BRIEF EXERCISE 4 6 Income before income tax 2014 2013 2012 180 000 145 000 170 000 54 000 43 500 51 000 126 000 101 500 119 000 Income tax 30 Net Income EXERCISE 4 16 15 20 minutes C REITHER CO Statement of Stockholders Equity For the Year Ended December 31 2014 Accumulated Other Total Retained Comprehensive Common Earning Income Stock 80 000 350 000 s Beginning balance 520 000 90 000 120 000 120 000 Comprehensive income Net income Other comprehensive income Unrealized holding loss 60 000 60 000 Comprehensive income Dividends Ending balance 10 000 570 000 10 000 200 000 20 000 350 000 700 000 500 000 80 000 PROBLEM 4 3 MAHER INC Income Statement Partial For the Year Ended December 31 2014 Income from continuing operations before income tax 838 500 a Income tax 220 350 b Income from continuing operations 618 150 Discontinued operations Loss from disposal of recreational division 115 000 Less Applicable income tax reduction 34 500 1 Income before extraordinary item 80 500 537 650 Extraordinary item Major casualty loss 90 000 Less Applicable income tax reduction 41 400 Net income 1 115 000 30 2 90 000 46 Per share of common stock 2 48 600 489 050 Income from continuing operations 5 15 Discontinued operations net of tax 0 67 Income before extraordinary items 4 48 Extraordinary item net of tax 0 40 Net income 489 050 120 000 4 08 Rounded a Computation of income from cont operations before taxes As previously stated 790 000 Loss on sale of securities 57 000 Gain on proceeds of life insurance 104 000 policy 150 000 46 000 Error in computation of depreciation As computed 54 000 6 9 000 Corrected 54 000 9 000 6 7 500 As restated b 1 500 838 500 Computation of income tax Income from continuing operations before taxes 838 500 Nontaxable income gain on life insurance 104 000 Taxable income 734 500 Tax rate X Income tax 30 220 350 Note No adjustment is needed for the inventory method change since the new method is reported in 2014 income The cumulative effect on prior years of retroactive application of the new inventory method will be recorded in retained earnings CA 4 2 a Earnings management is often defined as the planned timing of revenues expenses gains and losses to smooth out bumps in earnings In most cases earnings management is used to increase income in the current year at the expense of income in future years For example companies prematurely recognize sales in order to boost earnings Earnings management can also be used to decrease current earnings in order to increase income in the future The classic case is the use of cookie jar reserves which are established by using unrealistic assumptions to estimate liabilities for such items as loan losses restructuring charges and warranty returns b Proposed Accounting 2011 2012 2013 Income before warranty expense Warranty expense Income 20 000 25 000 30 000 2014 2015 43 000 43 000 7 000 3 000 36 000 40 000 Assuming the same income before warranty expense for both 2014 and 2015 and total warranty expense over the 2 year period of 10 000 this proposed accounting results in steadily increasing income over the two year period c Appropriate Accounting 2011 2012 2013 Income before warranty expense Warranty expense Income 20 000 25 000 30 000 2014 2015 43 000 43 000 5 000 5 000 38 000 38 000 The appropriate accounting would be to record 5 000 of warranty expense in 2014 resulting in income of 38 000 However with the same amount of warranty expense in 2015 Bobek no longer shows an increasing trend in income Thus by taking more expense in 2014 Bobek can save some income a classic case of cookie jar reserves and maintain growth in income CA 4 6 Classification Rationale Error has washed out that is subsequent income statement compensated for the error However prior year income statements should be restated 1 No disclosure 2 Extraordinary item section Material unusual in nature and infrequent in occurrence 3 Depreciation expense in body of income statement based on new useful life Material item but change in estimated useful life is considered part of normal business activity 4 No separate disclosure unless material Change in estimate considered part of normal business activity 5 Reported in body of the income statement possibly as an unusual item Sale does not meet criteria for either the disposal of a component of the business or an extraordinary item 6 Adjustment to the beginning balance of retained earnings A change in inventory methods is a change in accounting principle and prior periods are adjusted 7 Reported in body of the income statement possibly as an unusual item Loss on preparation of such proposals is not considered extraordinary in nature 8 Reported in body of the income statement possibly as an unusual item Strikes are not considered extraordinary in nature 9 Prior period adjustment adjust beginning retained earnings Corrections of errors are shown as prior period adjustments Extraordinary item section Material unusual in nature and infrequent in 10 occurrence 11 Discontinued operations section Division s assets results of operations and activities are clearly distinguishable physically operationally and for financial reporting purposes