Exam 2 Questions (conceptual)

(10) Under what circumstances will a company report a net pension asset? A net pension liability?

A company will report a net pension asset if the pension's funded status is positive (i.e., fair value of the plan assets exceeds the plan obligation). Otherwise, the company will report a net liability to represent the underfunding of the pension obligation (i.e., negative funded status).

(9) How does a weakening $US affect the consolidated balance sheet of a company with foreign subsidiaries?

A weaker US$ means that assets and liabilities measured in a foreign currency will be translated into larger dollar values. This creates a translation "gain" that is reported in AOCI in the equity section of the balance sheet.

(9)What is the underlying objective of consolidated financial statements?

Consolidated financial statements portray the financial position, operating results, and cash flows of affiliated companies as a single economic unit so that the scope of the entire (whole) entity is more realistically conveyed.

(8)Describe the difference between contributed capital and earned capital. Specifically, how can earned capital be considered as an investment by the company's stockholders?

Contributed capital represents the total investment "contributed" by shareholders when they purchase stock. It is considered contributed because the company is under no legal obligation to repay the shareholders. Earned capital represents the cumulative net income that the company has earned, less the portion of that income that has been paid out to shareholders in the form of dividends. When profit is earned, the company can either pay out a portion of that profit as a dividend or reinvest the earnings in order to grow the company. In fact, many companies title the Retained Earnings account Reinvested Earnings or Undistributed Earnings. Earned capital, thus, represents an implicit investment by the shareholders in the form of forgone dividends.

(6) Why do relatively stable inventory costs across periods reduce the importance of management's choice of an inventory costing method?

If inventory costs are stable, the per unit dollar cost of inventories (beginning or ending) tends to be approximately the same under different inventory costing methods and the choice of method does not materially affect net income. To see this, remember that FIFO profits include holding gains on inventories. If the inflation rate is low (or inventories turn quickly), there will be less holding gains (inflationary profit) in inventory.

(10) What is a valuation allowance for deferred tax assets? Provide two reasons why the valuation allowance would be reversed.

Like all assets, deferred tax assets represent future economic benefits. In particular, deferred tax assets will reduce a company's future tax bill. If the company is not likely to receive the anticipated future tax benefits, the deferred tax asset has lost value (it is impaired) and a write-down is called for. A valuation allowance is established, the deferred tax asset balance is reduced to reflect the loss in value. If later, the company determines that it will receive the tax benefits after all, the valuation allowance can be reversed. The second reason for a reversal is the benefits are actually lost, as in the case of a net operating loss carryforward that expires.

(6) What is a LIFO reserve? What information can we learn from the LIFO reserve and from the change in the reserve during the year?

The LIFO reserve is the difference between the LIFO cost of inventory and it's FIFO cost. The LIFO reserve gives financial statement users the ability to convert LIFO numbers to their FIFO equivalents in order to more accurately compare companies that use different inventory costing methods.

(9)What accounting method is used when a stock investment represents more than 50% of the investee company's voting stock and allows the investor company to "control" the investee company? Explain.

A stock investment representing more than 50% of the investee company's voting stock is generally viewed as conferring "control" over the investee company. The investor and investee companies must be consolidated for financial reporting purposes.

(7) What is an accrual? How do accruals impact the balance sheet and the income statement?

An accrual is the recognition of an event in the financial statements even though no related external transaction has occurred. Accruals can involve both liabilities (and expenses) and assets (and revenues). Accruals are vital to the fair presentation of the financial condition of a company as they impact both the recognition of revenue and the matching of expenses.

(7) Why do companies report a gain or loss when they repurchase their bonds? Is this a real economic gain or loss?

Bonds are reported at historical cost, that is, the face amount plus (minus) unamortized premium (discount). The market price of the bonds varies inversely with the prevailing interest rates, which fluctuate continuously. Gains and losses from bond redemptions typically arise during refinancing in which new bonds are issued to retire existing bonds. The resulting gains or losses are not real economic gains and losses. The recognition of the gain (loss) on redemption results from the use of historical costing for bonds. The gain (loss) that is reported upon redemption will be offset by correspondingly lower (higher) interest payments in the future.

(8) What are three common forms of stock-based compensation and why do companies use such forms of compensation?

Common forms of stock-based compensation include stock grants, stock appreciation rights, stock options and stock purchase plans. Companies use stock based plans to create "shareholders" of the employees. This give the employees the incentive to think and make decisions like shareholders. Presumably, this will improve firm performance and increase firm value.

(8) What features make preferred stock similar to debt? Similar to common stock?

Debt 1. Dividends are cumulative. 2. Dividends are nonparticipating. 3. Preferred stockholders have preference to assets in liquidation. Stock 1. Dividends are not cumulative. 2. Dividends are fully participating. 3. It is convertible into common stock. 4. Preferred stockholders do not have a preference to assets in liquidation.

(10) Why do deferred taxes arise?

Deferred taxes arise from the differences between how GAAP and tax rules recognize items on the income statement and balance sheet. Total tax expense is determined using GAAP rules, current taxes are determined using tax rules, and deferred taxes are the difference between the two. Deferred tax liabilities are amounts that will likely be paid in later years. Deferred tax assets will likely reduce taxes due in later years.

(6)In a recent annual report, Kaiser Aluminum Corp. made the following statement in reference to its inventories: "The Company recorded pretax charges of approximately $19.4 million because a reduction in the carrying values of its inventories caused principally by prevailing lower prices for alumina, primary aluminum, and fabricated products." What basic accounting principle caused Kaiser Aluminum to record this $19.4 million pretax charge? Briefly describe the rational for this principle.

Kaiser Aluminum Corporation is using the lower of cost or market (LCM) rule. When the replacement cost for inventory falls below its (FIFO or LIFO) historical cost, the inventory must be written down to its replacement cost (market value). The rationale is that, if market value has dropped, the inventory cost overstates the future economic benefit of selling the inventory.

(9)What are some limitations of consolidated financial statements?

Limitations of consolidated statements include the possibility that consolidation "masks" the performances of poor companies. Likewise, rates of return, other ratios, and percentages calculated from consolidated statements might prove deceptive because they are composites (weighted averages). Consolidated statements also eliminate detail about product lines, divisional operations, and the relative profitability of various business segments. (Some of this information may be available in the footnote disclosures relating to the business segments of certain public firms, but these disclosures are limited in scope.) Finally, shareholders and creditors of subsidiary companies find it difficult to isolate amounts related to their legal rights by inspecting only consolidated statements.

(8)Employee stock options potentially dilute earnings per share (EPS). What can companies do to offset these dilutive effects and how might this action affect the balance sheet?

Many companies repurchase shares (as treasury stock) in order to offset the dilutive effects of stock options, because stock options increase the number of outstanding shares in the diluted EPS calculation. Stock repurchases typically decrease cash, which has immediate and ongoing economic effects. Some companies increase debt to repurchase stock. Analysts need to be concerned about the consequences of increased leverage solely to manage diluted EPS.

(6) Identify three typical restructuring costs and their effects on the balance sheet and the income statement.

Restructuring costs consist of three general categories: (1) asset write-downs, (2) accruals for severance and relocation costs, and (3) accruals of other restructuring- related costs. Asset write-downs reduce assets' net book value and are recognized in the income statement as an expense. Liability accruals for severance and other expenses create a liability for the corresponding expense that reduces income and equity.

(9) What does significant influence imply regarding intercorporate investments? Describe the accounting procedures used for such investments.

Significant influence gives the owner of the stock the ability to significantly influence the operating and financing activities of the company whose stock is owned. Normally, a 20% through 50% ownership of the company's voting stock provides evidence of significant influence. The equity method is used to account for investments with significant influence. Such an investment is initially recorded at cost; the investment is increased by the proportionate share of the investee company's net income, and equity income is reported in the income statement. The investment account is decreased by dividends received on the investment, and is reported in the balance sheet at its book value. Unrealized gains or losses on the investment are not recognized in the financial statements.

(7) What is the difference between a bond's coupon rate and its market interest rate (yield)?

The coupon rate is the rate specified on the face of the bond. It is used to compute the amount of cash interest paid to the bondholder. The market rate is the rate of return expected by investors who purchase the bonds. The market rate determines the market price of the bond. It incorporates the current risk-free rate, expectations about the relative riskiness of the borrower, and the rate of inflation. In general, there is an inverse relation between the bond's market rate and the bond's market price.

(6) What is the benefit of accelerated depreciation for income tax purposes when the total depreciation taken over the asset's life is identical under any method of depreciation?

The primary benefit of accelerated depreciation relates to tax reporting - higher depreciation deductions in the early years of the asset's life reduce taxable income and income taxes. This increases cash flow that can be invested to yield additional cash inflows (e.g., an "interest-free loan" that can be used to generate additional income). Companies generally prefer to receive cash inflows sooner rather than later in order to maximize this investment potential.

(10) What effect does the use of expected returns on pension investments and the deferral of unexpected gains and losses on those investments have on income?

The use of expected returns and the deferral of unexpected gains and losses smooth corporate earnings by allocating over several years the effects of swings in the market values of investments and variation in pension liabilities resulting from changes in actuarial assumptions or plan amendments.

(10) Under current accounting rules, what are the financial reporting differences between an operating lease and a capital lease? How will this change with the new accounting rules effective in 2019?

Under an operating lease, the lessor retains the usual risks and rewards of owning the property. In accounting for an operating lease, the lessee doesn't record either the lease asset or the lease liability on the balance sheet, and charges each lease payment to rent expense. In contrast, a capital lease transfers to the lessee substantially all of the risks and rewards relating to the ownership of the property. Accordingly, the lessee accounts for a capital lease by recording the leased property as an asset and establishing a liability for the lease obligation. The leased asset is subsequently depreciated, and interest expense is accrued on the lease liability. With the new accounting rules, all leases will be treated as "capital" leases. The leased asset, called a right-of-use asset, and the lease liability will be added to the balance sheet.

(9) Where are unrealized gains and losses related to marketable equity securities reported in the financial statements?

Under new accounting rules (effective 2018), unrealized gains and losses related to marketable equity securities are reported in the current-year income statement (which flows to retained earnings). The balance sheet reports the securities at their fair value on the balance sheet date.

(10) Is the expense of a lease over its entire life the same whether or not it is capitalized? Explain.

Yes, over the term of the lease, the rent expense recorded on an operating lease will be equal to the sum of the interest expense and depreciation recorded on a capital lease; only the timing of the expense recognition changes. Expense is ultimately related to the cash flows required to discharge the obligation. Those cash flows are the same whether or not the lease is capitalized.

(8) Analyzing Financial Statement Effects of Convertible Securities

a. The conversion of any security, whether debt or equity, results in the following effects on the balance sheet: the book value of the converted security (just prior to the conversion) is removed and common stock is issued for the same amount. In JetBlue's case, the book value of the 6.75% convertible debentures would be removed from long-term debt and common stock issued for this book value amount. The conversion would increase the par value and additional paid-in capital accounts just like the issuance of shares for cash. b. Conversion of debt is a balance sheet transaction and does not impact the income statement in the conversion period. In subsequent years, JetBlue would report lower interest expense because the debentures would be removed from the balance sheet.