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Unformatted text preview: Solution to Problem Set 2
P2-2. Suggested solution: (4 marks, half mark for each row)
b. Going concern
d. Benefits vs. costs
e. Accrual basis
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 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):
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.
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
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)
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
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:
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
(250,000) 0 230,000 3 of 8 2010
(250,000) 0 260,000 2011
$4,000,000 (2,700,000) (360,000) (200,000) (250,000) 0 490,000 2012
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
$4,000,000 (2,700,000) (400,000) (200,000) 2012
(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
2009 Dec 31 balance
2010 Credit sales
3,500 2011 Dec 31 balance
2012 Credit sales
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
×40% = 1,200
120 ×40% = 875
4,000 Chapter 2 100 2,800
125 2010 Dec 31 balance
2011 Credit sales
Write-offs 2012 Dec 31 balance Allowance for
×40% = 4 of 8 Conceptual frameworks c.
Annual net cash flows (2 marks, half point for each Net cash flow number, no partial
Collections Cash operating expenses Warranty expense paid Purchase of capital asset Proceeds on disposal of capital asset Net cash flow 2009
$ (750,000) 2010
$ 25,000 2011
$3,800,000 (2,700,000) (410,000) 0 $ 690,000 2012
$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):
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.
c. Type of accounting change
Change in estimate
Change in accounting policy
Correction of an error Accounting change due to
No Information known (or
should have been known) in
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
suit different circumstances, then such policy
* Comparable financial statements allow for
changes should be considered to result from
better predictions about the future.
* 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
Total current assets
Long-term loan receivable
Less: accumulated depreciation
Total non-current assets Total assets Wan Industries Limited
As at December 31, 2011
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
Long-term loan payable
Total liabilities 300,000
750,000 Shareholders’ equity
Retained earnings (see below)
Total shareholders’ equity
1,260,000 Total liabilities and equity 142,000
1,260,000 Computation of retained earnings: Chapter 2 7 of 8 Conceptual frameworks Sales revenue
Cost of goods sold
Income tax expense
Retained earnings, Jan. 1
Retained earnings, Dec. 31 Chapter 2 800,000
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.
- Winter '10