SOLUTIONS MANUAL for Financial Accounting for MBAs 8th Edition by Peter Easton & John Wild. by StudyGuide

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Module 1 Financial Accounting for MBAs QUESTIONS Q1-1.

Organizations undertake four major activities: planning, financing, investing, and operating. Financing is the means a company uses to pay for resources. Investing refers to the buying and selling of resources necessary to carry out the organization’s plans. Operating activities are the actual carrying out of these plans. Planning is the glue that connects these activities, including the organization’s ideas, goals and strategies. Financial accounting information provides valuable input into the planning process, and, subsequently, reports on the results of plans so that corrective action can be taken, if necessary.

Q1-2.

An organization’s financing activities (liabilities and equity = sources of funds) pay for investing activities (assets = uses of funds). An organization’s assets cannot be more or less than its liabilities and equity combined. This means: assets = liabilities + equity. This relation is called the accounting equation (sometimes called the balance sheet equation), and it applies to all organizations at all times.

Q1-3.

The four main financial statements are: income statement, balance sheet, statement of stockholders’ equity, and statement of cash flows. The income statement provides information about the company’s revenues, expenses and profitability over a period of time. The balance sheet lists the company’s assets (what it owns), liabilities (what it owes), and stockholders’ equity (the residual claims of its owners) as of a point in time. The statement of stockholders’ equity reports on the changes to each stockholders’ equity account during the period. The statement of cash flows identifies the sources (inflows) and uses (outflows) of cash, that is, where the company got its cash from and what it did with it. Together, the four statements provide a complete picture of the financial condition of the company.

Q1-4.

The balance sheet provides information that helps users understand a company’s resources (assets) and claims to those resources (liabilities and stockholders’ equity) as of a given point in time.

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Q1-5.

The income statement covers a period of time. An income statement reports whether the business has earned a net income (also called profit or earnings) or incurred a net loss. Importantly, the income statement lists the types and amounts of revenues and expenses making up net income or net loss.

Q1-6.

The statement of cash flows reports on the cash inflows and outflows relating to a company’s operating, investing, and financing activities over a period of time. The sum of these three activities yields the net change in cash for the period. This statement is a useful complement to the income statement, which reports on revenues and expenses, but which conveys relatively little information about cash flows.

Q1-7.

Retained earnings (reported on the balance sheet) is increased each period by any net income earned during the period (as reported in the income statement) and decreased each period by the payment of dividends (as reported in the statement of cash flows and the statement of stockholders’ equity). Transactions reflected on the statement of cash flows link the previous period’s balance sheet to the current period’s balance sheet. The ending cash balance appears on both the balance sheet and the statement of cash flows.

Q1-8.

External users and their uses of accounting information include: (a) lenders for measuring the risk and return of loans; (b) shareholders for assessing the return and risk in acquiring shares; and (c) analysts for assessing investment potential. Other users are auditors, consultants, officers, directors for overseeing management, employees for judging employment opportunities, regulators, unions, suppliers, and appraisers.

Q1-9.

Managers deal with a variety of information about their employers and customers that is not generally available to the public. Ethical issues arise concerning the possibility that managers might personally benefit by using confidential information. There is also the possibility that their employers and/or customers might be harmed if certain information is not kept confidential.

Q1-10.

The five forces (according to Professor Michael Porter) are (A) industry competition, (B) buyer power, (C) supplier power, (D) product substitutes, and (E) threat of entry.

Q1-11.

W SWOT stands for Strengths and Weaknesses (both are internal factors) Opportunities and Threats (both external factors).

Q1-12.

Seagate’s independent auditor is EY LLP. The auditor expressly states that “our responsibility is to express an opinion on these financial statements based on our audits.” The auditor also states that “these financial statements are the responsibility of the company’s management.” Thus, the auditor does not assume responsibility for the financial statements.

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Q1-13.

While firms acknowledge the increasing need for more complete disclosure of financial and nonfinancial information, they have resisted these demands to protect their competitive position. Corporate executives must weigh the benefits they receive from the financial markets as a result of more transparent and revealing financial reporting against the costs of divulging proprietary information to competitors and others.

Q1-14.

Generally Accepted Accounting Principles (GAAP) are the various methods, rules, practices, and other procedures that have evolved over time in response to the need to regulate the preparation of financial statements. They are primarily set by the Financial Accounting Standards Board (FASB), a private sector entity with representatives from companies that issue financial statements, accounting firms that audit those statements, and users of financial information. Other bodies that contribute to GAAP are the AICPA, the EITF, and the SEC.

Q1-15.

Corporate governance is the system of policies, procedures and mechanisms that protect the interests of stakeholders in the business. These stakeholders include investors, creditors, regulatory bodies, and employees, to name a few. Sound corporate governance involves the maintenance of an effective internal auditing function, an independent and effective external auditing function, an informed and impartial board of directors, governmental oversight (such as from the SEC), and the oversight of the courts.

Q1-16.

The auditor’s primary function is to express an opinion as to whether the financial statements fairly present the financial condition of the company and are free from material misstatements. Auditors do not prepare the financial statements; they only audit them and issue their opinion on them. The auditors provide no guarantees about the financial statements or about the company’s continued performance.

Q1-17.

Financial accounting information is frequently used in order to evaluate management performance. The return on equity (ROE) and return on assets (ROA) provide useful measures of financial performance as they combine elements from both the income statement and the balance sheet. Financial accounting information is also frequently used to monitor compliance with external contract terms. Banks often set limits on such items as the amount of total liabilities in relation to stockholders’ equity or the amount of dividends that a company may pay. Audited financial statements provide information that can be used to monitor compliance with these limits (often called covenants). Regulators and taxing authorities also utilize financial information to monitor items of interest.

Q1-18.

Managers are vitally concerned about disclosing proprietary information that might benefit the company’s competitors. Of most concern, is the “cost” of losing some competitive advantage. There traditionally has been tension between companies and the financial professionals (especially investment analysts) who press firms for more and more financial and nonfinancial information. © Cambridge Business Publishers, 2021 1-3

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Q1-19.

Net income is an important measure of financial performance. It indicates that the market values the company’s products or services, that is, it is willing to pay a price for the products or services enough to cover the costs to bring them to market and to provide the company’s investors with a profit. Net income does not tell the whole story, however. A company can always increase its net income with additional investment in something as simple as a bank savings account. A more meaningful measure of financial performance comes from measuring the level of net income relative to the investment made. One investment measure is the balance of stockholders’ equity, and the comparison of net income to average stockholders’ equity (ROE) is a fundamental measure of financial performance.

Q1-20.

Borrowed money must be repaid, both the principal amount borrowed, as well as interest on the borrowed funds. These payments have contractual due dates. If payments are not prompt, creditors have powerful legal remedies, including forcing the company into bankruptcy. Consequently, when comparing two companies with the same return on equity, the one using less debt would generally be viewed as a safer (less risky) investment.

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MINI EXERCISES M1-21. (10 minutes) All three types of business activities will be affected. • Additional CAPEX of $23 billion will increase investing activities. The company will acquire additional property and equipment. • Operating activities will likely increase because the additional equipment is to either expand or improve on the company’s footprint. All things equal, this will increase the number of customers or perhaps increase revenue per customer. • Financing activities will likely increase. The additional CAPEX will need to be financed either by owners or nonowners.

M1-22. (10 minutes) Financial-statement users

Questions

A. Current shareholders

2. Will the company have enough cash to pay dividends?

B. Company CEO

4. Will there be sufficient profits and cash flow to pay bonuses?

C. Banker

5. Will the company have enough cash to repay its loans?

D. Equity analyst

1. What is expected net income for next quarter?

E. Supplier

3. Has the company paid for inventory purchases promptly in the past?

M1-23. (10 minutes) a. Answer: $176,130 million Explanation:$ millions Assets $258,848

Liabilities $176,130

Equity $82,718

b. Answer: NONOWNERS Explanation: Microsoft receives more of its financing from nonowners ($176,130 million) than from owners ($82,718 million). c. Answer: 32% Explanation: Owner financing is 32% of its total financing ($82,718 million / $258,848 million). Nonowners finance 68% of Microsoft’s total assets. © Cambridge Business Publishers, 2021 1-5

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M1-24. (10 minutes) a. Answer: 1, 3, and 4. b. Answer: $3,306 million Explanation: $ millions Assets

Liabilities

$12,901

Equity

$9,595

$3,306

c. Answer: Nonowners. Explanation: Best Buy received $9,595 million from nonowners which is larger than the $3,306 million from owners. d. 74.4% Explanation: $9,595 million / $12,901 million = 74.4%

M1-25. (15 minutes) ($ millions) Assets Hewlett-Packard General Mills Target

$106,882 $21,712 (c) $40,262

Levels of Owner vs. Nonowner Financing. company follows: Hewlett-Packard ................... General Mills ........................ Target ...................................

26.3% 24.4% 32.2%

Liabilities $78,731 (b) $16,405 $27,305

Equity (a) $28,151 $5,307 $12,957

The percent of owner financing for each

($28,151 million / $106,882 million) ($5,307 million / $ 21,712 million) ($12,957 million / $ 40,262 million)

Target has the highest percentage of owner financing. General Mills and HP are financed with roughly the same proportions of nonowner financing, with General Mills having slightly more.

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M1-26. (15 minutes) a. Answer: Assets $24,156.4

Liabilities $22,980.6

Equity $1,175.8

b. Answer: $24,156.4=$22,980.6+$1,175.8 c. Answer: 4.9% Explanation: $1,175.8 / $24,156.4 = 4.9%

M1-27. (20 minutes) Answer: Symantec Corp. Statement of Retained Earnings For Year Ended March 30, 2018 $ millions Balance, start of year $ (761) Net income (loss) 1,138 Cash dividends (49) Balance, end of year $ 328

M1-28. (20 minutes) a. BS and SCF

BS and SE

b. IS

g. SCF and SE

c. BS

h. SCF and SE

d. BS and SE

e. SCF

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M1-29. (10 minutes) There are many stakeholders impacted by this business decision, including the following (along with a description of how): • You as a Manager—your reputation, self-esteem, and potentially your livelihood could be negatively impacted. •

Creditors and Bondholders—credit decisions based on inaccurate information could occur.

•

Shareholders—buying or selling shares based on inaccurate information could occur.

•

Management and other Employees of your company—repercussions of your decision extend to all other employees. Also, a decision to record these revenues suggests an environment condoning dishonesty.

Indeed, your decisions can affect many more parties than you might initially realize. The short-term benefit of meeting Wall Street’s expectations could have serious long-term ramifications.

M1-30. (15 minutes) Apple—product differentiation and barriers to entry due to technological advantages and legal Walmart—buyer power due to size and cost leader Pfizer—product differentiation arising from specific compounds and barriers to entry due to technological advantages and legal Uber—none, low barriers to entry and product is essentially undifferentiated American Airlines—some competitive advantage due to barriers to entry arising from significant capital expenditures and government regulation UPS—none, product is essentially undifferentiated McDonald’s—buyer power due to size and cost leader

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M1-31. (25 minutes) a. Boston (in millions) Medtronic Scientific Total assets, start of fiscal year $91,393 $20,999 Total assets, end of fiscal year 99,857 19,042 Average total assets 95,625 20,021 Net income (consolidated) 3,095 1,671 Revenue 29,953 9,823 b.

Return on assets (ROA) Profit margin (PM) Asset turnover (AT)

Boston Medtronic Scientific 3.2% 8.3% 10.3% 17.0% 0.31 0.49

c. Answer: Boston Scientific Explanation: Boston Scientific’s ROA is 8.3% which is more than twice that of Medtronic. d. Answer: As compared to Boston Scientific, Medtronic has a weaker profit margin and a weaker asset turnover.

M1-32. (10 minutes) Internal controls are designed for the following purposes: • Monitoring an organization’s activities to promote efficiency and to prevent wrongful use of its resources •

Ensuring the validity and credibility of external accounting reports

•

Promoting effective operations

•

Ensuring reliable internal reporting

Congress has a special interest in internal controls and reports about them. Specifically, the absence or failure of internal controls can adversely affect the effectiveness of domestic and global financial markets. Enron provided Congress with a case in point.

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EXERCISES E1-33. (15 minutes) a. Target’s inventories consist of the product lines it carries: clothing, electronics, home furnishings, food products, and so forth. b. Target’s Property and Equipment assets consist of land, buildings, store improvements such as lighting, flooring, HVAC, store shelving, shopping carts, and cash registers. c. Although Target sells some of its merchandise via its Website, the majority of its sales activity is conducted in its retail locations. These stores represent a substantial and necessary capital investment for its business model.

E1-34. (20 minutes) a. ($ millions)

Assets, start of year

Assets, end of year

Liabilities, start of year

Liabilities, end of year

Stockholders' Equity, end of year

$3,552

$4,556

$2,956

$3,290

$1,266

$123,249

$127,963

$54,230

$53,400

$74,563

Advanced Micro Devices Intel Corp

Explanation: AMD assets: $4,556 - $1,004 = $3,552. AMD liabilities: $2,956 + $334 = $3,290. AMD equity: $4,556 - $3,290 = $1,266 Intel assets: $123,249 + $4,714 = $127,963. Intel liabilities: $53,400 + $830 = $54,230 Intel equity: $127,963 - $53,400 = $74,563 b. AMD: ($3,552 + $4,556) / 2 = $4,054 Intel: ($123,249 + $127,963) / 2 = $125,606 c. Intel Explanation: Assets, end of year Advanced Micro Devices Intel

Stockholders' Equity, end of year

Stockholders' Equity / Assets

$4,556

$1,266

28%

$127,963

$74,563

58%

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E1-35. (15 minutes) External constituents use accounting information from financial statements to answer questions such as the following: 1. Shareholders (investors), ask questions such as: a. Are the company’s resources adequate to carry out strategic plans? b. Are the company’s debts appropriate in amount given the company’s existing assets and plans for growth? c. What is the current level of income (and what are its components)? d. Is the current stock price indicative of the company’s profitability and level of debt? 2. Creditors, ask questions such as: a. Does the business have the ability to repay its debts as they come due? b. Can the business take on additional debt? c. Are current assets sufficient to cover current liabilities? 3. Employees, ask questions such as: a. Is the business financially stable? b. Can the business afford to pay higher salaries? c. What are growth prospects for the organization? d. Will the company be able to pay my pension when I retire?

E1-36. (10 minutes) a. Norfolk Southern Inc. Consolidated Statements of Changes In Retained Income Beginning Balance at Dec. 31, 2015 $ 10,191 Net income 1,668 Dividends on Common Stock (695) Share repurchases (731) Other (8) Ending Balance at Dec. 31, 2016 10,425 Net income 5,404 Dividends on Common Stock (703) Share repurchases (945) Other (5) Ending Balance at Dec. 31, 2017 14,176 Net income 2,666 Dividends on Common Stock (844) Share repurchases (2,639) Other 81 Ending Balance at Dec. 31, 2018 $ 13,440

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b. True. Norfolk Southern did repurchase shares each year. This is shown as a subtraction because shares repurchased decrease the amount of owners’ investment in the company. E1-37. (20 minutes) a. Yes. Norfolk Southern was profitable during 2018 as evidenced by its positive net profit margin of 23.3%. b. 2017 The 2018 profit margin is nearly half of the PM in 2017: 23.3% versus 51.2%. c. Positive. Norfolk Southern’s productivity measure (asset turnover) increased slightly from 0.299 in 2017 to 0.318 in 2018. This indicates that assets are generating a slightly higher level of sales than in the prior year. This is a positive development. d. ROA = Profit margin  asset turnover. 2018 ROA = 23.3%  0.318 = 7.4%. 2017 ROA = 51.2%  0.299 = 15.3%. e. Answer: 1 We do not have sufficient information to assess 3 and 4 so they are not true. Productivity improved in 2018 so 2 is false. 1 is correct because 2017’s PM is double 2018’s PM, causing 2018’s ROA to be half that of 2017.

E1-38. (15 minutes) Return on assets (ROA)

= = =

Net income / Average assets $564 / [($8,115 + $7,886) / 2] 7.05%

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E1-39. (20 minutes) a. Creditors are an important group of external stakeholders. They are primarily interested in the ability of the company to generate sufficient cash flow in order to repay the amounts owed. Stockholders are another significant stakeholder in the company. They are primarily interested in the company’s ability to effectively raise capital and to invest that capital in projects with a rate of return in excess of the cost of the capital raised, that is, to increase the value of the firm. Regulators such as the SEC and the tax authorities, including the IRS and state and local tax officials, are important constituents that are interested in knowing whether the company is complying with all applicable laws and regulations. b. Generally Accepted Accounting Principles (GAAP) are the various methods, rules, practices, and other procedures that have evolved over time in response to the need to regulate the preparation of financial statements. They are primarily set by the Financial Accounting Standards Board (FASB), a private sector entity with representatives from companies that issue financial statements, accounting firms that audit those statements, and users of financial information. Other bodies that contribute to GAAP are the AICPA, the EITF, and the SEC. c. Financial information provides users with information that is useful in assessing the financial performance of companies and, therefore, in setting stock and bond prices. To the extent that these prices are accurate, the costs of the funds that companies raise will accurately reflect their relative efficiency and risk of operations. Companies that can utilize capital more effectively will be able to obtain that capital at a reasonable cost and society’s financial resources will be effectively allocated. d. First, the preparation of financial statements involves an understanding of complex accounting rules and significant assumptions and considerable estimation. Second, GAAP allows for differing accounting treatments for the same transaction. And third, auditors are at a relative information disadvantage vis-à-vis company accountants. As the capital markets place increasing pressures on companies to perform, accountants are often placed in a difficult ethical position to use the flexibility given to them under GAAP in order to bias the financial results or to use their inside information to their advantage.

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E1-40. (20 minutes) a. ROE = Net income / Average stockholders’ equity = $4,518.3 million / [($5,450.1 million + $1,169.5 million) / 2] = 136.5% b. Increase. The repurchase of common stock reduces the denominator (average stockholders’ equity). The outflow of cash for the repurchase, however, reduces net income by the return on the cash that is forgone. Generally, the reduction in the denominator is greater than that for the numerator, and consequently ROE increases. That is one of the reasons cited for share repurchases. c. Equity would have been $1,169.5 million + $7,208.7 million = $8,378.2 million ROE = $4,518.3 million / [($5,450.1 million + $8,378.2 million) / 2] = 65.3%

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PROBLEMS P1-41. (40 minutes) a. 2018 ROE = $6,670 / [($72,496 + $77,869) / 2] = 8.9% 2017 ROE = $9,862 / [($77,869 + $77,798) / 2] = 12.7% b. 2018 ROA = $6,670 / [($219,295 + $204,522) / 2] = 3.1% 2017 ROA = $9,862 / [($204,522 + $198,825) / 2] = 4.9% c. 2018 PM = $6,670 / $510,329 = 1.3% 2017 PM = $9,862 / $495,761 = 2.0% d. 2018 AT = $510,329 / / [($219,295 + $204,522) / 2] = 2.41 2017 AT = $495,761 / [($204,522 + $198,825) / 2] = 2.46 e. Answer: 1 Profit in dollar terms fell and PM decreased from 2% to 1.3%, while small in absolute terms, this is a considerable decrease proportionately. Asset productivity (AT) weakened but not considerably, making choice 2 incorrect. The level of revenue and assets is a factor but not the best explanation, making choices 3 and 4 incorrect. P1-42. (30 minutes) a. General Mills Income Statement ($ millions) For the year ended May 27, 2018 Revenues Cost of goods sold Gross profit Expenses Income before taxes Income tax expense Net income

15,740.4 10,312.9 5,427.5 3,207.2 2,220.3 57.3 2,163.0

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c. General Mills Balance Sheet ($ millions) May 27, 2018 $399.0 Liabilities 30,225.0 Stockholders' equity $30,624.0 Total liabilities and equity

Cash Noncash assets Total assets

$24,131.6 6,492.4 $30,624.0

d. General Mills Statement of Cash Flow ($ millions) For the year ended May 27, 2018 Cash from operating activities Cash from investing activities Cash from financing activities ($5,445.5 + $31.8) Net increase (decrease) in cash Cash, beginning year (= $367.1 + $399.0) Cash, ending year

$2,841.0 (8,685.4) 5,477.3 (367.1) 766.1 $399.0

e. ROA = Net income / Average assets = $2,163 / [($30,624.0 + $21,812.6) / 2] = 8.2% f.

PM = Net income / Revenue = $2,163 / $15,740.4 = 13.7%

g. AT = Revenue / Average assets = $15,740.4 / [($30,624.0 + $21,812.6) / 2] = 0.60 P1-43. (30 minutes) a. Five Below Income Statement ($ thousands) For the year ended February 2, 2019 Revenues Cost of goods sold Gross profit Expenses Income before taxes Income tax expense Net income

$1,559,563 994,478 565,085 373,278 191,807 42,162 $149,645

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Cash Noncash assets Total assets

Five Below Balance Sheet ($ thousands) February 2, 2019 $251,748 Liabilities 700,516 Stockholders' equity $952,264 Total liabilities and equity

$337,170 615,094 $952,264

c. Five Below Statement of Cash Flow ($ thousands) For the year ended February 2, 2019 Cash from operating activities Cash from investing activities Cash from financing activities Net increase (decrease) in cash Cash, beginning year Cash, ending year

$184,133 (39,472) (5,582) 139,079 112,669 $251,748

d. ROA = Net income / Average assets = $149,645 / [($952,264 + $695,708) / 2] = 18.2% e. PM = Net income / Revenue = $149,645 / $1,559,563 = 9.6% f.

AT = Revenue / Average assets = $1,559,563 / [($952,264 + $695,708) / 2] = 1.89

g. ROE = Net income / Average equity = $149,645 / [($615,094 + $458,558) / 2] = 27.9%

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P1-44. (30 minutes) a. J M Smucker Co Income Statement ($ millions) For the year ended April 30, 2018 Revenues Cost of product sold Gross profit Expenses Net income

$7,357.1 4,521.0 2,836.1 1,497.5 $1,338.6

b. To solve this we can start with the balance sheet numbers we know for 2018 and solve for the missing number. 2018 Total assets Total liabilities Total equity

?? $7,410.1 $7,891.1

2018 Total assets = $7,891.1 + $7,410.1 = $15,301.2. Then, we can determine current versus long-term as follows: Long-term assets = $15,301.2 - $1,555.0 = $13,746.2. Current liabilities = $7,410.1 - $6,376.3 = $1,033.8. J M Smucker Co Balance Sheet ($ millions) April 30, 2018 $1,555.0 Current liabilities 13,746.2 Long-term liabilities Total liabilities Stockholders' equity $15,301.2 Total liabilities and equity

Current assets Long-term assets

Total assets

$1,033.8 6,376.3 7,410.1 7,891.1 $15,301.2

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c. J M Smucker Co Statement of Cash Flow ($ millions) For the year ended April 30, 2018 Cash from operating activities Cash from investing activities Cash from financing activities Net increase (decrease) in cash Cash, beginning of year Cash, end of year

$1,218.0 (277.6) (914.6) 25.8 166.8 $ 192.6

d. ROA = Net income / Average assets = $1,338.6 / [($15,301.2 + $15,639.7) / 2] = 8.7% e. PM = Net income / Revenue = $1,338.6 / $7,357.1 = 18.19% = 18.2% rounded f.

AT = Revenue / Average assets = $7,357.1 / [($15,301.2 + $15,639.7) / 2] = 0.48

g. ROE = Net income / Average equity = $1,338.6 / [($7,891.1 + $6,850.2) / 2] = 18.16% = 18.2% rounded P1-45. (15 minutes) CROCKER CORPORATION Statement of Stockholders’ Equity For Year Ended December 31, 2019 Contributed Capital December 31, 2018 ................................ $120,000 Issuance of common stock .............................. 30,000 Net income ...................................................... Cash dividends ................................................ _______ December 31, 2019 ................................ $150,000

Retained Earnings $ 30,000 50,000 (25,000) $ 55,000

Stockholders’ Equity $150,000 30,000 50,000 (25,000) $205,000

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P1-46. (20 minutes) WINNEBAGO INDUSTRIES Statement of Stockholders’ Equity For Year Ended August 25, 2018 Contributed Capital

$ thousands August 26 , 2017

$106,289

Issuance of stock

5,822

Treasury Stock

Repurchase of stock

Accum. Other Comp. Income

Retained Earnings

$(342,730)

$679,138

Total Stockholders’ Equity

$(1,023)

$441,674 5,822

(4,644)

Net income

102,416

Other comp. income (loss)

1,915

Dividends

1,915

(12,738)

August 25, 2018

$112,111

$(347,374)

$768,816

(12,738) $

892

$534,445

P1-47. (30 minutes) ($ thousands) a. Net income Total assets Average Total assets ROA = Net income / Average Total assets

2018 $ 208,542 1,743,157 1,620,917 12.9%

2017 $ 205,876 1,498,677 1,411,412 14.6%

2016 $1,324,147

b. Net income Sales Profit margin = Net income / Sales

2018 $ 208,542 2,566,863 8.1%

2017 $ 205,876 2,221,427 9.3%

c. Sales Total assets Average Total assets Asset turnover = Sales / Average Total assets

2018 $ 2,566,863 1,743,157 1,620,917 1.58

2017 2016 $ 2,221,427 1,498,677 $ 1,324,147 1,411,412 1.57

d. Profit margin. Logitech’s profit margin decreased by 120 basis points in 2018 from 9.3% to 8.1% while asset turnover was essentially flat from 2017 to 2018.

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e. Net income Equity Average Equity ROE = Net income / Average Equity f.

2018 $ 208,542 1,050,557 953,334 21.9%

2017 $ 205,876 856,111 808,030 25.5%

2016 $ 759,948

Increase The repurchase of common stock reduces both the numerator (net income) and denominator (stockholders’ equity) of the return on equity calculation. Repurchases reduce net income by the forgone profit on the cash that is used to buy the stock on the open market. This is likely very small in the current economic environment. Generally, the denominator effect dominates: its reduction is greater than the reduction of the numerator. Therefore, it is reasonable to predict that Logitech’s repurchase would increase ROE.

P1-48. (30 minutes) ($ millions) a.

Net income Total assets Average Total assets ROA = Net income / Average Total assets

Feb. 02, 2019 $ 564 7,886 8,001 7.0%

b. Answer Feb 2019: 3.6% Feb 2018: 2.8% Explanation Feb. 02, 2019 Net income $ 564 Sales 15,860 Profit margin = Net income / Sales 3.6%

Feb. 03, 2018 $ 437 8,115 7,987 5.5%

Jan. 28, 2017 $ 7,858

Feb. 03, 2018 $ 437 15,478 2.8%

Sales Total assets Average Total assets Asset turnover = Sales / Average Total assets

Feb. 02, 2019 $15,860 7,886 8,001 1.98

Feb. 03, 2018 $ 15,478 8,115 7,987 1.94

Jan. 28, 2017 $ 7,858

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d. Both. Nordstrom’s profit margin increased by 80 basis points in fiscal year ended February 2019 from 2.8% to 3.6% and asset turnover increased marginally from 1.94 to 1.98. e.

Net income Equity Average Equity ROE = Net income / Average Equity f.

Feb. 02, 2019 $ 564 873 925 61.0%

Feb. 03, 2018 $ 437 977 924 47.3%

Jan. 28, 2017 $ 870

Increase. The large negative balance decreases Equity, the denominator in the ROE ratio and so the ROE is higher as a result.

P1-49. (20 minutes) a.

Sales Cost of sales Gross profit

Capri Holdings ($ millions) 2018 2017 $ 4,718.6 $ 4,493.7 1,859.3 1,832.3 2,859.3 2,661.4

Five Below ($ thousands) 2018 2017 $ 1,559,563 $ 1,278,208 994,478 814,795 565,085 463,413

b. Capri Holdings ($ millions) 2018 2017 Sales $ 4,718.6 $ 4,493.7 Gross profit (from part a) 2,859.3 2,661.4 Gross profit margin % 60.6% 59.2%

Five Below ($ thousands) 2018 2017 $ 1,559,563 $ 1,278,208 565,085 463,413 36.2% 36.3%

Net income Average equity ROE

Capri Holdings ($ millions) 2018 2017 $ 592.1 $ 551.5 1,805 1,794 32.8% 30.7%

Five Below ($ thousands) 2018 2017 $ 149,645 $ 102,451 536,826 394,982 27.9% 25.9%

d. 3; Kors / Jimmy Choo / Versace brand loyalty and the nature of luxury goods, in general, create the opportunity for Capri to premium price its clothes and accessories. While costs of these goods is not low, the mark up can be significant because the consumer is willing to pay for the brand name and the perceived status that comes from wearing the labels. © Cambridge Business Publishers, 2021 1-22

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P1-50. (30 minutes) a. $ millions Net income Assets, start of year Assets, end of year Average assets ROA = Net income / Average assets

2018 $ 5,924.3 33,803.7 32,811.2 33,307.5 17.8%

2017 $ 5,192.3 31,023.9 33,803.7 32,413.8 16.0%

b. $ millions Net income Sales Profit margin (PM) = Net income / Sales

2018 $ 5,924.3 21,025.2 28.2%

2017 $ 5,192.3 22,820.4 22.8%

c. $ millions Sales Assets, start of year Assets, end of year Average assets Asset turnover (AT) = Sales / Average assets

2018 $21,025.2 33,803.7 32,811.2 33,307.5 0.63

2017 $22,820.4 31,023.9 33,803.7 32,413.8 0.70

d. Profit margin. McDonald’s ROA increased from 2017 to 2018 because profitability increased during the year (from 22.8% to 28.2%) and the increase in profitability was sufficient to outweigh the decrease in productivity (from 0.70 to 0.63).

P1-51. (30 minutes) a. $ millions Net income Assets, start of year Assets, end of year Average assets ROA = Net income / Average assets

2016 $ 5,058.0 32,883.0 32,906.0 32,894.5 15.4%

2017 $ 4,869.0 32,906.0 37,987.0 35,446.5 13.7%

2018 $ 5,363.0 37,987.0 36,500.0 37,243.5 14.4%

b. $ millions Net income Sales Profit margin (PM) = Net income / Sales

2016 $ 5,058.0 30,109.0 16.8%

2017 $ 4,869.0 31,657.0 15.4%

2018 $ 5,363.0 32,765.0 16.4%

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c. $ millions Sales Assets, start of year Assets, end of year Average assets Asset turnover (AT) = Sales / Average assets

2016 $30,109.0 32,883.0 32,906.0 32,894.5 0.92

2017 $31,657.0 32,906.0 37,987.0 35,446.5 0.89

2018 $32,765.0 37,987.0 36,500.0 37,243.5 0.88

d. Both. 3M’s ROA decreased from 15.4% in 2016 to 13.7% in 2017 because profitability margin decreased during the year (from 16.8% to 15.4%). Compounding this was the decrease in asset productivity (AT) (from 0.92 to 0.89). Thus, both factors decreased the ROA. e. Profit margin. 3M’s ROA increased from 13.7% 2017 to 14.4% in 2018 because profitability increased during the year (from 15.4% to 16.4%) and the increase in profitability was sufficient to outweigh the very slight decrease in productivity (from 0.89 to 0.88). P1-52 (35 minutes) a. To answer the questions, hover over the appropriate spot on the graphic on the left and read the pop-out boxes that appear. i. Assets in 2017 are $56,669 million, the largest in the 10-year period. ii. In general, Thermo Fisher’s asset grew steadily over the period. In 2015 assets dipped and then decreased slightly again in in 2018. iii. Liabilities track assets very closely. Equity increased smoothly during the period with no sharp increases or decreases. iv. Liabilities exceeded equity in four of the ten years: 2014, 2016, 2017 and 2018. b. To answer the questions, hover over the appropriate spot on the middle graphic and read the pop-out boxes that appear. i. Net income more than doubled from 2009 to 2017, increasing from $850 million to $2,225 million. ii. Revenue grew each year in the 10-year period. iii. In 2014, revenue increased $4 billion from about $13 billion to $17 billion. While revenue increased nearly that much in 2018, it was on a larger base, so proportionately the 2014 increase was the largest. iv. In $ millions: 2017 profit margin = $2,225 / $20,918 = 10.6%. 2018 profit margin = $2,838 / $24,358 = 12.1%. Profit margin is larger in 2018. v. In 2018, the company’s market cap $89,991 million.

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c. To answer the questions, hover over the appropriate spot on the graphic on the right and read the pop-out boxes that appear. i. Operating cash flow was smallest in 2010, $1,498 million. ii. The red bar represents financing cash flows, The red bar is left of $0 in four of the 10 years. iii. In 2014, investing cash flow is very large and negative. In the prior two years (2012 and 2013) and the next year (2015), investing cash flow fell to nearly $0. d. The ROA for 2018 = $2,938 million / $56,232 million = 5.2%. e. All three graphics show that 2014 was an unusual year. The negative investing cash flow is very large and corresponds to a significant increase in assets (left graphic) and revenue (middle graphic). One possible explanation is that Thermo Fisher acquired another company (investing cash flow), which immediately increased both assets and revenue. P1-53 (25 minutes) a. Twitter’s board of directors and shareholders. Auditors work for the benefit of the shareholders and report directly to the board of directors, the elected representatives of the shareholders whose job it is to protect shareholder interests. It would not be appropriate for the external auditors to report directly to management because the auditors are examining management’s activities as described in the company’s financial statements. Reporting to the board preserves the auditor’s independence. b. 1 and 4. Statement 1 is true because the nature of the independent auditors’ opinion is that the financial statements “present fairly, in all material respects, the financial condition of the company.” Because this is standard audit-report language, any deviations should raise a flag. “Present fairly” does not mean absolute assurance that the financials are error-free. It means that a reasonable person would conclude that the financial statements reasonably describe the financial condition of the company. Statement 2 is not true because auditors are not responsible for detecting fraud. While audit procedures might detect fraud, the auditors do not express an opinion about fraud existence. Statement 3 would be true if the word “misstatements” had read “material misstatements” Continued

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b. continued Statement 4 is true – PwC also rendered an opinion on the company’s system of internal controls. Internal controls are designed to insure the integrity of the financial reporting system and the preservation of the company’s assets. A well-functioning internal control system is a critical component of the company’s overall corporate governance system. Statement 5 is not true because it would be impossible for PwC to examine MOST of the transactions. Instead, they audit critical areas and then use statistical techniques to look at a representational sample of transactions. c. The opinion is unqualified. d. 3

P1-54. (20 minutes) a. Jack Dorsey made assertions that the Sarbanes-Oxley Act requires all CEOs and CFOs to make. In particular, Dorsey certified that: •

He has read the financial reports.

•

The financial reports do not contain any significant (material) misstatement or omit to state a significant fact that should have been included. The financial reports are, therefore, complete.

• •

The financial reports fairly present the financial condition of the company. The company maintains a system of internal controls and those controls are functioning correctly.

b. Congress passed the Sarbanes-Oxley Act following a spate of corporate accounting scandals in the early 2000s. The impetus for the legislation was the belief that some CEOs and CFOs no longer assumed responsibility for the financial reporting of their companies. By requiring these high-ranking executives to personally certify to the items referenced in part a above, Congress wanted to encourage closer scrutiny of the financial reporting process at the highest levels of the company. c. The Sarbanes-Oxley Act prescribes significant penalties for falsely certifying to the completeness and correctness of the financial reports. CEOs and CFOs face fines of up to $5 million and prison terms of up to 20 years. Additionally, should the company later restate its financial statements as a result of wrongful false reporting, the CEOs and CFOs may be required to forfeit any profits earned as a result of that reporting. This forfeiture has been labeled “disgorgement” in the financial press.

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P1-55. (30 minutes) Following is part of the statement of corporate governance from GE’s site. Source: https://www.ge.com/investor-relations/sites/default/files/governance_principles.pdf

continued © Cambridge Business Publishers, 2021 1-27

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continued

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a. The cornerstone of GE’s governance structure is its reliance on an independent and qualified Board of Directors. Independence means that insiders are not involved in oversight of the company’s managers. This helps avoid potential conflicts of interest. “Highly qualified” directors ensure that those responsible for oversight have the knowledge to perform their duties and the conviction to ask probing questions. b. Governance structures serve shareholders (and indirectly, public interest). The shareholders of GE hope to ensure that the company’s policies are adhered to and that the interests of shareholders are given paramount consideration in the management of the business.

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IFRS APPLICATIONS I1-56. (20 minutes) a. (currency in millions)

OMV Group Ericsson BAE Systems

Assets = € 36,961 SEK 268,761 (c) £30,364

Liabilities + € 21,619 (b) SEK 180,991 £24,746

Equity (a) €15,342 SEK 87,770 £5,618

b. OMV Group Explanation: Owner Financing = Equity / Assets OMV Group (Austria) Euros millions Ericsson (Sweden) SEK millions BAE Systems (UK) pounds millions

41.5% 32.7% 18.5%

c. BAE Systems Explanation: Nonowner Financing = Liabilities / Assets OMV Group (Austria) Euros millions Ericsson (Sweden) SEK millions BAE Systems (UK) pounds millions

58.5% 67.3% 77.3%

I1-57. (25 minutes) a. € millions Net profit (Loss) Assets, start of year Assets, end of year Average assets ROA = Net income / Average assets

2018 3,298.0 31,576.0 36,961.0 34,268.5 9.6%

2017 1,486.0 32,112.0 31,576.0 31,844.0 4.7%

2016 (230.0) 32,664.0 32,112.0 32,388.0 -0.7%

b. € millions Net profit (Loss) Sales Profit margin (PM) = Net income / Sales

2018 3,298.0 22,930.0 14.4%

2017 1,486.0 20,222.0 7.3%

2016 (230.0) 19,260.0 -1.2%

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c. € millions Sales Assets, start of year Assets, end of year Average assets Asset turnover (AT) = Sales / Average assets

2018 22,930.0 31,576.0 36,961.0 34,268.5 0.67

2017 20,222.0 32,112.0 31,576.0 31,844.0 0.64

2016 19,260.0 32,664.0 32,112.0 32,388.0 0.59

d. Both. OMV’s ROA increased from -0.7% in 2016 to 4.7% in 2017 because profitability margin improved during the year (from -1.2% to 7.3%). Compounding this was the increase in asset productivity (AT) (from 0.59 to 0.64). Thus, both factors increased the ROA. e. Both. OMV’s ROA increased from 7.3% in 2017 to 14.4% in 2018 because profitability increased during the year (from 7.3% to 14.4%) and the increase in profitability was augmented by the increase in productivity (from 0.64 to 0.67). f. € millions Net profit (Loss) Equity, start of year Equity, end of year Average equity ROE = Net income / Average equity

2018 3,298.0 14,334.0 15,342.0 14,838.0 22.2%

2017 1,486.0 13,925.0 14,334.0 14,129.5 10.5%

2016 (230.0) 14,298 13,925 14,111.5 -1.6%

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MANAGEMENT APPLICATIONS MA1-58. (30 minutes) Financing can come from a number of sources, including operating creditors, borrowed funds, and the sale of stock. Each has its strengths and weaknesses. 1. Operating creditors – operating creditors are merchandise and service suppliers, including employees. Generally, these liabilities are non-interest bearing. As a result, companies typically use this source of credit to the fullest extent possible, often stretching payment times. However, abuse of operating creditors has a significant downside. The company may be unable to supply its operating needs and the damage to employee morale might have significant repercussions. Operating credit must, therefore, be used with care. 2. Borrowed funds – borrowed money typically carries an interest rate. Because interest expense is deductible for tax purposes, borrowed funds reduce income tax expense. The taxes saved are called the “tax shield.” The deductibility of interest reduces the effective cost of borrowing. The downside of debt is that the company must make principal and interest payments as scheduled. Failure to make payments on time can result in severe consequences – creditors have significant legal remedies, including forcing the company into bankruptcy and requiring its liquidation. The lower cost of debt must be balanced against the fixed payment obligations. 3. Sale of stock – companies can sell various classes of stock to investors. Some classes of stock have mandatory dividend payments. On other classes of stock, dividends are not a legal requirement until declared by the board of directors. Consequently, unlike debt payments, some dividends can be curtailed in business downturns. The downside of stock issuance is its cost. Because equity is the most expensive source of capital, companies use it sparingly.

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MA1-59. (30 minutes) Each of the three primary financial statements provides a different perspective on the company’s financial performance and condition. 1. Income statement. The income statement provides information on the company’s sales, expenses, and net income or loss. Profitability indicates that the company’s goods or services are valued by the market, that is, customers are willing to pay a price that is sufficient to cover the costs of providing those goods and/or services together with an adequate return on invested capital. Further, the income statement is prepared on an accrual basis, where revenues are recognized when “earned” and expenses when “incurred.” Accountants do not wait for cash to be received or paid to record revenues and expenses. Consequently, management is able to communicate some of its private information about expected cash inflows or outflows through its recording of revenues and expenses. Presumably this information is valuable to financial statement readers because the income statement provides information about the economic profit of the company. 2. Balance sheet. The balance sheet reports the resources available to the company and how the company obtained those resources (the sources). The balance sheet also reveals asset categories (providing insight into management’s investment philosophy) and the manner in which management has financed its operations (the relative use of debt versus equity). Efficient management of the balance sheet is critical to financial performance and careful analysis of the balance sheet can provide clues into the effectiveness of the company’s management team and the viability of the company within the context of its industry. 3. Statement of cash flows. Cash is important to a company’s continued operations. Debts must be paid in cash and employees typically only accept cash in payment of their services. Companies must generate positive cash flow over the long run in order to survive. The income statement, prepared on an accrual basis, does not directly provide information about cash flows. But the statement of cash flows does, and, for that reason, it is a critical financial statement. The statement of cash flows tells us the sources of cash and how cash has been used. In particular, the statement reports operating, investing and financing cash flows. From the statement we can infer whether the company’s sources of cash are long-term or transitory. This is important to forecasting future cash flows. In addition, the uses of cash provide insight into management’s investment philosophy, which can be a valuable input into our evaluation of management and valuation of the company.

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MA1-60. (30 minutes) Transparency is the degree to which the financial statements accurately and completely portray the financial condition of the company and the results of its operating activities. Transparent financial statements are timely and provide all the information required to effectively evaluate the financial performance of the company. Accuracy, timeliness, and completeness are important to financial statement readers who seek financial information that is relevant and reliable. Transparency became a central issue in financial reporting following the accounting scandals of the early 2000s, when analysts believed too many financial statements lacked transparency. Balancing companies’ desire to issue transparent financial statements is their need to protect proprietary information. Markets are very competitive, and the information disclosed to investors and creditors is also disclosed to the company’s competitors. Most critical is information relating to the company’s strategic direction. Even historical information, however, provides insight into the relative profitability of the company’s operating units that can be effectively utilized by future competitors. There has traditionally been tension between companies and the financial professionals (especially investment analysts) who press firms for more and more financial and nonfinancial information. MA1-61. (30 minutes) Accounting measures other than net income have become commonplace in corporate press releases. By their use, companies seek to redefine the benchmark the market uses to evaluate the companies’ performance. These non-GAAP income metrics often create a lower bar that companies can more easily reach. By touting non-GAAP performance measures, companies hope to improve the market’s assessment of performance. The SEC will not accept non-GAAP financial statements for quarterly and annual financial reporting. In fact, auditors must cite GAAP exceptions in their audit opinion, which creates a significant red flag. Companies are allowed to use non-GAAP measures in press releases, provided that they also reconcile the non-GAAP numbers to GAAP numbers in the same press release. It is a criminal offense to issue false or misleading financial statements for the purpose of influencing security prices. Also, most companies have developed and published to employees, codes of conduct that prohibit the falsification of financial reporting for the purpose of job retention, promotion, or compensation. Officially, senior management believes that false financial reports pose significant ethical issues that must be clearly communicated to all employees. Nonetheless, we continue to witness corporate executives doing a “perp walk” on national TV as they are escorted to jail by federal authorities. Continued © Cambridge Business Publishers, 2021 1-34

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Condoning exceptions to financial reporting implicitly condones theft in all of its forms, and the corporate culture quickly deteriorates. Proper corporate governance requires the communication of clear guidelines about what information may be communicated in press releases and how internal performance measures are to be constructed. These must be enforced to the letter. MA1-62.B (30 minutes) The SEC has voiced its concern over the perceived lack of independence of auditors, and Congress has passed legislation to define the activities that auditors may and may not perform for their clients. The issue of independence first arose when auditors faced no controls. In response to declining audit fees, public accounting firms sought to bolster their income with management consulting engagements, such as software development, M&A assistance, internal audit outsourcing, supply chain management, and a host of other services. As management consulting revenues and profits grew disproportionately compared to traditional audit revenues and profit, the SEC became concerned that auditors might be unduly influenced to issue biased audit reports rather than risk losing lucrative management consulting fees from the same client. In response, the SEC compelled public accounting firms to divest their management consulting subsidiaries. Further, firms were limited as the types of non-audit engagements they could perform for clients. Auditors are an important component of the corporate governance system, and their effectiveness is lessened if their independence is compromised. The board of directors (specifically, the audit committee) must continually evaluate the independence of the company’s auditors.

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Module 2 Introducing Financial Statements QUESTIONS Q2-1.

Q2-2.

An asset represents resources a company owns or controls. Assets should provide future economic benefits. Assets arise from past events or transactions. A liability is an obligation that will require a future economic sacrifice. Equity is the difference between assets and liabilities. It represents the claims of the company’s owners to its income and assets. The following are some examples of each: Assets

• • • •

Cash Receivables Inventories Plant, property and equipment (PPE)

Liabilities

• • • • •

Accounts payable Accrued liabilities Deferred revenue Notes payable Long-term debt

Equity

• • • • •

Contributed capital (common and preferred stock) Additional paid-in capital Retained earnings Accumulated other comprehensive income Treasury stock

A cost that creates an immediate benefit is reported on the income statement as an expense. A cost that creates a future benefit is added to the balance sheet as an asset (capitalized) and will be transferred to the income statement as the benefit is realized. For example, PPE creates a future benefit and the cost of the PPE is transferred to the income statement (as depreciation expense) over the life of the PPE.

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Q2-3.

Accrual accounting means that we record revenues when earned (when the performance obligation is satisfied) and record expenses when they are incurred. Accrual accounting does not rely on cash flows in determining when items are revenues or expenses. This is why net income (a GAAP measure) differs from cash from operations.

Q2-4.

Transitory items are revenues and expenses that are not expected to recur. One objective of financial analysis is to predict future performance. Given that perspective, transitory (nonrecurring) items are not relevant except to the extent that they convey information about future financial performance.

Q2-5.

The statement of stockholders’ equity provides information about the events that impact stockholders’ equity during the period. It contains information relating to net income, stock sales and repurchases, option exercises, dividends and other accumulated comprehensive income.

Q2-6.

The statement of cash flows reports the company’s cash inflows and outflows during the period, and categorizes them according to operating, investing and financing activities. The income statement reports profit earned under accrual accounting, but does not provide sufficient information concerning cash flows. The statement of cash flows fills that void.

Q2-7.

Articulation refers to the fact that the four financial statements are linked to each other and that changes in one statement affect the other three. For example, net income reported on the income statement is linked to the statement of retained earnings, which in turn is linked to the balance sheet. Understanding how the financial statements articulate helps us to analyze transactions and events and to understand how events affect each financial statement separately and all four together.

Q2-8.

When a company purchases a machine it records the cost as an asset because it will provide future benefits. As the machine is used up, a portion of this cost is transferred from the balance sheet to the income statement as depreciation expense. The machine asset is, thus, reduced by the depreciation, and equity is reduced as the expense reduces net income and retained earnings. If the entire cost of the machine was immediately expensed, profit would be reduced considerably in the year the machine was purchased. Then, in subsequent years, net income would be far too high as none of the machine’s cost would be reported in those years even though the machine produced revenues during that period.

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Q2-9.

An asset must be “owned” or “controlled,” it must provide “future economic benefits,” and it must arise from a past transaction or event. Owning means having title to the asset (some leased assets are also recorded on the balance sheet because they are controlled, as we will discuss in our Module 10 entitled, “Reporting and Analyzing Off-Balance-Sheet Financing”). Future benefits may mean the future inflows of cash, or an increase in another asset, or reduction of a liability. Past event means the company has purchased the asset or acquired it in some other cash or noncash transaction or event.

Q2-10.

Liquidity refers to the ready availability of cash. That is, how much cash the company has on hand, how much cash is being generated, and how much cash can be raised quickly. Liquidity is essential to the survival of the business. After all, firms must pay loans and employee wages with cash.

Q2-11.

Current means that the asset will be liquidated (converted to cash) or used in operations within the next year (or the operating cycle if longer than one year).

Q2-12.

GAAP uses historical costs because they are less subjective than market values. Market values can be biased for two reasons: first, we may not be able to measure them accurately (consider our inability to accurately measure the market value of a manufacturing facility, for example), and second, managers may intervene in the reporting process to intentionally bias the results to achieve a particular objective (like enhancing the stock price).

Q2-13.

Generally, excluded intangible (unrecorded) assets are those that contribute to a company’s sustainable competitive advantage, but that cannot be measured accurately. Some examples include the value of a brand, the management of a company, employee morale, a strong supply chain, superior store locations, credibility with the financial markets, reputation, and so forth.

Q2-14.

An intangible asset is an asset that is not physical in nature. To be included on the balance sheet, it has to meet two tests: the company must own or control the asset, it must provide future economic benefits, and the asset must arise from a past event or transaction. Some examples are goodwill, patents and trademarks, contractual agreements like royalties, leases, and franchise agreements. An intangible asset is only recorded on the balance sheet when it is purchased from an outside party. For example, goodwill arises when the company acquires (either with cash or stock) another company’s brand name or any of the other intangibles listed above.

Q2-15.

An accrued liability is an obligation for expenses that have been incurred but not yet paid for with cash. Examples include wages that have been earned by employees and not yet paid, interest owing on a bank loan, and potential future warranty claims for products sold to customers. When the liability is recognized on the balance sheet, a corresponding expense is recognized in the income statement.

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Q2-16.

Net working capital = Current assets – Current liabilities. Increasing the amount of trade credit (e.g., accounts payable to suppliers) increases current liabilities and reduces net working capital. Trade credit is like borrowing from a supplier to make purchases. As trade credit increases, the supplier is lending more money than before. This frees up cash, which the company can use for other purposes such as paying down interest-bearing debt or purchasing additional productive assets. Thus, net working capital decreases. This can be a good thing. As a business grows, its net working capital grows because inventories and receivables generally grow faster than accounts payable and accrued liabilities do. Net working capital must be financed just like long-term assets.

Q2-17.

Book value is the amount at which an asset (or liability) is carried on the balance sheet. The book value of the company is the book value of all the assets less the book value of all the liabilities, that is, the book value of stockholders’ equity. Book values are determined in accordance with GAAP. Market value is the sale price of an asset or liability. Markets are not constrained by GAAP standards and, therefore, can consider a number of factors that accountants cannot. Market values, therefore, generally differ significantly from book values.

Q2-18

The income statement and the equity section on the balance sheet are linked via retained earnings. When a company reports net income, the amount increases retained earnings. Similarly, losses on the income statement decrease retained earnings on the balance sheet. When a company pays a dividend, retained earnings decrease. The amount of the dividend paid is reported on the statement of cash flows as a use of funds (outflow) in the financing section.

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MINI EXERCISES M2-19. (15 minutes) a. Income statement

Balance sheet

b. Balance sheet

g. Income statement

c. Income statement

h. Balance sheet

d. Balance sheet

Income statement

e. Income statement

M2-20. (15 minutes) a. Balance sheet

g. Balance sheet

b. Income statement

h. Balance sheet

c. Balance sheet

Income statement

d. Income statement

Income statement

e. Balance sheet

k. Balance sheet

Balance sheet

M2-21. (15 minutes) On February 28, 2019 Kraft Heinz announced that they would record a goodwill impairment of $7.1 billion in the next quarterly earnings report. The company’s stock price had recently fallen and had not rebounded. Goodwill impairment tests revealed that current fair value was less than the carrying value of seven of the company’s 20 reporting units (similar to subsidiaries) and six of its major brands.

M2-22. (15 minutes) a. A b. L c. E d. A

e. f. g. h.

L E E L

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M2-23. (10 minutes)

Beginning retained earnings ............................... Add: Net income (loss) .................................. Less: Dividends ............................................... Ending retained earnings ....................................

2020 $189,089 (19,455) 0 $169,634

2019 $ 155,957 48,192 (15,060) $189,089

M2-24. (10 minutes) ($ millions) Retained earnings, December 31, 2017 .............................................. Add: Net earnings .......................................................................... Less: Other retained earnings changes ........................................... Less: Dividends ............................................................................... Retained earnings, December 30, 2018 ..............................................

$101,793 15,297 (1,380) (9,494) $106,216

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EXERCISES E2-25. (15 minutes) a. One plausible reason that Credit Suisse prepared its financial statements in accordance with US GAAP, is to make it easier for financial statement users including securities analysts, investors, and regulators to compare to Credit Suisse’s close competitors, many of which are U.S. companies. b. Credit Suisse wants its investors, customer, regulators and other stakeholders to know that it is a good corporate citizen. A proactive statement claiming to take seriously the international anti-terrorist laws and to have implemented strong policies and procedures to combat crime, seeks to decrease the perceived riskiness of the company’s operations, and thereby decrease the company’s equity cost of capital.

E2-26. (15 minutes) Analysts would want to know about other income statement and balance sheet accounts that relate to the allowance. For example to assess the variability of the allowance account, the balance could be common-sized to total assets or as a percentage of total accounts receivable. The changes in the allowance account, when expressed in percentage terms, might be immaterial (a positive signal) or might vary even more drastically (a negative signal). Analysts would also want to use industry-wide information – what have H&R Block’s competitors experienced with bad debt and doubtful accounts? Answering that question will help determine if additional research and analysis are required.

E2-27. (20 minutes) BARTH COMPANY Income Statement For Year Ended December 31, 2019 Sales revenue ................................................................................ Expenses Cost of goods sold ................................................................ $180,000 Wages expense .......................................................................... 40,000 Supplies expense ................................................................ 6,000 Total expenses ........................................................................... Net income .....................................................................................

$500,000

226,000 $274,000

continued © Cambridge Business Publishers, 2021 2-7

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BARTH COMPANY Balance Sheet December 31, 2019 Assets Cash ...................................... $148,000 Accounts receivable .............. 30,000 Supplies inventory ................. 3,000 Inventory ............................... 36,000 Total current assets 217,000 Land ...................................... 80,000 Equipment ............................. 70,000 Buildings ................................ 151,000 Goodwill ................................ 8,000 Total assets ........................... $526,000

Liabilities and equity Accounts payable ................................ $ 16,000 Bonds payable ................................ 200,000 Total liabilities ................................ 216,000

Common stock ................................ 150,000 Retained earnings ................................ 160,000 Total equity ................................ 310,000 Total liabilities and equity ................................ $526,000

E2-28. (15 minutes) BAIMAN CORPORATION Income Statement For Month Ended January 31 Sales .................................... Wage expense ..................... Net income (loss)..................

$40,000 12,000 $28,000

BAIMAN CORPORATION Balance Sheet January 31 Cash ............................................................ $ 0 Accounts receivable ................................ 40,000 Total assets.................................................. $40,000 Wages payable ................................ $12,000 Retained earnings ................................ 28,000 Total liabilities and equity ............................. $40,000

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E2-29. (30 minutes)

Balance sheet Cash Noncash assets Total liabilities Contributed capital Retained earnings Other equity

+ +

–

+ –

–

Statement of cash flows Operating cash flow Investing cash flow Financing cash flow Income statement Revenues Expenses Net income

–

+ –

Statement of stockholders’ equity Contributed capital + Retained earnings –

–

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E2-30. (30 minutes)

Balance sheet Cash Noncash assets Total liabilities Contributed capital Retained earnings Other equity

– +

–

+ –

–

+ +

Statement of cash flows Operating cash flow Investing cash flow Financing cash flow

– +

–

Income statement Revenues Expenses Net income

+ + +

+ –

Statement of stockholders’ equity Contributed capital + Retained earnings

–

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E2-31. (15 minutes) a. Best Buy Inc. ($ millions) Sales .......................................................................... Accumulated depreciation .......................................... Depreciation expense................................................. Retained earnings ...................................................... Net income ................................................................. Property, plant and equipment, net ............................. Selling, general and admin expense ........................... Accounts receivable ................................................... Total liabilities ............................................................ Total stockholders' equity ...........................................

Amount

Classification

$42,879 6,690 770 2,985 1,464 2,510 8,015 1,015 9,595 3,306

I B I B I B I B B B

b. Total assets = Total liabilities + Total stockholders’ equity Total assets = $9,595 million + $3,306 million = $12,901 million Sales – Total expenses = Net income $42,879 million – Total expenses = $1,464 million Thus, Total expenses = $41,415 million

E2-32. (15 minutes) a. Terex Corp ($ millions) Total revenues .......................................................... Accrued compensation and benefits ......................... Depreciation and amortization expense .................... Retained earnings .................................................... Net income ............................................................... Property, plant & equipment .................................... Selling, general & admin expense ............................ Inventory Total liabilities ........................................................... Total stockholders' equity .........................................

Amount $5,125.0 152.2 59.7 749.0 113.7 345.6 673.5 1,212.0 2,624.9 861.0

Classification I B I B I B I B B B

b. Total assets = Total liabilities + Total stockholders’ equity Total Assets = $2,624.9 million+ $861.0 million = $3,485.9 million Total revenue – Total expenses = Net income $5,125.0 million – Total expenses = $113.7 million Thus, Total expenses = $5,011.3 million © Cambridge Business Publishers, 2021 2-11

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E2-33. (15 minutes) a. ($ thousands) Sales ............................... Cost of goods sold ........... Gross profit ...................... Total expenses ................ Net income ......................

ANF $3,590,109 100.0% 1,430,193 39.8% 2,159,916 60.2% 2,081,108 58.0% $ 78,808 2.2%

TJX $38,972,934 27,831,177 11,141,757 8,081,959 $ 3,059,798

100.0% 71.4% 28.6% 20.7% 7.9%

ANF is a high-end retailer and TJX operates in the value-priced segment of the market. Clearly, their respective business models are evident in the gross profit margin. ANF’s gross profit margin is more than twice that of TJX (60.2% compared to 28.6%). This implies that ANF adds a healthy markup to determine their merchandise sales price. The high-end segment also requires additional personnel, advertising, and other operating costs. ANF’s expense margin is nearly three times higher (58% compared to 20.7%). On balance, TJX is more profitable than ANF with each sales dollar (7.9% vs. 2.2%). b. ($ thousands) Current assets ................. Long-term assets ............. Total assets .....................

ANF $1,335,950 56.0% 1,049,643 44.0% $2,385,593 100.0%

TJX $ 8,469,222 59.1% 5,856,807 40.9% $14,326,029 100.0%

Current liabilities .............. Long-term liabilities .......... Total liabilities .................. Stockholders' equity ......... Total liab. and equity ........

$ 558,917 608,055 1,166,972 1,218,621 $2,385,593

$ 5,531,374 3,746,049 9,277,423 5,048,606 $14,326,029

23.4% 25.5% 48.9% 51.1% 100.0%

38.6% 26.1% 64.8% 35.2% 100.0%

ANF has slightly lower levels of current assets relative to total assets than does TJX. For clothing retailers, current assets are primarily cash and inventories. If the two companies have about the same levels of cash, we would conclude that ANF holds less inventory. This makes sense given that TJX has discount-type stores chock-full of merchandise. c. ANF has a much smaller proportion of total liabilities in its capital structure (48.9% compared to 64.8% at TJX) which might seem to imply that TJX relies more on debt to fund its assets and is therefore riskier. However, TJX has significantly more current liabilities that are low risk because they are typically non-interest bearing and are paid off with sales of inventory and available cash (current assets are greater than current liabilities for both companies). The proportion of long-term liabilities is about the same across the two companies. Because long-term debt bears interest and requires periodic payments of interest and principal, it is riskier than current liabilities. On par, TJX is a slightly riskier company. © Cambridge Business Publishers, 2021 2-12

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E2-34. (15 minutes) a. ($ millions)

Pfizer

Dr. Reddy’s

Sales ..................................... COGS ....................................

$53,647 11,248

100.0% 21.0%

$2,181 1,009

100.0% 46.3%

Gross profit ............................ Total expenses ......................

42,399 31,211

79.0% 58.2%

1,172 1,021

53.7% 46.8%

Net income ............................

$11,188

20.9%

$ 151

6.9%

Dr. Reddy’s COGS is more than twice that of Pfizer (46.3% compared to 21.0%). This is likely due to two factors: first, Pfizer manufactures and sells branded, patented drugs and therapeutics whereas Dr. Reddy’s is a generics and compounding firm. Dr. Reddy’s competition is more intense and Pfizer can premium price its products. Second, Dr. Reddy’s has a larger global footprint, selling in markets where price competition is fierce. b. ($ millions)

Pfizer

Dr. Reddy’s

Current assets ...................... Long-term assets ..................

49,926 109,496

31.3% 68.7%

1,684 1,781

48.6% 51.4%

Total assets ..........................

159,422

100.0%

3,465

100.0%

Current liabilities ................... Long-term liabilities ...............

31,858 63,806

20.0% 40.0%

1,070 453

30.9% 13.1%

Total liabilities ....................... Stockholders' equity ..............

95,664 63,758

60.0% 40.0%

1,523 1,942

44.0% 56.0%

Total liabilities and equity ......

159,422

100.0%

3,465

100.0%

Pfizer holds fewer current assets and liabilities than Dr. Reddy’s and has more liabilities (60% for Pfizer and only 44% for Dr. Reddy’s.) Pfizer has a smaller proportion of stockholders’ equity in its capital structure. A greater proportion of equity is generally viewed as a less risky capital structure. However, Pfizer’s relatively low level of equity arises from the fact that the company has repurchased its stock and retired shares. This decreases retained earnings, a component of equity.

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E2-35. (15 minutes) a. ($ millions)

CMCSA

Sales .................................... Operating costs ....................

$94,507 75,498

100.0% 79.9%

$130,863 108,585

100.0% 83.0%

Operating profit ..................... Nonoperating expenses ........

19,009 7,147

20.1% 7.6%

22,278 6,239

17.0% 4.8%

Net income ...........................

$11,862

12.6%

$ 16,039

12.3%

Verizon’s product lines yield slightly lower operating profit margin than do Comcast’s. Its nonoperating expense, however, is lower than Comcast’s. The operating and nonoperating relative effects offset leaving the two companies with profit margins that are roughly equal. b. ($ millions)

CMCSA

Current assets ....................... Long-term assets ...................

$ 21,848 229,836

8.7% 91.3%

$ 34,636 230,193

13.1% 86.9%

Total assets ...........................

$251,684

100.0%

$264,829

100.0%

Current liabilities .................... Long-term liabilities ................

$ 27,603 151,579

11.0% 60.2%

$ 37,930 172,189

14.3% 65.0%

Total liabilities ........................ Stockholders' equity ............... Total liabilities and equity .......

179,182 72,502 $251,684

71.2% 28.8% 100.0%

210,119 54,710 $264,829

79.3% 20.7% 100.0%

Verizon is larger in both sales and total assets. Both companies are highly capital intensive, with long-term assets accounting for about 90% of total assets. Both companies’ business models necessitate continued investment in long-term assets as they seek to continue to develop their telecom infrastructure. c. The two companies have relatively high debt loads. This is typical for capital-intensive industries like telecom. Given the large level of capital expenditures (CAPEX) that the companies will make over the next decade, and the amount of additional debt that they will have to incur to fund CAPEX, the debt levels will be a continuing financial issue for both companies.

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E2-36. (30 minutes) a. Sales .................................... COGS ................................... Gross profit ........................... Total expenses ..................... Net income ...........................

TJX ($ thousands) $38,972,934 100.0% 27,831,177 71.4% 11,141,757 28.6% 8,081,959 20.7% $ 3,059,798 7.9%

Pfizer ($ millions) $53,647 100.0% 11,248 21.0% 42,399 79.0% 31,211 58.2% $11,188 20.9%

TJX is a value-priced clothing retailer whose main expense is cost of sales. Pfizer brandname products are well differentiated and patent-protected. The difference in their respective business models is clearly evident in the level of gross profit. Pfizer’s gross profit margin percentage is more than 2.5 times greater than TJX’s. This does not imply that Pfizer is a better-managed company. Much of the difference in operating percentages between companies in different industries is related to differences in their respective business models. Pfizer incurs significant expenses for R&D, selling, marketing, and advertising, which contribute to the 58.2% expense margin compared to 20.7% at TJX. b. TJX ($ thousands) Sales ................................................ $38,972,934 Total assets ................................ 14,326,029 Sales / Total assets .......................... 2.72

Pfizer ($ millions) $53,647 159,422 0.34

TJX’s sales are almost three times its total assets. Pfizer’s sales are only one third its total assets. It might be tempting, therefore, to conclude that Pfizer is more capital intensive than TJX. However, significant levels of total assets consist of cash and marketable securities as well as intangible assets acquired when Pfizer bought other pharmaceutical companies. This points to the need to study the financial statements and footnotes more thoroughly before coming to broad conclusions. c. ($ millions) TJX ($ thousands) Total liabilities ........................................ $9,277,423 Stockholders' equity ............................... 5,048,606 Total liabilities / Stockholders' equity ...... 1.84

Pfizer ($ millions) $95,664 63,758 1.50

TJX operates with slightly more debt relative to equity than does Pfizer. Companies with higher proportions of debt are generally viewed as riskier because failure to make required debt payments can have significant negative consequences. Pfizer has high equity because of retained earnings – many years of large profits – but in recent years has repurchased large amounts of its own stock, which depresses equity and inflates the ratios above.

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E2-37. (35 minutes) a. Balance sheet Cash Noncash assets Total liabilities Contributed capital Retained earnings Other equity

+ +

–

– +

–

+ –

–

Statement of cash flows Operating cash flow Investing cash flow Financing cash flow Income statement Revenues Expenses Net income

–

– –

+ –

Statement of stockholders’ equity Contributed capital Retained earnings –

+ + +

+ –

–

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PROBLEMS P2-38. (30 minutes) a. ($ millions) 2018 2017 2016

Current Assets

Long-term Assets

Total Assets

Current Liabilities

Long-term Liabilities

Total Liabilities

Stockholders' Equity

13,709 14,277 11,726

22,791 23,710 21,180

36,500 37,987 32,906

7,244 7,687 6,219

19,408 18,678 16,344

26,652 26,365 22,563

9,848 11,622 10,343

b. The following would not be included among 3M’s current assets: 2. Property plant & equipment 4. Accounts payable 6. Goodwill 7. Accrued expenses c. The following would be included among 3M’s long-term assets: 2. Property, plant & equipment 3. Intangible assets 5. Goodwill

P2-39. (30 minutes) a. Common-sized balance sheet items, such as the allowance for doubtful accounts, express the item as a percentage of total assets. For Community Health Systems this is as follows: Allowance Total assets Common size allowance

2017 $ 3,870 17,450 22.2%

2016 $ 3,773 21,994 17.2%

2015 $ 4,110 26,861 15.3%

The allowance is higher percentage terms in 2017 as compared to both 2016 and 2015. This could indicate that the company is having more difficulty collecting money from its patients. b. Community Health Systems operates hospitals, which typically provide services for indigent and uninsured patients as well as for patients who can pay personally or who have insurance coverage. This means that many services are “charged” to patients but the company has no reasonable expectation of collecting the amount or the entire amount. To verify this idea, analysts would gather information from other hospitals and compute similar ratios and use those as a benchmark to assess Community Health Systems. © Cambridge Business Publishers, 2021 2-17

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c. Common-sized income statement items, such as the bad debt expense, express the item as a percentage of Revenue. For Community Health Systems this is as follows:

Bad debt expense Revenue Common size expense

2017 3,054 18,398 16.6%

2016 2,849 21,275 13.4%

2015 3,168 22,564 14.0%

In 2015, the common-size bad debt expense was 16.6%, which means that for every dollar of revenue, the company recorded nearly 17 cents of bad debt expense. This seems high and the ratio is higher than the prior two years. d. Answer: 3 If Community Health Systems had recorded $500 less of bad debt expense, total expenses would have been lower and thus, the operating loss before tax would have been $500 smaller, or $1,378 loss instead of $1,878 loss. This would have had no effect on cash from operations because bad debt expense is a non-cash item.

P2-40. (50 minutes) a. Facebook’s form 10-K was filed on January 31, 2019 and the company’s fiscal year end was December 31, 2018. The SEC filing is a month after year end because the auditors took a month to complete the audit. b. The company’s mission is “to give people the power to share and make the world more open and connected.” c. The company claims to compete with the following: • Companies that offer products that replicate the full range of capabilities that Facebook provides. For example, Google has integrated social functionality into a number of its products, including search and Android, as well as other, largely regional, social networks that have strong positions in particular countries. •

Companies that develop applications, particularly mobile applications, that provide social or other communications functionality, such as messaging, photo- and video-sharing, and micro-blogging.

•

Companies that provide web- and mobile-based information and entertainment products and services that are designed to engage people and capture time spent on mobile devices and online.

•

Traditional, online, and mobile businesses that provide media for marketers to reach their audiences and/or develop tools and systems for managing and optimizing advertising campaigns.

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d. As of December 31, 2018, Facebook employed approximately 33,587 people. e. Facebook had 1.52 billion daily active users (DAUs) on average in December 2018, an increase of 9% compared to December 2017. f.

Facebook does not include Schedule II. The Form 10-K says, “All schedules have been omitted because they are not required, not applicable, not present in amounts sufficient to require submission of the schedule, or the required information is otherwise included.” This implies that the uncollectible accounts receivable are relatively immaterial, or insubstantial. The balance sheet reports allowance of $229 million, which is immaterial compared to accounts receivable of $7,587 million and total assets of $97,334 million.

g. The company is audited by Ernst & Young out of the San Francisco office.

P2-41. (30 minutes) a.

Company Target ............................... Nike .................................. Harley-Davidson ............... Pfizer ................................

Gross Profit / Sales

Net Income/ Sales

29% 44% 41% 79%

4% 5% 9% 21%

Net Income/ Equity

Liabilities/ Equity

26% 20% 30% 18%

2.65 1.30 5.01 1.50

b. Companies generally realize higher gross profit margins if there is some limit on competition, such as a barrier to entry. This barrier to entry can be legal in nature such as that afforded by a patent; or operational, such as that created by strong brand identity. Pfizer, Nike and Harley all enjoy above-average gross profit margins. Pfizer is a pharmaceutical company that benefits from patents on desirable drugs and therapeutics. Nike and Harley have strong and valuable brands. Nike relies on its advertising campaigns while Harley enjoys its cult following. Target, while a strong brand, sells goods that are difficult to differentiate and the company cannot command the pricing power that the other three companies enjoy. Profit margin (Net income / Sales) is a function of both gross profit margin and expense control. Pfizer’s ratios is the highest of the companies in this sample, resulting from its high gross profit margin and excellent expense control. The other three companies have mid-range profit margin with Target’s being the lowest. Again, Target lacks the ability to differentiate itself and has significant advertising expense.

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c. Harley enjoys the highest return on equity (measured as net income to equity), followed by Target whose equity is relatively low due to recent stock buybacks (which decreases equity). Harley and Nike are premium brands that have effectively differentiated their products and can, therefore, enjoy above-average returns on stockholder investment. d. Harley has the highest proportion of debt in its capital structure because of the HarleyDavidson Financial Services (its loan and lease financing subsidiary). The balance sheets and income statements of Harley’s financial operations are similar to that of a bank – high debt levels and relatively low margins. Harley must consolidate its financial operations with its operating company. This inflates its consolidated debt level above what we typically observe for pure-play manufacturing operations. Finally, Nike and Pfizer have lower levels of fixed assets, which typically require debt financing. Thus their liabilities / equity ratios are relatively low.

P2-42. (30 minutes) a. Company Macy’s Home Depot Best Buy Target Walmart

Net Income / Sales 4.3% 10.3% 3.4% 3.9% 1.3%

Rank 2 1 4 3 5

Home Depot, Macy’s and Target report the highest profit margins. These companies have succeeded at effectively differentiating their brands and/or controlling their costs. Walmart operates in highly competitive markets with undifferentiated product lines and Best Buy products are easily purchased online because product characteristics are known and competition is fierce. b. Company Macy’s Home Depot Inc. Best Buy Target Corp. Walmart Stores

Operating Cash Flow / Sales 6.7% 12.0% 5.6% 7.9% 5.4%

Rank 3 1 4 2 5

Home Depot, Target, and Macy’s report the highest level of operating cash flow as a percentage of sales. These are very efficient operations. Walmart and Best Buy are not as effective on this dimension. The rankings for this ratio are nearly exactly the same as for the net profit margins.

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c. Company Macy’s Home Depot Inc. Best Buy Target Corp. Walmart Stores

Investing Cash Flow / Sales -1.8% -2.2% 1.2% -4.5% -4.7%

Rank 4 3 5 2 1

Investing cash flows are typically negative (cash outflow), representing the purchase of PPE and other long-lived assets including intangible assets and goodwill purchased in a merger or acquisition. The companies’ rankings here, do not correspond with their rankings in parts a and b. Best Buy is not expanding, its cash flow is positive. Walmart and Target are expanding most among the five companies.

P2-43. (45 minutes) a. The largest asset is marketable securities $275.3 billion or 66% of total assets. The smallest asset is inventory, only $4.9 billion or 1.29% of total assets. b. We can see that the company is slightly smaller in 2018 compared to 2017 (total assets of $275.3 billion compared to $265.7 billion). However, the composition of the balance sheet has changed noticeably. The most significant change on the asset side is the decrease in marketable securities both in dollar terms (from $249 billion to $211 billion) and in proportionate terms (from 66% of total assets down to 58%). c. On the liabilities and equity side, changes from 2017 to 2018 were less dramatic. Accounts payable and other liabilities grew proportionately. Earned capital decreased significantly, from 26% to 18% of total assets. The company was profitable but paid out dividends and bought back stock in excess of net income. d. Apple started paying dividends in 2012. Dividends have increased steadily over time but not by the same rate as net income. e. Apple has bought back significant amounts of stock beginning in 2013. In both 2014 and 2018, Apple bought back more stock than it earned in net income. We see that the red part is higher up on the graphic than the black part, in those year. In other years, the proportions were roughly the same. f.

In 2018, retained earnings decreased. The sum of dividends (green) and stock buybacks (red) is greater than net income (black).

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IFRS ASSIGNMENTS I2-44. (15 minutes) a. Income Statement Tesco February 24, 2019 £millions % £ 63,911 100.0% 59,767 93.5% 4,144 6.5% 2,824 4.4% £ 1,320 2.1%

Sales Cost of goods sold Gross profit Total expenses Net income

Carrefour December 31, 2019 €millions % € 77,917 100.0% 60,850 78.1% 17,067 21.9% 17,411 22.3% € (344) -0.4%

Carrefour’s gross profit margin (21.9%) is about three times that of Tesco (6.5%) due to their relatively low cost of goods sold. The difference might be in the type of product each company sells or the product mix. For example Carrefour might sell more specialty, high-end groceries or wines that command a higher margin. But the opposite pattern holds for the total expenses. This could indicate that the companies classify certain expenses differently—Tesco classifies more expenses as COGS. b. Balance Sheet

Current assets Long-term assets Total assets Current liabilities Long-term liabilities Total liabilities Equity Total liabilities and equity

Tesco February 24, 2019 (£ millions) % £12,668 25.8% 36,379 74.2% 49,047 100.0% 20,680 42.2% 13,533 27.6% 34,213 69.8% 14,834 30.2% £49,047 100.0%

Carrefour December 31, 2018 (€millions) % €18,670 39.4% 28,708 60.6% 47,378 100.0% 23,162 48.9% 12,930 27.3% 36,092 76.2% 11,286 23.8% €47,378 100.0%

Tesco holds far less current assets than Carrefour, 25.8% compared to 39.4%. We observe a similar difference for current liabilities, with 42.2% for Tesco and 48.9% for Carrefour. The two companies have about the same level of long-term liabilities. c. Tesco has a greater proportion of stockholders’ equity in its capital structure: 30.2% compared to Carrefour’s 23.8%. A greater proportion of debt is generally viewed as a riskier capital structure. So, on that basis, we would conclude that Carrefour is the riskier company. That said, neither of these companies carries a large percentage of long-term debt. We would conclude that they are both very solvent. © Cambridge Business Publishers, 2021 2-22

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MANAGEMENT APPLICATIONS MA2-45. (25 minutes) a. The cash conversion cycle is the number of days that pass from the time the company pays cash to purchase or manufacture inventory, sells the inventory and ultimately collects the accounts receivable. This period of time is reduced to the extent that suppliers finance a portion of the inventory purchase. Receivables and inventories are costly to maintain. They must be financed (either with borrowed funds or by forgoing investment in other earning assets), collected (with some prospect of loss), stored, insured, and moved. By reducing the amount of investment in these assets, companies can reduce their expenses and their need for external capital. b. A company might reduce its cash conversion cycle by reducing receivables and inventories and by increasing accounts payable. 1. Receivables—managers can reduce receivables by invoking more stringent creditgranting policies. Companies need appropriate policies to decide to whom to extend credit and in what dollar amount. As credit policies become more restrictive, the dollar amount of receivables declines. Managers can also implement more aggressive and or efficient collection practices 2. Inventories—for retailers, inventories are the cost of the goods purchased for resale. For manufacturers, inventory costs include raw materials, and additional labor and overhead costs to convert the goods into salable form. Reducing inventory levels will reduce the cash conversion cycle time. This can happen with more efficient buying (purchasing for actual orders rather than for estimated demand) and with leaner manufacturing processes. 3. Payables—lengthening the time to pay accounts payable (“leaning on the trade”) reduces the cash conversion cycle time because less of the company’s own capital is invested in receivables and inventories. c. Each action described above has implications for the company’s relations with customers and suppliers. 1. Receivables—receivables are a marketing tool, like advertising, product promotions and selling expenses. Tightening a company’s credit policies can adversely affect sales. On the other hand, more restrictive credit policies can reduce collection costs, bad debt expense, and financing costs. Establishing a credit policy and collection procedures involves balancing the competing effects of lost sales with cost savings. continued

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c. 2. Inventories—reducing finished goods inventory levels increases the risk of stock-outs and could result in lost sales. The decision about what depth and breadth of finished goods inventories to carry is as much a marketing decision as it is a financial one. Further, the amount of raw materials and work-in-process inventories on hand affects production efficiency and has financial implications. Inventory management is a delicate process that must be handled with care to balance competing needs. 3. Payables—lengthening the time to pay accounts payable, while reducing the cash conversion cycle, may also damage relations with suppliers. One company’s account payable is another’s account receivable. There is a natural tension between two companies seeking to balance the period of time that the credit is outstanding. Although extending payables is favorable from a financial viewpoint, should supplier relations become strained, the company’s ability to obtain additional products or services may be jeopardized. Policies relating to the payment of suppliers must be handled with care. Working capital management is as much art as it is science. Companies must consider many constituencies in framing the appropriate policies.

MA2-46. (30 minutes) The FASB has traditionally taken the position that accounting standards should reflect the diversity of business models by allowing discretion in their application. Revenue recognition and expense recording is a case in point. a. Following are some pros and cons of drafting more restrictive accounting standards: Pros: 1. “One size fits all” accounting standards simplify the accounting process and make the resulting financial statements easier to interpret. 2. Reducing the discretion available to accountants also reduces the temptation to manage the financial statements to achieve managers’ self-serving objectives. 3. Simplifying accounting standards will reduce complexity of the audit process as well as potential litigation costs because the rules are clear. Cons: 1. Businesses are too complex to use a “one size fits all” standard- setting philosophy. Unique transactions and corporate relations may not lend themselves to classification in a standardized accounting system. 2. Creating “bright line” accounting standards (e.g., standards with numerical guidelines that direct the appropriate accounting treatment, such as the rules regarding recognition of off-balance sheet entities) invites creative managers to structure their deals so as to meet the technical requirements of the standard while violating its intent. 3. Standardizing accounting rules reduces the value added by professional accountants. © Cambridge Business Publishers, 2021 2-24

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b. The “end justifies the means” argument, frequently used in support of earnings management, is flawed on at least two fronts: 1. Earnings management is generally performed to “smooth” earnings fluctuations or to meet earnings targets. Typically the parties benefiting from this action are managers (because their compensation is contingent on meeting targets and because there will be less shareholder dissent when earnings targets are met) and investors long in the stock. Future investors, investors short in the stock, suppliers, lenders, and future employees may all be damaged as a result of the failure to provide timely and accurate financial information. 2. The argument implicitly assumes that managers are more capable of understanding financial reports than other market participants. To be sure, managers have access to information that is not available to the market, but managing financial results to filter what is seen, or not seen, by the market is not the answer. Rather, management should divulge more of its information in an unfiltered form and let the market make its own assessment.

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Module 3 Transactions, Adjustments, and Financial Statements QUESTIONS Q3-1.

The four steps in the accounting cycle are: 1) Record all transactions as they occur. 2) Adjust accounts to reflect events that have occurred but that have not been captured as transactions. 3) Prepare the financial statements. 4) Close the books so that a new accounting cycle can begin with $0 balances in the temporary accounts.

Q3-2.

A journal entry records a transaction in a company’s “general ledger.” A general ledger is the book of original entry for the initial recording of any type of transaction or accounting adjustment. It contains space for dates and for accounts to be debited and credited, columns for the amounts of the debits and credits, and a posting reference column for numbers of the accounts that are posted. Most companies have electronic journals but the basics are the same.

Q3-3.

Posting means including the transaction amount in the affected general ledger accounts. This procedure enables company personnel to trace amounts in the ledger back to the originating journal entry and to determine which entries have been added to the ledger so that account totals are updated.

Q3-4.

1. Prepaid Expenses—Allocating assets to expense to reflect expenses incurred during the period. Example: Recording supplies used by increasing (debiting) Supplies Expense and decreasing (crediting) Supplies or recording depreciation expense and reducing PPE (or increasing accumulated depreciation). 2. Unearned Revenues—Adjusting unearned revenues to recognize only revenues earned during the period. Example: Recording service fees earned by decreasing (debiting) Unearned Service Fees, a liability, and increasing (crediting) Service Fees Earned, an equity account. continued © Cambridge Business Publishers, 2021

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3. Accrued Expenses—Accruing expenses to reflect expenses incurred during the period that are not yet paid or recorded. Example: Recording unpaid wages by increasing (debiting) Wages Expense and increasing (crediting) Wages Payable or recording interest owing on loans. 4. Accrued Revenues – Accruing revenues to reflect revenues earned during the period that are not yet received or invoiced. Example: Recording commissions earned by debiting Commissions Receivable and crediting Commissions Earned. Q3-5.

To adjust the account, we need to move 1/24th of the insurance prepayment from the balance sheet to the income statement to reflect the fact that one month out of 24 has elapsed and the insurance prepayment has been “used up.” The adjustment would be: Jan. 31

Q3-6.

Insurance Expense ......................................................... 79 Prepaid Insurance ............................................... To record insurance expense for January ($1,896 / 24 = $79).

Supplies Expense of $505 must be recorded for the period. This will reduce the asset account and increase the expense account by $505. ($875 + $260 - $630 = $505) a. If the adjustment is not made, Supplies Expense is understated by $505. b. Supplies (asset) and Stockholders’ Equity are both overstated by $505 on the January 31 balance sheet.

Q3-7. Balance Sheet Transaction

Cash Asset

Cash UR

9,768 9,768 (a) Received +9,768 $9,768 cash Cash Cash in advance 9,768 for subscriptions

Noncash Assets

Liabilities

+9,768 Unearned Revenue

-407 Unearned Revenue

Income Statement Contrib. Capital

Earned Capital

Revenues

–

Expenses

–

Net Income

UR 9,768

UR 407 Sales 407 (b) Delivered $407 of UR magazines 407

+407 Retained Earnings

+407 Sales

+407

Sales 407

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Q3-8.

Jan. 1

Cash

9,768

Subscriptions Received in Advance (UR) To record receipt of two-year subscriptions. b.

Q3-9.

Jan. 31

407

Wages Expense Wages Payable To record unpaid wages for Jan. 30–31 ......................... [($950 / 5) 2 = $380].

380 380

On January 31, the interest receivable account and the Interest Income account both should be increased by $720 to reflect the fact that the company has earned interest for one month but not yet received it. The journal entry would be as follows: Jan. 31

Q3-11.

407

Trombley needs to increase wages expense for the month of January by two work days: January 30 and 31 and record an accrued liability. The journal entry to accomplish this is: Jan. 31

Q3-10.

Subscriptions Received in Advance (UR) Subscriptions Revenue To record subscription revenue earned during January ($9,768 / 24 = $407).

9,768

Interest Receivable Interest Income To record interest earned during January.

720 720

All temporary accounts are closed at year-end. They consist of the income statement accounts (expense and revenue accounts) and the dividend account. Step 1)

Close revenue accounts: Debit each revenue account for an amount equal to its balance, and credit retained earnings for the total of revenues.

Step 2)

Close expense accounts: Credit each expense account for an amount equal to its balance, and debit retained earnings for the total of expenses.

Step 3)

Close the dividend account: Credit the dividend account for an amount equal to its balance, and debit retained earnings.

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MINI EXERCISES M3-12. (20 minutes) Balance Sheet Transaction Cash CS

12,000 12,000 June 1. Invested Cash $12,000 cash 12,000

Cash Asset

Noncash Assets

–

Expen= ses

–

+950 = Rent Expense

+6,400 = +6,400 Office Accounts Equipment Payable

–

+3,800 Supplies

–

+4,700 – Service Fees Earned ((Revenue)

+12,000 Cash

-950 Cash

Liabilities

Income Statement

Contrib. + Capital

Earned Capital

+12,000 Common Stock

Revenues

Net Income

CS 12,000

RNTE 950 Cash 950 June 2. Paid $950 cash RNTE for June rent

-950 Retained Earnings

950

-950

Cash 950

PPE AP

6,400 6,400

PPE 6,400 AP 6,400

SUP 3,800 Cash 1,800 AP 2,000 SUP 3,800 Cash 1,800

June 3. Purchased $6,400 of office equipment on credit

June 6. Purchased $3,800 of supplies; $1,800 cash, $2,000 on account

-1,800 Cash

+2,000 Accounts Payable

AP 2,000

4,700 4,700 June 11. $4,700 billed AR for services 4,700

Rev

+4,700 = Accounts Receivable

+4,700 Retained Earnings

Rev 4,700

+4,700

continued

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Table concluded Balance Sheet Transaction Cash AR

3,250 3,250

Cash 3,250

June 17. Collect $3,250 on accounts

Cash Asset

Noncash Assets

Liabilities

Income Statement Contrib. + Capital

Earned Capital

Revenues

–

Expen= ses

–

Net Income

+3,250 Cash

-3,250 = Accounts Receivable

-5,000 Cash

June 25. Paid cash dividend of $900

-900 Cash

-900 Dividends

–

June 30. Paid $350 utilities

-350 Cash

-350 Retained Earnings

–

+350 = Utilities Expense

-350

-2,500 Cash

-2,500 Retained Earnings

– +2,500 = Wages Expense

-2,500

AR 3,250

5,000 Cash 5,000 June 19. Paid $5,000 AP on office 5,000 equipment account

-5,000 Accounts Payable

Cash 5,000

DIV Cash

900 900

DIV 900 Cash 900

UTE Cash

350 350

UTE 350 Cash 350

WE 2,500 Cash 2,500 June 30. Paid $2,500 WE wages 2,500 Cash 2,500

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M3-13. (30 minutes) June

Cash Common stock Owner invested cash for stock.

12,000 12,000

Rent expense Cash Paid June rent.

950 950

Office equipment Accounts payable Purchased office equipment on account.

6,400

Supplies Cash Accounts payable Purchased $3,800 of supplies; paid $1,800 cash with balance due in 30 days.

3,800

Accounts receivable Service fees earned Billed clients for services.

4,700

Cash Accounts receivable Collections from clients on account.

3,250

Accounts payable Cash Payment on account.

5,000

6,400

1,800 2,000

4,700

3,250

5,000

Dividends Cash Paid dividends.

900

Utilities expense Cash Paid utilities bill for June.

350

900

350

Wages expense Cash Paid wages for June.

2,500 2,500

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June 1 17

Cash 12,000 950 3,250 1,800 5,000 900 350 2,500

June 2 6 19 25 30 30

June 6

Supplies 3,800

June 3

Office Equipment 6,400

Accounts Receivable June 11 4,700 3,250

June 17

June 19

Common Stock 12,000

June 1

June 25

Dividends 900

June 2

Rent Expense 950

June 30

Utilities Expense 350

Service Fees Earned 4,700

June 30

Wages Expense 2,500

June 11

Accounts Payable 5,000 6,400 2,000

June 3 June 6

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M3-14. (40 minutes) Balance Sheet Transaction Cash CS

9,000 9,000

Cash 9,000

Cash Asset

Noncash Assets

April 1. Invested $9,000 in cash

+9,000 Cash

April 2. Paid $2,850 cash for lease

-2,850 Cash

+2,850 = Prepaid Van Lease

April 3. Borrow $10,000

+10,000 Cash

April 4. Purchase $5,500 equipment for $2,500 cash with rest on account

April 5. Paid $4,300 cash for supplies

Liabilities

Income Statement Contrib. + Capital

+9,000 Common Stock

Earned Capital

Revenues

–

Expenses

–

+10,000 Notes Payable

–

-2,500 Cash

+5,500 = +3,000 Equipment Accounts Payable

–

-4,300 Cash

+4,300 Supplies

–

Net Income

CS 9,000

PPRNT 2,850 Cash 2,850 PPRNT 2,850 Cash 2,850

Cash NP

10,000 10,000

Cash 10,000 NP 10,000

PPE 5,500 Cash 2,500 AP 3,000 PPE 5,500 Cash 2,500 AP 3,000

SUP 4,300 Cash 4,300 SUP 4,300

Cash 4,300

continued

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Table concluded Balance Sheet

AE 350 Cash AE 350

Transaction

Cash Asset

350 April 7. Paid $350 cash for ad.

-350 Cash

Noncash Assets

Liabilities

Income Statement Contrib. + Capital

Earned Capital

Revenues

Expenses

–

Net Income

-350 Retained Earnings

–

+350 = Advertising Expense

-350

+3,500 = Accounts Receivable

+3,500 Retained Earnings

+3,500 – Cleaning Fees Earned (Revenue)

+3,500

–

Cash 350

AR Rev

3,500 3,500 April 21. Billed $3,500 AR for services 3,500 Rev 3,500

AP 3,000 Cash 3,000 April 23. Paid $3,000 AP cash on 3,000 account Cash 3,000 Cash AR

2,300 2,300 April 28. Collect Cash $2,300 on 2,300 account AR 2,300

DIV 1,000 Cash 1,000 April 29. Paid $1,000 DIV cash dividend 1,000

-3,000 Cash

-3,000 Accounts Payable

+2,300 Cash

-2,300 = Accounts Receivable

-1,000 Cash

-1,000 Dividends

–

-2,750 Cash

-2,750 Retained Earnings

–

+2,750 Wages Expense

-995 Cash

-995 Retained Earnings

–

+995 = Van Fuel Expense

Cash 1,000

WE 2,750 Cash 2,750 April 30. Paid $2,750 WE cash for 2,750 wages

= -2,750

Cash 2,750

OE 995 Cash 995 OE 995

April 30. Paid $995 cash for gas

Cash 995

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M3-15. (30 minutes) April

Cash Common stock Owner invested cash for stock.

9,000

Prepaid van lease Cash Paid six months' lease on van.

2,850

Cash Notes payable Borrowed money from bank for one year; interest rate is 10%.

10,000

Equipment Cash Accounts payable Purchased $5,500 of equipment; paid $2,500 cash with balance due in 30 days.

5,500

Supplies Cash Purchased supplies for cash.

4,300

9,000

2,850

10,000

2,500 3,000

4,300

Advertising expense Cash Paid for April advertising.

350

21 Accounts receivable Cleaning fees earned Billed customers for services.

3,500

23 Accounts payable Cash Payment on account.

3,000

28 Cash Accounts receivable Collections from customers on account.

2,300

29 Dividends Cash Paid cash dividends.

1,000

30 Wages expense Cash Paid wages for April.

2,750

350

3,500

3,000

2,300

1,000

2,750

30 Van fuel expense Cash Paid for gasoline used in April.

995 995

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April 1 3 28

Cash 9,000 2,850 10,000 2,500 2,300 4,300 350 3,000 1,000 2,750 995

April 2 4 5 7 23 29 30 30

April 21

Accounts Receivable 3,500 2,300

April 2

Prepaid Van Lease 2,850

April 4

Equipment 5,500

April 5

Supplies 4,300

Notes Payable 10,000

April 23

Accounts Payable 3,000 3,000

Dividends 1,000

Common Stock 9,000

April 7

Advertising Expense 350

April 30

Van Fuel Expense 995

April 4

April 29

Cleaning Fees Earned 3,500

April 1

April 28

April 3

April 21

Wages Expense 2,750

April 30

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M3-16. (10 minutes) a. Balance Sheet Transaction Cash UR

26,100 26,100 Received $26,100 in Cash advance for contract work 26,100

Cash Asset

Noncash = Assets

+26,100 Cash

Liabilities

Income Statement Contrib. + Capital

Earned Capital

Revenues

= +26,100 Unearned Revenue

–

Expen= ses

–

Net Income

UR 26,100

b. Balance Sheet Transaction UR Rev

4,350 4,350

UR 4,350

Cash Asset

Noncash = Assets

Adjusting entry for work completed by Jan. 31*

Liabilities

Contrib. + Capital

-4,350 Unearned Revenue

Income Statement Earned Capital

Revenues

–

Expenses

Net Income

+4,350 +4,350 – Retained Revenue Earnings

= +4,350

Rev 4,350

* $26,100/6 = $4,350

c. Balance Sheet Transaction AR Rev

570 570

AR 570

Adjusting entry for fees earned but not billed

Cash Asset

Noncash Assets

LiabilContrib. + + ities Capital

+570 = Fees Receivable

Income Statement Earned Capital

Revenues

Net Income

– Expen-ses =

+570 +570 – Retained Revenue Earnings

+570

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Rev 570

* $19 per hour × 30 hours = $570

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M3-17. (10 minutes) Jan.

Jan.

1 Cash Unearned service fees To record cash received for service fees.

26,100

31 Unearned service fees Service fees earned To reflect January service fees earned on contract ($26,100/6 = $4,350).

4,350

31 Fees receivable Service fees earned To record unbilled service fees earned at January 31 ($19 × 30 = $570).

570

26,100

4,350

570

M3-18. (25 minutes) a. Balance Sheet Transaction INSE PPI

135 135

INSE 135

Cash Asset

Noncash Assets

Adjusting entry for prepaid insurance

Liabilities

Contrib. + Capital

-135 = Prepaid Insurance

Income Statement Earned Capital

Revenues

-135 Retained Earnings

– –

Expenses

+135 = Insurance Expense

Net Income -135

PPI 135

b. Balance Sheet Transaction SUPE 830 SUP 830 SUPE 830

Adjusting entry for supplies used

Cash Asset

Noncash Assets -830 Supplies

LiabilContrib. + + ities Capital

Income Statement Earned Capital -830 Retained Earnings

Revenues

– –

Expen= ses

Net Income

+830 = Supplies Expense

-830

SUP 830

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c. Balance Sheet Transaction DE AD

65 65 DE 65

Cash Asset

Adjusting entry for equipment depreciation

Noncash Assets

Liabilities

Contrib. + Capital

-65 = Accum. Depreciation

Income Statement Earned Capital

Revenues

Expenses

–

-65 Retained Earnings

–

Net Income

+65 = Depreciation Expense

-65

AD 65

d. Balance Sheet Transaction UR Rev

Cash Asset

Noncash Assets

Liabilities

Contrib. + Capital

Income Statement Earned Capital

Revenues

–

Expen= ses

Net Income

–

+925

925

UR 925

925 Adjusting entry for rent revenue earned

-925 Unearned Rent Revenue

+925 +925 Retained Rent Earnings Revenue

Rev 925

e. Balance Sheet Transaction SE SP

Cash Asset

Noncash Assets

Liabilities

Contrib. + Capital

Income Statement Earned Rev-enues – Capital

Expen= ses

Net Income

-490 Retained Earnings

+490 = Salaries Expense

-490

490 SE 490

490 Adjusting entry for accrued salaries

+490 Salaries Payable

–

SP 490

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M3-19. (25 minutes) Jan.

Jan.

31 Insurance Expense Prepaid Insurance To record January insurance expense ($3,240/24 = $135).

135

31 Supplies Expense Supplies To record January supplies expense ($1,540−$710 = $830).

830

31 Depreciation Expense—Office Equipment ................................ Accumulated Depreciation—Office Equipment ................ To record January depreciation on office equipment ($6,240 / 96 = $65).

31 Unearned Rent Revenue Rent Revenue To record portion of advance rent earned in January.

925

31 Salaries Expense Salaries Payable To accrue salaries at January 31.

490

135

830

925

490

M3-20. (25 minutes) a. Balance Sheet Transaction INV 909,380 AP 909,380 INV 909,380

Cash Asset

Inventory purchased on account (credit purchases)

Noncash Assets +909,380 Inventory

Liabilities

Income Statement Contrib. + Capital

Earned Capital

Revenues

= +909,380 Accounts Payable

–

Expen= ses

–

Net Income

AP 909,380

b. $212,731 + $909,380 – $251,657 = Payments = $870,454. This is the amount in cash payments derived using the information in the Accounts Payable account and the purchases provided in the problem. c. Balance Sheet Transaction COGS INV

908,404 908,404 To record cost of goods sold for COGS the year

Cash Asset

Noncash Assets -908,404 Inventory

Liabilities

Contrib. Capital

908,404

Income Statement +

Earned Capital -908,404 Retained Earnings

Revenues

– –

Expenses

Net Income

+908,404 = -908,404 COGS*

INV 908,404

$123,895 + $909,380 – $124,871 = COGS = $908,404

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M3-21. (15 minutes) a. Various dates Inventories ........................................................................................ 909,380 Accounts payable ....................................................................... To record total purchases made during the year.

909,380

b. Various dates Accounts payable ............................................................................. 870,454 Cash ........................................................................................... To record total payments made to suppliers during the year.

870,454

c. Various dates Cost of goods sold (COGS) .............................................................. 908,404 Inventories .................................................................................. To record cost of goods sold during the year.

908,404

M3-22. (15 minutes) LEUZ ARCHITECT SERVICES Statement of Stockholders’ Equity For Year Ended December 31, 2020 Common Stock Balance at December 31, 2019 .................... $30,000 Stock issuance ...........................................

Retained Earnings $18,000

6,000

Total Stockholders’ Equity $48,000 6,000

Dividends ...................................................

(9,700)

Net income ................................................. ______

27,900

Balance at December 31, 2020 .................... $36,000

$36,200

$72,200

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M3-23. (20 minutes) ($ millions) Date 1. June 30

2. June 30

Description

Debit

Net sales Retained earnings To close the revenue account.

4,036,701

Retained Earnings Cost of sales SG&A expense and other Interest expense, net Income tax expense To close the expense accounts.

3,234,436

Credit

4,036,701

1,447,369 1,019,025 114,376 653,666

The balance of Retained Earnings after the closing entries above are posted (but before dividends and other items that close to Retained Earnings) is a $1,650,722 credit (normal) balance calculated as: $848,457 + $4,036,701 - $3,234,436. Net Sales (1) June 30

4,036,701

Retained Earnings

4,036,701 0

Bal. Bal.

Cost of Sales 1,447,369 1,447,369 0

Bal Bal.

Interest Expense, net 114,376 114,376 0

Bal. Bal.

(2) June 30

3,234,436

848,457 4,036,701 1,650,722

Bal. (1) June 30 Bal June 30

Bal. Bal.

SG&A Expense 1,019,025 1,019,025 0

(2) June 30

Bal. Bal.

Income Tax Expense 653,666 653,666 0

(2) June 30

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M3-24. (20 minutes) a. Balance Sheet Transaction INV AP

49,569 49,569

Cash Asset

Purchase of inventory on account

INV 49,569

Noncash = Assets

Liabilities

Contrib. + Capital

Income Statement Earned Capital

Revenues

+49,569 = +49,569 Inventory Accounts Payable

–

Expen= ses

–

Net Income

AP 59,569

b. Payments to suppliers during the year totaled $49,060. This is calculated using the accounts payable balances and the purchases from part a. as follows: $5,124 + $49,569 – $5,633 = $49,060. c. Balance Sheet Transaction COGS 49,022 INV 49,022

Record cost of goods sold for the year

COGS 49,022

Cash + Asset

Noncash Assets -49,022 Inventory

LiabilContrib. + + ities Capital

Income Statement Earned Capital -49,022 Retained Earnings

Revenues

– –

Expen= ses

Net Income

+49,022 = COGS*

-49,022

INV 49,022

*We calculate COGS using the information in the inventory account and the purchases, given. $8,911 + $49,569 - $9,458 = $49,022.

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M3-25. (20 minutes) 1. Dec. 31

2. Dec. 31

(1)

Service fees earned Retained earnings To close the revenue account.

80,300

Retained earnings Rent expense Salaries expense Supplies expense Depreciation expense To close the expense accounts.

85,300

Service Fees Earned 80,300 80,300 0

Bal. Bal.

Rent Expense 20,800 20,800 0

Bal. Bal.

Supplies Expense 5,600 5,600 0

Bal. Bal.

(2)

80,300

20,800 48,700 5,600 10,200

(2)

Retained Earnings 67,000 85,300 80,300 62,000

Bal. (1) Bal.

Bal. Bal.

Salaries Expense 48,700 48,700 0

(2)

Bal. Bal.

Depreciation Expense 10,200 10,200 0

(2)

After the accounts are closed, the balance in Retained Earnings is $62,000.

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M3-26. (20 minutes) a. Net income computation Service revenue (record when earned) ................................ $200,000 Wages expense (record when incurred, even if unpaid) ................. (40,000) ($25,000 + $15,000) Net income ..................................................................................... $160,000 b. Net cash flow computation Cash inflow from services rendered ................................................ $50,000 ($30,000 + $20,000) Cash outflow for wages paid ........................................................... (25,000) Net cash inflow ............................................................................... $25,000 Cash inflow from services rendered will be $150,000 less than service revenue per the income statement because Penno only collected $50,000 of revenues in cash but reported $200,000 as revenue. Cash outflow for wages paid will be $15,000 less than wages expense on the income statement because $15,000 remained unpaid at yearend. The combined effects of these two items yields an overall difference of $135,000 between net income and net cash inflow [$160,000 net income and $25,000 net cash inflows].

M3-27. (15 minutes)

Revenues ........................................................................... Expenses ........................................................................... Net income .........................................................................

2019 $350,000 225,000 $125,000

2020 $ 0 0 $ 0

Explanation: All of the revenue is reported in 2019 when it is earned—per the revenue recognition principle. Likewise, the wages expense is reported in 2020 when it is incurred, that is when the liability to pay the wages arises. The receipt or payment of cash does not affect the recording of revenues, expenses, and net income. There are no revenues or expenses in 2020.

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M3-28. (20 minutes) Balance Sheet Transaction Cash CS

1,000 1,000

Cash 1,000

Cash Asset

a. Issue stock for $1,000 cash

+1,000 Cash

b. Purchase inventory for $500 cash

-500 Cash

Noncash Assets

Liabilities

Income Statement Contrib. Capital

Earned Capital

+1,000 Common Stock

Revenues

–

Expenses

Net Income

–

CS 1,000

INV 500 Cash 500

INV 500

+500 Inventory

Cash 500 AR 3,000 Sales 3,000 COGS 500 INV 500 AR 3,000

c. Sell inventory in transaction b for $3,000 on credit

+3,000 = Accounts Receivable

+2,500 +3,000 – +500 = Retained Sales Cost of Earnings Goods Sold

+2,500

-500 Inventory

Sales 3,000 COGS 500 INV 500

Cash AR

2,000 2,000

Cash 2,000 AR 2,000

d. Receive $2,000 on account receivable in transaction c

+2,000 Cash

-2,000 = Accounts Receivable

–

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EXERCISES E3-29. (30 minutes) Balance Sheet Transaction DE AD

720 720

DE 720

Cash Asset

a. Adjusting entry for depreciation of equipment

Noncash Assets

Liabilities

Income Statement

Contrib. + Capital

Earned Capital

Revenues

–

Expen= ses

Net Income

-720 Accum. Depreciation

-720 Retained Earnings

–

+720 = Depreciation Expense

-720

-2,770 Supplies

-2,770 Retained Earnings

–

+2,770 = Supplies Expense

-2,770

-430 Retained Earnings

–

+430 = Utilities Expense

-430

-800 Retained Earnings

–

+800 = Rent Expense

-800

+1,404

+965 = Wages Expense

-965

AD 720

SUPE SUP

2,770 2,770 b. Adjusting entry for SUPE supplies 2,770 expense SUP 2,770

UE UP UE 430

430 430 c. Adjusting entry for utilities expense

+430 Utilities Payable

UP 430

RNTE 800 PPRNT 800 d. Adjusting entry for rent RNTE expense 800

-800 Prepaid Rent

PPRNT 800

UR Rev

1,404 1,404 e. Adjusting entry for UR premium 1,404 revenues

-1,404 Unearned Premium Revenue

+1,404 +1,404 – Retained Premium Earnings Revenue

+965 Wages Payable

-965 Retained Earnings

Rev 1,404

WE WP

965 965

WE 965

Adjusting entry for wages expense

–

WP 965

continued

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Table concluded Balance Sheet Transaction AR OI

300 300 g. Adjusting entry for AR 300 interest earned

Cash Asset

Noncash Assets

Liabilities

Income Statement

Contrib. + Capital

+300 = Interest Receivable

OI 300

Earned Capital

Revenues

+300 +300 Retained Interest Earnings (Other) Income

–

Expen= ses

Net Income

–

+300

E3-30. (30 minutes) a. Depreciation Expense—Equipment .................................................. Accumulated Depreciation—Equipment .................................. To record depreciation for the period.

720 720

b. Supplies Expense ............................................................................. 2,770 Supplies ................................................................................... To record supplies expense for the period ($3,870−$1,100 = $2,770). c. Utilities Expense ............................................................................... Utilities Payable ....................................................................... To record accrued utilities expense.

430

d. Rent Expense ................................................................................... Prepaid Rent ............................................................................ To record rent expense for the month ($3,200 / 4 = $800).

800

e. Unearned Revenue........................................................................... Revenue .................................................................................. To record premium revenue earned [($1,872/ 12)9 = $1,404].

1,404

Wages Expense ............................................................................... Wages Payable ....................................................................... To accrue wages at the end of the period.

965

g. Interest Receivable ........................................................................... Interest Income ........................................................................ To accrue interest earned but not yet received.

300

2,770

430

800

1,404

965

300

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E3-31. (15 minutes) a. Balance Sheet Transaction SE SP

4,700 4,700

SE 4,700

Cash Asset

Noncash = Assets

Adjusting entry for salaries owed at December 31

Liabilities

Income Statement

Contrib. + Capital

Earned Capital

= +4,700 Salaries Payable

Revenues

-4,700 Retained Earnings

Expen= ses

Net Income

– +4,700 = Salaries Expense

-4,700

–

SP 4,700

b. Balance Sheet Transaction

Cash Asset

SE 10,300 SP 4,700 Record Cash 15,000 salaries paid SE on January 9

-15,000 Cash

Noncash = Assets

10,300

Liabilities

Income Statement

Contrib. + Capital

= -4,700 Salaries Payable

Earned Capital -10,300 Retained Earnings

Revenues

Expen= ses

Net Income

– +10,300 = Salaries Expense

-10,300

–

SP 4,700 Cash 15,000

E3-32. (15 minutes) Dec.

Dec.

Salaries Expense Salaries Payable To record accrued salaries payable.

4,700 4,700

Retained Earnings Salaries Expense To close the Salaries Expense account.

390,000 390,000*

*Oakmont pays every two weeks, there are 26 such two-week periods per year. If Oakmont pays $15,000 every two weeks, total for the year is $15,000 × 26 = $390,000.

Following year: Jan.

Salaries Payable Salaries Expense Cash To record payment of salaries.

4,700 10,300 15,000

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E3-33. (15 minutes) a. Balance, January 1 = $960 + $900− $620 = $1,240. b. Amount of premium = $82  12 = $984. Therefore, five months' premium ($984− $574 = $410) has expired by January 31. The policy term began on September 1 of the previous year. c. Wages paid in January = $3,200− $700 = $2,500. d. Monthly depreciation expense = $8,700 / 60 months = $145. Bloomfield has owned the truck for 18 months ($2,610 / $145 = 18).

E3-34. (25 minutes) Balance Sheet Transaction

Cash Asset

RNTE 575 PPRNT 575 a. 7/31 Adjusting RNTE entry for 575 rent expense

Noncash Assets

Liabilities

Income Statement Contrib. + Capital

Earned Capital

Revenues

– Expen-ses =

Net Income

- 575 Prepaid Rent

-575 Retained Earnings

–

+575 = Rent Expense

-575

- 210 Prepaid Advertising

-210 Retained Earnings

–

+210 = Advertising Expense

-210

-1,900 Supplies

-1,900 Retained Earnings

–

+1,900 Supplies Expense

-1,900

+800 Fees (Accounts) Receivable

+800 +800 – Retained Refinish. Earnings Fees Revenue

+800

+300 +300 – Retained Refinish. Earnings Fees Revenue

+300

PPRNT 575

AE 210 PPDA 210 AE 210 PPDA 210

b. 7/31 Adjusting entry for advertising expense

SUPE SUP

1,900 1,900 c. 7/31 Adjusting SUPE entry for 1,900 supplies expense SUP 1,900

AR Rev

800 800

d. 7/31 Adjusting entry for fees revenue

300

e. 7/31 Adjusting entry for fees revenue

AR 800 Rev 800

UR Rev

300

UR 300 Rev 300

-300 Unearned Refinish. Fees

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E3-35. (25 minutes) a. July 31

b. July 31

c. July 31

d. July 31

e. July 31

Rent expense Prepaid rent To record July rent expense ($6,900 / 12 = $575).

575

Advertising expense Prepaid advertising To record July advertising expense ($630 / 3 = $210).

210

Supplies expense Supplies To record supplies expense for July ($3,000 −$1,100 = $1,900).

1,900 1,900

800

Unearned refinishing fees Refinishing fees revenue To record portion of advance fees earned in July ($600 / 2=$300).

300

Bal. Bal.

Prepaid Advertising 630 210 420

Bal. Bal.

Supplies 3,000 1,900 1,100

(e)

210

Fees receivable (Accounts receivable) Refinishing fees revenue To record unbilled revenue earned during July.

Prepaid Rent 6,900 575 6,325

(d)

575

(a)

(b)

(c)

(a)

Rent Expense 575

(b)

Advertising Expense 210

(c)

Supplies Expense 1,900

Fees Receivable 800

Unearned Refinishing Fees 300 600 300

800

300

Refinishing Fees Revenue 2,500 800 300 3,600

Bal. (d) (e) Bal.

Bal. Bal.

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E3-36. (15 minutes) a. We calculate COGS using the opening and closing inventory balances and the purchases during 2013, as follows: $1,997 + $10,392 - $2,131 = $10,258. Balance Sheet

COGS 10,258 INV 10,258 COGS 10,258

Transaction

Cash Noncash + = Asset Assets

Record cost of goods sold

-10,258 = Inventory

Income Statement

LiabilContrib. + + ities Capital

Earned Capital

Revenues

-10,258 Retained Earnings

– –

Expen -ses +10,258 COGS

Net Income

-10,258

INV 10,258

b. We calculate cash paid to suppliers using the opening and closing accounts payable balances and the inventory purchases during the year, as follows: $1,181 + $10,392– $1,126 = $10,447. Balance Sheet

AP 10,447 Cash 10,447 AP 10,447

Transaction

Cash Asset +

Record cash paid to suppliers

-10,447 Cash

Noncash Assets

= =

Liabilities

Income Statement Contrib. + Capital

Earned Capital

-10,447 Accounts Payable

Revenues

–

Expen= ses

–

Net Income

Cash 10,447

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E3-37. (10 minutes) Various dates Cost of goods sold

10,258*

Inventory

10,258

To recognize the cost of goods sold *$1,997 + $10,392 - $2,131 = $10,258

Various dates Accounts payable

10,447**

Cash

10,447

To record cash paid to suppliers. **$1,181 + $10,392– $1,126 = $10,447

E3-38. (20 minutes) 1. Feb. 2

2. Feb. 2

(2)

Net sales Retained earnings To close the revenue accounts.

16,580

Retained earnings Cost of goods sold Operating expenses Interest expense, net Income tax expense To close the expense accounts.

15,577

Retained Earnings 3,081 15,577 16,580 4,084

Bal. Bal.

Cost of Goods Sold 10,258 10,258 0

Bal. Bal.

Operating Expenses 4,960 4,960 0

Bal. (1) Bal.

(2)

16,580

10,258 4,960 40 319

Net Sales 16,580 16,580 0

(1)

Bal. Bal.

Interest Expense, Net 40 40 0

(2)

Bal. Bal.

Income Tax Expense 319 319 0

(2)

After the temporary accounts are closed, the balance in the Retained Earnings account is $4,084 ($3,081 + $16,580 - $15,577). © Cambridge Business Publishers, 2021 3-28

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E3-39 (20 minutes) a. Balance Sheet Transaction Cash 3,268 UR 3,268 Cash 3,268

Record cash received for membership fees

Cash Asset

Noncash = Assets

+3,268 Cash

Liabilities

Income Statement +

Contrib. + Capital

Earned Capital

Revenues

+3,268 Deferred Membership Income

–

Expen= ses

–

Net Income

UR 3,268

b. Balance Sheet Transaction

Cash Asset

COGS INV

123,152 123,152 Recognize cost of goods sold COGS 123,152

Noncash Assets -123,152 Inventory

Liabilities

Income Statement Contrib. + Capital

Earned Capital

Revenues

-123,152 Retained Earnings

–

Expen -ses

Net Income

– +123,152 = -123,152 Cost of Goods Sold

INV 123,152

c. We can calculate the inventory purchases using the opening and closing balances from the inventory account and the COGS during the year, as follows: $123,152 - $11,040 + $9,834 = $124,358 Balance Sheet Transaction INV AP

124,358 124,358

INV 124,358

Record inventory purchases

Cash Asset

Noncash Assets +124,358 Inventory

= =

Liabilities

Income Statement Contrib. + Capital

+124,358 Accounts Payable

Earned Capital

Revenues

–

Expenses

–

Net Income

AP 102,962

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E3-40. (20 minutes) a. Cash ............................................................................................... 3,268 Deferred membership income .............................................. To record cash received for membership fees during the year.

3,268

b. Cost of goods sold .......................................................................... 123,152 Inventory ............................................................................. To recognize the cost of goods sold.

123,152

c. Inventory .........................................................................................124,358 Accounts payable ................................................................ To record inventory purchases during the year $123,152 - $11,040 + $9,834 = $124,358.

124,358

E3-41. (40 minutes) a. BENEISH CORPORATION Income Statement For Year Ended December 31 Service fees earned ............................................................................................... $75,000 Rent expense ........................................................................................................ (18,000) Salaries expense ................................................................................................ (37,100) Depreciation expense ............................................................................................ (7,000) Net income ............................................................................................................$12,900 BENEISH CORPORATION Statement of Stockholders’ Equity For Year Ended December 31 Common Stock Balance at January 1 ................................ $43,000 Stock issuance .......................................... Dividends .................................................. Net income ................................................ Balance at December 31 ............................. $43,000

Retained Earnings $20,600

Total Stockholders’ Equity $63,600

(8,000) 12,900 $25,500

(8,000) 12,900 $68,500

continued

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continued BENEISH CORPORATION Balance Sheet December 31 Cash ...................................... $ 8,000 Notes payable ....................... $10,000 Accounts receivable ............... 6,500 Total liabilities ....................... 10,000 Equipment, gross ................... 78,000 Accumulated depreciation ...... (14,000) Common stock ...................... 43,000 Equipment, net ...................... 64,000 Retained earnings ................. 25,500 Total assets ........................... $78,500 Total liabilities and equity ...... $78,500

b. 1. 2. 3. 4. 5.

Service fees earned ................................................................ 75,000 Retained earnings ..............................................................

75,000

Retained earnings ................................................................ 18,000 Rent expense ................................................................

18,000

Retained earnings ................................................................ 37,100 Salaries expense ................................................................

37,100

Retained earnings ................................................................ 7,000 Depreciation expense .........................................................

7,000

Retained earnings ................................................................ 8,000 Dividends ................................................................

8,000

c. Note: Only those accounts affected by the closing process are shown here.

(2) (3) (4) (5)

Retained Earnings 20,600 18,000 75,000 37,100 7,000 8,000 25,500

Bal. Bal

Depreciation Expense 7,000 7,000 0

Bal. Bal.

Salaries Expense 37,100 37,100 0

Bal. (1)

Bal.

(4)

(1)

Service Fees Earned 75,000 75,000 0

Bal. Bal.

Bal. Bal

Rent Expense 18,000 18,000 0

(2)

Bal. Bal.

Dividends 8,000 8,000 0

(5)

(3)

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E3-42. (35 minutes) Balance Sheet Transaction Cash 100,000 PPE, net 20,000 a CS 120,000 Cash 100,000 PPE, net 20,000

Issued stock for $100,000 cash and PPE of $20,000.

Cash Asset

Noncash Assets

+100,000 Cash

+20,000 PPE, net

= =

Liabilities

Income Statement Contrib. Capital

Earned Capital

+120,000 Common Stock

Revenues

–

ExpenNet = ses Income

–

CS 120,000 RNTE 3,200 Cash 3,200 RNTE 3,200

b Paid $3,200 for rent.

-3,200 Cash

-3,200 Retained Earnings

–

+3,200 = Rent Expense

-3,200

c. Performed services for $4,000 cash.

+4,000 Cash

+4,000 +4,000 – Retained Revenue Earnings

+4,000

+24,000 = Accounts Receivable

+24,000 +24,000 – Retained Revenue Earnings

= +24,000

Cash 3,200

Cash 4,000 Rev 4,000 Cash 4,000 Rev 4,000

AR 24,000 Rev 24,000 AR 24,000 Rev 24,000

WE 4,800 Cash 4,800 WE 4,800 Cash 4,800

Cash AR

d. Performed services for $24,000 on account. e. Paid $4,800 cash for wages.

10,000 10,000 f. Cash 10,000 AR 10,000

RE 935 Cash 935 RE 935

Received $10,000 cash on receivable.

g. Paid dividends of $935.

-4,800 Cash

+10,000 Cash

-10,000 = Accounts Receivable

-935 Cash

-4,800 Retained Earnings

-935 Retained Earnings

–

+4,800 = Wages Expense

–

Cash 935

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E3-43. (20 minutes) CARTER COMPANY Income Statement For Month Ended March 31 Sales revenue ................................................................ Expenses ................................................................ Rent expense ................................................................ $3,200 Wage expense ................................................................ 4,800 Net income ................................................................

E3-44.

$28,000 ($4,000 + $24,000)

8,000 $20,000

(20 minutes) Balance Sheet Transaction

WE WP

Cash Asset

Noncash Assets

500 500 a. $500 of

WE 500 WP 500

INV AP

AP 2,000

inventory is purchased on credit

AR 4,000 Sales 4 ,000 c. The inventory COGS 2,000 purchased in INV 2,000 AR 4,000 Sales 4,000

transaction b is sold for $4,000 on credit

+2,000 Inventory

Liabilities

+500 Wages Payable

+2,000 Accounts Payable

wages are earned by employees but not yet paid

2,000 2,000 b. $2,000 of

INV 2,000

Income Statement Contrib. Capital

+4,000 = Accounts Receivable

Earned Capital

Revenues

-500 Retained Earnings

+2,000 +4,000 Retained Sales Earnings

– Expen-ses =

Net Income

–

+500 = Wages Expense

-500

–

+2,000 Cost of Goods Sold

= +2,000

-2,000 Inventory

COGS 2,000 INV 2,000

continued

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Table continued Balance Sheet Transaction

Cash AR

3,000 3,000 Cash 3,000

Cash Asset

d. Collected +3,000 $3,000 cash Cash from transaction c.

Noncash Assets

Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

–

Expenses

-3,000 = Accounts Receivable

–

+5,000 PPE, net

–

Net Income

AR 3,000

PPE, net 5,000 Cash 5,000 PPE, net 5,000

e. $5,000 equipment is acquired for cash

-5,000 Cash

Cash 5,000

DE 1,000 f. Record PPE, net 1,000 depreciation DE 1,000

-1,000 = PPE, net

-1,000 Retained Earnings

–

+1,000 Depreciation Expense

-1,000

PPE,net 1,000

NP 10,000 Cash 10,000 NP 10,000

g. Paid -10,000 $10,000 Cash cash on a note payable that came due

= -10,000 Note Payable

h. Paid $2,000 -2,000 cash interest Cash on borrowings

–

Cash 10,000

IE 2,000 Cash 2,000 IE 2,000

-2,000 Retained Earnings

–

+2,000 Interest Expense

-2,000

Cash 2,000

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PROBLEMS P3-45 (40 minutes) Balance Sheet Transaction SE SP

1,440 1,440

SE 1,440

Cash Asset

Noncash Assets

1. Accrue salaries expense

Liabilities

Contrib. + Capital

= +1,440 Salaries Payable

Income Statement Earned Capital

Revenues

–

Expenses

Net Income

-1,440 Retained Earnings

–

+1,440 = Salaries Expense

-1,440

-200 Retained Earnings

–

+200 = Interest Expense

-200

+900

SP 1,440

IE IP

200 200 IE 200

+200 = Interest Payable

2. Accrue Interest expense

IP 200

AR 900 Rev 900 AR 900

3. Accrue fees receivable

+900 Fees (Accounts) Receivable

+900 +900 – Retained Printing Earnings Revenue

4. Record maintenance expense

-400 Prepaid Maintenance

-400 Retained Earnings

–

-300 Prepaid Advertising

-300 Retained Earnings

–

+300 = Advertising Expense

-300

-320 Retained Earnings

–

+320 Rent Expense

-320

+38 +38 Retained Interest Earnings (Other) Income

–

+38

Rev 900

OE 400 PPD 400 OE 400 PPD 400

AE 300 PPDA 300 5. Record AE advertising 300 expense PPDA 300

RNTE RNTP

320 320 6. Accrue rent RNTE expense

320

+320 Rent Payable

+400 Mainten- = ance (Operating) Expense

-400

RNTP 320

AR OI

38 38 AR 38

7. Accrue interest revenue

OI 38

+38 Interest (Accounts) Receivable

continued

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Table continued Balance Sheet Cash Asset

Transaction DE AD

2,175 2,175 DE 2,175

8. Record depreciation expense

Noncash Assets -2,175 Accum. Depreciation

AD 2,175

Liabilities

Income Statement

Contrib. + Capital

Earned Capital

Revenues

-2,175 Retained Earnings

–

Expenses +2,175 Depreciation Expense

Net Income

-2,175

P3-46. (20 minutes) Date Dec

Dec

Description

Debit

31 Salaries expense Salaries payable To accrue salaries at December 31 ($3,6002/5 = $1,440).

Credit

1,440 1,440

31 Interest expense Interest payable To accrue interest expense at December 31.

200

31 Fees receivable Printing revenue To record revenue earned but not yet billed.

900

31 Maintenance expense Prepaid maintenance To record December maintenance expense.

400

31 Advertising expense Prepaid advertising To record December advertising expense ($9001/3 = $300).

300

31 Rent expense Rent payable To accrue one-half month's rent expense [(800 $0.80) / 2 = $320].

320

31 Interest receivable Interest income To accrue interest earned in December.

200

900

400

300

320

31 Depreciation expense—equipment Accumulated depreciation—equipment ...................... To record annual depreciation on equipment.

2,175 2,175

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P3-47 (35 minutes) a. Balance Sheet Transaction AE 400 PPDA 400 AE 400

1. Recognize advertising expense

Cash Asset

Noncash Assets -400 Prepaid Advertising

Liabilities

Income Statement Contrib. + Capital

Earned Capital

Revenues

–

Expenses

Net Income

-400 Retained Earnings

–

+400 = Advertising Expense

-400

-2,600 Retained Earnings

–

+2,600 Wages Expense

-2,600

-1,140 Retained Earnings

–

+1,140 Insurance Expense

-1,140

+2,400 Retained Earnings

+2,400 – Service Fees Earned

+2,400

+1,000

PPDA 400

WE WP

2,600 2,600

WE 2,600

2. Accrue wage expense

+2,600 Wages Payable*

WP 2,600

INSE PPI

1,140 1,140

INSE 1,140

3. Recognize insurance expense

-1,140 Prepaid Insurance

PPI 1,140

UR 2,400 Rev 2,400 4. Recognize service fees UR earned 2,400

-2,400 Unearned Service Fees

Rev 2,400

AR 1,000 Rev 1,000 AR 1,000

5. Recognize rent revenue

+1,000 Accounts Receivable

+1,000 +1,000 Retained Rent Earnings Income

–

Rev 1,000

* Assumes wages earned had not been accrued or recognized yet as an expense.

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b. Balance Sheet Cash Asset

Transaction WE 2,200 WP 2,600 Cash 4,800 WE 2,200

1. Pay wages in following year

Noncash Assets

Liabilities

-4,800 Cash

2. Receipt of +1,000 rent Cash revenue in the following year

-1,000 = Accounts Receivable

Contrib. + Capital

-2,600 Wages Payable

Income Statement Earned Capital

Revenues

-2,200 Retained Earnings

Expen= ses

Net Income

–

+2,200 = Wages Expense

-2,200

–

WP 2600 Cash 4,800

Cash AR

1,000 1,000

Cash 1,000 AR 1,000

P3-48. (25 minutes) Date Dec.

Dec.

Jan.

Description 31

Debit

Advertising expense Prepaid advertising To record advertising expense ($1,200−$800 = $400).

Credit

400 400

Wages expense Wages payable To record accrued wages.

2,600

Insurance expense Prepaid insurance To record insurance expense ($3,420−$2,280 = $1,140).

1,140

Unearned service fees Service fees earned To recognize fees earned ($5,400−$3,000 = $2,400).

2,400

Accounts receivable Rental income To record rent earned but not yet recorded.

1,000

Wages payable Wages expense Cash To record payment of wages.

2,600 2,200

Cash Accounts receivable To record collection of rent.

1,000

2,600

1,140

2,400

1,000

4,800

1,000

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P3-49 (45 minutes) a. The T-accounts follow the journal below (See Part c). (In this problem we have credited depreciation to a contra asset (XA) account titled Accumulated Depreciation. Crediting the asset would not be incorrect, but reporting the contra asset account provides more information to financial statement users.) b. Date Apr. 1

Apr. 2

Apr. 3

Apr. 5

Apr. 12

Apr. 18

Apr. 29

Apr. 30

Description Cash Common stock Owner invested cash.

Debit 11,500

Truck Cash Purchased used truck for $6,100 cash.

6,100

Equipment Cash Accounts payable Purchased equipment.

6,200

Prepaid insurance Cash Paid two-year premium on insurance policy.

2,880

Supplies Accounts payable Purchased supplies on account.

1,200

Cash Unearned roofing fees Received advance payment for services.

1,800

Accounts receivable Roofing fees earned Billed customers for services.

5,500

Cash Accounts receivable Collection on account from customers.

4,900

Credit 11,500

6,100

1,000 5,200

2,880

1,200

1,800

5,500

4,900

Fuel expense Cash Paid truck fuel bill for April.

675

Advertising expense Cash Paid for April newspaper advertising.

100

675

100

Wages expense Cash Paid wages.

4,500

Accounts receivable Roofing fees earned Recorded fees earned.

4,000

4,500

4,000

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c. These T-accounts reflect entries from Part b (above) as well as the adjustments from Part e (below).

Apr. 1 5 18

Bal.

Cash 11,500 6,100 1,800 1,000 4,900 2,880 675 100 4,500 2,945

Prepaid Insurance Apr. 3 2,880 Unadj. bal 2,880 120 (e) Adj Bal 2,760

Apr. 2 Bal.

Apr. 2 2 3 29 30 30

Apr. 30

Accounts Receivable 5,500 4,900 4,000 4,600

Apr. 5 Unadj. bal Adj. bal

Supplies 1,200 1,200 1,000(e) 200

Apr. 2 Bal.

Trucks 6,100 6,100

Equipment 6,200 6,200

Accounts Payable 5,200 1,200 6,400

Depreciation Expense - Trucks Apr. 30 (e) 125 Adj Bal 125

Roofing Fees Earned 5,500 Apr. 12 4,000 30 9,500 Unadj. bal 450(e) 30 9,950 Adj. Bal.

Apr. 30 Bal.

Apr. 12 30 Bal.

Advertising Expense 100 100

Apr. 18

Apr. 30

Apr. 2 5 Bal.

Unearned Roofing Fees 1,800 Apr. 5 1,800 Unadj. bal Apr. 30 (e) 450 1,350 Adj. Bal Common Stock 11,500 11,500

Apr. 29 Bal.

Fuel Expenses 675 675

Apr. 30 Bal.

Wages Expense 4,500 4,500

Apr. 1 Bal.

continued

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continued Depreciation Expense-Equipment Apr. 30 (e) 35 Adj. Bal 35

Apr. 30 Adj. Bal

Supplies Expense (e) 1,000 1,000

Apr. 30 Adj. Bal

Insurance Expense (e) 120 120

Accumulated Depreciation-Equipment 35 (e) Apr. 30 35 Adj. Bal Accumulated Depreciation -Trucks 125 (e) Apr. 30 125 Adj. Bal

d. Date

Description

Debit

April 30 Insurance expense Prepaid insurance To record April insurance expense ($2,880 / 24 months = $120).

120

April 30 Supplies expense Supplies To record April supplies expense ($1,200 −$200 = $1,000).

1,000

Credit 120

1,000

April 30 Depreciation expense—trucks Accumulated depreciation—trucks To record April depreciation on trucks.

125

April 30 Depreciation expense—equipment Accumulated depreciation—equipment To record April depreciation on equipment.

April 30 Unearned roofing fees Roofing fees earned To record portion of advance payment earned in April ($1,800 / 4 = $450).

450

125

450

e. Adjusting entries are posted in the T-accounts, Part c, above.

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P3-50. (25 minutes) a. Balance Sheet Transaction Cash CS

11,500 11,500 Apr. 1. Cash received Cash for stock 11,500

Cash Asset

Liabilities

+ Noncash Assets =

+11,500 Cash

Income Statement +

Contrib. Capital +11,500 Common stock

Earned RevCapital enues

–

Expen= ses

–

Net Income

CS 11,500

PPE 6,100 Cash 6,100 Apr. 2. Purchase PPE truck for 6,100 cash

-6,100 Cash

+ 6,100 Truck

Apr. 2. Purchase equipment

-1,000 Cash

+6,200 Equipment

Apr. 3. Purchase liability insurance

-2,880 Cash

+2,880 Prepaid Insurance

+ 1,200 Supplies

+1,200 Accounts Payable

–

+1,800 Unearned Roofing Fees

–

Cash 6,100

PPE 6,200 AP 5,200 Cash 1,000 PPE 6,200

+ 5,200 Accounts Payable

AP 5,200 Cash 1,000

PPI 2,880 Cash 2,880 PPI 2,880 Cash 2,880

SUP AP

1,200 1,200

SUP 1,200

Apr. 5. Purchase supplies on credit

AP 1,200

Cash UR

1,800 1,800

Cash 1,800

Apr. 5. Cash in advance for roofing repairs

+1,800 Cash

UR 1,800

continued © Cambridge Business Publishers, 2021 3-42

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a. table continued Income Statement

Balance Sheet Cash Asset

Transaction AR 5,500 Rev 5,500 AR 5,500

Noncash Assets

LiabilContrib. Earned + + Rev-enues – Expen-ses = ities Capital Capital

Net Income

+5,500

Accounts Receivable

Retained Earnings

Roofing Fees Earned

= =

Apr. 12. Bill customers for services

–

Rev 5,500

Cash AR

4,900 4,900

Cash 4,900

Apr. 18. Cash collected on account

+4,900

-4,900

Cash

Accounts Receivable

AR 4,900

OE Cash

675 675

OE 675

Apr. 29. Paid cash for fuel

Cash

-675

Apr. 30. Paid cash for ads

Cash

-675

–

Retained Earnings

+675 Fuel

-675

-100

-4,500

+4,000

(Operating) Expense

Cash 675

AE Cash

100 100

AE 100

-100

–

Retained Earnings

+100 Advertising Expense

Cash 100

WE 4,500 Cash 4,500 WE 4,500

Apr. 30. Paid cash wages

-4,500

Cash

–

Retained Earnings

+4,500 Wages Expense

Cash 4,500

AR Rev

4,000 4,000

AR 4,000

Apr. 30. Bill customers for services

+4,000

Accounts Receivable

+4,000

Retained Earnings

Roofing Fees Earned

–

Rev 4,000

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P3-50. concluded b. Balance Sheet Transaction INSE PPI

Cash Asset

Noncash Assets

-120

Liabilities

Income Statement Contrib. + Capital

Earned Capital

Revenues

–

Expenses

Net Income

+120

-120

-1,000

-125

-35

+450

120 120 1. Recognize one month of insurance expense

INSE 120

-120

Prepaid Insurance

–

Retained Earnings

Insurance Expense

PPI 120

SUPE 1,000 SUP 1,000 2. Recognize supplies SUPE expense

-1,000

Supplies

–

Retained Earnings

+1,000 Supplies Expense

1,000

SUP 1,000

DE AD

125 DE 125

125 3. Recognize depreciation expense Trucks

-125

Accum. Depr’n --Trucks *

–

Retained Earnings

+125 Depreciation Expense

AD 125

DE AD

35 35 DE 35

4. Recognize depreciation expense Equipment

-35

–

Retained Earnings

Accum. Depr’n --Equipment *

AD 35

UR Rev

+35 Depreciation Expense

450

UR 450

450 5. Recognize roofing fees earned

-450

+450

Unearned Roofing Fees

Retained Earnings

Roofing Fees Earned

–

Rev 450

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P3-51. (25 minutes) a. POWNALL PHOTOMAKE COMPANY December 31 Debit Cash .................................................................................. Accounts receivable ........................................................... Prepaid rent ....................................................................... Prepaid insurance .............................................................. Supplies ............................................................................. Equipment ......................................................................... Accounts payable .............................................................. Unearned photography fees .............................................. Common stock ................................................................... Photography fees earned .................................................. Wages expense ................................................................. Utilities expense ................................................................. Totals .................................................................................

Credit

$ 4,300 3,800 12,600 2,970 4,250 22,800 $ 4,060 2,600 24,000 34,480 11,000 3,420 $65,140

_______ $65,140

b. Balance Sheet Transaction AR Rev

1,850 1,850 1. Fees earned but not AR received

1,850

2,280 2,280

DE 2,280

Noncash Assets +1,850 Fees (Accounts)

Liabilities

Contrib. + Capital

Receivable

Rev 1,850

DE AD

Cash Asset

Income Statement

2. Recognize depreciation expense for one year

-2,280 = Accum. Depreciation Equipment

3. Recognize utilities expense

Earned Capital

Revenues

–

Expen-ses =

Net Income

+1,850 +1,850 Retained PhotoEarnings graphy Fees Earned

–

+1,850

-2,280 Retained Earnings

–

+2,280 Depreciation Expense

-2,280

-400 Retained Earnings

–

+400 Utilities Expense

-400

AD 2,280

OE UP

400 400 OE 400

+400 Utilities Payable

UP 400

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b. continued Balance Sheet

Transaction

Cash Asset

RNTE 6,300 PPRNT 6,300 4. Recognize rent expense RNTE for year 6,300

Noncash Assets -6,300 Prepaid Rent

Liabilities

Income Statement

Contrib. + Capital

Earned Capital -6,300 Retained Earnings

Revenues

–

Expenses

Net Income

–

+6,300 = Rent Expense

-6,300

+2,600 +2,600 – Retained PhotoEarnings graphy Fees Earned

+2,600

PPRNT 6,300

UR Rev

2,600 2,600 5. Recognize photo UR revenues 2,600

-2,600 Unearned Photo Fees

Rev 2,600

INSE PPI

990 990 6. Recognize insurance INSE expense

990

-990 = Prepaid Insurance

-990 Retained Earnings

–

+990 = Insurance Expense

-990

-3,230 Supplies

-3,230 Retained Earnings

–

+3,230 = Supplies Expense

-3,230

-375 Retained Earnings

–

+375 = Wages Expense

-375

PPI 990

SUPE SUP

3,230 3,230 7. Recognize supplies SUPE expense

3,230

SUP 3,230

WE WP

375 375

WE 375

8. Recognize wages expense

+375 Wages Payable

WP 375

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P3-52. (30 minutes) a. Date

Description

Dec. 31

Fees receivable Photography fees earned To record revenue earned but not billed.

1,850

Depreciation expense Accumulated depreciation—equipment To record depreciation for the year ($22,800 / 10 years = $2,280).

2,280

Dec. 31

Debit

Credit 1,850

Utilities expense Utilities payable To record estimated December utilities expense.

2,280

400 400

Rent expense Prepaid rent To record rent expense for the year ($12,600 / 2 years = $6,300).

6,300

Unearned photography fees Photography fees earned To record advance payments earned.

2,600

6,300

2,600

Insurance expense Prepaid insurance To record insurance expense for the year ($2,970 / 3 years = $990).

990

Supplies expense Supplies To record supplies expense for the year ($4,250 −$1, 020 = $3,230).

3,230

Wages expense Wages payable To record unpaid wages at December 31.

375

990

3,230

375

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Unadj. bal Adj. Bal.

Cash 4,300 4,300

Accounts Payable 4,060 4,060

Accounts Receivable Unadj. bal 3,800 Adj. Bal. 3,800 Dec. 31

Dec. 31

Fees Receivable (1)1,850

Adj. Bal.

1,850

Unadj. bal Adj. Bal.

Prepaid Rent 12,600 6,300 (4) 6,300

Unadj. bal Adj. Bal.

Unearned Photo Fees (5) 2,600 2,600 Unadj. bal 0 Adj. Bal. Utilities Payable 400 (3)

Dec.31

400

Prepaid Insurance Unadj. bal 2,970 990 (6) Adj. Bal. 1,980 Unadj. bal Adj. Bal.

Supplies 4,250 3,230 (7) 1, 020

Unadj. bal Adj. Bal.

Equipment 22,800 22,800

Dec.31

Wages Payable 375 (8) Dec.31 375 Adj. Bal.

Dec.31

Common Stock 24,000 24,000

Dec. 31 Adj. Bal. Dec. 31 Adj. Bal.

Insurance Expense (6) 990 990

Unadj. bal Adj. Bal.

Photo Fees Earned 34,480 Unadj. bal 1,850 (1) Dec.31 2,600 (5) Dec.31 38,930 Adj. Bal.

Dec.31

Accum. Depreciation - Equip 2,280 (2) Dec.31 2,280 Adj. Bal.

Supplies Expense (7) 3,230 3,230

Adj. Bal.

Wages Expense Unadj. bal 11,000 Dec.31 (8) 375 Adj. Bal. 11,375 Utilities Expense Unadj. bal 3,420 Dec.31 (3) 400 Adj. Bal. 3,820 Depreciation Expense - Equip Dec.31 (2) 2,280 Adj. Bal. 2,280 Dec.31 Adj. Bal.

Rent Expense (4) 6,300 6,300

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P3-53. (40 minutes) Balance Sheet Transaction AE 1,540 PPDA 1,540 AE 1,540

Cash Asset

Noncash Assets

Liabilities

Income Statement Contrib. + Capital

Earned Capital

Revenues

–

Expenses

Net Income

1. Recognize advertising expense

-1,540 Prepaid Advertising

-1,540 Retained Earnings

–

+1,540 Advertising Expense

-1,540

2. Recognize depr’n expense

-5,280 Accum. Depr. Equipment

-5,280 Retained Earnings

–

+5,280 Depreciation Expense

-5,280

PPDA 1,540

DE AD

5,280 5,280

DE 5,280 AD 5,280 OE UP

325 325 3. Recognize utilities expense

OE 325

+325 Utilities Payable

-325 Retained Earnings

–

+325 Utilities Expense

-325

+2,400 Wages Payable

-2,400 Retained Earnings

–

+2,400 Wages Expense

-2,400

-4,750 Retained Earnings

–

+4,750 Supplies Expense

-4,750

-450

UP 325

WE WP

2,400 2,400

WE 2,400

4. Accrue wages expense

WP 2,400

SUPE SUP

4,750 5. Record 4,750 supplies expense SUPE 4,750

-4,750 Supplies

SUP 4,750

450 IP

450

IE 450

6. Accrue interest expense

+450 Interest Payable

-450 Retained Earnings

–

+450 Interest Expense

7. Recognize rent expense*

+645 Accounts Payable

-645 Retained Earnings

–

+645 Rent Expense

IP 450 RNTE AP

645 645

RNTE 645

= -645

AP 645

* (0.75%  $86,000 = $645). The rent for the year ($6,900 = $575 × 12) has already been recognized in the accounts. See the beginning balances given in the problem statement.

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P3-54. (35 minutes) a. Date

Description

Debit

Dec. 31

Advertising expense Prepaid advertising To record 11 months' advertising expense ($1,680 11/12 = $1,540)

1,540

Depreciation expense Accumulated depreciation To record depreciation for the year ($42,240 / 8 years = $5,280)

5,280

Dec. 31

Credit

1,540

5,280

Utilities expense Utilities payable To record estimated December utilities expense.

325 325

Wages Expense Wages Payable To record unpaid wages at December 31.

2,400

Supplies expense Supplies To record supplies expense for the year ($6,270 −$1,520 = $4,750)

4,750

2,400

4,750

Interest expense Interest payable To accrue interest expense at December 31

450

Rent expense Accounts payable To record additional rent owed under lease (0.75% × $86,000 = $645)

645

450

645

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b. Note: Only those T-accounts required are shown here. Accounts Payable 2,700 645 3,345

Bal. 7. Bal.

Accumulated Depreciation Equipment 5,280 2.

Bal.

Prepaid Advertising 1,680 1,540 140

Bal. Bal.

Supplies 6,270 4,750 1,520

Bal.

Interest Payable 450 450

6. Bal.

1. Bal.

1,540 1,540 Rent Expense

5,280 5,280

Bal. 7. Bal.

Wages Payable 2,400 2,400

5. Bal.

Supplies Expense 4,750 4,750

6,900 645 7,545 Wages Expense

4. Bal.

Bal. 4. Bal.

Utilities Payable 325 325

Advertising Expense

Depreciation Expense 2. Bal.

38,800 2,400 41,200 Utilities Expense

3. Bal.

Bal. 3. Bal.

3,020 325 3,345 Interest Expense 450

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P3-55. (35 minutes) a. Date

Description

Debit

Mar. 31

Rent expense Prepaid rent To record March rent expense ($4,770 / 6 months = $795)

795

Mar. 31

Supplies expense Supplies To record March supplies expense ($3,700 −$1,360 = $2,340)

Credit

795

2,340 2,340

Depreciation expense—equipment Accumulated depreciation—equipment To record March depreciation ($36,180 / 108 months = $335) Wages expense Wages payable To record unpaid wages at March 31

335 335

1,560 1,560

Utilities expense Accounts payable To record estimated March utilities expense

390

Unearned service revenue Service revenue To record portion of revenue received in advance that was earned in March.

500

390

500

Continued next page

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P3-55. continued b. Only the affected T-accounts are included here. The closing entries required in Part d are referenced by 1d, 2d etc. Accounts Payable 3,510 390 3,900 Acc Depreciation - Equipment 335 335

1d.

Service Revenue 12,860 12,360 500

Depreciation Expense 335 335

Utilities Expense 390 390

Wages Payable 1,560

2d. 3d. 4d. 5d. 6d.

Retained Earnings 12,860 2,340 335 5,460 390 795 3,540

Bal. 5. Bal.

3. Bal.

Bal. 6.

3d.

5d.

Bal. Bal.

Prepaid Rent 4,770 795 3,975

Bal. Bal.

Supplies 3,700 2,340 1,360

Unearned Service Revenue 500 1,000 500

Bal. Bal.

Rent Expense 795 795

6d.

Supplies Expense 2,340 2,340

2d.

Bal. 4.

Wages Expense 3,900 1,560 5,460

4d.

1d.

Bal.

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c. WYSOCKI WHEELS Income Statement For Month Ended March 31 Service revenues ................................................................... Expenses Utilities expense ............................................................... Supplies expense ............................................................. Wage expense ................................................................. Depreciation expense ....................................................... Rent expense ................................................................... Net income ............................................................................

$12,860 $ 390 2,340 5,460 335 795

9,320 $ 3,540

WYSOCKI WHEELS BALANCE SHEET MARCH 31 Cash ......................................... $ 2,900 Wages payable ................................ $ 1,560 Accounts receivable .................. 3,820 Accounts payable ................................ 3,900 Prepaid rent .............................. 3,975 Unearned service revenue ...................... 500 Supplies .................................... 1,360 Total liabilities ................................ 5,960 Equipment, cost ........................ 36,180 Less accumulated depreciation . (335) Common stock ................................ 38,400 Equipment, net ......................... 35,845 Retained earnings ................................ 3,540 Total assets .............................. $47,900 Total liabilities and equity ........................ $47,900

d. 1d. Service revenue ............................................................................... 12,860 Retained earnings ................................................................

12,860

2d. Retained earnings ............................................................................ 2,340 Supplies expense................................................................

2,340

3d. Retained earnings ............................................................................ 335 Depreciation expense ................................................................

335

4d. Retained earnings ............................................................................ 5,460 Wages expense ................................................................

5,460

5d. Retained earnings ............................................................................ 390 Utilities expense ................................................................

390

6d. Retained earnings ............................................................................ 795 Rent expense .............................................................................

795

The closing journal entries are shown in the T- accounts above. © Cambridge Business Publishers, 2021 3-54

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P3-56 (30 minutes) a. Balance Sheet

Cash 150,000 NP 100,000 CS 50,000

Cash 150,000 NP 100,000 CS 50,000 PPE, net 95,000 INV 40,000 Cash 95,000 AP 40,000

PPE, net 95,000 INV 40,000

Transaction

Cash Asset

Beginning bal.

Noncash Assets

Liabilities

= +100,000 Note Payable

+50,000 Common Stock

1. Sefcik +150,000 invested Cash $50,000 in exchange for common stock; company borrowed $100,000 from a bank

2. Sefcik purchased equipment for $95,000 cash and inventory of $40,000 on credit

-95,000 Cash

3. Sefcik Co. sold inventory costing $30,000 for $50,000 cash

+50,000 Cash

Income Statement

+95,000 PPE, net

Contrib. Capital

Earned Capital

Revenues

+40,000 Accounts Payable

–

Expenses

–

Net Income

+40,000 Inventory

Cash 95,000 AP 40,000 Cash 50,000 COGS 30,000 Sales 50,000 INV 30,000 CASH 50,000 COGS 30,000

-30,000 Inventory

+20,000 Retained Earnings

+50,000 Sales

–

+30,000 Cost o Goods Sold

= +20,000

Sales 50,000 INV 30,000

continued

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Table continued Balance Sheet

WE 12,000 Cash 12,000

WE 12,000 Cash 12,000 IE Cash

1,000 1,000

IE 1,000 Cash

Noncash Assets

Transaction

Cash Asset

Beginning bal.

4. Sefcik Co. paid $12,000 cash for wages owed employees for October work

-12,000 Cash

5. Sefcik Co. paid interest on the bank loan of $1,000 cash

-1,000 Cash

Liabilities

Income Statement

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

–

-12,000 Retained Earnings

– +12,000 Wage Expense

-12,000

-1,000 Retained Earnings

–

+1,000 Interest Expense

-1,000

-500 Retained Earnings

–

+500 Deprec. Exp

-500

-2,000 Retained Earnings

–

43,500 =

1,000 DE 500 PPE, net 500

6. Sefcik Co. recorded $500 depreciation expense PPE, net related to 500 equipment

-500 PPE, net

DE 500

RE 2,000 Cash 2,000

RE 2,000

7. Sefcik Co. paid $2,000 cash dividend

-2,000 Cash

Ending balance

90,000

Cash 2,000

104,500

140,000

50,000

4,500

50,000

6,500

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b. SEFCIK CO. Income Statement For Month of October Sales revenue ................................................................................................ $50,000 Total expenses ................................................................................................ 43,500 Net income ................................................................................................................ $ 6,500 SEFCIK CO. Retained Earnings Reconciliation For Month of October Retained earnings, October 1 .................................................................................. $ 0 Add: Net income ................................................................................................ 6,500 Less: Dividends ................................................................................................(2,000) Retained earnings, October 31 ................................................................................ $ 4,500 SEFCIK CO. Balance Sheet October 31 Cash ........................................... $ 90,000 Liabilities ................................................................ $140,000 Noncash assets ........................... 104,500 Contributed capital ................................50,000 Retained earnings ................................ 4,500 ________ Total equity ................................................................ 54,500 Total assets ................................ $194,500 Total liabilities and equity ................................ $194,500

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P3-57 (30 minutes) Balance Sheet

Transaction Cash 10,000 CS 10,000

Cash 10,000 CS 10,000 WE

Noncash Assets

Liabilities

1. Shareholder +10,000 s contribute Cash $10,000 cash to the business in exchange for common stock

2. Employees earn $500 in wages that have not been paid at period-end

+500 Wages Payable

+3,000 Accounts Payable

Contrib. Capital

Earned Capital

Revenues

+10,000 Common Stock

–

Expenses

–

+500 = Wages Expense

–

Net Income

500 WP

500

WE 500 WP 500 INV

Cash Asset

Income Statement

3,000 AP 3,000 INV 3,000

-500 Retained Earnings

3. Inventory of $3,000 is purchased on credit

+3,000 Inventory

4. The inventory purchased in transaction 3 is sold for $4,500 on credit

+4,500 = Accounts Receivable

+4,500 +4,500 Retained Sales Earnings

-3,000 Inventory

-3,000 Retained Earnings

-500

AP 3,000 AR 4,500 COGS 3,000 Sales 4,500 INV 3,000 AR 4,500 COGS 3,000

–

+3,000 Cost of Goods Sold

+1,500

Sales 4,500 INV 3,000

Cash AR

4,500 4,500

Cash 4,500 AR 4,500

5. The company collected the $4,500 owed to it per transaction 4

+4,500 Cash

-4,500 = Accounts Receivable

–

continued

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Table continued Balance Sheet Noncash Assets

+5,000 PPE, net

7. Depreciation of $1,000 is recorded on the equipment from transaction 6

-1,000 PPE, net

8. Supplies account had a $3,800 balance at beginning of this period; a physical count at period-end shows $800 of supplies still available. No supplies were purchased this period.

-3,000 Supplies

Transaction PPE, net Cash

5,000 5,000

PPE, net 5,000

6. Equipment is purchased for $5,000 cash

Cash Asset -5,000 Cash

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

Expenses

–

Net Income

–

-1,000 Retained Earnings

–

+1,000 = Deprec. Expense

-1,000

-3,000 Retained Earnings

–

+3,000 = Supplies Expense

-3,000

9. The company -12,500 paid $12,000 Cash cash toward the principal on a note payable; also, $500 cash is paid to cover this note’s interest expense for the period

= -12,000 Note Payable

-500 Retained Earnings

–

+500 = Interest Expense

-500

10. The company +8,000 receive Cash $8,000 cash in advance for services to be delivered next period

Cash 5,000 DE 1,000 PPE, net 1,000 DE 1,000 PPE, net 1,000 SUPE SUP

3,000 3,000

SUPE 3,000 SUP 3,000

NP 12,000 IE 500 Cash 12,500

Cash UR

8,000 8,000

Cash 8,000 UR 8,000

+8,000 Unearned Revenue

–

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P3-58 (25 minutes) a. Balance Sheet Transaction Cash NP CS

155,000 55,000 100,000

Cash 155,000 NP 55,000

Cash Asset

Noncash = Assets

Liabilities

1. Received $100,000 cash for common stock and borrowed $55,000 cash

+155,000 Cash

+55,000 Notes Payable

2. Purchased $50,000 of equipment, for $10,000 cash and $40,000 note payable

-10,000 Cash

+50,000 = PPE, net

+40,000 Notes Payable

3. Purchased $80,000 of inventory for cash

-80,000 Cash

+80,000 = Inventory

4. Sold Inventory for $60,000 cash and $40,000 on credit, cost of inventory $70,000

+60,000 Cash

+40,000 = Accounts Receivable

Income Statement +

Contrib. + Capital

Earned Capital

Revenues

+100,000 Common Stock

– Expenses

–

Net Income

CS 100,000 PPE, net 50,000 NP 40,000 Cash 10,000 PPE, net 50,000 NP 40,000 Cash 10,000 INV 80,000 Cash 80,000 INV 80,000 Cash 80,000

Cash 60,000 AR 40,000 COGS 70,000 Sales 100,000 INV 70,000

AR 40,000 Cash 60,000

+30,000 Retained Earnings

+100,000 Sales

–

+70,000 Cost of Goods Sold

+30,000

-70,000 Inventory

COGS 70,000 Sales 100,000

INV 70,000

continued

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a. Table continued Balance Sheet Transaction PPDA 10,000 Cash 10,000

PPDA 10,000 Cash 10,000 AE

7,500 PPDA 7,500

AE 7,500 PPDA 7,500 WE 17,000 Cash 17,000

WE 17,000 Cash

5. Paid $10,000 cash for future advertising time

Cash Asset

-10,000 Cash

Liabilities

Contrib. + Capital

Earned Capital

Revenues – Expenses =

+10,000 = Prepaid Advertising

6. $7,500 of advertising time in transaction 5 is aired

7. Employees paid $17,000 cash in wages

Noncash = Assets

Income Statement

-17,000 Cash

–

Net Income

-7,500 = Prepaid Advertising

-7,500 Retained Earnings

–

+7,500 Advertising Expense

-7,500

-17,000 Retained Earnings

–

+17,000 Wages Expense

-17,000

-1,000 Retained Earnings

–

+1,000 Wages Expense

-1,000

-2,000 Retained Earnings

–

+2,000 Depreciation Expense

-2,000

–

97,500

2,500

17,000 WE WP

1,000 1,000

WE 1,000

8. Employees earn $1,000 in wages not yet paid

9. Record depreciation of $2,000 on equipment*

-2,000 = PPE, net

+1,000 Wages Payable

WP 1,000

DE 2,000 PPE, net 2,000

Ending Balances

98,000

100,500 =

96,000

+ 100,000 +

2,500

100,000

* PPE, net = Equipment, gross less Accumulated Depreciation.

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b. ANIFOODS, INC. Income Statement For Month Ended March 31 Sales ..................................................................................................................... $100,000 Cost of goods sold ................................................................................................ (70,000) Gross profit ................................................................................................ 30,000 Advertising expense .............................................................................................. (7,500) Wages expense ................................................................................................ (18,000) Depreciation expense ............................................................................................ (2,000) Net income ................................................................................................ $ 2,500

ANIFOODS, INC. Balance Sheet March 31 Cash ......................................... $ 98,000 Accounts receivable ..................40,000 Inventory ................................ 10,000 Prepaid advertising ................... 2,500 Equipment, gross ......................50,000 Less: Accum depreciation ......... (2,000) Equipment, net ......................... 48,000 Total assets .............................. $198,500

Wages payable ....................... $ 1,000 Note payable (to owner) .......... 55,000 Note payable (to vendor) ......... 40,000 Total liabilities .......................... 96,000 Common stock ........................ 100,000 Retained earnings ................... 2,500 Total liabilities and equity ........ $198,500

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P3-59. (45 minutes) a. Balance Sheet

SUP Cash

5,000 5,000

SUP 5,000 Cash 5,000 AR REV

2,500 2,500

AR 2,500 REV 2,500 Cash REV

10,000 10,000

Cash 10,000 REV 10,000 PPDA Cash

8,000 8,000

PPDA 8,000 Cash 8,000

Cash AR

1,200 1,200

Cash 1,200 AR 1,200

AP Cash

3,400 3,400

AP 3,400 Cash 3,400

Transaction

Cash Asset

Earned Capital

Revenues – Expenses

Beginning bal.

35,000

–

+2,500 = Accounts Receivable

+2,500 +2,500 – Retained Revenues Earnings

+2,500

+10,000 +10,000 – Retained Revenues Earnings

+10,000

-8,000 Cash

+8,000 = Prepaid Advertising

–

5. The +1,200 company Cash received $1,200 cash as partial payment on accounts receivable from transaction 2

-1,200 = Accounts Receivable

–

1. The company purchased supplies for $5,000 cash; none were used this month

Noncash Assets

Liabilities

80,000

135,000

70,000

-5,000 Cash

+5,000 Supplies

Income Statement

2. Services of $2,500 were performed this month on credit

3. Services +10,000 were Cash performed for $10,000 cash this month

4. The company purchased advertising for $8,000 cash; the ads will run next month

6. The company paid $3,400 cash toward accounts payable.

-3,400 Cash

Contrib. Capital

110,000

-3,400 Accounts Payable

Net Income

continued © Cambridge Business Publishers, 2021 Solutions Manual, Module 3

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a. Tabl continued Balance Sheet Transaction WE Cash

3, 500 3,500

WE 3,500 Cash 3,500 RE Cash

500 500

RE 500 Cash 500

Cash Asset

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues – Expenses

Net Income

-3, 500

7. Paid $3,100 -3, 500 cash toward Cash this month’s wages expenses

-3, 500 Retained Earnings

–

8. The company declared and paid dividends of $500 cash

–

Cash

-500 Retained Earnings

Ending balance

70,800

-500

149,300

66,600

110,000

43, 500

12,500

–

+3, 500 Wages Expense

3, 500

9, 000

b. HANLON ADVERTISING COMPANY Income Statement For Current Month Sales revenue ................................................................................................ $12,500 Wages expense ................................................................................................ 3,500 Net income ................................................................................................................ $ 9,000 HANLON ADVERTISING COMPANY Retained Earnings Reconciliation For Current Month Retained earnings, beginning of month ................................................................ $ 35,000 Add Net income ................................................................................................9,000 Less: Dividends ................................................................................................ (500) Retained earnings, end of month ............................................................................. $ 43,500 HANLON ADVERTISING COMPANY Balance Sheet Month-End Cash ............................................ $ 70,800 Liabilities ................................................................ $ 66,600 Noncash assets ........................... 149,300 Contributed capital ................................ 110,000 Retained earnings ................................ 43,500 ________ Total equity ................................................................ 153,500 Total assets ................................ $220,100 Total liabilities and equity ................................ $220,100

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P3-60. (35 minutes) a. Balance Sheet

SUP AP

6,000 6,000

SUP 6,000 AP 6,000 Cash UR

8,000 8,000

Cash 8,000 UR 8,000

RNTE PPRNT Cash

3,000 3,000 6,000

RNTE 3,000 PPRNT 3,000 Cash 6,000 AR REV

25,000 25,000

AR 25,000 REV 25,000 WE 6,000 Cash 6,000

WE 6,000 Cash 6,000

Transaction

Cash Asset

Beginning balance

30,000

1. The company purchased $6,000 of supplies on credit

Noncash Assets

Liabilities

225,000

90,000

+6,000 Supplies

2. The +8,000 company Cash received $8,000 cash from a new customer for services to be performed next month 3. The company paid $6,000 cash to cover office rent for two months (the current month and the next)

-6,000 Cash

4. The company billed clients for $25,000 of work performed

5. The -6,000 company Cash paid employees $6,000 cash for work performed

+3,000 Prepaid Rent

Income Statement Earned Capital

Revenues – Expenses

120,000

–

+6,000 Accounts Payable

–

+8,000 Unearned Revenues

–

Contrib. Capital 45,000

-3,000 Retained Earnings

+25,000 = Accounts Receivable

–

+3,000 Rent Expense

+25,000 +25,000 – Retained Revenues Earnings

-6,000 Retained Earnings

–

+6,000 Wages Expense

Net Income

-3,000

+25,000

-6,000

continued

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P3-60. continued a. continued Balance Sheet Transaction Cash 25,000 AR 25,000

Cash 25,000 AR 25,000

DE 4,000 PPE, net 4,000

SUPE 4,000 SUP 4,000

Cash Asset

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues – Expenses

–

Net Income

6. The +25,000 company Cash collected $25,000 cash from accounts receivable in trabsaction 4

-25,000 = Accounts Receivable

7. The company recorded $4,000 depreciation on its equipment

-4,000 PPE, net

-4,000 Retained Earnings

–

+4,000 Depreciation Expense

-4,000

8. At monthend, $2,000 of supplies purchased in transaction 1 are still available; no supplies were available when the month began

-4,000 Supplies

-4,000 Retained Earnings

–

+4,000 Supplies Expense

-4,000

226,000

–

17,000

8,000

Ending balance

51,000

104,000

45,000

128,000

25,000

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b. WERNER REALTY COMPANY Income Statement For Current Month Sales revenue ................................................................................................ $ 25,000 Total expenses ................................................................................................ 17,000 Net income ................................................................................................ $ 8,000 WERNER REALTY COMPANY Retained Earnings Reconciliation For Current Month Retained earnings, beginning of month ................................................................ $120,000 Add: Net income ................................................................................................ 8,000 Less: Dividends ................................................................................................ 0 Retained earnings, end of month ................................................................ $128,000 WERNER REALTY COMPANY Balance Sheet Current Month-End Cash ............................................ $ 51,000 Liabilities ................................................................ $104,000 Noncash assets ........................... 226,000 Contributed capital ................................ 45,000 Retained earnings ................................ 128,000 ________ Total equity ................................ 173,000 Total assets ................................ $277,000 Total liabilities and equity ................................ $277,000

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IFRS APPLICATIONS I3-61. (20 minutes) 1. Close all revenue accounts Total passenger and freight revenue Retained earnings

17,060 17,060

2. Close all expense accounts Retained earnings Manpower and staff related

4,300

Retained earnings Fuel

3,232

Retained earnings Aircraft operating variable

3,596

Retained earnings Depreciation and amortisation

1,528

Retained earnings Other expenses

2,831

Retained earnings Finance costs

182

Retained earnings Income tax expense

411

4,300 3,232

Total Passenger and Freight Revenue 17,060

3,596 1,528 2,831 182 411 Manpower and Staff Related 4,300

Retained Earnings 1,084 (bal) 17,060

4300 3232

182

Depreciation and Amortization 1,528

3,232

Other Expenses 2,831

Finance Costs

Fuel

Income Tax Expense 411

3596 1528 2831 182 411 2,064 (bal)

Aircraft Operating Variable 3,596

The balance in Retained earnings is AUD 2,064 million. © Cambridge Business Publishers, 2021 3-68

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I3-62. (15 minutes) Balance Sheet

Transaction AR Rev

18,485 18,485

AR 18,485

Cash Asset

Noncash Assets

Liabilities +

Income Statement Contrib. Capital +

Earned Capital

Net Income

–

+18,485

Revenues

+18,485

Expenses

Record sales revenue for 2018.

+18,485 = Accounts Receivable

+18,485 Retained Earnings

Record depreciation and amortization expense for 2018.

-4,015 PPE

-4,015 Retained Earnings

–

+4,015 = Depreciation and amortizatoin expense

-4,015

-4,242 Retained Earnings

–

+4,242 Tax expense

-4,242

Revenue 18,485

DE PPE

4,015 4,015

DE 4,015 PPE 4,015

TE 4,242 Cash 4,242

Record taxes paid for 2018.

-4,242

4,242 Cash 4,242

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MANAGEMENT APPLICATIONS MA3-63. (60 minutes) a. The financial statement effects template first shows the initial cash deposits and checks. These are entries i through viii. Entries 1—6 are the adjusting entries required at the end of the third month. We assume that expenditures for rent and salaries were initially debited to expense accounts. Balance Sheet

Cash CS

50,000 50,000

Cash 50,000

Transaction

Cash Asset

i. Cash investment

+50,000 Cash

ii. Collect from +81,000 customers Cash

iii. Bank borrowing

+10,000 Cash

iv. Paid rent

-24,000 Cash

+24,000 Prepaid Rent

v. Purchase equipment

-25,000 Cash

Noncash Assets

–

Expen= ses

–

+81,000 +81,000 – Retained Sales Earnings Revenues

= +10,000 Notes Payable

–

+25,000 = Equipment

–

Liabilities

Income Statement

Contrib. + Capital +50,000 Common Stock

Earned Capital

Revenues

Net Income

CS 50,000 Cash Rev

81,000 81,000

Cash 81,000

+81,000

Rev 81,000 Cash NP

10,000 10,000

Cash 10,000 NP 10,000 PPRNT Cash

24,000 24,000

RNTE 24,000 Cash 24,000 PPE 25,000 Cash 25,000

PPE 25,000 Cash 25,000

continued

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a. Table continued Balance Sheet

INV 62,000 Cash 62,000 INV 62,000

Transaction

Cash Asset

vi. Purchase inventory

-62,000 Cash

+62,000 = Inventory

vii. Pay salaries

-8,000 Cash

-8,000 Retained Earnings

–

+8,000 Salaries Expense

-8,000

viii. Pay other expenses

-13,000 Cash

-13,000 Retained Earnings

–

+13,000 Other (Operating) Expenses

-13,000

+9,000

Noncash Assets

Liabilities

Income Statement

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

–

Cash 62,000 SE 8,000 Cash 8,000 SE 8,000 Cash 8,000

OE 13,000 Cash 13,000 OE 13,000

Cash 13,000 AR 9,000 Rev 9,000 AR 9,000

1. Recognize credit sales

+9,000 A/R

+9,000 +9,000 – Retained Sales Earnings Revenue

2. Adjust rent expense

-12,000 Prepaid Rent

-12,000 Retained Earnings

–

12,000 Rent Expense

-12,000

= +4,000 Salaries Payable

-4,000 Retained Earnings

–

+4,000 Salaries Expense

-4,000

Rev 9,000

PPRNT 12,000 RNTE 12,000 PPRNT 12,000 RNTE 12,000

SE 4,000 SP 4,000 SE 4,000

3. Accrue salaries expense

SP 4,000

continued

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a. Table continued Balance Sheet

Transaction COGS 34,000 INV 34,000

COGS 34,000

Cash Asset

Noncash Assets

Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

4. Recognize cost of goods sold

-34,000 = Inventory

-34,000 Retained Earnings

–

+34,000 Cost of Goods Sold

-34,000

5. Accrue depreciation expense

- 1,250 Accum. Depreciation

-1,250 Retained Earnings

–

+1,250 Depreciation Expense

-1,250

-300 Retained Earnings

–

+300 Interest Expense

-300

INV 34,000 DE AD

1,250 1,250

DE 1,250 AD 1,250 IE

300 IP

300

IE 300

6. Accrue interest expense

+300 Interest Payable

IP 300

Journal entries are shown in the financial statements effects template, above. We repeat below, the journal entries for the adjustments 1 through 6. 1. Accounts Receivable .............................................................. Sales Revenue ................................................................. To recognize sales on account.

9,000 9,000

2. Rent Expense ......................................................................... 12,000 Prepaid Rent ..................................................................... To recognize rent expense ½ of $24,000.

12,000

3. Salaries Expense .................................................................... Salaries Payable ............................................................... To recognize prepaid salaries for September.

4,000

4. Cost of Goods Sold ................................................................. 34,000 Merchandise Inventory ..................................................... To recognize cost of sales. ($62,000 - $28,000)

34,000

continued

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a. continued 5. Depreciation Expense ............................................................. 1,250 Accumulated Depreciation ................................................ To accrue depreciation on the fixtures and equipment. .......... ($25,000 / 5 years × 3 months /12) 6. Interest Expense ..................................................................... Interest Payable ................................................................ To accrue interest on bank loan. ($10,000) × 0.12 × 3/12

1,250

300 300

The balances shown are the amounts in the accounts prior to the entry of the adjustments described in items 1 through 6. The cash balance represents the deposits made ($141,000) less the checks drawn ($132,000). Cash Bal.

62,000

Inventory 34,000

(4)

Bal.

Prepaid Rent 24,000 12,000

(2)

Accumulated Depreciation-Equipment 1,250 (5)

Salaries Payable 4,000

(3)

Accounts Receivable 9,000

Common Stock 50,000

Bal.

(1)

9,000 Fixtures & Equipment 25,000

Sales Revenue 81,000 9,000 (2)

Rent Expense 12,000

Bal. (1)

(4)

Cost of Goods Sold 34,000

(5)

Depreciation Expense 1,250

Other Expenses 13,00 0

Bank Loan Payable 10,000

Bal.

(6)

Interest Expense 300

Interest Payable 300

(6)

Bal. (3)

Salaries Expense 8,000 4,000

Bal.

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b. STOCKEN SURF SHOP Income Statement For Three Months Ended September 30 Sales Revenues Cost of Goods Sold Gross Margin Expenses Rent Expense Salaries Expense Depreciation Expense Interest Expense Other Expenses Net Income

$90,000 34,000 56,000 $12,000 12,000 1,250 300 13,000

38,550 $17,450

STOCKEN SURF SHOP Balance Sheet September 30 Assets Current assets Cash ................................................................................................ $ 9,000 Accounts receivable ................................................................................................ 9,000 Inventory ................................................................................................ 28,000 Prepaid rent ................................................................................................ 12,000 Total current assets ................................................................................................ 58,000 Fixtures and equipment, net ................................................................23,750 Total assets ................................................................................................ $ 81,750 Liabilities and equity Current liabilities Salaries payable ................................................................................................ $ 4,000 Bank loan payable ................................................................................................ 10,000 Interest payable ................................................................................................ 300 Total current liabilities ................................................................................................ 14,300 Contributed capital ................................................................................................ 50,000 Retained earnings ................................................................................................ 17,450 Total stockholders' equity ................................................................ 67,450 Total liabilities and equity ................................................................ $ 81,750

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c. Module 1 introduced the return on assets ratio as a simple performance measure that can be used to evaluate how well a business is doing. The return on assets is calculated as the ratio of net profit to assets. The return on assets for the three-month period (based on average assets) was almost 43% ($17,450 / [$0 + $81,750] / 2). This is a very good return for a three-month period. However, the favorable performance evaluation should be tempered by a few caveats: (1) Retail businesses are notoriously seasonal. That is, sales (and profits) fluctuate from season to season. A business such as this one would likely have its highest sales in the second and third quarters. This seasonality must be considered when we try to annualize quarterly results like these. Once the business has operated for a year or two, the owner would likely have a better idea about how seasonal fluctuations affect sales and returns and would be better able to interpret quarterly performance measures. (2) Stocken’s cash position is precarious. The firm has burned through most of the $60,000 cash raised to begin the business ($50,000 from the owner and the $10,000 loan) and is likely to have trouble replacing its inventory as well as paying its bills. Perhaps they can convince lenders to come to their rescue. If not, the firm will not last another three months.

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MA3-64. (15 minutes) a. The following analysis shows how the additional information from Kadous affects total assets, liabilities, and equity of the company:

Per original balance sheet

Assets

Liabilities

Equity

$88,500

$45,900

$42,600

1. Recognition of insurance expense ($6,500  1/2 = $3,250)

(3,250)

2. Depreciation correction (5%  $68,500 = $3,425)

3,425

8,000

3. No adjustments necessary 4. Unbilled services performed 5. Advance consulting fee earned ($11,300  1/2 = $5,650) 6. Recognition of supplies expense ($13,200 − $4,800 = $8,400) Revised totals

(5,650)

5,650

(8,400)

______

(8,400)

$88,275

$40,250

$48,025

Original debt-to-equity ratio: $45,900 / $42,600 = 1.08 Revised debt-to-equity ratio: $40,250 / $48,025 = 0.84 b. Based on the analysis above, the loan agreement has not been violated.

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MA3-65. (15 minutes) a. Beatty must weigh the following ethical considerations: 1. Balancing the long-run interests of the firm (securing the international contract) against the short-run requirements to present accurately the financial data of the company for the current year (recording $150,000 adjusting entry). 2. Compromising the confidentiality of the contract negotiations (by disclosing the contract negotiations to additional persons) versus compromising her professional responsibilities (by omitting a significant year-end adjusting entry). 3. Jeopardizing her position with the firm (by revealing information the president wants kept secret) versus risking possible future legal action by parties relying on the firm's financial statements (by not revealing a significant accrued expense and accrued liability in the financial statements). b. Beatty should consider that outside auditors frequently access confidential data and disclosing the contract negotiations to the auditor should not represent a significant breach of confidentiality. Perhaps Beatty can achieve a reasonable solution to her dilemma by suggesting that an adjusting entry be recorded and described in very general terms (for example, labeling the liability Payable to Consultants and indicating it is for marketing research and development). Such an adjustment would be factually correct, not misleading, and permit the disclosure of the significant liability without revealing important details to anyone else within or outside the company.

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Module 4 Analyzing and Interpreting Financial Statements QUESTIONS Q4-1.

Return on investment measures profitability in relation to the amount of investment that has been made in the business. A company can always increase dollar profit by increasing the amount of investment (assuming it is a profitable investment). So, dollar profits are not necessarily a meaningful way to look at financial performance. Using return on investment in our analysis, whether as investors or business managers, requires us to focus not only on the income statement, but also on the balance sheet.

Q4-2.

a. Increasing leverage increases ROE as long as the assets earn a greater operating return than the cost of the additional debt. b. Financial leverage is also related to risk: the risk of potential bankruptcy and the risk of increased variability of profits. Companies must, therefore, balance the positive effects of financial leverage against their potential negative consequences. It is for this reason that we do not witness companies entirely financed with debt.

Q4-3.

Gross profit margins can decline because 1) the industry has become more competitive, and/or the firm’s products have lost their competitive advantage so that the company has reduced selling prices or is selling fewer units or 2) product costs have increased, or 3) the sales mix has changed from higher-margin/slowly turning products to lower-margin/higher turning products. Declining gross profit margins are usually viewed negatively. On the other hand, cost increases that reflect broader economic events or certain strategic product mix changes might not be viewed as negatively.

Q4-4.

Reducing advertising or R&D expenditures can increase current operating profit at the expense of the long-term competitive position of the firm. Expenditures on advertising or R&D often create long-term economic benefits. ©Cambridge Business Publishers, 2021

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Q4-5.

Asset turnover measures the amount of revenue compared with the investment in an asset. Generally speaking, we want turnover to be higher rather than lower. Turnover measures productivity and an important company objective is to make assets as productive as possible. Because turnover is one of the components of ROE (via RNOA), increasing turnover increases shareholder value. Turnover is, therefore, viewed as a value driver.

Q4-6.

ROE>RNOA implies a positive return on nonoperating activities. This results from borrowed funds being invested in operating assets whose return (RNOA) exceeds the cost of borrowing. In this case, borrowing money increases ROE. When the reverse occurs, the company has net nonoperating assets (nonoperating assets > nonoperating liabilities). This is “negative” net nonoperating obligations in the ROE disaggregation. The net nonoperating assets earn a return, which, when scaled by the negative NNO yields a negative nonoperating return. The company is holding nonoperating assets that do not create more value than the operating activities and this reduces overall ROE.

Q4-7.

Once a business segment has been sold or designated for sale, it is classified as a discontinued operation. Consequently, sales and expenses related to the business segment are reported separately. Thus, the income statement reports income from continuing operations, discontinued operations, and net income (which includes both continuing and discontinued operations). On the balance sheet, the business segment’s assets and liabilities are similarly segregated. Because the business segment was or will be sold, it no longer contributes to the operating activities of the company. One of the primary uses of financial information is to project future financial results so that investors and others can properly price the company’s securities and evaluate strategic plans. The discontinued operations will not affect future results (other than via investment of the proceeds from the sale), and, therefore, should not be considered as a component of operating activities.

Q4-8.

The interest tax shield arises because interest expense is deductible for tax purposes. Thus, interest expense “shields” income from taxes by reducing taxable income. The after-tax cost of interest is, therefore, the pretax cost multiplied by 1 minus the appropriate tax rate (typically the sum of the federal and state tax rates).

Q4-9.

The “net” in net operating assets, means operating assets “net” of operating liabilities (after subtracting operating liabilities). This netting recognizes that a portion of the costs of operating assets is funded by third parties. For example, payables and accrued expenses help fund inventories, wages, utilities, and other operating costs. Similarly, long-term operating liabilities also help fund the cost of long-term operating assets. Thus, we deduct these long-term operating liabilities from long-term operating assets.

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Q4-10.

Companies must manage both the income statement and the balance sheet in order to maximize RNOA. This is important, as too often managers look only to the income statement and do not fully appreciate the value added by effective balance sheet management. The disaggregation of RNOA into its profit and turnover components focuses analysis on both of these areas.

Q4-11.

There are an infinite number of possible combinations of profit margin and asset turnover that will yield a given level of RNOA. The relative weighting of profit margin and asset turnover is driven in large part by the company’s business model. As a result, since companies in an industry tend to adopt similar business models, industries will generally trend toward points along the margin/turnover continuum.

Q4-12.

Liquidity refers to cash: how much cash a company has, how much cash is coming in the door, and how much cash can be raised quickly. Companies must generate cash in order to pay their debts, pay their employees, and provide their shareholders a return on investment. Cash is, therefore, critical to a company’s survival.

Q4-13.

Ratio analysis uses the balance sheet, income statement and statement of cash flows. It is, therefore, dependent on the quality of those statements. Differences in the application of GAAP across companies or within the same company across time can affect the reliability of the analysis. Limitations of GAAP itself (e.g., immediate expensing of R&D, non-recognition of assets that cannot be reliably measured) and differences in the makeup of the company (e.g., types of products or industries in which the company competes) can also affect the usefulness of ratio analysis.

Q4-14.

Net nonoperating obligations (NNO) is defined as the excess of (interest-bearing) debt over investments in nonoperating assets. Net nonoperating obligations can be either positive (excess of debt) or negative (excess of investments). Net nonoperating expense (NNE) is the excess of NOPAT over net income. Net nonoperating expense can also be positive (when nonoperating expenses exceed nonoperating income) or negative.

Q4-15.

The traditional DuPont analysis includes return on assets (ROA), which includes all assets in its denominator. That means that ROA is the average return on all the assets. The RNOA disaggregation method distinguishes between assets that are used for core operations and those that are held as investments and calculates a separate return for each, rather than one average return. The second difference is that the RNOA approach uses “net” assets, which distinguishes the operating liabilities (interest free and self-liquidating) from interest-bearing debt.

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Q4-16

The cash conversion cycle measures the average time (in days) to sell inventories, collect the receivables from the customer, repay the suppliers for the inventory purchases, and return to cash. Each time a company completes one cash conversion cycle, it generates profit and cash flow. Managers aim to shorten the cash conversion cycle.

Q4-17

A common sized financial statement has each line item expressed in percentage terms. The balance sheet is expressed as a percentage of total assets (the bottom line). This is a useful tool to assess the proportion of each asset and liability to the total company size and to monitor how the proportions change over time. It is also a useful way to compare companies of different sizes because the percentage numbers make the base “common.” A common sized income statement uses total revenue as the common denominator (top line). Each expense percentage shows the proportion of sales that are consumed by the expense. This is an effective way to track changes in costs and to identify reasons for increases or decreases in profitability. A common-sized income statement can be used to compare companies to each other and to benchmark a company to industry standards.

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MINI EXERCISES M4-18. (5 minutes) $ millions Total assets Less Total liabilities Equity Return on equity (ROE) = Net income / Average Equity

M4-19. (10 minutes) a. $ millions Total assets Less Total liabilities Equity Return on equity (ROE) = Net income / Average Equity Return on assets (ROA) = Net income / Average total assets Financial leverage (FL) = Average total assets / Average Equity

2018 $97,334 13,207 $84,127 27.91%

2017 $84,524 10,177 $74,347

2018 $97,334 13,207 $84,127

2017 $84,524 10,177 $74,347

27.91% 24.32% 1.15

b. $ millions Net income Revenue Total assets Profit margin (PM) = Net income / Revenue Asset turnover (AT) = Revenue / Average total assets

2018 $22,112 55,838 97,334 39.60%

2017

84,524

0.61

M4-20. (10 minutes) $ millions Operating assets Operating liabilities Net operating assets (NOA)

February 3, 2019 $ 42,225 16,679 $ 25,546

January 28, 2018 $ 40,934 16,047 $ 24,887

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M4-21. (10 minutes) $ millions Nonoperating expense before tax Less Tax shield @ 22% Net nonoperating expense (NNE)

February 3, 2019 $ 974 214 760

Net earnings NOPAT = Net earnings + NNE

11,121 11,881

Net operating profit before tax (NOPBT) Tax expense Tax on operating profit = Tax expense + Tax shield NOPAT = NOPBT – Tax on operating profit

15,530 3,435 3,649 11,881

M4-22. (20 minutes) a. February 3, 2019 $ 974 214 760 11,121 $11,881

January 28, 2018

Operating assets Less Operating liabilities Net operating assets (NOA)

42,225 16,679 25,546

40,934 16,047 24,887

RNOA = NOPAT / Average NOA

47.12%

$ millions Nonoperating expense, before tax Less Tax shield @ 22% Net nonoperating expense (NNE) Net earnings NOPAT = Net earnings + NNE

NOPM = NOPAT / Net Sales NOAT = Net Sales / Average NOA

February 3, 2019 10.98% 4.29

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M4-23. (20 minutes) ($ thousands) a. RNOA = NOPAT / Average net operating assets (NOA) = $1,506,681 / [($11,804,340 + $7,258,593) / 2] = 15.81% b. NOPM = NOPAT / Sales = $1,506,681 / $15,794,341 = 9.54% NOAT= Sales / Average NOA = $15,794,341 / [($11,804,340 + $7,258,593)/2] = 1.66 RNOA= NOPM × NOAT = 9.54% × 1.66 = 15.81%

M4-24. (15 minutes)

Merchandise inventory - net Other current assets Property, less accumulated depreciation Deferred income taxes - net Goodwill Other assets Operating assets

Feb. 01, 2019 $12,561 938 18,432 294 303 995 $33,523

Accounts payable Accrued compensation and employee benefits Deferred revenue Other current liabilities Deferred revenue - extended protection plans Other liabilities Operating liabilities

$8,279 662 1,299 2,425 827 1,149 $14,641

NOA = Operating assets - Operating liabilities

$18,882

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M4-25. (15 minutes) ($ millions) NOPAT = Net earnings + NNE = $2,314 + ($624 × (1 – 22%)) = $2,314 + $487 = $2,801 OR: NOPAT = NOPBT – (tax expense + tax shield) = $4,018 – ($1,080 + ($624 x 22%)) = $2,801

M4-26. (20 minutes) Return on equity (ROE) Profit margin (PM) Financial leverage (FL)

16.83% 2.96% 2.63

Computations:

Net income Equity ROE = Net income / Average equity

2018 $1,683 $10,161 16.83%

Net income Revenue Profit margin (PM) = Net income / Revenue

$1,683 $ 56,912 2.96%

Assets Equity Financial leverage = Average assets / Average equity

$ 25,413 $10,161 2.63

2017 $ 9,842

$27,178 $ 9,842

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M4-27. (15 minutes) Ratio Return on net operating assets (RNOA) Net operating profit margin (NOPM) Net operating asset turnover (NOAT)

ANF 10.47% 2.43% 4.30

TJX 73.31% 7.87% 9.32

NOPAT Average NOA RNOA = NOPAT / Average NOA

ANF 87.4 834.8 10.47%

TJX 3,066.7 4,183.2 73.31%

NOPAT Sales NOPM = NOPAT / Sales

87.4 3,590.1 2.43%

3,066.7 38,972.9 7.87%

Sales Average NOA NOAT = Net sales / Average NOA

3,590.1 834.8 4.30

38,972.9 4,183.2 9.32

Computations:

M4-28. (15 minutes) Ratio Current ratio Times interest earned Liabilities-to-Equity

2018 0.91 4.61 6.99

2017 0.91 5.79 8.77

Current assets Current liabilities Current ratio = Current assets / Current liabilities

2018 34,636 37,930 0.91

2017 29,913 33,037 0.91

Earnings before interest and tax Interest expense, gross Times interest earned

22,278 4,833 4.61

27,425 4,733 5.79

Total liabilities Equity Liabilities-to-Equity ratio

382,308 54,710 6.99

391,875 44,687 8.77

Computations:

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M4-29. (30 minutes) a. Ratio Net operating profit (NOPAT) Return on Net operating assets (RNOA) Net operating profit margin (NOPM) Net operating asset turnover (NOAT)

Home Depot $11,881 47.11% 10.98% 4.29

Lowe’s $2,801 13.78% 3.93% 3.51

Home Depot 974 214 3,435

Lowe’s 624 137 1,080

3,649

1,217

NOPBT NOPAT = NOPBT - Tax on operating profit

15,530 11,881

4,018 2,801

NOPAT Average NOA RNOA = NOPAT / Average NOA

11,881 25,217 47.11%

2,801 20,326 13.78%

NOPAT Sales NOPM = NOPAT / Sales

11,881 108,203 10.98%

2,801 71,309 3.93%

Sales Average NOA NOAT = Sales / Average NOA

108,203 25,217 4.29

71,309 20,326 3.51

Computation:

Pretax Net Nonoperating Expense Tax shield at 22% Tax expense Tax on operating profit = Tax expense + Tax shield

b. Home Depot Is more profitable (in $ terms).

Has higher profit margin ( in % terms).

Has more efficient NOA.

Has higher return on NOA.

Lowe’s

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EXERCISES E4-30. (30 minutes) a. Ratio Current ratio Quick ratio Times interest earned Liabilities-to-Equity

HAL 2.32 1.51 4.45 1.72

SLB 1.17 0.79 5.68 0.93

Computations Current assets Current liabilities Current ratio = Current assets / Current liabilities

HAL $11,151 4,802 2.32

SLB $15,731 13,486 1.17

Cash and equivalents Short-term investments Accounts receivable Quick assets Current liabilities Quick ratio = Quick assets / Current liabilities

2,008 0 5,234 7,242 4,802 1.51

1,433 1,344 7,881 10,658 13,486 0.79

Earnings before interest and tax Interest expense, gross Times interest earned = EBIT / Interest expense, gross

2,467 554 4.45

3,050 537 5.68

Total liabilities Equity Liabilities-to-Equity ratio

16,438 9,544 1.72

33,921 36,586 0.93

b. HAL Which company appears to be more liquid?

SLB

Which company appears to be more solvent?

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E4-31. (30 minutes) a. Ratio DSO = 365 / Accounts receivable turnover DIO = 365 / Inventory turnover DPO = 365 / Accounts payable turnover Cash conversion cycle = DSO + DIO - DPO

HAL 78.1 47.1 48.4 76.8

SLB 88.8 51.6 129.8 10.6

Computations Total revenue Average accounts receivable Accounts receivable turnover = Total revenue / Average accounts receivable DSO = 365 / Accounts receivable turnover

HAL 23,995 5,135

SLB 32,815 7,983

4.67 78.11

4.11 88.79

Cost of sales and services Average inventory Inventory turnover = Cost of sales and services / Average inventory DIO = 365 / Inventory turnover

21,009 2,712

28,478 4,028

7.75 47.12

7.07 51.63

Cost of sales and services Average accounts payable Accounts payable turnover = Cost of sales and services / Average accounts payable DPO = 365 / Accounts payable turnover

21,009 2,786

28,478 10,130

7.54 48.40

2.81 129.83

b. Which company better manages its accounts receivable? Which company uses inventory more efficiently? Which company better manages its accounts payable?

HAL X X

SLB

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E4-32. (30 minutes) $ millions a. Net income attributable to 3M shareholders Equity attributable to 3M shareholders ROE = Net income attributable to 3M / Average equity attributable to 3M

2018

2017

$5,349 9,796

$11,563

50.09%

b. Net income Sales Profit margin = Net income / Sales

5,363 32,765 16.37%

Sales Assets Asset turnover = Sales / Assets

32,765 36,500 0.880

37,987

Assets Total equity Financial leverage (FL) = Average assets / Average Total equity

36,500 9,848

37,987 11,622

Net income Assets Return on assets = Net income / Average assets

5,363 36,500 14.40%

Pre-tax interest expense, net Tax shield at 22% After-tax interest expense, net Net income Assets Adjusted ROA = (Net income + after-tax interest expense, net) / Average assets

207 46 161 5,363 36,500

3.4694

c. 37,987

37,987

14.83%

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E4-33. (30 minutes) HAL

SLB

653 144 509 1,657 2,166

426 81 345 2,177 2,522

Average net operating assets Average net operating liabilities Average NOA RNOA = NOPAT / Average NOA

23,361 5,888 17,473 12.40%

67,836 16,499 51,337 4.91%

NOPAT Total revenue NOPM = NOPAT / Total revenue Total revenue Average NOA NOAT = Total revenue / Average NOA

2,166 23,995 9.03% 23,995 17,474 1.37

2,522 32,815 7.69% 32,815 51,337 0.64

a. Net nonoperating expense, before tax Tax shield at statutory rate NNE = Net nonop exp before tax - tax shield Net income NOPAT

c. HAL’s higher RNOA derives from its higher NOPM and NOAT. We can conclude that HAL is better able to manage its income statement and balance sheet as compared to Schlumberger.

E4-34. (30 minutes) a. Net income Average equity ROE = Net income / Average equity

$802,265.0 1,473,464.0 54.45%

b. Net income Average operating assets + Average nonoperating assets = Average assets ROA = Net income / Average assets

802,265.0 2,627,235.5 2,948,529.0 5,575,764.5 14.39%

Average assets Average equity Financial leverage (FL) = Average assets / Average equity

5,575,764.5 1,473,464.0 3.78

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c. Net income Sales Profit margin (PM) = Net income / Sales

802,265.0 4,036,701.0 19.87%

Sales Average assets Asset turnover (AT) = Sales / Assets

4,036,701.0 5,575,764.5 0.724

d. ROE = PM × AT × FL ROE = 19.87% × 0.724 × 3.78 small rounding difference

54.38%

E4-35. (30 minutes) a. Earnings attributable to company shareholders Average Company shareholders' equity ROE = Earnings attributable to company shareholders / Average Company shareholders' equity

1,337.6 7,081.5 18.89%

Sales -- Operating expenses including tax = NOPAT

15,668.2 14,088.7 1,579.5

Average Operating assets – Average Operating liabilities = Average Net operating assets (NOA)

16,817.7 6,830.6 9,987.1

RNOA = NOPAT / Average NOA

15.82%

NOPAT Sales NOPM = NOPAT / Sales

1,579.5 15,668.2 10.08%

Sales Average NOA NOAT = Sales / Average NOA

15,668.2 9,987.1 1.569

c. The ratio of RNOA to ROE is 84% (15.82%% / 18.89%). Ingersoll Rand’s debt is used to finance assets that earn a return in excess of the cost of debt, thus improving the returns to shareholders. In this case, financial leverage is increasing the return to shareholders. We can compute the nonoperating return as ROE - RNOA = 18.89% - 15.82% = 3.07%.

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E4-36. (30 minutes) a. $ thousands Net income Average shareholders’ equity Return on equity (ROE) = Net income / Average equity

$802,265 1,473,464 54.45%

$ thousands Net income Average assets = Average op assets + Average nonop assets Return on assets (ROA) = Net income / Average assets

802,265 5,575,765 14.39%

$ thousands NOPAT = Net income + Interest expense × (1 - 22%) Average NOA = Average op assets - Average op liabilities RNOA = NOPAT / Average NOA

865,650 1,108,865 78.07%

d. ROE measures the total return to the company shareholders. RNOA measures how productive the net operating assets are. For KLA Tencor, ROE < RNOA because the company has negative NNO, meaning that the company is holding nonoperating assets in excess of any debt. These assets are not making the same return as the operating assets and so the return to shareholders is negatively impacted.

E4-37. (30 minutes) Return on equity = (Net income attributable to Company shareholders / Average equity attributable to Company shareholders) RNOA = NOPAT / Average NOA Nonoperating return = ROE - RNOA NNEP = NNE / Average NNO Spread = RNOA - NNEP FLEV = Average NNO / Average total equity NCI ratio = (Net income attributable to Company shareholders / Net income) / (Average equity attributable to Company shareholders / Average total equity) ROE = (RNOA + (Spread × FLEV)) × NCI ratio

7.71% 6.10% 1.61% 3.30% 2.80% 0.56

1.01 7.71%

continued

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Computations: Net income attributable to Company shareholders Average equity attributable to Company shareholders Return on equity = (Net income attributable to Company shareholders / Average equity attributable to Company shareholders)

2,368 30,711 7.71%

NOPAT Average NOA RNOA = NOPAT / Average NOA

2,940 48,222 6.10%

Net nonoperating expense (NNE) Average net nonoperating obligations (NNO) NNEP = NNE / Average NNO

572 17,312 3.30%

RNOA NNEP Spread = RNOA - NNEP

6.10% 3.30% 2.80%

Average NNO Average total equity FLEV = Average NNO / Average total equity

17,312 30,910 0.5601

Net income attributable to Company shareholders Net income Average equity attributable to Company shareholders Average total equity NCI ratio = (Net income attributable to Company shareholders / Net income) / (Average equity attributable to Company shareholders / Average total equity)

2,368 2,368 30,711 30,910

1.0065

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E4-38. (30 minutes) Return on equity = Net income / Average total equity RNOA = NOPAT / Average NOA Nonoperating return = ROE - RNOA NNEP = NNE / Average NNO Spread = RNOA - NNEP FLEV = Average NNO / Average total equity ROE = RNOA + (Spread × FLEV)

44.48% 49.70% -5.22% -65.42% 115.16% (0.0454) 44.48%

Computations: Net income Average total equity Return on equity = (Net income / Average total equity

$8,394.0 $18,871 44.48%

NOPAT Average NOA RNOA = NOPAT / Average NOA

$8,954.0 $18,015.0 49.70%

Net nonoperating expense (NNE) Average net nonoperating obligations (NNO) NNEP = NNE / Average NNO

$ 560.0 $(856) -65.46%

RNOA NNEP Spread = RNOA - NNEP

49.70% -65.42% 115.12%

Average NNO Average total equity FLEV = Average NNO / Average total equity

(856) 18,871 (0.0454)

ROE = RNOA + (Spread x FLEV) = 49.7% + (115.12% × -0.0454)

44.48%

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E4-39. (30 minutes) a. Ratio Current ratio Quick ratio Times interest earned Liabilities-to-Equity

2018 0.94 0.75 21.71 0.87

2017 0.81 0.65 27.17 1.13

Computations: Current assets Current liabilities Current ratio = Current assets / Current liabilities

2018 16,825 17,860 0.94

2017 15,889 19,595 0.81

Cash and equivalents Short-term investments Accounts receivable Quick assets Current liabilities Quick ratio = Quick assets / Current liabilities

4,150 0 9,334 13,484 17,860 0.75

4,017 0 8,633 12,650 19,595 0.65

Earnings before interest and tax (EBIT) Interest expense, gross Times interest earned = EBIT / Interest expense, gross

14,804 682

13,775 507

21.71

27.17

Total liabilities Equity Liabilities-to-Equity ratio

45,766 52,832 0.87

50,785 45,004 1.13

b. 2018 In which year does the company appear more liquid?

In which year does the company appear more solvent?

2017

* Although Times interest earned was higher (stronger) in 2018, the difference between 22 times and 27 times is not that significant. In contrast, the liabilities to equity ratio improved significantly in 2018, dropping from 1.13 to 0.87.

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E4-40. (20 minutes) $ thousands a. NNE before tax Tax shield at 22% = NNE before tax × 22% NNE after tax = NNE before tax - Tax Shield Net income

8,860 1,949 6,911 3,059,798

NOPAT = Net income + NNE

$3,066,709

Net operating profit before tax Tax expense Tax shield

$4,182,071 1,113,413 1,949

NOPAT = NOPBT -(Tax expense + Tax shield)

$ 3,066,709

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PROBLEMS P4-41. (45 minutes) $ millions a. Net nonoperating expense before tax tax shield at 22% Net nonoperating expense (NNE) Net income Net operating profit after tax (NOPAT) = Net income + NNE

2018

2017

207 46 161 5,363 5,524

Net operating profit before tax Tax expense Tax shield NOPAT = NOPBT -(Tax expense + Tax shield)

7,207 1,637 45.54 5,524.5

Accounts receivable Total inventories Prepaids Other current assets Property, plant and equipment, net Goodwill Intangible assets - net Other assets Operating assets

5,020 4,366 741 349 8,738 10,051 2,657 1,345 33,267

4,911 4,034 937 266 8,866 10,513 2,936 1,395 33,858

Accounts payable Accrued payroll Accrued income taxes Other current liabilities Pension and postretirement benefits Other liabilities Operating liabilities

2,266 749 243 2,775 2,987 3,010 12,030

1,945 870 310 2,709 3,620 2,962 12,416

NOA = Operating assets - Operating liabilities

21,237

21,442

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$ millions c. NOPAT NOA RNOA = NOPAT / Average NOA

2018

2017

5,524 21,237 25.89%

21,442

NOPAT Net sales NOPM = NOPAT / Net sales

5,524 32,765 16.86%

Net sales NOA NOAT = Net sales / Average NOA

32,765 21,237 1.54

RNOA = NOPM × NOAT

25.89%

Short-term borrowings and current portion of long-term debt Long-term debt Nonoperating liabilities

1,211 13,411 14,622

1,853 12,096 13,949

Cash and cash equivalents Marketable securities Nonoperating assets

$ 2,853 380 3,233

$ 3,053 1,076 4,129

NNO = Nonoperating liabilities - Nonoperating assets

11,389

9,820

Net income attributable to 3M Total 3M Company shareholders' equity ROE = Net income attributable to 3M / Average Total 3M Company shareholders' equity

5,349 9,796

11,563

50.09%

Nonoperating return = ROE - RNOA

24.20%

21,442

g. ROE>RNOA implies that 3M is able to borrow money to fund operating assets that yield a return greater than the cost of the debt. The excess of 24.20%, accrues to the benefit of 3M’s stockholders.

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P4-42. (30 minutes) 2018

2017

Net income Total equity ROE = Net income / Average Total equity

22,112 84,127 27.91%

74,347

Net income Total assets ROA = Net income / Average Total assets

22,112 97,334 24.32%

84,524

Total assets Total equity Financial leverage (FL) = Average Total assets / Average Total equity

97,334 84,127

84,524 74,347

ROE = ROA × FL

27.91%

Net income Revenue Profit margin (PM) = Net income / Revenue

22,112 55,838 39.60%

Revenue Total assets Asset turnover (AT) = Revenue / Average Total assets

55,838 97,334 0.614

ROE = PM × AT × FL= 39.60% × 0.614 × 1.148=

27.91%

1.148

84,524

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P4-43. (30 minutes) a. $ millions Current liabilities Current ratio = Current assets / Current liabilities

2018 7,244 1.89

2017 7,687 1.86

Cash and equivalents Marketable securities - current Accounts receivable - net Quick assets Current liabilities Quick ratio = Quick assets / Current liabilities

2,853 380 5,020 8,253 7,244 1.14

3,053 1,076 4,911 9,040 7,687 1.18

Current ratio improves very slightly and quick ratio weakens very slightly. We would conclude that the company is liquid, both current and quick ratios are above the 1.0 rule of thumb. b. $ millions Earnings before interest and tax Interest expense, gross Times interest earned = EBIT / Interest expense, gross

2018 7,207 350 20.59

2017 7,692 322 23.89

Total liabilities

26,652

26,365

Equity Liabilities-to-Equity ratio

9,848 2.71

11,622 2.27

Solvency metrics both weakened slightly in 2018. c. 3M is liquid (current ratio over 1.5) and is not highly financially leveraged. Its times interest earned ratio is high, thus lessening any solvency concerns. The company’s ability to meet its debt requirements is not at issue. 3M’s times interest earned decreased during 2018, however, it remains very high – there is no concern with the company’s ability to service its debt. The total liabilities-to-equity increased during 2018 and is above the 1.5 median for publicly traded companies. The ratios indicate modest financial leverage and strong coverage of interest expense.

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P4-44. (40 minutes) $ millions a. Net nonoperating expense, before tax Tax shield at 22% Net nonoperating expense (NNE) = Net nonoperating expense, before tax - Tax shield Net income NOPAT

2018

2017

207 46 161 5,363 5,524

b. Short-term borrowings and current portion of long-term debt Long-term debt Nonoperating liabilities

1,211 13,411 14,622

1,853 12,096 13,949

Cash and cash equivalents Marketable securities Nonoperating assets

2,853 380 3,233

3,053 1,076 4,129

NNO = Nonoperating liabilities - Nonoperating assets

11,389

9,820

NNO Equity FLEV = Average NNO / Average Equity

11,389 9,848 0.988

9,820 11,622

NNE NNO NNEP = NNE / Average NNO

161 11,389 1.52%

RNOA NNEP Spread = RNOA - NNEP

25.89% 1.52% 24.37%

d. 9,820

e. Net income attributable to 3M Net income Equity attributable to 3M shareholders Total equity NCI ratio = (Net income attributable to 3M / Net income) / (Average equity attrib to 3M shareholders / Average total equity)

5,349 5,363 9,796 9,848

11,563 11,622

1.0026

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f. $ millions ROE = [RNOA + (FLEV × Spread)] × NCI ratio = [25.89% + (0.988 × 24.37%)] × 1.0026 Small rounding difference

2018

2017

50.09%

g. 3M’s nonoperating return is positive, implying that 3M is able to borrow funds to acquire operating assets that yield a return greater than cost of debt.

P4-45. (45 minutes) $ millions a. NNE before tax tax shield at 22% NNE after tax Net income NOPAT

2-Sep-18

3-Sep-17

38 8 30 3,179 3,209

b. Receivables, net Merchandise inventories Other current assets Net property and equipment Other assets Operating assets

1,669 11,040 321 19,681 860 33,571

1,432 9,834 272 18,161 869 30,568

Accounts payable Accrued salaries and benefits Accrued member rewards Deferred membership fees Other current liabilities Other liabilities Operating liabilities

11,237 2,994 1,057 1,624 3,014 1,314 21,240

9,608 2,703 961 1,498 2,725 1,200 18,695

NOA = Operating assets - Operating liabilities

12,331

11,873

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$ millions c. RNOA = NOPAT / Average NOA NOPM = NOPAT / Total revenue NOAT = Total revenue / Average NOA

2-Sep-18

3-Sep-17

26.52% 2.27% 11.70

RNOA = 2.27% × 11.7

26.52%

Long-term debt Nonoperating liabilities

6,487 6,487

6,573 6,573

$ 6,055 1,204 7,259

$ 4,546 1,233 5,779

(772)

794

Cash and cash equivalents Short-term investments Nonoperating assets NNO = Nonoperating liabilities - Nonoperating assets NOA = (772)+13,103

12,331

Total equity Total Costco stockholders' equity

13,103 12,799

Return on equity = Net income attributable to Costco / Average Total Costco stockholders' equity

26.59%

f. Nonoperating return = ROE - RNOA

0.07%

11,079 10,778

g. ROE > RNOA implies that Costco is able to borrow money to fund operating assets that yield a return greater than the cost of its debt. The number is very small, but still positive. The excess accrues to the benefit of Costco’s stockholders.

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P4-46. (30 minutes) $ millions a. Current assets Current liabilities Current ratio = Current assets / Current liabilities

Sep. 02, 2018 Sep. 03, 2017 20,289 19,926 1.02

17,317 17,495 0.99

Cash and equivalents Short-term investments Accounts receivable - net Quick assets Current liabilities Quick ratio = Quick assets / Current liabilities

6,055 1,204 1,669 8,928 19,926 0.45

4,546 1,233 1,432 7,211 17,495 0.41

Earnings before interest and tax Interest expense, gross Times interest earned = EBIT / Interest expense, gross

4,480 159

4,111 134

28.18

30.68

Total liabilities Equity Liabilities-to-Equity ratio

27,727 13,103 2.12

25,268 11,079 2.28

c. Costco is reasonably liquid (current ratio near 1.0 and quick ratio near 0.40) especially for a retail organization that turns inventory frequently. The company has reasonable level of financial leveraged and its times interest earned ratio is fairly high. The company generates sizeable operating profits and cash flow. In sum, there are no liquidity or solvency concerns for Costco.

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P4-47. (40 minutes) $ millions a. Net nonoperating expense, before tax Tax shield at 22% Net nonoperating expense (NNE) = Net nonoperating expense, before tax - Tax shield Net income NOPAT

2018

2017

38 8 30 3,179 3,209

b. Long-term debt Nonoperating liabilities

6,487 6,487

6,573 6,573

$ 6,055 1,204 7,259

$ 4,546 1,233 5,779

(772)

794

NNO Total equity FLEV = Average NNO / Average Equity

(772) 13,103.0 0.001

794 11,079.0

NNE NNO NNEP = NNE / Average NNO

30 (772) 272.73%

RNOA NNEP Spread = RNOA - NNEP

26.52% 272.73% -246.21%

Cash and cash equivalents Short-term investments Nonoperating assets NNO = Nonoperating liabilities - Nonoperating assets c.

d. 794

e. Net income attributable to Costco Net income Equity attributable to Costco shareholders Total equity NCI ratio = (Net income attributable to Costco / Net income) / (Average equity attributable to Costco shareholders / Average total equity)

3,134 3,179 12,799 13,103

10,778 11,079

1.0111

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f. $ millions ROE = (RNOA + (Spread × FLEV)) × NCI ratio = [26.52% + (-246.21% × 0.001)] × 1.0111

2018

2017

26.59%

g. Costco’s NNO in 2018 is negative because nonoperating liabilities are less than nonoperating assets, which include significant levels of cash and short-term investments. In 2017 NNO was positive such that the average NNO in 2018 is very small (only $11 million) which creates a large NNEP and a negative Spread. The effect on ROE is minimal because FLEV is close to zero.

P4-48. (40 minutes) $ millions a. Nonoperating items before tax tax shield at 22% Nonoperating items after tax (NNE) Net income NOPAT

2018

2017

(448) (99) (349) 22,112 21,763

b. Accounts receivable, net Prepaid expenses and other current assets Property and equipment, net Intangible assets, net Goodwill Other assets Operating assets

7,587 1,779 24,683 1,294 18,301 2,576 56,220

5,832 1,020 13,721 1,884 18,221 2,135 42,813

Total liabilities Operating liabilities

13,207 13,207

10,177 10,177

NOA = Operating assets - Operating liabilities

43,013

32,636

RNOA = NOPAT / Average NOA NOPM = NOPAT / Total revenue NOAT = Total revenue / Average NOA

57.54% 38.98% 1.48

RNOA = 38.98% × 1.48

57.54%

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d. $ miillions Net income Total equity ROE = Net income / Average Total equity

2018 22,112 84,127 27.91%

2017 74,347

e. The difference between ROE and RNOA is -29.63% because Facebook is holding so much cash and marketable securities and not making a very high return. This is destroying shareholder value – return to the owners (ROE) would be nearly 30% higher absent all the cash the company holds.

P4-49. (20 minutes) $ millions a. Net income Total equity ROE = Net income / Average Total equity

2018

2017

22,112 84,127 27.91%

74,347

b. Net nonoperating items before tax Tax shield at 22% Net nonoperating expense (NNE ) Net income NOPAT = Net income + NNE

(448) (99) (349) 22,112 21,763

Nonoperating liabilities

Cash and cash equivalents Marketable securities Nonoperating assets

10,019 31,095 41,114

8,079 33,632 41,711

NNO = Nonoperating liabilities - Nonoperating assets NNEP = NNE / Average NNO

(41,114) 0.84%

(41,711)

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$ millions c. NNO Total equity FLEV = Average NNO / Average total equity

2018

2017

(41,114) 84,127 (0.5226)

(41,711) 74,347

NNE NNO NNEP = NNE / Average NNO

(349) (41,114) 0.84%

RNOA - given Spread = RNOA - NNEP

57.54% 56.70%

ROE = RNOA + (Spread × FLEV) ROE = 57.54% + (56.70% × -0.5226)

27.91%

Nonoperating return = FLEV × Spread

-29.63%

(41,711)

Facebook’s nonoperating return is negative because the company has a negative NNO, which means that the company holds very significant levels of cash and marketable securities. Like many other tech firms, Facebook has excess cash on hand, presumably to be able to respond to investment opportunities such as acquisitions. While this liquidity allows the company to be nimble, it comes at a cost. The cash and marketable securities earn a very small return (0.84%) while the operating assets earn a significant return. The company is tying up cash that could be returned to stockholders who could presumably, invest the cash at a return greater than 0.84%. Thus, Facebook is “destroying” shareholder value.

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P4-50. (45 minutes) $ thousands a. NNE before tax ($420,493 - $41,725) tax shield at 22% NNE after tax Net income NOPAT

2018

2017

$ 378,768 83,329 295,439 1,211,242 $1,506,681

b. Current content assets, net Other current assets Non-current content assets, net Property and equipment, net Other non-current assets Operating assets

$5,151,186 748,466 14,960,954 418,281 901,030 $22,179,917

4,310,934 536,245 10,371,055 319,404 652,309 16,189,947

Current content liabilities Accounts payable Accrued expenses Deferred revenue Non-current content liabilities Other non-current liabilities Operating liabilities

$4,686,019 562,985 477,417 760,899 3,759,026 129,231 $10,375,577

4,173,041 359,555 315,094 618,622 3,329,796 135,246 8,931,354

NOA = Operating assets - Operating liabilities

$11,804,340

$7,258,593

c. RNOA = NOPAT / Average NOA NOPM = NOPAT / Total revenue NOAT = Total revenue / Average NOA RNOA = 9.54% × 1.66

15.81% 9.54% 1.66 15.81%

d. Long-term debt Less Cash and cash equivalents Nonoperating obligations (NNO) Equity NOA = NNO + Equity

10,360,058 3,794,483 6,565,575 5,238,765 11,804,340

6,499,432 2,822,795 3,676,637 3,581,956 7,258,593

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$ thousands e. Net income Total equity ROE = Net income / Average Total equity

2017

1,211,242 5,238,765 27.46%

3,581,956

f. Nonoperating return = ROE - RNOA

11.65%

g. ROE > RNOA implies that Netflix is able to borrow money to fund operating assets that yield a return greater than the cost of its debt. The excess of 11.65% accrues to the benefit of the Netflix stockholders.

P4-51. (30 minutes) $ thousands a. Net income Total equity ROE = Net income / Average Total equity

2018

2017

1,211,242 5,238,765 27.46%

3,581,956

Net income Total assets ROA = Net income / Average Total assets

1,211,242 25,974,400 5.38%

19,012,742

Net income Revenue Profit margin (PM) = Net income / Revenue

1,211,242 15,794,341 7.67%

Revenue Total assets Asset turnover (AT) = Revenue / Average Total assets

15,794,341 25,974,400 0.70

19,012,742

Total assets Total equity Financial leverage (FL) = Average Total assets / Average Total equity

25,974,400 5,238,765

19,012,742 3,581,956

ROE = PM × AT × FL = 7.67% × 0.70 × 5.10 = 27.38% Small rounding difference

5.10 27.46%

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c. $ thousands Interest expense, net Interest expense, after tax Net income Adjusted ROA = (Net income + Interest expense, after tax) / Average Total assets

2018 378,768 295,439 1,211,242

2017

6.70%

P4-52. (30 minutes) a.

This graph is similar to the one in the module and reveals the trade-off between profit margin and asset turnover. Basic economics suggest that companies with high turnover have low margin and vice versa. b. High performing companies are those that exhibit a higher profit margin when holding asset turnover constant, and have a higher turnover when holding profit margin constant. Thus, increasing RNOA requires managers to manage both the income statement and the balance sheet.

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P4-53. (30 minutes) a. $ millions Ratio Days sales outstanding (DSO) Days inventory outstanding (DIO) Days payables outstanding (DPO) Cash conversion cycle

K 37.24 52.72 97.16 -7.20

GIS 36.11 55.32 86.11 5.32

Computations Total revenue Average accounts receivable Accounts receivable turnover = Total revenue / Average AR DSO = 365 / Accounts receivable turnover

K 13,547 1,382 9.80 37.24

GIS 15,740 1,557 10.11 36.11

Cost of goods sold Average inventory Inventory turnover = Cost of sales and services / Average inventory DIO = 365 / Inventory turnover

8,821 1,274

10,313 1,563

6.92 52.72

6.60 55.32

Cost of goods sold Average accounts payable Accounts payable turnover = Cost of sales and services / Average AP DPO = 365 / Accounts payable turnover

8,821 2,348

10,313 2,433

3.76 97.16

4.24 86.11

Cash conversion cycle = DSO + DIO - DPO

-7.20

5.32

b. K

GIS

Which company better manages its accounts receivable?

Which company uses inventory more efficiently?

Which company better manages its accounts payable?

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IFRS APPLICATIONS I4-54. (15 minutes) C$ millions

2018

2017

a. Net income attributable to Husky Equity attributable to Husky shareholders ROE = Net income attributable to Husky / Equity attributable to Husky shareholders

1,457 19,602

Pre-tax NNE Tax shield at 27.2% NNE Net income NOPAT = Net income + NNE

236 64 172 1,457 1,629

Operating assets Operating liabilities

32,231 9,864

30,222 9,520

Net operating assets (NOA) = Op Assets - Op Liab

22,367

20,702

RNOA = NOPAT / Average NOA

7.56%

NOPAT Revenues, net NOPM = NOPAT / Revenues

1,629 22,252 7.32%

Revenues, net NOA NOAT = Revenues / Average NOA

22,252 22,367 1.03

RNOA / ROE Nonoperating return = ROE - RNOA

97.42% 0.20%

17,956

7.76%

20,702

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I4-55. (25 minutes) C$ millions

2018

2019

Current assets Current liabilities Current ratio = Current assets / Current liabilities

5,688 4,994 1.14

5,616 3,507 1.60

Cash and equivalents Short-term investments Accounts receivable

2,866 0 1,355

2,513 0 1,355

Quick assets Current liabilities Quick ratio = Quick assets / Current liabilities

4,221 4,994 0.85

3,868 3,507 1.10

Earnings before interest and tax Interest expense, gross Times interest earned = EBIT / Interest expense, gross

2,095 314 6.67

724 392 1.85

Total liabilities Equity Liabilities-to-Equity ratio

15,611 19,614 0.80

14,960 17,967 0.83

Husky has a fairly solid liquidity: current ratio and quick ratio are both strong. Times interest earned is in the moderate range and the liabilities to equity ratio is low. The company is well able to service its debt and make its interest payments. The company is solvent.

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MANAGEMENT APPLICATIONS MA4-56. (30 minutes) a. Raising prices and/or reducing manufacturing costs are not necessarily independent solutions, and are likely related to other factors. The effect of a price increase on gross profit is a function of the demand curve for the company’s product. If the demand curve is relatively elastic, customers are sensitive to price hikes. Thus, a price increase could significantly reduce demand, thereby decreasing, rather than increasing, gross profit (an example is a 10% increase in price and a 20% decrease in demand). A price increase will have a more desired effect if the demand curve is relatively inelastic (an example is a 10% price increase with a 3% decrease in demand). Cutting manufacturing costs will increase gross profit (via reduction of COGS) if the more inexpensively made product is not perceived to be of lesser quality, thereby reducing demand. b. Raising prices is difficult in competitive markets. As the number of product substitutes increases, companies are less able to raise prices. Rather, they must be able to effectively differentiate their products in some manner in order to reduce consumers’ substitution. This can be accomplished, for example, by product design and/or advertising. These efforts, however, likely entail additional cost, and, while gross profit might be increased as a result, SG&A expense may also increase with little effect on the bottom line. Manufacturing costs consist of raw materials, labor and overhead. Each can be targeted for cost reduction. A reduction of raw materials costs generally implies some reduction in product quality, but not necessarily. It might be the case that the product contains features that are not in demand by consumers. Eliminating those features will reduce product costs with little effect on selling price. Similarly, companies can utilize less expensive sources of labor (off-shore production, for example), that can significantly reduce product costs and increase gross profit, provided that product quality is maintained. Finally, manufacturing overhead can be reduced by more efficient production. Wages and depreciation expense are two significant components of manufacturing overhead. These are largely fixed costs, and the per unit product cost can often be reduced by increasing capacity utilization of manufacturing facilities (provided, of course, that the increased inventory produced can be sold). The bottom line is that increasing gross profit is a difficult process that can only be accomplished by effective management and innovation.

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MA4-57. (30 minutes) a. Working capital management is an important component of the management of a company. By reducing the level of working capital, companies reduce the costs of carrying excess assets. This can have a significantly positive effect on financial performance. Common ways to decrease receivables and inventories, and increase payables, include the following: •

•

Reduce receivables ▪

Constricting the payment terms on product sales

▪

Better credit policies that limit credit to high-risk customers

▪

Better reporting to identify delinquencies

▪

Automated notices to delinquent accounts

▪

Increased collection efforts

▪

Prepayment of orders or billing as milestones are reached

▪

Use of electronic (ACH) payment

▪

Use of third-party guarantors, including bank letters of credit

Reduce inventories ▪

Reduce inventory costs via less costly components (of equal quality), produce with lower wage rates, eliminate product features (costs) not valued by customers

▪

Outsource production to reduce product cost and/or inventories the company must carry on its balance sheet

▪

Reduce raw materials inventories via just-in-time deliveries

▪

Eliminate bottlenecks in manufacturing to reduce work-in-process inventories

▪

Reduce finished goods inventories by producing to order rather than producing to estimated demand

Increase payables ▪

Extend the time for payment of low or no-cost payables—so long as the relationship with suppliers is not harmed

b. Payment terms to customers are a marketing tool, similar to product price and advertising programs. Many companies promote payment terms separately from other promotions (no payment for six months or interest-free financing, for example). As companies restrict credit terms, the level of receivables will likely decrease thereby reducing working capital. The restriction of credit terms may also have the undesirable effect of reducing demand for the company’s products. The cost of credit terms must be weighed against the benefits, and credit terms must be managed with care so as to optimize costs rather than minimize them. Credit policy is as much art as it is science. Likewise, the depth and breadth of the inventories that companies carry impact customer perception. At the extreme, inventory stock-outs result in not only the loss of current sales, but also the potential loss of future sales as customers are introduced to competitors and may develop an impression of the company as “thinly stocked.” Inventories are costly to maintain, as they must be financed, insured, stocked, moved, and so forth. Reduction in inventory levels can reduce these costs. On the other hand, the amount and type of inventories carried is a marketing decision and must be managed with care so as to optimize the level inventories, not necessarily to minimize them. continued

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b. continued One company’s account payable is another’s account receivable. So, just as one company seeks to extend the time of payment to reduce its working capital, so does the other company seek to reduce the average collection period to accomplish the same objective. Capable, dependable suppliers are a valuable resource for the company, and the supplier relation must be handled with care. All companies take as long to pay their accounts payable as the supplier allows in its credit terms. Extending the payment terms beyond that point begins to negatively impact the supplier relation, ultimately resulting in the loss of the supplier. The supplier relation must be managed with care so as to optimize the terms of payment, rather than necessarily to minimize them.

MA4-58. (30 minutes) a. The parties affected by schemes to manage earnings is often much broader than first thought. It includes the following affected parties: 1. employees above and below the level at which the scheme is implemented 2. stockholders and elected members of the board of directors 3. creditors of the company (suppliers and lenders) and their employees, stockholders, and board of directors 4. competitors of the company 5. the company’s independent auditors 6. regulators and taxing authorities b. Managers often believe that earnings management activities will be short-lived, and will be curtailed once its operations “turn around.” Often, this does not prove to be the case. Interviews with managers and employees who have engaged in this activity often reveal that they started rather innocuously (just managing earnings to “make the numbers” in one quarter), but, quickly, earnings management became a slippery slope. Ultimately, the parties the company was trying to protect (shareholders, for example) are hurt more than they would have been had the company reported its results correctly, exposing problems early so that corrective action could be taken (possibly by removing managers) to protect the broader stakeholders in the company. c.

Company managers are just ordinary people. They desire to improve their compensation, which is often linked to financial performance. Managers may act to maximize their current compensation at the expense of long-term growth in shareholder value. The reduction in the average employment period at all levels of the company has exacerbated the problem.

d. Unfortunately, the separation of ownership and control often leads to less informed shareholders who are unable to effectively monitor the actions of the managers they have hired. To the extent that compensation programs are linked to financial measures, managers can use the flexibility given to them under GAAP to their benefit, even without violating GAAP per se. These actions can only be uncovered by effective auditing and enforced by an effective audit committee of the board. Corporate governance has grown considerably in importance following the accounting scandals of the early 2000s. The Sarbanes-Oxley Act mandates new levels of corporate governance. The stock market and the courts are helping to enforce this mandate.

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Module 5 Revenues, Receivables, and Operating Expenses QUESTIONS Q5-1.

Performance obligations are the actions the seller must undertake to satisfy the customer and complete the sales contract. Every sale involves a contract (express or implied) between the customer and the company whereby the company agrees to transfer a good or service to the customer and the customer agrees to pay for it. All that is necessary for the company to recognize revenue is for the good to be transferred or the service performed. It is at that point the company’s performance obligation under the contract is satisfied and revenue can be recognized.

Q5-2.

When a company increases its allowance for uncollectible accounts, it also records bad debt expense in the income statement. If a company overestimates the allowance account, bad debt expense is too high and net income is understated. As well, accounts receivable (net of the allowance account) and total assets are both understated on the balance sheet. In future periods, the company will not need to add as much to its allowance account since it is already overestimated (or, it can reverse the excess existing allowance balance). As a result, future net income will be higher. On the other hand, if a company underestimates its allowance account, then current net income will be overstated. In future periods, however, net income will be understated as the company must add to the allowance account and report higher bad debts expense as accounts are written off.

Q5-3.

Companies allow customers to return goods purchased in order to increase sales. It has become a common practice especially among retailers and customers now expect it and might make shopping decisions based on return policies. Each period, the company must estimate the proportion of sales that are expected to be returned and deduct that amount from gross revenues. Net revenues are reported on the income statement.

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Q5-4.

The discontinued operations line item includes the net income or loss earned by the discontinued company or business unit, from the start of the year until the day the business is sold or closed. The discontinued operations line item also includes any gain or loss on the disposal of the net assets of the discontinued unit. The gain or loss is calculated as the difference between the sales proceeds and the net book value of the assets immediately before the sale.

Q5-5.

As the $US weakens vis-à-vis other currencies, sales and expenses that are denominated in foreign currencies increase when measured in US dollars. Because many U.S. companies operate subsidiaries outside of the US and maintain their financial records in non-$US currencies, a weakening $US can significantly increase both reported profit and loss at the consolidated level.

Q5-6.

Foreign exchange gains or losses are not “realized” unless and until the company repatriates the foreign earnings. If the foreign subsidiary keeps the profits (and cash) in the foreign country for future operations, the gain or loss will likely be mitigated or even reversed in subsequent periods. The gain or loss arises solely because of the requirement for consolidation of foreign financial statements into U.S. dollars for financial reporting purposes.

Q5-7.

Aging of accounts receivable means to sort the outstanding accounts into time buckets according to the age of the account as measured in the number of days since the account was due. For each time bucket, the company uses historical customer data to estimate the percentage of accounts that will likely prove uncollectible. The dollar value in each time bucket and the percentage uncollectible in each bucket, yields the total allowance necessary to cover anticipated future losses – this is the allowance for doubtful accounts.

Q5-8.

Cost-to-cost method is an appropriate method to recognize revenue for long-term contracts even if the company does not collect cash from the customer pro rata with the work performed. Under this method, revenue is recognized ratably with the costs incurred to create the product (as compared to the total expected contract costs).

Q5-9.

Pro forma income adjusts GAAP income to eliminate or add various items that the company believes do not reflect continuing, ongoing operations. Such pro forma disclosures are most often reported in earnings and press releases but occasionally as part of the published 10-Ks or other annual reports provided for shareholders. The SEC requires that reported pro forma income be reconciled to its GAAP equivalent. Non-GAAP information has the potential to confuse the reader about the true financial performance of the company. This has been cause for SEC concern. Also, pro forma numbers do not comply with accepted accounting standards (and, thus, we observe differing definitions of pro forma across companies), are not typically audited, and are subject to complete management latitude in what is and is not included and how items are measured.

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Q5-10.

Unearned revenue is cash a company receives from customers but has not yet been earned. Until the company earns the revenue, the amount received is a liability. If the company expects to earn the revenue in the coming year, it is a current liability; otherwise, it’s a long-term liability. Examples of unearned revenue include: customer deposits, gift cards, season tickets, membership fees, future software upgrades, partial payments in advance, and layaway plans of retailers.

Q5-11.

Current U.S. GAAP requires that all research and development costs be expensed as incurred. Equipment with alternate uses, is capitalized and depreciated over its useful life. The depreciation is typically included in R&D expense on the income statement.

Q5-12.

When products and services are bundled for one price, the sale is said to have multiple elements with multiple performance obligations. To recognize revenue, the company first identifies each performance obligation and then recognizes revenue when each obligation is satisfied. The revenue on the equipment is likely recognized at the point of sale and the service revenue over the period the services are rendered.

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MINI EXERCISES M5-13. (15 minutes) Instructor note:

The completed contract method is shown for those instructors who wish to cover it—it is not covered in the textbook. Cost-to-Cost Method

Completed Contract

Year

Costs incurred

Percent of total expected costs

Revenue recognized (percentage of costs incurred  total contract amount)

Income (Revenue – Costs incurred)

2016

$202,500

30%a

$270,000

$67,500

2017

337,500

50%b

450,000

112,500

2018

135,000

20%c

180,000

45,000

900,000

225,000

Total

$675,000

$900,000

$225,000

$900,000

$225,000

Revenue recognized $

Income $

$202,500 / $675,000 $337,500 / $675,000 c $135,000 / $675,000 b

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M5-14. Balance Sheet Transaction COGS 202,500 Cash 202,500 COGS 202,500 Cash 202,500

2016: Record $202,500 construction costs

Cash Asset

-202,500 Cash

Noncash Assets

–

Expenses

Net Income

-202,500 Retained Earnings

–

+202,500 Cost of Sales

-202,500

+270,000 +270,000 Retained Revenue Earnings

–

+270,000

-337,500 Retained Earnings

–

+337,500 = Cost of Sales

-337,500

+450,000 = Accounts Receivable

+450,000 Retained Earnings

–

+450,000

-135,000 Retained Earnings

–

+135,000 = Cost of Sales

-135,000

+180,000 +180,000 Retained Revenues Earnings

–

+180,000

LiabilContrib. + + ities Capital

Income Statement

Earned Capital

Revenues

AR 270,000 Rev 270,000

AR 270,000 Rev 270,000 COGS 337,500 Cash 337,500

COGS 337,500

Cash 337,500

2016: Recognize $270,000 revenue for contract

2017: Record $337,500 construction costs

+270,000 = Accounts Receivable

-337,500 Cash

AR 450,000 Rev 450,000 AR 450,000 Rev 450,000

2017: Recognize $450,000 revenue for contract

+450,000 Revenues

COGS 135,000 Cash 135,000

COGS 135,000 Cash 135,000 AR 180,000 Rev 180,000

AR 180,000 Rev 180,000

2018: Record $135,000 construction costs

-135,000 Cash

2018: Recognize $180,000 revenue for completed contract

+180,000 = Accounts Receivable

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M5-15. (20 minutes) Company a. GAP b. GlaxoSmithKline c. Deere & Co. d. Bank of America e. Johnson Controls

Revenue recognition 3 2 4 5 1

Company a. GAP b. GlaxoSmithKline c. Deere & Co. d. Bank of America e. Johnson Controls

Revenue recognition 3 2 4 5 1

M5-16. (15 minutes) OptimizeRx adds back depreciation and amortization expense. Then, the company adds back stock-based compensations. Both of these adjustments increase non-GAAP net income. For the fiscal quarter ended December 31, 2018, the adjustments changed a net loss into a significant net income. For the fiscal year, the small net income was changed to a nonGAAP net income by 13x. These adjustments affected the “net income” in very significant ways.

M5-17. (15 minutes) ModCloth Inc. can recognize revenues once the performance obligations have been satisfied. There are two: delivering the goods and standing ready to provide refunds. The first performance obligation is settled at the point of sale. The second one, only at the end of the return period. Therefore, at the time of sale, the company must estimate the proportion of product that is likely to be returned and deduct that amount from gross sales for the period. In this case, it would record $9.8 million in net sales (98% × $10 million) for the period. The company would create an allowance for sales returns on the balance sheet to offset the 2% of cash sales that they expect to have to refund.

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M5-18. (10 minutes) a. To bring the allowance from $700 to the desired balance of $2,100, the company will need to increase the allowance account by $1,400, resulting in bad debts expense of that same amount. b. The net amount of Accounts Receivable reported in current assets is calculated as follows: $86,000 − $2,100 = $83,900.

M5-19. (15 minutes) a. Credit losses are incurred in the process of generating sales revenue. Specific losses may not be known until many months after the sale. We set up an allowance for uncollectible accounts so that the expense of uncollectible accounts falls in the same accounting period as the sale. As well, the allowance ensures that we report accounts receivable at their estimated realizable value at the end of the accounting period. If we did not have an allowance, our net income and assets would be overstated and that could place you and all the directors in a risky position. b. The balance sheet presentation shows the gross amount of accounts receivable, the allowance amount, and the difference between the two, the estimated net realizable value. The balance sheet, thus, reports the net amount that we expect to collect. That is the amount that is the most relevant to financial statement users and to the board of directors as they assess the company’s financial performance. c. Accrual accounting requires that expenses (credit losses) be recorded in the income statement as incurred and not as paid. This dictates the use of the allowance method. Recognition of expense only upon the write-off of the account would delay the reporting of likely losses and, thereby, reduce the informativeness of the income statement. Accountants believe that providing more timely information justifies the use of estimates that may not be perfectly precise.

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M5-20. (20 minutes) a. Compute common-size Trade receivables, net, in 2018. iii. 3.61% = $2,262 / $62,729 b. What amount do Mondelez’ customers owe the company at December 31, 2018? ii. $2,302 = $2,262 + $40 c. What amount does Mondelez expect to collect from its customers at December 31, 2017? i. $2,691 = net amount d. The GROSS Receivables for 2018 is: ii. $3,093 = $2,262 + $40 + $744 + $47 e. What percentage of Trade receivables does the company deem uncollectible in 2018? iv. 1.74% = $40 / ($2,262 + $40) f.

Based on your analysis above, in which year does the company have higher quality trade receivables? i. 2018 because the percentage uncollectible is lower than in 2017, when the ratio was 1.82% (calculated as $50 / ($2,691 + $50)

M5-21. (20 minutes) a. Net sales 2018 Accounts receivable 2017 Accounts receivable Average accounts receivable AR turnover = Sales / Avg. AR DSO = 365 / AR turnover

Procter & Gamble $66,832 4,686 4,594 4,640 14.4 25.3

Colgate Palmolive $15,544 1,400 1,480 1,440 10.8 33.8

b. P&G collects its accounts receivable 8 days more quickly than Colgate-Palmolive. Differences can arise due to variations in the product mix of competitors, the types of customers they sell to, their willingness to offer discounts for early payment, and their relative bargaining strength vis-à-vis the companies or individuals owing them money. Both of these companies sell a significant amount of their product to Walmart. P&G is a sizable company, and may have greater bargaining power with Walmart than does the smaller Colgate-Palmolive.

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M5-22. (15 minutes) a. Total company sales increased by 3% in 2018. While prices decreased by an average of 1%, volume fell by an average of 1% -- the two effects cancelled each other out. b. Foreign exchange rate differences during the year caused sales to be higher in all segments with an average effect of 2% for the year. The average positive impact leads us to conclude that the U.S. dollar weakened during the year vis-à-vis the currencies in which P&G does business. c. No, this would be a false conclusion. The decrease for each segment is relative to that segment’s sales. If the two segments have different sales levels (measured in dollars) a percentage change will not be of the same magnitude. To compare the dollar impact across the two segments, we would need to know the total sales for each in 2018. M5-23. (20 minutes) a. Hamilton should record one-sixth of the season ticket receipts (or $105,000) after each production because this is when the revenue is earned. b. Balance Sheet Cash Asset

Transaction

Noncash Assets

Liabilities

Income Statement Contrib. + Capital

Earned Capital

Revenues

– Expenes =

Net Income

Cash 630,000 UR 630,000 Cash 630,000 UR 630,000

Receive cash in advance for season tickets

+630,000 Cash

+630,000 Unearned Revenue

-105,000 Unearned Revenue

–

= +105,000

105,000 Rev 105,000 Recognize revenue for first production

UR 105,000

+105,000 Retained Earnings

+105,000 Revenues

Rev 105,000

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M5-24. (20 minutes) a. Answer: iii. Explanation: When the customer uses the gift card, Target records revenue because this is when the performance obligation has been satisfied. Because the card sale itself is not the complete revenue producing activity, the company must wait till the card is used and which point Target also records an allowance for anticipated product returns. b. Answer: iv. Explanation: When Target receives the cash it does not record revenue. Rather, it records a liability called deferred revenue or unearned revenue because the company has a performance obligation (to sell goods when the cardholder redeems the card).

M5-25. (15 minutes) Answer d is true. Reducing the amount added to the allowance account increases net sales revenue, which increases profit. This may be due to management’s desire to increase profit for the period or it may indicate management’s expectation of lower future returns.

M5-26. (10 minutes) True. Revenue is recognized when the deferred revenue liability decreases. If the deferred revenue account has decreased, less cash came in from customer deposits and, all things equal, less revenue will be recognized in the future. Other interpretations are possible, but one valid interpretation is that future revenues will be lower.

M5-27. (10 minutes) False. Strengthening foreign currencies implies a weakening $US. As the $US weakens, foreign currencies purchase more $US, resulting in an increase in foreign currency-denominated sales, expense and profit. Consolidated revenues will therefore, likely be higher.

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M5-28. (15 minutes) a. True.

Amortization expense spreads out the cost of intangible assets over their useful life. Cash is expended when the intangible asset is acquired. Amortization expense is a noncash expense. b. False.

Corporate net income is apportioned between that attributable to noncontrolling interests and that attributable to the parent’s shareholders. It is not an expense; it is an apportionment of net income. c.

False. In order to be classified as a discontinued operation, the disposal of the business unit must represent a strategic shift for the company that has or will have a major effect on a company's financial results.

d. False.

Discontinued operations are segregated in the income statement because they represent a transitory item, which reflect transactions or events that affect the current period, but will not recur.

M5-29. (15 minutes) a. American Airlines discloses the issue because the flight cancellations had a significant

impact on the 2019 quarterly income statements. As well, the ongoing cancellations (through August 2019) will mean more lost revenue. Such a drop could impair any timeseries analysis of revenue and of net income. The company wants to be forthcoming about the problem – especially since it arises from factors being the control of American Airlines. The company squarely puts the blame on Boeing. b. Deferred revenue will fall. Most airline passengers pay for flight tickets in advance,

sometimes many months in advance. American Airlines records these advance payments as deferred revenue until the flight has been completed. With many cancelled flights, the company had to provide refunds to passengers; this decreased both cash and deferred revenue.

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M5-30. (15 minutes) a. Answer: ii

Explanation: With the signing of the definitive agreement, Campbell Soup has formally (and legally) decided to sell Bolthouse Farms. GAAP rules allow firms to classify operations as discontinued once a formal decision has been made. This presents an accurate picture of the operations that are expected to continue in the future. b. Answer: $666 million

Explanation: The table shows, that, for the nine months ended April 28, 2019 Bolthouse and Garden Fresh, had a combined revenue of $666 million, a fairly significant amount. c.

Answer: $(279) million. Explanation: The table shows a loss of $279 million for Bolthouse and Garden Fresh. Despite the combined sales revenue of $666 million, the two discontinued units reported an aggregate operating LOSS of $279 million. Perhaps the poor performance is the reason Campbell’s wanted to sell the two units. Or, in anticipation of the sale of Bolthouse, Campbell Soup might have recorded impairments on the Bolthouse or Garden Fresh assets including goodwill. These would reduce net income for the period but would have increased the loss on the asset sale.

d. Answer: $565 million.

Explanation: The proceeds on Garden Fresh Gourmet was $55 million and the anticipated proceeds from Bolthouse Farms is $510 million, for total proceeds of $565 million. e. Answer: $617 million.

Explanation: The loss on sale of Garden Fresh and the anticipated loss from the sale of Bolthouse, was $52. Ignoring tax effects, this suggests that the combined carrying value (net book value) of the two units was $617 million ($52 million + $565 million proceeds).

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EXERCISES E5-31. (20 minutes) Company

Revenue Recognition

a. American Eagle Outfitters Inc.

The performance obligation is satisfied when the customer takes the merchandise and the right of return period has expired or costs of returns can be reasonably estimated.

b. Raytheon Corporation

The performance obligation is satisfied during the contract period and thus, revenue is earned throughout the contract period. Under such long-term contracts, firms use the percentage-of-completion method, most often estimated by the cost-to-cost method.

c. Supervalu Inc.

The performance obligation is satisfied when the customer takes the merchandise and payment is received in cash, check, or credit card.

d. MTV

The performance obligation is satisfied when the content is aired by the TV stations.

e. Real estate developer

The performance obligation is satisfied when title to the houses is transferred to the buyers.

f. Bank of America Corp.

The performance obligation is satisfied over time and therefore, interest is earned during the life of the mortgage. Each period, Bank of America accrues income on each of its loans and establishes an account receivable on its balance sheet.

g. Harley-Davidson Inc.

There are multiple performance obligations in this sales contract. The first is satisfied when title to the motorcycles is transferred to the buyer. The second relates to the warranty on the motorcycles sold. Harley will recognize the estimated warranty revenue expense during the warranty period.

h. Time-Warner Inc.

The performance obligation is satisfied when the magazines are sent to subscribers. Subscriptions received in advance are deferred revenue (a liability) until the magazines are mailed. © Cambridge Business Publishers, 2021 5-13

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E5-32. (20 minutes) Company

Revenue Recognition

a. Real Money

The recognition of revenue is dependent upon Real Money providing updates—until then, the company has a performance obligation. Thus, the company should recognize revenue ratably over the period of time that customers can access its Website, not when the cash is received.

b. Oracle Corp.

The performance obligation is to provide the right to use the software. The company can record the up-front fee as revenue when the software is installed. A second performance obligation relates to the service contract. Service revenue can only be recognized ratably over the period of time covered by the service contract.

c. Intuit Inc.

Recognize revenue when the software is sent to customers. The company must estimate product returns and set up a reserve for that amount. But the performance obligation is satisfied at the point of sale.

d. Electronic Arts

Recognize revenue when the software is sold to customers because the performance obligation is satisfied at the point of sale. As for all product returns, the company must estimate the amount of anticipated returns and set up a reserve for that amount. The short returns window means that the returns allowance will be minimal.

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E5-33. (20 minutes) Instructor note:

The completed contract method is shown for those instructors who wish to cover it—it is not covered in the book.

a. ($ millions)

Cost-to-Cost Method Revenue recognized (percentage of costs incurred  total contract amount)

Completed Contract

Year

Costs incurred

Percent of total expected costs

2019

$240

40%a

$300

$ 60

2020

360

60%

450

750

150

Total

$600

$750

$150

$750

$150

Income (Revenue – Costs incurred)

Revenue recognized

Income

b. The cost-to-cost method normally provides a reasonable estimate of the revenues, expenses, and income earned for each period. A key is obtaining good estimates of expected costs and costs to date. This method is acceptable under the new revenue recognition rules, for construction contracts spanning more than one accounting period.

E5-34. (20 minutes) Instructor note:

The completed contract method is shown for those instructors who wish to cover it—it is not covered in the book.

a. ($ millions)

Cost-to-Cost Method Revenue recognized (percentage of Percent of Income costs incurred (Revenue total  total contract expected – Costs costs amount) incurred)

Year

Costs incurred

2019

$36

20% ($36/$180)

$ 44

$ 8

2020

45% ($81/$180)

2021

35% ($63/$180)

$180

Completed Contract

Revenue recognized

Income

$ 0

180

$220

$40

$180

$40

b. The cost-to-cost method provides a good estimate of the revenue and income earned in each period. This method is acceptable under GAAP for contracts spanning more than one accounting period. Note that recognition of revenue and income is not affected by the cash received. © Cambridge Business Publishers, 2021 5-15

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E5-35. (15 minutes) a. $ thousands Discounts Net revenues Gross revenues = Discounts + Net revenues Discount %

For the Three Months Ended 30-Mar-19 31-Mar-18 3,112 1,568 40,206 12,776 43,318 14,344 7.2% 10.9%

Beyond Meat is a very young company with an unusual product. The company provides significant discounts to build product awareness and brand loyalty. We observe that the level of discounts has decreased from 2018 to 2019. b.

$ thousands Fresh Platform Frozen Platform Retail Restaurant and Foodservice

For the Three Months Ended 30-Mar-19 31-Mar-18 38,806 9,596 4,512 4,748 19,579 9,288 20,627 3,488

Same Quarter growth 304% -5% 111% 491%

Sales grew across all platforms and channels except for the Frozen Platform. The growth in the other platform (Fresh) and across the two channels is spectacular but this is to be expected given the company’s age and life cycle. Looking at the growth rates together, we would conclude that sales of fresh product to restaurants account for the growth during the year. c. The company discloses the major customer information to help investors assess the risk associated with the company’s sales. With a few major customers, the company is exposed to potential revenue drops if any one of the major customers cut back on orders, or stopped buying the product altogether, or goes bankrupt. All else equal, investors prefer more diversified customer base.

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E5-36. (15 minutes) a. The FX impact is a gain – it increases Kellogg’s net income from $1,506 million

(currency neutral) to $1,510 million (GAAP). If the FX impact was related only to sales, foreign currency denominated sales increased, consistent with the USD weakening visà-vis other currencies. A weaker US dollar means that foreign currencies translate to more USD. b. If the FX impact was related only to expenses such as cost of goods sold, then

expenses decreased which is consistent with the dollar strengthening vis-à-vis other currencies. A stronger U.S. dollar means that the foreign currencies translate to less USD, expenses decrease and net income increases by the $4 million. c.

As an analyst, I would follow Kellogg’s lead and exclude this foreign currency effect from my analysis. The gains and losses on currencies for foreign subsidiaries can fluctuate wildly year to year. These fluctuations have little to do with the profitability of the foreign subsidiary in its own currency. Including the gain could impair my analysis of the company’s performance over time.

E5-37. (20 minutes) The following items are considered to be operating items on the income statement: •

Net sales

•

Cost of sales

•

Special inventory obsolescence charge

•

Selling general and administrative expense

•

Research and development

•

Merger and acquisition costs

•

In-process research and development

•

Litigation settlement

•

Gain on disposal of fixed assets

•

Income tax expense (the portion that relates to operating profit)

Note: “Other expense” is assumed to be operating unless information is provided in the footnotes that indicates otherwise OR the company shows it explicitly as non-operating. This is the case with Apollo – by showing the item after operating profit, the company is reporting that the item is not part of operations.

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E5-38. (20 minutes) a. The following items are operating: •

Net sales

•

Finance and interest income

•

Other income

•

Cost of sales

•

Research and development expenses

•

Selling, administrative and general expenses

•

Other operating expenses

•

Provision for income taxes (the portion that relates to operating profit)

•

Equity in income of unconsolidated affiliates. This relates to Deere’s strategic investments in companies over which it exerts significant influence, but does not control. This income is viewed as operating so long as the related investment is considered an operating asset.

Interest expense of $3,455.5 million is the only nonoperating item. b. John Deere’s finance and interest income is categorized as operating. Deere’s financial services business segment provides loans and leases for equipment sold to dealers and purchases end-customer receivables from those dealers. Thus, we consider these “financing” activities as an extension of the sales process, quite unlike an investment in marketable securities unrelated to the company’s activities. Analysts generally treat these sorts of captive finance operations as operating.

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E5-39. (20 minutes) a. Kellogg Consolidated ($ millions) Reported operating profit Currency-neutral adjusted Op’n profit

2018 $1,706 $1,883

2017 $1,387 $1,879

% change (2017 to 2018) ($1,706 / $1,387) -1 = 23% ($1,883 / $1,879) – 1 = 0.2%

The calculated growth rates align with what the company reported, with a small rounding error for the currency neutral numbers. b. “Adjusted growth” is a non-GAAP measure of operating-profit growth (or decline) after certain non-persistent (one-time) items have been removed. Kellogg provides the information in order to signal that the company believes certain items should be excluded when evaluating operating profit for the year. The Project K items relate to ongoing restructuring and the company expects these costs to bring future benefits in terms of profitability and efficiency. Brexit costs arise because the company operates in the U.K. which is undergoing a move away from the European Union and Kellogg’s has incurred costs associated with contracts and payment uncertainties. c. On a consolidated basis, foreign currency exchange rates had a negative effect on operating profits in all segments except Europe. The largest negative impacts were in the Asia Pacific market (-7.2%) and in the Latin American market (-2.8%). From these effects, we can conclude that during 2018, the U.S. dollar weakened with respect to the Euro, but strengthened with respect to all other currencies. d. U.S. public companies are required to report their financial statements in $US. This means that all foreign currency transactions must be translated into $US. As the $US weakens, each foreign currency unit is worth more in dollar terms. Consequently, sales and expenses denominated in a foreign currency have a higher $US equivalent. Indeed, each income statement item is greater, thus increasing reported profits or losses. Companies with significant foreign-currency based transactions can experience large swings in reported numbers when currencies change dramatically. e. The three sources of exposure are: 1) transactions the company makes in foreign currencies, including purchases, sales, and borrowed money; 2) translating foreign assets and liabilities into $ and bringing foreign profits back to the U.S. by way of dividends to investors (repatriation); and 3) translating the foreign profits into U.S. dollars.

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E5-40. (15 minutes) a. Online sale of merchandise owned by Amazon – the performance obligation is to deliver the goods to the customer and Amazon recognizes revenue when the customer takes physical possession of the goods. b. Online sale of merchandise owned by third parties – the performance obligation is to deliver the goods to the customer and Amazon recognizes revenue when the customer takes physical possession of the goods. However, the revenue to Amazon is not the gross sales amount, rather, it is only the commission that Amazon receives from the third-party vendor. c. Sale of a Kindle e-reader – there are two performance obligations. One is to deliver the goods to the customer and the second to replace or repair a damaged product (warranty obligations). Amazon recognizes the bulk of the revenue when the customer takes physical possession of the goods and some revenue related to the warranty is recognized over the term of the warranty. d. Collecting cash for an Amazon Prime membership – the obligation is to provide specified services such as free delivery and provide access to stream movies / TV shows. Amazon recognizes revenue over the year of the membership. e. Sale of media content such as a movie available for download – the performance obligation is to provide the media content for download. As soon as the download is performed by the customer, Amazon recognizes the revenue.

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E5-41. (20 minutes) a. Advertising expenses

SG&A

b. Compensation and benefit costs for headquarters employees

SG&A

Compensation and benefit costs for store employees

SG&A

d. Compensation and benefits costs for distribution center employees

COS

e. Distribution center costs,

COS

Freight expenses associated with moving merchandise from our vendors to our distribution centers and our retail stores

COS

g. Freight expenses associated with moving merchandise among our

distribution and retail stores

COS

h. Import costs

COS

Inventory shrink and theft

COS

Litigation and defense costs and related insurance recovery

SG&A

Markdowns on slow moving inventory

COS

Occupancy and operating costs for headquarters facilities

SG&A

m. Occupancy and operating costs of retail locations

SG&A

n. Outbound shipping and handling expenses associated with sales to

our guests

COS

o. Payment term cash discounts to our vendors

COS

p. Pre-opening costs of stores and other facilities

SG&A

q. U.S. credit cards servicing expenses

SG&A

Vendor reimbursement of specific, incremental, and identifiable advertising costs

SG&A

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E5-42. (20 minutes) a. Bad debts expense computation $110,000  1% 40,000  2% 27,000  5% 14,000  10% 9,000  25% Total required balance in allowance Less: Balance before adjustment Bad debt expense for the year

= = = = =

$ 1,100 800 1,350 1,400 2,250 $6,900 (1,100) $5,800

b. Balance Sheet Transaction

Cash Asset

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

BDE 5,800 AU 5,800 BDE 5,800 AU 5,800

Record bad debts expense

-5,800 = Allowance for Uncollectible Accounts

-5,800 Retained Earnings

–

+5,800 = Bad Debts Expense

-5,800

c. Accounts receivable, net = $200,000 - $6,900 = $193,100 Reported in the balance sheet as follows: Accounts receivable, net of allowance of $6,900

$193,100

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E5-43. (30 minutes) The ending balance of Penman’s accounts receivable and allowance accounts are as follows. Accounts receivable Less allowance for uncollectible accounts

$385,700 24,172

$361,528

Computations Allowance for Uncollectible Accounts

Accounts Receivable Beginning balance Sales Collections Write-offs* Bad debts expense** Ending balance

$ 356,000 2,008,000 (1,963,000) (15,300) ________ $ 385,700

$ 21,400

(15,300) 18,072 $ 24,172

* Write offs = $8,200 + $4,800 + $2,300 = $15,300 ** Bad debts expense = $2,008,000  0.9% = $18,072

E5-44. (25 minutes) a. and b. ($ millions) Accounts receivable (net) Allowance for uncollectible accounts Gross accounts receivable Percentage of uncollectible accounts to gross accounts receivable

2018 $5,113 129 $5,242 2.46% ($129 / $5,242)

2017 $4,414 101 $4,515 2.24% ($101 / $4,515)

c. ($ millions) Bad debts expense ................................................. Amounts actually written off ....................................

2018 $57 $29

2017 $30 $36

2016 $65 $38

Over the three years, HPQ accrued $152 million ($57 + $30 + $65) of bad debt expense and wrote off $103 million ($29 + $36 + $38) of uncollectible accounts. There is a slight difference between the expense and the write-offs. HP may need to reevaluate its estimation of bad debt expense in order to accrue more exactly, for anticipated credit losses. Given the difference is only $50 million over three years and HPQ has billions in revenue, we would likely not conclude that the company is managing its earnings.

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d. The allowance for uncollectible accounts has increased as a percentage of gross

accounts receivable from 2.24% in 2017 to 2.46% in 2018 (see part b). If we anticipate write-offs of $29 million (the amount of the 2018 write off) then the year-end balance of $129 million is sufficient to cover write-offs for more than four years ($129 million / $29 million). By this measure as well, it appears that HP has an excessive level of allowance. Further insight might be gained by comparing HP’s allowance account to those of its peers.

E5-45. (20 minutes) a. Aging schedule at December 31 Current ($346,000  1%) 1–60 days past due ($48,000 5%) 61–180 days past due ($17,000 15%) Over 180 days past due ($9,000 40%) Amount required Less current allowance balance Bad debts expense

$ 3,460 2,400 2,550 3,600 12,010 2,600 $9,410

b. Current Assets Accounts receivable Less allowance for uncollectible accounts

$420,000 (12,010)

$407,990

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E5-46. (30 minutes) a. Year 2018 2019 2020 Total

Sales $ 733,000 857,000 945,000 $2,535,000

Collections $ 716,000 842,000 928,000 $2,486,000

Accounts Written Off $ 5,300 5,800 6,500 $17,600

Accounts Receivable Balance $11,700 20,900 31,400

Bad Debts Expense is: 2018 2019 2020 2018–2020

$ 7,330 8,570 9,450 $25,350

computed as 1%  $733,000 computed as 1%  $857,000 computed as 1%  $945,000 computed as 1%  $2,535,000

Allowance for Uncollectible Accounts is $7,750, computed as $25,350 total provision for uncollectible accounts less $17,600 in total write-offs. b. The 1% rate appears to be too high. A 0.8% rate would have provided $20,280, which still exceeds the $17,600 total write-off by $5,070. Moreover, this smaller allowance seems large enough to provide an adequate margin for future write-offs.

E5-47. (20 minutes) a.

• • •

• •

•

Airlines: Flight tickets are routinely sold in advance. The airlines do not earn the revenue until the flight has been completed. Automotive deferred revenue relates to warranty obligations. The revenue is earned over the life of the warranty. Computer hardware companies sell operating systems software simultaneously with the hardware and such multi-element contracts have various performance obligations. The systems software revenue is earned over time, which gives rise to deferred revenue. These companies might also offer warranties. Pharmaceutical companies sell products which create a single performance obligation with little to no deferred revenue. Most retail companies, including clothing and grocery companies, have deferred revenue related to gift cards. These are not recorded as earned until the customer uses the gift card. Retail companies that sell durable goods have another source of deferred revenue: they often offer warranties which means revenue associated with the warranty element is earned over the life of the warranty. Software companies typically sell bundled products that create numerous performance obligations, many with a deferred revenue piece. © Cambridge Business Publishers, 2021 5-25

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b. The nature of the different business models explains the stark difference in the level of deferred revenue to assets. Almost all business and leisure travelers purchase tickets in advance and increasingly larger proportions of software packages are sold as subscriptions. The level of deferred revenue is high for airline and software companies. In contrast, pharmaceutical companies sell products as opposed to services. As such, the revenue is earned when the goods are shipped and any deferred revenue relates to R&D contract services the pharmaceutical companies perform for third parties.

E5-48. (20 minutes) a. •

•

Software companies have very R&D intensive operations. They are constantly designing new software or updating older versions. The industry has very short-lived products and technological advances force companies to invest aggressively in R&D.. Pharmaceutical companies spend billions each year on new drugs and therapies. Many products never make it to market due to stringent regulatory requirements from the FDA. But without high R&D investment, the companies will not continue to be competitive. Therefore R&D spending is a significant proportion of total revenues each year. Computer hardware companies continually innovate. The margins on hardware sales are smaller than for software because of the commoditization of computer components and thus, it is not as profitable for hardware companies to invest in R&D as compared to software companies. . Automotive companies engage in R&D to improve existing models and bring new technology to market. But, as a proportion of their total revenues, R&D will be smaller because of the high cost to manufacture the vehicles. The ratio is smaller partly due to the capital intensity of production.

b. R&D spending and Market to Book ratio are positively related. Companies that spend more on R&D (on average) expect higher future sales revenue from the new products and services. The current period income statement does not reflect the revenue associated with current period R&D expenditures. But investors impound future sales into the stock price. Hence, market value is higher and the market to book ratio reflects that fact.

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PROBLEMS P5-49. (35 minutes) a. To assess relative size, we divide each segment’s sales by the Total net sales each year.

$ millions Integrated Defense Systems Intelligence, Information and Services Missile Systems Space and Airborne Systems Forcepoint

2018 23% 25% 31% 25% 2%

2017 23% 24% 31% 25% 2%

2016 23% 25% 29% 26% 2%

Across all three years, the Missile Systems segment is the largest (31% of total sales in 2018) and the segment has grown slightly since 2016. However, with the exception of Forcepoint, the segments are relatively close in size. b. Operating profit margin = Operating income / Total net sales.

$ millions Integrated Defense Systems Intelligence, Information and Services Missile Systems Space and Airborne Systems Forcepoint Eliminations Total sales revenue

Total Net Sales $6,180 6,722 8,298 6,748 634 (1,514) $27,068

Operating Income $1,023 538 973 884 5

Operating Profit Margin 16.6% 8.0% 11.7% 13.1% 0.8%

We see that Integrated Defense Systems is the most profitable with a margin of 16.6%, followed by Space and Airborne Systems at 13.1%. The largest segment, Missile Systems, in third place, is less profitable but still reports a margin of 11.7%.

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c. To assess sales growth, we compute the percentage change in sales as (Current year Sales - Prior year Sales) / Prior year Sales.

Integrated Defense Systems Intelligence, Information and Services Missile Systems Space and Airborne Systems Forcepoint

2018

2017

6.5% 8.8% 6.6% 4.9% 4.3%

5.0% 0.1% 9.7% 4.0% 3.8%

All segments grew in 2018 with Intelligence showing the strongest growth at 8.8%, which was significantly better than in 2017 when the segment’s sales remained flat. d. $ millions

2018

Net sales Accounts receivable Average accounts receivable AR turnover = Net sales / Avg. AR DSO = 365 / AR turnover

2017

$27,068 1,648 1,486 18.2 20.0

1,324

A DSO of only 20 days is very low. The company’s main client is the U.S. government and it’s unlikely they pay within 20 days. However, the company might require that certain customers including some foreign governments, make up front deposits on specialty systems. Also, it is likely that the company bills customers for progress payments and these could create cash flow that is earlier than revenue recognition, thereby causing even negative DSO on some contracts. e. The allowance is small, as shown below. This makes sense given that the company’s primary customer is the U.S. government. $ millions

2018

2017

Allowance for doubtful accounts Accounts receivable net Accounts receivable, gross Allowance as % of AR gross = Allowance / AR gross

$ 8 1,324 1,332 0.6%

12 1,648 1,660 0.7%

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P5-50. (35 minutes) a. In all three years, the non-GAAP items increase the adjusted net income. In 2016, the

increase is modest. But, in 2017 and 2018 the adjustments convert a GAAP net loss to a non-GAAP net income. These are very significant adjustments and analysts should exercise caution in comparing numbers across the three-year period. b. The pension benefit cost is recorded on the income statement as part of pension

expense and the company is relabeling it as “nonoperating”. This adjustment is helpful because the adjustment relates to interest “expense” on the company’s pension liability. The gains on disposal, restructuring, and impairments arise from specific managerial decisions about operating versus selling specific business units. This is within the company’s control. The U.S. tax reform adjustment is largely beyond the company’s control. It represents the 2017 tax law changes and while the company might have lobbied for the changes, it would be difficult to argue that these adjustments arise from deliberate company decisions. c.

Reported net income Year over year changes

2018 -20,587 -1018%

2017 -1,841 -120%

2016 9,048

Non-GAAP net income Year over year changes

5,980 -22%

7,685 -28%

10,684

The trend for both numbers is extremely concerning – the company is losing money and is in dire straits. The reported net loss in 2018 is enormous due in large part to the onetime goodwill impairment charge. It is unlikely that a charge of this magnitude will occur again and thus, I would consider the trend in the non-GAAP net income to be more useful for analysis and prediction.

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P5-51. (45 minutes) a. The transaction for $1,000 will incur sales tax of $80, which Target will collect as cash

from the customer and remit later to the state. The 10% potential return creates a liability (reserve) because this is a cash sale and there are no A/R against which to create an allowance. The COGS on this transaction is $707 calculated as $1,000 × ($53,299 / $75,356), and the inventory that will be potentially returned is 10% of COGS or $71. Balance Sheet Transaction

In-store sale of $1,000

Cash Asset

Noncash Assets

-707 (Inventory) +1,080

= +71 (Inventory)

Income Statement

LiabilContrib. + + ities Capital +100 (Allowance for Sales Returns) +80 (Sales tax payable)

Earned Capital

Rev -enues

+264 (Retained Earnings)

+900 (Revenue)

–

Expenses

Net Income

+264

+707 (COGS) – -71 (COGS)

b. The order is a cash transaction that is fulfilled at a later date; therefore, there remains a

performance obligation when the cash is received. This creates a very short-term unearned revenue amount. The COGS on this transaction is $1,414 calculated as $2,000 × ($53,299 / $75,356). Balance Sheet Transaction March 4: Online sale of $2,000

Cash Asset

Liabilities

+2,000 (Unearned Revenue)

-1,414 = (Inventory)

-2,000 (Unearned Revenue)

+2,000

March 7: Goods delivered to customer

Noncash Assets

Income Statement Contrib. + Capital

Earned Capital

+586 (Retained Earnings)

Rev -enues

–

+2,000 (Revenue)

Expenses

–

+1,414 = (COGS)

Net Income

+586

Revenue is recorded only on the cards redeemed during the year, which is $532 million. The COGS for these redemptions is $376 million, calculated as $532 × ($53,299 / $75,356). Balance Sheet

Transaction (in $millions) May: Gift card sales of $645 (in $millions) May: Gift card redemptions of $532

Cash Asset

Noncash Assets

Liabilities

+645 (Unearned Revenue)

-376 = (Inventory)

-532 (Unearned Revenue)

+645 Cash

Income Statement Contrib. + Capital

Earned Capital

+153 (Retained Earnings)

Rev -enues

+532 (Revenue)

–

Expenses

–

+376 = (COGS)

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d. Feb. 02, 2019 Discounts on REDcard transactions Total REDcard transactions = (Discounts / 5%) Total sales REDcard transactions to Total sales

Feb. 03, 2018

Jan. 28, 2017

$953

$933

$899

$19,060 $ 75,356 25.29%

$18,660 $ 72,714 25.66%

$17,980 $ 70,271 25.59%

Over the three years, total REDcard sales increased slightly in $ terms and account for about 25% of total sales, which is about the same across the three years. The program seems to be a big success.

P5-52. (30 minutes) a. We can compare the R&D spending across years by scaling the expense by total

revenue. In 2018, IBM’s R&D expense was 6.8% of total revenues. This is about the same level compared to the Software and Services firms discussed in the module (in Exhibit 5.2) but at the low end of the range across all publicly traded companies. We also note, the R&D is down slightly in 2018 as compared to prior years (in $ terms and in % of total sales). Research, development and engineering Total revenue RD&E expense common-size

2018 5,379 79,591 6.8%

2017 5,590 79,139 7.1%

2016 5,726 79,919 7.2%

b. The company’s R&D spending per patent has decreased over the past three years,

when measured in dollar terms. The flaw in this measure is that the sales attributable to a specific patent may not be recognized in the same year as the patent is issued. RD&E expense ($ millions) Number of new patents awarded RD&E per patent ($ millions) c.

2018 5,379 9,100 0.59

2017 5,590 9,043 0.62

2016 5,726 8,088 0.71

Analysts would want more details on the following: • The specific projects IBM is researching. • Number of segments and whether there have been any changes to the companies R&D programs in each segment. • Number of patents that have been internally developed versus patents that are acquired from others. • IBM management’s explanation of the decrease in the level of spending. • What management believes about the R&D endeavors—their opinions as expressed in the MD&A about current and future plans. • What IBM’s direct competitors are spending on R&D to better assess IBM’s spending. © Cambridge Business Publishers, 2021 5-31

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P5-53. (20 minutes) a. Gift card breakage is simply gift cards that are never redeemed by the customer. b. The company has unredeemed gift cards every year and can use this historical data to estimate what the current period gift card breakage will be. Under the old standards, the company waited a full year after the gift card is sold, to record any estimated revenue from card breakage. Under the new rules, the company starts recording such estimated revenue immediately after the card is sold. d. The new card speeds up the revenue recognition. The company no longer waits a year

to start recognizing revenue. e. The new rules caused the company to decrease the deferred revenue liability. This

means that revenue previously “deferred” is now considered earned because of the new accounting standard.

P5-54. (45 minutes) a. Automotive sales revenue is normally earned when title to the vehicle passes to the customer. New cars are under warranty and Tesla has a performance obligation for the term of the warranty. Revenue would be recognized ratably over the warranty life. Automotive leasing revenue is recognized over the term of the lease. Promises of future services will be recognized when the services are performed. If customers pay in advance for any subscriptions or future software updates, the company will recognize revenue over the life of the subscription. Any sales of equipment or parts to other customers will be treated as a sale of a good and revenue recognized with the title passes or the customer takes physical possession of the good. Energy generation and storage revenues involve a bundled sale – the equipment portion of the revenue will be recognized when title of the equipment passes to the customer. The remainder of the revenue will be recognized when the solar system is completely installed, tested, and operational.

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b. Revenue in $ thousands 2018 2017 2016

As % of Total Revenue 2018 2017 2016

Automotive sales

17,631,522

8,534,752

5,589,007

82%

73%

80%

Automotive leasing

883,461

1,106,548

761,759

11%

Services and other

1,391,041

1,001,185

467,972

Energy generation & storage

1,555,244

1,116,266

181,394

Tesla earns the majority of its revenue from selling new cars. In 2018, this revenue was 82% of total sales. Leasing has lost ground from 2016, falling from 11% to 4% of total revenue. While growing in $ terms, Services as a percentage of total revenues is down compared to prior years. This is due entirely to the significant growth in Automotive sales. c. Revenue in $ thousands

% Growth

2018

2017

2016

2018

2017

Automotive sales

17,631,522

8,534,752

5,589,007

107%

53%

Automotive leasing

883,461

1,106,548

761,759

-20%

45%

Services and other

1,391,041

1,001,185

467,972

39%

114%

Energy generation & storage

1,555,244

1,116,266

181,394

39%

515%

The growth in all segments is stellar, with the exception of Automotive leasing. Tesla is like a start-up and is rapidly building a customer base and solid brand loyalty.

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P5-55. (50 minutes) a. Costco receives cash for year-long memberships throughout the year. When it receives cash, the company records a current liability. Then, it recognizes revenue evenly over the year so that, by the time the membership expires, Costco has recorded the entire membership fee as revenue. b. To compute the cash that Costco received for memberships, we begin with membership income of $3,142 million and make two adjustments. First, not all of the membership income earned in fiscal 2018 was received in cash. Costco’s balance sheet shows that the deferred membership fees liability had a balance of $1,498 million at the start of the year. Costco earned all of these memberships during fiscal 2018 because memberships run for one year. Thus, we need to deduct the opening balance of deferred membership fees liability from membership income. Second, Costco received cash for memberships during the year but Costco had not earned all of that cash as membership fees by the end of the year. Thus, to calculate total cash received, we need to add the ending balance of deferred membership fees liability of $1,624 million. Total cash received: $3,268 million = $3,142 million - $1,498 million + $1,624 million. Another way to determine the cash received is to construct the Deferred Membership Fees T-account as follows: Deferred Membership Fees 1,498 Membership fees revenue earned 3,142 ? 1,624

Begin balance Cash received End balance

c. Balance Sheet Transaction Cash UR

3,268 3,268 Cash

3,268

UR 3,268

UR Rev

Receive cash in advance for membership fees

Cash Asset

+3,268 Cash

Noncash = Assets

Liabilities

+3,268 Unearned Revenue

-3,142 Unearned Revenue

Income Statement Contrib. + Capital

Earned Capital

Revenues

–

Expen= ses

–

Net Income

3,142 3,142

Recognize membership fees earned

3,142

Rev

+3,142 Retained Earnings

+3,142 Membership Fees Revenues

+3,142

3,142

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d. To build customer loyalty Costco offers 2% reward to all Executive members, up to

$1,000 per year. Every time an Executive member spends $100, Costco records a liability for the 2% reward it promises to give the customer later. That liability is called “accrued member rewards” and the total represents the amount of product / services the company must provide free (the total cumulative rewards). e. Costco recorded sales of at least $52,850 million from the Company's Executive

members, during fiscal 2018. We can use the 2% rate and the accrued member rewards liability outstanding at the end of the year to calculate this: $1,057 million / 2% = $52,850 million. It could be higher, but each customer is capped at $1,000 per year.

P5-56. (35 minutes) a. $ thousands Accounts receivable, net Allowance for doubtful accounts Accounts receivable, gross

Dec. 31, 2018 414,209 3,742 417,951

Dec. 31, 2017 406,019 9,229 415,248

Dec. 31, 2016 477,825 282 478,107

$ thousands Allowance for doubtful accounts Accounts receivable, gross % allowance / AR gross

Dec. 31, 2018 3,742 417,951 0.9%

Dec. 31, 2017 9,229 415,248 2.2%

Dec. 31, 2016 282 478,107 0.1%

$ thousands Bad debt expense Revenue % Bad debt expense / Revenue

Dec. 31, 2018 56 1,511,983 0.004%

Dec. 31, 2017 30,551 1,615,519 1.9%

Dec. 31, 2016 339 2,169,461 0.016%

Bad debt expense is significant ONLY in 2017, with the one-time expense related to the bankruptcy. d. Wynit went bankrupt and was clearly a problem for the company in 2017 and we should not consider this a typical expense amount. We could adjust the 2017 allowance in part a which would significantly reduce the % allowance in part b. Then, we could omit the 2017 Wynit bad debt expense in part c. and this would bring the 1.9% identified in part c, down to be in line with the other years.

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e. $ thousands Revenue Accounts receivable, net Average AR AR turnover = Revenue / Average AR DSO = 365 / AR turnover f.

Dec. 31, 2018 1,511,983 414,209 410,114

Dec. 31, 2017 1,615,519 406,019 441,922

3.7

99.0

99.8

Dec. 31, 2016 477,825

In percentage terms, Fitbit’s allowance for uncollectible accounts has remained relatively low since 2016. The percentage of gross receivables increased in 2017 but this is entirely due to Wynit’s bankruptcy. The company collects its receivables slowly for a manufacturer but the DSO has not changed year over year, so this could be normal for the company. Perhaps Fitbit’s customers do not pay for the inventory until it is ultimately sold to the final customer.

P5-57. (25 minutes) a. Gross Revenue has skyrocketed over the eight-year period. The company began sales

in 2010 and has increased sales each year. In 2018, sales doubled, and now surpasses $20 billion. b. By examining the bar graph for COGS and R&D expense, we see that both expenses

are growing steadily in dollar terms. COGS appears to flatten out in 2014 and hovers between 60% to 70% through 2018. R&D has grown each year but not as steadily as revenue. As the company brings new models to market the rate of innovation drops off. This is expected with new product development. c.

When expressed as a % of sales, the two expenses appear very volatile. The sharp drop off in R&D expense from 2011 to 2013 is due entirely to the increase in sales from nearly $0 in 2011 to over $1 billion by 2013. This is a caution about examining only ratios and not the underlying data expressed in dollar terms.

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IFRS APPLICATIONS I5-58. (30 minutes) a. INR millions

2018

2017

Revenue from operations

158,042

174,943

Accounts receivable

51,922.1

43,073.4

Average accounts receivable

47,497.8

44,285.8

Days sales outstanding (DSO)

109.70

92.41

2016 45,498.1

b. INR millions

2018

2017

2016

Accounts receivable, net

51,922.1

43,073.4

45,498.1

306.9

318.4

448.2

Trade receivables, gross

52,229.0

43,391.8

45,946.3

INR millions

2018

2017

2016

306.9

318.4

448.2

Trade receivables, gross

52,229.0

43,391.8

45,946.3

Allowance / Trade receivables, gross

0.59%

0.73%

0.98%

Allowance for doubtful accounts

c. Allowance for doubtful accounts

From this ratio, we would conclude that the quality of receivables has increased over time – we observe the ratio of doubtful accounts is decreasing, which means the company is recording less allowance each year.

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I5-59. (30 minutes) a. We would consider the following items from the Repsol’s income statement, as operating: • • • •

All components of operating income including the reversal of impairment provisions All components of operating costs including the impairment charge Income investments accounted for using the equity method Income tax – the portion relating to the operating activities identified above

Nonoperating items include: •

All components of the financial result because these relate to interest and other charges, gains and losses associated with financial instruments.

b. There are two potential non-recurring items in 2018:

• •

Reversal of impairment provisions in the operating income section Impairment loss provisions in the operating costs section

Analysts would compare these amounts over time to determine if the nature or the amount is non-recurring. In assessing past performance, analysts would consider these amounts. But in forecasting future performance, analyst would leave these items out.

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MANAGEMENT APPLICATIONS MA5-60. (30 minutes) a. Companies use financial derivatives to mitigate foreign exchange exposure. For example, companies can enter into forward contracts, options, and currency swaps to reduce fluctuations in long currency positions or short currency positions. Another way to reduce volatility would be to structure transactions to afford a natural hedge. For example, borrowing in foreign currencies in countries where revenues are earned will mean the revenues and expenses are measured in the same currency, thereby dampening some of the volatility. b. Each of these measures has a “cost.” Conducting operations in specific countries (or transactions in specific currencies) may be costly if done solely to mitigate foreign exchange exposure and if not optimal. Second, the purchase of financial securities is costly. Companies generally view these costs as similar to buying insurance from a property insurer. Derivatives become a “cost of doing business.” MA5-61. (30 minutes) a. The SEC’s position is that if the company’s practice is to obtain sales authorization,

revenue is not recognized until such approval is obtained, even though product delivery is made and approval by the customer is anticipated. The SEC language is as follows: “Generally the staff believes that, in view of [the company’s] business practice of requiring a written sales agreement for this class of customer, persuasive evidence of an arrangement would require a final agreement that has been executed by the properly authorized personnel of the customer. In the staff's view, [the customer’s] execution of the sales agreement after the end of the quarter causes the transaction to be considered a transaction of the subsequent period. Further, if an arrangement is subject to subsequent approval (e.g., by the management committee or board of directors) or execution of another agreement, revenue recognition would be inappropriate until that subsequent approval or agreement is complete.”

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b. The sales commission for the quarter will be larger because of the sale. This might

motivate managers to book the revenue. Alternatively, perhaps management feels that the sales (and profit) increase will drive up the company’s stock price. The parties benefiting from this action include the salesperson, the company, its shareholders, other managers and employees, etc. There are parties who are adversely affected by this action, however. These include future shareholders and short-sellers of the company’s stock (who sell overvalued stock), the company’s auditors, suppliers, and current and future employees. c.

Corporate governance involves policies and procedures that protect the assets of the company, and protect the company and its stakeholders from unauthorized actions. These controls include a code of conduct, a clear set of operating procedures, and an effective audit function to ensure that those procedures are followed. The Board of Directors has a fiduciary responsibility to the shareholders, and a legal responsibility under the Sarbanes-Oxley Act, to establish and maintain an effective corporate governance system. Review procedures should be in place requiring officers to attest that requisite approvals have been obtained, and all other conditions of the sale fulfilled, before revenue can be recognized.

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Module 6 Inventories, Accounts Payable and Long-Term Assets QUESTIONS Q6-1.

If inventory costs are stable, the per unit dollar cost of inventories (beginning or ending) tends to be approximately the same under different inventory costing methods and the choice of method does not materially affect net income. To see this, remember that FIFO profits include holding gains on inventories. If the inflation rate is low (or inventories turn quickly), there will be less holding gains (inflationary profit) in inventory.

Q6-2.

FIFO holding gains occur when the costs of earlier purchased inventory are matched against current selling prices. Holding gains on inventories increase with an increase in the inflation rate and a decrease in the inventory turnover rate. Conversely, if the inflation rate is low or inventories turn quickly, there will be fewer holding gains (inflationary profit) in inventory.

Q6-3.

If inventory costs are rising, (a) Last-in, first-out yields the lowest ending inventory (b) Last-in, first-out yields the lowest net income, (c) First-in, first-out yields the highest ending inventory, (d) First-in, first-out yields the highest net income, (e) Last in, firstout yields the highest cash flow because taxes are lowest.

Q6-4.

When costs are consistently rising, the LIFO inventory costing method yields a significant tax benefit because LIFO increases COGS which reduces pretax income and taxes payable.

Q6-5.

Kaiser Aluminum Corporation is using the lower of cost or market (LCM) rule. When the replacement cost for inventory falls below its (FIFO or LIFO) historical cost, the inventory must be written down to its replacement cost (market value). The rationale is that, if market value has dropped, the inventory cost overstates the future economic benefit of selling the inventory.

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Q6-6.

Cash conversion cycle (CCC) measures the number of days that the company is out of pocket for cash from inventory transactions. That is, it measures the time it takes the company to purchase the inventory (on credit), pay for the inventory, sell the inventory and collect cash from the customer. The CCC is calculated as days sales outstanding (DSO) plus days inventory outstanding (DIO), less days payables outstanding (DPO).

Q6-7.

Straight-line depreciation expense is calculated as follows: (Cost – Salvage value) / Useful life. Thus, the annual expense is affected by both salvage value an useful life. As salvage value increases, the numerator decreases, which decreases depreciation expense. As useful life increases, the denominator decreases, which decreases depreciation expense.

Q6-8.

The primary benefit of accelerated depreciation relates to tax reporting – higher depreciation deductions in the early years of the asset’s life reduce taxable income and income taxes. This increases cash flow that can be invested to yield additional cash inflows (e.g., an "interest-free loan" that can be used to generate additional income). Companies generally prefer to receive cash inflows sooner rather than later in order to maximize this investment potential.

Q6-9.

The gain or loss on the sale of a PPE asset is calculated as the difference between the sales proceeds and the asset's net book value. Sales proceeds in excess of net book values create gains; sales proceeds less than net book values cause losses. Factors that affect the size of the gain or loss include the amount of sales proceeds (the selling price) and depreciation assumptions. Because accumulated depreciation at the time of the asset’s sale affects the net book value, the depreciation rate and salvage values used to compute depreciation expense affect the gain or loss.

Q6-10.

The cash conversion cycle is defined as days sales outstanding (DSO) plus days inventory outstanding (DIO) minus days payable outstanding (DPO). To improve the CCC a company should try to decrease both DSO and DIO and increase DPO. There are costs of taking such actions and companies must do a cost benefit analysis before undertaking significant changes.

Q6-11.

If the market value of inventory is less than its cost (carrying amount), the company “writes down” the inventory to its market value. The result is that the inventory is carried on the balance sheet at whichever amount is lower: the cost of the inventory or its market value. The benefit to financial statement users is that this accounting treatment prevents the balance sheet from reporting inflated values for assets.

Q6-12.

Restructuring costs consist of three general categories: asset write-downs, accruals for severance and relocation costs, and accruals of other restructuring-related costs. Asset write-downs reduce assets’ net book value and are recognized in the income statement as an expense. Liability accruals for severance and other expenses create a liability for the corresponding expense that reduces income and equity.

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MINI EXERCISES M6-13. (20 minutes) a. FIFO cost of goods sold = 1,300 @ $150 + 700 @ $180 = $321,000

FIFO ending inventories = $501,000 – $321,000 = $180,000 b. LIFO cost of goods sold = 1,700 @ $180 + 300 @ $150 = $351,000

LIFO ending inventories = $501,000 – $351,000 = $150,000 c.

Average cost of goods sold = 2,000 x $501,000 / 3,000 = $334,000 Average cost ending inventories = $501,000 – $334,000 = $167,000

M6-14. (10 minutes) a. FIFO cost of goods sold = 400 @ $12 + 200 @ $14 = $7,600

FIFO ending inventories = $14,600 – $7,600 = $7,000 b. LIFO cost of goods sold = 600 @ $14 = $8,400

LIFO ending inventories = $14,600 – $8,400 = $6,200 c.

Average cost of goods sold = 600 @ $14,600 / 1,100 = $7,964 Average cost ending inventories = $14,600 – $7,964 = $6,636

M6-15. (20 minutes) a.

Cost of goods sold (COGS) Inventory 2018 Inventory 2017 Average Inventory Inventory turnover = COGS / Avg Inventory

PriceSmart ($ thousands) $2,610,111 321,025 310,946 315,986 8.3

Nordstrom ($ millions) $10,155 1,978 2,027 2,003 5.1

b. PriceSmart’s inventory turnover rate is higher than Nordstrom. Price Smart concentrates

on the value-priced items in a warehouse setting. Thus, it realizes a lower profit margin that must be offset with higher turnover to yield an acceptable return on net operating assets (see discussion of profitability and turnover in Module 4).

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Inventory turnover improves as the volume of goods sold increases relative to the dollar value of goods available for sale. Retailers must balance the cost savings from inventory reductions against the marketing implications of lower inventory levels. Companies can lower inventory levels by reducing the depth and breadth of product lines carried (such as not carrying every style, size and color), eliminating slow-moving product lines, working with suppliers to arrange for delivery when needed, and marking down goods for sale at the end of product seasons.

M6-16. (5 minutes) Straight-line depreciation expense: ($37,000 – $2,900) / 5 years = $6,820 for both years

M6-17. (10 minutes) Straight-line depreciation expense 2020: ($129,000 – $6,000) × (6/60) = $12,300 2021: ($129,000 – $6,000) × (12/60) = $24,600

M6-18. (15 minutes) a. $ millions Sales PPE, net 2018 PPE, net 2017 Average PPE PPE turnover = Sales / Avg PPE, net

Intel $70,848 48,976 41,109 45,043 1.6

Texas Instruments $15,784 3,183 2,664 2,924 5.4

Texas Instruments generates more revenue from its PPE than does Intel. This is an efficiency measure and thus, we would conclude, that TI is more efficient with its PPE. b. PPE turnover increases with sales volume relative to the dollar amount of PPE on the balance sheet. The PPE turnover is often very difficult to improve because doing so typically requires creative thinking. Many companies are off-loading the manufacturing process in whole or in part to others in the supply chain. This is productive so long as the benefits realized by the reduction of manufacturing assets more than offset the higher cost of the goods that are now purchased rather than manufactured. Another approach is to utilize long-term operating assets in partnership with another firm, say in a joint venture.

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M6-19. (15 minutes) 2018 Cash conversion cycle

26.2 days + 35.9 days – 17.0 days = 45.1 days

2017 Cash conversion cycle

22.5 days + 36.5 days – 17.0 days = 42.0 days

Winnebago’s cash conversion cycle weakend by 3 days in 2018 (45.1 – 42 = 3.1). The days sales outstanding is the main cause -- the company collected its receivables 4 days more slowly in 2017. Countering that trend, is the fact that inventory sold half a day more quickly in 2018 while payable days stayed the same.

M6-20. (20 minutes) a. $ thousands Sales Cost of goods sold Gross profit = Sales - COGS Gross profit margin = Gross profit / Sales Cost of goods sold Average inventory Inventory turnover = COGS / Avg Inventory DIO = 365/inventory turnover

AutoZone O'Reilly 2018 2017 2018 2017 $11,221,077 $10,888,676 $9,536,428 $8,977,726 5,247,331 5,149,056 4,496,462 4,257,043 5,973,746 5,739,620 5,039,966 4,720,683 53.2%

52.7%

52.8%

52.6%

5,247,331 3,912,878

5,149,056 3,757,001

4,496,462 3,101,572

4,257,043 2,894,388

1.34 272 days

1.37 266 days

1.45 252 days

1.47 248 days

b. In 2017, the two companies were equally profitable selling their inventory for a margin of about 52.7%. In 2018, Autozone had a slight edge, improving the margin by 50 basis points from 52.7% to 53.2% while O’Reilly improved its margin by only 20 basis points. The two companies are very close competitors. c. In both 2018 and 2017, O’Reilly sold its inventory more quickly than Autozone did. For both companies, inventory efficiency declined in 2018 as compared to 2017, but the changes are very small.

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M6-21. (20 minutes) a. The company recorded an impairment loss because the fair value of the plane was lower than the plane’s net book value at the end of the year. GAAP requires that companies determine the fair value of each fixed asset at the end of the fiscal year and compare that fair value to the assets’ carrying value. If the fair value is less than the carrying value, the asset is “impaired” in value and the company must record a charge to the income statement. b. The amount of the impairment is determined as: Plane, net book value – Fair value. The net book value of the plane is $2,350,000 - $1,598,000 = $752,000. The company determined the fair value from external information such as an appraisal or a “blue book” value for planes. c. From the data above, we can compute the plane’s fair value as $290,000, which is the difference between net book value and the impairment loss: $752,000 - $462,000 = $290,000.

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EXERCISES E6-22. (30 minutes) a. Fiscal Year 2016 2017 2017 2017 2017 2018 2018 2018 2018 2019

Fiscal Quarter 4 1 2 3 4 1 2 3 4 1

Inventories $ 794 821 855 857 796 797 1,090 1,417 1,575 1,426

Total Assets $ 9,841 9,410 9,402 9,830 11,241 11,460 12,882 13,657 13,292 14,021

Inventories / Total Assets 8.1% 8.7% 9.1% 8.7% 7.1% 7.0% 8.5% 10.4% 11.8% 10.2%

The build up in Q3 2018 is significant in both dollar terms ($327 million) and percentage terms (30%). The common-size inventories increased from 8.5% to 10.4%, a 190 basispoint increase. b. Fiscal Year 2016 2017 2017 2017 2017 2018 2018 2018 2018 2019

Fiscal Quarter 4 1 2 3 4 1 2 3 4 1

Revenue 2,173 1,937 2,230 2,636 2,911 3,207 3,123 3,181 2,205 2,220

Cost of Goods Sold 824 740 879 1,018 1,056 1,082 1,089 1,178 899 833

Gross profit = Revenue – COGS 1,349 1,197 1,351 1,618 1,855 2,125 2,034 2,003 1,306 1,387

Gross Profit Margin = Gross Profit / Revenue 62.1% 61.8% 60.6% 61.4% 63.7% 66.3% 65.1% 63.0% 59.2% 62.5%

From Q4 2016 through Q2 2018, margins grew from 62.1% to 65.1% with a high of 66.3% in Q1 2018. Then in Q3 2018, margins “slipped” as the article mentioned. This decrease was not huge but neither was it insignificant. The margin dropped from 65.1% to 63% or a decrease of 210 basis points. Had Nvidia been able to maintain the 65.1% margin in Q3 2018, operating income would have been about $67 million higher. c. In the quarter subsequent to the article, gross margin dropped and inventory built up even more. Both metrics improved in Q1 2019 but have not returned to prior levels. © Cambridge Business Publishers, 2021 6-7

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E6-23. (30 minutes) Units 1,000 1,800 800 1,200 4,800

Beginning Inventory @ 32 Purchases: #1 @ 34 #2 @ 38 #3 @ 41 Goods available for sale

Cost $ 32,000 61,200 30,400 49,200 $172,800

Units in ending inventory = 4,800 – 2,800 = 2,000 a. First-in, first-out Units 1,200 800 2,000

Ending Inventory

Cost of goods available for sale Less: Ending inventory Cost of goods sold

Cost $41 $38

@ @

= =

Total $49,200 30,400 $79,600

$172,800 79,600 $ 93,200

Balance Sheet Transaction

Cash Asset

Noncash Assets

Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

COGS 93,200 INV 93,200

Record FIFO cost of goods sold

COGS 93,200 INV

-93,200 Inventory

-93,200 Retained Earnings

–

+93,200 = Cost of Goods Sold

-93,200

93,200

b. Last-in, first-out Units 1,000 1,000 2,000

Ending Inventory

Cost of goods available for sale Less: Ending inventory Cost of goods sold

@ @

Cost $32 $34

= =

Total $32,000 34,000 $66,000

$172,800 66,000 $ 106,800

c. Average cost $172,800 / 4,800 = $36 average unit cost 2,000 × $36 = $72,000 ending inventory $172,800 - $72,000 = $100,800 cost of goods sold (or $100,800 = 2,800 × $36) ©Cambridge Business Publishers, 2021 Financial Accounting for MBAs, 8

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d. 1. We don’t know the exact nature of Chen’s product. But, in many circumstances, the first-in, first-out method most closely reflects the physical flow of inventory. First-in, firstout physical flow is critical when inventory is perishable or in situations in which the earliest items acquired are moved out first because of risk of deterioration or obsolescence such as technology products and retail items. However, if Chen’s product purchases are intermixed and can’t be physically separated (such as for T-shirts, or gasoline in a tank) then the average cost method would be most descriptive of the physical flow of inventory. 2. Last-in, first-out yields the highest cost of goods sold expense during periods of rising unit costs, which in turn, results in the lowest taxable income and the lowest income tax. 3. The first-in, first-out method results in the lowest cost of goods sold, and the largest amount of income, in periods of rising prices. Of course, this assumes that prices will continue to rise as they have in the past. Companies cannot change inventory costing methods without justification, and the change may be restricted by tax laws as well. E6-24. (25 minutes) a. The Illinois Tool Works 2018 balance sheet reported $1,318 which is the LIFO inventory

value reported in the footnotes. b. Illinois Tool Works balance sheet includes the following inventory at FIFO cost:

$ millions Raw material Work-in-process Finished goods Total inventory reported on the balance sheet c.

2018 $523 161 731 $1,415

2017 $465 141 703 $1,309

Cumulative pretax income (as of the end of fiscal 2018) has been decreased by $97 million, the amount of the LIFO reserve, since Illinois Tool Works initially adopted LIFO inventory costing.

d. The LIFO reserve in 2016 was $86 million. Assuming a 35% tax rate, the company

saved taxes of $30.1 million through 2016. From 2016 to 2018, the LIFO reserve increased by $11 million from $86 million to $97 million. Assuming a 21% tax rate, the company saved an additional $2.3 million since 2017. The total taxes saved by using LIFO for inventory is $32.4 million ($30.1 + $2.3). e. For 2018 only, the LIFO reserve increased by $8 million, from $89 million to $97 million.

Consequently, 2015 LIFO pretax income is $8 million lower than under the FIFO method. This means that LIFO income taxes are lower by $1.7 million, computed as $8 million × 0.21. In sum, for fiscal 2018, the use of LIFO inventory costing saved a small amount. © Cambridge Business Publishers, 2021 6-9

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E6-25. (25 minutes) a. Under Armour wrote-off inventory due to a restructuring. The company as changing its

operations in some way and, consequently, the inventory was reduced in value by $20,801 thousand. The balance sheet would have been overstated had the company not recorded the write down. b. The inventory write-down decreased GAAP pre-tax income by $20,801. c.

$ thousands As reported -- After the inventory write-off Cost of goods sold Inventories Average inventories Inventory turnover after inventory write-off Days inventory outstanding (DIO)

2018 $2,852,714 1,019,496 1,089,022 2.62 times 139.3 days

2017

$1,158,548

d. Cost of good sold as reported Inventory write-off COGS restated = COGS as reported - Inventory write-off

$2,852,714 20,801 $2,831,913

Inventories as reported Inventory write-off 2018 Inventories, restated = Inventories as reported + Inventory write-off 2017 Inventories balance is unaffected

$1,019,496 20,801 $1,040,297 $1,158,548

e. $ thousands As reported -- After the inventory write-off Cost of goods sold Inventories Average inventories Inventory turnover after inventory write-off Days inventory outstanding (DIO)

2018 $2,831,913 1,040,297 1,099,423 2.58 141.70

2017

$1,158,548

The write-off was relatively small and thus, did not make a significant difference in the DIO metric. However, it did improve the number.

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E6-26. (25 minutes) a. Deere reports $6,149 million for inventories on its 2018 balance sheet. (Its 2017

inventories are $3,904 million.) b. Had Deere used the FIFO method, its 2018 balance sheet would have reported $7,786

million as inventories. (Its 2017 inventories would have been $5,365 million.) c.

Pretax income (until the end of fiscal 2018) has been decreased by $1,637 million cumulatively since Deere adopted LIFO inventory costing (the amount of the LIFO reserve). Pretax income was lower because inventory costs have been rising and Deere has matched current (higher) inventory costs against current selling prices thereby decreasing profits.

d. Cumulative tax savings have been $491 million calculated as follows.

$ millions LIFO reserve Tax rate 2018 tax savings = LIFO reserve change × Tax rate

2018 $1,637 30% $491

e. 2018 tax savings are $37 million calculated as follows.

$ millions LIFO reserve Change in LIFO reserve during 2018 Tax rate 2018 tax savings = LIFO reserve change × Tax rate

2018 $1,637 176 21% $37

2017 $1,461

E6-27. (15 minutes) a. We observe that all three metrics are increasing over time. Revenue is increasing more

than COGS, as evidenced by the widening gap between the two areas on the graphic. We also observe a quarterly (seasonal) component to each metric, which creates a pattern across each year. b. Revenue spikes each year in the th4 quarter. This is understandably the highest sales

period because it includes the holiday shopping period, from October through December. c.

As revenue spikes each period, the gross margin percentage drops. With added sales volume, Amazon faces proportionately higher costs and the difference (gross profit) shrinks

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E6-28. (25 minutes) a. 1. Cumulative depreciation expense to date of sale: [($1,280,000 - $160,000) / 10 years] × 7 years = $784,000 2. Net book value of the plane at date of sale: $1,280,000 - $784,000 = $496,000 b. 1. There is no gain or loss if the cash proceeds are equal to the plane’s net book value at the disposal date. 2. $211,000 loss on sale calculated as: $285,000 – $496,000 3. $204,000 gain on sale calculated as: $700,000 – $496,000

E6-29. (30 minutes) Both Target and Walmart have seasonal peaks in the quarter that includes December, each year. The revenue and COGS spike during that quarter. However, we observe a second increase for Walmart for the summer quarter, perhaps sales increase in the back-to-school shopping period for Walmart more than Target. A big difference between Walmart and Target is the volatility of the gross profit margin – Target’s gross profit line ranges from 28% to 39% and shows a dip when the revenue and COGS spike. Walmart’s gross profit line fluctuates pretty significantly with a dip in the 2012 time period and no discernible pattern with sales spikes. The biggest difference between Walmart and Target versus Amazon is that Amazon’s revenue has steadily increased during this period whereas the other two retailers have experienced only moderate growth.

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E6-30. (20 minutes) a. Depreciation expense to date of sale is [($46,400 - $5,000) / 6] per year × 4 years

= $27,600. The net book value of the van is, therefore, $46,400 - $27,600 = $18,800. b. 1. There is no gain or loss if the cash proceeds are equal to the net book value. 2. $2,200 gain ($21,000 - $18,800) 3. $1,800 loss ($17,000 - $18,800)

E6-31. (20 minutes) $ thousands a. Machinery, equipment, vehicles and office furniture Tooling Leasehold improvements Land and buildings ($4,047,000 × 75% & $2,617,247 × 75%) Computer equipment, hardware and software Total depreciable asset cost Average depreciable asset cost Depreciation expense (in thousands) Useful life = Average depreciable asset cost / Depreciation expense

2018

2017

$6,328,966 1,397,514 960,971

$4,251,711 1,255,952 789,751

3,035,255 487,421 12,210,127 10,395,271 1,100,000

1,887,935 395,067 8,580,416

9.45

b. Accumulated depreciation Average accumulated depreciation Average depreciable asset cost Percent used up = Average accumulated depreciation / Average depreciable asset cost

$2,699,098 2,211,446 10,395,271

$1,723,794

21.27%

Assuming that assets are replaced evenly as they are used up, we would expect assets to be 50% “used up,” on average. Tesla’s 21% ratio is much lower than this average. The implication is that the company’s equipment is on the newer side which makes sense given the company’s age.

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E6-32. (25 minutes) a.

COGS Inventory Average inventory Inventory turnover = COGS / Average inventory

2018 18,226 7,253 7,118 2.56

2017 15,685 6,983 6,268 2.50

Sales PPE, net Average PPE, net PPE turnover = Revenue / Average PPE, net

70,848 48,976 45,043 1.57

62,761 41,109 38,640 1.62

2016 5,553

59,387 36,171

b. Intel’s inventory and PPE turnover rates have stayed fairly constant during the 2017-

2108 time period. Without additional information, analysts would not see this as good news. Inventory turnover rates can be improved by weeding out slow-moving product lines, by reducing the depth and breadth of products carried, by implementing just-in-time deliveries, reducing work-in-process inventories through better manufacturing techniques, and by reducing finished goods inventories by producing to demand. PPE turns can be improved by off-loading manufacturing to other companies in the supply chain and acquiring long-term operating assets in partnership with other companies, say in a joint venture.

E6-33. (15 minutes) a. Annual straight-line depreciation is: $29,000 per year Computations: ($330,000 - $40,000) / 10 years b. As of the end of the fourth year, the net book value of the equipment would be: $214,000. Computations: $330,000 cost less $116,000 accumulated depreciation, computed as $29,000 × 4 years.

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c. An asset is impaired if it meets the following condition: Sum of undiscounted expected cash flows < Net book value of asset For this equipment: $185,000 < $214,000 This implies that “yes,” the equipment is impaired at the end of the fourth year. This is because the equipment will not generate sufficient expected cash flows to cover the current net book value. d. From part c we know that the equipment is impaired. The impairment loss is computed as the equipment's net book value minus its current fair value; computations follow: Impairment loss $54,000

= =

Net book value of asset $214,000

E6-34. (25 minutes) $ millions a. Sales PPE, net Average PPE, net PPE turnover

– −

Fair value of asset $160,000

Apr. 30, 2019 $7,838.0 1,912.4 1,820.8 4.3

Apr. 30, 2018

$1,729.1

b. Buildings and fixtures Machinery and equipment Total depreciable asset cost Average depreciable asset cost Depreciation expense (in thousands) Useful life = Avg depreciable cost / Depn expense

$ 903.2 2,185.0 3,088.2 3,006.2 206.0

Accumulated depreciation Average accumulated depreciation Average depreciable asset cost Percent used up = Avg accum depn / Avg depreciable cost

$1,619.7 1,573.5 3,006.2

$ 812.6 2,111.5 2,924.1

14.6

c. $1,527.2

52.3%

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E6-35 a. One measure of the freshness of the food is days inventory outstanding. It measures how many days it takes the store to sell the average inventory. Village Supermarket has the lowest DIO (half of the other two store’s DIO metrics) and therefore we might conclude that it has the freshest food. b. Efficiency (productivity) measure throughput. The Sales per square foot would be a reasonable productivity measure. Publix ranks lowest on that metric. c. Gross profit margin is a measure of prices IF we assume that all three companies buy about the same types of goods and at the same price structures. Under that assumption, we would conclude that Kroger has the lowest prices. d. Sales per square foot or COGS per square foot would measure traffic. However, given that the three stores don’t have the same gross profit margin, it would be safer to use COGS per square foot to avoid impounding profit margins into the metric (and skewing the metric higher for Publix). Using COGS per square foot, we see that Village Supermarket has a significantly higher measure ($848) compared to the other two companies. e. Average square feet per store store is a measure of store size. ON that metric, Village Supermarket is smallest (46,000 square feet per store) but Publix is not that much bigger (47,000 square feet per store).

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PROBLEMS P6-36. (30 minutes) a.

$ millions AUTOZONE COSTCO HOME DEPOT LOWE'S O'REILLY WALMART

COGS 4,902 121,715 71,043 48,396 4,237 374,623

Average Inventory 3,913 10,437 13,337 11,977 3,102 44,026

Turnover = COGS / Avg Inventory 1.3 11.7 5.3 4.0 1.4 8.5

DIO = 365 / Turnover 291 31 69 90 267 43

b. $ millions AUTOZONE COSTCO HOME DEPOT LOWE'S O'REILLY WALMART

Sales 11,221 141,576 108,203 71,309 9,536 511,729

COGS 4,902 121,715 71,043 48,396 4,237 374,623

Gross profit = Sales - COGS 6,319 19,861 37,160 22,913 5,299 137,106

Gross profit margin = Gross profit / Sales 56.3% 14.0% 34.3% 32.1% 55.6% 26.8%

AUTOZONE O'REILLY WALMART COSTCO HOME DEPOT LOWE'S

DIO = 365 / Turnover 291 267 43 31 69 90

Gross profit margin = Gross profit / Sales 56.3% 55.6% 26.8% 14.0% 34.3% 32.1%

continued

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c. continued Each set of competitors has ratios that are more comparable than when we compare all six companies. Autozone and O’Reilley both have very slow moving inventory and relatively high margins. At the other end of the spectrum, Walmart and Costco turn their inventory over more quickly and have lower margins. Costco’s margins are nearly half of Walmart’s but Costco turns its inventory over more quickly. Home Depot and Lowe’s have similar margins but Home Depot is significantly more efficient with its inventory. Walmart and Costco sell perishables as well as durable consumer products. Their turnover is the highest (DIO is lowest) given the nature of their inventory. Autozone and O’Reilly stock many auto parts and thus have a wide range of inventory items, some of which only sell once a year. They also have some very pricey inventory items which increase the value of inventory held. The biggest takeaway is that inventory turnover (DIO) and margins are negatively correlated for this group of companies and industries. d.

$ millions AUTOZONE COSTCO HOME DEPOT LOWE'S O'REILLY WALMART

Sales ($ millions) $ 11,221 141,576 108,203 71,309 9,536 511,729

Retail SQ Footage (000s) 41,066 110,700 237,700 209,000 38,455 1,129,000

Sales / SQ foot ($) $273 1,279 $455 $341 $248 $453

# of Stores 6,202 762 2,287 2,015 5,219 11,361

Sales / Store ($ millions) $ 1.81 185.80 47.31 35.39 1.83 45.04

Sales per square foot exhibits a wide range across the three retail sectors. Because the auto parts stores’ margins are so much higher than the other two retail sectors, their sales per square foot is lower. Costco clearly dominates on both productivity measures and the company has the lowest margins.

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P6-37. (45 minutes) ($ millions) a. Dow uses LIFO method of costing for its inventories. As of Q1 2019, the LIFO inventory reserve is $265 million. Thus, cumulatively, pretax income has been reduced by $265 million because Dow uses LIFO. Assuming a tax rate of 30%, Dow has been able to defer income taxes of $80 million ($265 million × 30%), cumulatively. During Q1 2019, Dow’s LIFO reserve decreased by $150 million ($415 million - $265 million). This meant LIFO COGS was $150 million less than it would have been under FIFO; meaning that the company reported pre-tax income that was higher by that same amount. With the current tax rate of 21%, the higher pre-tax income meant taxes were higher by $31.5 million ($150 million × 21%) (as compared to what taxes would have been with FIFO). This additional tax decreased operating cash flow by the same amount: $31.5 million. b. Inventory turnover LIFO inventory costing, for Q1 2019 is about 80 days computed as:

$ millions LIFO COGS LIFO inventory Average LIFO inventory LIFO Inventory turnover = COGS / Avg Inventory LIFO DIO = 91 / Inventory turnover

Mar 31, 2019 $10,707 9,508 9,384 1.14 79.8

Dec 31, 2018 $9,260

DOW is a manufacturer, thus, it requires a certain level of raw materials and continually maintains finished goods inventory awaiting delivery. Both inventory turnover and average inventory days outstanding appear reasonable and consistent with peers. We could usefully compare both of these ratios to those of other manufacturers in the same industry as DOW to make a more informed comparison. c. We can calculate FIFO inventory numbers as: LIFO reserve Change in reserve during the quarter FIFO COGS = LIFO COGS + Change in reserve FIFO inventory Average FIFO inventory FIFO Inventory turnover = COGS / Avg Inventory FIFO DIO = 91 / Inventory turnover

265 -150 10,557 9,773 9,724 1.09 83.8

415

9,675

The DIO using FIFO numbers is 83.8. This is about 4 days slower than if we used the LIFO numbers. It is more accurate to calculate and compare FIFO inventory ratios. For Dow, the ratios are not much different because the LIFO reserve is small compared to the size of the inventory. But for some companies, the differences can be significant. © Cambridge Business Publishers, 2021 6-19

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d. The decrease in the LIFO reserve during the quarter meant that older-costed inventories flowed to the income statement. This increased its pretax income by $150 million during the first quarter of 2019. This is an example of how the use of LIFO can result in profits that mix inventory cost numbers from different periods.

P6-38. (25 minutes) a. The level of PPE held for buildings and equipment is relatively low. From this we can

conclude that the company does not operate its own manufacturing facilities. Even if the company rented the manufacturing space, the equipment needed to produce the clothing line would be greater than what is reported on the balance sheet. b. Work in progress represents PPE that is under construction but not yet complete and not

yet in service, by the balance sheet date. Once lululemon puts these assets into use, they will be transferred to the appropriate asset class, such as computer software or equipment, depending on what type of PPE was being built. Once in service, depreciation expense will be recorded on the assets. c. $ thousands Buildings Leasehold improvements Furniture and fixtures Computer hardware Computer software Equipment and vehicles Total depreciable asset cost Average depreciable asset cost Depreciation expense (in thousands) Useful life =Average depreciable asset cost / Depreciation expense d. $ thousands Accumulated depreciation Average accumulated depreciation Average depreciable asset cost Percent used up = Average accumulated depreciation / Average depreciable asset cost

Feb. 3, 2019 Jan. 28, 2018 $38,030 $39,278 362,571 301,449 103,733 91,778 69,542 61,734 230,689 173,997 15,009 14,806 819,574 683,042 751,308 122,400 6.1

Feb. 3, 2019 Jan. 28, 2018 $405,244 $343,708 374,476 751,308 49.8%

Assuming that assets are replaced evenly as they are used up, we would expect assets to be 50% depreciated, on average. lululemon athletica’s 49.8% is exactly at this level.

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P6-39. (45 minutes) a.

$ millions

2018

Sales

$55,838

PPE, net

24,683

Average PPE, net

19,202

PPE turnover

2017 $13,721

2.9

$ millions

2018

2017

Buildings

$ 7,401

$ 4,909

Leasehold improvements

1,841

959

Network equipment

13,017

7,998

Computer software, office equipment and other

1,187

681

Total depreciable asset cost

23,446

14,547

Average depreciable asset cost

18,997

Depreciation expense (in thousands)

3,680

Useful life = Avg depreciable cost / Depreciation expense

5.2

c. $ millions

2018

2017

Accumulated depreciation

$ 6,890

$ 4,616

Average accumulated depreciation

5,753

Average depreciable asset cost Percent used up = Avg accum depreciation / Avg depreciable cost

18,997 30.3%

Assuming that assets are replaced evenly as they are used up, we would expect assets to be 50% “used up,” on average. The 30% ratio at Facebook is much lower than this average. The implication is that the company’s equipment is on the newer side which makes sense given the company’s age.

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d. The turnover ratio is 2.9 which is lower than the 5.0 median for all publicly traded companies. This indicates that Facebook is fairly capital intensive compared to the median publicly traded company. Facebook has a significant investment in network equipment and buildings given its revenue. The average life of Facebook’s assets is only 5.2 years. The equipment and software make up the lion’s share of the company’s PPE. These assets have short lives— technological obsolescence is a big risk for the company.Thus, the 5.2 years makes sense. If plant assets are replaced at a constant rate, we would expect those assets to be about 50% “used up,” on average. A substantially higher percentage “used up” indicates that the assets are closer to the end of their useful lives and will require replacement (and usually higher maintenance costs near the end of their useful lives). Such a situation would negatively impact future cash flows. Facebook’s depreciable assets are not really “used up” based on this analysis. The company replaces assets and is growing, which explains the relatively low numbers. e. Construction in progress represents building and network equipment that the company is building for future use. The amounts include labor and materials along with fees for engineering, architects, permits, and other costs to complete projects. The equipment / buildings are not yet in use, they are “in progress” at year end.

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P6-40. (30 minutes) a. GE’s restructuring programs relate to legacy and newly acquired businesses. The 2018 expenses include cash and noncash restructuring costs. The former include workforce reductions for employees laid off (also called severance pay) as well as fees paid to lawyers and consultants who are implementing restructuring activities. Noncash costs include items such as plant closures, fixed-asset write-downs, losses (or gains) on asset disposals, impairment charges on intangible assets, lease cancellations, inventory revaluations, and losses associated with deferred tax assets that are no longer viable. b. (in $ billions) Balance Sheet Transaction

Cash Asset

Noncash Assets

Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

- 3.6

RSE 3.6 RSL 3.6 (1) Record restructuring expense and liability

RSE 3.6 RSL

+3.6 Restructuring Liability

-2 Restructuring Liability

- 3.6 Retained Earnings

–

+3.6 Restructuring Expense

3.6

RSL Cash

2 2 (2) Paid $2 cash toward restructuring liability

RSL 2 Cash

-2 Cash

–

c. (1) Overestimation of the severance cost by $30 million in 2018 overstates the expense and understates pretax income by $30 million. The restructuring liability on the 2018 balance sheet will be overstated by $30 million. (2) In 2019, the liability will be reversed when severance costs are actually paid. Because the liability was overestimated in 2019, the cash paid out in 2019 will be less than the 2018 accrual and the payment would not completely eliminate the liability. Any excess (the $30 million) would reduce expense (increase pre-tax profit) in 2019. GE would show that as a reversal, which must be disclosed in the restructuring footnote.

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IFRS APPLICATIONS I6-41. (20 minutes) Carrefour Group in € millions 2018 2017

Tesco PLC in £ millions 2018 2017

Gross profit Sales Gross profit margin (%)

€15,150 €16,004 76,000 78,315 19.9% 20.4%

£3,350 57,491 5.8%

£2,902 55,917 5.2%

Inventories Total assets Common-size inventory

€6,135 47,378 12.9%

£2,263 44,862 5.0%

£2,301 45,853 5.0%

b. €6,690 47,813 14.0%

c. Cost of sales €60,850 Inventory 6,135 Average inventory 6,413 Inventory turnover = COGS / Average inventory 9.5 Days inventory outstanding = 365 / Inv. turnover 38.5

€6,690

£54,141 2,263 2,282 23.7 15.4

£2,301

d. The metrics calculated in parts a through c reveal the following: •

Tesco holds less inventory proportionately (5% of total assets compared to 13% for Carrefour in 2018).

•

Carrefour earns a much higher gross profit margin than Tesco, 20% compared to 6% for Tesco in 2018. This might be because Carrefour sells a different product mix (with higher margins) than Tesco. One possibility is beer and alcohol or spirits.

•

Tesco turns its inventory over in 15 days in 2018, far more quickly than Carrefour (38 days). This would be consistent with Carrefour selling more expensive products with longer shelf lives.

From this we would conclude that Tesco is more efficient with its inventory but Carrefour makes more profit from each sale, on average.

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I6-42. (20 minutes) (in CDN$ millions) a.

2018

2017

Depreciable cost Oil and gas properties Processing transporation and storage Upgrading Refining = $10,691 x 90% and $9,191 x 90% Retail and other Total depreciable cost

$44,196 101 2,659 9,622 3,090 59,668

$41,815 86 2,599 8,272 2,930 $55,702

Average depreciable cost

$57,685

Depreciation expense, given

$2,591

Avg useful life = Avg. depreciable cost / Depreciation expense = 22.2 years b. Accumulated depreciation Average accumulated depreciation

2018 $34,942 $33,743

Average depreciable cost, from part a.

$57,685

Percent used up = Avg. accum depr / Avg. depreciable cost

= 58.5%

c. Cost of disposals and derecognition Accumulated depreciation of disposals and derecognition Net book value Proceeds

2017 $32,543

2018 $632 586 46 4

Loss on disposal = Proceeds - NBV

$42

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MANAGEMENT APPLICATIONS MA6-43. (30 minutes) Reducing operating assets is an important means of increasing RNOA. Most companies focus first on reducing receivables and inventories. This is the low-hanging fruit that can lead to quick results. Some possible actions include the following: a. To manage inventories, the company would try to reduce inventory balances. This could

be accomplished through: 1. Use of less costly components (of equal quality) and production with lower wage rates 2. Elimination of product features not valued by customers 3. Outsourcing to reduce product cost 4. Just-in-time deliveries of raw materials 5. Elimination of manufacturing bottlenecks to reduce work-in-process inventories 6. Producing to order rather than to estimated demand to reduce finished goods inventories b. To manage PPE, the company would try to decrease the level of PPE assets on the

balance sheet. Some suggestions are the following: 1. Use of less costly equipment but only if it does not impair production or customer experience. 2. Eliminating redundant or low-producing equipment. 3. Centralizing administrative functions which could reduce computer or office equipment. 4. Outsourcing to reduce fixed assets including IT functions. c.

To manage payable, the company would try to increase payable balances. This must be done cautiously so as not to impair relationships with vendors and partners. Some suggestions are the following: 1. Negotiate contracts to have longer payment terms. 2. Seek discounts for early payment. 3. Find new suppliers with more favorable payment terms. 4. Ensure all payments to suppliers are made as late as possible under contract terms. That is, do not prepay or pay early UNLESS discounts are offered.

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Module 7 Current and Long-Term Liabilities QUESTIONS Q7-1.

Current liabilities are obligations that require payment within the coming year or operating cycle, whichever is longer. Generally, current liabilities are settled with existing current assets or operating cash flows.

Q7-2.

An accrual is the recognition of an event in the financial statements even though no related external transaction has occurred. Accruals can involve both liabilities (and expenses) and assets (and revenues). Accruals are vital to the fair presentation of the financial condition of a company as they impact both the recognition of revenue and the matching of expenses.

Q7-3.

The coupon rate is the rate specified on the face of the bond. It is used to compute the amount of cash interest paid to the bondholder. The market rate is the rate of return expected by investors who purchase the bonds. The market rate determines the market price of the bond. It incorporates the current risk-free rate, expectations about the relative riskiness of the borrower, and the rate of inflation. In general, there is an inverse relation between the bond’s market rate and the bond’s market price.

Q7-4.

Bonds are reported at historical cost, that is, the face amount plus (minus) unamortized premium (discount). The market price of the bonds varies inversely with the prevailing interest rates, which fluctuate continuously. Differences between the market price of a bond and its carrying amount (net book value) represent unrealized gains and losses. These unrealized gains (losses) are not reflected in the financial statements (although they are disclosed in the footnotes). They must be recognized if the issuer repurchases the bonds because at that point the gains or losses become “realized.”

continued

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Gains and losses from bond redemptions typically arise during refinancing in which new bonds are issued to retire existing bonds. The resulting gains or losses are not real economic gains and losses. The recognition of the gain (loss) on redemption results from the use of historical costing for bonds. The gain (loss) that is reported upon redemption will be offset by correspondingly lower (higher) interest payments in the future. The financial statements recognize neither the present value of these future interest payments, nor the present value of the difference between the current face amount of the bond and the former face amount. These present values exactly offset the reported gain (loss); thus, no “real” gain (loss) has been realized. Q7-5.

Debt ratings reflect the relative riskiness of the rated company. This riskiness relates to the probability of default (e.g., not repaying the principal and interest when due). Higher debt ratings result in higher market prices for the bonds and a correspondingly lower effective interest rate for the issuer. Lower debt ratings result in lower market prices for the bonds and a correspondingly higher effective interest rate for the issuer.

Q7-6.

Gains and losses from bond redemptions typically arise during refinancing, when new bonds are issued to retire existing bonds. The resulting gains or losses are not real economic gains and losses. Companies report gains or losses on bond redemption because they use historical cost accounting. The redemption gain or loss is offset by the present value of lower (higher) interest payments in the future. The present value of those future interest payments, as well as the present value of the difference between the current face amount of the bond and the former face amount, are not recognized in the financial statements, and no “real” economic gain or loss occurs. For analysis purposes, we typically consider gains or losses on bond redemption as transitory, nonoperating items.

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MINI EXERCISES M7-7. (15 minutes) a. NCI Building Systems does not recognize the liability related to future remediation on the face of its balance sheet not because the liability is not probable, but because the potential loss cannot be reasonably determined. As a result, NCI references the liability in its contingency footnote and does not recognize the liability on its balance sheet. To date, NCI has only accrued $0.1 million on its balance sheet, the cost to complete the site analysis and testing. b. The $0.1 million accrual is not a contingent liability. NCI has accrued this liability because it has made a commitment to complete site analysis and testing. It is, therefore, not subject to the two conditions that govern contingent liabilities.

M7-8. (10 minutes) Balance Sheet Transaction IE

Cash Asset

Noncash Assets

Liabilities

+45 Interest Payable

Income Statement Contrib. Capital

Earned Capital

Revenues

–

Expen -ses

Net Income

–

+45 Interest Expense

-45

45 IP

45 IE 45

To accrue interest at Dec 31*

-45 Retained Earnings

IP 45

* $13,800 0.08  15/365 = $45

M7-9. (15 minutes) a. Accounts Payable, $220,000 (current liability). b. Not recorded as a liability; an accounting transaction has not yet occurred because Bloomington did not receive the drill press before year-end and anticipated transactions are not recorded. c. Liability for Product Warranty, $3,100 (current liability).  5%. This liability d. Bonuses Payable, $40,000 (current liability)—computed as $800,000 must be reported because the bonus relates to executives’ efforts to generate operating results in 2019. ©Cambridge Business Publishers, 2021 7-3

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M7-10. (10 minutes) a. Citigroup is offering bonds (maturing 2038) with a coupon (stated) rate of 6.8% when the market rate (yield) is lower at 2.4%. To obtain this expected rate of return, the bonds must sell at a premium price of 166.43 (166.43% of par). b. The first bond matures in 2038 and yields 2.4% while the second matures in 2026 and yields 1.59%. The market generally demands a higher rate (yield) for a longer maturity debt instrument.

M7-11. (10 minutes) Amount paid to retire bonds ($200,000 × 101%) .................................................... $202,000 Book value of retired bonds, net of $3,400 unamortized discount ........................... 196,600 Loss on bond retirement ......................................................................................... $ 5,400 Gains and losses from bond redemptions typically arise during refinancing in which new bonds are issued to retire existing bonds. The resulting gains or losses are not real economic gains and losses. The loss on retirement results from Middleton’s use of historical costing for its bonds. The $5,400 loss will be offset by correspondingly lower interest payments in the future. Middleton does not recognize the present value of these future interest payments nor the present value of the difference between the current face amount of the bond and the former face amount. These present values will exactly offset the reported loss on retirement and no “real” loss is realized.

M7-12. (10 minutes) a. The information indicates that Marriott has $4,853 million in debt maturing in the next three years ($833 million + $912 million + $3,108 million). The payment in 2021 is significantly higher than in the prior two years. Marriott will either make these payments with operating cash flows or it will have to issue more debt (refinance), or sell stock to repay the debt as it comes due. b. Marriott’s debt maturity schedule indicates near-term maturities that will require cash payments. This information is important to analysts as they determine the company’s liquidity and solvency. Analysts may review the company’s recent operating cash-flows to determine how much of its operating cash flow would be required to pay-off the debt if Marriott cannot refinance the debt. Repayment out of operating cash flows may divert cash needed for operating activities or alternative investment opportunities. With this information, analysts can better determine whether or not there is a concern about the company’s liquidity and solvency.

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M7-13. (10 minutes) a. Gain on bond retirement: Income Statement—included in other (nonoperating) income and expense section. b. Discount on bonds payable: Balance Sheet—shown as a deduction from Long-term Debt (Bonds Payable); netted in the presentation of long-term liabilities. c. Mortgage notes payable: Balance Sheet—Long-term liability. d. Bonds payable: Balance Sheet—Long-term liability. e. Bond interest expense: Income Statement—included with other (nonoperating) income and expenses. f.

Bond interest payable: Balance Sheet—included with current liabilities.

g. Premium on bonds payable: Balance Sheet—shown as an addition to Bonds Payable; thus, part of long-term liabilities. h. Loss on bond retirement: Income Statement—included in other (nonoperating) income and expenses section.

M7-14. (15 minutes) a. Financial restrictions used in bond covenants are typically designed to protect the bondholders against detrimental managerial actions or excessively poor company performance. Restrictions might prohibit the impairment of liquidity, the increasing of financial leverage, and the paying of cash dividends. In addition, bondholders usually impose various covenants prohibiting the acquisition of other companies or the divestiture of business segments without bondholders’ consent. All of these covenants, by design, restrict management in such actions that might increase the bondholders’ risk. b. Managers who face imminent default in one or more bond covenants would likely take action to avoid such default. These actions can include, for example, operational responses, such as reducing R&D or advertising to improve profitability, or leaning on the trade (by delaying payment of bills), reducing receivables (via early payment incentives for customers), or reducing inventory (by marketing promotions or delaying restocking) to boost cash balances. Actions can also include fraudulent or aggressive accounting tactics, such as improper recognition of revenues or delayed recognition of expenses.

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M7-15. (15 minutes) (in $000) Balance Sheet Transaction

Cash Asset

To retire bonds at 103 and report gain on bond retirement*

-618 Cash

Noncash Assets

Liabilities

-626 Long-term Debt

Income Statement +

Contrib. Capital

Earned Capital

Rev enues

–

+8 Retained Earnings

+8 Gain on Bond Retirement

–

Expen -ses

Net Income

LTD 626 Cash 618 GN 8 626 Cash 618 GN 8

* Retirement price = $618,000, computed as $600,000 × 103%. Original net book value of bonds = $636,000, computed as $600,000 × 106% Net book value of bonds at retirement = $626,000, computed as $636,000 - $10,000.

M7-16. (15 minutes) (in $000) Balance Sheet Transaction

Cash Asset

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

+16.5 Loss on = Bond Retirement

-16.5

LTD 438 LS 16.5 Cash 454.5 To retire bonds at 101 and -454.5 report loss on Cash bond retirement*

LTD 438 LS 16.5

-438 = Long-Term Debt

-16.5 Retained Earnings

–

Cash 454.50

* Retirement price = $454,500, computed as $450,000 × 101% Original net book value of bonds = $450,000 × 96% = $432,000 Net book value of bonds at retirement = $432,000 + $6,000 = $438,000

M7-17. (10 minutes) Nissim: Klein: Bildersee:

$30,000 × 0.10 × 40/365 $22,000 × 0.08 × 18/365 $26,000 × 0.06 × 12/365

= = =

$328.77 86.79 51.29 $466.85

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M7-18. (10 minutes) a. KLA-Tencor is above investment grade according to all three ratings agencies. However, the company’s rating is near the cutoff line. b. Financial leverage (which measures debt levels) is one of the ratios that credit-rating agencies use to determine their ratings. Generally, the higher the financial leverage, the lower the bond rating and vice versa. In short, all else equal, less debt suggests a greater likelihood of payment on that lower level of debt. Therefore, by reducing its financial leverage, Cummins will improve its bond rating. c. Lower leverage will improve the company’s credit ratings, which reduces risk and lowers the company’s borrowing costs.

M7-19. (15 minutes) a. Selling price for $700,000, 9% bonds discounted at 8% (4% semiannually): Calculator inputs: N = 20 I/Y = 4 PV = 747,566.14

PMT = -31,500

Excel inputs: = PV(4%,20,-31500,-700000,0)

FV = -700,000,

Cell will display: 747,566.14

Present value of principal repayment ($700,000  0.45639a) Present value of interest payments ($31,500  13.59033b) Selling price of bonds

$319,473 428,095 $747,568

Table 1, 20 periods at 4%.

Table 2, 20 periods at 4%.

b. Selling price for $700,000, 9% bonds discounted at 10% (5% semiannually): Calculator inputs: N = 20 I/Y = 5 PV = 656,382.26

PMT = -31,500

Excel inputs: = PV(5%,20,-31500,-700000,0)

FV = -700,000,

Cell will display: 656,382.26

Present value of principal repayment ($700,000  0.37689a) Present value of interest payments ($31,500  12.46221b) Selling price of bonds

$263,823 392,560 $656,383

Table 1, 20 periods at 5%.

Table 2, 20 periods at 5%. ©Cambridge Business Publishers, 2021 7-7

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M7-20. (15 minutes) a. Selling price of zero coupon bonds discounted at 8% Calculator inputs: N =20 I/Y = 4 PV = 159,735.43

PMT = 0

Excel inputs: =PV(4%,20,0,-350000,0)

FV = -350,000,

Cell will display: 159,735.43

 0.45639a) Present value of principal repayment ($350,000

$159,737

Table 1, 20 periods at 4%

b. Selling price of zero coupon bonds discounted at 10% Calculator inputs: N =20 I/Y = 5 PV = 131,911.32

PMT = 0

Excel inputs: =PV(5%,20,0,-350000,0)

FV = -350,000,

Cell will display: 131,911.32

Present value of principal repayment ($350,000  0.37689a)

$131,912

Table 1, 20 periods at 5%

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M7-21. (15 minutes) Balance Sheet Noncash Assets

a. Purchases $1,260 of inventory on credit

+1,260 Inventory

+1,260 = Accounts Payable

b. Sells inventory for $1,650 on credit

+1,650 Accounts = Receivable

+1,650 Retained Earnings

c. Records $1,260 cost of sales

–1,260 Inventory

–1,260 Retained Earnings

Transaction

Cash Asset

Liabilities

Income Statement

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

INV 1,260 AP 1,260 INV 1,260 AP 1,260

–

+1,650

–1,260

AR 1,650 Sales 1,650 AR 1,650 Sales 1,650

COGS INV

1,260 1,260

COGS 1,260 INV 1,260

Cash AR

+1,650 Sales

–

+1,260 Cost of Sales

1,650 1,650

Cash 1,650 AR 1,650

AP 1,260 Cash 1,260 AP 1,260 Cash 1,260

d. Receives $1,650 cash for accounts receivable

+1,650 Cash

e. Pays $1,260 cash to settle accounts payable

–1,260 Cash

–1,650 Accounts = Receivable

–1,260 = Accounts Payable

–

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M7-22. (30 minutes) a. Data inputs into Excel— = price(settlement,maturity,rate,yld,redemption,frequency,basis) 01/01 12/31/26 8.00% 7.00% 100 2 1

Price………

Settlement date Maturity date Percent annual coupon rate Percent annual yield Redemption value Frequency is semiannual (given in problem) actual/actual basis Percent of par 107.10

Sale proceeds $428,400 ($400,000 × 1.0710)

b. Period 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Interest 14,994.00 14,958.79 14,922.35 14,884.63 14,845.59 14,805.19 14,763.37 14,720.09 14,675.29 14,628.93 14,580.94 14,531.27 14,479.86 14,426.66 14,371.59 14,314.60 14,255.61 14,194.56 14,131.37 14,115.32*

Cash Paid 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00 16,000.00

Premium Amortization

Premium Balance

Carrying Amount

1,006.00 1,041.21 1,077.65 1,115.37 1,154.41 1,194.81 1,236.63 1,279.91 1,324.71 1,371.07 1,419.06 1,468.73 1,520.14 1,573.34 1,628.41 1,685.40 1,744.39 1,805.44 1,868.63 1,884.68

28,400.00 27,394.00 26,352.79 25,275.14 24,159.77 23,005.36 21,810.55 20,573.92 19,294.00 17,969.29 16,598.22 15,179.16 13,710.43 12,190.29 10,616.95 8,988.55 7,303.14 5,558.75 3,753.31 1,884.68 (0.00)

428,400.00 427,394.00 426,352.79 425,275.14 424,159.77 423,005.36 421,810.55 420,573.92 419,294.00 417,969.29 416,598.22 415,179.16 413,710.43 412,190.29 410,616.95 408,988.55 407,303.14 405,558.75 403,753.31 401,884.68 400,000.00

* adjusted to absorb $49.36 cumulative rounding error.

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M7-23 (15 minutes) Company 1 has ratios that are similar to those for companies with a rating of “A.” Company 2 has ratios that are similar to those for companies with a rating of “Ba.” Company 3 has ratios that are similar to those for companies with a rating of “Aa.”

M7-24 (20 minutes)

Annual Yield

Years to Maturity

Coupon Rate

Face Value

Issue proceeds

8.00%

7.00%

$300,000

$274,062

=PV(8%/2, 15*2,300000*7%/2,-300000,0)

3.00%

0.00%

$750,000

$556,853

=FV(3%/2,10*2,0,-556853,0)

6.50%

5 (10 periods)

5.00%

$500,000

$468,416

=NPER(6.5%/2,500000*5%/2,468416, -500000)

2.10% (1.05% per period)

3.50%

$1,000,000

$1,147,822

=RATE(12*2,1000000*3.5%/2,1147822, -1000000,0)

0.80%

2.00%

$500,000

$610,688

=PV(.8%/2, 20*2,500000*2%/2,-500000,0)

Excel computation

M7-25 (10 minutes) To comply with the sinking fund provision, Ozona must have $125 million in the sinking fund in 10 years. The annual sinking fund payment required is $9,938,072. Excel formula: = PMT(5%,10,0,125000000,0).

M7-26 (15 minutes) Face Value

(Discount) Premium

Net Book Value

Fair Value

Gain (loss) on Early Retirement

$ 450,000

$42,300

$492,300

$502,189

$(9,889)

1,000,000

(69,034)

930,966

947,482

(16,516)

250,000

244,893

5,107

500,000

2,033

502,033

498,574

3,459

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EXERCISES E7-27. (20 minutes) a. Total expected failures from units sold (100,000  0.03) ........................... Average cost per failure ............................................................................ Total warranty expense for the current period ...........................................

3,000  $160 $480,000

 0.03) ........................... b. Total expected failures from units sold (100,000 Units repaired during the period ................................................................ Expected units left to be repaired .............................................................. Average cost per failure ............................................................................ Total warranty liability at end of current period ..........................................

3,000 2,400 600  $160 $96,000

At the end of the current period, Canton will have a product warranty liability of $96,000 related to current period sales. This amount will cover the expected $160 repair costs of the additional 600 units expected to fail in the next period. c. The warranty liability should be equal, at all times, to the expected dollar cost of future repairs. A key analysis issue is whether a warranty liability exists and, if so, is the balance sheet amount correct. Computing the warranty-expense-to-sales ratio (common-size warranty expense) will enable a comparative analysis over several periods. We must recognize that understating (overstating) the accrual overstates (understates) current-period income at the expense (benefit) of future income. This provides managers the opportunity to set up a “cookie jar” reserve for warranties.

E7-28. (20 minutes) 1. Neither record nor disclose (the loss is not probable, nor reasonably possible). 2. Record a current liability for the note. At the financial statement date, record a liability for any interest that has been incurred since the note was signed. 3. Disclose in a footnote (the loss is reasonably possible but the amount cannot be estimated). 4. Record warranty liability on the balance sheet and recognize an expense in the income statement (costs are probable and reasonably estimable).

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E7-29. (20 minutes) a. ($ 000s) Income Statement

Balance Sheet Transaction WRE 53,367 WRP 53,367 WRE 53,367 WRP

Cash Asset

Noncash = Assets

Liabilities

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

(1) To accrue warranties issued during the period

+53,367 Warranty Payable

-53,367 Retained Earnings

–

+53,367 Warranty Expense

-53,367

(2) To accrue recalls and changes to preexisting obligations

+63,473 Warranty Payable

-63,473 Retained Earnings

–

+63,473 Warranty Expense

-63,473

(3) To record settlements -79,300 made during Cash* the period

-79,300 Warranty Payable

53,367

WRE 63,473 WRP 63,473 WRE 63,473 WRP 63,473

WRP 79,300 Cash 79,300 WRP 79,300 Cash

–

79,300

Harley does not disclose the composition of the settlements made. These settlements typically include both cash payments (to consumers or for repair labor) and to inventories (parts and finished goods)

b. Harley’s warranty accruals for 2018, 2017, and 2016, including both “Warranties issued during the period” and “Recalls and changes to preexisting warranty obligations” amount to $116,840, $97,272 and $104,563 respectively. The total accrual is $318,675 compared with $261,152 in payments made to settle warranty claims. The difference is $57,523. This difference, along with the decrease in settlements every year, indicates that the warranty liability might be over accrued at 12/31/2018. However, we do not know the overall quality of the motorcycles that Harley has been selling recently and we have not history from prior years’ warranty claims on the parts and accessories. Therefore, it is impossible to indubitably assess whether the reserve is more than adequate to cover the liability on those recent sales.

E7-30. (15 minutes) Demski Company must accrue the $96,000 of wages that have been earned even though these wages will not be paid until the first of next month. The accrual will: • •

Increase wages payable by $96,000 on the balance sheet (current liability) Increase wages expense by $96,000 in the income statement (operating expense)

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E7-31. (25 minutes) a. Selling price of $500,000, 15-year, 10% semiannual bonds, discounted at 8%: Calculator inputs: N = 30 PV = 586,460.17

I/YR = 4

PMT = -25,000

Excel inputs: =PV(4%,30,-25000,-500000,0)

FV = -500,000,

Cell will display: 586,460.17

Present value of principal repayment ($500,000  0.30832) ..................... Present value of interest payments ($25,000  17.29203) ........................ Selling price of bonds ................................................................................

$154,160 432,301 $586,461

b. Balance Sheet Transaction

Cash Asset

Noncash = Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

Cash 586,460 LTD 586,460 Cash 586,460

1. Issue $500,000, +586,460 10% bonds to Cash yield 8%

+586,460 Long-Term Debt

2. Pay interest on June 30 (i)

–25,000 Cash

–1,542 Long-Term Debt

3. Pay interest on December 31(ii)

–25,000 Cash

–1,603 = Long-Term Debt

–

–23,458 Retained Earnings

–

+23,458 Interest = Expense

–23,458

–23,397 Retained Earnings

–

+23,397 Interest = Expense

–23,397

LTD 586,460

IE 23,458 LTD 1,542 Cash 25,000 IE 23,458 LTD 1,542 Cash 25,000

IE 23,397 LTD 1,603 Cash 25,000 IE 23,397 LTD 1,603 Cash 25,000

(i) $500,000 × 0.10 × 6/12 = $25,000 cash payment; 0.04 × $586,460 = $23,458 interest expense; the difference is the bond premium amortization ($25,000 – $23,458 = $1,542), which reduces the carrying amount of the bond by $1,542. (ii) 0.04 × ($586,460 − $1,542) = $23,397 interest expense. The difference between this amount and the cash payment of $25,000 is the bond premium amortization ($25,000 – $23,397 = $1,603), which reduces the carrying amount of the bond by $1,603.

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E7-32. (25 minutes) Balance Sheet Transaction

Cash Asset

Noncash = Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

Cash 1,000,000 LTD 1,000,000 Cash 1,000,000

(a) Issue +1,000,000 $1,000,000, Cash mortgage LTD note payable 1,000,000

IE 50,000 LTD 15,051 Cash 65,051 IE 50,000 LTD 15,051

+1,000,000 = Long-Term Debt

–

(b) Make first –65,051 installment on Cash (i) June 30

–15,051 = Long-Term Debt

–50,000 Retained Earnings

–

+50,000 Interest Expense

= –50,000

–15,804 = Long-Term Debt

–49,247 Retained Earnings

–

+49,247 Interest Expense

= –49,247

Cash 65,051

IE 49,247 LTD 15,804 Cash 65,051 IE 49,247 LTD 15,804 Cash 65,051

(i) 0.05 × $1,000,000 = $50,000 interest expense. The difference between interest expense and the cash payment is the reduction of the principal amount of the loan ($65,051 – $50,000 = $15,051). (ii) 0.05 × ($1,000,000 - $15,051) = $49,247 interest expense. The difference between interest expense and the cash payment is the reduction of the principal amount of the loan ($65,051 – $49,247 = $15,804).

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E7-33. (15 minutes) a. Credit rating companies such as the NRSROs listed, typically utilize financial ratios that measure liquidity and solvency (and sometimes profitability). Liquidity is measured with ratios like the current ratio, quick ratio, discussed in Module 4, and various operatingcash-flow-to-liabilities ratios. Solvency is measured using financial leverage, debt to equity, times interest earned, and various cash-flow-to-financial-payment ratios. b. An upgrade would signal a credit-rating improvement meaning that Ford was stronger financially and less risky as a borrower. The likely effect would be to reduce Ford’s borrowing cost, which would increase the fair value of the company’s outstanding bonds. This inverse relation arises because the fair value of the bonds is equal to the present value of the remaining interest payments plus the present value of the face value of the bonds. When the discount rate decreases (due to the credit rating uptick) the present value of the bonds’ cash flows increased. c. To improve its credit ratings, Ford could improve operating margins, or improve liquidity and solvency by reducing its debt level. All of these actions, while serving to improve its credit ratings, entail certain costs that Ford must seriously consider. For example, increasing liquidity by reducing inventories or foregoing capital expenditures can impact Ford’s future sales and competitive position. Likewise, reducing debt by issuing equity is costly because equity capital is usually more expensive (due to the subordinated position of equity investors vis-à-vis creditors and also the non-deductibility of dividends for tax purposes). In sum, Ford must carefully weigh the costs and benefits of various actions it can undertake to increase its credit ratings.

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E7-34. (25 minutes) Balance Sheet

Transaction

Cash Asset

Noncash = Assets

Liabilities

Income Statement

Contrib. + Capital

Earned Capital

Revenues

–

Expenses

Net Income

Cash 400,000 LTD 400,000 Cash 400,000

(a) Issue bonds +400,000 May 1 Cash

+400,000 = Long-Term Debt

(b) Pay interest on October 31(1)

–18,000 Retained Earnings

–

+18,000 Interest Expense

–18,000

–150,000 = Long-Term Debt

–3,000 Retained Earnings

–

+3,000 Loss

–3,000

–

LTD 400,000

IE 18,000 Cash 18,000 IE 18,000

–18,000 Cash

Cash 18,000

LTD 150,000 LS 3,000 Cash 153,000 LTD 150,000

LS 3,000 Cash 153,000

(1) $400,000 × 0.09 × 1/2 = $18,000 interest expense. Because the bonds were sold at par, there is no discount or premium amortization. (2) Cash required to retire $150,000 of bonds at 102 = $150,000 × 1.02 = $153,000. The difference between the cash paid and the carrying amount of the bonds is the loss on the redemption. In this case, the loss is $3,000.

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E7-35. (25 minutes) a. Selling price of bonds Calculator inputs: N = 18 PV = 309,086.45

I/YR = 5

PMT = -14,000

Excel inputs: =PV(5%,18,-14000,-350000,0)

FV = -350,000,

Cell will display: 309,086.45

Present value of principal repayment ($350,000  0.41552) Present value of interest payments ($14,000  11.68959) Selling price of bonds

$145,432 163,654 $309,086

b. Balance Sheet

Cash 309,086 LTD 309,086 Cash 309,086 LTD

Transaction

Cash Asset

Liabilities

1. Issue $350,000, 8% bonds to yield 10%(1)

+309,086 Cash

+309,086 Long-Term Debt

2. Pay interest on June 30 (2)

–14,000 Cash

+1,454 Long-Term Debt

–15,454 Retained Earnings

–

+15,454 Interest Expense

= –15,454

3. Pay interest on December 31 (3)

–14,000 Cash

+1,527 Long-Term Debt

–15,527 Retained Earnings

–

+15,527 Interest Expense

= –15,527

Noncash Assets

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

–

Net Income

309,086

IE 15,454 LTD 1,454 Cash 14,000 IE 15,454 LTD 1,454 Cash 14,000

IE 15,527 LTD 1,527 Cash 14,000 IE 15,527 LTD 1,527 Cash 14,000

(1) The bond is reported at its sale price, which is par value of $350,000 less the discount of $40,914. (2) $14,000 cash paid = bond face amount × coupon rate ($350,000 × 0.04). The $15,454 interest expense = bond carrying amount × discount rate ($309,086 × 0.05). The difference between the two is the amortization of the discount, which increases the bond carrying amount. (3) $14,000 cash paid = bond face amount × coupon rate ($350,000 × 0.04). The $15,527 interest expense = bond carrying amount × discount rate [($309,086 + $1,454) × 0.05]. The difference between the two is the amortization of the discount, which increases the bond carrying amount.

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E7-36. (25 minutes) a. Selling price of bonds Calculator inputs: N = 40 PV = 1,098,963.87

I/YR = 4

PMT = -45,000

Excel inputs: =PV(4%,40,-45000,-1000000,0)

FV = -1,000,000,

Cell will display: 1,098,963.87

Present value of principal repayment ($1,000,000  0.20829) Present value of interest payments ($45,000  19.79277) Selling price of bonds

208,290 890,675 $1,098,965

b. Balance Sheet Transaction Cash 1,098,965 LTD 1,098,965 Cash 1,098,965 LTD 1,098,965

Cash Asset

1. Issue $1,000,000, +1,098,965 9% bonds to Cash yield 8%(1)

Noncash Assets

Liabilities

+1,098,965 Long-Term Debt

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

–

Net Income

IE 43,959 LTD 1,041 Cash 45,000 IE 43,959 LTD 1,041

2. Pay interest on June 30(2)

–45,000 Cash

–1,041 Long-Term Debt

–43,959 Retained Earnings

–

+43,959 Interest Expense

= –43,959

3. Pay interest on Dec. 31(3)

–45,000 Cash

–1,083 Long-Term Debt

–43,917 Retained Earnings

–

+43,917 Interest Expense

= –43,917

Cash 45,000

IE 43,917 LTD 1,083 Cash 45,000 IE 43,917 LTD 1,083 Cash 45,000

(1) The bond is reported at its sale price, which represents the par value of $1,000,000 plus the premium of $98,965. (2) The cash paid = bond face amount × coupon rate ($1,000,000 × 0.045 = $45,000). The interest expense = bond carrying amount × discount rate ($1,098,965 × 0.04 = $43,959). The difference between the two is the amortization of the premium, which decreases the bond carrying amount. (3) The cash paid =bond face amount × coupon rate ($1,000,000 × 0.045 = $45,000). The interest expense = bond carrying amount × discount rate [($1,098,965 - $1,041) × 0.04 = $43,917]. The difference between the two is the amortization of the premium, which decreases the bond carrying amount.

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E7-37. (30 minutes) a. There is an inverse relation between interest rates and bond prices (to see this, observe how the discount factors decrease as the rate increases in present value tables of Appendix A). Given that Deere’s 7.125% debentures now trade at a premium (131.03) and assuming that Deere’s credit ratings have not changed, we conclude that interest rates for this type of debt have declined well below 7.125% since the bonds were issued. b. No, the change in interest rates since Deere issued the notes does not affect interest expense. Once the notes are recorded on the balance sheet, neither the coupon rate nor the yield (market) rate used to compute interest expense is changed. Notes (and bonds) are recorded at historical cost (like nearly all other balance sheet assets and liabilities, except some types of investments). As a result, changes in the general level of interest rates have no effect on Deere’s interest expense (or the interest payments) reflected in Deere’s financial statements. c. Because the bonds trade at a premium in the market (131.03), Deere would be paying more to retire the bonds than their balance sheet (carrying) value. Deere’s cash outflow would be $393.09 million ($300 million × 131.03%). This would result in a loss on repurchase of debentures of $93.09 million ($393.09 million - $300 million), which would lower current period pre-tax income. d. Deere must repay the face amount of the bonds at maturity. Because this is the only cash flow that the bondholders will receive, the market price of the bonds will be equal to the face amount at that time. For Deere, that would be $300 million at maturity. (Assumes the last annual interest payment was already distributed.)

E7-38. (30 minutes) a. (1) (2)

$120,000  0.38554 = $120,000  0.37689 =

$46,265 $45,227

b. $2,000  5.74664

$11,493

c. $800 15.37245

$12,298

d. $250,000  0.38554

$96,385

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E7-39. (25 minutes) a. Selling price of bonds Calculator inputs: N = 40 PV = $739,814.81

I/YR = 6

PMT = -44,000

Excel inputs: =PV(6%,40,-44000,-800000,0)

FV = -800,000,

Cell will display: 739,814.81

Present value of principal repayment ($800,000  0.09722) .................................... $77,776 Present value of interest payments ($44,000  15.04630) ....................................... 662,037 Selling price of bonds ............................................................................................. $739,813 b. Balance Sheet

Cash 739,815 LTD 739,815 Cash 739,815 LTD

Transaction

Cash Asset

1. Issue $800,000, 11% bonds to yield 12%(1)

+739,815 Cash

+739,815 Long-Term Debt

2. Pay interest on June 30(2)

–44,000 Cash

+389 LongTerm Debt

–44,389 Retained Earnings

–

+44,389 Interest Expense

3. Pay interest on December 31(3)

–44,000 Cash

+412 LongTerm Debt

–44,412 Retained Earnings

–

+44,412 Interest = Expense

Noncash = Assets

Liabilities

Income Statement +

Contrib. + Capital

Earned Capital

Revenues

–

Expenses

–

Net Income

739,815

IE 44,389 LTD 389 Cash 44,000 IE 44,389 LTD

= –44,389

389 Cash 44,000

IE 44,412 LTD 412 Cash 44,000 IE 44,412 LTD

–44,412

412 Cash 44,000

(1) The bond is reported at its sale price, which is par value of $800,000 less the discount of $60,185. (2) $44,000 cash paid = bond face amount × coupon rate ($800,000 × 0.055). The $44,389 interest expense = bond carrying  0.06). The difference between the two is the amortization of the discount, which amount × discount rate ($739,815 increases the carrying amount of the bond. (3) $44,000 cash paid = bond face amount × coupon rate ($800,000 × 0.055). The $44,412 interest expense = bond carrying amount × discount rate [($739,815 + $389) × 0.06]. The difference between the two is the amortization of the discount, which increases the bond carrying amount.

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E7-40. (25 minutes) a. Moody’s downgraded Xerox on December 14, 2018. b. Yes, Xerox’s rating was Baa3, just above the investment grade cut-off and the downgrade reduced it to Ba1, which is just below the cut-off. This is a particularly negative outcome for Xerox – interest rates will likely rise and investors who avoid “junk bonds” could sell their Xerox bonds, putting price pressure on the bonds and driving the cost of borrowing even higher. c. The primary rationale is that the company’s revenue is declining in the copier and printing segment despite new product launches that should have shored up revenues. Moody’s also faults Xerox’s inability to execute on its strategy. d. Moody’s sees the following four strengths: 1) good market position in the printing / outsourcing segment, 2) solid leverage measures, 3) strong free cash flow, and 4) higher operating margins from the post-sales activities line of business.

E7-41 (20 minutes) ($ millions) a. Ratio a. EBITA = $10,073 + $1,417 + $1,197 + $8,979

b. Moody’s Credit Rating

$21,666

EBITDA = EBITA + depreciation = $21,666 + $6,362 =

$28,028

EBITA / Average assets = $21,666 / $146,979 =

14.7%

EBITA Margin = $21,666 / $232,887 =

9.3%

EBITA / Interest expense = $21,666 / $1,417 =

15.29

A - Aa

Debt / EBITDA = $23,495 / $28,028 =

0.84

Aaa

CAPEX / Depreciation expense = $13,427 / $6,362 =

2.11

Aaa

b. Two ratios suggest a very high credit rating (Debt / EBITA and CAPEX / Depreciation) and two other ratios are in the range for a rating of Aa. One ratio is weak (EBITA Margin) and it is consistent with a very low rating. Most of the ratios are strong and Moody’s would likely rate Amazon as Aa.

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E7-42 (20 minutes) ($ millions) a. Ratio a. EBITA = $1,344 + $287 + $181 + $23 =

b. Moody’s Credit Rating

$1,835

EBITDA = EBITA + depreciation = $1,835 + $493

2,328

EBITA / Average assets = $1,835 / $17,066 =

10.8%

Baa

EBITA Margin = $1,835 / $13,547 =

13.5%

EBITA / Interest expense = $1,835 / $287 =

6.39

Baa

Debt / EBITDA = $8,893 / $2,328 =

3.82

CAPEX / Depreciation expense= $578 / $493 =

1.17

b. Most of the ratios suggest a credit rating of Ba. Kellogg’s has significant levels of debt and this increases the credit risk to lenders. However, the company has a proven ability to generate cash flows and thus, creditors are not likely concerned about default.

E7-43 (20 minutes) a. The annual mortgage payment is $530,671. Excel formula: = PMT(5.5%,10,4000000,0) b. Year 0 1 2 3 4 5 6 7 8 9 10

Interest at 5.5% 220,000 202,913 184,886 165,868 145,804 124,636 102,305 78,744 53,888 27,665

Annual Payment 530,671 530,671 530,671 530,671 530,671 530,671 530,671 530,671 530,671 530,671

Principal Reduction

Balance Owing 4,000,000 3,689,329 3,361,571 3,015,787 2,650,984 2,266,117 1,860,082 1,431,716 979,789 503,007 0

310,671 327,758 345,785 364,803 384,867 406,035 428,366 451,927 476,783 503,006

c. At the end of year 1, the balance sheet will show $ 327,758 as the current portion of longterm debt, which is the amount of the principal reduction in year 2 (from the amortization table).

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E7-44 (20 minutes) a. The annual mortgage payment is $1,415,894. Excel formula: = PMT(7%,20,15000000,0) b. Balance Sheet Transaction

Cash Asset

Record mortgage proceeds

15,000,000

15,000,000 = Long-term debt

Pay 1st year mortgage payment

-1,415,894

-365,894 = Long-term debt

Pay 2nd year mortgage payment

-1,415,894

-391,507 = Long-term debt

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

Cash 15,000,000 LTD 15,000,000 Cash 15,000,000

LTD

–

-1,050,000 Retained Earnings

–

+1,050,000 Interest = -1,050,000 expense

-1,024,387 Retained Earnings

–

+1,024,387 Interest = -1,024,387 expense

15,000,000

c. IE 1,050,000 LTD 365,894 Cash 1,415,894 IE 1,0 5 0 ,0 0 0

LTD 3 6 5 ,8 9 4

Cash 1, 4 15 , 8 9 4

IE 1,024,387 LTD 391,507 Cash 1,415,894 IE 1,0 2 4 ,3 8 7

LTD 3 9 1,5 0 7

Cash 1, 4 15 , 8 9 4

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E7-45 (15 minutes) a. The bond is trading at about 109 according to the graph. b. When bonds fall below par it means that the coupon rate of 4% was less than the rate demanded by investors for an investment of like risk. c. As the price of the bond rose during 2019, the bond’s yield decreased lower and lower. d. There are many reasons for the bond’s price increase including the following: the company became more profitable, the company reduced its debt load, the company acquired another company that had a better credit rating, the risk free rate decreased, the competitive environment became less volatile, the company’s market share increased, or other good news events happened.

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PROBLEMS P7-46. (40 minutes) a. The current maturities of long-term debt are repayments of long-term debt that must be made during the next year. Because they represent a current obligation of the company, they are included among current liabilities on the balance sheet. PepsiCo chose to group its current maturities of $3,953 million with its other short-term debt rather than report them as a separate line in the current liabilities section of the balance sheet. Both are common disclosure methods. The current maturities amount is important to our analysis of the company’s solvency. The company has two options in settling its debt: 1) refinance the maturing debt with a new debt issuance, or 2) repay the debt from cash flows in the year the debt matures. We would compare the cash from operating activities in recent years to the current maturity to see what proportion of operating cash flow PepsiCo would need to access if it could not refinance the debt. Accordingly, the larger the proportion the greater the concern unless we are comfortable with the company’s other sources of liquidity. b. There is an inverse relation between bond price and effective bond yield. The information here reveals that the PepsiCo bond maturing in 2022 is selling at a premium (102.27% of par). This premium will cause the effective yield to be less than the 2.75% coupon on this bond (1.87% in this case). The market rates reflect underlying interest rates and risk premia as of 2019, whereas PepsiCo established the coupon rates when the bond was issued . Thus, assuming that the bonds were originally issued at par, the premium price that exists at 2019 reflects the effect of decreasing interest rates. Since the problem assumes constant credit ratings, the premium must have resulted from an overall decrease in market interest rates since PepsiCo issued the bond. c. The total amount tendered is $1,328 million ($11 + $4 + $357 + $138 + $410 + $408, all in millions). Pepsico paid $1,600 million cash to repurchase bonds and recorded a loss on early retirement of $272 million ($1,600 - $1,328). d. Moody’s provided the rating on Pepsi’s new note issuance to provide an opinion about the company’s ability to repay the $1.25 billion. Investors can infer that the new notes did not impair PepsiCo’s creditworthiness because the rating action says, “Other ratings were unchanged.” The rating action will affect the proceeds that PepsiCo receives on the new notes. The credit rating of A1 indicates a low risk premium because the rating is fairly high. A low risk premium keeps PepsiCo’s borrowing costs down and, therefore, the note proceeds will be higher.

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e. To improve its credit ratings, PepsiCo must improve its liquidity and solvency and/or reduce its debt payments (by reducing its debt level). All of these actions, while serving to improve its credit ratings, entail certain costs that PepsiCo must seriously consider. For example, increasing liquidity by reducing inventories or foregoing capital expenditures can impact PepsiCo’s sales and competitive position. Likewise, reducing debt by issuing equity is costly because equity capital is usually more expensive (due to the subordinated position of equity investors vis-à-vis creditors and also the nondeductibility of dividends for tax purposes). In sum, PepsiCo must carefully weigh the costs and benefits of various actions it can undertake to increase its credit ratings.

P7-47. (20 minutes) a. In 2019, Boston Scientific must repay $2,248 million as reported in the debt repayment table. b. Total long-term debt is $ 7,051 million, computed as $4,803 million reported in the longterm debt footnote + $2,248 due in 2019. c. Short-term debt including current maturities Long term debt Total debt Average debt

2018 $2,253 4,803 7,056 6,336

Interest expense

$ 241

Avg interest rate = Interest exp / Avg debt

3.80%

2017 $1,801 3,815 5,616

The company reports average interest rate of 3.6%, which is close to the rate we calculate. The difference is due to our use of simple average using year-end numbers while the company has more exact average debt balance during the year. d. Interest paid can differ from interest expense if the bonds are sold at a premium or at a discount. Interest expense is computed using the effective interest rate method, which uses the debt’s net book value and the effective (yield) interest rate (the market rate prevailing when the bond was issued). Boston Scientific interest expense is nearly the same as its interest paid, which means that the company issued debt at rates at the coupon rate, on average.

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e. There is an inverse relation between bond price and effective bond yield. The information here reveals that the Boston Scientific bond maturing in 2028 is selling at a premium (109.35% of par). This premium will cause the effective yield to be less than the 4.0% coupon on this bond (2.80% in this case). The market rates reflect underlying interest rates and risk premia as of February 2019, whereas Boston Scientific established the coupon rates when the bond was issued. Thus, assuming that the bonds were originally issued at par, the premium price that exists at February 2019 reflects the effect of decreasing interest rates. Since the problem assumes constant credit ratings, the premium must have resulted from an overall decrease in market interest rates since Boston Scientific issued the bond. f.

It is typical for yields to increase as maturity lengthens. The higher yields compensate investors for having their money tied up for longer periods of time, resulting in increased collection (credit quality) risk and increased inflation (loss of purchasing power) risk. The bond that matures in 2023 has a lower yield than the bond that matures in 2028 (2.41% compared to 2.80%). The coupon rate on the bonds is irrelevant to our understanding of the yields and maturity. The coupon rate was set in the year the bonds were issued and reflected the risk-free rate and the company’s risk premia then.

P7-48. (50 minutes) a. The total amount of debt reported on Oracle’s May 31, 2019 balance sheet is $56,167 million. We see that the scheduled maturities of this indebtedness are: $4,500 million in 2020, $2,631 million in 2021, $8,250 million in 2022, $3,750 million in 2023, $3,500 million in 2024, and $33,984 million, thereafter. Analysts monitor these scheduled maturities amounts coming due over the next few years. Excessive payments required in any one year might present a cash flow problem if the debt cannot be refinanced. Such information can also be useful in forecasting cash flows. b. It is rarely the case that companies’ interest expense and interest payments are the same. The difference arises from the amortization of any discounts or premiums on the debt—recall, interest expense is equal to cash paid plus discount amortization (or less premium amortization). As second explanation is that Oracle might have accrued (added to the balance sheet as a liability such as interest payable) some of the interest incurred during the year.

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c. Credit rating agencies assess companies’ default risk by gauging the level of debt in relation to the companies’ operating cash flow and total assets. This is because cash flow is the primary source of repayment of the bonds and because assets serve as a secondary source (collateral) in the event of default. Credit rating agencies also look at profitability ratios and the ratios for long-term creditworthiness as shown in Exhibit 7.4. This credit analysis would also focus on the market conditions for Oracle’s product and services and compare all metrics to close competitors. d. The market value of these notes is $1,710 million calculated as $1,250 million × 1.3678. The difference between the current trading price of $1,710 million and its face amount of $1,250 million is $460 million, but the notes are reported at $1,250 million. The current market value of the notes is, therefore, not reflected in the balance sheet. If Oracle were to repurchase these notes, the $460 million difference would be reported as a pre-tax loss in the current income statement. This is because Oracle would pay market value to repurchase the notes, which is more than the notes’ carrying value on Oracle’s balance sheet. Because these notes have increased in value subsequent to their issuance, market interest rates must have decreased. Another possibility is that Oracle’s credit rating has improved while the market interest rates have remained unchanged (or a combination of these two factors). e. The table reveals the following relation: the longer the time to maturity, the higher the yield. Typically, there is an increasing relation between the term period of the debt and its yield. This is a general relation that exists in the market. The higher yields compensate investors for having their money tied up for longer periods of time, resulting in increased collection (credit quality) risk and increased inflation (loss of purchasing power) risk.

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IFRS APPLICATIONS I7-49. (15 minutes) a. Annual interest payments will be €5 million, calculated as €500 million × 0.01. b. I / YR = 1.06107% N 8

I / YR ?

PV 497.67 = (500 × 0.99534)

Excel inputs: =RATE(8,5,497.67,-500,0)

PMT 5

FV -500

Cell will display: 1.06107%

c. Interest expense in 2019 will be €3.52 million, calculated as €497.67 million × 1.06% x 8 /12.

I7-50. (20 minutes) a. From Bombardier’s perspective, a warranty represents a promise to fix or replace defective goods. This creates a future obligation, which would not exist if not for the sale of the equipment in the first place (past transaction). Bombardier can use data from past experience to estimate the amount it will pay to satisfy warranty claims. Thus, the warranty meets the definition of a contingent liability and Bombardier records the expected future warranty costs on its balance sheet concurrent with product sales. b. Bombardier’s 2018 balance sheet includes $515 million for warranty liability. The company calls this a provision for product warranties. c. Bombardier’s 2018 income statement includes the following (in millions): Additions: current period sales create additional liability Reversals: amount recorded in prior year was too large, anticipated warranty claims did not materialize Accretion expense: the liability is calculated as the present value of the future cash outflows, the accretion represents “interest” for the period Effect of changes in discount rates Effect of foreign currency exchange: the company warranties goods located in other countries and exchange rates changed making the liability in $ larger than at the start of the year Disposal of a business unit, including its warranty liability Total warranty expense

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d. Utilization is the cost of the warranty claims in the current period. The liability is being used up, hence the word utilization. The total cost of $223 million is the actual full cost to repair or replace malfunctioning goods. These costs would include parts, labor, overhead, shipping, and other costs to honor the customers’ claims.

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MANAGEMENT APPLICATIONS MA7-51. (15 minutes) This strategy will not work. As the coupon rate is lowered, the market price of the bond must fall in order to provide the yield that investors demand from a company of like risk. This will result in the bond selling at a discount. The reported interest expense on the income statement will be equal to the cash interest paid plus the amortization of the discount. The result will be an effective cost for the bond (interest expense / carrying amount) that is equal to the yield that investors demand. The coupon rate, therefore, does not affect the interest expense reported in the income statement. The selling price of the bond will always be adjusted to yield a return commensurate with the relative riskiness of your company and the maturity of the bond issue.

MA7-52. (15 minutes) Failure to abide by bond covenants can result in serious consequences. Ensuring that the company has complied with such restrictions is an important area of corporate governance. Companies can utilize internal and external auditing to monitor compliance. The board of directors must also be aware of the possibility of earnings management in order to avoid default on bond covenants. As the possibility of default increases, so does management’s desire to avoid default by whatever means it can, including earnings management.

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Module 8 Stock Transactions, Dividends, and EPS QUESTIONS Q8-1.

Par value stock is stock that has a face value printed (identified) on the stock certificate. Historically, par value was the minimum selling price for one share. From an accounting and analysis standpoint, there are no implications. The par value of the common stock is the amount added to the common stock account when the company sells stock. The remainder of the sale price is added to the additional paid-incapital account. Stockholders’ equity increases by the total amount regardless of whether one or two accounts (line items) are used.

Q8-2.

There are a number of differences between preferred and common stock. Typically, preferred stock has the following features: 1) Preferential claim to dividends and to assets in liquidation, 2) Cumulative dividend rights, and 3) No voting rights.

Q8-3.

Preferred stock is similar to debt when 1. Dividends are cumulative. 2. Dividends are nonparticipating. 3. Preferred stockholders have preference to assets in liquidation. Preferred stock is similar to common stock when 1. Dividends are not cumulative. 2. Dividends are fully participating. 3. It is convertible into common stock. 4. Preferred stockholders do not have a preference to assets in liquidation.

Q8-4.

Preferred dividends in arrears are the cumulative preferred dividends on preferred stock that have not been paid to date. The dividends in arrears and a current dividend must be paid to preferred stockholders before common stockholders can receive any dividends. The company must pay preferred stockholders $90,000 in dividends ($500,000  0.06  3 years = $90,000) before paying any dividends to common stockholders.

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Q8-5.

A corporation's authorized stock is the maximum number of shares of stock it may issue. When the corporation is formed, its charter specifies the authorized amounts and classes of stock. A corporation can later amend its charter to change the amount of authorized capital, but such actions must be approved by the company’s shareholders. Shares that have been sold and issued to stockholders are the company's issued stock. Shares that have been sold and issued can be subsequently reacquired by the corporation—these shares are called treasury stock. When treasury stock is held, the issued shares exceed the outstanding shares.

Q8-6.

Contributed capital represents the total investment “contributed” by shareholders when they purchase stock. It is considered contributed because the company is under no legal obligation to repay the shareholders. Earned capital represents the cumulative net income that the company has earned, less the portion of that income that has been paid out to shareholders in the form of dividends. When profit is earned, the company can either pay out a portion of that profit as a dividend or reinvest the earnings in order to grow the company. In fact, many companies title the Retained Earnings account Reinvested Earnings or Undistributed Earnings. Earned capital, thus, represents an implicit investment by the shareholders in the form of forgone dividends.

Q8-7.

Contributed capital is divided into two accounts: the common or preferred stock account at par and additional paid-in capital. The common stock or preferred stock accounts at par increase by the par value of each share issued. But, if companies sell shares for more than par, it is the market price of the stock that determines the company’s proceeds. The difference between the share’s market price and its par value is added to the additional paid-in capital account. The breakdown of contributed capital between the common or preferred stock accounts and additional paid-in capital is not informative —it does not yield any implications regarding the financial condition of the company.

Q8-8.

A stock split refers to the issuance of additional shares to the current stockholders in proportion to their ownership interests. This is normally accompanied by a proportionate reduction in the par or stated value of the stock. For example, a 2-for-1 stock split doubles the number of shares outstanding and halves the par or stated value of the shares. Consequently, there is no change to the company’s balance sheet; the amount of contributed capital remains the same after the stock split. The market value of the stock typically falls to half in the event of a 2:1 stock split. The major reason for a stock split is to reduce the share price of the stock. It is believed that when the stock price is very high, few investors can afford to purchase the stock. Another possible reason is to lead shareholders to believe that there has been some distribution of value.

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Q8-9.

Treasury stock is stock, previously issued, that the corporation has reacquired from stockholders on the open market. A corporation might repurchase treasury stock to give to employees who exercise stock options or to offset dilution resulting from option grants. Companies can return value to shareholders via stock buy backs—the cash is distributed to shareholders who chose to sell their stock to the company. It is sometimes used by management to increase stock price when management believes its stock is inappropriately underpriced. On the balance sheet, treasury stock is carried at its cost (the cash the corporation pays to acquire the stock) and is shown as a deduction (a negative amount) on the balance sheet. Thus, total stockholders' equity is net of treasury stock, which is known as a contra-equity account.

Q8-10.

The $40,000 increase is not included on the income statement as income or gain. The $40,000 is properly treated as additional paid-in capital and is shown as such in the stockholders' equity section of the balance sheet. GAAP prohibits companies from reporting gains or losses from stock transactions with their own shareholders, therefore no gain is reported. This proscription is justified because treasury stock transactions are considered capital rather than operating transactions. GAAP does not permit corporations to “own” themselves. Thus, the company’s treasury stock is not shown as an investment.

Q8-11.

The book value per share of common stock is the total stockholders' equity divided by the number of shares outstanding. Shares outstanding are 300,000 issued less 15,000 treasury shares. Thus book value is $18,995,250 / (300,000 – 15,000) = $66.65 per share.

Q8-12.

Market cap is short for market capitalization and it is the market value of the company’s stock. To calculate market cap we multiply the number of shares outstanding by the price per share. Market cap changes continually during each trading day as the stock price changes.

Q8-13.

One conclusion from negative retained earnings is that the company has reported cumulative net losses in excess of cumulative net income. But there are other explanations. It could be that the company has repurchased and cancelled (retired) stock and the excess of the buyback price over the original issue price exceeds the cumulative net income. This scenario is not impossible, considering that current stock prices can be many times higher than its original issue price. A second possibility is that the company has paid out dividends in excess of net income. This occurs most frequently for real-estate trust firms and limited liability partnerships.

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Q8-14.

Many companies repurchase shares (as treasury stock) in order to offset the dilutive effects of stock options, because stock options increase the number of outstanding shares in the diluted EPS calculation. Stock repurchases typically decrease cash, which has immediate and ongoing economic effects. Some companies increase debt to repurchase stock. Analysts need to be concerned about the consequences of increased leverage solely to manage diluted EPS.

Q8-15.

The statement of stockholders' equity analyzes and reconciles changes in all major components of stockholders' equity during an accounting period. The statement starts with the beginning balances of key stockholders' equity accounts, reports the items that explain the changes in these accounts, and ends with the period-end balances.

Q8-16.

Accumulated other comprehensive income (AOCI) represents changes in stockholders’ equity that are caused by factors other than net income and transactions with the company’s shareholders. There are four typical items in AOCI, including •

Unrealized gains (losses) on available-for-sale securities

•

Foreign-currency translation adjustments

• •

Unrealized gains (losses) on certain types of derivatives Certain pension liability adjustments.

Q8-17.

Common forms of stock-based compensation include stock grants, stock appreciation rights, stock options and stock purchase plans. Companies use stock based plans to create “shareholders” of the employees. This give the employees the incentive to think and make decisions like shareholders. Presumably, this will improve firm performance and increase firm value.

Q8-18.

When a convertible bond is converted, the company removes the net book value of the debt from the balance sheet. That is, the company removes both the face amount and any associated unamortized premium or discount. The stock is, then, issued for a “purchase price” equal to the bond’s net book value (face amount net of any unamortized premium or discount). Then, the purchase price is allocated to common stock and additional paid-in capital. No gain or loss is ever reported upon conversion.

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MINI EXERCISES M8-19. (10 minutes) Balance Sheet Transaction

Cash Asset

Noncash Assets

Liabilities

Cash 672,000 PS 400,000 APIC-PS 272,000 (a) Issue 8,000 Cash shares of $50 672,000 PS 400,000 APIC-PS 272,000

19,000

Contrib. Capital

Earned Capital

Rev -enues

–

Expenses

Net Income

+400,000 Preferred Stock

par value +672,000 preferred stock Cash at $84 cash per share

Cash 190,000 CS 19,000 APIC-CS 171,000 (b) Issue 19,000 Cash shares of $1 190,000 CS

Income Statement

+272,000 Additional Paid-in Capital-PS

–

+19,000 Common Stock

par value +190,000 common stock Cash at $10 cash per share

APIC-CS 171,000

+171,000 Additional Paid-in Capital-CS

M8-20. (10 minutes) a. $26,696 / 10,096.5 shares = $2.64 EPS b. $18,232 - $16,619 = $1,613 c.

10,096.5 shares × $1.63 EPS = $16,619 (rounded)

d. $16,140 + $1,682 = $17,822 e. $16,140 / $1.57 EPS = 10,280.3 shares

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M8-21. (10 minutes) (in $ millions) a. Common stock ................................. Additional paid-in capital ................... Total .................................................

4* 40,573 $40,577

*Cisco’s common stock has a par value of $0.001. The common stock account therefore includes, 4,313 million shares issued  $0.001 par value = $4.313 million, rounded down to $4 million.

b. Because the par value of Cisco’s common stock is so small (immaterial), Cisco management likely decided to include common stock and additional paid-in capital in one account on the balance sheet.

M8-22. (10 minutes) Balance Sheet Transaction

Cash Asset

Noncash Assets

Cash 2,100,000 PS 700,000 APIC-PS 1,400,000

Cash 2,100,000 PS

Issue 7,000 shares of $100 par value preferred stock 700,000 at $300 cash per share

+2,100,000 Cash

-1,092,000 Cash

1,092,000 Cash 1,092,000 Repurchase TS 7,000 shares of 1,092,000

$1 par value common stock at $156 per Cash 1,092,000 share

Contrib. Capital

Earned Capital

Revenues

Expenses

–

Net Income

+700,000 Preferred Stock

APIC-PS 1,400,000

Liabilities

Income Statement

+1,400,000 Additional Paid-in Capital-PS

-1,092,000 Treasury Stock

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M8-23. (10 minutes) a. A stock split in the form of a dividend has the following effects. The company adds the par value of the stock distributed to the common stock account and subtracts the same amount from retained earnings (similar to a cash dividend). Thus, there is no net effect on total stockholders’ equity. In Aflac’s two-for-one stock split, each shareholder receives one additional share for each share owned, thus doubling the outstanding shares. Earnings per share is also recomputed for all years presented in the income statement to reflect the additional shares outstanding after the split. The par value per share is unaffected. b. The Motley Fool article mentions “improving liquidity” which means liquidity in the stock market for Aflac stock. The company must believe that some investors are priced out of the market by the high stock value and so by halving the price, it will be more attractive.

M8-24. (15 minutes) a. At September 29, 2019 there were 2.9 billion shares issued.

The par value of these shares is $29 million (2,900,000,000 shares issued  $0.01 par = $29,000,000). This amount is included in the common stock line.

b. Outstanding shares are equal to issued shares less treasury shares. For 2018, Disney

has 2.9 billion issued – 1.4 billion treasury shares = 1.5 billion shares outstanding. c.

We calculate the average price at which the company issued shares as follows: $36,779 million / 2,900 million shares = $12.68 per share.

d. We calculate the average price at which the company repurchased common shares as

follows: $67,588 million / 1,400 million shares = $48.28 per share.

M8-25. (10 minutes) a. The face value is $25,000 calculated as $2.35 billion / 94,000 shares issued. b. Total dividends for 2018 will be $69 million calculated as $2.35 billion × 5.875% x 1/2.

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M8-26. (15 minutes) (Note to instructor: Appendix 8A provides students with information to answer this assignment) Stock purchase plan compensation expense is determined as the amount of the discount that employees received: 25,000 shares × 15% × $78.94 per share = $296,025 Compensation related to the stock options is determined by the options’ fair-value expensed over the vesting period of three years. Total compensation for the current year related to the options is: (20,000 options × $10.10 per option) / 3 = $67,333. Total current year compensation expense is $363,358.

M8-27. (10 minutes) a. Immediately after the 3-for-2 stock split, the company has 450,000 shares [300,000 shares × (3/2) = 450,000] of $6 par value common stock issued and outstanding. b. The dollar balance in the Common stock account is unchanged by the stock split; the balance remains at $2,700,000 (450,000 shares at the new $6 par value per share). c. The usual reason for a corporation to split its stock is to reduce the share price of the stock thereby improving the stock's marketability. Apstein’s stock is trading at $148 which is pricey if investors want to buy the stock in a round lot, which is 100 shares. To increase transactions (and hence demand for the stock), Apstein has dropped its stock price just below $100 ($148 × 2/3 = $99).

M8-28. (15 minutes)

a. $2,000,000  6% ............................................................. Balance to common ($280,000 - $120,000) .............. Per share $120,000 / 40,000 shares ............................. $160,000 / 100,000 shares ........................... b. $2,000,000  6%  2 years ............................................. Balance to common ($280,000 - $240,000) .............. Per share $240,000 / 40,000 shares ............................. $40,000 / 100,000 shares .............................

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Distribution to Preferred Common $120,000 $160,000 $3.00 $1.60 $240,000 $40,000 $6.00 $0.40

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M8-29. (10 minutes) SPRINGWERTH COMPANY STATEMENT OF RETAINED EARNINGS FOR YEAR ENDED DECEMBER 31, 2019 Retained earnings, December 31, 2018 ......................................... Add: Net income .............................................................................

$537,000 203,000 740,000

Less: Cash dividends declared ....................................................... $46,000 Stock dividends declared .......................................................... 55,000 Retained earnings, December 31, 2019 .........................................

101,000 $639,000

M8-30. (10 minutes) a.

$ millions Wells Fargo net income Less Preferred stock dividends Income available to common shareholders

2018 $22,393 1,556 $ 20,837

2017 $ 22,183 1,629 $ 20,554

Average common shares outstanding Earnings per common share (in dollars/ share)

4,799.7 $ 4.34

4,964.6 $ 4.14

b. There is a difference of 38.7 million shares between the number of basic and diluted

common shares outstanding. The difference could be attributable to one or more of the following: 1. Convertible preferred stock. We see that Wells Fargo paid preferred dividends during the year and perhaps some of this preferred stock is convertible. 2. Stock options granted to Wells Fargo employees. If these were in the money, they would be dilutive 3. Convertible bonds.

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M8-31. (15 minutes) The total dividend is $910.8 million calculated as 785.2 million shares outstanding × $1.16 per share. Balance Sheet Transaction

Cash Asset

May 23, 2019 RE 910.8 DP 910.8 Retained Earnings To record declaration of 910.8 dividend

Noncash Assets

Liabilities

Income Statement Contrib. Capital

+910.8 = Dividends Payable

Earned Capital

Revenues

-910.8 Retained Earnings

–

Expen -ses

–

+910.8 = Dividends Payable

–

Net Income

Dividends payable 910.8

No transaction

Jun 3, 2019

Jun 17, 2019 DP 910.8 RE 910.8 Dividends payable To record payment of 910.8 dividend

-910.8

Cash 910.8

M8-32. (10 minutes) a. If AAPL par value was originally $1, Apple would report $0.01786 as par value per share

on its 2018 balance sheet. This is calculated (starting at the bottom of the chart) as: Effective Date

Split Amount

Revised Par

June 9, 2014

7 for 1

$0.125 / 7 = $0.01786

Feb 28, 2005

2 for 1

$0.25 / 2 = $0.125

June 21, 2000

2 for 1

$0.50 / 2 = $0.250

June 16, 1987

2 for 1

$1 / 2 = $0.500

June 15, 1987

b. We can use the par calculation to obtain the ratio of pre to post-splits of 0.01786. The

stock price would have been $11,564 calculated as $206.50 / 0.01786.

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M8-33. (10 minutes) a. False. AOCI can be, and often is, a negative amount. Treasury stock is also a “negative”

amount reported on the balance sheet. b. True.

Other Comprehensive Income includes increases and decreases in stockholders' equity that are not reflected in net income and, therefore, in Retained earnings.

True. OCI represents unrealized gains and losses and does not result in cash inflows and outflows until the underlying transactions occur.

M8-34. (10 minutes) a. CenterPoint issued 19,550,000 depositary shares each representing a 1/20th interest in a

share of its Series B Preferred Stock. This is equivalent to 977,500 Series B Preferred shares (19,550,000 / 20). b. The conversion of any security, whether debt or equity, has the following balance-sheet

effects: the book value of the converted security (just prior to the conversion) is removed and common stock is issued for the same amount. In Centerpoint Energy’s case, $977,500 million would be removed from the Series B Preferred stock account (reducing it to $0) and common stock accounts (par and APIC) would be increased by the same amount. CenterPoint would issue 29,893,905 common shares (977,500 preferred shares × 30.582). c.

Converting preferred shares to common shares will not impact the income statement.

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EXERCISES E8-35. (20 minutes) Balance Sheet Transaction

Cash Asset

Noncash Assets

Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

Expenses

–

Net Income

Cash 300,000 CS 10,000 APIC-CS 290,000

Cash 300,000 CS 10,000

March 2: Issued 10,000 shares of +300,000 $1 par value Cash common stock at $30 cash per share

+10,000 Common Stock =

APIC 290,000

+290,000 Additional Paid-in Capital-CS

–

Cash 3,750,000 PS 1,500,000 APIC-PS 2,250,000

Cash 3,750,000 PS 1,500,000

+1,500,000 Preferred Stock

April 14: Issued 15,000 shares of $100 par value 8% +3,750,000 preferred stock at Cash $250 cash per share

June 30: Purchased 3,000 –66,000 shares of common Cash stock at $22 per share

APIC

+2,250,000 Additional Paid-in Capital-PS

2,250,000

66,000 Cash 66,000 TS 66,000 Cash

–66,000 Treasury Stock

66,000 Cash 39,000 TS 33,000 APIC-CS 6,000

Cash 39,000

Sep 25: Sold 1,500 shares of treasury +39,000 stock at $26 cash Cash per share

TS 33,000

+33,000 Treasury Stock =

+6,000 Additional Paid-in Capital-CS

APIC 6,000

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E8-36. (25 minutes) Balance Sheet Cash Asset

Transaction

Noncash Assets

Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

Cash 1,080,000 CS 200,000 APIC-CS 880,000

Cash 1,080,000

CS 200,000

Feb. 3: Issued 40,000 shares of $5 par value +1,080,000 common stock at Cash $27 cash per share

+200,000 Common Stock =

APIC

+880,000 Additional Paid-in Capital-CS

–

880,000 Cash 792,000 PS 450,000 APIC-PS 342,000

Cash 792,000 PS 450,000

+450,000 Preferred Stock

Feb. 27: Issued 9,000 shares of $50 par value 8% preferred stock at $88 cash per share

+792,000 Cash

Mar 31: Purchased 5,000 shares of common stock at $30 per share

–150,000 Cash

APIC 342,000 TS

+342,000 Add'l Paid-in Capital-PS

150,000 Cash 150,000

TS 150,000 Cash 150,000

–150,000 Treasury Stock

Cash 114,000 TS 90,000 APIC-CS 24,000

Cash 114,000 TS 90,000

Jun 25: Sold 3,000 shares of treasury stock at $38 cash per share

+90,000 Treasury Stock +114,000 Cash

APIC

+24,000 Additional Paid-in Capital-CS

24,000 Cash APIC-CS TS

58,000 2,000 60,000

Cash 58,000 TS 60,000

Jul 15: Sold 2,000 shares of treasury stock at $29 cash per share

APIC 2,000

+60,000 Treasury Stock +58,000 Cash

–2,000 Additional Paid-in Capital-CS

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E8-37. (20 minutes) a. Campbell Soup has issued 323 million shares. At its $0.0375 par value, its common

stock is recorded at $12.1125 million, which is rounded down to $12 million. b. Campbell Soup issued shares at an average price of $1.12 per share, computed as ($12

million + $349 million) / 323 million shares. c.

($ millions) Retained earnings, July 30, 2017 Net earnings Dividends Retained earnings, July 31, 2018

$2,385 261 (422) $2,224

d. The exercise of employee stock options resulted in the issuance of 2 million shares of

stock for a total of $39 million. Because the treasury stock shares were sold, the treasury stock account is reduced (an addition reduces the negative amount for treasury stock) by the original purchase cost of the shares ($49 million) and additional paid-in capital is decreased for the difference. e. Campbell Soup repurchased 2 million shares of common stock for a total of $86 million,

or at a cost of $43 per share. The effect of the repurchase of stock is to reduce cash and shareowners’ equity, thereby shrinking the company. f.

$32.99 × (323 million shares issued – 22 million Treasury shares) = $9,930 million

g. $9,930 / $1,373 = 7.23

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E8-38. (15 minutes) a. Benefits to Hearne from using stock options include making “shareholders” of the computer

engineers. The options give the engineers the incentive to think and make decisions like shareholders. Presumably, this will improve firm performance and increase firm value. A second benefit is that cash was not used for compensation. Given that the company just started, cash might be scarce and using non-cash compensation preserved liquidity. b. Total expense is the fair value of the options, $250,000 (250,000 options × $1 per option. c.

In 2017, Hearne will expense $62,500 as compensation calculated as the total expense of the options spread over the four-year vesting period: $250,000 / 4 = $62,500.

d. When the options are exercised, cash and contributed capital (common stock at par and

APIC) will increase by the cash received (250,000 options × $5 = $1,250,000). There will be no income statement effect. The statement of cash flows will report the $1,250,000 as a financing cash inflow, consistent with the ordinary issuance of stock.

E8-39. (20 minutes) a. Distribution to Preferred Common $ 0 $ 0

Year 1 Year 2:

Year 3:

Dividends in Arrears from Year 1: ($1,500,000 6%) Current year dividend: ($1,500,000  6%) Balance to common Total for Year 2

$180,000

$130,000 $130,000

Current year dividend (1,500,000 6%)

$90,000

$ 90,000 90,000

b. Distribution to Preferred Common $ 0 $ 0

Year 1 Year 2: Year 3:

Current year dividend: ($1,500,000  6%) Balance to common

$ 90,000

Current year dividend ($1,500,000 6%)

$ 90,000

$220,000 $

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E8-40. (20 minutes) a. Public Storage reports 174,130,881 shares issued at the year-end 2018. Its par value is

$0.10 per share. The common stock amount is 174,130,881 shares  $0.10 par value, which yields $17,413,088. This value is rounded down to $17,413 thousand on the balance sheet. b. Public Storage issued its common shares at the average price of $32.94 per share. This

value is computed as: ($17,413 thousand common stock + $5,718,485 thousand paid-in capital) / 174,130,881 shares. c.

Public Storage issued preferred shares at $25,000 per share calculated as $4,025,000 thousand / 161,000 shares issued.

d. If the balance were positive, the account would be titled retained earnings. e. Retained earnings could be negative for several reasons, these include:

1. The company has paid out dividends in excess of the cumulative net income. 2. The company has repurchased and retired stock rather than retaining the stock in treasury for future sale or stock-compensation award. f.

The Noncontrolling interests account represents the equity of the noncontrolling shareholders. These shareholders have an ownership interest in one or more of Public Storage’s subsidiaries. Their equity fluctuates much like that of Public Storage’s shareholders (it is increased by the profit attributable to noncontrolling shareholders and is decreased by dividends paid to those shareholders).

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E8-41. (30 minutes) a.

Preferred 2018— Current year preferred dividends [8%  (25,000  $40)] Remainder to common

Dividend Distribution Preferred Common per Share

$80,000 $23,000

Per share Preferred ($80,000 / 25,000) Common ($23,000 / 100,000) 2019— Preferred Common

$3.20 $0.23

$0.00 $0

2020— Preferred dividends in arrears [8%  (25,000  $40)] Current year preferred dividends [8%  (25,000  $40)] Remainder to common Total distribution

Common per Share

$0.00

$ 80,000 80,000 $301,000 $160,000

$301,000

Per share Preferred ($160,000 / 25,000) Common ($301,000 / 100,000)

$6.40 $3.01

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2018— Preferred Common

Preferred

Dividend Distribution Preferred Common per Share

$0.00

Common per Share

2019— Preferred dividends in arrears [8%  (25,000  $40)] Current year preferred dividends [8%  (25,000  $40)] Common Total distribution

$ 80,000 80,000 $0 $160,000

Per share Preferred ($160,000 / 25,000) Common 2020— Current year preferred dividends [8%  (25,000  $40)] Remainder to common

$0.00

$6.40 $0.00

$ 80,000 $198,000

Per share Preferred ($80,000 / 25,000) Common ($198,000 / 100,000)

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$3.20 $1.98

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E8-42. (15 minutes) Balance Sheet

Transaction

Cash Asset

Pay cash dividend on common stock1

-41,400 Cash

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

Expenses

–

Net Income

41,400 Cash 41,400 RE 41,400 Cash

-41,400 Retained Earnings

–

-16,000 Retained Earnings

–

41,400

CS 20,000 APIC 28,000 RE 16,000 Issue 5% stock Cash 64,000 dividend on

common stock2

-20,000 Common Stock -64,000 Cash

-28,000 Additional Paid-in Capital

$1.80  23,000 = $41,400.

 $32 market value = $64,000). Common Stock is Cash is reduced by the market price of the shares repurchased (2,000 shares  $10) and Additional Paid-in Capital is reduced by the difference between decreased by $20,000, the par value (2,000 shares the original issue price ($24) less par ($10). The balance of the market price over issue price reduces Retained Earnings..

E8-43. (20 minutes) a. Balance Sheet $ thousands

Transaction

Cash Asset

Declare and pay preferred dividend

-216,316 Cash

-216,316 Retained Earnings

–

Declare and pay cash dividend 2

-1,396,364 Cash

-1,396,364 Retained Earnings

–

Noncash Assets

Liabilities

Income Statement

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

RE 216,316 Cash 216,316 RE 216,316 Cash 216,316

RE 1,396,364 Cash 1,396,364 RE 1,396,364 Cash 1,396,364

b. Preferred dividends per share = $216,316 thousand / 161,000 shares = $1,343.58 per share Common dividends per share = $1,396,364 thousand / 174,130,881 shares = $8.02 per share. ©Cambridge Business Publishers, 2021 8-19

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E8-44. (30 minutes) a. Balance Sheet Transaction

Cash Asset

4/15/19 RE 400,000 Cash 400,000 RE Apr 15: pay -400,000 400,000 preferred Cash stock dividend Cash 400,000 4/15/19 RE 910,000 Cash 910,000

Apr 15: Pay --910,000 common stock Cash dividends1

RE 910,000

Noncash = Assets

Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

–

Expenses

-400,000 Retained Earnings

–

-910,000 Retained Earnings

–

-1,050,000 Retained Earnings

–

Net Income

Cash 910,000

10/1/19

No transaction

3/1/20 RE 1,050,000 Cash 1,050,000

Mar 1: Pay --1,050,000 common stock Cash dividends2

RE 1,050,000 Cash 1,050,000 1

 $1.3 = $910,000 Total common dividends are 700,000 shares issued

 $0.50 = $1,050,000 Total common dividends are 2,100,000 shares issued

b. Retained Earnings, March 31, 2019 Add: Net Income Less: Preferred Dividends Declared Common Dividends Declared Retained Earnings, March 31, 2020

©Cambridge Business Publishers, 2021 8-20

$49,005,689 8,900,610 $400,000 1,960,000

2,360,000 $55,546,299

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E8-45. (15 minutes) (NOTE: Students need to access the Power BI dashboard available at the publisher’s website to answer these questions. They cannot be answered from the graphics printed in the textbook, alone.) a. The consumer staples sector has the highest market to book ratio at between 4 and 5.

From the graph on the lower right, we see that this sector also has the highest proportion of treasury shares to shares outstanding. The two measures are related because book value of equity decreases with treasury stock so as treasury stock increases market to book value increases. b. The financial services sector has the lowest market to book ratio, just over 1.0. The majority of banks’ assets are financial assets that do not have fair value that deviate significantly from their book values and the financial services industry is somewhat commoditized. Therefore there is less opportunity for shares to soar in value. c.

The market to book ratio increased through 2014 and then leveled off before increasing significantly in 2019 when stock prices climbed significantly.

d. The energy sector’s dividend payout and ROA graphic is below. The ROA plummets in

2015 and 2016 when oil prices dropped from $100 to $35 per barrel. In these two years, dividend payout ratio spiked. This is mechanical because dividend payout ratio is defined as dividends / net income. So as net income dropped in 2015 and 2016, it caused ROA to decrease and dividend payout to increase. To better understand dividends paid, we would use dividends in dollars and not as a percentage of income.

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E8-46. (20 minutes) a. Caterpillar’s outstanding shares equal the number of issued shares less the number of

treasury shares: 814,894,624 – 239,351,886 = 575,542,738 shares outstanding. b. The phrase “at paid-in amount” refers to the total paid-in-capital, including the common

stock par value along with the additional paid-in capital. That is, Caterpillar’s balance sheet does not distinguish between par value and the additional paid-in amounts for common stock. c.

Caterpillar purchased treasury shares, on average, for $85.78 per share; this is computed as: $20,531 million treasury stock / 239,351,886 treasury shares.

d. Companies repurchase shares for many reasons, including:

1. To offset the dilutive effects of shares issued to employees under stock option plans. 2. To mitigate a takeover threat if the remaining shares are concentrated in “friendly hands.” 3. To send a signal to the market that the company feels its shares are undervalued. 4. To return excess cash to shareholders; companies often repurchase shares instead of declaring a cash dividend to respect those shareholders who do not want a cash dividend, and yet provide an “implicit cash dividend” to those who wish to sell their shares back to the company. e. Profit employed in the business is another term for retained earnings.

If no other transactions affected retained earnings during the year, then CAT recorded dividends of $2,021 in 2018, calculated as $26,301 million - $30,427 million + $6,147 million.

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E8-47. (25 minutes) a. Companies typically describe the required dividends on Preferred Stock either as a

percentage, as in Xerox’s case, or as a dollar value. When expressed as a percentage, the required dividends are equal to the percentage rate multiplied by the par value of the Preferred Stock. Since we assume that the preferred shares carry a par value of $1,000 per share, the required dividends on Xerox’s Preferred Stock are $80.00 per share (8% × $1,000 par value). Thus, the dividends that must be paid each year are $14.4 million computed as 180,000 shares × $80.00 per share. b. When convertible preferred stock is converted, the balance of $214 in the convertible

preferred stock will be eliminated and total contributed capital (common stock plus additional paid-in capital) will increase by the same amount, $214. Xerox will issue 6,742 thousand common shares. This will increase the common stock account by $6.742 million (6,742 thousand shares issued multiplied by the $1.00 par value per share), which will be rounded to $7 million on the financial statements. Thus, APIC will increase by $207 million ($214 million - $7 million). c.

Companies typically issue debt and preferred stock with conversion features to get a higher price for the securities. This higher price reduces the cost of the debt and equity, respectively. Companies must balance this higher price, however, with the future dilution of the interests of existing shareholders when the securities are converted. Since conversion will increase the number of shares outstanding, the dilutive effect of these convertible securities is included in the computation of diluted EPS

E8-48. (20 minutes) a. Merck has issued 3,577,103,522 shares at a par value of $0.50.

Shares issued  Par value = Common stock amount 3,577,103,522  $0.50 = $1,788,551,761 rounded to $1,788 million. b. Merck issued its common stock at an average price of $11.35 per share. (Common stock + Other paid-in capital) /Shares issued = Average issue price. ($1,788 million + $38,808 million) / 3,577,103,522 = $11.35 per share c. Merck repurchased its common stock at an average price of $51.73 per share. Treasury Stock / Treasury shares = Average cost per share $50,929 million / 984,543,979 = $51.73 per share d. Shares issued – Treasury shares = Shares outstanding 3,577,103,522 – 984,543,979 = 2,592,559,543 shares outstanding e. Market cap = 2,592,559,543 $76.41 per share = $198,097 million ©Cambridge Business Publishers, 2021 8-23

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PROBLEMS P8-49. (30 minutes) a. Balance Sheet Transaction

Cash Asset

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

Cash 504,000 CS 280,000 APIC-CS 224,000

+280,000 Common Stock

Cash 504,000 CS

Jan 10 1

+504,000 Cash

Jan 23 2

–160,000 Cash

+224,000 Additional Paid-in Capital-CS

280,000 APIC 224,000 TS

–

160,000 Cash 160,000

TS 160,000

–160,000 Treasury Stock

Cash 160,000 Cash 88,000 TS 80,000 APIC-CS 8,000

+80,000 Treasury Stock

Cash 88,000 Mar 14 3

+88,000 Cash

+8,000 Additional Paid-in Capital-CS

80,000 APIC 8,000 Cash 128,000 PS 65,000 APIC-PS 63,000

+65,000 Preferred Stock

Cash 128,000 Jul 15 4

+128,000 Cash

+63,000 Additional Paid-in Capital-PS

65,000

APIC 63,000

continued

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a. Table continued Balance Sheet Cash Asset

Transaction

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

Cash 26,000 TS 20,000 APIC-CS 6,000

+20,000 Treasury Stock

Cash 26,000 Nov 15: 5

+26,000 Cash

20,000 APIC

–

+6,000 Additional Paid-in Capital-CS

6,000 1

 $18 = $504,000. Common Stock increases by the par value of the shares Cash increases by the total proceeds of 28,000 issued (28,000 $10 = $280,000) and Additional Paid-In Capital increases by the remainder ($224,000).

 $20 = $160,000. The increase in Cash decreases and Treasury Stock increases by the purchase price of 8,000 shares Treasury Stock reduces paid-in capital because Treasury Stock is a contra-equity account.

Cash received is 4,000 shares $22 = $88,000. Treasury Stock is reduced by the original cost of $20 per share and the remainder of $8,000 is reflected as an increase in Additional Paid-In Capital.

XPress Media receives cash of $128,000. The Preferred Stock account increases by the par value of the preferred shares issued (2,600 $25 = $65,000) and Additional Paid-In Capital increases by the remainder ($63,000).

 $26 = $26,000. Treasury Stock is reduced by its original cost of 1,000 shares XPress Media receives cash of 1,000 shares  $20 = $20,000, thus increasing paid-in-capital, and Additional Paid-In Capital increases by the remainder ($6,000).

b. XPRESS MEDIA COMPANY Stockholders’ Equity Paid-in capital 8% preferred stock, $25 par value, 50,000 shares authorized; 11,000 shares issued and outstanding Common stock, $10 par value, 200,000 shares authorized; 78,000 shares issued, (3,000 shares in treasury) Additional paid-in capital Paid-in capital in excess of par value—preferred stock Paid-in capital in excess of par value—common stock Paid-in capital from treasury stock Total paid-in capital Retained earnings

$275,000 780,000

148,000 524,000 14,000

$1,055,000

686,000 1,741,000 491,000 2,232,000 (60,000) $2,172,000

Less: Treasury stock (3,000 common shares) at cost Total stockholders’ equity

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P8-50. (30 minutes) a.

Shares authorized Shares issued and outstanding Proportion of ownership of UA Shareholders of record Votes per share Total votes Proportion of voting rights

Class A 400,000,000 187,710,319 41.8% 1,628 1 187,710,319 35.3%

Class B 34,450,000 34,450,000 7.7% 6 10 344,500,000 64.7%

Class C 400,000,000 226,421,963 50.5% 1,216 0 0

Total 834,500,000 448,582,282 100% NA NA 532,210,319 100%

b. The conversion of Class B to Class Common Stock would have the following balance

sheet effects: The par value of the Class B shares would be reduced by $11,000 and added to the par value of the Class A shares. The same would be true of the APIC account but because the company only reports one amount for the APIC of all three classes of stock, we can’t determine the amount. The balance sheet total would be unaffected. Mr. Plank would lose control of the firm. He would receive 34,450,000 shares of Class A (one for one conversion) and his voting rights would drop from 64.7% to 7.7%. It is unlikely that he would do such a conversion. c.

Employees have incentives to earn Class C shares by working hard and staying with the firm. They would enjoy any subsequent stock price appreciation. However, employees who own Class C stock have no vote and therefore when UA issues the Class C stock, there is no dilution in the control of the firm.

Accumulated other comprehensive loss at December 31, 2017 Unrealized foreign currency losses Unrealized losses of derivatives Accumulated other comprehensive loss at December 31, 2018

$(38,211) (23,576) 22,800 $(38,987)

The foreign currency losses during the year occurred because the dollar strengthened vis-à-vis the currency in the countries where Under Armour has subsidiaries. Thus, the net assets of the subsidiaries were converted to fewer $US in 2018 than in 2017, which resulted in an unrealized loss.

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P8-51. (30 minutes) ASPEN CORPORATION Statement of Stockholders’ Equity Preferred Stock

Start of year

Shares Issued 4,000

Retained Earnings

Common Stock

Par $100

Paid-in Capital in Excess

Shares Issued

Par $15

Paid-in Capital in Excess

$450,000

$36,000

30,000

$450,000

$360,000

Stock options exercised

12,000

180,000

12,000

Stock award

1,000

15,000

21,000

Employee stock purchase

10,000

150,000

180,0002

—

80,0003

Stock options granted

217,1004

Net income End of year 1

$325,000 1

4,000

$450,000

$36,000

53,000

$795,000

$653,000

$542,100

Stock options exercised at $16, cash received = 12,000 options × $16 = $192,000. The grant-date fair value is irrelevant.

Employee stock purchase at 10% discount, cash received = 10,000 shares × $33 × 90% = 297,000, Expense recorded on the income statement = 10,000 shares × $33 × 10% = 33,000. Total $33 per share recorded as contributed capital. 3

40,000 stock options granted × $6 fair value per option = $240,000/ 3 year vesting period = $80,000. This is the amount of the expense recorded on the income statement. The grant-date strike price is irrelevant. 4 Pre-tax income before stock-based compensation

$ 483,000

Stock award

(36,000)

Employee stock purchase plan

(33,000)

Stock options granted

(80,000)

Pre-tax income

334,000

Tax at 35%

116,900

Net income

$ 217,100

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P8-52. (45 minutes) a. Balance Sheet Transaction Cash 130,000 CS 50,000 APIC-CS 80,000 Cash 130,000

Cash Asset

Noncash Assets

+130,000 Cash

–64,000 Cash

50,000

APIC 80,000 64,000 Cash 64,000 TS 64,000

Jan. 18 2

Cash

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

+50,000 Common Stock Jan. 5 1

Liabilities

Income Statement

+80,000 Additional Paid-in Capital-CS

–64,000 Treasury Stock

–

64,000

Cash 19,000 TS 16,000 APIC-CS 3,000

+16,000 Treasury Stock

Cash 19,000

Mar. 12 3 TS

+19,000 Cash

16,000 APIC

+3,000 Additional Paid-in Capital-CS

3,000

Cash 7,000 APIC-CS 1,000 TS 8,000 Cash 7,000

+8,000 Treasury Stock Jul. 17 4

APIC 1,000

+7,000 Cash

-1,000 Additional Paid-in Capital-CS

8,000

Cash 180,000 PS 125,000 APIC-PS 55,000 Cash 180,000

+125,000 Preferred Stock Oct. 1 5

+180,000 Cash

125,000 APIC

+55,000 Additional Paid-in Capital-PS

55,000 1 2 3 4 5

Cash increases by the proceeds from the stock sale (10,000 shares  $13 = $130,000). Common Stock increases by the par value (10,000 shares  $5) and Additional Paid-In Capital increases by the remainder ($80,000). Cash decreases by the cost of the Treasury Stock (4,000 shares  $16 = $64,000). The Treasury Stock account increases by the same amount. Because Treasury Stock is a contra-equity account, the share repurchase reduces stockholders’ equity (paid-in capital). Cash increases by the proceeds from the sale of the Treasury Stock (1,000 shares  $19 = $19,000). The Treasury Stock account is reduced by the original cost of the shares (1,000 $16 = $16,000) and Additional Paid-In Capital increases by the remainder ($3,000).  $14 = $7,000). Treasury Stock is reduced by its Cash is increased by the proceeds from the sale of the Treasury Stock (500 shares original cost (500 shares  $16 = $8,000) and Additional Paid-In Capital is reduced by the difference. Cash increases by the proceeds from the sale of the Preferred Stock (5,000 shares $36 per share = $180,000). Preferred Stock increases by its par value (5,000 shares  $25 = $125,000) and Additional Paid-in Capital increases by the remainder ($55,000).

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b. GAULIN COMPANY Stockholders' Equity Paid-in capital 8% Preferred stock, $25 par value, 50,000 shares authorized, 5,000 shares issued and outstanding Common stock, $5 par value, 500,000 shares authorized; 360,000 shares issued

$125,000 1,800,000

Additional paid-in capital Paid-in capital in excess of par value— preferred stock Paid-in capital in excess of par value— common stock Paid-in capital from treasury stock Total paid-in capital Retained earnings

$ 1,925,000

55,000 880,000 2,000

Less: Treasury stock (2,500 shares) at cost Total Stockholders' Equity

937,000 2,862,000 710,900 3,572,900 (40,000) $3,532,900

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P8-53. (30 minutes) Balance Sheet Transaction

Cash Asset

Noncash Assets

Liabilities

Income Statement +

Cash 60,000 PS 50,000 APIC-PS 10,000

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

+50,000 Preferred Stock

Cash 60,000

Jan. 15 1 PS

+60,000 Cash

+10,000 Additional Paid-in Capital-PS

50,000

APIC

–

10,000 Cash 136,000 CS 80,000 APIC-CS 56,000

Cash 136,000

+80,000 Common Stock Jan. 20 2

+136,000 Cash

+56,000 Additional Paid-in Capital-CS

CS 80,000 APIC 56,000

No transaction recorded

May 18 3

Cash 56,000 CS 20,000 APIC-CS 36,000

Cash 56,000

+20,000 Common Stock Jun. 1 4

+56,000 Cash

Sep. 1 5

–40,000 Cash

+36,000 Additional Paid-in Capital-CS

20,000 APIC 36,000 TS

40,000 Cash 40,000 TS 40,000

–40,000 Treasury Stock

Cash 40,000

continued

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Table continued Balance Sheet Transaction

Cash Asset

Noncash Assets

Cash 17,100 TS 14,400 APIC-CS 2,700

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

+14,400 Treasury Stock

Cash 17,100

Oct. 12 6

+17,100 Cash

14,400 APIC

+2,700 Additional Paid-in Capital-CS

–

2,700 Cash 28,500 PS 25,000 APIC-PS 3,500

+25,000 Preferred Stock

Cash 28,500

Dec. 22 7

+28,500 Cash

PS 25,000

+3,500 Additional Paid-in Capital-PS

APIC 3,500 1

Cash increases by the proceeds from the sale of the Preferred Stock (1,000 shares $60 per share = $60,000). The Preferred Stock  $50 par = $50,000) and Additional Paid-In Capital is increased for the account is increased for its par value (1,000 shares remainder ($10,000).

Cash increases by the proceeds from the sale of the Common Stock (4,000 shares $34 = $136,000). Common Stock increases by its par value (4,000  $20 = $80,000) and Additional Paid-In Capital increases by the remainder ($56,000).

(Memorandum) Common stock split 2 for 1, with authorized shares increased to 100,000 and par value reduced to $10 per share.

After the stock split, the par value is $10. Therefore, Common Stock increases by $20,000 (2,000 shares  $10 par) and Additional Paid-In Capital increases by the remainder ($36,000).

Cash decreases by the cost of the Treasury Stock (2,500 shares  $16 per share = $40,000). Because Treasury Stock is a contraequity account, the stock repurchase decreases paid-in-capital.

Cash increases by the proceeds from the sale of the Treasury Stock (900  $19 = $17,100). The Treasury Stock account decreases by the original cost of the shares (900  $16 = $14,400), thereby increasing paid-in-capital, and Additional Paid-In Capital increases by the remainder ($2,700).

Cash increases by the proceeds from the sale of the Preferred Stock (500 $57 = $28,500). The Preferred Stock account increases for its par value (500 shares $50 = $25,000) and Additional Paid-In Capital increases for the remainder ($3,500).

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P8-54. (50 minutes) a. During fiscal 2019, P&G issued 4,638,000 common shares when preferred shares were

converted. The decrease to preferred stock was $39 million. The average price was $8.41 per share computed as $39 million / 4,638,000 shares issued. The shares issued came from Treasury stock and so no new previously unissued shares were used for this conversion. b. During fiscal 2019, P&G issued 55,734 thousand shares of common stock to satisfy

employee stock plans. P&G issued its common shares at an average price of $69.51 per share. This value is computed as: $3,874 million total equity added / 55,734 thousand shares issued. The statement of shareholders’ equity also reveals that these common shares came from treasury stock. c.

In 2019, P&G paid common dividends of $2.8975 per share. The dividend payout is 207% calculated as $2.8975 / $1.40. Dividends are rarely cut or decreased and thus, a payout greater than 100% likely arises because dividends remained constant and EPS dropped in 2019. Dividend yield is 2.6% calculated as $2.8975 / $109.65. The company paid significant dividends during the year.

d. In fiscal 2019, P&G repurchased 53,714 thousand shares for $5,003 million for an

average price of $93.14 per shares. The chief reason that P&G repurchases stock is to honor share-based compensation awards. The statement of equity shows that the number of shares repurchased in the year is very close to the number awarded. From this we can conclude that stock based compensation is fairly level year over year. e. The company’s stock price closed at $109.65 at year end. There were 2,504,751 shares

outstanding and thus market cap on that day was $ 274,645,947,150 or $275 billion. The market to book ratio is $274,646 million/$47,579 million = 5.77.

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P8-55. (50 minutes) a. The retained earnings column shows that there were no dividends paid on any of the

classes of stock during 2018. b. The stock based compensation expense during the year was $9,353 million and is

shown as an increase in additional paid in capital. There is no cash effect of this expense. c.

The statement of shareholders’ equity reports 8,975,000 common shares issued during the year and these are primarily for stock-based compensation awards. The average price per share is $16.49 calculated as $148 million / 8,975,000 shares. This is significantly lower than the $1,000 stock price at year end.

d. During the year, Alphabet repurchased 8,202,000 Class C shares for $9,075 million or

$1,106.44 per share ($9,075 million / 8,202,000 shares). The original issue price of $576 million was subtracted from Additional paid in capital, and amounted to $70.23 per share ($576 million / 8,202,000 shares). e. Alphabet’s accumulated other comprehensive income account includes foreign currency

translation adjustments, unrealized loss on available for sale investments, and a gain related to cash-flow hedges. The loss on foreign currency translation increased during the year by $781 million. This occurred because the US dollar strengthened vis-à-vis currencies where Alphabet has net assets and when the assets were translated to US dollars, the amount was smaller than the previous year. The loss is unrealized and therefore, held in AOCI.

P8-56. (30 minutes) a. IPO firms are highly risky investments because of the high level of uncertainty about the

company’s long-term prospects – IPO firms are unproven. Equity holders will be able to share in any price appreciation and thus, are compensated for the added risk of their investment. Debt holders however, do not benefit from stock price appreciation and the interest rate they would be willing to accept is often prohibitively expensive for the IPO firm – debt and interest must be repaid and IPO firms are often cash constrained and want to avoid debt. It is rare for IPO companies to issue debt. Two years after the IPO, there is some evidence of cash flow level and debtholders have more comfort in the level of risk associated with lending to Snapchat. b. The new notes add debt to the balance sheet where there was no interest-bearing

liabilities (debt) before. Leverage, as measured by debt / equity, was 0 before the new notes were sold, after the sale leverage was about 0.5 ($1,265,000,000 / $2,992,327,000). ©Cambridge Business Publishers, 2021 8-33

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Each $1,000 bond is convertible to 43.8481 common shares. Therefore, at any price above $22.806 per share ($1,000 / 43.8481), debenture holders would have economic incentives to convert. The stock price that day was $16.29 so the conversion price is aspirational – the bondholders receive 0.75% interest and if stock price increases, they can convert and earn a higher return.

d. Bondholders can convert any time after May 1, 2026. Prior to that, they may convert only

if the stock price is 130% of the conversion price. That is, if the price is greater than $29.64 per share ($22.81 conversion × 130%) for 30 days or longer before May 1, 2026, bondholders can choose to convert. e. The interest expense will be 0.75% per year on the outstanding balance.

The notes were issued on August 6, 2019 and Snapchat has a December 31 year end. The notes are outstanding 147 days in 2019 (25 + 30 + 31 + 30 + 31). Interest is calculated as $1,265 million × 0.75% × 147 / 365 = $3.82 million for fiscal 2019.

The convertible bonds do not affect basic EPS but do affect diluted EPS. In the computation of diluted EPS, the company assumes that the bonds are converted at their earliest possible opportunity (August 6, 2019 and January 1 for all subsequent years). As a result, the after-tax interest (e.g., interest expense  [1-tax rate]) accrued on the bonds is added to net income in the numerator, and the shares issued upon conversion are added to the denominator. The net result is diluted EPS that is smaller than basic EPS.

g. If bondholders convert notes worth a total $400 million, Snapchat will reduce debt by that

amount ($400,000 thousand on the balance sheet) and add the same amount to shareholders’ equity. With the conversion, the company will issue 17,539,240 Class A shares (43.8481 shares per note × $400 million / $1,000). The par value for Class A shares is $0.00001 and par will be increased by $175 ($0.175 thousand on the balance sheet). The difference ($399,999.82 thousand is added to APIC.

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P8-57. (30 minutes) a. “Mandatorily redeemable” means that the company must buy the stock back from

shareholders at some pre-specified price and date. This reduces the downside risk to the preferred stockholders. “Preferred stock” means that the stockholders have no voting rights but receive dividends before common voting stockholders. This is spelled out in the preferred stock contract. b. and c. Amount Outstanding

Class and Year 6.75% Series B March 31, 2019 March 31, 2018 6.50% Series C March 31, 2019 March 31, 2018 6.25% Series D March 31, 2019 March 31, 2018 6.375% Series E March 31, 2019 March 31, 2018 Total

Dividends 2018

2019

— $41,400

— $2,794.50

— —

— 40,250

2,616.25

—

57,500 57,500

— 3,593.75

$3,593.75 —

74,750 —

—

4,765.31

$9,004.50

$8,359.06

d. (in thousands) Balance Sheet Cash Asset

Transaction

Noncash Assets

PS 74,750 PS 41,400 PS 40,250 Cash 6,900

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

+74,750 Series E Preferred Stock

2018

-6,900 Cash

-$41,400 Series B Preferred Stock

–

-$40,250 Series C Preferred Stock

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Net Income

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P8-58. (50 minutes) a. Balance Sheet Transaction WE 1,200,000 CS 1,200,000 WE 1.2 mil. CS 1.2 mil.

Cash Asset

Noncash Assets

Record compensation expense each year: 2017 through 2019*

Liabilities

Income Statement +

Contrib. Capital

+1.2 mil. Common Stock

Earned Capital

Revenues

-1.2 mil. Retained Earnings

Expenses

–

+1.2 mil. Wages Expense

Net Income

-1.2 mil.

*(100,000 options × 2 executives × $18 fair value) / 3-year vesting period

b. No—if the stock price is $24 per share, the options are underwater (out-of-the-money).

The options should not be exercised because the cost to purchase the shares (the strike price of $27 per share) is less than what the shares could be sold for ($24 per share). c. Balance Sheet

Cash CS

Transaction

Cash Asset

Exercise options in 2017*

+2.7 mil. Cash

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

Expenses

–

Net Income

2,700,000 2,700,000 Cash

2.7 mil

+2.7 mil. Common Stock

–

CS 2.7 mil

*(100,000 options × $27 strike price)

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P8-59. (50 minutes) a. RSUs are shares of stock that are granted to the employee but not available to the

employee until a service (vesting) period elapses. OSUs have another condition, they only vest if certain performance targets are hit before the service period expires. b. During 2018, Intel expensed share-based compensation of $1.5 billion. c. The fair value of RSUs (including OSUs) granted to employees in 2018 is $1,782 million

(36.4 million RSUs granted × $48.95 per share fair value). Intel records this as an expense on the income statement, evenly over the vesting period, say 3 years. Each year from 2018 to 2020, Intel will expense 1/3 of $1,782 million for the 2018 grants. And each year, Intel will expense 1/3 of prior year’s grants. The $1,500 million expense in 2018 is the sum of 1/3 of the fair value of the 2016 grants + 1/3 of the fair value of the 2017 grants +1/3 of the fair value of the 2018 grants. The fair value of grants must be about the same amount each year over the past few years because $1,782 million 2018 grant is not much different from $1,500 million 2018 expense. d. The fair value of RSUs increases with risk-free rate and volatility and decreases with

dividend yield. •

Risk free rate: 2017 < 2018 thus, RSUs would have been lower in 2018 if the assumption had not changed.

•

Dividend yield: 2017 > 2018 thus, RSUs would have been lower in 2018 if the assumption had not changed.

•

Volatility: 2017 > 2018 thus, RSUs would have been higher in 2018 if the assumption had not changed.

e. We can estimate the profit to the employee as follows: fair value when the stock vested

multiplied by the number of shares that vested during the year. This yields a total profit of $1,934 million in 2018 ($48.95 × 39.5 million shares). f. RSUs are forfeited if employees leave Intel before the service (vesting) period expires or,

in the case of OSUs if the performance targets are not met.

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P8-60. (50 minutes) (NOTE: Students need to access the Power BI dashboard available at the publisher’s website to answer these questions. They cannot be answered from the graphics printed in the textbook, alone.) a. To determine which industry has the smallest proportion of assets financed by owners

we click on the industry bar in Average Total Assets graphic and then observe the pie chart in the top left. Financial services has the smallest proportion of assets financed by owners. Banks have large deposits (liabilities) relative to their assets and their liabilities are insured by the Federal government so they can afford to have higher leverage (risk is insured by the government). b. To determine which industry has the largest proportion of treasury stock we can click on

the industry bar in the Total Assets graphic (top right) and then observe the pie chart in the lower right. We can observe the proportions by hovering over the pie chart segment. Pharmaceuticals at 30% is bigger than the other industries. c.

From the bar and line graph (lower left) we can see that the difference between basic and diluted has decreased over time across all four industries. To understand the industry pattern of diluted versus basic shares, click on the industry bar in Average Total Assets graphic (top right) and then observe the mixed graph on the bottom left. With the exception of financial services, the difference between basic and diluted EPS dropped significantly in 2016. The pattern is most pronounced for pharmaceutical and retail which both experienced sharp drops in 2016.

P8-61. (50 minutes) a. Stock options grant the holder the right, but not the obligation, to purchase shares in the

future at a preset price. Restricted stock is the actual shares of stock but the employee cannot sell the stock until a vesting period has expired. The two are different in that the options can expire worthless if the stock price falls below the exercise price. Restricted stock will always have some value, unless the stock price falls to $0. The two forms of share-based compensation are similar in that they provide incentive to employees to increase share price. b. The vesting period is designed to retain the employee. Until the employee can “sell” the

stock, the employee has incentive to both stay with the company and work to increase the stock price. This aligns the employees’ incentives with those of other stockholders.

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Stock options are exercised years after they are granted. If stock prices are increasing, then we would expect that the fair value of option exercises (older prices) would be lower than the fair value of option grants (current prices). That is what we observe for Lululemon. For example, in 2018 exercised options have a fair value of $56.29, which is lower than the grant fair value of $96.96.

d. (in millions) Balance Sheet Transaction

Cash Asset

Noncash Assets

Liabilities

DC 745.14 CS 0.03 APIC 745.11

DC 745.14

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

+0.03 Common Stock

Restricted stock grants in 2018*

Income Statement

+745.11 Additional Paid-in Capital

0.03

–

-745.14 Deferred Compensation

APIC 745.11

*6 thousand shares × $124.19 per share is total deferred compensation of $745.14 thousand. The par value of the stock is $0.005 so 6 thousand shares have a par value of $0.03 thousand. The remainder increases APIC.

e. Wage expense = $29.6 million reported in the footnote to the table. At 21%, the income

tax effect would be $6.2 million. Balance Sheet Transaction

Cash Asset

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

-23.4

WE 29.6 TP 6.2 TE 6.2 CE 29.6 WE 29.6

Compensation expense in 2018

CC 29.6

-6.2 Taxes Payable

+29.6 Various Equity accounts

-23.4 Retained Earnings

TE 6.2

-6.2 Tax Expense – +29.6 Compensation expense

TP 6.2

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IFRS APPLICATIONS I8-62. (30 minutes) a. No, there was no activity in either the ordinary or preferred share accounts during fiscal

2018. b. Henkel paid €772 million during 2018 per the retained earnings column of the table. . c.

No, the treasury shares columns in the table show no activity during 2018.

d. No, the treasury shares columns in the table show no activity during 2018. e. The currency gain arose because of changes in the rates of exchange between the euro

(the currency of Henkel’s financial statements) and the currencies where Henkel has operations (net assets in place in foreign countries). During the year, the euro weakened vis-à-vis these other currencies, thus, the net assets (measured in foreign currencies) translated to more euros at the end of fiscal 2018 compared to fiscal 2017. f.

Noncontrolling interest represents the portion of subsidiaries that Henkel controls but does not own. The Noncontrolling interest increased during fiscal 2018 because these subsidiaries were profitable. The profit on the portion of the stock that Henkel does not own is added to the Noncontrolling interest on the balance sheet. The Noncontrolling interest is decreased by dividends paid to Noncontrolling stockholders.

g. For fiscal 2018, ROE was 14.2%, calculated as: €2,311 million / [€15,514 million +

€17,016 million) / 2]. This is a very solid return for 2018.

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I8-63. (40 minutes) a. The company is authorized to issue an unlimited number of shares. b. The total number of shares issued is 608,535,477. The total proceeds for these shares is

$16,740 + $231 = $16,971 million. We can determine that the average price per share is $27.88, calculated as $16,971 million / 608,535,477. c.

During 2018, the company issued 670,201 shares under the option plans. Total consideration (from the statement of stockholders' equity) was $34 million + $17 million = $51 million. The average price per share was $76.10, calculated as $51 million / 670,201 shares.

d. The company does not have any treasury stock. The statement of stockholders' equity

does not have a column for treasury stock. e. The total number of shares issued on December 31, 2018 (assumed for March 29, 2019)

is 608,535,477. The dividend is $0.43 per share for a total of $261.7 million. f.

Comprehensive income = Net income + Other comprehensive income. For 2018, this amounted to $3,573 million + $(302) million = $3,271 million. Comprehensive income and Net income are different because the former includes changes during the year in the unrealized gains and losses on the following items: available for sale securities, currency translation, and pension plans.

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Module 9 Intercorporate Investments QUESTIONS Q9-1.

Passive investments are debt and equity securities where the investor has no influence over the investee’s decisions. Passive investments are typically held to generate a return (interest, dividends, capital gains) on excess cash. Companies hold passive investments until they need the cash for strategic purposes such as acquisitions or capital expenditures.

Q9-2.

An unrealized gain (loss) is an increase (decrease) in the fair value of an asset (including an investment security) that is still owned. If the fair value of an investment security has changed during the period but the security has not yet been sold, the gain/loss has not yet been realized.

Q9-3.

Unrealized gains and losses related to marketable equity securities are reported in the current-year income statement (which flows to retained earnings). The balance sheet reports the securities at their fair value on the balance sheet date.

Q9-4.

Significant influence gives the owner of the stock the ability to significantly influence the operating and financing activities of the company whose stock is owned. Normally, a 20% through 50% ownership of the company's voting stock provides evidence of significant influence. The equity method is used to account for investments with significant influence. Such an investment is initially recorded at cost; the investment is increased by the proportionate share of the investee company's net income, and equity income is reported in the income statement. The investment account is decreased by dividends received on the investment, and is reported in the balance sheet at its book value. Unrealized gains or losses on the investment are not recognized in the financial statements.

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Q9-5.

Because Tse Company's investment in Green Company is an investment with significant influence, it should be accounted for using the equity method. At year-end, the investment should be reported in the balance sheet at $1,353,400 [$1,300,000 + (30%  $220,000) - (30% $42,000)].

Q9-6.

A stock investment representing more than 50% of the investee company's voting stock is generally viewed as conferring “control” over the investee company. The investor and investee companies must be consolidated for financial reporting purposes.

Q9-7.

Consolidated financial statements portray the financial position, operating results, and cash flows of affiliated companies as a single economic unit so that the scope of the entire (whole) entity is more realistically conveyed.

Q9-8A.

Derivatives are securities or contracts whose value is related to the price of another asset, or index. For example, the “value” of a derivative contract to purchase wheat in the future at a price determined today, depends on the spot price of wheat. The wheat contract “derives” its value from the price of wheat (among other factors). Companies commonly use derivatives to mitigate the risk associated with price movements in commodities, foreign currencies, and interest rates.

Q9-9 A.

For accounting purposes hedges are classified as fair-value or cash-flow. Unrealized gains and losses on fair-value hedges are reported in current period income. Unrealized gains and losses on cash-flow hedges are recorded in AOCI in the equity section of the balance sheet. The gain / loss on a cash-flow hedge is transferred to the income statement when the hedged transaction occurs.

Q9-10.

Limitations of consolidated statements include the possibility that consolidation “masks” the performances of poor companies. Likewise, rates of return, other ratios, and percentages calculated from consolidated statements might prove deceptive because they are composites (weighted averages). Consolidated statements also eliminate detail about product lines, divisional operations, and the relative profitability of various business segments. (Some of this information may be available in the footnote disclosures relating to the business segments of certain public firms, but these disclosures are limited in scope.) Finally, shareholders and creditors of subsidiary companies find it difficult to isolate amounts related to their legal rights by inspecting only consolidated statements.

Q9-11.

A weaker US$ means that assets and liabilities measured in a foreign currency will be translated into larger dollar values. This creates a translation “gain” that is reported in AOCI in the equity section of the balance sheet.

Q9-12 B.

A spin-off is the distribution of shares of a subsidiary company to shareholders in the form of a dividend. In a split-off, the parent company exchanges shares that it owns in a subsidiary for shares of the parent company owned by its stockholders.

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MINI EXERCISES M9-13. (15 minutes) Bava reports $52,900 as income: $29,900 of dividend income (23,000 $1.30) plus $23,000 of unrealized gains relating to the increase in the stock price [($13 –$12) 23,000 shares].

M9-14. (10 minutes) a. Unrealized gains and losses on the following types of investments would be included in Amgen’s AOCI account. i. Bonds issued by US corporations iv. Debt securities issued by a foreign government v. Municipal bonds vi. U.S. Treasury bills b. The AOCI account includes an unrealized loss. Thus, i. is true. c. The AOCI account decreased by $556 million during the year and ii is true. d. Amgen increased AOCI and reduced the unrealized losses and moved them to the P&L. thus iv. is true. Once the securities were sold, the losses were transferred to the P&L.

M9-15. (10 minutes) a. Amgen uses cash flow hedges to mitigate the risk associated with future cash flows. Amgen enters into a derivative contract to lock in a price for the future cash flow. One example is future purchases of equipment from a foreign supplier. Amgen needs foreign currency to pay for these anticipated purchases. If the dollar weakens, the purchases will be more expensive than planned. To hedge this risk, Amgen could enter into a futures contract to buy the foreign currency at a price set today. When Amgen needs to pay for the equipment the company buys foreign currency to settle the account with the supplier. b. Pre-tax losses of $262 million on the cash flow hedges were reclassified from AOCI to net income during 2018. This decreased net income $262 million. c. Fair-value hedges do not affect AOCI so $0 would have been added to AOCI for the year.

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M9-16. (10 minutes) a. Cash-flow hedge for anticipated inventory purchases. b. Fair-value hedge to lock in the USD value of the Canadian debt. c. Fair-value hedge to lock in the value of the account payable in euros. d. Cash-flow hedge for anticipated inventory purchases. e. Cash-flow hedge for future cash inflows associated with anticipated revenue.

M9-17. (20 minutes) a. The 30% ownership suggests “significant influence” so the investment must be accounted for using the equity method. The investment’s year-end balance is computed as follows: Beginning balance ............................................. % Bloomingdale income earned ........................ % Dividends received from Bloomingdale .......... Ending balance ..................................................

$2,000,000 90,000 ($300,000  0.3) (27,000) ($90,000  0.3) $2,063,000

b. Concord reports income from investments of $90,000 ($300,000  0.3). Equity-method earnings are computed as the reported net income of the investee (Bloomingdale Company) multiplied by the percentage of the outstanding common stock owned by the investor (30%). c. (1) In contrast to the fair-value method of accounting for investments, the equity method does not report investments at fair (or market) value. Neither the balance sheet nor the income statement reflects the unrealized gain.

M9-18. (10 minutes) Equity income on this investment is computed as Penno’s earnings multiplied by the 40% percent that Kross owns. In this case, equity earnings equal: $300,000 40% = $120,000. Dividends are not income to Kross. Dividends are treated as a return of investment. Kross reduces the investment balance by $40,000, computed as $100,000  40%. Also, Kross records the investment at adjusted cost, not at fair value or market value, and unrealized gains (losses) are neither recognized on the balance sheet nor in the income statement.

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M9-19. (10 minutes) a. As of December 31, 2018, Facebook reports a total of $7,306 million Cash equivalents, calculated as $6,792, $90 + $54 + $369 + $1, all in millions. As of December 31, 2018, Facebook reports $31,095 million as Marketable securities, calculated as $13,836 + $8,333 + $8,926, all in millions. b. Cash equivalents have remaining maturity of 90 days or less. Marketable securities that are classified as current assets have maturity between 90 days and a year. c. From part a., we determined that the balance sheet value of marketable securities is $31,095, which is the fair value. The note at the bottom of the table says that the securities are in a loss position. From this, we can compute the cost as follows: $31,095 + $357 = $31,452

M9-20. (15 minutes) a. Because of the magnitude of the ownership, Pfizer will report the GSK investment as an equity method investment. Equity method investments are reported at adjusted cost, not at current fair value. Adjusted cost is the original purchase price plus (minus) Pfizer’s proportionate share of investee companies’ profits (losses), less dividends received. b. When Pfizer receives cash distributions from the equity method investment, it reduces the investment balance. With a $350 million total distribution, Pfizer would receive $112 million. c. Pfizer reports its proportionate share of the net income of the GSK investment as equity income. Pfizer would increase the equity method investment on the balance sheet by $448 million calculated as: $1,400 million × 32% = $448 million.

M9-21. (10 minutes) The $400,000 investment in Kensington that is on Patterson Company's balance sheet along with the $300,000 common stock and $200,000 retained earnings of Kensington Company would be eliminated. In addition, a $100,000 noncontrolling interest [20% × ($200,000 + $300,000)] would appear on the consolidated balance sheet. Beginning in the acquisition year, the noncontrolling interest will be included with shareholders’ equity.

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M9-22. (10 minutes) Bedford Company net income ..................................................................... $400,000 90% of $90,000 Midway Company net income ............................................ 81,000 Consolidated net income attributable to Bedford shareholders .................... $481,000

M9-23. (10 minutes) The $150,000 excess purchase price will be added to the consolidated assets regardless of what sort of intangible Jasper Company purchased. The only difference will be the classification on the balance sheet. However, there would be an income statement effect. If the excess relates to patents, the $150,000 will be amortized over the patents’ useful lives. Each year, the amortization will reduce the net book value of the patents on the balance sheet. If the $150,000 excess relates to goodwill, there is no additional amortization because goodwill is not amortized, but is analyzed each year for impairment. If impaired, goodwill is written down to fair value.

M9-24. (15 minutes) a. The transaction appears to be a sell off. The CEO mentions sale or spin-off and then cited a sale as the best alternative. This means that Jack in the Box sold its Qdoba stock to another party rather than distributing the shares to the existing shareholders. b. The transaction will free up cash that Jack in the Box can deploy for projects / investments with higher return. The buyer is willing to pay more for the Qdoba assets that those same assets would bring if Jack in the Box continued to operate them. This means that Jack in the Box investors will make a profit by the sale. c. Jack in the Box carried the Qdoba investment on its balance sheet as an equity method investment. That investment will be eliminated. At consolidation, Jack in the Box will no longer add all of the Qdoba assets and liabilities on the balance sheet or the revenue and expenses on the income statement. The total size of the company will decrease.

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M9-25. (10 minutes) a. A spin-off would be a distribution of Synchrony’s shares to GE’s shareholders in the form of a dividend. A split-off would be the exchange of Synchrony shares (owned by GE) and GE shares (owned by investors). It is like a stock buy-back by GE except instead of using cash, GE uses the Synchrony shares it owns. The latter seems to describe the transaction. b. The repurchased shares are treated as treasury stock; GE’s outstanding shares will decline. c. The word “opportunity” in the disclosure, seems to imply that GE stockholders have a choice whether to exchange their shares or not, making it a non-pro-rata split off.

M9-26. (10 minutes) a. The transaction is an IPO followed by a spin-off. Two new companies will be created and The Gap will own all of the shares. Then the Gap will distribute shares of each new company to its existing Gap shareholders in the form of a dividend. A spin-off is accounted for as a dividend. The Gap reduces both the investment account and the retained earnings account by the book value of the shares distributed. b. The spin-off will reduce net assets (the assets and liabilities of the two new companies) and stockholders’ equity (retained earnings) by the net book value of the assets. There is no effect on income or cash flow.

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EXERCISES E9-27. (25 minutes)

Balance Sheet

MS 216,000 Cash 216,000 MS 216,000 Cash 216,000

Cash DI

21,600 21,600

Cash 21,600 DI

Transaction

Cash Asset

1. Purchased 18,000 common shares of Baez Inc., for $12 per share

-216,000 Cash

+216,000 = Investment

2. Received a cash dividend of $1.20 per common share from Baez

+21,600 Cash

+21,600 Retained Earnings

-13,500 = Investment

-13,500 Retained Earnings

-202,500 = Investment

+11,100 Retained Earnings

Noncash Assets

Liabilities

Income Statement

Contrib. Capital

Earned Capital

Revenues

+21,600 Dividend Income

–

Expenses

Net Income

–

+21,600

–

+13,500 Unrealized = Loss

–13,500

–

+11,100

21,600

13,500 3. Year-end 13,500 market price of Baez UL common 13,500 stock is $11.25 per MS share. MS

13,500

Cash 213,600 GN 11,100 MS 202,500 Cash 213,600 GN 11,100

4. Sold all 18,000 common shares of Baez for $213,600

+213,600 Cash

+11,100 Gain on Sale

MS 202,500

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E9-28. (25 minutes) Balance Sheet

MS 320,000 Cash 320,000 MS 320,000 Cash 320,000

Cash DI

25,000 25,000

Cash 25,000 DI

Transaction

Cash Asset

1. Purchased 20,000 common shares of Heller Co. at $16 per share

-320,000 Cash

2. Received a cash dividend of $1.25 per common share from Heller

+25,000 Cash

Noncash Assets

Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

+320,000 = Investment

–

Expenses

Net Income

–

+25,000

+30,000 = Investment

+30,000 +30,000 Retained Unrealized – Earnings Gain

+30,000

-350,000 = Investment

-34,400 Retained Earnings

–34,400

+25,000 Retained Earnings

+25,000 Dividend Income

25,000

MS 30,000 3. Year-end UG 30,000 market price of Heller MS common 30,000 stock is $17.50 per UG share 30,000

Cash 315,600 LS 34,400 MS 350,000 Cash 315,600 LS 34,400

4. Sold all 20,000 common shares of Heller for $315,600 cash

+315,600 Cash

–

+34,400 Loss on Sale

MS 350,000

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E9-29. (25 minutes) In $ 000’s Balance Sheet Transaction

Cash Asset

1. Purchased 5,000 bonds at $1,000 per bond

-5,000 Cash

+5,000 = Investment

2. Received cash interest of $100,000

+100 Cash

Noncash Assets

Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

MS 5,000 Cash 5,000 MS 5,000

–

Cash 5,000

Cash DI

100 100 Cash 100

+100 Retained Earnings

+100 Interest Income

+100

INTI 100

AOCI MS

110 110

AOCI 110 MS

3. Year-end fair value of bonds is $978 per bond

-110 = Investment

-110 AOCI

110

Cash 4,850 LS 150 AOCI 110 MS 4,890 Cash 4,850

4. Sold the bonds for $970 per bond

LS 150

+110 AOCI +4,850 Cash

-4,890 = Investment

AOCI

-150 Retained Earnings

–

+150 Loss on Sale

-150

110 MS 4,890

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E9-30. (15 minutes) a. Snapchat’s AOCI account has unrealized losses of $368 million from marketable securities and unrealized gains of $3,515 million from foreign currency translation. b. Comprehensive income = Net income + Other comprehensive income (loss). For Snapchat in 2018, comprehensive is $1,244,901 thousand calculated as $1,255,911 thousand - $11,010 thousand. c. 2018 comprehensive income included a loss of $11,720 thousand related to the foreign currency translation. This loss means that the currencies in which Snapchat’s subsidiaries transacted, weakened during the year vis-à-vis the $US. d. Level 1 inputs are actual, observable prices for actively traded securities. Level 2 inputs also come from observable market prices but for other assets or indices that are used to approximate fair values. e. The fair value of any marketable debt security is inversely related to interest rates. The Level 1 US government debt have net unrealized losses at year end, meaning that interest rates have increased since Snapchat acquired the securities.

E9-31. (15 minutes) a. CNA reports both available-for-sale and trading debt investments in its footnote for a total of $39,546 million ($39,542 million available for sale securities and $4 million trading securities). The cost of the portfolio is $38,085 million ($38,081 million + $4 million). Included in the balance sheet total are $1,982 million in unrealized gains and $521 million of unrealized losses. Notice that all the unrealized gains and losses pertain to available-for-sale investments. b. There is a net unrealized gain of $1,461 million on the available-for-sale securities calculated as $1,982 million - $521 million. This unrealized gain is reported in Accumulated Other Comprehensive Income (AOCI) on the balance sheet, rather than in current income and retained earnings. Thus, unrealized gains and losses do not affect the income statement. The available-for-sale investments are reported on the balance sheet at current fair value. c. Gains and losses realized from the sale of securities are recognized in current income, calculated as the difference between the sales price and amortized cost. For availablefor-sale securities sold, any unrealized gains (losses) on the date of sale need to be removed from AOCI to avoid double-counting the gains and losses in stockholders’ equity. Thus, the company records an accounting (reclassification) adjustment in the Accumulated Other Comprehensive Income account because the unrealized gains and losses from prior periods have been previously recorded in AOCI. ©Cambridge Business Publishers, 2021 Solutions Manual, Module 9

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E9-32. (25 minutes) Balance Sheet

EMI 108,000 Cash 108,000 EMI 108,000 Cash 108,000

Transaction

Cash Asset

a. Purchased 12,000 common shares of Bakersfield Co. at $9 per share; the shares represent 30% ownership in Bakersfield

-108,000 Cash

+108,000 = Investment

–

+15,000 Cash

-15,000 = Investment

–

Cash 15,000 EMI 15,000 b. Received a cash dividend Cash of $1.25 per 15,000 common share from Bakersfield EMI

Noncash Assets

Liabilities

Income Statement

Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

15,000

EMI EI

18,000 18,000

EMI 18,000 EI 18,000

c. Recorded income from Bakersfield stock investment when Bakersfield's net income is $60,000

+18,000 = Investment

+18,000 Retained Earnings

+18,000 Equity Income

–

+18,000

d. Sold all 12,000 common +114,500 shares of Cash Bakersfield for $114,500

-111,000 = Investment

+3,500 Retained Earnings

+3,500 Gain on Sale

–

+3,500

Cash 114,500 EMI 111,000 GN 3,500 Cash 114,500 EMI 111,000 GN 3,500

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E9-33. (25 minutes) a. With 100% of the Tableau stock, Salesforce has control. On the parent-only balance sheet, the investment will be accounted for as an equity method investment. b. Salesforce files consolidated financial statements with the SEC. This means that the equity method investment will be eliminated and all of the assets and liabilities of Tableau will be added. Also, any intangible assets or goodwill that Salesforce bought in the acquisition will be added to the consolidated balance sheet. c. The Tableau net assets had a book value of $1 billion. Salesforce would have determined the fair value of these assets. The difference between the acquisition price of $14.9 billion and the net asset value $1 billion would represent the fair value of the identifiable intangible assets and the goodwill combined, which is $13.9 billion.

E9-34. (35 minutes) a. Fair-value method accounting—marketable equity securities. Balance Sheet

MS 75,000 Cash 75,000 MS 75,000 Cash 75,000

Cash DI

5,500 5,500

Cash 5,500 DI 5,500

MS GN

20,000 20,000

MS 20,000 GN

Transaction

Cash Asset

1. Ball purchased 5,000 common shares of Leftwich (15%) at $15 per share.

-75,000 Cash

2. Leftwich reported annual net income of $40,000

NO ENTRY

3. Received a cash dividend of $1.10 per common share from Leftwich

+5,500 Cash

4. Year-end market price of Leftwich common stock is $19 per share

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

+75,000 = Investment

+20,000 Investment =

–

Expenses

Net Income

–

+5,500 Retained Earnings

+5,500 Dividend Income

–

+5,500

+20,000 Retained Earnings

+20,000 Gain

–

+20,000

20,000

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b. Equity method accounting Balance Sheet

EMI 75,000 Cash 75,000 EMI 75,000 Cash 75,000

EMI EI

12,000 12,000

EMI 12,000 EI

Transaction

Cash Asset

1. Ball purchased 5,000 common shares of Leftwich (30%) at $15 per share.

-75,000 Cash

2. Leftwich reported annual net income of $40,000

Noncash Assets

Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

+75,000 = Investment

+12,000 = Investment

+12,000 Retained Earnings

+12,000 Equity Income

–

Expenses

–

Net Income

+12,000

12,000

Cash EMI

5,500 5,500

Cash 5,500 EMI 5,500

3. Received a cash dividend of $1.10 per common share from Leftwich

+5,500 Cash

4. Year-end market price of Leftwich common stock is $19 per share

NO ENTRY

-5,500 Investment

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E9-35. (25 minutes) a. Ford reports a total of $2,709 million at the end of 2018. This represents the adjusted cost of the investments. This balance reflects the original purchase price plus Ford’s share of the investee’s net income (or less Ford’s share of any losses) and less all dividends received from the investee. b. Ford’s carrying value of Changan Ford Mazda Engine Company is $71 million and Ford owns 25% of the company’s equity. Therefore, the stockholders’ equity for Changan Ford Mazda Engine Company is $284 million calculated as $71 million / 0.25. c. Investments are consolidated when the parent company has control over the operating, investing, and financing activities of the subsidiary. By the fact that DealerDirect is not consolidated despite Ford’s 97.7% ownership, means that some other party can influence key decisions. Ford retained some influence and thus used the equity method to account for this investment. Therefore, the assets and the liabilities for DealerDirect are missing from Ford’s consolidated balance sheet (only a net amount of the investment was included), and the revenues and expenses of DealerDirect were also missing from the income statement (only 97.7% of DealerDirect’s net income was included). d. Ford’s investment in Getrag Ford Transmission Motors increased by $14 million during 2018, calculated as $236 million - $222 million. Ford increased its investment account by its share of Getrag’s net income during the year and decreased the investment by dividends received. Because dividends are assumed to be $0, the change of $14 million is 50% of Getrag’s net income, which we can determine to be $28 million (calculated at $14 million / 0.50). e. Ford manufactures cars in various locations around the world to meet customer demand there and to take advantage of strategic operational conditions such as lower labor costs or tax regimes. Some governments (including China and Malaysia) require a significant local ownership and so Ford structures its operations to comply with these laws. Other investments are made to share the risk of the operation. f.

Equity method investment at end of year = balance at start of year + Net income of investees - Dividends and distributions. $3,085 million + $1,780 million – dividends and distributions = $2,709 million. Thus, we compute dividends and distributions as $2,156 million.

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E9-36. (25 minutes) a. Cummins reports these equity method investments on its balance sheet at $1,144 million. Consequently, Cummins’ balance sheet reports net assets of only $1,144 million and, importantly, none of the liabilities of the investee companies ($2,887 million). The lack of full reporting of the investees’ assets and liabilities fails to present a clear picture of the capital investment required to conduct Cummins’ business or the financial leverage inherent in its operations, even though its accounting is in conformity with GAAP. b. Although Cummins is not directly obligated for the debts of these unconsolidated affiliates (unless it has legally guaranteed those debts), if the affiliates were to fail, would Cummins have to invest additional capital to support it? Probably not, from a strictly legal standpoint. Yet, if this investment is necessary for Cummins’ strategic plan, it might find it difficult to arrange future ventures of this type if it does not support the failing investee. This means that there can be an effective liability even when no legal liability exists. Analysts can, of course, replace the equity investment with the assets and liabilities to which it relates (pro forma consolidation for analysis purposes) if they feel consolidated numbers better represent the company’s balance sheet and income statement. c. The equity method reports only Cummins’ proportion of the affiliated companies’ equity and Cummins’ proportion of the affiliated companies’ earnings. As a result, the equity method, arguably, omits assets and liabilities from the face of Cummins’ balance sheet, and omits sales and expenses from the income statement (compared with the assets, liabilities, sales and expenses that would be recorded with consolidation). Net income and stockholders’ equity are the same whether the equity method or consolidation is used so ROE is the same. But, net operating profit margin and net operating asset turnover are likely biased upward and downward, respectively (due to the omission of assets and sales).

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E9-37. (30 minutes) a. AT&T’s December 2018 balance sheet reports $6,245 million for equity method investments. b. Affiliates did pay dividends during 2018. AT&T’s share was $243 million as shown on the table. The receipt of dividends reduces the equity method investment on AT&T’s books. Thus, AT&T subtracts the $243 million in dividends for 2018. c. AT&T reported equity in net loss of $48 million related to the affiliates in 2018. d. Undistributed earnings of $292 million are earnings that have not yet been paid out as dividends; this is retained earnings of the affiliates at December 31, 2018. e. The equity method reports only the proportion of the investee company’s equity that is owned as an investment on the balance sheet. Similarly, the income statement includes one line item for the proportion of the investee’s earnings. This method, arguably, omits assets and liabilities from the balance sheet and omits sales and expenses from the income statement (compared with the assets and liabilities and the sales and expenses that would be recorded with consolidation). ROE is the same because net income and stockholders’ equity are the same whether the equity method or consolidation is used. However, net operating profit margin (Net operating profit after tax / Sales) and net operating asset turnover (Sales / Average net operating assets) are likely biased upward and downward, respectively (due to omitted assets and sales). f.

The equity method of accounting must be used if the investor can exert “significant influence,” but cannot “control” the investee. AT&T must have significant ownership in each affiliate but does not have control.

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E9-38. (20 minutes)

Liu

Consolidating Adjustments

Reed

Current assets .........................$950,000

$70,000

$1,020,000

Investment in Reed ................. 380,000 PPE, net................................1,600,000 Goodwill ................................

$(380,000)

27,000

1,932,000

33,000

305,000 .

Consolidated

Total assets ............................. $2,930,000

$375,000

$2,985,000

Liabilities ................................ $ 450,000

$ 55,000

$ 505,000

Contributed capital .................. 1,850,000

280,000

(280,000)

1,850,000

Retained earnings ................... 630,000 Total liabilities & stockholders’ equity ............... $2,930,000

40,000

(40,000)

630,000

$375,000

$2,985,000

E9-39. (30 minutes)

Winston

Consolidating adjustments

Marcus

Investment in Marcus ................... $ 600,000

$(600,000)

Other assets ................................2,300,000 Goodwill .......................................

$700,000

Consolidated $

20,000

3,020,000

40,000

Total assets ................................ $2,900,000

$700,000

$3,060,000

Liabilities ...................................... $ 900,000

$160,000

$1,060,000

Contributed capital ....................... 1,400,000

300,000

(300,000)

1,400,000

Retained earnings ........................600,000 Total liabilities & stockholders’ equity .................. $2,900,000

240,000

(240,000)

600,000

$700,000

$3,060,000

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E9-40. (20 minutes) Balance Sheet Transaction EMI 150,000 APIC 150,000 EMI 150,000 APIC 150,000

Cash Asset

Sale of 60,000 shares of stock by Walton

Noncash Assets

+150,000* = Investment

Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

+150,000 Additional Paid-In Capital

–

Expenses

Net Income

* New book value of stockholders’ equity for Walton = $900,000 + $840,000= $1,740,000 % owned by Sykora = [80,000/(100,000 + 60,000)]  $1,740,000 = $870,000.

The investment is currently carried on Sykora Company’s books at $720,000 and, therefore, must be written up by $150,000. The increase is recorded as an increase in contributed (paid-in) capital.

E9-41. (20 minutes) a. Because the fair value of Ball is less than the carrying amount of the investment on Engel’s balance sheet at December 31, 2019, the goodwill is deemed to be impaired. To determine the amount of the impairment charge, we calculate the difference between the carrying value and fair value of Engel’s investment in Ball: $8,400,000 - $6,250,000 = $2,275,000 million. We compare the difference to the total book value of goodwill – the impairment is the smaller of the two amounts. The goodwill has a book value of $300,000, which is less than the full decline in value of the investment. Goodwill must be written off completely; the impairment charge is $300,000. Note: under former GAAP, the impairment would have been equal to the difference between the carrying value and implied fair value of goodwill itself. This second step was eliminated in 2017 because it was very costly for firms to determine an “implied” fair value for goodwill. b. The write-off will reduce the carrying amount of goodwill by $300,000 and yield a loss in Engel’s income statement, thus reducing retained earnings by that amount. Given the magnitude of the decline in fair value of the Ball investment, other assets are also impaired and would need adjusting as well.

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E9-42. (40 minutes) a. The acquisition included total assets of $2,652 million. Of that, $2,145 million (or 77%) was allocated to intangible assets, detailed below. Goodwill Brand Customer relationships Favorable lease

$ 878 948 203 16

Total

$2,045

a. All of the assets and liabilities of Versace (the acquired company) are reported on Capri’s consolidated balance sheet at their fair values on the date of the acquisition, not at their net book values. b. The intangible assets with a determinable life are amortized (depreciated) over their useful lives. Intangible assets with an indeterminate useful life are not amortized, but are tested annually for impairment, or more often if circumstances require. Goodwill is in this latter category. c. Goodwill is reported on the consolidated balance sheet at $848 million and it is not routinely amortized but rather, tested for impairment at each balance sheet date. Capri Holdings will consider the fair value of Versace and if that value falls below the investment carrying value (which is $2.005 billion at December 31, 2018), then Capri would consider goodwill to be impaired.

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E9-43. (60 minutes) a. Cash paid ........................................................................... Fair value of shares issued ($72 per share × 5,000 shares) Purchase price ................................................................... Less: Book value of Harris .................................................. Payment in excess of book value ....................................... Excess assigned to specific accounts based on fair value: Buildings ....................................................................... Patent ........................................................................... Goodwill ........................................................................ Total payment in excess of book value ...............................

$420,000 360,000 780,000 560,000 $220,000 $ 80,000 60,000 80,000 $220,000

b. Easton, Co.

Harris Co.

Cash Receivables Inventory Investment in Harris Land Buildings, net Equipment, net Patent Goodwill Totals

168,000 320,000 440,000 780,000 200,000 800,000 240,000 — $2,948,000

$ 80,000 180,000 260,000

Accounts payable Long-term liabilities Common stock Additional paid-in capital Retained earnings Totals

$ 320,000 760,000 1,000,000 148,000 720,000 $2,948,000

$ 60,000 340,000 80,000 — 480,000 $ 960,000

Consolidation Entries

(780,000) 120,000 220,000 100,000 — — $ 960,000

80,000 60,000 80,000

(80,000) (480,000)

Consolidated Totals $ 248,000 500,000 700,000 — 320,000 1,100,000 340,000 60,000 80,000 $3,348,000 $ 380,000 1,100,000 1,000,000 148,000 720,000 $3,348,000

c. The fair-value adjustment to fixed assets will be depreciated over the assets’ estimated useful lives. The patent will be amortized over its useful life. Intangible assets with an indeterminate useful life (such as goodwill) are not amortized, but are tested annually for impairment or more often if circumstances require.

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E9-44. (20 minutes) a. General Mills has subsidiaries headquartered in foreign locations. The balance sheets of these subs are denominated in foreign currencies and must be translated to USD before consolidation. As foreign exchange rates fluctuate the US dollar value of the foreign subsidiaries’ assets and liabilities fluctuate. The change in the net assets (assets minus liabilities) is added to Comprehensive income for the year, which flows to AOCI. This adjustment is needed to balance the USD balance sheet. This adjustment amounted to a loss of $82.8 million at May 26, 2019. b. When the $US strengthens, the assets and liabilities of the foreign subsidiaries translate into fewer dollars, which creates a loss. That is, the foreign currency translation adjustment is negative as is the case for General Mills in 2019. Thus we can conclude that, on average, the U.S. dollar strengthened vis-à-vis the currencies of the companies’ foreign subsidiaries. c. The cash portion of the foreign currency translation loss in 2019 was $0. All Comprehensive income amounts are non-cash. They represent unrealized gains and losses on various items and so, by definition, involve no cash. d. The $12.1 million gain related to hedge derivatives relates to a cash-flow hedge. Unrealized gains on cash-flow hedges are accumulated in AOCI until the anticipated (hedged) transaction occurs. Unrealized gains on fair-value hedges flow to income and are offset by losses on the hedged item. e. General Mills might hedge inventory purchases, other planned purchases of assets such as equipment, foreign debt repayments, interest payments on foreign debt, anticipated sales in foreign currencies, and interest rates. f.

In 2019, net income decreased by $0.9 million due to the cash-flow hedges. Comprehensive income increased by that amount and thus, net income decreased by the same amount.

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E9-45. (15 minutes) a. The first paragraph discusses Intel’s foreign currency denominated debt and loans receivable. Intel hedges these balance sheet amounts so that it can mitigate the risk associated with the fair value of these items. These are fair-value hedges. b. The unrealized loss on the currency forward contracts would be included in the value of the derivative reported on the balance sheet because all derivatives are reported on the balance sheet at fair value. Given that these hedges are fair-value hedges, the unrealized loss would flow to income. That loss would be mitigated by the corresponding gain on the hedged item, either the foreign debt or loans receivable. c. The second paragraph discusses “forecasted future cash flows” these are Intel’s planned operating and capital expenditures. Intel hedges these anticipated transactions so that it can mitigate the risk associated with the cash flow required for these purchases. These are cash-flow hedges. The paragraph also discusses “existing non-US dollar monetary assets and liabilities.” These hedges are fair value hedges. d. The unrealized loss on the currency forward contracts would be included in the value of the derivative reported on the balance sheet because all derivatives are reported on the balance sheet at fair value. Given that these hedges are cash-flow hedges, the unrealized loss would be held in AOCI until the anticipated expenditure happened. Then, the loss would flow to the income statement. e. Hedge ineffectiveness arises when the fair value of a hedging instrument is not perfectly negatively related to the fair value of the hedged item. For example, perhaps the derivative contract to hedge the purchase of inventory closes a few days before the anticipated inventory purchase. This would leave the company exposed to fluctuations in the price of inventory for a few days. This would make the hedge less than perfectly effective. The ineffective portion of a hedge flows to the income statement in the current period.

E9-46. (20 minutes) a. Ford Motors hedges commodities that it uses to manufacture automobiles. It also hedges energy such as natural gas and electricity, presumably used to manufacture automobiles. These hedges are to counter price movements – either for the better or the worse. b. Ford uses derivative instruments to hedge the price risk with respect to forecasted purchases. This is a cash-flow hedging strategy. c. Comprehensive income comprises unrealized gains and losses from various items including derivatives classified as cash-flow hedges. The line item labelled “derivative instruments” represents the changes in the unrealized gains and losses on the derivatives during the year. ©Cambridge Business Publishers, 2021 Solutions Manual, Module 9

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d. In 2018 and 2016, comprehensive income increased by $219 million and $183 million respectively, because of Ford’s derivatives designated as cash-flow hedges. From this we can conclude that the unrealized gains on these instruments increased (or losses decreased). In 2017, the unrealized losses grew by $265 million.

E9-47. (20 minutes) a. The graphic depicts the composition of total assets for all 11 years and all companies. Two assets (cash and marketable securities) are shown separately. The black portion represents all assets other than the two liquid investments. There are several ways to determine that cash to total assets was the lowest in 2008. One way is to display the pie chart by year. We can click on any of the other charts that show data by year. Then, by moving from year to year in that chart, the pie chart will display for that year only. A second way is to change the variable definition for the proportions from “average” to “minimum” and click the pie chart. This will highlight 2008 data in one of the bar charts. b. The AOCI is negative in all years except 2008. Thus, in most years, the average firm reports unrealized losses as opposed to unrealized gains. These arise from all sources (marketable securities, derivative, currency translation adjustments, and pension plans). The line measures the proportion of liquid assets (cash and marketable securities) to total assets. We see the proportion generally decreasing over time. Thus, bar chart indicates that AOCI / Equity is getting larger over time. One conclusion is that unrealized losses are arising from items other than the liquid investments. c. The graphic shows the cumulative amount of debt for all of the S&P companies in the information technology sector. In 2017, the amount of debt hit its peak at approximately $600 billion. d. As debt increases so does the size of the aggregate liquid investments. This is puzzling because it means that on average, firms hold more debt AND more liquid investments. Of particular note is the fact that the liquid investments are larger than the total debt every year. In 2017, cumulative liquid assets are $750 billion. The pattern may not hold for every firm in the dataset, but across all the firms, there are sufficient liquid assets to repay 100% of the debt. e. Both assets and market cap are growing over time, there is no year in which either metric declined, in aggregate. We observe that the gap between the two is widening. One possible explanation is that firms’ balance sheets do not include the fair value of all assets. The companies included in the graphic are in an industry with high intellectual property and offbalance sheet intangible assets created by knowledge worker.

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PROBLEMS P9-48. (60 minutes) a. General Mills accounts for the investments in its joint ventures “at cost plus our share of undistributed earnings or losses.” This is the equity method. Consolidation is not appropriate because General Mills does not control these entities. Also, the market method is inappropriate because General Mills is able to exert “significant influence” in the management of these businesses. Under the equity method, General Mills’ balance sheet reports these investments at adjusted cost (e.g., beginning balance plus proportionate share of joint venture earnings less any dividends received). On its income statement, General Mills reports its proportionate share of joint venture earnings as income. In 2019, the two joint ventures reported net income of $111.9 million. A 50% share of this is $55.95 million, which approximates what General Mills would include in its income statement. b. The $117.5 million investment balance on General Mills’ balance sheet (net of advances) represents its share of the equity (net assets) of its joint ventures. General Mills’ proportionate share of the assets of the joint ventures, as well as its proportionate share of the joint ventures’ liabilities, are not reflected on its balance sheet, only the equity (net assets). As a result, General Mills’ balance sheet does not reflect the actual investment and liabilities required to conduct these operations. For example, the total joint venture assets are $1,734.8 million ($895.6 million + $839.2 million) but General Mills shows an asset of only $117.5 million (investment asset). This means that General Mills’ balance sheet omits $1,617.3 million of assets. Similarly, the balance sheet excludes liabilities of $1,594.4 million. This is the primary criticism of equity method accounting. c. Although General Mills may not have legal liability for the obligations of its joint ventures, it might have an implicit obligation to stand behind the entities that it has created (which includes their financing). That is, General Mills would be hard-pressed to walk away from one of these entities should it fail to pay its debts. Equity method accounting presents at least three challenges for analysis purposes. (i) Equity method accounting obscures the actual assets and liabilities of the investee company on the books of the investor company. (ii) The equity investments are reported at adjusted cost. As a result, unrealized gains (say, from market value appreciation) are not reflected on the balance sheet or in the income statement. (iii) Any income-statement related analysis is also biased because sales and expenses are reported NET instead of gross. For all of these reasons, it is important for financial statement users to consider the additional information reported in footnotes. ©Cambridge Business Publishers, 2021 Solutions Manual, Module 9

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P9-49. (60 minutes) a. Each individual company (parent and subsidiary) maintains its own financial statements. This is necessary to report on the activities of the individual units and to report to the respective stakeholders of each unit, including banks and other lenders, and tax authorities. Typically, tax returns are prepared for individual companies and not for consolidated entities. The purpose of consolidation is to combine these separate financial statements to more clearly reflect the operations and financial condition of the combined (whole) entity. b. The Investment in Financial Services is reported on the parent’s (Operations) balance sheet at $329.5 million. This is the same balance as reported for stockholders’ equity by the Financial Services subsidiary. This relation holds because Snap-on owns 100% of the subsidiary. This relation will always exist so long as the investment was originally purchased at book value. c. The consolidated balance sheet more clearly reflects the actual assets and liabilities of the combined company compared to the equity method of accounting. That is, the consolidated balance sheet reflects operations of the entire entity as far as investors and creditors are concerned. The equity method of accounting that is used by the parent company to account for its investment in the subsidiary, reflects only its proportionate share (100% in this case) of the investee company’s net assets (the stockholders’ equity) and does not report the individual assets and liabilities comprising that equity. d. Consolidated net income will equal the net income of the parent company. The reason for this is that the parent reflects the income of the subsidiary via the equity method of accounting for its investment. The consolidation process merely replaces the equity income account with the subsidiaries’ individual sales and expenses. Net income is unaffected but each of the line items on the income statement will be different between the two methods of accounting. e. The consolidated balance sheet is not affected by fair-value changes in the subsidiary’s stock. Unrealized gains on the stock of a subsidiary are not reflected on the consolidated balance sheet or on the income statement. Instead, the subsidiary is reflected on the balance sheet at its purchase price, net of depreciation and amortization, just like any other asset. The consolidation process merely replaces the investment account with the actual assets and liabilities to which it relates. Thus, substantial unrealized gains subsequent to the acquisition are not reflected in the consolidated financial statements.

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IFRS APPLICATIONS I9-50. (30 minutes) a. Deutsche Telekom will record all the acquired tangible and intangible assets of Hellenic at their fair values on the date of the acquisition, not at their net carrying values. The carrying values (net book values) are irrelevant to Deutsche Telekom at the date of acquisition. b. Because Hellenic had goodwill on its own balance sheet prior to the acquisition means that Hellenic recorded goodwill from one of its prior acquisitions. The carrying value of this goodwill exceeded the value that Deutsche Telekom independently determined to be its fair value. The fair value of goodwill at acquisition is recorded on the books and the former fair value is irrelevant. c. Valuation of intangible assets can vary from company to company due to the acquiring company’s potential to benefit from those intangible assets. Deutsche Telekom may believe that it can more effectively utilize certain trademarks, customer relationships, patents, trade secrets, etc. than Hellenic. This corporate network and other possible synergies are valuable to Deutsche Telekom and thus, the fair value of the intangibles was higher than the carrying value at the time of the acquisition. d. Goodwill is recorded on the balance sheet at acquisition and not amortized. It is considered an indefinite-lived intangible asset. At each balance sheet date, the company scrutinizes the fair value of the original investment and compares the fair value to the current carrying value (net book value). If the fair value has fallen below carrying value, then the goodwill is deemed impaired. The process is challenging because fair value of the investment may not be readily available and the company must use Level 3 fair value process to determine value. This can be costly and time consuming.

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I9-51. (30 minutes) a. BHP Billiton accounts for its investment in the two investee companies using the equity method of accounting because Billiton has significant influence over the operations of these two companies, with 33.33% and 33.75% percentage ownership. With such significant ownership, it is easy to imagine that Billiton wields significant influence over operating, investing, and financing decisions. b. BHP included a total of $656 million from all of its equity method investments. The equity method of accounting records as equity method income, the proportion of each investee’s net income. Billiton reported $736 million from the two associates, for 2018. We can determine how much each of the associates contributed to this as follows. Cerrejon $576 million × 33.33% = $192 million. Antamina $1,613 million × 33.75% = $544 million. The total included is less than the amounts from the two associates above ($656 million total compared to $736), which indicates that collectively, the other equity method investments reported a cumulative LOSS for the year. c. Dividends received from equity method investees reduce the investment account. This is because the dividends themselves reduce the equity account (retained earnings) on the investee’s own books. Billiton’s investment account (asset) mirrors the decrease, proportionately. d. The use of the equity method of accounting has no effect on equity (in the ROE calculation) but strictly understates the measurement of net operating assets (in the RNOA calculation). This is because the equity method records only Billiton’s proportionate share of the net assets of its investees. It does not separately report the proportionate share of either the assets or liabilities. This is the primary criticism of equity method accounting.

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MANAGEMENT APPLICATIONS MA9-52. (20 minutes) a. The financial statement effects of the three possible accounting methods for this investment are as follows: Fair-value method—the investment is recorded at fair value on each statement date. Changes in fair value affect either profitability (if the investment is classified as “trading”) or Accumulated Other Comprehensive Income (if the investment is classified as “available-for-sale”). Equity method—the investment is recorded at its initial purchase price, which represents the percentage of APEX’s stockholders’ equity owned, plus any excess paid. Income is recognized as the proportionate share of APEX’s net income. Dividends are treated as a return of investment and, therefore, reduce the investment balance. Consolidation—the balance sheets and income statements of the parent and subsidiary companies are added together, net of intercompany transactions and investments. b. The appropriate accounting method is determined by the degree of influence that the investor company has over the investee company. Because APEX employs your company’s software engineers, and your company is integrally involved in the software design, you appear to have significant influence over APEX. The equity method is appropriate in this case (as compared to consolidation) because your 20% ownership interest does not confer effective “control” over APEX. Likewise, the fair-value method is not appropriate because you are not a passive investor.

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Module 10 Leases, Pensions, and Income Taxes QUESTIONS Q10-1.

Under the new accounting standard, all leases are added to the balance sheet as an asset for the benefits associated with the lease and a liability for the lease obligation. The leased asset is amortized and the lease liability repaid over the term of the lease such that by the end of the lease term, both asset and liability have reached a zero balance. Leases are classified as either finance or operating leases. Regardless of the classification, the present value of the future lease payments is added to the balance sheet as asset and as liability. However, the location of the asset on the balance sheet differs. For finance leases, the leased asset is included with PPE. For operating leases, the leased asset is called a right-of-use asset and displayed separately. The income statement treatment differs for the two types of leases. Finance leases create interest expense (on the lease liability) and deprecation or amortization expense (on the leased asset). Operating lease payments are reported as rent expense.

Q10-2.

A lease is a finance lease if it meets any ONE of the following criteria: •

Transfer of ownership. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

•

Purchase option. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

•

Lease term. The lease term is for a major part of the remaining economic life of the underlying asset.

•

Present value. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already included in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.

•

Specialized asset. The underlying asset is of such a specialized nature that the company does not expect that the asset will have any alternative use to the lessor at the end of the lease term. © Cambridge Business Publishers, 2021 10-1

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Q10-3.

Yes, over the term of the lease, the rent expense recorded on an operating lease will be equal to the sum of the interest expense and depreciation recorded on a finance lease; only the timing of the expense recognition changes. Expense is ultimately related to the cash flows required to discharge the obligation. Those cash flows are the same regardless of lease classification.

Q10-4.

Under defined contribution plans, companies make contributions to the plans which, together with earnings on the amounts invested, provide the sole source of funding for payments to retirees. Under defined benefit plans, companies are obligated to make future payments whose amount and timing is defined by the rules of the pension plan. Pension payments typically depend on an employee’s years of service and pay level. Defined benefit plans may or may not be fully funded. Because the company’s obligation is extinguished upon payment for a defined contribution plan, the accounting is relatively simple: record an expense when paid or accrued. Defined benefit plans present a number of complications in that the liability is very difficult to estimate and involves several critical assumptions. In addition, companies lobbied for (and the FASB agreed to) various mechanisms to smooth the impact of pension costs on reported earnings. These smoothing mechanisms further complicate the accounting for defined benefit plans vis-à-vis defined contribution plans. (Note: the FASB is considering amending the pension standard to eliminate these smoothing mechanisms.)

Q10-5.

A company will report a net pension asset if the pension’s funded status is positive (i.e., fair value of the plan assets exceeds the plan obligation). Otherwise, the company will report a net liability to represent the underfunding of the pension obligation (i.e., negative funded status).

Q10-6.

Service cost, interest cost and the expected return on plan investments (a reduction of the pension cost) are the basic components of pension expense. The expense might also include amortization of deferred gains and losses should these exceed prescribed limits.

Q10-7.

The use of expected returns and the deferral of unexpected gains and losses smooth corporate earnings by allocating over several years the effects of swings in the market values of investments and variation in pension liabilities resulting from changes in actuarial assumptions or plan amendments.

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Q10-8.

Income tax expense has two components: the current and deferred portions. Current taxes are the cash taxes that are due to the IRS, State or other taxing authority. Some of the current portion could have been paid during the year as installments. Deferred tax is the portion of the tax provision that will likely be due or received in future years. Deferred taxes arise because of the differences between GAAP rules used to calculate tax expense for financial reporting purposes and tax rules used to calculate the company’s tax bill.

Q10-9.

Deferred taxes arise from the differences between how GAAP and tax rules recognize items on the income statement and balance sheet. Total tax expense is determined using GAAP rules, current taxes are determined using tax rules. In the simplest terms, deferred taxes arise because of the differences between the two. Deferred tax liabilities are amounts that will likely be paid in later years. Deferred tax assets will likely reduce taxes due in later years.

Q10-10.

Like all assets, deferred tax assets represent future economic benefits. In particular, deferred tax assets will reduce a company’s future tax bill. If the company is not likely to receive the anticipated future tax benefits, the deferred tax asset has lost value (it is impaired) and a write-down is called for. To reflect the loss in value, a company establishes a valuation allowance and reduces the deferred tax asset balance. If later, the company determines that it will receive the tax benefits after all, the company can reverse the valuation allowance. The second reason for a reversal is the benefits are actually lost, as in the case of a company fails and the net operating loss carryforward is worthless.

Q10-11.

Changes in the deferred tax valuation allowance affect net income dollar for dollar in the opposite direction. When the allowance is established (i.e. increases), net income decreases. So when a valuation allowance is reversed, net income increases. For a reversal of $10 million, net income would increase by that amount.

Q10-12.

Tax loss carryforwards arise when a company has negative taxable income in a year. The tax laws allow companies to offset current losses against future income indefinitely, but they are capped to 80% of taxable income. The benefit is that the company will have a lower tax bill in future years IF it generates sufficient taxable income.

Q10-13.

Income tax expense is the sum of current taxes (that is, currently payable as determined from the company’s Federal, state, and foreign tax returns) plus the change in deferred tax assets and liabilities. It is a calculated figure, not a percentage that is applied to pretax income.

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MINI EXERCISES M10-14. (15 minutes) a. (in $ millions) The discount factors to determine the present value of GAP’s operating lease payments are: Year 1 2 3 4 5 >5

Discount Factor 0.94340 0.89000 0.83962 0.79209 0.74726 1.99743*

* Annuity factor for 3 years ($1,520 / $539 = 2.82 years rounded to 3) at 6% × Lump sum factor for 5 years at 6% = 2.67301 × 0.74726 = 1.99743

The present value of GAP’s operating lease payments using Excel is: A 1

YEAR

B Operating Lease Payment

1,156

$1,090.57

=PV($B$10,A2,0,-B2)

1,098

$977.22

=PV($B$10,A3,0,-B3)

892

$748.94

=PV($B$10,A4,0,-B4)

730

$578.23

=PV($B$10,A5,0,-B5)

539

$402.77

=PV($B$10,A6,0,-B6)

1,520

$1,076.62

=PV($B$10,B11,-B6,0,0)*PV(B10,A6,0,-1)

$ 4,874.35

=SUM(C2:C7)

C Present Value

D Cell formula

9 10

Discount Rate:

6.00%

Remaining life:

3.00

=B7/B6

b. GAP’s total assets and total liabilities would be increased by $4,874 million. In its income statement, rent expense of $1,156 (next year’s operating lease payment) would be unchanged.

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M10-15. (15 minutes) a. It appears that Costco has NOT yet adopted the standard. We know this because the company reports operating and CAPITAL lease obligations in its footnote. Had the company adopted the standard, the labels would have been operating and FINANCE lease obligations. b. To determine how to classify the leases, Costco would consider the following five criteria. 1. Transfer of ownership. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term. 2. Purchase option. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise. 3. Lease term. The lease term is for a major part of the remaining economic life of the underlying asset. 4. Present value. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already included in the lease payments equals or exceeds substantially all of the fair value of the underlying asset. 5. Specialized asset. The underlying asset is of such a specialized nature that the company does not expect that the asset will have any alternative use to the lessor at the end of the lease term. c. Costco describes the leased assets as membership warehouses, which could imply either operating or finance leases. However, the “thereafter” lease payments extend about 6 years ($2,215 / $358 = 6.19 years) and the capital lease payments extend about 9 years ($647 / $72 = 8.99 years). Buildings such as warehouses have longer lives than 6 or 9 years, so we might conclude that the leases are operating.

M10-16. (15 minutes) a. Stanley Black & Decker reports negative $4.3 million in pension expense for 2018. The footnote also reports the component parts of the total expense. The expected return on plan assets exceeded the other cost components and thus, the expense was an “income” for the year. b. Expected returns on plan assets are subtracted from service and interest costs and therefore, reduce reported pension expense. In 2018, expected returns reduced Stanley Black & Decker’s pension expense by $115.2 million. c. “Expected” refers to companies’ use of long-term expected average returns on the investment portfolio. Expected returns are used in the computation of pension expense rather than actual returns. This results in smoother pension expense and thus, smoother reported income. © Cambridge Business Publishers, 2021 10-5

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M10-17. (15 minutes) a. Service cost represents the present value of additional pension benefits earned by employees during the current year. These benefits will be paid to employees in the future, hence the service cost is the present value of those benefits. Interest cost is an expense that accrues on the pension obligation (PBO) during the year as the PBO increases due to the passage of time. b. Actuarial losses arise when companies make changes in their pension plan rules or make changes in actuarial assumptions which increase the PBO. These actuarial assumptions include decreases in the rate used to discount future pension payments, increases in the expected wage inflation rate, and increases in the expected life span of current and former employees. c. The funded status is $(118), calculated as the PBO minus the fair value of the plan assets ($873 PBO - $755 Plan assets). The negative amount indicates that the plan is underfunded as of 2018. YUM!’s balance sheet will show a liability for this amount.

M10-18. (15 minutes) a. The actual return of $49 million on pension assets has no effect on profits for the year. It is the expected return on pension assets that affects the pension expense that YUM! reports on its income statement. The actual return on plan assets does, however, affect the balance of the plan assets. b. Answer: v Explanation: YUM! did not recognize the $13 million cash payment as pension expense, thus option i) is incorrect. The explanation in each answer ii through iv is incorrect. The contribution was recorded as an increase in plan assets. c. The benefit payments of $73 million reduce plan assets and the PBO.

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M10-19. (15 minutes) a. Lululemon maintains a defined contribution plan for the benefit of its employees. Lululemon makes contributions to the plan by matching employee’s contributions. These cash deposits together with earnings on the amounts invested, provides the sole source of funding for payments to retirees. b. Lululemon expenses its retirement-plan contributions as they are made. c. Only the unpaid contribution required per the plan, if any, appears on the Lululemon balance sheet as a liability.

M10-20. (15 minutes) a. AT&T added a right-of-use asset of $20,960 million related to operating leases. The total asset was higher but the amount was reduced due to upfront charges and rent accruals. The net amount was added as an asset. The company also added lease liabilities amounting to $22,121 million. b. The modified retrospective method updates the balance sheet for the new lease asset and lease obligations as of the adoption date, which for AT&T was January 1, 2019. On that day, the company added assets and liabilities that were not of the same value. The difference would require an adjustment to retained earnings. As well, the company reclassified some previously deferred gains. In the end, the company increased retained earnings by a cumulative amount of $316 million. Prior years’ assets and liabilities were left unchanged, which impairs comparability. c. The effect of the adoption is as shown below. The adoption was significant, increasing total assets by about 4% and total liabilities by 5%. The effect on equity was immaterial.

Total assets Total liabilities Total equity

1/1/2019 ($ millions)

Adoption Effect ($ millions)

Adoption Effect (%)

$531,864 $445,290 $86,574

$20,960 $22,121 $316

$20,960 / $531,864 - $20,960) = 4.1% $22,121 / ($445,290 - $22,121) = 5.2% $316 / ($86,574 - $316) = 0.4%

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M10-21. (15 minutes) a. The funded status is negative $(11,303) million, which indicates an underfunded pension plan. It is, therefore, reported as a liability under current GAAP on Lockheed’s balance sheet. b. The negative funded status represents the present value of expected pension benefit payments to retirees in excess of the fair value of the assets available to pay those benefits. It is primarily a long-term liability that should be treated no differently from other debt obligations. Our analysis, therefore, focuses on the company’s ability to repay the obligations when they mature. c. The recent market upturn increased the actual return on the plan assets. By law, companies are required to fund a certain proportion of the pension obligation. When actual returns are higher, the fair value of the plan assets is higher making the required employer contribution lower. However, the Lockheed made a massive contribution of $5 billion in 2018 which is unusual.

M10-22. (15 minutes) a. Apple reports $13,372 million of tax expense in its 2018 income statement. This is the total of federal, state, and foreign taxes. b. The current portion is $45,962 million ($41,425 million + $551 million + $3,986 million). The deferred portion is $(32,590) million ($48 million + $1,181 million - $33,819 million), which decreased the total tax expense for the year. c. Companies maintain two set of books. One is maintained in conformity with GAAP and is used to prepare publicly available financial statements. The other is maintained in conformity with tax regulations, and is used to prepare the company’s tax return. Although many (but not all) revenues and expense will be recognized in the same amount for GAAP and tax purposes, they are recognized in different periods. Deferred tax liabilities and assets reflect future tax expense and deductions, respectively. As deferred tax liabilities (assets) increase, reported tax expense increases (decreases), and as deferred tax liabilities (assets) decrease, reported tax expense decreases (increases). For Apple in 2018, deferred taxes decreased total tax expense.

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M10-23. (10 minutes) a. Walmart's total tax expense for the year is $4,281 million, computed as $4,751 million $470 million. b. The company used its tax returns to determine the current portion of income tax expense, or $4,751 million. c. Deferred taxes decreased Walmart's income tax provision for the year. The deferred provision was $(470) million, a tax benefit, which is like a "negative" tax expense. When the benefit is added to the current provision, total tax expense decreased on the income statement.

M10-24. (10 minutes) Answer: c Both a and b are plausible. The tax expense equation in Appendix 10C is as follows: Tax Expense = Taxes Paid – Increase (or + Decrease) in Deferred Tax Assets + Increase (or – Decrease) in Deferred Liabilities Because the deferred portion of the expense was negative (a tax benefit), either deferred tax assets increased during the year or deferred tax liabilities decreased during the year, or both.

M10-25. (10 minutes) Tax Expense = Taxes Paid + Deferred Tax Expense Tax Expense = Taxes Paid – Increase (or + Decrease) in Deferred Tax Assets + Increase (or – Decrease) in Deferred Tax Liabilities Tax Expense = Taxes Paid – Increase in DTA $57 million + Increase in DTL $963 million Deferred Tax Expense = $906 million

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M10-26. (15 minutes) a. The company’s pension plan is large and growing. To limit the future cash flow implications, the company off-loads the pension liability to an insurance company that is better able to manage future payments. In the years leading up to the 2018 transaction, stock markets have performed well and thus, the net liability is likely at a relatively low point and the company wants to capitalize on the strong asset position. b. Employees can take a one-time cash lump sum payment OR have a retirement annuity paid by Athene Life Insurance company instead of the Bristol-Myers pension fund. c. After the transaction the net funded status will be $0 because that was the intended effect of the transaction.

M10-27. (15 minutes) a. The pension and other postretirement benefit cost includes a number of components including expected return on plan assets. The pension plan assets’ expected return for each of the three years presented must have exceeded the sum of the other cost components (service cost and interest cost) creating an income instead of a net expense. b. We would not classify the net amount. A more accurate analysis would consider the service cost component (not reported separately in the note provided) as operating and the other cost components as nonoperating. We would need to access another footnote to make that classification.

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EXERCISES E10-28. (20 minutes) a. The implicit discount rate on the capital leases can be determined using Excel as follows:

3.99%*

-4,564

463

664

636

642

554

275#

275

…

275

184^

* Cell formula: =IRR(B1:r1) = 3.99% # Remaining payments / remaining years = $2,934 million / 10.68 years = $275 per year ^ $2,934 – ($275 x 10) = $184

b. Capitalizing the operating leases for the first time added a right-of-use asset of $4,564 million and a lease liability of the same amount to Lowe’s balance sheet. c. Lowe’s will amortize the right-of-use asset from the initial balance of $4,564 million to $0 over the life of the lease. This amortization will not appear on the income statement. Rather the amount will reduce the asset balance year of year by an amount that equals the rent expense less the interest portion on the lease liability. d. Lowe’s will reduce the lease liability to $0 over the life of the lease. Each lease payment will have an interest portion (which will flow to the income statement) and a principal repayment portion, which will reduce the liability on the balance sheet. E10-29. (20 minutes) a. The company added a right-of-use asset amounting to $23,241 million on January 1, 2019. b. Verizon will amortize the right-of-use asset from the initial balance of $23,241 million to $0 over the life of the lease. This amortization will not appear on the income statement. Rather the amount will reduce the asset balance year by year by an amount that equals the rent expense less the interest portion on the lease liability c. The company amortizes the book value of the right-of-use asset (straight-line) over 12 years. In Q1 of 2019, the rental expense would be: $23,241 / 48 fiscal quarters = $ 484 million. d. The company added a lease liability amounting to $22,134 million on January 1, 2019 calculated as $2,931 million + $19,203 million. The amount differs from the right-of-use asset due to upfront fees or rental credits that the company faces at lease inception. e. Because the company did not add equivalent lease assets or liabilities to prior years, we cannot compare the balance sheet over time. © Cambridge Business Publishers, 2021 10-11

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E10-30. (25 minutes) a. TJX used the modified retrospective method, which means that the company added the right-of-use lease asset and the lease liability to its balance sheet on the first day of the fiscal year, February 3, 2019. However, the company did not adjust the prior year’s balances for comparative purposes on the balance sheet for the year ended February 2, 2019. Therefore, the analysis challenge is that the balance sheet for the first quarter ended May 4, 2019 is not comparable to the balance sheet for the fiscal year ended February 2, 2019. b. We can calculate the present value of the expected lease payments to both assets and liabilities. Assuming an 3.75% discount rate, the present value using Excel is computed as $8,860,913 thousand: A

1 2

YEAR 1

B Operating Lease Payment $ thousands 1,676,700

1,603,378

1,489,566

=PV($B$10,A3,0,-B3)

1,441,444

1,290,724

=PV($B$10,A4,0,-B4)

1,253,420

1,081,793

=PV($B$10,A5,0,-B5)

1,042,184

866,970

=PV($B$10,A6,0,-B6)

2,774,845

2,158,585

=PV($B$10,B11,-B6,0,0)*PV(B10,A6,0,-1,0)

Total

8,503,734

=SUM(C2:C7)

Present Value 1,616,096

Cell formula =PV($B$10,A2,0,-B2)

9 10

Discount Rate:

3.75%

Remaining life

2.662529

=B7/B6

c. To enhance the comparability of the TJX financial statements we could add $8,503,734 thousand to both operating assets and nonoperating liabilities. d. TJX’ assets would increase from $14,326,029 thousand to $22,829,763 thousand, a 59% increase following this adjustment, calculated as ($8,503,734 / $14,326,029). Liabilities would nearly double from $9,277,423 thousand (assets less equity: $14,326,029 thousand – $5,048,606 thousand) to $17,781,157 thousand. The modified retrospective adoption significantly impairs our ability to compare the company’s balance sheets across the two dates.

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E10-31. (20 minutes) a. Service cost represents the present value of additional pension benefits earned by employees during the current year. These benefits will be paid to employees in the future, hence the service cost is the present value of those benefits. Interest cost is an expense that accrues on the pension obligation (PBO) during the year as the passage of time increases its present value. b. During 2019, retirees received payments totaling $305.2 million. These payments came from the pension plan assets and not from General Mills’ operating cash flows. (Note: General Mill’s footnote reports slightly different amounts for the benefit payments in the Plan Assets versus the PBO. The two items should be the same amount. This appears to be a discrepancy in the published footnote.) c. Funded status is defined as the pension obligation less the fair value of the pension investments. In this case, the funded status is computed as: $6,291.6 million (pension assets) – $6,750.7 million (pension obligation) = $(459.1) million. The company’s pension plans are underfunded by $459.1 million. d. Actuarial gains (losses) are decreases (increases) to the PBO resulting from changes in the assumptions used to estimate the pension or health care liability. The assumptions include the expected wage inflation rate, mortality and termination rates, and the discount rate used to compute the present value of the obligation. Plan amendment adjustments are changes to the liability arising from amendments to the plan itself, such as the level of benefits, qualifications of employees eligible to receive benefits, or the period of time over which benefits will be paid. e. Payments to retirees come from the pension assets—they fund the future payments. General Mills’ pension plan assets yield investment returns that help provide the cash that is paid to retirees. Due to strong market conditions over the past few years, the pension assets have grown enough such that General Mills does not need to make as big a contribution as in prior years. f.

Should pension investments decline as a result of a decline in the financial markets, General Mills might be required to increase its cash contribution to the pension plan. This contribution would come from operating cash flow and/or borrowing and might impact the company’s ability to fund needed capital expenditures.

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E10-32. (20 minutes) a. Service cost represents the present value of additional pension and other benefits earned by employees during the current year. These benefits will be paid to employees in the future; hence the service cost is the present value of those benefits. Interest cost is an expense (financing) that accrues on the benefit obligation during the year, as the passage of time increases its present value. b. In 2018, Norfolk Southern recorded an “actual” return on pension investments as a loss of $162 million ($143 million loss on pension assets and a $19 million loss associated with other benefits). Each of these losses decreased their respective asset portfolios. The expected return of $177 million (not the actual return) on the pension plan assets and $15 million on the other assets impacts Norfolk Southern’s income for 2018. Pension expense is reduced by this amount. c. Actuarial gains generally arise as a result of increases in the discount rate used to compute the present value of the pension and postretirement benefit obligation. Because the pension and postretirement benefit obligations are the present value of expected future payouts to retirees, an increase in the discount rate decreases the obligation. Changes in other assumptions can also decrease the obligation, again, giving rise to an actuarial gain. d. Benefits paid to retirees come from the pension and postretirement benefit assets. There is a corresponding reduction in the pension and postretirement benefit obligations as cash payments are made. For 2018, both the pension plan and the postretirement benefit plans had sufficient assets from which to make these cash payments. e. In 2018, Norfolk Southern contributed $18 million to its pension plan and another $18 million to its postretirement benefit plan. f.

In 2018, retirees received $143 million from the Norfolk Southern pension plan and $42 million from the postretirement benefits plan. Norfolk Southern did not make these payments directly; rather, they came from the plan investments.

g. The funded status is the obligation less the fair value of the plan investments. The pension plan is underfunded by $266 million ($2,371 million - $2,105 million). The OPEB plan is underfunded by $308 million ($466 million - $158 million).

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E10-33. (20 minutes) a. Service cost represents the present value of additional pension benefits earned by employees during the current year. These benefits will be paid to employees in the future; hence the service cost is the present value of those benefits. Interest cost is an expense that accrues on the pension obligation (PBO) during the year due to the passage of time. b. During 2018, retirees received $1,475 million for pensions. These payments were made from the pension assets – the company does not pay retirees directly. Payments to retirees are made from the pension investment account. As the plan administrator pays the retirees, there is corresponding decrease in the amount owed to the retirees and thus, the benefit obligation decreases. c. The funded status is the difference between the obligation and the fair market value of the plan assets. For Verizon, the funded status of its pension plan is $(1,751) million ($17,816 million plan assets - $19,567 million PBO). This implies an underfunded pension plan. d. Verizon reports pension expense of $279 million, primarily due to the large expected returns compared to the other components. e. The company reports the pension expense on the income statement on the line item that reflects the related employees’ wages. The income statement reports expenses by function (cost of sales, SG&A, etc) rather than by type (wages, rent, etc). f.

The effect on each of the components is as follows: PBO

Pension Plan Assets

2018 Pension Expense

Discount rate used in determining benefit obligations increases

Decrease

No effect

Cannot determine*

Expected return on plan assets decreases

Increase

No effect

Increase

* While the higher discount rate (4.4% versus 3.7%) reduces the PBO, the lower PBO is multiplied by a higher rate when the company computes the interest component of pension expense. The net effect is, therefore, indeterminate.

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E10-34. (30 minutes) a. Boeing reports total income tax expense of $1,144 million in 2018, $1,649 million in 2017, and $749 million in 2016. We determine these amounts by adding the current and the deferred provisions each year. b. $ millions Total current Total income tax expense % current = total current / Total income tax expense

2018 $ 2,139 1,144 187.0%

2017 $ 1,448 1,649 87.8%

2016 $1,341 749 179.0%

The % current is over 100% in 2018 and 2016 because the deferred portion of the tax expense is negative (a benefit) in those two years. c. Boeing’s effective tax rate for each of the three years is as follows: $ millions Total income tax expense Total income before tax Effective (average) income tax rate

2018 $ 1,144 11,604 9.9%

2017 $ 1,649 10,107 16.3%

2016 $ 749 5,783 13.0%

U.S. ($ millions) U.S. federal current tax expense U.S. federal deferred tax expense U.S. federal total tax expense Total income before tax Effective (average) income tax rate

2018 $ 1,873 (996) 877 11,166 7.9%

2017 $ 1,276 204 1,480 9,660 15.3%

2016 $1,193 (544) 649 5,386 12.0%

Non-U.S. ($ millions) Non-U.S. current tax expense Non-U.S. deferred tax expense Non-U.S. total tax expense Total income before tax Effective (average) income tax rate

2018 $ 169 (4) 165 438 37.7%

2017 $ 149 3 152 447 34.0%

2016 $133 (4) 129 397 32.5%

d. Effective tax rate by jurisdiction are as follows:

We observe that the effective tax rate on U.S. profits is exceedingly low especially in 2018 (although this might be a temporary drop due to the new tax laws). The non U.S. operations have tax at a rate in the mid 30% range.

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e. Boeing’s effective cash tax rate for U.S. operations is as follows: U.S. ($ millions) U.S. federal current tax expense U.S. state current tax expense Total U.S. current tax expense Total U.S. income before tax Effective (average) cash tax rate

2018 $1,873 97 1,970 11,166 17.6%

2017 $ 1,276 23 1,299 9,660 13.4%

2016 $1,193 15 1,208 5,386 22.4%

The rate for cash taxes looks more reasonable but is still much lower than the statutory rates each year.

E10-35. (25 minutes) a. The deferred tax liability suggests that Colgate depreciates its property using an accelerated method for tax purposes, but not for GAAP purposes. This would reduce taxable income and the income tax liability. Since total depreciation over the life of the asset is independent of the depreciation method, accelerated depreciation in the earlier years of the asset’s life will be offset by lower depreciation later. That lower depreciation expense will result in higher taxable income and increased tax liability, as the deferred tax liability reflects. (It can also help to see that the GAAP book value is greater than the tax-reporting book value, which yields the deferred tax liability.) b. Colgate has accrued expenses and recorded a deferred tax liability for postretirement benefits. This liability reflects the future payments that Colgate will make to retired employees. The tax authorities do not allow companies to record these expenses until cash is paid. Thus, Colgate has no tax-reporting liability for postretirement benefits. Deferred tax assets arise when tax-reporting liabilities are less than financial reporting liabilities. In the future, this will reverse, resulting in the tax asset being used up. The deferred tax asset reflects future tax deductions and the consequent lower tax payments. c. When companies report losses on their tax returns, they can be carried forward indefinitely to offset future taxable income (to a maximum of 80% of taxable income in any one year). These are called tax loss carryforwards. Tax loss carryforwards will reduce Colgate’s future tax liability and, therefore, meet the test of an asset, but only if the company reports future taxable income. If no future income occurs, the tax loss carryforwards will not be realized—they will expire unused. Thus, for the company to record a deferred tax asset, it must be more likely than not to make sufficient profits in the future.

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Balance Sheet

(in millions) Transaction

Cash Asset

Noncash = Assets

TE 906 DTA 45 TP 8 DTL 112 Cash 847 TE 906

Record deferred tax expense

DTA 45

- 847 Cash

DTL 112

45 Deferred = Tax Assets

Cash 847

Liabilities

Income Statement Contrib. Capital

-8 Income Taxes Payable 112 Deferred Tax Liabilities

Earned Capital

- 906 Retained Earnings

Revenues

–

Expenses

Net Income

–

+906 Income Tax Expense

- 906

TP 8

Adjustments: Increase of $45 in Deferred Tax Assets, computed as $828 - $783. Increase of $112 for Deferred Tax Liabilities, computed as $911 - $799.

E10-36. (20 minutes) a. The graphic on the top left shows that the present value of operating leases is increasing over this and that this is consistent year over year. Given that these data come from the period before the new lease standard, we have increasingly more hidden debt. This impairs our ability to see the true level leverage for the average firm over time. b. The pie chart in the bottom right shows that Consumer Discretionary has the most leases across the time period. These are primarily retail companies that lease large store spaces in malls and big box locations. c. The graph of the top left displays the average lease by sector (compared to the pie chart on the bottom right that displays the total leases for all sectors). We see that telecommunications has the largest average operating leases. These assets relate to telecom equipment such as cell towers and all the related infrastructure. These are enormous assets in both physical size and monetary value. d. In the pie chart (lower left) the section marked “thereafter” represents all payments in year 6 and beyond. If we assume that the 5th year payment is made indefinitely, then the relative size of the 5 th year to the “thereafter” will give an indication of lease term. By clicking on the sectors in the adjacent pie chart, we will see the “thereafter” by sector – consumer discretionary has the largest “thereafter” sector and we can conclude that that sector has the longest leases.

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E10-37. (20 minutes) a. The graphic on the top right shows that industrial have the largest PBO / liabilities. These firms are heavy manufacturing often with unionized workers that have defined benefit plans (or at least legacy plans). b. We see that PBO has increased over time with a dip in 2018. More firms are off-loading their defined benefit plans with one time cash buyouts or fixed annuity plans administered by a third party such as an insurance company. To determine the year with the highest PBO, click on a sector bar in the top left graph and view the top middle panel to find the highest year for that sector. 2017 is the highest year for PBO across all of the sectors and is highest for all sectors except as follows: •

Consumer staples – highest in 2016

•

Telecom – highest in 2011

•

Utilities – highest in 2014

•

Consumer discretionary – highest in 2014

•

Energy – highest in 2018

•

IT – highest in 2016

c. By comparing the size of the PBO to the funded status, we observe a nearly complete negative correlation. The larger the PBO the less the company has funded. This makes sense because companies typically only contribute to the pension plan when required to do so by law or when there are other compelling reasons to do so such as tax law incentives. d. The actual returns on pension plans increase the pension assets, the expected returns affect the income statement. When the bars are below the line it means that the company overestimated the amount of profit and gains the pension asset would earn. When the bars are above the line, the company has underestimated the assets’ return. Across the time period, companies underestimate expected return, on average. e. As we would expect, payments for health care are much less than for pension plans. The magnitude across all sectors is about 1:8 for health care to pension. To see this, hover over the pie chart and pop-up displays 89% as the median of pension benefits paid across all sectors. The proportions of pension to healthcare benefits vary by industry but are roughly the same except for Telecom (60%/40%), Information Technology (96%/4%), and Real Estate (100%/0%). To see this, set a filter for Sector and then move down the list of Sectors, selecting each sector individually to display the pie chart for that sector only.

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PROBLEMS P10-38. (40 minutes) a. The right-of-use asset gives the lessee the right to use an asset over its life. Right-of-use assets convey benefit by providing exclusive access to the asset. For example, a right-ofuse asset related to rental property means the lessee can enjoy using the property and exclude others from doing so. b. On March 31, 2019 the company reported an operating lease liability of $2,413 million. Part of this was included in current liabilities and the remainder in long-term liabilities. c. Goldman Sachs calculated the present value of the company’s operating lease payments to determine the value of the liability. d. We can calculate the present value using the assumptions provided by Goldman Sachs. This yields at a total amount of $2,568 million, which is slightly higher than the $2,413 reported by the company. A

1 2

YEAR

Operating Lease Payment

Present Value

Cell formula

318

303

=PV($B$10,A2,0,-B2)

341

310

=PV($B$10,A3,0,-B3)

262

227

=PV($B$10,A4,0,-B4)

235

194

=PV($B$10,A5,0,-B5)

204

161

=PV($B$10,A6,0,-B6)

193

145

=PV($B$10,A7,0,-B7)

Thereafter

2,494

1,228

=PV($B$10,B11,-B12,0,0)*PV(B10,A7,0,-1,0)

2,568*

=SUM(C2:C8)

9 10

Discount Rate:

Remaining life Payment thereafter

4.85% 18.00 138

=B8/B11

* The =SUM function is not rounded in Excel and yields $2,568. The numbers above are rounded and sum to $2,570.

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e. Goldman Sachs’ rents real estate for office space. The company added a right-of-use asset on January 1, 2019 and the value of the asset was of $2,386 million by the end of the first quarter. f.

The difference between the right-of-use asset and the lease liability relates to any upfront cash fees the company paid for the leases or any lease sub-rental payments at inception.

g. We can calculate the present value for December 2018 using the assumptions provided by Goldman Sachs for March 2019. We arrive at a total amount of $1,641 million. A

1 2

YEAR

Operating Lease Payment 281

Present Value 268

Cell formula

6 7

5 Thereafter

271

247

218

189

177

146

142

112

1,310

679 1,641

8 9

Discount Rate:

Remaining life Payment thereafter

=PV($B$9,A2,0,-B2) =PV($B$9,A3,0,-B3) =PV($B$9,A4,0,-B4) =PV($B$9,A5,0,-B5) =PV($B$9,A6,0,-B6) =PV($B$9,B10,-B11,0,0)*PV($B$9,A6,0,-1,0) =SUM(C2:C7)

4.85% 18.00 72.78

=B8/B11

h. We can add the present value of the future lease payments ($1,641 million) to the asset side and liability side of Goldman Sachs’ balance sheet in order to enhance inter-period comparability.

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P10-39. (45 minutes) a. The leased asset is office space and with a lease term of 5 years, the value of the leased asset is not being conveyed to CCH. Therefore this is an operating lease (consistent with most leases for office, retail, or production space). b. We can use Excel and the PV function to determine that the present value of the future lease payments as follows: =PV(5%,5,115,487,0,0) = $500,000. c. CCH Corporation will add $510,000 to the balance sheet as a right-of-use asset. This includes the $500,000 present value of future lease payments along with the $10,000 up front fees paid at the lease inception. d. The lease amortization schedule follows: e.

Implicit Interest (Lease Liability, Start x 5%)

Lease Amortization (Lease payment – Implicit interest)

Lease Liability, End (Lease Liability, Start – Lease Amortization)

Year

Lease Liability, Start

500,000

25,000

90,487

409,513

20,476

95,012

314,501

15,725

99,762

214,738

10,737

104,750

109,988

5,499

109,988

―

The financial statement effects template shows the transactions for the first two years. Balance Sheet Transaction

Cash Asset

Noncash = Assets

Liabilities

510,000

Income Statement Contrib. Capital

Earned Capital

Revenues

–

Expenses

Net Income

ROU 510,000 LL 500,000 Cash 10,000

Record lease - 10,000 at inception Cash

Right-of- = use asset

500,000 Lease Liability

RE 115,487 LL 90,487 Cash 115,487 ROU 92,487

Year 1 lease payment and - 115,487 lease Cash amortization

-92,487 Right-of- = use asset

-90,487 Lease Liability

-117,487 Retained Earnings

117,487 Rent Expense

-117,487

RE 115,487 LL 95,012 Cash 115,487 ROU 97,012

Year 2 lease payment and - 115,487 lease Cash amortization

-97,012 Right-of- = use asset

-95,012 Lease Liability

-117,487 Retained Earnings

117,487 Rent Expense

-117,487

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g. The table below presents future lease payments.

2021 2022 2023 2024 2025 Thereafter Total undiscounted lease payments Imputed interest Total operating lease liability

December 2020 $ 115,487 115,487 115,487 115,487 461,948 (52,437) $409,511

Weighted average remaining lease life Weighted average discount rate

4 years 5%

h. To enhance comparability we could reclassify the rent expense of $117,487 as interest expense (from the amounts in the lease amortization table, in part d, above) and amortization of the ROU asset (the principal portion from the lease amortization table above PLUS the upfront fee of $10,000 divided by the lease term of 5 years.) These are the amounts shown for the first two years, in part e, above.

P10-40. (45 minutes) a. The first leased asset is land that the company will convert to an RV park. The lease term is 15 years, the value of the leased asset is not being conveyed to Alexander Mack because land lasts longer than 15 years. Therefore, this is an operating lease (consistent with most leases for office, retail, or production space). The second lease is computer equipment and two facts indicate that this is a finance lease: 1) the lease term of 4 years will cover the bulk of the computer equipment’s life and 2) the bargain purchase option at the end of the lease term. b. We can use Excel and the PV function to determine that the present value of the future lease payments for both leases. This will represent the amount of lease liability that Alexander Mack will add to its balance sheet. The formulas are as follows: Operating lease =PV(9%,15,-500,000,0,0) = $4,030,344 Finance lease = PV(9%,4,-24,694,0,0) = $80,000

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c. Operating lease: Alexander Mack will add $4,480,344 to the balance sheet as a right-of-use asset. This includes the $4,030,344 present value of future lease payments (above) along with the $450,000 up front fees paid at the lease inception. Finance lease: the company will add $85,000 to the balance sheet as PPE. This includes the $80,000 present value of future lease payments and the $5,000 upfront fees at the inception of the lease. d. The operating lease amortization schedule follows: Implicit Interest (Lease Liability, Start x 9%)

Lease Amortization (Lease payment – Implicit interest)

Lease Liability, End (Lease Liability, Start – Lease Amortization)

Year

Lease Liability, Start

4,030,344

362,731

137,269

3,893,075

350,377

149,623

3,743,452

336,911

163,089

3,580,363

322,233

177,767

3,402,595

306,234

193,766

3,208,829

288,795

211,205

2,997,623

269,786

230,214

2,767,410

249,067

250,933

2,516,476

226,483

273,517

2,242,959

201,866

298,134

1,944,826

175,034

324,966

1,619,860

145,787

354,213

1,265,647

113,908

386,092

879,556

79,160

420,840

458,716

41,284

458,716

The finance lease amortization schedule follows:

Year

Lease Liability, Start

Implicit Interest (Lease Liability, Start x 9%)

Lease Amortization (Lease payment – Implicit interest)

Lease Liability, End (Lease Liability, Start – Lease Amortization)

80,000

7,200

17,493

62,507

5,626

19,068

43,439

3,909

20,784

22,655

2,039

22,655

―

e. The operating lease for land will create a rent expense for the lease payment of $500,000 plus $30,000 per year (the upfront cost of $450,000 divided by the lease term of 15 years). The total rent expense each period will be $530.000.

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The finance lease for the equipment will create interest expense of $7,200 (from the amortization table above) and straight-line depreciation of $21,250 (= $85,000/4) on the PPE asset, for a total expense of $28,450. The expense will decrease over time because the interest declines each year.

g. At the end of 2020, the company would make the following disclosure: At the end of the fiscal year, remaining operating lease payments were as following:

2021 2022 2023 2024 2025 Thereafter Total undiscounted lease payments Imputed interest Total operating lease liability

December 2020 $ 500,000 500,000 500,000 500,000 500,000 4,500,000 7,000,000 (3,106,925) $3,893,075

Weighted average remaining lease life Weighted average discount rate

14 years 9%

h. The ROU asset and the lease liability would have the following balances at the end of 2021: Operating lease: Asset = $4,133,452 calculated as $4,480,344 less two years of principal payments ($137,269 and $149,623 from the table in part d., above) and less two years of amortization of the up-front costs ($450,000 × 2/15). Liability = $3,743,452 per the table in part d. Finance lease: Asset = $85,000 – 2 × $21,250 = $42,500. Liability = $43,439 per the table in part d. i.

To enhance comparability, we could convert the operating leases to be equivalent on the income statement to the finance lease. We would replace the rent expense of $530,000 with interest expense (from the amounts in the lease amortization table, in part d, above) and SL amortization of the ROU asset ($4,480,344/15). © Cambridge Business Publishers, 2021 10-25

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P10-41. (50 minutes) a. From the footnote we can determine that DowDuPont’s income statement includes pension expense of $58 million for 2018. DowDuPont’s footnotes call this “Net periodic benefit cost.” The reason that the company reports such a small pension cost is that DowDuPont’s pension assets are generating expected returns that far exceed its estimated service and interest costs. b. The expected return is computed as the beginning fair market value of the pension plan assets multiplied by the long-term expected return on these plan assets. Both of these are disclosed in the pension footnote. If DowDuPont had not changed its expected return on plan assets, the expected return would have been .0694 x $43,685 million = $3,032 million. In contrast to the $2,846 million of expected gain on plan investments (used to compute pension expense for 2018), the plan assets reported an actual loss of $1,524 million. If DowDuPont used actual returns instead of expected returns, company profits would fluctuate with investment market swings. The logic behind using the long-term expected rate is that investment returns are expected to fluctuate around this average, and its use presumably more accurately captures the average cost of the pension plan. It is similar to the logic of reporting held-to-maturity debt securities at historical cost rather than current market value. c. The pension liability increased during 2018 by the $651 million service cost and the $1,638 million interest cost and decreased by $3,223 million in payments made to plan participants. Also during 2018, DowDuPont experienced a $2,832 million actuarial gain arising from changes in assumptions used to compute future obligations, including changes to the discount rate and/or the rate of expected wage inflation. This actuarial gain decreased DowDuPont’s pension liability. Foreign exchange rate changes decreased the liability by a significant amount: $627 million. Other smaller changes resulted from plan participants’ contributions and amendments to the plan. Overall, the PBO decreased in 2018 by $4,387 million. The pension plan assets decreased by $1,524 million from actual investment losses and increased by $2,964 million from DowDuPont’s contributions during the year. The plan’s assets decreased by $3,223 million in benefits paid to plan participants. Pension assets decreased by $462 million due to foreign exchange losses. d. “Funded status” is the excess or deficiency of the pension obligation over plan assets. If plan assets exceed pension obligations, the funded status is positive (overfunded). If plan assets are less than pension obligations, the funded status is negative (underfunded). DowDuPont’s pension plan is underfunded by $11,552 million at year-end 2018. Pension obligations are $53,014 million and pension assets are $41,462 million.

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e. Balance sheet effect: Because the pension obligation is the present value of expected future pension payments, an increase in the discount rate decreases the present value (PBO) reported on the balance sheet. Income statement effect: The effect on the income statement is more difficult to predict as we must examine two effects. The interest cost component of pension expense is the product of the beginning of the year pension obligation and the discount rate. The effect of an increase in the discount rate is to apply a higher discount rate to a higher pension obligation. These two effects are offsetting and thus we cannot definitively know which dominates. f.

DowDuPont contributed $2,964 million cash to its pension plan in 2018. These payments directly affect the company’s cash flow. Note: The payment of benefits to retirees is made from plan assets and does not have a direct effect on the company’s cash flow.

g. Returns on pension assets are inversely related to the amount that DowDuPont must contribute to the pension plans. Should pension investments decline as a result of a decline in the financial markets, DowDuPont might be required to increase its cash contribution to the pension plan. This contribution would come from operating cash flow and/or borrowing and might impact its ability to fund needed capital expenditures.

P10-42. (50 minutes) a. Johnson & Johnson reported pension expense (called net periodic benefit cost) of $923 million for 2018 and other postretirement expense of $502 million. b. The expected return is computed as the beginning fair market value of the pension plan assets multiplied by the long-term expected return on these investments. For 2018, this is computed as $28,404 million  8.46% = $2,403 million, slightly higher than the reported $2,212 million. In contrast to the $2,212 million of expected return on plan assets that is used in computing pension expense for 2018, plan assets report an actual LOSS of $1,269 million, a fairly significant difference. If JNJ used actual returns instead of expected returns, company profits would fluctuate with investment-market swings. The logic behind using the long-term expected rate is that investment returns are expected to fluctuate around this average and its use would more accurately capture the average cost of the pension plan. It is similar to the logic of reporting held-to-maturity debt securities at historical cost rather than current market value. © Cambridge Business Publishers, 2021 10-27

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c. The pension liability increased by $1,283 million in service costs and $996 million in interest costs and decreased by $1,018 million in payments made to retirees. During 2018, JNJ revised the actuarial assumptions used to compute its pension liability, including a change in the discount rate, rate for expected long-term rate of return on plan assets and rate of increase in compensation levels. These changes decreased JNJ’s pension liability by $2,326 million (this is called an actuarial gain). The company also had a $528 million decrease in the PBO during the year from exchange rates – the increase implies that the dollar strengthened during 2018 vis-à-vis the currencies that dominate J&J’s pension obligation. The pension plan assets decreased by $1,269 million from losses on the plan asset portfolio and increased by $1,140 million from JNJ’s contributions during the year. The plan assets decreased by $1,018 million for benefits paid to plan participants. Exchange rate fluctuations (a stronger US dollar) decreased the value of the company’s plan assets by $475 million. d. “Funded status” refers to the difference between the pension obligation and plan assets. If plan assets exceed the pension obligation, the funded status is positive (overfunded). If plan assets are less than the pension obligation, the funded status is negative (underfunded). Johnson & Johnson’s pension plan is underfunded by $4,852 million at the end of 2018. Pension obligations are $31,670 million and pension assets are $26,818 million. JNJ’s health care plan is almost entirely unfunded ($4,300 million). Health care obligations amount to $4,480 million, while plan assets are a mere $180 million. Companies typically do not fund health care obligations unless they receive a tax benefit from contributions or it is required by law. e. Balance sheet effect: Because the pension obligation is computed as the present value of expected future pension payments, a decrease in the discount rate increases the present value of that obligation reported on the balance sheet. Income statement effect: The effect on the income statement is more difficult to predict. The interest cost component of pension expense is the product of the beginning of the year pension obligation and the discount rate. The effect of a reduction in the discount rate is to apply a lower discount rate to a higher pension obligation. These two effects are offsetting. In general, the interest rate effect dominates, and a decrease in the discount rate generally decreases pension expense.

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JNJ’s cash flow was affected by the company’s contribution of $1,140 million cash to its pension plan. During 2018, JNJ also paid $282 million to its health care plan. Note that the cash payment of benefits to retirees is made from plan assets and does not have a direct effect on JNJ’s cash flow. Only the contributions to the pension plan affect the company’s cash flow.

g. The plan asset are so small for Other benefits because the company is not required by law to fund these plans and so most companies do not do so. h. During 2018, JNJ revised the actuarial assumptions used to compute its pension liability, including a change in the discount rate, rate for expected long-term rate of return on plan assets and rate of increase in compensation levels. These changes decreased JNJ’s pension liability by $2,326 million (this is called an actuarial gain). The actuarial gain is reported in other comprehensive income and does not have a direct income statement effect, but because it reduces the PBO it indirectly reduces the interest component of the pension cost for the year and thereby does affect net income.

P10-43. (30 minutes) a. During the most recent fiscal year, Snapchat’s deferred tax assets increased by $352,576 thousand ($1,501,830 thousand - $1,149,254 thousand). The two biggest increases occurred with net operating losses, which increased by $376,114 thousand (from $473,110 to $849,224 thousand), and with tax credit carryforwards, which increased by $111,222 (from $124,078 thousand to $235,300 thousand). b. The deferred tax liability reported in 2017 arose from a lower tax basis for PPE versus its basis for financial reporting. c. As of December 31, 2018, the company believed that all of the deferred tax assets would expire unused. During 2018 there was a significant increase in the valuation allowance – the allowance is larger than the deferred tax assets in total. This warrants further analysis of the tax footnote. d. Changes to the valuation allowance account affect net income in an equal and opposite way. Because the allowance increased by $357,803 thousand during the year, net income decreased (tax expense increased) by that same amount for the year.

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e. Balance Sheet

Income Statement

(in thousands) Transaction TE 2547 DTA 352576 DTL 5883 Record tax expense, part TP 755 Cash 3958 cash and part deferred Val All 357803

Cash Asset

- 3,958 Cash

Noncash Assets +352,576 Deferred Tax Assets -357,803 Valuation Allowance

Liabilities

Contrib. Capital

Earned Capital

-5,883 Deferred Tax Liability

- 2,547 Retained Earnings

-755* Taxes Payable

Revenues

–

Expen -ses

Net Income

–

+2,547 Tax Expense

- 2,547

*The plug ($755) is to taxes payable, as indicated in the problem.

P10-44. (20 minutes) a. Oracle reports $1,185 million of tax expense in its 2019 income statement. The “current” portion of $2,376 million is the amount the company paid during the year or anticipates paying in 2020. b. A deferred tax liability relating to intangible assets arises because Oracle is amortizing these assets more quickly for tax purposes than for financial reporting purposes. Since the same total amount of amortization expense is reported for both GAAP and tax over the life of the asset, the excess amortization in the early years for tax purposes will be offset by lower amortization in the later years, thus increasing taxable income and the taxes owing. It is this expected tax liability that Oracle is accruing in 2019 with its deferred tax liability. If Oracle adds more and more intangible assets, the first-year accelerated amortization will offset the lower amortization on the older intangibles. And, if Oracle adds these new assets fast enough (such as with a growth company), the deferred tax liability can be deferred indefinitely, at least until the new asset additions begin to slow. We observe that the deferred tax liability decreases in 2019, thus we can conclude that Oracle is slowing down on acquiring new intangible assets. c. Deferred tax assets arise when expenses are recognized for financial reporting purposes that are not yet deductible for tax purposes. In this case, Oracle has accrued employee compensation expenses that are not deductible for tax purposes until they are paid.

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d. A reported loss for tax purposes can be carried forward indefinitely to reduce future taxable income. Oracle will realize the benefits of loss carryforwards to the extent that it reports future taxable income that can offset the loss carryforwards. e. If it is more likely than not that the future benefit of a deferred tax asset will not be realized, the company must reduce the deferred tax asset by a valuation allowance account. This is similar to recording an impairment on the asset. During 2019, the valuation allowance decreased by $42 million ($1,308 million - $1,266 million). This increased net income by $42 million in 2019. The benefits from the losses carried forward will be realized if and when Oracle reports taxable income in the same tax jurisdictions where the losses originally arose. If the company does not expect sufficient income in the future in that tax jurisdiction to absorb the loss carryforward, then an allowance is created. If an allowance is created and later the company feels that the benefit is now likely to be realized, it can reverse the allowance account. Doing so will increase deferred tax assets and reduce income tax expense. f.

The effective income tax rates are as follows:

Total tax provision Income before tax provision Effective tax rate

2019 $ 1,185 12,268 9.7%

2018 $ 8,837 12,424 71.1%

2017 $ 2,228 11,680 19.1%

g. The largest difference between the tax rate in fiscal 2017 compared to 2018 is due to the TCJA tax law of 2017. Because Oracle is a non-calendar year firm, part of the tax effects were in the 2018 fiscal year and part in 2019 fiscal year. The large increase owes to the foreign income being taxed regardless of repatriation. h. The income tax rates would have been significantly different if not for the new tax law changes. Calculations are as follows:

Total tax provision One time transition tax Deferred tax effect Restated tax expense Income before tax provision Effective tax rate - restated

2019 1,185 529 (140) 1,574 12,268 12.8%

2018 8,837 (7,781) 911 1,967 12,424 15.8%

2017 2,228 ― ― 2,228 11,680 19.1%

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P10-45. (30 minutes) a. 2018 $ 473 234 $ 707

Current tax Deferred tax Total tax

2017 $ 17,156 (26,205) $ (9,049)

2016 $ 1,822 (700) $ 1,122

b. Total tax Income from continuing operations before provision/(benefit) for taxes Effective tax rate

2018 $707

2017 $(9,049)

2016 $1,122

11,885 5.9%

12,305 -73.5%

8,351 13.4%

Current tax -- US and state Deferred tax -- US and state TCJA taxes Total US and state taxes Income from US operations Effective US tax rate

2018 $ 677 (1,647) (596) (1,566) (4,403) 35.6%

2017 $ 1,312 (2,368) (10,660) (11,716) (6,879) 170.3%

2016 $ 290 (525) ― (235) (8,534) 2.8%

Current tax -- US and state Deferred tax -- US and state Total US and state taxes

2018 $ (3,035) 2,439 $ (596)

2017 $ 13,135 (23,795) $ (10,660)

The TCJA reduced tax expense in 2018 and 2017 by $596 million and $10,660 million, respectively. e. The items that affect taxes in 2017 are as follows: (i)

US corporate tax rate falls from 35% to 21% -- the company owes less taxes BUT the value of all deferred tax items also falls.

(ii)

the impact on valuation allowances and other state income tax considerations – the valuation allowance required for a lower deferred tax asset increases taxes (but that will be offset by the decrease in the deferred tax asset itself)

(iii)

the company must pay tax on all foreign earnings even if the company has no intention of actually repatriating the earnings

(iv)

future taxes on global intangible low-taxed income – Tax law changes that decrease future taxes.

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IFRS APPLICATIONS I10-46. (50 minutes) a. Nutrien reported pension expense of $52 million for 2018. b. The pension liability increased by $67 million in service costs and by another $347 million for pension obligations acquired in a merger during the year. The liability also increased by $77 million in interest costs and decreased by $114 million in payments made to plan participants. During 2018, Nutrien revised certain actuarial assumptions used to compute its pension liability. These changes decreased Nutrien’s pension liability by $157 million (which was included in pension expense) and by an additional $210 million (which did not flow to the income statement during the year). The company also had a $39 million decrease in the liability during the year from exchange rates – the increase implies that the Canadian dollar strengthened during 2018 vis-à-vis the currencies that dominate Nutrien’s pension obligation. The pension plan assets increased by $205 due to the merger and by $53 million from employer contributions. The assets decreased by negative returns of $149 million. The assets decreased by $114 million for benefits paid to plan participants. Exchange rate fluctuations (a strengthening Canadian dollar) decreased the value of the company’s plan assets by $27 million. c.

“Funded status” refers to the difference between the pension obligation and plan assets. If plan assets exceed the pension obligation, the funded status is positive (overfunded). If plan assets are less than the pension obligation, the funded status is negative (underfunded). Nutrien’s pension plan is underfunded by $381 million at the end of 2018. Pension obligations are $1,797 million and pension assets are $1,416 million.

d. Balance sheet effect: Because the pension obligation is computed as the present value of expected future pension payments, an increase in the discount rate decreases the present value of that obligation reported on the balance sheet. Income statement effect: The effect on the income statement is more difficult to predict. The interest cost component of pension expense is the product of the beginning of the year pension obligation and the discount rate. The effect of an increase in the discount rate is to apply a higher discount rate to a lower pension obligation. These two effects are offsetting. In general, the interest rate effect dominates, and an increase in the discount rate generally increases pension expense. e. Nutrien’s cash flow was affected by the company’s contribution of $53 million cash to its pension plan. Note that the cash payment of benefits to retirees is made from plan assets and does not have a direct effect on Nutrien’s cash flow. Only the contributions to the pension plan affect the company’s cash flow. © Cambridge Business Publishers, 2021 10-33

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I10-47. (50 minutes) a. Tax expense in 2018 was €2,575 million. Of this, €2,220 million was paid during the year or is currently payable. b. Total tax expense €2,575 million divided by profit before income tax €9,815 million = 26.2% effective tax rate. c. The marginal tax rate is approximated by the German statutory rate of 30.8% as reported in the footnote. d. The company reports a net deferred tax liability of €216 million (liabilities of €1,806 million – assets of €1,590 million). e. A deferred tax liability related to PPE arises when the company depreciates PPE assets more quickly for tax purposes than for financial reporting purposes. An asset arises when financial depreciation is faster than tax depreciation. In different jurisdictions around the world, the relative rates of depreciation differ as do tax laws. So in some countries the PPE gives rise to a deferred tax liability and in other countries, it is an asset. IFRS does not permit netting across taxable jurisdictions. f.

Loss carryforwards are only valuable if the company will be able to generate income in the future to offset the past losses. The valuation allowance signals that BMW is not certain of the benefit in all jurisdictions.

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Module 11 Cash Flows QUESTIONS Q11-1.

Cash equivalents are short-term, highly liquid investments that firms acquire with temporarily idle cash to earn interest on these excess funds. To be classified as a cash equivalent, an investment must be (1) easily convertible into a known cash amount and (2) close enough to maturity so that its market value is not sensitive to interest rate changes (generally, investments with initial maturities of three months or less). Three examples of cash equivalents are Treasury bills, commercial paper (short-term notes), and money market funds.

Q11-2.

Cash equivalents are included with cash in a statement of cash flows because the purchase and sale of such investments are considered to be part of a firm's overall management of cash rather than a source or use of cash. Similarly, as statement users evaluate cash flows, it may matter very little to them whether the cash is on hand, deposited in a bank account, or invested in cash equivalents.

Q11-3.

Operating activities: Inflow: Cash received from customers Outflow: Cash paid to suppliers and service providers Investing activities: Inflow: Sale of equipment or investments such as stocks and bonds Outflow: Purchase of equipment or stocks and bonds Financing activities: Inflow: Issuance of stock or debt Outflow: Payment of dividends, repurchase of stock, or repayment of debt

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Q11-4.

a. Investing; outflow b. Investing; inflow c. Financing; outflow d. Operating (direct method, not shown separately under indirect method); inflow. e. Financing; inflow f.

Operating (direct method, not shown separately under indirect method); inflow.

g. Operating (direct method, shown as supplemental information under indirect method); outflow. h. Operating (direct method, not shown separately under indirect method); inflow. Q11-5.

This is a noncash investing and financing event. It must be reported in a supplementary schedule to the statement of cash flows.

Q11-6.

Noncash investing and financing transactions are disclosed as supplemental information to a statement of cash flows because a secondary objective of cash flow reporting is to present information about investing and financing activities. Noncash investing and financing transactions generally affect future cash flows. Issuing bonds payable to acquire equipment, for example, requires future cash payments for interest and principal on the bonds. On the other hand, converting bonds payable into common stock eliminates future cash payments related to the bonds. Knowledge of these types of events, therefore, should be helpful to users of cash flow data who wish to assess a firm's future cash flows.

Q11-7.

A statement of cash flows helps external users assess the amount, timing, and uncertainty of future cash flows to the enterprise. These assessments help users evaluate their own future cash receipts from their investments in, or loans to, the firm. A statement of cash flows shows the periodic cash effects of a firm's operating, investing, and financing activities. Distinguishing among these different categories of cash flows helps users compare, evaluate, and predict cash flows. With cash flow information, creditors and investors are better able to assess a firm's ability to settle its liabilities and pay its dividends. Over time, the statement of cash flows permits users to observe and analyze management's investing and financing policies. A statement of cash flows also provides information useful in evaluating a firm's financial flexibility (which is its ability to generate cash to respond to unanticipated needs and opportunities).

Q11-8.A

The direct method presents the net cash flow from operating activities by showing the major categories of operating cash receipts and cash payments (such as cash received from customers, cash paid to employees and suppliers, cash paid for interest, and cash paid for income taxes). The indirect (or reconciliation) method, in contrast, presents the net cash flow from operating activities by applying a series of adjustments to the accrual net income to convert it to a cash basis.

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Q11-9.

Under the indirect method, depreciation is added to net income because as a noncash expense, it was deducted in computing net income. Adding depreciation to net income, therefore, eliminates it from the cash basis income amount. Amortization and depletion expenses are also added back to net income under the indirect method.

Q11-10.

Under the indirect method, the $98,000 cash received from the sale of the land will appear in the cash flows from investing activities section of the statement of cash flows. In addition, the $28,000 gain from the sale will be deducted from net income as one of the adjustments made to determine the net cash flow from operating activities.

Q11-11.

Net Income Add (Deduct) Items to Convert Net Income to Cash Basis Depreciation Accounts Receivable Decrease Inventory Increase Accounts Payable Decrease Income Tax Payable Increase Net Cash Provided by Operating Activities

$ 99,000 12,000 13,000 (9,000) (3,500) 1,500 $113,000

Q11-12.

The separate disclosures required for a company using the indirect method in the statement of cash flows are (1) cash paid during the year for interest (net of amount capitalized) and for income taxes, (2) all noncash investing and financing transactions, and (3) the policy for determining which highly liquid, short-term investments are treated as cash equivalents.

Q11-13.

The statement of cash flows will show a positive net cash flow from operating activities if operating cash receipts exceed operating cash payments. This could happen, for example, if noncash expenses (such as depreciation and amortization) exceed the net loss. It would also happen if operating cash receipts exceed sales by more than the loss or if operating cash payments are less than accrual expenses by more than the loss (or some combination of these events).

Q11-14.A + =

Sales Accounts receivable decrease Cash received from customers

$925,000 14,000 $939,000

+ =

Wages expense Wages payable decrease Cash paid to employees

$ 86,000 1,100 $ 87,100

+ =

Advertising expense Prepaid advertising increase Cash paid for advertising

$ 43,000 1,600 $ 44,600

Q11-15.A

Q11-16.A

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Q11-17.A Under the direct method, the $5,100 cash received from the sale of equipment will appear in the cash flows from investing activities section of the statement of cash flows. There is no loss on disposal reported in the operating activities section because the direct method is used. However, this loss would be included in supplemental disclosures as a reconciling item under the indirect method. Q11-18.A The separate disclosures required for a company using the direct method in the statement of cash flows are (1) a reconciliation of net income to net cash flow from operating activities, (2) all noncash investing and financing transactions, and (3) the policy for determining which highly liquid, short-term investments are treated as cash equivalents. Q11-19.

The operating cash flow to current liabilities ratio is calculated by dividing a firm’s net cash flow from operating activities by average current liabilities. This ratio is a measure of a firm's ability to liquidate its current liabilities with cash generated from operations.

Q11-20.

The operating cash flow to capital expenditures ratio is calculated by dividing a firm's net cash flow from operating activities by its annual capital expenditures. A ratio below 1.00 means that the firm's current operating activities do not provide enough cash to cover the capital expenditures. A ratio above 1.0 is normally considered a sign of financial strength.

Q11-21. Operating Cash Flow

Investing Cash Flow

Financing Cash Flow

Life-Cycle Stage

–

Growth (late)

–

Maturity

–

Introduction

–

Decline

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MINI EXERCISES M11-22. (10 minutes) a. Cash inflow from an operating activity. b. Cash inflow from an investing activity. c. Cash outflow from an investing activity. d. Cash outflow from an operating activity. e. Cash inflow from a financing activity. f.

Cash outflow from a financing activity.

g. Cash outflow from an investing activity. h. Cash outflow from an operating activity.

M11-23. (10 minutes) a. Change in accounts payable

Operating

b. Repayment of debt

Financing

c. Stock-based compensation

Operating

d. Proceeds from issuance of common stock

Financing

e. Change in inventories

Operating

Investing

Purchase of property and equipment

g. Acquisitions, net of cash acquired

Investing

h. Net loss

Operating

Depreciation

Operating

Purchase of marketable securities

Investing

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M11-24. (15 minutes)—Indirect Method Net Income Add (Deduct) Items to Convert Net Income to Cash Basis Depreciation Gain on Sale of Investments Accounts Receivable Increase Inventory Increase Prepaid Rent Decrease Accounts Payable Increase Income Tax Payable Decrease Net Cash Provided by Operating Activities

$ 40,000 9,000 (11,000) (10,000) (6,000) 1,000 5,000 (2,000) $ 26,000

M11-25. (15 minutes)—Indirect Method Increase or decrease during the year

Balance sheet item Trade receivables, net

Increase

Inventories

Increase

Other assets

Decrease

Accounts payable

Decrease

Accrued income taxes, net

Decrease

Long-term tax liabilities

Increase

Other liabilities

Increase

M11-26. (15 minutes)—Direct Method a. Rent Expense – Prepaid Rent Decrease = Cash Paid for Rent

$ 65,000 (3,000) $ 62,000

b. Interest Income – Interest Receivable Increase = Cash Received as Interest

$ 15,500 (800) $ 14,700

c. Cost of Goods Sold + Inventory Increase + Accounts Payable Decrease = Cash Paid for Merchandise Purchased

$ 87,000 4,000 3,000 $ 94,000

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M11-27. (15 minutes)—Direct Method Sales – Accounts Receivable Increase = Cash Received from Customers

$785,000 (8,000) $777,000

Cost of Goods Sold + Inventory Increase + Accounts Payable Decrease = Cash Paid for Merchandise Purchased

$450,000 10,000 5,000 $465,000

M11-28. (10 minutes) Company

Life-Cycle Stage

Growth (late)

Maturity

Introduction

Growth (late)

Decline (early)

Growth (early)

Introduction

Decline (late)

M11-29. (20 minutes) a.

a. b. c. d.

Operating Cash Flow to Current Liabilities $2,106 / $6,581 = 0.32 $5,668 / $2,181 = 2.60 $3,702 / $3,365 = 1.10 $2,700 / $5,192 = 0.52

Liquidity Low High Medium High Medium

a. b. c. d.

Operating Cash to CAPEX $2,106 / $2,425 = 0.87 $5,668 / $1,007 = 5.63 $3,702 / $1,220 = 3.03 $2,700 / $1,984 = 1.36

Solvency Low High High Medium

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M11-30. (20 minutes) a. Net income computation Service revenue (record when earned) .............................$200,000 Wages expense (record when incurred, even if unpaid) ...... (40,000) ($25,000 + $15,000) Net income ..........................................................................$160,000 b. Net cash flow computation Cash inflow from services rendered ................................ $50,000 ($30,000 + $20,000) Cash outflow for wages paid ................................................ (25,000) Net cash inflow ................................................................ $25,000 Cash inflow from services rendered will be $150,000 less than service revenue per the income statement because Penno only collected $50,000 of revenues in cash but reported $200,000 as revenue. Cash outflow for wages paid will be $15,000 less than wages expense on the income statement because $15,000 remained unpaid at yearend. The combined effects of these two items yields an overall difference of $135,000 between net income and net cash inflow [$160,000 net income and $25,000 net cash inflows].

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EXERCISES E11-31. (15 minutes)—Indirect Method Net Income Add (Deduct) Items to Convert Net Income to Cash Basis Accounts Receivable Increase Inventory Decrease Prepaid Insurance Increase Accounts Payable Increase Wages Payable Decrease Net Cash Provided by Operating Activities

$112,000 (8,000) 6,000 (2,000) 4,000 (4,000) $108,000

E11-32. (30 minutes)—INDIRECT METHOD LUND CORPORATION Statement of Cash Flows For the Month of August Operating Activities $76,000 Net Income Add (Deduct) Items to Convert Income to Cash Basis 29,000 Depreciation 6,000 Amortization (4,000) Gain on Sale of Equipment (4,000) Accounts Receivable Increase 13,000 Inventory Decrease (2,000) Prepaid Expenses Increase 9,000 Accounts Payable Increase (3,000) Accrued Liabilities Decrease Net Cash Provided by Operating Activities Investing Activities 17,000 Sale of Equipment (90,000) Purchase of Land Net Cash Used by Investing Activities Financing Activities 35,000 Issuance of Common Stock (60,000) Retirement of Bonds Payable (29,000) Payment of Dividends Net Cash Used by Financing Activities Net Decrease in Cash Cash at Beginning of Year Cash at End of Year

$120,000

(73,000)

(54,000) (7,000) 22,000 $ 15,000

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E11-33 (20 minutes)—Indirect Method NIKE INC. Statement of Cash Flows ($ millions) Forecasted For Year Ended May 31, 2020 Net income Depreciation Amortization Stock-based compensation Accounts receivable increase Inventories increase Prepaid expenses and other current assets increase Deferred income taxes and other assets increase Accounts payable increase Accrued liabilities increase Income taxes payable increase Deferred income taxes and other liabilities increase Net cash from operating activities

$ 4,146 751 2 325 (333) (461) (144) (144) 218 397 24 286 $ 5,067

E11-34. (15 minutes)—Indirect Method MEDTRONIC PLC. Statement of Cash Flows ($ Millions) Forecasted For Year Ended April 2020 Net income including noncontrolling interest ................................... $4,927 Add (Deduct) items to convert net income to cash basis Depreciation 953 Amortization 1,914 Change in Accounts receivable (510) Change in Inventories, net (306) Change in Other current assets (166) Change in Tax assets (131) Change in Other assets (75) Change in Accounts payable 159 Change in Accrued compensation 187 Change in Accrued income taxes 60 Change in Other accrued expenses 243 Change in Accrued income taxes 231 Change in Deferred tax liabilities 108 Change in Other liabilities 68 Net cash from operating activities $7,662

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E11-35. (20 minutes)—Direct Method a. Advertising expense + Prepaid advertising increase = Cash paid for advertising

$ 62,000 4,000 $ 66,000

b. Income tax expense + Income tax payable decrease = Cash paid for income taxes

$ 29,000 2,200 $ 31,200

c. Cost of goods sold – Inventory decrease – Accounts payable increase = Cash paid for merchandise purchased

$180,000 (5,000) (2,000) $173,000

E11-36. (30 minutes)—DIRECT METHOD MASON CORPORATION Statement of Cash Flows For Year Ended 2020 Cash Flows from Operating Activities Cash Received from Customers Cash Received as Interest Cash Paid to Employees and Suppliers Cash Paid as Income Taxes Net Cash Provided by Operating Activities Cash Flows from Investing Activities Sale of Land Purchase of Equipment Net Cash Used by Investing Activities Cash Flows from Financing Activities Issuance of Bonds Payable Acquisition of Treasury Stock Payment of Dividends Net Cash Provided by Financing Activities Net Decrease in Cash Cash at Beginning of Year Cash at End of Year

$194,000 6,000 148,000 11,000

$200,000 (159,000) 41,000

40,000 (89,000) (49,000) 30,000 (10,000) (16,000) 4,000 (4,000) 16,000 $ 12,000

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E11-37. (30 minutes)—Direct Method Sales ............................................................................................................... – Accounts Receivable Increase .................................................................. = Cash Received from Customers ...............................................................

$700,000 (8,000) $692,000

Cost of Goods Sold ................................................................................... Inventory Decrease ................................................................................... Accounts Payable Increase ...................................................................... Cash Paid for Merchandise Purchased ....................................................

$425,000 (6,000) (4,000) $415,000

Wages Expense ............................................................................................. + Wages Payable Decrease ........................................................................ = Cash Paid to Employees ..........................................................................

$110,000 4,000 $114,000

Insurance Expense ......................................................................................... + Prepaid Insurance Increase ...................................................................... = Cash Paid for Insurance ...........................................................................

$ 15,000 2,000 $ 17,000

– – =

Operating Activities Cash Received from Customers Cash Paid for Merchandise Purchased Cash Paid to Employees Cash Paid for Rent Cash Paid for Insurance Net Cash Provided by Operating Activities

$692,000 $(415,000) (114,000) (38,000) (17,000)

(584,000) $108,000

E11-38. (20 minutes) a. Cash flows from investing activities will show Purchase of Intangible assets ................................................................... Sale of Intangible assets ...........................................................................

$ (80,000) 59,000

b. Cash flows from financing activities will show Issuance of Bonds .................................................................................... Retirement of Bonds .................................................................................

$103,000 (131,000)

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E11-39. (15 minutes) Some elements of the cash flow pattern over Facebook’s life as a public company conform to the life-cycle diagrams discussed in the textbook and other elements do not. Net income Facebook had very low net income in the early years but did not report net losses early on, as the diagram suggests. Operating cash flow Facebook’s operating cash flows were fairly strong from the start. The diagram shows negative cash flows for early-stage companies, Facebook managed to avoid negative operating cash flows. With the exception of 2012 and 2014, operating cash flow has increased consistently. The upward trend fits the pattern shown in the textbook. Investing cash flow Facebook’s investing cash flow pattern is consistent with the textbook – cash outflows in the beginning, with the investing outflow increasing through the maturity stage. Financing cash flow Facebook raised a significant amount of cash early on and since then financing cash flow has been negative. This does not conform with the expected pattern, typically financing is positive until the company is more mature and begins to pay dividends. But Facebook’s strong operating cash flow has enabled the company to return value to shareholders very quickly.

E11-40. (25 minutes) Life Cycle Rank (4 is most mature)

Company

Life Cycle Stage (O / I / F)

ARCONIC INC

Maturity Cash flow pattern + + -

CARMAX INC

Growth Cash flow pattern + - +

FLOWSERVE CORP

Maturity Cash flow pattern + - -

FLUOR CORP

Maturity Cash flow pattern + + -

All four companies have positive operating cash flow. CarMax has negative investing and positive financing cash flow consistent with a growth company. Fluor and Arconic are both very mature companies. With positive investing cash flow, neither is expanding via asset growth. The relative size of cash flows compared to net income, reveals that Arconic is farther along in the life cycle diagram. Flowserve is still growing (investing cash flows negative) but has negative financing cash flows consistent with a mature company.

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E11-41. (20 minutes) a. and b. Company ARCONIC INC CARMAX INC FLOWSERVE CORP FLUOR CORP

Liquidity 0.062 0.124 0.177 0.046

Liquidity Rank (1 Highest) 3 2 1 4

Based on the average ratio for cash flow from operations to current liabilities of 0.5, none of the companies is particularly liquid. Further analysis is needed to make a firm conclusion about liquidity, but the level of these ratios is of concern. c. and d. Company ARCONIC INC CARMAX INC FLOWSERVE CORP FLUOR CORP

Solvency 0.283 0.534 2.274 0.768

Solvency Rank (1 Highest) 4 3 1 2

A rule of thumb for cash flow from operations to CAPEX ratio is 1. Based on this, all of the companies have solvency issues except Flowserve. Again, further analysis is required.

E11-42. (20 minutes) a. Cisco Systems: $13,666 / $27,035 = 0.505 Liquidity is medium—near the average of 0.5. Oracle: $14,551 / $18,630= 0.781 Liquidity is medium high—above average but not significantly. Seagate Technologies: $2,113 / $3,190 = 0.662 Liquidity is medium high—above average but not significantly. b. Cisco Systems: $13,666 / $834 = 16.386. The ratio is 16 times the rule of thumb of 1.0 and so the company’s solvency is very high. Oracle Corp: $14,551 / $1,660 = 8.766. The ratio is nearly 9 times the rule of thumb of 1.0 and so the company’s solvency is very high. Seagate Technologies: $2,113 / $366 = 5.773. The ratio is 5 times higher than the rule of thumb of 1.0 but not significantly higher, the solvency is high. c. In order from least mature to most mature: Seagate (all three cash flows about equal in absolute value), Cisco, and Oracle (significantly higher operating cash flows relative to investing cash flows, and with large financing outflows). ©Cambridge Business Publishers, 2021 11-14

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PROBLEMS P11-43. (45 minutes)—INDIRECT METHOD a. Cash, December 31, 2019 .......................................... Less: Cash, December 31, 2018 ................................ Cash increase during 2019 .........................................

$11,000 5,000 $ 6,000

b. (INDIRECT METHOD) WOLFF COMPANY Statement of Cash Flows For Year Ended December 31, 2019 Net Cash Flow from Operating Activities Net Income Add (Deduct) Items to Convert Net Income to Cash Basis Depreciation Accounts Receivable Increase Inventory Increase Prepaid Insurance Decrease Accounts Payable Decrease Wages Payable Increase Income Tax Payable Decrease Net Cash Provided by Operating Activities Cash Flows from Investing Activities Purchase of PPE Cash Flows from Financing Activities Issuance of Bonds Payable Payment of Dividends Net Cash Provided by Financing Activities Net Increase in Cash Cash at Beginning of Year Cash at End of Year

$56,000 17,000 (9,000) (30,000) 2,000 (3,000) 3,000 (1,000) $35,000 (55,000) 55,000 (29,000) 26,000 6,000 5,000 $11,000

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P11-44. (30 minutes)—INDIRECT METHOD SEAGATE TECHNOLOGY PLC Statement of Cash Flows ($ Millions) Forecasted for Year Ended June 30, 2020 Net income Add: Depreciation Add: Amortization Add: Stock-based compensation Accounts receivable, net increase Inventories increase Other current assets increase Deferred income taxes increase Other assets, net increase Accounts payable increase Accrued employee compensation increase Accrued warranty increase Accrued expenses increase Long-term accrued warranty increase Other non-current liabilities increase Net cash from operating activities

$ 1,124 531 23 99 (47) (45) (12) (53) (5) 75 6 7 26 5 12 1,746

CAPEX Net cash from investing activities

(633) (633)

Payments of dividends Net cash from financing activities

(750) (750)

Net change in cash Beginning cash Ending cash

363 2,220 $2,583

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P11-45. (45 minutes)—INDIRECT METHOD a. Cash, December 31, 2019 ......................................................... $49,000 Less: Cash, December 31, 2018 ............................................... 28,000 Cash increase during 2019 ........................................................ $21,000 b. (INDIRECT METHOD) ARCTIC COMPANY Statement of Cash Flows For Year Ended December 31, 2019 Operating Activities Net Loss Add (Deduct) Items to Convert Net Loss to Cash Basis Depreciation Gain on Sale of Land Accounts Receivable Decrease Inventory Decrease Prepaid Advertising Decrease Accounts Payable Decrease Interest Payable Increase Net Cash Used by Operating Activities Investing Activities Sale of Land Purchase of Equipment Net Cash Used by Investing Activities

$ (42,000) 22,000 (25,000) 8,000 6,000 3,000 (14,000) 6,000 $ (36,000)

70,000 (183,000)* (113,000)

Financing Activities Issuance of Bonds Payable Purchase of Treasury Stock Net Cash Provided by Financing Activities Net Increase in Cash

200,000 (30,000) 170,000 21,000

Cash at Beginning of Year Cash at End of Year

28,000 $ 49,000

* The equipment purchased is equal to the sum of the increase in PPE assets account ($138,000) and the book value of the land sold ($45,000).

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P11-46. (50 minutes)—INDIRECT METHOD a. Cash, December 31, 2019 ......................................................... $27,000 Less: Cash, December 31, 2018 ............................................... 18,000 Cash increase during 2019 ........................................................ $ 9,000 b. (INDIRECT METHOD) DAIR COMPANY Statement of Cash Flows For Year Ended December 31, 2019 Net Cash Flow from Operating Activities Net Income $ 85,000 Add (Deduct) Items to Convert Net Income to Cash Basis Depreciation 22,000 Amortization 7,000 Loss on Bond Retirement 5,000 Accounts Receivable Increase (5,000) Inventory Decrease 6,000 Prepaid Expenses Increase (2,000) Accounts Payable Increase 6,000 Interest Payable Decrease (3,000) Income Tax Payable Decrease (2,000) Net Cash Provided by Operating Activities Cash Flows from Investing Activities Sale of Equipment Cash Flows from Financing Activities Retirement of Bonds Payable (125,000) Issuance of Common Stock 24,000 Payment of Dividends (26,000) Net Cash Used by Financing Activities Net Increase in Cash Cash at Beginning of Year Cash at End of Year

(127,000) 9,000 18,000 $ 27,000

c. (1) Supplemental Cash Flow Disclosures Cash Paid for Interest ............................................................................... Cash Paid for Income Taxes .....................................................................

$ 13,000* $ 38,000†

Interest expense + Interest payable decrease Cash paid for interest

$10,000 3,000 $13,000

†

Income tax expense + Income tax payable decrease Cash paid for income taxes

119,000 17,000

$36,000 2,000 $38,000

(2) Schedule of Noncash Investing and Financing Activities Issuance of Bonds Payable to Acquire Equipment

$ 60,000

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P11-47. (50 minutes)—INDIRECT METHOD AUTOMATIC DATA PROCESSING INC. Statement of Cash Flows ($ millions) Forecasted For Year Ended June 30, 2020 Net income ................................................................................ $2,463.7 Add (deduct) items to convert net income to cash Depreciation ........................................................................ 184.4 Amortization ........................................................................ 276.1 Stock based compensation ................................................. 167.3 Accounts receivable, net increase ........................................ (315.8) Other current assets increase .............................................. (73.1) Funds held for clients increase ............................................. (3,819.2) Long-term receivables, net increase .................................... (8.2) Capitalized contract cost, net increase ................................ (310.6) Other assets increase .......................................................... (122.8) Accounts payable increase .................................................. 18.7 Accrued expenses & other current liabilities increase........... 227.2 Accrued payroll and payroll-related expenses increase ............................................................................... 95.8 Short-term deferred revenues increase ................................ 35.6 Obligations under reverse repurchase agreements .............. 26.3 Income taxes payable increase ............................................ 8.4 Client funds obligations increase .......................................... 3,788.5 Other liabilities increase ....................................................... 98.3 Deferred income taxes increase ........................................... 92.9 Long-term deferred revenues increase ................................ 49.2 Net cash from operating activities ....................................... 2,882.7 Capital expenditures ........................................................... Intangible assets acquired ................................................... Net cash from investing activities ........................................

(183.1) (457.1) (640.2)

Repurchase of shares .......................................................... (750.0) Dividends ($1,389.4 – ($365.4 - $340.1)) ............................. (1,364.1) Net cash from financing activities ........................................ (2,114.1 Net change in cash .............................................................. (128.4) Beginning cash ................................................................ 1,949.2 Ending cash ........................................................................ $ 2,077.6

11-19

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P11-48. (50 minutes)—INDIRECT METHOD a. Cash and Cash Equivalents, December 31, 2019 .......................................... $19,000 Less: Cash and Cash Equivalents, December 31, 2018 ................................. 25,000 Cash and Cash Equivalents decrease during 2019 ........................................ $ 6,000 b. RAINBOW COMPANY Statement of Cash Flows For Year Ended December 31, 2019 Operating Activities Net Income ......................................................................... $ 97,000 Add (Deduct) Items to Convert Net Income to Cash from Operations Depreciation........................................................................ 39,000 Patent Amortization ............................................................ 7,000 Loss on Sale of Equipment ................................................. 5,000 Gain on Sale of Investments ............................................... (10,000) Accounts Receivable Increase ............................................ (10,000) Inventory Increase .............................................................. (26,000) Prepaid Expenses Increase ................................................ (4,000) Accounts Payable Increase ................................................ 4,000 Interest Payable Increase ................................................... 1,000 Income Tax Payable Decrease ........................................... (2,000) Net Cash Provided by Operating Activities ......................... Investing Activities Sale of Investments ............................................................ 60,000 Purchase of Land ................................................................ (90,000) Improvements to Building ................................................... (95,000) Sale of Equipment .............................................................. 14,000 Net Cash Used by Investing Activities ................................ Financing Activities Issuance of Bonds Payable ................................................ 30,000 Issuance of Common Stock ................................................ 24,000 Payment of Dividends ......................................................... (50,000) Net Cash Provided by Financing Activities ......................... Net Decrease in Cash and Cash Equivalents ........................... Cash and Cash Equivalents at Beginning of Year .................... Cash and Cash Equivalents at End of Year ..............................

101,000

(111,000)

4,000 (6,000) 25,000 $ 19,000

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Interest expense – Interest payable increase Cash paid for interest

$13,000 (1,000) $12,000

†

Income tax expense + Income tax payable decrease Cash paid for income taxes

(2) Schedule of Noncash Investing and Financing Activities Issuance of Preferred Stock to Acquire Patent

$ 12,000* $ 46,000†

$44,000 2,000 $46,000

$ 25,000

P11-49. (40 minutes) a. Depreciation is added back to undo the effect it had on the income statement. Stryker deducted $306 million of depreciation expense in computing net income. Depreciation is a noncash expense so Stryker did not actually use $306 million of cash to pay depreciation expense. Thus, to determine how much cash was generated, net income is too low by the depreciation amount of $306 million. The depreciation add-back is NOT a source of cash as some mistakenly believe. Cash is, ultimately, generated by profitable operations, not by depreciation. b. Revenue is recognized, and profit increased, when it is earned, whether or not cash is received. Sales on account, therefore, increase profit, and the deduction for the increase in receivables reflects the fact that cash has not yet been received. The negative sign on the adjustment for the increase in inventories reflects the outflow of cash when inventories are purchased. Inventories are typically purchased on account. As a result, payment is not made when the inventories are purchased. The positive sign on the increase in accounts payable offsets a portion of the negative sign on the inventory increase, and the net amount represents the net cash paid for the increase in inventories. Accounts payable are typically non-interest bearing, thus providing a cheap and important source of cash. Accrued liabilities relate to expenses that have been recognized in the income statement that have not yet been paid. An increase in accrued liabilities means that cash paid out for expenses during the year was less than the expenses recognized in the income statement. Therefore, an increase in accrued expenses is shown as a positive adjustment to net income .

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c. Companies must continue to invest in their infrastructure, both for new additions and replacement, to remain competitive. Depreciation expense represents the using up of depreciable assets. In general, we should expect capital expenditures (CAPEX) to exceed depreciation expense. This indicates that the company is growing its infrastructure as well as replacing the portion that is wearing out. This is the case for Stryker in fiscal 2018, depreciation of $306 million is less than CAPEX of $572 million. d. If Stryker can make a better return on reinvesting its cash back into the business than the return shareholders can earn for themselves on the cash they would receive, Stryker should forgo paying dividends or repurchasing shares. Many companies with large cash inflows, especially mature companies in relatively saturated markets, find it hard to uncover additional investment opportunities. In those cases, returning the cash to investors is better than investing it in marketable securities, because investors can do that for themselves. e. Stryker is a large, mature, and profitable company. In fiscal 2018, the company generated less operating cash flows than reported profits but the difference relates to income tax changes arising from the 2017 tax law changes. The company funds capital expenditures primarily with operating cash flows with minimal need for external financing. In the financing area, the company is borrowing to repurchase stock and to pay dividends, a substitution of lower-cost debt for higher-cost equity. This is a typical profile for a large, well-capitalized company like Stryker. In sum, Stryker is exceptionally strong, and the company will likely continue investing in its infrastructure.

P11-50. (40 minutes) a. Depreciation is added back to undo the effect it had on the income statement. Verizon deducted $17,403 million of depreciation expense in computing net income. Depreciation is a noncash expense so Verizon did not actually use $17,403 million cash to pay depreciation. Thus, to determine how much cash was generated, net income is too low by the depreciation amount of $17,403 million. The depreciation add-back is NOT a source of cash as some mistakenly believe. Cash is, ultimately, generated by profitable operations, not by depreciation. The relative size of the add-back indicates that the company is extremely capital intensive. The add-back is 109% of net income ($17,403 / $16,039). b. The MD&A section of the 10-K provides management’s assessment of the operating results and investment activities of the company. Because it is regulated by SEC disclosure rules, the 10-K is a source of useful information that includes less promotional material than other statements by the company. continued

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b. continued Companies must continue to invest in their infrastructure, both for new additions and replacement, to remain competitive. Depreciation expense represents the using up of depreciable assets. In general, we should expect capital expenditures (CAPEX) to exceed depreciation expense. This indicates that the company is growing its infrastructure as well as replacing the portion that is wearing out. Verizon’s CAPEX is slightly smaller than its depreciation expense in 2018. The company appears to be replacing depreciated assets but not making new additions to its infrastructure. c. During 2018, Verizon used cash of $3,781 million to repay debt, net ($5,967 + $4,810 – $10,923 - $3,635 all in millions). While the level of debt decreased during the year, the balance is still very high. This high debt load places severe demands on Verizon’s operating cash flow. Cash that should be used to develop its infrastructure must be allocated to the payment of debt. This is particularly problematic for Verizon as it is facing stiff competition from rival Comcast and must make substantial capital investments to remain competitive. d. Unlike debt, dividends are not a contractual obligation until declared by the board of directors. Although its stock price may fall if the company reduces dividends, shareholders cannot force the company into bankruptcy like debt holders can. Nevertheless, high dividend-paying companies, such as Verizon, typically continue their dividend payout even if they must borrow funds to do so as failure to maintain dividend payment levels would depress the market price of the company stock and increase the cost of equity capital should the company need to use its stock to raise capital or acquire another company. e. Verizon’s operations generated a significant amount of cash. Its capital expenditures are significant as the company continues to replace depreciating assets. High capital outlays would, ordinarily, not be a problem were it not for the company’s significant existing debt load. Verizon’s debt repayment for 2018 was $3,781 million and the company paid interest expense on top of that amount (recorded in its income statement). Although the company is financially strong, balancing its debt level with the cash flow needs for capital expenditures to support its operating activities and dividends to support its stock price is a difficult challenge facing the company.

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P11-51. (20 minutes) a. Operating activities Net income Adjustments to reconcile net income to operating cash flow Depreciation Accounts receivable increase Prepaid expense decrease Accounts payable increase Wages payable decrease Net cash provided from operating activities

$130,000

$28,000 (10,000) 3,000 6,000 (4,000)

23,000 $153,000

b. No, the positive sign on depreciation expense does not mean that Petroni Company is generating cash by recording depreciation. The depreciation add-back undoes the noncash depreciation expense that is included in the computation of net income. Sales and profitable operations generate cash; depreciation expense does not. c. The increase in accounts receivable relates to sales on credit. Because Petroni Company uses GAAP, the company recognizes revenues when “earned,” even if no cash is received. These credit sales are included in net income even though the company received no cash from the sale. That means that net income is higher than cash from operations. Subtracting the increase in receivables offsets the noncash sales included in net income. d. Prepaid expenses arise when a company pays out cash in advance of incurring the expense. An example is the payment for radio or TV advertising that does not air in the current period. When paid, the company records the decrease in cash and records an asset, prepaid advertising. When the ads air, the company reduces the prepaid advertising account and recognizes an expense even though no cash was paid in the period the ads aired. The effect is that net income is lower (by the advertising expense) than cash from operations. To reconcile the two, the company needs to add back the decrease in the prepaid expense asset.

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P11-52. (35 minutes)—DIRECT METHOD a. Cash, December 31, 2019 Less: Cash, December 31, 2018 Cash increase during 2019

$11,000 5,000 $ 6,000

b. WOLFF COMPANY Statement of Cash Flows For Year Ended December 31, 2019 Cash Flows from Operating Activities Cash Received from Customers Cash Paid for Merchandise Purchased $ 463,000 Cash Paid to Employees 83,000 Cash Paid for Insurance 6,000 Cash Paid for Interest 9,000 Cash Paid for Income Taxes 30,000 Net Cash Provided by Operating Activities Cash Flows from Investing Activities Purchase of PPE

$626,000

591,000 35,000

(55,000)

Cash Flows from Financing Activities Issuance of Bonds Payable Payment of Dividends Net Cash Provided by Financing Activities Net Increase in Cash Cash at Beginning of Year Cash at End of Year

55,000 (29,000) 26,000 6,000 5,000 $ 11,000

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P11-53. (50 minutes)—DIRECT METHOD a. Cash, December 31, 2019 .......................................... Less: Cash, December 31, 2018 ................................ Cash increase during 2019 .........................................

$49,000 28,000 $21,000

b. ARCTIC COMPANY Statement of Cash Flows For Year Ended December 31, 2019 Operating Activities Cash Received from Customers Cash Paid for Merchandise Purchased Cash Paid to Employees Cash Paid for Advertising Cash Paid for Interest Net Cash Used by Operating Activities

$736,000 $ 542,000 190,000 28,000 12,000

Investing Activities Sale of Land Purchase of Equipment Net Cash Used by Investing Activities

70,000 (183,000)*

Financing Activities Issuance of Bonds Payable Purchase of Treasury Stock Net Cash Provided by Financing Activities

200,000 (30,000)

772,000 (36,000)

(113,000)

170,000

Net Increase in Cash Cash at Beginning of Year Cash at End of Year

21,000 28,000 $ 49,000

* The equipment purchased is equal to the sum of the increase in PPE assets account ($138,000) and the book value of the land sold ($45,000).

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P11-54. (60 minutes)—DIRECT METHOD a. Cash, December 31, 2019 .......................................... $27,000 Less: Cash, December 31, 2018 ................................ 18,000 Cash increase during 2019 ......................................... $ 9,000 b. DAIR COMPANY Statement of Cash Flows For Year Ended December 31, 2019 Cash Flows from Operating Activities Cash Received from Customers .......................................... Cash Paid for Merchandise Purchased ...............................$428,000 Cash Paid for Wages and Other Operating Expenses ......... 97,000 Cash Paid for Interest .......................................................... 13,000 Cash Paid for Income Taxes ................................................ 38,000 Net Cash Provided by Operating Activities .......................... Cash Flows from Investing Activities Sale of Equipment ............................................................... Cash Flows from Financing Activities Retirement of Bonds Payable .............................................. (125,000) Issuance of Common Stock ................................................. 24,000 Payment of Dividends .......................................................... (26,000) Net Cash Used by Financing Activities ................................ Net Increase in Cash ................................................................. Cash at Beginning of Year ......................................................... Cash at End of Year ..................................................................

$695,000

(576,000) 119,000 17,000

(127,000) 9,000 18,000 $ 27,000

c. (1) Reconciliation of Net Income to Net Cash Flow from Operating Activities Operating Activities Net Income $ 85,000 Add (Deduct) Items to Convert Net Income to Cash Basis Depreciation 22,000 Amortization 7,000 Loss on Bond Retirement 5,000 Accounts Receivable Increase (5,000) Inventory Decrease 6,000 Prepaid Expenses Increase (2,000) Accounts Payable Increase 6,000 Interest Payable Decrease (3,000) Income Tax Payable Decrease (2,000) Net Cash Provided by Operating Activities $119,000 (2) Schedule of Noncash Investing and Financing Activities Issuance of Bonds Payable to Acquire Equipment

$ 60,000

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P11-55. (60 minutes)—DIRECT METHOD a. Cash and Cash Equivalents, December 31, 2019 Less: Cash and Cash Equivalents, December 31, 2018 Cash and Cash Equivalents decrease during 2019

$19,000 25,000 $ 6,000

b. RAINBOW COMPANY Statement of Cash Flows For Year Ended December 31, 2019 Operating Activities Cash Received from Customers ........................................... $740,000 Cash Received as Dividends ................................................ 15,000 Cash Paid for Merchandise Purchased ................................ 462,000 Cash Paid for Wages and Other Op Expenses ..................... 134,000 Cash Paid for Interest ........................................................... 12,000 Cash Paid for Income Taxes ................................................. 46,000 Net Cash Provided by Operating Activities ........................... Investing Activities Sale of Investments .............................................................. 60,000 Purchase of Land .................................................................. (90,000) Improvements to Building ..................................................... (95,000) Sale of Equipment ................................................................ 14,000 Net Cash Used by Investing Activities .................................. Financing Activities Issuance of Bonds Payable .................................................. 30,000 Issuance of Common Stock .................................................. 24,000 Payment of Dividends ........................................................... (50,000) Net Cash Provided by Financing Activities ........................... Net Decrease in Cash and Cash Equivalents ............................. Cash and Cash Equivalents at Beginning of Year ...................... Cash and Cash Equivalents at End of Year ................................

$755,000

(654,000) 101,000

(111,000)

4,000 (6,000) 25,000 $ 19,000

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c. (1) Reconciliation of Net Income to Net Cash Flow from Operating Activities Net Income Add (Deduct) Items to Convert Net Income to Cash Basis Depreciation Patent Amortization Loss on Sale of Equipment Gain on Sale of Investments Accounts Receivable Increase Inventory Increase Prepaid Expenses Increase Accounts Payable Increase Interest Payable Increase Income Tax Payable Decrease Net Cash Provided by Operating Activities

$ 97,000 39,000 7,000 5,000 (10,000) (10,000) (26,000) (4,000) 4,000 1,000 (2,000) $101,000

(2) Schedule of Noncash Investing and Financing Activities Issuance of Preferred Stock to Acquire Patent

$ 25,000

P11-56. (45 minutes) a. Amgen reports net cash provided by operating activities of $11,296 million, net income of $8,394 million, and depreciation and amortization of $1,946. Depreciation is a noncash expense that is deducted in the computation of net income. The depreciation add-back zeros this expense out of the income statement to focus on cash profitability. The positive amount for depreciation does not mean that the company is generating cash from depreciation, a common misconception. It is merely an adjustment to remove that expense from the computation of profit. b. Under current GAAP, companies are required to estimate the expense related to stock compensation expense and include that expense in the computation of net income. That form of compensation, however, is paid with stock, not with cash. As a result, this is a noncash expense. The addition of $311 million eliminates that expense from the statement of cash flows in much the same way that the addition of depreciation expense eliminates that expense in part a above. c. The negative sign on trade receivables in 2018 indicates that the receivables increased during the year. The negative sign on accounts payable in 2018 indicates that payables decreased during the year.

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d. Cash flow from operations to average current liabilities: 2018: $11,296 million / ($13,488 million + $9,020 million) / 2 = 1.004 2017: $11,177 million / ($9,020 million + $11,204 million) / 2 = 1.105 This ratio is fairly liquid both years. Compared to the 0.5 rule of thumb given in the textbook, Amgen is relatively strong. Cash flow from operations to CAPEX: 2018: $11,296 million / $738 million = 15.31 2017: $11,177 million / $664 million = 16.83 These ratios are unreasonably high, at first glance. However, a closer look at the cash flow statement reveals that Amgen has acquired other companies in both years. It seems that Amgen grows via mergers and acquisitions rather than organically. Also, Amgen is in the mature phase of its life and is generating more cash flow that it needs to sustain its growth. e. Amgen is very healthy. During 2018, Amgen generated $11,296 million in cash flows from operating activities. It generated an additional $14,339 million for investing activities, primarily related to net sales of marketable securities. The company used this cash to repay debt and repurchase nearly $18 billion of its own stock. Amgen paid a healthy dividend of $3,507 million. In sum, the cash flow picture of the company is healthy but indicates a very mature company that does not have any real growth opportunities in which to invest its significant operating cash flows. P11-57. (45 minutes) a. Thermo Fisher Scientific reports net income of $2,938 million and operating cash flow of $4,543 million. The single biggest reason for the difference between net income and operating cash flow is the depreciation and amortization expenses. The company deducted these noncash expenses to compute net income. The depreciation and amortization addback of $2,267 million “zeros out” these expenses from the income statement in order to focus on cash flow. The positive amount for these expenses does not mean that the company is generating cash from depreciation and amortization, a common misconception. They are merely adjustments to remove those expenses from the computation of profit. b. Under current GAAP, companies are required to expense stock-based compensation in the income statement. By definition, stock-based compensation is paid by stock, not with cash. Adding back the non-cash expense of $181 million eliminates the item from the statement of cash flows in much the same way that the addition of depreciation expense eliminates that expense in part a above.

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c. The $758 million outflow relating to the purchase of property, plant and equipment (PPE) should not be a source of concern provided that the PPE acquisitions are related to the company’s operating activities. If so, the company is growing its infrastructure and this should be considered a positive sign. Yes, the company did dispose of some PPE. We know because we observe the proceeds from sale of PPE of $50 million in the investing section of the statement of cash flows. d. The $2,237 million cash outflow for financing activities resulted from the following activities. Repayments of debt, net of new debt Stock buybacks Dividends Cash from shares sold to employees Other financing activities

(1,556) (500) (266) 136 (51)

The net cash outflow should not be viewed as a negative sign because the company is otherwise healthy. Strong operating cash flows free up cash for the company to return value to both the lenders and the owners. This seems to be Thermo Fisher’s strategy. e. Cash flow from operations to average current liabilities: $ 4,543 million / ($6,147 million + $7,048 million) / 2 = 0.69 This ratio is acceptable compared to the rule of thumb given in the text (> 0.5). The company’s cash flow is positive and sufficient to cover its liabilities that will come due in the next year, which is what this ratio measures. Cash flow from operations to CAPEX: $4,543 million / $758 million = 5.99. This is significantly higher than the 1.0 rule of thumb from the textbook. Thermo Fisher is more than able to cover its capital expenditures with operating cash flow. Thermo Fisher has a fairly healthy cash flow picture in 2018. It generated positive operating cash flow and strong net income. The company grew its infrastructure. The company also used the remaining cash to pay to repurchase common stock, to pay down debt, and to pay dividends to shareholders.

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IFRS APPLICATION I11-58. (30 minutes) a. We can calculate change in cash and cash equivalents for the year as the difference between the balance at the start and the end of the fiscal year. $2,314 million - $116 million = $2,198 million. b. Operating Cash acquired in merger Cash provided by operating activities Proceeds from disposal of discont. operations Repurchase of common shares Additions to PPE (CAPEX) Dividends paid Repayment of short-term debt Other Total cash flow

Investing Financing $ 466

$2,052 5,394 $(1,800) (1,405) (952) (927) $2,052

(630) $3,825

$(3,679)

c. $ millions Cash from operating activities Cash from investing activities Cash from financing activities Cash flow for the year Cash and cash equivalents, start of year Cash and cash equivalents, end of year

2018 $2,052 3,825 (3,679) 2,198 116 $2,314

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Module 12 Financial Statement Forecasting QUESTIONS Q12-1.

Analysts and investors forecast financial statements to value equity and debt securities, and to rate firms’ credit. Others, including company insiders, prepare and use forecasted financial statements to evaluate alternative strategic courses of action and to budget and plan for the future.

Q12-2.

We forecast the financial statements in the following order: income statement, balance sheet, statement of cash flows. This order is important because income statement activity determines many balance sheet accounts. Cash flows cannot be determined without net income (which determined cash from operating activities) or the balance sheet (which affects all three types of cash flows). Thus, the cash flow statement is forecast last.

Q12-3.

GAAP financial statements do not always accurately reflect the “true” financial condition and performance of the company. Income statements often include onetime (i.e., transitory or non-persistent) revenue and expense items that can skew profit for the year. Because we are trying to forecast future income and cash flow, we eliminate transitory items because, by definition, they will not recur in the future.

Q12-4.

The forecasted income statement, balance sheet, and statement of cash flows should articulate in the same way that historical financial statements do; that is, they should tie together as we discussed in Module 2. We also need to be sure that our forecast assumptions are internally consistent (i.e., that they articulate across the financial statements). For example, it doesn’t make much sense to forecast an increase in gross profit margins if we are forecasting a recession and higher levels of (unsold) inventory.

Q12-5.

Sensitivity analysis means that the analyst increases and decreases the forecast assumptions to determine the effect on the forecasts. If an assumption has a big impact on the forecasts, the analyst works to make sure that that particular forecast assumption is as accurate as possible.

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Q12-6.

Cash is the last item forecast because all other assets and liabilities have balances that will change for known reasons, or the balances will not change. The assumption is that, after all the forecasted transactions, the account that will absorb the difference is cash. Cash is the “plug” figure which means the amount needed to balance the balance sheet.

Q12-7.

In addition to analyzing historical revenue trends, we can incorporate external (nonfinancial) information into the forecasting process. Some examples include incorporating the expected level of macroeconomic activity, the degree to which the competitive landscape is changing, recent changes in laws or regulations, and any strategic initiatives that have been announced by management, and so forth.

Q12-8.

We refine the forecasted cash balance so that we don’t forecast an amount that deviates from “normal” levels. If the cash balance is significantly too low, we infer that the company will need to raise additional cash by borrowing money, selling stock, or selling marketable securities, or any combination of these actions. We adjust our forecasted amounts accordingly.

Q12-9.

We can access any of the following information sources:

Q12-10.

•

Financial statement footnotes

•

The Management Discussion & Analysis (MD&A) section of the 10-K

•

Notes and press releases found at the investor relations section of corporate websites

•

Management guidance filed in an 8-K with the SEC

•

PowerPoint presentations the company provides for use during earnings calls and meetings with analysts

•

Conference call transcripts (available online )

Historical capital expenditures are reported in the statement of cash flows. Forecasted capital expenditures (CAPEX) are sometimes discussed in the Management Discussion and Analysis (MD&A) section of the 10-K and also in meetings with analysts or in other public disclosures.

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MINI EXERCISES M12-11. (20 minutes) AUTOMATIC DATA PROCESSING, INC. Forecasted Income Statement For Year Ended $ millions

June 2019 Actual

Total Revenues

$ 14,175.2

14,175.2

1.13

$ 16,018.0

7,145.9

16,018.0

50.4%

8,073.1

Systems development & programming costs

636.3

16,018.0

4.5%

720.8

Depreciation and Amortization

304.4

Operating expenses

Total cost of revenues

8,086.6

Selling, general, and administrative expenses

3,064.2

June 2020 Forecast

Assumptions

460.5 Subtotal 16,018.0

9,254.4

21.6%

3,459.9

Interest expense

129.9

No change

129.9

Total Expenses

11,280.7

Subtotal

12,844.2

Other (income)/expense, net

(111.1)

No change

(111.1)

Earnings before Income Taxes

3,005.6

Subtotal

3,284.9

Provision for income taxes

712.8

Net Earnings

3,284.9

25%

$ 2,292.8

821.2 $ 2,463.7

M12-12. (20 minutes) SEAGATE TECHNOLOGY PLC Forecasted Income Statement June 2019 Actual Assumptions $ 10,390 × 1.05 7,458 10,910 × 71.8% 991 10,910 × 9.5% 453 10,910 × 4.4% 23 No change (22) Assume $0 8,903 Subtotal 1,487 Subtotal 84 No change (224) No change 25 No change

For Year Ended $ millions Revenue Cost of revenue Product development Marketing and administrative Amortization of intangibles Restructuring and other, net Total operating expenses Income from operations Interest income Interest expense Other, net Other expense, net Income before income taxes (Benefit) provision for income taxes Net income

(115) 1,372 (640)

Subtotal Subtotal 1,423 ×

$ 2,012

21%

June 2020 Forecast $ 10,910 7,833 1,036 480 23 9,372 1,538 84 (224) 25 (115) 1,423 299 $ 1,124

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M12-13. (20 minutes) MEDTRONIC PLC Forecasted Income Statement April 2019

For Year Ended

April 2020

$ millions

Actual

Assumptions

Forecast

Net sales

$ 30,557

1.08

$ 33,002

Costs and expenses Cost of products sold

9,155

33,002

30.8%

10,165

Research and development expense Selling, general, and administrative expense

2,330

33,002

7.6%

2,508

10,418

33,002

34.1%

11,254

Amortization of intangible assets

1,764

33,002

5.8%

1,914

Restructuring charges, net

198

75.0%

149

Certain litigation charges

166

Other operating expense, net

258

150 No change

258

Operating profit (loss)

6,268

Sub-total

6,604

Other nonoperating income, net

(373)

No change

(373)

Interest expense

1,444

No change

1,444

Income (loss) before income taxes

5,197

Income tax provision

547

Net income (loss)

5,533 5,533

15%

830

4,650

Net (income) loss attributable to noncontrolling interests

4,703

(19)

Net income (loss) attributable to Medtronic

No change

(19)

$ 4,631

$ 4,684

M12-14. (15 minutes) a. Yes, forecasted cash deviates from the normal level for the company. The normal level of cash as a percentage of Net sales, as measured with the FY2019 numbers, is 10.7% ($4,558 million / $42,668 million = 10.7%). With this percentage, the normal cash balance for FY2020 would be $4,660 million ($43,552 million x 10.7%). The forecasted cash balance of $6,127 million is $1,467 million too high. b. The deviation is 32% of FY2019 cash level. Yes, this is significant. c. To adjust the forecasted cash balance, we could increase forecasted marketable securities by $1,467, or repay long-term debt in that amount, or repurchase that amount of stock on the open market. d. Adjusted forecast for marketable securities would be $7,447 million ($5,980 million + $1,467 million). e. Adjusted forecasts for treasury stock would be $6,278 million ($4,811 million + $1,467 million). ©Cambridge Business Publishers, 2021 12-4

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M12-15. (20 minutes) a. Yes, forecasted cash deviates from the normal level for the company. The normal level of cash as a percentage of Net sales, as measured with the FY2019 numbers, is 7.2% ($51,141 million / $708,554 million = 7.2%). With this percentage, the normal cash balance for FY2020 would be $53,312 million ($740,439 million x 7.2%). The forecasted cash balance of $39,269 million is $14,043 million too low. b. The deviation is 27% of FY2019 cash level. Yes, this is significant. c. To adjust the forecasted cash balance, we could sell marketable securities of $14,043 million, or increase long-term debt by that amount, or sell some treasury stock on the open market. d. If long-term debt is adjusted, the statement of cash flow would be: Cash generated by operations Cash used for investing Cash used for financing Total change in cash Cash at beginning of period Cash at end of period

$57,696 (14,908) (40,617) 2,171 51,141 $53,312

e. If marketable securities are adjusted, the statement of cash flow would be: Cash generated by operations Cash used for investing Cash used for financing Total change in cash Cash at beginning of period Cash at end of period

$57,696 (865) (54,660) 2,171 51,141 $53,312

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M12-16. (40 minutes) MEDTRONIC PLC Forecasted Balance Sheet April 2019 $ millions

Actual

April 2020

Assumptions

Forecast

Current assets Cash and cash equivalents

$ 4,393

$ 7,140

Investments

5,455

No change

5,455

Accounts receivable, less allowance of $190

6,222

33,002

20.4%

6,732

Inventories, net

3,753

33,002

12.3%

4,059

Other current assets

2,144

33,002

7.0%

Total current assets

21,967

2,310 25,696

Property, plant, and equipment, net

4,675

1,221 - 950

4,946

Goodwill

39,959

No change

39,959

Other intangible assets, net

20,560

Tax assets

1,519

33,002

5.0%

1,650

Other assets

1,014

33,002

3.3%

1,089

Total assets

$ 89,694

(1,914)

18,646

$ 91,986

Current liabilities Current debt obligations

838

2,058

838

$ 2,058

Accounts payable

1,953

33,002

6.4%

2,112

Accrued compensation

2,189

33,002

7.2%

2,376

Accrued income taxes

567

33,002

1.9%

627

Other accrued expenses

2,925

33,002

9.6%

3,168

Total current liabilities

8,472

10,341

Long-term debt

24,486

Accrued compensation and retirement benefits

1,651

No change

Accrued income taxes

2,838

33,002

9.3%

3,069

Deferred tax liabilities

1,278

33,002

4.2%

1,386

Other liabilities

757

33,002

2.5%

825

Total liabilities

39,482

Shareholders’ equity Ordinary shares— par value $0.0001, 2.6 billion shares authorized, 1,340,697,595 and 1,354,218,154 shares issued and outstanding, respectively Additional paid-in capital

0 26,532

No change No change

― 26,532

Retained earnings

26,270

4,927 – 19 – 2,853

28,325

Accumulated other comprehensive loss

(2,711)

No change

Total shareholders’ equity

50,091

Noncontrolling interests

121

Total equity Total liabilities and equity

2,058

22,428 1,651

39,700

(2,711) 52,146

Add $19 NCI from the income statement

140

50,212

52,286

$ 89,694

$ 91,986

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M12-17. (15 minutes) a. Honeywell’s tax expense (and the effective rates) for 2018 and 2017 include several non-persistent items. As such, we should eliminate them as we forecast Honeywell’s income for 2020. b. The effective tax reconciliation note shows three items that have no significant effect in 2020: U.S. Tax Reform, Reduction on taxes on unremitted earnings, and Separation tax costs. By eliminating them, we find a fairly steady tax rate of 21% to 25%. We could use a 3-year average of about 23% to forecast 2020 tax expense.

Effective rate, as reported Eliminate one-time items U.S. Tax Reform Reduction on taxes on unremitted earnings Separation tax costs Effective rate, restated

2018 8.8%

2017 77.2%

2016 24.8%

5.8 14.2 (5.5) 23.3%

(56.0) ― ― 21.2%

― ― ― 24.8%

M12-18. (15 minutes) a. Historic ratio of Depreciation expense to PPE, gross

$895 / $10,259 = 8.7%

Forecasted April 2020 Depreciation expense

$10,920 × 8.7% = $950

Historic ratio of CAPEX to Sales

$1,134 / $30,557 = 3.7%

Forecasted April 2020 CAPEX

$33,002 × 3.7% = $1,221

Forecasted April 2020 PPE, net

$4,675 + $1,221 – $950 = $4,946

b. Using the guidance provided by the company, we would estimate PPE for year ended April 2020 as follows: $4,675 + $1,500 – $950 = $5,225.

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M12-19. (15 minutes) a. Dividend payout ratio in 2019

$2,693 / $4,631 = 58.2%

Forecasted 2020 Dividends

$4,908 × 58.2% = $2,856

Forecasted 2020 Retained earnings

$26,270 + $4,908 – $2,856 = $28,322

b. Using the guidance provided by the company, we would estimate dividends as follows: 1,340,697,595 shares × $2 per share = $2,681 million. Forecasted retained earnings for FY2020 would be as $28,497 calculated as $26,270 + $4,908 – $2,681. The two differ because the company does not set its dividend policy by using a payout ratio. Rather, it sets a dividend per share amount. The dividends per share approach is more accurate.

M12-20. (20 minutes) a. Growth by year is as follows: in $ millions Net sales Sales growth rate

2019 $42,879 1.7%

2018 $42,151 7.0%

2017 $39,403 -0.3%

2016 $39,528 -2.0%

2015 $40,339

b. The 2019 sales growth rate is 1.7%, which appears to be down significantly from 7% in 2018. If we used the numbers as reported, we would forecast earnings growth to be 1.7% in 2020. c. Adjusting for the 53 rd week in the 2018 consolidated sales has a marked impact on the sales trend we observe: in $ millions Net sales Sales growth rate

2019 $42,879 3.7%

2018 $41,356 5.0%

2017 $39,403 -0.3%

2016 $39,528 -2.0%

2015 $40,339

With the adjusted numbers, the 2019 sales growth rate is 3.7%, still lower than 2018 but significantly higher than 1.7% from the unadjusted numbers.

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EXERCISES E12-21. (45 minutes) a. AUTOMATIC DATA PROCESSING, INC. Forecasted Income Statement June 2019 Actual Assumptions

For Year Ended $ millions Total Revenues

June 2020 Forecast

$14,175.2

14,175.2

1.13

$ 16,018.0

7,145.9

16,018.0

50.4%

8,073.1

Systems development & programming costs

636.3

16,018.0

4.5%

720.8

Depreciation and Amortization

304.4

184.4

276.1

460.5

Operating expenses

Total cost of revenues

8,086.6

Selling, general, and administrative expenses

3,064.2

Subtotal 16,018.0

9,254.4 21.6%

3,459.9

Interest expense

129.9

No change

129.9

Total Expenses

11,280.7

Subtotal

12,844.2

Other (income)/expense, net

(111.1)

No change

(111.1)

Earnings before income taxes

3,005.6

Subtotal

3,284.9

Provision for income taxes Net Earnings

712.8

3,284.9

$ 2,292.8

Subtotal

25%

821.2 $ 2,463.7

continued

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a. continued AUTOMATIC DATA PROCESSING, INC. Forecasted Balance Sheet June 2019 Actual Assumptions

$ millions Current assets Cash and cash equivalents Accounts receivable, net Other current assets Total current assets before funds held for clients Funds held for clients Total current assets Long-term receivables, net Property, plant and equipment, net Capitalized Contract Cost, Net Other assets Goodwill Intangible assets, net Total assets Current liabilities Accounts payable Accrued expenses and other current liabilities Accrued payroll and payroll-related expenses Dividends payable Short-term deferred revenues Obligations under reverse repo agreements Income taxes payable Total current liabilities before client funds obligations Client funds obligations Total current liabilities Long-term debt Other liabilities Deferred income taxes Long-term deferred revenues Total liabilities

$ 1,949.2 2,439.3 519.6

16,018.0 16,018.0

PLUG × ×

June 2020 Forecast

17.2% 3.7%

$ 2,077.1 2,755.1 592.7

4,908.1 29,434.2 34,342.3 23.8 764.2 2,428.5 934.4 2,323.0 1,071.5 $ 41,887.7

Subtotal 16,018.0 × 207.6% Subtotal 16,018.0 × 0.2% + 176.2 – 184.4 16,018.0 × 17.1% 16,018.0 × 6.6% No change +464.5 – 276.1

125.5

16,018.0

0.9%

144.2

1,759.0

16,018.0

12.4%

1,986.2

721.1 340.1 220.7

16,018.0 1,389.4 16,018.0

× × ×

5.1% 26.3% 1.6%

816.9 365.4 256.3

262.0 54.8

16,018.0 821.2

× ×

1.8% 7.7%

288.3 63.2

Subtotal 16,018.0 × 205.6% Subtotal No change 16,018.0 × 5.6% 16,018.0 × 4.7% 16,018.0 × 2.8% Subtotal

3,920.5 32,933.0 36,853.5 2,002.2 897.0 752.8 448.5 40,954.0

No change

―

3,483.2 29,144.5 32,627.7 2,002.2 798.7 659.9 399.3 36,487.8

Shareholders’ equity: Preferred stock, $1.00 par value: Authorized, 0.3 shares; issued, none Common stock, $0.10 par value: authorized, 1,000.0; issued, 638.7; outstanding 434.2 63.9 Capital in excess of par value 1,183.2 Retained earnings 17,500.6 Treasury stock - at cost: 204.5 shares (13,090.5) Accumulated other comprehensive loss (257.3) Total stockholders’ equity 5,399.9 Total liabilities and stockholders’ equity $ 41,887.7

No change +167.3 +2,463.7 – 1,389.4 -750 No change

5,424.9 33,253.4 38,678.3 32.0 756.0 2,739.1 1,057.2 2,323.0 1,259.9 $ 46,845.5

63.9 1,350.5 18,574.9 (13,840.5) (257.3) 5,891.5 $ 46,845.5

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a. continued •

CAPEX is $176.2 million calculated as $16,018 × 1.1%.

•

Intangible assets are $464.5 million calculated as $16,018 × 2.9%.

b. The forecasted cash balance in fiscal 2020 is about the same percentage of total assets as in 2019. The company plans to repurchase $750 million of its stock in fiscal 2020. The strong operating cash flow and no planned debt repayments make this possible.

E12-22. (25 minutes) AUTOMATIC DATA PROCESSING, INC. Forecasted Statement of Cash Flows For Year Ended

$ millions Net income (loss) Add: Depreciation Add: Amortization Add: Stock based compensation Accounts receivable, net Other current assets Funds held for clients Long-term receivables, net Capitalized Contract Cost, Net Other assets Accounts payable Accrued expenses and other current liabilities Accrued payroll and payroll-related expenses Short-term deferred revenues Obligations under reverse repurchase agreements Income taxes payable Client funds obligations Other liabilities Deferred income taxes Long-term deferred revenues Operating cash flow

$2,439.3 519.6 29,434.2 23.8 2,428.5 934.4 144.2 1,986.2 816.9 256.3 288.3 63.2 32,933.0 897.0 752.8 448.5

$2,755.1 592.7 33,253.4 32.0 2,739.1 1,057.2 125.5 1,759.0 721.1 220.7 262.0 54.8 29,144.5 798.7 659.9 399.3

Capital Expenditures Additional intangibles acquired Net cash from investing activities Dividends Dividends payable Stock buy backs Net cash from financing activities

June 2020 $2,463.7 184.4 276.1 167.3 (315.8) (73.1) (3,819.2) (8.2) (310.6) (122.8) 18.7 227.2 95.8 35.6 26.3 8.4 3,788.5 98.3 92.9 49.2 2,882.7 (176.2) (464.5) (640.7)

365.4

Net change in cash Beginning cash Ending cash

340.1

(1,389.4) 25.3 (750.0) (2,114.1) 127.9 1,949.2 $2,077.1

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E12-23. (45 minutes) a. SEAGATE TECHNOLOGY PLC Forecasted Income Statement For Year Ended

June 2019

$ millions

June 2020

Actual

Assumptions

Forecast

$ 10,390 7,458 991 453 23 (22)

× 1.05 10,910 × 71.8% 10,910 × 9.5% 10,910 × 4.4% No change Assume $0

$ 10,910 7,833 1,036 480 23 ―

Total operating expenses Income from operations

8,903 1,487

Subtotal Subtotal

9,372 1,538

Interest income Interest expense Other, net

84 (224) 25

No change No change No change

84 (224) 25

Other expense, net

(115)

Subtotal

(115)

Income before income taxes (Benefit) provision for income taxes

1,372 (640)

Subtotal 1,423 × 21%

1,423 299

Revenue Cost of revenue Product development Marketing and administrative Amortization of intangibles Restructuring and other, net

Net income

$ 2,012

$ 1,124

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a. continued SEAGATE TECHNOLOGY PLC Forecasted Balance Sheet

$ millions Current assets Cash and cash equivalents Accounts receivable, net Inventories Other current assets Total current assets Property, equipment and leasehold improvements, net Goodwill Other intangible assets, net Deferred income taxes Other assets, net Total Assets Current liabilities Accounts payable Accrued employee compensation Accrued warranty Accrued expenses Total current liabilities Long-term accrued warranty Long-term accrued income taxes Other non-current liabilities Long-term debt, less current portion Total Liabilities Shareholders’ equity Ordinary shares— par value $0.0001, 2.6 billion shares authorized, 1,340,697,595 and 1,354,218,154 shares issued and outstanding, respectively Additional paid-in capital Accumulated other comprehensive loss Accumulated deficit Total Shareholders' Equity Total Liabilities and Shareholders' Equity

June 2019 Actual $ 2,220 989 970 184 4,363

June 2020

Assumptions

Forecast

PLUG

10,910 10,910 10,910

× × ×

9.5% 9.3% 1.8%

$ 2,935 1,036 1,015 196 5,182

1,869 1,237 111 1,114 191 $ 8,885

+633 - 531 No change -23 10,910 × 10.7% 10,910 × 1.8%

1,971 1,237 88 1,167 196 $ 9,841

$ 1,420 169 91 552 2,232 104 4 130 4,253 6,723

10,910 10,910 10,910 10,910

$ 1,495 175 98 578 2,346 109 4 142 4,253 6,854

× × × ×

13.7% 1.6% 0.9% 5.3%

10,910 × 1.0% No change 10,910 × 1.3% No change

― 6,545

No change +99

― 6,644

(34) (4,349) 2,162

No change +1,124 - 398 Subtotal

(34) (3,623) 2,987

$ 8,885

$ 9,841

b. Seagate will generate sufficient cash for the coming year. The cash balance increases slightly but not enough to require an adjustment.

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E12-24. (30 minutes) SEAGATE TECHNOLOGY PLC Forecast Statement of Cash Flows $ millions For Year Ended

June 2020

Net income Add: Depreciation Add: Amortization Add: Stock based compensation Change in Accounts receivable, net Change in Inventories Change in Other current assets Change in Deferred income taxes Change in Other assets, net Change in Accounts payable Change in Accrued employee compensation Change in Accrued warranty Change in Accrued expenses Change in Long-term accrued warranty Change in Long-term accrued income taxes Change in Other non-current liabilities

$ 1,124 531 23 99 (47) (45) (12) (53) (5) 75 6 7 26 5 12

989 970 184 1,114 191 1,495 175 98 578 109 4 142

1,036 1,015 196 1,167 196 1,420 169 91 552 104 4 130

Cash from operating activities

1,746

Capital Expenditures Net cash from investing activities

(633) (633)

Dividends

(398)

Net cash from financing activities

(398)

Net change in cash Beginning cash Ending cash

715 2,220 $ 2,935

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E12-25. (40 minutes) a. MEDTRONIC PLC Forecast Statement of Income April 2019 Actual Assumptions

For Year Ended $ millions Net sales

April 2020 Forecast

$ 30,557

1.08

$ 33,002

9,155

33,002.0

30.0%

9,901

Research and development expense

2,330

33,002.0

7.6%

2,508

Selling, general, and admin expense

10,418

33,002.0

34.1%

11,254

Amortization of intangible assets

1,764

33,002.0

5.8%

1,914

Restructuring charges, net

198

198.0

75.0%

149

Certain litigation charges

166

Other operating expense, net

258

No change

258

Operating profit (loss)

6,268

Subtotal

6,868

Other non-operating income, net

(373)

No change

(373)

Interest expense

1,444

No change

1,444

Income (loss) before income taxes

5,197

Costs and expenses Cost of products sold

Income tax provision

547

Net income (loss)

150

5,797 5,797

4,650

Net (income) loss attrib to NCI Net income (loss) attrib to Medtronic

(19)

15%

870 4,927

No change

$ 4,631

(19) $ 4,908

continued

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a. continued MEDTRONIC PLC Forecasted Balance Sheet April 2019 $ millions

Assumptions

Actual

Cash and cash equivalents

April 2020 Forecast

$ 4,393

$ 7,140

Investments Accounts receivable, less allowance of $190

5,455

No change

5,455

6,222

$33,002

20.4%

6,732

Inventories, net

3,753

33,002

12.3%

4,059

Other current assets

2,144

33,002

7.0%

2,310

Total current assets

21,967

Property, plant, and equipment, net

4,675

1,221 - 950

4,946

Goodwill

39,959

No change

39,959

Other intangible assets, net

20,560

(1,914)

18,646

Tax assets

1,519

33,002

5.0%

Other assets

1,014

33,002

3.3%

Total assets

$ 89,694

25,696

1,650 1,089 $ 91,986

Current liabilities Current debt obligations

838

2,058

838

$ 2,058

Accounts payable

1,953

33,002

6.4%

2,112

Accrued compensation

2,189

33,002

7.2%

2,376

Accrued income taxes

567

33,002

1.9%

627

Other accrued expenses

2,925

33,002

9.6%

Total current liabilities

8,472

3,168 10,341

Long-term debt Accrued compensation and retirement benefits

24,486

1,651

No change

Accrued income taxes

2,838

33,002

9.3%

3,069

Deferred tax liabilities

1,278

33,002

4.2%

1,386

Other liabilities

757

33,002

2.5%

825

Total liabilities

39,482

Shareholders’ equity Ordinary shares— par value $0.0001, 2.6 billion shares authorized, 1,340,697,595 and 1,354,218,154 shares issued and outstanding, respectively

2,058

22,428 1,651

39,700

No change

―

Additional paid-in capital

26,532

No change

26,532

Retained earnings

26,270

4,927 – 19 – 2,853

28,325

Accumulated other comprehensive loss

(2,711)

No change

(2,711)

Total shareholders’ equity

50,091

Noncontrolling interests Total equity Total liabilities and equity

121

52,146 Add $19 NCI from the income statement

140

50,212

52,286

$ 89,694

$ 91,986

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a. continued Forecasting CAPEX, and PPE, net Historic ratio of CAPEX to Sales Forecasted April 2020 CAPEX Forecasted April 2020 PPE, net

$1,134 / $30,557 = 3.7% $33,002 × 3.7% = $1,221 $4,675 + $1,221 - $950 = $4,946

Forecasting retained earnings Forecasted April 2020 Retained earnings

$26,270 + ($4,927 - $19) - $2,853 = $28,325

b. The historic “normal” cash balance is 14% calculated as $4,393 million / $30,557 million). The forecasted cash balance is $7,140 million, which is 22% of forecasted sales ($7,140 / $33,002). This means that the company does not need additional financing and could use the excess cash to pay down long-term debt or use the excess cash for share repurchases. E12-26. (30 minutes) MEDTRONIC PLC Statement of Cash Flow For Year Ended

$ millions

Net income (before non-controlling interest) Add: Depreciation Add: Amortization Change in Accounts receivable Change in Inventories, net Change in Other current assets Change in Tax assets Change in Other assets Change in Accounts payable Change in Accrued compensation Change in Accrued income taxes Change in Other accrued expenses Change in Accrued income taxes Change in Deferred tax liabilities Change in Other liabilities

6,222 3,753 2,144 1,519 1,014 2,112 2,376 627 3,168 3,069 1,386 825

April 2020

6,732 4,059 2,310 1,650 1,089 1,953 2,189 567 2,925 2,838 1,278 757

$4,927 950 1,914 (510) (306) (166) (131) (75) 159 187 60 243 231 108 68

Net cash from operating activities Capital Expenditures

7,659 (1,221)

Net cash from investing activities Dividends Change in current debt obligations Change in L-T Debt

(1,221) (2,853) 1,220 (2,058)

2,058 22,428

Net cash from financing activities Net change in cash Beginning cash Ending cash

838 24,486

Solutions Manual, Module 12

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E12-27. (30 minutes) NOTE to Instructor: This is a challenging exercise and requires students to use Excel “What-If” analysis. a. Based on FY2019, the company’s normal cash level is 10.1%, computed as $2,918 / $29,009. b. Yes, an adjustment to cash is warranted. The forecasted cash balance of $4,378 is 13.6% of net sales, or 35% higher than it should be (0.136 / 0.101 = 1.3465). The amount of the needed adjustment is decrease of $1,136 [($4,378 – (10.1% x $32,102)]. c. The liabilities to equity ratios are as follows: FY2019 historical = $8,755 / $5,837 = 1.50 FY2020 forecasted = $9,923 / $6,128 = 1.62 The forecasted numbers have changed the company’s capital structure. d.- h. d.

Debt Only

Treasury Stock Only

Debt and Marketable Securities

Debt and Treasury Stock

$14,915 $14,915

$15,320

$14,915

$ millions

Marketable As Securities Forecasted Only

Total assets

$16,051

Total liabilities

9,923

8,787

9,923

9,192

8,949

Total equity

6,128

4,992

6,128

5,966

Cash

4,378

3,242

730

1,866

730

1,135

730

(2,627)

(3,763)

(2,627)

(2,789)

1.62

1.43

1.99

1.50

Marketable securities Treasury stock Liabilities to equity ratio

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E12-28. (30 minutes) a.

c. The difference between the two forecasted net income amounts is not material, only $205 million. However, the second forecast is more accurate. Individual segments have different growth rates and cost structures, and a more accurate forecast would not ignore that information.

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E12-29. (30 minutes)

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E12-30. (20 minutes) The parsimonious forecast for Target, using the assumptions given, is as follows.

E12-31. (20 minutes) The parsimonious forecast for Logitech, using the assumptions given, is as follows:

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PROBLEMS P12-32. (60 minutes) We forecast Costco’s 2020 financial statements using the following forecast assumptions. Net sales % growth rate Membership fees % growth rate

7.9% 6.7%

continued

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continued

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(1) We forecast depreciation as follows: ($2,998 / $152,703) × $164,727 = $3,295 (2) We forecast CAPEX as follows: ($1,492 / $30,714) × $32,626 = $1,599 (3) We forecast dividends as follows: ($1,038 / $3,659) × $3,884 = $1,103

Assessment of Financing and Cash Levels: Our forecasts indicate that Costco will generate sufficient cash during the year and end up with a 2020 cash balance that 18.5% of total assets, exactly the same proportion as in 2019 (18.5%). The forecast would not require any adjustment to the cash balance.

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P12-33. (60 minutes) Consistent with the instructions, we assume the following (details are shown in the financial statements themselves). 1.

All expenses and assets at their 2019 percentage of Revenues, except as noted below.

Capital expenditures for 2019 are $1,143 million.

Depreciation expense for 2019 is $649 million.

Amortization expense for 2019 is $13 million.

Tax expense is 18.7% of pretax income.

Dividends for 2019 are $1,022 million.

Current portion of long-term debt due in 2021 is $6 million.

Tax expense is estimated as 18.7% of pretax income.

No change in interest or other non-operating expenses or income.

10.

No change in intangibles, except for the amortization expense.

11.

No change in short- term investments, goodwill, notes payable, common stock, capital in excess, and accumulated other comprehensive income.

Based on the above assumptions, we estimate Victoria’s income statement, balance sheet, and statement of cash flows as follows: VICTORIA, INC. Forecasted Income Statement For Year Ended Dec. 2019 ($ millions) Actual Assumptions Revenues $ 32,376 32,376 × 1.06 Cost of sales 17,405 34,319 × 53.8% Gross profit 14,971 Subtotal Research and development expense 3,278 34,319 × 10.1% Operating overhead expense 7,191 34,319 × 22.2% Total selling and administrative expense 10,469 Subtotal Interest expense (income), net 19 No change Other (income) expense, net (140) No change Income before income taxes 4,623 Subtotal Income tax expense 863 4,891 × 18.7% Net income $ 3,760 Subtotal

Dec. 2020 Forecast $ 34,319 18,464 15,855 3,466 7,619 11,085 19 (140) 4,891 915 $ 3,976

continued

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P12-33. (continued) Victoria Inc. Forecasted Balance Sheet Dec. 2019 Actual Assumptions

($ millions) Current assets Cash and equivalents Short-term investments Accounts receivable, net Inventories Prepaid expenses and other current assets Total current assets Property, plant and equipment, net Identifiable intangible assets, net Goodwill Deferred income taxes and other assets Total assets

Dec. 2020 Forecast

$ 3,138 2,319 3,241 4,838

PLUG No change 34,319 × 10.0% 34,319 × 14.9%

$ 5,337 2,319 3,432 5,114

1,489 15,025 3,520 281 131 2,439 $21,396

34,319 × 4.6% Subtotal 1,2011 7602 0 133 No change 34,319 × 7.5% Subtotal

1,579 17,781 3,961 268 131 2,574 $24,715

Current liabilities Current portion of long-term debt $44 Notes payable 1 Accounts payable 2,191 Accrued liabilities 3,037 Income taxes payable 85 Total current liabilities 5,358 Long-term debt 2,010 Deferred income taxes and other liabilities 1,770 Total liabilities 9,138 Shareholders’ equity Class A Convertible Common Stock 0 Class B Common Stock 3 Capital in excess of stated value 7,786 Accumulated other comprehensive income 318 Retained earnings 4,151 Total shareholders’ equity 12,258 Total liabilities and shareholders’ equity $21,396

44 No change 34,319 × 6.8% 34,319 × 9.4% 34,319 × 0.3% Subtotal 6 34,319 × 5.5%

$6 1 2,334 3,226 103 5,670 2,004 1,888 9,562

No change No change No change No change 3,976 - 1,0814 Subtotal Subtotal

0 3 7,786 318 7,046 15,153 $24,715

CAPEX = $1,143 / $32,376 = 3.5%. $34,319 × 3.5% = $1,201. $3,520 × 21.6% = $760. 3 Amortization expense = $13 / $281 = 4.6%. $281 × 4.6% = $13. 4 Dividends = $1,022 / $3,760 = 27.2%. $3,976 × 27.2% = $1,081. 2Depreciation expense = $649 / $3,011 = 21.6%.

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VICTORIA INC. Forecasted Statement of Cash Flows $ millions For Year Ended Net income Add: Depreciation Add: Amortization Change in: Accounts receivable, net Change in: Inventories Change in: Prepaid expenses and other current assets Change in: Deferred income taxes and other assets Change in: Accounts payable Change in: Accrued liabilities Change in: Income taxes payable Change in: Deferred income taxes and other liabilities Cash from operations

3,241 4,838 1,489 2,439 2,334 3,226 103 1,888

- 3,432 - 5,114 - 1,579 - 2,574 - 2,191 - 3,037 85 - 1,770

Dec. 2020 $ 3,976 760 13 (191) (276) (90) (135) 143 189 18 118 4,525

CAPEX Cash for investing

(1,201) (1,201)

Decrease in debt, net Dividends Cash for financing

(44) (1,081) (1,125)

Change in cash Cash at start of year Cash at end of year

2,199 3,138 $ 5,337

Summary: Cash is forecast to increase significantly during the year. Victoria has paid high dividends in the past and has retired common stock. The company could use the extra cash to repay its debt or to purchase treasury shares. The company is mature and new opportunities are scarce. Cash will likely be returned to shareholders.

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P12-34. (60 minutes) We forecast Target’s financials beginning with the income statement for both years.

continued

Financial A

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Camb Solutions Manual, Module 12

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P12-35. (60 minutes) a. The effective tax rate for 2019 was a benefit of 1.18% calculated as $6,156 thousand / $519,835 thousand. In 2018, it was a tax expense of 7.22% ($31,188 / $432,101), and in 2017, it was tax expense of 7.90% ($30,098 / $380,979). We observe varying tax expense / benefit for these three years. In 2019, the company received tax benefits, likely due to the tax credits associated with the solar energy industry. b. SUN SAVERS INC. Consolidated Statements of Operations For Year Ended

Dec. 2019

$ Thousands

Actual

Assumptions

Dec. 2020 Forecast

Net sales

$3,578,995

$3,578,995 × 1.06

$3,793,735

Cost of sales

2,659,728

$3,793,735 × 74%

2,807,364

Gross profit

919,267

986,371

Operating expenses Research and development

130,593

$ 3,793,735 × 3.60%

136,574

Selling, general and administrative

255,192

$3,793,735 × 7.1%

269,355

Production start-up

16,818

$3,793,735 × 0.5%

18,969

Restructuring and asset impairments

Forecast $0

Total operating expenses

402,603

424,898

Operating income

516,664

561,473

Foreign currency (loss) gain, net

(6,868)

Forecast $0

Interest income

22,516

No change

22,516

Interest expense, net

(6,975)

No change

(6,975)

Other expense, net

(5,502)

No change

(5,502)

Income before taxes and equity in earnings of unconsolidated affiliates

519,835

571,512

Income tax benefit (expense)

6,156

1.18% benefit

6,744

Equity in earnings of unconsol affiliates, net

20,430

$20,430

22,473

Net income

× 1.10

$ 546,421

$ 600,729

c. Net income grew by 9.9% calculated as [($600,729 thousand / $546,421 thousand) – 1] = 9.94%

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d. The average tax rate for the 2017 / 2018 period was 7.56%. In 2018, the effective rate was 7.22% (calculated as $31,188 / $432,101) and in 2017, the effective rate was 7.90% (calculated as $30,098 / $380,979). The average of the two rates is 7.56%. Using this as the effective rate, we see the effect on net income, as follows: SUN SAVERS INC. Consolidated Statements of Operations Dec. 2019 Dec. 2020 Actual Forecast

Dec. 2020 Forecast

Benefit 1.18% $3,578,995 2,659,728

Benefit 1.18% $3,793,735 2,807,364

Expense 7.56% $3,793,735 2,807,364

Gross profit Operating expenses Research and development Selling, general and administrative Production start-up

919,267

986,371

130,593 255,192 16,818

136,574 269,355 18,969

986,371 ― 136,574 269,355 18,969

Total operating expenses

402,603

424,898

Operating income Foreign currency (loss) gain, net Interest income Interest expense, net Other expense, net

516,664 (6,868) 22,516 (6,975) (5,502)

561,473 ― 22,516 (6,975) (5,502)

Income before taxes and equity in earnings of unconsolidated affiliates Income tax benefit (expense)

519,835 6,156

571,512 6,744

571,512 (43,206)

Equity in earnings (loss) of unconsolidated affiliates, net of tax

20,430

22,473

$ 546,421

$ 600,729

$ 550,779

9.94%

0.80%

For Year Ended $ Thousands Tax benefit/expense Net sales Cost of sales

Net income Growth in net income

continued

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d. continued SUN SAVERS INC.—Consolidated Statements of Operations $ Thousands

Forecast

Actual Dec. 31, 2019

Dec. 31, 2020 Sales growth 5.00%

Dec. 31, 2020 Sales growth 5.50%

Dec. 31, 2020 Sales growth 6.00%

Net sales

3,578,995

3,757,945

3,775,840

3,793,735

Cost of sales forecast at 74% of Net Sales

2,659,728

2,780,879

2,794,122

2,807,364

919,267

977,066

981,718

986,371

Research and development

130,593

135,286

135,930

136,574

Selling, general and administrative

255,192

266,814

268,085

269,355

Production start-up

16,818

18,790

18,879

18,969

Total operating expenses

402,603

420,890

422,894

424,898

Operating income

516,664

556,176

558,824

561,473

For Year Ended

Gross profit Operating expenses:

Foreign currency (loss) gain, net

(6,868)

―

Interest income

22,516

Interest expense, net

(6,975)

Other expense, net Income before taxes and equity in earnings of unconsolidated affiliates

(5,502)

519,835

566,215

568,863

571,512

Income tax benefit (expense) forecast at 7.56% expense Equity in earnings (loss) of unconsolidated affiliates, net of tax

6,156

(42,806)

(43,006)

(43,206)

20,430

22,473

Net income

546,421

545,882

548,330

550,779

-0.10%

0.35%

0.80%

Growth in net income

Financial A

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e. Net income $ and growth Sales Growth 5.0%

Sales Growth 5.5%

Sales Growth 6.0%

Sales Grow 6.5%

Cost of Sales / Sales = 73.5% Net income growth

$563,251 3.08%

$565,783 3.54%

$ 568,314 4.01%

$570, 4.4

Cost of Sales / Sales = 74.0% Net income growth

$ 545,882 -0.10%

$548,330 0.35%

$ 550,779 0.80%

$ 553, 1.2

Cost of Sales / Sales = 74.5% Net income growth

$528,513 -3.28%

$530,878 -2.84%

$533,244 -2.41%

$535, -1.9

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Module 13 Using Financial Statements for Valuation QUESTIONS Q13-1.

Current and historical financial information are the primary sources of information for forecasting future financial performance. Analysts frequently eliminate transitory items from reported earnings to gain a clearer perspective of the expected future earnings of the company, that is, those earnings that are likely to persist into the future. The trend in these persistent earnings is, then, used to form an initial estimate of future earnings. Thus, transitory items are less useful in valuing equity securities. Nonfinancial information, such as order backlog, an assessment of macroeconomic activity, the industry competitive environment, and so forth, is also used in the forecasting process.

Q13-2.

The DCF and ROPI models define the price of a security in terms of the company’s expected free cash flow to the firm (FCFF) and the expected residual operating income (ROPI), respectively. These expectations are, then, discounted to the present, using the WACC as the discount rate, to calculate an estimated share price. Expectations about the future financial performance of a company, therefore, significantly influence expected market value. There is an inverse relation between securities prices and expected return, the discount rate (WACC in this case).

Q13-3.

Free cash flows to the firm are equal to NOPAT minus the increase in NOA (or plus the decrease in NOA). The discounted cash flow (DCF) model defines securities prices in terms of the present value of expected free cash flows to the firm (FCFF).

Q13-4.

The “weighted average cost of capital” captures the average cost of funds that the firm has raised from both debt and equity sources, weighted by the proportion received from each financing source. The cost of debt is measured as the company’s after-tax interest rate. The cost of equity is the expected return required by equity investors, usually approximated using the Capital Asset Pricing Model (CAPM) which posits the expected return as a function of the risk-free rate, the company’s beta (the historic variability of its stock returns), and the “spread” of equity securities over the risk-free rate.

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Q13-5.

NOPAT is pretax operating profit adjusted for taxes on operating profit. Pretax operating profit is sales less cost of goods sold and SG&A expenses, in short, all income and expenses other than nonoperating items, such as financial income and interest expense related to investments and borrowing. Operating tax expense is total taxes plus the tax shield relating to net interest expense (or minus the additional taxes resulting from net interest income).

Q13-6.

Net operating assets are equal to total operating assets less total operating liabilities. Typically excluded are nonoperating assets such as cash, investments in marketable securities, non-strategic equity investments (but not equity method investments made for strategic purposes), net assets of discontinued operations, and nonoperating liabilities such as interest-bearing debt and capitalized lease obligations.

Q13-7.

Residual operating income (ROPI) is NOPAT – (WACC  NOA Beg), where WACC is the weighted average cost of capital (see Question 13-4). ROPI is, therefore, the excess of reported NOPAT over what we expected NOPAT to be, given the level of NOA and the firm’s WACC. The ROPI model defines the value of the company as its current NOA plus the present value of its expected future ROPI.

Q13-8.

Disaggregating RNOA into its component parts (as the ROPI model does) highlights that the value of a firm depends critically on both turnover and profit margin. Company value will be increased if managers can increase NOPAT while holding NOA constant, and/or if managers can reduce NOA while holding NOPAT constant. Of course, any action to improve either NOA or NOPAT likely has consequences on the other measure, which points out that the company must manage both measures to increase ROPI and therefore, increase stock price.

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MINI EXERCISES M13-9. (10 minutes) Earnings are an important determinant of stock prices whether investors view earnings as an indicator of prospective free cash flows or consider earnings within the context of the residual operating income model. Under both models, stock prices incorporate the market’s expectations of future financial performance. Thus, when Facebook reported that earnings and net income were both up significantly over the previous year, most of this increase had already been impounded into Facebook’s stock price. That is, the announcement did not contain any news and, thus, the market price did not react. The stock price effect of the announcement itself, then, is limited to the effect that it has on the market’s expectations of future performance. We don’t know what the market expected, but even if the earnings were as expected or higher, the stock price could have fallen. This fall could be related to other information revealed in the earnings announcement such as news that indicated a decrease in future earnings and cash flows. While earnings are related to stock price, they are not the only relevant variable in valuation models.

M13-10. (10 minutes) ROPI = =

NOPAT – (WACC × NOABEG) $12,073 million – (7.85% × $24,887 million) = $10,119 million

M13-11. (10 minutes) FCFF = = =

NOPAT - increase in NOA $12,073 million – ($25,546 million – $24,887 million) $11,414 million

M13-12. (15 minutes) a. Cisco Systems earned a positive ROPI in the fiscal year ended July 27, 2019 because realized NOPAT exceeds the expected NOPAT (given the cost of capital and the beginning NOA). $11,346 million – (7.6% × $22,225 million) = $9,657 million. b. Cisco Systems will earn a positive ROPI up to a WACC of 51%. At this level of WACC, ROPI = $22,225 million × 51.05% = $11,346 million, which is the current year NOPAT.

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M13-13. (30 minutes) a. Forecast Horizon TGT ($ millions)

Reported 2018

2019

2020

2021

2022

Terminal Period

NOPAT ................................................. $ 3,269

$ 3,402

$ 3,572

$ 3,751

$ 3,939

$ 4,017

NOA ......................................................

24,197

25,407

26,677

28,011

28,571

Increase in NOA ...................................

1,177

1,210

1,270

1,334

560

FCFF = (NOPAT - Increase in NOA)

2,225

2,362

2,481

2,605

3,457

0.92911

0.86324

0.80205

0.74519

2,067

2,039

1,990

1,941

23,020

DCF Model

Discount factor [1 / (1 + r w

)t ]

...............

Present value of horizon FCFF ............ Cumulative present value of horizon FCFF .................................................. $ 8,037 Present value of terminal FCFF ...........

45,757

Total firm value .....................................

53,794

Less (plus) NNO ...................................

11,723

Firm equity value .................................. $42,071 Shares outstanding (millions) ..............

517.8

Stock price per share ...........................

$ 81.25

b. Our stock price estimate of $81.25 is higher than the TGT market price of $77.12 as of 3/13/19, indicating that we believe that Target’s stock is undervalued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our higher stock price estimate may be due to more optimistic NOPAT forecasts or a lower discount rate compared to other investors’ and analysts’ model assumptions.

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M13-14. (30 minutes) a. Forecast Horizon TGT ($ millions)

Reported 2018

2019

2020

2021

2022

Terminal Period

NOPAT .................................................

$ 3,269

$ 3,402

$ 3,572

$ 3,751

$ 3,939

$ 4,017

NOA ......................................................

23,020

24,197

25,407

26,677

28,011

28,571

1,646

1,726

1,812

1,904

1,880

....................

0.92911

0.86324

0.80205

0.74519

Present value of horizon ROPI .................

1,529

1,490

1,454

1,419

ROPI Model ROPI = (NOPAT - [NOA Beg × r w]) ............. Discount factor [1 / (1 + r w

)t ]

Cum. present value of horizon ROPI ....

$ 5,892

Present value of terminal ROPI ...........

24,884

NOA

23,020

Total firm value .....................................

53,796

Less (plus) NNO ...................................

11,723

Firm equity value ..................................

$42,073

Shares outstanding (millions) ..............

517.8

Stock price per share ...........................

$ 81.25

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M13-15. (15 minutes) Alcoa’s restructuring could have any of the following effects that would improve ROPI:

•

Reduce raw materials costs which would increase NOPAT (via smaller COGS) and decrease NOA (via lower inventory levels in $ terms)

•

Increase time to pay suppliers which would increase accounts payable which would decrease NOA

•

Reduce inventory manufacturing costs (labor contracts renegotiated) which would increase NOPAT (via smaller COGS) and decrease NOA (via lower inventory levels in $ terms)

•

Reduce inventory held with manufacturing process efficiencies to decrease NOA (via lower inventory levels)

•

Reduce SG&A costs by negotiating price concessions with third-parties, which would increase NOPAT (via higher sales) Increase sales (in dollars) by negotiating sales terms with customers, which would increase NOPAT

•

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EXERCISES E13-16. (30 minutes) a. Stock value per share using Discounted Cash Flow model Illinois Tool Works (ITW) ($ millions)

Forecast Horizon

Reported 2018

2019

2020

2021

2022

Terminal Period

NOPAT ..............................................

$ 2,711

$ 2,880

$ 3,053

$ 3,236

$ 3,430

$ 3,499

NOA ...................................................

9,462

10,028

10,630

11,268

11,944

12,183

Increase in NOA ................................

566

602

638

676

239

FCFF = (NOPAT - Increase in NOA)

2,314

2,451

2,598

2,754

3,260

............

0.93153

0.86775

0.80834

0.75299

Present value of horizon FCFF .........

2,156

2,127

2,100

2,074

Discount factor [1 / (1 + r w

)t ]

Cum present value of horizon FCFF .

$8,457

Present value of terminal FCFF ........

45,883

Total firm value ..................................

54,340

Less (plus) NNO ................................

6,204

Firm equity value ............................... $ 48,136 Shares outstanding (millions) ...........

328.1

Stock price per share ........................

$146.71

b. Our stock price estimate of $146.71 is only slightly higher than the ITW market price of $144.21 as of February 15, 2019, indicating that ITW is accurately priced according to our model.

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E13-17 (30 minutes) a. Stock value per share using the Residual Operating Income Model Forecast Horizon Illinois Tool Works ($ millions)

Reported 2018

2019

2020

2021

2022

Terminal Period

NOPAT ...........................................

$ 2,880

$ 3,053

$ 3,236

$ 3,430

$ 3,499

NOA ................................................ $ 9,462

10,028

10,630

11,268

11,944

12,183

ROPI = (NOPAT - [NOA Beg × r w]) ...

2,185

2,316

2,455

2,602

2,621

0.93153

0.86775

0.80834

0.75299

2,035

2,010

1,984

1,959

Discount factor [1 / (1 + r w

)t ]

.........

Present value of horizon ROPI ...... Cum present value of horizon ROPI ............................................ $ 7,988 Present value of terminal ROPI .....

36,889

NOA ................................................

9,462

Total firm value ...............................

54,339

Less (plus) NNO .............................

6,204

Firm equity value ............................ $ 48,135 Shares outstanding (millions) ........

328.1

Stock price per share ..................... $146.71

b. Our stock price estimate of $146.71 is only slightly higher than the ITW market price of $144.21 as of February 15, 2019, indicating that ITW is accurately priced according to our model.

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E13- 18. (30 minutes) a. Stock value using the Discounted Cash Flow Model Forecast Horizon Humana (HUM) ($ millions)

Reported 2018

2019

2020

2021

2022

Terminal Period

$ 2,542

$ 2,580

$ 2,619

$ 2,658

$ 2,684

4,097

4,158

4,221

4,284

4,327

Increase in NOA ...............................

FCFF = (NOPAT - Increase in NOA)

2,477

2,519

2,556

2,595

2,641

Discount factor [1 / (1 + r w)t ] ...........

0.92764

0.86052

0.79826

0.74050

Present value of horizon FCFF ........

2,298

2,168

2,040

1,922

NOPAT ............................................. NOA ..................................................

$ 4,032

Cum present value of horizon FCFF

$8,428

Present value of terminal FCFF .......

28,760

Total firm value .................................

37,188

Less (plus) NNO ...............................

(6,129)

Firm equity value ..............................

$43,317

Shares outstanding (millions) ..........

135.6

Stock price per share .......................

$ 319.45

b. Our estimated Humana stock price of $319.45 is slightly higher than the market price of $307.56 on February 21, 2019, indicating that we believe the HUM stock is slightly undervalued on that date. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Differences in estimated stock price may be due to more optimistic forecasts or a lower discount rate compared to other investors’ and analysts’ model assumptions.

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E13-19. (30 minutes) a. Forecast Horizon Humana (HUM) ($ millions)

Reported 2018

2019

2020

2021

2022

NOPAT .........................................

$ 2,492

$ 2,542

$ 2,580

$ 2,619

$ 2,658

$ 2,684

NOA ..............................................

4,032

4,097

4,158

4,221

4,284

4,327

2,228

2,260

2,295

2,329

2,350

.......

0.92764

0.86052

0.79826

0.74050

Present value of horizon ROPI .... Cum present value of horizon ROPI ..........................................

2,067

1,945

1,832

1,725

$ 7,569

Present value of terminal ROPI ...

25,591

NOA ..............................................

4,032

Total firm value .............................

37,192

Less NNO .....................................

(6,129)

Firm equity value ..........................

$43,321

Shares outstanding (millions) ......

135.6

Stock value per share ..................

$ 319.48

ROPI = (NOPAT - [NOA Beg × r w]) Discount factor [1 / (1 + r w

)t ]

Terminal Period

b. Our estimated Humana stock price of $319.48 is slightly higher than the market price of $307.56 on February 21, 2019, indicating that we believe the HUM stock is slightly undervalued on that date. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Differences in estimated stock price may be due to more optimistic forecasts or a lower discount rate compared to other investors’ and analysts’ model assumptions.

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E13-20. (20 minutes) ($ millions) a. NOA = Operating assets – Operating liabilities Operating assets = $44,003 – $1,778 = $42,225 Operating liabilities = $45,881 – $1,339– $1,056 – $26,807 = $16,679 NOA = $42,225 – $16,679 = $25,546 NNO = Nonoperating assets – Nonoperating liabilities Nonoperating liabilities = $1,339 + $1,056 + $26,807= $29,202 Nonoperating assets = $1,778 NNO = $29,202 – $1,778 = $27,424 b. $25,546 = $27,424 (NOA) = (NNO)

+ +

$(1,878) (EQ)

c. Tax expense Add: Tax shield = $974 × 22% Tax on operating income

$ 3,435 214 $ 3,649

Net operating profit before tax Add back: after-tax impairment loss Subtract: Tax on operating income (above) NOPAT

$15,530 193 3,649 $ 12,074

An alternative approach is as follows. Consolidated net income Add: Net nonoperating expense = $974 × (1- 22%) Add back: after-tax impairment loss NOPAT

$11,121 760 193 $ 12,074

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E13-21. (30 minutes) a. Forecast Horizon Home Depot (HD) ($ millions)

Reported 2018

2019

2020

2021

NOPAT .................................................. $ 12,073 $12,967

$13,875

$14,846

$15,885

$16,203

NOA .......................................................

27,332

29,245

31,292

33,483

34,152

Increase in NOA ....................................

1,786

1,913

2,047

2,191

669

FCFF (NOPAT - Increase in NOA) .......

11,181

11,962

12,799

13,694

15,534

................

0.92721

0.85973

0.79715

0.73913

Present value of horizon FCFF .............

10,367

10,284

10,203

10,122

25,546

2022 Terminal

DCF Model

Discount factor [1 / (1 + r w

)t ]

Cum present value of horizon FCFF ..... $40,976 Present value of terminal FCFF ............ 196,267 Total firm value ...................................... 237,243 Less (plus) NNO ....................................

27,424

Firm equity value ................................... $209,819 Shares outstanding (millions) ...............

1,105.0

Stock price per share ............................ $189.88

b. Our stock price estimate of $189.88 is slightly lower than the HD market price of $190.06 as of March 28, 2019, indicating that we believe that the stock is appropriately valued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. It appears that our choice of valuation inputs match closely with the consensus in the market.

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E13-22. (30 minutes) a. Forecast Horizon Home Depot (HD) ($ millions)

Reported 2018

2019

2020

2021

2022

Terminal Period

NOPAT ........................................................ $12,073

$12,967

$13,875

$14,846

$15,885

$16,203

NOA ............................................................. 25,546

27,332

29,245

31,292

33,483

34,152

ROPI (NOPAT - [NOA Beg × rw]) ................

10,962

11,729

12,550

13,429

13,575

0.92721

0.85973

0.79715

0.73913

10,164

10,084

10,004

9,926

Discount factor [1 / (1 + r w

)t ]

....................

Present value of horizon ROPI ................. Cum present value of horizon ROPI ....................................................... $40,178 Present value of terminal ROPI ................ 171,516 NOA ........................................................... 25,546 Total firm value ................................ 237,240 Less (plus) NNO ................................ 27,424 Firm equity value ................................ $209,816 Shares outstanding (millions)

1,105.0

Stock value per share ............................... $189.88

b. Our stock price estimate of $189.87 is slightly lower than the HD market price of $190.06 as of March 28, 2019, indicating that we believe that the stock is appropriately valued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. It appears that our choice of valuation inputs match closely with the consensus in the market.

E13-23. (15 minutes) a. Remembering that FCFF = NOPAT – Increase in NOA, we see that both models utilize the same fundamental inputs. As a result, if the firm is in a steady state (e.g., NOPAT and NOA are growing at the same rate so that RNOA is constant), the two models will yield equivalent estimates of stock price. b. Companies can and do manage earnings. They also can and do manage cash flows; that is, they manage the classification of cash flows between operating and nonoperating categories and manage operating cash flows through the use of asset securitizations, operating leases, and other operating decisions (for example, by reducing advertising expenditures or cutting inventories). continued

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b. continued The fact that earnings can be managed does not render them irrelevant. Accrual accounting provides a wealth of information about future operations. And, generally, earnings over a short (say, five-year) period will capture much more of the value of the firm than will cash flows. Earnings are, arguably, more relevant than cash flows in valuation. Notice that earnings forecasts are generally readily available for most traded firms, while cash flow forecasts are not. This suggests that earnings are, indeed, most often the basis of valuation.

E13-24. (15 minutes) a. The ROPI model focuses on NOA and ROPI, where ROPI = NOPAT – (WACC × NOABeg).The components of ROPI, then, are the same components used in the computation of RNOA. The components of RNOA, profit margin (NOPM) and turnover (NOAT), are, therefore, called “value drivers” since they determine the value of the company according to this model. b. Managers must manage both the income statement and the balance sheet if they are to achieve high performance. This is the valuable insight that the ROPI model highlights.

E13-25. (15 minutes) a. ROPI = NOPAT – (WACC × NOABeg) 2019 ROPI = $210 – (7% × $1,350) = $115.5 2020 ROPI = $216 – (7% × $1,500) = $111 b.

NOPAT NOABeg ROPI = NOPAT – (7% x NOABeg )

Actual June 2019 $ 210 1,350 115.5

Forecasted June 2020 $ 216 1,500 111

Action 1 $216 1,4651 113.5

2 $216 1,3002 125

3 $1863 1,0004 116

4 $216 1,5005 111

1 $1,500 – (10% × 500) +(5% × 300) = $1,465 2 $1,500 – (20% × 1,000) = $1,300 3 $216 - $30 = $186 4 $1,500 – (50% x 1000) = $1,000 5

Increasing debt has no effect on NOPAT because interest expense is not included in NOPAT.The debt is a nonoperating liability and thus, does not affect NOA.

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PROBLEMS P13-26. (60 minutes) Cisco Systems ($ millions) a. NOA = ($97,793 – $11,750 – $21,663) – ($64,222 – $10,191 – $14,475) = $24,824 b. 2019 NOPAT = $14,219 – [$2,950 - (0.22 × $352] = $11,346 c. CSCO ($millions)

Reported 2019

Sales growth ................................

Forecast Horizon 2020

2021

2022

Terminal Period

2023

Sales, unrounded ................................ 51,904.00 54,499.20

57,224.16

Sales, rounded ................................ 51,904 54,499 1 NOPAT ................................ 11,346 11,935

57,224

60,085

63,090

63,721

12,532

13,159

13,817

13,955

NOA2 ................................

27,367

28,735

30,172

30,474

24,824

26,064

60,085.37 63,089.64

63,720.53

2019 NOPM is calculated as $11,346 / $51,904 = 0.2186 or 21.9% rounded to 3 decimals. We use NOPM to determine NOPAT as Sales (rounded) x 21.9%. 2 2019 NOAT is calculated as $51,904 / $24,824= 2.09088 or 2.091 rounded to 3 decimals. We use NOAT to determine NOA as Sales (rounded) / 2.091.

d. CSCO

Forecast Horizon

($millions)

Terminal 2023 Period

2020

2021

2022

DCF Model Increase in NOA ................................

$1,240

$1,303

$1,368

$1,437

$ 302

FCFF (NOPAT - Increase in NOA)

10,695

11,229

11,791

12,380

13,653

....................

0.92937

0.86372

0.80272

0.74602

Present value of horizon FCFF .................

9,940

9,699

9,465

9,236

Discount factor [1 / (1 + r w

)t ]

Cum PV of horizon FCFF .......................... $38,340 Present value of terminal FCFF ................ 154,324 Total firm value ................................192,664 Less (plus) NNO ................................ (8,747) Firm equity value ................................ $201,411 Shares outstanding (millions) .................... 5,029 Stock price per share ................................ $ 40.05 ©Cambridge Business Publishers, 2021 Solutions Manual, Module 13

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e. Our stock price estimate of $40.05 is somewhat lower than the CSCO market price of $48.42 as of September 5, 2019, indicating that we believe that the stock is over-valued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our forecasts for NOPM and NOAT likely do not agree with other investors’ and analysts’ model assumptions. Because our estimate is lower than the current price, we would likely NOT invest in the company at this time.

P13-27. (60 minutes) a. CSCO ($millions)

Reported 2019

Sales growth ................................

2020

Forecast Horizon 2021 2022

Terminal Period

2023

Sales, unrounded ................................ 51,904.00 54,499.20

57,224.16

Sales, rounded ................................ 51,904 54,499

57,224

60,085

63,090

63,721

NOPAT 1 ................................

11,935

12,532

13,159

13,817

13,955

NOA2 ................................

26,064

27,367

28,735

30,172

30,474

11,346 24,824

1 2

60,085.37 63,089.64

63,720.53

2019 NOPM = $11,346 / $51,904 = 0.2186 or 21.9% rounded. We determine NOPAT as Sales (rounded) x 21.9%. 2019 NOAT is calculated as $51,904 / $24,824= 2.09088 or 2.091 rounded. We use NOAT to determine NOA as Sales (rounded) / 2.091.

CSCO

Reported 2019

($ millions)

ROPI Model: ROPI (NOPAT - [NOA Beg × rw]) ................. Discount factor [1 / (1 + r w)t ] .................... Present value of horizon ROPI ................. Cum PV of horizon ROPI .......................... $ 36,022 Present value of terminal ROPI ................ 131,819 NOA ........................................................... 24,824

2020

Forecast Horizon 2021 2022

$10,048 0.92937 9,338

$10,551 0.86372 9,113

Terminal Period

2023

$11,079 $11,633 0.80272 0.74602 8,893 8,678

$11,662

Total firm value ................................192,665 Less (plus) NNO ................................ (8,747) Firm equity value ................................ $201,412 Shares outstanding (millions) .................... 5,029 Stock price per share ................................ $ 40.05

b. Our stock price estimate of $40.05 is somewhat lower than CSCO’s stock price of $48.42 as of September 5, 2019, indicating that we believe that the stock is over-valued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our forecasts for NOPM and NOAT likely do not agree with other investors’ and analysts’ model assumptions. Because our estimate is lower than the current price, we would likely NOT invest in the company at this time. ©Cambridge Business Publishers, 2021 13-16

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P13-28. (60 minutes) a. Terminal period sales = $215,576 × 1.02 = $219,887 Terminal period NOPAT = $ 26,300 × 1.02 = $26,826 Terminal period NOA = $465,607 x 1.02 = $474,918 b. Forecast Horizon

AT&T ($ millions)

Reported 2018

2019

2020

2021

2022

Sales, rounded .......

$170,756

$181,001

$191,861

$203,373

$215,576

$219,887

NOPAT ...................

20,895

22,082

23,407

24,812

26,300

26,826

NOA ........................

369,039

390,931

414,387

439,251

465,607

474,918

AT&T ($ millions)

2019

Forecast Horizon 2020 2021

Terminal Period

2022

Terminal Period

DCF Model Increase in NOA ...............................

$21,892

FCFF (NOPAT - Increase in NOA) ..

190

Discount factor [1 / (1 + r w

)t ]

...........

0.94607

Present value of horizon FCFF ........

180

Cum PV of horizon FCFF .................

$47

Present value of terminal FCFF .......

379,233

Total firm value .................................

379,280

Less (plus) NNO ...............................

175,155

Less NCI...........................................

9,795

$23,456 $24,864 $26,356 (49)

(52)

$9,311

(56)

17,515

0.89506 0.84679 0.80112 (44)

(44)

(45)

Firm equity value .............................. $ 194,330 Shares outstanding (thousands) .....

7,281.6

Stock price per share .......................

$26.69

c. Our stock price estimate of $26.69 is slightly lower than the actual AT&T market price of $30.85 as of February 20, 2019 indicating that we see a very slight overvaluation. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Differences in stock price estimates may be due to our having a slightly less optimistic forecast or a higher discount rate compared to other investors’ and analysts’ model assumptions. d. If WACC was 6.2%, the stock price would be $19.63, significantly lower because the discount rate increased. In particular, the discount rate is higher than the sales growth rate (which is 6% during the horizon period) and the stock price declines sharply. In contrast, with a WACC of 5.2%, stock price would have been $35.98. This is evidence that the modeling assumptions we use can significantly affect our price estimates. ©Cambridge Business Publishers, 2021 Solutions Manual, Module 13

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P13-29. (60 minutes) a. Forecast Horizon AT&T ($ millions)

2019

2020

2021

2022

Terminal Period

ROPI (NOPAT - [NOA Beg × rw]) ................

$1,047

$1,124

$1,192

$1,263

$286

Discount factor [1 / (1 + r w)t ] ....................

0.94607

0.89506

0.84679

0.80112

Present value of horizon ROPI .................

991

1,006

1,009

1,012

Cumulative present value of horizon ROPI ................................ $ 4,018 Present value of terminal ROPI ................ 6,192 NOA ........................................... …………. 369,039 Total firm value ................................ 379,249 Less (plus) NNO ................................ 175,155 Less NCI.................................................... 9,795 Firm equity value ................................ $194,299 Shares outstanding

7,281.6 Stock value per share ............................... $ 26.68

b. Our stock price estimate of $26.68 is slightly lower than the actual AT&T market price of $30.85 as of February 20, 2019 indicating that we see a very slight overvaluation. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Differences in stock price estimates may be due to our having a slightly less optimistic forecast or a higher discount rate compared to other investors’ and analysts’ model assumptions. Given the fact that our estimate indicates the stock is overvalued, we would likely not invest at this time.

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P13-30. (60 minutes) Nike Inc. (NKE) $ millions a. Operating assets ($23,717 - $ 4,466 - $197) Operating liabilities ($2,612 + $5,010 + $229 + $3,347) NOA

$ 19,054 11,198 $7,856

Nonoperating liabilities ($6 + $9 + $3,464) Nonoperating assets ($4,466 + $197) NNO

$3,479 4,663 $(1,184)

b. There are two approaches to calculating NOPAT, as follows. Nonoperating items before tax ($49 - $78) Tax shield at 22% Net nonoperating expense (NNE) Net income NOPAT = Net income + NNE

$(29) (6) (23) 4,029 $ 4,006

Net operating profit before tax (NOPBT) Tax expense Plus Tax shield (from above) NOPAT = NOPBT - Tax on operations

$ 4,772 772 (6) $ 4,006

c. Nike (NKE) ($ millions)

Forecast Horizon Reported 2019

2020

Sales, unrounded ................................ $39,117 $42,246.36

2021

2022

2023

$45,626.07 $49,276.15 $53,218.25

Terminal Period $54,282.61

Sales, rounded ................................ 39,117 42,246

45,626

49,276

53,218

54,283

NOPAT 1 ................................ 4,006

4,309

4,654

5,026

5,428

5,537

NOA2 ................................ 7,856

8,485

9,164

9,897

10,688

10,902

Using the numbers from part b., 2019 NOPM is calculated as $4,006 / $39,117 = 0.10241 or 10.2% rounded to 3 decimals. We use NOPM to determine NOPAT as Sales (rounded) x 10.2%. 2 Using the numbers from part a., 2019 NOAT is calculated as $39,117 / $7,856= 4.979252 or 4.979 rounded to 3 decimals. We use NOAT to determine NOA as Sales (rounded) / 4.979.

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d. Nike (NKE)

Forecast Horizon Reported 2019

2020

2021

2022

2023

Terminal Period

Increase in NOA ...............................

$629

$679

$733

$791

$214

FCFF (NOPAT - Increase in NOA) ..

3,680

3,975

4,293

4,637

5,323

Discount factor [1 / (1 + r w)t ] ............

0.93633

0.87671

0.82089

0.76863

Present value of horizon FCFF ........

3,446

3,485

3,524

3,564

($ millions)

Cum PV of horizon FCFF ................. $ 14,019 Present value of terminal FCFF .......

85,238

Total firm value .................................

99,257

Less NNO .........................................

(1,184)

Firm equity value .............................. $100,441 Shares outstanding (millions) ...........

1,682

Stock value per share ......................

$ 59.72

e. Our s tock price estimate of $59.72 is considerably lower than the NKE market price of

$86.70 as of July 23, 2019, indicating that we believe that Nike’s stock is very overvalued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our lower stock price estimate might be due to less optimistic forecasts or a higher discount rate compared to other investors’ and analysts’ model assumptions. One possible explanation is that the 2019 ratios for NOPM and NOAT (as we computed them) are expected to improve in the horizon period. If we are confident in the valuation techniques, the estimated price suggests that we should sell Nike stock.

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P13-31. (60 minutes) a. (Refer to the solution for P13-30 for NOPAT and NOA computations) NKE

Forecast Horizon Reported 2019

2020

2021

2022

2023

Terminal Period

ROPI (NOPAT - [NOA Beg × rw]) ...

$3,775

$4,077

$4,403

$4,755

$4,810

Discount factor [1 / (1 + r w)t ] .......

0.93633

0.87671

0.82089

0.76863

Present value of horizon ROPI ...

3,535

3,574

3,614

3,655

($ millions)

Cumulative PV of horizon ROPI .. $ 14,378 Present value of terminal ROPI ..

77,023

NOA .............................................

7,856

Total firm value ............................

99,257

Less NNO ....................................

(1,184)

Firm equity value ......................... $100,441 Shares outstanding (millions) ......

1,682

Stock value per share .................

$ 59.72

b. Our s tock price estimate of $59.72 is considerably lower than the NKE market price of

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P13-32. (60 minutes) a. Terminal period sales = $17,495 × 1.01 = $17,670 Terminal period NOPAT = $3,079 x 1.01 = $3,110 Terminal period NOA = $6,570 x 1.01 = $6,636 b. Colgate Palmolive (CL)

Forecast Horizon

($ millions)

Reported 2018

2019

2020

2021

2022

Terminal Period

Sales ...........................................

$15,544

$16,010

$16,491

$16,985

$17,495

$17,670

NOPAT ........................................

2,737

2,818

2,902

2,989

3,079

3,110

NOA .............................................

5,837

6,012

6,193

6,378

6,570

6,636

Increase in NOA ..........................

175

181

185

192

FCFF (NOPAT - Increase in NOA)

2,643

2,721

2,804

2,887

3,044

)t ] .......

0.94607

0.89506

0.84679

0.80112

Present value of horizon FCFF ...

2,500

2,435

2,374

2,313

Discount factor [1 / (1 + r w

Cum PV of horizon FCFF ............

$ 9,622

Present value of terminal FCFF ..

51,885

Total firm value ............................

61,507

Less NNO ....................................

5,640

Less NCI......................................

299

Firm equity value .........................

$ 55,568

Shares outstanding (millions) ......

862.9

Stock value per share .................

$64.40

c. Our stock price estimate of $64.40 is two dollars lower than the CL market price of $66.70 as of February 21, 2019, indicating that we believe that the stock is slightly overvalued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our lower stock price estimate might be due to more pessimistic forecasts or a higher discount rate compared to other investors’ and analysts’ model assumptions. If we are confident in the valuation techniques, the estimated price suggests that we should not purchase Colgate-Palmolive stock and if we are holding stock, we should sell. d. If the terminal period growth rate had been 2%, the stock price would have been about $80, much higher than the actual price. e. Using Excel What-If analysis and the Goal Seek function, we can determine that WACC would have needed to be 5.56% for the stock price of $66.70 to prevail.

Financial Accounting for MBAs, 8

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P13-33. (60 minutes) a. (Refer to the solution for P13-32 for NOPAT and NOA computations) Colgate Palmolive (CL)

Forecast Horizon Reported 2018

2019

2020

2021

2022

Terminal Period

NOPAT ........................................................... $ 2,737 $ 2,818

$ 2,902

$ 2,989

$ 3,079

$ 3,110

($ millions)

NOA ................................................................ 5,837

6,012

6,193

6,378

6,570

6,636

ROPI (NOPAT - [NOA Beg × rw]) ......................

2,485

2,559

2,636

2,715

2,736

)t ] ..........................

0.94607

0.89506

0.84679

0.80112

Present value of horizon ROPI ...................... Cum present value of horizon ROPI ............................................................ $ 9,048

2,351

2,290

2,232

2,175

Discount factor [1 / (1 + r w

Present value of terminal ROPI ..................... 46,635 NOA ................................................................ 5,837 Total firm value ................................ 61,520 Less NNO ....................................................... 5,640 Less NCI......................................................... 299 Firm equity value ................................ $ 55,581 Shares outstanding (millions) ......................... 862.9 Stock value per share ................................ $64.41

b. Our stock price estimate of $64.41 is two dollars lower than the CL market price of $66.70 as of February 21, 2019, indicating that we believe that the stock is slightly overvalued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our lower stock price estimate might be due to more pessimistic forecasts or a higher discount rate compared to other investors’ and analysts’ model assumptions. If we are confident in the valuation techniques, the estimated price suggests that we should not purchase Colgate-Palmolive stock and if we are holding stock, we should sell.

13-23

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MANAGEMENT APPLICATIONS MA13-34. (45 minutes) Your evaluation of the CFO’s proposals might include the following observations. 1. Reducing raw material inventories and work-in-progress is desirable so long as the reduction does not hinder the manufacturing process. This activity must, therefore, be undertaken with care, reducing only those inventories that are deemed to be excessive, and not making cuts to raw materials inventory that will jeopardize the company’s production or manufacturing flow. Finished goods inventories, while costly to hold, are necessary to support the sales process – reducing inventory too much can cause stockouts. Managers must also take care not to reduce finished goods inventory levels below that which is necessary to support sales. Companies can also improve operating cash flow by reducing receivables. If this reduction can be accomplished by improvements in operating procedures, such as by timely billing and elimination of billing errors, it can be an effective way of improving operating cash flow. Reducing receivables by more restrictive credit standards or aggressive collection efforts may be counterproductive if such tactics create ill will with customers and could cost the firm legitimate sales. Changes to receivables’ policies need to be handled carefully. 2. Lengthening the time to pay our vendors (leaning on the trade) will increase operating cash flow, but may also damage relations with our vendors. This may have longer-term adverse consequences. We need to be careful, therefore, about an across-the-board lengthening of the payable days outstanding, applying this technique judiciously and understanding well the potential adverse consequences. 3. Big Baths are common in cyclical downturns as companies seek to purge the balance sheet of assets that represent future expenses in the form of depreciation or impairment charges. By taking the write-off in the current period, we will shift profit from the current period into the future. This is cosmetic, however, as our operating activities have not been improved as a result of the write-off. Further, write-offs that cannot be justified are not in accordance with GAAP and may cause additional audit fees as the external auditor wastes time auditing fictitious charges and accruals.

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4. Increasing the expected return on pension investments will decrease pension expense and increase profitability. The expected return, however, is neither typically classified by analysts as an operating activity, nor does it represent a real improvement in our operating activities. Only actual improvement in investment returns will accomplish our objective because higher pension investment balances (from the higher returns) will reduce the need for company contributions and improve operating cash flow. 5. Corporate alliances are becoming increasingly popular as a means to increase throughput, thus lowering unit costs as overhead is spread over a wider volume base. Further, net operating assets will be lower as only the equity investment is recognized on the balance sheet. Even if an analyst proportionally consolidates this investment, only half of the trucking division will appear on our balance sheet. The effect is more than cosmetic. Since the assets are jointly owned, our net investment is reduced in actuality, not only for financial reporting purposes. This approach can have a positive effect on operating performance so long as our joint venture partner’s needs are compatible with ours. We must be careful to separate the cosmetic effects from real operating improvements. In addition, we must also be careful not to implement approaches with short-term benefits and longer- term costs.

13-25

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