CHAPTER 14

UNDERSTANDING FINANCIAL STATEMENTS

Changes from Eleventh Edition

Updated from the Eleventh Edition.

Approach
Some pulling together and review of financial accounting seems to be desirable at this point. When the
basic concepts were first introduced in Chapters 2 and 3, their full meaning, and especially the
qualifications relating to them, was undoubtedly not entirely clear. This chapter reviews these concepts in
the light of the additional information that the student has acquired in intervening chapters.

There is no way of ensuring, of course, that students will come away with just the right balance between
appreciating the value of accounting information and recognizing its limitations. We have tried to strike
such a balance as best we can, but instructors may lean more in one direction or the other, according to
their own opinion.

Cases
Quick Lunch is a complete accounting cycle, requiring the construction of financial statements from a
narrative explanation of events.

Scientific Instrument Corporation explores the issues involved in considering whether to qualify the
auditors opinion.

Limited Editions examine revenue recognition issues.

Accounting at MacCloud Winery requires decisions on a number of accounting issues. This case is new to
this edition.

PolyMedica Corporation exercises a companys decision to capitalize direct response advertising costs.
This case is new to this edition.

Porter Lumber Company has been moved from Chapter 14 to Chapter 13 (Case 13-8).

Problems
Problem 14-1
The auditors decide what audit procedures are necessary to provide reasonable assurance that the
financial statements do not include material misstatements. The auditors fee should not play a role in
setting the scope of an audit.

In making their examination, auditors do not rely primarily on a detailed rechecking of the analysis,
journalizing, and posting of each transaction. Rather, they satisfy themselves that the accounting system is
designed to ensure that the data are processed properly. The auditors (1) make test checks of how well the
system is working, (2) verify the existence of assets (for example, they must observe the taking of
physical inventory), (3) ask a sample of customers to confirm, or verify, the accuracy of the accounts

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receivable, (4) check bank balances and investment securities, and (5) make sure that especially important
or non-routine transactions are recorded in conformity with generally accepted accounting principles
(GAAP).

These checks provide reasonable assurance that material errors have not been committed through
oversight or carelessness and that there has been no misstatement of financial statements due to fraudulent
activity. They do not provide absolute assurance, however; almost any system can be beaten by someone
intent on doing so. Although spectacular frauds receive much publicity, they are infrequent relative to the
number of companies audited every year.

The word fairly should be contrasted with the word accurately. The auditors do not say that the reported
net income is the only, or even the most accurate, number that could have been reported. Rather, they say
that of the many alternative principles that could have been used, those actually selected by management
do give a fair picture in the circumstances relevant to the particular company. This contrast between
fairness and accuracy is further emphasized by the fact that the auditors report is called an opinion.
Auditors do not certify the accuracy of the statements; instead, they give their professional opinion that
the presentation is fair.

If a company uses an accounting principles that is inconsistent with an FASB pronouncement, the auditors
will write an adverse opinion. Qualification may occur for any of three reasons: (1) a lack of consistency,
(2) existence of a major uncertainty, or (3) doubt as to the entitys ability to continue as a going concern.

Problem 14-2
a. Typically, accounting does not recognize these changes in value. The cost of assets shown on
financial statements seldom reflects the assets current market value. Some believe that the historical
cost convention flows from the going concern concept, which implies that since the business is not
going to sell its fixed assets as such, there is little point in revaluing assets to reflect current values.
For practical reasons, the accountant prefers the reporting of actual original costs to less certain
estimates, which are more difficult to verify. By using historical costs, the accountants already
difficult task is not further complicated by the need to keep additional records of changing market
values.

b. dr. Property Plant and Equipment...........................................................................................................................................

1,750,000
cr. Revaluation Reserve......................................................................................................................................................
1,750,000

The credit to a revaluation reserve is to an equity account. Depreciation would be based on the new
carrying value of the asset. The revaluation gain should not be included as income.

Problem 14-3
The principal exceptions to the historical cost concept are the lower of cost or market rule, the recording
at market of trading and available-for-sale securities and the accounting for derivatives at fair value.
Pension plan assets are also reported at their market values. Another departure from the cost concept is
the reporting of foreign exchange denominated payables and receivables at current exchange rates.

Problem 14-4
a. The company lists a number of sources of deferred tax assets. Deferred tax assets arise when the
company records expenses for book purposes before it does for tax purposes or records revenue for
tax purposes before it does for book purposes.

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The company lists several sources of deferred tax liabilities. Deferred tax liabilities arise when a
company recognizes expenses for tax purposes before it does for book purposes or records revenue
for book purposes before it does for tax purposes.

The different treatment of revenue and expense items for book and tax purposes leads to differences
between its book carrying values of assets and liabilities and their tax basis. These differences and the
changes in them are used to measure deferred tax balances.
b. The actual tax payments (cash outflow) are disclosed along with the reasons why the companys book
tax rate is considerably lower than the federal statutory rate. The deferred tax asset and liability
disclosure indicates the sources of the deferred tax credits that result in its companys low book tax
rate.

c. In measuring deferred taxes, management can assume possible future feasible tax strategies. The
treatment of the valuation allowance requires a probability determination by management (more
likely or not).

The tax note provides detailed tax information beyond that communicated in the primary financial
statements. These data help readers to understand better the companys tax accounting practices, tax
policies and tax position and its role of management judgment in measuring deferred taxes.
Problem 14-5
The factors not captured in financial statements that are vitally important in evaluating the health and
prospects of a company might include the health of its chief executive officer; the morale of the work
force; the intellectual capital of the company; the market prospects for its products and services; the
companys competitive strengths and weaknesses; the state of the economy; the soundness of the
companys strategy; and the companys access to funding sources.

Cases
*
Case 14-1: Quick Lunch
Note: Unchanged from the Eleventh Edition.

Approach

This is a good review case in which the student must exercise judgment in the treatment of some items.
As a result, students will come up with more than one net income figure, which seems to be within the
framework of generally accepted accounting principles. If he or she wishes, the instructor can use the
discussion on these specific matters in Quick Lunch as a springboard for a broader discussion of the
meaning and usefulness of financial statements prepared under GAAP. (Statements appear on the next
two pages of this manual.)

Notes
1. This treatment shows the redeemed coupons at their net value (27.5/30 of face value). An acceptable
alternative is to charge off the full amount of the discount in 2002 and show $1,500 as a liability. This
makes for simpler accounting and could be defended on the grounds that the discount was given to
acquire cash in advance of eating, the full benefit of which has been obtained in 2002.

2. The withdrawal could have been regarded as a labor expense, although it is less than the value of
*
This teaching note was prepared by Robert N. Anthony. Copyright Robert N. Anthony.

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Binghams services as measured by his earnings previously. Alternatively, an estimate of the value of
these services could have been shown as wages. It is important that the Binghams understand
whatever method is used, or they will misinterpret their net income.

QUICK LUNCH
Income Statement for the Four Months Ended December 31, 2002
Cash sales................................................................................................................................................................................
$29,315
Coupon sales (Note 1).............................................................................................................................................................
$ 2,475
Net sales..................................................................................................................................................................................
31,790
Expenses.................................................................................................................................................................................
Food.....................................................................................................................................................................................
14,415
Rent......................................................................................................................................................................................
4,975
Depreciation of equipment (Note 4).....................................................................................................................................
440
Amortization of leasehold....................................................................................................................................................
1,900
License fee...........................................................................................................................................................................
75
Other expenses.....................................................................................................................................................................
90
Total expenses...................................................................................................................................................................
21,895
Net income..............................................................................................................................................................................
9,895
Less: Withdrawals (Note 2)..................................................................................................................................................
3,800
Addition to capital...................................................................................................................................................................
$ 6,095

QUICK LUNCH
Balance Sheet as of December 31,2002
Assets
Current assets:
Cash.....................................................................................................................................................................................
$12,265
Merchandise inventory.........................................................................................................................................................
750
Prepaid license fee...............................................................................................................................................................
150
Total current assets............................................................................................................................................................
$13,165
Plant and equipment:
Equipment (Note 3)..............................................................................................................................................................
8,800
Less: Accumulated depreciation (Note 4).........................................................................................................................
440 8,360
Leasehold (or goodwill) (Note 5)......................................................................................................................................
3,800
Total assets....................................................................................................................................................................
$25,325

Liabilities and Owners Equity

Current liabilities:....................................................................................................................................................................
Accounts payable.................................................................................................................................................................
$ 2,405
Coupons payable..................................................................................................................................................................
1,375
Total current liabilities......................................................................................................................................................
3,780
Owners equity:
Original capital....................................................................................................................................................................
$15,450
Plus: Addition from operations............................................................................................................................................
6,095
Total owners equity..........................................................................................................................................................
21,545
Total liabilities and owners equity................................................................................................................................
$25,325

3. The installation cost of $600 has been included as a fixed asset. Since the value of the installation is
lost if the lease is terminated, an argument can be made for setting up the installation separately and
writing it off over one year or four years, the life of the lease without or with extensions.

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QUICK LUNCH
Statement of Cash Flows
For the Four Months Ended December 31, 2002
Net cash flow from operating activities:
Net income......................................................................................................................................................................
$ 9,895
Noncash items included in net income:
Depreciation.................................................................................................................................................................
440
Amortization of leasehold............................................................................................................................................
1,900
Increase in inventory....................................................................................................................................................
(750)
Increase in prepaid fee.................................................................................................................................................
(150)
Increase in accounts payable........................................................................................................................................
2,405
Increase in coupons payable........................................................................................................................................
1,375
Net cash from operating activities............................................................................................................................
15,115

Cash flows from investing activities:

Acquisition of equipment................................................................................................................................................
(4,600)
Proceeds from disposal of old equipment.......................................................................................................................
400
Net cash used for investing activities...........................................................................................................................
(4,200)

Cash flows from financing activities:

Withdrawals by owner....................................................................................................................................................
(3,800)
Net increase in cash............................................................................................................................................................
7,115
Cash at beginning of the period..........................................................................................................................................
5,150
Cash at the end of the period..............................................................................................................................................
$12,265

Notes:
A. This statement has been prepared for the period starting with the commencement of operations.
An alternative would be to prepare it for the period starting with the owners initial investment of
capital (a $15,450 financing activity, $10,300 investing activity, and additional cash increase of
$5,150 from the beginning cash balance of zero).
B. The cash flow from operations could also have been developed using the direct method, instead
of the indirect (reconciliation) method. The data come right out of the cash receipts and
disbursements table in the case: $33,165 - $14,275 - $225 - $3,460 - $90 = $15,115.
4. Depreciation could be estimated on the basis of one year (on assumption that equipment is worthless
if lease is not renewed), 4 years (assuming that lease will be renewed once), 10 years (useful life of
equipment), or any other reasonable estimate of life. The solution uses straight-line over 10 years and
follows the convention (not necessarily valid) of taking one-half-years depreciation in the first year.
Arguments can, of course, also be made for accelerated depreciation and for including an estimate of
salvage value.

5. The solution takes the very conservative route of writing off the leasehold over one year. Four years
can easily be defended. $10,300 4,600 = $5,700 excess of amount paid over value of assets
received. $5,700 x 4/12 = $1,900 amortization; $3,800 unamortized cost.

6. The coffee urn repairs are disregarded although an argument can be made for showing the value of
Mr. Binghams labor (at Sunday rates?) as an expense. The amount should not be capitalized.

7. No provision is made for income taxes on the grounds that these are a personal matter.

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Question 2
At his old job, Mr. Bingham made perhaps $390 per week, or $6,630 for 17 weeks. This is less than the
income for the venture, but does not allow anything for Mrs. Binghams services or for a return on the
$15,450 investment. On the other hand, the business is just getting started, and the stated profit is
conservative because of the large write-off of fixed assets.

Case 14-3: Limited Editions, Inc.*

Note: This case is unchanged from the Eleventh Edition.

Introduction
Limited Editions, Inc. has been successfully used as an exam case and a teaching case in the second-year
Corporate Financial Reporting Course. In addition, a slightly different version (gross margins are much
smaller) entitled Foxes in Spring, has been used as an exam and taught in the first-year Control course.
This case requires the student to take a simple but unique fact situation, select a portfolio of financial
reporting policies, defend the selected polices, and construct a set of financial statements consistent with
the selected policies. This case should not be taught until students have developed a reasonable
knowledge of basic accounting principles and some skill in constructing financial statements. Time
required depends on how many alternative accounting policies the instructor wants to demonstrate in the
class. Setting a fast pace, I have found 80 minutes to be .just sufficient for the second-year MBAs. With
other audiences and a more thorough exploration of alternative accounting policies, two full class periods
could be justified.

Teaching Strategy
Opening this class is easy but demands careful selection of a student who has (1) enumerated which
accounting decisions are necessary, (2) made each decision, and (3) has prepared an articulated set of
financial statements consistent with the students decisions. Selection of a strong student is advisable.
Place on the board the decisions to be made, the choices, and the financial statements. This should take
10-15 minutes. Then let the class question the student on the numbers but not on the accounting choices.
Once the class understands the numbers, I open it up for general discussion about each particular
accounting choice. Time usage is important since most of the decisions are not black or white. As we
discuss revenue recognition, I am building a list of relevant criteria on the board. Finally, I actively seek
two alternative sets of financial statements based on different revenue recognition methods (but holding
other variables constant).

To conclude, I discuss the basis for the case and emphasize that we must pick a portfolio of accounting
policies for a business, that the financial statements will look significantly different depending on the
choice, that we tend to pick accounting policies on an individual, sequential basis, and that we must have
the: ability to tie together a set of financial statements consistent with the whole portfolio of accounting
policies.

Although I recommend this case for students who have already mastered the basis of GAAP accounting
and financial statement presentation, this case could easily be used as the lead-off case in introducing
transaction analysis and statement preparation. It would definitely require two class periods. My
reluctance to use it as a lead-off case stems from my feeling that the richness of the case will not be as
appreciated by the students so early in their studies.

*
Teaching Note based on one prepared by Dennis Frolin, Harvard Business School.

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Key Decisions
1. Revenue Recognition: when does the company earn a profit
2. Inventory Valuation Method
3. Basic capitalization versus expense decisions

Alternatives
1. Revenue Recognition: Order
Shipment
Cash Collected
Three months pass
5 years
Neverthis is a finance company
Two-step process: when cash is collected and when three-months pass

2. Inventory Valuation: What costs belong in Inventorydesign cost?

Actual or expected cost? (400 units or 500 units)
What valuation method: FIFO, LIFO, Average?

3. Capitalization versus Expenses: How to treat display figures.

How to treat advertising.

Basic Considerations
Critical Event
Certainty of Collection
Ability to Estimate refunds
-- 3 months
-- 5 years

Ability to estimate and match cost

Timeless: which accounting method promptly signals good or bad performance
Continuing Interest in the product by the seller
Arms length
What is the essence of this business
Legal form versus economic substance
Management Strategy
-- Trend in earnings
-- Image desired
-- Goals of management for the company
-- Ability to manage earnings

Transfer of Title
Cash Flow
-- has there been any
-- should profits be tied to cash flow

Financial Statements
There are a number of different feasible financial statements students may generate. They will all be

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variations of the basic statements presented below.

Statement of Cash Flows

Cash receipts
Stock sale $100,000
Customer collections 452,000 $552,000

Cash disbursements
Design fee $50,000

Advertising cost 25,000

Production costs 240,000
General and Adm. 50,000 365,000
Ending cash $187,000

Balance Sheet

Cash $187,000 Accounts payable $ 40,000

Accounts receivable 90,000 Common stock 100,000
Inventory 40,000 Retained earnings 177,000
Total $317,000 Total $317,000

Income Statement

Sales $542,000
COGS 240,000

Gross margin $302,000

G&A 50,000
Advertising 25,000
Design fee 50,000
Profit $177,000

The above statements assume

Inventory is recorded on a FIFO basis

The 10 display models are expensed and included in cost of goods sold
The design fee and advertising costs are expensed as incurred

Student variations will include

Various revenue recognition policies
Various return provision alternatives
Alternative inventory policies (LIFO, average cost)
Different capitalization and amortization of the design fee schedules

The discussion of the variations should focus on their consistency with each other, reasonableness and
coherence as a complete financial reporting policy.

Alternatives

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Comments by Professor Mark T. Bradshaw and F. de Asis Martinez-Jerez, Harvard Business School, on
some of the possible, alternatives students may offer are reproduced below. These comments relate to
student examination answers. A version of the case was used for the 2002 final first-year MBA course,
Financial Reporting and Control examination.
a. Design fee
The main discussion here is whether it should be capitalized or not. The secondary discussion is how it
should be amortized if the fee is capitalized. They should argue to capitalize because the objective should
be to match. Economic reality in this case is for the benefits of this expenditure extend beyond the
moment of the payment and into the future. The work done by the designer is an asset. Matching expenses
to revenues is the main reason to this treatment (best answer). They might argue to expense because it is
similar to R&D (low points) or because of the prototype reasoning in Chemalite. They may also use the
argument of materiality to expense the amount, however, they should have recognized the amount is
material. If they want to use a similar argument they should compare this expenditure to the development
phase in software (or R&D in, for instance, Spain).
If they argue it should be capitalized then they have to think more deeply about how to accomplish
matching. I would like the argument of depreciation for units produced to be used, i.e., $50,000/1,000
figurines=S50 per figurine.

b. Inventory costing method

Discuss the benefits and costs of LIFO and FIFO, and Average costing.

The main argument should recognize the implications of each method for an environment of declining
costs. What method will represent better economic reality? It could be argued that average costing is the
method that brings to todays costs the benefits of learning that are being developed today and captured in
the future through lower production costs. Given the uncertainty of production for the latest units,
students might argue to use average pricing among the units produced each year. They should discuss the
impact on the Balance sheet and on the Income Statement of their choice.

Finally, the best responses should comment on what should be included in the inventory cost. I think it
should be enough to say that the amortization of the design fee and the production costs should be
included.

c. Revenue recognition

a. Should you recognize total revenue or net revenue?

i. Net because they do not receive the full amount
ii. Net because in case of default you can go against the retailer not the end buyer
iii. Gross because they might be forced to return the full amount (after 5 years) and it does
not seem that the returns will affect the commissions paid. However, $2,000 in 5 years is
less than the $1,800 today
b. When should the revenues be recognized?
i. When received the subscription. No, because it is not earned
ii. When shipped, the question here is is it realized? You might decide to recognize
revenues and provision for returns. You could argue you do not have enough experience
and you cannot recognize any revenues. But you could look at other sources of
information and try to be conservative.

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c. Provision for bad debts (usual reasoning).

d. Provision for short-term returns.
i. It should be at least some amount because of the experience, even though returns
occurred subsequent to year end.
ii. The provision should be for the 80% of the sale. 20% (or 19% if net sales method) should
be recognized as revenue
iii. Really it is more than three months, so do not reverse the provision at the end of the third
month (conceptually, in reality made by differences). Therefore they should recognize for
the effective not the stated return policy.
e. Provision for long-term returns.
i. No experience, recognize the possibility of not recognizing revenues at all.
ii. 5 years later you have to recognize the present value not the nominal value of the returns.
iii. Period could be effectively 5 years even though it is possible to be longer. At 5 years you
know if the figurine has the value of an antique or if it is a disaster and people return it. If
valued as an antique people will sell figurines in the secondary market.

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