SOLUTIONS MANUAL for Financial Reporting and Analysis 13th Edition by Charles H. Gibson. by StudyGuide

SOLUTIONS MANUAL for Financial Reporting and Analysis 13th Edition by Charles H. Gibson

TABLE OF CONTENTS CHAPTER 1: Introduction to Financial Reporting CHAPTER 2: Introduction to Financial Statements and Other Financial Reporting Topics CHAPTER 3: Balance Sheet CHAPTER 4: Income Statement CHAPTER 5: Basics of Analysis CHAPTER 6: Liquidity of Short-term Assets: Related Debt-Paying Ability CHAPTER 7: Long-Term Debt-Paying Ability CHAPTER 8: Profitability CHAPTER 9: For the Investor CHAPTER 10: Statement of Cash Flows CHAPTER 11: Expanded Analysis CHAPTER 12: Special Industries: Banks, Utilities, Oil and Gas, Transportation, Insurance, and Real Estate Companies CHAPTER 13: Personal Financial Statements and Accounting for Governments and Not-For-Profit Organizations

Chapter 1 Introduction to Financial Reporting

QUESTIONS 1- 1.

The AICPA is an organization of CPAs that prior to 1973 accepted the primary responsibility for the development of generally accepted accounting principles. Their role was substantially reduced in 1973 when the Financial Accounting Standards Board was established. Their role was further reduced with the establishment of the Public Company Accounting Oversight Board was established in 2002.

The Financial Accounting Standards Board replaced the Accounting Principles Board as the primary rule-making body for accounting standards. It is an independent organization and includes members other than public accountants.

The SEC has the authority to determine generally accepted accounting principles and to regulate the accounting profession. The SEC has elected to leave much of the determination of generally accepted accounting principles to the private sector. The Financial Accounting Standards Board has played the major role in establishing accounting standards since 1973. Regulation of the accounting profession was substantially turned over to the Public Company Accounting Oversight Board in 2002.

1- 2.

Consistency is obtained through the application of the same accounting principle from period to period. A change in principle requires statement disclosure.

1- 3.

The concept of historical cost determines the balance sheet valuation of land. The realization concept requires that a transaction needs to occur for the profit to be recognized.

1- 4.

a. Entity

e. Historical cost

b. Realization

f. Historical cost

c. Materiality

g. Disclosure

d. Conservatism 1- 5.

Entity concept

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1- 6.

Generally accepted accounting principles do not apply when a firm does not appear to be a going concern. If the decision is made that this is not a going concern, then the use of GAAP would not be appropriate.

1- 7.

With the time period assumption, inaccuracies of accounting for the entity, short of its complete life span, are accepted. The assumption is made that the entity can be accounted for reasonably accurately for a particular period of time. In other words, the decision is made to accept some inaccuracy because of incomplete information about the future in exchange for more timely reporting. The statements are considered to be meaningful because material inaccuracies are not acceptable.

1- 8.

It is true that the only accurate way to account for the success or failure of an entity is to accumulate all transactions from the opening of business until the business eventually liquidates. But it is not necessary that the statements be completely accurate in order for them to be meaningful.

1- 9.

A year that ends when operations are at a low ebb for the year.

The accounting time period is ended on December 31.

A twelve-month accounting period that ends at the end of a month other than December 31.

1-10.

Money.

1-11.

When money does not hold a stable value, the financial statements can lose much of their significance. To the extent that money does not remain stable, it loses usefulness as the standard for measuring financial transactions.

1-12.

No. There is a problem with determining the index in order to adjust the statements. The items that are included in the index must be representative. In addition, the prices of items change because of various factors, such as quality, technology, and inflation. Yes. A reasonable adjustment to the statements can be made for inflation.

1-13.

False. An arbitrary write-off of inventory cannot be justified under the conservatism concept. The conservatism concept can only be applied where there are alternative measurements and each of these alternative measurements has reasonable support.

1-14.

Yes, inventory that has a market value below the historical cost should be written down in order to recognize a loss. This is done based upon the concept of conservatism. Losses that can be reasonably anticipated should be taken in order to reflect the least favorable effect on net income of the current period.

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1-15.

End of production The realization of revenue at the completion of the production process is acceptable when the price of the item is known and there is a ready market. Receipt of cash This method should only be used when the prospects of collection are especially doubtful at the time of sale. During production This method is allowed for long-term construction projects because recognizing revenue on long-term construction projects as work progresses tends to give a fairer picture of the results for a given period in comparison with having the entire revenue realized in one period of time.

1-16.

It is difficult to apply the matching concept when there is no direct connection between the cost and revenue. Under these circumstances, accountants often charge off the cost in the period incurred in order to be conservative.

1-17.

If the entity can justify the use of an alternative accounting method on the basis that it is rational, then the change can be made.

1-18.

The accounting reports must disclose all facts that may influence the judgment of an informed reader. Usually this is a judgment decision for the accountant to make. Because of the complexity of many businesses and the increased expectations of the public, the full disclosure concept has become one of the most difficult concepts for the accountant to apply.

1-19.

There is a preference for the use of objectivity in the preparation of financial statements, but financial statements cannot be completely prepared based upon objective data; estimates must be made in many situations.

1-20.

This is a true statement. The concept of materiality allows the accountant to handle immaterial items in the most economical and expedient manner possible.

1-21.

Some industry practices lead to accounting reports that do not conform to generally accepted accounting principles. These reports are considered to be acceptable, but the accounting profession is making an effort to eliminate particular industry practices that do not conform to the normal generally accepted accounting principles.

1-22.

Events that fall outside of the financial transactions of the entity are not recorded. An example would be the loss of a major customer.

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1-23.

True. The accounting profession is making an effort to reduce or eliminate specific industry practices.

1-24.

The entity must usually use the accrual basis of accounting. Only under limited circumstances can the entity use the cash basis.

1-25.

The FASB commenced the Accounting Standards Codification™ project to provide a single source of authoritative U.S. GAAP and provide one level of authoritative GAAP.

1-26.

The separate entity concept directs that personal transactions of the owners must be kept separate from their business transactions. At the point of sale

1-27. 1-28.

a. The building should be recorded at cost, which is $50,000. b. Revenue should not be recorded for the savings between the cost of $50,000 and the bid of $60,000. Revenue comes from selling, not from purchasing.

1-29.

The materiality concept supports this policy.

1-30.

The Securities and Exchange Commission (SEC).

1-31.

The basic problem with the monetary assumption when there has been significant inflation is that the monetary assumption assumes a stable dollar in terms of purchasing power. When there has been inflation, the dollar has not been stable in terms of purchasing power, and therefore, dollars are being compared that are not of the same purchasing power.

1-32.

The matching principle deals with the costs to be matched against revenue. The realization concept has to do with the determination of revenue. The combination of revenue and costs determine income.

1-33.

The term "generally accepted accounting principles" is used to refer to accounting principles that have substantial authoritative support.

1-34.

The process of considering a Statement of Financial Accounting Standards begins when the Board elects to add a topic to its technical agenda. The Board only considers topics that are "broken" for its technical agenda. On projects with a broad impact, a Discussion Memorandum or an Invitation to Comment is issued. The Discussion Memorandum or Invitation to Comment is distributed as a basis for public comment. After considering the written comments and the public hearing comments, the Board resumes deliberations in one or more public Board meetings. The final Statement on

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Financial Accounting Standards must receive a majority affirmative vote of the Board. 1-35.

The FASB Conceptual Framework for Accounting and Reporting is intended to set forth a system of interrelated objectives and underlying concepts that will serve as the basis for evaluating existing standards of financial accounting and reporting.

1-36.

A committee of the AICPA that played an important role in the determination of generally accepted accounting principles in the United States between 1939 and 1959.

A committee of the AICPA that played an important role in the defining of accounting terminology between 1939 and 1959.

An AICPA board that played a leading role in the development of generally accepted accounting principles in the United States between 1959 and 1973.

The Board that has played the leading role in the development of generally accepted accounting principles in the United States since 1973.

1-37.

Concepts Statement No. 1 indicates that the objectives of general-purpose external financial reporting are primarily for the needs of external users who lack the authority to prescribe the information they want and must rely on information management communicates to them.

1-38.

Financial accounting is not designed to measure directly the value of a business enterprise. Concepts Statement No. 1 indicates that financial accounting is not designed to measure directly the value of a business enterprise, but the information it provides may be helpful to those who wish to estimate its value.

1-39.

According to Concepts Statement No. 2, to be relevant, information must be timely and it must have predictive value or feedback value, or both. To be reliable, information must have representational faithfulness and it must be verifiable and neutral.

1-40.

1. Definition 2. Measurability 3. Relevance 4. Reliability

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1-41.

1. Historical cost 2. Current cost 3. Current market value 4. Net realizable value 5. Present value

1-42.

The accrual basis income statement recognizes revenue when it is realized (realization concept) and expenses recognized when they are incurred (matching concept). The cash basis recognizes revenue when the cash is received and expenses when payments are made.

1-43.

True. Usually the cash basis does not indicate when the revenue was earned and when the cost should be recognized. The cash basis recognizes cash receipts as revenue and cash payments as expenses.

1-44.

When cash is received and when payment is made is important. For example, the timing of cash receipts and cash payments can have a bearing on a company's ability to pay bills on time.

1-45.

Sarbanes-Oxley Section 404 requires companies to document adequate internal controls and procedures for financial reporting. They must be able to assess the effectiveness of the internal controls and financial reporting.

1-46.

The financial statements auditor must report on management’s assertion as to the effectiveness of the internal controls and procedures as of the company’s year end.

1-47.

There have been many benefits for implementing Sarbanes-Oxley. Companies have improved their internal controls, procedures, and financial reporting. Many companies have improved their fraud prevention. Systems put in place to review budgets will enable companies to be more proactive in preventing problems and improve their ability to be proactive. Users of financial statements benefit from an improved financial product that they review and analyze to make investment decisions.

1-48.

Private companies are not required to report under Sarbanes-Oxley.

1-49.

In many instances, the natural business year of a company ends on December 31. Other businesses use the calendar year and thus end the accounting on December 31. For a fiscal year, the accounting period closes at the end of a month other than December.

1-50.

Accounting Trends & Techniques is a compilation of data obtained by a survey of 600 annual reports to stockholders undertaken for the purpose of analyzing the accounting information disclosed in such reports.

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1-51.

The Sarbanes-Oxley Act of 2002 has put demands on management to detect and prevent material control weaknesses in a timely manner.

1-52.

The PCAOB is the private sector corporation created by the Sarbanes-Oxley Act of 2002. They are responsible for overseeing the audits of public companies. They have broad authority over public accounting firms and auditors. Their actions are subject to the approval of the Securities and Exchange Commission. The Serious concerns were about the cost of adoption, the benefits of adoption compared to convergence, and whether IFRS were in fact as good as or better than U.S. GAAP.

1-53.

1-54.

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) met jointly in Norwalk, Connecticut on September 18, 2002. They acknowledge their commitment to the development of high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting (this is known as the Norwalk Agreement).

1-55.

The American Accounting Association Committee on Financial Reporting Policy concluded that eliminating the reconciliation in requirements was premature. Several of their points follow: 1. Material reconciling items exist between U.S. GAAP and IFRS and the reconciliation currently reflects information that participants in U.S. stock markets appear to impound to stock prices. 2. Cross-country institutional differences will likely result in differences in the implementation of any single set of standards. 3. Legal and institutional obstacles inhibit private litigation against foreign firms in the United States and the SEC rarely undertakes enforcement actions against cross-listed firms. 4. Differential implementation of standards across countries and a differential enforcement efforts directed toward domestic and cross-listed firms creates differences in financial reporting even with converged standards. 5. Harmonization appears to be occurring via the joint standard-setting activities of the FASB and the IASB; thus, special statutory intervention by the SEC appears to be unnecessary.

1-56.

Professor Ball noted these problems with implementing IFRS: 1. On the con side, a deep concern is that the differences in financial reporting quality that are inevitable among countries have been pushed down to the level of implementation and now will be concealed by a veneer of uniformity. 2. Despite increased globalization, most political and economic influences on financial reporting practice remain local.

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3. The fundamental reason for being skeptical about uniformity of implementation in practice is that the incentives of preparers and enforcers remain primarily local. 4. Under its constitution, the IASB is a standard setter and does not have an enforcement mechanism for its standards. 5. Over time the IASB risks becoming a politicized, polarized, bureaucratic on-style body. 1-57.

2009. The issue of SMEs is not part of the roadmap of convergence between IFRSs and U.S. GAAP.

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PROBLEMS PROBLEM 1-1 1.

11.

16. g

12. m

17. e

13.

18.

14.

19.

10.

15.

PROBLEM 1-2 a.

Sales on credit Cost of inventory sold on credit Payment to sales clerk Income

$ 80,000 (65,000) (10,000) $ 5,000

Collections from customers Payment for purchases Payment to sales clerk Loss

$ 60,000 (55,000) (10,000) $(5,000)

PROBLEM 1-3 a.

Statements of Position have been issued by the AICPA.

This is the definition contained in SFAC No. 6

This is the definition contained in SFAC No. 6.

Comparability is not one of the criteria for an item to be recognized.

Future cost is not one of the measurement attributes recognized in SFAC No. 5.

Revenue is usually recognized at point of sale.

Financial accounting is not designed to measure directly the value of a business enterprise.

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PROBLEM 1-4 a.

Typically, much judgment and estimates go into the preparation of financial statements.

Financial accounting is not designed to measure directly the value of a business enterprise. The end result statements can be used as part of the data to aid in estimating the value of the business.

FASB Statement of Concepts No. 2 lists timeliness, predictive value, and feedback value as ingredients of the quality of relevance.

The Securities and Exchange Commission has the primary right and responsibility for generally accepted accounting principles. They have primarily elected to have the private sector develop generally accepted accounting principles and have designated the Financial Accounting Standards Board as the primary source.

The concept of conservatism directs that the measurement with the least favorable effect on net income and financial position in the current period be selected.

The Internal Revenue Service deals with Federal tax law, not generally accepted accounting principles.

Opinions were issued by The Accounting Principles Board.

PROBLEM 1-5 1.

11.

12.

13.

14. m

PROBLEM 1-6 1.

9. g

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CASES CASE 1-1 STANDARD-SETTING: "A POLITICAL ASPECT" (This case provides an opportunity to view some of the political aspects of standard setting.) a. The hierarchy of accounting qualities in SFAC No. 2 includes neutrality as one of the ingredients. SFAC No.2 indicates that, to be reliable, the information must be verifiable, subject to representational faithfulness, and neutral. To quote from the Beresford letter: "If financial statements are to be useful, they must report economic activity without coloring the message to influence behavior in a particular direction." b. Costs of transactions do exist whether or not the FASB mandates their recognition in financial statements. The markets may not be able to recognize these costs in the short run if they are not reported. Thus investors, creditors, regulators, and other users of financial reports may not be able to make reasonable business and economic decisions if the costs are not reported. c. Much of the standard setting in the U.S. is in the private sector. A major role in the private sector has been played by The American Institute of Certified Public Accountants. Since 1973 the primary role in the private sector has been played by The Financial Accounting Standards Board. It should be noted that the Securities Act of 1934 gave the SEC the authority to determine generally accepted accounting principles and to regulate the accounting profession. The Beresford letter recognizes that the SEC and congressional committees maintain an active oversight of the FASB. d. True. Quoting from the letter: "We expect that changes in financial reporting will have economic consequences, just as economic consequences are inherent in existing financial reporting practices."

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CASE 1-2 POLITICIZATION OF ACCOUNTING STANDARDS – A NECESSARY ACT? (This case addresses the role of the Emergency Economic Stabilization Act of 2008 and the subsequent role of the SEC and the FASB). a. This is an opinion question: A review of the accounting standard was likely justified considering the economic situation. Should the review have been done by the SEC or FASB independently of congress? b. Yes. The SEC has the authority to govern GAAP in the U.S. A case could be made that the SEC should have acted sooner. c. As indicated in (b), the SEC has the authority to govern GAAP. d. No. The time frame was very short. e. Probably not. In the long run, the involvement of congress is likely to be negative.

CASE 1-3 INDEPENDENCE OF ACCOUNTING STANDARD-SETTERS (This case provides a forum to discuss the independence of accounting standardsetters. The timing of this case (December 2008) was during the period when congress was putting pressure on the SEC and the FASB to address the standard for fair value accounting). Some politicians and others thought that a standard change was needed to overt material write down of investments by financial institutions). a. Standard setters have traditionally resisted using accounting standards as a fiscal policy tool. Standard setters have tried to use standards as a neutral and objective measurement of the financial performance of public companies. b. Should the deliberative process be waived when a national emergency exists in the financial system? Note: In an Op Ed in the Washington Post, author A. Levitt, a former SEC chair, clearly disapproved of FASB’s expedited due process for new fair value guidance in FAS 157-e.

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CASE 1-4 LOOKING OUT FOR INVESTORS (The SEC plays an important role in “Looking Out for Investors.” This case provides an opportunity to discuss that role). a. Mary Schapiro addresses some of the cost of over-regulation as stifling of innovation and the superior ability of markets to protect themselves from excess. Over regulation will be costly for businesses because compliance costs tend to be high and compliance sometimes takes time to put those controls into place e.g. internal controls related to Sarbanes-Oxley. b. Under-regulation can result in inefficient capital markets. To ensure that capital markets are efficient, Mary Schapiro indicates that the SEC will approach this in four ways as follows: 1. First, structured effectively 2. Second, that they’re fed by timely and reliable information 3. Third, that they’re well-served by financial intermediaries and other market professionals 4. And fourth, that they’re supported by a strong and focused enforcement arm that will not be afraid to prosecute securities fraud. c. This is an opinion question.

CASE 1-5 FLYING HIGH (This is a good case to discuss revenue recognition and compare program accounting with the percentage of completion and completed contract method of revenue recognition used by contractors.) a. It would be difficult to separate contracts that contain provisions to earn incentive and award fees that can be reasonably estimated from contracts that cannot be reasonably estimated. b. It appears that Boeing Company is using a completed contract method for commercial airplanes. It does not represent a difficult situation in determining sales, but sales may not be representative of the production for any particular time period. They are estimating costs of sales while sales are based on deliveries. c. It is probably not difficult to determine service revenue. The service likely does not represent a long period of time. d. It should not be difficult to determine revenue from notes receivable. The terms of the notes would be objective.

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CASE 1-6 CENTERED IN HAWAII (This is a good case to discuss revenue recognition.) a. “In general, the Company recognizes revenue when persuasive evidence of an arrangement exists, delivery of the service or product has occurred, the sales price is fixed or determinable, and collectability is reasonably assured. b. Voyage Revenue Recognition. Yes, this could represent a challenge of matching cost with revenue. We likely have a situation here where expenses are incurred approximately at the same rate as the recognition of revenue. c. Yes. Appears to be a type of percentage-of-completion method. d. 1. Generally on closing date, “adequate initial and continuing investments have been received and collection of remaining balances, if any, is reasonably assured. 2. Percentage-of-completion method. Used when there is material continuing post-closing involvement. e. In general, recognizing revenue as rent over the time of the lease. For revenue related to contingent sales, the revenue is recognized only after the contingency has been resolved.

CASE 1-7 GOING CONCERN? a. The going-concern assumption is that the entity in question will remain in business for an indefinite period of time. b. Yes. The potential problem is that the firm may not be able to continue in business as a going concern. This puts into question the recoverability and classification of assets or the amounts and classification of liabilities. c. This disclosure puts the user of the statements on warning that the statements may be misleading if the company cannot continue as a going concern.

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CASE 1-8 ECONOMICS AND ACCOUNTING: THE UNCONGENIAL TWINS a. No. Per Kenneth E. Boulding: "Ritual is always the proper response when a man has to give an answer to a question, the answer to which he cannot really know. Ritual under these circumstances has two functions. It is comforting (and in the face of the great uncertainties of the future, comfort is not to be despised) and it is also an answer sufficient for action." b. No. Per Kenneth E. Boulding: "The wise businessman will not believe his accountant although he takes what his accountant tells him as important evidence. The quality of that evidence, however, depends in considerable degree on the simplicity of the procedures and the awareness which we have of them." c. Per Kenneth E. Boulding: "It is the sufficient answer rather than the right answer which the accountant really seeks." Boulding indicates that accounting does not need to be accurate in order to serve a useful function. The financial statements does not attest that they are correct only that they are presented fairly in accordance with generally accepted accounting principles.

CASE 1-9 I OFTEN PAINT FAKES (This case is intended to serve as a forum for discussing the accuracy of financial statements prepared using generally accepted accounting principles.) a. Accounting reports prepared using generally accepted accounting principles are not exactly accurate. They are intended to be sufficient to aid in making informed decisions. Reports are only as good as the underlying numbers. If numbers are not reliable, then it doesn’t matter if GAAP is properly applied. b. No, accountants do not paint fakes. But, it may take an understanding of generally accepted accounting principles to reasonably comprehend the significance of the statements.

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CASE 1-10 OVERSIGHT (This case reviews selected sections of the Sarbanes-Oxley Act.) a. Securities and Exchange Commission b. The Securities and Exchange Commission oversees the Public Company Accounting Oversight Board. c. The Public Company Accounting Oversight Board oversees the audits and related matters of public companies that are subject to the securities laws, and related matters. The intent is to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies, the securities of which are sold to, and held by and for public investors. d. Title 1 Sec. 101 (b)

Duties of the Board The Board shall, subject to action by the Commission under section 107, and once a determination is made by the Commission under subsection (d) of this section - (1) register public accounting firms that prepare audit reports for issuers, in accordance with section 102; (2) establish or adopt, or both, by rule, auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports for issuers, in accordance with section 103; (3) conduct inspections of registered public accounting firms, in accordance with section 104 and the rules of the Board; (4) conduct investigations and disciplinary proceedings concerning, and impose appropriate sanctions where justified upon, registered public accounting firms and associated persons of such firms in accordance with section 105; (5) perform such other duties or functions as the Board (or the Commission, by rule or order) determines are necessary or appropriate to promote high professional standards among, and improve the quality of audit services offered by, registered public accounting firms and associated persons thereof, or otherwise to carry out this act, in order to protect investors, or to further the public interest; (6) enforce compliance with the Act, the rules of the Board, professional standards and the securities laws relating to the preparation and issuance of audit reports and the obligations and liabilities of accountants with respect thereto, by registered public accounting firms and associated persons thereof; and

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(7) set the budget and manage the operations of the Board and the staff of the Board e. Public accounting firms that prepare or issue, or participate in the preparation or issuance of, any audit report with respect to any issuer. f. Sec 104 (a) In General – The Board shall conduct a continuing program of inspections to assess the degree of compliance of each registered public accounting firm and associated persons of that firm with this Act, the rules of the Board, the rules of the Commission, or professional standards in connection with its performance of audits, issuance of audit reports, and related matters involving issuers. g. Sec 103 (a) (1) …amend or otherwise modify or alter, such auditing and related attestation standards, such quality control standards, and such ethics standards to be used by registered public accounting firms in the preparation and issuance of audit reports, as required by this Act or the rules of the Commission, or as may be necessary or appropriate in the public interest or for the protection of investors. h. Sec 106 (a) (1) In General Any foreign public accounting firm that prepares or furnishes an audit report with respect to any issuer, shall be subject to this act and the rules of the Board and the Commission issued under this Act, in the same manner and to the same extent as a public accounting firm that is organized and operates under the laws of the United States or any state, except… i.

Recognition of Accounting Standards (1) In General – In carrying out its authority under subsection (a) and under section 13(b) of the Securities Act of 1934, the Commission may recognize, as generally accepted for purposes of the securities laws, any accounting principles established by a standard setting body…

Funding 1. The “Board” – annual accounting support fee for the Board (among issuers) 2. Financial Accounting Standards Board – Annual Accounting Support for Standard Setting Body (among issuers)

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k. Title 11 Sec 201 Non-audit service excluded (1) bookkeeping or other services related to the accounting records or financial statements of the audit client; (2) financial information systems design and implementation; (3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit outsourcing services; (6) management functions or human resources; (7) broker or dealer, investment adviser, or investment banking services; (8) legal services and expert services unrelated to the audit; and (9) any other service that the Board determines, by regulation, is impermissible. Tax services for an audit client Only if the activity is approved in advance by the audit committee of the issuer, in accordance with subsection (i) l.

Title IV Sec 404

Management Assessment of Internal Controls

(a) …each annual report… contain an internal control report, which shall – (1) state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and (2) contain an assessment, as of the end of the most recent fiscal year of the issuer, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting m. Management does not like the responsibility relating to internal controls and management may not have very much expertise in this area.

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CASE 1-11 REGULATION OF SMALLER PUBLIC COMPANIES a. There is substantial cost to a company to comply with the SEC securities regulations. These costs could result in companies leaving the United States to avoid the SEC regulations. Companies could also decide to go private, which would reduce the number of securities available to the public. Companies could also decide to go out of business. CASE 1-12 STABLE FUNDING (This case provides for a discussion of the importance of stable funding for standard setters.) a. The FASB is funded through the issuer accounting support fee since enactment of Sarbanes-Oxley. b. The Dodd-Frank Act recognized the importance of sufficient and stable resources by authorizing the commission to require a national securities association to fund the GASB by establishing directed FINRA to establish this fee which will strengthen the independence of GASB). (Note: This fee has likely been established). c. IASB (IFRS) does not have stable funding mechanisms.

CASE 1-13 RULES OR FEEL? (This case provides the opportunity to compare the IFRSs more principles-based GAAP with the U.S. rules-based GAAP.) a. U.S. accounting standards consist of hundreds of pages of rules. The principlesbased approach (a broad-brush approach) relies more on companies to reasonably apply the rules and using their professional judgment. Some maintain that principles-based approach would result in more lawsuits because of the subjectivity of professional judgment. Others maintain that a principles-based approach would result in fewer lawsuits. b. This is an opinion question. Several reasons for giving up U.S. GAAP should be given along with several reasons for not giving up U.S. GAAP.

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CASE 1-14 PCAOB ENFORCEMENT – IFRS STANDARDS (This case is intended to serve as a forum for discussing enforcement under an IFRS environment.) a. It will be more difficult for the PCAOB to enforce standards under an IFRS environment. b. If the only attempt at enforcement is in the United States, then companies in the United States will be at a disadvantage in an IFRS environment.

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Chapter 2 Introduction to Financial Statements and Other Financial Reporting Topics

QUESTIONS 2- 1.

a. b. c. d. e.

2- 2.

The responsibility for the preparation and integrity of financial statements rests with management. The auditor simply examines them for fairness, conformity with GAAP, and consistency.

2- 3.

The basic purpose of the integrated disclosure system is to achieve uniformity between annual reports and SEC filings. It is hoped that this will improve the quality of disclosure and lighten the disclosure load for the companies reporting.

2- 4.

The explanatory paragraphs explain important considerations that the reviewer of the financial statements should be aware of. An example would be a doubt as to the ability of the business to continue on as a going concern. A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an examination in accordance with generally accepted auditing standards.

2- 5.

Unqualified opinion with explanatory paragraph Unqualified opinion with explanatory paragraph Unqualified opinion Adverse opinion Qualified opinion

2- 6.

No. The accountant's report will indicate that they are not aware of any material modifications that should be made to the financial statements in order for them to be in conformity with generally accepted accounting principles, and the report will indicate departures from generally accepted accounting principles. The accountant does not express an opinion on reviewed financial statements.

2- 7.

The accountant does not express an opinion or any other form of assurance with a compilation.

2- 8.

No. Some statements have not been audited, reviewed, or compiled. These statements are presented without being accompanied by an accountant's report.

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2- 9.

Balance Sheet The purpose of a balance sheet is to show the financial position of an accounting entity as of a particular date. Income Statement The income statement summarizes the results of operations for an accounting period. Statement of Cash Flows The statement of cash flows details the inflows and outflows of cash during a specified period of time.

2-10.

Notes to the financial statements increase the full disclosure of the statements by providing additional information on inventory and depreciation methods, subsequent events, contingent liabilities, etc.

2-11.

Contingent liabilities depend on the outcome of a future event that financially may or may not be favorable to the company. Lawsuits represent contingent liabilities since their outcome may occur months or years in the future and the company may or may not incur a financial loss due to the outcome of the case.

2-12.

a, c

2-13.

A proxy is the solicitation sent to stockholders for the election of directors and for the approval of other corporation actions. The proxy represents the shareholder authorization regarding the casting of that shareholder’s vote.

2-14.

A summary annual report is a condensed annual report that omits much of the financial information included in a typical annual report.

2-15.

The firm must include a set of fully audited statements and other required financial disclosures in the proxy materials sent to shareholders. The 10-K is also available to the public.

2-16.

There is typically a substantial reduction in non-financial pages and financial pages. The greatest reduction in pages is usually in the financial pages.

2-17.

Cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

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2-18.

The income statement and the statement of cash flows. The income statement describes income between two balance sheet dates. The statement of cash flows describes cash flows between two balance sheet dates.

2-19.

Assets, liabilities, and owners’ equity.

2-20.

No. Cash dividends are paid with cash. This reduces the cash account and the retained earnings account.

2-21.

Notes are an integral part of financial statements. A detailed review of footnotes is absolutely essential in order to understand the financial statements.

2-22.

APB Opinion No. 22 requires disclosure of accounting policies as the first note to financial statements or just prior to the notes.

2-23.

They are interchangeable terms referring to ideals of character and conduct. These ideals, in the form of codes of conduct, furnish criteria for distinguishing between right and wrong.

2-24.

Law can be viewed as the minimum standard of ethics.

2-25.

Assets = Liabilities + Stockholders' equity (capital).

2-26.

The scheme of the double-entry system revolves around the accounting equation: Assets = Liabilities + Stockholders' Equity With double-entry, each transaction is recorded with the total dollar amount of the debits equal to the total dollar amount of the credits. Each transaction affects two or more asset, liability, or owners' equity accounts (including the temporary accounts).

2-27.

2-28.

Assets, liabilities, and stockholders' equity accounts are referred to as permanent accounts because the balances in these accounts carry forward to the next accounting period.

Revenue, expense, gain, loss, and dividend accounts are not carried into the next period. These accounts are closed to Retained Earnings. They are referred to as temporary accounts.

Because the employee worked in the period just ended, the salary must be matched to that period's revenue whether or not cash was paid to the employee.

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2-29.

Adjusting entries are necessary to match revenues with the expenses that produced those revenues. This is the main tenant of accrual accounting. For example, at the end of the accounting cycle depreciation must be calculated to reflect the use of an asset.

2-30.

Companies use a number of special journals to improve record keeping efficiency that could not be obtained by using only the general journal.

2-31.

Filing deadline for Form 10-K follow: 1. Large accelerated filer ($700 million or more market value) – 60 days 2. Accelerated filer ($75 million or more and less than $700 million market value) – 75 days 3. Non-accelerated filer (less than $75 million market value) – 90 days

2-32.

Sole Proprietorship A sole proprietorship is a business entity owned by one person. Partnership A partnership is a business owned by two or more individuals. Corporation A corporation is a legal entity incorporated in a particular state. Ownership is evidenced by shares of stock.

2-33.

Even an efficient market does not have access to “inside” information; therefore, the use of insider information could result in abnormal returns.

2-34.

In an efficient market, the method of disclosure is not as important as whether or not the item is disclosed.

2-35.

Abnormal returns could be achieved if the market does not have access to relevant information or if fraudulent information is provided.

2-36.

With the purchase method the firm doing the acquiring records the identifiable assets and liabilities at fair value at the date of acquisition. The difference between the fair value of the identifiable assets and liabilities and the amount paid is recorded as goodwill (an asset).

2-37.

Consolidated statements reflect an economic, rather than a legal, concept of the entity.

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2-38.

The financial statements of the parent and the subsidiary are consolidated for all majority-owned subsidiaries unless control is temporary or does not rest with the majority owner.

2-39.

The SEC requires that a copy of the companies code of ethics be made available by filing and exhibit with its annual report, or by providing it on the company’s Internet Web Site.

2-40.

Treadway Commission is the popular name for the National Commission on Fraudulent Reporting, named after its first chairman, former SEC Commissioner James C. Treadway. The commission has issued a number of recommendations for the prevention of fraud in financial reports, ethics, and effective internal controls.

2-41.

The Sarbanes-Oxley Act requires the auditor to present a report on the firm’s internal controls. The Sarbanes-Oxley Act also requires a report of management on internal control over financial reporting.

2-42.

Audit Report Report on the firm’s internal controls

2-43.

A report of management on internal control over financial reporting.

2-44.

Reasons why some private companies elect to follow the law follow: 1. Owners hope to sell the company or take it public 2. Directors who sit on public company boards see the law’s’ benefit 3. Executives believe strong internal controls will improve efficiency 4. Customers require strong internal controls 5. Lenders are more likely to approve loans

2-45.

1. The subsidiary’s accounts are shown separately from the parent’s. 2. Present the parent’s and subsidiary accounts summed.

2-46.

Control can be gained by means other than obtaining majority stock ownership. The FASB recognizes a risk, rewards, decision-making ability and the primary beneficiary.

2-47.

Some countries do not consolidate. Other countries use consolidation with different rules.

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PROBLEMS PROBLEM 2-1 a.

All-purpose statement is not a classification for an audit opinion.

An unqualified opinion usually has the highest degree of reliability.

The typical unqualified opinion has three paragraphs.

All of the above.

Two years of audited balance sheets and three years of audited statements of income and three years of statements of cash flows.

Form 10-K is the annual financial report submitted to the Securities and Exchange Commission.

PROBLEM 2-2

Amount paid

Prepaid Insurance 180,000 320,000 310,000

December 31, 2011

170,000

December 31, 2011

Insurance Expense X 320,00

PROBLEM 2-3 a.

5 The balance sheet equation is defined as assets are equal to liabilities plus stockholder’s equity.

Assets ($40,000) = liabilities(?) + stockholders’ equity ($10,000).

Assets ($100,000) = liabilities ($40,000) + stockholder’s equity(?)

Accounts receivable is a balance sheet account and therefore a permanent account.

Insurance expense is an income statement account and therefore a temporary account.

Expenses, assets, and dividends all have a normal balance of a debit.

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PROBLEM 2-4 c b a d

1 2 3 4

PROBLEM 2-5 Prepaid Insurance (1)

640

(2)

100

(3)

100

(4)

800

May 1

960

Insurance Expense (1) 640

Supplies Expense December 1 400

Supplies (2)

100

Interest Receivable

Interest Income (3) 100

Salaries Expense

Salaries Payable (4) 800

Unearned Revenue (5) 600

(5)

Revenue 600

Accounts Payable (6) 400

(6)

400

Advertising Expense

PROBLEM 2-6

Cash Accounts receivable Equipment Accounts payable Common stock Sales Purchases Rent expense Utility expense Selling expenses

Permanent (P) or Temporary (T) P P P P P T T T T T

Normal Balance Dr. (Cr.) Dr. Dr. Dr. Cr. Cr. Cr. Dr. Dr. Dr. Dr.

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PROBLEM 2-7 Insurance Expense (1)December 31 600

July 1 1,200

Supplies Expense (2)

300

(3)

1,000

(4)

200

(5)

500

Supplies September 10 500 (2)

Revenue December 1 1,000

300

Unearned Revenue (3) 1,000

Interest Expense

Interest Payable (4)

Salaries Expense

Revenue (6)

Prepaid Insurance (1) December 31 600

200

Salaries Payable (5) 500

400

(6)

Accounts Receivable 400

PROBLEM 2-8 c 1 d 2 b 3 a 4

PROBLEM 2-9 Cash July 1 10,000 July 20 300 July 24 400

July 15 500

July 8

Accounts Receivable 3,000 July 15 500

July 1

10,000

July 20

300

Revenue July 8

Land

Accounts Payable July 12 600

3,000

Repair Expense July 12 600 Wages Expense July 24 400

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PROBLEM 2-10 a.

Management has the primary responsibility for the financial statements

Unqualified opinion states that the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the entity, in conformity with generally accepted accounting principles

A review consists principally of inquiries made to company personal and analytical procedures applied to financial data

A twenty-year summary of operations need not be provided with a complete set of financial statements

Financial statements of legally separate entities may be issued to show financial position, income, and cash flow as they would appear if the companies were a single entity (consolidated)

PROBLEM 2-11 Cash Dec 10 Dec 17 Dec 28

Dec 6 Dec 14 Dec 24

2,500 3,000 1,200

Dec 2 Dec 21

Accounts Receivable 4,000 Dec 24 1,200 900

2,200 original cost

Land Dec 14

Sales Dec 2 Dec 6

500 6,000 700

4,000 2,500

Office Salaries Dec 10 500

Gain on Sale of Land Dec 14 800

2,200

Equipment

Services Dec 21 900

Dec 17 6,000

Accounts Payable Dec 28

700

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CASES CASE 2-1 THE CEO RETIRES Teaching Note: The CEO Retires (Teaching note prepared by the American Accounting Association) PURPOSE: This case is meant to illustrate that the accounting choices available can be used by management to manipulate the reported financial results of the company. CONTENT: The CEO of a company is entering the last year of his employment. For reasons of enhanced reputation, maximum compensation in his final year, and maximum compensation through the years via his pension, he has the incentive to manipulate the financial results of the company. Since this is his last year with the company, any long-term effects of the decisions he may make are not considered relevant. Furthermore, there are numerous directions the CEO can take: changing accounting estimates, deferring investing decisions, or changing accounting methods. After consideration of a variety of alternatives, the CEO meets with the CFO to get his response to the CEO’s proposed options. Decision Model a.

Determine the Facts

Work through the case, identifying essential facts, especially those included in the contents section above. Known facts should be listed first; then determine what one would want to know if possible. NOTE: Make the point to students that we never have all the facts; decisions are almost always made on incomplete information. b.

Define the Ethical Issues (1)

List all stakeholders - be sure that the class is thorough in this step -- the ethical issues will most likely arise out of conflicting interests between and among the stakeholders. the CEO, Dan Murphy the CFO, Mike Harrington the other members of top management the members of the Board of Directors the company’s auditors

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the company’s employees (i.e., if inventory builds, it may lead to later layoffs; a lack of repair work may create dangers in the workplace) the company’s customers (i.e., if inventory builds, it may lead to obsolescence; lack of repair work may lead to product quality problems) (2) List the ethical issues The CEO’s compensation

vs.

The integrity of the company’s financial statements

The CFO’s loyalty to his superior

vs.

The CFO’s responsibility to his job

The CFO’s loyalty to his superior

vs.

The CFO’s responsibility to protect the interests of the company and its employees

Top management’s responsibility to represent the interests of the shareholders

vs.

Each individual’s desire for promotion and advancement

The Board of Director’s duty to provide oversight on the behalf of the shareholders

vs.

Rewarding the CEO for a job well done

The auditor’s duty to ensure that the financial statements present fairly the condition of the company

vs.

The auditor’s desire to remain engaged a the auditor of the company

(This list can be extended, but you should be sure that these issues are identified) c.

Identify Major Principles, Rules, and Values (Here you will repeat some of the above, e.g. integrity, but you will translate others into ethical language, e.g., fairness, obligation, rights) Integrity (of the CEO and of the financial statements) Equity Fairness Credibility Protection of the business

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Specify the Alternatives Identify major options: encourage creative solutions that may be closer to win-win if possible. The CFO could support a favorable plan for the CEO The CFO could object to the proposals and refuse to sign off on them The CFO could object to the proposals and threaten to go to the Board if the CEO persists The CFO could communicate his concerns to the outside auditors

Note:

At this point, or even earlier, some students will have begun to take a position. The instructor should be aware of these positions and challenge students to be open to questioning their position, as well as to be open to similar questioning by others. You may want to return to this "position taking" in the discussion over Step (g), Make Your decision.

Compare Norms, Principles, and Values with the Various Alternatives See how many of the class members will move to a decision at this point, based on the force or strength of a norm or principle. In some cases, a principle is so strong or the harm so egregious that some will decide now. For example, the concern for integrity of the financial statements may lead to strong resistance by the CFO to the CEO’s proposals. Regardless of whether a decision is reached, work through Steps f and g as if such steps were still required.

Assess the Consequences Take two or three differing alternatives and examine the long- and short-range consequences. The CFO could support a favorable plan for the CEO The CEO benefits from enhanced retirement benefits (if the outside auditors sign off) The CFO may be rewarded by the CEO with increased salary or bonus.

The firm, including successor leaders and employees, may suffer from reduced earnings in the years following the CEO’s retirement. 32 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

The CFO may have problems with successor leaders if his agreement to the CEO’s plan is discovered. The CFO’s integrity will be compromised. The CFO could object to the proposals and refuse to sign off on them The CEO may drop his plans to enhance his retirement. The CEO may threaten to penalize the CFO’s job security or income. The CEO may take his plan to the Board without concurrence of the CFO. The CFO’s integrity will be intact. The CFO could object to the proposals and threaten to go to the Board if the CEO persists The CEO may drop his plans to enhance his retirement. The CEO may threaten to penalize the CFO’s job security or income. The CFO may stand fast or may capitulate and agree. The CEO may persist and the CFO may go to the Board. The Board may reject the CEO’s plans. The Board may agree with the CEO. The Board may seek the advice of the outside auditors. The CFO’s integrity is intact. The CFO could communicate his concerns to the outside auditors. The outside auditors may agree with the CFO and indicate that they will refuse to issue an unqualified report. The outside auditors may support the CEO’s plan. The CFO will then have to drop the matter or decide whether to go to the Board. The CFO’s integrity will be intact. 33 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

(There may be additional consequences to alternatives reviewed. There may also be other alternatives. The task now is to weigh or evaluate the consequences of the various alternatives. Some kind of numerical weighting, like a +3, -3 scale, can be used to determine comparative value of alternatives. Point out to the class the difficulty of assigning numerical values, but also note that we do compare, routinely, the significance of various consequences, although not always quantitatively.) (If a decision was not reached in Step (e) above, then no principle or value was determinative. Now the consequence with the highest numerical value should be the choice if it squares with one of the basic listed principles and values.) g.

Make Your Decision Take a vote; insist that everyone choose. Examine the outcome and rationale for different positions, if there is time.

TIME ALLOCATION A full discussion and analysis of the case will take approximately an hour. If you are interested in focusing on the identification of ethical issues at various points in the course, you could deal with the identification of stakeholders and defining of the ethical issues in 15-20 minutes.

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CASE 2-2 THE DANGEROUS MORALITY OF MANAGING EARNINGS a.

According to the article, "most managers and their accountants know otherwise that managing short-term earnings can be part of a manager's job."

"It seems many managers are convinced that if a practice is not explicitly prohibited or is only a slight deviation from rules, it is an ethical practice regardless of who might be affected either by the practice or the information that flows from it."

"A major finding of the survey was a striking lack of agreement. None of the respondent groups viewed any of the 13 practices unanimously as an ethical or unethical practice."

On average, the respondents viewed management of short-term earnings by accounting methods as significantly less acceptable than accomplishing the same ends by changing or manipulating operating decisions or procedures.

The direction of the effect on earnings matters. Increasing earnings is judged less acceptable than reducing earnings.

Materiality matters. Short-term earnings management is judged less acceptable if the earnings effect is large rather than small.

The time period to the effect may affect ethical judgments.

The method of managing earnings has an effect.

Management does not have the ability to manage earnings in the long run by influencing financial accounting.

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CASE 2-3 FIRM COMMITMENT? a.

Yes. SFAC No. 6, "Elements of Financial Statements:" "Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events."

The airlines had millions and millions of miles accumulated in unused miles. Thousands of these accounts are inactive and will never accumulate adequate miles for a flight or any award. In addition, the airlines apparently have the right to change the terms for granting a flight or any awards.

A contingent liability is dependent upon the occurrence or non-occurrence of one or more future events to confirm the liability.

Yes. In practical terms, the unused miles represent a contingent liability. The situation is complicated by the fact that the airlines apparently have the right to make changes to their frequent-flier programs.

Recommend that the contingent liability be recorded and the accounting policy be disclosed. In practice, the airlines record this liability and briefly describe their policy. Seldom is the dollar amount of the liability disclosed. Most airlines use the incremental method to account for their frequent flier awards. Once a program member accumulates the required number of miles to qualify for free travel, then the liability is recorded. The dollar amount of the liability is estimated at the incremental cost of providing the free transportation. The incremental cost may be computed differently by each airline. Examples of cost factors to be considered are costs of food, additional fuel, issuing the ticket and handling of baggage.

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CASE 2-4 MULTIPLE COUNTRY ENFORCEMENT (This case brings out that a company can be subject to securities enforcement actions in more than one country.) a.

The Netherlands company sold securities in the United States.

The Netherlands is conducting a parallel criminal investigation because it was a Netherlands company selling securities in the Netherlands.

Many countries may run parallel criminal investigations. Some companies register their securities on several exchanges around the world.

CASE 2-5 MATERIALITY: IN PRACTICE (This case provides the opportunity to review the application of the materiality concept.) a.

Professional standards require auditors to make a preliminary judgment about materiality levels during the planning of an audit. Therefore it would be prudent for auditors to give careful consideration to planning materiality decisions.

SAS No. 47 recognizes that it ordinarily is not practical to design procedures to detect misstatements that could be qualitatively material.

It is difficult to design procedures to detect misstatements that could be quantitatively material. Although difficult to design these procedures, a number of rule of thumb materiality calculations have emerged. A difficulty with these rule of thumb materiality calculations is that sizeable differences can result depending on the rule of thumb.

Because of the difficulty of applying the materiality concept it is often an issue in court cases involving financial statements.

It is difficult to determine materiality as it relates to control weaknesses. But the materiality concept must be considered when reviewing for control weaknesses.

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CASE 2-6 MANAGEMENT’S RESPONSIBILITY a.

The official position as presented by the accounting profession is that the financial statements are the responsibility of the Company’s management.

The accountant (auditor) expresses an opinion on the financial statements based on the audit. The audit is to be conducted in accordance with generally accepted auditing standards.

Society appears to focus on the role of the independent auditor as a public watchdog. This includes taking responsibility for the financial statements. This role is broader than the official position as to the responsibility of the accountant (auditor). Another factor is that the accountant (auditor) is perceived as having the ability to pay, either directly, or by way of insurance.

The Sarbanes-Oxley Act requires that management issue annually a report on internal control systems.

CASE 2-7 SAFE HARBOR (This case provides the opportunity for the student to express opinions as to any benefits to users of financial reports from forward-looking statements.) a.

Management is in an ideal position to project financial results. Users of financial reports will likely be aided in making decisions by the forward-looking statements of management.

Yes. Investors will be aided in making decisions because management can use their knowledge of accounting, finance and economics to prepare forward looking financial statements. Abusive litigation is probably of little benefit to investors, since the lion’s share of recoveries under the litigation may go to the attorneys who brought the suit than to the investors.

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CASE 2-8 ENFORCEMENT (This news release comments on the first disciplines of an accounting firm and auditors under the Sarbanes-Oxley Act of 2002). a.

“The order bars Mr. Morris from association with a registered accounting firm and revokes the firm’s registration.” He could possibly work for a non registered accounting firm. He could also work in industry.

Mr. Morris will not be able to function as a certified public accountant in a registered accounting firm. Mr. Morris apparently can still function as a certified public accountant outside a registered accounting firm. Goldberger and Postelnik were only censured. There were no restrictions on where they could work. Certification is granted by individual states. All three may have subsequent problems with New York State as to their certification.

CASE 2-9 NOTIFY THE SEC a. Form 8-K. b. The circumstances surrounding the resignation would be of interest to the public because this information could be important when valuing the company. Note: Comments from the Administrative Proceeding Legal Background “Under the Exchange act, a public company must file with the Commission a report on Form 8-K when a director resigns from the board. If a director has resigned because of a disagreement with the company, known to an executive officer, on any matter relating to the company’s operations, policies, or practices, the company must, among other things, disclose a brief description of the circumstances of the disagreement. In addition, the company must give the director the opportunity for timely review and to respond to the company’s disclosure about the director’s resignation, and the company is required to file any letter written by the director to the company in response to the company’s disclosure. Absent such a disagreement, the company must report the resignation, but need not provide the reasons…”

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HP Fails to Disclose the Reasons for Mr. Perkins’ Resignation “HP executives understood that, in the event a director resigned over a disagreement with the company on a matter relating to its operations, policies, or practices, the company would need to report to the Commission (and thereby disclose to investors) the circumstances of the disagreement…” “Accordingly, it is hereby ORDERED that Respondent HP cease and desist from committing or causing any violations and any future violations of Section 13(a) of the Exchange Act and Rule 13a-11 thereunder.”

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Chapter 3 Balance Sheet

QUESTIONS 3-1.

Assets - Resources of the firm Liabilities – Debts or obligations of the firm; creditors' interest Shareholders’ Equity - Owners' interest in the firm

3-2.

a. L b. L c. A

3-3.

a. TA b. CA

3-4.

They are listed in order of liquidity, which is the ease with which they can be converted to cash.

3-5.

Marketable securities are held as temporary investments or idle cash. They are short-term, low risk, highly liquid, low yield. Examples are treasury bills and commercial paper. Investments are long-term, held for control or future use in operations. They are usually less liquid and expected to earn a higher return.

3- 6.

Accounts receivable represents the money that the firm expects to collect; accounts payable represents the debts for goods purchased by a firm.

3-7.

A retailing firm will have merchandise inventory and supplies. A manufacturing firm will have raw materials, work in process, finished goods, and supplies.

3-8.

Depreciation represents the allocation of an asset’s cost over the period it is utilized. Tools, machinery, and buildings are depreciated because they wear out. Land is not depreciated, since its value typically does not decline. If the land has minerals or natural resources, it may be subject to depletion.

3-9.

Straight-line depreciation is better for reporting, since it results in higher profits than does accelerated depreciation. Double-declining balance is preferable for tax purposes, since it allows the highest depreciation and, thereby, lower taxes in the early years of the life of the asset. Using doubledeclining-balance for taxes increases the firm's cash flow in the short run.

d. A e. A f. A c. IA d. CA

g. L h. A i. A

j. E k. E l. A

e. IA f. CA

m. L n. L o. A g. TA h. CA

p. q. r. i. TA j. CA

A A A

k. IV l. TA

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3-10.

The rent is treated as a liability because it is unearned. The rental agency owes the tenant the use of the property until the end of the term of the agreement. The rent should be recognized as income over the period covered by the rent.

3-11.

A bond will sell at a discount if its stated rate of interest is less than the market rate. It sells to yield the market rate. It might also sell low if there were a great deal of risk involved.

The discount is shown as a reduction of the liability. Bonds payable Less: bond discount

$1000 (170) $830

The bond discount is amortized, with the amortization shown as interest expense on the income statement. 3-12.

Include noncontrolling interest as a long-term liability for primary analysis.

3-13.

Historical cost causes difficulties in analysis because cost does not measure the current worth or value of the asset.

3-14.

At the option of the bondholder (creditor), the bond is exchanged for a specified number of common shares (and the bondholder becomes a common stockholder). Often convertible bonds are issued when the common stock price is low, in the opinion of management, and the firm eventually wants to increase its common equity. By issuing a convertible bond, the firm may get more for the specified number of common shares. When the common stock price increases sufficiently, the bondholder will convert the bond to common stock.

3-15. a. b. c. d. e.

3-16.

CA CA CL CL E

f. g. h. i. j.

CA E NA CA E

k. l. m. n. o.

CL NL CL CA E

p. q. r. s.

NA CA CL CA

With the cumulative feature, if a corporation fails to declare the usual dividend on the cumulative preferred stock, the amount of past dividends becomes dividends in arrears. Common stockholders cannot be paid any dividends until the preferred dividends in arrears and the current preferred dividends are paid.

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When preferred stock is participating, preferred stockholders may receive an extra dividend beyond the stated rate. The terms of the participation depend on the terms included with the stock certificates.

Convertible preferred stock contains a provision that allows the preferred stockholders, at their option, to convert the share of preferred stock at a specific exchange ratio into another security of the corporation.

Callable preferred stock may be retired (recalled) by the corporation at its option.

When the corporation either files bankruptcy or liquidates the preferred stockholders normally have preference to have their claims settled prior to any payment to common stockholders.

3-17.

The account “unrealized exchange gains or losses” is an shareholders’ equity account that is used to record gains or losses from translating financial statements in a foreign currency into U.S. dollars so entity can be incorporated into the financial statements of an enterprise by consolidation, combination, or the equity method of accounting.

3-18.

Treasury stock represents the stock of the company that has been sold, repurchased, and not retired. It is subtracted from stockholders' equity so that net stockholders' equity is for shares outstanding only.

3-19.

The $60, or any portion, will occur as cost of sales if the goods are sold and as inventory if they are not sold.

3-20.

These subsidiaries are presented as an investment on the parent's balance sheet.

3-21.

Noncontrolling interest is presented on a balance sheet when an entity in which the parent company has less than 100% ownership is consolidated.

3-22.

If DeLand Company owns 100% of Little Florida, Inc., it will not have a noncontrolling interest, since noncontrolling interest reflects ownership of noncontrolling shareholders in the equity of consolidated subsidiaries that are not wholly owned. If it only owns 60%, then there would be a noncontrolling interest. Little Florida would not be consolidated when control is temporary or does not rest with the majority owner.

3-23.

The account “unrealized decline in market value of noncurrent equity investments” is an shareholders’ equity account that is used to record unrealized losses on long-term equity investments.

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3-24.

Redeemable preferred stock is subject to mandatory redemption requirements or has a redemption feature that is outside the control of the issuer. Coupled with the typical characteristics of no vote and fixed return, this security is more like debt than equity for the issuing firm.

3-25.

Fair value is the price that a company would receive to sell an asset (or transfer a liability) in an orderly transaction between market participants on the date of measurement.

3-26.

This represents the most objective active market.

3-27.

Level 3 valuation can be very subjective.

3-28.

A quasi-reorganization is an accounting procedure equivalent to an accounting fresh start. A quasi-reorganization involves the reclassification of a deficit in retained earnings to paid-in capital. It changes the carrying values of assets and liabilities to reflect current values.

3-29.

An ESOP is a qualified stock-bonus, or combination stock-bonus and money-purchase pension plan, designed to invest primarily in the employer's securities.

3-30.

These institutions are willing to grant a reduced rate of interest because they are permitted an exclusion from income for 50% of the interest received on loans used to finance an ESOP's acquisition of company stock.

3-31.

Some firms do not find an ESOP attractive because it can result in a significant amount of voting stock in the hands of employees. This will likely dilute the control of management.

3-32.

This firm records the commitment as a liability and as a deferred compensation deduction within stockholders' equity.

3-33.

Depreciation is the process of allocating the cost of building and machinery over the periods of benefit. Spreading the cost of an intangible asset is called amortization, while spreading the cost of a natural resource is called depletion. The three factors usually considered when computing depreciation are asset cost, length of the life of the asset, and the salvage value when it is retired from service.

3-34.

3-35.

A firm will often want to depreciate slowly for the financial statements because this results in the highest immediate income. The same firm would want to depreciate at a fast pace for income tax returns because this results in the lowest immediate income and thus lower income taxes.

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3-36.

Over the life of an asset, the total depreciation will be the same, regardless of the depreciation method selected.

3-37.

Yes. Depreciation is the process of allocating the cost of buildings and machinery over the periods of benefit.

3-38.

Conceptually, this account balance represents retained earnings from other comprehensive income.

3-39.

Donated capital results from donations to the company by stockholders, creditors, or other parties.

3-40.

The land account under assets would be increased and the donated capital account in stockholders’ equity would be increased. The donated transaction would be recorded at the appraisal amount.

3-41.

Those that require retroactive recognition (those require balance sheet and income statement recognition).

Those that do not require retroactive recognition but require disclosure in the notes to the financial statements.

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PROBLEMS PROBLEM 3-1 a.

Noncontrolling interest will be 20% of the total equity of $300,000, or $60,000.

The noncontrolling interest share of earnings will be 20% of $50,000, or $10,000.

PROBLEM 3-2 a.

The dividends would not be shown on the balance sheet. The dividends have reduced retained earnings. The ending balance of retained earnings is shown on the balance sheet.

You would disclose a contingent liability in note format.

No accounting recognition is given for possible general business risks for which losses cannot be estimated.

This subsequent event requires a note.

Restricted cash should be classified as a long-term asset.

Securities held for control should be classified as long-term investments.

Land must be listed at cost. It will have to be written back down.

This would be disclosed in a note. (Also on the income statement, the loss will be disclosed as an extraordinary item.) The asset should be removed from the balance sheet.

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PROBLEM 3-3

a. Year 1 Year 2 Preferred Cumulative from year 1 10,000 shares x $100 par value = $1,000,000 x 10% Year 2 dividend 10,000 shares x $100 par value = $1,000,000 x 10% Total Year 3 Preferred Year 3 dividend 10,000 shares x $100 par value = $1,000,000 x 10% Common The common gets the remaining dividends because the preferred is nonparticipating Total

b. Year 1 Year 2 Preferred Arrears [See computation in (a)] Year 2 dividend [See computation in (a)] Total

Preferred 0

Common 0

$100,000

100,000 $200,000

$100,000

$ 120,000 $ 120,000

Preferred 0

Common 0

$100,000

100,000 $200,000

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Year 3 Preferred Year 3 dividend [See computation in (a)] Common 80,000 shares x $5 = $400,000 x 10% = 40,000 2% to preferred (2% x $1,000,000)

$100,000

$ 40,000 20,000

2% to common (2% x $400,000) Remaining dividend to common Total

8,000

$120,000

52,000 $ 100,000

Year 1

Preferred 0

Common 0

Year 2 Preferred Arrears [See computation in (a)]

$100,000

Year 2 Dividend [See computation in (a)] Total Year 3 Preferred Year 3 dividend [See computation in (a)] Common 80,000 shares x $5 = $400,000 x 10% = 40,000

100,000 $200,000

$100,000

$ 40,000

Fully participating; therefore, the remaining dividend will be split between preferred and common in proportion to their outstanding stock at total par value.

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Total par value of preferred $1,000,000 71.43% Total par value of common $ 400,000 28.57% Total $1,400,000 100.00% Preferred 71.43% x $80,000 = Common 28.57% x $80,000 = Total

$157,144

22,856 $ 62,856

d. Year 1

Preferred 0

Common 0

Year 2 Preferred Year 2 dividend [See computation in (a)] Common Remainder to common Total Year 3 Preferred Year 3 dividend [See computation in (a)] Common Remainder to common Total

57,144

$100,000

$ 100,000 $ 100,000

$100,000

$ 120,000 $ 120,000

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PROBLEM 3-4 a.

“Balance sheet” should be in the heading.

$10,000 cash should be classified under “other assets” (restricted for payment of long-term note).

Disclose accumulated depreciation related to building.

Patent should be classified under intangibles.

Organizational costs should be disclosed under intangibles.

Prepaid insurance should be under current assets.

Dividends payable should be classified as a current liability.

Notes payable and bonds payable due in the years 2014 and 2018, respectively, should not be classified as a current liability.

PROBLEM 3-5 a. Year 1 Preferred 5,000 x $100 x 9% = $45,000 Year 2 Preferred Cumulative 5,000 x $100 x 9% = $45,000 Common 10,000 x $10 x 9% = 9,000

Preferred

Common

$ 40,000

5,000 45,000

9,000

Fully participating; therefore, the remaining dividend will be split between preferred and common in proportion to their outstanding stock at total par value.

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Total par value of preferred $500,000 83.3% Total par value of common $ 100,000 16.7% Total $ 600,000 100.00% $65,000 - $5,000 - $45,000 - $9,000 = $6,000

b. Year 1 Preferred 5,000 x $100 x 9% = $45,000 Year 2 Preferred 5,000 x $100 x 9% = $45,000 Common Remaining divided to common ($65,000 - $45,000) c. Year 1 Preferred 5,000 x $100 x 9% = $45,000 Year 2 Preferred Cumulative 5,000 x $100 x 9% = $45,000 Common $10,000 x $10 x 9% =

5,000 $ 55,000

1,000 $ 10,000

Preferred

Common

$ 40,000

$ 45,000

$ 20,000 $ 20,000

Preferred

Common

$ 40,000

$ 5,000 $ 45,000 $

9,000

Additional % to preferred and common: Preferred: 5,000 x $100 x 1% Common: 10,000 x $10 x 1%

5,000 $ 55,000

1,000 $ 10,000

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d. Year 1 Preferred 5,000 x $100 x 9% = $45,000 Year 2 Preferred Cumulative 5,000 x $100 x 9% = $45,000 Remaining to common

Preferred

Common

$ 40,000

$ 5,000 $ 45,000 $ 50,000

$ 15,000 $ 15,000

PROBLEM 3-6 a.

Heading date is wrong. It should read December 31, 2012.

Preferable to disclose allowance for doubtful accounts on face of statement. Some firms disclose this account in a note.

Treasury stock should be deducted from stockholders' equity.

Land and building are disclosed net. Accumulated depreciation should be disclosed.

Short-term U.S. Notes should be classified under current assets.

Supplies should be classified under current assets.

For most industries, liabilities should be classified as current and longterm. Short-term bonds should be under current liabilities. Long-term bonds payable should be under long-term liabilities.

Redeemable preferred stock should be presented before stockholders' equity.

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PROBLEM 3-7 a. Straight-line method = $100,000 - $10,000 = $9,000 10 per year b. Declining-balance method Year 1 1/10 x 2 x $100,000 =

$20,000

Year 2 1/10 x 2 x $ 80,000 =

$16,000

Year 3 1/10 x 2 x $ 64,000 =

$12,800

Sum-of-the-years’-digits method Year 1 10/55 x $90,000 =

$16,363.63

Year 2 9/55 x $90,000 =

$14,727.27

Year 3 8/55 x $90,000 =

$13,090.91

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PROBLEM 3-8 a.

Restricted cash in sinking fund should be classified as long-term investment.

Investment in Subsidiary Company is long-term.

Measurement basis of marketable securities should be disclosed.

Preferable to show land and buildings separately, since land is not depreciable.

Treasury stock should be deducted from stockholders' equity.

Discount on bonds payable is a contra liability and should be classified as a deduction from bonds payable.

Prepaid expenses should be classified as a current asset.

For most industries, liabilities should be classified as current and long-term.

Preferred and common stock should be separated, as should capital in excess of par.

PROBLEM 3-9 $60,000 - $10,000 = $2.00 per hour 25,000 hrs. Year 1 5,000 x $2.00

$10,000

Year 2 6,000 x $2.00

$12,000

Year 3 4,000 x $2.00

$ 8,000

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PROBLEM 3-10 Alleg, Inc. Balance SheetDecember 31, 2012 ASSETS Current assets: Cash Marketable securities Accounts receivable Inventories Total current assets Plant and equipment: Land and buildings Machinery and equipment Less: Accumulated depreciation

$ 13,000 17,000 26,000 30,000 86,000

57,000 125,000 182,000 61,000 121,000

Total plant and equipment Intangibles: Goodwill Patents

8,000 10,000 18,000 50,000 $275,000

Other assets Total assets LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable Current maturities of long-term debt Total current liabilities

$ 15,000 11,000 26,000

Long-term liabilities: Mortgages payable Bonds payable Deferred income taxes Total long-term liabilities

80,000 70,000 18,000 168,000

Shareholders’ equity: Common stock 21,000 shares authorized at $1 par value, 10,000 shares issued and outstanding Additional paid-in capital Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity

10,000 38,000 33,000 81,000 $275,000

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PROBLEM 3-11 a.

The straight line method will result in the lowest depreciation in the first year. With the depreciation being the lowest for straight-line, the income will be the highest using the straight-line method. The straight-line method should be used for the financial statements. The declining-balance method will result in the maximum depreciation in the first year. With the depreciation being the highest, the income will be the lowest. The declining-balance method should be used for taxes. Straight-line ($50,000 - $10,000)/5 = $8,000 Double-declining-balance method = 1/5 x 2 x $50,000 = $20,000 Sum-of-the-years’-digits = 5/15 x ($50,000 - $10,000) = $13,333

It is permissible to use different depreciation methods in financial statements than in tax returns.

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PROBLEM 3-12 Lukes, Inc. Balance Sheet December 31, 2012 ASETS Current assets: Cash Receivables, less allowance of $3,000 Inventories Prepaid expenses Total current assets Plant and equipment: Buildings Machinery and equipment Less: accumulated depreciation Land Other assets Total assets

3,000 58,000 54,000 2,000 $ 117,000

$ 75,000 300,000 375,000 200,000

175,000 11,000 7,000 $ 310,000

LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable Accrued income taxes Other accrued expenses Current portion of long-term debt Total current liabilities: Long-term liabilities: Long-term debt, less current portion Deferred income tax liability Total long-term liabilities Stockholders’ equity: Common stock, no par value 10,000 shares authorized, 5,724 shares issued Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity

$ 35,000 3,000 8,000 7,000 $ 53,000 99,870 24,000 $ 123,870

3,180 129,950 $ 133,130 $ 310,000

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PROBLEM 3-13 a.

Gain from the sale of land would be on the statement of income.

Cash restricted for the retirement of bonds would be under other assets.

Accounts payable is usually one of the larger current liabilities.

Construction in process is part of plant and equipment.

Bonds payable is usually long term.

Redeemable preferred stock is shown above shareholders’ equity.

Accounts receivable is a current asset.

Research and development is expensed.

Assets $100,000 = Liabilities $60,000 + Stockholders’ Equity

Inventory is a current asset.

Pension liabilities are usually long-term.

Unearned rent income is a current liability.

m. 3

Treasury stock represents a reduction of stockholders’ equity.

Statements 1, 2, 3, and 4 are true.

IFRS model balance sheet does not put an emphasis on liquidity.

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PROBLEM 3-14 Airlines International Balance Sheet December 31, 2012 ASSETS Current assets: Cash Marketable securities Accounts receivable Less: Allowance for doubtful accounts Inventory Prepaid expenses Total current assets Investment and special funds Property, plant, and equipment: Property, plant and equipment

$ 28,837 10,042 $ 67,551 248

67,303 16,643 3,963 $ 126,788 11,901

$809,980

Less: Accumulated depreciation

220,541

Other assets Total assets

589,439 727 $ 728,855

LIABILITIES AND STOCKHOLDERS’ EQUITY: Current Liabilities: Accounts payable Accrued expenses Unearned transportation revenue Current installments of long-term debt

$ 77,916 23,952 6,808 36,875

Total current liabilities

$ 145,551

Long-term debt, less current portion Deferred income taxes Stockholders’ equity: Common stock (par $0.50, authorized 20,000 shares, issued and authorized 14,304) Capital in excess of par Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity

393,808 42,070

7,152 72,913 67,361 147,426 $ 728,855

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CASES CASE 3-1 CONVENIENCE FOODS (This case provides an opportunity to review a moderately complicated balance sheet.) a.

The financial statements of the parent and the subsidiary are consolidated. A subsidiary is a company controlled by another company.

No. There is noncontrolling interest presented.

No. Only the net accounts receivable is disclosed.

$1,190,000,000

$1,056,000,000

Inventories are valued at the lower of cost or market.

A moderate increase in inventory balance.

$3,128,000,000

Straight-line methods for financial reporting and accelerated methods, where permitted, for tax reporting. The company wants to defer the payment of taxes.

$0. Depreciation of land is not recorded.

Treasury stock is company stock that has been sold and has been bought back.

Kellogg is using the cost method.

Treasury stock represents stock that has been sold and bought back and not retired.

The company’s fiscal year normally ends on the Saturday closest to December 31 and as a result, a 53rd week is added approximately every sixth year.

Most fiscal years will be 52 weeks. A 53rd week is added approximately every sixth year.

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Management makes estimates and assumptions that affect the reported amounts of assets and liabilities.

Yes. Highly liquid investments with original maturities of three months or less are considered to be cash equivalents.

Goodwill is the difference between the purchase price of the acquired company and the fair value of the reported identifiable net assets.

They must be reviewed for impairment at least annually.

The costs of research and development are expenses as incurred.

There are uncertain tax positions.

CASE 3-2 THE ENTERTAINMENT COMPANY (This case provides an opportunity to review the balance sheet). a.

The financial statements of the parent and the subsidiary are consolidated.

The majority-owned and controlled subsidiaries were consolidated.

$5,784,000,000 326,000,000 $6,110,000,000

The receivables have increased materially.

Yes.

No. Land will never be depreciated. Projects in progress will be depreciated when completed.

$69,206,000,000

$12,225,000,000

$1,442,000,000

2,180 1,350

61% increase

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Management makes estimates and assumption that affect the amounts reported in the financial statements and footnotes thereto.

Advertising expenses are expenses as incurred. It would be too subjective to determine the period or periods of benefit.

Yes. Original maturities of three months or less.

Revenue Recognition 1. Broadcast advertising revenues Revenues are recognized when commercials are aired 2. Revenues from advance theme park ticket sales Recognized when the tickets are used 3. Revenues from theatrical distribution of motion pictures Recognized when motion pictures are exhibited 4. Merchandise licensing advances and guarantee royalty payments Recognized based on the contractual royalty rate when the licensed product is sold by the licensee 5. Revenues from internet and mobile operations Recognized when advertisements are viewed online 6. Different business situations call for different revenue recognitions. 7. In some cases, they are industry-specific, but many recognition methods go across industries.

Treasury stock – A firm creates treasury stock when it repurchases its own stock and does not retire it. Reported as a reduction to equity.

Noncontrolling interest reflects the ownership of noncontrolling shareholders in the equity of consolidated subsidiaries less than wholly owned.

The Company’s fiscal year ends on the Saturday closest to September 20 and consists of fifty-two weeks with the exception that approximately every six years we have a fifty-three week year.

Yes. Fiscal 2010 had a fifty-two week year. Fiscal 2009 had a fifty-three week year.

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CASE 3-3 HEALTH CARE PRODUCTS (This case provides an opportunity to review liabilities and shareholders’ investment). a.

The financial statements of the parent and the subsidiary are consolidated when the subsidiary is controlled by another company.

Obligation in connection with the conclusion of the TAP Pharmaceutical Products Inc. joint venture.

Short-term borrowings.

$1,619,689,876

72,705,928

1,619,689,876 (72,705,928) 1,546,983,948

4. d.

Cost method

Retained earnings.

CASE 3-4 BEST (This case represents an opportunity to review assets.) a.

Receivables February 26, 2011 February 27, 2010 Gross Receivable: February 26, 2011 Allowances February 27, 2010 Allowances

$2,348,000,000 $2,020,000,00

$2,348,000,000 107,000,000 $2,455,000,000 $2,020,000,000 $101,000,000 $2,121,000,000

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Merchandise inventories “Physical inventory counts are taken on a regular basis.” They were not taken at the end of the year; therefore, they are adjusting for anticipated physical inventory losses that have occurred since the last physical inventory.

Consolidated balance sheet Consolidation occurs when the investor controls the investee through an investment in equity securities

“We consolidate the financial results of our Europe, China and Mexico operations on a two-month lag.”

Estimates and assumptions are made. They affect the reported results. These estimates and assumptions are necessary to prepare the financial statements.

“Our fiscal year ends on the Saturday nearest the end of February. Fiscal 2011, 2010 and 2009 each included 52 weeks.”

. f.

Yes. “Cash equivalents consist of money market funds, U.S. Treasury bills, commercial paper and time deposits such as certificates of deposit with an original maturity of three months or less when purchased.” 1.

“Accelerated depreciation methods are generally used for income tax purposes.”

“We compute depreciation using the straight-line method over the estimated useful lives of the assets.”

They are trying to achieve higher reported income and lower cash outlays for taxes.

CASE 3-5 OUR PRINCIPAL ASSET IS OUR PEOPLE a.

It would be very subjective to identify which payments relating to people would be considered an asset and which would be considered an expense. Also, if considered an asset, the subsequent deterioration would be difficult to determine. The legal implications likely also have a bearing on not considering people as an asset; but it should be noted that accountants use an economic definition of an asset.

They are using a broad definition of an asset, recognizing the importance of people to the firm.

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CASE 3-6 BRAND VALUE a.

SFAC No. 6: "Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events."

As a practical matter, brands would represent a valuable asset. Brands also appear to fall within the definition of an asset presented in SFAC No. 6.

Brands appear to fall within the definition of an asset presented in SFAC No. 6. In practice, however, generally accepted accounting principles in the United States do not recognize brands as an asset when internally generated. This apparent inconsistent position is likely rationalized by conservatism.

A brand purchased would be recognized as an asset. This would be considered to be objective for valuation purposes.

CASE 3-7 ADVERTISING - ASSET? a.

SFAC No. 6: "Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events."

To be conservative, advertising is not usually recognized as an asset in the United States. Identifying the future benefits of advertising is usually considered to be too subjective. Examples of advertising being presented as an asset can be found in U.S. accounting. When it is recognized as an asset, it may be presented under other assets and possibly disclosed in a note.

CASE 3-8 TELECOMMUNICATIONS PART 1 (This case presents an opportunity to review the financial report of a Chinese company as filed on Form 20-F to the SEC.) a.

Prepared in accordance with International Financial Reporting Standards (IFRS)

No, they are not required to reconcile to U.S. GAAP.

No. “As applied to our company, HKFRS is consistent with IFRS in all material respects.”

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Audit Report 1.

Three (December 31, 2010, 2009, and 2008)

IFRS standards

3. “The Group maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). 4. “The Group’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting.” 5. “We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 6. Proper internal controls will not prevent or detect misstatements. They prevent or detect material misstatements. c.

Consolidated Balance Sheet 1. Since this report is being presented to the SEC, it is helpful that it be translated to U.S. 2. The presentation follows the usual IFRS presentation. Emphasis is on noncurrent assets and not on current assets. 3. Equity is presented before liabilities. This is a usual IFRS presentation. 4. As indicated in (3) above, liabilities usually come after equity with a IFRS presentation.

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CASE 3-9 GLOBAL HEALTH CARE (This case presents an opportunity to review fair value measurements.) a.

This maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value.

Level 1 – Quoted prices in active markets for identical assets or liabilities. Level 2 – Observable inputs other than Level 1 prices, such as quoted prices for similar assets and liabilities, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 – Unobservable inputs that are supported by little or no market activity and that are financial instruments whose values are determined using pricing models discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation.

Level 1 – The Company’s Level 1 assets include equity securities that are traded in an active exchange market. Level 2 – The Company’s Level 2 assets and liabilities primarily include debt securities with quoted prices that are traded less frequently than exchangetraded instruments, corporate notes and bonds, U.S. foreign government and agency securities, certain mortgage-backed and asset-backed securities, municipal securities, commercial paper and derivative contracts whose values are determined using pricing models with inputs that are observable in the market or can be derives principally from or corroborated by observable market data. Level 3 – The Company’s Level 3 assets include certain mortgage-backed securities with limited market activity. At December 31, 2010, $13 million, or approximately 0.4%, of the Company’s investment.

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Chapter 4 Income Statement QUESTIONS 4- 1.

Extraordinary items are events or transactions that are distinguished by their unusual nature and infrequency of occurrence. They might include casualty losses or losses from expropriation or prohibition. They must be shown separately, net of tax, in order that trend analysis can be made of income before extraordinary items.

4- 2.

d, f

4- 3.

Examples include sales of securities, write-down of inventories, disposal of a product line not qualifying as a segment, gain or loss from a lawsuit, etc. They are shown separately because of their materiality and the desire to achieve full disclosure. They are not given net-of-tax treatment because they are included in income before the income tax is deducted. Also, net-of-tax treatment would infer that these items are extraordinary.

4- 4.

Under the equity method, equity in earnings of nonconsolidated subsidiaries is a problem in profitability analysis because the income recognized is not a cash inflow. The cash inflow is only the amount of the investor share of dividends declared and paid. Further, equity earnings do not come directly from the operations of the business in question, but rather from a subsidiary.

4- 5.

It would appear that this is the disposal of a product line that is specifically separate from the dairy products line. The disposal of the vitamin line should be identified as discontinued operations and be presented net-of-tax after income from continuing operations on the income statement.

4- 6.

Unusual or infrequent items relate to operations. Examples are write-downs of receivables and write-downs of inventory.

4- 7.

A new FASB issued in May, 2005 requires retrospective application to prior periodical financial statements of a voluntary change in accounting principle unless it is impracticable.

4- 8.

The declaration of a cash dividend reduces retained earnings and increases current liabilities. The payment of a cash dividend reduces current liabilities and cash.

4- 9.

First, a stock split is usually for a larger number of shares. Secondly, a stock dividend reduces retained earnings and increases paid-in capital. A stock split merely increases the shares and reduces the par value, leaving the capital stock account intact. Both require restatement of any per share items.

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4-10.

If a firm consolidates subsidiaries that are not wholly owned, the total revenues and expenses of the subsidiaries are included with those of the parent. To determine the income that would accrue to the parent, however, it is necessary to deduct the portion of income that would belong to the net income – noncontrolling interest.

4-11.

The statement of retained earnings summarizes the changes to retained earnings. Retained earnings represents the undistributed earnings of the corporation. The income statement net income is added to retained earnings. A loss is deducted from retained earnings. A dividend is deducted from retained earnings.

4-12.

1. 2. 3.

Appropriations as a result of a legal requirement Appropriations as a result of a contractual agreement Appropriations as a result of management discretion

Appropriations as a result of management discretion are not likely a detriment to the payment of a dividend. 4-13.

The balance sheet shows the account balances as of a particular point in time. The income statement shows the revenues and expenses resulting from transactions for the period of time.

4-14.

a. Net income – noncontrolling interest is an income statement item that represents the minority owners’ share of consolidated earnings. b. Equity in earnings is the proportionate share of the earnings of the investor that relate to the investor's investment.

4-15.

The two traditional formats for presenting the income statement are the multiple-step and single-step. The multiple-step is preferable for analysis because it provides intermediate profit figures that are useful in analysis and discloses the different sources that the revenues and expenses come from (full disclosure). 2012 2011 2010 $1.40 $1.00 $ .80

4-16.

Earnings per share

4-17.

Accountants have not accepted the role of disclosing the firm’s capacity to make distributions to stockholders. Therefore, the firm’s capacity to make distributions to stockholders cannot be determined using published financial statements.

4-18.

Management does not usually like to tie comprehensive income closely with the income statement because the items within accumulated other comprehensive income have the potential to be volatile.

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4-19.

This represents a finer line item disclosure that under U.S. GAAP. Many of the items are similar but with an IAS describing what goes in each function. For example, U.S. GAAP has other gains and losses but the content may be different than under IFRS.

4-20.

This represents a finer line item disclosure than under U.S. GAAP. Many of the items are similar but with an IAS describing what goes by each nature. U.S. GAAP would have some similar items such as (1) revenue, (2) other gains and losses, and (3) share of profits of associates.

PROBLEMS PROBLEM 4-1 a.

Beginning inventory Purchases Purchase returns Total available Less ending inventory Cost of goods sold

80,000 580,000 (8,000) 652,000 (132,000) Computed $ 520,000

Assets increase

$ 400,000

The increase in assets is equal to the change in liabilities and stockholders’ equity. Liabilities increase $150,000 Capital stock increases 120,000 Additional paid-in capital increases 110,000 Therefore, increase in retained earnings 20,000 $400,000 Decrease to retained earnings related to dividends $ 20,000 Net increase to retained earnings 20,000 Therefore, net income was $ 40,000 c.

An extraordinary item is a material event or transaction distinguished by unusual nature and by infrequency of occurrence.

If a firm consolidates subsidiaries not wholly owned, the total revenues and expenses of the subsidiaries area included with those of the parent. However, to determine the income that would accrue to the parent, it is necessary to deduct the portion of income that would belong to the minority owners.

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An adjustment for an error of the current period is adjusted during the current period.

2,000,000 x .05% = 100,000 x $10 = $1,000,000

100,000 x .05% = 5,000 x $10 = 50,000

200,000 x 2 = 400,000

Extraordinary items are not part of accumulated other comprehensive income.

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PROBLEM 4-2 Victor, Inc. Partial Income Statement For the Year Ended December 31, 2012 Income from continuing operations, unadjusted Adjustments: Settlement of lawsuit Gain on sale of securities

$ 400,000

Income from continuing operations, adjusted, before tax Income tax (30%)

$ 420,000 (126,000)

Income from continuing operations

$ 294,000

Discontinued operations: Loss on operations of consumer products division Loss from disposal of assets Tax effect (30%) Loss from discontinued operations Income before extraordinary item Extraordinary item: Loss from hailstorm Tax effect (30%) Income before cumulative change in accounting principle Cumulative change in accounting principle from average cost to FIFO Tax effect (30%) Increase in income from change in accounting principle Net income Earnings per share: (100,000 shares outstanding) Income from continuing operations Discontinued operations Extraordinary loss Cumulative effect of a change in accounting principle Net income

(10,000) 30,000

$ 60,000 90,000 $150,000 45,000 (105,000) $ 189,000 $ 20,000 6,000

(14,000) $ 175,000

$ 30,000 (9,000) 21,000 $ 196,000

2.94 (1.05) (0.14) 0.21 1.96

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PROBLEM 4-3 a.

Advertising expense would be classified as an operating expense.

Equity in earnings of nonconsolidated subsidiaries would be recurring as long as there is an investment in the subsidiary. If our firm gained control, then there would be consolidation.

Beginning inventory Purchases Purchase returns Total available Less ending inventory Cost of goods sold

$ 65,000 Computed $ 180,000 (5,000)

175,000 240,000 Computed (30,000) $ 210,000

3, 4, 5 Discontinued operations and extraordinary items are considered to be nonrecurring items.

30% x $150,000 = $45,000

Extraordinary items are material events and transactions distinguished by their unusual nature and by the infrequency of their occurrence. A loss from a tornado would qualify as an extraordinary item.

A cash dividend declared by the board of directors reduces retained earnings by the amount of the dividend declared.

The overall effect is to leave stockholders’ equity in total unchanged and each owner’s share of stockholders’ equity unchanged; however, the total number of shares increase.

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PROBLEM 4-4 Total revenues from regular operations Total expenses from regular operations Income from operations Extraordinary gain, net of tax Net income Earnings per share: Before extraordinary items Extraordinary gain Net income

$ 832,000 776,000 56,000 30,000 $ 86,000

$56,000/10,000 = $5.60 $30,000/10,000 = $3.00 $86,000/10,000 = $8.60

PROBLEM 4-5 a.

Comprehensive income will tend to be more volatile than net income because the items within other comprehensive income tend to be more volatile than net income.

The standard directs that earnings per share be computed based on net income.

$30,000 5,000 3,000 $38,000

No. These items could net out as an addition to net income or a deduction from net income.

PROBLEM 4-6

Tax Rate =

Taxes Income Before Taxes

$20,000 = $40,000 =

50%

Provision for unusual write-offs Less: tax effects (50% x $50,000) Net item Extraordinary charge, net of tax of $10,000

$ 50,000 25,000 $ 25,000 $ 50,000

Net earnings (loss) Net earnings with nonrecurring items removed [(30,000) + $25,000 + $50,000]

(30,000) $ 45,000

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PROBLEM 4-7 a.

No. This loss does not relate to the cost of goods sold. It is likely an extraordinary loss meeting the criteria of being of unusual in nature and infrequent in occurrence.

No. Land is carried at historical cost.

Yes. The cost of machinery and equipment should be charged to a fixed asset account and allocated to expense over the life of the asset (depreciation expense)

No. Depreciation should be recognized over the useful life of the asset.

Yes. Some loss to employees would be expected and it is immaterial in relation to the cost of goods sold.

No. This car should not be recorded on the company’s books, unless it is to be used for company business.

PROBLEM 4-8 Sales Cost of sales Gross profit Operating expenses: Administrative expenses Selling expenses Operating income Interest expense Earnings before tax Income tax (48%) Net income Earnings per share

$ 4,000,0001 (2,000,000) $ 2,000,000 $ 400,0001 600,0002

(1,000,000) $ 1,000,000 (110,000)3 $ 890,000 (427,200) $ 462,800 $9.26

Administrative expenses are 20% of $2,000,000. This is 10% of sales. Therefore, sales are $4,000,000.

150% times $400,000

$1,000,000 x 11% = $110,000

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PROBLEM 4-9 a. 1.

Receipt of cash: Sales, 210,000 ounces x $300 Cost of goods sold (1), 210,000 ounces x $250 Gross profit

$ 63,000,000

(52,500,000) $ 10,500,000

Selling expenses Administrative expenses Profit before taxes Taxes Net income (1) $50,000,000 200,000

(2,000,000) (1,250,000) $ 7,250,000 (3,625,000) $ 3,625,000 $250 ounce

Point of sale: Sales, 230,000 ounces x $300 Cost of goods sold, 230,000 ounces x $250 Gross profit

$ 69,000,000

57,500,000 $ 11,500,000

Selling expenses Administrative expenses Profit before taxes Taxes Net income

End of production: Sales, 200,000 ounces x $300 Cost of goods sold, 200,000 ounces x $250 Gross profit Selling expenses Administrative expenses Profit before taxes Taxes Net income

(2,000,000) (1,250,000) $ 8,250,000 (4,125,000) $ 4,125,000

$ 60,000,000

(50,000,000) $ 10,000,000 (2,000,000) (1,250,000) $ 6,750,000 (3,375,000) $ 3,375,000

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Based on delivery: Sales, 190,000 ounces x $300 Cost of goods sold, 190,000 ounces x $250 Gross profit Selling expenses Administrative expenses Profit before taxes Taxes Net income

$ 57,000,000

(47,500,000) $ 9,500,000 (2,000,000) (1,250,000) $ 6,250,000 (3,125,000) $ 3,125,000

Receipt of cash This method should only be used when the prospects of collection are especially doubtful at the time of sale.

Point of sale In practice, the point of realization usually is the point of sale. At this point, the earnings process is virtually complete and the exchange value can be determined.

End of production The realization of revenue at the completion of the production process is acceptable when the price of the item is known and there is a ready market. This method should receive strong consideration in this case. The question that needs to be resolved is how fixed is the price of uranium. Since the price has gone from $150 per ounce in 1983 to $300 per ounce in 2012, the price does not appear to be fixed.

Based on delivery This is not usually an acceptable realization point. Delivery is an objective guideline, but delivery does not usually represent a significant event.

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PROBLEM 4-10 a. Taperline Corporation Income Statement For the Year Ended December 31, 2012 Revenues: Sales Rental income Gain on the sale of fixed assets Total revenues Expenses: Cost of sales Selling expenses General and administrative expenses Depreciation expense Interest expense Income before extraordinary items and taxes on income Income tax Income before extraordinary item Casualty loss Less: Tax saving Net income Income per share on common stock: (30,000 shares outstanding) Income before extraordinary items Net income

$ 670,000 3,600 3,000 $ 676,600 $ 300,000 97,000 110,000 10,000 1,900

(518,900) $ 157,700 (63,080) $ 94,620

$ 30,000 12,000

(18,000) $

76,620

$ $

3.15 2.55

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b. Taperline Corporation Income Statement For the Year Ended December 31, 2012 Sales Cost of sales Gross profit

$ 670,000 (300,000) 370,000

Operating expenses Selling expenses General and administrative expenses Depreciation expense Operating income

$ 97,000 110,000 10,000

Other revenue: Rental income Gain on the sale of fixed assets

Other expenses: Interest expense Income before extraordinary items and taxes on income Income tax Income before extraordinary item Casualty loss Less: Tax saving

3,600 3,000

217,000 $ 153,000

6,600 $ 159,600 (1,900) $ 157,700 (63,080) $ 94,620

$ 30,000 12,000

(18,000)

Net income

76,620

Income per share on common stock: (30,000 shares outstanding) Income before extraordinary items Net income

$ $

3.15 2.55

PROBLEM 4-11 a. Net income from operations $146,000 b. $20,000 Loss c.

$94,000 –30,000 –50,000 +25,000 $39,000

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PROBLEM 4-12 Consolidated Can Income Statement For the Year Ended December 31, 2012 Sales Cost of products sold Gross profit Selling and administrative expenses Operating income Other income Interest expense Income before tax and extraordinary items Income tax Income before extraordinary items Extraordinary gain, net of tax Net income Retained earnings 1/1 Less: dividends Retained earnings

$ 480,000 (410,000) 70,000 ( 42,000) 28,000 1,600 29,600 (8,700) 20,900 (9,300) 11,600 1,000 12,600 270,000 282,600 (3,000) $ 279,600

PROBLEM 4-13 a. Net income Plus: Extraordinary loss from flood

$ 20,000 120,000 $ 140,000

b. $60,000 c. $60,000 d. $40,000 e. $100,000 – $50,000 = $50,000

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PROBLEM 4-14 Lesky Corporation Income Statement For the Year Ended December 31, 2012 Revenue from sales Cost of products sold Gross profit Operating expenses: Selling expenses Administrative and general expenses Operating income Other items: Other income: Rental income Interest income Other expense: Interest expense Income before tax Federal and state income taxes Net income

$ 362,000 (242,000) $ 120,000 $ 47,000 11,400

(58,400) $ 61,600

$ 1,000 2,400 (2,200) 62,800 (20,300) $ 42,500 $

PROBLEM 4-15 a. b. c. d. e. f. g.

C B A B A B C

h. i. j. k. l. m. n.

B B A B A B B

o. p. q. r.

A B A B

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PROBLEM 4-16 a. Decher Automotives Income Statement For the Year Ended December 31, 2012 Sales Cost of sales Beginning inventory Purchases Merchandise available for sale Less: Ending inventory Cost of sales Gross profit Operating expense: Selling expenses Administrative expenses Operating income Other income: Dividend income Other expense: Interest expense Income before taxes and extraordinary items Income taxes Income before extraordinary items Extraordinary items: flood loss, net of tax Net income

$1,000,000 $ 650,000 460,000 $ 1,110,000 (440,000) 670,000 330,000 $

43,000 62,000

105,000 225,000 10,000 235,000 (20,000) 215,000 (100,000) 115,000 (30,000) $ 85,000

b. Earnings per share: Before extraordinary items Extraordinary items (loss) Net income

$ 1.15 (0.30) $ 0.85

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c. Decher Automotives Income Statement For the Year Ended December 31, 2012 Revenue: Sales Other income Total revenue

$1,000,000 10,000 $1,010,000

Expenses: Cost of sales Operating expense Interest expense Income before taxes and extraordinary items Income taxes Income before extraordinary items Extraordinary items: flood loss, net of tax Net income

$ 670,000 105,000 20,000

(795,000) $ 215,000 (100,000) $ 115,000 (30,000) $ 85,000

PROBLEM 4-17 a. b. c. d. e. f. g.

A A A B B A A

h. i. j. k. l. m. n. o.

B C B B B A B B

p. q. r. s. t. u. v.

A A A A B B A

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CASES CASE 4-1 HOMEBUILDERS (This case provides a good review of the income statement). a.

Modified single-step income statement.

No. Net earnings (loss) attributable to noncontrolling interests (6) appears on the income statement.

No. Equity income would be presented. This would represent the same amount of income.

Equity earnings (losses) are the investor’s proportionate share of the investee’s earnings (losses). If the firm gained control, then there would be consolidation.

The decline in 2010 of valuation adjustments and write-offs of option deposits and pre-acquisition costs is very favorable, but those write-offs indicate that there are continuing problems.

CASE 4-2 COMMUNICATION PRODUCTS (This case provides an opportunity to review a split-off, name change and reverse stock split). a.

Motorola Inc. split off part of its company to a new separate company called Motorola Mobility. Motorola Mobility will now be a separate company under the symbol (“MMI”).

Motorola Inc. changed its name to “Motorola Solutions.”

Immediately following the distribution of Motorola Mobility common stock, the company completed a 1 for 7 reverse stock split.

They wanted to increase the market price of a single share. This indicates the higher stock price would appear to be more respectable.

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CASE 4-3 APPAREL COMPANIES (This case represents a selected review of the income statement). a.

The Company’s consolidation principles would also consolidate any entity in which the Company would be deemed a primary beneficiary.

No. Noncontrolling interest is present (minority interest).

Management makes estimates and assumptions that affect the amounts in the consolidated financial statements and the accompanying footnotes.

No. Not if they were classified under current assets.

Unusual or infrequent item.

CASE 4-4 THE BIG ORDER a.

United Airlines should record the purchase of these planes when a plane is delivered.

In general, revenue recognition is being made at the completion of production. Under summary of significant accounting policies in the notes to the 1990 financial statements, Boeing describes its revenue recognition with this statement. “Sales under commercial programs and U.S. Government and foreign military fixed-price type contracts are generally recorded as deliveries are made.”

The case indicates that the order was equally split between firm orders and options. This would lead us to believe that the firm orders were “firm” and that United Airlines would be committed to accept delivery of these planes. In reality, the orders may not be firm in the sense that Boeing may be willing to negotiate a reduction if United Airlines were in financial trouble or if the need for the planes had substantially declined. In the 1990 annual report of Boeing, in the section Management’s Discussion and Analysis of Financial Condition and Results of Operations, a section on backlog had this comment: “In evaluating the Company’s firm backlog for commercial customers, certain risk factors should be considered. Approximately 55% of the firm backlog for commercial airplanes is scheduled to be delivered beyond 1992. An extended economic downturn could result in less than currently anticipated airline equipment requirements resulting in requests to negotiate the rescheduling, or possible cancellation, of firm orders.”

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There would not necessarily be disclosure in the financial statements and notes. This was not a transaction that was recorded. There was disclosure of credit agreements in a note “long-term debt.” This note did not specifically refer to this order.

Disclosure would likely be found in the president’s letter and the section Management’s Discussion and Analysis. In fact, extensive disclosure was located in these sections.

There would not necessarily be disclosure in the financial statements and notes. This was not a transaction that was recorded. A review of the financial statements and notes did not turn up disclosure.

Disclosure would likely be found in the president’s letter and the section Management’s Discussion and Analysis. In fact, extensive disclosure relating to orders was found. Some of this disclosure specifically commented on the United Airlines order, while some was general on orders.

CASE 4-5 CELTICS (This case provides the opportunity to review the statements of income of the Boston Celtics.) a.

Franchise and other intangible assets were recognized as intangible assets on the balance sheet.

No. Since these operations were discontinued they would not be included in projecting the future.

Possibly there was a new contract with players that called for substantial increases.

Revenues from ticket sales and television and radio broadcast rights fee increased substantially between 1997 and 1998.

Much of the income in 1996 came from discontinued operations. The board would typically not want to consider the income from discontinued operations when setting the distribution.

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CASE 4-6 HOMEBUILDING (This case provides a view of impairments and early retirement of debt.) a.

No. Inventory includes such things as construction in progress, finished homes, residential land and lots developed and under development, and land held for development, based on the stage of production or plans for future development.

This implies that D. R. Horton invested in a subsidiary in the past for a sum greater than the physical asset value. It now estimates that it will not recover some or all of the cost that were greater than the physical asset value.

They have substantial cash flow and limited opportunities to use the cash. The interest rate on the debt would also be a factor.

CASE 4-7 TELECOMMUNICATIONS – PART 2 (This case provides the opportunity to review a Hong Kong company presentation of Consolidated Statements of Income.) 1.

This was done to help the understanding of the U.S. investor.

The note reference is different than for U.S. GAAP. U.S. GAAP does have some note reference within the statement.

U.S. GAAP does not have a specific presentation at the end of the statement, but it is somewhat similar. U.S. GAAP now uses the term “noncontrolling interests.”

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Chapter 5 Basics of Analysis QUESTIONS 5 - 1.

A ratio is a fraction comparing two numbers. Ratios make the comparisons in relative, rather than absolute, terms, which helps alleviate the problem of size difference.

5 - 2.

Liquidity is the ability to meet current obligations. Short-term creditors such as banks or suppliers would be particularly interested in these ratios.

Borrowing capacity measures the protection of long-term creditors. Long-term bond holders would be particularly interested in these ratios.

Profitability means earning ability. Investors would be particularly interested in these ratios.

5 - 3.

Comparisons of historical data, industry average, earnings of competitors, etc.

5 - 4.

An absolute change would be plus or minus X dollars; a percentage change would be plus or minus X percent of the base. Percentage changes usually give better measures because they recognize the difference in the size of the base.

5 - 5.

Horizontal analysis expresses an item in relation to that same item for a previous base year. This analysis measures change over time. Example In 2010, sales were $750,000; in 2009, they were $500,000. Horizontal analysis shows 2010 sales as 150% of those in 2009. Vertical analysis compares one item with another base item for that same year. Example In 2010, selling expenses were $75,000 and sales were $750,000. Vertical analysis would show selling expenses as 10% of 2010 sales.

5 - 6.

Trend analysis involves comparing the past to the present. It can be used both for ratios and absolute figures.

5 - 7.

When comparing two firms of different size, relative figures are most meaningful. These include ratios and common-size analysis. The relative amounts of sales, assets, profits, or market share help evaluate relative size.

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5 - 8.

While managers make great use of financial reports, investors, creditors, employers, suppliers, regulators, auditors, and consumers also use financial reports.

5 - 9.

Managers analyze data to study profitability, evaluate how efficiently they use their assets to generate revenues, and the overall financial position of the firm. Investors study profitability and the chance to earn on their investment. Creditors study the ability of the firm to handle debt.

5 -10.

Best Buy Co. (Exhibit 5-3) Current assets is the single-largest asset category. This would be typical for a retailer. Property and equipment will often be a high category unless it is held down by leases which limit investment in productive (capital) assets. Kelly Services, Inc. (Exhibit 5-4) Current assets is the single-largest asset category. This would be typical for a service firm. Cooper Tire & Rubber Company (Exhibit 5-5) Current assets is the largest asset category. Property, plant, and equipment would typically also be high for a manufacturer.

Cooper Tire & Rubber Company We would expect a manufacturing firm to have a large amount in current assets because of receivables and inventory. We would also expect a service firm to have a large amount in current assets in relation to current liabilities because of receivables.

5 -11.

A manufacturing firm will have raw materials, work in process, finished goods, and supplies. A retail firm will only have merchandise inventories.

5 -12.

Some types of products must be processed and immediately packaged for sale. They cannot be held in the processing state. Each night, all raw materials must be converted to finished goods. Cosmetics, such as nail polish, would dry up overnight. Foods might spoil. They, therefore, cannot be left in a semi-finished state.

5 -13.

Median 10.5%; upper quartile 13%; lower quartile 9.3%.

5 -14.

Reference Book of Corporate Managements

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5 -15.

5 -16.

5 -17.

Manufacturing, construction, transportation, retail trade, banking, and wholesale trade.

Yes. The Department of Commerce Financial Reports includes industry sales. We could relate the sales of the firm in question to the total industry amount.

Yes. The Department of Commercial Financial Report includes total assets for the total industry. We could relate the total assets of the firm in question to the total in the industry.

The SIC is the Standard Industrial Classification. It was developed for use in the classification of establishments by type of activity in which they are engaged. Determining a company's SIC is a good starting point in your search of a company, industry, or product. Many library sources use the SIC number as a method of classification. Thus, knowing a company's SIC will be necessary in order to use some library sources.

The North American Industry Classification system (NAICS) was created jointly by the United States, Canada, and Mexico. NAICS provides enhanced industry comparability among the three NAFTA trading partners. NAIS divides the economy into twenty sectors. Industries within these sectors are grouped according to the production criterion. Four sectors are largely goods-producing industries and sixteen sectors are entirely services-producing industries.

5 -18.

Standard & Poor's Register of Corporations, Directors and Executives, Volume 2, Section 5, lists the officer deaths that have been reported to the publisher.

5 -19.

Standard & Poor's Analyst's Handbook

5 -20.

Value Line Investment Survey

5 -21.

The Securities Owner's Stock Guide

5 -22.

Sources that contain a dividend record of payments are the following: 1. Mergent dividend record, and 2. Standard & Poor’s Annual Dividend Record

5 -23.

Standard & Poor’s Statistical Services

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5 -24.

The Standard & Poor's Register of Corporations, Directors and Executives, Volume 2, contains information on principal business affiliations of officers.

5 -25.

1. 2.

5 -26.

Thomas Register of American Manufacturers

Standard & Poor's Industry Survey Value Line Investment Survey

PROBLEMS PROBLEM 5-1 a. Best Buy Co., Inc. Consolidated Statements of Earnings Vertical Common-Size

For the fiscal years ended Revenue Cost of goods sold Restructuring charges – cost of goods sold Gross profit Selling, general and administrative expenses Restructuring charges Goodwill and tradename impairment Operating income Other income (expense) Investment income and other Investment impairment Interest expense Earnings before income tax expense, and equity in income of affiliates Income tax expense Equity in income of affiliates Net earnings including noncontrolling interests Net earnings attributable to noncontrolling interests Net earnings attributable to Best Buy Co., Inc.

February 26, 2011 100.0 74.8

February 27, 2010 100.0 75.5

February 28, 2009 100.0 75.6

0.0 25.1

----24.5

----24.4

20.5 0.4 ----4.2

19.9 0.1 ----4.5

20.0 0.2 0.1 4.2

0.1 ----(0.2)

0.1 (0.2) (0.2)

4.1 1.4 0.0

4.4 1.6 0.0

3.8 1.5 0.0

2.7

2.8

2.3

(0.2)

(0.0)

2.5

2.7

2.2

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Problem 5-1 Concluded b. Best Buy Co., Inc. Consolidated Statements of Earnings Horizontal Common-Size

For the fiscal years ended Revenue Cost of goods sold Restructuring charges – cost of goods sold Gross profit Selling, general and administrative expenses Restructuring charges Goodwill and tradename impairment Operating income Operating income (expense) Investment income and other Investment impairment Interest expense Earnings before income tax expense and equity income of affiliates Income tax expense Equity in income of affiliates Net earnings including noncontrolling interests Net earnings attributable to noncontrolling interests Net earnings attributable to Best Buy Co., Inc. c.

February 26, 2011 111.7 110.6 ----114.9 114.9 253.8 ----113.0

February 27, 2010 110.4 110.3 ----110.6 109.9 66.7 ----119.5

February 28, 2009 100.0 100.0 N/A 100.0 100.0 100.0 N/A 100.0

145.7 ----92.6

154.3 ----100.0

100.0 100.0 -----

122.2 105.9 28.6 132.2

129.1 119.0 14.3 134.9

100.0 100.0 100.0 100.0

296.7 127.3

256.7 131.3

100.0 100.0

Vertical Common-Size Material increases in 2010, then a substantial decrease in 2011. Material increases in 2010 were in earnings before income tax expense and equity in income of affiliates; net earnings including noncontrolling interests; and net earnings attributable to Best Buy Co., Inc. Horizontal Common-Size All of the items materially increased or decreased in 2010 except for interest expense, which increased substantially. Restructuring charges very materially increased in 2011. This contributed to a material decrease in income tax expense in 2011. Equity in income of affiliates materially increased in 2011 as did net earnings attributable to noncontrolling interests.

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PROBLEM 5-2 a. Best Buy Co., Inc. Vertical Common-Size Balance Sheet

In Percentage* February 26, February 27, 2011 2010 Assets Current assets Cash and cash equivalents Short-term investments Receivables Merchandise inventories Other current assets Total current assets Property and equipment Land and buildings Leasehold improvements Fixtures and equipment Property under capital lease Less accumulated depreciation Net property and equipment Goodwill Tradenames, net Customer relationships, net Equity and other investments Other assets Total assets

6.2 0.1 13.2 33.0 6.2 58.7

10.0 0.5 11.0 30.0 6.3 57.7

4.3 13.0 26.3 0.7 44.3 22.9 21.4 13.7 0.7 1.1 1.8 2.4 100.0

4.1 11.8 24.3 0.5 40.7 18.5 22.2 13.4 0.9 1.5 1.8 2.5 100.0

*Some rounding differences

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Problem 5-2a Continued In Percentage* February 26, February 27, 2011 2010 Liabilities and equity Current liabilities Accounts payable Unredeemed gift card liabilities Accrued compensation and related expense Accrued liabilities Accrued income taxes Short-term debt Current portion of long-term debt Total current liabilities Long-term liabilities Long-term debt Contingencies and commitments Equity Preferred stock Common stock Additional paid-in capital Retained earnings Accumulated other comprehensive income Total Best Buy Co., Inc. shareholders’ equity Noncontrolling interests Total equity Total liabilities and equity

27.4 2.7

28.8 2.5

3.2 8.2 1.4 3.1 2.5 48.5 6.6 4.0

3.0 9.2 1.7 3.6 0.2 49.1 6.9 6.0

----0.2 0.1 35.7 1.0 37.0 3.9 40.9 100.0

----0.2 2.4 31.7 0.2 34.5 3.5 38.1 100.0

* Some rounding differences

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Problem 5-2 Continued b. Best Buy Co., Inc. Horizontal Common-Size Balance Sheet

In Percentage February 26, February 27, 2011 2010 Assets Current assets Cash and cash equivalents Short-term investments Receivables Merchandise inventories Other current assets Total current assets Property and equipment Land and buildings Leasehold improvements Fixtures and equipment Property under capital lease Less accumulated depreciation Net property and equipment Goodwill Tradenames, net Customer relationships, net Equity and other investments Other assets Total assets

60.5 24.4 116.2 107.5 96.4 99.1

100.0 100.0 100.0 100.0 100.0 100.0

101.2 107.6 105.7 126.3 106.1 120.7 93.9 100.1 83.6 72.8 101.2 96.2 97.5

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

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Problem 5-2b Concluded

In Percentage February 26, February 27, 2011 2010 Liabilities and equity Current liabilities Accounts payable Unredeemed gift card liabilities Accrued compensation and related expense Accrued liabilities Accrued income taxes Short-term debt Current portion of long-term debt Total current liabilities Long-term liabilities Long-term debt Contingencies and commitments Equity Preferred stock Common stock Additional paid-in capital Retained earnings Accumulated other comprehensive income Total Best Buy Co., Inc. shareholders’ equity Noncontrolling interests Total equity Total liabilities and equity

92.8 102.4

100.0 100.0

104.8 87.5 81.0 84.0 1,260.0 96.5 94.2 64.4

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

----92.9 4.1 109.9

----100.0 100.0 100.0

432.5

100.0

104.5 107.1 104.7 97.5

100.0 100.0 100.0 100.0

Vertical Common-Size Assets: No material changes Liabilities: No material changes, except decline in long-term debt and increase in noncontrolling interests. A substantial increase in total Best Buy Co., Inc. shareholders’ equity and total equity.

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PROBLEM 5-3 a. Kelly Services, Inc. and Subsidiaries Consolidated Statement of Earnings For the three fiscal years ended December 31, 2010 Vertical Common-Size Analysis*

Revenue from services Cost of services Gross Profit Selling, general, and administrative expenses Asset impairments Earnings (loss) from operations Other expense, net Earnings (loss) from continuing operations before taxes Income taxes Earnings (loss) from continuing operations Earnings (loss) from discontinued operations, net of tax Net earnings (loss) (1)

2010 100.0 84.0 16.0 15.2 0.0 0.8 (0.1) 0.7 (0.1) 0.5 ----0.5

2009(1) 100.0 83.7 16.3 18.4 1.2 (3.4) (0.0) (3.4) 1.0 (2.4) 0.0 (2.4)

2008 100.0 82.3 17.7 17.5 1.5 (1.3) (0.0) (1.3) (0.1) (1.5) 0.0 (1.5)

Fiscal year included 53 weeks

*Some rounding differences

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Problem 5-3 Continued

b. Kelly Services, Inc. and Subsidiaries Consolidated Statements of Earnings For the three fiscal years ended December 31, 2010 Horizontal Common-Size Analysis

Revenues from services Cost of services Gross Profit Selling, general, and administrative expense Asset impairments Earnings (loss) from operations Other expense, net Earnings (loss) from continuing operations before taxes Income taxes Earnings (loss) from continuing operations Earnings (loss) from discontinued operations, net of tax Net earnings (loss) (1)

2010 89.7 91.5 81.3 78.0 2.5 N/A 158.8

2009(1) 78.2 79.6 71.8 82.1 66.0 (207.8) 64.7

2008 100.0 100.0 100.0 100.0 100.0 (100.0) 100.0

N/A 82.5 N/A

(`201.22) N/A (128.6)

(100.0) 100.0 (100.0)

----N/A

N/A (127.1)

100.0 100.0

Fiscal year included 53 weeks

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Problem 5-3 Concluded c.

Vertical Common-Size Analysis Gross profit decreased materially between 2008 and 2010. This was caused by the increase in cost of services. Selling, general and administrative expenses increased moderately in 2009 and decreased materially in 2010. Asset impairments decreased materially between 2008 and 2010. The items described here resulted in a material increase in losses for 2009 and the minor profit in 2010.

Horizontal Common-Size Analysis Gross profit decreased materially in 2009 and then increased materially in 2010. Selling, general and administrative expenses decreased materially in 2009 and then decreased moderately in 2010. Asset impairments decreased materially in both 2009 and 2010. Earnings (loss) from operations materially increased its loss in 2009 and then turned to a profit in 2010. Other expense, net decreased materially in 2009 and increased materially in 2010. Earnings (loss) from continuing operations before taxes materially increased its loss in 2009 and turned to a profit. Earnings (loss) from continuing operations materially increased its loss in 2009 and turned to a profit in 2010. Net earnings (loss) materially increased its loss in 2009 and turned to a profit in 2010.

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PROBLEM 5-4 a. Kelly Securities, Inc. and Subsidiaries Balance Sheets December 31, 2010 and December 31, 2009 Vertical Common-Size Analysis

In Percentage* 2010 2009 Assets Current assets Cash and equivalents Trade accounts receivable Prepaid expenses and other current assets Deferred taxes Total current assets Property and equipment Land and buildings Computer hardware, software and other Accumulated depreciation Net property and equipment Noncurrent deferred taxes Goodwill, net Other assets Total assets

5.9 59.3 3.3 1.6 70.1

6.8 54.7 5.4 1.6 68.4

4.3 19.0 (15.7) 7.6 6.1 4.9 11.3 100.0

4.5 20.1 (14.9) 9.7 5.9 5.1 10.8 100.0

* There are some rounding differences

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Problem 5-4 Continued

Liabilities and Stockholders’ Equity Current liabilities: Short-term borrowings and current portion of longterm debt Accounts payable and accrued liabilities Accrued payroll and related taxes Accrued insurance Income and other taxes Total current liabilities Noncurrent liabilities Long-term debt Accrued insurance Accrued retirement benefits Other long-term liabilities Total noncurrent liabilities Stockholders’ equity Capital stocks $1.00 par value Class A common stock Class B common stock Treasury stock, at cost Class A common stock Class B common stock Paid-in capital Earnings invested in the business Accumulated other comprehensive income Total stockholders’ equity Total liabilities and stockholders’ equity

(In Percentage) 2010 2009

5.8 13.3 17.8 2.3 4.1 43.2

6.1 13.9 15.9 1.7 3.6 41.2

---3.9 6.2 1.1 11.2

4.4 4.2 5.9 1.2 15.6

2.7 .3

2.8 .3

(5.1) (0.0) 2.0 43.7 2.1 45.6 100.0

(8.1) (0.0) 2.8 43.5 1.9 43.2 100.0

* There are some rounding differences

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Problem 5-4 Continued

b. Kelly Services, Inc. and Subsidiaries Balance Sheets December 31, 2010 and December 31, 2009 Horizontal Common-Size Analysis

Assets Current assets Cash and equivalents Trade accounts receivable Prepaid expenses and other current assets Deferred taxes Total current assets Property and equipment Land and buildings Computer hardware, software and other Accumulated depreciation Net property and equipment Noncurrent deferred taxes Goodwill, net Other assets Total assets

In Percentage 2010 2009 90.6 113.0 63.5 106.7 106.7

100.0 100.0 100.0 100.0 100.0

100.3 98.6 110.0 81.8 108.4 100.0 108.6 104.3

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

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Problem 5-4 Continued

Liabilities and Stockholders’ Equity Current liabilities Short-term borrowings and current portion of longterm debt Accounts payable and accrued liabilities Accrued payroll and related taxes Accrued insurance Income and other taxes Total current liabilities Noncurrent Liabilities Long-term debt Accrued insurance Accrued retirement benefits Other long term liabilities Total noncurrent liabilities Stockholders’ Equity Capital stocks $1.00 par value Class A common stock Class B common stock Treasury stock, at cost Class A common stock Class B common stock Paid-in capital Earnings invested in the business Accumulated other comprehensive income Total stockholders’ equity Total liabilities and stockholders’ equity

In Percentage 2010 2009

99.0 99.5 116.8 136.7 118.1 109.3

100.0 100.0 100.0 100.0 100.0 100.0

0.0 97.6 111.1 91.3 74.8

100.0 100.0 100.0 100.0 100.0

100.0 100.0

65.9 100.0 75.9 104.6 115.5 110.1 104.3

100.0 100.0 100.0 100.0 100.0 100.0 100.0

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Problem 5-4 Concluded c.

Vertical Common-Size Analysis Assets Substantial increase in trade accounts receivable. Trade accounts receivable was already the dominate asset. Noncurrent deferred taxes increased materially. Liabilities and Stockholders’ Equity Liabilities These current liabilities increased materially; 1) accrued payroll and related taxes, 2) accrued insurance, and 3) income and other taxes. Long-term debt was retired, which resulted in total noncurrent liabilities decreasing materially. Stockholders’ Equity Material decline in treasury stock, Class A. Material decline in paid-in capital.

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PROBLEM 5-5

Item 1 2 3 4 5

Year 1 4,000 5,000 (9,000) 7,000 -----

Year 2 ----(3,000) 2,000 ----15,000

Change Analysis Amount Percent (4,000) 100 (8,000) ----11,000 ----(7,000) 100 15,000 -----

Year 2 3,000 (4,000) 4,000 ----10,000

Change Analysis Amount Percent 3,000 ----(10,000) 11,000 (4,000) 100 2,000 25

PROBLEM 5-6

Item 1 2 3 4 5

Year 1 ----6,000 (7,000) 4,000 8,000

PROBLEM 5-7 a.

Most ratios are computed comparing selected income statement and balance sheet numbers.

A figure from the year’s statement is compared with a base selected from the current year. This would be described as a vertical common-size statement.

Since we do not know the resources employed, Fremont Electronics could be more profitable than Columbus Electronics in relation to resources employed.

The fact that financial services may be private independent firms does not relate to industry ratios being considered as absolute norms for a given industry.

The Department of Commerce Financial Report is a publication of the federal government for manufacturing, mining, and trade corporations.

The Almanac of Business and Industrial Financial Ratios represents a compilation of corporate tax return data.

Industry Norms and Key Business Ratios, desktop edition, includes over 800 different lines of business.

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A horizontal analysis compares each amount with a base amount for a selected base year.

Relative numbers would be most meaningful for comparing two firms in the coal industry.

The statement “management is not interested in the view of investors” does not represent a fair statement as to the management perspective.

PROBLEM 5-8 a.

Net sales Cost of goods sold Gross profit Selling, general, and administrative expense Operating income Interest expense Income before taxes Income tax expense Net income

December 31, 2011 2010 $30,000 $28,000 20,000 19,500 10,000 8,500 3,000 7,000 100 6,900 2,000 4,900

2,900 5,600 80 5,520 1,600 3,920

Increase Dollars $2,000 500 1,500

(Decrease) Percent 107.1 102.6 117.6

100 1,400 20 1,380 400 980

103.4 125.0 125.0 125.0 125.0 125.0

Net Sales increased substantially more than Cost of Goods Sold. Net Sales increased substantially more than Selling, General, and Administrative Expense. Interest Expense, Income Tax Expense, and Net Income increased materiality faster than Net Sales.

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Chapter 6 Liquidity of Short-term Assets: Related Debt-Paying Ability QUESTIONS 6- 1.

In the very short run, the procedure of making more funds available by slowing the rate of payments on accounts payable would work and the firm would have more funds to purchase inventory, which would in turn enable the firm to generate more sales. This procedure would not work very long because creditors would demand payment and they may refuse to sell to our firm or demand cash upon delivery. In either case, the end result would be the opposite of what was intended.

6- 2.

When a firm is growing fast, it needs a large amount of funds to expand its inventory and receivables. At the same time, payroll and payables require funds. Although Jones Wholesale Company has maintained an above average current ratio for the wholesale industry, it has probably built up inventory and receivables, which require funds. The inventory and the receivables are probably being carried for longer periods of time than the credit terms received on the payables. Funds may have also been applied from current operations towards long-term assets in order to expand capacity. Fast-growing firms typically do have a problem with a shortage of funds. It is important that they minimize this problem in order to avoid a bad credit rating and possible bankruptcy.

6- 3.

Current assets are assets that are in the form of cash or that will be realized in cash or that conserve the use of cash within an operating cycle of a business, or one year, whichever is the longer period of time. The other assets are not expected to be realized in cash in the near future and should, therefore, be segregated from current assets.

6- 4.

The operating cycle is the period of time elapsing between the acquisition of goods and the final cash realization resulting from sales and subsequent collections.

6- 5.

Current assets are assets that are in the form of cash or that will be realized in cash or that conserve the use of cash within the operating cycle of a business, or one year, whichever is the longer period of time.

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6- 6.

The five major categories of items that are found in current assets are the following: a. cash b. marketable securities c. receivables

d. inventories e. prepayments

6- 7.

The cash frozen in a bank in Cuba should not be classified as a current asset because it is not readily available to be used in operations.

6- 8.

This guaranteed note would not be recorded by A.B. Smith Company; therefore, it would not influence the liquidity ratios. The potential impact on the liquidity of A.B. Smith Company should be considered, because A.B. Smith Company could be called upon to pay the note. The guaranteed would be disclosed in a footnote to the financial statements.

6- 9.

This investment would not be classified as a marketable security because there is no intent to sell the securities and use the funds in current operations.

6-10.

a. b.

Number of days' sales in receivables Accounts receivable turnover

6-11.

a. b.

Number of days' sales in inventory Inventory turnover

6-12.

A company that uses a natural business year would tend to overstate the liquidity of its receivables. The two computations that are made to indicate the liquidity of receivables are the days' sales in receivables and the accounts receivable turnover. Because the receivables would be at or near their low point at the end of a natural business year, the days' sales in receivables would be low at the end of the year in comparison with usual days' sales in receivables during the year. The accounts receivable turnover would be high, based on the natural business year in relation to the turnover and the receivables figures during the year.

6-13.

Since the receivables will be at their peak at the end of the year, the days' sales in receivables will be high and the accounts receivable turnover will be low; thus, the liquidity will be understated when a firm closes its year at or near the peak of its business.

6-14.

This distortion can be eliminated by using the average monthly receivables figures in the liquidity computations. The average monthly receivables figure will eliminate the year’s high or low in receivables.

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6-15.

The liquidity of the receivables will be overstated if the sales figure includes both cash sales and credit sales. The exact liquidity indicated by the days' sales in receivables and the accounts receivable turnover will be meaningless but the trend that can be determined from these computations will be meaningful.

6-16.

Inventories of a retail company are usually classified in one inventory account called "merchandise inventory." Inventories of a manufacturing concern are normally classified in three inventory accounts. These inventory accounts distinguish between getting ready to produce - raw material inventory; inventory in production, work in process inventory; and inventory completed finished goods inventory.

6-17.

The most realistic valuation of inventory would be the FIFO method because the most recent cost would be in the inventory. The LIFO method would result in the least realistic valuation of inventory. This is the result of having old cost in inventory.

6-18.

If the company uses a natural business year for its accounting period, the number of days' sales in inventory will tend to be understated. When the average daily cost of goods sold for the year is divided into the ending inventory, the resulting answer will be a lower number of days' sales in inventory than actually exists.

If the company closes the year when the activities are at a peak, the number of days' sales in inventory would tend to be overstated and the liquidity would be understated. When the average daily cost of goods sold for the year is divided into the ending inventory, the resulting answer will be a higher number of days' sales in inventory than actually exists.

If the company uses LIFO inventory, the number of days' sales in inventory would tend to be understated during inflation because the inventory would be at low cost figures, while the cost of goods sold would be at higher current cost.

There is no ideal number of days' sales in inventory. The number that a company should have would be guided by company policy and industry averages.

In general, a company wants to minimize the days' sales in inventory. Excess inventory is expensive to the company. Some of these costs are storage cost, additional funds required, and financing cost.

Days' sales in inventory can be too low, resulting in lost sales, limited production runs, higher transportation costs, etc.

6-19.

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6-20.

When the cost of goods sold is not available to compute days' sales in inventory, use net sales. The result will not be a realistic number of days' sales in inventory, but the result will be useful in comparing one period with another for the same firm and in comparing one firm with another firm, also using net sales.

6-21.

The distortions from seasonal fluctuations or the use of a natural business year can be eliminated by using monthly inventory figures when computing the average inventory that will then be divided into cost of goods sold.

6-22.

When prices are rising, the use of LIFO inventory will result in a much higher inventory turnover because of the lower inventory and the higher cost of goods sold. Therefore, the inventory turnover of a firm that uses LIFO should not be compared with the inventory turnover of a firm that does not use LIFO.

6-23.

Working capital is defined as current assets less current liabilities.

6-24.

Current liabilities are obligations whose liquidation is reasonably expected to require the use of existing current assets or the creation of other current liabilities within a year or an operating cycle, whichever is longer.

6-25.

(1)

a. Working capital The excess of current assets over current liabilities. b. Current ratio The ratio of total current assets to total current liabilities. c. Acid-test ratio The ratio of total current assets less inventory to total current liabilities. d. Cash ratio The ratio of total current assets less inventory and receivables to total current liabilities.

(2)

a. Working capital Working capital based on cost figures will tend to be understated because inventory will be stated at amounts that do not represent current value. b. Current ratio The current ratio will tend to be understated because inventory will be stated at amounts that do not represent current value.

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d. Cash ratio The cash ratio will tend to be accurate. (3)

To avoid the understatements in working capital and the current ratio, use the replacement (current) cost of inventory when it is disclosed.

6-26.

The current working capital amount should be compared with past working capital amounts to determine if working capital is reasonable. Caution must be exercised because the relative size of the firm may be expanding or contracting. Comparing working capital of one firm with working capital of another firm will usually be meaningless because of the different sizes of the firms.

6-27.

The current ratio is considered to be more indicative of the short-term debtpaying ability than the working capital because the current ratio takes into account the relative relation between the size of the current assets and the size of the current liabilities. Working capital only determines the absolute difference between the current assets and the current liabilities.

6-28.

The acid-test ratio is considered to be a better guide to short-term liquidity than the current ratio when there are problems with the short-run liquidity of inventory. Some problems with inventory could be in determining a reasonable dollar amount in relation to the quantity on hand (LIFO inventory), the inventory has been pledged, or the inventory is held for a long period of time. The cash ratio would be preferred over the acid-test ratio when there is a problem with the liquidity of receivables. An example would be an entity that has a long collection period for receivables.

6-29.

If a firm can reduce its operating cycle, it can benefit from having more funds available for operating or it could reduce the funds that it uses in operations. Since funds cost the firm money, it can increase profits by operating at a more efficient operating cycle. An improved operating cycle will enable the firm to operate with less plant and equipment and still maintain the present level of sales, thereby increasing profits. Or, the firm could expand the level of sales with the improved operating cycle without expanding plant and equipment. This expansion in sales could also mean greater profits. Opportunities to improve the operating cycle will be found in the management of the inventory and the accounts receivable.

6-30.

Some industries naturally need a longer operating cycle than others because of the nature of the industry. For example, we could not expect the car manufacturer to have an operating cycle that compares with that of a food store because it takes much longer to manufacture cars and collect the receivables from the sales than it does for the food store to buy its inventory and sell it for cash. Thus, comparing the operating cycles of a car manufacturer and a food store would not be a fair comparison.

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6-31.

Because funds to operate the business are costly to the firm, a firm with a longer operating cycle usually charges a high mark-up on its inventory cost when selling than does a firm with a short operating cycle. This enables the firm to recover the cost for the funds that are used to operate the business. A food store usually has a very low mark-up, while a car manufacturer would have a higher mark-up. Within the same industry, it is difficult to have a different mark-up from firm to firm, unless different services are provided or a different quality is supplied, due to competitive forces in price.

6-32.

Profitability is often not of major importance in determining the short-term debtpaying ability of a firm. One of the reasons for this is that many revenue items and many expense items do not directly affect cash flow during the same period.

6-33.

The use of the allowance for doubtful accounts approach results in the bad debt expense being charged to the period of sale, thus matching this expense in the period of sale. It also results in the recognition of the impairment of the asset.

6-34.

This is true because the most recent purchases end up in cost of goods sold on the income statement.

6-35.

This type of a current asset would not be a normal recurring current asset. The firm's liquidity would be overstated in terms of normal sources.

6-36.

Accounts receivable and inventory are often major segments of current assets. Therefore, they can have a material influence on the current ratio. Accounts receivable turnover and the merchandise inventory turnover are ratios that will aid the analyst in forming an opinion as to the quality of receivables and inventory. Poor quality in receivables and/or inventory will increase the current ratio, which indicates better liquidity than is the case.

6-37.

Receivables can have a material influence on the acid-test ratio. Accounts receivable turnover will give some indication as to the quality of receivables. Poor quality in receivables will increase the acid-test ratio, which will result in the acid-test ratio appearing to be more favorable than it actually is.

6-38.

FIFO represents the highest inventory balance under inflationary conditions.

6-39.

Under inflationary conditions the cash flow under LIFO is greater than the cash flow under the other inventory methods by the difference in the resulting tax between the alternative cost methods.

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6-40.

No, a low sales-to-working capital ratio is an indication of an unprofitable use of working capital. It indicates that low amounts of sales are being generated for each dollar of working capital. Yes, a high ratio is a tentative indication that the firm is undercapitalized. This firm will likely have a high inventory turnover and a low current ratio.

6-41.

6-42.

(1)

Unused bank credit lines

(2)

Long-term assets that have the potential to be converted to cash quickly

(3)

Capability to issue debt or stock

There are many situations where the liquidity position of the firm may not be as good as that indicated by the liquidity ratios. Some of the situations are the following: (1)

Notes discounted in which the other party has full recourse against the firm

(2)

Guarantee of a bank note for another firm

(3)

Major pending lawsuits against the firm

(4)

A major portion of the inventory is obsolete

(5)

A major portion of the receivables are uncollectible

6-43.

The sales-to-working capital ratio gives an indication of whether working capital is used unprofitably or is possibly overworked.

6-44.

Because the higher costs are reflected in the cost of sales (last in, first out), leaving old costs (lower) in inventory.

6-45.

FIFO inventory - reported profit Reported profit under LIFO Increase in ending inventory Reported profit under FIFO

$100,000 10,000 $110,000

Reported profit under LIFO Increase in ending inventory Reported profit under average cost

$100,000 5,000 $105,000

Yes, the inventory costing method should be disclosed. The disclosure is necessary to have an understanding of how the amount was computed.

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PROBLEMS

PROBLEM 6-1 Company T has twice the working capital of Company R. Both companies have a current ratio of 2 to 1. In general, both companies are in the same relative position because of the same current ratio. The greater amount of working capital in Company T is not very significant because the amount of working capital does not indicate the relative size of the companies and the amount needed.

PROBLEM 6-2 a. (1) Working Capital: 2011: $500,000 - $340,000 = $160,000 2010: $400,000 - $300,000 = $100,000 (2) Current Ratio: 2011: $500,000 / $340,000 = 1.47 to 1 2010: $400,000 / $300,000 = 1.33 to 1 (3) Acid-Test Ratio: 2011: $500,000 - $250,000 = 0.74 to 1 $340,000 2010: $400,000 - $200,000 = 0.67 to 1 $300,000

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(4) Accounts Receivable Turnover: 2011:

$1,400,000 ($110,000 + $105,000)/2

= 13.02 times per year

2010:

$1,500,000 ($120,000 + $110,000)/2

= 13.04 times per year

(5) Inventory Turnover: 2011:

$1,120,000 = 4.98 times per year ($200,000 + $250,000)/2

2010:

$1,020,000 = 4.25 times per year ($280,000 + $200,000)/2

(6) Inventory Turnover In Days: 2011: 365/4.98 = 73.29 days 2010: 365/4.25 = 85.88 days b. The short-term liquidity of the firm has improved between 2010 and 2011. The working capital increased by $60,000, while the current ratio increased from 1.33 to 1.47. The acid-test ratio increased from 0.67 to 0.74. Using a rule of thumb of two for the current ratio and one for the acid-test, this firm needs to improve its current liquidity position. The accounts receivable turnover stayed the same, while the inventory improved from 4.25 to 4.98. The days' sales in inventory improved from 85.88 to 73.29 days. Much of the improvement in the current position can be attributed to the improved control of the inventory.

PROBLEM 6-3 Company E and Company D have the same amount of working capital. Company D has a current ratio of 2 to 1, while Company E has a current ratio of 1.29 to 1. Company D is in a better short-term financial position than Company E because its liabilities are covered better with a higher current ratio. Working capital is not very significant because the amount of working capital does not indicate the relative size of the companies and the amount needed.

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PROBLEM 6-4 a. Based on the year-end figures (1) Accounts Receivable Turnover in Days: Average Gross Receivables Net Sales / 365

($75,000 + 50,000)/2 $4,000,000/365

5.70 Days

$4,000,000 ($75,000 + $50,000)/2

64.00 Times per year

($350,000 + $400,000)/2 $1,800,000/365

76.04 Days

(2) Accounts Receivable Turnover per Year: Net Sales Average Gross Receivables

(3) Inventory Turnover in Days: Average Inventory Cost of Goods Sold / 365

(4) Inventory Turnover per Year: Cost of Goods Sold Average Inventory

$1,800,000 ($350,000 + 400,000)/2

4.80 Times per year

b. Using average figures: Total Monthly Gross Receivables Average Total Monthly Inventory Average

$ 6,360,000 12 $ 530,000 $ 5,875,000 12 $ 489,583

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(1) Accounts Receivable Turnover in Days: Average Gross Receivables Net Sales / 365

$530,000 $4,000,000 / 365

48.36 days

(2) Accounts Receivable Turnover per Year: Net Sales Average Gross Receivables

$4,000,000 $530,000

7.55 times per year

$489,583 $1,800,000/365

99.28 days

(3) Inventory Turnover in Days: Average Inventory Cost of Goods Sold/365

(4) Inventory Turnover per Year: Cost of Goods Sold Average Inventory

$1,800,000 $489,583

3.68 times per year

c. Based on the year-end averages, the liquidity of the receivables and inventory are overstated and, therefore, they are unrealistic. The table shows the overstatement of liquidity in comparison with monthly averages. Based on Year-End Figures 5.70 days

Based on Monthly Figures 48.36 days

Accounts Receivable Turnover per Year

64.00 times per year

7.55 times per year

Inventory Turnover in Days

76.04 days

99.28 days

Inventory Turnover per Year

4.80 times per year

3.68 times per year

Accounts Receivable Turnover in Days

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d. Days' Sales in Receivables: Gross Receivables Net Sales/365

$50,000 $4,000,000/365

4.56 days

e. Days' Sales in Inventory: Ending Inventory Cost of Goods Sold/365

$400,000 $1,800,000/365

81.11 days

f. The days' sales in receivables and the days' sales in inventory are understated based on the year-end figures because the receivables and inventory numbers are abnormally low at this time. Therefore, the liquidity of the receivables and the inventory is overstated. Anne Elizabeth Corporation is using a natural business year; therefore, at year-end, the receivables and the inventory are below average for the year.

PROBLEM 6-5

a. b. c. d. e. f. g. h. i. j. k. l. m. n. o.

Total Current Assets + + + — — 0 + 0 — 0 0 0 + 0 —

Total Current Liabilities 0 0 0 — 0 0 0 0 0 — 0 + + + 0

Net Working Capital + + + 0 — 0 + 0 — + 0 — 0 — —

Current Ratio + + + + — 0 + 0 — + 0 — — — —

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PROBLEM 6-6 a. First-In, First-Out (FIFO): Ending Inventory August 1, Purchase 200 @ $7.00 November 1, Purchase 200 @ $7.50

$1,400 1,500 $2,900

Remaining cost is cost of goods sold ($10,900 - $2,900) $8,000

b. Last-In, First-Out (LIFO): Ending Inventory January 1, Inventory (400 x $5.00) = $2,000 Remaining cost is cost of goods sold ($10,900 - $2,000) $8,900

c. Average Cost (Weighted Average): Average Cost

Total Cost Total Units

$10,900 1,800

$6.06

Inventory (400 x $6.06) = $2,424 Remaining cost is cost of goods sold ($10,900 - $2,424) $8,476

d. Specific Identification: March 1, Purchase cost $6.00 Ending Inventory (400 x $6.00) = $2,400 Remaining cost is cost of goods sold ($10,900 - $2,400) $8,500

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PROBLEM 6-7 a.

Working Capital

Current Assets

–

Current Liabilities

$1,052,820 –

$459,842

Current Ratio

Acid-Test Ratio

Current Assets Current Liabilities

Cash Ratio

$248,640 $459,842

Days’ Sales in Receivables

$255,000 + $6,000 $3,050,600/365

$1,052,820 $459,842

2.29

$503,640 $459,842

1.10

Cash Equivalents + Marketable Securities Current Liabilities

$33,493 + $215,147 $459,842

$592,978

Cash Equivalents & Net Receivables & Marketable Securities Current Liabilities

$33,493 + $215,147 + $255,000 $459,842

0.54

Gross Receivables Net Sales/365

$261,000 $3,050,600/365

Accounts Receivable Turnover in Days

($255,000 + $6,000 + $288,000)/2 $3,050,600/365

31.23 days

Average Gross Receivables Net Sales/365

$274,500 $3,050,600/365

32.84 days

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Days’ Sales in Inventory

Inventory Turnover in Days

Ending Inventory Cost of Goods Sold/365

($523,000 + $565,000)/2 $2,185,100/365

$532,000 $2,185,100/365

87.36 days

Average Inventory Cost of Goods Sold/365

$544,000 $2,185,100/365

90.87 days

Operating Cycle

Accounts Receivable Turnover in Days

Inventory Turnover in days

123.71 days

32.84 days

90.87 days

PROBLEM 6-8 a. First-In, First-Out (FIFO): Ending Inventory December 10 Purchase 500 x $5.00 October 22 Purchase 100 x $4.90

Cost of Goods Sold

$2,500 490 $2,990

Remaining cost is cost of goods sold ($20,325 - $2,990) $17,335

b. Last-In, First-Out (LIFO): Ending Inventory January 1, Beginning Inventory (600 x $4.00)

Cost of Goods Sold

$2,400

Remaining cost is cost of goods sold ($20,325 - $2,400) $17,925

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c. Average Cost (Weighted Average): Total Cost Total Units

$20,325 4,400

$4,619

Ending Inventory (600 x $4.62) = $2,772 Cost of Goods Sold ($20,325 - $2,772) = $17,553

d. Specific Identification: July 1 purchase cost $5.00 Ending Inventory (600 x $5.00) = $ 3,000 Cost of Goods Sold ($20,325 - $3,000) = $17,325

PROBLEM 6-9 a. Days’ Sales in Receivables

Gross Receivables Net Sales/365

$480,000 + $25,000 $3,650,000/365

50.50 days

Days’ Sales in Ending Inventory $570,000 Inventory Using = Cost of Goods Sold/365 = $2,850,000/365 = 73.00 days the Cost Figure

c. Days' sales in inventory using the replacement cost for the inventory and the cost of goods sold. Ending Inventory Cost of Goods Sold/365

$900,000 $3,150,000/365

104.29 days

d. The replacement cost data should be used for inventory and cost of goods sold when it is disclosed. Replacement cost places inventory and cost of goods sold on a comparable basis. When the historical cost figures are used and the company uses LIFO, then the cost of goods sold and the inventory are not on a comparable basis. This is because the inventory has the older costs and the cost of goods sold has recent costs. For Laura Badora Company, the actual days' sales in inventory based on replacement cost are over 30 days more than was indicated by using the cost figures.

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PROBLEM 6-10 a. Sales to Working Capital: 2011

2010

$650,000 = 2.41 $270,000 Industry Average

2009

$600,000 = 2.31 $260,000

$500,000 = 2.08 $240,000

4.05

4.00

4.10

b. The sales to working capital ratio for J. A. Appliance Company was substantially below the industry average for all three years. This tentatively indicates that working capital is not efficient in relation to the sales. There was some improvement in the ratio each year.

PROBLEM 6-11 Days’ Sales in Receivables

Days Sales in Inventory

Days’ Sales in Receivables

$560,000 + $30,000 $4,350,000/365

Estimated days to realize cash from ending inventory

Gross Receivables Net Sales/365

$590,000 $4,350,000/365

49.51 days

$680,000 $3,600,000/365

Days’ Sales in Inventory

Ending Inventory Cost of Goods Sold/365

49.51 Days

68.94 Days

68.94 days

118.45 days

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PROBLEM 6-12 a. 3

A payment of a trade account payable would reduce both current assets and current liabilities. This would have the effect of increasing both the current and quick ratios since total quick assets exceeded total current liabilities both before and after the transactions.

b. 2

This would increase current assets and current liabilities by the same amount. This would have the effect of decreasing the current ratio because total quick assets exceeded total current liabilities both before and after the transaction.

c. 5

The collection of a current account receivable would not change the numerator or the denominator in either the current or quick ratios.

d. 4

A write-off of inventory would decrease the numerator in the current ratio.

e. 2

The liquidation of a long-term note would reduce the numerator in both the quick ratio and the current ratio, but it would reduce the numerator of the quick ratio proportionately more than the numerator of the current ratio.

PROBLEM 6-13 a. Accounts Receivable Turnover (in days)

($180,000 + $160,000)/2 $3,150,000/365

b. Inventory Turnover (in days)

($480,000 + $390,000)/2 $2,250,000/365

Operating Cycle

Average Gross Receivable Net Sales/365

19.70 days

Average Inventory Cost of Goods Sold/365

$435,000 $2,250,000/365

70.57 days

Accounts Receivable Turnover in Days

Inventory Turnover In Days

19.70 days

70.57 days = 90.27 days

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PROBLEM 6-14 a.

Cash Equivalents + Marketable Securities + Net Receivables Current Liabilities $2,100,000 + 7,200,000 + $50,500,000 $34,000,000

1.76

The collection of accounts receivable does not change the total numerator or the denominator of the current ratio formula, nor does the collection change total current assets or total current liabilities.

PROBLEM 6-15 a.

Average Inventory Cost of Goods Sold/365

$280,000 $1,250,000/365

Cost of Goods Sold Average Inventory

$1,250,000 $280,000

Inventory Turnover in Days

81.76 Days

Merchandise Inventory Turnover

4.46 times per year

or 365 Inventory Turnover in Days

365 81.8

Merchandise Inventory Turnover

4.46 times per year

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PROBLEM 6-16 a.

Net Sales Average Gross Receivables $1,500,000 ($8,000 + $72,000 + $10,000 + $60,000)/2

20.0 times per year

December 31 represents a date when the accounts receivable would be low and unrepresentative; thus, the accounts receivable turnover computed on December 31 will be overstated.

PROBLEM 6-17 a.

Ending Inventory Cost of Goods Sold/365

$360,500 $2,100,000/365

Days’ Sales in Inventory

62.66 days

b. No. Since J. Shaffer Company uses LIFO inventory, the ending inventory is computed using costs that are not representative of the current cost. The cost of goods sold is representative of the approximate current cost and, therefore, the average daily cost of goods sold is representative of current cost. When the average daily cost of goods sold is divided into the inventory, the result is an unrealistically low number of days' sales in inventory. Thus, the liquidity is overstated. c. The number of days' sales in inventory would be a helpful guide when compared with prior periods. The actual computed number of days' sales in inventory would not be meaningful because of the LIFO inventory.

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PROBLEM 6-18 a.

Cash Equivalents + Marketable Securities + Net Receivables Current Liabilities $8,000 + $32,000 + $40,000 $60,000 + $30,000

$80,000 $90,000

0.89

Net Sales (use only credit sales when available)/Average Gross Receivables (only net receivables in this problem) Net Sales Average Gross Receivables Note: Use only credit sales when available. $600,000 ($40,000 + $110,000)/2

8.00 times

$1,260,000 $110,000

11.45 times

Current Assets Current Liabilities $8,000 + $32,000 + $40,000 + $80,000 $60,000 + $30,000

Cost of Goods Sold Average Inventory $1,260,000 ($80,000 + $140,000)/2

$600,000 $75,000

$160,000 $90,000

1.78 times

As long as the current ratio is greater than 1 to 1, any payment will increase the current ratio because the current liabilities go down more in proportion than do the current assets.

PROBLEM 6-19 a.

365 days Accounts receivable turnover in days

365 36

365 days 12.0 times per year

30.42 days

10.14 times per year

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Gross Receivables Net Sales/365

$280,000 $2,158,000/365

Net Sales Accounts Gross Receivables

47.36 days

10.80 times per year

$3,500,000 $324,000

PROBLEM 6-20 a.

An increase in inventory would increase the current ratio. To the extent that the increase in inventory used current funds available, this would decrease the acid-test.

LIFO would result in a lower inventory figure. This would decrease the current ratio and increase inventory turnover.

Current Assets Current Liabilities

X $600,000

3.0

X = $1,800,000 Current Assets - Inventory Current Liabilities

$1,800,000 – Y $600,000

2.5

Y = $300,000 Cost of Sales Inventory

$500,000 $300,000

1.67

The most logical reason for the current ratio to be high and the quick ratio low is that the firm has a large investment in inventory.

Low default risk, readily marketable, and a short-term to maturity is a proper description of investment instruments used to invest temporarily idle cash balances.

A proper management of accounts receivable should achieve a combination of sales volume, bad debt experience, and receivables turnover that maximizes the profits of the corporation.

Any of the four items could be used to cover payroll expenses.

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PROBLEM 6-21 a. Days’ sales in receivables

Gross Receivables Net Sales/365

$110,000 + $8,000 L. Solomon company days’ sales in receivables $1,800,000/365

23.93 days

$60,000 + $4,000 $1,850,000/365

12.63 days

L. Konrath Company days’ sales in receivables

It appears that the L. Konrath Company manages receivables better than does L. Solomon Company. They have 12.63 days' sales in receivables, while the L. Solomon Company has 23.93 days' sales in receivables. Actually, we cannot make a fair comparison between these two companies because the L. Solomon Company is using the calendar year, while the L. Konrath Company appears to be using a natural business year. By using a natural business year, the L. Konrath Company has its receivables at a low point at the end of the year. This would make its liquidity overstated at the end of the year.

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PROBLEM 6-22 a.

Days’ Sales in Receivables

Gross Receivables Net Sales/365

2011:

$131,000 + $1,000 $880,000/365

54.75 days

2010:

$128,000 + $900 $910,000/365

51.70 days

2009:

$127,000 + $900 $840,000/365

55.58 days

2008:

$126,000 + $800 $825,000/365

56.10 days

2007:

$125,000 + $1,200 $820,000/365

56.17 days

2. Accounts Receivable Turnover

Net Sales Gross Receivables

2011:

$880,000 $131,000 + $1,000

6.67 times per year

2010:

$910,000 $128,000 + $900

7.06 times per year

2009:

$840,000 $127,000 + $900

6.57 times per year

2008:

$825,000 $126,000 + $800

6.51 times per year

2007:

$820,000 $125,000 + $1,200

6.50 times per year

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3. Accounts Receivable Turnover in Days

Gross Receivables Net Sales/365

2011:

$131,000 + $1,000 $880,000/365

= 54.75 days

2010:

$128,000 + $900 $910,000/365

= 51.70 days

2009:

$127,000 + $900 $840,000/365

= 55.58 days

2008:

$126,000 + $800 $825,000/365

= 56.10 days

2007:

$125,000 + $1,200 $820,000/365

= 56.17 days

4. Days’ Sales in Inventory

Ending Inventory Cost of Goods Sold/365

2011:

$122,000 $740,000/365

= 60.18 days

2010:

$124,000 $760,000/365

= 59.55 days

2009:

$126,000 $704,000/365

= 65.33 days

2008:

$127,000 $695,000/365

= 66.70 days

2007:

$125,000 $692,000/365

= 65.93 days

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Inventory Turnover

Cost of Goods Sold Ending Inventory

2011:

$740,000 $122,000

= 6.07 times per year

2010:

$760,000 $124,000

= 6.13 times per year

2009:

$704,000 $126,000

= 5.59 times per year

2008:

$695,000 $127,000

= 5.47 times per year

2007:

$692,000 $125,000

= 5.54 times per year

6. Inventory Turnover in Days

Ending Inventory Cost of Goods Sold/365

2011:

$122,000 $740,000/365

= 60.18 days

2010:

$124,000 $760,000/365

= 59.55 days

2009:

$126,000 $704,000/365

= 65.33 days

2008:

$127,000 $695,000/365

= 66.70 days

2007:

$125,000 $692,000/365

= 65.93 days

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7. Operating Cycle

Accounts Receivable Turnover in Days

2011:

54.75 + 60.18

= 114.93

2010:

51.70 + 59.55

= 111.25

2009:

55.58 + 65.33

= 120.91

2008:

56.10 + 66.70

= 122.80

2007:

56.17 + 65.93

= 122.10

8. Working Capital

Current Assets

Inventory Turnover in Days

– Current Liabilities

2011:

$305,200 – $109,500

= $195,700

2010:

$303,000 – $110,000

= $193,000

2009:

$303,000 – $113,500

= $189,500

2008:

$301,000 – $114,500

= $186,500

2007:

$297,000 – $115,500

= $181,500

9. Current Ratio

Current Assets Current Liabilities

2011:

$305,200 $109,500

= 2.79

2010:

$303,000 $110,000

= 2.75

2009:

$303,000 $113,500

= 2.67

2008:

$301,000 $114,500

= 2.63

2007:

$297,000 $115,500

= 2.57

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10. Acid-Test Ratio =

Cash Equivalents + Marketable Services + Net Receivables Current Liabilities

2011:

$47,200 + $2,000 + $131,000 $109,500

= 1.65

2010:

$46,000 + $2,500 + $128,000 $110,000

= 1.60

2009:

$45,000 + $3,000 + $127,000 $113,500

= 1.54

2008:

$44,000 + $3,000 + $126,000 $114,500

= 1.51

2007:

$43,000 + $3,000 + $125,000 $115,500

= 1.48

11. Cash Ratio

Cash Equivalents + Marketable Securities Current Liabilities

2011:

$47,200 + $2,000 $109,500

= 0.45

2010:

$46,000 + $2,500 $110,000

= 0.44

2009:

$45,000 + $3,000 $113,500

= 0.42

2008:

$44,000 + $3,000 $114,500

= 0.41

2007:

$43,000 + $3,000 $115,500

= 0.40

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12. Sales to Working Capital

2011:

$880,000 $195,700

= 4.50

2010:

$910,000 $193,000

= 4.72

2009:

$840,000 $189,500

= 4.43

2008:

$825,000 $186,500

= 4.42

2007:

$820,000 $181,500

= 4.52

1. Days' Sales in Receivables

Net Sales Working Capital

Average Gross Receivables Net Sales/365

2011:

($131,000 + $1,000 + $128,000 + $900)/2 $880,000/365

= 54.11 days

2010:

($128,000 + $900 + $127,000 + $900)/2 $910,000/365

= 51.50 days

2009:

($127,000 + $900 + $126,000 + $800)/2 $840,000/365

= 55.34 days

2008:

($126,000 + $800 + $125,000 + $1,200)/2 $825,000/365

= 55.97 days

2007:

Not sufficient data to compute using average gross receivables.

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2. Accounts Receivable Turnover

Net Sales Average Gross Receivables

2011:

$880,000 (131,000 + $1,000 + $128,000 + $900)/2

= 6.75

2010:

$910,000 ($128,000 + $900 + $127,000 + $900)/2

= 7.09

2009:

$840,000 ($127,000 + $900 + $127,000 + $900)/2

= 6.60

2008:

$825,000 ($126,000 + $800 + $125,000 + $1,200)/2

= 6.52

2007:

Not sufficient data to compute using average gross receivables.

3. Accounts Receivable Turnover in Days

Average Gross Receivables Net Sales/365

2011:

($131,000 + $1,000 + $128,000 + $900)/2 $880,000/365

= 54.11 days

2010:

($128,000 + $900 + $127,000 + $900)/2 $910,000/365

= 51.50 days

2009:

($127,000 + $900 + $126,000 + $800)/2 $840,000/365

= 55.34 days

2008:

($126,000 + $800 + $125,000 + $1,200)/2 $825,000/365

= 55.97 days

2007:

Not sufficient data to compute using average gross receivables.

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4. Days' Sales In Inventory

Average Inventory Cost of Goods Sold/365

2011:

($122,000 + $124,000)/2 $740,000/365

= 60.67 days

2010:

($124,000 + $126,000)/2 $760,000/365

= 60.03 days

2009:

($126,000 + $127,000)/2 $704,000/365

= 65.59 days

2008:

($127,000 + $125,000)/2 $695,000/365

= 66.17 days

2007:

Not sufficient data to compute using average inventory.

Inventory Turnover

Cost of Goods Sold Average Inventory

2011:

$740,000 ($122,000 + $124,000)/2

6.02 times per year

2010:

$760,000 ($124,000 + $126,000)/2

6.08 times per year

2009:

$704,000 ($126,000 + $127,000)/2

5.57 times per year

2008:

$695,000 ($127,000 + $125,000)/2

5.52 times per year

2007:

Not sufficient data to compute using average inventory.

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6. Inventory Turnover In Days

Average Inventory Cost of Goods Sold/365

2011:

($122,000 + $124,000)/2 $740,000/365

= 60.67 days

2010:

($124,000 + $126,000)/2 $760,000/365

= 60.03 days

2009:

($126,000 + $127,000)/2 $704,000/365

= 65.59 days

2008:

($127,000 + $125,000)/2 $695,000/365

= 66.17 days

2007:

Not sufficient data to compute using average inventory.

7. Operating Cycle

Accounts Receivable Turnover In Days

2011:

54.11

60.67

= 114.78

2010:

51.50

60.03

= 111.53

2009:

55.34

65.59

= 120.93

2008:

55.97

66.17

= 122.14

2007:

Not sufficient data to compute.

Inventory Turnover in Days

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8. Working Capital = Average Current Assets – Average Current Liabilities 2011:

2010:

2009:

2008:

2007:

($305,200 + $303,000)/2

($109,500 + $110,000)/2

$304,100

$109,750

($303,000 + $303,000)/2

($110,000 + $113,500)/2

$303,000

$111,750

($303,000 + $301,000)/2

($113,500 + $114,500)/2

$302,000

$114,000

($301,000 + $297,000)/2

($114,500 + $115,500)/2

$299,000

$115,000

= $194,350

= $191,250

= $188,000

= $184,000

Not sufficient data to compute.

9. Current Ratio

Average Current Assets Average Current Liabilities

2011:

$304,100 $109,750

2.77

2010:

$303,000 $111,750

2.71

2009:

$302,000 $114,000

2.65

2008:

$299,000 $115,000

2.60

2007:

Not sufficient data to compute using average inventory.

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10. Acid-Test Ratio

2011:

Average (Cash Equivalents + Marketable Securities + Net Receivables) Average Current Liabilities

(($47,200 + $2,000 + $131,000) + ($46,000 + $2,500 + $128,000))/2 ($109,500 + $110,000)/2 $178,350 $109,750

2010:

1.57

1.53

(($44,000 + $3,000 + $126,000) + ($43,000 + $3,000 + $125,000))/2 ($114,500 + $115,500)/2 $172,000 $115,000

2007:

(($45,000 + $3,000 + $127,000) + ($44,000 + $3,000 + $126,000))/2 ($113,500 + $114,500)/2 $174,000 $114,000

2008:

1.63

(($46,000 + $2,500 + $128,000) + ($45,000 + $3,000 + $127,000))/2 ($110,000 + $113,500)/2 $175,750 $111,750

2009:

1.50

Not sufficient data to compute using average inventory.

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11. Cash Ratio

2011:

Average (Cash Equivalents + Marketable Securities) Average Current Liabilities

($47,200 + $2,000) + ($46,000 + $2,500)/2 ($109,500 + $110,000)/2 $48,850 $109,750

2010:

0.43

0.42

($44,000 + $3,000) + ($43,000 + 3,000)/2 ($114,500 + $115,500)/2 $46,500 $115,000

2007:

($45,000 + $3,000) + ($44,000 + 3,000)/2 ($113,500 + $114,500)/2 $47,500 $114,000

2009:

0.45

($46,000 + $2,500) + ($45,000 + 3,000)/2 ($110,000 + $113,500)/2 $48,250 $111,750

2009:

0.40

Not sufficient data to compute using average inventory.

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12. Sales to Working Capital

Net Sales Average Working Capital

2011:

$880,000 ($305,200 - $109,500 + $303,000 - $110,000)/2

4.53

2010:

$910,000 ($303,000 - $110,000 + $303,000 - $113,500)/2

4.76

2009:

$840,000 ($303,000 - $113,500 + $301,000 - $114,500)/2

4.47

2008:

$825,000 ($301,000 - $114,500 + $297,000 - $115,500)/2

4.48

2007:

Not sufficient data to compute.

c. 1. Days' Sales in Receivables increased slightly each year using year end data. 2. Accounts Receivable Turnover decreased slightly each year using year end dates. 3. Account Receivable Turnover in days increased slightly each year using year end data. 4. Days Sales in Inventory decreased slightly each year using year end data except for 2008. 5. Inventory Turnover increased slightly each year using year end data except for 2008. 6. Inventory Turnover in days decreased slightly each year using year end data except for 2008. 7. Operating cycle in some years increased slightly and in some years decreased slightly. 8. Working Capital increased slightly each year using year end data. 9. Current Ratio increased slightly each year using year end data. 10. Acid-Test Ratio increased slightly each year using year end data. 11. Cash Ratio stayed the same in 2011 and 2009. It increased slightly using 2010 and 2008. 12. Sales to Working Capital decreased slightly each year using year end data. 142 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

PROBLEM 6-23 a. Days’ sales in receivables

Gross Receivables Net Sales/365

December 31, 2011:

$55,400 + $3,500 $800,000/365

26.87 days

July 31, 2011:

$90,150 + $4,100 $790,000/365

43.55 days

b. Accounts receivable turnover

December 31, 2011:

Net Sales Average Gross Receivables

$800,000 ($50,000 + $3,000 + $55,400 + $3,500)/2 14.30 times per year

July 31, 2011:

$790,000 ($89,000 + $4,000 + $90,150 + $4,100)/2 8.44 times per year

c. This company appears to have a seasonal business because of the materially different days' sales in receivables and accounts receivable turnover when computed at the two different dates. The ratios computed will not be meaningful in an absolute sense, but they would be meaningful in a comparative sense when comparing the same dates from year to year. They would not be meaningful when comparing different dates.

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PROBLEM 6-24 a. Days’ sales in receivables

Gross Receivables Net Sales/365

2011:

$220,385 + $11,180 $1,180,178/365

71.62 days

2010:

$240,360 + $12,300 $2,200,000/365

41.92 days

b. Accounts receivable turnover =

Net Sales Average Gross Receivables

2011:

$1,180,178 ($240,360 + $12,300 + $220,385 + $11,180) / 2

4.87 times per year

2010:

$2,200,000 ($230,180 + $7,180 + $240,360 + $12,300) / 2

8.98 times per year

The Hawk Company receivables have been much less liquid in 2011 in comparison with 2010. The days' sales in receivables at the end of the year have increased from 41.92 days in 2010 to 71.62 days in 2011. The accounts receivable turnover declined in 2011 to 4.87 from a turnover of 8.98 in 2010. These figures represent a major deterioration in the liquidation of receivables. The reasons for this deterioration should be determined. Some possible reasons are a major customer not paying its bills, a general deterioration of all receivable accounts, or a change in the Hawk Company credit terms.

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PROBLEM 6-25 ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS – ETHICS vs. CONSERVATISM

1. Current balance Needed to adjust Adjusted balance

$2,000 4,050 $6,050

This will add $4,050 to expense 2. Current balance Needed to adjust Adjusted balance

$ 2,000 10,000 $12,000

This will add $10,000 to expense b. Unethical The accountant cannot use the conservatism concept to justify arbitrarily low numbers, such as lower income. What is proposed would be unethical.

PROBLEM 6-26 ACCOUNTS RECEIVABLE – NOTE RECEIVABLE - ETHICS a. Yes b. It should improve the liquidity appearance. In reality, it will likely make the liquidity worse. c.

As stated in the case, it would be unethical. It could be made ethical with a detailed review of the customers situation, adequate discussions with Eric Page, the CEO, and adequate disclosure.

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PROBLEM 6-27

Current Assets Current Liabilities

Current Ratio

Current Assets – Inventory Current Liabilities

Acid-Test Ratio

Current Assets $400,000

2.5

$1,000,000 – Inventory $400,000

2.0

Current Assets

$1,000,000 – Inventory $1,000,000 – $800,000 $200,000 = Inventory

= =

$800,000 Inventory

$1,000,000

Cost of Sales Inventory

Inventory Turnover =

Cost of Sales Inventory

Cost of Sales $200,000

Cost of Sales = $600,000

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CASES CASE 6-1 STEEL MAN (This case provides an opportunity to compare LIFO and FIFO.) a. Total current assets Total current liabilities Working Capital b.

$1,404,100,000 844,500,000 $559,600,000

$514,200,000 The LIFO reserve reduces the inventory balance to an approximate current cost.

c. $448,700,000 514,200,000 $962,900,000 The $962,900,000 is more realistic because it approximates current replacement costs. d.

(1)

Price increases: LIFO results in lower income

(2)

Price decreases: LIFO results in higher income

(3)

Constant cost: If prices remain constant, then the same profit will result with LIFO and FIFO.

(1)

Price increases: (a) Pre-tax cash flows: No difference in cash flow (b)

(2)

After-tax cash flows: Because of the lower income under LIFO, there will be less tax. This will result in higher cash flow.

Price decreases: (a) Pre-tax cash flows: No difference in cash flow (b)

After-tax cash flows: Because of the higher income under LIFO, there will be more tax and this will result in a lower cash flow.

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(3)

Constant cost: (a) Pre-tax cash flows: No difference in cash flow (b)

After-tax cash flow: There will be no difference in cash flow because the tax will be the same.

f. Using LIFO, the purchase on the last day of the year would be included in cost of goods sold, thus influencing the income statement. g. The reduction in inventory would result in older costs being matched against current sales. This distorts profits on the high side.

CASE 6-2 RISING PRICES, A TIME TO SWITCH OFF LIFO? (This case helps demonstrate that the individual investor must read comments from the company in a critical manner. The reasons given for a change in accounting principle may not appear to be the reasons stated when the data are analyzed critically.) a.

Matching current costs against current revenue is usually considered to result in more realistic earnings, just the opposite of the claim of the anonymous corporation.

Taxes on past earnings of $6,150,000 will need to be paid if the company switches from LIFO. The corporation will seek permission to pay these taxes over a tenyear period, thus influencing the company’s tax liability for the next ten years. Taxes in the future will be higher because of the increased profits resulting from the switch from LIFO.

Profits for 2011 will be higher because of the lower cost of goods sold.

Future profits will be higher because of the matching of older costs against current revenue.

This year's cash flow will be lower to the extent that there are higher taxes paid.

Cash flow for 2011 will be lower by the amount of the increase in taxes.

The profit picture has declined; it appears that the corporation wants to report higher profits. It will be able to achieve higher profits because of the switch from LIFO. The results will probably not be worth the price of higher taxes and, therefore, reduced cash flow.

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CASE 6-3 IMAGING (This case provides an opportunity to review the liquidity of the Eastman Kodak Company.) a. 1. Days’ sales in receivables (use trade receivables) Gross Trade Receivables Net Sales/365

2010

2009

$1,137,000,000 + $77,000,000* $7,187,000,000/365

$1,238,000,000 + $98,000,000* $7,606,000,000/365

61.65 days

64.11 days

*Assumption made that all of the allowance related to trade receivables

2. Accounts receivable turnover Net Sales Gross Receivables

2010

2009

$7,187,000,000 $1,214,000,000

$7,606,000,000 $1,336,000,000

5.92 times

5.69 times

3. Days’ Sales in Inventory Ending Inventory Cost of Goods Sold/365

2010 $696,000,000 $5,236,000,000/365

2009 $679,000,000 $5,838,000,000/365

48.52 days

42.45 days

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4. Inventory turnover Cost of Goods Sold Average Inventory

2010 $5,236,000,000 $696,000,000

2009 $5,838,000,000 $679,000,000

7.52 times

8.60 times

5. Working capital Current Assets – Current Liabilities

Current assets Current liabilities

2010 $3,799,000,000 (2,833,000,000) $966,000,000

2009 $4,303,000,000 (2,896,000,000) $1,407,000,000

6. Current ratio Current Assets Current Liabilities 2010 $3,799,000,000 $2,833,000,000

2009 $4,303,000,000 $2,896,000,000

1.34

1.49

7. Acid-test ratio Cash Equivalents + Marketable Securities + Net Receivables Current Liabilities 2010

2009

$1,624,000,000 + $1,259,000,000 $2,833,000,000

$2,024,000,000 + $1,395,000,000 $2,896,000,000

1.02

1.18

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Days’ sales in receivables Material positive trend between 2009 and 2010

Accounts receivable turnover Material positive trend between 2009 and 2010

Days’ sales in inventory Material negative trend between 2009 and 2010

Inventory turnover Substantial negative trend between 2009 and 2010

Working capital Moderate negative trend between 2009 and 2010

Current ratio Moderate positive trend between 2009 and 2010

Acid-test ratio The acid-test ratio improved slightly between 2009 and 2010

Some of the previous long term debt has become current.

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d. Eastman Kodak Company Vertical Common-Size Consolidated Statement of Financial Position At December 31 2010 2009 Assets Current Assets Cash and cash equivalents Receivables, net Inventories, net Deferred income taxes Other current assets Total current assets Property, plant and equipment, net Goodwill Other long-term assets Total assets Liabilities and Shareholders’ Equity Current Liabilities Accounts payable trade Short-term borrowings and current portion of long-term debt Accrued income taxes Other current liabilities Total current liabilities Long-term debt, net of current portion Pension and other postretirement liabilities Other long-term liabilities Total liabilities Shareholders’ Equity Common stock Additional paid in capital Retained earnings Accumulated other comprehensive loss Treasury stock, at cost Total Eastman Kodak Company shareholders’ (deficit) equity Noncontrolling interests Total (deficit) equity Total liabilities and equity (deficit)

26.0 20.2 11.2 1.9 1.6 60.9 16.6 4.7 17.8 100.0

26.3 18.1 8.8 1.6 1.0 55.9 16.3 11.8 16.0 100.0

15.4 .8 5.5 23.7 45.4 19.2 42.7 10.0 117.2

11.9 .8 .3 24.6 37.7 14.7 35.0 13.1 100.4

15.7 17.7 79.6 (34.2) 78.8 (96.1) (17.3) 0.0 (17.2) 100.0

12.7 14.2 73.8 (22.9) 77.8 (78.3) (0.5) 0.0 (0.4) 100.0

* There are some rounding differences

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e. Total current assets increased substantially. All items in current assets increased except for cash and cash equivalents, which decreased slightly. Material decrease in goodwill. Material increase in total current liabilities. This increase came from accounts payable and accrued income taxes. Material increase in long-term debt, net of current portion. Material increase in total liabilities. Material increase in treasury stock, which materially increased the deficit in total shareholders’ equity.

CASE 6-4 TECHNOLOGY (This case provides an opportunity to review liquidity.) a. 1. Days’ Sales in Receivables (In millions) Gross Receivables Net Sales/365 2010 $3,615,000,000 + $98,000,000 $26,662,000,000

2009 $3,250,000,000 + $109,000,000 $23,123,000,000

50.83 days

53.02 days

2. Accounts Receivable Turnover Net Sales Gross Receivables at Year-End 2010 $26,662,000,000 $3,615,000,000 + $98,000,000

2009 $23,123,000,0000 $3,250,000,000 + $109,000,000

7.18 times

6.88 times

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3. Days’ Sales in Inventory Ending Inventory Cost of Goods Sold/365 2010 $3,155,000,000 $13,831,000,000/365

2009 $2,639,000,000 $12,109,000,000/365

83.26 days

79.55 days

4. Inventory Turnover Cost of Goods Sold Year-End Inventory 2010 $13,831,000,000 $3,155,000,000

2009 $12,109,000,000 $2,639,000,000

4.38 times

4.59 times

5. Working Capital Current Assets – Current Liabilities 2010 $12,215,000,000 - $6,089,000,000

2009 $10,795,000,000 - $4,897,000,000

$6,126,000,000

$5,898,000,000

6. Current Ratio Current Assets Current Liabilities 2010 $12,215,000,000 $6,089,000,000

2009 $10,795,000,000 $4,897,000,000

2.01

2.20

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7. Acid Test Ratio Cash Equivalents + Marketable Securities + Net Receivables Current Liabilities

2010

2009

$3,377,000,000 + $3,615,000,000 + $1,101,000,000 $6,089,000,000

$3,040,000,000 + $3,250,000,000 + $744,000,000 $4,897,000,000

1.33

1.44

b. 1. Days’ Sales in Receivables A material decrease in days’ sales in receivables. This would be positive. 2. Accounts Receivable Turnover A moderate increase in accounts receivable turnover. This would be positive. 3. Days’ Sales in Inventory A moderate increase in days’ sales in inventory. This would be negative. 4. Inventory Turnover A moderate decrease in inventory turnover. This would be negative. 5. Working Capital Working capital increased moderately. This would positive. 6. Current Ratio The current ratio decreased substantially. This would be negative. 7. Acid-Test Ratio The acid-test ratio decreases substantially. This would be negative.

c. Total liquidity decreased substantially. This would be a negative. The negative indicators for inventory more than compensated for the moderate improvement in receivables.

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CASE 6-5 BOOMING RETAIL (The data for this case relate to W.T. Grant for the years ended January 3, 1966 - 1970. This relatively short case provides insight into why W. T. Grant went bankrupt.) a.

Sales Net accounts receivable

5 136.2%

4 131.5%

Year 3 119.0%

182.2%

159.8%

135.7%

2 106.4%

1 100.0%

118.2%

100.0%

b. Accounts Receivable Turnover

Net Sales Average Gross Receivables

Year 5:

$1,254,131 ($419,731 + $368,267)/2

$1,254,131 $393,999

3.18 times per year

Year 4:

$1,210,918 ($368,267 + $312,776)/2

$1,210,918 $340,521

3.56 times per year

Year 3:

$1,096,152 (312,776 + 272,450)/2

$1,096,152 $292,613

3.75 times per year

Year 2:

$979,458 ($272,450 + $230,427)/2

$979,458 $251,438

3.90 times per year

Yes. With installment sales, the period to pay is relatively long. Thus, it is important that the firms have good credit controls and policies.

It appears that The Grand has a problem with credit controls and subsequent collection of the receivables. Net accounts receivable has been increasing much faster than sales. This could result in substantial write-offs of receivables and recognition of losses.

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CASE 6-6 GREETING (This case presents the opportunity to review liquidity and LIFO). a. 1. Days’ sales in receivables Gross Receivables Net Sale/365 2011

2010

$119,779,000 + $98,247,000 $1,560,213,000/365

$135,758,000 + $103,243,000 $1,598,292,000/365

51.01 days

54.58 days

2. Accounts Receivable Turnover Net Sales Gross Receivables at Year-End 2011 $1,560,213,000 $119,779,000 + $98,247,000

2010 $1,598,292,000 $135,758,000 + $103,243,000

7.16 days

6.69 days

3. Days’ Sales in Inventory Ending Inventory Cost of Goods Sold/365 2011 $179,730,000 $682,368,000/365

2010 $163,956,000 $713,075,000/365

96.14 days

83.92 days

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4. Inventory Turnover Cost of Goods Sold Year-End Inventory 2011 $682,368,000 $179,730,000

2010 $713,075,000 $163,956,000

3.80 times

4.35 times

5. Working Capital Current Assets – Current Liabilities 2011 $700,924,000 - $342,545,000

2010 $679,291,000 - $368,587,000

$358,379,000

$310,704,000

6. Current Ratio Current Assets Current Liabilities 2011 $700,924,000 $342,545,000

2010 $679,291,000 $368,587,000

2.05

1.84

7. Acid Test Ratio Cash Equivalents + Marketable Securities + Net Receivables Current Liabilities 2011 $215,838,000 + $119,779,000 $342,545,000

2010 $137,949,000 + $135,758,000 $368,587,000

.98

.74

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b. 1. Days’ Sales in Receivables A moderate decrease in days’ sales in receivables. This would be positive. 2. Accounts Receivable Turnover A material increase in accounts receivable turnover. This would be positive. 3. Days’ Sales in Inventory A moderate increase in days’ sales in inventory. This would be negative. 4. Inventory Turnover A material decrease in inventory turnover. This would be negative. 5. Working Capital A material increase in working capital. This would be positive. 6. Current Ratio A material increase in the current ratio. This would be positive. 7. Acid-Test Ratio A material increase in the acid-test ratio. This would be positive.

c. 1. American Greetings has several unique allowance accounts for example allowance for outdated products. 2. Most of these allowance considerations are not normal for most companies, but they are normal for this industry. d. Net inventory Add back LIFO reserve

$179,730,000 78,358,000 $258,088,000

e. There were no material LIFO liquidations in 2011 and 2009. liquidation resulted in increasing income by $13,000,000.-

The 2010 LIFO

f. The total liquidity situation appeared to be good, but days’ sales in inventory increased and inventory turnover decreases. The inventory trends were negative.

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CASE 6-7 LIFO – TAX, U.S. GAAP AND IFRS IMPLICATIONS (This case provides the tax, U.S. GAAP and IFRS implications of LIFO). Required a. They would need to switch off of LIFO for financial reporting. The implications for taxes are not clear. The law requiring a firm to use LIFO for financial reporting if LIFO is used for federal taxes could be changed to allow LIFO for federal taxes and remove the conformity requirement. It is also possible that these firms would need to pay the tax benefit relating to prior years when LIFO was used. b. $26,965,000,000 X 40% = $10,786,000,000

CASE 6-8 SPECIALTY RETAILER – LIQUIDITY REVIEW (This case provides the opportunity to review the liquidity of three specialty retail companies). a. Abercrombie & Fitch The current ratio decreased moderately while the acid test decreased materially. This indicates a decline in liquidity, although we should check the liquidity of receivables and inventory. Limited Brands The current ratio and acid test decreased materially. This indicates a material decline in liquidity, although we should check the liquidity of receivables and inventory. GAP The current ratio and acid-test decreased materially. This indicates a material decline in liquidity, although we should check the liquidity of receivables and inventory. b. Abercrombie & Fitch had the best liquidity position. Limited Brands had a materially better current ratio in 2010 than did GAP, Inc. GAP, Inc. had a substantially better current ratio in 2011 than did Limited Brands. Limited Brands had a materially better acid test in both years than did GAP, Inc.

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CASE 6-9 EAT AT MY RESTAURANT – LIQUIDITY REVIEW (This case provides the opportunity to review the liquidity of three restaurant companies). a. Yum Brands, Inc. The current ratio and the acid test improved materially. We should check the liquidity of receivables and inventory. Panera Bread The current ratio and the acid test declined materially. We should check the liquidity of receivables and inventory. Starbucks The current ratio and the acid test improved materially. We should check the liquidity of receivables and inventory. b. Panera Bread had the best liquidity position, although it was only slightly better than Starbucks for the current ratio in 2010. Starbucks liquidity position was materially better than Yum Brands.

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Chapter 7 Long-Term Debt-Paying Ability

QUESTIONS 7- 1.

Yes, profitability is important to a firm's long-term, debtpaying ability. Although the reported income does not agree with cash available in the short run, eventually the revenue and expense items do result in cash movements. Because there is a close relationship between the reported income and the ability of the entity to meet its long-run obligations, the major emphasis when determining the long-term, debt-paying ability is on the profitability of the entity.

7- 2.

(1) Income statement. (2) Balance sheet The income statement approach is important because, in the long run, there is usually a relationship between the reported income that is the result of accrual accounting and the ability of the firm to meet its long-term obligations. The balance sheet indicates the amount of funds provided by outsiders in relation to those provided by owners of the firm. If a high proportion of the resources have been provided by outsiders, then this indicates that the risks of the business have been shifted to outsiders.

7- 3.

A relatively high, stable coverage of interest over the years is desirable. A relatively low, fluctuating coverage of interest over the years is not desirable.

7- 4.

No. The auto manufacturing business is known for its cyclical nature. The times interest expense, therefore, would fluctuate materially. We would expect the auto manufacturer to finance a relatively small proportion of its long-term funds from debt.

7- 5.

A telephone company has its rate of return and, therefore, profits controlled by public utility commissions. We would expect the times interest earned to be moderate and relatively stable, which should be a relatively favorable times interest earned ratio. This stability allows for carrying a high portion of debt financing.

7- 6.

A firm must pay for the interest capitalized; therefore, this interest should be included along with interest expense in order to obtain total interest.

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7- 7.

To get a better indication of a firm's ability to cover interest payments in the short run, the non-cash charges for depreciation, depletion, and amortization can be added back to the times interest earned numerator. The resulting income can be related to interest earned on a cash basis for a short-run indication of the firm's ability to cover interest.

7- 8.

The financial statements are predominately prepared based upon historical cost. Seldom is the market value or liquidation value disclosed.

7- 9.

No, the determination of the current value of the long-term assets is very subjective. The best that can be achieved is a reasonable relationship of long-term assets to long-term debt, based on historical cost or estimates of current value (appraisals of the assets by third parties).

7-10.

The intent of this ratio is to indicate the percentage of the assets that were financed by creditors. The ratio should indicate a reasonably accurate picture of how the assets were financed, but it will not be precise because all of the liabilities have been included, while the assets are at book value, which may be less than or more than their liquidation value.

7-11.

No, the debt ratio would not be as high as the debt/equity ratio because the debt ratio relates total liabilities to total assets, while the debt/equity ratio relates total liabilities to shareholders' equity. The total asset figure is equal to both the liabilities and the shareholders' equity.

7-12.

The balance sheet equation has assets = liabilities + shareholders' equity. Given any set of figures that agree with the basic balance sheet equation, the liabilities are the same whether they are related to assets or shareholders' equity. For example, assets ($100,000) = liabilities ($40,000) + shareholders' equity ($60,000). Debt Ratio = $ 40,000 = 40% $100,000 Debt / Equity Ratio = $ 40,000 = 66 2/3% $60,000

7-13.

Industry averages tend to indicate the degree of debt that is considered to be acceptable for an industry. The industry average does not necessarily indicate the degree of debt that an individual firm should have, but it is the best indication of a reasonable amount outside of the individual firm. Comparing the company’s ratios to the industry averages lets the company know if it is under performing or over performing the industry for example if the industry

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average for the debt ratio is 40% and the company’s debt ratio is 30% then the company is carrying less debt than the other companies in that industry. 7-14.

Operating leases simply require recording rent expense in the income statement accounts. Under a capital lease, the asset and related lease obligations are recorded on the balance sheet of the lessee. The lessee then records depreciation expense and interest expense as would be done if the asset had been acquired with a loan.

7-15.

If a firm has not capitalized its leases, then its debt ratios will be lower than those of a firm that has capitalized leases because the lease will not be included in assets and liabilities on the company’s balance sheet. Also, its times interest earned will be higher because interest expense is not included on the income statement, only rent expense. These two factors overstate the debt position.

7-16.

When capital leases are not capitalized then there will be less interest expense recorded on the income statement which means that the company will have less interest expense to cover thus lowering their times interest earned ratio. Pension claims have the status of tax liens, which gives them senior claim over other creditors.

7-17.

7-18.

When an employee is vested in the pension plan, he/she is eligible to receive some pension benefits at retirement regardless of whether they continue working for the employer. ERISA has had a major impact on reducing the vesting time.

7-19.

Under the Employee Retirement Income Security Act, a contributor to a multiemployer pension plan may be liable, upon withdrawal from or upon termination of such plan, for its share of any unfunded liability.

7-20.

An operating lease for a relatively long term is a type of long-term financing. Therefore, a part of the lease payment, in reality, is a financing charge called interest. When a portion of operating lease payments is included in fixed charges, it is an effort to recognize the true total interest that the firm is paying.

7-21.

The Employee Retirement Income Security Act contains a feature that a company can be liable for its pension plan up to 30% of its net worth. Also, the pension claims have the same status as tax liens, which gives them senior claim over other creditors.

7-22.

Short-term funds in total become part of the total sources of outside funds in the long run. Thus, short-term funds should be included in the debt ratio. Another view is that the debt ratio is intended to relate long-term outside

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sources of funds to total assets, and short-term funds are not a valid part of long-term funds. The approach that includes short-term liabilities is the more conservative. 7-23.

The bond payable account would represent a definite commitment that must be paid at some date in the future. This would be considered to be a firm liability. The reserve for rebuilding furnaces does not represent a firm commitment to pay out funds in the future, and when funds are used for rebuilding furnaces, this will be at the discretion of management. The reserve for rebuilding furnaces could be considered to be a soft liability account.

7-24.

The specific assets that caused the deferred tax will likely be replaced by similar specific assets in the future, and also the firm may expand. The replacement assets are likely to cost more than the original items. This would result in an additional deferred tax. This is the total firm view of deferred taxes, and this view indicates that the deferred tax amount may not result in actual cash outlays in the future. In any specific year, there may be a cash outlay because the firm may not have acquired sufficient assets in that year in relation to the assets being expensed.

7-25.

This tentatively indicates that this firm has higher risk in terms of paying commitments than it did in prior periods and in relation to competitors and the industry.

7-26.

This would indicate an increase in risk as management will more frequently be faced with debt coming due. It also indicates that short-term debt is becoming a more permanent part of the financial structure of the firm.

7-27.

This statement would be correct. . A guarantee of a loan is a type of contingent liability and unless it meets the standards for accruing such a liability it will be disclosed in a note to the financial statements. For readers of financial statements this guarantee will not be obvious from the face of the balance sheet.

7-28.

True. Significant potential liabilities may be described in the contingency note. If a contingency loss meets one, but not both, of the criteria for recording and as a result is not accrued, disclosure by note is made when it is at least reasonably possible that there has been an impairment of assets or that a liability has been incurred.

7-29.

Instead of having a potential additional liability from a pension plan, the plan may be overfunded. This may present an opportunity for the company to cancel the pension plan by paying off the pension obligations and transferring the remaining money in the pension plan to the company.

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7-30.

Most firms must accrue or set a reserve for postretirement benefits other than pensions. Firms can usually spread the catch-up accrual costs over twenty years or take the charge in one lump sum. This choice can impair comparability when comparing financial results of two or more firms.

7-31

Concentration of credit risk (lack of diversification) is perceived as indicative of greater credit risk. Disclosure in this area allows investors, creditors, and other users to make their own assessments of credit risk related to concentration.

7-32.

Off-balance-sheet means that the risk has not been recorded. There is a potential accounting loss from these obligations that is not apparent from the face of the balance sheet.

7-33.

The disclosure of the fair value of financial instruments could possibly indicate significant opportunity or additional risk to the company.

PROBLEMS PROBLEM 7-1 a. Times Interest Earned: Times interest earned relates earnings before interest expense, tax, minority earnings, and equity income to interest expense. The higher this ratio, the better the interest coverage. The times interest earned has improved materially in strengthening the long-term debt position. Considering that the debt ratio and the debt to tangible net worth have remained fairly constant, the probable reason for the improvement is an increase in profits. The times interest earned only indicates the interest coverage. It is limited in that it does not consider other possible fixed charges, and it does not indicate the proportion of the firm’s resources that have come from debt. Debt Ratio: The debt ratio relates the total liabilities to the total assets. The lower this ratio, the lower the proportion of assets that have been financed by creditors.

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For Arodex Company, this ratio has been steady for the past three years. This ratio indicates that about 40% of the total assets have been financed by creditors. For most firms, a 40% debt ratio would be considered to be reasonable. The debt ratio is limited in that it relates liabilities to the book value of total assets. Many assets would have a value greater than book value. This tends to overstate the debt ratio and, therefore, usually results in a conservative ratio. The debt ratio does not consider immediate profitability and, therefore, can be misleading as to the firm’s ability to handle long-term debt. Debt to Tangible Net Worth: The debt to tangible net worth relates total liabilities to shareholders' equity less intangible assets. The lower this ratio, the lower the proportion of tangible assets that has been financed by creditors. Arodex Company has had a stable ratio of approximately 81% for the past three years. This indicates that creditors have financed 81% as much as the shareholders after eliminating intangibles from the shareholders contribution – for most firms, this would be considered to be reasonable. The debt to tangible net worth ratio is more conservative than the debt ratio because of the elimination of intangible items. It is also conservative for the same reason that the debt ratio was conservative, in that book value is used for the assets and many assets have a value greater than book value. The debt to tangible net worth ratio also does not consider immediate profitability and, therefore, can be misleading as to the firm's ability to handle long-term debt. Collective inferences one may draw from the ratios of Arodex Company: Overall it appears that Arodex Company has a reasonable and improving long-term debt position. The debt ratio and the debt to tangible net worth ratios indicate that the proportion of debt appears to be reasonable. The times interest earned appears to be reasonable and improving. The stability of earnings and comparison with industry ratios will be important in reaching a conclusion on the long-term debt position of Arodex Company. b. Ratios are based on past data. The future is what is important, and uncertainties of the future cannot be accurately determined by ratios based upon past data. Ratios provide only one aspect of a firm's long-term debt-paying ability. Other information, such as information about management and products, is also important. A comparison of this firm's ratios with ratios of other firms in the same industry would be helpful in order to decide if the ratios are reasonable.

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PROBLEM 7-2 Times Interest Earned

Debt Ratio

Debt/Equity Ratio

Debt to Tangible Net Worth

b. Purchase of inventory on shortterm loan at 1% over prime rate

c. Declaration and payment of cash dividend

d. Declaration and payment of stock dividend

e. Firm increases profits by cutting cost of sales

g. Sale of common stock

h. Repayment of long-term bank loan

Conversion of bonds to common stock

Sale of inventory at greater than cost

Transaction a. Purchase of buildings financed by mortgage

Appropriation of retained earnings

PROBLEM 7-3

a. Times Interest Earned

Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings, and Noncontrolling Interest Interest Expense, Including Capitalized Interest

Earnings from continuing operations before income taxes and equity earnings Add back interest expense $ 74,780,000 Adjusted earnings (1) $ 37,646,000 (2) $ 112,426,000 Times interest earned: [(2) + (1)] 2.99 times per year 168 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

b. Adjusted earnings (see a, above) Plus equity earnings Interest expense

$ 112,426,000 27,749,000 (1) $ 140,175,000 (2) $ 37,646,000

Times interest earned: (1) / (2) = 3.72 times per year c.

Including equity earnings gives a less conservative times interest earned ratio. The equity income is usually substantially more than the cash dividend received from the related investments. Therefore, the firm cannot depend on this income to cover interest payments.

PROBLEM 7-4

Times Interest Earned

Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings, and Minority Earnings Interest Expense, Including Capitalized Interest

Income before income taxes and extraordinary charges Plus interest (1) Adjusted income (2) Interest expense

$ 36 16 52 $ 16

Times Interest Earned: (1) divided by (2) = 3.25 times per year

Fixed Charge Coverage

Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings, and Minority Earnings + Interest Portion of Rentals Interest Expense, Including Capitalized Interest + Interest Portion of Rentals

Adjusted income from part (a) 1/3 of operating lease payments (1/3 x $150) (1) Adjusted income, including rentals

52 50 $ 102

Interest expense 1/3 of operating lease payments (2) Adjusted interest expense

$ $

16 50 66

Fixed charge coverage: (1) ÷ (2) = 1.55 times per year 169 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

PROBLEM 7-5

a. 1. Times Interest Earned

$162,000 $20,000

2. Debt Ratio =

Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings, and Noncontrolling Interest Interest Expense, Including Capitalized Interest

8.1 times per year Total Liabilities Total Assets

$162,000 = 8.1 times per year $ 20,000 $193,000 $600,000

32.2%

3. Debt/Equity Ratio $193,000 $407,000

Total Liabilities Stockholders’ Equity

47.4%

4. Debt to Tangible Net Worth Ratio $193,000 $407,000 – $20,000

Total Liabilities Tangible Net Worth

49.9%

b. New asset structure for all plans: Assets Current Assets Property, plant and equipment Intangibles Total assets

$ 226,000 554,000 20,000 $ 800,000

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Liabilities and Equity Plan A Current Liabilities Long-term debt Preferred stock Common equity

$ 93,000 100,000 250,000 357,000 $ 800,000

No change in net income

Plan B Current Liabilities Long-term debt Preferred stock Common stock Premium on common stock Retained earnings

$ 93,000 100,000 50,000 120,000 300,000 137,000 $ 800,000

No change in net income

Plan C Current liabilities Long-term debt Preferred stock Common equity

$ 93,000 300,000 50,000 357,000 $ 800,000

Operating income Interest expense Taxes (40%) Net income

$ 162,000 36,000* $ 126,000 50,400 $ 75,600

*$20,000 + 8%($200,000) = $36,000

1. Times Interest Earned

Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings, and Noncontrolling Interest Interest Expense, Including Capitalized Interest

Plan A

Plan B

Plan C

$162,000 = 8.1 times $20,000

$162,000 = 4.5 times $36,000

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2. Debt Ratio

Total Liabilities Total Assets

Plan A

Plan B

$193,000 = 24.1% $800,000

3. Debt/Equity Ratio =

$193,000 = 24.1% $800,000

Plan C $393,000 = 49.1% $800,000

Total Liabilities Stockholders’ Equity

Plan A $193,000 = 31.8% $607,000

4. Debt to Tangible Net Worth

Plan B $193,000 = 31.8% $607,000

Plan C $393,000 = 96.6% 407,000

Total Liabilities Tangible Net Worth

Plan A

Plan B

Plan C

$193,000 = 32.9% $607,000 – $20,000

$393,000 = 101.6% $407,000 – $20,000

Preferred Stock Alternative: Advantages: 1. Lesser drop in earnings per share than under the common stock alternative. 2. Not the absolute reduction in earnings that accompanied the debt alternative. 3. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and Total Debt to Tangible Net Worth Ratio. 4. Does not have the reduced times interest earned that accompanied alternative of issuing long-term debt. Disadvantage: 1. An increase in the fixed preferred dividend charge that the firm must pay before any dividends can be paid to common stockholders.

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Common Stock Alternative: Advantages: 1. No increase in fixed obligations. 2. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and the Total Debt to Tangible Net Worth Ratio. 3. Not the absolute reduction in earnings that accompanied the debt alternative. 4. Does not have the reduced times interest earned that accompanied alternative of issuing long-term debt. Disadvantage: 1. Maximum dilution in earnings per share of the three alternatives.

Long-Term Bonds Alternative: Advantage: 1. Higher earnings per share than with common stock. Disadvantages: 1. Material decline in Times Interest Earned. 2. A material increase in the Debt Ratio, Debt/Equity Ratio, and Total Debt to Tangible Net Worth Ratio. 3. Absolute reduction in earnings. 4. Increase in the interest fixed charge that must be paid. d. The 5% preferred stock increased the preferred dividends which are not tax deductible; therefore, the cost of these funds is the 5% amount. The 8% bond interest is tax deductible and, therefore, the after-tax cost is 4.8% [8% x (1-.40)(1the corporate tax rate)]. Note to Instructor: You may want to take this opportunity to point out to the students that the alternative that should be selected is greatly influenced by the change in earnings and the specific debt structure. The conclusions in this problem would not necessarily be true with changed assumptions.

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PROBLEM 7-6

Total Liabilities Total Assets

Debt Ratio

Debt/Equity Ratio

Ratio of Total Debt to Tangible Net Worth = Total Liabilities Tangible Net Worth

$174,979 $424,201

Total Liabilities Stockholders’ Equity

$174,979 $249,222 – $2,324

41.2%

$174,979 $249,222

$174,979 $246,898

70.2%

70.9%

d. Kaufman Company has financed over 41% of its assets by the use of funds from outside creditors. The Debt/Equity Ratio and the Debt to Tangible Net Worth Ratio are over 70%. Whether these ratios are reasonable depends upon the stability of earnings.

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PROBLEM 7-7

a. 1. Times Interest Earned

$95,000 $10,000

2. Debt Ratio =

Recurring Earnings, Excluding Interest Expense, Tax = Expense, Equity Earnings, and Noncontrolling Interest Interest Expense, Including Capitalized Interest $170,000 $32,000

9.5 times

Total Liabilities $160,000 = Total Assets $356,000

3. Debt Equity =

5.3 times

= 44.9%

$575,000 = 58.4% $985,000

Total Liabilities $160,000 = = 81.6% Shareholders’ Equity $196,000

4. Debt to Tangible Net Worth

$575,000 = 140.2% $410,000

Total Liabilities Shareholders’ Equity – Intangibles

$160,000 $196,000 – $11,000

= 86.5%

$575,000 $410,000 – $20,000

= 147.4%

b. No, Barker Company has a times interest earned of 5.3 times while the industry average is 7.2 times. This indicates that Barker Company has less than average coverage of its interest. Also, Barker Company has a much higher than average debt/equity ratio, and debt to tangible net worth ratio. c. Allen Company has a better times interest earned, debt ratio, debt/equity ratio, and debt to tangible net worth.

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PROBLEM 7-8

Times Interest Earned

Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings, and Minority Earnings Interest Expense, Including Capitalized Interest

Income before income taxes Plus interest Adjusted income Interest expense Times interest earned

Fixed Charge Coverage

$ 675 60 $ 735 $ 60

$735 $60

12.25 times per year

Adjusted income from part (a) 1/3 of operating lease payments (1/3 x $150) Adjusted income, including rentals

$ 735 50 $ 785

Interest expense 1/3 of operating lease payments

Fixed Charge Coverage

$785 $110

60 50 $ 110 =

7.14 times per year

PROBLEM 7-9 a.

The times interest earned ratio indicates a firm’s long-term debt-paying ability from the income statement view.

Preferred stock is owned by stockholders.

The bonds payable liability will be shown on the balance sheet.

The denominator of the debt ratio is total assets. Therefore, none of these assets are subtracted.

The current ratio is considered to be a liquidity ratio.

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The debt/equity ratio represents a balance sheet view of debt.

There is not adequate information to form an opinion on the long-term debt position.

With a times interest earned ratio of .20 to 1, net income is less than the interest expense.

Intangible assets are subtracted in the denominator. Land and bonds payable are not intangible assets.

The ratio fixed charge coverage is an income statement indication of debtpaying ability.

The Employee Retirement Income Security Act calls for a company to be liable for its pension plan up to 30 percent of its net worth.

Capitalized interest should be included with interest expense when computing times interest earned.

Minority shareholders’ interest does not represent a definite commitment to pay out funds in the future.

PROBLEM 7-10

Times Interest Earned

Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings, and Minority Earnings Interest Expense, Including Capitalized Interest

Earnings before interest and tax: Net sales Cost of sales Selling and administration

$21,822 $4,311

Times Interest Earned

Cash basis times interest earned: $21,822 + $40,000 $4,311

$ 1,079,143 (792,755) (264,566) $ 21,822

$61,822 $4,311

5.06 times per year

14.34 times per year

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PROBLEM 7-11

a. 1.

Recurring Earnings, Excluding Interest Expense, Tax Times Interest Earned = Expense, Equity Earnings, and Noncontrolling Interest Interest Expense, Including Capitalized Interest 2011:

$280,000 – $156,000 $17,000

= 7.29 times per year

2010:

$302,000 – $157,000 $16,000

= 9.06 times per year

2009:

$286,000 – $154,000 $15,000

= 8.80 times per year

2008:

$270,000 – $150,000 $14,500

= 8.28 times per year

2007:

$248,000 – $147,000 $23,000

= 4.39 times per year

Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings, and Noncontrolling Interest + Interest Portion of Rentals 2. Fixed Charge Coverage = Interest Expense, Including Capitalized Interest + Interest Portion of Rentals 2011:

$280,000 – $156,000 + $10,000 = 4.96 times per year $17,000 + $10,000

2010:

$302,000 – $157,000 + $9,000 $16,000 + $9,000

= 6.16 times per year

2009:

$286,000 – $154,000 + $9,500 $15,000 + $9,500

= 5.78 times per year

2008:

$270,000 – $150,000 + $10,000 = 5.31 times per year $14,500 + $10,000

2007:

$248,000 – $147,000 + $9,000 $23,000 + $9,000

= 3.44 times per year

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3. Debt Ratio

Total Liabilities Total Assets

2011:

$88,000 + $170,000 $560,000

= 46.07%

2010:

$89,500 + $168,000 $554,000

= 46.48%

2009:

$90,500 + $165,000 $553,800

= 46.14%

2008:

$90,000 + $164,000 $548,500

= 46.31%

2007:

$91,500 + $262,000 $537,000

= 65.83%

4. Debt/Equity Ratio

Total Liabilities Shareholders’ Equity

2011:

$88,000 + $170,000 $302,000

= 85.43%

2010:

$89,500 + $168,000 $296,500

= 86.85%

2009:

$90,500 + $165,000 $298,300

= 85.65%

2008:

$90,000 + $164,000 $294,500

= 86.25%

2007:

$91,500 + $262,000 $183,500

= 192.64%

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5. Debt to Tangible Net Worth

Total Liabilities Shareholders’ Equity – Intangible Assets

2011:

$88,000 + $170,000 $302,000 – $20,000

= 91.49%

2010:

$89,500 + $168,000 $296,500 – $18,000

= 92.46%

2009:

$90,500 + $165,000 $298,300 – $17,000

= 90.83%

2008:

$90,000 + $164,000 $294,500 – $16,000

= 91.20%

2007:

$91,500 + $262,000 $183,500 – $15,000

= 209.79%

b. Both the times interest earned and the fixed charge coverage are good. The times interest earned is substantially better than the fixed charge coverage because of the operating leases. Both of these ratios materially declined in 2011. The debt ratio, debt/equity ratio, and debt to tangible net worth materially improved between 2007 and 2008 when long-term debt was reduced and funding shifted to equity. During the period 2008 – 2011, these ratios were relatively steady and appeared to be good. The debt to tangible net worth ratio is not as good as the debt/equity ratio because of the influence of intangibles.

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CASES CASE 7-1 OUTSOURCED SERVICES (This case provides an opportunity to review capitalized interest.) a. Income statement interest expense Capitalized interest Total interest

2010 $ 40,707,000 4,100,000 $ 44,807,000

2009 $ 28,518,000 4,900,000 $ 33,418,000

b. Interest expense on income statement

2010 $ 40,707,000

2009 $ 28,518,000

2008 $ 30,202,000

c. Interest added to the cost of property, plant, and equipment

2010

2009

$4,100,000

$ 4,900,000

d. It is capitalized on fixed assets and becomes part of the depreciation expense when the fixed asset is depreciated. e. Since the interest is capitalized, the interest does not appear on the income statement until the asset is depreciated. Recurring Earnings, Excluding Interest Expense, Tax f. Times Interest Earned = Expense, Equity Earnings, and Noncontrolling Interest Interest Expense, Including Capitalized Interest

2010 $98,104,000 + $40,707,000 $44,807,000

2009 $105,031,000 + $28,518,000 $33,418,000

3.10 times

4.00 times

Material decrease and may be relatively low.

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CASE 7-2 GLOBAL PROVIDER (This case provides the opportunity to review capital and operating leases.) a. 1. $777,739,000 2. $484,641,000 3. $3,612,000 4. $1,600,000 5. $1,600,000 / $484,641,000 = 0.33% Capital leases are immaterial in relation to total property and equipment. b. Capital lease obligations Debt

(A) $ 1,379,000 (B) $ 1,524,753,000

(A) ÷ (B)

0.09%

Capital lease obligations are immaterial in relation to debt. c.

1. $359,382,000 2. 2/3 X $359,382,000 = $239,600,000 3. Operating leases Capital (A) ÷ (B)

(B) $ 239,600,000 (A) $ 1,379,000 0.58%

Operating leases are very material in relation to capital leases.

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CASE 7-3 SAVING PEOPLE MONEY (This case provides an opportunity to review an amortization vs. payments on leases) a. The lease is a type of intangible. It is described as amortization if it is a periodic reduction of the cost of an intangible asset. b. Assets Property under capital lease: Property under capital lease Less accumulated amortization Liabilities Current liabilities: Obligations under capital leases due within one year Long-term liabilities: Long-term obligations under capital leases Total related to capital leases

(In millions) 2011 2010 $ 5,905 (3,125) $ 2,780

$ 5,669 (2,906) $ 2,763

336

3,150 $ 3,486

346

3,170 $ 3,516

The asset is being amortized while the liability goes down based upon payments.

CASE 7-4 LOCKOUT (This case provides an opportunity to review an interesting commitments and contingencies note of the Boston Celtics.) The note must be subjectively incorporated into the analysis. This is part of the art of analysis. To quote from the note: “Although the ultimate outcome of this matter cannot be determined at this time, any loss of games as a result of the absence of a collective bargaining agreement or the continuation of the lockout will have material advance effect on the Partnership’s financial condition and its results of operations.” In the long run, the lockout may be positive as aggregate salaries may be reduced.

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CASE 7-5 SAFE-MANY EMPLOYERS (This case provides an opportunity to review a multi-employer pension plan.) a. Contributions (a)

2010 $292,300,000

2009 $278,100,000

2008 $286,900,000

A slight decrease between 2008 and 2009 followed by a moderate increase in 2010. b.

“These multi-employer retirement plans are generally defined benefit plans and are pursuant to agreements between the Company and various unions. In many cases, specific benefit levels are not negotiated with contributing employers or in some cases even known by the contributing employers.”

They have agreed with the unions to participate in various multi-employer retirement plans. They have no control over the payments.

CASE 7-6 SAFE-OTHER THAN PENSIONS (This case provides an opportunity to review a defined benefit plans and other post retirement benefits) a. 1. Pension 2010 Projected benefit obligation $2,257.2

Other post retirement benefit

(In millions) 2009 2010 $2,095.5 $ 132.8

2009 $ 121.7

2. Pension

Fair value of plan assets

2010 $1,652.2

Other post retirement benefit

(In millions) 2009 2010 $1,572.1 $ 0

2009 $

3. Pension

Funded status

2010 $ (605.0)

Other post retirement benefit

(In millions) 2009 2010 $ (523.4) $ (132.8)

2009 $(121.7)

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4. The post retirement benefits are not funded. 5. Yes. “Information for Safeway’s pension plans, all of which have an accumulated benefit obligation in excess of plan assets.” 6. Other post retirement benefit

Pension 2010 Projected benefit obligation (A) $2,257.2 (A) ÷ (B)

(In millions) 2009 2010 (B) $2,095.5

7.72%

2009

(A) $ 132.8

(B) $ 121.7

9.12%

Both the pension and other post retirement benefits had substantial increases in projected benefit obligation in 2010.

Pension

Funded status

2010 (A) $ (605.0)

(A) ÷ (B)

Other post retirement benefit

(In millions) 2009 2010 (B) $ (523.4) (A) $(132.8)

15.6%

2009 (B) $ (121.7)

9.12%

The pension plan had a material increase in funded status, while the other post retirement benefits had a substantial increase in funded status.

CASE 7-7 SPECIALTY COFFEE (This case provides an opportunity to review a defined contribution plan.) a. This is a defined contribution plan where employees elect to participate. b. The company needs to contribute a matching contribution. There would be no additional liability. c.

The employee determine the fluctuations by electing or not electing to participate.

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d. Company contributions (A) Net revenues (B)

2010 2009 2008 $23,500,000 $19,700,000 $25,300,000 $10,707,400,000 $9,774,600,000 $10,383,000,000

(A) ÷ (B)

0.22%

0.20%

0.24%

The company contributions are immaterial in relation to net revenues.

CASE 7-8 TRANSACTION PRINTERS (This case provides an opportunity to review a defined contribution plan.) a. Defined contribution plan 401(K) plan, but in general a defined contribution plan. b. Matching contributions (A) Net income (B) (A) ÷ (B)

2010 $223,000 $3,904,000 5.71%

2009 $237,000 $2,140,000 11.07%

2008 $244,000 $1,444,000 16.9%

Material in 2009 and 2008, declining materially in 2010 as income increased.

Matching contributions (A) Net sales (B) (A) ÷ (B)

2010 $223,000 $63,194,000 0.35%

2009 $237,000 $58,346,000 0.41%

2008 $244,000 $62,207,000 0.39%

Matching contributions appear reasonable in relation to net sales. c.

Reasonable control of pension expenses. “We match employees’ contributions at a rate of 50% of employees’ contributions up to the first 6% of the employees’ compensation contributed to the 401(K) plan.”

CASE 7-9 SIMULATION SOLUTIONS (This case provides an opportunity to review the credit risk concentration.) a. $50 million loss as of January 1, 2011 b. There were no collateral balance requirements at January 1, 2011

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Management believes a concentration of credit risk with respect to derivative counterparties is limited due to credit ratings of the counterparties and the use of master netting and reciprocal collateralization agreements.

d. Management believes concentrations of credit risk with respect to accounts receivable is limited due to the generally high quality of the Company’s major customers. CASE 7-10 SPECIALTY RETAILER – DEBT VIEW (This case provides an opportunity to view the debt position of three specialty retail stores.) a. Disclosure not adequate to compute for Abercrombie & Fitch, nor for GAP. A material improvement for Limited Brands and the coverage appears to be good for Limited Brands. b. Disclosure not adequate to compute for Abercrombie & Fitch, nor for GAP. A material improvement for Limited Brands and the coverage appears to be good for Limited Brands. c. Times interest earned only relates to interest coverage. Fixed charge coverage included interest portion of rentals. d. The debt ratio relates liabilities to total assets, a much wider base than the debt/equity, which only relates liabilities to equity. e. Considering the debt ratio, Abercrombie & Fitch is in the best position followed by the GAP and then Limited Brands. f. The debt to tangible net worth has intangible assets subtracted from shareholders’ equity.

CASE 7-11 EAT AT MY RESTAURANT – DEBT VIEW (This case provides an opportunity to view the debt position of several restaurant companies.) a. Yum Brands, Inc. presented “interest expense, net,” therefore the disclosure is not adequate to compute times interest earned. Both Panera Bread and Starbucks had a material increase in times interest earned in 2010. Panera Bread had a materially better times interest earned than Starbucks. They both appear to have a very good coverage. 187 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

b. Yum Brands, Inc. presented “interest expense, net” therefore, the disclosure is not adequate to compute the fixed charge coverage. Fixed charge coverage increased materially for both Panera Bread and Starbucks. It was materially higher for Panera Bread. c. Times interest earned only relates to interest coverage. Fixed charge coverage relates to interest and interest portion of rentals. d. The debt ratio relates liabilities to total assets, a much wider base than the debt/equity, which only relates liabilities to equity. e. The debt ratio is materially better for Panera Bread than for either Yum Brands, Inc. or Starbucks. This was especially true when compared with Yum Brands. The debt ratio appears to be high for Yum Brands. f. The debt to tangible net worth has intangible assets subtracted from shareholders’ equity.

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Chapter 8 Profitability

QUESTIONS 8- 1. Profits can be compared to the sales from which they are the residual. They can be compared to the assets that generate sales. Or, they can be viewed as return to the owner. Each measure looks at profits differently. The trends might move in different directions, depending on the base. 8- 2. Extraordinary items are by nature nonrecurring. They should be segregated in order to concentrate on profit that will be expected in the next period. Recurring earnings should be used in trend analysis of profitability. 8- 3. Expenses as a percent of sales must have increased if profits as a percent of sales declined. 8- 4. Profit margin in jewelry is usually much higher than in groceries. Groceries generate total profits based on volume of sales rather than high markup. 8- 5. A drop in profits or a rise in the asset base could cause a decline in the ratio. For example, higher cost of sales could cause a decline; or, a substantial investment in fixed assets that are not yet fully utilized could cause a decline. 8- 6. DuPont analysis relates return on assets to turnover and margin. It allows for further analysis of return on assets by this breakdown. 8- 7. Operating income is sales minus cost of sales and operating expenses. It does not include nonoperating items, such as other income, interest, and taxes. Operating assets are basically current assets plus plant, property, and equipment. They do not include investments, intangibles, and other assets. Removing non-operating items from the DuPont analysis gives a clearer picture of productive operations and the efficient use of the company’s assets. 8- 8. Equity earnings are the owner’s proportionate share of the nonconsolidated subsidiary earnings. These earnings are usually greater than the cash from dividends from the nonconsolidated subsidiary. 8- 9. Return on assets is a function of net profit margin and total asset turnover. Return on assets could decline, given an increase in net profit margin, if the total asset turnover declined sufficiently.

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8-10. Return on investment measures return to all long-term supplies of funds. It includes net income plus tax-adjusted interest in the numerator and all long-term funds in the denominator. Return on total equity is just return to shareholders. Return on common equity is return only to common shareholders. Net income is reduced by preferred dividends in the numerator, and only common equity is in the denominator. 8-11. Return on investment is a profitability measure comparing income to capital utilized by the firm. Some measures are return on assts, return on equity, or income available to all capital sources, divided by capital. The given ratio is preferred, since it measures the profit available to all long-term sources of capital against that capital. The interest is multiplied by the tax adjustment factor to put interest on an after-tax basis. 8-12. This cannot be determined based only upon the absolute measures. It is necessary to compare these dollar figures to a base, such as investment or sales. Also, it is necessary to know if nonrecurring items are part of the firm’s income picture. 8-13. Interim reports are less reliable because they are not audited, but they can be very meaningful in indicating trends before the end of the year. 8-14. An objective considered here is timeliness rather than completeness. Full statements would take too long and involve too much cost to produce. 8-15. Comprehensive income includes net changes in (a) foreign currency translation adjustments, (b) unrealized holding gains and losses on available-for-sale marketable securities, and (c) changes to stockholders’ equity resulting from additional minimum pension liability adjustment. These items will tend to fluctuate more than other income items. 8-16. Pro forma financial information is hypothetical or a projected amount. For pro forma formation to be meaningful the company must use a reliable estimate to project future sales, expenses, etc. Used improperly pro forma financial information can be a negative contribution to financial reporting.

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PROBLEMS PROBLEM 8 - 1 a. 1. Balance in account Adjustment needed Adjusting to

$400,000 200,000 $600,000

Adjusting to $600,000 will result in $200,000 in expense for the current year. 2. Balance in account Adjustment needed Adjusting to

$400,000 500,000 $900,000

Adjusting to $900,000 will result in $500,000 in expense for the current year. b. No. Payments will result from meeting obligations. The warranty obligation account could be too high or too low. c. The account should not be manipulated. It would not be ethical to provide too much or too little on the account with the objective of manipulating profits.

PROBLEM 8-2

Net Profit Margin

Return on Assets

Net Income Before Minority Share of Earnings and Nonrecurring Items Net Sales 2011 $52,500 $1,050,000

2010 $40,000 $1,000,000

= 5.00%

= 4.00%

Net Income Before Minority Share of Earnings and Nonrecurring Items Average Total Assets 2011 $52,500 $230,000

2010 $40,000 $200,000

= 22.83%

= 20.00%

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Total Asset Turnover

Return on Common Equity

Net Sales Average Total Assets 2011 $1,050,000 $230,000

2010 $1,000,000 $200,000

=4.57 times per year

=5.00 times per year

Net Income Before Nonrecurring Items – Preferred Dividends Average Common Equity

2011 $52,500 $170,000

2010 $40,000 $160,000

= 30.88% = 25.00% Ahl Enterprise has had a substantial rise in profit to sales. This is somewhat tempered by a reduction in asset turnover. Given a slight rise in common equity, there is a substantial rise in return on common equity.

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PROBLEM 8 - 3 a.

Interest expense represents a recurring item.

Ideally, return on common equity will indicate the highest return. This is the way it should be since the common equity holders take the most risk.

A selling price increase would increase the gross profit.

It would not be feasible to estimate administrative expenses by using gross profit analysis.

Total asset turnover measures the ability of the firm to generate sales through the use of assets.

Equity earnings can represent a problem in analyzing profitability because equity earnings are not from operations.

Intangibles are not considered to be an operating asset.

Earnings based on percent of holdings by outside owners of consolidated subsidiaries are termed minority earnings.

Net profit margin x total asset turnover measures DuPont return on assets.

If net profit margin declines and the total asset turnover declines, then the return on assets cannot rise.

A reason that equity earnings create a problem in analyzing profitability is because equity earnings are usually less than the related cash flow.

Usually the return on common equity will have the highest percent of the ratios listed.

Usually the return on total assets will have the lowest percent of the ratios listed.

Gain from selling land will be reported on the income statement.

None of the above describes minority share of earnings.

Purchase of land at year-end could cause return on assets to decline when the net profit margin is increasing. The year-end purchase of land would not have contributed to profits.

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PROBLEM 8-4 a. 2011 100.0% 60.7 39.3 14.6 10.0 14.7 5.9 8.8%

Sales Cost of goods sold Gross profit Selling expense General expense Operating income Income tax Net income

2010 100.0% 60.8 39.2 20.0 8.3 10.9 4.2 6.7%

Starr Canning has had a sharp decrease in selling expense coupled with only a modest rise in general expenses giving an overall rise in the net profit margin.

PROBLEM 8-5

a. 1. Net Profit Margin

Net Income Before Noncontrolling Interest, Equity Income and Nonrecurring Items Net Sales

2011:

$72,700 $980,000

= 7.42%

2010:

$64,900 $960,000

= 6.76%

2009:

$57,800 $940,000

= 6.15%

2008:

$51,200 $900,000

= 5.69%

2007:

$44,900 $880,000

= 5.10%

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2. Total Asset Turnover

Net Sales Average Total Assets

2011:

$980,000 ($859,000 + $861,000)/2

= 1.14 times per year

2010:

$960,000 ($861,000 + $870,000)/2

= 1.11 times per year

2009:

$940,000 ($870,000 + $867,000)/2

= 1.08 times per year

2008:

$900,000 ($867,000 + $863,000)/2

= 1.04 times per year

2007:

Cannot compute average assets.

Year-End Balance Sheet Figures – Total Asset Turnover 2011:

$980,000 $859,000

= 1.14 times per year

2010:

$960,000 $861,000

= 1.11 times per year

2009:

$940,000 $870,000

= 1.08 times per year

2008:

$900,000 $867,000

= 1.04 times per year

2007:

$880,000 $863,000

= 1.02 times per year

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3. Return on Assets

Net Income Before Noncontrolling and Nonrecurring Items Average Total Assets

Average Balance Sheet Figures 2011:

$72,700 ($859,000 + $861,000)/2

= 8.45%

2010:

$64,900 ($861,000 + $870,000)/2

= 7.50%

2009:

$57,800 ($870,000 + $867,000)/2

= 6.66%

2008:

$51,200 ($867,000 + $863,000)/2

= 5.92%

2007:

Cannot compute average assets.

Year-End Balance Sheet Figures – Return on Assets 2011:

$72,700 $859,000

= 8.46%

2010:

$64,900 $861,000

= 7.54%

2009:

$57,800 $870,000

= 6.64%

2008:

$51,200 $867,000

= 5.91%

2007:

$44,900 $863,000

= 5.20%

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4. DuPont Return on Assets

Net Profit Margin x Total Asset Turnover

Average Balance Sheet Figures

2011: 2010: 2009 2008: 2007:

Net Profit Margin Total Asset Turnover 7.42% X 1.14 times 6.76% X 1.11 times 6.15% X 1.08 times 5.69% X 1.04 times Cannot compute average assets

= = = =

8.46% 7.50% 6.64% 5.92%

= = = = =

8.46% 7.50% 6.64% 5.92% 5.20%

Year-End Balance Sheet Figures

2011: 2010: 2009 2008: 2007:

Net Profit Margin 7.42% 6.76% 6.15% 5.69% 5.10%

5. Operating Income Margin

Total Asset Turnover 1.14 times 1.11 times 1.08 times 1.04 times 1.02 times

X X X X X =

Operating Income Net Sales

2011:

$355,000 – $240,000 $980,000

= 11.73%

2010:

$344,000 – $239,000 $960,000

= 10.94%

2009:

$333,000 – $238,000 $940,000

= 10.11%

2008:

$320,000 – $239,000 $900,000

= 9.00%

2007:

$314,000 – $235,000 $880,000

= 8.98%

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6. Operating Asset Turnover

Net Sales Average Operating Assets

2011:

$980,000 ($859,000 – $80,000 – $861,000 – $85,000)/2

= 1.26 times per year

2010:

$960,000 ($861,000 – $85,000 – $870,000 – $90,000)/2

= 1.23 times per year

2009:

$940,000 ($870,000 – $90,000 – $867,000 – $95,000)/2

= 1.21 times per year

2008:

$900,000 = 1.17 times per year ($867,000 – $95,000 – $863,000 – $100,000)/2

2007: Average assets cannot be computed. Year-End Balance Sheet Figures – Operating Asset Turnover 2011:

$980,000 $859,000 – $80,000

= 1.26 times per year

2010:

$960,000 $861,000 – $85,000

= 1.24 times per year

2009:

$940,000 $870,000 – $90,000

= 1.21 times per year

2008:

$900,000 $867,000 – $95,000

= 1.17 times per year

2007:

$880,000 $863,000 – $100,000

= 1.15 times per year

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7. Return on Operating Assets

Operating Income Average Operating Assets

2011:

$355,000 – $240,000 ($859,000 – $80,000 – $861,000 – $85,000)/2

= 14.79%

2010:

$344,000 – $239,000 ($861,000 – $85,000 – $870,000 – $90,000)/2

= 13.50%

2009:

$333,000 – $238,000 ($870,000 – $90,000 – $867,000 – $95,000)/2

= 12.24%

2008:

$320,000 – $239,000 = 10.55% ($867,000 – $95,000 – $863,000 – $100,000)/2

2007: Average assets cannot be computed. Year-End Balance Sheet Figures – Return on Operating Assts 2011:

$355,000 – $240,000 $859,000 – $80,000

= 14.76%

2010:

$344,000 – $239,000 $861,000 – $85,000

= 13.53%

2009:

$333,000 – $238,000 $870,000 – $90,000

= 12.81%

2008:

$320,000 – $239,000 $867,000 – $95,000

= 10.49%

2007:

$314,000 – $235,000 $863,000 – $100,000

= 10.35%

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8. DuPont Return on Operating Assets

Operating Income Margin x Operating Asset Turnover

Average Balance Sheet Figures

2011: 2010: 2009 2008: 2007:

Operating Operating Income Margin Asset Turnover 11.73% X 1.26 10.94% X 1.23 10.11% X 1.21 9.00% X 1.17 Average assets cannot be computed

= = = =

Return on Operating Assets 14.78% 13.46% 12.23% 10.53%

= = = = =

Return on Operating Assets 14.78% 13.46% 12.23% 10.53% 10.33%

Year-End Balance Sheet Figures

2011: 2010: 2009 2008: 2007:

Operating Income Margin 11.73% 10.94% 10.11% 9.00% 8.98%

9. Sales to Fixed Assets

X X X X X

Operating Asset Turnover 1.26 1.23 1.21 1.17 1.15

Net Sales Average Net Fixed Assets

2011:

$980,000 ($500,000 + $491,000)/2

= 1.98

2010:

$960,000 ($491,000 + $485,000)/2

= 1.97

2009:

$940,000 ($485,000 + $479,000)/2

= 1.95

2008:

$900,000 ($479,000 + $470,000)/2

= 1.90

2007: Average net fixed assets cannot be computed.

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Year-End Balance Sheet Figures – Sales to Fixed Assets 2011:

$980,000 $500,000

= 1.96

2010:

$960,000 $491,000

= 1.96

2009:

$940,000 $485,000

= 1.94

2008:

$900,000 $479,000

= 1.88

2007:

$880,000 $470,000

= 1.87

Net Income Before Noncontrolling Interest and 10. Return on Investment = Nonrecurring Items + [Interest Expense x (1 – Tax Rate)] Average (Long-Term Liabilities + Equity) Average Balance Sheet Figures 2011:

$72,700 + $6,500(1 – 0.33) ($859,000 – $194,000 + $861,000 – $195,500)/2

= 11.58%

2010:

$64,900 + $6,700(1 – 0.34) ($861,000 – $195,500 + $870,000 – $195,500)/2

= 10.35%

2009:

$57,800 + $8,000(1 – 0.34) ($870,000 – $195,500 + $867,000 – $195,000)/2

= 9.37%

2008:

$51,200 + $8,100(1 – 0.30) ($867,000 – $195,000 + $863,000 – $196,500)/2

= 8.50%

2007: Average long-term liabilities + equity cannot be computed.

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Year-End Balance Sheet Figures – Return on Investment

2011:

$72,700 + $6,500(1 – 0.33) $859,000 – $194,000

= 11.59%

2010:

$64,900 + $6,700(1 – 0.34) $861,000 – $195,500

= 10.42%

2009:

$57,800 + $8,000(1 – 0.34) $870,000 – $195,500

= 9.35%

2008:

$51,200 + $8,100(1 – 0.30) $867,000 – $195,000

= 8.46%

2007:

$44,900 + $11,000(1 – 0.34) $863,000 – $196,500

= 7.83%

11. Return on Total Equity

Net Income Before Nonrecurring Items – Dividends on Redeemable Preferred Stock Average Total Equity

Average Balance Sheet Figures 2011:

$72,700 – $6,400 ($520,000 + $518,000)/2

= 12.77%

2010:

$64,900 – $6,400 ($518,000 + $515,000)/2

= 11.33%

2009:

$57,800 – $6,400 ($515,000 + $510,000)/2

= 10.03%

2008:

$51,200 – $6,400 ($510,000 + $559,000)/2

= 8.38%

2007: Average total equity cannot be computed.

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Year-End Balance Sheet Figures – Return on Total Equity 2011:

$72,700 – $6,400 $520,000

= 12.75%

2010:

$64,900 – $6,400 $518,000

= 11.29%

2009:

$57,800 – $6,400 $515,000

= 9.98%

2008:

$51,200 – $6,400 $510,000

= 8.78%

2007:

$44,900 $559,000

= 8.03%

12. Return on Common Equity

Net Income Before Nonrecurring Items – Preferred Dividends Average Common Equity

Average Balance Sheet Figures 2011:

$72,700 – $6,400 – $6,300 ($520,000 – $70,000 + $518,000 – $70,200)/2

= 13.36%

2010:

$64,900 – $6,400 – $6,300 ($518,000 – $70,000 + $515,000 – $70,000)/2

= 11.69%

2009:

$57,800 – $ 6,400 – $6,300 ($515,000 – $70,000 + $510,000 – $70,000)/2

= 10.19%

2008:

$51,200 – $6,400 – $6,300 ($510,000 – $70,000 + $559,000 – $120,000)/2

= 8.76%

2007: Average common equity cannot be computed.

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Year-End Balance Sheet Figures – Return on Common Equity 2011:

$72,700 – $6,400 – $6,300 $520,000 – $70,000

= 13.33%

2010:

$64,900 – $6,400 – $6,300 $518,000 – $70,000

= 11.65%

2009:

$57,800 – $ 6,400 – $6,300 $515,000 – $70,000

= 10.13%

2008:

$51,200 – $6,400 – $6,300 $510,000 – $70,000

= 8.75%

2007:

$44,900 – $10,800 $559,000 – $120,000

13. Gross Profit Margin

= 7.77%

Gross Profit Net Sales

2011:

$355,000 $980,000

= 36.22%

2010:

$344,000 $960,000

= 35.83%

2009:

$333,000 $940,000

= 35.43%

2008:

$320,000 $900,000

= 35.56%

2007:

$314,000 $880,000

= 35.68%

In general, the profitability appears to be very good and the trend is positive. There was not a significant difference in results between using average balance sheet figures and year-end figures. The year-end figure allowed for an additional year was not a very profitable year in relation to subsequent years.

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PROBLEM 8-6 Earnings before interest and tax Interest (750,000 x 6%) Earnings before tax Tax Net income Preferred dividends Income available to common

$ 245,000 45,000 $ 200,000 80,000 $ 120,000 15,000 $ 105,000

Net Income Before Minority Share of Earnings Equity Income and a. Return on Assets = Nonrecurring Items = $120,000 = 4.00% Average Total Assets $3,000,000

b. Return on Total Equity

Net Income Before Nonrecurring Items – Dividends on = Redeemable Preferred Stock = $120,000 = 6.67% Average Total Equity $1,800,000

c. Return on Common Equity

Net Income Before Nonrecurring Items – Preferred Dividends Average Common Equity $120,000 – $15,000 = 7.00% $1,500,000

Recurring Earnings, Excluding Interest Expense, Tax Expense Equity d. Times Interest Earned = Earnings, and Noncontrolling Interest = $245,000 = 5.44 times Interest Expense, Including $45,000 per year Capitalized Interest

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PROBLEM 8-7

Net Profit

Retained Earnings

Total Stockholders’ Equity

a. A stock dividend is declared and paid.

b. Merchandise is purchased on credit.

c. Marketable securities are sold above cost.

d. Accounts receivable are collected.

e. A cash dividend is declared and paid.

f. Treasury stock is purchased and recorded at cost.

g. Treasury stock is sold above cost.

h. Common stock is sold.

i. A fixed asset is sold for less than book value.

j. Bonds are converted into common stock.

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PROBLEM 8-8

Sales Sales returns Cost of goods sold Selling expense General expense Other income Other expense Income tax Net income

Vent Molded Plastics 101.0% 1.0 72.1 9.4 7.0 0.4 1.5 4.8 5.5%

Plastics Industry 100.3% 0.3 67.1 10.1 7.9 0.4 1.3 5.5 8.5%

Sales returns are higher than the industry. Cost of sales is much higher, offset some by lower operating expenses. Other expense (perhaps interest) is somewhat higher. Lower taxes are perhaps caused by lower income. Overall profit is less, primarily due to cost of sales. PROBLEM 8-9 a. Sales Gross profit (40%) Cost of goods sold (60%)

$ 120,000 48,000 $ 72,000

Beginning inventory + Purchases Total available – Ending inventory Cost of goods sold

$ 10,000 100,000 $ 110,000 ? $ 72,000

Ending inventory ($110,000 – $72,000)

$ 38,000

b. If gross profit were 50%, the analysis would be as follows: Sales Gross profit (50%) Cost of goods sold (50%)

$ 120,000 60,000 $ 60,000

Beginning inventory + Purchases Total available – Ending inventory Cost of goods sold

$ 10,000 100,000 $ 110,000 50,000 $ 60,000 207

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Ending inventory ($110,000 – $60,000) $50,000 If gross profit were higher, the loss would be higher because ending inventory would be estimated at $50,000 instead of $38,000. PROBLEM 8-10 a.

$1,589,150 $1,294,966

122.72%

2011 sales were 122.72% of those in 2010. b.

$138,204 $137,110

100.80%

2011 net earnings were 100.80% of those in 2010.

c. 1. Net Profit Margin

Net Income Before Minority Share of Earnings, Equity Income and Nonrecurring Items Net Sales

2011 $149,260 $1,589,150

2010 =

$149,760 $1,294,966

9.39%

2. Return on Assets

11.56%

Net Income Before Minority Share of Earnings and Nonrecurring Items Average Total Assets

2011 $149,260 $1,437,636*

2010 =

10.38%

$149,760 $1,182,110*

12.67%

*Used year end because average could not be computed for 2010. 3. Total Asset Turnover

Net Sales Average Total Assets

2011 $1,589,150 $1,437,636*

2010 =

$1,294,966 $1,182,110*

1.11 times

1.10 times

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4. DuPont Analysis: Return on Assets

2011 2010

10.42* 10.72*

Net Profit Margin

Total Asset Turnover

= =

9.39% 11.56%

x x

1.11 1.10

*Rounding causes the difference from the 10.38% and 12.67% computed in (2). 5. Operating income Net sales Less: Cost of product sold Research and development expenses General and selling Operating income Operating Income Margin

6. Return on Operating Assets

2011

2010

$ 1,589,150 $ 651,390 135,314 526,680 $ 275,766

$ 1,294,966 $ 466,250 113,100 446,110 $ 269,506

Operating Income Net Sales 2011

2010

$275,766 $1,589,150

$269,506 $1,294,966

= 17.35%

= 20.81%

Operating Income Average Operating Assets 2011

2010

$275,766 $1,411,686*

$269,506 $1,159,666*

= 19.53%

= 23.24%

*Used year end because average could not be computed for 2010.

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7. Operating Asset Turnover

Net Sales Average Operating Assets

2011

2010

$1,589,150 $1,411,686*

$1,294,966 $1,159,666*

= 1.13 times per year

= 1.12 times per year

*Used year end because average could not be computed for 2010.

Return on 8. DuPont Analysis: Operating Assets

2011: 2010:

19.61%* 23.31%*

Operating Income Margin

Operating Asset Turnover

= =

17.35% 20.81

x x

1.13 1.12

*Rounding causes the difference from the 19.53% and 23.24% computed in (6).

Net Income Before Minority Share of Earnings and 9. Return on Investment = Nonrecurring Items + [(Interest Expense) x (1 – Tax Rate)] Average (Long-Term Liabilities) + Equity

Net earnings before minority share Interest expense Earnings before tax Provision for income tax Tax rate 1 – tax rate Interest expense x (1 – tax rate) Net earnings before minority share + interest expense x 1(1 – tax rate)] Long-term debt and equity Return on investment

2011 $ 149,260 18,768 263,762 114,502 43.4% 56.6% 10,623

2010 $ 149,760 11,522 271,500 121,740 44.8% 55.2% 6,360

159,883 1,019,420 15.7%

156,120 933,232 16.7%

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10. Return on Common Equity

Net Income Before Nonrecurring Items – Preferred Dividends Ending Common Equity 2011 $138,204 $810,292

2010 $137,110 $720,530

= 17.06%

= 19.03%

d. Profits in relation to sales, assets, and equity have all declined. Turnover has remained stable. Overall, although absolute profits have increased in 2011, compared with 2010, the profitability ratios show a decline.

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PROBLEM 8-11

Net Income Before Noncontrolling Interest and Nonrecurring Items End of Year Total Assets

2011

2010

2009

$ 2,100,000 $ 2,600,000 7,000,000 100,000 10,000,000 $19,700,000

$ 1,950,000 $ 2,300,000 6,200,000 100,000 9,000,000 $17,600,000

$ 1,700,000 $ 2,200,000 5,800,000 100,000 8,300,000 $16,400,000

10.66%

11.08%

10.37%

a. 1. Return on Assets

(A)

(B) (A) ÷ (B)

Net Income Before Noncontrolling Interest and 2. Return on Investment = Nonrecurring Items + [(Interest Expense) x (1 – Tax Rate)] End of Year (Long-Term Liabilities + Equity) Estimated tax rate: 2011

2010

2009

$ 1,500,000 3,600,000

$ 1,450,000 3,400,000

$ 1,050,000 2,750,000

Tax rate = (1) ÷ (2)

41.67%

42.65%

38.18%

1 – tax rate

58.33%

57.35%

61.82%

(1) Provision for income taxes (2) Income before tax

(3) Interest expense x (1 – tax rate) $800,000 x 58.33% $600,000 x 57.35% $550,000 x 61.82%

(4) Net income

$ 2,100,000

$ 1,950,000

$ 1,700,000

(3) + (4)

(A)

$ 2,566,640

$ 2,294,100

$ 2,040,010

Long-term debt Preferred stock Common equity (B)

$ 7,000,000 100,000 10,000,000 $ 17,100,000

$ 6,200,000 100,000 9,000,000 $ 15,300,000

$ 5,800,000 100,000 8,300,000 $ 14,200,000

15.01%

14.99%

14.37%

466,640 $

344,100 $

(A) ÷ (B)

340,010

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3. Return on Total Equity

Net Income Before Nonrecurring Items – Dividends on Redeemable Preferred Stock Ending Total Equity

2011

2010

2009

$2,100,000 $100,000 + $10,000,000

$1,950,000 $100,000 + $9,000,000

$1,700,000 $100,000 + $8,300,000

= 20.79%

= 21.43%

= 20.24%

4. Return on Common Equity

Net Income Before Nonrecurring Items – Preferred Dividends Ending Common Equity

2011

2010

2009

$2,100,000 – $14,000 $10,000,000

$1,950,000 – $14,000 $9,000,000

$1,700,000 – $14,000 $8,300,000

= 20.86%

= 21.51%

= 20.31%

b. Return on assets improved in 2010 and then declined in 2011. Return on investment improved each year. Return on total equity improved and then declined. Return on common equity improved and then declined. In general, profitability has improved in 2010 over 2009 but was down slightly in 2011. c. The use of long-term debt and preferred stock both benefited profitability. Return on common equity is slightly more than return on total equity, indicating a benefit from preferred stock. Return on total equity is substantially higher than return on investment, indicating a benefit from long-term debt.

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PROBLEM 8-12

a. 1. Net Profit Margin

Net Income Before Noncontrolling Interest, Equity Income and Nonrecurring Items Net Sales

2011

2010

2009

$97,051 $1,600,000

$51,419 $1,300,000

$45,101 $1,200,000

= 6.07%

= 3.96%

= 3.76%

2. Return on Assets

Net Income Before Noncontrolling Interest and Nonrecurring Items Average Total Assets

2011

2010

2009

$97,051 $1,440,600

$51,419 $1,220,000

$45,101 $1,180,000

= 6.74%

= 4.21%

= 3.82%

3. Total Asset Turnover

Net Sales Average Total Assets

2011

2010

2009

$1,600,000 $1,440,600

$1,300,000 $1,220,000

$1,200,000 $1,180,000

= 1.11 times per year

= 1.07 times per year

= 1.02 times per year

4. DuPont Analysis Return on Assets 2011: 6.74% 2010: 4.24%* 2009: 3.84%*

= = = =

Net Profit Margin 6.07% 3.96% 3.76%

x x x x

Total Asset Turnover 1.11 times 1.07 times 1.02 times

*Rounding difference from the 4.21% and 3.82% computed in (2).

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5. Operating Income Margin

Operating Income Net Sales

(2) Net sales Less: Material and manufacturing costs of products sold Research and development General and selling (1) Operating income

2011

2010

2009

$ 1,600,000

$1,300,000

$ 1,200,000

740,000 90,000 600,000 $ 1,430,000 $ 170,000

624,000 78,000 500,500 $1,202,500 $ 97,500

576,000 71,400 465,000 $ 1,112,400 $ 87,600

10.63%

7.50%

7.30%

(1) Divided by (2)

6. Return on Operating Assets

Operating Income Average Operating Assets

7. Operating Asset Turnover

2011

2010

2009

$170,000 $1,390,200

$97,500 $1,160,000

$87,000 $1,090,000

= 12.23%

= 8.41%

= 7.98%

Net Sales Average Operating Assets

2011

2010

2009

$1,600,000 $1,390,200

$1,300,000 $1,160,000

$1,200,000 $1,090,000

= 1.15 times

= 1.12 times

= 1.10 times

8. DuPont Analysis with operating ratios Return on Operating Assets 2011: 12.22%* 2010: 8.40%* 2009: 8.03%

Net Profit Margin

Total Asset Turnover

= = =

10.63% 7.50% 7.30%

x x x

1.15 1.12 1.10

*Rounding difference from the 12.23%, 8.41%, and 7.98% computed in (6). 215 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

Net Income Before Minority Share of Earnings and 9. Return on Investment = Nonrecurring Items + [(Interest Expense) x (1 – Tax Rate)] Average (Long-Term Liabilities) + Equity Estimated tax rate: 2011

2010

(1) Provision for income taxes $ 62,049 (2) Earnings before income taxes and minority equity $ 159,100 (1) ÷ (2) 1 – tax rate

$ 35,731

32,659

$ 87,150

77,760

41.00% 59.00%

42.00% 58.00%

(3) Interest expense x (1 – tax rate) $19,000 x 61.00% $18,200 x 59.00% $17,040 x 58.00%

11,590

(4) Earnings before minority equity (3) + (4) (A)

97,051 108,641

51,419 62,157

45,101 54,984

(5) Total long-term debt (6) Total stockholders’ equity (5) + (6) = (B)

211,100 811,200 1,022,300

121,800 790,100 911,900

214,000 770,000 984,000

(A) ÷ (B)

10.63%

6.82%

5.59%

10. Return on Total Equity

Net income etc. Average total equity

39.00% 61.00%

2009

10,738 9,883

Net Income Before Nonrecurring Items – Dividends on Redeemable Preferred Stock Average Total Equity 2011

2010

2009

$ 86,851 $ 811,200

$ 42,919 $ 790,100

$ 37,001 $ 770,000

=10.71%

= 5.43%

= 4.81

All ratios computed indicate a significant improvement in profitability

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PROBLEM 8-13

a. 1. Net Profit Margin

Net Income Before Noncontrolling Interest, Equity Income and Nonrecurring Items Net Sales

2011

2010

2009

$20,070 – $8,028 $297,580

$16,660 – $6,830 $256,360

$15,380 – $6,229 $242,150

= 4.05%

= 3.83%

= 3.78%

2. Return on Assets

Net Income Before Minority Share of Earnings and Nonrecurring Items Total Assets

2011

2010

2009

$20,070 – $8,028 $145,760

$16,660 – $6,830 $137,000

$15,380 – $6,229 $136,000

= 8.26%

= 7.18%

= 6.73%

3. Total Asset Turnover

Net Sales Total Assets

2011

2010

2009

$297,580 $145,760

$256,360 $137,000

$242,150 $136,000

= 2.04 times per year

= 1.87 times per year

= 1.78 times per year

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4. DuPont Analysis

2011: 2010: 2009:

Return on Assets 8.26% 7.16%* 6.73%

Operating Income Margin 4.05% 3.83% 3.78%

= = = =

x x x x

Total Asset Turnover 2.04 times 1.87 times 1.78 times

*Rounding difference from the 7.18% computed in (2).

5. Operating Income Margin

Operating Income Net Sales

2011

2010

2009

$26,380 $297,580

$22,860 $256,360

$20,180 $242,150

= 8.86%

= 8.92%

= 8.33%

6. Return on Operating Assets

Operating Income End of Year Operating Assets

2011

2010

2009

$26,380 $89,800 + $45,850

$22,860 $84,500 + $40,300

$20,180 $83,100 + $39,800

= 19.45%

= 18.32%

= 16.42%

7. Operating Assets Turnover

Net Sales End of Year Operating Assets

2011

2010

2009

$297,580 $89,800 + $45,850

$265,360 $84,500 + $40,300

$242,150 $83,100 + $39,800

= 2.19 times per year

= 2.13 times per year

= 1.97 times per year

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8. DuPont Analysis Return on Operating Assets 2011: 19.40%* 2010: 18.29%* 2009: 16.41%*

= = = =

Operating Income Margin 8.86% 8.92% 8.33%

x x x x

Operating Asset Turnover 2.19 times 2.05 times 1.97 times

*Rounding difference from the 19.45%, 18.32%, and 16.42% computed in (6).

Gross Profit Net Sales

9. Gross Profit Margin

2011

2010

2009

$91,580 $297,580

$80,060 $256,360

$76,180 $242,150

= 30.77%

= 31.23%

= 31.46%

b. Net profit margin and total asset turnover both improved. This resulted in a substantial improvement to return on assets. Operating income margin declined slightly in 2011 after a substantial improvement in 2010. Operating asset turnover improved each year. The result of the improvement in operating income margin and operating asset turnover was a substantial improvement in return on operating assets. Gross profit margin declined slightly each year. Overall profitability improved substantially over the three-year period.

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PROBLEM 8-14

a. 1. Net Profit Margin

Net Income Before Noncontrolling Interest, Equity Income and Nonrecurring Items Net Sales

2011

2010

2009

$171,115 $1,002,100

$163,497 $980,500

$143,990 $900,000

= 17.08%

= 16.67%

= 16.00%

2. Return on Assets

Net Income Before Noncontrolling Interest and Nonrecurring Items Average Total Assets

2011

2010

2009

$171,115 $839,000

$163,497 $770,000

$143,990 $765,000

= 20.40%

= 21.23%

= 18.82% Net Sales Average Total Assets

3. Total Asset Turnover

2011

2010

2009

$1,002,100 $839,000

$980,500 $770,000

$900,000 $765,000

= 1.19 times per year

= 1.27 times per year

= 1.18 times per year

4. DuPont Analysis

2011: 2010: 2009:

Return on Assets 20.33%* 21.17%* 18.88%*

= = = =

Net Profit Margin 17.08% 16.67% 16.00%

x x x x

Total Asset Turnover 1.19 times per year 1.27 times per year 1.18 times per year

*Rounding difference from the 20.40%, 21.23%, and 18.82% computed in (2). 220 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

Net Income Before Noncontrolling Interest and 5. Return on Investment = Nonrecurring Items + [(Interest Expense) x (1 – Tax Rate)] Average (Long-Term Liabilities) + Equity Estimated tax rate:

(1) Provision for income taxes (2) Earnings before income taxes Tax rate [(1) + (2)] 1 – tax rate (3) Interest expense x (1 – tax rate) $14,620 x 59.50% $12,100 x 59.00% $11,250 x 57.70%

2011

2010

2009

$ 116,473 $ 287,588 40.50% 59.50%

$ 113,616 $ 277,113 41.00% 59.00%

$ 105,560 $ 249,550 42.30% 57.70%

8,699 7,139 6,491

(4) Net earnings (3) + (4) = (A)

171,115 179,814

163,497 170,636

143,990 150,481

(5) Average long-term debt (6) Average shareholders’ equity (5) + (6) = (B) (A) ÷ (B)

120,000 406,000 526,000 34.19%

112,000 369,500 481,500 35.44%

101,000 342,000 443,000 33.97%

6. Return on Total Equity

Net earnings Average total equity

Net Income Before Nonrecurring Items – Dividends on Redeemable Preferred Stock Average Total Equity 2011

2010

2009

$171,115 $406,000

$163,497 $369,500

$143,990 $342,000

= 42.15%

= 44.25%

= 42.10%

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7. Sales to Fixed Assets

Net Sales Average Net Fixed Assets

2011

2010

2009

$1,002,100 $302,500

$980,500 $281,000

$900,000 $173,000

= 3.31 = 3.49 = 5.20 b. The ratios computed indicate a very profitable firm. Most ratios indicate a very slight reduction in profitability in 2011. Sales to fixed assets has declined materially, but this is the only ratio for which the trend appears to be negative.

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CASES CASE 8-1 JEFF’S SELF-SERVICE STATION Profitability Planning (This case is effective in illustrating the entity concept, return on investment, cash flow, and the subjective nature of decision making.) a. Indicated return on investment: Average profit for 2011 and 2010:

2011: 2010:

$ 20,630 17,925 $ 38,555

Average

$ 19,277

Depreciation as computed on the prior cost base Depreciation as computed on the purchase cost Adjusted profit Tax, 50% rate Net income

Return on Investment

$9,138 $70,000

$ 1,000 (2,000) 18,277 9,139 $ 9,138

13.05%

b. Indicated return on investment if help were hired to operate the station: Adjusted profit in part (a) Less cost of hired help New adjusted profit Tax, 50% rate Net income

Return on Investment

$ 182,77 10,000 $ 8,277 4,139 $ 4,138

$4,138 $70,000

5.91%

c. In (a), there is no salary expense. In (b), the salary expense for hired help of $10,000 is deducted. This lowers the taxable income and taxes, giving a net effect of $5,000. The rate of return in (a) must be higher to compensate for the opportunity cost of the salary to the owner. 223 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

The difference between the rates of return is misleading in terms of judging the investment. The records only reflect the actual cost, while disregarding opportunity cost and personnel time not compensated. All costs need to be considered when judging the investment. d. Indicated cash flow: Receipts: Revenue

2012 $ 185,060

Outlays: Cost of goods sold Added inventory Real estate and property taxes Repairs and maintenance Other expenses Total outlays

160,180 10,000 1,100 1,470 680 $ 173,430

Net cash flow, excluding tax expense

11,630

Less taxes (a) Net cash flow

9,815 1,815

(a) Cash flow prior to taxes Add inventory Deduct depreciation Profit Taxes

$ 11,630 10,000 (2,000) $ 19,630 $ 9,815

e. Many other considerations can be discussed. Some of these include: 1. Future tax rate. 2. Psychic value of owning the business. 3. Can Mr. Dearden adequately serve as manager? 4. Will he be able to maintain or increase the business that was enjoyed by Mr. Szabo? 5. Will there be appreciation in the value of the property? 6. Other investment alternatives. f. This is a subjective question. Either a yes or no answer is acceptable. This question should be discussed in relation to the above questions. 224 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

CASE 8-2 DIVERSIFIED MANUFACTURER (This case provides an opportunity to review segment reporting). a. Segment Reporting – Crane Co. Horizontal Common-Size Net Sales United States Canada Europe Other international Total Net Sales

2010 84.2 80.9 89.0 88.8 85.2

2009 84.4 74.0 91.2 76.5 84.3

2008 100.0 100.0 100.0 100.0 100.0

Assets United States Canada Europe Other international Corporate Total Assets

98.9 137.4 69.5 332.9 84.1 97.6

89.0 152.6 67.5 234.8 107.8 97.8

100.0 100.0 100.0 100.0 100.0 100.0

b. Net Sales Material decline in net sales in 2009, especially for Canada and Other International. Canada and Other International recovered in 2010. Assets Very, very material increase in Canada and Other International in 2009. Very, very material decline in Europe in 2009. This decline stayed low in 2010.

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CASE 8-3 LEADING ROASTER (This case provides the opportunity to view segments using common-size analysis.) a. Beverage represents approximately 64% of revenue. Food represents an increasing share of revenue and is the second leading contributor. It increased from 15% in 2008, 17% in 2009, to 18% in 2010. b. 1.

Beverage Food Whole bean and soluble coffees Other Total

October 3, 2010 103.3 124.3 114.5 77.6 103.1

September 27, 2009 93.6 111.1 97.7 73.0 94.1

September 28, 2008 100.0 100.0 100.0 100.0 100.0

2. The dominant area, beverage, went up slightly in 2010 in relation to 2008 after declining substantially in 2009. Food had a material increase in both 2009 and 2010. Whole bean and soluble coffees decreased slightly in 2009 and then increased materially in 2010. Other decreased materially in 2009 and then increased moderately in 2010. Total only had a slight increase when comparing 2010 with 2008. It decreased substantially in 2009 and then increased materially in 2010.

c. 1. Vertical Common Size

Net revenues from external customers: United States Other countries Total

October 3, 2010

September 27, 2009

September 28, 2008

77.8 22.2 100.0

79.7 20.3 100.0

79.2 20.8 100.0

2. A slight decrease in the United States while there was a slight increase for Other Countries.

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3. Horizontal Common-Size

Net revenues from external customers: United States Other countries Total

October 3, 2010

September 27, 2009

September 28, 2008

101.3 110.0 103.1

94.7 92.2 94.1

100.0 100.0 100.0

4. United States, Other Countries, and Total decreased substantially in 2009 and increased materially in 2010.

d. 1. Vertical Common-Size Long-Lived Assets

Long-Lived Assets: United States Other countries Total

October 3, 2010

September 27, 2009

September 28, 2008

77.4 22.6 100.0

78.4 21.6 100.0

79.0 21.0 100.0

2. A slight decrease in the United States, while a slight increase in Other Contries.

3. October 3, 2010 Long-Lived Assets: United States Other countries Total

90.6 99.6 92.5

September 27, 2009

September 28, 2008

89.6 92.7 90.2

100.0 100.0 100.0

4. A material decrease in 2009 for all segments. Other Countries increased substantially in 2010 while United States and Total increased slightly in 2010.

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CASE 8-4 CERTIFIED ORGANIC (This case provides an opportunity to review a number of profitability ratios.) a. 1. Net Profit Margin

Net Income Before Noncontrolling Interest, Equity Income and Nonrecurring Items Net Sales

2010

2009

$245,833 $9,005,794

$146,804 $8,031,620

2.73%

1.83%

2. Total Asset Turnover

Net Sales Year End Total Assets

2010

2009

$9,005,794 $3,986,540

$8,031,620 $3,783,388

2.26%

2.12%

3. Return on Assets

Net Income Before Noncontrolling Interest, Equity Income and Nonrecurring Items Year End Total Assets

2010

2009

$245,833 $3,986,540

$146,804 $3,783,388

6.17%

3.88%

4. Operating Income Margin

Operating Income Net Sales

2010

2009

$437,975 $9,005,794

$284,349 $8,031,620

4.86%

3.54%

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5. Return on Operating Assets

Operating Income Year-End Operating Assets

2010

2009

$437,975 ($1,161,519 + $1,886,130 + $99,156)

$284,349 ($1,055,380 + $1,897,853+ $91,000)

$3,146,805

$3,044,233

13.92%

9.34%

6. Sales to Fixed Assets

Net Sales Year-End Fixed Assets

2010

2009

$9,005,794 $1,886,130

$8,031,620 $1,897,853

4.77%

4.23%

7. Return on Investment

Net Income Before Noncontrolling Interest and Nonrecurring Items + [(Interest Expense) X (1 – Tax Rate)] Year-End Long-Term Liabilities + Equity

2010

2009

$245,833 + [$33,048 X (1 – Tax Rate) ($245,833 + $19,729.66) $265,562.66)] ($508,288 + $2,373,258) $2,881,546.00

$146,804 + [$36,856 X (1 – 41.50) ($146,804 + $21,560.76) $168,364.76] ($738,848 + $1,627,876) $2,366,724

9.22%

7.11%

8. Return on Total Equity

Net Income Before Noncontrolling Items – Dividends on Redeemable Preferred Stock Year-End Total Equity

2010

2009

$245,833 $2,373,258

$146,804 $1,627,876

10.36%

9.02%

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9. Gross Profit Margin

Gross Proft Net Sales

2010

2009

$3,135,401 $9,005,794

$2,754,310 $8,031,620

34.82%

34.29%

b. A material increase in ratios 1 through 8. A slight increase in ratio 9, gross profit margin. The substantial increase in ratios 1 through 8 came from the increase in sales.

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CASE 8-5 DIGITAL MEDIA (This case provides an opportunity to review a number of profitability ratios and a horizontal common size.)

a. 1. Net Profit Margin

Net Income Before Noncontrolling Interest, Equity Income and Nonrecurring Items Net Sales

2009

2010

$597,992 - $250,390 $6,460,315

$1,231,663 - $395,758 $6,324,651

5.38%

13.22%

2. Total Asset Turnover

Net Sales Year End Total Assets

2006

2010

$6,460,315 $14,936,030

$6,324,651 $14,928,104

43.25%

42.37%

3. Return on Assets

Net Income Before Noncontrolling Interest, Equity Income and Nonrecurring Items Year End Total Assets

2009

2010

$597,992 – $250,390 $14,936,030

$1,231,663 – $395,758 $14,928,104

2.33%

5.60%

4. Operating Income Margin

Operating Income Net Sales

2009

2010

$386,692 $6,460,315

$772,524 $6,324,651

5.99%

12.21% 231

5. Return on Operating Assets

Operating Income Year-End Operating Assets

2009

2010

$386,692 ($4,594,772 + $1,426,862 – $142,899) + $5,878,735

$772,524 ($4,345,548 + $1,653,422 – $175,830) + $5,823,040

6.58%

13.27%

6. Sales to Fixed Assets

Net Sales Year End Fixed Assets (Exclude construction in progress)

2009

2010

$6,460,315 $1,426,862 - $142,899

$6,324,651 $1,653,422 - $175,830

5.03%

4.28%

7. Return on Total Equity

Net Income Before Noncontrolling Items – Dividends on Redeemable Preferred Stock Year-End Total Equity

2009

2010

$597,992 $12,518,636

$1,231,663 $12,596,410

4.78%

9.78%

9. Gross Profit Margin

Gross Proft Net Sales

2009

2010

$3,588,569 $6,460,315

$3,697,106 $6,324,651

55.55%

58.46%

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b. 1. Net Profit Margin Material increase in 2010 2. Total Asset Turnover A slight decrease in 2010 3. Return on Assets Material increase in 2010 4. Operating Income Margin Material increase in 2010 5. Return on Operating Assets Material increase in 2010 6. Sales to Fixed Assets A material decrease in 2010 7. Return on Total Equity A material increase in 2010 8. Gross Profit Margin A substantial increase in 2010

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c. 1. Yahoo Services Consolidated Statements of Income Horizontal Common-Size 2008 - 2010 2008 100.0 % 100.0 100.0

Revenues Cost of revenues Gross profit Operating expenses: Sales and marketing Product development General and administrative Amortization of intangibles Restructuring charges, net Goodwill impairment charge Total operating expenses Income from operations Other income, net Income before income taxes and earnings in equity interests Provision for income taxes Earnings in equity interests Net income

2009 89.6 % 95.0 85.7

2010 87.7 % 86.9 88.3

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

79.7 99.0 82.3 44.7 118.8 N/A 76.7 29,830.04 254.3

80.9 88.6 69.3 36.1 54.2 N/A 70.1 59,594.5 403.9

100.0 100.0 100.0 100.0

662.2 84.7 41.9 142.5

1,234,4 85.5 66.3 293.1

2. Material decline in Revenue, Cost of Revenue, Gross Profit, Operating Expenses (except Goodwill Impairment Charge in 2008). Income from Operations up materially in 2009 because there was no charge for Goodwill Impairment Charge. Income from Operations up materially in 2010 because Gross Profit up slightly while Operating Expenses were down substantially.

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CASE 8-6 RETURN ON ASSETS – INDUSTRY COMPARISON (This case represents the opportunity to compare two companies from different industries on how Net Profit Margin and Total Asset Turnover impacted Return on Assets.) a. Johnson & Johnson 1. Net Profit Margin

$13,334 $61,587

Net Income Before Noncontrolling Interest Equity Income and Nonrecurring Items Net Sales

21.65%

2. Total Asset Turnover

Net Sales Average Total Assets

$61,587 ($102,908 + $94,682)/2

3. Return on Assets

.62 Times

Net Income Before Noncontrolling Interest and Nonrecurring Items Average Total Assets

$13,334 ($102,908 + $94,682)/2

13.50%

b. Best Buy, Co.

1. Net Profit Margin $1,277 – $2 $50,272

Net Income Before Noncontrolling Interest Equity Income and Nonrecurring Items Net Sales 2.54%

2. Total Asset Turnover

$50,372 $17,849 + $18,302

Net Sales Average Total Assets 2.78 Times

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3. Return on Assets

Net Income Before Noncontrolling Interest and Nonrecurring Items Average Total Assets

$1,277 – $2 ($17,849 + $18,302 + $18,075.5)

7.05%

c. Johnson & Johnson is in the health care field. This influenced the high Net Profit Margin and low Total Asset Turnover. Best Buy is a specialty retailer of consumer electronics. This influenced the low Net Profit Margin and high Total Asset Turnover. Johnson & Johnson has a materially higher Return on Assets than does Best Buy, Co. This does not directly relate to the industry (Best Buy could have been higher).

CASE 8-7 NAME THE INDUSTRY (This case provides an opportunity to compare three firms in different industries using net profit margin, total asset turnover and current ratio.) a. Firm A Costco The low Profit Margin and high Total Asset Turnover makes Firm A Costco. The low Current Ratio also points to Costco. b. Firm B Apple The high Profit Margin and low Total Asset Turnover makes Firm B Apple. The high Current Ratio also points to Apple. c. Firm C Target Corporation We would expect Target Corporation to have a Net Profit Margin higher than Costco but much lower than Apple. We would expect Target Corporation to have A Total Asset Turnover higher than Apple but much lower than Costco.

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CASE 8-8 SPECIALTY RETAILER – PROFITABILITY (This case provides the opportunity to compare three profitability ratios among three firms in the same industry.) a. Net Profit Margin Limited Brands and GAP had approximately the same Profit Margin in 2010. The increase in Net Profit Margin in 2010 was materially better for Limited Brands, although the Net Profit Margin was materially higher for GAP than for Limited Brands in 2009. The trend was good for all three companies. b. Return on Assets Return on Assets increased materially in 2010 for all three companies. The Return on Assets was materially higher for GAP than Limited Brands. The return for GAP was materially better than the return for Abercrombie & Fitch. c. Return on Total Equity In 2010, the Return on Total Equity increased for all three companies with Abercrombie & Fitch and Limited Brands approximately doubling their return. The Return on Total Equity is very high for Limited Brands. d. Would possibly rank these companies as follows: 1. Limited Brands Trend is positive and they have the highest Return on Total Equity. We would like more information on why Return on Total Equity was so high. 2. GAP Very good profit indicators. GAP actually has a higher Return on Assets than Limited Brands. With more detail we would possibly rank GAP number one. 3. Abercrombie & Fitch For the period reviewed, Abercrombie & Fitch had the lowed profit indicators.

CASE 8-9 – EAT AT MY RESTAURANT - PROFITABILITY (This case provides the opportunity to compare three profitability ratios among three firms in the same industry.) a. Net Profit Margin The net profit margin was the best for Yum Brands. Starbucks had a very material increase in Net Profit Margin in 2010. All of the companies increased their Net Profit Margin in 2010.

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b. Return on Assets Over the two-year period, Yum Brands had the best Return on Assets. The highest return was Starbucks in 2010, which was slightly better than Yum Brands. c. Return on Total Equity Return on Total Equity was very, very high for Yum Brands. Not shown in the case is the low Total Equity for Yum Brands. This results in an unrealistic Return on Total Equity. Both Starbucks and Panera Bread appear to have a very good Return on Total Equity. d. Yum Brands appears to have the best profitability based on 2010 and 2009. Their Net Profit Margin and Return on Assets were both consistent and relatively high. Based on 2010, Starbucks appears to be a second place choice. CASE 8-10 – EAT AT MY RESTAURANT - PROFITABILITY VIEW (Comprehensive Income Included) (This case provides the opportunity to review the profitability of Yum Brands, Panera Bread and Starbucks, including comprehensive income for 2010 and 2009.) a. Net Profit Margin Yum Brands appears to have the better Net Profit Margin. b. Return on Assets Yum Brands appears to have the better Return on Assets. Starbucks had the highest in 2010, but Yum Brands was more consistent and the highest or close to the highest in each year. c. Return on Total Equity Yum Brands was very high. Note: Not shown in the table, Yum Brands had a low Total Equity. This makes its Return on Total Equity misleading.

d. 1. Yum Brands

Net profit margin % Return on assets % Return on total equity %

Case 8-9 2010 2009 10.21 9.88 14.98 15.66 84.66 210.00

Comprehensive Income Case 8-10 2010 2009 10.18 11.67 14.94 18.50 83.00 248.04

Comprehensive Income ratios were materially higher in 2009, a slight negative influence in 2010. 238 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

The ratios fluctuated materially more under Comprehensive Income. Panera Bread Comprehensive Income Case 8-9 Case 8-10 2010 2009 2010 2009 Net profit margin % 7.25 6.36 7.26 6.40 Return on assets % 12.70 11.39 12.71 11.47 Return on total equity % 18.71 15.71 18.72 15.82 Comprehensive Income ratios were slightly higher in both 2009 and 2010. The ratios fluctuated slightly more under Comprehensive Income.

Starbucks

Net profit margin % Return on assets % Return on total equity %

Case 8-9 2010 2009 8.83 4.00 15.81 6.95 28.14 14.11

Comprehensive Income Case 8-10 2010 2009 8.75 4.17 15.67 7.25 27.90 14.73

Comprehensive Income ratios were slightly lower in 2010 and slightly higher in 2009. The ratios fluctuated slightly more under Comprehensive Income. 2. No, the changes in Comprehensive Income can fluctuate materially.

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Chapter 9 For the Investor QUESTIONS 9- 1.

Earnings per share is the amount of income earned on a share of common stock during an accounting period.

9- 2.

The Financial Accounting Standards Board suspended the reporting of earnings per share for nonpublic companies.

9- 3.

Keller & Fink is a partnership. Earnings per share is a concept that only applies to corporate income statements.

9- 4.

Earnings per share is a concept that only applies to common stock. The earnings per common share computation only uses earnings available to common stockholders. To arrive at the income that applies to common stock, preferred dividends are subtracted from net income in the numerator of the ratio.

9- 5.

Since earnings pertain to an entire year, they should be related to the common shares outstanding during the year. The year-end common shares outstanding may not be representative of the shares outstanding during the year. Potentially dilutive securities must be converted to common shares for the part of the year that if converted those shares would be outstanding during the year if they decrease the earnings per share. The converted shares must be included in the weighted average common shares outstanding during the year.

9- 6.

Less preferred dividends will be subtracted from net income in the numerator of the earnings per share computation. This will increase earnings per share. In practice, whether earnings per share will be increased or decreased depends on the after-tax earnings that the firm would have from the funds used to retire the preferred stock in relation to the dividend decrease.

9- 7.

Stock dividends and stock splits do not provide the firm with more funds; they only change the number of outstanding shares. Earnings per share should be related to the outstanding common stock after the stock dividend or stock split.

9- 8.

Many firms try to maintain a stable percentage because they have a policy on the percentage of earnings that they want retained for internal growth.

9- 9.

Financial leverage is the use of financing with a fixed charge. Financial leverage will magnify changes in earnings available to the common shareholder. Its use is advantageous when a firm obtains a greater return on the resources obtained than the rate of interest expense. Its use is disadvantageous when a firm obtains a lower return on the resources obtained than the rate of interest expense.

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9-10.

If the interest rate rises, the degree of financial leverage will rise. For example, suppose the firm has the following pattern of earnings with $1,000,000 in long-term debt: Earnings before interest and tax Interest ($1,000,000 at 8%) Earnings before tax

Degree of Financial Leverage

$1,000,000 (80,000) $ 920,000

Income Before Interest and Tax Earnings before tax

$1,000,000 $920,000

1.09

If the rate of interest rises to 12%, then the degree of financial leverage will be as follows: Earnings before interest and tax Interest ($1,000,000 at 12%) Earnings before tax Degree of financial leverage

$ 1,000,000 (120,000) $ 880,000 =

$ 1,000,000 880,000

1.14

The degree of financial leverage has risen due to the decrease in earnings before tax. 9-11.

Investors attach a higher price to securities that they feel have higher potential. This gives a higher price/earnings ratio.

9-12.

A relatively new firm often has a low dividend payout ratio because it needs funds to establish itself (i.e. increase inventory, increase accounts receivable, etc.). A firm with a substantial growth record and/or substantial growth prospects needs funds for expansion. They utilize them in this manner rather than paying them out to the owners.

9-13.

A low dividend yield may indicate that the firm is retaining its earnings for growth. The investor might expect to get his/her returns in the form of market price appreciation.

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9-14.

Book value is based on a mixture of valuation basis, such as historical costs. Current value accounting should make book value closer to market.

9-15.

Stock options are a form of potential dilution of earnings. With the requirement that stock option expense be recorded in the income statement, the dilution will reduce earnings each year.

9-16.

A relatively small number of stock appreciation rights can prove to be a material drain on future earnings and cash of a company because stock appreciation rights are tied to the future market price of the stock.

9-17.

If the stock price decreases in relation to the prior year, then the estimate of total compensation expense related to the stock appreciation rights will decrease. The decrease in the estimate of total compensation expense will be added to income for the current year.

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PROBLEMS PROBLEM 9-1 a.

3 EPS previously reported 2011 declared a 4-for-1 stock split 2011 reported .30 EPS

.30

2010 $1.00 .25 .25

2009 $.80 .20 .20

4 New EBIT Prior EBIT

(a) $ Financial leverage (b) (a) x (b) $ c.

2011 -----

2,000,000 1,000,000 1,000,000 1.5 1,500,000

Adjust the shares in 2011 by adding 10% additional shares. Divide the previous number of shares for 2011 by the new number of shares. This is the percentage of the previous reported earnings per share that should be reported as the adjusted earnings per share. For illustration, assume the following; (A) (B) (A) ÷ (B)

Previous shares 10% stock dividend New number of shares 100,000/110,000

100,000 10,000 110,000 = .909

The price/earnings ratio usually reflects investor’s opinions of the future prospects for the firm.

Degree of financial leverage gives a perspective on risk in the capital structure.

The earnings per share ratio is computed for common stock.

Increasing financial leverage can be a risky strategy from the viewpoint of stockholders of companies having low and falling profits.

10% x 1.3 = 13%

Dividend yield represents dividends per common share in relation to market price per common share.

Book value per share may not approximate market value per share because of all of the reasons listed.

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PROBLEM 9-2

Degree of Financial Leverage

Earnings Before Interest, Tax, Noncontrolling Interest, Equity Income and Nonrecurring Items Earnings Before Tax, Noncontrolling Interest, Equity Income, and Nonrecurring Items $975,000 + $70,000 $975,000

$1,045,000 $975,000

1.07

PROBLEM 9-3 Earnings Before Interest, Tax, Noncontrolling Interest, Equity Income, and Nonrecurring Items a. 1. Degree of Financial Leverage = Earnings Before Tax, Noncontrolling Interest, Equity Income, and Nonrecurring Items 2011:

$110,500 + $9,500 $110,500

= 1.09

2010:

$107,700 + $6,600 $107,700

= 1.06

2009:

$100,450 + $6,800 $100,450

= 1.07

2008:

$124,100 + $6,900 $124,100

= 1.06

2007:

$119,000 + $7,000 $119,000

= 1.06

2. Earnings Per Common Share 2011:

Continuing operations Extraordinary gain

$ 2.67* .69 $ 3.36

2010:

* Should be used in primary analysis. $2.57

2009:

$2.36

2008:

$3.23

2007:

$2.81

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3. Price/Earnings Ratio

Market Price Per Share Earnings Per Share

2011:

$24.00 $2.67

= 8.99

2010:

$22.00 $2.57

= 8.56

2009:

$21.00 $2.36

= 8.90

2008:

$37.00 $3.23

= 11.46

2007:

$29.00 $2.81

= 10.32

4. Percentage of Earnings Retained

Net Income – All Dividends Net Income

2011:

$97,500 – $3,920 – $91,640 $97,500

= 1.99%

2010:

$74,400 – $6,100 – $66,410 $74,400

= 2.54%

2009:

$68,350 – $6,400 – $60,900 $68,350

= 1.54%

2008:

$93,700 – $6,600 – $84,970 $93,700

= 2.27%

2007:

$81,600 – $6,000 – $81,200 $81,600

= (6.86%)

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5. Dividend Payout

Dividends Per Common Share Fully Diluted Earnings Per Share

2011:

$3.16 $2.67

= 118.35%

2010:

$2.29 $2.57

= 89.11%

2009:

$2.10 $2.36

= 88.98%

2008:

$2.93 $3.23

= 90.71%

2007:

$2.80 $2.81

= 99.64%

6. Dividend Yield

Dividends Per Common Share Market Price Per Common Share

2011:

$3.16 $24.00

= 13.17%

2010:

$2.29 $22.00

= 10.41%

2009:

$2.10 $21.00

= 10.00%

2008:

$2.93 $37.00

= 7.92%

2007:

$2.80 $29.00

= 9.66%

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7. Book Value Per Share

Total Stockholders’ Equity – Preferred Stock Equity Number of Common Shares Outstanding

2011:

$489,000 – $49,000 29,000

= $15.17

2010:

$514,000 – $76,000 29,000

= $15.10

2009:

$516,000 – $80,000 29,000

= $15.03

2008:

$517,000 – $82,000 29,000

= $15.00

2007:

$508,000 – $75,000 29,000

= $14.93

8. Materiality of Options

2007 - 2011:

Stock Options Outstanding Number of Shares of Common Stock Outstanding

$1,000,000 29,000,000

= 3.45%

b. This firm has a very low degree of financial leverage. Earnings from continuing operations and the price/earnings ratio have been relatively stable. Practically all of the earnings have been paid out in dividends, thus, book value per share has only increased slightly. The dividend yield is very high. The market price has declined substantially. Options outstanding appear to be immaterial. In general, the investor analysis is positive if the investor wants high dividends. Growth prospects do not appear to be good.

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PROBLEM 9-4

Degree of Financial Leverage

Earnings Before Interest, Tax Noncontrolling Interest, Equity Income, and Nonrecurring Items Earnings Before Tax, Noncontrolling Interest, Equity Income, and Nonrecurring Items

$1,000,000 $800,000

1.25

b. Prior earnings before interest and tax 10% increase Adjusted income before interest and tax Interest Income before tax Tax (50% rate) Net income Earnings will increase by 12.5% to $450,000 ($400,000 x 112.5% = $450,000)

$ 1,000,000 100,000 $ 1,100,000 200,000 $ 900,000 450,000 450,000

c. $800,000 Earnings before interest and tax 200,000 Interest 600,000 Earnings before tax 300,000 Tax $300,000 Net Income This is a decline in profit of 25%. PROBLEM 9-5 a.

Common shareholders’ equity divided by the number of common chares outstanding gives book value per share.

Book Value Per Share

Total Stockholders’ Equity – Preferred Stock (At Liquidation) Number of Common Shares Outstanding

$1,000,000 + $1,500,000 + $500,000 + $1,100,000 150,000 Shares

$12.67

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PROBLEM 9-6 a. 1. Percentage of Earnings Retained

Net income (A) Less: Common dividend Preferred dividend (B) (A) – (B) = (C) (C) ÷ (A)

2. Price/Earnings Ratio

3. Dividend Payout

4. Dividend Yield

Net Income – All Dividends Net Income

2011 $ 31,200,000

2010 $ 30,600,000

2009 $ 29,800,000

21,700,000 910,000 $ 22,610,000 8,590,000 27.53%

19,500,000 910,000 $ 20,410,000 10,190,000 33.30%

18,360,000 910,000 $ 19,270,000 10,530,000 35.34%

Market Price Per Share Fully Diluted Earnings Per Share 2011 $12.80 $1.12

2010 $14.00 $1.20

2009 $16.30 $1.27

= 11.43

= 11.67

= 12.83

Dividends Per Common Share Fully Diluted Earnings Per Share 2011 $0.90 $1.12

2010 $0.85 $1.20

2009 $0.82 $1.27

= 80.36%

= 70.83%

= 64.57%

Dividends Per Common Share Market Price Per Common Share 2011 $0.90 $12.80

2010 $0.85 $14.00

2009 $0.82 $16.30

= 7.03%

= 6.07%

= 5.03%

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5. Book Value Per Share =

2011 $ $1,280,100,000

2010 $ $1,267,200,000

2009 $ 1,260,400,000

(800,400,000) 479,700,000

(808,500,000) 458,700,000

(799,200,000) 461,200,000

(15,300,000)

$443,400,000

$ $445,900,000

23,100,000

22,500,000

Total assets: Less: Liabilities Stockholders’ Equity Less: Nonredeemable preferred stock (A) Common stock equity $ (B) Shares outstanding end of year (A) ÷ (B)

Total Stockholders' Equity – Preferred Stock Equity Number of Common Shares Outstanding

$464,400,000

24,280,000 $19.13

$19.19

$19.82

b. The percentage of earnings retained is decreasing. The related ratio, dividend payout, is therefore increasing. The price/earnings ratio has been relatively stable. The dividend yield has increased and is relatively high. The market price per share is substantially below the book value. It appears that this stock is being purchased for the relatively high dividend and not for growth potential.

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PROBLEM 9-7 a. The major advantage of receiving stock appreciation rights instead of stock options is that the executive does not have to make a big cash outlay at the date of exercise, but rather receives a payment for the share appreciation. This helps the executive’s cash flow. b. The related credit is to a liability under the stock appreciation plan that would probably be classified as long-term, since exercise cannot occur until 2014. c. In 2014, the company must pay off the liability related to the appreciation in cash. For this problem, it is $30,000. In doing financial statement analysis, this future cash flow, if material, must be considered. As in this case, the full impact may not be apparent until the last year, if the market price rises sharply. PROBLEM 9-8 a. 1. Percentage of Earnings Retained

Net income (B) Less: Cash dividends (A)

3. Dividend Payout

2010 $ 13,300,000

2009 $ 16,500,000

(6,080,000) $ 3,020,000

(5,900,000) $ 7,400,000

(6,050,000) $ 10,450,000

33.19%

55.64%

63.33%

Net Income – All Dividends Net Income

2011 $ 9,100,000

(A) ÷ (B)

2. Price/Earnings Ratio

Market Price Per Share Fully Diluted Earnings Per Share 2011 $41.25 $2.30

2010 $35.00 $3.40

2009 $29.00 $4.54

= 17.93

= 10.29

= 6.39

Dividends Per Common Share Fully Diluted Earnings Per Share 2011 $1.90 $2.30

2010 $1.90 $3.40

2009 $1.90 $4.54

= 82.61%

= 55.88%

= 41.85%

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4. Dividend Yield

5. Book Value Per Share

Dividends Per Common Share Market Price Per Common Share

2011 $1.90 $41.25

2010 $1.90 $35.00

2009 $1.90 $29.00

= 4.61%

= 5.43%

= 6.55%

Market Price Value Ratio of Market Price to Book Value 2011 $41.25 120.5%

2010 $35.00 108.0%

2009 $29.00 105.0%

= $34.23

= $32.41

= $27.62

b. The percentage of earnings retained materially declined. The related ratio, dividend payout, materially increased. The price earnings ratio materially increased, which is difficult to explain, considering the decline in earnings and the other ratios computed. The dividend yield has declined each year, while the book value per share increased each year. The increase in market price and the increase in price earnings ratio appears to be explained by the increase in order backlog at year-end and the increase in net contracts awarded.

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PROBLEM 9-9 a. 1. Percentage of Earnings Retained

Cash dividends Preferred dividends Total dividends Net income (B) Net income – dividends (A) Percentage of earnings retained (A) ÷ (B)

2. Price/Earnings Ratio

3. Dividend Payout

4. Dividend Yield

Net Income – All Dividends Net Income

2011 $0.80 x 25,380,000 $20,304,000 4,567,000 24,871,000 32,094,000 7,223,000

2010 $0.76 x 25,316,000 $19,240,160 930,000 20,170,160 31,049,000 10,878,840

22.51%

35.04%

Market Price Fully Diluted Earnings Per Share 2011

2010

$12.94 $1.08

$15.19 $1.14

= 11.98%

= 13.32%

Dividends Per Share Fully Diluted Earnings Per Share 2011

2010

$0.80 $1.08

$0.76 $1.14

= 74.07%

= 66.67%

Dividends Per Share Market Price Per Share 2011

2010

$0.80 $12.94

$0.76 $15.19

= 6.18%

= 5.00%

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5. Book Value Per Share

Common Equity Shares Outstanding

Total assets Less: total liabilities Less: nonredeemable preferred stock Common equity (A) Shares outstanding Book value per share (A) ÷ (B)

2011 $ 1,264,086,000 (823,758,000) (16,600,000) $ 423,728,000 + 25,380,000 $16.70

2010 $ 1,173,924,000 (742,499,000) (16,600,000) $ 414,825,000 + 25,316,000 $16.39

b. Having the percentage of earnings retained decline provides mixed feelings. It implies that more is going to shareholders, but at the same time, earnings retained for growth have diminished. The rise in the dividend payout ratio supports this position. The price/earnings ratio has declined as a result of the drop in price. This decline indicates lower shareholder expectations but might also indicate a good time to buy. Dividend yield is up, caused by the rise in dividends and more so by the drop in price. Book value per share is up. However, book value is above market, which shows that the investors do not view the assets as worth their book value. This is not a good sign. Overall the signals are mixed. There is not enough information to determine if this is a good security. PROBLEM 9-10

Simple Earnings Per Share

Net Income – Preferred Dividends Weighted Average Number of Common Shares Outstanding Year 1 $40,000 – $22,500 38,000

Year 2 $42,000 – $27,500 38,000

$0.46

$0.38

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PROBLEM 9-11

Numerator $ 200,000 (10,000)

Net income Preferred dividends Common shares outstanding on January 1 Common stock issue on July 1, 5,000 shares Weighted average Two-for-one stock split on December 31

20,000 shares 2,500 (5,000 x ½) 22,500

(a) Earnings per share (a) ÷ (b)

Denominator

$ 190,000

2 (b) 45,000 shares

Current Year

Prior Year

$4.27

b. Earnings per share reported for the prior year Two-for-one stock split on December 31 of the current year ($8.00 x 0.5) = $4.00 Earnings per share computed in (a) for the current year

$8.00

$4.00

$4.27

PROBLEM 9-12 January 1, shares outstanding July 1, two-for-one stock split Adjusted shares outstanding for the year

50,000 shares 2 (A) 100,000

October 1 stock issue 10,000 shares Proportion of year that the new shares were outstanding 0.25 Weighted average for the new shares on an annual basis (B) 2,500 Denominator of the earnings per share computation for the current year (A) + (B) 102,500

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PROBLEM 9-13 a. Net income Preferred dividends January 1, 2011 shares of common stock outstanding July 1, 2011 common stock issue, 1,000 shares x ½

Numerator $ 35,000 (3,000)

20,000

$ 32,000 Earnings per share

$1.56

b. From (a) Less extraordinary gain

$ 32,000 5,000 $ 27,000

Recurring earnings per share

Denominator

500 20,500

20,500 shares 20,500

$1.32

PROBLEM 9-14 Revision of 2010 earnings per share: 2010 reported earnings per share July 1, 2011 stock split Adjusted 2010 earnings per share December 31, 2011 stock split Adjusted 2010 earnings per share

$ 2.00 x 0.5 $ 1.00 x 0.5 $ 0.50

Comparative Earnings Per Share 2011 2010 Earnings Per Share

$1.50

$.50

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CASES CASE 9-1 FOREST PRODUCTS (This case provides the opportunity to review shares issued, shares outstanding, shares to compute earnings per share, and book value.) a. 1. 535,975,518 2. 535,975,518 3. 319,976,000 (Basic earnings per share is computed by dividing net income less preferred dividends by the weighted average number of shares of common stock outstanding during the period). 4. 321,096,000 (Diluted earnings per share is computed by dividing net income less preferred dividends by the weighted average number of shares of common stock outstanding plus the dilutive effect by potentially dilutive securities). b. Diluted earnings per share attributable to Weyerhaeuser common shares from continuing operations. c. Book value = Total Shareholders’ Equity – Preferred Stock Equity Number of Common Shares Outstanding $4,614,000,000 $535,975,518

$8.61

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CASE 9-2 INTEGRATED ELECTRONICS (This case provides an opportunity to review a revenue stock split.) a. September 27, 2008 Loss from Continuing Operations 1. October 2, 2010 Statements September 27, 2008 ($512,936) (in thousands) 2. October 3, 2009 Statements September 27, 2008 $511,336 (in thousands) 3. September 27, 2008 Statements September 27, 2008 $511,336 (in thousands) 4. These numbers should have been the same. No apparent reason for the increase in October 2, 2010 statements. b. September 27, 2008 Diluted earnings (loss) per share from continuing operations 1. October 2, 2010 Statements September 27, 2008 ($5.80) 2. October 3, 2009 statements September 27, 2008 ($5.78) 3. September 27, 2008 Statements September 27, 2008 ($0.96) The number from the October 2, 2010 and October 3, 2009 statements should be the same. Not aware of why there is a difference. Reverse stock split. On July 20, 2009, the Board of Directors of the Company authorized a reverse split of its common stock at a ratio of one for six, effective August 14, 2009. Amount reported September 27, 2008 Reverse stock split

$(0.96) 6 $(5.76)

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Fiscal year ended October 3, 2009 statements – September 27, 2008 Fiscal year ended October 2, 2010 statements – September 27, 2008

$5.78 $5.80

4. Not aware why the amount reported in 2009 and 2010 was not adjusted to ($5.76) for 2008. c. September 7, 2008 1. October 2, 2010 statements September 27, 2008 88,454 2. October 3, 2009 statements September 27, 2008 88,454 3. September 27, 2008 statements September 27, 2008 530,721 4. Reverse stock split July 20, 2009 September 27, 2008 statements Number of shares 530,721 Reverse split ÷ 6 88,453.5

CASE 9-3 GLOBAL DIVERSIFIED FINANCIAL SERVICES (This case provides an opportunity to review a reverse stock split.) a. The stock price should increase by a factor of ten times. b. No change

Citigroup’s Net Income (Loss)

Year Ended December 31, 2010 2009 2008 In Millions $10,602 ($1,606) ($27,684)

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c. Year Ended December 31, 2010 2009 2008 Basic earnings per share Income (loss) from continuing operations Income (loss) from discontinued operations, net of tax Net income (loss) Weighted average common shares outstanding Diluted earnings per share Income (loss) from continuing operations Income (loss) from discontinued operations, net of taxes Net income (loss) Adjusted weighted average common shares outstanding Basic earnings per share X Income (loss) from continuing operations Income (loss) from discontinued operations, net of tax X Net income (loss)

$3.70

($7.60)

($63.90)

(0.10) $3.60

(0.40) ($8.00)

7.60 ($50.30)

287,760

115,683

52,654

$3.50

($7.60)

($63.90)

----$3.50

(0.40) ($8.00)

7.60 ($56.30)

296,781 $0.37 10 3.70

120,993 ($0.76) 10 (7.60)

57,689 ($6.39) 10 (63.90)

(0.01) 10 (0.10) .36 10 3.60

(0.04) 10 (0.40) (0.80) 10 (8.00)

0.76 10 7.60 (5.03) 10 (50.30)

28,776.0 10 287,760

11,568.3 10 115,683

5,265.4 10 52,654

.35 10 3.50

(.76) 10 (7.60)

(6.39) 10 (63.90)

----10 ----.35 10 3.50

(0.04) 10 (0.40) (0.80) 10 (8.00)

.76 10 7.60 (5.63) 10 (56.30)

Adjusted weighted average common shares outstanding 29,678.1 X 10 296,781

12,099.3 10 120,993

5,768.9 10 57,689

X Weighted average common shares outstanding X Diluted earnings per share Income (loss) from continuing operations X Income (loss) from discontinued operations, net of taxes X Net income (loss) X

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CASE 9-4 FAMILY STYLE (This case provides the opportunity to compute several of the ratios introduced in their chapter.) a. 1. Degree of Financial Leverage = Earnings Before Interest and Tax Earnings Before Tax 2010 $16,453,270 $14,704,728

2009 $16,937,360 $14,936,918

1.12

1.13

2. Price / Earnings Ratio = Market Price Per Share Diluted Earnings Per Share, Before Nonrecurring Items 2010 $20.87 $1.93

2009 $28.00 $2.08

10.81

13.46

3. Percentage of Earnings Retained = Net Income Before Nonrecurring Items – All Dividends Net Income Before Nonrecurring Items 2010 $9,998,931 – $2,603,767 $9,998,931

2009 $10,720,855 – $2,449,347 $10,720,855

73.96%

77.15%

4. Dividend Yield = Dividends Per Common Share Market Price Per Common Share 2010 $0.51 $20.87

2009 $0.48 $28.00

2.44%

1.71%

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5. Common Stock – Authorized 2010 12,000,000

2009 $12,000,000

6. Common Stock – Issued 2010 7,585,764

2009 $7,582,347

7. Treasury Stock 2010 2,525,174

2009 $2,482,233

8. Common Stock Outstanding

Issued Treasury

2010 7,585,764 (2,525,174) 5,060,590

2009 $7,582,347 (2,482,233) 5,100,114

9. Book Value Per Share = Total Shareholders’ Equity – Preferred Stock Equity Number of Common Shares Outstanding 2010 $120,094,016 5,060,590

2009 $114,377,144 5,100,114

$23.73

$22.43

b. 1. Degree of Financial Leverage decreased slightly and appears to be moderate. 2. Price / Earnings Ratio 3. Percentage of Earnings Retained decreased slightly and would likely be reasonable 4. Dividend Yield 5. Common Stock – Authorized stayed the same between 2009 and 2010. 6. Common Stock – Issued increased slightly between 2009 and 2010. 262 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

7. Treasury Stock increased slightly between 2009 and 2010. 8. Common Stock Outstanding decreased slightly between 2009 and 2010. 9. Book Value Per Share increased moderately between 2009 and 2010. c. 1. Special Items 2010 None 2009 Gains on Sale of Assets Litigation settlement 2. Remove the Special Items Net of Tax from Net Earnings

CASE 9-5 DELICIOUS APPLE a. 1. Apple Inc. Consolidated Statements of Operations Three Fiscal Years Ended September 25, 2010 Horizontal Common-Size

Net sales Cost of sales Gross margin Operating expenses: Research and development Selling, general and administrative Total operating expenses Operating income Other income and expense Income before provision for income taxes Provision for income taxes Net income

2010 174.0 162.8 194.6

2009 114.4 105.7 130.5

2008 100.0 100.0 100.0

160.7 146.7 149.9 220.8 25.0 207.2 160.1 229.0

120.2 110.3 112.6 141.0 52.6 134.9 135.5 134.6

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

2. A very material increase in net sales. Cost of sales also increased very materially, but not as much as net sales. Total operating expenses increased materially less than net sales or cost of sales. The resulting operating income increased materially more than net sales and net income.

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b. 1. Apple Inc. Consolidated Statements of Operations Three Fiscal Years Ended September 25, 2010 Vertical Common-Size

2010 100.0 60.6 39.4

2009 100.0 59.9 40.1

2008 100.0 64.8 35.2

2.7 8.5 11.2 28.2 .2

3.1 9.7 12.8 27.4 .8

3.0 10.0 13.0 22.2 1.7

28.4 6.9 21.5

28.1 8.9 19.42

23.9 7.5 16.3

2. Cost of sales decreased substantially between 2008 and 2009 but increased slightly in 2010. Total operating expenses decreased slightly between 2008 and 2009, but decreased materially in 2010. These changes resulted in a material operating income increase and a material net income increase. c.

1. Price / Earnings Ratio = Market Price Per Share Diluted Earnings Per Share, Before Nonrecurring Items 2010 $292.33 $15.15

2009 $182.37 $9.08

2008 $128.24 $6.78

19.30

20.08

18.91

2. Dividend Yield = Dividends Per Common Share Market Price Per Common Share 2010 0 0%

2009 0 0%

2008 0 0%

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3. There are no dividends c(2). The price/earnings ratio was relatively steady while the market price increased very, very materially. CASE 9-6 SPECIALTY RETAILER – INVESTOR VIEW (This case provides the opportunity to review several specialty retail stores using an investor view). a. Abercrombie & Fitch Diluted earnings per share before nonrecurring items increased materially. Percentage of earnings retained increased materially. Dividend yield decreased materially. Price/earnings ratio decreased materially. Market price per share increased materially.

Limited Brands, Inc. All-inclusive degree of financial leverage decreased materially, but it is still relatively high. Diluted earnings per share before nonrecurring items increased materially. Percentage of earnings retained went from relatively low to more dividends than earnings. Dividend yield increased materially helped by special dividends. Price/earnings ratio decreased moderately. Market price per share increased materially.

GAP, Inc. Diluted earnings per share before nonrecurring items increased materially. Percentage of earnings retained is high and increased slightly. Dividend yield increased moderately. Price/earnings ratio decreased materially. Market price per share increased slightly. 265 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

b. Limited Brands appears to be a good choice, but a difficult choice. Its financial coverage is relatively high and its dividends are high; both of these could be considered a negative. Impressed by the diluted earnings per share increase and the competitive price/earnings ratio. CASE 9-7 EAT AT MY RESTAURANT – INVESTOR VIEW (This case provides the opportunity to review the profitability of several restaurant companies.) a. Yum Brands, Inc. Diluted earnings per share before nonrecurring items increased moderately. Percentage of earnings retained declined slightly but was still substantial. Dividend yield declined materially. Price/earnings ratio increased materially. Market price per share increased materially. Panera Bread Very little financial leverage Diluted earnings per share increased materially. There were no dividends; therefore, percentage of earnings retained was 100% and dividend yield was 0%. Price/earnings ratio increased materially. Market price per share increased materially.

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Starbucks All-inclusive degree of financial leverage decreased moderately to a minor amount. Diluted earnings per share before nonrecurring items increased materially. Percentage of earnings retained decreased materially, but it is very high and dividends were not paid in 2009. Dividend yield is moderate and no dividends were paid in 2009. Price/earnings ratio decreased materially, but is still relatively high. Market price per share increased materially. b. A reasonable selection would be Starbucks. Diluted earnings per share more than doubled and the price/earnings is approximately the same as Yum Brands and is materially lower than Panera Bread.

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Chapter 10 Statement of Cash Flows QUESTIONS 10- 1. The basic justification for a statement of cash flows is that the balance sheet and the income statement do not adequately indicate changes in cash. The balance sheet indicates the position of the firm at a particular point of time. Some idea of how the changes in cash occurred can be obtained by comparing consecutive balance sheets, but only a limited amount of information can be obtained this way. The income statement shows the income or loss for a period of time, but it does not indicate cash generated by operations. Neither the balance sheet nor the income statement summarize the cash flows related to investing or financing activities. Neither presents such items as sale of stock, retirement of bonds, purchase of machinery, or sale of a subsidiary. Thus, there is a need to summarize the cash flows in another statement. 10- 2. 1. Cash flows from operating activities 2. Cash flows from investing activities 3. Cash flows from financing activities 10- 3. The cash inflows (outflows) will be determined by analyzing all balance sheet accounts other than the cash and cash equivalent accounts. The cash inflows will be generated from the following accounts: 1. Decreases in assets 2. Increases in liabilities 3. Increases in stockholders' equity The cash outflows will be generated from the following accounts. 1. Increases in assets 2. Decreases in liabilities 3. Decreases in stockholders' equity 10- 4. This statement is not correct. The land account may contain an explanation of a source and use of cash. 10- 5. 1. Visual method 2. T-account method 3. Worksheet method

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10- 6. For the direct approach, the revenue and expense accounts on the income statement are presented on a cash basis. For this purpose, the accrual basis income statement is adjusted to a cash basis. For the indirect approach, start with net income and add back or deduct adjustments necessary to change the income on an accrual basis to income on a cash basis after eliminating gains or losses that relate to investing or financing activities. 10- 7. Items have been included in income that did not provide cash and items have been deducted from income that did not use cash. Net income must be converted to a cash-from-operations figure for the statement of cash flows. 10- 8. Cash and short-term highly liquid investments. This would include cash on hand, cash on deposit, and investments in short-term, highly liquid investments. 10- 9. The purpose of the statement of cash flows is to provide information on why the cash position of the company changed during the period. 10-10. These transactions represent significant investing and/or financing activities, and one purpose of the statement of cash flows is to present investing and financing activities. 10-11. No. The write-off of uncollectible accounts against allowance for doubtful accounts would reduce accounts receivable and the allowance for doubtful accounts. It would relate to operations and be a noncash item. The net receivables amount would not change. 10-12. Discarding a fully depreciated asset with no salvage value will not result in cash flow. 10-13. This may be the result of noncash charges for depreciation, amortization, and depletion. Also, receivables or inventory may have decreased or accounts payable may have increased. 10-14. An increase in accounts payable would be considered to be an increase in cash from operations (source of funds). 10-15. Investments in receivables, inventories, fixed assets, and the paying off of debt are examples of situations where cash will be used but will not reduce profits. 10-16. Depreciation is not a source of funds. Depreciation has been deducted on the income statement in arriving at income. Since depreciation is a non-cash charge to the income statement, it is added back to income to compute cash from operations.

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10-17. The decrease in accounts receivable would increase cash from operations. 10-18. This is an example of noncash investing and financing. As such, it should be disclosed on a schedule that accompanies the statement of cash flows. 10-19. Cash flow per share is not as good an indicator of profitability as earnings per share. In the short-run, cash flow per share is a better indicator of liquidity and ability to pay dividends. 10-20. Since cash flow from operating activities is substantially greater than the cash paid out for dividends, it appears that the company can maintain and possibly increase dividend payments in the future, depending also on its investing and financing goals. 10-21. Credit Sales in 2010 Decrease Cash Flow from receivable increase (A) Cash from credit sales (B) Cash sales (A) ÷ (B)

$ 450,000 (10,000) 440,000 100,000 $ 540,000

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PROBLEMS PROBLEM 10-1 a. Revenues from customers Decrease in accounts receivable

$ 150,000 8,000 $ 158,000

b. No. Depreciation expense is a noncash charge reducing income. PROBLEM 10-2 Cash Flows Classification Data

Operating Activity

Investing Activity

Financing Activity

Effect on Cash Increase

Noncash Decrease Transaction

a. Net loss

b. Increase in inventory

c. Decrease in receivables

d. Increase in prepaid insurance

e. Issuance of common stock

f. Acquisition of land using notes payable

g. Purchase of land, using cash

h. Paid cash dividend i. Payment of income taxes

j. Retirement of bonds, using cash k. Sale of equipment for cash

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PROBLEM 10-3 a. Accounts receivable, January 1, 2011 Sales Accounts receivable, December 31, 2011

$ 30,000 480,000 $ 510,000 (40,000) $ 470,000

b. Accounts receivable increased by $10,000 during the year 2011. Thus cash collected from customers was $10,000 less than sales. PROBLEM 10-4 a. BBB COMPANY Statement of Cash Flows For the Year Ended December 31, 2011 Cash flow from operating activities: Net income Non cash expenses, revenues, losses, and gains included in income: Depreciation Gain on sale of land Decrease in accounts receivable Decrease in inventory Increase in accounts payable Increase in wages payable Decrease in taxes payable

$ 2,800 (800) 400 500 800 50 (1,000)

500

$ 2,750

Net cash flow from operating activities

$ 3,250

Cash flows from investing activities: Land was sold for Equipment was purchased for Net cash used for investing activities

1,800 (3,500) $(1,700)

Cash flows from financing activities: Dividends declared and paid Common stock was sold for Net cash used for financing activities

(4,350) 3,800 $ (550)

Net increase in cash and marketable securities

$ 1,000

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b. Net cash flow from operating activities was substantially more than the net income. Cash dividends were greater than the net cash flow from operating activities. The cash from issuing the common stock was sufficient to cover the net cash used for investing activities, increase the cash and marketable securities accounts, and partially cover the large cash dividend. The fact that a long-term source of funds (common stock) was used to cover part of the cash dividends is a negative observation. The large cash dividend in relation to net cash flow from operating activities would also be considered a negative situation.

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PROBLEM 10-5 a. Donna Szabo Company Statement of Cash Flows Years Ended December 31, 2011, 2010, 2009 Total

2011

2010

2009

$ 508,381

$ 173,233

$ 176,446

$ 158,702

(451,801) 326 (1,357) (12,225) 43,324

(150,668) 132 (191) (6,626) 15,880

(157,073) 105 (389) (4,754) 14,335

(144,060) 89 (777) (845) 13,109

(21,156)

(8,988)

(5,387)

(6,781)

1,452 (19,704)

1,215 (7,773)

114 (5,273)

123 (6,658)

Cash flows from financing activities: Net increase (decrease) in short-term debt Increase in long-term debt Dividends paid Purchase of company stock Net cash used in financing activities

12,300 13,000 (22,250) (11,412) (8,362)

----4,100 (6,050) (8,233) (10,183)

5,100 3,700 (8,200) (3,109) (2,509)

7,200 5,200 (8,000) (70) 4,330

Net increase (decrease) in cash & cash equivalents Cash & cash equivalents at beginning of year Cash & cash equivalents at end of year

15,258 50,768 66,026

(2,076) 24,885 22,809

6,553 18,332 24,885

10,781 7,551 18,332

Increase (decrease) in cash: Cash flows from operating activities: Cash received from customers Cash paid to suppliers & employees Interest received Interest paid Income taxes paid Net cash provided from operation Cash flow from investing activities: Capital expenditures Proceeds from property, plant & equipment disposals Net cash used in investing activities

Reconciliation of Net Income To Net Cash Provided by Operating Activities Net income Provision for depreciation & amortization Provision for losses on accounts receivable Gains on property, plant & equipment disposals Changes in operating assets & liabilities Accounts receivable Inventories Other assets Accounts payable Accrued income taxes Deferred income taxes Net cash provided by operating activities

2011

Total

$ 11,358

30,700 473 (4,620)

7,610 12,000 170 (2,000)

(5,350) (8,100) (57) 12,300 1,200 5,420 43,324

(2,000) (3,100) --------1,200 2,000 15,880

2010 $

3,242 9,700 163 (1,120) (1,750) (2,700) ----5,100 ----1,700 14,335

2009 $

506 9,000 140 (1,500) (1,600) (2,300) (57) 7,200 ----1,720 13,109

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b. The three-year analysis revealed that 45% of cash flows from operations went into investing activities. The company is not replacing its productive assets. Cash flows used in financing activities are 19% of the cash flows from operating activities. At first glance, one might assume the company is paying down debt. Closer analysis reveals that the company actually increased its debt levels, but payment to stockholders in the form of dividends and share purchases used more cash than was raised in the borrowing. The company is borrowing, and therefore, increasing debt. Further analysis reveals that a substantial part of the borrowing is short-term rather than long-term. Such money is riskier. c. DONNA SZABO COMPANY Statement of Cash Flows For Year Ended December 31, 2011 (Inflow & Outflow by Activity) Inflow

Outflow

Inflow %

Outflow %

Cash flows from operating activities: Cash received from customers Cash paid to suppliers & employees Interest received Interest paid Income taxes paid Net cash provided by operationg activities Cash flows from investing activities: Capital expenditures Proceeds from property, plant & equipment disposals Net cash used in investing activities Cash flows from financing activities: Net increase (decrease) in short-term debt Increase in long-term debt Dividends paid Purchase of company stock Net cash used in financing activities Total cash flows Increase (decrease) in cash

173,233

96.95

$ 150,668 132

173,365

83.35 0.08

191 6,626 157,485

97.03

8,988 1,215 1,215

8,988

----4,100

4,100 $ 178,680 (180,756) $ (2,076)

0.11 3.67 87.13

4.97 0.68 0.68

4.97

2.29 6,050 8,233 14,283

2.29

3.35 4.55 7.90

$ 180,756

100.00

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d. 97% of cash inflows came from operations and 2% came from financing activities. Significant cash inflows coming from operations is positive. 83% of cash outflows were payments to suppliers and employees. 5% of outflows were used for investment in property, plant, and equipment. 8% of cash outflows were used to pay dividends and purchase shares. Almost as much was spent to pay stockholders as for outflows for capital expenditures.

PROBLEM 10-6 a. FRISH COMPANY Schedule of Change from Accrual to Cash Basis Income Statement For Year Ended December 31, 2011 Accrual Basis

Adjustments

Net sales Less expenses:

$ 640,000

Cost of goods sold

360,000

Selling and administrative expenses

Other expense

Income before income taxes Income tax Net income

43,000

2,000

Add (Subtract)

Cash Basis

Increase in accounts receivable

$ (27,000)

$ 613,000

Increase in accounts payable Increase in inventories Depreciation expense

(15,000) 35,000 (15,000)

365,000

Decrease in prepaid expenses Increase in accrued liabilities Depreciation expense Amortization of patent Amortization of bond premium

$ (1,000) (3,000) (5,000) $ (3,000) 1,000

$ 235,000 92,000 $ 143,000

34,000

$ 214,000 Decrease in income taxes payable

10,000

102,000 $ 112,000

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1. Direct Approach Receipts from customers

$ 613,000

Payments to suppliers Selling and administrative expenses Income taxes paid Cash flows from operating activities

(365,000) ( 34,000) (102,000) $ 112,000

2. Indirect Approach Net income Add (deduct) items not affecting cash Depreciation Amortization of patent Amortization of bond premium Increase in accounts receivable Increase in accounts payable Increase in inventories Decrease in prepaid expenses Increase in accrued liabilities Decrease in income taxes payable

$ 143,000

Cash flow from operating activities

$ 112,000

20,000 3,000 (1,000) (27,000) 15,000 (35,000) 1,000 3,000 (10,000)

PROBLEM 10-7 Owens appears to be the growth firm. Operating activities may represent a use of cash because of the expansion of receivables and inventory. The expansion of fixed assets would use cash in investing activities. Financing activities are providing cash for expansion. Alpha appears to be the firm in danger of bankruptcy. Cash is used in operations, capital expenditures appear to be nominal, and financing activities are using instead of providing cash. Arrow appears to be the older firm expanding slowly. Arrow is generating significant cash from operating activities, while nominal cash is used for investing activities. Financing activities are using cash instead of providing cash (dividends, repayment of long-term debt, etc.).

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PROBLEM 10-8 a. BOYER COMPANY Schedule of Change from Accrual to Cash Basis Income Statement For the Year Ended December 31, 2011 Accrual Basis

Adjustments

Add (Subtract)

Cash Basis

Sales

$ 19,000

Increase in Receivables

$ (400)

$ 18,600

Less operating expenses: Depreciation Other operating expenses

2,300 12,000

Depreciation expense Increase in inventories Increase in accounts payable

(2,300) 800 (500)

Operating Income

$ 4,700

Loss on sale of land

1,500

Loss on sale of land

(1,500)

0 $ 6,300

400

1,400

Income before tax expense Tax expense

$ 3,200 1,000

Net income

$ 2,200

Decrease in income taxes payable

12,300 $ 6,300

$ 4,900

1. Direct Approach Receipts from customers Payments to suppliers Income taxes paid Cash flows from operating activities

$ 18,600 (12,300) (1,400) $ 4,900

2. Indirect Approach Net income Add (deduct) items not affecting cash: Depreciation Increase in receivables Increase in inventories Increase in accounts payable Loss on sale of land Decrease in income taxes payable Cash flow from operating activities

$ 2,200 $ 2,300 (400) (800) 500 1,500 (400)

2,700 $ 4,900

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PROBLEM 10-9 a.

Tightening of credit by suppliers could lead to cash flow problems.

For a profitable firm, a substantial decrease in receivables would not contribute to bankruptcy.

Change in notes payable to bands is not part of cash flows from operating activities.

d. 5 & 2

Proceeds from selling land is not part of cash flows from operating activities. (Note: 2 is also correct. There is no amortization of goodwill).

Cash inflows from operating activities represents an internal source of cash.

Revenue from services represents an operating inflow.

Inventory represents an operating activity.

Short-term investments in marketable securities is part of cash and cash equivalents.

Cash inflows from sale of property, plant, and equipment represents cash inflows related to investing activities.

The sale of common stock will increase working capital.

Working capital is defined as current assets less current liabilities.

Management should use the statement of cash flows to determine cash flow from investing activities.

This is a noncash investing and financing activity.

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PROBLEM 10-10 Cash Flows Classification Data a. Net income

Operating Activity

Investing Activity

Increase

Noncash Decrease Transaction

b. Paid cash dividend c. Increase in receivables

Financing Activity

Effect on Cash

d. Retirement of debt, paying cash

e. Purchase of treasury stock

f. Purchase of equipment

g. Sale of equipment

h. Decrease in inventory

X X X

i. Acquisition of land, using common stock

j. Retired bonds, using common stock

k. Decrease in accounts payable

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PROBLEM 10-11 a. THE LADIES STORE Statement of Cash Flows For the Year Ended December 31, 2011 Cash flow from operating activities: Cash receipts from customers Cash receipts from interest Cash payments for merchandise Cash payments for interest Cash payments for income taxes Net cash flow from operating activities

$ 150,000 $ 5,000 (110,000) (2,000) (15,000)

Cash flows from investing activities: Cash outflow for purchase of truck Cash outflow for purchase of investment Cash outflow for purchase of equipment Net outflow for investing activities

$ (20,000) (80,000) (45,000)

Cash flows from financing activities: Cash inflow from sale of bonds Cash inflow from issuance of note payable Cash inflow from financing activities

$ 100,000 40,000

Net increase in cash

$ 28,000

(145,000)

140,000 $ 23,000

b. The major inflow of cash was from financing activities. The major outflow of cash was for investing activities.

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PROBLEM 10-12 a. SAMPSON COMPANY Statement of Cash Flows For the Year Ended December 31, 2011

Net cash flow from operating activities: Net income Noncash expenses, revenues, losses, and gains included in income: Depreciation expense Increase in net receivables Increase in inventory Increase in accounts payable Decrease in accrued liabilities Net cash outflow from operating activities

$ 19,000

$ 10,000 (7,000) (13,000) 5,000 (17,000) (3,000)

Cash flows from investing activities: Plant assets increase Cash flows from financing activities: Mortgage payable increase Common stock increase Dividends paid Net cash flows from financing activities Net decrease in cash

(15,000)

$ 11,000 6,000 (21,000) (4,000) $ (22,000)

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b. SAMPSON COMPANY Statement of Cash Flows For Year Ended December 31, 2011

Cash flow from operating activities: Cash flow from customers ($145,000 – $7,000)

$ 138,000

Cash payments to suppliers ($108,000 – $10,000 + $13,000 – $5,000 + $17,000)

(123,000)

Cash outflow for other expenses

(6,000)

Tax payments

(12,000)

Net cash outflow from operating activities

$ (3,000)

Cash flows from investing activities: Plant assets increase

(15,000)

Cash flows from financing activities: Mortgage payable increase Common stock increase Dividends paid Net cash outflow from financing activities Net decrease in cash

$ 11,000 6,000 (21,000) (4,000) $ (22,000)

c. All major segments of cash flows were negative. Net cash outflow from operating activities was negative by $3,000, and yet dividends were paid in the amount of $21,000. Also, the company had a negative cash flow from investing activities. These negative cash flows were partially made up for by issuing a mortgage payable ($11,000) and common stock ($6,000). PROBLEM 10-13 a. Zaro had substantially more net cash flow from operating activities than it had net income. Major reasons for this were depreciation, decrease in accounts receivable, and decrease in inventory. The substantial cash flows from operating activities were used for investing activities and financing activities. Cash was particularly used for the financing activity of paying dividends. 283 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

1. Current Ratio: Current assets: Cash Accounts receivable, net Inventory Prepaid expense

Current Liabilities: Accounts payable Income taxes payable Accrued liabilities Current portion of bonds payable

(A) (B)

$ 25, 500 2,500 5,000 20,000 $ 53,000 (B)

$198,000 = 3.74 $53,000 to 1

2. Acid-Test Ratio: Cash Accounts receivable, net Current liabilities (A) (B)

$ 30,000 75,000 90,000 3,000 $ 198,000 (A)

$105,000 $53,000

$ 30,000 75,000 $ 105,000 (A) $ 53,000 (B)

1.98

3. Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable: Operating cash flow Current maturities of long-term debt and current notes payable (A) (B)

$51,000 $20,000

$ 51,000 (A) $ 20,000 (B)

2.55

4. Cash Ratio: Cash Current liabilities (A) (B)

$30,000 $53,000

$ 30,000 (A) $ 53,000 (B) =

0.57%

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1. Times Interest Earned: Income before taxes Plus interest expense

(A) (B)

$42,000 $8,000

$ 34,000 8,000 (B) $ 42,000 (A) 5.25 times per year

2. Debt Ratio: Total Liabilities: Accounts payable Income taxes payable Accrued liabilities Bonds payable

$ 25,500 2,500 5,000 90,000 $ 123,000 (A)

Total assets (A) (B)

$123,000 $253,000

$ 253,000 (B) =

48.62%

1. Return on assets: $20,000 ($253,000 + $274,000)/2

$20,000 $263,500

7.59%

2. Return on Common Equity: $20,000 ($85,000 + $54,000 + $85,000 + $45,000)/2

$20,000 = 14.87% $134,500 All liquidity ratios are very good.

The debt position is good.

Profitability is good.

Substantial cash flow came from operating activities. A relatively small amount of funds were used for investing activities and paying down bonds. This left substantial cash available.

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PROBLEM 10-14 a.

The usual guideline for the current ratio is two to one. Arrowbell Company had a 1.14 to 1 ratio in 2010 and a 0.85 to 1 ratio in 2011. The usual guideline for the acid-test ratio is one to one. Arrowbell Company had a 0.68 to 1 ratio in 2010 and a 0.49 to 1 ratio in 2011. The cash ratio dropped from 0.19 in 2010 to 0.12 in 2011. The working capital in 2008 was $197,958, and in 2011 it had declined to a negative $319,988. The short-term debt position appears to be very poor. Computation of Ratios Current Ratio

Current Assets Current Liabilities

2011 $1,755,303 = $2,075,291

Acid-Test Ratio

2010 $1,599,193 = $1,401,235

0.85

Cash Equivalents & Net Receivables & Marketable Securities Current Liabilities

2011 $250,480 + $760,950 = 0.49 $2,075,291

Cash Ratio

1.14

2010 $260,155 + $690,550 = 0.68 $1,401,235

Cash Equivalents & Marketable Securities Current Liabilities

2011 $250,480 = $2,075,291

2010 $260,155 = $1,401,235

0.12

Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable 2011 $429,491 = 46.93% $915,180

0.19

Operating Cash Flow Current Maturities of Long-Term Debt and Current Notes Payable 2010 $177,658 = 32.29% $550,155

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b. Suppliers will be concerned that Arrowbell Company will not be able to pay its creditors and, if payment is made, it will be later than the credit terms. The shortterm creditors are financing the expansion program. c. The debt ratio has increased in 2011 to 0.61 from 0.58 in 2010. The debt/equity ratio has increased in 2011 to 1.55 from 1.36 in 2010. (A similar increase in the debt to tangible net worth as the increase in the debt/equity ratio.) There was an improvement in the operating cash flow/total debt, but this ratio remains very low. This indicates that a substantial amount of funds are coming from creditors. In general, the dependence on creditors worsened in 2011. Not enough information is available to compute the times interest earned, but we can estimate this to be between 2 and 3, based on the earnings and the debt. We would like to see the times interest earned to be higher than this amount. The review of the Statement of Cash Flows indicates that long-term creditors are going to be concerned by the use of debt to expand property, plant, and equipment. They also are going to be concerned by the payment of a dividend while the working capital is in poor condition. Debt Ratio

2011 $2,625,291 = $4,316,598 Debt/Equity

2011 $2,625,291 = $1,691,307

Total Debt Total Assets 2010 $2,176,894 = $3,776,711

0.61

0.58

Total Debt Stockholders’ Equity 2010 $2,176,894 = $1,599,817

1.55

Debt to Tangible Net Worth

Total Liabilities Shareholders’ Equity – Intangible Assets

2011 $2,625,291 = 155.22% $1,691,307 – 0 Operating Cash Flow/Total Debt 2011 $429,491 = 16.36% $2,625,291

1.36

2010 $2,176,894 = 136.07% $1,599,817 – 0 =

Operating Cash Flow Total Debt

2010 $177,658 = 8.16% $2,176,894

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d. A banker would be especially concerned about the short-term debt situation. This could lead to bankruptcy, even though the firm is profitable. A banker would be particularly concerned why management had used short-term credit to finance longterm expansion. e. Management should consider the following or a combination of the following: 1. Discontinue the expansion program at this time and get the short-term debt situation in order. Tighten control of accounts receivable and inventory, along with using funds from operations to reduce short-term debt. 2. Issue additional stock to improve the short-term liquidity problem and the longterm debt situation. Because of the poor record on profitability and the way that management has financed past expansion, additional stock will probably not be well-accepted in the market place at this time.

PROBLEM 10-15 a. Bernett Company had a decrease in cash of $23,000, although net cash flow from operating activities was $21,000. Net cash provided by financing activities was $116,000, while net cash used by investing activities was $160,000. The cash flows from operations and financing activities were not sufficient to cover the very significant net cash used by investing activities. b.

1. Current Ratio: Current assets: Cash Accounts receivable Inventory Prepaid expense Total current assets

5,000 92,000 130,000 4,000 $ 231,000 (A)

Current Liabilities: Accounts payable Income taxes payable Accrued liabilities Current bonds payable Total current liabilities (A) (B)

$231,000 $70,000

$ 49,000 5,000 6,000 10,000 $ 70,000 (B) 3.30

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2. Acid-Test Ratio: Cash Accounts receivable

$ 5,000 92,000 $ 97,000 (A)

Total current liabilities (A) (B)

$97,000 $70,000

$ 70,000 (B) 1.39

3. Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable: Operating cash flow [from (a)] Current maturities of long-term debt and current notes payable (A) (B)

$21,000 $10,000

$ 21,000 (A) $ 10,000 (B)

2.10

4. Cash Ratio: Cash Total current liabilities (A) (B)

$5,000 $70,000

$ 5,000 (A) $ 70,000 (B) .0714%

1. Times Interest Earned: Income before taxes Plus interest expense

$ 99,000 11,000 $ 110,000 (A)

Interest expense

$ 11,000 (B)

(A) (B)

$110,000 $11,000

10 times per year

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2. Debt Ratio: Total Liabilities: Accounts payable Income taxes payable Accrued liabilities Bonds payable Total liabilities

$ 49,000 5,000 6,000 175,000 $ 235,000 (A)

Total assets

$ 411,000 (B)

(A) (B)

$235,000 $411,000

57.18%

3. Operating Cash Flow/Total Debt: Operating cash flow [from (a)]

$ 21,000 (A)

Total debt [from (c.2.)]

$ 235,000 (B)

(A) (B)

$21,000 $235,000

8.94%

1. Return on assets: Net income Average assets [($219,000 + $411,000)/2] (A) (B)

$69,000 $315,000

$ 69,000 (A) $ 315,000 (B)

21.90%

2. Return on Common Equity: Net income Average common equity [($96,000 + $50,000 + $106,000 + $70,000)/2] (A) (B)

$69,000 $161,000

$ 69,000 (A) $ 161,000 (B)

42.86%

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Operating Cash Flow/Cash Dividends: Operating cash flow [from (a)] Cash dividends (A) (B)

$21,000 $49,000

$ 21,000 (A) $ 49,000 (B)

0.43

f. In general, the liquidity ratios look very good except for the cash ratio. The cash ratio is approximately 7%. g. Overall, the debt position appears to be good. Times interest earned is very good, and the debt ratio and cash flow/total debt are good. h. The profitability appears to be extremely good. Both the return on assets and return on common equity are very high. i.

Operating cash flow/cash dividends indicates that operating cash flow was less than half the cash dividends.

Alternatives appear to be as follows: 1. Reduce the rate of expansion or possibly stop expansion at this time. This would reduce the need to increase receivables and inventory in the future and provide cash to pay accounts payable. 2. Issue additional long-term debt. 3. Issue additional common stock. Possibly a combination of these alternatives should be considered. This company is very profitable, has a good debt position, and in general a good liquidity position, except for the most immediate ability to pay its bills. This needs to be corrected or there is the possibility of bankruptcy. The growth rate of this company is very high. Immediate cash is needed to fund the growth.

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CASES CASE 10-1 TRAVEL COMPANY (This case provides the opportunity to review Priceline.Com for the period 2008-2010.) a. 1. Current ratio

Current Assets Current Liabilities

2010 $1,957,464 $471,168

2009 $1,022,941 $408,765

4.15

2.50

Material increase in current ratio. 2. Debt Ratio

Total Liabilities Total Assets

2010 $1,046,828 $2,905,953

2009 $476,610 $1,834,224

36.02%

25.98%

Material increase in debt ratio.

3. Total revenues

2010 163.7

Horizontal Common Size 2009 2008 124.06 100.0

Material increase in total revenues.

4. Gross Profit

2010 199.7

Horizontal Common Size 2009 2008 131.9 100.0

Material increase in gross profit.

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5. Net income

2010 284.5

Horizontal Common Size 2009 2008 263.7 100.0

Material increase in net income.

6. Per diluted common share 2010 276.74

2009 264.2

2008 100.0

Material increase in per diluted common share.

7. Net cash provided by operating activities 2010 246.3

2009 161.5

2008 100.0

Material increase in net cash provided by operating activities.

b. Very impressive results. The increase in the debt ratio could be considered a negative, but the resulting debt ratio is reasonable.

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CASE 10-2 CASH FLOW THE DIRECT METHOD (This case represents an opportunity to review a cash flow statement presented on a direct method.) a. ARDEN GROUP, INC. AND CONSOIDATED SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Fifty-Two Fifty-Two Weeks Weeks Ended Ended January 1, January 2, 2011 2010

Fifty-Two Weeks Ended January 3, 2009

$ 1,328,266 (1,214,551) 4,658 (290) (40,794) 77,289

$ 417,580 (384,624) 1,580 (94) (11,354) 23,088

$ 431,108 (391,957) 565 (87) (13,895) 25,734

$ 479,578 (437,970) 2,513 (109) (15,545) 28,467

(10,646) (85,155) 100,609 85 4,893

(2,597) (29,861) 51,926 16 19,484

(2,890) (30,164) 13,127 48 (19,879)

(5,159) (25,130) 35,556 21 5,288

(88,510) (88,510) (6,328) 58,919 82,585 52,591 76,257

(3,161) (3,161) 39,411

(3,161) (3,161) 2,694

(82,188) (82,188) (48,433)

13,180

10,486

58,919

Total Cash flows from operating activities: Cash received from customers Cash paid to suppliers and employees Interest and dividends received Interest paid Income taxes paid Net cash provided by operating activities Cash flows from investing activities: Capital expenditures Purchases of investments Sales of investments Proceeds from the sale of property, plant and equipment Net cash provided by (used in) investing activities Cash flows from financing activities: Cash Dividends Paid Net cash used in financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

52,591

13,180

b. Net Cash Provided by Operating Activities declined materially each year. Purchase of investments represented the major use of investing activities, while sales of investments represented the major source of cash from investments. Cash dividends paid was the only financing activity. Most of the dividends paid were in the first year. There was a decline in cash and cash equivalents. Cash and cash equivalents at end of year increased materially. 294 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

10,486

c. ARDEN GROUP, INC. AND CONSOIDATED SUBSIDIARIES STATEMENTS OF CASH FLOWS Fifty-Two Weeks Ended January 1, 2011 Inflows Separated from Outflows In Thousands Inflow Outflow Cash flows from operating activities: Cash received from customers Cash paid to suppliers and employees Interest and dividends received Interest paid Income taxes paid Net cash provided by operating activities Cash flows from investing activities: Capital expenditures Purchases of investments Sales of investments Proceeds from the sale of property, plant and equipment Net cash provided by (used in) investing activities Cash flows from financing activities: Cash dividends paid Net cash used in financing activities Changes in cash: Total cash inflows (outflows) Total cash outflow Net increase in cash

$ 417,580

Percent Inflow Outflow 88.6

384,624 1,580

419,160

89.1 0.3

94 11,354 396,072

90.0

2,597 29,681 51,926 16 51,942

0.6 6.9 11.0

32,2783 2,278

0.0 11.0

3,161 3,161 471,102 431,511 $ 431,691 39,591

0.0 2.6 91.7

431,511 431

7.5 0.7 0.7

100.0

Note: Some rounding differences

d. Cash received from customers represents approximately eight seven percent of cash inflow. Sales of investments represents eleven percent of cash inflow. Cash paid to suppliers and employees represents approximately eighty nine percent of cash outflow. Purchase of investments represents approximately seven percent of outflow.

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CASE 10-3 THE GLOBAL TECHNOLOGY (This case provides the opportunity to review a cash flow statement presented on the indirect method.) a. 1. Net income Net cash provided by operating activities

2008 100.0 100.0

2009 154.2 118.6

2010 201.2 141.1

2. Net income increased more than net cash provided by operating activities. b. Depreciation and amortization are added back to net income because they did not provide the company with any cash flow. They are simply non-cash charges. c. Yes. Acquisitions, net of cash acquired and proceeds received from divestiture, and purchases of intangible and other assets. d. These transactions represent significant investing and/or financing activities, and one purpose of the Statement of Cash Flows is to present investing and financing activities and disclose those activities that are non-cash transactions.

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CASE 10-4 THE RETAIL MOVER (This case represents a firm on the verge of bankruptcy. The company is W.T. Grant. The years in the case are not the actual years. a. 1. 2007 $ 628,408,895 366,718,656 261,690,239

Total current assets Total current liabilities Working capital

2008 $ 719,478,441 458,999,682 260,478,759

2011 $ 1,044,689,000 661,058,000 383,631,000

Working capital was fairly constant between 2007 and 2008. Working capital increased materially in 2011 in relation to 2008. 2. Current ratio Current Assets Current Liabilities

2007

2008

2011

1.71

1.57

1.58

The absolute current ratios appear to be too low. There was a substantial decline in the current ratio between 2007 and 2008. b. Net income Cash (outflow) from operating activities

2008 $ 39,577,000 $ (15,319,217)

2011 $ 10,902,000 $ (93,204,000)

A net increase in receivables and inventories were the major reasons for the substantial difference between net income and cash (outflow) from operating activities in both 2008 and 2011. c. There was an apparent write down in customers’ installment accounts receivable and merchandise inventories. The substantial decrease in deferred finance income is apparently related to the write down in customers’ installment accounts receivable. d. Company perspective The company was apparently desperate for liquidity. The company would have preferred a longer term, but under the circumstances would take whatever they could get. Bank perspective This loan appears to be a major blunder on the part of the bank. Apparently the short-term commercial notes were no longer available, probably because of the financial condition of the company. 297 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

CASE 10-5 NON-CASH CHARGES (Companies frequently announce noncash charges. This case provides an opportunity to discuss if noncash charges are noncash charges in the long run.) a. True. Cash inflow from operations will equal the revenue from operations in the long run. b. 1992 — $800 million 1992 – 1999. It was estimated that the accrual would be sufficient to cover the company’s uninsured costs for cases received until the year 2000. c. $545 million in 1996 Cash payments associated with charge will begin after the year 2000 and will be spread over 15 years or more. d. Cash inflow will be recorded when received. The related revenue will likely be recorded in the same period that the cash is received. This is an example of conservatism. e. If they do not win the suit, the expenses (cash outflow) for asbestos claims will likely be substantially higher than previously provided for. f. Asbestos related expenses (cash outflow) will likely be more than previously estimated. g. 1. 1996 — $875,000,000 2. 1997 — $97,000,000 1996 — $101,000,000 1995 — $251,000,000 3. 1997 — $300,000,000 1996 — $267,000,000 1995 — $308,000,000 Note: On Thursday, October 5, 2000, Owens Corning voluntarily filed a petition for reorganization under Chapter 11 bankruptcy protection in the United States Bankruptcy Court in Wilmington, Delaware.

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Owens Corning News release, January 17, 2003 “Owens Corning file Joint Plan of Reorganization with Asbestos Creditors in Chapter 11 Case.” . . . “The plan sets forth a proposed consensual framework to determine creditor distributions, with recoveries based on aggregate asbestos claims of $16 billion, and a preferred recovery to holders of bank claims of $400 million, in addition to pro rata recovery on the balance of their claims. . . .”

CASE 10-6 CASH MOVEMENTS AND PERIODIC INCOME DETERMINATION a. Income determination is not an exact science. A substantial amount of subjectivity is used in income determination. Many estimates are typically involved when determining income. b. Cash flow is determined in an objective manner. c. In theory, this is a true statement. United States accounting principles provide for by-passing the income statement for some apparent revenue or expense items. The balance of these items is presented in shareholders’ equity in the balance sheet. Examples are net unrealized loss in noncurrent marketable equity securities, cumulative foreign currency translation adjustments, and cumulative pension liability adjustments. In the long run the revenue (expense) from these items goes through the income statement. d. In the short run, a negative cash flow from operations could be compensated for by cash flow from investing and financing activities. e. Revenue and expense items that were more positive for income in the past than they were for cash flow will need to materialize in future cash flow. An example would be sales on account (credit). Collection will need to be made.

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CASE 10-7 THE BIG.COM (This case represents an opportunity to review Amazon.com over a 10-year period.) a. Except for 2001, when cash and cash equivalents, end of period declined, the net cash inflows increased. b. Debt ratio 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total liabilities (a) $2,205 $3,102 $3,077 $3,343 $3,198 $3,475 $3,450 $3,932 $5,288 $5,642 $8,556 $11,933 Total assets (b) $2,471 $2,135 $1,637 $1,990 $2,162 $3,249 $3,696 $4,363 $6,485 $8,314 $13,813 $18,797 Debt ratio % (a) ÷ 89.24 145.29 187.97 167.99 147.92 106.96 93.34 90.12 81.54 67.86 61.94 63.48 (b)

The debt ratio increased materially between 1999 and 2002 (total liabilities more than total assets). The debt ratio then declined materially between 2002 and 2009, with a slight increase in 2010 (total liabilities less than total assets). The trend is very positive. c. Net cash provided by financing activities (1998 – 2002) There was substantial cash provided by financing activities during the period of 1998 – 2002. d. The trend in net cash provided by operating activities 2002 – 2010 was very positive. It went from a negative amount in 2000 to very material net cash provided by operating activities. e. Net sales increased materially each year. The net income (loss) trended up materially, but with material fluctuations. f. Net loss was material in each of these years. The market apparently responded to these losses. Stockholders’ (deficit) was material and total liabilities was material. 1. Total market capitalization Outstanding shares of common stock (a) Market price per share (b) (a) x (b) 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

345 76.12

357 15.56

373 10.82

388 18.89

403 52.62

410 44.29

416 47.15

414 39.46

416 92.64

428 51.28

444 134.52

451 180.00

26,261,400,000 5,554,920,000 4,035,860,000 7,329,320,000 21,205,860,000 18,158,900,000 19,614,400,000 16,336,440,000 38,538,240,000 21,947,840,000 59,726,880,000 81,180,000,000

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2. Compare the total stock market price with total stockholders’ equity.

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Total Stock Market Price $26,261,400,000 5,554,920,000 4,035,860,000 7,329,320,000 21,205,860,000 18,158,900,000 19,614,400,000 16,336,440,000 38,538,240,000 21,947,840,000 59,726,880,000 81,180,000,000

Stockholders’ Equity $266,000,000 (967,000,000) (1,440,000,000) (1,353,000,000) (1,036,000,000) (227,000,000) 246,000,000 431,000,000 1,197,000,000 2,672,000,000 5,257,000,000 6,864,000,000

Total stock market price is materially more than the total stockholders’ equity. g. Price/earnings ratio 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Market price (a) $76.12 $15.56 $10.82 $18.89 $52.62 $44.29 $47.15 $39.46 $92.64 $51.28 $134.52 $180.00 Fully diluted earnings per share (b) ($2.20) ($4.02) ($1.53) ($0.40) .08 1.39 .78 .45 1.12 1.49 2.04 2.53 Price/earnings (a)/(b) * * * * 657.8 31.9 60.4 87.7 82.7 34.4 65.94 71.15

*Negative earnings h. Yes. Many positive items including the following: 1. Increase in sales 2. Increase in gross profit 3. Increase in net income 4. Increase in net cash provided in operating activities

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CASE 10-8 GLASS CONTAINERS (This case represents an opportunity to review a firm that has had material changes for asbestos.) a.

1. Current ratio Current assets (a) Current liabilities (b)

2010 $2,738 $2,079

2009 $2,797 $2,034

2008 $2,444.7 $2,003.0

(a) ÷ (b)

1.32

1.38

1.22

$7,728 $9,754

$6,991 $8,727

$6,683.1 $7,876.5

79.23%

80.11%

84.85%

$1,350 $6,633

$1,335 $6,652

$1,546 $7,540

20.35%

20.07%

20.50%

$592 $7,728 7.66%

$800 $6,991 11.44%

$757 $6,683.1 11.33%

2. Debt ratio Total liabilities (a) Total assets (b) (a) ÷ (b) 3. Gross profit margin Gross profit (a) Net sales (b) (a) ÷ (b) 4. Operating cash flow/total debt Operating cash flow (a) Total debt (b) (a) ÷ (b)

b. The current ratio has improved materially in 2009 and then declined in 2010. It appears to be relatively low. The debt ratio is relatively high but declined in 2009 and 2010. Gross profit margin was relatively stable. Operating cash flow / total debt increased slightly in 2009 and then decreased materially in 2010. c.

Asbestos related 1.

2010

Recognized in expense

$170

2009 Millions $180

2. Asbestos related payments

$179

$190

2008

$210

$250

3. The expense is related to an estimate related to that specific year. Cash payments represent specific cash payments during the period. 302 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

2010 Expense did not require cash Payments did require cash

d. 1. Capitalization Outstanding shares of common stock (a) Shares Issued (A) Treasury Stock (B) (A) – (B) = (C) Market Price (D) Capitalization (D) X (C)

----$179

2009 Millions ----$190

2008 ----$210

2010

2009

180,808,992 17,093,509 163,715,483 $30.70 $502,606,532.81

179,923,309 11,322,544 168,600,765 $32.87 $554,190,714.56

2. Total capitalization is materially more than shareowners’ equity.

CASE 10-9 SPECIALTY RETAILER (This case represents an opportunity to review the cash flow of three specialty retail stores.) a. There can be material differences between income and net cash provided by operating activities, as was the case with these firms. Following GAAP and accrual accounting, net income would be considered to be the better long run indicator. b. Abercrombie & Fitch Co. Operating cash provided by operating activities declined slightly while net income increased materially. There was no current maturities of long-term debt and current notes payable. Operating cash flow / total debt declined substantially. A slight decrease in operating cash flow per share declined slightly. Operating cash flow / cash dividends declined slightly.

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Limited Brands, Inc. Net cash provided by operating activities increased materially. Net income increased materially. No current maturities of long-term debt and current notes payable. Operating cash flow/total debt was approximately 25% and increased materially. Operating cash flow per share increased materially. Operating cash flow/cash dividends decreased materially.

GAP, Inc. Net cash provided by operating activities declined materially. Net income increased materially. No current maturities of long-term debt and current notes payable. Operating cash flow/total debt increased materially. Operating cash flow per share decreased slightly. Operating cash flow/cash dividends decreased materially. c. No. Most of the indicators were positive. Operating cash flow/cash dividends were low in 2010 for Limited Brands. This was caused by a very material increase in cash dividends.

CASE 10-10 EAT AT MY RESTAURANT – CASH FLOW (This case provides an opportunity to review the cash flow of three restaurant companies.) a. There was a material difference between net cash provided by operating activities and net income. The net cash provided by operating activities was usually materially higher. Under generally accepted accounting principles, net income would be the better indicator of long-term profitability.

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b. Yum Brands, Inc. Net cash provided by operating activities increased materially. Net income, including noncontrolling interest increased substantially. Operating cash flow/current maturities of long-term debt and current notes payable decreased materially. Operating cash flow/total debt increased materially. Operating cash flow per share increased materially. Operating cash flow/cash dividends increased materially.

Panera Bread Net cash provided by operating activities increased materially. Net income including noncontrolling interest increased materially. No current maturities of long-term debt and current notes payable in either year. Operating cash flow/total debt decreased materially but still was very high. Operating cash flow per share increased materially. There were no dividends.

Starbucks Net cash provided by operating activities increased materially Net income including noncontrolling interest increased materially. No current maturities of long-term debt and current notes payable. Operating cash flow/total debt increased materially and appears to be very good. Operating cash flow per share increased materially. Operating cash flow/cash dividends appears to be very good in 2010 and there was no cash dividend in 2009.

c. No. None of these firms appear to have a cash flow problem. All three firms did very good in 2010 in relation to 2009. 305 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 11 Expanded Analysis QUESTIONS 11- 1.

Based on the study reported in the text, liquidity and debt ratios are regarded as the most significant ratios by commercial loan officers.

11- 2.

(a) Debt/equity, current ratio (b) Debt/equity, current ratio

11- 3.

The dividend payout ratio does not primarily indicate liquidity, debt, or profitability. It is a ratio that is of interest to investors because it indicates the percentage of earnings that is being paid out in dividends. From a view of controlling a loan and preventing the stockholders from being paid before the bank is paid, the dividend payout ratio can be used as an effective ratio.

11- 4.

Based on the study reported in the text, financial executives do regard profitability ratios as the most significant ratios.

11- 5.

1) Earnings per Share – profitability 3) Return on Equity – profitability 5) Net Profit Margin – profitability

11- 6.

The CPAs gave the highest significance rating to two liquidity ratios. These ratios are the current ratio and the accounts receivable turnover days. The highest-rated profitability ratio was after-tax return on equity, while the highestrated debt ratio was debt/equity.

11- 7.

According to the study reported in this book, financial ratios are not used extensively in annual reports to interpret and explain financial statements. Likely reasons for this are that management does not want to interpret and explain the financial statements to the users, or management is of the opinion that interpretations and explanations can be made more effectively in a descriptive way rather than by the use of financial ratios. Also, there are no authoritative guidelines as to what financial ratios should be included in the annual report, except for earnings per share.

11- 8.

(a) Financial summary (c) Financial review (e) Management discussion

11- 9.

Profitability ratios and ratios related to investing are the most likely to be included in annual reports.

2) Debt/Equity – debt 4) Current Ratio – liquidity

(b) Management highlights (d) President’s letter

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Profitability ratios are the most popular ratios with management. Ratios related to investing are logical to be included in the annual report because one of the major objectives of the annual report is to inform stockholders. 11-10. Earnings per share is the only ratio that is required to be disclosed in the annual report. It must be disclosed at the bottom of the income statement. 11-11. Presently, no regulatory agency such as the Securities and Exchange Commission or the Financial Accounting Standards Board accepts responsibility for determining either the content of financial ratios or the format of presentation for annual reports. The exception to this is earnings per share. There are many practical and theoretical issues related to the computation of financial ratios. As long as each individual is allowed to exercise his/her opinion as to the practical and theoretical issues, there will be a great divergence of opinion on how a particular ratio should be computed. 11-12. Accounting policies that result in the slowest reporting of income are the most conservative. 11-13.

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k)

Conservative Yes No X X X X X X X X X X X

11-14. Substantial research and development will result in more conservative earnings because research and development expenses are charged to the period in which they are incurred. 11-15. Such a model could be used by management to take preventive measures. Such a model could aid investors in selecting and disposing of stocks. Banks could use this model to aid in loan decision making and in monitoring loans. Firms could use this model in making credit decisions and in monitoring accounts receivable. An auditor could use such a model to aid in the determination of audit procedures and in making a decision as to whether the firm will remain as a going concern. 307 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

11-16. There are many definitions or descriptions of financial failure. Financial failure can include liquidation, deferment of payments to short-term creditors, deferment of payment of interest on bonds, deferment of payment of principal on bonds, and the omission of a preferred dividend. 11-17. (a) Cash flow/Total debt (b) Net income/Total assets (return on assets) (c) Total debt/Total assets (debt ratio) 11-18. (a) (c)

Cash - low Inventory - low

(b) Accounts receivable - high

11-19. Firms that scored below 2.675 are assumed to have similar characteristics of past failures. 11-20.

Variable X4 in the model requires that the market value of the stock be determined. Determining the market value of the stock of a closely held company can be difficult if not impossible.

11-21.

False. These studies help substantiate that firms that have weak ratios are more likely to go bankrupt than firms that have strong ratios.

11-22.

The abnormally low turnover for accounts receivable indicates that a very detailed audit of accounts receivable should be performed to satisfy ourselves of the collectibility of the receivables.

11-23.

A proposed comprehensive budget should be compared with financial ratios that have been agreed upon as part of the firm's corporate objectives. If the proposed comprehensive budget will not result in the firm achieving its objectives, then attempts should be made to change the game plan in order to achieve the corporate objectives.

11-24.

1. 2. 3. 4.

Line Column Pie Bar

11-25.

1. 2.

Not extending the vertical axis to zero Having a broken vertical axis

11-26.

Visually, a pie graph can be misleading. Also, some accounting data do not fit on a pie graph.

11-27.

The surveyed analysts gave the highest significance ratings to profitability ratios.

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11-28. 11-29.

This statement is not true. Chartered Financial Analysts gave relatively low significance ratings to liquidity ratios. a. The proper use of estimates and judgments to prepare financial statements. b.

Some firms use estimates and judgments to improperly manipulate financial statements. Also some firms deliberately make errors to manipulate financial statements.

11-30.

No. Fundamental valuation typically uses one or more multiples. Multiples frequently used are price-to-earnings (PE), price-to-book, price-to-operating cash flow, and price-to-sales.

11-31.

True. The use of multiples and conventional financial reports is not well accepted by the traditional financial literature or many valuation books.

11-32.

True. There is ample evidence that the use of multiples is predominately in use by security analysts and fund managers.

11-33.

From the Barker study – (analysts and fund managers) They both “perceive their own assessment of company management to be the heart of investment decision-making.”

11-34.

Traditional financial statements are important when using fundamental analysis. Fundamental valuation typically uses one or more multiples that are related to the traditional financial statements. Traditional financial statements and perception of management help project the future.

11.35.

In an August, 2006 correspondence, the GAO made this comment related to its July, 2006 study: “Although there are many reasons for restatements, most restatements involve more routine reporting issues… and are not symptomatic of financial reporting, fraud and/or accounting errors.”

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PROBLEMS PROBLEM 11-1 a.

A decline in the number of days' sales outstanding will indicate tighter credit policies. Lower prices might cause more sales and receivables as would better credit terms. Lower sales would give lower sales per day, not an overall decline in days' sales.

Financial leverage causes magnification of changes in earnings and is only good strategy when earnings are stable.

This is basically the same as current assets - inventory.

The times interest earned ratio measures long-term borrowing ability and the risk inherent therein.

Net income plus income taxes and bond interest expense by annual bond interest expense would be a reasonable computation of times bond interest earned.

PROBLEM 11-2 PUSH FOR YEAR END SALES – ETHICAL? a. This promotion appears to be ethical and likely does not require special disclosure. b. This promotion may not be ethical without special disclosure describing the promotion and the risk. There needs to be a sales cutoff at December 31 not allowing for any guaranteed returns. Having a guaranteed return policy up until March of the following year violates the matching principle of accounting. PROBLEM 11-3 a.

An incorrect presentation in the financial statements should be corrected.

Collection of accounts receivable would increase cash but would not increase working capital.

From the expense side, writing off expenditures reduces income and reduces assets. From the revenue side, not recognizing revenue reduces income and assets.

This type of situation would have high expenses in relation to revenue. The plant expansion and start-up costs would increase financing requirements.

A high turnover of net working capital would indicate good management of working capital.

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PROBLEM 11-4 PROVISION FOR OBSOLETE INVENTORY – ETHICAL a. The current earnings will be reduced. The expense will be recognized in the current year and the reserve will be set up. b. No. The inventory will be reduced and the reserve account will be reduced. c. No. The obsolete inventory should be identified and written off in the current year. PROBLEM 11-5 a.

Multiperiod discounted earnings models is not an example of the use of a multiple when valuing common equity.

Discounted abnormal earnings and residual income.

Shareholders of acquired companies are often big winners of “receiving on average a 20 percent premium in a friendly merger.”

Overuse of conventional financial statements was not given as a reason for acquirers paying too much in an acquisition.

The authors referenced in the book maintain that the correct way to value dot.coms is by using the classic discounted-cash-flow (DCF) approach to valuating.

PROBLEM 11-6 The vertical axis does not start at zero.

PROBLEM 11-7 a. The current ratio has all current assets in the numerator, while in the acid-test ratio, inventory is removed. A large inventory would cause the lower acid-test ratio. The decline in the inventory turnover supports this conclusion. b. Financial leverage is the extent to which fixed costs of financing are used, namely debt. The greater the financial leverage, the greater the magnification of changes in earnings. The measures of debt, as indicated by total debt to total assets and long-term debt to total assets, have declined. This increases financial leverage. The firm has a decrease in leverage and the decline in profit to shareholders is indicative of it.

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c. The fixed asset turnover has risen, generally indicating either a rise in sales or a decline in fixed assets. Sales as a percent of 2009 sales are given. Assume 2009 sales were $100; 2010, $103, and 2011, $106. If $100/fixed assets = 1.75, then fixed assets = $57 in 2009 If $103/fixed assets = 1.88, then fixed assets = $55 in 2010 If $106/fixed assets = 1.99, then fixed assets = $53 in 2011 There has actually been a slight decline in net fixed assets. PROBLEM 11-8 2011 Net Income as Reported Net Change in Inventory Reserve: 2011 2010 (a) (b) Effective Federal Tax Rate (c) Change in Taxes (axb) (d) Net Change in Income (a-c) 2011 Approximate Income If Inventory Had Been Valued At Approximate Current Cost

$45,000,000

$20,000,000 28,000,000 ($8,000,000) 23.7% 1,896,000 (6,104,000) $38,896,000

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PROBLEM 11-9 a. 1. Rate of Return on Total Assets: Return on Assets Net Income Before Noncontrolling Interest and Nonrecurring Items Average Total Assets

- $0.2 ($19.7 + 19.4)/2

(-1.0%) Negative

The rate of return on total assets is negative in 2004, due to the negative net income figure. 2. Acid-Test Ratio: Cash Equivalents + Marketable Securities + Net Receivables Current Liabilities

$13.5 – $2.8 – $0.6 $9.3

1.09

3. Return on Sales: Net Profit Margin Net Income Before Noncontrolling Interest and Nonrecurring Items Net Sales

– $0.2 $24.9

(–0.8%) Negative

4. Current Ratio: Current Assets Current Liabilities

$13.5 $9.3

1.45

5. Inventory Turnover: Cost of Goods Sold Average Inventory

$18.0 ($3.2 + $2.8 )/2

6 times per year

b. 1. Rate of Return on Total Assets: Unfavorable. The rate is negative and has been declining. 2. Return on Sales: Unfavorable. The rate is low and has been declining.

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3. Acid-Test Ratio: Unfavorable. The direction of change is unfavorable, but it is probably more than adequate. 4. Current Ratio: Unfavorable. The decline has been sharp, and the ratio is probably too low. 5. Inventory Turnover: Neutral. Inventory turnover has been fairly constant, and we don't know enough about the business to determine if the turnover is adequate. 6. Equity Relationships: Unfavorable. The trend towards a heavy reliance on current liabilities is unfavorable. This high proportion of current liabilities could result in short-term liquidity problems. 7. Asset Relationships: Neutral. The reduction in the proportion of assets that are current could indicate that the firm is working its current assets harder. The reduction in the proportion of assets that are current could also indicate that there has been an expansion in property, plant, and equipment, without an adequate increase in current assets. c. The facts available from the problem are inadequate to make final judgment; additional information as listed in Part D would be necessary. However, the facts given do not present an overall good picture of D. Hawk. The company doesn't appear to be in serious trouble at the moment, but most of the trends reflected in figures are unfavorable. The company appears to be developing liquidity problems: 1. Cash and securities are declining. 2. Inventories and plant and equipment are an increasing portion of the assets. 3. Current liabilities are an increasing portion of debt. The operations of the company also show unfavorable trends: 1. Cost of goods sold is increasing as a percent of sales. 2. Administrative expenses are increasing as a percent of sales.

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3. Recognizing that prices have risen, it appears that physical volume at D. Hawk might have actually decreased. On the basis of these observations and the fact that D. Hawk would be a very large customer (thus a potentially large loss if the accounts become uncollectible), credit should be extended to D. Hawk only under carefully controlled and monitored conditions. d. Additional information would be: 1. Quality of management of D. Hawk Company 2. The locations of the D. Hawk stores 3. The current activities of D. Hawk, which have increased plant and equipment but not inventories 4. Industry position of D. Hawk Company 5. Credit rating of the D. Hawk Company 6. Current economic conditions 7. Capacity of L. Konrath Company to handle such a large single account 8. Normal ratios for the industry

PROBLEM 11-10 2011 Net Income as Reported Net Change in Inventory Reserve: 2011 2010 (a) (b) Effective Federal Tax Rate (c) Change In Taxes (a x b) (d) Net Change In Income (a-c) 2011 Approximate Income If Inventory Had Been Valued At Approximate Current Cost

$90,200,000

$50,000,000 46,000,000 $ 4,000,000 37.9% $ 1,516,000 2,484,000 $92,684,000

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PROBLEM 11-11 a. Liquidity Ratios: 1. Days' Sales in Inventory $63,414 $495,651/365

Ending Inventory Cost of Goods Sold/365

$63,414 $1,357.95

2. Merchandise Inventory Turnover $495,651 ($63,414 + $74,890)/2

46.70 days

Cost of Goods Sold Average Inventory

$495,651 $69,152

Average Inventory Cost Of Goods Sold/365

Inventory Turnover in Days

($63,414 + $74,890)/2 $495,651/365

$69,152 $1,357.95

Operating Cycle

Accounts Receivable Turnover in Days

7.17 times per year

50.92 days

Inventory Turnover in Days

Average Gross Receivables Net Sales/365

($99,021 + $750 + $83,575 + $750)/2 $578,530/365

$92,048 $1,585.01

58.07 days

58.07 days + 50.92 days = 108.99 days

Working Capital $227,615

–

Current Assets

$73,730

= $153,885

– Current Liabilities

Current Assets Current Liabilities

Current Ratio

$227,615 = $73,730

3.09

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Acid-Test Ratio

Cash Equivalents + Marketable Securities + Accounts Receivable Current Liabilities

$64,346 + $99,021 $73,730

Cash Ratio $64,346 $73,730

2.22

Cash Equivalents + Marketable Securities Current Liabilities

0.87

Debt: 1.

Debt Ratio $172,180 $370,264

Debt/Equity $172,180 $198,084

Total Liabilities Total Assets

46.50%

Total Liabilities Shareholders' Equity

86.92%

Recurring Earnings, Excluded Interest Expense, Tax Expense, Equity Earnings, and Noncontrolling Interest Interest Expense, Including Capitalized Interest

Times Interest Earned

$43,138 + $4,308 $4,308

$47,446 $4,308

11.01 times per year

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Profitability:

Net Income Before Noncontrolling Interest, Equity Income and Nonrecurring Items Net Sales

Net Profit Margin

$23,018 $578,530

3.98%

Total Asset Turnover

$578,530 ($370,264 + $295,433)/2

Return on Assets

Return on Total Equity

$23,018 ($198,084 + $175,583)/2

$578,530 $332,848.5

1.74 times per year

Net Income Before Noncontrolling Interest and Nonrecurring Items Average Total Assets

$23,018 ($370,264 + $295,433)/2

Net Sales Average Total Assets

$23,018 $332,848.5

6.92%

Net Income Before Nonrecurring Items – Dividends on Redeemable Preferred Stock Average Total Equity

$23,018 $186,833.5

12.32%

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b. Approximate income for 2011 if inventory had been valued at approximate current cost: 2011 net income as reported Net decrease in inventory reserve 2011 2010 (a) (b) Effective tax rate (c) Decrease in taxes (a) x (b) (d) Net decrease in income [(a) - (c)] $5,800 - $2,123

$ 23,018 $ 35,300 41,100 $ (5,800) 36.6% $ 2,123

(3,677)

Approximate income for 2011 if inventory had been valued at approximate current cost Inventory adjusted: As disclosed on the balance sheet Increase in inventory

$ 19,341

$ 63,414 35,300 $ 98,714

Deferred current tax liability: Increase related to inventory reserve $35,300 x 36.6% =

12,920

Retained earnings adjusted: As disclosed on the balance sheet Increase related to inventory reserve ($35,300 – $12,920)

$ 154,084 22,380 $ 176,464

Liquidity: 1. Days' Sales in Inventory $63,414 + $35,300 $495,651/365

$98,714 $1,357.95

72.69 days

2. Merchandise Inventory Turnover $495,651 $495,651 = = 4.62 times per year ($63,414 + $35,300 + $74,890 + 41,100)/2 $107,352 319 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

3. Inventory Turnover in Days $107,352 $495,651/365

$107,352 $1,357.95

79.05 days

4. Operating Cycle 58.07 days + 79.05 days = 137.12 days

5. Working Capital ($227,615 + $35,300) – ($73,730 + $12,920)*

$176,265

*$35,300 x $36.6% = $12,920

6. Current Ratio $262,915 = $86,650

3.03

7. Acid-Test Ratio $64,346 + $99,021 $73,730 + $12,920

$163,367 $86,650

$64,346 $86,650

1.89

8. Cash Ratio $64,346 $73,730 + $12,920

0.74

Debt: 1.

Debt Ratio $370,264 – $198,084 + $12,920 $370,264 + $35,300

$185,100 $405,564

45.64%

$185,100 $220,464

83.96%

Debt/Equity $370,264 – $198,084 + $12,920 $198,084 + $22,380

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3. Times Interest Earned $43,138 + $4,308 – $5,800 $4,308

$41,646 $4,308

9.67 times per year

Profitability: 1. Net Profit Margin $23,018 – $3,677 $578,530

$19,341 $578,530

3.34%

2. Total Asset Turnover $578,530 ($370,264 + $295,433 + $35,300 + $41,200)/2 $578,530 $742,097/2

$578,530 $371,049

1.56 times per year

3. Return on Assets $23,018 – $3,677 ($370,264 + $295,433 + $35,300 + $41,200)/2 $19,341 $371,049

5.21%

4. Return on Total Equity $19,341 ($198,084 + $175,583 + $22,380 + $28,482*)/2

*$41,100 x (1 – 30.7%) $41,100 x 69.30% = $28,482.30 $19,341 $212,265

9.11%

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c. Without considering the LIFO reserve

Considering the LIFO reserve

46.70 days

72.69 days

7.17 times per year 50.92 days 108.99 days $153,885 3.09 2.22 .87

4.62 times per year 79.05 days 137.12 days $176,265 3.03 1.89 .74

Debt: Debt ratio Debt/equity Times interest earned

46.50% 86.92% 11.01 times per year

45.64% 83.96% 9.67 times per year

Profitability: Net profit margin Total asset turnover Return on assets Return on total equity

3.98% 1.74 times per year 6.92% 12.32%

3.34% 1.56 times per year 5.21% 9.11%

Ratio Liquidity: Days’ sales in inventory Merchandise inventory turnover Inventory turnover in days Operating cycle Working capital Current ratio Acid-test ratio Cash ratio

All but one liquidity ratio was less favorable when considering the LIFO reserve. Some of the liquidity ratios declined substantially. The only liquidity indicator to improve was working capital. Debt ratios were slightly more favorable when considering the LIFO reserve. Most profitability measures declined moderately when the LIFO reserve was considered, and return on total equity declined substantially.

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PROBLEM 11-12 a. X1

Working Capital Total Assets

$152,800 = $494,500

30.90

Retained Earnings Total Assets

$248,000 = $494,500

50.15

E.B.I.T Total Assets

$84,000 = $494,500

16.99

Market Value of Equity Book Value of Total Debt

$690,000 = 344.14 $200,500

Sales Total Assets

$860,000 = 173.91 $494,500

Z = .012X1 + .014X2 + .033X3 + .006X4 + .010X5 Z = 0.012 x 30.90 + 0.014 x 50.15 + 0.033 x 16.99 + 0.006 x 344.14 + 0.010 x 173.91

Z = 0.37 + 0.70 + 0.56 + 2.06 + 1.74

Z = 5.43

b. No. In a study using 1970-1973, a Z score of 2.675 was established as a practical cutoff point. The Z score for General Company is substantially above 2.675.

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PROBLEM 11-13 1. Decreases retained earnings, increases payables a, c, g, i, j 2. Reduces retained earnings, increases common stock f, g, i 3. Increases cash, increases retained earnings b, d, h 4. This creates an arrearage, which would increase the amount for preferred stock in calculating book value for common i 5. This merely increases the number of shares. No effect until the stock is sold. d (assumption that the preferred shares would be held as a temporary investment) 6. Decreases cash, decreases dividends payable; increases current ratio if originally more than 1:1 d 7. No change in equity, but more shares; therefore reduces equity per share of common stock i

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PROBLEM 11-14 a. A Company Z Score

Working Capital Total Assets

$90,000 $300,000

30.00

Retained Earnings Total Assets

$80,000 $300,000

26.67

E.B.I.T. Total Assets

$70,000 $300,000

23.33

Market Value of Equity Book Value of Total Debt

$180,000 $30,000

600.0

Sales Total Assets

$430,000 $300,000

143.33

= .012X1 + .014X2 + .033X3 + .006X4

Z = 0.012 + 0.014 + 0.033 + 0.006 + 0.010 Z = + + + +

+ .010X5

x 30.00 x 26.67 x 23.33 x 600.00 x 143.33

0.36 0.37 0.77 3.60 1.43

Z = 6.53

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B Company Z Score X1

Working Capital Total Assets

$120,000 = 42.86 $280,000

Retained Earnings Total Assets

$90,000 = 32.14 $280,000

E.B.I.T. Total Assets

$60,000 = 21.43 $280,000

Market Value of Equity Book Value of Total Debt

$168,750 = 337.50 $50,000

Sales Total Assets

$400,000 = 142.86 $280,000

Z = .012X1 + .014X2 + .033X3 + .006X4 + .010X5 Z = 0.012 x 42.86 + 0.014 x 32.14 + 0.033 x 21.43 + 0.006 x 337.50 + 0.010 x 142.86 Z = 0.51 + 0.45 + 0.71 + 2.03 + 1.43

Z = 5.13

C Company Z Score X1

Working Capital Total Assets

$150,000 = $250,000

60.00

Retained Earnings Total Assets

$60,000 = $250,000

24.00

E.B.I.T Total Assets

$50,000 = $250,000

20.00

Market Value of Equity Book Value of Total Debt

$148,500 = 185.63 $80,000

Sales Total Assets

$200,000 = $250,000

80.00

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Z = .012X1 + .014X2 + .033X3 + .006X4 + .010X5 Z = 0.012 x 60.00 + 0.014 x 24.00 + 0.033 x 20.00 + 0.006 x 185.63 + 0.010 x 80.00 Z = 0.72 + 0.34 + 0.66 + 1.11 + 0.80

Z = 3.63

b. All of these companies appear to have good financial condition. The company with the lowest score is Company C; therefore, Company C is most likely to experience financial failure.

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PROBLEM 11-15 a. Argo Sales Corporation Balance Sheet December 31, 2011 Current assets: Cash Marketable securities Accounts receivable Inventory Prepaid expenses (10) Total current assets

(14)

Fixed assets: Land, buildings, and equipment Less accumulated depreciation Total fixed assets

(13)

Intangible assets

(12)

Total assets

(9)

Current liabilities: Accounts payable Accrued expenses payable Total current liabilities

(21)

Long-term liabilities: 5% Bonds payable - due 2020

(20)

Total liabilities

Stockholders’ Equity: 6% Preferred stock, $100 par value, 500 shares authorized, issued and outstanding (25) Common stock, $10 par value, $22,500 shares authorized, issued and outstanding (22) Contributed capital in excess of par value Retained earnings (19) Total stockholders' equity

(28)

Total liabilities and stockholders' equity

$ 20,000 (6) 80,000 (7) 150,000 (5) 120,000 (8) 5,000 (11) $375,000

$292,500 (15) 97,500 (16) 195,000 30,000 $600,000

$100,000 (17) 25,000 (18) $125,000

75,000 $200,000

$ 50,000 (24)

225,000 (23) 27,500 (26) 97,500 (27) 400,000

$600,000

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Argo Sales Corporation Income Statement For the Year Ended December 31, 2011 (1) Net sales

$1,200,000

(3) Less cost of goods sold

720,000

(2) Gross profit on sales

480,000

Selling expenses Administrative expenses Interest expense Net income

$240,000 (4) 116,250 (30) 3,750 (29)

360,000 $ 120,000

Notes: Supporting Computations for Amounts on Financial Statements (1) Sales

Net Income Net Profit Rate

$120,000 0.10

$1,200,000

(2) Gross Profit: Sales x Gross Profit Rate = $1,200,000 x 0.40 = $480,000 (3) Cost Of Goods Sold: Sales – Gross Profit = $1,200,000 – $480,000 = $720,000 (4) Selling Expenses: Sales x Selling Expenses Rate: $1,200,000 x 0.20 = $240,000 (5) Accounts Receivable: Sales Accounts Receivable Turnover

$1,200,000 8

$150,000

$150,000 0.60

(6) Cash: Quick assets

Accounts Receivable Percent of Accounts Receivable in Quick Assets

$250,000

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7) Marketable Securities: Quick Assets x Percent of Quick Assets in Securities = $250,000 x 0.32 = $80,000 (8) Inventory

Cost of Goods Sold $720,000 = Inventory Turnover 6

$120,000

(9) Current Liabilities

Quick Assets 2*

$250,000 2

$125,000

*From Acid-Test Ratio (10)

Current Assets: Current Liabilities x 3* = $125,000 x 3 = $375,000 *From Current Ratio

(11)

Prepaid Expenses: Current Assets – (Cash + Securities + Receivables + Inventory) = $375,000 – ($20,000 + $80,000 + $150,000 + $120,000) = $5,000

(12) Total Assets

Sales Asset Turnover

$1,200,000 2

$600,000

$600,000 20

$30,000

(13) Intangible Assets

Total Assets 20*

*From Ratio Of Total Assets To Intangibles (14)

Fixed Assets (Net): Total Assets - (Current Assets + Intangibles) $600,000 – ($375,000 + $30,000) = $195,000

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(15)

Land, Buildings, and Equipment: Let: A = land, buildings, and equipment D = accumulated depreciation N = net fixes assets A – D = N A – [(A/3*)] = $195,000 x 2/3A = $195,000 A = $292,500 *From Ratio of Depreciation to Cost

(16)

Accumulated Depreciation: Land, Buildings and Equipment 3*

$292,500 3

$97,500

*From Ratio of Depreciation to Cost (17) Accounts Payable

Accounts Receivable 1.5*

$150,000 1.5

$100,000

*From Ratio of Accounts Receivable to Accounts Payable (18)

Accrued Expenses Payable: Current Liabilities – Accounts Payable = $125,000 – $100,000 = $25,000

(19)

Total Stockholders' Equity: Working Capital x 1.6* = 1.6 x ($375,000 – $125,000) = $400,000 *From Ratio of Working Capital to Stockholders' Equity

(20)

Total Liabilities: Total Assets – Stockholders' Equity = $600,000 – $400,000 = $200,000

(21)

5% Bonds Payable – Due 2017: Total Liabilities – Current Liabilities = $200,000 – $125,000 = $75,000

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(22) Common Stock Shares

Net Income – Preferred Dividends Earnings Per Share

$120,000 – $3,000 $5.20

22,500 Shares

(23) Common Stock Shares x Par Value = $22,500 x $10 = $225,000 (24) Preferred Stock

Preferred Dividends Dividend Rate

$3,000 0.06

$50,000

(25) Preferred Stock Shares =

Preferred Stock = Par Value

$50,000 $100

500 shares

(26) Contributed Capital in Excess of Par Value: Common x % Premium = $225,000 x 0.10 Preferred x % Premium

$22,500 5,000 = $50,000 x .10 $27,500

(27) Retained Earnings: Stockholders' Equity – (Common + Preferred + Premium) = $400,000 – ($225,000 + $50,000 + $27,500) = $97,500 (28)

Total Liabilities and Stockholders’ Equity: Total Assets = Total Liabilities and Stockholders' Equity Total Assets = $600,000 (from 12)

(29)

Interest Expense: Bonds Payable x Interest Rate = $75,000 x 0.05 = $3,750

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(30)

Administrative Expenses: Gross profit Less net income Total expenses Less: Selling expenses Interest Administrative expenses

$ 480,000 120,000 360,000 $ 240,000 3,750 243,750 $ 116,250

Proof statistics supplied: 1. Debt to Equity Ratio = $200,00 to $400,000 = 1 to 2 2. Times Interest Earned = Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings and Minority Income = $120,000 + $3,750 = 33 times per year Interest Expense, Including $3,750 Capitalized Interest b. 1. Rate of Return on Stockholders' Equity: Net Income Before Nonrecurring Items Total Equity

$120,000 = 30% $400,000

2. Price-Earnings Ratio for Common Stock: Market Value Per Share to Earnings Per Share $78.00 to $5.20 = 15 to 1 3. Dividends Paid Per Share Of Common Stock: Net income Less dividends on preferred stock Dividends on common stock Dividends on Common Shares of Common

$120,000 3,000 $117,000

$117,000 22,500

$5.20

4. Dividends Paid Per Share of Preferred Stock: Dividends On Preferred Shares Of Preferred

$3,000 500 shares

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Yield on Common Stock: Dividends Per Share Market Value

$5.20 $78.00

6 2/3 %

PROBLEM 11-16 a.

Calcor Company Pro Forma Income Statement For the Year Ending November 30, 2012

Net sales ($8,400,000 x 1.05 x 1.10) Expenses: Cost of goods sold ($6,300,000 x 1.05 x 1.04) Selling expense ($780,000 + $420,000) Administrative expense Interest expense [$140,000 + ($300,000 x .10)] Total expense Income before income taxes Income taxes Net income

$9,702,000 6,879,600 1,200,000 900,000 170,000 9,149,600 552,400 220,960 $ 331,440

b. President Kuhn's entire goal is not achieved because the return on sales (8 percent) and the turnover of average assets (five times per year) are not met. However, the return on average assets before interest and taxes, which is a multiplication of the first two ratios, would be achieved. This is reflected by the calculation of the following ratios. 1.

Return on Sales Before Interest and Taxes

Income Before Interest and Taxes Sales

$552,400 + $170,000 $9,702,000

$722,400 $9,702,000

7.4%

The goal of an 8 percent return on sales before interest and taxes would not be achieved (7.4% < 8%).

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2. Turnover of Average Assets

*2008 Average Assets

Sales Average Assets

$9,702,000 $2,100,000* + $300,000

4.0425 times per year

2008 Sales 2008 Turnover of Average Assets

$8,400,000 4

$2,100,000

The goal of a turnover of average assets of 5 times would not be achieved (4.0425 < 5). 3.

Return on Average Assets Before Interest and Taxes

Income Before Interest and Taxes Average Assets

$552,400 + $170,000 $2,100,000 + $300,000

$722,400 $2,400,000

30.1%

The goal of return on average assets before interest and taxes of 30 percent would be achieved.

c. No. Return on average assets before interest and taxes (third goal) is equal to return on sales before interest and taxes (first goal) times turnover of average assets (second goal). If Calcor Company achieved the first two goals, the return on average assets before interest and taxes would be at least 40 percent (0.08 x 5), which is greater than the goal of 30 percent.

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PROBLEM 11-17 Current Assets Current Liabilities

a. 1. Current Ratio:

2010 $235,000 $132,500

1.77 to 1

2.00 to 1

Cash Equivalents & Marketable Securities & Net Receivables Current Liabilities

2. Acid-Test Ratio:

2010 $185,000 $132,500

2011 $290,000 $145,000

2011 $210,000 $145,000

1.40 to 1

1.45 to 1

Cost of Goods Sold Average Inventory

3. Inventory Turnover: 2011 $1,902,500 ($50,000 + $80,000)/2

4. Return on Assets:

29 times per year

Net Income Before Noncontrolling Interest and Nonrecurring Items Average Total Assets

2010 $120,000 $881,000

13.62 (Average Assets not Available)

2011 $151,000 $881,000 + $970,000/2

16.32%

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5. Percent Changes: Amounts (000s omitted) 2011

2010

Sales

$3,000.0

$2,700.0

$3000 $2,700.0

= 111.11 %

Cost of goods sold

$1,902.5

$1,720.0

$1902.5 $1,720.0

= 110.61 %

Gross profit

$1,097.5

$980.0

$1097.5 5 $980.0

111.99 %

$151.5

$120.0

$151.5 $120.0

126.25 %

Net income after taxes

Percent

b. Other financial reports and financial analyses which might be helpful to the commercial loan officer of Bell National Bank include:  Statement of cash flows would highlight the amount of cash flows from operations, investing, and financing activities  Projected financial statements for 2012. In addition, a review of Warford's comprehensive budgets might be useful. These items would present management's estimates of operations for the coming year, as well as investing and financing activities.  A closer examination of Warford liquidity by calculating some additional ratios such as days’ sales in receivables, accounts receivable turnover, and days' sales in inventory  An examination as to the extent that leverage is being used by Warford

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c. Warford Corporation should be able to finance the plant expansion from internally generated funds as shown in the calculations presented below.

Sales Cost of goods sold Gross profit Operating expenses Income before taxes Income taxes (40%) Net income

2011

(000's omitted) 2012

2013

$ 3,000.0 1,902.5 $ 1,097.5 845.0 $ 252.5 101.0 $ 151.5

$ 3,333.3 2,104.3 $ 1,229.0 910.2 $ 318.8 127.5 $ 191.3

$ 3,703.6 2,327.6 $ 1,376.0 973.5 $ 402.5 161.0 $ 241.5

102.5

(75.0) (7.0) 211.8 (150.0) 61.8

(75.0) (60.0) 209.0 (150.0) 59.0

Add: Depreciation Deduct: Dividends Note interest and repayments Funds available for plant expansion Plant expansion Excess funds

Assumptions:  Sales increase at a rate of 11.1%.  Cost of goods sold increases at a rate of 10.6%.  Net income after tax increases at a rate of 26.25%.  Depreciation remains constant at $102,500.  Dividends remain at $1.25 per share.  Plant expansion is financed equally over the two years ($150,000 each year).  Loan extension is granted. d. Bell National Bank should probably grant the extension of the loan, if it is really required, because the projected cash flows for 2012 and 2013 indicate that an adequate amount of cash will be generated from operations to finance the plant expansion and repay the loan. In actuality, there is some question whether or not Warford needs the extension because the excess funds generated from 2011 338 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

operations might cover the $60,000 loan repayment. However, Warford may want the loan extension to provide a cushion because their cash balance is low. The financial ratios indicate that Warford has a solid financial structure. If the bank wanted some extra protection, it could require Warford to appropriate retained earnings for the amount of the loan and/or restrict cash dividends for the next two years to the 2011 amount of $1.25 per share.

PROBLEM 11-18 a.

Current Ratio $30,000 – $2,000 $12,000 – $2,000

Current Assets Current Liabilities

$28,000 $10,000

Quick (Acid-Test) Ratio

Cash Equivalents + Marketable Securities + Net Receivables Current Liabilities

$6,000 + $6,600 - $2,000 $12,000 – $2,000

= 2.8 to 1.00

$10,600 = 1.06 to 1.00 $10,000

A two-for-one common stock split would result in doubling the number of common shares. It would result in the par value being reduced from $1.00 to 50¢. It would not influence retained earnings or total stockholders' equity. Each $1,000 bond that was convertible into 300 shares of common stock would now be convertible into 600 shares of common stock.

$36,000 – $6,000 20

$30,000 20

$1,500 Per Year

$13,500 ÷ $1,500 = 9

Book Value

Total Stockholders’ Equity – Preferred Stock Equity Number of Common Shares Outstanding

$48,200 – 0 20,000 Shares

$2.41

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2 Sales Gross profit Cost of goods sold Cost of goods sold Divided by turnover Average inventory

$90,000,000 20 percent 80 percent $72,000,000 5 14,400,000

Ending inventory $16,000,000 Beginning inventory ? (a) Total ? (b) Total inventory = Average inventory x 2 = $14,400,000 x 2 = $28,800,000 = ($28,800,000) less ending inventory ($16,000,000) = Beginning inventory $12,800,000 g.

Payout ratio of 80 percent (this is,80 percent of net income is being paid out in dividends): $4,000,000 = .8X X = $5,000,000 (Net income) Retained earnings, November 30, 2011 Less net income for year Plus dividends Retained earnings, December 1, 2010

$16,000 (5,000) 4,000 $15,000

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PROBLEM 11-19 a.

Cash Equivalents + Marketable Securities + Net Receivables Current Liabilities $400 + $1,700 $2,400

$2,100 $2,400

Average Receivables Net Sales/365

.88

Net Sales Average Total Assets

$28,800 ($8,500 + $9,500) ÷ 2

3.2 times per year

Cost of Goods Sold Average Inventory

$15,120 ($2,120 + $2,200) ÷ 2

7.0 times per year

Operating Income Net Sales

8.3%

Dividends Per Share Fully Diluted Earnings Per Share

($1,500 + $1,700) ÷ 2 $28,800/365

20.28 days

Recurring Earnings Before Interest and Tax = $1,200 + $400 + $800 = 6.00 times per year Interest Expense $400

$1,200 + $800 + $400 $28,800

= The data for this formula is not provided. Since there is no preferred stock, the following formula will also give the correct answer: Cash Dividends Net Income

$400 $1,200

33.3%

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CASES CASE 11-1 SMOKE AND SMOKELESS (This case provides the opportunity to review LIFO reserve, undistributed foreign earnings and stock split.) a. 1. 2010 Net earnings (in millions): $1,113 Net increase in inventory reserve: 2010 2009

$197 190 $7

2. Effective tax rate: 39.4% 3. Change in Taxes $7 X 39.4%

2.76

4. Net increase in Income [1 – 3] $7 – 2.76

4.24

5. Estimated Adjusted Income 2010 Net Earnings Net Increase in Income

b. 1. Days' Sales in Inventory $1,055 $4,544/365

$ 1,113.00 4.24 $ 1,117.24 =

$1,055 12.45

Ending Inventory Cost of Goods Sold/365 =

84.74 days

2. Working Capital

Current Assets – Current Liabilities

$4,802 – $4,372

$430

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3. Current Ratio $4,802 $4,372

1.10

4. Acid-Test Ratio

$2,195 + $118 $4,372

5. Debt Ratio

Current Assets Current Liabilities

Cash Equivalents + Marketable Securities + Net Receivables Current Liabilities $2,313 $4,372

.53%

Total Liabilities Total Assets

$4,372 + $3,701 + $518 + $1,668 + $309 $17,078

$10,568 $17,078

61.88%

c. 2010, with Adjustment for LIFO Reserve Computations of Changes Inventory Inventory Reported Increase in Inventory Adjusted inventory

$ 1,055 197 $ 1,252

Cost of Goods Sold Reported Net Increase in Inventory Reserve Adjusted Cost of Goods Sold

$ 4,544 (7) $ 4,537

Current Assets Reported Increase in Inventory Adjusted Current Assets

$ 4,802 197 $ 4,999

Current Liabilities Reported Increase in Taxes Adjusted Current Liabilities

$ 4,372.00 2.76 $ 4,374.76

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Total Liabilities Reported Increase in Taxes Adjusted Total Liabilities

$ 10,568.00 2.76 $ 10,570.76

Total Assets Reported Increase in Inventory Adjusted Total Assets 1. Days' Sales in Inventory $1,252 $4,537/365

2. Working Capital $4,999 – $4,374.76

3. Current Ratio $4,999 $4,374.76

100.72 days

Current Assets – Current Liabilities

$624.24

Current Assets Current Liabilities

$1,252 12.43

$ 17,078 197 $ 17,275 Ending Inventory Cost of Goods Sold/365

1.14

4. Acid-Test Ratio

$2,195 + $118 $4,374.76

Cash Equivalents + Marketable Securities + Net Receivables Current Liabilities $2,313 $4,374.76

5. Debt Ratio

Total Liabilities Total Assets

$10,570.76 $17,275

.61

.53

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d. Days Sales in Inventory Working Capital $ Current Ratio Acid-Test Ratio Debt Ratio

No Adjustment 84.74 Days 430 1.10 .53 61.88%

Adjustment 100.72 Days $ 624.24 1.14 .53 61.19%

Days’ Sales in Inventory increased materially, as did working capital. e. 2009 Financial Statements Diluted income per share for 2009 and 2008 2009 2008

$ $

1.65 2.28

f. 125 million This is conservative. The firm may increase its planned overseas investments and not be required to pay this tax. Note: The following is the inventory reserve for 2007 – 2010: 2007 2008 2009 2010

$ 51,000,000 112,000,000 190,000,000 197,000,000

The amount of inventory reserve can change materially as can the change in inventory reserve. This will influence the impact on the ratios.

CASE 11-2 ACCOUNTING HOCUS-POCUS (This case represents an opportunity to review the comments of Chairman, Arthur Levitt, Securities and Exchange Commission.) a. “Big Bath” With a “Big Bath,” substantial charges are recognized; this helps “clean up” the balance sheet. The stock market tends to look beyond a one-time loss and focus on future earnings. b. In an acquisition, if there is a large write off of “in-process” research and development, this amounts to a one time charge. This removes the future earnings drag. 345 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

c. If an unrealistic amount is provided in “allowance for doubtful accounts” in good times, it can then be used in bad profit years to cover up expenses. d. A company can account for immaterial items without regard to generally accepted accounting standards. Thus the company could use “materiality” to improperly account for items. Companies establish a materiality threshold so that items that are below the threshold can be expensed immediately and those items above the threshold can be capitalized. Companies that change their materiality threshholds frequently are using materiality to expense items that should have been capitalized.

CASE 11-3 TURN A CHEEK (This case provides an opportunity to review the Nike case that involves the first and second amendment.) a. Each student will write a different position paper on why the Nike reply should be viewed under the first amendment. b. Each student will write a different position paper on why the Nike reply should be viewed under the fifth amendment. Note: In June 2003, the United States Supreme Court declined to hear the case on procedural grounds. A good article on the Supreme Court decision to decline to hear the case is “Nike and the Free-Speech Knot,” by Eugene Volokh, The Wall Street Journal, page A16, June 30, 2003. In September 2003, Nike settled with California activist Marc Kasky in a deal that obliges Nike to pay $1.5 million during the next three years to a Washington workerrights group. The money will be used “to promote workers’ education, increase training, and help create a global reporting standard for factory working conditions. The money also will go toward monitoring factory processes, which will directly affect some of Nike’s employees in China, Vietnam, and Indonesia…” “Clouding the muddy-free speech waters is the acknowledgement from justices in both California and federal courts that Nike’s campaign contained elements of commercial and noncommercial speech.” The comments on the settlement are from “Nike Settles Case with an Activist for $1.5 Million” by Stephanie Kang, The Wall Street Journal, Page 10, September 15, 2003.

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CASE 11-4 BOOKS UNLIMITED (Part 1) (This case provides the opportunity to review Borders Group, Inc.) a. Liquidity Ratios 1. Days' Sales in Inventory

Ending Inventory Cost of Goods Sold/365

$915,200,000 $6,807,671

134.44 days

$1,242,000,000 $7,310,410

169.89 days

2009 $915,200,000 $2,484,800,000/365 2008 $1,242,000,000 $2,668,300,000/365

2. Inventory Turnover

Cost of Goods Sold Average Inventory

2.72 times

2.15 times

(use ending inventory) 2009 $2,484,800,000 $915,200,000 2008 $2,668,300,000 $915,200,000

3. Working Capital

Current Assets – Current Liabilities

2009 $1,071,200,000 – $993,700,000

$77,500,000

2008 $1,506,000,000 – $1,467,800,000

$38,200,000

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4. Current Ratio

Current Assets Current Liabilities

1.08

1.03

2009 $1,071,200,000 $993,700,000 2008 $1,506,000,000 $1,467,800,000

5. Cash Ratio

2009 $53,600,000 $993,700,000

Cash Equivalents + Marketable Securities Current Liabilities

.05

2008 $58,500,000 $1,467,800,000

6. Sales to Working Capital

.04

Sales Average Working Capital

(use ending working capital) 2009 $3,242,100,000 $1,071,200,000 – $993,700,000 77,500,000 2008 $3,555,100,000 $38,200,000

41.83 times

93.07 times

7. Operating Cash Flow / Current Maturities of Long-Term Debt and Current Notes Payable 2009 $233,600,000 $329,800,000 2008 $105,000,000 $548,600,000

70.83%

19.14%

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b. Long-Term Debt-Paying Ability 1. Debt Ratio

Total Liabilities Total Assets

2009 1,346,400,000 $1,609,000,000 2008 $1,825,800,000 $2,302,700,000

83.68%

79.29%

2. Operating Cash Flow / Total Debt 2009 $233,600,000 $1,346,400,000 2008 $105,000,000 $1,825,800,000

17.35%

5.75%

c. Profitability Ratios

1. Net Profit Margin

2009 ($184,700,000) $3,242,100,000 2008 ($19,900,000) $3,555,100,000

2. Return on Assets

2009 ($184,700,000) $1,609,000,000

Net Income Before Noncontrolling Income (loss), Equity Income and Nonrecurring Items Net Sales

Negative

Negative Net Income Before Noncontrolling Income (loss) and Nonrecurring Items Average Total Assets

Negative

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2008 ($19,900,000) $2,302,700,000

Negative

3. Return on Total Equity

2009 ($184,700,000) $262,600,000 2008 ($19,900,000) $476,900,000 4. Gross Profit Margin 2009 $790,600,000 3,242,100,000 $929,100,000 $3,555,100,000

Net Income Before Nonrecurring Items – Dividends on Redeemable Preferred Stock Average Total Equity

Negative

Gross Profit Net Sales

24.39% 2008 =

26.13%

d. Investor Analysis 1. Earnings Per Common Share 2009 ($3.07) Loss 2008 ($.34) Loss 2. Operating Cash Flow / Cash Dividends 2009 $233,600,000 $6,500,000 2008 $105,000,000 $19,400,000

35.94 times

5.41 times

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e. Liquidity 1. Days’ Sales in Inventory improved materially but still appears to be very high 2. Inventory Turnover improved materially but still appears to be very low 3. Working Capital improved materially 4. The current ratio improved moderately but still appears to be low 5. The cash ratio improved materially but still appears to be low 6. Sales to Working Capital appears to be very good. This may be because of a relatively low working capital. 7. Operating Cash Flow / Current Maturities of Long-Term Debt and Current Notes Payable; this ratio improved materially and is very good Summary – Liquidity There were material improvements in liquidity. Several of the areas appear to need substantial additional improvement. Long-Term Debt-Paying Ability 1. Debt Ratio – This ratio appears to be very high and got moderately higher in 2009 2. Operating Cash Flow / Total Debt – This ratio was very low in 2008 and improved materially in 2009 Summary – Long-Term Debt The debt ratio appears to be very high while the operating cash flow / total debt materially improved in 2009. Profitability Ratios 1. Net Profit Margin – Negative in both years 2. Return on Assets – Negative in both years 3. Return on Total Equity – Negative in both years 4. Gross Profit Margin – Declined slightly in 2009 Summary – Profitability Substantial profitability problems. Investor Analysis The loss increased materially in 2009. Operating Cash Flow / Cash Dividends increased materially. Investors will not be impressed with the losses. f. Trend in net income (loss) is very negative 2007 – $21,900,000 loss 2008 – $19,900,000 loss 2009 – $184,800,000 loss

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g. Significant trends (items) in the Consolidated Statements of Cash Flows. Net cash provided by operating activities of continuing operations increased materially in 2008 and 2009 [$39,100,000 (2007); $105,000,000 (2008); and $233,600,000 (2009)] This increase came form decreasing inventories in 2008 and 2009 [$52,200,000 (2008) and $321,400,000 (2009)] Capital expenditures declined materially each year. Net cash used for financing activities of continuing operations was very material in 2009 ($226,400,000). Cash and cash equivalents at end of year declined materially. How long can decreasing inventories provide significant cash flow? Can this firm continue to pay cash dividends? h. Beaver Study Indicators 1. Cash Flow / Total Debt 2009 – 17.35% 2008 – 5.75% 2. Net Income / Total Assets 2009 – Negative 2008 – Negative 3. Total Debt / Total Assets 2009 – 83.68% 2008 – 79.29% The situation is somewhat negative. The positive increase in cash flow / total debt came from decreasing inventories.

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CASE 11-5 BOOKS UNLIMITED (Part 2) (This case provides the opportunity to review Borders Group, Inc. per the 10-K for the fiscal year ended January 29, 2011.) This comment is included in Note 1: On February 16, 2011 (the “Petition Date”), Borders Group, Inc., Borders, Inc. and certain of our subsidiaries (collectively, the “Debtors”) filed voluntary petitions for relief under Chapter 11 of the United States Code (the “Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”). The cases (the “Chapter 11 Cases”) are being jointly administered as Case No. 1110614(MG) under the caption “In re Borders Group, Inc., et al.” The Debtors continue to operate their business as “debtors-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of Chapter 11 and orders of the Bankruptcy Court. Our international franchised operations are not included in the Chapter 11 Cases. The Chapter 11 Cases were filed in response to an environment of curtailed customer spending, increasing industry competition and an anticipated lack of sufficient liquidity, including trade credit provided by our vendors, to permit us to pursue our business strategy to position the Borders brand successfully for the long term. As part of the Chapter 11 Cases and as discussed further below, our goal is to develop and implement a Chapter 11 plan that meets the standards for confirmation under the Bankruptcy Code. However, we may ultimately determine that it is in the best interests of the Debtors’ Chapter 11 estates to sell all or a portion of our assets pursuant to Section 363 of the Bankruptcy Code or seek confirmation of a Chapter 11 plan providing for such a sale or other arrangement, including liquidation. Confirmation of a Chapter 11 plan or other arrangement could materially alter the classifications and amounts reported in our consolidated financial statements, which do not give effect to any adjustments to the carrying values of assets or amounts of liabilities that might be necessary as a consequence of confirmation of a Chapter 11 plan or other arrangement or the effect of any operational changes that may be implemented. On February 16, 2011, the New York Stock Exchange (the “NYSE”) suspended trading in our common stock following our announcement of the commencement of the Chapter 11 Cases. On March 9, 2011, the NYSE formally notified the Securities and Exchange Commission of the delisting of our common stock.

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a. Horizontal Common-Size Analysis Consolidated Statements of Operations (In Part)

Sales Other revenue Total revenue Cost of merchandise sold (includes occupancy) Gross margin

Jan. 30, 2010 78.5 77.5 78.5

Jan. 31, 2009 91.2 78.7 91.0

Feb. 2, 2008 100.0 100.0 100.0

82.1 68.1

93.1 85.1

100.0 100.0

Material change for Sales, Total Revenue, Cost of Merchandise Sold, and Gross Margin for 2009 and 2010. Other Revenue declined materially in 2009 and slightly in 2010.

b. Vertical Common-Size Analysis Consolidated Statements of Operations (In Part)

Sales Other revenue Total revenue Cost of merchandise sold (includes occupancy) Gross margin

Jan. 30, 2010 100.0 1.2 101.2

Jan. 31, 2009 100.0 1.0 101.0

Feb. 2, 2008 100.0 1.2 101.2

78.5 22.7

76.6 24.4

75.1 26.1

Cost of Merchandise Sold Increased slightly in 2009 and 2010. This resulted in a substantial decrease in gross margin for 2009 and 2010.

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c. Jan. 30, 2010

Jan. 31, 2009

1. Cash flow/total debt a. Cash flow b. Total debt (a) ÷ (b)

$56,100,000 $1,266,900,000 4.4%

$233,600,000 $1,345,900,000 17.4%

2. Net income/total assets a. Net income (loss) b. Total assets (a) ÷ (b)

($110,200,000) ($184,700,000) $1,425,200,000 $1,609,000,000 Negative return

3. Total debt/total assets a. Total debt b. Total assets (a) ÷ (b)

$1,266,900,000 $1,425,200,000 88.9%

$1,345,900,000 $1,609,000,000 83.6%

Cash Flow/Total Debt declined materially in 2010 and is very low for 2010. Net Income/Total Assets is negative in 2009 and 2010. Total Debt/Total Assets increased substantially in 2010 and is very high.

d. Jan. 30, 2010 $56,100,000

Net Cash Provided by Operating Activities of Continuing Operations Cash Provided by Decrease in $43,900,000 Inventories

Jan. 31, 2009 $233,600,000

Feb. 2, 2008 $105,000,000

$321,400,000

$52,200,000

Cash Provided by Decrease in Inventories is very significant in relation to Net Cash Provided by Operating Activities of Continuing Operations. This is especially the case in 2009 and 2010. e. Borders had losses in 2009 and 2010 that were carried back to prior profit years. f. In general, a standard audit report. There is no indication of an assumption of a going concern. Note: The audit report of April 29, 2011 does have an assumption of a going concern. Borders filed Chapter 11 bankruptcy on February 16, 2011.

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CASE 11-5 VALUE NIKE (This case represents an opportunity to value Nike.) a. 1. Per summary-liquidity – (2009 – 2011) Liquidity appears to be good to very good. 2. Current Ratio 2007 3.1 2008 2.7 2009 3.0 2010 3.3 2011 2.9 Current Ratio is very good 3. Cash Provided by Operations 2007 $1,879,000,000 2008 $1,936,000,000 2009 $1,736,000,000 2010 $3,164,000,000 2011 $1,812,000,000 Cash Provided by Operations was very good with a material peak in 2010. b. Long-Term Debt-Paying Ability 1. The Long-Term Debt-Paying Ability was very good. 2. The Debt Ratio was very good in all three years. c. Profitability 1. Profitability was very good 2. Trend in Revenues (2007 – 2011) 2007 $16,326,000,000 2008 $18,627,000,000 2009 $19,176,000,000 2010 $19,014,000,000 2011 $20,862,000,000 3. Trend in Gross Profit Margin 2007 43.9 2008 45.0 2009 44.9 2010 46.3 2011 45.6

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No particular trend in gross profit margin. The gross margin appears to be very stable. It does appear to be very good. d. Investor Analysis 1. Price/Earnings Ratio 2007 19.4 2008 18.3 2009 18.8 2010 18.8 2011 19.2 The absolute amount is very good. The trend has been slightly positive from 2009 – 2011. 2. Trend in Market Capitalization 2007 $28,472,000,000 2008 $33,577,000,000 2009 $27,698,000,000 2010 $35,032,000,000 2011 $39,523,000,000 Market Capitalization increased materially between 2009 and 2011. 3. Cash Dividends Declared per Common Share 2007 - 2011 2007 0.71 2008 0.875 2009 0.98 2010 1.06 2011 1.20 Yes. The Cash Dividends increased each year. 4. The author feels confident of at least a 6% increase in the stock price for 2012 and 2013. The Price/Earnings Ratio was very good and the gross margin % was very good. It will be difficult to improve these indicators. Nike could increase its market price by revenue increases. Stock Price May 31, 2011 Increase of 6% ($84.45 x 1.06) May 31, 2012 Increase of 6% ($89.52 x 1.06) May 31, 2013

$84.45 $89.52 $94.89

e. Yes. This chapter indicates that multi-period discounted valuation models do not seem to play a significant role in analysis for fund managers’ normal valuation activity. Fundamental analysis does appear to be predominant. 357 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 12 Special Industries: Banks, Utilities, Oil and Gas, Transportation, Insurance, and Real Estate Companies

QUESTIONS 12- 1.

Interest income, service charges, and earnings in investments are the main sources of revenue for banks.

12- 2.

Loans are assets because they are an investment of the banks’ money. They are like receivables; money is owed to the bank, not by the bank.

12- 3.

Savings accounts are liabilities because they hold cash owed to customers.

12- 4.

Loans/deposits is a type of debt coverage, since loans are a main amount to repay depositors.

12- 5.

Banks report to the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and to their shareholders; and they must publish their reports in newspapers for the general public.

12- 6.

Bank holding companies own banks and other types of subsidiaries that may not be financially related. These holdings can affect the special bank ratios.

12- 7.

Interest expense will usually be the biggest expense item for banks.

12- 8.

Total deposits times capital is a measure of liabilities to equity, of creditors' to owners' funds.

12- 9.

Interest margin to average assets, earnings per share, return on equity, and return on assets are all ratios that indicate a bank's profitability.

12-10. Earning assets are those that generate interest from which the firm earns its profits. 12-11. The loan loss coverage ratio measures the quality of the loans and the level of protection related to loan payment. 12-12. Deposits times capital is a type of debt to equity or leverage ratio. 12-13. A review of assets may indicate that the bank has a substantial investment in long-term bonds. Such an investment could reflect substantial risk if interest rates increase. Another example would be a bank holding long-term, fixed-rate mortgages. The value of these mortgages could decline substantially if interest rates increase. 358 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

12-14. This review may indicate that investments have a market value that is substantially above or below the book amount. 12-15. In general, foreign loans are perceived as being more risky than domestic loans. 12-16. It may indicate a significant change and/or significant losses charged. 12-17. In general, nonperforming assets are assets that the bank is not receiving income on or that are receiving inadequate income. The amount and trend of nonperforming assets should be observed closely. This can be an early indication of troubles to come for a bank. 12-18. A decreasing amount in savings deposits would indicate that the bank is losing one of its cheapest source of funds. 12-19. This note may reveal significant additional commitments that the bank may or may not fund in the future and contingent liabilities. 12-20. Utilities have heavy investment in fixed assets, necessitating long-term debt. Further, they are able to use leverage favorably, since their profits are controlled and are reasonably stable, due to the regulatory control and to the nature of the product. 12-21. Demand for utilities is inelastic; there are no substitute services. There is virtually no competition hence it is considered to be a regulated monopoly. 12-22. Plant and equipment are usually listed first because the uniform accounting system recognized their importance in the operation. Current assets are usually a very small part of total assets. 12-23. Inventory ratios have little meaning for utilities because they are unable to store their finished product. 12-24. Funded debt to operating property is a type of debt coverage ratio. It tells how funds are supplied for long-term investment. 12-25. Yes, the times interest earned ratio is meaningful for utilities since they have such a heavy use of debt. The times interest earned ratio shows how many times the utility can cover their interest payments. 12-26. No. Long-term capitalization, the major source of funds, including long-term debt, is presented first. Current liabilities are quite immaterial.

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12-27. Electric utilities that have substantial construction work in progress are usually viewed as being more risky investments than electric utilities that do not have substantial construction work in progress. Most utility commissions allow none or only a small amount of construction work in progress in the rate base. Therefore the utility rates essentially do not reflect the construction work in progress. It is possible that the utility commission will not allow all of this property and plant in the rate base. The utility commission may rule that part of the cost was due to inefficiency and disallow this cost. The utility commission may also disallow part of the cost on the grounds that the utility used bad judgment and provided for excess capacity. For the costs that are allowed, the risk is that the utility commission will not allow a reasonable rate of return. 12-28. The account allowance for equity funds used during construction represents an assumed rate of return on equity funds used for construction. The account allowance for borrowed funds used during construction represents the cost of borrowed funds that are used for construction. 12-29. Each relates to accounting for exploration costs. Successful efforts capitalize only those costs of successful projects. Full cost capitalizes the outlays for both successful and unsuccessful projects. 12-30. Regulation makes their accounting systems uniform, and their revenues are controlled by rate structure. 12-31. A variation of one of two costing methods is used by an oil or gas company to account for exploration and production costs. These methods are the successful-efforts method and the full-costing method. The selection has a significant influence on the financial statements. The successful-efforts method places only exploration and production costs of successful wells on the balance sheet under property, plant, and equipment. Exploration and production costs of unsuccessful (or dry) wells are expensed when it is determined that there is a dry hole. With the full-costing method, exploration and production costs of all the wells are placed on the balance sheet under property, plant, and equipment. 12-32. Major items on this schedule are typically revisions of previous estimates, improved recovery, discoveries and other additions, and production. This information can be significant in terms of the companies' reserves.

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12-33. This is a true statement. One of the reasons is that large sums can be spent for exploration and development years in advance of revenue from the found reserves. The other reason is that there can be significant differences between when expenses are deducted on the financial statements and when they are deducted on the tax return. This is referred to as a timing difference. 12-34. A decreasing operating ratio means a lower proportion of expenses and more profits. 12-35. Operating revenue to operating property is a turnover ratio. Because of the heavy investment in fixed assets, this ratio will usually be less than 1 to 1 for a utility. 12-36. Fixed assets is the most important asset category. 12-37. Revenue is divided into categories by type or function of service, such as passenger, freight, mail, etc. 12-38. Differences in traffic volume and distance traveled will change revenues. The price level, type of service and effectiveness of asset use will change expenses for a transportation firm. 12-39. Higher revenue per passenger mile basically indicates higher rates on fares. 12-40. The passenger load factor indicates utilization of capacity. The greater the utilization, the lower the fixed charge per passenger and the higher the profit. 12-41. In this publication, data are compiled by composite carrier groups. It includes industry total dollars for income statement accounts, such as total revenue. 12-42. The annual reports filed with the state insurance departments are in accordance with Statutory Accounting Practices (SAP). 12-43. Annual reports that insurance companies issue to the public are in accordance with generally accepted accounting principles (GAAP). 12-44. Real estate investments are reported at cost less accumulated depreciation and an allowance for impairment in value. An insurance company with substantial real estate investments is risky because there is a great deal of subjectivity in establishing the allowance for impairment in value. 12-45. Under GAAP, these costs are deferred and charged to expense over the premium-paying period. Under SAP, these costs are charged to expense as incurred. 12-46. Intangibles are recognized as an asset under GAAP, while intangibles are not recognized as an asset under SAP. 361 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

12-47. For short-duration contracts, revenue is ordinarily recognized over the period of the contract in proportion to the amount of insurance protection provided. When the risk differs significantly from the contract period, revenue is recognized over the period of risk in proportion to the amount of insurance protection. 12-48. Insurance industry-specific ratios are frequently based on SAP financial reporting to the states and not GAAP financial reporting that is used for the annual report and SEC reporting. 12-49. Insurance is a highly regulated industry that some perceive as having relatively low growth prospects. It is also an industry with substantial competition. The accounting environment probably also contributes to the relatively low market price for insurance company stocks. 12-50. Conventional accounting recognizes depreciation but not the value of the property. This potentially presents a problem to investors in judging the value of the company. Some real estate companies have sold substantial portions of their property in order to realize value for their investors, while some have attempted to reflect value by disclosing current value in addition to the conventional accounting.

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PROBLEMS PROBLEM 12-1 a. Operating Ratio

Operating Expense Operating Revenue

2011 $625,000 $624,000

2010 $617,000 $618,000

100.2%

99.8%

This firm is having profit problems. Expenses have increased faster than revenues.

b. Long-Term Debt to Operating Property

Long-Term Debt Operating Property

2011 $280,000 $365,000

2010 76.7%

$270,000 $360,000

75.0%

This firm is using more debt in absolute terms and in relation to operating property.

c. Operating Revenue to Operating Property

Operating Revenue Operating Property

2011 $624,000 $365,000

2010 $618,000 $360,000

170.96%

171.67%

The turnover has remained relatively constant. d.

Revenue per Passenger Mile: 2011 $624,000 7,340,000

2010 8.5¢/Mile

$618,000 7,600,000

8.1¢/Mile

The firm is generating more revenue per passenger mile, but is suffering from a serious decline in passenger miles.

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PROBLEM 12-2 a.

The ratio funded debt to operating property indicates how funds are supplied to a utility.

The ratio percent earned on operating property relates net earnings to the assets primarily intended to generate earnings for a utility.

For a utility, the operating revenue to operating property ratio is basically an operating assets turnover ratio.

The operating ratio indicates a measure of operating efficiency for a utility.

For a transportation firm, long-term debt to operating property is a measure of the source of funds with which property is obtained.

The operating revenue to operating property ratio is a measure of turnover of operating assets for a transportation firm.

Banks, utilities, and transportation firms have a uniform system of accounts. Oil and gas firms do not have a uniform system of accounts.

None of the above types of companies have a balance sheet similar in format to a manufacturing firm.

PROBLEM 12-3 a. 1. Operating Ratio

Operating Expenses Operating Revenues

2011

2010

2009

$850,600 $1,080,500

$820,200 $1,037,200

$780,000 $974,000

= 78.72%

= 79.08%

= 80.08%

2. Funded Debt to Operating Property 2011

2010

2009

$1,500,000 $3,900,000

$1,480,000 $3,750,000

$1,470,000 $3,600,000

= 38.46%

= 39.47%

= 40.83%

Funded Debt (Long-Term) Operating Property

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3. Percent Earned on Operating Property 2011

2010

2009

$280,000 $3,900,000

$260,000 $3,750,000

$230,000 $3,600,000

= 7.18%

= 6.93%

= 6.39%

4. Operating Revenue to Operating Property 2011

2010

2009

$1,080,500 $3,900,000

$1,037,200 $3,750,000

$974,000 $3,600,000

= 27.71%

= 27.66%

= 27.06%

Net Income Operating Property

Operating Revenue Operating Property

b. The operating ratio decreased, indicating improved efficiency. Funded debt to operating property decreased, indicating less risk because a lower percentage of funds were supplied by funded debt. Percent earned to operating property increased, indicating improved profitability. Operating revenue to operating property increased slightly, indicating improved profitability. c. Cash flow per share has increased much more than earnings per share. This would be considered to be positive.

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PROBLEM 12-4 a.

Savings accounts would be a representative liability of a bank.

Cash is not an earning asset of a bank for the earning assets to total assets ratio.

Interest margin to average total assets provides an indication of management’s ability to control the spread between interest income and interest expense.

Cash on hand would not be a representative liability of a bank.

Typically, the largest expense for a bank will be interest expense.

Equity capital to total assets indicates the extent of equity ownership in a bank.

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PROBLEM 12-5 a.

2011

2010

Operating Ratio: Operating expense Operating revenue

$20,340,000 – $3,200,000 $22,830,000

$18,125,000 – $3,000,000 $20,500,000

= 75.1%

= 73.8%

Operating expenses as a percent of revenue have increased.

b. Times Interest Earned = Operating Income Interest Expense

Operating income (after tax) Income tax Operating income (before tax) Interest expense Times interest earned

2011

2010

$2,490,000 3,200,000 $5,690,000 $1,200,000 4.74

$2,375,000 3,000,000 $5,375,000 $1,000,000 5.38

This utility has experienced a heavy increase in interest expense, causing a decline in the times interest earned.

c. Vertical common-size analysis: 2011 Residential Commercial Other Total

$11,800,000 10,430,000 600,000 $22,830,000

2010 51.7% 45.7% 2.6% 100.0%

$10,000,000 10,000,000 500,000 $20,500,000

48.8% 48.8% 2.4% 100.0%

There has been a rise in residential usage, and this causes a proportionate increase in revenue from this source. Commercial use has not fallen.

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PROBLEM 12-6 a.

Bond companies do not represent a basic type of insurance organization.

For insurance financial reporting, the balance sheet is not a class.

Investment gains/losses are not part of the quantification process when estimating the reserves.

For investment contracts, termination fees are not booked as revenue over the period of the contract.

After the annual reports are files with the individual state insurance departments, a testing process is conducted by the NAIC. If a company’s ratio is outside the prescribed limit, the NAIC brings that to the attention of the state insurance department.

All of the above contribute to the relatively low market value of insurance companies.

PROBLEM 12-7 a. 1. Earning Assets to Total Assets = Average Earning Assets Average Total Assets 2011

2010

2009

$50,000,000 $58,823,529

$45,000,000 $54,216,867

$43,000,000 $52,000,000

= 85.00%

= 83.00%

= 82.69%

2. Interest Margin to Average = Interest Margin Earning Assets Average Earning Assets 2011

2010

2009

$2,550,000 $50,000,000

$2,200,000 $45,000,000

$2,020,000 $43,000,000

= 5.10%

= 4.89%

= 4.70%

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Pretax Income (Before Security Transactions) + Provision For 3. Loan Loss Coverage Ratio = Loan Losses Net Charge-Offs 2011

2010

2009

($562,000 +$190,000) $180,000

($480,500 +$160,000) $162,000

($440,000 +$142,000) $160,000

= 4.17 times = 3.95 times = 3.64 times per year per year per year 4. Equity to Total Assets =

Average Equity Average Total Assets

2011

2010

2009

$4,117,600 $58,823,529

$3,524,000 $54,216,867

$3,120,000 $52,000,000

= 7.00%

= 6.50%

= 6.00%

5. Deposits Times Capital = Average Deposits Average Stockholders' Equity 2011

2010

2009

$52,500,000 $ 4,117,600

$42,500,000 $ 3,524,000

$37,857,000 $ 3,120,000

= 12.75 times = 12.06 times = 12.13 times per year per year per year 6. Loans to Deposits = Average Net Loans Average Deposits 2011

2010

2009

$32,500,000 $52,500,000

$26,000,000 $42,500,000

$22,500,000 $37,857,000

= 61.90%

= 61.18%

= 59.43%

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b. Earning assets to total assets has increased. This indicates that management has improved in putting bank assets to work. Interest margin to average earning assets have increased. This indicates improved profitability. The loan loss coverage ratio has increased, indicating an improved level of protection of loans. Equity to total assets increased, indicating an improved cushion against the risk of using debt and leverage. Deposits times capital increased, indicating a prospect of higher return to shareholders. Loans to deposits increased, indicating increased risk.

PROBLEM 12-8 a. 1. Operating Ratio = Operating Expenses Operating Revenues 2011

2010

2009

$1,550,000 $1,840,000

$1,520,000 $1,670,400

$1,480,000 $1,620,700

= 84.24%

= 91.00%

= 91.32%

2. Long-Term Debt To Operating Property = Long -Term Debt Operating Property 2011

2010

2009

$910,000 $995,000

$900,500 $990,000

$895,000 $985,000

= 91.46%

= 90.96%

= 90.86%

3. Operating Revenue to Operating Property = Operating Revenue Operating Property 2011

2010

2009

$1,840,000 $995,000

$1,670,400 $990,000

$1,620,700 $985,000

= 184.92%

= 168.73%

= 164.54%

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b. The operating ratio decreased significantly, indicating improved profitability. Long-term debt to operating property increased slightly, indicating a slight increase in risk. Operating revenue to operating property increased moderately, indicating improved profitability. c. The passenger load factor increased materially, indicating improved profitability.

PROBLEM 12-9 a.

Total Deposits Times Capital

Average Total Deposits Average Total Capital

2011

2010

$24,000,000 $1,850,000

$20,000,000 $ 1,600,000

= 12.97

= 12.50

$16,000,000 $24,000,000

$13,200,000 $20,000,000

= 66.7%

= 66.0%

$1,850,000 $26,000,000

$1,600,000 $22,000,000

= 7.12%

= 7.27%

$1,750,000 - $1,615,00 $26,000,000

$1,650,000 - $1,512,250 $22,000,000

= .52%

= .63%

2. Loans to Total Deposits

Average Loans Average Total Deposits

3. Capital Funds to Total Assets

Capital Funds Average Total Assets

4. Interest Margin to Average Total Assets

Interest Margin Average Total Assets

b. McEttrick National Bank has experienced a faster rise in deposits than in capital. This has caused the deposits to capital to rise. Loans have risen faster than deposits, so that loans to total deposits has risen. Capital to total assets has dropped, probably due to a faster rise in deposits. The interest margin to average total assets has dropped, which indicates a drop in profitability. 371 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

CASES CASE 12-1 AFUDC EQUITY AND DEBT (Primary emphasis on "allowance for equity funds used during construction" and "allowance for borrowing funds used during construction". Also, several ratios are included. The utility industry typically capitalizes interest on construction funds and a rate of return on equity funds used for construction. This can result in reported earnings being substantially different than cash flow from operations. This case also covers construction work in progress and financial ratios that relate to utilities. Notice that the balance sheet is not presented in the order described in the book.) a. AFUDC is the estimated cost of debt and equity used to finance regulated plant additions that can be recorded as part of the cost of construction projects. AFUDC is recoverable from customers through rates over the life of the related property once the property is placed in service. b. Capitalizing interest on borrowed funds prevents this expense from reducing income during the current period. If this interest had not been capitalized but expensed as incurred, then current income would have been lower. c. Yes. When interest on borrowed funds is capitalized, then the interest does not reduce income this year, but the interest payments will require funds. d. Capitalizing allowance for equity funds used during construction increases income during the period of capitalization. e. Both the capitalization of interest on borrowed funds and the capitalization allowance for equity funds result in the reported income being higher than the cash flow. f. 1. Operating ratio In Millions Operating expenses (A) Operating revenues (B) Operating ratio (A ÷ B)

2010 $ 11,533 $ 13,841 83.32%

2009 $ 11,100 $ 13,399 82.84%

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2. Funded debt to operating property In Millions

Funded debt* (A) Operating property (B) Funded debt to operating property (A ÷ B)

2010 $809 + $10,906 + $423 = $12,138 $31,449

2009 $342 + 10,381 + $827 = $11,550 $28,892

38.60%

39.98%

*Included long-term debt and current maturities of long-term debt.

3. Percent earned on operating property

Net income (A) Operating property Less: Construction in progress Operating property adjusted for construction in progress (B) Percent earned on operating property (A ÷ B)

In Millions 2010 2009 $1,113 $1,234 $31,449 $28,892 $1,384 $1,888 $30,065

$27,004

3.70%

4.57%

4. Operating revenue to operating property

Operating revenues (A) Operating property (B)*

In Millions 2010 2009 $13,841 $13,399 $30,065 $27,004

Operating revenue to operating property (A ÷ B)

46.04%

49.62%

*Excluded construction in progress

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Comment on the Above Ratios 1. Operating ratio Stayed approximately the same, with a slight increase 2. Funded debt to operating property Decreased slightly 3. Percent earned on operating property A material decrease 4. Operating revenue to operating property A substantial decrease

CASE 12-2 RESULTS OF OPERATIONS FOR OIL AND GAS PRODUCING ACTIVITIES (This case provides the opportunity to view results of operations for oil and gas producing activities using vertical and horizontal common-size analysis.) a.

Vertical Common-Size For the Years Ended December 31 2010 Sales and other operating revenues Unaffiliated customers Inter-company Total revenues Cost and expenses Production expenses, including related taxes Exploration expenses, including dry holes and lease impairment (b) General administrative and other expenses Depreciation, depletion and Amortization Asset impairments Total costs and expenses Results of operations before income taxes Provision for income taxes Results of operations

Total

United States

Europe

Africa

Asia and other

98.4 1.6 100.0

94.2 5.8 100.0

100.0 ----100.0

22.0

19.9

32.3

16.5

19.6

9.9

14.8

2.2

5.2

24.0

3.2

6.6

2.1

4.0

25.4 6.1 66.6

26.5 ----67.8

20.6 ----57.2

28.1 19.3 69.9

26.2 ----73.8

33.4 18.1 15.3

32.2 12.4 19.8

42.8 21.2 21.6

30.1 21.1 9.0

26.2 17.1 9.1

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Horizontal Common-Size For the Years Ended December 31 2010 Sales and other operating revenues Unaffiliated customers Inter-company Total revenues Cost and expenses Production expenses, including related taxes Exploration expenses, including dry holes and lease impairment General, administrative and other expenses Depreciation, depletion and amortization Asset impairments Total costs and expenses Results of operations before income taxes Provision for income taxes Results of operations

Total

United States

Europe

Africa

Asia and other

100.0 100.0 100.0

26.9 100.0 28.1

26.2 -----25.7

32.0 -----31.5

15.0 -----14.8

100.0

25.4

37.8

23.6

13.1

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

42.1 57.3 29.2 ----28.6 27.1 19.3 36.3

5.7 17.1 20.8 ----22.1 33.0 30.1 36.4

16.5 7.1 34.7 100.0 33.0 28.4 36.6 18.5

35.7 18.5 15.2 ----16.3 11.6 14.0 8.8

c. Comment on the Common-Size Analysis in (a) and (b) Comments on Vertical Common-Size Production expenses, including related taxes and depreciation, depletion, and amortization are the major costs and expenses. Results of operations before income taxes fluctuated materially, which led to material fluctuation in results of operations. Comments on Horizontal Common-Size Three areas contribute substantially to revenues from unaffiliated customers (Africa, United States, and Europe). Europe has a material amount of production expenses. The United States has a material amount of exploration expenses. The United States has a material amount of the general, administrative and other expenses. Africa has a material amount of the depreciation, depletion and amortization. Africa and United States have the largest amount of total costs and expenses. Europe contributes the largest amount of results of operations before income taxes. Results of operations were lead by Europe and closely followed by United States. 375 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

CASE 12-3 FINANCIAL SERVICES PROVIDER (This case provides an opportunity to review provision for loan losses.) a. Net charge-offs increased materially in 2009 and then decreased materially in 2010. Recoveries increased slightly in 2009 and increased materially in 2010. Provision for loan losses increased materially in 2009 (excluding acquired from Union Trust), and decreased materially in 2010. Balance at end of year increased materially in 2009 and 2010. Note: The trend appears to be positive between 2009 and 2010. CASE 12-4 ATTRACTING DEPOSITS (This case provides an opportunity to review statements of a bank). a. 1. Total interest income 2. Total interest expense 3. Provision for credit losses 4. Total fees and other income 5. Total general and administrative 6. Total other expenses 7. Net (loss) income

2010 122.0 67.9 178.6 130.2 105.98 69.2 Income

2009 112.8 87.2 217.8 78.6 102.44 199.9 Income

2008 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Note: Net income was $143,756,000 in 2009 and $1,022,136,000 in 2010. This was an increase of 711.0%. b. Total interest income increased materially in 2009 and 2010. Total interest expense decreased materially in both 2009 and 2010. Provision for credit losses increased very materially in 2009 and then decreased materially in 2010. Total fees and other income decreased very materially in 2009 and then increased very materially in 2010. Total general and administrative increased slightly in 2009 and slightly in

2010.

Total other expenses increased very materially in 2009 and decreased very materially in 2010. 2008 had a loss turning to a profit in 2009. A very material increase in profits in 2010. 376 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

c. 1. Total charge-offs Increased very materially in 2009 and then decreased materially in 2010. 2. Charge-offs, net of recoveries Increased very materially in 2009 and then decreased materially in 2010. 3. Allowance for loan losses balance, end of period Increased very materially in 2009 and then increased materially in 2010. 4. Total impaired loans Impaired loans with a related allowance increased very materially in 2010. 5. Allowance for impaired loans Allowance for impaired loans increased very materially in 2010. 6. Total loans past due 90 days as to interest or principal and accruing interest This amount went from $27,321,000 in 2009 to a very nil $169,000 in 2010. d. Ratios for 2010 and 2009 1. Earning assets to total assets = Earning Assets/Total Assets

Earnings assets (a) Total assets (b) (a)  (b)

2010 $76,806,523 $89,651,815 85.7%

2009 $70,035,591 $82,953,215 84.4%

2010 $1,771,613 $76,806,523 2.31%

2009 $658,967 $70,035,591 .94%

2010 1,018,985 1,585,545 2,604,530 1,212,310 2.15%

2009 ($1,122,899) 1,790,559 667,660 1,422,390 .47%

2. Interest margin to earning assets Interest margin (a) Earning assets (b) (a)  (b)

3. Loan loss coverage ratio Pretax income Provision for loan losses Total (a) Net charge-offs (b) (a)  (b)

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4. Equity to total assets

(a)  (b)

2010 $11,260,670 $89,651,815 12.6%

2009 $9,387,535 $82,953,215 11.3%

(a)  (b)

2010 $42,673,293 $11,260,670 3.79 times

2009 $44,428,065 $9,387,535 4.73 times

(a)  (b)

2010 $62,820,434 $42,673,293 1.47%

2009 $55,733,953 $44,428,065 1.25%

Equity (a) Total assets (b)

5. Deposits times capital Deposits (a) Equity (b)

6. Loans to deposits Loans (a) Deposits (b)

e. Trends indicated by the ratios 1. Earnings assets to total assets slightly increased 2. Interest margin to earning assets increased materially 3. Loan loss coverage increased materially 4. Equity to total assets increased materially 5. Deposits times capital decreased very materially 6. Loans to deposits increased materially

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CASE 12-5 COVERED (This case provides an opportunity to review the consolidated statement of income for the Chubb Corporation using horizontal common-size analysis). a. The Chubb Corporation Consolidated Statements of Income Horizontal Common-Size In Millions, Years Ended December 31 2010 2009 2008 Revenues Premiums Earned Investment Income Other Revenues Realized Investment Gains (Losses), Net Total Other-Than-Temporary Impairment Losses on Investments Other-Than-Temporary Impairment Losses on Investments Recognized in Other Comprehensive Income Other Realized Investment Gains, Net Total TOTAL REVENUES Losses and Expenses Losses and Loss Expenses Amortization of Deferred Policy Acquisition Costs Other Insurance Operating Costs and Expenses Investment Expenses Other Expenses Corporate Expenses TOTAL LOSSES AND EXPENSES INCOME BEFORE FEDERAL AND FOREIGN INCOME TAX Federal and Foreign Tax NET INCOME

94.8 96.1 40.6

95.8 95.2 40.6

100.0 100.0 100.0

Loss

N/A 582.7

N/A 180.0

N/A 100.0

100.7

98.4

100.0

94.2

90.9

100.0

98.2 96.4 109.4 41.7 102.1 95.5

96.7 94.3 121.9 44.4 103.5 93.0

100.0 100.0 100.0 100.0 100.0 100.0

124.1 135.0 120.5

123.1 129.2 121.0

100.0 100.0 100.0

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Revenues Premiums earned decreased moderately in 2009 and slightly in 2010 Investment income decreased moderately in 2009 and increased slightly in 2010 Other revenues decreased very materially in 2009 and stayed the same for 2010 Other realized investment gains, net increased very materially in 2009 and 2010 Total revenues decreased slightly in 2009 and increased slightly in 2010

Losses and Expenses Losses and loss expensed decreased materially in 2009 and then increased moderately in 2010 Amortization of deferred policy acquisition costs decreased moderately in 2009 and then increased slightly in 2010 Other insurance operating costs and expenses decreased moderately in 2009 and then increased slightly in 2010 Investment expenses increased materially in 2009 and then decreased materially in 2010 Other expenses decreased very materially in 2009 and slightly in 2010 Corporate expenses increased slightly in 2009 and decreases slightly in 2010 Total losses and expenses decreased moderately in 2009 and increased slightly in 2010 Income before federal and foreign income tax increased materially in 2009 and slightly in 2010 Federal and foreign in come tax increased very materially in 2009 and moderately in 2010 Net income increased very materially in 2009 and then decreased slightly in 2010

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Chapter 13 Personal Financial Statements and Accounting for Governments and Not-For-Profit Organizations QUESTIONS 13- 1. Personal financial statements may be prepared for an individual, a husband and wife, or a larger family group. 13- 2. The basic personal financial statement is the Statement of Financial Condition. 13- 3. No. 13- 4. No. 13- 5. Estimated current value basis 13- 6. Net worth 13- 7. Statement of Changes in Net Worth 13- 8. No. 13- 9. False. Generally accepted accounting principles as they apply to personal financial statements require the accrual basis. 13-10. No. Assets and liabilities are not classified as current and noncurrent. Assets and liabilities are classified in order of liquidity and maturity. 13-11. Broker’s statements Income tax returns Safe deposit box Insurance policies Real estate tax return Checkbook Bank statements 13-12. Examples would be methods used in determining current values of major assets, descriptions of intangible assets, and assumptions used to compute the estimated income taxes. 13-13. If quoted market prices are not available, then reasonable estimates should be used.

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13-14. This is an open-ended question. The responses here are merely suggestions. Dues will not increase A monthly magazine will be started Add 100 new members Retain a minimum of 90% of the current members 13-15. No. Not-for-profit organizations are not allowed to use fund accounting. 13-16. No. The accounting for a profit-oriented business is centered on the entity concept and the efficiency of the entity. The accounting for governments does not include a single entity concept or efficiency. 13-17. a. General fund All cash receipts and disbursements not required to be accounted for in another fund. b. Proprietary fund Funds whose purpose is to maintain the assets through cost reimbursement by users or partial cost recovery from users and periodic infusion of additional assets. c. Fiduciary fund Fund whose principal must remain intact. Typically, revenues earned may be distributed. 13-18. The number of funds that will be utilized will depend upon the responsibilities of the particular state or local government and the grouping of these responsibilities. 13-19. When the representatives of the citizens approve the budget, then the individual expenditures become limits. An increase in an approved expenditure will require approval by the same representatives of the citizens. Thus, the representatives of the citizens set up a legal control over expenditures. 13-20. Government Finance Officers’ Association 13-21. False. Industrial revenue bonds are not backed by the full faith and credit of the governmental unit. 13-22. Budgeting by objectives and/or measures of productivity can be incorporated into the financial reporting.

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13-23. No. The accounting for a profit enterprise is centered on the entity concept and the efficiency of the entity. Fund accounting is centered on a self-balancing set of accounts. Fund accounting would not be a reasonable method for a profit enterprise. 13-24. The GASB has a seven-member board. A simple majority of four votes is needed to issue a pronouncement. 13-25. This book is periodically updated for subsequent changes to governmental accounting standards. 13-26. Under GASB, the most substantial pronouncement has been GASB Statement No. 34, which was issued in 1999. 13-27. Examples of governmental activities are police and fire. Examples of businesstype activities are airports and utilities. 13-28. The financial data of the component units are included with the government entities reporting entity because of the significance of their operational or financial relationship with the government entity.

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PROBLEMS PROBLEM 13-1 a. Jim and Carrie Statement of Changes in Net Worth For the Year Ended December 31, 2012 Realized increases in net worth Salary Interest income

Realized decreases in net worth Income taxes Interest expense Personal property taxes Real estate taxes Personal expenditures Net realized increases in net worth Unrealized increases in net worth Marketable securities Land Residence Stock options Unrealized decreases in net worth Furnishings Estimated income taxes on the differences between the estimated current values of assets and the estimated current amounts of liabilities and their tax bases Net unrealized decreases in net worth Net increase in net worth Net worth at the beginning of year Net worth at end of year

$ 50,000 6,000 $ 56,000

$ 15,000 3,000 1,000 1,500 25,000 $ 45,500 $ 10,500

2,000 5,000 3,000 4,000 $ 14,000 3,000

12,000 $ 15,000 $ 1,000 $ 9,500 130,000 $ 139,500

b. Net increase in net worth was $9,500, which brought the net worth at the end of the year to $139,500. The major increase in realized net worth was salary ($50,000). The major realized decrease in net worth was personal expenditures ($25,000). 384 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

PROBLEM 13-2 a. City of Toledo Revenues – Business-Type Activities Charge for Services Horizontal Common-Size Business-type activities: Charges for services: Water Sewer Storm utility Utilities administration Parking Property management Small business development Tow lot Capital grants Total business-type activities revenues

2003

2004

2005

2006

2007

2008

2009

2010

100.0 100.0 100.0 100.0

105.2 112.9 92.7 96.8

114.6 123.1 103.9 127.2

106.8 125.5 97.8 96.5

118.6 138.3 103.7 119.7

116.9 158.5 108.6 130.7

110.2 153.2 121.1 107.6

130.4 162.2 117.8 124.6

100.0 100.0 100.0 100.0 100.0

101.9 31.3 148.1 N/A -----

105.8 29.8 73.1 N/A -----

109.6 N/A N/A N/A -----

103.5 30.0 ----N/A -----

111.3 29.6 ----N/A -----

107.6 23.5 ----N/A -----

102.0 53.0 340.4 N/A 343.9

100.0

103.7

115.7

111.2

124.5

133.8

126.9

146.3

Material increase in water and sewer, which are material items. Small business development also increased materially when comparing 2010 with 2003. Property management decreased materially and then increased sharply in 2010, but in 2010 it was only approximately one half the amount in 2003. Total business-type activities revenues increased moderately.

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PROBLEM 13-3 a. City of Toledo Revenues – Business-Type Activities Charge for Services Vertical Common-Size Business-type activities: Charges for services: Water Sewer Storm utility Utilities administration Parking Property management Small business development Tow lot Capital grants Total business-type activities revenues

2003

2004

2005

2006

2007

2008

2009

2010

36.9 40.0 9.4 9.2 1.5 1.0 0.1 ----1.8

37.5 43.7 8.4 8.6 1.5 0.3 0.1 ---------

36.6 42.7 8.5 10.1 1.4 0.3 0.0 0.5 -----

35.5 45.2 8.3 8.0 1.5 (0.7) (0.0) 2.3 -----

35.2 44.5 7.9 8.8 1.3 0.2 ----2.1 -----

32.2 47.5 7.7 8.9 1.3 0.2 ----2.2 -----

32.1 48.4 9.0 7.8 1.3 0.2 ----1.3 -----

32.9 44.4 7.6 7.8 1.1 0.4 0.1 1.5 4.2

100.0

Material decrease in water Material increase in sewer Material decrease in storm utility Material decrease in utilities administration Material decrease in property management Material fluctuations in small business development, tow lot, and capital grants

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PROBLEM 13-4 a. City of Toledo Ratio of Net General Bonded Debt to Assessed Value and Net Bonded Debt Per Capita, Last Ten Fiscal Years Vertical Common-Size Fiscal Year 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001

Assessed Value(2) 94.5 102.6 106.8 114.1 119.6 108.5 109.9 109.6 99.6 100.0

Net General Bonded Debt(2) 116.6 123.7 111.0 106.9 102.8 104.2 103.2 102.2 103.5 100.0

Net Bonded Debt Per Capital 127.3 123.7 111.0 106.9 102.8 104.2 103.2 102.2 103.5 100.0

(2) Personal property starting in 2010 is not part of this calculation. b.

Assessed value increased materially, peaking in 2006. It then decreased materially from 2006 to 2010. It ended up in 2010 below 2001. Net general bonded debt increased materially. Net bonded debt per capita increased materially at approximately the same rate as net general bonded debt, except for 2010 when net bonded debt per capita increased slightly while net general bonded debt decreased materially.

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PROBLEM 13-5 a. The Ohio Society of Certified Public Accountants Consolidated Statement of Financial Position April 30, 2011 Vertical Common-Size Assets Cash and cash equivalents Accounts receivable, net Pledged receivable, net Prepaid expenses and deposits Prepaid pension Investments Property, net Total assets

3.9 0.5 6.1 2.2 3.3 66.3 17.8 100.0

Liabilities and Net Assets Liabilities Accounts payable and accrued liabilities Deferred revenue Short-term borrowings Mortgage payable Total liabilities

13.0 12.5 ----12.9 38.4

Net assets Unrestricted Temporarily restricted Permanently restricted Total net assets Total Liabilities and Net Assets

32.9 3.4 25.3 61.6 100.0

The most significant asset is investments, followed by property. The three liabilities are approximately the same. Unrestricted is the major net asset, followed by permanently restricted, with temporarily restricted far behind.

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b. The Ohio Society of Certified Public Accountants Consolidated Statement of Activities Year Ended April 30, 2011 Vertical Common-Size Unrestricted

Total

Revenue Dues Education and training course fees Peer review fees Public relations and publications Investment income, net Member connections and sections Other Foundation contributions Membership affinity programs Released from restrictions – scholarships – net assets Total revenue

49.8 37.0 5.3 4.1 3.3 2.7 2.1 0.6 0.5

49.8 37.0 5.3 4.1 4.0 2.7 2.1 1.2 0.5

0.3 0.4 106.1

--------106.8

Expenses Education and training programs Public relations and publications General and administrative Governmental affairs Membership Peer review Member Connections and sections Interest Foundation scholarships Total expenses

40.2 18.1 13.3 8.1 7.4 5.9 5.8 0.8 0.4 100.0

Dues make up approximately one-half the revenue. The other major revenue item is education and training course fees. Education and training programs make up approximately 40% of the expenses. The other major expense item is public relations and publications.

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PROBLEM 13-6 Items that indicate that the Ohio Society of Certified Public Accountants is achieving their mission. Expenses as follows: 1. Education and training course programs 2. Public relations and publications 3. Member connections and sections 4. Membership 5. Peer review PROBLEM 13-7 a.

Not-for-profit organizations are to present three aggregated financial statements.

A bank is an example of a profit institution.

Not-for-profit accounting principles were derived form numerous not-forprofit industry accounting manuals and audit guides.

The accounting for a nonprofit institution does not have a bottom-line net income.

PROBLEM 13-8 a.

A reasonable definition of proprietary funds is funds whose purpose is to maintain the assets through cost reimbursement by users or partial cost recovery from users and periodic infusion of additional assets.

Funds established for a specific purpose would include highway maintenance, parks, debt repayment, and endowment.

Statement of cash flow is not a minimum requirement for generalpurpose external financial statements – state and local governments.

Know facts, decisions or conditions expected to have a significant impact on financial position or results of operations.

GASB statement No. 34 makes it clear that neither government-wide statements nor fund statements are considered superior or subordinate to the other.

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PROBLEM 13-9 a.

For a statement of changes in net worth, dividend income would be a realized increase in net worth.

For a statement of changes in net worth, an increase in the value of land would be an unrealized increase in net worth.

Reviewing realized decreases in net worth is not a suggestion for reviewing the statement of financial condition.

Bank statements, checkbooks, real estate tax returns, and insurance policies would be a source of information for personal financial statements.

Presenting a car at cost would not be an acceptable presentation on a personal financial statement.

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PROBLEM 13-10 a. Mike Szabo Statement of Changes in Net Worth For the Year Ended December 31, 2012 Realized increases in net worth Salary Dividend income Interest income Gain on sale of marketable securities

Realized decreases in net worth Income taxes Interest expense Personal expenditures Net realized increases in net worth Unrealized increases in net worth Stock options Land Residence Unrealized decreases in net worth Boat Jewelry Furnishings Estimated income taxes on the differences between the estimated current values of assets and the estimated current amounts of liabilities and their tax bases Net unrealized decreases in net worth Net increase in net worth Net worth at the beginning of year Net worth at end of year

$ 60,000 2,500 2,000 500 $ 65,000

$ 20,000 6,000 29,000 $ 55,000 $ 10,000

3,000 7,000 5,000 $ 15,000 $

3,000 1,000 4,000

15,000 $ 23,000 $ 8,000 $ 2,000 150,000 $ 152,000

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b. Most of the realized increases in net worth came from salary ($60,000). The major decreases in realized net worth were income taxes ($20,000) and personal expenditures ($29,000). Net realized increases in net worth were $10,000. Land had the most material increase in unrealized net worth ($7,000) The greatest unrealized decrease in net worth was the estimated income taxes on the difference between the estimated current values of assets and the estimated amounts of liabilities and their tax bases ($15,000). Net unrealized decreases in net worth were $8,000. Net increase in net worth was $2,000. Net worth at the end of the year was $152,000.

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PROBLEM 13-11 a. Marketable securities: Options: Residence: Royalties:

$20,000 x 28% = $ 5,600 $30,000 x 28% = 8,400 $50,000 x 28% = $ 14,000 $20,000 x 28% = 5,600 $ 33,600

b. Mary Lou and Ernie Statement of Financial Condition December 31, 2012 Assets Cash Marketable securities Options Residence Royalties Furnishings Auto

$ 20,000 100,000 30,000 150,000 20,000 20,000 15,000 $ 355,000

Liabilities Mortgage Auto loan Total liabilities

$ 70,000 10,000 $ 80,000

Estimated income taxes on differences between estimated current value of assets and their tax basis Net worth Total liabilities and net worth

33,600* 241,400 $ 355,000

*($20,000 + $30,000 + $50,000 + $20,000) x 28% = $33,600 c. The net worth is $241,000 Liquid assets total $120,000 (cash, $20,000; marketable securities, $100,000). Most of the liabilities appear to be long-term (mortgage payable, $70,000). Comparison of specific assets with related liabilities: Auto Current value Auto loan Net investment

$ 15,000 10,000 $ 5,000

Residence Current value Mortgage Net investment

$ 150,000 70,000 $ 80,000

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PROBLEM 13-12 a. Marketable securities Residence

$5,000 x 28% = $ 1,400 25,000 x 28% = 7,000 $ 8,400

b. Barb and Carl Statement of Financial Condition December 31, 2012 Assets Cash Marketable securities Life insurance Residence Furnishings Jewelry Autos Total Assets

20,000 50,000 50,000 125,000 25,000 20,000 12,000 $ 302,000

Liabilities Mortgage payable Note payable Credit cards Total liabilities

Estimated income taxes on differences between estimated current value of assets and their tax basis Net worth Total liabilities and net worth

90,000 30,000 10,000 130,000

8,400* 163,600 $ 302,000

* ($5,000 + $25,000) x 28% = $8,400 c. The net worth is $163,000. Many would consider this a relatively high amount. Liquid assets total $70,000 (cash, $20,000; marketable securities, $50,000). The majority of the liabilities are long-term (mortgage payable, $90,000). Comparison of specific assets with related liabilities: Residence: Current value Mortgage payable Net investment

$ 125,000 90,000 $ 35,000

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PROBLEM 13-13 a.

Ree’s: 1,000 shares x $20 = Less commission

$ 20,000 14 $ 19,986

Bell’s: 2,000 shares x $8 = Less commission

$ 16,000 17 $ 15,983

b. Certificate of deposit Accrued interest Less early withdrawal penalty

$10,000 500 10,500 300 $10,200

c. Present selling price per share Option price per share Estimated value of options per share (a) Number of options (b) Total estimated value of options (a) x (b)

25 20 $ 5 x 500 $ 2,500

d. Cash value Less loan outstanding Estimated current value

$50,000 20,000 $30,000

e. $ 90,000 estimate of current value 4,500 broker fee (5% x $90,000) $ 85,500 Note: it would be better to get an independent appraisal of the home than to use Larry’s estimate.

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PROBLEM 13-14 a.

$ 80,000 Purchase price 10,000 Improvements 90,000 x 1.40 Increase in inflation rate 126,000 20,000 Less mortgage $ 106,000 Note: An appraisal would likely be preferable to this computation.

b. $9,000; the average selling price for this model of car. c. Estimated current value of the IRA: IRA Less Taxes: 1. 10% IRS penalty for early withdrawal 2. $20,000 x 30% Estimated current value of the IRA

$20,000 $ (2,000) (6,000) $ (8,000) $12,000

d. The guarantee should not be presented as a liability. It should be disclosed in a note, if material. e. If the offer to buy back the mortgage is still outstanding, the estimated current value of the debt would be $40,000. If the buy-back offer has expired, then the estimated current value of the mortgage is $45,000.

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CASES CASE 13-1 DEFICIT BUDGET? a. This is an opinion question. It should be recognized that an accounting standard adopted by public colleges in 2000 required colleges to account for depreciation. b. According to the efficient market hypothesis, disclosure is the important element, not where it is disclosed. Many would disagree with this position and would prefer recognition in the statements. c. This is an opinion question. The opinion of the author is that the standard should be explicit for maximum benefit.

CASE 13-2 MY MUD HENS (This case provides the opportunity to view the Toledo Mud Hens Baseball Club, which is considered to be a component of Lucas County, Ohio.) a. The Mud Hens would present a nonprofit statement. It should disclose the relationship with Lucas County, Ohio. b. Lucas County, Ohio, presents the Toledo Mud Hens Baseball Club, Inc. as a discretely presented component unit. A component unit is a legally separate organization for which the elected officials of the primary government are financially accountable. c. Yes. Net assets increased from $8,703,382 to $10,003,382 (an increase in net assets of $1,300,000). d. Yes. Net Assets: Invested in capital assets, net of related debt $ 3,452,865 Unrestricted 6,550,516 Total net assets $ 10,003,382

398 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

CASE 13-3 JEEP (This case provides an opportunity to view the relationship between Lucas County, Ohio, and DaimlerChrysler. DaimlerChrysler, on May 14, 2007 agreed to sell an 80% stake in its U.S. brand to Cerberus Capital Management, a private equity investment firm.) a. The County would account for the $2 million expenditure as a normal expenditure. DaimlerChrysler is an independent private company. It does not qualify to be consolidated into the Lucas County statements, nor does it qualify to be presented as a component unit. CASE 13-4 GOVERNOR LUCAS – THIS IS YOUR COUNTY (This case represents an opportunity to make a limited review of the Lucas County financial report.) a. Table 5 Lucas County, Ohio Revenues by Service Last Ten Fiscal Years Horizontal Common-Size

Fiscal Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

General & Tangible Personal Property Taxes 20.4 24.2 24.0 24.7 24.5 21.8 18.5 17.7 19.4 18.9

Sales Tax 15.9 15.9 15.2 16.1 15.9 14.9 13.6 14.3 12.8 14.0

Lodging Tax 0.8 0.9 0.8 0.8 0.8 0.8 0.7 1.3 0.8 0.9

Investment Income 3.0 1.9 0.9 0.7 1.6 2.4 2.7 3.0 1.0 1.0

Charges For Services 5.5 5.8 5.9 6.5 6.4 6.2 6.6 6.8 6.5 7.4

Fines & Forfeitures 0.2 0.1 0.2 0.1 0.2 0.1 0.1 0.1 0.2 0.1

Licenses & Permits 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 0.2

Special Assessments 0.6 0.5 0.4 0.5 0.6 0.5 1.4 0.7 0.4 0.7

Intergovernmental Revenue 43.9 41.6 41.9 45.3 45.5 49.1 43.7 52.4 51.5 50.6

Other 9.8 9.0 10.8 5.2 4.5 4.1 12.7 3.7 7.2 6.3

Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

b. Intergovernmental revenue represented the major source of revenue and it increased materially. General & tangible personal property taxes represented a second major source of revenue. This source increased materially and decreased materially. Sales tax was the third major source of revenue. In general, it decreased slightly. Charges for services was the fourth major source of revenue. This source increased materially. Other was the fifth major source of revenue. This source fluctuated materially. 399 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

c. Table 5 Lucas County, Ohio Revenues by Service Last Ten Fiscal Years Vertical Common-Size

Fiscal Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

General & Tangible Personal Property Taxes 100.0 114.5 116.9 118.3 119.8 114.6 107.2 97.4 107.8 101.5

Sales Tax 100.0 96.8 95.1 99.3 100.2 100.5 101.3 101.2 91.3 96.6

Lodging Tax 100.0 118.9 106.2 106.4 110.6 115.4 108.6 188.1 122.4 132.0

Investment Income 100.0 61.5 29.7 23.4 52.2 85.6 104.7 111.3 37.4 34.7

Charges For Services 100.0 100.5 104.9 115.3 115.8 120.2 140.7 137.0 133.0 145.9

Fines & Forfeitures 100.0 90.2 101.7 97.3 108.7 121.2 102.0 111.7 146.1 101.2

Licenses & Permits 100.0 108.8 158.5 211.8 97.1 88.2 88.2 76.5 2,138.2 2,382.4

Special Assessments 100.0 89.2 68.3 78.8 97.8 91.8 293.7 132.3 82.2 123.7

Intergovernmental Revenue 100.1 91.6 94.8 100.9 103.5 120.2 118.1 133.9 132.7 126.6

Other 100.0 88.6 109.5 51.8 45.7 45.2 153.4 42.3 83.3 71.2

Total 100.0 96.5 99.3 97.7 99.8 107.3 118.4 112.2 113.1 109.8

d. Licenses and permits had a very material increase. This increase took place in 2009 and 2010. Material increases were in lodging tax, charges and services, special assessments, and intergovernmental revenue. Material decrease in investment income and other.

400 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

CASE 13-5 COUNTY-WIDE (This case represents an opportunity to prepare a descriptive county-wide financial analysis.) Provided here is a quote from the management’s discussion and analysis. Not all of the information in the analysis can be determined from the table. It was decided to include the entire analysis because it is a good representative description (quote from page 16, December 31, 2010 annual report). County-Wide Financial Analysis As noted earlier, net assets may serve over time as a useful indicator of a county’s financial position. In the case of the county, assets exceeded liabilities by $490,826,558 ($395,063,131 in governmental activities and $95,763,427 in businesstype activities) as of December 31, 2010. This is an increase of $34,675,402 (9.62%) for governmental activities and a increase of $473,591 (0.50%) for business-type activities. By far, the largest portion of the county’s net assets (52.18%) reflects its investment in capital assets, which includes land, buildings, machinery and equipment, and infrastructure, less any related debt used to acquire those assets that is still outstanding. The county uses these capital assets to provide services to citizens; consequently, these assets are not available for future spending. Although the county’s investment in its capital assets is reported net of related debt, the resources needed to repay this debt must be provided from other sources since the capital assets themselves cannot be used to liquidate these liabilities. An additional portion of the county’s net assets (35.42%) represents resources that are subject to restrictions on how they can be used. The remaining balance of unrestricted assets of $60, $870, $344, or 12.4%, may be used to meet the county’s ongoing obligations to citizens and creditors.

401 © 2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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