CHAPTER 4 Solutions FINANCIAL REPORTING AND ANALYSIS

Transcription

1 CHAPTER 4 Solutions FINANCIAL REPORTING AND ANALYSIS Chapter 4, SE O Q O Q O Chapter 4, SE Full disclosure Materiality Cost-benefit Conservatism Consistency Chapter 4, SE Property, plant, and equipment Current liability Current liability Not on the balance sheet Stockholders' equity Current asset Intangible asset Current asset Current liability Investment 193

2 Chapter 4, SE 4. Balance Sheet May 31, 2011 Assets Current assets Cash Accounts receivable Merchandise inventory Total current assets Investments Property, plant, and equipment Equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Franchise Total assets Liabilities Current liabilities Accounts payable Wages payable Total current liabilities Long-term liabilities Notes payable Total liabilities Stockholders' Equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 200 1, $3, $ $1,000 2,600* $1, , $4,900 $ $1,300 3,600 $4,900 *Balancing amount ( $4,900 $1,300 $1,000 ) 194

3 Chapter 4, SE 5. Balance Sheet July 31, 2011 Assets Current assets Cash Accounts receivable Merchandise inventory Total current assets Investments Property, plant, and equipment Equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Franchise Total assets Liabilities Current liabilities Accounts payable Wages payable Total current liabilities Long-term liabilities Notes payable Total liabilities Stockholders' Equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 300 1, $4,500 1,050 $1, $1,500 3,900* $2, , $7,350 $1, $1,950 5,400 $7,350 *Balancing amount ( $7,350 $1,950 $1,500 ) 195

4 Chapter 4, SE Operating expenses Other revenues and expenses Not on the income statement Net sales Operating expenses Other revenues and expenses Not on the income statement Chapter 4, SE 7. Income Statement For the Year Ended May 31, 2011 Revenues Net sales $2,400 Interest income 90 Total revenues $2,490 Costs and expenses Cost of goods sold $840 Selling expenses 555 General expenses 450 Interest expense 210 Total costs and expenses 2,055 Income before income taxes Income taxes $ Net income $

5 Chapter 4, SE 8. Net sales Cost of goods sold Gross margin Operating expenses Income Statement For the Year Ended May 31, 2011 $2, $1,560 Selling expenses $555 General expenses 450 Total operating expenses 1,005 Income from operations Other revenues and expenses $ 555 Interest income $ 90 Less interest expense 210 Excess of other expenses over other revenues 120 Income before income taxes Income taxes $ Net income $

6 Chapter 4, SE 9. Revenues Income Statement For the Year Ended July 31, 2011 Net sales $3,600 Interest income 135 Total revenues $3,735 Costs and expenses Cost of goods sold $1,260 Selling expenses 833 General expenses 675 Interest expense 315 Total costs and expenses 3,083 Income before income taxes Income taxes $ Net income $

7 Chapter 4, SE 10. Net sales Cost of goods sold Gross margin Operating expenses Income Statement For the Year Ended July 31, 2011 $3,600 1,260 $2,340 Selling expenses $833 General expenses 675 Total operating expenses 1,508 Income from operations $ 832 Other revenues and expenses Interest income $135 Less interest expense 315 Excess of other expenses over other revenues 180 Income before income taxes Income taxes $ Net income $

8 Chapter 4, SE 11. Financial ratios computed 1. Profit Margin Net Sales $30,000* $260, % * $260,000 $140,000 $80,000 $10,000 $30, Net Sales $260,000 Asset Turnover Average Total Assets $220,000* 1.2 times * ( $240,000 + $200,000 ) 2 $220, Cash Flow Yield Cash Flows from Operating Activities $30,000 $30, Debt to $60,000 Equity Ratio Total Liabilities Total $180, % Stockholders' Equity 5. Return on Assets Average Total Assets $30,000 $220, % 6. Cash Return on Assets Cash Flows from Operating Activities $30,000 Average Total Assets $220, % 7. Return on Equity Average Total Stockholders' Equity $30,000 $160,000* 18.8% * ( $180,000 + $140,000 ) 2 $160,

9 Chapter 4, SE 12. Profit Margin 8.0% Asset Turnover Return on Assets 2.1 times 16.8% If the debt to equity ratio equals 50 percent, then stockholders' equity is two-thirds of total assets. Show why this is true, using numbers. Return on Assets 16.8% Return on Equity 25.2% 201

10 Chapter 4, E The balance sheet provides information about a company's resources (assets) and claims to those resources (liabilities and stockholders' equity). The income statement, statement of cash flows, and statement of retained earnings provide information about changes in resources and claims to them. To record depreciation expense, it is necessary to estimate the useful life of the asset. To record the amount of unearned revenue that is now earned or the amount of accrued revenue on a project, it is necessary to estimate the amount of revenue earned. Consistency in accounting applies only to the use of the accounting principles for presenting the financial information. It does not apply to the conditions that are represented in the financial statements. For example, changes in business operations or the economy may make financial information incomparable from year to year, even though the same accounting policies have been followed. Illegal acts, such as stealing $1,000, are important to management even though for a multimillion-dollar business, it might not be important to the auditors. It would not be material to the overall fairness of the financial statements. 202

11 Chapter 4, E They are classified as investments because doing so helps users of financial statements assess the performance of the company using such measures as return on assets. Also, the investment category gives users some idea of resources the company may be able to draw on without disturbing the current business operations. Neither measure is better than the other because both measure different aspects of profitability. Income from operations measures the income from a company's ongoing operations before considering issues of financing (interest expense), nonoperating revenues, and income taxes. Net income measures whether a business has been operating successfully. When calculating ratios to measure performance, analysts need benchmarks to measure whether the performance was good or bad. Past performance of the company is one measure, but a better measure is the financial performance of similar companies. This is done by examining industry averages. The statement is false because neither measure is better than the other. However, the return on assets ratio is a more comprehensive measure of profitability because it reflects both profit margin and asset turnover. 203

12 Chapter 4, E g f h g f d g f b g g 22. c b d a f e d a f f c Chapter 4, E Cost-benefit Comparability and consistency Full disclosure Materiality Conservatism Chapter 4, E d a a e f c b a 16. a h a h e a c g 204

13 Chapter 4, E 6. Mamba, Inc. Balance Sheet December 31, 2011 Assets Current assets Cash Short-term investments Accounts receivable Inventory Prepaid rent $12,480 6,560 15,200 16, Total current assets Investments Investment in corporate securities Property, plant, and equipment Land $ 3,200 Building $28,000 Less accumulated depreciation 5,600 22,400 Equipment $60,800 Less accumulated depreciation 6,800 54,000 Total property, plant, and equipment Intangible assets Copyright Total assets $ 50,720 8,000 79,600 2,480 $140,800 (continued) 205

14 Chapter 4, E 6. (Continued) Liabilities Current liabilities Accounts payable Revenue received in advance Total current liabilities Long-term liabilities Bonds payable Total liabilities Stockholders' Equity Contributed capital Common stock, $10 par, 4,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $20,400 1,120 $40,000 20,000 $60,000 35,280 $ 21,520 24,000 $ 45,520 95,280 $140,800 Chapter 4, E a b e c d c f c and/or d c c and/or d c f e 206

15 Chapter 4, E Single-step income statement prepared Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold Selling expenses General and administrative expenses Interest expense Total costs and expenses Income before income taxes Income taxes Net income Earnings per share $220,000 90,000 60,000 4,000 $405,000 3,000 $408, ,000 $ 34,000 7,500 $ 26,500 $ Multistep income statement prepared Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes Net income Earnings per share $90,000 60,000 $ 3,000 4,000 $405, ,000 $185, ,000 $ 35,000 1,000 $ 34,000 7,500 $ 26,500 $

16 Chapter 4, E 9. Net sales Cost of goods sold Gross margin Operating expenses Pasica, Inc. Income Statement For the Year Ended December 31, 2011 $1,197, ,080 $ 420,052 Selling expenses $203,740 General and administrative expenses 100,688 Total operating expenses 304,428 Income from operations $ 115,624 Other revenues and expenses Interest income $ 5,720 Less interest expense 13,560 Excess of other expenses over other revenues 7,840 Income before income taxes Income taxes $ 107,784 24,000 Net income $ 83,784 Earnings per share $ 8.38 The multistep income statement lists the gross margin from sales and separates income from operations from other revenues and expenses. In this way, it is possible to evaluate separately the company's ability to sell its products at a satisfactory price and its ability to operate efficiently. Also, its current operations are evaluated sepa- rately from financing activities. 208

17 Chapter 4, E 10. Financial ratios computed 1. Profit Margin Net Sales $23,500 * $195, % * $195,500 $116,500 $47,000 $8,500 $23, Asset Turnover Net Sales Average Total Assets $195,500 ( $106,500 + $87,750 * ) 2 $195,500 $97, times * $106,500 $18,750 $87, Return on Assets Average Total Assets $23, % $97,

18 Chapter 4, E 10. (Continued) 4. Cash Flow Yield Cash Flows from Operating Activities $35, $23, Cash Return on Assets Cash Flows from Operating Activities Average Total Assets $35,000 $97, % 6. Debt to Equity Ratio Total Liabilities Total Stockholders' Equity $43,000 $63,500* 67.7% 7. Return on Equity Average Stockholders' Equity $23,500 ( $63,500 + $50,000 ) 2 $23,500 $56, % * $63,500 $23,500 + $10,000 $50,

19 Chapter 4, E 11. Profitability measures computed 1. Profit Margin Net Sales $60,000 $830, % 2. Asset Turnover Net Sales Average Total Assets $830,000 ( $460,000 + $360,000 ) 2 $830,000 $410, times Return $60, % on Assets Average Total Assets $410, Cash Flow Yield Cash Flows from Operating Activities $72,000 $60, Cash Return on Assets Cash Flows from Operating Activities Average Total Assets $72,000 $410, % 6. Debt to Equity Ratio Total Liabilities Total Stockholders' Equity $110,000 $350, % 7. Return on Equity Average Stockholders' Equity $60,000 ( $350,000 + $280,000 ) 2 $60,000 $315, % 211

20 Chapter 4, P 1. User Insight: Accounting convention explained Valuing inventory at lower of cost or market is a generally accepted application of the conservatism convention. This method of valuing inventory is less likely to overstate assets and income than the cost method is, especially if inventory costs are decreasing or inventory faces obsolescence. Charging items of small unit value as an expense rather than incurring the cost of capitalizing and depreciating them is an acceptable application of the materiality convention. The fact that several chairs are purchased during the year does not affect the decision unless such a substantial quantity is purchased that a distortion of the financial position results. Not disclosing the fire loss in a note to the 2011 financial statements is a violation of the full disclosure convention. Although the fire loss did not affect 2011 operations, it will have a significant or material effect on 2012, which means that knowledge of it is important to users of the financial statements. This is an acceptable application of the cost-benefit convention if management has determined that the benefits of the new reporting system outweigh the costs. The change in inventory methods is a violation of the consistency convention. If a company changes its method of accounting for inventory, it must disclose the change, disclose the effect of the change on net income, and explain why the newly adopted accounting principle is preferable in the notes to its finan- cial statements, making the reader aware of the inconsistency. 212

21 Chapter 4, P Multistep income statements prepared Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes Net income Elm Nursery Corporation Income Statements For the Years Ended April 30, 2011 and % 2010 $262, % $237, % 117, % 85, % $145, % $151, % $ 80, % $ 75, % 31, % 21, % $112, % $ 96, % $ 33, % $ 55, % * $ % * $ % 1, % * % $ % $ % * $ 32, % $ 54, % * 8, % 14, % $ 24, % $ 40, % % Earnings per share $ 1.22 $ User insight: Income from operations discussed Income from operations decreased from 2010 to The primary reasons for this decline were the decrease in gross margin caused by the increase in cost of goods sold as a percentage of sales and the increase in general and administrative expenses as a percentage of net sales. 213

22 Chapter 4, P 2. (Continued) 3. User Insight: Income before income taxes discussed Income before income taxes also decreased from 2010 to The primary reason for this decline was the decrease in operating income. However, the decrease in income before income taxes ($22,576) is greater than the decrease in operating income ($22,101) because of the percent increase in interest expense from 2010 to This means that management took on additional debt to finance the business operations. 214

23 Chapter 4, P 3. Bissel Hardware Corporation Balance Sheet June 30, 2011 Assets Current assets Cash Short-term investments Notes receivable Accounts receivable Merchandise inventory Prepaid rent Prepaid insurance Sales supplies Office supplies Deposit for future advertising $ 64,000 66,000 20, , ,000 3,200 9,600 2, ,360 Total current assets Investments Building, not in use Property, plant, and equipment Land $ 46,800 Delivery equipment $82,400 Less accumulated depreciation 56,800 25,600 Total property, plant, and equipment Intangible assets Trademark Total assets $1,015,600 99,200 72,400 8,000 $1,195,200 (continued) 215

24 Chapter 4, P 3. (Continued) Liabilities Current liabilities Accounts payable Salaries payable Interest payable Total current liabilities Long-term liabilities Notes payable Total liabilities Stockholders' Equity Contributed capital Common stock, $1.10 par value, 40,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $229,200 10,400 3,680 $ 44, ,000 $364, ,920 $ 243, ,000 $ 403, ,920 $1,195,

25 Chapter 4, P 3. (Continued) 2. User Insight: Ratio discussed A user of the classified balance sheet would want to know the debt to equity ratio because it shows the proportion of the company financed by creditors in compariand the stockholders' return on son with that financed by stockholders. This measure is very important to liquidity analysis because it is related to debt and its repayment. It is also relevant to profitability analysis because the amount of debt affects the amount of interest expense investments. 217

26 Chapter 4, P Profitability measures computed a. Profit Margin Net Sales 2011: 2010: $75,000 $1,150,000 $51,000 $870, % 5.9% b. Asset Turnover Net Sales Average Total Assets 2011: $1,150,000 ( $580,000 + $435,000 ) 2 $1,150,000 $507, times 2010: $870,000 ( $435,000 + $340,000 ) 2 $870,000 $387, times c. Return on Assets Average Total Assets 2011: $75,000 $507, % $51, : $387, % 218

27 Chapter 4, P 4. (Continued) d. Cash Flow Yield Cash Flows from Operating Activities 2011: $82,500 $75, : $67,500 $51, e. Cash Return on Assets Cash Flow from Operating Activities Average Total Assets 2011: $82,500 $507, % 2010: $67,500 $387, % f. Debt to Equity Ratio Total Liabilities Total Stockholders' Equity 2011: $245,000 $335, % $175, : 67.3% $260,

28 Chapter 4, P 4. (Continued) g. Return on Equity Average Stockholders' Equity 2011: $75,000 ( $335,000 + $260,000 ) 2 $75,000 $297, % 2010: $51,000 ( $260,000 + $210,000 ) 2 $51,000 $235, % 2. User Insight There was an increase in both profit margin and asset turnover from 2010 to 2011, which resulted in an increase in return on assets. Note that return on assets is more than twice as large as profit margin because of the asset turnover being greater than 2.0 times. The debt to equity ratio in both years exceeds 50 percent and leads to a strong return on equity. Note that all factors combine to produce a very satisfactory return on equity. 220

29 Chapter 4, P 5. 1a. Single-step income statement prepared Surosa Corporation Income Statement For the Year Ended December 31, 2011 Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold $175,210 Selling expenses 110,100 Administrative expenses 40,400 Interest expense 11,320 Total costs and expenses Income before income taxes Income taxes Net income Earnings per share $357,195 1,400 $358, ,030 $ 21,565 3,500 $ 18,065 $ b. Statement of retained earnings prepared Surosa Corporation Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2010 Net income Subtotal Less dividends Retained earnings, December 31, 2011 $141,585 18,065 $159,650 30,000 $129,

30 Chapter 4, P 5. (Continued) 1c. Classified balance sheet prepared Surosa Corporation Balance Sheet December 31, 2011 Assets Current assets Cash Investment in U.S. government securities Accounts receivable Inventory Prepaid expenses Total current assets Investments Investment in securities Property, plant, and equipment Store fixtures Less accumulated depreciation Delivery equipment Total property, plant, and equipment Total assets Less accumulated depreciation $14,200 19,800 52,400 68,270 2,880 $70,810 21,110 $49,700 $44,250 8,550 35,700 $157,550 28,000 85,400 $270,950 (continued) 222

31 Chapter 4, P 5. (Continued) Liabilities Current liabilities Notes payable Accounts payable Total current liabilities Long-term liabilities Notes payable Total liabilities Stockholders' Equity Contributed capital Common stock, $0.50 par value, 10,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 25,000 16,300 $ 5,000 45,000 $ 50, ,650 $ 41,300 50,000 $ 91, ,650 $270,

32 Chapter 4, P 5. (Continued) 2. Profitability measures computed (a) Profit Margin Net Sales $18,065 $357, % (b) Asset Turnover Net Sales Average Total Assets $357,195 ( $270,950 + $262,200 ) 2 $357,195 $266, times (c) Cash Flow Yield Cash Flows from Operating Activities $20,000 $18, (d) Debt to Equity $91,300 Ratio Total Liabilities Total Stockholders' Equity $179, % (e) Return on Assets Average Total Assets $18,065 $266, % 224

33 Chapter 4, P 5. (Continued) (f) Cash Return on Assets Cash Flows from Operating Activities Average Total Assets $20,000 $266, % (g) Return on Equity Average Stockholders' Equity $18,065 ( $179,650 + $191,585 ) 2 $18,065 $185, % 225

34 Chapter 4, P 5. (Continued) User Insight: Financial ratios discussed 3. The corporation's profit margin of 5.1 percent exceeds the industry average of 2.3 percent, but its asset turnover ratio of 1.3 is much lower than the industry average of 2.0. Thus, its return on assets of 6.8 percent is higher than the industry average of 4.6 percent. Further, it has a debt to equity ratio of only 50.8 perequity is only 9.7 percent compared with an industry average of 9.4 percent. cent compared with the industry average of percent. Thus, its return on Since the industry average is 9.4 percent for ROE and Surosa's exceeds that even with relatively more equity. 226

35 Chapter 4, P 6. User Insight: Accounting convention explained This is an acceptable application of the cost-benefit convention if management has determined that the benefits of the new classification system outweigh the costs. This is an unacceptable application of the materiality convention because illegal actions by a company's personnel whatever the amount involved are inherquire that this kind of illegal activity be ently important to the users of financial statements. Full disclosure would re- disclosed. This is an unacceptable application of the conservatism convention because conservatism can be used only when two equally acceptable accounting methods are available. Expensing an item of property, plant, and equipment and that's what the addition is is not an acceptable method. Uncertainties are always present. The going concern assumption requires that the addition be recorded as property, plant, and equipment and be depreciated over a number of years. The change in depreciation methods is a violation of the comparability and consistency convention. However, management can change its accounting meth- ods if it complies with the convention of full disclosure by reporting the change in the notes to its financial statements. 5. The failure to disclose the inventory method is a violation of the full disclosure convention. To interpret the statements, users of financial statements must know which method is used, even though the method used has not changed in a number of years. This situation is also an application of the consistency convention, since they used the same method every year. 227

36 Chapter 4, P Multistep income statements prepared Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes Net income Kaluza Hardware Corporation Income Statements For the Years Ended July 31, 2011 and % 2010 % $464, % $388, % 243, % 198, % $220, % $189, % $ 95, % $ 55, % 90, % 49, % $186, % $104, % $ 34, % $ 84, % $ 1, % $ % 5, % 1, % $ 4, % $ % $ 30, % $ 84, % 8, % 21, % $ 22, % $ 63, % * Earnings per share $ 2.21 $ 6.31 *Rounded. 2. User Insight: Income from operations discussed Income from operations decreased from 2010 to 2011 in absolute amount by $50,428 ($84,748 $34,320) and decreased in percentage from 21.8 percent to 7.4 percent of net sales despite an increase in net sales. There were two reasons for the decrease in income from operations. First, although gross margin increased in absolute amount by $30,642 ($220,320 $189,678), it decreased in percentage from 48.8 percent of net sales to 47.5 percent. Second and more important, operating expenses increased as a percentage of net sales from 27.0 percent to 40.1 percent. Increases in both selling expenses and general and administrative expenses contributed to this large increase. Management must examine its selling expenses and the com- pany's overhead (general and administrative expenses) to improve its profitability. 228

37 Chapter 4, P 7. (Continued) 3. User Insight: Income before income taxes discussed Income before income taxes also decreased from 2010 to The primary reason for this decline was the decrease in operating income. However, the decrease in income before income taxes ($54,258) is greater than the decrease in operating income ($50,428) primarily because of the 409 percent increase in interest expense from 2010 to This means that management took on additional debt to finance the business operations. 229

38 Chapter 4, P Profitability measures computed a. Profit Margin Net Sales 2011: $8,000 $131, % 2010: $5,500 $100, % b. Asset Turnover Net Sales Average Total Assets 2011: $131,000 ( $72,500 + $55,000 ) 2 $131,000 $63, times 2010: $100,000 ( $55,000 + $45,000 ) 2 $100,000 $50, times c. Cash Flow Yield Cash flow from Operating Activities 2011: $12,000 $8, : $7,500 $5, d. Debt to Equity Ratio Total Liabilities Total Stockholders' Equity 2011: $20,000 $52, % 2010: $5,000 $50, % 230

39 Chapter 4, P 8. (Continued) e. Return on Assets Average Total Assets 2011: $8,000 $63, % 2010: $5,500 $50, % Cash Return f. on Assets Cash Flow from Operating Activities Average Total Assets $12, : $63, % 2010: $7,500 $50, % g. Return on Equity Average Stockholders' Equity 2011: $8,000 ( $52,500 + $50,000 ) 2 $8,000 $51, % 2010: $5,500 ( $50,000 + $40,000 ) 2 $5,500 $45, % 231

40 Chapter 4, P 8. (Continued) 2. User Insight Both profit margin and asset turnover increased from 2010 to 2011, causing return on assets to increase by 1.5 percent. Return on equity increased by 3.4 percent because the company increased its debt to equity ratio. It used more assets to proholders' equity. Although management may view the level of profitability as disap- duce income by increasing its debt proportionally more than it increased stockpointing, the company has shown improvement in the key performance measures of return on assets and return on equity. 232

41 Chapter 4, P 9. Beauty Supplies Corporation Balance Sheet June 30, 2011 Assets Current assets Cash Short-term investments Notes receivable Accounts receivable Merchandise inventory Prepaid rent Prepaid insurance Sales supplies Office supplies Deposit for future advertising $ 16,000 16,500 5, ,000 72, , ,840 Total current assets Investments Building, not in use Property, plant, and equipment Land $ 11,700 Delivery equipment $20,600 Less accumulated depreciation 14,200 6,400 Total property, plant, and equipment Intangible assets Trademark Total assets $253,900 24,800 18,100 2,000 $298,800 (continued) 233

42 Chapter 4, P 9. (Continued) Liabilities Current liabilities Accounts payable Salaries payable Interest payable Total current liabilities Long-term liabilities Notes payable Total liabilities Stockholders' Equity Contributed capital Common stock, $1.10 par value, 10,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 57,300 2, $ 11,000 80,000 $ 91, ,980 $ 60,820 40,000 $100, ,980 $298, User Insight In addition to considering the key elements of the balance sheet, such as total assets, liabilities, and equity, it's also important to consider Net Revenue and from the income statement and Cash Flows from Operating Activities from the statement of cash flows. The elements from these three statements are used to compute important financial ratios. 234

43 Chapter 4, P 10. 1a. Single-step income statement prepared Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold Selling expenses Administrative expenses Interest expense Total costs and expenses Income before income taxes Income taxes Net income Earnings per share Cubicle Corporation Income Statement For the Year Ended December 31, 2011 $700, , ,600 45,280 $1,428,780 5,600 $1,434,380 1,348,120 $ 86,260 14,000 $ 72,260 $ b. Statement of retained earnings prepared Cubicle Corporation Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2010 Net income Subtotal Less dividends Retained earnings, December 31, 2011 $566,340 72,260 $638, ,000 $518,

44 Chapter 4, P 10. (Continued) 1c. Classified balance sheet prepared Cubicle Corporation Balance Sheet December 31, 2011 Assets Current assets Cash Investment in U.S. government securities Accounts receivable Inventory Prepaid expenses Total current assets Investments Investment in securities Property, plant, and equipment Store fixtures Total property, plant, and equipment Total assets Less accumulated depreciation Delivery equipment Less accumulated depreciation $ 56,800 79, , ,080 11,520 $283,240 84,440 $198,800 $177,000 34, ,800 $ 630, , ,600 $1,083,800 (continued) 236

45 Chapter 4, P 10. (Continued) Liabilities Current liabilities Notes payable Accounts payable Total current liabilities Long-term liabilities Notes payable Total liabilities Stockholders' Equity Contributed capital Common stock, $1.00 par value, 20,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $100,000 65,200 $ 20, ,000 $200, ,600 $ 165, ,000 $ 365, ,600 $1,083,

46 Chapter 4, P 10. (Continued) 2. Profitability measures computed $72,260 (a) Profit Margin 5.1% Net Sales $1,428,780 (b) Asset Turnover Net Sales Average Total Assets $1,428,780 ( $1,083,800 + $1,048,800 ) 2 $1,428,780 $1,066, times Cash Flow from (c) Cash Flow Yield Operating Activities $60,000 $72, (d) Debt to Equity Ratio Total Liabilities Total Stockholders' Equity $365,200 $718, % (e) Return on Assets Average Total Assets $72,260 $1,066, % (f) Cash Return on Assets Cash Flow from Operating Activities Average Total Assets $60,000 $1,066, % 238

47 Chapter 4, P 10. (Continued) (g) Return on Equity Average Stockholders' Equity $72,260 ( $718,600 + $766,340 ) 2 $72,260 $742, % 3. User Insight: Financial ratios discussed Cubicle Corporation's profit margin of 5.1 percent exceeds the industry average of 3.6 percent, but its asset turnover ratio of 1.3 is much lower than the industry average of 1.9. Thus, its return on assets of 6.8 percent is equal to the industry average of 6.8 percent. Further, it has a debt to equity ratio of only 50.8 percent compared with the industry average of percent. Thus, its return on equity is only 9.7 percent compared with an industry average of 14.5 percent. Cubicle needs to consider increasing its debt financing as one method of increasing return on equity. 239

48 Chapter 4, C 1. Consistency requires that an accounting procedure, once adopted by a company, remain in use from one accounting period to another unless management decides that a new procedure is preferable and discloses information about the change in its financial statements. Such consistency ensures the comparability of financial results from one period to another. In this case, a change from the cash method to the accrual method would violate the consistency convention if the change was not disclosed in the financial statements. Full disclosure requires that financial statements and accompanying notes present all information relevant to the user's understanding of the statements. In this case, the notes should disclose the nature of the change, the justification for making it, and its probable effect on net income. Thus, readers of the financial statements will know that a change has been made and can assess its effects. Materiality refers to the relative importance of an item or event. In general, an item is material if there is a reasonable expectation that knowledge of it would influence the decisions of users of financial statements. In this case, the change from the cash to the accrual method would have a 5 percent ($62,500 $1,250,000) effect on net income. Many people consider 5 percent to be the point at which an amount starts to matter to decision makers. So this is a material effect, and the change in accounting method should be disclosed. (An adjustment may also be made at the beginning of the year, which could mitigate the year-end effect on the financial statements.) Chapter 4, C 2. Materiality refers to the relative importance of an item or event. In general, an item is material if there is a reasonable expectation that knowledge of it would influence the decisions of users of financial statements. The $120,000 inventory loss represents 4 percent of net income ($120,000 $3,000,000). Whether or not this loss is material depends on who is using the financial statements. To management, it repsions because of an item that represents only 4 percent of net income. The auditors resents a loss of income that impairs the company's ability to improve operations and results. To the auditors, the loss is reflected in the financial statements and thus is not misstated. In most retail operations, some inventory loss is expected. It is unlikely that external users of financial statements would change their deci- may become concerned if the loss is greater in the future or if management does not take action to try to reduce it. 240

49 Chapter 4, C Profitability ratios computed (in millions) and discussed (Loss) Net Sales Profit Margin Net Sales Average Total Assets Asset Turnover Supervalu A&P ($2,855) ($140) $44, % $44,564 ( $17,604 + $21,062 ) 2 $19,333 ( $3,546 + $3,644 ) 2 $3, times 2.6 times Average Stockholders' Equity ( $2,581 + $5,953 ) 2 $4,267 ( $268 + $418 ) 2 $343 Return on Equity -66.9% -40.8% $9, % $9,516 ($2,855) ($140) Average Total Assets (from above) $19,333 $3,595 Debt to Equity Ratio 582.1% 1,223.1% Return on Assets -14.8% -3.9% Total Liabilities $15,023 $3,278 Total Stockholders' Equity $2,581 $268 ($2,855) ($140) From these figures, it is clear that A&P was the more profitable company for the period analyzed. Its profit margin, return on assets, and return on equity were superior to the same measures for Supervalu because A&P has a smaller net loss. 241

50 Chapter 4, C 3. (Continued) 2. Return on assets discussed Return on assets is a combination of profit margin and asset turnover. The grocery industry has low profit margins. The profit margins of the two companies are -6.4 and -1.5 percent. The industry tries to overcome its low profit margin by turning over its assets many times during the year. A&P has an asset turnover of 2.6 times, which exceeds that of Supervalu of 2.3. The relationships of the two companies' ratios and the industry ratios are as follows: Supervalu A&P Industry* Profit Margin Asset Turnover Return on Assets -6.4% 2.3 times -14.8% -1.5% 2.6 times -3.9% * 2.2% 5.5 times 12.1% *Industry graphs are provided on pages , page 224, and page 225 of the text. The higher negative profit margin at Supervalu makes it less profitable than A&P in spite of its lower turnover. However, both companies are less profitable than the industry in terms of asset turnover and return on assets. 3. Debt financing discussed Despite low profit margins, grocery stores tend to have high debt because they are very stable businesses. Both companies use this method to increase their return on equity over what they earn on assets. Both companies have more debt than equity; the debt to equity ratio was 1,223.1 percent for A&P, which is considerably higher than the industry average, and percent for Supervalu. When debt is excessive, a company can be in a risky situation. In the case of Supervalu and A&B, the large and A&P, the large amount of debt in relation to equity may put these companies in a vulnerable situation. A&P, with the higher debt to equity ratio, helps its return on equity, but it is still in a more risky situation due to its low profit margin. 242

51 Chapter 4, C To evaluate profitability, the profit margin and return on assets must be computed as follows: Profit Margin 2011: 2010: Net Sales $89,512 $1,222,600 $82,912 $1,386, % 6.0% Return on Assets 2011: Average Total Assets $89,512 ( $1,536,910 + $1,386,810 ) 2 $89, % $1,461, : $82,912 ( $1,386,810 + $1,246,780 ) 2 $82, % $1,316,795 Wish Linens, Inc.'s profit margin did improve, from 6.0 percent to 7.3 percent, because of the increase in prices; however, return on assets, which is the broadest measure of profitability, fell from 6.3 percent to 6.1 percent. The reason is that assets are growing at a faster rate than revenues, causing asset turnover to drop, as shown next. 243

52 Chapter 4, C 4. (Continued) 2. In her evaluation of profitability, Wish is focusing only on the profit margin, failing to take into account that the overall profitability must be evaluated in terms of total investment in assets and the amount of sales generated by those assets. Net Sales Asset Turnover Average Total Assets 2011: $1,222,600 $1,461, times $1,386, : 1.1 times $1,316,795 The asset turnover has decreased from 1.1 times in 2010 to 0.8 times in 2011 because of the decrease in sales (due to higher prices) and the increase in average total assets. This decrease in asset turnover has an adverse affect on profitability as measured by return on assets: Profit Asset Return on Margin Turnover Assets 2011: 7.3% % 2010: 6.0% % 244

53 Chapter 4, C a. b. Consolidated balance sheets ($ amounts in millions) Yes, CVS uses a classified balance sheet. It shows different categories of assets like contra assets, property and equipment, goodwill, intangible assets, and other assets. It further divides current assets into six subcategories. Yes, the debt to equity ratio decreased from 76.3 percent in 2008 to 72.3 percent in Debt to Equity Ratio Total Liabilities Total Stockholders' Equity 2009: $25,873 $26, % 2008: $35,768 $34, % c. Contributed capital for 2009 was $27,214 million ($16 + $27,198). ( Note: In 2008, CVS had two types of stock: preference and common; in 2009, just common.) Also, capital surplus is the same as additional paid-in capital. Retained earnings were $16,355 million, or about 60 percent as great as contributed capital. 245

54 Chapter 4, C 5. (Continued) 2. Consolidated statements of operations a. b. c. d. CVS uses a multistep form of income statement. Yes, it is a comparative statement because it presents more than one year of data for comparison. There was an increase in net earnings from $2,623 million in 2007 to $3,198 million in 2008 to $3,696 million in (Note: The preference dividends are distributions to stockholders, not a part of net earnings.) Income taxes were $2,205 million in 2009 compared with pretax income of $5,913 million, or 37.3 percent. Income taxes were $2,193 million in 2008 compared with pretax earnings of $5,537 million, or 39.6 percent. 246

55 Chapter 4, C 6. (Continued) 1. Liquidity and profitability calculated Profit Margin Profit Margin (Loss) Net Sales or Total Operating Revenue CVS 2009: $3,696 $3, % 2008: $98,729 $87, % Southwest 2009: $99 $ % 2008: $10,350 $11, % Asset Turnover Asset Turnover Net Sales Average Total Assets CVS 2009: $98,729 ( $61,641 + $60,960 ) 2 $98,729 $61, times 2008: $87,472 ( $60,960 + $54,722 ) 2 $87,472 $57, times Southwest 2009: $10,350 ( $14,269 + $14,068 ) 2 $10,350 $14, times 2008: $11,023 ( $14,068 + $16,772 ) 2 $11,023 $15, times 247

56 Chapter 4, C 6. (Continued) Cash Flow Yield Cash Flow Yield CVS $4, : $3, Cash Flows from Operating Activities 2008: $3,947 $3, Southwest 2009: $985 $ : ($1,521) $ Debt to Equity Ratio Debt to Equity Ratio Total Liabilities Total Stockholders' Equity CVS $25, : 72.3% $35, : $26,386 $34, % Southwest 2009: $8,803 $5, % 2008: $9,115 $4, % 248

57 Chapter 4, C 6. (Continued) Return on Assets Return on Assets CVS 2009: Average Total Assets $3,696 ( $61,641 + $60,960 ) 2 $3, % $61, : $3,198 ( $60,960 + $54,722 ) 2 $3,198 $57, % Southwest 2009: 2008: $99 ( $14,269 + $14,068 ) 2 $99 $14, % $178 ( $14,068 + $16,772 ) 2 $178 $15, % 249

58 Chapter 4, C 6. (Continued) Return on Equity Return on Equity CVS 2009: Average Stockholders' Equity $3,696 ( $35,768 + $34,574 ) 2 $3, % $35, : $3,198 ( $34,574 + $31,322 ) 2 Southwest 2009: 2008: $3,198 $32, % $99 ( $5,466 + $4,953 ) 2 $99 $5, % $178 ( $4,953 + $6,941 ) 2 $ % $5, Performance discussed In general, CVS's peformance exceeds the performance of Southwest, both in respect to liquidity and profitability. CVS's profitability measures, especially return on assets and return on equity, are much better than those of Southwest. Also, CVS has a higher profit margin than Southwest does, and it has a much higher asset turnover ratio. CVS also had lower debt to equity ratios for both years: 72.3 percent in 2009, a decrease from 76.3 percent in Southwest's ratio also decreased in 2009, from percent to percent. In terms of cash flow yield, CVS is a lot more stable with yield of slightly stable with yield of slightly more than 1, which means that for every dollar of net income, CVS generated one dollar of cash. On the other hand, Southwest's cash flow yield fluctuated greatly from 2008 to 2009, from negative 8.5 to about positive

59 Chapter 4, C 7. This situation is framed so that the difference between 75 percent and 90 percent is material but also falls within the range of judgment. Thus, one can take either side of the issue. Some students may say that the first report is tentative and that a reevaluation may legitimately result in an estimate of 90 percent completion. Others may argue that the action is unethical, particularly in view of the bonuses that are tied to revenue, and there is no indication that the customer has approved or accepted the work performed to date. Discussion of whether a student, in assuming the position of the controller, would prepare the report may center on the conflict between the controller's duty to top management and his or her personal ethics. The proper action would be to reexbe unethical and perhaps fraudulent. If top management persists, the controller amine the preliminary report to see whether new estimates are justified under the circumstances. If the preliminary report turns out to be the best estimate, then the controller should try to convince top management that changing the report would should not prepare the report and may have to decide whether he or she wants to continue working for the company. 251