Chapter 06 - Analyzing Operating Activities

Chapter 6
Analyzing Operating Activities
REVIEW
Income is the residual of revenues and gains less expenses and losses. Net income is
measured using the accrual basis of accounting. Accrual accounting recognizes
revenues and gains when earned, and recognizes expenses and losses when incurred.
The income statement (also referred to as statement of operations or earnings) reports
net income during a period of time. This statement also reports income components-revenues, expenses, gains, and losses. We analyze income and its components to
evaluate company performance, assess risk exposures, and predict amounts, timing,
and uncertainty of future cash flows. While "bottom line" net income frames our
analysis, income components provide pieces of a mosaic revealing the economic portrait
of a company. This chapter examines the analysis and interpretation of income
components. We consider current reporting requirements and their implications for our
analysis of income components. We describe how we might usefully apply analytical
adjustments to income components and related disclosures to better our analysis. We
direct special attention to revenue recognition and the recording of major expenses and
costs. Further use and analysis is made of income components in Part Three of the
book.

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OUTLINE

Income Measurement
Concept of Income
Measuring Accounting Income
Alternative Classification and Income Measures

Non-recurring items
Extraordinary Items
Discontinued Operations
Accounting Changes
Special Items

Revenue and Gain Recognition

Guidelines for Revenue Recognition
Uncertainty in Revenue Collection
Revenue When Right of Return Exists
Franchise Revenues
Product Financing Arrangements
Revenue under Contracts
Analysis Implications of Revenue Recognition

Deferred Charges
Research and Development
Computer Software Expenses
Exploration and Development Costs in Extractive Industries
Supplementary Employee Benefits
Employee Stock Options
Interest Costs
Income Taxes

Appendix 6A Earnings per Share: Computation and Analysis

Appendix 6B Economics of Employee Stock Options

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ANALYSIS OBJECTIVES

Explain the concepts of income measurement and their implications for analysis of
operating activities.

Describe and analyze the impact of non-recurring items - including extraordinary

items, discontinued segments, accounting changes, and restructuring charges and
write-offs.

Analyze revenue and expense recognition and its risks for financial analysis.

Analyze deferred charges, including expenditures for research, development, and

exploration.

Explain supplementary employee benefits and analyze disclosures for employee

stock options (ESOs)

Describe and interpret interest costs and the accounting for income taxes.

Analyze and interpret earnings per share data (Appendix 6A).

Understand the economics of employee stock options (appendix 6B).

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QUESTIONS
1. The income statement portrays the net results of operations of an enterprise. Since
results are what enterprises are established to achieve and since their value is, in
large measure, determined by the size and quality of these results, it follows that the
analyst attaches great importance to the income statement.
2. Income summarizes in financial terms the operating activities of a company. Income
is the amount of revenues and gains for the period in excess of expenses and losses,
all computed under accrual accounting. Income provides a measure of the change in
shareholder wealth for a period and an indication of a companys future earning
power. Accounting income differs from cash flows because certain revenues and
gains are recognized in periods before or after cash is received and certain expenses
and losses are recognized in periods before or after cash is paid.
3. Economic income is net cash flows plus the change in the present value of future
cash flows. Another similar concept, the Hicksian concept of income, considers
income for the period to be the amount that can be withdrawn from the company in a
period without changing the net wealth of the company. Hicksian income equals cash
flow plus the change in the fair value of net assets.
4. Accounting income is the excess of revenues and gains over expenses and losses
measured using accrual accounting. As such, revenues (and gains) are recognized
when earned and expenses (losses) are matched against the revenues (and gains).
5. Net income is the excess of the revenues and gains of the company over the
expenses and losses of the company. Net income often is called the bottom line,
although that is a misnomer because certain unrealized holding gains and losses are
charged directly to equity and bypass net income. Comprehensive income includes
all changes in equity that result from non-owner transactions (excluding items such
as dividends and stock issuances). Items creating differences between net income
and comprehensive income include unrealized gains and losses on available for sale
securities, foreign currency translation adjustments, minimum pension liability
adjustments, and unrealized holding gains or losses on derivative instruments.
Comprehensive income is the ultimate bottom line income number. Continuing
income is a measure of net income earned by ongoing segments of the company.
Continuing income differs from net income because continuing income excludes the
income or loss of segments of the company that are to be discontinued or sold (it
also excludes extraordinary items and effects from changes in accounting
principles).
6. Details regarding comprehensive income are reported by the vast majority of
companies in the statement of stockholders equity rather than the income statement.
7. Core income is a measure of income that excludes all non-recurring items that are
reported as separate items on the income statement.

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8. Operating income is a measure of firm performance from operating activities.

Examples of operating income include product sales, cost of product sales, and
selling, general, and administrative costs. Non-operating income includes all
components of income not included in operating income. Examples of non-operating
income include interest revenue and interest expense.
9. Operating versus non-operating and recurring versus non-recurring are distinct
dimensions of classifying income. While there is overlap across selected items, these
dimensions reflect different characteristics of business activities. For example, the
interest income and interest expense of most companies recur in net income; hence,
they are included in recurring income. However, these items are non-operating in
nature. Similarly, non-recurring items such as restructuring charge are operating in
nature.
10. Accounting standards (APB 30) restricted the use of the "extraordinary" category by
requiring that an extraordinary item be both unusual in nature and infrequent in
occurrence. These attributes are defined as follows:
a. Unusual nature of the underlying event or transaction should possess a high
degree of abnormality and be of a type clearly unrelated to, or only incidentally
related to, the ordinary and typical activities of the entity, taking into account the
environment in which the entity operates.
b. Infrequency of occurrence of the underlying event or transaction should be of a
type that would not reasonably be expected to recur in the foreseeable future,
taking into account the environment in which the entity operates.
Three examples of extraordinary items are:
Major casualty losses from an event such as an earthquake, flood, or fire.
A gain or loss from expropriation of property.
A gain or loss from condemnation of land by eminent domain.
11. To qualify as discontinued operations, the assets and business activities of the
divested segment must be clearly distinguishable from the assets and business
activities of the remaining entity. Accounting and reporting for discontinued
operations is two-fold. First, the income statement for the current and prior two years
are restated after excluding the effects of the discontinued operations from the line
items that determine continuing income. Second, gains or losses pertaining to the
discontinued operations are reported separately, net of related tax effects. An analyst
should separate and ignore discontinued operations in predicting future performance
and financial condition.
12. To qualify as a prior period adjustment, an item must meet the following
requirements:
Material in amount.
Specifically identifiable with the business activities of specific prior periods.
Not attributable to economic events occurring subsequent to the prior period.
Dependent primarily on determinations by persons other than management.
Not reasonably estimable prior to such determination.

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13. Distortions in revenues (gains) and expenses (losses) can arise from several
accounting sources. These include choices in the timing of transactions (such as
revenue recognition and expense matching), selections from the variety of generally
accepted principles and methods available, the introduction of conservative or
aggressive estimates and assumptions, and choices in how revenues, gains,
expenses, and losses are classified and presented in financial statements. Generally,
a company wishing to increase current income at the expense of future income will
engage in one or more of the following practices:
(a) It will choose inventory methods that allow for maximum inventory carrying values
and minimum current charges to cost of goods or services sold.
(b) It will choose depreciation methods and useful lives of property that will result in
minimum current charges as depreciation expense.
(c) It will defer all managed costs to the future such as, for example: pre-operating,
moving, rearrangement and start-up costs, and marketing costs. Such costs
would be carried as deferred charges or included with the costs of other assets
such as property, plant, and equipment.
(d) It will amortize assets and defer costs over the largest possible period. Such
assets include goodwill, leasehold improvements, patents, and copyrights.
(e) It will elect the method requiring the lowest possible pension and other
employment compensation cost accruals.
(f) It will inventory rather than expense administrative costs, taxes, and similar items.
(g) It will choose the most accelerated methods of income recognition such as in the
areas of leasing, franchising, real estate sales, and contracting.
(h) It immediately will recognize as revenue, rather than defer the taking up of
benefits, items such as investment tax credits.
(i) Companies that wish to manage the size of accounting income can regulate the
flow of income and expense by means of reserves for future costs and losses.
14. (1) Depreciation
a. Straight Line: This is calculated by taking the salvage value (S) from the
original cost (C) and dividing by the useful life of the asset in question; that is,
(C-S)/(Useful life). Sum-of-Years'-Digits: This depreciation formula is: (C-S) x
(X/Y); where C and S are the same as above, X is the remaining years (that is, if
item is being depreciated over 5 years and this is the first year, then X=5), and
Y equals the "sum-of-years'-digits" (that is, for a 5-year asset,
Y=5+4+3+2+1=15).
b. Straight line is easily understood and provides level depreciation and earnings
effects. The sum-of-the-years'-digits gives heavier weight to earlier years and
causes higher depreciation and lower earnings in the early years and lower
depreciation and higher earnings toward the end of the asset's life.
(2) Inventory
a. LIFO (last-in, first-out) method: The LIFO method assumes the inventory
employed are those most recently acquired. FIFO (first-in, first-out) method:
The FIFO method assumes the first inventory items acquired are used first.
b. The effect on earnings depends on whether the economy is in an inflationary
or deflationary period. In times of inflation (the more usual case), LIFO
inventory accounting would result in lower earnings being reported than would
be the case had FIFO been employed.

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c.
(3) Installment sales
a. Accrual method: Assumes income is recognized when the sale is made
(earned). Installment method: Assumes income is recognized only when cash
is received as the various installments come in.
b. The installment method is commonly used for tax purposes while the accrual
method is employed in financial statements. The accrual method would result
in a higher earnings figure being reported than the installment method.
15. Three different types of accounting changes include:
(a) Changes in accounting principle
(b) Changes in accounting estimate
(c) Changes in reporting entity
16. Special items refer to transactions and events that are unusual or infrequent, not
both. These items are reported as separate line items on the income statement before
continuing income. Examples of special items include restructuring charges,
impairments of long-lived assets, and asset write-offs.
17. Special (one-time) charges usually receive less attention by investors because it
often is believed that such charges will not recur in the future. As a result, companies
often include as much operating expense and loss as possible in special charges
hoping that investors will focus on income before special charges that excludes
these expenses and losses. If investors do focus on income before these charges,
company value may be erroneously perceived to be higher than is supported by the
fundamentals.
18. Many special charges should be viewed as operating expenses that need to be
reflected in permanent income. Essentially, many special charges are either
corrections of understated past expenses or investments for improved future
profitability. As such, analysts should adjust their income measurements to include
special charges in operating income.
19. The following criteria exemplify the rules that have been established to prevent the
premature anticipation of revenue. Realization is deemed to take place only after the
following conditions have been met:
(a) The earning activities undertaken to create revenue are substantially complete;
for example, no significant effort is necessary to complete the transaction.
(b) In the case of a sale, the risk of ownership has effectively passed to the buyer.
(c) The revenue, as well as the associated expenses, can be measured or estimated
with substantial accuracy.
(d) The revenue recognized should normally result in an increase in cash,
receivables, or marketable securities and, under certain conditions, in an increase
in inventories or other assets, or a decrease in a liability.
(e) The business transactions giving rise to the income should be at arm's-length with
independent parties (that is, not with controlled parties).
(f) The transactions should not be subject to revocation, for example, carrying the
right of return of merchandise sold.
20. SFAS 48 ("Revenue Recognition When Right of Return Exists") specifies that revenue
from sales transactions in which the buyer has a right to return the product should be
recognized at the time of sale only if all of the following conditions are met:
At the date of sale, the price is substantially fixed or determinable.
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The buyer has paid the seller, or is obligated to pay the seller (not contingent on
resale of the product).
In the event of theft or physical damage to the product, the buyer's obligation to
the seller would not be changed.
The buyer acquiring the product for resale has economic substance apart from
that provided by the seller.
The seller does not have significant obligations for future performance to directly
bring about resale of the product.
Product returns can be reasonably estimated.
If these conditions are not met, revenue recognition is postponed; if they are met,
sales revenue and cost of sales should be reduced to reflect estimated returns and
expected costs or losses should be accrued. Note: The Statement does not apply to
accounting for revenue in (a) service industries if part or all of the service revenue
may be returned under cancellation privileges granted to the buyer, (b) transactions
involving real estate or leases, or (c) sales transactions in which a customer may
return defective goods such as under warranty provisions.
21. Some of the factors that might impair the ability to predict returns (when right of
return exists in transactions) are: (1) susceptibility to significant external factors,
such as technological obsolescence or swings in market demand, (2) long return
privilege periods, and (3) absence of appropriate historical return experience.
22. SFAS 49 ("Accounting for Product Financing Arrangements") is concerned with the
issue of whether revenue has been earned. A product financing arrangement is an
agreement involving the transfer or sponsored acquisition of inventory that, although
it resembles a sale, is in substance a means of financing inventory through a second
party. For example, if a company transfers inventory to another company in an
apparent sale, and in a related transaction agrees to repurchase the inventory at a
later date, the arrangement may be a product financing arrangement rather than a
sale and subsequent purchase of inventory. If the party bearing the risks and
rewards of ownership transfers inventory to a purchaser, and in a related transaction
agrees to repurchase the product at a specified
price, or guarantees some specified resale price for sales of the product to outside
parties, the arrangement is a product financing arrangement and should be
accounted for as such.
23. The percentage-of-completion method is preferred when estimates of costs to
complete along with estimates of progress toward completion of the contract can be
made with reasonable dependability. A common basis of profit estimation is to record
that part of the estimated total profit that corresponds to the ratio that costs incurred
to date bears to expected total costs. Other methods of estimation of completion can
be based on units completed or on qualified engineering estimates or on units
delivered.
The completed-contract method of accounting is preferable where the conditions
inherent in the contract present risks and uncertainties that result in an inability to
make reasonable estimates of costs and completion time. Problems under this
method concern the point at which completion of the contract is deemed to have
occurred as well as the kind of expenses to be deferred. For example, some
companies defer all costs to the completion date, including general and
administrative overhead while others consider such costs as period costs to be
expensed as they are incurred.
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Under either of the two contract accounting methods, losses (present or

anticipated) must be fully provided for in the period in which the loss first becomes
apparent.

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24. The recording of revenue is the first step in the process of income determination and
is a step for which the recognition of any and all revenue depends. The analyst
should be particularly inquisitive about revenue recognition policies and procedures.
Some specific aspects include the following: (1) One element that casts doubt on the
validity of revenue is uncertainty about the ability of the seller to collect the resulting
receivable. Special collection problems exist with respect to installment sales, real
estate sales, and franchise sales. Problems of collection exist, however, in the case of
all sales and the analyst must be alert to them. (2) The analyst must also be alert to
the problems related to the timing of revenue recognition. The present rules generally
do not allow for recognition of profit in advance of salesuch as with increases in
market value of property such as land or equipment, the accretion of values in
growing timber, or the increase in the value of inventories are not recognized in the
accounts. As a consequence, income will not be recorded before sale and the timing
of sales is a matter that lies within the discretion of management. That, in turn, gives
management a certain degree of discretion in the timing of profit recognition. (3) In
the area of contract accounting, the analyst should recognize that the use of the
completed contract method is justified only in cases where reasonable estimates of
costs and the degree of completion are not possible. Yet, some companies consider
the choice of method a matter of discretion. (4) Other alternative methods of taking
up revenue, as in the case of lessors or finance companies, must be fully understood
by the analyst before an evaluation of a company's earnings or a comparison among
companies in the same industry is undertaken.
25. SFAS 2 ("Accounting for Research and Development Costs") offers a simple solution
to the complex problem of accounting for research and development costs. Namely,
it requires that R&D costs be charged to expense when incurred. It defines research
and development activities as follows:
(a) Research activities are aimed at discovery of new knowledge for the development
of a new product or process or in bringing about a significant improvement to an
existing product or process.
(b) Development activities translate the research findings into a plan or design for a
new product or process or a significant improvement to an existing product or
process.
R&D specifically excludes routine or periodic alterations to ongoing operations and
market research and testing activities.
The Board recommended the following accounting treatment for R&D costs:
(a) The majority of expenditures incurred in research and development activities as
defined above constitutes the costs of that activity and should be charged to
expense when incurred.
(b) Costs of materials, equipment, and facilities that have alternative future uses (in
research and development projects or otherwise) should be capitalized as
tangible assets.
(c) Intangibles purchased from an external party for R&D use that have alternative
future uses should also be capitalized.
(d) Indirect costs involved in acquiring patents should be capitalized as well.

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Elements of costs that should be identified with R&D activities are:

(a) Costs of materials, equipment, and facilities that are acquired or constructed for a
particular research and development project and purchased intangibles, that have
no alternative future uses (in research and development projects or otherwise).
(b) Costs of materials consumed in research and development activities, the
depreciation of equipment or facilities, and the amortization of intangible assets
used in research and development activities that have alternative future uses.
(c) Salaries and other related costs of personnel engaged in R&D activities.
(d) Costs of services performed by others.
(e) A reasonable allocation of indirect costs. General and administrative costs that
are not clearly related to R&D activities should be excluded.
The specific disclosure requirements as stipulated by SFAS 2 are: (1) for each income
statement presented, the total R&D costs charged to expense is to be disclosed, and
(2) government-regulated companies that defer R&D costs in accordance with the
addendum to SFAS 2 must make certain additional disclosures to that effect.
26. For an analyst to form a reliable opinion on the quality and the future potential value
of research outlays, the analyst needs to know a great deal more than the totals of
periodic research and development outlays. The analyst needs information on (1) the
types of research performed, (2) the outlays by category, (3) the technical feasibility,
commercial viability, and future potential of each project assessed and reevaluated at
the time of each periodic report, and (4) information on a company's success-failure
experience in its several areas of research activity to date. Of course, present
disclosure requirements will not give the analyst such information and it appears that,
except in cases of voluntary disclosure, only the investor or the lender with the
necessary clout will be able to obtain such information. In general, one can assume
that the outright expensing of all research and development outlays will result in
more conservative balance sheets and fewer bad-news surprises stemming from the
wholesale write-offs of previously capitalized research and development outlays.
However, the analyst must realize that along with a lack of knowledge about future
potential s/he may also be unaware of the potential disasters that can befall an
enterprise tempted or forced to sink ever greater amounts of funds into research and
development projects whose promise was great but whose failure is nevertheless
inevitable.
27. One of the most common solutions applied by analysts to the complex problem of the
analysis of goodwill is to simply ignore it. That is, they ignore the asset shown on the
balance sheet. Unfortunately, by ignoring goodwill, analysts ignore investments of
very substantial resources in what may often be a company's most important asset.
Ignoring the impact of goodwill impairment losses on reported periodic income is no
solution to the analysis of this complex cost. Even considering the limited amount of
information available to the analyst, it is far better that the analyst understand the
effects of accounting practices in this area on accounting income rather than dismiss
them altogether.

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28.
Goodwill is measured by the excess of cost over the fair market value of tangible net
assets acquired in a transaction accounted for as a purchase. That is the theory of it.
The financial analyst must be alert to the makeup and the method of valuation of the
Goodwill account as well as to the method of its ultimate disposition. One way of
disposing of the Goodwill account, frequently chosen by management, is to write it
off at a time when it would have the least serious impact on the market's judgment of
the company's earnings, for example, at a time of loss or reduced earnings. Under
normal circumstances, goodwill is not indestructible but is rather an asset with a
limited useful life. Still, whatever the advantages of location, market dominance and
competitive stance, sales skill, product acceptance, or other benefits are, they cannot
be unaffected by the passing of time and by changes in the business environment.
Thus, the analyst must assess the carrying amount of goodwill by reference to such
evidence of continuing value as the profitability of units for which the goodwill
consideration was originally paid.
29. The interest cost to a company is the nominal rate paid including, in the case of
bonds, the amortization of any bond discount or premium. A complication arises
when companies issue convertible debt or debt with warrants, thus achieving a
nominal debt coupon cost that is below the cost of similar debt not carrying these
features. After trial pronouncements on the subject and much controversy, APB 14
concluded in the case of convertible debt that the inseparability of the debt and
equity features is such that no portion of the proceeds from the issuance should be
accounted for as attributable to the conversion feature. In the case of debt issued
with stock warrants attached, the proceeds of the debt attributable to the warrants
should be accounted for as paid-in capital. The corresponding charge is to a debt
discount account that must be amortized over the life of the debt issue thus
increasing the effective interest cost.
30. a. SFAS 34 ("Capitalization of Interest Cost") requires capitalization of interest cost
as part of the historical cost of "assets that are constructed or otherwise
produced for an enterprise's own use (including assets constructed or produced
for the enterprise by others for which deposits or progress payments have been
made)." Inventory items that are routinely manufactured or produced in large
quantities on a repetitive basis do not qualify for interest capitalization. The
objectives of interest capitalization, according to the FASB, are (1) to measure
more accurately the acquisition cost of an asset, and (2) to amortize that
acquisition cost against revenues generated by the asset.
b. The amount of interest to be capitalized is based on the entity's actual borrowings
and interest payments. The rate to be used for capitalization may be ascertained
in this order: (1) the rate of specific borrowings associated with the assets and (2)
if borrowings are not specific for the asset, or the asset exceeds specific
borrowings therefore, a weighted average of rates applicable to other appropriate
borrowings may
be used. Alternatively, a company may use a weighted average of rates of all
appropriate borrowings regardless of specific borrowings incurred to finance the
asset.

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c. Interest capitalization is not permitted to exceed total interest costs for any period,
nor is imputing interest cost to equity funds permitted. A company without debt
will have no interest to capitalize. The capitalization period begins when three
conditions are present: (1) expenditures for the asset have been made by the
entity, (2) work on the asset is in progress, and (3) interest cost is being incurred.
Interest capitalization ceases when the asset is ready for its intended use.
31. The intrinsic value of an option is the amount by which the market value of the
underlying security exceeds the option exercise price at the time of measurement.
The fair value of an option is the amount that market participants would be willing to
pay today to purchase the option.
32. The fair value of an option is affected by the exercise price, the current market price,
the risk-free rate of interest, the expected life of the option, the expected volatility of
the stock price, and the expected dividend yield.
33. SFAS 123 requires that the company amortize the fair value of employee stock
options (estimated using various option pricing models) at the grant date over the
expected life of the option. The cumulative amortization of all employee stock
options granted in the past is collectively called the option compensation expense.
Until recently, option compensation expense was not charged to income. However, a
recent revision of the standard, SFAS 123R, requires that the option compensation
expense be charged to income. Compensation expense may be included in various
expense categories such as cost of goods sold, SG&A, R&D etc. based on which area
of the company the respective employee works for.
34. The economic cost of issuing options at the prevailing market price are: (1) the
interest cost, which is that the employee is able to pay for the stock purchase many
years later using the current stock price; and (2) cost of providing an option to
exercise, which arises because the employee can share in the potential upside but is
protected from sharing in the potential downside risk.
35. Option overhang refers to the intrinsic value of outstanding options (both exercisable
and otherwise) as a proportion of the companys market value. It is a measure of the
value of potential dilution that arises from option grants to employees. It measured by
aggregating the intrinsic value of all outstanding employee stock options, using the
current stock price, and dividing it by the current market capitalization of the
companys equity.
35. The net income computed on the basis of generally accepted accounting principles
(also known as "book income") is usually not identical to the "taxable income"
computed on the entity's tax return. This is due to two types of difference. Permanent
differences (discussed here) and temporary, or timing, differences. Permanent
differences result from provisions of the tax law under which:
(a) Certain items may be nontaxablefor example, income on tax exempt obligations
and proceeds of life insurance on an officer

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(b)
(c) Certain deductions are not allowedfor example, penalties for filing certain
returns, government fines, and officer life insurance premiums.
(d) Special deductions granted by lawfor example, dividend exclusion on dividends
from unconsolidated subsidiaries and from dividends received from other
domestic corporations.
36. The effective tax rate paid by a corporation on its income will vary from the statutory
rate because:
The basis of carrying property for accounting purposes may differ from that for
tax purposes from reorganizations, business combinations, or other transactions.
Nonqualified and qualified stock-option plans may result in book-tax differences.
Certain industries, such as savings and loan associations, shipping lines, and
insurance companies enjoy special tax privileges.
Up to $100,000 of corporate income is taxed at lower tax rates.
Certain credits may apply, such as R&D credits and foreign tax credits.
State and local income taxes, net of federal tax benefit, are included in total tax
expenses.
What makes these differences and factors permanent is the fact that they do not have
any future repercussions on a company's taxable income. Thus, they must be taken
into account when reconciling a company's actual (effective) tax rate to the statutory
rate.
37. SFAS 109 ("Accounting for Income Taxes") establishes financial accounting and
reporting standards for the effects of income taxes that result from an enterprise's
activities during the current and preceding years, and requires an asset and liability
approach. SFAS 109 requires that deferred taxes should be determined separately
for each tax-paying component (an individual entity or group of entities that is
consolidated for tax purposes) in each tax jurisdiction. The determination includes
the following procedures:
Identify the types and amounts of existing temporary differences and the nature
and amount of each type of operating loss and tax credit carry forward, plus the
remaining length of the carry forward period.
Measure the total deferred tax liability for taxable temporary differences, using the
applicable tax rate.
Measure the total deferred tax asset for deductible temporary differences and
operating loss carry forwards, using the applicable tax rate.
Measure deferred tax assets for each type of tax credit carry forward.
Reduce deferred tax assets by a valuation allowance if based on the weight of
available evidence. It is more likely than not (a likelihood of more than 50 percent)
that some portion or all of the deferred tax assets will not be realized. The
valuation allowance should be sufficient to reduce the deferred tax asset to the
amount that is more likely than not to be realized.
Deferred tax assets and liabilities should be adjusted for the effect of a change in tax
laws or rates. The effect should be included in income from continuing operations for
the period that includes the enactment date.

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38. (a) Revenues or gains are included in taxable income later than they are included in
pretax accounting income.
(b) Expenses or losses are deducted in determining taxable income later than they
are deducted in determining pretax accounting income.
(c) Revenues or gains are included in taxable income earlier than they are included in
pretax accounting income.
(d) Expenses or losses are deducted in determining taxable income earlier than they
are deducted in determining pretax accounting income.
39. The components of the net deferred tax liability or net deferred tax asset recognized
in a company's balance sheet should be disclosed. These include the:
Total of all deferred tax liabilities.
Total of all deferred tax assets.
Total valuation allowance recognized for deferred tax assets.
Additional disclosures include the significant components of income tax expense
attributable to continuing operations for each year presented which include, for
example:
Current tax expense or benefit.
Deferred tax expense or benefit (exclusive of the effects of other components).
Investment tax credits.
Government grants (to the extent recognized as a reduction of income tax
expense).
The benefits of operating loss carry forwards.
Tax expense that results from allocating certain tax benefits either directly to
contributed capital or to reduce goodwill or other noncurrent intangible assets of
an acquired entity.
Adjustments of a deferred tax liability or asset for enacted changes in tax laws or
rates or a change in the tax status of the enterprise.
Adjustments of the beginning-of-year balance of a valuation allowance because of
a change in circumstances that causes a change in judgment about the
realizability of the related deferred tax asset in future years.
Also to be disclosed is a reconciliation between the effective income tax rate and the
statutory federal income tax rate. In addition, the amounts and expiration dates of
operating loss and tax credit carry forwards for tax purposes must be disclosed.
40. (1) One of the flaws remaining in tax allocation procedures is that no recognition is
given to the fact that a future obligation, or loss of benefits, should be discounted
rather than shown at its entire amount as today's tax deferred accounts actually are.
The FASB has reviewed the issue and decided not to address it because of the
conceptual and implementation issues involved. (2) Another flaw is that the Board
allowed parent companies to avoid providing taxes on unremitted earnings of
subsidiaries and other specialized exceptions to the requirements of deferred tax
accounting.
41. A The determination of the earnings level of an enterprise, which is relevant to the
purpose of the analyst, is a complex analytical process. The earnings figure can be
converted into a per-share amount that is useful in evaluating the price of the
common stock, its dividend coverage, and the potential effects of dilution. As with
any measure, there are strengths and weaknesses associated with its computation.
Thus, the analyst must have a thorough understanding of the principles that govern
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the computation of earnings per share to effectively analyze it and use it in decision
making.

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Chapter 06 - Analyzing Operating Activities

42. A Earnings per share data are used in making investment decisions. They are used in
evaluating the past operating performance of a company and in forming an opinion
as to its future potential. They are commonly presented in prospectuses, proxy
material, and reports to stockholders, and is the only financial statement ratio that is
audited. They are used in the compilation of business earnings data for the press,
statistical services, and other publications. When presented with formal financial
statements, they assist the investor in weighing the significance of a corporation's
current net income and of changes in its net income from period to period in relation
to the shares an analyst holds or may acquire.
Current GAAP regarding EPS conforms to international standards. The analyst
must be aware that basic EPS does not take into account securities that, although not
common stock, are in substance equivalent to common stock. The analyst must take
care to focus on diluted EPS, which intends to show the maximum extent of potential
dilution of current earnings that conversions of securities could create.
43. A Diluted earnings per share is the amount of current earnings per share reflecting the
maximum dilution that would result from conversions, exercises, and other
contingent issuances that individually would decreased earnings per share and in the
aggregate yield a dilutive effect. All such issuances are assumed to have taken place
at the beginning of the period (or at the time the contingency arose, if later).
44. A The amount of any dividends on preferred stock that have been paid (declared) for
the year should be deducted from net income before computing earnings per share.
45. A Yes, if warrants or options are present, an increase in the market price of the
common stock can increase the number of common equivalent shares by decreasing
the number of shares repurchasable under the treasury stock method.
46. A SFAS 128 has a number of flaws and inconsistencies that the analyst must consider
in interpreting EPS data:
(a) The computation of basic EPS completely ignores the potentially dilutive effects
of options and warrants.
(b) There is a basic inconsistency in treating certain securities as the equivalent of
common stock for purposes of computing EPS while not considering them as part
of the stockholders' equity in the balance sheet. Consequently, the analyst will
have difficulty in interrelating reported EPS with the debt-leverage position
pertaining to the same earnings.
(c) Generally, EPS are considered to be a factor influencing stock prices. Whether
options and warrants are dilutive or not depends on the price of the common
stock. Thus we can get a circular effect in that the reporting of EPS may influence
the market price which, in turn, influences EPS. Under these rules earnings may
depend on market prices of the stock rather than only on economic factors within
the enterprise. In the extreme, this suggests that the projection of future EPS
requires not only the projection of earnings levels but also the projection of future
market prices.
47. A (a) Earnings per share data are used in making investment decisions. They are
used in evaluating the past operating performance of a company and in forming
an opinion as to its future potential.
They are commonly presented in
prospectuses, proxy material, and reports to stockholders. They are used in the
compilation of business earnings data for the press, statistical services, and other
publications. When
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Chapter 06 - Analyzing Operating Activities

presented with formal financial statements, they assist the investor in weighing the
significance of a corporation's current net income and of changes in its net
income from period to period in relation to the shares an analyst holds or may
acquire.
(b) Earnings per common share are not fully relevant to the valuation of preferred
stock. For purposes of preferred stock evaluation, the earnings coverage ratio of
preferred stock is among the most relevant. It measures the number of times
preferred dividends have been earned and, thus, is a measure of the safety of the
dividend as well as the safety of the preferred issue.

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EXERCISES
Exercise 6-1 (25 minutes)
a. Cash
xxx
Gain on disposition*
Net assets of discontinued operations
* (A loss on disposition would be recorded as a debit)

xxx
xxx

b. Income (expense) related to discontinued operations include the operating

profit (loss) recorded prior to sale and the gain (loss) on sale. These are
reported net of applicable tax.
c. When estimating future earning power, the results from discontinued
operations should not be treated as recurring. This is important for an
assessment of the permanent income of a company.
d. Separately reporting discontinued operations allows the analyst to view the
results of operations without the segment that will not be ongoing. As a
result, the analyst can better assess the permanent component of income, for
which results of discontinuing operations will be excluded.
Exercise 6-2 (30 minutes)
a. By the use of reserves, a company can allocate costs in excess of actual
experience in the current period, based on estimates of additional costs in the
future, or even based on the simple possibility of further costs in the future.
Then, in later periods, actual costs can be written off against the reserve
rather than reported as expenses in the company's income statement for
those periods. The advantage to the company is that earnings trends can be
"smoothed," and a cushion for future earnings can be built up during good
economic years for use during leaner periods. To the extent that stability and
predictability of earnings are market virtues, the company's common stock
might be accorded a higher multiple for these efforts, in effect lowering the
cost of capital to the company. The use of reserves both poses problems for
the analyst and conflicts with some basic accounting principles. These
include:
(1) Use of reserves contradicts the matching principle, by which revenues and
related costs should be recognized in the same period.
(2) Reserving for future events (especially contingencies) is obviously subject
to estimate, and accounting should attempt to record quantifiable value as
much as possible.

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Exercise 6-2continued
(3) The reserving technique makes reported earnings less indicative of
fundamental trends in the company. The effects of the economic cycle are
reduced, making correlation techniques (such as GNP growth vs. EPS
growth) invalid. These reported numbers might mislead the uninformed
investor. In contrast to the artificial smoothing referred to earlier, the
company's growth rate may be exaggerated, by over-reserving for losses in
a bad year, and subsequent writing off of the reserve.
It should be noted that a reserve can be properly taken such as when it
recognizes a liability that (1) likely exists in the relatively near futuresuch as
costs of winding up a plant shutdown with the next year or (2) is subject to
quantificationsuch as the outright expropriation of net assets in a foreign
country.
b. If the analyst is able to discern the impact of reserves, s/he should exclude the
reserves' impact from accounting income when assessing past trends. Only
operating or normal earnings should be compared over the short-term.
However, over a longer period of time, the losses against which reserves have
been taken should be included. In estimating future earnings, the analyst
must carefully consider the impact of reserves and exclude the impact when
forecasting normal earnings. By doing this, the analyst will have a better
understanding of the true operations of the company. In the valuation of
common stock, the analyst must focus on the sustainable earning power of
the company. Thus, earnings may have to be adjusted upward or downward
depending on the degree of abuse of reserves.
c. Several examples of reserves are cited in the chapter. Also, students often
benefit from a review of business magazines in attempting to identify such
reserves.
(CFA Adapted)

Exercise 6-3 (35 minutes)

a. A change from the sum-of-the-years'-digits method of depreciation to the
straight-line method for previously recorded assets is a change in accounting
principle. Both the sum-of-the-years'-digits method and the straight-line
method are generally accepted. A change in accounting principle results from
adoption of a generally accepted accounting principle different from the
generally accepted accounting principle used previously for reporting
purposes.

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Chapter 06 - Analyzing Operating Activities

Exercise 6-3continued
b. A change in the expected service life of an asset arising because of more
experience with the asset is a change in accounting estimate. A change in
accounting estimate occurs because future events and their effects cannot be
perceived with certainty. Estimates are an inherent part of the accounting
process. Therefore, accounting and reporting for certain financial statement
elements requires the exercise of judgment, subject to revision based on
experience.
c. 1. The cumulative effect of a change in accounting principle is the difference
between: (1) the amount of retained earnings at the beginning of the period
of change and (2) the amount of retained earnings that would have been
reported at that date if the new accounting principle had been used in prior
periods.
2. FASB 2005 Statement Accounting Changes and Error Corrections
requires that effective in 2005, companies should apply the retrospective
approach to changes in accounting principle. Thus, all presented periods
must be restated as if the change were in effect during those periods, and
any cumulative effect from periods before those presented is an
adjustment to beginning retained earnings of the earliest period presented.
d. Consistent use of accounting principles from one accounting period to
another enhances the usefulness of financial statements in comparative
analysis of accounting data across time.
e. If a change in accounting principle occurs, the nature and effect of a change in
accounting principle should be disclosed to avoid misleading financial
statement users. There is a presumption that an accounting principle, once
adopted, should not be changed in accounting for events and transactions of
a similar type.
f. Mandatory accounting changes are largely non-discretionary.
Thus,
managerial discretion is not present, or at least is to a lesser degree. One
should examine the motivations for voluntary accounting changes and assess
any earnings quality impact.
g. Mandatory accounting changes are largely non-discretionary. However, there
is often a window of time for a company to adopt a mandatory accounting
change. If a window exists, management has discretion as to the timing of the
adoption. Thus, the timing of adoption and any accounting ramifications
should be considered. For example, if a manager is going to adopt an
accounting change that includes a large charge, the manager might choose to
adopt in a relatively poor quarter to attempt to potentially conceal or downplay
the poor operating performance.

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Chapter 06 - Analyzing Operating Activities

Exercise 6-3concluded
h. Mandatory accounting changes often include the recognition of retroactive
earnings affects. For example, the rules in accounting for other postemployment benefits require that companies establish a liability for the
accrued benefits to date. This results in a large charge for many companies.
Of course, the market potentially views the charge as largely the fault of
accounting rule makers. Thus, managers have incentive to increase the
amount of the charge and use the bloated liability to increase future earnings.

Exercise 6-4 (20 minutes)

Comprehensive income computation:*
a. Computation:
$1,000,000
- 100,000
+ 50,000
- 25,000
- 12,000
$ 913,000

b. Balance sheet accounts affected:

Net income (closed to equity)
Unrealized holding loss on available for sale securities
Foreign currency translation gain
Additional minimum pension liability adjustment
Unrealized holding losses on derivative instruments
Comprehensive income (component of equity)

* The unexpected return on pension fund assets ($40,000) does not affect net income or
stockholders equity in the current period.

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Chapter 06 - Analyzing Operating Activities

Exercise 6-5 (30 minutes)

a. The point of sale is the most widely used basis for the timing of revenue
recognition because in most cases it provides the degree of objective
evidence many consider necessary to measure reliably periodic business
income. That is, sales transactions with outsiders represent the point in the
revenue generating process when most of the uncertainty about the final
outcome of business activity has been alleviated. It is also at the point of sale
in most cases that substantially all of the costs of generating revenues are
known, and they can at this point be matched with the revenues generated to
produce a reliable statement of a firm's effort and accomplishment for the
period. Any attempt to measure business income prior to the point of sale
would, in the vast majority of cases, introduce considerably more subjectivity
into financial reporting than most accountants are willing to accept.
b. 1. Though it is recognized that revenue is earned throughout the entire
production process, generally it is not feasible to measure revenue on the
basis of operating activity. It is not feasible because of the absence of
suitable criteria for consistently and objectively arriving at a periodic
determination of the amount of revenue to take up. Also, in most situations
the sale is the most important single step in the earning process. Prior to
the sale the amount of revenue anticipated from the processes of
production is merely prospective revenue; its realization remains to be
validated by actual sales. The accumulation of costs during production
does not alone generate revenue; rather, revenues are earned by the entire
process including the actual sales. Thus, as a general rule the sale cannot
be regarded as being an unduly conservative basis for the timing of
revenue recognition. Except in unusual circumstances, revenue
recognition prior to sale would be anticipatory in nature and unverifiable in
amount.
2. To criticize the sales basis as not being sufficiently conservative because
accounts receivable do not represent disposable funds, it is necessary to
assume that collection of receivables is the decisive step in the earning
process and that periodic revenue measurement and, therefore, net income
should depend on the amount of cash generated during the period. This
assumption disregards the fact that the sale usually represents the
decisive factor in the earning process and substitutes for it the
administrative function of managing and collecting receivables. That is, the
investment of funds in receivables should be regarded as a policy
designed to increase total revenues, properly recognized at the point of
sale; and the cost of managing receivables (e.g., bad debts and collection
costs) should be matched with the sales in the proper period. The fact that
some revenue adjustments (such as sales returns) and some expenses
(such as bad debts and collection costs) can occur in a period subsequent
to the sale does not detract from the overall usefulness of the sales basis
for the timing of revenue recognition. Both can be estimated with sufficient
accuracy so as not to detract from the reliability

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Chapter 06 - Analyzing Operating Activities

Exercise 6-5concluded
of reported net income. Thus, in the vast majority of cases for which the
sales basis is used, estimating errors, though unavoidable, will be too
immaterial in amount to warrant deferring revenue recognition to a later
point in time.
c. 1. During production. This basis of recognizing revenue is frequently used by
companies whose major source of revenue are long-term construction
projects. For these companies the point of sale is far less significant to the
earning process than is production activity because the sale is assured
under the contract, except of course where performance is not
substantially in accordance with the contract terms. To defer revenue
recognition until the completion of long-term construction projects could
impair significantly the usefulness of the intervening annual financial
statements because the volume of completed contracts during a period is
likely to bear no relationship to production volume. During each year that a
project is in process a portion of the contract price is therefore
appropriately recognized as that year's revenue. The amount of the
contract price to be recognized should be proportionate to the year's
production progress on the project. It should be noted that the use of the
production basis in lieu of the sales basis for the timing of revenue
recognition is justifiable only when total profit or loss on the contracts can
be estimated with reasonable accuracy and its ultimate realization is
reasonably assured.
2. When cash is received. The most common application of this basis for the
timing of revenue recognition is in connection with installment sales
contracts. Its use is justified on the grounds that, due to the length of the
collection period, increased risks of default, and higher collection costs,
there is too much uncertainty to warrant revenue recognition until cash is
received. The mere fact that sales are made on an installment contract
basis does not justify using the cash receipts basis of revenue recognition.
The justification for this departure from the sales depends essentially upon
an absence of a reasonably objective basis for estimating the amount of
collection costs and bad debts that will be incurred in later periods. If
these expenses can be estimated with reasonable accuracy, the sales
basis should be used.
(AICPA Adapted)

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Chapter 06 - Analyzing Operating Activities

Exercise 6-6 (25 minutes)

a. Michael Company should recognize revenue as it performs the work on the
contract (the percentage-of-completion method) given that the right to
revenue is established and collectibility is reasonably assured. Furthermore,
the use of the percentage-of-completion method avoids distortion of income
from period to period, and it provides for better matching of revenues with the
related expenses.
b. Progress billings would be accounted for by increasing Accounts Receivable
and increasing Progress Billings on Contract, a contra asset account that is
offset against the Construction Costs in Progress account. If the Construction
Costs in Progress account exceeds the Progress Billings on Contract
account, the two accounts would be shown in the current assets section of
the balance sheet. If the Progress Billings on Contract account exceeds the
Construction Costs in Progress account, the two accounts would be shown, in
most cases, in the current liabilities section of the balance sheet.
c. The income recognized in the second year of the four-year contract would be
determined as follows:
First, the estimated total income from the contract would be determined by
deducting the estimated total costs of the contract (the actual costs to date
plus the estimated cost to complete) from the contract price.
Second, the actual costs to date would be divided by the estimated total
costs of the contract to arrive at a percentage completed, which would be
multiplied by the estimated total income from the contract to arrive at the
total income recognized to date.
Third, the total income recognized in the second year of the contract would
be determined by deducting the income recognized in the first year of the
contract from the total income recognized to date.
d. Earnings in the second year of the four-year contract would be higher using
the percentage-of-completion method instead of the completed-contract
method. This is because income would be recognized in the second year of
the contract using the percentage-of-completion method, whereas no income
would be recognized in the second year of the contract using the
completed-contract method.

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Chapter 06 - Analyzing Operating Activities

Exercise 6-7 (15 minutes)

a. Crime Control's revenue recognition practices, while not the most
conservative, conform to GAAP. The important issue is whether lessees will, in
fact, continue for their eight-year terms. Should large cancellations occur,
substantial portions of the revenue recognized in earlier years might have to
be reversed in subsequent years. This would result in distortions of earning
power and earning trends. Thus, a critical issue of this accounting is whether
the company provides adequately for contingencies such as cancellations.
Should the pace of newly written sales-type leases slow, the company's
earnings growth may stop or earnings may even decline.
b. While the tax accounting does provide the company with significant funds
from tax postponement, it does not affect reported results because under
GAAP the company is required to provide for deferred taxes which it is
assumed will be payable in the future.
c. While it is true that the sale of the receivables without recourse would enable
the company to book profits in the year the lease originated, this practice
would at the same time substantially increase the company's tax bill.

Exercise 6-8 (20 minutes)

a. This revenue recognition issue stirs controversy. Many believe that it is
reasonable for both companies to record offsetting advertising revenues and
advertising expenses from this contract.
This is justified in that the
transaction seemingly meets the usual revenue recognition criteria.
Opponents of this treatment worry about uncertainty and completeness of the
earning process.
b. Revenues and revenue growth are considered good indicators of future
prospects for Dot.Com (Internet) companies. Accordingly, Internet companies
want to maximize the amount of reported revenues; even if those revenues are
entirely offset with expenses.
c. An analyst should seek to determine the percent of revenues that come from
advertising in such barter transactions versus revenues from cash-paying (or
credit) customers. Some believe that barter-based revenues should be
segregated and viewed in a different light from that of more normal revenues.
This might affect revenue multiples in determining stock price or decisions in
other applications that rely on financial statements. Analysts should adjust
their models according to their beliefs about the relative merits of such
revenues.

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Chapter 06 - Analyzing Operating Activities

Exercise 6-9 (30 minutes)

a. Some costs are recognized as expenses on the basis of a presumed direct
association with specific revenue. This has been identified both as
"associating cause and effect" and as the "matching concept." Direct
cause-and-effect relations can seldom be conclusively demonstrated, but
many costs appear to be related to particular revenue, and recognizing them
as expenses accompanies recognition of the revenue. Generally, the matching
concept requires that the revenue recognized and the expenses incurred to
produce the revenue be given concurrent periodic recognition in the
accounting records. Only if effort is properly related to accomplishment will
the results, called earnings, have useful significance concerning the efficient
utilization of business resources. Thus, applying the matching principle
recognizes the cause-and-effect relationship that exists between expense and
revenue. Examples of expenses that are usually recognized by associating
cause and effect are sales commissions, freight-out on merchandise sold, and
cost of goods sold or services provided.
b.

Some costs are assigned as expenses to the current accounting period

because (1) their incurrence during the period provides no discernible future
benefits; (2) they are measures of assets recorded in previous periods from
which no future benefits are expected or can be discerned; (3) they must be
incurred each accounting year, and no buildup of expected future benefits
occurs; (4) by their nature they relate to current revenues even though they
cannot be directly associated with any specific revenues; (5) the amount of
cost to be deferred can be measured only in an arbitrary manner or great
uncertainty exists regarding the realization of future benefits, or both; and (6)
uncertainty exists regarding whether allocating them to current and future
periods will serve any useful purpose. Thus, many costs are called "period
costs" and are treated as expenses in the period incurred because neither do
they have a direct relationship with revenue earned nor can their occurrence
be directly shown to give rise to an asset. The application of this principle of
expense recognition results in charging many costs to expense in the period
in which they are paid or accrued for payment. Examples of costs treated as
period expenses would include officers' salaries, advertising, research and
development, and auditors' fees.

c. A cost should be capitalized, that is, treated as an asset, when it is expected

that the asset will produce benefits in future periods. The important concept
here is that the incurrence of the cost has resulted in the acquisition of an
asset, a future service potential. If a cost is incurred that resulted in the
acquisition of an asset from which benefits are not expected beyond the
current period, the cost may be expensed as a measure of the service
potential that expired in producing the current period's revenues. Not only
should the incurrence of the cost result in the acquisition of an asset from
which future benefits are expected, but also the cost should be measurable
with a reasonable degree of objectivity, and there should be reasonable
grounds for associating it with the asset acquired. Examples of costs that
should be treated as measures of assets are the costs of merchandise
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Chapter 06 - Analyzing Operating Activities

Exercise 6-9concluded
on hand at the end of an accounting period, the costs of insurance coverage
relating to future periods, and the costs of self-constructed plant or
equipment.
d. In the absence of a direct basis for associating asset cost with revenue, and if
the asset provides benefits for two or more accounting periods, its cost
should be allocated to these periods (as an expense) in a systematic and
rational manner. When it is impractical, or impossible, to find a close
cause-and-effect relationship between revenue and cost, this relationship is
often assumed to exist. Therefore, the asset cost is allocated to the
accounting periods by some method. The allocation method used should
appear reasonable to an unbiased observer and should be followed
consistently from period to period. Examples of systematic and rational
allocation of asset cost would include depreciation of fixed assets,
amortization of intangibles, and allocation of rent and insurance.
e. A cost should be treated as a loss when an unfavorable event results from an
activity other than a normal business activity. The matching of losses to
specific revenue should not be attempted because, by definition, they are
expired service potentials not related to revenue produced. That is, losses
resulting from extraneous and exogenous events that are not recurring or
anticipated as necessary in the process of producing revenue. There is no
simple way of identifying a loss, because ascertaining whether a cost should
be a loss is often a matter of judgment. The accounting distinction between an
asset, expense, loss, and prior-period adjustment is not clear-cut. For
example, an expense is usually voluntary, planned, and expected as necessary
in the generation of revenue. But a loss is a measure of the service potential
expired that is considered abnormal, unnecessary, unanticipated, and
possibly nonrecurring and is usually not taken into direct consideration in
planning the size of the revenue stream.
(AICPA Adapted)
Exercise 6-10 (15 minutes)
a. Research and development costs are expensed in the year that they are
incurred. This means R&D costs impact current income dollar for dollar. Also,
to the extent that research and development efforts lead to future revenues,
this is a violation of the matching principle in relating costs to revenues in
determining future income.
b. R&D expenditures at Frontier Biotech decreased substantially in fiscal 2006.
As a result, fiscal 2006 net income is substantially higher. However, this may
not be a good signal for future profitability. To the extent that one has
confidence in the ability of the R&D department at Frontier Biotech, future
revenues may be compromised by managements decision to curtail research
efforts.
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Chapter 06 - Analyzing Operating Activities

Exercise 6-11 (15 minutes)

a. Theoretically, presentation in the body of the statement or in the footnotes
should have no influence on the analysis of the financial statements. In
practice, however, footnote disclosures are typically insufficient. In addition,
information is more difficult to overlook when presented in the body of the
financial statements.
b. An analyst would adjust the analysis of financial statements by recasting
expenses and income computations to include the disclosed stock option
expense. In addition, the analyst would recast retained earnings to reflect the
stock option expense (net of tax).
c. Numerous ratios are affected by the accrual versus non-accrual of
compensation expense related to employee stock options. For example, all
ratios that include operating expense, net income, and equity are affected,
such as return on equity, return on net operating assets, net operating profit
margin, and operating expenses as a percent of sales.

Exercise 6-12 (40 minutes)

a. The plan will be deemed to be compensatory. This is because the stock
option plan is only offered to certain employees and the life of the option is
not short.
b. Incent.Com would offer such a lucrative plan to its employees to attract and
retain a talented work force. Human capital is a key asset in technology
companies.
c. The grant date is January 1, 2004; Vesting date is January 1, 2009; First
exercise date is January 1, 2009.
d. No, the employee stock options are not in-the-money at the grant date. This
is because at the grant date the exercise price is greater than or equal to (not
less than) the market price of the stock.
e. Total compensation cost should be measured at the date of measurement.
The date of measurement is the earliest date that the number of shares and
the stock option price is knownwhich is January 1, 2004, in this case.

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Chapter 06 - Analyzing Operating Activities

Exercise 6-12concluded
f. Total compensation cost to be recognized will depend upon the accounting
rules applied. Under APB 25, total compensation cost is $0; computed as the
intrinsic value of the options times the number of shares, or [($20$20) x
100,000 shares]. Under SFAS 123, the 81,538 options (rounded up) are
expected to vest based on the 4% forfeiture rate. Specifically, 100,000 x 4% =
4,000 options in 2000; 96,000 x 4% = 3,840 options in 2001; 92,160 x 4% =
3,686 options in 2002; 88,474 x 4% = 3,539 options in 2003; and 84,935 x 4% =
3,397 options in 2004. Consequently, $652,304 in total compensation expense
should be recognized (81,538 options x $8 fair value per option).
g. Compensation cost should be allocated over the service period, years 2004
through 2008.
h. The employee stock option plan transfers wealth from stockholders to
employees by granting potential ownership rights to employees with less than
full buy-in to acquire these ownership rights. That is, if existing ownership
were diluted via a normal issuance of shares to investors, contributed capital
received from the investors would be much greater than that received from the
exercise price of stock options.

Exercise 6-13 (15 minutes)

a. Managers often hold, or expect to hold, stock options. As a result, they will
increase their wealth when the market price of the stock increasing exceeds
the exercise price of stock options they hold. By withholding good news and
selectively releasing bad news before the date that the options exercise price
is established, the managers allegedly depress the price of the stock (at least
temporarily) until the exercise price is established.
b. In the analysis of company performance and stock valuation, silence before a
grant date might be interpreted as a sign that no significant bad news is
known by the managers (given their incentive to release bad news prior to the
date to establish an exercise price when managers hold stock options).
Moreover, an analyst might expect that good news would be withheld by
managers until after the date that the exercise price of the stock options is
established.

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Chapter 06 - Analyzing Operating Activities

Exercise 6-14 (20 minutes)

a. Some transactions affect the determination of net income for accounting
purposes in one reporting period and the computation of taxable income and
income taxes payable in a different reporting period. In accordance with the
matching principle, the appropriate income tax expense represents the
income tax consequences of revenues and expenses recognized for
accounting purposes in the current period, whether those income taxes are
paid or payable in current, future, or past periods. Accordingly, a deferred
income taxes account is setup to reflect such timing differences.
b. When depreciation expense for machinery purchased this year is reported
using the MACRS for income tax purposes and the straight-line basis for
accounting purposes, a timing difference arises. Because more depreciation
expense is reported for income tax purposes than for accounting purposes
this year, pretax accounting income is more than taxable income. The
difference creates a credit to deferred income taxes equal to the difference in
depreciation multiplied by the appropriate income tax rate.
When rent revenues received in advance this year are included in this year's
taxable income but as unearned revenues (a current liability) for accounting
purposes, a timing difference arises. Because rent revenues are reported this
year for income tax purposes but not for accounting purposes, pretax
accounting income is less than taxable income. The difference creates a debit
to deferred income taxes equal to the difference in rent revenues multiplied by
the appropriate income tax rate.
c. The income tax effect of the depreciation (timing difference) is classified on
the balance sheet as a noncurrent liability because the asset to which it is
related is noncurrent. The income tax effect of the rent revenues received in
advance (timing difference) is classified on the balance sheet as a current
asset because the liability to which it is related is current. The noncurrent
liability and the current asset should not be netted on the balance sheet
because one is current and one is noncurrent.
On the income statement, the income tax effect of the depreciation (timing
difference) and the rent revenues received in advance (timing difference)
should be netted. This amount is classified as a deferred component of
income tax expense.

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Chapter 06 - Analyzing Operating Activities

Exercise 6-15 (15 minutes)

There are at least two earnings targets that are typically relevant for managers
and investors. The first is the consensus earnings expectation of the analyst
community. The second is the earnings in the same quarter of the previous fiscal
year. (A third might be an earnings forecast previously released by management.)
Beating these targets by even a penny is typically viewed as a sign of sustained
profit growth and skilled leadership. This means that companies near these
targets will use earnings management to meet or exceed these targets, even if
only by a penny. Accordingly, earnings increases of $0.01 can be significant
when the change pushes earnings equal to or above relevant earnings targets.
Of course, a magnitude or scale issue can be relevant as well. A $0.01 change in
an earnings per share figure that is approximately $0.05 per share in total can be
quite relevant, whereas a $0.01 change for an earnings per share figure that is
approximately $10.00 per share can be substantially less relevant.

Exercise 6-16 (20 minutes)

a. The effects of dilutive stock options and warrants are not included in the
computation of the number of shares for basic earnings per share. They are,
however, included in diluted earnings per share computations.
b. The effects of dilutive convertible securities are not included in the
computation of the number of shares for basic earnings per share. They are,
however, included in diluted earnings per share computations.
c. Antidilutive securities are excluded from both basic and diluted earnings per
share.

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Chapter 06 - Analyzing Operating Activities

Exercise 6-17 (20 minutes)

a. Basic earnings per share is the amount of earnings attributable to common
shareholders (that is, net income less preferred dividends) divided by the
weighted average number of common shares outstanding for that period.
b. Diluted earnings per share is the amount of current earnings per share that
reflects the maximum dilution that would result from the conversion of all
convertible securities and the exercise of all warrants and options. The
conversion of these securities individually would decrease earnings per share
and in the aggregate would have a dilutive effect. The computation of diluted
earnings per share should be based upon the assumption that all such issued
and issuable shares are outstanding from the beginning of the period, or from
their inception if after the beginning of the period. To summarize, whereas
basic earnings per share does not reflect any securities convertible or
exercisable into common shares, diluted earnings per share includes all such
securities and considers their dilutive effect upon earnings per share, taking
into account necessary adjustments to income resulting from the conversion
process.
(CFA Adapted)

Exercise 6-18 (15 minutes)

1. b. Shares outstanding after the stock dividend are 2 million shares
outstanding entire year + 10% of 2 million shares outstanding for 9/12 of year,
OR 2 mill + .2 mill(.75) = 2,150,000 shares.
2. a (potentially dilutive securities are not considered in basic earnings per
share)
3. a (warrants are antidilutive because more shares are assumed bought back at
the average market price with the proceeds than were issued)

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Chapter 06 - Analyzing Operating Activities

PROBLEMS
Problem 6-1 (30 minutes)
The income statements of Disposo Corp. should be shown as follows
Year 8 Year 7
Sales.............................................................................
$775
$600
Costs and expenses ..................................................
(657)
(576)
Pretax income..............................................................
118
24
Tax expense.................................................................
(59)
(12)
Income from continuing operations .........................
$ 59
$ 12
Discontinued operations:
Operations (net of tax) [a].....................................
(3)
8
Disposal (net of $6 tax) [b]...................................
(6)
Net Income...................................................................

$ 50

$ 20

[a] Represents net income (loss) from operations for Year 7 and for Year 8 until
August 15.
[b] Represents:
Loss from operations August 15 to December 31.......................
$ (1)
Loss on sale of assets (after $5 tax).............................................
(5)
Total.................................................................................................
$ (6)
The $10 loss and related tax benefit of $5 would still be recorded (anticipated) at
December 31, Year 8 (the asset would be reduced by $10 to market value).

Problem 6-2 (30 minutes)

1. a
2 b (40% of revenues and costs are recognized)
3. a
4. d
5 a
6. c
7. d [($120,000/30%) + ($440,000/40%)]

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Chapter 06 - Analyzing Operating Activities

Problem 6-3 (25 minutes)

a. (1) Failing to timely record returned credit card purchases and membership
cancellations: An accounts receivable analysis would be the focal point to
identifying this problem. We would examine for either continual growth in
accounts receivable or unusual (unexplained) write-offs of receivables.
Ratios or techniques that compare cash collections to accounts receivable
also could potentially identify a problem area or fraudulent behavior.
(2) Improperly capitalizing and amortizing expenses related to attracting new
members: This behavior would be difficult to uncover. The key is to
understand the growth in reported intangible assets and deferred charges,
and to assess its reasonableness. Unusual increases should be viewed as
a potential red flag.
(3) Recording fictitious sales: One key to uncovering fictitious sales is to
monitor the joint behavior of sales and accounts receivable,
simultaneously. Increasing sales should not necessarily lead to slower
accounts receivable turnover.
Increases in the accounts receivable
turnover ratio should be investigated because this can be caused by,
among other factors, the recognition of fictitious or uncollectible sales.
b. The external auditor must conduct the audit according to generally accepted
auditing standards. The culpability of auditors in a fraud situation varies on a
case by case basis. It is often difficult to detect a fraud if key client personnel
are colluding and conspiring to cover up. However, in this case the fraud was
so widespread that auditor negligence is part of the problem. From an
economic perspective, this question will ultimately be answered via litigation.

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Chapter 06 - Analyzing Operating Activities

Problem 6-4 (45 minutes)

a. Estimation of Depreciation on Tax Returns:
Depreciation expense [162A].............................

11
$194.5

10
$184.1

9
$175.9

(ii) Depreciation timing difference [128].................

5.9

18.6

11.9

(iii) Excess depreciation (divide tax difference

by statutory tax rate [(ii)/34%].........................

17.4

54.7

35.0

Depreciation on tax return [(i)+(iii)]...................

$211.9

$238.8

$210.9

(i)

b. Identification of Amounts & Sources (combining federal, state and foreign taxes):
11
10
9
1. Earnings before income taxes [26]..........................
$667.4
$179.4 $106.5
2. Expected income tax @ 34% (confirmed by [134])....
226.9
61.0
36.2
3. Total income tax expense [27]..................................
265.9
175.0
93.4
4. Total income tax due *...............................................
230.4
171.1
161.2
5. Total income tax due and not yet paid [44].............
67.7
46.4
30.1
*Includes items [122], [123], and [124].

c. Differences between Effective Tax Rate and Statutory Rate (34%):*

11
%
10
%
Tax at statutory rate.................................$226.9 34.0
$36.2...................................................34.0
State tax (net of fed benefit).................... 20.0
3.0
3.8.........................................................3.6
Nondeductible divestitures, restructuring and unusual charges...........

101.4 56.5
[137] Nondeductible amortization of
intangibles.................................................
4.0
0.6
1.6 0.9
[138] Foreign earnings not taxed or taxed
at other than statutory rate...................... (2.0) (0.3)
2.2 1.2
[139] Other.......................................................... 16.7
2.5
2.2 1.2

51.9

48.7

1.2

1.1

0.2
0.1

0.2
0.1

$93.4

87.7

[134]
34.0
[135]
3.7
[136]

Totals..........................................................$265.6

39.8 $175.0 97.5

*Numbers are computed by multiplying EBIT [26] by applicable percent as given.

d. Campbell can probably deduct for tax purposes only cash actually spent in
Year 10 for these charges. If this is so, an estimate of cash spent is (see item
[105]):
$339.1 - $301.6 = $37.5; $37.5 / 34% = $110 million

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Chapter 06 - Analyzing Operating Activities

Problem 6-5 (45 minutes)

BIG-DEAL CONSTRUCTION CO.

a.

b.

Dam Year 1

Year 2

Year 3

Book income

1 $24,000

$ 72,000

$ 24,000

Book income

37,800

75,600

$ 12,600

Book income

15,000

45,000

75,000

$ 15,000

150,000

$124,800

$144,600

$ 87,600

$ 15,000

$396,000

Total book income

Taxable income

Taxable income

Taxable income

Year 5

126,000

$120,000
$126,000

150,000

$150,000

$396,000

$(38,400) $(135,000 )

$ 24,600

Incr. in def. tax (cr.) $12,000

$ 62,400

$ 12,300
$ 19,200

6-37

$150,000
$126,000

$124,800

Decr. in def. tax (dr.)

126,000

$120,000
$24,000

Total
$120,000

$120,000

Total taxable Inc.

Line 4 less Line 8

c.

$24,000

Year 4

$ 67,500

Chapter 06 - Analyzing Operating Activities

Problem 6-6 (45 minutes)

STEAD CORPORATION
Year 4

($ in thousands)

Year 5

Year 6

a. Income Statement
Sales................................................................

$10,000 $10,000

Expenses *......................................................
Income before tax..........................................

9,000

$10,000

9,000

$ 1,000 $ 1,000 $

10,400
(400)

Tax expense:
Current **....................................................

300

500

Deferred.....................................................

500

200

(700)

Total tax expense.......................................

500 $

500 $

(200)

Net income (loss)...........................................

500 $

500 $

(200)

* Includes unusual expense of $1,400 in Year 6.

**Taxable income (loss):
Before loss carryforward.....................................
$ (400)
$ 1,000
$ 1,000
After deducting loss carryforward......................

600

Tax due (at 50%)....................................................

300
500
Note: The timing difference regarding deferred preoperating costs is $1,400 in Year 4.
However, only $1,000 of this amount results in a reduction of Year 4 taxable income (the
remaining $400 becomes a loss carryforward and reduces taxable income in Year 5). The
tax effect (at 50 percent) of these differences is $500 in Year 4 and $200 in Year 5. The
entire timing difference reverses in Year 6.

b. Balance Sheet
Current tax payable......................................
Deferred tax payable....................................

6-38

$ 300

$ 500

500

700

Chapter 06 - Analyzing Operating Activities

Problem 6-7 (60 minutes)

Income Statement
Years

Sales.............................................. $50 $80 $120 $100

Cost of sales................................. 20
30
50 300
General and administrative......... 10

15

Net income before tax................. $20 $35

20

$200 $400
50 120

100

20

30

$50 $(300) $130 $250

8
$500 $600
200 250
40

50

$260 $300

Tax expense (refund)*

Current provision....................... 10

17.5

Refund from carryback..............

25

92.5 130
(52.5)

Tax effect of loss carryforward

65

32.5

Total tax expense......................... $10 $17.5 $25 $(52.5) $65 $125

Income before extraordinary items. 10

150

17.5

Extraordinary gain (reduction)

of taxes due to carryforward....

25 (247.5)

65
65

125

$130 $150
130

150

32.5

Net income (**).............................. $10 $17.5 $25 $(247.5) $130 $157.5 $130 $150

* Taxable income.................................... $20 $35

$50 $(300) $(65)b $185c $260 $300
Tax due at 50% rate.............................. 10
17.5
25
(52.5)a
0
92.5 130
150
a
Operating loss of $300 carried back to eliminate all taxable income for Year 1, Year 2 and Year
3 and secure refund of $52.5 for total taxes paid during those years.
b
Income for Year 5 of $130 less loss carryforward of $195.
c
Income for Year 6 of $250 less loss carryforward of $65.
** Disclosure: Tax loss carryforwards are $195 at end of Year 4 and $65 at end of Year 5.
Accounting effects [journal entries Dr. (Cr.)]:
Tax expense.....................................
10
17.5
25
(52.5)
65
125
130
150
FIT Receivable.................................
52.5
FIT Payable...................................... (10) (17.5) (25)
(92.5) (130) (150)
Extraordinary gains.........................
(65)
(32.5)

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Chapter 06 - Analyzing Operating Activities

Problem 6-8 (30 minutes)

1. c ($6,500,000 net income / 2,500,000 shares = $2.60)
2. b
Diluted EPS =

Adjusted net income

wtd. avg. of
+ wtd. avg. number
common stock
of common shares
outstanding
issuable from options
and convertibles

Since average market price of stock exceeds exercise price of options, the
options are dilutive. Using treasury stock method for options we obtain:
i. 200,000 shares $15 = $3,000,000 proceeds
ii. $3,000,000 / 20 average price = 150,000 shares purchased in open market
Thus, 50,000 additional shares would be issued.
Are the convertible bonds dilutive? No. Assuming conversion of bonds, 100,000
additional shares would be issued. The net income adjustment would be:
Interest expense related to bonds...........................
$500,000
Less taxes..................................................................
(200,000)
Increase in net income.............................................
$300,000
Consequently:
EPS = ($6,500,000+$300,000)/(2,500,000+100,000) = $2.62
Diluted EPS = $6,500,000/(2,500,000+50,000) = $2.55

Problem 6-9 (40 minutes)

a. Basic EPS Computations:
Basic EPS = $4,000,000 / 3,000,000 shares = $1.33
Diluted EPS Computations:
Since average market price of stock exceeds exercise price of options and
warrants, the options and warrants are dilutive. Using treasury stock method:
i. 1,000,000 shares $15 = $15,000,000 proceeds
ii. $15,000,000 / $20 = 750,000 shares purchased in open market
Thus, 250,000 additional shares would be issued.
Diluted EPS = $4,000,000 / 3,250,000 shares = $1.23
b. Basic EPS Computations:
Basic EPS = $3,000,000 / 3,000,000 shares = $1.00
Diluted EPS Computations:
Since average market price of stock exceeds exercise price of options and
warrants, the options and warrants are dilutive. Using treasury stock method:
i. 1,000,000 shares $15 = $15,000,000 proceeds
ii. $15,000,000 / $18 = 833,333 shares purchased in open market
Thus, 166,667 additional shares would be issued.
Diluted EPS = $3,000,000 / 3,166,667 shares = $0.95

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Chapter 06 - Analyzing Operating Activities

CASES
Case 6-1 (50 minutes)
a. Balance Sheets and Income Statements with Alternative Revenue Recognition:
Shipment

Production b

Collection

Balance Sheet
Cash .......................................................
Receivables............................................
Inventory, at cost...................................
Inventory, at market...............................
Total assets............................................

$1,670
1,800
700
-$4,170

$1,670
1,800
700
-$4,170

$1,670
1,800
-900
$4,370

$1,670
1,800
-790c
$4,260

Accrued shipping cost..........................

Accrued sales commission..................
Deferred income....................................
Invested capital......................................
Retained earnings.................................
Total liabilities and equity....................

-$ 180
-3,000
990
$4,170

-$ 180
180a
3,000
810
$4,170

-$ 180
-3,000
1,080
$4,260

Income Statement
Sales............................................$9,900
Costs and expenses:
Cost of goods sold............................
Selling expense.................................
Shipping expense..............................
Net income.............................................

$8,100 $10,800
7,700
990
220
$ 990

20
270
-3,000
1,080
$4,370

$9,900

6,300
8,400
810
1,080
180
240
$ 810 $ 1,080

7,610d
990
220
$1,080

Notes:
a. Deferred income: Sales is $1,800 less costs of ($1,400 + $180 + $40) = $180.
b. Time of production: Figures can be reflected gross as in left column or net as in right
column.
c. Inventory, at net realizable value $790 = $900 less $20 less $90.
d. Cost of goods sold is a "to-balance" figure based on inventory (for example, Beg. $0 plus
purchases $8,400 less End. $790 = COGS $7,610).

6-41

Chapter 06 - Analyzing Operating Activities

Case 6-1continued
b. The installment method delays the reporting of revenues and thereby delays
the time for payment of taxes. The time value of money is a major motivation
for delaying cash payments for taxes.
c. Balance Sheet: Some analysts prefer the installment method because it is
more conservative. However, the installment method attempts to value
receivables (less deferred income) at the historical cost of the inventory. It
would appear that the credit analyst should be future-oriented and view
receivables at the expected future cash inflow.
Income Statement: Some analysts prefer the installment method because it is
more conservative. However, this method has two critical weaknesses:
(i) Revenues and profits are not recognized when performance (earning)
occurs; instead, recognition is delayed until cash is collected.
(ii) Selling costs are mismatched (this is most dramatic in a period of rapid
growth or decline in sales).
The installment method does not show economic reality.

6-42

Chapter 06 - Analyzing Operating Activities

Case 6-2 (60 minutes)

a. Computation of earnings components as a percent of sales
Year 11 Year 10
Sales............................................................................. 100%
100%

Year 9
100%

Cost of products sold.................................................

66.0%

68.6%

70.5%

Marketing and selling expenses................................

15.4%

15.8%

14.4%

Administrative expenses............................................

4.9%

4.7%

4.4%

Research and development expenses......................

0.9%

0.9%

0.8%

Interest expense..........................................................

1.9%

1.8%

1.7%

Interest income............................................................

-0.4%

-0.3%

-0.7%

Foreign exchange losses, net....................................

0.0%

0.1%

0.3%

Other expense.............................................................

0.4%

0.2%

0.6%

Divestitures, restructuring and unusual charges....

0.0%

5.5%

6.0%

Cost of products (goods) sold has declined in each of the 3 years as a

percentage of sales. This has accounted for most of the change in pre-tax
profits as all other expense categories have remained fairly constant aside
from restructuring costs, which were not present in Year 11.
b. Sales and cost of goods sold are typically the most highly persistent, and
reductions on COGS as a percentage of sales such as we see in this example
are rare. SG&A costs are also typically highly persistent. However, the
company may be able to find ways to cut some of these through operating
efficiencies. The R&D costs are also reasonably persistent. Again, the
company can choose to increase or decrease these, but such a decision can
have severe ramifications for future profitability. Restructuring costs are
generally viewed as transitory.
c. Provision for taxes as a percent of earnings before income taxes:
Year 11 = $265.9/$667.4 = 39.8%
Year 10 = $175.0/$179.4 = 97.5%
Year 9 = $93.4/$106.5 = 87.7%
Deviations from the statutory percentage of 35% commonly arise as a result of
expenses that are recognized for financial reporting purposes that are not
deductible for tax purposes. An example is a restructuring charge that must
be recognized when incurred for financial reporting purposes, but cannot be
deducted for tax purposes until paid.

6-43

Chapter 06 - Analyzing Operating Activities

Case 6-2concluded
d. Campbell reports $339.1 million and $343.0 million in divestitures,
restructuring and unusual charges in Years 10 and 9, respectively.
Restructuring costs typically include asset write-downs and severance costs.
Asset write-downs are non-cash charges that typically relate to reduced cash
flows of those assets that likely have occurred over several prior years.
Severance costs typically relate to accruals of costs that will not be paid until
some future period.
e. Removal of costs relating to depreciable assets will reduce future
depreciation expense. A cost is, therefore, recognized in the current period
that would have been recognized in future periods, thus shifting income from
the present into the future. Similarly, severance costs include the accrual of a
liability for future costs. This liability is reduced in future periods instead of
recording an expense, thus increasing future periods profitability.

6-44

Chapter 06 - Analyzing Operating Activities

Case 6-3 (45 minutes)

1.
BREAK-DOWN OF RESTRUCTURING AND OTHER CHARGES
Charge
Classific PrePost- Utilized Balance
Description
ation
Tax
Tax
Pre-Tax Pre-Tax
Lease Commitments.............................
Restruc.

81

81

Severance/Closing Costs.....................
Restruc.

29

25

PP&E Write-Down..................................
Restruc.

155

155

Other.......................................................
Restruc.

29

24

164

130

Total Restructuring................................

294

266

Change in acctg estimate/legal

SG&A
provision.................................................

39

39

3rd party claims/FTC..............................

SG&A

20

13

20

TOTAL..............................................

353

279

184

169

Markdown-Clear Excess Inventory......

CGS

253

179

74

Markdown-Store Closedowns..............
CGS

29

27

Inventory Systems Refine/Change CGS

in estimates............................................

63

57

TOTAL..............................................

345

229

238

107

GRAND TOTAL.......................................

698

508

422

276

6-45

Chapter 06 - Analyzing Operating Activities

Case 6-3continued
2.
RECAST INCOME STATEMENT AFTER REMOVING CHARGE
1999
1998
Reported
Recast
Reported
$
%
$
%
$
%
Net Sales......................................................................
11170
100% 11170

100%

11038

100%

Cost of goods sold.....................................................

8191 73.3%

7846

70.2%

7710

69.8%

Gross Profit..................................................................
2979 26.7%

3324

29.8%

3328

30.2%

Selling, general & administrative...............................

2443 21.9%

2384

21.3%

2231

20.2%

Depreciation.................................................................
255
2.3%

255

2.3%

253

2.3%

Restructuring Charge.................................................
294
2.6%

0.0%

0.0%

Interest Expense less Income....................................

93
0.8%

93

0.8%

72

0.7%

Earnings before tax.....................................................

(106) -0.9%

592

5.3%

772

7.0%

Tax Provision...............................................................
26
0.2%

216

1.9%

282

2.6%

Earnings after tax........................................................

(132) -1.2%

376

3.4%

490

4.4%

Total Charge.................................................................

508

4.5%

EAT after charge..........................................................

(132) -1.2%

(132)

-1.2%

490

4.4%

Cost of goods sold is increasing, resulting in decreasing gross profit. Selling,

general and administrative expense and interest expense are also increasing,
resulting in a decrease in earnings before tax and a 1% drop in net profit margin
on sales.

6-46

Chapter 06 - Analyzing Operating Activities

Case 6-3continued
3.
Elements of Restructuring Plan and Expected Economic Effects
Element
Store
Closing

C3 PlanStore
Reformatti
ng etc

Consolidati on of
distribution
centers
and admin offices
Legal
Contingenc
ies
TOTAL

Description
Close 50
international and
9 Toys R Us
stores that do
not meet
strategic
profitability
objectives
Close 31 US
Kids R Us
stores and
convert 28
nearby Toys R
Us stores into
combo stores

Cost
Leases
Severance etc
PPE Write down
Markdown
Acctg change &
legal settlements
Total

Expected Economic
Effects
81 Sales reduction $ 322
29 MM, operating loss
155 saving $ 5 MM pa
29 2600 employees
terminated ($ 100-150
39 MM pa saving)
333
Closings: Eliminate
loss making
stores/focus on more
profitable opportunities
Combo Stores: Release
working capital, lower
operating costs,
increase productivity

Reformat stores,
expand product
lines
Supply chain
reengineering

Markdown
Systems Refined
Total

Consolidate
distribution
centers/warehou
ses
Consolidate 6
admin offices
FTC related 3rd
party claim

Other

29

3rd party claims

20

253
63
316

698

6-47

$ 580 (24%) reduction in

stores inventory
Enhanced customer
experience
Higher
productivity/lower
inventory/lower
cost/heightened
flexibility
Improve SG&A
efficiencies
Flatten management
and increase customer
responsiveness

Expected savings $ 97
MM pa

Chapter 06 - Analyzing Operating Activities

Case 6-3continued
4. The restructuring liability can be purposefully overstated to create a hidden
reserve. This hidden reserve can be used to manage earnings in at least
two ways. First, the company can charge some operating expenses of
future periods to the restructuring liability. Second, the company can
reverse a portion of the charge to create net income in the period of the
reversal.
In the case of Toys R Us it is unlikely that it is managing its earnings.
Using charges to manage earnings is a form of classificatory earnings
management (see Chapter 2). However, by burying various elements of the
charge in different line items the very purpose of the charge, i.e., inducing
users to ignore the entire charge is lost. Therefore it is not likely that the
purpose of the restructuring charge was earnings management.
5. The following adjustments would be made to the financial statements to
recast the restructuring charge as an investment to create future cost
savings. First, the charge is recorded as an asset and amortized over 10
years. Second, 20x8 income is increased by reversing the charge. Income
in fiscal 20x9 and the next 10 years will then be reduced by a pro-rata
amount of the investment.
6. The relative success of restructuring activities can and must be assessed.
The company should report higher return on assets and higher return on
equity. Also, the company should report substantially lower costs such as
selling and administrative costs. These costs should also decrease as a
percentage of sales.
Case 6-4 (60 minutes)
a. Basic Earnings Per Share Computations:
Basic EPS = $1,500,000 / 900,000 shares = $1.67
Diluted Earnings Per Share Computations:
The warrants are dilutive since the average market price of common stock
($13) exceeds the exercise price of the warrants ($10).
i. 900,000 shares x $10 = $9,000,000 proceeds
ii. $9,000,000 / $13 = 692,307 shares purchased in open market
Thus, 207,693 additional shares would be issued.
As if EPS = $1,500,000/(900,000+207,693) = $1.35
Are the subordinated convertible debentures dilutive? Yes. Assuming
conversion, a total of 500,000 ($9,000,000/$18) additional common shares
would be issued at June 30, Year 1. The net income adjustment would be:
Interest expense for debentures.....................
$270,000
Less taxes.........................................................
(135,000)
Increase in net income....................................
$135,000

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Chapter 06 - Analyzing Operating Activities

As if EPS = ($1,500,000+$135,000)/(900,000+250,000) = $1.42

Consequently:
Diluted EPS = ($1,500,000+$135,000)/(900,000+207,693+250,000) = $1.20
b. Interest expense (Year 2):
Debentures ($9,000,000 x 6%)............................
Term loan: ($3,000,000 x 7%)/2..........................
($2,500,000 x 7%)/2..........................
Interest expense..................................................

$540,000
105,000
87,500
$732,500

Earnings before interest and taxes (Year 2):

Net income...........................................................
Taxes (50%)..........................................................
Interest expense..................................................
Earnings before interest and taxes...................

$1,500,000
1,500,000
500,000
$3,000,000

Times interest earned = $3,500,000/$732,500 = 4.78

Case 6-5 (45 minutes)
I. a. Basic EPS = [$285,000- ($2.40 x 10,000 shares)] / 90,000 shares = $2.90
b. Diluted EPS:
Are the convertible bonds dilutive? Yes. Assuming conversion, the net
income adjustment would be:
Interest expense for debentures.....................................
Less taxes.........................................................................
Increase in net income.....................................................

$80,000
(40,000)
$40,000

As if EPS = ($285,000+$40,000)/(90,000+30,000) = $2.71

Is the convertible preferred dilutive? Yes. Assuming conversion:
As if EPS = $285,000/(90,000+20,000) = $2.59
Diluted EPS = ($285,000+$40,000)/(90,000+30,000+20,000 shares) = $2.32
II. Computation of Basic Earnings Per Share:
Weighted average shares outstanding during Year 6:
January 1............................................. 10,000 sh.
July 1.................................................... 2,000 sh.

1 yr.
1/2 yr.

Basic EPS = ($10,000 - $1,000) / 11,000 shares = $0.82

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10,000 sh.
1,000 sh.
11,000 sh.