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.
9.Extraordinary items are reported on the income statement separately. They are items that are both unusualand 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.
EXERCISES
E5-2.
Information Release Definition
E(1) Form 10-KB(2) Quarterly report
D(3) Press release
C(4) Form 10-Q
F(5) Annual report
A(6) Form 8-K / 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.
E5-6.
Req. 1.
Lance Inc.
Consolidated Balance Sheet
December 31, Current Year
(in millions)
AssetsCURRENT ASSETS
Cash and cash equivalents / $ 1,224
Accounts receivable, net / 47,188
Inventories / 23,205
Prepaid expenses and other / 6,550
Other current assets / 4,161
Total current assets / 82,328
Property, plant and equipment, net / 179,283
Goodwill / 42,069
Other intangible assets, net / 10,177
Other assets / 3,216
TOTAL ASSETS / $317,073
Liabilities and Stockholders’ Equity
CURRENT LIABILITIES
Accounts payable / $ 14,718
Accrued compensation / 8,844
Other payables and accrued liabilities / 15,439
Current portion of long-term debt / 395
Total current liabilities / 39,396
NONCURRENT LIABILITIES
Long-term debt / 63,536
Accrued postretirement health care costs / 11,317
Other long-term liabilities / 28,231
Total noncurrent liabilities / 103,084
STOCKHOLDERS' EQUITY
Common stock, 28,947,222 outstanding / 24,123
Additional paid-in capital / 1,229
Retained earnings / 149,241
Total stockholders' equity / 174,593
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY / $317,073
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
E5-9.
Terms Definitions
A (1) Net incomeG (2) Pretax income from operations
K (3) Income before extraordinary items
E (4) Cost of goods sold
F (5) Operating expenses
D (6) Gross margin on sales
J (7) EPS
H (8) Interest expense
C (9) Service revenue
B (10) Income tax expense on operations
I (11) Extraordinary item / 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.
E5-12.
THAYER APPLIANCES, INCORPORATED
Income Statement
For the Year Ended December 31, 2010
Computations in Order
Sales revenue...... Given $130,000
Cost of goods sold...... (a)$130,000 - $60,000 (given) 70,000
Gross profit...... Given 60,000
Operating expenses:
Administrative expense...... Given $16,000
Selling expense...... Given 18,000
Total operating expenses....(b)$16,000 + $18,000 34,000
Income before income taxes.....(c)$60,000 - $34,000 26,000
Income tax expense...... (d)25%* x $26,000 6,500
Net income...... (e)$26,000 - $6,500 $19,500
Earnings per share ($19,500 2,500 shares*) = $7.8
*Given
E5-17.
Req. 1.
CurrentYear / Prior
Year
Net income (given)
Average Shareholders' Equity (given) / $33,563 = 0.24
$140,610 / $46,797 = 0.31
$148,790
The decrease in ROE from 0.31in 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
/ CurrentYear / Prior
Year
Net Income
Net Sales
/ $33,563 = 0.037$917,378 / $46,797 = 0.049
$946,219
x Net Sales
Average Total Assets
/ $917,378 = 2.57$357,023 / $946,219 = 2.51
$377,136
xAverage Total Assets
Average Shareholders' Equity
/ $357,023 = 2.54$140,610 / $377,136 = 2.53
$148,790
Return on Equity
/ 0.24 / 0.31The 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 decreasetheir estimates of share value on the basis of this change. The company decreased its earnings by $0.07for each $1 of stockholders’ investment and, hence, decreased the corresponding value of that investment.
PROBLEMS
P5-3.
Req. 1
GOLD JEWELERS
Balance Sheet
December 31, 2011
Assets
Current Assets
Cash...... $ 58,000
Accounts receivable...... 71,000
Prepaid insurance...... 1,000
Merchandise inventory...... 154,000
Total current assets...... $284,000
Long-Term Investments
Stock of Z Corporation...... 36,000
Fixed Assets
Store equipment...... 67,000
Less accumulated depreciation...... 13,000
Total fixed assets...... 54,000
Other Assets
Used store equipment held for disposal...... 9,000
Total assets...... $383,000
Liabilities
Current Liabilities
Accounts payable...... $ 58,000
Income taxes payable...... 9,000
Total current liabilities...... $ 67,000
Long-Term Liabilities
Note payable ...... 42,000
Total liabilities...... 109,000
Stockholders' Equity
Contributed Capital
Common stock, par $1 per share, 100,000 shares... 100,000
Additional paid-in capital...... 10,000
Total contributed capital...... 110,000
Retained Earnings...... 164,000
Total stockholders' equity...... 274,000
Total liabilities and stockholders' equity...... $383,000
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 CORPORATIONConsolidated Statement of Income
For Year Ended March 31, Current Year
In Thousands Except Per Share Amounts
Net revenue / $1,875,797
Cost of goods sold / 1,012,156
Gross profit / 863,641
Depreciation and amortization / 76,307
Other selling, general and administrative expenses / 583,502
Total operating expenses / 659,809
Operating income / 203,832
Interest expense / 31,756
Interest income / 3,577
Income before income taxes / 175,653
Provision for income taxes / 37,445
Net income / $138,208
Earnings per share:
Basic earnings per share / $1.52
Weighted average shares outstanding / 90,692
CASES AND PROJECTS
ANNUAL REPORT CASES
CP5-3.
Req. 1.
American Eagle Outfitters / Urban OutfittersNet Income _ Average Stockholders’ Equity / $387,359 = 0.30
$(1,417,312+1,155,552)/2 / $116,206 = .19
$(675,283+560,880)/2
American Eagle Outfitters provided the highest return to shareholders during the current year.
Req. 2.
ROE Analysis
/ American Eagle Outfitters / Urban OutfittersNet Income
Net Sales
/ 387,359 = 0.142,794,409 / 116,206_ = 0.09
1,224,717
Net Sales
Average Total Assets
/ 2,794,409 = 1.561,796,566.5 / 1,224,717 = 1.47
834,228
Average Total Assets
Average Stockholders’ Equity
/ 1,796,566.5 = 1.401,286,432 / 834,228 = 1.35
618,081.5
Return on Equity
/ 0.30 / 0.19American 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.
CP5-3. (continued)
Req. 3.
Industry Return on Equity (ROE) profit driver analysis:
ROE = Net Profit Margin Asset Turnover Financial Leverage
ROE Analysis
/ IndustryAverage / 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**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© The McGraw-Hill Companies, Inc., 2009
Financial Accounting, 6/e 5-1