CHAPTER 8

Case 8-1

a. Trading securities - Securities held for resale

Securities available-for-sale - Securities not classified as trading securities or held-to-

maturity securities.

Securities held-to-maturity - Securities for which the reporting enterprise has both the
positive intent, and ability to hold to maturity.

Trading securities are reported at fair value, and all unrealized holding gains and losses
are also reported at fair value and included in periodic net income. Available-for-sale
securities are reported at fair value; however, unrealized holding gains and losses for
these securities are not included in periodic net income, rather they are reported as
comprehensive income until realized. Held-to-maturity securities are accounted for by
the historical cost the security's maturity value, is amortized over the remaining life of the
security.

b. Trading securities are reported as current assets on the balance sheet. Individual held-to-
maturity and available-for-sale securities are reported as either current assets or
investments as appropriate.

c. The individuals supporting current value maintain that all gains and losses affecting the
company during an accounting period that can be measured should be recorded and
reported. Since current values are generally available for marketable securities,
proponents of current value accounting hold that these current values should be reported
on the annual financial statements.

The individuals who fear that current value accounting might allow earnings management
are concerned about gains trading. A manager using a gains trading strategy would
transfer securities that have declined in value to a long-term asset account and retain
those securities that have increased in value under the temporary investment category.

Case 8-2

a. The average cost method is based on the assumption that the average costs of the goods
in the beginning inventory and the goods purchased during the period should be used for
both the inventory and the cost of goods sold.

The FIFO (first-in, first-out) method is based on the assumption that the first goods
purchased are the first sold. As a result, the inventory is at the most recent purchase
prices, while cost of goods sold is at older purchase prices.
The LIFO (last-in, first-out) method is based on the assumption that the latest goods
purchased are the first sold. As a result, the inventory is at the oldest purchase prices,
while cost of goods sold is at more recent purchase prices.
b. In an inflationary economy, LIFO provides a better matching of current costs with current
revenues because cost of goods sold is at more recent purchase prices. Net cash inflow is
generally increased because taxable income is generally decreased, resulting in payment
of lower income taxes.

c. Where there is evidence that the utility of goods to be disposed of in the ordinary course
of business will be less than cost, the difference should be recognized as a loss in the
current period, and the inventory should be stated at market value in the financial
statements. In accordance with the concept of conservatism, inventory should be valued
at the lower of cost or market.

Case 8-3

a. Inventory cost should include all reasonable and necessary costs of preparing inventory
for sale. These costs include not only the purchase price of the inventories, but also the
other costs associated with readying inventories for sale.

b. The lower of cost or market rule produces a realistic estimate of future cash flows to be
realized from the sale of inventories. This is consistent with the principle of
conservatism, and recognizes (matches) the anticipated loss in the income statement in
the period in which the price decline occurs.

c. Steel's inventories should be reported on the balance sheet at market. According to the
lower of cost or market rule, market is defined as replacement cost. Market cannot exceed
net realizable value and cannot be less than net realizable value less the normal profit
margin. In this instance, replacement cost is between net realizable value and net
realizable value less the normal profit margin. Therefore, market is established as
replacement cost. Since market is less than original cost, inventory should be reported at
market.

d. Ending inventories and net income would have been the same under either lower of
average cost or market or lower of FIFO cost or market. In periods of declining prices,
the lower of cost or market rule results in a write-down of inventory cost to market under
both methods, resulting in the same inventory cost. Therefore, net income using either
inventory method is the same.

Case 8-4

a. The direct write-off method overstates the trade accounts receivable on the balance sheet
by reporting them at more than their net realizable value. Furthermore, because the write-
off often occurs in a period after the revenues were generated, the specific write-off
method does not match bad debts expense with the revenues generated by sales in the
same period.

b. One allowance method estimates bad debts based on credit sales. The method focuses on
the income statement and attempts to match bad debts with the revenues generated by the
sales in the same period.
 The other allowance method estimates bad debts based on the balance in the trade
accounts receivable accounts. The method focuses on the balance sheet and attempts to
value the accounts receivable at their future collectible amounts.

c. Anth should account for the collection of the specific accounts previously written off as
uncollectible as follows:

* Correction of allowance account by debiting accounts receivable and crediting

allowance for doubtful accounts.
* Collection of specific accounts previously written off as uncollectible by debiting
cash and crediting accounts receivable.

d. Anth should report the face amount of the interest-bearing notes receivable and the
related interest receivable for the period July 1, 2013 through December 31, 2013, on its
December 31, 2013, balance sheet as current assets. Both assets are due on June 30, 2014,
which is within one year of the date of the balance sheet.

Anth should report interest income from the notes receivable on its income statement for
the years ended December 31, 2013 and 2014. The interest income would be equal to the
amount accrued on the notes receivable at the stated rate for six months in 2013. Interest
accrues with the passage of time, and it should be accounted for as an element of income
over this period. The remaining six months of interest will be reported on Arths
December31,2014 income statement.

Case 8-5

a. Cost, which has been defined generally as the price paid or consideration given to acquire
an asset, is the primary basis for accounting for inventories. As applied to inventories,
cost means, in principle, the sum of the applicable expenditures and charges directly or
indirectly incurred in bringing an article to its existing condition and location. These
applicable expenditures and charges include all acquisition and production costs but
exclude all selling expenses and that portion of general and administrative expenses not
clearly related to production.

b. Market, as applied to the valuations of inventories, means the current bid price prevailing
at the date of the inventory for the particular merchandise in the volume which is usually
purchased by the company. The term is applicable to inventories of purchased goods and
to the basic elements of cost (materials, labor and overhead) of goods that have been
manufactured. Therefore, market means current replacement cost except that it should not
exceed the net realizable value (estimated selling price less predicted cost of completion
and disposal) and should not be less than net realizable value reduced by an allowance for
a normal profit margin.

c. The usual basis for carrying forward the inventory to the next period is cost. Departure
from cost is required, however, when the utility of the goods included in the inventory is
less than their cost. This loss in utility should be recognized as a loss of the current
period, the period in which it occurred. Furthermore, the subsequent period should be
charged for goods at an amount that measures their expected contribution to that period.
In other words, the subsequent period should be charged for inventory at prices no higher
than those which would have been paid if the inventory had been obtained at the
 beginning of that period. (Historically, the lower of cost or market rule arose from the
accounting convention of providing for all losses and anticipating no profits.)

In accordance with the foregoing reasoning the rule of "Cost or market, whichever is
lower" may be applied to each item in the inventory, to the total of the components of
each major category, or to the total of the inventory, whichever most clearly interprets
operations The rule is usually applied to each item, but if individual inventory items enter
into the same category or categories of finished product alternative procedures are
suitable.

d. The arguments against the use of the lower of cost or market method of valuing
inventories include the following:

1. The method requires the reporting of estimated losses (all or a portion of the excess
of actual cost over replacement cost) as definite income charges even though the
losses have not been sustained to date and may never be sustained. Under a consistent
criterion of realization a drop in selling price below cost is no more a sustained loss
than a rise above cost is a realized gain.

2. A price shrinkage is brought into the income statement before the loss has been
sustained through sale. Furthermore, if the charge for the inventory write-down is not
made to a special loss account, the cost figure for goods actually sold is inflated by
the amount of the estimated shrinkage in price of the unsold goods. The title "Cost of
Goods Sold" therefore becomes a misnomer.

3. The method is inconsistent in application in a given year because it recognizes the

propriety of implied price reductions but gives no recognition in the accounts or
financial statements to the effect of price advances.

4. The method is also inconsistent in application in one year as opposed to another

because the inventory of a company may be valued at cost one year end and at
market at the next year end.

5. The lower of cost or market method values the inventory on the balance sheet
conservatively. Its effect on the income statement, however, may be the opposite.
Although the income statement for the year in which the unsustained loss is taken is
stated conservatively, the net income on the income statement of the subsequent
period may be distorted if the expected reductions in sales prices do not materialize.

Case 8-6

a. The use of the allowance method based on credit sales to estimate bad debt is consistent
with the matching principle because bad debts arise from and are a function of making
credit sales. Therefore, bad debt expense for the current period should be matched with
current credit sales. This is an income statement approach because the balance in the
allowance for bad debts account is ignored when computing bad debt expense.

The allowance method based on the balance in accounts receivable is not consistent with
the matching principle. This method attempts to value accounts receivable at the amount
expected to be collected. The method is facilitated by preparing an aging schedule of
accounts receivable and plugging bad debt expense with the adjustment necessary to
 bring the allowance account to the required balance. Alternatively, the ending balance in
accounts receivable can be used to determine the required balance in the allowance
account without preparing an aging schedule by using composite percentage. Bad debt
expense is then determined in the same manner as when an aging schedule is used.
However, neither of these approaches associates bad debt expense with the period of sale,
especially for sales made in the last month or two of the period.

b. On the balance sheet, the allowance for bad debts is presented as a contra asset account to
accounts receivable with the resulting difference representing the accounts receivable net
(i.e., their net realizable value). Bad debt expense would generally be included on
Carme's income statement with the other operating (selling/general and administrative)
expenses for the period. However, theoretical arguments can be made for (1) reducing
sales revenue by the bad debts adjustment in the same manner that sales returns and
allowances and trade discounts are considered reductions of the amount to be received
from sales of products or (2) classifying the bad debts expense as a financial expense.

Case 8-7

a. During the first year Key should report the securities at $550,000 on the balance sheet
under the long-term investment category (Original cost of $500,000 and an increase in
market valuation of $50,000. (It is possible that some of the portfolio could be disclosed
as a current asset if Key plans on selling some of its investment during the next year.)
This $50,000 increase in market valuation would be disclosed on Keys financial
statements as an increase in other comprehensive income. During the second year Key
should disclose the securities at $475,000 on the balance sheet under the long-term
investment category. Since the original cost of the investments remaining at the end of
year 1 was $475,000, the cost balance indicates that additional investments of $105,000
(500,000- 80,000-525,000) were purchased in year 2). The decrease in market valuation
will be reported on Key's financial statements as a $95,000 decrease in other
comprehensive income ($550,000 30,000 + 50,000 - 95,000). Additionally, Key should
report a gain on the sale of investments of $20,000 during the second year ($100,000
80,000). The previously recorded increase in value was reported as an increase in other
comprehensive income and is removed from that category and classified as a gain at the
time of the sale).

b. If these securities had been categorized as trading securities, the asset valuations and
method of reporting on the balance sheet will be the same as Part (a) except that the
securities will be disclosed under the current assets section of the balance sheet instead of
the long-term investments section. In the first year Key will report an unrealized gain of
$50,000 on its income statement ($550,000 - 500,000). In the second year Key will
report an unrealized loss of $95,000 on its income statement. Key will not record a gain
on the sale of the securities in the second year because this gain was reported as an
unrealized gain on Keys income statement in the first year.

Case 8-8

a. Arguments for the specific identification method are as follows:

(1) It provides an accurate and ideal matching of costs and revenues because the cost
is specifically identified with the sales price.
 (2) The method is realistic and objective since it adheres to the actual physical flow
of goods rather than an artificial flow of costs.

(3) Inventory is valued at actual cost instead of an assumed cost

Objections to the specific identification method include the following:

(1) The cost of using it-restricts its use to goods of high unit value.

(2) The method is impractical for manufacturing processes or cases in which units
are commingled and identity lost.

(3) It allows an artificial determination of income by permitting arbitrary selection of

the items to be sold from a homogenous group.

(4) It may not be a meaningful method of assigning costs in periods of changing

price levels.

b. The first-in, first-out method approximates the specific identification method when the
physical flow of goods is on a FIFO basis. When the goods are subject to spoilage or
deterioration, FIFO is particularly appropriate. In comparison to the specific
identification method, an attractive aspect of FIFO is the elimination of the danger of
artificial determination of income by the selection of advantageously priced items to be
sold. The basic assumption is that costs should be charged in the order in which occurred.
As a result the inventories are stated at the latest costs. When the inventory is consumed
and valued in the FIFO manner, there is no accounting recognition of unrealized gain or
loss. A criticism of the FIFO method is that it maximizes the effects of price fluctuations
upon reported income because current revenue is matched with the oldest costs which are
probably least similar to current replacement costs. On the other hand, this method
produces a balance sheet value for the asset close to current replacement costs. It is
claimed that FIFO is deceptive when used in a period of rising prices because the
reported profit is not fully available since a part of it must be used to replace inventory at
a higher cost.

The results achieved by weighted average method resemble those of the specific
identification method where items are chosen at random or there is a rapid inventory
turnover. Compared with the specific identification method, the weighted average has the
advantage that the goods need not be individually identified; therefore accounting is not
so costly and the method can be applied to fungible goods. The weighted average method
is also appropriate when there is no marked trend in price changes. In opposition, it is
argued that the method is illogical. Since it assumes that all sales are made proportionally
from all purchases and that inventories will always include units from the first purchases,
it is argued that the method is illogical because it is contrary to the chronological flow of
goods. In addition, in periods of price changes there is a lag between current costs and
costs assigned to income or to the valuation of inventories.

If it be assumed that actual cost is the appropriate method of valuing inventories, last-in,
first-out is not theoretically correct. In general, LIFO is directly adverse to the specific
identification method because the goods are not valued in accordance with their usual
physical flow. An exception is the application of LIFO to piled coal or ores which are
 more or less consumed in a LIFO manner. Proponents argue that LIFO provides a better
matching of current costs and revenues.

During periods of sharp price movements, LIFO has a stabilizing effect upon reported
profit figures because it eliminates paper profits and losses on inventory and smoothens
the impact of income taxes. LIFO opponents object to the method principally because the
inventory valuation reported in the balance sheet could be seriously misleading. The
profit figure can be artificially influenced by management through contracting or
expanding inventory quantities. Temporary involuntary depletion of LIFO inventories
would distort current income by the previously unrecognized price gains or losses
applicable to the inventory reduction.

Case 8-9

a. According to SFAC 5, net realizable value is the nondiscounted amount of cash, or its
equivalent, into which an asset is expected to be converted in the future net of direct
costs, if any, necessary to make the conversion.

b. i. The balance sheet approach to estimating bad debts provides the better estimate of
net realizable value. Aging reports receivables measured in terms of how much is
expected to be collected from subsets of the receivables categorized by age. Older
receivables would be expected to yield proportionately less cash than more recent
receivables. The income statement approach does not purport to measure how much
is expected to be collected from the receivables.

Rather it measures how much is expected to be uncollectible from a given years

sales.

ii. Liquidity is the ability to pay current debt and continue operations. Working capital
is the difference between current assets and current liabilities. The balance sheet
approach to measuring bad debts would be more useful in providing a measure of
liquidity. As stated above this approach provides a better estimate of net
realizability and hence the amount of cash that would be available to pay current
liabilities.

iii. The income statement approach provides better matching. The matching concept
implies that revenues should be matched with the cost of generating them.
Estimating bad debts based on net sales attempts to subtract from sales those that
will not be collected thereby matching them with cost, those that will not realize
cash.

iv. The balance sheet approach is more consistent with the definition of comprehensive
income. Comprehensive income is the change in net assets occurring during the
accounting period for non-owner transactions. The balance sheet approach provides
a direct measure of those changes and hence a direct measure of the effect of those
changes on comprehensive income.

v. The income statement approach is more consistent with financial capital

maintenance. It provides a direct measure of the effect of transactions, sales, on
future cash flows.
 vi. The balance sheet approach is more consistent with physical capital maintenance
because it provides balance sheet measures which are closer to current value.

Case 8-10

a. .i. Short-term prepaids are classified as current assets because they will be consumed
during the current operating cycle or one year whichever is longer. These assets will
not be converted into cash. Rather, they would require the use of cash in the near
future had cash not already been expended.

Prepaids meet the definition of assets found in the conceptual framework because
they will provide future benefit. For example, prepaid rent is an asset. The right to
use an asset, say office space, was paid for in advance. That payment provides future
benefit: the use of the asset over some future time period.

Prepaids do not provide working capital in the usual sense of the definition of
working capital. Working capital is a measure of the ability of the firm to pay
currently maturing debt. Since prepaids will not generate cash, they will not be used
to pay debt. However, it may be argued that they indirectly provide liquidity because
the services which have already been paid for are needed for operations. If they had
not already been paid for, they would require the use of cash which would decrease
the firms ability to pay current debt.

ii. The most convincing argument for excluding prepaids from working capital is that
they will not provide cash to pay currently maturing debt. They have no net
realizable value. If not, it is difficult to say that prepaids provide liquidity.

b. Accountants include short-term unearned revenues as current liabilities because they will
be earned by performing services during the current operating cycle or year whichever is
longer. The conceptual framework defines liabilities as probable future sacrifices of
economic benefits arising from present obligations of a particular entity to transfer assets
or provide services to other entities in the future as the result of prior transactions or
events. Yes, unearned revenues meet the definition of liabilities. They are present
obligations to provide services to other entities in the future as a result of prior
transactions or events (the receipt of cash from an arms length transaction).

Since they are classified as current liabilities, current unearned revenues decrease
working capital. However, they will not require the expenditure of current assets.

c. Current liabilities are defined as liabilities that will be paid out of current assets or
replaced by other current liabilities. Current unearned revenues will not be paid with
cash or any other assets. Moreover, they will not be replaced by other current liabilities.
And if the purpose of classification of liabilities as current is to provide measures of
liquidity, it is difficult to see how a liability that will not be paid affects liquidity.

FASB ASC 8-1 Current Assets and Current Liabilities

Information on the disclosure of current assets and current liabilities is found at FASB
ASC 210. It can be accessed by searching the glossary for current assets and current
 liabilities. The relevant information is found at 210-10-45. After accessing the topic use
the printer friendly with sources option .

FASB ASC 8-2 Offsetting Assets and Liabilities

Search offsetting assets and liabilities

Found at 210-20
Us printer friendly with sources option after accessing the topic

FASB ASC 8-3 Inventory

The objective of accounting for inventory is found at FASB ASC 330-10-10.

Search objective of accounting for inventory.

Found at FASB ASC 330 Inventory > 10 Overall > 10 Objectives

Use the printer friendly with sources option to find the original source.

FASB ASC 8-4 Examples of Current Assets

From topic list select Presentation and Balance Sheet. Found under Other Presentation
Matter

Classification of Current Assets

Topic 210-10-45

FASB ASC 8-5 Classification of Current Liabilities

From topic list select Presentation and Balance Sheet. Found From topic list select
Presentation and Balance Sheet. Found under Other Presentation Matter

Classification of Current Liabilities

Topic 210-10-45

FASB ASC 8- 6 Compensating Balances

Search compensating balances

Found at 210-10-S99

FASB ASC 8-7 SFAS 115

Cross Reference FAS 115.

Found at 320-10 Investments-Debt and Equity Securities.

FASB ASC 8-8 ARB 43 and Inventory

Found through Cross Reference.ARB 43 Topic 330-10-05

Use printer friendly with sources option to find relevant items.

Room for Debate

Debate 8- 1

Team 1 Defend LIFO

Cost of goods sold if the purchase is postponed until 2015:

Beginning Inventory:
First Layer 10,000 x $15 $ 150,000
Second Layer 22,000 x $18 396,000
Purchases 250,000 x $20 5,000,000
Available 282,000 $5,546,000
Sold (245,000)
Ending Inventory 37,000 646,000
Cost of Goods Sold $4,900,000

Cost of goods sold if the purchase is made in 2014:

Available from above 282,000 $5,546,000

Additional Purchase 40,000 x $17 680,000
Available 322,000 $6,226,000
Sold ( 245,000)
Ending Inventory 77,000 1,446,000
Cost of Goods Sold $4,780,000

Difference $ 120,000

Calculation of ending inventory:

Purchase in 2014 2015

10,000 x $15 $ 150,000 $ 150,000
22,000 x $18 396,000 396,000
5,000 x $20 100,000
45,000 x $20 900,000
Ending Inventory $ 1,446,000 $ 646,000

Cost of sales
Purchase in 2014 2015
40,000 x $17 $ 680,000
205,000 x $20 4,100,000
245,000 x $20 $ 4,780,000 $ 4,900,000

The difference: 40,000 x ($20-17) = $ 120,000

The use of LIFO allows MVP to expense 40,000 units as cost of sold at $17 rather than
$20, thereby lowering cost of sales by $120,000 if the purchase is made in 2014. This
shows that management can manipulate earnings under LIFO simply by choosing when
to purchase. Even though it is obvious that these items were not sold or consumed during
the period. This makes the income statement look better than it otherwise would. Hence,
for MVP the use of LIFO has value. To management, it could mean a bigger bonus.

The use of LIFO is based on the assumption that current costs should be matched against
it. Although LIFO does not use current cost, the most recent costs are used to calculate
cost of sales; hence, LIFO yields the closest approximation to current value of any cost
based method of inventory valuation. As such, it provides the closest historical cost
measure of real income and is consistent with the concept of physical capital
maintenance. In addition, LIFO may eliminate inventory holding gains when the
inventory remains stable from year to year, and the use of LIFO when prices are rising
reduces taxable income and hence, the payment of income tax.

LIFO is better than FIFO because during inflation, FIFO results in matching older, lower
cost against revenues. The result is inflated profits that could be misleading to inventors,
creditors and other users. Inflated profits can result in the payment of additional income
taxes and it makes it appear as though the company has more available to distribute in
dividends than it should.

Team 2 Defend FIFO

Cost of goods sold under FIFO would be the same regardless of whether the inventory
were purchased in 2014 or 2015 because sales would be calculated using old costs, and
would not be affected by recent purchases. The following calculations are made under
the assumption that the inventory layers result from the application of FIFO.

Cost of goods sold if the purchase is postponed until 2015:

Beginning Inventory:
First Layer 10,000 x $15 $150,000
Second Layer 22,000 x $18 396,000
Purchases 250,000 x $20 5,000,000
Available 282,000 $5,546,000
Sold (245,000)
Ending Inventory 37,000 740,000
Cost of Goods Sold $4,806,000

Cost of goods sold if the purchase is made in 2014:

Available from above 282,000 $5,546,000

Additional Purchase 40,000 x $17 680,000
Available 322,000 $6,226,000
Sold ( 245,000)
Ending Inventory 77,000 1,42000
Cost of Goods Sold $4,806,000

Difference $ 0
 Calculation of ending inventory:

Purchase in 2014 2015

37,000 x $20 $ 740,000 $ 740,000
40,000 x $17 680,000
Ending Inventory $1,420,000 $ 740,000

Cost of sales
Purchase in 2014 2015
10,000 x $15 $ 150,000 $ 150,000
22,000 x $18 396,000 396,000
213,000 x $20 4,260,000 4,260,000
$4,860,000 $4,860,000

The use of FIFO satisfies the historical cost principle. The valuation of flows is
consistent with the typical actual flow of goods. It also satisfies the matching principle
since the historical cost is matched with revenue. And, inventory valuation on the
balance sheet more closely resembles replacement cost because it comprises recent
prices. This allows users to better evaluate future cash flows to replace the inventory.

An added advantage of FIFO over LIFO is demonstrated by this case. It is not possible to
manipulate cost of sales by the use of FIFO, while manipulation is obviously possible
under LIFO. Hence, the use of FIFO would satisfy the qualitative characteristic of
neutrality.

Debate 8-2 Components of working capital

Team 1

A companys working capital is the net short-term investment needed to carry on day-to-
day activities. Since inventory is used in day-to-day activities it should be included. The
inventory must be sold to generate cash flow. If anything we could argue that because
inventory is reported at cost, it is actually undervalued, but it would not follow that it
should be excluded. Except for a few industries (such as breweries) that have long
operating cycles, companies typically turn their inventory many times during the year,
continuously providing operating cash inflows to pay currently incurred short term
obligations.

Paton argued that a fixed asset will remain in the enterprise two or more periods, whereas
current assets will be used more rapidly; fixed assets may be charged to expense over
many periods, whereas current assets are used more quickly; and fixed assets are used
entirely to furnish a series of similar services, whereas current assets are consumed.
Therefore, all assets that meet the definition of current assets, should be included in
calculating working capital

The working capital concept provides useful information by giving an indication of an

entitys liquidity and the degree of protection given to short-term creditors. Specifically,
the presentation of working capital can be said to add to the flow of information to
financial statement users by (1) indicating the amount of margin or buffer available to
meet current obligations, (2) presenting the flow of current assets and current liabilities
from past periods, and (3) presenting information on which to base predictions of future
 inflows and outflows. In the following sections, we examine the measurement of the
items included under working capital.

Prepaid expenses have been included as current assets because if they had not been
acquired, they would require the use of current assets in the normal operations of the
business

Team 2

Current U.S. and international practice is based on the assumption that the items
classified as current assets are available to retire existing current liabilities and that the
measurement procedures used in valuing these items provide a valid indicator of the
amount of cash expected to be realized or paid. Closer examination of these assumptions
discloses two fallacies: (1) not all the items are measured in terms of their expected cash
equivalent, and (2) some of the items will never be received or paid in cash.

However, prepaids will be used rather than exchanged for cash and, therefore, do not aid
in predicting future cash flows.

If the working capital concept is to become truly operational, it would seem necessary to
modify it to show the amount of actual buffer between maturing obligations and the
resources expected to be used in retiring them. Such a presentation should include only
the current cash equivalent of the assets to be used to pay the existing debts. It would
therefore seem more reasonable to base the working capital presentation on the
monetarynonmonetary dichotomy used in price level accounting (See Chapter 17.)
because monetary items are claims to or against specific amounts of money; all other
assets and liabilities are nonmonetary.

The monetary working capital presentation would list as assets: cash, cash equivalents,
temporary investments, and receivables and would list as liabilities current payables. It
would not include inventories, prepaid assets or deferred liabilities. Also more
meaningful information could be provided if all temporary investments were measured
by their current market price, including securities held to maturity. This presentation
would have the following advantages: (1) it would be a more representative measure of
liquidity and buffer because it would be more closely associated with future cash flows,
(2) it would provide more information about actual flows because only items expected to
be realized or retired by cash transactions would be included, and (3) it would allow
greater predictive ability because actual cash flows could be traced.

Debate 8-3 Capitalization vs expense

Team 1: Present arguments for capitalizing all of the above costs. Your arguments should utilize
the Conceptual Framework definitions and concepts.

The primary argument in favor of capitalizing all of the costs is the historical cost
principle. According to the historical cost principle, the historical cost of an asset is all
costs that it takes to acquire the asset and get it ready for its intended use. To apply the
historical cost principle to an item, it must first meet the definition of an asset. We argue
that all of these costs (the purchase price of the property, the cost to remove the building,
the cost to remove the tanks and refine the soil) are necessary to acquire the site for the
 restaurant and thus will provide future economic benefit. We also argue that the cost to
construct the building, as well as the cost of the avoidable interest that was incurred
during construction, were necessary to acquire the building and get it ready for its
intended use. Thus, they should all be capitalized as part of the historical cost of the
assets land and building.

SFAC No. 6 defines an asset as a probable future economic benefit obtained or controlled
by a particular entity as a result of a past transaction. Without question, the acquisition
of the site for the restaurant meets this definition of an asset. It will provide a future
economic benefit because the restaurant will be built there and is intended to generate a
profit for its owner(s).

No one would argue that the purchase price of $900,000 should be capitalized as part of
the assets cost. In addition it has been standard accounting practice (and thus a part of
GAAP) that the $30,000 cost to remove a building is a part of getting the land ready for
its intended use and thus should be capitalized as land, along with the purchase price.

In addition, Entre is required by the government to remove underground tanks and to

refine the soil. The cost to remove the tanks is $40,000 and the cost to refine the soil is
$30,000. Like the cost incurred to remove the building these costs are necessary to get
the land ready to build the building. Without incurring these costs, Entre cannot build the
restaurant and will not be able to receive future benefits (return) from his investment.
Thus, we argue that these costs meet the definition of an asset and are consistent with the
historical cost principle.

Obviously, the $1,800,000 cost incurred to construct the building to house the restaurant
should be capitalized as part of the building cost. The building is arguably an asset. It
will be used as Entres place of business where his employees will prepare and serve food
to customers. Thus, it meets the definition of an asset because it provides a probable
future benefit.

In addition, the FASB determined in SFAS No. 34, that avoidable interest incurred to
construct an asset, such as Entres restaurant, should be capitalized as a part of the cost of
the asset. It is a necessary cost to construct the asset because had the asset not been
constructed the debt used to finance the construction and thus the cost of borrowing
(interest) could have been avoided. Because it could have been avoided, the interest is
deemed to be necessary to acquire the asset and get it ready for its intended use. Thus,
capitalization of $22,000 of avoidable interest incurred during construction as part of the
assets cost is consistent with the historical cost principle.

Team 2: Criticize capitalization of the cost to remove the tanks and refine the soil and the
capitalization of interest during construction. Do they provide added service
potential? Your arguments should utilize the Conceptual Framework definitions and
concepts

We believe that neither the costs of removing the tanks and refining the soil nor the cost
of avoidable interest incurred during construction of the restaurant should be capitalized
and reported as costs of assets. Our argument is based primarily on the position that
these expenditures do not add future service potential to the land or to the building. Thus,
they do not meet the definition of an asset. This means that if we report these costs as
assets we would be violating the qualitative characteristic of representational faithfulness.
 We would be reporting a non-asset as an asset. Thus, it would not be what it purports to
be.

SFAC No. 6 defines an asset as a probable future economic benefit obtained or controlled
by a particular entity as a result of a past transaction. Neither removing the tanks at a
cost of $40,000 nor incurring a $30,000 expenditure to refine the soil once the tanks are
removed does not increase the expected future cash inflow from the operation of the
restaurant. Thus, it provides no future benefit and is not an asset. Furthermore, if we
were to purchase an identical adjacent site that does not have a service station on it, the
current site would not be more valuable than the adjacent site. Since both sites could be
used to generate the same future cash flows and profit, one is not more valuable than the
other. As a result, if we were to capitalize the costs of removing the tanks and refining
the soil, we contend that the historical cost of the land would be overstated. Is not the
initial value of an asset equivalent to the present value of the future cash flows expected
from its use?

With regard to the capitalization of the $22,000 of so called avoidable interest that is
incurred during construction, we can make similar arguments. It does not add to the
future service potential of the building because it has no impact on the future cash flows
or profit expected from the buildings use and thus does not add to its value. Moreover,
the source of financing has nothing to do with the cost or value of the asset itself.
Modern finance theory would separate the two. What would make a building financed
with debt more valuable than a building that was financed with equity? Nothing would.
If Entre financed the building with equity it would produce the same future cash flows as
it would if he financed it with debt. Moreover, we could argue that the cost of financing
with equity is potentially more expensive than the cost of financing with debt. Due to the
riskiness associated with uncertain returns to investors, the return on an equity investment
is generally higher than the companys incremental borrowing rate. We argue that if
capitalization of avoidable interest should be added to the cost of the asset, then so should
the avoidable cost of capital that is effectively incurred when financing the construction
with equity.

WWW

Case 8-12

a. If the terms of the purchase are f.o.b. shipping point (manufacturers plant), Zippy
Enterprises should include in its inventory goods purchased from its suppliers when the
goods are shipped. For accounting purposes, title is presumed to pass at that time.
b. Freight-in expenditures should be considered an inventoriable cost because they are part
of the price paid or the consideration given to acquire the asset.
c. Theoretically the net approach is the more appropriate because the net amount (1)
provides a correct reporting of the cost of the asset and related liability and (2) presents
the opportunity to measure the inefficiency of financial management if the discount is not
taken. Many believe, however, that the difficulty involved in using the somewhat more
complicated net method is not justified by the resulting benefits.
d. Products on consignment represent inventories owned by Zippy Enterprises, which are
physically transferred to another enterprise. However, Zippy Enterprises retains title to
the goods until their sale by the other company (Touk Inc.). The goods consigned are still
included by Zippy Enterprises in the inventory section of its balance sheet. Frequently the
inventory is reclassified from regular inventory to consigned inventory

Case 8-13

The gross method of recording inventory is easy to apply. Purchases are recorded at the
gross price. When a discount is taken, it is recorded as discounts taken. However, at the
end of the accounting period, net purchases will be overstated unless adjusted for
discounts that are expected not to be taken. Also, this method does not take into
consideration that the discount theoretically represents interest on the net amount
borrowed. Finally, the method does not highlight the cost of not taking discounts.

The net method is also easy to apply. Purchases are recorded net of the discount. The
theoretical justification is that discounts not taken are due to the passage of time and
hence are more like interest on borrowed funds. The net method treats discounts not
taken as interest expense. Also, the net method allows for better management control by
reporting the cost of borrowing (the discount lost) separately. At the end of the
accounting period, an adjustment should be made for the estimated discounts that will be
lost.

Case 8-14

In IAS No. 2, the IASB held that the objective of inventory reporting is to determine the
proper amount of cost to recognize as an asset and carry forward until the related
revenues are recognized. The board stated a preference for the specific identification
method of inventory valuation when the items are interchangeable or are produced and
segregated for specific projects. This method was viewed as inappropriate when large
numbers of interchangeable items are present. In these cases the IASB stated a preference
for either FIFO or weighted average methods; however, LIFO was an allowed alternative.
Under the revised IAS No. 2, the use of LIFO is no longer allowed. Additionally, under
IAS N0. 2, inventory is to be measured at the lower of cost or net realizable value
(estimated selling price less estimated costs of completion and sale). Inventory write-
downs are calculated using net realizable value on an item-by-item basis, but allows
write-downs to occur by groups of similar products in special circumstances.. IAS No. 2
requires inventory to be written down to net realizable value (floor) on an item-by-item
basis, but allows write-downs to occur by groups of similar products in special
circumstances. This contrasts to U. S. GAAP under which write-downs are normally
determined either on an item-by-item, group, or categorical basis. Also, IAS No 2 allows
previous inventory write-down reversals to be recognized in the same period as the write-
down; whereas, any inventory write-downs under U.S. GAAP cannot subsequently be
reversed.

As the FASB and the IASB move toward convergence of accounting standards, the LIFO
issue will need to be resolved. Although the process of converging U.S. GAAP with
international GAAP has made a great deal of progress, there are still many issues yet to
be addressed, including the fate of the LIFO method. For over a decade, FASB and the
IASB have had an ongoing agenda of projects, the objective of which is to move the
 process of convergence forward. For the period 20062008, numerous convergence-
related issues were identified as either being on an active agenda or on a research agenda
prior to being added to an active agenda. However, the issues of LIFO and inventory
valuation in general are not included on the active or the research agenda of either board.

Case 8-15

Answer will depend on companies selected.

Financial Analysis Case

Answer will depend on company selected.