Chapter 05 - Financial Reporting and Analysis

Chapter 05 - Financial Reporting and Analysis

Chapter 5

Financial Reporting and Analysis

ANSWERS TO QUESTIONS

1.Managers at all levels within a company use accounting information to run the business by making decisions, such as obtaining debt versus issuing more shares.

Directors use accounting information to oversee the business. One decision the directors make is the CEO’s pay.

Creditors use accounting information to administer business contracts by evaluating loan covenant compliance.

Investors value the business by using accounting information to estimate future earnings and share price.

Government agencies regulate businesses, relying on accounting information to determine income taxes for example.

2.The three points of the fraud triangle are incentive (which answers the question, “Why would someone commit fraud?”), opportunity (which answers the question “How would someone commit a fraud?”) and personality(which answers the question, “Who would commit a fraud?”). If any one of the elements is missing, (the person lacks the incentive, lacks the opportunity, or does not possess a questionablepersonality), the chances are less likely that a fraud will be committed.

3.Managers can be motivated to misreport financial results to create business opportunities (by satisfying loan covenants, increasing equity financing, and attracting business partners) and to satisfy personal greed (enhancing job security, increasing personal wealth, and obtaining a bigger paycheck).

4.The changes made to corporate governance in Canada counteracts the incentive to commit fraud by stipulating steeper fines and longer jail terms for those who willfully misrepresent financial data.

5.The changes made to corporate governance in Canada reduces the opportunity to commit fraud by requiring that management monitor their internal controls and submit a report that indicates whether the controls over financial reporting operated effectively. The board of directors must appoint an audit committee to oversee the financial matters of the company. External auditors must test the effectiveness of the company’s internal controls and submit a report stating whether they agree with the internal control report issued by management.

6.The changes made to corporate governance in Canada attempts to encourage good personality in employees by mandating the creation of confidential tip lines whereby employees can report potentially fraudulent conduct. It also offers protection to whistle-blowers.

7.Auditors provide quality assurance by reporting on the effectiveness of a company’s internal controls over financial reporting and byproviding an independent opinion about whether the company’s financial statements are prepared in accordance with GAAP.

8.Like fraudulent financial reporting, academic dishonesty will occur only if an individual has incentives, opportunities, and the personality to cheat. Like the impact of bonuses and share options on managers, the impact of potentially higher grades on assignments and exams may heighten the incentive to cheat. The opportunity to cheat depends on how closely managers (and students) are audited (watched) and how much subjectivity is involved in determining whether fraud (academic dishonesty) has been committed. Finally, whether someone will act on these incentives and opportunities depends on the personality of the individual involved. We’d like to believe that most students possess apersonalityto “do the right thing” and not succumb to the temptation to cheat.

9.The financial statements of companies using IFRS may differ from what was shown in Chapters 1-4 in the following ways:

• A company may present comparative financial statements, which show account balances for more than one period in order to facilitate comparison of a company’s past performance from one period to the next.
• A company may present multistep income statements, which divide income and expenses into subtotals for core and peripheral activities.
• Finally, a company may present a more comprehensive version of the statement of retained earnings called the statement of shareholders’ equity.
• The statement titles may be different (ie, Balance Sheet vs Statement of Financial Position)
• The order of items on the Statement of Financial Position are different based on liquidity and time to maturity.

10. Countries are adopting IFRS to reduce or eliminate differences in accounting rules that have developed previously on a country-by-country basis. As well, these improvements in comparability are needed as a result of increasing globalization in corporate operations and investing.

11. Three main differences between GAAP and IFRS financial statements are:

• Financial Statement Titles: the financial statements report similar items but under different titles.
• Presentation of Expenses: similar expenses are reported, but they may be grouped in different ways.
• Balance Sheet Order: similar accounts are shown, but they are presented in different order of liquidity (for assets) and order of maturity (for liabilities).

12. Two commonly used benchmarks are:

• Prior periods - By comparing a company’s current period results to its own results in prior periods, we can gain a sense of how the company’s performance is changing over time.
• Competitors - Although an analysis focused on one company is useful, it doesn’t show what’s happening in the industry. To get this industry-wide perspective, most analysts will compare competitors within a particular industry.

13.The goal of ratio analysis is to get to the heart of how a company performed given the resources it had available.

14.There are four parts to the business model:

• Obtain financing from lenders and investors, which is used to invest in assets.
• Invest in assets, which are used to generate revenues.
• Generate revenues, which produce net income.
• Produce net income, which is needed to satisfy lenders and investors.

15.The key to understanding why averages are included in some ratios but not others is to remember that the income statement reports the results of an entire period of time, whereas the balance sheet reports the results at a single point in time. Some ratios are calculated by combining information from both the income statement and balance sheet. The asset turnover ratio, for example, takes sales revenue from the income statement for the top part of the ratio and total assets from the balance sheet for the bottom. To allow the bottom part of the ratio to represent the same time period as the top, we need to calculate the average of the beginning and ending balance sheet amounts. When calculating ratios that use only balance sheet amounts, we would take the ending balance sheet amount for the calculation.

16.The debt-to-assets ratio assesses the sources of financing of the company’s assets and is used in assessing financial risk. The asset turnover ratio evaluates how well assets are used to generate sales and measures efficiency. The net profit margin ratio determines the ability of the company to control expenses incurred to generate revenues and measures performance.

Authors' Recommended Solution Time

(Time in minutes)

Mini-exercises / Exercises / Problems / Skills Development Cases* / Continuing
Case
No. / Time / No. / Time / No. / Time / No. / Time / No. Time
1 / 5 / 1 / 10 / CP5-1 / 10 / 1 / 20 / 1 30
2 / 10 / 2 / 10 / CP5-2 / 10 / 2 / 20 / 2 20
3 / 5 / 3 / 10 / CP5-3 / 10 / 3 / 30
4 / 3 / 4 / 10 / CP5-4 / 20 / 4 / 40
5 / 5 / 5 / 5 / PA5-1 / 10 / 5 / 20
6 / 3 / 6 / 5 / PA5-2 / 10 / 6 / 20
7 / 5 / 7 / 10 / PA5-3 / 10 / 7 / 40
8 / 3 / 8 / 15 / PA5-4 / 5
9 / 5 / 9 / 5 / PA5-5 / 20
10 / 5 / 10 / 5 / PB5-1 / 10
11 / 5 / 11 / 5 / PB5-2 / 10
12 / 5 / PB5-3 / 10
13 / 10 / PB5-4 / 20
PB5-5 / 20
C5-1 / 60
C5-2 / 60
C5-3 / 60

* Due to the nature of cases, it is very difficult to estimate the amount of time students will need to complete them. As with any open-ended project, it is possible for students to devote a large amount of time to these assignments. While students often benefit from the extra effort, we find that some become frustrated by the perceived difficulty of the task. You can reduce student frustration and anxiety by making your expectations clear, and by offering suggestions (about how to research topics or what companies to select). The skills developed by these cases are indicated below.

Case / Financial Analysis / Research / Ethical Reasoning / Critical Thinking / Technology / Writing / Teamwork
1 / x
2 / x
3 / x / x / x / x / x
4 / x / x / x
5 / x / x / x / x
6 / x / x / x
7 / x / x

ANSWERS TO MINI-EXERCISES

M5-1

Players / Definitions
____C____(1)Independent auditors
____A____(2)External users
____B____(3)Directors / A.Investors and creditors (among others).
B.People who are elected by shareholders to oversee a company’s management.
C.Professional accountants who examine financial statements and attest to their fairness.

M5-2

Nutboy TheatRE Company

Income Statement

For the Year Ended December 31, 2014

Revenues:
Ticket Sales / $ 50,000
Concession Sales / 2,500
Total Sales Revenues / 52,500
Operating Expenses:
Salaries and Wage Expense / 30,000
Advertising Expense / 8,000
Utilities Expense / 7,000
Total Operating Expenses / 45,000
Income from Operations / 7,500
Other Revenue (Expense):
Interest Revenue / 200
Other Revenue / 50
Income before Income Tax Expense / 7,750
Income Tax Expense / 2,500
Net Income / $ 5,250

Net Profit Margin = Net Income / Total Sales Revenues

= $5,250 / $52,500

= 10%

Nutboy produced more net income per dollar of sales (ten cents) than in the previous year (8 cents).

M5-3

WOR Productions
Statement of Shareholders’ Equity
For the Year Ended December 31, 2014
Contributed
Capital / Retained
Earnings
Balances at December 31, 2013 / $ 100,000 / $ 20,000
Short-term investments / - / -
Net Income ($120,000- 87,000) / 33,000
Dividends Declared / (5,000)
Issuance of Shares / 50,000
Balances at December 31, 2014 / $ 150,000 / $ 48,000

M5-4

Transaction / Assets / Liabilities / Shareholders’ Equity
a. / +500 / NE / Services Revenue (+R)+500
b. / +50 / +50 / NE
c. / NE / +1,000 / Advertising Expense (+E) –1,000

The effects of the transactions can be seen by making the related journal entries.

a.dr Accounts Receivable (+A) ...... 500

cr Services Revenue (+R, +SE)...... 500

b.dr Supplies (+A)...... 50

cr Accounts Payable (+L) ...... 50

c.dr Advertising Expense (+E,–SE) ...... 1,000

cr Accounts Payable (+L) ...... 1,000

M5-5

Transaction / Debt-to-Assets / Asset Turnover / Net Profit Margin
a. / – / CD / +
b. / + / − / NE
c. / + / NE / –

M5-6

Transaction / Assets / Liabilities / Shareholders’ Equity
a. / +90,000 / NE / Contributed Capital+90,000
b. / +4,000 / +4,000 / NE
c. / -1,000 / NE / Depreciation Expense (+E) –1,000

The effects of the transactions can be seen by making the related journal entries.

a.dr Cash (+A) ...... 90,000

cr Contributed Capital (+SE) ...... 90,000

b.dr Equipment (+A) ...... 4,000

cr Note Payable (long-term) (+L)...... 4,000

c.dr Depreciation Expense (+E, –SE) ...... 1,000

cr Accumulated Depreciation (+xA,-A)...... 1,000

M5-7

Transaction / Debt-to-Assets / Asset Turnover / Net Profit Margin
a. / – / – / NE
b. / + / – / NE
c. / + / + / –

M5-8

a)Income from Operations

b)Income before Income Tax Expense

c)100

d)480

e)80 (from December 31, 2013 Balance Sheet)

f)120

g)480

h)180

M5-9

ELECbooks Corporation

Statement of Financial Position

At December 31

2014 / 2013
Assets
Total Assets / $800 / $600
Shareholders’Equity and Liabilities
Shareholders’ Equity
Contributed Capital / $480 / $400
Retained Earnings / 180 / 80
Total Shareholders’ Equity / 660 / 480
Total Liabilities / 140 / 120
Total Shareholders’ Equity and Liabilities / $800 / $600

M5-10

Prior Year

Net profit margin / = / Net Income / = / $850 / = / .094 / = / 9.4%
Sales Revenue / $9,000

Current Year

Net profit margin / = / Net Income / = / $700 / = / .10 / = / 10%
Sales Revenue / $7,000

Happy’s has increased its net profit margin to 10% in the current year from 9.4% in the prior year. This means that, in the current year, Happy’s made about 10 cents of profit for each dollar of sales. The increase in net profit margin indicates that Happy’s has improved its control of expenses incurred to generate revenues.

M5-11

Prior Year

Debt-to-assets / = / Total Liabilities / = / $10,000 – $8,000 / = / .20 / = / 20%
Total Assets / $10,000

Current Year

Debt-to-assets / = / Total Liabilities / = / $9,000 – $7,500 / = / .167 / = / 16.7%
Total Assets / $9,000

The debt-to-assets ratio indicates the percentage of assets financed by debt. This is a sign of the company’s financing risk. This analysis indicates that Happy’s has moved towards less debt financing with a decrease in debt-to-assets from 20% in the prior year to 16.7% in the current year, making the company less risky.

M5-12

Current Year

Asset turnover / = / Sales Revenue / = / $7,000 / = / $7,000 / = / 0.737
Average Total Assets / ($10,000 + $9,000)/2 / $9,500

The asset turnover ratio determines how efficiently assets are used to generate sales. Happy’s generated less sales per dollar invested in assets in the current year (0.737) than in the prior year (0.852), which means the company decreased its efficiency in using assets to generate sales.

M5-13

a. Generating Sales from Assets

Columbia

Asset turnover / = / Sales Revenue / = / $1,484 / = / $1,484 / = / 1.18
Average Total Assets / ($1,295 + $1,213)/2 / $1,254

Levi Strauss

Asset turnover / = / Sales Revenue / = / $4,326 / = / $4,326 / = / 1.41
Average Total Assets / ($3,135 + $2,989)/2 / $3,062

Levi Strauss appears to be more efficient at generating sales from assets. It generates $1.41 for every dollar of assets, versus $1.18 for Columbia.

b. Generating Net Income from Sales

Columbia

Net profit margin / = / Net Income / = / $77 / = / .052 / = / 5.2%
Sales Revenue / $1,484

Levi Strauss

Net profit margin / = / Net Income / = / $149 / = / 0.34 / = / 3.4%
Sales Revenue / $4,326

Columbia is more effective at generating net income from sales. For every dollar of sales, Columbia generates just over 5 cents in net income, versus 3.4 cents per dollar for Levi Strauss.

ANSWERS TO EXERCISES

E5-1

Components / Definitions
D(1) Investor information Web site
C (2) External auditor
A (3) Investor
B (4) Creditor
___E_(5)CSA / A.Individual who purchases shares in companies for personal ownership or for pension funds or mutual funds.
B.Financial institution or supplier that lends money to the company.
C.Independent professional accountant who examines financial statements and attests to their fairness.
D.Gathers, combines, and transmits financial and related information from various sources.
E.Canadian Securities Administratorswhich has regulators from every province and territory in Canada, monitors the information that is reported in financial statements prepared by public companies.

E5-2

Answers / Events
B (1) Users of financial statements
D (2) Objective of financial statements
G (3) Faithful representation
F (4) Comparability
E (5) Separate entity
A (6) Unit of measure
I (7) Cost principle
C (8) Revenue recognition principle
H (9) Expense recognition principle / A.Counted unused supplies at the end of the period and valued them in Canadian dollars.
B.Analyzed the financial statements to assess the company’s performance.
C.Established an accounting policy that sales revenue shall be recognized only when services have been provided to the customer.
D.Prepared and distributed financial statements that provide useful financial information for creditors and investors.
E.Established a policy not to include in the financial statements the personal financial affairs of the owners of the business.
F.Used the same accounting policies over several years to facilitate analyses.
G. Established policies to report the company’s business activities in a way that depicts their economic substance.
H.Adjusted the rent accounts to show the cost of rent used up in the current period.
I. Acquired a vehicle for use in the business, reporting it at the agreed-upon purchase price rather than its higher sticker price.

E5-3

Req. 1

The company is referring to the characteristic of comparability. By changing the year-end date, the company allows more meaningful cross-sectional analysis with other firms in the industry.

Req. 2

Yes, all the ratios will be meaningful in 2014. The debt-to-assets ratio will not be affected by the change since it looks at a specific point in time. The asset turnover is meaningful if it is compared to other nine-month periods or “scaled” to a full year by multiplying by 12/9. The net profit margin ratio is still meaningful since both the top and the bottom of the ratio are for the same time period.

E5-4

Req. 1

The reason given seems to be internal to THQ since it will make it easier for THQ to provide “financial guidance” (i.e. earnings forecasts). The change in year-end may be more useful to users if it enhances comparability with other companies.

Req. 2

Yes, all the ratios will be meaningful for the period. The debt-to-assets ratio will not be affected by the change since it looks at a specific point in time. The asset turnover is meaningful if it is compared to other three month periods or “scaled” to a full year by multiplying by 12/3. The net profit margin ratio is still meaningful since both the top and the bottom of the ratio are for the same time period.

E5-5

2013

Net profit margin / = / Net Income / = / $1,341 / = / .074 / = / 7.4%
Sales Revenue / $18,236

2012

Net profit margin / = / Net Income / = / $2,082 / = / .125 / = / 12.5%
Sales Revenue / $16,689

Cendant Corporation’s net profit margin has decreased from 12.5% in 2012 to 7.4% in 2013. This means that in 2013, Cendant made about 7 cents of profit for each dollar of sales. The decrease in net profit margin indicates that Cendant’s performance of controlling expenseswhile generating sales deteriorated.

E5-6

Req. 1

The company waited so long to issue the press release because it needed that time to determine the adjusting journal entries, prepare the financial statements and have the audit completed.

E5-7

Req. 1

2014

Asset turnover / = / Total Revenues / = / $1,132 / = / 2.87
Average Total Assets / ($402 + $386)/2

2013

Asset turnover / = / Total Revenues / = / $1,064 / = / 2.72
Average Total Assets / ($380 + $402)/2

2014

Net profit margin / = / Net Income / = / $37 / = / .033 / = / 3.3%
Total Revenues / $1,132

2013

Net profit margin / = / Net Income / = / $33 / = / .031 / = / 3.1%
Total Revenues / $1,064

Req. 2

The asset turnover ratio determines how well assets are used to generate sales. This analysis indicates that the company has increased its efficiency in using assets to generate sales, from 2.72 to 2.87.

Net profit margin measures a company’s ability to control expenses while generating sales. This analysis indicates the company’s performance in this area has improved from 3.1% to 3.3%.

Analysts would most likely increase their estimates of share value, since there was an increase in the net profit margin and the asset turnover ratio.

E5-8

Req. 1

2014

Asset turnover / = / Sales Revenue / = / $4,225 / = / 1.98
Average Total Assets / ($2,284 + $1,990)/2

2013

Asset turnover / = / Sales Revenue / = / $4,252 / = / 2.09
Average Total Assets / ($1,990 + $2,070)/2

2014

Net profit margin / = / Net Income / = / $192 / = / .045 / = / 4.5%
Sales Revenue / $4,225

2013

Net profit margin / = / Net Income / = / $237 / = / .056 / = / 5.6%
Sales Revenue / $4,252

Req. 2

The asset turnover ratio determines how well assets are used to generate sales. This analysis indicates that the company has decreased its efficiency in using assets to generate sales from 2.09 in 2013 to 1.98 in 2014.

Net profit margin measures a company’s ability to control expenses while generating sales. This analysis indicates that the company’s performance in this regard has declined from 5.6% in 2013 to 4.5% in 2014.

Analysts would be concerned with the decrease in asset turnover (decreased sales per dollar invested in assets) and the declining net profit margin (less profit per dollar of sales). This would cause share analysts to decrease their estimates of share value.

Req. 3

2014

Debt-to-assets / = / Total Liabilities / = / $1,466 / = / .642 / = / 64.2%
Total Assets / $2,284

2013

Debt-to-assets / = / Total Liabilities / = / $1,220 / = / .613 / = / 61.3%
Total Assets / $1,990

Req. 4

The debt-to-assets ratio indicates the percentage of assets financed by debt as a sign of the company’s financing risk. This analysis indicates that the company has increased its debt financing from 61.3% in 2013 to 64.2% in 2014. Analysts would likely decrease their estimates of SnarkShark’s ability to repay lenders because the company increased its relative reliance on debt financing, making the company more risky.