CHAPTER 4—Solutions FINANCIAL REPORTING AND ANALYSIS

Chapter 4, SE 1. 1. 2. 3. 4. 5.

O Q O Q O

Chapter 4, SE 2. 1. 2. 3. 4. 5.

Full disclosure Materiality Cost-benefit Conservatism Consistency

Chapter 4, SE 3. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Property, plant, and equipment Current liability Current liability Not on the balance sheet Stockholders' equity Current asset Intangible asset Current asset Current liability Investment

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Chapter 4, SE 4. Balance Sheet May 31, 2011 Assets Current assets Cash Accounts receivable Merchandise inventory Total current assets Investments Property, plant, and equipment Equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Franchise

$ 200 1,100 600 $1,900 500 $3,000 700 2,300 200 $4,900

Total assets Liabilities Current liabilities Accounts payable Wages payable Total current liabilities Long-term liabilities Notes payable

$ 800 100 $ 900 400

Total liabilities

$1,300 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$1,000 2,600* 3,600 $4,900

Total liabilities and stockholders' equity *Balancing amount ( $4,900

–

$1,300

–

$1,000 )

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Chapter 4, SE 5. Balance Sheet July 31, 2011 Assets Current assets Cash Accounts receivable Merchandise inventory Total current assets Investments Property, plant, and equipment Equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Franchise

$ 300 1,650 900 $2,850 750 $4,500 1,050 3,450 300 $7,350

Total assets Liabilities Current liabilities Accounts payable Wages payable Total current liabilities Long-term liabilities Notes payable

$1,200 150 $1,350 600

Total liabilities

$1,950 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$1,500 3,900 * 5,400 $7,350

Total liabilities and stockholders' equity *Balancing amount ( $7,350

–

$1,950

–

$1,500 )

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Chapter 4, SE 6. 1. 2. 3. 4. 5. 6. 7.

Operating expenses Other revenues and expenses Not on the income statement Net sales Operating expenses Other revenues and expenses Not on the income statement

Chapter 4, SE 7. Income Statement For the Year Ended May 31, 2011 Revenues Net sales Interest income Total revenues Costs and expenses

$2,400 90 $2,490

Cost of goods sold Selling expenses General expenses Interest expense Total costs and expenses Income before income taxes Income taxes

$840 555 450 210 2,055 $ 435 105 $ 330

Net income

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Chapter 4, SE 8. Income Statement For the Year Ended May 31, 2011 Net sales Cost of goods sold Gross margin Operating expenses

$2,400 840 $1,560

Selling expenses General expenses Total operating expenses Income from operations Other revenues and expenses

$555 450

Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes

$ 90 210

1,005 $ 555

120 $ 435 105 $ 330

Net income

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Chapter 4, SE 9. Income Statement For the Year Ended July 31, 2011 Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold Selling expenses General expenses Interest expense Total costs and expenses Income before income taxes Income taxes

$3,600 135 $3,735 $1,260 833 675 315 3,083 $ 652 158 $ 494

Net income

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Chapter 4, SE 10. Income Statement For the Year Ended July 31, 2011 Net sales Cost of goods sold Gross margin Operating expenses

$3,600 1,260 $2,340

Selling expenses General expenses Total operating expenses Income from operations Other revenues and expenses

$833 675

Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes

$135 315

1,508 $ 832

180 $ 652 158 $ 494

Net income

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Chapter 4, SE 11. Financial ratios computed 1.

Profit Margin = * $260,000

2.

–

+

Cash Flow Yield =

4.

Debt to = Equity Ratio

5. Return on Assets =

6.

7.

Cash Return on Assets =

Return on Equity =

* ( $180,000

+

–

$80,000

Net Sales Average Total Assets

$200,000 ) ÷ 2

3.

=

Net Sales

$140,000

Asset Turnover = * ( $240,000

Net Income

=

Net Income Total Liabilities Total Stockholders' Equity Net Income Average Total Assets Cash Flows from Operating Activities Average Total Assets Net Income Average Total Stockholders' Equity =

$260,000 – =

= 11.5%

$10,000 $260,000 $220,000*

=

$30,000

= 1.2 times

$220,000

Cash Flows from Operating Activities

$140,000 ) ÷ 2

$30,000 *

=

=

=

=

=

$30,000 $30,000 $60,000 $180,000

$30,000 $220,000

$30,000 $220,000 $30,000 $160,000 *

= 1.0

= 33.3%

= 13.6%

= 13.6%

= 18.8%

$160,000

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Chapter 4, SE 12. Profit Margin 8.0%

Asset Turnover 2.1 times

× ×

= Return on Assets = 16.8%

If the debt to equity ratio equals 50 percent, then stockholders' equity is two-thirds of total assets. Show why this is true, using numbers. Return on Assets 16.8%

÷ ÷

2 2

× ×

3 3

= =

Return on Equity 25.2%

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Chapter 4, E 1. 1. The balance sheet provides information about a company's resources (assets) and claims to those resources (liabilities and stockholders' equity). The income statement, statement of cash flows, and statement of retained earnings provide information about changes in resources and claims to them. 2. To record depreciation expense, it is necessary to estimate the useful life of the asset. To record the amount of unearned revenue that is now earned or the amount of accrued revenue on a project, it is necessary to estimate the amount of revenue earned. 3. Consistency in accounting applies only to the use of the accounting principles for presenting the financial information. It does not apply to the conditions that are represented in the financial statements. For example, changes in business operations or the economy may make financial information incomparable from year to year, even though the same accounting policies have been followed. 4. Illegal acts, such as stealing $1,000, are important to management even though for a multimillion-dollar business, it might not be important to the auditors. It would not be material to the overall fairness of the financial statements.

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Chapter 4, E 2. 1.

2.

3.

4.

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

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Chapter 4, E 3. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

g f h g f d g f b g g

12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22.

c b d a f e d a f f c

Chapter 4, E 4. 1. 2. 3. 4. 5.

Cost-benefit Comparability and consistency Full disclosure Materiality Conservatism

Chapter 4, E 5. 1. 2. 3. 4. 5. 6. 7. 8.

d a a e f c b a

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

a h a h e a c g

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Chapter 4, E 6. Mamba, Inc. Balance Sheet December 31, 2011 Assets Current assets Cash Short-term investments Accounts receivable Inventory Prepaid rent Total current assets Investments Investment in corporate securities Property, plant, and equipment Land Building Less accumulated depreciation Equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Copyright

$12,480 6,560 15,200 16,000 480 $ 50,720 8,000 $ 3,200 $28,000 5,600

22,400

$60,800 6,800

54,000 79,600 2,480 $140,800

Total assets

(continued)

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Chapter 4, E 6. (Continued) Liabilities Current liabilities Accounts payable Revenue received in advance Total current liabilities Long-term liabilities Bonds payable

$20,400 1,120 $ 21,520 24,000

Total liabilities

$ 45,520 Stockholders' Equity

Contributed capital Common stock, $10 par, 4,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity

$40,000 20,000 $60,000 35,280 95,280 $140,800

Total liabilities and stockholders' equity Chapter 4, E 7. 1. 2. 3. 4. 5. 6. 7.

a b e c d c f

8. 9. 10. 11. 12. 13.

c and/or d c c and/or d c f e

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Chapter 4, E 8. 1.

Single-step income statement prepared

Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold Selling expenses General and administrative expenses Interest expense Total costs and expenses Income before income taxes Income taxes

$405,000 3,000 $408,000 $220,000 90,000 60,000 4,000 374,000 $ 34,000 7,500

Net income

$ 26,500

Earnings per share

$

2.

1.06

Multistep income statement prepared

Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes

$405,000 220,000 $185,000 $90,000 60,000 150,000 $ 35,000 $ 3,000 4,000 1,000 $ 34,000 7,500

Net income

$ 26,500

Earnings per share

$

1.06

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Chapter 4, E 9. Pasica, Inc. Income Statement For the Year Ended December 31, 2011 Net sales Cost of goods sold Gross margin Operating expenses

$1,197,132 777,080 $ 420,052

Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses

$203,740 100,688

Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes

$

304,428 $ 115,624 5,720 13,560 7,840 $ 107,784 24,000

Net income

$

83,784

Earnings per share

$

8.38

The multistep income statement lists the gross margin from sales and separates income from operations from other revenues and expenses. In this way, it is possible to evaluate separately the company's ability to sell its products at a satisfactory price and its ability to operate efficiently. Also, its current operations are evaluated separately from financing activities.

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Chapter 4, E 10. Financial ratios computed 1.

= * $195,500 2.

–

Net Sales $23,500 *

* $106,500

–

=

–

$8,500

=

$23,500

Average Total Assets $195,500 (

$106,500

+

$195,500

=

$97,125

$18,750

Return on = Assets

$47,000

–

Net Sales

Asset Turnover =

=

= 12.0%

$195,500

$116,500

=

3.

Net Income

Profit Margin =

=

$87,750 * ) ÷ 2 2.0 times

$87,750 Net Income

Average Total Assets $23,500 $97,125

= 24.2%

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Chapter 4, E 10. (Continued) 4.

Cash Flow Yield

=

Cash Flows from Operating Activities Net Income $35,000

=

= 1.5

$23,500

Cash Flows from Operating Activities Cash Return = on Assets Average Total Assets

5.

$35,000

= 36.0%

$97,125 6.

Total Liabilities

Debt to Equity Ratio

Total Stockholders' Equity $43,000

= 7.

Net Income

Return on = Equity =

= *

$63,500

–

= 67.7%

$63,500 *

Average Stockholders' Equity $23,500 $63,500

(

$23,500 $56,750

$23,500

+

$50,000

+

) ÷ 2

= 41.4% $10,000

=

$50,000

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Chapter 4, E 11. Profitability measures computed 1.

Profit Margin =

2.

Asset Turnover =

=

=

Net Income

$60,000

=

Net Sales

$830,000

= 7.2%

Net Sales Average Total Assets $830,000 (

$460,000

$830,000 $410,000

$360,000

+

)

Net Income $60,000 Return = = on Assets Average Total Assets $410,000

4.

Cash Flow Yield =

Cash Flows from Operating Activities Net Income

5.

Cash Return on Assets =

=

Cash Flows from Operating Activities

=

Average Total Assets

6.

7.

Return = on Equity

=

=

2

= 2.0 times

3.

Debt to = Equity Ratio

÷

Total Liabilities Total Stockholders' Equity

$72,000 $60,000

$72,000 $410,000

=

$110,000 $350,000

= 14.6%

= 1.2

= 17.6%

= 31.4%

Net Income Average Stockholders' Equity $60,000 (

$350,000 $60,000

$315,000

+

$280,000

)

÷

2

= 19.0%

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Chapter 4, P 1. User Insight: Accounting convention explained 1.

2.

3.

4.

5.

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

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Chapter 4, P 2. 1. Multistep income statements prepared Elm Nursery Corporation Income Statements For the Years Ended April 30, 2011 and 2010 % 2011

2010

Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes Net income

$262,966 117,474 $145,492

100.0% 44.7% 55.3%

$237,632 85,925 $151,707

$ 80,846 31,433 $112,279 $ 33,213

30.7% 12.0% 42.7% 12.6%

$ 75,350 21,043 $ 96,393 $ 55,314

Earnings per share

$

$

900 1,800

$ 900 $ 32,313 8,000 $ 24,313 1.22

0.3% * $ 0.7% * 0.3% 12.3% 3.0% 9.2%

425 850

$ 425 $ 54,889 14,300 $ 40,589 $

% 100.0% 36.2% 63.8% 31.7% 8.9% 40.6% 23.3% * 0.2% 0.4% 0.2% * 23.1% * 6.0% 17.1%

2.03

2. User insight: Income from operations discussed Income from operations decreased from 2010 to 2011. The primary reasons for this decline were the decrease in gross margin caused by the increase in cost of goods sold as a percentage of sales and the increase in general and administrative expenses as a percentage of net sales.

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Chapter 4, P 2. (Continued) 3.

User Insight: Income before income taxes discussed

Income before income taxes also decreased from 2010 to 2011. The primary reason for this decline was the decrease in operating income. However, the decrease in income before income taxes ($22,576) is greater than the decrease in operating income ($22,101) because of the 111.8 percent increase in interest expense from 2010 to 2011. This means that management took on additional debt to finance the business operations.

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Chapter 4, P 3. Bissel Hardware Corporation Balance Sheet June 30, 2011 Assets Current assets Cash Short-term investments Notes receivable Accounts receivable Merchandise inventory Prepaid rent Prepaid insurance Sales supplies Office supplies Deposit for future advertising Total current assets Investments Building, not in use Property, plant, and equipment Land Delivery equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Trademark

$ 64,000 66,000 20,000 552,000 290,000 3,200 9,600 2,560 880 7,360 $1,015,600 99,200 $ 46,800 $82,400 56,800

25,600 72,400 8,000 $1,195,200

Total assets

(continued)

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Chapter 4, P 3. (Continued) Liabilities Current liabilities Accounts payable Salaries payable Interest payable Total current liabilities Long-term liabilities Notes payable

$229,200 10,400 3,680 $ 243,280 160,000

Total liabilities

$ 403,280 Stockholders' Equity

Contributed capital Common stock, $1.10 par value, 40,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity

$ 44,000 320,000 $364,000 427,920 791,920 $1,195,200

Total liabilities and stockholders' equity

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Chapter 4, P 3. (Continued) 2.

User Insight: Ratio discussed

A user of the classified balance sheet would want to know the debt to equity ratio because it shows the proportion of the company financed by creditors in comparison with that financed by stockholders. This measure is very important to liquidity analysis because it is related to debt and its repayment. It is also relevant to profitability analysis because the amount of debt affects the amount of interest expense and the stockholders' return on investments.

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Chapter 4, P 4. 1. Profitability measures computed a.

Profit Margin =

$51,000

(

(

Return on Assets =

2010:

Average Total Assets

$580,000

$435,000

+

$1,150,000

)

÷ 2

)

÷ 2

= 2.3 times

$507,500

$870,000

=

2011:

Net Sales

$1,150,000

=

c.

= 5.9%

$870,000

Asset Turnover =

2010:

= 6.5%

$1,150,000

2010:

2011:

Net Sales $75,000

2011:

b.

Net Income

$435,000 $870,000 $387,500

$340,000

+

= 2.2 times

Net Income Average Total Assets $75,000 $507,500 $51,000 $387,500

= 14.8%

= 13.2%

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Chapter 4, P 4. (Continued) d.

Cash Flow Yield =

2011:

2010:

e.

2010:

f.

$82,500 $75,000 $67,500 $51,000

Cash Return on Assets =

2011:

2010:

= 1.1

= 1.3

Cash Flow from Operating Activities Average Total Assets

$82,500 $507,500 $67,500 $387,500

Debt to Equity Ratio =

2011:

Cash Flows from Operating Activities Net Income

= 16.3%

= 17.4%

Total Liabilities Total Stockholders' Equity

$245,000 $335,000 $175,000 $260,000

= 73.1%

= 67.3%

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Chapter 4, P 4. (Continued) g.

Return on Equity =

2011:

Average Stockholders' Equity $75,000

( =

2010:

Net Income

$335,000 $75,000 $297,500

+

$260,000

)

÷ 2

)

÷ 2

= 25.2% $51,000

( =

$260,000 $51,000 $235,000

+

$210,000

= 21.7%

2. User Insight There was an increase in both profit margin and asset turnover from 2010 to 2011, which resulted in an increase in return on assets. Note that return on assets is more than twice as large as profit margin because of the asset turnover being greater than 2.0 times. The debt to equity ratio in both years exceeds 50 percent and leads to a strong return on equity. Note that all factors combine to produce a very satisfactory return on equity.

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Chapter 4, P 5. 1a. Single-step income statement prepared Surosa Corporation Income Statement For the Year Ended December 31, 2011 Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold Selling expenses Administrative expenses Interest expense Total costs and expenses Income before income taxes Income taxes

$357,195 1,400 $358,595 $175,210 110,100 40,400 11,320 337,030 $ 21,565 3,500

Net income

$ 18,065

Earnings per share

$

1.81

1b. Statement of retained earnings prepared Surosa Corporation Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2010 Net income Subtotal Less dividends

$141,585 18,065

Retained earnings, December 31, 2011

$129,650

$159,650 30,000

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Chapter 4, P 5. (Continued) 1c. Classified balance sheet prepared Surosa Corporation Balance Sheet December 31, 2011 Assets Current assets Cash Investment in U.S. government securities Accounts receivable Inventory Prepaid expenses Total current assets Investments Investment in securities Property, plant, and equipment Store fixtures Less accumulated depreciation Delivery equipment Less accumulated depreciation Total property, plant, and equipment

$14,200 19,800 52,400 68,270 2,880 $157,550 28,000 $70,810 21,110

$49,700

$44,250 8,550

35,700 85,400 $270,950

Total assets

(continued)

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Chapter 4, P 5. (Continued) Liabilities Current liabilities Notes payable Accounts payable Total current liabilities Long-term liabilities Notes payable Total liabilities

$ 25,000 16,300 $ 41,300 50,000 $ 91,300 Stockholders' Equity

Contributed capital Common stock, $0.50 par value, 10,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

$

5,000 45,000

$ 50,000 129,650 179,650 $270,950

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Chapter 4, P 5. (Continued) 2.

Profitability measures computed (a) Profit Margin =

Net Income Net Sales

=

(c) Cash Flow Yield =

= (d) Debt to Equity = Ratio (e) Return on Assets =

=

$357,195

= 5.1%

Net Sales

(b) Asset Turnover =

=

$18,065

=

Average Total Assets $357,195 (

$270,950 $357,195 $266,575

+

$262,200 ) ÷ 2

= 1.3 times

Cash Flows from Operating Activities Net Income $20,000 $18,065

= 1.1

Total Liabilities Total Stockholders' Equity

=

$91,300 $179,650

= 50.8%

Net Income Average Total Assets $18,065 $266,575

= 6.8%

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Chapter 4, P 5. (Continued) Cash Flows from Operating Activities

(f) Cash Return = on Assets =

Average Total Assets $20,000 $266,575

Net Income

(g) Return on Equity =

=

=

= 7.5%

Average Stockholders' Equity $18,065 (

$179,650 $18,065

$185,618

+

$191,585

) ÷ 2

= 9.7%

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Chapter 4, P 5. (Continued) User Insight: Financial ratios discussed 3.

The corporation's profit margin of 5.1 percent exceeds the industry average of 2.3 percent, but its asset turnover ratio of 1.3 is much lower than the industry average of 2.0. Thus, its return on assets of 6.8 percent is higher than the industry average of 4.6 percent. Further, it has a debt to equity ratio of only 50.8 percent compared with the industry average of 108.9 percent. Thus, its return on equity is only 9.7 percent compared with an industry average of 9.4 percent. Since the industry average is 9.4 percent for ROE and Surosa's exceeds that even with relatively more equity.

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Chapter 4, P 6. User Insight: Accounting convention explained 1.

The change in depreciation methods is a violation of the comparability and consistency convention. However, management can change its accounting methods if it complies with the convention of full disclosure by reporting the change in the notes to its financial statements.

2.

This is an acceptable application of the cost-benefit convention if management has determined that the benefits of the new classification system outweigh the costs. This is an unacceptable application of the materiality convention because illegal actions by a company's personnel—whatever the amount involved—are inherently important to the users of financial statements. Full disclosure would require that this kind of illegal activity be disclosed. This is an unacceptable application of the conservatism convention because conservatism can be used only when two equally acceptable accounting methods are available. Expensing an item of property, plant, and equipment—and that's what the addition is—is not an acceptable method. Uncertainties are always present. The going concern assumption requires that the addition be recorded as property, plant, and equipment and be depreciated over a number of years. The failure to disclose the inventory method is a violation of the full disclosure convention. To interpret the statements, users of financial statements must know which method is used, even though the method used has not changed in a number of years. This situation is also an application of the consistency convention, since they used the same method every year.

3.

4.

5.

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Chapter 4, P 7. 1. Multistep income statements prepared Kaluza Hardware Corporation Income Statements For the Years Ended July 31, 2011 and 2010 2011 %

2010

%

Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes Net income

$464,200 243,880 $220,320

100.0% $388,466 52.5% 198,788 47.5% $189,678

100.0% 51.2% 48.8%

$ 95,160 90,840 $186,000 $ 34,320

20.5% $ 55,644 19.6% 49,286 40.1% $104,930 7.4% $ 84,748

14.3% 12.7% 27.0% 21.8%

Earnings per share

$

$

1,420 5,600

$ 4,180 $ 30,140 8,000 $ 22,140 2.21

0.3% $ 1.2%

750 1,100

0.9% $ 350 6.5% $ 84,398 1.7% 21,250 4.8% $ 63,148 $

0.2% 0.3% 0.1% 21.7% 5.5% 16.3% *

6.31

*Rounded. 2. User Insight: Income from operations discussed Income from operations decreased from 2010 to 2011 in absolute amount by $50,428 ($84,748 – $34,320) and decreased in percentage from 21.8 percent to 7.4 percent of net sales despite an increase in net sales. There were two reasons for the decrease in income from operations. First, although gross margin increased in absolute amount by $30,642 ($220,320 – $189,678), it decreased in percentage from 48.8 percent of net sales to 47.5 percent. Second and more important, operating expenses increased as a percentage of net sales from 27.0 percent to 40.1 percent. Increases in both selling expenses and general and administrative expenses contributed to this large increase. Management must examine its selling expenses and the company's overhead (general and administrative expenses) to improve its profitability.

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Chapter 4, P 7. (Continued) 3.

User Insight: Income before income taxes discussed

Income before income taxes also decreased from 2010 to 2011. The primary reason for this decline was the decrease in operating income. However, the decrease in income before income taxes ($54,258) is greater than the decrease in operating income ($50,428) primarily because of the 409 percent increase in interest expense from 2010 to 2011. This means that management took on additional debt to finance the business operations.

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Chapter 4, P 8. 1. Profitability measures computed a.

2011:

2010:

b.

Net Income

Profit Margin =

Net Sales $8,000

$131,000 $5,500 $100,000

Average Total Assets $131,000

(

d.

$63,750

+ =

(

Cash Flow Yield =

$55,000 $100,000 $50,000

+ =

2.1 times

= 1.5

2010:

$7,500 $5,500

= 1.4

Debt to Equity Ratio =

$45,000

) ÷ 2

2.0 times

Net Income

$12,000 $8,000

2010:

) ÷ 2

Cash flow from Operating Activities

2011:

2011:

$55,000

$100,000

=

c.

$72,500 $131,000

=

2010:

= 5.5% Net Sales

Asset Turnover =

2011:

= 6.1%

Total Liabilities Total Stockholders' Equity

$20,000 $52,500 $5,000 $50,000

= 38.1%

= 10.0%

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Chapter 4, P 8. (Continued) e.

Return on Assets =

2011:

2010:

f.

g.

Cash Return = on Assets

Net Income Average Total Assets $8,000 $63,750 $5,500 $50,000

= 12.5%

= 11.0%

Cash Flow from Operating Activities Average Total Assets

2011:

$12,000 $63,750

= 18.8%

2010:

$7,500 $50,000

= 15.0%

Return on Equity =

2011:

Net Income Average Stockholders' Equity $8,000

(

$52,500 =

2010:

+

$8,000 $51,250

$50,000

) ÷ 2

= 15.6%

$5,500 (

$50,000 =

+

$5,500 $45,000

$40,000

) ÷ 2

= 12.2%

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

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Chapter 4, P 9. Beauty Supplies Corporation Balance Sheet June 30, 2011 Assets Current assets Cash Short-term investments Notes receivable Accounts receivable Merchandise inventory Prepaid rent Prepaid insurance Sales supplies Office supplies Deposit for future advertising Total current assets Investments Building, not in use Property, plant, and equipment Land Delivery equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Trademark

$ 16,000 16,500 5,000 138,000 72,500 800 2,400 640 220 1,840 $253,900 24,800 $ 11,700 $20,600 14,200

6,400 18,100 2,000 $298,800

Total assets

(continued)

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Chapter 4, P 9. (Continued) Liabilities Current liabilities Accounts payable Salaries payable Interest payable Total current liabilities Long-term liabilities Notes payable

$ 57,300 2,600 920 $ 60,820 40,000

Total liabilities

$100,820 Stockholders' Equity

Contributed capital Common stock, $1.10 par value, 10,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity

$ 11,000 80,000 $ 91,000 106,980 197,980 $298,800

Total liabilities and stockholders' equity 2. User Insight

In addition to considering the key elements of the balance sheet, such as total assets, liabilities, and equity, it's also important to consider Net Revenue and Net Income from the income statement and Cash Flows from Operating Activities from the statement of cash flows. The elements from these three statements are used to compute important financial ratios.

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Chapter 4, P 10. 1a. Single-step income statement prepared Cubicle Corporation Income Statement For the Year Ended December 31, 2011 Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold Selling expenses Administrative expenses Interest expense Total costs and expenses Income before income taxes Income taxes

$1,428,780 5,600 $1,434,380 $700,840 440,400 161,600 45,280 1,348,120 $

86,260 14,000

Net income

$

72,260

Earnings per share

$

3.61

1b. Statement of retained earnings prepared Cubicle Corporation Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2010 Net income Subtotal Less dividends

$566,340 72,260

Retained earnings, December 31, 2011

$518,600

$638,600 120,000

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Chapter 4, P 10. (Continued) 1c. Classified balance sheet prepared Cubicle Corporation Balance Sheet December 31, 2011 Assets Current assets Cash Investment in U.S. government securities Accounts receivable Inventory Prepaid expenses Total current assets Investments Investment in securities Property, plant, and equipment Store fixtures Less accumulated depreciation Delivery equipment Less accumulated depreciation Total property, plant, and equipment

$ 56,800 79,200 209,600 273,080 11,520 $ 630,200 112,000 $283,240 84,440

$198,800

$177,000 34,200

142,800 341,600 $1,083,800

Total assets

(continued)

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Chapter 4, P 10. (Continued) Liabilities Current liabilities Notes payable Accounts payable Total current liabilities Long-term liabilities Notes payable Total liabilities

$100,000 65,200 $ 165,200 200,000 $ 365,200 Stockholders' Equity

Contributed capital Common stock, $1.00 par value, 20,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

$ 20,000 180,000 $200,000 518,600 718,600 $1,083,800

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Chapter 4, P 10. (Continued) 2.

Profitability measures computed (a) Profit Margin =

(b) Asset Turnover =

=

=

(c) Cash Flow Yield =

Net Income Net Sales

$72,260

=

$1,428,780

Net Sales Average Total Assets $1,428,780 ( $1,083,800 $1,428,780 $1,066,300

+ =

$1,048,800 ) ÷ 2 1.3 times

Cash Flow from Operating Activities

=

Net Income (d) Debt to Equity = Ratio (e) Return on Assets =

=

(f) Cash Return = on Assets

=

= 5.1%

Total Liabilities Total Stockholders' Equity

$60,000 $72,260 =

= 0.8

$365,200 $718,600

= 50.8%

Net Income Average Total Assets $72,260 $1,066,300

= 6.8%

Cash Flow from Operating Activities Average Total Assets $60,000 $1,066,300

= 5.6%

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Chapter 4, P 10. (Continued) Net Income

(g) Return on Equity =

=

=

Average Stockholders' Equity $72,260 (

$718,600 $72,260

$742,470

+

$766,340

) ÷ 2

= 9.7%

3. User Insight: Financial ratios discussed Cubicle Corporation's profit margin of 5.1 percent exceeds the industry average of 3.6 percent, but its asset turnover ratio of 1.3 is much lower than the industry average of 1.9. Thus, its return on assets of 6.8 percent is equal to the industry average of 6.8 percent. Further, it has a debt to equity ratio of only 50.8 percent compared with the industry average of 160.4 percent. Thus, its return on equity is only 9.7 percent compared with an industry average of 14.5 percent. Cubicle needs to consider increasing its debt financing as one method of increasing return on equity.

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

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$268 ($140) $268 + $418 ) -40.8%

$2,581 ($2,855) + $5,953 ) -66.9%

Total Stockholders' Equity

Net Income

÷

2 = $343

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241

From these figures, it is clear that A&P was the more profitable company for the period analyzed. Its profit margin, return on assets, and return on equity were superior to the same measures for Supervalu because A&P has a smaller net loss.

Return on Equity

Average Stockholders' Equity

(

$3,278

$15,023

Total Liabilities

$2,581

-3.9%

-14.8%

Return on Assets

(

$3,595 1,223.1%

$19,333 582.1%

Average Total Assets (from above)

Debt to Equity Ratio

($140)

($2,855)

$3,644 ) ÷ 2 = $3,595 2.6 times

Net Income

2 = $4,267

Average Total Assets Asset Turnover

÷

$21,062 ) ÷ 2 = $19,333 2.3 times

Net Sales

( $3,546 +

$44,564

Profit Margin ( $17,604 +

$9,516 -1.5%

$44,564 -6.4%

Net Sales

$9,516

($140)

($2,855)

A&P

Net Income (Loss)

Supervalu

1. Profitability ratios computed (in millions) and discussed

Chapter 4, C 3.

Chapter 4, C 3. (Continued) 2. Return on assets discussed Return on assets is a combination of profit margin and asset turnover. The grocery industry has low profit margins. The profit margins of the two companies are -6.4 and -1.5 percent. The industry tries to overcome its low profit margin by turning over its assets many times during the year. A&P has an asset turnover of 2.6 times, which exceeds that of Supervalu of 2.3. The relationships of the two companies' ratios and the industry ratios are as follows: Profit Margin Supervalu A&P Industry*

-6.4% -1.5% 2.2%

× × × ×

Asset Turnover 2.3 times 2.6 times 5.5 times

= = = =

Return on Assets -14.8% -3.9% * 12.1%

*Industry graphs are provided on pages 218–222, page 224, and page 225 of the text. The higher negative profit margin at Supervalu makes it less profitable than A&P in spite of its lower turnover. However, both companies are less profitable than the industry in terms of asset turnover and return on assets. 3. Debt financing discussed Despite low profit margins, grocery stores tend to have high debt because they are very stable businesses. Both companies use this method to increase their return on equity over what they earn on assets. Both companies have more debt than equity; the debt to equity ratio was 1,223.1 percent for A&P, which is considerably higher than the industry average, and 582.1 percent for Supervalu. When debt is excessive, a company can be in a risky situation. In the case of Supervalu and A&B, the large and A&P, the large amount of debt in relation to equity may put these companies in a vulnerable situation. A&P, with the higher debt to equity ratio, helps its return on equity, but it is still in a more risky situation due to its low profit margin.

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Chapter 4, C 4. 1. To evaluate profitability, the profit margin and return on assets must be computed as follows: Net Income

Profit Margin =

Net Sales $89,512

2011:

$1,222,600 $82,912

2010:

$1,386,400

Average Total Assets $89,512 ( $1,536,910 =

2010:

= 6.0%

Net Income

Return on Assets =

2011:

= 7.3%

$89,512 $1,461,860

+

$1,386,810 ) ÷ 2

= 6.1% $82,912

( $1,386,810 =

$82,912 $1,316,795

+

$1,246,780 ) ÷ 2

= 6.3%

Wish Linens, Inc.'s profit margin did improve, from 6.0 percent to 7.3 percent, because of the increase in prices; however, return on assets, which is the broadest measure of profitability, fell from 6.3 percent to 6.1 percent. The reason is that assets are growing at a faster rate than revenues, causing asset turnover to drop, as shown next.

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Chapter 4, C 4. (Continued) 2.

In her evaluation of profitability, Wish is focusing only on the profit margin, failing to take into account that the overall profitability must be evaluated in terms of total investment in assets and the amount of sales generated by those assets. Asset Turnover =

2011:

2010:

Net Sales Average Total Assets $1,222,600 $1,461,860 $1,386,400 $1,316,795

= 0.8

times

= 1.1

times

The asset turnover has decreased from 1.1 times in 2010 to 0.8 times in 2011 because of the decrease in sales (due to higher prices) and the increase in average total assets. This decrease in asset turnover has an adverse affect on profitability as measured by return on assets: Asset Return on Profit × = Turnover Margin Assets 2011: 2010:

7.3% 6.0%

× ×

0.8 1.1

= =

5.8% 6.6%

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Chapter 4, C 5. 1.

Consolidated balance sheets ($ amounts in millions)

a.

Yes, CVS uses a classified balance sheet. It shows different categories of assets like contra assets, property and equipment, goodwill, intangible assets, and other assets. It further divides current assets into six subcategories.

b.

Yes, the debt to equity ratio decreased from 76.3 percent in 2008 to 72.3 percent in 2009. Debt to Equity Ratio =

2009: c.

$25,873 $35,768

Total Liabilities Total Stockholders' Equity = 72.3%

2008:

$26,386 $34,574

= 76.3%

Contributed capital for 2009 was $27,214 million ($16 + $27,198). ( Note: In 2008, CVS had two types of stock: preference and common; in 2009, just common.) Also, capital surplus is the same as additional paid-in capital. Retained earnings were $16,355 million, or about 60 percent as great as contributed capital.

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Chapter 4, C 5. (Continued) 2.

Consolidated statements of operations

a. b.

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

c.

d.

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Chapter 4, C 6. (Continued) 1. Liquidity and profitability calculated Profit Margin Net Income (Loss) Net Sales or Total Operating Revenue

Profit Margin = CVS $3,696

2009:

$98,729

= 3.7%

2008:

= 1.0%

2008:

$3,198 $87,472

= 3.7%

Southwest $99

2009:

$10,350

$178 $11,023

= 1.6%

Asset Turnover Asset Turnover =

Net Sales Average Total Assets

CVS 2009:

$98,729 ( =

2008:

( =

$61,641 $98,729 $61,301

$60,960 $87,472 $57,841

$60,960

+ =

÷

2

÷

2

÷

2

÷

2

1.6 times

$87,472 $54,722 + =

)

)

1.5 times

Southwest 2009:

( =

2008:

( =

$14,269 $10,350 $14,169

$14,068 $11,023 $15,420

$10,350 $14,068 + =

0.7 times

$11,023 $16,772 + =

)

)

0.7 times

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Chapter 4, C 6. (Continued) Cash Flow Yield Cash Flow Yield =

Cash Flows from Operating Activities Net Income

CVS 2009:

2008:

$4,035 $3,696 $3,947 $3,198

= 1.1

= 1.2

Southwest 2009:

2008:

$985 $99 ($1,521) $178

= 9.9

= -8.5

Debt to Equity Ratio Debt to Equity Ratio =

Total Liabilities Total Stockholders' Equity

CVS 2009:

$25,873 $35,768

= 72.3%

2008:

= 161.1%

2008:

$26,386 $34,574

= 76.3%

Southwest 2009:

$8,803 $5,466

$9,115 $4,953

= 184.0%

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Chapter 4, C 6. (Continued) Return on Assets Return on Assets =

Net Income Average Total Assets

CVS 2009:

$3,696 ( =

2008:

$61,641 $3,696 $61,301

+

$60,960

)

÷

2

)

÷

2

)

÷

2

)

÷

2

= 6.0% $3,198

( =

$60,960 $3,198 $57,841

+

$54,722

= 5.5%

Southwest 2009:

2008:

(

$14,269

=

$99 $14,169

( =

$14,068 $178 $15,420

$99 + $14,068 = 0.7% $178 + $16,772 = 1.2%

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Chapter 4, C 6. (Continued) Return on Equity Return on Equity =

Net Income Average Stockholders' Equity

CVS 2009:

$3,696 ( =

2008:

$35,768 $3,696 $35,171

+

$34,574

)

÷

2

)

÷

2

)

÷

2

)

÷

2

= 10.5% $3,198

( =

$34,574 $3,198 $32,948

+

$31,322

= 9.7%

Southwest 2009:

$99 ( =

2008:

$5,466 $99 $5,210

+

$4,953

= 1.9% $178

( =

$4,953 $178 $5,947

+

$6,941

= 3.0%

2. Performance discussed In general, CVS's peformance exceeds the performance of Southwest, both in respect to liquidity and profitability. CVS's profitability measures, especially return on assets and return on equity, are much better than those of Southwest. Also, CVS has a higher profit margin than Southwest does, and it has a much higher asset turnover ratio. CVS also had lower debt to equity ratios for both years: 72.3 percent in 2009, a decrease from 76.3 percent in 2008. Southwest's ratio also decreased in 2009, from 184.0 percent to 161.1 percent. In terms of cash flow yield, CVS is a lot more stable with yield of slightly stable with yield of slightly more than 1, which means that for every dollar of net income, CVS generated one dollar of cash. On the other hand, Southwest's cash flow yield fluctuated greatly from 2008 to 2009, from negative 8.5 to about positive 10.

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

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