14
P3–8
a. Book value on 12/31/14 = Total book value of assets – Total value of liabilities
= $124,000 – ($8,000 + $20,000)
= $96,000
b. The economic value of Myers and Myers equals its future cash flows discounted to reflect the time value
of money. Myers and Myers have two streams of future cash flows. The first type is annual cash flows,
which is an annuity, and the second type is the cash flow from the sale of the business. The present
values of these two cash flows are calculated below.
Annual cash flows
= $153,734.60
c. Liquidation value = Total fair market value of assets – Total value of liabilities
= $124,000 – ($8,000 + $20,000)
= $96,000
d. Book value is based upon the original cost of individual assets. This value provides little indication of a
company’s current value due to price changes. The problem is magnified as the company’s assets age.
Liquidation value is based upon the fair market values of individual assets and liabilities. This value
value amounts do not satisfy the principle of objectivity.
A difference between a company‘s book value and its economic value (i.e., present value of future cash
flows) can arise for two reasons. First, this difference can be due to a difference between a company’s
book value and the fair market value of its individual assets and liabilities. The assets are usually carried
on the books at their original cost. However, over time the actual value of the assets would be expected
to diverge from their original cost.
15
P3–9
a. Ending retained earnings = Beginning retained earnings + Net Income – Dividends
$40,000 = $16,000 + Net Income – $0
Net Income = $24,000
b. 2015 FMV = FMV of total assets – Total liabilities
= $148,000 – ($6,000 + $20,000)
= $122,000
c. Present value of future cash flows as of December 31, 2015:
Annual cash flows
Present value = $20,000 Present value of ordinary annuity factor for i = 10%, n = 9
= $20,000 5.75902 (from Table 5)
= $115,180.40
Proceeds from sale of business
Present value = $80,000 Present value factor for i = 10%, n = 9
16
P3–9 Concluded
d. All three income measures provide a performance measure of Myers and Myers. Of the three measures,
economic income is the only one that incorporates the time value of money. In theory, holding
values are being used. Unfortunately, it is not possible to find a market for all assets. For example, a
manufacturing company may use highly specialized equipment in its production process. If no other
company would use this equipment, does the equipment have a fair market value? Do we assign it a
value of zero, assign it a scrap value, or assign it an arbitrary fair market value? The end result is that the
P3–10
a.
ABC XYZ
Inventory Depreciation Working Working
Method Method Income Capital Income Capital
B Y $28,000 $26,000 $24,000 $30,000
b. ABC and XYZ both have the highest net income and working capital under the combination of Method B
and Y depreciation. Managers could have many reasons for selecting one accounting method over
another method. Management is a party to many contracts that may rely on accounting numbers. For
example, a manager may have an incentive compensation contract based upon accounting income. A
P3–10 Concluded
17
c. As an investor, one must realize that different companies may face different environments. To the extent
that two companies face different environments, we would expect them to select the accounting
methods appropriate to their particular environments. Further, an investor must realize that managers
have their own interests and will work to satisfy their interests. In some cases the interests of the
P3–11
a. Revenues Year 1 Year 2 Year 3 Year 4
Assumption 1
[$2,400,000 (2/12)] $400,000
[$2,400,000 (6/12)] $1,200,000
[$2,400,000 (285/1,140)] 600,000
[$2,400,000 (95/1,140)] 200,000
Assumption 3
[$2,400,000 (600/2,400)] 600,000
P3–11 Concluded
b. Costs Year 1 Year 2 Year 3 Year 4
Assumption 1
[$1,140,000 (2/12)] $190,000
Assumption 3
[$1,140,000 (600/2,400)] 285,000
[$1,140,000 (900/2,400)] 427,500
Net Income Year 1 Year 2 Year 3 Year 4
Assumption 1
$ 400,000 – $190,000 $210,000
600,000 – 285,000 315,000
200,000 – 95,000 105,000
Assumption 3
$600,000 – $ 285,000 315,000
c.
Total RevenueTotal Cost Total Net Income
Assumption 1 $2,400,000 $ 1,140,000 $1,260,000
19
P3–12
a. Hydra Aire would recognize the following revenue in each of the 3 years based on the number of toasters
produced times the selling price per toaster.
Year 1: 200 $100 = $20,000
b. Hydra Aire would recognize the following revenue in each of the 3 years based on the number of toasters
delivered times the selling price per toaster.
Year 1: 150 $100 = $15,000
c. Year 1 Year 2 Year 3 Total
Assumption 1
Revenues (from part [a]) $ 20,000 $ 20,000 $10,000 $ 50,000
Year 1 Year 2 Year 3 Total
Assumption 2
Revenues (from Part [b]) $ 15,000 $ 20,000 $ 15,000 $ 50,000
d. If Hydra Aire’s management is compensated based on the net income of the company, they would prefer
to recognize revenues at the point of production. Why? Because it results in higher net income in year 1
P3–13
a. Cost of Error 1: If Joe McGuire requires disclosure of the lawsuit, and Nelson Repairs, Inc., does not lose
the lawsuit, McGuire could incur some costs. If the president of Nelson Repairs, Inc., is serious about not
wanting the lawsuit disclosed and McGuire requires that it be disclosed, Nelson could fire McGuire. In
this case, McGuire would lose the audit fees of his biggest client. If these audit fees make up a substantial
20
P3–13 Concluded
new clients did hire McGuire, they might demand a lower audit fee to compensate for a “lower quality”
service. Furthermore, some of McGuire’s existing clients may
no longer wish to engage him as their auditor. Consequently, it appears that the cost of a Type 2 error
exceeds the cost of a Type 1 error.
b. Expected cost of an error = Cost of an error Probability of an error
Expected cost of a Type 1 error = $10,000 80%
= $8,000
c. Conservatism means that “when in doubt, understate rather than overstate.” This statement means that
when a company faces some uncertainty concerning how to value or record an event, the company
should understate, rather than overstate, the financial health of the company. In this case, McGuire has
21
ISSUES FOR DISCUSSION
ID3–1
a. Revenue recognition refers to the recording of revenues when they are earned. Matching refers to
recognizing costs as expenses when the costs help generate a benefit (such as revenue). The criteria for
recognizing revenue are:
(2) The amount of the revenues can be objectively measured.
(4) The eventual collection of cash is reasonably assured.
The FASB requirement that airlines defer a portion of the current revenues is consistent with these
criteria in that at the time of selling a ticket the airlines have not completed a significant portion of the
production and sales effort associated with the eventual free trip. In essence the airlines are charging
b. As a result of implementing this new accounting policy, Continental Airlines would recognize less
revenue. This would cause income to be lower than if Continental continued to use its previous policy
ID3–2
a. Priceline’s method of booking revenue has the potential to mislead investors. It is not the same method
that traditional companies in this industry use. It does not make sense from the standpoint that Priceline
is reporting revenues for products and services that it does not provide. Priceline is not an airline or a
b. If investors are going to value the stock of a company based on a multiple of revenue then management
has an incentive to report the highest amount of revenue as possible. So by reporting these “gross
bookings” as revenue Priceline is able to increase its stock price. This is particularly significant for a
company that is losing a lot of cash in its operations. The most common way for a company that is losing
22
ID3–3
a. Because Blockbuster is the franchiser, it can dictate policies that the franchises must follow. For example,
Blockbuster could dictate when new franchises must purchase merchandise from Blockbuster and how
much they must purchase. Blockbuster cannot, however, dictate when the franchises will actually
generate revenue; that depends on the franchises’ customers. By recognizing revenue when it ships
true amount of sales since dealers have the ability to return product to U.S. Robotics.
b. The criteria for recognizing revenue under the revenue recognition principle are (1) the company must
have completed a significant portion of the production and sales effort, (2) the amount of the revenues
ID3–4
a. If Campbell Soup had not made the accounting change, it would have reported $626 for net income in
the third year. The restated amounts are more consistent—and hence more comparable—because they
ID3–5
a. Investors are interested in earnings that can be repeated, earnings that can be counted on in future fiscal
periods. Therefore, investors would be interested in the 81 cents EPS, because future quarters will not
contain any more charges related to the Pfizer acquisition.
ID3–6
To be able to compare financial results across companies, financial statement users would like those
companies to use uniform accounting methods. If the companies do not use uniform accounting
ID3–7
a. Capitalizing an item simply means putting that dollar amount on the balance sheet. When
WorldCom put $3.9 billion on the balance sheet, that same amount was not put on the income
statement; in other words, expenses were understated by $3.9 billion since the expenditures were
capitalized.
ID3–8
When Citi erroneously reported results in 2008, only to correct them in 2009, the company did not accurately
reflect its financial results in the 2008 fiscal period. A reader of those financial statements—such as the U.S.
Government after its bailout investment in the bank—would have seen an inaccurate picture of Citi.
Correcting those mistakes in 2009 again put the reader of the financial statements in the position of not
seeing the results in the correct period. Financial statements are designed to tie together, in the same time
ID3–9
a. Writedown: 246 million Euros – Recovery of prior Writedowns: 23 milliion Euros = Net Writedown:
223 million Euros
24
ID3–10
a. Smoothing earnings means that companies are making accounting assumptions to eliminate the
fluctuations in the net income over a period of time. Many suspect that companies smooth earnings to
meet targets set by Wall Street analysts; often, meeting earnings targets assures a healthy stock price.
ID3-11
The economic entity assumption states that individual entities can be shown as distinct from their owners and all
other entities and that financial results can be measured for an entity separate from all others. By requiring
ID3-12
a. KeyCorp valued its marketable securities and other equity investments at fair market value. In the case
of equity and real estate investments that were not able to be valued at FMV, Key made estimates of
value based on present value.
b. Investments in privately held firms, by definition not subject to valuation on public markets, can be
difficult to objectively value in terms of fair market value. Mainly subjective considerations are entered
25
ID3–13
a. The FASB is suggesting that companies use a valuation that is like net realizable value. This is the fair
value of the asset minus the cost of disposal or the fair value of the liabilities plus the cost of repurchase.
This is slightly different than fair market value because the FASB is saying that the cost of disposal or
repurchase be reflected in the value reported on the balance sheet.
d. Under U.S. GAAP, the principle of objectivity ensures that fair market values are not used unless they
can be objectively determined; also, the concept of conservatism dictates that fair market value is used
only if it is below historical cost. IFRS, conversely, allows adjustments to the balance sheet values of
assets for changes in market value, and these adjustments can be upward or downward.
ID3–14
Economic entity assumption: This assumption states that the financial statements report financial
information about an identifiable and measurable entity that is separate and distinct from its owners and
all other entities. The financial statements of Google are for Google, Inc. and subsidiaries. Thus, the
identifiable and measurable entity is Google and its subsidiaries.
Stable dollar assumption: This assumption states that the U.S. dollar is used to measure economic events
and that the purchasing power of a dollar is constant across time. The absence of any adjustments for
inflation in Google’s financial statements is an example of the application of this assumption.
26
fixed assets; and recognizing operating expenses for the products that were sold.
Revenue recognition principle: This principle provides guidelines for when it is acceptable for a company
to recognize revenue. As disclosed in the first footnote, Google recognizes revenue upon shipment or
delivery of products and services to the customer.
Conservatism: Conservatism states that, when in doubt about how to record or report an event, a
company should understate assets, overstate liabilities, delay recognizing revenues or gains, and
accelerate recognizing expenses or losses. According to the first footnote, Google values its inventory at
the lower of cost or market, an application of the conservatism principle of U.S. GAAP.
Fair Valuation: The first footnote indicates that Google values its financial assets and liabilities (including