthquake, net of $160,000 tax benefit .........
Net income ........................................................................
Earnings per share:
Income before extraordinary item......................................
Loss from earthquake .......................................................
Net income .......................................................................
$ 850,000
340,000
510,000
(240,000)
$ 270,000
$ 5.10
(2.40)
$ 2.70
*$850,000 x 40%
Note: Restructuring costs, interest revenue, and loss on sale of investments are
included in income before income taxes and extraordinary item.

4-9
Brief Exercise 4-7

CALIFORNIA MICROTECH CORPORATION
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
1,740,000
$ 4,060,000
(1,600,000)
480,000
(1,120,000)
$ 2,940,000
* $5,800,000 x 30%
** Loss from operations of discontinued component:
Gain on sale of assets
Operating loss
Total before-tax loss

4-10
$ 2,000,000 ($10 million less $8 million)

(3,600,000)
$(1,600,000)
Brief Exercise 4-8

Loss from operations of discontinued component** ......
Net income ........................................................................
$ 5,800,000
1,740,000
$ 4,060,000
(3,600,000)
1,080,000
(2,520,000)
$ 1,540,000
* $5,800,000 x 30%
** Includes only the operating loss. There is no impairment loss.

4-11
Brief Exercise 4-9

(including impairment loss of $1,000,000)** .........................
Net income ........................................................................
$ 5,800,000
1,740,000
$ 4,060,000
(4,600,000)
1,380,000
(3,220,000)
$ 840,000
* $5,800,000 x 30%
** Loss from operations of discontinued component:
Impairment loss ($8 million book value less
$7 million net fair value)
Operating loss

4-12
$(1,000,000)
(3,600,000)
$(4,600,000)
Brief Exercise 4-10

The change in inventory method is a change in accounting principle. The
depreciation method change is considered to be a change in accounting estimate that is
achieved by a change in accounting principle and is accounted for prospectively,
exactly as we would account for any other change in estimate. The inventory method
change, however, is accounted for by retrospectively recasting prior years financial
statements presented with the current year for comparative purposes, applying the new
inventory method (FIFO in this case) in those years.
Brief Exercise 4-11

This is a change in accounting estimate.
When an estimate is revised as new information comes to light, accounting for
the change in estimate is quite straightforward. We do not restate prior years'
financial statements to reflect the new estimate. Instead, we merely incorporate the
new estimate in any related accounting determinations from there on. If the after-tax
income effect of the change in estimate is material, the effect on net income and
earnings per share must be disclosed in a note, along with the justification for the
change. Depreciation for 2006 is $25,000:
$300,000
Cost
$ 50,000
Old annual depreciation ($300,000 6 years)
x 2 years 100,000
Depreciation to date (2004-2005)
200,000
Book value
_ 8 yrs. Estimated remaining life (10 years - 2 years)
$ 25,000
New annual depreciation

4-13
Brief Exercise 4-12

Cash Flows from Operating Activities:
Collections from customers
Interest on note receivable
Interest on note payable
Payment of 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.
Brief Exercise 4-13

Cash Flows from Investing Activities:
Sale of land
Purchase of equipment
Net cash flows from investing activities
$ 40,000
(120,000)
Cash Flows from Financing Activities:

Proceeds from note payable collection
Issuance of common stock
Payment of dividends
Net cash flows from financing activities
$100,000
200,000
(30,000)

4-14
$(80,000)
270,000
Brief Exercise 4-14

Cash Flows from Operating Activities:
Net income
Adjustments for noncash effects:
Depreciation expense
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

4-15
EXERCISES
Exercise 4-1
Requirement 1
THE MASSOUD CONSULTING GROUP
Statement of Income and Comprehensive Income (in part)
Net income ........................................................
Foreign currency translation gain, net of tax ...
Unrealized losses on investment securities,
net of tax ......................................................
Total other comprehensive income ....................
$1,354,000
$168,000
(56,000)
112,000
$1,466,000
Requirement 2
THE MASSOUD CONSULTING GROUP

Statement of Comprehensive Income
Net income ........................................................
Foreign currency translation gain, net of tax ...
Unrealized losses on investment securities
net of tax ......................................................
Total other comprehensive income ....................

4-16
$1,354,000
$168,000
(56,000)
112,000
$1,466,000
Exercise 4-2
Requirement 1
GREEN STAR CORPORATION
Income Statement
Revenues and gains:
Sales ...............................................................
Interest ............................................................
Gain on sale of equipment ..............................
Salaries ............................................................
Depreciation ....................................................
Interest.............................................................
Rent .................................................................
Income tax ......................................................
Net income ........................................................
Earnings per share .............................................
$1,300,000
30,000
50,000
1,380,000
$720,000
160,000
50,000
40,000
25,000
130,000
1,125,000
$ 255,000
$2.55

4-17
Exercise 4-2 (concluded)

Requirement 2
GREEN STAR CORPORATION
Income Statement
Sales revenue .....................................................
Gross profit .......................................................
Operating expenses:
Salaries ............................................................
Depreciation ....................................................
Rent ................................................................
Interest revenue ...............................................
Gain on sale of equipment ..............................
Total other income, net ................................
Income before income taxes .............................
Income tax expense ...........................................
Net income ........................................................
Earnings per share .............................................

4-18
$1,300,000
720,000
580,000
$160,000
50,000
25,000
235,000
345,000
30,000
50,000
(40,000)
40,000
385,000
130,000
$ 255,000
$2.55
Exercise 4-3
Requirement 1
GENERAL LIGHTING CORPORATION
Income Statement
Revenues and gains:
Sales ...............................................................
Rental revenue ................................................
Salaries ...........................................................
Depreciation ....................................................
Interest.............................................................
Rent ................................................................
Loss on sale of equipment ...............................
Loss from inventory write-down .....................
Income tax expense *.......................................
Income before extraordinary item ......................
Extraordinary item:
Loss from flood damage (net of $48,000 tax benefit)
Net income ........................................................
Earnings per share:
Extraordinary loss .............................................
Net income ........................................................
$2,350,000
80,000
2,430,000
$1,200,300
300,000
100,000
90,000
50,000
22,500
200,000
186,880
2,149,680
280,320
(72,000)
$ 208,320
$ .93
(.24)
$ .69
* 40% x $467,200

4-19

Requirement 2
GENERAL LIGHTING CORPORATION
Income Statement
Sales revenue .....................................................
Gross profit .......................................................
Operating expenses:
Salaries ...........................................................
Depreciation ...................................................
Rent ................................................................
Loss from inventory write-down .....................
Rental revenue ................................................
Loss on sale of equipment ...............................
Total other income (expense), net ................
Income before taxes and extraordinary item ......
Income tax expense * .........................................
Extraordinary item:
Loss from flood damage (net of $48,000 tax benefit)
Net income ........................................................
Earnings per share:
Extraordinary loss .............................................
Net income ........................................................
$2,350,000
1,200,300
1,149,700
$300,000
100,000
50,000
200,000
650,000
499,700
80,000
(22,500)
(90,000)
(32,500)
467,200
186,880
280,320
(72,000)
$ 208,320
$ .93
(.24)
$ .69
* 40% x $467,200

4-20
Exercise 4-4
LINDOR CORPORATION
Statement of Income and Comprehensive Income
Sales revenue ................................................................
Cost of goods sold .........................................................
Gross profit ...................................................................
$2,300,000
1,400,000
900,000
Operating expenses:
Selling and administrative ...........................................
Operating income ..........................................................
420,000
480,000

Interest expense .............................................................
Income before income taxes and extraordinary item ......
Income tax expense * .....................................................
Income before extraordinary item ..................................
Extraordinary item:
Gain on early debt extinguishment (net of $120,000
tax expense) ...............................................................
Net income
Other comprehensive income:
Unrealized holding gains on investment securities,
net of tax .................................................................
Comprehensive income .................................................
56,000
$644,000
Earnings per share:

Extraordinary gain .........................................................
Net income ....................................................................
$ 0.31
0.28
$ 0.59
(40,000)
440,000
132,000
308,000
280,000
588,000
* 30% x $440,000

4-21
Exercise 4-5
AXEL CORPORATION
Income Statement
Sales revenue .................................................................
Gross profit ...................................................................
Operating expenses:
Selling .......................................................................
Administrative ...........................................................
Restructuring costs .....................................................
Total operating expenses ..........................................
Interest and dividends .................................................
Interest expense ..........................................................
Total other income, net ...............................................
Income before income taxes and extraordinary item .....
Income tax expense* .....................................................
Extraordinary item:
Gain on early debt extinguishment (net of $34,400
tax expense) ................................................................
Net income ....................................................................
Earnings per share:
Net income ....................................................................
$ 592,000
325,000
267,000
$67,000
87,000
55,000
209,000
58,000
32,000
(26,000)
6,000
64,000
25,600
38,400
51,600
$ 90,000
$ .38
.52
$0.90
* 40% x $64,000

4-22
Exercise 4-6
CHANCE COMPANY
(including loss on disposal of $400,000)* ..............................
Net income ........................................................................
Earnings per share:
Loss from discontinued operations ...................................
Net income .......................................................................
$ 350,000
(530,000)
212,000
(318,000)
$ 32,000
$ 3.50
(3.18)
$ .32
* Loss on discontinued operations:

Loss on sale of assets
Operating loss
Less: Income tax benefit (40%)
Net-of-tax loss
$(400,000)
(130,000)
(530,000)
212,000
$(318,000)

4-23
Exercise 4-7
ESQUIRE COMIC BOOK COMPANY
Income from continuing operations * .................................
$ 552,000
Income from operations of discontinued component
(including loss on disposal of $350,000) .................................
Income tax expense .........................................................
Income on discontinued operations ..................................
Net income ..........................................................................
150,000
60,000
90,000
642,000
* Income from continuing operations:

Income before considering additional items
Decrease in income due to restructuring costs
Before-tax income from continuing operations
Income tax expense (40%)
Income from continuing operations

4-24
$1,000,000
(80,000)
920,000
(368,000)
$ 552,000
Exercise 4-8
Requirement 1
KANDON ENTERPRISES, INC.
$ 400,000
(including impairment loss of $50,000) * .............................
Net income .......................................................................
(190,000)
76,000
(114,000)
$ 286,000
* Loss on discontinued operations:

Operating loss
Impairment loss ($250,000 - 200,000)
Net before-tax loss
Income tax benefit (40%)
Net after-tax loss on discontinued operations
$(140,000)
(50,000)
(190,000)
76,000
$(114,000)
Requirement 2
KANDON ENTERPRISES, INC.
$ 400,000
Loss from operations of discontinued component * ........
Income tax benefit .........................................................
Net income .......................................................................
(140,000)
56,000
(84,000)
$ 316,000
*Includes only the operating loss during the year. There is no impairment loss.

4-25
Exercise 4-9
Pretax income from continuing operations
Income tax expense
Less: Net income
Loss from discontinued operations
$14,000,000
(5,600,000)
8,400,000
7,200,000
$1,200,000
$1,200,000 60%* = $2,000,000 = before tax loss from discontinued

operations.
*1-tax rate of 40% = 60%
Pretax income of division
Add: Net loss from discontinued operations
Impairment loss
Fair value of divisions assets
Plus impairment loss
Book value of divisions assets

4-26
$4,000,000
2,000,000
$6,000,000
$11,000,000
6,000,000
$17,000,000
Exercise 4-10
Requirement 1
This is a change in accounting estimate.
Requirement 2
When an estimate is revised as new information comes to light, accounting for
the change in estimate is quite straightforward. We do not restate prior years'
financial statements to reflect the new estimate. Instead, we merely incorporate the
new estimate in any related accounting determinations from there on. If the after-tax
income effect of the change in estimate is material, the effect on net income and
earnings per share must be disclosed in a note, along with the justification for the
change.
Requirement 3
$800,000
$160,000
x 2 years 320,000
480,000
_ 6 yrs.
$ 80,000
Cost
Old annual depreciation ($800,000 5 years)
Depreciation to date (2004-2005)
Book value
Estimated remaining life (8 years - 2 years)
New annual depreciation

4-27
Exercise 4-11
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 companys 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 straight-line method from
now on. The undepreciated cost remaining at the time of the change would be
depreciated using the straight-line method 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
Assets cost
Accumulated depreciation to date ($320,000 + 192,000)
To be depreciated over remaining 3 years
$800,000
(512,000)
$288,000
2006 straight-line depreciation: $288,000 3 years = $96,000

Adjusting entry:
Depreciation expense (calculated above).....................
Accumulated depreciation .....................................
96,000
96,000
Exercise 4-12
Earnings per share:
Loss from discontinued operations
Extraordinary gain
Net income
4-28
$5.00
(1.60)
2.20
$5.60
Exercise 4-13
1.
2.
d
d
Exercise 4-14
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
b
a
a
c
b
c
b
a
d
c
c
Purchase of equipment for cash.

Payment of employee salaries.
Collection of cash from customers.
Cash proceeds from a note payable.
Purchase of common stock of another corporation for cash.
Issuance of common stock for cash.
Sale of machinery for cash.
Payment of interest on note payable.
Issuance of bonds payable in exchange for land and building.
Payment of cash dividends to shareholders.
Payment of principal on note payable.

4-29
Exercise 4-15
Bluebonnet Bakers
Statement of Cash Flows
Cash flows from operating activities:
$ 380,000
Interest on note receivable
6,000
Purchase of inventory
(160,000)
Interest on note payable
(5,000)
Payment of salaries
(90,000)
Cash flows from investing activities:
Collection of note receivable
Sale of investments
50,000
30,000
(85,000)
Cash flows from financing activities:

Proceeds from note payable
100,000
Payment of note payable
(25,000)
(20,000)
Net increase in cash
Cash and cash equivalents, January 1
Cash and cash equivalents, December 31

4-30
$131,000
(5,000)
55,000
181,000
17,000
$ 198,000
Exercise 4-16
Requirement 1
1.
2.
3.
4.
5.
6.
7.
8.
9.
Financing
$300,000
Investing
$(10,000)
Operating
$ (5,000)
(6,000)
(70,000)
55,000
__________
__________
__________
$300,000
$(10,000)
$(26,000)
$264,000

4-31

Requirement 2
Wainwright Corporation
For the Month Ended March 31, 2006
Payment of rent
Payment of one-year insurance premium
Payment to suppliers of merchandise for sale
Issuance of common stock
Cash and cash equivalents, March 1
Cash and cash equivalents, March 31
$ 55,000
(5,000)
(6,000)
(70,000)
$ (26,000)
(10,000)
(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

4-32
Exercise 4-17
1.
2.
3.
c
d
b

4-33
Exercise 4-18
Tiger Enterprises
($ in thousands)
Net income
Decrease in accounts receivable
Increase in inventory
Increase in prepaid insurance
Decrease in accounts payable
Decrease in administrative & other payables
Increase in income taxes payable
$ 900
240
80
(40)
(30)
(60)
(100)
50

Purchase of plant and equipment
$1,040
(300)

Proceeds from issuance of common stock
100
Proceeds from note payable
200
Payment of dividends (1)
(940)
Net cash flows from financing activities (640)
100
Cash, January 1
Cash, December 31
200
$ 300
(1)
Retained earnings, beginning
+ Net income
- Dividends
Retained earnings, ending

4-34
$540
900
x
$500
x = $940
Exercise 4-19
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
100
Accounts Payable
Inventory
(c.) 3,460 1/1
360
1/1
600
3,400 <----------->
3,400
12/31
300
12/31
640
3,360 <----------->
Cost of Goods Sold

3,360
Admin. & Other Payables

Admin. & Other Expense
(d.) 1,900 1/1
400
1,800 <----------->
1,800
12/31
300
Income Taxes Payable
(e.) 550 1/1
150
600 <----------->
12/31
200
Income Tax Expense

600
Based on the information in the T-accounts above, the operating activities section
of the SCF for Tiger Enterprises would be as shown below.

4-35

Tiger Enterprises
($ in thousands)
$ 7,080
Prepayment of insurance
(130)
Payment to inventory suppliers
(3,460)
Payment for administrative & other exp.
(1,900)
Payment of income taxes
(550)
$ 1,040
Exercise 4-20
List A
f
1. Intraperiod tax allocation
2. Comprehensive income
3. Extraordinary items
l
k
j
d
e
4.
5.
6.
7.
8.
9. Operating activities (SCF)
Operating income
An operation (according to SFAS 144)
Earnings per share
Prior period adjustment
Financing activities
10. Investing activities
c 11. Direct method

b 12. Indirect method

4-36
List B
a. Unusual, infrequent, and material gains and
losses.
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 revenue-generating
activities.
Exercise 4-21
1. c. The operating section of a retailers income statement includes all revenues and
costs necessary for the operation of the retail establishment, e.g., sales, cost of
goods sold, administrative expenses, and selling expenses.
2. d. Discontinued operations and extraordinary gains and losses are shown
separately in the income statement, below income from continuing operations.
The cumulative effect of a change in accounting principle is accounted for by
retrospectively revising prior years financial statements.
3. a. Extraordinary items should be presented net of tax after income from
operations.

4-37
PROBLEMS
Problem 4-1
DUKE COMPANY
Statement of Income and Comprehensive Income
Sales revenue ................................................................
Cost of goods sold ........................................................
Gross profit ...................................................................
Operating expenses:
General and administrative .........................................
Selling ......................................................................
Loss from write-down of obsolete inventory
Total operating expenses .........................................
Operating income .........................................................
Interest expense .........................................................
Income before income taxes and extraordinary item ......
Income tax expense .......................................................
Income before extraordinary item .................................
Extraordinary item:
Loss from expropriation of overseas plant (net
of $1,200,000 tax benefit) ..........................................
Net Income ....................................................................
Foreign currency translation adjustment loss, net of tax
Unrealized gains on investment securities, net of tax
Total other comprehensive 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
1,240,000
1,860,000
(1,800,000)
60,000
(120,000)
108,000
(12,000)
$ 48,000
Notes:
1. The restructuring costs and the loss from write-down of inventory are not extraordinary items.
2. The depreciation expense error is a prior period adjustment and is not reported in the income
statement.

4-38
Problem 4-2
REED COMPANY
Comparative Income Statements
For the Years Ended December 31
Sales revenue ......................................................[1]
Cost of goods sold ............................................... [2]
Gross profit .........................................................
2006
$4,000,000
2,570,000
1,430,000
Operating expenses:
Administrative ..................................................[3]
Selling .............................................................. [4]
Loss from fire damage .......................................
Loss from write-down of obsolete inventory ......
Total operating expenses ...............................
Operating income ................................................
750,000
340,000
50,000
35,000
1,175,000
255,000

Interest revenue ..................................................
Interest expense .................................................
Total other expenses (net) ..............................
Income from continuing operations before
income taxes and extraordinary item...............
Income tax expense .............................................
extraordinary item ............................................
Income (loss) from operations of discontinued
component (including loss on disposal of
$50,000 in 2006) .............................................
Income tax benefit (expense) ...............................
Income (loss) on discontinued operations ......... [5]
Income before extraordinary item ........................
Extraordinary item:
Loss from early extinguishment of debt (net
of $40,000 tax benefit) ..................................
Net income ..........................................................
Earnings per share:
extraordinary item ............................................
Discontinued operations .....................................
Extraordinary item .............................................
Net income ..........................................................
[6]
[7]
[8]
[9]
2005
$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
82,000
343,000
137,200
123,000
205,800
(10,000)
4,000
(6,000)
117,000
110,000
(44,000)
66,000
271,800
(60,000)
$ 57,000
.41
(.02)
(.20)
$ .19
-$ 271,800
$ .69
.22
-$ .91

4-39
Problem 4-2 (concluded)

[1] $4,400,000 - 400,000
[2]
$2,860,000 - 290,000
[3]
$800,000 - 50,000
[4]
$360,000 - 20,000
[5] Loss in 2006:

Operating income
Loss on sale of assets
Loss before tax benefit
Tax benefit (40% x $10,000)
Loss on discontinued operations, net of tax benefit
$ 40,000
(50,000)
(10,000)
4,000
$ (6,000)
[6]
$3,500,000 - 500,000 (sales from discontinued operation)
[7]
$2,000,000 - 320,000 (cost of goods sold from discontinued operation)
[8]
$675,000 - 40,000 (administrative expenses from discontinued operations)
[9]
$312,000 - 30,000 (selling expenses from discontinued operations)

4-40
Problem 4-3
Requirement 1
JACKSON HOLDING COMPANY
Comparative Income Statements (in part)
For the Years Ended December 31
2006
income taxes [1] ......................................... $3,000,000
Income tax expense ........................................
1,200,000
Income from continuing operations ................
1,800,000
Income from operations of discontinued
component (including gain on disposal of
$600,000 in 2006) [2] .......................................
200,000
Income tax expense (benefit) ........................
80,000
Income (loss) on discontinued operations .....
120,000
Net Income ..................................................... $1,920,000
2005
$1,300,000
520,000
780,000
(300,000)
120,000
(180,000)
$ 600,000
[1]
Income from continuing operations before income taxes:

2006
2005
Unadjusted
$2,600,000 $1,000,000
Add: Loss from discontinued operation
400,000
300,000
Adjusted
$3,000,000 $1,300,000
[2]
Income from discontinued operations:

2006
Operating loss
$(400,000)
Gain on disposal
600,000
Total
$ 200,000
2005
$(300,000)
$(300,000)

Requirement 2
The 2006 income from discontinued operations would include only the operating
loss of $400,000. Since no impairment loss is indicated ($5,000,000 4,400,000 =

4-41
$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 2006 income from discontinued operations would include the operating loss
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).

4-42
Problem 4-4
Requirement 1
MICRON CORPORATION
income taxes and extraordinary item .......
Income tax expense ...................................
Income from continuing operations ...........
Loss from operations of discontinued
component (including loss on disposal of
$300,000) ...............................................
Income tax benefit ..................................
Loss on discontinued operations ..............
Income before extraordinary item ..............
Extraordinary item:
Gain from early extinguishment of debt
(net of $120,000 tax expense) ....................
Net Income ................................................
[1] $1,300,000
390,000
910,000
$ (140,000)
(42,000)
[2]
(98,000)
812,000
280,000
$1,092,000
[1] Income from continuing operations before taxes:

Unadjusted
$1,200,000
Add: Gain from sale of factory
100,000
Adjusted
$1,300,000
[2] Loss on discontinued operations:
Operating income
Deduct: Loss on sale of assets
Loss before tax
Tax benefit (30% x $140,000)
Loss on discontinued operations
$ 160,000
(300,000)
(140,000)
42,000
$ (98,000)
Requirement 2
These events will not, or are unlikely to occur again in the near future. By
segregating them, users are better able to predict future cash flows.

4-43
Problem 4-5
Requirement 1
Diversified Portfolio Corporation
Collections from customers (1)
Payment of operating expenses (2)
Payment of income taxes (3)
Sale of investments
Proceeds from issue of common stock
Increase in cash
Cash and cash equivalents, January 1
Cash and cash equivalents, December 31
$880,000
(660,000)
(85,000)
$135,000
50,000
50,000
100,000
(80,000)
20,000
205,000
70,000
$275,000
(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) $80,000 in income tax expense plus $5,000 decrease in income taxes payable.

4-44

Requirement 2
Diversified Portfolio Corporation
Net income
$120,000
30,000
Increase in accounts receivable
(20,000)
Increase in accounts payable
10,000
Decrease in income taxes payable
(5,000)
$135,000

4-45
Problem 4-6
1. Restructuring is an example of an event that is either unusual or infrequent, but not
both. Restructuring costs should be included in income from continuing operations
but reported as a separate income statement component. The item is reported
gross, not net of tax as with extraordinary gains and losses.
2. The extraordinary gain should be presented, net of tax, in the income statement
below income from continuing operations. Also, earnings per share for income
from continuing operations and for the extraordinary item 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 2005 financial statements should be restated to reflect the
correction, and a disclosure note is required that communicates the impact of the
error on 2005 income.

4-46
Problem 4-7
ALEXIAN SYSTEMS, INC.
Income Statement
($ in millions except per share date)
Net sales revenue ...............................................

Gross profit .......................................................
Operating expenses:
Selling and administrative ...............................
Restructuring costs ..........................................
Other income:
Interest revenue ...............................................
Gain on sale of assets ......................................
Total other income .......................................
Income before income taxes and extraordinary
item ...............................................................
Income tax expense ...........................................
Extraordinary gain (net of $48 in taxes) ....................
Net income ........................................................
Earnings per share:
Extraordinary gain .............................................
Net income ........................................................
$425
[1]
265
160
[2] $128
26
154
6
3
6
9
15
[3]
6
9
[4]
72
$ 81
$ 0.45
3.60
$ 4.05
[1] $270 - 5 (prior period adjustment)

[2] $154 - 26 (restructuring costs)
[3] 40% x $15
[4] $120 less taxes of $48 (40% x $120)
Note: The difference in net income of $3 million ($81 million compared to $78 million on the
original income statement) is the effect of the inventory error of $5 million, less the 40% tax effect.

4-47
Problem 4-8
REMBRANDT PAINT COMPANY
Income Statement
($ in thousands, except per share
amounts)
Sales revenue .................................................................

Gross profit ...................................................................
Operating expenses:
Selling and administrative ..........................................
Interest income (expense), net .......................................
Income from continuing operations before income taxes
and extraordinary item ...............................................
Income tax expense .......................................................
Income from continuing operations before extraordinary
item ...........................................................................
Income from operations of discontinued component
(including gain on disposal of $2,000) ....................................
Income tax expense ....................................................

Income on discontinued operations ............................
Extraordinary gain (net of $900 tax expense) ....................
Net income.....................................................................
Earnings per share:
Income from continuing operations before extraordinary
item ............................................................................
Income on discontinued operations ................................
Net income ....................................................................

4-48
$18,000
10,500
7,500
$2,500
800
3,300
4,200
(150)
4,050
1,215
2,835
400
120
280
3,115
2,100
5,215
$ 5.67
.56
4.20
$10.43
Problem 4-9
Requirement 1
2005 Cash:
2005 Cash + Net increase in cash = 2006 Cash
2005 Cash +
61
= 120
2005 Cash = 59
2006 A/R:
2005 A/R + Cr. Sales Cash collections = 2006 A/R
84
+ 80
71
= 93
2005 Inventory:
2005 A/P + Purchases Cash Paid = 2006 A/P
30 + Purchases 30 = 40
Therefore, Purchases = 40
2005 Inventory + Purchases 2006 Inventory = Cost of goods sold
2005 Inventory +
40
60
=
32
2005 Inventory = 52
2005 Accumulated depreciation:
Gain on sale of equipment was 15; Cash received was 40; therefore, book value of
equipment was 25. Since the cost of equipment sold was 50 (200 - 150), accumulated
depreciation on equipment sold must have been 25.
2005 Accumulated depreciation + Depreciation expense Accumulated depreciation on
equipment sold = 2006 Accumulated depreciation
2005 Accumulated depreciation + 10 25 = 40
2005 Accumulated depreciation = 30 + 25 = $55

4-49
Problem 4-9 (continued)

2005 Total assets:
$59 + 84 + 52 + 200 55 = $340
2006 Total assets:
$120 + 93 + 60 + 150 40 = $383
2005 Income taxes payable:
2005 Inc. taxes payable + Inc. tax expense Income taxes paid =
2006 Inc. taxes payable
2005 Inc. taxes payable =2006 Inc. taxes payable + Taxes paid Inc. tax expense
2005 Inc. taxes payable = 22 + 9 7 = $24
2006 Retained earnings:
2005 R/E + Net income Dividends = 2006 R/E
47
+
28
3
=
72
2005 Total liabilities and shareholders equity:
$30 + 9 + 24 + 230 + 47 = $340
2006 Total liabilities and shareholders equity:
$40 + 9 + 22 + 240 + 72 = $383

4-50

Requirement 2
Grandview Corporation
($ in millions)

Net income
Gain on sale of equipment
Increase in accounts receivable1
Increase in inventory2
Increase in accounts payable3
Decrease in income taxes payable4
1
2
3
4
$ 28
10
(15)
(9)
(8)
10
(2)
$14
$93 84
$60 52
$40 30
$22 24

4-51
CASES
Judgment Case 4-1
Requirement 1
The term earnings quality refers to the ability of reported earnings (income) to
predict a companys 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 companys 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
companys 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.

4-52
Judgment Case 4-2

Requirement 1
Restructuring costs include costs associated with shutdown or relocation of
facilities or downsizing of operations. Facility closings and related employee layoffs
translate into costs incurred for severance pay and relocation costs as well as asset
write-downs or write-offs.
Requirement 2
Prior to 2003, restructuring costs were recognized (expensed) in the period the
decision to restructure was made, not in the period or periods in which the actual
activities took place. Now, restructuring costs are expensed in the period(s) incurred.
Requirement 3
Restructuring costs would be included as an operating expense in a multi-step
income statement.
Requirement 4
An analyst must interpret restructuring charges in light of a companys past
history in this area. Information in disclosure notes describing the restructuring and
management plans related to the business involved also can be helpful.
Judgment Case 4-3

No. Companies generally prefer to report earnings that follow a smooth, regular,
upward path. They try to avoid declines, but they also want to avoid increases that
vary wildly from year to year. It is better to have two years of 15% earnings
increases than a 30% gain one year and none the next. As a result, some companies
bank earnings by understating them in particularly good years and use the banked
profits to increase earnings in bad years.

4-53
Real World Case 4-4

Requirement 1
Companies often voluntarily provide a pro forma earnings number when they
announce annual or quarterly earnings calculated according to GAAP. These pro
forma earnings numbers are managements view of permanent earnings. These pro
forma earnings numbers are controversial as they represent managements biased view
of permanent earnings and should be interpreted in that light.
Requirement 2
The term earnings quality refers to the ability of reported earnings (income) to
predict a companys future earnings. Management believes that pro forma earnings
are of much higher quality than reported earnings because they are more indicative of
future profitability.
Requirement 3
There are some obvious reconciling items, to include restructuring costs and
other special charges of $1,170 million, Inventory charges of $2,249 million and inprocess research and development of $109 million. Cisco offered the following
reconciliation ($ in millions):
GAAP loss
Add:
Restructuring costs and other special charges
In-process research and development
Amortization of goodwill and other acquisition costs*
Payroll tax on stock options exercised
Inventory charges
Total adjustments
Tax effects (approximately 24.7% tax rate)
Net of tax adjustments
Pro forma net income
$(2,693)
$1,170
109
346
10
2,249
3,884
961
2,923
$ 230
*New accounting standards discussed in Chapters 10 and 11 require that

goodwill no longer be amortized. This standard became effective after August of
2001.

4-54
Communication Case 4-5

The critical question that student groups should address is whether or not the gain
on the sale of the timber tracts should be reported as an extraordinary item on the 2006
income statement. 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. Is the gain material? A consensus should be reached that the gain is material.
2. Is the event both unusual and infrequent? Debate should center on the critical
issue of whether the event is likely to occur again in the foreseeable future.
3. If the event is deemed to require presentation as an extraordinary item, the
gain should be reported net of tax below income from continuing operations.
A disclosure note also is required and earnings per share disclosure should
reflect the income statement presentation.
As a real world example of a similar situation, in 1974 Johns Manville
Corporation, manufacturer of asbestos products, reported a $21 million extraordinary
gain from the sale of timber tracts. No disclosure note was provided to explain the
event, so we can only speculate as to the circumstances leading to the company's
presentation of the gain as extraordinary.
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, and
(b) clarifying or modifying ideas already expressed, or (c) suggesting alternative
direction.

4-55
Communication Case 4-6

Suggested Grading Concepts and Grading Scheme:
Content (70%)
______ 10 Is the loss material?
______
25 Lists the alternative treatments.

_____ Present before-tax amount as a separate line item.
_____ Present the after-tax amount as an extraordinary item.
_____ In either case, disclosure is required.
______
25 Cites the appropriate authoritative pronouncement,

APBO 30, and discusses the concepts of unusual
and infrequent in the context of the companys environment.
______
10 A clear, well supported recommendation is made.

____
______ 70 points
Writing (30%)
______ 6 Terminology and tone appropriate to the audience of a chief
financial officer.
______
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

4-56
Case 4-6 (continued)

The following is provided as an example.
August, 1990
TO:
Chief Financial Officer, Carter Hawley Hale Stores (CHHS)
FROM: John Doe, Controller (CHHS)

RE:
Income Statement treatment of October 17, 1989, earthquake damage costs.
A decision on the income statement treatment of the earthquake damage costs

involves a number of considerations. First, the damage costs are clearly material.
Inclusion of the costs in earnings results in an increase in the net loss for the fiscal
year ended August 4, 1990, from $9.47 million to $25.97 million. This leaves us only
two options for the income statement presentation of the loss:
1. Present the before-tax amount of the loss ($27.5 million) as a separate line
item in the income statement.
2. Present the after-tax effect of the loss ($16.5 million) as an extraordinary
item, below income from continuing operations.
In both cases, a disclosure note would be required to explain the loss.
The appropriate authoritative pronouncement pertaining to this case is
Accounting Principles Board Opinion No. 30. The opinion states that judgment is
required in determining whether or not an event warrants separate reporting in the
income statement as an extraordinary item. However, the following broad guideline is
provided:
Extraordinary items are events and transactions
that are distinguished by their unusual nature and
by the infrequency of their occurrence.(par. 20)
The opinion adds that the characteristics of unusual nature and infrequency of
occurrence must be considered in light of the environment in which the company
operates.
These characteristics are only aids in answering the important question: What is
the likelihood that this event will occur again in the foreseeable future? If it is not
likely to occur again, then this should be communicated to financial statement users
by segregating the income effect of the event as an extraordinary item. This will help
them in using the income statement to predict future cash flows.

4-57
Case 4-6 (concluded)

RECOMMENDATION
I recommend that the earthquake damage costs be treated as an extraordinary
loss, net of tax, in the income statement for the fiscal year ended August 4, 1990. In
addition, earnings per share for income both before and after the loss must be
presented. While many earthquakes do occur in California, extremely large
earthquakes causing significant amounts of damage are both unusual and infrequent. I
do not believe that this type of loss will occur again in the foreseeable future.

4-58
Ethics Case 4-7

Discussion should include these elements.
Facts:
The company incurred $10 million in expenses related to a product recall. The
company had experienced product recalls in the past and they do occur in the industry.
To show a profit from continuing operations, Jim Dietz, the controller, wants to report
the $10 million as an extraordinary loss, rather than as an expense included in
operating income. He tells the CEO that the company has never had a product recall
of this magnitude and that the company fixed the design flaw and upgraded quality
control.
Extraordinary items are gains and losses that are material, and result from events
that are both unusual and infrequent. These criteria must be considered in light of the
environment in which the entity operates. There obviously is a considerable degree of
subjectivity involved in the determination. The concepts of unusual and infrequent
require judgment. In making these judgments, an accountant should keep in mind the
overall objective of the income statement. The key question is how the event relates to
a firms future profitability. If it is judged that the event, because of its unusual nature
and infrequency of occurrence, is not likely to occur again, separate reporting as an
extraordinary item is warranted.
Ethical Dilemma:
It appears from the facts of the case that it would be difficult for the company to
come to the conclusion that a material product recall is not likely to occur again in the
foreseeable future. This type of event has occurred before and is common in the
industry. While a subjective judgment, extraordinary treatment of the $10 million
does not appear warranted. Is the obligation of Jim and the CEO to maximize income
from continuing operations, the company's position on the stock market and
management bonuses stronger than their obligation to fairly present accounting
information to the users of financial statements?
Who is affected?
Jim Dietz
CEO and other managers
Other employees
Shareholders
Potential shareholders from the stock market
Creditors
Company auditors

4-59
Research Case 4-8

Requirement 1
Most would agree that the events of September 11, 2001 were extraordinary.
The terrorist attacks were unprecedented in terms of the magnitude of the losses
incurred, the number of entities affected, the unprecedented federal ground stop order
that closed the U.S. air travel system for over 24 hours, and the unprecedented efforts
undertaken by the U.S. and other nations to prevent future terrorist attacks.
Requirement 3
The EITF was initially reluctant to address the issue because of its importance.
However, timely accounting guidance was necessary to help companies in deciding
how to measure and report the losses sustained as a result of the attacks. The Task
Force noted that without such guidance, financial statement preparers and auditors
would be faced with individually resolving the difficult questions presented by this
issue. The FASBs elaborate process would have not provided the necessary guidance
in a timely manner.
Requirement 4
The Task Force concluded that despite the incredible nature of the September 11
events, extraordinary item financial reporting treatment would not be an effective way
to communicate the financial effects of those events and, therefore, should not be used
in this case. The Task Force noted that it would be impossible to isolate and therefore
distinguish, in a consistent way, the effects of the September 11 events in any single
line item on companies financial statements because of the inability to separate losses
that are directly attributable to the events from those that were not.

4-60
Judgment Case 4-9

Situation
1.
2.
3.
4.
5.
6.
7.
8.
Treatment (a-g)
b
c
f
g
a
b
e
d.
Financial Statement
Presentation
(CO, BC, or RE)
CO
RE
CO
CO
BC
CO
BC
RE
Judgment Case 4-10

1. The loss is not unusual or infrequent. It is included in income from continuing
operations along with other gains and losses.
2. The sale of the financing component is treated as a 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. The remaining book value is depreciated, using the new method,
over the remaining useful life.
4. This event is not unusual but may be infrequent. It usually is presented as a
separate 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 included in income, but as an adjustment to retained earnings.
Prior years financial statements are restated to correct the error.
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 continuing operations along
with other gains and losses.

4-61
International Case 4-11

1.
2.
3.
4.
5.
6.
Differences in income statement presentation:

The title of the statement is "Group Profit and Loss Account" as opposed to
Income Statement.
The term "turnover" is used instead of sales or revenue.
The current years turnover and operating profit are presented for both continuing
operations and for acquisitions. In the U.S., the income effect of acquisitions is not
disclosed separately in the income statement. That information is contained in a
disclosure note.
The Cadbury statement contains a column for exceptional items. In the U.S., these
exceptional items are either separately reported below continuing operations, or are
reported as a separate line item in continuing operations.
Dividends on ordinary shares are deducted on the Cadbury Schweppes statement to
arrive at "profit retained." In the U.S., dividends to shareholders do not appear in
the income statement. They are shown as distributions to owners in either the
statement of shareholders' equity or the statement of retained earnings.
There is no earnings per share presentation on the face of the statement as there
commonly is in the U.S.

4-62
Judgment Case 4-12

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 managements
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
firms 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
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 Ten
Year 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.

4-63
Research Case 4-13

(Note: This case requires the student to reference a journal article.]
Requirement 2
The most frequent type of voluntary accounting change involves inventory
methods (38% of all voluntary accounting changes in the sample). More specifically,
adoptions of LIFO are the most common accounting change and these adoptions
increase with the rate of inflation.
Requirement 3
The authors infer that the typical non-LIFO voluntary accounting change is
income-increasing, and firms making income-increasing changes have significantly
lower sales and earnings growth prior to making a change, and lower interest coverage
ratios, higher debt-to-equity ratios, and tighter dividends constraints in the year of
change compared to a random sample of firms. They conclude that their results
suggest that voluntary accounting changes are most likely to have been made for
opportunistic or earnings management purposes.

4-64
Integrating Case 4-14

DEFICIENCIES:
Balance Sheet:
1. The asset section of the balance sheet should be classified. Cash, short-term
investments, accounts receivable, and inventories should be included as
current assets.
2. Accounts receivable should be shown net of the allowance for uncollectible
accounts.
3. Inventories - the method used to cost inventory should be disclosed in a note.
4. Marketable securities - $21,000 of investments ($78,000 - 57,000) should be
classified in a noncurrent investments category.
5. Property and Equipment - should be classified in a separate category.
Original cost should be disclosed along with the accumulated depreciation to
arrive at the net amount. Also, the method used to compute depreciation
should be disclosed in a note.
6. 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.
7. Current liabilities should include accounts payable and accruals, notes payable
(the $80,000 note due in 2007 and the $60,000 installment on note # 2 due in
2007). The latter should be classified as current maturities of long-term debt.
Also, note disclosure is required for the notes providing information such as
payment terms, interest rates, and collateral pledged as security for the debt.
8. Long-term liabilities should include the $60,000 second installment on note
#2.
9. Common stock - the par value, if any, and the number of shares authorized,
issued and outstanding should be disclosed.
Income Statement:
1. The miscellaneous expense should be classified as an extraordinary item and
shown net of tax below income from continuing operations. A note should
describe the event.
2. Earnings per share disclosure is required.
3. The restructuring charges should be shown as a separate operating expense
item in the income statement and described in a note.

4-65
Financial Analysis Case 4-15

Requirement 1
2003 to 2004: ($838 830) $830 = 1% increase
2002 to 2003: ($830 710) $710 = 17% increase
Requirement 2
$481 $1,319 = 36%
Requirement 3
$838 $24,710 = 3%. FedEx is able to generate three cents in net income for
every sales revenue dollar. This is a common financial ratio, known as the profit
margin on sales. Chapter 5 discusses this and other ratios related to profitability.
Real World Case 4-16

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 multiple-step formats that might be
considered the two extremes, with the income statements of most companies falling
somewhere in between.
The presentation of separately reported items, however, is mandated and students
should be able to easily identify them.
Trueblood Accounting Case 4-17

A solution and extensive discussion materials can be obtained from the Deloitte
Foundation.

4-66

Questions For Review of Key Topics: The Income Statement and Statement of Cash Flows

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The Income Statement and Statement of Cash Flows

QUESTIONS FOR REVIEW OF KEY TOPICS

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Answers to Questions (continued)

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Intermediate Accounting, 4/e

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Answers to Questions (continued)

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Answers to Questions (concluded)

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Intermediate Accounting, 4/e

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Brief Exercise 4-2

Revenues and gains:

Expenses and losses:

*$2,151 (1,240 + 126 + 105 + 35) = $645 x 40% = $258

Brief Exercise 4-3

Gain on sale of investments

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Brief Exercise 4-4

PACIFIC SCIENTIFIC CORPORATION

Sales revenue .....................................................

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Brief Exercise 4-5

Income before extraordinary item

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Intermediate Accounting, 4/e

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Brief Exercise 4-6

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Brief Exercise 4-7

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$ 2,000,000 ($10 million less $8 million)

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Brief Exercise 4-8

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Brief Exercise 4-9

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Brief Exercise 4-10

Brief Exercise 4-11

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