CONCEPTS FOR ANALYSIS
CA4-1 (Identification of Income Statement Deficiencies) O’Malley Corporation was incorporated and began business on January
1, 2017. It has been successful and now requires a bank loan for additional working capital to finance expansion. The bank has requested an audited income statement for the year 2017. The accountant for O’Malley Corporation provides you with the following income statement which O’Malley plans to submit to the bank.
190 Chapter 4 Income Statement and Related Information
O’MALLEY CORPORATION
INCOME STATEMENT
Sales revenue $850,000
Dividends 32,300
Gain on recovery of insurance proceeds from earthquake loss 38,500
920,800
Less:
Selling expenses $101,100
Cost of goods sold 510,000
Advertising expense 13,700
Loss on obsolescence of inventories 34,000
Loss on discontinued operations 48,600
Administrative expense 73,400 780,800
Income before income tax 140,000
Income tax 56,000
Net income $ 84,000
Instructions
Indicate the deficiencies in the income statement presented above. Assume that the corporation desires a single-step income statement.
CA4-2 GROUPWORK (Earnings Management) Bobek Inc. has recently reported steadily increasing income. The company reported income of $20,000 in 2014, $25,000 in 2015, and $30,000 in 2016. A number of market analysts have recommended that investors buy the stock because they expect the steady growth in income to continue. Bobek is approaching the end of its fiscal year in 2017, and it again appears to be a good year. However, it has not yet recorded warranty expense.
Based on prior experience, this year’s warranty expense should be around $5,000, but some managers have approached the controller to suggest a larger, more conservative warranty expense should be recorded this year. Income before warranty expense is $43,000. Specifically, by recording a $7,000 warranty accrual this year, Bobek could report an increase in income for this year and still be in a position to cover its warranty costs in future years.
Instructions
(a) What is earnings management?
(b) Assume income before warranty expense is $43,000 for both 2017 and 2018 and that total warranty expense over the
2-year period is $10,000. What is the effect of the proposed accounting in 2017? In 2018?
(c) What is the appropriate accounting in this situation?
CA4-3 ETHICS (Earnings Management) Charlie Brown, controller for Kelly Corporation, is preparing the company’s income statement at year-end. He notes that the company lost a considerable sum on the sale of some equipment it had decided to replace.
Since the company has sold equipment routinely in the past, Brown knows the losses cannot be reported as an unusual item. He also does not want to highlight it as a material loss since he feels that will reflect poorly on him and the company. He reasons that if the company had recorded more depreciation during the assets’ lives, the losses would not be so great. Since depreciation is included among the company’s operating expenses, he wants to report the losses along with the company’s expenses, where he hopes it will not be noticed.
Instructions
(a) What are the ethical issues involved?
(b) What should Brown do?
CA4-4 (Income Reporting Items) Simpson Corp. is an entertainment firm that derives approximately 30% of its income from the Casino Knights Division, which manages gambling facilities. As auditor for Simpson Corp., you have recently overheard the following discussion between the controller and financial vice president.
Vice President: If we sell the Casino Knights Division, it seems ridiculous to segregate the results of the sale in the income statement. Separate categories tend to be absurd and confusing to the stockholders. I believe that we should simply report the gain on the sale as other income or expense without detail.
Controller: Professional pronouncements would require that we report this information separately in the income statement. If a sale of this type is considered unusual and infrequent, it must be reported separate from income from continuing operations.
Vice President: What about the walkout we had last month when employees were upset about their commission income? Would this situation not also be subject to reporting outside operating income?
Controller: I am not sure whether this item should get special reporting or not.
Vice President: Oh well, it doesn’t make any difference because the net effect of all these items is immaterial, so no disclosure is necessary.
Instructions
(a) On the basis of the foregoing discussion, answer the following questions. Who is correct about handling the sale? What would be the correct income statement presentation for the sale of the Casino Knights Division?
(b) How should the walkout by the employees be reported?
(c) What do you think about the vice president’s observation on materiality?
(d) What are the earnings per share implications of these topics?
CA4-5 (Identification of Income Statement Weaknesses) The following financial statement was prepared by employees of Walters Corporation.
Instructions
Identify and discuss the weaknesses in classification and disclosure in the single-step income statement above. You should explain why these treatments are weaknesses and what the proper presentation of the items would be in accordance with GAAP.
CA4-6 ETHICS (Classification of Income Statement Items) As audit partner for Grupo and Rijo, you are in charge of reviewing the classification of unusual items that have occurred during the current year. The following material items have come to your attention.
Instructions
From the foregoing information, indicate in what section of the income statement or retained earnings statement these items should be classified. Provide a brief rationale for your position.
CA4-7 (Comprehensive Income) Willie Nelson, Jr., controller for Jenkins Corporation, is preparing the company’s financial statements at year-end. Currently, he is focusing on the income statement and determining the format for reporting comprehensive income. During the year, the company earned net income of $400,000 and had unrealized gains on available-for-sale securities of $15,000. In the previous year, net income was $410,000, and the company had no unrealized gains or losses.
Instructions
(a) Show how income and comprehensive income will be reported on a comparative basis for the current and prior years, using the two statement format.
(b) Show how income and comprehensive income will be reported on a comparative basis for the current and prior years, using the one statement format.
(c) Which format should Nelson recommend?
