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1Chapter 3 Financial Statements, Cash Flows, and Taxes LEARNING OBJECTIVES 1. Discuss generally accepted accounting principles (GAAP) and their importance to the economy. GAAP are a set of authoritative guidelines that define accounting practices at a particular point in time. Thus, GAAP principles determine the rules for how a company maintains its accounting system and how it prepares financial statements. Accounting standards are important because without them, each firm could develop its own unique accounting practices, which would make it difficult for stakeholders to monitor the firm’s true performance or compare the performance of different firms. The result would be a loss of confidence in the accounting system and the financial reports it produces. 2. Know the balance sheet identity, and explain why a balance sheet must balance. A balance sheet provides a summary of a firm’s financial position at a particular point in time. The balance sheet identifies the productive resources (assets) that a firm uses to generate income, as well as the sources of funding from creditors (liabilities) and owners (shareholders’ equity) that were used to buy the assets. The balance sheet identity is: Total assets = Total liabilities + Total stockholders’ equity. Stockholders’ equity represents ownership in the firm and is the residual claim of the owners after all other obligations to creditors, employees, and vendors have been paid. The balance sheet must always balance because the owners get what is left over after all creditors have been paid—that is, Total stockholders’ equity = Total assets – Total liabilities. 2 3. Describe how market-value balance sheets differ from book-value balance sheets. Book value is the amount a firm paid for its assets at the time of purchase. The current market value of an asset is the amount that a firm would receive for the asset if it was sold on the open market (not in a forced liquidation). Most managers and investors are more concerned about what a firm’s assets can earn in the future than in what the assets cost in the past. Thus, balance sheets marked to market are more helpful in showing a company’s true financial condition than balance sheets based on historical costs. Of course, the problem with marked-to-market balance sheets is that it is difficult to estimate market values for some assets and liabilities. In addition, there are fears that the management of some firms may be tempted to manipulate the estimates of market value to favorably distort their firm’s true financial picture. 4. Identify the basic equation for the income statement and the information it provides. An income statement is a snapshot that provides a picture of the firm’s profit or loss for a period of time, usually a month, quarter, or year. The income statement identifies the major sources of revenues generated by the firm and the corresponding expenses that were needed to generate those revenues. The equation for the income statement is: Net income = Revenues – Expenses. If revenues exceed expenses, the firm generates a net profit for the period. If expenses exceed revenues, the firm generates a net loss. Net profit or income is the most comprehensive accounting measure of a firm’s performance. 5. Explain the difference between cash flows and accounting income. 3 Cash flows represent the movement of cash within the firm. Cash flows are important in finance because the value of any asset—stocks, bonds, or a business—is determined by the future cash flows generated by the asset. Accounting profits, in contrast, are calculated according to GAAP to determine taxes and to report to stakeholders in a consistent manner. Accounting profits include noncash revenues (such as prepaid rent) and noncash expenses (such as depreciation), whereas cash flows do not include these items. 6. Explain how the four financial statements discussed in this chapter are related. The four financial statements discussed in this chapter are the balance sheet, the income statement, the statement of cash flows, and the statement of retained earnings. The key financial statement that ties the other three statements together is the statement of cash flows, which summarizes changes in the balance sheet from the beginning of the year to the end. These changes reflect the information in the income statement and in the statement of retained earnings. 7. Discuss the difference between the average and marginal tax rates. The average tax rate is the total taxes divided by taxable income. It takes into account the taxes paid at all levels of income, and therefore it will be lower than the marginal tax rate, which is the rate that is paid on the last dollar of income earned. However, for very high income earners, these two rates can be equal. When companies are making financial decisions, they use the marginal tax rate, because new projects are expected to generate additional cash flows, which will be taxed at the firm’s marginal tax rate. 4 I. 1. True or False Questions GAAP represents a set of guidelines that define accounting practice at a particular point in time. a. b. True False 2. GAAP principles determine the rules for how a company can issue stock to raise money. a. b. True False 3. Hong Kong and India use a variant of U.K. GAAP. a. b. True False 4. The cost principle assumes that both parties to a transaction are economically rational and are free to act independently of each other. a. b. True False 5 5. The balance sheet identifies the productive resources (assets) that a firm uses to generate income, as well as the sources of funding from creditors (liabilities) and owners (shareholders’ equity) that were used to buy the assets. a. b. True False 6. The balance sheet identity can be stated as Total assets = Total liabilities + Total stockholders’ equity. a. b. True False 7. The balance sheet identity can be stated as Total assets – Total liabilities = Total stockholders’ equity. a. b. True False 6 8. Book value is the amount a firm paid for its assets at the time of purchase. a. b. True False 9. The book value of an asset is the historical cost of the asset less the accumulated depreciation. a. b. True False 10. The current market value of an asset is the amount that a firm would receive for the asset if it was sold on the open market. a. b. True False 11. Preparing a market-value balance sheet is rather straightforward because it is easy to obtain market values for all assets and liabilities. a. b. True False 7 12. The net cash flow from operating activities (NCFOA) is another term for net income. a. b. True False 13. The income statement identifies the major sources of revenues generated by the firm and the corresponding expenses that were needed to generate those revenues. a. b. True False 14. Accounting profits include noncash revenues (e.g., prepaid rent) and noncash expenses (e.g., depreciation), whereas cash flows do not include these items. a. b. True False 15. The key financial statement that ties the other three statements together is the balance sheet, which summarizes the firm’s investment and financing activities at a point in time. a. b. True False 8 16. The average tax rate is the total taxes divided by taxable income. It takes into account the taxes paid at all levels of income, and therefore it will usually be lower than the marginal tax rate, which is the rate that is paid on the last dollar of income earned. a. b. True False 17. Depreciation and amortization are examples of prepaid expenses. a. b. True False 18. Cash flows from operations are the net cash flows that support a firm’s principal business activities. a. b. True False 19. Rent and insurance are examples of depletion expenses. a. b. True False 9 20. Cash flows from operating activities relate to the buying and selling of long-term assets. a. b. True False 21. Making and collecting loans, issuing and paying out on insurance contracts, and buying and selling debt or equity instruments of other firms are examples of financing activities. a. b. True False 22. Typical financing activities include cash payments on the principal of long-term debt, cash payments of dividends to shareholders, and cash purchases of treasury stock. a. b. True False 23. The going concern assumption states that a business will be shutting down its operation in the near future. a. b. True False 10 24. In a rising price environment, a company using the LIFO method assumes that the sale of a product is from the newest, highest-cost inventory. a. b. True False 25. If a company values its inventory using the FIFO method, when the firm makes a sale in a rising price environment, it assumes the sale is from the newest, highest-cost inventory. a. b. True False 11 II. 26. Multiple-Choice Questions Which of the following sections do annual reports typically contain? a. b. c. d. financial summary related to the past year’s performance information about the company, its products, and its activities audited financial statements, including limited historical financial data All three of the above sections are included in the annual report. 27. Annual reports are prepared by a firm’s management to a. b. c. d. communicate to shareholders the firm’s failures in the previous year. provide overview of the firm’s financial and operating performance. highlight the performance of its chief competitors. provide a forecast of the economy in the coming years. 28. The generally accepted accounting principles (GAAP) are a. b. c. rules that outline how a firm can operate ethically. rules on how the firm will be valued in the event of a merger. rules and procedures that define how companies are to maintain financial records and prepare financial reports. 12 d. rules for how a company can issue stock to raise money. 29. Accounting standards prescribed by GAAP are important because a. b. c. they make the financial statements of all firms standardized. they allow one to examine a firm’s performance over time. they make it possible for management or analysts to compare the firm’s performance to that of other competitors. d. all of the above. 30. The assumption of arm’s-length transaction states that a. both parties to a transaction can act independently of each other and make economically rational decisions. b. c. both parties to a transaction must have had previous transactions. one of the parties to the transaction is a bank that has full knowledge of the firm’s creditworthiness. d. none of the above 13 31. Your uncle, who has a second home in Bethany Beach, Delaware, is planning to sell it in the next few weeks. You are interested in buying this beachside property, so your agent negotiates a price for the house with your uncle’s agent. This transaction is an example of a. b. c. d. e. The cost principle. the assumption of arm’s-length transactions. the realization principle. the going-concern assumption. the matching principle. 32. The going concern assumption implies that a. b. c. a firm will continue to be in business for the foreseeable future. a firm will be going out of business in the near future. a firm will continue to operate in the near future but only after being acquired by another firm. d. none of the above 33. Dell Computer Corporation has receivables of $2.5 million and inventory worth $1.8 million. The firm plans to borrow $2 million for working capital purposes from Austin First National Bank. In evaluating the loan request, the bank should place the most emphasis on 14 a. b. c. d. the matching principle. the realization principle. the going-concern assumption. the assumption of arm’s-length transactions. 34. The matching principle calls for the accountant of a firm to a. b. identify an asset with each liability of the firm. associate the revenue generated from a sale to the costs incurred to produce the product. c. d. match each item of inventory with the historical cost at which it was acquired. none of the above 35. Tyson Corporation bought raw materials on April 23, 2008 and also on July 2, 2008. Products produced in the months of May were sold in July. The firm uses FIFO to value its inventory. According to the matching principle, the firm’s accountant should associate a. b. c. d. the inventory acquired on July 2 with the products sold. the inventory acquired on April 23 with the products sold. Neither of these dates is valid because the products were sold in July. None of the above. 15 36. According to the realization principle, revenue from a sale of the firm’s products are recognized a. b. c. d. when the products are shipped to the buyer. when the buyer orders the goods. when cash is realized from the sale of the products. at the time of the sale. 37. On June 23, 2008, Mikhal Cosmetics sold $250,000 worth of its products to Rynex Corporation, with the payment to be made in 90 days on September 20. The goods were shipped to Rynex on July 2. The firm’s accountants should recognize the sale on a. b. c. d. June 23, 2008. July 2, 2008. September 20, 2008. none of the above. 38. The cost principle states that an asset should reflect its a. tmarket value. 16 b. market value less the accumulated depreciation on the asset. historical cost. none of the above. c. d. 39. Trekkers Footwear bought a piece of machinery on January 1, 2006 at a cost of $2.3 million, and the machinery is being depreciated annually at an amount of $230,000 for 10 years. Its market value on December 31, 2008 is $1.75 million. The firm’s accountant is preparing its financial statement for the fiscal year end on December 31, 2008. The asset’s value should be recognized on the balance sheet at a. b. c. d. $2.3 million. $1.61 million. $230,000. $1.75 million. 40. International accounting standards are said to be “principles based,” implying that a. b. there are explicit rules to cover virtually every situation a firm may encounter. they are no different than the U.S. GAAP in the directions provided to accountants. 17 c. it calls for relying more on general guidelines than on precise rules for how companies must report transactions. d. All of the above are true. 41. Current assets can generally considered to a. b. have little value. have been completely depreciated. be converted to cash within one year. have been financed with owners equity. c. d. 42. Petra, Inc., has $400,000 as current assets, $1.225 million as plant and equipment, and $250,000 as goodwill. In preparing the balance sheet, these assets should be listed in which of the following orders? a. b. c. d. current assets, goodwill, and plant and equipment current assets, plant and equipment, and goodwill goodwill is not an asset and is not listed here none of the above. 18 43. When prices are rising, valuing ending inventory using the FIFO method rather than LIFO gives a. b. c. d. inventory a higher value but lowers net income. inventory a lower value and also lowers net income. both inventory and net income a higher value. inventory a lower value and net income a higher value. 44. When prices are falling, valuing inventory using the LIFO method rather than FIFO gives a. b. c. d. inventory a higher value but lowers net income. inventory a lower value and also lowers net income. both inventory and net income a higher value. inventory a lower value and net income a higher value. 45. Which one of the following is NOT true about goodwill? a. b. c. It is an intangible asset. It represents the value of all unrecorded assets acquired in a merger. It equals the premium paid over the fair market value of the assets acquired in a merger. 19 d. When goodwill appears on a firm’s balance sheet, it reduces the firm’s net worth by that amount. 46. Which of the following is NOT true about treasury stock? a. b. c. d. It is the firm’s own shares repurchased in the market by the firm. It can be reissued under stock option and other employee benefit plans. It lowers the value of the company. It increases the net worth of the company. 47. The major disadvantages of market-value accounting include a. b. the difficulty in estimating the current value for some assets. the difficulty in applying some of the valuation models used to estimate market values. c. d. the resulting numbers are potentially open to abuse. All of the above are disadvantages of market-value accounting. 48. Which one of the following does NOT belong on an income statement? 20 a. b. c. d. depreciation and amortization goodwill extraordinary items nonrecurring expenses 49. Which one of the following are NOT all noncash items? a. b. c. d. depreciation, deferred taxes, and prepaid expenses depletion charges, taxes, and amortization depletion charges, deferred taxes, and prepaid expenses depreciation, amortization, and prepaid taxes 50. Which one of the following is NOT a cash flow from operating activities? a. b. c. d. cash payments on the principal of long-term debt payments for utilities and rent payments to purchase raw materials cash receipts from selling goods and services 51. Cash flows from financing activities include all but one of the following: 21 a. b. c. d. cash payments on the principal of long-term debt issuing and paying out on insurance contracts cash purchases of treasury stock cash proceeds from a bank loan 52. Which one of the following is NOT a cash flow from investing activities? a. b. c. d. buying and selling bonds or stock of other firms buying or selling of land, buildings, and plant and equipment cash payments of dividends to shareholders issuing and paying out on insurance contracts 53. Trident Corporation had the following cash flows in the current year. Which one of the following is a financing activity cash flow? a. b. Rent on a warehouse amounting to $1.1 million Purchase of $125,000 worth of five-year bonds issued by Towson Utilities Preferred dividends to the tune of $330,000 paid to shareholders Lease income received on a piece of land c. d. 22 54. Clarity Music Company has a marginal tax rate of 34 percent and an average tax rate of 32 percent this year. It is planning to construct a new recording studio next year. The appropriate tax rate to be applied on the income generated from the new studio is a. b. the average tax rate. the marginal tax rate. either one. none of the above. c. d. 55. Which one of the following is NOT true for a corporation? a. b. c. Interest paid on bonds issued last year is tax deductible. Common-stock dividends to be paid this year are not tax deductible. Common-stock dividends to be paid this year will be tax deductible if the firm has a net loss for the year. d. Preferred stock dividends to be paid this year are not tax deductible. 56. Maddux, Inc., has completed its fiscal year and reported the following information. The company had current assets of $153,413, net fixed assets of $ 412,331, and other assets of 23 $7,822. The firm also has current liabilities worth $65,314, long-term debt of $178,334, and common stock of $162,000. How much retained earnings does the firm have? a. b. c. d. $ 405,648 $243,648 $167,918 $573,566 57. Galan Associates prepared its financial statement for 2008 based on the information given here. The company had cash worth $1,234, inventory worth $13,480, and accounts receivables of $7,789. The company’s net fixed assets are $42,331, and other assets are $1,822. It had accounts payables of $9,558, notes payables of $2,756, common stock of $22,000, and retained earnings of $14,008. How much long-term debt does the firm have? a. b. c. d. $54,342 $76,342 $12,314 $18,334 24 58. Tumbling Haven, a gymnastic equipment manufacturer, provided the following information to its accountants. The company had current assets of $145,332, net fixed assets of $356,190, and other assets of $4,176. The firm has long-term debt of $76,445, common stock of $200,000, and retained earnings of $134,461. What amount of current liabilities does this firm have? a. $94,792 $505,678 $171,217 none of the above b. c. d. 59. Teakap, Inc., has current assets of $ 1,456,312 and total assets of $4,812,369 for the year ending September 30, 2006. It also has current liabilities of $1,041,012, common equity of $1,500,000, and retained earnings of $1,468,347. How much long-term debt does the firm have? a. $1,844,022 $2,303,010 $2,123,612 $803,010 b. c. d. 25 60. Chandler Sporting Goods produces baseball and football equipment and lines of clothing. This year the company had cash and marketable securities worth $335,485, accounts payables worth $1,159,357, inventory of $1,651,599, accounts receivables of $1,488,121, short-term notes payable worth $313,663, and other current assets of $121,427. What is the company’s net working capital? a. $3,596,632 $1,801,784 $2,123,612 $1,673,421 b. c. d. 61. Tre-Bien Bakeries generated net income of $233,412 this year. At year end, the company had accounts receivables of $47,199, inventory of $63,781, and cash of $21,461. It also had accounts payables of $51,369, short-term notes payables of $11,417, and accrued taxes of $6,145. The net working capital of the firm is a. $68,931 $63,510 $69,655 none of the above b. c. d. 26 62. Spartan, Inc., is a manufacturer of automobile parts located in Greenville, South Carolina. At the end of the current fiscal year, the company had net working capital of $157,903. The company showed accounts payables of $94,233, accounts receivables of $83,112, inventory of $171,284, and cash and marketable securities of $12,311. What amount of notes payables does the firm have? a. b. c. d. $14,571 $26,882 $15,471 none of the above 63. Centennial Brewery produced revenues of $1,145,227 in 2008. It has expenses (excluding depreciation) of $812,640, depreciation of $131,335, and interest expense of $81,112. It pays a marginal tax rate of 34 percent. What is the firm’s net income after taxes? a. $120,140 $248,475 $79,292 $40,848 b. c. d. 27 64. Simplex Healthcare had net income of $5,411,623 after paying taxes at 34 percent. The firm had revenues of $20,433,770. Their interest expense for the year was $1,122,376, while depreciation expense was $2,079,112. What was the firm’s operating expenses excluding depreciation? a. b. c. d. $8,199,429 $9,032,853 $9,321,805 none of the above 65. Triumph Trading Company provided the following information to its auditors. For the year ended March 31, 2008, the company had revenues of $1,122,878, operating expenses (excluding depreciation and leasing expenses) of $612,663, depreciation expenses of $231,415, leasing expenses of $126,193, and interest expenses equal to $87,125. If the company’s tax rate was 34 percent, what is its net income after taxes? a. b. c. d. $43,218 $65,482 $152,607 none of the above 28 66. Parrino Corporation has announced that its net income for the year ended June 30, 2008, is $1,824,214. The company had an EBITDA of $ 5,174,366, and its depreciation and amortization expense was equal to $1,241,790. The company’s tax rate is 34 percent. What is the amount of interest expense for the firm? a. b. c. d. $2,763,961 $939,747 $1,187,720 $1,168,615 67. During 2008, Towson Recording Company increased its investment in marketable securities by $36,845, funded fixed assets acquisition by $109,455, and had marketable securities to the tune of $14,215 mature. What is the net cash used in investing activities? a. $132,085 $145,940 –$132,085 none of the above b. c. d. 68. Trident Manufacturing Company’s treasurer identified the following cash flows during this year as significant. It had repaid existing debt to the tune of $425,110, while raising 29 additional debt capital of $750,000. It also repurchased stock in the open markets for a total of $63,250. It paid $233,144 in dividends to its shareholders. What is the net cash provided by financing activities? a. $28,496 $91,746 –$28,496 –$91,746 b. c. d. 69. Super Grocers, Inc., provided the following financial information for the quarter ending September 30, 2006: Depreciation and amortization – $133,414 Increase in receivables – $ 112,709 Increase in accounts payables – $62,411 Decrease in marketable securities – $31,225 Net income – $341,463 Increase in inventory – $81,336 What is the cash flow from operating activities generated during this quarter by the firm? a. b. c. $308,458 $374,468 –$374,468 30 d. –$308,458 The following information applies to the next three questions. Thunderbird Amusement Park—Balance Sheet as of June 30 Assets 2007 2008 Cash $ 13,221 $ 11,729 Accounts receivables 31,323 37,909 Inventory 77,244 91,617 Total current assets $121,788 $141,255 Net fixed assets 344,712 390,836 Total assets $466,500 $532,091 Liabilities and Stockholders’ Equity Accounts payable Notes payable Deferred taxes Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and stockholders’ equity $ 38,549 12,004 21,934 $ 72,487 78,445 125,000 190,568 $466,500 $ 42,881 16,753 16,788 $ 76,422 61,290 175,000 219,379 $532,091 The company had a net income of $248,462, and depreciation expenses were equal to $72,487. 70. What is the firm’s cash flow from operating activities? a. b. $304,322 $297,684 $192,602 none of the above c. d. 31 71. What is the firm’s cash flow from investing activities? a. b. c. d. $0 $118,611 –$118,611 none of the above 72. What is the firm’s cash flow from financing activities? a. b. c. d. –$54,749 -$54,749 $182,057 -$182,057 73. Trimeton Corporation announced that in the year ended June 30, 2008, its earnings before taxes amounted to $2,367,045. Calculate its taxes using the following table. Tax Rate 15% 25 34 Taxable Income $0 to $50,000 50,001 − 75,000 75,001 − 100,000 32 39 34 35 38 35 a. b. c. d. 100,001 − 335,000 335,001 − 10,000,000 10,000,001 − 15,000,000 15,000,001 − 18,333,333 More than $18,333,333 $804,795 $690,895 $713,145 none of the above 74. Chartworth Associates’ financial statements indicated that the company had EBITDA of $3,145,903. It had depreciation of $633,000, and its interest rate on debt of $1.25 million was 7.5 percent. Calculate the amount of taxes the company is likely to owe. Tax Rate 15% 25 34 39 34 35 38 35 a. b. $1,069,607 $1,037,732 Taxable Income $0 to $50,000 50,001 − 75,000 75,001 − 100,000 100,001 − 335,000 335,001 − 10,000,000 10,000,001 − 15,000,000 15,000,001 − 18,333,333 More than $18,333,333 33 c. d. $822,512 none of the above 75. Refer to the information in Problem 74. What are the marginal and the average tax rates for this company? a. 34%, 35% b. 35%, 34% c. 34%, 34% d. none of the above III. Essay Questions 76. Identify and explain the five fundamental principles that form the basis of accounting standards in the United States. Answer: The U.S. GAAP is based on a set of five principles. These include the assumption of arm’s-length transaction, the cost principle, the realization principle, the matching principle, and the going concern assumption. • The assumption of arm’s-length transaction assumes that the two parties involved in the transaction have the ability to make economic decisions independently and rationally without having any influence on the other party’s decision making. 34 • The cost principle calls for recording the value of an asset and its cost at the time of acquisition. At any point in time, the book value represents a fair value for the asset. This book value is determined by depreciating the cost of the asset over time. • The realization principle reflects the fact that the revenue from a sale is recognized only when the sale of a firm’s product or service is completed and can be reliably confirmed. • The matching principle requires that any revenue generated from a sale is matched with the costs associated with producing the revenue. • The going concern assumption refers to the idea that a firm is expected to continue functioning for the near future. 77. Explain the differences in using FIFO versus LIFO in accounting for inventory. Answer: There are two common approaches that firms can use to value inventory. The first one is referred to as FIFO, or first in, first out, which requires a firm making a sale to associate the sale with the oldest inventory on the balance sheet. The second method is called LIFO, or last in, first out, and the firm using this approach is required to associate any sale with the newest inventory on the balance sheet. Although firms may switch from one approach to another, the switch cannot occur except under extraordinary circumstances. Choosing one approach over the other has an impact on a firm’s balance sheet and income statement, especially during a time of changing prices. When prices are rising, a firm using FIFO accounting has a lower cost of goods sold and a higher net income. In 35 addition, the remaining inventory will be valued at the more recent higher cost, which will result in a higher inventory value on the balance sheet. When prices are declining, firms using LIFO benefit because LIFO provides the highest inventory valuation and net income. 78. What are the advantages and disadvantages of using market-value accounting? Answer: Using market-value financial statements has several advantages. Having current information about a firm’s financial condition and the expected cash flows it is able to generate will allow a firm’s management to make better decisions. It allows investors and creditors to better evaluate the firm, and it improves its ability to raise capital. There are also some negatives associated with market-value accounting. First, assessing the market value of some assets is quite difficult, and accountants would be wary of making estimates. Second, the valuation models used in practice are not easy to use and could result in unreliable values. Third, unscrupulous executives could very well use these estimates to their advantage. 79. Explain the following income statement items. a. b. c. d. Amortization expense Nonrecurring expense Extraordinary items EBITDA 36 Answer: a. Amortization expense is similar to depreciation. Just as depreciation is used to write off the cost of real assets such as plant and equipment, amortization is a means of writing off expenses for intangible assets—such as patents, licenses, copyrights, trademarks, and goodwill. The costs are assigned to the fiscal periods in which the firm is assumed to have benefited from these intangible assets. b. A nonrecurring expense is typically a one-time expense that arises from situations such as closing down or consolidating obsolete or unprofitable operations, as well as any restructuring of the firm’s operations. c. Extraordinary items are also expenses that are unusual and unlikely to occur frequently. These are gains or losses that do not arise from operations and are a result of occurrences such as floods, fires, and earthquakes. d. EBITDA represents a firm’s earnings after accounting for cost of goods sold, but not expenses related to the asset base that was used to produce the revenues for the firm. The higher the value of the earnings before interest, taxes, depreciation, and amortization, the more efficiently the firm is operating. 80. Identify the noncash items that a firm may have on its financial statement and explain their impact on the shareholders of the firm. 37 Answer: Several noncash items can be found on a firm’s financial statement. Although some firms may have all of these items, others may not. But one noncash item that all firms will have is depreciation. This is typically the largest noncash item. Another is amortization. Other noncash items include the following:  Depletion charges, which are like depreciation but apply to extractive natural resources, such as crude oil, natural gas, timber, and mineral deposits.  Deferred taxes, which are the portion of a firm’s income tax expense that is postponed because of differences in the accounting policies adopted for management financial reporting and tax reporting.   Prepaid expenses, such as prepaid rent and insurance. Deferred revenues, which are revenues received as cash but not yet earned. An example of deferred revenue would be prepaid magazine subscriptions to a publishing company. The noncash expenses on a firm’s income statement reduce the taxable income and hence the tax paid by the firm. This in turn increases the cash flow available to shareholders. Noncash revenue items reduce the cash flow available to the firm but are typically nowhere near the magnitude of the largest noncash expenses. 38 IV. Answers to True or False Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. True False True False True True True True False True False False True True True True False True False False False 39 22. 23. 24. 25. True False True False 40 V. Answers to Multiple-Choice Questions 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. d b c d a b a c b b d a c a c c b c c d c 41 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69. d b b a b c c b c c d a d c b a c b a d c a b 42 70. 71. 72. 73. 74. 75. b c d a c c 43 VI. Solutions to Multiple-Choice Questions 56. Solution: Total assets = $153,413 + $412,331 + $7,822 = $573,566 Total liabilities = $65,314 + $178,334 = $243,648 Total stockholders’ equity = Total assets – Total liabilities = $573,466 – $243,648 = $329,918 Retained earnings = Stockholders’ equity – Common stock = $329,918 – $162,000 = $167,918 57. Solution: Current assets = $1,234 + $7,789 + $13,480 = $22,503 Total assets = $22,503 + $42,331 + $1,822 = $66,656 Current liabilities = $9,558 + $2,756 = $12,314 Stockholders’ equity = $22,000 + $14,008 = $36,008 Long-term debt = Total assets – Current liabilities – Stockholders’ equity = $66,656 – $12,314 – $36,008 = $18,334 58. Solution: Total assets = $145,332 + 356,190 + $4,176 = $505,698 Stockholders’ equity = $200,000 + $134,461 = $334,461 Current liabilities = Total liabilities – Long-term debt – Stockholders’ equity = $505,698 – $76,445 – $334,461 = $94,792 44 59. Solution: Stockholders’ equity = $1,500,000 + $1,468,347 = $2,968,347 Long-term debt = Total assets – Current liabilities – Stockholders’ equity = $4,812,369 – $1,041,012 – $2,968,347 = $803,010 60. Solution: Total current assets = $335,485 + 1,488,121 + $1,651,599 + $121,427 = $3,596,632 Total current liabilities = $1,159,357 + $313,663 = $1,473,020 Net working capital = $3,596,632 – $1,473,020 = $2,123,612 61. Solution: Total current assets = $21,461 + $47,199 +$63,781 = $132,481 Total current liabilities = $51,369 + $11,417 + $6,145 = $68,931 Net working capital = $132,481 – $68,931 = $63,510 62. Solution: Total current assets = $12,311 + $83,112 + $171,284 = $266,707 Net working capital = $266,707 – Total current liabilities = $157,903 Total current liabilities = $266,707 – $157,903 = $108,804 Total current liabilities = $108,804 = Accounts payables + Notes payables Notes payables = $108,804 - $94,233 = $14,571 63. Solution: 45 Earnings before taxes = $1,145,227 – ($812,640 + $131,335 + $81,112) = $120,140 Net income = $120,140 (1 – 0.34) = $79,292 64. Solution: Earnings before taxes = Net income / (1 – Tax rate) = $5,411,623 / (1 – 0.34) = $8,199,429 EBIT = EBT + Interest expense = $8,199,429 + $1,122,376 = $9,321,805 Revenues – Operating expenses – Depreciation = EBIT Operating expenses = Revenues – Depreciation – EBIT = $20,433,770 – $2,079,112 – $9,321,805 = $9,032,853 65. Solution: EBIT = $1,122,878 – ($612,663 + $231,415 + $126,193) = $152,607 Earnings before taxes = ($152,607 – $87,125) = $65,482 Net income = $65,482 (1 – 0.34) = $43,218 46 66. Solution: EBITDA Depreciation EBIT Interest EBT Taxes (34%) Net income 67. Solution: Amount $5,174,366.00 1,241,790.00 $3,932,576.00 1,168,615.39 $2,763,960.61 939,746.61 $1,824,214.00 Cash inflows from investing activities = $14,215 Cash outflows from investing activities = $36,845 + $ 109,455 = $146,300 Net cash flows from investing activities = $14,215 – $146,300 = $(132,085) 68. Solution: Cash inflows from financing activities = $750,000 Cash outflows from financing activities = $425,110 + $63,250 + $233,144 = $721,504 Net cash flows from financing activities = $750,000 – $721,504 = $28,496 69. Solution: 2008 Statement of Cash Flows ($ thousands) Operating Activities Net income $341,463 Additions (sources of cash) Depreciation and amortization 133,414 Increase in accounts payable 62,411 47 Decrease in marketable securities Subtractions (uses of cash) Increase in accounts receivable Increase in inventories Net cash provided by operating activities 70. Solution: 31,225 (112,709) (81,336) $374,468 Operating Activities Net income Additions (sources of cash) Depreciation and amortization Increase in accounts payable Subtractions (uses of cash) Decrease in cash Increase in accounts receivable Increase in inventories Decrease in deferred taxes Net cash provided by operating activities 71. Solution: Cash inflows from investing activities = $0 $248,462 72,487 4,332 (1,492) (6,586) (14,373) (5,146) $297,684 Cash outflows from investing activities = $46,124 + $72,487=118,611 Net cash flows from investing activities = –$$118,611 72. Solution: Cash inflows from financing activities = $4,749 + $50,000 = $54,749 Cash outflows from financing activities = $17,155 + 219,651 (dividends) = $236,806 Net cash flows from financing activities = $54,749 – $236,806 = -$182,057 73. Solution: 48 Earnings before tax = $2,367,045 Tax Tax rate 15% 25 34 39 34 35 38 35 Income $0 to $50,000 50,001 − 75,000 75,001 − 100,000 100,001 − 335,000 335,001 − 10,000,000 10,000,001 − 15,000,000 15,000,001 − 18,333,333 More than $18,333,333 Total taxes payable 74. Solution: $ 7,500.00 6,250.00 8,500.00 91,650.00 690,895.30 $804,795.3 0 EBITDA Depreciation Interest EBT $3,145,903 (633,000) (93,750) $2,419,153 Tax Tax rate 15% 25 34 39 34 35 38 35 Income $0 to $50,000 50,001 − 75,000 75,001 − 100,000 100,001 − 335,000 335,001 − 10,000,000 10,000,001 − 15,000,000 15,000,001 − 18,333,333 More than $18,333,333 Total taxes payable $ 7,500.00 6,250.00 8,500.00 91,650.00 690,895.30 $822,512 49 75. Solution: Marginal tax rate = Average tax rate = = = 34% Total taxes ÷ Taxable income $822,512 ÷ $2,419,153 34%