Question & Answer

What is the fair value option? Where do companies that elect the fair value option report unrealized holding gains and losses?

What is “imputed interest”? In what situations is it necessary to impute an interest rate for notes receivable? What are the considerations in imputing an appropriate interest rate?

On January 1, 2014, Lombard Co. sells property for which it had paid $690,000 to Sargent Company, receiving in return Sargent’s zero-interest-bearing note for $1,000,000 payable in 5 years. What entry would Lombard make to record the sale, assuming that Lombard frequently sells similar items of property for a cash sales price of $640,000?

What is the normal procedure for handling the collection of accounts receivable previously written off using the direct write-off method? The allowance method?

Because of calamitous earthquake losses, Bernstein Company, one of your client’s oldest and largest customers, suddenly and unexpectedly became bankrupt. Approximately

30% of your client’s total sales have been made to Bernstein Company during each of the past several years.

The amount due from Bernstein Company—none of which is collectible—equals 22% of total accounts receivable, an amount that is considerably in excess of what was determined to be an adequate provision for doubtful accounts at the close of the preceding year. How would your client record the write-off of the Bernstein Company receivable if it is using the allowance method of accounting for bad debts? Justify your suggested treatment.

Explain how the accounting for bad debts can be used for earnings management.

Of what merit is the contention that the allowance method lacks the objectivity of the direct write-off method? Discuss in terms of accounting’s measurement function.

Indicate how well the percentage-of-sales method and the aging method accomplish the objectives of the allowance method of accounting for bad debts.

What is the theoretical justification of the allowance method as contrasted with the direct write-off method of accounting for bad debts?

What are the basic problems that occur in the valuation of accounts receivable?

What are two methods of recording accounts receivable transactions when a cash discount situation is involved? Which is more theoretically correct? Which is used in practice more of the time? Why?

What are the reasons that a company gives trade discounts? Why are trade discounts not recorded in the accounts like cash discounts?

Springsteen Inc. reported in a recent annual report “Restricted cash for debt redemption.” What section of the balance sheet would report this item?

Define a “compensating balance.” How should a compensating balance be reported?

In what accounts should the following items be classified?

(a) Coins and currency.

(b) U.S. Treasury (government) bonds.

(c) Certificate of deposit.

(d) Cash in a bank that is in receivership.

(e) NSF check (returned with bank statement).

(f) Deposit in foreign bank (exchangeability limited).

(g) Postdated checks.

(h) Cash to be used for retirement of long-term bonds.

(i) Deposits in transit.

(j) 100 shares of Dell stock (intention is to sell in one year or less).

(k) Savings and checking accounts.

(l) Petty cash.

(m) Stamps.

(n) Travel advances.

What may be included under the heading of “cash”?

with corporate headquarters in Pittsburgh, Pennsylvania, is one of the largest producers, transporters, distributors, and marketers of natural gas in North America.

Periodically, the company experiences a decrease in the value of its gas- and oil-producing properties,and a special charge to income was recorded in order to reduce the carrying value of those assets. Assume the following information. In 2013, CNG estimated the cash inflows from its oil- and gasproducing properties to be $375,000 per year. During 2014, the write-downs described above caused the estimate to be decreased to $275,000 per year. Production costs (cash outflows) associated with all these properties were estimated to be $125,000 per year in 2013, but this amount was revised to $155,000 per year in 2014.

Instructions

(Assume that all cash flows occur at the end of the year.)

(a) Calculate the present value of net cash flows for 2013–2015 (three years), using the 2013 estimates and a 10% discount factor.

(b) Calculate the present value of net cash flows for 2014–2016 (three years), using the 2014 estimates and a 10% discount factor.

(c) Compare the results using the two estimates. Is information on future cash flows from oil- and gasproducing properties useful, considering that the estimates must be revised each year? Explain.

At a recent meeting of the accounting staff in your company, the controller raised the issue of using present value techniques to conduct impairment tests for some of the company’s fixed assets. Some of the more senior members of the staff admitted having little knowledge of present value concepts in this context, but they had heard about a FASB Concepts Statement that may be relevant. As the junior staff in the department, you have been asked to conduct some research of the authoritative literature on this topic and report back at the staff meeting next week.

Instructions

If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and access the FASB Statements of Financial Accounting Concepts. When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.)

(a) Identify the recent concept statement that addresses present value measurement in accounting.

(b) What are some of the contexts in which present value concepts are applied in accounting measurement?

(c) Provide definitions for the following terms:

(1) Best estimate.

(2) Estimated cash flow (contrasted to expected cash flow).

(3) Fresh-start measurement.

(4) Interest methods of allocation.

The financial statements of P&G are presented in Appendix 5B. The company's complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website,

www.wiley.com/college/kieso.

Instructions

(a) Examining each item in P&G’s balance sheet, identify those items that require present value, discounting, or interest computations in establishing the amount reported. (The accompanying notes are an additional source for this information.)

(b) (1) What interest rates are disclosed by P&G as being used to compute interest and present values?

(2) Why are there so many different interest rates applied to P&G’s financial statement elements (assets, liabilities, revenues, and expenses)?

Murphy Mining Company recently purchased a quartz mine that it intends to work for the next 10 years. According to state environmental laws, Murphy must restore the mine site to its original natural prairie state after it ceases mining operations at the site. To properly account for the mine, Murphy must estimate the fair value of this asset retirement obligation. This amount will be recorded as a liability and added to the value of the mine on Murphy’s books. (You will learn more about these asset retirement obligations in Chapters 10 and 13.) There is no active market for retirement obligations such as these, but Murphy has developed the following cash flow estimates based on its prior experience in mining-site restoration. It will take 3 years to restore the mine site when mining operations cease in 10 years. Each estimated cash outflow reflects an annual payment at the end of each year of the 3-year restoration period.

Instructions

(a) What is the estimated fair value of Murphy’s asset retirement obligation? Murphy determines that the appropriate discount rate for this estimation is 5%. Round calculations to the nearest dollar.

(b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain.

Restoration Estimated Probability

Cash Outflow Assessment

$15,000 10%

22,000 30%

25,000 50%

30,000 10%

At the end of 2014, Sawyer Company is conducting an impairment test and needs to develop a fair value estimate for machinery used in its manufacturing operations.

Given the nature of Sawyer’s production process, the equipment is for special use. (No secondhand market values are available.) The equipment will be obsolete in 2 years, and Sawyer’s accountants have developed the following cash flow information for the equipment.

7 9

Net Cash Flow Probability

Year Estimate Assessment

2015 $6,000 40%

9,000 60%

2016 $ (500) 20%

2,000 60%

4,000 20%

Scrap value

2016 $ 500 50%

900 50%

Instructions

Using expected cash flow and present value techniques, determine the fair value of the machinery at the end of 2014. Use a 6% discount rate. Assume all cash flows occur at the end of the year.

Danny’s Lawn Equipment sells high-quality lawn mowers and offers a 3-year warranty on all new lawn mowers sold. In 2014, Danny sold $300,000 of new specialty mowers for golf greens for which Danny’s service department does not have the equipment to do the service. Danny has entered into an agreement with Mower Mavens to provide all warranty service on the special mowers sold in 2014. Danny wishes to measure the fair value of the agreement to determine the warranty liability for sales made in 2014. The controller for Danny’s Lawn Equipment estimates the following expected warranty cash outflows associated with the mowers sold in 2014.

Cash Flow Probability

Year Estimate Assessment

2015 $2,500 20%

4,000 60%

5,000 20%

2016 $3,000 30%

5,000 50%

6,000 20%

2017 $4,000 30%

6,000 40%

7,000 30%

Instructions

Using expected cash flow and present value techniques, determine the value of the warranty liability for the 2014 sales. Use an annual discount rate of 5%. Assume all cash flows occur at the end of the year.

Craig Brokaw, newly appointed controller of STL, is considering ways to reduce his company’s expenditures on annual pension costs. One way to do this is to switch STL’s pension fund assets from First Security to NET Life. STL is a very well-respected computer manufacturer that recently has experienced a sharp decline in its financial performance for the first time in its 25-year history. Despite financial problems, STL still is committed to providing its employees with good pension and postretirement health benefits.

Under its present plan with First Security, STL is obligated to pay $43 million to meet the expected value of future pension benefits that are payable to employees as an annuity upon their retirement from thecompany. On the other hand, NET Life requires STL to pay only $35 million for identical future pension benefits. First Security is one of the oldest and most reputable insurance companies in North America. NET Life has a much weaker reputation in the insurance industry. In pondering the significant difference in annual pension costs, Brokaw asks himself, “Is this too good to be true?”

Instructions

Answer the following questions.

(a) Why might NET Life’s pension cost requirement be $8 million less than First Security’s requirement for the same future value?

(b) What ethical issues should Craig Brokaw consider before switching STL’s pension fund assets?

(c) Who are the stakeholders that could be affected by Brokaw’s decision?

You have been hired as a benefit consultant by Jean Honore, the owner of Attic Angels. She wants to establish a retirement plan for herself and her three employees. Jean has provided the following information. The retirement plan is to be based upon annual salary for the last year before retirement and is to provide 50% of Jean’s last-year annual salary and 40% of the last-year annual salary for each employee.

The plan will make annual payments at the beginning of each year for 20 years from the date of retirement.

Jean wishes to fund the plan by making 15 annual deposits beginning January 1, 2014. Invested funds will earn 12% compounded annually. Information about plan participants as of January 1, 2014, is as follows.

Jean Honore, owner: Current annual salary of $48,000; estimated retirement date January 1, 2039.

Colin Davis, fl ower arranger: Current annual salary of $36,000; estimated retirement date January 1, 2044.

Anita Baker, sales clerk: Current annual salary of $18,000; estimated retirement date January 1, 2034.

Gavin Bryars, part-time bookkeeper: Current annual salary of $15,000; estimated retirement date January 1, 2029.

In the past, Jean has given herself and each employee a year-end salary increase of 4%. Jean plans to continue this policy in the future.

Instructions

(a) Based upon the above information, what will be the annual retirement benefit for each plan participant? (Round to the nearest dollar.) (Hint: Jean will receive raises for 24 years.)

(b) What amount must be on deposit at the end of 15 years to ensure that all benefits will be paid? (Round to the nearest dollar.)

(c) What is the amount of each annual deposit Jean must make to the retirement plan?

Dunn Inc. owns and operates a number of hardware stores in the New England region. Recently, the company has decided to locate another store in a rapidly growing area of Maryland. The company is trying to decide whether to purchase or lease the building and related facilities.

Purchase: The company can purchase the site, construct the building, and purchase all store fi xtures. The cost would be $1,850,000. An immediate down payment of $400,000 is required, and the remaining $1,450,000 would be paid off over 5 years at $350,000 per year (including interest payments made at end of year). The property is expected to have a useful life of 12 years, and then it will be sold for $500,000. As the owner of the property, the company will have the following out-of-pocket expenses each period.

Property taxes (to be paid at the end of each year) $40,000

Insurance (to be paid at the beginning of each year) 27,000

Other (primarily maintenance which occurs at the end of each year) 16,000 $83,000

Lease: First National Bank has agreed to purchase the site, construct the building, and install the appropriate fi xtures for Dunn Inc. if Dunn will lease the completed facility for 12 years. The annual costs for the lease would be $270,000. Dunn would have no responsibility related to the facility over the 12 years.

The terms of the lease are that Dunn would be required to make 12 annual payments (the fi rst payment to be made at the time the store opens and then each following year). In addition, a deposit of $100,000 is required when the store is opened. This deposit will be returned at the end of the twelfth year, assuming no unusual damage to the building structure or fi xtures.

Instructions

Which of the two approaches should Dunn Inc. follow? (Currently, the cost of funds for Dunn Inc. is 10%.)