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Chapter 9
Operating Activities
9-28
in whole or in part.
date suggests that actual costs have coincided with expectations, but this is
due in part to the way the authors constructed the numbers for the case.
3. An increase in interest rates reduces the economic value of the notes receiva-
ble. Increased costs, or prices, usually accompany increased interest rates so
and the personal wealth that Joan Locker and Bill Dasher have invested in
the firm make abandonment unlikely.
We then have the students evaluate each of the four income recognition methods
measures.
1. Income Recognition at Time of Sale—No Discounting of Cash Flows: This
method focuses on the sale of the land as the critical wealth-generating event.
probably does not have a legal right to the interest revenue on the notes until
time passes and a legal right to the gross profit on the land until it transfers
in uncertainties about future costs. The absence of reasonable estimates of
future costs injects error into the measurement of gross profit. Second, one
Firms must now discount cash flows in measuring income.
Chapter 9
Operating Activities
9-29
in whole or in part.
2. Income Recognition at Time of Sale—With Discounting of Cash Flows:
This method assumes the presence of two wealth-generating events: the sale
the amounts for ALDC are a bit unrealistic. Recognizing the interest revenue
(and expense) over time is consistent with the revenue recognition criteria.
3. Income Recognition Using the Installment Method—With Discounting of
Cash Flows: This method assumes two wealth-generating events: the collec-
regard, although it is usually an issue in more typical settings. The argument
for delayed recognition of the interest revenue is the same as that discussed
above.
4. Income Recognition Using the Percentage-of-Completion Method—This
method assumes one wealth-generating event; the development of the land.
As an earlier section discussed, ALDC’s greatest uncertainty is probably the
gross profit from the contract and the degree of completion each year.
Student discussions of the preferred income recognition method usually center
on the second and third methods. Those who extrapolate the high degree of
certainty with respect to cash flows tend to choose the second method. Those
and tax reporting reduces record keeping costs.
Chapter 9
Operating Activities
9-30
in whole or in part.
c. This question gets students to think about management’s reporting strategy. The
first method maximizes cumulative reported earnings, and perhaps, thereby,
selects? This question gets students to address issues of capital market efficiency
and the ability of analysts to restate the financial statements to an alternative
d. The installment method minimizes cumulative reported earnings. With a stable
tax rate, this method, therefore, minimizes the present value of income tax
payments.
method ranks second because it allocates the gross profit (discounted) to the year
of sale and allocates the interest over future periods. Either the third or fourth
f. This question’s purpose is to get students to see the relation between income
measurement and asset valuation. The recognition of income results in an equal
increase in net assets (assets minus liabilities) to maintain the balance sheet
equation. Note that the first income recognition method results in the largest
Chapter 9
Operating Activities
9-31
in whole or in part.
Income Recognition Method Method 1 Method 2 Difference
Increase in cash from operations (not financ-
ing) ($273,720 from Year 6 balance sheet
– $100,000 from financing – $100,000
recognition method used for financial reporting. Because the four methods result in
different amounts of net income before taxes, their total tax expenses differ as
well.
the four income recognition methods.
Chapter 9
Operating Activities
9-32
in whole or in part.
Case 9.3: Coca-Cola Pensions
a. The memorandum should include the following points (all amounts in millions):
PBO increased $114 due to service cost. Service cost represents the present value of
(Solution b: Recognized as an increase in current pension expense, and thus, as a
decrease in current income.)
Chapter 7.)
PBO decreased $13 due to plan amendments. The amendment reduced the pension
benefits earned by employees in past periods (called prior service cost). (Solution b:
Recognized as an increase in other comprehensive income; recycled as a reduction of
process in future years.)
PBO increased $125 due to an actuarial loss. Actuarial losses are changes in actuarial
assumptions to compute the PBO. For example, if employee useful life increases, the
PBO increases. (Solution b: Recognized as a decrease in other comprehensive
PBO decreased by $199 due to benefits paid. (Solution b: No effect on pension
expense. Cash flow event.)
PBO decreased $4 due to settlements/curtailments of existing plans. (Solution b:
separately if material.)
Chapter 9
Operating Activities
9-33
in whole or in part.
(Solution b: Increase in current pension expense and a decrease in net income. Might
be disclosed separately if material.)
Plan assets decreased by a $961 actual loss from investing plan assets in a declining
securities market. (Solution b: Pension expense is decreased by the expected return on
plan assets. The actual loss on plan assets and the expected return on plan assets, when
added together, yield the asset loss. Like liability gains and losses, the asset loss is
corridor.)
Plan assets increased $96 due to Coca-Cola’s contributions to the plan. (Solution b:
No effect on pension expense. Cash flow event.)
Plan assets decreased $155 due to benefits paid. The amount of the decrease is $44
million less than the PBO decrease for the same event, suggesting that the $44 million
came from a different source. Some pension plans are “unfunded” meaning that the
company does not hire an independent trustee and send the funds to the trustee for
Plan assets decreased $3 when certain plans were settled or curtailed. (Solution b:
Increase in current pension expense and a decrease in net income. Might be disclosed
separately if material.)
c. The justification for keeping some PBO and fair value of plan asset changes out of
current period net income is that they are not indicative of current operating perfor-
mance and thus are not predictive of future operating performance. For example, the
transitory nature of security market movements and the long-run nature of PepsiCo’s
out of current period income.
Chapter 9
Operating Activities
9-34
in whole or in part.
d. If the expected rate of increase in compensation levels was decreased by 1%, the
actuary will reduce the PBO (the present value of expected future benefits to em-
ployees), which are generally based on final pay. Current pension expense is lower
because service cost is lower. Future pension expense will be affected by both the
corridor.
