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Chapter 5 Communicating and Interpreting Accounting Information ANSWERS TO QUESTIONS 2. Financial analysts, who normally work for brokerage and investment banking houses, mutual funds, and investment advisory services, gather extensive financial and nonfinancial information about a company, on which they base forecasts and stock purchase and sale recommendations. Private investors include individuals who purchase shares in companies, often on the basis of recommendations from financial analysts. Institutional investors are managers of pension, mutual, endowment, and other funds that invest on behalf of others. 4. To be useful, information must be relevant; that is, it must be timely and have predictive and/or feedback value. However, if the information is not reliable (accurate, unbiased, and verifiable) it will not be relied upon, and thus will not be useful. 7. Public companies issue quarterly press releases, quarterly reports, and annual reports to shareholders and Forms 10Q (quarterly reports), 10K (annual reports), and 8-K (special events) reports to the SEC. Press releases include a summary of the quarterly report information and are the first announcement of quarterly financial information. The quarterly reports normally present unaudited summary income statement and balance sheet information along with an abbreviated management discussion and analysis. Annual reports are often elaborate reports including extensive discussions and color photos. The financial section includes: (1) summarized financial data for a 5- or 10-year period; (2) management’s discussion and analysis of financial condition and results of operations and disclosures about market risk; (3) the four basic financial statements; (4) notes (footnotes); (5) report of independent registered public accounting firm (auditor’s opinion) and the management certification; (6) recent stock price information; (7) summaries of the unaudited quarterly financial data; and (8) listings of directors and officers of the company and relevant addresses. The Form 10-Q and 10-K, provide more detailed information than the quarterly and annual reports including additional disclosures not included in those reports. The 8-K is issued irregularly when special events such as a change in auditors occur. 8. The four major subtotals or totals on the income statement are: (a) gross profit, (b) income from operations, (c) income before income taxes, and (d) net income. McGraw-Hill/ Irwin Financial Accounting, 6/e © The McGraw-Hill Companies, Inc., 2009 5-1 9. Extraordinary items are reported on the income statement separately. They are items that are both unusual and infrequent. They are set out separately to aid the user in evaluating the profit performance of the business. Inclusion of extraordinary items in the regularly occurring revenue and expense categories would lead the user to believe that they are normal and will recur often in the future, which would be misleading. 10. The six major classifications on the balance sheet are: (a) current assets, (b) noncurrent assets, (c) current liabilities, (d) long-term liabilities, (e) contributed capital and (f) retained earnings. 12. The major classifications of stockholders’ equity are: (1) contributed capital, which represents the stockholders' investments and (2) retained earnings, which represent the earnings of the company to date less any dividends paid to the owners. Contributed capital is often split between the account common stock (which consists of a nominal legal amount called par value) and additional paid-in capital. 15. Return on equity (ROE) is a ratio measure defined as net income divided by average stockholders’ equity. It measures how much the firm earned for each dollar of stockholders’ investment. A return on equity analysis provides an overall framework for evaluating company performance by breaking down ROE into its three determinants: net profit margin, asset turnover, and financial leverage. Together, these indicate why ROE differs from prior levels or that of competitors, and provide insights into strategies to improve ROE in future periods. McGraw-Hill/ Irwin 5-2 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual EXERCISES E5-2. Information Release E (1) Form 10-K B (2) Quarterly report D (3) Press release C (4) Form 10-Q F (5) Annual report A (6) Form 8-K McGraw-Hill/ Irwin Financial Accounting, 6/e Definition A. Report of special events (e.g., auditor changes, mergers) filed by public companies with the SEC. B. Brief unaudited report for quarter normally containing summary income statement and balance sheet (unaudited). C. Quarterly report filed by public companies with the SEC that contains additional unaudited financial information. D. Written public news announcement that is normally distributed to major news services. E. Annual report filed by public companies with the SEC that contains additional detailed financial information. F. Report containing the four basic financial statements for the year, related notes, and often statements by management and auditors. © The McGraw-Hill Companies, Inc., 2009 5-3 E5-6. Req. 1. Lance Inc. Consolidated Balance Sheet December 31, Current Year (in millions) Assets CURRENT ASSETS Cash and cash equivalents Accounts receivable, net Inventories Prepaid expenses and other Other current assets Total current assets Property, plant and equipment, net Goodwill Other intangible assets, net Other assets TOTAL ASSETS Liabilities and Stockholders’ Equity CURRENT LIABILITIES Accounts payable Accrued compensation Other payables and accrued liabilities Current portion of long-term debt Total current liabilities NONCURRENT LIABILITIES Long-term debt Accrued postretirement health care costs Other long-term liabilities Total noncurrent liabilities STOCKHOLDERS' EQUITY Common stock, 28,947,222 outstanding Additional paid-in capital Retained earnings Total stockholders' equity TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY McGraw-Hill/ Irwin 5-4 $ 1,224 47,188 23,205 6,550 4,161 82,328 179,283 42,069 10,177 3,216 $317,073 $ 14,718 8,844 15,439 395 39,396 63,536 11,317 28,231 103,084 24,123 1,229 149,241 174,593 $317,073 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual E5-6. (continued) Req. 2. In each case, the term “net” means that the account is reported after the balance in the related contra account has been subtracted. Accounts receivable, net means that the allowance for doubtful accounts contra account has been subtracted. Other intangible assets, net means that the accumulated amortization contra account has been subtracted. Property, plant and equipment, net means that the accumulated depreciation contra account has been subtracted. E5-8. Req. 1. Beginning RE + Net income - Dividends = Ending RE Dividends = Beginning RE + Net income - Ending RE Dividends = $177,277,000 + $50,371,000 - $227,648,000 = $0 Oakley paid no dividends during the year. Req. 2. Cash (+A) ....................................................... 4,323,000 Common stock ($688,000 – $686,000) (+SE) 2,000 Additional paid-in capital ($40,805,000 – $36,484,000) (+SE) 4,321,000 McGraw-Hill/ Irwin Financial Accounting, 6/e © The McGraw-Hill Companies, Inc., 2009 5-5 E5-9. Terms A G K E F D J H C B I (1) Net income (2) Pretax income from operations (3) Income before extraordinary items (4) Cost of goods sold (5) Operating expenses (6) Gross margin on sales (7) EPS (8) Interest expense (9) Service revenue (10) Income tax expense on operations (11) Extraordinary item McGraw-Hill/ Irwin 5-6 Definitions A. Revenues + Gains - Expenses - Losses including effects of discontinued operations and extraordinary items (if any). B. Income tax on revenues minus operating expenses. C. Sales of services for cash or on credit. D. Sales revenue minus cost of goods sold. E. Amount of resources used to purchase or produce the goods that were sold during the reporting period. F. Total expenses directly related to operations. G. Income before all income tax and before discontinued operations and extraordinary items (if any). H. Cost of money (borrowing) over time. I. Item that is both unusual and infrequent. J. Net income divided by average shares outstanding. K. Income before unusual and infrequent items and the related income tax. L. None of the above. © The McGraw-Hill Companies, Inc., 2009 Solutions Manual E5-12. THAYER APPLIANCES, INCORPORATED Income Statement For the Year Ended December 31, 2010 Sales revenue ................................ Cost of goods sold ......................... (a) Gross profit..................................... Operating expenses: Administrative expense ............... Selling expense ........................... Total operating expenses ......... (b) Income before income taxes .......... (c) Income tax expense ................... (d) Net income ..................................... (e) Computations in Order Given $130,000 - $60,000 (given) Given $130,000 70,000 60,000 Given $16,000 Given 18,000 $16,000 + $18,000 $60,000 - $34,000 25%* x $26,000 $26,000 - $6,500 34,000 26,000 6,500 $19,500 Earnings per share ($19,500 2,500 shares*) = $7.8 *Given McGraw-Hill/ Irwin Financial Accounting, 6/e © The McGraw-Hill Companies, Inc., 2009 5-7 E5-17. Req. 1. Net income (given) Average Shareholders' Equity (given) Current Year $33,563 = 0.24 $140,610 Prior Year $46,797 = 0.31 $148,790 The decrease in ROE from 0.31 in the prior year to 0.24 in the current year means that the firm earned $0.07 less for each $1 of stockholders’ investment. Req. 2. ROE Analysis Net Income Net Sales Current Prior Year Year $33,563 = 0.037 $46,797 = 0.049 $917,378 $946,219 x Net Sales Average Total Assets $917,378 = 2.57 $357,023 $946,219 = 2.51 $377,136 x Average Total Assets Average Shareholders' Equity $357,023 = 2.54 $140,610 $377,136 = 2.53 $148,790 Return on Equity 0.24 0.31 The decrease in ROE is caused by the decrease in profit margin (from .049 in the prior year to .037 in the current year). Req. 3. Security analysts would be more likely to decrease their estimates of share value on the basis of this change. The company decreased its earnings by $0.07 for each $1 of stockholders’ investment and, hence, decreased the corresponding value of that investment. McGraw-Hill/ Irwin 5-8 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual PROBLEMS P5-3. Req. 1 GOLD JEWELERS Balance Sheet December 31, 2011 Assets Current Assets Cash ........................................................................... Accounts receivable .................................................... Prepaid insurance ....................................................... Merchandise inventory ................................................ Total current assets ............................................ Long-Term Investments Stock of Z Corporation ................................................ Fixed Assets Store equipment ......................................................... Less accumulated depreciation .............................. Total fixed assets ............................................... Other Assets Used store equipment held for disposal ..................... Total assets ........................................................ Liabilities Current Liabilities Accounts payable ....................................................... Income taxes payable ................................................. Total current liabilities ........................................ Long-Term Liabilities Note payable .............................................................. Total liabilities..................................................... Stockholders' Equity Contributed Capital Common stock, par $1 per share, 100,000 shares ..... Additional paid-in capital ............................................. Total contributed capital ..................................... Retained Earnings ............................................................. Total stockholders' equity ................................... Total liabilities and stockholders' equity ............. McGraw-Hill/ Irwin Financial Accounting, 6/e $ 58,000 71,000 1,000 154,000 $284,000 36,000 67,000 13,000 54,000 9,000 $383,000 $ 58,000 9,000 $ 67,000 42,000 109,000 100,000 10,000 110,000 164,000 274,000 $383,000 © The McGraw-Hill Companies, Inc., 2009 5-9 P5-3. (continued) Req. 2 Store equipment $67,000 - $13,000 = $54,000 Acquisition cost less sum of all depreciation expense to date. Net book value (sometimes called book value or carrying value) is the amount of cost reported on the balance sheet less any contra accounts (offsets). P5-5. TOMMY HILFIGER CORPORATION Consolidated Statement of Income For Year Ended March 31, Current Year In Thousands Except Per Share Amounts Net revenue Cost of goods sold Gross profit Depreciation and amortization Other selling, general and administrative expenses Total operating expenses Operating income Interest expense Interest income Income before income taxes Provision for income taxes Net income Earnings per share: Basic earnings per share Weighted average shares outstanding McGraw-Hill/ Irwin 5-10 $1,875,797 1,012,156 863,641 76,307 583,502 659,809 203,832 31,756 3,577 175,653 37,445 $138,208 $1.52 90,692 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual CASES AND PROJECTS ANNUAL REPORT CASES CP5-3. Req. 1. American Eagle Outfitters Net Income _ Average Stockholders’ Equity $387,359 $(1,417,312+1,155,552)/2 = 0.30 Urban Outfitters $116,206 = .19 $(675,283+560,880)/2 American Eagle Outfitters provided the highest return to shareholders during the current year. Req. 2. Net Income Net Sales Net Sales Average Total Assets American Eagle Outfitters 387,359 2,794,409 = 0.14 2,794,409 1,796,566.5 = 1.56 116,206_ 1,224,717 1,224,717 834,228 Average Total Assets Average Stockholders’ Equity 1,796,566.5 = 1.40 1,286,432 834,228 618,081.5 = 1.35 ROE Analysis Return on Equity 0.30 Urban Outfitters = 0.09 = 1.47 0.19 American Eagle Outfitters has a higher ROE than Urban Outfitters because it is higher in all three measures: It has a higher profit margin, a higher asset turnover ratio, and a higher financial leverage ratio. Ownership of property, plant, and equipment decreases the total asset turnover ratio relative to rentals. The owned assets would be included in “average total assets” while rented assets would not be included—thus, for the same level of sales, asset turnover would be lower. McGraw-Hill/ Irwin Financial Accounting, 6/e © The McGraw-Hill Companies, Inc., 2009 5-11 CP5-3. (continued) Req. 3. Industry Return on Equity (ROE) profit driver analysis: ROE = Net Profit Margin Asset Turnover Financial Leverage Industry Average American Eagle Outfitters Urban Outfitters Net Profit Margin .077 .139 .095 Asset Turnover 1.85 1.56 1.47 Financial Leverage 1.77 1.40 1.35 Return on Equity 0.25* 0.30* 0.19* ROE Analysis *product slightly different due to rounding American Eagle has a higher ROE than the industry average. This is being driven solely by their higher net profit margins. This is expected, given that the company competes by differentiating their product rather than competing only on price. Both firms have asset turnover lower than the industry average, and are not quite as highly levered. Urban Outfitters has a lower ROE than the industry average because its higher net profit margin is not high enough to make up for its lower asset turnover and financial leverage. McGraw-Hill/ Irwin 5-12 © The McGraw-Hill Companies, Inc., 2009 Solutions Manual