Supplymentary Chapter 3 - Solutions to Supplementary...

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Unformatted text preview: Solutions to Supplementary problems—Chapter3 P3-1. Suggested solution: a. b. c. d. e. f. g. Factor Improved technological capability (computers, Internet) A diffuse investor base comprising many people Increased pace of business transactions Invention of the printing press Establishment of regulators such as the Ontario Securities Commission Creation of indefinite-life entities such as corporations Establishment of professional accounting organizations Significant contributor Not a significant contributor √ √ √ √ √ √ √ P3-2. Suggested solution: Significant contributor Not a significant contributor √ Factor Establishment of accounting standard setters such as the International Accounting Standards Board b. Invention of the double-entry system of bookkeeping √ c. Creation of indefinite-life entities such as corporations √ d. Development of credit cards and other substitutes for cash √ e. Preparation of periodic financial reports √ f. Incomplete transactions at reporting dates √ g. The going-concern assumption √ h. Accounting standards such as IFRS require accrual √* accounting i. Financial reports using accrual accounting are simpler to √ understand compared with those prepared using cash accounting *For (h), accounting standards arguably are a contributing factor. However, accounting standards regarding the use of accrual accounting are only formalizations of practices that derive from the demand for accrual accounting. Indeed, we observe the use of accrual accounting for entities that do not need to follow IFRS or other formal accounting standards. a. P3-3. Suggested solution: The easy answer is that regulations (accounting standards, stock exchange requirements, etc.) require companies to do so. However, this answer does not address the question of why regulations have this requirement. Both business and regulations respond to market demands. Investors and creditors ofpublicly accountable enterprises are numerous and have needs for information at different times for their investing and lending decisions. It would be impractical Chapter 3 1 of 14 Accrual accounting for enterprises to provide financial statements according to when each of these investors/creditors requires the information. Therefore, companies provide the information on fixed schedules annually or quarterly. P3-4. Suggested solution: Accrual accounting numbers can be a better predictor of future cash flows because they smooth out and reallocate cash flows to periods that better reflect the long-term average cash flow of the enterprise. For example, an equipment purchase results in a large cash outflow but benefits the company over many years, so allocating the cost of purchase over those years makes each year more representative of the cash flow expected in a typical year. P3-5. Suggested solution: * While it is true that the calculation of net present value (NPV) involves discounting cash flows, this does not imply that accrual accounting numbers are not useful. * It is important to recognize that capital budgeting and other applications of NPV always involve the future, and the future is always uncertain. * The difficult part of an NPV exercise is not the computation of discounted values, but forecasting future cash flows accurately. * Accounting numbers can help forecast those future cash flows because accrual accounting reflects the results of both complete and incomplete transactions. * Accrual accounting numbers also smooth out irregularities in cash flows such as large purchases of property, plant, and equipment that produce benefits over many years. * Thus, while accruals are not cash flows, they provide information that is useful for the prediction of future cash flows. P3-6. Suggested solution: a. When PPE are acquired, the business and finance assumption is that these assets will be used for a number of years to directly or indirectly generate earnings. PPE will create productive capacity that will allow the firm to operate in the future and produce revenues or reduce costs, with the overall consequence of increasing net income and net cash flows. As PPE are held for use, not for resale, they can be recorded on the balance sheet at their depreciated net book value. The goal of recording PPE in this manner is to match the recognition of the cost of the asset to expense with the period when the benefit of the asset is realized. As PPE are expected to last for several years for the future service potential of the asset to be realized, it is essential that the firm continue to exist into the foreseeable future (i.e., continue to be a going concern) for this allocation process to resolve itself. Restated, if a piece of PPE is to be depreciated over a 10-year useful life, we are assuming that the firm will continue to operate for those 10 years for the depreciation allocation process to fully expense the cost of the asset. b. If the going-concern assumption is no longer valid (and the firm is going into bankruptcy), then assets should be valued at their exit value. This usually will be their net realizable value, which will likely result in a major reduction in the carrying value of the asset on the balance sheet and a large loss recorded on the income statement. Chapter 3 2 of 14 Accrual accounting c. Depreciation expense for 2010 and 2011 = $900,000 per year ($10,000,000 – 1,000,000)/10). The depreciation for 2012 will not be the same because the firm will not continue to operate, so the asset should be valued at its net realizable value. The value of the machine on the balance sheet on December 31, 2012: $5,500,000. The downward adjustment to the carrying value of the machine in 2012: $2,700,000 (= 10,000,000 – 2 × 900,000 – 5,500,000). Technically, as will be seen in Chapter 10, this amount would be separated into two components. The first is the normal amount of depreciation that would have been recorded were the going concern assumption were valid (i.e., $900,000). The remaining $1,800,000 is an additional expense or loss due to the need to write down the machine’s value to net realizable value. d. Prepaid rent should be reported at the unexpired value of the rent of $100,000. If the company were not a going concern, it should value this amount at its net realizable value—the amount it could recover if it were to ask for a refund from the landlord— which is likely to be $0. If the premises could be sub-leased to another tenant, then the prepaid rent could be reported at the value obtainable from the sub-lease. e. When a company goes into bankruptcy, inventories should be valued at net realizable value, such as the amount that would be received if it were sold in an auction. Such forced liquidation would likely be less than the FIFO or average-cost values. P3-7. Suggested solution: Item a. Accounts receivable b. Inventories c. Equipment d. e. f. Warranty liability Sales revenue Revenue from long-term contract g. Cost of goods sold Estimates required Customer default rate; speed of collection Costs of items sold/held; prices of inventory items Useful lives; pattern of benefits obtained; residual values at end of useful lives Rate of defect; cost to repair or to replace product Customer default rate; speed of collection Profitability of contract; degree of progress fulfilling contract Costs of each item sold/held P3-8. Suggested solution: a. Quality of earnings refers to how closely reported earnings correspond to earnings that would be reported in the absence of management bias. b. The practice of assessing earnings quality by comparing earnings and cash flows has some merit but is imperfect. The difference between earnings and cash flows generally can be referred to as accruals. These accruals reflect economic circumstances, accounting standards, professional judgment, ethics (the unbiased portion), as well as management bias Chapter 3 3 of 14 Accrual accounting resulting from contractual incentives and managerial opportunism. To the extent accruals reflect management bias, comparing earnings and cash flows helps to uncover that bias. On the other hand, management bias comprises only one component of the accruals; the other component is an unbiased reflection of economic circumstances. The fundamental idea/assumption underlying accrual accounting is that accrual numbers are more useful/meaningful compared to cash basis accounting. Using the difference between accrual numbers and cash flows to assess the quality of earnings in effect says that cash flows are more useful, and accruals made by accountants/management confuse the picture rather than make the numbers more meaningful. If this were true, only the cash flow statement is meaningful, while the balance sheet and income statement would be useless. However, this is inconsistent with the observed demand for information in the balance sheet and income statement. P3-9. Suggested solution: a. ($ 000’s) Cash flow statement Operations Inflow from sale of goods Outflow for operating costs Cash flow from operations Cash flow from investing activities Cash flow from financing activities Net cash flow for the year Cash at beginning of year Cash at end of year Chapter 3 Year 1 $ 5 (3) 2 (15) 20 7 0 $ 7 4 of 14 Year 2 $ 5 (2) 3 0 0 3 7 $10 Year 3 $10 (1) 9 0 0 9 10 $19 Year 4 $10 (1) 9 7 0 16 19 $35 4‐year Total $30 (7) 23 (8) 20 35 0 $35 Accrual accounting ($ millions) Statement of income and retained earnings Revenue ($5m/arrival) Operating expenses ($1m/departure) Depreciation ($0.5m/arrival) Loss on ships Write‐off of prepaid expenses Net income (loss) Retained earnings at beginning of year Retained earnings at end of year Balance sheet Cash Prepaid expenses Ships at cost Less: accumulated depreciation Total assets Year 1 Year 2 $5.0 (1.0) (0.5) 0.0 0.0 3.5 0.0 $3.5 $7.0 2.0 15.0 (0.5) 23.5 $5.0 (1.0) (0.5) (4.5) (1.0) (2.0) 3.5 $1.5 $10.0 2.0 10.0 (0.5) 21.5 Contributed capital Retained earnings Total equity $20.0 3.5 $23.5 $20.0 1.5 $21.5 Year 4 4‐year Total $10.0 (2.0) (1.0) 0.0 0.0 7.0 1.5 $ 8.5 $19.0 1.0 10.0 (1.5) $28.5 $10.0 (2.0) (1.0) (0.5) 0.0 6.5 8.5 $15.0 $35 0 0 0 $ 0 $30 (6) (3) (5) (1) 15 0 $15 $35 0 0 0 $ 0 $20.0 8.5 $28.5 $20 15 $35 $20 15 $35 Year 3 b. We observe that the total cash flows for operating activities ($23 million) and investing activities (–$8 million) combine to result in $15 million, which equals the amount of net income of $15 million over the four years. In addition, just prior to dissolution of the company, we observe that the amount of cash equals the balance in owners’ equity, at $35 million. Of this amount, $15 million is return on capital (i.e., retained earnings), while $20 million is return of capital supplied by the investors. P3-11. Suggested solution: a. Net Income B would likely result in the highest share price as it shows a continuous pattern of improving/growing earnings. Users are likely to extrapolate this growth pattern into the future as earnings growth is an important component in the valuation of a share, with higher growth expectation resulting in higher share prices. Net Income C would likely have the lowest share price as there is a declining pattern of earnings. Net Income D might be the lowest, as the high variability of earnings (volatility) would suggest that the firm is very risky and predicting net income will be highly uncertain. Higher degrees of risk should result in lower share prices. Chapter 3 5 of 14 Accrual accounting b. Net Income B would likely give you the highest aggregate bonus, as each year’s earnings are growing and the growth rate is increasing from 14% (3/22) in 2006 to 18% (6/34) in 2009. Clearly, you appear to be doing something right! If bonuses were based on earnings, the absolute and relative growth in net income would have direct bearing on your bonus as president. c. As sole owner and chief executive officer, I am less concerned with what others think about my company’s performance and more interested in its true economic performance. Whereas Net Income A is the least interesting sequence, it likely captures the true condition of the company—it shows that the firm is stable, neither growing nor declining in profitability for the past five years. I may not like this summary, but it is likely the most faithful representation of the company’s underlying condition. As owner/manager I would also be interested in reducing or delaying the income taxes I pay. Net Income B would likely do that, but it presents a distorted view of the company’s achievement that may cause lower-level managers to make the wrong decisions. d. Accounting does not change what actually occurs, but it does change what people may believe occurred. In particular, accounting does not change cash flows (except income tax and bonus payments), but different accrual policies will change reported net income. The way financial accounting derives net income will influence what people think happened in the past and present and therefore influence what users believe the future will be. This is because users of financial statements use past and present achievement to predict future achievements. P3-12. Suggested solution: Pros of GAAP accrual accounting in government: * Information becomes more relevant to users (taxpayers) for evaluating the use of tax dollars. * Provides better information on financial position—more complete reporting of assets and liabilities. * Budget balance not adversely affected by large capital investments. * Increases government’s willingness to invest in projects that have long-term benefits, such as infrastructure. * Decreases incentives to sell assets just to get cash flow even if it is a bad deal. * Therefore, accrual number will better measure performance than will cash surplus/deficit. * Politicians are agents of the citizens in that taxpayers have entrusted the money to them. * Having a better performance measure reduces agency problems (politicians being the agents managing taxpayers’ money). Cons: * Accrual accounting uses more judgments. * Politicians will have more latitude to affect reported numbers. * Therefore, the numbers will be less reliable. * Accrual numbers may be more difficult to understand for the average citizen. * It will be more difficult to evaluate the government’s performance if the numbers are more subjectively determined. Chapter 3 6 of 14 Accrual accounting * Skeptics claim that some government spending programs (e.g., “make-work” projects) do not have much future benefit and therefore would not qualify as assets. P3-14. Suggested solution: a. Derivation of net income for the two sets of accounting policies: Accounting policy set A 2009 2010 Sales $11,000,000 $12,000,000 Cost of goods sold (FIFO) (3,000,000) (3,200,000) Bad debts expense (6% of sales) (660,000) (720,000) Warranty expense (4% of sales) (440,000) (480,000) Depreciation expense (1,000,000) (1,000,000) Other operating expenses (3,000,000) (3,300,000) Net income $2,900,000 $3,300,000 Accounting policy set B Sales Cost of goods sold (average cost) Bad debt expense (allowance at 10% of gross A/R – see below) Warranty expense (aged analysis) Depreciation expense Other operating expenses Net income Chapter 3 2011 $12,800,000 (3,500,000) (768,000) (512,000) (1,000,000) (3,900,000) $3,120,000 2009 $11,000,000 (3,200,000) 2010 $12,000,000 (3,300,000) 2011 $12,800,000 (3,200,000) (740,000) (735,000) (673,000) (450,000) (1,000,000) (3,000,000) (490,000) (1,000,000) (3,300,000) (492,000) (1,000,000) (3,900,000) $2,610,000 $3,175,000 $3,535,000 7 of 14 Accrual accounting Derivation of bad debt expense (BDE) for Accounting policy set B ($000’s): Allowance for Accounts doubtful accounts receivable (ADA) 2009 Jan 1 balance 0 2009 Credit sales 11,000 Collections 9,000 Write-offs 600 600 740 2009 Dec 31 balance 1,400 ×10% = 140 2010 Credit sales 12,000 Collections 10,500 Write-offs 650 650 735 2010 Dec 31 balance 2,250 ×10% = 225 2011 Credit sales 12,800 Collections 13,270 Write-offs 800 800 673 2011 Dec 31 balance 980 ×10% = 98 BDE (plug) Required balance BDE (plug) Required balance BDE (plug) Required balance b. By coincidence, cumulative net income for the three years is the same for both situations ($9,320,000). As a result, retained earnings will be equivalent between the two methods. c. Cumulative operating cash flows for the three years: Total collections – purchases – warranties paid – other operating expenses: $9,108,000. This amount is the same for both set of policies because the balance sheet accounts for the affected accounts are the same at the end of 2011. If the relevant balance sheet accounts are the same, all timing differences between different accrual/allocation methods havecancelled out. (This problem was designed to show identical total net income for the three years.) d. Net incomes are different between methods for each of the three years due to the timing of when certain amounts were expensed. As the cumulative net incomes for the three years happen to be the same, it is just a matter of when the warranty and bad debt expenses were accrued. As accruals try to estimate actual expenditures or events that occur later, the aggregate effects over multiple periods eventually net or wash out. Accrual or allocation methods are ways of estimating amounts that will only be clarified later when confirming events occur (warranty actually paid) or fail to occur (account receivable actually written off due to non-payment). Accruals are essential as accounting seeks to implement the matching principle, whereby expenses are matched with revenues recognized to determine net income for a period. Chapter 3 8 of 14 Accrual accounting P3-15. Suggested solution: Type of accounting change a. Change in estimate b. Change in accounting policy c. Correction of an error P3-17. Suggested solution: Type of Situation change a. Furniture Change in maker bad estimate debts b. Manufacturer Change in credit losses estimate c. Parking service bad debts d. Shipbuilder revenue recognition e. Electronics retailer warranties Clothing company inventory f. Accounting treatment Prospective Retrospective with restatement Retrospective with restatement Treatment Prospective Discussion (not part of required) Due to new information Prospective Due to new information (that credit losses are becoming material). Could also be a change in accounting policy and treat retrospectively to maintain comparability from year to year. Not due to new information, but just a choice by management Change in accounting policy Change in estimate Retrospective with restatement of prior periods Prospective Change in estimate Prospective Change in accounting policy or correction of error Retrospective but likely unable to restate prior periods This is a change in circumstance, which is a change in estimate. It is due to new information. This is a change in accounting that reflects a change in business policy, not a change in accounting policy. Due to new information (enactment of new law) Not due to new information. Retrospective treatment would be ideal, but information on net realizable values for prior years is unlikely to be obtainable. P3-18. Suggested solution: A change in accounting policy is a change that is due to management choice rather than the arrival of new information. Accounting standards require such changes in policy choice to be reflected retrospectively such that the financial statements in different periods are prepared with the same accounting policies. This requirement enhances the comparability (consistency) or financial statements from one period to another. In contrast, changes in estimates reflect new information, and the arrival of new information is not a choice made by management. Fundamentally, accrual accounting requires making estimates using available information, and we accept that these estimates will be imperfect due to Chapter 3 9 of 14 Accrual accounting uncertainty. Consequently, new information leads us to update these estimates going forward but do not result in changes to estimates made in the past. P3-20. Suggested solution: Effects in year prior to change a. b. c. Type of accounting change Change in estimate Correction of error Change in accounting policy Treatment Prospective Retrospective Retrospective Assets or liabilities — ↑$8,000 asset ↓$3,000 assets Equity — Income — ↑$8,000 ↑$8,000 ↓$3,000 ↓$3,000 Effects in year of change Assets or liabilities Equity Income ↓$5,000 ↓$5,000 ↓$5,000 assets no effect no effect ↓$8,000 ↓$7,000 assets ↓$7,000 ↓$4,000 P3-21. Suggested solution: a. Each of the six issues should be addressed as follows: i. Long-Term Contracts: This is a clear change in accounting policy where the new policy is deemed to be more appropriate, so it should be retrospectively applied. ii. Accounts Receivable: This is not an error, but rather a change in estimate due to new information. As the bankruptcy occurred after the subsequent-events period (i.e., after completion of the audit), no adjustment to the 2009 financial statements is permitted. iii. Machine Depreciation: This is a change in estimate of the useful life of the machine. This new information should be applied prospectively to the 2010 and subsequent depreciation charges. The depreciation expense for 2009 should remain and reduce the carrying value of the machine accordingly for 2010. The remaining useful life of the machine should be changed from 9 to 14 years (15 years total – 1 year elapsed) as at January 1, 2010. iv. Building Depreciation: The new deprecation method should be treated prospectively as the new method is judged to be a more appropriate reflection of the consumption of benefits than the prior method. v. Inventories: This is an error correction as lower of cost and net realizable value should have been used in 2009. The 2009 income statement should be adjusted accordingly. The 2010 inventory should be valued using this allowance. vi. Warranties: This is an error as warranties should be accrued and matched with the revenue recognized in that period. The 2009 and 2010 income statements should reflect the warranty accrual and related change in expense. Chapter 3 10 of 14 Accrual accounting b. The amended statements of comprehensive income: 2009 as 2009 as 2010 as originally amended originally presented (answer) presented Long‐term contract income $3,000,000 $4,200,000 $4,000,000 Other income (loss) (800,000) (800,000) (900,000) Bad debt expense (400,000) (400,000) (500,000) Depreciation expense—machine (500,000) (500,000) (500,000) Depreciation expense—building (300,000) (300,000) (270,000) Inventory write‐down 0 (200,000) 0 4 Warranty expense (200,000) (350,000) (320,000) Income before taxes 800,000 1,650,000 1,510,000 Income taxes (at 30%) (240,000) (495,000) (453,000) Net income $560,000 $1,155,000 $1,057,000 2010 as amended (answer) $3,700,000 (900,000) (500,000) (321,429) 1 (142,105) 2 (100,000) 3 (445,000) 5 1,291,466 (387,440) $904,026 1 (5,000,000 – 500,000) / (15 – 1) = 321,429 (3,000,000 – 300,000) / (20 – 1) = 142,105 3 (300,000 – 200,000) = 100,000 4 200,000 + 150,000 = 350,000 5 320,000 – 150,000 + 275,000 = 445,000 2 P3-22. Suggested solution: a. b. c. d. e. f. g. h. Criteria The asset is expected to be sold in the entity’s normal operating cycle. The asset is traded in an active market. The asset is expected to be realized within 12 months after the balance sheet date. The asset is held primarily for the purpose of being traded. The asset is expected to be consumed in the entity’s normal operating cycle. The asset is an item of inventory. The asset is cash or cash equivalent. The asset is a receivable from another company. Chapter 3 11 of 14 Relevant for classification as current? (Yes/No) Yes No Yes Yes Yes No Yes No Accrual accounting P3-23. Suggested solution: a. b. c. d. e. f. g. Relevant for classification as current? (Yes/No) Yes Criteria The liability is expected to be settled in the entity’s normal operating cycle. The liability requires settlement in cash. The liability is expected to be realized within 12 months after the balance sheet date. The liability is held primarily for the purpose of being traded. The entity does not have an unconditional right to defer settlement of the liability for at least 12 months after the balance sheet date. The liability is a line of credit owing to a financial institution. The liability is unavoidable. No Yes Yes Yes No No P3-24. Suggested solution: a. b. c. d. e. f. g. h. i. Required? (Yes/No) Yes Yes No No Yes No Yes Yes Yes Line item Revenue Profit or loss (net income) Cost of goods sold General and administrative expenses Comprehensive income Labour costs Income tax expense Other comprehensive income Finance costs (interest expense) P3-25. Suggested solution: Type of operating expense a. Cost of goods sold b. Delivery c. Employee wages and benefits d. Administration e. Building depreciation f. Utilities (electricity, heating, etc.) g. Marketing and advertising h. Sales commissions i. Raw materials consumed j. Insurance Nature √ √ √ √ √ Function √ √ √ √ √ “Nature” refers to the source of the expense, whereas “function” refers to the use. For example, employees are the source of wage costs, so employee wages is according to nature. Some of Chapter 3 12 of 14 Accrual accounting these wages go toward the production of goods that are later sold, so cost of goods sold is according to use. P3-27. Suggested solution: Assets Liabilities Common Stock Retained Earnings Liabilities + Equity Opening Retained Earnings + Net Income (Loss) – Dividends Closing Retained Earnings Company A $500 350 20 130 $500 $100 70 (40) 130 Company B $800 425 175 200 $800 $140 70 (10) 200 Company C $1,500 1,100 125 275 $1,500 $200 160 (85) $275 Company D $2,500 1,800 100 600 $2,500 $500 160 (60) $600 Company E $4,000 2,800 500 700 $4,000 $750 (40) (10) $700 P3-28. Suggested solution: a. * Asset valuation is a process of determining the amount of benefit to carry forward to future periods. Therefore, uncertainty is inherent in the process. * The balance sheet embodies the most fundamental elements of the financial statements, from which the elements of the income statement derive. * Asset valuation involves capital maintenance concepts that enter into the computation of income. * Examples: – Historical cost implies revenue recognition and expense matching on a transactional basis (i.e., only when transactions occur). – Making general price-level adjustments also implies revenue and expense recognition on a transactional basis, but with adjustments for overall price level changes. – Using current values to measure the value of assets disregards transactional data in favour of prevailing market price data. – Stating assets at their present value implies revenue recognition as time elapses, not at the dates of transactions. b. * Revenue involves increases in economic benefits during an accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants, and arising from ordinary activities. * Thus, recognition of revenue impacts the balance sheet by way of increments to assets, decrements to liabilities. * Examples: Chapter 3 13 of 14 Accrual accounting – Recognizing revenue on a transactional basis only results in balance sheet amounts that do not reflect changes in prices and market values. c. * The uncertainty of future benefits associated with research activities has resulted in the rejection of recording research costs as an asset, which also implies recognition of an expense. This expense does not match the revenues that could be generated in the future from the research efforts. P3-29. Suggested solution: The following are some of the articulation and reasonability tests that could be used. This is not an exhaustive list. First Articulation Test: Do the retained earnings add up? If one takes opening retained earnings plus net income less dividends, does this equal closing retained earnings? Second Articulation Test: Is the cash position correct? If a statement of cash flows has been prepared, does it reconcile the change in cash? If there is no statement of cash flows, does the cash position seem reasonable given the investment and financing activities of the company? Third Articulation Test: Does the depreciation expense on the income statement agree with the change in accumulated depreciation on the balance sheet? (Note that this articulation test works if there are no planned disposals of property, plant, and equipment in the forecast period. First Reasonableness Test: Does the change in total assets support the change in revenue? If revenues grow significantly, does the balance sheet expand in approximately the same percentage? Second Reasonableness Test: Are the return on equity and return on assets reasonable percentages? Returns on equity or assets of more than 20% are suspicious if there is competition that prevents enormous returns. Third Reasonableness Test: Do the balances of inventory and accounts receivable appear reasonable given the changes in revenue and cost of goods sold? Are the accounts receivable and inventory turnover ratios reasonable given the seasonality of the industry? Fourth Reasonableness Test: If there were major investments in new property, plant, and equipment, do the changes in financing (long-term debt and share balances) appear reasonable? Chapter 3 14 of 14 Accrual accounting ...
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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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