intermediate accounting kieso15e continuingcase sols vol1

Continuing Case – Solution

Chapter 1

MemorandumTo: Eric Conner and Phil Martin, CM CorporationFrom: L. HarbachRe: SEC Regulations and FASB Standards for Non-Public CompaniesDate: January 2, 2013

(a) As a non-public company, CM Corporation is not subject to SEC regulations. The SEC has jurisdiction only over public companies whose stock is traded on a U.S. national exchange.

(b) Although CM Corporation is not required to have a formal audit that is required of companies registered with the SEC, an audit is a valuable service. An independent auditor’s verification of a non-public company’s financial statements provides various external users with credible evidence related to the company’s financial position and results of operations. External users of this information may include lenders and suppliers/vendors who may negotiate sales or credit terms based on the information presented in the financial statements. Audited financial statements provide these users with information to assess whether a company is creditworthy.

Non-public companies are not required to prepare their financials in accordance with GAAP. However, financial statements prepared in accordance with GAAP provide external users the ability to more confidently interpret and compare the financial position of a company. The use of GAAP also assists management in preparing forecasts and analyzing the company’s financial position and results of operations.

If CMC is considering listing securities on a national stock exchange in the future, the company might benefit from preparing its financial statements in accordance with GAAP and having those statements audited. These steps would ease CMC’s transition to public company status, since registering securities with the SEC requires audited comparative financial statements.


Chapter 2

MemorandumTo: Eric Conner and Phil Martin, CM CorporationFrom: L. HarbachRe: Elements of FASB Conceptual FrameworkDate: January 4, 2013

(a) The objective of financial reporting is to provide financial information that is useful to the reporting entity’s present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. General-purpose financial statements provide financial information to users who cannot otherwise demand such information from the entity. These users rely, at least partly, on the information in financial statements when making decisions about allocating resources.

(b) The term “relevant” as applied to financial statements means that the information can make a difference in a decision. In order to meet this criterion, information must be material. Information is material if omitting it or misstating it could influence users’ decisions. Relevance also requires either predictive value and/or confirmatory value. Information has predictive value if it can be used to form expectations about the future. Information has confirmatory value if it helps users in confirming or correcting their prior expectations.

The term “faithful representation” means that information (numbers and narrative) matches reality (i.e. that its factual content is accurate). In order to faithfully represent reality, financial accounting information must be complete. In other words, it must provide all data that is necessary in order not to be false, misleading, or both. Information that has the quality of “faithful representation” must also be neutral and free from error. In order to be neutral, the information must not be selected in a manner that favors a specific set of interested parties over others. It is important to note that information that is free from error does not have to be completely accurate. For example, financial statements contain many estimates that involve judgment. Such estimates by definition will not be completely accurate. They will often differ to some extent from actual results, but should be free of computation errors and should be based on the latest and best information available to management.

Both relevance and faithful representation are considered fundamental qualities of financial information as described in Statement of Accounting Concepts No. 8. Ideally both characteristics should be present in financial statement information. However, sometimes one characteristic may have to take precedence over the other. For example, U.S. accounting standards require companies to report property used in their business at historical cost. This value is deemed to faithfully represent the historical cost of property, plant, and equipment because it


can be verified from purchase documents; and this value is considered objective. This value is not strong with respect to relevance because it usually does not reflect the fair value of the asset.

(c) The enhancing qualities of financial information are comparability, verifiability, timeliness, and understandability. Comparability can be applied to information across companies or over time. When comparability exists between companies, multiple companies have measured and reported information in a similar manner. For example, if two companies use the same method of valuing their inventories, their inventory and cost of sales numbers are likely to be comparable. Another form of comparability is consistency. Information is consistent when a single company measures and reports information similarly from period to period.

Information is verifiable when independent measurers, using the same methods, obtain similar results. External audits help provide assurance as to the verifiability of financial statement information.

Information is timely when it is available to decision makers early enough to influence their decisions.

Understandability allows reasonably informed readers to see the significance of financial information. Reasonably informed users of financial statements are assumed to have a reasonable knowledge of business and economic activities.


Chapter 3

MemorandumTo: Eric Conner and Phil Martin, CMFrom: L. HarbachRe: Adjusting Entries and Accrual AccountingDate: January 5, 2013

At the end of the year, it is critical to perform adjusting entries to ensure that the company records revenues and expenses in the period in which they are earned/ incurred and that balance sheet accounts have the correct balances. I made the following adjusting entries in order to properly report revenues and expenses earned/incurred during the year and related balance sheet accounts as of year-end:

An adjustment was made to the unearned revenue account to recognize as revenue six months’ of the service that had been earned by year-end.

An adjustment was made to correct product sales revenue and the related cost of goods sold because a sale that occurred on January 3, 2013, was recorded incorrectly in December 2012.

Accrual adjustments were made for the following expenses incurred prior to year-end even though cash has not been paid: wages, bad debt, depreciation, interest, and income taxes.

Adjustments were made to recognize a portion of the related asset that had expired by year-end: insurance expense (one-year of the prepaid insurance), and depreciation of the property, plant, and equipment.

An adjustment was made to record the dividend declared December 15, 2012. This adjustment reduced equity (reduction to retained earnings after closing entries – with amounts recorded directly to Retained Earnings) and increased dividends payable by $110,000.

These adjustments allow the company to present its financial statements using the accrual basis of accounting. The accrual basis of accounting allows external users to measure a company’s performance based on the dates when income is earned or expenses are incurred, regardless of the inflow/outflow of cash. This method results in a report of company’s performance that may not correspond to cash flow. Thus, accrual accounting enhances users’ ability to make predictions about the future of the company’s operations and to compare results from one period to the next.


Additional Activity: Extend your accounting knowledge

Financial Assessment

2012 2011Current assets / Current liabilities

$2,126,086 / $1,722,962 = 1.23

$1,483,062 / $845,198 = 1.75

Total debt / Total assets $2,311,462 / $3,739,019 =0.62

$1,123,723 / $2,287,792 = 0.49

Net income / Sales $373,488/ $9,994,329=0.04

$703,892 / $9,960,712 = 0.07

CM2’s current assets / current liability ratio for both years is over 1.0, which means that the company has the liquidity to cover its current liabilities. In other words, CM2 has slightly more current assets each year than current liabilities. This ratio has declined and is something that management needs to monitor to ensure that the company’s liquidity stays within reasonable boundaries.

Looking at the total debt / total assets ratio, CM2 may be relying too heavily on debt to finance its operations: By 2012, the company has over 60% of its assets funded by debt. If CM2 continues with its stock offering at the end of 2013, it may be able to rely less on debt financing, and more on equity.

Finally, looking at its net Income / sales ratio, CM2’s profit per sales dollar has declined from 2011. The current number shows that 4% of every sales dollar contributes to profit. This shows that CM2 has incurred substantially more expenses, relative to sales, since last year. Management should look at its expense numbers to see where it might be able to cut costs.


Chapter 4

(a) Ratio Discussion

2011 2012 2013Gross margin** / Sales $4,159,057 / $9,960,712 = 0.4176 $4,107,670 / $9,994,329 =

0.4110$3,725,000 / $9,575,000 = 0.3890

Operating income / Sales $1,128,431 / $9,960,712 = 0.1133 $614,332 / $9,994,329 = 0.0615

$537,500 / $9,575,000 = 0.0561

Net income / Sales $703,892 / $9,960,712 = 0.0707 $373,488 / $9,994,329 = 0.0374

$331,500 / $9,575,000 = 0.0346

** Gross margin is also called gross profit.

Ratio Analysis:

The gross margin ratio measures the ability of a company to buy and sell goods and/orservices at a profit. Looking at CM2’s gross margin percentage, it appears that there is little varianceyear to year. However, in 2013, management expects this ratio to decline. This indicates thepossibility that CM2 expects either that the price of its goods and/or services will decline, thatthe cost of these goods/services is increasing, or that certain products/services will not contributeas much to profit as they do now.


The relationship between operating income and sales measures the profitability of acompany’s normal operations without peripheral items such as interest expense, gain/loss onsale of assets, and income tax expense. This measurement is an indicator of management’sefficiency in controlling the day-to-day operations of the business. An increasing ratioillustrates a firm’s ability to increase efficiency. CM2’s ratio is declining, which meansmanagement should examine its core business structure / strategy. CM2 may want to examine itsproduction efficiency, or look at how well they are controlling some of their general andadministrative costs.

The Net income / Sales ratio measures the overall profitability of a firm, including allsources of income and expenses. There is a decline from 2011 to 2012 in this ratio, and itappears that in 2013 management expects this number to remain about the same as in 2012.The decline from 2011 to 2012 appears attributable to the decreasing operating efficiency noted above. It appears that management expects that the decrease in efficiency from 2011 to 2012 will continue into 2013.


(b) Comment on Trends

Also see: Excel File

Entries to increase sales

J/E # Account Name DR CR***See note below

1 Accounts Receivable 1,007,500 Sales Revenue 910,000 Service Revenue 97,500

2 Product COGS 540,000Service COGS 45,000Product Sales Returns & Discounts 50,000 Inventory 585,000 Accounts Receivable 50,000

3 Bad Debt Expense 1,600 Allowance for Doubtful Accounts 1,600

4 Depreciation Expense 11,000 Accumulated Depreciation 11,000

5 Insurance 6,400 Prepaid Expenses 6,400

6 Other Operating Expenses 72,000 Accrued Liabilities 72,000

7 R & D 16,000 Accrued Liabilities 16,000

8 Wages—Employees 84,000 Accrued Liabilities 84,000

9 Wages—Officers 64,000 Accrued Liabilities 64,000


Assume Increase in 2013 Projections:

2011 2012 2013Gross margin** / Sales

$4,159,057 / $9,960,712 = 0.4176

$4,107,670 / $9,994,329 = 0.4110

$4,097,500 / $10,532,500 = 0.3890

Operating income / Sales

$1,128,431 / $9,960,712 = 0.1133

$614,332 / $9,994,329 = 0.0615

$655,000 / $10,532,500 = 0.0622

Net income / Sales

$703,892 / $9,960,712 = 0.0707

$373,488 / $9,994,329 = 0.0374

$407,875 / $10,532,500 = 0.0387

** Gross margin is also called gross profit.


The gross margin ratio is the same as before, which would be expected since therelationship between sales revenue and the cost of the product remains the same. Theoperating income and net income relationships both increased, which illustrates the increasein revenue which, when paired with a smaller increase in related expenses,will allow CM2 to remain profitable.The overall trend, however, from 2011 to 2013 is still in decline.

(c) Comment on Trends

Also see: Excel File

Entries to decrease sales

J/E # Account Name DR CR***See note below

1 Sales Revenue 455,000Service Revenue 48,750

Accounts Receivable503,75

0

2 Inventory 292,500Accounts Receivable 25,000

Product COGS270,00

0 Service COGS 22,500 Product Sales Returns and Discounts 25,000

3 Allowance for Bad Debt 1,600 Bad Debt Expense 1,600

4 Accumulated Depreciation 11,000 Depreciation Expense 11,000

5 Prepaid Expenses 6,400 Insurance 6,400


6 Accrued Liabilities 72,000 Other Operating Expenses 72,000

7 Accrued Liabilities 16,000 R & D 16,000

8 Accrued Liabilities 84,000 Wages—Employees 84,000

9 Accrued Liabilities 64,000 Wages—Officers 64,000


Assume Decrease in 2013 Projections:

2011 2012 2013Gross margin** / Sales $4,159,05

7 / $9,960,712 = 0.4176

$4,107,670 / $9,994,329 = 0.4110

$3,538,750 / $9,096,250 = 0.3890

Operating income / Sales $1,128,431 / $9,960,712 = 0.1133

$614,332 / $9,994,329 = 0.0615

$606,250/ $9,096,250 = 0.0666

Net income / Sales $703,892 / $9,960,712 = 0.0707

$373,488 / $9,994,329 = 0.0374

$376,188 / $9,096,250 = 0.0414

**Gross margin is also called gross profit.


The gross margin ratio is the same as before, which would be expected since therelationship between sales revenue and the cost of the product remains the same.Decreasing revenues by 5% while decreasing operating expenses by 8% actuallyimproved the operating and net income ratios. In fact, both ratios increased over 1% from theoriginal projections. In spite of lower revenues, it appears that lowering operating expenseshad a positive effect on the profitability of the company.

(d) The memo should discuss the following points:

A discontinued operation occurs when two things happen: (a) a company eliminates the results of operations and cash flows of a component from its ongoing operations, and (b) there is no significant continuing involvement in that component after the disposal transaction.

Companies report as discontinued operations (in a separate income statement category) the gain or loss from disposal of a component of a business. In addition, companies report the results of operations of a component that has been or will be disposed of separately from continuing operations. Companies show the effects ofdiscontinued operations net of tax as a separate category, after continuing operationsbut before extraordinary items. It is important to note that a component, for purposes of idetnifying discontinued operations, is defined as the lowest level at which a company can clearly distinguish operations and cash flows from the rest of the company’s operations.

Restructuring charges, relate to a major reorganization of company affairs, (e.g., costs associated with employee layoffs, plant closing costs, write-offs of assets, and so on). A company should not report a restructuring charge as an extraordinary item, because these write-offs are part of a company’s ordinary andtypical activities. Companies tend to report unusual items in a separate section just above “Income from operations before income taxes” and “Extraordinary items,” especially when there are multiple unusual items. For example, when General Electric Company experienced multiple unusual items in one year, it reported them in a separate “Unusual items” section of the income statement below “Income before unusual items and income taxes.”

In dealing with events that are either unusual or nonrecurring but not both, the profession attempted to prevent a practice that many believed was misleading. Companies often reported such transactions on a net-of-tax basis and prominently displayed the earnings per share effect of these items. Although not captioned “Extraordinary items,” companies presented them in the same manner. Some had referred to these as “first cousins” to extraordinary items. As a consequence, the FASB specifically prohibited a net-of-tax treatment for such items, to ensure that users of financial statements can easily differentiate extraordinary items—reported net of tax—from material items that are unusual or infrequent, but not both.


Chapter 5

Part I: Analysis of Balance Sheet and Cash Flows

(a) Liquidity and Solvency Ratios

2011 2012 2013Liquidity Ratios:Current Ratio = Current assets / Current liabilities

$1,483,062 / $845,198 = 1.7547

$2,126,086 / $1,722,962 = 1.2340

$2,817,434 / $1,980,810 = 1.4224

Quick Ratio = (Cash + Net receivables) / Current liabilities

($120,670 + $491,479) / $845,198 = 0.7243

($72,337 + $679,610) / $1,722,962 = 0.4364

($242,337 + $796,275) / $1,980,810 = 0.5243

Solvency Ratios:Debt to Equity = Total debt / Total shareholder equity

$1,123,723 / $1,164,069 = 0.9653

$2,311,462 / $1,427,557 = 1.6192

$2,489,310 / $1,644,057 = 1.5141

Debt to Total Assets = Total debt / Total assets

$1,123,723 / $2,287,792 = 0.4912

$2,311,462 / $3,739,019 = 0.6182

$2,489,310 / $4,133,367 = 0.6022

The liquidity ratios for CM2 are declining from 2011 to 2013. The current ratio for all three years is healthy because it is greater than 1.0, meaning that CM2 has enough current assets to cover its current liabilities. The decline in this number may be attributed to the fact that while CM2 is increasing both its current assets and current liabilities, it is incurring a greater percentage of liabilities to assets.

The quick ratio, or acid-test ratio as it is often called, examines a company’s “quick” assets (cash, marketable securities, and receivables), and compares these assets to the total current liabilities. It measures liquidity in a worst-case scenario, as if these quick assets were the only resources available to cover the company’s current liabilities. A ratio of 0.3 is generally regarded as ”healthy,” although this number may vary according to industry averages. CM2 is above this average, but this ratio is on the decline as well. The decline may also be indicative of CM2’s reliance on debt.

CM2’s solvency ratios, which measure debt as a percentage of equity and as a percentage of total assets, are increasing from 2011 to 2013. The total debt to equity ratio measures the risk to creditors in the event of insolvency. An increase in this ratio indicates greater reliance on debt. The greater the ratio, the more risky the company is to creditors, because there exists a substantial number of claims to the company assets by other creditors. In this case, CM2 may be relying too heavily on debt, and may want to develop a plan to use more of their equity.

The increase in CM2’s debt to total assets also illustrates the company’s increasing reliance on debt. Again, a larger ratio indicates a greater risk of


default. However, in the event of insolvency, CM2 could liquidate all of its assets and still manage to cover its debt.

(b) Free Cash Flow

2011 2012 2013Free Cash Flow = Cash flow from operating activities – Cash paid for capital expenditures – Dividends

$553,985 – $274,300 – $32,000 = $247,685

$645,015 – $460,087 – $48,000 =$136,928

$190,500 – $0 – $110,000=$80,500

Examining the three years’ of statements of cash flows, and the above free cash flow amounts, we see that CM2 could improve on its investment decisions and cash management strategies. The company had healthy figures in 2011, as cash from operating activities was strong and more than sufficient to cover their investing and financing activities, and other unexpected payments requiring cash. In 2012, CM2 had more cash outflow in investing activities than it generated from operations but supplemented its cash using proceeds obtained from long-term liabilities. The large amount invested in the company in 2012 is an indication of growth and investment in the company; however, management of CM2 should be concerned about the declining amount of cash it is generating from operating activities. For example, 2013 operating cash flows are projected to be less than half of what they were in 2011. Additionally, the company is not projecting any capital expenditures in 2013. Looking more closely at the adjustments to net income, it appears that CM2 continues to increase its inventory and accounts receivable without a corresponding increase in overall revenues. Could there be earnings management going on? Net income has been consistently greater than $300,000 in 2012 and 2013 (projected), but operating cash flows have plummeted during this same period. Could there be obsolete inventory maintained on the books that really should be written off? Are there receivables that either are not valid or should be written off as uncollectible?

Part II: Transparent Reporting

(a) CM2 is required to reclassify as current the portion of any long-term liability required to be paid within one year and to reclassify the portion of short-term assets that it does not expect to collect for over one year as long-term. Because one-quarter of the long-term debt is due in 10 months (less than a year), CM2 would need to remove one-quarter of the balance in the long-term debt account, and reclassify it as a current liability. The 20% of accounts receivable that is due in 18 months (greater than one year) should be removed from the current asset portion and reclassified as a long-term asset. The fact that 80% of CM2’s


suppliers want faster payment requires no adjustment, but it may be a source of strain on CM2’s current assets, particularly cash.

2011 2012 2013Liquidity Ratios:Current Ratio = Current assets / Current liabilities

($1,483,062 – $98,296) / ($845,198 + $69,631)= 1.5137

($2,126086 – $135,922) / ($1,722,962 + $147,125)= 1.0642

($2,817,434 – $159,255) / ($1,980,810 + $127,125) = 1.2610

Quick Ratio = (Cash + Marketable securities + Net receivables) / Current liabilities

($120,670 + $491,479 – $98,296) / ($845,198 + $69,631)= 0.5617

($72,377 + $679,610 – $135,922) / ($1,722,962 + $147,125) = 0.3294

($242,337 + $796,275 – $159,255) / ($1,980,810 + $127,125)= 0.4172

Solvency Ratios:Debt to Equity = Total liabilities / Total shareholder equity

$1,123,723 / $1,164,069 = 0.9653

$2,311,462 / $1,427,557 = 1.6192

$2,489,310 / $1,644,057 = 1.5141

Debt to Total Assets = Total debt / Total assets

$1,123,723 / $2,287,792 = 0.4912

$2,311,462 / $3,739,019 = 0.6182

$2,489,310 / $4,133,367 = 0.6022

The current and quick ratios are lower all three years because of the reclassification of items in the current sections. There was no effect on the solvency ratios since these ratios are not affected by changes in current and non-current classifications of assets and liabilities.

(b) CM2 is required to make the necessary adjustments to accurately reflect current and non-current portions of their long-term assets/liabilities on the balance sheet. If CM2 believed that specific account information would be useful to external users, they may disclose the details of this information in the notes to the financial statements. This is an example of application of the full disclosure principle. While these items do not meet recognition criteria, statement users nonetheless need information on the liquidity of these assets and liabilities. According to FASC 210-10-05-5

“Financial position, as it is reflected by the records and accounts from which the statement is prepared, is revealed in a presentation of the assets and liabilities of the entity. In the statements of manufacturing, trading, and service entities, these assets and liabilities are generally classified and segregated; if they are classified logically, summations or totals of the current or circulating or working assets, (referred to as current assets) and of obligations currently payable (designated as current liabilities) will permit the ready determination of working capital.”


According to FASC 210-10-20, “Working capital (also called net working capital) is represented by the excess of current assets over current liabilities and identifies the relatively liquid portion of total entity capital that constitutes a margin or buffer for meeting obligations within the ordinary operating cycle of the entity.”


Chapter 7

Part I MemorandumTo: Eric Conner and Phil Martin, CM2

From: L. HarbachRe: Bad Debt ExpenseDate: January 9, 2013

The accrual-based accounting system under GAAP requires that revenues and expenses be matched in the period in which they are earned or incurred, respectively. The direct write-off approach does not match the cost of bad debts with the related revenue earned. In other words, bad debt expense is recorded when actual accounts receivable are determined to be uncollectible, which could be in a different accounting period than when the revenue is recorded.

Moreover, accounts receivable should be stated at their net realizable value, which is the net amount expected to be received in cash. In order to accurately reflect this amount, an adjusting entry to estimate bad debt expense (and, at the same time, adjust the allowance for doubtful accounts) is required at the end of the accounting period. The estimate can be predicted with a fair amount of accuracy by using past experience, examining current market conditions, or by analyzing outstanding balances.


Part II MemorandumTo: Eric Conner and Phil Martin, CM2

From: L. HarbachRe: Sales and Trade DiscountsDate: January 9, 2013

The terms “2/10, n/30” and “4/15, n/45” are descriptions of payment terms offered to customers, with the first term (e.g. “2/10” or “4/15”) referring to the discount offered and the second term (e.g. “n/30” or “n/45”) referring to the normal (no discount) payment terms. The terms 2/10, n/30 give the customer a 2% sales discount if the account is paid within 10 days, meaning the customer has to pay only 98% of the sales invoice price if paid in full within 10 days of the invoice date. If payment is made after 10 days, the customer must remit the full invoice price within 30 days of the invoice date. The terms 4/15, n/45 give the customer a 4% sales discount if full payment is made within 15 days of the invoice date. If payment is made after the 15-day period, the customer must remit the full invoice amount within 45 days of the invoice date.

Offering sales discounts to clients encourages prompt payment and can even boost sales because of the incentive given to customers to save money by utilizing the sales discount offered. The down side is that sales discounts taken reduce the amount of cash the company receives for a particular sale.

A trade discount differs from a sales discount in that it is a quoted percentage off of a list price for merchandise. Trade discounts are generally offered to large- volume-buying customers. Companies also use trade discounts to avoid frequent changes in catalogs or to hide the actual invoice price from competitors. The benefit of using trade discounts over sales discounts is that they may stimulate a significant increase in sales revenues by motivating customers to purchase much larger quantities of a company’s product than they would normally buy if the discounts were not offered. Trade discounts, however, do not encourage prompt payment.


Additional Activity: Extend your accounting knowledge

MemorandumTo: Eric Conner and Phil Martin, CM2

From: L. HarbachRe: Accounts Receivable ManagementDate: January 9, 2013

(a)

AJE # Account DR CR1 A/R 455,000

Product Revenue 455,000

2 Product Sales Returns/Discounts 150,000 A/R 75,000 Cash 75,000

3 Cash 227,500 A/R 227,500


(b) An analysis of accounts receivable shows that the current management of receivables can be improved. The rationale for this conclusion is as follows: 1. The ratio of Allowance for Doubtful Accounts to Accounts Receivable is projected to be 0.1114 in 2013, compared to 0.1310 in 2012. Considering that the balance of accounts receivable is projected to increase from $782,080 in 2009 to $1,067,775 in 2010, the expense for bad debt and thus the allowance for bad debts should increase accordingly. If we are going to offer a more liberal credit plan to clients to boost revenues, we should increase the expense of the related risk associated with credit as well. Therefore, we should adjust the allowance for doubtful accounts to a balance of $139,879 ($1,067,775 x .1310). This adjustment would increase bad debt expense and the allowance for doubtful accounts by $20,879 each.

2. After adjustments for the anticipated increases in bad debt expense the following results occur: The projected accounts receivable turnover, which measures how quickly the accounts receivable are collected, drops from 17 times per year (2013) to 12 times a year (2012); thus the collection of accounts is much slower. The collection period increases from 21 days to 30 days, implying the cash will come in much more slowly. Neither of these numbers bodes well for a company relying on a consistent pattern of cash collection.

Cisco, a competitor of CM2 , has a slightly lower turnover and a slightly longer collection period, as reflected in their recent statements. It is important to keep in mind, though, that CM2‘s ratios will probably change after management addresses the bad debt issue discussed above. Cisco’s allowance for doubtful accounts is lower ($207 million; approximately 4.5 percent of its gross accounts receivable balance) than CM2’s allowance as a percentage of gross accounts receivable.

In conclusion, after analyzing the above ratios and those of a competitor, I see room for improvement in the management of our Accounts Receivable. Offering more liberal credit terms may indeed increase sales but will also be likely to increase uncollectible accounts. It is necessary then that the allowance for doubtful accounts reflect this added risk, and CM2 should be increasingly careful to sell its products to clients with good credit ratings.


Supporting Calculations:

2012 2013 Original 2013AdjustedAccounts Receivable Turnover = Net Sales/ Average Trade Receivables (net)

$9,994,329 / ($679,610 + $491,479/2)= 17.0684

$9,575,000 / ($796,275 + $679,610/2) = 12.9753

$9,880,000 / ($948,775 + $679,610/2) = 12.1347

Average Collection Period = 365 days/ Accounts Receivable Turnover Ratio

365 / 17.6084 = 21 days

365 / 12.9753 = 28 days 365 / 12.1347 = 30 days

Allowance for Doubtful Accounts /Gross Accounts Receivable

$102,470 / $782,080 = 0.1310

$119,000 / $915,275 = 0.13

$119,000 / $1,067,775= 0.1114

Sales Discounts/Sales

$50,000 / $9,575,000 = .05222%

$200,000 / $9,880,000 =2.0243%

Cisco Calculations

*Based on 2012 Financials

In millions

Accounts Receivable Turnover = Net Sales/ Average Trade Receivables (net)

$36,117 / ($4,369 + $4,698/2) = 10.1601

Average Collection Period = 365 days/ Accounts Receivable Turnover Ratio

365/10.1601 = 36 days


Chapter 8

(a)MemorandumTo: Eric Conner and Phil Martin, CM2

From: L. HarbachRe: Inventory Costing MethodsDate: January 11, 2013

Presented below are answers to the questions you posed at our last meeting.

There are four allowable cost flow assumptions when valuing inventory:

Specific identification traces the cost of the specific item sold and includes that amount in cost of goods sold. This method is practical only if a company sells a small number of items that are costly and easily distinguishable.

The average-cost method measures the average cost of all similar goods available during the period, and applies this amount to generate ending inventory and cost of goods sold.

The FIFO method assumes that the first goods in are the first goods sold. It uses the cost of the oldest inventory at the time of the sale as the cost of goods sold and the cost of newer goods as ending inventory, regardless of the actual physical flow.

The LIFO method is the opposite of the FIFO method. Under the LIFO method, the last goods in are assumed to be the first goods sold. Therefore, the cost of the later purchases (the newest inventory at the time of the sale) is used to calculate cost of goods sold.

FIFO produces the lowest cost of goods value and the higher ending inventory value in periods of rising prices when FIFO and LIFO results are compared. As a result, in a period of rising prices, switching from LIFO to FIFO will yield a lower cost of goods sold, which will result in a higher reported net income on the income statement. Inventory will also be reported at a higher value on the balance sheet.


(b) MemorandumTo: Eric Conner and Phil Martin, CM2

From: L. HarbachRe: Dangers of a LIFO LiquidationDate: January 11, 2013

A LIFO liquidation tends to increase net income (assuming rising sales prices and inventory costs), because the lower cost of inventory from prior periods is matched to revenues at current prices. Because the current revenue isn’t matched to current costs, net income is distorted (overstated). The danger of managing earnings in this manner is that once the older layers of inventory are liquidated, and the company must return to its former method of costing inventory, earnings may look significantly worse. The company also generally pays more in taxes in a LIFO liquidation, thereby losing one of the principal advantages of LIFO.

(c) MemorandumTo: Eric Conner and Phil Martin, CM2

From: L. HarbachRe: Dollar-Value LIFODate: January 11, 2013

For most companies, dollar-value LIFO is a more practical method than traditional LIFO, and its application minimizes LIFO liquidations. With dollar-value LIFO, goods are measured in terms of the total dollar value in the inventory pool, not the physical quantity of goods in an inventory pool. Companies can combine similar goods into one pool, which are comprised of layers of dollar values over different years, rather than layers of goods from different purchases. As a result, increases in prices of some items in the pool can be offset by price decreases of other items, thereby avoiding LIFO liquidation effects. This method of classifying inventory into dollar-value pools minimizes the erosion of layers that is typical in LIFO liquidations.


Chapter 9


From: L. HarbachRe: Lower-of-Cost-or-MarketDate: January 13, 2013

Presented below is my analysis of the lower-of-cost-or-market approach.

The lower-of-cost-or-market (LCM) principle is applied to ensure that when inventory has experienced a decline in utility its value is not overstated on the balance sheet. Cost is the original acquisition price, and market is the cost to replace the item by purchase or reproduction. The method is a conservative approach because “conservatism” implies that efforts are made to not overstate inventory. The market price to be used for comparison is constrained by a ceiling and floor. The ceiling value, also known as the net realizable value (NRV), is defined as the estimated selling price in the normal course of business less predictable costs of completion and disposal. The floor is defined as the NRV less a normal profit margin. The market price used for LCM cannot be greater than NRV (ceiling) or less than NRV minus a normal profit margin (floor).

As a consequence, inventory cannot be reported at an amount in excess of the NRV or less than the NRV minus normal profit margin. The upper limit (ceiling) covers obsolete, damaged, or shopworn material. It would not be a good business decision to re-value inventory to a price greater than the potential selling price. The ceiling also prevents overstatement of inventories and understatement of the loss associated with a decline in the inventory’s utility in the current period.

The minimum (floor) deters understatement of inventory and overstatement of loss in the current period. Inventory should not be priced below this minimum floor amount because it measures what the company can receive for the inventory while still earning a normal profit. Valuing the inventory below the floor would permit a company to generate a windfall profit in future periods simply through the use of GAAP, which is unacceptable.

The ceiling, the floor, and the replacement cost are compared to determine the market value. The middle value is identified as the market value to be used for the LCM calculation and is next compared to the currently recorded cost. Inventory is then valued at the lower of these two values.


(b)Current Replacement Selling Item by Total

Inventory Cost Cost Price Market Item Classification InventoryCategory OneScanners $143,320 $144,200 $180,000 $147,600 $143,320Optical Readers 116,900 115,500 135,000 115,500 115,500Card Digitizers 125,460 127,400 140,000 127,400 125,460

$385,680 $390,500 $385,680Category TwoServers $120,870 $118,300 $145,000 $118,900 $118,900Routers 175,980 195,000 200,000 194,000 175,980Network Cards 262,150 260,500 270,000 260,500 260,500

$559,000 $573,400 $559,000Category ThreeFire Wire $95,610 $94,600 $100,000 $94,600 $94,600USB Cabling 86,240 86,400 95,000 86,400 86,240Fiber Optic Cabling 77,590 78,100 80,000 77,600 77,590

$259,440 $258,600 $258,600

Total $1,204,120 $1,222,500 $1,198,090 $1,203,280 $1,204,120

Note: Disposal costs are 3% of gross selling price.Normal profit is 15% of selling price.


Chapter 10


From: L. HarbachRe: Equipment ReplacementDate: January 16, 2013

I have analyzed the four options you presented for handling the old equipment, and the following summarizes my findings. For reference, the original Property, Plant, and Equipment account was stated at $1,195,192, and net income was projected at $331,500.

Option 1: Self-construction of new equipment

Journal Entries DR CR

Sale of old equipment (JE 1):Cash 60,000Accumulated Depreciation—Equipment 390,000 Equipment 440,000 Gain on Sale 10,000

Record interest on construction loan (JE 2)Interest expense 35,000 Accounts payable and short-term debt 35,000

Construction of new equipment (JE 3):Equipment (new) 691,300 ($650,000 + $41,300)

Interest Expense 41,300 Accounts Payable and Short-Term Debt 650,000

Calculations:

Construction loan: $350,000 @ 10% = $35,000 interest cost

Existing Debt: Weighted Average = $42,680 8.4%$508,500

$200,000 @ 9% = $18,000


$308,500 @ 8% = $24,680$508,500 $42,680

Actual interest costs = $35,000 + $18,000 + $24,680 = $77,680

Interest expense after considering capitalized interest: = $77,680 - $41,300 = $36,380

Construction Costs:

Total: $650,000 Weighted Average $425,000

Specific debt: $350,000 x 11% = $35,000Non-specific debt: $75,000 X 8.4% = 6,300

$41,300

Self-constructing the equipment will allow you to increase the Property, Plant, and Equipment account, net of accumulated depreciation by $691,300. This method will also allow you to capitalize the interest costs associated with construction. CM2 can thus minimize the amount of interest expense recorded on the 2013 income statement, even though interest payments will increase by $35,000 because interest-bearing liabilities will have increased by $350,000. This option will require an annual interest payment by year-end because the construction loan will be taken out at the beginning of 2013. It should be noted that since the construction loan is a one-year loan, you will have to repay that loan in 2014. Finally, self-construction will guarantee that the equipment is designed and built according to company specifications.

Option 2: Exchange the old equipment for new equipment

Journal EntriesDR CR

Equipment 685,000Accumulated Depreciation - Equipment 390,000 Equipment 440,000 Accounts Payable and Short-term Debt 625,000 Gain on Disposal of Equipment 10,000

Exchanging the equipment will allow you to recognize a $10,000 gain, therebyincreasing net income to $338,000. The PP&E asset account, net of accumulateddepreciation, will increase by $635,000, but liabilities will also increase by $628,500($625,000 + $3,500additional income tax liability on the gain of $10,000 @ 35% tax rate).


Option 3: Purchase new equipment with a non-interest-bearing note


Sale of old equipment (JE 1):Cash 60,000Accumulated Depreciation—Equipment 390,000 Equipment 440,000 Gain on Disposal of Equipment 10,000

Acquisition of equipment (JE 2):Equipment 683,857 Accounts Payable and Short-Term Debt 164,000 Long-term Liabilities 519,857

Purchasing new equipment with a non-interest-bearing note will increase theProperty, Plant, and Equipment account, net of accumulated depreciation by $683,857; itwill increase short-term liabilities by $164,000 and long-term liabilities by $519,857.The advantage of this option is that short-term liabilities will increase by only $164,000,whereas for all of the other options this account will increase well over $400,000 to$700,000. Although the form of the note is non-interest-bearing, the note will accrue interest each year it is outstanding, thereby increasing interest expense in future years.

Therefore, the immediate demand on cash will be less because most of the liability increasewill not have to be paid in 2014.

Option 4: Overhauling the old equipment


Record repair expense (JE 1):Repair Expense 27,000 Cash 27,000

Record capitalized costs (JE 2):Accumulated Depreciation 417,000 Accounts Payable and Short-term Debt 417,000

Finally, overhauling the old equipment will allow you to reduce the amount ofaccumulated depreciation accrued to date on the equipment, but will requireyou to pay out $27,000 cash and incur repair expense of the same amount. Netincome will be $313,950. Total liabilities will increase by $417,000, but this


amount is considerably less than the liability increase reflected in the other options. This is an important consideration in terms of future cash flows as well as its effect onliquidity and solvency relationships.

Qualitative ConsiderationsIt is also important to take into consideration the non-financial elements ofreplacing the equipment. New equipment and technology may allow CM2 tooperate more efficiently, but a consequence may be layoffs of skilled labor.Layoffs could lead to decreased employee morale, which may lead toemployees being disgruntled and as a result, less productive. Analyzingthe effects of such a qualitative factor is an important consideration alongwith the quantitative effects of replacing the equipment.Refer to Excel File Solutions:Chapter 10 Option 1Chapter 10 Option 2Chapter 10 Option 3Chapter 10 Option 4


Chapter 11


From: L. HarbachRe: Depreciation and ImpairmentDate: January 18, 2013

According to FASB ASC 360-10-35-4:

“The cost of a productive facility is one of the costs of the services it renders during its useful economic life. Generally accepted accounting principles require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility. This procedure is known as depreciation accounting, a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation.”

The general concept of depreciation is a method of cost allocation, rather than asset valuation. The definition of depreciation is the process of allocating costs of tangible assets to an expense in those periods expected to benefit from the use of the asset. Depreciation expense attempts to match costs to the revenues the asset produces. Not recording depreciation expense will overstate income on the income statement. By not recognizing depreciation expense, income from continuing operations will be inflated, and will not correctly match the costs associated with the revenue generated in the period.


(b) See the table below, excerpted from the spreadsheet.

YearAsset Cost

Accumulated Depreciation

Book Value Rate* Depreciation Expense

1 $440,000 — $440,000 25% $110,0002 440,000 $110,000 330,000 25% 82,5003 440,000 192,500 247,500 25% 61,8754 440,000 254,375 185,625 25% 46,4065 440,000 300,781 139,219 25% 34,8056 440,000 335,586 104,414 25% 26,1047 440,000 361,689 78,311 25% 19,5788 440,000 381,267 58,733 25% 8,733**

Total: $440,000 $390,000 $50,000 $390,000*Rate = 1/8 X 2 = 0.25

Year 3 Journal Entry:

Depreciation Expense 61,875 Accumulated Depreciation—Equipment 61,875**8,733 depreciation expense in final year brings asset to salvage value at end of eight years.


(c) According to FASB ASC 360-10-35-7:

“The declining-balance method is an example of one of the methods that meet the requirements of being systematic and rational. If the expected productivity or revenue-earning power of the asset is relatively greater during the earlier years of its life, or where maintenance charges tend to increase during later years, the declining-balance method may provide the most satisfactory allocation of cost.”

In industries where obsolescence due to the development of new technology is the primary factor for determining an asset’s useful life, a method such as straight-line depreciation is preferred because the decline in usefulness is simply a function of time rather than usage. Accelerated methods of depreciation recognize a greater expense in the first years than straight-line depreciation, and gradually lesser amounts toward the end of the asset’s useful life. Thus, all else being equal, in early years of an asset’s life, companies using straight-line have a lower depreciation expense and a higher net income than companies using accelerated methods; in later years, this relationship is reversed.

One argument for using an accelerated method is that an asset is most productive and thus generates greater revenue in the early years, and thus the early years should bear the greatest cost. Another argument for using an accelerated method is that, when repair and maintenance charges are also considered, these methods actually result in a constant expense; in early years where depreciation expense is greatest, repair and maintenance expense is lower and in the later years this relationship is reversed.


(d) FASB ASC 360-10-20 (Glossary) defines impairment as “the condition that exists when the carrying amount of a long-lived asset (asset group) exceeds its fair value.” FASB ASC 360-10-35-21 identifies the following circumstances that indicate an asset or asset group should be reviewed for impairment:

A significant decrease in the market price of a long-lived asset (asset group) A significant adverse change in the extent or manner in which a long-lived asset

(asset group) is being used or in its physical condition A significant adverse change in legal factors or in the business climate that could

affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator

An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group)

A current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset .

To determine if a long-lived asset is impaired, the first step is to estimate the undiscounted future cash flows expected to be generated from the asset’s use and eventual disposal. If this amount is less than the carrying value of the asset, an impairment loss is recognized to write down the asset to its fair value. The impairment loss is the difference between the asset’s fair value and its pre-impairment net book value. This loss on impairment is reported as a component of income from continuing operations on the income statement. The reasoning behind this classification is that the asset is still being used.

An asset impairment does not affect current cash flows, but the write-down indicates the loss of productive capacity of an operational asset. Future cash flows will likely be affected because of the decline in the productive capacity of the operational asset.


Additional Activities: Extend your accounting knowledge


From: L. HarbachRe: Impairments and Earnings ManagementDate: January 18, 2013

There is room for manipulation of income through the recognition of impairments. A company can incur a large write-off in one year and show an increase in future earnings by recognizing a smaller depreciation expense on the assets. If a company overstates the amount of an asset impairment, it will understate depreciation expense in future periods. This type of intentional overestimation of impairment losses constitutes earnings management and is not acceptable under GAAP.

Examples of companies with large asset impairments:

In connection with store closings, Blockbuster recorded significant asset impairment charges of $35.9 million and $20.4 million on its property and equipment in fiscal 2009 and 2010, respectively. Blockbuster recorded substantial additional impairment charges on its goodwill and other intangible assets in those years. The impairment charges related to Blockbuster’s continued declining performance and competition from companies like Netflix.

Due to declining performance in some of its stores, Gap, Inc. recorded impairment charges on long-lived assets of $16 million, $8 million, and $14 million, respectively, in fiscal 2011, 2010, and 2009.

In the Altria Group, Inc. 2004 Annual Report it was reported that during 2004, Kraft recorded $603 million of asset impairment and exit costs on the consolidated statement of earnings. These pre-tax charges were composed of $583 million of costs under the restructuring program, $12 million of impairment charges relating to intangible assets and $8 million of impairment charges related to the sale of Kraft’s yogurt business. The restructuring charges resulted from the 2004 announcement of the closing of thirteen plants, the termination of co-manufacturing agreements and the commencement of a number of workforce reduction programs. Approximately $216 million of the pre-tax charges incurred in 2004 will require cash payments. (Source: www.altria.com/AnnualReport/ar2004/2004ar_06_0803.aspx.)

In its third quarter, 2003, Eastman Chemical Company recorded a total of $496 million in charges against its bottom line. Of that, $482 million consisted of non-cash asset impairments, representing a decline in value of the company's capital and intangible assets. "The non-cash asset impairments of $482 million for third quarter


reflect adjustments to the company's balance sheet and do not represent cash leaving the company," said Eastman spokeswoman Nancy Ledford. (Source: www.sullivan-county.com/id2/eastman.)

Lucent Technologies’ fiscal 2002 charges were primarily comprised of headcount reductions, facility consolidations and property, plant and equipment write-downs. (Source: www.lucent.com/investor/annual/02/notes/notes_02.html.)

http://www.lucent.com/investor/annual/02/notes/notes_02.html


Chapter 12

Part IMemorandumTo: Eric Conner and Phil Martin, CM2

From: L. HarbachRe: Goodwill and R&D CostsDate: January 20, 2013

Goodwill: Goodwill is defined as the excess cost over the fair value of the identifiable net assets acquired when an entire business is purchased.

According to FASB ASC 350-20-35-1 through 350-20-35-3: Goodwill shall not be amortized. Goodwill shall be tested for impairment at a level of reporting referred to as a reporting unit. (Paragraphs 33–46 of FASB ASC 350-20-35 provide guidance on determining reporting units.) Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. The two-step impairment test discussed in paragraphs 4–19 shall be used to identify potential goodwill impairment and measure the amount of a goodwill impairment loss to be recognized (if any).

According to the transition guidance in FASB ASC 350-20-65-1, an entity may, based on qualitative factors, deem the two-step impairment test unnecessary under certain conditions. These qualitative factors are described in FASB ASC 350-20-35-3A through 35-3G. This assessment of qualitative factors has been referred to by some accountants as “Step Zero,” as it precedes step 1 of the two-part impairment test. The goal of step zero is to determine whether it is more likely than not that the fair value of the reporting unit containing goodwill is less than its carrying amount. If, based on a review of qualitative factors, an entity decides that one of its reporting units’ fair value is more likely than not greater than its carrying value, the entity may skip the two-step impairment test for that unit. Although not all-inclusive, the following is a list of qualitative factors per FASB ASC 350-20-35-3C:

Macroeconomic conditions Industry and market considerations Cost factors (including increases in raw materials, labor or other costs) Overall financial performance (including cash flows) Other relevant entity-specific events (e.g. changes in management, key

personnel, strategy, or customers) Events such as an expectation of selling assets significant to the reporting

group Sustained decreases in share price


If it so chooses, an entity may skip “step zero” and proceed directly to the two-step impairment test described below.

Step one of the two-step impairment test for goodwill consists of comparing the fair value of a reporting unit containing goodwill to its carrying value. If the fair value is greater, no impairment is recorded. However, if the reporting unit’s fair value is less than its carrying value, the entity proceeds to the second step of the impairment process. The second step of the impairment process is a comparison of the implied fair value of the reporting unit’s goodwill to its carrying value. Implied fair value of goodwill is computed as the difference between the reporting unit’s fair value and the fair value of its other (non-goodwill) assets and liabilities. The excess of the goodwill’s carrying amount over its implied fair value is recorded as a reduction in the goodwill’s carrying value and an impairment loss.

An internally developed trade name, such as CM2, cannot be recorded and reported as an asset. FASB ASC 350-30-25-3states “Costs of internally developing, maintaining, or restoring intangible assets that are not specifically identifiable, that have indeterminate lives, or that are inherent in a continuing business or nonprofit activity and related to an entity as a whole, shall be recognized as an expense when incurred.” The CM2 trade name would fall under the classification of an internally developed intangible asset inherently in a continuing business and an entity as a whole. Therefore, all amounts spent developing the trade name must be expensed as incurred.


* Part IIMemorandumTo: Eric Conner and Phil Martin, CM2

From: L. HarbachRe: Goodwill and R&D CostsDate: January 20, 2010

Software R&D: FASB ASC 985-730 explains the accounting for software research and development costs. The statement requires that costs incurred before reaching technological feasibility must be expensed as research and development.

FASB ASC 985-20-25: All costs incurred to establish the technological feasibility of a computer software product to be sold, leased, or otherwise marketed are research and development costs. Those costs shall be charged to expense when incurred as required by subtopic 730-10. FASB ASC 985-20-25-2 states that the technological feasibility of a computer software product is established when the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements.

After technological feasibility has been reached, but before release to the general public, software development costs incurred can be capitalized and amortized after release.

Of the $200,000, 15% ($30,000) represents intangible software costs that can be capitalized and amortized (once the product is being sold) over the greater of the ratio of current revenues to current and future anticipated revenues or the useful life (straight-line) of the software. The $70,000 to be incurred for employee wages is considered R&D expense. The legal and filing costs totaling $60,000 associated with filing for the patent may be capitalized and amortized over the lesser of the useful life of the patent or its legal life. The remaining balance of the research and development account, $40,000 must be expensed in the periods in which they are incurred.


Chapter 13

Part IMemorandumTo: Eric Conner and Phil Martin, CM2

From: L. HarbachRe: Unearned Revenue and ContingenciesDate: January 24, 2013

Here are the answers to your questions for the year ended December 31, 2013:

(a) The balance in the unearned revenue account should be equal to: Service Contract 1 $ 21,000 (3 months X $7,000) Service Contract 2 62,500 (10 months X $6,250) Service Contract 3 82,500 (11 months X $7,500) Total: $166,000

(b) Service Revenue 28,940 Unearned Revenue 28,940

The above journal entry is necessary to correct the unearned revenue liability account. The balance sheet should report obligations for any commitments that are redeemable in goods/services. Since the company’s customers prepaid for services, the company is obligated to provide those services. The income statement should report revenues earned during the period. The above journal entry corrects the balance in the Unearned Revenue account to make sure that the company reports the actual obligation of CM2 to its customers at the end of 2013.


Part IIMemorandumTo: Eric Conner and Phil Martin, CM2

From: L. HarbachRe: Unearned Revenue and ContingenciesDate: January 24, 2013

If CM2 is sued and wins its patent defense, the company would capitalize to the Patent account the costs incurred to defend the patent, and would amortize those costs over the useful life of the patent. These costs are capitalized because they are necessary to establish the legal rights of the holder of the patent.

In the event that CM2 loses the lawsuit, the company would write off (expense) the patent and the legal fees, thereby incurring a substantial decrease to net income.

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