Accounting 312 with Mackie Ch 14-22 plus Ch A and Ch 7 Review questions from book

What is a compensated absence? When should the expense related to compensated absences be recognized?

. A compensated absence is time away from work (represented by vacation, holiday, and sick leave) given to employees without reducing their salaries or wages. The related expense should be recognized when all of the following criteria are met: • The absence from work relates to services already rendered. • The benefits accumulate (carry over), or vest. • The payment is probable (the absence will occur). • The amount (i.e., cost) can be reliably estimated.

How is treasury stock reported on the balance sheet under the cost method?

0-18. Under the cost method, treasury stock is reported on the balance sheet as an unallocated deduction from stockholders' equity.

Define a security. Debt vs equity

14-1. A security is a share, participation, or other interest in property or in an issuer that is represented by an instrument that is either traded on an exchange or is otherwise commonly recognized as a medium of investment, and is one of a class or series of such shares, participations or interests. Debt securities represent a creditor relationship with an entity, and equity securities represent an ownership relationship with an entity. Debt securities include bonds, and certain types of mortgage-backed debt, whereas equity securities include common and preferred stock. The former offers a fixed or variable interest return and relatively limited potential for price appreciation, whereas the dividend return on equity securities is not obligatory. However, the risk and potential for price appreciation are greater for equity securities.

Indicate reasons why a 30% ownership interest in another company may not be considered significant

14-10. Answers will vary but the following are suggested by GAAP: 1. Opposition by the investee, such as litigation or complaints to governmental regulatory agencies, challenges the investor's ability to exercise influence. 2. The investor and investee sign an agreement under which the investor surrenders significant rights as a stockholder. 3. Majority ownership of the investee is concentrated among a small group of stockholders who operate the company without regard to the views of the investor company. 4. The investor is unsuccessful in attempts to obtain representation on the investee's board of directors.

When are unrealized holding gains and losses on debt securities included in the determination of net income? When are unrealized holding gains and losses on equity securities included in the determination of net income?

14-11. The difference between the fair value and original cost (amortized cost for debt securities acquired at a premium or discount) of the investment security is an unrealized holding gain or loss. For investments in debt securities classified as trading securities, the unrealized holding gain or loss for the period is included in the determination of income (FV-NI). For investments in debt securities classified as available-for-sale securities, the unrealized holding gain or loss for the period is included as other comprehensive income (FV-OCI). Investments in debt securities classified as held-to-maturity are carried at amortized cost; no unrealized holding gain or loss is recognized. For equity securities measured at FV-NI, unrealized gains and losses are included in net income at reporting dates. However, under the equity method, investments are not adjusted to fair value.

describe the balance sheet categorization and valuations within the asset section when investment in securities is classified as Trading Debt securities

14-12. a. Trading debt securities: Current (investment at fair value)

What is the financial statement impact when an investment is reclassified from a trading debt security to an AFS debt security? When an AFS debt security is reclassified as a trading debt security

14-13. When an investment security is reclassified from a trading security to an available-for-sale security, the fair value at the reclassified date becomes the new cost basis for the investment. Subsequent changes in fair value are unrealized holding gains or losses, and are reported in other comprehensive income. When an investment security is reclassified from an available-for-sale security to a trading security, any accumulated unrealized holding gain or loss as of the reclassification is recorded in net income, and the new cost basis for the security is its fair value at the reclassification date. Subsequent changes in fair value are unrealized holding gains or losses, and are included in the determination of income.

Explain when the fair value option of accounting for equity investments is applicable. What is the financial statement impact of accounting for investments under the fair value option?

14-14. The fair value option of accounting is applicable when the investor chooses this accounting option at the time of the purchase of an equity investment where the investor has significant influence over the investee. Under this method, the investment is measured at FV-NI.

What approaches are used to analyze impairment on AFS and HTM debt securities

14-15. The expected credit loss model (ECL) is used to estimate credit losses on HTM securities while the AFS debt security model is used to account for losses on impairment of AFS. Under the ECL model, an asset is reduced to the present value of the amount expected to be collected over the investment's lifetime. Information to make the estimate is based upon historical information, current conditions, and reasonable forecasts of the future that affect the collectability of the amounts. Under AFS impairment model, an AFS security is considered impaired if the fair value of the investment is less than its amortized cost. Unrealized losses are recorded through an allowance account.

describe method to account for debt investments. How does an investor determine the appropiate accounting method?

14-2. (1) Amortized cost is where an investment is recognized at amortized cost over the life of the investment with no adjustment to fair value (unless impaired). Held-to-maturity (HTM) securities, where the investor has the intent and ability to hold the investment to maturity, are recorded at amortized cost. (2) FV-OCI is where an investment is adjusted to fair value through other comprehensive income. Available-for-sale securities (AFS), where the investor's intended holding period is uncertain, are measured at FV-OCI . An investment is classified as AFS if it is not classified as HTM or TS. (3) FV-NI is where an investment is adjusted to fair value through net income. Trading securities (TS), where the investor intends to hold the investment for short-term gains through a sale in the near term, are measured at FV-NI. In addition, an investor may opt at the date of purchase to measure an AFS or HTM investment at FV-NI. With this election, the security will not be included in the AFS or HTM security totals on the balance sheet, but instead may be included with TS securities or presented as a separate line item on the balance sheet. The final classification and how the security is accounted for is left to the discretion of the holder.

If an investor holds and equity security investment where the investor does not exert significant influence, explain the appropiate accounting for the investment

14-4. For equity securities where the investor does not exert significant control over the investee, the investment is measured at FV-NI.

What accounts are affected by a sale of a debt security classified as HTM?

14-5. A sale of a debt security classified as HTM results in a reduction of the investment account at the current amortized cost, an increase in cash for the sales price, and a difference (if any) would result in an increase or decrease to other gains or losses on the income statement.

What is the most significant difference in the accounting treatment of an AFS debt security compared to a trading debt security

14-6. The most significant difference in the accounting treatment of available-for-sale debt securities as compared to trading debt securities is in the financial presentation of any unrealized holding gains or losses. Unrealized holding gains or losses, computed as the difference between fair value and amortized cost, are included in net income if they are classified as trading securities, and are included as other comprehensive income if classified as available-for-sale securities.

Explain the basic features of the equity method of accounting for long-term investments. What is the equity method applicable?

14-7. The equity method of accounting for long term investments is based on the presumption that the investor exercises significant influence (although not control) over the operating and financial policies of the other company. Under the equity method, the Investment account of the investor is debited, and the Investment Income account is credited, for the proportionate share of the net income reported by the investee company. Dividends received by the investor from the investee increase Cash (or noncash asset, if a property dividend) and decrease the Investment account of the investor.

Why is the equity method sometimes called the one-line consolidation method

14-8. The equity method is sometimes called the one-line consolidation method because it results in the same effect on earnings and retained earnings that would result from consolidating the financial statements of the investor and investee companies but does so without combining both companies' financial statements, as in a complete consolidation.

How would an investor typically report a dividend decalred by a company in which it holds a 40% voting interest? A 10% voting interest?

14-9. The equity method of accounting for long term investments is based on the presumption that the investor exercises significant influence (although not control) over the operating and financial policies of the other company. An investor with a 40% interest in the voting shares is presumed to have significant influence over the affiliated company unless facts and circumstances indicate otherwise. Under the equity method, dividends received by the investor from the investee increase Cash and decrease the Investment account of the investor. If the voting percentage is 10%, the investor is presumed to have little or no influence, thus the investment would be accounted for using the fair value method. In this case, dividends would be recorded as Dividend Revenue in the income statement. Because the investor has little or no influence when profits are shared with the investee, the investor waits until dividends are paid before income on the investment is recorded.

Def of liability

15-1. A liability is an enforceable obligation that requires settlement by probable future transfer or use of assets or services.

What are example of secured and unsecured liabilities

15-10. Examples of unsecured liabilities include accounts payable and commercial paper. Examples of secured liabilities include notes payable and lines of credit.

Distinguish between the stated rate and the market rate on a debt

15-11. Stated rate of interest—the rate specified in the debt agreement; it determines the cash interest to be paid. Market or effective rate—the true rate of interest based on the cash equivalents received, and the total cash equivalents paid back.

Briefly define the following terms related to a note payable: OV of the note and maturity value of the note

15-12. Present value amount—actual cash equivalent amount borrowed; interest expense is based on this amount. Maturity amount—amount payable at maturity date, excluding any separate interest payments due on that date.

Distiguish between and interest-bearing note and a non-interest bearing note

15-13. An interest-bearing note specifies a face amount equal to the maturity value of the note; the interest rate is specified. Its present value and maturity amounts are the same (when the stated and market interest rates are the same). A noninterest-bearing note does not specify either a stated or market interest rate; its face amount is the face amount plus the amount of interest implicit in the note.

assume that $4,000 cash is borrowed on a $4,000, 10%, one-year note payable that is interest-bear- ing and that another $4,000 cash is borrowed on a $4,400 one-year note that is noninterest-bearing. For each note, provide the following: Present value of the note. b. Maturity amount. c. Total interest paid.

15-14. Interest-Bearing Note Noninterest-Bearing Note Present value of the note $4,000 $4,000 Maturity amount 4,000 4,400 Interest paid $4,000 (.10) = 400 $4,400 - $4,000 = 400

How is gift card breakage recognized as revenue using the proportional method?

15-15. Under the proportional method, gift card breakage is recognized as revenue at the same rate as actual gift card redemption. This method may be used if it is probable that a significant reversal of revenue will not occur and the company is not affected by escheatment laws which require unredeemed gift card revenue to be paid to the state.q

Why is deferred revenue classified as a liability?

15-16. Deferred revenue, which is revenue collected in advance of completing a performance obligation, is a liability because the transfer of control of goods or services to the customer has not occurred.

What is the accounting definition of a contingency? What are the three characteristics of a contingen- cy? Why is this concept important?

15-18. A contingency is an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (a gain contingency) or loss (a loss contingency) to a company that will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm (1) the acquisition of an asset or the reduction of a liability or (2) impairment of an asset or the incurrence of a liability. The three characteristics of a contingency are (1) an existing condition, (2) uncertainty as to the ultimate effect, and (3) its resolution depending on one or more future events. The concept is important because it represents a potential future asset or future liability that has arisen as the result of an event or transaction that has already occurred. The high degree of uncertainty results in extra caution in accounting for contingencies.

How is the likelihood of the outcome of a contingency measured? In general, how does this affect the accounting for and reporting of contingencies?

15-19. The likelihood of the outcome of a contingency is measured in three degrees— Probable: Future event(s) are likely to occur. Reasonably possible: The chance of the future event(s) occurring is more than remote but less than probable. Remote: The chance of the future event(s) occurring is slight. The effect of this measurement on the accounting for loss contingencies is that the accounting and reporting requirements depend upon the degree of certainty of a contingency. Therefore, the degree of certainty will establish a basis for the accounting and reporting requirements for the specific loss contingency. Gain contingencies, however, are not recorded.

definition of a current liability

15-2. A current liability is an obligation that will be settled by using current assets or the creation of other current liabilities. That is, it will be paid with current assets during the coming year or next operating cycle, whichever is longer. Short-term obligations that will be paid with noncurrent assets should not be classified as current liabilities.

Briefly explain the accounting and reporting for loss contingencies.

15-20. Loss contingencies are either accrued or reported by note, depending upon the degree of certainty and whether they can be reasonably estimated. If probable and measurable, they are accrued; if probable but cannot be reasonably estimated or if reasonably possible, they should be disclosed by note (but not accrued); and, if remote, disclosure is not mandated except under certain situations.

What costs are recognized for environmental obligations?

15-21. Companies recognize a liability for the costs of clean-up, restoration, post-closure, monitoring, and other exit costs as asset retirement obligations. Asset retirement obligations are recorded at the present value of the future obligations.

Under what conditions may a debt due within the next year (as measured at year-end) be reported as a noncurrent liability? Under what conditions may a long-term debt (as measured at year-end) be re-ported as a current liability?

15-22. Debt due within a year (as measured at year end) may be recorded as a noncurrent liability under the following scenarios: • The debtor has the ability and intent to refinance the debt on a long-term basis. • The debt will be paid from proceeds of long-term assets or equity issuances. Long-term debt may be recorded as current under the following scenarios: • Debt is callable by the creditor. • Debt (held over the long-term) is due within the following year.

Explain how the measurement of a liability is related to its cause

15-3. A liability is created because of the acquisition of an asset, payment of another liability, incurrence of an expense, declaration of cash or property dividend, a loss, or revenue collected in advance. Each of these "causes" usually provides the basis for measuring the liability.

Why are most current liabilties recognized at maturity value at the beginning of their term

15-4. Current liabilities are typically recorded at maturity value rather than at fair value or present value because the cost of an asset received and the maturity amount of the liability are similar. Specifically, ASC 835-30-15-3 excludes presentation of specific current liabilities at present value including (1) payables arising from transactions with suppliers in the normal course of business that are due within one year, (2) advance payments for the purchase of resources and raw materials, and (3) amounts intended to provide security for one party to an agreement (security deposits). However, significant financing components of contract liabilities (deferred revenue) with customers must be identified.

compute the present value of a $10,000 one-year note payable that specifies no interset although 10% would be a realistic rate. IS the PV less than greater than or equal to the maturity value

15-5. Present value =PV(0.1,1,0,-10000) or $9,091. Present value of $9,091 is less than the maturity value of $10,000.

in evaluating a balance sheet some creditors say the liability section is one of the most important sections. What are some reasons justifying this position?

15-6. The primary reason is to assess the liquidity, and, in the extreme, the solvency, of the company. For this assessment, one would need to know (a) the current versus long-term liabilities and (b) their maturity dates, interest rates, and other terms. Also, liabilities are often the most difficult of all the items listed on the balance sheet to ascertain with respect to their existence. Auditors routinely conduct tests to detect unrecorded liabilities.

Some liabilities are reported at their maturity amount. In general when should liabilities prior to the maturity date, be reported at less than their maturity amount?

15-7. A liability will be reported at less than its maturity amount prior to the maturity date if (a) it is a noninterest-bearing note, (b) the stated rate of interest on the liability is lower than the market rate of interest, or (c) there is a significant financing component of deferred revenue in a revenue contract.

Explain why the amount of cash salaries paid to employees does not equal salaries expense for the employer?

15-8. Cash paid to an employee does not equal salaries expense for the employer due to a number of items that are withheld from the employee's paycheck and paid to a third party on behalf of the employee. Examples of such items include taxes and withholdings for health care premiums, union dues, and contributions to health care savings accounts.

Differentiate between secured and unsecured liabilities. Explain the reporting

15-9. A secured liability is one that has a mortgage on real or personal property or other collateral. An unsecured liability may be either oral or written (notes payable) and does not have a mortgage. Secured and unsecured liabilities are reported in the same manner except that, in the case of secured liabilities, a note to the financial statements should disclose that the liability is secured and the characteristics of the pledged assets.

. List and briefly explain the primary characteristics of long-term debt securities. What are the primary distinctions between a debt security and an equity security?

16-1. The primary characteristics of long-term debt securities are: a. An obligation to transfer assets or services. b. A transaction or event has occurred. c. An enforceable contract. d. Future payment of principal beyond one year from the date of the balance sheet, or operating cycle if longer. The primary distinctions between debt and equity securities are: a. Debt security—fixed principal and interest; no voting privileges; fixed maturity date; cash flow dates and amounts are fixed. b. Equity security—no fixed principal and interest; voting privileges (common stock), no maturity date.

Assume that a $1,000, 8% (payable semiannually), 10-year bond is sold at a market rate of 6%. Ex- plain how to compute the price of this bond.

16-10. The way to determine the price of a bond is compute the present value, at the market rate, of the face amount ($1,000) plus the present value of the cash interest payments ($1,000 × 4% = $40) at the market rate of 3%. PV(0.03,20,1000*0.04,1000) Price = $1,148.78

Explain why and how bond discount and bond premium affect (a) the balance sheet and (b) the in- come statement of the investor.

16-11. Unamortized bond premium or discount is reflected on the balance sheet of the investor as an addition to or subtraction from, respectively, the face amount to report the carrying amount of the bond. On the income statement bond premium or discount is reflected by the periodic amortization amount. The interest amount reported is the stated cash interest for the period plus the amount of discount amortized for the period or minus the amount of premium amortized for the period.

What is the primary conceptual difference between the straight-line and effective interest methods of amortizing bond discount and premium?

16-12. Conceptually, the primary difference between straight-line amortization and effective interest method amortization is that under the straight-line method, an equal dollar amount of the discount or premium is amortized each period, whereas under the effective interest method, a constant rate (i.e., the yield rate) is applied to the carrying amount of the bonds to derive the amount of interest expense, or revenue.

Under GAAP, when is it appropriate to use the (a) straight-line interest method and (b) effective interest method of amortization for bond discount or premium?

16-13. Under generally accepted accounting principles (GAAP), it is acceptable to use the straight-line method only if its results are not materially different in amount from the results produced by the effective interest method; otherwise, the effective interest method must be used.

When the end of the accounting period of the issuer is not on a bond interest date, adjusting entries must be made for (a) accrued interest and (b) discount or premium amortization. Explain in general terms what each adjustment amount represents.

16-14. a. The amount of accrued interest expense recognized at the end of the accounting period is the amount of interest that has accumulated (i.e., incurred and not yet paid) since the last interest payment. It will be paid on the next interest date. b. The amount of discount or premium amortization recognized is the amount related to the time since the last interest date—if straight-line is used, it is proportionate to time; if the effective interest method is used, it is related to time and the carrying amount of the bond.

When bonds are sold (or purchased) between interest dates, accrued interest must be recognized. Ex- plain why.

16-15 Accrued interest must be recognized when bonds are sold (or purchased) between interest dates because the full amount of the specified periodic stated cash interest is paid to the holder of the bond on each interest date regardless of the sale (or issue) date. Thus, the purchaser advances to the seller that portion of the periodic interest accrued (i.e., incurred) up to the date of sale.

What are convertible bonds? What are the primary reasons for their use?

16-16. A convertible bond is convertible, at the option of the holder and under specified conditions, to another security (usually common stock) of the issuer. The primary reasons for the use of convertible bonds are: (a) to have a lower rate of interest on a bond and (b) a means of securing equity financing in the long run. For the investor, convertible bonds combine a fixed return with the opportunity for higher returns on the stock after conversion.

When may extinguishment of debt occur? List the various ways in which extinguishment of debt occurs.

16-18. Extinguishment of debt may occur before, at, or after the scheduled maturity date. The usual ways are: (a) direct cash payments, (b) exercise of a call privilege, (c) purchase of the debt securities in the open market, and (d) refunding.

Explain how an accounting gain or loss to the debtor may occur when a call privilege is exercised.

16-19. When a call privilege is exercised, an accounting gain or loss may result because of a difference between the call price and the carrying value of the debt. The gain or loss is reported in other gains and losses on the income statement.

Explain the difference between the stated rate and the market rate on a long-term debt security.

16-2. Stated rate —contractual rate specified on the debt instrument; it determines the amount of cash interest each interest period. The market rate is the true interest rate on a debt security. It is determined by the market and it is based on the resources received currently and the future resource flows.

When the issuer purchases its own debt securities in the open market to extinguish the debt, two en- tries must usually be made. Explain

16-20. When the issuer purchases its own debt securities, the transaction usually is not on an interest date. In this situation, two entries must be made on the reacquisition date: (1) update all of the related accounts (for accruals and amortization) and (2) record the reacquisition transaction (including any gain or loss).

What is meant by refunding?

16-21. Refunding means that extinguishment of debt is effected by the issuance of new bonds to replace the old bonds. Refunding may be accomplished either by (a) exchanging the new bonds for the old bonds (directly with the bondholders), or (b) selling the new bonds and using the proceeds to purchase the old bonds in the market.

Interest rates have increased since a company issued its bonds. Why would the company want to re- fund the bonds with another issue of bonds paying a higher rate?

16-22. When interest rates rise, the market value of bonds decreases, allowing the refunding of the older bond issue at a gain, thus increasing earnings.

Acompany retired a bond issue early, at a loss . Is the company in an economically worse position af - ter the retirement?

16-23. This question does not have a definite answer. However, the company would not have retired the bonds if it were not in its best interest. Also, the company paid the market value of the bonds. Therefore, one could argue that they are in an equivalent position before and after the retirement. In addition, the loss occurred because interest rates have fallen. The company may take this opportunity to issue lower rate debt, reduce its future interest costs, and extend the maturity of its debt. This argument suggests the company is in a better economic position after the retirement.

Why is the accounting different for nonconvertible bonds with detachable stock purchase warrants and nonconvertible bonds with nondetachable stock purchase warrants?

16-24. A detachable stock purchase warrant is separable from the nonconvertible bond to which it relates; therefore, the warrants can be sold separately in the market. An objective valuation of the bonds and the warrants separately can be made, making possible separate recording and reporting of the debt and equity components. In accounting for nonconvertible bonds with nondetachable stock purchase warrants, separate accounting for debt and equity is not feasible due to the inseparability of the two different securities (there will be no separate market for either the bond or the warrants). It is difficult to objectively assign the amounts that should be allocated between the debt and equity components.

How is the issue price of a zero-interest-bearing note payable determined?

16-3. The issue price of a zero-interest bearing note payable is the present value of the principal amount, discounted at the market rate. There are no cash interest payments to discount.

Briefly explain the effects on interest recognized when the stated and market rates of interest are different

16-4. A market rate above the stated rate causes a discount and the opposite causes a premium on the debt. A discount increases interest reported on the income statement and a premium decreases interest reported on the income statement (compared with the effects of the stated rate).

What are the primary characteristics of a bond? What distinguishes it from capital stock?

16-5. The primary characteristics of a bond are: (a) a formal (written) promise, (b) a promise to pay a specified principal at a designated future date, and (c) a promise to pay periodic interest at a specified rate per period on the principal. A bond is distinguished from capital stock in that it (a) is a liability, (b) requires the payment of periodic interest, (c) may be secured by a mortgage (lien) on specified assets and (d) does not have voting privileges. In contrast, capital stock represents ownership in a corporation; dividends are not a legal liability until declared; and capital stock often has voting privileges. The risk of owning stock is greater than the risk of owning a bond.

Contrast the following classes of bonds: (a) corporate versus municipal, (b) secured versus unse-cured, (c) term versus serial, and (d) callable versus convertible.

16-6. Corporate bonds—issued by a private corporation. Municipal bonds—issued by a governmental body. Secured bonds—supported by a lien (mortgage) on specific assets. Unsecured bonds—not supported by a lien of any type. Term bonds—the entire issue matures at a specified date. Serial bonds—mature at several stated installment dates. Callable bonds—give the issuer the option to pay off the bonds at a stated price prior to the obligatory maturity date. Convertible bonds—give the investor the option to turn in the bonds and to receive other specified securities (usually common stock) in exchange.

What are the principal advantages and disadvantages of issuing bonds versus common stock for (a) the issuer and (b) the investor

16-7. From the issuer's point of view, a primary advantage of issuing bonds versus common stock is that interest payments are deductible as an expense for income tax purposes, whereas dividends paid are not. The disadvantages are that interest payments on bonds constitute a legal and fixed obligation that must be paid in cash, whereas dividends on common stock are paid only when sufficient funds and retained earnings are available; and that bonds have a specific maturity date but common stock does not. Issuers expect to earn a higher rate of return on their investment (than the return paid on bonds) to satisfy stockholders. Each investor weighs whether the guaranteed fixed interest rate and maturity amount, or the potential for dividends and increase in stock prices would be more advantageous. Stock investments usually are considered to be more risky.

Distinguish between the face value and the issue price of a bond. When are they the same? When are they different?

16-8. The face (i.e., par) amount of a bond is the maturity amount specified on the bond certificate. The bond issue price represents the present value of the future cash flows (principal plus all interest payments) at the market rate. The face amount of a bond and its price are the same if the bond has the same stated and market rates of interest when issued; otherwise, they will be different.

Explain the impact on interest of a bond discount and bond premium to (a) the issuer and (b) the investor.

16-9. A bond sold at a discount will incur interest expense for the issuer at the market rate which is higher than the stated rate and will earn a higher interest rate for the investor. A bond sold at a premium will incur interest expense for the issuer at a market rate which is lower than the stated rate and will earn a lower interest rate for the investor.

What are the advantages of leasing from the lessee's perspective?

17-1. Lessee Advantages • Leasing may resolve a lessee's cash problems by making financing available for up to 100% of the leased asset's value. Bank loans are typically limited to 80% of the asset's value. Also, interest rates on leases may be negotiated at fixed rates, whereas some bank loans feature only variable rates. • In the case of industrial equipment that might need to be built to order and can require lengthy asset-implementation delays, leasing ready-to-use equipment can be attractive. • Leasing may enable the lessee to avoid owning assets that are needed only temporarily, seasonally, or sporadically. • Leasing assets for relatively short lease periods rather than owning them affords the lessee protection from equipment obsolescence. • Leasing can provide income tax advantages derived from accelerated depreciation and interest expense. • In general, lease payment schedules can be tailored to dovetail with the lessee's expected cash inflows from operations.

How is a guaranteed residual value treated differently by the lessee when determining the classifica- tion of leases as compared to the recording of a lease liability?

17-10. In the lease classification test, a full guaranteed value is included as a lease payment in the present value of lease payment criterion. However, in computing the lease liability, only the amount of residual value that is expected to be owed because of shortage in estimated residual value as compared to the guaranteed residual value.

Define initial direct costs.

17-11. Initial direct costs are incremental costs of a lease that would not have been incurred if the lease had not been obtained. In other words, costs that would have been incurred regardless of whether the lease was obtained are not initial direct costs.

How does a lessee derecognize a right-of-use asset and lease liability over the term of an operating lease?

17-12. At the commencement of an operating lease, a right-to-use asset and lease liability are reported on the balance sheet. The straight-line method is used to compute an equal amount of lease expense every period (total lease cost to lessee divided by total periods). The equal amount of expense is made up of interest expense (computed on the lease liability outstanding balance using the effective interest rate method), and the remaining amount (the plug) is amortization expense of the right-to-use asset. Thus, both the liability and the right-to-use asset are reduced to zero by the end of the lease term.

How does a lessee derecognize a right-of-use asset and lease liability over the term of a finance lease?

17-13. At the commencement of a finance lease, a right-to-use asset and lease liability are reported on the balance sheet. Subsequently, interest expense is computed on the lease liability outstanding balance using the effective interest rate method, and amortization expense of the right-to-use asset is typically computed using the straight-line method. Thus, both the liability and the right-to-use asset are reduced to zero by the end of the lease term; however, the expense (write-off of the asset and liability) will be greater in earlier years.

If a lessee records a right-of-use asset related to a finance lease, over what period would the lessee recognize amortization expense? What conditions impact your answer?

17-14. If a lessee has entered into a lease which has a purchase option that the lessee reasonably expects to exercise or which has an automatic transfer to the lessee at the end of the lease, the lessee will amortize the asset over the economic life of the asset. Otherwise, the lessee will amortize the right-to-use asset over the lease term.

How does a lessor account for an operating lease?

17-15. For an operating lease, the lessor continues to report the underlying asset on its balance sheet and depreciates the asset over its useful life. Lease revenue is recognized on a straight-line basis over the term of the lease.

How does a lessor account for a sales-type lease?

17-16. For a sales-type lease, the lessor reports a lease receivable and derecognizes the asset (inventory, fixed asset, etc.). At the lease commencement, the lessor reports the selling profit or loss on the lease transaction or sales less cost of goods sold. Over the term of the lease, the company increases the lease receivable by interest income (calculated through the effective interest rate method) and decreases the lease receivable for lease payments collected.

If a lessor determines that payments from a lessee pertaining to a sales-type lease are not probable, how would the lessor account for the lease?

17-17. The lessor would not derecognize the underlying asset and would not report a lease receivable. Instead, the lessor would report the payments received by the lessee as a deposit liability.

What qualifies as a short-term lease and how would a lessee account for a short-term lease?

17-18. A short-term lease has a term of 12 months or less and contains no renewal terms that the lessee would reasonably expect to exercise that would extend the lease beyond one year. In the case of a short-term lease, the lessee will not record a right-of-use asset or a lease liability. Instead, the lessee will expense lease payments as incurred.

What determines whether a lease modification results in a separate lease or in a modification of an existing lease?

17-19. If the lessee is granted an additional right at a standalone market price, a separate lease is recorded at the lease modification date. Otherwise, the lease is considered to be a single modified lease after the modification.

What is meant by capitalization of a lease from the viewpoint of the lessee?

17-2 Capitalization of a lease means that at the inception of a lease the lessee computes the present value of the rents to be paid under the lease. This amount is debited to an appropriately described asset account (e.g., right-to-use) and credited to a related liability account (lease liability).

What types of qualitative information should be disclosed about a company's leases?

17-20. The lessee shall disclose all of the following: 1. Information about the nature of its leases, including: • Lease description. • Basis on which variable lease payments are determined. • Terms and conditions of options to extend or terminate the lease. • Terms and conditions of residual value guarantees provided by the lessee. • The restrictions or covenants imposed by leases. 2. Information about leases creating significant rights and obligations that have not commenced. 3. Information about significant assumptions including determining whether a lease exists, allocation between lease and nonlease components, and the determination of a discount rate.

What types of leases are capitalized by a lessee? Under what condition would a lessee not capitalize a lease?

17-3. A lessee capitalizes both an operating and finance lease. A short-term lease (one year or less) would not be capitalized if a company elects the short term lease option.

From a lessee's standpoint, leases are classified as finance or operating leases. What criteria are used to identify a finance lease?

17-4. If any one of the following criteria is met, the lease is classified as a finance lease: • Transfer of ownership at the end of the lease to the lessee • Option to purchase the underlying asset reasonably expected to be exercised by the lessee • The lease term is a major part of the economic life of the asset • Present value of the lease payments equals or exceeds substantially all of the fair value of the underlying asset • The underlying asset is expected to have no alternative use to the lessor at the end of the lease term

What lease payments are used in determining whether the present value of lease payments is greater than or equal to substantially all of the fair value of the underlying asset?

17-5. The lease payments used in the lease classification test include: • Fixed payments less lease incentives • Variable payments • Purchase option (reasonably expected to be exercised) • Lease termination penalty • Guaranteed residual value

How is a lease liability calculated?

17-6. Lease liability: • Present value of lease payments from lease classification test with two exceptions: 1. Use remaining lease payments only. 2. Use only the expected amounts owed of a guaranteed residual value.

How is a right-of-use asset calculated?

17-7. Right-to-use asset: • Initial measurement of lease liability • Add lease payments made at or prior to lease commencement • Subtract any lease incentives received at or prior to lease commencement • Add any initial direct lease costs made at or prior to lease commencement

How does a lessee determine what interest rate is appropriate to discount the lease liability?

17-8. A lessee should use the implicit rate of the lease (determined by the lessor) if known; otherwise, the lessee would use their incremental borrowing rate.

How does an unguaranteed residual value in a sales-type lease affect the lessor's accounting in re- cording the entries at the date of inception of the lease?

17-9. Unguaranteed residual value in the case of a sales-type lease reduces both sales revenue and cost of goods sold for the lessor by the present value of the unguaranteed residual value (computed by using the interest rate implicit in the lease). The lessor does not assume that the unguaranteed value is sold. Therefore, reduction is required.

Briefly explain intraperiod tax allocation.

18-1. Intraperiod income tax allocation—the allocation of income tax expense to the components on the income statement, comprehensive income statement, and retained earnings section of the statement of stockholders' equity that caused the tax expense.

Suppose Wilson Company has one item that gives rise to a temporary difference and that item is expected to continue indefinitely. Specifically , Wilson prepays the following year's annual rent of $100,000 each December 31. In years subsequent to the first year, what will the effects be of this tem- porary difference on the income statement and the balance sheet? Assume a constant tax rate of 25%

18-10. A $100,000 rent expense that is not tax deductible in a given year is offset by a prepayment of next year's rent that is tax deductible. On the balance sheet, the asset/liability method will show a deferred tax liability of $25,000. The deferred tax liability will be a constant $25,000 so long as the amount of the rent payment and the tax rate do not change.

Explain the difference between a deferred tax liability and a deferred tax asset.

18-11. Deferred tax assets are expected (estimated) future tax benefits arising from temporary deductible differences existing at the end of the accounting period. Deferred tax liabilities are expected future tax obligations arising from temporary taxable differences existing at the end of the accounting period.

Define net operating loss (NOL) carryforwards. Briefly explain the process of a tax loss carryforward.

18-12. Income tax law permits a taxpayer to offset income tax losses (i.e., NOLs) in the current period against earnings of the future; this results in a reduction of future tax payments. Carryforwards may only offset a maximum of 80% of income reported in the future year; however there is no limit as to how long a company can carryforward the loss into the future.

With respect to NOL carryforwards, how does uncertainty affect the accounting treatment?

18-13. The realization of the benefit from a tax loss carryforward is uncertain because of the uncertainty of future income. A tax loss carryforward is recorded in the loss year. However, a valuation allowance will be established for any deferred tax asset arising from a tax loss carryforward (or any other source) for the amount of the asset for which there is a greater than 50% probability that it will not be realized. Because of uncertainty of ultimate realization, in general tax loss carryforwards may well result in valuation allowances, thus reducing the net benefit recognized in the year of loss. Deferred tax assets and liabilities are required to be revalued at the new enacted tax rate.

Is deferred tax arising from an NOL carryforward classified as current or noncurrent?

18-14. The deferred tax asset arising from an NOL carryforward is classified as noncurrent.

Explain the limitation on the carrying value of deferred income tax assets.

18-15. The net amount of a deferred tax asset (after recording any needed valuation allowance) cannot exceed the amount of tax benefit more likely than not to be realized.

How does a company account for a change in tax rates?

18-16. A company accounts for a change in enacted tax rates (legislative changes) in the period that the change is enacted.

Describe the two-step process required when uncertain tax positions are taken.

18-17. In cases of uncertain tax positions, a company performs a two-step process. First, a company must determine whether a tax position meets the recognition threshold: Is it more likely than not that the taxpayer will sustain the tax position? If yes, the tax benefit is measured as the largest amount of tax benefit that is greater than 50% likely of being realized.

Briefly describe the balance sheet approach in accounting for income taxes.

18-2. The balance sheet approach focuses on the differences between the tax and GAAP basis of assets and liabilities. Temporary differences between the tax and GAAP basis result in future taxable or deductible amounts. The tax effects of these differences (the difference x the tax rate) are recorded as deferred tax liabilities and deferred tax assets.

Explain why deferred income tax can be either an asset or a liability.

18-3. Deferred income tax is an asset when there is a future deductible amount that will reduce taxable income relative to financial accounting income in accounting periods. Deferred income tax is a liability when there is a future taxable amount that will increase future periods' taxable income relative to financial accounting income.

Explain the main overriding reasons why pretax GAAP income and taxable income are often quite

18-4. Pretax GAAP or financial income—the amount of pretax income on the income statement. Taxable income—the amount of computed on the income tax return to compute the amount of income taxes required to be paid for the year. Pretax GAAP income is determined in conformity with GAAP; taxable income is in conformity with the income tax law and regulations. GAAP income is determined in accordance with rules set forth by the accounting and securities regulators. It is intended to provide information about firm performance to outside stakeholders in the company. Taxable income is determined by rules set forth by the tax authorities and governments. It is intended to provide a measure of income to tax to raise revenue and to provide incentives and disincentives for certain behaviors. In addition to the objectives and rules being different, management has different reporting incentives - often there are incentives to increase financial accounting income and decrease taxable income.

Differentiate between a temporary difference and a permanent difference.

18-5. The two types of differences are: (a) Temporary differences—difference between the GAAP basis and tax basis of assets and liabilities. Temporary differences will reverse or turn around in one or more subsequent periods. (b) Permanent differences—items which are reported on the income statement or tax return but not on both. They do not reverse or turn around.

Landend Corporation (a) uses straight-line depreciation for its financial accounting and uses acceler- ated depreciation on its income tax return and (b) holds a $50,000 investment in tax-free municipal bonds. What kind of tax difference is caused by each of these items? Explain.

18-6. a. Straight-line versus accelerated depreciation causes a temporary difference because (1) the carrying value of the related asset differs from the tax basis of the related asset, and (2) the tax effect will reverse or turn around over the life of the asset. b. Tax-free municipal bonds cause a permanent difference because (1) the revenue is recognized for accounting purposes but not for income tax purposes and (2) the differences will not reverse or turn around in any subsequent period.

How are deferred tax accounts presented on the balance sheet?

18-7. A net deferred tax amount must be reported on the balance sheet as noncurrent (long term).

ATW Corporation has completed an analysis of its pretax GAAP income, its taxable income, and temporary differences. Taxable income is $100,000, and there are several temporary differences that result in (a) a deferred tax asset of $15,000 and (b) a deferred tax liability of $20,000. The income tax rate for the current period and all future periods is 25%. There were no deferred tax assets or deferred tax liabilities as of the beginning of the current year. Provide the entry to record income taxes and in- dicate how the amounts were determined.

18-8. Income Tax Expense ($25,000 + $20,000 - $15,000) $30,000 Deferred Income Tax Asset (Given) 15,000 Deferred Income Tax Liability (Given) 20,000 Income Tax Payable ($100,000 × .25) 25,000

Explain the difference between a taxable temporary difference and a deductible temporary difference.

18-9. A taxable temporary difference increases future taxable income relative to pretax GAAP income in future years. A deductible temporary difference decreases future taxable income relative to pretax GAAP income in future years.

Distinguish between a defined contribution pension plan and a defined benefit pension plan.

19-1. A defined-contribution pension plan does not define specific benefits to be paid at employee retirement. Rather, it specifies the periodic amount that the employer must pay into the pension fund. The employees receive whatever benefits can be paid from the pension fund accumulation and its earnings. A defined benefit plan specifies the amount of benefits to be received by employees after retirement. The employer is responsible for ensuring assets are sufficient to pay benefits. If the plan's investments perform poorly, the employer must make additional contributions.

Explain why pension expense is not simply recognized when benefits are paid to employees.

19-10. The employer incurs a pension obligation (a liability) to pay retired employees pension benefits in the future. The employer's cost is incurred as the qualified employees provide years of service. Attribution requires that the employer record pension expense in the accounting periods in which the benefits are earned, rather than in the periods in which the benefits are paid to retirees. Therefore, the primary problem in pension accounting is to attribute pension expense to accounting periods.

What does attribution mean in pension accounting?

19-11. Attribution refers to the process of allocating (or assigning) pension expense to the accounting period in which the employees earned (by rendering services to the company) the right to future pension benefits.

Two special features of pension accounting are (a) income smoothing in the income statement, and (b) offsetting in the balance sheet. Explain each feature.

19-12. Special features of pension accounting: a. Income smoothing—the effects of certain pension obligations (or assets)— prior service and losses and gains—are not recognized when they occur. Instead, they are recognized systematically and gradually over subsequent periods through amortization. The purpose is to avoid large fluctuations in pension expense that would be recognized if all changes in the pension liability were recognized as a component of pension expense when incurred. b. Offsetting—the offsetting of pension assets and liabilities and the reporting of a single net amount as net pension asset/liability. Rather than showing plan assets as investment assets of the entity and the PBO as a separate liability of the entity, the net amount called the funded status is reported. This reflects the fact the pension plan is a separate entity. Recognition of the net funded status when the plan is overfunded is similar to the presentation used for equity method investments (a single line item consolidation). However, presentation of an underfunded plan differs from the equity method because a net liability is presented. This reflects the fact that unlike an investment in equity securities, the company does not have limited liability. It must contribute more to ensure the pension obligations are satisfied.

What is the vested benefit obligation?

19-13 The vested benefit obligation is the present value of the current and future pension benefit rights that are no longer contingent on remaining service of an employee of the company. In other words, the VBO is an estimate of the amount of benefit the employee would be entitled to even if he or she quit working for the company.

List and define the five components of pension expense.

19-14. Components of net periodic pension expense: a. Service cost—the cost (at actuarial present value) of future pension benefits earned by employees during the current accounting period by virtue of completing additional service during the period. b. Interest cost—the beginning balance of the projected benefit obligation multiplied by the settlement rate. c. Expected return on plan assets—the expected return on the pension plan investments equal to the beginning balance of the fair value of plan assets multiplied by the expected rate of return. d. Amortization of unrecognized prior service cost—prior service cost is caused by plan amendments that are retroactive. The cost is not recognized as expense when granted, but instead is amortized (and recognized) over future periods as expense. e. Amortization of unrecognized gains or losses—due to (a) differences between expected and actual returns on plan assets, and (b) other gains and losses due to changes in actuarial assumptions. This cost is not recognized when incurred, but is amortized (and recognized) over future periods as expense when using the corridor approach (unless the company elects another systematic method to amortize the gain/loss).

Define and explain the projected benefit obligation (PBO).

19-15. The projected benefit obligation (PBO) is the present value of the pension liability, based on actuarial estimates of the benefits already earned by the employees. This liability is funded by making contributions to the pension plan assets. The liability is settled when payments are made to retirees out of the plan assets.

What information is typically found in the report from the trustee on plan assets?

19-16. The status of plan assets is prepared by the pension fund trustee. This report shows the beginning balance of fund assets (at fair value), the actual earnings of the fund, payments to retired employees, contributions to the fund, and the ending balance of the fund (at fair value).

Explain what is meant by underfunded pension plan.

19-17. An underfunded plan is one in which the plan assets are less than the PBO. Under (over) funded PBO is computed as follows (assumed amounts) where the PBO exceeds plan assets at a reporting date: Projected benefit obligation $100,000 Pension fund assets at fair value 80,000 Underfunded PBO $ 20,000

Explain the difference between the projected benefit obligation and the accumulated benefit obligation.

19-18. The accumulated benefit obligation is exactly the same as the projected benefit obligation except for one difference in the computations. The projected benefit obligation includes the effect of estimated future changes in the salaries of the employees covered. The accumulated benefit obligation does not include the effects of estimated changes in the salaries of employees. The projected benefit obligation is recognized in the primary financial statements, while the accumulated benefit obligation is disclosed.

Explain the primary approaches for amortizing unrecognized pension costs.

19-19. The two deferred pension items—prior service cost, and pension gain/loss—although not recognized as part of pension expense when incurred, are amortized to pension expense. Prior service cost often is large in amount and the amortization rules permit long periods of amortization. Prior service cost is amortized on a straight-line basis (or using the service method described in Appendix 19C). For gains/losses that become large, the corridor calculation defines the minimum level of amortization required for pension gains/losses (unless the company elects to amortize the gain/loss using another systematic method).

Describe the role and responsibilities of the employer, the trustee, and the employees in their involve- ment in a defined benefit pension plan.

19-2. The three primary accounting parties are: (a) employer, (b) funding agency (trustee), and (c) employees. The employer must account for pension expense, cash contributions to the funding agency, plan assets, and the pension obligation. The funding agency accounts for the funds received from the employer, invests the funds as directed by the employer, and pays benefits to the retirees. The employees qualify for benefits through services provided to the employer and receive benefit payments from the trustee.

In the case of unrecognized prior service cost, first incurred during 2020, amortization may or may not be appropriate at the end of 2020. Explain why

19-20. If such costs are incurred effective for the beginning of 2020, amortization for one year (2020) should be recognized for the year ended December 31, 2020. Alternatively, if they are incurred at the end of 2020, the first year's amortization should be recorded as an addition to pension expense in 2021.

What are actuarial assumptions used to develop estimates of future retirement benefit payments of a pension plan?

19-3. Actuarial assumptions include estimated retirement ages, mortality (i.e., life expectancies), number and ages of employees at retirement, turnover rates, future salary levels, interest rates, and vesting of benefits.

Distinguish between a contributory pension plan and a noncontributory pension plan.

19-4. Contributory pension plan—The employees pay some or all of the costs of the future benefits. Noncontributory pension plan—The employer pays all of the costs of the future benefits.

5. Employer Mac sponsors a defined benefit pension plan. The estimated pension expense for 2020 is $100,000, the first year of the plan. Provide the balance sheet presentation for each of the following separate scenarios. Mac contributes 100% of the pension expense b. Mac contributes 80% of the expense Mac contributes 120% of the expense

19-5. a. The pension obligation is fully funded so the net pension asset/liability on the balance sheet is $0. b. The pension obligation is underfunded; thus there is a net pension liability on the balance sheet of $20,000. c. The pension obligation is overfunded; thus there is a net pension asset on the balance sheet of $20,000.

Employee Justin will receive an annual pension benefit of $12,000 for five years, starting on Decem- ber 31, 2021. Assuming an interest rate of 8%, how much must be in the pension fund on January 1, 2021? Explain why the answer is not $60,000.

19-6. PV(0.08,5,12000) = $47,913. The answer is less than $60,000 (5 x $12,000) by the interest that will be earned on the fund during the payout period. The interest is: $60,000 - $47,913 = $12,087.

Employer Beeber must build a pension fund of $50,000 by December 31, 2024. Five equal annual payments are made into the fund starting on December 31, 2020. The fund will earn 8%. What is the amount of each payment? Explain why it is not $10,000.

19-7 PMT(0.08,5,0,50000)= $8,523. The annual payments are less than $10,000 ($50,000/5) because of interest earned during the accumulation period. Interest is: $50,000 - ($8,523 x 5 = $42,615) = $7,385.

Explain why accounting for defined benefit plans must be based on assumptions and estimates.

19-8. Defined benefit pension accounting must be based on assumptions and estimates because the pension benefits to retirees will be paid many years after the employee earns those benefits. The costs of the benefits must be recognized (i.e., recorded) when they are earned, not when they are paid. This requires many estimates that include wages growth, settlement rates, and actuarial assumptions about mortality and vesting.

What is the pension benefit formula?

19-9. The pension benefit formula specifies how nominal retirement payments will be determined in conformity with the pension plan. For example, a pension benefit formula might specify that retiring employees are entitled to receive an annuity equal to 2% of the employee's final salary for each year of service. Thus, an employee retiring after 30 years of service would receive annual retirement benefits equal to 2% x 30 = 60% of his or her final wage.

Identify four basic rights of stockholders. How may one or more of these rights be withheld from the stockholders?

20-1. The four basic rights of stockholders are: a. The right to participate in the management of the corporation through participation in the voting at stockholders' meetings. b. The right to participate, on a pro rata basis, in the earnings of the corporation through dividends declared by the board of directors. c. The right to share, on a pro rata basis, in the distribution of assets during the corporation's liquidation or through liquidating dividends paid. d. The right to purchase shares of stock in the corporation, on a pro rata basis, when such shares represent additional capital stock issues. This pre-emptive right is designed to protect the proportional ownership interest of each stockholder in the ownership. One or more of these rights may be withheld from the stockholders only through provision in the corporate charter with respect to a specific class of stock. The withholding of such rights must be printed on the face of the stock certificate.

Distinguish between callable and redeemable preferred stock.

20-10. Callable preferred stock can be called in at the option of the issuer for redemption at a specified price and time. In contrast, redeemable preferred stock can be turned in for redemption in cash, at the option of the stockholder at a specified price and time.

How are assets valued when shares of stock are given in payment to acquire these assets?

20-11. When a corporation issues stock as payment for services or in exchange for other noncash assets, the following GAAP guideline should be applied: a. Use current market value of the stock issued or the current market value of the assets or services received, whichever is the more reliably determinable. b. Use appraised market value of the assets if (a) cannot be applied reliably. c. Use valuations of the assets or services established by the board of directors if (a) or (b) cannot be applied.

Briefly describe the accounting for stock issue costs.

20-12. Stock issue costs arise from expenditures made to sell and issue capital stock and are deducted from the proceeds of the sale of the stock by debiting (i.e., reducing) Paid-in Capital in Excess of Par.

Define treasury stock.

20-13. Treasury stock is a corporation's own stock that (a) has been issued; (b) is subsequently reacquired by the issuing corporation; and (c) has not been resold or canceled. Treasury stock does not carry voting, dividend, or liquidation privileges. Treasury stock, when resold, again becomes outstanding stock. During the period held, treasury stock is issued but not outstanding stock.

What is the effect on the amounts of assets, liabilities, and stockholders' equity of (a) the purchase of treasury stock and (b) the sale of treasury stock?

20-14. Effects of treasury stock on total: (a) Purchase (b) Sale Assets Decrease Increase Liabilities None None Stockholders' equity Decrease Increase

Total stockholders' equity is not affected by the use of the cost method of accounting for treasury stock, yet some components of stockholders' equity are affected. Is this statement correct? Explain.

20-15. Under the cost method, the purchase and subsequent sale of treasury stock are, in effect, one continuous capital transaction. Consequently, under this concept, treasury stock is debited to the Treasury Stock account at cost and held in suspense, in effect, as an unallocated reduction of total capital. When the treasury stock is resold or retired, as the case may be, the capital transaction is completed, and at that time, the Treasury Stock account is removed at cost, and the various effects on capital recognized.

Why may states limit purchases of treasury stock to the amount reported as retained earnings?

20-16. Many states limit the purchases of treasury stock to the amount of reported retained earnings in order to provide an additional measure of protection to the creditors. This restriction prevents the corporation from returning assets to the owners through the purchase of treasury stock and, thereby, draining assets from the corporation with a consequent potential loss to creditors. The theory behind such laws is that the corporation could, aside from purchasing treasury stock, declare dividends up to the amount of retained earnings. This law prevents a company from declaring dividends for the full amount of retained earnings and, at the same time, transferring assets to the shareholders by means of treasury stock purchases. The restriction on retained earnings may be removed by reselling the treasury stock or by canceling (retiring) it. Cancellation of treasury stock in such circumstances must be done in accordance with state laws.

In recording treasury stock transactions, explain why "gains" are recorded in additional paid-in capi- tal account, whereas "losses" may involve a debit to retained earnings.

20-17. The generally accepted accounting definitions of "gains" and "losses" exclude "gains" and "losses" on transactions affecting a corporation's own stock. Underlying this position is the notion that a corporation cannot make a gain or loss in transactions concerning its own equity. As a consequence, such gains are recorded as paid-in capital, appropriately designated. Losses, to the extent that they cannot be offset against appropriate contributed capital accounts, are debited to retained earnings on the presumption that they represent a form of dividend to the stockholder involved in the transaction.

When treasury stock is formally retired, retained earnings may be affected. Explain how this situation may occur.

20-19. When treasury stock is retired all capital balances related to the shares retired should be removed. Any balancing difference required, if a debit, is to retained earnings (if a credit, to additional paid-in capital from stock retirement).

Explain the meaning of authorized capital stock, issued capital stock, unissued capital stock, out- standing capital stock, and treasury stock.

20-2. The following terms are defined as follows: a. Authorized capital stock—the number of shares of stock that can be issued legally as specified in the charter. b. Issued capital stock—the number of shares of authorized stock that have been issued to date; includes treasury stock. c. Unissued capital stock—the number of shares of authorized capital stock that are not issued. d. Outstanding capital stock—the number of shares of stock that have been issued and are being held by shareholders at a given date; shares issued less treasury stock held. e. Treasury stock—shares once issued and later reacquired, and currently held by the corporation, i.e., the difference between issued shares and outstanding shares.

What are the principal sources and uses of retained earnings?

20-20. The principal source of retained earnings is income from operations. The primary uses of retained earnings are cash dividends, stock dividends, recapitalizations, retirement of stock and treasury stock transactions, and absorption of losses.

Explain the significance of the declaration date, record date, and payment date related to dividends.

20-21. Accounting for dividends involves three important dates: (1) declaration date; (2) record date; and (3) payment date. The declaration date is the date on which the corporation formally announces the dividend. As to cash and property dividends, this is the date on which the dividend becomes irrevocable; therefore, on this date the dividends are recorded in the accounts. The record date is the date on which the list of stockholders of record is prepared. No entry is made in the accounts on this date. The payment date is the date on which the dividend is paid. On this date, an entry is made for the disbursement of cash or other assets in payment of the dividend.

Distinguish between cash dividends and property dividends.

20-22. A cash dividend is one paid in cash. A property dividend is the same as a cash dividend except payment is in noncash assets.

What is a liquidating dividend? What is the proper accounting treatment for such dividends?

20-23. A dividend that constitutes a return of contributed capital rather than earnings is known as a liquidating dividend. In accounting for liquidating dividends, additional paid-in capital, rather than retained earnings, should be debited because a portion of stockholder investment is returned. There must be full disclosure to the stockholders; that is, they should be informed of the portion of any dividend that represents a return of contributed capital.

What is the difference between a cash or property dividend and a stock dividend?

20-24. A cash or property dividend reduces both assets and total stockholders' equity (i.e., debit to Retained Earnings). A stock dividend does not require the distribution of corporate assets; therefore, assets are unaffected. A stock dividend also does not affect total stockholders' equity; however, it does change the components of total stockholders' equity. The "amount" of a stock dividend is transferred from retained earnings (usually) to contributed capital accounts.

explain this statement: When property dividends are declared and paid, a loss or gain often must be reported.

20-25. When a property dividend is declared, it must be recorded at the market value of the property distributed. Therefore, a gain or loss on disposal of the property must be recorded. The gain or loss is the difference between the market value and carrying value of the property distributed at declaration date.

Contrast the effects of a stock dividend (declared and issued) versus a cash dividend (declared and paid) on assets, liabilities, and total stockholders' equity.

20-26. Dividend Assets Liabilities Total Stockholders' Equity Cash Decrease No effect Decrease Stock No effect No effect No effect

Contrast the effects of a typical small stock dividend (declared and issued and ignoring fractional shares) versus a typical cash dividend (declared and paid) on the components of stockholders' equity.

20-27. Dividend Capital Stock Additional Paid-in Retained Earnings Cash No effect No effect Decrease Stock Increase Increase Decrease

Explain why the amount of retained earnings reported on the balance sheet is often not the net amount of all accumulated earnings (and losses) less all accumulated cash and property dividends.

20-28. Total reported retained earnings often is less than total accumulated earnings minus total accumulated cash and property dividends because some of retained earnings often is capitalized (i.e., transferred to contributed or permanent capital) primarily as a result of stock dividends.

Distinguish between a stock split effected in the form of a dividend and a stock split.

20-29. A stock dividend involves the issuance of additional shares of stock to the stockholders in proportion to the shares that they held prior to the dividend. It reduces retained earnings and increases contributed capital by the same amounts, but does not change total stockholders' equity. In contrast, a pure stock split involves the replacing of the old shares with a larger number of new shares with a proportionately lower par value per share. A pure stock split does not change the components or total of stockholders' equity. Neither a stock dividend nor a stock split requires the disbursement of corporate assets; both reduce earnings per share.

Describe the main categories of stockholders' equity in accounting for corporate capital.

20-3. Accounting for corporate capital emphasizes the categories of capital usually thought of as sources of capital. To apply this concept, corporate capital accounts are established in a manner such that the apparent sources of the capital used in the enterprise are segregated. Source is important because the laws of the several states relating to corporations frequently are specific concerning sources of capital. For example, dividends may be "paid" from certain sources and not from others in the legal sense. For legal reasons, the source is considered important for full disclosure in the financial statements. Five main categories of stockholders' equity are: paid-in capital, retained earnings, accumulated other comprehensive income, treasury stock, and noncontrolling interests.

What are the primary reasons for appropriating and for restricting retained earnings?

20-30. Fundamentally, retained earnings are appropriated and restricted to indicate that such amounts are not available for dividends during the period of appropriation or restriction, thereby protecting the working capital position of the corporation. Such appropriations and restrictions arise for a number of reasons. The primary reasons are: a. To fulfill a legal restriction. b. To fulfill a contractual restriction. c. To record a discretionary action by the board of directors to appropriate a portion of retained earnings as an aspect of financial planning. d. To record a discretionary action by the board of directors to appropriate a portion of retained earnings in anticipation of possible future losses.

What is a noncontrolling interest and how is it presented in a company's statement of stockholders' equity?

20-4. Noncontrolling interest is the amount of net assets of any subsidiaries owned by investors other than the parent company. The equity attributable to the noncontrolling interest is shown separately from the equity attributable to the controlling interest in the stockholders' equity section of the consolidated balance sheet.

Define legal capital.

20-5. Legal capital is that amount of stockholders' equity specified by the laws of the state in which the corporation received its charter that is maintained in a company for the protection of the creditors (i.e., par for par stock, and stated or full amount paid in for nopar stock).

Distinguish between par and no-par stock. Distinguish between common and preferred stock.

20-6. Par value stock has a designated dollar "value" per share, as specified in the charter of the corporation. The par value has no necessary relationship to market price. True nopar stock does not carry a designated or assigned value per share. Common stock is the basic issue of stock with no particular preferences or priorities; normally, it carries the four rights accruing to stockholders. Preferred stock is so designated because it has some preference or priority over the common stock; the preference or priority may be positive or negative and may relate to: (a) dividends, (b) assets upon liquidation, (c) redemption, (d) convertibility, and (e) voting.

Identify and explain a transaction that causes paid-in capital to increase but does not result in any in- crease in the assets or decrease in the liabilities of the corporation.

20-7. A stock dividend increases various accounts included in the "paid-in capital" category without the company receiving any contribution of assets. It is a reclassification, sometimes called "capitalization" of retained earnings, or sometimes "additional contributed capital," in order to maintain legal capital.

Explain the difference between cumulative and noncumulative preferred stock.

20-8. Noncumulative preferred stock provides that dividends not declared for any prior year, or series of prior years, are lost permanently as far as the preferred stockholder is concerned. Cumulative preferred stock provides that dividends passed (dividends in arrears) for any prior year, or series of prior years, accumulate and must be paid to the preferred shareholders when dividends are declared, before the common stockholders are entitled to receive a dividend. In most states preferred stock is cumulative unless otherwise stated.

Under what conditions is preferred stock reported as a liability?

20-9. Preferred stock is reported as a liability when preferred stock is mandatorily redeemable which means the issuer is required to redeem the stock at a specified or determinable date.

What is the difference between a restricted stock award plan and a restricted stock unit plan?

21-1. In a restricted stock award plan, employees receive grants of restricted stock whereas in a restricted stock unit plan, the employees receive the right to a specified number of shares of stock. In both cases, the awards are compensatory and receipt of stock is based upon specific requirements.

Why are dividends from dilutive convertible preferred stock added back to the numerator of basic EPS without tax effect, while interest recognized on dilutive convertible bonds is added back to the numerator on an after-tax basis?

21-10. There is no tax effect for dividends declared or paid. Interest reduces net income on an after-tax basis. Therefore, the amount added back must also be after-tax.

What is the difference between a dilutive security and an antidilutive security? Why is the distinction important in EPS computations?

21-11. A dilutive security is a security that causes a reduction in the earnings per share amount. An example is stock options for which the market value of the stock exceeds the option price of the stock. An antidilutive security is a security that causes the opposite effect, an increase in the earnings per share amount above that which would otherwise be reported. An example is stock options for which the market value of the stock is less than the option price. The distinction is important in earnings per share considerations because dilutive securities are included in the computation of diluted earnings per share, whereas antidilutive securities are omitted from the computation. Diluted EPS presents the lowest amount of income available to each share of common stock assuming conversion of all dilutive securities.

A company split its common stock two-for-one on June 30 of its accounting year ended December 31. Before the split, there were 4,000 shares of common stock outstanding. How many shares of com- mon stock should be used in computing EPS for the year? How many shares of common stock should be used in computing a comparative EPS amount for the preceding year?

21-12. In computing EPS for the year, 8,000 shares of common stock should be used because retroactive treatment for stock dividends and stock splits for all periods presented is required. Therefore, 8,000 shares would also be used to compute EPS (restated) for the preceding year as well. The two EPS amounts are therefore (a) comparable and (b) both related to the current capital structure.

Explain why nonconvertible securities do not cause a complex capital structure, whereas convertible securities do cause a complex capital structure.

21-13. If nonconvertible, a security does not cause a complex capital structure because it never results in common stock. A convertible security causes a complex capital structure because it can be exchanged for capital stock. Conversion effects must be included in diluted EPS.

Explain why and when dividends on nonconvertible preferred stock must be subtracted from income to compute EPS in both simple and complex capital structures.

21-14. Dividends on nonconvertible preferred stock must be subtracted from income to compute EPS because EPS is based on earnings available to common stock holders. Subtraction of the dividends reduces income to the amount available to common stockholders. If the preferred stock is cumulative, the deduction of dividends is necessary because the preferred stockholders' right to the dividend is not lost. If the preferred stock is not cumulative the deduction is made only if the current dividend on the preferred stock has been declared.

Suppose a company has a convertible bond outstanding among other dilutive securities. What calcu- lations must be made to establish an impact on EPS?

21-15. The interest expense on the bond, net of tax, must be divided by the shares outstanding from conversion. This ratio is compared to basic EPS to ascertain if the bond is dilutive. If so, it is considered sequentially behind all other more dilutive securities. If after considering all other more dilutive securities, the bond's effect is still dilutive, interest net of tax is added to the numerator of the EPS calculation and the number of converted shares is added to the denominator in calculating the new diluted EPS figure. If it is not dilutive, no further calculation is made.

Why are potentially dilutive securities ranked (in cases of multiple security holdings), and why is it useful?

21-16 Securities are ranked through a computation of a ratio of numerator to denominator effects for each potentially dilutive security. The ratio is the addition to income divided by the increased number of outstanding shares. By ordering these ratios, smallest to largest, the dilutive securities can be used one by one until maximum dilution is achieved. This occurs when the ratio for the next security exceeds the calculation of EPS using all other securities with lower ratios (i.e., larger dilutive effects). It is useful since it gives a means of proceeding one security at a time. For example, if there are 10 potentially dilutive securities, at most 10 calculations are required. Alternatively, 210 calculations would be required to evaluate all possible sets.

What are contingent shares, and do they need to be considered in computing EPS?

21-17. Contingent shares are those issuable under specified conditions. If all conditions are met by the balance sheet date, or are met in the current period as comparable to the contingent period, they are included in the computation of diluted EPS.

A dilutive convertible bond was issued at a premium. Explain how to compute the numerator effect for such a bond when computing dilutive EPS.

21-18. The numerator effect equals the interest expense for the period. This amount is cash interest minus the amortization of bond premium for the period.

Explain in general how to handle actual conversions of convertible dilutive securities for basic and diluted EPS purposes (denominator effect only).

21-19. Basic EPS reflects the shares from actual conversion weighted for the portion of the period after conversion. Diluted EPS reflects the denominator effect from assumed conversion weighted for the portion of the period before conversion.

Explain how a company classifies share-based compensation plans for employees as either noncom- pensatory or compensatory.

21-2. A non-compensatory plan is one that does not involve additional compensation to the grantee and involves no cost to the corporation. It is characterized by the following four attributes; (1) the discount from market price is no greater than would be reasonable in an offer of stock to stockholders or other outside parties (the discount is less than or equal to 5%) (2) substantially all full-time employees who meet the limited employment qualifications may participate on an equitable basis, (3) stock is offered to those eligible equally or based on a uniform percentage of salary or wages (the number of shares of stock purchased by an employee may be limited), and (4) the time permitted for exercise of an option or purchase right is limited to a reasonable period. All plans not possessing all four of the above attributes are classified as compensatory. They involve a cost to the corporation and additional compensation to the employee.

Shares of a parent corporation will be issued in the future based on the number of retail outlets opened by a recently acquired subsidiary. The subsidiary predicts that 10 new outlets will be opened in the next three years. However, to date, no outlets have been opened. Describe how the contingent shares would be calculated for the parent company's diluted EPS in this situation.

21-20. The parent would include no contingent shares in diluted EPS because the current level of the variable governing the number of shares to be issued (number of retail stores opened of 0) has not reached the threshold level of 10 stores.

Would antidilutive securities be included in the calculation of diluted earnings per share?

21-21. Computation of diluted earnings per share should not give effect to common stock equivalents or other contingent issues for any period in which their inclusion would have an antidilutive effect (i.e., increase the earnings per share amount or decrease the loss per share amount otherwise computed).

Are the following items required to be disclosed on the face of the financial statements, or either on the face or in the notes to the financial statements?

21-22. 1. Face of the income statement 2. Face of the income statement 3. Face of the income statement or in the notes

What are the required disclosures for share-based compensation plans?

21-3. Disclosure requirements include the following: a. The nature and terms of such arrangements that existed during the period and the potential effects of those arrangements on shareholders b. The effect of compensation cost arising from share-based payment arrangements on the income statement c. The method of estimating the fair value of the equity instruments granted (or offered to grant), during the period d. The cash flow effects resulting from share-based payment arrangements.

What are some factors used in the estimation of fair value in the accounting for stock option plans using a pricing model?

21-4. Factors needed to estimate fair value include the exercise price of the option and the grant-date market price of the stock. Also needed on the grant date for determining the option price are: the risk-free rate of interest, an estimate of the volatility of the stock price, expected dividends in the future, and the expected life of the option.

What is the fundamental difference in EPS computations and reporting between a simple capital structure and a complex capital structure?

21-5. In a simple capital structure, a single presentation of the basic amounts for earnings per share is required. A simple capital structure is one in which stockholders' equity either consists only of common stock or does not contain convertible securities, stock warrants, or other rights convertible to common stock. If a company has a complex capital structure, it presents diluted EPS—this calculation is based on common stock plus the number of shares of common stock that would also be issued assuming all convertible securities, warrants, etc. with dilutive effects are converted to common stock. This calculation represents maximum dilution of EPS.

Is the undeclared annual dividend on cumulative convertible preferred stock outstanding all tracted from net income in computing basic EPS? Why or why not?

21-6. Yes, because basic EPS treats all preferred stock the same way, whether or not convertible. Undeclared cumulative preferred dividends must be paid before current common dividends, which is why they are subtracted even if not declared. However, only the current-year claim is subtracted. Prior years' cumulative preferred stock dividends were subtracted in computing EPS in prior years and should not be subtracted again. The dividends reduce the actual return to common shareholders because the preferred was not converted during the period.

Explain the treasury stock method as it is applied to stock options. Is the treasury stock method's use of average market price consistent with the overall objective of EPS reporting? Explain.

21-7. The treasury stock method is used to compute the number of incremental equivalent common shares when a complex capital structure includes securities such as stock options. The treasury stock method assumes that the options will be exercised and the required number of common shares issued. The cash that would be received (at the option price) from the recipients is assumed to be invested in the acquisition of treasury common shares (at the average price for the period). The difference between the two amounts—the assumed number of shares that would be issued and the assumed number of treasury shares that would be acquired—represents the number of common stock equivalents associated with the options that must be added to the weighted average number of common shares outstanding.

Is the treasury stock method's use of average market price consistent with the overall objective of EPS reporting? Explain.

21-8. The overall objective of EPS is to report on the performance of a company during a period of time. The use of average price reflects the assumption that options and warrants would be exercised during the year at various prices, rather than all at the end of a period.

Briefly, how are stock dividends and splits reflected in the calculation of basic EPS if the dividend or split occurs (a) before the balance sheet date or (b) after the balance sheet date but before the issuance of the statements?

21-9. Both situations are treated the same way in that all common stock transactions occurring before the dividend or split are adjusted.

Explain the purpose of the statement of cash flows.

22-1. The statement of cash flows reports cash flows for three different activities—operating, investing, and financing. The primary purpose of the statement of cash flows is to provide cash flow information in a manner that maximizes its usefulness to investors, creditors, and other interested parties in projecting future cash inflows related to the entity.

What three reconciling amounts must be reported at the bottom of the statement of cash flows? Which one(s) must agree with a key amount in another financial statement? Use assumed amounts for

22-10. The three reconciling lines are as follows: Net increase (decrease) in cash during the period. $(10,000) Cash balance, beginning 50,000 Cash balance, ending $40,000 The $40,000 must agree with the ending cash (plus cash equivalents and restricted cash) amounts reported on the balance sheet. The $50,000 must agree with the beginning balance.

One of the criticisms of the statement of cash flows indirect method is that it does not report each of the three activities consistently. Explain the basis for this argument.

22-11. The indirect method reports adjustments to net income and changes in various asset and liability accounts, in the operating section. The investing and financing sections report direct cash flows for each major item. This is an inconsistency. By contrast, all three sections report direct cash flows under the direct method.

Explain why an adjustment must be made to compute cash flow from operating activities for depreci- ation expense, bad debt expense, amortization of intangibles (such as patents, copyrights, franchises), and bond discount.

22-12. An adjustment must be made for all of these items because they are all noncash expenses treated as deductions to compute net income. Under the indirect method these items must be added to net income to cancel or remove their effect. Under the direct method they are simply excluded because they do not reflect cash flows.

Explain why gains and losses reported on the income statement usually must be omitted (or removed) from operating activities to compute cash flow from operating activities.

22-13. Gains and losses on the income statement often must be omitted or removed to compute cash flow from operating activities because their dominant characteristic is either an investing or financing activity. Also, such gains and losses are not equivalent to cash flows resulting from the transactions. Under the direct method they are simply excluded from operating activities. Under the indirect method they are adjustments necessary to reconcile net income to cash provided by operating activities. In both cases, any related gross proceeds associated with the transactions giving rise to gains and losses are shown in the appropriate investing or financing section.

A corporation's records showed the following: sales, $80,000, and gross accounts receivable de- crease, $10,000, after the write-off of a $3,000 bad debt. Assuming the direct method, compute the cash inflow from customers.

22-14. Sales (accrual basis) $80,000 Gross accounts receivable decrease before write-offs ($10,000-$3,000) + 7,000 Cash from customers $87,000

Why are cash, cash equivalents, and restricted cash grouped together for purposes of the statement of cash flows?

22-15. Cash equivalents have little risk of price fluctuation due to interest rate changes given their short maturity. They also are convertible to cash in an amount close to their carrying value due to their ready marketability and low credit risk. Therefore, they are considered so similar to cash that the assessment of a company's cash flows would be incomplete without considering them as cash. Restricted cash is also included in the cash balance to promote consistency of treatment of restricted cash across companies.

Why is a two-year Treasury note purchased three months before maturity a cash equivalent for cash flow purposes, although the same security purchased one year before maturity is not? cash flows?

22-16. The risk of significant price fluctuation is minimal for a security purchased 3 months before maturity, but not for a security purchased 1 year before maturity. In the latter case, the value of the security could change materially from its face value due to interest rate changes, causing it to behave differently from cash.

If the intent is to hold an investment in common stock less than three months, why is the investment not a cash equivalent?

22-17. Stock values can change significantly on a daily basis. Stocks do not have maturity dates and their values change due to interest rates and credit risk. They are significantly different from cash in that regard.

What general disclosure requirements are required related to the statement of cash flows?

22-18. Reconciliation of net income to operating cash flow, amount of interest paid (net of amounts capitalized), income taxes paid during the period, information about material noncash investing and financing activities, information about the nature of restrictions on cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents.

How is a lease payment (after inception) on a finance lease classified in the statement of cash flows of a lessee?

22-19. The interest portion of the lease payment is classified as an operating cash outflow, because all interest is so classified. The principal portion of the payment is a financing cash outflow because it is a partial extinguishment of a liability.

Explain the basic difference between the three activities reported in the statement of cash flows: oper- ating, investing, and financing.

22-2. Operating activities— Those activities not defined as investing or financing. Primarily relates to items reported on the income statement (cash inflows and outflows); these relate to its primary operations, including gains and losses, investment income, and income taxes. Investing activities—primarily relates to obtaining productive facilities and investments in noncash assets. These activities include cash outflows to obtain investments, and cash inflows from disposition of the investments previously made. Investing inflows do not include cash received from investment income. Financing activities—primarily relates to obtaining resources for the entity to use (cash inflows from borrowing and from issuance of equity) and the repayment of borrowings and returns to owners. The outflows do not include interest on debt.

Certain equity securities and trading debt securities are treated differently in the statement of cash flows. What are the major differences in treatment?

22-20. Purchases and proceeds from sales (and maturities) of certain debt securities and certain equity securities purchased specifically for resale and held in trading accounts are classified as operating cash flows whereas other investments are classified as investing.

List three major cash inflows and three major cash outflows under (a) operating activities, (b) invest- ing activities, and (c) financing activities.

22-3. Inflows Outflows Operating Cash from customers Payments to suppliers Activities Dividends received Payments for salaries and wages Interest received Payments for taxes Investing Cash received from sale of Purchase of operating assets Activities operating assets Purchase of investments (not in trading accounts) Cash received from sale of Loans or nontrade notes to others entities investments (not in trading accounts) Cash received from collection of Loan or nontrade note principal Financing Cash received from borrowing Payment of loans or nontrade notes (principal) Activities using loans or nontrade notes Retirement of bonds payable (principal) Cash received from issuing Cash dividends bonds payable Cash received from sale of common stock

Define a noncash investing activity. Give examples of two possible cases.

22-4. Noncash investing activity—an investing activity that involves either: No cash; Example: acquire an operating asset with 100% debt financing. Issue stock for acquisition of property Distribute property to shareholders as a dividend Part cash; Example: acquire an operating asset by paying 10% down and giving a long-term note for the difference.

Define a noncash financing activity. Give examples of two possible cases.

22-5. Noncash financing activity—a financing activity that involves either: No cash; Example: Acquire a company by issuing stock Acquire property by issuing stock or debt Convert bonds to shares of equity Distribute property to shareholders as a dividend Part cash; Example: acquire an asset using 10% cash and debt financing for the balance.

Define a cash equivalent.

22-6. A cash equivalent is short-term (i.e. maturity of 3 months or less), highly liquid investment in securities readily convertible into known amounts of cash with low risk of loss

Explain the basic difference between the direct and indirect methods of reporting on the statement of cash flows. Use net income, $5,000, sales revenue, $100,000, and an increase in net accounts receiv- able, $10,000, to illustrate the basic difference. Which method provides the most relevant information to investors and creditors?

22-7. The difference between the direct and indirect methods relates only to cash flows from operating activities. The direct method reports individual cash inflows from each major source and individual cash outflows for each major use. Other cash flows not included in the determination of income also are provided on a gross basis. In contrast, the indirect method reports a reconciliation of net income to net cash flow from operating activities. This reconciliation reports changes in asset and liability accounts directly related to net income, noncash income and expense items, and other adjustments necessary to reconcile income to cash provided by operating activities. Illustration: Direct method: Cash inflow from sales (i.e., from customers) $90,000 Indirect Method: Net income (includes sales revenue of $100,000) $5,000 Reconciliation Net accounts receivable increase (10,000) The information provided by the direct method is the most relevant to investors and creditors. The $10,000 change in accounts receivable is already shown on the comparative balance sheets. Also, the reconciliation is a required disclosure for the direct method.

Explain why cash paid during the period for purchases and for salaries is not specifically reported on the statement of cash flows, indirect method, as cash outflows.

22-8 Cash expenditures for purchases and salaries are not reported on the statement of cash flows, indirect method because that method does not report cash inflows and outflows for each operating activity. Rather it reports only net income, and adjustments necessary to reconcile net income to cash provided by operating activities such as changes in accounts receivable and salaries payable. Both the indirect and direct method statements report the same subtotal: net cash inflow from operating activities.

Explain why a $50,000 increase in inventory during the year must be considered when developing disclosures for operating activities under both the direct method and the indirect method.

22-9. Direct method—add increase in inventory to cost of goods sold to compute total purchases. (Total purchases are adjusted to cash purchases by analyzing changes in accounts payable.) Indirect method—Subtract increase in inventory from net income as a reconciling item with cash flows from operating activities.

What are the five steps in the revenue recognition process?

7-1 The five steps in the revenue recognition process include the following: Step 1: Identify the contract(s) with a customer. Step 2: Identify the performance obligation(s) in the contract. Step 3: Determine the transaction price. Step 4: Allocate the transaction price to the performance obligation(s) in the contract. Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation by transferring control of a promised good or service to customer.

In determining variable consideration, when is it appropriate to use the expected value method? When is it appropriate to use the most likely amount method?

7-10 The expected value method is appropriate if a company has a large number of contracts with similar characteristics. The most likely amount method is appropriate in situations where there are only two (or very limited) possible outcomes.

How is a transaction price determined when noncash consideration is received?

7-11 If noncash consideration is received from a customer as part of a revenue contract, the seller values the transaction price as the fair value of the noncash consideration at the contract inception date. If the fair value of the noncash consideration is not reasonably estimable, the transaction price is valued at the standalone selling price of the goods or services promised to the customer.

What is the difference between a principal and an agent? How is revenue recognized differently for a principal in contrast to an agent?

7-12 A principal promises to provide goods or services to its customers. An agent arranges for goods or services to be provided by the principal to an end customer for a commission or fee. A principal records the revenue at the gross amount paid by the customer and the agent records revenue at the net amount or the fee/commission paid by the customer.

Describe three approaches to estimate the standalone selling price of a good or service when the sell- ing price is not directly observable.

7-13 When the standalone selling price is not directly observable, a seller may estimate the standalone selling price using the following methods: a. Adjusted market approach: Seller estimates the standalone selling price by obtaining comparable information from the market, such as a competitor's price. b. Expected cost plus a margin approach: Seller estimates the standalone selling price by adding its typical profit margin to the cost of the good or service. c. Residual approach: Seller takes the total selling price and subtracts the value of known good(s) or service(s) to arrive at the unknown standalone selling price of the remaining good or service. This method may only be used if (1) the good or service is sold to different customers at different amounts and (2) the good or service does not have an established selling price because it has not been sold before.

When is revenue recognized over time instead of at one point in time?

7-14 Revenue is recognized over time if any of the three requirements are met: a. Customer receives the benefit of the seller's performance as the seller performs. b. The seller creates an asset that is under control of the customer while the asset is created. c. The asset created has no alternative use to the customer and the seller has an enforceable right to payment. If none of the criteria are met, the company records revenue at a point in time.

If a seller of goods to a customer has an obligation to later repurchase goods from that customer, the transaction is treated as a financing agreement. Explain.

7-15 If a seller sells goods to a customer under contract that also requires the seller to later repurchase the goods, the transaction is treated as a financing transaction. The seller has received cash upfront but also has a debt to the customer (contract liability). Interest expense on the contract liability is recorded over the contract term. At the end of the contract term, the original seller pays cash for the goods and takes control of the goods as part of the repurchase agreement.

What is a consignment arrangement? How is revenue recognized on a consignment transaction?

7-16 A consignment is a type of marketing arrangement in which the seller ships goods to a second party (a consignee) who acts as a sales agent for the seller (the consignor). The consignee does not purchase the goods but usually does accept responsibility for their care and for attempting to sell the goods. The goods, however, remain the legal property of the consignor until they are sold to a third party. When this happens, the consignee forwards to the consignor the proceeds from the sale, less any specifically allowed expense reimbursement and commissions. Only at this point can the original seller, the consignor, record a sale.

For a long-term construction project, when is revenue recognized if revenue is recognized (a) at a point in time? (b) over time?

7-17 Income is recognized: At a point in time when the performance obligation is satisfied. Over time as progress is made toward fulfilling the performance obligation(s), provided it is expected to culminate in an income (not loss).

From a seller's perspective, why does a customer prepayment result in a contract liability such as de. ferred revenue?

7-2 Because the seller has an obligation to perform the service after receiving cash, a contract liability is appropriately recorded.

What are indicators that a customer has taken control of an asset? Why is this concept important in the revenue recognition process?

7-3 The following are indicators that a customer has taken control of an asset: a. The seller has the right to payment. b. The customer has legal title. c. The customer has physical possession. d. The customer has significant risks and rewards of ownership. e. The customer has accepted the asset. Determining when control of an asset has passed from a seller to a buyer is a key determinant in recognizing revenue.

Explain the components of a valid contract.

7-4 The components of a valid contract include the following: a. Approval by both parties (in writing, orally, or in accordance with other customary business practices) and both parities are committed to perform obligations. b. Identification of rights of each party regarding the goods or services to be transferred. c. Identification of payment terms for the goods or services to be transferred. d. Has commercial substance (risk, timing, or amount of the seller's future cash flows is expected to change due to the contract). e. Collection of substantially all of the consideration is probable.

How does a seller determine whether the modification of a contract represents a new separate con- tract or the termination of an existing contract and replacement with a new combined contract?

7-5 If a company modifies a contract, the modification is classified as a new and separate contract if both of the following conditions are met: a. The addition of the promised good or services are distinct. b. The contract price increases by the standalone selling price of the additional promised goods or services. If the criteria are not met, the original contract is terminated and a new contract replaces it that combines the remaining performance obligations of the old contract with any new performance obligations in the modification. (Note: a contract modification is accounted for as a cumulative catch-up adjustment if the goods or services in the modification are distinct but are part of a single performance obligation that is only partially satisfied when the contract is modified.)

What criteria are used to determine whether a contract has single or multiple performance obligations?

7-6. In order to determine whether a contract has single or multiple performance obligations, the seller must determine how many distinct performance obligations are included in the contract. Each distinct performance obligation is a separate obligation or promise to perform. In order to be distinct, the obligation (1) must be capable of being distinct and (2) must be distinct within the context of the contract. A performance obligation is not distinct if the goods or services are highly interdependent or interrelated, combined with other goods or services in the contract into a combined output or significantly modified or customized by other goods or services in the contract.

Are nonrefundable membership fees to an art museum considered to be a separate performance obli- gation? Why or why not?

7-7 Nonrefundable joining fees to an organization with a physical location are not considered to be a separate performance obligation because they are not distinct from the right to access the given facility.

Does a right of return represent a separate performance obligation?

7-8 The right of return does not represent a separate performance obligation. Rather, the potential for a return is the potential for failure of the original performance obligation to deliver the goods to the customer. The right of return is a variable consideration because the consideration due from the customer is unknown and depends on a future event.

What is variable consideration? What is the constraint when including variable consideration in the transaction price? Identify specific examples of variable consideration.

7-9 Variable consideration results when the price of goods or services that a seller is entitled to is dependent on future events. The constraint on variable consideration is as follows: Include in the transaction price only to the extent that it is probable that a significant reversal of revenue will not take place when the uncertainty is resolved. Examples of variable consideration include price concessions, retroactive volume discounts, rebates, refunds, and bonuses.

Distinguish among the following (a) change in principal, b. change in estimate, c. Chnage in reporting entity, d. Accounting error

A-1. a. A change in principle—a different generally accepted accounting principle or procedure is adopted. b. A change in estimate—a prior estimate is changed based upon more current and improved information. c. A change in reporting entity—a change that affects accounting applications due to a change in the composition of the entity for which financial statements are reported. d. An accounting error—facts existing at the time of an event or exchange transaction were incorrectly recorded or a transaction was not recorded at all.

A company failed to accrue $12,000 of salaries at the end of 2020. Explain (a) why the discovery of the error in 2021, after the issuance of the 2020 statements, requires a correcting entry and (b) why discovery of the error in 2022, after the issuance of the 2021 statements, does not require a correcting entry.

A-10. If discovery occurs in 2021, a prior period adjustment is recognized to correct the overstatement of 2020 net income, and salary expense is reduced to correct overstatement in 2021. If discovery occurs in 2022, no entry is needed because the overstatement of 2020 income affecting retained earnings is offset by the understatement of 2021 income. The errors have counterbalanced.

What is the difference between retrospective treatment with a change in accounting principle and a retrospective restatement with an error correction?

A-11. In both a change in accounting principle and an error correction, a company would report revised amounts in its comparative financial statements showing the updated prior year amounts. However, only under a correction of an error are the previously issued financial statements restated (revised) to show the updated information. This requires filing or issuing amended financial statements from prior years.

What are the similarities and differences between a cumulative effect on prior years of applying a new accounting principle and a prior period adjustment due to the discovery of an error?

A-12. Both a cumulative adjustment and a prior period adjustment are after-tax adjustments to the beginning retained earnings balance for the effect a change or error on prior years. The adjustment is a net adjustment for the impact on financial statements prior to the earliest year presented. The main difference between the two adjustments is that the cumulative effect is caused by a change in accounting principle and a prior period adjustment is due to an error.

What are the two basic ways to account for the effects of accounting changes and error corrections?

A-2. The two basic ways to account for the effects of accounting changes and error corrections are as follows: Retrospective—The cumulative effect of the change to the new accounting principle on periods prior to those presented is reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented and to the opening balance of retained earnings if applicable. Financial statements for each prior period presented are adjusted to reflect the period specific effects of applying the new accounting principle. Prospective— the change effect is spread over the current and future periods.

Explain the basic difference between an accounting change and an error correction.

A-4. An accounting change involves a change in accounting (a) principle, (b) estimate, or (c) entity. It is made with intent and by decision. An accounting error involves incorrect application of accounting principles and estimates, and mathematical errors. Accounting errors usually are made inadvertently and are not planned.

How is the book value of a plant asset at the beginning of the year of a change in estimated life used in the accounting for the change?

A-6. The book value is treated as if it were the new original cost. The revised residual value is subtracted from the book value, resulting in revised depreciable cost, the basis for subsequent depreciation.

What is the difference between a counterbalancing error and a noncounterbalancing error? Why is the distinction significant in the analysis of errors?

A-7. A counterbalancing (self-correcting) error results from failure to properly allocate an expense or revenue item between two consecutive accounting periods. No error remains in retained earnings or other balance sheet accounts at the end of the second period because the total revenue and total expense to that date are correct. However, the interim reports are incorrect. A noncounterbalancing (not self-correcting) error continues to affect the account balances and reports beyond a two-year period. This distinction is significant in the analysis of errors because the correcting entry depends upon whether the error is counterbalancing or noncounterbalancing, as well as upon when the error is corrected relative to when the error was made.

Define extinguishment of debt.

Extinguishment of debt is a transaction or event in which the debt is revised or settled when: a. The debtor pays the creditor and is relieved of its obligation, or b. The debtor is legally released from being the primary obligor under the liability either judicially or by the creditor.

describe the balance sheet categorization and valuations within the asset section when investment in securities is classified as: Available for sale debt security

b. Available-for-sale debt securities: Current or noncurrent asset (investment at fair value)

describe the balance sheet categorization and valuations within the asset section when investment in securities is classified as: Held-to-maturity debt securities

c. Held-to-maturity debt securities: Noncurrent asset (asset at amortized cost) or current if within one year of maturity.

describe the balance sheet categorization and valuations within the asset section when investment in securities is classified as: Equity securities measured at FV-NI

d. Equity securities measured at FV-NI: Current or noncurrent asset (investment at fair value)

describe the balance sheet categorization and valuations within the asset section when investment in securities is classified as: Equity method securities

e Equity method investment: Noncurrent asset (Proportionate share of investee earnings and dividends, adjusted by prorated depreciation of difference between fair value and investee carrying value of specific assets)