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CHAPTER 15: SHORT-TERM LIABILITIES

QUESTIONS

2. Conceptually, how should a liability be measured?

Answer:Conceptually, a liability should be measured as the present value of all relatedfuture cash flows discounted at a rate of interest consistent with the risk involved.

6. In evaluating a balance sheet, some bankers say the liability section is one of the mostimportant parts. What are the reasons ustifying this position?

Answer:The primary reason is to assess the liquidity, and in the extreme, the solvency of thecompany. For this assessment, one would need to know (a) the current versus lon!termliabilities and (b) their maturity dates, interest rates, and other terms. "lso, liabilities are oftenthe most difficult of all the items listed on the balance sheet to ascertain with respect to theirexistence. "n individual, so inclined, can intentionally fail to report selected liabilities. "uditors

routinely conduct tests to detect unrecorded liabilities.

!. "ome liabilities are reported at their maturity amount. In general, when shouldliabilities, prior to maturity date, be reported at less than their maturity amount?

Answer:" liability will be reported at less than its maturity amount prior to the maturity date if(a) it is a non!interest!bearin note, or (b) the stated rate of interest on the liability is lowerthan the market rate of interest.

#. $efine a current liability.

Answer:" current liability is an obliation that will be settled by usin current assets or thecreation of other current liabilities. That is, it will be paid with current assets durin the cominyear or next operatin cycle, whichever is loner. #hort!term obliations that will be paid withnoncurrent assets should not be classified with current liabilities.

%%. $istinguish between the stated rate of interest and the effective rate of interest &yield'on a debt.

Answer:#tated rate of interest$the rate specified in the debt areement% it determines thecash interest to be paid. &ffective or yield rate$the true rate of interest based on the cashequivalents received and the total cash equivalents paid back.

%(. )re all declared dividends a liability between declaration and payment dates?*+plain.

Answer:" cash or property dividend is a liability between declaration and payment dates

because there is a contract to distribute assets. " stock dividend is not a liability because noassets will be distributed.

%6. Why is unearned revenue classified as a liability?

Answer:'nearned revenue, which is revenue collected in advance of bein earned, is aliability because oods or services must be expended in the future to earn the deferredrevenue.

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%!. What is compensated absence? When should the e+pense related to compensatedabsences be recognied?

Answer:" compensated absence is time away from work (represented by vacation, holiday,and sick leave) iven to employees without reducin their salaries or waes. The related

expense should be reconied when earned and not when the time is taken off, if the two aredifferent.

%-. What is the accounting definition of a contingency? What are the three characteristicsof a contingency? Why is the concept important?

Answer:" continency, as defined in SFAS No. 5, is an existin condition, situation or set ofcircumstances involvin uncertainty as to possible ain (a ain continency) or loss (a losscontinency) to an enterprise that will ultimately be resolved when one or more future eventsoccur or fail to occur. /esolution of the uncertainty may confirm () the acquisition of an assetor the reduction of a liability, or (+) impairment of an asset or the incurrin of a liability.

The three characteristics of a continency are () an existin condition, (+) uncertainty as tothe ultimate effect, and (0) its resolution dependin on one or more future events.

The concept is important because it represents a potential future asset or liability that hasarisen as a result of an event or transaction that has already occurred. The hih deree ofuncertainty results in extra caution in accountin for continencies.

2. /riefly e+plain the accounting and reporting for loss contingencies.

Answer:-oss continencies are either accrued or reported in a footnote, dependin upon thederee of uncertainty and whether they can be reasonably estimated. 1f probable andmeasurable, they are accrued% if probable but not sub2ect to reasonable estimation or if onlyreasonably possible, they should be disclosed by footnote. 1f the possibility of their arisin isremote, no disclosure is required.

EXERCISES

E 15-1 Multiple Choice

%. 0n 1anuary %!, %##-, an e+plosion occurred at a Cord Company plant causinge+tensive property damage to area buildings. )lthough no claims have yet beenasserted against Cord by arch %, %##-, Cord3s management and counsel concludedthat it was reasonably possible that Cord would be responsible for damages, and that42,(, would be a reasonable estimate of its liability. Cord3s 4%,,comprehensive public liability policy has a 4(, deductible clause. In Cord3s$ecember 5%, %##! financial statements, which were issued on arch 2(, %##-, howshould this item be reported?a. o footnote disclosure or accrual is necessary.b. )s a footnote disclosure indicating the possible loss of 4(,.c. )s an accrued liability of 4(,.d. )s a footnote disclosure indicating the possible loss of 42,(,.

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Answer:B. 3er #F"# , a loss continency should be accrued if it is probablethat a liabilityhas been incurred at the balance sheet date and the amount of the loss is reasonablyestimable. "lthouh the continency is reasonably estimable, it is notprobable. Therefore, noloss is accrued. 4owever, since the continency is reasonably possible, it will be disclosed inthe footnotes to the +*0*5 financial statements. The possible loss will be disclosed as

677,777. The additional potential liability above the deductible would be covered by theinsurance policy and would not be a loss for Cord.

2. 7one Company is the defendant in a lawsuit filed by Witt in %##! disputing thevalidity of a copyright held by 7one. )t $ecember 5%, %##!, 7one determined thatWitt would probably be successful against 7one for an estimated amount of 4-,.)ppropriately, an 4-, loss was accrued by a charge to income for the yearended $ecember 5%, %##!. 0n $ecember %(, %##-, 7one and Witt agreed to asettlement providing for cash payment of 4(, by 7one to Witt and transfer of7one3s copyright to Witt. 7he carrying amount of the copyright on 7one3s accountingrecords was 4%2, at $ecember %(, %##-. What would be the effect of the

settlement of this liability on 7one3s income before income ta+ in %##-?a. o effect.b. 4%2, decrease.c. 4%-, increase.d. 45, increase.

Answer: C. "t +*0*5, the continent liability from the lawsuit met #F"# 8s criteria foraccrual (probable and reasonably estimable), so a loss and liability of 6977,777 wasreconied. 1n 559, the lawsuit was settled and the actual loss was 6:+7,777 (6+7,777copyriht transfer and 677,777 cash payment). This is a chane in estimate which should beaccounted for in the period of chane per "3; ain from settlement of lawsuit........................................ 97,777Cash.............................................................. .... ... ... .... ... .. 77,777Copyriht........................................................ ... .... ... ... .... . +7,777

5. ) manufacturer of household appliances has potential losses due to the discovery of apossible defect in one of its products. 7he occurrence of the loss is reasonablypossible and the costs can be reasonably estimated. 7he possible loss should be

DisclosedAccrued in Footnotes

a. o ob. o 8es

c. 8es 8esd. 8es o

Answer:B. 3er #F"# , a loss continency will be accrued only if its occurrence is probableand the amount can be reasonably estimated. 1n this case the loss is not considered probableand, therefore, should not be accrued. "lthouh a continent loss is not accrued if it is onlyreasonably possible (not probable) it will be disclosed in the footnotes to the financialstatements. Therefore, the correct answer is ;, the reasonably possible loss will not be

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accrued but it will be disclosed. #uch disclosure should include the nature of the continencyand should ive an estimate of the possible loss or rane of loss or state that such anestimate cannot be made.

9. )n e+propriation of assets which is imminent and for which the amount of loss can bereasonably estimated should be

DisclosedAccrued in Footnotes

a. o ob. o 8esc. 8es 8esd. 8es o

Answer:C. The requirement is to determine the proper treatment of an expected loss that isimminent (probable) and the amount of which can be reasonably estimated. "nswer (C) iscorrect because, per #F"# ?o. , para. 9, an estimated loss from continencies shall beaccrued and chared to income when it isprobablethat an asset has been impaired or a

liability incurred and when the amount of the loss can be reasonably estimated. ;oth of theserequirements are met by the expropriation of assets described in this question. Therefore, thisloss continency should be accrued. "dditionally, per para. 5, the nature of the continencyshould be disclosed in a note to the financial statements. Therefore, answers (a), (b) and (c)are incorrect.


%. 0n $ecember 5%, %##-, /eal Company was involved in a ta+ dispute with the I:"./eal3s ta+ counsel believed that an unfavorable outcome was probable and areasonable estimate of additional ta+es was 42!(,, with a chance that theadditional ta+es could be as much as 492(,. )fter the %##- financial statementswere issued, /eal accepted the I:" settlement offer of 452(,. What amount ofadditional ta+es should have been accrued in %##-?a. 492(,.b. 452(,.c. 42!(,.d. 4

Answer:C. The additional taxes must be accrued as a loss continency in accordance with#F"# ?o. because an unfavorable outcome is probableand the amount of the loss isreasonably estimable. 3er F"#; 1nterpretation @, when a rane of possible losses exists,the best estimate in the rane (in this case 6+,777) is accrued. #ince the 60+,777

settlement occurred after the statements were issued, this information was not availablewhen the estimates were made. 1f, however, it had become available after the end of thefiscal year but before the financial statements were issued, it would have been a Type #ubsequent &vent and 60+,777 would be accrued in 559.

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2. 0n ovember (, %##!, a $unn Corporation truck was in an accident with anautomobile driven by :. /ell. $unn received notice on 1anuary %2, %##- of a lawsuitfor 45(, in damages for personal inuries suffered by /ell. $un Corporation3scounsel believes it is probable that /ell will be awarded an estimated amount in the

range between 4%, and 422(,, and that 4%(, is a better estimate ofpotential liability than any other amount. $unn3s accounting year ends on $ecember5%, and the %##! financial statements were issued on arch 2, %##-. What liabilityshould $unn accrue at $ecember 5%, %##!?a. 4.b. 4%,.c. 4%(,.d. 422(,.

Answer:C. 3er #F"# , a loss continency should be accrued if it is probablethat a liabilityhas been incurred at the balance sheet date and the amount of the loss is reasonablyestimable. This loss must be accrued because it meets both criteria. &ven thouh the lawsuit

was not initiated until *+*59, the liability was incurred on **5 when the accidentoccurred. F"#; 1nterpretation @ requires that when some amount within an estimated raneis a better estimate than any other amount in the rane, that amount is accrued. Therefore, aloss of 67,777 should be accrued. 1f no amount within the rane is a better estimate thanany other amount, the amount at the low end of the rane is accrued and the amount at thehih end is disclosed.

5. 7he following information pertains to a fire insurance policy in effect during thecalendar year %##-, covering ;ail Company3s inventory

;ail3s inventory averages 4(, uniformly throughout the year. ;ail3s income ta+rate is 9>. ow much of a contingent liability should ;ail accrue at $ecember 5%,%##- to cover possible future fire losses?a. 4.b. 4%(,.c. 425,.d. 46,.

Answer:A. The requirement is to determine the amount Aail should accrue as a continentliability at +*0*59 to cover possible future fire losses. "nswer (a) is correct because, per#F"# , para. 9, a continent liability shall only be accrued if the likelihood of its occurrenceis probableand the amount of the loss can be reasonably estimated. "n event such as afuture fire loss is not considered probable at +*0*59 based on the information iven, nor canan amount of the loss from such an event be reasonably estimated. Thus, no accrual isrequired at +*0*59.



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9. When the occurrence of a gain contingency is reasonably possible and the amount canbe reasonably estimated, the gain contingency should bea. Included in net income and disclosed.b. Included in an appropriation of retained earnings.

c. $isclosed, but not included in net income.d. either included in net income nor disclosed.

Answer:C. 3er #F"# , para. , continencies that miht result in ains usually are notreflected in the accounts since to do so miht result in revenue bein reconied prior to itsrealiation. "lthouh adequate disclosure shall be made of continencies that miht result inains, care should be exercised to avoid misleadin implications as to the likelihood ofrealiation. Therefore, answer (c) is correct. "nswer (a) is incorrect because the aincontinency should not be reconied in the income statement. "nswer (b) is incorrectbecause the ain continency would not be reflected in anyof the accounts. "nswer (d) isincorrect because the continency should be disclosed in the notes to the financialstatements.


%. :obb Company re@uires advance payments with special orders from customers formachinery constructed to their specification. Information for %##- is is incurred evenly during the first contract year and 6> evenlyduring the second contract year. :eceipts from service contract sales for the two yearsended $ecember 5%, %##- are 42(, in %##! and 45, in %##-. :eceipts fromcontracts are credited to unearned service contract revenue. )ssume that all contractsales are made evenly during the year. What amount should Cobb report as unearnedservice contract revenue at $ecember 5%, %##-?a. 4%-,.b. 425(,.c. 429,.d. 45%(,.

Answer:D. "ll contract sales are made evenlydurin the year. Therefore, the 55 contractsrane from one year expired (if sold on +*0*5) to two years expired (if sold on **5), foran averae of E years expired. #imilarly, the 559 contracts rane from 7 years expired to year expired, for and averae of E year expired. The averae unearnedportion of the 55contracts is E year. The amount of unearned revenue related to the 55 contracts iscalculated as follows=

6+7,777 x :7 x E G 6,777

The averae unearnedportion of the 559 contracts is E years. The amount of unearnedrevenue related to the 559 contracts is calculated as follows=

6077,777 x @7 x E G 6 :7,7776077,777 x :7 G 97,777

6+@7,777

Therefore, the total unearned revenue is 6,777 H 6+@7,777 G 60,777.

5. In packages of its products, Curran Co. includes coupons that may be presented atretail stores to obtain discounts on other Curran products. :etailers are reimbursed forthe face amount of coupons redeemed plus %> of that amount for handling costs.Curran honors re@uests for coupon redemption by retailers up to three months afterthe consumer e+piration date. Curran estimates that !> of all coupons issued willultimately be redeemed. Information relating to coupons issued by Curran during%##- is as follows< consumer e+piration date, $ecember 5%, %##-D total face amountof coupons issued, 45,D and total payments to retailers as of $ecember 5%,%##-, 4%%,. What amount should Curran report as a liability for unredeemed

coupons at $ecember %, %##-?a. 4.b. 4%,.c. 4%2%,.d. 4%(9,.

Answer: C. "t +*0*59, Curran should report a liability even thouh the coupons expired+*0*59 because retailers may submit coupons to Curran for three months after the



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expiration date. Thus, Curran will still have to redeem coupons until 0*0*55. Total expectedredemptions are 6+7,777 (.7 x 6077,777), and on those redemptions Curran expects to payout 6+0,777 (6+7,777 plus .7 x 6+7,777 for handlin) "s of +*0*59, total payments toretailers have been 67,777, which means a liability of 6+,777 should be reported(6+0,777 ! 67,777).

9. )n employer3s obligation relating to employees3 rights to receive compensation forfuture absences is attributable to employees3 services already rendered. 7he paymentof compensation is probable and the amount of compensation can be reasonablyestimated. *mployees3 compensation should bea. )ccrued if the obligation relates to rights that vest or accumulate.b. )ccrued if the obligation relates to rights that do not vest or accumulate.c. *+pensed when paid.d. $isclosed but not accrued if the obligation relates to rights that vest or

accumulate.

Answer: A. #F"# @0, para. : requires employers to accrue a liability for future absences

when all of the followin conditions are met=) The employees8 services have already been rendered.+) The obliation relates to rihts that vest or accumulate.0) 3ayment is probable% and@) The amount can be easily estimated.


%. /loy Company pays all salaried employees on a biweekly basis. 0vertime pay,however, is paid in the ne+t biweekly period. /loy accrues salary e+pense only at its

$ecember 5% yearend. $ata relating to salaries earned in $ecember %##- are< East payroll was paid on $ecember 26, %##-, for the twoweek period ended on

that day.

0vertime pay earned in the twoweek period ended $ecember 26, %##- was

4-,9.

:emaining work days in %##- were $ecember 2#,5, and 5%, on which days there

was no overtime.

7he recurring biweekly salaries total 4%(,.

)ssuming a fiveday workweek, /loy should record a liability at $ecember 5%, %##-,for accrued salaries ofa. 49(,.

b. 4(5,9.c. 4#,.d. 4#-,9.

Answer:B. the liability for accrued salaries at +*0*59 should include all salaries expensethat has been accrued but not yet paid. This would include the overtime pay earned byemployees for the two!week period ended +*+:*59 (69,@77), which will not be paid until thenext pay period. "ccrued salaries would also include the reular pay for the workdays



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(Iecember +5, 07, and 0). #ince each biweekly pay period results in 67,777 reular payfor 7 workdays (+ five!day weeks), the accrued salaries for three workdays would be 0*7 of67,777, 6@,777. Therefore, the total liability for accrued salaries at +*0*59 is 60,@77(6@,777 H 69,@77).

2. 0n "eptember %, %##!, the Fine Company issued a note payable to ational /ank inthe amount of 4#,, bearing interest at %2>, and payable in three e@ual annualprincipal payments of 45,. 0n this date the bank3s prime rate was %%>. 7he firstinterest and principal payment was made on "eptember %, %##-. )t $ecember 5%,%##-, Fine should record interest payable ofa. 422,.b. 429,.c. 455,.d. 456,.

Answer:B. "ccrued interest payable at +*0*59 is interest expense that has been incurredby +*0*59 but not yet paid. 1n this case, interest was last paid on #eptember , 559, so the

accrued interest payable includes interest expense incurred for 5* throuh +*0 (@ months).The oriinal balance of the note was 6577,777, but the 5**59 principal payment of 6077,777reduced the balance to 6:77,777. Therefore, the interest payable at +*0*59 is 6+@,777.

6:77,777 x .+ x @*+ G 6+@,777

The stated rate of + is used rather than the bank8s prime rate of because + is therate neotiated for this particular note.

5. Fam, Inc. has 4(, of notes payable due 1une %(, %###. )t the financial statementdate of $ecember 5%, %##-, Fam signed an agreement to borrow up to 4(, torefinance the notes payable on a longterm basis. 7he financing agreement called forborrowings not to e+ceed -> of the face value of the collateral that Fam wasproviding. )t the date of issue of $ecember 5%, %##- financial statements, the valueof the collateral was 46, and was not e+pected to fall below this amount during%###. In its $ecember 5%, %##- balance, Fam should classify notes payable as

Short-term Long-termObligations Obligations

a. 4 4(,b. 4 2, 49-,c. 4%, 49,d. 4(, 4

Answer:B. "ll the notes are due :**55 and normally the entire amount would be classifiedas current. 4owever, #F"# ?o. : states that a short!term obliation can be reclassified aslon!term if the enterprise intends to refinance the obliation on a lon!term basis and theintent is supported by the ability to refinance. 3am demonstrated its ability by enterin into afinancin areement before the statements are issued. #F"# ?o. : further states that theamount to be excluded from current liabilities cannot exceed the amount available forrefinancin under the areement. 3am expects to be able to refinance at least 6@97,777 (.97x 6:77,777) of the notes. Therefore, that amount can be classified as lon!term while theremainin 6+7,777 must be classified as short!term.



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9. Which of the following is classified as an accrued liability?

Liability for Liability forFederal Employers

nemployment Share of !a"es F#$A !a"es

a. 8es 8esb. 8es oc. o od. o 8es

Answer: A. "ccrued liabilities include expenses that have been incurred but not yet paid.;oth federal unemployment taxes and the employer8s share of F1C" taxes represent taxexpense that is incurred as employees earn waes, but which is only paid periodically.Therefore, both types of expenses represent accrued liabilities.

E 15-7 Identi!in" Cu##ent $i%&ilitie'(Consider the following five itemsiven% same for both notes.5. Katurity value is the amount due at maturity, excludin any separate interest

payments.7. >iven for interest!bearin% not applicable to noninterest! bearin note,. #ame as stated rare on interest!bearin note% implicit (iven as the oin rate) on

noninterest!bearin note, +. 'sed to compute cash received,

E15-14 Cu##ent $i%&ilitie'. O#i"in%l %nd *d/u'tin" Ent#ie';intage "ales Company, a largeretail outlet, completed the following selected transactions during %##- and %### Convertible subordinated debentures 4%##

In 1uly %##(, the (N percent debentures were called by the company and converted into (.- millionshares of common stock.

)dditional information ACCO?NTIN6 3OR LEASES

QUESTIONS

9. ive the primary ))F concepts of accounting for an operating lease by lessors and lessees.

Answer:


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will differ (the lessor includes the uaranteed residual value in minimum lease payments, but thelessee does not).

The second case arises when the lease does not meet any of the first three criteria iven in the text in&xhibit !+ for a capital lease. 1nclusion of uaranteed residual value by a third party may make thelease a capital lease for the lessor (it meets criterion @ of &xhibit !+) because the present value ofthe lease payments (includin the uaranteed amount) exceeds 57 percent of the market value of the

asset at lease inception. 4owever. the lease may not satisfy criterion @ for the lessee because thepresent value of the lease payments (excludin the uaranteed amount) does not exceed 57 percentof the market value of the asset. 1n this case, the lease will be treated as a capital lease by the lessorand an operatin lease by the lessee.

%(. When computing annual depreciation, what residual value should the lessee use for a leased assetunder a capital lease? /riefly e+plain each alternative.

Answer:The residual value used by the lessee to compute depreciation on a leased asset dependson the lease contract. 1f the lease contains no barain purchase option, does not transfer ownershipto the lessee at the end of the lease term, and the lessee does not uarantee the residual value, thelessee inores the residual value (uses a residual value of ero). 1f the lessee does uarantee theresidual value. the uaranteed amount must be used as the residual value.

1f the lease contains a barain purchase option or transfers the asset to the lessee at the end of thelease term, the lessee must use the estimated residual value at the end of the useful life of the asset(rather than at the end of the lease term.)

EXERCISES


%. :ent should be reported by the lessor as revenue over the lease term as it becomes receivableaccording to the provisions of which of the following leases?

0i#ect Ain%ncin" $e%'e Ope#%tin" $e%'e S%le'-T!pe $e%'e

a. 8es 8es 8esb. 8es o oc. o 8es od. o o 8es

Answer:C3er #F"# ?o. 0. rent should be reported by the lessor as revenue over the lease termfor an operatin lease as it becomes receivable accordin to the lease provisions. ;oth direct!financin and sales!type leases are types of capital leases. For these lease types. the lessor reportsinterest income over the lease term rather than rental income. Therefore. answer (C) is correct. andanswers ("). (;). and (I) are incorrect.

2. 7he present value of minimum lease payments should be used by the lessee in determining theamount of a lease liability under a lease classified by the lessee as which of the following?

C%pit%l $e%'e Ope#%tin" $e%'ea. 8es 8esb. 8es oc. o od. o 8es

Answer:B. 3er #F"# ?o. 0. para . rental on an operatin lease is to be chared to expense overthe lease term as it becomes payable, unless the payment pattern does not represent a systematic

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and rational allocation over the lease term (in which case the straiht!line method is recommended).?< lease liability is established for operatin leases. nor is a Ulease assetP reconied. The statementdoes. however. require the lessee in a capital leasin transaction to both establish a lease liabilityequal to the present value of the minimum lease payments. and reconie the leased asset for thesame amount. Therefore. answer (;) is correct.

5. Eease 8 does not contain a bargain purchase option, but the lease term is e@ual to # percent of theestimated economic life of the leased property. Eease O does not transfer ownership of the property tothe lessee by the end of the lease term. but the lease term is e@ual to !( percent of the estimatedeconomic life of the leased property. ow should the lessee classify these leases?

$e%'e B $e%'e

a. Capital lease 0perating leaseb. Capital lease Capital leasec. 0perating lease Capital leased. 0perating lease 0perating lease

Answer: B3er #F"# ?o. 0. para , if a lease meets one or more of four criteria. the lease isclassified as a capital lease by the lessee.


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leased property. "nswer (d) is incorrect because a sales!type lease involves a manufacturer8s ordealer8s profit while a direct!financin lease does not.

2. ) lease is recorded as a salestype lease by the lessor. 7he difference between the gross investment inthe lease and the net receivable should bea. )mortied over the period of lease as interest revenue by the interest method.

b. )mortied over the period of lease as interest revenue by the straightline method.c. :ecognied in full as interest revenue at the leaseKs inception.d. :ecognied in full as manufacturer K or dealerKs profit at the leaseKs inception.

Answer:A. 3er #F"# ?o. 0, para lb. the difference between the ross investment in the leaseand the sum of the present values of the two components of the ross investment shall be recordedas unearned income. The unearned income shall be amortied to income over the lease term so as toprovide a constant periodic rate of return on the net investment in the lease. 3er "3; ?o. +. para :.the ob2ective of the interest method is to arrive at a level (i.e.. constant) effective rate (of interest).Therefore. answers (;), (C), and (I) are incorrect.

5. In a lease that is recorded as a sales type lease by the lessor. interest revenuea. $oes not arise.

b. "hould be recognied over the life of the lease by the interest method.c. "hould be recognied over the life of the lease by the straightline method.d. "hould be recognied in full as revenue at the leaseKs inception.

Answer:B. 3er #F"# ?o. 0, para b, revenue is to be reconied for a sales!type lease over thelease term so as to produce a constant rate of return on the net investment in the lease. This requiresthe use of the interest met!od. Therefore, answer (;) is correct and answer (C) is incorrect. "nswer(") is incorrect because, per #F"# ?o. 0, interest revenue does arise in a sales!type lease. "nswer(I) is incorrect because the interest is to be earned over the life of the lease, not in full at the leaseSsinception.


%. 0n 1anuary %, %##-, ill Corporation leased a machine to 0tt Corporation for a fiveyear term at anannual rental of 4(,. 7he lease is an operating lease. )t the inception of the lease, ill received4%, covering the first year . s rent of 4(. and a security deposit of 4(,. 7his depositwill not be returned to 0tt upon e+piration of the lease but will instead be applied to payment of rentfor the last year of the lease. ill properly reported rental revenue of 4%, in its %##- income ta+return. illKs ta+ rate was 5 percent. In illKs $ecember 5%. %##-, balance sheet, what portion of the4%, should be reported as a liability?a. 4(,.b. 49,.c. 45(,.d. 42-,.

Answer: A. Ieposits and prepayments received for services to be provided in the future areunearned revenues which should be recorded as a liability until earned. The first yearSs rent isrecorded as rent revenue, but the #7,777 deposit is recorded as rent collected in advance(unearned rent) because Kil is required to render future services (use of the machine) to the lessee.The rate (07) does not affect the amount of the liability to the lessee, althouh a separate deferredtax asset may he recorded in certain circumstances.

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2. /eal, Inc., intends to lease a machine from Faul Corporation. /ealKs incremental borrowing rate is %9percent. 7he prime rate of interest is - percent. FaulKs implicit rate in the lease is % percent, which isknown to /eal. /eal computes the present value of the minimum lease payments using what rate?a. - percent.b. % percent.c. %2 percent.

d. %9 percent.

Answer: B. #F"# ?o. 0 states that the lessee should compute the 3A of the minimum leasepayments usin the lesser of the lesseeSs incremental borrowin rate (@ in this case) or the implicitrate used by the lessor if known (7 in this case). The 3A of the minimum lease payments shouldbe computed usin we implicit rate of 7 because it is known by the lessee and is lower than theincremental rate. The prime rate (9) is never used unless it happens to be the same as theincremental or implicit rate.

5. 0n 1anuary 2, %##-. )she Company entered into a %year noncancelable lease re@uiring yearendpayments of 4%,. )sheKs incremental borrowing rate is %2 percent. and the lessorKs implicitinterest rate, known to )she, is % percent. 0wnership of the property remains with the lessor ate+piration of the lease. 7here is no bargain purchase option. 7he leased property has an estimated

economic life of %2 years. What amount &rounded' should )she capitalie for this leased property on1anuary 2, %##-?a. 4%,,.b. 46%9,(.c. 4(6(,.d. 4.

Answer:B. This is a capital lease for the lessee because the lease term (7 years) covers more than of the economic life of the leased asset (.x + G 5 years). 1n a capital lease. the lesseerecords the 3A of the minimum lease payments as an asset and a liability. The lease payments arediscounted usin the lesser of the lessee8s incremental borrowin rate or the= implicit rate used by thelessor, if known. 1n this case, the lessee knows the implicit rate is 7, which is lower than theincremental rate of +. Thus. when the lease is sined. the 3A amount recorded as in asset and

liability is 6:@,77 (677,777 x (3A", 7, 7).

9. 0n $ecember 5, %##!, $rew Company leased e@uipment under a capital lease for a period of %years. $rew contracted to pay 4#. annual rent on $ecember 5%, %##!, and on $ecember 5% ofeach of the ne+t nine years. 7he capital lease liability was appropriately recorded at 46-,9 on$ecember 5, %##!, before the first payment. 7he leased e@uipment has a useful life of %2 years, andthe interest rate implicit in the lease is % percent. $rew, uses the straightline method fordepreciating all e@uipment. In recording the $ecember 5%, %##-. payment. $rew should reduce thecapital lease liability bya. 45-,%6.b. 4(,!.c. 4(%,-9.

d. 46,-9.Answer:A8The initial lease liability at +*07*5, before the first lease payment, is 6:79,@77. The+*0*5 payment consists entirely ofS principal, brinin the +*0*5 balance down to 69.@77(6:79,@77 ! 657,777). The +*0*59 payment consists of both principal and the interest incurreddurin 559. 559 interest is 6,9@7 (69,@77 x 7), so the principal portion of the +*0*59payment is 609.:7 (657,777 ! 6,9@7).

Chapter !*+7! "ccountin for -eases


52/191


%. 0n 1anuary %, %##!. Perr Company signed a %year noncancelable lease for a new machine.re@uiring 42. annual payments at the beginning of each year. 7he machine has a useful life of %(years, with no salvage value. 7itle passes to Perr at the lease e+piration date. Perr uses straightlinedepreciation for all of its plant assets. )ggregate lease payments have a present value on 1anuary %.

%##!. of 4%26.. based on an appropriate rate of interest. =or %##!, Perr should record depreciation&amortiation' e+pense for the leased machine ata. 42,.b. 4%2,6.c. 4-,9.d. 4.

Answer:C. #ince title passes to the lessee at the end of the lease, this is a capital lease for thelessee. The lessee records the leased asset and lease liability at an amount equal to the lesser of theFKA of the leased asset or the 3A of the minimum lease payments (6+:,777). This asset isdepreciated on a straiht!line basis over its useful life of years. resultin in a yearly depreciationchare of 69,@77 (6+:,777 ). The asset is depreciated over its useful life rather than over thelease term because title transfers to the lessee, allowin the lessee to use the asset for years.

2. 7he lessee should amortie the capitaliable cost of the leased asset in a manner consistent with thelessee3s normal depreciation policy for owned assets for leases that do which of the following?

T#%n'e# 9;ne#'hip

o the #ope#l! to the

Cont%in % ,%#"%in $e''ee &! the End o>

u#ch%'e Option the $e%'e Te#+

a. o ob. o 8esc. 8es 8esd. 8es o

Answer:C. The requirement is to determine if a lessee should amortie the capitaliable cost of a

leased asset in a manner consistent with the lesseeSs normal depreciation policy for owned assets forleases that contain a barain purchase option and*or transfer ownership at the end of the lease term.Transfer of ownership of the property to the lessee by the end of the lease term and a lease thatcontains a barain purchase option are properly classified as capital leases (#F"# ?o. 0. paras (a)and (b)). 3er #F"# ?o. 0. para (a), if the lease meets either of the above criteria, the assetshould be amortied in a manner consistent with the lesseeSs normal depreciation policy for ownedassets. Therefore. answers ("). (;). and (I) arc incorrect.

5. ) lease contains a bargain purchase option. In determining the lesseeKs capitaliable cost at thebeginning of the lease term, the payment called for by the bargain purchase option woulda. ot be capitalied.b. /e subtracted at its present value.

c. /e added at its e+ercise price.d. /e added at its present value.

Answer: D. The requirement is to determine whether or not a barain purchase option should becapitalied as part of the minimum lease payments. 3er #F"# ?o. 0. para . minimum leasepayments include the= rental payments plus the amount of the barain purchase option, if it exists.3er para 7, the amount to be capitalied is the present value of the minimum lease payments.Therefore. the present value of the barain purchase option would be added to the present value of

Chapter !:*+7! "ccountin for -eases


53/191

the rental payments (assumed to be previously calculated) in determinin the lesseeSs capitaliablecost.

9. 0n 1anuary 2. %##(. Wayne. Inc.. signed an eightyear lease for office space. Wayne has the option torenew the lease for an additional fouryear period on or before 1anuary 2. 25. $uring 1anuary %##!,two years after occupying the leased premises. Wayne made general improvements to the premises

costing 456. and having an estimated useful life of % years. )t $ecember 5%. %##!. Wayne3sintentions as to e+ercise of the renewal option are uncertain because they depend upon future officespace re@uirements. ) full yearKs amortiation e+pense is taken for calendar year %##!. Wayne shouldrecord amortiation of leasehold improvements for %##! ata. 45..b. 456,.c. 4"9(,.d. 46,.

Answer: D. The requirement is the amount ofS 55 amortiation expense for leaseholdimprovements. The cost of leasehold improvements (60:7,777) should be amortied over theremainin life of the lease, or the useful life of the improvements. whichever is shorter. Bhen thelease contains a renewal option, the life of the lease does not include the renewal period unless it is

probable that the option will be exercised. Therefore, in this case. the remainin life of the lease is sixyears (9!year lease term less the two years one by). The renewal period of four years is notconsidered since exercise of the option is uncertain. The useful life of the improvements is ten years.so the improvements are amortied over the remainin lease life of six years, This results in 55amortiation of 6:7,777 (60:7,777K : years).


%. In a saleleaseback transaction the sellerlessee has retained the property. 7he gain on the sale shouldbe recognied at the time of the saleleaseback if the lease is classified as which of the following?

C%pit%l $e%'e Ope#%tin" $e%'e

a. 8es 8esb. o oc. o 8esd. 8es o

Answer:B. 3er #F"# ?o. +9. any profit related to a sale!1easeback transaction in which the sellerretains the property leased (i.e., the seller!lessee retains substantially all of the benefits and risks ofthe ownership of the property sold), shall be deferred and amortied in proportion to the amortiationof the leased asset, if a capital lease. 1f it is an operatin lease, the profit will be deferred in proportionto the related ross rental chared to expense over the lease term. -osses, however, are reconiedimmediately for either a capital or operatin lease. #ince the ain on the sale should be deferred ineither case, no ain is reconied at the time of the sale, and answer (;) is correct.

2. 0n $ecember %. %##-. /arr Company' leases office space for five years at a monthly rental of

46,. 0n that date, /arr pays the lessor, the following amountsrocery) durin 559=

Dan. , 559=

(a) To record sale of the asset=Cash.................................................................... 77,777

"sset............................................................. @7,777'nearned ain, sale*leaseback..................... 7,777

(b) To record inception of the direct financin lease=-eased asset (buildin)........................................ 77,777

-ease liability................................................. 77,777

Iec. 0, 559=

(c) To record lease payment=1nterest expense (677,777 x .+)....................... :7,777

-ease liability (699,@5+ ! 6:7.777)..... .. .. .. .. .. . +9,@5+Cash.............................................................. 99,@5+

Chapter !@*+7! "ccountin for -eases


61/191

(d) "d2ustin entry!to record depreciation=Iepreciation expense (677.777 L 7)....... ... ... ... 7,777

"ccumulated depreciation (leased asset)...... 7,777

(e) To amortie unearned ain='nearned ain on sale*leaseback...................... .. ,777

Iepreciation expense.................................... ,777

67,777 L 7 years G 6,777.

E 17-22 $e%'e %nd R%tio *n%l!'i'"uppose a firm were re@uired to place its operating leases on itsbalance sheetD that is, the firm is re@uired to capitalie its leases. What would be the impact on thefollowing ratios% @.1% .&% :.;% .C% 9."% 5.I% 7.4.

E 1-4 Reco#din" %nd Repo#tin" Inco+e T% Con'e?uence' o# % T;o-Be%# e#iod 7he records of"tar Corporation provided the following data related to accounting and ta+able income C%pit%l Stoc= to O#"%niFe#'. 8%lu%tion C. /anfield, an engineer, developed aspecial safety device to be installed in backyard swimming pools< When turned on, it would set off analarm if anything should fall into the water. 0ver a twoyear period. /anfieldKs spare time was spent

developing and testing the device. )fter receiving a patent, three of /anfieldKs friends, including a lawyer,considered plans to produce and market the device, )ccordingly. a charter wits obtained, whichauthoried 2, shares of 4% par value stock. *ach of the four organiers contributed 42,, andeach received in return 2, shares of stock. 7hey also agree that, for other consideration, each wouldreceive (, additional shares. 7he remaining shares were to be held as unissued stock. *ach organiermade a proposal concerning how the additional (, shares would be paid for. 7hese individualproposals were made independentlyD then the group considered them as a package. 7he four proposalswere""3% nothin is stipulated about what happens if dividends are deficient.

Re(uirement )

"n equitable recommendation that conforms with >""3 is=

. &stablish a 67,777 value to be paid by each party, because=

(a) a market value of 67 per share has already been set as a ood measure by the priortransactions (see comments above under ;anfield), and

(b) Friend ]0 has established a sound >""3 basis for 67 per share

+. ;anfield$The 67,777 valuation on the patent is suspect. 1nsist upon two independent appraisals ofthis patent$there are competent experts available. 1nsist upon cash or a note (like Friend ]0) for anydifference between the appraisal and the 67,777 to be paid in.

0. -awyer$Io not accept the 67,777 prepaid leal fees. 1nsist upon cash or a note like the oneproposed by Friend ]0. "scertain that the past leal fees are competitive.

@. Friend ]+$1nsist upon two independent appraisals. 1f the appraisals are lower than 6:07,777, requirecash, or a reduction of the loan assumed, for the difference.

. Friend ]0$"ccept as is, except insist upon deletion of the stipulation Uto be paid out of dividendsbecause (a) nothin is said about the responsibility for payment if dividends are inadequate, and (b) itplaces an undue, and probably illeal, constraint on the board of directors in the future.

Chapter 2 %9B%6 Corporations< Contributed Capital


117/191

*29-3 O;ne#' E?uit! St%te+ent< Stuc= I''ue Co't'tech oldings Corporation is a computer andcommunications services company. Its consolidated statements of shareholders3 e@uity for the threeyearperiod ending =ebruary 2!, %##5, followross proceeds=Common stock, par value................................................. 6 @,777

"dditional paid!in capital................................................... 0,0@,777 60,057,777-ess= stock issue costs........................................................... 9+,777?et proceeds...................................................................... .... . 60,+79,777

3roceeds per share G 60,+79,777*@,+5,7@7 G 67.

Re(uirement

3urchase price per share G 607,777*@7,757 shares G 67.>tech is usin the cost method to account for treasury stock.

Re(uirement 4

;ook value per share at February +0, 55=

6,:,777*(0@,95,7@0 @7,757) G 67.0+ per share

;ook value per share at February +, 550=

6:9,7,777*(@+,55,75 ^ @7,757 H 0,@:0D) G 60.5+ per share

;ook value per share has increased more than tenfold over the two!year period. The primary source ofthe increase is not in the profitability of the firm, but rather the issuance of ,577,777 shares for more

than657.7 million, an averae price of 6.0 per share.

Re(uirement 5

The averae price per share paid for treasury stock acquired durin fiscal 550 was=

60,777*0,@:0 shares G 6.@ per share

The averae proceeds per share for shares issued in 550 were=

(65,777 G 657,+5@,777)*,577,777 shares G 6.0 per share

The lare difference between the cost of treasury stock and proceeds per share for newly acquired issuesis difficult to explain. 3ossible reasons include=

>tech has developed a product or made a discovery such that future prospects for

the company8s profitability have skyrocketed between the date the shares wereacquired and the shares issued.

#ome continency (such as a ma2or lawsuit) is resolved in favor of >tech.

Chapter 2 %6B%6 Corporations< Contributed Capital


119/191

C:*TER 21

COROR*TIONS. RET*INE0 E*RNINDS *N0 STOCJ OTIONS

%. *+plain what an appropriation of retained earnings is, and why it is. made.

Answer:"n appropriation of retained earnins reduces the amount of retained earnins availablefor dividends. "ppropriations are established to protect the cash position of the corporation byreducin the amount of cash dividends that miht otherwise be paid. To the extent that the amountof cash dividends is reduced because of inadequate retained earnins. cash is saved.

2. What are the principal sources and uses of retained earnings?

Answer: The principal source of retained earnins is income from operations (includinextraordinary ains). The primary uses of retained earnins are cash dividends. stock dividends,recapitaliations, retirement of stock and treasury stock transactions, and absorption of losses.

9. What are the four important dates relative to dividends? *+plain the significance of each.

Answer:"ccountin for dividends involves four important dates= () declaration date% (+) recorddate% (0) ex dividend date, and (@) payment date. The e$/"r"tin "te is the date on which thecorporation formally announces the dividend. "s to cash and property dividends, it is the date onwhich the dividend becomes irrevocable% therefore. on this date the dividends are recorded in theaccounts. The re$r "teis the date on which the list of stockholders of record is prepared. ?oentry is made in the accounts on this date. The e i2ien "teis the day followin the recorddate.


120/191

%2. Contrast the effects of a typical small stock dividend &declared and issued' versus a typical cashdividend &declared and paid' on the components of stockholdersK e@uity.

Answer: $apital Additional $ontributed %etainedDi5idend Stoc> C"#it"/ E"rnings

Cash ?o effect ?o effect Iecrease#tock, small 1ncrease 1ncrease Iecrease

%9. $istinguish between a large stock dividend and a pure stock split.

Answer:" stock dividend involves the issuance of additional shares of stock to the stockholders inproportion to the shares that they held prior to the dividend. 1t reduces retained earnin. andincreases contributed capital by the same amounts, but does not chane total stockholders equity.1n contrast. a pure stock split involves the replacin of the old shares with a larer number of newshares with a proportionately lower par value per share. " pure stock split does not chane thecomponents or total of stockholders8 equity. ?either a stock dividend nor a stock split requires thedisbursement of corporate assets% both reduce earnins per share.

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

Answer:Fundamentally. retained earnins are appropriated and restricted to indicate that such

amounts are not available for dividends durin the period of appropriation or restriction, therebyprotectin the workin capital position of the corporation. 4owever, such appropriations andrestrictions arise for a number of reasons. The primary reasons are=(a) To fulfill a leal restriction.(b) To fulfill a contractual restriction.(c) To record a discretionary action by the board of directors to appropriate a portion of retained

earnins as an aspect of financial plannin.(d) To record a discretionary action by the board of directors to appropriate a portion of retained

earnins in anticipation of possible future losses.

%6. *+plain the distinction between &a' a bond sinking fund and &b' an appropriation of retainedearnings for a bond sinking fund.

Answer:

(a) " bond sinkin fund is created by depositin cash in a special fund (like a savins account) andrecordin it in a separate account as an investment. 'sually the fund is under the control of atrustee% the fund is an asset and is used at maturity to retire bonds.

(b) " restriction of retained earnins for a bond sinkin fund is a constraint on retained earnins% itdoes not directly involve assets nor does it chane total stockholdersS equity. The amount istemporarily restricted from payin dividends% therefore, it serves to protect workin capital bypreventin a noncurrent drain on cash for dividends. 1t provides a measure of security to thebondholders.

2. What is the difference between stock rights and stock warrants?

Answer:St$< rights$provide the holder with an option to acquire a specified number of sharesof the capital stock of a company under specified conditions. St$< w"rr"nts$a certificate that

evidences ownership of one or more stock rihts.

22. Eist the three important dates with respect to stock rights. When will the related stock sell (a)rightson and (b)e+ rights?

Answer:/ihts$important dates and market status=(a) "nnouncement date(b) 1ssuance date #tock sells!rihts on(c) &xpiration date #tock sells!ex rihts

Chapter + +* Corporations= /etained &arnins O#tock


121/191

2(. "tock option incentive plans for employees may be either noncompensatory or compensatory./riefly e+plain each.

Answer:" nn$m#ens"tr0 plan is one that does not involve additional compensation to therantee and involves no cost to the corporation. 1t is characteried by the followin four attributes=() substantially all full!time employees who meet the limited employment qualifications mayparticipate (employees ownin a specified percent of the outstandin shares and executives may

be excluded), (+) stock is offered to those eliible equally or based on a uniform percentae ofsalary or waes (the number of shares of stock purchased by an employee may be limited), (0) thetime permitted for exercise of an option or purchase riht is limited to a reasonable period, and (@)the discount from market price is no reater than would be reasonable in an offer of stock tostockholders or other outside parties (the discount varies up to percent in practice).

"ll plans not possessin all four of the above attributes are classified as $m#ens"tr0. Theyinvolve a cost to the corporation and additional compensation to the employee.

5. What are stock appreciation right?

Answer:#tock appreciation rihts (#"/s) usually provide a cash bonus to the employee (rantee)based upon the chane in the market value of specified shares of capital stock from the date ofrant to the exercise date.

5%. $iscuss how SFAS No /0 H)ccounting, for "tock/ased Compensation,H differs from A1O2inion No /3in recording the compensation cost of fi+ed stock options with the e+ercise price sete@ual to the grantdate market price of the stock.

Answer:'nder "3; Opinion No. 15) the cost of fixed options is measured at the market price ofthe option stock as of the rant date. less the exercise price. multiplied by the number of shares.Bhen the exercise price is equal to the current stock price. the cost (which would normally beexpensed over the service period) is ero. 'nder the procedures specified in SFAS No. (1,) thecost of options is determined at the rant date usin an option pricin model. 1n every case.includin options ranted with exercise prices equal to or even reater than the current stock price.the cost will be reater than ero. SFAS No. (1, increases the measured value of the options,resultin in increased compensation expense.

E 21-2#ope#t! 0iidend Reco#ded. Co++on %nd #ee##ed Stoc=7he records of =rost Corporationshowed the following at the end of %##-

Iecember 0, +77+$&xercise of stock options=Cash (,777 shares x 6+7)................................................................... +7,777&xecutive stock options outstandin.................................................... @.777

Common stock, par 6 (,777 shares)................ ... .... ... ... .... ... .... .. ,777Contributed capital in excess of par............................................... +0,777

Re(uirement +

P"ctual valueP received by /oe (rantee)=(697 ! 6+7) x ,777 shares G 6:7,777.

"dditional compensation expense reported by /ex Corporation (rantor)=(6+@ ! 6+7) x ,777 shares G 6@,777.

E21-14 Stoc= Incentie l%n6$%A$ &o' 1):*n%l!'i' %nd Ent#ie')ssumeall the data given in*+ercise 2%%5 with the following modifications and additional facts, nonconvertible, issued at par %BlB#!..........%,,Income before e+traordinary items...................................................%-2,*+traordinary loss &net of ta+'...........................................................&%-,'et income........................................................................................%69,)verage income ta+ rate.........................................................................9>

Required:

%. Is this a simple or comple+ capital structure? *+plain.

2. What kind of *F" presentation is re@uired? *+plain.

5. Compute the re@uired *F" amounts &show computations'.

9. Compute the re@uired *F" amounts, assuming that the preferred is cumulative.

Answers:

%e&uirement '

This is a simple capital structure because (a) the preferred stock is nonconvertible, (b) the bonds payableare nonconvertible, and (c) there are no rihts, options, or other securities convertible to common stock.

%e&uirement (

Chapter ++ *: &arnins per #hare


143/191

;ecause this is a simple capital structure. only a sinle set of &3# amounts is presented for incomebefore extraordinary items and net income.

%e&uirement )

Computations of &3# amounts=

(a) 3referred dividend claim for current year=6+77,777 x : G 6+,777. /econied on the noncumulative preferred stock because the currentyear preferred dividend has been declared.

(b) "verae number of common shares outstandin durin year=

A$tu"/ Retr"$ti2e Mnths Sh"re-Time Peri Sh"res Austment Outst"ning Mnths

Manuary , shares outstandin @77,777Manuary to Karch 0 @77,777 x .7 x 0 G ,+:7,777

"pril , sold additional shares +,777"pril to #eptember 07 @7+,777 x .7 x : G +,0+,:77#ept 07, 55, stock dividend +7,77#ept 07 to Iecember 0 @++,77 x 0 G ,+::,077

Total #hare Konths + ,79,577

"verae number of shares outstandin, ,79,577 L + G @+,

(c) &arnins per share on common stock=

1ncome before extraordinary items (69+,777 !6+,777N) L @+, shares G 6.@7&xtraordinary lossNN (69,777) L @+, shares G (.7@)?et income (6:@,777 ! 6+,777N) L @+, shares G 6.0:

N 3referred dividend claim.

NN ?et required to be shown on face of the income statement. ;ut if not, the value must be in thenotes

%e&uirement *

"ssumin the preferred stock is cumulative, the &3# amounts, in this case, would be the same ascomputed in /equirement 0 because (a) the current preferred dividend claim must be honored forcumulative preferred stock whether declared or not and (b) the claim must be honored for noncumulativepreferred stock only if declared (the situation iven in the problem data$see the notation for retainedearnins).

E 22- Co+pute ES o# Th#ee Be%#'. Stoc= 0iidend %nd Split:ambo CorporationKs accounting yearends on $ecember 5%. $uring the following three years, its common shares outstanding changed asfollows stock dividend, !B%B%##! 5,2for% stock split, !B%B%##- %(, L

"hares sold, %B%B%##- (, GGGGGG GGGGGG "hares outstanding, $ecember 5% 5(, %(, %2,

et Income 45!(, 455, 42##,

L =or each share turned in, two new shares were issued so that the sharesdoubled.

Required:

%. =or purposes of calculating *F" at the end of each year, for each year independently, determine thenumber of shares outstanding.

2. =or purposes of calculating *F" at the end of %##-, when comparative statements are being preparedon a threeyear basis, determine the number of shares outstanding for each year.

5. Compute *F" for each year based on year computations in &2'.

Answers:

%e&uirement '

This is a simple capital structure. For 55:, because the +7,777 added shares were sold at the start of thesecond quarter, on an equivalent basis they were outstandin of the year.

77,777 oriinal shares H (0*@ x +7,777) G ,777

For 55, because the only chane was due to a stock dividend, reardless of when it occurred durinthe year, the year!end fiure of 7,777 shares outstandin would be used for &3# purposes as thouhthat number had been outstandin for all of 55.

For 559, it is important to note that the +!for! stock split occurred on Muly before the sale on :The doublin of the number of shares durin 559 would pro2ect back to 55, raisin the 7,777for 55 (standin alone) to 077,777.

1**:For 55:, because the "pril sale of +7,777 shares preceded the + percent stock dividend of55 and the +!for! split of 559, a multiplier effect of +. (i.e., .+ x +) applies to the +7,777 shares, aswell as to the oriinal 77,777 shares, as shown below=

Chapter ++ 5*: &arnins per #hare


145/191

)59 )-.r-1D"te Origin"/ St$< St$D each 4%, bond is convertible to # shares of commonstock after the stock dividend &bonds issued at par in %##('.....................5,Income before e+traordinary items............................................................2%,

*+traordinary gain........................................................................................%2,et income.................................................................................................222,)verage income ta+ rate..................................................................................9>.

Required:

%. Is this a simple or a comple+ capital structure? *+plain.

2. What kind of *F" presentation is re@uired? *+plain.

5. Frepare the re@uired *F" disclosures.

Answers:

%e&uirement '

This is a complex capital structure because there are convertible bonds payable.

%e&uirement (

;ecause this is a complex capital structure, a dual set of &3# amounts$basic &3# and diluted &3#$isreported for (a) income before extraordinary items, (b) extraordinary items, and (c) net income.

Chapter ++ @*: &arnins per #hare


150/191

%e&uirement )

Computation of &3# amounts=

(a) #hares from assumed conversion of bonds=

;onds payable, @!E, convertible, 677,777

(677,777 L 6,777) x 97 G 9,777 shares;onds payable, :!E, convertible, 6077,777

(6077,777 L 6,777) x 57 G +,777 shares

(b) ;asic &3# for income before extraordinary items=

(6+++,777 ! 6+,777)*(77,777 H 7,777) G 6.@7

(c) ?umerator effects=

@!E bonds 677,777 (.7@) ( ! .@) G 6+,77

:!E bonds 6077,777 (.7:) ( ! .@) G 6,77

(d) I*" ratios and rankin ';A 0an@!E bonds= 6+,77*9,777 G 67.0@

:!E bonds= 6,77*+,777 G 67.@0 +

(e) I*" Tests

&nter the @!E bonds into tentative I&3# because 67.0@ W 6.@7 (;asic &3#). Tentative I&3# G(6+7,777 H 6+,77)*(7,777 H 9,777) G 6.0.

&nter the :!E bonds into tentative I&3# because 67.@0 W 6.0 (previous tentative I&3#).Tentative I&3# G final I&3# (there are no more potentially dilutive securities) G (6+7,777 H 6+,77H 6,77)*(7,777 H 9,777 H +,777) G 6++@,@77*9,777 G 6.+.

(f) &arnins per share

;asic=1ncome before extraordinary ain.........................................6.@7&xtraordinary ain (6+,777*7,777).................................... .79?et income.................................................................... .......6.@9

Iiluted=income before extraordinary ain.........................................6.+&xtraordinary ain (6+,777*9,777).................................... .7:?et income (6+++,777 H 6+,77 H 6,77)*9,777D..........6.+

Chapter ++ *: &arnins per #hare


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* 22-1 ES 0i'clo'u#e')merican ome Froducts Corporation &)F', a large company in the healthcare field, reported the following information &dollar amounts in thousands' in its $ecember 5%, %##(consolidated statement of incomeain on sale of equipment................................... (0,777)

?et cash inflow from operations...................... 609,777

2nvesting Activities3roceeds from sale of equipment........................ 60,777a

3urchase of equipment........................................ (7,777)a

?et cash outflow from investin activities........(5,777)

2nvesting Activities/etirement of bonds............................................ 6(,777)b

Iividends paid..................................................... (+,777)c

1ssuance of common stock.................................. 5,777d

?et cash outflow from financin activities.. .. .. . (+7,777

?et decrease in cash.................................................. (,777)Cash at beinnin of year.................. .... ... ... .... ... ... .... :7,777Cash at end of year.................................................... 65,777

?on!cash activity schedule=

"cquisition of plant assets throuh bond issuance 6+7,777

Chapter 25 #B%! "tatement of Cash =lows


161/191

Computation=

a To determine cash proceeds from sale of equipment and purchase of equipment=

&ntry for sale of equipment=

Cash (derived)..................................................................... 0+,777

"ccumulated depreciation.................................................... ++,777 N3lant assets.................................................................... @7,777>ain................................................................................ 0,777

N600,777 depreciation ! 6,777 increase in accumulated depreciation

4lant Assets* balance +@,777 @7,777 cost of assets soldacquisition (bonds) +7,777 Rac$uisition


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23- SCA< Indi#ect Method7he following is 0rem CorporationKs comparative balance sheets for %##-and %##!.

0ece+&e# 31

1) 17

Cash................................................................ 4 9, 4 5(,)ccounts receivable....................................... (69, (-9,Inventories...................................................... #29, -(!,(Froperty, plant and e@uipment....................... %,6(5,( %,9-5,()ccumulated depreciation............................. &(-2,(' &(2,'Investment in /elle Co................................... %(2,( %5!,(Eoan receivable.............................................. %5(, GGGGGGG

7otal assets..................................................45,29!,(........................................................42,-#2,(

)ccounts payable........................................... 4 (!,( 4 9!!,(

Income ta+es payable..................................... %(, 2(,$ividends payable.......................................... 9, 9(,Capital lease obligation.................................. 2,Capital stock, common, 4% par...................... 2(, 2(,)dditional paidin capital.............................. !(, !(,:etained earnings........................................... %,9-(, %,59(,

7otal liabilities and stockholders3 [email protected],29!,(........................................................42,-#2,(

)dditional informationain on sale of equipment................................... +,77

N 607,777 ! 6,77

@. 3roperty, plant and equipment.................................... +77,777Capital lease obliation........................................ +77,777

Orem Cr#r"tinSt"tement . C"sh 3/ws

3r the 7e"r Ene De$em'er 1= 1**+


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Financin activitiesIividends paid..................................................................... (@,777)

?et Financin cash flow............................................. (@,777)

?et increase in cash................................................................ 7,777Cash at beinnin of year....................................................... 07,777Cash at end of year................................................................. 6@77,777

N "ccumulated depreciation increased 6:+,77, net, durin 559, but was reduced6+,77 on the sale of equipment. Therefore, depreciation expense was 6,777.

1on-cash acti5ity schedule"cquisition of office buildin throuh capital lease................................ ..... 6+77,777

23-14 SCA( Indi#ect Method. Option%l Sp#e%d'heet7he income statement, balance sheet, andanalysis of selected accounts of "ummer Company are given below.

,%l%nce Sheet

0ece+&e# 31 Inc#e%'e

0e&it' 17 1) @dec#e%'e

Cash plus shortterm investmentsL......... 4 -, 4 -#,- 4 #,-)ccounts receivable &net'....................... %2, %(, &%(,'erchandise inventory &perpetual'......... 56, 2-5,2 &!6,-'Frepaid insurance.................................... 9,- 2,9 &2,9'Investments, longterm........................... 6, &6,'Eand........................................................ 2, !6,- (6,-Flant assets.............................................. (, (%-, %-,Fatent &net'.............................................. 5,2 2,- &9'................................................................ 4%,%9-, 4%,!-, 4&!,'

C#edit'

)ccumulated depreciation... ... ... ... ... .. .. .. . 4 %5, 4 %(-, 4 2-,)ccounts payable.................................... %, %6, 6,Wages payable........................................ 9, 5, &%,'Income ta+es payable.............................. %-, 26,- -,-/onds payable......................................... 2, %, &%,'Fremium on bonds payable..................... %, 5,9 &6,6'Common stock, par 4%.......................... 6, 6%2, %2,Contributed capital in e+cess of par........ 5, 56, 6,:etained earnings.................................... (6, 52,- &25,2'................................................................ 4%,%9-, 4%,!-, 4&!,'

Chapter 25 %5B%! "tatement of Cash =lows


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Inco+e St%te+ent 1)

"ales revenue............................................. 4 -,Cost of goods sold...................................... &99-,-'$epreciation e+pense................................. &2-,'Fatent amortiation.................................... &9'

:emaining e+penses &including interest'.... &2-!,-'*+traordinary gain, net of 4(, ta+......... %(,et income................................................. 4 (,

)nalysis of selected accounts and entries Dr8 Cr8 1)@1@*+

Cash and short!term investments... 97,777 (q) 5,977 95,977"ccounts receivable, net................. +7,777 ,777 (b) 7,777Kerchandise inventory.................... 0:7,777 :,977 (c) +90,+773repaid insurance........................... @,977 +,@77 () +,@771nvestments, lon!term................... :7,777 :7,777 (k)-and............................................... +7,777 (m) :,977 :,9773lant............................................... 77,777 (l) 9,777 9,7773atent, net...................................... 0,+77 @77 (f) +,977

"ccumulated depreciation........ ...... (07,777) +9,777 (e) (9,777Total "ssets................................ ,79,777 5+7,777

"ccounts payable.......................... . 77,777 :,777 (d) 7:,777Baes payable............................... @,777 (h) ,777 0,7771ncome taxes payable..................... 9,777 9,977 (i) +:,977;onds payable................................ +77,777 (n) 77,777 77,7773remium on bonds payable............ 7,777 (2) :,:77 0,@77Common stock, 67 par.................. :77,777 +,777 (l) :+,777Contrib capital in excess of par....... 07,777 :,777 (l) 0:,777/etained earnins.......................... :,777 (p) :7,777 7,777 (a) 0+,977

................................................... (o) 0,+77 Total -iabs O


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"d2ustments -eadin to #CF=

Inire$t MethO#er"ting A$ti2ities Dr8 Cr8

?et income..................................... 7,777 (a) 7,777#ales............................................... 977,777 (b) ,777

Cost of oods sold.......................... @@9,977 (c) :,977....................................................... (d) :,777Iepreciation................................... +9,977 (e) +9,7773atent amortiation......................... @77 (f) @77/emainin expenses...................... +9,977 () +,@77....................................................... ,777 (h)....................................................... (i) 9,977....................................................... :,:77 (2)&xtraordinary ain.......................... +7,777 +7,777 (k)Tax on extraordinary ain............... ,7773rior period ad2ustment$tax pymt. 0,+77 (o)

#n5esting Acti5ities

#ale of investments........................ (k) 97,7773urchase of land............................. :,977 (m)

Financing Acti5ities

/etirement of bonds....................... 77,777 (n)Iividends paid................................ :7,777 (p)....................................................... +,:77?et cash increase........................... 5,977 (q)....................................................... +:,@77 +:,@77

Summer Cr#r"tinSt"tement . C"sh 3/ws

3r the 7e"r Ene De$em'er 1= 1**+

$ash flow from operating acti5ities:?et income........................................................................... 67,777

"dd (deduct) to reconcile net income to net cash flowIepreciation expense....................................................... +9,977

"mortiation of patent....................................................... @77&xtraordinary ain on lon!term investment..................... (+7,777)Iecrease in prepaid insurance......................................... +,@77Kerchandise inventory decrease...................................... :,977

"mortiation of bond premium.......................................... (:,:77)"ccounts receivable decrease.......................................... ,777"ccounts payable increase............................................... :,777Baes payable decrease................................................. (,777)1ncome taxes payable increase........................................ 9,9773ayment on prior years8 income tax (prior period ad2.)...... (0,+77)

?et cash inflow from operatin activities.............................. 6@:,:77

$ash flow from in5esting acti5ities:#old lon!term investment................................................... 97,7773urchased land.................................................................... (:,977)

?et cash inflow from investin activities (?ote ").................... +0,+77

Chapter 25 %(B%! "tatement of Cash =lows


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$ash flow from financing acti5ities:Cash dividends paid............................................................. (:7,777);onds payable retired.......................................................... (77,777)

?et cash outflow from financin activities............................... (:7,777

?et increase in cash and cash equivalents durin 559......... 5,977Cash and cash equivalents balance, Manuary , 559............ 97,777

Cash and cash equivalents balance, Iecember 0, 559...... 695,977

?ote " 3urchased operational asset, cost 69,777% paid in full by issuin ,+77 sharesof common stock.

* 23- U'in" the o#ld ide e&. St%te+ent o C%'h Alo;' 7his problem re@uires access to theWorld Wide Web portion of the Internet. 7he data for use in this problem is the most recent %P annualreport of Cisco "ystems. 7o obtain that information, use the "ecurities and *+change CommissionKs*lectronic $ata athering, )nalysis and :etrieval "ystem &*$):' to retrieve CiscoKs report. "teps toaccess *$): on the World Wide Web 4 6,#!! 46,(9% 4(,#%-International..... %#> .5,(!% 5.%96 2.!2%> %,(9- #,6-! -,65-

"nack =oods< J." .................. %> (,9#( (,%% 9,56(International..... %#> 5,( 5,2(5 2,662

%2> -,(9( -,269 !,2!

:estaurants< J." .................. %%> #,22 -,6#9 -,26International..... 2(> 2,%26 %,-2! %,55

%5> %%,52- %,(2% #,5(6

Co+&ined Se"+ent'

J." .................. #> 42%,6!9 42,296 4%-,5#International..... 2> -,!9! -,226 6,!%2

%2> 5,92% 2-,9!2 2(,2%

/y J.". :estaurant ChainFia ut.......... -> 4 5,#!! 4 5,!%2 4 5,(#(7aco /ell.......... %(> 5,(5 5,59 2,-((P=C.................. #> %,!22 %,692 %,(!6

%%> 4 #,22 4 -,6#9 4 -,26

Ope#%tin" #oit

/everages< J." .................. %%> 4 %,%9( 4 %,22 4 #5!

International..... %#> %69 %#( %!2%2> %,5# %,2%! %,%#

"nack =oods< J." .................. #> %,%52 %,2( #%International..... %9> 5 5(2 2-#

%> %,952 %,5!! %,%#

:estaurants< J." .................. %> 9(% 6(# 6-(International..... -> &2%' !% #5

#> 95 !5 !!-

Co+&ined Se"+ent'

J." .................. %> 4 2,!2- 4 2,!6 4 2,(25

International..... %9> 955 6%- ((9%> 5,%!% 5,529 5,!!

*@uity &Eoss' Income............. &5' 5- 5Jnallocated e+penses, et...... &%-%' &%6%' &2'0perating Frofit...................... %%> 4 2,#-! 4 5,2% 4 2,#!

Chapter + 7*+ #pecial Topics, Iisclosures, etc.


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Co+&ined Se"+ent'

D#o;th R%te

Net S%le' 19-15 15 14 13

/y J.". :estaurant ChainFia ut.......... #> 4 5- 4 2-( 4 55-

7aco /ell.......... %2> %( 2!5 2(6P=C.................. !> 5- %% #%%> 4 9(% 4 6(# 4 6-(

Se"+ent Ope#%tin"

Net S%le' #oit @$o'' Identii%&le *''et'

Deo"#%phic *#e%' 15 14 13 15 14 13 15 14 13

Jnited "tates. .. . 42%,6!9 42,296 %-,5# 42,!2- 42,!6 42,(25 4%9,(( 4%9,2%- 4%5,(#*urope.............. 2,!-5 2,%!! %,-%# &6(' %! 9! 5,%2! 5,62 2,666e+ico ............ %,22- 2,25 %,6%9 - 26% 225 65! ##( %,2%!Canada ............ %,2## %,299 %,26 -6 -2 %2 %,599 %,592 %,.5690ther.................. 5,95! 2,!-2 2,!5 592 2(- %-2 2,62# 2,%#6 %,6!(

Combined "egments45,92%42-,9!242(,2% 45,%!% 45,529 45,!! 22,292 2%,-%5 2,(%2

Investments in Jnconsolidated )ffiliates............................................................. %,65( %,2#( %,#%

Corporate............................................................................................................. %,((( %,6-9 2,%5

42(,952 429,!#2 425,!6

/everages......... #> 4%,52 4#,(66 4 #,%( /y J.". :estaurant Chain"nack =oods..... !> (,9(% (,99 9,##( Fia ut..... -> 4%,! 4%,-52 4%,!55:estaurants....... %9> 6,!(# !,25 6,9%2 7aco /ell..... %#> 2,2!6 2,52! 2,6Investments in Jncon P=C............. !> %,%%% %,2(5 %,26(

solidated )ffiliates #> %,65( %,2#( %,#% 7otal J."....... %2> (,-! (,9%2 (,(-Corporate.......... #> %,((( %,6-9 2,%5 International. . 2!> %,6!2 %,!#% %,5(9

-> 42(,952 429,!#2 425,!6 %9> 46,!(# 4!,25 46,9%2

Required:

% . In what different lines of business does FepsiCo report? =or %##(, which line of business earned thelargest profit margin &operating profit as a percent of revenues'? 7he smallest profit margin? Whichof the restaurant chains has the highest profit margin?

2. In what lines of business does FepsiCo appear to be growing the most rapidly? ow does this growthrelate to the profit margins of the various lines of business?

5. In general how important is international operations to FepsiCo? Comment on the relative profitmargin of J.". versus international operations.

9. Consider another measure of profitability such as operating income divided by identifiable assets.*valuate the profitability of FepsiCoKs various businesses.

Answer:

Cmment:"s a roup assinment. this case can involve a reat deal more analysis than that specificallyasked for in the assinment. For example, students could be asked to analye operatin marins andreturn on investment for earlier years, lookin for trends in the data. " more detailed profitability analysisof each restaurant chain could be conducted. Finally, the importance of unconsolidated affiliates could beanalyed. These areas are not specifically addressed in the assined material, and thus are notaddressed here.

Chapter + *+ #pecial Topics, Iisclosures, etc.


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%e&uirement '

3epsiCo reports three lines of business= ;everaes, #nack Foods, and /estaurants. 1t is also possible tofurther break out each of these sements into '.#. and international components. The 55 profitmarins for the three basic sements are=

;everaes 6,075*67,@9 +.@

#nack Foods 6,@0+*69,@ :.9/estaurants 6@07*6,0+9 0.9

The snack foods sement has to hihest marin at :.9, and the restaurant sement has the lowest at0.9.

The profit marins for the three restaurant chains are=

3ia 4ut 6079*60,5 .Taco ;ell 67*60,70 0.7YFC 609*61,++ +.+

3ia 4ut has the hihest marin.

%e&uirement (

#omewhat surprisin, sales rowth in the restaurant sement is rowin most rapidly, especially in theinternational area (+ rowth). "lso, restaurants is the sement with the hihest rowth rate as

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