Chapter 5 solutions



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 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.

EXERCISES

E5-2.

Information Release Definition

| E (1) Form 10-K |A. Report of special events (e.g., auditor changes, mergers) filed by public |

|B (2) Quarterly report |companies with the SEC. |

|D (3) Press release |B. Brief unaudited report for quarter normally containing summary income statement |

|C (4) Form 10-Q |and balance sheet (unaudited). |

|F (5) Annual report |C. Quarterly report filed by public companies with the SEC that contains additional |

|A (6) Form 8-K |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)

|Assets | |

| CURRENT 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 income |A. Revenues + Gains - Expenses - Losses including effects of discontinued operations |

|G (2) Pretax income from operations |and extraordinary items (if any). |

|K (3) Income before extraordinary items |B. Income tax on revenues minus operating expenses. |

|E (4) Cost of goods sold |C. Sales of services for cash or on credit. |

|F (5) Operating expenses |D. Sales revenue minus cost of goods sold. |

|D (6) Gross margin on sales |E. Amount of resources used to purchase or produce the goods that were sold during |

|J (7) EPS |the reporting period. |

|H (8) Interest expense |F. Total expenses directly related to operations. |

|C (9) Service revenue |G. Income before all income tax and before discontinued operations and extraordinary |

|B (10) Income tax expense on operations |items (if any). |

|I (11) Extraordinary item |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.

| | |Current |Prior |

| | |Year |Year |

|Net income (given) | | $33,563 = 0.24 | $46,797 = 0.31 |

|Average Shareholders' Equity (given) | |$140,610 |$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 |Current |Prior |

| |Year |Year |

| Net Income | $33,563 = 0.037 | $46,797 = 0.049 |

|Net Sales |$917,378 |$946,219 |

|x Net Sales |$917,378 = 2.57 |$946,219 = 2.51 |

|Average Total Assets |$357,023 |$377,136 |

|x Average Total Assets |$357,023 = 2.54 |$377,136 = 2.53 |

|Average Shareholders' Equity |$140,610 |$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.

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 CORPORATION |

|Consolidated 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 Outfitters |

|Net Income _ Average | $387,359 = 0.30 | $116,206 = .19 |

|Stockholders’ Equity |$(1,417,312+1,155,552)/2 |$(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 Outfitters |

| Net Income | 387,359 = 0.14 | 116,206_ = 0.09 |

|Net Sales |2,794,409 |1,224,717 |

| Net Sales | 2,794,409 = 1.56 | 1,224,717 = 1.47 |

|Average Total Assets |1,796,566.5 |834,228 |

| Average Total Assets |1,796,566.5 = 1.40 | 834,228 = 1.35 |

|Average Stockholders’ Equity |1,286,432 |618,081.5 |

| Return on Equity |0.30 |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.

CP5-3. (continued)

Req. 3.

Industry Return on Equity (ROE) profit driver analysis:

ROE = Net Profit Margin ( Asset Turnover ( Financial Leverage

|ROE Analysis |Industry |American Eagle Outfitters |Urban Outfitters |

| |Average | | |

| 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.

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