5 Balance Sheet and Statement of Cash Flows CONCEPTS FOR ANALYSIS 5

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CONCEPTS FOR ANALYSIS

CA5-1 (Reporting the Financial Effects of Varied Transactions) In an examination of Arenes Corporation as of December 31, 2017, you have learned that the following situations exist. No entries have been made in the accounting records for these items.
1. The corporation erected its present factory building in 2001. Depreciation was calculated by the straight-line method, using an estimated life of 35 years. Early in 2017, the board of directors conducted a careful survey and estimated that the factory building had a remaining useful life of 25 years as of January 1, 2017.
2. An additional assessment of 2016 income taxes was levied and paid in 2017.
3. When calculating the accrual for officers’ salaries at December 31, 2017, it was discovered that the accrual for officers’ salaries for December 31, 2016, had been overstated.
4. On December 15, 2017, Arenes Corporation declared a cash dividend on its common stock outstanding, payable February 1, 2018, to the common stockholders of record December 31, 2017.
Instructions
Describe fully how each of the items above should be reported in the financial statements of Arenes Corporation for the year 2017.

CA5-2 (Identifying Balance Sheet Deficiencies) The assets of Fonzarelli Corporation are presented below (000s omitted).
…
Instructions
Indicate the deficiencies, if any, in the foregoing presentation of Fonzarelli Corporation’s assets.

CA5-3 WRITING (Critique of Balance Sheet Format and Content) The following is the balance sheet of Sameed Brothers Corporation (000s omitted).
Instructions
Evaluate the balance sheet presented. State briefly the proper treatment of any item criticized.

CA5-4 ETHICS (Presentation of Property, Plant, and Equipment) Carol Keene, corporate comptroller for Dumaine
Industries, is trying to decide how to present “Property, plant, and equipment” in the balance sheet. She realizes that the statement of cash flows will show that the company made a significant investment in purchasing new equipment this year, but overall she knows the company’s plant assets are rather old. She feels that she can disclose one figure titled “Property, plant, and equipment, net of depreciation,” and the result will be a low figure. However, it will not disclose the age of the assets. If she chooses to show the cost less accumulated depreciation, the age of the assets will be apparent. She proposes the following.

Property, plant, and equipment, net of depreciation $10,000,000 rather than
Property, plant, and equipment $50,000,000
Less: Accumulated depreciation 40,000,000
Net book value $10,000,000
Instructions
Answer the following questions.
(a) What are the ethical issues involved?
(b) What should Keene do?

CA5-5 WRITING (Cash Flow Analysis) The partner in charge of the Kappeler Corporation audit comes by your desk and leaves a letter he has started to the CEO and a copy of the cash flow statement for the year ended December 31, 2017. Because he must leave on an emergency, he asks you to finish the letter by explaining: (1) the disparity between net income and cash flow, (2) the importance of operating cash flow, (3) the renewable source(s) of cash flow, and (4) possible suggestions to improve the cash position.
….
Instructions
Complete the letter to the CEO, including the four components requested by your boss.

7 Cash and Receivables CONCEPTS FOR ANALYSIS 7

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CONCEPTS FOR ANALYSIS

CA7-1 (Bad-Debt Accounting) Simms Company has significant amounts of trade accounts receivable. Simms uses the allowance method to estimate bad debts instead of the direct write-off method. During the year, some specific accounts were written off as uncollectible, and some that were previously written off as uncollectible were collected.
Instructions
(a) What are the deficiencies of the direct write-off method?
(b) Briefly describe the allowance method to estimate bad debts and the theoretical justification for its use?
(c) How should Simms account for the collection of the specific accounts previously written off as uncollectible?

CA7-2 (Various Receivable Accounting Issues) Kimmel Company uses the net method of accounting for sales discounts. Kimmel also offers trade discounts to various groups of buyers.
On August 1, 2017, Kimmel sold some accounts receivable on a without recourse basis. Kimmel incurred a finance charge.
Kimmel also has some notes receivable bearing an appropriate rate of interest. The principal and total interest are due at maturity. The notes were received on October 1, 2017, and mature on September 30, 2019. Kimmel’s operating cycle is less than one year.
Instructions
(a) (1) Using the net method, how should Kimmel account for the sales discounts at the date of sale? What is the rationale for the amount recorded as sales under the net method?
(2) Using the net method, what is the effect on Kimmel’s sales revenues and net income when customers do not take the sales discounts?
(b) What is the effect of trade discounts on sales revenues and accounts receivable? Why?
(c) How should Kimmel account for the accounts receivable factored on August 1, 2017? Why?
(d) How should Kimmel account for the note receivable and the related interest on December 31, 2017? Why?

CA7-3 WRITING (Bad-Debt Reporting Issues) Clark Pierce conducts a wholesale merchandising business that sells approximately
5,000 items per month with a total monthly average sales value of $250,000. Its annual bad debt rate has been approximately
1½% of sales. In recent discussions with his bookkeeper, Mr. Pierce has become confused by all the alternatives apparently available in handling the Allowance for Doubtful Accounts balance. The following information has been presented to Pierce.
1. An allowance can be set up (a) on the basis of a percentage of receivables or (b) on the basis of a valuation of all past due or otherwise questionable accounts receivable. Those considered uncollectible can be charged to such allowance at the close of the accounting period, or specific items can be charged off directly against (1) Gross Sales or to (2) Bad Debt Expense in the year in which they are determined to be uncollectible.
2. Collection agency and legal fees, and so on, incurred in connection with the attempted recovery of bad debts can be charged to (a) Bad Debt Expense, (b) Allowance for Doubtful Accounts, (c) Legal Expense, or (d) Administrative Expense.
3. Debts previously written off in whole or in part but currently recovered can be credited to (a) Other Revenue, (b) Bad Debt
Expense, or (c) Allowance for Doubtful Accounts.
Instructions
Which of the foregoing methods would you recommend to Mr. Pierce in regard to (1) allowances and charge-offs, (2) collection expenses, and (3) recoveries? State briefly and clearly the reasons supporting your recommendations.

CA7-4 WRITING (Basic Note and Accounts Receivable Transactions)
Part 1: On July 1, 2017, Wallace Company, a calendar-year company, sold special-order merchandise on credit and received in return an interest-bearing note receivable from the customer. Wallace Company will receive interest at the prevailing rate for a note of this type. Both the principal and interest are due in one lump sum on June 30, 2018.
Instructions
When should Wallace Company report interest revenue from the note receivable? Discuss the rationale for your answer.

Part 2: On December 31, 2017, Wallace Company had significant amounts of accounts receivable as a result of credit sales to its customers. Wallace uses the allowance method based on credit sales to estimate bad debts. Past experience indicates a reliable estimate of uncollectible accounts can be developed based on an aging analysis of receivable balances. This pattern is expected to continue.
Instructions
(a) Discuss the rationale for using the allowance method based on the balance in the trade receivables accounts.
(b) How should Wallace Company report the allowance for doubtful accounts on its balance sheet at December 31, 2017?
Also, describe the alternatives, if any, for presentation of bad debt expense in Wallace Company’s 2017 income statement.
(AICPA adapted)

CA7-5 (Sale of Notes Receivable) Corrs Wholesalers Co. sells industrial equipment for a standard 3-year note receivable. Revenue is recognized at time of sale. Each note is secured by a lien on the equipment and has a face amount equal to the equipment’s list price. Each note’s stated interest rate is below the customer’s market rate at date of sale. All notes are to be collected in three equal annual installments beginning one year after sale. Some of the notes are subsequently sold to a bank with recourse, some are subsequently sold without recourse, and some are retained by Corrs. At year end, Corrs evaluates all outstanding notes receivable and provides for estimated losses arising from defaults.
Instructions
(a) What is the appropriate valuation basis for Corrs’s notes receivable at the date it sells equipment?
(b) How should Corrs account for the sale, without recourse, of a February 1, 2017, note receivable sold on May 1, 2017? Why is it appropriate to account for it in this way?
(c) At December 31, 2017, how should Corrs measure and account for the impact of estimated losses resulting from notes receivable that it
(1) Retained and did not sell?
(2) Sold to bank with recourse?
(AICPA adapted)

CA7-6 (Zero-Interest-Bearing Note Receivable) On September 30, 2016, Rolen Machinery Co. sold a machine and accepted the customer’s zero-interest-bearing note. Rolen normally makes sales on a cash basis. Since the machine was unique, its sales price was not determinable using Rolen’s normal pricing practices.
After receiving the first of two equal annual installments on September 30, 2017, Rolen immediately sold the note with recourse.
On October 9, 2018, Rolen received notice that the note was dishonored, and it paid all amounts due. At all times prior to default, the note was reasonably expected to be paid in full.
Instructions
(a) (1) How should Rolen determine the sales price of the machine?
(2) How should Rolen report the effects of the zero-interest-bearing note on its income statement for the year ended December 31, 2016? Why is this accounting presentation appropriate?
(b) What are the effects of the sale of the note receivable with recourse on Rolen’s income statement for the year ended December 31, 2017, and its balance sheet at December 31, 2017?
(c) How should Rolen account for the effects of the note being dishonored?

CA7-7 GROUPWORK (Reporting of Notes Receivable, Interest, and Sale of Receivables) On July 1, 2017, Moresan Company sold special-order merchandise on credit and received in return an interest-bearing note receivable from the customer. Moresan will receive interest at the prevailing rate for a note of this type. Both the principal and interest are due in one lump sum on June 30, 2018.
On September 1, 2017, Moresan sold special-order merchandise on credit and received in return a zero-interest-bearing note receivable from the customer. The prevailing rate of interest for a note of this type is determinable. The note receivable is due in one lump sum on August 31, 2019.
Moresan also has significant amounts of trade accounts receivable as a result of credit sales to its customers. On October 1, 2017, some trade accounts receivable were assigned to Indigo Finance Company on a non-notification (Moresan handles collections) basis for an advance of 75% of their amount at an interest charge of 8% on the balance outstanding.
On November 1, 2017, other trade accounts receivable were sold on a without recourse basis. The factor withheld 5% of the trade accounts receivable factored as protection against sales returns and allowances and charged a finance charge of 3%.
Instructions
(a) How should Moresan determine the interest revenue for 2017 on the:
(1) Interest-bearing note receivable? Why?
(2) Zero-interest-bearing note receivable? Why?

(b) How should Moresan report the interest-bearing note receivable and the zero-interest-bearing note receivable on its balance sheet at December 31, 2017?
(c) How should Moresan account for subsequent collections on the trade accounts receivable assigned on October 1, 2017, and the payments to Indigo Finance? Why?
(d) How should Moresan account for the trade accounts receivable factored on November 1, 2017? Why?
(AICPA adapted)

CA7-8 WRITING (Accounting for Zero-Interest-Bearing Note) Soon after beginning the year-end audit work on March 10 at Engone Company, the auditor has the following conversation with the controller.
Controller: The year ended March 31st should be our most profitable in history and, as a consequence, the board of directors has just awarded the officers generous bonuses.
Auditor: I thought profits were down this year in the industry, according to your latest interim report.
Controller: Well, they were down, but 10 days ago we closed a deal that will give us a substantial increase for the year.
Auditor: Oh, what was it?
Controller: Well, you remember a few years ago our former president bought stock in Henderson Enterprises because he had those grandiose ideas about becoming a conglomerate. For 6 years we have not been able to sell this stock, which cost us $3,000,000 and has not paid a nickel in dividends. Thursday we sold this stock to Bimini Inc. for $4,000,000. So, we will have a gain of $700,000 ($1,000,000 pretax) which will increase our net income for the year to $4,000,000, compared with last year’s $3,800,000. As far as I know, we’ll be the only company in the industry to register an increase in net income this year. That should help the market value of the stock!
Auditor: Do you expect to receive the $4,000,000 in cash by March 31st, your fiscal year-end?
Controller: No. Although Bimini Inc. is an excellent company, they are a little tight for cash because of their rapid growth.
Consequently, they are going to give us a $4,000,000 zero-interest-bearing note with payments of $400,000 per year for the next 10 years. The first payment is due on March 31 of next year.
Auditor: Why is the note zero-interest-bearing?
Controller: Because that’s what everybody agreed to. Since we don’t have any interest-bearing debt, the funds invested in the note do not cost us anything and besides, we were not getting any dividends on the Henderson Enterprises stock.
Instructions
Do you agree with the way the controller has accounted for the transaction? If not, how should the transaction be accounted for?

CA7-9 WRITING (Receivables Management) As the manager of the accounts receivable department for Beavis Leather Goods, Ltd., you recently noticed that Kelly Collins, your accounts receivable clerk who is paid $1,200 per month, has been wearing unusually tasteful and expensive clothing. (This is Beavis’s first year in business.) This morning, Collins drove up to work in a brand new Lexus.
Naturally suspicious by nature, you decide to test the accuracy of the accounts receivable balance of $192,000 as shown in the ledger. The following information is available for your first year (precisely 9 months ended September 30, 2017) in business.
(1) Collections from customers $188,000
(2) Merchandise purchased 360,000
(3) Ending merchandise inventory 90,000
(4) Goods are marked to sell at 40% above cost.
Instructions
Assuming all sales were made on account, compute the ending accounts receivable balance that should appear in the ledger, noting any apparent shortage. Then, draft a memo dated October 3, 2017, to Mark Price, the branch manager, explaining the facts in this situation. Remember that this problem is serious, and you do not want to make hasty accusations.

CA7-10 ETHICS (Bad-Debt Reporting) Marvin Company is a subsidiary of Hughes Corp. The controller believes that the yearly allowance for doubtful accounts for Marvin should be 8% of gross accounts receivable. Given the recession and the high interest rate environment, the president, nervous that the parent company might expect the subsidiary to sustain its 10% growth rate, suggests that the controller increase the allowance for doubtful accounts to 9%. The president thinks that the lower net income, which reflects a 6% growth rate, will be a more sustainable rate for Marvin Company.
Instructions
(a) In a recessionary environment with tight credit and high interest rates:
(1) Identify steps Marvin Company might consider to improve the accounts receivable situation.
(2) Then evaluate each step identified in terms of the risks and costs involved.
(b) Should the controller be concerned with Marvin Company’s growth rate in estimating the allowance? Explain your answer.
(c) Does the president’s request pose an ethical dilemma for the controller? Give your reasons.

8 Valuation of Inventories: A Cost-Basis Approach CONCEPTS FOR ANALYSIS 8

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CONCEPTS FOR ANALYSIS

CA8-1 (Inventoriable Goods and Costs) You are asked to travel to Milwaukee to observe and verify the inventory of the Milwaukee branch of one of your clients. You arrive on Thursday, December 30, and find that the inventory procedures have just been started. You spot a railway car on the sidetrack at the unloading door and ask the warehouse superintendent, Buck Rogers, how he plans to inventory the contents of the car. He responds, “We are not going to include the contents in the inventory.”
Later in the day, you ask the bookkeeper for the invoice on the carload and the related freight bill. The invoice lists the various items, prices, and extensions of the goods in the car. You note that the carload was shipped December 24 from Albuquerque, f.o.b. Albuquerque, and that the total invoice price of the goods in the car was $35,300. The freight bill called for a payment of $1,500. Terms were net 30 days. The bookkeeper affirms the fact that this invoice is to be held for recording in January.
Instructions
(a) Does your client have a liability that should be recorded at December 31? Discuss.
(b) Prepare a journal entry(ies), if required, to reflect any accounting adjustment required. Assume a perpetual inventory system is used by your client.
(c) For what possible reason(s) might your client wish to postpone recording the transaction?

CA8-2 (Inventoriable Goods and Costs) Clay Mattews, an inventory control specialist, is interested in better understanding the accounting for inventories. Although Clay understands the more sophisticated computer inventory control systems, he has little knowledge of how inventory cost is determined. In studying the records of Strider Enterprises, which sells normal brand-name goods from its own store and on consignment through Chavez Inc., he asks you to answer the following questions.
Instructions
(a) Should Strider Enterprises include in its inventory normal brand-name goods purchased from its suppliers but not yet received if the terms of purchase are f.o.b. shipping point (manufacturer’s plant)? Why?
(b) Should Strider Enterprises include freight-in expenditures as an inventory cost? Why?
(c) If Strider Enterprises purchases its goods on terms 2/10, net 30, should the purchases be recorded gross or net? Why?
(d) What are products on consignment? How should they be reported in the financial statements?
(AICPA adapted)

CA8-3 (Inventoriable Goods and Costs) George Solti, the controller for Garrison Lumber Company, has recently hired you as assistant controller. He wishes to determine your expertise in the area of inventory accounting and therefore asks you to answer the following unrelated questions.
(a) A company is involved in the wholesaling and retailing of automobile tires for foreign cars. Most of the inventory is imported, and it is valued on the company’s records at the actual inventory cost plus freight-in. At year-end, the warehousing costs are prorated over cost of goods sold and ending inventory. Are warehousing costs considered a product cost or a period cost?
(b) A certain portion of a company’s “inventory” is composed of obsolete items. Should obsolete items that are not currently consumed in the production of “goods or services to be available for sale” be classified as part of inventory?
(c) A company purchases airplanes for sale to others. However, until they are sold, the company charters and services the planes. What is the proper way to report these airplanes in the company’s financial statements?
(d) A company wants to buy coal deposits but does not want the financing for the purchase to be reported on its financial statements. The company therefore establishes a trust to acquire the coal deposits. The company agrees to buy the coal over a certain period of time at specified prices. The trust is able to finance the coal purchase and pay off the loan as it is paid by the company for the minerals. How should this transaction be reported?

CA8-4 (Accounting Treatment of Purchase Discounts) Shawnee Corp., a household appliances dealer, purchases its inventories from various suppliers. Shawnee has consistently stated its inventories at FIFO cost.
Instructions
Shawnee is considering alternate methods of accounting for the cash discounts it takes when paying its suppliers promptly.
From a theoretical standpoint, discuss the acceptability of each of the following methods.
(a) Financial income when payments are made.
(b) Reduction of cost of goods sold for the period when payments are made.
(c) Direct reduction of purchase cost.
(AICPA adapted)

CA8-5 (General Inventory Issues) In January 2017, Susquehanna Inc. requested and secured permission from the commissioner of the Internal Revenue Service to compute inventories under the last-in, first-out (LIFO) method and elected to determine inventory cost under the dollar-value LIFO method. Susquehanna Inc. satisfied the commissioner that cost could be accurately determined by use of an index number computed from a representative sample selected from the company’s single inventory pool.
Instructions
(a) Why should inventories be included in (1) a balance sheet and (2) the computation of net income?
(b) The Internal Revenue Code allows some accountable events to be considered differently for income tax reporting purposes and financial accounting purposes, while other accountable events must be reported the same for both purposes.
Discuss why it might be desirable to report some accountable events differently for financial accounting purposes than for income tax reporting purposes.
(c) Discuss the ways and conditions under which the FIFO and LIFO inventory costing methods produce different inventory valuations. Do not discuss procedures for computing inventory cost.
(AICPA adapted)

CA8-6 (LIFO Inventory Advantages) Jane Yoakam, president of Estefan Co., recently read an article that claimed that at least 100 of the country’s largest 500 companies were either adopting or considering adopting the last-in, first-out (LIFO) method for valuing inventories. The article stated that the firms were switching to LIFO to (1) neutralize the effect of inflation in their financial statements,
(2) eliminate inventory profits, and (3) reduce income taxes. Ms. Yoakam wonders if the switch would benefit her company.
Estefan currently uses the first-in, first-out (FIFO) method of inventory valuation in its periodic inventory system. The company has a high inventory turnover rate, and inventories represent a significant proportion of the assets.
Ms. Yoakam has been told that the LIFO system is more costly to operate and will provide little benefit to companies with high turnover. She intends to use the inventory method that is best for the company in the long run rather than selecting a method just because it is the current fad.
Instructions
(a) Explain to Ms. Yoakam what “inventory profits” are and how the LIFO method of inventory valuation could reduce them.
(b) Explain to Ms. Yoakam the conditions that must exist for Estefan Co. to receive tax benefits from a switch to the LIFO method.

CA8-7 WRITING (Average-Cost, FIFO, and LIFO) Prepare a memorandum containing responses to the following items.
(a) Describe the cost flow assumptions used in average-cost, FIFO, and LIFO methods of inventory valuation.
(b) Distinguish between weighted-average-cost and moving-average-cost for inventory costing purposes.
(c) Identify the effects on both the balance sheet and the income statement of using the LIFO method instead of the FIFO method for inventory costing purposes over a substantial time period when purchase prices of inventoriable items are rising. State why these effects take place.

CA8-8 WRITING (LIFO Application and Advantages) Geddes Corporation is a medium-sized manufacturing company with two divisions and three subsidiaries, all located in the United States. The Metallic Division manufactures metal castings for the automotive industry, and the Plastic Division produces small plastic items for electrical products and other uses. The three subsidiaries manufacture various products for other industrial users.
Geddes Corporation plans to change from the lower of first-in, first-out (FIFO)-cost-or market method of inventory valuation to the last-in, first-out (LIFO) method of inventory valuation to obtain tax benefits. To make the method acceptable for tax purposes, the change also will be made for its annual financial statements.
Instructions
(a) Describe the establishment of and subsequent pricing procedures for each of the following LIFO inventory methods.
(1) LIFO applied to units of product when the periodic inventory system is used.
(2) Application of the dollar-value method to LIFO units of product.
(b) Discuss the specific advantages and disadvantages of using the dollar-value LIFO application as compared to specific goods LIFO (unit LIFO). (Ignore income tax considerations.)
(c) Discuss the general advantages and disadvantages claimed for LIFO methods.

CA8-9 WRITING (Dollar-Value LIFO Issues) Arruza Co. is considering switching from the specific-goods LIFO approach to the dollar-value LIFO approach. Because the financial personnel at Arruza know very little about dollar-value LIFO, they ask you to answer the following questions.
(a) What is a LIFO pool?
(b) Is it possible to use a LIFO pool concept and not use dollar-value LIFO? Explain.
(c) What is a LIFO liquidation?
(d) How are price indexes used in the dollar-value LIFO method?
(e) What are the advantages of dollar-value LIFO over specific-goods LIFO?

CA8-10 WRITING (FIFO and LIFO) Harrisburg Company is considering changing its inventory valuation method from FIFO to LIFO because of the potential tax savings. However, management wishes to consider all of the effects on the company, including its reported performance, before making the final decision.
The inventory account, currently valued on the FIFO basis, consists of 1,000,000 units at $8 per unit on January 1, 2017. There are 1,000,000 shares of common stock outstanding as of January 1, 2017, and the cash balance is $400,000.

The company has made the following forecasts for the period 2017–2019.
Instructions
(a) Prepare a schedule that illustrates and compares the following data for Harrisburg Company under the FIFO and the
LIFO inventory method for 2017–2019. Assume the company would begin LIFO at the beginning of 2017.
(1) Year-end inventory balances. (3) Earnings per share.
(2) Annual net income after taxes. (4) Cash balance.
Assume all sales are collected in the year of sale and all purchases, operating expenses, and taxes are paid during the year incurred.
(b) Using the data above, your answer to (a), and any additional issues you believe need to be considered, prepare a report that recommends whether or not Harrisburg Company should change to the LIFO inventory method. Support your conclusions with appropriate arguments.
(CMA adapted)

CA8-11 ETHICS (LIFO Choices) Wilkens Company uses the LIFO method for inventory costing. In an effort to lower net income, company president Mike Wilkens tells the plant accountant to take the unusual step of recommending to the purchasing department a large purchase of inventory at year-end. The price of the item to be purchased has nearly doubled during the year, and the item represents a major portion of inventory value.
Instructions
Answer the following questions.
(a) Identify the major stakeholders. If the plant accountant recommends the purchase, what are the consequences?
(b) If Wilkens Company were using the FIFO method of inventory costing, would Mike Wilkens give the same order? Why or why not?

9 Inventories: Additional Valuation Issues CONCEPTS FOR ANALYSIS 9

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CONCEPTS FOR ANALYSIS

CA9-1 (LCNRV) You have been asked by the financial vice president to develop a short presentation on the LCNRV method for inventory purposes. The financial VP needs to explain this method to the president because it appears that a portion of the company’s inventory has declined in value.
Instructions
The financial vice president asks you to answer the following questions.
(a) What is the purpose of the LCNRV method?
(b) What is meant by “net realizable value”?
(c) Do you apply the LCNRV method to each individual item, to a category, or to the total of the inventory? Explain.
(d) What are the potential disadvantages of the LCNRV method?

CA9-2 ETHICS (LCNRV) The net realizable value of Lake Corporation’s inventory has declined below its cost. Allyn Conan, the controller, wants to use the loss method to write down inventory because it more clearly discloses the decline in the net realizable value and does not distort the cost of goods sold. His supervisor, financial vice president Bill Ortiz, prefers the costof- goods-sold method to write down inventory because it does not call attention to the decline in net realizable value.
Instructions
Answer the following questions.
(a) What, if any, is the ethical issue involved?
(b) Is any stakeholder harmed if Bill Ortiz’s preference is used?
(c) What should Allyn Conan do?

CA9-3 (LCNRV) Ogala Corporation purchased a significant amount of raw materials inventory for a new product that it is manufacturing.
Ogala uses the LCNRV rule for these raw materials. The net realizable value of the raw materials is below the original cost.
Ogala uses the FIFO inventory method for these raw materials. In the last 2 years, each purchase has been at a lower price than the previous purchase, and the ending inventory quantity for each period has been higher than the beginning inventory quantity for that period.
Instructions
(a) At which amount should Ogala’s raw materials inventory be reported on the balance sheet? Why?
(b) In general, why is the LCNRV rule used to report inventory?
(c) What would have been the effect on ending inventory and cost of goods sold had Ogala used the average-cost inventory method instead of the FIFO inventory method for the raw materials? Why?

CA9-4 (LCNRV) Steele Corporation purchased a significant amount of raw materials inventory for a new product that it is manufacturing. Steele uses the lower-of-average-cost-or-net realizable value (LCNRV) rule for these raw materials. The net realizable value of the raw materials is below the original cost.
In the last 2 years, each purchase has been at a lower price than the previous purchase, and the ending inventory quantity for each period has been higher than the beginning inventory quantity for that period.
Instructions
(a) (1) At which amount should Steele’s raw materials inventory be reported on the balance sheet? Why?
(2) In general, why is the LCNRV rule used to report inventory?
(b) What would have been the effect on ending inventory and cost of goods sold had Steele used the LIFO inventory method instead of the average-cost inventory method for the raw materials? Why?

CA9-5 WRITING (Retail Inventory Method) Saurez Company, your client, manufactures paint. The company’s president,
Maria Saurez, has decided to open a retail store to sell Saurez paint as well as wallpaper and other supplies that would be purchased from other suppliers. She has asked you for information about the conventional retail method of pricing inventories at the retail store.
Instructions
Prepare a report to the president explaining the retail method of pricing inventories. Your report should include the following points.
(a) Description and accounting features of the method.
(b) The conditions that may distort the results under the method.
(c) A comparison of the advantages of using the retail method with those of using cost methods of inventory pricing.
(d) The accounting theory underlying the treatment of net markdowns and net markups under the method.
(AICPA adapted)

CA9-6 (Cost Determination, LCM, Retail Method) Olson Corporation, a retailer and wholesaler of national brand-name household lighting fixtures, purchases its inventories from various suppliers.
Instructions
(a) (1) What criteria should be used to determine which of Olson’s costs are inventoriable?
(2) Are Olson’s administrative costs inventoriable? Defend your answer.
(b) (1) Olson uses the lower-of-cost-or-market rule for its wholesale inventories. What are the theoretical arguments for that rule?
(2) The replacement cost of the inventories is below the net realizable value less a normal profit margin, which, in turn, is below the original cost. What amount should be used to value the inventories? Why?
(c) Olson calculates the estimated cost of its ending inventories held for sale at retail using the conventional retail inventory method. How would Olson treat the beginning inventories and net markdowns in calculating the cost ratio used to determine its ending inventories? Why?
(AICPA adapted)

CA9-7 ETHICS (Purchase Commitments) Prophet Company signed a long-term purchase contract to buy timber from the U.S.
Forest Service at $300 per thousand board feet. Under these terms, Prophet must cut and pay $6,000,000 for this timber during the next year. Currently, the market value is $250 per thousand board feet. At this rate, the market price is $5,000,000. Jerry Herman, the controller, wants to recognize the loss in value on the year-end financial statements, but the financial vice president, Billie Hands, argues that the loss is temporary and should be ignored. Herman notes that market value has remained near $250 for many months, and he sees no sign of significant change.
Instructions
(a) What are the ethical issues, if any?
(b) Is any particular stakeholder harmed by the financial vice president’s decision?
(c) What should the controller do?

10 Acquisition and Disposition of Property, Plant, and Equipment CONCEPTS FOR ANALYSIS 10

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CONCEPTS FOR ANALYSIS

CA10-1 WRITING (Acquisition, Improvements, and Sale of Realty) Tonkawa Company purchased land for use as its corporate headquarters. A small factory that was on the land when it was purchased was torn down before construction of the office building began. Furthermore, a substantial amount of rock blasting and removal had to be done to the site before construction of the building foundation began. Because the office building was set back on the land far from the public road, Tonkawa Company had the contractor construct a paved road that led from the public road to the parking lot of the office building.
Three years after the office building was occupied, Tonkawa Company added four stories to the office building. The four stories had an estimated useful life of 5 years more than the remaining estimated useful life of the original office building.
Ten years later, the land and building were sold at an amount more than their net book value, and Tonkawa Company had a new office building constructed in another state for use as its new corporate headquarters.
Instructions
(a) Which of the expenditures above should be capitalized? How should each be depreciated or amortized? Discuss the rationale for your answers.
(b) How would the sale of the land and building be accounted for? Include in your answer an explanation of how to determine the net book value at the date of sale. Discuss the rationale for your answer.

CA10-2 (Accounting for Self-Constructed Assets) Troopers Medical Labs, Inc., began operations 5 years ago producing stetrics, a new type of instrument it hoped to sell to doctors, dentists, and hospitals. The demand for stetrics far exceeded initial expectations, and the company was unable to produce enough stetrics to meet demand.
The company was manufacturing its product on equipment that it built at the start of its operations. To meet demand, more efficient equipment was needed. The company decided to design and build the equipment, because the equipment currently available on the market was unsuitable for producing stetrics.
In 2017, a section of the plant was devoted to development of the new equipment and a special staff was hired. Within 6 months, a machine developed at a cost of $714,000 increased production dramatically and reduced labor costs substantially.
Elated by the success of the new machine, the company built three more machines of the same type at a cost of $441,000 each.
Instructions
(a) In general, what costs should be capitalized for self-constructed equipment?
(b) Discuss the propriety of including in the capitalized cost of self-constructed assets:
(1) The increase in overhead caused by the self-construction of fixed assets.
(2) A proportionate share of overhead on the same basis as that applied to goods manufactured for sale.
(c) Discuss the proper accounting treatment of the $273,000 ($714,000 − $441,000) by which the cost of the first machine exceeded the cost of the subsequent machines. This additional cost should not be considered research and development costs.

CA10-3 WRITING (Capitalization of Interest) Vania Magazine Company started construction of a warehouse building for its own use at an estimated cost of $5,000,000 on January 1, 2016, and completed the building on December 31, 2016. During the construction period, Vania has the following debt obligations outstanding…
Total cost amounted to $5,200,000, and the weighted average of accumulated expenditures was $3,500,000.
Jane Esplanade, the president of the company, has been shown the costs associated with this construction project and capitalized on the balance sheet. She is bothered by the “avoidable interest” included in the cost. She argues that, first, all the interest is unavoidable—no one lends money without expecting to be compensated for it. Second, why can’t the company use all the interest on all the loans when computing this avoidable interest? Finally, why can’t her company capitalize all the annual interest that accrued over the period of construction?
Instructions
(Round the weighted-average interest rate to two decimal places.)
You are the manager of accounting for the company. In a memo, explain what avoidable interest is, how you computed it (being especially careful to explain why you used the interest rates that you did), and why the company cannot capitalize all its interest for the year. Attach a schedule supporting any computations that you use.

CA10-4 WRITING (Nonmonetary Exchanges) You have two clients that are considering trading machinery with each other.
Although the machines are different from each other, you believe that an assessment of expected cash flows on the exchanged assets will indicate the exchange lacks commercial substance. Your clients would prefer that the exchange be deemed to have commercial substance, to allow them to record gains. Here are the facts:…
Instructions
(a) Record the trade-in on Client A’s books assuming the exchange has commercial substance.
(b) Record the trade-in on Client A’s books assuming the exchange lacks commercial substance.
(c) Write a memo to the controller of Company A indicating and explaining the dollar impact on current and future statements of treating the exchange as having, versus lacking, commercial substance.
(d) Record the entry on Client B’s books assuming the exchange has commercial substance.
(e) Record the entry on Client B’s books assuming the exchange lacks commercial substance.
(f) Write a memo to the controller of Company B indicating and explaining the dollar impact on current and future statements of treating the exchange as having, versus lacking, commercial substance.

CA10-5 (Costs of Acquisition) The invoice price of a machine is $50,000. Various other costs relating to the acquisition and installation of the machine including transportation, electrical wiring, special base, and so on amount to $7,500. The machine has an estimated life of 10 years, with no salvage value at the end of that period.
The owner of the business suggests that the incidental costs of $7,500 be charged to expense immediately for the following reasons.
1. If the machine should be sold, these costs cannot be recovered in the sales price.
2. The inclusion of the $7,500 in the machinery account on the books will not necessarily result in a closer approximation of the market price of this asset over the years, because of the possibility of changing demand and supply levels.
3. Charging the $7,500 to expense immediately will reduce federal income taxes.
Instructions
Discuss each of the points raised by the owner of the business.
(AICPA adapted)

CA10-6 ETHICS (Cost of Land vs. Building—Ethics) Tones Company purchased a warehouse in a downtown district where land values are rapidly increasing. Gerald Carter, controller, and Wilma Ankara, financial vice president, are trying to allocate the cost of the purchase between the land and the building. Noting that depreciation can be taken only on the building, Carter favors placing a very high proportion of the cost on the warehouse itself, thus reducing taxable income and income taxes. Ankara, his supervisor, argues that the allocation should recognize the increasing value of the land, regardless of the depreciation potential of the warehouse.
Besides, she says, net income is negatively impacted by additional depreciation and will cause the company’s stock price to go down.
Instructions
Answer the following questions.
(a) What stakeholder interests are in conflict?
(b) What ethical issues does Carter face?
(c) How should these costs be allocated?

Accounting, Analysis, and Principles
Durler Company purchased equipment on January 2, 2013, for $112,000. The equipment had an estimated useful life of 5 years with an estimated salvage value of $12,000. Durler uses straight-line depreciation on all assets. On January 2, 2017, Durler exchanged this equipment plus $12,000 in cash for newer equipment. The old equipment has a fair value of $50,000.
Accounting
Prepare the journal entry to record the exchange on the books of Durler Company. Assume that the exchange has commercial substance.
Analysis
How will this exchange affect comparisons of the return on asset ratio for Durler in the year of the exchange compared to prior years?
Principles
How does the concept of commercial substance affect the accounting and analysis of this exchange?

11 Depreciation, Impairments, and Depletion CONCEPTS FOR ANALYSIS 11

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CONCEPTS FOR ANALYSIS

CA11-1 (Depreciation Basic Concepts) Burnitz Manufacturing Company was organized on January 1, 2017. During 2017, it has used in its reports to management the straight-line method of depreciating its plant assets.
On November 8, you are having a conference with Burnitz’s officers to discuss the depreciation method to be used for income tax and stockholder reporting. James Bryant, president of Burnitz, has suggested the use of a new method, which he feels is more suitable than the straight-line method for the needs of the company during the period of rapid expansion of production and capacity that he foresees. Following is an example in which the proposed method is applied to a fixed asset with an original cost of $248,000, an estimated useful life of 5 years, and a salvage value of approximately $8,000.
…
The president favors the new method because he has heard that:
1. It will increase the funds recovered during the years near the end of the assets’ useful lives when maintenance and replacement disbursements are high.
2. It will result in increased write-offs in later years and thereby will reduce taxes.
Instructions
(a) What is the purpose of accounting for depreciation?
(b) Is the president’s proposal within the scope of generally accepted accounting principles? In making your decision, discuss the circumstances, if any, under which use of the method would be reasonable and those, if any, under which it would not be reasonable.
(c) The president wants your advice on the following issues.
(1) Do depreciation charges recover or create funds? Explain.
(2) Assume that the Internal Revenue Service accepts the proposed depreciation method in this case. If the proposed method were used for stockholder and tax reporting purposes, how would it affect the availability of cash flows generated by operations?

CA11-2 WRITING (Unit, Group, and Composite Depreciation) The certified public accountant is frequently called upon by management for advice regarding methods of computing depreciation. Of comparable importance, although it arises less frequently, is the question of whether the depreciation method should be based on consideration of the assets as units, as a group, or as having a composite life.
Instructions
(a) Briefly describe the depreciation methods based on treating assets as (1) units and (2) a group or as having a composite life.
(b) Present the arguments for and against the use of each of the two methods.
(c) Describe how retirements are recorded under each of the two methods.
(AICPA adapted)

CA11-3 (Depreciation—Strike, Units-of-Production, Obsolescence) The following are three different and unrelated situations involving depreciation accounting. Answer the question(s) at the end of each situation.
Situation I: Recently, Broderick Company experienced a strike that affected a number of its operating plants. The controller of this company indicated that it was not appropriate to report depreciation expense during this period because the equipment did not depreciate and an improper matching of costs and revenues would result. She based her position on the following points.
1. It is inappropriate to charge the period with costs for which there are no related revenues arising from production.
2. The basic factor of depreciation in this instance is wear and tear. Because equipment was idle, no wear and tear occurred.
Instructions
Comment on the appropriateness of the controller’s comments.

Situation II: Etheridge Company manufactures electrical appliances, most of which are used in homes. Company engineers have designed a new type of blender which, through the use of a few attachments, will perform more functions than any blender currently on the market. Demand for the new blender can be projected with reasonable probability. In order to make the blenders, Etheridge needs a specialized machine that is not available from outside sources. It has been decided to make such a machine in Etheridge’s own plant.
Instructions
(a) Discuss the effect of projected demand in units for the new blenders (which may be steady, decreasing, or increasing) on the determination of a depreciation method for the machine.
(b) What other matters should be considered in determining the depreciation method? (Ignore income tax considerations.)

Situation III: Haley Paper Company operates a 300-ton-per-day kraft pulp mill and four sawmills in Wisconsin. The company is in the process of expanding its pulp mill facilities to a capacity of 1,000 tons per day and plans to replace three of its older, less efficient sawmills with an expanded facility. One of the mills to be replaced did not operate for most of 2017 (current year), and there are no plans to reopen it before the new sawmill facility becomes operational.
In reviewing the depreciation rates and in discussing the salvage values of the sawmills that were to be replaced, it was noted that if present depreciation rates were not adjusted, substantial amounts of plant costs on these three mills would not be depreciated by the time the new mill came on stream.
Instructions
What is the proper accounting for the four sawmills at the end of 2017?

CA11-4 WRITING (Depreciation Concepts) As a cost accountant for San Francisco Cannery, you have been approached by Phil
Perriman, canning room supervisor, about the 2017 costs charged to his department. In particular, he is concerned about the line item “depreciation.” Perriman is very proud of the excellent condition of his canning room equipment. He has always been vigilant about keeping all equipment serviced and well oiled. He is sure that the huge charge to depreciation is a mistake; it does not at all reflect the cost of minimal wear and tear that the machines have experienced over the last year. He believes that the charge should be considerably lower.
The machines being depreciated are six automatic canning machines. All were put into use on January 1, 2017. Each cost $625,000, having a salvage value of $55,000 and a useful life of 12 years. San Francisco depreciates this and similar assets using double-declining-balance depreciation. Perriman has also pointed out that if you used straight-line depreciation, the charge to his department would not be so great.
Instructions
Write a memo dated January 22, 2017, to Phil Perriman to clear up his misunderstanding of the term “depreciation.” Also, calculate year-1 depreciation on all machines using both methods. Explain the theoretical justification for double-declining-balance and why, in the long run, the aggregate charge to depreciation will be the same under both methods.

CA11-5 ETHICS (Depreciation Choice—Ethics) Jerry Prior, Beeler Corporation’s controller, is concerned that net income may be lower this year. He is afraid upper-level management might recommend cost reductions by laying off accounting staff, including him.
Prior knows that depreciation is a major expense for Beeler. The company currently uses the double-declining-balance method for both financial reporting and tax purposes, and he’s thinking of selling equipment that, given its age, is primarily used when there are periodic spikes in demand. The equipment has a carrying value of $2,000,000 and a fair value of $2,180,000.
The gain on the sale would be reported in the income statement. He doesn’t want to highlight this method of increasing income.
He thinks, “Why don’t I increase the estimated useful lives and the salvage values? That will decrease depreciation

Instructions
Answer the following questions.
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues involved?
(c) What should Prior do?

12 Intangible Assets CONCEPTS FOR ANALYSIS 12

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CONCEPTS FOR ANALYSIS

CA12-1 (Accounting for Pre-Opening Costs) After securing lease commitments from several major stores, Auer Shopping Center, Inc. was organized and built a shopping center in a growing suburb.
The shopping center would have opened on schedule on January 1, 2017, if it had not been struck by a severe tornado in December. Instead, it opened for business on October 1, 2017. All of the additional construction costs that were incurred as a result of the tornado were covered by insurance.
In July 2016, in anticipation of the scheduled January opening, a permanent staff had been hired to promote the shopping center, obtain tenants for the uncommitted space, and manage the property.
A summary of some of the costs incurred in 2016 and the first nine months of 2017 follows...
The promotional advertising campaign was designed to familiarize shoppers with the center. Had it been known in time that the center would not open until October 2017, the 2016 expenditure for promotional advertising would not have been made. The advertising had to be repeated in 2017.
All of the tenants who had leased space in the shopping center at the time of the tornado accepted the October occupancy date on condition that the monthly rental charges for the first 9 months of 2017 be canceled.
Instructions
Explain how each of the costs for 2016 and the first 9 months of 2017 should be treated in the accounts of the shopping center corporation. Give the reasons for each treatment.
(AICPA adapted)

CA12-2 WRITING (Accounting for Patents) On June 30, 2017, your client, Ferry Company, was granted two patents covering plastic cartons that it had been producing and marketing profitably for the past 3 years. One patent covers the manufacturing process, and the other covers the related products.
Ferry executives tell you that these patents represent the most significant breakthrough in the industry in the past 30 years. The products have been marketed under the registered trademarks Evertight, Duratainer, and Sealrite. Licenses under the patents have already been granted by your client to other manufacturers in the United States and abroad, and are producing substantial royalties.
On July 1, Ferry commenced patent infringement actions against several companies whose names you recognize as those of substantial and prominent competitors. Ferry’s management is optimistic that these suits will result in a permanent injunction against the manufacture and sale of the infringing products as well as collection of damages for loss of profits caused by the alleged infringement.
The financial vice president has suggested that the patents be recorded at the discounted value of expected net royalty receipts.
Instructions
(a) What is the meaning of “discounted value of expected net receipts”? Explain.
(b) How would such a value be calculated for net royalty receipts?
(c) What basis of valuation for Ferry’s patents would be generally accepted in accounting? Give supporting reasons for this basis.
(d) Assuming no practical problems of implementation and ignoring generally accepted accounting principles, what is the preferable basis of valuation for patents? Explain.
(e) What would be the preferable theoretical basis of amortization? Explain.
(f) What recognition, if any, should be made of the infringement litigation in the financial statements for the year ending September 30, 2017? Discuss. (AICPA adapted)

CA12-3 WRITING (Accounting for Research and Development Costs) Cuevas Co. is in the process of developing a revolutionary new product. A new division of the company was formed to develop, manufacture, and market this new product. As of year-end (December 31, 2017), the new product has not been manufactured for resale. However, a prototype unit was built and is in operation.
Throughout 2017, the new division incurred certain costs. These costs include design and engineering studies, prototype manufacturing costs, administrative expenses (including salaries of administrative personnel), and market research costs. In addition, approximately $900,000 in equipment (with an estimated useful life of 10 years) was purchased for use in developing and manufacturing the new product. Approximately $315,000 of this equipment was built specifically for the design development of the new product. The remaining $585,000 of equipment was used to manufacture the pre-production prototype and will be used to manufacture the new product once it is in commercial production.
Instructions
(a) How are “research” and “development” defined in the authoritative literature (GAAP)?
(b) Briefly indicate the practical and conceptual reasons for the conclusion reached by the Financial Accounting Standards
Board on accounting and reporting practices for research and development costs.
(c) In accordance with GAAP, how should the various costs of Cuevas described above be recorded on the financial statements for the year ended December 31, 2017? (AICPA adapted)

CA12-4 ETHICS (Accounting for Research and Development Costs) Czeslaw Corporation’s research and development department has an idea for a project it believes will culminate in a new product that would be very profitable for the company. Because the project will be very expensive, the department requests approval from the company’s controller, Jeff Reid.
Reid recognizes that corporate profits have been down lately and is hesitant to approve a project that will incur significant expenses that cannot be capitalized due to the requirements of the authoritative literature. He knows that if they hire an outside firm that does the work and obtains a patent for the process, Czeslaw Corporation can purchase the patent from the outside firm and record the expenditure as an asset. Reid knows that the company’s own R&D department is first-rate, and he is confident they can do the work well.
Instructions
Answer the following questions.
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues involved?
(c) What should Reid do?

13 Current Liabilities and Contingencies CONCEPTS FOR ANALYSIS 13

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CONCEPTS FOR ANALYSIS

CA13-1 (Nature of Liabilities) Presented below is the current liabilities section of Micro Corporation…
Instructions
Answer the following questions.
(a) What are the essential characteristics that make an item a liability?
(b) How does one distinguish between a current liability and a long-term liability?
(c) What are accrued liabilities? Give three examples of accrued liabilities that Micro might have.
(d) What is the theoretically correct way to value liabilities? How are current liabilities usually valued?
(e) Why are notes payable reported first in the current liabilities section?
(f) What might be the items that comprise Micro’s liability for “Compensation to employees”?

CA13-2 (Current versus Noncurrent Classification) Rodriguez Corporation includes the following items in its liabilities at December 31, 2017.
1. Notes payable, $25,000,000, due June 30, 2018.
2. Deposits from customers on equipment ordered by them from Rodriguez, $6,250,000.
3. Salaries and wages payable, $3,750,000, due January 14, 2018.
Instructions
Indicate in what circumstances, if any, each of the three liabilities above would be excluded from current liabilities.

CA13-3 WRITING (Refinancing of Short-Term Debt) Dumars Corporation reports in the current liability section of its balance sheet at December 31, 2017 (its year-end), short-term obligations of $15,000,000, which includes the current portion of 12% long-term debt in the amount of $10,000,000 (matures in March 2018). Management has stated its intention to refinance the 12% debt whereby no portion of it will mature during 2018. The date of issuance of the financial statements is March 25, 2018.
Instructions
(a) Is management’s intent enough to support long-term classification of the obligation in this situation?
(b) Assume that Dumars Corporation issues $13,000,000 of 10-year debentures to the public in January 2018 and that management intends to use the proceeds to liquidate the $10,000,000 debt maturing in March 2018.
Furthermore, assume that the debt maturing in March 2018 is paid from these proceeds prior to the issuance of the financial statements. Will this have any impact on the balance sheet classification at December 31, 2017?
Explain your answer.
(c) Assume that Dumars Corporation issues common stock to the public in January and that management intends to entirely liquidate the $10,000,000 debt maturing in March 2018 with the proceeds of this equity securities issue. In light of these events, should the $10,000,000 debt maturing in March 2018 be included in current liabilities at December 31, 2017?
(d) Assume that Dumars Corporation, on February 15, 2018, entered into a financing agreement with a commercial bank that permits Dumars Corporation to borrow at any time through 2019 up to $15,000,000 at the bank’s prime rate of interest.
Borrowings under the financing agreement mature three years after the date of the loan. The agreement is not cancelable except for violation of a provision with which compliance is objectively determinable. No violation of any provision exists at the date of issuance of the financial statements. Assume further that the current portion of long-term debt does not mature until August 2018. In addition, management intends to refinance the $10,000,000 obligation under the terms of the financial agreement with the bank, which is expected to be financially capable of honoring the agreement.
(1) Given these facts, should the $10,000,000 be classified as current on the balance sheet at December 31, 2017?
(2) Is disclosure of the refinancing method required?

CA13-4 WRITING (Loss Contingencies) On February 1, 2018, one of the huge storage tanks of Viking Manufacturing Company exploded. Windows in houses and other buildings within a one-mile radius of the explosion were severely damaged, and a number of people were injured. As of February 15, 2018 (when the December 31, 2017, financial statements were completed and sent to the publisher for printing and public distribution), no suits had been filed or claims asserted against the company as a consequence of the explosion. The company fully anticipates that suits will be filed and claims asserted for injuries and damages.
Because the casualty was uninsured and the company is considered at fault, Viking Manufacturing will have to cover the damages from its own resources.
Instructions
Discuss fully the accounting treatment and disclosures that should be accorded the casualty and related contingent losses in the financial statements dated December 31, 2017.

CA13-5 (Loss Contingency) Presented below is a note disclosure for Matsui Corporation.
Litigation and Environmental: The Company has been notified, or is a named or a potentially responsible party in a number of governmental (federal, state and local) and private actions associated with environmental matters, such as those relating to hazardous wastes, including certain sites which are on the United States EPA National Priorities List (“Superfund”). These actions seek clean-up costs, penalties and/or damages for personal injury or to property or natural resources.
In 2017, the Company recorded a pre-tax charge of $56,229,000, included in the “Other expense (income)—net” caption of the Company’s consolidated income statements, as an additional provision for environmental matters. These expenditures are expected to take place over the next several years and are indicative of the Company’s commitment to improve and maintain the environment in which it operates. At December 31, 2017, environmental accruals amounted to $69,931,000, of which $61,535,000 are considered noncurrent and are included in the “Deferred credits and other liabilities” caption of the Company’s consolidated balance sheets.
While it is impossible at this time to determine with certainty the ultimate outcome of environmental matters, it is management’s opinion, based in part on the advice of independent counsel (after taking into account accruals and insurance coverage applicable to such actions) that when the costs are finally determined they will not have a material adverse effect on the financial position of the Company.
Instructions
Answer the following questions.
(a) What conditions must exist before a loss contingency can be recorded in the accounts?
(b) Suppose that Matsui Corporation could not reasonably estimate the amount of the loss, although it could establish with a high degree of probability the minimum and maximum loss possible. How should this information be reported in the financial statements?
(c) If the amount of the loss is uncertain, how would the loss contingency be reported in the financial statements?

CA13-6 (Warranties and Loss Contingencies) The following two independent situations involve loss contingencies.
Part 1: Benson Company sells two products, Grey and Yellow. Each carries a 1-year warranty.
1. Product Grey—Product warranty costs, based on past experience, will normally be 1% of sales.
2. Product Yellow—Product warranty costs cannot be reasonably estimated because this is a new product line. However, the chief engineer believes that product warranty costs are likely to be incurred.
Instructions
How should Benson report the estimated product warranty costs for each of the two types of merchandise above? Discuss the rationale for your answer. Do not discuss disclosures that should be made in Benson’s financial statements or notes.

Part 2: Constantine Company is being sued for $4,000,000 for an injury caused to a child as a result of alleged negligence while the child was visiting the Constantine Company plant in March 2017. The suit was filed in July 2017. Constantine’s lawyer states that it is probable that Constantine will lose the suit and be found liable for a judgment costing anywhere from $400,000 to $2,000,000. However, the lawyer states that the most probable judgment is $1,000,000.
Instructions
How should Constantine report the suit in its 2017 financial statements? Discuss the rationale for your answer. Include in your answer disclosures, if any, that should be made in Constantine’s financial statements or notes.
(AICPA adapted)

CA13-7 ETHICS (Warranties) The Dotson Company, owner of Bleacher Mall, charges Rich Clothing Store a rental fee of $600 per month plus 5% of yearly profits over $500,000. Matt Rich, the owner of the store, directs his accountant, Ron Hamilton, to increase the estimate of bad debt expense and warranty costs in order to keep profits at $475,000.
Instructions
Answer the following questions.
(a) Should Hamilton follow his boss’s directive?
(b) Who is harmed if the estimates are increased?
(c) Is Matt Rich’s directive ethical?

14 Long-Term Liabilities CONCEPTS FOR ANALYSIS 14

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CONCEPTS FOR ANALYSIS

CA14-1 (Bond Theory: Balance Sheet Presentations, Interest Rate, Premium) On January 1, 2017, Nichols Company issued for $1,085,800 its 20-year, 11% bonds that have a maturity value of $1,000,000 and pay interest semiannually on January 1 and July 1.
The following are three presentations of the long-term liability section of the balance sheet that might be used for these bonds at the issue date…
Instructions
(a) Discuss the conceptual merit(s) of each of the date-of-issue balance sheet presentations shown above for these bonds.
(b) Explain why investors would pay $1,085,800 for bonds that have a maturity value of only $1,000,000.
(c) Assuming that a discount rate is needed to compute the carrying value of the obligations arising from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of using for this purpose:
(1) The coupon or nominal rate.
(2) The effective or yield rate at date of issue.
(d) If the obligations arising from these bonds are to be carried at their present value computed by means of the current market rate of interest, how would the bond valuation at dates subsequent to the date of issue be affected by an increase or a decrease in the market rate of interest?
(AICPA adapted)

CA14-2 (Bond Theory: Price, Presentation, and Redemption) On March 1, 2017, Sealy Company sold its 5-year, $1,000 face value, 9% bonds dated March 1, 2017, at an effective annual interest rate (yield) of 11%. Interest is payable semiannually, and the first interest payment date is September 1, 2017. Sealy uses the effective-interest method of amortization. The bonds can be called by Sealy at 101 at any time on or after March 1, 2018.
Instructions
(a) (1) How would the selling price of the bond be determined?
(2) Specify how all items related to the bonds would be presented in a balance sheet prepared immediately after the bond issue was sold.
(b) What items related to the bond issue would be included in Sealy’s 2017 income statement, and how would each be determined?
(c) Would the amount of bond discount amortization using the effective-interest method of amortization be lower in the second or third year of the life of the bond issue? Why?
(d) Assuming that the bonds were called in and redeemed on March 1, 2018, how should Sealy report the redemption of the bonds on the 2018 income statement?
(AICPA adapted)

CA14-3 WRITING (Bond Theory: Amortization and Gain or Loss Recognition)
Part I: The appropriate method of amortizing a premium or discount on issuance of bonds is the effective-interest method.
Instructions
(a) What is the effective-interest method of amortization and how is it different from and similar to the straight-line method of amortization?
(b) How is amortization computed using the effective-interest method, and why and how do amounts obtained using the effective-interest method differ from amounts computed under the straight-line method?
Part II: Gains or losses from the early extinguishment of debt that is refunded can theoretically be accounted for in three ways:
1. Amortized over remaining life of old debt.
2. Amortized over the life of the new debt issue.
3. Recognized in the period of extinguishment.
Instructions
(a) Develop supporting arguments for each of the three theoretical methods of accounting for gains and losses from the early extinguishment of debt.
(b) Which of the methods above is generally accepted and how should the appropriate amount of gain or loss be shown in a company’s financial statements?
(AICPA adapted)

CA14-4 WRITING (Off-Balance-Sheet Financing) Matt Ryan Corporation is interested in building its own soda can manufacturing plant adjacent to its existing plant in Partyville, Kansas. The objective would be to ensure a steady supply of cans at a stable price and to minimize transportation costs. However, the company has been experiencing some financial problems and has been reluctant to borrow any additional cash to fund the project. The company is not concerned with the cash flow problems of making payments, but rather with the impact of adding additional long-term debt to its balance sheet.
The president of Ryan, Andy Newlin, approached the president of the Aluminum Can Company (ACC), its major supplier, to see if some agreement could be reached. ACC was anxious to work out an arrangement, since it seemed inevitable that Ryan would begin its own can production. The Aluminum Can Company could not afford to lose the account.
After some discussion, a two-part plan was worked out. First, ACC was to construct the plant on Ryan’s land adjacent to the existing plant. Second, Ryan would sign a 20-year purchase agreement. Under the purchase agreement, Ryan would express its intention to buy all of its cans from ACC, paying a unit price which at normal capacity would cover labor and material, an operating management fee, and the debt service requirements on the plant. The expected unit price, if transportation costs are taken into consideration, is lower than current market. If Ryan did not take enough production in any one year and if the excess cans could not be sold at a high enough price on the open market, Ryan agrees to make up any cash shortfall so that ACC could make the payments on its debt. The bank will be willing to make a 20-year loan for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 years, the plant is to become the property of Ryan.
Instructions
(a) What are project financing arrangements using special-purpose entities?
(b) What are take-or-pay contracts?
(c) Should Ryan record the plant as an asset together with the related obligation?
(d) If not, should Ryan record an asset relating to the future commitment?
(e) What is meant by off-balance-sheet financing?

CA14-5 ETHICS (Bond Issue) Donald Lennon is the president, founder, and majority owner of Wichita Medical Corporation, an emerging medical technology products company. Wichita is in dire need of additional capital to keep operating and to bring several promising products to final development, testing, and production. Donald, as owner of 51% of the outstanding stock, manages the company’s operations. He places heavy emphasis on research and development and long-term growth. The other principal stockholder is Nina Friendly who, as a nonemployee investor, owns 40% of the stock. Nina would like to deemphasize the R &
D functions and emphasize the marketing function to maximize short-run sales and profits from existing products. She believes this strategy would raise the market price of Wichita’s stock.
All of Donald’s personal capital and borrowing power is tied up in his 51% stock ownership. He knows that any offering of additional shares of stock will dilute his controlling interest because he won’t be able to participate in such an issuance. But,
Nina has money and would likely buy enough shares to gain control of Wichita. She then would dictate the company’s future direction, even if it meant replacing Donald as president and CEO.
The company already has considerable debt. Raising additional debt will be costly, will adversely affect Wichita’s credit rating, and will increase the company’s reported losses due to the growth in interest expense. Nina and the other minority stockholders express opposition to the assumption of additional debt, fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain his control and to preserve the direction of “his” company, Donald is doing everything to avoid a stock issuance and is contemplating a large issuance of bonds, even if it means the bonds are issued with a high effective-interest rate.
Instructions
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues in this case?
(c) What would you do if you were Donald?

15 Stockholders’ Equity CONCEPTS FOR ANALYSIS 15

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CONCEPTS FOR ANALYSIS

CA15-1 (Preemptive Rights and Dilution of Ownership) Wallace Computer Company is a small, closely held corporation. Eighty percent of the stock is held by Derek Wallace, president. Of the remainder, 10% is held by members of his family and 10% by Kathy Baker, a former officer who is now retired. The balance sheet of the company at June 30, 2017, was substantially as shown below.
…
Additional authorized common stock of $300,000 par value had never been issued. To strengthen the cash position of the company, Wallace issued common stock with a par value of $100,000 to himself at par for cash. At the next stockholders’ meeting, Baker objected and claimed that her interests had been injured.
Instructions
(a) Which stockholder’s right was ignored in the issue of shares to Derek Wallace?
(b) How may the damage to Baker’s interests be repaired most simply?
(c) If Derek Wallace offered Baker a personal cash settlement and they agreed to employ you as an impartial arbitrator to determine the amount, what settlement would you propose? Present your calculations with sufficient explanation to satisfy both parties.

CA15-2 (Issuance of Stock for Land) Martin Corporation is planning to issue 3,000 shares of its own $10 par value common stock for two acres of land to be used as a building site.
Instructions
(a) What general rule should be applied to determine the amount at which the land should be recorded?
(b) Under what circumstances should this transaction be recorded at the fair value of the land?
(c) Under what circumstances should this transaction be recorded at the fair value of the stock issued?
(d) Assume Martin intentionally records this transaction at an amount greater than the fair value of the land and the stock. Discuss this situation.

CA15-3 WRITING (Conceptual Issues—Equity) Statements of Financial Accounting Concepts set forth financial accounting and reporting objectives and fundamentals that will be used by the Financial Accounting Standards Board in developing standards. Concepts Statement No. 6 defines various elements of financial statements.
Instructions
Answer the following questions based on SFAC No. 6.
(a) Define and discuss the term “equity.”
(b) What transactions or events change owners’ equity?
(c) Define “investments by owners” and provide examples of this type of transaction. What financial statement element other than equity is typically affected by owner investments?
(d) Define “distributions to owners” and provide examples of this type of transaction. What financial statement element other than equity is typically affected by distributions?
(e) What are examples of changes within owners’ equity that do not change the total amount of owners’ equity?

CA15-4 (Stock Dividends and Splits) The directors of Merchant Corporation are considering the issuance of a stock dividend.
They have asked you to discuss the proposed action by answering the following questions.
Instructions
(a) What is a stock dividend? How is a stock dividend distinguished from a stock split (1) from a legal standpoint, and (2) from an accounting standpoint?
(b) For what reasons does a corporation usually declare a stock dividend? A stock split?
(c) Discuss the amount, if any, of retained earnings to be capitalized in connection with a stock dividend.
(AICPA adapted)

CA15-5 (Stock Dividends) Kulikowski Inc., a client, is considering the authorization of a 10% common stock dividend to common stockholders. The financial vice president of Kulikowski wishes to discuss the accounting implications of such an authorization with you before the next meeting of the board of directors.
Instructions
(a) The first topic the vice president wishes to discuss is the nature of the stock dividend to the recipient. Discuss the case against considering the stock dividend as income to the recipient.
(b) The other topic for discussion is the propriety of issuing the stock dividend to all “stockholders of record” or to “stockholders of record exclusive of shares held in the name of the corporation as treasury stock.” Discuss the case against issuing stock dividends on treasury shares.
(AICPA adapted)

CA15-6 (Stock Dividend, Cash Dividend, and Treasury Stock) Mask Company has 30,000 shares of $10 par value common stock authorized and 20,000 shares issued and outstanding. On August 15, 2017, Mask purchased 1,000 shares of treasury stock for $18 per share. Mask uses the cost method to account for treasury stock. On September 14, 2017, Mask sold 500 shares of the treasury stock for $20 per share.
In October 2017, Mask declared and distributed 1,950 shares as a stock dividend from unissued shares when the market price of the common stock was $21 per share.
On December 20, 2017, Mask declared a $1 per share cash dividend, payable on January 10, 2018, to shareholders of record on December 31, 2017.
Instructions
(a) How should Mask account for the purchase and sale of the treasury stock, and how should the treasury stock be presented in the balance sheet at December 31, 2017?
(b) How should Mask account for the stock dividend, and how would it affect the stockholders’ equity at December 31, 2017? Why?
(c) How should Mask account for the cash dividend, and how would it affect the balance sheet at December 31, 2017? Why?
(AICPA adapted)

CA15-7 ETHICS (Treasury Stock—Ethics) Lois Kenseth, president of Sycamore Corporation, is concerned about several large stockholders who have been very vocal lately in their criticisms of her leadership. She thinks they might mount a campaign to have her removed as the corporation’s CEO. She decides that buying them out by purchasing their shares could eliminate them as opponents, and she is confident they would accept a “good” offer. Kenseth knows the corporation’s cash position is decent, so it has the cash to complete the transaction. She also knows the purchase of these shares will increase earnings per share, which should make other investors quite happy. (Earnings per share is calculated by dividing net income available for the common shareholders by the weighted-average number of shares outstanding. Therefore, if the number of shares outstanding is decreased by purchasing treasury shares, earnings per share increases.)
Instructions
Answer the following questions.
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues involved?
(c) Should Kenseth authorize the transaction?

16 Dilutive Securities and Earnings per Share CONCEPTS FOR ANALYSIS 16

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CONCEPTS FOR ANALYSIS

CA16-1 (Warrants Issued with Bonds and Convertible Bonds) Incurring long-term debt with an arrangement whereby lenders receive an option to buy common stock during all or a portion of the time the debt is outstanding is a frequent corporate financing practice. In some situations, the result is achieved through the issuance of convertible bonds; in others, the debt instruments and the warrants to buy stock are separate.
Instructions
(a) (1) Describe the differences that exist in current accounting for original proceeds of the issuance of convertible bonds and of debt instruments with separate warrants to purchase common stock.
(2) Discuss the underlying rationale for the differences described in (a)(1) above.
(3) Summarize the arguments that have been presented in favor of accounting for convertible bonds in the same manner as accounting for debt with separate warrants.
(b) At the start of the year, Huish Company issued $18,000,000 of 12% bonds along with detachable warrants to buy 1,200,000 shares of its $10 par value common stock at $18 per share. The bonds mature over the next 10 years, starting one year from date of issuance, with annual maturities of $1,800,000. At the time, Huish had 9,600,000 shares of common stock outstanding. The company received $20,040,000 for the bonds and the warrants. For Huish Company, 12% was a relatively low borrowing rate. If offered alone, at this time, the bonds would have sold in the market at a 22% discount. Prepare the journal entry (or entries) for the issuance of the bonds and warrants for the cash consideration received. (AICPA adapted)

CA16-2 ETHICS (Ethical Issues—Compensation Plan) The executive officers of Rouse Corporation have a performance-based compensation plan. The performance criteria of this plan is linked to growth in earnings per share. When annual EPS growth is 12%, the Rouse executives earn 100% of the shares; if growth is 16%, they earn 125%. If EPS growth is lower than 8%, the executives receive no additional compensation.
In 2014, Joan Devers, the controller of Rouse, reviews year-end estimates of bad debt expense and warranty expense. She calculates the EPS growth at 15%. Kurt Adkins, a member of the executive group, remarks over lunch one day that the estimate of bad debt expense might be decreased, increasing EPS growth to 16.1%. Devers is not sure she should do this because she believes that the current estimate of bad debts is sound. On the other hand, she recognizes that a great deal of subjectivity is involved in the computation.
Instructions
Answer the following questions.
(a) What, if any, is the ethical dilemma for Devers?
(b) Should Devers’s knowledge of the compensation plan be a factor that influences her estimate?
(c) How should Devers respond to Adkins’s request?

CA16-3 WRITING (Stock Warrants—Various Types) For various reasons a corporation may issue warrants to purchase shares of its common stock at specified prices that, depending on the circumstances, may be less than, equal to, or greater than the current market price. For example, warrants may be issued:
1. To existing stockholders on a pro rata basis.
2. To certain key employees under an incentive stock-option plan.
3. To purchasers of the corporation’s bonds.
Instructions
For each of the three examples of how stock warrants are used:
(a) Explain why they are used.
(b) Discuss the significance of the price (or prices) at which the warrants are issued (or granted) in relation to (1) the current market price of the company’s stock, and (2) the length of time over which they can be exercised.
(c) Describe the information that should be disclosed in financial statements, or notes thereto, that are prepared when stock warrants are outstanding in the hands of the three groups listed above.
(AICPA adapted)

CA16-4 WRITING (Stock Compensation Plans) The following two items appeared on the Internet concerning the GAAP requirement to expense stock options…
Instructions
(a) What are the major recommendations of the stock-based compensation pronouncement?
(b) How do the provisions of GAAP in this area differ from the bill introduced by members of Congress (Dreier and Eshoo), which would require expensing for options issued to only the top five officers in a company? Which approach do you think would result in more useful information? (Focus on comparability.)
(c) The bill in Congress urges the FASB to develop a rule that preserves “the ability of companies to use this innovative tool to attract talented employees.” Write a response to these Congress-people explaining the importance of neutrality in financial accounting and reporting.

CA16-5 (EPS: Preferred Dividends, Options, and Convertible Debt) “Earnings per share” (EPS) is the most featured, single financial statistic about modern corporations. Daily published quotations of stock prices have recently been expanded to include for many securities a “times earnings” figure that is based on EPS. Stock analysts often focus their discussions on the EPS of the corporations they study.
Instructions
(a) Explain how dividends or dividend requirements on any class of preferred stock that may be outstanding affect the computation of EPS.
(b) One of the technical procedures applicable in EPS computations is the “treasury-stock method.” Briefly describe the circumstances under which it might be appropriate to apply the treasury-stock method.
(c) Convertible debentures are considered potentially dilutive common shares. Explain how convertible debentures are handled for purposes of EPS computations.
(AICPA adapted)

CA16-6 WRITING (EPS, Antidilution) Brad Dolan, a stockholder of Rhode Corporation, has asked you, the firm’s accountant, to explain why his stock warrants were not included in diluted EPS. In order to explain this situation, you must briefly explain what dilutive securities are, why they are included in the EPS calculation, and why some securities are antidilutive and thus not included in this calculation.
Rhode Corporation earned $228,000 during the period, when it had an average of 100,000 shares of common stock outstanding.
The common stock sold at an average market price of $25 per share during the period. Also outstanding were 30,000 warrants that could be exercised to purchase one share of common stock at $30 per warrant.
Instructions
Write Mr. Dolan a 1–1.5-page letter explaining why the warrants are not included in the calculation.