The following balances in the revenue and expense T-accounts of Murphy Oil are extracted from its trial balance as of December 31, Year 1:

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1 CHAPTER 2 Accrual Accounting and Income Determination 2-1 This problem is based on the financial statements of Ingersoll Rand. The operating income before taxes (all numbers in thousands) for the years ended Year 2 and Year 1 are $161,136 and $160,945, respectively. These income numbers were arrived at without considering the following items (all numbers provided in this problem are on a pre-tax basis): a. A loss associated with a restructuring of operations during Year 1 totaled $23,000. The management felt that this significant charge merited a separate line-item disclosure in that portion of the income statement permitted by GAAP. b. During Year 1 the company sold certain unused property for a gain of $33,694. The company had not reported similar events in the past several years. c. During Year 1 the company wrote off investments of $17,305 in some depressed energyrelated businesses. The management felt that this item should be treated as a nonrecurring charge. d. During Year 1 the company incurred a before-tax loss of $11,100 for the early extinguishment of long-term debt. This is treated as an extraordinary item. e. Effective January 1, Year 2 the company changed its method of accounting to include in inventory certain manufacturing overhead costs that were previously charged to operating expense. The cumulative effect of this change for the years prior to January 1, Year 2 amounted to a net benefit of $16,260. Assume the new method of accounting had been applied retroactively for Year 1 and Year 0. In this case the before-tax income would have been lower by $890 and $2,468, respectively. Note this change is considered to be a change in accounting principle by GAAP. P2 19 Determining sustainable earnings 1. Assume a tax rate of 40% for all items. After incorporating the preceding items, prepare comparative income statements for Year 2 and Year 1 as required by GAAP. 2. Assume you are an analyst following the stock of the company. Compute the growth rate in sustainable earnings from Year 1 to Year 2. Sustainable earnings can be considered as that portion of a given period s earnings that can be used to form an expectation about the next period s earnings. If the company maintains the same growth rate in Year 3, provide a forecast for the sustainable earnings for Year 3. The following balances in the revenue and expense T-accounts of Murphy Oil are extracted from its trial balance as of December 31, Year 1: ($ in 000) DR CR Sales $1,646,053 Other operating revenues 45,189 Nonoperating revenue (interest income, etc.) 19,971 Income tax benefit 15,415 Crude oil, products, and related expenses $1,274,780 Exploration expenses 65,755 Selling and general expenses 67,461 Depreciation, depletion, and amortization 225,924 Impairment of long-lived assets 198,988 Provision for reduction in workforce 6,610 Interest expense 5,722 The component Impairment of long-lived assets represents a write-down of property, plant, and equipment. The asset impairment resulted from management s expectation of a continuation into the foreseeable future of the low-price environment for crude oil, natural gas, and petroleum products that confronted the oil and gas industry throughout most of Year 1. Although asset impairment is not unusual in the oil industry, it is not expected to occur frequently. P2 20 Preparing a multiple-step income statement 1. Prepare the income statement of Murphy Oil Corporation for the year ended December 31, Year 1 in good form. 2. On December 31, Year 2 Murphy completed a tax-free spin-off to its stockholders of all the common stock of its wholly owned farm, timber, and real estate subsidiary, Deltic Farm & Timber Company, Inc. (reincorporated as Deltic Timber Corporation ). The following balances in the

2 2-2 CHAPTER 2 Accrual Accounting and Income Determination revenue and expense T-accounts of Deltic Farm & Timber Company, Inc. are taken from its trial balance as of December 31, Year 1: ($ in 000) DR CR Sales $74,124 Other operating revenues 4,618 Nonoperating revenue (interest income, etc.) 691 Product and other expenses $56,697 Selling and general expenses 3,673 Depreciation and amortization 4,053 Interest expense 309 Provision for income taxes (income tax expense) 5,394 As a result of the spin-off transaction, activities of the farm, timber, and real estate segment have to be accounted for as discontinued operations by Murphy Oil, with the Year 1 income statement restated to conform to the Year 2 presentation. On the basis of the additional information, reconstruct Murphy Oil s Year 1 income statement after considering the spin-off as a discontinued operation.

3 CHAPTER 2 Accrual Accounting and Income Determination 2-3 Fuentes Corporation reported the following in its 2005 annual report: Fuentes Corporation Income Statements For the Years Ended December 31, ($ in millions) Net sales $7,475 $6,952 Cost of goods sold (5,803) (5,284) Selling, general, and administrative (793) (820) Income from continuing operations before income taxes Income tax expense (317) (305) Income from continuing operations $ 562 $ 543 C2 5 Fuentes Corporation: Preparation of a multiplestep income statement One year later in its 2006 annual report Fuentes disclosed a number of significant financial events: 1. A loss associated with a corporate headquarters restructuring during 2006 totaled $60 million (net of tax benefit of $31 million). A previous managerial restructuring occurred in Fuentes management felt that this significant change merited separate line item disclosure in that portion of the income statement permitted by GAAP. 2. In October 2006, Fuentes discontinued its Geegaw product line entirely, choosing to concentrate its efforts on its remaining two products, Chatchkies and Baubles. All Geegaws were manufactured at the Kishinev, MD, plant, which was closed in November. The 2006 income from the Geegaw operation, net of tax, was $143 million. The loss on disposal of this segment (net of a tax benefit of $25 million) was $53 million. The 2005 and 2004 results of the discontinued operations are shown below: ($ in millions) Net sales $3,125 $3,063 Cost of goods sold (2,515) (2,419) Selling, general, and administrative (465) (478) Income before tax Income tax expense (52) (60) Income after tax $ 93 $ Effective January 1, 2006 Fuentes changed from the sum-of-the-years digits method for depreciating production equipment to the straight-line method in the Chatchkies and Baubles divisions. (The depreciation method used in the Kishinev plant where Geegaws were manufactured was not changed.) The cumulative effect of this change in accounting principle on all prior years income as of January 1, 2006 was to increase income by $56 million, net of an income tax effect of $29 million. If the new accounting principle had been in use in those years, the 2005 and 2004 results would have been as shown as follows: Adjusted Amounts ($ in millions) 2005 Change 2004 Change Net sales $7,475 $ 0 $6,952 $ 0 Cost of goods sold (5,793) 10 (5,270) 14 Selling, general, and administrative (791) 2 (817) 3 Income from continuing operations before income taxes Income tax expense (321) +(4) (311) +(6) Income from continuing operations $ 570 $+8 $ 554 $+11

4 2-4 CHAPTER 2 Accrual Accounting and Income Determination 4. A partial income statement for 2006 follows: ($ in millions) 2006 Net sales $5,002 Cost of goods sold (3,927) Selling, general, and administrative (350) Income before tax 725 Income tax expense (261) Income after tax $ 464 This statement is partial because it excludes entirely the events described in parts 1 and 2 of this question that is, the discontinued operation has already been removed from these figures; also excluded is the restructuring cost (and its tax effect). The partial income statement does, however, compute depreciation expense using the new straight-line depreciation method described in part 3. Prepare comparative income statements for the years 2006 and 2005, as they would be reflected under GAAP. C2 6 The Quaker Oats Company: Classification of gains versus losses In 1991 and again in 1995 Quaker Oats Company disposed of business segments. The 1991 transaction was a spin-off of Fisher-Price (a toy manufacturing operation) to the company s shareholders. The 1995 transaction was principally composed of the sale of both the North American and European pet food businesses. Exhibit 1 contains the consolidated statements of income from the 1991 Annual Report as well as the financial statement footnote on discontinued operations, which also appeared in that report. Exhibit 2 reflects the consolidated statements of income from the 1995 Annual Report; in addition Exhibit 2 also contains excerpts from two 1995 financial statement footnotes. EXHIBIT 1 The Quaker Oats Company and Subsidiaries Consolidated Statements of Income Years Ended June 30 ($ in millions, except per-share data) Net sales $5,491.2 $5,030.6 $4,879.4 Cost of goods sold 2, , ,655.3 Gross profit 2, , ,224.1 Selling, general, and administrative expenses 2, , ,779.0 Interest expense net of $9.0, $11.0, and $12.4 interest income Other expense net Income from continuing operations before income taxes Provision for income taxes Income from continuing operations Income (loss) from discontinued operations net of tax (30.0) (59.9) 54.1 Net income Preferred dividends net of tax Net income available for common $ $ $ Per common share Income from continuing operations $3.05 $2.93 $1.88 Income (loss) from discontinued operations (.40) (.78).68 Net income $2.65 $2.15 $2.56 Dividends declared $1.56 $1.40 $1.20 Average number of common shares outstanding (in thousands) 75,904 76,537 79,307

5 CHAPTER 2 Accrual Accounting and Income Determination 2-5 EXHIBIT 2 The Quaker Oats Company and Subsidiaries Consolidated Statements of Income Years Ended June 30 ($ in millions, except per-share data) Net sales $6,365.2 $5,955.0 $5,730.6 Cost of goods sold 3, , ,870.0 Gross profit 2, , ,860.6 Selling, general, and administrative expenses 2, , ,302.3 Gains on divestitures and restructuring charges net (1,094.3) Interest expense net of $6.3, $8.9, and $10.5 interest income, respectively Foreign exchange loss net Income before income taxes and cumulative effect of accounting changes 1, Provisions for income taxes Income before cumulative effect of accounting changes Cumulative effect of accounting changes net of tax (4.1) (115.5) Net income Preferred dividends net of tax Net income available for common $ $ $ Per common share amounts Income before cumulative effect of accounting changes $6.00 $1.68 $1.96 Cumulative effect of accounting changes (0.03) (0.79) Net income $5.97 $1.68 $1.17 Dividends declared $1.14 $1.06 $0.96 Average number of common shares outstanding (in thousands) 133, , ,948 Notice that Quaker treated the 1991 transaction as a discontinued operation below the line, while the 1995 transaction was treated differently. Note 2: Discontinued Operations In April 1990 the Company s Board of Directors approved in principle the distribution of Fisher- Price to the Company s shareholders. Accordingly, Fisher-Price has been reflected as a discontinued operation in the accompanying financial statements for all periods presented. The tax-free distribution was completed on June 28, 1991 and Fisher-Price, Inc., an independent free-standing company, was created. The distribution reduced reinvested earnings by $200 million. The $29.6 million payable to Fisher-Price at June 30, 1991 represents an estimate of the final cash settlement pursuant to the Distribution Agreement. Each holder of Quaker common stock on July 8, 1991 received one share of Fisher-Price, Inc. common stock for every five shares of Quaker common stock held as of such date. Fisher-Price, Inc. common stock is publicly traded. The loss from discontinued operations for fiscal 1990 was $59.9 million, or 78 cents per share, including $25.5 million, or 33 cents per share, for the loss from the first nine months of fiscal 1990 and an after-tax provision of $34.4 million, or 45 cents per share, recorded in the fourth quarter. The third-quarter results included charges of $10.7 million, or 8 cents per share, for the East Aurora, New York manufacturing facility closing and $17 million, or 23 cents per share, for anticipated transaction expenses of the planned spin-off and projected operating losses (including allocated interest expense) through the expected completion date of the spin-off. The fourth-quarter

6 2-6 CHAPTER 2 Accrual Accounting and Income Determination provision included charges of $8.6 million, or 7 cents per share, for the pending closing of Fisher- Price s Holland, New York manufacturing facility and $4.8 million, or 4 cents per share, for costs relating to staff reductions. The fourth-quarter provision also included $25.4 million, or 21 cents per share, for inventory write-downs and the cost of maintaining related trade programs and $18.1 million, or 13 cents per share, for higher projected operating losses through the spin-off date due to lower than previously anticipated sales volumes. During fiscal 1991, the Company recorded an additional $50 million pre-tax charge ($30 million after-tax), or 40 cents per share to discontinued operations. The charge related primarily to receivables credit risk exposure, product recall reserves, and severance costs. The following summarizes the results of operations for discontinued operations ($ in millions): Sales $ $ $844.8 Pretax earnings (loss) (50.0) (96.2) 89.6 Income tax benefit (expense) (35.5) Income (loss) from discontinued operations $( 30.0) $( 59.9) $ 54.1 Fisher-Price operating loss for fiscal 1991 was approximately $35 million. Fisher-Price operating losses for the fourth quarter of fiscal 1990, including the Holland, New York plant closing and severance charges, were $40 million, including allocated interest expense of $1.2 million. Interest expense of $6.7 million, $7.4 million, and $7.1 million was allocated to discontinued operations in fiscal 1991, 1990, and 1989, respectively. Acquisitions and Divestitures Footnote Excerpt On March 14, 1995 the Company completed the sale of its North American pet food business to H. J. Heinz Company for $725.0 million and realized a gain of $513.0 million. On April 24, 1995 the Company completed the sale of its European pet food business to Dalgety PLC for $700.0 million and realized a gain of $487.2 million. Other divestitures in fiscal 1995 included the Dutch honey business in February 1995, the Mexican chocolate business in May 1995, and the U.S. bean and chili businesses in June The Company realized gains on these divestitures of $4.9 million, $74.5 million, and $91.2 million, respectively. The following table presents sales and operating income from the businesses divested in fiscal 1995 through the sale dates. Operating income includes certain allocations of overhead expenses and excludes gains on divestitures and restructuring charges in all fiscal years. ($ in millions) Sales U.S. and Canadian grocery products $ $ $ International grocery products Sales from divested business $1,315.0 $1,633.3 $1,690.6 Operating income U.S. and Canadian grocery products $ 39.3 $ 54.2 $ 55.6 International grocery products Operating income from divested business $ 73.4 $ $ Restructuring Charges In fiscal 1995 the Company recorded a restructuring charge of $76.5 million for cost-reduction and realignment activities in order to address the changes in its business portfolio and to allow it to quickly and effectively respond to the needs of trade customers and consumers. These changes result in the elimination of approximately 850 positions and primarily include the realignment of the corporate, shared services and business unit structures, the European cereals business, and the U.S. distribution center network. Savings from these activities are expected to be about $50 million annually beginning in calendar Approximately 90% of the annual savings will be in cash.

7 CHAPTER 2 Accrual Accounting and Income Determination Why do you think the 1991 and 1995 divestiture transactions were treated so differently? 2. Do you agree with each year s financial statement placement? 3. What factors do you think were used to justify the fact that each treatment was in conformity to GAAP?