978-1285190907 Chapter 2 Part 1

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in whole or in part.

CHAPTER 2

ASSET AND LIABILITY VALUATION

AND INCOME RECOGNITION

Solutions to Questions, Exercises, and Problems, and Teaching Notes to Cases

2.1 Relevance versus Representational Faithfulness. Relevance describes accounting

information that is timely and has the capacity to affect a user’s decisions based on

the information; relevant asset valuations incorporate all available information,

including the acquisition cost and subsequent developments. Relevant asset

valuations may or may not be subjective; the existence of subjectivity in an asset

valuation does not necessarily mean the valuation will not be reliable. Reliability is

an attribute of accounting information that relates to the degree of verifiability of

the reported amounts; representationally faithful asset valuations are supported by

source documents, liquid market prices, or other credible evidence. There is limited

room for subjectivity in these valuations. For example, reporting assets at

acquisition cost provides management with fewer opportunities to bias the valuation

compared to using current replacement costs or fair value inputs.

Examples:

Historical cost/relevant and representationally faithful: accounts receivable,

fixed assets, and other assets with values that remain relatively stable

Historical cost/representationally faithful but less relevant: LIFO inventory

layers, acquired research and development and other intangible assets, and real

estate that has appreciated

Fair value/representationally faithful: Marketable equity securities, commodities,

and financial assets traded in liquid markets

Fair value/relevant but less representationally faithful: Real estate valuations

based on comparable analysis, internally generated intangible asset valuations, and

pension plan assets invested in illiquid investments

2.2 Asset Valuation and Income Recognition. The important part of the question is

that it focuses on net income (as opposed to comprehensive income). Changes in the

valuation of assets generally result in an increase in shareholders’ equity (to

maintain the balance of the accounting equation), which is accomplished through

associated effects captured as part of net income. For example, sales generate cash

or receivables, which increase both assets and net income. Similarly, recognition of

depreciation expense decreases both assets and net income. However, certain

changes in asset valuations result in corresponding amounts being temporarily held

as part of “accumulated other comprehensive income” on the balance sheet (in

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and Income Recognition

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in whole or in part.

shareholders’ equity). Such changes would be part of Approach 2 as shown in

Exhibit 2.4 and discussed in the text. In these situations, asset valuations do not

have to relate to the recognition of net income (although such asset valuations relate

to comprehensive income).

2.3 Trade-offs among Acceptable Accounting Alternatives. For the balance sheet,

FIFO results in inventory that was purchased most recently before the fiscal year (or

quarter) end remaining on the balance sheet. Relative to inventory purchases made

earlier, those purchases are probably more closely aligned with prevailing prices at

year end. As a consequence, relative to LIFO, FIFO more accurately captures the

value of the inventory (close to replacement cost). For the income statement, the

opposite inference is made. The income statement should pair the appropriate costs

of revenues with the revenues recognized. Matching the current costs of inventory

with the currently recognized revenues is accomplished with LIFO. Thus,

depending on a user’s perspective, either FIFO or LIFO can be the preferable

accounting method.

2.4 Income Flows versus Cash Flows. The analysis below demonstrates that the

change in cash for the five years as a whole is $117,000. Subtracting the $100,000

cash contribution by the owners equals $17,000, which equals the amount of net

income for the five years and the balance in retained earnings at the end of five

years. Note that the cash outflow to purchase the machine occurs at the beginning of

the first year, whereas depreciation on the machine occurs throughout the five

years, and the remaining book value of the machine of $20,000 affects computation

of the gain on sale at the end of five years. Thus, the statement about the

equivalence of cash flows and earnings holds for this example and in general.

Common Net

Transaction or Event Cash Equipment Stock Income

Cash Contributed by Owners ….. + $ 100,000 + $ 100,000

Purchase of Machine for Cash … – 100,000 + $ 100,000

Recognition of Rent Revenue …. + 125,000 + $125,000

Recognition of Operating

Expenses ………………………….. – 30,000 – 30,000

Recognition of Depreciation …… – 80,000 – 80,000

Sale of Machine ……………………. + 22,000 – 20,000 + 2,000

Totals ………………………………. $ 117,000 $ 0 $ 100,000 $ 17,000

2.5 Measurement of Acquisition Cost. Acquisition cost is $240,500 ($250,000

invoice price – $15,000 cash discount + $4,000 for the title + $1,500 to paint

company’s name on the truck). The license fee of $800 and the insurance of $2,500

are not costs to prepare the truck for its intended use, but costs to operate the truck

during its first year. Therefore, these latter two costs are prepayments that become

expenses of the first year.

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and Income Recognition

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in whole or in part.

2.6 Measurement of a Monetary Asset.

Balance, January 1, 2009: $10 million × 9.81815 (Part a) ……………. $ 98,181,500

Interest for 2009: 0.08 × $98,181,500 ……………………………………….. 7,854,520

Less Cash Received ………………………………………………………………… (10,000,000)

Balance, December 31, 2009 (Part b) ………………………………………… $ 96,036,020

Interest for 2010: 0.08 × $96,036,020 ……………………………………….. 7,682,882

Less Cash Received ………………………………………………………………… (10,000,000)

Balance, December 31, 2010 (Part c) ………………………………………… $ 93,718,902

2.7 Measurement of a Nonmonetary Asset. American Airlines amortizes the $150

million over the five years of use. Accordingly, the acquisition cost of the landing

rights is initially recognized at its historical cost of $150 million, but then it is

valued at adjusted historical cost with each annual amortization of $30 million,

which reduces the valuation ratably to a final adjusted historical cost of $0.

2.8 Fair Value Measurements.

a. The stocks are Level 1 assets, assuming they are for public companies for which

the prices of each share are available via closing quotes from one of the major

exchanges.

b. Bonds are also likely Level 1 assets if they are publicly traded; however, if they

are privately placed issues, they would be Level 2 assets because their values

would be determined by reliable inputs such as market interest rates and yield

curves.

c. Real estate is more likely comprised of Level 2 assets, given ready availability

of real estate valuation data.

d. Timber investments are either Level 2 or Level 3 assets depending on the

availability of directly applicable current and future timber prices.

e. Private equity funds are typically invested in young privately held start-up

companies, and due to the illiquidity of such investments and difficulty in

obtaining directly comparable asset prices, these would likely be Level 3 assets.

f. Illiquid asset-backed securities are, by definition, illiquid, and although various

models exist for valuing manufactured securities (such as mortgage-backed

securities), the inputs are generally well-placed guesses, making such assets

Level 3.

2.9 Computation of Income Tax Expense.

a. Taxes Currently Payable ……………………………………………………….. $ 50,000

Plus Decrease in Deferred Tax Assets: $42,900 – $38,700 ………… 4,200

Plus Increase in Deferred Tax Liabilities: $34,200 – $28,600 ……. 5,600

Income Tax Expense …………………………………………………………….. $ 59,800

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in whole or in part.

b. Taxes Currently Payable ……………………………………………………….. $ 50,000

Plus Decrease in Deferred Tax Assets: $42,900 – $38,700 ………… 4,200

Less Decrease in Deferred Tax Liability: $58,600 – $47,100 …….. (11,500)

Income Tax Expense …………………………………………………………….. $ 42,700

c. In both Part a and Part b, the value of the deferred tax asset decreased, which

means that the company utilized deferred tax assets to decrease taxes owed

relative to the amount expensed. However, the difference lies in the change in

the deferred tax liability. In Part a, the deferred tax liability increased, which

occurs when the firm has larger deductions (lower income) on its tax return

relative to amounts expensed (amounts recognized in income). The

advantageous treatment of these amounts leads to lower current cash outflows

for taxes than amounts recognized as income tax expense. For Part b, the

situation is reversed. In Part b, the decrease in the deferred tax liability means

that previous timing differences likely reversed, leading to higher cash

payments required for current income tax payments relative to amounts

recognized as income tax expense.

2.10 Computation of Income Tax Expense.

a. Taxes Currently Payable ……………………………………………………….. $ 35,000

Less Increase in Deferred Tax Assets:

Beginning of Year: $24,600 – $6,400 = $ 18,200

End of Year: $27,200 – $7,200 = 20,000………… (1,800)

Less Decrease in Deferred Tax Liabilities: $18,900 – $16,300 …… (2,600)

Income Tax Expense …………………………………………………………….. $ 30,600

b. Taxes Currently Payable ……………………………………………………….. $ 35,000

Less Increase in Deferred Tax Assets:

Beginning of Year: $24,600 – $6,400 = $ 18,200

End of Year: $27,200 – $4,800 = 22,400………… (4,200)

Less Decrease in Deferred Tax Liabilities: $18,900 – $16,300 …… (2,600)

Income Tax Expense …………………………………………………………….. $ 28,200

2.11 Costs to Be Included in Historical Cost Valuation.

a. The acquisition cost of the land is $210,000 ($200,000 + $7,500 + $2,500). The

costs for building permits of $1,200 would be included in the historical cost of

the restaurant building to be built.

2.12 Effect of Valuation Method for Nonmonetary Asset on Balance Sheet and

Income Statement.

a. Valuation of the land at acquisition until sale of land: Land would be valued at

acquisition cost of $100,000 initially, and would not change through 2011. In

2011, when the building is sold for $180,000, Walmart would recognize a gain

of $80,000 on the income statement.

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and Income Recognition

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in whole or in part.

2009

Land ………………………………………………………………………… 100,000

Cash …………………………………………………………………….. 100,000

2010

No Entry

2011

Cash…………………………………………………………………………. 180,000

Land …………………………………………………………………….. 100,000

Gain on Sale of Land ……………………………………………… 80,000

b. Valuation of the land at current market value but including unrealized gains and

losses in accumulated other comprehensive income until sale of land:

2009

The land would initially be recognized at acquisition cost of $100,000. At the

end of 2009, Walmart would remeasure the land at fair value and increase the

asset by $50,000, which would also be reflected in AOCI as “Unrealized

Holding Gain or Loss,” reducing shareholders’ equity.

Land ………………………………………………………………………… 100,000

Cash …………………………………………………………………….. 100,000

Land ………………………………………………………………………… 50,000

Unrealized Holding Gain or Loss – OCI …………………… 50,000

2010

Part of the end-of-year 2009 upward adjustment would be reversed to reflect the

$30,000 decline in fair value of the land. Land would be decreased by $30,000

to $120,000, and the “Unrealized Holding Gain or Loss” sitting in AOCI in the

equity section would also be reduced by $30,000, from $50,000 to $20,000.

Unrealized Holding Gain or Loss – OCI ………………………. 30,000

Land …………………………………………………………………….. 30,000

2011

The fair value of the land at the end of 2011 is $180,000 (as evidenced by the

price received upon sale). We can consider this effect in two ways. First, we

could view Walmart as remeasuring the land to $180,000, which would mean

that land is increased by $60,000 and “Unrealized Holding Gain or Loss” in

OCI is also increased by $60,000, from $20,000 to $80,000. Then, the sale of

the land would bring in $180,000 as cash (asset) and trigger derecognition of the

land (from $180,000 to $0), and finally, the “Unrealized Holding Gain or Loss”

that resides in the holding tank of AOCI in the equity section becomes realized,

so Walmart would reclassified from ‘unrealized’ to ‘realized,’ the net effect

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and Income Recognition

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in whole or in part.

being that “Unrealized Holding Gain or Loss” in AOCI is reduced from $80,000

to zero, and a “Gain on Sale of Land” would be recognized in the income

statement. The second approach results in the same outcome, but views the

changes in all four accounts simultaneously, with the journal entries as follows:

Cash…………………………………………………………………………. 180,000

Unrealized Holding Gain or Loss – OCI ………………………. 20,000

Land …………………………………………………………………….. 120,000

Gain on Sale of Land ……………………………………………… 80,000

c. Valuation of the land at current market value and including market value

changes each year in net income:

2009

The land would initially be recognized at acquisition cost of $100,000. At the

end of 2009, Walmart would remeasure the land at fair value and increase the

asset by $50,000, which would be reflected on the income statement as “Gain

on Fair Market Value of Land.”

Land ………………………………………………………………………… 100,000

Cash …………………………………………………………………….. 100,000

Land ………………………………………………………………………… 50,000

Gain on Fair Market Value of Land …………………………. 50,000

2010

Part of the end-of-year 2009 upward adjustment would be reversed to reflect the

$30,000 decline in fair value of the land. Land would be decreased by $30,000

to $120,000, and Walmart would recognize a “Loss on Fair Market Value of

Land” in the income statement.

Loss on Fair Market Value of Land ……………………………… 30,000

Land …………………………………………………………………….. 30,000

2011

The firm would realize $180,000 of cash, derecognize the land—now valued at

the 2010 fair value of $120,000, the difference being recognized as a $60,000

“Gain on Sale of Land.”

Cash…………………………………………………………………………. 180,000

Land …………………………………………………………………….. 120,000

Gain on Sale of Land ……………………………………………… 60,000

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and Income Recognition

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in whole or in part.

d. Net income over sufficiently long time periods equals cash inflows minus cash

outflows, other than cash transactions with owners. Walmart acquired the land

in 2009 for $100,000 and sold it for $180,000 in 2011. Thus, the total effect on

net income through the realization of the increase in the value of the land

bought and sold is $80,000. The three different methods of asset valuation and

income measurement recognize this $80,000 in different patterns over time, but

the total is the same.

2.13 Effect of Valuation Method for Monetary Asset on Balance Sheet and Income

Statement.

a. Valuation of the note at the present value of future cash flows using the

historical market interest rate of 8% (Approach 1):

2011

Walmart would recognize an asset for the Note Receivable at its then present

value of $180,000 (the cash equivalent), derecognize the land which remains

recorded at historical cost of $100,000, and realize the difference of $80,000 as

“Gain on Sale of Land.”

Note Receivable ………………………………………………………… 180,000

Land …………………………………………………………………….. 100,000

Gain on Sale of Land ……………………………………………… 80,000

2012

Walmart would receive the cash payment of $100,939, recognize interest

revenue of $14,400 (0.08 × $180,000), and the difference of $86,539 would

reduce the historical value of the Note Receivable.

Cash…………………………………………………………………………. 100,939

Interest Revenue ……………………………………………………. 14,400a

Note Receivable ……………………………………………………. 86,539

2013

Walmart would receive the second cash payment of $100,939, recognize interest

revenue of $7,478 [0.08 × ($180,000 – $86,539), + $1 for rounding], and the

difference of $93,461 would reduce the historical value of the Note Receivable

to 0.

Cash…………………………………………………………………………. 100,939

Interest Revenue ……………………………………………………. 7,478b

Note Receivable ……………………………………………………. 93,461

b. Valuation of the note at the present value of future cash flows, adjusting the

note to fair value upon changes in market interest rates and including unrealized

gains and losses in net income (Approach 3)

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and Income Recognition

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in whole or in part.

2011

Walmart would recognize an asset for the Note Receivable at its then present

value of $180,000 (the cash equivalent), derecognize the land which remains

recorded at historical cost of $100,000, and realize the difference of $80,000 as

“Gain on Sale of Land.”

Note Receivable ………………………………………………………… 180,000

Land …………………………………………………………………….. 100,000

Gain on Sale of Land ……………………………………………… 80,000

2012

Walmart would receive the cash payment of $100,939, recognize interest

revenue of $14,400 (0.08 × $180,000), and the difference of $86,539 would

reduce the historical value of the Note Receivable. In addition, Walmart would

recognize a loss on the receivable commensurate with the increase in interest

rate. A “Loss on Note Receivable” of $1,699 [$91,762 – ($180,000 – $86,539)]

would be recognized, and the value of the Note Receivable would be decreased

by the same amount.

Cash…………………………………………………………………………. 100,939

Interest Revenue ……………………………………………………. 14,400a

Note Receivable ……………………………………………………. 86,539

Loss on Note Receivable ……………………………………………. 1,699c

Note Receivable ……………………………………………………. 1,699

2013

Walmart would receive the second cash payment of $100,939, recognize interest

revenue of $9,177 (0.10 × $91,762, plus an additional $1 due to rounding), and

the difference of $91,762 would reduce the 2012 fair value of the Note

Receivable to 0.

Cash…………………………………………………………………………. 100,939

Interest Revenue ……………………………………………………. 9,177d

Note Receivable ……………………………………………………. 91,762

c. Over sufficiently long time periods, net income equals cash inflows minus cash

outflows, other than cash transactions with owners. Walmart receives $101,878

net in cash from purchasing the land for $100,000 and selling it for $201,878

($100,939 × 2). Problem 2.12 indicates that net income across 2009 to 2011

includes the $80,000 change in market value of the land as of the time of sale on

December 31, 2011. The $21,878 difference between the cash received of

$201,878 and the market value of the land on December 31, 2011, of $180,000

is income for 2012 and 2013. The valuation method in Part a uses the 8%

interest rate applicable to this note on December 31, 2011, both to value the

note and to recognize interest revenue for both years (acquisition cost valuation

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and Income Recognition

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in whole or in part.

of the asset, Approach 1 for income recognition). The valuation method in Part b

uses the market interest rate for this note each year (8% for 2012 and 10% for

2013) to value the note and to recognize interest revenue and holding gains and

losses (fair value for the asset, Approach 3 for income recognition). These two

methods report the same total income but in a different pattern over time.

2.14 Effect of Valuation Method for Nonmonetary Asset on Balance Sheet and

Income Statement.

a. Assume for this part that PCU accounts for the equipment using historical cost

adjusted for depreciation and impairment losses.

(1) PCU records the equipment at historical cost of $100,000 (and reduces cash

by the same amount).

Equipment ………………………………………………………………… 100,000

Cash …………………………………………………………………….. 100,000

(2) PCU records depreciation expense of $25,000 [($100,000 – $0)/4], and

adjusts the historical cost of the equipment by recognizing a contra-asset,

Accumulated Depreciation for the same amount. The adjusted historical cost of

the equipment is now $75,000 ($100,000 – $25,000).

Depreciation Expense ………………………………………………… 25,000

Accumulated Depreciation ……………………………………… 25,000

(3) The adjusted historical cost of the equipment is reduced by $15,000

($60,000 – $75,000) and an “Impairment Loss” of the same amount is

recognized on the income statement.

Impairment Loss ……………………………………………………….. 15,000

Equipment ……………………………………………………………. 15,000

(4) PCU records depreciation expense of $20,000 [($60,000 – $0)/3], and

adjusts the historical cost of the equipment by recognizing a contra-asset,

Accumulated Depreciation for the same amount. The adjusted historical cost of

the equipment is now $40,000 ($100,000 – $25,000 – $15,000 – $20,000).

Depreciation Expense ………………………………………………… 20,000

Accumulated Depreciation ……………………………………… 20,000

(5) Same as (4). The adjusted historical cost of the equipment is now $20,000

(in these formulas $100,000 – $25,000 – $15,000 – $20,000 – $20,000).

Depreciation Expense ………………………………………………… 20,000

Accumulated Depreciation ……………………………………… 20,000

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and Income Recognition

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in whole or in part.

(6) PCU receives cash of $26,000 (asset increase), derecognizes both the

equipment (asset decrease of $85,000) and accumulated depreciation (asset

increase of $65,000), and the difference of $6,000 [$26,000 – ($85,000 –

$65,000)] is recognized on the income statement as “Gain on Sale of

Equipment.”

Cash…………………………………………………………………………. 26,000

Accumulated Depreciation ………………………………………….. 65,000

Equipment ……………………………………………………………. 85,000

Gain on Sale of Equipment …………………………………….. 6,000

b. Assume that PCU accounts for the equipment using current market values

adjusted for depreciation and impairment losses.

(1) PCU records the equipment at historical cost of $100,000 (and reduces cash

by the same amount).

Equipment ………………………………………………………………… 100,000

Cash …………………………………………………………………….. 100,000

(2) PCU records depreciation expense of $25,000 [($100,000 – $0)/4], and

adjusts the historical cost of the equipment by recognizing a contra-asset,

Accumulated Depreciation for the same amount. The adjusted historical cost of

the equipment is now $75,000 ($100,000 – $25,000).

Depreciation Expense ………………………………………………… 25,000

Accumulated Depreciation ……………………………………… 25,000

(3) The adjusted historical cost of the equipment is reduced by $15,000

($60,000 – $75,000) and an “Impairment Loss” of the same amount is

recognized on the income statement.

Impairment Loss ……………………………………………………….. 15,000

Equipment ……………………………………………………………. 15,000

(4) PCU records depreciation expense of $20,000 [($60,000 – $0)/3], and

adjusts the historical cost of the equipment by recognizing a contra-asset,

Accumulated Depreciation for the same amount. The adjusted historical cost of

the equipment is now $40,000 ($100,000 – $25,000 – $15,000 – $20,000),

reflecting an equipment balance of $85,000 ($100,000 – $15,000) and

accumulated depreciation of $45,000 ($25,000 + 20,000).

Depreciation Expense ………………………………………………… 20,000

Accumulated Depreciation ……………………………………… 20,000