Solution to Problem Set 2 - Solution to Problem Set 2 P2-2....

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Unformatted text preview: Solution to Problem Set 2 P2-2. Suggested solution: (4 marks, half mark for each row) Qualitative Concept characteristics Assumption a. Understandability √ b. Going concern √ c. Relevance √ d. Benefits vs. costs e. Accrual basis √ f. Reliability √ g. Comparability √ h. Financial capital maintenance √ Constraint √ P2-12. Suggested solution (8 marks) Each acquisition on average is $11 million, so they are immaterial. However, materiality should be assessed on a class of transactions, so the acquisitions are material as a group. $8 billion is material relative to the market value of equity ($60b) and earnings ($5b). Materiality is defined with respect to users of the financial statements. The large negative stock price reaction is an indication that information on the acquisitions is material to investors. Information on how Tyco spends its money and what kinds of businesses it is buying is relevant to investors for predicting future cash flows. Summary disclosure of the net cash amount paid may be inadequate for investors; full disclosure of the nature of the acquisitions (e.g., line of business, price paid relative to book value) would be useful for predictions. Full disclosure may be very costly and impractical given the large number of acquisitions; management may have determined that the costs exceed the benefits of disclosure. Management may have selectively concealed information on acquisitions, disclosing information on those that may be viewed favourably and hiding the bad acquisitions. Such concealed information, if it exists, would bias the financial statements and make them unreliable. Unreliable financial statements increase the moral hazard problem by allowing management to cover up its mistakes. Market efficiency suggests that the WSJ article provided new information to investors—the information was not what they had expected. The WSJ’s revelation could indicate to investors that Tyco has been hiding bad news (adverse selection); therefore, they are now more skeptical of Tyco (it is now considered a “lemon”). Chapter 2 1 of 8 Conceptual frameworks P2-13. Suggested solution (8 marks: 4 for pros and 4 for cons): Pros: * The alternative income number Amazon is using could be more relevant for predicting future cash flows by removing items that are not recurring; e.g., restructuring charges. * Amazon provides full disclosure of the accounting policies that have been used to come up with the alternative income numbers. * Given the full disclosure, sophisticated readers can interpret these numbers and undo Amazon’s policies if they wish. * Information is provided in addition to GAAP income, so at least the GAAP number is reliable as it is audited. * The accounting method is popular in the high-tech industry so the information is comparable to those of similar firms. Cons: * The alternative numbers are less reliable because management has discretion over how “pro forma operating profit” and “pro forma net profit” are defined. * The alternative numbers are biased because they “inevitably make the numbers look a lot better”—only expenses and losses (and not gains) are being excluded. * Lower reliability increases moral hazard; management can present good results even if things don’t turn out to be so good. * Measuring income excluding certain costs provides management with the incentive to classify costs into those categories. * The income numbers could mislead naïve investors who interpret them as if they are GAAP income numbers. * Could also mislead investors if there is inadequate disclosure of how the non-GAAP income number is derived. * Comparability of non-GAAP numbers is lower because different firms could define their income measures differently. * Consistency is also lower because Amazon can change the income definitions from year to year. The non-GAAP numbers are not based on standards and are not auditable, lowering their quality (reliability, comparability, consistency). P2-19. Suggested solution (8 marks: 4 for uniformity, 4 against uniformity) For uniformity: * Increases comparability of financial reports for companies in different countries. * Decreases costs to users; they don’t need to learn many different GAAPs. * Investors need to be less sophisticated to understand financial statements of companies from different countries, thereby decreasing information asymmetry, increasing the size of the pool of potential investors. * Increased geographical diversification of investments reduces risk and lowers the cost of capital. * Resources can be focused on developing and refining one set of standards, resulting in a superior set of standards. Chapter 2 2 of 8 Conceptual frameworks Against uniformity: * Uniform standards do not imply uniform application; differing circumstances in each country lead to different interpretations of standards and different reporting outcomes. * Global accounting standards result in conflict with local laws and regulations. * Uniformity does not respect diversity of cultures, history, and legal structures. * Uniformity hinders innovation by eliminating competition. * Flaws in standards have potentially catastrophic effects around the world. * Increases systemic risk since most of the world is covered by the same set of standards. From Chapter 3 P3-10. Suggested solution: a. Annual net income with accounting policy set 1 (2 marks, half mark to each Net Income number for every year, no partial credits) Sales Operating expenses Warranty expense (9% of sales, except 2012) Bad debt expense (5% of sales, except 2012) Depreciation expense (straight line) Gain on disposal Net income Chapter 2 2009 $3,000,000 (2,100,000) (270,000) (150,000) (250,000) 0 230,000 3 of 8 2010 $3,500,000 (2,500,000) (315,000) (175,000) (250,000) 0 260,000 2011 $4,000,000 (2,700,000) (360,000) (200,000) (250,000) 0 490,000 2012 $500,000 (350,000) (170,000) (75,000) (250,000) 400,000 55,000 Conceptual frameworks b. Annual net income with accounting policy set 2 (4 marks, 1 mark for each Net income number for every year, no partial credit). Sales Operating expenses Warranty expense (10% of sales, except 2012) Bad debt expense or recovery (ADA at 40% of gross A/R—see below) Depreciation expense (50% declining balance) Gain on disposal Net income (loss) 2009 $3,000,000 (2,100,000) (300,000) (220,000) 2010 $3,500,000 (2,500,000) (350,000) (355,000) 2011 $4,000,000 (2,700,000) (400,000) (200,000) 2012 $500,000 (350,000) (65,000) (175,000) (500,000) 0 (120,000) (250,000) 0 45,000 (125,000) 0 575,000 (62,500) 337,500 535,000 Derivation of bad debt expense (BDE) for each year: 2009 Jan 1 balance 2009 Credit sales Collections Write-offs 2009 Dec 31 balance 2010 Credit sales Collections Write-offs 300 3,500 2011 Dec 31 balance 2012 Credit sales Collections Write-offs 875 500 BDE (plug) Required balance 355 350 BDE (plug) Required balance 200 350 BDE (plug) Required balance 0 BDE (plug) Required balance 125 ×40% = 3,800 200 200 ×40% = 1,200 175 0 220 120 ×40% = 875 4,000 Chapter 2 100 2,800 125 2010 Dec 31 balance 2011 Credit sales Collections Write-offs 2012 Dec 31 balance Allowance for doubtful accounts (ADA) Accounts receivable 0 3,000 2,600 100 175 175 ×40% = 4 of 8 Conceptual frameworks c. Annual net cash flows (2 marks, half point for each Net cash flow number, no partial credit). Collections Cash operating expenses Warranty expense paid Purchase of capital asset Proceeds on disposal of capital asset Net cash flow 2009 $2,600,000 (2,100,000) (250,000) (1,000,000) 0 $ (750,000) 2010 $2,800,000 (2,500,000) (275,000) 0 $ 25,000 2011 $3,800,000 (2,700,000) (410,000) 0 $ 690,000 2012 $1,200,000 (350,000) (180,000) 400,000 $1,070,000 d. (3 marks) Sum of income over four years using accounting policy set 1: $1,035,000 Sum of income over four years using accounting policy set 2: $1,035,000 Sum of net cash flows over four years: $1,035,000 These sums show that, from a company’s beginning to its end (cradle to grave), the sum of net income and cash flows must be equal. e. (1 mark) The differences in net incomes for the two scenarios is the result of using different methods of accruing (or allocating, calculating) warranty, bad debt, and depreciation expense. f. (2 marks) The net income for 2012 is significantly higher using accounting policy set 2 than set 1 $535,000 versus $55,000). This is due to the fact that the first set of accounting policies recorded much lower expenses in the earlier years, which means in later years and when the firm was wound up this understatement of expenses must be reversed such that the total of all the years for any type of expense is the same. For example, total bad debt expense must equal the actual accounts written off (of $600,000), total warranty expense must equal warranties paid (of $1115,000), and the sum of depreciation expense and gain on disposal together must equal the difference in the cost of the computer and final proceeds on disposal (of $600,000). P3-13. Suggested solution (6 marks, 1 mark for each item): a. No adjustment is required as the fire does not change any estimates or assumptions used in valuing year-end amounts. This event should be disclosed in the notes to the financial statements and the amount of the loss quantified; but not recorded, only described in the notes. Mention should be made of the effect of the fire on the following year’s earnings. Disclosure is required as all the relevant information is known and the event is significant to the future operations of the company. b. If the new technology comes out before Dec. 31st, then an adjustment is required as the market price is lower than cost, and inventory should be valued at the lower of cost and market. The firm only need to disclose in the footnote, however, if the new technology comes out after Dec. 31st. Chapter 2 5 of 8 Conceptual frameworks c. New competition requires neither recognition nor disclosure. The event does not relate to conditions at or prior to the year-end for recognition. The event is neither specific nor unusual in nature to warrant disclosure. d. Due to the new technology, you should review the assumptions for useful life, salvage value, and depreciation methods and change the assumptions that are no longer appropriate based on this new information. The depreciation expense for the current year should reflect these new estimates. This is required as this information clarifies estimates used at the year-end for calculating depreciation expense. e. For the bankruptcy of a client, recognize the reduction in the carrying value of the accounts receivable by 70% and make the necessary adjustment. This is required as this new information relates to the measurement of receivables recognized at the year-end. f. No adjustment and no disclosure; labour strikes are just an unfortunate aspect of normal business operations. However, if the strike threatens the survival of the company it should be disclosed, as this would put into question the validity of the going-concern assumption. P3-16. Suggested solution (3 marks, half mark for each cell): a. b. c. Type of accounting change Change in estimate Change in accounting policy Correction of an error Accounting change due to management choice? No Yes No Information known (or should have been known) in prior period? No n/a Yes P3-19. Suggested solution (8 marks: 4 for prospective treatment, 4 for retrospective treatment) For prospective treatment For retrospective treatment (GAAP) * If accounting policy alternatives are * Ensures comparability (consistency) among available because different alternatives best reporting periods. suit different circumstances, then such policy * Comparable financial statements allow for changes should be considered to result from better predictions about the future. changed circumstances. * Retrospective treatment provides more * Changing circumstances cannot be relevant information because the impact of the predicted with accuracy, so retrospective accounting change on several periods is not treatment would inappropriately assume a artificially included in one reporting period. certain amount of clairvoyance (the ability to * Retrospective treatment prevents see the future). management from making accounting policy * Retrospective treatment is not changes that temporarily and superficially representationally faithful for the prior periods improve the appearance of current-year results because the new accounting policy was not the due to one-time changes in accounting policy. alternative chosen in those prior periods. * Reduction in earnings management * Retrospective treatment allows management opportunities increases earnings quality and to change past reported numbers, which erodes users’ confidence in financial reports. readers’ confidence in the reliability of Chapter 2 6 of 8 Conceptual frameworks financial statements. * Retrospective treatment allows management to spread out the effect of accounting policy changes rather than show the full effect in the year of change, potentially increasing chances for earnings management. P3-26. Suggested solution (5 marks: 1 mark each for total current assets, total non-current assets, total current liabilities, total liabilities, and total shareholders’ equity): Current assets Cash Accounts receivable Inventory Stationery Prepaid rent Total current assets Non-current assets Long-term loan receivable Equipment Less: accumulated depreciation Total non-current assets Total assets Wan Industries Limited Balance Sheet As at December 31, 2011 Current liabilities 334,000 Accounts payable 95,000 Interest payable 51,000 Wages payable 5,000 Unearned revenue 25,000 Current portion of LT debt 510,000 Total current liabilities Non-current liabilities Long-term loan payable Total liabilities 300,000 500,000 (50,000) 750,000 Shareholders’ equity Common stock Retained earnings (see below) Total shareholders’ equity 1,260,000 Total liabilities and equity 142,000 10,000 15,000 23,000 40,000 230,000 360,000 590,000 200,000 470,000 670,000 1,260,000 Computation of retained earnings: Chapter 2 7 of 8 Conceptual frameworks Sales revenue Cost of goods sold Advertising expense Depreciation expense Income tax expense Interest expense Rent expense Stationery expense Wages expense Net income Less dividends Retained earnings, Jan. 1 Retained earnings, Dec. 31 Chapter 2 800,000 (410,000) (16,000) (12,000) (35,000) (41,000) (75,000) (14,000) (91,000) 106,000 (21,000) 385,000 470,000 8 of 8 Conceptual frameworks ...
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This note was uploaded on 02/21/2011 for the course COMM 353 taught by Professor Jennyzhang during the Winter '10 term at The University of British Columbia.

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