Solutions Manuals Accounting Concepts and Applications 10th Edition by Albrecht

CHAPTER 2 DISCUSSION QUESTIONS inspect the company by, among other things, reviewing the financial statements.

1. Investors, creditors, and other external users need to know a company's financial status.

For example, what assets does the company own? Are the assets still productive? How hard would it be to sell the assets, if needed? Also, what debts must be paid? Are the owners' interests in the business increasing or decreasing and why?

External users also need information on the profitability of the company. Is the company making or losing money? In addition, external users need to know what the total inflows and outflows of cash are—those from operations as well as those from investing and financing activities. This information is provided in the primary financial statements consisting of a balance sheet, an income statement, and a statement of cash flows.

By researching the past and current financial statements of the company, you can determine (1) if past and present stock performances are indicative of the projected 150% return; (2) if the company has a history of positive or negative cash flows; (3) if sales have been steadily increasing or decreasing over time; and (4) if the company historically has had net earnings or losses.

These are but a few of the many reasons why it is important to do the research yourself before immediately jumping into an investment just on your friends' advice.

4. Readers of annual reports need to compare the financial status and results of operations of a company with other companies and with the same company's results for previous periods. In this way, users can judge the relative progress of a company toward its goals. Statements covering more than one accounting period and those statements that classify and highlight key relationships assist in this comparative analysis.

2. a. A balance sheet shows a company's financial status (the relationships among assets, liabilities, and owners' equity) at a particular date. b. An income statement shows the results of an entity's operations during a period of time. c. A statement of cash flows shows the major inflows and outflows of cash during a period of time.

5. There are three ways that economic resources can be brought into a business: borrowing from others, owner contributions, and earnings. The first is a liability, whereas the latter two are included in the owners' equity section. Together these two balance sheet sections (liabilities and owners' equity) inform readers of the ―sources'' of assets.

3. The answer might seem obvious to you, but you would be surprised at how often people get so caught up in dreaming of the ―guaranteed‖ return that they forget to research the company's financial situation before investing.

6. Owners' equity is a residual value showing the amount of net assets (assets minus liabilities) that are claimed by the owners of the business. If a business were to sell all its assets, then pay all its creditors, the remaining amount would go to the owners.

The amount of owners' equity reported on a balance sheet generally will not be equal to

Would you buy a home on your friends' advice without seeing the home yourself?

No, you would view the home and most likely hire an inspector to check it for problems before deciding if it would be a good investment. Just as you would inspect a home before investing, so should you

15

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Chapter 2

the current worth of a business since the assets generally are reported at their historical costs, not at their current values.

The amount of owners' equity is represented by all assets (after deducting liabilities), not just cash.

operations is a key figure that should be highlighted.

11.

When financial statements are prepared in accordance with generally accepted accounting principles (GAAP), certain guidelines or rules have been followed in measuring and reporting the yearly financial activities. In expressing an opinion, an auditor attests and affirms that the guidelines followed are commonly accepted by the accounting profession. Thus, the auditor's opinion gives assurance that the results of operations have not been distorted because a firm uses different or incorrect accounting principles and procedures. The auditor's opinion also gives some assurance that management's financial statements fairly represent what actually occurred during the year. Without such assurances, misleading or ill-prepared financial statements could cause substantial losses to unwary investors.

12.

Auditors cannot assure that the financial statements are accurate, because their examination is not based on a test of every item and every transaction. Time and fee constraints require that an audit be based on a sample of items. Auditors review a sufficient sample of evidential material to form a professional opinion, but accuracy is still the responsibility of the preparer of the statements—management. The auditor's function is to express an opinion about the financial statements.

13.

The four types of financial statement notes typically included in an annual report are (1) summary of significant accounting policies, (2) additional information about summary totals, (3) disclosure of information not recognized, and (4) supplementary information.

14.

The importance of the basic accounting concepts or assumptions is as follows:

7. The balance sheet has two main limitations.

First, assets are initially recorded at their purchase cost and subsequent changes in value may or may not be recorded on the books. The second limitation is that some important economic assets, called intangible assets, are not reported at all, although they may be the most valuable assets to the company.

It is important to be aware of these limitations when evaluating a company's growth potential because the company may be worth much more (or less) than its book value shows.

8. Some people feel that the income statement is more important than the balance sheet because it shows the profitability of a company. In turn, profitability relates to future cash-generating ability, which is of prime interest to most users of financial reports. Others feel that the balance sheet is more important than the income statement because cash flow is eventually translated into the asset and equity balances reported on the balance sheet. Properly informed people realize that all three primary financial statements are equally important and complementary.

9. By looking only at the net income or EPS number, an investor might not see the important relationships of various categories on an income statement. For example, revenues less operating expenses equals operating income. If an unusual gain or loss on some nonoperating item is added to or subtracted from operating income, net income and the EPS number may be distorted and would not reflect the results of normal operations for the period.

10.

Cash flows should be classified according to operating, investing, and financing activities in order to help investors and others see the sources and uses of cash by major activity.

For example, if a company is not providing a net cash inflow from operations and instead has to borrow cash to keep the business running, it may not stay in business long.

Thus, the amount of net cash provided from

a. The separate entity concept identifies the particular organizational unit for which accounting data are compiled.

The entity is the focal point for accumulating, measuring, and communicating accounting data. b. Arm's-length transactions are those in which the buyer and seller are rational and free to act independently.

Accounting for and analyzing economic

Chapter 2

transactions enable the accountant to measure the successes and failures of a reporting entity. If transactions between entities involve any favoritism or irregularity, the data measured by the accountant will lose validity; that is, the data will not accurately measure the success of the reporting entity. c. The cost principle requires transactions to be recorded at historical costs, the amounts originally paid in an arm'slength transaction. This ensures that accounting data are objective, since the exchange price (historical cost) at the date of the transaction is presumed to reflect the fair market value of an item at that date. d. Monetary measurement provides a quantitive means of measuring transactions and comparing the results of operations for various reporting entities.

17

e. The going concern assumption states that, unless there is evidence to the contrary, the entity will continue in operation for the foreseeable future. If the opposite assumption were made— that the entity was about to go out of business—accountants would record liquidation values on the books of the entity.

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Chapter 2

PRACTICE EXERCISES PE 2–1 (LO1)

Total Assets

Computation of total assets: $

Cash ............................................................................

Accounts receivable ..................................................

Inventory .....................................................................

Equipment ...................................................................

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

PE 2–2 (LO1)

800 1,000 3,500 10,000 $15,300

Total Liabilities

Computation of total liabilities: Accounts payable .......................................................

Wages payable ...........................................................

Loan payable ..............................................................

Total liabilities ............................................................

PE 2–3 (LO1)

$

900 500 9,000 $10,400

Total Owners’ Equity

Computation of total owners’ equity: Capital stock ...............................................................

Retained earnings ......................................................

Total owners’ equity...................................................

$ 1,500 3,400 $ 4,900

Refer to the solutions for PE 2–1, 2–2, and 2–3. To confirm the accuracy of the solutions, we can verify assets are equal to liabilities plus owners’ equity: Total assets ................................................................

$15,300

Total liabilities ............................................................

Total owners’ equity...................................................

Total liabilities and owners’ equity ...........................

$10,400 4,900 $15,300

PE 2–4 (LO1)

The Accounting Equation

Case A

$10,000 – $4,000 = $6,000 Owners’ equity

Case B

$8,000 – $3,500 = $4,500 Liabilities

Case C

$5,500 + $7,000 = $12,500 Assets

Case D

$13,000 – $15,000 = ($2,000) Owners’ equity Note that in this case, total owners’ equity is negative because liabilities are greater than assets.

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Chapter 2

PE 2–5 (LO1)

Balance Sheet

Assets Cash ............................................................................

Accounts receivable ..................................................

Inventory .....................................................................

Equipment ...................................................................

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

$

800 1,000 3,500 10,000 $15,300

Liabilities Accounts payable .......................................................

Wages payable ...........................................................

Loan payable ..............................................................

Total liabilities ............................................................

900 500 9,000 $10,400

Owners’ Equity Capital stock ...............................................................

Retained earnings ......................................................

Total owners’ equity...................................................

Total liabilities and owners’ equity ...........................

$ 1,500 3,400 $ 4,900 $15,300

PE 2–6 (LO1)

$

Current Assets

Computation of total current assets: Cash ............................................................................

Accounts receivable ..................................................

Inventory .....................................................................

Total current assets ...................................................

PE 2–7 (LO1)

$ 625 800 2,100 $3,525

Current Liabilities

Computation of total current liabilities: Accounts payable .......................................................

Loan payable (due in 6 months)................................

Total current assets ...................................................

$700 250 $950

For simplicity, the entire $10,000 amount of the mortgage payable is assumed to be a long-term liability. However, if monthly payments are to be made on the mortgage during the next year, some part of the liability is current. This portion might be labeled as ―current portion of mortgage payable.‖

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Chapter 2

PE 2–8 (LO1)

1.

Book value of equity: Case A Case B Case C Case D

2.

Book Value and Market Value of Equity

Assets $ 10,000 8,000 13,500 100,000

=

Liabilities $ 4,000 7,000 5,500 150,000

Owners’ Equity $ 6,000 1,000 8,000 (50,000)

+

Market value of equity:

Case A Case B Case C Case D

Shares of Stock Outstanding 1,000 500 300 1,000



Price per Share $15 10 20 7

=

Market Value $15,000 5,000 6,000 7,000

Cases A and B illustrate the normal case in which the accounting book value understates the actual value of the company. In Case C, the market value is actually less than the book value; this can occur when a company makes unwise investment and operating decisions after the owners have invested their money. Case D illustrates that a company can have positive market value even when the book value of equity is negative. Surprisingly, about 5% of publicly-traded U.S. companies have negative equity book values.

PE 2–9 (LO2)

Total Revenues

Computation of total revenues: Sales ............................................................................

Consulting revenue ....................................................

Interest revenue .........................................................

Total revenues ............................................................

PE 2–10 (LO2)

$13,600 2,700 900 $17,200

Total Expenses

Computation of total expenses: Cost of goods sold .....................................................

Advertising expense ..................................................

Total expenses ...........................................................

$10,200 2,150 $12,350

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Chapter 2

PE 2–11 (LO2)

Computation of Net Income

Computation of net income (or net loss): Sales Rent revenue Cost of goods sold Interest expense Net income (loss) PE 2–12 (LO2)

Case A $ 100,000 5,000 (60,000) (18,000) $ 27,000

Case B $150,000 1,000 (30,000) (47,000) $ 74,000

Case C $ 70,000 12,000 (60,000) (25,000) $ (3,000)

Case D $ 200,000 10,000 (110,000) (31,000) $ 69,000

Income Statement

Income statement: $12,000

Sales .................................................................

Expenses: Cost of goods sold ....................................

Wage expense ............................................

Interest expense ........................................

Income tax expense ................................... ................................................Totalexpenses

$7,300 900 1,200 800 10,200 $ 1,800

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

PE 2–13 (LO2)

Computation of Ending Retained Earnings

Computation of ending retained earnings: Beginning retained earnings Net income (loss) Less: Dividends Ending retained earnings PE 2–14 (LO2)

Case A $50,000 5,000 $55,000 3,000 $52,000

Case B $15,000 1,000 $16,000 4,500 $11,500

Case C $31,000 12,000 $43,000 2,100 $40,900

Case D $ 70,000 (10,000) $ 60,000 6,000 $ 54,000

Expanded Accounting Equation

Case A

$23,000 – $11,000 – $4,500 = $7,500 Capital stock

Case B

$17,500 – $4,500 – $3,600 = $9,400 Liabilities

Case C

$14,000 + $11,000 + $27,000 = $52,000 Assets

Case D

$45,000 – $29,000 – $18,000 = ($2,000) Retained earnings Note that in this case, retained earnings is negative indicating that either the company has reported a cumulative loss over its history or cumulative dividends have exceeded cumulative income.

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PE 2–15 (LO3)

Chapter 2

Computing Cash from Operating Activities

Computation of cash flow from operating activities: Cash collected from customers .....................................................

Cash received from tenants renting part of a building ................

Cash paid for interest .....................................................................

Cash paid for income taxes............................................................

Cash flow from operating activities ...............................................

PE 2–16 (LO3)

$10,000 600 (450) (1,320) $ 8,830

Computing Cash from Investing Activities

Computation of cash flow from investing activities: Cash received from sale of a building ...........................................

Cash paid to purchase land ...........................................................

Cash flow used by investing activities ..........................................

PE 2–17 (LO3)

$ 5,600 (12,000) $ (6,400)

Computing Cash from Financing Activities

Computation of cash flow from financing activities: Cash paid to repay a loan ...............................................................

Cash paid for dividends ..................................................................

Cash received upon the issuance of new shares of stock ..........

Cash flow from financing activities ...............................................

$(1,000) (780) 3,000 $ 1,220

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Chapter 2

PE 2–18 (LO3)

Preparing a Statement of Cash Flows Statement of Cash Flows

OPERATING ACTIVITIES: Cash collected from customers ....................................

Cash received from tenants renting part of a building Cash paid for interest .....................................................

Cash paid for income taxes ...........................................

$ 10,000 600 (450) (1,320)

..............................Cashflowfromoperatingacti vities

$ 8,830

INVESTING ACTIVITIES: Cash received from sale of a building ..........................

$ 5,600 (12,000)

Cash paid to purchase land ...........................................

.........................Cashflowusedbyinvestingactiv ities

(6,400)

FINANCING ACTIVITIES: $ (1,000) (780) Cash received upon the issuance of new shares of stock 3,000 ...............................Cashflowfromfinancingacti vities Cash paid to repay a loan ..............................................

Cash paid for dividends .................................................

Net increase in cash ............................................................

Cash balance, beginning of year ........................................

Cash balance, end of year ...................................................

PE 2–19 (LO3)

1,220 $ 3,650 2,000 $ 5,650

Financial Statement Articulation

Case A Cash, beginning $13,000 Net increase (decrease) in cash 8,200 Cash, ending $21,200B Beginning retained earnings Net income (loss) Less: Dividends Ending retained earnings

Case A $41,000 18,000 $59,000 6,500 $52,500A

Case B $15,700 C 5,300 $21,000 Case B $ (1,700) 25,000 $ 23,300 7,300 $ 16,000

D

Case C $ 4,200 (2,600)E $ 1,600

Case D $ 22,000 (6,300) $ 15,700 H

Case C $22,000 (5,700)F $16,300 800 $15,500

Case D $ 51,000 (11,000) $ 40,000 5,000G $ 35,000

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Chapter 2

EXERCISES E 2–20 (LO1) 1.

2.

3.

4.

5.

6.

BS/L IS BS/A IS BS/A BS/A

E 2–21 (LO1)

Classification of Financial Statement Elements 7.

8.

9.

10.

11.

12.

IS BS/A BS/OE IS BS/A BS/A

13.

14.

15.

16.

17.

18.

BS/L BS/L BS/A IS BS/OE IS

Accounting Equation A

Cash .................................................................

Accounts receivable .......................................

Land and buildings .........................................

Accounts payable ............................................

Mortgage payable ............................................

Owners' equity.................................................

B

$31,000 14,000 95,000 15,000 80,000 45,000

$ 8,400 13,000 42,600 16,000 31,000 17,000

C $13,000 16,500 67,000 23,000 41,500 32,000

E 2–22 (LO1, LO2) Comprehensive Accounting Equation X Assets: January 1, 2009 ..................................

Liabilities: January 1, 2009 .............................

Owners' equity: January 1, 2009 ....................

Assets: December 31, 2009 ............................

Liabilities: December 31, 2009 .......................

Owners' equity: December 31, 2009 ..............

Revenues in 2009 ............................................

Expenses in 2009 ............................................

$360 280 80 380 320 60 80 100

Y $1,080 460 620 1,240 520 720 216 116

Z $230 80 150 310 90 220 400 330

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Chapter 2

E 2–23 (LO1, LO2) Computing Elements of Owners' Equity 1. Total assets at December 31 ($180,000 + $15,000) .........................

Less liabilities at December 31 .........................................................

Owners' equity at December 31 ........................................................

Less capital stock at December 31 ($60,000 + $10,000) .................

Retained earnings at December 31...................................................

2. Beginning retained earnings balance ........................

$195,000 45,000 $150,000 70,000 $ 80,000

$75,000 X (11,500) $80,000 (see item 1)

Add net income for period ...........................................

Less dividends for period ............................................

Ending retained earnings balance ..............................

Therefore: $75,000 +

X – X =

$11,500 $16,500

= $80,000 = Net Income

Net Income = Revenues – Expenses $16,500 =

X – X =

$75,000 $91,500

= Revenues

E 2–24 (LO1, LO2) Balance Sheet Relationships Canfield Corporation Balance Sheet December 31, 2009 Assets Cash ...................................

Accounts receivable .........

Interest receivable .............

Equipment ..........................

Buildings ............................

$ 55,000 75,000 20,000 85,000 325,000

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

$560,000

Liabilities Accounts payable ..............

Mortgage payable ..............

$ 65,000 150,000

Owners' Equity Capital stock ......................

200,000 .............Retainedearnings Total liabilities and owners' equity ............................ $560,000

Note: Sales revenue, rent expense, and utilities expense are not part of the balance sheet, but instead are components of the income statement.

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Chapter 2

E 2–25 (LO1, LO2) Balance Sheet Preparation Taylorsville Construction Company Balance Sheet December 31, 2009 Assets Current assets: Cash .................................................................................

Accounts receivable .......................................................

Supplies ...........................................................................

Total current assets ..................................................

Long-term assets: Land .................................................................................

Buildings .........................................................................

Total long-term assets ..............................................

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

Liabilities and Owners' Equity Liabilities: Accounts payable ...........................................................

Mortgage payable ...........................................................

Total liabilities ...........................................................

Owners' equity......................................................................

Total liabilities and owners' equity .....................................

$ 153,600 113,500 4,250 $271,350 $ 90,000 512,000 602,000 $873,350

$ 74,300 423,400 $497,700 375,650* $873,350

*Computations of Owners' Equity: Owners' equity, January 1, 2009 .........................................

Add net income for 2009 ......................................................

Less distribution to owners during 2009 ...........................

Owners' equity, December 31, 2009 ...................................

$ 314,300 109,450 $ 423,750 48,100 $ 375,650

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Chapter 2

E 2–26 (LO2) 1.

Income Statement Computations

Revenues ......................................................................

Expenses: Supplies expense ...................................................

Salaries expense .....................................................

Rent expense ..........................................................

Administrative expense ..........................................

Income before taxes ....................................................

$175,000 $45,000 70,000 1,500 6,000

122,500 $ 52,500

2.

Income before taxes ....................................................

Income tax rate .............................................................

Income taxes ................................................................

$ 52,500  30% $ 15,750

3.

Income before taxes ....................................................

Income taxes ................................................................

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

$ 52,500 15,750 $ 36,750

4. Earnings per share ($36,750/15,000 shares) ..............

E 2–27 (LO2) 1.

$

Income Statement Preparation Pickard and Associates Income Statement For the Year Ended December 31, 2009

Fees (revenues) ............................................................

Expenses: Advertising expense ..............................................

Supplies expense ...................................................

Rent expense ..........................................................

Utilities expense .....................................................

Miscellaneous expense ..........................................

Salaries expense .....................................................

Income before taxes ....................................................

Income taxes (30%) ......................................................

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

Earnings per share ($232,680/11,000 shares) ............

2.

2.45

$476,000 $14,500 31,500 12,000 2,500 5,100 78,000

143,600 $332,400 99,720 $ 232,680 $

21.15

EPS tells the reader that for every individual share of stock outstanding, Pickard and Associates earned $21.15 during 2009. This helps investors see how profitable their individual investments in Pickard and Associates are.

28

E 2–28 (LO2)

Chapter 2

Income and Retained Earnings Relationships

1. Increase in retained earnings ...........................................................

Plus dividends paid ...........................................................................

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

$375,000 135,000 $510,000

2. Revenues ............................................................................................

Less net income .................................................................................

Expenses for the year ........................................................................

$830,000 510,000 $320,000

E 2–29 (LO2)

Retained Earnings Computations

Retained earnings, December 31, 2008 = $60,000 Retained earnings, December 31, 2009 = $75,000 Computations: Revenues in 2009 .......................................................................................

Expenses in 2009 .......................................................................................

Net income in 2009 .....................................................................................

$ 230,000 (190,000) $ 40,000

Assets: December 31, 2008 .......................................................................

Liabilities: December 31, 2008 ..................................................................

Owners' equity: December 31, 2008 .........................................................

$ 350,000 (80,000) $ 270,000

Owners' equity: December 31, 2008 .........................................................

Capital stock: December 31, 2008 ............................................................

Retained earnings: December 31, 2008....................................................

$ 270,000 (210,000) $ 60,000

Retained earnings: December 31, 2008....................................................

Add net income for 2009 ($230,000 – $190,000) ......................................

Deduct dividends for 2009 .........................................................................

Retained earnings: December 31, 2009....................................................

$ 60,000 40,000 (25,000) $ 75,000

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Chapter 2

E 2–30 (LO2)

Preparation of Income Statement and Retained Earnings Statement Big Sky Corporation Income Statement For the Year Ended June 30, 2009

Ski rental revenue ......................................................

$77,900

Expenses: Rent expense ........................................................ $ 6,000 Salaries expense ................................................... 38,600 Utilities expense ...................................................

2,400 Advertising expense .............................................

7,500 Miscellaneous expense ........................................

7,700 Income before taxes ..................................................

Income taxes ..............................................................

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

62,200 $15,700 2,100 $13,600

Earnings per share ($13,600/1,500 shares) ..............

$ 9.07 (rounded)

Big Sky Corporation Statement of Retained Earnings For the Year Ended June 30, 2009 Retained earnings, July 1, 2008 ................................................................

Add net income for the year ......................................................................

Less dividends ...........................................................................................

Retained earnings, June 30, 2009 .............................................................

E 2–31 (LO2)

$76,800 13,600 $90,400 6,500 $83,900

Articulation: Relationships between a Balance Sheet and an Income Statement

1.

Assets (increased $64,000) = Liabilities (increased $16,000) + Owners' equity (increased $48,000). If owners' equity increased by $48,000 and dividends of $12,100 were paid, net income must have been $48,000 + $12,100, or $60,100.

2.

Assets (increased $64,000) = Liabilities (increased $16,000) + Owners' equity (increased $48,000). If owners' equity increased $48,000 and $18,000 of this was the result of additional issuance of stock, net income must have been $48,000 – $18,000, or $30,000.

3.

Again, if owners' equity increased by $48,000 but additional stock was issued for $72,000 and dividends of $12,400 were paid, then the net loss must have been $48,000 – $72,000 + $12,400, or ($11,600).

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Chapter 2

E 2–32 (LO3)

Cash Flow Computations

1. Cash receipts from: Customers ...............................................................

Cash payments for: Wages ......................................................................

Utilities .....................................................................

Advertising ..............................................................

Rent ..........................................................................

Taxes........................................................................

Net cash provided by operating activities .................

$ 270,000 $ 82,000 3,000 4,000 36,000 67,000

2. Cash receipts from sale of building ...........................

Cash payments for purchase of land .........................

Net cash used by investing activities .........................

3.

Cash receipts from: Investments by owners ..........................................

Bank loan .................................................................

Cash payments for: Dividends .................................................................

Repayment of principal on loan.............................

Net cash provided by financing activities ..................

$ 90,000 (106,000) $ (16,000)

$ 54,000 60,000 $ 20,000 40,000

4.

Cash flows from operating activities Cash flows from investing activities ..........................

Cash flows from financing activities ..........................

Net increase in cash ....................................................

$ 78,000 (16,000) 54,000 $116,000

5.

Cash balance at beginning of year .............................

Net increase in cash during the year ..........................

Cash balance at the end of the year ...........................

$386,000 116,000 $502,000

E 2–33 (LO3) a. b. c. d. e. f. g. h. i. j.

OA OA FA IA FA FA OA OA OA IA

Cash Flow Classifications

192,000 $ 78,000

$ 114,000

60,000 $ 54,000

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Chapter 2

E 2–34 (LO4)

Notes to Financial Statements

The notes to financial statements are very important because they explain how a company has prepared its financial statements and also clarify specific items that need more detail. The first section of its notes to financial statements is entitled ―Summary of Significant Accounting Policies.‖ The second section gives additional information regarding long-term debt, financial instruments, income taxes, and other items. This section explains how Wal-Mart came up with the totals given earlier in its financial statements. The third section examines WalMart's stock and employee stock and savings plans. The last section of the notes to financial statements details segment information for Wal-Mart, as well as unaudited quarterly information.

E 2–35 (LO6)

The Cost Principle

The property purchased by Save-More Construction Company on January 1, 2009, should be recorded at $150,000, the amount of cash paid for the property.

This assumes that the land was purchased in an arm's-length transaction. The amount reported at year-end, after the rezoning decision, would still be $150,000—the historical cost, or exchange price, at the date of the transaction.

The historical cost provides an objective measure of value in accounting measurements. The increased value of the land would be recognized later, when the land is sold in another arm's-length transaction.

E 2–36 (LO6)

The Monetary Measurement Concept

Accounting records report only those transactions and events that can be measured in dollars. Some items are not measurable in monetary terms and therefore are not reported on financial statements. There can be little doubt that good employees add great value to a business enterprise. However, measuring that value is very difficult, and it is the main reason why that information is not reported on a balance sheet.

E 2–37 (LO6)

The Going Concern Assumption

If the auto repair business is regarded as a going concern, the values assigned to the assets will be equal to the original exchange prices of the transactions. If the business is not regarded as a going concern, the values assigned to the assets will likely be much lower (reflecting the lower liquidation values that the entity would obtain if it were forced to sell the assets immediately).

32

Chapter 2

PROBLEMS P 2–38 (LO1)

Balance Sheet Classifications and Relationships

1. Cash ....................................................................................................

Accounts receivable ..........................................................................

Inventory .............................................................................................

Total current assets ......................................................................

$ 71,000* 119,000 72,000 $262,000

*Computations: Total liabilities plus stockholders' equity = Total current liabilities ($199,000) + Long-term liabilities ($253,000) + Total stockholders' equity ($386,000) = $838,000.

Total current assets ($262,000) = Total assets ($838,000) – Total long-term assets ($576,000).

Cash ($71,000) = Total current assets ($262,000) – ($119,000) – Inventory ($72,000).

Accounts receivable

2. Land.....................................................................................................

Building ...............................................................................................

Equipment ...........................................................................................

Total long-term assets..................................................................

$136,000 225,000 215,000 $576,000

3. Accounts payable ...............................................................................

Notes payable (short-term) ................................................................

Total current liabilities .................................................................

$101,000 98,000 $199,000

4. Mortgage payable (Total long-term liabilities) .................................

$253,000

5. Capital stock .......................................................................................

Retained earnings ..............................................................................

Total stockholders' equity ............................................................

$200,000 186,000 $386,000

33

Chapter 2

P 2–39 (LO1, LO2) Preparation of a Classified Balance Sheet 1.

Siraco Company Balance Sheet December 31, 2009 Assets Current assets: Cash .........................................................................

Accounts receivable ...............................................

Supplies ...................................................................

Total current assets ..........................................

Long-term assets: Equipment ...............................................................

Total long-term assets ......................................

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

Liabilities and Owners' Equity Current liabilities: Accounts payable ...................................................

Wages payable .......................................................

Total current liabilities ......................................

Owners' equity: Capital stock ...........................................................

Retained earnings ...................................................

Total owners' equity ..........................................

Total liabilities and owners' equity .............................

$ 1,950 2,500 1,800 $ 6,250 $11,275 11,275 $17,525

$ 3,450 250 $ 3,700 $ 775 13,050* 13,825 $17,525

*Retained Earnings as of December 31, 2009, is equal to the January 1, 2009, Retained Earnings balance plus net income, less dividends paid for 2009.

Beginning retained earnings .............................................................

Net income (see following calculation) ............................................

Dividends paid ....................................................................................

Ending retained earnings ..................................................................

$12,000 2,550 (1,500) $13,050

During 2009, Siraco earned $2,550, as shown below.

Revenues ............................................................................................

Expenses: Wages expense .......................................................

Supplies expense ...................................................

Miscellaneous expense ..........................................

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

$10,000 $2,200 3,700 1,550

7,450 $ 2,550

34

Chapter 2

P 2–39 (LO1, LO2) (Concluded) 2.

The decision to pay dividends was probably a reasonable one. The earnings were positive, and sufficient cash was available to cover the amount of dividends paid.

P 2–40 (LO1) 1.

Balance Sheet Preparation with a Missing Element Schubert Products Inc. Balance Sheet December 31, 2009

Assets Cash ..............................................................................

Accounts receivable ....................................................

Supplies ........................................................................

Building .........................................................................

Land............................................................................... .............................................................Totalassets

$ 7,500 20,000 2,000 49,500 20,000 $99,000

Liabilities and Owners' Equity Liabilities: Accounts payable ...................................................

Owners' equity: Capital stock ...........................................................

Retained earnings ...................................................

Total liabilities and owners' equity .............................

$24,000 $42,000 33,000*

75,000 $99,000

*2. Assets – Liabilities = Owners' equity – Capital stock = Retained earnings $99,000 – $24,000 = $75,000 – $42,000 = $33,000 3. The balance sheet is a depiction of the accounting equation because it shows total assets being equal to total liabilities and owners' equity. Thus, A = L + OE, as shown on each balance sheet.

35

Chapter 2

P 2–41 (LO2) 1.

Income Statement Preparation Rulon Candies, Inc. Comparative Income Statement For the Years Ended December 31, 2009 and 2008

Sales ..............................................................................

Cost of goods sold .......................................................

Gross margin ................................................................

2009

2008

$300,000 115,000 $185,000

$350,000 85,000 $265,000

$115,000 10,000 15,000 $140,000

$110,000 20,000 8,500 $138,500

$ 45,000 10,000 (25,000) $ 30,000 9,000

$126,500 10,000 (15,000) $121,500 36,500

$ 21,000

$ 85,000

$

$

Operating expenses: Employee salaries ..................................................

Advertising expenses .............................................

Utilities expenses ...................................................

Total operating expenses ............................................

Operating income .........................................................

Interest revenue ......................................................

Interest expense .....................................................

Income before taxes ....................................................

Income tax expense ................................................

Net income

....................................................................

Earnings per share .......................................................

2.  





5.25

21.25

From just the limited information on the income statements, the following recommendations could be made to improve profitability for the year 2010: 

Increase sales. Sales dropped by nearly 15% from 2008 to 2009.



Reduce cost of goods sold if possible. Cost of goods sold per dollar of net revenues increased 58% from $0.24 in 2008 to $0.38 in 2009.



Why did employee salaries increase when both revenues and profits significantly decreased? Instead of increasing salaries in 2010, give bonus incentives to employees for reaching sales and cost-saving goals.



Expenditures for advertising decreased 50% from 2008 to 2009. The decrease in advertising may have caused the lower sales volume.

Increase advertising expenditures in the year 2010.



Interest expense increased from $15,000 in 2008 to $25,000 in 2009, a 67% increase. Did Rulon borrow a large amount in 2009? It may be a good idea to repay some loans and increase owner investment.

36

Chapter 2

P 2–42 (LO2)

Income Statement Preparation Wadley’s Car Wash Income Statement For the Year Ended December 31, 2009

Service revenues .............................................

Expenses: Rent expense ............................................. $ 6,000 Salaries expense ........................................ 41,000 Utilities expense ........................................

4,300 Supplies expense ...................................... 10,300 Miscellaneous expense .............................

970 Income before taxes .......................................

Income taxes ...................................................

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

Earnings per share ($102,430/3,000 shares).

$210,000

62,570 $ 147,430 45,000 $ 102,430 $

34.14 (rounded)

P 2–43 (LO1, LO2) Expanded Accounting Equation 1.

Compute net increase in assets: Cash ....................................................................................................

Interest receivable ..............................................................................

Inventory .............................................................................................

Accounts receivable ..........................................................................

Building ...............................................................................................

Net increase in assets ..................................................................

2.

Compute net increase in liabilities: Accounts payable ...............................................................................

Mortgage payable ...............................................................................

Wages payable ...................................................................................

Net increase in liabilities ..............................................................

3.

$ 12,500 (7,500) 50,000 (11,750) 157,500 $200,750

$ 22,500 137,500 (35,250) $124,750

Figure overall increase in owners' equity from net increases in assets and liabilities: Net increase in assets .......................................................................

Less: Net increase in liabilities .........................................................

Net increase in owners' equity ....................................................

$200,750 124,750 $ 76,000

37

Chapter 2

P 2–43 (LO1, LO2) (Concluded) 4.

Compute known net increase in owners' equity: Capital stock .......................................................................................

Retained earnings (dividends paid) ..................................................

Known net increase in owners' equity ........................................

5.

$ 26,250 (25,000) $ 1,250

Net increase of $76,000 in owners' equity resulted from changes in (1) the known net increase in owners' equity and (2) net income. Thus, net income can be figured by: Overall net increase in owners' equity .............................................

Less: Known net increase in owners' equity ...................................

Net income for 2009 ......................................................................

P 2–44 (LO2) 1.

$ 76,000 (1,250) $ 74,750

Income Statement Preparation Precision Corporation Income Statement For the Year Ended December 31, 2009

Sales revenue ...............................................................

Expenses: Advertising expense ...............................................

Delivery expense .....................................................

Packaging expense ................................................

Salaries expense .....................................................

Supplies expense ...................................................

Income before taxes ....................................................

Income taxes ................................................................

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

Earnings per share .......................................................

2. 10,000 shares 

*Rounded

 $34,515  $3.45



 10,004 shares * 



$68,000 $ 1,530 480 355 18,350 8,410

29,125 $38,875 4,360 $34,515 $ 3.45

38

Chapter 2

P 2–45 (LO2) 1.

Net Income Streuling Company Income Statement For the Year Ended May 31, 2009

Consulting fees ...............................................

$115,100

Expenses: Advertising expense ..................................

Supplies expense ......................................

Rent expense .............................................

Salaries expense ........................................

Miscellaneous expense .............................

Administrative expense .............................

Income before taxes .......................................

Income taxes ...................................................

2.

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

71,650 $ 43,450 21,180 $ 22,270

Earnings per share ($22,270/3,000 shares) ...

$

7.42 (rounded)

If Streuling Company had a loss, it may or may not be a good idea to pay dividends. It would depend on the amount of cash available, whether the loss is considered only a temporary situation, and the expectations of the shareholders. Many large companies do continue to pay dividends, even though they have a loss, in order to satisfy both perceived and real shareholder expectations.

P 2–46 (LO2) 1.

$ 2,760 37,820 1,500 18,150 4,170 7,250

Net Income and Statement of Retained Earnings Quincy Company Income Statement For the Year Ended May 31, 2009

Consulting fees ...............................................

Expenses: Advertising expense .................................. $ 4,650 Supplies expense ...................................... 38,410 Rent expense .............................................

2,400 Salaries expense ........................................ 25,340 Miscellaneous expense ............................. 10,200 Administrative expense ............................. 13,900 Income before taxes .......................................

Income taxes ...................................................

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

Earnings per share ($60,740/8,000 shares) ...

$176,400

94,900 $ 81,500 20,760 $ 60,740 $

7.59 (rounded)

39

Chapter 2

P 2–46 (LO2) 2.

(Concluded) Quincy Company Statement of Retained Earnings For the Year Ended May 31, 2009

Retained earnings, June 1, 2008 .......................................................

Add net income for the year ..............................................................

Less dividends ...................................................................................

Retained earnings, May 31, 2009 ......................................................

3.

Quincy Company Statement of Retained Earnings For the Year Ended May 31, 2009 Retained earnings, June 1, 2008 .................................

Less: Net loss for year ..............................................

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

Retained earnings, May 31, 2009 ................................

4.

$175,670 60,740 $236,410 19,500 $216,910

$175,670 $38,000 19,500

57,500 $118,170

If Quincy Company had a loss, as in (3) above, it may or may not be a good idea to pay dividends. It would depend on the amount of cash available, whether the loss is considered only a temporary situation, and the expectations of the shareholders. Many large companies do continue to pay dividends, even though they have a loss, in order to satisfy both perceived and real shareholder expectations.

P 2–47 (LO1, LO2) Comprehensive Financial Statement Preparation 1.

Wilcox, Inc. Income Statement For the Year Ended December 31, 2009 Revenues ......................................................................

Expenses: Salaries expense .....................................................

Utilities expense .....................................................

Supplies expense ...................................................

Rent expense ..........................................................

Other expenses .......................................................

Income before taxes ....................................................

Income taxes ................................................................

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

Earnings per share ($81,300/2,000 shares) ................

$389,950 $125,350 5,250 110,600 21,200 11,250

273,650 $116,300 35,000 $ 81,300 $ 40.65

40

Chapter 2

P 2–47 (LO1, LO2) (Concluded) 2.

Wilcox, Inc. Balance Sheet December 31, 2009 Assets Current assets: Cash .........................................................................

Accounts receivable ...............................................

Supplies ...................................................................

Total current assets ..........................................

Long-term assets: Land .........................................................................

Buildings .................................................................

Total long-term assets ......................................

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

Liabilities and Owners' Equity Current liabilities: Accounts payable ...................................................

Long-term liabilities: Notes payable..........................................................

Total liabilities ...................................................

Owners' equity: Capital stock ...........................................................

Retained earnings ...................................................

Total owners' equity ..........................................

Total liabilities and owners' equity .............................

$ 61,100* 90,000 72,500 $223,600 $ 42,500 197,550 240,050 $463,650

$ 38,050 63,800 $101,850 $ 65,000 296,800* 361,800 $463,650

*Computations: Retained earnings, December 31, 2009 ($296,800) = Retained earnings, January 1, 2009 ($311,000) + Net income ($81,300) – Dividends ($95,500) Total current assets ($223,600) = Total assets ($463,650) – Total long-term assets ($240,050) Cash ($61,100) = Total current assets ($223,600) – Accounts receivable ($90,000) – Supplies ($72,500) 3.

The company has been profitable over the past several years, even though more was paid out in dividends this year than was earned. The company apparently has retained most of the past years' earnings in the business.

Chapter 2

41

P 2–48 (LO1, LO2) Elements of Comparative Financial Statements

4.

1. Utilities expense .................................................................................

Salaries and commissions expense .................................................

Miscellaneous expenses ...................................................................

Income tax expense ...........................................................................

Total expenses ..............................................................................

$ 5,700 38,700 2,200 4,500 $51,100

2. Retained earnings, December 31, 2009 ............................................

Less retained earnings, December 31, 2008 ....................................

Net increase for 2009 .........................................................................

Add dividends paid ............................................................................

Net income for 2009 ...........................................................................

$35,000 18,000 $17,000 8,000 $25,000

3. Total expenses (item 1) .....................................................................

Add net income (item 2) .....................................................................

Total revenue ......................................................................................

$51,100 25,000 $76,100

Comparative financial statements enable users to compare operating results and the financial position of the company for more than one year. Often, trends in a company's financial position are more important than absolute figures.

42

Chapter 2

P 2–49 (LO3) 1.

Statement of Cash Flows Pratt & Jordan Development, Inc. Statement of Cash Flows For the Year Ended December 31, 2009

Cash Flows from Operating Activities Cash inflows from: Customer sales ..................................................

Cash outflows from: Payment of operating expenses.......................

Payment of wages and salaries .......................

Payment of taxes ...............................................

Other expenses .................................................

Net cash provided by operating activities ............

$ 215,000 135,000 43,000 32,000

Cash Flows from Investing Activities Investments in securities ..................................

Net cash used by investing activities ...................

$(245,000)

Cash Flows from Financing Activities Proceeds from land loans .................................

Payment of building loan ..................................

Distributions to owners .................................... ...................Netcashusedbyfinancingactivities

$ 75,000 (50,000) (60,000)

Net increase in cash ....................................................

Cash at beginning of year ...........................................

Cash at end of year ......................................................

2.

$ 750,000

425,000 $ 325,000

(245,000)

(35,000) $ 45,000 130,000 $ 175,000

Yes, Pratt & Jordan Development, Inc., appears to be in good shape from a cash flow standpoint. It generated $325,000 in cash flows from operating activities, which was used for investing and financing activities. Pratt & Jordan Development, Inc., was able to distribute an amount to its owners and still add $45,000 toward its end-of-year cash balance. It would help to have comparative statements of cash flows, as well as the other financial statements, to see the trends and relationships of the information.

43

Chapter 2

P 2–50 (LO3)

Statement of Cash Flows Esplin Enterprises Statement of Cash Flows For the Year Ended December 31, 2009

Cash Flows from Operating Activities Cash receipts from: Services ...................................................................... $2,214,000 Cash payments for: Operating expenses .................................................. $1,735,000 Taxes ..........................................................................

207,000 1,942,000 Net cash provided by operating activities ......................... $ 272,000 Cash Flows from Investing Activities Cash receipts from sale of land ..................................... $ 194,000 Cash payment to purchase building .............................

(352,000) .................................Netcashusedbyinvestingactivities Cash Flows from Financing Activities Cash receipts from investments by owners ................. $ Cash payments for distributions to owners ................. ..........................Netcashprovidedbyfinancingactivities Net increase in cash ............................................................

Cash at beginning of year ...................................................

Cash at end of year .............................................................. *X + $139,000 = X=

$815,000 $676,000

(158,000)

93,000 (68,000) 25,000 $ 139,000 676,000* $ 815,000

44

Chapter 2

ANALYTICAL ASSIGNMENTS AA 2–51

Creditor and Investor Information Needs

Discussion As the bank's loan officer, you would want to see comparative balance sheets, income statements, and statements of cash flows. The profitability of a company is a major factor in determining whether a company will have sufficient future cash flows to repay its loans as well as to pay the interest on those loans. In analyzing the liquidity, solvency, and overall financial position of the company, you also would be interested in the relationships disclosed on the balance sheet and the cash flow statement.

As a potential investor, you would want to determine Ink Spot's cash flow position and its operating profitability during its first two years of existence. These factors will affect the value of the company's stock (and therefore its resale value) as well as the company's ability to pay dividends to its stockholders.

AA 2–52

Analyzing Trends and Key Financial Relationships

Discussion Net income and earnings per share (EPS) increased in 2008 and again in 2009. The cause of this increase, however, was the reduction in selling and advertising expenses. Revenues actually decreased during the three-year period. Revenues in 2008 were approximately 3% less than in 2007. In 2009 there was a further decline of more than 8%. Another significant trend was the increase in interest expense.

A potential investor would be very concerned about the declining revenues and the increasing interest expense. The increase in interest expense from 2007 to 2009 could indicate that the company has been forced to rely more and more on borrowed funds to meet its operating expenses. Also, the significant decrease in selling and advertising expenses suggests that the company may be cutting back on sales staff and promotional efforts in an attempt to show increasing income and EPS. Administrative and other expenses have remained fairly stable, indicating that they are relatively ―fixed'' costs. Future decreases in selling and advertising expenses may accelerate the downward trend in revenues.

This case illustrates the danger in looking only at the ―bottom line'' results, such as net income and EPS. In addition to the income statement data presented, a prospective investor would want to analyze comparative balance sheet and cash flow data. The balance sheet and statement of cash flows, combined with the notes to the financial statements and the independent auditor's report, would help the investor determine the significance of the trends reflected in the income statement. This information considered collectively provides the basis for an informed investment decision.

AA 2–53

How Many Accounting Equations Are There?

Discussion Congratulations to your friend for remembering a few important terms from his accounting class.

However, you might want to ask your friend what grade he got in the class because his ―equations‖ are all wrong. His mistakes are as follows: Revenues = Assets. It is common for introductory students to mistakenly think that revenues and assets are one and the same thing. Assets are items of value owned or controlled by a company. Those assets can arise from a number of sources—the cash to buy the assets can be borrowed, can be invested, or can be generated through business operations. When describing the source of assets, ―revenue‖ is the

45

Chapter 2

AA 2–53

(Concluded)

label given to the source of assets that are generated through business operations, just as ―loan payable‖ is the label used when the source of assets is a bank loan and ―paid-in capital‖ is the label used when the source of the assets is owner investment.

Net Income = Cash from Operating Activities. As explained in the chapter, accountants make many adjustments, assumptions, and estimates in the computation of net income. These adjustments are made in order to convert the raw cash from operating activities number, computed simply as the difference between cash inflows and cash outflows from operating activities, into a better measure of the company’s economic performance, net income.

Retained Earnings = Cash. Net income represents the amount of assets generated through profitable operations. Some of these assets are used to pay dividends to investors. The difference between the assets generated (net income) and the assets paid out to investors (dividends) is called retained earnings. Once these excess assets are generated, they can be converted into any form the company desires. They can be turned into cash in order to increase the cash balance. They can be turned into inventory, into land, or into buildings. The point is that there is no reason to think that all of a company’s retained earnings will be used to increase the company’s cash balance.

AA 2–54Can Financial Statement Information Be Used to Successfully Pick Stocks?

Discussion This is an extremely controversial question. For some stock traders, the answer is unequivocally ―yes.‖ These stock traders believe in the usefulness of fundamental analysis which involves using existing information, including financial statement information, to determine the fundamental underlying value of a company. Using this approach, if a stock’s current price is below its computed fundamental value, then shares of that stock should be purchased.

An alternate view is based on the belief in an efficient market. In an efficient stock market, stock prices respond very quickly (within a few minutes or hours) to any information contained in a company’s financial statements. This means that potential investors who come along a week or a month later cannot use those financial statements to identify winning and losing stocks because stock prices have already moved to reflect the financial statement information. For example, it seems foolish to think that an investor can use the fact that Wal-Mart’s net income, announced six weeks ago, had increased 25% over the preceding year in order to predict that Wal-Mart’s stock price will jump in the future. Any jump that was going to occur would have occurred six weeks ago when the big-money investors in New York City first got the news about the net income increase.

Some academic research has indicated that financial models using accounting information can be used to identify, in advance, winning and losing stocks. However, one must have a little skepticism about these models because we typically don’t observe accounting professors getting rich on their ability to pick stocks.

AA 2–55

Who Audits American Companies?

Discussion Your sister is completely correct about the importance of financial statement reliability to the ability of U.S. companies to compete in the global marketplace. However, she is mistaken about who pays audit fees.

Auditors are not hired by the U.S. federal government; instead, each company chooses and pays its own

46

AA 2–55

Chapter 2

(Concluded)

auditor. As explained in the chapter, this market for auditors works because auditors want to maintain their reputations and because they want to avoid lawsuits.

As explained in the chapter, the Sarbanes-Oxley Act of 2002 increased the federal government oversight of the auditing profession. However, auditors are still hired and paid by the companies they audit, not by the federal government.

AA 2–56

Accounting for the Proper Entity

Discussion You would need to explain to Mr. Masters that the financial reports you have been asked to prepare are for the company, which is a separate and distinct reporting entity. Mixing personal and business transactions will not accurately reflect the financial results of the business. The payments should be classified as personal expenses, not business expenses.

The entity concept of reporting is an important consideration in this situation. Of equal or greater importance is the fact that deducting personal expenditures on the tax return as business expenses is not only improper, but illegal. You should encourage Mr. Masters to do what is right, not what he might get away with. If he insists on including the payments as business expenses, you should decline to provide further services for him.

AA 2–57You Decide: What is the most important number in the financial statements—net income or EPS? Judgment Call Issues to be discussed are: 1. There is an almost fixated focus on EPS these days. And, instead of annual EPS, the focus seems to be on quarterly EPS and whether or not the company has met Wall Street’s estimate of the EPS. 2. EPS is only a summary of much more information. Sometimes, focusing on EPS doesn’t allow you to see why things changed the way they did.

3. Net income by itself isn’t much more useful than EPS because it is a net number that, when looked at alone, obscures the reasons why it increased or decreased.

4. The best thing to do is to study the detail of the income statement (and the other financial statements) and not just look at one number. It is only when you have a complete financial picture by looking at all the financial statements and the way and reasons they changed that you really understand what went on.

AA 2–58

You Decide: Is the cash flow statement necessary?

Judgment Call Issues to be discussed are: 1. Many companies focus on EBITDA these days and pay much more attention to EBITDA than to cash flows.

47

Chapter 2

AA 2–58

(Concluded)

2. Most of the information on the statement of cash flows can be derived from looking at successive balance sheets and income statements, although it is much harder to obtain.

3. In the end, it is cash flows, much more than earnings or EBITDA, that really matters. If a company doesn’t have sufficient cash, it cannot pay its obligations and will have liquidity problems.

4. It is important to see how much of cash flows comes from the three activities of operations, financing, and investments.

5. EBITDA is often used as a surrogate for cash flows. It adjusts earnings for depreciation and amortization, which is also done on the statement of cash flows.

AA 2–59You Decide: Should Wall Street place so much importance on the EPS figure or not?

Judgment Call Issues to be discussed are: 1. There is a huge penalty for missing expected EPS. The stock market is built and based on expectations. When those expectations are not met, it often doesn’t matter by how much. Rather, the ―bad news‖ often results in a stock price dropping considerably.

2. It is the EPS number that Wall Street focuses on—usually quarterly EPS. 3. If she diversifies enough, unless the entire market drops, the stocks that go up should compensate for the stocks that go down. In fact, in a market where gains are unlimited and losses are limited (by the amount of the investment), in a portfolio, often one or two stocks increase enough to more than compensate for all the losers.

4. People care about EPS because it is a nice, easy-to-understand summary of the financial statements and the performance of a company.

AA 2–60

You Decide: Are the notes to the financial statements necessary?

Judgment Call Issues to be discussed are: 1. It is impossible to completely understand the financial statements without reading and understanding the notes. There are many estimates and assumptions involved in preparing financial statements and those estimates and assumptions must be explained in the notes.

2. The notes also provide additional detail that helps explain many of the changes in the financial statements from year to year.

3. The notes help readers understand the risk posture of the company—is it using aggressive accounting principles or conservative accounting principles?

4. Without notes, it would be difficult to know whether or not GAAP is being followed.

48

Chapter 2

AA 2–61

Wal-Mart

Real Company Analysis 1. On January 31, 2006, Wal-Mart had $6.414 billion in cash and cash equivalents. This amount comprised 4.6% of Wal-Mart's total assets. Wal-Mart had $31.024 billion in long-term debt, including the current portion. Wal-Mart typically has a large amount of long-term debt because of the large amount of property it finances.

2. Revenues increased 9.5% [($312,427 – $285,222)/$285,222] over the previous year. Compared to the prior year, when sales increased by 11.3%, the company's rate of increase in sales has decreased slightly.

3. Wal-Mart paid a dividend of $2.511 billion in 2005. Wal-Mart both issued shares under its stock option plan and purchased shares of its own stock in 2005. The amount of stock repurchased ($3,580) during the year exceeded the amount of stock issued under its stock option plan during the year ($276).

4. Wal-Mart generates most of its cash from operations. The company uses that cash to repurchase its own stock, pay dividends, make long-term debt payments, invest in other companies, and invest in other operating assets like property and equipment.

AA 2–62

Safeway

Real Company Analysis 1. Current assets as a percentage of total assets increased slightly from 23.4% in 2004 to 23.5% in 2005. The primary reason for the increase was a slight increase in all of the current asset accounts.

2.

The gross profit ratio was slightly higher for 2004 (29.6% vs. 28.9%). The slight increase indicates that groceries (and other products sold by Safeway) were being sold with a slightly higher margin in 2004.

3. For 2005, Safeway generated more cash from operations than was spent through investing activities ($1.9 billion from operations compared to $1.3 billion spent relating to investing). Safeway borrowed $0.8 billion in long-term financing and paid $1.2 billion to reduce the company’s long-term debt. It would be reasonable to expect that Safeway’s long-term debt decreased during the year.

AA 2–63

Diageo

International 1. The first major difference students should notice on Diageo's balance sheet is the listing of fixed assets first. Most companies in the United States list current assets first and fixed assets second.

Another thing students will notice is that there is no easy way to conclude that the balance sheet does balance. As indicated in the next question, there is no total for assets or for liabilities and stockholders' equity.

2. Diageo does not provide a number indicating total assets. The company nets current assets and liabilities and then adds that net figure to its fixed assets. In the United States, a number indicating total assets is always provided.

3. Companies around the world use different terms than we might be accustomed to, but we can unravel the meaning of the words. For example, stocks is included in the current assets section. The most common current assets include cash, inventory, and accounts receivable. By a process of elimination we can conclude that Stocks means Inventory. Likewise, Debtors represents Accounts Receivable.

Called-up Share Capital is the same as Common Stock, and Profit and Loss Account is the English equivalent of Retained Earnings.

49

Chapter 2

AA 2–64

Violating a Covenant

Ethics There are many ways to change the current ratio. Some of them have a legitimate business purpose and some don't. For example, selling a product or service at a profit will cause the current ratio to increase, as will selling equipment. The difference is that selling a product or service is a long-term solution to the current problem, while selling equipment that the company will need is a short-term solution.

Would investors want management deciding on short-term, quick-fix solutions to avoid violating debt covenants? Management might argue that it is in the best interest of shareholders to keep the bank out of the company's business. Thus, manipulating the current ratio is the proper thing to do. The lender would counter that selling equipment to inflate the current ratio violates the spirit of the debt covenant.

What's the right answer? As is often the case in gray areas, it is probably not clear. But one thing is certain: you must always be careful when making business decisions that do not have a clear business purpose.

AA 2–65

The Most Important Financial Statement

Writing Obviously, there is no one most important financial statement. Each is used for a different purpose. While students may disagree on how well the individual financial statements fulfill the objectives for which they were designed, each financial statement provides valuable information. Although it is a good exercise for students to be able to provide support for their most important financial statement, it is equally important for them to be able to identify the limitations of each of the financial statements. Thus, make sure students also focus on identifying why they determined the other statements are not as important.

AA 2–66

Creating a Balance Sheet and Income Statement

Cumulative Spreadsheet Project The solutions to the Cumulative Spreadsheet Project are in the Solutions Manual files in the Instructor’s Resource section of the Albrecht Web site at http://www.thomsonedu.com/accounting/albrecht. In addition, the solutions can be found on the Instructor’s Resource CD-ROM, ISBN 0-324-64578-3.