Chapter 5 Second Extraordinary Item Shown Net Applicable Income

5-74

P5-22 GIBB COMPANY

Balance Sheet

December 31, 2010

Assets

Current Assets

Cash $ 3,300a

Liabilities

Current Liabilities

Accounts payable $ 3,000g

Salaries payable 1,500h

Stockholders’ Equity

Contributed Capital

Common stock, $10 par $16,500j

aLast item on statement of cash flows

b$5,000 = $3,900 + $1,100

ANSWERS TO CASES

C5-1

Recognition is the process of formally recording and reporting an item in a company’s

financial statements. To be recognized, an item must meet the definition of an element

In the first criterion, realization means the process of converting noncash resources into

cash or rights to cash. Realization encompasses two terms: (1) realized and (2) realizable.

Realized refers to the actual exchange of noncash resources into cash or near cash (e.g.,

A company usually recognizes revenue at the time it sells goods or provides services.

Revenue might be recognized prior to the sale or after the sale in special cases to more

accurately reflect the nature of a company’s operations (i.e., to increase the predictive

C5-2

The three principles for recognizing the expenses to be matched against revenues are:

1. Association of cause and effect. Some costs are recognized as expenses on the basis

of a presumed direct association with specific revenues. Some transactions result

C5-2

C5-2 (continued)

2. Systematic and rational allocation. Some costs are recognized as expenses in a particular

accounting period based on a systematic and rational allocation among the periods in

3. Immediate recognition. Some costs are recognized as expenses in the current

accounting period because (1) the costs incurred during the period provide no

4.

C5-3 (AICPA adapted solution)

1. a. Cost is the amount measured by the current monetary value of economic resources

given up or to be given up in obtaining goods and services. Economic resources may

b. Expense in its broadest sense includes all expired costs; that is, costs that do not have

any potential future economic benefit. A more precise definition limits the use of the

c. A loss is an unplanned cost expiration and for this reason is often included in the

broad definition of expenses. A more precise definition restricts the use of the term

2. a. Cost of goods sold is an expired cost and may be referred to as an expense in the

broad sense of the term. On the income statement it is most often identified as a

cost. Inventory held for sale that is destroyed by an abnormal casualty should be

classified as a loss.

C5-3 (continued)

2. (continued)

b. Bad debts expense is usually classified as an expense. However, some authorities

c. Depreciation expense for plant machinery is a component of factory overhead and

represents the reclassification of a portion of the machinery cost to product cost

3. Period costs and product costs are usually differentiated under one of two major

concepts. One concept identifies a cost as a period or a product cost according to

whether the cost expires primarily with the passage of time or directly for the production of

revenue. The other concept identifies a cost as a product or a period cost according to

whether or not the cost is included in inventory.

Under the first concept, period costs are all costs that expire within the accounting period

C5-4

The elements included in a company’s results of discontinued operations section of its

income statement are (1) the operating income (or loss) from a discontinued component

and (2) the gain (or loss) on the sale of the discontinued component.

When the company has operated the component for part of a year before the

component is sold, the company reports the operating income (or operating loss) from

the discontinued component for the period up to the date of sale separately from the

income from continuing operations of the rest of the company. To calculate the

operating income (or loss) of the discontinued component for the period of time up to the

C5-5

1. The two criteria identified by GAAP that must be met in order for an event or transaction

to be classified as an extraordinary item are:

a. Unusual nature. The underlying event or transaction possesses a high degree of

abnormality and is of a type clearly unrelated to, or only incidentally related to, the

b. Infrequency of occurrence. The underlying event or transaction is of a type that is not

2. a. An earthquake is likely to be extraordinary for a company in Missouri but may not be

C5-5 (continued)

2. (continued)

In each of the preceding examples, the environment in which the company operates is

examples could be equally appropriate.

3. a. An extraordinary item is reported separately (net of tax effect) immediately below the

section summarizing the results from discontinued operations. Individual extraordinary

C5-6 (AICPA adapted solution)

1. Morgan should report the effects of the hailstorm as an extraordinary item in its income

2. The classification in the income statement of an extraordinary item differs from that of an

operating item in the following ways. First, an extraordinary item is shown as a separate

C5-7 (AICPA adapted solution)

1. Lynn should report the results of discontinued operations separately from continuing

operations. Discontinued operations should be shown on Lynn‘s income statement

2. Both of the following criteria must be met for classification as an extraordinary item. An

extraordinary item must be unusual in nature and infrequent in occurrence, taking into

account the environment in which the company operates.

C5-7 (continued)

C5-8

A statement of cash flows is a statement that reports on a company’s cash inflows, cash

outflows, and net change in cash from its operating, investing, and financing activities

during the accounting period, in a manner that reconciles the beginning and ending cash

balances. The statement of cash flows provides information to external users to assess a

C5-9

HILL CORPORATION

Income Statement (Lifetime)

January 1, 1998 to December 31, 2010

Net Assets at Liquidation

Assets’ selling price $600,000

5-81

C5-9 (continued)

The additional information in which you might be interested includes:

1. The history of the activities in which the corporation was involved.

5. The debt ratio of the corporation throughout its lifetime to determine its overall capital

structure.

C5-10 (AICPA adapted solution)

1. Accrual accounting recognizes and reports the effects of transactions and other events

on the assets and liabilities of a company in the time periods to which they relate rather

than only when cash is received or paid. Accrual accounting attempts to match

revenues and the expenses associated with those revenues in order to determine the

C5-10 (continued)

An accrual represents a transaction that affects the determination of a company’s

income for the period but has not yet been reflected in its cash accounts of that period.

Accrued revenue is revenue earned but not yet collected in cash. An example of

2. In cash accounting, the effects of transactions and other events on the assets and

liabilities of a company are recognized and reported only when cash is received or paid;

C5-11

Note to Instructor: This case does not have a definitive answer. From a financial reporting

perspective, GAAP is identified and summarized. From an ethical perspective, various

5-83

C5-11 (continued)

However, if the company has committed to a plan to sell a component and the sale has

not occurred by the end of the year, then the component is to be classified as held for

sale if several criteria are met. These criteria include: (1) management has committed to a

plan to sell the component, (2) the component is available for immediate sale in its

From an ethical perspective, the issue is when to report the results from discontinued

operations on Newell Company’s income statement. The timing of the reporting will have

an impact on the rights of, and fairness to, the stakeholders. The primary stakeholders

include the president and the accountant of Newell Company, as well as its creditors and

stockholders. If the criteria for identifying a held-for-sale component are met in 2010 and

(from those discussed above) on the different stakeholders.

What is critical in this situation is to fairly determine whether each of the criteria for

classifying a significant component as held for sale is met. It appears that criteria (1), (4),

and (5) are met. However, from the information presented, it is unclear whether (2) the

component is available for immediate sale (since some legal work still has to be

ANSWERS TO RESEARCH SIMULATIONS

R5-1

Note to Instructor: Students are expected to cite references to GAAP in their research of

this issue. They might use the FARS electronic database, pronouncements listed on the

FASB web site, the FASB Original Pronouncements, the FASB Current text, or other primary

sources of GAAP to obtain these references. They may also use the FASB Accounting

Standards Codification which is cited in parentheses.

To: President, Klote Company

From: Student

I have researched the issue of how to report the $40,000 loss from the write-off of a major

customer’s accounts receivable due to its bankruptcy on the Klote Company’s 2010

R5-2

Note to Instructor: Students are expected to cite references to GAAP in their research of

this issue. They might use the FARS electronic database, pronouncements listed on the

FASB web site, the FASB Original Pronouncements, the FASB Current text, or other primary

sources of GAAP to obtain these references. They may also use the FASB Accounting

Standards Codification which is cited in parentheses.

To: President, Kelly Company

From: Student

5-85

R5-2 (continued)

Based on these findings, I recommend that the $20,000 be reported on the company’s

statement of cash flows for 2010 as follows: