CHAPTER 4
QUESTIONS
1. The objective of financial reporting is to
provide useful information for users of the
financial
statements.
The
relevant
information for decision making is future
data, especially information dealing with
cash flows. The primary financial
statements reflect economic transactions
and events that have taken place. The
past is used to help project the future.
Income, however, is only one of many
sources of cash flow. The balance sheet
and statement of cash flows also furnish
relevant information upon which the
investor may project other future cash
flows. In summary, the income statement
contains only some of the information that
is relevant for making economic decisions.

(c) The current value of net assets
acquired in exchange transactions as
determined by either their replacement
or market values.
(d) Some variation of the above (a
through c) but including in assets all
resources and claims to resources, not
just those acquired in exchange

maintenance approach uses the balance
sheet elements to determine the change in
total
equity
after
eliminating
any
investments and withdrawals of resources
by owners. The transaction approach
determines income by analyzing individual
transactions and events and their effect on
related assets, liabilities, and owners’
equity.
Although
the
method
of
determining
income
differs,
both
approaches arrive at the same total
income figure if the same attributes and
measurements are used. However, the
transaction approach produces more
detail as to the composition of income
than does the capital maintenance
approach.

5. A code law country is one in which rules,

and adjusted for a change in price
levels since original acquisition.

121


circumstances
enterprise.

and

activities

of

an

7. The following two factors must be
considered when deciding at what point
revenues and gains should be recognized:
(a) The resources from the transaction are
either already realized in cash or claims to
cash or are readily realizable in cash, and
(b) the revenues and gains have been
earned through substantial completion of
clearly identified tasks and activities. Both
factors are usually met when merchandise
is delivered or services are rendered to
customers. This is referred to as the point
of sale.

10. The multiple-step income statement can
contain too much information that might
be confusing to the reader and require
excess time to evaluate. The detailed
listing of purchases and inventory might
best be displayed in a supplementary
schedule.
The single-step income statement can be
too brief. Information required for

122

investment
decisions
is
sometimes
presented in supporting schedules or not
reported. Because of these factors, the
statement could also be confusing, and
valuable time could be lost by the
statement reader in seeking additional
information.
11. The major sections that may be included
in a multiple-step income statement may
be divided into two categories: (a) income
from continuing operations, separated into
six sections, and (b) irregular or
extraordinary items, separated into three
sections. The sections of income from
continuing operations are

income.
13. This flexibility in the timing of the
recognition of restructuring charges is
reduced by SFAS No. 146. Intraperiod
income tax allocation involves the
separation of income tax expense
between
income
from
continuing
operations and transitory, irregular, or
extraordinary items. Under this concept,
each section of the transitory, irregular, or
extraordinary items category is reported
net of its income tax effect.


14. Pop-Up must separately disclose the
current year’s income related to the
operations of the segment that will be
discontinued together with the $10,000
loss resulting from the sale. This total
would be reported on the income
statement, along with any associated
income tax impact, immediately following
income from continuing operations.
15. The following items would not normally
qualify as extraordinary items:
(a) The write-down or write-off of
receivables.

b. The effect of a change in accounting
estimate is disclosed entirely in the
current period or in the current and
future periods. No adjustments are
made to prior periods’ statements as
may be done for a change in principle.
The change in an estimate should be
sufficiently disclosed in the financial
statements so that readers are alerted
to those changes that will materially
affect future periods.
17. Under International Financial Reporting
Standard (IFRS) 8, the cumulative effect of

18. a change in accounting principle is
reported as a direct adjustment to
beginning retained earnings of the
current year.
18. Generally accepted accounting principles
require entities to report earnings-pershare information for income from
continuing operations and for each section
of the transitory, irregular, or extraordinary
items category of an income statement.
The computation is made by dividing the
income or loss from each of these
sections by the weighted average number
of common shares outstanding during the
reporting period. If a potential dilution of
earnings exists due to the existence of
convertible securities, stock options, or

123


1Statement of Financial Accounting Concepts No. 6, “Elements of Financial Statements” (Stamford, CT:
Financial Accounting Standards Board, December 1985), par. 70.

124


PRACTICE EXERCISES
PRACTICE 41

FINANCIAL CAPITAL MAINTENANCE

Net assets, end of period
Net assets, beginning of period
Increase in net assets
Deduct investment by owners
Income
PRACTICE 42

$345,000
170,000
$175,000
100,000
$75,000

PHYSICAL CAPITAL MAINTENANCE

Net assets, end of period

in the same year in which the revenue from the sale of the machines is reported. In the
meantime, this $350,000 cost is shown as an asset, Inventory, in the balance sheet.
PRACTICE 44

REVENUE RECOGNITION

Cash Collected
or Collectibility
Reasonably Assured?
a.
b.
c.

Work
Completed?

No
Yes
Yes

Yes
No
Yes

Total revenue to be recognized this year

Amount of
Revenue to Be
Recognized
$

45,000
Rational allocation
f.
50,000
Direct matching
Total expense recognized this year
PRACTICE 46

Expense
to Be Recognized
This Year
$ 30,000
70,000
5,000
27,000
9,000
0
$141,000

SINGLE-STEP INCOME STATEMENT
Sales

$10,000

Less expenses:
Cost of goods sold
6,000
Selling and administrative expense
750
Interest expense

Income tax expense
1,200
Net income
$ 950
PRACTICE 48

COMPUTATION OF GROSS PROFIT
Revenues..............................................

$9,488.8

Cost of sales..........................................

5,784.9

Gross profit....................................

$3,703.9

Gross profit/Sales = $3,703.9/$9,488.8 = 39.0%

126


PRACTICE 49

COMPUTATION OF OPERATING INCOME
Revenues............................................................

$9,488.8

Gross profit
Less: Selling and administrative expense
Operating income
Interest expense
Income before income taxes
Income tax expense (40%)
Income from continuing operations

PRACTICE 411

$10,000
4,000
$ 6,000
1,750
$ 4,250
1,100
$ 3,150
1,260
$ 1,890

COMPUTATION OF INCOME FROM DISCONTINUED OPERATIONS

Sales
Expenses
Income before income taxes
Income tax expense (30%)
Income from continuing operations
Discontinued operations:
Income (loss) from operations
(including loss on disposal

$ 770


PRACTICE 412

COMPUTATION OF INCOME FROM DISCONTINUED OPERATIONS
2005
$ 3,500
3,900
$ (400)
(120)
$ (280)

Sales
Expenses
Income before income taxes
Income tax expense (benefit) 30%
Income from continuing operations
Discontinued operations:
Income from operations
(including gain on disposal
in 2005 of $1,500)
Income tax expense30%
Income on discontinued operations
Net income

PRACTICE 413

2,100
630

Loss from an unusual but frequent event$(1,000)
Gain from a normal but infrequent event 1,250
Interest expense
(2,100)
(1,850)
Income before income taxes
$ 5,400
Income tax expense (40%)
2,160
Income from continuing operations
$ 3,240
Extraordinary loss (net of tax benefit of $160)
(240)
Net income
$ 3,000

PRACTICE 414

CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE

Sales
Oil and gas exploration expense
Income before income taxes
Income tax expense (30%)
Income from continuing operations
Cumulative effect of change
in accounting principle (net of income
tax benefit of $510)
Net income


Cumulative effect = [($400 + $600) – ($1,500 + $1,200)] = ($1,700)

128


PRACTICE 415

ACCOUNTING FOR CHANGES IN ESTIMATES

Original depreciation = $100,000/20 years = $5,000 per year
Accumulated depreciation as of January 1, 2005 = $5,000 per year  5 years = $25,000
Revised depreciation
= Remaining depreciable book value/Remaining life
= ($100,000  $25,000)/(30 years  5 years elapsed already)
= $75,000/25 years
= $3,000 per year
PRACTICE 416

RETURN ON SALES

Return on sales = Net income/Sales = $200/$13,000 = 1.5%
PRACTICE 417

EARNINGS PER SHARE

Net income
Average shares outstanding
Earnings per share

2005

Extraordinary loss
(1,000)
Cumulative effect of a change in accounting principle
(400)
Net income
$ 9,600
Net income
$ 9,600
Unrealized loss on available-for-sale securities
(2,100)
Foreign currency translation adjustment (equity increase)
Comprehensive income
$ 8,750

129

1,250


PRACTICE 420

FORECASTED BALANCE SHEET

Cash
Accounts receivable
Inventory
Land
Plant and equipment (net)
Total assets
PRACTICE 421

910
Net income
$ 1,690

130

2006
Forecasted
$
125
625
1,250
2,500
7,000
$11,500

2006
Forecasted
$13,000
7,800
1,200
500
$ 3,500
1,225
$ 2,275

30% increase (given)
30% natural increase
same proportion with PPE
same apparent 10% interest rate

100,000
50,000

$ 452,500

335,000
$ 117,500
25,000
$ 142,500

4–23.
(a) The receipt of an order from a customer does not constitute realization,
nor does it qualify as an earnings activity. Therefore no revenue is
recognized.
(b) There has been no sale of the asset to support the recognition of
revenue. Production remains to be performed, followed by sale of the
finished product. Accretion may give rise to revenue in certain
instances in which it can be objectively determined and the product has
a ready market at a definite price.
(c) The rendering of services is the earning activity, and it is assumed that a
valid claim exists against the client. The recognition criteria are met.
(d) The appreciation in value of the land is generally not recognized
because it is not yet realized.
(e) The receipt of cash meets the realization criteria; however, the revenue
is generally not reported as earned because the product has not yet
been delivered. Some argue that an estimate of the costs incurred to
honor the certificate can be made so that revenue could be recognized
at the time of certificate sale.
(f) Collection of cash on the subscriptions is realization. However, the
earning activity has yet to take place.

such as Deposit Liability.
(f) The initial agreement does not represent a claim against the client until
the contract is at least partially complete. Because part of the work was
accomplished in 2005, a portion of the revenue could be recognized in
2005 on a percentage basis. However, because the bulk of the work will
be done in 2006, revenue could be deferred until the audit is completed
and billed.
4–25.
(a) Immediate recognition. The future benefits of the new drug are highly
uncertain.
(b) Direct matching. The warranty costs are anticipated expenses that are
directly related to revenues.
(c) Systematic and rational allocation. The lease agreement benefits
several accounting periods in a systematic and rational way.
(d) Direct matching. Labor associated with assembling a product is
matched with revenues and reported in the period the goods are sold.
(e) Systematic and rational allocation. The delivery trucks are expected to
benefit several accounting periods in a systematic and rational way.
(f) Immediate recognition. The advertising indirectly helps to generate
revenues and is not related to specific revenues.

132


4–26.
Original cost of patent....................................................................
Amortization for 5 years ($30,000 per year 2000–2004)...............
Remaining unamortized balance...................................................

$450,000


133


4–28.

Caribou Inc.
Income Statement
For the Year Ended December 31, 2005
Sales.....................................................................
$1,600,000 (a)
Cost of goods sold:
Beginning inventory......................................... $ 136,000
Net purchases...................................................
919,200 (b)
Cost of goods available for sale..................... $ 1,055,200
Less: Ending inventory....................................
95,200
Cost of goods sold...........................................
960,000
Gross profit on sales..........................................
$ 640,000
Operating expenses:
Selling expenses.............................................. $ 208,000 (c)
General expenses (including bad debts ).........
272,000 (d)
480,000
Income before income taxes
and extraordinary items...................................
$ 160,000

17
30
Income before income taxes.........................
10%
Sales: $160,000 (income before income taxes) ÷ 0.10 = $1,600,000
Cost of goods sold:
General expenses, excluding bad debts = 15% of sales and 25% of
cost of sales: therefore, 0.15  sales = 0.25  Cost of goods sold
Cost of goods sold = 0.15 ÷ 0.25 = 0.60 of sales

134


4–28.

(Concluded)
(b) Net purchases
Cost of goods sold = Beginning inventory  Net purchases less
ending inventory
Let X equal net purchases.
0.60  $1,600,000 = $136,000 + X  0.70 ($136,000)
$960,000 = $40,800 + X
X = $919,200
(c) 0.13  $1,600,000 = $208,000
(d) (0.15  $1,600,000) + (0.02  $1,600,000) = $272,000
(e) Earnings per share (130,000 shares of common stock outstanding):
Income before extraordinary gain: $112,000 ÷ 130,000 shares = $0.86
Extraordinary gain: $21,000 ÷ 130,000 shares = $0.16
Net income: $133,000 ÷ 130,000 shares = $1.02


to compare the relative size and operating profitability of the continuing
and discontinued operations. This practice is also similar to the
reporting requirements of IFRS 35.
4–31.

135


2005
2004
2003
Sales
$50,000
$43,000
$35,000
Cost of goods sold
20,000
18,000
15,000
Other expenses
13,000
12,000
11,000
Income before income taxes
$17,000
$13,000
$ 9,000
Income tax expense (35%)
5,950
4,550

of dollars)
Income from continuing operations...........................................
$1,032.3
Cumulative effect of change in accounting for income taxes
(net of applicable taxes)...............................................................
544.2
Net income....................................................................................
$ 1,576.5
Earnings per common share:
Income from continuing operations........................................
Cumulative effect of accounting change.................................
Net income.................................................................................

(b)

$ 2.06
1.09
$ 3.15

If Sears were a non-U.S. company reporting under the provisions of IFRS 8, the
$544.2 million “gain” from the cumulative effect of the change in accounting
principle would not be shown in the income statement at all. Instead, the $544.2
million amount would be shown as a direct adjustment (an increase) to the
beginning balance in retained earnings for the year.

4–33.
(a)
(b)

Sales revenue.

(n) Other Revenues and Gains section of income statement.
(o) Operating Expense or Other Expenses and Losses section, depending on
nature of business unless the event is considered unusual and infrequent, in
which case, it would be reported as an extraordinary item.
(p) Operating expense or adjustment to cost of goods sold.
(q) Included with current-year tax expense.
(r) Other Expenses and Losses section because the sale is only a portion of
business segment.
(s) Operating expense because the move does not qualify as discontinued
operations.
(t) Operating expense.

137


4–34.

Income Statement
Revenue:
Sales
Less: Sales discounts
Sales returns and allowances
Cost of goods sold:
Inventory—beginning
Net purchases:
Purchases
Less: Purchase discounts
Purchase returns and allowances
Freight-in
Cost of goods available for sale

Net income
Earnings per common share:
Income from continuing operations
Loss from discontinued operations
Extraordinary gain
Net income

4–35.

138

The Pensacola Awning Company
Income Statement


For the Year Ended December 31, 2005
Sales revenue............................................................
$1,380,000
Expenses:
Costs of goods sold.............................................. $765,000
Selling expenses....................................................
288,720
General and administrative expenses..................
236,400
Interest expense....................................................
13,390
Income taxes..........................................................
30,596 (a) 1,334,106
Net income................................................................
$ 45,894

Less: Increased depreciation—change in estimate..
Loss on sale of equipment...............................
Extraordinary casualty loss..............................
Corrected net income...................................................

139

$13,680
$ 2,800
18,350
4,500
$ 5,000
3,860
27,730

25,650
$39,330
36,590
$ 2,740


4–36.

(Concluded)

2.
Losser Corporation
Retained Earnings Statement
For the Year Ended December 31, 2005
Retained earnings, January 1, 2005................................................

Statement of Comprehensive Income
For the Year Ended December 31, 2005
Net income............................................................................
Unrealized losses on available for sale securities............
Foreign currency translation adjustment..........................
Minimum pension liability adjustment...............................
Comprehensive income......................................................

$17,650
(1,285)
(287)
(315)
$15,763


4-38.

Han Incorporated
Forecasted Income Statement
For the Year Ended December 31, 2006

Sales................................................
Cost of goods sold........................

2005
$2,000
700

Gross profit....................................
Depreciation expense....................

$2,200
given
770
35% of sales,
as last year
$1,430
160
20% of PPE,
same as last year
1,111
50.5% of sales,
same as last year
$ 159
75
15% of bank loan,
same as last year
$ 84
32
37.5% of pretax,
same as last year
$ 52

4-39.
Ryan Company
Forecasted Balance Sheet
December 31, 2006
2005
$ 10
250


Total stockholders’ equity.............
Total liabilities and
stockholders’ equities................

260

140

50% natural increase
new loan of $200,
item (c)
to balance

$ 1,060

$ 1,190

141


4-39.

(Concluded)
Ryan Company
Forecasted Income Statement
For the Year Ended December 31, 2006

Sales................................................
Cost of goods sold........................


$

40

2006
Forecasted
$1,500
given, item (a)
1,125
75% of sales,
same as last year
$ 375
40
5% of PPE,
same as last year
120
8% of sales,
same as last year
$ 215
90
10% of bank loan,
same as last year
$ 125
42
33.3% of pretax,
same as last year
$ 83

Note: Total stockholders’ equity is forecasted to decrease by $120 ($260  $140). This
will happen even though net income will cause stockholders’ equity to increase by

1,963,800
$ 438,200
$

1.35

Payette Co.
Retained Earnings Statement
For the Year Ended June 30, 2005
Retained earnings, July 1, 2004................................
Add: Net income.........................................................
Deduct: Dividends......................................................
Retained earnings, June 30, 2005.............................

143

$1,356,800
438,200
$1,795,000
260,000
$ 1,535,000


4–41.

1. Income statement–time of shipment:
Richmond Company
Income Statement
For the Years Ended December 31
Sales...............................................................................

(15,000)
(22,000)
$ 28,340

2005
$ 84,000
42,000
$ 42,000
(420)
(25,000)
(22,000)
$ (5,420)

Income statement—time of sale:
Richmond Company
Income Statement
For the Years Ended December 31
Sales...............................................................................
Cost of goods sold.......................................................
Gross profit...................................................................
Bad debt expense.........................................................
Selling expenses...........................................................
General and administrative expenses.........................
Net income (loss)..........................................................

2. Under the first dealer agreement, revenue is recognized when goods are
shipped to the dealers. The dealer makes payment after receipt of the
goods. Possible bad debt losses are greater under this agreement
because the dealer may not have the cash to pay for the toys until they
are sold. The second type of dealer agreement is actually a

(d) It is difficult to determine the period of time that is benefited by general
advertising. Because the advertising costs cannot be related to specific
revenues, the costs are typically recognized as expenses immediately.
(e) Current cost information is currently not disclosed on the face of the
income statement. Some companies elect to provide supplemental
information of this nature in the notes to the financial statements.
(f) If warranty costs can be reasonably estimated, the expenses are
matched directly to the period in which the revenue is generated. Using
the actual costs incurred to approximate warranty expense violates the
matching principle.

2.

Sales.............................................................................................
Cost of goods sold.....................................................................
Gross profit.................................................................................
Rent expense...............................................................................
Advertising expense...................................................................
Warranty expense.......................................................................
Other expenses...........................................................................
Net income...................................................................................
Sales: $185,000 – $18,000 + $16,000 = $183,000
Cost of goods sold: $94,000 + $7,500 = $101,500
Rent expense: $18,000 – $6,000 = $12,000
Advertising expense: $6,000 + $18,000 = $24,000
Warranty expense: $183,000  0.05 = $9,150

145

$183,000