QUESTIONS

1. The income statement portrays the net results of operations of an enterprise. Since
results are what enterprises are established to achieve and since their value is, in
large measure, determined by the size and quality of these results, it follows that the
analyst attaches great importance to the income statement.

2. Income summarizes in financial terms the operating activities of a company. Income

is the amount of revenues and gains for the period in excess of expenses and losses,
all computed under accrual accounting. Income provides a measure of the change in
shareholder wealth for a period and an indication of a company’s future earning
power. Accounting income differs from cash flows because certain revenues and
gains are recognized in periods before or after cash is received and certain expenses
and losses are recognized in periods before or after cash is paid.

3. Economic income is net cash flows plus the change in the present value of future
cash flows. Another similar concept, the Hicksian concept of income, considers
income for the period to be the amount that can be withdrawn from the company in a
period without changing the net wealth of the company. Hicksian income equals
cash flow plus the change in the fair value of net assets.

4. Accounting income is the excess of revenues and gains over expenses and losses
measured using accrual accounting. As such, revenues (and gains) are recognized
when earned and expenses (losses) are matched against the revenues (and gains).

5. Net income is the excess of the revenues and gains of the company over the
expenses and losses of the company. Net income often is called the “bottom line,”
although that is a misnomer because certain unrealized holding gains and losses are
charged directly to equity and bypass net income. Comprehensive income includes
all changes in equity that result from non-owner transactions (excluding items such
as dividends and stock issuances). Items creating differences between net income
and comprehensive income include unrealized gains and losses on available for sale
securities, foreign currency translation adjustments, minimum pension liability
adjustments, and unrealized holding gains or losses on derivative instruments.
Comprehensive income is the ultimate “bottom line” income number. Continuing
income is a measure of net income earned by ongoing segments of the company.
Continuing income differs from net income because continuing income excludes the
income or loss of segments of the company that are to be discontinued or sold (it
also excludes extraordinary items and effects from changes in accounting principles).

6. Details regarding comprehensive income are reported by the vast majority of

companies in the statement of stockholders’ equity rather than the income statement.

7. Core income is a measure of income that excludes all non-recurring items that are
reported as separate items on the income statement.
8. Operating income is a measure of firm performance from operating activities.
Examples of operating income include product sales, cost of product sales, and
selling, general, and administrative costs. Non-operating income includes all
components of income not included in operating income. Examples of non-operating
income include interest revenue and interest expense.

9. Operating versus non-operating and recurring versus non-recurring are distinct

dimensions of classifying income. While there is overlap across selected items,
these dimensions reflect different characteristics of business activities. For example,
the interest income and interest expense of most companies recur in net income;
hence, they are included in recurring income. However, these items are non-
operating in nature. Similarly, non-recurring items such as restructuring charge are
operating in nature.

10. Accounting standards (APB 30) restricted the use of the "extraordinary" category by
requiring that an extraordinary item be both unusual in nature and infrequent in
occurrence. These attributes are defined as follows:
a. Unusual nature of the underlying event or transaction should possess a high
degree of abnormality and be of a type clearly unrelated to, or only incidentally
related to, the ordinary and typical activities of the entity, taking into account the
environment in which the entity operates.
b. Infrequency of occurrence of the underlying event or transaction should be of a
type that would not reasonably be expected to recur in the foreseeable future,
taking into account the environment in which the entity operates.
Three examples of extraordinary items are:
 Major casualty losses from an event such as an earthquake, flood, or fire.
 A gain or loss from expropriation of property.
 A gain or loss from condemnation of land by eminent domain.
11. To qualify as discontinued operations, the assets and business activities of the
divested segment must be clearly distinguishable from the assets and business
activities of the remaining entity. Accounting and reporting for discontinued
operations is two-fold. First, the income statement for the current and prior two years
are restated after excluding the effects of the discontinued operations from the line
items that determine continuing income. Second, gains or losses pertaining to the
discontinued operations are reported separately, net of related tax effects. An analyst
should separate and ignore discontinued operations in predicting future performance
and financial condition.

12. To qualify as a prior period adjustment, an item must meet the following
requirements:
 Material in amount.
 Specifically identifiable with the business activities of specific prior periods.
 Not attributable to economic events occurring subsequent to the prior period.
 Dependent primarily on determinations by persons other than management.
 Not reasonably estimable prior to such determination.
13. Distortions in revenues (gains) and expenses (losses) can arise from several
accounting sources. These include choices in the timing of transactions (such as
revenue recognition and expense matching), selections from the variety of generally
accepted principles and methods available, the introduction of conservative or
aggressive estimates and assumptions, and choices in how revenues, gains,
expenses, and losses are classified and presented in financial statements. Generally,
a company wishing to increase current income at the expense of future income will
engage in one or more of the following practices:
(a) It will choose inventory methods that allow for maximum inventory carrying
values and minimum current charges to cost of goods or services sold.
(b) It will choose depreciation methods and useful lives of property that will result in
minimum current charges as depreciation expense.
(c) It will defer all managed costs to the future such as, for example: pre-operating,
moving, rearrangement and start-up costs, and marketing costs. Such costs
would be carried as deferred charges or included with the costs of other assets
such as property, plant, and equipment.
(d) It will amortize assets and defer costs over the largest possible period. Such
assets include goodwill, leasehold improvements, patents, and copyrights.
(e) It will elect the method requiring the lowest possible pension and other
employment compensation cost accruals.
(f) It will inventory rather than expense administrative costs, taxes, and similar items.
(g) It will choose the most accelerated methods of income recognition such as in the
areas of leasing, franchising, real estate sales, and contracting.
(h) It immediately will recognize as revenue, rather than defer the taking up of
benefits, items such as investment tax credits.
(i) Companies that wish to “manage” the size of accounting income can regulate the
flow of income and expense by means of reserves for future costs and losses.

14. (1) Depreciation

a. Straight Line: This is calculated by taking the salvage value (S) from the
original cost (C) and dividing by the useful life of the asset in question; that is,
(C-S)/(Useful life). Sum-of-Years'-Digits: This depreciation formula is: (C-S) x
(X/Y); where C and S are the same as above, X is the remaining years (that is, if
item is being depreciated over 5 years and this is the first year, then X=5), and
Y equals the "sum-of-years'-digits" (that is, for a 5-year asset,
Y=5+4+3+2+1=15).
b. Straight line is easily understood and provides level depreciation and earnings
effects. The sum-of-the-years'-digits gives heavier weight to earlier years and
causes higher depreciation and lower earnings in the early years and lower
depreciation and higher earnings toward the end of the asset's life.
(2) Inventory
a. LIFO (last-in, first-out) method: The LIFO method assumes the inventory
employed are those most recently acquired. FIFO (first-in, first-out) method:
The FIFO method assumes the first inventory items acquired are used first.
b. The effect on earnings depends on whether the economy is in an inflationary
or deflationary period. In times of inflation (the more usual case), LIFO
inventory accounting would result in lower earnings being reported than would
be the case had FIFO been employed.
(3) Installment sales
a. Accrual method: Assumes income is recognized when the sale is made
(earned). Installment method: Assumes income is recognized only when cash
is received as the various installments come in.
b. The installment method is commonly used for tax purposes while the accrual
method is employed in financial statements. The accrual method would result
in a higher earnings figure being reported than the installment method.

15. Three different types of accounting changes include:

(a) Changes in accounting principle
(b) Changes in accounting estimate
(c) Changes in reporting entity

16. Special items refer to transactions and events that are unusual or infrequent, not
both. These items are reported as separate line items on the income statement before
continuing income. Examples of special items include restructuring charges,
impairments of long-lived assets, and asset write-offs.

EXERCISES

Exercise 6-1 (25 minutes)

a. Cash xxx
Gain on disposition* xxx
Net assets of discontinued operations xxx
* (A loss on disposition would be recorded as a debit)

b. Income (expense) related to discontinued operations include the operating profit

(loss) recorded prior to sale and the gain (loss) on sale. These are reported net of
applicable tax.

c. When estimating future earning power, the results from discontinued operations
should not be treated as recurring. This is important for an assessment of the
permanent income of a company.

d. Separately reporting discontinued operations allows the analyst to view the results of
operations without the segment that will not be ongoing. As a result, the analyst can
 better assess the permanent component of income, for which results of discontinuing
operations will be excluded.

Exercise 6-2 (30 minutes)

a. By the use of reserves, a company can allocate costs in excess of actual experience
in the current period, based on estimates of additional costs in the future, or even
based on the simple possibility of further costs in the future. Then, in later periods,
actual costs can be written off against the reserve rather than reported as expenses
in the company's income statement for those periods. The advantage to the company
is that earnings trends can be "smoothed," and a cushion for future earnings can be
built up during good economic years for use during leaner periods. To the extent that
stability and predictability of earnings are market virtues, the company's common
stock might be accorded a higher multiple for these efforts, in effect lowering the cost
of capital to the company. The use of reserves both poses problems for the analyst
and conflicts with some basic accounting principles. These include:
(1) Use of reserves contradicts the matching principle, by which revenues and related
costs should be recognized in the same period.
(2) Reserving for future events (especially contingencies) is obviously subject to
estimate, and accounting should attempt to record quantifiable value as much as
possible.
Exercise 6-2—continued

(3) The reserving technique makes reported earnings less indicative of fundamental
trends in the company. The effects of the economic cycle are reduced, making
correlation techniques (such as GNP growth vs. EPS growth) invalid. These
reported numbers might mislead the “uninformed” investor. In contrast to the
artificial smoothing referred to earlier, the company's growth rate may be
exaggerated, by over-reserving for losses in a bad year, and subsequent writing
off of the reserve.

It should be noted that a reserve can be properly taken such as when it recognizes a
liability that (1) likely exists in the relatively near future—such as costs of winding up
a plant shutdown with the next year or (2) is subject to quantification—such as the
outright expropriation of net assets in a foreign country.

b. If the analyst is able to discern the impact of reserves, s/he should exclude the
reserves' impact from accounting income when assessing past trends. Only
operating or normal earnings should be compared over the short-term. However,
over a longer period of time, the losses against which reserves have been taken
should be included. In estimating future earnings, the analyst must carefully
consider the impact of reserves and exclude the impact when forecasting normal
earnings. By doing this, the analyst will have a better understanding of the true
operations of the company. In the valuation of common stock, the analyst must focus
on the sustainable earning power of the company. Thus, earnings may have to be
adjusted upward or downward depending on the degree of abuse of reserves.

c. Several examples of reserves are cited in the chapter. Also, students often benefit
from a review of business magazines in attempting to identify such reserves.
(CFA Adapted)

Exercise 6-3 (35 minutes)

a. A change from the sum-of-the-years'-digits method of depreciation to the straight-line

method for previously recorded assets is a change in accounting principle. Both the
sum-of-the-years'-digits method and the straight-line method are generally accepted.
A change in accounting principle results from adoption of a generally accepted
accounting principle different from the generally accepted accounting principle used
previously for reporting purposes.
Exercise 6-3—continued

b. A change in the expected service life of an asset arising because of more experience
with the asset is a change in accounting estimate. A change in accounting estimate
occurs because future events and their effects cannot be perceived with certainty.
Estimates are an inherent part of the accounting process. Therefore, accounting and
reporting for certain financial statement elements requires the exercise of judgment,
subject to revision based on experience.

c. 1. The cumulative effect of a change in accounting principle is the difference

between: (1) the amount of retained earnings at the beginning of the period
of change and (2) the amount of retained earnings that would have been
reported at that date if the new accounting principle had been used in prior
periods.
2. FASB 2005 Statement “Accounting Changes and Error Corrections”
requires that effective in 2005, companies should apply the “retrospective
approach” to changes in accounting principle. Thus, all presented periods
must be restated as if the change were in effect during those periods, and
any cumulative effect from periods before those presented is an
adjustment to beginning retained earnings of the earliest period presented.

d. Consistent use of accounting principles from one accounting period to another

enhances the usefulness of financial statements in comparative analysis of
accounting data across time.

e. If a change in accounting principle occurs, the nature and effect of a change in

accounting principle should be disclosed to avoid misleading financial statement
users. There is a presumption that an accounting principle, once adopted, should not
be changed in accounting for events and transactions of a similar type.

f. Mandatory accounting changes are largely non-discretionary. Thus, managerial

discretion is not present, or at least is to a lesser degree. One should examine the
motivations for voluntary accounting changes and assess any earnings quality
impact.

g. Mandatory accounting changes are largely non-discretionary. However, there is often

a window of time for a company to adopt a mandatory accounting change. If a
window exists, management has discretion as to the timing of the adoption. Thus,
the timing of adoption and any accounting ramifications should be considered. For
example, if a manager is going to adopt an accounting change that includes a large
charge, the manager might choose to adopt in a relatively poor quarter to attempt to
potentially conceal or downplay the poor operating performance.
Exercise 6-3—concluded

h. Mandatory accounting changes often include the recognition of retroactive earnings

affects. For example, the rules in accounting for other post-employment benefits
require that companies establish a liability for the accrued benefits to date. This
results in a large charge for many companies. Of course, the market potentially views
the charge as largely the fault of accounting rule makers. Thus, managers have
incentive to increase the amount of the charge and use the bloated liability to
increase future earnings.

Exercise 6-4 (20 minutes)

Comprehensive income computation:

a. Computation: b. Balance sheet accounts affected:

$1,000,000 Net income (closed to equity)
+ 50,000 Foreign currency translation gain
- 75,000 Unrealized gain or loss on pension assets/liabilities
- 12,000 Unrealized holding losses on derivative instruments
$ 963,000 Comprehensive income (component of equity)
Exercise 6-5 (30 minutes)

a. The point of sale is the most widely used basis for the timing of revenue
recognition because in most cases it provides the degree of objective
evidence many consider necessary to measure reliably periodic business
income. That is, sales transactions with outsiders represent the point in the
revenue generating process when most of the uncertainty about the final
outcome of business activity has been alleviated. It is also at the point of sale
in most cases that substantially all of the costs of generating revenues are
known, and they can at this point be matched with the revenues generated to
produce a reliable statement of a firm's effort and accomplishment for the
period. Any attempt to measure business income prior to the point of sale
would, in the vast majority of cases, introduce considerably more subjectivity
into financial reporting than most accountants are willing to accept.

b. 1. Though it is recognized that revenue is earned throughout the entire

production process, generally it is not feasible to measure revenue on the
basis of operating activity. It is not feasible because of the absence of
suitable criteria for consistently and objectively arriving at a periodic
determination of the amount of revenue to take up. Also, in most situations
the sale is the most important single step in the earning process. Prior to
the sale the amount of revenue anticipated from the processes of
production is merely prospective revenue; its realization remains to be
validated by actual sales. The accumulation of costs during production
does not alone generate revenue; rather, revenues are earned by the entire
process including the actual sales. Thus, as a general rule the sale cannot
be regarded as being an unduly conservative basis for the timing of
revenue recognition. Except in unusual circumstances, revenue
recognition prior to sale would be anticipatory in nature and unverifiable in
amount.

2. To criticize the sales basis as not being sufficiently conservative because

accounts receivable do not represent disposable funds, it is necessary to
assume that collection of receivables is the decisive step in the earning
process and that periodic revenue measurement and, therefore, net income
should depend on the amount of cash generated during the period. This
assumption disregards the fact that the sale usually represents the
decisive factor in the earning process and substitutes for it the
administrative function of managing and collecting receivables. That is, the
investment of funds in receivables should be regarded as a policy
designed to increase total revenues, properly recognized at the point of
sale; and the cost of managing receivables (e.g., bad debts and collection
costs) should be matched with the sales in the proper period. The fact that
some revenue adjustments (such as sales returns) and some expenses
(such as bad debts and collection costs) can occur in a period subsequent
to the sale does not detract from the overall usefulness of the sales basis
for the timing of revenue recognition. Both can be estimated with sufficient
accuracy so as not to detract from the reliability
Exercise 6-5—concluded

of reported net income. Thus, in the vast majority of cases for which the
sales basis is used, estimating errors, though unavoidable, will be too
immaterial in amount to warrant deferring revenue recognition to a later
point in time.

c. 1. During production. This basis of recognizing revenue is frequently used by

companies whose major source of revenue are long-term construction
projects. For these companies the point of sale is far less significant to the
earning process than is production activity because the sale is assured
under the contract, except of course where performance is not
substantially in accordance with the contract terms. To defer revenue
recognition until the completion of long-term construction projects could
impair significantly the usefulness of the intervening annual financial
statements because the volume of completed contracts during a period is
likely to bear no relationship to production volume. During each year that a
project is in process a portion of the contract price is therefore
appropriately recognized as that year's revenue. The amount of the
contract price to be recognized should be proportionate to the year's
production progress on the project. It should be noted that the use of the
production basis in lieu of the sales basis for the timing of revenue
recognition is justifiable only when total profit or loss on the contracts can
be estimated with reasonable accuracy and its ultimate realization is
reasonably assured.

2. When cash is received. The most common application of this basis for the
timing of revenue recognition is in connection with installment sales
contracts. Its use is justified on the grounds that, due to the length of the
collection period, increased risks of default, and higher collection costs,
there is too much uncertainty to warrant revenue recognition until cash is
received. The mere fact that sales are made on an installment contract
basis does not justify using the cash receipts basis of revenue recognition.
The justification for this departure from the sales depends essentially upon
an absence of a reasonably objective basis for estimating the amount of
collection costs and bad debts that will be incurred in later periods. If these
expenses can be estimated with reasonable accuracy, the sales basis
should be used.
(AICPA Adapted)
Exercise 6-6 (25 minutes)

a. Michael Company should recognize revenue as it performs the work on the contract
(the percentage-of-completion method) given that the right to revenue is established
and collectibility is reasonably assured. Furthermore, the use of the
percentage-of-completion method avoids distortion of income from period to period,
and it provides for better matching of revenues with the related expenses.

b. Progress billings would be accounted for by increasing Accounts Receivable and

increasing Progress Billings on Contract, a contra asset account that is offset against
the Construction Costs in Progress account. If the Construction Costs in Progress
account exceeds the Progress Billings on Contract account, the two accounts would
be shown in the current assets section of the balance sheet. If the Progress Billings
on Contract account exceeds the Construction Costs in Progress account, the two
accounts would be shown, in most cases, in the current liabilities section of the
balance sheet.

c. The income recognized in the second year of the four-year contract would be
determined as follows:

 First, the estimated total income from the contract would be determined by
deducting the estimated total costs of the contract (the actual costs to date
plus the estimated cost to complete) from the contract price.
 Second, the actual costs to date would be divided by the estimated total
costs of the contract to arrive at a percentage completed, which would be
multiplied by the estimated total income from the contract to arrive at the
total income recognized to date.
 Third, the total income recognized in the second year of the contract would
be determined by deducting the income recognized in the first year of the
contract from the total income recognized to date.

d. Earnings in the second year of the four-year contract would be higher using the
percentage-of-completion method instead of the completed-contract method. This is
because income would be recognized in the second year of the contract using the
percentage-of-completion method, whereas no income would be recognized in the
second year of the contract using the completed-contract method.
Exercise 6-7 (15 minutes)

a. Crime Control's revenue recognition practices, while not the most conservative,
conform to GAAP. The important issue is whether lessees will, in fact, continue for
their eight-year terms. Should large cancellations occur, substantial portions of the
revenue recognized in earlier years might have to be reversed in subsequent years.
This would result in distortions of earning power and earning trends. Thus, a critical
issue of this accounting is whether the company provides adequately for
contingencies such as cancellations. Should the pace of newly written sales-type
leases slow, the company's earnings growth may stop or earnings may even decline.

b. While the tax accounting does provide the company with significant funds from tax
postponement, it does not affect reported results because under GAAP the company
is required to provide for deferred taxes which it is assumed will be payable in the
future.

c. While it is true that the sale of the receivables without recourse would enable the
company to book profits in the year the lease originated, this practice would at the
same time substantially increase the company's tax bill.

Exercise 6-8 (20 minutes)

a. This revenue recognition issue stirs controversy. Many believe that it is reasonable
for both companies to record offsetting advertising revenues and advertising
expenses from this contract. This is justified in that the transaction seemingly meets
the usual revenue recognition criteria. Opponents of this treatment worry about
uncertainty and completeness of the earning process.

b. Revenues and revenue growth are considered good indicators of future prospects for
Dot.Com (Internet) companies. Accordingly, Internet companies want to maximize
the amount of reported revenues; even if those revenues are entirely offset with
expenses.

c. An analyst should seek to determine the percent of revenues that come from
advertising in such barter transactions versus revenues from cash-paying (or credit)
customers. Some believe that barter-based revenues should be segregated and
viewed in a different light from that of more normal revenues. This might affect
revenue multiples in determining stock price or decisions in other applications that
rely on financial statements. Analysts should adjust their models according to their
beliefs about the relative merits of such revenues.
Exercise 6-9 (30 minutes)

a. Some costs are recognized as expenses on the basis of a presumed direct

association with specific revenue. This has been identified both as "associating
cause and effect" and as the "matching concept." Direct cause-and-effect relations
can seldom be conclusively demonstrated, but many costs appear to be related to
particular revenue, and recognizing them as expenses accompanies recognition of
the revenue. Generally, the matching concept requires that the revenue recognized
and the expenses incurred to produce the revenue be given concurrent periodic
recognition in the accounting records. Only if effort is properly related to
accomplishment will the results, called earnings, have useful significance concerning
the efficient utilization of business resources. Thus, applying the matching principle
recognizes the cause-and-effect relationship that exists between expense and
revenue. Examples of expenses that are usually recognized by associating cause
and effect are sales commissions, freight-out on merchandise sold, and cost of
goods sold or services provided.

b. Some costs are assigned as expenses to the current accounting period because (1)
their incurrence during the period provides no discernible future benefits; (2) they are
measures of assets recorded in previous periods from which no future benefits are
expected or can be discerned; (3) they must be incurred each accounting year, and
no buildup of expected future benefits occurs; (4) by their nature they relate to
current revenues even though they cannot be directly associated with any specific
revenues; (5) the amount of cost to be deferred can be measured only in an arbitrary
manner or great uncertainty exists regarding the realization of future benefits, or
both; and (6) uncertainty exists regarding whether allocating them to current and
future periods will serve any useful purpose. Thus, many costs are called "period
costs" and are treated as expenses in the period incurred because neither do they
have a direct relationship with revenue earned nor can their occurrence be directly
shown to give rise to an asset. The application of this principle of expense
recognition results in charging many costs to expense in the period in which they are
paid or accrued for payment. Examples of costs treated as period expenses would
include officers' salaries, advertising, research and development, and auditors' fees.

c. A cost should be capitalized, that is, treated as an asset, when it is expected that the
asset will produce benefits in future periods. The important concept here is that the
incurrence of the cost has resulted in the acquisition of an asset, a future service
potential. If a cost is incurred that resulted in the acquisition of an asset from which
benefits are not expected beyond the current period, the cost may be expensed as a
measure of the service potential that expired in producing the current period's
revenues. Not only should the incurrence of the cost result in the acquisition of an
asset from which future benefits are expected, but also the cost should be
measurable with a reasonable degree of objectivity, and there should be reasonable
grounds for associating it with the asset acquired. Examples of costs that should be
treated as measures of assets are the costs of merchandise
Exercise 6-9—concluded

on hand at the end of an accounting period, the costs of insurance coverage relating
to future periods, and the costs of self-constructed plant or equipment.

d. In the absence of a direct basis for associating asset cost with revenue, and if the
asset provides benefits for two or more accounting periods, its cost should be
allocated to these periods (as an expense) in a systematic and rational manner. When
it is impractical, or impossible, to find a close cause-and-effect relationship between
revenue and cost, this relationship is often assumed to exist. Therefore, the asset
cost is allocated to the accounting periods by some method. The allocation method
used should appear reasonable to an unbiased observer and should be followed
consistently from period to period. Examples of systematic and rational allocation of
asset cost would include depreciation of fixed assets, amortization of intangibles, and
allocation of rent and insurance.

e. A cost should be treated as a loss when an unfavorable event results from an activity
other than a normal business activity. The matching of losses to specific revenue
should not be attempted because, by definition, they are expired service potentials
not related to revenue produced. That is, losses resulting from extraneous and
exogenous events that are not recurring or anticipated as necessary in the process of
producing revenue. There is no simple way of identifying a loss, because
ascertaining whether a cost should be a loss is often a matter of judgment. The
accounting distinction between an asset, expense, loss, and prior-period adjustment
is not clear-cut. For example, an expense is usually voluntary, planned, and expected
as necessary in the generation of revenue. But a loss is a measure of the service
potential expired that is considered abnormal, unnecessary, unanticipated, and
possibly nonrecurring and is usually not taken into direct consideration in planning
the size of the revenue stream.

Exercise 6-10 (15 minutes)

a. Research and development costs are expensed in the year that they are incurred.
This means R&D costs impact current income dollar for dollar. Also, to the extent
that research and development efforts lead to future revenues, this is a violation of
the matching principle in relating costs to revenues in determining future income.
b. R&D expenditures at Frontier Biotech decreased substantially in fiscal 2006. As a
result, fiscal 2006 net income is substantially higher. However, this may not be a
good signal for future profitability. To the extent that one has confidence in the
ability of the R&D department at Frontier Biotech, future revenues may be
compromised by management’s decision to curtail research efforts.
Exercise 6-11 (15 minutes)

a. First, the fair value of the option grant is determined on the date of the grant using an
option pricing model, such as Black-Scholes. Second, this fair value amount is
amortized over the period that the employee is expected to hold on to the option, i.e.,
the expected “term” of the ESO by charging it to income as compensation expense.
In the balance sheet, the option expense reduces retained earnings and increases a
special account in the share capital. This special account is closed to paid-in share
capital when the employee exercises the option.

b. The cost arises because of the (1) interest cost and the (2) option cost. One way to
understand the cost is to realize that issuing of ESO is like selling a call option.
Therefore to perfectly hedge the transaction the company needs to buy a similar call
option. Call option have a price and therefore this transaction is not costless to the
company.

c. This is untrue. The benefits of options arising from more motivated and long-lived
workforce will translate to higher income through improved revenues or reduced
costs. The options cost is amortized to match the benefits that are expected to arise.

d. For equity analysis the compensation expense is a legitimate expense that reflects
potential reduction in value of shareholdings of current shareholders. For credit
analysis option expense is irrelevant because it is only a transfer of wealth between
current and potential shareholders.

Exercise 6-12 (40 minutes)

a. The plan will be deemed to be compensatory. This is because the stock option plan
is only offered to certain employees and the life of the option is not short.

b. Incent.Com would offer such a lucrative plan to its employees to attract and retain a
talented work force. Human capital is a key asset in technology companies.

c. The grant date is January 1, 2004; Vesting date is January 1, 2009; First exercise
date is January 1, 2009.

d. No, the employee stock options are not “in-the-money” at the grant date. This is
because at the grant date the exercise price is greater than or equal to (not less than)
the market price of the stock.
e. Total compensation cost should be measured at the date of measurement. The date
of measurement is the earliest date that the number of shares and the stock option
price is known—which is January 1, 2004, in this case.

f. Total compensation cost to be recognized will depend upon the accounting rules
applied. Under APB 25, total compensation cost is $0; computed as the intrinsic
value of the options times the number of shares, or [($20–$20) x 100,000 shares].
Under SFAS 123, the 81,538 options (rounded up) are expected to vest based on the
4% forfeiture rate. Specifically, 100,000 x 4% = 4,000 options in 2000; 96,000 x 4% =
3,840 options in 2001; 92,160 x 4% = 3,686 options in 2002; 88,474 x 4% = 3,539
options in 2003; and 84,935 x 4% = 3,397 options in 2004. Consequently, $652,304 in
total compensation expense should be recognized (81,538 options x $8 fair value per
option).

g. Compensation cost should be allocated over the service period, years 2004 through
2008.

h. The employee stock option plan transfers wealth from stockholders to employees by
granting potential ownership rights to employees with less than “full buy-in” to
acquire these ownership rights. That is, if existing ownership were diluted via a
normal issuance of shares to investors, contributed capital received from the
investors would be much greater than that received from the exercise price of stock
options.

Exercise 6-13 (15 minutes)

a. Managers often hold, or expect to hold, stock options. As a result, they will increase
their wealth when the market price of the stock increasing exceeds the exercise price
of stock options they hold. By withholding good news and selectively releasing bad
news before the date that the option’s exercise price is established, the managers
allegedly depress the price of the stock (at least temporarily) until the exercise price
is established.

b. In the analysis of company performance and stock valuation, silence before a grant
date might be interpreted as a sign that no significant bad news is known by the
managers (given their incentive to release bad news prior to the date to establish an
exercise price when managers hold stock options). Moreover, an analyst might
expect that good news would be withheld by managers until after the date that the
exercise price of the stock options is established.

c. The “backdating’ of employee stock options was a scandal that embarrassed

corporate America. This was clearly unethical practice, whereby current shareholders
were unfairly affected. The beneficiaries were the employees who were able to get the
ESO exercise prices set at the lowest level possible after the fact.
Exercise 6-14 (20 minutes)

a. Some transactions affect the determination of net income for accounting purposes in
one reporting period and the computation of taxable income and income taxes
payable in a different reporting period. In accordance with the matching principle, the
appropriate income tax expense represents the income tax consequences of
revenues and expenses recognized for accounting purposes in the current period,
whether those income taxes are paid or payable in current, future, or past periods.
Accordingly, a deferred income taxes account is setup to reflect such timing
differences.

b. When depreciation expense for machinery purchased this year is reported using the
MACRS for income tax purposes and the straight-line basis for accounting purposes,
a timing difference arises. Because more depreciation expense is reported for income
tax purposes than for accounting purposes this year, pretax accounting income is
more than taxable income. The difference creates a credit to deferred income taxes
equal to the difference in depreciation multiplied by the appropriate income tax rate.

When rent revenues received in advance this year are included in this year's taxable
income but as unearned revenues (a current liability) for accounting purposes, a
timing difference arises. Because rent revenues are reported this year for income tax
purposes but not for accounting purposes, pretax accounting income is less than
taxable income. The difference creates a debit to deferred income taxes equal to the
difference in rent revenues multiplied by the appropriate income tax rate.

c. The income tax effect of the depreciation (timing difference) is classified on the
balance sheet as a noncurrent liability because the asset to which it is related is
noncurrent. The income tax effect of the rent revenues received in advance (timing
difference) is classified on the balance sheet as a current asset because the liability
to which it is related is current. The noncurrent liability and the current asset should
not be netted on the balance sheet because one is current and one is noncurrent.

On the income statement, the income tax effect of the depreciation (timing difference)
and the rent revenues received in advance (timing difference) should be netted. This
amount is classified as a deferred component of income tax expense.
Exercise 6-15 (15 minutes)

There are at least two earnings targets that are typically relevant for managers and investors. The first is
the consensus earnings expectation of the analyst community. The second is the earnings in the same
quarter of the previous fiscal year. (A third might be an earnings forecast previously released by
management.) Beating these targets by even a penny is typically viewed as a sign of sustained profit
growth and skilled leadership. This means that companies near these targets will use earnings
management to meet or exceed these targets, even if only by a penny. Accordingly, earnings increases
of $0.01 can be significant when the change pushes earnings equal to or above relevant earnings
targets. Of course, a magnitude or scale issue can be relevant as well. A $0.01 change in an earnings per
share figure that is approximately $0.05 per share in total can be quite relevant, whereas a $0.01 change
for an earnings per share figure that is approximately $10.00 per share can be substantially less relevant.