Spiceland SM Ch03

Chapter 3

The Balance Sheet and Financial Disclosures

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

Question 3-2 The balance sheet does not portray the market value of the entity for a number of reasons. Most assets are not reported at market value, but instead are measured according to historical cost. Also, there are certain resources, such as trained employees, an experienced management team, and a good reputation, that are not recorded as assets at all. Therefore, the assets of a company minus its liabilities, as shown in the balance sheet, will not be representative of the company’s market value.

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

Question 3-4 Current liabilities are those obligations that are expected to be satisfied through the use of current assets or the creation of other current liabilities. liabilities. So, this classification classification will include all liabilities that are scheduled to be liquidated within one year or the operating cycle, whichever is longer, except those that management intends to refinance on a long-term basis. basis. The typical liability categories classified as current liabilities include: — Accounts payable — Short-term notes payable — Accrued liabilities — Current maturities of long-term debt

Solutions Manual, Vol.1, Chapter 3

© The McGraw-Hill Companies, Inc., 2007 3-1

Answers to Questions (continued)

Question 3-5 The operating cycle for a typical manufacturing company refers to the period of time required to convert cash to raw materials, raw materials to a finished product, finished product to receivables, and then finally receivables back to cash.

Question 3-6 Investments in equity securities are classified as current if the company’s management (1) intends to liquidate the investment in the next year or operating cycle, whichever is longer, and (2) has the ability to do so, i.e., the investment is marketable. If either of these criteria does not hold, the investment is classified as noncurrent.

Question 3-7 The common characteristics that these assets have in common are that they are tangible, long assets used in the operations of the business. They usually are the primary revenue-generating lived assets assets of the business. business. These assets include land, buildings, equipment, machinery, furniture and other assets used in the operations of the business, as well as natural resources, such as mineral mines, timber tracts and oil wells.

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

Question 3-9 A note payable of $100,000 due in five years would be classified as a long-term liability. A $100,000 note due in five annual installments of $20,000 each would be classified as a $20,000 current liability — current maturities of long-term debt — and an $80,000 long-term liability.

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

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


Intermediate Accounting, 4/e

Answers to Questions (continued)

Question 3-12 The disclosure of the company’s significant accounting policies is extremely important to external users in terms of their ability to compare financial information across across companies. It is critical to a financial analyst involved in assessing future cash flows of two construction companies to know that one company uses the percentage-of-completion method in recognizing gross profit, while the other company uses the completed contract method.

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

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

Question 3-15 1.

2.

3.

4.

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

Question 3-16 A proxy statement must be sent each each year to all shareholders. It usually is in the same mailing with the annual report. The statement invites invites shareholders to the shareholders’ shareholders’ meeting to elect board members and to vote on issues before the shareholders. It also permits shareholders to vote using an enclosed proxy card. Beginning with 1992 1992 financial statements, the proxy statement also provides for more disclosures on compensation to directors and executives, and in particular, stock options granted to executives.



Answers to Questions (concluded)

Question 3-17 Working capital is the difference between current assets assets and current liabilities. The current ratio is computed by dividing current assets assets by current liabilities. liabilities. The acid-test ratio (or quick ratio) ratio) is computed by dividing quick assets (cash and cash equivalents, marketable securities, and accounts receivable) by current liabilities.

Question 3-18

Debt to equity ratio

=

Times interest earned ratio

=

Total liabilities Shareholders' equity Net income + interest + taxes Interest

Question 3-19 An operating segment is a component of o f an enterprise: 1. That engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise). 2. Whose operating results are regularly reviewed by the enterprise's chief operating decisionmaker to make decisions about resources to be allocated to the segment, and to assess its performance. 3. For which discrete financial information information is available.

Question 3-20 1. 2. 3. 4.

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



BRIEF EXERCISES Brief Exercise 3-1 (a) (b) (c) (d) (e) (f)

Current Current Noncurrent Current Noncurrent Noncurrent

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

Brief Exercise 3-3 Assets:

minus Liabilities

equals Shareholders’ equity


$ 52,000 current assets 80,000 equipment $132,000 total assets $ 24,000 current liabilities 30,000 notes payable 54,000 total liabilities $78,000 (50,000) common stock $28,000 retained earnings


Brief Exercise 3-4 K and J Nursery, Inc. Balance Sheet At December 31, 2006 Assets

Current assets: Cash ......................... ..................................... ......................... .......................... ............... .. Accounts Accounts receivable receivable ........................ ..................................... ................. .... Inventories Inventories ......................... ...................................... .......................... ................. .... Total Total current assets ......................... ...................................... ............. Property, plant, and equipment: equipment: Equipment Equipment ........................ ..................................... .......................... ................... ...... Less: Accumulated Accumulated depreciati depreciation on ....................... ....................... Net property, plant, and equipment ............. .......... ... Total assets .......................... ...................................... ..................... .........

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

Liabilities and Shareholders' Equity Current liabilit liabilities: ies: Accounts Accounts payable payable .......................... ....................................... ................... ...... Wages payable payable .......................... ...................................... ....................... ........... Interest Interest payable ......................... ..................................... ....................... ........... Total Total current liabiliti liabilities es .......................... ................................ ......

$ 14,000 9,000 1,000 24,000

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

30,000 $50,000 28,000 78,000 $132,000

$28,000 is the amount needed to cause caus e total assets to equal total liabilities and shareholders’ equity. This is calculated in BE 3-3.



Brief Exercise 3-5 Culver City Lighting, Inc. Balance Sheet At December 31, 2006 Assets

Current assets: Cash ......................... ..................................... ......................... .......................... ............... .. Accounts Accounts receivable receivable ........................ ..................................... ................. .... Inventories Inventories ......................... ...................................... .......................... ................. .... Prepaid Prepaid insurance insurance .......................... ....................................... ................... ...... Total Total current assets ......................... ...................................... ............. Property, plant, and equipment: equipment: Equipment Equipment ........................ ..................................... .......................... ................... ...... Less: Accumulated Accumulated depreciati depreciation on ....................... ....................... Net property, plant, and equipment ............. .......... ...

$ 55,000 39,000 45,000 15,000 154,000 $100,000 (34,000) (34,000) 66,000

Intangibles: Patent Patent ......................... ...................................... ......................... ....................... ........... Total assets .......................... ...................................... ..................... .........

40,000 $260,000

Liabilities and Shareholders' Equity Current liabilit liabilities: ies: Accounts Accounts payable payable .......................... ....................................... ................... ...... Interest Interest payable .......................... ...................................... ....................... ........... Current Current maturities maturities of long-term long-term debt ................ ................ Total Total current liabiliti liabilities es .......................... ................................ ......

$ 12,000 2,000 10,000 24,000

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


90,000 $70,000 76,000 146,000 $260,000 © The McGraw-Hill Companies, Inc., 2007 3-7

Brief Exercise 3-6 1. 2.

3.

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

Brief Exercise 3-7 Current assets – cash and cash equivalents – accounts receivable = Inventories $235,000 – 40,000 – 120,000 = $75,000 Total assets – current assets = property, plant, and equipment $400,000 – 235,000 = $165,000 Total assets – accounts payable – note payable – common stock = retained earnings $400,000 – 32,000 – 50,000 – 100,000 = $218,000

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

A B B A B A

Brief Exercise 3-9 (a)

Current assets


÷

current liabilities Intermediate Accounting, 4/e

($55,000 + 39,000 + 45,000 + 15,000) ÷ ($12,000 + 2,000 + 10,000) $154,000 $24,000 = 6.42 ÷ (b) (Cash + short-term investments + accounts receivable) ($55,000 + 0 + 39,000)

÷ ÷

current liabilities $24,000 = 3.92

(c) Total liabilities ÷ shareholders’ equity $24,000 current liabilities + 90,000 long-term liabilities = $114,000 $70,000 common stock + 76,000 retained earnings = $146,000 $114,000 ÷ $146,000 = .78

Brief Exercise 3-10 Paying accounts payable reduces both current assets and current liabilities. If the ratio before the payment were above 1.0, the transaction would cause the ratio to increase. However, if the ratio ratio before the transaction were less than 1.0, the ratio would decrease.

Brief Exercise 3-11 Acid-test ratio = (cash + short-term investments + A/R) ÷ current liabilities 1.5 = ($20,000 + 0 + 40,000) ÷ current liabilities 1.5 x current liabilities = $60,000 current liabilities = $60,000 ÷ 1.5 current liabilities = $40,000 Current ratio = current assets ÷ current liabilities 2.0 = current assets ÷ $40,000 current assets = $40,000 x 2.0 current assets = $80,000 $80,000 – 20,000(cash) – 40,000(A/R) = $20,000 inventories



EXERCISES Exercise 3-1 1. Total current assets

Current liabilities liabilities = $44,000 + 15,000 + 1,000 1,000 (accrued interest) = $60,000 Since the current ratio is 1.5:1, current assets = 1.5 x $60,000 = $90,000 2. Short-term investments

$90,000 - 5,000 - 20,000 - 60,000 = $5,000 3. Retained earnings

Current assets + Noncurrent assets = Current liabilities liabilities + Long-term liabilities + Paid-in capital + Retained earnings (RE) $90,000 + 120,000 = $60,000 + 30,000 (Note payable) + 100,000 + RE RE = $20,000

Exercise 3-2 1. 2. 3. 4. 5. 6. 7. 8. 9.

c f -a b_ g_ f f i b

Equipment Accounts payable Allowance for uncollectible accounts Land, held for investment Note payable, due in 5 years Unearned rent revenue Note payable, due in 6 months Income less dividends, accumulated Investment in XYZ Corp., long-term


10. 11. 12. 13. 14. 15. 16. 17. 18.

a d c f a h c a f

Inventories Patent Land, in use Accrued liabilities Prepaid rent Common stock Building, in use Cash Taxes payable


Exercise 3-3 1. 2. 3. 4. 5. 6. 7. 8. 9.

f Accrued interest payable d Franchise -c Accumulated depreciation e Prepaid insurance, for 2005 g Bonds payable, due in 10 years f Current maturities of long-term debt f Note payable, due in 3 months b Long-term receivables b Bond sinking fund, will be used to retire bonds in 10 years


10. 11. 12. 13. 14. 15. 16. 17. 18.

a c c f d h b a f

Supplies Machinery Land, in use Unearned revenue Copyrights Preferred stock Land, held for speculation Cash equivalents Wages payable


Exercise 3-4 JACKSON CORPORATION Balance Sheet At December 31, 2006 Assets

Current assets: Cash ......................... ..................................... ......................... .......................... ............... .. Marketable Marketable securities securities ......................... ...................................... ............... .. Accounts Accounts receivable receivable ........................ ..................................... ................. .... Inventories Inventories ......................... ...................................... .......................... ................. .... Prepaid Prepaid rent ........................ ..................................... .......................... ................. .... Total Total current assets ......................... ...................................... ............. Property, plant, and equipment: equipment: Machinery Machinery ........................ ..................................... .......................... ................... ...... Less: Accumulated Accumulated depreciati depreciation on ....................... ....................... Net property, plant, and equipment ............. .......... ...

$ 40,000 10,000 34,000 75,000 16,000 175,000 $145,000 (11,000) (11,000) 134,000

Intangibles: Patent Patent ......................... ...................................... ......................... ....................... ........... Total assets .......................... ...................................... ..................... .........

83,000 $392,000

Liabilities and Shareholders' Equity Current liabilit liabilities: ies: Accounts Accounts payable payable .......................... ....................................... ................... ...... Wages payable payable .......................... ...................................... ....................... ........... Taxes payable payable ......................... ...................................... .......................... ............. Total Total current liabiliti liabilities es .......................... ................................ ......

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

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

200,000

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


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


Exercise 3-5 VALLEY PUMP CORPORATION Balance Sheet At December 31, 2006 Assets

Current assets: Cash ............................................................................. Marketable Marketable securities securities .................................................... Accounts receivable, net of allowance for uncollectibl uncollectiblee accounts accounts of $5,000 ............................. Inventories Inventories .................................................................... Prepaid Prepaid expenses expenses .......................................................... Total current current assets assets .................................................

$ 25,000 22,000 51,000 81,000 32,000 211,000

Investments: Marketable Marketable securities securities .................................................... Land ............................................................................. Total investment investmentss ....................................................

$22,000 20,000 42,000

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

100,000 300,000 75,000 475,000 (125,000) (125,000)

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

350,000

Intangibles: Copyright Copyright ..................................................................... Total assets assets ..........................................................

12,000 $615,000

Liabilities and Shareholders' Equity

Current liabilities: Accounts Accounts payable payable .......................................................... Interest Interest payable payable ............................................................. Unearned Unearned revenues revenues ....................................................... Note payable ........... ..... ............ ............ ............ ............ ............ ............ ............ ............ ............ ...... Current maturities of long-term debt ............ ...... ............ ............ ........... ..... Total current current liabilitie liabilitiess ............................................

$ 65,000 10,000 20,000 100,000 50,000 245,000

Long-term liabilities: Note payable ........... ..... ............ ............ ............ ............ ............ ............ ............ ............ ............ ......

100,000

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


$200,000 70,000 270,000 270,000 $615,000 © The McGraw-Hill Companies, Inc., 2007 3-13

Exercise 3-6 LOS GATOS CORPORATION Balance Sheet At December 31, 2006 Assets

Current assets: Cash ................................................ ....................................................................... ....................... Accounts receivable, net of allowance for uncollectible accounts of $5,000 ................ ........ ................ .......... Inventori Inventories es ............................................... ............................................................. .............. Total current assets ............... ....... ................ ................ ................ ............ ....

$ 20,000 55,000 55,000 55,000 130,000

Investments: Bond sinking sinking fund ................................................ .................................................. .. Note receivable receivable ................ ........ ................ ................ ............... ............... ............... ....... Total investments ................ ........ ................ ............... ............... ............... .......

$ 20,000 20,000

Property, plant, and equipment: Machiner Machinery y ................................................ .............................................................. .............. Less: Accumulated depreciation ................ ........ ................ ............. ..... Net property, plant, and equipment equipment ............... ....... ............ ....

190,000 190,000 (70,000)

40,000

120,000

Intangibles: Franchise Franchise .................................................. ................................................................ .............. Total Total assets assets ............................................... ..................................................... ......

30,000 30,000 $320,000 $320,000


Current liabilities: Accounts payable ............... ........ ............... ................ ................ ................ ............ .... Interest Interest payable payable ................................................ ...................................................... ...... Note payable ................ ........ ................ ................ ................ ............... ............... ........... ... Total current liabilities ................ ........ ............... ............... ............... .......

$ 50,000 5,000 50,000 105,000

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

110,000 110,000

Shareholders’ equity: Common stock, no par value; 100,000 shares authorized; 50,000 shares issued and outstanding Retained earnings ............... ........ ............... ................ ................ ................ ............ .... Total shareholders’ equity ................ ........ ................ ................ .......... Total liabilities and shareholders’ equity ........


$ 70,000 35,000 105,000 $320,000


Exercise 3-7 CONE CORPORATION Balance Sheet (Partial) At December 31, 2006 Assets

Current assets: Marketable securities ...................... ........... ....................... .................. ...... Prepaid rent ....................... ............ ...................... ....................... .................... ........

$ 40,000 12,000

Investments: Bond sinking sinking fund ......................... ..................................... ................... ....... Marketable securities ...................... ........... ....................... .................. ......

50,000 40,000

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

12,000

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

Long-term liabilities: liabilities: Note payable ...................... ........... ...................... ....................... .................... ........

$ 12,000 20,000

180,000

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

current assets.



Exercise 3-8 See calculations below the balance sheet. Korver Supply Company Balance Sheet At December 31, 2006 Assets

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

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

Liabilities and Shareholders' Equity Current liabilit liabilities: ies: Accounts Accounts payable payable .......................... ....................................... ................... ...... Interest Interest payable ......................... ..................................... ....................... ........... Note payable ....................... ........... ....................... ...................... .................. ....... Total Total current liabiliti liabilities es .......................... ................................ ......

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

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

482,000 $868,000

$100,000 382,000

Exercise 3-8 (concluded) © The McGraw-Hill Companies, Inc., 2007 3-16


Beginning balance in cash + Cash collected from customers - Cash paid to suppliers - Cash paid for operating expenses - Cash paid for interest Ending cash balance

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

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

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

Beginning balance in inventories + Purchases - Cost of merchandise sold Ending balance in inventories

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

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

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

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

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

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

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

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


$6,000


Exercise 3-9 1. 2. 3. 4. 5. 6. 7. 8.

Inventory costing method Information on related party transactions Composition of property, plant, and equipment Depreciation method Subsequent event information Basis of revenue recognition on long-term contracts Important merger occurring after year-end Composition of receivables

A B B A B A B B

Exercise 3-10 1.

2.

3.

4. 5.

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

Exercise 3-11 1. 2. 3.

a c c



Exercise 3-12 List A d h

1. Balance sheet 2. Liquidity

b

3. Current assets

j a

4. Operating cycle 5. Current liabilities

k m

6. 7.

l

8. Working capital

g

9. Accrued liabilities

e i c f

Cash equivalent Intangible asset

10. Summary of significant accounting policies 11. Subsequent events 12. Unqualified opinion 13. Qualified opinion

List B a. Will be satisfied through the use of current assets. b. Items expected to be converted to cash or consumed within one year or the operating cycle. c. The statements are presented fairly in conformity with GAAP. d. An organized array of assets, liabilities and equity. e. Important to a user in comparing financial information across companies. f. Scope limitation or a departure from GAAP. g. Recorded when an expense is incurred but not yet paid. h. Relates to the amount of time before an asset is converted to cash or a liability is paid. i. Occurs after the fiscal year-end but before the statements are issued. j. Cash to cash. k. One-month U.S. treasury bill. l. Current assets minus current liabilities. m. Lacks physical existence.

Exercise 3-13 1. Current ratio 2. Acid-test ratio 3. Debt to equity ratio 4. Times interest earned ratio


[$200 + 150 + 200 + 350] ÷ $400 = 2.25 [$200 + 150 + 200] ÷ $400 = 1.375 [$400 + 350] ÷ [$750 + 400] = .65 [$160 + 40 + 100] ÷ $40 = 7.5 times


Exercise 3-14 1. Acid-test ratio = Quick assets ÷ Current liabilities = Quick assets = Current assets - Inventories Quick assets = Current assets - $840,000

1.20

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

2.25 1.20 1.05

2. Debt to equity ratio ratio = Total liabilities ÷ Shareholders’ equity = 1.8 Total liabilities + Shareholders' equity = Total assets Total liabilities + Shareholders' equity = $2,800,000 Let x equal shareholders' equity 1.8 x + x = $2,800,000 x = $1,000,000 = Shareholders' equity 3. Noncurrent assets = Total assets - Current assets Noncurrent assets = $2,800,000 $2,800, 000 – 1,800,000 = $1,000,000 4. Long-term liabilities = Total assets - Current liabilities liabilities - Shareholders' equity Long-term liabilities = $2,800,000 - 800,000 - 1,000,000 = $1,000,000



Exercise 3-15 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Action Issuance of long-term bonds Issuance of short-term notes Payment of accounts payable Purchase of inventory on account Purchase of inventory for cash Purchase of equipment with a 4-year note Retirement of bonds Sale of common stock Write-off of obsolete inventory Purchase of short-term investment for cash Decision to refinance on a long-term basis some currently maturing debt

Current Ratio I I D I N N D I D N

I

Acid-test Debt to Ratio Equity Ratio I I I I D D D I D N N I D D I D N I N N

I

N

Exercise 3-16 1. 2.

a a



Exercise 3-17 1. d. SFAS 57 requires requires disclosure of related-party transactions except for compensation agreements, expense allowances, and transactions eliminated in consolidated working papers. Required disclosures include the relationship(s) of the related parties; a description and dollar amounts of transactions for each period presented and the effects of any change in the method of o f establishing their terms; and amounts due to or from the related parties and, if not apparent, the terms and manner manner of settlement. The effect on the cash flow statement statement need not be disclosed. 2. b. The MD&A section is included in SEC filings. It addresses in a nonquantified manner the prospects of a company. The SEC examines examines it with care to determine that management has disclosed material information affecting the company’s future results. Disclosures about commitments commitments and events that may affect operations or liquidity are mandatory. Thus, the MD&A section pertains to liquidity, capital resources, and results of operations. 3. c. The current current ratio equals current assets divided by current liabilities. An equal increase in both the numerator and denominator of a current ratio less than 1.0 causes the ratio to increase. Windham Company’s current ratio ratio is .8 ($400,000/ $500,000). The purchase of $100,000 of inventory on account would increase the current assets to $500,000 and the current liabilities to $600,000, resulting in a new current ratio of .833.



Exercise 3-18 Requirement 1 The pharmaceuticals, plastics plastics and farm equipment segments are are reportable. Only segments representing 10% or more of total company revenues, assets or net income must be reported. The electronics segment does not meet this criterion. Requirement 2 For segments determined to be reportable, the following disclosures are required: a. General information about the operating segment. b. Information about reported segment profit or loss, including certain revenues and expenses included in reported segment profit or loss, segments assets, and the basis of measurement. c. Reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items to corresponding enterprise amounts. d. Interim period information.



PROBLEMS Problem 3-1 Balance Sheet Assets Current assets: Cash Short-term investments Accounts receivable, net of allowance for uncollectible accounts Interest receivable Inventories Prepaid expenses Total current assets Investments: Bond sinking fund Long-term investments Notes receivable Total investments Property, plant, plant , and equipment: Land Buildings Equipment Less: Accumulated depreciation Net property, plant, plant , and equipment Intangibl es: Intangibles: Patent Copyright Total intangibles Total assets Liabilities and Shareholders' Equity

Current liabilities: Accounts payable Rent payable Taxes payable Wages payable Notes payable Total current liabilities Long-term liabilities: liabi lities: Bonds payable Shareholders’ equity: Common stock Preferred stock Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity



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



Problem 3-2 (concluded)

Requirement 2 AMDAHL CORPORATION Balance Sheet Assets ($ in thousands)

Current assets: assets : Cash and cash equivalents ...................... .......... ................. ..... Short-term investments ....................... ............ .................... ......... Accounts receivable, net of allowance for uncollectible accounts ....................... ........... ................. ..... Inventories Inventories ........................ ..................................... ......................... .............. .. Prepaid Prepaid expenses ......................... ..................................... ................ .... Total current assets ...................... ........... ...................... ...........

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

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

110,800

Property and equipment equipment (net) .......................... Total assets ....................... ........... ....................... .................... .........

621,040 $2,326,767

Liabilities and Shareholders' Equity Current liabiliti liabilities: es: Notes payable and short-term debt ................ ............ .... Accounts Accounts payable ......................... ..................................... ................. ..... Accrued liabilities ...................... .......... ....................... ................... ........ Other current liabilities ....................... ............ ..................... .......... Total current liabilities ....................... ........... .................. ......

$

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

Long-term debt and deferred deferred taxes .................

262,576

Shareholders’ equity ....................................... Total liabilities and shareholders’ equity

1,370,627 $2,326,767



Problem 3-3 ALMWAY CORPORATION Balance Sheet At December 31, 2006 Assets

Current assets: Cash and cash equivalents ...................... ................................. ...................... ...................... ............. Short-term investments ...................... ................................. ...................... ...................... ................. ...... Accounts receivable, net of allowance for uncollectible uncollecti ble accounts of $8,000 ...................... ................................. ................... ........ Inventories ...................... ................................. ...................... ...................... ...................... ...................... ............... .... Prepaid insurance ..................... ................................ ...................... ...................... ...................... ................. ...... Total current assets ...................... ................................. ...................... ...................... ................. ...... Investments: Marketable securities ..................... ................................ ...................... ...................... ..................... .......... Land held for sale ...................... ................................. ...................... ...................... ...................... ............... .... Bond sinking fund ...................... ................................. ...................... ....................... ....................... ............. .. Total investments investment s ..................... ................................ ...................... ...................... ..................... .......... Property, plant, plant , and equipment: Land ...................... ................................. ...................... ...................... ...................... ...................... ...................... ............... .... Buildings ..................... ................................ ...................... ...................... ...................... ...................... ................... ........ Equipment ..................... ................................ ...................... ...................... ...................... ...................... ................. ......

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

$ 30,000 80,000 60,000 200,000 9,000 379,000 $ 30,000 25,000 15,000 70,000 65,000 420,000 110,000 595,000 (160,000) 435,000

Intangibles : Intangibles: Patents ..................... ................................ ...................... ...................... ...................... ...................... ...................... ............. Total assets ...................... ................................. ...................... ...................... ...................... ................... ........

10,000 $894,000


Current liabilities: Accounts payable ..................... ................................ ...................... ...................... ...................... ................. ...... Interest payable ...................... ................................. ...................... ...................... ...................... ................... ........ Note payable ...................... ................................. ...................... ...................... ...................... ...................... ............. Current maturities of long-term debt ..................... ................................ ................... ........ Total current liabilities liabilit ies ..................... ................................ ...................... ...................... .............

$ 75,000 20,000 30,000 10,000 135,000

Long-term liabilities: liabi lities: Notes payable ............................. ........................................ ...................... ...................... ...................... ............... .... Bonds payable ...................... ................................. ...................... ...................... ...................... ..................... .......... Total long-term liabilities liabilit ies ..................... ................................ ...................... ................... ........

$ 90,000 240,000

Shareholders’ equity: Common stock, no par value; 500,000 shares authorized; 100,000 shares issued and outstanding outstandi ng ............. ............. Retained earnings ...................... ................................. ...................... ...................... ...................... ............... .... Total shareholders’ equity ...................... ................................. ...................... ................. ...... Total liabilities liabilit ies and shareholders’ equity ...................... ........................

300,000 129,000


330,000

429,000 $894,000


Problem 3-4 WEISMULLER PUBLISHING COMPANY Balance Sheet At December 31, 2006 Assets

Current assets: Cash and cash equivalents (1) ...................... ................................. ...................... ................. ...... Short-term investments ...................... ................................. ...................... ...................... ................. ...... Accounts receivable, net of allowance for uncollectible accounts of $16,000 ...................... ................................. ...................... ...................... ................... ........ Inventories ...................... ................................. ...................... ...................... ...................... ...................... ............... .... Prepaid expenses (2)...................... ................................. ...................... ...................... ...................... ............. Total current assets ...................... ................................. ...................... ...................... ................. ...... Property, plant, plant , and equipment : Machinery and equipment ..................... ................................ ....................... ....................... ............. .. Less: Accumulated depreciation ...................... .................................. ....................... ............. .. Net property, plant, plant , and equipment ...................... ................................. ............. ..

$ 95,000 110,000 144,000 285,000 88,000 722,000 $320,000 (110,000) (110,000) 210,000

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

60,000 $992,000


Current liabilities: Accounts payable ..................... ................................ ...................... ...................... ...................... ................. ...... Interest payable ...................... ................................. ...................... ...................... ...................... ................... ........ Unearned revenues ..................... ................................ ...................... ....................... ....................... ............. .. Taxes payable ...................... ................................. ...................... ...................... ...................... ..................... .......... Note payable ...................... ................................. ...................... ...................... ...................... ...................... ............. Current maturities of long-term debt ..................... ................................ ................... ........ Total current liabilities liabilit ies ..................... ................................ ...................... ...................... .............

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

Long-term liabilities: liabi lities: Notes payable ............................. ........................................ ...................... ...................... ...................... ............... ....

140,000


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

(1) Includes $30,000 in U.S. treasury bills. (2) Excludes $60,000 in prepaid rent for the second year on the building lease.



Problem 3-5 EXCELL COMPANY Balance Sheet At June 30, 2006 Assets

Current assets: Cash and cash equivalents (1) ...................... ................................. ...................... ................. ...... Short-term investments ...................... ................................. ...................... ...................... ................. ...... Accounts receivable, net of allowance for uncollectible accounts of $15,000 ...................... ................................. ...................... ...................... ................... ........ Interest receivable ...................... ................................. ...................... ...................... ...................... ............... .... Prepaid expenses ..................... ................................ ...................... ...................... ...................... ................. ...... Total current assets ...................... ................................. ...................... ...................... ................. ...... Investments: Note receivable ...................... ................................. ...................... ...................... ...................... ................... ........ Land held for sale ...................... ................................. ...................... ...................... ...................... ............... .... Property, plant, plant , and equipment : Land ...................... ................................. ...................... ...................... ...................... ...................... ...................... ............... .... Buildings ..................... ................................ ...................... ...................... ...................... ...................... ................... ........ Equipment ..................... ................................ ...................... ...................... ...................... ...................... ................. ......

Less: Accumulated depreciation ...................... .................................. ....................... ............. .. Net property, plant, plant , and equipment ...................... ................................. ............. .. Total assets ...................... ................................. ...................... ...................... ...................... ............... ....

$101,000 47,000 210,000 5,000 32,000 395,000 $65,000 25,000

90,000

50,000 320,000 265,000 635,000 (280,000) (280,000) 355,000 $840,000


Current liabilities: Accounts payable ..................... ................................ ...................... ...................... ...................... ................. ...... Accrued expenses ...................... ................................. ...................... ...................... ...................... ............... .... Note payable ...................... ................................. ...................... ...................... ...................... ...................... ............. Current maturities of long-term debt ..................... ................................ ................... ........ Total current liabilities liabilit ies ..................... ................................ ...................... ...................... .............

$173,000 45,000 50,000 10,000 278,000

Long-term liabilities: liabi lities: Note payable ...................... ................................. ...................... ...................... ...................... ...................... ............. Mortgage payable ...................... ................................. ...................... ...................... ...................... ............... .... Total long-term liabilities liabilit ies ..................... ................................ ...................... ................... ........

50,000 240,000


100,000 172,000

290,000

272,000 $840,000

(1) Includes $18,000 in U.S. treasury bills



Problem 3-6 HUBBARD CORPORATION Balance Sheet At December 31, 2006 Assets Current assets: Cash ...................... ................................. ...................... ...................... ...................... ...................... ...................... ............... .... Marketable securities ..................... ................................ ...................... ...................... ..................... .......... Accounts receivable (net) ..................... ................................ ....................... ....................... ............. .. Inventories ...................... ................................. ...................... ...................... ...................... ...................... ............... .... Total current assets ...................... ................................. ...................... ...................... ................. ......

Investments: Marketable securities.............................. securities......................................... ....................... ....................... ............. .. Land held for sale ...................... ................................. ...................... ...................... ...................... ............... .... Total investments investment s ..................... ................................ ...................... ...................... ..................... .......... Property, plant, plant , and equipment: Land (1) ..................... ................................ ...................... ...................... ...................... ...................... ..................... .......... Buildings ..................... ................................ ...................... ...................... ...................... ...................... ................... ........ Machinery ..................... ................................ ...................... ...................... ...................... ...................... ................. ......


$

$

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

40,000 50,000 90,000

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

Intangibles : Intangibles: Patent ..................... ................................ ...................... ...................... ...................... ....................... ....................... ............. .. Total assets ...................... ................................. ...................... ...................... ...................... ............... ....

100,000 $1,455,000


Current liabilities: Accounts payable ..................... ................................ ...................... ...................... ...................... ................. ...... Current maturities of long-term debt ..................... ................................ ................... ........ Total current liabilities liabilit ies ..................... ................................ ...................... ...................... .............

$ 215,000 25,000 240,000

Long-term liabilities: liabi lities: Notes payable ............................. ........................................ ...................... ...................... ...................... ............... ....

475,000

Shareholders’ equity: Common stock, no par value; 100,000 shares authorized; 100,000 shares issued and outstanding outstandi ng ............. ............. Retained earnings (2) ..................... ................................ ...................... ...................... ..................... .......... Total shareholders’ equity ...................... ................................. ...................... ................. ...... Total liabilities liabilit ies and shareholders’ equity ...................... ........................

$ 430,000 310,000 740,000 $1,455,000

(1) $250,000 - $50,000 in land held for sale - $70,000 increase in land (2) $380,000 - $70,000 increase in land © The McGraw-Hill Companies, Inc., 2007 3-30


Problem 3-7 HHD, Inc. Balance Sheet At December 31, 2006 Assets

Current assets: Cash ...................... ................................. ...................... ...................... ...................... ...................... ...................... ............... .... Investment in stocks ..................... ................................ ...................... ...................... ...................... ............. Accounts receivable ...................... ................................. ...................... ...................... ...................... ............. Inventories ..................... ................................ ...................... ...................... ...................... ...................... ................. ...... Prepaid insurance ..................... ................................ ...................... ...................... ...................... ................. ...... Total current assets ...................... ................................. ...................... ...................... ................. ...... Investments: Investment in stocks ..................... ................................ ...................... ...................... ...................... ............. Bond sinking fund ...................... ................................. ...................... ....................... ....................... ............. .. Total investments investment s ..................... ................................ ...................... ...................... ..................... ..........

$

150,000 90,000 200,000 225,000 25,000 690,000

$ 160,000 250,000 410,000

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

800,000 1,500,000 500,000 2,800,000 (800,000)


2,000,000

Intangibl es: Intangibles: Patent ..................... ................................ ...................... ...................... ...................... ....................... ....................... ............. .. Copyright ..................... ................................ ...................... ...................... ...................... ...................... ................... ........ Total intangibles intangibl es ...................... ................................. ...................... ...................... ..................... .......... Total assets ..................... ................................ ...................... ...................... ...................... ................. ......

110,000 90,000 200,000 $3,300,000


Current liabilities: Accounts payable ..................... ................................ ...................... ...................... ...................... ............... .... Notes payable ..................... ................................ ...................... ...................... ...................... ..................... .......... Taxes payable ...................... ................................. ...................... ...................... ...................... ................... ........ Total current liabilities liabilit ies ..................... ................................ ...................... ..................... .......... Long-term liabilities: liabi lities: Notes payable ..................... ................................ ...................... ...................... ...................... ..................... .......... Bonds payable ...................... ................................. ...................... ...................... ...................... ................... ........ Total long-term liabilities liabilit ies ..................... ................................ ...................... ................. ...... Shareholders’ equity: Common stock ..................... ................................ ...................... ...................... ...................... ................... ........ Preferred stock ..................... ................................ ...................... ...................... ...................... ................... ........ Retained earnings ...................... ................................. ...................... ...................... ...................... ............. .. Total shareholders’ equity ...................... ................................. ...................... ............... .... Total liabilities liabilit ies and shareholders’ equity ..................... .....................


$

100,000 150,000 60,000 310,000

$ 90,000 1,100,000 1,190,000 1,000,000 450,000 350,000 1,800,000 $3,300,000


Problem 3-8 MELODY LANE MUSIC COMPANY Balance Sheet At December 31, 2006 Assets

Current assets: Cash (1) ............................................................. Inventories Inventories ........................ ..................................... ......................... ................... ....... Prepaid rent ....................... ............ ...................... ....................... .................... ........ Total current assets ...................... ........... ...................... ................ ..... Property, plant, and equipment: equipment: Equipment and furniture ....................... ............ ...................... ............. Less: Accumulated depreciation ...................... ........... ............. Net property, plant, and equipment .............. ........... ... Total assets ....................... ........... ....................... ...................... .............. ...

$167,000 100,000 3,000 270,000

$ 40,000 (4,000 ) 36,000 $306,000

Liabilities and Shareholders' Equity Current liabilities: Accounts payable (2) .......................... ....................................... ............... .. Interest payable ...................... .......... ....................... ...................... ................ ..... Loan payable ....................... ............ ...................... ....................... .................. ...... Total current liabilities ....................... ........... ...................... ..........

$ 21,000 9,000 100,000 130,000

Shareholders’ equity: equity : Common stock ........................ ..................................... .......................... ............. $100,000 Retained earnings (3) ......................................... 76,000 Total shareholders’ equity ...................... .......... .................. ...... Total liabilities and shareholders’ equity ...

176,000 $306,000

(1) Cash receipts of $560,000 less cash disbursements of $393,000 (2) $20,000 owed to suppliers + $1,000 owed to utility company (3) Net income for the year



CASES Communication Case 3-1 IBM manufactures and sells sells personal and main frame computers. The computers included as current assets in the balance sheet for the company represent the cost of its operations. The inventory available for sale. In addition, IBM uses computers in its cost of these computers is included in the property, plant, and equipment category in the balance sheet. Marketable securities could be classified as either current or noncurrent assets depending on the intent of management. If management intends to sell the securities in the next year or operating cycle, they they are classified as current assets. If management intends to hold the securities beyond the coming year or operating cycle, they are classified as noncurrent assets.

Analysis Case 3-2 Requirement 1 Current assets include cash and other assets that are reasonably expected to be converted to cash or consumed during one year, or within the normal operating cycle of the business if the operating cycle is longer than one year. Current liabilities liabilities include all liabilities that are scheduled to be liquidated within one year or the operating cycle, whichever is longer, except those that management intends to refinance on a long-term basis. Therefore, key factors determining classification are the nature of the asset or liability, management’ management’ss intent , and the length of the operating cycle . Requirement 2 Assets: Cash

Normally classified as current, however, if restriction prohibits use of the cash, could be classified as noncurrent.

Receivables

Depends on the expected date of collection.

Marketable securities

Depends on when management intends to sell the securities.

Prepaid expenses

Depends on the period of time prepaid.

Liabilities: Notes payable

Unearned revenue


Depends on scheduled payment date and management’s intent to pay or refinance. Depends on the period the revenue will be earned. © The McGraw-Hill Companies, Inc., 2007 3-33

Communication Case 3-3 The critical question that student groups should address is whether the cost of the egg-producing flock should be classified as inventory or as property, plant, and equipment. There is no right or wrong answer. The process of developing the the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole. Solutions should address the following issues: 1. The definitions of inventory and property, plant, and equipment. The definition of inventory according to ARB No. 43 is “goods awaiting sale, goods in the course of production, and goods to be consumed directly in production.” The chickens certainly represent goods awaiting sale, since they will eventually be sold to soup companies. However, they also represent property, plant, and equipment, since they are used in in the production of product — the eggs. 2. The definition of a current asset. ARB No. 43 also provides the following definition of a current asset: “..., the term current assets is used to designate cash and other assets or resources commonly identified as those which are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.” ARB No. 43 also states that a one-year time period is to be used where there are several operating cycles cycles occurring within a year. In this case, it could be argued that the operating cycle is two years, since the chickens are not sold until after the laying life and, therefore, the cost of the flock should be classified as a current asset. However, if the chickens are considered productive assets, then the concept of an operating cycle is not relevant. According to this this argument, the the chickens should be classified as a noncurrent asset, i.e., a producing asset, and not a saleable asset. It appears that the primary benefits of the chickens come from the sale of eggs, not the sale of the chickens themselves. 3. Regardless of the classification of the cost of the chickens, the cost capitalized when the chickens begin to lay must be depreciated down to an estimated salvage value at the the end of the laying life. life. This is necessary to properly match expenses with revenues. © The McGraw-Hill Companies, Inc., 2007 3-34


Case 3-3 (concluded)

(Industry practice is to classify the costs of the egg-producing flock as inventory in the current asset section of the balance sheet, but to depreciate the inventory down to estimated salvage value.) It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction.

Judgment Case 3-4 DEFICIENCIES: 1. Accounts receivable - if material, the allowance allowance for uncollectible accounts accounts should be disclosed. 2. Note receivable receivable - only the interest receivable of $3,000 should be classified as a current asset. The $50,000 note receivable should be classified in the noncurrent Investments category. 3. Inventories - the method method used to cost inventory should be disclosed in a note. 4. Investments - should be classified in the noncurrent Investments category. category. 5. Prepaid expenses - in the absence of information to the contrary, should be classified as a current asset. 6. Land - should be classified in the noncurrent Investments Investments category. 7. Equipment, net - should be classified in the Property, plant and equipment category. Original cost should be disclosed along along with with the accumulated depreciation to arrive at the net amount. Also, the method method used to compute depreciation should be disclosed in a note. 8. Patent - should be classified in the Intangibles Intangibles category of noncurrent assets. 9. Note payable - $20,000, the next installment, should be classified as a current liability as current maturities of long-term debt. Also, note disclosure is required for the note and bonds payable that provides information such as payment terms, interest rates, and collateral pledged as security for the debt. 10. Interest payable - should be classified as a current liability. liability. 11. Common stock - the the par value, if if any, and the number of shares authorized, authorized, issued and outstanding should be disclosed.



Judgment Case 3-5 Accounts receivable, net - disclosure on the face of the statement of the allowance for uncollectible accounts, if material. Inventories - disclosure in Accounting Policies note of the cost method used. Also, for a manufacturer, note disclosure of the breakout of inventory into raw materials, work in process and finished goods. Property, plant and equipment - original cost by major category should be disclosed along with the accumulated depreciation either on the face of the statement or in a note. Also, the method used to compute depreciation should be disclosed disclosed in the Accounting Policies disclosure note. Long-term liabilities - disclosure in a note of the various debt instruments comprising long-term liabilities to include information such as payment terms, interest rates, and collateral pledged as security for the debt. Common stock - disclosure on the face of the statement of par value, if any, and the number of shares authorized, issued and outstanding.



Real World Case 3-6 Requirement 1 The asset classifications are 1) Current assets, 2) Plant, rental machines and other property, 3) Long-term financing receivables, 4) Prepaid pension assets, (5) Investments and sundry assets, (6) Goodwill, and (7) Intangible assets – net. Requirement 2 a. Total assets b. Current assets c. Current liabilities d. Total shareholders' equity e. Retained earnings f. Inventories Requirement 3 The par value is is $.20 per share. 1,962,687,087 shares are issued.

= = = = = =

$109,183 million $46,970 million $39,798 million $29,747 million $44,525 million $3,316 million

4,687,500,000 shares are authorized and

Requirement 4 Current ratio = Current assets divided by Current Current liabilities. liabilities. Current ratio = $46,970 ÷ $39,798 = 1.18 Requirement 5

a. b. c.

The lower of average cost or net realizable value. The straight-line method. All highly liquid investments with a maturity of three months or less at date of purchase are carried at fair value and considered to be cash equivalents.



Judgment Case 3-7 1.

2.

3.

This is a significant event occurring after the end of the the fiscal fiscal year but prior to the issuance of the financial financial statements. Details of the merger should be disclosed in a note to the financial statements. This is a significant event occurring after the end of the the fiscal fiscal year but prior to the issuance of the financial statements. Details of the the issuance of the new debt should be described in a note to the financial statements. This is a significant event occurring after the end of the the fiscal fiscal year but prior to the issuance of the financial statements. statements. The event should be described in a note to to the financial statements along with the amount of uninsured damage.



Research Case 3-8 Requirement 1 Statement of Financial Accounting Standards No. 57, “Related Party Disclosures,” requires the disclosure of related party transactions. This statement was issued in March of 1982 and became effective for fiscal years ending after June 15,1982. Requirement 2 When related-party transactions occur, companies must disclose the nature of the relationship(s) involved, provide a description of the transactions, and report the dollar amounts of the transactions and any amounts due from or to related parties. Requirement 3 The related party transactions disclosure note describes transactions with limited partnerships whose general partner’s managing member is a senior officer of Enron. The transactions include various hedging and derivative transactions with the related party, as well as the sale of inventory and other assets to the related party. Requirement 4 The potential problem with related party transactions is that their economic substance may differ from their legal legal form. One of Enron’s disclosed transactions involved the sale of dark fiber inventory to the related party in exchange for $30 million in cash and a $70 million million note receivable. Enron recognized gross margin on the sale of $67 million. Is the $100 million million sales price a proper representation of the sales price of the inventory in a normal transaction transaction to an unrelated party? Is the interest rate charged by Enron on the note a fair interest rate? If the answer to these questions is no, then income (wealth) has been transferred from one party to the other, to the detriment of the shareholders of one of the entities and the benefit of the other.



Research Case 3-9 (Note: This case requires the student to reference a journal article.]

Requirement 2 Affirmative covenants contain pledges by the borrower to take actions such as insuring and maintaining assets and paying taxes, as well as agreements to keep certain financial amounts and ratios within within specified limits. limits. Negative covenants can prohibit activities and specify limits for accounting ratios. Accounting-based covenants are typically used to limit leverage levels (amount of debt compared to equity) and dividend payouts as well as to establish minimum levels of net worth, working capital, and interest coverage. Requirement 3 The authors conclude that annual report disclosures of debt covenants is presently inadequate. They state that a user user relying on annual report covenant disclosures is often not on an equal footing with someone having access to other costly resources. Only after a covenant violation has occurred or is imminent does GAAP require financial statement presentation.

International Case 3-10 The standard audit report used in the U.S.A. consists of three paragraphs. The first two paragraphs of the report deal with the scope of the audit (the work that was done by the auditor) and the third paragraph states the auditor's opinion on whether or not the statements covered in the scope paragraphs have been presented fairly in conformity with GAAP. The U.K. report is quite similar similar to the report used in the U.S.A. The introduction and first two sections deal with the scope of the audit. Both reports describe the responsibility of the company's management (directors) as well as the responsibility of the auditors, and they both briefly discuss auditing standards. The last section of the U.K. report is similar to the opinion paragraph of the U.S.A. report.



Real World Case 3-11 Requirement 3 a. The disclosure note describes the acquisition of Simplicity Manufacturing, Inc. for $227 million in cash plus certain transaction related expenses. b. The company's auditor was Deloitte & Touche LLP. The firm rendered an unqualified opinion on the company's financial statements. Requirement 4 a. J. S. Shiely is listed as the the Chairman, President, President, and Chief Executive Executive Officer. b. The annual compensation for Mr. Shiely in 2004 included $737,768 in salary and a bonus of $1,000,000.



Judgment Case 3-12 Comparative income for the first year of operations resulting from the two alternative financing choices is illustrated below. DEBT VS. EQUITY Comparative Income For Two Financing Alternatives

Income before interest and taxes Less: Interest Income before taxes Less: Income taxes Net Income

Alternative 1 $5,000,000 -05,000,000 (2,500,000)** $2,500,000

Alternative 2 $5,000,000 (1,600,000)* 3,400,000 (1,700,000)** $1,700,000

$2,500,000

$1,700,000

* 8% x $20,000,000. ** 50% x Income before taxes. Return on investment

= 5% (Net income ÷ investment)

$50,000,000

=5.67%

$30,000,000

We can see that Alternative 1 generated a higher net income. However, the return on shareholders’ investment is actually higher for Alternative 2. Alternative 2 generated a higher return for each dollar invested by shareholders. This was made possible because the corporation was able to generate income on borrowed funds at a higher rate than the cost of the debt. This represents financial leverage. However, alternative 2 also results in a riskier capital structure. The debt in Alternative 2 requires fixed fixed payments of interest and principal to be made. The company's income before interest and income taxes could drop to zero under Alternative 1 and the company would still be solvent (i.e., able to pay its debts). Under Alternative 2, however, if income before interest and taxes drops below the required interest payments of $1,600,000, the company could become insolvent and eventually go bankrupt.

Analysis Case 3-13 The objective of this case is to motivate students to obtain hands-on familiarity with an actual annual report. report. You may wish to to provide students with with multiple copies © The McGraw-Hill Companies, Inc., 2007 3-42


of the same annual report and compare responses. Another approach is to divide the class into teams who evaluate reports from a group perspective.

Analysis Case 3-14 The objectives of this case are to motivate students to obtain hands-on familiarity with an actual actual annual report and to apply the techniques techniques learned in the chapter. You may wish to provide students with multiple copies of the same annual reports and compare responses. Another approach is to divide the class into into teams who evaluate reports from a group perspective.

Analysis Case 3-15 Requirement 1 The balance sheet includes three asset classifications: Current assets, Property and equipment, and Other long-term assets; and three liability classifications: Current liabilities, Long-term debt and Other long-term liabilities. Requirement 2 These assets are shown as current because the company intends to use them in the next year or operating cycle. Requirement 3 Current portion of long-term debt represents the principal amounts due in the next year on long-term debt. Requirement 4 Disclosure notes explain or elaborate upon the data presented in the financial statements themselves. They must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third party transactions, but many notes are company specific. Actually, any explanation that contributes to investors’ and creditors’ understanding of the results of operations, financial position, or cash flows of the company should be included. Requirement 5 Straight-line. Requirement 6 No.



Analysis Case 3-16 Requirement 1 Segment disclosures assist in analyzing and understanding financial statements by permitting better assessment of past performance and future prospects. Disaggregated information provides more precise details of the uncertainties surrounding the timing and the amount of expected cash flows, because the various segments may have different rates of profitability, degrees and types of risk, opportunities for growth, and future capital demands. Requirement 2 An operating segment is a component of an enterprise: 1. That engages in business activities activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise). 2. Whose operating results are regularly reviewed by the enterprise's chief operating decision-maker to make decisions about resources to be allocated to the segment and assess its performance. 3. For which discrete financial financial information is available. Requirement 3 For areas determined to be reportable operating segments, the following disclosures are required: 1. General information information about the operating operating segment. 2. Information about segment profit or loss, including certain revenues and expenses included in reported segment profit or loss, segment assets, and the basis of measurement. 3. Reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items to corresponding enterprise amounts. 4. Interim period information.



Ethics Case 3-17 Discussion should include these elements. Facts: The impact of following the controller's suggestions would be to obscure financial information by aggregating the financial data of segment operations and investments. Aggregation of data makes projections projections of future performance for African or European segments difficult and does not reveal relative investments for each segment. SFAS 131 "Disclosures about Segments of an Enterprise and Related Information," suggests that reportable segments are those for whom financial data is available and whose results are regularly reviewed by company management in assessing performance. The data for South Africa, Egypt, France and Denmark are available and most likely reviewed for performance purposes by the controller and higher management levels. Ethical Dilemma: Should you as staff accountant challenge the controller's combination of segments or follow the controller's suggestion to obscure financial information by aggregating the financial data of segment operations and investments? Who is affected?

You as a staff accountant Controller and other managers Other employees Shareholders Potential shareholders Creditors Financial analysts Auditors Who benefits and who is injured: Company management may benefit from aggregating the African and European data by attracting more investors to their company and obtaining more loans from creditors than would be the case with more complete disclosure regarding the South African segment. Injured parties include current and future investors and creditors with economic, social and political concerns regarding Africa and Europe. If investors and creditors later learn about undisclosed segment operations that prove unprofitable or violate their value systems, they may take action against McCarver-Lynn.



Spiceland SM Ch03

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