Chapter 11
Evaluating Performance: Earnings
Quality, the Income Statement & the
Statement of Comprehensive Income
Ethics Check
(5-10 min.) EC 11-1
a. Integrity
b. Due care
c. Objectivity and independence
d. Integrity
Short Exercises
(5-10 min.) S 11-1
There are several ways that companies improperly recognize revenue
which results in financial statement fraud whereby revenues are
overstated.
a. “Channel stuffing” where a company may ship inventory to regular
customers in amounts in excess of the amounts ordered by the
b. Reporting revenue when a significant portion of the services are still
to be performed or goods are still to be delivered.
c. Providing incentives for customers to purchase more inventory than
is needed in return for future discounts or other benefits.
(10 min.) S 11-2
Req. 1
Gross profit = $760,212 thousand ($1,806,092 − $1,045,880)
Income from continuing operations = $117,187 thousand
Net income = $117,397 thousand
Req. 2
(10-15 min.) S 11-3
Musicality, Inc.
Income Statement
Year Ended December 31, 2016
(Thousands)
Net sales revenue ………………………………………………………….
$195,000
Cost of goods sold ………………………………………………………..
74,000
Gross profit ……………………………………………………………………
121,000
Operating expenses ……………….. ………………………………
66,000
Operating income…………………………………………………………..
55,000
Other gains (losses) ………………………………………………………
Income from continuing operations before income tax …..
32,000
Income tax expense (40%) ……………………………………………..
Income from continuing operations ……………………………….
Loss on discontinued operations, $10,000,
less income tax savings of $4,000 ………………………………
Net income …………………………………………………………………….
(10-15 min.) S 11-4
Orange’s stock is quoted at $71.04. At that price, an investor should sell
because the investor believes the stock is worth only $21.00.
(10 min.) S 11-5
Journal
DATE
ACCOUNT TITLES AND EXPLANATION
DEBIT
CREDIT
Sept.
12
Accounts Receivable (200,000 x $.36) …….
72,000
Sales Revenue ………………………………….
72,000
18
Cash (100,000 x $.31) …………………………….
31,000
Foreign-Currency Transaction Loss ………
Accounts Receivable ($72,000 x ½) ……
36,000
Nov.
Cash (100,000 x $.39) …………………………….
39,000
Accounts Receivable ………………………..
Foreign-Currency Transaction Gain …..
(10-15 min.) S 11-6
Journal
DATE
ACCOUNT TITLES AND EXPLANATION
DEBIT
CREDIT
Apr.
24
Cash (700,000 pesos × $0.096) ………………..
67,200
Accounts Receivable
(700,000 pesos × $0.092) ……………….
64,400
Foreign-Currency Transaction Gain ….
2,800
Collection on account.
25
Accounts Payable
(29,000 Swiss francs × $0.78) ………………….
Foreign-Currency Transaction Loss ………..
Cash (29,000 Swiss francs × 0.83) ……..
Payment on account.
(15 min.) S 11-7
Req. 1
The discontinued operations were more like a revenue. This is clear from
the fact that their amount is added in determining net income.
Req. 2
The discontinued operations should be included in net income because
they represent revenues, which are a basic component of net income.
Req. 3
(5-10 min.) S 11-8
Journal
DATE
ACCOUNT TITLES AND EXPLANATION
DEBIT
CREDIT
1.
Income Tax Expense ($171,000 × .40) …………
68,400
Income Tax Payable ($148,000 × .40) ……..
59,200
Deferred Tax Liability …………………………...
9,200
Recorded income tax for the year.
2.
INCOME STATEMENT
Income before income tax …………………………
$171,000
Income tax expense ………………………………….
Net income ……………………………………………….
BALANCE SHEET
Current liabilities:
Income tax payable ……………………………….
Long-term liabilities:
(10 min.) S 11-9
Req. 1
Earnings
=
Net income − preferred dividends
per share
Weighted-average number of common shares
outstanding
Req. 2
Earnings per share of common stock:
Income (loss) from continuing operations …………………………..
$X.XX
Income (loss) from discontinued operations ……………………….
.XX
Net income (net loss) …………………………………………………………
$X.XX
Req. 3
(10-15 min.) S 11-10
Earnings per share of common stock
(10,000 shares of common stock outstanding):
Income from continuing operations
[($19,200 − $1,000) / 10,000] ……………………………………..
$1.82
(5-10 min.) S 11-11
Musicality, Inc.
Statement of Comprehensive Income
Year Ended December 31, 2016
(in
thousands)
Net income …………………………..…………………………..
$13,200
Other comprehensive income:
Unrealized gains on investments in AFSS,
net of tax …………………………..……………………….
$2,100
Foreign-currency translation gain, net of tax ….
Comprehensive income …………………………………….
The other comprehensive income would also be added to the
Accumulated Other Comprehensive Income in the stockholders’ equity
section of the balance sheet.
Musicality, Inc.
Balance Sheet (Partial)
December 31, 2016
(in
thousands)
Stockholders’ Equity:
Accumulated Other Comprehensive Income
(assuming no beginning balance)
(10 min.) S 11-12
iWorld, Inc.
Statement of Retained Earnings
Year Ended December 31, 2016
Retained earnings balance, December 31, 2015,
as originally reported …………………………………………………..
$ 55,000
Prior period adjustment — debit to correct error
in 2015 ………………………………………………………………………..
(10,000)
Retained earnings balance, December 31, 2015,
Net income for 2016 …………………………………………………………
Subtotal
Dividends declared for 2016 ……………………………………………..
Retained earnings balance, December 31, 2016 …………………
(10-15 min.) S 11-13
Req. 1
A segment is any subset or division of a business that earns revenues
and incurs expenses. Typically, large corporations have segments that
may be by product line, by type of business, or by geographic region.
Req. 2
Segment reporting provides the user with more detailed information
about a company and its different types of business activities, and the
Student responses will vary.
(10-15 min.) S 11-14
Req. 1
Management of Meinike Computer Inc. is responsible for the company’s
financial statements.
Req. 2
Req. 3
Management has established and maintains internal accounting control
over financial reporting to fulfill its responsibility for reliable financial
information. Management has also conducted an evaluation of the
effectiveness of the company’s internal control over financial reporting.
Req. 4
Req. 5
The audit covered Meinike’s consolidated balance sheets at September
30, 2016, and September 30, 2015, and consolidated income statements
(statements of operations), statements of comprehensive income,
statements of shareholders’ equity, and statements of cash flows for
each of the three years in the period ended September 30, 2016.
(continued) S 11-14
Req. 6
The standards for conducting an audit are the standards of the Public
Company Accounting Oversight Board (United States).
Req. 7
Exercises
(15-20 min.) E 11-15A
Req.1
Searstown Cycles, Inc.
Income Statement
Year Ended September 30, 2016
Thousands
Net sales …………………………………………………………………
$13,500
Total operating expenses …………………………………………
12,200
Income from continuing operations before
income tax ……………………………………………………….
1,300
Income tax expense …………………………………………………
Income from continuing operations ………………………….
Income from discontinued operations,
$290, less income tax, $58 …………………………………
232
Req.2
Searstown Cycles, Inc.
Statement of Comprehensive Income
Year Ended September 30, 2016
Thousands
Net income ………………………………………………………………
$1,227
Other comprehensive income (loss):
Unrealized gain on investments in AFSS, net of tax…
$ 36
Foreign-currency translation gain, net of tax ………….
350
Total other comprehensive income …………………………..
Comprehensive income
(20-25 min.) E 11-16A
Req. 1
Hooper Book Company
Income Statement
Year Ended December 31, 2016
Thousands
Sales revenue ………………………………………………………….
$122,000
Other revenues ………………………………………………………..
1,600
Total revenue …………………………………………………………..
123,600
Total operating expenses …………………………………………
104,800
Income tax expense …………………………………………………
5,640
Net income ……………………………………………………….……..
Earnings per share (EPS):
Req. 2
The company’s quality of earnings would be considered to be very good,
based on its steady growth each year and no discontinued operations
during recent years.
Req. 3
(10-15 min.) E 11-17A
Estimated
EPS from
value of
=
continuing operations
one share of
Investment
Flash Bytes, Inc.
stock
capitalization rate
=
(10-15 min.) E 11-18A
Req. 1
Journal
DATE
ACCOUNT TITLES AND EXPLANATION
DEBIT
CREDIT
May
9
Inventory …………………………………………………….
6,440
Accounts Payable (700,000 yen × $.0092) ….
6,440
June
18
Accounts Payable ………………………………………..
6,440
Cash (700,000 yen × $.0085) ……………………..
5,950
Foreign-Currency Transaction Gain ………….
490
Accounts Receivable (40,000 euros × $1.22) ….
Sales Revenue …………………………………………
Cash (40,000 euros × $1.18) ………………………….
Foreign-Currency Transaction Loss ……………..
Accounts Receivable …………………………..…..
Req. 2
On May 10, Holloway wanted the dollar to strengthen in order to pay
Toyita with yen that cost fewer dollars. That was what happened, and
Holloway had a foreign-currency transaction gain.
(10 min.) E 11-19A
Req. 1
Income Tax Expense ($320,000 × .25) ………………..
80,000
Income Tax Payable ($280,000 × .25)…………….
70,000
Deferred Tax Liability ………………………………….
10,000
Req. 2
Tax to pay currently ……………………………………………………….
Req. 3
Deferred tax liability ($31,000 + $10,000) ………………………….
(10 min.) E 11-20A
Net income –
preferred dividends
=
$6,200,000 − ($900,000 × .06)
=
$7.40
Common shares
outstanding
830,000*