Module 5

Q5-1.

Revenue must be realized or realizable and earned before it can be

reported in the income statement. Realized or realizable means
that the companys net assets have increased, that is, the
company has received an asset (for example, cash or accounts
receivable) or satisfied a liability (for example, unearned revenue)
as a result of the transaction. Earned means that the company has
done everything it must do under the terms of the sale.
For retailers, like Abercrombie & Fitch, revenue is generally earned
when title to the merchandise passes to the buyer (e.g., when the
buyer takes possession of the merchandise), and the right of
return period has passed or returns can be estimated with some
certainty. For companies operating under long-term contracts, the
earnings process is typically measured using the percentage of
completion method, that is, by the percentage of costs incurred
relative to total expected costs.

Q5-2.

Investors and analysts often use financial statements to forecast

future financial performance of the company. Extraordinary items
are, by definition, not expected to continue to affect the profits and
cash flows of the company. Accordingly, the financial statements
separately report extraordinary items from continuing operations
to yield an income measure that is more likely to persist into the
future.

Q5-3.

In order for an item to be classified as extraordinary, it must be

both unusual and infrequent. Examples include the destruction of
property by natural disaster or the expropriation of assets by a
foreign government. Gains and losses on early retirement of longterm bonds, once the most common type of extraordinary item, are
no longer considered extraordinary unless they meet the tests
outlined above. Other events not likely to be included as
extraordinary items include asset write-downs, gains and losses
on the sales of assets, and costs related to an employee strike.
IFRS does not permit any items to be reported as extraordinary.

Q5-4.

Basic earnings per share uses reported net income and common
shares outstanding in its computation. Diluted earnings per share

include the effects of dilutive securities, assuming that they are

exercised at the beginning of the year (or when issued if issued
during the year). The numerator, thus, adds back any dividends
paid on convertible preferred stock and interest expense that
would have been avoided on convertible debt. The denominator
reflects the additional common shares assumed to be issued upon
conversion of convertible securities or upon the exercise of
options.
Securities cannot be included in the diluted EPS computation if
they are antidilutive. Antidilutive securities are those that cause an
increase, rather than a decrease in basic EPS. An example is
employee stock options whose exercise price exceeds the current
market price (underwater or out-of-the-money options).
Q5-6.

Restructuring costs consist of three general categories: asset

write-downs, accruals for severance and relocation costs, and
accruals of other restructuring-related costs. Asset write-downs
reduce assets net book value and are recognized in the income
statement as an expense. Liability accruals for severance and
other expenses create a liability and yield a corresponding
expense that reduces income and equity.
Big bath refers to a companys overestimating the amount of asset
write-downs or liability accruals to deliberately reduce current
period earnings so as to remove future expenses from the balance
sheet. Big baths create reserves that can be used to increase
future period earnings.

Q5-7.

Under current US GAAP, research and development costs must be

expensed as they are incurred. This policy applies to all R&D
costs, including fixed-asset costs, unless the fixed assets have
alternative future uses. Equipment relating to a specific research
project with no alternative use would, therefore, be expensed
rather than capitalized and subsequently depreciated.
Under IFRS, all research costs are expensed as incurred. However,
certain development costs are capitalized if they meet criteria for
existence of an asset. These capitalized costs are amortized over
the expected useful life of the intangible asset.
U.S. accounting standard-setters have justified this expense as
incurred treatment for R&D costs on the grounds that the outputs
from research and development activities are very difficult to

identify and measure. There is such high uncertainty about the

amount and timing of any expected cash flows, that recognition as
assets (capitalization) is unwarranted.
Q5-9.

Pro forma income adjusts GAAP income to eliminate (and

sometimes add) various items that the company believes do not
reflect continuing, ongoing operations. Such pro forma
disclosures are most often reported in earnings and press
releases but occasionally as part of the published 10-Ks or other
annual reports provided for shareholders. The SEC requires that
reported pro forma income be reconciled to its GAAP equivalent.
Non-GAAP information has the potential to confuse the reader
about the true financial performance of the company. This was
cause for SEC concern. Also, pro forma numbers are not subject
to accepted accounting standards (and, thus, we observe differing
definitions of pro forma across companies), are not typically
audited, and are subject to complete management latitude in what
is and is not included and how items are measured.

Q5-10.

Unearned revenue is cash a company receives from customers

but has not yet been earned. Until the company earns the revenue,
the amount received is a liability. If the company expects to earn
the revenue in the coming year, it is a current liability; otherwise,
its a long-term liability. Examples of unearned revenue include:
customer deposits, gift cards, season tickets, membership fees,
future software upgrades, partial payments in advance, and
layaway plans of retailers.

E5-22
Company

Revenue Recognition

a. The Limited

When the customer takes the merchandise and the right of

return period has expired or costs of returns can be
reasonably estimated.

b. Boeing
Corporation

Revenue is recognized under long-term contracts under the

percentage-of-completion method.

c. Supervalu

When the customer takes the merchandise and payment is

received.

d. MTV

When the content is aired by the TV stations.

e. Real estate
developer

When title to the houses is transferred to the buyers.

f. Bank of
America

Interest is earned by the passage of time. Each period, Bank

of America accrues income on each of its loans and
establishes an account receivable on its balance sheet.

g. HarleyDavidson

When title to the motorcycles is transferred to the buyer.

Harley will also set up a reserve for anticipated warranty costs
and recognize the expected warranty cost expense when it
recognizes the sales revenue.

h. Time-Warner

When the magazines are sent to subscribers. Subscriptions

received in advance are deferred revenue (a liability) until the
magazines are mailed.

E5-25
a.
($ millions)

Year

Percentage of Completion Method

Costs
incurred

Percent of
total
expected
costs

Revenue
recognized
(percentage of
costs incurred
total contract
amount)

Income
(Revenue
Costs
incurred)

2012

$15

18%
($15/$85)

$ 21.6

$ 6.6

2013

40

47%
($40/$85)

56.4

16.4

2014

30

35%
($30/$85)

42.0

12.0

$120.0

$35.0

$85

b. The percentage-of-completion method provides a good estimate of the

revenue and income earned in each period. This method is acceptable
under GAAP for contracts spanning more than one accounting period.
Note that recognition of revenue and income is not affected by the cash
received.
E5-28
a. The following items are operating:
Net sales
Finance and interest income
Other income
Cost of sales
Research and development expenses
Selling, administrative and general expenses
Other operating expenses
Provision for income taxes (the portion that relates to operating
profit)
Equity in income of unconsolidated affiliates; this relates to Deeres
investments in companies over which it exerts significant influence,
but does not control. This income is viewed as operating so long as
the related investment is considered an operating asset.
Interest expense is the only nonoperating item.
b. John Deeres finance and interest income is categorized as operating.
Deeres financial services business segment provides loans and leases
for equipment sold to dealers as well as purchasing end-customer
receivables from those dealers. The financing activities can, thus, be
viewed as an extension of the sales process, quite unlike the investment
in marketable securities unrelated to the companys activities. These
captive finance operations are generally viewed as operating.

P5-35
a. Equipment sales revenue is normally earned when title to the
equipment passes to the customer who either purchases the equipment
for cash or on credit. If there are undelivered parts or if the company
must install and test the equipment for the customer, then revenue
would not be recognized until those deliverables are completed.
Supplies, paper and other the company likely recognizes revenue on
these sales at the time the goods are shipped.
Service, outsourcing and rentals revenue from services is normally
earned as the service is performed, usually ratably over the service
contract period. The same applies to outsourcing and rentals. The
company may use the percentage of completion method if there are
long-term service contracts involved.
Finance income revenue from finance income (interest earned) is
recognized with the passage of time. For example, each period, Xerox
accrues interest on its loans and leases based on the interest rates
stipulated in the contracts.
b.
Revenue in $
2010
2009

2008

As % of Total Revenue
2010
2009
2008

Sales ................................
Service, outsourcing and
rentals ..........................

7,234

6,646

8,325

33.4%

43.8%

47.3%

13,739

7,820

8,485

63.5%

51.5%

48.2%

..................

21,633

15,179

17,608

Total Revenues

In 2010, revenue from services was nearly twice as large as revenue

from sales (63.5% versus 33.4%). This was not the case in prior years,
when the two types of revenue accounted for roughly the same amount.
Revenue from Services grew by 76% during 2010 ($13,739 / $7,820 =
1.757), which was significantly higher than the 9% revenue growth in
Sales ($7,234 / $6,646 = 1.088).

P5-35 (continued)
c.
2010

In $
2009

2008

R&D expenses................

781

840

884

..............

21,633

15,179

17,608

Total Revenues

As % of Total Revenue
2010
2009
2008
3.6%

5.5%

5.0%

In 2008 and 2009, R&D spending was 5 to 5.5% of total revenue. This
dropped significantly in 2010. One explanation is that R&D spending in
dollars dropped while revenues increased. Another explanation is that
services revenue increased dramatically during the year. This type of
revenue is likely not directly related to R&D. Sales of equipment are
more impacted by R&D spending. Therefore, using total revenues to
scale R&D spending makes it appear that the company has cut way back
on research. A better denominator would be Equipment sales revenue,
which yields proportions of 20.2% in 2010, 23.7% in 2009, and 18.9% in
2008.
d. 1. Restructuring costs typically fall into three general categories. (i)
accrual of liabilities for items, such as employee severance
payments, (ii) gains or losses from the write-off of assets, such as
plant assets and goodwill, and (iii) other restructuring and exit costs
including legal fees and costs to cancel contracts such as leases.
2. These restructuring costs are expensed in the current period despite
the fact that the impaired assets may not be formally written off and
the employees not paid their severance until future periods. In any
event, most analysts treat restructuring costs as transitory (one-time
occurrences). Accordingly, while restructuring costs should impact
the analysis, they typically do not affect the analysis to the same
degree as more persistent items such as recurring revenues and
expenses.
1. Some companies regularly report restructuring costs. Many analysts
treat these costs as recurring operating expenses and do not
consider them to be transitory items. This treatment implies that
these costs are more persistent in nature.

P5-35 (concluded)
2. Negative expense typically implies that an accrual in one or more
previous year(s) is overstated and the company is reversing the
overstatement in the current year. As a result, the previous years
expense was overstated, thus underestimating profit for that year.
e. Companies are not required to separately disclose revenue and expense
items unless they are deemed to be material. If not separately disclosed,
these items are aggregated with other immaterial items. Such
aggregation generally reduces the informativeness of income
statements. More problematic is that revenues and expenses can be
comingled in this other category to yield a small (net) number that
obscures the magnitude of the individual items comprising this
category. (Be aware that some companies net recurring operating
losses with nonrecurring nonoperating gains, yielding an immaterial
amount for other.)
D5-48
a. The affected parties include the managers who are making the decision,
as well as the company, its current and future stakeholders, the
companys auditors, suppliers, and current and future employees of a
firm with lower ethical standards. The sphere of parties who are affected
by ethical decisions is often much wider than one first believes.
b. The most common response of those supporting the proposed action is
a Machiavellian argument (the ends justify the means). The argument
goes that the company will soon return to profitability and affected
parties will benefit from the higher profitability that the subsequent
reversal of the deferred tax asset allowance will provide.
Other points to consider include the long-term effects of creating a
permissive environment that condones such action, including other
employee actions that may be counter to the interests of the company
(cheating on expense reports, etc.), possible retribution (termination,
litigation, criminal actions) against responsible employees if the activity
is discovered, etc.

Module 6
Q6-1.

When a company increases its allowance for uncollectible

accounts, it also records bad debt expense in the income
statement. If a company overestimates the allowance account, bad
debt expense is too high and net income is understated. As well,
accounts receivable (net of the allowance account) and total
assets are both understated on the balance sheet. In future
periods, the company will not need to add as much to its
allowance account since it is already overestimated (or, it can
reverse the excess existing allowance balance). As a result, future
net income will be higher.
On the other hand, if a company underestimates its allowance
account, then current net income will be overstated. In future
periods, however, net income will be understated as the company
must add to the allowance account and report higher bad debts
expense as accounts are written off.

Q6-2.

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

Q6-3.

FIFO holding gains occur when the costs of earlier purchased

inventory are matched against current selling prices. Holding gains
on inventories increase with an increase in the inflation rate and a
decrease in the inventory turnover rate. Conversely, if the inflation
rate is low or inventories turn quickly, there will be fewer holding
gains (inflationary profit) in inventory.

Q6-4.

If inventory costs are rising, (a) Last-in, first-out yields the lowest
ending inventory (b) Last-in, first-out yields the lowest net income,
(c) First-in, first-out yields the highest ending inventory, (d) First-in,
first-out yields the highest net income, (e) Last in, first-out yields the
highest cash flow because taxes are lowest.

Q6-5.

When costs are consistently rising, LIFO inventory costing method

yields a significant tax benefit because LIFO increases COGS
which reduces pretax income and taxes payable.

Q6-7.

As an asset is used up, its cost is removed from the balance sheet
and transferred to the income statement as expense. Capitalization
of costs onto the balance sheet and subsequent removal as
expense is the essence of accrual accounting. If a depreciable
asset is immediately expensed upon purchase, profit would be too
low in the year of purchase and too high in later years as revenues
earned by the asset are not matched with a corresponding cost.
The proper matching of expenses and revenues is essential for
proper income measurement.

Q6-8.

When a company revises its estimate of an asset's useful life or its

salvage value, depreciation expense must be recalculated. One way
is to depreciate the current undepreciated cost of the asset (original
cost accumulated depreciation) using the revised assumptions of
remaining useful life and salvage value.

Q6-11.

The gain or loss on the sale of a PPE asset is calculated as the

difference between the sales proceeds and the asset's net book
value. Sales proceeds in excess of net book values create gains;
sales proceeds less than net book values cause losses. Factors that
affect the size of the gain or loss include the amount of sales
proceeds (the selling price) and depreciation assumptions. Because
accumulated depreciation at the time of the assets sale affects the
net book value, the depreciation rate and salvage values used to
compute depreciation expense affect the gain or loss.

E 6-22
a. Bad debts expense computation
$90,000 1%
20,000 2%
11,000 5%
6,000 10%
4,000 25%
Total required balance in allowance
Less: Unused balance before adjustment
Bad debt expense for the year

=
=
=
=
=

$ 900
400
550
600
1,000
$3,450
(520)
$2,930

b.
Balance Sheet
Transaction

Cash
+
Asset

Record bad
debts
expense

Noncash
Assets
-2,930

Income Statement

LiabilContrib.
Earned
=
+
+
ities
Capital
Capital

Revenues

-2,930

Allowance for
=
Uncollectible
Accounts

Expenses

+2,930
Bad Debt =

Retained
Earnings

Net
Income
-2,930

Expense

c. Accounts receivable, net = $131,000 - $3,450 = $127,550

Reported in the balance sheet as follows:
Accounts receivable, net of allowance of $3,450 .......................

$127,550

E6-27
Units
1,000
1,800
800
1,200
4,800

Beginning Inventory
Purchases: #1
#2
#3
Goods available for sale

Cost
$ 20,000
39,600
20,800
34,800
$115,200

Units in ending inventory = 4,800 2,800 = 2,000

a. First-in, first-out

Ending Inventory

Units
1,200
800
2,000

Cost of goods available for sale

Less: Ending inventory
Cost of goods sold

@
@

Cost
$29
$26

=
=

Total
$34,800
20,800
$55,600

$115,200
55,600
$ 59,600

Balance Sheet
Transaction
Record FIFO
cost of goods
sold

Income Statement

Cash
Noncash
Liabil- Contrib.
Earned
+
=
+
+
Asset
Assets
ities
Capital
Capital
-59,600
Inventory

-59,600
Retained
Earnings

Revenues

ExpenNet
=
ses
Income
+59,600
-59,600
Cost of

Goods
Sold

b. Last-in, first-out

Ending inventory

Units
1,000
1,000
2,000

Cost of goods available for sale

Less: Ending inventory
Cost of goods sold

@
@

Cost
$20
$22

=
=

Total
$20,000
22,000
$42,000

$115,200
42,000
$ 73,200

c. Average cost
$115,200 / 4,800 = $24 average unit cost
2,000 $24 = $48,000 ending inventory
$115,200 - $48,000 = $67,200 cost of goods sold (or 2,800 $24)
d. 1. In most circumstances, the first-in, first-out method most closely
reflects the physical flow of inventory. First-in, first-out physical flow is
critical when inventory is perishable or in situations in which the
earliest items acquired are moved out first because of risk of
deterioration or obsolescence such as technology products and retail
items.
2. Last-in, first-out yields the highest cost of goods sold expense during
periods of rising unit costs, which in turn, results in the lowest taxable
income and the lowest income tax.
3. The first-in, first-out method results in the lowest cost of goods sold,
and the largest amount of income, in periods of rising prices. Of
course, this assumes that prices will continue to rise as they have in
the past. Companies cannot change inventory costing methods
without justification, and the change may be restricted by tax laws as
well.

E6-29

Beginning inventory
Purchases:
Purchase #1
Purchase #2
Purchase #3
Cost of goods available for sale

Units
100
650
550
200
1,500

@
@
@
@

Cost
$46
42
38
36

@
@

Cost
$36
38

=
=
=
=

Total
$ 4,600
27,300
20,900
7,200
$60,000

=
=

Total
$ 7,200
5,700
$12,900

a. First-in, first-out

Ending inventory ..........................

Units
200
150
350

Cost of goods available for sale .

Less: Ending inventory ...............
Cost of goods sold.......................

$60,000
12,900
$47,100

b. Average cost
Cost of Goods Available for Sale/Total Units Available for Sale
= $60,000 / 1,500 = $40 Average Unit Cost
Ending Inventory = 350 units $40 = $14,000
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold

$60,000
14,000
$46,000

c. Last-in, first-out

Ending inventory .........................

Cost of goods available for sale
Less: Ending inventory ..............
Cost of goods sold......................

Units
100
@
250
@
350

Cost
$46
42

=
=

Total
$ 4,600
10,500
$15,100
$60,000
15,100
$44,900

E6-31
a. Straight line:
($80,000 - $5,000) / 5 years = $15,000 per year
Balance Sheet
Cash
Transaction
+
Asset
Record
$15,000
depreciation
as part of
COGS*

Noncash
Assets

Income Statement

LiabilContrib.
Earned
=
+
+
ities
Capital
Capital

-15,000

Revenues

Expenses

+15,000

-15,000

Accumulated =
Depreciation

Retained
Earnings

Cost of
Goods
Sold*

Net
Income
-15,000

* Because the equipment is used exclusively in the manufacturing process, the

depreciation is more accurately recorded as part of cost of goods sold and not as
depreciation expense.

b. Double-declining-balance: Twice straight-line rate = 2 (100%/5) = 40%

Year
1
2
3
4

Book Value Rate Depreciation Expense

$80,000 0.40 = $32,000
($80,000 - $32,000) 0.40 =
19,200
($80,000 - $51,200) 0.40 =
11,520
($80,000 - $62,720) 0.40 =
6,912

5,368**
Total

$75,000

** The calculated depreciation expense of $4,147 [($80,000 - $69,632) 0.40] is not

enough to result in the $5,000 salvage value. Therefore, we adjust the depreciation in
year 5 to $5,368 so that the total depreciation expense is $75,000. This is called a
plug.

Balance Sheet
Transaction
Record
$32,000
depreciation
as part of
COGS*

Cash
+
Asset

Noncash
Assets
-32,000

Accumulated =
Depreciation

Income Statement

LiabilContrib.
Earned
+
+
ities
Capital
Capital
-32,000
Retained
Earnings

Revenues

Expenses

+32,000

Cost of
Goods
Sold*

Net
Income
-32,000

E6-35
$ millions
a. Average useful life = Depreciable asset cost / Depreciation expense
= ($8,579 - $113 - $478) / $540
= 14.8 years
Note: We eliminate land and construction in progress from the
numerator because land is never depreciated and construction in
progress represents assets that are not in service yet and are,
consequently, not yet depreciable. The footnote indicates that buildings
have estimated average useful lives of 23 years, machinery and
equipment of 11 years, dies, etc of 7 years, and all other of 5 years.
b. Percent used up

= Accumulated depreciation/ Depreciable asset cost

= $4,856 / ($8,579 - $113 - $478)
= 60.8%

Assuming that assets are replaced evenly as they are used up, we would
expect assets to be 50% used up, on average. Deeres 60.8% is higher
than this average. The implication is that Deere will require higher
capital expenditures in the near future to replace aging assets.

Module 7
Q7-1.

Current liabilities are obligations that require payment within the

coming year or operating cycle, whichever is longer.
Generally, current liabilities are settled with existing current assets
or operating cash flows.

Q7-2.

An accrual is the recognition of an event in the financial

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

Q7-3.

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

Q7-5.

Debt ratings reflect the relative riskiness of the rated company. This
riskiness relates to the probability of default (e.g., not repaying the
principal and interest when due). Higher debt ratings result in higher
market prices for the bonds and a correspondingly lower effective
interest rate for the issuer. Lower debt ratings result in lower market
prices for the bonds and a correspondingly higher effective interest
rate for the issuer.

M7-9
a. Accounts Payable, $110,000 (current liability).
b. Not recorded as a liability; an accounting transaction has not yet occurred
because Basu did not receive the drill press before year-end.
c. Liability for Product Warranty, $2,200 (current liability).
d. Bonuses Payable, $30,000 (current liability)computed as $600,000 5%.
This liability must be reported because the bonus relates to operating
results of 2012.

M7-10
a. Boston Scientific is offering bonds (maturing 2040) with a coupon
(stated) rate of 7.375% when the market rate (yield) is lower at 5.873%.
To obtain this expected rate of return, the bonds must sell at a premium
price of 120.71 (120.71% of par). The other bonds also sell at a premium,
but the premium is smaller because the market rate and the coupon rate
are closer than that for the bonds maturing in 2040.
b. The first bond matures in 2040 while the second matures in 2020. The
market generally demands a higher rate (yield) for a longer maturity debt
instrument.
M7-18
a. Financial leverage (which measures debt levels) is one of the ratios that
credit-rating agencies use to determine their ratings. Generally, the
higher (lower) the financial leverage, the lower (higher) the bond rating.
Therefore, by reducing its financial leverage, Cummins will improve its
bond rating. In short, all else equal, less debt suggests a greater
likelihood of payment on that lower level of debt.
b. Higher credit ratings on debt issues, reduce the yield expected by
investors and, therefore, higher debt issuance proceeds realized by the
issuing company. This implies that a higher credit rating for Cummins
will lower its borrowing costs.

M7-19
a. Selling price for $500,000, 9% bonds discounted at 8% (4% semiannually):
Present value of principal repayment ($500,000 0.45639a).......... $228,195
Present value of interest payments ($22,500 13.59033b) ............. 305,782
Selling price of bonds......................................................................... $533,977
a

Table 1, 20 periods at 4%.

Table 2, 20 periods at 4%.

Calculator inputs: N =20, I/YR = 4, PMT = 22,500, FV = 500,000,

PV = 533,975.82

b. Selling price for $500,000, 9% bonds discounted at 10% (5% semiannually):

Present value of principal repayment ($500,000 0.37689a).......... $188,445
Present value of interest payments ($22,500 12.46221b) ............. 280,400
Selling price of bonds......................................................................... $468,845
a

Table 1, 20 periods at 5%.

Table 2, 20 periods at 5%.

Calculator inputs: N =20, I/YR = 5, PMT = 22,500, FV = 500,000,

PV = 468,844.47

M7-20
a. Selling price of zero coupon bonds discounted at 8%
Present value of principal repayment ($500,000 0.45639a)......... $228,195
a

Table 1, 20 periods at 4%

Calculator inputs: N =20, I/YR = 4, PMT = 0, FV = 500,000,

PV = 228,193.47

b. Selling price of zero coupon bonds discounted at 10%

Present value of principal repayment ($500,000 0.37689a)......... $188,445
a

Table 1, 20 periods at 5%

Calculator inputs: N =20, I/YR = 5, PMT = 0, FV = 500,000,

PV = 188,444.74

M7-21
Balance Sheet
Transaction
a. Purchases
$300 of
inventory on
credit
b. Sells
inventory for
$420 on credit
c. Records
$300 cost of
sales
d. Receives
$420 cash for
accounts
receivable
e. Pays $300
cash to settle
accounts
payable

Income Statement

Cash
Noncash
LiabilContrib.
Earned
+
=
+
+
Asset
Assets
ities
Capital
Capital

Revenues

+300
=
Accounts
Inventory
Payable
+300

+420

+420

Retained
Earnings

=
Inventory

Retained
Earnings

Accounts
Receivable

300

300

+420
Cash

300
Cash

420
Accounts
Receivable

300
= Accounts
Payable

+420
Sales

ExpenNet
=
ses
Income

+420

300

+300
Cost of
Sales

Module 8
Q8-1.

Par value stock is stock that has a face value printed (identified) on
the stock certificate. Historically, par value was the minimum selling
price for one share.
From an accounting and analysis standpoint, there are no
implications. The par value of the common stock is the amount
added to the common stock account when the company sells stock.
The remainder of the sale price is added to the additional paid-incapital account. Stockholders equity increases by the total amount
regardless of whether one or two accounts (line items) are used.

Q8-2.

Typically, preferred stock has the following features: 1) Preferential

claim to dividends and to assets in liquidation, 2) Cumulative
dividend rights, and 3) No voting rights.

Q8-3.

Preferred stock is similar to debt when

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

Q8-4.

Dividends in arrears on preferred stock are the cumulative preferred

dividends that have not been paid to date. The dividends in arrears
and a current dividend must be paid to preferred stockholders
before common stockholders can receive any dividends. In the
example, the company must pay preferred stockholders $90,000 in
dividends ($500,000 0.06 3 years = $90,000) before paying any
dividends to common stockholders.

Q8-5.

A corporation's authorized stock is the maximum number of shares

of stock it may issue. When the corporation is formed, its charter
specifies the authorized amounts and classes of stock. A
corporation can later amend its charter to change the amount of

authorized capital, but such actions must be approved by the

companys shareholders. Shares that have been sold and issued to
stockholders are the company's issued stock.
Shares that have been sold and issued can be subsequently
reacquired by the corporationthese shares are called treasury
stock. When treasury stock is held, the issued shares exceed the
outstanding shares.
Q8-6.

Q8-7.

Q8-8.

Contributed capital represents the total investment contributed by

shareholders when they purchase stock. It is considered
contributed because the company is under no legal obligation to
repay the shareholders. Earned capital represents the cumulative
net income that the company has earned, less the portion of that
income that has been paid out to shareholders in the form of
dividends.
When profit is earned, the company can either pay out a portion of
that profit as a dividend or reinvest the earnings in order to grow the
company. In fact, many companies title the Retained Earnings
account as Reinvested Earnings. Earned capital, thus, represents an
implicit investment by the shareholders in the form of forgone
dividends.
Contributed capital is dividend into two accounts: the common or
preferred stock account at par and additional paid-in capital. The
common stock or preferred stock accounts at par increase by the
par value of each share issued. But, if companies sell shares for
more than par, it is the market price of the stock that determines the
companys proceeds. The difference between the shares market
price and its par value is added to the additional paid-in capital
account. The breakdown of contributed capital between the
common or preferred stock accounts and additional paid-in capital
is not informative it does not yield any implications regarding the
financial condition of the company.
A stock split refers to the issuance of additional shares to the
current stockholders in proportion to their ownership interests. This
is normally accompanied by a proportionate reduction in the par or
stated value of the stock. For example, a 2-for-1 stock split doubles
the number of shares outstanding and halves the par or stated value
of the shares. The market value of the stock typically falls to half in
the event of a 2:1 stock split. Consequently, there is no change to
the companys balance sheet; the amount of contributed capital
remains the same after the stock split. The major reason for a stock

split is to reduce the share price of the stock. It is believed that

when the stock price is very high, few investors can afford to
purchase the stock. Another possible reason is to lead shareholders
to believe that there has been some distribution of value.
Q8-9.

Treasury stock is stock, previously issued, that the corporation has

reacquired from shareholders.
A corporation might repurchase treasury stock to give to employees
who exercise stock options or to offset dilution resulting from
option grants. It is also used by management to prop up stock price
when management believes its stock is inappropriately underpriced.
On the balance sheet, treasury stock is carried at its cost (the cash
the corporation pays to acquire the stock) and is shown as a
deduction (a negative amount) on the balance sheet. Thus, total
stockholders' equity is net of treasury stock, which is known as a
contra-equity account.

Q8-10.

The $2,400 increase should not be shown on the income statement

as income or gain. The $2,400 is properly treated as additional
paid-in capital and is shown as such in the stockholders' equity
section of the balance sheet. The latter treatment is justified
because treasury stock transactions are considered capital rather
than operating transactions. GAAP does not permit corporations to
own themselves. Thus, the companys treasury stock is not
shown as an investment. GAAP prohibits companies from reporting
gains or losses from stock transactions with their own
shareholders, therefore no gain is reported.

Q8-11.

The book value per share of common stock is the total

stockholders' equity divided by the number of shares outstanding.
Shares outstanding are 300,000 issued less 40,000 treasury shares.
Thus book value is $4,628,000 / 260,000 = $17.80 per share.

Q8-12.

A stock dividend is the distribution of additional shares of a

corporation's stock to its existing stockholders. A stock dividend
does not change a stockholder's relative ownership interest,
because each stockholder owns the same fractional share of the
corporation before and after the stock dividend. There is empirical
evidence, however, suggesting that the stock price does not decline
fully to compensate for the additional shares issued. That is, if a
company does a 2-for-1 stock split, the market price of each share
should be half as much after the split. This does not always happen.

The price usually falls by only 45 to 48% of the pre-split price. One
hypothesis to explain this phenomenon is that, by splitting the
stock, the company is sending a signal to the market that the firm is
going to have a price increase (which warrants the split).
Q8-14.

Many companies repurchase shares (as treasury stock) in order to

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

M8-28

a. $1,000,000 6% .....................................................
Balance to common ..............................................
Per share
$60,000 / 20,000 shares ..............................
$100,000 / 80,000 shares ............................
b. $1,000,000 6% 2 years ....................................
Balance to common ..............................................
Per share
$120,000 / 20,000 shares ............................
$40,000 / 80,000 shares ..............................

Distribution to
Preferred
Common
$60,000
$100,000
$3.00
$1.25
$120,000
$40,000
$6.00
$0.50

M8-29
BAMBER COMPANY
STATEMENT OF RETAINED EARNINGS
FOR YEAR ENDED DECEMBER 31, 2012
Retained Earnings, December 31, 2011 ...........................

$347,000

Add: Net Income .................................................................

94,000
441,000

Less: Cash Dividends Declared .......................................

$35,000

Stock Dividends Declared.......................................

28,000

Retained Earnings, December 31, 2012 ...........................

63,000
$378,000

E8-34
Balance Sheet
Transaction

Cash
Asset

Feb 20: Issued

10,000 shares
of $1 par value +250,000
common stock Cash
at $25 cash per
share
Feb 21: Issued
15,000 shares
of $100 par
+4,125,000
value 8%
Cash
preferred stock
at $275 cash
per share
Jun 30:
Purchased
2,000 shares of 30,000
common stock Cash
at $15 per
share
Sep 25: Sold
1,000 shares of
treasury stock +21,000
Cash
at $21 cash per
share

Income Statement

Noncash
LiabilContrib.
Earned
=
+
+
Assets
ities
Capital
Capital
+10,000

Revenues

ExpenNet
=
ses
Income

Common
Stock

+240,000
Additional
Paid-in
Capital

+1,500,000
Preferred
Stock

+2,625,000
Additional
Paid-in
Capital

30,000
Treasury
Stock

+15,000
Treasury
Stock

+6,000
Additional
Paid-in
Capital

E8-38
Distribution to
Preferred
Common
a. Year 1

Year 2: Dividends in
arrears from Year 1
($750,000 8%)
Current year dividend
($750,000 8%)
Balance to common

$ 60,000
60,000
_______

$160,000

Total for Year 2

Year 3: Current year dividend
($750,000 8%)

b. Year 1
Year 2: Current year dividend
($750,000 8%)
Balance to common

$120,000

$160,000

$ 60,000

$ 60,000
$220,000

Year 3: Current year dividend

($750,000 8%)

$ 60,000

E8-43
a.
Balance Sheet
Transaction

Cash
Asset

Apr 1: Issue
stock dividend
on common
1
stock

Income Statement

Noncash
LiabilContrib.
=
+
+
Assets
ities
Capital
=

Earned
Capital

+250,000

-250,000

Common
Stock

Retained
Earnings

Revenues

ExpenNet
=
ses
Income

+15,000
Common
Stock

Dec 7: Issue
3% stock
dividend on
common
2
stock

Dec 20: Pay

cash
dividends on -102,400
Cash
preferred and
common
3
stock

+27,000
Additional
Paid-in
Capital

-42,000
Retained
Earnings

-102,400
Retained
Earnings

Large stock dividends are recorded at par value. The company reduces Retained Earnings and
increases Common Stock by $250,000 (50,000 shares 100% $5 par value). There is no effect
on APIC.

Small stock dividends are recorded at market value. The company reduces Retained Earnings
by the market value of the shares to be distributed (3% 100,000 shares $14 per share =
$42,000). Common Stock increases by the par value of the shares distributed (3% 100,000
$5 = $15,000) and APIC increases by the balance ($27,000).

Total dividends are 4,000 $5 = $20,000 for the preferred shares and 103,000 $0.80 = $82,400
for the common shares. Retained Earnings and Cash decrease to reflect the payment.

b.
KINNEY COMPANY
STATEMENT OF RETAINED EARNINGS
FOR YEAR ENDED DECEMBER 31, 2012
Retained Earnings, December 31, 2011
Add: Net Income
909,000
Less: Cash Dividends Declared
Stock Dividends Declared
Retained Earnings, December 31, 2012

$656,000
253,000
$102,400
292,000

394,400
$514,600