Accounting Theory and Analysis

11th Edition

Solutions Manual

By

Richard G. Schroeder
University of North Carolina at Charlotte

Myrtle W. Clark
University of Kentucky

Jack M. Cathey
University of North Carolina at Charlotte

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 1
 CHAPTER 6
Case 6-1

a. The basic markets available to Warmen Brothers are (1) domestic screening, (2) foreign
screening, (3) video rentals, (4) cable broadcasting (5) network television stations and
(6) independent television stations.

b. The entry order should be as specified in Part a because any other order would
jeopardize the maximization of revenue from each source. For example, if a film were
sold to independent television stations prior to distribution to cable and network stations,
the viewership levels of cable and network stations would decrease.

c. Revenues should be recognized from each market as they are earned under the
realization principle. Under this concept, revenue from each of the markets should be
recognized as contracts are signed or film rights are sold to each of the various markets.

d. The matching of costs with revenues for the motion picture industry is a difficult process.
The amount of revenue available from secondary markets is highly dependent upon the
success of the film in the domestic screening market. Consequently, holding production
costs to match against secondary markets may result in distorted net income figures.
Additionally, many top film stars contracts are based upon a percentage of total profits.
A conservative method of recognizing costs is to charge all production costs against
domestic and foreign screenings, and to charge other secondary markets only
incremental costs. This is somewhat similar to the sunk cost method of income
recognition. Although this method is generally not appropriate for most situations, the
highly speculative nature of the secondary film markets make it an acceptable practice.
During the past several years some film making companies have experienced
bankruptcy partially due to faulty revenue recognition methods. Attempting to allocate
production costs across all of the secondary markets will require estimates of the total
revenues to be received from each of those markets prior to the distribution of the film.
This is a very risky process and could lead to distorted financial statements

e. Recognizing all production costs in the period of domestic and foreign screenings will
result in conservative income figures until the secondary market revenues are realized.
This procedure might also be criticized as distorting future net income amounts because
all production costs have been recognized prior to the recognition of some revenues.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 2
 Never-the-less, holding production cost and matching them with secondary market
revenues is a less favorable option.

Note to the instructor:

This solution may, or may not, be chosen by the students. It is a good example of a
situation needing critical thinking skills where no clear-cut solution is available. The
development of the issues is of more importance than the final decision.

Case 6-2

a.. i. Extraordinary items are material items of a character significantly different from
the typical or customary business activities of the entity. Extraordinary items are
events and transactions that are distinguished by their unusual nature and
infrequent occurrence. The product tampering and recall is material because the
credits and refunds alone are ten percent of earnings before income taxes, is
unusual because of its catastrophic nature, and is infrequent because it is the first
occurrence in the more than fifty year history of Goods

Company with no indication that the event will recur.

ii. The extraordinary charge should be properly described as "Loss from product
tampering and recall" and placed in a separate section in the 2014 income
statement after discontinued operations. The charge must be presented net of its
applicable income taxes and the taxes may be shown parenthetically of in
columnar form. Reporting per share amounts on extraordinary items is optional.
Details of the extraordinary charge should be disclosed in the notes to 2014
financial statements.

b. i. Items 1, 3,5,6,7,8,10 and 13 should be included in the extraordinary charge for

2014.

ii. Items not included in the extraordinary charge and the reason for each is as
follows.

Item Number Reason Not Included

2 Insurance to cover possible future events is not directly related to the 2014 event.
Should be capitalized and expensed over future periods.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 3
 4 Future security measures are future costs and not directly related to the 2014
event. Should be expensed over future periods.

9 These packaging costs are not directly related to the 2014 event and should be
matched against revenues from the sale of the packaged products.

11 These costs resulted from a decision of the company in its reaction to the 2014
event. The costs are related to future operations and should be charged to
operating expense or spread over the estimated period that the redesigned
package will be in use.

12 The cost of the packaging equipment should be charged to an asset account and
expensed over its estimated useful life.

14 Lost sales revenue is an opportunity cost and is not recorded or disclosed

anywhere on the financial statements.

Case 6-3

a. The important distinction between revenues and gains and expenses and losses is
whether or not they are associated with ongoing operations. Over the years, this
distinction has generated questions concerning the nature of income reporting desired
by various financial-statement users. Historically, two viewpoints have dominated this
dialogue and have been termed the current operating performance concept and the all-
inclusive concept of income reporting.

The proponents of the current operating performance concept base their arguments on
the belief that normal and recurring items should constitute the principal measure of
enterprise performance. That is, net income should reflect the day-to-day, profit-directed
activities of the enterprise, and the inclusion of other items of profit or loss distort the
meaning of the term net income.

On the other hand, the advocates of the all-inclusive view believe that net income should
reflect all items that affected the net increase or decrease in stockholders equity during
the period, with the exception of capital transactions. Specifically, these individuals
believe that the total net income for the life of an enterprise should be determinable by
summing the periods’ net income figures.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 4
 The underlying assumption behind this controversy is that the method of presentation of
financial information is important. That is both viewpoints agree on the information to be
presented but disagree on where to disclose different types of revenues, expenses,
gains, and losses.

B .i. Cost of goods sold is considered an expense under both the current operating
performance and all-inclusive concepts of income.

ii. Selling expenses are considered expenses under both the current operating
performance and all-inclusive concepts.

iii. Extraordinary items are considered gains and losses under the current operating
performance concept and revenues and expenses under the all-inclusive concept.

iv. Prior period adjustments are considered gains and losses under a strict interpretation
of the current operating performance concept. However, they have been defined as
nonowner changes in equity under Statement of Financial Accounting Concepts
No.5. Prior period adjustments are considered revenues and expenses under a strict
interpretation of the all-inclusive concept.

Case 6-4

a. A change from the sum-of-the-years-digits depreciation method to the straight-line

method for fixed assets is a change in accounting principle. The concept of consistency
presumes that an accounting principle, once adopted, should not be changed in
accounting for events and transactions of a similar type. A change is permissible only if
the enterprise justifies the preferability of an alternative acceptable accounting principle.
Under the provisions of FASB ASC 250, this accounting change requires retrospective
application to prior periods as if it had always been used.

b. If a public company obtained additional information about the service lives of some of its
fixed assets showing that the service lives previously used should be shortened, such a
change would be a change in accounting estimate. The change in accounting estimate
should be accounted for in the year of change and future years since the change affects
both. Specifically, the operating item, depreciation expense, would be increased. In
addition, the effect on income before extraordinary items, net income, and related per-
share amounts of the current period should be disclosed.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 5
c. Changing specific subsidiaries comprising the group of companies for which
consolidated financial statements are presented is an example of a change in the
reporting entity. Such a change requires that the consolidated income statements be
restated to reflect the different reporting entity.

Case 6-5

a. Earnings per share, as it applies to a corporation with a capitalization structure

composed of only one class of common stock, is the amount of earnings applicable to
each share of common stock outstanding during the period for which the earnings are
reported. The computation of earnings per share should be based on a weighted
average of the number of shares outstanding during the period with retroactive
recognition given to stock splits or reverse splits and to stock dividends, except relatively
small nonrecurring stock dividends may be ignored. The computation should be made
for income before extraordinary items, extraordinary items net of income tax, and net
income. The earnings per share from each of the foregoing should be presented in the
income statement and it is desirable that the method of computation be disclosed.

b. Meanings of terms often used in discussing earnings per share and the types of items to
which they apply follow:

1. Senior securities are securities which have preference to before earnings are
allocated to common stock. Cumulative preferred dividends whether or not earned
should be deducted from net income except "if earned" dividends should be
deducted only to the extent earned. Preferred stock is a senior security if it has a
preference on dividends. Bonds are a senior security and interest expense on the
bonds enters into the determination of net income.

2. For purposes of computing earnings per share residual securities are those
securities deriving a major portion of their value from their right to be converted
into common stock through the exercise of an option or conversion privilege by
the owner of the security. Convertible preferred stock, convertible debt, common
stock options and common stock warrants are examples of such securities.

c. Treatments to be given to the listed items in computing earnings per share are:

i. Dividends on preferred stock should be deducted from net income and also net
income before extraordinary items before computing earnings per share
applicable to the common stock and other residual securities. If the preferred

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 6
 stock is cumulative this adjustment is appropriate whether or not the amounts
of the dividends are declared or earned.

ii. Minor reacquisitions of outstanding common stock which are placed in the
treasury may be excluded in the computation of earnings per share. However,
in determining earnings per share during the period when a major acquisition of
treasury common stock was made, the computation should be based on the
weighted average number of shares outstanding during the period.

iii. When the number of common shares outstanding increases as a result of a

stock split during the year, the computation should be based on shares
outstanding at year end and retroactive recognition should be given for an
appropriate number of prior years.

iv. The existence of a provision for a contingent liability on a possible lawsuit

created out of retained earnings will not affect the computation of earnings per
share since the appropriation of retained earnings does not affect net income
or the number of shares of stock outstanding.

v. Outstanding preferred stock with a par value liquidation right issued at a

premium, although affecting the determination of book value, will not affect the
computation of earnings per share for common stock except with respect to the
dividends as discussed in c.i. above.

vi. The exercise of a common stock option which results only in a minor increase
in the number of shares outstanding during the period may be disregarded in
the computation of earnings per share. If, however, the exercise of a common
stock option results in a major increase in the number of shares outstanding,
the computation of earnings per share should be based on the weighted
average number of shares outstanding during the period. The exercise of a
stock option by the grantee does not affect earnings, but any compensation to
the officers from the granting of the options would reduce net income and
earnings per share.

vii. The replacement of a machine immediately prior to the close of the current
fiscal year will not affect the computation of earnings per share for the year in

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 7
 which the machine is replaced. The number of shares remains unchanged and
since the old machine was sold for its book value, earnings are unaffected

Case 6-6

a .i. The term accounting change means a change in (1) an accounting principle, (2) an
accounting estimate or (3) the reporting entity.

A change in accounting principle results from adoption of a generally accepted

accounting principle different from the one used previously fry reporting purposes.
The term accounting principle includes not only accounting principles and practices
but also the methods of applying them.

A characteristic of a change in accounting principle is that it concerns a choice from

among two or more generally accepted accounting principles. But neither (1)initial
adoption of an accounting principle in recognition of events or transactions occurring
for the first time or that previously were immaterial in their effect nor (2) adoption or
modification of an accounting principle necessitated by transactions or events that
are clearly different in substance from those previously occurring is a change in
accounting principle.

Changes in accounting principle are numerous and varied. They include, for
example, a change in the method of inventory pricing, such as from the last-in, first-
out (LIFO) method to the first-in, first-out (FIFO) method; a change in depreciation
method for previously recorded assets, such as from the double-declining balance
method to the straight-line method (other than a change to the straight-line method
at a specific point in the service life of an asset that was planned at the time the
accelerated method was adopted to fully depreciate the cost of the asset over its
estimated life); and a change in the method of accounting for long-term construction-
type contracts, such as from the completed contract method to the percentage-of-
completion method.

Changes in accounting estimates are necessary consequences of periodic

presentations of financial statements. Preparing financial statements requires
estimating the effects of future events. Examples of items for which estimates are
necessary are uncollectible receivables, inventory obsolescence, service lives and
salvage values of depreciable assets, warranty costs, periods benefited by a
deferred cost and recoverable mineral reserves. Future events and their effects

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 8
 cannot be perceived with certainty; estimating requires the exercise of judgment.
Thus accounting estimates change as new events occur, as more experience is
acquired or as additional information is obtained.

Distinguishing between a change in accounting principle and a change in an

accounting estimate sometimes is difficult. For example, a company may change
from deferring and amortizing cost to recording it as an expense when incurred
because future benefits from the cost have become doubtful. The new accounting
method is adopted, therefore, in partial or complete recognition of the change in
estimated future benefits. The effect of the change in accounting principle is
inseparable from the effect of the change in accounting estimate.

Changes of this type often are related to the continuing process of obtaining
additional information and revising estimates and are therefore considered as
changes in estimates.

Changes in the reporting entity are limited mainly to (1) presenting consolidated or
combined statements in place of statements of individual companies, (2) changing
specific subsidiaries comprising the group of companies for which consolidated
financial statements are presented and (3) changing the companies included in
combined financial statements. A different group of companies comprises the
reporting entity after each change.

ii. A correction of an error in previously issued financial statements concerns factors

similar to those relating to an accounting change. Errors in financial statements result
from mathematical mistakes, mistakes in the application of accounting principles or
oversight or misuse of facts that existed at the time the financial statements were
prepared. In contrast a change in accounting estimate results from new information
or subsequent developments and accordingly from better insight or improved
judgment. Thus an error is distinguishable from a change in estimate. A change from
an accounting principle that is not generally accepted to one that is generally
accepted to one that is generally accepted is considered to be a correction of an
error.

b. There is a presumption that an accounting principle once adopted should not be

changed in accounting for events and transactions of a similar type. Consistent use of
accounting principles from one accounting period to another enhances the utility of

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 9
 financial statements to users by facilitating analysis and understanding of comparative
accounting data.

The presumption that an entity should not change an accounting principle may be
overcome only if the enterprise justifies the use of an alternative acceptable accounting
principle on the basis that it is preferable. But a method of accounting that was
previously adopted for a type of transaction or event that is being terminated or that was
a single, nonrecurring event in the past should not be changed. For example, the
method of accounting should not be changed for a tax or tax credit that is being
discontinued or for preoperating costs relating to a specific plant. But this does not imply
that a change in the estimated period to be benefited for a deferred cost (if justified by
the facts) should not be recognized as a change in accounting estimate. The issuance of
an Accounting Standards Update by the FASB that creates a new accounting principle,
that expresses a preference for an accounting principle is sufficient support for a change
in accounting principle.

The burden of justifying other change rests with the entity proposing the change. The
nature of and justification for a change in the method of inventory pricing should be
disclosed in the financial statements for the period the change was adopted; the change
should be justified on the basis that the new method is more appropriate than the old. In
addition, the effect of the change on income before extraordinary items, net income and
the related per share amounts should be disclosed for all periods presented. This
disclosure may be on the face of the income statement or in the notes. Financial
statements of subsequent periods need not repeat the disclosures.

In one specific situation the application of these provisions may result in financial
statement presentations of results of operations that are not of maximum usefulness to
intended users. For example, a company owned by a few individuals may decide to
change from one acceptable inventory method to another in connection with a
forthcoming public offering of shares of its equity securities. The potential investors may
be better served by the statements of income for a period of years reflecting the use of
the newly adopted accounting principle because it will be the same as that expected to
be used in future periods. In recognition of this situation, financial statements for all prior
periods presented may be restated retroactively when a company first issues its financial
statements for any one of the following purposes: (1) obtaining additional capital from
investors, (2) effecting a business combination or (3) registering securities. This
exemption is available only once for changes made at the time a company's financial
statements are first used for any of the purposes and is not available to companies
whose securities currently are widely held. Under these specific circumstances the

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 10
 company should disclose in financial statements issued the nature of the change in
accounting principle and the justification for it.

C & d. The general conclusion of APB Opinion No. 20 was that previously issued financial
statements need not be revised for changes in accounting principles. However, the
FASB revisited this issue and in May 2005 issued SFAS No. 154, “Accounting Changes
and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No.
3,” now contained at FASB ASC 250-10. This pronouncement required retrospective
application to prior periods’ financial statements of changes in accounting principles.
Retrospective application is defined at FASB ASC 250-10-20 as:

The application of a different accounting principle to one or more previously issued

financial statements, or to the statement of financial position at the beginning of the
current period, as if that principle had always been used, or a change to financial
statements of prior accounting periods to present the financial statements of a new
reporting entity as if it had existed in those prior years.

When it is impracticable to determine the period-specific effects of an accounting change

on one or more prior periods presented, or the cumulative effect FASBASC 250-10,
requires that the new accounting principle be applied to the balances of the appropriate
assets and liabilities as of the beginning of the earliest period for which retrospective
application is practicable and that a corresponding adjustment be made to the opening
balance of retained earnings for that period rather than being reported in an income
statement. Finally, FASB ASC 250-10 requires that a change in depreciation,
amortization, or depletion method for long-lived, nonfinancial assets be accounted for as
a change in accounting estimate (discussed below) effected by a change in accounting
principle.

Case 6-7

Situation 1

a. A change in the depreciable lives of fixed assets is a change in accounting estimate.

b. In accordance with generally accepted accounting principles, the change in estimate

should be reflected in the current period and in future periods.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 11
 c. This change in accounting estimate will affect the statement of financial position in
that the accumulated depreciation in the current and future years will increase at a
different rate than previously reported, and this will also be reflected in depreciation
expense in the earnings statement in the current and future years.

d. A footnote should disclose the effect of the change in accounting estimate on income
before extraordinary items, net income, and related per-share amounts for the
current period.

Situation 2

a. The change from reporting the investment in Allen using the cost method to using a
consolidated financial statement basis is a change in reporting entity. The change in
reporting entity is actually a change in accounting principle, but the APB Opinion No.
20 excluded this change from the general category to give it special reporting
procedures.

b. A change in reporting entity is effected and disclosed by restating all prior-period

financial statements in accordance with the method of presenting the current
financial statements of the new reporting entity. In the initial set of financial
statements occurring after the change, the nature of and reason for the change must
be disclosed by footnote, but subsequent financial statements need not repeat the
disclosures.

c. The statement of financial position will be affected by this change in that the
investment account of the parent and the equity section of the subsidiary will be
eliminated, intercompany accounts will be eliminated, and a goodwill account as well
as a minority interest account may arise. The income statement will be affected in
that intercompany transactions will be eliminated and a minority interest in earnings
will be shown. Also, if goodwill has been created, the income statement may disclose
an expense for goodwill impairment.

d. The financial statements of the period of the change in the reporting entity should
describe by footnote disclosure the nature of the change and the reason for it. In
addition, the effect of the change in earnings before extraordinary items, net
earnings, and related per-share amounts should be disclosed for all periods
presented. Financial statements of subsequent periods need not repeat the
disclosures.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 12
Situation 3

a. The change in the method of computing depreciation for all fixed assets (previously
recorded and future acquisitions) represents a change in an accounting estimate.

b. Accordingly, the effect of the change should be reflected in the current-year future
financial statements.

c. As a result of the change to straight line, current and future depreciation charges will
differ from what they might have been under the accelerated method, the direction of
this difference will depend on the life of the individual assets.

d. The nature of and justification for the change should also be disclosed in the
footnotes to the financial statements.

Case 6-8

a. Morgan should recognize the change in depreciation method as a change in accounting

estimate

b. The effects of the hailstorm should be reported as an extraordinary item in the income
statement because it meets both of the criteria for classification as an extraordinary item.
It is unusual in nature and infrequent in occurrence, taking into account the environment
in which the entity operates.

c. The classification in the income statement of an extraordinary item differs from that of an
operating item in the following ways. First, an extraordinary item should be shown as a
separate item in the income statement below the continuing operations section of the
income statement. Second, an extraordinary item should be shown net of applicable
income taxes. An extraordinary item is unrelated to Morgan's normal and ongoing
operations.

Case 6-9

a. Under the current operating performance concept of income, only changes and events
under the control of management that result from current period decisions should be
included in income. Normal and recurring items should constitute the basis for
evaluating current period performance.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 13
b. Earnings as defined under SFAC No. 5 reflect the current operating performance
concept because it excludes cumulative effects of changes in accounting principles.
These effects are the accumulation of differences in earnings of prior periods that would
have occurred had the new method been used in the past rather than the old one.
Because cumulative effects relate to the past, they are not relevant in assessing current
operating performance and as such should be excluded from the current period
measurement of income.

c. Under the all-inclusive concept of income, net income would reflect all items that
affected the net increase or decrease in equity (net assets) during the accounting period,
with the exception of capital transactions (investments by owners and distributions to
owners).

d. The definition of comprehensive income is that it is the change in net assets occurring
during the accounting period from non-owner sources. Since it would therefore include
the effects of all items that affected the net increase or decrease in equity during the
accounting period exclusive of transactions with owners, this definition essentially
reflects the all-inclusive concept of income.

e. Under the financial capital maintenance concept of income, income is the change in the
recorded (monetary) values of net assets occurring during the accounting period which
do not result from investments by owners or distributions to owners. These changes
would include recorded changes due to changes in price level (holding gains and losses)
as well as changes due to the cumulative effect of accounting changes. Hence,
comprehensive income, which purports to measure these changes in net assets relies
upon the financial capital maintenance concept and hence is consistent with it.

f. For financial reporting practices to be consistent with the concept of physical capital
maintenance, assets would need to measured at current replacement values and
holding gains and losses would be removed from the income statement and treated as
equity adjustments. Current practice for recording net assets is slowly evolving in this
direction. For example, investments in equity securities with readily determinable fair
values and investments in debt instruments are reported at fair value, a current value
measure. Moreover, the gains and losses resulting from revaluing investments in
securities that are classified as available for sale are excluded from net income and
treated as adjustments to equity. Accounting for impaired loans and impaired fixed
assets also results in the recording of fair value when impairment occurs.

FASB ASC 6-1 Extraordinary Items

Search extraordinary items

Extraordinary items are contained at FASB ASC 225-20.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 14
 FASB ASC 225-20-55-3&4 give examples of items that satisfy and fail to satisfy the
infrequent and unusual criteria.

The only EITF pronouncement dealing with extraordinary items identified in the FASB
ASC is:

225-20-20   Glossary

Business Interruption Insurance

FASB ASC 6-2 Comprehensive Income

Reporting Comprehensive Income is contained in sections FASB ASC 220-10-45. It is

found by searching comprehensive income or by cross referencing SFAS No. 130.

FASB ASC 6-3 Net Income

Found by searching net income

205-10 and 220-10

FASB ASC 6-4 APB Opinion No. 9

Found by cross reference to APB No. 9.

225-10-05-05

FASB ASC 6-5 Extraordinary Items

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 15
 Search extraordinary items

225-20

FASB ASC 6-6 Discontinued Operations

Search discontinued operations.

205-20

FASB ASC 6-7 Accounting Changes

Search accounting changes

250-10

FASB ASC 6-8 Earnings Per Share

Search earnings per share

260-10

Room for Debate

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 16
Debate 6-1

Team 1 Defend comprehensive income

1. Comprehensive income is the change in net assets during the period, excluding
transactions with owners. Thus it is consistent with the all-inclusive concept of income
and provides income measures which are closer to economic (real) income than is
provided by net income, and with the financial capital maintenance concept of income.

In 1936, the AAA stated that income should reflect all revenue properly given accounting
recognition and all costs written off during the accounting period regardless of whether
or not they are the results of operations in that period. Such inclusion is needed to
determine those amounts that are available for distribution to stockholders. It thus
provides an appropriate measure of the change in wealth (income) of the enterprise and
the change in wealth provided by the enterprise to its owners.

2. Comprehensive income would include changes due to price level, holding gains, which
under GAAP are excluded from net income. These changes provide information on the
effectiveness of the company’s investment strategies and the changes in wealth
resulting from those strategies.

3. Comprehensive income includes the effects of all non-owner changes that previously
were reported as separate adjustment to equity. Their inclusion in comprehensive
income is preferable because these are non-owner changes, and hence affect owner’s
wealth during the accounting period. As such they affect enterprise performance during
the period are properly included as components of income.

4. Comprehensive income is consistent with the concept of financial capital maintenance

because it includes all reported items that affect net assets during the accounting period.
It does not strictly follow historical cost, but it does include holding gains and losses in
the computation of income.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 17
Team 2 Oppose comprehensive income

1. Comprehensive income should not be reported because it is not consistent with the
current-operating performance concept of income and it represents a departure from the
realization principle

2. For the most part, net income includes the results of transactions and events on the
performance of the company for the period. It is historical in nature and provides
accounting information which is relevant, objective and reliable. It provides information
to investors on how their monetary investments were used to generate dollars for the
enterprise and to increase investor wealth.

3. Because net income is primarily based on the current-operating concept of income, it

provides predictive ability regarding future performance of the company. It shows the
amount of revenues realized or realizable during the accounting period. These amounts
can be extrapolated into the future. It shows the expenses associated with generating
those revenues. These too can be extrapolated.

1. Comprehensive income includes items which do not have predictive ability. It includes the
effects of price level adjustments and foreign currency translation adjustments.
Including holding gains and losses obscures the measure of income available for
distribution to stockholders. Holding gains have not been realized and are not yet
available for distribution. Foreign currency translation adjustments are bookkeeping
“plugs” that result from using the average exchange rate for income statement
adjustments and the current rate for balance sheet adjustments. They are not realized
and do not affect the amount of dollars that are currently.

Debate 6-2 Income Concepts

Comprehensive Income

Issues about income reporting have been characterized broadly in terms of a contrast
between the current operating performance and the all-inclusive income concepts.
Although the FASB generally has followed the all-inclusive income concept, as
introduced in Chapter 5, it has made some specific exceptions to that concept. Several
accounting standards require that certain items that qualify as components of
comprehensive income bypass the income statement. Other components are required to
be disclosed in the notes. The rationale for this treatment is that the earnings process is
incomplete. Examples of items currently not disclosed on the traditional income

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 18
 statement and reported elsewhere are unrealized gains and losses on available for sale
securities and certain foreign currency gains and losses.
Current operating performance concept (COPC): The application of this concept is one
of the two main approaches to measuring earnings. The concept is explained in the
International

Accounting Standard No.8, “Unusual and Prior Period Items and Changes in Accounting
Policy”. When earnings are measured on the basis of this concept, such earnings
consist of income from normal enterprise operations before non-recurring items (such as
write-offs) and capital gains and losses are accounted for.

This latter concept would require the income statement to be designed on what might be
called a ‘current operating performance’ basis, because its chief purpose is to aid those
primarily interested in what a company was able to earn under the operating conditions
of the period covered by the statement.”

Team 1

As advocates of the all-inclusive concept of income (sometimes called clean surplus),

we hold that net income should reflect all items that affected the net increase or
decrease in stockholders’ equity during the period, with the exception of capital
transactions. We believe that the total net income for the life of an enterprise should be
determinable by summing the periodic net income figures.

We advocate the all-inclusive income statement because we feel that it is more

transparent to have everything clearly disclosed in the income statement, and that to put
items directly into retained earnings does not meet the criterion of full disclosure.
Further, we believe that the all-inclusive concept of income aids in the avoidance of
biased reporting, where management might be able to pick and chose what to report in
the income statement.

The FASB noted in SFAC No. 5 that the all-inclusive income statement is intended to
avoid discretionary omissions from the income statement, even though “inclusion of
unusual or non-recurring gains or losses might reduce the usefulness of an income
statement for one year for predictive purposes.” The FASB has also stated that because
the effects of an entity’s activities vary in terms of stability, risks, and predictability, there
is a need for information about the various components of income.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 19
 Consistent with the above, the FASB now requires that companies report
Comprehensive income – the change in net assets that do not result from transactions
with owners. Comprehensive income includes earnings (net income) plus all other
changes in net assets from non-owner events or transactions. For example, translation
adjustments and changes in the value of investments in available-for-sale securities are
not included in net income, but are included in comprehensive income.

Team 2

Members of our team are proponents of the current operating performance concept of
income. We base our arguments on the belief that only changes and events controllable
by management that result from current-period decisions should be included in income.
This concept implies that normal and recurring items should constitute the principal
measure of enterprise performance. That is, net income should reflect the day-to-day,
profit-directed activities of the enterprise, and the inclusion of other items of profit or loss
distorts the meaning of the term net income.
We believe that income statements that report only the current operating performance of
the company provide an appropriate basis for comparing one firm with another and for
comparing what a company does from one year to the next. A purpose of financial
reports is to provide users with a means of predicting future cash flows. If so, a current
operating performance measure of income is more relevant for decision-making. It
would not include non-recurring items. So, it could be more readily relied upon as a
basis for prediction. This helps fulfill the concept of relevance because it would provide
predictive and feedback value.

WWW

Case 6-10

The company’s primary financial statements provide information about the earnings of a
company and its present cash flows. The primary financial statements also provide
information about financial position, including assets and debt, and can use this
information to evaluate risk, such as liquidity risk.

Investors can use this information to project the amount and timing of future cash flows.
These projections are then used to value the company. Hence, the primary financial
statements meet the objectives of financial reporting found in SFAS No. 8. According to
SFAS No. 8 financial statements provide information useful for investors, creditors and
other users. They provide information useful in projecting the amount and timing of
future cash flows. They provide information about resources and claims to resources

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 20
 (provided by balance sheet.) They provide information about how those resources are
used and about company performance.

Case 6-11

1. No disclosure is required. The error has “washed out”; that is, subsequent income
statement compensated for the error. However, prior year income statements should
be restated.

2. Extraordinary item. The sale of the auto is material, unusual in nature, and infrequent
in occurrence.

3. Should be reported as depreciation expense in body of income statement, based on

the new useful life. Changes in the estimated useful life of assets are changes in
estimates that are reported in the current and future periods.

4. No separate disclosure is generally required. This is a change in estimate that is

considered part of normal business activity.

5. Report in the body of the income statement, possibly as an unusual item. The sale of
the subsidiary does not meet criteria for either the disposal of a component of the
business or an extraordinary item.

6. Adjustment to the beginning balance of retained earnings. A change in inventory

methods is a change in accounting principle and prior periods are adjusted.

7. Report in body of the income statement, possibly as an unusual item. The loss on
the preparation of such proposals is not considered extraordinary in nature.

8. Report in body of the income statement, possibly as an unusual item. Strikes are not
considered extraordinary items.

9. Prior period adjustment, adjust beginning retained earnings. Corrections of errors are
shown as prior period adjustments.

10. Extraordinary item. This occurrence is material, unusual in nature, and infrequent in
occurrence.

11. Discontinued operations. The division’s assets, results of operations, and activities
are distinguishable physically, operationally, and for financial reporting purposes.

Case 6-12

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 21
 The new proposed income statement has separate categories for the disclosure of a
company’s operating business, its financing activities, investing activities, and tax
payments. Each category also contains an income subtotal. The proposal adopts a
single statement of comprehensive income format that combines income statement
elements and components of other comprehensive income into a single statement.
Items of other comprehensive income are to be presented in a separate section
following the income statement elements. This presentation format includes a subtotal of
net income and a total of comprehensive income in the period. The Boards the
eliminated the current alternative presentation format that allows items of other
comprehensive income to be presented either: (1) On a separate statement, (2) On a
combined statement of comprehensive income, or (3) On the statement of stockholder’s
equity because research studies suggested that investors and other users’ ability to
process the information will be enhanced if a uniform format of comprehensive income
statement is presented.

According to the proposal, all income and expense items will be classified into operating,
investing, and financing categories. Within those categories, an entity will disaggregate
line items by function. Within those functions, an entity should further disaggregate line
items by nature when such presentation will enhance the usefulness of the information in
predicting future cash flows. Function refers to the primary activities in which an entity is
engaged. For example, an entity’s operating activities consist of selling goods, marketing
or administration. Nature refers to the economic characteristics or attributes that
distinguish assets, liabilities, and income and expense items that do not respond equally
to similar economic events. Examples of disaggregation by nature include
disaggregating total sales into wholesale and retail or disaggregating total cost of sales
into materials, labor, transport, and energy costs. The desegregations will result in more
subtotals than current income statement therefore facilitate the comparison of effects
across financial statement.

Another difference between the proposed format and current practice is in the treatment
of foreign currency transaction gains and losses. Currently, these gains and losses are
reported in the income statement at a net amount. Under the proposal, individual foreign
currency transactions gains or losses are to be included in the same category as the
related asset or liability on the balance sheet. Gains or losses may also arise when a
company remeasures its subsidiary’s financial statements from the local currency to its
functional currency. The proposal requires companies to identify the components of
gains or losses from remeasurement and classify them into the operating, investing or
financing categories accordingly.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 22
 The Boards agreed on retaining the current intraperiod tax allocation method. The
Boards did not support allocation of income tax expense or benefit to the operating,
investing, financing asset, or financing liability categories because they determined that
the cost of doing so would exceed the benefit. Similarly, there are no proposed changes
in the current reporting format for discontinued operations, extraordinary items and
changes in accounting principles. The exposure draft didn’t provide guidance on which
items should be included in the comprehensive income because they are discussed in
other exposure drafts.

Case 6-13

IAS No. 8 indicates that in making that judgment, the following sources should be
considered in descending order:
 the requirements and guidance in IASB standards and interpretations dealing with
similar and related issues; and
 the definitions, recognition criteria and measurement concepts for assets, liabilities,
income and expenses in the Framework for the Presentation of Financial
Statements.
 the most recent pronouncements of other standard-setting bodies that use a similar
conceptual framework to develop accounting standards.
 other accounting literature and accepted industry practices, to the extent that these
do not conflict with the sources in paragraph.

Case 6-14

a. The objective of IAS 1 is to prescribe the basis for presentation of general-purpose

financial statements, to ensure comparability both with the entity’s financial statements
of previous periods and with the financial statements of other entities.
b. IAS No. 1 indicates that a complete set of financial statements should include a
statement of comprehensive income for the period (or an income statement and a
statement of comprehensive income).
c. An entity has the choice of presenting a single statement of comprehensive income or
two statements: an income statement displaying components of profit or loss and a
statement of comprehensive income that begins with profit or loss and displays
components of other comprehensive income. It requires that as a minimum, the
statement of comprehensive income include line items that present the following
amounts for the period: revenue, finance costs, share of the profit or loss of associates
and joint ventures accounted for using the equity method, tax expense, a single amount
comprising the total of the post-tax profit or loss of discontinued operations, and the
post-tax gain or loss recognized on the measurement to fair value less costs to sell or on
the disposal of the assets or disposal group(s) constituting the discontinued operation,
profit or loss, each component of other comprehensive income classified by nature,

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 23
 share of the other comprehensive income of associates and joint ventures accounted for
using the equity method, and total comprehensive income.

Case 6-15

The solution to this case depends upon the companies selected. Requiring the students
to print the relevant information from the financial statements is a good method to use to
check their answers.

Financial Analysis Case

Solution will depend on the companies selected to analyze.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 6 Page 24