Test Bank For Financial Statement Analysis and Valuation 2nd Edition Easton

Test Bank for Financial Statement Analysis and Valuation, 2nd Edition: Easton
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Valuation, 2nd Edition: Easton
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Module 5
Revenue Recognition and
Operating Income
Learning Objectives – coverage by question
Multiple Essay
Exercises Problems
Choice Questions
LO1 Explain revenue

recognition criteria and
1-6 1-6 1-2 1-3
identify transactions of
special concern for analysis.
LO2 Describe and analyze

accounting for operating
expenses, including research 7-12 7-12 3-5 4-6
and development, and
restructuring.
LO3 Explain and analyze

13-19 13-19 6-8 7
accounting for income taxes.
LO4 Explain how foreign

currency fluctuations affect 20-21 20-21 - 8, 10
the income statement.
LO5 Compute earnings per

share and explain the effect of 22-25 22-25 9-10 9
dilutive securities.
© Cambridge Business Publishers, 2010

Test Bank, Module 5 5-1
Module 5: Revenue Recognition and Operating Income
Multiple Choice
Topic: Revenue recognition
LO: 1
1. Which of the following items do not create risk related to revenue recognition?
a. Bonuses tied to sales goals
b. Long-term construction contracts
c. Multiple element sales contracts
d. Consignment goods
e. All of the above
Answer: e
Rationale: Each of these types of revenue or business conditions creates risk associated with
revenue recognition. Each requires good internal controls to prevent and detect inappropriate
revenue recognition, as well as extra management vigilance and auditor care.
Topic: Revenue recognition at a service firm

LO: 1
2. Boston Consulting Group (BCG) is a management consulting, technology services and
outsourcing organization. Which of the following actions should managers take when there is
evidence that a fixed-rate contract is over budget and will generate a loss for the firm?
a. Use the percentage of completion method to recognize the loss over the remaining term of the
engagement.
b. Recognize the loss in the current period rather than over the remaining term of the
engagement.
c. Restate the financial statements and recognize the loss in the earliest period of the
engagement.
d. Use the percentage of completion method and pro rate the loss over the entire term of the
engagement.
e. None of the above is an appropriate action.
Answer: b
Rationale: When contracts are over-budget, managers should estimate the new, revised, total
engagement cost. If this results in a loss on the engagement, that loss should be recognized
immediately rather than over the remaining term of the engagement.
Cambridge Business Publishers, ©2010

5-2 Financial Statement Analysis & Valuation, 2nd Edition
Topic: Percentage-of-completion method – Numerical calculations required
LO: 1
3. On December 31, 2009, Tri-State Construction Inc. signs a contract with the state of Texas
Department of Transportation to manufacture a bridge over the Rio Grande. Tri-State anticipates
the construction will take three years. The company’s accountants provide the following contract
details relating to the project:
Contract price $210 million

Estimated construction costs $150 million
Estimated total profit $ 60 million
During the three-year construction period, Tri-State incurred costs as follows:

2010 $ 15 million
2011 $ 90 million
2012 $ 45 million
Tri-State uses the percentage of completion method to recognize revenue. Which of the following
represent the revenue recognized in 2010, 2011, and 2012?
a. $70 million, $70 million, $70 million
b. $15 million, $90 million, $45 million
c. $6 million, $36 million, $18 million
d. $21 million, $126 million, $ 63 million
e. None of the above
Answer: d
Rationale:
($ in millions) Year 1 Year 2 Year 3
Construction costs incurred $15 $90 $45
Percentage to total costs $15 / $150 = 10% $90 / $150 = 60% $45 / $150 = 30%
Revenue recognized 10% × $210 = $21 60% ×210 = $126 30% × 210= $63
Topic: Percentage-of-completion method – Numerical calculations required

LO: 1
4. In spring 2009, Mainline Engineering Company signed a $40 million contract with the city of
Duluth, to construct a new city hall. Mainline expects to construct the building within two years
and incur expenses of $30 million. The city of Duluth paid $10 million when the contract was
signed, $20 million within the next six months, and the final $10 million exactly one year from the
signing of the contract. Mainline incurred $12 million in costs during 2009 and rest in 2010 to
complete the contract on time. Using the percentage-of-completion method how much revenue
should Mainline recognize in 2009?
a. $16 million
b. $30 million
c. $10 million
d. $20 million
Answer: a.
Rationale: According to the percentage-of-completion method Mainline Engineering Company
should recognize the revenues as shown in the table below:
Total
Year contract Percentage completed Revenue Recognized
40% × $40 million =
2010 $40 million $12 million/$30 million = 40% $16 million

Topic: Risk exposures to revenue recognition
LO: 1
5. Sam’s Club (part of the WalMart consolidated operations) collects annual non-refundable
membership fees from customers. When should Sam’s Club recognize revenue for these
membership fees?
a. immediately when cash is received because the fees are nonrefundable
b. evenly over the membership year
c. evenly over the current fiscal year
d. at the end of the membership year when Sam’s has discharged its obligation to the customer
e. pro rata over the customer’s actual purchasing pattern
Answer: b
Rationale: Sam’s should record membership fees evenly over the year even if the fee is
nonrefundable because Sam’s has an obligation to stay open for business for a year to honor the
customer’s membership.

LO: 1
6. Tickets Now contracts with the producer of Riverdance to sell tickets online. Tickets Now
charges each customer a fee of $2 per ticket and receives $5 per ticket from the producer.
Tickets Now does not take control of the ticket inventory. Average ticket price for the event is $75.
How much revenue should Tickets Now recognize for each Riverdance ticket sold?
a. $2 because the $5 from the producer is similar to a negative cost of goods sold
b. $7 because both the fee from the customer and the producer are earned
c. $75 because the $70 is cost of goods sold paid to the Riverdance producer
d. $77 because the $70 is cost of goods sold paid to the Riverdance producer
Answer: b
Tickets Now should record $7 revenue each time it sells a ticket. Of that $2 will be received in
cash and $5 will be recorded as receivable from the Riverdance producers.
Topic: Research and development expenses

LO: 2
7. On its 2008 income statement, Yahoo! reported Product development expense of $1,221,787.
Which of the following statements must be true?
a. Yahoo spent $1,221,787 in cash to develop new products and improve old products
b. Product development expense reduced Yahoo’s 2008 net income by $1,221,787
c. Yahoo capitalized at least $1,221,787 of product development costs in 2008
d. The $1,221,787 included amortized product development costs from prior years that were not
previously expensed, because Yahoo incurs such expenses each year
e. none of the above
Answer: e
Rationale: Yahoo included in product development expense certain non-cash expenses such as
depreciation on related assets, thus a is not correct. Yahoo recorded deferred tax expense on the
product development expense, thus net income was affected on an after-tax basis and b is
therefore not correct. Under US GAAP firms may not capitalize R&D costs, thus c is not correct.
All R&D expenses must be included in the income statement in the period, thus d is wrong.

LO: 2
8. Life Technologies Corporation reported research and development expense of $142,505
thousand on its 2008 income statement. This expense included many types of costs. Which of the
following types of costs would not be included in the $142,505 thousand?
a. salaries and wages for R&D personnel
b. supplies and inventory related to R&D activities and new-product sales
c. depreciation on equipment used in experiments
d. costs of applying for FDA approval
Answer: b
Rationale: R&D expenses exclude any costs related to sales.
Topic: Research and development expenses – Numerical calculations required

LO: 2
9. Life Technologies Corporation and Affymetrix Inc. are competitors in the life sciences and
clinical healthcare industry. Following is a table of Total revenue and R&D expenses for both
companies.
Life Technologies Corporation Affymetrix Inc
2008 2007 2006 2008 2007 2006
Total revenue $1,620,323 $1,281,747 $1,151,175 $410,249 $371,320 $355,317
R&D expenses $142,505 $115,833 $104,343 $84,482 $72,740 $86,296
Which of the following is true?

a. Life Technologies Corporation is the more R&D intensive company of the two.
b. Life Technologies Corporation has become more R&D intensive over the three years.
c. Affymetrix grew its R&D by more in 2008 as compared to Life Technologies.
d. Affymetrix is less R&D intensive in 2008 than in 2006.
Answer: d
Rationale: To make comparisons, we need to common size the R&D expenditures of both firms
by scaling by total revenues and calculate growth rates.
2008 2007 2006 2008 2007 2006
Common
sized R&D 8.8% 9.0% 9.1% 20.6% 19.6% 24.3%
R&D growth 23.03% 11.01% 14.14% -15.71%
Affymetrix spends proportionately more on R&D than Life Technologies, thus a is not true. Life
Technologies has spent less on R&D over the three year period, thus b is not true. Affymetrix
grew R&D by 14% in 2008 compared to Life Technologies’ growth of 23%, thus c is not true.
Affymetrix decreased R&D from 24.2% in 2006 to 20.6% in 2008, thus d is true.

Topic: Research and development expenses – building with no alternate use
LO: 2
10. Dow Chemical Corporation plans to build a laboratory dedicated to a special project. The
company will not use the laboratory after the project is finished. Under GAAP, this laboratory
should be
a. capitalized and depreciated.
b. expensed in the current year.
c. depreciated and expensed.
d. capitalized only.
Answer: b
Rationale: Project-directed or highly-specific research buildings and equipment with no alternate
uses must be expensed as incurred.
Topic: Research and development expenses– Numerical calculations required

LO: 2
11. Yahoo! reported the following in its 2008 financial statements (in thousands):
December December
31, 2007 31, 2008
Total assets $12,229,741 $13,689,848
Revenues $6,969,274 $7,208,502
Product development expense $1,084,238 $1,221,787
Net income $660,000 $424,298
What is Yahoo’s common-sized product development expense for 2008?

a. 4.026%
b. 8.925%
c. 9.428%
d. 16.949%
Answer: d
Rationale: To common-size income statement items, we divide by current period sales.
Common-sized product development expense for 2008 is therefore $1,221,787/ $7,208,502 =
16.949%.

Topic: Restructuring charges– Numerical calculations required
LO: 2
12. Mariposa Imports recorded a restructuring charge of $5.4 million during fiscal 2009 related
entirely to the closing of its California based operations in San Diego and in Tijuana, Mexico. The
company’s financial statement footnotes indicated that expected employee separation payments
amounted to $4.2 million and that fixed asset write-downs accounted for the remainder. Mariposa
had never before incurred restructuring charges. At the end of the year, the company’s balance
sheet included a restructuring accrual of $900,000. The cash flow effect of Mariposa’s
restructuring during fiscal 2009 is:
a. $0 (there was no cash flow effect in 2009)
b. $900,000
c. $3,300,000
d. $4,200,000
e. $5,400,000
Answer: c.
Rationale: The total restructuring charge accrued was $4.2 million because asset write-downs are
not accrued. That is there is no credit to a liability account for write-downs, the assets are credited
(reduced). Thus, the company must have paid $4,200,000 - $900,000 = $3,300,000 in cash
during fiscal 2009.

LO: 2
13. Dow Chemical recorded pretax restructuring charges of $785 million in the fourth quarter of
2008. The charges consisted of asset write-downs of $336 million, costs associated with exit or
disposal activities of $128 million, and employee severance costs of $321 million. The company
paid $2 million cash to settle these restructuring charges during the year (2008). At year end, the
restructuring accrual associated with these charges was:
a. $783 million
b. $447 million
c. $126 million
d. $319 million
e. There is not enough information to determine the amount.
Answer: b
Rationale: Of the $785 million total restructuring charge, only the exit costs and severance costs
must eventually be settled in cash. The asset write downs are not accrued – they reduce the
assets on the balance sheet. The company accrued $128 million + $321 million = $449 million as
a liability. Thus, if the company paid $2 million cash, the remaining accrual is $447 million at year
end.

LO: 2
14. Intelligentsia Corp. recorded restructuring charges of $78,514 thousand during fiscal 2009
related entirely to anticipated employee separation payments. Intelligentsia had never before
incurred restructuring charges. At the end of the year, the company’s balance sheet included a
restructuring accrual of $9,881. The cash flow effect of Intelligentsia’s restructuring during fiscal
2009 was:
a. $9,881 thousand
b. $78,514 thousand
c. $68,633 thousand
d. $88,395 thousand
Answer: c
Rationale: The total restructuring charge accrued was $78,514 of which $9,881 was still unpaid
(a liability) at the end of the year. The difference of $68,633 must have been paid in cash during
the year. The cash flow effect is $68,633.
Topic: Tax expense– Numerical calculations required

LO: 3
15. In fiscal 2008, Microsoft Corp. reported a statutory tax rate of 35.0%, an effective tax rate of
25.75% and a tax rate on operating profit of 29.32%. The 2008 income statement reported
income tax expense of $6,133 million. What did Microsoft report as income before income tax
expense that year?
a. $23,817 million
b. $20,917 million
c. $17,523 million
d. $3,986 million
Answer: a.
Rationale: Microsoft reported income before income tax expense of $23,817 million. This is
calculated as Income tax expense / Effective tax rate = $6,133 million / 0.2575 = $23,817 million.
Topic: Tax expense– Numerical calculations required

LO: 3
16. In fiscal 2008, Snap-On Inc. reported a statutory tax rate of 37.4%, an effective tax rate of
32.9% and a tax rate on net operating profit of 33.3%. Income before income tax for 2008 was
$357.8 million. What did Snap-On report as tax expense (on its income statement) in 2008?
a. $117.7 million
b. $119.1 million
c. $125.2 million
d. $133.8 million
Answer: a
Rationale: Snap-On reported taxes on the income statement of $117.7 million. This is calculated
as Income before tax × Effective tax rate = $357.8 × 0.329 = $117.7

Topic: Deferred tax valuation allowance– Numerical calculations required
LO: 4
17. The 2008 annual report of Dow Chemical Company disclosed a valuation allowance of $487
million related to various deferred tax assets. The 2007 valuation allowance had a balance of
$323 million. What effect did this increase in the allowance have on Dow Chemical’s net income
in 2008?
a. Increase net income by $487 million
b. Decrease net income by $487 million
c. Increase net income by $164 million
d. Decrease net income by $164 million
Answer: d
Rationale: Changes in valuation allowance affect net income in the opposite direction, dollar for
dollar. Dow Chemical increased the allowance by $164 million ($487 million - $323 million). The
effect was to reduce Dow’s net income by $164 million in 2008.
Topic: Changes in deferred income tax accounts– Numerical calculations required

LO: 3
18. The 2008 annual report of Dow Chemical disclosed the following: Deferred tax assets
increased by $1,205 million and deferred tax liabilities decreased by $726 million. How do these
balance-sheet changes affect tax expense on the income statement for the year?
a. Increase tax expense by $1,931 million
b. Decrease tax expense by $1,931 million
c. Increase tax expense by $1,205 million
d. Decrease tax expense by $1,205 million
Answer: b.
Rationale: Changes in the deferred tax asset account, inversely affects tax expense. Changes in
the deferred tax liability account, directly affects tax expense. Therefore Dow’s increase in
deferred tax assets and decrease in deferred tax liabilities, both decrease tax expense for the
year by $1,931 million ( $1,205 million + $726 million = $ 1,931 million decrease in tax expense).
Topic: Deferred portion of income tax expense– Numerical calculations required

LO: 3
19. As a result of using accelerated depreciation for tax purposes, The Ahmed Corporation
reported $93 million income tax expense in its income statement, while the actual amount of
taxes paid by the company was $103 million. How did these tax transactions affect the company’s
balance sheet?
a. Increase deferred tax liability by $10 million
b. Decrease deferred tax assets by $93 million
c. Decrease retained earnings by $93 million
d. Decrease cash by $93 million
e. Both c and d
Answer: c
Rationale: The tax expense of $93 million will reduce net income by that amount and thus,
retained earnings on the balance sheet will be $93 million lower. The company pays $103 million
tax in cash, which reduces assets (cash). The difference of $10 million is recorded as an increase
in deferred tax asset.

Topic: Income tax expense – Numerical calculations required
LO: 3
20. The income tax footnote to the financial statements of Life Technologies Company for the
year ended December 31, 2008, includes the following information (in thousands). How much of
the income tax expense is payable in 2008?
Current tax provision

Federal $ 27,064
State 3,377
Foreign 37,458
67,899
Deferred tax provision
Federal 65,287
State 847
Foreign (9,734)
56,400
Provision for income taxes $124,299
a. $124,299 thousand
b. $67,899 thousand
c. $56,400 thousand
d. $27,064 thousand
Answer: b.
Rationale: The current tax provision of $67,899 is payable in 2008.
Topic: Foreign currency translation

LO: 4
21. The 2009 annual report of Dell Computer Corporation included the following disclosure:
During fiscal 2009, the U.S. dollar strengthened relative to the other principal currencies in which
we transact business with the exception of the Japanese Yen.
What effect did these currency fluctuations have on Dell’s 2009 consolidated income statement?
a. Net profit of the Japanese subsidiary will be higher
b. Net profit of the Japanese subsidiary will be lower
c. Net assets of the subsidiaries that report in the other principal currencies will be higher
d. Net assets of the subsidiaries that report in the other principal currencies will be lower
e. Both a and d
Answer: a
Because the US dollar weakened during the year, each Yen will translate to more dollars. Thus,
revenues, expenses, and net profit of the Japanese subsidiary will be higher than they would
have been absent the foreign currency fluctuations. With respect to the other principal currencies,
given that the US dollar strengthened during the year, the profits in these countries will translate
to fewer dollars. Thus, revenues, expenses, and net profits of these subsidiaries will be lower
than they would have been absent the foreign currency fluctuations. However, d is not a correct
answer because the question asked about the income statement, not the balance sheet. This
render answer e incorrect too.

Topic: Computing EPS and explaining anti-dilutive stock options– Numerical calculations required
LO: 5
22. Oracle reported the following earnings per share information in its 2008 annual report. The
company has only one class of stock. ($ in millions).
Net income $5,521

Dividends to common shareholders $1,563
Weighted average common shares outstanding 5,133

Weighted average dilutive shares from employee stock plans 96
Weighted average anti-dilutive shares from employee stock plans 98
Basic and diluted earnings per share were, respectively:
a. $0.77 and $0.76
b. $0.77 and $0.74
c. $1.08 and $1.06
d. $1.08 and $1.04
Answer: c.
Rationale: Basic EPS = $5,521 / 5,133 = $1.07559 = $1.08
Diluted EPS = $5,521 / 5,229 = $1.05584 = $1.06
Stock options are only included in the computation of EPS if they are, in fact, dilutive. If they are
anti-dilutive, they are excluded from the computation.
Topic: Diluted earnings per share– Numerical calculations required

LO: 5
23. BJ Services, an oil and gas service firm, reports the following EPS data in its 2008 annual
report (in thousands except per share data).
Net income $609,365

Earnings per share:
Basic $2.08
Diluted $2.06
Weighted average shares outstanding:
Basic 293,479
How many weighted average shares were dilutive in 2008?

a. 2,329 thousand
b. 293,479 thousand
c. 295,808 thousand
d. 589,287 thousand
Answer: a
The company included about 295,808 thousand shares for the diluted EPS calculation. This is
computed as: $609,365 thousand / $2.06 = 295,808 thousand. Thus, the company included 2,329
thousand dilutive shares computed as: 295,808 thousand – 293,479 thousand.

Topic: Basic earnings per share– Numerical calculations required
LO: 5
24. Cisco Inc. reported the following in its income statement for the year ended July 26, 2008:
Basic earnings per share of $1.35 and diluted earnings per share of $1.31. 5,986 million weighted
average shares were outstanding during the year. What approximate net income, did the
company report for 2008?
a. $8,081 million
b. $7,842 million
c. $15,923 million
d. $7,962 million
Answer: a.
Rationale: Net income = basic EPS × Average number of shares outstanding during the year.
Thus, net income is $1.35 × 5,986 million = $8,081 million
Topic: Earnings per share definition and computations

LO: 5
25. All of the following are potentially dilutive in computing diluted EPS except:
a. Employee stock options
b. Preferred stock
c. Convertible bonds
d. Warrants
e. All of the above are dilutive securities.
Answer: b
Rationale: Preferred stock is not considered dilutive unless it is convertible.

Exercises
LO: 1
1. Identify when each of the following companies should recognize revenue.
a) Valero Energy – integrated petroleum company that sells crude oil, natural gas and petroleum
and chemical products under short-term agreements at prevailing market prices
b) Boeing – airplane manufacturer whose revenue is derived largely from long-term fixed-price
contracts with airlines
c) Wells Fargo – large commercial bank that earns interest on loans
d) Harley Davidson – manufactures and retails motorcycles, provides financing for dealers and
customers
Answer:
a) Valero: revenues are recognized when the products are delivered, which occurs when the gas
station owner (for independent stations) or the retail customer (for company owned locations) has
taken delivery of the gasoline.
b) Boeing: Record revenue using a percentage of completion method.
c) Wells Fargo: Interest is earned by the passage of time. If cash is not received, Citibank
accrues income on its loans and establishes an account receivable on its balance sheet.
d) Harley Davidson: Retail revenue recorded when customer takes delivery of the motorcycle.
Sales that are financed will yield interest revenue over the life of the note. This is similar to how
banks earn revenue.
Topic: Revenue recognition at a service firm

LO: 1
2. Boston Consulting Group (BCG) is a management consulting, technology services and
outsourcing organization.
a. Identify the revenue recognition method that BCG should use for its consulting services.
b. How should BCG account for client deposits?
c. Sometimes a fixed-rate contract goes over budget such that BCG will incur a loss on the
engagement. How should BCG account for such an event?
Answer:
a. BCG should recognize revenues from long-term contracts on a percentage-of-completion basis
as services are provided.
b. Client deposits and prepayments (even if nonrefundable) should not be recorded as revenue.
Instead, BCG should record deferred revenue (a liability) recognize the revenue over future
periods as services are delivered or performed.
c. When contracts are over-budget, managers should estimate the new, revised, total
engagement cost. If this results in a loss on the engagement, that loss should be recognized
immediately rather than over the remaining term of the engagement.

Topic: Revenue recognition percentage-of-completion method – Numerical calculations required
LO: 1
3. On December 31, 2009, Tri-State Construction Inc. signs a contract with the state of Texas
Department of Transportation to manufacture a bridge over the Rio Grande. Tri-State anticipates
the construction will take three years. The company’s accountants provide the following contract
details relating to the project:
Contract price $210 million

Estimated construction costs $150 million
Estimated total profit $ 60 million
During the three-year construction period, Tri-State incurred costs as follows:
2010 $ 15 million
2011 $ 90 million
2012 $ 45 million
Compute the revenue recognized, construction costs expensed, and income earned for each year
using the percentage of completion method.
Answer:
($ in millions) 2010 2011 2012
Construction costs incurred $15 $90 $45
Percentage to total costs $15 / $150 = 10% $90 / $150 = 60% $45 / $150 = 30%
Revenue recognized 10% × $210 = $21 60% ×210 = $126 30% × 210= $63
Income earned $21 - $15 = $6 $126 - $90 = $36 $63 - $45 = $18
Topic: Revenue Recognition Multiple elements contract– Numerical calculations required

LO: 1
4. On December 31, 2009, Bainbridge Independents, a network solutions consultancy, signs a
multi-year contract with UPS Inc. Under the terms of the contract, Bainbridge will install hardware
and software for UPS and provide a one-year warranty on the hardware. In addition, Bainbridge
will provide software updates and tech support for two years. The total contract price for the
solution, is $4,500,000. In addition, Bainbridge will train UPS employees via on-site classes and
provide one-on-one training for supervisors and higher level managers. UPS will pay $50 per
hour per employee for classes and $250 per hour for one-on-one training. UPS must pay
Bainbridge an upfront fee of $250,000 for the educational package, which will be used to offset
educational hours in the future. How should Bainbridge recognize revenue on the $4,500,000
contract? How should Bainbridge record the $250,000?
Answer:
Bainbridge has a multiple element contract with UPS. Each of the four elements must be
accounted for separately: hardware (recognize revenue when installed and running), software
(recognize when client signs off on installation and beta tests), warranty (recognize over the one-
year coverage period), and software updates / tech support (recognize over the two-year
coverage period). To determine the amount of each part, Bainbridge must determine the fair
value of each element separately and then allocate the contract price $4,500,000 to each
element. The retainer received is unearned revenue (a liability) until the educational services are
rendered. Each month, as Bainbridge provides training, it will bill UPS and reduce the unearned
revenue liability. When total educational services exceed $250,000, Bainbridge will set up a
receivable from UPS.

Topic: Revenue recognition percentage-of-completion method– Numerical calculations required
LO: 1
5. In spring 2009, Mainline Engineering Company signed a contract with the city of Duluth, to
construct a new city hall. Mainline expects to construct the building within two years and incur
expenses of $30 million, which means the company earns a $10 million profit on the contract. The
city of Duluth paid $10 million when the contract was signed, $20 million within the next six
months, and the final $10 million exactly one year from the signing of the contract. Mainline
incurred $12 million in costs during 2009 and rest in 2010 to complete the contract on time. Using
the percentage-of-completion method how much revenue should Mainline recognize in 2009?
revenues? What profit from the Duluth contract, will the company report each year?
Answer: According to the percentage-of-completion method Mainline Engineering Company

should recognize the revenues as shown in the table below:
Contracted
Year Sales Percentage completed Revenue Recognized
(40% of $40 million)
2010 $12 million/$30 million = 40% or $16 million
$40 million
(60% of $40 million)
2011 $18 million/$30 million = 60% or $24 million
Mainline will earn profits according to the revenue recognized, which means that 40% of the
profits ($4 million) should be recorded in 2009 and the rest ($6 million) in 2010 when the building
construction is completed.

Topic: Risk exposures to revenue recognition
LO: 1
6. When should each of the following companies recognize revenue for the following operations?
Identify potential revenue recognition issues or risk exposures facing the company:
a. Sam’s Club (part of the WalMart consolidated operations) collects annual membership fees
from customers.
b. Wall Street Journal receives advertising revenues in advance from Banco do Brasil, for an ad
campaign that will run a full-page spread once a week for six months.
c. J. Jill is an internet clothing retailer. It receives credit card payments when customers place
their orders and ships products from warehouses within 5-7 business days.
d. Tickets Now contracts with the producer of Riverdance to sell tickets online. Tickets Now
charges each customer a fee of $2 per ticket and receives $5 per ticket from the producer.
Tickets Now does not take control of the ticket inventory. Average ticket price for the event is $75.
Answer:
a. Sam’s should record membership fees evenly over the year. A risk is that they might record all
the fees as revenue when the customer makes the initial payment. This won’t really be a
significant issue if Sam’s receives about the same membership fees over the year.
b. The Wall Street Journal should record the revenue as each ad appears (weekly). There is a
potential risk that the company could record all of the advance payment as revenue when Banco
do Brasil pays it. This could be a significant issue if advance advertising revenues are not uniform
during the year.
c. Even though cash is received (credit cards are essentially cash), revenue should not be
recognized until the product is shipped. Until that time, the cash received is recognized as an
asset on the balance sheet and a liability (deferred revenue) is recorded to reflect an obligation to
deliver product. Thus, one revenue risk is that J. Jill could record the cash receipts as revenue,
before the product is delivered, to boost current sales and profit. This risk is small however in that
most shipments follow cash receipt by only a few days.
d. Tickets Now should record $7 revenue each time it sells a ticket. Of that $2 will be received in
cash and $5 will be recorded as receivable from the Riverdance producers. The risk exposure is
that Tickets Now could record $77 for each ticket sold and offset that with a cost of goods sold of
$70 (along with a $70 accounts payable) to the Riverdance producer. This would seriously
overinflate the company’s top line but would not have any effect on the bottom line.
Topic: Research and development expense– Numerical calculations required

LO: 2
7. Google reported the following in its 2008, Form 10K (in thousands). Use the information to
determine in which year, Google reported a more significant R&D expenditure.
2007 2008
Total assets $25,335,806 $31,767,575
Revenues $16,593,986 $21,795,550
Research and development expense $ 2,119,985 $ 2,793,192
Answer: Google spent more dollars on R&D in 2008, $2.8 billion versus $2.1 billion in 2007. But
to determine the more significant expenditure, we need to common-size the R&D expense. To
common-size income statement items, we divide by current period sales. Common-sized R&D for
2008 is $2,793,192 / $21,795,550 = 12.82% and for 2007 is $2,119,985 / $16,593,986 = 12.78%.
Thus, even on a percentage basis, Google spent more in 2008.

Topic: Research and development expenses– Numerical calculations required
LO: 2
8. Yahoo! reported the following in its 2008 financial statements (in millions):
December 31, December 31, December 31,

(in millions) 2006 2007 2008
Revenues $6,425,679 $6,969,274 $7,208,502
Product development expense $ 833,147 $1,084,238 $1,221,787
a. List three types of costs that Yahoo likely includes in the product development line item on the
income statement. b. What trend do you notice in Yahoo’s spending for product development?
Answer:
a. Types of costs included in product development could include:
• salaries and wages for R&D personnel
• computer and other types of equipment used by programmers
• costs of applying for patents and copyright protection
• legal fees for new patents
• overhead for R&D activities (heat, lighting, etc in research labs and offices)
• depreciation of capitalized R&D fixed assets
• lease payments for leased equipment or space
b. To detect a trend, we need to calculate common sized R&D expense, which means to divide
each year’s expense by that year’s revenues. Yahoo is spending proportionately more each year,
thus the trend is an increase in R&D spending.
December 31, December 31, December 31,

2006 2007 2008
Product development / Revenues 12.97% 15.56% 16.95%

LO: 2
9. Life Technologies Corporation reported research and development expense of $142,505
thousand on its 2008 income statement. This expense included many types of costs. Briefly
explain how Life Technologies Corporation would account for each of the following types of R&D
costs:
a. salaries and wages for R&D personnel
b. supplies and inventory
c. equipment used in experiments
d. costs of applying for FDA approval
e. overhead for R&D activities
Answer: Life Technologies Corporation would report for each of the R&D items as follows:
a. salaries and wages for R&D personnel – as paid and would include amounts incurred at year
end but not yet paid
b. supplies and inventory – would set up inventory as asset and expense items as they are used
up in R&D activities
c. equipment used in experiments – if equipment has no alternate use, Merck would expense in
period acquired. But if equipment has alternate use, Merck would capitalize as PPE and
depreciate over assets’ lives.
d. costs of applying for FDA approval – as incurred
e. overhead for R&D activities – allocate R&D related overhead as incurred

LO: 2
10. Life Technologies Corporation and Affymetrix Inc. are competitors in the life sciences and
clinical healthcare industry. Following is a table of R&D expenses and sales revenues for both
companies (in thousands).
2008 2007 2006 2008 2007 2006
Total revenue $1,620,323 $1,281,747 $1,151,175 $410,249 $371,320 $355,317
R&D expenses $142,505 $115,833 $104,343 $84,482 $72,740 $86,296
a. Compare R&D expenses of the two companies. Which company is more R&D intensive?
b. What trend do you notice in the R&D expense of each company over time?
Answer:
a. Comparing R&D measured in dollars indicates that Life Technologies spends more. However,
common sizing the expense is more appropriate to make comparisons:
2008 2007 2006 2008 2007 2006
8.8% 9.0% 9.1% 20.6% 19.6% 24.3%
Affymetrix spends proportionately more on R&D than Life Technologies – nearly 2.5 times more
which is a significant difference. Affymetrix is more R&D intensive.
b. Life Technologies maintained R&D spending at about 9% over the three-year period.
Affymetrix decreased R&D spending but still has significant R&D expenses.
Topic: Restructuring charges—Numerical calculations required

LO: 2
11. Mariposa Imports recorded a restructuring charge of $5.4 million during fiscal 2009 related
entirely to the closing of its California based operations in San Diego and in Tijuana, Mexico. The
company’s financial statement footnotes indicated that expected employee separation payments
amounted to $4.2 million and that fixed asset write-downs accounting for the remainder. Mariposa
had never before incurred restructuring charges. At the end of the year, the company’s balance
sheet included a restructuring accrual of $900,000. Calculate the cash flow effect of Mariposa’s
restructuring during fiscal 2009.
Answer: The total restructuring charge accrued was $4.2 million because asset write-downs are
not accrued. That is there is no credit to a liability account for write-downs, the assets are credited
(reduced). Thus, the company must have paid $4,200,000 - $900,000 = $3,300,000 in cash
during fiscal 2009.

Topic: Restructuring charges – Numerical calculations required
LO: 2
12. Dow Chemical included the following information in a footnote to its 2008 annual report:
On December 5, 2008, the Company’s Board of Directors approved a restructuring plan as part of
a series of actions to advance the Company’s strategy and respond to the recent, severe
economic downturn. The restructuring plan includes the shutdown of a number of facilities and a
global workforce reduction, which are targeted for completion by the end of 2010. As a result of
the shutdowns and global workforce reduction, the Company recorded pretax restructuring
charges of $785 million in the fourth quarter of 2008. The charges consisted of asset write-downs
and write-offs of $336 million, costs associated with exit or disposal activities of $128 million and
severance costs of $321 million.
a) Reconcile the various parts of Dow Chemical’s “Restructuring charges” of $785 million.
b) How should Dow Chemical report the restructuring charges in its income statement? On its
balance sheet?
c) The SEC has expressed concern about abuses surrounding restructuring charges. What is the
nature of the SEC’s concerns?
Answer:
a) (in millions)
Asset write-downs and write-offs $336
Exit or disposal activities 128
Severance costs 321
$785
b) Under GAAP, the net restructuring gain (loss) would be reported as a separate line item in the
income statement, if it’s material, which $785 certainly is. In addition, any accrued liabilities
resulting from the restructuring would be reflected on the balance sheet. The footnotes detail the
change in the accrual (liability) account each period.
c) The timing and magnitude of restructuring costs is subject to management’s discretion. Thus,
some companies might overestimate such costs, especially if earnings are already low, a practice
which is referred to as a “big bath.” Overestimating the restructuring costs creates a cushion for
adjusting future earnings. On the other hand, because materiality is also discretionary,
management could deem these costs to be immaterial in order to avoid recording them as
separate items. Either tactic would impair the quality of the companies’ financial reports.
Topic: Tax expense – Numerical calculations required

LO: 3
13. In fiscal 2008, Microsoft Corp. reported a statutory tax rate of 35.0%, an effective tax rate of
25.75% and a tax rate on operating profit of 29.32%. The 2008 income statement reported
income tax expense of $6,133 million. What did Microsoft report as income before income tax
expense that year?
Answer: Microsoft reported income before income tax expense of $23,817 million. This is
calculated as Income tax expense / Effective tax rate = $6,133 million / 0.2575 = $23,817 million.

Topic: Tax expense – Numerical calculations required
LO: 3
14. In fiscal 2008, Snap-On Inc. reported a statutory tax rate of 37.4%, an effective tax rate of
32.9% and a tax rate on net operating profit of 33.3%. Income before income tax for 2008 was
$357.8 million. What did Snap-On report as tax expense (on its income statement) in 2008?
Answer: Snap-On reported taxes on the income statement of $117.7 million. This is calculated as
Income before tax × Effective tax rate = $357.8 million × 0.329 = $117.7 million.
Topic: Deferred tax valuation allowance – Numerical calculations required

LO: 3
15. The 2008 annual report of Dow Chemical disclosed a valuation allowance of $487 million on
its deferred tax assets. During 2008, the company increased this allowance from $323 million
reported in 2007. Quantify the effect that this increase in the allowance had on Dow Chemical’s
net income in 2008.
Answer: Changes in valuation allowance affect net income in the opposite direction, dollar for
dollar. Dow Chemical increased the allowance by $164 million ($487 million - $323 million). The
effect was to reduce Dow’s net income by $164 million in 2008.
Topic: Changes in deferred income tax accounts – Numerical calculations required

LO: 3
16. The 2008 annual report of Dow Chemical disclosed the following: Deferred tax assets
increased by $1,205 million and deferred tax liabilities decreased by $726 milliion. How do these
changes affect tax expense for the year?
Answer: Changes in deferred tax asset account, inversely affects tax expense. Changes in the
deferred tax liability account, directly affects tax expense. Therefore Dow’s increase in deferred
tax assets and decrease in deferred tax liabilities, both decrease tax expense for the year by
$1,931 million ( $1,205 million + $726 million = $ 1,931 million decrease in tax expense).
Topic: Income tax expense: deferred portion – Numerical calculations required

LO: 3
17. As a result of using accelerated depreciation for tax purposes, The Ahmed Corporation
reported $93 million income tax expense in its income statement, while the actual amount of
taxes paid by the company was $103 million. How did this tax transaction affect the company’s
balance sheet?
Answer: The tax expense of $93 million will reduce net income by that amount and thus, retained
earnings on the balance sheet will be $93 million lower. The company pays $103 million tax in
cash, which reduces assets. The difference of $10 million is recorded as an increase in deferred
tax asset.

Topic: Deferred tax assets arising from restructuring charge – Numerical calculations required
LO: 3
18. Dow Chemical recorded a pretax restructuring charge of $785 million in the fourth quarter of
2008. By year end (December 31, 2008), the company had paid only $2 million of cash related to
the restructuring charges. How did the restructuring charge of $785 million affect income before
taxes? How did this charge affect deferred taxes on the balance sheet? Assume a tax rate of
35%.
Answer: The restructuring charge of $785 million reduces income before taxes by that amount.
However, restructuring charges are not deductible until they are paid. Thus, during 2008, the tax-
basis expense for restructuring was $2 million. The difference of $783 million gives rise to a
deferred tax asset of $274 million ($785 million × 0.35) reported on the 2008 balance sheet.
Topic: Income tax expense – Numerical calculations required

LO: 3
19. The income tax footnote to the financial statements of Life Technologies Company for the
year ended December 31, 2008, includes the following information (in thousands):
Current tax provision

Federal $ 27,064
State 3,377
Foreign 37,458
67,899
Deferred tax provision
Federal 65,287
State 847
Foreign (9,734)
56,400
Provision for income taxes $124,299
a. What income tax expense did Life Technologies Company report in its 2008 income
statement?
b. How much of the income tax expense is payable in 2008?
Answer:
a. The income statement will show $124,299 for income tax expense.
b. The current tax provision of $67,899 is payable in 2008.
Topic: Foreign Currency Translation

LO: 4
20. Delgado Import Export Corp. has a profitable Portugese subsidiary that maintains its financial
records in Euros. During the economic turmoil of 2008, the U.S. dollar strengthened vis-à-vis the
Euro. What affect did this have on Delgado’s consolidated income statement for 2008?
Answer:
Because the US $ strengthened during the year, each Euro will translate to fewer dollars. Thus,
revenues, expenses, and net profit of the Portugese subsidiary will be lower than they would have
been absent the foreign currency fluctuations.

LO: 4
21. The 2009 annual report of Dell Computer Corporation included the following disclosure:
During fiscal 2009, the U.S. dollar strengthened relative to the other principal currencies in which
we transact business with the exception of the Japanese Yen.
Explain the effect on Dell’s 2009 income statement of the U.S. dollar a) weakening vis-à-vis the
Japanese Yen, and b) strengthening versus all other currencies. Assume that Dell reported a net
profit in each of the countries involved.
Answer:
a) Because the US dollar weakened during the year, each Yen will translate to more dollars.
Thus, revenues, expenses, and net profit of the Japanese subsidiary will be higher than they
would have been absent the foreign currency fluctuations.
b) With respect to the other principal currencies, given that the US dollar strengthened during the
year, the profits in these countries will translate to fewer dollars. Thus, revenues, expenses, and
net profits of these subsidiaries will be lower than they would have been absent the foreign
currency fluctuations.
Topic: Computing EPS and explaining anti-dilutive stock options – Numerical calculations
required
LO: 5
22. Oracle reported the following earnings per share information in its 2008 annual report filed on
Form 10-K (in millions except per share data). The company has only one class of stock. a)
Compute basic and diluted earnings per share. b) Oracle also reports that it excludes 98 million
stock options from the diluted earnings per share calculation. Explain why Oracle excludes these
shares.
Net income $5,521
Weighted average common shares outstanding 5,133

Dilutive effect of employee stock plans 96
Diluted weighted average common shares outstanding 5,229
Answer:
a. Basic EPS = $5,521 / 5,133 = $1.07559 = $1.08
Diluted EPS = $5,521 / 5,229 = $1.05584 = $1.06
b. Stock options are only included in the computation of EPS if they are, in fact, dilutive. If they
are anti-dilutive, they are excluded from the computation. Oracle reports the number of these anti-
dilutive securities because they could be dilutive in the future if stock price increases.

Topic: Diluted earnings per share– Numerical calculations required
LO: 5
23. BJ Services, an oil and gas service firm, reports the following EPS data in its 2008 annual
report (in thousands except per share data). a) Recompute basic earnings per share. b) How
many weighted average shares were dilutive in 2008?
Net income $609,365

Earnings per share:
Basic $2.08
Diluted $2.06
Weighted average shares outstanding:
Basic 293,479
Answer:
a. $609,365 / 293,479 = $2.07635
b. The company included about 295,808 thousand shares for the diluted EPS calculation. This is
computed as: $609,365 thousand / $2.06 = 295,808 thousand. Thus, the company included 2,329
thousand dilutive shares computed as: 295,808 thousand – 293,479 thousand.
Topic: Basic earnings per share– Numerical calculations required

LO: 5
24. Cisco Inc. reported the following in its income statement for the year ended July 26, 2008:
Net income $8,052 million, basic earnings per share of $1.35 and diluted earnings per share of
$1.31. How many additional dilutive shares did Cisco include in the diluted EPS for the year?
Answer: Average number of shares outstanding during the year = Net income / basic EPS =
$8,052 million / $1.35 = 5,964.4 million shares. Average diluted number of shares outstanding
during the year = Net income / diluted EPS = $8,052 million / $1.35 = 6,146.6 million shares.
Total number of dilutive additional shares = 6,146.6 million shares - 5,964.4 million shares =
182.2 million shares
Topic: Earnings per share definition and computations– Numerical calculations required
LO: 5
25. OMNICARE, INC. reports the following in its 2008 10-K report (in thousands). Use the
information to calculate basic and diluted earnings per share (EPS) numbers.
Net income $156,108

Weighted-average common shares: Basic 117,466
Weighted-average common shares: Diluted 118,313
Answer:
Basic EPS: $156,108 / 117,466 = $1.33
Diluted EPS: $156,108 118,313 = $1.32

Problems
Topic: Interpreting revenue recognition policy and recording revenue
LO: 1
1. The annual report of Costco Wholesale Corporation for fiscal year ended August 31, 2008,
includes the following footnote (excerpted):
Revenue Recognition
The Company generally recognizes sales, net of estimated returns, at the time the member takes
possession of merchandise or receives services. When the Company collects payments from
customers prior to the transfer of ownership of merchandise or the performance of services, the
amounts received are generally recorded as deferred revenue until the sale or service is
completed. The Company provides for estimated sales returns based on historical merchandise
returns levels.
The Company evaluates the criteria of the FASB Emerging Issues Task Force (EITF) 99-19,
“Reporting Revenue Gross as a Principal Versus Net as an Agent,” in determining whether it is
appropriate to record the gross amount of merchandise sales and related costs or the net amount
earned as commissions. Generally, when Costco is the primary obligor, is subject to inventory
risk, has latitude in establishing prices and selecting suppliers, can influence product or service
specifications, or has several but not all of these indicators, revenue is recorded on a gross basis.
If the Company is not the primary obligor and does not possess other indicators of gross reporting
as noted above, it records the net amounts as commissions earned, which is reflected in net
sales.
Membership fee revenue represents annual membership fees paid by substantially all of the
Company’s members. The Company accounts for membership fee revenue on a deferred basis,
whereby revenue is recognized ratably over the one-year membership period.
Required:
a. Explain in plain English how Costco recognizes the cash received from customers who
purchase goods or services.
b. What are “sales returns” and how does Costco record them in their financial statements?
c. Explain in plain English how Costco recognizes revenue from annual memberships.
d. Assume that on September 1, 2008, Costco collected $1,800 in membership fees from
customers. Use the financial statements effects template below to show how Costco would record
this transaction and what accounting adjustment Costco would record on November 30, 2008.
e. Costco is contemplating adding a fitness facility to its warehouses – customers would pay a
monthly fee to use fitness equipment and take classes. How would Costco record monthly fees
from customers if Costco runs the facility itself, that is Costco purchases all the equipment and
the fitness facility is staffed entirely by Costco employees? How would Costco record revenue if
the company sub-contracts the fitness facility to a third-party operator and receives a percentage
of monthly customer fees from the sub-contractor?
Balance Sheet Income Statement
Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction
Asset
+
Assets = ities
+
Capital
+
Capital enues – ses = Income
Sep. 1/08 = – =
Nov. 20/08 = – =
Answer:
a. Costco recognizes cash from customers as the goods or services are delivered. For goods,
revenue is recognized when the customer leaves the store with the products. For services,
revenue is recognized with completion of the service. Deposits for either goods or services are
not recorded as revenue.
b. Sales returns happen when customers bring goods back. This represents revenue that was not
really earned, in the end. In anticipation of this, Costco estimates the value of goods that will be
returned, based on historical experience. Costco reduces sales revenue for this and sets up a
“sales return” liability for the same amount.
c. Members join for a year at a time. Costco recognizes the membership fee over the year, likely
recognizing 1/12 per month.
d.

Transaction
Asset
+
Assets
= ities
+
Capital
+
Capital enues
– ses
= Income
Collect $1,800 +1,800
membership +1,800 = (Unearned – =
fees revenue)
Record -450 +450
membership = (Unearned (Retained +450 – = +450
fees earned revenue) earnings)
e. Costco would apply EITF 99-19 to determine how to recognize revenue. If Costco runs the
fitness facility itself, it would seem like the company “is subject to inventory risk, has latitude in
establishing prices and selecting suppliers, can influence product or service specifications” and
so Costco should record revenue from customers on a gross basis – record the fitness facility
monthly fees at the end of each month. If however, Costco sub-contracts the fitness facility to a
third-party operator, it would seem like the company is not the primary obligor and should only
record the “commission earned” which would be the contractual percentage of the fitness fees
received from the third party.

Topic: Interpreting revenue recognition policy
LO: 1
2. The 2008 annual report of Oracle Corporation includes the following footnote (excerpted):
Revenue Recognition
We derive revenues from the following sources: (1) software, which includes new software
license and software license updates and product support revenues, and (2) services, which
include consulting, On Demand, and education revenues.
We recognize new software license revenue when: (1) we enter into a legally binding
arrangement with a customer for the license of software; (2) we deliver the products; (3) customer
payment is deemed fixed or determinable and free of contingencies or significant uncertainties;
and (4) collection is probable. Substantially all of our new software license revenues are
recognized in this manner.
The vast majority of our software license arrangements include software license updates and
product support, which are recognized ratably over the term of the arrangement, typically one
year.
Revenues for consulting services are generally recognized as the services are performed. If there
is a significant uncertainty about the project completion or receipt of payment for the consulting
services, revenues are deferred until the uncertainty is sufficiently resolved. We estimate the
proportional performance on contracts with fixed or “not to exceed” fees on a monthly basis
utilizing hours incurred to date as a percentage of total estimated hours to complete the project. If
we do not have a sufficient basis to measure progress towards completion, revenue is recognized
when we receive final acceptance from the customer.
Oracle On Demand provides multi-featured software and hardware management and

maintenance services delivered either at our data center facilities, at select partner data centers,
or at customer facilities. Revenue from On Demand services is recognized over the term of the
service period, which is generally one year.
Education revenues include instructor-led, media-based and internet-based training in the use of
our products. Education revenues are recognized as the classes or other education offerings are
delivered.
For arrangements with multiple elements, we allocate revenue to each element of a transaction
based upon its fair value as determined by “vendor specific objective evidence.” Vendor specific
objective evidence of fair value for all elements of an arrangement is based upon the normal
pricing and discounting practices for those products and services when sold separately and for
software license updates and product support services is also measured by the renewal rate
offered to the customer.
Required:
a. What are the five sources of revenue for Oracle Corporation?
b. Explain in plain English how Oracle recognizes revenue for each of the five types of revenue.
c. What are “arrangements with multiple elements”? How does Oracle account for such
arrangements?
d. Assume that Oracle has a sale that involves new software, software license updates and
product support for two years, and an educational package for the customer’s employees, which
will be fulfilled in six months. If sold separately, Oracle would charge the following for each of
these elements: $1 million, $150,000, and $400,000. Because the customer buys the entire
package, the sales price is $1,317,500. What revenue would Oracle record for each element?

Answer:
a. Oracle’s five types of revenue are: 1) new software licenses, 2) software license updates and
product support, 3) consulting services, 4) On Demand, and 5) education revenues.
b. Revenue on new software licenses is recorded when the customer takes delivery of the
software provided that the sales price is established and the customer has the ability to pay.
Revenue on updates and product support is pro rated over the contractual period that Oracle
promises the updates or support. Consulting revenues are recognized as the services are
performed. On Demand revenues are spread out evenly over a year. Education revenues are
recognized at the end of the training sessions.
c. Arrangements with multiple elements are sales that include two or more of the five types of
revenue items that Oracle has. To account for these, Oracle first determines the fair value of each
element separately and then pro rates the total sales amount to each element. Then the company
recognizes revenue as earned on each element according to when it is earned.
d. If sold separately the bill would come to $1,550,000 for this sale ($1,000,000 + $150,000 +
$400,000). Oracle allocates the sales price of $1,317,500 in proportion to the market value of
each piece. The allocation would be: new software: $850,000 recognized when the software is
delivered, updates and support: $127,500 recognized over two years, and educational package:
$340,000 recognized over six months.

LO: 2
3. Following are income statements for Life Technologies Corporation and Affymetrix Inc.,
competitors in the life sciences and clinical healthcare industry. Use these financial statements to
answer the required.
LIFE TECHNOLOGIES CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands)
For the Years Ended December 31, 2008 2007 2006
Revenues $1,620,323 $1,281,747 $1,151,175

Cost of revenues 592,696 467,139 432,176
Purchased intangibles amortization 86,875 98,721 110,668
Gross profit 940,752 715,887 608,331
Sales and marketing 310,959 252,057 232,388

General and administrative 188,353 164,042 150,068
Research and development 142,505 115,833 104,343
Purchased in-process research and development 93,287 - -
Business consolidation costs 38,647 5,635 12,540
Total operating expenses 773,751 537,567 499,339
Operating income 167,001 178,320 108,992
Other income (expense):
Interest income 24,595 27,961 26,687
Interest expense (43,039) (27,967) (32,156)
Other income, net 5,704 332 540
Income before provision for income taxes 154,261 178,646 104,063
Income tax provision (124,299) (48,367) (28,304)
Net income from continuing operations 29,962 130,279 75,759
Net income (loss) from discontinued operations (net) 1,359 12,911 (266,808)
Net Income (loss) $ 31,321 $ 143,190 $ (191,049)

AFFYMETRIX INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands)
Year Ended December 31, 2008 2007 2006
Product sales $270,392 $291,828 $ 275,437

Services 32,096 38,074 40,397
Royalties and other revenue 107,761 41,418 39,483
Total revenue 410,249 371,320 355,317
Cost of product sales 126,909 108,884 99,801
Cost of services 25,121 29,602 28,951
Cost of royalties and other revenue 110 230 191
Research and development 84,482 72,740 86,296
Selling, general and administrative 127,161 138,488 145,126
Acquired in-process technology 6,200 - -
Restructuring charges 43,707 15,296 13,497
Goodwill impairment charges 239,098 - -
Total costs and expenses 652,788 365,240 373,862
(Loss) income from operations (242,539) 6,080 (18,545)

Interest income and other, net 14,629 15,420 14,078
Interest expense (14,091) (3,218) (1,600)
(Loss) income before income taxes (242,001) 18,282 (6,067)
Income tax provision (65,918) (5,689) (7,637)
Net (loss) income $ (307,919) $ 12,593 $(13,704)
Required:
a. How do Life Technologies and Affymetrix account for R&D expenditures?
b. Life Technologies and Affymetrix R&D expense includes many different types of costs. List
three specific costs included in R&D expense on the income statement.
c. Compare R&D expenses of the two companies. (Hint: prepare common size R&D expenses.
Consider both direct R&D expenses as well as acquired R&D.)
d. What trend do you notice in the R&D expenses of each company over time?

Answer:
a. R&D expenditures are expensed in the income statement, except for the portion relating to
depreciable assets that have alternate uses. Expensing R&D costs (rather than capitalizing and
depreciating them) reduces assets on both Life Technologies’ and Affymetrix’ balance sheets. As
well, expensing R&D expenses as incurred increases expenses, which reduces profit reported on
the income statement and stockholders’ equity on the balance sheet (via the reduction in retained
earnings).
b. R&D costs could include the following types of costs:
• salaries and wages for R&D personnel
• supplies and inventory
• equipment used in experiments
• costs of applying for FDA approval
• legal fees for lawyers applying for patents
• overhead for R&D activities
• depreciation on PPE equipment capitalized and used for R&D
c. R&D expenses as a proportion of revenues (i.e. common sized R&D expense).

2008 2007 2006 2008 2007 2006
Total revenue 1,620,323 1,281,747 1,151,175 410,249 371,320 355,317
R&D expenses 142,505 115,833 104,343 84,482 72,740 86,296
Common-size R&D 8.8% 9.0% 9.1% 20.6% 19.6% 24.3%
Affymetrix spends proportionately more on R&D than Life Technologies – nearly 2.5 times more
which is a significant difference.
We can extend the analysis to include both in-house R&D expenses as well as purchased R&D,
which is research acquired in a merger or acquisition.

2008 2007 2006 2008 2007 2006
Total revenue 1,620,323 1,281,747 1,151,175 410,249 371,320 355,317
R&D expenses 142,505 115,833 104,343 84,482 72,740 86,296
Acquired R&D 93,287 - - 6200 0 0
Total R&D 235,792 115,833 104,343 90,682 72,740 86,296
Common-size R&D 14.6% 9.0% 9.1% 22.1% 19.6% 24.3%
d. Life Technologies maintained R&D spending at about 9% over the three-year period.
Affymetrix decreased R&D spending but still has significant R&D expenses. When we consider
both types of R&D, the company’s comparisons are closer. However the acquired R&D at both
firms does not appear to be a persistent item. Thus, it appears that Affymetrix is a more research
intensive firm.

Topic: Analyzing and assessing R&D expenses—Numerical calculations required
LO: 2
4. Below are income statements for Google and Yahoo for fiscal 2008. Use these financial
statements to answer the required.
Google Inc.
CONSOLIDATED STATEMENTS OF INCOME
(In thousands)
Revenues $10,604,917 $16,593,986 $21,795,550
Cost of revenues 4,225,027 6,649,085 8,621,506
Research and development 1,228,589 2,119,985 2,793,192
Sales and marketing 849,518 1,461,266 1,946,244
General and administrative 751,787 1,279,250 1,802,639
Total costs and expenses 7,054,921 11,509,586 15,163,581
Income from operations 3,549,996 5,084,400 6,631,969
Impairment of equity investments - - (1,094,757)
Interest income and other, net 461,044 589,580 316,384
Income before income taxes 4,011,040 5,673,980 5,853,596
Provision for income taxes 933,594 1,470,260 1,626,738
Net income $ 3,077,446 $ 4,203,720 $ 4,226,858
Yahoo, Inc.
(In thousands)
Years Ended December 31, 2006 2007 2008
Revenues $6,425,679 $6,969,274 $7,208,502
Cost of revenues 2,675,723 2,838,758 3,023,362
Gross profit 3,749,956 4,130,516 4,185,140
Sales and marketing 1,322,259 1,610,357 1,563,313
Product development 833,147 1,084,238 1,221,787
General and administrative 528,798 633,431 705,136
Amortization of intangibles 124,786 107,077 87,550
Restructuring charges, net - - 106,854
Goodwill impairment charge - - 487,537
Total operating expenses 2,808,990 3,435,103 4,172,177
Income from operations 940,966 695,413 12,963
Other income, net 157,034 154,011 82,838
Income before provision for income taxes,
earnings in equity interests and other 1,098,000 849,424 95,801
Provision for income taxes (458,011) (337,263) (262,717)
Earnings in equity interests and other 111,402 147,839 591,214
Net income $ 751,391 $ 660,000 $ 424,298

Required:
a. How are the balance sheets and income statements of Google and Yahoo affected by the
accounting for R&D costs?
b. Compute common-sized R&D expense for both firms for the three-year period. Assess the
differences and any trends that you notice.
c. How can one evaluate the effectiveness of R&D spending? Does the difference in R&D as a
percentage of sales necessarily imply that one company is more heavily invested in R&D? Why
might this not be the case?
d. In your opinion, would Google and Yahoo favor capitalizing R&D expenses, if that were an
available alternative?
Answer:
a. All R&D costs are expensed in the income statement, except for the portion relating to
depreciable assets that have alternate uses. Expensing of R&D expenses (rather than
capitalizing and depreciating them) reduces assets on both Google and Yahoo’s balance sheets.
As well, expensing R&D expenses as incurred, increases expenses, which reduces profit
reported on the income statement and stockholders’ equity on the balance sheet (via the
reduction in retained earnings).
b.
Google (in thousands) 2006 2007 2008
Revenues $10,604,917 $16,593,986 $21,795,550
Research and development expense $ 1,228,589 $ 2,119,985 $ 2,793,192
Common-sized R&D expense 11.59% 12.78% 12.82%
Yahoo (in thousands) 2006 2007 2008

Revenues $6,425,679 $6,969,274 $7,208,502
Research and development expense $ 833,147 $1,084,238 $1,221,787
Common-sized R&D expense 12.97% 15.56% 16.95%
Google spent more dollars on R&D than Yahoo, in 2008: $2.8 billion versus $1.2 billion. But to
determine the more significant expenditure, we need to common-size the R&D expense. To
common-size income statement items, we divide by current period sales. The table below shows
the common-sized amount. From this we see that, on a percentage basis, Yahoo spent more for
product development each year.
As far as trends, both firms have increased the R&D expenses over the past three years. Yahoo
has increased spending more, which has increased the difference between common-sized
expense from about 1.5 percentage points in 2006 (11.59% versus 12.97%) to 4 percentage
points (12.82% versus 16.95%).
c. It is very difficult to evaluate the effectiveness of R&D because R&D spending affects revenues
but with some time lag (current period R&D expenditures yield future sales). Over time, however,
the number and quality of new product introductions, number of patents, market share, etc., can
be compared across companies and against relative levels of R&D spending. Both Google and
Yahoo spend considerable amounts on their R&D because innovating and developing new web
technologies is the lifeblood for these companies.
d. Google is very profitable, and as a consequence, very visible to the public and to governmental
agencies. Thus, Google probably welcomes additional expenses and would not favor capitalizing
their R&D expenses. Yahoo is less profitable and likely could improve its income statement by
capitalizing some R&D expenses.

Topic: Restructuring costs—Numerical calculations required
LO: 2
5. The following footnote (excerpted) of Dow Chemical Corporation comes from the December
31, 2008 financial statements:
On December 5, 2008, the Company’s Board of Directors approved a restructuring plan as part of
a series of actions to advance the Company’s strategy and respond to the recent, severe
economic downturn. The restructuring plan includes the shutdown of a number of facilities and a
global workforce reduction, which are targeted to be completed by the end of 2010. As a result of
the shutdowns and global workforce reduction, the Company recorded pretax restructuring
charges of $785 million in the fourth quarter of 2008. The following table summarizes the
activities related to the Company’s restructuring charge and reserve (liability):
Costs
Impairment of associated with
(in millions) long-lived exit or disposal Severance
assets activities costs Total
Restructuring charge in
fourth quarter 336 128 321 785
Cash payments 0 0 (2) (2)
Charges against reserve (336) 0 0 (336)
Reserve balance at
December 31, 2008 0 128 319 447
Required:
a. Explain why Dow Chemical planned this restructuring. When did the company record the
restructuring expense? When will the restructuring take place? Explain the difference.
b. What are the three types of restructuring costs for Dow Chemical for 2008?
c. Explain why no cash is involved in settling the impairment of long-lived assets portion of the
restructuring reserve.
d. Dow Chemical managers estimated all of the charges above. What would be the income-
statement consequences next year (in 2009) if only $300 million of additional cash payments
were necessary to completely settle the employee severance costs? Assume that Dow Chemical
did not intentionally overestimate these severance costs.

Answer:
a. 2007 and 2008 were difficult years for Dow Chemical. The company’s revenues have slowed
but costs are still high. To stem further loses, the company decided in December 2008 to cut
employees, sell assets, and try to trim down operations. Because the board of directors passed a
motion to restructure in 2008, GAAP allows Dow to accrue the costs in 2008. The restructuring
will be started in 2009 and that’s when the bulk of the cash will be paid out.
b. Asset impairment charges relate to the write-down of assets to fair values. This likely
represents plants that will be shuttered, equipment that will be scrapped, and office locations that
will be closed. Costs associated with exit or disposal relate to the costs that will arise as the
company tries to sell off long-term assets, charges of early termination of leases, legal fees,
closure and relocation of manufacturing and administrative facilities etc. Employee severance
costs represent accrued costs for the termination of employees whose jobs are to be eliminated
under the restructuring. This includes layoff packages, pension payouts, and any other costs paid
to or on behalf of, the laid-off employees.
c. Asset write-offs are non-cash charges. The income statement shows the $336 million as part of
the total restructuring expense and assets (property, land, equipment, etc) are reduced on the
balance sheet.
d. If only $300 million additional severance costs will be paid, Dow Chemical has an excess
liability on its balance sheet for $19 and this will never be paid. The consequence is that the
charge will be reversed. This reversal will reduce expenses, which will increase net income, likely
in 2009.

Topic: Analyzing and Interpreting Income Tax Footnote—Numerical calculations required
LO: 3
6. The following are excerpts from the 2008 annual report of Valero Energy. Use the information
to answer the required.
Components of income tax expense (benefit) related to continuing operations were as follows (in
millions):

Current:
U.S. federal $ 732 $1,764 $2,198
U.S. state 13 96 76
Canada 45 202 51
Aruba 2 3 3
Total current 792 2,065 2,328
Deferred:
U.S. federal 543 155 285
U.S. state (8) 31 (5)
Canada 140 (90) 3
Total deferred 675 96 283
Income tax expense $1,467 $2,161 $2,611
The significant components of deferred tax assets and liabilities were as follows (in millions):
As of December 31, 2008 2007

Deferred income tax assets:
Tax credit carryforwards $ 91 $ 95
Net operating losses (NOL) 78 36
Compensation and employee benefit liabilities 394 175
Environmental 93 86
Inventories 72 224
Other assets 298 360
Total deferred income tax assets 1,026 976
Less: Valuation allowance (62) (54)
Net deferred income tax assets 964 922
Deferred income tax liabilities:

Turnarounds (250) (264)
Property, plant and equipment (4,530) (4,297)
Inventories (628) (302)
Other (106) (126)
Total deferred income tax liabilities (5,514) (4,989)
Net deferred income tax liabilities $(4,550) $(4,067)

Required:
a. What income tax expense does Valero Energy report in its 2008 income statement? How much
of this expense is currently payable?
b. Valero Energy reports deferred tax liabilities related to “Property, plant and equipment.”
Describe how these liabilities arise. How likely is it that these liabilities will be paid? Specifically,
describe a scenario that will (i) defer these taxes indefinitely, and (ii) will result in these liabilities
requiring payment within the near future.
c. Valero Energy reports a deferred tax asset relating to “Compensation and employee benefit
liabilities.” When a company has a pension plan it records an expense and related liability each
year while the employee works for the company. Pension payments are not made to employees
until they retire. Explain why pension plans create a deferred tax asset.
d. Valero Energy reports deferred tax assets from net loss carry forwards. Explain how these
arise and how they will result in a future benefit.
e. Valero Energy reports a valuation allowance of $62 million in 2008 and of $54 million in 2007,
which is deducted from the deferred tax assets. Why? How did the change in the allowance from
2007 to 2008 affect net income in 2008? How can a company use this allowance to meet its
income targets in a particular year?
Answer:
a. Valero Energy reports $1,467 million of tax expense in its 2008 income statement. Of this
amount, $792 million is currently payable.
b. Deferred tax liabilities relating to property plant and equipment relate to accelerated
depreciation. These liabilities arise because the company is depreciating buildings and equipment
more quickly in its tax return than in its GAAP income statement. Thus, the assets’ tax-reporting
book value is less than the financial-reporting book value, which yields a deferred tax liability. For
any particular asset, future depreciation expense in the tax return will be lower and the difference
between the two net book values will shrink and the liability will reverse. However, if Valero adds
significant depreciable assets each year, the first-year’s accelerated depreciation on the new
assets will more than offset the lower depreciation on the older assets, resulting in a permanent
deferred tax liability. Once the growth rate for assets subsides, the depreciation expense
deduction in the tax return will as well, and the deferred tax liability will shrink.
c. Valero reports an accrued liability of $394 million for compensation and employee benefit
liabilities on its balance sheet. This does not create a tax-basis liability however because the tax
authorities do not permit a deduction for this sort of expense until employees (retirees) are paid.
Consequently, GAAP liabilities are greater than tax-basis liabilities, which creates a deferred tax
asset that recognizes the future deductions of pension payments.
d. Net operating losses (NOL) arise when a company reports a tax loss. Such losses can be
carried back for up to two years to offset against taxable income and the company receives a tax
refund. Unused tax losses can be carried forward for up to 20 years as future tax deductions to
reduce future taxable income and tax liability. This creates a deferred tax asset because at some
point in the future, the company will pay fewer taxes than it would absent the NOL carryforward.
e. The valuation allowance arises when the company believes that some of the related deferred
tax assets will not generate future benefits. These allowances typically arise because the carry
forward deduction will likely not be used before it expires. Increases and decreases in deferred
tax valuation allowances affect net income dollar-for-dollar in the opposite direction. For 2008, the
increase in the allowance decreased net income by $8 million. Since establishing and
subsequently adjusting the valuation allowance is highly subjective (dependent upon the
company’s estimation of whether the deductions will or will not be realized), companies might
increase or decrease this account to manage net income to reach income targets. Financial
statement users need to be aware of how changes in the valuation allowance affects net income
in their analysis of the profitability of the company.

Topic: Analyzing and Interpreting Income Tax Footnote—Numerical calculations required
LO: 3
7. The 2008 annual report of Netflix, Inc. includes the following footnote.
The components of provision for income taxes for all periods presented were as follows (in
thousands)
Year ended December 31, 2008 2007 2006
Current tax provision:
Federal $41,883 $37,770 $10,119
State 14,585 7,208 4,804
Total current 56,468 44,978 14,923
Deferred tax provision:
Federal (3,680) (413) 15,005
State (4,314) (248) 1,145
Total deferred (7,994) (661) 16,150
Provision for income taxes $48,474 $44,317 $31,073
Deferred tax assets were as follows (in thousands):

As of December 31, 2008 2007
Accruals and reserves $ 1,378 $ 2,986
Depreciation 2,947 473
Stock-based compensation 17,440 15,736
R&D credits 5,158 -
Other 1,103 (76)
Deferred tax assets $28,026 $19,119
Required:
a. Use the financial statement effects template below to record income tax expense for Netflix for
2008.

Transaction
Asset
+
Assets
= ities
+
Capital
+
Capital enues
– ses
= Income
12/31/2008 = – =
b. Netflix reports deferred tax assets relating to depreciation. Describe how these assets arise.
How likely is it that these assets will be recouped?
c. Assume that Netflix records deferred tax assets at a rate of 35%. The balance sheet reports
property, plant and equipment, net of $124,948 thousand. Compute the tax basis for these
assets. Hint: recall that the difference between the assets’ net book value and the tax basis is the
timing difference and that deferred taxes are recorded as timing difference × tax rate.
d. Netflix reports a significant deferred tax asset relating to stock-based compensation. The
company has compensated executives and other managers with stock options. Explain why this
gives rise to a deferred tax asset.

Answer:
a.

Transaction
Asset
+
Assets = ities
+
Capital
+
Capital enues – ses = Income
+7,994 -48,474 48,474

12/31/2008 -56,468 (Deferred tax = (Retained – (Tax = -48,474
assets) earnings) expense)
b. Deferred tax assets relating to depreciation arise because Netflix is depreciating buildings and
equipment less quickly in its tax return than for its GAAP income statement. This could relate to
its investment in a movie library. Thus, the assets’ tax-reporting book value is greater than the
financial-reporting book value, which yields a deferred tax asset. This is the opposite of the typical
situation.
c. Timing difference = Deferred tax asset / Tax rate = $2,947 thousand / 0.35 = $8,420 thousand.
Tax basis = GAAP net book value + timing differences. Tax basis = $124,948 thousand + $8,420
thousand = $133,368 thousand.
d. Netflix Co. reports GAAP expense for stock options as the options are granted. However for
tax purposes, the company may only expense the options if and when they exercised. This
creates a timing difference and, a deferred tax asset.
d. Operating loss carry forwards arise when a company reports a tax loss, which it can carry back
for up to 2 years to offset against taxable income and receive a tax refund. Unused tax losses can
be carried forward for up to 20 years as future tax deductions to reduce future taxable income
and tax liability. This creates a deferred tax asset.

LO: 3
8. Oracle reports the following in footnotes to its 2008 form 10-K.
Disclosed in the table below is geographic information for each country that comprised greater
than three percent of our total revenues for fiscal 2008, fiscal 2007 or fiscal 2006.
Year Ended May 31,
2008 2007 2006
Long Lived Long Lived Long Lived
(in millions) Revenues Assets(1) Revenues Assets(1) Revenues Assets(1)
United States $ 9,650 $1,465 $7,826 $1,404 $6,449 $1,351

United Kingdom 1,655 110 1,293 111 1,153 109
Japan 1,068 207 909 164 841 105
Germany 983 9 720 11 579 8
France 858 21 635 16 509 16
Canada 737 15 548 10 472 12
Other foreign countries 7,479 532 6,065 415 4,377 179
Total $22,430 $2,359 $17,996 $2,131 $14,380 $1,780
(1) Long-lived assets exclude goodwill, intangible assets, equity investments and deferred taxes, which are
not allocated to specific geographic locations as it is impracticable to do so.
a. What proportion of Oracle’s total revenue is potentially exposed to foreign currency risk?
b. Assume that Oracle does not undertake any measures to reduce its foreign currency exposure.
If the U.S. dollar strengthens on average 10% vis-à-vis the European currencies in which the
company transacts, and weakens 5% relative to the Japanese yen, what will be the impact on
revenues in 2008?
c. Explain what steps Oracle can take to reduce its foreign currency risk.

Answer:
a. Domestic revenues are $9,650. This is 43% of total revenues ($9,650 / $22,430). Thus, 57% of
2008 revenues are exposed to foreign currency risk.
b. When the USD strengthens, the foreign currency decreases when translated to dollars.
Conversely, when the USD weakens, the foreign currency increases in US dollar equivalents.
Thus, the changes in the European and Japanese currency rates will affect revenues as follows:
Europe Japan
USD strengthens USD
10% weakens 5%
United States 9,650 9,650
United Kingdom 1,655 1,505 1,505
Japan 1,068 1,121 1,121
Germany 983 894 894
France 858 780 780
Canada 737 737
Other foreign
countries 7,479 7,479
Total 22,430 22,166
c. Company such as Oracle, can take several steps to mitigate foreign currency risk. The
company can match its revenues and expenses in the various foreign currencies. This will mean
that only the total (net income) will be exposed to risk. The company can also use hedging
instruments such as options and forward contracts that pay off when the company’s foreign
currency position is in a loss.

Topic: Earnings per share—Numerical calculations required
LO: 5
9. The 2008 annual report of NetFlix includes the following footnoted information. Use this
information to answer the required.
The computation of net income per share is as follows:

(in thousands, except per share data)
Basic earnings per share:
Net income $83,026 $66,608 $48,839
Weighted-average common shares outstanding 60,961 67,076 62,577
Diluted earnings per share:

Net income $83,026 $66,608 $48,839
Weighted-average common shares outstanding 60,961 67,076 62,577

Warrants — — 4,093
Employee stock options and employee stock purchase
plan shares 1,875 1,826 2,405
Weighted-average number of shares 62,836 68,902 69,075
The following table summarizes the potential common shares excluded from the diluted
calculation (in thousands):
Shares 726 1,973 1,196
Required:
a. What are the potential sources of dilution of NetFlix’s earnings per share?
b. List two additional dilutive securities (other than those NetFlix includes).
c. NetFlix did not include all outstanding employee stock options in the calculation of diluted net
income per share in 2008? Why not? How many options were excluded?
d. Calculate basic EPS for each of the three years.
e. Calculate diluted EPS for each of the three years.

Answer:
a. NetFlix has warrants outstanding that allow holders to purchase common stock at reduced
prices. NetFlix also has granted employee stock options, which, if exercised would increase the
number of shares outstanding. Both of these are potential sources of dilution.
b. Convertible preferred stock and convertible bonds are two additional potentially dilutive
securities.
c. Some of NetFlix’s outstanding employee stock options are out of the money – the strike price
on these options is greater than NetFlix’s current stock price. Employees who hold these options
are not going to exercise them. Thus, these options are not included in the calculation of diluted
net income per share for 2008 because they are anti-dilutive. NetFlix excluded 726 thousand of
these anti-dilutive options in 2008.
d.
2008 2007 2006
Basic earnings per share = Net income / Weighted-
average common shares outstanding $ 1.36 $ 0.99 $ 0.78
e.
2008 2007 2006
Basic earnings per share = Net income / Weighted-
average common shares outstanding + Dilutive securities $ 1.32 $ 0.97 $ 0.71
Topic: Earnings per share—Numerical calculations required

LO: 5
10. The 2008 annual report of SLM Corporation (also known as Sallie Mae) includes the
following information in the footnotes. Compute the missing amounts.
SLM CORPORATION
(Dollars and shares in thousands, except per share amounts)
For the year ended December 31, 2008 2007 2006
Net income (loss) (212,626) (896,394) 1,156,956

Preferred stock dividends 111,206 37,145
Average common shares outstanding 466,642 410,805
Basic earnings (loss) per common share $(2.26) $2.73
Answer:
For the year ended December 31, 2008 2007 2006
Net income (loss) (212,626) (896,394) 1,156,956

Preferred stock dividends 111,206 37,145 35,458
Average common shares outstanding 466,642 413,070 410,805
Basic earnings (loss) per common share $(0.69) $(2.26) $2.73

Essay Questions
Topic: Revenue Recognition timing and determination
LO: 1
1. Discuss when each of the following types of businesses should likely recognize revenue:
a. A software company such as Microsoft when significant production, modification, or
customization does not exist.
b. A clothing retailer like Neiman Marcus.
Answer:
a. Microsoft recognizes revenue when there exists persuasive evidence of an arrangement,
delivery has occurred, the contract or sales price is fixed or determinable, and collectibility is
probable.
b. Neiman Marcus is a retailer and revenue recognition is fairly straight-forward. The company will
record revenue when the customer takes possession of the merchandise and pays (primarily with
either cash or credit card). Catalogue and e-commerce sales are recorded upon customer receipt
of merchandise. Amounts relating to shipping and handling billed to customers are classified as
revenue and the related costs are classified as cost of goods sold.

LO: 1
2. Why would a company deliberately report sales on consignment as gross instead of at the net
amount. Explain why you believe this is or is not a fair method of reporting revenue this way.
Answer: Companies sometimes act as agents for other companies. A company might attempt to
inflate revenues by reporting these transactions on a “gross” basis, when in fact these
commissions or revenues should be reported on a net basis. Start-up and dot.com companies
may employ this method under the assumption that the market prices of their stocks are
determined by revenue growth and profitability. The SEC mandates that all such sales should be
reported on a net basis.
Topic: Percentage-of-completion
LO: 1
3. When is the percentage-of-completion method an appropriate method to recognize revenues.
What are some of the potential risks associated with this practice?
Answer: Companies that are awarded long-term contracts that span over one year typically use
the percentage-of-completion method to recognize revenue. The difficulty arises when a company
must forecast all project-related costs in order to accurately estimate at any given point in time
how far along the percentage of completion. Errors can result whereby the company recognizes
too much revenue on the front end, only to be reversed at the end of the project.

Topic: Restructuring charges
LO: 2
4. Firms typically report three categories of restructuring costs. What are they and how to they
affect the balance sheet and the income statement?
Answer: Restructuring costs consist of three general categories: asset write-downs, liability
accruals for severance and relocation costs, and accruals of other restructuring-related costs.
Asset write-downs reduce assets’ net book value and are recognized in the income statement as
an expense. Liability accruals for severance and other expenses create a liability, such as for
anticipated severance costs and exit costs, and yield a corresponding expense that reduces
income and equity.
Topic: Big bath

LO: 2
5. Discuss what is meant when a company takes a “big bath.” In addition, provide an example of
“big bath” behavior and discuss why an analyst or potential investor may be concerned with this
behavior.
Answer: “Big Bath” behavior refers to an event in which companies are perceived as
overestimating the amount of asset write-downs or liability accruals to deliberately reduce current
period earnings. The effect is to remove future costs from the balance sheet or to create reserves
that can be used to increase future period earnings. An example of big bath behavior would be to
time recognition of restructuring costs for a year when its income is already depressed. An
analyst or potential investor may be concerned with this behavior because of the inaccurate
portrayal of a company’s costs and or earnings that result.
Topic: Gross profit margin

LO: 2
6. Is a company with a higher gross profit margin necessarily a better performer? Explain why or
why not.
Answer: Gross profit margin is an important profitability measure. However, it is just one
measure and needs to be viewed in conjunction with other equally important measures such as
SG&A, R&D and net income percentages. Retailers, for example, cannot charge higher prices
per unit given the significant competition and product similarity across companies in this industry.
However, they compensate for these low margins in other areas e.g. with lower R&D costs (given
a lack of need for product differentiation) and lower SG&A expenses. Conversely, companies in
the Oil & Gas sector typically require higher profit margins to off-set much higher SG&A expenses
as well as R&D costs in order to remain economically viable. Hence, different companies may
use different combinations of margin and turnover to achieve the same return on net operating
assets, given the dynamics of their particular sector.

Topic: Deferred taxes
LO: 3
7. What are deferred taxes? When do they arise?
Answer: There are two kinds of deferred taxes: deferred tax liabilities and deferred tax assets.
The former arise when a company’s taxable income is less than its book income, typically
resulting from higher depreciation expense for tax reporting. The company records this effect in
its financial statements as an increase in deferred tax liability to recognize the taxes that will be
paid when the item causing the difference reverses. Deferred tax assets arise for the opposite
reason: taxable income is greater than financial reporting income. This can arise, for example,
when a company reports a restructuring expense that is recognized for financial reporting
purposes when incurred, but is not deductible for tax purposes until paid.
Topic: Foreign currency fluctuations

LO: 4
8. What effect, if any, does a strengthening of the dollar have on reported sales and net income
for companies operating outside the United States, when those foreign operations are translated
to U.S. dollars for consolidation purposes?
Answer: When the U.S. dollar strengthens foreign currencies weaken – they are translated to
fewer USD. This reduces every reported number on the financial statements compared to what
the USD equivalent would have been if the U.S. dollar had not strengthened. Thus, reported
sales, expenses and net income are all smaller.
Topic: Earnings per share

LO: 5
9. How are earnings per share calculated? What is the main problem in comparing operating
results for companies of different sizes, using EPS figures?
Answer: There are two measures of reporting the earnings per share (EPS) figures: basic and
diluted EPS.
Basic EPS is equal to the ratio of net income less dividends on preferred stock to the weighted
average of common shares outstanding for the year. Computation of diluted EPS reflects the
additional shares that would be issued assuming all stock options and convertible securities are
exercised at the beginning of the year. Therefore, diluted EPS is calculated by subtracting the
EPS impact of dilutive options and warrants and the EPS impact of dilutive convertibles from
basic EPS.
Some financial analysts and investors compare EPS figures across companies of different sizes.
The assumption is that the number of shares outstanding is proportional to the income level.
However, this assumption is not correct, since the number of shares outstanding is controlled by
managers, and different companies may have different share issuance and repurchase attitudes.

Test Bank for Financial Statement Analysis and Valuation, 2nd Edition: Easton
Topic: Earnings per share definitions and computations

LO: 4
10. The SEC requires that firms report both basic and diluted earnings per share in their 10-K
reports. Why do firms’ basic EPS and diluted EPS differ? Which EPS number is more informative
to you as an investor?
Answer: Basic earnings per share is defined as net income less any preferred dividends divided
by the weighted average number of common shares outstanding for the period. Diluted earnings
per share adjusts the numerator (earnings) for the impact of issuing dilutive securities (such as
convertible securities or employee stock options); and the denominator. Consequently, diluted
earnings per share is always less than or equal to basic earnings per share. As an investor, I pay
more attention to diluted earnings per share because it tells me about the worst-case scenario if
all dilutive security holders converted their debt or exercised their options. This informs me about
the potential loss in value of my holdings.

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LO1 Explain revenue

LO2 Describe and analyze

LO3 Explain and analyze

LO4 Explain how foreign

LO5 Compute earnings per

© Cambridge Business Publishers, 2010

Topic: Revenue recognition at a service firm

Cambridge Business Publishers, ©2010

Contract price $210 million

During the three-year construction period, Tri-State incurred costs as follows:

Topic: Percentage-of-completion method – Numerical calculations required

© Cambridge Business Publishers, 2010

Topic: Revenue recognition

Topic: Research and development expenses

Cambridge Business Publishers, ©2010

Topic: Research and development expenses – Numerical calculations required

Which of the following is true?

© Cambridge Business Publishers, 2010

Topic: Research and development expenses– Numerical calculations required

What is Yahoo’s common-sized product development expense for 2008?

Cambridge Business Publishers, ©2010

Topic: Restructuring charges– Numerical calculations required

© Cambridge Business Publishers, 2010

Topic: Tax expense– Numerical calculations required

Topic: Tax expense– Numerical calculations required

Cambridge Business Publishers, ©2010

Topic: Changes in deferred income tax accounts– Numerical calculations required

Topic: Deferred portion of income tax expense– Numerical calculations required

© Cambridge Business Publishers, 2010

Current tax provision

Topic: Foreign currency translation

Cambridge Business Publishers, ©2010

Net income $5,521

Weighted average common shares outstanding 5,133

Topic: Diluted earnings per share– Numerical calculations required

Net income $609,365

How many weighted average shares were dilutive in 2008?

© Cambridge Business Publishers, 2010

Topic: Earnings per share definition and computations

Cambridge Business Publishers, ©2010

Topic: Revenue recognition at a service firm

© Cambridge Business Publishers, 2010

Contract price $210 million

During the three-year construction period, Tri-State incurred costs as follows:

Topic: Revenue Recognition Multiple elements contract– Numerical calculations required

Cambridge Business Publishers, ©2010

Answer: According to the percentage-of-completion method Mainline Engineering Company

© Cambridge Business Publishers, 2010

Topic: Research and development expense– Numerical calculations required

Cambridge Business Publishers, ©2010

December 31, December 31, December 31,

December 31, December 31, December 31,

Topic: Research and development expenses

© Cambridge Business Publishers, 2010