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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.
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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
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© 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
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© 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
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© 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
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© 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.
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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
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© The McGraw-Hill Companies, Inc., 2009
Solutions Manual