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Financial Reporting, Financial Statement Analysis and Valuation

James M. Wahlen, Stephen P. Baginski, Mark Bradshaw

Chapter 2

Asset and Liability Valuation and Income Recognition - all with Video Answers

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Chapter Questions

Problem 1

"Some asset valuations using historical costs are highly relevant and very representationally faithful, whereas others may be representationally faithful but lack relevance. Some asset valuations based on fair values are highly relevant and very representational faithful, whereas others may be relevant but lack representational faithfulness." Explain and provide examples of each.

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Problem 2

"Asset valuation and recognition of net income closely relate." Explain, including conditions when they do not.

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Problem 3

Firms value inventory under a variety of assumptions, including two common methods: last-in firstout (LIFO) and first-in first-out (FIFO). Ignore taxes, assume that prices increase over time, and assume that a firm's inventory balance is stable or grows over time. Which inventory method provides a balance sheet that better reflects the underlying economics, and why? Which method provides an income statement that better reflects the underlying economics, and why?

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Problem 4

The text states, "Over sufficiently long time periods, net income equals cash inflows minus cash outflows, other than cash flows with owners." Demonstrate the accuracy of this statement in the following scenario: Two friends contributed $$\$ 50,000$$ each to form a new business. The owners used the amounts contributed to purchase a machine for $$\$ 100,000$$ cash. They estimated that the useful life of the machine was five years and the salvage value was $$\$ 20,000$$. They rented out the machine to a customer for an annual rental of $$\$ 25,000$$ a year for five years. Annual cash operating costs for insurance, taxes, and other items totaled $$\$ 6,000$$ annually. At the end of the fifth year, the owmers sold the equipment for $$\$ 22,000$$, instead of the $$\$ 20,000$$ salvage value initially estimated. (Hint: Compute the total net income and the total cash flows other than cash flows with owners for the five-year periad as a whole.)

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Problem 5

Measurement of Acquisition Cost. United Van Lines purchased a truck with a list price of $$\$ 250,000$$ subject to a $6 \%$ discount if paid within 30 days. United Van Lines paid within the discount period. It paid $$\$ 4,000$$ to obtain title to the truck with the state and an $$\$ 800$$ license fee for the first year of operation. It paid $$\$ 1,500$$ to paint the firm's name on the truck and $$\$ 2,500$$ for property and liability insurance for the first year of operation. What acquisition cost of this truck should United Van Lines record in its accounting records? Indicate the appropriate accounting treatment of any amount not included in acquisition cost.

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Problem 6

Measurement of a Monetary Asset. Assume Boeing sold a 767 aircraft to American Airlines on January 1, 2009. The sales agreement required American Airlines to pay $$\$ 10$$ million immediately and $$\$ 10$$ million on December 31 of each year for 20 years, beginning on December 31, 2009. Boeing and American Airlines judge that $8 \%$ is an appropriate interest rate for this arrangement.
a. Compute the present value of the receivable on Boeing's books on January 1, 2009, immediately after receiving the $$\$ 10$$ million down payment.
b. Compute the present value of the receivable on Boeing's books on December 31,2009 .
c. Compute the present value of the receivable on Boeing's books on December 31, 2010 .

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Problem 7

Measurement of a Nonmonetary Asset. Assume American Airlines acquires a regional airline in the midwestern United States for $$\$ 450$$ million. American Airlines allocates $$\$ 150$$ million of the purchase price to landing rights at various airports. The landing rights expire in five years. What type of measurement is applicable to the valuation of the landing rights at acquisition and at the end of each of the five years?

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Problem 8

Fair Value Measurements. The text discusses inputs managers might use to determine fair values of assets and liabilities and identifies different classifications of assets identified in SFAS No. 157. Suppose a major university endowment has investments in a wide array of assets, including (a) common stocks; (b) bonds; (c) real estate; (d) timber investments, which receive cash flows from sales of timber; (e) private equity funds; and ( $f$ ) illiquid assetbacked securities. Consider how the portfolio manager would estimate the fair values of each of those classes of assets, and characterize the inputs you identify as Level 1, Level 2, or Level 3.

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Problem 9

Computation of Income Tax Expense. A firm's income tax return shows $$\$ 50,000$$ of income taxes owed for 2009 . For financial reporting, the firm reports deferred tax assets of $$\$ 42,900$$ at the beginning of 2009 and $$\$ 38,700$$ at the end of 2009 . It reports deferred tax liabilities of $$\$ 28,600$$ at the beginning of 2009 and $$\$ 34,200$$ at the end of 2009 .
a. Compute the amount of income tax expense for 2009 .
b. Assume for this part that the firm's deferred tax assets are as stated above for 2009 but that its deferred tax liabilities were $$\$ 58,600$$ at the beginning of 2009 and $$\$ 47,100$$ at the end of 2009 . Compute the amount of income tax expense for 2009 .
c. Explain contextually why income tax expense is higher than taxes owed in Part a and lower than taxes owed in Part b.

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Problem 10

Computation of Income Tax Expense. A firm's income tax return shows income taxes for 2009 of $$\$ 35,000$$. The firm reports deferred tax assets before any valuation allowance of $$\$ 24,600$$ at the beginning of 2009 and $$\$ 27,200$$ at the end of 2009 . It reports deferred tax liabilities of $$\$ 18,900$$ at the beginning of 2009 and $$\$ 16,300$$ at the end of 2009 .
a. Assume for this part that the valuation allowance on the deferred tax assets totaled $$\$ 6,400$$ at the beginning of 2009 and $$\$ 7,200$$ at the end of 2009 . Compute the amount of income tax expense for 2009 .
b. Assume for this part that the valuation allowance on the deferred tax assets totaled $$\$ 6,400$$ at the beginning of 2009 and $$\$ 4,800$$ at the end of 2009 . Compute the amount of income tax expense for 2009.

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Problem 11

Costs to Be Included in Historical Cost Valuation. At a cost of $$\$ 200,000$$, Assume In-N-Out Burger acquired a tract of land for a restaurant site. It paid attorneys $$\$ 7,500$$ to conduct a title search and to prepare the required legal documents for the purchase. State real estate transfer taxes totaled $$\$ 2,500$$. Building permits totaled $$\$ 1,200$$. Compute the acquisition cost of the land.

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Problem 12

Effect of Valuation Method for Nonmonetary Asset on Balance Sheet and Income Statement. Assume Walmart acquires a tract of land on January 1, 2009, for $$\$ 100,000$$ cash. On December 31, 2009, the current market value of the land is $$\$ 150,000$$. On December 31,2010 , the current market value of the land is $$\$ 120,000$$. The firm sells the land on December 31,2011 , for $$\$ 180,000$$ cash.

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Problem 13

Effect of Valuation Method for Monetary Asset on Balance Sheet and Income Statement. Refer to Problem 2.12. Assume that Walmart has accounted for the value of the land at acquisition cost and sells the land on December 31, 2011, for a two-year note receivable with a present value of $$\$ 180,000$$ instead of for cash. The note bears interest at $8 \%$ and requires cash payments of $$\$ 100,939$$ on December 31,2012 and 2013 . Interest rates for notes of this risk level increase to $10 \%$ on December 31,2012 , resulting in a market value for the note on this date of $$\$ 91,762$$.

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Problem 14

Effect of Valuation Method for Nonmonetary Asset on Balance Sheet and Income Statement. Assume Southern Copper Corporation (PCU) acquired mining equipment for $$\$ 100,000$$ cash on January 1, 2009. The equipment had an expected useful life of four years and zero salvage value. PCU calculates depreciation using the straight-line method over the remaining expected useful life in all cases. On December 31, 2009, after recognizing depreciation for the year, PCU learns that new equipment now offered on the market makes the purchased equipment partially obsolete. The market value of the equipment on December 31, 2009, reflecting this obsolescence, is $$\$ 60,000$$. The expected useful life does not change. On December 31,2010 , the market value of the equipment is $$\$ 48,000$$. PCU sells the equipment on January 1,2012 , for $$\$ 26,000$$.

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Problem 15

Effect of Valuation Method for Monetary Asset on Balance Sheet and Income Statement. Alfa Romeo incurs direct cash costs of $$\$ 30,000$$ in manufacturing a red convertible automobile during 2009. Assume that it incurs all of these costs in cash. Alfa Romeo sells this automobile to you on January 1, 2010, for $$\$ 45,000$$. You pay $$\$ 5,000$$ immediately and agree to make annual payments of $$\$ 14,414$$ on December 31,2010 , 2011, and 2012. Based on the interest rate appropriate for this note of $4 \%$ on January 1, 2012, the present value of the note is $$\$ 40,000$$. The interest rate appropriate for this note is $5 \%$ on December 31,2010 , resulting in a present value of the remaining cash flows of $$\$ 26,802$$. The interest rate appropriate for this note is $8 \%$ on December 31,2011 , resulting in a present value of the remaining cash flows of $$\$ 13,346$$.

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Problem 16

Deferred Tax Assets. Components of the deferred tax asset of Biosante Pharmaceuticals, Inc., are shown in Exhibit 2.14. The company had no deferred tax liabilities.

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Problem 17

Interpreting Income Tax Disclosures. The financial statements of ABC Corporation, a retail chain, reveal the information for income taxes shown in Exhibit 2.15.

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Problem 18

Interpreting Income Tax Disclosures. Prepaid Legal Services (PPD) is a company that sells insurance for legal expenses. Customers pay premiums in advance for coverage over some specified period. Thus, PPD obtains cash but has unearned revenue until the passage of time over the specified period of coverage. Also, the company pays various costs to acquire customers (such as sales materials, commissions, and prepayments to legal firms who provide services to customers). These upfront payments are expensed over the specified period that customers' contracts span. Exhibit 2.16 provides information from PPD's income tax note.

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Problem 19

Interpreting Income Tax Disclosures. The financial statements of Nike, Inc., reveal the information regarding income taxes shown in Exhibit 2.17.

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02:15

Problem 20

Analyzing Transactions. Using the analytical framework, indicate the effect of the following related transactions of a firm.
a. January 1: Issued 10,000 shares of common stock for $$\$ 50,000$$.
b. January 1: Acquired a building costing $$\$ 35,000$$, paying $$\$ 5,000$$ in cash and borrowing the remainder from a bank.
c. During the year: Acquired inventory costing $$\$ 40,000$$ on account from various suppliers.
d. During the year: Sold inventory costing $$\$ 30,000$$ for $$\$ 65,000$$ on account.
e. During the year: Paid employees $$\$ 15,000$$ as compensation for services rendered during the year.
f. During the year: Collected $$\$ 45,000$$ from customers related to sales on account.
g. During the year: Paid merchandise suppliers $$\$ 28,000$$ related to purchases on account.
h. December 31: Recognized depreciation on the building of $$\$ 7,000$$ for financial reporting. Depreciation expense for income tax purposes was $$\$ 10,000$$.
i. December 31: Recognized compensation for services rendered during the last week in December but not paid by year-end of $$\$ 4,000$$.
j. December 31: Recognized and paid interest on the bank loan in Part b of $$\$ 2,400$$ for the year.
k. Recognized income taxes on the net effect of the preceding transactions at an income tax rate of $40 \%$. Assume that the firm pays cash immediately for any taxes currently due to the government.

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Akash M
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Problem 21

Analyzing Transactions. Using the analytical framework, indicate the effect of each of the three independent sets of transactions described next.
(1) a. January 15, 2014: Purchased marketable equity securities for $$\$ 100,000$$.
b. December 31, 2014: Revalued the marketable securities to their market value of $$\$ 90,000$$. Unrealized changes in the market value of marketable equity securities appear in accumulated other comprehensive income.
c. December 31, 2014: Recognized income tax effects of the revaluation in Part $b$ at an income tax rate of $40 \%$. The income tax law includes changes in the market value of equity securities in taxable income only when the investor sells the securities.
d. January 5, 2015: Sold the marketable equity securities for $$\$ 94,000$$.
e. January 5, 2015: Recognized the tax effect of the sale of the securities in Part d. Assume that the tax is paid in cash immediately.
(2) a. During 2015: Sold inventory on account for $$\$ 500,000$$.
b. During 2015: The cost of the goods sold in Part b is $$\$ 400,000$$.
c. During 2015: Estimated that uncollectible accounts on the goods sold in Part a will equal $2 \%$ of the selling price.
d. During 2015: Estimated that warranty claims on the goods sold in Part a will equal $4 \%$ of the selling price.
e. During 2015: Actual accounts written off as uncollectible totaled $$\$ 3,000$$.
f. During 2015: Actual cash expenditures on warranty claims totaled $$\$ 8,000$$.
g. December 31, 2015: Recognized income tax effects of the preceding six transactions. The income tax rate is $40 \%$. The income tax law permits a deduction for uncollectible accounts when a firm writes off accounts as uncollectible and for warranty claims when a firm makes warranty expenditures. Assume that any tax is paid in cash immediately.
(3) a. January 1, 2015: Purchased $$\$ 100,000$$ face value of zero-coupon bonds for $$\$ 68,058$$. These bonds mature on December 31, 2019, and are priced on the market at the time of issuance to yield $8 \%$ compounded annually. Zero-coupon bonds earn interest as time passes for financial and tax reporting, but the issuer does not pay

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