Student Cases with Solutions to accompany Accounting & Auditing

Research: Tools & Strategies (7th edition)

NOTE: In addition to the in-chapter and end-of-chapter exercises which serve as
short cases you will find the following short cases arranged by course title that can
also be utilized as short cases that require the student to access the authoritative
literature to address the issue presented in the case. Other excellent sources of
longer and more detailed cases include the Deloitte Trueblood cases
(www.deloitte.com/more/DTF/cases_subj.htm), as well as the AICPA cases
(www.aicpa.org).
A topical listing of the cases is presented with the case and solution following the
listing.

Topical Index of Student Cases

INTERMEDIATE ACCOUNTING Cases
Case 1: Reporting acquisition and repayment transactions in the Statement of Cash Flows
Case 2: Recording a forfeited payment
Case 3: Revenue and expense recognition associated extended warranties
Case 4: Accounting for due on demand note payable
Case 5: Purchase of a controlling interest with a greenmail premium
Case 6: Revenue recognition in the construction industry
Case 7: Accrual and measurement of interest payments
Case 8: Recognition of an asset transfer when title has not yet been received
Case 9: Capitalization of interest and property taxes on a construction project
Case 10: Deferred compensation and life insurance policy recognition
Case 11: Reporting earnings per share balances for subsidiary companies
Case 12: Deferment of lease payments
Case 13: Disclosure of prior period adjustments in the statement of cash flows
Case 14: Measurement and recording of payments for sick days

Case 15: Comparative cash flow statements

Case 16: Social security benefits as assets
Case 17: Recording a stock dividend as a stock split
Case 18: Gain on a nonmonetary exchange

ADVANCED ACCOUNTING Cases

Case 1: Reporting of letters of guarantee notes payable
Case 2: Factors affecting minority interest control
Case 3: Profits and losses in the investment in foreign currencies
Case 4: Amortization of foreign currency transaction gains and losses
Case 5: Reflection of expensed computer programs on consolidated financial statements
Case 6: Classification of a proposed financial instrument as a hedge
Case 7: Disclosure of proceeds and payments from cash flow hedging activities
Case 8: Proper valuation of a guaranteed business combination

GOVERNMENT AND NOT-FOR-PROFIT ACCOUNTING Cases

Case 1: Recognition restricted or non-restricted assets that are promised but not received
Case 2: Affect of permanent reductions in the value of promised assets
Case 3: Disclosure and classification on a companys Statement of cash Flows
Case 4: Disclosure of potential interest rate swings and commercial paper by a city
Case 5: Capital and operating leases between related parties
Case 6: Elimination of profits on intercompany sales
Case 7: Reporting of funds and potential obligations on bonds issued for third parties
Case 8: Disclosure of payments made to agents or brokers
Case 9: Accrual of vacation time of unestablished employees

AUDITING Cases
Case 1: Communication with predecessor auditors
Case 2: Scope limitations
Case 3: Outside services for inventory counts
Case 4: Supplementary disclosures
Case 5: Restating prior years financial statements
Case 6: Independence in a review or compilation engagement
Case 7: Qualified report and account classification
Case 8: Re-issuance of financial statements
Case 9: Communication with audit committees
Case 10: Accounting for assets held for sale

TAX Cases
Case 1: When should gross income be accrued?
Case 2: Stock purchased by an employee
Case 3: Income sourcing- international
Case 4: Business deductions
Case 5: Deduction for foreign travel
Case 6: Contingent liabilities
INTERMEDIATE ACCOUNTING Cases
Case 1: Mead Motors purchases an automobile for its new car inventory from Generous
Motors, which finances this transaction through its financial subsidiary, Generous Motors
Credit Company (GMCC). Mead pays no funds to Generous Motors or GMCC until it
sells the automobile. Mead must then repay the balance of the loan plus interest to
GMCC. How should Mead report the acquisition and repayment transactions in its
Statement of Cash Flows?

Case 1 Solution:
Problem Identification: How should a company report, if at all, cash and non-cash
transactions owed to an entitys financial subsidiary?
Keywords: Cash flows; financ* subsidiaries; operating income.
Conclusion: Per ASC 230-10-50-5), Mead should exclude transactions that involve no
cash payments or receipts. However, per 230-10-45-17, it should record cash payments
to GMCC for repayments of principle (and interest thereon) due to suppliers or their
subsidiaries as operating cash (out) flows.
Case 2: Narda Corporation agreed to sell all of its capital stock to Effie Corporation for
three monthly payments of $200,000. After Effie made the first required payment, it
ceased making other payments. The stock subscription agreement states that Effie, thus,
forfeits its payments and is entitled to no other future consideration. How should Narda
record the $200,000 forfeited payment?
Case 2 Solution:
Problem Identification: How should a company account for forfeited stock
subscriptions? Moreover, do such payments constitute operating or other income?
Keywords: Stock Subscription; operating income; additional paid-in capital; owners
equity; net income; operating income.
Conclusion: Per 505-10-25-2, capital transactions that incur no future corporate
obligations should be excluded from calculating net or operating income. Thus, the
forfeited cash should become part of additional paid-in capital about any required
disclosures for such transactions.
Case 3: Lowland Appliance Stores offers customers purchasing its appliances separately
priced (extended) warranties. Lowland services these extended warranties. Its customers
can receive no refunds for not using these warranties, and, of course, Lowland must
honor these contractsregardless of any future costs in doing so. It also tracks the
profits and losses these types of warranties generate by appliance categoryin order to
help maintain a competitive price and costing structures. How should Lowland recognize
the revenues and expenses of such extended warranties?
Case 3 Solution:
Problem Identification: How should a company recognize revenues and expenses
associated with separately priced, extended warranties? Such contracts generally are
(potential) loss contingencies.
Keywords: Loss contingency; non-refundable

Conclusion: Per 605-20-25-3, such extended warranties constitute product maintenance

contracts, where Lowland agrees to perform certain agreed-upon services to these
products for a specific time period. As such, it should recognize revenue on a straightline basis over the contract period, unless sufficient historical evidence indicates a
superior alternative method of doing so. Lowland should also match any related costs
in the same time period as the associated revenues. Moreover, Lowland should recognize
a loss on such contracts that have an expected net cumulative loss over the remaining
contract periods. Further information on this topic also appears in 450-20-05-3 and 46010-25-5; FASB Concepts Statement No. 5, pars. 83 and 84; and FASB Concepts
Statement No. 6, par.197.
Case 4: As of January 1, the Lohse Company owes the First Arbor Bank $350,000 which
is due on December 31. Since Lohse seems unable to repay the note, the bank agreed that
Lohse can settle this balance by agreeing to make four, annual installments on each of
the next four years, provided that it adds a due on demand clause to the note.
Specifically, the lender will do its best not to call the note provided that no adverse
significant shift in operations occurs." However, First Arbor Bank has the sole discretion
to ascertain if these adverse conditions arose, and then to call the note due immediately.
How should Lohse account for this above situation?
Case 4 Solution:
Problem Identification: How should a company account for notes payable containing a
due on demand clause and both a short- and long-term schedule of payments due?
Keywords: Due on Demand; Notes Payable; Classification of Obligations; Installments.
Conclusion: Per 470-10-45-9 and 10, notes that are due on demand should be
considered as a current liability However, if Lohse expected to refinance this note on a
long-term basis (and a reasonable basis to demonstrate such refinancing existed), it would
then reclassify the note as a long-term liability.
Case 5: On January 1, the Chin Company agreed to purchase all of Jack Jacksons
interest in the company for $30 per share. Jack, who owns 15%and a controlling
interest of Chinpreviously threatened to engage in a hostile takeover attempt of Chin.
For the last two years, Chins stock traded from about $12-23reaching $23 on
December 31 of last year. How should Chin record this transaction?
Case 5 Solution:
Problem Identification: Do greenmail payments constitute treasury stock
transactions? Should Chin assign any premium to acquiring Jacksons controlling
interest in the Company, and, if so, how much should it assign to the greenmail
premium?
Keywords: Treasury Stock; Greenmail; Capital Stock; Capital Transactions.

Conclusion: Per 505-30-25-3, companies often pay premiums (and can even receive
discounts) to acquire large (potentially controlling) blocks of stocks in the open market.
An entity offering a higher purchase price than the open market price should allocate
some portion to the unstated rights or privileges and give separate accounting
recognition.
Case 6: Bo Broker Company charges a fee for bringing together the Acme Construction
Company and the First Bank Company. The parties agree that Bo earns her fee when
Acme and First agree to the terms of the construction mortgage. However, Bo can
receive four types of documents to settle this matter: (a) a non-interest bearing,
unsecured negotiable note in payment of the fees earned, which is payable over the
time period of the related construction mortgage; (b) a non-negotiable note payable over
the same time period as in case (a); (c) a commitment letter, not contingent upon the
future event of the borrower receiving certain construction draws; or (d) a commitment
letter, where the fees would be paid only if the borrower actually receives the draws for
the construction from the lender. Bo asks the accountant when to recognize revenues
under each of these four scenarios.
Case 6 Solution:
Problem Identification: What circumstances must exist for an entity to recognize
incomeespecially regarding the issue of when it can control the events leading to
recognizing revenue?
Keywords: Revenue recognition; construction industry; commitment letter; contingency.
Conclusion: Per 450-20-25-3 Bo should recognize the revenues for each of the four
cases as follows: (a) for the negotiable note, recognize income at the earlier of when
services are performed and billed or when receiving consideration for the proceeds of the
note; (b) same as (a), except that early consideration is not feasible; (c) for the
commitment letter, recognize revenues upon receipt of this outside commitment letter
which shows the completion of the earnings process; and (d) defer recognizing revenues
until both outside parties fulfill their contract obligations.
Case 7: James Olds buys a four-year, $1,000,000 certificate of deposit from the Second
National Bank. James will receive 5% interest in year 1; 5.5% in year 2; 6% in year
three; and 6.5% interest in year 4. If James redeems this certificate before the maturity
date, he would receive a cumulative 4.5% annual rate of interest of 4.5%. The Bank has
ascertained that less than one percent of its depositors redeem their certificates before the
maturity date. The bank asks its accountant how to accrue and measure such interest
payment obligations.
Case 7 Solution:
Problem Identification: Should the Bank recognize the future interest costs by: (1)
accruing interest @ 5% for the first year, 5.5% for the second year, 6% for the third year,
and 6.5% for the third year, plus appropriate compounding factorsand debit interest
expense and credit interest payable for these bonds? Or, instead, should the Bank

determine the total interest that James is slated to receive at the end of the term of the
bond, and accrue a pro rata share of this amount for each month of the four-year term of
the bond?
Keywords: Bond amortization and discount; contingent liability; interest expense.
Conclusion: Per 450-20-25-1 and 3, since only a remote possibility of early withdrawals
exists, the Bank should use the above, monthly pro rata approach to recognize the interest
due to James.
Case 8: On January 1, year 1, Melvin Corporation promises to unconditionally transfer
a building that cost $100,000 (appraised recently at $300,000) to the Vivian Company on
January 1, year 2 for a boat she bought for $250,000. As of December 31, year 2, Melvin
still has not transferred title to the building, although it received title to the boat. How
should Vivian and Melvin record these transactions?
Case 8 Solution:
Problem Identification: At what value should Vivian and Melvin recognize like and/or
non-like kind exchanges? Should the parties recognize this transaction before Vivian
receives title to the building?
Keywords: Like-kind exchanges, nonmonetary transactions; barter transactions;
contributions recognition; revenue recognition.
Conclusion: Per the provisions of 845-10-30-1, for different types of assets
exchanged, both parties should recognize the acquired assets at their fair market value(s).
Since Vivians transaction seem more recent and objective than Melvins, the $250,000
value seems more appropriate. 958-605-25-8, a donee receiving an unconditional
promise to receive an asset should recognize it as a receivable (until it is received). Thus,
Vivian should recognize the $250,000 receivable, unless reasonable, contrary evidence
arises that she should recognize some allowance for uncollectibles for the possibility of
not receiving it.
Case 9: Herb Construction Company is building a hotel for speculative purposes. That
is, the Company has not yet found a buyer for the hotel, but expects to do so within a few
months. Herb, who expects to spend about another two years to complete construction of
the hotel, asks his accountant if interest and property taxes associated with this
construction site should be capitalized or expensed. At what rate of interest should Herb
use, if any, to capitalize any interest costs?
Case 9 Solution:
Problem Identification: Should property taxes and interest during construction of a
hotel be capitalized or expensed? What rate of interest should be used to capitalize any
interest costs? Does the fact that no present buyer for the project does not exists affects
he results derived?

Keywords: Property taxes; interest: capitalization; construction.

Conclusion: Per 720-30-45-3, property taxes paid for property under development for
use or sale can be capitalized but is usually treated as a period expense. Assets
constructed for sale are considered qualifying assets for interest capitalization per 83520-15-5. Per 835-20-30-3 through 30-4, Herb should use a rate of interest that can be
directly associated with the project under construction. Or a weighted average of rates
applicable to other debt that Herb has incurred (even if it were associated with other
projects).
Case 10: In order to help induce Jill Gregory to remain as president of the Reed
Company, in 2000 it promises to pay her (or her estate) $200,000 per year for the next 15
yearseven if she leaves the company or dies. Reed wants to properly record this
transaction as deferred compensation, but is unsure of how many years it should use to
amortize this cost. Moreover, Reed also purchased a whole life life insurance policy
for Jill, naming the company as the sole beneficiary. Reed wants to ascertain if it can
offset the cash surrender value of the policy against the above deferred compensation
liability.
Case 10 Solution:
Problem Identification: How many years should be used to amortize deferred
compensation? Can a company offset the cash surrender value of the policy against
deferred compensation liability?
Keywords: Deferred compensation; purchase life insurance.
Conclusion: Per the provisions of 710-10-25-9, the future payments should be amortized
over the 15 remaining years of the contract. Moreover, per 325-30-35-1 through 35-6,
Reed should report changes in the cash surrender values of life insurance policies as
offsets to insurance expense costsnot as reductions in deferred compensation.
Case 11: The Bootsie Holding Company has sales exceeding $10 billion and each of its
three, wholly-owned subsidiaries has sales exceeding $2 billion. Three years ago, the
subsidiaries had complex capital structuresuntil Bootsie acquired them. Bootsies
annual report shows its consolidated income and individual income statement accounts of
each subsidiary company. Should Bootsie also report separate earnings-per-share
balances for the three subsidiary companies?
Case 11 Solution:
Problem Identification: Should wholly owned subsidiaries report separate earnings per
share balances?
Keywords: Earnings per share; earnings per share: applicability.

Conclusion: Per 260-10-15-2, companies whose securities are traded publicly (or soon
expect to do so) should disclose such earnings per share data. However, wholly owned
subsidiaries need not do so (since no separate market for their securities exists).
Case 12: Leila Company began an operating lease arrangement with Debco Industries,
which was slated to begin on January 1, at monthly lease payments of $10,000.
However, Debcos negligence prevented Leila from moving in on timesince it failed to
clean up the place adequately enough to earn a Certificate of Occupancy from the
township. Thus, on January 1, Leila spent $5,000 for leasehold improvements, which
enabled her to obtain the needed Certificate of Occupancy on April 1. In any event, Leila
paid Debco all the required $30,000 lease payments and has decided not to pursue legal
action for the un-ready building. However, can Leila defer the $30,000 January-March
lease payments over the remaining 33 months of the lease contract?
Case 12 Solution:
Problem Identification: Can a lessee defer portions of an operating lease payment for
conditions beyond its control? I.e., do the periods of an operating lease begin when the
payments are made or when the lessee takes operating control of the asset?
Keywords: Operating lease; leasehold improvement; capitalization of interest (or other)
costs
Conclusion: 840-20-25-2 states that lessees should consider rent inducements or rent
holidays as part of the operating term of a lease. i.e., the physical period that rental
property is available for use for the lessee serves as a better indicator of the amortization
period of the rental contract than any payment period. Next, 840-30-25-3 states that
lessees should account for scheduled rate increases over the time that the lessee takes
possession of or controls the property. 835-20-15-2 also considers the time needed to get
property ready for its intended use as the prime criteria to ascertain the capitalization
period. Thus, Leila should amortize the $30,000 over the remaining 33 months of the
lease.
Case 13: After the Julie Company issued its previous years financial statements, it
noticed that it incorrectly calculated depreciation expense and, thus, disclosed this fact as
a prior period adjustment in its current years financial statements. (This difference also
did not affect any cash balances, since Julie maintained an operating loss for both
periods.) However, Julie did not issue comparative financial statements in the current
year. Julie now wonders how to disclose this prior period adjustment in its current years
Statement of Cash Flows.
Case 13 Solution:
Problem Identification: How should a company disclose prior period adjustments in its
Statements of Cash Flows?
Keywords: Prior period adjustments; retained earnings; Statement of Cash Flows.

Conclusion: Per 250-10-50-9, Julie should disclose the effect of a prior period
adjustment (for a single periods financial statement) as an adjustment in the opening
balance in retained earningsplus make adequate footnote disclosures of the reasons for
and effect of the adjustment. Moreover, per 230-10-50-3, Julie should also disclose
information about investing and financing activities that did not result in cash receipts for
the current period. Thus, Julie should also disclose the differences in the account
balances of the two consecutive balance sheets both in the statement of cash flows and in
an appropriate footnote.
Case 14: The Heather Companys fiscal year ends on June 30. Its employees (with at
least three months of experience) are entitled to 12 paid sick days annually for each
calendar year beginning on January 1. An employee not taking his/her earned sick days
would receive payment thereon on December 31 of that year. How should Heather
record and measure such a liability as of June 30th?
Case 14 Solution:
Problem Identification: Should Heather recognize any liability for the above potential
contingency, and, if so, how should it measure and record it?
Keywords: Contingency; compensated absence; matching concept.
Conclusion: Per 710-10-25-1, if : (a) the employees have worked the required time
periods to earn the compensated sick pay; (b) these rights are vested; (c) payment of
compensation is probable; and (d) the amount can be reasonably estimated, the liability
exists. These conclusions follow reasonable and probable criteria of SFAS No. 5,
pars. 5 and 22, which also require measuring the past history of employees using these
benefits (e.g., also consider employee turnover). In this above, relatively simple
example, an employee who used four days of vacation would be entitled to eight more
i.e., the balance that Heather must accrue. However, if, the employer plan were based
upon an accrual concept, it would pro rate the untaken days for the remainder of year.
Case 15: Alex Corporation is planning this year to present comparative income
statements but only the current years balance sheet. James Johnston, president of Alex
Corporation requests your advice as to whether comparative cash flow statements for
both the current and prior periods are necessary considering only the current years
balance sheet is presented. Are there any authoritative pronouncements that address this
issue that you could present to Mr. Johnston?
Case 15 Solution:
Problem Identification: The issue is whether comparative cash flow statements are
necessary when comparative income statements are presented, but only a single year
balance sheet is also presented.
Key Words: comparative statements, cash flow statements

Conclusion: 230-10-15-3 states that a business enterprise that reports both financial
position and results of operations shall also provide a statement of cash flows for each
period for which results of operations are provided. Therefore, comparative cash flow
statements need also be presented.
Case 16: A new client for your firm is Sam Jones who is preparing personal financial
statements for a bank loan. Mr. Jones is attempting to list his social security benefits to
be received based on his future life expectancy as an asset on his financial statements.
Mr. Jones states that such benefits meet the definition of an asset. Would you agree to
allow the social security benefits to be listed as an asset?
Case 16: Solution
Problem identification: The issue is whether social security benefits to be received
based on ones future life expectancy should be considered an asset on personal financial
statements.
Key Words: assets, personal financial statements
Conclusion: 274-10-35-11 states that nonforfeitable rights to receive future sums must
meet certain criteria to qualify as an asset. One criteria states that the rights must not be
contingent on the individuals life expectancy or the occurrence of a particular event,
such as disability or death. Since social security benefits are contingent on ones life
expectancy, such benefits do not qualify to be listed as assets on ones personal financial
statements.
Case 17: Albright Inc. has recently issued a 10% stock dividend to its existing
stockholders. As a result of the issuance of the stock dividend the market price of the
stock declined 25%. Albright has requested your assistance as to treating this stock
dividend as a stock split. Would this be acceptable under GAAP?
Case 17: Solution
Problem identification: The issue for this case is whether a 10% stock dividend that
reduces the market price of the stock can be accounted for as a stock split.
Key Words: Stock dividends, stock splits
Conclusion: 505-20-25-1 through 25-3 state that to treat the 10% stock dividend as a
stock split, Albright would need to demonstrate that the additional shares issued is large
enough to materially influence the unit market price of the stock.
Case 18: Horizons Inc. has agreed to sell an investment in a subsidiary that has been
accounted for on the equity method of accounting to a minority stockholder in exchange
for the stockholders share in Horizons. Since the fair value of the investment exceeds its
book value, Horizons CEO is considering recognizing a gain on the exchange. However,

the new CFO at Horizons is recommending to the board of directors that the excess from
the exchange be accounted as a credit to equity. Horizons turns to you for advice!
Case 18: Solution
Problem identification: The problem under review in this case is whether a gain on a
nonmonetary exchange can be recorded.
Key Words: Nonmonetary exchange, nonmonetary asset, or nonreciprocal transfer
Conclusion: 845-10-30-1 states that a transfer of a nonmonetary asset is a nonreciprocal
transfer and should be recorded at the fair value of the asset transferred, and that a gain or
loss should be recognized on the disposition of the asset.
ADVANCED ACCOUNTING Cases
Case 1: Rosie Corporation has 70% of the outstanding voting stock of Smith Corporation
and 10% of the voting stock of Tommy Corporation. Smith also just spent $10,000 to
acquire 20% of Tommys voting stock. Smith has issued irrevocable letters of credit to
guarantee Tommys notes payable. In the current year, Tommy lost $100,000. How
should the parties report the above arrangements in its consolidated financial statements?
Case 1 Solution:
Problem Identification: How should guarantees among related (but not fully owned)
parties be disclosed in both their consolidated and separate financial statements?
Keywords: Control; consolidated financial statements; related party transactions; gain
and loss contingencies.
Conclusion: First, Smiths share of Tommys net losses (20% of $100,000 = $20,000)
exceeds its cost basis of Tommy ($10,000). Per 430-30-25-1, entities should normally
not recognize gain contingencies. Thus, the guarantee should not be recognized in
Rosies or Tommys financial statementsother than through disclosures in the
footnotes. Similarly, per 810-10-45-7, in the unusual case in which losses applicable to
the minority interest in a subsidiary exceed the minority interest in the equity capital,
such excess should be charged against the majority interest. Per 810-10-45-21, losses
excess, and any further losses, shall be attributed to those interests even if that attribution
results in a deficit noncontrolling interest balance.

Case 2: Joe Brock owns 10,000 of the 60,000 outstanding shares of Big Corporation;
Leslie Ross own 20,000 shares; Mark Jones and his twin brother Sam each own 5,000
shares; and about 300 other shareholders own the remaining 20,000 shareswith no one
other shareholder owning more than 1,000 shares. According to the provisions of SFAS
94, since Leslie owns half of the outstanding shares, he, in general, controls Big

Corporation and, thus, should consolidate his interest with that of the corporation.
However, Joe Brock is unhappy with Marks management decisions and plans to
challenge his authority. What factors arise in considering if a minority investor can
maintain such control or even prevent others from exercising such control?
Case 2 Solution:
Problem Identification: Can corporate control rest with others besides the majority
owner? What factors should we examine to make such a determination? Should we
separately analyze situations where the minority shareholder seeks actual control, or
(merely) wishes to veto another party (e.g., majority shareholder) from exercising this
control?
Keywords: Consolidated financial statements; consolidation (of majority owned
subsidiaries); contingencies; related parties; accounting changes.
Conclusion: Per 810-10-25-1 through 25-14, deciding if a minority shareholder can
overcome the presumption that the majority shareholder maintains this control depends
on many facts and judgments. First, can the minority shareholder participate, veto, or
cause certain operating ordinary operating (e.g., which bank to hold corporate assets)
(i.e., which it calls protective rights) and long-term (e.g., who sets top managements
salary and which tender offer to acquire the company to accept) (i.e., which it calls
participating rights) management decisions to occur. Other factors include restating prior
years financial statements if control passes to the minority shareholder; and does the
minority shareholder control technology or customers of crucial interest to the company.
Case 3: The Treasury Department of Drof Motors invests excess funds daily (e.g., in
foreign currencies). It, thus, earns profits and losses, which are included in the
companys consolidated financial statements. Should Drof consider its Treasury
operations as a (distinct) segment in preparing its external financial statements?
Case 3 Solution:
Problem Identification: Should corporate divisions that generate revenues and expenses
qualify as an operating segment for financial statement purposes?
Keywords: Segment; operating division.
Conclusion: Per 280-10-50-1 all operating segments can be reported separately if they
meet the guidelines: it generates revenues and expenses that a corporate decision-maker
reviews, and has discrete financial information available. However, management should
also believe that such additional information can contribute to outside readers and users
better understanding the enterprises operations.
Case 4: The Builtwell Construction Company is building a hospital for a third party. As
such it borrows substantial funds from a foreign bank and repays the required interest
costs as scheduled. Builtwell also incurs some foreign currency truncation gains and
losses on these transactions. Builtwell properly amortizes the interest costs over the life

of the construction project, but would now also like to amortize the associated foreign
currency transaction gains and losses as well. Can Builtwell amortize such costs?
Case 4 Solution:
Problem Identification: Should a construction company amortize or expense the gains
and losses of foreign currency transaction gains and losses expended while a building
was under construction?
Keywords: Foreign currency translation; capitalization (of interest costs).
Conclusion: Although Builtwell apparently correctly amortized interest costs during
constructionper the provisions of 835, it can not amortize such foreign currency
transaction gains and losses. Per 830-20-35-1, increases or decreases in expected
functional currency cash flows become foreign currency transaction gains or losses, i.e.,
period costs.
Case 5: Tony Computer Services Corporation trades 50% of its common stock for the
rights to certain computer programs of the Janet Corporation. Janet previously expensed
such costs of developing these computer programs. Tony concurrently sold the other
50% interest in its stock to the Jeannette Company for $1,000,000. Tony later acquired
another the rights to the Udder Computer Companys computer programs in exchange for
stock valued at $1,500,000. Tony, thus, debited Investments in Subsidiaries and credited
Earnings for $1.5 million to reflect this latest transaction. How should Tonys
consolidated financial statement reflect the value of the expensed computer programs?
Case 5 Solution:
Problem Identification: Should Tony recognize the value of the acquired computer
programs, or should these results be consolidated, i.e., eliminated?
Keywords: Equity method of accounting; inter-company gains and losses.
Conclusion: Per 810-10-45-18, for fiscal years after December 15, 2008, complete
elimination of intercompany income and loss is consistent with consolidated financial
statements. The elimination of the intercompany income or loss may be allocated equally
between the parent and the non-controlling interest. Moreover, Tony should ascertain
that the $1.5 million stated value of the stock issued for the Udder Company is
appropriate, e.g., by using market valuation models to test such valuations.
Case 6: The Rich Company seeks to limit its potential exposure from future variableinterest debt by engaging in a cash flow hedge. Thus, it seeks to acquire a financial
instrument that varies in price in opposition to Ricks expected payments on this debt
instrument. However, it is unsure of the effectiveness of this hedging instrumentsince
it is unsure of the expected timing of such transactions. Can Rich classify this
proposed financial instrument as a cash flow (or other) hedge?
Case 6 Solution:

Problem Identification: How much detail must a company have about proposed hedging
activities in order to categorize them as such?
Keywords: Hedging; interest rate swaps; financial instruments.
Conclusion: 815-20-25-1 lists the criteria whereas 815-20-25-2 through 25-132 list
specifics to fulfill 25-1. 815-20-25-1 requires that at the inception of the hedge the
company must document the risk being hedged and how it will assess the effectiveness of
the hedging instrument. Thus, if the Company can not document the time period the
forecasted transaction that it wants to hedge is expected to occur, and the nature of the
associated asset or liability involved, the transaction does not qualify as a hedge under
GAAP.
Case 7: Merrill Corporation engages in a valid cash flow hedge where it minimizes the
risk from variable interest rated debt by promising to issue dividend payments from both
its own portfolio and its portfolio of outside marketable securities. Since interest
payments normally are classified on the Statement of Cash Flows as Operating Activities;
payments of dividends from outside investments are classified as Investing Activities;
and dividend payments from its own stock are financing activities, where should Merrill
disclose the cash flows from the above transactions?
Case 7 Solution:
Problem Identification: Where in the Statement of Cash Flows should Merrill disclose
proceeds and payments from cash flow hedging activities?
Keywords: Hedging; cash flow hedging; statement of cash flow.
Conclusion: Per 230-10-45-27, cash flows from derivative instruments accounted for as
fair value or cash flow hedges may be classified in the same category as cash flows from
the (associated) item being hedgedprovided that such an accounting policy is disclosed
and the instrument does not include an other significant financing element at inception in
which case it should be classified as a financing transaction. Thus, the cash flows should
be categorized into the operating, investing, and financing categoriesprovided adequate
disclosures are made.
Case 8: On January 1, year 1, the Allen Company issues 100,000 shares of its stock
(which is valued at $10 per share) to acquire the Natie Company. The purchase
agreement also states that Allen will pay $200,000 in year two if Natie has net income of
at least $400,000 in year 2. There is a 50% chance Natie will meet or exceed $400,000 of
net income in year 2. How should Allen recognize this transaction?
Case 8 Solution:
Problem Identification: This contingent value of additional payment during a
proposed business combination asks the researcher to obtain a proper value for the
proposed transaction.

Keywords: Business combination; measurement date; contingent payment.

Conclusion: Per 805-30-25-5, the acquirer shall recognize the contingent consideration
and the acquisition at the fair value = (100,000 shares * $10) + (0.5 *$200,000)
=$1,100,000 (not considering time value of money)
GOVERNMENT AND NOT-FOR-PROFIT ACCOUNTING Cases
CASE 1:
On January 1, the Hawaii Cancer Institute has received a promise from the Obama
Foundation to receive a building that the Foundation recently appraised at $200,000.
However, the building cost only $125,000. The Cancer Institute promised to keep the
building permanently restricted, i.e., never to sell it and to use it only for its work in
helping cancer patients. As of the end of the Cancer Institutes fiscal year (December 31),
no title to the building was received by the Institute. How should the Institute record this
transaction?
CASE 1 SOLUTION:
Problem Identification: Should a not-for-profit organization recognize assets that
contributors promised, but have not yet delivered? If recognition is required, what must
the organization report?
Keywords: Not-for-profit, Restricted, Contributions.
Conclusion: Recognize unconditional promises to receive gifts at their fair market
value. ASC 958-605-30-2. Thus, the Cancer Institute should recognize $200,000. Report
the gift or contribution as permanently restricted support. ASC 958-605-45-4. Upon
receipt of the building, the Cancer Institute may need to adjust the valuation of the
contribution, based on how the initial fair market value appraisal was made. ASC 958310-55-4. For example, if the valuation to the Foundation was based on the amount of
future cash flows from the building, the Cancer Institute must make an adjustment when
it receives the contributed building.
CASE 2:
On January 1, the Hawaii Cancer Institute has received a promise from the Obama
Foundation to receive a building that the Foundation recently appraised at $200,000but
cost it only $125,000. The Institute promised to keep the building permanently
restricted, i.e., never to sell it and to use it only for its work in helping cancer patients.
After not receiving title by December 30, the Institute inquired as to the status of the
promised building. The Foundation stated that water damage to the building (from last
years flood) has permanently reduced the carrying value of the building to $100,000.

The Foundation had initially hoped to set up a fund drive to help clean up the building.
However, both parties have agreed that as of December 31, this fund drive would not
materialize and the date to receive the building would remain unknown. How should the
Institute now record the promised gift?
CASE 2 SOLUTION:
Problem Identification: Whether permanent reductions in the value of promised
assets affect the not-for-profit entitys valuation of promised assets?
Keywords: Restricted contributions, valuation allowances (for doubtful accounts).
Conclusion: The Institute should reduce its valuation for the decline in the value of the
contributed receivable. ASC 958-310-55-4. After receipt the valuation may change
because of the nature of the amount or prior fair market value if based on present value.
If the Institute decides that it does not want the building any longer (since it does not
wish to spend $100,000 fixing it up), it may decide to reserve and write off the entire
balance. Alternatively, if the Foundation removes the permanent restriction upon
donation, the Institute can place the asset as an investmentwhich it can later sell to
generate funds for other purposes.
CASE 3:
On January 1, the Old Town Heart Association received a $1,000,000 endowment from
the Chamber family. Under terms of the gift, the Association must permanently restrict
the endowmentbut may spend up to half of the interest earned on the gift or half of all
profits earned from selling such investments for operating purposes. The Association
immediately invested the gift proceeds in some blue chip stocks. Afterwards, the
Association spent half of the $50,000 dividends earned from the Chamber portfolio for
operating purposes. Where in the Statement of Cash Flows (i.e., operating, investing, or
financing activities) should the Association report these transactions?
CASE 3 SOLUTION:
Problem Identification: In which parts of a Statement of Cash Flows should a not-forprofit Association disclose and classify its activities?
Keywords: Statement of Cash Flows; not-for-profit organization; restricted funds.
Conclusion: The Association should generate a statement of Cash Flows. ASC 958-23005-2. The Association generated operating funds by decreasing the cash invested in assets
restricted for endowment purposes. Thus, the Association should record as investing
activities the difference between cash used to purchase investments and cash received
upon their sale.

CASE 4:
On April 15, the City of Old Putz invests its available excess cash with an investment
broker. The investment broker then purchases 90-day commercial paper from a set of
blue chip companies. On June 30, the last day of the Citys fiscal year, the City planned
to roll over the commercial paper when they mature. However, interest rates fell
dramatically in late June resulting in a lower value for the maturing commercial paper.
More importantly, the City now expects to receive a much lower return on its investment
after reinvestment. Should the City make any disclosures or adjustments regarding these
transactions?
CASE 4 SOLUTION:
Problem Identification: Should a City disclose potential interest rate swings affecting
bond values? Should the City remeasure and disclose the value of the maturing
commercial paper? If so, what disclosures seem necessary?
Keywords: Not-for-profit, Investments, interest-earning investments.
Conclusion: Entities need not report the effect of changing market values of short-term
money market investments in high quality commercial paper. GAS 31, 22. As such no
further disclosures regarding this matter seem necessary. However, the City may wish to
report both the amount of funds invested in such securities and its plans to roll over
these investments.
CASE 5:
Mount Pleasant Epilepsy Association is a not-for-profit agency. Joseph Howard is the
Chair of its Voluntary Board of Directors. He is also the owner of Howard Insurance
Company. The Association rents its facilities from Howard Insurance Company. The
Company charges the Association $10 per square foot of space per month. This amount is
considerably below the Citys average market rate of $14 for similar office space. The
rental rates have not changed during the five years that the Association has occupied its
present location. However, no formal agreement for this rental situation exists. Joseph has
hinted that one day the Company may ask the Association to significantly increase its
rental payments or move to another location. What disclosures, if any, should the
Association make regarding this situation?
CASE 5 SOLUTION:
Problem Identification: Does a related party situation exist between an Association and
the chair of its voluntary Board of Directors? Does a capital or operating lease exist for
the Associations rental relationship? What disclosures, if any, should the Association
make regarding the lease?
Keywords: Related party transactions, lease, operating lease, capital lease, disclosure.

Conclusion: The Mount Pleasant Epilepsy Association has a potential related party
arrangement through the Chair of its Board of Directors. The Association should thus
disclose this informationeven though the lease terms seem quite favorable. ASC 85010-50-3. However, since the Association engages in a month-to-month lease (i.e., its noncancelable terms are less than one year), per, it need only disclose the terms of the lease.
ASC 958-20-60-15 (expected, but not in the exposure draft version).
CASE 6:
The Oakland County Hospital performs lots of work for Medicare and Medicaid patients.
This results in both reimbursement of certain operating costs and some profit.
Transfers among related subsidiaries within the Hospital also contain some Medicare
and Medicaid profits. For example, the pharmacy, nursing and anesthesiology
subsidiaries often all participate in a Medicare and Medicaid surgical operation. When
the Hospital prepares consolidated financial statements, it asks you whether the Hospital
should eliminate gains on such transactionsespecially if others consider such
transactions as dealings with regulated affiliates.
CASE 6 SOLUTION:
Problem Identification: Should a Hospital eliminate profits on intercompany sales and
assets among controlled groups that participate in Medicare and Medicaid
reimbursement policies?
Keywords: Consolidated financial statements; regulation; affiliates.
Conclusion: A Hospital should not eliminate sales to regulated affiliates if the sales
price is reasonable, and through the rate-making process, future revenues are expected to
equal the sales price from the regulated affiliates use of the products or services. ASC
980-810-45-1. Since the Hospital could receive profits on reimbursements on
intercompany sales, its financial statements should not eliminate the intercompany
profits. ASC 980-10-15-2.
Medicare and Medicaid are excluded because they are contractual-type arrangements
between the provider and the government agency responsible to pay for the services
provided. ASC 980-10-15-7. Thus, the Hospital should eliminate these inter-entity gains
and losses from its consolidated statementsbut could report them in the individual
group members separate financial statements.

CASE 7: Some community leaders in St. Paul, MN desire a major league baseball team
to relocate there. They want to build a domed stadium to attract such a team. After asking
the City to help finance it, the City agreed to issue Stadium Bonds for this capital
purpose. These bonds would not become part of the Citys consolidated financing,
reporting entity. Also, the City would neither guarantee nor warrant the repayments of
any proceeds. The City has asked how to account for these proposed transactions.

CASE 7 SOLUTION:
Problem Identification: How should the City report on the bonds issued for third
parties?
Keywords: Debt transactions, debt obligations, third party bonds.
Conclusion: Although the stadium bonds are conduit bonds which bear the Citys name,
the City has no obligation for such debt beyond the resources provided in a related lease
or loan with the third party. GASI 2 (Interpretation 2). The City should merely disclose a
general description of the debt transactions, aggregate the amount of all debt obligations
outstanding at the balance sheet date, and clearly indicate that the City has no obligation
for the debt beyond the resources provided by the bonds.

CASE 8: The City of James has $10 million of 10% bonds payable in its financial
statements. These bonds contain a call provision. The Agent Company told the City that it
will help find parties to call back the old bond and refinance the bonds with 7% interest
payments. The new bonds will not change the original redemption dates from the old
bonds. However, Agent Company demands a $100,000 service charge for its role in
these transactions. While the City Council recognizes the benefits of the proposed
services, the City is unsure how to disclose such payments when the transactions are
completed. Thus, City asks its accountants for guidance.
CASE 8 SOLUTION:
Problem Identification: Should a City disclose payments made to agents or brokers who
help them refinance its debt?
Keywords: Refunding of debt; debt defeasance.
Conclusion: The City must disclose the old and new cash flows generated by such
refinancing and the resulting net savings (i.e., economic gain or loss). GAS 11, 7.
However, requires making additional disclosures regarding additional payments to
escrow agents. GAS 11, 22 (Appendix A). Thus, the City should disclose any payment
made to the Agent Company.
CASE 9: The City of Mall uses a June 30th year-end. On March 1, the City hired Frank
Sears as its City Manager at an annual salary of $100,000. Franklike all other
employeesearns 12 vacation days per year for the first 10 years with the City.
Thereafter, he earns 18 vacation days per year.
Employees who leave the City receive payment for all vested, unused vacation days.
However, all employees must work for at least six months before they can take any
vacation days. The City believes that Frank will be an excellent employee and assumes

that he will work past the required six months. Should the City accrue vacation time for
the City Manager?
CASE 9 SOLUTION:
Problem Identification: Should the City accrue vacation time for an employee who has
not yet vested the necessary time to earn vacation time?
Keywords: Compensated absences, Vacation pay, and vesting.
Conclusion: Franks continued employment with the City is beyond the Citys control.
Some employees leave before vesting their vacation time. Thus, the City should not
accrue vacation benefits. GAS 16, 7. After six months, to better match the vacation
accrual expense, make a prior-period adjustment in the current period. This adjustment is
made even if this amount is immaterial.

AUDITING Cases
Case 1: In year 1, Joe Josephs, CPA, reviewed Lander Companys financial statements.
However, in year 2, the Lander Company hired Tom Holstrum, CPA, to audit its
financial statements. Should Tom meet with Joe, and would Joe be considered as a
predecessor auditor?
Case 1 Solution:
Problem Identification: Is a CPA who reviewed prior period financial statements
considered as a predecessor auditor?
Keywords: Review, predecessor auditor.
Conclusion: SAS No.84 (AU Section 315) does require CPAs to meet with the
predecessor auditors. However, Footnote 3 of this authoritative pronouncement states
that CPAs performing compilations and reviews are not predecessor auditors.
Nonetheless, Tom may still wish to meet with him to discuss problem encountered
during this review engagement.
Case 2: In Tom Holstrums audit of the Lander Company, Tom seeks to obtain an
attorney representation letter regarding any, undisclosed potential corporate liabilities.
John Engle, the Lander Company General Council responded to this letter by citing
American Bar Association (ABA) language that emphasizes attorney-client privilege
regarding such unasserted claims. E.g., the letter uses such phrases as it would be
inappropriate for this firm to respond to such general inquiries and we can not
comment upon the adequacy of the companys listing, if any, of unasserted possible

claims or assessments. Do such responses constitute limitations in the scope of the

audit?
Case 2 Solution:
Problem Identification: Do attorneys citing ABA language about the adequacy or
inadequacy of client legal representations impairs the scope of the CPAs audit services?
Keywords: Legal liability, unasserted claims; attorney representation letter.
Conclusion: According to the AICPAs Interpretation of AU Section 337 (AU Section
9337.31), such responses are not limitations to the auditors scope of engagement.
Moreover, the ABA has advised attorneys that, under certain circumstances, attorneys
should inform the CPAs of certain, pending litigation that could impair the
reasonableness of the presented financial statements.
Case 3: Mary Howard, CPA, has long audited the Wheat City Grain Companys financial
statements. Much of Wheat Citys assets consist of wheat stored in three of its grain
elevators, and the Company maintains perpetual inventory records of the quantity of
wheat stored there. Concurrently, on a surprise basis, at different times each month, state
grain inspectors also count the quantity of wheat found in these elevatorsand have
found no material differences in the perpetual records for the five years that they have
performed this function. To save both time and audit fees, Mary wants to rely on the state
inspectors counts instead of her making independent counts thereof. Can Mary do this?
Case 3 Solution:
Problem Identification: Can a CPA rely on an objective, independent third party (i.e.,
part of a government agency) to substitute required generally accepted auditing
procedures (i.e., observing the counting of the clients inventory)?
Keywords: Reliance on specialists; inventory observation; outside inventory-taking firm;
independence.
Conclusion: First, the concept of independence requires the CPA not to subordinate his
or her judgment to an outside party. Next, SAS No. 73, pars. 8 and 12 (AU Section 336,
pars. 8 &12), require auditors to both review the qualifications and independence of the
specialistand to make appropriate tests of the data the specialist provided.
Furthermore, SAS No. 58, pars. 5-6 (AU Section 508, pars. 5 & 6) allow the CPA to rely
heavily on such reportsalong as it does not substitute for the CPAs own work.
Case 4: Aaron Jones, CPA, is auditing the current years financial statements of Low
Company, a publicly traded company. Aaron notices some major fluctuations in Lows
fourth quarter of the previous years financial statement balances. He is aware that
security holders of publicly traded company stock that does not separately report fourth
quarter results often impute such results by subtracting data based on third quarter
interim balances from the year-end balances. Thus, companies should report such
significant events as disposals of segments and other unusual items for that quarter as a

note to the annual financial statements. Aaron notices that Low makes such disclosures,
but is unsure if his firm should audit these additional, supplementary disclosures.
Case 4 Solution:
Problem Identification: Is it mandated that the CPA audit supplementary fourth quarter
disclosures of publicly traded companies? What other steps should the CPA perform in
this regard?
Keywords: Association with the financial statements; interim reporting; auditor
independence.
Conclusion: AU Section 9504, pars. 4 & 5 (an Interpretation of AU Section 504,
Association With Financial Statements) states that auditors have no obligation to audit
fourth quarter data, unless he or she was engaged to do so. However, the auditor should
ascertain that management makes this separate disclosure, in which case the auditor can
ask management if it wants him or her to audit or review it. In most cases, the auditor
would state that such information was unaudited or not covered by the auditors
report. Moreover, if management refuses to make such a disclosure, this exception is
not material enough to warrant the auditor modifying his or hr unqualified opinion.
Case 5: Joe Josephs, CPA, issued an unqualified audit opinion for the Johnson
Companys previous years financial statements, which used a modified accrual basis of
accounting, which is considered as an other comprehensive base of accounting
(OCBOA). In the current year, Johnson switched to (normal, full) accrual system, and
wants to show comparative financial statements for the two years. Should Joe require the
restatement of the prior years financial statements using this new basis of accounting,
and what disclosures, if any, should be made to the financial statements and Joes audit
report?
Case 5 Solution:
Problem Identification: Does a change in the basis of accounting warrant a restatement
of the prior years financial statements, changes in the current years footnotes, or
modifications to the auditors report?
Keywords: Auditor report; consistency; other comprehensive basis of accounting;
Conclusion: SAS No. 58, par. 16 (AU Section 508.16), states that the auditors report
should alert financial statement readers about any lack in consistency of presented
financial reports. Moreover, SAS 62, footnote 35 (AU Section 623, footnote 35) states
that a change from OCBOA to GAAP is not a change in consistency warranting a
departure from an unqualified opinion. Thus, Joe should (merely) disclose this change as
an explanatory paragraph to his audit report, while the Johnson Company should restate
its previous financial statements under the new basis of accounting. It should also
disclose the effects of this change in accounting principle on last years balances in its
financial statements and footnotes

Case 6: Hugo Crossman, CPA, issued a review statement for the CUNY Company for
last year and a compiled statement for them in the current year. During the current year,
Hugo purchased some CUNY securities, which made him lose his independencea fact
noted in his CPA compilation report. Now, the CUNY Company management wants
Hugo to issue comparative two year financial statements (last year and this year). Can
Hugo re-issue his review report now that he is no longer independent of the CUNY
Company?
Case 6 Solution:
Problem Identification: Does a subsequent lack of CPA independence impair his or her
ability to re-issue prior years financial statements when independence was not an issue?
Keywords: Independence; compilation; review; comparative financial statements
Conclusion: SSARS 2, par. 8 states that a continuing accountant who performs a
lower level of service in a subsequent period can re-issue the prior report. The
accountant should, include a separate paragraph attached to his or her latest report that
indicates this new, lack of independence and indicate that he or she performed no
update procedures since last issuing the review report.
Case 7: Joseph Josephs, CPA is auditing the Elder Companys current years annual
financial statements and notices that the Company has violated the 2.1 to 1.0 current ratio
requirements as part of its debt agreement with the Sunshine Bank. The companys
current ratio is 1.85 to 1. Elders management believes (strongly) that it will improve
their current ratio during the 90-day grace period. Nonetheless, the bank has the right
to call in the entire $2 million loan. However, Joseph is not so sure and must issue his
report before this grace period expires. Should Joseph qualify his opinion or demand that
Elder re-classify this loan as a short-term liability, in light of the above circumstances?
Case 7 Solution:
Problem Identification: Does this present violation warrant re-classifying the loan from
a long- to a short-term liability? Should Lander make any additional footnote
disclosures? Should Joseph modify his audit report accordingly?
Keywords: Callable debt; audit reports (qualified or adverse); contingencies.
Conclusion: Per the FASB Codification 470-10-45-11, Elder needs to receive a waiver
from the creditor or develop other evidence that the bank will not call this loan. These
circumstances do not appear to be an uncertainty (per the provisions of SAS 58), since
they do not involve matters to be resolved at a later date. Thus, if Joseph disagrees with
Elders decision, he should issue a qualified (except for) or adverse audit opinion.
Case 8: During Joseph Josephs, CPA, audit of the Belton Companys prior years
financial statements, he notices that sales and profits have fallen dramatically from their
previous year highs. His subsequent (January 20, current year) discussion with John
Land and Jill Her (equal 50% shareholders of the Company) indicate that John recognizes

that he spent much less time in the previous year with the business than he did in prior
years. He agreed to refund $100,000 of his $1 million previous years compensation
immediately, and John and Jill agreed that he would receive his original $1 million
compensation in future years (as long as he re-dedicated his efforts on behalf of the
company). Joseph then reduced the Belton Companys previous years salary expense for
the $100,000 refund, since the parties attributed these transactions to previous years
events. He then issued the audited financial statements on March 2, of the current year.
However, on May 2, of the current year, the Sunshine bank called him and asked him to
attribute the $100,000 to the current years events (since it was paid then) and to recall
and re-issue the financial statements. Should Joseph require the recall and re-issuance of
the previous years financial statements?
Case 8 Solution:
Problem Identification: Was Johns $100,000 refund of over-compensation a prior
year or current year event? If it were a current year event, should the parties recall and
re-issue the prior years financial statements?
Keywords: Audit reports; subsequent events; matching principle.
Conclusion: Per AU Section 560, a Type I subsequent event provides additional
information that occurred on the entitys balance sheet date, and a Type II subsequent
event consists of information arising past the balance sheet date. Type I events can be
ignored in the current period or placed as a footnote to the financial statements. AU
Section 561 states that auditors subsequently becoming aware of significant Type I
subsequent events may need to recall and re-issue previously issued reports. Assuming
that the $100,000 was material, the issue becomes if the refund was made due to prior
year or current year events. Given the evidence presented, the parties made the decision
in the current year based upon the prior years facts and transactionsand used good
faith to do so. Thus, no adjustments seem necessary.
Case 9: Joseph Josephs is completing his audit of the Bolton Companys current years
financial statements and reads in SAS 114 (AU Section 380) that he should communicate
his results with members of Boltons audit committee. But, despite many requests for
many years, Bolton has established no such committeeprimarily since it has only two
stockholders. What should Joseph do now?
Case 9 Solution:
Problem Identification: Does the lack of an (independent or other type of) audit
committee impair Joseph from completing the audit?
Keywords: Audit committee; communications with those charged with governance;
Conclusion: The provisions of SAS 114 (AU Section 380) are only applicable to entities
that have established bodies charged with corporate governance. Since Bolton does not
have a corporate governance body, Joseph need (and can) not report to such a committee.
This fact will not impair him from completing the audit. However, Joseph may well

suggest (again) that Bolton establish such a committee (e.g., as part of his letter of
reportable conditions)
Case 10: You are auditing the financial statements of Air Service Inc., an airplane
wholesaler that purchases various types of corporate jets for sale to different companies
or individuals. Prior to the sale of an airplane, Air Service utilizes the jet for charter
service. In reviewing the financial statements, you noticed that Air Service reports these
jets before selling them as part of fixed assets and depreciates such planes. The
engagement partner questions such accounting and requests that you research this issue as
to the proper treatment for these jets used in the chartering service.
Case 10 Solution:
Problem Identification: The issue in this case is how the planes used in the chartering
business should be accounted foreither as inventory or fixed assets which should be
depreciated.
Keywords: Inventory, assets held for sale.
Conclusion: Per the FASB Codification the definition of inventory one would
conclude that the primary use of the jets would determine their treatment in Air Services
financial statements. Since the jets are held primarily for sale, and the chartering is only a
temporary use, the jets should be listed as inventory (current asset) and should not be
depreciated.

TAX Cases
Instructions: In writing a tax memo begin the discussion of the law with at least one
paragraph on the relevant Code language. Pinpoint the location of the relevant language
in the Code as precisely as possible. Then add a paragraph(s) on any relevant Treasury
Regulation. Then describe any relevant cases or Revenue Rulings. Write clearly and
concisely so that the tax memo is normally limited to three pages.
Write a memo identifying the legal ISSUE(s), conclusion, list of relevant authorities,
discussion of the law, and the application of the law. Use these subheadings, as it is not
enough to describe the law. For each CASE discuss and apply at least one relevant
CASE or revenue ruling. The most important aspects of the memo are the ISSUE
statement(s) and the application of the law to the problem facts. The application should
integrate reference to every source of law previously discussed. Do not just answer the
question asked in the problem.
CASE 1. When Gross Income is Accrued (Basic)
Taxpayer is a securities firm which uses the accrual method of accounting.
Taxpayer executes stock trades and performs settlement functions. Settlement

functions include recording the sale and confirming it with the customer. Trades
made on December 28, 20X5, until the end of the month are not settled until
January of 20X6. Taxpayer made $1,000,000 of net commissions from these
trades in late December. Since the security is not credited to the customers
account until settlement date, taxpayer wants to declare the income on the
settlement dates in 20X6. Taxpayer does not receive the money until January
20X6. Advise the taxpayer.
ISSUE:
Whether an accrual basis securities firm has gross income under sec. 451(a) on
the trading date or the next year on the settlement date when all the work is
performed, payment is due, and money received?
CASE 1 SOLUTION:
CONCLUSION: The trading date is the date for $1,000,000 of gross income from
the net commissions on the securities because all the events have occurred then
which fixes the right to receive the income.
DISCUSSION OF THE LAW:
Gross income under section 61(a)(1) includes commissions. Gross income is
included in taxable year received, unless the method of accounting is properly
accounted for in a different period. Section 451(a). The accrual method generates
income when all the events have occurred which fixes the right to receive such
income and amount is determinable with reasonable accuracy. Reg. 1.451-1(a).
Taxpayer was a securities company declaring income from trades on the settlement
date. The Tax Court held that sales contract on the trading date was a condition
precedent that fixed the Taxpayers right to receive the income. The settlement
functions were conditions subsequent, so that the settlement was irrelevant to the
determination of gross income.
Charles Schwab Corp v. Commissioner, 107 TC 282 (1996).
APPLICATION OF THE LAW:
Taxpayer has $1,000,0000 of gross income under section 61(a)(1) for the net
commissions. This gross income is included in taxable year 20X5 because it is
accounted for under the accrual method of accounting. Sec. 451(a). The accrual
method generates income for the taxpayer when the trading has occurred, because
at that time all the events have occurred which fixes the right to receive such
income and amount of commissions is determined with reasonable accuracy. Reg.
1.451-1(a). As in Charles Schwab Corp v. Commissioner, 107 TC 282 (1996),
taxpayers settlement functions were conditions subsequent, so that the settlement
date is irrelevant to the determination of gross income.

CASE 2. Business Deductions? (Basic)

For the past two years, Minsu, a Korean American, has worked as a high school
physical education teacher. He is also a body-builder and a part-time graduate
student in educational technology at State University. In preparing for a masters
thesis he has decided to participate in Arnolds World Body-building training
program and analyzing advanced technology used to help students absorb
physical education. Arnolds training program has a regular faculty, curriculum,
an enrolled body of students, and advanced technology in its gym equipment.
Minsu earned $4,000 during the fall 20X5 as a body-builder by coming in second
in the state contest. Minsu paid $3,000 in spring 20X5 for his masters degree
tuition at State University for one class on advanced computer technology and
another $5,000 to participate at Arnolds. How much can Minsu deduct? Minsu
knows about relevant educational tax credits and want you to focus just on the
deductions.
CASE 2 SOLUTION:
CONCLUSION: Minsu may not deduct the cost of his graduate degree or the
body-building training program since Minsu is not yet in the trade or business
when the expense arose. Minsus father may not deduct any expenses, since they
are not his business expenses.
DISCUSSION OF THE LAW:
Section 162(a) allows a deduction for all ordinary and necessary expenses
incurred in carrying on a trade or business. Educational expenses are never
deductible if the education is part of taxpayers study program that will lead to
qualifying for a new trade or business, Reg. 1.162-5(b)(3), or if the study is
required in order to meet the minimum educational requirements for qualification
in the job. Reg. 1.162-5(b)(2). If the education passes these two tests then the
educational expense must either (1) maintain or improve existing skills required
in the individual's trade or business or (2) meet the express requirements of the
employer to retain his or her employment status. Reg. 1.162-5(a).
For an employee, a change of duties does not constitute a new trade or business if
the new duties involve the same general type of work as performed at the
individual's present employment. Although additional education may qualify a
taxpayer for a position with new duties, the education does not qualify her for a
new trade or business if the new duties are in the similar type of work. Reg.
1.162-5(b)(3).
Taxpayer had graduate educational expenses in educational psychology as part of
a college's adult education program. The education was part of a degree program
that led to employment as a high school guidance counselor. The Tax Court held

that these educational expenses were deductible business expenses in Schwerm v.

Commissioner, T.C. Memo 1986-16. The Tax Court agreed that the taxpayer was
in the trade or business of teaching and found that the graduate education did not
qualify the taxpayer for a new trade or business. Although the degree qualified
the taxpayer for high school counseling, the court distinguished the result as
merely a change of duties involving the same general work of teaching and
related duties. A master's degree was not required to meet the minimum
educational requirements for the job. The education in educational psychology
helped the taxpayer maintain her job skills in education.
The Tax Court denied a deduction of a masters degree in social work for a teacher
of learning-disabled students, reasoning that it qualified her for a new trade or
business of entering social work fields. Reisinger v. Commissioner, 71 T.C. 568
(1979).
Deductions attributable to a hobby are deductible only to the extent that the gross
income derived from such activity exceeds the deductions that would be
allowable under the tax law without regard to whether the activity is engaged in
for profit. Sec. 183(b)(1). Activities not engaged for in profit are defined with
nine criteria in Reg. 1.183-2. Hobby expenses are subject to the 2% floor on
miscellaneous items deductions under sec. 67(b). Personal living expenses are not
deductible under sec. 262(a).
APPLICATION OF THE LAW:
Minsus educational expenses are not deductible if the education is part of a study
program that will lead to qualifying for a new trade or business, Reg. 1.162-5(b)
(3). The fact that the education helps Minsu maintain or improve existing skills
required in the individual's trade or business is not enough. Reg. 1.162-5(a).
Minsus earning a masters degree in a related but slightly different field is similar
to the taxpayer who was a teacher of learning-disabled students and earning a
masters degree in social work. v. Commissioner, 71 T.C. 568 (1979). Applying
the rationale in Reisinger, Minsus educational technology program could qualify
him for a new trade or business in technology related careers.
Although Minsu might argue that he will have a mere change in duties after
earning a masters degree, similar to a masters in counseling and guidance for a
teacher under Schwerm v. Commissioner, T.C. Memo 1986-16. However,
Schwerm appears distinguishable because of the threshold test that it could qualify
Minsu for a new trade or business.
Arnolds training program was an activity that appears more as one not engaged
for in a trade or business, applying the factors of a hobby under Reg. 1.183-2.
Thus, Minsu deductions attributable to the hobby of body-building are deductible
only to the extent that the gross income derived from such activity exceeds the

deductions that would be allowable under the tax law without regard to whether
the activity is engaged in for profit. Sec. 183(b)(1). Although gym costs are
normally nondeductible personal living expenses under sec. 262(a), Minsu should
be able to deduct $4,000 of the costs (subject to the limitations of sec. 67(b), equal
to the $4,000 earnings from the body-building contest.
CASE 3. Stock purchased by an employee (Intermediate)
Sally became an employee of DotGismo, Inc., a privately held firm. On December
15, 20X3, Sally was allowed to buy 20,000 shares of DotGismo stock for $40,000
dollars. When Sally bought the stock, each share was worth $2. DotGismo
retained the right to repurchase each share for $2 original purchase price if Sally
leaves DotGismo at any time during the next two years for any reason. DotGismo
stock increased to $5 per share in December 15, 20X5, when the two year
restriction ended. Sally sold the stock on January 18, 20X6 for $9 per share, after
the announcement of a new patent for DotGismo. Advise Sally roughly how much
tax she must pay and for what year(s). Assume Sally is in the 35% tax bracket for
ordinary income and 15% for long term capital gains.
CASE 3 SOLUTION:
CONCLUSION: Any failure to make a section 83(b) election creates gross
income from the restricted stock when the restriction lapsed in 20X5. The gain
included in gross income is ordinary income measured by the FMV less the
purchase cost basis.
DISCUSSION OF THE LAW:
Gross income includes compensation for services under section 61(a)(1) and gains
from the sale of property under sec. 61(a)(3). Property having a substantial risk of
forfeiture which is transferred in connection with the performance of services is
gross income. The income is measured by its fair market value upon the removal
of the substantial risk of forfeiture, less any price paid for the stock. 83(a).
Thus, property received in connection with the performance of services is not
taxed under 83(a) until the property has substantially vested. Reg. 1.83-1(a)
(1). Substantial risk of forfeiture is defined as rights to full enjoyment of such
property which are conditioned upon future performance of services. 83(c)(1).
The holding period for stock having a substantial risk of forfeiture begins when
the restriction is lifted. 83(h).
An election exists to include in gross income in the year of transfer. 83(b)(1).
The gross income is the excess of the fair market value over the amount paid for
the property. Make the election not later than 30 days after the transfer. 83(b)
(2).
An employer made a stock option plan available for key employees. The U.S.

Supreme Court held that a purchase from employer for stock options is
compensation for services, since it is not a gift. Commissioner v. LoBue, 351 U.S.
243 (1956).
Employee purchased employers restricted stock when the amount paid for the
stock equaled its full fair market value. The Tax Court held that section 83
applies to all restricted stock that is transferred for services. Unless taxpayer
elected at time of purchase to include income difference between purchase price
and fair market value, taxpayer must recognize ordinary income for any
appreciation in value. Alves v. Commissioner, 734 F.2d 478 (9th Cir. 1984).
APPLICATION OF THE LAW:
Sally has gross income from compensation for services. 61(a)(1). Sallys
purchase of Gismo stock is transfer of property in connection with the
performance of services, because the stock was not widely available for purchase.
Commissioner v. LoBue, 351 U.S. 243 (1956). Sallys stock had a substantial risk
of forfeiture under section 83(c)(1) because the employer could buy it back.
Assuming that Sally did not make a section 83(b) election when she purchased
her employers stock, Sally has income in 20X5 when the rights in her stock were
substantially vested under Reg. 1.83-1(a)(1). In 20X5, Sallys gross income is
$60,000. This is measured by its fair market value upon the removal of the
substantial risk of forfeiture, less the price paid for the stock (20,000 shares
having a $5 per share FMV less $2 per share paid for the stock). 83(a). Sally
must recognize ordinary income for the $60,000 appreciation in value. Alves v.
Commissioner, 734 F.2d 478 (9th Cir. 1984).
In 20X6 when Sally sells the stock her gross income is $80,000 (20,000 shares
times [$9 per share FMV less $5 per share basis ($2 cost + $3 prior gain
recognized). The $80,000 is short term capital gain since the holding period for
Sallys stock starts when the restriction lapsed. 83(f). Sally pays $28,000 of tax
in 20X6 (plus the $21,000 of tax in 20X5).
However, if Sally made a Section 83(b)(1) election to include in gross income in
the year of transfer, then gross income is the excess of the fair market value over
the amount paid for the property, which was -0-. Sally must have made the
election not later than 30 days after the transfer. 83(b)(2). So she does not have
additional income until 20X6, when she sells the stock. 61(a)(3). The $140,000
gross income (20,000 shares times [$9 per share selling price less $2 basis]) is
long term capital gain. Sally pays about 21,000 of taxes. (15% LTCG rate).

CASE 4. Deduction for Foreign Travel (Intermediate)

Sylvia is a professor in business at the University of Hawaii. She went on
sabbatical for an academic year to take courses in Chinese at National Taiwan
University in Taipei, Taiwan, to expand her knowledge of international business

and to conduct research. On weekends and during the three week winter break
Sylvia went sight-seeing by herself around the island, but one time gave a lecture
in Tainan, Taiwan. Sylvia has documented her expenses and saved her receipts.
Advise Sylvia.
CASE 4 SOLUTION:
CONCLUSION: Sylvias foreign travel expenses are generally deductible,
because she is doing more than mere travel for educational purposes. However,
disallow the extra traveling expenses around the island of Taiwan during the
winter break and on weekends when she did not have a lecture to present.
DISCUSSION OF THE LAW:
Section 162(a)(2) allows a deduction for all the ordinary and necessary expenses
paid or incurred during the taxable year in carrying on any trade or business,
including traveling expenses while away from home in the pursuit of a trade or
business.
If travel expenses are incurred for both business and other purposes, the
travel expenses are deductible only if the travel is primarily related to the
taxpayer's trade or business. Reg. 1.162-2(b)(1).
Section 274(c)(1) requires an allocation for foreign travel pursuant to the
regulations. The exception under sec. 274(c)(1)(B) is if the time not
attributable to the trade or business outside the U.S. is less than 25% of the
total time on business. Reg. 1.274-4(d)(2) requires a daily allocation for
calculating nonbusiness activity constituting 25% of travel time. Travel
expenses are deemed entirely allocable to business activity, if the
individual incurring the expenses does not have substantial control over
the arrangements of the trip. Reg. 1-274-4(f)(5)(i).
No deduction is allowed for travel as a form of education. Sec. 274(l)(2).
A teachers extension course travel to Southeast Asia was not disallowed
because the courses included lectures by university professors, tours of
related sights, and significant reading assignment. Ann Jorgensen, RIA
TCMemo 2000-138 (9th Cir. 2000).
Section 274(d)(1) requires substantiation for the travel expense by
adequate records or sufficient evidence provides various disallowance
provisions on travel. Business meals are deductible by only 50% of the
cost. Sec. 274(n).
APPLICATION OF THE LAW:
Sylvias travel was more than just disallowed education expenses under
Sec. 274(l)(2). Similar to a teachers deductible extension course travel to
Southeast courses Ann Jorgensen, RIA TCMemo 2000-138 (9th Cir.

2000), Sylvias classes at National Taiwan University would include

lectures by university professors and significant reading assignment.
A business purpose for Sylvias course work is established by integrating
some of her new knowledge into her activities of teaching and researching
international business. Since Sylvia has travel expenses are incurred for
both business and other purposes, the travel expenses are deductible only
if the travel is primarily related to the taxpayer's trade or business. Reg.
1.162-2(b)(1).
Section 162(a)(2) allows a deduction for all the ordinary and necessary expenses
paid or incurred during the taxable year in carrying on any trade or business,
including traveling expenses while away from home in the pursuit of a trade or
business.
Sylvia need not allocate the foreign travel expenses under section 274(c)
(1) because the exception under sec. 274(c)(1)(B) applies that the time that
she spent not attributable to the trade or business outside the U.S. is less
than 25% of the total time on business. Thus, reg. 1.274-4(d)(2) is not
applicable.
Instead, the business travel expenses while Sylvias classes are in session
are deemed entirely allocable to business activity, because Sylvia not have
substantial control over the arrangements of the trip under Reg. 1.2744(f)(5)(i).
Sylvias records should overcome the Section 274(d)(1) substantiation
requirements. Sylvia can deduct her travel, lodging and 50% of the
business meals. Sec. 274(n).
CASE 5. Income Sourcing International Tax (Advanced)
Hidetoshi was a world-renowned rock star from NewCountry. Sony-USA Records
contracted with Hidetoshi to produce records. Sony-USA Records retained all
intellectual property rights in the recordings. The contract granted Hidetoshi
payments or royalties based upon future sales of recordings. Hidetoshi paid
taxes on the payments in NewCountry as royalties. The U.S.-NewCountry treaty
exempts royalties from tax in the U.S. However, NewCountry tax treaty, did not
define royalties or compensation for personal services. The IRS has told
Hidetoshi, his contract with Sony-USA generates personal service income in the
United States. Advise Hidetoshi.
CASE 5 SOLUTION:
CONCLUSION: A recording contract generates personal service income if
taxpayer has no intellectual property right, so income exists.
DISCUSSION OF THE LAW:

In the United States personal service income is sourced according to the location
in which the services were performed. Services performed in the U.S. are U.S.
source income. Sec. 861(a)(3). The commercial traveler exception is foreignsource income if the recipient is a NRA who is in the U.S. for 90 days or less
during the tax year, the compensation does not exceed $3,000 for the services
performed in the U.S., and the services performed are not effectively connected
with a U.S. trade or business. Sec. 863(a)(3).
Royalties from tangible property located outside the U.S. are foreign source
income. Sec. 862(a)(4). The location of royalties attributable to the use of
intangible property (customer based-intangibles) is sourced according to the
country in which the property producing the income is used. Rev. Rul. 72-232,
1972-1 C.B. 276.
In Ingram v. Bowers, 57 F.2d 65 (CA-2, 1932), the ISSUE was whether income
received from master records cut by taxpayers deceased spouse was royalty
income or personal service income. The master records were used in foreign
countries (thus royalty income would be foreign source), while the records had
been cut in the U.S. (thus personal service income would be U.S. source). The
Second Circuit Court of Appeals determined that it was personal service income.
The IRS determined that broadcast rights in a foreign country of a live boxing
match held in the U.S. were a license, rather than a sale. This resulted in the
income being characterized as foreign-source royalty income since the rights were
for use in a foreign country. Rev. Rul. 84-78, 1984-1 C.B. 173.
A record company contracted with Foreign Taxpayer to produce recordings. The
company retained all intellectual property rights in the recordings. The contract
granted Taxpayer royalties based upon future sales of the recordings. The
applicable tax treaty, did not define royalties or compensation for personal
services. The Tax Court in Boulez v. Commissioner, 83 T.C. 584 (1984), decided
the contract was intended as a contract for personal services. Although the
payments were based on future sales, existence of a property right of the taxpayer
is fundamental for the purpose of determining whether royalty income exists.
Under applicable (US) intellectual property law, Taxpayer owned no intellectual
property rights that he could license; the recordings were works for hire and
therefore earned income from personal services. Because taxpayer performed his
services in the U.S., his income was U.S. source and taxable in the U.S.
APPLICATION OF THE LAW:
Hidetoshis contract is probably service income based on the cases and
distinguishing revenue ruling.
Similar to Ingram v. Bowers, 57 F.2d 65 (2d Cir., 1932), the ISSUE is whether
income received from master records was royalty income or personal service
income. In both cases, while the master records were used in foreign countries,

while the records were produced in the U.S. Thus, the same conclusion arises that
the income generated is personal service income.
Hidetoshis case is factually similar to Boulez v. Commissioner, 83 T.C. 584
(1984). In both cases, a record company contracted with Foreign Taxpayer to
produce recordings. The record company retained all intellectual property rights
in the recordings. Because Hidetoshi owned no intellectual property rights, no
royalty payment existed, instead the recordings were compensation for services.
Given that Hidetoshi performed his services in the U.S., his income was U.S.
source. Sec. 861(a)(3).
Hidetoshis case is distinguishable from the facts in Rev. Rul. 84-78, 1984-1 C.B.
173, because no license or intellectual property was produced for Hidetoshi.
Thus, the characterization of the income is different. Hidetoshi does not qualify
for the commercial traveler exception when the compensation exceeds $3,000
for the services performed in the U.S. Sec. 863(a)(3). Since Hidetoshis income is
not royalties, so Sec. 862(a)(4) and Rev. Rul. 72-232, 1972-1 C.B. 276, are not
applicable.
CASE 6. Contingent liabilities in a Section 351 transfer (Advanced)
Xco is an accrual basis taxpayer with multiple lines of businesses. One business
is a gas station. The land underneath the gas station did not appear contaminated
when Xco purchased it. However, the land now has potential soil and
groundwater problems (environmental liabilities). Xco engaged in a section 351
tax free exchange transferring the gas station to a new subsidiary Sco in exchange
for the stock of Sco and the assumption of the environmental liabilities. Before
the transfer, Xco did not take any environmental remediation efforts to clean up
the lands soil and groundwater problems. How is the basis of Xcos land
determined?
CASE 6 SOLUTION:
CONCLUSION: No gain is recognized from the contingent liabilities, however,
they can affect shareholders basis in the stock under sec. 358(h).
DISCUSSION OF THE LAW:
Sec. 351(a) provides for tax free exchanges of property contributed to a
corporation when the transferors receive 80% or more of the corporations stock.
However, gain is recognized if either other property or money, known as boot, is
involved in the transaction. Sec. 351(b).
Liabilities included in the transferred property are generally not considered as
boot. Sec. 357(a). However, gain is recognized on liabilities transferred if the

liabilities exceed the adjusted basis sec. 357(c)(1) or represent bad purpose
liabilities for tax avoidance purposes. Sec. 357(b)
The basis of the property received is determined under sec. 358(a)(1) as a
carryover basis of the property exchanged, decreased by boot received, and
increased by gain recognized. However, for purposes of sec. 358 basis, the
liabilities assumed are treated as boot received. Sec. 358(d)(1).
Contingent environmental liabilities were removed under 357(c)(1), because
they have neither created a deduction nor effected basis. Rev. Rul. 95-74. Thus,
contingent liabilities assumed, would not trigger gain to the extent such liabilities
exceeded the adjusted basis of property contributed under 357(c)(1).
Contingent liability is included in the definition of liability for purposes of
determining whether basis exceeds the fair market value, so that a reduction in
basis should occur. 358(h)(3). Section 358(h) is aimed at contingent-liabilities
tax shelters; so that 358(h) reduces the basis of stock received by the amount of
liabilities assumed but not below its FMV. However, sec. 358(h) does not apply if
either the entire trade or business or substantially all of its assets are contributed.
Sec. 358(h)(2).
APPLICATION OF THE LAW:
Xco contributed property to a corporation under Sec. 351(a) for a tax free
exchange for receiving Scos stock. Xcos liabilities included in the transferred
property are generally not considered as boot, Sec. 357(a), so no gain is
recognized under sec. 351(b). However, if Xcos liabilities exceed its adjusted
basis, gain is recognized on liabilities transferred under sec. 357(c)(1). No facts
on Xco indicate that the contingent liabilities represent bad purpose liabilities for
tax avoidance purposes. Sec. 357(b)
The basis of the property received by Xco is determined under sec. 358(a)(1) as a
carryover basis of the property exchanged, decreased by boot received, and
increased by gain recognized. However, for purposes of Xcos sec. 358 basis, the
liabilities assumed are treated as boot received. Sec. 358(d)(1).
An exception exists for contingent liabilities which Rev Rul 95-74, removed from
section 357(c)(1), because they had not given rise to a deduction nor effected
basis. So, Xcos contingent liabilities assumed by Sco, would not trigger gain to
the extent such liabilities exceeded Xcos adjusted basis of property contributed
under sec. 357(c)(1).
Xcos contingent liabilities under Sec. 358(h)(3), are used to determine whether
basis exceeds the fair market value, so that a reduction in basis should occur.
However, sec. 358(h) does not apply if either the entire trade or business or
substantially all of its assets are contributed. Sec. 358(h)(2).