PROBLEM 4-3

(a) Lanestar Inc. Income Statement (Partial) For the Year Ended December 31, 2010 $1,658,500* 673,800** 984,700 $115,000 46,000 69,000 $915,700

Income from continuing operations before taxes Income taxes Income from continuing operations: Discontinued operations: Loss from disposal of recreational division Less applicable income tax reduction Net income Earnings per share: Income from continuing operations Discontinued operations Net income

$12.31 (0.86) 11. 45

*Calculation of income from continuing operations before taxes: As previously stated $1,790,000 Loss on sale of securities (107,000) Gain on proceeds of life insurance policy ($100,000 $46,000) Error in calculation of amortization: As calculated ($54,000 6) Corrected ($54,000 $9,000) 6 As restated 54,000 $9,000 7,500 1,500 $1,738,500

**Calculation of income tax: Income from continuing operations before income tax Nontaxable income (gain on life insurance) Taxable income Tax rate Tax expense

$1,738,500 (54,000) 1,684,500 X .40 $673,800

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PROBLEM 4-3 (Continued)

(b) Lanestar Inc. Retained Earnings Statement For the Year Ended December 31, 2010 $2,540,000 1,800 24,000 25,800 $2,565,800 915,700 3,481,500 175,000 $3,306,500

Retained earnings, January 1, 2010, as reported Correction of amortization overstatement (net of tax of $1,200) * Retroactive adjustment for change in inventory method (net of tax of $16,000) ** Retained earnings, January 1, 2010, as adjusted Add: Net income Less: Dividends declared Retained earnings, December 31, 2010 * Error in calculation of amortization: As calculated ($54,000 6) Corrected ($54,000 $9,000) 6 Understatement of net income per year Total understatement of beginning retained earnings After-tax understatement ($3,000 X [1-40%]) **Understatement of 2008 income Overstatement of 2009 income Net understatement of beginning retained earnings After-tax understatement ($40,000 X [1-40%])

$9,000 7,500 1,500 X2 3,000 $1,800 $60,000 (20,000) $40,000 $24,000

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PROBLEM 4-3 (Continued) (c) The GAAP classification rules assist in assessing the quality of earnings by separating discontinued operations from continuing operations. Discontinued operations are presented separately to provide predictive value. By separating the results of operations that are being discontinued from ongoing operations, users can assess ongoing operations and more easily predict future performance. Results from continuing operations usually have greater significance for predicting future performance than do results from nonrecurring activities. The GAAP classification rules also apply to financial statement elements and separate revenues and expenses from gains and losses. This separation helps users assess the past performance and profitability based on recurring, regular transactions and predict sustainability of earnings. GAAP also requires various other items of the income statement to be disclosed. These also provide information to users to assess the quality, recurrence, and sustainability of earnings and managements performance. For example: government assistance, goodwill impairment, income taxes, etc.

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PROBLEM 4-8 Hamad Corporation Income Statement For the Year Ended December 31, 2010 Sales $9,500,000 Cost of goods sold 5,900,000 Gross profit 3,600,000 Selling and administrative expenses $1,280,000 * Loss due to write-down of inventory 112,000** Total operating expenses 1,392,000 Income before taxes and discontinued operations 2,208,000 Income taxes 662,400*** Income before discontinued operations 1,545,600 Discontinued operations Loss from discontinued operations (net of taxes of $69,429****) 162,000 Net income $1,383,600 Earnings per share: Income before discontinued operations Discontinued operations Net income

$3.86 (.40) $3.46

* The 2009 sales commissions of $20,000 are deducted. ** The $112,000 may be identified as an unusual item if unusual or infrequent in nature. *** (30% of $2,208,000). **** The loss from discontinued operations before taxes = $162,000 / [100% - 30%] = $231,429. Income taxes = $231,429 - $162,000 = $69,429.

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PROBLEM 4-8 (Continued) (b) Hamad Corporation Income Statement For the Year Ended December 31, 2010 Sales Cost of goods sold Gross profit Selling and administrative expenses $1,280,000 Loss due to write-down of inventory 112,000 Total operating expenses Income before taxes and discontinued operations Income taxes Income before discontinued operations Discontinued operations Loss from discontinued operations (net of income tax recovery of $69,429****) Net income Retained earnings, January 1, as reported Less:Cumulative effect on prior years of change in amortization method (net of taxes of $36,563) Correction of error in prior years income (net of taxes of $6,000) Retained earnings, January 1, as restated Less: Cash dividends Retained earnings, December 31 $9,500,000 5,900,000 3,600,000 1,392,000 2,208,000 662,400 1,545,600 162,000 $1,383,600 $2,800,00 0 85,312 14,000 99,312 2,700,688 4,084,288 700,000 $3,384,288

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PROBLEM 4-8 (Continued) (c) The income tax is allocated in the same manner as the underlying irregular item or adjustment to opening retained earnings. Since income taxes are a major expense for companies, it is important to reflect the individual impact of taxes for discontinued operations, corrections of errors, and changes in accounting policies. This helps users assess the quality of earnings and their related tax impact. Earnings per share information is also highlighted separately, net of taxes, for discontinued operations. Intraperiod tax allocation also helps readers in trend analysis of income tax expense and income from continuing operations, by placing the current year amount on a comparable basis with prior years.

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PROBLEM 4-10 (a) The Rocketeer Divisions assets should be identified separately on Campbell Corporations balance sheet as of May 31, 2011 as held for sale current assets and carried at their net realizable value of $87 million, i.e., the amount of cash sale. The operating loss must be reported as a separate component after income from continuing operations. The operating loss up to year end is presented as a loss from discontinued operations. The operating loss from a discontinued segment is presented net of tax. Separate earnings per share figures would also be required. The division assets would be measured at the lower of net book value and fair market value less costs to sell. The loss would be presented as a separate component of discontinued operations, on an after-tax basis.
$XXX $(6,000) (5,400) $(11,400) $XXX

(b)

All figures in thousands, except earnings per share: Income from continuing operations (Note): Loss from operations of the Rocketeer division less applicable income tax recovery of $4,000 Loss from impairment of Rocketeer division assets less applicable income tax recovery of $3,600* Net income

* Book value of assets Fair value Impairment loss Applicable taxes (40%) After-tax loss

$96,000,000 87,000,000 $(9,000,000 ) 3,600,000 $(5,400,000 )

(Note to instructor: We have presented the calculations in this format in order for the student to better understand how the loss on disposal was calculated. Other formats are acceptable.)

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PROBLEM 4-10 (Continued) (c) The operating loss from June 1-30, 2011 is reported as a separate component after income from continuing operations. The operating loss is presented as a loss from discontinued operations on a net of tax basis. The loss on the disposal of the division assets would be presented as a separate component of discontinued operations, on an after-tax basis. The amounts would be disclosed on a comparative basis with the results of 2011 year end. Separate earnings per share figures for the discontinued operations would also be required.
$XXX $(450) (1,800) $(2,250) $XXX

All figures in thousands, except earnings per share: Income from continuing operations (Note): Loss from operations of the Rocketeer division less applicable income tax recovery of $300 Loss from disposal of Rocketeer division assets less applicable income tax recovery of $1,200 Net income

(d)

The Rocketeer Division financial results should be shown as a discontinued operation according to the following factors: The Rocketeer Division meets the definition of a segment as provided in IFRS 8 Management has formally decided to dispose of the Rocketeer Division The division is a separate component of the entity and is operationally distinct as evidenced by the measurement of the division losses There is an active program to find a buyer (negotiations are in process) Management could argue the following points against using discontinued operations treatment: Changes to the plan are possible or likely, and

PROBLEM 4-10 (Continued)

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 The assets are not available for immediate sale in their current state Management would usually prefer using the discontinued operations treatment. This separates the financial results of the division from continuing operations and allows users to concentrate on continuing financial results and to assess management performance on the more profitable parts of the business. This also allows users to see the unprofitable impact of the Rocketeer Division on prior years results since comparative figures are presented. For a user, showing discontinued operations at the bottom of the income statement after income tax expense and with its own earnings per share information provides more information about the quality and recurrence of earnings.

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PROBLEM 4-14
(a) Earnings management is often defined as the planned timing of

revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize revenue before it is earned in order to boost income. Earnings management can also be used to decrease current earnings in order to increase income in the future. This is done through the creation of reserves by using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses, and warranty returns. (b) Proposed Accounting Income: 2007 2008 2009 2010 2011 Income before $43,00 $43,00 warr. expense 0 0 Warr. expense 8,000 2,000 Income $20,000 $25,000 $30,000 $35,000 $41,000 Assuming the same income before warranty expense for both 2010 and 2011 and total warranty expense over the 2-year period of $10,000, this proposed accounting results in steadily increasing income over the two-year period. (c) Appropriate Accounting Income: 2007 2008 2009 2010 2011 Income before $43,00 $43,00 warr. expense 0 0 Warr. expense 5,000 5,000 Income $20,000 $25,000 $30,000 $38,000 $38,000 The appropriate accounting would be to record $5,000 in 2010, resulting in income of $38,000. However, with the same amount of warranty expense in 2011, Grace no longer shows an increasing trend in income. Thus, by taking more expense in 2010, Grace can maintain its growth trend in income.

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