Solutions Manual CHAPTER 11 UNDERSTANDING FINANCIAL STATEMENTS
EVIEW QUESTIONS AND PROBLEMS SUGGESTED ANSWERS TO THE R EVIEW
I.
Questions
1. The four four financia financiall state statemen ments ts contain contained ed in most annual annual reports reports are the balance sheet statement, statement of comprehensive income, statement of stockholders’ equity, and statement of cash flows. 2. Bank Banker erss and and inve invest stor orss use use fina financ ncia iall stat statem emen ents ts to make make inte intell llig igen entt decis decision ionss about about what what firms firms to etend etend credit credit or in which which to inves invest, t, mana manage gers rs need need fina financ ncia iall stat statem emen ents ts to oper operat atee thei theirr busi busine ness sses es effi effici cien entl tly y, and and tai taing ng auth author orit itie iess need need them them to asse assess ss tae taess in a reasonable way. !. "o, because because the the #2$ million million of of retained retained earning earningss would would probably probably not not be held as cash. The retained earnings figure figure represents the reinvestment reinvestment of earnings by the the firm over its life. life. %onsequently, %onsequently, the #2$ million would be an investment in all all of the firm’s firm’s assets. &. The balance balance sheet sheet shows shows the firm’s firm’s financ financial ial positio position n on a specific specific date, date, for eample, 'ecember !1, 2$11. 2$11. (t shows each account account balance at that particular point in time. )or eample, the cash account shown on the balance sheet would represent the cash the firm has on hand and in the bank on 'ecember !1, 2$11. 2$11. The income statement, on the other hand, reports on the firm’s operations over a period of time, for eample, over the last 12 months. months. (t reports reports revenues revenues and epenses epenses that the firm has incurred over that that particular time period. )or eample, the sales sales figures reported on the income statement for the period ending 'ecember !1, 2$11, would represent the firm’s sales over the period from *anuary 1, 2$11, through 'ecember !1, 2$11, not +ust sales for 'ecember !1, 2$11. 2$11. . (nvest (nvestors ors need need to be cautio cautious us when they review review financ financial ial statem statement ents. s. -hile companies are required to follow the financial reporting standard, managers still have quite a lot of discretion in deciding how and when to report certain transactions. transactions. %onsequently, %onsequently, two firms in eactly the same operating situation may report financial statements that convey different 11-1
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Understanding Financial Statements
impressions about their financial strength. ome variations may stem from legitimate differences of opinion about the correct way to record transactions. (n other cases, managers may choose to report numbers in a way that helps them present either higher earnings or more stable earnings over time. /s long as they follow the financial reporting standard, such actions are not illegal, but these differences make it harder for investors to compare companies and gauge their true performances. 0nfortunately, there have also been cases where managers overstepped the bounds and reported fraudulent statements. (ndeed, a number of highprofile eecutives have faced criminal charges because of their misleading accounting practices. . The earnings 3less dividends4 reported in the income statement is transferred to the ownership section of the balance sheet as retained earnings. Thus, what we earn in the income statement becomes part of the ownership interest in the balance sheet. 5. The balance sheet is based on historical costs. -hen prices are rising rapidly, historical cost data may lose much of their meaning particularly for plant, equipment and inventory. 6. The income statement and balance sheet are based on the accrual method of accounting, which attempts to match revenues and epenses in the period in which they occur. 7owever, accrual accounting does not attempt to properly assess the cash flow position of the firm. The statement of cash flows fulfills this need. 8. The three primary sections of the statement of cash flows are9 a4 %ash flows from operating activities b4 %ash flows from investing activities c4 %ash flows from financing activities The payment of cash dividends falls into the financing activities category.
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1$. )ree cash flow is equal to cash flow from operating activities9 :inus9
%apital ependitures required to maintain the productive capacity of the firm
:inus9
'ividends 3required to maintain the payout on common stock and to cover any preferred stock obligation4
The analyst or banker normally looks at free cash flow to determine whether there are sufficient ecess funds to pay back the loan associated with the leveraged buyout. 11. (nterest epense is a ta deductible item to the corporation, while dividend payments are not. The net cost to the corporation of interest epense is the amount paid multiplied by the difference of one minus the applicable ta rate. 12. %0;;<"T 3%4 = ">"%0;;<"T ? 3"%4 ;etained earnings /ccounts payable @repaid epenses @lant and equipment (nventory %ommon stock
"% % % "% % "%
Bonds payable /ccrued wages payable /ccounts receivable %apital in ecess of par @referred stock :arketable securities
1!. ales %ost of Aoods old Aross profit elling and administrative epense 'epreciation epense >perating profit (nterest epense
utstanding
"% % % "% "% %
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Understanding Financial Statements
1&. (ncrease in accounts receivable (ncrease in notes payable 'epreciation epense (ncrease in investments 'ecrease in accounts payable 'ecrease in prepaid epenses (ncrease in inventory 'ividend payment (ncrease in accrued epenses
'ecreases cash flow 3use4 (ncreases cash flow 3source4 (ncreases cash flow 3source4 'ecreases cash flow 3use4 'ecreases cash flow 3use4 (ncreases cash flow 3source4 'ecreases cash flow 3use4 'ecreases cash flow 3use4 (ncreases cash flow 3source4
1. 1. 2. !. &.
Balance heet 3B4 (ncome tatement 3(4 %urrent /ssets 3%/4 )ied /ssets 3)/4
(ndicate whether (tems is on Balance heet 3B4 or (ncome tatement 3(4 B ( B B B B B ( ( B B B B ( ( B B (
. %urrent iabilities 3%4 . ongterm iabilities 34 5. tockholders’
(f on Balance heet, 'esignate which %ategory < %/ < < %
%/ % %/ )/
%/ %
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(tem
;etained earnings (ncome ta epense /ccounts receivable %ommon stock %apital in ecess of par value Bonds payable "otes payable "et income elling and administrative epenses (nventories /ccrued epenses %ash @lant and equipment ales >perating epenses :arketable securities /ccounts payable (nterest epense
Understanding Financial Statements
B II. Problems
%
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(ncome ta payable
P"o$l!% # &Balan'! Sh!!t(
)rom the data given in the problem, we know the following9 %urrent assets "et plant and equipment
Total assets a.
# $$,$$$
/ccounts payable and accruals "otes payable 2,$$$,$$$ %urrent liabilities ongterm debt Total common equity Total liabilities and #2,$$,$$$ equity
# 1$$,$$$ 1$,$$$ # 2$,$$$ 5$,$$$ 1,$$,$$$ #2,$$,$$$
-e are given that the firm’s total assets equal #2,$$,$$$. ince both sides of the balance sheet must equal, total liabilities and equity must equal total assets C #2,$$,$$$.
b. Total assets C %urrent assets D "et plant and equipment #2,$$,$$$ C %urrent assets D #2,$$$,$$$ %urrent assets C #2,$$,$$$ ? #2,$$$,$$$ %urrent assets C #$$,$$$ c.
Total liabilities and equity C %urrent liabilities D ongterm debt D Total common equity #2,$$,$$$ C %urrent liabilities D #5$,$$$ D #1,$$,$$$ #2,$$,$$$ C %urrent liabilities D #2,2$,$$$ %urrent liabilities C #2,$$,$$$ ? #2,2$,$$$ %urrent liabilities ) #2$,$$$
d. %urrent liabilities C /ccounts payable and accruals D "otes payable #2$,$$$ C /ccounts payable and accruals D #1$,$$$ /ccounts payable and accruals C #2$,$$$ ? #1$,$$$ /ccounts payable and accruals C #1$$,$$$ e.
"et working capital C %urrent assets ? %urrent liabilities "et working capital C #$$,$$$ ? #2$,$$$ "et working capital C #2$,$$$
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f.
Understanding Financial Statements
"et operating working capital C %urrent assets ? 3%urrent liabilities ? "otes payable4 "et operating working capital C #$$,$$$ ? 32$,$$$ ? #1$,$$$4 "et operating working capital C #&$$,$$$
P"o$l!% * &Stat!%!nt o+ Sto',hol-!"s E/uit0(
"( C #$,$$$,$$$= ;E
*ennifer’s /pparel a.
b.
Total assets %urrent liabilities ongterm liabilities tockholders’ equity @referred stock "et worth assigned to common %ommon shares outstanding
!$,$$$
Book value 3net worth4 per share
#1.$
c.
#6$$,$$$ 1$,$$$ 12$,$$$ #!$,$$$ ,$$$ #&,$$$
#&6,$$$ !$,$$$ #1.$
:arket value per share 3price4 to Book value per share #2&.$$ H #1.$ C 1.
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Understanding Financial Statements
d.
2 2
x x
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Book value per share C @rice #1.$ C #!1.$$
@rice
C @E<
C 18.!5 @E< ratio
round to 18
P"o$l!% 3 &D!t!"%ination o+ P"o+ita$ilit0(
;ed Book (nc. tatement of %omprehensive (ncome ales 31,!$$ books at #$ each4 %ost of goods sold 31,!$$ books at #&$ each4 Aross @rofit elling epense 'epreciation epense >perating profit (nterest epense
#6&,$$$ 6,$$$ 2$,$$$ 2$,$$$ $,$$$ 16$,$$$ !,$$$ 1&,$$$ 28,$$$ #11,$$$
P"o$l!% 4 &D!t!"%ination o+ P"o+ita$ilit0(
Toyota /uto hop tatement of %omprehensive (ncome a.
ales %ost of goods sold 35$J of sales4 Aross profit elling and administrative epense 312J of sales4 'epreciation >perating profit (nterest epense
#5$$,$$$ &8$,$$$ 21$,$$$ 6&,$$$ 1$,$$$ 11,$$$ 6,$$$ 1$6,$$$ !2,&$$
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b.
Understanding Financial Statements
perating profit (nterest epense
# 5,$$ #5$,$$$ &8,$$$ 2,$$$ 1$,$$$ 1$,$$$ 1&$,$$$ 1,$$$ 12,$$$ !5,$$ #65,$$
Analysis: :s. im’s idea will increase profitability. P"o$l!% 5 &D!t!"%ination o+ Ea"nin6s an- Ea"nin6s !" Sha"!(
/ngelique %orporation a.
;etained earnings, 'ec. !1, 2$12 ess9 ;etained earnings, 'ec. !1, 2$11 %hange in retained earnings /dd9 %ommon stock dividends
b.
#5,$$$ 2$,$$$ shares
#&$,$$$ &$$,$$$ $,$$$ 2,$$$ # 5,$$$
C #!.5 per share
P"o$l!% 7 &Const"u'tion o+ In'o%! Stat!%!nt an- Balan'! Sh!!t(
hadow %orporation 2$12 (ncome tatement a.
ales %ost of goods sold 3$J4 Aross profit elling and administrative epense 'epreciation epense 36J4 >perating profit 3
#22$,$$$ 1!2,$$$ 66,$$$ 22,$$$ 2$,$$$ 1 &,$$$ 6,$$$ 2 !6,$$$
Understanding Financial Statements
Taes 32$J4
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5,$$ !$,&$$ 2,$$$ #2&,6$$
hares outstanding
1$,$$$
#2.6&
hadow %orporation 2$12 tatement of ;etained
;etained earnings balance, *an. 1, 2$11 /dd9
# 6$,$$$ 26,&$$ 6,&$$ #1$$,$$$
hadow %orporation 2$12 Balance heet c.
Assets %urrent assets %ash /ccounts receivable (nventory @repaid epenses Total current assets )ied assets Aross plant /ccumulated depreciation "et plant Total assets Liabilities and Owners’ equity iabilities9 /ccounts payable "otes payable Bonds payable 11-9
#1$,$$$ 1,$$ 25,$$ 12,$$$ #,$$$ 26,$$$ 35$,$$$4 ! 21,$$$ #261,$$$
#1,$$$ 2,$$$ &$,$$$
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Understanding Financial Statements
Total liabilities >wners’ equity9 ! #$,$$$ D #2$,$$$ C #5$,$$$ %ommon stock @aid in capital in ecess of par ;etained earnings Total equity Total liabilities and equity
#61,$$$ # 5,$$$ 2,$$$ 1$$,$$$ #2$$,$$$ #261,$$$
P"o$l!% 8 &Stat!%!nt o+ Cash 9lo:s(
:aris %orporation tatement of %ash )lows )or the Fear
#2$,$$$
2!$,$$$ 31$,$$$4 3!$,$$$4 !$,$$$ 2$,$$$ 32$,$$$4 &$,$$$ #5$$,$$$
%ash flows from investing activities9 'ecrease in investments (ncrease in plant and equipment "et cash flows from investing activities
1$,$$$ 3$$,$$$4
%ash flows from financing activities9 (ncrease in bonds payable @referred stock dividends paid %ommon stock dividends paid "et cash flows from financing activities
$,$$$ 31$,$$$4 31&$,$$$4
"et increase 3decrease4 in cash flows
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38$,$$$4
38$,$$$4 #2$,$$$
Understanding Financial Statements
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Analysis: (t should be observe that the increase in cash flows of #2$,$$$ equals the #2$,$$$ change in the cash account on the balance sheet. This indicates the statement is correct. a.
%ash flows from operating activities far eceeds net income. This occurs primarily because we add back depreciation of #2!$,$$$ and accounts payable increase by #2$,$$$. Thus, the reader of the cash flow statement gets important insights as to how much cash flow was developed from daily operations.
b. The buildup in plant and equipment of #$$,$$$ 3gross4 and #!5$,$$$ 3net4 has been financed, in part, by the large increase in accounts payable 3#2$,$$$4. This is not a very satisfactory situation. hortterm sources of funds can always dry up while fied asset needs are permanent in nature. The firm may wish to consider more longterm financing such as a mortgage, to go along with profits, the increase in bonds payable and the add back of depreciation. c.
The book value per common share for both 2$11 and 2$12 are9 Book value per share
C
tockholders’ equity K @referred stock %ommon shares outstanding
Book value per share 32$114
C
3#1,!8$,$$$ K #8$,$$$4 1$,$$$
C
#1,!$$,$$$ 1$,$$$
32$114
C
#6.5
Book value per share 32$124
C
3#1,&8$,$$$ K #8$,$$$4 1$,$$$
C
#1,&$$,$$$ 1$,$$$
C
#8.!!
32$124
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Understanding Financial Statements
d. The firm’s @E< ratio for 2$12 is9 :arket value C 2.6 @E< ratio
x
C #2.12 H
#8.!! C #2.12 #1.$ C 1.!2 round to 1
P"o$l!% ; &P"!a"in6 a Balan'! Sh!!t(
: )arms Balance heet eptember !$, 2$12 a.
Assets %ash /ccounts receivable and Barns and sheds %itrus trees ivestock (rrigation system )arm machinery )ences and gates Total assets
#1,51$ 22,! $,$$$ 56,!$$ 5,$ 12$,56$ 2$,12 &2,85$ !!,5$ #81,&5$
Liabilities and Owners’ equity iabilities9 "otes payable /ccounts payable @roperty taes payable -ages payable Total liabilities >wners’ equity9 hare capital ;etained earningsL Total liabilities and equity b.
#!$,$$$ 55,$8 8,1! 1,62$ #16,$$ #2$,$$$ 8!,&2$ #81,&5$
The loss of an asset, barns and heds, from a typhoon would cause a decrease in total assets. -hen total assets are decreased, the balance sheet total of liabilities and equity must also decrease. ince there is no change in liabilities as a result of the
L
Total assets, #81,&5$, minus total liabilities, #16,$$, less share capital, #2$,$$$. 11-12
Understanding Financial Statements
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destruction of an asset, the decrease on the right hand side of the balance sheet must be in the retained earnings account. The amount of the decrease in Barns and heds, in the equity, and in both balance sheet totals is #2!,6$$. P"o$l!% #< &P"!a"in6 a Balan'! Sh!!t an- Cash 9lo: Stat!%!nt= E++!'ts o+ Busin!ss T"ansa'tions(
The Tasty Bakery Balance heet /ugust 1, 2$12 a.
Assets %ash /ccounts receivable upplies and Building
#,8&$
Total assets
#22$,5$$
11,2$ 5,$$$ 5,$$$ 6&,$$$ &&,$$
Liabilities and Owners’ equity iabilities9 "otes payable # 5&,8$$ /ccounts payable 1,2$$ alaries payable 6,8$$ Total liabilities 1$$,$$$
The Tasty Bakery Balance heet /ugust !, 2$12 b.
Assets %ash #1&,&8$ /ccounts receivable 11,2$ upplies 6,2$ and 5,$$$ Building 6&,$$$
Total assets
#2!,5$$ 11-13
Liabilities and Owners’ equity iabilities9 "otes payable # 5&,8$$ /ccounts payable 5,2$$ alaries payable 6,8$$ Total liabilities 81,$$$
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Understanding Financial Statements
The Tasty Bakery tatement of %ash )lows )or the @eriod /ugust 1 ? !, 2$12 %ash flows from operating activities9 %ash payment of accounts payable %ash purchase of supplies %ash used in operating activities
#31,2$$4 31,2$4 #315,&$4
%ash flows from investing activities9 "one %ash flows from financing activities9 ale of share capital (ncrease in cash %ash balance, /ugust 1, 2$12 %ash balance, /ugust !, 2$12 c.
2,$$$ 5,$ ,8&$ # 1&,&8$
The Tasty Bakery is in a stronger financial position on /ugust ! than it was on /ugust 1. >n /ugust 1, the highly liquid assets 3cash and accounts receivable4 total only #16,2$$ but the company has #2,1$$ in debts due in the near future 3accounts payable plus salaries payable4. >n /ugust !, after additional infusion of cash from the sale of stock, the liquid assets total #2,5$, and debts due in the near future amount to #1,1$$. Note to Instructor 9 The analysis of financial position strength in requirement 3c4 is based solely upon the balance sheets at /ugust 1 and /ugust !. 7opefully, students will raise many legitimate issues regarding necessity of information about operations, rate at which cash flows into the business, etc. (n this problem, the improvement in financial position results solely from the sale of share capital.
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Understanding Financial Statements
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P"o$l!% ## &P"!a"in6 9inan'ial Stat!%!nts= E++!'ts o+ Busin!ss T"ansa'tions(
The )irst :alt hop Balance heet eptember !$, 2$12 a.
Assets %ash /ccounts receivable upplies and Building )urniture and fitures
#
5,&$$
Total assets
#1!2,8$
1,2$ !,&&$ ,$$$ &,$$ 2$,$$$
Liabilities and Owners’ equity iabilities9 "otes payableL # 5$,$$$ /ccounts payable 6,$$ Total liabilities 56,$$
LTotal assets, #1!2,8$, less equity, #&,$8$, less accounts payable, #6,$$, equals notes payable. The )irst :alt hop Balance heet >ctober , 2$12 b.
Assets %ash /ccounts receivable upplies and Building )urniture and fitures
# 28,&$$
Total assets
#15!,8$
1,2$ &,&&$ ,$$$ &,$$ !6,$$$
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Liabilities and Owners’ equity iabilities9 "otes payable # 5$,$$$ /ccounts payable 16,$$$ Total liabilities 66,$$$
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Understanding Financial Statements
The )irst :alt hop (ncome tatement )or the @eriod >ctober 1 ? , 2$12 ;evenues <penses "et income
# ,$$ 3&,$$$4 # 1,$$
The )irst :alt hop tatement of %ash )lows )or the @eriod >ctober 1 ? , 2$12 %ash flows from operating activities9 %ash received from revenues %ash paid for epenses %ash paid for accounts payable %ash for paid supplies %ash used in operating activities
#,$$ 3&,$$$4 36,$$4 31,$$$4 #36,$$$4
%ash flows from investing activities9 "one %ash flows from financing activities9 %ash received from sale of share capital
#!$,$$$
(ncrease in cash %ash balance, >ctober 1, 2$12 %ash balance, >ctober , 2$12
#22,$$$ 5,&$$ #28,&$$
c.
The )irst :alt hop is in a stronger financial position on >ctober than on eptember !$. >n eptember !$, the company had highly liquid assets 3cash and accounts receivable4 of #6,$, which barely eceeded the #6,$$ in liabilities 3accounts payable4 due in the near future. >n >ctober , after the additional investment of cash by shareholders, the company’s cash alone eceeded its shortterm obligations.
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