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Chapter 2 - Problem Solutions
Review Questions
1.
Pros, relative to partnerships, for the corporate business form include
limited liability of owners (to the amount of their initial investment),
ease of ownership transfer and ability to grow the company by issuing
additional stock. The major con is double taxation (on corporate
earnings and dividends paid to shareholders).
2.
Assets: Items owned by the company or that the company has a right
to use that have probable future value to the firm. Include cash;
accounts receivable, property plant and equipment, inventories and
various property rights. There are also other items classified as assets
that are discussed later in this book.
Liabilities: Amounts owed to others. Represent probable future
sacrifices of resources. Include notes payable, mortgages payable,
bonds payable, accounts payable, salaries payable and other items
owed to others outside the entity. There are other items considered
liabilities discussed later in this course.
Stockholders’ Equity: Represents the residual claim on the assets of
the firm after all liabilities are settled. Includes Common stock,
additional paid in capital and retained earnings.
3.
Statement of financial position: Provides a snapshot of a company’s
assets, liabilities and stockholders’ equity at a point in time. The
statement of financial position describes the firm’s resources and
claims to those resources.
Statement of earnings: Provides a report of changes in stockholders’
equity resulting from a firm’s operating activities. It reports the
revenues from sale of goods and services and the expenses from
generating those revenues.
Statement of cash flows: Describes changes in a company's cash
and cash equivalents for a period. The statement shows how
investing, financing and operating activities affect cash.
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Statement of stockholders’ equity: Provides details about all the
transactions that affect stockholders’ equity including stock issuances,
stock repurchases, earnings (net income) and dividends paid.
4.
Net assets are the same as net book value and total stockholder’s
equity. It can be calculated as assets- liabilities.
5.
In order to be classified as an asset an item must meet the
measurement criteria specified in the conceptual framework. It must
be accurate, neutral and verifiable. It must also normally be owned
or controlled by the entity. Some items such as internally developed
brands, customer satisfaction and the value of a high quality work
force cannot be reliably valued or are not owned and so are not
reported as assets.
6.
Assets = Liabilities + Stockholders’ Equity
7.
A classified balance sheet lists items in order of liquidity and
classifies assets and liabilities into categories of current and
noncurrent.
8.
Current assets are cash and assets expected to be converted to cash
or expire within one year or the operating cycle of the business,
whichever is longer. Current liabilities are those that become due or
expected to be settled within one year.
9.
Retained earnings represent the cumulative amount of earnings less
dividends distributed to stockholders’ since the formation of a
business. Note that it does not represent cash as earnings may not be
in the form of cash, and even cash that is generated by earnings may
have been reinvested in the business.
10.
The book value of a company represents the assets minus liabilities
of a company recognized according to generally accepted accounting
standards. The market value of a company’s stock is based on
investors’ expectations about future earnings and cash flows to the
company and is determined by a market trading process. In general,
because accounting is conservative (meaning that losses and
expenses are recognized earlier than gains and revenues) the book
value of a company will be less than the market value. For example,
some items of value (such as the value of McDonald’s arches) are not
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reported as assets.
Therefore, the book value and market value of
a firm will often differ because of accounting recognition lags changes
in market value. Items are recognized in the market but not yet in the
accounting records (relates to conservatism above). The difference
in these two values can be measured using a market/book value ratio.
11. Net income is the same as net earnings, which is revenues less
expenses.
12. The two methods are the direct method and the indirect method. Under
the direct method cash flows from operations report cash received
from customers and cash paid for various operating costs. The indirect
method starts with net income and adjusts income for non-cash
earnings items. The indirect method is the most common in practice.
13.
FASB Concepts Statement 6 defines comprehensive income as the
change in equity of a firm due to transactions and other events and
circumstances from non-owner sources. It includes all changes in
equity except those resulting from investments by owners and
distributions to owners. At first glance, this appears to be a definition
of earnings. The difference is that accounting standards allow for
some items that affect owners’ equity to bypass the income statement
and be recorded directly in stockholders’ equity. Comprehensive
income is discussed in Chapter 4.
14.
Note to Instructors: In the earlier drafts of this chapter we had
covered comprehensive income. However, in the final version this
was dropped. We inadvertently left this problem in the chapter and
will be removing it in the next printing and replacing it with a different
problem.
Comprehensive income must be reported separately from earnings.
The FASB has recently concluded that a business entity should report
all items of revenue, expense, gains, and losses in a single statement
of comprehensive income. Note: in prior years many companies
reported comprehensive income in the statement of shareholders’
equity. Now it is being reported in the statement of earnings.
Applying Your Knowledge
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15.
An income statement presents the results of the operating activities
of a firm for a period of time. A cash flow statement reports the net
cash flows of a firm for a period of time. An income statement
presents mainly the results of the operating activities while a cash flow
statement reports cash flows relating to operating, investing and
financing activities. An Income statement gives the net income,
earnings/profits of a firm whereas a cash flow statement explains the
inflow and outflow of cash for the period. The Income statement
includes items which are not related to cash, such as depreciation.
The cash flow statement includes items only related to cash.
16.
a.
b.
c.
d.
e.
CA
CL
NI and/or CF
RE and/or CF
NI and/or CF
f.
g.
h.
i.
j.
NCA
CS and/or CF
CA
NCL
NI and/or CF
17.
a.
b.
c.
d.
O
F
F
I
e.
f.
g.
h.
O
I
I
O
18.
Current Assets
Noncurrent Assets
Total Assets
Current Liabilities
Noncurrent Liabilities
Owners' Equity
Total Liabilities
& Owners' Equity
19.
Retained Earnings
Dec. 31, Year 1
Net Income
Dividends Declared
and Paid
Retained Earnings
Dec. 31, Year 2
A
$100,000
250,000
350,000
50,000
75,000
225,000
B
C
$650,000 $230,000
400,000
400,000
1,050,000
630,000
500,000
300,000
90,000
250,000
460,000
80,000
D
$40,000
150,000
190,000
25,000
10,000
155,000
350,000
1,050,000
630,000
190,000
A
$20,000
B
C
$100,000 $150,000
D
$40,000
15,000
6,000
50,000
35,000
400,000
250,000
22,000
10,000
29,000
115,000
300,000
52,000
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20.
COMPANY
Washington Post
ASSETS
-Printing machines
-Newsprint
LIABILITIES
-Accounts payable
-Deferred subscription
revenue
-Subscription receivables -Long-term debt
International Paper
-Timberland
-Accrued income tax
-Timber/Paper
-Notes payable
Inventories
-Plant & equipment
-Long-term debt
SBC
-Telephone equipment
-Advance billings &
customer deposits
-Receivables from
-Long-term debt
customers
-Receivables from
-Accounts payable
leased equipment
Hartford Financial Services -Investments
-Loss reserves
Inc.
-Loans to policyholders
-Commissions payable
-Premiums due
-Contract claims payable
Philip Morris Companies
-Food inventories
-Tax payable
(now part of Altria Group
Inc.)
-Tobacco inventories
-Interest payable
-Receivables from
-Long-term debt
customers
Citibank
-Investments
-Commercial paper
(short-term debt)
-Third world loans
-Time deposits
-Mortgage loans
-Demand deposits
Delta
-Spare parts & supplies
-Traffic balances payable
-Flight equipment
-Unearned airline
revenue
-Ground plant &
-Accrued expenses
equipment
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21. & 22.
COMPANY
Washington Post
INCOME STATEMENT
-Sale of newspapers
-Cost of printing
-Royalties
International Paper
-Cost of timber harvested
-Depreciation
SBC
Hartford Financial Services
Inc.
Philip Morris Companies
(now part of Altria Group
Inc.)
Citibank
Delta
-Sales revenues
-Revenue from local
service
-Interstate toll revenue
-Maintenance expense
-Premiums earned
CASH FLOW
-Advertising costs
-Royalties paid
-Receipts from
advertising
-Investments in
timberland
-Proceeds from sale of
properties
-Purchase of stock
-Investment in phone
equipment
-Redemption of stock
-Increase in investments
-Dividends paid
-Investment income
-Losses
-Revenues from tobacco
sales
-Loans repaid
-Claims paid
-Dividends paid
-Federal excise taxes
-Cost of goods sold
-Receipts from customers
-Proceeds from issuance
of debt
-Interest payments
-Interest income from
time deposits with banks
-Dividends from
companies
-Interest expense on
commercial paper
-Revenue from freight,
mail, passengers
-Travel agency
commissions
-Airport rental fees
-Increase in investments
-Sale of property
-Additions to PP&E
-Dividends paid
-Reduction of long-term
debt
Note: Some of the items related to operations would only appear directly in the cash
flow statement if it were prepared using the direct method. If the indirect method
were used the net affect would be reported but would be difficult to see.
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23. Funds can be raised from several sources but the two primary sources
are from lenders and owners. The advantage of borrowing from a
lender is that your friend would retain complete ownership of the
business and would not be required to share the decision-making and
the profit of the firm with anyone else. Bringing in another owner
would obviously result in the dilution of control over the firm and would
also give up some share of the future profits. The disadvantage of
borrowing from a lender is that the loan contracts will require
repayment of the amount on a set schedule. This increases the risk
to the firm that it will not be able to make payments on a timely basis.
There could be significant consequences to not making payment
including losing ownership of the business. A new owner would not
have this same type of contractual arrangement and would be at risk
in the same way as your friend. However, the new owner would
probably expect a higher return from their investment than would a
lender. Therefore, your friend would be giving up more potential
profit to a new owner than a lender. There are also tax incentives for
borrowing in that from a corporate point of view the interest payments
on the loan are deductible for tax purposes. Payments to owners
(such as dividends) are not tax deductible.
24. In a partnership it is often very difficult to determine whether payments
made to owners are salaries earned by the partners for work
performed for the partnership, repayment of loans made by the partner
to the partnership or profit sharing by the partners. As an example
suppose that the profits earned by the partnership for the month are
$5,000 prior to considering the $1,500 paid to the partner. Under the
profit sharing arrangement each partner is entitled to $2,500 in profits.
If the $1,500 is considered part of the profit sharing then the partner
could withdraw another $1,000 as part of his or her profit sharing. If
on the other hand the $1,500 is considered salary then the profit of the
firm would only be $3,500, which would entitle each partner to $1,750.
Therefore, the partner would receive $1,500 for his/her salary and
another $1,750 as profit sharing or a total of $3,250. How this
situation should be handled would depend on what the partners have
agreed to do. It would seem that since the other partner is a “silent”
partner that the partner who spends his or her time working for the
company should receive a salary. However, this must be specified in
the partnership agreement.
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Using Real Data
25.
a. $1,855,600,000
b. $696,400,000
c. $85,300,000
d. $4,700,000
e. $8,700,000
f. $482,500,000
g. $338,000,000
h. $1,219,500,000
i.
$(68,900,000)
j.
$573,000,000
k. $(500,000)
l.
$129,200,000
m. $27,000,000
n.
$108,200,000
o. $(68,100,000)
p. $(20,000,000) Note: must be computed from the change in the
balance sheet accumulated other comprehensive income from 1999
to 2000 (68,900,000- 48,900,000).
26.
Earnings are increasing each year from 1998-2000 from a loss of
$51 million in 1998 to positive earnings of $37.7 million in 2000 (an
increase of 174%).
27.
Cash flow from operations rose from 1998 to 1999 but fell sharply
in 2000 (to minus $500,000) a decrease of 101%.
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28.
Sales are fairly flat. They increased slightly in 1999 from 1998 but
overall the change in sales from 1998 to 2000 is only an increase of 1%.
29. Total assets: $927,207 (in thousand)
Total liabilities: $101,419+105,000+152,403+32,301=$391,123
Total stockholders’ equity: $536,084
$391,123 + $536,084 =$927,207.
30.
All amounts are in thousands of $
a. $1,214,628
b. $429,825
c. $8,169
d. $36,787
e. $60,011
f.
$7,329
g. $35,686
h. $447,943
i. $120,000
j.
$170,147
k. $169,113
l.
$4,710
m. $10,000
n.
$(113,218)
31. During 2000 Werner repaid long term and short-term debt in the
amount of $50,000 and borrowed only $10,000. Werner supported its
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cash needs primarily from cash from operation. Since this cash belongs
to owners you could say it financed its cash needs primarily from owners
equity. Looking at the balance sheet Werner’ equity financing is about
58% of its overall financing ($536,084/927,207).
32. Two largest sources:
Cash from operations $170,147
Retirement of property and equipment $60,608
Two largest uses:
Additions to plant and equipment: $169,113
Repayment of short and long-term debt; $50,000 (25,000 s.t. + 25,000 l.t.)
33. The biggest reason is due to depreciation expense. Depreciation is a
non-cash charge and was $109,107 thousand. In addition deferred tax
liability increased implying that cash paid for income taxes was less than
the expense. This amount was $18,751 thousand. These two items
account for a total difference between cash from operations and net
income of $127,858. The difference between net income and cash from
operations was $122,124; thus most of the difference can be attributed to
these items. The balance is due primarily to changes if various non-cash
current asset and current liability accounts.
34. Note to Instructors: In the earlier drafts of this chapter we had
covered comprehensive income. However, in the final version this was
dropped. We inadvertently left this problem in the chapter and will be
removing it in the next printing and replacing it with a different problem.
$(34,000) (note the 1999 balance in the accumulated comprehensive loss
account was zero.
35. 12/31/2000 was a Sunday. The closing price the previous Friday
December 29, 2000 was $17. Shares outstanding on that date were
47,039,290. Hence the total market cap for Werner as of 12/31/2000 was
$17 x 47,039,290 = $799,667,930. The book value of Werner’s
shareholders’ equity on that date was $536,084,000. The ratio of the
market value to the book value is 1.49. The higher market value of
Werner’s stock than its book value occurs because accounting does not
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reflect all economic resources and because the book value is based
primarily on historic cost while market value reflects expectations about
future cash inflows.
36. July 1.
37. a. $245,307,000
b.
$120,812,000
c. 0 or not material. No interest is reported and Emulex has no
notes or bonds payable. The cash flow statement reports some principal
payments on capital leases suggesting that there would be some interest
on this but the amount appears immaterial.
d. $32,187,000
e. 2001 -$52,085,000 (reported with other intangibles on cash
flow statement and on the income statement)
2000- 0
f.
$(23,603,000) loss
g.
$38,616,000
h.
$590,316,000
i.
$861,461,000
j.
$59,941,000
k. $(54,785,000)
l.
$10,844,000
38. Emulex finances its business primarily from owners. Total
Stockholder’s equity is $876,686,000 and total liabilities are only
$41,328,000. 95% of Emulex is financed with equity. The only debt relates
to operating liabilities.
39. They issued common stock and options in the amount of
$661,678,000.
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40.
1999
2000
2001
Sales
$68,485,000
$139,772,000
$245,307,000
Income
$5,265,000
$32,814,000
$(23,603,000)
Sales have grown 258% between 1999 and 2001. Income grew 523% from
1999 to 2000 but in 2001 the company suffered a loss of over $23 million.
The primary reason for the loss seems to be due to amortization of
goodwill and the associated tax effects and the write-off of in-process R&D
acquired in the acquisition. Note that the provision for taxes is greater than
income before tax suggesting that the goodwill amortization and write off of
in-process R&D were not tax deductible. Without these two charges
Emulex would have reported income before taxes of $82,949,000, and net
income of $50,762,000.
41. No. The cash flow statement shows no dividends. Also this can be
verified from the balance sheet.
Beginning Retained earnings + net income – dividends = ending retained
earnings
$43,014,000 -$23,603,000 =$19,411,000
42. July 1, 2000 was a Sunday. The price on the most recent trading date
(June 29, 2000) was $40.4 Shares outstanding were 81,799,322 for a total
market capitalization of 81,799,322 x $40.4 = $3,304,692,609. The book
value of equity as of that date is $876,686,000. The ratio of the market
value to book value for Emulex is $3,304,692,609/$876,686,000= 3.77.
Emulex is a high tech company that designs, develops and sells fibre
channel host bus adaptors (HBA’s). Emulex appears to engage in
considerable research and development activities that may create value for
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Emulex. However, because of high uncertainty in future realizations GAAP
requires that Emulex expense these costs. Note that separate from the inprocess R&D write off that Emulex reported engineering and development
cost of over $27 million on 2001. At the time of the July 1, 2000 balance
sheet the market valued Emulex’s future cash flow prospects as much
stronger than reflected on the balance sheet. Most recently Emulex’s stock
price has plunged and as of October 25, 2004 Emulex is trading at a little
over $10/share suggesting a significant drop in the market’s view of its
prospects.
Beyond the Book
The answers depend on the company selected.
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