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CHAPTER 1 FINANCIAL ACCOUNTING IN AN ECONOMIC CONTEXT ISSUES FOR DISCUSSION ID1–1 Security analysts and stockholders: These users would use financial statements to try to estimate the future earnings and cash flow potential of the company, which would be used to project a value for the company’s stock. Bank loan officers: These users would use the financial statements to determine the ability of a company to repay loans to the bank. A company’s customers and suppliers: These users would use financial statements to determine whether to extend credit to the company (suppliers) or whether to rely upon the company to be a supplier (customers). Both suppliers and customers would also use the financial statements to monitor the company’s profit margins. Public utilities: This group would use the financial statements to determine the company’s growth rate and how that might impact upon the company’s utility needs. Also, they would evaluate the company’s ability to pay its bills. Labor unions: These groups would use the financial statements to monitor the profitability of the company to help determine the amount of pay raises and benefits that it will negotiate for from the company. A company’s managers: The company’s managers will use the financial statements to assess the overall financial health of the company. This could impact the managers in a number of ways: raises, promotion opportunities, performance of other departments, etc.

ID1–2 The board of directors serves various functions for a company. One is to represent and protect the interests of the stockholders who are not on the board. Another is to provide oversight and input to management. The managers are involved in running the business on a day to day basis whereas the board is more focused on the bigger, long term picture. A weak board may not ask probing questions of management but instead may take everything at face value and believe anything that management says to them. A healthy management team would want a strong board that delivers valuable input. A management team that wants a weak board of directors may be trying to hide something (management fraud). Auditors are concerned with management fraud because, if there is a problem, in many cases the auditors will be sued by the stockholders on the basis that the auditors should have detected the fraud. 1

ID1–3 The function of the audit committee is to provide a channel whereby the auditors report their findings and concerns, if any, to the board of directors. Typically there are outside members of the board that are on the audit committee so that if the auditors have concerns about management’s financial statements or activities, then the auditors have a way to speak directly to the board of directors. The auditors are in a sensitive position because the financial statements and activities that they are auditing are prepared by the same people who hire and pay the auditors. Therefore, they may be reluctant to jeopardize their relationship with the company by being too negative.

ID1–4 Banks make loans to customers and depend on those customers to repay the loans (called the “principal”) plus interest for the banks to earn a profit. If customers are not able to pay the interest, the banks cannot make a profit; further, if the customers are not able to repay the principal the banks will show a loss that reduces the equity on the balance sheet. Banks look at a number of factors, both “macro” and “micro” in nature. Banks will look at the overall strength of the economy and the likelihood for future growth; these are the macro issues a bank considers. Banks will also examine the specifics of a company’s individual performance within the economy; these micro issues often are seen in the financial statements of companies. Issues such as the amount of debt, the level of profits, the amount of cash on hand and the amount of cash generated by the business, and the quality and size of the assets can all be seen from the financial reporting system. Banks require borrowers to submit financial statements to show these performance measures. During the 2008-2009 recession and related credit crunch, banks were concerned about the macro issues shown in general economic data, as well as the micro issues shown in companies’ individual financial reports. The reluctance of banks to lend has been cited as one of the reasons for the length of the economic downturn.

ID1–5 Sales for Home Depot decreased because of the economic conditions during the years shown. One of the hardest hit sectors of the economy was housing, which means that builders purchased less materials from Home Depot to construct houses; existing homeowners were hurt during the recession and had less money to purchase goods from the company for home improvements. Profits decreased because the drop in sales was not offset with an equal drop in expenses. Home Depot was not able to reduce its fixed and variable expenses as quickly as the company saw its revenue drop. Assets decreased as the company depreciated existing stores without adding new locations—again, due to the weakness in the economy. Equity remained flat because the company kept (“retained”) more of its profits by lowering its dividends paid to shareholders. Finally, the cash balance slightly increased due to less cash outflows for investments in new stores; due to the economy, the company did not invest nearly as much cash in building new stores, keeping that cash in the business for the time being.

ID1–6 Creditors would impose these types of restrictions on Continental Airlines so that the creditors would be protected for their loans. These types of restrictions are fairly common and act as a trip wire to warn the creditors that business may not be going well. The cash restriction would force Continental to have enough cash to pay the interest on the debt, the minimum stockholders’ equity makes sure that there are assets to act as collateral for the loans, and the restriction of dividends insures that management doesn’t distribute cash or assets out to the stockholders and not leave assets in the company to satisfy the creditors.

These restrictions act as trip wires in that as soon as a restriction is violated the creditors can call the debt and force the company to pay back the loans. What is more typical is for the loans to be restructured. This usually means higher interest rates and fees to do the restructuring. These all put the creditors in a better position to protect their loans.

ID1–7 Companies would usually engage in this type of behavior to try to improve their stock price. By showing higher revenues or lower expenses investors are more likely to reward the company with a higher stock price. Companies that have negative cash flow are under a lot of pressure to maintain a high stock price since selling stock is the only way to fund the business. This type of incentive can lead to questionable behavior. The ethical implications are significant because if investors lose faith in the financial statements that are reported this would severely impact the stock market. A strong driver to a robust economy is access to capital (stock markets). If this source is reduced because investors don’t believe the numbers that are reported, a very bad impact on the overall economy would result.

ID1–8

This is the normal statement that an auditor would make about a company whose books it had audited and found no significant problems. This would be part of what is called a “non-qualified opinion”. If there was a particular item that the auditors did not agree with they would issue a “qualified opinion” – they would agree with everything except the qualified item that would be identified. “In our opinion”, shows that the statement represents the auditor’s opinion and not a fact; “fairly, in all material respects” means that the auditors can not say that every single number is exactly accurate to the penny but that the numbers are generally accurate. This reflects the concept of materiality; the auditors believe that all material items have been presented accurately. Finally, “in conformity with accounting principles generally accepted in the United States of America” means that the financial statements have been compiled in a way that meets all of the accounting principles that are called GAAP in the U.S but not necessarily in conformance with international standards. ID1–9 Corporate governance describes the relationship among the stakeholders of a company, mainly : the shareholders, the Board of Directors, management and the company’s auditors. Corporate governance mechanisms encourage management and the Board of Directors to act in the best interest of the shareholders and to provide the shareholders with accurate and timely financial information. The Sarbanes-Oxley Act was passed to upgrade the financial transparency of corporate operations, 3

requiring increased financial disclosures and management responsibilities for the intergrity of the financial statements. Improved information provided to shareholders and other providers of capital will strenghten the confidence in the financial system, ultimately benefitting both providers and users of capital.

ID1–10 Management is charged with the responsibility to benefit the shareholders’ investment in the company. Choosing investments that will boost the short-term results of the company in lieu of long-term gains does not meet this requirement. While satisfying the needs of Wall Street analysts for short term results, a management decision to forego larger long term returns violates the relationship between the owners of the company and the management of the company. Many observers feel that short term profit pressures from analysts have caused management to ignore its responsibility to work for the long term benefit of the shareholder. ID1–11 Financial analysts are charged with the task of following companies in specified industries and evaluating the past financial performance of those companies, as well as providing guidance for expectations for future financial performance. Until financial reporting is consistent across global lines, analysts must be in a position to understand, interpret, analyze and forecast financial performance using different financial systems. An analyst following the pharmaceutical industry needs to understand how companies compare against each other, how Novartis stacks up against Johnson & Johnson. Now, not only does an analyst have to understand two sets of financial reporting systems (IFRS and GAAP), but that analyst then has to perform some type of conversion, so the companies can be compared under the same (“apples to apples”) basis. Fluency in GAAP is not sufficient; an analyst must also speak the language of IFRS and be able to translate back and forth between the two systems. ID1–12 Accounting guidelines that are established based on a number of general principles have the advantage of being simplified and easier to understand and document. On the other hand, guidelines that are principle-based are more ripe to be exploited by companies desiring to present their financial statements in good light. Guidelines that are based on a detailed set of rules are, by definition, lengthy and complicated, trying to anticipate every possible business situation. However, some argue that the more detailed rules-based approach allows the users of financial statements to review companies’ financial performance from a consistent perspective.

ID1–13 Management accounting is the accounting system that generates information that is used exclusively by the managers of the company. Financial accounting refers to the financial statements that are prepared and distributed outside of the company. So in many cases management accounting information is the operational information used by the managers of the company. This can be very 4

proprietary to the company and so is not made public. Management accounting numbers are not subject to audit and therefore are prepared in whatever form is helpful to the manager.

Financial accounting information is audited and therefore has to follow GAAP. Its primary purpose is to be used by people outside of the company.

ID1-14 a. Nike is a manufacturing company, primarily engaged in the manufacture and distribution of athletic footwear and apparel. b. The firm of PriceWaterhouseCoopers audits the financial statements of Nike. The audit report states what years and financial statements were audited and therefore being commented upon by the auditor. The second paragraph explains what an audit is intended to do and how the company has gone about doing this audit. The company’s internal control procedures are discussed. Finally, the report states the auditors’ opinion regarding the financial statements that have been audited. The auditors do not evaluate the financial strength of the company; the auditor states that the financial statements “present fairly” the position of Nike; it is up to the user of the financial statements to analyze the company’s performance. c.

Net income in 2007 was $1,491,500,000, for 2008 net income was $1,883,400,000 and for 2009 net income was $1,486,700,000.

d. The amounts shown below are in millions:

Total liabilities Total assets TL/TA (%)

2009 $4,556.5 $13,249.6 34.39%

2008 . $4,617.4 $12,442.7 37.11%

Total liabilities include both Current and Long Term liabilities. From 2008 to 2009 Nike decreased the percentage of its assets that were financed by liabilities. This fact, of course, means that the company increased the percentage of its assets that were financed by equity. e. Cash from operating activities was $1,878,700,000 in 2007, in 2008 it was $1,936,300,000 and in 2009 it was $1,736,100,000. f.

Nike decreased its profitability (in both raw dollars and as a percentage of revenue) and decreased the amount of cash it generated from operating its core businesses. The company, however, reduced liabilities (in both raw dollars and as a percentage of total assets) and increased its shareholder equity. The economy certainly affected Nike, but the company is quite strong and well-positioned for the future.

CHAPTER 2 THE FINANCIAL STATEMENTS BRIEF EXERCISES BE2–1 2008 2008 Beginning Retained Earnings

2008 Revenues

$28.2

$43.3 X

–

2008 Expenses

–

$38.2

$2.7

–

2008 Dividends

2008 Ending Retained Earnings

–

$30.6

2008 Dividends as a percentage of 2008 net income: 2008 Dividends 2008 Net income ($43.3-$38.2)

$ 2.7 $ 5.1

= 52.9%

BE2–2 (1)

Current Liabilities financed $32 billion of the assets. Current Liabilities divided by Total assets = $32/$59 = 54.2%

(2)

Long-term debt financed $18 billion of the assets. Long-term debt divided by total assets = $18/$59 = 30.5%

(3)

Stockholders’ equity financed $9 billion of the assets. Stockholders’ equity divided by total assets = $9/$59 = 15.3%

BE2–3 (a)

Working capital = current assets – current liabilities. Boeing’s current assets total $27 billion, less $32 billion of current liabilities, gives the company negative working capital of $5 billion. Another measure of solvency would be the current ratio. The current ratio is current assets divided by current liabilities or $27 billion divided by $32 billion = 0.84. Both measures indicate that Boeing appears to have a solvency problem. Current assets are not sufficient to cover current liabilities. Under existing circumstances the Company will have to look to other sources to pay its current obligations.

(b)

No, Boeing has $15 billion of liquid current assets (cash, short term investments, and accounts receivable) but it has $32 billion of current liabilities.

(c)

Boeing would be more solvent if accounts receivable were $9.6 billion and inventory was $5.7 billion. Accounts receivable are closer to cash than inventory. This means that accounts receivable are expected to be converted to cash in a shorter period of time than inventory.

BE2-4 2008

2007

2006

Net cash flow from operating activities ......................... Net cash flow from investing activities .......................... Net cash flow from financing activities ..........................

$ 33,656 (29,143) (4,691)

$ 34,242 (18,616) (16,074)

$ 15,688 (8,366) (6,128)

Net change in cash .........................................................

$ ( 178) $

Cash at beginning of period ........................................... Cash at end of period………………………………. ...................

1,970 $ 1,792

(448)$ 1,194 $

2,418 1,224 1,970 $ 2,418

AT & T’s cash management activities over the three-year period of 2006 - 2008 appear to be extremely strong. The company is generating significant amounts of cash flow from operating activities, with 2007 and 2008 at roughly twice the level of 2006. AT & T is then able to reinvest substantial amounts in its asset base. At the same time AT & T is also able to fund its financing activities from its operating cash flow. The large amount of funds being used in investing activities indicates that AT & T is growing its capital-intensive business.

BE2–5 IFRS Format Non-current assets Current assets Less: Current liabilities Total

154,073 115,397 (94,384) 175,086

Non-current liabilities Equity Total

49,118 125,968 175,086

GAAP Format Non-current assets Current assets Total

154,073 115,397 269,470

Current liabilities Non-current liabilities Equity Total

94,384 49,118 125,968 269,470

Many non-US companies begin with non-current assets, add current assets, and then subtract current liabilities to reflect the resources available to generate revenues and profits. The IFRS balance sheet then

lists non-current liabilities and shareholders’ equity, which represent the financing sources of company resources; this amount is often labeled “capital employed.” GAAP balance sheets, on the other hand, list all assets owned (current and long-term) and then categorizes the financing sources (current and long-term liabilities, as well as shareholder equity) for those assets.

EXERCISES E2–1

1 2 3 4 5 6 7 8

Operating, Investing, or Financing Financing Operating Operating Investing Financing Financing Investing Operating

Balance Sheet

Income Statement

Statement of Cash Flows

Yes Yes Yes Yes Yes Yes Yes Yes

No Yes Yes No No No No No

Yes Cannot tell Yes Cannot tell Yes Yes Yes Yes

Operating, Investing, or Financing Financing Operating Operating Operating Investing Investing Financing Operating

Balance Sheet

Income Statement

Statement of Cash Flows

Yes Yes Yes Yes Yes Yes Yes Yes

No No Yes Yes No Cannot tell No No

Yes No Yes No Yes Yes Yes Yes

Statement of Stockholders Equity Yes Yes Yes No No Yes No No

E2–2

1 2 3 4 5 6 7 8

Statement of Shareholders Equity No No Yes Yes No Cannot tell No No

E2–3 a. b. c. d. e. f.

Balance sheet Income statement Balance sheet Income statement Balance sheet Income statement

g. h. i. j. k. l.

Balance sheet Balance sheet Balance sheet Balance sheet Income statement Income statement

m. n. o. p. q. r.

Balance sheet Balance sheet Balance sheet Income statement Balance sheet Balance sheet

E2–4 1. Statement of Stockholders’ Equity (Retained Earnings); Statement of Cash Flow, Income Statement 2. Income Statement 3. Balance Sheet 4. Statement of Cash Flow, Balance Sheet 5. Statement of Stockholders’ Equity; Statement of Cash Flow 6. Income Statement, Balance Sheet 7. Income Statement 8. Balance Sheet, Income Statement

E2–5 2006 2006 Beginning Retained Earnings

2006 Revenues

$5.3

$10.6 X

–

2006 Expenses

–

$8.7

$1.5

–

2006 Dividends

2006 Ending Retained Earnings

–

$5.7

2007* 2007 Beginning Retained Earnings

$5.7

2008 2008 Beginning Retained Earnings X

+ +

2007 Revenues

–

2007 Expenses

$12.7 X

– =

X $11.2

2008 Revenues $13.2 X

– – =

2008 Expenses 11.8 $1.4

–

2007 Dividends

2007 Ending Retained Earnings

–

$5.8

$1.4

= =

2008 Ending Retained Earnings $1.6

– –

2008 Dividends $1.2

*you must calculate the 2008 equation before you can calculate the 2007 equation

Sales growth ($) Sales growth (%) Profits ($)

2008 $0.5 3.9% $1.4

2007 $2.1 19.8% $1.5

2006 N/A N/A $1.9

Profits (% of sales) 10.6% 11.8% 17.9% Dividends (% of net income) 85.7% 386.7% 78.9%

The company saw significant sales growth, but profits were relatively flat (meaning that profits as a percentage of sales decreased). Dividends are a consistently high percentage of profits (well above profits in 2007), which is common in the utility industry.

E2–6 2007 2007 Ending Retained Earnings or 2008Beginning Retained Earnings

($523) X

= =

($499) $1,407

2007 Beginning Retained Earnings + Revenues for 2007 – Expenses for 2007 – Dividends for 2007

$1,383

–

$1,522

–

$1,608

–

$1,550

–

Expenses for 2007 are $1,407. 2008 ($758) X

($523)

$149

Dividends declared for 2008 are $149.

2009 ($596) X

= =

($758) $1,717

Revenue for 2009 is $1,717. 2007

2008

2009

Sales growth (%) .......................................................... Profits ............................................................................

N/A ($24)

10.0% ($86)

12.8% $ 167

Profits as a percentage of sales...................................... Dividends........................................................................ Dividends as a percentage of net income ......................

(1.7%) $ 0 N/A

(5.7%) $ 149 N/A

9.7% $ 5 3.0%

The advertising agency had modest sales growth from 2007 to 2009. However, from 2008 to 2009, the Company was able to go from losses to a profit. Even though the Company had a loss in 2008 the Company paid a healthy dividend. Then in 2009, when the Company showed a profit, it virtually eliminated the dividend. There is reason to be optimistic going forward. In 2009 the Company was able to show a nice growth in its sales while at the same time showing a reduction in its expenses.

E2–7 Solvency primarily indicates a company’s ability to meet its debt payments as they come due. Current liabilities are obligations that will be settled within one year or the company’s operating cycle, whichever is longer, through the use of current assets or the creation of new current liabilities. Current assets are those assets that will be consumed or converted to cash within one year or the company’s operating cycle, whichever is longer. Consequently, comparing current assets to current liabilities provides an indication of a company’s ability to meet its short-term debts. In this case, current assets were 2.76 ($348/$126) and 2.60 ($427/$164) times greater than current liabilities as of December 31, 2009 and December 31, 2008, respectively. Although comparing current assets to current liabilities provides a measure of a company’s solvency, this measure is not perfect. A true test of a company’s short-term solvency would be to compare the cash value of its current assets to the cash value of its current liabilities. For current liabilities, the book value is usually a good approximation of the cash value, since a company cannot, from a legal viewpoint, unilaterally change its debts. The situation is different for current assets though. The book value may or may not bear any relation to the cash value. Consequently, comparing the book value of current assets to current liabilities may not give an accurate measure of a company’s solvency.

E2–8 Method 1 Working capital as of 12/31/2009 ($348 – $126) ................................................................. Impact of method on current assets .............................. Impact of method on current liabilities ......................... New working capital as of January 2010 ........................

222

0 (200) 22

Method 2 $

222

0 0 222

It seems that only the second method would be acceptable to the company in terms of maintaining compliance with the minimum working capital covenant.

E2–9 2009

2008

2007

Beginning cash balance .................................................. Net cash flow from operating activities ......................... Net cash flow from investing activities .......................... Net cash flow from financing activities .......................... Ending cash balance .......................................................

5,191 9,897 (9,959) X $ 5,718

Y* X (4,193) (6,433) $ 5,191

X equals

589

12,089

$ (8,342)

................................................................. $

3,297 10,104 X (1,331) $ 3,728

*Beginning cash balance for 2008 = Ending cash balance for 2007. Cisco Systems’ cash management activities over the three-year period of 2007, 2008, and 2009 appear to be strong. The Company is generating a significant amount of net cash flow from operations each year (with

2008 being especially strong) and then is investing in its business. Financing activities (including dividends and/or share repurchases) reduced cash in 2007 and 2008, but turned positive in 2009.

E2–10 2008 Beginning cash balance .................................................. Net cash flow from operating activities ......................... Net cash flow from investing activities .......................... Net cash flow from financing activities .......................... Ending cash balance .......................................................

X equals

(978)

................................................................. $

2,213**$ (1,521) X 1,654 1,368

2007

2006

1,390 $ 2,845 (1,529) X $ 2,213$

2,280

(493)$

1,406 (1,495) (801) 1,390*

*2007 Beginning balance = 2006 Ending balance **2008 Beginning balance = 2007 Ending balance. Southwest Airlines’ cash management activities appear to be very good for the years 2006 and 2007, but significantly deteriorated in 2008 (due to the economic recession). The company generated a net cash inflow from its operating activities for the first two years shown, but dropped to a negative operating cash flow in 2008. A look at its investing activities reveals that the company is expanding its asset base, but had to curtail the amount spent in the third year due to the downturn. During 2008, the company had a cash inflow due to financing activities, possibly in response to a need for cash due to the poor operations. Overall, Southwest Airlines is a strong company experiencing a difficult time in its cyclical business.

E2–11 Lana & Son Statement of Cash Flows For the Year Ended Cash flows from operating activities: Cash collection from services provided.................................................. Cash payment for expenses ................................................................... Net cash increase (decrease) from operating activities .................. Cash flows from investing activities: Purchase of machinery ........................................................................... Net cash increase (decrease) from investing activities ................... Cash flows from financing activities: Proceeds from stockholders’ contributions ........................................... Payment of dividends ............................................................................. Net cash increase (decrease) from financing activities ................... Increase (decrease) in cash balance.............................................................. Beginning cash balance ................................................................................. Ending cash balance ......................................................................................

$4,000 (3,000) $1,000 $(3,000) (3,000) $7,000 (1,500) 5,500 3,500 13,000 $ 16,500 $

Based on just one year’s statement of cash flows it is difficult to comment adequately on Lana & Son’s cash management activities. However, one can observe that most of the cash during the year was generated as a

result of issuing equity. The company seems to be investing in its asset base. That will certainly help it grow in the future. Cash flows from operations is positive, which certainly is a good sign.

E2–12 Emory Inc. Statement of Cash Flows For the Year Ended Cash flows from operating activities: Cash collection from services provided.................................................. Cash payment for expenses ................................................................... Net cash increase (decrease) from operating activities .................. Cash flows from investing activities: Purchase of equipment .......................................................................... Net cash increase (decrease) from investing activities ................... Cash flows from financing activities: Proceeds from the bank loan ................................................................. Payment of dividends Net cash increase (decrease) from financing activities ................... Increase (decrease) in cash balance.............................................................. Beginning cash balance ................................................................................. Ending cash balance ......................................................................................

$40,000 (23,000) $17,000 $(23,000) (23,000) $30,000 (24,000) 6,000 0 25,000 $ 25,000 $

Based on just one year’s statement of cash flows, it is difficult to comment adequately on Emory’s cash management activities. However, it seems that the company is generating a substantial portion of its cash flows from operating activities. The company is taking some loans to finance its asset base which would be helpful in the future. Return on total assets and return on equity would probably increase.

E2–13 George’s Business Income Statement For the Year Ended Lease revenue................................................................................................... Expenses ........................................................................................................... Net income .......................................................................................................

George’s Business Statement of Stockholders’ Equity For the Year Ended Contributed Capital

Retained Earnings

$3,000 2,500 $ 500

Beginning Balance Stock Issue Net Income Cash Dividends Ending Balance

E2–13

$ 0 6,000 _____ $6,000

500 (800) $ (300)

Concluded George’s Business Balance Sheet As of Assets Cash ................................................................................................................ Land ................................................................................................................ Total assets ....................................................................................................... Liabilities & Stockholders’ Equity Note payable .................................................................................................... Contributed capital ........................................................................................... Retained earnings ............................................................................................. Total liabilities & stockholders’ equity .............................................................

2,700 8,000 $ 10,700 $

5,000 6,000 (300) $ 10,700

George’s Business Statement of Cash Flows For the Year Ended Cash flows from operating activities: Cash collections from customers .................................................. Cash payments for expenses ......................................................... Net cash flow from operating activities ................................... Cash flows from investing activities: Purchase of land ............................................................................ Net cash flow from investing activities .................................... Cash flows from financing activities: Proceeds from equity investor ...................................................... Proceeds from borrowing ............................................................. Cash payments for dividends ........................................................ Net cash flow from financing activities .................................... Increase in cash .................................................................................. Beginning cash balance ...................................................................... Ending cash balance ...........................................................................

3,000 (2,500) $

500

$ (8,000) (8,000) $

6,000 5,000 (800) 10,200 2,700 0 $ 2,700 $

Upon examining George’s financial statements the bank would certainly be concerned because George paid out more in dividends than the net income he realized during the year. George’s statement of retained

earnings shows a negative balance, which means that the payment to equity investors which was disguised as return on capital was in fact a return of capital. Generally, dividend payments cannot exceed the Retained Earnings balance.

E2–14 Mary’s Business Income Statement For the Year Ended Lease revenue................................................................................................... Expenses ........................................................................................................... Net income .......................................................................................................

$ 12,000 14,000 $ (2,000)

Mary’s Business Statement of Stockholders’ Equity For the Year Ended

Beginning Balance Stock Issue Net Income (Loss) Cash Dividends Ending Balance

Contributed Capital $ 0 30,000 ______ $30,000

Retained Earnings $ 0 (2,000) (1,000) $ (3,000)

Mary’s Business Balance Sheet As of Assets Cash ................................................................................................................ Land ................................................................................................................ Total assets ....................................................................................................... Liabilities & Stockholders’ Equity Note payable .................................................................................................... Contributed capital ........................................................................................... Retained earnings ............................................................................................. Total liabilities & stockholders’ equity .............................................................

2,000 40,000 $ 42,000 $ 15,000 30,000 (3,000) $ 42,000

E2–14

Concluded Mary’s Business Statement of Cash Flows For the Year Ended Cash flows from operating activities: Cash collections from customers .................................................. Cash payments for expenses ......................................................... Net cash flow from operating activities ................................... Cash flows from investing activities: Purchase of land ............................................................................ Net cash flow from investing activities .................................... Cash flows from financing activities: Proceeds from equity investor ...................................................... Proceeds from borrowing ............................................................. Cash payments for dividends ........................................................ Net cash flow from financing activities .................................... Increase in cash .................................................................................. Beginning cash balance ...................................................................... Ending cash balance ...........................................................................

$ 12,000 (14,000) $ (2,000) $ (40,000) (40,000) $ 30,000 15,000 (1,000) 44,000 2,000 0 $ 2,000 $

Mary should not have paid a cash dividend of $1,000 because of her dwindling cash position and negative earnings during the year. The dividend was a return of capital rather than a return on capital.

PROBLEMS P2–1 1. 2. 3. 4. 5. 6. 7. 8.

e e a a g c f c

9. 10. 11. 12. 13. 14. 15. 16.

a a c d c b e a

17. 18. 19. 20. 21. 22. 23.

c a d b e e e

X Company Balance Sheet (Date) Assets Current assets: Cash ................................................................................... Short-term investments .................................................... Accounts receivable .......................................................... Less: Allowance for uncollectible accounts ....................... Inventory ........................................................................... Prepaid rent ....................................................................... Total current assets ...................................................... Long-term investments: Land held for investment .................................................. Investment fund for plant expansion ................................ Total long-term investments ........................................ Property, plant, & equipment: Property............................................................................. Building .............................................................................. Less: Accumulated depreciation (building) ....................... Net book value of building ................................................ Machinery and equipment ................................................ Less: Accumulated depreciation (machinery & equipment) ................................................................... Net book value of machinery and equipment................... Total property, plant, & equipment ............................. Intangible assets: Patents............................................................................... Trademarks........................................................................ Total intangible assets .................................................. Total assets .............................................................................

$XX XX $XX XX

XX XX XX $XX $XX XX XX $XX

$XX XX XX $XX XX XX XX $XX XX XX $XX

P2–1

Concluded Liabilities and Stockholders' Equity Current liabilities: Accounts payable .............................................................. Wages payable .................................................................. Dividend payable ............................................................... Short-term notes payable ................................................. Current portion due of long-term debt ............................ Payments received in advance .......................................... Total current liabilities ................................................. Long-term liabilities: Bonds payable ................................................................... Total long-term liabilities ............................................. Stockholders' equity: Capital stock ...................................................................... Retained earnings.............................................................. Total stockholders' equity ............................................ Total liabilities and stockholders' equity ................................

P2–2 1. 2. 3. 4. 5.

e b e a e

6. 7. 8. 9. 10.

e e f c c

11. 12. 13. 14. 15.

e f f d c

$XX XX XX XX XX XX $XX $XX XX $XX XX XX $XX

P2–2 Concluded X Company Income Statement For the Period Ended Revenues: Sales................................................................................... Fees earned ....................................................................... Interest income ................................................................. Dividend income................................................................ Gain on sale of short-term investments............................ Total revenues .............................................................. Expenses: Cost of goods sold ............................................................. Operating expenses: Office salary expense ................................................... Insurance expense........................................................ Salesmen commission expense .................................... Depreciation expense................................................... Office supplies expense................................................ Advertising expense ..................................................... Total operating expenses ........................................ Other expenses: Interest expense ........................................................... Loss on sale of equipment............................................ Loss on sale of building ................................................ Total other expenses ............................................... Total expenses ................................................................... Net income .............................................................................

$XX XX XX XX XX $XX $XX $XX XX XX XX XX XX XX $XX XX XX XX XX $XX

P2–3 Nimmo Brothers Corporation Statement of Cash Flows Balance Sheet for the year ending 12/31/2011 as of 12/31/2011 Cash-Operating 275 Cash Cash-Investing (200) Other Current Assets Cash-Financing 330 Long-term Assets ∆ in Cash 405 Total Assets Cash-12/31/10 420 Cash-12/31/11 825

825 1,550 1,600 3,975

Income Statement Current Liabilities 995 for the year ending 12/31/2011 Long-term Liabilities 1,200 Revenue 4,200 Contributed Capital 1,200 Expenses 4,050 Retained Earnings 580 Net Income 150 Total 3,975

Statement of Stockholders’ Equity for the year ending 12/31/2011 Contributed Retained Capital Earnings 12/31/10 1,000 500 Net Income 150 Dividends (70) Stock Issuance 200 ___ 12/31/11 1,200 580

P2–4 Johnson Company Balance Sheet December 31, 2011 Assets Current assets: Cash ................................................................................................ Short-term investments .................................................................. Accounts receivable ........................................................................ Less: Allowance for uncollectible accounts .................................... Net accounts receivable ........................................................... Inventory ......................................................................................... Total current assets .................................................................. Property, plant, & equipment: Buildings .......................................................................................... Less: Accumulated depreciation ..................................................... Total property, plant, & equipment ......................................... Total assets ........................................................................................... Liabilities & Stockholders' Equity Current liabilities: Accounts payable ............................................................................ Taxes payable .................................................................................. Total current liabilities.............................................................. Long-term notes payable ....................................................................... Stockholders' equity: Contributed capital.......................................................................... Retained earnings............................................................................ Total stockholders' equity ........................................................ Total liabilities & stockholders' equity ...................................................

$ 8,000 40,000 $125,000 2,400 122,600 161,000a $331,600 $ 35,000 8,000 27,000 $358,600

$110,000 29,400 $139,400 79,100 $100,000b 40,100c 140,100 $358,600

__________________ a Inventory is reported at the lower of its cost or its market value. b $100,000 = $12,500 shares  $8 per share. c $40,100 = $65,000 cumulative earnings – $24,900 cumulative declared dividends. Based on only one year’s balance sheet it is a very difficult question to answer. This fact proves the point that (1) all the financial statements must be interpreted as a whole, and (2) that the information should be analyzed over a number of years to draw any meaningful conclusions.

However, based on what we have, I would not invest in this company. The current ratio is 2.379 but debt/equity ratio is 1.560, which is a cause for concern in the long term. Further, the company seems to be paying approximately 38% of its retained earnings beginning balance in dividends, which is good for the investors who are looking for short-term return on their capital.

P2–4 Concluded Johnson Company Balance Sheet December 31, 2011 Property, plant, & equipment: Buildings .......................................................................................... Less: Accumulated depreciation ..................................................... Total property, plant, & equipment ......................................... Current assets: Cash ................................................................................................ $ 8,000 Short-term investments .................................................................. Accounts receivable ........................................................................ $125,000 Less: Allowance for uncollectible accounts .................................... 2,400 Net accounts receivable ........................................................... Inventory ......................................................................................... Total current assets .................................................................. Less: Current liabilities: Accounts payable ............................................................................ Taxes payable .................................................................................. Total current liabilities.............................................................. Total…………………………………………………………………… $219,200

$ 35,000 8,000 $ 27,000

40,000

122,600 161,000a 331,600

$110,000 29,400 139,400

Capital Employed: Long-term notes payable ....................................................................... Stockholders' equity: Contributed capital.......................................................................... Retained earnings............................................................................ Total stockholders' equity ........................................................ Total ...........................................................................................

79,100

$100,000 40,100 140,100 $219,200

P2–5 2008 Contributed Capital: Total assets = Total liabilities + Total stockholders' equity ($300 + $200 + $500 + $100 + $700) = ($200 + $500) + (Contributed cap. + $400) Contributed capital = $700 Net Income: Net income = Sales – Expenses = $1,000 – $400 = $600 Dividends: Ending retained earnings = Beginning retained earnings + Net income – Dividends $400 = $0 + $600 – Dividends Dividends = $200 2009 Inventory: Total assets = Total liabilities + Total stockholders' equity ($300 + $300 + Inventory + $200 + $600) = ($300 + $600) + ($400 + $800) Inventory = $700 Expenses: Net income = Sales – Expenses $400 = $1,100 – Expenses Expenses = $700 Dividends: Ending retained earnings = Beginning retained earnings + Net income – Dividends $800 = $400 + $400 – Dividends Dividends = $0 2010 Accounts Receivable: Total assets ($200 + Accts. rec. + $400 + $400 + $700) Accounts receivable

= Total liab. + Total stockholders' equity = ($500 + $800) + ($600 + $300) = $500

Expenses: Net income = Sales – Expenses ($100) = $700 – Expenses Expenses = $800 Dividends: Ending retained earnings = Beginning retained earnings + Net income – Dividends $300 = $800 + ($100) – Dividends Dividends = $400

P2–5

Concluded

2011 Accounts Payable: Total assets = Total liabilities + Total stockholders' equity ($500 + $700 + $400 + $400 + $800) = (Accts. pay. + $700) + ($600 + $600) Accounts payable = $900 Net income: Ending retained earnings = Beginning retained earnings + Net income – Dividends $600 = $300 + Net income – $200 Net income = $500 Sales: Net income = Sales – Expenses $500 = Sales – $600 Sales = $1,100 In order to assess the financial performance of this company, we need to calculate the measures of solvency and earning power. Respective measures are computed as follows: Measures of Solvency

2008

2009

2010

2011

Current Ratio: Working Capital: Debt/Equity Ratio:

5 $800 .64

4.33 $1,000 .75

2.20 $600 1.44

1.78 $700 1.33

The only measure of earning power that we can compute for this company is Return on Equity. The other measures, such as EPS and P/E Ratio, cannot be computed since the relevant information is not available. Measures of Earning Power

2008

2009

2010

2011

Return on Equity:

.55

.33

—*

.42

*No return on stockholder’s equity during 2010 since the company suffered a loss of $100. Overall, looking at the measures of solvency and earning power, one can safely conclude that the financial performance and position of the company has deteriorated since its inception in 2008. The current ratio has continued to decline and working capital has also gone down. While the company has taken more debt, it has been unable to leverage against the interest of the stockholders, since the return on equity has declined considerably. In one year, 2010, the company even suffered a loss. The company paid dividends even during the year of loss, indicating a poorly devised dividend policy.

P2–6 Kroger Balance Sheet December 31, 2009, 2008 2009 Assets Cash ............................................................................................. Accounts receivable ....................................................................... Inventory ........................................................................................ Property, plant, and equipment (net) ............................................ Other assets ................................................................................... Total assets .................................................................................$ Liabilities and Stockholders’ Equity Accounts payable ........................................................................... Other short-term debts .................................................................. Long term debt............................................................................... Stockholders’ Equity....................................................................... Total liabilities and stockholders’ equity........................................

2008

263 944 4,859 13,161 3,984 23,211 $

3,822 3,807 10,406 5,176 $ 23,211

242 786 4,849 12,498 3,918 22,293 3,867 4,816 8,696 4,914 $ 22,293

Supervalu Income Statement For the Years Ended December 31, 2009, 2008 Sales ............................................................................................. Expenses......................................................................................... Net income .....................................................................................

2009 $ 76,000 74,751 $ 1,249

2008 $ 70,235 69,054 $ 1,181

Solvency refers to a company’s ability to pay its obligations as they come due. The current ratio provides a measure of solvency by comparing those obligations that are coming due in the near future against those assets that the company expects to convert into cash or consume in the near future. Based on its current ratio, Kroger does not have sufficient current assets to cover its existing current liabilities in either year. In 2009 the current ratio was 0.80 ($6,066/$7,629), while it was 0.68 ($5,877/$8,683) in 2008. The Company’s solvency has improved in the time period shown. Earning power refers to a company’s ability to generate net assets through operations. Income has been fairly constant, as measured in terms of dollars and as a percentage of sales. Margins are thin in the company’s industry, but Kroger has shown consistent earnings in the time period.

P2–7 a. Assets are, for the most part, recorded at original cost. Over a period of time, the value of an item will change. For instance, the value of Eat and Run's property, plant, and equipment will most likely change as the items become older. Consequently, over time the cost of an item may have no relation to the item's market value. Since the cash received from selling an asset is based on the asset's market value, the asset's book value is not an accurate indicator of a company's value. b. The value of the firm would equal the sum of the fair market value of the assets less the sum of liabilities. The value of Eat and Run would, therefore, be as follows:

Market Value Cash ................................................................................... Short-term investments .................................................... Accounts receivable........................................................... Inventory ........................................................................... Prepaid insurance .............................................................. Property, plant, & equipment ........................................... Other assets ....................................................................... Total market value of assets.............................................. Less: Total liabilities .......................................................... Value of Eat and Run ......................................................... c.

25,000 19,000 25,000 33,000 0 100,000 0 $ 202,000 196,000 $ 6,000

If Eat and Run were to go bankrupt, the stockholders would receive anything left after all the assets were sold and the creditors were paid. In this case the fair market value of the assets exceeds the total liabilities, so the stockholders would receive the residual, which would be $6,000. As a practical matter, Eat and Run might have to hire lawyers and accountants for the bankruptcy proceedings. If this were the case, the lawyers and accountants would have to be paid before the stockholders received anything. So in this particular case, there may be nothing left for the stockholders once the creditors, lawyers, and accountants are paid.

P2–8 First, let us compute some relevant ratios that would help to evaluate the financial statements submitted by Romney Heights in support of its loan application to Acme Bank. Ratios 2011

2010

Liquidity Current Ratio (Current Assets ÷ Current Liabilities) Working Capital (Current Assets – Current Liabilities)

2.00

$7,000

$6,000

1.06

0.96

0.45

0.33

Long-Term Debt Paying Ability Debt/Equity Ratio (Total Liabilities ÷ Stockholders’ Equity) Operating Cash Flow to Total Debt

(Operating Cash Flow ÷ Total Debt) Ratios 2011

2010

Profitability Net Profit Margin (Net Income ÷ Sales)

0.34

0.19

Total Asset Turnover (Sales ÷ Total Assets)

0.55

0.58

Return on Assets (Net Income ÷ Total Assets)

0.19

0.11

Return on Assets (Net Profit Margin  Total Asset Turnover)

0.187

.110

Return on Equity (Net Income ÷ Stockholders’ Equity)

0.39

0.21

A thorough review of the various ratios reveals that Romney Heights is worth the risk. The bank should consider its loan application, at least for a short-term loan. The short-term solvency position is reasonably good. Working capital is positive and the current assets are twice the current liabilities. Regarding long-term debt paying ability the company seems to be heavily leveraged. The debt to equity ratio is more than 1 and has increased from 2010 to 2011. However, the concern is somewhat mitigated by a substantial increase in the proportion of operating cash flows to the total debt held by the company. The overall profitability of the company is on the rise, but the asset utilization is poor and flat. Since the return on equity has almost doubled, the company seems to be able to effectively leverage the increment in its debt to the advantage of its stockholders. Regarding the statement of cash flows, the company seems to be doing fine. Net cash flow from operating activities is positive. The company is investing in its asset base, probably intending to expand in the future by supplementing its cash flow from operating activities with financing either from bank loans or from equity.

P2–9 First, let us compute some relevant ratios that would help us evaluate the financial statements of Ted Tooney. Ratios 2011

2010

Liquidity Current Ratio (Current Assets ÷ Current Liabilities)

1.29

2.00

Working Capital (Current Assets – Current Liabilities)

$2,000

$4,000

Debt/Equity Ratio (Total Liabilities ÷ Stockholders’ Equity)

1.45

0.92

Operating Cash Flow to Total Debt (Operating Cash Flow ÷ Total Debt)

0.75

1.36

Net Profit Margin (Net Income ÷ Sales)

0.15

0.19

Total Asset Turnover (Sales ÷ Total Assets)

3.41

3.87

Return on Assets (Net Income ÷ Total Assets)

0.52

0.74

Return on Assets (Net Profit Margin  Total Asset Turnover)

0.51

0.74

Return on Equity (Net Income ÷ Stockholders’ Equity)

1.27

1.42

Long-Term Debt Paying Ability

Profitability

Looking at the declining trends of all financial indicators, it would be safe to decline Ted’s request for an equity investment in his company. The short-term liquidity of the company is going down. The working capital as well as the current ratio has declined. The company is becoming highly leveraged and the amount of operating cash flow as a percentage of total debt has considerably declined. This all indicates a worsening position. The profitability and return on assets are mediocre and declining. The return on equity has also declined as the company is not able to leverage its debt to the advantage of its stockholders. Even though the overall liquidity position is not that serious, the trend is towards the decline. In summary, a loan position may be taken with the company, but certainly not an equity position.

P2–10 a. As of 12/31/11 the current asset balance of Ellington Industries is 1.33 times the current liability balance. Since the debt covenant requires this balance to be 2 times the current liability balance, Ellington Industries must have current assets of at least $18,000. Since, it already has $12,000 invested in current assets, it will need to invest an additional $6,000 out of the long-term borrowing of $40,000 to comply with the debt covenant. That would leave $34,000 ($40,000 – $6,000) for additional investment in the land. b. Ellington Industries Balance Sheet January 1, 2012 Assets Current assets ......................................................................... Land investment ..................................................................... Total assets ............................................................................. Liabilities & Stockholders’ Equity Accounts payable ................................................................... Long-term liabilities ................................................................ Stockholders’ equity ............................................................... Total liabilities and stockholders’ equity ................................

18,000 89,000 $ 107,000 $

9,000 70,000 28,000 $ 107,000

Ratios Current assets/Current liabilities = $18,000/$9,000 = 2 Total liabilities/Total assets = $79,000/$107,000 ........ = .74 c. Ellington Industries Balance Sheet December 31, 2012 Assets Current assets ......................................................................... Land investment ..................................................................... Total assets ............................................................................. Liabilities & Stockholders’ Equity Accounts payable ................................................................... Long-term liabilities ................................................................ Stockholders’ equity ............................................................... Total liabilities and stockholders’ equity ................................

36,000 89,000 $ 125,000

7,000 70,000 48,000 $ 125,000

Since the dividend has to be paid in cash, it will come out of the current assets. According to the restrictions imposed by the debt covenant, the current assets must be twice the current liabilities, i.e., at least $14,000. This would result in an excess of $22,000 ($36,000 – $14,000) in the current assets.

Therefore, the company can pay a maximum of $22,000 in dividends without violating the debt covenant. If the company declares and pays $22,000 in dividends, then total liabilities/total assets would be equal to .75 ($77,000/$103,000).

ISSUES FOR DISCUSSION ID2–1 a. Net income represents the change in net assets (i.e., assets less liabilities) generated during the year from operating activities. Alternatively, cash flows from operating activities is the amount of cash the company generated during the year from operating activities. Since cash is simply one of many assets a company has, it is obvious that net income and cash flows from operating activities are not the same. Thus, it is quite possible for a company to have an increase in net assets from operating activities (i.e., net income) and at the same time have negative cash flows from operating activities. The ability of a company to pay dividends is a function of how much cash the company has available. A company could generate negative cash flows from operating activities but have large cash reserves from generating cash from operating activities in prior years. Alternatively, a company may have obtained enough cash to pay a dividend by borrowing the money or by selling assets. Remember, companies can generate cash from investing activities and financing activities in addition to cash from operating activities. b. A company could not continue generating negative cash flows from operating activities and expect to continue in business. A company cannot borrow money or issue stock indefinitely. At some point the creditors will demand to be repaid and the owners will demand some return on their investment. Sooner or later the company will have to generate cash from its operations to repay the creditors. Paying out dividends while generating negative cash flows from operating activities will only increase the company's cash problems.

ID2–2 The income statement of Disney would have shown increases in service revenue due to the movie Wild Hogs and increases in sales revenue from the products tied in to the movie Cars. The income statement would not yet reflect the upcoming two movies, as revenue cannot be recognized until the earnings process is substantially completed (which will not occur until the movies are released). Assuming the ESPN mobile phone licensing agreement has started, Disney would show an increase in service revenue (which would help to offset the softer service revenue from the theme parks). Finally, on the expenses portion of the income statement, the increase in programming costs for events shown on ESPN would be reflected as higher operating expenses (which would, of course, result in lower profitability).

ID2–3 a. The excerpt indicates that the Cummins Engine Company's creditors have imposed restrictions on Cummins as part of the borrowing agreement. The covenants restrict Cummins' abilities to pay dividends and borrow money and the relative amount of its current assets and current liabilities. If Cummins fails to comply with the covenants, its creditors could require Cummins to repay the loans immediately.

b. A bank or other creditor would impose such restrictions to protect itself from a loan default. That is, creditors impose restrictions on borrowers, such as the amount of cash that can be paid out for dividends, that increase the probability that the borrower will have sufficient resources to be able to make the interest and principal payments required under the borrowing agreement. c.

Debt covenants are often explicitly based on financial accounting numbers. For example, the current ratio is based on the amount of current assets and current liabilities reported on Cummins' balance sheet. Similarly, compliance with the dividend restriction can be assessed by examining the amount of dividends declared reported in the statement of retained earnings.

ID2–4 Hewlett Packard – HP is able to generate strong cash flow from its current operations ($14,591). The company appears to invest heavily ($13,711) in long term assets, probably for acquisitions and growth in its manufacturing operations. The company also spends significant funds ($2,020) by either retiring debt or returning money to the shareholders (in dividends and stock repurchases). The company’s strong cash flow from operations fuels its investments and its outflow of cash for financing. Southwest Airlines – Southwest operates in a very cyclical business that suffered greatly from the economic downturn. Cash from its operations (-$1,521) was negative, meaning the company lost cash by operating its core business. Due to the capital-intensive nature of its business, Southwest must continually purchase and upgrade aircraft to remain competitive, thus the large outflow (-$978) even in a difficult year. Southwest has raised cash from its financing activities, either from debt or equity proceeds, necessitated by the weak operating year. Boeing – Boeing suffered from the same macro economic problems that affected Southwest Airlines; the company generated negative cash from operations (-$401). Boeing differed from Southwest in that it was actively selling long term assets instead of purchasing additional ones. The positive cash from investing ($1,888) indicates the company is selling more long term assets than it is purchasing. Perhaps the company was downsizing its operations due to the recession. Finally, the company heavily used cash in financing, for debt repayments and/or share repurchases and dividend payments.

ID2–5 From the data given about the Goodrich Corporation it can be surmised that Goodrich has done a good job of generating positive operating cash flow, and that the amounts generated are increasing substantially over the time period shown. Given the fact that the company is a defense contractor and that defense spending has been heavy in the years shown, the increasing operational cash flow is an understandable trend. Strategically, the large investment in long term assets shown by the company’s cash from investing activities implies that the company is investing in long term assets such as equipment that will be used in the operations of the business. The performance of cash from financing activities shows that Goodrich has been able to return cash to shareholders and/or pay down debt, with the amounts increasing over the period shown (as the company’s operations throw off more cash). Overall, cash balances have remained relatively constant, as the strong cash inflows from operations have been used for the outflows of investing and financing.

ID2–6

A U.S. GAAP balance sheet shows the most liquid accounts first and then lists accounts in the order that they are convertible to cash. Those accounts being closest to cash are listed first. Secondly, liabilities are not shown in parentheses. Finally, some of the equity accounts carry slightly different titles. GlaxoSmithKline Consolidated Balance Sheet As of 12/31/2008 2008

2007

ASSETS: Cash Short term investments Accounts receivable Inventory Other assets Current assets

5,623 1,247 6,265 4,056 78 17,269

3,379 1,628 5,495 3,062 62 13,626

Non-Current Assets Investment in Affiliates Property, Plant & Equipment Other Investments Total

552 9,678 3,924 14,154

329 7,821 3,401 11,551

7,970

5,826

Goodwill & Other

Total Assets

LIABILITIES Loans Accounts payable Other current liabilities Current liabilities Long term liabilities Loans Long term payables Long term liabilities Shareholders’ Equity Common stock Additional paid in capital

39,393

31,003

956 6,075 2,986 10,017

3,504 4,861 1,980 10,345

15,231

7,067

5,827 21,058

1,415 1,326

3,681 10,748

1,503 1,266

Minority Interest Retained earnings Total shareholder’s equity

387 5,190 8,318

Total Liabilities and Shareholders’ Equity ID2–7

39,393

307 6,834 9,910

31,003

Earnings according to GAAP are accrual numbers, meaning that they don’t represent cash. For example, net income is derived by subtracting expenses from revenue, but revenue can be recognized even if the company has yet to receive the cash (accounts receivable are booked). If the accounts receivable, which represent a promise from a customer to pay cash, never convert into cash, the accrual net income figure is an overstatement of the company’s earnings power. Investors, therefore, look at net income in conjunction with operating cash flow to determine if the various components of accrual net income are supported by cash flows.

ID2–8 Both GE and Comcast are interested in focusing efforts on core business activities: for GE, running a television network did not fit in with its manufacturing and financial businesses, while Comcast saw a television network as a logical vertical extension of its core business of providing cable television services to consumers. The NBC transaction was completed simultaneously, with NBC’s ownership switching from GE/Vivendi to Comcast/GE. From GE’s perspective, it saw a net cash inflow (cash from investing activities decreased to purchase Vivendi’s 20% share and then increased when the 51% stake was sold to Comcast), while its balance sheet ultimately showed a decrease in NBC-related assets (from a consolidation of all NBC assets to a line item investment in NBC).

ID2–9 An analyst following both Nike (GAAP) and Adidas (IFRS) would not be pleased with the SEC decision. An analyst would like to review the financial results of the companies in a side-by-side, “apples-to-apples” comparison. With the previous requirement, the analyst could take the reconciliation prepared by Adidas and compare its net income and stockholders’ equity to those of Nike. Once the requirement was dropped, the analyst (with the same need for industry peer comparison) would effectively have to do the reconciliation by herself. The analyst would therefore need to be an expert in both GAAP and IFRS in order to compare the results of the two footwear and athletic apparel firms.

ID2–10 a. Sales Cost of sales

2009 $ 19,176 $ 18,627 10,572 55.1%

2008

2007

$ 16,326 10,240 55.0%

9,165 56.1%

S G & A expenses Interest expense* Taxes Net income

6,150 32.1% 40 0.2% 470 2.5% $ 1,487 7.8%

5,954 32.0% 39 0.2% 620 3.3% $ 1,883 10.1%

5,029 30.8% 50 0.3% 708 4.3% $ 1,492 9.1%

From 2007 to 2009 gross margin (the profit after cost of sales have been deducted from sales) improved by the same amount that operating margin (after overhead expenses have been deducted) deteriorated, leaving margins relatively constant; the dollar amount of profits increased due to the sales growth. In 2009, however, a series of impairment and restructuring expenses (one-time charges) decreased profits relative to prior years. *see Footnote #1 re: Interest Income and Interest Income, net b. Current assets Noncurrent assets Total assets

2009 $ 9,734 73.5% 3,516 26.5% $13,250

2008 . $ 8,839 71.0% 3,604 29.0% $12,443

From 2008 to 2009 there has been a slight change in the allocation between current and non-current assets. The company has marginally increased its share of shorter term assets. c. Current liabilities Long-term liabilities Total assets

2009 $3,277 1,279 $13,250

2008 . 24.7% $3,322 26.7% 9.7% 1,296 10.4% $12,443

From 2008 to 2009 Nike decreased the percentage of assets financed with current and long-term liabilities, meaning it increased the percentage of assets financed with equity. d. Nike is continuing to grow its business by investing over $400 million in property, plant and equipment annually and by acquiring another business in 2008. The main source of this spending was cash flow from operations ($1.7 billion in 2009, down slightly from prior years). The company’s financing operations represent a use of cash, mainly for dividend payments and share repurchases (combining for over $1 billion annually), forcing reliance on operations to fund its long-term investments. e. 2009 Net income Dividends paid Dividends as a percentage of net income

2008

$1,487 $ 467

$ 413

31.4%

21.9%

2007 . $1,883

$1,492 $344 23.1%

Nike also returns cash to shareholders by repurchasing their shares of stock ($649 million in 2009 and $1.2 billion in 2008, for example).

CHAPTER 3 THE MEASUREMENT FUNDAMENTALS OF FINANCIAL ACCOUNTING BRIEF EXERCISE BE3–1 1. Fiscal period 2. Economic entity 3. Conservatism 4. Consistency 5. Revenue recognition

6. Materiality 7. Matching 8. Objectivity 9. Objectivity 10. Stable dollar

EXERCISES E3–1 At the beginning of the period, $6 billion would allow the corporation to buy a "basket of goods." Due to the increase in the general price level, the same basket of goods would cost more than $6 billion at the end of the period. Therefore, the corporation would have less purchasing power at the end of the period than at the beginning of the period. The decrease in purchasing power would be computed as follows: 1. Compute the cost of the basket of goods at the end of the period: = $6,000,000,000 (1 + inflation rate) = $6,000,000,000  1.02 = $6,120,000,000 2. Compute change in cost of the basket of goods for the period: = $6,120,000,000 – $6,000,000,000 = $120,000,000 This decrease in purchasing power would not be reflected in the corporation's financial statements. Accountants adhere to the stable dollar assumption, which means that changes in the general price level are ignored when determining the value of assets and liabilities. This assumption allows users of financial statements to compare financial statements from different points in time. Boeing would want to keep its cash balance as low as possible because money sitting as cash makes very little to no investment income. Most companies would try to maximize its interest income by investing most of its cash. At the same time the company would not reduce its cash balance to zero because it has to have cash on hand to pay bills as they come due everyday.

E3–2 a. Each land acquisition would be recorded at its original cost of $15,000, for a total of $30,000. b. No, the company could not purchase the same basket of goods for $15,000 in 2011 as in 1993. To purchase the same basket of goods in 2011, the company would need $24,000 [$15,000  (1 + 60%)]. Therefore, cash held by the company from 1993 to 2011 would be subject to an economic loss of $9,000 ($24,000 – $15,000).

There are two alternatives for reporting the value of the land if the stable dollar assumption is ignored. The first alternative is to report both pieces of land at 1993 dollars. The second alternative is to report both pieces of land at 2011 dollars. The two alternatives are shown below.

E3–2 Concluded 1993 land in 1993 dollars 2011 land in 1993 dollars Total land in 1993 dollars a b

$ $

15,000 9,375a 24,375

2011 land in 2011 dollars 1993 land in 2011 dollars Total land in 2011 dollars

$ $

15,000 24,000b 39,000

$9,375 = $15,000 cost of land in 2011 ÷ 1.6 $24,000= $15,000 cost of land in 1993  1.6

E3–3 Original Cost Cash Short-Term Investments Inventories Prepaid Expenses Long-Term Investments Notes Receivable Machinery Equipment Land Intangible Assets Short-Term Payables Long-Term Payables 1 2 3 4

2 X 3

Fair Market Value

Present Value

X 1 2 3

Replacement Cost

2 3 X

4 4 X 4 X X

Short-term investments are recorded at fair market value. Inventory is reported at the lower of original cost or market value, where market value can be based on fair market value or replacement cost. Long-term investments are carried on the books at original cost, fair market value, or amortized value, depending upon the type of investment. Long-lived assets, such as machinery, equipment, and intangible assets, are reported on the balance sheet at net book value, which equals original cost less the portion of original cost amortized to date.

E3–4 a. If Cisco were to determine that a portion of its inventory were obsolete, the company would lower the value of the inventory (an asset on the balance sheet) and would book an expense on the current income statement (which would ultimately lower stockholder equity on the balance sheet). b. Ultimately, the management of Cisco is responsible for forecasting future demand for its products (currently held in inventory) and the valuation to be used in the financial statements. Ultimately, therefore, it is management who controls the value of the asset and any associated writedown expense on the income statement.

Driving the valuation of inventory is the aim to not overstate the value of items yet to be sold. We do not want financial statements to list the value of inventory at its cost if market forces have changed to the point that the company could only sell the inventory for a price below its cost. In this sense, conservatism rules the day, requiring companies to list their inventory at the lower of the cost of the inventory or the inventory’s value in the market. In equivalent terms, an owner of a gas station should not list his gasoline inventory at his cost of $2.50 per gallon if market forces have pushed down the selling price (the value in the market) of gasoline to $2.25 per gallon. We need, however, the company’s management to be able to back up the market values used with objective data (such as the published current selling prices of gasoline) in order to prevent manipulation of the financial statements. If a company uses a subjective measure of market value to book a loss in one reporting period (due to the writedown expense) and then generates a larger profit the following period (when the marked-down inventory is sold in the market at typical market prices), the financial statements have not provided the reader a clear understanding of the business performance.

E3–5 a. The most common point at which a company would recognize revenue is at the time of delivery. So in this case McKey and Company would recognize revenue in February. b. The four criteria for recognizing revenue are (1) the company has completed a significant portion of the production and sales effort, (2) the amount of revenue can be objectively measured, (3) the company has incurred the majority of costs, and remaining costs can be reasonably estimated, and (4) cash collection is reasonably assured. Presumably McKey and Company is reasonably assured that Cascades Enterprises will eventually be able to pay the $40,000, or McKey would not have entered into the agreement with Cascades Enterprises. Since the production and sales effort was not really complete until McKey shipped the brackets on February 9, February 9 appears to be the appropriate date to recognize the revenue. c.

Under the appropriate conditions, revenue can be recognized at several points in time. Revenue could be recognized (1) during production, (2) at the completion of production, (3) at the point of delivery, or (4) when the cash is collected. Case 1 normally arises in long-term construction projects such as office buildings, bridges, and so forth. Case 2 arises where goods are manufactured to the exact specifications of a customer, and the goods cannot be sold to another party. Case 3 is the most common point of revenue recognition. Case 4 arises when cash collection is not reasonably assured.

d. McKey's managers could be interested in the timing of revenue recognition due to incentives provided by contracts. For example, the managers may be paid a bonus based upon accounting income. A manager who is trying to maximize his or her bonus might prefer recognizing revenue in a particular period rather than in a different period. Another contract that might influence the actions of managers would be a debt covenant. If a debt covenant stipulates a maximum debt-to-equity ratio, and the company is nearing the ratio, the managers could improve the ratio by increasing stockholders' equity. One way to increase stockholders' equity is to increase net income. Consequently, speeding up the recognition of revenue (called front loading) might prevent the company from violating a debt covenant.

E3–6 a. (1) Revenue recognized at the end of the project. Lahmont Bridge Builders Income Statement For the Period Ended

Revenues from long-term contracts 3

Period 1

Period 2

$600,000

Construction expenses Net income

E3–6

0 $0

400,000 $200,000

Period 1

Period 2

$ 450,000a 300,000 $ 150,000

$ 150,000b 100,000 $ 50,000

Concluded

(2) Revenue recognized during production. Lahmont Bridge Builders Income Statement For the Period Ended

Revenues from long-term contracts Construction expenses Net income

a $450,000 = ($300,000 ÷ $400,000)  $600,000 b $150,000 = $600,000 – $450,000, or ($100,000 ÷ $400,000)  $600,000

(3) Revenue recognized when payments are received. Lahmont Bridge Builders Income Statement For the Period Ended Period 1 $ 400,000 300,000 $ 100,000

Revenues from long-term contracts Construction expenses Net income Note:

In all three cases, costs are recognized as expenses in accordance with the matching principle. That is, the costs are not expensed until the costs have helped generate a benefit in the form of revenue.

b. Assumption (1) (2) (3)

Period 2 $200,000 100,000 $100,000

Period 1 Income $

Period 2 Income

0 150,000 100,000

$200,000 50,000 100,000

Total Income $200,000 200,000 200,000

E3–7 a. Original cost Depreciation expense Accumulated depreciation Net book value

2011

2012

2013

2014

2015

$25,000 5,000 5,000 20,000

$25,000 5,000 10,000 15,000

$25,000 5,000 15,000 10,000

$25,000 5000 20,000 5,000

$25,000 5,000 25,000 0

b. Since the truck has an estimated useful life of five years, it is assumed that RDP and Brothers will receive a benefit from using the truck in each of the five years. Consequently, RDP and Brothers expect to receive benefits from the truck in the future. According to the matching principle, costs should be matched against the benefits the costs help generate. Since the benefits from the truck will not be realized until future periods, the cost of the truck should be capitalized. In addition, an asset, by definition, is something that a company controls that is expected to provide benefits in the future. In order to receive the future benefits from using the truck, RDP and Brothers must continue to exist. In other words, RDP and Brothers is assumed to be a going concern. If accountants did not use the going concern assumption, it would be inappropriate to capitalize costs because the company may not exist when the expected benefits resulting from the cost are to be realized. c.

It is assumed that the truck will help generate a benefit (i.e., revenue) in each year of its useful life. Under the matching principle, the cost of an item should be allocated to the period(s) in which the cost helps generate a benefit for the company. In this particular case, the truck is expected to provide a benefit for five years. If the entire cost was expensed in 2011, then an improper matching of costs with the related benefits would arise in 2011–2015. However, by capitalizing the cost of the truck in 2011 and then allocating a portion of the cost to each of the next five years, RDP and Brothers is able to match the cost of the truck with each period in which the truck is expected to provide a benefit to the company.

E3–8 a. Costs that are expected to provide future benefits to a company are, by definition, assets. Hence, all such costs should be capitalized. As these costs help generate benefits, such as revenue, the costs are recognized as expenses and matched against the corresponding benefits. b. Capitalizing expenditures and subsequently amortizing these costs are not costless activities. A company incurs costs, such as bookkeepers' salaries, supplies, and so forth, when engaging in such activities. In certain instances, these bookkeeping costs may exceed the benefits derived from properly capitalizing and amortizing expenditures. This situation is most likely to arise when the amount of an expenditure is very small in relation to some criteria such as total expenditures, net income, or total assets. Such an expenditure is so small that users of financial statements would not care whether the expenditure was capitalized or immediately expensed. The financial statement users' decision process would not be influenced by the accounting treatment given such expenditures. In these cases, a company would apply the concept of materiality to decide whether an expenditure should be capitalized or expensed.

E3–9 a. (1) During 2010 the company changed depreciation methods. This change resulted in an increase of the book value of the assets versus if no change in accounting method had occurred. In other words, the depreciation expense went down by the same amount, i.e., $5,000. A decrease in the depreciation expenses would increase the net income by the same amount, i.e., $5,000. (2) During 2012 the company changed its method of inventory valuation, which also increased the book value of the inventory. Since the cost of inventory is allocated either to the cost of goods sold account or to the ending inventory account, this change implies that the Cost of Goods Sold decreased by $9,000. This would also increase the net income by $9,000. Overall it seems the company is having a bad year and is attempting to use liberal accounting policies to paint a “rosy” picture of the operations. b. Net income as reported Effect of depreciation change Effect of inventory change Adjusted net income

2009

2010

2011

2012

$ 21,000 0 0 $ 21,000

$ 24,000 (5,000) 0 $ 19,000

$ 23,000 (5,000) 0 $ 18,000

$ 29,000 (5,000) (9,000) $ 15,000

The adjusted net income figures indicate that if the company had not changed accounting methods, it would have reported declining profits. In fact, the company would have reported net income of only $15,000 in 2012. The reported net income figures have been enhanced with accounting techniques rather than by sound economic health. Consequently, the company's performance would be viewed less positively.

E3–9 c.

Concluded

Companies should adhere to the principle of consistency. This principle states that a company should use the same accounting principles and methods from year to year. Such a practice promotes the comparability of the company's financial statements over time and also promotes user confidence in the financial statements. If a company was free to switch accounting principles and methods at will, financial statement users would place very little faith in the statements. Under certain conditions, companies may switch accounting principles. The primary condition that must be met before a company may switch methods is the approval of the company's auditors. The company must convince its auditors that the environment it faces has changed sufficiently so that the new accounting principle, rather than the old principle, more appropriately reflects the company's financial position and performance.

E3–10 a. Under U.S. GAAP, conservatism and objectivity are important concepts in the valuation of assets such as inventory. GAAP statements are going to list inventory at its historic cost (an objective number), unless it can be documented objectively that market value has dropped below cost, in which case the inventory will be carried at the lower (more conservative) market value figure. IFRS statements, on the other hand, are going to first look to market value to determine carrying amounts. If management determines (without necessarily providing objective verification) that market value is different than the current carrying cost, the balance sheet value will be changed— and it may be changed higher or lower, depending on the move in market prices. (Inventory changes in GAAP will only be write-downs, never write-ups.) b. It is possible that year-end adjustments for inventory at Adidas will be positive (that is, the carrying amount of inventory will increase), due to management’s belief that its current ending inventory is more valuable than previously thought. If, for example, Adidas has a shoe line that is very popular in current youth fashion and the company is able to sell the shoes for a higher price (due to the demand from its customers), the company could write up the value of the ending inventory to its higher market value. Nike, on the other hand, follows U.S. GAAP, which would preclude such a move; Nike could have a hugely popular line of shoes (which may indeed prove to sell at higher market prices than previously thought), but the company would have to leave its ending inventory at its (objective) historic cost. Any increase in value in Nike’s inventory would have to be recorded only when the company actually sells the inventory at that higher price; GAAP does not allow the higher market value to be figured until the asset is sold in the market.

PROBLEMS P3–1 a. The company would report a gain of $10,000. b. No. During 2011 the purchasing power of money decreased by 10%. On December 31, 2011, it would require $1,100 [$1,100  (1 + 10%)] to purchase the same basket of goods that $1,000 would have purchased on January 1, 2011. The difference in purchasing power gives rise to an economic loss of $100. Therefore, $20,000 would not allow someone to purchase twice as many goods and services on December 31, 2011 as on January 1, 2011. To be able to purchase the same amount of goods, an individual would need $11,000 [$10,000  (1 + 10%)], which implies that to be able to purchase twice as many goods and services, an individual would need $22,000. c.

The $10,000 gain can be broken down into two components: a gain due to the increase in the value of the property and a gain due to general inflation. Since the inflation rate during 2011 is 10%, the value of the land would be expected to increase during 2011 by 10%, or $1,000. The remaining $9,000 of the gain is due to an increase in the value of the property, which represents an economic gain. Accountants ignore the effects of inflation due to the stable dollar assumption. This assumption allows financial statement users to compare financial statements from different points in time. Further, the stable dollar assumption gives rise to more objective financial statements. In order to adjust for the effects of inflation, the inflation rate must be known. Should the adjustment be based on wholesale, retail, global, national, state, industry, or company-specific inflation rates? Company-specific rates are probably the most relevant rate, yet they are probably the most subjective. The other rates may not be relevant for some companies. If managers were allowed to select the appropriate rate for their companies, they could manipulate the financial statements. On the other hand, if the FASB or SEC mandated the use of a particular inflation rate, the rate would not be relevant for many companies. Consequently, the choice of an inflation rate would be arbitrary and could lead to distortions in the financial statements. The use of original costs is arbitrary and also leads to distortions in the financial statements. However, the use of original costs has at least two advantages over the inflation-adjusted amounts. First, the use of original costs eliminates a potential source of manipulation of financial statements by managers. Second, users may disagree on the appropriate inflation rate for a company, and original-cost financial statements allow users to individually adjust the financial statements for their perceptions of inflation.

P3–2 a. The Banking Corporation will recognize interest revenue of $240. The amount of cash given to Bush Enterprises was $4,760 and in exchange Banking Corporation received a note receivable for $5,000. The difference is the amount of interest revenue that Banking Corporation will recognize in its books on December 31. b. Banking Corporation is better off at the end of the year than if the company had not invested the $4,760 on January 1. Overall, however, the company is worse off financially on December 31 than on January 1. To purchase the same basket of goods on December 31 as it could purchase for $4,760 on January 1, Banking Corporation would need $5,236 [$4,760  (1 + 10%)]. In other words, the company would need an additional $476. By loaning the money to Bush Enterprises during the year, Banking Corporation acquired $240. Hence, during the year the company became economically worse off by $236 ($476 – $240). Just to maintain its purchasing power, Banking Corporation would have to loan money at the inflation rate. To improve its purchasing power, Banking Corporation would have to loan money at a rate that exceeds the inflation rate. c.

As indicated in Part (b), Banking Corporation actually lost $236 of purchasing power during the year. On the other hand, Bush Enterprises gained purchasing power during the year. Bush could have invested the $4,760 it borrowed in a basket of goods on January 1. On December 31, Bush could sell the basket of goods for $5,236, repay Banking Corporation $5,000, and still have $236 left over. Consequently, Bush Enterprises ended up with the better deal. Whenever the interest rate on a loan is less than the inflation rate, the borrower has an advantage. Since accountants adhere to the stable dollar assumption, inflation is not reflected in financial statements. Consequently, the financial statements of Banking Corporation would indicate the company is better off by the amount of interest revenue, while the financial statements of Bush Enterprises would indicate the company is worse off by the amount of interest expense.

P3–3 a. Cash Inflows From Sale Asset A: Option 1 Option 2 Option 3

$1,500 1,500 0

Asset B: Option 1 Option 2 Option 3

500 500 0

Asset C: Option 1 Option 2 Option 3

3,000 3,000 0

Cash Outflow for Replacement $

0 (1,000) 0

Future Cash Flows 0 5,000 2,500

$1,500 5,500 2,500

0 (2,000) 0

0 3,500 2,500

500 2,000 2,500

0 (3,500) 0

0 5,000 2,500

3,000 4,500 2,500

Total Cash Flows

P3–3

Concluded

Kathy made the correct decision with respect to Assets B and C, but not to Asset A. As demonstrated above, Option 3 (i.e., retaining the asset) yields the highest net cash flows for Asset B. For Asset C, Option 2 (i.e., selling and replacing the asset) yields the highest net cash flows. However, the best option for Asset A is Option 2. If Kathy had selected this option, she would expect to generate a total of $5,500 in net cash inflows, an increase of $3,000 over the net cash inflows that are expected under the option she selected. b. The original cost information should not be used in evaluating Kathy’s decisions. Original costs represent sunk costs, and sunk costs should not be considered in future decisions. In evaluating the performance of a manager, we are interested in the cash flows generated by the manager. If the cash flow information is not available, then proxies for the cash flows must be used in the evaluation process. One such proxy is original cost data, which may be helpful in computing net income. However, if the cash flow information is available, then this information should be used in evaluating the performance. Since the cash flow information is available in this case, the original cost data can and should be ignored. c.

Under generally accepted accounting principles, assets should be carried on the balance sheet at original cost. Assuming that Kathy proceeds with her decision and keeps Assets A and B and replaces Asset C, the company should report the following amounts for each asset. Asset A Asset B Asset C

$4,000 1,500 3,500

The company is applying the principle of objectivity, which states that financial accounting information must be verifiable and reliable and that the value of transactions be objective. In many cases, original cost is the most objective of the potential valuation bases.

P3–4 a. Real sales did not actually increase by 9% from 2006 to 2008. To compute the real percentage change in sales, inflation must be considered. Converting 2008 sales to 2006 dollars reveals that 2008 real sales were actually $6.79 = [$7.2 ÷ (1 + 6%)]. Consequently, sales increased from 2006 to 2008 by $192 million, which is only a 2.9% increase in sales. b. (1) 2008 sales in 2006 dollars = $7.2 ÷ (1 + 10%) = $6.55 (2) Real change in sales = 2008 sales in 2006 dollars – 2006 sales in 2006 dollars = $6.55 – $6.6 = ($0.05) (3) Real percentage change in sales

= Real change in sales ÷ 2006 sales in 2006 dollar = ($0.05) ÷ $6.6 = (0.76%)

P3–4 c.

Concluded The stable dollar assumption assumes that inflation does not exist. So under this assumption, sales actually increased by 9%. However, once one realizes that the stable dollar assumption is simply an assumption that promotes the comparability of financial statements from different points in time and that it does not accurately reflect reality, one must consider price changes when comparing financial data from different points in time.

P3–5 a.

The first step in a comparison across currencies is to convert the different statements into one currency, using the latest available exchange rate. Converting the pounds of GlaxoSmithKline into U.S. dollars is shown below: Sales 24.3 pounds x $1/.69 pounds = $35.2 Assets 39.3 pounds x $1/.69 pounds = $57.0 Equity 7.9 pounds x $1/.69 pounds = $11.4 Converting the Euros of Sanofi-Aventis into U.S. dollars is shown below: Sales 27.5 Euros x $1/.71 Euros = $ 38.7 Assets 71.9 Euros x $1/.71 Euros = $101.3 Equity 45.1 Euros x $1/.71 Euros = $ 63.5

From a Sales and an Asset perspective, Pfizer is the largest of the three companies. From an Equity perspective, Sanofi-Aventis is the largest firm. b. If exchange rates move drastically, the comparison might yield a different answer. For example, if the exchange rate between the dollar and the Euro changed from .71 to .55 (due to macroeconomic events, such as a global debt crisis) then the Sales of Sanofi-Aventis would be larger (compared U.S. dollar to U.S. dollar) than those of Pfizer.

P3–6 a. In this case, the purchase price should equal the stream of future cash flows discounted to reflect the time value of money. The purchase price would be calculated as follows. Purchase price

= Present value of future cash flows = $219  Present value of an ordinary annuity factor for r = 12% and n = 10 = $219  5.65022 (from Table 5 in Appendix) = $1,237.4

b. Book value represents the residual ownership interest in the company based upon the financial statement values. This residual interest is, by definition, total stockholders' equity. Therefore, the book value of Manpower, Inc. is $2,484 ($1,283 of common stock + $1,201 of retained earnings). Using the accounting equation, the book value can also be calculated as total assets less total liabilities. c.

The purchase value of a company can be different from the book value of the company because the fair market value of individual assets and liabilities may be different from the book value of individual assets 11

and liabilities. The book values of many assets are largely based upon original costs, which ordinarily do not reflect fair market values.

P3–7 a. The book value of the building equals the value of the building according to Barry Smith's company's financial records. Long-lived assets are initially recorded at their cost, and then over time the assets are reported at net book value, which is original cost less the portion of the asset's cost amortized to date. In this case, Barry Smith paid $90,000 for the apartment building, and as of January 1, 2011, none of the cost had been amortized. Thus, the book value of the building on January 1, 2011 is $90,000. The economic value of the building is equal to the present value of the cash inflows the building will generate in the future less the present value of cash outflows the building will require in the future. In this particular case, there are two different types of cash inflows: the annual rental amounts of $65,000, which would be an annuity, and the expected proceeds of $40,000 from selling the building. The net present values of the cash flows are calculated below. Annual net cash flows Present value = ($65,000 cash inflow – $45,000 cash outflow)  Present value of an ordinary annuity factor for i = 10% and n = 10 = $20,000  6.14457 (from Table 5) = $122,891.40 Proceeds from sale of building Present value = $40,000  Present value factor for i = 10% and n = 10 = $40,000  .38554 (from Table 4) = $15,421.60 Total present value

= $122,891.40 + $15,421.60 = $138,313

Since the present value of future cash flows exceeds the purchase price of $90,000, it appears that Barry made a wise investment. b. Barry Smith Income Statement For the Year Ended December 31, 2011 Rental revenue ................................................................................................... $ Management expenses ......................................................................................... Depreciation expense............................................................................................ Net income ..........................................................................................................

65,000 (45,000) (5,000) $ 15,000

P3–7

Concluded Barry Smith Balance Sheet As of December 31, 2011

Assets

Liabilities & Stockholders' Equity

Cash Building Accumulated depreciation

$ 20,000 90,000 (5,000)

Total assets

$ 105,000

Liabilities Contributed capital Retained earnings Total liabilities and stockholders' equity

0 90,000 15,000

$ 105,000

Present value of future cash flows on December 31, 2011: Present value of annual net rentals

Present value of sale proceeds

Total present value

= $20,000  Present value of an ordinary annuity factor for i = 10% and n = 9 = $20,000  5.75902 (from Table 5) = $115,180.40 = $40,000  Present value factor for i = 10% and n = 9 = $40,000  .42410 (from Table 4) = $16,964

= $115,180.40 + $16,964.00 = $132,144.40

Economic income = Net cash received during 2011 + (12/31/11 present value – 1/1/11 present value) = ($65,000 cash inflow – $45,000 cash outflow) + ($132,144.40 – $138,313.00 (from part [a]) = $20,000.00 – $6,168.60 = $13,831.40 Accounting income differs from economic income because economic income incorporates the time value of money. Hence, economic income reflects that the purchasing power of $1.00 received on December 31, 2011 is not equivalent to the purchasing power of $1.00 received on December 31, 2012. Accounting income, through the stable dollar assumption, ignores the time value of money. Further, economic income considers future events (i.e., discounted future cash inflows and outflows), whereas accounting income considers only past events. d. The book value of the building on December 31, 2011 equals the cost of the building less the associated accumulated depreciation. Therefore, the book value is $85,000 ($90,000 – $5,000). The present value of the building equals the present value of future cash flow, which as of December 31, 2011, is $132,144.40 (from Part [c]).

P3–8 a. Book value on 12/31/11

= Total book value of assets – Total value of liabilities = $124,000 – ($8,000 + $20,000) = $96,000

b. The economic value of Myers and Myers equals its future cash flows discounted to reflect the time value of money. Myers and Myers have two streams of future cash flows. The first type is annual cash flows, which is an annuity, and the second type is the cash flow from the sale of the business. The present values of these two cash flows are calculated below. Annual cash flows Present value = = =

$20,000  Present value of ordinary annuity factor for i = 10%, n = 10 $20,000  6.14457 (from Table 5) $122,891.40

Proceeds from sale of business Present value = $80,000  present value factor for i = 10%, n = 10 = $80,000  .38554 (from Table 4) = $30,843.20 Total present value of future cash flows c.

Liquidation value

= = =

= =

$122,891.40 + $30,843.20 $153,734.60

Total fair market value of assets – Total value of liabilities $124,000 – ($8,000 + $20,000) $96,000

d. Book value is based upon the original cost of individual assets. This value provides little indication of a company's current value due to price changes. The problem is magnified as the company's assets age. Liquidation value is based upon the fair market values of individual assets and liabilities. This value provides an accurate measure for a company planning to cease operations. However, such a measure provides little indication for a company that is a going concern. Under the going concern assumption, accountants are concerned with providing accounting numbers for companies that will continue operating indefinitely. Present value is based upon future cash flows; as such, it incorporates all non-quantifiable assets, such as employee loyalty and customer loyalty. This value more accurately reflects the economic value of a company, since it captures items not included on a balance sheet under GAAP. Unfortunately, it is difficult, if not impossible, to accurately predict future cash flows. Hence, in most instances, present value amounts do not satisfy the principle of objectivity. A difference between a company's book value and its economic value (i.e., present value of future cash flows) can arise for two reasons. First, this difference can be due to a difference between a company's book value and the fair market value of its individual assets and liabilities. The assets are usually carried on the books at their original cost. However, over time the actual value of the assets would be expected to diverge from their original cost. Second, the difference between a company's book value and its economic value can be due to the excess of the company's economic value over the fair market value of its net assets (i.e., total assets less total liabilities). The net assets are worth more grouped together than individually. Companies generate customer loyalty and name recognition that has value, yet is not reflected in the value of any particular asset. This value is, however, reflected in its economic value. The excess of the company's economic value over the fair market value of its net assets represents goodwill. In this case, Myers and Myers goodwill would be approximately $153,734.60 – $96,000, or $57,734.60.

P3–9 a. Ending retained earnings = Beginning retained earnings + Net Income – Dividends $40,000 = $16,000 + Net Income – $0 Net Income = $24,000 b. 2012 FMV

= = =

FMV of total assets – Total liabilities $148,000 – ($6,000 + $20,000) $122,000

2011 FMV

= = =

FMV of total assets – Total liabilities $124,000 – ($8,000 + $20,000) $96,000

2012 Net income

= = =

2012 FMV – 2011 FMV $122,000 – $96,000 $26,000

Present value of future cash flows as of December 31, 2012: Annual cash flows Present value = $20,000  Present value of ordinary annuity factor for i = 10%, n = 9 = $20,000  5.75902 (from Table 5) = $115,180.40 Proceeds from sale of business Present value = $80,000  Present value factor for i = 10%, n = 9 = $80,000  .42410 (from Table 4) = $33,928.00 Total present value of future cash flows

= =

$115,180.40 + $33,928.00 $149,108.40

Economic income = Net cash received during 2012 + (12/31/12 present value – 12/31/11 present value) = $20,000 + ($149,108.40 – $153,734.60 = $20,000 – $4,626.20 = $15,373.80

P3–9

Concluded

d. All three income measures provide a performance measure of Myers and Myers. Of the three measures, economic income is the only one that incorporates the time value of money. In theory, holding everything else constant, economic income is probably more accurate than the other measures. Unfortunately, in the real world it is extremely rare that the future cash flows can be predicted with any reasonable degree of accuracy. So in the end, economic income is simply a guess based upon estimates of the timing and amount of future cash flows. Lack of objectivity can also plague income computed using fair market values. If a strong market exists for each of the company's assets, such as with marketable securities, then the company could probably obtain reasonably accurate estimates of what it could receive for selling the assets. In this case, net income would be more relevant than income computed using original costs, since more up-to-date values are being used. Unfortunately, it is not possible to find a market for all assets. For example, a manufacturing company may use highly specialized equipment in its production process. If no other company would use this equipment, does the equipment have a fair market value? Do we assign it a value of zero, assign it a scrap value, or assign it an arbitrary fair market value? The end result is that the value assigned to some assets will be arbitrary and not objective. Computing net income under GAAP circumvents the problem of arbitrary values and lack of objectivity. The values assigned to most assets are based upon their original costs. Assets are usually acquired in arm's-length transactions. Since each party would have opposing interests, the purchase price should accurately reflect the value of the asset on the purchase date. Further, anybody examining the value of the asset could verify the original cost. Although using original cost as a basis for valuing assets provides objective values, original cost amounts can be extremely outdated.

P3–10 a. ABC Inventory Method

Depreciation Method

Income

XYZ Working Capital

Income

Working Capital

B Y $28,000 $26,000 $24,000 $30,000 B X 20,000 26,000 16,000 30,000 A Y 18,000 16,000 14,000 20,000 A X 10,000 16,000 6,000 20,000 Note: Changes in the companies' inventory balances affect net income through Cost of Goods Sold. b. ABC and XYZ both have the highest net income and working capital under the combination of Method B and Y depreciation. Managers could have many reasons for selecting one accounting method over another method. Management is a party to many contracts that may rely on accounting numbers. For example, a manager may have an incentive compensation contract based upon accounting income. A company may have a debt covenant with a creditor that stipulates a minimum level of working capital (or some other relevant measure). Or a manager may have incentives to minimize the company's tax liability. To the extent that the accounting methods used for tax reporting must also be used for financial reporting, a manager may select those methods that provide a tax benefit. In selecting a particular accounting method, a manager will consider the factors that provide an incentive for selecting one method over another, and in the end the manager would be expected to select the accounting method that gives him or her the greatest benefit. In some cases, the accounting method selected by the manager may actually cause net income to decrease. The most likely reason for a manager to select an

P3–10 Concluded 16

accounting method that would cause net income to decrease would be to minimize taxable income, thereby minimizing cash outflows for taxes. c. As an investor, one must realize that different companies may face different environments. To the extent that two companies face different environments, we would expect them to select the accounting methods appropriate to their particular environments. Further, an investor must realize that managers have their own interests and will work to satisfy their interests. In some cases the interests of the managers will be congruent with the investors' interests, and in some cases they will not. Generally accepted accounting principles allow companies to use different accounting methods because it is impossible to select a method that would be appropriate across different companies and environments. Consequently, companies are allowed to select those methods that they deem appropriate for their situation. To an investor, the underlying economic reality (i.e., expected future cash flows) of the company is of interest. Consequently, if companies use different accounting methods, the effects of the different methods on the amounts reported in the financial statements must be considered in comparing different companies.

P3–11 a. Revenues Assumption 1 [$2,400,000  (2/12)] [$2,400,000  (6/12)] [$2,400,000  (3/12)] [$2,400,000  (1/12)] Assumption 2 [$2,400,000  (380/1,140)] [$2,400,000  (380/1,140)] [$2,400,000  (285/1,140)] [$2,400,000  (95/1,140)] Assumption 3 [$2,400,000  (600/2,400)] [$2,400,000  (900/2,400)] [$2,400,000  (300/2,400)] [$2,400,000  (600/2,400)]

Year 1

Year 2

Year 3

Year 4

$400,000 $1,200,000 $600,000 $200,000

800,000 800,000 600,000 200,000

600,000 900,000 300,000 600,000

P3–11 Concluded b. Costs Assumption 1 [$1,140,000  (2/12)] [$1,140,000  (6/12)] [$1,140,000  (3/12)] [$1,140,000  (1/12)] Assumption 2 [$1,140,000  (380/1,140)] [$1,140,000  (380/1,140)] [$1,140,000  (285/1,140)] [$1,140,000  (95/1,140)] Assumption 3 [$1,140,000  (600/2,400)] [$1,140,000  (900/2,400)] [$1,140,000  (300/2,400)] [$1,140,000  (600/2,400)]

Year 1

Year 2

Year 3

$190,000 $570,000 $285,000 $ 95,000

380,000 380,000 285,000 95,000

285,000 427,500 142,500 285,000

Net Income Assumption 1 $ 400,000 1,200,000 600,000 200,000

Year 1 – – – –

$190,000 570,000 285,000 95,000

$210,000

Assumption 2 $ 800,000 800,000 600,000 200,000

– – – –

$ 380,000 380,000 285,000 95,000

420,000

Assumption 3 $600,000 900,000 300,000 600,000

– – – –

$ 285,000 427,500 142,500 285,000

315,000

Year 2

Year 3

Year 4

$630,000 $315,000 $105,000

420,000 315,000 105,000

472,500 157,500 315,000

c. Assumption 1 Assumption 2 Assumption 3

Year 4

Total RevenueTotal Cost $2,400,000 2,400,000 2,400,000

Total Net Income $ 1,140,000 1,140,000 1,140,000

$1,260,000 1,260,000 1,260,000

P3–12 a. Hydra Aire would recognize the following revenue in each of the 3 years based on the number of toasters produced times the selling price per toaster. Year 1: Year 2: Year 3:

200 200 100

  

$100 $100 $100

= = =

$20,000 $20,000 $10,000

b. Hydra Aire would recognize the following revenue in each of the 3 years based on the number of toasters delivered times the selling price per toaster. Year 1: Year 2: Year 3:

150 200 150

  

c. Assumption 1 Revenues (from part [a]) Expenses Net income

$100 $100 $100

= = =

$15,000 $20,000 $15,000

Year 1

Year 2

Year 3

Total

$ 20,000 8,000 * $ 12,000

$ 20,000 8,000* $ 12,000

$10,000 4,000* $ 6,000

$ 50,000 20,000 $ 30,000

* Expenses = Number of units produced  $40 per unit.

Assumption 2 Revenues (from Part [b]) Expenses Net income

Year 1

Year 2

Year 3

Total

$ 15,000 6,000 * $ 9,000

$ 20,000 8,000* $ 12,000

$ 15,000 6,000* $ 9,000

$ 50,000 20,000 $ 30,000

* Expenses = Number of units delivered  $40 per unit. d. If Hydra Aire’s management is compensated based on the net income of the company, they would prefer to recognize revenues at the point of production. Why? Because it results in higher net income in year 1 and therefore in a higher bonus for the management.

P3–13 a. Cost of Error 1: If Joe McGuire requires disclosure of the lawsuit, and Nelson Repairs, Inc., does not lose the lawsuit, McGuire could incur some costs. If the president of Nelson Repairs, Inc., is serious about not wanting the lawsuit disclosed and McGuire requires that it be disclosed, Nelson could fire McGuire. In this case, McGuire would lose the audit fees of his biggest client. If these audit fees make up a substantial portion of McGuire's total revenues, it is even possible that the loss of Nelson Repairs, Inc., as a client could cause McGuire to cease operations. Cost of Error 2: If McGuire does not require disclosure of the lawsuit, and Nelson Repairs, Inc., loses the lawsuit, McGuire could incur some costs. If any of the stockholders or creditors relied on the financial statements and incurred a loss, these stockholders could sue McGuire for their losses. Since the lawsuit could force Nelson Repairs, Inc., out of business, the potential losses to stockholders and creditors could be quite substantial. A Type 2 error could also damage McGuire's reputation. Financial statement users might view McGuire as a "low quality" auditor and might be unwilling to accept financial statements auditied by McGuire. Loss of reputation might cause some potential clients to no longer be interested in hiring McGuire. Even if some 19

P3–13 Concluded new clients did hire McGuire, they might demand a lower audit fee to compensate for a "lower quality" service. Furthermore, some of McGuire's existing clients may no longer wish to engage him as their auditor. Consequently, it appears that the cost of a Type 2 error exceeds the cost of a Type 1 error. McGuire faces a tough decision, though. Although the cost of a Type 2 error appears higher, the probability that Nelson Repairs, Inc., will lose the lawsuit is not very likely. Which factor should McGuire focus on: the cost of the errors or the probability of an adverse outcome? Luckily, McGuire can refer to Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies" for guidance on whether to disclose this lawsuit. =

Cost of an error  Probability of an error

Expected cost of a Type 1 error

= =

$10,000  80% $8,000

Expected cost of a Type 2 error

= =

$50,000  20% $10,000

b. Expected cost of an error

Based upon the expected cost of each type of error, it appears that Joe McGuire should disclose the lawsuit. c.

Conservatism means that "when in doubt, understate rather than overstate." This statement means that when a company faces some uncertainty concerning how to value or record an event, the company should understate, rather than overstate, the financial health of the company. In this case, McGuire has some doubt as to whether Nelson Repairs, Inc., will win or lose the pending lawsuit. McGuire's framework focuses on the relative costs of errors. He wants to determine the cost of a Type 1 error compared to the cost of a Type 2 error. Since the cost of overstatement (i.e., a Type 2 error) exceeds the cost of understatement (i.e., a Type 1 error), McGuire should risk making a Type 1 error. Hence, due to McGuire's doubt concerning the outcome of the lawsuit, he should understate the financial health of Nelson Repairs, Inc., by requiring management to disclose the lawsuit.

ISSUES FOR DISCUSSION ID3–1 a. Revenue recognition refers to the recording of revenues when they are earned. Matching refers to recognizing costs as expenses when the costs help generate a benefit (such as revenue). The criteria for recognizing revenue are: (1) The company must have completed a significant portion of the production and sales effort. (2) The amount of the revenues can be objectively measured. (3) The major portion of the costs have been incurred, and the remaining costs can be reasonably estimated. (4) The eventual collection of cash is reasonably assured. The FASB requirement that airlines defer a portion of the current revenues is consistent with these criteria in that at the time of selling a ticket the airlines have not completed a significant portion of the production and sales effort associated with the eventual free trip. In essence the airlines are charging more for the tickets now to cover the cost of "free" trips later. Accordingly, deferred revenue should be established for each ticket sold and then recognized as revenue when passengers use their "free" tickets. Related costs should be capitalized and matched against the revenue when it is recognized. b. As a result of implementing this new accounting policy, Continental Airlines would recognize less revenue. This would cause income to be lower than if Continental continued to use its previous policy for frequent flyer tickets. The new approach to recognizing revenue does a better job of matching revenues with expenses. Part of the overall revenue is recognized at the time when the passenger uses the frequent flyer ticket and the expense for the ticket is incurred by Continental Airlines.

ID3–2 a. Priceline’s method of booking revenue has the potential to mislead investors. It is not the same method that traditional companies in this industry use. It does not make sense from the standpoint that Priceline is reporting revenues for products and services that it does not provide. Priceline is not an airline or a hotel but yet is reporting the revenues that relate to those activities. Priceline provides a service of matching buyers and sellers (like stock brokers) and should only report revenues that relate to the service that it actually provides. b. If investors are going to value the stock of a company based on a multiple of revenue then management has an incentive to report the highest amount of revenue as possible. So by reporting these “gross bookings” as revenue Priceline is able to increase its stock price. This is particularly significant for a company that is losing a lot of cash in its operations. The most common way for a company that is losing cash from its operations is to raise money by selling stock. Typically companies that are losing money do not have the option of issuing bonds and so the only way the company can fund itself is to sell stock. A higher stock price allows the company to give up fewer shares for the needed amount of cash. c.

Allowing internet companies to record revenues differently than traditional companies has a couple of impacts, both of which are negative. One of the goals of GAAP accounting is to have financial statements comparable from one company to another. If different accounting methods are used then this is not possible. If investors are going to value the stock of a company based on a multiple of revenue then 21

management has an incentive to manipulate this number. It is much easier to manipulate revenues than net income.

ID3–3 a. Because Blockbuster is the franchiser, it can dictate policies that the franchises must follow. For example, Blockbuster could dictate when new franchises must purchase merchandise from Blockbuster and how much they must purchase. Blockbuster cannot, however, dictate when the franchises will actually generate revenue; that depends on the franchises' customers. By recognizing revenue when it ships merchandise to franchises, Blockbuster can manage earnings because it has some control over when and how much merchandise is shipped to the franchises. In the case of U.S. Robotics, it is possible to “manage” earnings by shipping some orders early or conversely delaying the shipping of orders to the next period. There is always some risk of capturing the true amount of sales since dealers have the ability to return product to U.S. Robotics. b. The criteria for recognizing revenue under the revenue recognition principle are (1) the company must have completed a significant portion of the production and sales effort, (2) the amount of the revenues can be objectively measured, (3) the major portion of the costs have been incurred, and the remaining costs can be reasonably estimated, and (4) the eventual collection of cash is reasonably assured. If a company meets these criteria when it ships merchandise, then recognizing revenue when merchandise is shipped does not violate GAAP. In fact, most manufacturers and distributors recognize revenue when they ship merchandise to their customers.

ID3–4 a. If Campbell Soup had not made the accounting change, it would have reported $626 for net income in 2003. The restated amounts are more consistent—and hence more comparable—because they are all based on the same accounting principles and methods, whereas the original amounts are based on different accounting principles and methods. b. Changes in accounting methods would be referenced in the audit opinion and the footnotes to the financial statements. In addition, the dollar amount associated with a change in accounting method would be reported separately in the income statement. c.

Based on the information provided in the initial section of the question, it seems Campbell Soup is following the “big bath theory,” which means clean-up the books by taking all the possible losses that you can. The intention is to be able to report higher net income numbers from next year onwards.

ID3–5 a.

Investors are interested in earnings that can be repeated, earnings that can be counted on in future fiscal periods. Therefore, investors would be interested in the 81 cents EPS, because future quarters will not contain any more charges related to the Pfizer acquisition.

Since the analysts were expecting earnings of 79 cents per share and the (repeatable) earnings were 81 cents per share, the analysts should have been pleased. The analysts would take into consideration the one-time expenses related to Pfizer and would adjust the 74 cents EPS to 81 cents.

Companies such as J & J are constantly buying and selling subsidiaries, so comparing results from quarter to quarter, or from year to year, is problematic because the company changes so much over time. Excluding one-time expenses (or gains, for that matter) is one technique analysts use to improve comparability over time.

ID3–6 To be able to compare financial results across companies, financial statement users would like those companies to use uniform accounting methods. If the companies do not use uniform accounting methods—as is the case with General Electric and IBM—the financial statement users would have to adjust the amounts reported in the financial statements as if both companies used the same accounting methods. For example, financial statement users would have to adjust IBM's financial statements so that they would reflect accounting numbers as if IBM had used the same depreciation method as General Electric or, alternatively, adjust General Electric's financial statements to reflect accounting numbers as if General Electric had used the same depreciation method as IBM.

ID3–7 a. Capitalizing an item simply means putting that dollar amount on the balance sheet. When WorldCom put $3.9 billion on the balance sheet, that same amount was not put on the income statement; in other words, expenses were understated by $3.9 billion since the expenditures were capitalized. b. The matching principle is the first violation. WorldCom inaccurately capitalized the expenditures in the attempt to spread the cost over future years when it should have “matched” the current expenditures with the (current) revenues derived from those expenditures. Another principle that was violated was the consistency principle, as this accounting treatment was a change from past practices by the company.

ID3–8 When Citi erroneously reported results in 2008, only to correct them in 2009, the company did not accurately reflect its financial results in the 2008 fiscal period. A reader of those financial statements—such as the U.S. Government after its bailout investment in the bank—would have seen an inaccurate picture of Citi. Correcting those mistakes in 2009 again put the reader of the financial statements in the position of not seeing the results in the correct period. Financial statements are designed to tie together, in the same time period, results and the efforts needed to get those results. The statements should “match” revenues and expenditures that are related to the activities of the fiscal period; by mismatching the 2008 costs and benefits, the bank did not accurately tell the reader of its financial statements the net result of its efforts and accomplishments in 2008—some of those results were not reported until 2009. Ideally, the financial statements should consistently attach costs in a period to the benefits that resulted in that same period. An analyst reading the financial statements of CitiBank, or a taxpayer analyzing the investment made by her government, would need to judge the results of 2008’s cost and benefits, not the results of 2008 tied to the costs of 2009.

ID3–9 a. Writedown: 246 million Euros – Recovery of prior Writedowns: 23 milliion Euros = Net Writedown: 223 million Euros b. If Unilever followed U.S. GAAP, the company would not have “written up” the inventory that had previously been written down. The writedown would have been 246 million Euros. c. IFRS is driven by a focus on market values, which allows for assets such as inventory to be both written up and written down to market value. U.S. GAAP, on the other hand, is driven by 23

conservatism and objectivity, which limits inventory adjustments to writedowns, if market values have been objectively determined to be below historic cost.

ID3–10 a. Smoothing earnings means that companies are making accounting assumptions to eliminate the fluctuations in the net income over a period of time. Many suspect that companies smooth earnings to meet targets set by Wall Street analysts; often, meeting earnings targets assures a healthy stock price. Financial services companies can manipulate their earnings by adjusting the annual “bad debt expense” (see Chapter 6 for more discussion) with higher or lower estimates of the number of loans that will be uncollectible. The charge for bad debts is one of the largest for financial services companies and is subject to management discretion for estimates. A financial services company could manipulate its net income by adjusting its annual bad debt expense to achieve its earnings goals for the year. b. Some analysts argue that smoothing earnings is an accurate way for a financial services company to show its net income over a long period of time, due to the extreme fluctuations in loan losses (due to macroeconomic conditions, for example). The financial statements could be seen as more “conservative” if the company takes a large charge for bad debts today, in anticipation of future losses. However, the counterargument is that future earnings, therefore, would be inaccurately shown as higher when the financial services company does not have to take the charge, as it has already been booked.

ID3-11 The economic entity assumption states that individual entities can be shown as distinct from their owners and all other entities and that financial results can be measured for an entity separate from all others. By requiring consolidation, FASB is attempting to force companies to accurately portray their financial condition by including all resources and obligations that belong together. In Enron’s case, shareholders and creditors could not accurately gauge the financial condition of the company because certain assets, and more importantly, certain liabilities that were the responsibility of Enron were not directly shown on the Enron balance sheet. If Enron had consolidated the entities that carried the debt, shareholders and creditors (as well as government regulators) could have better understood the financial condition and the related risks of the company. That increased level of understanding would have allowed the financial markets to better judge and price the risks associated with the company.

ID3-12 a.

KeyCorp valued its marketable securities and other equity investments at fair market value. In the case of equity and real estate investments that were not able to be valued at FMV, Key made estimates of value based on present value.

Investments in privately held firms, by definition not subject to valuation on public markets, can be difficult to objectively value in terms of fair market value. Mainly subjective considerations are entered into the valuation analysis. Privately held firms do not actively turn over their ownership and therefore do not have external, objective valuations. Analysts looking into KeyCorp’s assets would need to review the subjective assumptions made when the valuations were placed on the balance sheet.

If the estimation of fair value used present value as its driving determinant, then the assumptions regarding time and interest rates would need to be reviewed. By definition, present value requires the future cash flows to be determined. If those future cash flows are projected based on management assumptions, a responsible analyst would review the assumptions that underlie the valuation process.

ID3–13 a. The FASB is suggesting that companies use a valuation that is like net realizable value. This is the fair value of the asset minus the cost of disposal or the fair value of the liabilities plus the cost of repurchase. This is slightly different than fair market value because the FASB is saying that the cost of disposal or repurchase be reflected in the value reported on the balance sheet. b. Reporting these securities at fair market value has the impact of adding more volatility to reported income. Previously these assets and liabilities would not change in value and so there would have been no impact on the income statement. Now the companies have these additional items that will have to be included on the income statement. c.

Forcing companies to report equity and debt securities at fair value would improve the value of the balance sheet. It would give a truer representation as to the value of assets and liabilities. This policy would also increase the volatility of the reported net income of the company. Profits and losses unrelated to the operations of the company could be somewhat confusing to the users of the financial statements. Overall, the benefit of having the balance sheet reflect more current values probably outweighs any potential perceived negative impacts on the income statement. d. Under U.S. GAAP, the principle of objectivity ensures that fair market values are not used unless they can be objectively determined; also, the concept of conservatism dictates that fair market value is used only if it is below historical cost. IFRS, conversely, allows adjustments to the balance sheet values of assets for changes in market value, and these adjustments can be upward or downward.

ID3–14 Economic entity assumption: This assumption states that the financial statements report financial information about an identifiable and measurable entity that is separate and distinct from its owners and all other entities. The financial statements of Nike are for Nike, Inc. and subsidiaries. Thus, the identifiable and measurable entity is Nike and its subsidiaries. Fiscal period assumption: This assumption states that the operating life of an economic entity can be divided into arbitrary time periods. Nike has broken its operating life into fiscal years, where its fiscal year is defined as the 12 months ending on May 31. The fiscal years are reflected on the company's consolidated statements of earnings, cash flows, and stockholders' equity and on its consolidated balance sheets. Going concern assumption: This assumption states that a company's life extends beyond the current period. Nike reports assets and liabilities on its consolidated balance sheets. Because assets are defined in terms of expected future benefits and liabilities are defined in terms of probable obligations that will be settled in the future, it is necessary to assume that Nike will exist beyond the current period to derive the benefits from the assets or to pay its obligations. Stable dollar assumption: This assumption states that the U.S. dollar is used to measure economic events and that the purchasing power of a dollar is constant across time. The absence of any adjustments for inflation in Nike’s financial statements is an example of the application of this assumption. Principle of objectivity: This principle states that financial accounting information must be verifiable and reliable. An excellent example of Nike applying this principle is the company’s recording of property, plant and equipment at historic cost.

Matching principle: This principle states that the efforts of a given period should be matched against the benefits that result from them. Examples of Nike applying the matching principle include recording expenditures, such as prepaid expenses, as assets because the expenditures have not yet helped generate a benefit; recognizing depreciation and amortization as the company consumes a portion of the fixed assets; and recognizing operating expenses for the products that were sold. Revenue recognition principle: This principle provides guidelines for when it is acceptable for a company to recognize revenue. As disclosed in the first footnote, Nike recognizes revenue upon shipment or delivery to the customer. Principle of consistency: This principle states that companies should choose a set of accounting methods and procedures and use them from one period to the next. An example of Nike applying the principle of consistency is using similar average useful lives of its fixed assets when calculating annual depreciation. Materiality: Materiality states that only those transactions dealing with dollar amounts large enough to make a difference to financial statement users need to be accounted for in a manner consistent with the principles of financial accounting. It is difficult to identify immaterial events in a company's financial statements, because by their very nature, immaterial events would not be disclosed in a way that would make them very noticeable. However, one example of Nike applying the materiality exception in reporting items is lumping together various other assets. Conservatism: Conservatism states that, when in doubt about how to record or report an event, a company should understate assets, overstate liabilities, delay recognizing revenues or gains, and accelerate recognizing expenses or losses. According to the first footnote, Nike values its inventory at the lower of cost or market, an application of the conservatism principle of U.S. GAAP.

122

Chapter 5

CHAPTER 4 THE MECHANICS OF FINANCIAL ACCOUNTING BRIEF EXERCISES

BE4–1 Transaction

Assets

Liabilities

+ Stockholders’ Equity

Paid $5,197 to purchase property, plant and equip.

+ 5,197 - 5,197

Issued common stock for $1,105

+1,105

Recorded depreciation of $4,360

-4,360

Net effect

-3,255 =

-3,255

b. The transaction to purchase property, plant and equipment does not appear to affect the accounting equation. This is because both sides of the transaction affect the asset side of the balance sheet. Intel pays cash for p,p,&e; this reduces cash and increases fixed assets. All of the other transactions affect both sides of the balance sheet.

BE4–2 Transaction Repaid $15 of long-term debt

Assets ,

- 15

= Liabilities + Stockholders’ Equity

- 15

Paid cash dividends of $201 - 201

- 201

Repurchased common stock -379 for $379

-379

Net effect

-595

- 15

-580

b. Both transactions reduce assets and equity and can be viewed as alternate ways to return cash to shareholders, by either paying cash in the form of dividends or paying cash in return for shares.