Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Chapter The Balance Sheet and Financial Disclosures QUESTIONS FOR REVIEW OF KEY TOPICS Question 3-1 The purpose of the balance sheet, also known as the statement of financial position, is to present the financial position of the company on a particular date Unlike the income statement, which is a change statement that reports events occurring during a period of time, the balance sheet is a statement that presents an organized array of assets, liabilities, and shareholders’ equity at a point in time It is a freeze frame or snapshot picture of financial position at the end of a particular day marking the end of an accounting period Question 3-2 The balance sheet does not portray the market value of the entity for a number of reasons Most assets are not reported at market value, but instead are measured according to historical cost Also, there are certain resources, such as trained employees, an experienced management team, and a good reputation, that are not recorded as assets at all Therefore, the assets of a company minus its liabilities, as shown in the balance sheet, will not be representative of the company’s market value Question 3-3 Current assets include cash and other assets that are reasonably expected to be converted to cash or consumed during one year, or within the normal operating cycle of the business if the operating cycle is longer than one year The typical asset categories classified as current assets include: — Cash and cash equivalents — Short-term investments — Accounts receivable — Inventories — Prepaid expenses Question 3-4 Current liabilities are those obligations that are expected to be satisfied through the use of current assets or the creation of other current liabilities So, this classification will include all liabilities that are scheduled to be liquidated within one year or the operating cycle, whichever is longer, except those that management intends to refinance on a long-term basis The typical liability categories classified as current liabilities include: — Accounts payable — Short-term notes payable — Accrued liabilities — Current maturities of long-term debt Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 3-1 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 3-5 The operating cycle for a typical manufacturing company refers to the period of time required to convert cash to raw materials, raw materials to a finished product, finished product to receivables, and then finally receivables back to cash Question 3-6 Investments in equity securities are classified as current if the company’s management (1) intends to liquidate the investment in the next year or operating cycle, whichever is longer, and (2) has the ability to so, i.e., the investment is marketable If either of these criteria does not hold, the investment is classified as noncurrent Question 3-7 The common characteristics that these assets have in common are that they are tangible, longlived assets used in the operations of the business They usually are the primary revenue-generating assets of the business These assets include land, buildings, equipment, machinery, furniture and other assets used in the operations of the business, as well as natural resources, such as mineral mines, timber tracts and oil wells Question 3-8 Property, plant, and equipment and intangible assets each represent assets that are long-lived and are used in the operations of the business The difference is that property, plant, and equipment represent physical assets, while intangibles lack physical substance Generally, intangibles represent the ownership of an exclusive right, such as a patent, copyright or franchise Question 3-9 A note payable of $100,000 due in five years would be classified as a long-term liability A $100,000 note due in five annual installments of $20,000 each would be classified as a $20,000 current liability — current maturities of long-term debt — and an $80,000 long-term liability Question 3-10 Paid-in-capital consists of amounts invested by shareholders in the corporation Retained earnings equals net income less dividends paid to shareholders from the inception of the corporation Question 3-11 Disclosure notes provide additional detail concerning specific financial statement items Included are such data as the market values of financial instruments and off-balance-sheet risk associated with financial instruments and details of pension plans, leases, debt, and assets Common to all companies’ disclosures are certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions However, many notes are designed to fit the disclosure needs of the particular reporting company In fact, any explanation that helps investors and creditors make decisions should be included © The McGraw-Hill Companies, Inc., 2007 3-2 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 3-12 The disclosure of the company’s significant accounting policies is extremely important to external users in terms of their ability to compare financial information across companies It is critical to a financial analyst involved in assessing future cash flows of two construction companies to know that one company uses the percentage-of-completion method in recognizing gross profit, while the other company uses the completed contract method Question 3-13 A subsequent event is an event that occurs after the date of the financial statements but prior to the date on which the statements are actually issued It may help to clarify a previously existing situation or it may represent a new event not directly affecting financial position at the end of the reporting period Question 3-14 The discussion provides management’s views on significant events, trends and uncertainties pertaining to the company’s (a) operations, (b) liquidity, and (c) capital resources Certainly the Management Discussion and Analysis section may be slanted to management’s biased perspective and therefore can lack objectivity However, management can offer an informed insight that might not be available elsewhere, so if the reader maintains awareness of the information’s source, it can offer a unique view of the situation Question 3-15 Depending on the circumstances, the auditor will issue a (an): Unqualified opinion – The auditors are satisfied that the financial statements “present fairly” the financial position, results of operations, and cash flows and are “prepared in accordance with generally accepted accounting principles.” Qualified opinion – This contains an exception to the standard unqualified opinion, but not of sufficient seriousness to invalidate the financial statements as a whole Examples of exceptions are (a) unconformity with generally accepted accounting principles, (b) inadequate disclosures, and (c) a limitation or restriction of the scope of the examination Adverse opinion – This is necessary when the exceptions are so serious that a qualified opinion is not justified Adverse opinions are rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report Disclaimer – An auditor will disclaim an opinion if insufficient information has been gathered to express an opinion Question 3-16 A proxy statement must be sent each year to all shareholders It usually is in the same mailing with the annual report The statement invites shareholders to the shareholders’ meeting to elect board members and to vote on issues before the shareholders It also permits shareholders to vote using an enclosed proxy card Beginning with 1992 financial statements, the proxy statement also provides for more disclosures on compensation to directors and executives, and in particular, stock options granted to executives Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 3-3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (concluded) Question 3-17 Working capital is the difference between current assets and current liabilities The current ratio is computed by dividing current assets by current liabilities The acid-test ratio (or quick ratio) is computed by dividing quick assets (cash and cash equivalents, marketable securities, and accounts receivable) by current liabilities Question 3-18 Debt to equity ratio = Times interest earned ratio = Total liabilities Shareholders' equity Net income + interest + taxes Interest Question 3-19 An operating segment is a component of an enterprise: That engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise) Whose operating results are regularly reviewed by the enterprise's chief operating decisionmaker to make decisions about resources to be allocated to the segment, and to assess its performance For which discrete financial information is available Question 3-20 For areas determined to be reportable operating segments, the following disclosures are required: General information about the operating segment, Information about reported segment profit or loss, including certain revenues and expenses included in reported segment profit or loss, segments assets, and the basis of measurement Reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items to corresponding enterprise amounts Interim period information © The McGraw-Hill Companies, Inc., 2007 3-4 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com BRIEF EXERCISES Brief Exercise 3-1 (a) (b) (c) (d) (e) (f) Current Current Noncurrent Current Noncurrent Noncurrent Brief Exercise 3-2 Current Assets: $16,000 + 11,000 + 25,000 = $52,000 Current liabilities: $14,000 + 9,000 + 1,000 = $24,000 Brief Exercise 3-3 Assets: minus Liabilities equals Shareholders’ equity Solutions Manual, Vol.1, Chapter $ 52,000 current assets 80,000 equipment $132,000 total assets $ 24,000 current liabilities 30,000 notes payable 54,000 total liabilities $78,000 (50,000) common stock $28,000 retained earnings © The McGraw-Hill Companies, Inc., 2007 3-5 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 3-4 K and J Nursery, Inc Balance Sheet At December 31, 2006 Assets Current assets: Cash Accounts receivable Inventories Total current assets Property, plant, and equipment: Equipment Less: Accumulated depreciation Net property, plant, and equipment Total assets $ 16,000 11,000 25,000 52,000 $140,000 (60,000) 80,000 $132,000 Liabilities and Shareholders' Equity Current liabilities: Accounts payable Wages payable Interest payable Total current liabilities $ 14,000 9,000 1,000 24,000 Long-term liabilities: Note payable Shareholders’ equity: Common stock Retained earnings* Total shareholders’ equity Total liabilities and shareholders’ equity 30,000 $50,000 28,000 78,000 $132,000 $28,000 is the amount needed to cause total assets to equal total liabilities and shareholders’ equity This is calculated in BE 3-3 © The McGraw-Hill Companies, Inc., 2007 3-6 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 3-5 Culver City Lighting, Inc Balance Sheet At December 31, 2006 Assets Current assets: Cash Accounts receivable Inventories Prepaid insurance Total current assets Property, plant, and equipment: Equipment Less: Accumulated depreciation Net property, plant, and equipment $ 55,000 39,000 45,000 15,000 154,000 $100,000 (34,000) 66,000 Intangibles: Patent Total assets 40,000 $260,000 Liabilities and Shareholders' Equity Current liabilities: Accounts payable Interest payable Current maturities of long-term debt Total current liabilities $ 12,000 2,000 10,000 24,000 Long-term liabilities: Note payable Shareholders’ equity: Common stock Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity Solutions Manual, Vol.1, Chapter 90,000 $70,000 76,000 146,000 $260,000 © The McGraw-Hill Companies, Inc., 2007 3-7 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 3-6 The $30,000 should be classified as a noncurrent asset, under the investments and funds classification $10,000, next year’s installment, should be classified as a current liability, current maturities of long-term debt The remaining $90,000 is included in long-term liabilities Two-thirds of the unearned revenue, $40,000, should be classified as a current liability, the remaining $20,000 as a long-term liability Brief Exercise 3-7 Current assets – cash and cash equivalents – accounts receivable = Inventories $235,000 – 40,000 – 120,000 = $75,000 Total assets – current assets = property, plant, and equipment $400,000 – 235,000 = $165,000 Total assets – accounts payable – note payable – common stock = retained earnings $400,000 – 32,000 – 50,000 – 100,000 = $218,000 Brief Exercise 3-8 (1) (2) (3) (4) (5) (6) A B B A B A Brief Exercise 3-9 (a) Current assets © The McGraw-Hill Companies, Inc., 2007 3-8 ÷ current liabilities Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com ($55,000 + 39,000 + 45,000 + 15,000) ÷ ($12,000 + 2,000 + 10,000) $154,000 ÷ $24,000 = 6.42 (b) (Cash + short-term investments + accounts receivable) ÷ current liabilities ($55,000 + + 39,000) ÷ $24,000 = 3.92 (c) Total liabilities ÷ shareholders’ equity $24,000 current liabilities + 90,000 long-term liabilities = $114,000 $70,000 common stock + 76,000 retained earnings = $146,000 $114,000 ÷ $146,000 = 78 Brief Exercise 3-10 Paying accounts payable reduces both current assets and current liabilities If the ratio before the payment were above 1.0, the transaction would cause the ratio to increase However, if the ratio before the transaction were less than 1.0, the ratio would decrease Brief Exercise 3-11 Acid-test ratio = (cash + short-term investments + A/R) ÷ current liabilities 1.5 = ($20,000 + + 40,000) ÷ current liabilities 1.5 x current liabilities = $60,000 current liabilities = $60,000 ÷ 1.5 current liabilities = $40,000 Current ratio = current assets ÷ current liabilities 2.0 = current assets ÷ $40,000 current assets = $40,000 x 2.0 current assets = $80,000 $80,000 – 20,000(cash) – 40,000(A/R) = $20,000 inventories Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 3-9 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com EXERCISES Exercise 3-1 Total current assets Current liabilities = $44,000 + 15,000 + 1,000 (accrued interest) = $60,000 Since the current ratio is 1.5:1, current assets = 1.5 x $60,000 = $90,000 Short-term investments $90,000 - 5,000 - 20,000 - 60,000 = $5,000 Retained earnings Current assets + Noncurrent assets = Current liabilities + Long-term liabilities + Paid-in capital + Retained earnings (RE) $90,000 + 120,000 = $60,000 + 30,000 (Note payable) + 100,000 + RE RE = $20,000 Exercise 3-2 c f -a b_ g_ f f i b Equipment Accounts payable Allowance for uncollectible accounts Land, held for investment Note payable, due in years Unearned rent revenue Note payable, due in months Income less dividends, accumulated Investment in XYZ Corp., long-term © The McGraw-Hill Companies, Inc., 2007 3-10 10 11 12 13 14 15 16 17 18 a d c f a h c a f Inventories Patent Land, in use Accrued liabilities Prepaid rent Common stock Building, in use Cash Taxes payable Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Problem 3-7 HHD, Inc Balance Sheet At December 31, 2006 Assets Current assets: Cash Investment in stocks Accounts receivable Inventories Prepaid insurance Total current assets Investments: Investment in stocks Bond sinking fund Total investments $ 150,000 90,000 200,000 225,000 25,000 690,000 $ 160,000 250,000 410,000 Property, plant, and equipment: Land Buildings Equipment 800,000 1,500,000 500,000 2,800,000 (800,000) Less: Accumulated depreciation Net property, plant, and equipment 2,000,000 Intangibles: Patent Copyright Total intangibles Total assets 110,000 90,000 200,000 $3,300,000 Liabilities and Shareholders' Equity Current liabilities: Accounts payable Notes payable Taxes payable Total current liabilities Long-term liabilities: Notes payable Bonds payable Total long-term liabilities Shareholders’ equity: Common stock Preferred stock Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity Solutions Manual, Vol.1, Chapter $ 100,000 150,000 60,000 310,000 $ 90,000 1,100,000 1,190,000 1,000,000 450,000 350,000 1,800,000 $3,300,000 © The McGraw-Hill Companies, Inc., 2007 3-31 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Problem 3-8 MELODY LANE MUSIC COMPANY Balance Sheet At December 31, 2006 Assets Current assets: Cash (1) Inventories Prepaid rent Total current assets Property, plant, and equipment: Equipment and furniture Less: Accumulated depreciation Net property, plant, and equipment Total assets $167,000 100,000 3,000 270,000 $ 40,000 (4,000) 36,000 $306,000 Liabilities and Shareholders' Equity Current liabilities: Accounts payable (2) Interest payable Loan payable Total current liabilities $ 21,000 9,000 100,000 130,000 Shareholders’ equity: Common stock Retained earnings (3) Total shareholders’ equity Total liabilities and shareholders’ equity 176,000 $306,000 $100,000 76,000 (1) Cash receipts of $560,000 less cash disbursements of $393,000 (2) $20,000 owed to suppliers + $1,000 owed to utility company (3) Net income for the year © The McGraw-Hill Companies, Inc., 2007 3-32 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com CASES Communication Case 3-1 IBM manufactures and sells personal and main frame computers The computers included as current assets in the balance sheet for the company represent the cost of inventory available for sale In addition, IBM uses computers in its operations The cost of these computers is included in the property, plant, and equipment category in the balance sheet Marketable securities could be classified as either current or noncurrent assets depending on the intent of management If management intends to sell the securities in the next year or operating cycle, they are classified as current assets If management intends to hold the securities beyond the coming year or operating cycle, they are classified as noncurrent assets Analysis Case 3-2 Requirement Current assets include cash and other assets that are reasonably expected to be converted to cash or consumed during one year, or within the normal operating cycle of the business if the operating cycle is longer than one year Current liabilities include all liabilities that are scheduled to be liquidated within one year or the operating cycle, whichever is longer, except those that management intends to refinance on a long-term basis Therefore, key factors determining classification are the nature of the asset or liability, management’s intent, and the length of the operating cycle Requirement Assets: Cash Normally classified as current, however, if restriction prohibits use of the cash, could be classified as noncurrent Receivables Depends on the expected date of collection Marketable securities Depends on when management intends to sell the securities Prepaid expenses Depends on the period of time prepaid Liabilities: Notes payable Unearned revenue Solutions Manual, Vol.1, Chapter Depends on scheduled payment date and management’s intent to pay or refinance Depends on the period the revenue will be earned © The McGraw-Hill Companies, Inc., 2007 3-33 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Communication Case 3-3 The critical question that student groups should address is whether the cost of the egg-producing flock should be classified as inventory or as property, plant, and equipment There is no right or wrong answer The process of developing the proposed solutions will likely be more beneficial than the solutions themselves Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole Solutions should address the following issues: The definitions of inventory and property, plant, and equipment The definition of inventory according to ARB No 43 is “goods awaiting sale, goods in the course of production, and goods to be consumed directly in production.” The chickens certainly represent goods awaiting sale, since they will eventually be sold to soup companies However, they also represent property, plant, and equipment, since they are used in the production of product — the eggs The definition of a current asset ARB No 43 also provides the following definition of a current asset: “ , the term current assets is used to designate cash and other assets or resources commonly identified as those which are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.” ARB No 43 also states that a one-year time period is to be used where there are several operating cycles occurring within a year In this case, it could be argued that the operating cycle is two years, since the chickens are not sold until after the laying life and, therefore, the cost of the flock should be classified as a current asset However, if the chickens are considered productive assets, then the concept of an operating cycle is not relevant According to this argument, the chickens should be classified as a noncurrent asset, i.e., a producing asset, and not a saleable asset It appears that the primary benefits of the chickens come from the sale of eggs, not the sale of the chickens themselves Regardless of the classification of the cost of the chickens, the cost capitalized when the chickens begin to lay must be depreciated down to an estimated salvage value at the end of the laying life This is necessary to properly match expenses with revenues © The McGraw-Hill Companies, Inc., 2007 3-34 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 3-3 (concluded) (Industry practice is to classify the costs of the egg-producing flock as inventory in the current asset section of the balance sheet, but to depreciate the inventory down to estimated salvage value.) It is important that each student actively participate in the process Domination by one or two individuals should be discouraged Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction Judgment Case 3-4 DEFICIENCIES: Accounts receivable - if material, the allowance for uncollectible accounts should be disclosed Note receivable - only the interest receivable of $3,000 should be classified as a current asset The $50,000 note receivable should be classified in the noncurrent Investments category Inventories - the method used to cost inventory should be disclosed in a note Investments - should be classified in the noncurrent Investments category Prepaid expenses - in the absence of information to the contrary, should be classified as a current asset Land - should be classified in the noncurrent Investments category Equipment, net - should be classified in the Property, plant and equipment category Original cost should be disclosed along with the accumulated depreciation to arrive at the net amount Also, the method used to compute depreciation should be disclosed in a note Patent - should be classified in the Intangibles category of noncurrent assets Note payable - $20,000, the next installment, should be classified as a current liability as current maturities of long-term debt Also, note disclosure is required for the note and bonds payable that provides information such as payment terms, interest rates, and collateral pledged as security for the debt 10 Interest payable - should be classified as a current liability 11 Common stock - the par value, if any, and the number of shares authorized, issued and outstanding should be disclosed Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 3-35 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Judgment Case 3-5 Accounts receivable, net - disclosure on the face of the statement of the allowance for uncollectible accounts, if material Inventories - disclosure in Accounting Policies note of the cost method used Also, for a manufacturer, note disclosure of the breakout of inventory into raw materials, work in process and finished goods Property, plant and equipment - original cost by major category should be disclosed along with the accumulated depreciation either on the face of the statement or in a note Also, the method used to compute depreciation should be disclosed in the Accounting Policies disclosure note Long-term liabilities - disclosure in a note of the various debt instruments comprising long-term liabilities to include information such as payment terms, interest rates, and collateral pledged as security for the debt Common stock - disclosure on the face of the statement of par value, if any, and the number of shares authorized, issued and outstanding © The McGraw-Hill Companies, Inc., 2007 3-36 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Real World Case 3-6 Requirement The asset classifications are 1) Current assets, 2) Plant, rental machines and other property, 3) Long-term financing receivables, 4) Prepaid pension assets, (5) Investments and sundry assets, (6) Goodwill, and (7) Intangible assets – net Requirement a Total assets b Current assets c Current liabilities d Total shareholders' equity e Retained earnings f Inventories Requirement The par value is $.20 per share 1,962,687,087 shares are issued = = = = = = $109,183 million $46,970 million $39,798 million $29,747 million $44,525 million $3,316 million 4,687,500,000 shares are authorized and Requirement Current ratio = Current assets divided by Current liabilities Current ratio = $46,970 ÷ $39,798 = 1.18 Requirement a b c The lower of average cost or net realizable value The straight-line method All highly liquid investments with a maturity of three months or less at date of purchase are carried at fair value and considered to be cash equivalents Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 3-37 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Judgment Case 3-7 This is a significant event occurring after the end of the fiscal year but prior to the issuance of the financial statements Details of the merger should be disclosed in a note to the financial statements This is a significant event occurring after the end of the fiscal year but prior to the issuance of the financial statements Details of the issuance of the new debt should be described in a note to the financial statements This is a significant event occurring after the end of the fiscal year but prior to the issuance of the financial statements The event should be described in a note to the financial statements along with the amount of uninsured damage © The McGraw-Hill Companies, Inc., 2007 3-38 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Research Case 3-8 Requirement Statement of Financial Accounting Standards No 57, “Related Party Disclosures,” requires the disclosure of related party transactions This statement was issued in March of 1982 and became effective for fiscal years ending after June 15,1982 Requirement When related-party transactions occur, companies must disclose the nature of the relationship(s) involved, provide a description of the transactions, and report the dollar amounts of the transactions and any amounts due from or to related parties Requirement The related party transactions disclosure note describes transactions with limited partnerships whose general partner’s managing member is a senior officer of Enron The transactions include various hedging and derivative transactions with the related party, as well as the sale of inventory and other assets to the related party Requirement The potential problem with related party transactions is that their economic substance may differ from their legal form One of Enron’s disclosed transactions involved the sale of dark fiber inventory to the related party in exchange for $30 million in cash and a $70 million note receivable Enron recognized gross margin on the sale of $67 million Is the $100 million sales price a proper representation of the sales price of the inventory in a normal transaction to an unrelated party? Is the interest rate charged by Enron on the note a fair interest rate? If the answer to these questions is no, then income (wealth) has been transferred from one party to the other, to the detriment of the shareholders of one of the entities and the benefit of the other Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 3-39 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Research Case 3-9 (Note: This case requires the student to reference a journal article.] Requirement Affirmative covenants contain pledges by the borrower to take actions such as insuring and maintaining assets and paying taxes, as well as agreements to keep certain financial amounts and ratios within specified limits Negative covenants can prohibit activities and specify limits for accounting ratios Accounting-based covenants are typically used to limit leverage levels (amount of debt compared to equity) and dividend payouts as well as to establish minimum levels of net worth, working capital, and interest coverage Requirement The authors conclude that annual report disclosures of debt covenants is presently inadequate They state that a user relying on annual report covenant disclosures is often not on an equal footing with someone having access to other costly resources Only after a covenant violation has occurred or is imminent does GAAP require financial statement presentation International Case 3-10 The standard audit report used in the U.S.A consists of three paragraphs The first two paragraphs of the report deal with the scope of the audit (the work that was done by the auditor) and the third paragraph states the auditor's opinion on whether or not the statements covered in the scope paragraphs have been presented fairly in conformity with GAAP The U.K report is quite similar to the report used in the U.S.A The introduction and first two sections deal with the scope of the audit Both reports describe the responsibility of the company's management (directors) as well as the responsibility of the auditors, and they both briefly discuss auditing standards The last section of the U.K report is similar to the opinion paragraph of the U.S.A report © The McGraw-Hill Companies, Inc., 2007 3-40 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Real World Case 3-11 Requirement a The disclosure note describes the acquisition of Simplicity Manufacturing, Inc for $227 million in cash plus certain transaction related expenses b The company's auditor was Deloitte & Touche LLP The firm rendered an unqualified opinion on the company's financial statements Requirement a J S Shiely is listed as the Chairman, President, and Chief Executive Officer b The annual compensation for Mr Shiely in 2004 included $737,768 in salary and a bonus of $1,000,000 Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 3-41 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Judgment Case 3-12 Comparative income for the first year of operations resulting from the two alternative financing choices is illustrated below DEBT VS EQUITY Comparative Income For Two Financing Alternatives Income before interest and taxes Less: Interest Income before taxes Less: Income taxes Net Income Alternative $5,000,000 -05,000,000 (2,500,000)** $2,500,000 Alternative $5,000,000 (1,600,000)* 3,400,000 (1,700,000)** $1,700,000 $2,500,000 $1,700,000 * 8% x $20,000,000 ** 50% x Income before taxes Return on investment = 5% (Net income ÷ investment) $50,000,000 =5.67% $30,000,000 We can see that Alternative generated a higher net income However, the return on shareholders’ investment is actually higher for Alternative Alternative generated a higher return for each dollar invested by shareholders This was made possible because the corporation was able to generate income on borrowed funds at a higher rate than the cost of the debt This represents financial leverage However, alternative also results in a riskier capital structure The debt in Alternative requires fixed payments of interest and principal to be made The company's income before interest and income taxes could drop to zero under Alternative and the company would still be solvent (i.e., able to pay its debts) Under Alternative 2, however, if income before interest and taxes drops below the required interest payments of $1,600,000, the company could become insolvent and eventually go bankrupt Analysis Case 3-13 The objective of this case is to motivate students to obtain hands-on familiarity with an actual annual report You may wish to provide students with multiple copies © The McGraw-Hill Companies, Inc., 2007 3-42 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com of the same annual report and compare responses Another approach is to divide the class into teams who evaluate reports from a group perspective Analysis Case 3-14 The objectives of this case are to motivate students to obtain hands-on familiarity with an actual annual report and to apply the techniques learned in the chapter You may wish to provide students with multiple copies of the same annual reports and compare responses Another approach is to divide the class into teams who evaluate reports from a group perspective Analysis Case 3-15 Requirement The balance sheet includes three asset classifications: Current assets, Property and equipment, and Other long-term assets; and three liability classifications: Current liabilities, Long-term debt and Other long-term liabilities Requirement These assets are shown as current because the company intends to use them in the next year or operating cycle Requirement Current portion of long-term debt represents the principal amounts due in the next year on long-term debt Requirement Disclosure notes explain or elaborate upon the data presented in the financial statements themselves They must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related thirdparty transactions, but many notes are company specific Actually, any explanation that contributes to investors’ and creditors’ understanding of the results of operations, financial position, or cash flows of the company should be included Requirement Straight-line Requirement No Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 3-43 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Analysis Case 3-16 Requirement Segment disclosures assist in analyzing and understanding financial statements by permitting better assessment of past performance and future prospects Disaggregated information provides more precise details of the uncertainties surrounding the timing and the amount of expected cash flows, because the various segments may have different rates of profitability, degrees and types of risk, opportunities for growth, and future capital demands Requirement An operating segment is a component of an enterprise: That engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise) Whose operating results are regularly reviewed by the enterprise's chief operating decision-maker to make decisions about resources to be allocated to the segment and assess its performance For which discrete financial information is available Requirement For areas determined to be reportable operating segments, the following disclosures are required: General information about the operating segment Information about segment profit or loss, including certain revenues and expenses included in reported segment profit or loss, segment assets, and the basis of measurement Reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items to corresponding enterprise amounts Interim period information © The McGraw-Hill Companies, Inc., 2007 3-44 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Ethics Case 3-17 Discussion should include these elements Facts: The impact of following the controller's suggestions would be to obscure financial information by aggregating the financial data of segment operations and investments Aggregation of data makes projections of future performance for African or European segments difficult and does not reveal relative investments for each segment SFAS 131 "Disclosures about Segments of an Enterprise and Related Information," suggests that reportable segments are those for whom financial data is available and whose results are regularly reviewed by company management in assessing performance The data for South Africa, Egypt, France and Denmark are available and most likely reviewed for performance purposes by the controller and higher management levels Ethical Dilemma: Should you as staff accountant challenge the controller's combination of segments or follow the controller's suggestion to obscure financial information by aggregating the financial data of segment operations and investments? Who is affected? You as a staff accountant Controller and other managers Other employees Shareholders Potential shareholders Creditors Financial analysts Auditors Who benefits and who is injured: Company management may benefit from aggregating the African and European data by attracting more investors to their company and obtaining more loans from creditors than would be the case with more complete disclosure regarding the South African segment Injured parties include current and future investors and creditors with economic, social and political concerns regarding Africa and Europe If investors and creditors later learn about undisclosed segment operations that prove unprofitable or violate their value systems, they may take action against McCarver-Lynn Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 3-45 ... particular, stock options granted to executives Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 3-3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com... shareholders’ equity Solutions Manual, Vol.1, Chapter 90,000 $70,000 76,000 146,000 $260,000 © The McGraw-Hill Companies, Inc., 2007 3-7 Find more slides, ebooks, solution manual and testbank... 20,000(cash) – 40,000(A/R) = $20,000 inventories Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 3-9 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com