Chapter 2

2.4 Income Flows Versus Cash Flows

The text states, "Over sufficiently long time periods, net income equals cash inflows minus cash outflows
flows with owners." Demonstrate the accuracy of this statement in the following scenario: Two friends c
$50,000 each to form a new business. The owners used the amounts contributed to purchase a machine
cash. They estimated that the useful life of the machine was five years and the salvage value was $20,00
the machine to a customer for an annual rental of $25,000 a year for five years. Annual cash operating c
taxes, and other items totaled $6,000 annually. At the end of the fifth year, the owners sold the equipme
instead of the $20,000 salvage value initially estimated. (Hint: Compute the total net income and the tot
than cash flows with owners for the five-year period as a whole. If it doesn't impact Net Income, don't in

Common
Transaction or Event Cash Equipment Stock
Cash Contributed by Owners 100,000 100,000
Purchase of Machine for Cash (100,000) 100,000
Recognition of Rent Revenue 125,000
Recognition of Operating Expenses (30,000)
Recognition of Depreciation (80,000)
Sale of Machine 22,000 (20,000)
Totals $ 117,000 $ - $ 100,000

Use drop-down to select

answers in yellow cells

2.8 Fair Value Measurements

The text discusses inputs managers might use to determine fair values of assets and liabilities and identifi
classifications of assets identified in SFAS No. 157. Suppose a major university endowment has investme
of assets, including (a) common stocks; (b) bonds; (c) real estate; (d) timber investments, which receive c
sales of timber, private equity funds, and illiquid asset-backed securities. Consider how the portfolio man
estimate the fair values of each of those classes of assets, and characterize the inputs you identify as Lev
Level 3.

(a) common stocks Level 1

(b) bonds Level 1
(c) real estate Level 2
(d) timber investments Level 3
(e) private equity funds Level 2
(f) illiquid asset-backed securities Level 3
2.12 Effect of Valuation Method for Nonmonetary Asset on Balance Sheet and Income Statement
Assume Walmart acquires a tract of land on January 1, 2016, for $100,000 cash. On December 31, 2016,
market value of the land is $150,000. On December 31, 2017, the current market value of the land is $12
sells the land on December 31, 2018, for $180,000 cash.

REQUIRED

Ignore income taxes. Indicate the effect on the balance sheet and income statement of the preceding inf
2016, 2017, and 2018 under each of the following valuation methods (Parts a-c).

a. Valuation of the land at acquisition cost until sale of the land (Approach 1)
Land would be valued at acquisition cost of $100,000 initially, and would not change through 2018. In 20
building is sold for $180,000, Walmart would recognize a gain of $80,000 on the income statement.
b. Valuation of the land at current market value and including market value changes each year in net
2)

2016 2017
Dr Cr Dr Cr
Cash 100,000
Land 150,000 30,000
Gain on land 50,000
Loss on land 30,000
150,000 150,000 30,000 30,000

c. Valuation of the land at current market value but including unrealized gains and losses in accumula
comprehensive income until sale of the land (Approach 3)

2016 2017
Dr Cr Dr Cr
Cash 100,000
Land 150,000 30,000
Gain on sale of land
Unrealized gain - OCI 50,000
Unrealized loss - OCI 30,000
150,000 150,000 30,000 30,000
d. Why is retained earnings on December 31, 2018, equal to $80,000 in all three cases despite the rep
amounts of net income each year?
 Net income over sufficiently long time periods equals cash inflows minus cash outflows. Walmart acquire
for $100,000 and sold it for $180,000 in 2018. Thus, the total effect on net income through the realizatio
in the value of the land bought and sold is $80,000. The three different methods of asset valuation and in
measurement recognize this $80,000 in different patterns over time, but the total is the same.

2.16 Deferred Tax Assets

Components of the deferred tax asset of Biosante Pharmaceuticals, Inc., are shown in Exhibit 2.10. The c
deferred tax liabilities.

REQUIRED

a. At the end of 2008, the largest deferred tax asset is for net operating loss carryforwards. (Net operatin
carryforwards, also referred to as tax loss carryforwards, are amounts reported as taxable losses on tax fi
tax authorities generally do not "pay" corporations for incurring losses, companies are allowed to "carry
losses to future years to offset taxable income. These future tax benefits give rise to deferred tax assets.
2008, what is the dollar amount of the company's net operating loss carryforwards?
 $23,609,594

What is the dollar amount of the deferred tax asset for the net operating loss carryforwards?

$62,542,000

b. Biosante has gross deferred tax assets of $28,946,363. However, the net deferred tax assets balance i

The company has recorded a valuation allowance for the deferred tax asset equal to the entire amount o
asset. This means that the company believes that it is “more likely than not” going to use its deferred tax
they expire. This implies that management is not optimistic about the company’s ability to generate futu

c. The valuation allowance for the deferred tax asset increased from $21,818,084 to $28,946,363 betwee
How did this change affect the company's net income?

The income tax expense entry decreased net income; the valuation allowance entry increased the deferr
h inflows minus cash outflows, other than cash
owing scenario: Two friends contributed
buted to purchase a machine for $100,000
the salvage value was $20,000. They rented out
ears. Annual cash operating costs for insurance,
the owners sold the equipment for $22,000,
total net income and the total cash flows other
t impact Net Income, don't include it.)

Net Income
200,000
-
125,000
(30,000)
(80,000)
2,000
$ 217,000

sets and liabilities and identifies different

ity endowment has investments in a wide array
investments, which receive cash flows from
onsider how the portfolio manager would
the inputs you identify as Level 1, Level 2, or
 Income Statement
cash. On December 31, 2016, the current
market value of the land is $120,000. The firm

tatement of the preceding information for

a-c).

ot change through 2018. In 2018, when the

n the income statement.
lue changes each year in net income (Approach

2018
Dr Cr
180,000
120,000
60,000

180,000 180,000

gains and losses in accumulated other

2018
Dr Cr
180,000
120,000
60,000

180,000 180,000
all three cases despite the reporting of different
Net income over sufficiently long time periods equals cash inflows minus cash ou
 e shown in Exhibit 2.10. The company had no

s carryforwards. (Net operating loss

rted as taxable losses on tax filings. Because the
mpanies are allowed to "carry forward" taxable
ve rise to deferred tax assets.) As of the end of
orwards?
ss carryforwards?

deferred tax assets balance is zero. Explain.

equal to the entire amount of the deferred tax

” going to use its deferred tax assets before
pany’s ability to generate future taxable income.

18,084 to $28,946,363 between 2007 and 2008.

nce entry increased the deferred tax asset.

 100,000
(100,000)
125,000

30,000
22,000
(80,000)
(20,000)
(30,000)
2,000
(20,000)
-

Level 1
Level 2
Level 3
Level 1 or 2
Level 2 or 3
Land would be valued at acquisition cost of $100,000 initially, and would not change through 2018. In 2018, when t
Land would be valued at acquisition cost of $100,000 initially, and would not change through 2018. In 2018, when t
Land would be valued at acquisition cost of $100,000 initially, and would be marked to market immediately upon le

20,000
30,000
50,000
60,000
80,000
100,000
120,000
150,000
180,000
Net income over sufficiently long time periods equals cash inflows minus cash outflows. Walmart acquired the land
inflows minus cash ou
Net income over sufficiently long time periods equals cash inflows plus cash outflows. Walmart acquired the land in
Net income over sufficiently long time periods equals cash inflows minus cash outflows. Walmart acquired the land

$62,542,000
$23,609,594
 $0 Text
assetsolution
for theseanswer
net operating loss carryforwards is $23,609,594. This is the income tax
$62,542,000), it would be able to save $0.3775 in tax because it would offset that dolla

$62,542,000
$23,609,594
$0

The company has recorded a valuation allowance for the deferred tax asset equal to the entire amount of the defer
The company has recorded a valuation allowance for the deferred tax asset equal to the entire amount of the defer
The company has recorded a valuation allowance for the deferred tax asset equal to the entire amount of the defer

The income tax expense entry increased net income; the valuation allowance entry increased the deferred tax asse
The income tax expense entry decreased net income; the valuation allowance entry decreased the deferred tax ass
The income tax expense entry decreased net income; the valuation allowance entry increased the deferred tax asse
through 2018. In 2018, when the building is sold for $180,000, Walmart would recognize a gain of $30,000 on the income statement.
through 2018. In 2018, when the building is sold for $180,000, Walmart would recognize a gain of $80,000 on the income statement.
o market immediately upon learning its fair market value. Walmart would recognize a gain of $50,000 on the income statement.
ws. Walmart acquired the land in 2016 for $100,000 and sold it for $180,000 in 2018. Thus, the total effect on net income through the real
. Walmart acquired the land in 2016 for $100,000 and sold it for $180,000 in 2018. Thus, the total effect on net income through the realiza
ws. Walmart acquired the land in 2016 for $100,000 and sold it for $180,000 in 2018. Thus, the total effect on net income through the real
09,594. This is the income tax “shield” available due to the $62,542,000 tax loss carryforwards. The link between these two amounts is tha
cause it would offset that dollar of taxable income with a dollar of its tax loss carryforwards.

the entire amount of the deferred tax asset. This means that the company believes that it is “more likely than not” going to use its deferre
the entire amount of the deferred tax asset. This means that the company plans on using recognizing the asset in a later year. This implies
the entire amount of the deferred tax asset. This means that the company believes that it has "a low likelihood" of being used in the curre

ncreased the deferred tax asset.

decreased the deferred tax asset.
ncreased the deferred tax asset.
n the income statement.
n the income statement.
e income statement.
n net income through the realization of the increase in the value of the land bought and sold is $180,000. The three different methods of a
net income through the realization of the increase in the value of the land bought and sold is $100,000. The three different methods of ass
n net income through the realization of the increase in the value of the land bought and sold is $80,000. The three different methods of as
ween these two amounts is that the deferred tax asset represents the tax effect of the tax loss carryforwards. Generally, this text uses 35–4

n not” going to use its deferred tax assets before they expire. This implies that management is not optimistic about the company’s ability
set in a later year. This implies that management is not optimistic about the company’s ability to generate future taxable income.
od" of being used in the current or any future year. This implies that management is not optimistic about the company’s ability to generat
e three different methods of asset valuation and income measurement recognize this $180,000 in different patterns over time, but the tot
three different methods of asset valuation and income measurement recognize this $100,000 in different patterns over time, but the total
three different methods of asset valuation and income measurement recognize this $80,000 in different patterns over time, but the total
. Generally, this text uses 35–40% as the tax effect of income and deductions. You can back into the rate that was assumed by Biosante. $2

c about the company’s ability to generate future taxable income.

ture taxable income.
e company’s ability to generate future taxable income.
patterns over time, but the total is the same.
tterns over time, but the total is the same.
tterns over time, but the total is the same.
t was assumed by Biosante. $23,609,594/$62,542,000 = 37.75%. Intuitively, for each dollar of taxable income the company might report in
e the company might report in the future (up to