ACC500 ... Shannon, Donald S.

FFINANCIAL ACCOUNTING

AUTHORS' COMMENTS SOME UPDATING IS REQUIRED

The authors of your text, Financial Accounting: 7th Ed, have provided these comments on the DISCUSSION topics. The topics are arranged as in the same sequence as they appear in your class lecture notes.

 

[CH 3&4, Topic 3] SD 1-3: FOOTE, CONE & BELDING

Assets are economic resources owned by a business that are expected to benefit future operations. The people in an organization are not assets of the business because they are not owned by the business. Businesses pay their employees on a periodic basis (hourly, weekly, monthly); they do not buy employees. Salaries, wages, and other costs associated with employment are considered expenses and appear on the income statement.

Foote, Cone & Belding considers its personnel to be its principal asset because of the costs of hiring, training, motivating, and compensating quality employees who will benefit future operations. Advertising agencies depend on their ability to develop and keep creative and motivated individuals. And their success here depends on the opportunities and compensation they provide.

 

[CH 3&4, Topic 12] SD 2-1: NIKE

According to our "Summary of Significant Accounting Policies," "Property, plant, and equipment are recorded at cost." The reason for this policy is that generally accepted accounting principles state that all transactions are recorded at either their cost or their exchange price at the point of recognition. This cost principle applies to the purchase of property, plant, and equipment. It is generally not the purpose of accounting to record changes in "value" that occur after an asset is purchased. Thus Nike's policy agrees with accepted accounting practice.

 

[CH 5, Topic 2] SD 3-2: LYRIC OPERA OF CHICAGO

Deferred production and other costs result from expenditures for scenery, costumes, and stage properties that are specifically related to future productions. These costs are recorded as assets in the year in which the expenditures are made and should be expensed through an adjusting entry in the year in which the production is shown. Deferred revenue from ticket sales relates to ticket sales for the following opera season; deferred revenue from contributions represents contributions received in the current year that are intended by the donors to support the following year's productions. Both of these amounts are taken into revenue through an adjusting entry in the year in which the production is put on. These accounting policies apply accrual accounting and the matching rule to the preparation of financial statements, enabling Lyric Opera's management to assess the financial success of each year's operations and to make year-to-year comparisons of operating results.

 

[CH 5, Topic 9] FRA 3-3: TAKASHIMAYA COMPANY

Gift Certificates is a liability account: Takashimaya is obligated to exchange merchandise for the certificates when they are presented by the holders.

The account arises when a person pays cash to Takashimaya for a certificate that can later be exchanged for merchandise. The entry is a debit to Cash and a credit to Gift Certificates.

This is an application of accrual accounting. Under accrual accounting, it is not appropriate to credit a revenue account at this point because the payment in cash, in effect, is payment in advance. The actual sale will take place when the certificate is redeemed. When that happens, Gift Certificates is debited and Sales Revenue is credited. (Moreover, the cost of the item for which the gift certificate is redeemed is also recognized in the accounting period in which the certificate is redeemed.)

To make adjusting entries, the accountant must address the accounting period issue ( assigning revenues and expenses to a short period of time), the continuity issue (assuming that the company is a going concern and will exist long enough to honor the certificates), and the matching issue (assigning revenues and expenses to the appropriate accounting periods).

 

[CH 5, Topic 10] SD 6-3: WAL-MART

The three aspects of the practice are as follows:

  1. Wal-Mart has the use of the funds for fifteen additional days (30 - 15).
  2. By taking a discount on the gross price of the merchandise, Wal-Mart is also taking a discount on the trade discounts.
  3. Wal-Mart takes a discount on the freight costs.

Wal-Mart looks on this practice as good cash management. It figures that its suppliers are happy to have the business and will allow the discount without much complaint. However, this can also be looked at from the perspective that Wal-Mart, because of its size, has power over the suppliers and by virtue of this power is able to take the discount even though it is not entitled to it because it did not pay within fifteen days. Also, taking the discount on the gross price before trade discounts is questionable because the trade discounts are reductions in the price that Wal-Mart pays. Wal-Mart is in effect taking a discount on a discount. Further, freight costs are simply reimbursement of a cost. The supplier has to pay the entire freight cost and is thus losing money in the amount of the discount. Financially, all three aspects of the practice help Wal-Mart and hurt the supplier. However, the suppliers probably will accept the practice because they do not want to lose the business of a major customer.

 

[CH7, Topic 2] SD 5-4: TREON MICROSYSTEMS

Fraudulent financial reporting is the intentional preparation of misleading financial statements. The financial vice president is intentionally disregarding information that, if it is true, would materially affect the value of ending inventory and would reduce net income. Although the information may be only "party tale," it may also be true. It is apparent that the financial vice president does not want a negative adjustment at this time. The failure to investigate the possible need for a writedown of the inventory is an example of fraudulent financial reporting. If people who are privy to this information engage in any stock transactions, they may violate inside information laws.

The senior accountant is in a difficult situation because his or her job may be in jeopardy if further action is taken. One step the accountant might take is to write a memorandum to the financial vice president documenting the possible inventory valuation problem and recommending that it be investigated. This accomplishes two things: It gives the financial vice president the opportunity to change her mind, and it establishes the accountant's position on the issue. If no further steps are taken, subsequent action may depend on the organization itself. There may be an established mechanism in the organization for reporting such matters. This mechanism might involve the internal auditors' group, the president's office, or the audit committee of the board of directors. But if the financial vice president's failure to act seems to represent the prevailing attitude in the company, the ethical step for the accountant to take is to resign and look for another job.

 

[CH7, Topic 12] SD 13-1: INTERNATIONAL BUSINESS MACHINES

Four quality of earnings issues identified in the article are:

Income tax rates decreased. A decrease in the effective tax rate is a positive benefit, but is likely to be a one-year change because tax rates cannot be counted on to decrease every year. They are likely to go up in future years.

Currency gains. Because of the fluctuation of foreign currencies in relation to the dollar, losses and gains are unpredictable and not a result of the company's normal operations.

Gain on sale of Intel stock. This is a one-time, nonrecurring gain.

Corporate buyback of stock. This action reduces the number of shares outstanding and thus increases earnings per share. It does not improve the company's earning power from normal operations. Earnings per share were up 52.2 percent, but analysts were disappointed in the revenue growth.

The analysts estimated the effects of the currency gain to be as much as $.50 per share. This would amount to as much as 14.4 percent of earnings per share of $3.47. Thus, the increase in earnings per share might have been only 30.3* percent instead of 52.2 percent if the currency gain had not existed.

* 30.3% = [ ($3.47 - $.50) - $2.28 ] / $2.28

It is not clear whether management is referring to the growth in earnings or to the growth in sales when it speaks of effectiveness and planning for growth. It is important to know, because earnings per share were up 52.2 percent, but growth in revenues was disappointing. Much if not all of the growth in earnings came from the items mentioned above. However, management may mean that IBM is going to see increased income from operations in future periods. Obviously, the stock market is skeptical, because the price of the stock dropped by $6 to $111.75 after the announcement.

Optional question:

The quality of earnings issues raised by IBM's financial reporting in 1988 proved to be a portent of further problems for the company. By 1993, the company's top management had been changed and poor operations had forced the layoff of tens of thousands of employees. The price of the company's stock continued to fall to below $50 per share in 1993, which is less than one-half of its price in 1988.

 

[CH9, Topic 8] FRA 9-2: TEXACO

1. FASB conditions: The two conditions established by the FASB for recording a contingent liability are that the liability must be (a) probable and (b) reasonably estimated.

Normally, when a company loses a lawsuit, as Texaco did, the loss is recorded, because both the loss and its amount are set by the court. However, in this case, Texaco's management felt that it would ultimately win or that the award would be reduced on appeal. Therefore, management felt that the loss was not probable and that the amount could not be reasonably estimated. As a result, no entry was made in the records, but the contingency was disclosed as a note to the financial statements.

2. Events of 1987: Yes, the events of 1987 change the answer to part 1. Since the lawsuit was settled, the loss and its amount are known and should be recorded in the accounting records. A contingency no longer exists.

The entry to record the loss increases both the Loss on Settlement of Lawsuit and the Settlement of Lawsuit Liability by $3,000,000.

3. Effect of settlement: The loss will reduce retained earnings by almost 25%. Payment of the liability will use all the company's available cash and marketable securities. This loss will result in a large net loss for 1987, because it is more than four times the amount of net income earned in 1986.

The Chicago Tribune reported on January 28, 1989, that Texaco's net loss for 1987 would total at least $4.45 billion. This was believed at the time to be the largest loss in the history of the business. In addition, Texaco could face a claim of $6.5 million from the Internal Revenue Service for back taxes. There may also be other costs associated with the settlement.

 

[CH 10, Topic 2] SD 8-1: THE GAP

Since The Gap has an inventory turnover of 7.5 times per year, its average inventory is on hand only 48.7 days (365 days / 7.5), whereas the competition's average inventory is on hand an average of 104.3 days (365 / 3.5), more than twice as long. This is a business advantage for The Gap because it is replenishing its inventory more often and thus providing more variety to its customers. As the quote says, customers will want to come in more often to see what's new. Fewer goods have to be sold at a discount because they are not selling. Financially, it means that The Gap has to provide fewer funds to finance the inventory relative to sales. This means that its interest and inventory carrying costs are relatively less than those of the competition and that the company is more profitable.

The just-in-time operating environment means that The Gap is working closely with its suppliers to control the level of inventory by monitoring the level of inventory and timing shipments so that the inventory arrives just in time to be sold. This strategy is very effective in improving inventory turnover, thereby reducing the funds necessary to carry inventory and improve profitability.

 

[CH 10, Topic 11] SD 10-1: GENERAL MOTORS

The purpose of depreciation and amortization is to allocate the cost of a long-term asset to the periods that benefit from the services of that asset. The estimated service life of a long-term asset is the total number of service periods expected from the asset. In this case, General Motors Corp. revised the estimated service lives of its plants and equipment and special tools based on studies done by the company. Since the resulting changes decreased 1987 depreciation and amortization, income before taxes was positively affected. Without the change, reported income before taxes would presumably have been about $768.8 million 9$2,005.4 million - $1,235.6 million) instead of $2,005.4 million. The company may be viewed more favorably in the marketplace for having reported greater income before taxes, but economically the company is no better or worse off (except for possible effects on income taxes) after the change than it was before, because depreciation and amortization expenses represent and allocation of past expenditures, not current outlays of funds. As a result, the amount of cash the company has at the end of the year is the same regardless of the current amount of depreciation and amortization.

 

[CH 10, Topic 18] SD 10-3: QUAKER OATS

A trademark is a registered symbol or name that the holder has the exclusive right to use to identify a product or service. It is considered an intangible asset because while it has no physical substance, it provides some advantage to the owner. Its value comes from the long-term benefits that it confers on the owner. In this case, the judge ruled that Sands Taylor & Wood was the owner of the trademark "thirst aid," and that therefore Sands Taylor & Wood should receive the advantages of ownership. Since the judge ruled that the trademark had contributed to Quaker Oats Company's increased sales, Quaker Oats had to pay Sands Taylor & Wood the income that it derived from use of the trademark, plus legal fees and interest.

 

[CH 11, Topic 18] SD 11-6: WEISS CHEMICAL

In deciding whether to issue long-term bonds and purchase the new fertilizer plant or to use a capital lease, the following issues should be considered:

  1. Cash flow requirements
  2. The effective interest rates of the two alternatives
  3. The income tax effects
  4. Effects on the financial structure (balance sheet) of the business
  5. Effects on the earnings of the business (interest expense and depreciation expense)
  6. Effects on the company's future financing plans

 

[CH13, Topic 6] SD 13-2: WESTINGHOUSE

1. The auditor's report mentions two accounting changes in 1992. The first change is in connection with SFAS 106, on postretirement benefits other than pensions, which resulted in a negative effect of $742 million. The second change is in connection with SFAS 109, on accounting for income taxes, which resulted in a positive effect of $404 million. The report also commented on the discontinued operations, which resulted in a loss of $1,351 million in 1991 and $1,301 million (including the loss on disposal) in 1992.

2. Discontinued operations are segments of a business that are no longer part of its ongoing operations. Loss from operations is the loss from the business operations of the segment, whereas the estimated loss on disposal of discontinued operations is the amount management expects to lose from selling the discontinued segment. These items are shown separately on the income statement to make it possible for the user to evaluate the ongoing or continuing operations in assessing the future of the company.

3. The cumulative effect of an accounting change is the effect that a new accounting principle would have had on net income in prior periods if it, instead of an old principle, had been applied. Both changes in accounting principles applicable to Westinghouse were mandated by an outside authority, the FASB.

4. Earnings per common share is given for major components of the corporate income statement so that the user of the statement may separate those items that apply only to the current period from the results of continuing operations. Earnings from continuing operations are most relevant to future operations because although the company showed a large loss per share overall in 1991 and 1992, it had a profit from continuing operations in both years. Income from continuing operations increased from $.84 to $.93 per share and exceeded the reduced cash dividends per share in 1992.