Interpreting and Analyzing Financial Statements Sixth Edition by Karen p Schoenebeck and Mark p Holtzman

March 25, 2018 | Author: Alisha Rebello | Category: Generally Accepted Accounting Principles (United States), Equity (Finance), Revenue, Balance Sheet, International Financial Reporting Standards
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INTERPRETING AND ANALYZING FINANCIAL STATEMENTS A PROJECT-BASED APPROACH SIXTH EDITION KAREN P. SCHOENEBECK MARK P. HOLTZMAN Editor in Chief: Donna Battista Director, Product Development: Ashley Santora Editorial Project Manager: Christina Rumbaugh Editorial Assistant: Jane Avery and Lauren Zanedis Director of Marketing: Maggie Moylan Leen Marketing Manager: Alison Haskins Production Project Manager: Clara Bartunek Cover Designer: Suzanne Behnke Cover Image: FikMik / Fotolia.com Printer/Binder: Edwards Bros. Cover Printer: Lehigh / Phoenix Hagerstown Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text. Copyright © 2013, 2010, 2007, 2004 Pearson Education, Inc., publishing as Prentice Hall, Upper Saddle River, New Jersey, 07458. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Permissions Department, Upper Saddle River, New Jersey 07458. Many of the designations by manufacturers and seller to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. Library of Congress Cataloging-in-Publication Data is available. 10 9 8 7 6 5 4 3 2 1 www.pearsonhighered.com ISBN 10: 0-13-274624-7 ISBN 13: 978-0-13-274624-3 TABLE OF CONTENTS Preface.......................................................................................................................................................... ix CHAPTER 1—INTRODUCTION Nike, Under Armour, Adidas WHAT IS ACCOUNTING?.......................................................................................................................1 THE FOUR FINANCIAL STATEMENTS......................................................................................................2 THE BALANCE SHEET ............................................................................................................................3 THE INCOME STATEMENT ....................................................................................................................5 STATEMENT OF STOCKHOLDERS’ EQUITY .............................................................................................6 STATEMENT OF CASH FLOWS ...............................................................................................................6 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) .....................................................................7 Historical Cost Principle.............................................................................................7 INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) ................................................................8 RATIO ANALYSIS ..................................................................................................................................8 Debt Ratio.................................................................................................................8 Asset Turnover Ratio ...............................................................................................10 Return on Sales (ROS) Ratio.....................................................................................10 Return on Assets (ROA) Ratio ..................................................................................11 TREND ANALYSIS ...............................................................................................................................12 COMMON-SIZE STATEMENTS .............................................................................................................13 ACTIVITIES 1–11 .................................................................................................................................15 CHAPTER 2—BALANCE SHEET The Walt Disney Company, News Corp, Time Warner INTRODUCTION..................................................................................................................................32 UNDERSTANDING THE WALT DISNEY COMPANY’S BALANCE SHEET ....................................................34 Current Assets.........................................................................................................35 Noncurrent Assets...................................................................................................36 Current Liabilities ....................................................................................................37 iii Noncurrent Liabilities.............................................................................................. 37 INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) ............................................................. 38 DEBT VERSUS EQUITY ........................................................................................................................ 39 ANALYZING THE BALANCE SHEET ....................................................................................................... 39 Liquidity: Current Ratio ............................................................................................... 39 Solvency: Debt Ratio ................................................................................................... 40 Trend Analysis ............................................................................................................. 41 Common-size Balance Sheet......................................................................................... 42 ACTIVITIES 12–22............................................................................................................................... 45 CHAPTER 3—INCOME STATEMENT Amazon.com, Sears Holdings, eBay, Starbucks INTRODUCTION ................................................................................................................................. 60 UNDERSTANDING AMAZON.COM’S INCOME STATEMENT .................................................................. 60 STEP ONE: REVENUES – COST OF SALES = GROSS PROFIT .................................................................... 62 Revenues and Revenue Recognition ............................................................................. 62 Expenses and the Matching Principle ........................................................................... 63 STEP TWO: GROSS PROFIT – OPERATING EXPENSES = OPERATING INCOME ........................................ 65 STEP THREE: OPERATING INCOME +/- NONOPERATING REVENUES AND EXPENSES = INCOME BEFORE INCOME TAX ................................................................................................... 66 STEP FOUR: INCOME BEFORE INCOME TAX – PROVISION FOR INCOME TAX = INCOME FROM CONTINUING OPERATIONS........................................................................................... 67 STEP FIVE: INCOME FROM CONTINUING OPERATIONS +/- NONRECURRING ITEMS = NET INCOME...... 68 ANALYZING THE INCOME STATEMENT ............................................................................................... 69 Return on Sales............................................................................................................ 70 Asset Turnover Ratio.................................................................................................... 71 Return on Assets.......................................................................................................... 72 Gross Profit Margin...................................................................................................... 73 Trend Analysis ............................................................................................................. 74 Common-Size Analysis ................................................................................................. 75 ACTIVITIES 23–33............................................................................................................................... 77 iv CHAPTER 4—STATEMENT OF STOCKHOLDERS’ EQUITY Freeport-McMoRan Copper & Gold INTRODUCTION..................................................................................................................................94 STOCKHOLDERS’ EQUITY ON THE BALANCE SHEET ..............................................................................96 STATEMENT OF STOCKHOLDERS’ EQUITY ...........................................................................................97 TREASURY STOCK...............................................................................................................................99 RETAINED EARNINGS .......................................................................................................................100 OTHER COMPREHENSIVE INCOME....................................................................................................100 STOCK SPLITS & STOCK DIVIDENDS...................................................................................................101 RETURN ON EQUITY .........................................................................................................................101 FINANCIAL LEVERAGE RATIO ............................................................................................................102 TIMES INTEREST EARNED RATIO.......................................................................................................103 EARNINGS PER SHARE ......................................................................................................................104 DIVIDEND RATE................................................................................................................................105 PRICE EARNINGS RATIO....................................................................................................................105 ACTIVITIES 34–41 .............................................................................................................................108 CHAPTER 5—STATEMENT OF CASH FLOWS Cedar Fair, L.P. INTRODUCTION................................................................................................................................121 THREE CATEGORIES OF CASH FLOWS ................................................................................................124 Financing Activities.....................................................................................................125 Investing Activities .....................................................................................................126 Operating Activities....................................................................................................127 Operating Activities—The Direct Method ...................................................................127 Operating Activities—The Indirect Method.................................................................129 INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS).............................................................131 ANALYZING THE STATEMENT OF CASH FLOWS..................................................................................132 Free Cash Flow ...........................................................................................................132 Cash Flow Adequacy...................................................................................................133 Cash Flow Liquidity.....................................................................................................133 Quality of Income.......................................................................................................134 ACTIVITIES 42–54 .............................................................................................................................136 v CHAPTER 6—SPECIFIC ACCOUNTS Research in Motion Limited, Motorola Mobility, Inc. INTRODUCTION ............................................................................................................................... 156 CASH AND CASH EQUIVALENTS........................................................................................................ 158 INVESTMENTS ................................................................................................................................. 158 ACCOUNTS RECEIVABLE ................................................................................................................... 159 Accounts Receivable Turnover ................................................................................... 161 Accounts Receivable Days .......................................................................................... 161 INVENTORY ..................................................................................................................................... 162 Specific Identification................................................................................................. 162 First-In, First-Out........................................................................................................ 162 Last-In, First-Out ........................................................................................................ 165 International Financial Reporting Standards ............................................................... 166 Gross Profit Margin.................................................................................................... 166 Inventory Turnover .................................................................................................... 167 Inventory Days........................................................................................................... 168 PROPERTY, PLANT, AND EQUIPMENT............................................................................................... 169 Straight-Line Depreciation.......................................................................................... 169 Double-Declining Balance Depreciation...................................................................... 170 Comparing Straight-Line with Double-Declining Balance............................................. 172 Gains and Losses on Sale of PPE ................................................................................. 172 International Financial Reporting Standards ............................................................... 174 CURRENT AND LONG-TERM LIABILITIES............................................................................................ 174 ACTIVITIES 55–82............................................................................................................................. 179 CHAPTER 7—THE ACCOUNTING CYCLE INTRODUCTION ............................................................................................................................... 212 THE 10-STEP ACCOUNTING CYCLE .................................................................................................... 212 ANALYZE TRANSACTIONS USING THE ACCOUNTING EQUATION ....................................................... 216 PREPARE JOURNAL ENTRIES USING DEBITS AND CREDITS................................................................. 220 Step 1: Analyze and Prepare Transaction Journal Entries (TJEs)................................... 221 Step 2: Post TJEs to the Ledger ................................................................................... 223 Step 3: Prepare the Unadjusted Trial Balance ............................................................. 224 Step 4: Prepare Adjusting Journal Entries (AJEs) ......................................................... 224 vi ............232 ACTIVITIES 83–96 .......................315 APPENDIX B—RATIOS ......................................................................Step 5: Post AJEs to the Ledger ...............................................................................................................323 GLOSSARY....................................................................337 vii .............................................231 TRANSACTION JOURNAL ENTRIES OF A MERCHANDISE RETAILER ....................................................300 APPENDIX A—FEATURED CORPORATIONS......226 Step 8: Prepare Closing Journal Entries (CJEs)...........................231 MORE ADJUSTING JOURNAL ENTRIES ...............................................................................270 CHAPTER 9—CAPSTONE PROJECT ACTIVITIES 108–109 ..............................................................................330 INDEX ......................................................................................................................................................................................................228 Step 9: Post CJEs to the Ledger ....225 Step 6: Prepare the Adjusted Trial Balance .......................................................................................................................................................................................................230 Step 10: Prepare the Post-Closing Trial Balance....235 CHAPTER 8—COMPREHENSIVE REVIEW ACTIVITIES 97–107 ................................................................................................................................................................................................................................................................................................................................................................................226 Step 7: Prepare the Financial Statements.............................................................................. This page intentionally left blank . And at the end of the course. In the first part of the course. We found that what became known as the “user approach” was still transaction-based. we identified two fundamental skills that students should learn in the first accounting course. thinking about whether or not these companies would make good investments. First. with debits and credits. and the debit–credit system. Furthermore. so that students can begin to understand the appropriate ranges for different financial analysis ratios. students should be able to record basic debit–credit journal entries and prepare simple financial statements. efficiency. they had less trouble learning the accounting cycle. With the fundamental goals of the course redesigned. as analysis takes time to develop. and it helps motivate them to learn more. under a transaction-based approach. building a firm foundation in the accounting cycle. or inventive new charts. and second in transaction analysis. students get little exposure to analyzing profitability. the focus of the course was still on teaching students how transactions affect accounts. and solvency. builds up students’ skills for intermediate accounting and what follows. liquidity. teacher-course evaluations improved. it arouses their curiosity. Accounting majors go into Intermediate Accounting with a firm foundation in understanding the financial statements. They enjoyed analyzing real companies’ financial statements. with debits and credits. and is a joy for the experienced instructor to teach. fits beautifully into the standard curriculum. These fundamental concepts should be understood by all business students. As they learn these skills. Whether students used debits and credits in journal entries. students can immediately grasp the importance of the lessons. The traditional first course in financial accounting emphasizes building students’ knowledge of different kinds of transactions and accounts. students learn the contents of the four financial statements and how to analyze them for profitability. THE CURRICULUM We have taught this course with many of the innovative methods developed over the past 20 years. efficiency. ix . rather than rote calculations. As we developed this new approach. and solvency. and solvency. their uses. efficiency. Our students enjoy the redesigned course. Other business majors finish the course understanding how to read and analyze the “language” of accounting. we shifted the emphasis of the course toward building students’ skills first in financial statement analysis. While retaining the course content that has been collectively developed by the Academy over many decades. The emphasis is on building students’ analytical skills. and their applicability to the real world. the redesigned course that we present in this book appeals to the needs and interests of today’s students. liquidity. Second. As such. in all majors. INCREASED STUDENT MOTIVATION After we redesigned the first course in accounting with these goals in mind. using the financial statements of real companies that they might already be familiar with. Students appreciated acquiring skills needed in the real business world. liquidity. business students should be able to analyze a company’s annual report and conclude as to its profitability.PREFACE This book introduces a financial statement analysis approach to the first course in accounting. and equipment. Chapter 6 deals with topics that are traditionally covered in the first accounting course. We like to challenge them to think about difficult problems that have no clear solution. common-size analysis. Throughout the text. Our finance faculty have remarked how. after our course redesign. ENJOYABLE TO TEACH We love teaching accounting this way. They can better understand how to speak in the “language of business. revenue. such as inventory and property. with the debit–credit system. a written report and a presentation. The common-size Statement of Cash Flows is now introduced in Chapter 5. a powerful conceptual base for future professionals. Most importantly. The Capstone Project is streamlined into only two activites.” This helps them in other business courses. after they are already familiar with asset. we feel confident that our approach is comprehensive. Anheuser-Busch InBev. It includes almost all of the topics included in the traditional first course in accounting. adjusting. financial statements have been updated to the most current amounts available on December 31. liquidity. analyze. students immediately learn about the basic financial statements. and trend analysis. We also took this opportunity to fully integrate International Financial Reporting Standards (IFRS) into the course. and Research in Motion. we use many international companies that are based outside the United States. our creativity.Furthermore. Chapters 2 through 5 cover the basic financial statements. At once they learn four basic financial analysis ratios. students learn the accounting cycle.S. We also feel that we can draw on our full depth of knowledge about accounting. In Chapter 1. To complete the project. In Chapter 7. plant. Another comprehensive problem is added to Chapter 8 … Chipotle Mexican Grill. and closing journal entries. efficiency. it is almost a trivial exercise for most students to learn to prepare financial statements. 2011. We get great satisfaction from helping students learn to improve their analytical skills. are generally better learned in intermediate and bookkeeping courses. Chapter 9 provides a project for each student to research. As examples. Chapter 8 offers a comprehensive review of all topics covered in previous chapters. working with more than one financial statement and combining issues in profitability. This cuts out much of the rote memorization that students must otherwise go through at the beginning of the course to learn how to record journal entries and prepare financial statements. Lenovo Group. It’s not watered-down. such as Adidas. accounting students understand how to analyze financial statements. THE CHAPTERS NEW in this Edition … crossword puzzles that reinforce accounting concepts and vocabulary. equity. GAAP and IFRS differ. liability. They will use these tools throughout the course. Activities walk students through financial analyses of real companies. the chapters explain where U. Non-accounting majors also have the skills to understand how to read and analyze financial statements. with full chapters dedicated to the statement of cash flows and the statement of stockholders’ equity. such as bond amortization and special journals. and solvency. and expense accounts. Furthermore. We found that debits and credits are much easier for students to learn at the end of the course. each student obtains a copy of the corporate financial statements and utilizes a variety of resources. and prepare a comprehensive written report and presentation on the public corporation of their choice. At this point in the course. The few topics we omitted. and our experience to develop compelling and enjoyable classroom sessions. students seem better prepared for finance classes. Because the x . and delivers a presentation. Our e-mail addresses are kaliforniakaren@gmail. then have students compare answers. Activities can be assigned for homework. and financial statement analysis. One of the most powerful aspects of our course design is that it includes most of the classic elements of the traditional accounting course. Feel free to contact us with comments and questions. We cover the financial statements. When implementing this text. The text and activities format allow the instructor to use this book as a stand-alone text for the first accounting course. reviewed in lecture sessions. and closing entries. Faculty can cover the entire chapter or specific sections. while Chapter 5 helps students to understand concepts of cash flow and interactions among operating. Students learn the complete accounting cycle with debits and credits. using real companies of their choice. inventory. financial statements. and stockholders’ equity. receivables. The text sections are engaging to read but also provide students with a useful reference tool. and financing activities. such as inventory and depreciation of noncurrent assets. completing more and more parts as the course progresses. This chapter covers cash. Holtzman. adjusting journal entries. From here. prepares a written report. 2 (Balance Sheet). while reordering the topics to emphasize financial statement analysis and decision making. This project has several parts. Have fun with this course! Integrate real-world numbers and actual companies into the classroom! Challenge your students to use accounting information to make decisions! Our students enjoy the redesigned course. Please visit www. Schoenebeck and Mark P. stock market activity. to interact with the companies studied.edu. which can be assigned throughout the semester or as a capstone project at the end. debits and credits. Karen P. Review exercises titled “Test Your Understanding” provide thorough comprehensive reviews that will build students’ confidence. and we hope that yours do too. • The comprehensive review in Chapter 8 ties together topics in all chapters. • The capstone project in Chapter 9 is designed to help students integrate all of the topics learned in the course. • The accounting cycle in Chapter 7. liabilities. and common-size statements. authors xi . Chapter 4 provides additional focus on stock and investment issues. noncurrent assets. including ratios.com and mark. given for small-group discussion.holtzman@shu. researches news. journal entries. These form the fundamental core of the book. Students can begin parts of the written activity after completing Chapter 1.company is the student’s choice. and then review the answers in class. The activity sections encourage students to learn accounting through real-life examples. Each student prepares a financial statement analysis and ratio analysis of their company. trend analysis. We like to assign them for home or in-class preparation. faculty can choose to emphasize: • The financial statements in Chapter 4 (Statement of Stockholders’ Equity) and Chapter 5 (Statement of Cash Flow). investing. specific areas in the financial statements. interest is high and a quality product results.ƉĞĂƌƐŽŶŚŝŐŚĞƌĞĚ͘ĐŽŵ to download the Solutions Manual that accompanies this text. faculty have many options. • Accounting for different kinds of transactions in Chapter 6. We recommend that faculty always include Chapters 1 (Introduction). investments. and 3 (Income Statement). or a combination of the three. We’d approximate that 90% of the curriculum in the typical first financial accounting course is right here in this book. he began his accounting career in the New York office of Deloitte & Touche.com. CPA Journal. leading educational tours to Europe. PhD. and hiking with his family.ABOUT THE AUTHORS Karen P. studying Talmud. MBA. national and international. South Orange. xii . practitioner.com. and Financial Executives Institute. As a Master Presenter for the Leadership Training Series and the Institute of Management Accountants (IMA) Leadership Academy she is a regular presenter at national and regional conferences. She received her MBA from the University of Minnesota and is currently a Senior University Lecturer at New Jersey Institute of Technology. Karen is a licensed CPA with over 20 years of academic experience. consultant. His blogs can be found at www. and author. Seton Hall University.accountinator. In his spare time. and has been cited for outstanding teaching. undergraduate and graduate. he enjoys blogging. Karen is an avid traveler. Using her practical experience as a consultant. and Egypt.edu. CPA. His twitter handles are @accountinator and @freakingcpa. She is president and founder of Two-Paved Roads. a consulting firm. and Accounting Historian’s Journal. He can be reached at mark. Holtzman has published articles in Journal of Accountancy. and is currently serving on the national board of directors for the Educational Foundation for Women in Accounting. Financial Statement Analysis is used to introduce financial accounting and decision making is the focus of managerial accounting. New Jersey.freakingaccountant. Research in Accounting Regulation. Dr.holtzman@shu. Holtzman.com and www. served as Director of the MBA program at Southwestern College in Kansas. is a professor. CPA is Associate Professor of Accounting and Chair of the Department of Accounting and Taxation at the Stillman School of Business. Mark P. she brings realworld relevance into the accounting classroom for all business majors. After receiving a bachelor’s degree in business administration at Hofstra University. Strategic Finance. Schoenebeck. She can be reached at kaliforniakaren@gmail. In addition. Southeast Asia. He is a member of the American Accounting Association. Karen is a leader in curriculum redesign. the American Institute of Certified Public Accountants. Advances in Accounting. He later earned a PhD in accounting from The University of Texas at Austin. Our students who provide continued opportunities for us to learn and are always ready to give honest and helpful feedback. Brian Greenstein. Aharon Yehuda. authors xiii . David Mest. Michael Ojo. Levi Shalom. providing invaluable ideas and feedback. and Drew Tomafsky for their help in preparing this text. Especially to Rachel Rasmussen. Michael Massood. Theresa Henry. David Gelb. Christie Deskiewicz. who helped develop and implement the redesigned course. Karen P. To Karen Boroff. Susan Pinto.DEDICATIONS To Casey and Grant and my friends who encourage me to take chances. Scott King. Reed Easton. —Mark P.. Holtzman. The Pearson staff including Christina Rumbaugh and Deborah Hoffman who discovered Karen’s materials and encouraged her to submit them for publishing. Andrew Jurkiewicz. Jonathan Stout. Jacqueline Munguia. Holtzman ACKNOWLEDGMENTS WE WOULD LIKE TO THANK . Our friends and family who continue to support our writing and encourage us to explore new endeavors. Michael Lelescu. —Karen P. and Esther Chaya. Schoenebeck To Rikki. Brian Nelson. Dovid. Shalu Oza. Chris Ives. Simin Ma. Mark Scimeca. Schoenebeck and Mark P. and Renee Weiss. Riad Twal. Elven Riley.. This page intentionally left blank . 6. This book will help you to learn how to interpret and analyze financial statements. assets. suppose that you invest $100. net income.000 of your savings in a new convenience store. You give the entrepreneur starting this business a $100. it is the language for conducting business. 8. Introduction Page 1 Chapter 1 . accounting allows you to measure the performance of your business and to make important decisions for it. If you are a manager. After a year. and she gives you stock certificates representing a 50% share in the business. liabilities. “How’s it going?” What kind of answer would you expect? You would want facts and figures. if you invest in a business. Understand what accounting is and why it is important. expenses. If you are an entrepreneur. Explain the basic information provided by each financial statement. As you build a career you will accumulate savings to invest. downloaded off the Internet. Identify the elements of the financial statements. Based on financial statements. 3. Identify the four financial statements. Business people speak about revenues. so that. Understand that accountants use Generally Accepted Accounting Principles (GAAP) when preparing financial statements and apply the historical cost principle. equity. Accounting is the system of recording. you visit this entrepreneur and ask. accounting gives you a language with which to present your performance to investors and creditors. 7. WHAT IS ACCOUNTING? Look forward a few years. After much research. you can understand how it presents its operations and financial position. 4.CHAPTER 1 INTRODUCTION LEARNING OBJECTIVES 1. More importantly. allowing you to read almost any company’s annual report in order to decide whether to invest in that company. which are also based on financial statements. Learning accounting helps you learn the language of business.000 investment of equity. trend.S. classifying. Prepare and interpret ratio. such as purchasing machinery and compensating employees. and common-size analysis. investors rely on accounting information to make investment decisions. and cash flow: all accounting terms. How much money did the business receive this year? How much did it pay for expenses? How valuable are the assets that it owns? How much money does it owe? How much profit did it earn? How much salary did the entrepreneur receive? Are there any lawsuits? You would need to converse in the language of accounting. Understand that U. and reporting financial information. companies may soon be required to use International Financial Reporting Standards (IFRS). investors choose among a dizzying array of investments. Perhaps most importantly. Compute and interpret basic financial statement ratios. 2. Other investors read analyst reports. 5. beginning Contributed capital. It reports assets. What does the company own and who has claims against the company? The BALANCE SHEET provides a snapshot of a company’s financial position as of a certain date. 3. Balance Sheet Income Statement Statement of Stockholders’ Equity Statement of Cash Flows Each statement provides information about a different perspective of the company’s finances. BALANCE SHEET Assets Liabilities Stockholders’ equity How profitable is the company? The INCOME STATEMENT reports the company’s profitability during an accounting period. amounts received from customers for products sold or services provided. 2. ending Does the company generate cash flow? The STATEMENT OF CASH FLOWS reports cash inflows and cash outflows during an accounting period. INCOME STATEMENT Revenues (Expenses) Net income Who owns the company? The STATEMENT OF STOCKHOLDERS’ EQUITY reports if the earnings (net income) of this accounting period are distributed as dividends or retained in the business as retained earnings. 4.THE FOUR FINANCIAL STATEMENTS Companies present four basic financial statements: 1. STATEMENT OF CASH FLOWS Cash inflows (Cash outflows) Change in the cash account Together. the costs incurred to produce revenues. Their difference is net income (also called earnings). and expenses. It reports revenues. ending Contributed capital. beginning + Net income + Issuance of shares (Dividends) (Repurchase to retire shares) Retained earnings. and whether the assets are financed with liabilities (debts) or stockholders’ equity (owners’ shares). these four financial statements help investors understand a company’s finances. Introduction Page 2 Chapter 1 . It also reports amounts paid (contributed) to the company by stockholders to purchase common stock and preferred stock. items of value such as inventory and equipment. STATEMENT OF STOCKHOLDERS’ EQUITY Retained earnings. 2011 Balance Sheet: Nike (NKE) May 31. and equipment is relatively low. net Inventories Other current assets Property. Because almost all of Nike’s products are manufactured by independent contractors. of $2. which consist of land. net” of $3. plant. Focus is on innovation and high-quality construction. Almost all of Nike’s products are manufactured by independent contractors and virtually all footwear and apparel products are produced outside the United States.998 ASSETS are items of value that a corporation has a right to use.947 5. items held for sale to retailers. Here is Nike’s May 31. Converse. and land. and other equipment.469 2.: Nike is the largest seller of athletic footwear and athletic apparel in the world. inventory. professional team. property.998 LIABILITIES Notes payable Accounts payable Other current liabilities Long-term debt Other noncurrent liabilities Total liabilities STOCKHOLDERS’ EQUITY Contributed capital Retained earnings Other stockholders’ equity Total SE Total L & SE $ 187 1. Jack Purcell.715 million.955 2. These are moneys that customers owe to Nike for items purchased. plant. plant. Typical asset accounts include cash.THE BALANCE SHEET The Balance Sheet reports assets and the amount of assets financed with liabilities and stockholders’ equity as of a certain date. equipment. buildings. One Star. 2011. we explore the financial statements of Nike.715 906 2. Accounts receivable are amounts to be received in the future from customers. selling in over 170 countries.138 million. 2011 BALANCE SHEET ($ in millions) ASSETS Cash and cash equivalents Short-term investments Accounts receivable. Therefore.583 3.843 $ 14. It also markets apparel with licensed college team. and equipment. Nike had $1. Nike also sells products under the Cole Haan. and Umbro brands.115 of property. Inc.955 million in cash on May 31. It is based on the accounting equation: Assets = Liabilities + Stockholders’ Equity In this chapter.155 3. Notice that Nike’s largest reported asset is “accounts receivable.115 692 894 $ 14. and equipment.302 276 921 5. vehicles. The second largest asset item is inventory. Chuck Taylor. Nike had $2. net Goodwill and other intangibles Other noncurrent assets Total Assets $ 1. Hurley. accounts receivable. it has not had to invest in factories to manufacture its own goods.801 95 9. buildings. Introduction Page 3 Chapter 1 . All Star.138 2. and league logos. 801 million in net income that has not yet been distributed to stockholders as dividends.843 million in stockholders’ equity. and bonds payable. Typical liability accounts include accounts payable. wages payable. Retained Earnings—net income earned by the company since its incorporation and not yet distributed as dividends. over these years. Accounts Payable are amounts that the corporation must pay to suppliers in the future. Nike has earned $5.998 million in assets were financed with $5. The company’s largest liability item was “other current liabilities” of $2.302 million.155 million worth of liabilities (debt) and $9.155 million + Introduction Page 4 Stockholders’ Equity $9. notes payable. it received $3. The retained earnings account indicates that. Based on the accounting equation. assets can be financed either with liabilities or with stockholders’ equity.998 million = $5.LIABILITIES are amounts owed to creditors. Typical stockholders’ equity accounts include: Contributed Capital—amounts paid-in (contributed) to the company by stockholders to purchase common stock and preferred stock. Stockholders’ equity may also be referred to as shareholders’ equity or owners’ equity. Since Nike opened in 1968. Nike’s $14. The key word found in many liability accounts is payable. the amount of debt owed to third parties. STOCKHOLDERS’ EQUITY is the portion of assets the owners own free and clear of any liabilities. Accounts payable of $1.843 million Chapter 1 .947 million in investments from stockholders. For example.469 million was Nike’s second-largest liability. To use the accounting equation: Assets = Liabilities + $14. THE INCOME STATEMENT The income statement reports a company’s profitability during an accounting period. Nike (NKE) 2011 INCOME STATEMENT ($ in millions) Revenues Cost of sales Gross profit Selling and administrative expense Interest (income) expense. apparel. it would only make sense for companies to incur expenses that will generate revenue and increase profits. or approximately $2.1 billion in profits for the year ending May 31.133 million. It also incurred $6.354 million.354 9. Introduction Page 5 Chapter 1 .694 in selling and administrative expense and $4 million in interest expense. Obviously.862 11.862 million worth of footwear. net Income before income tax Provision for income tax Net income $ $ 20. NET INCOME is the difference between revenues and expenses.508 6. It earned $2. and accessories. net Other (income) expense. Revenues – Expenses = Net Income Nike was profitable. Nike sold $20.693 4 (33) 2. Related income taxes were $711 million. The largest expense item for manufacturers and retailers is usually cost of sales expense (also referred to as cost of goods sold). Net income is also referred to as profit (loss). 2011. earnings. EXPENSES are the costs incurred to produce revenues. Sales Revenue and Service Revenue are amounts earned engaging in the primary business activity.844 711 2. equipment.133 REVENUES are amounts received from customers for products sold and services provided. which reports the wholesale costs of inventory sold to customers during the accounting period. Nike’s largest expense is “Cost of sales” of $11. or the bottom line. earnings not distributed as dividends.133 million in net income the company earned. but decreased by the $569 million paid as dividends to stockholders. Nike (NKE) 2011 STATEMENT OF STOCKHOLDERS’ EQUITY ($ in millions) Beginning balance Issuance of shares Net income Dividends Other transactions Ending balance Contributed Capital $ 3. Introduction Page 6 Chapter 1 . Nike’s sales generated $1.095 Other Equity $ 215 2.STATEMENT OF STOCKHOLDERS’ EQUITY The Statement of Stockholders’ Equity reports changes in the contributed capital and retained earnings accounts during an accounting period.133 (569) (1. Most of these payments went to repurchase stock and to pay dividends.947 Retained Earnings $ 6.812 (1.444 503 $ 3. The Statement of Cash Flows describes a company’s cash inflows and outflows for each of these three areas. Contributed capital is increased when the company receives new investments from investors in exchange for newly issued stock.124) 3. is increased by net income (earnings) of the accounting period and decreased when earnings are distributed as dividends to the stockholders. Nike (NKE) 2008 STATEMENT OF CASH FLOWS ($ in millions) Net cash received from operating activities (NCOA) Net cash paid for investing activities (NCIA) Net cash paid for financing activities (NCFA) Effect of exchange rate changes Change in cash + Cash. beginning of the period $ = Cash. STATEMENT OF CASH FLOWS The Statement of Cash Flows reports cash inflows and outflows during an accounting period.843 Retained earnings.021) (1. It issued new stock certificates in exchange for these investments. end of the period $ 1.947 million. which increased contributed capital to $3.972 for financing activities. Nike’s retained earnings increased by $2. and financing.754 503 2.801 $ Total SE 95 $ 9. Nike paid $1. The company paid $1.021 for new investing activities.978) $ 9. Nike received $503 million in investments from owners. FINANCING ACTIVITIES relate to how a company finances its assets—with debt or stockholders’ equity. It is decreased when the company buys back and retires stock. resulting in ending retained earnings of $5. plant.133 (569) (1. investing. INVESTING ACTIVITIES relate to the need for investing in property. and equipment or expanding by making investments in other companies. OPERATING ACTIVITIES relate to a company’s main business: selling products or services to earn net income.812 million in cash flow after paying the company’s expenses.858) (120) $ 5.955 Business activity can be divided into three distinct areas: operating.079 1.972) 57 $ (1.801 million. Assume that in 2012 the land is appraised to be worth $1. HISTORICAL COST PRINCIPLE The Historical Cost Principle states that companies should record assets and services at their acquisition cost. not the appraised value. Only CPA s (Certified Public Accountants). most accounting reporting standards that formulate GAAP are set by the seven full-time voting members of the FASB (Financial Accounting Standards Board). The land would appear on Nike’s 2012 balance sheet at $1 million. because different appraisers would suggest different estimates of the land’s current market value. to be the official rules. For example. saying that some assets’ historical costs mislead investors because they are outdated or insignificant in comparison with their market value. With few exceptions. can conduct these audits. The SEC (Securities and Exchange Commission) has legislative authority to set the reporting rules for accounting information of publicly held corporations.GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) Accountants and the federal government have created a system of setting rules and auditing companies to verify that they follow those rules. because this is the most reliable information. licensed by the states. Currently. The five full-time members of the Public Company Accounting Oversight Board (PCAOB ) establish auditing standards and conduct inspections of the public accounting firms that perform audits. Market value is difficult to verify and could easily change. it has designated GAAP. Suppose that Nike purchased land for $1 million in 2002. GAAP requires financial statements to use historical cost. this real estate will appear as a $1 million dollar asset. Ethical behavior is defined by the AICPA (American Institute of CPA) Code of Professional Conduct.2 million. Therefore. On Nike’s balance sheet. GAAP (Generally Accepted Accounting Principles) are the rules that companies must follow when preparing financial statements available to investors. The SEC oversees the Financial Accounting Standards Board (FASB) and the Public Company Accounting Oversight Board (PCAOB). giving investors with no clue that the property is now worth more. Introduction Page 7 Chapter 1 . This code holds CPAs accountable for serving the public interest. Many have criticized the Historical Cost Principle. as written by the FASB. the amount paid for them. Audits attest to whether a company’s financial statements comply with the GAAP rules. suppose that Nike acquired prime real estate in 1968 for $1 million and today the market value is $30 million. S.S. This is no small task. GAAP and IFRS. If a company cannot pay its debts on time it could lose assets to creditors or even go bankrupt.INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) We are a global economy. The financial statements of the three companies appear on the following page. analysts often compare a company’s ratios with prior periods. the International Accounting Standards Committee (IASC) was formed to develop a single set of global accounting standards. and compare them with those of two competitors. Now more than 100 jurisdictions.S. including China. and all of the countries in the European Union (EU). When computing ratios. there was British GAAP. as each country had its own unique set of accounting principles. and so on. In 2001. Hong Kong. In 2002. Throughout the text we point out important differences that still remain between U. efficiency in managing assets. or industry averages. U. RATIO ANALYSIS Ratio analysis can reveal valuable information about a company’s financial attributes. Debt Ratio = Total Liabilities / Total Assets Companies owing too much debt might not be able to make regular payments of interest or the full amount due at maturity. We will compute certain financial ratios for Nike (NKE). and it is expected that soon U. Under Armour (UA) and Adidas (ADDYY). the three companies’ ratios can still be compared. this committee was reorganized to become the International Accounting Standards Board (IASB) with the objectives (1) to develop a single set of high quality. and whether the company has too much debt. Why should the United States adopt IFRS? Differences among the accounting standards of different countries make it difficult for global investors to compare companies and for multinational corporations to comply with multiple accounting standards. Australia. but progress continues to be made. either require or permit IFRS in some form. companies will be permitted to or required to use International Financial Reporting Standards (IFRS). GAAP and IFRS. formalizing their commitment to converging U. the United States has not fully adopted IFRS. German GAAP. As of early 2012. DEBT RATIO The Debt Ratio reveals the proportion of assets financed with debt. the FASB and IASB signed the Norwalk Agreement. In 1973. such as profitability. and (2) to cooperate with national accounting standard-setters to achieve convergence in accounting standards across the world. Introduction Page 8 Chapter 1 . rather than U. competitors. understandable and enforceable global accounting standards that lead to transparent and comparable information in general purpose financial statements. GAAP. Although Adidas Group’s financial statements are denominated in euros. Egyptian GAAP. GAAP.S. In essence.S. 064 533 531 418 4 109 40 $ 2. Under Armour’s $178 million in debt looks much smaller than the other two companies’.297 2.844 711 $ 1.995 STOCKHOLDERS’ EQUITY Contributed capital Retained earnings Other SE Total equity ($ and € in millions) Sales revenue Cost of goods sold Gross profit Operating expenses Nonoperating (rev) exp Income B4 income tax Provision for income tax Net income Introduction Consolidated Income Statements Nike (NKE) Under Armour (UA) May 31.998 $ 3.623 $ $ € € 5. 2010 $ 20.998 676 10. 2010 556 76 4 40 676 € 149 29 178 € $ 225 270 2 € 0 4.958 1.947 5.618 million equals approximately $13.508 6.133 $ 69 Page 9 Adidas (ADDYY) December 31.836 88 806 238 € 568 Chapter 1 .801 95 $ 9.843 $ $ $ Adidas (ADDYY) December 31. 2010 Dec 31.908 2.880 855 3.087 5.($ and € in millions) Date Total Assets Nike (NKE) Under Armour (UA) Adidas (ADDYY) May 31. 2010 ($ and € in millions) ASSETS Current assets PPE. 2010 € 11. 2011 Dec 31.730 4.354 9.618 Total Liabilities $ $ € Debt Ratio 5.616 7 $ 497 € 4.34 in decimal form) and Adidas has significantly more debt—56% of assets.862 11.700 million). 2010 $ $ € 14. Under Armour is significantly smaller with only 5% of the assets of Nike.990 6. 2011 December 31. However. 2011 December 31.155 $ $ 3.128 755 10.197 5.995 34% 26% 56% Whereas Nike and Adidas both have more than $10 billion in assets (€10.618 3. net Goodwill and intangibles Other assets Total Assets LIABILITIES Current liabilities Noncurrent liabilities Total liabilities $ 11.115 692 894 14.260 5. Nike’s liabilities are 34% of assets (0.693 (29) 2. Under Armour’s liabilities are still 26% of assets. Consolidated Balance Sheets Nike (NKE) Under Armour (UA) May 31.155 178 5. 2010 $ 2. nearly twice that of Under Armour’s 6. computed by dividing total revenues by total assets.064 € 11. Introduction Page 10 Chapter 1 .064 € 11. Return on Sales = Net Income / Sales Revenue How well does a company control expenses? A high ROS ratio depends on controlling expenses to keep net income high. Adidas was much less efficient at using its assets to produce revenues.13. measures how efficiently the company uses assets to generate revenue. even though Nike is larger than Under Armour. (also referred to as Net Profit Margin). Either way.2% 6.990 10. compared to Under Armour’s average earnings of 6. 2010 $ 20. indicating that Nike earns. the higher its revenues should be.5 cents of expense to generate a dollar of revenue. ($ and € in millions) Nike (NKE) Under Armour (UA) Adidas (ADDYY) Year Ended Net Income Sales Revenue ROS May 31.ASSET TURNOVER RATIO Asset Turnover. Asset Turnover = Sales Revenue / Total Assets How well does a company produce revenues from its assets? The more assets a company has. 2011 Dec 31.57.998 676 10. Another way of looking at this is that it takes Nike approximately 89. measures the profitability of each dollar of revenue.39 1. on average.862 $ 1. the asset turnover ratios indicate that Under Armour is more efficient.13 However.862 $ 1. Nike has an asset turnover of 1.102 in decimal form). Nike is better at controlling expenses than both Under Armour and Adidas. 2011 Dec 31.5% 4. 2010 Dec 31. ($ and € in millions) Year Ended Sales Revenue Nike (NKE) Under Armour (UA) Adidas (ADDYY) May 31.133 $ 69 € 568 $ 20. one would expect Under Armour to have lower revenues than Nike because it is smaller. whereas Under Armour uses 93. delivering an asset turnover ratio of just 1.7% Nike’s ROS is 10. more than 10 cents of profit for each dollar of revenue.2% (0.5%. For example.990 Total Assets $ $ € 14. whereas Under Armour’s is 1. resulting in higher profits.8 cents of expense to generate a dollar of revenue.57 1. 2010 Dec 31. RETURN ON SALES (ROS) RATIO The Return on Sales (ROS) ratio.618 Asset Turnover 1. Under Armour has fewer assets available to produce revenues than Nike.39.5 cents of profit per revenue dollar. 2% 5. 2011 Dec 31.2% 10. Nike outperforms its competitors.7% 1. using high volume to gain strong net income. 2010 $ 2. and a less efficient asset turnover of 1.2% 6. resulting in return of assets almost 50% higher than that of Under Armour.618 14. Customers are willing to pay more for Nike’s strong brand names. on the other hand. Introduction Page 11 Chapter 1 .3%.3% Even though Under Armour has about 5% of the assets of Nike.2%. Some companies focus on return on sales. This indicates that Nike is able to follow the business strategy of product differentiation. Others focus on asset turnover. comprised of a meager return on sales of 4.RETURN ON ASSETS (ROA) RATIO The Return on Asset (ROA) ratio reveals how efficiently assets are used to generate profit (net income).39 1. Return on Assets = Net Income / Total Assets A high ROA ratio depends on managing asset investments and controlling expenses to keep net income high. is not faring as well. relying on product differentiation to boost profits.7%. 2010 Dec 31. Return on Assets is the broadest measure of profitability.5% 4. 2010 10. whereas Adidas Group comes in third with 5. Nike showed its ability to control costs with its strong return on sales of 10.2% 5.57 1. Adidas. Return on Assets can also be computed by multiplying the two components. 2011 Dec 31. Return on Sales by Asset Turnover: Return on Sales x Asset Turnover = Return on Assets Net income Sales revenue x Sales revenue Total assets = Net income Total assets Analyzing the two components of Return on Assets will help describe corporate strategy. with an ROA of 10. 2010 Dec 31.998 $ 676 € 10. ($ and € in millions) Year Ended Net Income Total Assets ROA Nike (NKE) Under Armour (UA) Adidas (ADDYY) May 31. ($ and € in millions) Year Ended ROS Asset Turnover ROA Nike (NKE) Under Armour (UA) Adidas (ADDYY) May 31. earning its investors a weak 5.13. The company is less profitable than the other two.13 14. Under Armour is second. it generated higher asset turnover. However.3% With Return on Assets of 14.2% 10.3% return on assets.142 in decimal form).2% (0.133 $ 69 € 568 $ 14.2%. 107 1. For 2010. The trend index for 2009 of 103 is the result of dividing 2009 sales revenue of $19.617 100 $ 126 $ 125 $ 111 $ 2011 9. the earliest year being studied.176 17. liabilities increased 12%. And for 2011. Nike relied more heavily on stockholders’ equity. likewise.133 2010 112 112 113 $ $ 19.826 100 From 2008 to 2011. From 2008 to 2009.627 x 100 results in a trend index of 112. By 2011.883 100 Note that the most recent year (2011) is shown on the left.627 and multiplying by 100. Because a number divided by itself is always 100%. Let’s examine the computations of the trend index using Nike’s sales revenue.TREND ANALYSIS Trend Analysis compares amounts of a more recent year to a base year.689 1.744 100 1. sales had increased by 12% since the base year of 2008.014 17. and net income increased 13%. and stockholders’ equity increased 26%.249 101 4.556 106 99 2008 Base Year $ 12.627 x 100 results in a trend index of 102.729 2. the trend index will always be 100 for the base year. expenses increased 12%.754 2009 8.79). A similar trend analysis can be constructed for Nike’s balance sheet: NIKE ($ in millions) Assets Liabilities Stockholders’ Equity $ 14. sales had increased 3% (trend index of 103 less 100) and expenses increased 6%.014 / $18.443 100 $ 4. For 2008.155 121 112 $ 14. This is because users in the world of accounting ask “What have you done for me lately?” They are more interested in the most recent year’s result.907 2009 102 102 101 $ $ 19.419 4.176 by the sales revenue of the base year of $18.665 116 $ 13. Although asset growth was financed with both liabilities and stockholders’ equity. divide the amount reported for each account by the amount reported for the base year and multiply by 100. Introduction Page 12 Chapter 1 . $20.693 7. To compute the trend index.998 5.627 and multiply by 100. $19. divide $18. assets increased 21%. resulting in a 21% decrease in net income (100 . The analysis measures the percentage of change from the base year and indicates growth trends for a company.862 / $18.627 of sales revenue by the amount of sales revenue reported for the base year $18. Trend Index = Current amount / Base year amount x 100 For example. consider this trend analysis for Nike from 2008 to 2011: NIKE ($ in millions) Sales revenue Total expenses Net income 2011 $ $ 20.843 2010 9.862 18.487 103 106 79 $ $ 2008 Base Year 18.627 100 16. 556 100 34 $ 9.443 4.826 % 100 37 63 Even though total liabilities increased from $4. total expenses are always about 90% of sales revenue and net income about 10% of sales revenue. The analysis measures each balance sheet amount as a percentage of total assets.754 68 $ 8.693 66 2008 Base Year $ 12.883 % 100 90 10 Even though Nike’s sales have grown by 12% from 2008 to 2011 (per the trend analysis).249 4.107 1.689 1.419 4.155 in 2011.843 66 $ 9. The Common-Size Balance Sheet compares all amounts within one year to total assets of that same year.617 in 2008 to $5. Here are common-size income statements for Nike: NIKE ($ in millions) Sales revenue Total expenses Net income 2011 $ $ 20.744 $ 1.729 2.155 100 34 $ 14. making it easier to compare income statements for different years and different-size companies.617 $ 7.176 17.014 17.133 % 100 90 10 2010 $ $ 19. 31.862 18.487 % 100 92 8 2008 Base Year $ 18.COMMON-SIZE STATEMENTS The Common-Size Income Statement compares all amounts within one year to revenue of that same year.998 5. liabilities have actually decreased 3% as a percentage of assets. The analysis measures each income statement as a percentage of revenue. ($ in millions) Assets Liabilities Stockholders’ Equity 2011 % 2010 % 2009 % $ 14. Introduction Page 13 Chapter 1 . keeping the company in a stable financial position.907 % 100 90 10 2009 $ $ 19.627 16. Here are four years of common-size balance sheets for Nike: NIKE Dec.665 100 32 $ 13. investors.S. and (4) the statement of cash flows.39 1. divide all amounts by the corresponding amounts for a base year and multiply by 100.3% 19. Financial statement ratios reveal valuable information about a company’s finances. One principle behind GAAP is the Historical Cost Principle. To prepare a common-size analysis on the income statement. and whether the company has too much debt.0% Nike (NKE) Under Armour (UA) Adidas (ADDYY) * **Industry **S&P 500 * ** Industry: Textile—Apparel Footwear and Accessories Industry and S&P 500 ratio averages from moneycentral. a system of rules formulated by the Financial Accounting Standards Board (FASB). classifying.2% 5.msn. Common-size analysis permits easy comparison of financial statements for different years and different companies in the same industry.6 1.7% 13. The statement of stockholders’ equity reports changes in retained earnings and contributed capital during an accounting period. Introduction Page 14 Chapter 1 . which states that assets and services provided should be reported at the cost of acquisition.57 1. RATIO Type ROS x Profitability ASSET TURNOVER Efficiency = ROA Profitability DEBT RATIO Solvency Formula NI / Sales Revenue Sales Revenue / Total Assets NI / Total Assets Total Liabilities / Total Assets 10. managers. The income statement reports a company’s profitability during an accounting period.3% 60.8% 10.0% 34. The statement of cash flows reports cash inflows and outflows during an accounting period. The balance sheet reports assets and the amount of assets financed with liabilities and stockholders’ equity as of a certain date. As U. (3) the statement of stockholders’ equity. In their financial statements.0% 1.SUMMARY Accounting provides a system for recording.2% 10. In 2002.1% 10. Therefore.4% 26.5% 33. divide all amounts by net revenues.com There are no official rules governing how these ratios are calculated. The debt ratio (total liabilities divided by total assets) indicates the proportion of assets financed with debt.0 14. companies present four basic financial statements: (1) the balance sheet. GAAP and International Financial Reporting Standards (IFRS). indicates how efficiently assets are used to generate profits. Return on assets (net income divided by total assets). Asset turnover (revenue divided by total assets) indicates how efficiently a company uses assets to generate revenue. efficiency in managing assets. Return on sales (net income divided by revenue) measures a company’s ability to control expenses. throughout the text we point out important differences that still remain between the two sets of accounting standards. formalizing a commitment to the convergence of U. and reporting transactions.2% 6. This reveals information about a company’s growth. To prepare a common-size analysis on the balance sheet. the FASB and the International Accounting Standards Board (IASB) signed the Norwalk Agreement. and creditors use accounting information as a language for conducting business.3% 56. (2) the income statement. the ratio formulas used may differ from the formulas in the text. divide all amounts by total assets.S. the amount paid for them. Companies prepare financial statements in accordance with Generally Accepted Accounting Principles (GAAP). Entrepreneurs.5% 4. The purpose of this book is to help you learn to interpret and analyze financial statements in order to make investment decisions.13 1. the most comprehensive profitability ratio. such as profitability. GAAP and IFRS are still in the process of converging. To prepare a trend analysis on the balance sheet or income statement. Activity including cash transactions from a company's central business 22. Profit (loss). Principle that requires assets be recorded at the amount paid for them (2 Words) 15. earnings. Rules for preparing the financial statements (abbreviation) 10. classifying.ACTIVITY 1 CHAPTER 1 CROSSWORD PUZZLE Across Down 5. and summarizing financial information 2. Activity including cash transactions that involve stockholders and creditors 4. Wholesale costs of inventory sold (abbreviation) 3. Assets = Liabilities + ____ (abbreviation) 21. Amounts to be received from customers (abbreviation) Introduction Page 15 Chapter 1 . Items of value 8. Statement reporting assets and how they are financed (abbreviation) 18. Costs incurred to produce revenues 9. Amounts owed 25. System for recording. Statement reporting changes in contributed capital and retained earnings (2 Words) 20. or the bottom line (2 Words) 23. Amounts paid-in by stockholders to purchase stock (2 Words) 11. Amounts to be paid to suppliers (2 Words) 13. Net income earned. Activity including cash transactions involving long-term assets 17. Statement reporting profitability (2 Words) 19. Proportion of assets financed by debt (2 Words) 26. Analysis revealing relationships among two or more accounts 16. Measures how efficiently assets are used to generate revenue (2 Words) 24. Analysis used to compare revenues over a 5-year period 12. Reveals how efficiently assets generate profits (3 Words) 1. Statement reporting changes in cash (2 Words) 28. Statement reporting all amounts as percentages (2 Words) 7. Proportion of profit from revenue (abbreviation) 27. but not yet distributed to stockholders (2 Words) 14. Amounts earned selling to or servicing customers 6. whether the company was profitable or not? (BS / IS / SE / CF) c. Accounting is the system of recording. statement of stockholders’ equity.ACTIVITY 2 Purpose: THE FOUR FINANCIAL STATEMENTS • • Identify the four financial statements. Understand the basic information provided by each financial statement. classifying. cash received from customers during the accounting period? (BS / IS / SE / CF) d. ending Contributed capital. the assets of a corporation? (BS / IS / SE / CF) Introduction Page 16 Chapter 1 . It reports revenues. Four financial statements report this information: balance sheet. and expenses. It also reports amounts paid-in (contributed) by stockholders to purchase common stock and preferred stock. items of value such as inventory and equipment. ending The Statement of Stockholders’ Equity (SE) reports if the earnings (net income) of this accounting period are distributed as dividends or retained in the business as retained earnings. Q1 Which financial statement reports: a. BALANCE SHEET Assets Liabilities Stockholders’ equity The Balance Sheet (BS) provides a snapshot of a company’s financial position as of a certain date. The difference is net income. and whether the assets are financed with liabilities (debt) or stockholders’ equity (equity). income statement. It reports assets. whether assets are primarily financed with debt or equity? (BS / IS / SE / CF) b. STATEMENT OF CASH FLOWS Cash inflows (Cash outflows) Change in the cash account The Statement of Cash Flows (CF) reports cash inflows and cash outflows during an accounting period. INCOME STATEMENT Revenues (Expenses) Net income The Income Statement (IS) reports the company’s profitability during an accounting period. dividends declared by the board of directors for shareholders? (BS / IS / SE / CF) e. and reporting financial information. the expenses of a corporation? (BS / IS / SE / CF) g. the costs incurred to produce revenues. amounts received from customers for products sold or services provided. beginning + Net income + Issuance of shares (Dividends) (Repurchase to retire shares) Retained earnings. and the statement of cash flows. retained earnings at the beginning of the accounting period? (BS / IS / SE / CF) f. STATEMENT OF STOCKHOLDERS’ EQUITY Retained earnings. beginning Contributed capital. liability.153 LIABILITIES Accounts payable Short-term debt Other current liabilities Long-term debt Other noncurrent liabilities $ 3. Identify asset.323 3. Typical asset accounts include cash. wages payable.ACTIVITY 3 Purpose: BALANCE SHEET • • • Understand the information provided by the balance sheet.090 (20.865 4.058 14. accounts receivable. Accounts payable are amounts to be paid in the future to suppliers.898 7. and stockholders’ equity accounts reported on the balance sheet.661 13. This relationship is summarized by the accounting equation which is: Assets = Liabilities + Stockholders’ Equity Assets are items of value that a corporation owns or has a right to use.943 426 6. notes payable. Retained Earnings—Net income earned by the company since its incorporation and not yet distributed as dividends. buildings. Introduction Page 17 Chapter 1 . Q1 Identify the accounting equation amounts for PepsiCo Corporation using the information above. Assets $_______ million = Liabilities $_______ million + Stockholders’ Equity $_______ million Q2 Assets can either be financed with ______________________ or __________________________.375) Total L & SE $68.368 1.808 1. Liabilities are amounts owed to creditors.689 $68.098 STOCKHOLDERS' EQUITY Contributed capital Retained earnings Treasury stock and other equity 4.372 1. Typical stockholders’ equity accounts include: Contributed Capital—Amounts paid-in (contributed) by stockholders to purchase common stock and preferred stock.153 The balance sheet reports assets and the amount of financing from liabilities and stockholders’ equity as of a certain date. net Inventories Other current assets Property.505 19. PEPSICO (PEP*) 12/25/2010 BALANCE SHEET ($ in millions) ASSETS Cash and cash equivalents Short-term investments Accounts receivable.449 37. the amount of debt owed to third parties. net Goodwill Other intangible assets Long-term investments Other noncurrent assets Total Assets $ 5. Q3 Will the accounting equation hold true for every corporation? (Yes / No / Can’t tell) Why? * Stock market symbols are shown in parentheses. plant.999 11. equipment. and land.129 19. Stockholders’ Equity is the portion of assets the owners own free and clear. The key word found in many liability accounts is payable. Accounts receivable are amounts to be received in the future from customers. Stockholders’ equity may also be referred to as shareholders’ equity or owners’ equity. Understand the accounting equation. and equipment. Typical liability accounts include accounts payable. inventory. and bonds payable. Cash (A / L / SE) b. How can you tell? Q5 Circle whether the account is classified as an (A)sset. The largest asset account is___________________ reporting $__________ million. what is the total amount shareholders have paid for their shares of stock? $__________ million e. Retained earnings (A / L / SE) j. Common stock (A / L / SE) f. What types of asset costs are included in this account? c. Accounts receivable (A / L / SE) d. Building (A / L / SE) i. or part of Stockholders’ Equity (SE) on the balance sheet. Since the company started business. What amount of cash does this company expect to receive from customers within the next few months? $__________ million b. how much net income was earned and not yet distributed as dividends? $__________ million Introduction Page 18 Chapter 1 . Land (A / L / SE) e. Q6 a. How much does this company currently owe suppliers? $__________ million d. Bonds payable (A / L / SE) Use PepsiCo’s balance sheet on the previous page to answer the following questions: a. (L)iability. Mortgage payable (A / L / SE) l. Equipment (A / L / SE) g. Notes payable (A / L / SE) h. Accounts payable (A / L / SE) c. Inventory (A / L / SE) k. Since the company started business.Q4 PepsiCo is primarly financed with (liabilities / stockholders’ equity). Cost of goods sold (Rev / Exp / Not) f. or the bottom line. Sales revenue and service revenue are amounts earned engaging in the primary business activity.912 Net income $ 6. Expenses are recorded in the accounting period they benefit (if a cause and effect relationship exists) or are incurred (if there is no cause and effect relationship). which is typically the largest expense account for a company within the (retail / service) industry.320 The income statement reports the company’s profitability during an accounting period. Building (Rev / Exp / Not) Review PepsiCo’s 2010 income statement above and answer the following questions: a. Net income is also referred to as profit (loss).326 488 217 8. b. a. Wage expense (Rev / Exp / Not) d. Introduction Page 19 Chapter 1 . (Exp)ense. general and administrative (SGA) expense Research and development expense Other operating expenses Income before income tax Provision for income tax $ 57. Service revenue (Rev / Exp / Not) b. What specific types of costs would be included in this account for PepsiCo? d. Revenues – Expenses = Net income Q1 Q2 Circle whether the account is classified as a (Rev)enue. Inventory (Rev / Exp / Not) e. Rent expense (Rev / Exp / Not) c.ACTIVITY 4 Purpose: INCOME STATEMENT • • Understand the information reported on the income statement.575 31. earnings.838 26.263 22. Beverages and snacks were sold to customers for $__________ million that cost the company $__________ million to produce. Q3 Was PepsiCo profitable? (Yes / No) How much profit was reported? $__________ million Net income can also be referred to as (revenues / expenses / common stock / earnings).232 1. Expenses are the costs incurred to produce revenues. PEPSICO (PEP) 2010 INCOME STATEMENT ($ in millions) Sales revenue Cost of goods sold Gross profit Selling. or (Not) reported on the income statement. Revenues are amounts received from customers for products sold and services provided. Net income is the difference between revenues and expenses. c. Cost of goods sold expense reports the wholesale costs of inventory sold to customers during the accounting period. This company reports (1 / 2 / 3 / 4) revenue account(s) and (2 / 3 / 4 / 5) expense accounts. Identify revenue and expense accounts reported on the income statement. The title of the largest expense account is _______________ reporting $__________ million. RE.041) (3. Introduction Page 20 Chapter 1 .273 6.320 (3. When the company buys back shares of stock.320 (3. b. Earnings of a corporation belong to the (managers / stockholders). Q1 Earnings is another word for (revenue / receivables / net income).ACTIVITY 5 Purpose: STATEMENT OF STOCKHOLDERS’ EQUITY • • • Understand information provided by the Statement of Stockholders’ Equity. which is the amount shareholders paid for (net income / dividends / issued shares). Q5 Revenues . Ending retained earnings is reported on the Statement of Stockholders’ Equity and then transferred to the (IS / SE / BS). and other equity accounts during an accounting period.041) 6 (3.177) 6. Sales revenue Accounts receivable Wage expense Bonds payable (IS / SE / BS) (IS / SE / BS) (IS / SE / BS) (IS / SE / BS) Use PepsiCo’s 2010 statement of stockholders’ equity above to answer the following questions: a. or the Balance Sheet (BS).805 $ (17. Earnings can either be distributed to the stockholders as (dividends / expenses / retained earnings) or kept in the business as (dividends / expenses / retained earnings). Contributed capital (CC) is increased when additional shares of stock are issued and decreased when those shares are retired. Note: Three amounts are reported on two statements. retained earnings. Q4 Circle whether the account is reported on the Income Statement (IS).192) $ 21.Dividends = _____________ Contributed capital Net income Dividends Retained earnings (IS / SE / BS) (IS / SE / BS) (IS / SE / BS) (IS / SE / BS) e. Statement of Stockholders’ Equity (SE). Retained earnings increased by (net income / dividends / issued shares) of $__________ million and decreased by (net income / dividends / issued shares) of $__________ million. total stockholders’ equity (increases / decreases). Q2 Income statement: Balance sheet: Stockholders’ Equity Statement of SE: Q3 Net income is computed on the (IS / SE / BS) and then transferred to the Statement of Stockholders’ Equity to increase (CC / RE / Other SE).Expenses = ____________________ Assets = ____________________+ ____________________ = Contributed capital + ___________ + Other Equity Beg Retained Earnings + ______________ . b.449 Retained Earnings Other Equity $ 33. g.375) Total Stockholders Equity $ 16. d. PEPSICO (PEP) 2010 STATEMENT OF STOCKHOLDERS’ EQUITY ($ in millions) Contributed Capital Beginning balance Issuance of shares Net income Dividends Other transactions $ Ending balance $ 176 4. When the company issues shares of stock.273 4. Understand changes within contributed capital and retained earnings. Earnings not distributed as dividends are reported as retained earnings.164 The statement of stockholders’ equity reports changes within the contributed capital. a. Contributed capital reported at the end of the accounting period is $__________ million. total stockholders’ equity (increases / decreases). c.804 4.198) $ 37. Retained earnings (RE) is increased by net income (earnings) of the accounting period and decreased when earnings are distributed as dividends to the stockholders.090 $(20. c. Identify relationships among the IS. f. h. and the BS. Rent payable (IS / BS / CF) g. Cash from issuing common stock (IS / BS / CF) b. which resulted in a cash (inflow / outflow) of $__________ million from (operating / investing / financing) activities. and financing. The statement of cash flows organizes cash inflows and cash outflows as operating activities. PepsiCo’s operating activities generated cash inflows of $__________ million. investing. and equipment. Circle whether the account is reported on the Income Statement (IS). and financing activities. resulting in an ending cash balance of $__________ million. PepsiCo borrowed money. end of the period $ 5. plant. Rent expense (IS / BS / CF) f. Cash at the end of 2010 is the (same as / different than) cash at the beginning of 2011. investing activities. Operating Activities relate to a company’s main business of selling products or services to earn net income. Accounts receivable (IS / BS / CF) d. cash was $__________ million.000 3. investing. and equipment or expanding by making investments in other companies. cash (increased / decreased) by $__________ million.668) 1. the Balance Sheet (BS). Retained earnings (IS / BS / CF) e.386 (166) 2. Understand that cash flows are organized as operating. or the Statement of Cash Flows (CF). e. At the beginning of 2010.448 (7. The Statement of Cash Flows describes a company’s cash inflows and outflows for each of these three areas. During the year. c. Q1 Q2 Use PepsiCo’s 2010 statement of cash flows above to answer the following questions: a. PepsiCo purchased property.943 = Cash.943 Business activities can be classified into three distinct categories: operating. a. Cash received from customers (IS / BS / CF) Introduction Page 21 Chapter 1 . plant. d. beginning of the period $ 8. PEPSICO (PEP) 2010 STATEMENT OF CASH FLOWS ($ in millions) Net cash received from operating activities (NCOA) Net cash paid for investing activities (NCIA) Net cash received from financing activities (NCFA) Effect of exchange rate changes Change in cash + Cash. and financing activities. b. Sales revenue (IS / BS / CF) c. Cash paid for rent (IS / BS / CF) h.ACTIVITY 6 Purpose: STATEMENT OF CASH FLOWS • • Understand information provided by the Statement of Cash Flows. Financing Activities relate to how a company finances its assets—with debt or stockholders’ equity. which resulted in a cash (inflow / outflow) of $__________ million from (operating / investing / financing) activities. Investing Activities relate to the need for investing in property. Introduction Page 22 Chapter 1 . Q3 (CPAs / Management / Corporate accountants) conduct audits that attest to whether a company’s financial statements comply with GAAP.000. Ethical behavior is defined by the AICPA’s (American Institute of CPA’s) Code of Professional Conduct. GAAP is (converging toward / in full compliance with). GAAP (Generally Accepted Accounting Principles) are the rules that companies must follow when preparing financial statements.000 / $100. The SEC provides oversight and enforcement authority over the Financial Accounting Standards Board (FASB) and the Public Company Accounting Oversight Board (PCAOB). when? (Yes / No) INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) Q7 There (are / are not) differences among the accounting standards of different countries. ($18. Q2 GAAP stands for ______________ ______________ ______________ ______________. Q4 An auto has a sticker price of $20. thus using verifiable information that is the most reliable information. On the balance sheet. On the balance sheet. land was purchased for $2. The seven full-time voting members of the FASB (Financial Accounting Standards Board) set accounting reporting standards and formulate GAAP. which now has a current market value of $100.000. Q5 When the financial statements are prepared according to GAAP. This code holds CPAs accountable for serving the public interest. Audits attest to whether a company’s financial statements comply with GAAP. • • • • • The SEC (Securities and Exchange Commission) has legislative authority to set the reporting rules for accounting information of the publicly held corporations it regulates. assets and services are reported at their (acquisition cost / current market value).000) will be reported for the land. Only CPAs (Certified Public Accountants). Thirty years ago.000 / $20.000. The five full-time members of the PCAOB (Public Company Accounting Oversight Board) establish auditing standards and conduct inspections of the public accounting firms that perform audits. It has designated GAAP to be the official rules. Apply the historical cost principle. A company purchases the auto. can conduct the audits. but negotiates with the sales person and pays a price of only $18.ACTIVITY 7 Purpose: GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) • • Understand that GAAP (Generally Accepted Accounting Principles) are the rules of financial accounting. Q1 (FASB / SEC / GAAP / AICPA) are the rules that must be followed when preparing the financial statements for external use. Q6 THINK ABOUT IT: Is knowledge of an asset’s current market value ever useful? If so. ($2. IFRS are global accounting standards that U.000. licensed by the state. HISTORICAL COST PRINCIPLE GAAP #1: The Historical Cost Principle states that assets and services should be recorded at their acquisition cost.S.000) will be reported for the auto. Analysis reveals relationships by comparing amounts to: (1) other amounts for the same period (ratios and common-size statements). but how much do you really know about them? Q1 FINANCIAL TRIVIA For the fiscal years ending below.687 FINANCIAL TRIVIA In each large circle. TIF Jan 31. liabilities. the greatest amount of revenue. the greatest amount of revenue. place the amount that you guess for … a. 2011 F Dec 31. (3) competitor information. Now turn to page 25 and see how well you guessed. Explore the relationships among assets.) b. and Common-Size Statements (vertical analysis). (This is completed for you. Trend Analysis (horizontal analysis).) b. c. 2010 ASSETS $ $ $ LIABILITIES $ $ $ REVENUE $ $ $ NET INCOME $ $ $ 164. Examine the debt ratio. ROS (return-on-sales) ratio. and Ford Motor Company (F) are well-known companies. and industry norms. the greatest amount of assets. the greatest amount of net income. and the ROA (return-on-asset) ratio. (2) the same information from a prior period (trend analysis). revenues. put a large circle in the box of the company that you guess has … a.ACTIVITY 8 Purpose: ANALYSIS: RATIOS • • • Understand that analysis reveals relationships. asset-turnover ratio. the greatest amount of liabilities. The three types of analysis are Ratio Analysis. 2011 ($ in millions) Q2 WMT Jan 31. d. the greatest amount of liabilities. Introduction Page 23 Chapter 1 . the greatest amount of assets. d. the greatest amount of net income. RATIOS Tiffany & Co (TIF). c. (This one is completed for you. and net income. Wal-Mart Stores (WMT). whereas a company primarily financed with equity will have a debt ratio that is (less / more) than 50. (TIF / WMT / F) has the strongest asset turnover. The debt ratio reveals the proportion of assets financed with debt. leaving __________ cents of each revenue dollar for profit. c. The corporation with the strongest ROS ratio is (TIF / WMT / F). Wal-Mart is primarily financed with (debt / equity).389 $ 6.93% % % b. c.Q3 a.954 $ 164. Does a low ROS ratio indicate a weak corporation? (Yes / No) Why? a.687 Total Liabilities $ 1. How can a company increase its ROS ratio? e. indicating the company makes profits by generating a large volume of revenue using relatively few assets.360 Debt Ratio 41. d. a.663 F 12/31/2010 $ 128.70% % % b.687 3.849 $ 180.8257 b. ROS reveals the portion of each revenue dollar that results in profit. __________ cents of each revenue dollar went to pay for all of the costs of running the business. Wal-Mart generates $__________ in revenue for every $1 invested in assets. Introduction Page 24 Chapter 1 . but for Wal-Mart only __________% of every revenue dollar resulted in profit. but Tiffany & Co has a (higher / lower) ROS ratio than Wal-Mart. Ford has a debt ratio greater than (50% / 100%).558 $ 112. Compute the debt ratio for each company listed below.00%. resulting in a debt ratio that is (less / more) than 50. Asset Turnover reveals how efficiently assets are used to generate revenue.736 $ 180.849 $ 128. Debt ratio = Total liabilities / Total assets ($ in millions) Tiffany & Co (TIF) Wal-Mart Stores (WMT) Ford Motor Company (F) Q4 Total Assets $ 3. indicating its liabilities are (greater / less) than its assets.736 Asset Turnover 0. ROS = Net income / Sales revenue ($ in millions) TIF WMT F Q5 Year Ended 1/31/2011 1/31/2011 12/31/2010 Year Ended 1/31/2011 1/31/2011 12/31/2010 Revenue $ 3.954 Net income $ 368 $ 16.085 Total Assets $ 3.085 $ 421. For Wal-Mart.00%.121 $ 165. Compute Return on Sales (ROS) for each company listed below. The asset turnover ratios computed above are in the range (less than 3 / 3 or more). Compute Asset Turnover for each company listed below. Asset Turnover = Sales Revenue / Total Assets ($ in millions) Year Ended Revenue TIF 1/31/2011 $ WMT 1/31/2011 $ 421.561 ROS 11. Wal-Mart has (greater / less) revenue than Tiffany & Co. The ROS ratio for Tiffany & Co indicates __________% of every revenue dollar resulted in profit (net income).663 $ 164. 389 6. to better understand corporate strategy (productdifferentiation vs. b. Analyze the components. a.85% % % % % The corporation with the strongest overall measure of profitability is (TIF / WMT / F) with an ROA of _______%. 2010 $ 164.Q6 a. ROA is the broadest measure of profitability. 2011 $ 3. The broadest measure of profitability that can be broken down into components to better understand corporate strategy is the (Debt / ROS / Asset Turnover / ROA) ratio. indicating that a (lowcost / product-differentiation) strategy is used. ($ in millions) ASSETS LIABILITIES STOCKHOLDERS’ EQUITY REVENUE NET INCOME Introduction TIF Jan 31. Compute Return on Assets (ROA) for each company listed below. The ratio that measures the ability to translate revenue into profit is the (Debt / ROS / Asset Turnover / ROA) ratio. Ford Motor Company has (high / low) ROS and (high / low) Asset Turnover.542 421. A high ROA ratio depends on managing asset investments and controlling expenses to keep net income high. ROS and Asset Turnover. The ratio that measures the proportion of debt used to finance assets is the (Debt / ROS / Asset Turnover / ROA) ratio.954 $ 6.736 $ 180. on average.121 68.687 ROA 9. whereas Tiffany & Co has a (high / low) ROS and a (high / low) Asset Turnover. indicating that a (low-cost / product-differentiation) strategy is used. Q7 d.93% Asset Turnover 0. A high (Debt / ROS / Asset Turnover / ROA) ratio indicates a high-volume strategy Solutions to FINANCIAL TRIVIA Q1 and Q2. the company generates.085 $ 368 Page 25 WMT Jan 31. Year Ended 1/31/2011 1/31/2011 12/31/2010 Year Ended 1/31/2011 1/31/2011 12/31/2010 ROS x 11.178 3.736 1.389 F Dec 31. compute ROA by multiplying the two components.663 $ 167. ROA = ROS x Asset T/O ($ in millions) TIF WMT F c. Wal-Mart has a (high / low) ROS and a (high / low) Asset Turnover.85% % % For each company below.687 165. _______ cents in profits. ROA reveals how efficiently a company uses its assets to generate profit (net income).663 $ 112. Return on Sales and Asset Turnover (previously computed). low-cost strategies).558 2. The corporation with the weakest ROA is (TIF / WMT / F). c. indicating that it is (doing well / still recovering).360 (673) 128. $ $ $ Net Income 368 16.849 16. indicating that for each dollar invested in assets.561 Chapter 1 . 2011 $ 180.8257 = ROA 9. ROA = Net Income / Total Assets ($ in millions) TIF WMT F b. d.561 Total Assets $ 3. 164 $16. To compute.394 $21. Q1 Complete the trend indexes for Total expenses and Net income using the amounts listed below. During the same period. Q7 Stockholders’ equity amounts are greater than the base year on (12/25/2010 / 12/26/2009 / 12/27/2008) when the trend index is (greater / less) than 100.286 38. The analysis measures the percentage of change from the base year.142 $ 5.251 110 $39. From 12/29/2007 to 12/25/2010.994 $34.682 Net income 147 $43. Stockholders’ equity amounts are less than the base year on (12/25/2010 / 12/26/2009 / 12/27/2008) when the trend index is (greater / less) than 100. Use 2007 as the base year.474 100 Q2 From 2007 to 2010 sales growth for PepsiCo was 47%. divide each amount by the amount of the base year and multiply by 100. PEPSICO ($ in millions) 12/25/2010 Assets $68.989 23. indicating the corporation is relying (more / less) on debt to finance assets.804 $12.946 $ 5. Why? The worst year financially for PepsiCo was (2010 / 2009 / 2008). Q3 Assume PepsiCo had a goal of increasing profits by 5% each year. The base year is the earliest year being studied.888 17.234 100 Q6 The assets of PepsiCo increased by 97% from 12/29/2007 to 12/25/2010.518 37.848 115 12/27/2008 Base Year 12/29/2007 $35. which is (favorable / unfavorable). indicating PepsiCo is (growing / shrinking).628 104 46. Q4 The best year financially for PepsiCo was (2010 / 2009 / 2008).153 Liabilities SEquity 197 12/26/2009 $39.109 33.232 Base Year 2007 2008 110 $43. Record the resulting trend index in the shaded area below. Why? Q5 Complete the trend indexes for Liabilities and Stockholders’ Equity using the amounts listed below.794 $ 6. A trend analysis compares amounts of a more recent year to a base year. It is favorable when sales increase by 47% and expenses increase at a (greater / lesser) rate than 47%. When net sales increase. Introduction Page 26 Chapter 1 .838 Total expenses 51.044 23. Use 2007 as the base year. PEPSICO ($ in millions) 2010 2009 Sales revenue $57. resulting in a (small / large) increase in net income.320 $ 5. This goal was (met / not met). From 2007 to 2010 (revenues / expenses) of PepsiCo increased at a greater rate.106 $17. divide each amount by the amount for the base year and multiply by 100. expenses would be expected to (increase / stay the same / decrease). total expenses increased __________%. (assets / liabilities) increased at a greater rate.ACTIVITY 9 Purpose: ANALYSIS: TREND • Prepare a trend analysis and understand the information provided. Q8 It is easier to analyze PepsiCo (before / after) preparing the trend analysis. Record the resulting trend index in the shaded area below. To compute. ACTIVITY 10 Purpose: ANALYSIS: COMMON-SIZE STATEMENTS • Prepare common-size statements and understand the information provided.518 89 23. To compute. every amount is compared to or divided by total (assets / liabilities / sales revenue / net income). On the commonsize balance sheet.918 2.320 11 $11. ROS = NI / Revenue Q3 On the common-size income statement.003 $3. Q1 Prepare the common-size statements for the Coca-Cola (KO) and the Starbucks (SBUX) companies listed below. divide each amount on the balance sheet by total assets. every amount is compared to or divided by total (assets / liabilities)._______ in decimal form. Record the resulting common-size percent in the shaded area provided. 2010 ($ in millions) COCA-COLA (KO) STARBUCKS (SBUX) Amount % Amount Sales revenue Amount $57.989 69 41.707 Total expenses 51. The COMMON-SIZE INCOME STATEMENT compares all amounts within one year to revenue of that same year. ROS for PepsiCo is __________% or ___.838 100 $35.164 31 $31. The debt ratio for Starbucks is __________%. To compute.386 46.119 $10. which indicates debt (liabilities) is used to finance __________% of assets and equity (stockholders’ equity) is used to finance __________% of assets.674 SEquity % STARBUCKS (SBUX) ($ in millions) Liabilities Q7 PEPSICO (PEP) Amount % Starbucks primarily finances assets with (liabilities / stockholders’ equity). (True / False) Q5 Based only on the information provided above. Debt Ratio = Liabilities / Assets Introduction Page 27 Chapter 1 . Q4 Common-size statements are helpful when comparing companies of different size.712 $21.809 Net income Q2 PEPSICO (PEP) % $ % 946 (PEP / KO / SBUX) is the largest company above. divide each amount on the income statement by sales revenue.153 100 $72.8 (trillion / billion / million / thousand). 2010 COCA-COLA (KO) Amount % Amount Assets $68. The analysis measures each income statement amount as a percentage of revenue. which company would be your choice of investment? (PEP / KO / SBUX) Why? The COMMON-SIZE BALANCE SHEET compares all amounts within one year to total assets of that same year. Q6 Prepare the common-size statements for the Coca-Cola (KO) and Starbucks (SBUX) companies listed below. which indicates __________ cents of every dollar of sales revenue resulted in profit.921 $6. The analysis measures each balance sheet amount as a percentage of total assets. Record the resulting common-size percent in the shaded area provided.761 $ 6. reporting sales revenue of approximately $57.310 9. 520 Retained Earnings $ 41.199 6.100 8.809 (4.434 $ 11.119 12.465) (166) 1.520 11.003 COCA-COLA (KO) 2010 STATEMENT OF CASH FLOWS ($ in millions) Introduction Net cash received from operating activities (NCOA) Net cash paid from investing activities (NCIA) Net cash paid from financing activities (NCFA) Effect of exchange rate changes Change in cash + Cash.243 2.COCA-COLA (KO*) 12/31/2010 BALANCE SHEET ($ in millions) ASSETS Cash and cash equivalents Short-term investments Accounts receivable.278 (29. and equipment.937 49. net Inventories Other current assets Property.794) 14.244 7.426 7.921 TOTAL L & SE $ 1.799 1.405) (3.537 Other Equity $ (26.727 11.212) TOTAL S/E $ 24. beginning of the period $ 9.278 $(29.417 1.041 9.057) $ 10. net Goodwill Other intangibles Long-term investments Other non-current assets TOTAL ASSETS LIABILITIES Accounts payable Short-term debt Other current liabilities Long-term debt Other non-current liabilities $ 8.517 2.921 COCA-COLA (KO) 2010 INCOME STATEMENT ($ in millions) Sales revenue Cost of goods sold Gross profit Selling.212) $ 72.532 (4. general.068) (3.937 $ 49. end of the period $ 8.521 14.021 = Cash.068) (3.369 10.693 22.496 7.665 15.162 14. plant.121 STOCKHOLDERS’ EQUITY Contributed capital Retained earnings Other stockholders’ equity $ 72. and administrative expense Other operating expenses Nonoperating (revenues) and expenses Income before income tax Provision for income tax Net income $ 35.778 ( 5.650 3.057) $ 31.517 Page 28 Chapter 1 .585 2.809 (4.430 2.887 8.809 COCA-COLA (KO) 2010 STATEMENT OF STOCKHOLDERS’ EQUITY ($ in millions) Beginning balance Issuance of shares Net income Dividends Other transactions Ending balance Contributed Capital $ 9.155) 11.820 4. 000 Net income totals $____________________ Q3 Suppose that during the first year of business $100. Prepare and evaluate trend analyses.000 Common stock Cost of goods sold 70. common-size statements. Note: There may be more than one way to correct the false information. Net income distributed to shareholders is referred to as contributed capital. and the remaining wages will be paid to employees on January 3 of the coming year. statement of contributed capital. What account title and amount will be reported on the following year-end financial statements? a. Circle the income statement amounts and cross out amounts not reported on the income statement. Supply expense $ 8. d. asset sheet. Then compute net income. a. Balance Sheet account title: Wages (expense / payable / paid) of $__________ c. Accounts receivable are amounts to be paid later to suppliers by the corporation. f. and accounts payable is a stockholders’ equity account. Make the following statements true by correcting the false information. the next payday.000 Dividends $100.000 50. Retained earnings is an asset account. i. The statement of cash flows reports the assets of the business and how those assets are financed. h. Compute net income.000 2. j. accounts receivable is a liability account. b. The income statement reports cash inflows and cash outflows. $90.000 Sales revenue Notes payable 30. c. Cash is the amount earned engaging in the primary business activity. Earnings is another term for revenue.ACTIVITY 11 Purpose: Q1 Q2 TEST YOUR UNDERSTANDING • • • Review the four financial statements. Statement of Cash Flows account title: Wages (expense / payable / paid) of $__________ Introduction Page 29 Chapter 1 . and the statement of cash flows.000 of wage costs were incurred. Dividends are reported as an expense on the income statement.000 were paid in cash to employees. Assets are financed either by liabilities or expenses. Income Statement account title: Wages (expense / payable / paid) of $__________ b. The four financial statements include the revenue statement. e. g. and ratios. For CocaCola.119 23. Total Assets of $__________ million helped to generate Sales Revenue of $__________ million. which results in a ROA ratio of ________%.______. which results in an Asset Turnover ratio of 0. c. Coca-Cola has (kept /not kept) spending under control. which results in a ROS ratio of ________%.809 2009 122 $30.166 $ 6. Net Income of $__________ million is reported on the Income Statement. It is also reported on the (Income Statement / Balance Sheet / Statement of Cash Flows). resulting in an increase in net income of __________%. The ending balance of retained earnings on the Statement of Stockholders’ Equity is $__________ million. h. f. while expenses increased by __________%.994 111 26. Use 2007 as the base year. resulting in a (small / large) increase in net income that is (greater / less) than the increase in sales revenue over the same time period. Introduction Page 30 Chapter 1 .Q4 Review the 2010 Financial Statements of the Coca-Cola Company on page 28 to answer the following questions: a. Complete Coca-Cola’s trend indexes for Total expenses and Net income using the amounts listed below. It is also reported on the (Statement of Stockholders’ Equity / Balance Sheet / Statement of Cash Flows).187 $ 5. Total Assets of $__________ million helped to generate Net Income of $__________ million. d.981 100 From 2007 to 2010 sales revenue of Coca-Cola increased by __________%. Record the resulting trend index in the shaded area. ROA of ________% = Asset Turnover of 0. Cash reported on the Balance Sheet is $__________ million. Assets $__________ million = Liabilities $__________ million + SE $__________ million Is the accounting equation in balance? (Yes / No) Q5 b. It is also reported on the (Income Statement / Statement of Stockholders’ Equity / Statement of Cash Flows). indicating that a (low-cost / product-differentiation) strategy is used. Coca-Cola (KO) ($ in millions) Sales revenue Total expenses Net income 2010 $35. g.310 $11.807 Base Year 2007 $28. Sales Revenue of $__________ million helped to generate Net Income of $__________ million.824 2008 107 $31.990 24.857 22.876 $ 5. e.______ x ROS of ________%. The most comprehensive measure of profitability is (Asset Turnover / ROS / ROA). Q6 Complete Coca-Cola’s common-size statements for 12/31/2008, 12/31/2009, and 12/31/2010 using the amounts listed below. Record the resulting common-size percent in the shaded area provided. Coca-Cola (KO) ($ in millions) Assets Liabilities SEquity Dec 31, 2010 % Dec 31, 2009 $72,921 41,918 $31,003 100 57 43 $48,671 23,872 $24,799 % Dec 31, 2008 $40,519 20,047 $20,472 % Dec 31, 2007 % $43,269 21,525 $21,744 On 12/31/2007, _______% of assets were financed with liabilities and on 12/31/2010 assets were primarily financed with (liabilities / stockholders’ equity), indicating that on 12/31/2010 this company is relying (more / less) on debt to finance assets. In the common-size balance sheet, every amount is compared to or divided by _______________. In the common-size income statement, every amount is compared to or divided by ____________. Q7 To answer the following questions, use the chart below that presents financial information for PepsiCo, Coca-Cola, and ratio averages for the beverage industry. ($ in millions) Assets Liabilities Stockholders’ Equity Revenue Net Income ROS Asset Turnover ROA Debt Ratio Q8 PEP 12/25/2010 KO 12/31/2010 $ 68,153 46,989 21,164 57,838 $ 6,320 $ 72,921 41,918 31,003 35,119 $ 11,809 10.93% 0.8486 9.27% 68.95% 33.63% 0.4816 16.19% 57.48% Beverage Industry Average NA NA NA NA NA 19% 0.80 15% 74% a. (PEP / KO) has a stronger ROS, indicating it generates more (expense / profit) from each dollar of revenue. b. (PEP / KO) reports the greatest volume of sales as indicated by the (ROS / Asset Turnover / ROA) ratio. c. The most comprehensive measure of profitability, the (ROS / Asset Turnover / ROA) ratio, indicates (PEP / KO) is the more profitable company. d. (PEP / KO / both / neither) are at greater financial risk than average for the beverage industry, which is indicated by the (ROS / Asset Turnover / ROA / Debt) ratio. Are Generally Accepted Accounting Principles (GAAP) necessary? (Yes / No) Why or why not? Introduction Page 31 Chapter 1 CHAPTER 2 BALANCE SHEET LEARNING OBJECTIVES 1. Understand how the balance sheet is organized. 2. Identify individual components of the balance sheet. 3. Understand similarities and differences between U.S. GAAP and IFRS among asset items. 4. Explain how debt and equity affect financial risk. 5. Compute and interpret liquidity and solvency ratios. 6. Prepare and interpret trend and common-size balance sheets. INTRODUCTION How would you assess your personal finances? One approach is to consider your net worth. First of all, add up everything you own: cash in the bank account, your car, books, and gadgets. These are your assets. Then add up everything you owe: credit card bills, student loans, and perhaps personal debts. These are your liabilities. Subtracting your liabilities from your assets will give you “net worth,” the value of your assets after all liabilities have been paid. For example, suppose that Kirsten, a college student, has $1,000 in the bank and an auto she recently purchased for $4,000 in cash. That makes $5,000 in assets. She also owes $700 on a credit card. That’s $700 in liabilities. Kirsten has net worth of $4,300 ($5,000 - 700). Kirsten has financed her assets primarily with her own net worth. Mike also has $1,000 in the bank and a car recently purchased for $4,000 in cash; $5,000 in assets. He owes $700 on a credit card, just like Kirsten, but also owes $20,000 in student loans. Mike has liabilities of $20,700 and net worth of negative $15,700 ($5,000 - 20,700). Mike has financed his assets with liabilities. The Balance Sheet provides a snapshot of a company’s financial position as of a certain date. It reports assets and whether those assets are financed with liabilities or stockholders’ equity. The Balance Sheet is also referred to as the Statement of Financial Position. Both Kirstin and Mike have the same amount of cash in the bank, $1,000. However, learning about their net worth helps us understand how easily they can pay off debt. In the long term, Mike will need to obtain more assets than Kirsten to pay off his student loan liabilities. If he can’t obtain those assets, he will not be able to pay the liabilities. Kirsten, on the other hand, will not have this problem. However, because student loans won’t begin to come due until a year after graduation, both Kirsten and Mike should have the same ability to pay off their liabilities in the next year. The Balance Sheet is important because investors use it to understand a company’s liquidity and solvency. Liquidity describes a company’s ability to pay liabilities as they come due in the next year. Solvency Balance Sheet Page 32 Chapter 2 describes a company’s ability to pay liabilities for many years into the future. To survive, companies must have strong liquidity and healthy solvency. In this chapter, we learn to understand and interpret amounts reported on the balance sheet in order to evaluate the liquidity and solvency of The Walt Disney Company. The following are Walt Disney’s consolidated balance sheets (Consolidated means that this financial statement combines the results of all Walt Disney subsidiaries). The Walt Disney Company (DIS) BALANCE SHEET ASSETS Current assets: Cash and cash equivalents Receivables Inventories Television costs Deferred income taxes Other current assets Total current assets Film and television costs Investments Parks, resorts, and other property, at cost: Attractions, buildings, and equipment Accumulated depreciation 10/2/2010 $ 10/3/2009 2,722 5,784 1,442 678 1,018 581 12,225 4,773 2,513 $32,875 (18,373) $ Intangible assets, net Goodwill Other assets TOTAL ASSETS LIABILITIES Current liabilities: Accounts payable and other accrued liabilities Current portion of borrowings Unearned royalties and other advances Total current liabilities Borrowings Deferred income taxes Other long-term liabilities Commitments and contingencies SHAREHOLDERS’ EQUITY Preferred stock, $.01 par value Authorized—100 million shares, Issued—none Common stock, $.01 par value Authorized—4.6 billion shares at 10/2/2010 and 3.6 billion shares at 10/3/2009, Issued—2.7 billion shares at 10/2/2010 and 2.6 billion shares at 10/3/2009 Retained earnings Accumulated other comprehensive loss Treasury stock, at cost, 803.1 million shares at 10/2/2010 and 781.7 million shares at 10/3/2009 Noncontrolling Interests Page 33 3,417 4,854 1,271 631 1,140 576 11,889 5,125 2,554 $32,475 (17,395) 14,502 2,180 1,124 17,806 5,081 24,100 2,708 Projects in progress Land Balance Sheet ($ in millions) 15,080 1,350 1,167 17,597 2,247 21,683 2,022 $ 69,206 $ 63,117 $ 6,109 2,350 2,541 11,000 10,130 2,630 6,104 -- $ 5,616 1,206 2,112 8,934 11,495 1,819 5,444 -- -- -- 28,736 34,327 (1,881) 27,038 31,033 (1,644) (23,663) 1,823 39,342 (22,693) 1,691 35,425 Chapter 2 TOTAL L & SE $ 69,206 $ 63,117 UNDERSTANDING THE WALT DISNEY COMPANY’S BALANCE SHEET This financial statement is called the “balance sheet” because assets are “equal to” or “balance” with the sum of liabilities and stockholders’ equity. It is based on the accounting equation: Assets = Liabilities + Stockholders’ Equity Recall that Assets are items of value that a corporation has a right to use. Liabilities are amounts owed to creditors, the amount of debt owed to third parties. Stockholders’ Equity is the portion of assets the owners own free and clear of the liabilities. Stockholders’ Equity is also referred to as Shareholders’ Equity, as on Disney’s Balance Sheet: October 2, 2010 Assets $ 69,206 Liabilities Stockholders’ Equity (SE) Total assets $ 69,206 Total liabilities and SE $ 29,864 39,342 $ 69,206 Above, Disney owns $69,206 million in assets. It also owes $29,864 million in liabilities to its creditors (6,109+ 2,350 + 2,541 + 10,130 + 2,630 + 6,104). This leaves $39,342 million of assets that are financed by stockholders. Disney is accountable to the creditors to pay back loans received from them, with interest. Similarly, Disney managers are accountable to the stockholders, to take good care of their company and earn a healthy return on investment. From 2009 to 2010, Disney’s assets have increased from $63,117 to $69,206, or 9.6%. This indicates that Disney’s assets are growing relatively quickly. By comparison, the trend analysis in Chapter 1 revealed that Nike’s assets grew 21% over the past three years, or about 7% per year. The Balance Sheet lists assets and liabilities in the order of liquidity, the ease with which each account can be converted into cash. The most liquid asset, cash, always appears first. The least liquid asset, often goodwill, is listed last. Similarly, liabilities are listed in the order of payment, so that the most liquid liability, that which is due earliest, is listed at the top. Usually this is accounts payable. The least liquid liabilities are usually long-term debt. Along these lines, assets and liabilities are both split into “current” and “noncurrent” portions. Current assets are expected to be converted into cash, sold, or consumed within the next twelve months. Noncurrent assets are all assets not listed as current. Current liabilities are liabilities due within 12 months. Noncurrent liabilities are due after 12 months. As we will see later in this chapter, these distinctions help financial statement users assess a company’s liquidity and solvency. In the next sections, we discuss current and noncurrent assets, and current and noncurrent liabilities. Stockholders’ Equity is discussed in Chapter 4. Balance Sheet Page 34 Chapter 2 CURRENT ASSETS Current assets are those assets that are expected to be converted into cash, sold, or consumed within 12 months. These assets are highly liquid items that the company can readily use to pay for its operations. The Walt Disney Company (DIS) BALANCE SHEET ASSETS Current assets: Cash and cash equivalents Receivables Inventories Television costs Deferred income taxes Other current assets ($ in millions) 10/2/2010 $ Total current assets 2,722 5,784 1,442 678 1,018 581 $ 12,225 10/3/2009 $ 3,417 4,854 1,271 631 1,140 576 $ 11,889 The balance sheet always begins with cash and cash equivalents, which are actual currency, bank accounts, and investments that can be liquidated immediately. Cash flow is extremely important to operating a business. After all, banks don’t take net income, they take cash. To pay banks, suppliers, and employees, a company must use cash. The Statement of Cash Flows is designed to help investors understand the nature of a company's cash flows and will be discussed in Chapter 5. Receivables are monies to be received by the company from customers. Companies typically conduct business by extending credit to one another rather than demanding cash immediately. For example, if you owned a video store and sold a Muppets DVD, you would most likely collect payment in cash. However, if Disney sold Target Stores a truckload of Muppets DVDs, it would most likely extend credit to Target Stores and then collect payment weeks later. It would not demand payment from the loading dock workers before unloading the truck. Accounts Receivable and bad debts are discussed in Chapter 6. Inventories are merchandise held for sale to customers. For Disney, inventories would include DVDs for resale and licensed merchandise sold by the Disney Stores and at their Parks and Resorts. Retail companies typically own a great deal of merchandise, which they sell to earn net income. On the other hand, service companies own little or no inventory. They sell services which do not require inventory, such as theme park experiences or cable television shows. Because the sale of consumer products is a relatively small portion of Disney’s operations, inventory is only 2% of Disney’s total assets. Inventory is explained in greater depth in Chapter 6. Television costs are the cost of television programs that will be aired during the next year. To film new television shows, such as the Suite Life of Zack and Cody, Disney must pay costs such as actors’ salaries and set design. The costs of these new shows are considered assets because Disney will use them to earn revenues from advertising. Balance Sheet Page 35 Chapter 2 NONCURRENT ASSETS Noncurrent assets are all assets not listed as current. Companies use noncurrent assets in their operations, but do not plan to sell them anytime soon. The first noncurrent asset listed is Film and television costs. These are the costs of films and television shows that the company plans to air long into the future. For example, in 2010 Disney released Toy Story 3 and Alice in Wonderland. Film and television costs may include the cost of this film and other successful films that have become part of Disney’s archive. In order to generate advertising and other revenues, the company can regularly broadcast these films and television shows, and sell DVDs. Parks, resorts, and other property, also known as Property, plant, and equipment or Fixed Assets, summarize attractions, buildings, equipment, and land. These are long-term assets that are expected to benefit future years. For Disney, these costs include theme parks, such as Disneyland, Disney World, Euro Disney, Hong Kong Disneyland, and even ships in Disney’s own cruise line. Depreciation expense is the cost allocated to each year of the asset’s life. For example, if a new Disney attraction cost $1 million and had an expected life of 20 years, the company would record $50,000 of depreciation expense each year. Accumulated depreciation is the total amount of depreciation expensed since the assets’ date of purchase. Here, Disney’s attractions, buildings, and equipment originally cost $32,875 million. However, the company has recorded $18,373 million worth of depreciation, leaving Disney with $14,502 in Book Value. This is the cost that Disney can still depreciate—expense on the income statement. The Walt Disney Company (DIS) BALANCE SHEET Film and television costs Investments Parks, resorts, and other property, at cost: Attractions, buildings, and equipment Accumulated depreciation [Book value] Projects in progress Land [Total parks, resorts, and other property, net] Intangible assets, net Goodwill Other assets Total noncurrent assets ($ in millions) 10/2/2010 $ 4,773 2,513 10/3/2009 $ 5,125 2,554 $32,875 (18,373) 14,502 2,180 1,124 17,806 5,081 24,100 2,708 $32,475 (17,395) 15,080 1,350 1,167 17,597 2,247 21,683 2,022 $ 56,981 $ 51,228 Disney has also recorded Projects in progress. These are fixed assets that are being constructed, such as new theme park attractions and resort hotels. Land is a separate category for all land held by the company. Because land is not depreciated, accountants keep the cost of land separate from the cost of buildings. Property, plant, and equipment and depreciation expense are discussed in greater depth in Chapter 6. Intangible assets include patents, trademarks, and copyrights that have value but not any physical presence. Disney has a rich portfolio of intangibles: Mickey Mouse, Goofy, Winnie the Pooh, Muppets, Balance Sheet Page 36 Chapter 2 and many classic films and television programs. Goodwill is extra value that is recorded when buying another company. For example, on December 31, 2010, Disney acquired Marvel. Disney paid $4,200 million, even though Marvel had only $2,000 million in stockholders’ equity (assets minus liabilities). The difference of $2,200 million was goodwill, extra value that Disney paid when making this acquisition. Companies can record goodwill only when buying other companies. They cannot include goodwill that comes from their own good business practices. CURRENT LIABILITIES The Walt Disney Company (DIS) BALANCE SHEET LIABILITIES Current liabilities: Accounts payable and other accrued liabilities Current portion of borrowings Unearned royalties and other advances Total current liabilities ($ in millions) 10/2/2010 10/3/2009 $ 6,109 2,350 2,541 $ 5,616 1,206 2,112 $ 11,000 $ 8,934 Current liabilities are liabilities due within 12 months. These are bills that are usually paid from a company’s current assets, usually cash. Accounts payable are amounts owed to suppliers in the future. Accounts payable are the mirror image of accounts receivable, in the sense that Disney’s accounts payable are, to its suppliers, accounts receivable. Current portion of borrowings is the portion of long-term debt due within the next 12 months. For example, if Disney has an installment loan payable, which requires the company to make a monthly payment, the next 12 months’ payments would be classified as current, whereas any later payments would be classified as noncurrent. Unearned royalties and other advances include prepaid amounts from advertising subscribers and advance theme park ticket sales. NONCURRENT LIABILITIES The Walt Disney Company (DIS) BALANCE SHEET 10/2/2010 $ 10,130 2,630 6,104 -- Borrowings Deferred income taxes Other long-term liabilities Commitments and contingencies ($ in millions) 10/3/2009 $ 11,495 1,819 5,444 -- Noncurrent liabilities are amounts due after 12 months. Borrowings are loans or other payables due over the long term. Deferred income tax liabilities usually come from tax rules that allow companies to earn income now but pay taxes later. Following the expression that “there are only two certainties in life: death and taxes,” companies must record these as Balance Sheet Page 37 Chapter 2 liabilities. As companies earn income, they must record liabilities for income taxes even if the taxes might not come due for many years. Most companies place a line item for commitments and contingencies on their balance sheets. This line reminds investors that lawsuits and other events could create new liabilities for the company. For example, Mr. Stephen Slesinger sued Disney, claiming that the company owed him royalties for the use of Winnie the Pooh. More information is provided about these items in the notes to the financial statements. Stockholders’ Equity is discussed in Chapter 4. Current and Long-term Liabilities are discussed in greater depth in Chapter 6. Here are 10 years’ selected data from Disney’s balance sheets with reported amounts in millions of dollars. Fiscal year ended in Current assets Total assets Current liabilities Total liabilities Stockholders’ equity 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 7,029 7,849 8,314 9,369 8,845 9,562 11,314 11,666 11,889 12,225 43,810 50,045 49,988 53,902 53,158 59,998 60,928 62,497 63,117 69,206 6,219 7,819 8,669 11,059 9,168 10,210 11,391 11,591 8,934 11,000 21,138 26,600 26,197 27,821 26,948 28,178 30,175 30,174 27,692 29,864 22,672 23,445 23,791 26,081 26,210 31,820 30,753 32,323 35,425 39,342 Disney’s total assets have increased from $43,810 million in 2001 to $69,206 million in 2010. INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) The joint “financial statement presentation” project of the FASB (Financial Accounting Standards Board of the United States) and the IASB (International Accounting Standards Board) will dramatically change the format of all financial statements, including the balance sheet. They are working toward a common format, organized into operating, investing, and financing activities. IFRS and U.S. GAAP treatment of cash and receivables are essentially the same. However, IFRS allows a company to revalue property, plant, and equipment (PPE) to fair value, rather than keeping it at historical cost as required by U.S. GAAP. Also, the FASB and the IASB are working together to develop a common conceptual framework, which could alter the way liabilities are reported. Balance Sheet Page 38 Chapter 2 Bonds are discussed in Chapter 6. and do not appear to have liquidity problems. 2010 ($ in millions) Current assets Current liabilities Current ratio Disney (DIS) $12. Time Warner owns AOL. Current Assets Current Ratio = Current Liabilities Here are current ratios for Disney. In general. Dividends are the distribution of profits to stockholders.DEBT VERSUS EQUITY Companies finance their assets with a mix of debt and equity. If stockholders sell their shares of stock.11 News Corp (NWS) $18.138 $ 8. All three companies seem to have healthy current ratios. The borrowing corporation records bonds payable and is referred to as the debtor. which is low compared to News Corp (2. measures the ability to pay current liabilities as they come due. The interest paid by the borrowing corporation is an expense that reduces taxable income. It is a measure of short-term liquidity.03) and Time Warner (1. Entities owning shares of stock are the owners of the corporation and are referred to as stockholders or shareholders. the more a corporation relies on debt to finance assets. HBO and many other cable channels.52). In 2010. who in turn executes the trade on a stock exchange such as the New York Stock Exchange or NASDAQ. News Corp owns Fox Broadcasting and many newspapers. they have no ownership rights.52 A healthy current ratio is generally considered to be around one. Warner Brothers films. which may be common stock or preferred stock. Large amounts of debt are usually issued in the form of bonds. they usually sell to another investor using a stockbroker.03 Time Warner (TWX) $ 13.862 2. Balance Sheet Page 39 Chapter 2 .643 1. current assets divided by current liabilities. Disney reported a current ratio of 1.225 $11. compared with two similar companies: News Corporation and Time Warner. indicating that current assets are at least equal to current liabilities. and magazines such as Time and Sports Illustrated. the greater the corporation’s financial risk. Stockholders earn a return on their investment by receiving dividends or selling the stock for a greater amount than the purchase price. Stockholders’ primary ownership rights include a right to vote at annual meetings and a right to a portion of the profits (net income). ANALYZING THE BALANCE SHEET LIQUIDITY: CURRENT RATIO The current ratio. The debtor must pay back the amount borrowed plus interest to the creditor. The entity loaning the money records an asset—bond receivable—and is referred to as the creditor. The balance sheet helps both creditors and stockholders to assess a corporation’s financial risk.000 1. Equity refers to the issuance of stock. Because creditors are not owners of the corporation. a company’s ability to pay amounts due in the next 12 months.024 $ 8. The corporate board of directors decides whether to pay dividends or not and has no obligation to purchase the shares of stock back from the stockholders.11. When the debt ratio is lower. a company’s ability to pay back long-term debt when due. The difference between the current ratio and the debt ratio. Time Warner’s 2010 debt ratio was 51%. has more financial risk than Disney.524 50.206 43.0% Time Warner (TWX) $ 33. has a 53% debt ratio.2% News Corp (NWS) $ 28.SOLVENCY: DEBT RATIO The debt ratio. measuring solvency. indicates the percentage of the company financed with debt (liabilities). If it cannot pay back principal plus interest on its long-term debt. and therefore. there is less financial risk and stronger solvency. between liquidity and solvency. is that the current ratio. Debt Ratio = Total Liabilities Total Assets Here are debt ratios for Disney and our two comparison companies: 2010 ($ in millions) Total liabilities Total assets Debt ratio Disney (DIS) $ 29.579 $ 66. addresses the company’s ability to pay amounts due in the next 12 months. indicating that 53% of its assets are financed by debt. This means that 43% of assets are financed with debt. Balance Sheet Page 40 Chapter 2 . It is used to measure solvency.384 53.864 $ 69. measuring liquidity.5% Disney’s debt ratio is approximately 43%. This indicates News Corp. indicate that a company might have too much debt. the creditors could claim collateral owned by the company or even force it into bankruptcy. total liabilities divided by total assets.43%) of assets are financed with equity. addresses the company’s ability to pay amounts owed over a longer term. The debt ratio. High debt ratios. slightly lower than News Corp.. 47% by stockholders’ equity.843 $ 54. which could sometimes exceed 100%. News Corp. whereas 57% (1 . an increase greater than the increase in assets.100) increase from 2007.934 78 11.546 110 24.391 100 NC liabilities 18. For example.579 100 24.784 100 Common stock 28.720 115 7. Based on this analysis.181 119 23. reflected in the trend index of 108. the base year.497 103 60.433 100 29.314 million in 2007 to $12.806 102 17.928 100 Other SE Total L and SE In the above table. we see total assets increased by 14% (trend figure of 114).928 100 Total assets Current liabilities 11. whereas noncurrent liabilities barely changed (trend index in 2011 is 100).532 101 17. For each subsequent year.314 Trend 100 PPE.721) 130 (22.206 114 63.207 100 R/Earnings 34.636) 124 (18. current assets increased from $11. trend indexes of 100.000 97 8.579 100 9.413 115 24.805 100 (23.206 114 63. at an average rate of approximately 4. we see that Disney’s assets have grown slowly.591 102 11. Common stock has increased by 19% and retained earnings by 38%.117 104 62.497 103 60. while decreases are below 100. not liabilities.327 138 31.930 97 24.602 100 69.736 119 27. an 8% (108 . Analyzing this table from 2007 to 2011. we assign 2007.225 Trend 108 $ 11.646) 124 (22.117 104 62. All trend indexes reflect changes from the base year rather than the previous year. we compute the trend index as: Trend Index = Current amount / Base year amount x 100 Increases from the base year are above 100. Balance Sheet Page 41 Chapter 2 .033 125 28.758 100 18.701 128 8. DISNEY 2010 2009 2008 2007 ($ in millions) Current assets $ 12. The base year is the earliest year being studied.597 101 17. net Goodwill + intangibles Other assets 17.889 Trend 105 $ 11.583 99 18. This analysis measures the percentage of change from the base year to shed light on growth trends in the company’s financial position.259) 100 69.7% ( = 14%/3 years) per year.666 Trend 103 $ 11. indicating asset growth was primarily financed by equity.225 million in 2011.994 131 9.864 100 18.038 112 26.TREND ANALYSIS Trend analysis helps to compare amounts of a more recent year to an older base year. 2010 ($ in millions) Current assets PPE. PPE (property.524 100% Current liabilities NC liabilities Common stock Retained earnings Other SE 11. common stock (41%). and the high price of tech stocks fell. It is difficult to directly compare different companies’ balance sheets because each company is a different size. The percentages should add up to 100% for assets. Soon after the merger.557) (29. Disney reports a lower percentage of noncurrent liabilities (27%) when compared with News Corp (37%) and Time Warner (38%). therefore. the greatest proportion of assets is in goodwill and other Intangibles.055 41% 40.024 5.736 34.721) 16% 27% 41% 50% -34% 8. indicating that these companies primarily expand through the acquisition of other companies. net is 26% of Disney’s assets.327 (23. Time Warner also has a huge negative retained earnings (also referred to as an accumulated deficit) of $94. compared with News Corp and Time Warner.206 100% 54.981 17. of lesser significance for all three companies. and retained earnings (50%) to finance assets.206 100% 54. the original amount reported for goodwill as a result of the merger had to be written down.874 % 20% 6% 29. as that intangible value no longer existed. Disney reports using about the same percentage of current liabilities (16%) as News Corp (16%) and Time Warner (13%). whereas Time Warner primarily finances assets with common stock.660) 13% 38% 236% -142% -45% Total L and SE 69.COMMON-SIZE BALANCE SHEET The common-size balance sheet measures each balance sheet item as a percentage of total assets.980 % 33% 11% $ 13. common-size analysis simplifies these comparisons. See the common-size balance sheet for Disney. AOL and Time Warner merged on January 11. when the market price of technology stocks was at an all time high.181 42% 22.524 100% For all three companies.643 24. Divide each balance sheet figure by total assets of that year.162 (94. 2001. This is because Disney invests in theme parks such as Disneyland and Walt Disney World. plant. and also.806 % 18% 26% $ 18.325 15% 9.936 157. net Goodwill + intangibles Other assets Disney (DIS) News Corp (NWS) Time Warner (TWX) $ 12.384 100% 66. Current assets and other assets are of lower proportions and.679 428 16% 37% 32% 14% 1% 8.199 14% Total assets 69. Therefore. compared with only 11% for News Corp.557 million.225 17. Under Armour is just 4% the size of Nike—how could you compare them? By standardizing each balance sheet on a 100 percentage point scale. Also of interest is that Disney uses approximately equal parts of liabilities (43%). and 6% for Time Warner.384 100% 66.994 14% 8. and equipment).862 19.000 18.138 3. the tech bubble burst. The impairment of Balance Sheet Page 42 Chapter 2 .434 7. Consider our comparison of Nike with Under Armour in the prior chapter.313 60% 9.864 28. for liabilities plus stockholders’ equity. which continues to be reflected in retained earnings today. Accumulated depreciation is the total amount of depreciation expensed since the date an asset was purchased. the company’s financial condition appears to be relatively safe. the ability to pay off debts in the long term. trademarks. Receivables are monies expected to be received from customers. how easily each asset can be converted into cash. and copyrights that have value but no physical presence. Solvency addresses the company’s ability to pay amounts owed over the long term. Balance Sheet Page 43 Chapter 2 . patents. current liabilities are due within 12 months. It is prepared based on the formula. Stockholders’ Equity is the portion of assets that owners own free and clear. Current portion of borrowings is the portion of longterm debt due within the next 12 months. Liquidity measures a company’s ability to pay debts due in the next 12 months. due to its investment in theme parks.goodwill was reflected in a $97. and adequate solvency. Inventories are merchandise held for sale to customers. In short. or consumed within the next 12 months. Liabilities are amounts owed to creditors. after subtracting all liabilities. Depreciation expense is recorded for property. we learn from this analysis that Disney has a substantial investment in goodwill as a result of acquiring other companies. SUMMARY The balance sheet reports assets and the amount of assets financed with liabilities and stockholders’ equity as of a certain date. plant. and equipment are long-term assets expected to benefit future years. the ability to pay debts that come due over the next 12 months. the next chapter’s topic. we learned that the company has sufficient liquidity. plant. The debt ratio (total liabilities divided by total assets) is one measure of solvency. and equipment. One difference is that IFRS allows revaluation of property. Borrowings. or long-term debt. Property. But is it a good investment? To understand whether a company might be a good investment. and equipment (PPE) to fair value. Accounts payable are amounts owed to suppliers. Current assets are expected to be converted into cash.S.217 loss reported in 2002. allocating its historical cost to each year of an asset’s life. whereas noncurrent assets are due later. plant. and in PPE. All assets not listed as current are classified as noncurrent. while the least liquid assets and liabilities appear last. Most companies place a line item on the balance sheet for commitments and contingencies to remind investors that lawsuits and other events could create new liabilities for the company. The balance sheet lists assets and liabilities in the order of liquidity. Similarly. GAAP treatment of cash and receivables are essentially the same. IFRS and U. The most liquid assets and liabilities appear first. From the current ratio. In summary. you must delve into the income statement to understand its profitability. Assets = Liabilities + Stockholders’ Equity. Assets are items of value that a company has the right to use. are due more than 12 months from the balance sheet date. sold. The current ratio (current assets divided by current liabilities) is used to measure liquidity. Intangible assets include goodwill. and when each liability is expected to be paid. Balance Sheet Page 44 Chapter 2 .404 0.50 32.11 43.600 1.550 0.com There are no official rules governing how these ratios are calculated.0% 3.0% 1.msn.03 53.9% 1.9% 2.0% = ROA Industry: Entertainment—Diversified Industry and S&P 500 ratio averages from money.40 60. Therefore. the ratio formulas used may differ from the formulas in the text.6% 10.Trend analysis can help users to compare different years’ balance sheets.52 50.1% 9.4% 10.2% 4.5% 6. RATIO Type Formula Disney (DIS) News Corp (NWS) Time Warner (TWX) * **Industry **S&P 500 * ** Profitability ASSET TURNOVER Efficiency NI / Revenue Revenue / Total Assets 10.602 0. Common-size analysis can help users to compare the balance sheets of different companies in the same industry.4% 8.0% 0.0% 1.0 ROS x CURRENT DEBT RATIO RATIO Profitability Liquidity Solvency Current Assets / Total NI / Current Liabilities / Total Assets Liabilities Total Assets 5.7% 1.8% 10. equipment. Liabilities due within 12 months Page 45 Chapter 2 . Extra value recorded when buying another company 8. Accounts payable is a _____ account 16. Total liabilities divided by total assets (2 words) Balance Sheet Down 1. and land (abbreviation) 17. Distribution of earnings 3. Amounts owed to suppliers (2 words) 2. Buildings. Reports assets. Owners of a corporation 23. Borrows money 7. Merchandise held for sale 4. Lawsuits and other events that could create new liabilities for the company 10. Patents. Ratios that measure the ability to pay liabilities for many years 19. Investments available for quick liquidation (2 words) 12. Balance Sheet reporting all amounts as a percentage of total assets (2 words) 21. Ratio that measures the ability to pay current liabilities with current assets 26. and stockholders’ equity (2 words) 9. Money in the bank 25. Income tax amounts to be paid later 24. Ratios that measure the ability to pay liabilities as they come due 9. Monies to be received from customers 15. and brand names 13. Inventory is an _____ account 11. Lends money 6. liabilities.ACTIVITY 12 CROSSWORD PUZZLE FOR CHAPTER 2 Across 5. Cost allocation 20. Equipment is a _____ asset account. Total amount of depreciation expensed since the assets' date of purchase 14. copyrights. which is used for more than one year 18. Acquisition Cost less Accumulated Depreciation (2 words) 22. Plant.297.8 549. Typical classifications and a brief description follow. which is the amount added to compute total assets on the balance sheet. Current liabilities (CL) are amounts owed to creditors that are expected to be repaid within 12 months.4 TOTAL L & SE $ 540. Depreciation expense is the cost allocated to each year of an asset’s long-term useful life. and Equipment? (1 / 3 / 5) Goodwill and Intangibles? (1 / 3 / 5) Q2 Other Assets? (1 / 2 / 5) What is the total amount reported for Current Liabilities? $__________ million Noncurrent Liabilities? $__________ million Balance Sheet Total Stockholders’ Equity? $__________ million Page 46 Chapter 2 .3 297. Q1 How many accounts listed are Current Assets? (1 / 3 / 5) Property. These are long-term assets that are expected to benefit more than one accounting period.4 46.6 385. Land is not depreciated. and stockholders’ equity) into smaller classifications to help decision makers better understand the information presented. copyrights.0 0.0 433.355.360.ACTIVITY 13 Purpose: THE CLASSIFIED BALANCE SHEET • Identify account classifications typically used on the balance sheet. Acquisition cost – accumulated depreciation = the book value of PPE. buildings. amounts paid for the value of its management team. Retained earnings (RE) is net income earned by the company since its incorporation and not yet distributed as dividends. Other stockholders’ equity includes treasury stock and adjustments to stockholders’ equity such as the change in value of long-term investments.360. Noncurrent liabilities (NCL) are amounts owed to creditors that are expected to be repaid in more than 12 months. and land.535.2 41. Goodwill is created when acquiring a company for an amount greater than its net assets. STARBUCKS (SBUX) ASSETS Cash and cash equivalents Short-term investments Accounts receivable Inventories Other current assets PPE. Other intangible assets include amounts paid for patents.5 479.4 A classified balance sheet breaks the three major account types (assets. and overall reputation.0 1. Examples include bonds payable and long-term debt. Contributed capital (CC) are amounts paid-in (contributed) by stockholders to purchase common stock and preferred stock.6 965.5 350.8 2.1 902.8 392.3 $7. customer base. or consumed within 12 months.2 4. and equipment (PPE) summarize amounts for equipment. To answer the following questions refer to the balance sheet presented above. and brand names. Accounts include capital stock and additional-paid-in capital (APIC). • • • • • • • • • Current assets (CA) are those assets expected to be converted into cash. liabilities. sold. which are not included in any other asset classification. net Goodwill and intangibles Long-term investments Other noncurrent assets TOTAL ASSETS 10/02/2011 BALANCE SHEET ($ in millions) LIABILITIES Accounts payable Short-term debt Other current liabilities Long-term debt Other noncurrent liabilities STOCKHOLDERS’ EQUITY Contributed capital Retained earnings Other stockholders’ equity $ 1.7 $7. Accumulated depreciation is the total amount of depreciation expensed since the asset’s date of purchase. plant.148. Other assets are noncurrent asset (NCA) accounts such as long-term investments. Property. Examples include accounts payable and short-term debt. f.8 million is the (acquisition cost / current market value / can’t tell). The balance sheet reports a company’s financial position (as of a certain date / over a period of time). This company is relying primarily on (long-term debt / contributed capital / retained earnings) to finance assets. Use Starbucks’ balance sheet dated 10/02/2011 (on the opposite page) to answer the following questions. j. and equipment. Assets and liabilities are recorded on the balance sheet in order of (magnitude / alphabetically / liquidity). How much does this company owe to suppliers? $__________ million g. Current assets total $__________ million and current liabilities total $__________ million. $2. This company has (sufficient / insufficient) current assets to pay off its current liabilities. What amount of investments does this company intend to hold for more than a year? $__________ million e. c. U. How much do customers owe this company? $__________ million b. Contributed capital represents (amounts borrowed / amounts paid-in by shareholders / net income earned by the company).S. i. net. h. a. $965. which is an (external / internal) source of financing.S. k. GAAP requires (historical cost / fair value). GAAP and IFRS treat (cash / PPE) essentially the same. which means that (PPE / cash) will always be reported before (PPE / cash). for (cash / PPE). plant. For inventories. whereas U. IFRS allows valuation at fair value. For property.355. (PPE / Goodwill / Long-term Investments) is created when a company is acquired. Noncurrent assets total $__________ million and noncurrent liabilities total $__________ million. Current assets are used to pay off (current / noncurrent) liabilities. However. Balance Sheet Page 47 Chapter 2 . l. Noncurrent liabilities are used to finance (current / noncurrent) assets.0 million is the (acquisition cost / current market value / book value / can’t tell). d.ACTIVITY 14 Purpose: UNDERSTANDING THE BALANCE SHEET • Identify the value at which amounts are reported on the balance sheet. m. Understand what an increase or a decrease in an account indicates.1) 2.0 285.355.0 1. and equipment Accumulated depreciation PPE.793.6 442.4 $ 5.4 46.164.0 433.1 2.4 41. Balance Sheet Page 48 Chapter 2 .1 374.5) 2.3 3.2 533.8 6.5 253.6 $ 540.3 (2.8 549.5 333.7 (3.7 ($ in millions) 10/03/2010 $ 1.9 $ 5.472.1 902.1 0. This company paid off accounts payable during fiscal years ended in (2011 / 2010 / 2009).5 549.ACTIVITY 15 Purpose: UNDERSTANDING THE BALANCE SHEET • • • Identify the value at which amounts are reported on the balance sheet.4 48. net Goodwill and other intangibles Long-term investments Other noncurrent assets TOTAL ASSETS LIABILITIES Accounts payable Short-term debt Other current liabilities Long-term debt Other noncurrent liabilities STOCKHOLDERS’ EQUITY Contributed capital Retained earnings Other stockholders’ equity TOTAL L & SE BALANCE SHEET 10/02/2011 $ 1.5 479.536.8 9/28/2008 $ 269.0 (L) $ 7.3 423.164.5 329.9 433.148.2 57.416.7 5.7 $ 267.9) 2.5 9/27/2009 $ 599.2 $ 282.6 385.4 $ (Z) Q1 Calculate the amounts that should be reported for (L) and (Z) on the 9/28/2008 balance sheet: (L) = $__________ million (Z) = $__________ million Q2 What was the beginning balance of the inventories account for the fiscal year ended on 10/02/2011? $______ million 10/03/2010? $______ million 9/27/2009? $______ million Q3 What amount of property.0 1. Develop strategies for analyzing the balance sheet.8 66.5 692.4 $ 6.8 403.360.3 460.3 297.0 1.535.8 5.3 400.956. and equipment was purchased (assuming no PPE was sold) during fiscal year ended 10/02/2011? $______ million 10/03/2010? $______ million Q4 From 9/28/2008 to 10/02/2011 accounts payable (increased / decreased).576.4 146.9 713.313.1 (3.8 549.496.888.3 271.4 333.4 327.717.8 52.3 $ 7. As of 10/02/2011 this company owes $__________ million to its suppliers.7 543.2) 2.8 392.8 $ 324.2 65.5 350.471.8 $ 5.9 187. plant.0 0. plant.2 4.808.3 346.7 302.6 965.360.760.8 40.385.9 549.385.672.402.297.6 0.4 5. STARBUCKS (SBUX) ASSETS Cash and cash equivalents Short-term investments Accounts receivable Inventories Other current assets Property.163.700.1 2.4 382. indicating (more / less) financial risk.9 (3.0 664.151.576.2 $ 6.0 1. Q8 Retained Earnings is (increasing / decreasing). This company appears to report a (strong / weak) financial position. Q6 Compute total liabilities for the fiscal year ended on: 10/02/2011? $_______ million 9/28/2008? $_______ million Now compute the debt ratio for the fiscal year ended on: 10/02/2011? _______ % 9/28/2008? _______ % Discuss the change in the company’s use of debt over this 4-year period. indicating the company (issued more stock / purchased more assets / reported net income) during this accounting period. Why? Support your response with at least two observations. Which line would you look at first? Second? Third? Why? Q10 Review the series of balance sheets. Contributed Capital (increased / decreased).Q5 Total Assets are (increasing / decreasing). how much net income (loss) was reported for the fiscal year ended on: 10/02/2011? $_______ million 10/03/2010? $_______ million 9/27/2009? $_______ million The most profitable year was fiscal year ended (2011 / 2010 / 2009). Q9 Develop a strategy to analyze the balance sheet. Assuming no dividends were issued. Balance Sheet Page 49 Chapter 2 . indicating the company (issued more stock / purchased more assets / reported net income) during this accounting period. indicating that this company is (expanding / shrinking). Q7 From 9/28/2008 to 9/27/2009. a. Entities owning shares of stock are the owners of the corporation and are referred to as stockholders or shareholders. The balance sheet helps investors. ($ in millions) Assets Liabilities Stockholders’ equity Debt ratio Google (GOOG) 12/31/2011 $ 72. but (does / does not) have to pay dividends to shareholders. Based only on the information presented above. the more a corporation relies on debt to finance assets. assess the degree of financial risk a corporation is assuming. both creditors and stockholders. Stockholders’ primary ownership rights include a right to vote at annual meetings and a right to a portion of the profits (net income). c. (Google / GIS) is financing assets primarily with debt. The interest expense of debt (reduces / does not reduce) taxable income. If stockholders sell their shares of stock.ACTIVITY 16 Purpose: DEBT VS. have no ownership rights. The borrowing corporation records a bond payable and is referred to as the debtor. The interest paid by the borrowing corporation is an expense that reduces taxable income. while the entity loaning the money records a bond receivable and is referred to as the creditor. If you were the CFO of a company. d. how would you recommend financing assets? Primarily with (debt / equity). b. Creditors are not owners of the corporation and. Assets = Liabilities + Stockholders’ Equity Large amounts of debt are usually issued in the form of bonds. “contributed” capital. they usually sell to another investor using a stockbroker.429 $ (B) _________% General Mills (GIS) 5/29/2011 $ (Y) $ 12. Equity refers to the issuance of stock. Issuing additional debt (does / does not) dilute current shareholders’ ownership. e. which may be common stock or preferred stock. EQUITY • • Identify the characteristics of debt and equity. Compute the Debt Ratio and record in the above chart. The return to creditors is the interest received. The corporation (does / does not) have to pay interest to creditors. (Debt ratio = Liabilities / Assets) This ratio quantifies the proportion of assets financed with debt. which company would you choose as an investment? (Google / GIS) Why? Q2 For each item circle the correct response when comparing the issuance of debt and equity. therefore. therefore. Dividends are the distribution of profits to stockholders. but dividends paid to shareholders (reduce / do not reduce) taxable income. who in turn executes the trade on a stock exchange such as the New York Stock Exchange or NASDAQ. but issuing additional shares of common stock (does / does not) dilute current shareholders’ ownership. Corporations externally finance the purchase of assets with debt (liabilities) or equity (common stock). the greater the financial risk of the corporation. (Google / GIS) is assuming the greater financial risk. The corporation (must / never has to) repay amounts borrowed from creditors.309 $ 6. Assess financial risk. In general. thus the title. Stockholders earn a return on their investment by receiving dividends or selling the stock for a greater amount than the purchase price.366 _________% Q1 Compute the values for (B) and (Y) in the above chart. The corporate board of directors decides whether to pay dividends or not and has no obligation to purchase the shares of stock back from the stockholders.574 $ 14. Why? Balance Sheet Page 50 Chapter 2 . The debtor must pay back the amount borrowed plus interest to the creditor. but (must / never has to) repay amounts invested by shareholders. For a company wanting to be lower risk and less dependent on debt.54 64% 1.32 97% 33. It is a measure of short-term liquidity. The Current Ratio measures the ability to pay current payables as they come due by comparing current assets to current liabilities. Liquidity and Solvency Ratios measure the ability to meet financial obligations and the level of financial risk. in general. It is a measure of long-term solvency.0. which is your favorite? (DIN / DRI / NATH) • DIN operates Applebee’s Neighborhood Grill & Bar and IHOP. Q1 Of the above three restaurant chains. some financial sources report the Debt-to-Equity ratio. therefore. computed as liabilities divided by stockholders’ equity. Olive Garden.20 Use the chart above to answer the following questions. * Instead of reporting the Debt Ratio. Does this indicate that this corporation is insolvent or unable to pay its bills? (Yes / No) Explain. A current ratio that is (lower / higher) than the industry average may indicate a lack of short-term liquidity. Q3 (DIN / DRI / NATH) are relying more on debt to finance assets and have a debt ratio (greater / less) than 50%.12 17% 0. have a current ratio (greater / less) than 1. Stock symbols are shown in parentheses.17 Darden Restaurants (DRI) 0. which includes (DIN / DRI / NATH). • DRI operates Red Lobster. a(n) (increasing / decreasing) trend in the debt ratio is considered favorable. Q4 Why does a company with a higher debt ratio tend to have greater financial risk? Q5 Does a high debt ratio indicate a weak corporation? (Yes / No) Explain your answer.97 = 33. For DineEquity 0.10 = Total liabilities Total assets DineEquity (DIN) 1.17 Balance Sheet Page 51 Chapter 2 . be required to pay (higher / lower) interest rates when borrowing money.1 52% 1.17 / 34. and Smokey Bones Barbeque and Grill. A company that has higher financial risk will. Debt Ratio For the year 2010 Current Ratio Debt Ratio Debt-to-Equity Ratio* Industry Average for Restaurants 1. Current Ratio = Current assets Current liabilities The Debt Ratio measures the proportion of assets financed by debt by comparing total liabilities to total assets.ACTIVITY 17 Purpose: ANALYSIS: RATIOS • Understand the information provided by the current ratio and the debt ratio. Darden Restaurants is financing __________% of assets with debt. A higher ratio indicates a stronger ability to pay current debts.77 Nathan’s Famous (NATH) 6. • NATH operates Nathan’s Famous. Bahama Breeze. Q2 (DIN / DRI / NATH) have sufficient current assets to pay off current liabilities and. A higher ratio indicates greater financial risk. To convert: Debt ratio = [Debt-to-equity ratio/(1 + Debt-to-equity ratio)]. Assume less than 5% is low.1 187.4 130 6.576. A Trend Analysis compares amounts of a more recent year to a base year.0 217 80 130 122 2.2 4. Q4 The annual total asset growth rate can be compared between companies.7 41.5 777.9 113 5.4 100 _______ _______ _______ 100 TOTAL L and SE 7.756.1 932.385.8 98 5.1 100 TOTAL ASSETS 7.748.672.9 113 5.9 2.2 81 _______ _______ _______ 118 1.779.1 146.581.2 65. For total assets.4 (total assets on 10/02/2011) by $__________ million (total assets of the base year).297.3 116 86 98 107 BASE YEAR 1. net) indicates the dollar amount is (greater / less) than the (previous / base) year.4 327.1 100 635.3 95 _______ _______ _______ 96 1.672.355. Other assets 3. the trend index of 130 is computed by dividing $7. 5 to 15% is moderate. A trend index of 130 indicates total assets (increased / decreased) by __________% (from an index of 100 to 130) from 9/28/2008 to 10/02/2011.0 100 2.794.2 879.360.2 57.3 3. Q2 A trend index of 130 (total assets) indicates that the dollar amount is (greater / less) than the (previous / base) year. common stock.4 72 _______ _______ _______ 135 2.360. Record the resulting trend index in the shaded area.471. STARBUCKS ($ in millions) 10/02/2011 $ Trend 10/03/2010 $ Trend 9/27/2009 $ Trend 9/28/2008 Current assets PPE.6 100 Refer to the series of balance sheets and the trend analysis above to answer the following questions. Q3 From 9/28/2008 to 10/02/2011. Issuing stocks and bonds are forms of (internal / external) financing because these funds come from investors outside of the firm.0 40. and more than 15% is high. The analysis measures the percentage of change from the base year.793.4 2.6 100 Current liabilities NC liabilities Common stock Retained earnings Other SE 2.576. whereas a trend index of 80 (PPE. This is referred to as (internal / external) financing because these funds are generated by operations. use the amounts listed below to compute the trend indexes for noncurrent (NC) liabilities. which of the following accounts increased at a greater rate than total assets? (Noncurrent liabilities / Common stock / Retained earnings).416.4 100 333.4 130 6.8 98 5. Use 9/28/2008 as the base year.956.075.3 677.7 992.1 2.8 158 82 100 139 2.402.4 48.5 333.4 46.8 2.385.035.1 2.189. Q1 For Starbucks.0 950. The base year is the earliest year being studied.536. and retained earnings by the amount for the base year. The assets of this company are primarily financed with (liabilities / contributed capital / retained earnings). Balance Sheet Page 52 Chapter 2 . The three-year average total asset growth rate of this company is considered (low / moderate / high). Q5 Examine the financial information reported above and comment on at least two items of significance that the trend analysis helps to reveal.ACTIVITY 18 Purpose: ANALYSIS: TREND • Prepare a trend analysis and understand the information provided.0 433.360.8 899. net Goodwill + Intang. 82 5.9% 3._______ (decimal form).2% Nathan’s Famous (NATH) $ CS% 43.025. net Goodwill + intangibles Other assets DineEquity (DIN) $ CS% 351.0% 170.1% 43.0% 23. The analysis measures each item as a percentage of total assets.ACTIVITY 19 Purpose: ANALYSIS: COMMON-SIZE STATEMENTS • Prepare common-size statements and understand the information provided.9% 12.7 64.8% 50.621.7 234.0 494. Which company finances assets primarily with amounts borrowed long term? (DIN / DRI / NATH) Which company finances assets primarily with amounts invested by shareholders? (DIN / DRI / NATH) Which company finances assets primarily with past profits? (DIN / DRI / NATH) Review the balance sheet information presented above for the three restaurant chains and comment on at least two items of significance that the common-size statements help to reveal. The Common-Size Balance Sheet compares all amounts to total assets of that same year.47 1.8 (24. net + Goodwill + Other = 100% and CL + LTD + Other NCL + CS + RE + Other = 100 %.013.9 19.63 % % % % 53.856. Record the resulting common-size percentage in the shaded area provided.6 % 5.8) TOTAL L and SE 2.9% 27.0) % % % % % % 1.0 612.4 360.247.5 12.6) % % % % % % 53.4 Current liabilities Long-term debt Other NC liabilities Contributed capital Retained earnings Other SE 265.466.0% (57. Q1 For DineEquity and Chipotle Mexican Grill listed below.0 % % % % Darden Restaurants (DRI) $ CS% 678.254.856.9 (3.4 100.44 2.247.1 16.) 2010 ($ in millions) Current assets PPE. Refer to the information above to answer the following questions.297.2 1533.403. (Hint: Percentages for CA + PPE.9% 994.0 1.16 0. These companies were easier to compare (before / after) you prepared the common-size statements.6 %* 5.37 % TOTAL ASSETS 2.1 2.37 % 7. Why? Balance Sheet Page 53 Chapter 2 .5 124.7)% 100. Q2 Q3 Q4 Q5 Q6 Q7 The debt ratio (Total liabilities / Total assets) for Darden Restaurants is __________% or ___. complete the common-size statements by dividing each item on the balance sheet by the amount of total assets.3 632.9 2.3 3.3 (275.91 52.6 1.0% * Note: The percentages may not sum to 100% due to rounding error.5 2. 8% 14.481 3.0% 15.7% 6.377 $ 499 59 1.710 940 65 861 12/29/2007 $ 789 225 128 339 7.4% 75.897 (3.316 $7. plant.235 2.5% 14.6% 53.7% 55.062 3. Other assets CS% % % % % TOTAL ASSETS % % 6.849 1.283) 3. and equipment Accumulated depreciation PPE.316 YUM! BRANDS (YUM) ($ in millions) 7 303 (418) $7.ACTIVITY 20 Purpose: ANALYSIS OF YUM! BRANDS • Understand and interpret amounts reported on the balance sheet. YUM! BRANDS (YUM) ASSETS Cash and cash equivalents Accounts receivable Inventories Other current assets Property.2% $ 1.426 256 189 442 7.527 100.063 0 1.4% 14.349 TOTAL ASSETS LIABILITIES Accounts payable Short-term debt Other current liabilities Long-term debt Other noncurrent liabilities STOCKHOLDERS’ EQUITY Contributed capital (CC) Retained earnings (RE) Other stockholders’ equity (SE) 86 1.915 1.049 84.255 2.148 $6.207 1.189 3.132 (3.710 940 926 CS% 14.6% Chapter 2 .5% % % 6.0% 4.7)% 1.722 4.026 832 CS% 20.348) 3.6% 56.830 1.564 1.924 1.0% % % % % 1.148 $6.188 100.5% 0.263 $ 508 25 1.103 (3.026 153 679 $8.4)% 0 1.188 ($ in millions) 12/29/2007 Current assets PPE. net Goodwill and other intangibles Long-term investments Other noncurrent assets BALANCE SHEET 12/25/2010 $ 1.527 Classified Balance Sheet / Common-Size Statements 12/25/2010 $ 12/26/2009 12/27/2008 519 288 1.717 (227) TOTAL L & SE 253 996 (224) $8.119 20 $7.188 $ 540 673 1.913 26.134 154 885 12/26/2009 $ 353 239 122 494 7.187) 3.527 $7.899 1.119 20 0.987 28.7% (6.849 1.273) 3.0% 7.247 (3.102 144 795 12/27/2008 $ 216 229 143 363 6.095 3.3% 11.139 15.8% C liabilities NC liabilities TOTAL LIAB CCapital REarnings Other SE TOTAL SE Balance Sheet $ $ Page 54 CS% % % % % $ 951 3.3% % % (108) (1.635 101.2% % % % % % % 7 303 (418) 0. net Goodwill + Intang.3% 2. Record your results in the area provided on the previous page. an increase of ________%. would you consider investing in this company? (Yes / No) Why? Support your response with at least three good reasons.000.55 12/29/2007 0. Q7 For 12/26/2009 and 12/25/2010 compute the current ratio and the debt ratio. and $412 million in 2010. Q3 On 12/29/2007. Record your results in the area provided above. Balance Sheet Page 55 Chapter 2 .10 12/25/2010 RATIOS 12/26/2009 12/27/2008 0.000 restaurants in more than 110 countries.YUM! BRANDS (YUM) Current ratio Debt ratio Industry Norm 1. (Remember CA + PPE. 2008 $__________ million For 12/26/2009 and 12/25/2010 complete the classified balance sheet by adding the items within each classification. Q5 2009 $__________ million. Use this information to compute net income for: 2010 $__________ million. which is most likely the result of previously (selling assets / purchasing treasury stock / reporting net income). Common-size statements for 12/29/2007 and 12/27/2008 have already been completed. which (is / is not) expected. which is the result of (purchasing additional assets / issuing more common stock / increasing net income). Classified balance sheets for 12/29/2007 and 12/27/2008 have already been completed. $362 million in 2009. Comment on the results. Comment on the trends in Total Liabilities and Total Stockholders’ Equity and what this indicates. Q8 If you had $10. (Hint: Refer to company descriptions in Appendix A—Featured Corporations). This company has a major investment in (inventories / PPE / goodwill). Record your results in the area provided on the previous page.72 102% 84% 52% Refer to the series of balance sheets for Yum! Brands (on the previous page) to answer the following questions. net + Goodwill + Other = Total Assets and CL + NCL + CS + RE + Other = Total L + SE) Q6 For 12/26/2009 and 12/25/2010 complete the common-size statements by dividing each item on the classified balance sheet by the amount of total assets for the same year. Q1 YUM! Brands is the largest restaurant chain (larger than McDonald’s) when measured by (sales / # of units) and operates more than 36. Which is your favorite YUM! Brands restaurant? (KFC / Pizza Hut / Taco Bell / Long John Silver’s / A&W) Q2 Total Assets increased by $________ million since 12/29/2007. Ratios for 12/29/2007 and 12/27/2008 have already been computed. the retained earnings account reports a (positive / negative) amount. Q4 This company distributed dividends and other amounts to shareholders of $322 million in 2008. 355.811.7 10.9 Classified Balance Sheet / Trend Analysis 12/31/2010 $ ($ in millions) 12/31/2010 Trend 12/31/2009 $ Current assets PPE.9 $28.8 11.152.4) 1.4 (10.4 (12.279.4) 752. McDONALD’s (MCD) ASSETS Cash and cash equivalents Accounts receivable Inventories Other current assets Property. net Goodwill Other assets Trend 620.747.7 100 Current liabilities NC Liabilities 2.8 100 Contributed capital Retained earnings Other SE TOTAL SE Balance Sheet Page 56 Chapter 2 .1 109.2 111.616.537.0 2.984.387.0) 21.5 10.6 2.367.9 (20.581.0 16.303.560.7 ($ in millions) 12/31/2008 Tren d $ 3.229.919.270.5 411.9 692. par Additional paid-in capital Retained earnings Treasury stock Other stockholders’ equity 943.9) 20.203.301.6 5.237.6 88 15.1 1.0 1.4) 101.5 $31.5 (16.7 $33.188.0 1.143.6 98 20.060.391.541.421.624.4 1.5 $34.060.3 26.853.3 624.586.4 100 100 TOTAL Liab 15.9 100 20.523.289.0 97 12/31/2007 BASE YEAR 3.461.226.7 26.2 $ 2.212.5 2.917.5 97 29.3 100 2.8 (22.6 4.7 2.425.7 (25.3 1.186.4 $31.8 125.482.0 2. net Goodwill Long-term investments Other noncurrent assets BALANCE SHEET 12/31/2009 12/31/2008 12/31/2007 $ 2.639.237.5 (15.9 100 4.310.5 9.0 1.9 31.196.7 $ $ $ $ TOTAL ASSETS LIABILITIES Accounts payable Short-term debt Other current liabilities Long-term debt Other noncurrent liabilities STOCKHOLDERS’ EQUITY Common stock.4 33.7 1.600.3 1.219.8 7.0 16.531.254.382.224.6 2.224.5 (11.9 (20.5 97 2.762.4 $28.517.8 100 TOTAL Assets 28.1) 109 109 131 4.8 28.9 12.7 $ 1.5 2.0) 100 100 100 13.1 1.6 4.352.3 2.984.222.975.0 56 130 4.3 421.254.063.7 (11.0 2.642.4 931.6 4.0 1.0 0.4 0.3 1.2 28.854.391. and equipmt Accumulated depreciation PPE.9 107 14.391.0) 20.953.461.ACTIVITY 21 Purpose: ANALYSIS OF MCDONALD’S • Understand and interpret amounts reported on the balance sheet.7 $ 1.4 106.2 1.111.156.2 McDONALD’s 636.337.461.461.897.126.3 1.425.243.179.498.8) 747.053.0 2.301.2 453.461.452.5 $29.953.9 TOTAL L & SE $31.4 16.2 $30.440.4 97 2.8) 22.5 $29.613.497.4 1.981.078.980.5 $32.335.796.4 $30.909.9 0. plant.3 16.975.7 100 2. which is (internal / external) financing. As of 12/31/2010 shareholders have contributed a total of $__________ million to this corporation. Q9 For 12/31/2009 and 12/31/2010 complete the trend analysis by dividing each amount by the amount for the base year of 12/31/2007. Record the resulting trend index in the area provided on the previous page. which is the result of (purchasing additional assets / acquiring other companies / reporting net income). and then multiply by 100. while total stockholders’ equity (increased / decreased) by _____%. Current liabilities (increased / decreased) by _____%.4 million in 2008. Q1 McDonald’s is the world’s (#1 / #2) restaurant chain when measured by (sales / # of units) and has more than 32.5 million in 2009. b. Q5 This company distributed dividends of $1. Q11 For 12/31/2009 and 12/31/2010 compute the current ratio and the debt ratio. At the end of 2008.408. Q7 For 12/31/2009 and 12/31/2010 complete the classified balance sheet by adding the accounts within each classification. Since the base year. 2009 $__________ million.000. while noncurrent liabilities (increased / decreased) by _____%.1 million in 2010.000 restaurants in more than 120 countries. while at the end of 2010 assets were (above / below) base year levels. warning signs or signs of financial weakness. net + Goodwill + Other = Total Assets and CL + NCL + CS + RE + Other = Total L + SE) Q8 Refer to the Classified Balance Sheet. Retained earnings (increased / decreased) by _____%.McDONALD's (MCD) Current ratio Debt ratio Industry Norm 1. On average. indicating a greater reliance on (debt / equity) financing. assets were (above / below) base year levels. Record your results in the area provided above. Additional treasury stock was acquired during (2010 / 2009 / 2008). the PPE has been used for (more / less) than half of its useful life. Q12 Review the financial information of this company and comment on a. Q3 Long-term debt was borrowed during (2010 / 2009 / 2008). an indication of a (recovering / poor) economy. total liabilities (increased / decreased) by _____%.10 52% 12/31/2010 RATIOS 12/31/2009 12/31/2008 1. For 12/31/2007 and 12/31/2008 the trend indexes have already been computed. an indication of a (recovering / poor) economy. and $2. Record your results in the area provided on the previous page. 2008 $__________ million Q6 Treasury stock results from (selling assets / refinancing debt / repurchasing common stock). Q2 In regard to assets. The assets of this company are primarily financed with (liabilities / contributed capital / retained earnings). (Remember CA + PPE. Q4 This company was able to attract new shareholders during (2010 / 2009 / 2008). Q13 If you had $10. this company has a major investment in (inventories / PPE / goodwill). would you consider investing in this company? (Yes / No) Why or why not? Balance Sheet Page 57 Chapter 2 . Q10 Refer to the trend index.823. $2. signs of financial strength. Use this information to compute net income for: 2010 $__________ million. Hint: Refer to company descriptions in Appendix A—Featured Corporations. indicating (greater / lesser) reliance on long-term financing. total assets (increased / decreased) by _____%. Classified balance sheets for 12/31/2007 and 12/31/2008 have already been completed.39 53% 12/31/2007 0.80 48% Refer to McDonald’s balance sheets on the previous page to answer the following questions. Ratios for 12/31/2007 and 12/31/2008 have already been computed.235. 4 3.7 504.419.1 $1.044.4 0.3 36.5 215.6 CS% 76.099.1 445.1 163.1 103.628 79.913.9 42.3 9.364.7 TTL Liab 1.8 (2.370.463.1 23.357.210 194.719) 5.680.210 0 194.4 $ 1.749 258.928.991 162.9 (90.928.653.9 1.959.348 873.971.0 45.9 654.9) 1.902 $ $ 1. and equipment Accumulated depreciation PPE.0 0 38.3 $14.301.5 Cont capital R/Earnings Other SE 483.419.1 $ 4.8 0.3 100.5 C Liabilities NC Liabilities TTL SE Balance Sheet Page 58 Chapter 2 .2 1.066.186 101.4 101.0 3.3 1.6 0.1 23.991.7 84.678.750. plant.8 1.0 CS% 27.1 26.6 $1.972 1.928.4 3.678.095.923.2 TTL Assets 1.665.5 138.3) 1.3 32.0 432.4 3.931.913.8 2.0 337.0 14. BALANCE SHEETS ASSETS Cash and cash equivalents Short-term investments Accounts receivable Inventories Other current assets Property.0 1.4 6.1 A 6/30/2010 B 10.559 (17.1 98.4 4.942.139 0 0 51.2 (1.0 14.1 100.0) 728.4 1.6 2.2 1.1 11.0 1.937.5 6.1 0.913.559 (17.5 4.345.0 873.7 4.1 524.419.6 1.5 149.2 $14.3 $14.1 2.169 61.9 654.2 1.902 ($ in millions) 12/31/2010 D 12/31/2010 Current assets PPE.551.1 84.5 24.4 1.931.443.7 39.590 608.8 601.0 124.129.6 CS% 29.5 10.129.0 98.8 0.983 204.4 6.2 67.0 1.1 10.1 5/31/2010 C 0.6 (1.628 79.8 2.4 33.6 2.5 4.8 855.0 61.0 188.1 $14.719) $1.7 12.3 2.ACTIVITY 22 Purpose: TEST YOUR UNDERSTANDING • Understand and interpret amounts reported on the balance sheet.0 67.4 60.9 0.2 (897.6 0.122.457.079.111.183.701 -038.923.0 124.434 91.649.6 873.3 (970.5 215.9 744.7 504.0 13.0 0.7 4.0 CORP B 5/31/2010 $ 3.0 2.7 1.0 6.754.0 10.902 100.254.653. net Goodwill + Intangibles Long-term investments Other noncurrent assets ($ in millions) CORP A 6/30/2010 $ 344.265 567.0 483.3 $ $ TOTAL ASSETS LIABILITIES Accounts payable Short-term debt Other current liabilities Long-term debt Other noncurrent liabilities STOCKHOLDERS’ EQUITY Contributed capital Retained earnings Other stockholders’ equity 112.111.389.7 5.0 1.9 5.3 3.0 15.468 8.040.3 9.2 1.7 13.8) 1.0 449.942.852.095.3) 26.6 CORP C 12/31/2010 $ 1.1 100. net Goodwill+ Other assets $ 501.852.0 1.028.852.1 26.168 362.6 (1.9 673.3 4.6 1.123.4 1.3) TOTAL L & SE $1.526.3 $ 10.991 CS% 87.937.443.558.625.803.5 142.7) 3.1 Classified Balance Sheets / Common-Size Statements CORP D 12/31/2010 $ 27.8 29. and Connected Life. BRINKER INTERNATIONAL (EAT) owns. and through a mix of independent distributors and licensees. develops. Audience. Why? NIKE (NKE) is engaged in the design. Brinker International must be Corporation (A / B / C / D). Then comment on why you selected the match. The company operates in five business segments: Global Cards. and franchises the Chili’s Grill & Bar (Chili’s). It sells its products to retail accounts. Nike must be Corporation (A / B / C / D). Why? YAHOO! (YHOO) is a global Internet brand. The Company’s offerings to users fall into six categories: Front Doors. through NIKE-owned retail. Yahoo! generates revenues by providing marketing services to advertisers across a majority of Yahoo! Properties and Affiliate sites. Why? CITIGROUP (C) is a diversified global financial services holding company whose businesses provide a range of financial services to consumer and corporate customers.42 61% 32% 16% 91% Debt ratio Q1 Analyze the financial attributes of the four corporations on the previous page by placing an X in the box when the company has the characteristics noted below. plant. Citigroup must be Corporation (A / B / C / D). development. operates. Communications. and equipment? Finances assets primarily with… liabilities? contributed capital? retained earnings? Is the smallest company? Is the largest company? Q2 Use the descriptions below to match each corporation with its corresponding financial information. Why? Page 59 Chapter 2 . Maggiano’s Little Italy (Maggiano’s). Yahoo! must be Corporation Balance Sheet (A / B / C / D).11 CORP B 5/31/2010 3. Communities. and worldwide marketing of athletic footwear.26 CORP C 12/31/2010 2. and accessory products. ST or LT investments? Has significant receivables and inventory? Has no inventories? Has significant property. On The Border Mexican Grill & Cantina (On The Border). and Other. Global Wealth Management. including stores and Internet sales.67 CORP D 12/31/2010 1. The majority of its offerings are available in more than 30 languages. equipment. Consumer Banking. and Romano’s Macaroni Grill (Macaroni Grill) restaurant brands. Institutional Clients Group. Which corporation … CORP A CORP B CORP C CORP D Has significant cash. in more than 180 countries around the world.RATIOS Current ratio CORP A 6/25/2010 1. apparel. Search. revenue recognition. interpret amounts reported on its income statement. we will evaluate the profitability of Amazon. and net income are increasing. Statement of Operations.COM’S INCOME STATEMENT Some companies use a single-step income statement that combines all revenues and gains at the top of the income statement and then subtracts all expenses and losses below.CHAPTER 3 INCOME STATEMENT LEARNING OBJECTIVES 1. and the matching principle. Compute and interpret profitability ratios. net income is probably the most commonly used number when evaluating a company’s performance. (Revenues and Gains) – (Expenses and Losses) = Net Income On the other hand.com. and totals. These are followed by Operating Expenses. the multi-step income statement lists items in order of importance. or Statement of Profit and Loss (P&L). In this chapter. and Nonrecurring Items. expenses. subtotals. 2. Nonoperating Items. In fact. Understand how the multi-step income statement is organized. Revenues and Cost of Sales. Income Statement Page 60 Chapter 3 . INTRODUCTION The Income Statement reports a company’s profitability by adding revenues and subtracting expenses. Statement of Earnings. Understand the accrual basis for accounting. The Income Statement is important because investors use it to understand the results of a company’s operations. Investors can compare a company’s performance to competitors by comparing income statement amounts to other companies in the same industry. By comparing income statement amounts to prior periods. This statement is also called the Statement of Income. Interpret trends in income statement revenues. and analyze this statement using simple financial analysis tools. 4. UNDERSTANDING AMAZON. the Provision for Income Tax. Prepare and interpret trend and common-size income statements. which are deemed most important. are listed at the top. introduce the concepts used to prepare the statement. investors can understand whether a company’s sales. 3. 5. expenses. net 79 29 47 Remeasurements and other 0 0 0 Total nonoperating expense 91 32 59 Income before income tax 1.237 4.04 $1.270 Operating expenses: Fulfillment 2.643 5.161 901 Provision (benefit) for income tax (352) (253) (247) Equity-movement investment activity.406 1.240 1. Inc.029 680 482 Technology and content 1.53 $2. except per share data) Year Ended December 31.152 902 645 Nonrecurring items Net income $ 1. Income Statement Page 61 Chapter 3 .08 $2.509 $19.052 1.52 $1.561 18.978 14.898 2.com.033 General and administrative 470 328 279 Other operating expense (income) 106 102 -24 Total operating expenses 6.428 Income from operations 1.AMAZON.152 $ 908 $ 645 Basic earnings per share Diluted earnings per share Weighted average shares used in computation of earnings per share: Basic Diluted $2. 2010 2009 2008 Net sales $34.129 842 Interest income 51 37 83 Interest expense (39) (34) (71) Other income (expense).49 447 456 433 442 423 432 See accompanying notes to consolidated financial statements.734 1.531 4.166 Cost of sales 26.658 Marketing 1.204 $24. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions.896 Gross profit 7.402 3.COM Step One Step Two Step Three Step Four Step Five Amazon. net of tax 7 (6) (9) Income before nonrecurring items 1.497 1.58 $2. 166 14.com’s Net Sales includes a wide range of products. furniture and décor. magazines and newspapers. apparel and accessories. VHS tapes. video games. This company will not record a sale on its income statement when the user downloads the software.204 26. home and garden. and the company collects payment in March. the company’s wide range of products has generated phenomenal growth in Net Sales. the company must wait until the user actually pays for the software.STEP ONE: REVENUES – COST OF SALES = GROSS PROFIT Amazon. earning a commission for each sale (similar to eBay). Inc.com reports one revenue item. outlet merchandise. Similarly. Amazon.643 2009 $24.com’s initial public offering (IPO) in 1997. According to the Notes to the Financial Statements. groceries. Net Sales indicate that returns or discounts were subtracted from total sales. not necessarily in the period that the company collects the money.com delivers it in February. Exceptions to the Revenue Recognition Principle occur when the company is uncertain whether it will be able to collect payment from customers or when the price has not been set. Amazon. cell phones and service.270 REVENUES AND REVENUE RECOGNITION Revenues are inflows from a company’s primary operations. Amazon. jewelry and watches. almost half of the Company’s sales were outside North America ($15. electronics. rent-to- Income Statement Page 62 Chapter 3 .896 $ 4. Rather. gourmet food. Since Amazon. outdoor living. CONSOLIDATED STATEMENTS OF OPERATIONS ($ in millions) Year Ended December 31. This means revenues are recorded in the period earned. suppose that a customer orders a book in January. (Excerpts) Net sales Cost of sales Gross profit 2010 $34. toys and games. software. It offers e-commerce services to retailers such as Target and Web services to program developers. automotive.561 $ 7.497 or 45% of total Net Sales). pet supplies.com also works with third-party sellers. musical instruments. The company must record the revenue in its February income statement because that was when the company earned the revenue by delivering the merchandise. and baby merchandise. Sales typically refer to revenues from the sale of merchandise. DVD’s. Accountants record revenue according to the Revenue Recognition Principle. consider a software company that allows customers to try software for 30 days before purchasing it. bed and bath. health and personal care products.com sells books.978 $ 5. This may occur with customers who have poor credit history or who are likely to return merchandise. sports and outdoors products. camera and photo equipment. industrial and scientific. Net Sales of $34. office products.531 2008 $19. kitchen and housewares. Amazon. Revenues are typically earned when merchandise is delivered or when services are provided.509 18. Amazon. computers and PC hardware. In these cases a company cannot record revenue until collection takes place or at least until collection is more certain. shoes. beauty aids.com. music. For example. In its retail division. tools and hardware. For example. audio and video equipment.204 in 2010. 697 Net Cash Provided by Operating Activities (from the Statement of Cash Flows) Amazon. prepared under accrual principles. Cost of Sales includes the cost of purchasing merchandise that was sold during the year plus delivery costs. and factory costs associated with producing the merchandise sold during the year. is significantly lower than related cash flows. ($ in millions) Year Ended December 31. Under accrual accounting. Suppose that Amazon. the cost of purchasing or manufacturing the actual products sold. the idea that accountants usually record transactions when they occur.406 $1. when it earned the revenue. The difference could also be caused by collecting accounts receivable more quickly or paying accounts payable more slowly. and then collected payment in September. Cost of Sales would also be recorded in August.own companies that rent inexpensive furniture and appliances to college students typically do not record revenue until they collect payment. we record expenses in the period they help to generate revenues. Currently. Since we define expenses as the cost of bringing in revenues. Don’t confuse accrual accounting with Cash-basis Accounting. The Revenue Recognition and Matching Principles form the basis for Accrual Accounting. Cost of Sales includes materials. labor. typically do not report Cost of Sales but may report Cost of Services. Both of these strategies would improve a company’s cash flows but not affect net income under accrual accounting. which are recorded under the accrual method but don’t actually cost the company any cash.com would record the revenue in August. which do not sell merchandise.com’s Income Statement with cash-basis accounting from the Statement of Cash Flows: Amazon. Now compare the results under accrual accounting from Amazon. GAAP provide similar guidance regarding revenue recognition.129 $ 842 $3. Service companies. For retail companies. Cost of sales is also known as Cost of Goods Sold (COGS).com purchased a DVD for $10 in June. which records transactions when cash is received or paid. Income Statement Page 63 Chapter 3 . 2008 Income from Operations (from the Income Statement) 2007 2006 $1.495 $3.com were to purchase a book for $100 and resell it for $120. Most companies’ largest expense is Cost of Sales.S. paid for it in July. For example. Inc. EXPENSES AND THE MATCHING PRINCIPLE Expenses are the costs incurred to produce revenues. According to the Revenue Recognition Principle discussed above. suppose that Amazon. such as depreciation expense. IFRS and U.com. Cost of Sales equals the actual cost of purchasing the merchandise that was sold during the year. However. matching expenses to revenues. For manufacturing companies. It would report Net Sales of $120 and Cost of Sales of $100. The year that the company actually paid for the merchandise is irrelevant.com’s Income from Operations. delivered it in August. the FASB and the IASB have undertaken a major project that is reconsidering the timing and measurement of revenue. not necessarily when cash is received or paid.293 $1. It does not include the cost of merchandise sold in other years. This difference could be caused by noncash expenses. This is called the Matching Principle. Amazon. the company’s sales generated $7. Gross Profit equals the difference between Revenues and Cost of Sales.643 million in 2010. Amazon. It represents the profit left over after covering the cost of producing or manufacturing the merchandise. Amazon has benefited from the Internet explosion.204 – Cost of Sales $26.643 in 2010.561 = Gross Profit $7.com reported Gross Profit of $7.643). This means that after deducting the cost of merchandise sold.com’s Gross Profit has increased dramatically: Income Statement Page 64 Chapter 3 . Many investors use gross profit to measure a company’s profitability. As can be seen in the following graph. With gross profit increasing from just $29 million in 1997 to $7.643 (Net Sales $34.Concluding the first step of the multi-step income statement. Amazon. 3. a company’s profit from its primary operations. General and Administrative Expenses include the cost of paying employees in corporate functions such as accounting. and human resources.531 $4. (Excerpts) Gross profit Operating expenses: Fulfillment Marketing Technology and content General and administrative Other operating expense (income) Total operating expenses Income from operations 2010 2009 2008 $7. 4. Fulfillment Expenses for Amazon.428 $ 842 Operating Expenses include all costs of generating sales besides Cost of Sales.643 $5. Amazon. Inc. and employees who select and buy merchandise. computer systems managers. tax.898 1. Marketing Costs consist of online advertising. commissions. finance.406 2.033 279 (24) 3. Technology and Content Costs include the cost of paying Web developers. Companies set up different categories of operating expenses based on their operations. The following chart indicates that Amazon. CONSOLIDATED STATEMENTS OF OPERATIONS ($ in millions) Year Ended December 31. 5.com include the costs of operating and staffing the fulfillment and customer services centers that warehouse and distribute inventories to customers.com. Operating expenses of other companies typically include Depreciation Expense.com’s Operating Income rose dramatically from an $864 million Operating Loss in 2000 to an all-time high of $1406 million in 2010. Other Operating Expense.237 $1. Operating Income excludes items not central to a company’s operations.052 680 1.STEP TWO: GROSS PROFIT – OPERATING EXPENSES = OPERATING INCOME Amazon. this income statement amount is suitable for comparing different companies’ operating income.402 $1. website editors. public relations.734 470 106 6. legal.658 482 1. After subtracting operating expenses from gross profit.029 1. and other related costs.240 328 102 4. They also include costs of handling customer payments and inquiries. financing costs. 2. which is the cost of using buildings and equipment owned by the company. we arrive at Operating Income. and income tax transactions. such as investing costs.129 1.com reports five categories of Operating Expenses. also referred to as Income from Operations. and Research and Development Expense. according to the Notes to the Financial Statements: 1. Therefore. Income Statement Page 65 Chapter 3 .270 2. CONSOLIDATED STATEMENTS OF OPERATIONS ($ in millions) Year Ended December 31.com reported interest income and expense. if Amazon. They are computed as the difference between the selling price and the book value of any asset sold. and later sold them for $2.406 51 (39) 79 91 $1.000.000.com.161 2008 $842 83 (71) 47 59 $901 The third section of the multi-step income statement reports items that affect income but have little relevance to operations. if Amazon.STEP THREE: OPERATING INCOME +/. Similarly. Also found in this section are Gains and Losses.000. in this section Amazon. For example. it would include interest as part of operations.NONOPERATING REVENUES AND EXPENSES = INCOME BEFORE INCOME TAX Amazon. it would report a $500. net Total nonoperating expense Income before income tax 2010 2009 $1. Gains and losses arise from the sale of long-lived assets or investments. (Excerpts) Income from operations Interest income Interest expense Other income (expense). Inc.com sold Income Statement Page 66 Chapter 3 . For example.com were a bank. If Amazon.497 $1129 37 (34) 29 32 $1.000 gain on this transaction.500.com purchased shares of IBM stock for $2. Income Statement Page 67 Chapter 3 . However. Inc. After subtracting provision for income tax.com added a $233 million Income Tax Benefit to $355 million in Income before Income Tax. companies can get money back from the government. state governments. or foreign governments issuing tax refunds to the company. If Amazon. is the result of federal. This benefit. Similarly. In 2004.com. also known as Income Tax Provision or Income Tax Expense. Think of it this way: The government is your “partner. net of tax Income before nonrecurring items $1497 (352) 7 $1152 2009 $1161 (253) (6) $ 902 2008 $ 901 (247) (9) $ 645 Corporations pay income taxes to the federal government. when you incur losses. the company will arrive at Income Before Income Tax. when recording a loss. it would include revenues from sales of IBM stock in operations. your “partner” must also share the loss.com were an investment firm. state. Typically.com’s first nine years. it would include revenues from sales of land in operations.000 million of net losses accumulated during Amazon. claiming refunds of prior years’ taxes paid or taking credits that offset future years’ taxes. CONSOLIDATED STATEMENTS OF OPERATIONS ($ in millions) Year Ended December 31. Note that gains and losses are only recorded for items that are outside a company’s primary operations. sometimes reported as Income from Continuing Operations before Income Tax. accountants arrive at Income from Continuing Operations. (Excerpts) 2010 Income before income tax Provision (benefit) for income tax Equity-movement investment activity. After adding or subtracting this miscellaneous category of items. typically ranges from 25% to 45% of a company’s income before income tax. if it were a real estate developer. and foreign governments. Amazon. it would record a $1 million loss. Provision for Income Tax. This tax windfall resulted from over $2. Corporations reporting a taxable loss can actually report an Income Tax Benefit.land for $4 million that had originally cost $5 million. reducing the company’s loss.” When you earn profits. your “partner” takes its share. STEP FOUR: INCOME BEFORE INCOME TAX – PROVISION FOR INCOME TAX = INCOME FROM CONTINUING OPERATIONS Amazon. S. (Excerpts) Income before nonrecurring items Nonrecurring items Net income 2010 2009 2008 $1. These include: • Discontinued Operations. Losses from Hurricane Katrina? Not extraordinary.STEP FIVE: INCOME FROM CONTINUING OPERATIONS +/. GAAP uses a much broader definition.com had no nonrecurring items for the three years shown. IFRS restricts the discontinued component of the entity to either a major line of business or a geographical area of operations. CONSOLIDATED STATEMENTS OF OPERATIONS ($ in millions) Year Ended December 31. which equals all revenues and gains less all expenses and losses from operating. Tornados? No. In the future. the bottom line. IFRS does not allow the reporting of extraordinary items due to the difficulty of defining extraordinary across cultures. and financing activities. Income Statement Page 68 Chapter 3 . After adding or subtracting these items. if Amazon. we arrive at net income.152 $902 $902 $645 $645 Nonrecurring Items. the Income Statement (like the other financial statements) will use a common format (specified by the FASB and the IASB) that organizes the financial information into operating. These are highly unusual transactions that are considered unusual in nature and infrequent in occurrence. the gain or loss would be recorded here. • Extraordinary Items. The definition of Discontinued Operations differs considerably between IFRS and U. only a few rare transactions related to government regulation or changes in accounting rules have qualified as extraordinary. Amazon. and nonrecurring items.com. may appear in the bottom section of a company’s income statement.com sold its Developer Services Division to Google. whereas U.152 $1. These are recorded when a company closes down or sells part of its business.NONRECURRING ITEMS = NET INCOME Amazon. Inc.S. investing. or profit (loss). Acts of terror on September 11? Not extraordinary. It is also referred to as earnings. nonoperating. GAAP. For example. which accountants deem unusual and infrequent. In the past. For example. nurses. Because of its limited resources. In the next sections. the doctor’s office could not be expected to perform open-heart surgery in an examination room. we typically compute “Miles per Gallon” by dividing the miles driven (output) by the number of gallons used (input): Miles per Gallon = Miles Driven (output) Number of Gallons Used (input) After filling the tank of my car. a physician’s assistant. the hospital might have dozens of physicians. it is important to understand the concept of Productivity. we can’t expect Google-class performance from a new Internet start-up. for example. which revealed that the tank needed 9. However. Ideally. consider a common measure of automotive productivity: gas mileage. and a receptionist to treat patients during 30-minute appointments. nor should we expect Internet-startup performance from Google. the ultimate reward for careful investors. which indicated that I drove 275 miles. • Compare income statement amounts to prior years (trend analysis). has historically produced a strong record of profitability: Income Statement Page 69 Chapter 3 . Most income statement ratios are premised on the idea that companies should generate as much revenue and squeeze as much profit as they can from the limited resources available. Then. Both are in the business of helping people to get well. profits increase smoothly at an increasing rate.ANALYZING THE INCOME STATEMENT When reading an income statement. To measure gas mileage. Three comparisons will help: • Compare income statement amounts to other amounts in the company’s financial statements of the same year (ratios and common-size statements).0 = 30. 275/9. operating rooms. you can better predict a company’s future profits and dividends. and beds for overnight stays. compare a doctor’s office with a hospital. On the other hand. I looked at the trip odometer. Similarly. a hospital’s resources would be completely wasted if it treated only one patient at a time for short visits.0 gallons to fill. we’ll measure how productively a company uses its resources to generate profits. your goal is to interpret and understand a company’s profitability. Productivity measures how efficiently you can generate desired outputs from given inputs.6 MPG. Similarly. The doctor’s office might have a single physician. expensive equipment. Then I zeroed-out the trip odometer for the next tank of gas. when looking at a company’s performance. Microsoft. profitability ratios divide output by input. The more assets a company has. • Compare income statement amounts to competitors and industry norms. in accounting. the higher our expectations should be. Furthermore. For example. By analyzing the Income Statement and understanding a company’s profitability. I looked at the gas pump. The analysis in this chapter will compare Amazon. plus other transactions.com to Sears Holdings and online retailer eBay. measures the profitability from each dollar of revenue. It expresses net income as a percentage of revenue: Return on Sales = Net Income Sales Revenue This is a key test of how effectively a company can squeeze net income from net sales.156 million in revenues in 2010 from fees on sales that it brokered. Comparing results to prior periods will help you to understand whether the company’s performance is improving or deteriorating.” ROS = Net Income / Sales Revenue To help analyze financial statement ratios. Following is a comparison of the three companies’ Return on Sales.038 bricks-and-mortar stores. Sears Holdings sells a wide array of products. squeezing as much net income as they can out of each sales dollar. computed “on” or over. or net income. Comparing results to similar companies will help you to understand the nature of competition within an industry.com. However. most of its sales are made through its 4. “Sales. as well as return on sales. How well can a company control expenses to maximize the amount of net income it earns for each dollar of revenue? It’s easy to remember ratio formulas because their names typically explain their computation. also known as Net Profit Margin. “Return” indicates profitability. Companies try to maximize net income. For example.RETURN ON SALES Return on Sales (ROS). Income Statement Page 70 Chapter 3 . eBay is an online auction website that earned $9. take the ratio “Return on Sales” literally. Like Amazon. it is useful to make comparisons with other companies and previous periods. com. recalculate the ratios excluding that hurricane loss.389 1.8% A B A/B Return on Sales indicates that Amazon.4% 20. consider recalculating the ratios to exclude the unusual item from the financial statements.7% 0.4 0. The decrease from 2008 to 2009 and 2010 indicates that Amazon.204 24.326 44.801 2. For example.592 B 0. Therefore. analysts commonly exclude research and development expense.043 46.314 24.3 1. When an unusual item appears. They do not consider research and development a real expense.509 19.156 8. and sell pharmaceuticals. eBay’s ROS increased from 20. To better understand the rest of the company’s operations.4% 3. Following are asset turnover ratios for Amazon.808 25.4% and 3.043 46. Barnes & Noble.4% 0.004 18. It is computed by dividing Revenue by Assets: Asset Turnover Sales Revenue Total Assets = Company assets are necessary for generating revenues and profits.8 0.8 in sales revenue.Return on Sales Sears Holdings Amazon.8 1.797 13.268 24. between 3. and eBay: Asset Turnover Sears Holdings Amazon. ASSET TURNOVER RATIO The Asset Turnover ratio measures how efficiently a company uses its assets to produce revenue. Suppose that a hurricane destroyed one of a company’s factories.3% 0.813 1. Asset turnover measures how efficiently a company uses its limited assets (input) to generate revenue (output).541 A 8.8 Asset turnover 2008 2010 2009 2008 eBay 2010 2009 2008 9.779 34. Sears Holdings’ ROS is very low: less than 1%.8 1.com’s performance remains steady.541 3.156 8. Because productive use of assets is a worthwhile objective.com ($ in millions) 2010 2009 Sales revenue 34.7% in 2010.770 2.com used its assets less productively to generate revenues in 2009 and 2010.7% 3. When computing ratios like ROS.5 In 2010 for every $1 in assets.7%. but rather.152 902 645 150 297 99 1.2% 19. produce.166 43. an investment that will generate future revenues. Income Statement Page 71 Chapter 3 .com ($ in millions) Net income Sales revenue Return on sales 2010 2009 2008 2010 2009 eBay 2008 2010 2009 2008 1.727 8. then dropping to 19.326 44.8% in 2008 to 27.166 43. a pharmaceutical company needs to invest in research laboratories and factories in order to develop.770 9.7% 27. It sometimes pays to investigate the financial statement amounts that underlie the ratios. they exclude it from expenses when calculating certain ratios.204 24.408 15. Amazon.727 8.com generated $1.4% in 2009.509 Total assets 18. investors should look for high asset turnovers that increase.5 A/B 19.342 22.8 1. 2%. ROA compares an income statement amount to total assets: Net Income Total Assets = Return on Assets Given the amount of assets they have.67% x Asset Turnover Productivity (Efficiency) 1.268 0. returns the highest ROA shown.2% Companies’ strategies can focus on high profitability that comes from high prices and strong product differentiation. industries.8% 150 24. managers try to maximize the amount of net income they generate.2% 13.813 6. The resulting high profit margin (ROS). as does Sears Holdings.RETURN ON ASSETS Return on Assets (ROA) measures how productively a company uses its assets to generate profits.4% in 2008 to 13.6% 8. in spite of low asset turnover.408 8.0% 2009 2008 1.1% 0. This ratio can be compared among other companies. Recall from Chapter 1 that Return on Assets can be broken down into elements of profitability and productivity (efficiency). Amazon. and then decreased to 8.314 7.785 0. Sears Holdings stagnated between just 0. and investments.4% 1. reporting low profit margin (ROS) and high turnover.com Return on Assets Sears Holdings eBay ($ in millions) 2010 2009 2008 2010 2009 2008 2010 Net income Total assets Return on assets 1. It appears that because eBay earned the highest ROS. On the other hand.004 18. eBay’s ROA increased from 11.37% 0.4% and 1.416 = Net Income Total Assets Return on Assets Profitability 6.797 6.0% in 2009.820 1.com Sears Holdings eBay Profitability 3. Income Statement Page 72 Chapter 3 .779 15.4% A B A/B The above chart summarizes the three companies’ ROA.2% 99 25. multiplying Return on Sales by Asset Turnover to arrive at Return on Assets: Return on Assets = Return on Sales x Asset Turnover = Return on Sales 2010 Amazon.342 0.5% 645 8.152 18.1% 902 13.com focuses on productivity. Like Asset Turnover.808 1. or they can focus on high turnover that comes from efficient use of assets.801 2. Amazon. Amazon.592 11. eBay has very strong product differentiation.com’s net income and ROA decreased during the three years.2% in 2010.389 22.35% 19. it also produced the highest ROA.6% 297 24. This table clearly distinguishes the three companies’ strategies. 6% 73.770 9. Income Statement Page 73 Chapter 3 . Gross Profit Margin Gross Profit Sales Revenue = How much does it cost to brew a cup of coffee? Suppose that you purchased a latte at Starbucks this morning for $4. Gross profit is an especially important measure for companies in the retail and manufacturing industries. Amazon.00 1.541 B 27.043 46.3% 27. Here is an excerpt from Starbucks’ Income Statement: Starbucks .$2. such as discount retailers and department stores.248 Cup of Coffee 100.com in Gross Profit Margin.4% $4.6% Gross Profit 2009 2008 11.9% A/B In terms of Gross Profit. 2010 Sales revenues Cost of sales Gross profit $10. we learn that. Gross Profit Margin ($ in millions) FYE October 3.33 of gross profit for Starbucks.com ($ in millions) Gross Profit Margin Sears Holdings 2010 2009 2008 2010 7. Therefore.248 6. eBay sells access to its website so that some customers (buyers) can purchase products from other customers (vendors). eBay earns much more than Amazon. Tiny improvements in gross profit can have a tremendous impact on net income.707 = 58.00 cup of coffee creates $2. Therefore.643 5.00.531 4.1% 72.0% 71.com and Sears Holdings offer a wide variety of physical products.com or Sears Holdings.204 24.4%. According to Starbucks’ own financial statements.33 Starbucks’ gross profit margin = 6.156 8.313 A 44.com to Sears Holdings. Amazon. This is because eBay sells a service while the other companies sell merchandise.509 Gross Profit Margin 22.3% 22. This gross profit would be used to cover other expenses of the company.270 Sales Revenue 34.4% eBay 2010 2009 2008 12. while both companies’ ratios decrease from 2009 to 2010.727 8. Investors can use this information to compare Starbucks’ operations with other companies within the industry. reporting a lower Gross Profit Margin.248/10. that cup of coffee cost the company $1.00 . on average.0% 41. It simply collects a fee for each sale. also known as Gross Margin.33) to make.326 22. However. expressing gross profit as a percentage of net revenue.67 $2.7% 27. one could estimate that a $4.67 ($4.219 19. Sears Holdings consistently outperforms Amazon.707 4. compares gross profit to revenue.878 12.GROSS PROFIT MARGIN Gross Profit Margin (GP%).652 6. These two companies must deduct the cost of these products as part of Cost of Sales.166 43.459 $ 6. comparing eBay with the other two companies is like comparing apples and oranges. It measures how successfully a company buys and sells merchandise at a profit.6% 58. Comparing Amazon.592 6. To prepare a trend analysis of the income statement. Income Statement Trend Analysis Year Ended December 31. net Remeasurements and other Total nonoperating expense Income before income tax Provision (benefit) for income tax Equity-movement investment activity. the trend analysis indicates that Amazon. consider Sears Holdings and eBay: Income Statement Trend Analysis Amazon. 2010 2009 2008 Net sales Cost of sales Gross profit Operating expenses: Fulfillment Marketing Technology and content General and administrative Other operating expense (income) Total operating expenses Income from operations Interest income Interest expense Other income (expense). all dramatic increases over two years. Inc.100). eBay’s results seem to be stagnating over these three years. Inc.com. the company managed to increase its Net Income by 52%. For comparison.com’s Net Sales increased 78% (178 .com.” Then divide each line item amount by the base year and multiply by 100.com: Amazon. set the earliest year as a “base year. However. Income Statement Page 74 Chapter 3 . While Sears reduced Revenues by 6%. Here is the trend analysis for Amazon.TREND ANALYSIS Trend analysis indicates how different accounts on the income statement are changing. Sears Holdings (Excerpts) Revenue Gross profit Net income eBay 2010 2009 2008 2010 2009 2008 2010 2009 2008 178 179 179 128 130 140 100 100 100 94 93 152 97 94 300 100 100 100 104 107 101 99 102 134 100 100 100 Amazon is showing amazing growth: 79% in two years. and Net Income increased by 79% (179-100). Gross Profit increased 79% (179 . net of tax Income before nonrecurring items Nonrecurring items Net income 178 178 179 128 127 130 100 100 100 175 213 168 168 442 179 179 167 61 55 NA 154 166 -143 124 141 120 118 425 128 128 134 45 48 NA 54 129 102 100 100 100 100 100 100 100 100 100 100 NA 100 100 100 NA NA NA 179 NA 179 140 NA 140 100 NA 100 First of all.100). 6% 100. divide all amounts by sales revenue or net sales for that year. as a percentage of net sales.1% 0.com’s increase in net income. Accrual accounting is different from cash-basis accounting. For example. In 2010. common-size analysis allows comparisons among different years and even among companies of different size.1%) 95.4% (0. net of tax Net income 2010 2009 2008 100.8% 5.4% 22.4% 0.4% The common-size income statement helps to explain Amazon.2% 0. These are followed by Operating Expenses.5% 3. decreased from 4.0% 3.1% 1.3% 8.9% 4.0% 5.5% (0.4% 2. Fullfillment Expense.1%) 0.5% 5.1% (0.7% 2.1% 4.COMMON-SIZE ANALYSIS By reducing financial statements to a 100-point scale.0% 3.2% (0.0% 0. Income before Income Tax. Accordingly.7% to 4.1% 0.7% 1. It is based on accrual accounting. Amazon.3% 4. most expenses.com.1% 1.0% 3.4% 0.7% 22. Common-Size Income Statement Year Ended December 31. and Gross Profit are reported at the top of the multi-step income statement.4% 1. net Total nonoperating expense Income before income tax Provision (benefit) for income tax Equity-movement investment activity. and Nonrecurring Items. as a percentage of Net Sales.7% 1. Cost of Sales.4% 95.3% 95. as a percentage of Net Sales.6% 4. SUMMARY The Income Statement provides information about a company’s profitability by adding revenues and gains and subtracting expenses and losses.0% 77. which records cash inflows when received and cash outflows when paid. To prepare a common-size income statement. we attribute most of the increase in Net Income to the 78% increase in Net Sales over two years (see Trend Analysis).0% 77. Nonoperating Revenues and Expenses. Income Statement Page 75 Chapter 3 .4% 4. The multi-step income statement is organized according to the importance of each item to the company’s operations.2% 0. Revenues.0% 77.3% 0.4% 8. changed very little.0% 0.4%.3% 0.3% 4. equaled between 8% and 9% every year.6% 0. which recognizes revenues when earned and records expenses when the company benefits from those expenses.4% 1.3% 100.7% 22. the Provision for Income Tax.1%) 0. However.7% 8. Inc. Net sales Cost of sales Gross profit Operating expenses: Fulfillment Marketing Technology and content General and administrative Other operating expense (income) Total operating expenses Income from operations Interest income Interest expense Other income (expense).4%) 0. The Asset Turnover Ratio measures how productively a company uses its assets to produce revenue.8 1.8 0.7% 9.com Page 76 Chapter 3 .msn.0% * Industry: Catalog and Mail Order Houses ** There are no official rules governing how these ratios are calculated.1% 0. Return on Assets measures how efficiently the company uses available assets to generate profits.4 1.com (AMZN) Sears Holdings (SHLD) eBay (EBAY) * **Industry **S&P 500 ROS x Profitability NI / Sales Revenue 3.0% 38.8 1.3% 19. Return on Sales measures the profits earned from each dollar of revenue.0% GROSS PROFIT MARGIN Profitability Gross Profit / Sales Revenue 22.3% 10. the ratio formulas used may differ from the formulas in the text. Trend analysis describes how individual items on the income statement “grow” with the rest of the company. Therefore. Income Statement Industry and S&P 500 ratio averages from moneycentral. RATIO Type Formula Amazon. Common-size analysis helps the user to compare different years’ income statements and understand how a company’s cost structure is changing.9% 10.4% 0.Profitability ratios measure how well a company uses resources to generate profits.2% 7. These ratios can be compared to prior years and to other companies in the same industry. Gross Profit Margin measures how much Gross Profit the company generates from Sales Revenues.4% 72.6% 8.0 = ROA Profitability NI / Total Assets 6.7% 40.3% 27.0% ASSET TURNOVER Efficiency Sales Revenue / Total Assets 1. Costs of generating sales besides COGS (2 words) 9. Difference between Revenues and Cost of Sales (2 words) Income Statement Down 1. ______ ______ (2 words) 13. A high ratio indicates a low-cost. Cost of purchasing or manufacturing products sold (4 words) 12. Subtotal reporting profitability from both operating and nonoperating activities (4 words) 3. but have little relevance to operations 6. Net profit margin (3 words) 21. high-volume business strategy (2 words) 2. Subtotal equaling gross profit less all operating expenses (2 words) 14. (Revenues and Gains) minus (Expenses and Losses) (2 words) 20. Income from _____ Operations is the profit resulting from operating and non-operating activities. Ratios measuring the ability to generate income 16. _____ for Income Tax is based on the amount reported for income before income tax Page 77 Chapter 3 . Principle requiring expenses be recorded in the period they help to generate revenues 17. Amounts earned from a company’s primary operations 22. Principle stating revenues are recorded in the period earned. Statement of profit and loss or the P&L (2 words) 5. Income Statement reporting all amounts as a percentage of revenue (2 words) 19. Results when the selling price is less than the book value 8. Accrual-based vs.ACTIVITY 23 CROSSWORD PUZZLE FOR CHAPTER 3 Across 2. including the impact of income tax 7. Accounting method following the Revenue Recognition and Matching Principles 11. Unusual and infrequent items. not necessarily in the period money is collected (2 words) 18. Gross Profit _____ expresses gross profit as a percentage of revenue 4. _____ revenues and expenses affect net income. ROS times Asset Turnover (abbreviation) 10. including Discontinued Operations and Extraordinary Items 15. iPads. Cost of Goods Sold (COGS). plant. nonoperating revenues and expenses total $__________ million. Q1 Sales revenue earned from the sale of Mac computers. and therefore. Inc. They include (D)iscontinued operations. Q4 Apple’s average income tax rate was (7% / 18% / 24%). Q6 The income statement reports the results of operations (as of a certain date / over a period of time). Nonoperating revenues and expenses affect income. iPhones. Identify each of the following as either a (D)iscontinued or (E)xtraordinary type of nonrecurring item. Provision for income tax is income tax expense based on the amount reported for income before income tax. (operating revenues / nonrecurring items) are reported at the top and (operating revenues / nonrecurring items) are reported at the bottom of the income statement. Q5 Nonrecurring items are items that occur (once / twice / continuously) within the life of a company. • Understand the organization of the multi-step income statement. (D / E) Due to global warming the tundra melts in Barrow. also referred to as Cost of Sales. iTunes. and when they sell property. Nonrecurring items are gains and losses which accountants deem unusual and infrequent.ACTIVITY 24 Purpose: THE MULTI-STEP INCOME STATEMENT • Identify the types of accounts presented on the income statement. Revenues are inflows from a company’s primary operations. Therefore. Income Statement Page 78 Chapter 3 . Expenses are the costs of bringing in revenues. (COGS / operating expenses) is(are) greater (by far / by a little bit). Q3 Nonoperating revenues and expenses refer to (operating / investing / financing) revenues and expenses. For Apple. iPods. Q7 Income statement accounts are listed in (alphabetical order / order of relationship to the primary business activity / no particular order). investment income. but have little relevance to operations. refer to the income statement of Apple. and equipment (revenue / a gain (loss)) is reported. It is an operating expense. IFRS does not allow (D / E) items and has a narrower definition of (D / E) items. (D / E) PepsiCo sells off Pizza Hut. Interest expense reflects the firm’s cost of borrowing and is a(n) (operating / investing / financing) cost that is classified on the income statement as a(n) (operating / nonoperating) expense. Alaska. and (E)xtraordinary items. Taco Bell. When amounts are requested. on the next page. should be classified as (operating / nonoperating) revenue. Investment income (does / does not) result from Apple’s primary business activity. is the cost of purchasing or manufacturing the actual products sold. Operating expenses include all costs of generating sales besides COGS. When retailers and manufactures sell inventory (revenue / a gain (loss)) is reported. resulting in flooding an entire factory and closing it indefinitely. and gains and losses on the sale of assets other than inventory. which is (expected / unexpected) for a manufacturing firm. These typically include financing expenses. and other related products and services totals ($__________ million / can’t tell) and the cost of those products totals ($__________ million / can’t tell). and KFC. Q2 Apple’s income statement lists (2 / 3 / 4) operating expense accounts (other than COGS) that total $__________ million. 385 0 0 0 155 + 155 18. administrative expense (SGA) Depreciation and amortization expense Other operating expenses Total operating expenses Operating Income Interest income (expense) Investment income (expense) Gains (losses) on the sale of assets Other revenues (expenses) Total nonoperating revenues and expenses Income before income tax Provision for income tax Income from continuing operations Nonrecurring items Net income Income Statement 9/25/2010 $ 1.517 0 0 7.541 25.540 4.Apple Computer (AAPL) INCOME STATEMENT ($ in millions) Fiscal year ended (FYE) Sales revenue Cost of goods sold (COGS) Gross profit Research and development expense (R&D) $ Selling.782 5.225 39.684 14.013 Chapter 3 .013 0 $ Page 79 65. general.299 18.527 14. the bottom line. It is also referred to as earnings. refer to the income statement of Apple Computer for the fiscal year ended on 9/25/2010 on the previous page.ACTIVITY 25 Purpose: MULTI-STEP SUBTOTALS AND TOTALS • Identify subtotals and totals on the multi-step income statement and how they are computed. Q7 On the multi-step income statement. Q2 Gross profit minus (provision for income tax / operating expenses (other than COGS) / nonoperating revenues and expenses) equal Operating Income that totals $__________ million. Q3 Operating income plus or minus (provision for income tax / operating expenses / nonoperating revenues and expenses) equal Income before Income Tax that totals $__________ million. Income from continuing operations indicates profitability from operating and nonoperating activities including the impact of income tax. Gross profit is the difference between sales revenue (inflows from a company’s primary operations) and cost of sales (the cost of purchasing or manufacturing the actual products sold). It indicates how well a firm is managed. it is best to compare (Operating Income / Income from Continuing Operations / Net Income). Operating income is gross profit less all operating expenses. Net income is all revenues and gains less all expenses and losses from operating. Income before income tax indicates profitability from both operating and nonoperating activities. It is the first indication of profitability. Q6 Net income can either be distributed to stockholders as (dividends / gross profit / retained earnings) or be retained in the business as (dividends / gross profit / retained earnings). (3 / 4 / 5 / 6) different subtotals and totals provide helpful information for decision makers. Q8 When comparing companies within the same industry. • Understand the information presented by each multi-step subtotal and total. nonoperating. Q5 Income from continuing operations plus or minus (provision for income tax / nonrecurring items / nonoperating revenues and expenses) equal Net Income that totals $__________ million. Why? Income Statement Page 80 Chapter 3 . or profit (loss). Q1 Sales Revenue minus (operating expenses / nonoperating revenues and expenses / COGS) equals Gross Profit that totals $__________ million. When amounts are requested. Q4 Income before income tax minus (provision for income tax / nonoperating revenues and expenses / COGS) equals Income from Continuing Operations that totals $__________ million. and nonrecurring items. Wages and other operating expenses total $3. a florist shop. organizing information into operating. prepare the income statement for Bloomin’ Flowers below. a gain. and net income? Q11 The FASB and the IASB are working to establish a common format.000 (that was never utilized) and sold it during this accounting period for $6. Using these events. purchased flowers from a wholesaler costing $24. Back in the year 2003. investing. Bloomin’ Flowers INCOME STATEMENT Sales revenue $ Cost of sales $ Gross profit $ Operating expenses $ Operating income $ Nonoperating revenues and expenses $ Income before income tax $ Q10 What is the difference between revenue.Q9 In this accounting period BLOOMIN’ FLOWERS.000.000 and sold them to customers for $32.000. and financing activities for the (balance sheet / income statement / statement of cash flows). the company purchased land for $2.000. Income Statement Page 81 Chapter 3 . then expense immediately.000 to be paid the following year.000 for merchandise inventory. 2) If no association can be found. This means revenues are recorded in the period earned. Received cash from customers. In Year 1 $__________ b. then use a systematic and rational allocation method if you can. Received and paid a $1. Compute August net income (using accrual-based accounting) and the August 31 cash balance. On the income statement of RETAIL STORE.000 wholesale. Revenues are typically earned when merchandise is delivered or when services are provided.000. Accrual Cash $ $ $ $ Aug 1 Aug 5 $ $ Aug 16 $ $ Aug 17 $ $ $ Aug 30 Paid August office rent of $4. The cost of the four unsold bicycles will remain part of (inventory / COGS / retained earnings) reported on the (BS / IS / RE / CF). GAAP #2: Q1 Accountants record revenue according to the Revenue Recognition Principle. On the income statement of CYCLES GALORE. Gross profit? $__________ d. Examples include advertising. Customer Nancy pays $500 in cash and signs an installment agreement for the remaining $1. and October. Q2 In this accounting period. Aug 31 Aug 31 Change in cash balance August net income XXXXXXX $ Income Statement XXXXXXX Page 82 Chapter 3 . In Year 2 $__________ GAAP #3: The Matching Principle requires accountants to record expenses in the period they help to generate revenues. utility. • Apply the Realization Concept and the Matching Concept. which means that companies must comply with the Revenue Recognition and Matching Principles described below. Paid September office rent of $4. a sporting goods retailer. GAAP requires companies to use accrual accounting to report revenues and expenses.000. how much revenue should be recognized? a. Sold merchandise for $54. Sales revenue? $__________ b. Examples include depreciation and amortization. Purchased and paid $32. What amount will be reported? $__________ Q3 Kiger Kayaking. CYCLES GALORE purchased 10 bicycles for $200 each at wholesale and sold 6 bicycles for $500 each to customers. Cost of goods sold? $__________ c.000 to customers at retail that cost $20. not necessarily in the period that the company collects the money.500 computer. 3) If neither (1) nor (2) apply. and administrative expenses. Examples include cost of goods sold and commissions.ACTIVITY 26 ACCRUAL ACCOUNTING AND GAAP Purpose: • Understand accrual accounting and how it differs from cash accounting. September. Therefore: 1) If there is an associated cause and effect. report the expense in the same period as the revenues it helped to generate. Year 2. On December 1. Year 1 RETAIL STORE sells a $1. began operations on August 1 with the following transactions during the first month of operation. how much will be reported for: a.500 advertising bill for August. Income Statement Page 83 Chapter 3 . From 9/29/2007 to 9/25/2010. no parentheses indicate to (add / subtract) the amount. This amount of increase is (expected / unexpected). A minus sign may be used instead of parentheses. From 9/29/2007 to 9/25/2010. For example. o Accounts that are typically subtracted to compute net income … use no parentheses when subtracted and parentheses when added. Sales Revenue (decreased / more than doubled / tripled). R&D (decreased / more than doubled / tripled). indicating the company is (competitive within its industry / successful at controlling costs / well managed). Q5 b. and therefore. Q1 From 9/29/2007 to 9/25/2010 sales revenues (increased / decreased). o Accounts that are typically added or that can either be added or subtracted to compute net income … use no parentheses when added and parentheses when subtracted. From 9/29/2007 to 9/25/2010. Why? e. Q6 Develop a strategy to evaluate the income statement. COGS is typically (added / subtracted) to arrive at net income. When preparing financial statements. net income (decreased / more than tripled / more than quadrupled). use the following rules for placing parentheses.When amounts are requested. refer to the series of income statements of Apple Computer presented on the previous page. Which line of the income statement would you look at first? Second? Third? Why? Income Statement Page 84 Chapter 3 . This amount of increase is (expected / unexpected). From 9/29/2007 to 9/25/2010. COGS (decreased / more than doubled / tripled). From 9/29/2007 to 9/25/2010. What typical costs might be included in this expense? Q4 Let’s compare some trends in the data: a. which is an extremely (favorable / unfavorable) trend. Parentheses indicate to (subtract / add / do the opposite of typical). Why? c. provision for income tax (decreased / doubled / tripled). Q2 Cost of goods sold (COGS) is a(n) (revenue / expense / asset / liability) account that totaled what amount for fiscal year ended … 9/25/2008? $________ million 9/26/2009? $________ million 9/27/2010? $________ million The beginning balance of COGS was what amount for fiscal year ended … 9/25/2008? $________ million 9/26/2009? $________ million 9/27/2010? $________ million Q3 What is the greatest expense for this company? (COGS / SGA expense / provision for income tax). indicating the company is (selling more merchandise / collecting amounts due from customers / increasingly earning more revenues and gains than incurring expenses and losses). What does this indicate? d. ROS x Asset T/O = ROA Net income ROA = Total assets Gross Profit Margin (GP%). It is computed by dividing Revenue by Assets. RATIOS Profitability Ratios measure the ability to generate profits. See Appendix B—Ratios for additional profitability ratios. Gross profit GP% = Sales revenue Income Statement Page 85 Chapter 3 . Net income ROS = Sales revenue Asset Turnover (A T/O) measures how efficiently a company uses its assets to produce revenue. A high ROA ratio depends on managing asset investments to produce the greatest amount of revenue and controlling expenses to keep net income high. (b) The same information from a prior period (trend analysis). and Common-Size Statement Analysis (vertical analysis). ROA is the most comprehensive measure of profitability because it takes into account both the profitability of each dollar of revenue (ROS) and sales volume (Asset T/O). The three types of analysis are Ratio Analysis. Sales revenue Asset Turnover = Total assets Return on Assets (ROA) measures how productively a company uses its assets to generate profits. This ratio is also referred to as Net Profit Margin. (c) Competitor information.ACTIVITY 28 Purpose: ANALYSIS: RATIOS • • • • • Understand the information provided by profitability ratios. It measures how successfully a company buys and sells merchandise at a profit. also known as Gross Margin. Understand that comparing a ratio to industry norms enhances meaning. Trend Analysis (horizontal analysis). It is a measure of asset management efficiency and of profitability. It expresses net income as a percentage of revenue. Understand that reviewing a number of ratios helps to provide an overall impression of profitability. and industry norms. Analysis reveals relationships by comparing amounts to: (a) Other amounts for the same period (ratios and common-size statements). the overall performance of a firm. compares gross profit to revenue. A higher ratio indicates greater profitability. Understand that an increasing trend is preferred for profitability ratios. expressing gross profit as a percentage of net revenue. Return on Sales (ROS) measures the profitability from each dollar of revenue. Understand that the expected range of ratios varies by industry. Income Statement Page 86 Chapter 3 . Penney Corp (JCP) $ 17.759 (A) $ 389 _________ % $ $ Intel (INTC) (X) 32. 1. profits were __________ cents of each revenue dollar.87 25. whereas net income for INTC is approximately (2 times / 10 times / 30 times) greater than net income for JCP. c. because ROA (is / is not) comparable among industries.C.2% 37. Use the chart below to answer the following questions. Calculate ROS and record in the space provided above. But does the higher ROS mean that one company is better than the other company? (Yes / No).67% 1. For AAPL. ROS of (JCP / INTC) is clearly much higher.3% Apple Computer (AAPL) 29. b.03 7. 3. while __________ cents of each revenue dollar were used to pay for the costs of running the business. Revenue for INTC is more than (2 times / 10 times) greater than revenue for JCP. to increase net income. One measure of sales volume is the (ROS / Asset Turnover / ROA) ratio. Is a company with a greater ROA ratio using assets more efficiently to generate profits than a company with a lower ROA ratio? (Yes / No / Can’t tell).3% a.464 _________ % a. Examine the relationship between Sales Revenue and Net Income.84% Hewlett Packard (HPQ) 7.54% 0. Penney and Intel to answer the following questions.1% 1. Stock symbols are shown in parentheses.75% 39.Q1 Use the information below for J. Let’s examine three companies within the Personal Computer Systems industry. This relationship is measured by the (ROS / Asset Turnover / ROA) ratio.30% DELL (DELL) 5.61% 1. keep expenses under control. b.159 11. revealing that (JCP / INTC) has a greater ability to translate revenue into profits. Calculate the values for (A) and (X).84% 22.00 24. 4. FYE 2010 ($ in millions) Sales revenue Expense Net income ROS Q2 J.60 9. 2.07% 18.C. Companies invest in assets to generate additional revenue. (JCP / INTC) corporation is generating the most net income from each dollar of revenue. because these companies are from different industries. and ROS averages (are the same / differ) among industries. AAPL earned _____ cent(s) in profit from each dollar invested in assets. Personal Computer Systems Industry FYE 2011 Return on Sales (ROS) Asset Turnover (Asset TO) Return on Assets (ROA) Gross Profit Margin (GP%) Industry Average 12. iPads. Which company has the lowest product costs compared to sales revenue? (AAPL / DELL / HPQ) Which ratio reveals this information? (ROS / Asset TO / ROA / GP%) 5. and profits. iTunes. which company is the most profitable? (AAPL / DELL / HPQ) Which ratio reveals this information? (ROS / Asset TO / ROA / GP%) 4.d. cross out each ratio that is weaker than the Personal Computer Systems industry average. ROS x Asset T/O = (ROA / GP% / debt ratio). On the previous page. Which company has the greatest markup on products sold? (AAPL / DELL / HPQ) Which ratio reveals this information? (ROS / Asset TO / ROA / GP%) 2. It was shown in Activity 8 that Wal-Mart makes profits by generating a large volume of sales on items with low profitability. Review the ratios that were circled as the strongest and those ratios that were crossed out for being lower than the industry average to answer the following questions. The information for both the numerator and denominator of the GP% ratio come from the (balance sheet / income statement / statement of cash flows). 1. Which company has the strongest profitability? (AAPL / DELL / HPQ) Why? 6. which is considered the (least / most) comprehensive measure of profitability. According to the most comprehensive measure of profitability. ROS for Wal-Mart is relatively (low / high). During 2010. Which company appears to sell at a low markup to generate a greater volume of sales? (AAPL / DELL / HPQ) Which two ratios reveal this information? (ROS / Asset TO / ROA / GP%) 3. h. it cost AAPL _______ cents of each revenue dollar to produce Mac computers. whereas Asset Turnover is relatively (low / high / can’t tell). iPhones. e. Which company has the weakest profitability? (AAPL / DELL / HPQ) Why? Income Statement Page 87 Chapter 3 . f. iPods. The Gross Profit Margin (GP%) is the (first / second / last) indication of profitability shown on the income statement. circle the strongest among the three companies in the Personal Computer Systems industry. For profitability ratios a (high / low) ratio indicates greater profitability and an increasing trend is considered (favorable / unfavorable). and other related products and services leaving __________ cents of each revenue dollar to cover all remaining operating expenses. g. Meaning is added to a ratio by comparing that ratio to industry norms because success may vary by industry. for each ratio. On the previous page. nonoperating expenses. Income Statement Page 88 Chapter 3 . What does this trend indicate? Q7 Compute the Return on Sales (Net income / Sales revenue) for fiscal years ended: 9-25-2010 ________%. which is (favorable / unfavorable). Q2 Sales growth was 172% (272–100) from FYE 9-29-2007 to FYE 9-25-2010 with the greatest increase during FYE ( 9-25-10 / 9-26-09 / 9-27-08 / 9-29-07 ). 9/29/2007 14. Why? Income Statement Page 89 Chapter 3 . the most important cost to keep under control is (COGS / operating expenses / provision for income tax). Why? List as many items as you can to support your response. The FYE 9-25-2010 trend index for Net Income of 401 is (greater / less) than 100. 5 to 15% is moderate. Overall. the best year was FYE (9-25-10 / 9-26-09 / 9-27-08 / 9-29-07). indicating (revenues / expenses) increased at a greater rate from FYE 9-29-2007 to FYE 9-25-2010. which is a(n) (favorable / unfavorable) trend. which of the following expenses increased at a greater rate than sales revenue? (COGS / Operating expenses / Provision for income tax). 9-26-2009 ________%. If an expense account increases at a rate greater than sales revenue. and more than 15% is high. 9-27-2008 ________%.Refer to the series of income statements and the trend analysis on the previous page to answer the following questions. expenses would be expected to (increase / stay the same / decrease). Q10 It is easier to analyze Apple (before / after) preparing the trend analysis. which is a(n) (favorable / unfavorable) trend.56% During this time period ROS (increased / decreased). It is favorable when sales revenue increases by 172% and expenses increase at a (higher / lower) rate than 172%. For Apple. The three-year average revenue growth rate is (low / moderate / high). Q4 The FYE 9-25-2010 trend index for Sales Revenue of 272 is (greater / less) than 100. 9-27-2008 ________%. Q6 Compute gross profit margin (Gross profit / Sales revenue) for fiscal years ended: 9-25-2010 ________%. Q5 The annual revenue growth rate can be compared between companies. What does this trend indicate? Q8 Operationally. 9-26-2009 ________%. (Sales revenue / Net Income) increased at a greater rate. Q3 From FYE 9-29-2007 to FYE 9-25-2010. Assume less than 5% is low.97% During this time period the gross profit margin (increased / decreased). it appears that Apple costs (were kept under control / got out of control). indicating the amount for that year is (about the same as / double / quadrupled) the (base year / previous year) amount. the worst year was FYE (9-25-10 / 9-26-09 / 9-27-08 / 9-29-07). Q9 Operationally. indicating the amount for that year is (about the same as / almost double / almost triple) the (base year / previous year) amount. Why? List as many items as you can to support your response. 9-29-2007 33. this indicates costs (were kept under control / got out of control). When sales revenue increases. 974 _____% 2.213 _____% $ 8.033 _____% 96.761 _____% _____% Refer to the information above to answer the following questions.790 ______% 1. which is considered (favorable / unfavorable).5% (155) --% 3.479 _____% (505) _____% 10. which is considered (favorable / unfavorable).494 100.761 _____% 0 8. COGS (LNVGY/ DELL / HPQ).5% 11. Operating income as a percentage of sales? (LNVGY / DELL / HPQ) c. Q1 For Lenovo and Hewlett Packard companies listed below.ACTIVITY 30 Purpose: ANALYSIS: COMMON-SIZE STATEMENTS • Prepare common-size statements and understand the information provided.089 _____% 29. (LNVGF / DELL / HPQ) remained the #1 direct-sale computer vendor. ROS? (LNVGY / DELL / HPQ) d. A (higher / lower) profitability ratio is preferred.0% 0 --% 3. Q4 The company that reported the greatest percentage of expense for: a.585 _____% 2.921 _____% 11.0% 50.2% $ 2. Why? During 2010. Why? c.605 ______% 14.635 4. Gross profit margin? (LNVGY / DELL / HPQ) b. Record the resulting common-size percentage in the shaded area provided.5% 7.3% 0 2.3% Hewlett Packard (HPQ) 10/31/2010 Amount CS% $ 126. Why? Q5 b. Q2 The greatest amount of sales revenue was reported by (LNVGY/ DELL / HPQ) and the greatest net income was reported by (LNVGF / DELL / HPQ). which would be (expected / unexpected). Adm expenses Research and development Other expenses Operating income Nonoperating rev (exp) Income before income tax Provision for income tax Income from continuing operations Nonrecurring items Net income Lenovo (LNVGY) 3/31/2010 Amount CS% $ 16.944 _____% 12.234 11. Q3 The company that reported the highest ratio for: a.815 ______% 1. Fiscal year ended ($ in millions) Sales revenue Cost of goods sold (COGS) Gross profit Selling.098 81. (Hint: Refer to company descriptions in Appendix A—Featured Corporations) Income Statement Page 90 Chapter 3 .406 ______% 214 ______% 34 ______% 136 ______% + 41 ______% 177 ______% 47 ______% $ 130 ______% 0 130 ______% ______% DELL (DELL) 1/30/2011 Amount CS% $ 61.959 _____% 2. which is considered (favorable / unfavorable). The analysis measures each item as a percentage of revenue.396 18.350 5. Gen .505 5.0% 4. R&D (LNVGY/ DELL / HPQ). SGA (LNVGY/ DELL / HPQ). complete the common-size statements by dividing each item on the income statement by sales revenue.5% 715 1. The common-size income statement compares all amounts to revenues.9% 657 1.635 0. which is a _________% change in sales revenue.892 17.543 3. Q1 Since 10/31/2007.473 8.585 11.719 Interest income (expense) and other (505) (721) 0 +458 Total nonoperating revenue (expense) (505) (721) 0 +458 Income before income tax 10. Cost of goods sold __________ trend index c.761 7.613 13.524 90.680 Operating income 11.069 78.264 Nonrecurring items / Minority interest 0 0 0 0 Net income $ 8. and more than 15% is high The three-year average revenue growth rate is considered (low / moderate / high). Gross profit __________ trend index d.136 10. As a result.959 2.415 10.913 Income from continuing operations 8.286 Cost of goods sold (COGS) 96.033 $ 114.000.028 28.777 1.755 2. would you consider investing in this company? (Yes / No) Why? Income Statement Page 91 Chapter 3 .465 16.944 27. 5 to 15% is moderate.660 8. 10/31/2009 _______% 10/31/2008 _______% 10/31/2007 _______% The trend is (increasing / decreasing / steady). sales revenue growth was $__________ million. Q3 Compute ROS (Net income / Sales revenue) for fiscal years ended on: 10/31/2010 _______%.329 $ 7.ACTIVITY 31 ANALYSIS OF HEWLETT-PACKARD COMPANY Purpose: • Understand and interpret amounts reported on the income statement Hewlett-Packard (HPQ) INCOME STATEMENTS ($ in millions) Fiscal years ended October 31. If you had $10. Sales revenue __________ trend index b.264 Refer to the series of income statements presented above to answer the following questions. From 10/31/2007 to 10/31/2010.887 Gross profit 29.329 7.761 $ 7.364 $ 104.820 642 456 Total operating expenses 18. general.611 Restructuring changes 1.473 9. which is considered (favorable / unfavorable). Q2 Using 10/31/2007 as the base year.177 Provision for income tax 2. Assume less than 5% is low. compute the trend index on 10/31/2010 for: a.144 1. 2010 2009 2008 2007 Sales revenue $ 126.144 640 311 387 Other operating expenses 1.552 $ 118. Q4 Review all of the information presented above.326 12.974 9.399 Selling.089 87. and admin expense (SGA) 12.213 1. COGS increased at a (greater / lesser) rate than sales revenue. which is (favorable / unfavorable / neutral).822 16.226 Research and development expense (R&D) 2.479 10. gross profit margin will also (increase / decrease).819 3. The annual revenue growth rate can be compared between companies.660 $ 8.295 25. Income Statement Page 92 Chapter 3 .ACTIVITY 32 Purpose: ANALYSIS OF LENOVO GROUP • Understand and interpret amounts reported on the income statement. Lenovo is a (manufacturing / retail / service) company so COGS is (expected / not expected) to be the largest expense.352 13. Lenovo Group appears to report a (strengthening / steady / weakening) operating position.726 161 35 29 (6) 155 27 128 +33 161 Refer to the series of income statements presented above to answer the following questions. Q3 Compute common-size percentages during 2010 and 2008 for the amounts below.901 13.091 1.902 2.571 219 63 21 (42) 177 47 130 0 130 $ $ 14.566 220 203 1. Sales revenue Cost of sales (COGS) Gross profit Selling.978 12.790 1.815 1.989 (192) 38 42 4 (188) 38 (226) 0 (226) ($ in millions) 2008 $ $ 16.797 1.887 1. general. What are some likely reasons for this increase? Q2 The greatest expense is (COGS / SGA / R&D) followed by (COGS / SGA / R&D).700 230 21 1. Why? Support your response with at least two observations.450 1. 2010 Sales revenue COGS Gross profit Operating expenses Operating income Q4 2008 % % % % % % % % % % Review all of the information presented above.951 499 38 52 14 513 48 465 +19 484 2007 $ $ 13.605 14. and distribution exp (SGA) Research and development expense (R&D) Other operating expenses Total operating expenses Operating income Interest Expense Other nonoperating income Total nonoperating revenue (expense) Income before income tax Provision for income tax Income from continuing operations Nonrecurring items Net income INCOME STATEMENTS 2010 2009 $ $ 16.521 196 9 1.406 214 (49) 1.104 1. Q1 Prepare a trend analysis of Sales Revenue for all four years: Fiscal year ended March 31 Sales revenue 2010 2009 2008 2007 The greatest increase took place in (2010 / 2009 / 2008). LENOVO GROUP (LNVGY) For fiscal year ended March 31. 205. A true consumer-centric.7% 0. Dell is the company’s largest customer.0% 228. significant R&D expense CORP (A / B / C) c.5% 132 -0.0% $/€ % CORP B 12/31/2011 Amount CS% 53. significant interest expense CORP (A / B / C) d. Belgium.5% % 7. and other content through its multi-channel distribution platform.046 100.0% 1.4% $/€ % Q1 Compute gross profit.0% 469 -1.629. Belgium. net income. and Beck’s®.0% 0 0% $/€ % CORP C 12/31/2011 Amount CS% 39.998.999 100.0% 57. magazines. sales-driven company.3% 0.670 -14.0% 5. Why? BARNES & NOBLE (BKS) operates in the highly competitive retail industry of selling books. Anheuser-Busch InBev manages a portfolio of nearly 300 brands that includes global flagship brands Budweiser®.0 0. the lowest ROS CORP (A / B / C) Q3 Use the descriptions below to identify each corporation using their financial information.7 -3.856 -4.ACTIVITY 33 Purpose: TEST YOUR UNDERSTANDING • Understand and interpret amounts reported on the income statement.0% 0 0. newspapers.0% 0. Why? Income Statement Page 93 Chapter 3 .619 -4.0% 20.2% 1. brewery.499 -26.5% 260 -0.8% 2. AnheuserBusch InBev’s dedication to heritage and quality is rooted in brewing traditions that originate from the Den Hoorn brewery in Leuven. ANHEUSER-BUSCH INBEV (BUD) is a publicly-traded company based in Leuven.2% (135) +0.242 -37.4% (112) +0. Louis.5 -0. and the return on sales ratio for each corporation.2% 0 0. gross profit margin.0 0.9% 0 0.0% (48. (in millions of $ or €) Sales revenue Cost of goods sold (COGS) Gross profit SGA expense R&D Depreciation/amortization Other operating expenses Interest expense (income) Investment expense (income) Other expenses (revenues) Provision for income tax Minority interest Net income CORP A 04/30/2011 Amount CS% 6. Q2 Analyze the financial attributes of the three corporations by circling the corporation with… a.6% % 10.2% (192) +0. Intel also makes flash memories and is #1 globally in this market. Stella Artois®. Anheuser-Busch InBev has significant debt financing.0% 16.4% % 1. dating back to 1366 and the pioneering spirit of the Anheuser & Co.8% 0. Intel must be Corporation (A / B / C).104 -5.839 -9. currently possessing 80% of the market share. Anheuser-Busch InBev must be Corporation (A / B / C) Why? INTEL CORPORATION (INTC) is the largest producer of semiconductors in the world.0 0.634 -42.3% 0.0% 0 0. the lowest GP% CORP (A / B / C) b.2% 4. USA. Intel’s most notable products include its Pentium and Celeron microprocessors.2% 8. Barnes & Noble must be Corporation (A / B / C).4 -23.7 -74.0 0.5) +0.4 -0. Record the amounts in the appropriate space above. It is the leading global brewer and one of the world’s top five consumer products companies.350 -15.6 100. established in 1860 in St. 7. Understand accumulated other comprehensive income. (FCX). reducing their value. Inc. Understand how the statement of stockholders’ equity is organized. thereby reducing their own shares in any profits to 1/3 each.000 of the total ownership of the corporation.CHAPTER 4 STATEMENT OF STOCKHOLDERS’ EQUITY LEARNING OBJECTIVES 1. 2.500 each. Compute ratios and use ratio analysis to evaluate solvency. Before Tex came along. Then they hired prospector Tex. Others offer employees stock at a discount. to no avail. How a company divvies up ownership shares is important. Understand treasury stock.000) of the corporation. Identify and explain common and preferred stock. with Tex. they became equal partners. Having no money. 6. Investors ignore this information at their peril. if a corporation issues 1. they offered Tex a 1/3 share in the mine in exchange for his hard work. finding nothing. It helps investors understand the structure of a company’s ownership. They invested $100 each. meaning that their shares are bought and sold on stock exchanges such Statement of Stockholders’ Equity Page 94 Chapter 4 . Understand typical items that affect retained earnings. An investor purchasing 100 shares of this stock would own 10% (100/1. With Tex now a full partner. Harry and Sam reduced their shares in any profits. gold prospectors Harry and Sam put their life savings into a plot of Nevada land. 4. an operator of copper and gold mines. profitability. some more valuable than others.000 shares of stock. The Statement of Stockholders’ Equity provides information about changes in a company’s stockholders’ equity. Agreeing to share any profits half-and-half. INTRODUCTION More than a hundred years ago. Corporations divide their ownership into shares of stock. Some companies offer more than one type of ownership shares. They may not realize that their own shares are not entitled to dividends until after dividends on “higher priority” shares are paid. For example. $15. then each share of stock represents 1/1. and investment performance. They dug a mine. we evaluate the stockholders’ equity of Freeport-McMoRan Copper & Gold. In this chapter. including contributed capital and retained earnings.000. 5. Understand par value and additional paid-in capital. a self-professed expert in finding gold ore. 3. thereby diluting existing stockholders’ shares. We will review the different components of FCX’s Statement of Stockholders’ Equity and analyze how it distributes its dividends.000 in gold could be split 50–50. Many corporations are publicly traded. They suspected that the land contained gold. Now. and they may not realize how stock options and other transactions reduce the value of their ownership in the company. $7. each partner would have to be content with $5. thereby defaulting on their debts.000 of par value ($20. Companies with high debt ratios have high liabilities and low stockholders’ equity in relation to total assets. Preferred stock usually carries a dividend rate. These companies finance most of their operations with stockholders’ equity.400.000 in dividends.000 for preferred and the remaining $600. If the preferred stock carried a dividend rate of 7% on $20.00.000.000 x 7% = $1.00 per share. Suppose that a company with both preferred and common stock declared $1. which equals the number of shares issued less the number of shares of treasury stock that were bought back by the company. is recorded in a separate account on the balance sheet. The amount received in excess of par.000.000 for common shareholders. it’s important to understand the concept of Par Value.00 par stock for $5. Preferred stock is “preferred” over common in two ways. Because liabilities and the related interest must be paid back. Statement of Stockholders’ Equity Page 95 Chapter 4 .000 million in annual dividends). titled Additional Paid-in Capital or Capital in Excess of Par. If the company declared $2. companies with a low debt ratio have strong solvency. This will be the maximum number of shares that a corporation is permitted to print. then everyone—preferred and common—would receive payments—$1. selling them to investors in exchange for assets. usually cash. This is a legal value assigned to each share of stock. in the event of bankruptcy liquidation. Some companies issue more than one type of stock. It would record the stock on its balance sheet for $1.000. their prices change with supply and demand. As we previously stated.00. The Board of Directors also has the right to declare no dividends. such as Delaware. which must be paid to preferred stockholders before any dividends can be paid to common stockholders. then preferred stockholders would receive the entire dividend and common stockholders would receive nothing. whereas others issue more stock (equity). the corporation will issue shares. $4.as the New York Stock Exchange. Second. Corporations can also buy back shares of stock from investors. and can more easily pay their debts. For example. preferred stock dividends take precedence over Common Stock dividends. This issuance can occur as part of an Initial Public Offering (IPO). Such stock is called Treasury Stock. Default can result in giving up valuable assets to creditors or even bankruptcy. companies with poor solvency might not be able to pay their liabilities. some offer two types of stock—preferred stock and common stock. Then. in which case no stockholders— preferred or common—would receive anything. Corporations must file a charter with a state. when a company sells stock to the public for the first time as a publicly traded corporation. As shares of stock are traded. The number of Shares Outstanding is the total number of shares actually held by investors at a given time. Shares outstanding = Shares issued – Treasury shares When analyzing stockholders’ equity. when the Board of Directors declares a dividend. Recall that the debt ratio (total liabilities / total assets) measures solvency. suppose that a company issues $1. companies must choose a mix of liabilities and equity to finance their assets. Par value is usually less than the actual amount of money that the company received when it originally issued the stock. This filing will determine the total number of stock shares authorized. Investors can easily buy and sell shares by calling a stockbroker or through a broker’s website. First.400. On the other hand. preferred stockholders receive a return of their investments before the common stockholders receive anything.000. To pay for assets some companies borrow more (liabilities).000 in dividends. Headquarters are located in Phoenix. Its portfolio of assets include the Grasberg minerals district in Indonesia (that contains the largest single recoverable copper reserve and the largest single gold reserve of any mine in the world). gold.441) 15. at cost Total stockholders’ equity $ 2009 0 $ 2875 107 98 18. 29 shares issued and outstanding at December 31. 2010. How do these different classes of stock affect investors? Like our gold prospectors Harry and Sam. According to the Consolidated Balance Sheet.590) (323) (3. who admit Tex as a new partner. We can get a quick introduction to FCX’s stockholders’ equity by looking at the stockholders’ equity section of its Consolidated Balance Sheet: Freeport McMoRan Copper & Gold. respectively Capital in excess of par value Retained earnings (Accumulated Deficit) Accumulated other comprehensive income (loss) Common stock held in treasury—122 shares. as explained in the Notes to the Financial Statements: On March 28. possibly diluting existing common stockholders’ own portion of the profits.413) $12. It also operates Atlantic Copper.805 million in 2009 up to negative $2. a wholly owned copper smelting and refining unit in Spain. Stockholders’ equity: 2010 6 ¾% Mandatory Convertible Preferred Stock. and molybdenum in the world. Later on we’ll explore the reasons for this. This appears to be caused by a huge decrease in the accumulated deficit. The 6¾% Mandatory Convertible Preferred Stock will automatically convert on May 1. into between approximately 39 million and 47 million shares of FCX common stock at a conversion rate that will be determined based on FCX’s common stock price or other certain events. from negative $5. FCX will issue new common stock shares to the preferred stockholders.504 million in 2010.637 (5.10. with a liquidation preference of $100 per share.751 (2. Arizona.75 million shares of 6¾% Mandatory Convertible Preferred Stock.805) (273) (3.119 The Balance Sheet indicates that Stockholders’ Equity increased from $9.STOCKHOLDERS’ EQUITY ON THE BALANCE SHEET Here’s a description of FCX: FCX is an international mining company with one of the largest reserves of copper. Consolidated Balance Sheets (Excerpts) (In millions) December 31. FCX sold 28. for net proceeds of $2.119 million in 2009 to $12. the Tenke Fungurume minerals district in the Democratic Republic of Congo (DRC). and significant mining operations in North and South America. 2007. Statement of Stockholders’ Equity Page 96 Chapter 4 . 1067 shares and 981 shares issued. 2009 Common stock.8 billion.504 $9. Inc. par value $0. FCX has offered two classes of stock: • Mandatorily convertible preferred stock • Common stock The 6¾% Mandatory Convertible Preferred Stock automatically converted into common stock.590 in 2010. refer to FCX’s Statement of Stockholders’ Equity on the next page.067 shares and 981 shares issued.637 FCX has 1. The total par value is $107 million. computed as 1.751 million). This helps us understand changes in stockholders’ equity from one year’s balance sheet to the next. including contributed capital and retained earnings.067. common stock investors paid $17. For the following discussion. STATEMENT OF STOCKHOLDERS’ EQUITY The Statement of Stockholders’ Equity provides information about changes in a company’s stockholders’ equity. with a par value of $0.10.858 million ($107 million + $18.000. respectively Capital in excess of par value $ 107 18. 1.000 shares x $0. above and beyond par value. The total amount of capital common stockholders paid into the company equals $18. It is interesting to note that IFRS classifies preferred stock as debt. On average. Statement of Stockholders’ Equity Page 97 Chapter 4 .67 ($18. presenting the number of shares issued: ($ in millions) December 31.10.10 each. not as equity. rounded.Note how the Balance Sheet discloses Common Stock. Analyzing the Statement of Stockholders’ Equity reveals many important issues.000 shares of common stock issued.067. par value $0. on the balance sheet and reports dividends on preferred stock as interest expense on the income statement.067 million) per share when purchasing stock from the company. The capital in excess of par value represents amounts investors paid FCX for stock issued. 2010 Common stock.858 million / 1.000.751 2009 $ 98 15. It emphasizes stockholders’ equity transactions that affect different classes of stockholders. Statement of Stockholders’ Equity Page 98 Chapter 4 . is to issue the stock to executives as stock-based compensation. is the estimated cost benefit of the discount to the employees exercising their stock options. Statement of Stockholders’ Equity Page 99 Chapter 4 . In its Consolidated Statement of Stockholders’ Equity.” was for the purchase of treasury stock in order to resell the stock to executives for stock-based compensation. as we previously discussed. and later selling it back to shareholders at a higher price. reduces stockholders’ equity on the balance sheet. but rather as an increase in Additional Paid-in Capital. Buying stock at a low price. creates cash flow for the company. is the amount of money received from executives to exercise their stock options and purchase stock at a discounted price from FCX. Therefore. Executives will personally benefit from stock price increases if they work to maximize the value of stock. TREASURY STOCK Treasury Stock is stock bought back from investors. Managers often buy treasury stock when they believe that the company’s stock price will increase. The accounting treatment of treasury stock is important to understand. $110 million. the $28 million “Tender of shares for stock-based awards. Furthermore. Another reason is to increase earnings per share (EPS). and then resells it at a higher price. Likewise. begs a question: Where does the stock sold to executives come from? Does the company issue new shares? Not usually. if a company buys treasury stock at a low price. which permit them to buy shares of stock at a discount.EXERCISED AND ISSUED STOCK-BASED AWARDS. This stock is called Treasury Stock. By reducing the number of shares outstanding. just discussed. or in stock options. $129 million. the profits per shareholder. EPS. The third. This. is the tax savings from providing this type of compensation. Many executives receive a portion of their compensation in stock. the difference between the selling price and cost is not recorded as a gain. a lower selling price would not be recorded as a loss. In this Statement of Stockholders’ Equity. However. $8 million. stock bought back from investors. It is generally believed that this type of compensation encourages executives to think like shareholders. (As I heard one investment manager put it. companies make many disclosures about stock-based awards in the Notes to the Financial Statements. The first. of course. It is not recorded as an asset because it is impossible for a company to own itself. but rather as a decrease to Additional Paid-in Capital. One reason for this. detailed disclosures after the financial statements in the annual report. stock-based awards can dilute other stockholders’ proportion of net income. Instead. STOCK-BASED COMPENSATION COSTS. buying back treasury stock has the effect of increasing shareholder wealth. Treasury stock. companies usually buy the shares back from other stockholders. The second. FCX presents three separate figures. this is compensation to the employee. “Why would you give the company away for free to the help?”) Because of the danger of dilution. and to act in their best interest. will increase. AND TAX BENEFIT FOR STOCK-BASED AWARDS FCX distributed $110 million in stock-based awards to employees. It’s negative stockholders’ equity. What happened? Copper prices dropped from an average price of $3. increasing retained earnings. Statement of Stockholders’ Equity Page 100 Chapter 4 . However. on the income statement. dropped in price from $33 per pound for the first nine months of 2008 to just $9. the company paid $1. these price decreases caused a $17 billion dollar loss. As shown in the Statement of Stockholders’ Equity. but instead go straight to stockholders’ equity.336 million in Net Income in 2010.32 per pound on December 31. Other Comprehensive Income (Loss) consists primarily of three gain/loss items that are not recorded on the income statement. This murky category of items combines to form other comprehensive income. 2.058 million in dividends on common stock. 2008.RETAINED EARNINGS Recall that Retained Earnings is net income earned by the company since its incorporation and not yet distributed as dividends. This dramatically reduced the value of FCX’s copper and molybdenum mines and reserves. some felt that these items would mislead investors. the company recorded something called a “goodwill impairment” for $5. Unrealized gains/losses on certain securities. Accordingly. Foreign currency translation adjustments. increasing the Accumulated Other Comprehensive Loss to $323 million on December 31. In effect.1 instead they are recorded as part of Accumulated Other Comprehensive Income (Loss) in Stockholders’ Equity. There was significant debate over whether these items should be included in net income. just to see what would happen. During 2010. there are “back door” exceptions that are not included in net income. and 3. Certain gains/losses on pension plans. Another ore.965 million. If included in net income. in 2008.978 million. 2010. part of stockholders’ equity. molybdenum. wiping out most of the company’s stockholders’ equity. OTHER COMPREHENSIVE INCOME Almost all income and loss items are recorded in net income. FCX paid dividends to common and preferred stockholders. We’ll call these “front door” items. FCX recorded $50 million in Other Comprehensive Losses during the year. FCX earned $4. both reducing retained earnings. 1 The specifics of these items are outside the scope of this book. and then flow into retained earnings. because they are openly announced to shareholders as part of net income. reducing Retained Earnings.50 per pound on December 31. the three items are: 1. Together. which reduced retained earnings.067 million.987 million and “long-lived asset impairments and other charges” totaling $10.61 per pound during the first nine months of 2008 to just $1. net income increases retained earnings and dividends decrease retained earnings. That year. However. the company experienced a loss of $11. even though they are not directly related to a company’s operations. However. A net loss would be treated as negative net income. 2008. However. these items reduced operating income by a whopping $16. it dramatically reduced the value of goodwill that FCX paid when it bought another company two years earlier. and $63 million in dividends on preferred stock. Furthermore. there’s nothing to stop investors from adding or subtracting these items from income. before they hit stockholders’ equity. It was thought that many of these items are caused by risky investments that fluctuate widely in value. research shows that when companies announce planned stock splits. On February 1. considering profitability from the entire company’s perspective. stock prices usually increase. Like stock splits. Are they better off? Previously. perspective. Numerator Denominator What do they have in common? What’s different? Return on Sales Return on Assets Net Income Sales Revenue Net Income Assets Return on Equity Net Income Stockholders’ Equity They all have net income in the numerator and measure profitability. For example. a 10% stock dividend would award the holder of 100 shares of stock 10 new shares of stock. For example.2 To compute this ratio. Interestingly. Now each owns ten shares in the gold mine. How well did the How much profit How much profit company control was earned with was earned with costs? the company’s stockholders’ assets. ROS is computed solely from the income statement. each prospector held 1/3 of the company.Preferred Dividends Return on Common Equity = Common Stockholders’ equity Statement of Stockholders’ Equity Page 101 Chapter 4 . Consider Harry. using both investments? creditors’ and stockholders’ investments? 2 Financial Analysts also use the ratio Return on Common Equity to analyze stock performance. the same proportional share. Each owns a single share in the gold mine. whereas ROE looks at profitability only from the stockholders’ perspective. divide net income by stockholders’ equity: Return on Equity = Net Income Stockholders’ Equity Compare the three “Return” ratios: Return on Sales (ROS). It is computed by excluding preferred stock dividends and preferred stock from the ratio: Net Income . Let’s be generous and give them a ten-for-one stock split. reporting how well the company controlled costs to deliver net income from Sales Revenue. a two-for-one stock split would multiply each share of stock into two new shares of stock in the same company. perspective. and Return on Equity (ROE). after a stock split. Stock Dividends are smaller proportional increases in the number of shares outstanding. RETURN ON EQUITY Return on Equity (ROE) measures how effectively stockholders’ equity is used to produce net income.STOCK SPLITS AND STOCK DIVIDENDS Stock Splits are proportional increases in the number of shares outstanding. Sam. each stockholder received one new share for every share that they held. it could be argued. An investor holding 100 shares would. stock dividends do not increase investors’ proportionate share in the company. do not provide any value to investors. 2011. and Tex. hold 200 shares. Now each prospector holds 10/30 of the company. ROA includes the return on liabilities plus stockholders’ equity (Assets = Liabilities + Stockholders’ Equity). and therefore. Income Statement Entire company Stockholders’ perspective. FCX declared a stock dividend in December 2010. Return on Assets (ROA). Financial Leverage is computed as: Financial Leverage = Total Assets Stockholders’ Equity Financial Leverage is similar to the debt ratio. the higher the Financial Leverage. and then the lion’s share of profits will go to the stockholders.544 $ 3. Consider how a ratio called “Financial Leverage” explains the difference between Return on Assets and Return on Equity. 2010 2009 2008 Return on Assets x Financial Leverage = Return on Equity 18. such as FCX. pushing net income higher.Below we compute FCX’s return ratios for three years: FYE December 31. This can be demonstrated with FCX’s results for three years. and the high financial risk that comes with it. Whether profits are high.3% 13. we explained that a high debt ratio indicates solvency problems and higher financial risk.85 38. This is the risk that a company might not be able to pay back its debts. Accordingly.534 $(10. high debts will push them further into net loss territory.6% -44.773 million because of the tremendous net loss that year.34= 44. 2010 2009 2008 Return on Sales 29.9% 13. only a small portion of the profits go to pay interest. When profits are high.6% 2.040 17.0% Return on Equity can be derived by multiplying Return on Assets by Financial Leverage (with a slight rounding difference): 18. or even a loss.3% Statement of Stockholders’ Equity Page 102 Chapter 4 .34 44.2% 23.353 C Stockholders’ equity 12. or losses. must still pay interest on its debt. a high debt ratio. It measures how debt “boosts” return on assets to increase return on equity. FCX’s Stockholders’ equity dropped from $18. interest payments do not increase.3% 38.7% A/C Return on Equity 44.9% x 2. The company can pay the same fixed interest payments.982 15. can also boost profits. the interest payments do not change.05 -181.996 23.9% 2. Failure to pay interest on debts may result in default and bankruptcy.450) A Sales revenue 18.5% -58. low. FINANCIAL LEVERAGE RATIO In Chapter 2. in 2008. Therefore. FCX’s Return on Equity bounced back to 38. and when net income is low or a net loss.8% -181. To demonstrate: FYE December 31. These interest payments are fixed and don’t vary with profits. in the sense that the more debt a company has.0% A/D Net income (loss) $ 5.504 9.796 B Assets 29. a company with little or no profit.7% 4.8% in 2009 and 44. when net income is high.234 million to $5. However.3% in 2010. Accordingly.119 5.773 D Recall that. we will dismiss 2008 as an aberration. or go into default and possibly bankruptcy.7% A/B Return on Assets 18.8% -44. high debts increase the variability of net income.386 25. a times interest earned ratio of 4 is considered adequate. Simple multiplication can explain this effect.101 An interesting aside is to note the relationship between the amount of interest-bearing long-term debt and interest expense. to 10% in 2010? Statement of Stockholders’ Equity Page 103 Chapter 4 .10 indicates FCX could cover its interest payments with operating income more than 11 times. FCX’s debts had the effect of multiplying Return on Assets by 2.In 2010.826 14.386 4. as Total Assets cancel out in each term of the equation: Return on Equity = Net Income Stockholders' equity = Return on Assets Net Income Total Assets Net Income Total Assets X X X Financial Leverage Total Assets Stockholders' Equity Total Assets Stockholders' Equity TIMES INTEREST EARNED RATIO Another risk to a company with high debt is its ability to make timely interest payments.10 (12.34 to equal Return on Equity. Can you calculate the average long-term interest rate of 10% during 2010? Can you determine that the average cost of borrowing has increased from 8% in 2008.63 6.503 586 11.284 16.7% negative Return on Assets to a whopping 181.05. In 2008.710) 584 (21. Financial Leverage increased FCX’s 44. which is more than adequate coverage.068 462 19.353 7. as the amount of long-term debt increases.239 10. interest expense also increases.757 23.560 25.0% negative Return on Equity. Operating income Interest expense Times interest earned ratio 2010 2009 2008 9. Operating Income Interest Expense Times Interest Earned Ratio = ($ in millions) FYE December 31. Total assets Long-term debt Total liabilities Stockholders’ equity 2010 2009 2008 29. the times interest earned ratio of 11. It compares the amount of income available to make interest payments to interest payment requirements. In 2009. the multiplier factor increased to 4.330 15. that was when the company incurred a giant loss. the negative Operating Income indicates interest obligations may be difficult to meet.252 7.660 14. and in 2010 more than 19 times. ($ in millions) December 31. Unfortunately for FCX. The Times Interest Earned Ratio indicates a company’s ability to earn (cover) its periodic interest payments. to 9% in 2009.76) A B A/B In general. Back in 2008.996 6. where Tex’s new ownership dilutes Harry and Sam’s shares. unless noted otherwise. like many companies.67 $3. so Basic EPS will always exceed Diluted EPS. except per share data) Year Ended December 31. This amount is reported at the bottom of the income statement (see above) or in the Notes to the Financial Statements. 2010 2009 Net (loss) income per share of common stock: Basic $4. CONSOLIDATED STATEMENTS OF OPERATIONS (Excerpts) (In millions. for each share of stock. on average. Companies with nonrecurring items.86) $(14. To compute basic earnings per share.075 $0. An investor holding 100 shares would have earned paper profits of $467. Accountants use the following formula to compute EPS: Earnings per Share = Net Income . To compute diluted EPS. would report earnings per share from these items separately.05 Diluted $4.67 in 2010. reports two earnings per share figures.86) 915 949 829 938 763 763 $1. companies are required to report both basic and diluted EPS. FCX is not reporting any nonrecurring items. For example.Preferred Dividends Average Number of Common Shares Outstanding FCX. as we discussed before. which are contracts that give their holders the right to buy or sell shares of stock at a certain market price. Do not confuse the Average Number of Common Shares Outstanding with the Number of Common Shares Outstanding at Year End.6875 Earnings per share (EPS) is the amount of net income (loss) earned by each individual share of stock held by investors. FCX lost $4. Inc. such as discontinued operations or extraordinary items (as we discussed in Chapter 3). EPS refers to Basic EPS. companies divide net income by the potential average number of common shares outstanding. some companies issue stock options. and Tex. In this text. Average Number of Common Shares Outstanding indicates how many shares of common stock. companies divide net income by the actual average number of common shares outstanding. When dilution could occur. (listed in the Balance Sheet and the Statement of Stockholders’ Equity). investors who want to be on the safe side should use Diluted EPS rather than Basic EPS. This decrease is similar to the case of Harry. basic and diluted.57 $2. When evaluating performance.125 $0.EARNINGS PER SHARE Freeport McMoRan Copper & Gold. Exercise of these stock options increase the number of common shares outstanding and may lower earnings per share. Sam. Statement of Stockholders’ Equity Page 104 Chapter 4 .93 Average common shares outstanding: Basic Diluted Dividends declared per share of common stock 2008 $(14. were held by investors during the accounting period. However. Dividend Rate = Annual common stock dividends paid Average number of common Shares outstanding Companies usually report the dividend rate in the notes to the financial statement or directly on the income statement. A PE ratio below 10 is a “bargain” stock.14 $ 2. FCX’s market value on December 31.6875 13.04 $ 4. based on predicted earnings per share. Contrast this with FCX’s performance on December 31. as a sign that a company has a steady performance record. over a long period of time. December 31. For each dollar of earnings an investor paid $4. 2009). when the stock was trading at $12. Here. for which an investor can purchase a share for less than $10 for each $1 of EPS.04 / $4. Statement of Stockholders’ Equity Page 105 Chapter 4 . 2010. was $60.57 $40. It can be computed by dividing the annual common stock dividend by the average number of common shares outstanding for the year.1 ($60.86) $1. the PE ratio on this date would mean nothing.27 for FCX (according to Google Finance.57).93 $ 12. This is remarkably consistent with actual 2009 performance. 2008. This means that FCX’s stock was considered to be moderately priced—not too expensive.1 13. FCX reported on the income statement that they issued a dividend of $1. Market price per share Earnings per share Dividend rate per share (as reported on the income statement) Price earnings ratio 2010 2009 2008 $60.7 NA A B A/B PRICE EARNINGS RATIO Investors use the Price Earnings (PE) Ratio to measure how “expensive” a company’s stock is compared to EPS.72 loss per share. Here.125 $0.22 $ (14. a PE ratio above 20 would be considered an “expensive” stock because an investor must pay more than $20 for each $1 of EPS. an investor could buy stock in a company for a low price compared to market value. Analysts compute a second PE ratio. resulting in a PE ratio of 13. would still make an effort to continue paying steady dividends. March 7. It is computed as: Price Earnings Ratio = Market Price per Share EPS For most stocks. This is called “Forward PE. Investors often look for a steady stream of dividends. Because the company incurred a net loss.04. analysts estimated a forward PE of 14.57 in market value. not too cheap. the PE ratio ranges between 10 and 20.DIVIDEND RATE The Dividend Rate is the amount of dividends paid annually for each share of stock held by investors.075 $ 0.375 even though they incurred a $29. even when incurring tremendous losses in 2008. Alternatively.22.” In March 2009. This is why FCX. 5 NA NA NA 11.com There are no official rules governing how these ratios are calculated. because it offers great potential for future earnings. it might be too high. and outstanding must be disclosed.76) 12.34 44.msn.63 $60.1% 22.04 $4. Freeport McMoRan Copper & Gold.8% 11.0% 10.0% 2.86) 0. Other Comprehensive Income primarily includes gain/loss items not directly related to the company’s operations and not reported on the income statement.67 $1.688 NA * ** Industry 41.1 2009 23. GAAP reports preferred stock as equity.0% 30. Alternatively. including contributed capital and retained earnings.00 38. preventing investors from earning a reasonable return on their investments.S. Stock splits and stock dividends change the number of shares outstanding.Regrettably. net income increases retained earnings and dividends decrease retained earnings. Inc. Preferred shareholders receive preferential treatment. shares authorized. Retained Earnings is net income earned by the company since incorporation and not yet distributed as dividends.7% -44. but do not change investors’ proportionate share of the company.7% 21. The PE ratio for a company could be high.6% 2. A low PE ratio might occur because the company is unlikely to grow in the future.6 ** S&P 500 10. It helps investors understand the structure of a company’s ownership. amounts paid in addition to the par value. Accordingly.50 25. as they receive dividends before common shareholders. which equal shares issued less shares repurchased as treasury stock.3% 19.075 13. These amounts are classified as either Par Value or Additional Paid-in Capital.0 * ** NA NI – Annual Div Preferred Paid / Avg Div / CS OS Avg CS OS Market Price / EPS Industry: Copper—Industry and S&P 500 ratio averages from moneycentral. There are two types of stock—preferred and common.1% 2.125 13.9% 2. the PE ratio doesn’t explain why a stock is expensive or cheap.7 2008 -58. issued.14 3. this low price could indicate a good opportunity for investors to buy a stock that will rebound and increase in value.05 0.00 14. Therefore. Shares outstanding are those shares in the hands of shareholders. whereas IFRS reports it as debt and the associated dividends as interest expense on the income statement. the ratio formulas used may differ from the formulas in the text. Contributed Capital reports amounts paid (contributed) for shares of stock by investors.00 NA NA $2.0% (21.22 (14.2% 18.04 -181.5% 13. SUMMARY The Statement of Stockholders’ Equity provides information about changes in a company’s stockholders’ equity.10 40. Statement of Stockholders’ Equity Page 106 Chapter 4 . Alternatively.85 38.7% 4. U. (FCX) RATIO ROS ROA x Financial Leverage = ROE Type Profit Profit Solvency Profit Times Interest Earned Solvency Market Price EPS (Basic) Dividend Rate PE Ratio Invest Profit Invest Invest Formula NI / Sales Revenue NI / Total Assets Total Assets/ SE NI / SE Operating Income / Interest Expense 2010 29. For each type of stock. 2012 $546.597 Retained Earnings (4.549 151.510) (17. 2012and January 29.797 (4.705 151. and investment potential.There are several ratios introduced in this chapter that help investors further evaluate solvency. 366 - Common Contributed Stock Capital (Par) (APIC) $2. $0.851 (1) $0.929 $(938. 2012 (In thousands) Shares Outstanding (1) Balance at January 29.023) Accumulated Other Comprehensive Income $28. First. 2012 and January 29.909) Other (3) Balance at January 28.351.549 6. The Times Interest Earned ratio (operating income divided by interest expense) indicates a company’s ability to earn (cover) its periodic interest payments.532 (1. 2011: 600.665 $28.366 outstanding.848 $2. Regrettably.349) 992 6.332) 193.261) 587 (87.416. 249. respectively. Return on equity (net income divided by stockholders’ equity) measures how effectively stockholders’ equity is used to produce net income. 2011 Stock awards Repurchase of common stock Reissuance of treasury stock Net income Other comprehensive income.496 - Treasury Stock (2) $1. 249. (3) Reclassified amounts for easier understanding in this text.072 10.464 $(938.566 issued and 194.349) (17.01 par value common stock at January 28. it does not explain why a stock is expensive or cheap. 2011.071 10.711. Inc. Statement of Stockholders’ Equity Page 107 Chapter 4 .000 authorized. Earnings per share (net income less preferred dividends divided by the average number of common shares outstanding) is the amount of net income (loss) earned by each share of common stock. American Eagle Outfitters.566 issued and 193. 2011: 5.258 $1. (2) Treasury stock: 55.200 shares [in treasury] at January 28.565) 1.909) 10.718 shares and 55.000 authorized. profitability. with none issued or outstanding.496 $552.01 par value common stock at January 29.659 $1.000 authorized. $0. Investors use the price earnings ratio (market price per share divided by EPS) to measure how “expensive” a company’s stock is compared to EPS. (AEO) STATEMENT OF STOCKHOLDERS’ EQUITY For the year ended January 28.705 587 (87. 2012: 600.771. whereas the dividend rate is the amount of dividends paid annually for each share of stock.01 par value preferred stock at January 28.848 outstanding. 922 shares were reissued from treasury stock for the issuance of share-based payments. net of tax Cash dividends 194. During Fiscal 2011.532 Total Stockholders’ Equity $1. the financial leverage ratio (total assets divided by stockholders’ equity) measures how debt “boosts” return on assets to increase return on equity. Amounts received in excess of par (4 words) 8. Shares receiving dividends before common shares.ACTIVITY 34 CROSSWORD PUZZLE FOR CHAPTER 4 Across 4. usually less than the market price of the stock (2 words) 19. Total amount paid-in for shares of stock by investors (2 words) 14. Statement reporting changes in shares outstanding. If three-for-one. Amount of net income earned by each share of stock (3 words) 9. Maximum number of shares permitted to be issued 17. and the distribution of earnings (2 words) 15. Legal value assigned to each share of stock. Shares held by investors. Issued shares less treasury shares Page 108 Chapter 4 . Type of stock that all corporations must issue Introduction Down 1. Ratio measuring profitability from the shareholders’ perspective (3 words) 16. Per share amount of dividends paid annually (2 words) 5. Net income not yet distributed as dividends (2 words) 12. First time sale of stock to the public (3 words) 13. Shares sold to investors 2. Ratio measuring the ability to pay periodic interest payments (3 words) 18. usually carrying a dividend rate 3. Ratio measuring how expensive a company’s stock price is compared to EPS (2 words) 6. Shares bought back from investors 7. Solvency ratio that measures how debt boosts ROA to increase ROE (2 words) 10. an investor holding 100 shares before holds 300 shares after (2 words) 11. earnings. which must be recorded separately in the financial statements. and (600. It helps investors understand the structure of a company’s ownership.597 / $549. Inc.023) thousand. and outstanding. a company is authorized (by the state of incorporation) to issue a designated number of shares to investors. and (0 / 5. there are __________ thousand shares of treasury stock with a total cost of ($2.000) thousand shares issued.496 / $546. equaling shares issued less shares of treasury stock. • Identify the number of shares authorized. Additional Paid-in-Capital (APIC) is the amount received in excess of par. On January 29.000) thousand shares authorized. while the Additional Paid-in-Capital account is titled (Common Stock / Contributed Capital). AEO repurchased common stock. Also. 2012. 2011 for common stock: __________ thousand shares issued . averaging ($3 / $17) per share.____ per share. whereas preferred stock is optional.ACTIVITY 35 STATEMENT OF STOCKHOLDERS’ EQUITY—TYPES OF STOCK Purpose: • Identify three types of stock.366) thousand shares authorized. averaging ($3 / $17) per share. issued.093 / $938. these are referred to as Treasury Stock.000 / 249.093 / $938. Each corporation must issue common stock. There are two types of stock: common stock and preferred stock. 2011 $__________ thousand was reported as Common Stock (Par) and $__________ thousand reported as Contributed Capital (APIC) for total contributions of $__________ thousand for issued shares. Upon incorporation.366) thousand shares issued. Shares outstanding are the total number of shares actually held by investors at a given time. which (increased / decreased) total stockholders’ equity by $__________ thousand and reissued treasury stock which (increased / decreased) total stockholders’ equity by $__________ thousand. When originally issued. • Compute the total cost of contributed capital and the average cost per share. Shares issued . including contributed capital and retained earnings.000 / 249.000 / 600.000 / 600.023) thousand. Par Value + Additional Paid-in-Capital = Total Issue Price of Stock Refer to the Statement of Stockholders’ Equity for American Eagle Outfitters. (0 / 5.366) thousand shares outstanding.496 / $546.Treasury shares = Shares outstanding Q4 Q5 Q6 On January 29. 2011 there are (600. 2011 there are __________ thousand shares of common stock issued for a total contribution of ($2. [Refer to Note (1)] On January 29. and accompanying notes on page 107 to answer the following questions.566 / 194.__________ thousand shares in treasury [Refer to Note (2)] = __________ thousand shares outstanding. amounts received from investors are recorded in two separate accounts— the Par Value account and an Additional Paid-in-Capital account. During FYE January 28.000 / 249. Whereas for common stock on January 29.566 / 194. Why does the average cost of issued common shares differ from the average cost of treasury shares? Statement of Stockholders’ Equity Page 109 Chapter 4 .566 / 194. (600. Q1 Q2 Q3 For AEO the Par Value account is titled (Common Stock / Contributed Capital) and is $0.597 / $549. Sometimes corporations buy back shares of stock that have been issued.000 / 600. On January 29. • • Contributed capital (CC) includes amounts paid-in (contributed) by stockholders to purchase the stock of a corporation. Par Value is a legal value assigned to each share of stock upon incorporation. 2011 for preferred stock there are (0 / 5.000) thousand shares outstanding. The Statement of Stockholders’ Equity provides information about changes in a company’s stockholders’ equity. Cash dividends (increase / decrease / have no effect on) stockholders’ equity. if the Board of Directors declared an $80 million dividend. after the stock split there would be (113 / 170 / 255 / 340 / 510) million common shares outstanding. b. January 28. the stock split (increases / decreases / has no effect) on shareholder wealth. It is increased by net income. after the stock split there would be (113 / 170 / 255 / 340 / 510) million common shares outstanding.Other = Ending Retained Earnings. c. b. A company has 170 Assume there was a two-for-one stock split. Therefore. Retained earnings (RE) are net income earned by the company since its incorporation and not yet distributed as dividends. Repurchase of treasury stock (increases / decreases / has no effect on) stockholders’ equity. and accompanying notes presented on page 107 to answer the following questions. Q6 (Common / Preferred / Treasury) stock is publicly traded. • Understand preferred and common stock dividends. d. the earnings of this accounting period. Net income (increases / decreases / has no effect on) stockholders’ equity. and decreased by dividends. Q3 Assume that AEO issued 1 million shares of preferred stock with a dividend rate of $5 per share.ACTIVITY 36 Purpose: STATEMENT OF STOCKHOLDERS’ EQUITY • Interpret an increase and decrease in Stockholders’ Equity. (January 29/ January 28).261) thousand $__________ thousand Q2 On January 28.Dividends = Ending Retained Earnings Refer to the Statement of Stockholders’ Equity for American Eagle Outfitters (AEO). a distribution of earnings. Preferred shareholders would expect to receive $_________ million in dividends each year. c. 2012 $__________ thousand __________ thousand __________ thousand ____(4. 2012 for AEO: Beginning Retained Earnings.Dividends . identify the effect on stockholders’ equity. Because shareholders maintain the same proportionate share of a company’s wealth before and after a stock split. (Preferred / Common) stock usually has a stated dividend rate. Under International Financial Reporting Standards (IFRS). this is part of the “preferred” treatment. Q5 For each of the following events. Statement of Stockholders’ Equity Page 110 Chapter 4 . Inc. Reissue of treasury stock (increases / decreases / has no effect on) stockholders’ equity. preferred shareholders would receive $_________ million in dividends and common shareholders would receive $_________ million in dividends. a. b. preferred stock would be classified as (a liability / stockholders’ equity) and the preferred dividend reported as (interest / dividends) on the income statement. (Preferred / Common) shareholders always receive their dividends first. Q1 For fiscal year ended on January 28. 2012 stockholders’ equity totaled $__________ thousand. which is the amount of business assets owned by shareholders. Assume there was a three-for-two stock split. million common shares outstanding. 2011 + Net income . • Compute shares outstanding after a stock split. meaning the shares are bought and sold on public stock exchanges such as the New York Stock Exchange and NASDAQ. Beginning Retained Earnings + Net Income . c. Q4 a. a. 000 Avg. Even though Wagdy Company reports (greater / lower) EPS. while Wagdy Company stock is (a bargain / moderately-priced / expensive). # of CShares OS 2. The increase in EPS looks (good / bad) to shareholders because their proportionate ownership interest is (increased / decreased).000 Wagdy Company EPS = $2.20 $0. # of CShares OS 500.000. how much investors are willing to pay for each $1 of EPS. • Identify EPS trends and compare EPS to Market Price to enhance meaning. Statement of Stockholders’ Equity Page 111 Chapter 4 .Preferred dividends EPS = Average number of common shares outstanding Use the EPS information below for Athar and Wagdy Companies to answer the following questions.000 Avg. The decrease in EPS looks (good / bad) to shareholders because their proportionate ownership interest is (increased / decreased). EPS (can / cannot) be more meaningful when compared to market price per share.33 / $1 / $2) per share. Athar Company stock is (a bargain / moderately-priced / expensive).00 of 30 Refer to the EPS and the Market Price information immediately above.10 $0.00 Market Price $60/share = PE Ratio EPS $2. whereas a PE of more than 20 is considered “expensive. both companies have (the same / different) net income. whereas Wagdy Company has a/an (increasing / decreasing) trend.50 of 12 Q4 Wagdy Company EPS = $2. Athar Company EPS = $0. and EPS would (increase / decrease) to ($0.50 Market Price = $6/share = PE Ratio EPS $0. • Compute how treasury stock affects EPS. Athar Company EPS = $0.” Measured by the PE ratio. EPS for Athar Company has a/an (increasing / decreasing) trend.000. then treasury stock would (increase / decrease). Alternatively. A company with greater EPS (does / does not) indicate greater profitability. Athar Company EPS = $0.50 Year 1 Year 2 Year 3 EPS $0.00 Year 1 Year 2 Year 3 EPS $8 $4 $2 Wagdy Company EPS = $2. EPS (can / cannot) be more meaningful when compared over time.50 Q3 Refer to the EPS information immediately above. Q2 If Athar Company buys back 1 million shares of common stock.000 Q1 Refer to the EPS information immediately above. Earnings per Share (EPS) indicates the amount of net income earned by each individual share of stock held by investors.000. The PE Ratio measures how expensive a stock is.33 / $1 / $2) per share. A PE below 10 is considered a “bargain” stock.00 Net income = $1. if Athar Company issues an additional 1 million shares of common stock then common shares outstanding would (increase / decrease) and EPS would (increase / decrease) to ($0. Net income .ACTIVITY 37 Purpose: RATIO ANALYSIS: EARNINGS PER SHARE • Understand that EPS cannot be used to compare profitability among companies.50 Net income = $1. common shares outstanding would (increase / decrease). which results in Financial Leverage of (2 / 4 / 25). b. Corp A has no debt. As liabilities increase (ROS / Asset turnover / ROA / Financial leverage / ROE / Debt) ratios remain the same. b. Circle the Primary Driver of ROA as either ROS or Asset Turnover. which results in higher (ROA / ROE) because shareholders are assuming (higher / lower) risk. Asset Turnover. therefore.ACTIVITY 38 Purpose: RATIO ANALYSIS: FINANCIAL LEVERAGE • Understand how debt affects financial leverage and ROE. Financial Leverage. Q2 Compute the ratios for Corp C. Less than 50%? (ROA / = / LEV) b. ROE. Circle the Primary Driver of ROE as either ROA. All corporations have the same amount of (Sales revenue / Net income / Assets / Liabilities / Stockholders’ equity). and Corp E and record in the DuPont Analysis of ROE chart on page 113.Debt Ratio) Q3 Corp D has a debt ratio of 75%. What is the primary driver of ROE when the debt ratio is: a. • Compute ROS. and the Debt Ratio. Q4 Higher debt results in a (higher / lower) debt ratio. but different amounts of (Sales revenue / Net income / Assets / Liabilities / Stockholders’ equity). Q5 In the Primary Driver chart on the previous page: Q6 Q7 a. which leads to (higher / lower) Financial Leverage. Greater than 50%? (ROA / = / LEV) Statement of Stockholders’ Equity Page 112 Chapter 4 . Corp A has the (least / greatest) amount of liabilities. therefore. The primary driver of ROA remains the same because (sales revenue / expenses / assets / liabilities) remain the same. whereas Corp E has the (least / greatest) amount of liabilities. Financial Leverage Ratio = Assets / SE Debt Ratio = Liabilities / Assets Because A = L + SE you can convert: Financial Leverage Ratio = 1 / (1 . or of equal (=) contribution. Financial Leverage. but the (ROS / Asset turnover / ROA / Financial leverage / ROE / Debt) ratios increase. ROE is (2 / 4 / 25) times greater than ROA. Q1 Review Corporations A through E on page 113. The primary driver of ROE changes because (sales revenue / expenses / assets / liabilities) change. ROA ( < / = / > ) ROE. a. Corp D. ROA. Equal to 50%? (ROA / = / LEV) c. DUPONT ANALYSIS of ROE Formula CORP A CORP B CORP C CORP D CORP E $ 100 10 100 0 $ 100 $ 100 10 100 25 $ 75 $ 100 10 100 50 $ 50 $ 100 10 100 75 $ 25 $ 100 10 100 96 $ 4 10.00% 10.00% 1.00 1.00% 13.00% = ROE Debt ratio Primary Driver PRIMARY DRIVER CHART CORP A CORP B CORP C CORP D CORP E Of ROA? (ROS / A TO) (ROS / A TO) (ROS / A TO) (ROS / A TO) (ROS / A TO) Of ROE? (ROA/ = /Lev) (ROA/ = /Lev) (ROA/ = /Lev) (ROA/ = /Lev) (ROA/ = /Lev) Statement of Stockholders’ Equity Page 113 Chapter 4 .00 Sales revenue Net income Assets Liabilities Stockholders’ equity ROS x Asset turnover NI / Sales revenue Sales revenue / Assets = ROA NI / Assets 10.00% x Financial leverage Assets / SE 1.00% 10.33% Liabilities / Assets 0.00% 25.00 1.33 NI / SE 10. ROE is (1 / 2 / 6) times greater than ROA. therefore. resulting in a Financial Leverage ratio of around (1 / 2 / 6). whereas the (low / high) volume strategy is reflected in (ROS / Asset Turnover / Financial Leverage) of _______. • Compute Financial Leverage and ROE.049 14.05% 55.ACTIVITY 39 Purpose: FINANCIAL LEVERAGE OF THREE COMPANIES • Understand how debt affects financial leverage and ROE.759 12. (YHOO / COST / CAT) reports the greatest ROE and (YHOO / COST / CAT) is assuming the greatest amount of financial risk. The (low / high) pricing strategy is reflected in (ROS / Asset Turnover / Financial Leverage) of _______.883 8.563 12. Q3 Compute Financial Leverage and ROE for Costco and Caterpillar and record in the chart above. therefore. Q6 Using only the financial information above.446 68. resulting in a Financial Leverage ratio of around (1 / 2 / 6). Q1 Which company offers products to members in a range of merchandise categories that have been purchased directly from manufacturers? (YHOO / COST / CAT) The business strategy of this company is to purchase merchandise at (low / high) prices and then sell the merchandise to members at (low / high) prices to generate (low / high) volume. Q4 Costco has a debt ratio of approximately (15% / 55% / 84%).915 1. Q5 In the Primary Driver chart above: a. Circle the Primary Driver of ROA as either ROS or Asset Turnover.7384 6. Costco Wholesale Corporation (COST).3371 7.761 14. Caterpillar has a debt ratio of approximately (15% / 55% / 84%). and of the three companies. ROE is (1 / 2 / 6) times greater than ROA. $ in Millions Sales revenue Net income Assets Liabilities Stockholders’ equity ROS x Asset turnover = ROA x Financial leverage = ROE Debt ratio Formula YHOO COST CAT 12/31/2011 8/29/2011 12/31/2011 NI / Sales Revenue Sales Revenue / Assets NI / Assets Assets / SE NI / SE Liabilities / Assets Primary Driver Of ROA? Of ROE? 4.36% 15.64% 3.783 2.19% 0.096% 1. (CAT) to answer the following questions.928 81.1788 8.984 1. and Caterpillar Inc. Q2 (ROS / ROA / ROE) is the most comprehensive profitability ratio.541 21.15% 84.05% 0.46% 60. which company would you prefer to invest in? (YHOO / COST / CAT) Why? Statement of Stockholders’ Equity Page 114 Chapter 4 .462 26. b.18% YHOO COST CAT (ROS / A TO) (ROS / A TO) (ROS / A TO) (ROA / = / Lev) (ROA / = / Lev) (ROA / = / Lev) Refer to the financial information above for Yahoo! Inc. Circle the Primary Driver of ROE as either ROA. Financial Leverage. (YHOO).242 12.3226 5. (YHOO / COST / CAT) has the greatest profitability as measured by this ratio. or of approximately equal (=) contribution.17% 88.138 4.002 1. Ratios reveal relationships. Total assets Financial Leverage = Stockholders’ equity The Return on Equity (ROE) ratio measures how effectively stockholders’ equity is used to produce net income. See Appendix B for additional ratios. in the sense that the more debt a company has. Below are ratios with explanations introduced in this chapter. Market price per share PE Ratio = EPS Statement of Stockholders’ Equity Page 115 Chapter 4 . the higher the Financial Leverage. Regrettably. • Understand that the expected range of ratios varies by industry. • Understand that comparing a ratio to industry norms enhances meaning. ROA x Financial Leverage = ROE Net income ROE = Stockholders’ equity Times Interest Earned indicates a company’s ability to earn (cover) its periodic interest payments. It measures how debt “boosts” return on assets to increase return on equity.Preferred dividends EPS = Average number of common shares outstanding The Dividend Rate is the amount of dividends paid annually for each share of stock held by investors. Net income . Times Interest Earned = Operating income Interest expense Earnings per Share (EPS) is the amount of net income (loss) earned by each individual share of stock held by investors.ACTIVITY 40 Purpose: RATIO ANALYSIS • Review a number of ratios to better evaluate a company. it does not explain why a stock is expensive or cheap. Financial Leverage is similar to the debt ratio. Dividend Rate = Annual common stock dividends paid Average number of common shares outstanding Investors use the Price Earnings (PE) ratio to measure how “expensive” a company’s stock is compared to EPS. (URBN).Below are ratios and selected financial information for three companies within the Retail Apparel industry: American Eagle Outfitters.880 7.50 25.00 14 URBN Industry * ** S&P 500 ** * ** Industry Averages for Apparel Stores—Industry and S&P 500 ratio averages from moneycentral.5% 46 NA NA NA 15 10.50 10 12.0% 2.01% 15.204 273 Total assets 1.412 Long-term debt 0 0 0 Interest expense 0 0 0 Total liabilities Stockholders’ equity Annual dividends paid Average number of common shares outstanding Statement of Stockholders’ Equity $ 185 209 Page 116 $ 252 588 $ 0 170 Chapter 4 . Therefore.351 4.89 $ 0. and Urban Outfitters Inc.21% 17.080 1.274 3170 1.20% 2.64 -- 21 6.39 10.065 1. GAP Inc. (GPS).44 15 GPS 8.985 382 1.0% 30 NA NA $ 2.5% NA $ 19 $ 1.75% 7.794 529 2. (AEO). Inc.968 414 Net income 141 1. 2011 RATIO ROS ROA x Financial Leverage = ROE Type Profit Profit Solvency Profit Formula NI / Sales Revenue NI / Total Assets Total Assets/ SE Times Market Interest Price Earned Solvency Invest NI / SE Operating Income / Interest Expense NA Dividend PE Rate Ratio EPS Profit Invest Invest NI – Annual Div Preferred Market paid / Avg # Div / Avg # Price / of CShares of CShares EPS OS OS AEO 4.4% NA $ 14 $ 0.968 Operating income Gap (GPS) $ Urban Outfitters (URBN) 14. RATIOS for the fiscal year ended January 29.01 16.com There are no official rules governing how these ratios are calculated.3% NA $ 34 $ 1.73 29. 2011 (In Millions) Sales revenue American Eagle Outfitters (AEO) $ 2.msn. the ratio formulas used may differ from the formulas in the text.27 19.22% 1.0% 10.04% 1.91 $ 0.3% 8.664 $ 2.50% 1. For the fiscal year ended January 29. The average Financial Leverage for the S&P 500 is (higher / lower) than the average for the Apparel Store Industry. which company has the greatest profitability? (AEO / GPS / URBN) How can you tell? Which company is assuming the greatest financial risk? (AEO / GPS / URBN) How can you tell? Which company would you invest in? (AEO / GPS / URBN) Why? Statement of Stockholders’ Equity Page 117 Chapter 4 . on average. AEO has (bargain-priced / moderately-priced / expensive) stock when compared to EPS. which will boost ROA almost (1 / 2 / 4) times to increase (ROS / ROE / EPS / PE). Companies within the Apparel Store Industry. Q5 A Times Interest Earned ratio greater than 4 generally indicates the ability to make interest payments. (GPS). Using the PE ratio scale immediately above. Q9 Overall. An ROA ratio greater than the industry norm is reported by (AEO / GPS / URBN). Therefore. As measured by the PE ratio. indicating (AEO / URBN / can’t tell) is more profitable.Refer to the ratios and selected financial information for three companies within the Retail Apparel Industry: American Eagle Outfitters. (have / don’t have) the ability to make interest payments. The dividend rate of AEO is (more / less) than the average for the S&P 500. indicating that the S&P 500 stocks carry (more / less) debt on average than the Apparel Store Industry. but (does / does not) reflect shareholders’ proportionate share of earnings. Q1 The strongest ROS ratio is reported by (AEO / GPS / URBN). indicating these companies have (greater / less) overall profitability than average within the Apparel Store Industry. GAP Inc. EPS (does / does not) compare profitability among companies. (AEO / GPS / URBN) stock is the most expensive. Q4 The strongest ROE is reported by (AEO / GPS / URBN). (ROA / Financial Leverage) is the primary driver of ROE. A higher PE ratio indicates (superior / inferior / can’t tell) stock. ROS expresses net income as a percentage of (revenue / expenses / assets) and measures the firm’s ability to control (revenue / expenses / net income) to keep (revenue / expenses / net income) high. Q7 The companies paying dividends are (AEO / GPS / URBN). Q2 Meaning is added to a ratio by comparing it to industry norms because success may vary by industry. on the previous page to answer the following questions. (AEO). Inc. Bargain PE < PE Ratio of 10 to 20 < Expensive PE Q8 Urban Outfitter’s PE Ratio of __________ indicates there is $__________ of market price for each $1 of EPS. with ROA contributing 17% to ROE and Financial Leverage contributing _____% to ROE. Q3 The greatest financial leverage ratio of __________ is reported by (AEO / GPS / URBN). Q6 The higher EPS is reported by (AEO / URBN). AEO is paying out approximately (25% / 50% / 75%) of this year’s EPS. and Urban Outfitters Inc. net income (increased / decreased). a. What did Bill Gates do with his dividend? (Buy a super-duper sports car / Donate it to charity / Give it to his children) Statement of Stockholders’ Equity Page 118 Chapter 4 . c. During FYE 6/30/2006 cash equivalents (increased / decreased) primarily as a result of (a net loss / repurchasing common stock / paying dividends). To pay this dividend. At this time Bill Gates owned 1. During FYE (6-30-2004 / 6-30-2005 / 6-30-2006) Microsoft paid a huge special one-time $3 per share dividend totaling $__________ billion. During FYE 6/30/2005 cash equivalents (increased / decreased) significantly as a result of (a net loss / repurchasing common stock / paying dividends).36) billion dollars. b. and EPS (increased / decreased). b.ACTIVITY 41 Purpose: TEST YOUR UNDERSTANDING • Identify reasons for change in cash. a. • Explain the effect of a huge cash dividend payment. From 6/30/2004 to 6/30/2007 total liabilities (increased / decreased) whereas stockholders’ equity (increased / decreased). d. • Explain how changes in the balance sheet and income statement affect ROA and ROE. resulting in a(n) (increasing / decreasing) debt ratio and (increasing / decreasing) financial leverage. During FYE 6/30/2004 stockholders’ equity (increased / decreased) primarily as a result of (net income / issuing common stock / repurchasing common stock / paying dividends).24 / 3. From 6/30/2003 to 6/30/2007 revenues (increased / decreased). Q3 Study the Income Statement for the five years presented.12 / 2. did Microsoft have enough cash? (Yes / No) Enough retained earnings? (Yes / No) b. Refer to the financial statement and ratio information for Microsoft on page 119 to answer the following questions. and stockholders’ equity. During FYE 6/30/2006 stockholders’ equity (increased / decreased) primarily as a result of (net income / issuing common stock / repurchasing common stock / paying dividends). During fiscal year ended (FYE) 6/30/2003 stockholders’ equity increased primarily as a result of (net income / issuing common stock / repurchasing common stock / paying dividends). During FYE 6/30/2007 stockholders’ equity (increased / decreased) primarily as a result of (net income / issuing common stock / repurchasing common stock / paying dividends). e. Q1 Q2 Study the Statement of Stockholders’ Equity for the five years presented.12 billion shares of Microsoft stock so his dividend was (1. During FYE 6/30/2005 stockholders’ equity (increased / decreased) primarily as a result of (net income / issuing common stock / repurchasing common stock / paying dividends). total liabilities. Q4 a. c. Study the Balance Sheet for the five years presented. 13 $ 0.005 60.552 (1.912 BALANCE SHEET Selected Amounts in Millions 6/30/2007 Cash/Assets 6/30/2006 37.250) $ 64.66% 9.26% 18.413 56.438 10.097 MICROSOFT 307 (857) (29.92% 11.389 Ending CS 60.948) (14.76 $ 0.017 7.44 $ 1.250) Beginning TS Repurchase CS Ending TS ENDING SE (197) (51.51% 28.493 $ 22.06% 20.6363 0.47 1.659 Stockholders’ equity $ 31.928 (8.26 1.967) (5.5619 0.35 $ 3.239 26.948) $ 40.234 41.70 Div rate per share $ 0.3903 0.537) (8.531 EPS $ 1.537) $ 48.597 $ 70.803 10.571 Liabilities $ 32.187 Net income $ 14.42% 25.104 (721) (14.065 12.64% Cash equivalents $ 23.254 8.21% 61.413 56.23% 31.411 $ 34.122 $ 44.250) -- (21.408) 4.31% 6/30/2003 64.161 $ 37.38% 32.815 $ 94.592 $ 49.254 $ 8.065 $ 12.Dividends (3.46% 2.217) (5.47% 10.45% 30.212) (15.396 49.997 + Net income 14.557 59. $ in millions 6/30/2007 6/30/2006 6/30/2005 6/30/2004 6/30/2003 $ $ $ $ $ 59.599 $ 12. Except per Share Data 6/30/2007 6/30/2006 6/30/2005 6/30/2004 6/30/2003 Revenue $ 51.115 1.60% Debt Ratio 50.723 DUPONT ANALYSIS of ROE 6/30/2007 6/30/2006 6/30/2005 6/30/2004 6/30/2003 27.239 26.23 = ROE 45.700 11.825 (5.396 49.217) $ 74.543 $ 14.171 $ 69.MICROSOFT Beginning CS STATEMENT OF STOCKHOLDERS’ EQUITY Adapted from the Form 10-K.162 7.368 $ 79.700 $ 19.729) Other 425 Ending RE 21.599 12.257 20.788 $ 36.160) $ 31.742 MICROSOFT 10.8093 0.40% 0.837) (3.646 (29.282 $ 39.048 Assets $ 63.594) (36.234 Beginning RE 11.42% ROS x Asset Turnover = ROA x Financial Leverage Statement of Stockholders’ Equity Page 119 Chapter 4 .115 $ 74.4045 22.168 7.097 $ 40.751 $ 60.968) (1.77% 42.912 MICROSOFT Fiscal year ended INCOME STATEMENT Selected Amounts in Millions.047 2.74 1.168 $ 7.30% 8.825 $ 64.17% 23.03 1.531 .835 $ 32.411) (6.08% 6/30/2004 53.71% 18.845 1.928 12.06% 6/30/2005 49.005 Issue CS 60.40 $ 0.646 20.80% 22.839 0.08 10.10% 17.047 2.104 $ 48.40 $ 0.16 $ Avg C/S O/S 9.320) (2.074 $ 29.21 $ 1. During FYE 6/30/2005 ROS (increased / decreased) and asset turnover (increased / decreased). which (increased /decreased) the debt ratio and (increased /decreased) financial leverage. Asset turnover = Sales revenue / Total assets. Debt Ratio. During FYE 6/30/2005 liabilities (increased /decreased). Financial Leverage. which (increased /decreased) total assets. Cash. resulting in ROA (decreasing / doubling / more than doubling). The payment of this special dividend (increased /decreased) cash. ROA = ROS x Asset turnover. while SE (increased /decreased). During FYE 6/30/2005 revenue (increased /decreased). During FYE 6/30/2005 ROA (increased / decreased) and financial leverage (increased / decreased). resulting in ROE (decreasing / doubling / more than doubling). Financial Leverage = SE / Total Assets. Q9 Review the financial information presented for Microsoft. resulting in (increased /decreased) asset turnover. Asset Turnover. Cash. Q6 What might have prompted this special one-time dividend? Q7 Review the financial information presented for Microsoft. a. c. ROE = ROA x Financial Leverage. d. Explain how the purchase of common stock (treasury stock) affected each of the following items. b. Debt Ratio. Financial Leverage. and ROE Statement of Stockholders’ Equity Page 120 Chapter 4 . a. and ROA b. Explain. and ROE Q8 Cash is a (high / low) earning asset. and ROA b. Asset Turnover. a. Explain how the special one-time $3 dividend affected each of the following items.Q5 Review the DuPont Analysis of ROE for the five years presented. an amusement park operator. not necessarily when they are paid for. Prepare and interpret trend and common-size statements of cash flows. (together with its affiliated companies. expenses generally don’t equal cash outflows.CHAPTER 5 STATEMENT OF CASH FLOWS LEARNING OBJECTIVES 1. and investors.. the “Partnership”) is a publicly traded Delaware limited partnership formed in 1987 and managed by Cedar Fair Management. including Cedar Point in Ohio and Dorney Park in Pennsylvania. Identify operating. so that they are recorded when a company gets the benefits from them. 3. INTRODUCTION Many investment analysts will tell you that “cash is king. we evaluate the cash flows of Cedar Fair. 5. an Ohio corporation (the “General Partner”) whose shares are held by an Ohio trust. Accordingly. Understand direct and indirect methods for computing operating cash flows. so that a profitable company can have net cash outflows from its operations. one indoor water park and five hotels. Here’s how Cedar Fair describes itself in its Annual Report: Cedar Fair. revenues can often be different from the cash flows that a company receives from customers. Cedar Fair operates 11 amusement parks and other attractions. It helps investors understand how much a company pays its employees. six outdoor water parks. We will review the different components of Cedar Fair’s Statement of Cash Flows and analyze the company’s liquidity and solvency. Collectively. Therefore. L. Revenue is recorded based on the revenue recognition principle. this means that a company’s net income and its cash flows could actually move in opposite directions. investing. L. a company can report a net loss but enjoy positive cash inflows from its operations. suppliers. you recognize revenue when it is earned and receivable. Inc.P. 2.. Understand how the Statement of Cash Flows is organized. creditors. In this chapter. such a company would be earning income but losing money! Similarly. What’s the difference between cash and net income? As we have already learned.P. many assumptions go into the computation of net income. Expenses are “matched” to revenues. Statement of Cash Flows Page 121 Chapter 5 . The Partnership is one of the largest regional amusement park operators in the world and owns eleven amusement parks. and financing activities. Compute and interpret cash flow ratios. The Statement of Cash Flows provides information about a company’s cash inflows and cash outflows during an accounting period. 4.” Banks and creditors only take cash—they don’t take profits. P. 2009. CONSOLIDATED BALANCE SHEETS ($ in thousands) 12/31/10 (excerpts) Partners’ Equity: Special L. 55. Cedar Fair reports Partners’ Equity. Withdrawals of profits. Cedar Fair also has a general partner. Worlds of Fun. Valleyfair.854 $ (87.Cedar Fair owns and operates Cedar Point. L.290 (1) 209.281) 127.334 and 55. Canada’s Wonderland.P. Carowinds. as shown: Cedar Fair. Knott’s Berry Farm.555 $ (33. Statement of Cash Flows Page 122 Chapter 5 . California’s Great America. not a corporation. Although limited partners have the same limited liability as common stockholders in a corporation.708) 137. are subtracted from these interests. which are like dividends.136 5.234 units outstanding at December 31. Cedar Fair is a Limited Partnership. who has personal liability for the company’s obligations. 2010 and December 31. Kings Dominion. Instead. and Castaway Bay Indoor Waterpark Resort. Dorney Park & Wildwater Kingdom. profits are credited to general and limited partners’ interests listed in the balance sheets. limited partnerships do not report retained earnings. interests General partner Limited partners. respectively Accumulated other comprehensive loss $ 5. Michigan’s Adventure. Kings Island. This means that Cedar Park issues limited partnership units rather than stock.290 (1) 12/31/09 $ 165.862 Unlike corporations. Instead of reporting a Stockholders’ Equity section on its Balance Sheet. 264) Exercise of limited partnership unit options 7 Excess tax benefit from unit-based compensation expense Net cash from (for) financing activities (112.442 Net cash from operating activities 182. expense Change in assets and liabilities.831 (69.349 857 1.653 Increase in other liabilities 2.706) Net cash (for) investing activities (71.838 716 86.567) $ Adjustments to reconcile net income (loss) to net cash from operating activities: Depreciation and amortization 126.729) 551 918 (2.115 CASH FLOWS (FOR) INVESTING ACTIVITIES Acquisition of Paramount Parks.446 (1.966 $ $ 120.671 Unrealized foreign currency gain on notes (17.725 (559) 20.933 185.617 18.765 $ SUPPLEMENTAL INFORMATION Cash payments for interest expense $ 129.773 (257) (5.Cedar Fair.815 $ Interest capitalized 1.197 (2.944 (445) (17. net of acquisition (Increase) decrease in current assets (11.635) 1.175.928 (17.890) Distributions paid to partners (13.P.098) 9.706 125.501 13.429 2008 $ 132.541 1.893) Deferred income taxes (14.945) 13.873 117.000 Note borrowings 399.431 (83.619 Chapter 5 .481) (77.200 Term debt borrowings 1.163) Balance.486 215.008 1.136) (15.694) 4 (173.425 7.383 Term debt payments.305) 6.242) Increase (decrease) in self-insurance reserves (383) Increase (decrease) in deferred revenue and other current liabilities 7.464) Other noncash (income) expense (1.500 244 (23.623 14.674 555 (5.170 7.074 Statement of Cash Flows Page 123 2009 35.855) (Increase) decrease in other assets 6 Increase (decrease) in accounts payable 652 Increase (decrease) in accrued taxes (2.808) 2.873 11.372 5.644) (2. L.101) 3.522) 8.588 53.988 8.450) (105.300) Net borrowings on revolving credit loans—existing credit agreement 23.386) (161.329) (67. 2010 CASH FLOWS FROM (FOR) OPERATING ACTIVITIES Net income (loss) $ (31.194 Amortization of debt issuance costs 5.684) - 5. beginning of year 11.050) 63. including early termination penalties (1.566.928 Balance.340 1.289 Loss on impairment of goodwill and oth.834 Payment of debt issuance costs (43.729 (127.600 (11.293 Impairment loss on fixed assets / retirement 62.140) Excess tax benefit from unit-based comp.864) (7.745 (26) 4. intangibles 2. (FUN) CONSOLIDATED STATEMENTS OF CASH FLOWS ($ in thousands) For the years ended December 31.078) 4.827) (1.283) 1.796 Noncash equity-based compensation expense (89) Loss on early extinguishment of debt 35. net of cash acquired Sale of Canadian real estate Capital expenditures (71. end of year $ 9.343 Cash payments for income taxes 19.428 2.698) Effect of exchange rate changes 126 Net increase (decrease) for the year (2.752 Gain on sale of other assets Net effect of swaps 18.706) CASH FLOWS FROM (FOR) FINANCING ACTIVITIES Net (payments) borrowings on revolving credit loans— previous credit agreement (86. and paying dividends. The company might reinvest the funds received from operating activities in more revenue-generating assets (Investing Activities). plant. and equipment or the purchase and sale of stock in other companies. Statement of Cash Flows Page 124 Chapter 5 .THREE CATEGORIES OF CASH FLOWS Accountants classify cash flows into three categories: Financing. we begin from the bottom and work our way up. then discussing investing activities. plant. plant. such as the purchase of property. such as receipts from customers and payments to suppliers and employees. As the business grows. Investing activities are transactions involving noncurrent assets. and then finally discussing operating activities. and Operating. and equipment Sell investment securities Purchase securities Receive loan repayments Make loans FINANCING ACTIVITIES Cash Inflows Cash Outflows Borrow cash from creditors Repay amounts borrowed (debt principal) Issue debt securities (bonds) Repurchase equity shares (treasury stock) Issue equity securities (capital stock) Pay cash dividends In this chapter. When the business begins operations. Then. spending funds on revenue-generating assets. using property. It could also use the funds to pay off debts or to pay dividends to stockholders (Financing Activities). As a business prepares to begin operations. and equipment Purchase property. the business will engage in Investing Activities. paying off loans. Here is a summary of typical Transactions Reported on the Statement of Cash Flows for each category: OPERATING ACTIVITIES (DIRECT METHOD) Cash Inflows Cash Outflows Cash from customers Cash paid to suppliers Cash from interest and dividends Interest paid Other operating cash receipts Other operating cash payments INVESTING ACTIVITIES Cash Inflows Cash Outflows Sell property. it could borrow more money (Financing Activities) to purchase more revenue-generating assets (Investing Activities). it would have to first raise money through Financing Activities. such as receiving common stock investments. Financing activities are typically transactions that involve stockholders and creditors. Operating activities typically involve cash inflows and outflows from a company’s central business. Investing. and equipment. it generates cash flows for Operating Activities. such as property. and other revenue-generating assets to manufacture and sell goods or offer services to customers. plant. plant. starting with financing activities. and equipment. issuing capital stock or issuing long-term debt. such as borrowing cash from creditors.541 - - 1.600 $ (11. pay careful attention to the largest numbers. Cedar Fair used some of this money to make payments on revolving credit loans ($86.834 thousand).383 - - (1.729 $ (173.698 thousand.P. Cedar Fair also paid distributions to partners ($13. Cedar Fair took out one loan and paid back others. This section of the statement of cash flows summarizes the financing transactions that occur during a year. repaying amounts to creditors.000 - - 399. 2010 2009 2008 CASH FLOWS FROM (FOR) FINANCING ACTIVITIES Net (payments) borrowings on revolving Net borrowings on revolving credit loans—existing credit agreement Term debt borrowings $ Note borrowings Term debt payments. In short. For example.864) (105. ($1.283) $ (127. Following this strategy. and paying cash dividends. such as issuing partnership units and paying distributions to partners.834) (67.386) 23.890 thousand). (Note that paying dividends is a financing activity. primarily debt or equity.) In a limited partnership such as Cedar Fair. here is the financing activities section of Cedar Fair’s statement of cash flows: Cedar Fair.300 thousand) and to make term debt payments.000 thousand (that’s $1.450) (13.329) (17. By the end of the year.698) To understand financial statements. whereas receiving cash dividends from investments is an operating activity.890) (161. companies have options when financing their operations.264) (7.175. L. repurchasing equity shares (treasury stock). Cedar Fair had a net outflow for financing activities of $112. As we discussed in Chapter 2.175 billion) borrowed to repay in full all amounts outstanding under previous credit agreements. including early termination penalties Distributions paid to partners Payment of debt issuance costs (86.200 - - 1.078) (43.FINANCING ACTIVITIES Financing activities are transactions that involve owners and creditors.300) $ 63.566. Statement of Cash Flows Page 125 Chapter 5 .694) - 7 4 4.175. In 2010. financing activities also include transactions between the partnership and its partners. issuing capital stock in exchange for investments by stockholders. CONSOLIDATED STATEMENTS OF CASH FLOWS ($ in thousands) (excerpts) For the years ended December 31.644) Exercise of limited partnership unit options Excess tax benefit from unit-based compensation expense Net cash from (for) financing activities $ (112. the first item that we notice is the $1.566. 625. not many new rides at Cedar Park’s attractions in 2010.403 .295. which include new land. receiving $6.842 1.641 $ 12/31/2008 305.431 thousand.796 thousand in depreciation expense for 2010.5% Statement of Cash Flows Page 126 Chapter 5 .595 34.076 28. 2010 2009 CASH FLOWS (FOR) INVESTING ACTIVITIES Acquisition of Paramount Parks. This amounts to a percentage increase of 3.734 575.656) 1.) Cedar Fair.403 16.595 thousand at the beginning of 2010 and a total cost of $1. L.401 326.069 $ 320.519 573.107 (826.351.1 Another useful comparison to determine whether Cedar Fair spends enough on capital expenditures is to compare capital expenditures to depreciation.5%. the company spent only $71.219 1. Cedar Fair reports $126. and.706 thousand in 2010 on capital expenditures.825.747 (707. On its Income Statement.P.398. 1 (1.403 thousand at the end of 2010.468 2.595 = 3.595) / 1. Cedar Fair sold Paramount Parks. (Note that the receipt of loan principal is classified as an investing activity. plant.607. or receiving loan payments.746 2.351. so that capital expenditures aren’t keeping up with the rate of depreciation on older equipment.431 (83.351.038) $ 1.980 324. L.588 (948. the purchase or sale of investments. To attract guests.305) $ (77.091 Consider that Cedar Fair’s “Rides and Equipment” account had a total cost of $1. Let’s look more carefully at Cedar Fair’s Property and Equipment: ($ in thousands) Cedar Fair.706) $ 53.398. CONSOLIDATED BALANCE SHEETS (excerpts) 12/31/2010 12/31/2009 Property and Equipment: Land Land improvements Buildings Rides and equipment Construction in progress $ Less accumulated deprec $ 309.050) In 2008. CONSOLIDATED STATEMENTS OF CASH FLOWS (excerpts) ($ in thousands) For the years ended December 31. such as the purchase or sale of property.481) $ (71. land improvements. net of cash acquired Sale of Canadian real estate Capital expenditures Net cash (for) investing activities 2008 $ (71.532.200 315. consider whether the company is making adequate investments in new revenue-generating assets. making loans.725 1.947) $ 1.398. of course. This section of the statement of cash flows also indicates that Cedar Fair spent $71.706) $ (15.424 589.351. rides and equipment.P. and equipment.136) $ 6.110 2.706 thousand in new capital expenditures.676.831 (69.INVESTING ACTIVITIES Investing activities are transactions involving noncurrent assets.781.1. amusement parks advertise exciting new rides and must maintain and upgrade older ones. However. whereas the receipt of interest revenue on the loan is classified as an operating activity. When you look at a statement of cash flows. buildings. L. from $1.002.” We will first discuss the direct method.542) (418. Further similarities include: net revenues (similar to cash received from customers).815) (117.939 thousand in 2010. 2010 2009 2008 CASH FLOWS FROM OPERATING ACTIVITIES Cash received from customers $ Cash paid for food and merchandise Cash paid for operating expenses Cash paid for selling.939 $ 923. such as receipts from customers and payments to suppliers and employees.619) (6. In addition. general. merchandise.190) (401.001) (128.074) (18. and so on.OPERATING ACTIVITIES Operating activities involve cash inflows and outflows from a company’s central business. we see that the largest cash outflow of $412. we avoid the terms “revenues.340) (19.976 thousand in 2008 to $974. record expenses when they are paid.190 is for operating expenses. without the revenue recognition and matching principles.743 (6. but the timing is based on the timing of cash flows. when preparing the direct method.255) (134. the “direct method” and the “indirect method. operating expenses (similar to cash paid for operating expenses). and games revenue (similar to cash paid for food and merchandise). There are two methods for preparing the operating activities section of the statement of cash flows.115 $ 185.473) (131.020) 182. which is also the greatest expense reported on the income statement.197 $ 215. prepared by the authors using the direct method: Cedar Fair.976 (90.882) (129.008) (120. we see that Cedar Fair’s Cash received from customers decreased over the last three years. the operating activities section of the statement of cash flows is actually similar to an income statement.749) (88. and admin expenses Cash paid for interest Cash paid for taxes Other operating cash flows Net cash from operating activities $ 974. CONSOLIDATED STATEMENTS OF CASH FLOWS (excerpts) ($ in thousands) For the years ended December 31. Statement of Cash Flows Page 127 Chapter 5 .995) 15. Looking at the direct method operating activities section of the statement of cash flows.966) (14.644 $ 1.” “sales. rather than when they would be matched to revenues under the revenue recognition principle. cost of food. To avoid confusion.” Here you can see Cedar Fair’s Operating Cash Flows. In other words.P.272) (412.” and “expenses” on the cash flows statement because these are associated with accrual accounting. such as “cash received from customers” and “cash paid for suchand-such.” “cost of goods sold. Similarly. this section of the statement of cash flows is similar to the income statement.002. as you would for the income statement. Instead use simple cash-related terms.201) (96. rather than the accrual method. rather than when they are earned and received or receivable.588 In short. simply record sales when the company receives cash from customers. OPERATING ACTIVITIES—THE DIRECT METHOD Using the direct method. 049 996.550 131.728 Selling.882 125.500 Loss on impairment/retirement of fixed assets 62. and games 337.386 Accommodations and other 71.923 $ $ 129.232 = -1. merchandise.752 244 (Gain) on sale of other assets (23.592 916.001 128.429 / 916. and games” with other components of Cedar Fair’s income in 2010: 2 (977. merchandise. Return on sales increased to 3. Let’s see if they’re right.619 84.729 185.978 35.293 4.561 561 (970) 4.P.567 / 977. CONSOLIDATED STATEMENTS OF OPERATIONS ($ in thousands) For the years ended December 31. and arcade games.9% 3 35.154) (28.706 Revenues decreased by 1. L.266 355.626 418. general.592) = 3.402 402.567) $ $ 124.875 977. merchandise.098) 823.796 132.863 730.814 Food.194 35.592 – 996.170 445 815 50.232) / 996. Compare gross profit from “food.838 86.2%3 in 2009 and then decreased to -3.9% over these years2.706 9.309 133.940 Operating expenses 411.2%4 in 2010.745 Loss on impairment of goodwill and other intangibles 2.407 14. 2010 2009 Net revenues: Admissions $ 568.532 Operating income 153. Many people think that amusement parks make most of their profits from refreshments.771 (935) 5.322) 3.429 2008 $ 566. and administrative 134.474 66.2% Statement of Cash Flows Page 128 Chapter 5 .9% 4 (31.473 Depreciation and amortization 126.543 Interest expense Net effect of swaps Loss on early debt extinguishment Unrealized/realized foreign currency (gain) loss Other income Income before taxes Provision (benefit) for taxes Net income (loss) Net income (loss) allocated to general partner Net income (loss) allocated to limited partners $ $ 150.356 316.762 $ 532.075 = 3.285 18. and games revenues 86.425 862.917 74.Cedar Fair.075 Costs and expenses: Cost of food.563) (1.232 90.245 (31.289 (20. souvenir stands.988 8.567) (31.429 35.706 5. accommodations.” “Accommodations and other” primarily comes from several hotels located on Cedar Fair properties. but experienced a loss of net income of $31. Accommodations. However.155 thousand in net cash from operating activities. and Other5 $ 640. Furthermore. and Games $337. this can be confusing. It does not simply list cash flows. directly. those $5 souvenir soft drink cups. GAAP requires companies to present something called the indirect method.762 + 71. Statement of Cash Flows Page 129 Chapter 5 . and then list items that reconcile net income (or loss) to cash flows for operating activities. helping you to better understand the sources and uses of a company’s cash flows. OPERATING ACTIVITIES—THE INDIRECT METHOD When companies prepare the indirect method for computing cash flows for operating activities. When it comes to Cedar Fair’s profits. Merchandise. explaining why net income is different from operating cash flows. To the uninitiated.2366 100% 7 411.567 thousand. or the format of investing and financing activities. It emphasizes the differences between net income (or net loss) and cash flows from operations. $20 T-shirts.2010 Net revenue Costs Gross Profit Food. merchandise. take a look at the difference in gross profit margins. and other. and games was a whopping 74%. In 2010.834). they start with net income (or loss).356 100% 86. the direct method is optional. and the stability of the company’s cash flows in what could be called a bad year. merchandise. and games ($250. The indirect method answers our question. Here is the indirect method for Cedar Fair: 5 This category combines “Admissions” with “Accommodations and other.737 74% Admissions.474 = $640.834 36% Wow! Cedar Fair earned more gross profit on food. er. and cheap stuffed-animal prizes really do add up! In Generally Accepted Accounting Principles. The gross profit margin on food. How did Cedar Fair receive so much cash flow while earning so little net income? Understanding the difference between cash flow and net income reveals the nature of Cedar Fair’s profitability. the statement of cash flows indicates that Cedar Fair received $182.737 thousand) than on admissions and hotel accommodations ($228. Instead. and most companies do not provide it. like the direct method. either on the face of the statement of cash flows or as supplemental information which may be in the notes. this is why the indirect method is so useful.619 26% $250.402 64% $ 228.236 7 Here we assume that all operating expenses match to admissions. 6 $568. L.098) Net effect of swaps 18.000 in net cash from operations? For 2010.000 net loss while still taking in $185. Therefore.827) (1. there are usually two kinds of reconciling items that explain the difference between net income and cash flows from operations.567) $ 35.Cedar Fair.242) 1.486 $ 215.293 4.140) (5.773 Unrealized foreign currency gain on notes (17. consider inventory. An increase in inventory will cost a company money—the company has to pay for that inventory.115 thousand.567.729) 1.349 Increase (decrease) in self-insurance reserves (383) 857 Increase (decrease) in deferred revenue and other 7.808) 2.893) (257) Deferred income taxes (14. These typically affect cash flow but don’t affect net income.725 (559) (2.464) Other noncash (income) expense (1.101) 3.653 20.684) Excess tax benefit from unit-based compensation expense Change in assets and liabilities. the increase in inventory will be subtracted in arriving at cash Statement of Cash Flows Page 130 Chapter 5 .635) Increase (decrease) in accrued taxes (2. • The second category of reconciling items is changes in current assets and liabilities. it has no effect on income. The most common noncash expense is depreciation and amortization expense. • The first kind is noncash expenses.289 Loss on impairment of goodwill and other intangibles 2.838 716 86. which is the allocation of the cost of certain noncurrent assets.115.197 2008 $ 5. Although companies subtract depreciation and amortization in arriving at net income.855) 551 (Increase) decrease in other assets 6 918 Increase (decrease) in accounts payable 652 (2.752 244 Gain on sale of other assets (23. depreciation and amortization expense does not affect operating cash flows because companies don’t pay for depreciation. which have no effect on operating cash flows.674 555 (5.194 9.671 7. reported as an investing cash outflow.745 Noncash equity-based compensation expense (89) (26) Loss on early extinguishment of debt 35.442 2. subtracted in arriving at net income.706 125. an increase in inventory will reduce operating cash flows.567 thousand. For example. These are expenses reported on the income statement.944 (445) (17. the indirect method starts with Cedar Fair’s net loss of $31. In the indirect method. Therefore. However.P.170 Amortization of debt issuance costs 5. but do pay for the asset.988 9.588 How did Cedar Fair incur a $31.500 Impairment loss on fixed assets/retirement fixed assets 62. net of effects from acquis: (Increase) decrease in current assets (11.428 current liabilities Increase in other liabilities 2. and lists all of the reconciling items in arriving at net cash from operating activities of $182.115 $ 185. CONSOLIDATED STATEMENTS OF CASH FLOWS (excerpts) ($ in thousands) For the years ended December 31.796 132.933 Net cash from operating activities $ 182. 2010 2009 CASH FLOWS FROM (FOR) OPERATING ACTIVITIES Net income (loss) $ (31.429 Adjustments to reconcile net income (loss) to net cash from operating activities: Depreciation and amortization 126.425 7. a current asset. by taking their value off of the balance sheet and moving it directly to the income statement.S. a decrease in accounts payable will be subtracted in arriving at cash flows from operations. an increase in accounts payable will be added in arriving at cash flows from operations. These reconciling items help explain how a business should manage its current assets and cash flows. Statement of Cash Flows Page 131 Chapter 5 . a schedule of noncash investing and financing activities is required by both. GAAP and IFRS. it’s now clear why the company received so much cash flow in 2010. For example. Now consider a decrease in accounts payable.855 thousand increase in current assets reported in 2010. as accounts receivable increases.S. Also. a company will also have cash flow problems if it doesn’t sell inventory quickly. will have the opposite effect. GAAP and IFRS require similar information but different disclosures for certain items. As the company chooses to let bills pile up. Accounts payable increased by $652 thousand. This is because such increases absorb a company’s cash flow. accounts payable will increase. such as accounts receivable or inventory. the indirect method can be explained with the following formula: Net income + Noncash expenses - Increases in current assets + Decreases in current assets + Increases in current liabilities - Decreases in current liabilities = Cash flows from operations Looking at Cedar Fair. The Company also reported a $35.855 thousand. On the other hand. because of just these three noncash items. Therefore. cash flows from operations were $224. they would not affect operating cash flows. Because payments of debt are a financing activity. As we already noted. such as accounts payable. Accordingly. INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) U. Buildups of current liabilities. and not an operating activity. a decrease in inventory will be added in arriving at cash flows from operations. This reduced net income but not operating cash flow. the company will experience cash flow problems. If a company doesn’t collect accounts receivable quickly.289 thousand loss on early extinguishment of debt. The only way to decrease accounts payable is to pay off bills. Accordingly. On the other hand. These differences are summarized in the chart below. By investing in current assets (such as inventory and accounts receivable).752 thousand impairment loss on fixed assets/retirement fixed assets. This would be related to the pay-off of debt described in the financing cash flows section.289 + 62. Cedar Fair paid cash flow of $11. its cash flow increased by $652 thousand. buildups in current assets. Such an entry would have no effect on cash flow. but the company will have more money in the bank. but the location of disclosure differs. 8 $126.796 thousand in depreciation and amortization. Reporting cash inflows from interest and dividends received and cash outflows of interest and dividend payments differ between U. even though it earned a net loss. This costs money.752 = $224.flows from operations.827. As Cedar Fair allowed its accounts receivable to accumulate. This loss reduced the book value of various assets.837 thousand higher than net income.8 Cedar Fair also lists changes in seven different current assets and current liabilities.796 + 35. The Company reported a $62. are subtractions in arriving at cash flows from operations. Cedar Fair recorded $126. consider the $11. Similarly. ANALYZING THE STATEMENT OF CASH FLOWS The statement of cash flows provides important insights into how a company raises and spends cash and how its operations generate cash.029 A B C A-(B+C) Chapter 5 . the FASB and IASB are working on a joint project to establish a common standard for presenting information in the financial statements. GAAP requires the indirect method for operating activities. but rarely disclose capital expenditures required to maintain productive capacity. The current proposal suggests organizing all financial information into three classifications—operating. subtracting both capital expenditures and dividends paid.115 71.Interest received Dividends received Interest paid Dividends paid Noncash investing and financing activities schedule U.864 $ 48. U.078 $ 27. Free Cash Flow = NCOA - ( Capital expenditures + Dividends paid) Let’s consider Cedar Fair’s free cash flow: ($ in thousands) NCOA Capital expenditures Distributions paid to partners Free cash flow Statement of Cash Flows 2010 $ 182. Adequate free cash flow allows for growth and financial flexibility. either displayed on the face of the statement of cash flows or as supplemental information that may be in the notes. Accordingly. and financing.834 $ 96. This would mean that the income statement and the balance sheet would be organized in a similar manner to the current statement of cash flows. as a practical matter. In regard to formatting. The formula is based on Net Cash from Operating Activities (NCOA).481 105. investing.S. whereas IFRS currently encourages the direct method.197 Page 132 2008 $215. FREE CASH FLOW Free Cash Flow reflects the amount of cash available for business activities after allowances for investing and financing activity requirements to maintain productive capacity at current levels. Companies usually disclose total capital expenditures in their statements of cash flow. GAAP IFRS Operating activities Operating activities Operating activities Financing activities Face of the statement of cash flows or the notes Operating or Investing activities Operating or Investing activities Operating or Financing activities Operating or Financing activities Notes only As discussed earlier.575 2009 $ 185197 69. Analysts commonly use several ratios to better understand a company’s ability to generate cash.706 13.136 67.S.588 83. analysts often use total capital expenditures in this formula. This can be attributed to the decrease in distribution to partners.) ($ in thousands) 2010 $182.078 1. This ratio uses cash and marketable securities (truly liquid current assets) and NCOA to evaluate whether adequate cash is generated from selling inventory and offering services.143 A B C A/(B+C) In 2010. we substitute distributions paid to partners for dividends paid. Is there enough NCOA to maintain productive capacity at current levels? This ratio presents free cash flow information in a ratio format and is used by credit-rating agencies to identify if there is adequate cash coverage of capital expenditures. (Because Cedar Fair is a partnership. CASH FLOW ADEQUACY The Cash Flow Adequacy ratio evaluates whether cash flow from operating activities is sufficient to cover annual payment requirements. Even a profitable business will fail without sufficient cash.129 NCOA Capital expenditures Distributions paid to partners Cash flow adequacy 2009 $185. as a practical matter. Below 1. except that it includes NCOA in its numerator.834 2. As we noted before. to $96.0 would indicate that they are inadequate. from $27.575 thousand in 2010. we substitute distributions paid to partners for dividends paid. and other annual payments.029 thousand in 2008 to $48.197 thousand in 2009.481 105. Cash Flow Adequacy = Net cash from operating activities (NCOA) Capital expenditures + Dividends paid A Cash Flow Adequacy Ratio of 1.864 1. Accordingly. it does not pay dividends. analysts often use total capital expenditures in this formula.136 67.197 69. This is a cash-basis measure of short-term liquidity that is similar to the current ratio. the likely source of funds that will ultimately be used to pay current liabilities. dividends. cash flow adequacy has vastly improved over the previous two years. CASH FLOW LIQUIDITY The Cash Flow Liquidity ratio compares cash resources to current liabilities.0 or above indicates cash flows are high enough to pay for capital expenditures and dividends.352 2008 $215. debt.706 13.588 83. Cedar Fair’s free cash flow is improving nicely.115 71. Cash Flow Liquidity Statement of Cash Flows = Cash + Marketable securities + NCOA Current liabilities Page 133 Chapter 5 .Note that because Cedar Fair is a partnership. Profits that don’t come with cash flows might have been generated from accounting tricks or from customers who are unable to pay the company later on.239 1.99 in 2008 to 1.567) NA 2009 $185. Accordingly. A ratio below 1.99 A B C D (A+B+C)/D Here we also see Cedar Fair’s liquidity worsening. Quality of Income = Net cash from operating activities (NCOA) Net income Computing quality of income for Cedar Fair in 2010 is risky business because the company incurred a loss. A ratio higher than 1. a cash flow liquidity ratio of 1.520 1. this company’s operations continue to generate operating cash flow. we have to focus on 2008 and 2009: ($ in thousands) NCOA Net income (Loss) Quality of income 2010 $182. and to ensure long-term success. we learned that.588 5. decreasing from 37. and so on.78 in 2008 to just 5.0 warns of inadequacy.115 168. Statement of Cash Flows Page 134 Chapter 5 .765 182.23 in 2009. Let’s consider Cedar Fair’s Cash Flow Liquidity: ($ in thousands) Cash Marketable securities NCOA Current liabilities Cash flow liquidity 2010 9.928 185. Ideally. dropping from 1. “the bottom line.706 37. The investor who looks only at net income.14 in 2010.78 A B A/B Cedar Fair’s quality of income fell dramatically in 2010. It is cash (not accrual-based net income) that is needed to pay suppliers.429 5.Like the current ratio. in spite of Cedar Fair’s 2010 net loss.23 2008 $215.588 115.” could miss out on a quality investment.0 or above indicates cash and operating cash flows are adequate to cover current liabilities. There’s no point in computing quality of income for 2010 because of the net loss reporting that year.852 1.197 131.50 2008 $ 13.197 35. QUALITY OF INCOME The Quality of Income ratio compares cash flows from operating activities to net income.873 215.115 (31.50 in 2009 to 1. net income should be accompanied by strong cash flows from operations. to invest in income-producing assets. employees. In summary.14 $ 2009 $ 11.0 indicates high quality income because each dollar of net income is supported by one dollar or more of operating cash flows. Free Cash Flow is a commonly used measure of liquidity. and equipment or the purchase and sale of stock in other companies. cash inflows and outflows from a company’s central business. but different disclosures for certain items. For net cash from operating activities. L. It helps investors understand how much a company pays its employees. companies start with net income.SUMMARY The Statement of Cash Flows provides information about a company’s cash inflows and outflows. but IFRS requires that it be in the notes. Cedar Fair.” is optional.23 2008 27. Under IFRS. The Statement of Cash Flows includes three categories. and (3) financing activities.197 1.029 1. Cash Flow Adequacy is similar to Free Cash Flow. including net cash from operating activities. with current liabilities. suppliers. High quality of income indicates a company’s net income is accompanied by cash flow. U. such as the purchase of property. plant. listed in the following order: (1) operating activities. Quality of Income. to arrive at net cash flows from operating activities.352 1.14 Profitability Formula 2010 NCOA / Net income NA 2009 48.50 5. adding and subtracting reconciling items. GAAP and IFRS require similar information. (FUN) RATIO Free Cash Flow Cash Flow Adequacy Cash Flow Liquidity Quality of Income Type Solvency NCOA – (Capital expenditures + Dividends paid) $ 96. Under the indirect method.575 Solvency NCOA / (Capital expenditures + Dividends paid) 2. and investors. companies list cash flows such as cash received from customers and cash paid to suppliers. Another method. GAAP requires the indirect method whereas IFRS encourages the direct method. Both require a noncash investing and financing section. transactions involving long-lived assets. and rarely provided.S. such as receipts from customers and payments to suppliers and employees. but measured as a ratio that can be compared to other companies. Companies are required to report the “indirect method” of computing net cash flows from operating activities.143 1. Under this method.P.78 Statement of Cash Flows Page 135 Chapter 5 .S. paying off loans. such as issuing common stock. compares net cash from operating activities with net income. Cash Flow Liquidity compares cash resources. rather than a whole number. U.99 37. and paying dividends. transactions that involve owners and creditors. such as noncash expenses. interest and dividends received may be reported either as an operating or an investing activity and interest and dividends paid as operating or financing activities. creditors. a profitability measure.129 Liquidity (Cash +Marketable securities +NCOA) / Current liabilities 1. (2) investing activities. the “direct method. These reconciling items can reveal interesting facets of a company’s cash flows and net income. reflecting the amount of cash available for business activities after allowances for investing and financing activities required to maintain productive capacity. such as _____ expense. not a corporation (2 words) 3. Operating activity method reconciling accrual-based net income with cash-based flows from operating activities 10.ACTIVITY 42 CROSSWORD PUZZLE FOR CHAPTER 5 Across 1. Activities including cash paid to purchase property. have no effect on operating cash flows Page 136 Chapter 5 . Noncash expenses. investing. Activities including cash received from issuing common stock 9. Free cash flow in a ratio format. compares cash resources to current liabilities (3 words) Statement of Cash Flows Down 2. Discretionary cash available for pursuing growth opportunities (3 words) 12. evaluates whether operating cash flow is sufficient to cover annual payment requirements (3 words) 5. Organization that has a general partner and many limited partners. Operating activity method reporting a cash-based income statement 8. Ratio of 1. Statement organized into operating.0 indicating each dollar of profit is supported by a dollar of operating cash flow (3 words) 6. and equipment 7. and financing activities (2 words) 11. Similar to the current ratio. plant. Activities including cash received from customers 4. 114 1.055 $ $ 152 5 387 Chapter 5 . CASH FLOWS FROM (FOR) OPERATING ACTIVITIES Net income (loss) Depreciation expense (Increase) decrease in accounts receivable (Increase) decrease in other current assets Increase (decrease)in payables Other operating changes.051) (493) (5.261 829 0 55 (155) 0 (13) (36) (149) 147 1. net Net cash from financing activities (NCFA) Effect of exchange rate changes Net change in cash + Beginning cash and cash equivalents = Ending cash and cash equivalents $ SUPPLEMENTAL INFORMATION Cash interest paid Cash taxes paid Free cash flow Statement of Cash Flows $ $ Page 137 178 715 (26) 65 253 200 1. net Net cash (for) investing activities CASH FLOWS FROM (FOR) FINANCING ACTIVITIES Issuance of long-term debt Issuance of capital stock Repayment of long-term debt Repurchase of capital stock Payment of dividends Other financing changes.261 455 20 (86) 0 (13) (46) 330 (254) 1.569) 0 39 (577) (225) (14) 11 (766) (432) 1.561 2009 $ 99 616 40 85 59 86 985 (968) (5. net Net cash from operating activities (NCOA) CASH FLOWS (FOR) INVESTING ACTIVITIES Purchase of property.114 485 13 403 $ $ 135 274 1. and equipment.106) 5.852 (1.385 2010 $ 459 628 (26) 49 193 258 1.362) 5. plant.368 1.624) 4.314 (35) (1. net Purchase of investments Proceeds from the sale of investments Other investing changes.265) (585) (6.Southwest Airlines (LUV) CONSOLIDATED STATEMENT OF CASH FLOWS ($ in millions) 2011 For the years ended December 31.120 2 (1. plant. The ongoing operation of any business depends on its ability to generate cash from operations. and financing activities.ACTIVITY 43 Purpose: UNDERSTANDING THE STATEMENT OF CASH FLOWS • • Understand positive amounts indicate cash inflows and negative amounts indicate cash outflows. It is cash that an organization needs to pay employees. whereas a negative amount indicates a cash (inflow / outflow). that in turn result in $$$ profits. investing activities. The statement of cash flows organizes cash inflows and cash outflows as operating activities. Identify operating. and generate dividends and interest. INVESTING ACTIVITIES: The $$$ obtained through financing is used to purchase revenuegenerating assets such as property. plant. the real issue is cash. Therefore. OPERATING ACTIVITIES: PPE and other revenue-producing assets are used to manufacture goods. and financing activities because … MANAGEMENT uses accounting information to make decisions regarding Financing —> Investing —> Operating —> FINANCING ACTIVITIES: Creditors lend and owners contribute $$$ to finance a company. and equipment (PPE) and investment securities. INVESTING ACTIVITIES: $$$ obtained through financing are used to purchase revenueproducing assets … and the cycle continues. suppliers. a positive amount indicates a cash (inflow / outflow). investing. Statement of Cash Flows Page 138 Chapter 5 . equipment Purchase property. and investors … not profits. TRANSACTIONS REPORTED ON THE STATEMENT OF CASH FLOWS OPERATING ACTIVITIES (Direct Method) CASH INFLOWS CASH OUTFLOWS Cash from customers Cash paid to suppliers Cash from interest and dividends Cash paid to employees Other operating cash receipts Interest paid Other operating cash payments INVESTING ACTIVITIES CASH INFLOWS CASH OUTFLOWS Sell property. FINANCING ACTIVITIES: $$$ profits are reinvested to internally finance the company. equipment Sell investment securities Purchase securities Receive loan repayments Make loans FINANCING ACTIVITIES CASH INFLOWS CASH OUTFLOWS Borrow cash from creditors Repay amounts borrowed (debt principal) Issue debt securities (bonds) Repurchase equity shares (treasury stock) Issue equity securities (capital stock) Pay cash dividends Q1 On the statement of cash flows. offer services. creditors. plant. a net cash (inflow / outflow / depends) is preferred. For operating activities. plant. Pay back long-term debt Q3 Refer to the cash flow information displayed below to answer the following questions. which is considered (favorable / unfavorable / depends). indicating this company (issued / repurchased) more common stock.569) 330 For Southwest Airlines. Southwest Airlines is a(n) (young / established) company. c. Why? Statement of Cash Flows Page 139 Chapter 5 . Purchase property. During 2011. During 2011. a net cash (inflow / outflow / depends) is preferred. d.051) (766) (1. issuing and repurchasing common stock are the primary financing activities. and (operating / investing / financing) activities. This company is (purchasing / selling) long-term assets. issuing stock. b. Pay employee wages (O / I / F) d. Issue common stock (O / I / F) e. a net cash (inflow / outflow / depends) is preferred. which is considered (favorable / unfavorable / depends).265) (149) (1. and equipment (O / I / F) c. (O / I / F) a. the primary source of cash is (operating / investing / financing) activities. or Financing activities. Borrowing funds.Q2 Identify the following transactions as Operating. paying dividends are reported as During 2009. The purchase and sale of long-term assets are reported as (operating / investing / financing) activities. indicating this company (borrowed / paid off) more long-term debt. financing activities report a net cash (inflow / outflow). (1. During 2009. For an established company. Investing.561 $ 985 Net cash from investing activities Net cash from financing activities a.385 $ 1. Why? For financing activities. the expected primary source of cash is (operating / investing / financing) activities. Pay suppliers (O / I / F) f. which for this company is a cash (inflow / outflow). Southwest Airlines STATEMENT OF CASH FLOWS ($ in millions) 2011 2010 2009 $ Net cash from operating activities 1. borrowing and repaying debt are the primary financing activities. Why? For investing activities. financing activities report a net cash (inflow / outflow). Receive cash from customers (O / I / F) b. Receive cash from customers paying on account. Why? Q5 The weakest year for LUV was (2011/ 2010 / 2009). (Operating / Not) d. (Operating / Not) f. Receive the utility bill for this accounting period that will be paid next accounting period. Q3 Cash flows from operating activities is reported using the (direct / indirect) method. net Net cash from operating activities (NCOA) 2010 $ 178 715 (26) 65 253 200 $ $ 1. (Operating / Not) c.000. (Operating / Not) a. Pay rent for the next accounting period. Why? (Hint: Refer to company descriptions in Appendix A—Featured Corporations) Statement of Cash Flows Page 140 Chapter 5 . (Circle all that apply) Q2 Identify transactions recorded in the operating section of the statement of cash flows. Extend $100. The indirect method reconciles accrual-based “Net Income” to cash-based “Net Cash from Operating Activities. Q4 The strongest year for LUV was (2011/ 2010 / 2009).385 $ 459 628 (26) 49 193 258 1. Supplier Barry pays off the $100.000 of credit to Supplier Barry for a purchase. The direct method reports sources and uses of cash during the accounting period. Receive interest payment of $8.000 from Supplier Barry.” Southwest Airlines (LUV) STATEMENT OF CASH FLOWS—Operating Activities ($ in millions) 2011 Net income (loss) Depreciation expense (Increase) decrease in accounts receivable (Increase) decrease in other current assets Increase (decrease)in payables Other operating changes. OPERATING ACTIVITIES (Direct Method) CASH INFLOWS CASH OUTFLOWS Cash from customers Cash paid to suppliers Cash from interest and dividends Cash paid to employees Other operating cash receipts Interest paid Other operating cash payments Q1 Operating activities include cash transactions that primarily affect (current asset / long-term asset/ current liability / long-term liability / stockholders’ equity) accounts. (Operating / Not) b. Why? Q6 LUV operates all (Boeing / Airbus / Raytheon) aircraft. (Operating / Not) e.561 2009 $ 99 616 40 85 59 86 $ 985 Refer to the information immediately above to answer the following questions. The operating activity section on the face of the statement of cash flows can be reported using the direct or the indirect method.ACTIVITY 44 Purpose: OPERATING ACTIVITIES • Understand operating activities on the statement of cash flows. (Circle all that apply) Q3 Refer to Statement B above. most companies choose the (direct / indirect) method.050) (1.ACTIVITY 45 Purpose: OPERATING ACTIVITIES—DIRECT AND INDIRECT METHODS • Understand the direct and indirect method of reporting operating activities STATEMENT OF CASH FLOWS—Operating activities STATEMENT A Adapted from COCA-COLA Cash received from customers Cash paid to suppliers Cash paid for operating expenses Other expenses paid Net cash from operating activities ($ in millions) $ 20.751 863 (37) (21) 80 (177) $ 4.160) (8. However. the (direct / indirect) method conveys amounts already reported on the income statement and changes in balance sheet accounts. Statement A above reports net cash from operating activities using the (direct / indirect) method.459 Refer to the information immediately above to answer the following questions. So no additional information is shared with (shareholders / suppliers / competitors). Q4 Is it possible to report a net loss on the income statement and still report a net cash inflow from operating activities? (Yes / No) Why? Statement of Cash Flows Page 141 Chapter 5 . Because most companies report depreciation expense.457 (6.788) $ 4.459 STATEMENT B Adapted from COCA-COLA Net income (loss) Depreciation expense (Increase) decrease in accounts receivable (Increase) decrease in inventory Increase (decrease) in accounts payable Increase (decrease) in accrued expenses Net cash from operating activities ($ in millions) $ 3. whereas the (direct / indirect) method reveals new information not found on other financial statements. Q2 The direct and indirect methods report the (same / different) amount for net cash from operating activities. most companies also report net cash from operating activities as (greater / less) than net income. Q1 The indirect format of the operating section starts with (sales revenue / net income). This difference is primarily due to the adjustment for (depreciation expense / change in accounts receivable). whereas Statement B uses the (direct / indirect) method. Net cash from operating activities is (greater / less) than net income. S. it is preferable to report the same accounts on both the income statement and the operating activity section of the statement of cash flows. therefore. • Dividends paid (are / are not) reported on the income statement. GAAP. dividend revenue. GAAP. as a(n) (operating / investing / financing) activity. Net income includes (cost of goods sold / cash paid to suppliers). • Interest expense (is / is not) reported on the income statement. Net income includes (sales revenue earned / cash received from customers). IFRS allows more flexibility in reporting interest revenue. • Dividends paid may be reported the same as U.Direct Method Q5 Q6 a. • Interest paid may be reported the same as U.S. interest expense. or because interest is typically owed as a result of (short-term / long-term) debt (liabilities) as a(n) (operating / investing / financing) activity. Net income reported on the income statement is primarily based on (accrual / cash) accounting.” To make these two amounts more comparable. on the statement of cash flows dividends paid are reported as a(n) (operating / investing / financing) activity. Under IFRS: • Interest received may be reported the same as U. therefore. therefore. • Dividend revenue (is / is not) reported on the income statement. or because interest is earned by (current / long-term) assets as a(n) (operating / investing / financing) activity. • Dividends received may be reported the same as U. whereas cash from operating activities includes (cost of goods sold / cash paid to suppliers). as a(n) (operating / investing / financing) activity. Which of the following accounts are used to compute net income? (Interest revenue / Interest expense / Dividend revenue / Dividends paid) (Circle all that apply) Q7 • Interest revenue (is / is not) reported on the income statement. GAAP. GAAP. and dividends paid. on the statement of cash flows dividends received are reported as a(n) (operating / investing / financing) activity. Decision makers compare “net income” to “net cash from operating activities. whereas net cash from operating activities reported on the statement of cash flows is primarily based on (accrual / cash) accounting. or as a(n) (operating / investing / financing) activity.S. whereas net cash from operating activities includes (sales revenue earned / cash received from customers). b. on the statement of cash flows interest received is reported as a(n) (operating / investing / financing) activity. therefore. as a(n) (operating / investing / financing) activity. on the statement of cash flows interest payments are reported as a(n) (operating / investing / financing) activity.S. or because dividends are typically earned by (current / long-term) assets as a(n) (operating / investing / financing) activity. Statement of Cash Flows Page 142 Chapter 5 . c. as a(n) (operating / investing / financing) activity. 569) $ Refer to the accounting information immediately above to answer the following questions. Purchase office building. net (35) Net cash from investing activities (NCIA) $ (1. (Investing / Not) b. Sell the 1. Inc. (Investing / Not) a.120 2 $ (1. equipment Sell investment securities Receive loan repayments INVESTING ACTIVITIES CASH OUTFLOWS Purchase property.314 4. This most likely indicates the business is (expanding / down-sizing).ACTIVITY 46 Purpose: INVESTING ACTIVITIES • Understand investing activities on the statement of cash flows. Receive $560 in dividends from Best Buy Company. For investing activities.000 shares of Best Buy Company. (Investing / Not) c. CASH INFLOWS Sell property. and equipment.265) Q5 2009 (585) (6. What PPE items is LUV most likely purchasing/selling? b. which is considered (favorable / unfavorable). at a loss. plant. If a company is selling income-producing assets. Southwest Airlines (LUV) STATEMENT OF CASH FLOWS—Investing Activities ($ in millions) 2011 2010 Purchase of PPE. plant.051) $ (1. Q3 A net cash inflow results from (purchasing / selling) more property. this is considered (favorable / unfavorable). If the reason for selling the investments is to finance operations. (Investing / Not) g. Sell equipment. Q4 A net cash inflow results from (purchasing / selling) investment securities. resulting future revenues will most likely be (higher / lower). then it would be considered (favorable / unfavorable).624) Proceeds from the sale of investments 5.000 shares of common stock in Best Buy Company. LUV reports a (strong / weak) cash position.362) (5. if the asset being sold is an unprofitable division. plant. (Circle all that apply) Q2 Identify the transactions that are recorded in the investing section of the statement of cash flows. equipment Purchase securities Make loans Q1 Investing activities include cash transactions that primarily affect the purchasing and selling of (current assets / long-term assets / current liabilities / long-term liabilities / stockholders’ equity). net $ (968) $ (493) Purchase of investments (5. Pay rent for the next accounting period. Inc. Why? Statement of Cash Flows Page 143 Chapter 5 . (Investing / Not) d. Issue additional shares of your company’s common stock. Purchase 1. a.106) 5. (Investing / Not) f. (Investing / Not) e.852 Other investing changes. this is considered (favorable / unfavorable). From the sale/purchase of PPE. If the reason for selling the investments is to take profits. However. Inc. If a gain is realized on the sale of assets (more / less / the same amount of) cash will be received if a loss is reported. LUV has a net cash (inflow / outflow). which indicates the company is (purchasing / selling) more PPE. (Financing / Not) i. Q3 Debt transactions: In 2009 LUV had a net cash (inflow / outflow). which (increases / decreases) shares outstanding and results in (higher / lower) earnings per share for current shareholders. If debt is issued to finance growth and expansion. Southwest Airlines (LUV) STATEMENT OF CASH FLOWS—Financing Activities ($ in millions) 2011 2010 Issuance of long-term debt $ 0 $ 0 Issuance of capital stock 39 55 Repayment of long-term debt (540) (155) Repurchase of capital stock (225) 0 Payment of dividends (14) (13) Other financing changes. it is considered (favorable / unfavorable). (Financing / Not) d. Repay note payable #1234. Pay interest on note payable #1234. (Financing / Not) g. Therefore. Record a 2-for-1 stock split. (Financing / Not) h. (Circle all that apply) Q2 Identify the transactions that are recorded in the financing section of the statement of cash flows. A company’s own stock that is bought back with the intent to reissue to shareholders in the future is referred to as (common / preferred / treasury) stock. FINANCING ACTIVITIES CASH INFLOWS CASH OUTFLOWS Borrow cash from creditors Repay amounts borrowed (debt principal) Issue debt securities (bonds) Repurchase equity shares (treasury stock) Issue equity securities (capital stock) Pay cash dividends Q1 Financing activities include cash transactions that primarily affect (current asset / long-term asset / current liability / long-term liability / stockholders’ equity) accounts. indicating that more stock was (issued / purchased). The ability to attract equity investors is (favorable / unfavorable). (Financing / Not) c. (Financing / Not) a. Purchase treasury stock. Issuing additional debt (does / does not) dilute earnings per share. buying back a company’s own stock is regarded (favorably / unfavorably) by current shareholders. (Financing / Not) e. is assuming (more / less) financial risk. and therefore. net (26) (36) Net cash from financing activities (NCFA) $ (766) $ (149) 2009 $ 455 20 (86) 0 (13) (46) $ 330 Refer to the accounting information immediately above to answer the following questions. Issue note payable #1234. Q4 Capital stock transactions: In 2010 LUV had a net cash (inflow / outflow). indicating that more debt was (issued / repaid).ACTIVITY 47 Purpose: FINANCING ACTIVITIES • Understand financing activities on the statement of cash flows. Q6 Which year is LUV’s cash position most appealing to shareholders? (2011 / 2010 / 2009) Why? Statement of Cash Flows Page 144 Chapter 5 . (Financing / Not) f. However. Issue common stock to Shareholder Adam. Issue preferred stock. Q5 LUV is paying (steady / random) dividends. it is considered (favorable / unfavorable). (Financing / Not) b. if debt is issued because cash from operating activities is insufficient. Pay dividends to Shareholder Adam. Call a bond payable currently outstanding. 000 shares of $100 par. Statement of cash flows $ 5. or F.000 (O / I / F) Cash from customers Income statement $ Sales revenue Income statement $ Cost of goods sold Income statement $ Gross profit Sell equipment with a book value (carrying value) of $65. Statement of cash flows $ (O / I / F) Income statement $ Balance sheet $ Equipment Balance sheet $ Note Payable Statement of Cash Flows Page 145 Chapter 5 . or Financing activity by circling O. $ Statement of cash flows (O / I / F) $ Income statement $ Balance sheet Q6 Sell 500 shares of Microsoft common stock for $12. $ Statement of cash flows (O / I / F) $ Income statement Q7 Purchase equipment for $50.000 cash. INVESTING. preferred stock for $180 per share.000. A portion of Q1 is completed for you.000 from a bank at an annual interest rate of 7%. including the amount of change and the title of the account. Record increases as a positive amount and decreases as a negative. investing. 6%. $ Statement of cash flows (O / I / F) $ Income statement Balance sheet Issue 1. $ Statement of cash flows (O / I / F) $ Income statement $ Balance sheet $ Balance sheet Q5 Receive a bill for $60. I. record the effect on the financial statements.000.000 long-term note payable. $ Statement of cash flows (O / I / F) $ Income statement Borrow $100. Understand the difference between cash-based and accrual-based accounting.000 cash.000 from a supplier.ACTIVITY 48 Purpose: OPERATING.000 cash down and a $150. Kristin Incorporated is preparing her financial statements. originally acquired for $5.000 for $50. • For each transaction.000 cash. The note is due in three years.000 of inventory to customers for $5. also identify whether the amount would be reported as an Operating. Investing. • For the Statement of Cash Flows. OR FINANCING? • • • Identify operating. Identify cash inflows and outflows. and financing activities. Pay $6. Q1 Q2 Q3 Q4 Kristin Incorporated Financial Statement Amount Account Title Sell $2. (Capital expenditures + Dividends paid) The Cash-Flow-Adequacy ratio evaluates whether cash flow from operating activities is sufficient to cover annual payment requirements. and other annual payments. Free Cash Flow reflects the amount of cash available for business activities after allowances for investing and financing activity requirements to maintain productive capacity at current levels. This ratio (with modifications in the denominator) is used by credit-rating agencies to identify if there is adequate cash coverage of capital expenditures. A ratio higher than 1. The above ratio is defined to evaluate whether net cash from operating activities is adequate to maintain productive capacity at current levels. and to ensure long-term success. It is a cash-basis measure of short-term liquidity. It is cash (not accrual-based net income) that is needed to pay suppliers. debt.ACTIVITY 49 Purpose: ANALYSIS: RATIOS • Understand the information provided by cash flow ratios. This ratio uses cash and marketable securities (truly liquid current assets) and net cash from operating activities to evaluate whether adequate cash is generated from selling inventory and offering services to pay current liabilities when they come due. (Cash + Marketable securities + NCOA) Cash Flow Liquidity = Current liabilities The Quality-of-Income ratio compares cash flows from operating activities to net income. employees.0 indicates high-quality income because each dollar of net income is supported by one dollar or more of cash. dividends. Even a profitable business will fail without sufficient cash. Adequate free cash flow allows for growth and financial flexibility Free Cash Flow = NCOA . and so on. to invest in income-producing assets. Cash Flow Ratios measure a company’s ability to generate cash. Net cash from operating activities (NCOA) Cash Flow Adequacy = (Capital expenditures + Dividends paid) The Cash-Flow-Liquidity ratio compares cash resources to current liabilities. It presents free cash flow information in a ratio format. Net cash from operating activities (NCOA) Quality of Income = Net income Statement of Cash Flows Page 146 Chapter 5 . 806 0.09 829 2.Southwest Airlines (LUV)—RATIOS ($ in millions) 2011 2010 2009 2008 FREE CASH FLOW Net cash from operating activities (NCOA) $ 1. Q4 QUALITY OF INCOME: Southwest Airlines had adequate cash to support each $1 of net income during (2011 / 2010 / 2009 / 2008).78 $ $ $ 985 $ (585) (13) 387 $ (1.561 459 3.479 985 2.385 4.385 178 7.561 (493) ( 13) 1.277 1.521) (923) (13) (2.055 $ $ $ 1.457) $ $ 985 598 1. Why? Support your response with at least two relevant observations.63) 1.00 $ $ $ $ 1. as indicated by a quality of income ratio greater than (0.368 435 (1.385 982 1.33 $ $ $ $ 1.385 (968) ( 14) 403 $ $ $ 1. Statement of Cash Flows Page 147 Chapter 5 .305 1.54 $ $ $ $ 1.561 3.261 2. Q3 CASH FLOW LIQUIDITY RATIO: Southwest Airlines lacked cash resources to cover current liability obligations during (2011 / 2010 / 2009 / 2008).Capital exp . Q1 FREE CASH FLOW: Southwest Airlines would have been able to take advantage of a $1 billion opportunity during (2011 / 2010 / 2009 / 2008). as indicated by a cash flow adequacy ratio of (greater / less) than 1.0.95 $ $ (1.533 1.521) 2.41 $ $ $ $ $ $ Capital expenditures Dividends paid NCOA .521) 178 (8.40 $ $ 985 99 9.676 1.0 / 1.561 506 3.315 1.65 $ $ (1. Q2 CASH FLOW ADEQUACY: Southwest Airlines had adequate cash for capital expenditures and dividends during (2011 / 2010 / 2009 / 2008).Dividends paid $ 1.0 / 2. as indicated by a cash flow liquidity ratio of (greater / less) than 1.0.521) 936 (1.114 1. Q5 The strongest cash position for Southwest Airlines was during (2011 / 2010 / 2009 / 2008).55) $ CASH FLOW ADEQUACY Net cash from operating activities (NCOA) Capital expenditures + Dividends paid NCOA / (Capital exp + Dividends paid) CASH FLOW LIQUIDITY RATIO Cash and cash equivalents Marketable securities (MS) Net cash from operating activities (NCOA) Current liabilities (Cash + MS + NCOA) / Current liabilities QUALITY OF INCOME Net cash from operating activities (NCOA) Net income NCOA / Net income Refer to the information above to answer the following questions.0).10 1. Divide each amount by the amount for the base year.385 141 1. Assume less than 5% is low. Q1 Complete the trend analysis for 2011. sometimes a trend analysis of the statement of cash flows is less meaningful than for the other financial statements. indicating NCIA (increased / decreased) by _____% since the base year.051) _____ (1. Q6 Refer to the information above. 5 to 15% is moderate. Refer to the Statement of Cash Flows and the trend analysis below to answer the following questions. The base year is the earliest year being studied. Q5 Trend analysis (enhances / lacks) meaning.ACTIVITY 50 Purpose: ANALYSIS: TREND • Prepare a trend analysis for the statement of cash flows and understand the information provided. and more than 15% is high. indicating NCOA (increased / decreased) by _____% since the base year. dividends grew by _____%. Southwest Airlines (LUV) STATEMENT OF CASH FLOWS Trend Analysis 2011 ($ in millions) Net cash from operating activities (Purchase) proceeds of PPE 2009 $ $ Trend Index Trend Index 1.265) Issue (payment) of debt (577) NA (155) NA 369 100 Issue (repurchase) of stock (186) NA 55 275 20 100 (14) _____ (13) 100 (13) 100 11 NA (36) 78 (46) 100 (766) NA (149) NA 330 100 (432) _____ 147 NA (254) 100 Payment of dividends Other financing changes. Use 2009 as the base year. Why? Support your response with at least two valid observations. A trend analysis compares amounts of a more recent year to a base year. The two-year average rate of growth of NCOA from 2009 to 2011 is (low / moderate / high). The analysis measures the percentage of change from the base year.561 158 985 100 $ (968) _____ (493) 84 (585) 100 (Purchase) proceeds of investments (48) _____ (772) 78 (986) 100 Other investing changes. Statement of Cash Flows Page 148 Chapter 5 . net (35) _____ - 2 100 81 (1. Q3 Net cash from investing activities (NCIA): In 2011 the trend index for NCOA is _______. since amounts with opposite signs cannot be accurately compared and division by zero is not applicable. Q4 Net cash from financing activities (NCFA): Since the base year. The strongest cash position for LUV was in (2011 / 2010 / 2009).569) 100 Net cash for investing activities - (1. net Net cash from financing activities Net change in cash Q2 2010 Trend Index Net cash from operating activities (NCOA): The annual rate of growth in NCOA can be compared among companies. Whereas the 2011 trend index for NCIA is _______. However. Record the resulting trend index in the shaded area. The analysis measures each item as a percentage of NCOA. Q4 During 2011 the greatest source of cash was (NCOA / selling PPE / issuing debt) and the greatest use of cash was (purchasing PPE / paying back debt / paying cash dividends). Q5 Total cash increased (2011 / 2010 / 2009). Statement of Cash Flows during (2011 / Page 149 2010 / 2009) and decreased during Chapter 5 . The Common-Size Statement of Cash Flows Statement compares all amounts to Cash from Operating Activities (NCOA) of that same year. net Cash from investing activities (NCIA) Issue (payment) of debt Issue (repurchase) of stock Payment of dividends Other financing changes. net Cash from financing activities (NCFA) Net Change in cash 2010 2009 13% 52% 21% 14% _______% _______% _______% _______% 10% 63% 20% 7% 100% -70% -3% -3% 100% _______% _______% 0% 100% -59% -100% 0% -76% -45% -15% -1% 6% -81% -13% 4% -1% 0% -159% -5% 2% -1% 38% -55% -31% -10% 9% 34% -25% Q2 LUV made payments on long-term debt during (2011 / 2010 / 2009). Q3 LUV issued additional shares of common stock during (2011 / 2010 / 2009). net Cash from operating activities (NCOA) (Purchase) proceeds of PPE (Purchase) proceeds of investments Other investing changes. Q1 Complete the common-size statements for 2010 by dividing each amount on the Statement of Cash Flows by the amount of NCOA of the same year. Southwest Airlines (LUV) STATEMENT OF CASH FLOWS Common-Size 2011 Net income Depreciation expense Changes in working capital Other operating changes. Refer to the common-size statement of cash flows below to answer the following questions.ACTIVITY 51 Purpose: ANALYSIS: COMMON-SIZE STATEMENTS • Prepare common-size statements using the statement of cash flow and understand the information provided. 226) 12.322 19.875) 10.314 Page 150 Year 8 $ 87.797 882 18.050) 8.559 61.287 34.014 157.605 26.710 531 (48) (7.293) 222.878 (208.216 (268.443 16.474) (15.607 (1.152) 7.867) (8.567) 345 870 17.261) 4.871) 1.119) 7.943.147) 37.242) 240.364) (17.392) 405.500) 1.829 2.381 (31.195 (688) (636) (1.549 15.777) (16.180 5.848 (2.324) 6.089 1.937.ACTIVITY 52 Purpose: ANALYSIS OF DINE EQUITY • Understand and interpret amounts reported on the statement of cash flows.864 (315) 259 31.429) 2.000 (173.443 $ 82.091) (605) 324 48 (52.839 (22.838 Chapter 5 . net Repurchase of restricted stock Proceeds from stock options exercised Excess tax benefit from stock options exercised Payment of debt issuance costs Payment of early debt extinguishment costs Restricted cash related to securitization Cash flows (used in) provided by financing activities Net change in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Statement of Cash Flows Year 9 $ 31.017 (15.947) (14.379 (45.372) 1.479) 512 (17.929 110.300) (5.131 4.516 26.362) (1.749) 15.199) (5.418) (23.323 (15.617 $ 7. net of cash acquired Collateral released by captive insurance subsidiary Proceeds from sale of property and equipment Principal receipts from notes and equipment contracts receivable Reductions (additions) to assets held for sale Other Cash flows provided by (used in) investing activities Cash flows from financing activities: Proceeds from issuance of long-term debt Repayment of long-term debt Principal payments on capital lease obligations Dividends paid (Payment of costs) issuance of preferred stock Reissuance (purchase) of treasury stock.630 (65.538 (1.749) (11.868) 43.409 $ (154.838.743) (10.835 476 (5) 35.038) 1.902) (103) 49. Cash flows from operating activities: Net (loss) income Adjustments to reconcile net (loss) income to cash flows provided by operating activities: Depreciation and amortization (Gain) loss on extinguishment of debt Loss on derivative financial instrument Impairment and closure charges Deferred income taxes Stock-based compensation expense Tax benefit from stock-based compensation Excess tax benefit from stock options exercised Loss (gain) on disposition of assets Changes in operating assets and liabilities: Receivables Inventories Prepaid expenses Accounts payable Accrued employee compensation and benefits Deferred revenues Other accrued expenses Other Cash flows provided by operating activities Cash flows from investing activities: Additions to property and equipment (Additions) reductions to long-term receivables Acquisition of business.459) Year 7 $ (480) 65.553 (3.129) 114.391 10.291) (186.094 (19.777 (31.693) (98) 11.685 13.838 114.355) 112.694 (138.137 (11.441) 182 (7.678) 105.765) (4.296.223 62.266 (21. DineEquity (DIN) STATEMENT OF CASH FLOWS ($ in thousands) For the years ended December 31.609) 18.879) (33.012) (1.812) (32.160) (24.602) 106.502 (425.216 (58.928 2.800 (76.958 3.480 (2.135 (540) 989 315 (48.553 15.476 (2. the company reported cash (inflows / outflows) from operations. (Circle all that apply) Q10 At December 31. Q3 DineEquity acquired Applebee’s in Year (9 / 8 / 7). Therefore. Statement of Cash Flows Page 151 Chapter 5 . How much did the company pay to acquire Applebee’s? $__________ thousand. Q4 DineEquity borrowed more long-term debt than it repaid during Year (9 / 8 / 7).Q1 In Year 8 the primary source of cash is (operating / investing / financing) activities. How can you tell? Support your response with at least five observations. DineEquity had $__________ thousand in cash and cash equivalents. DineEquity reported (Net income / a Net loss) of $__________ thousand. However. Q9 In Year 8. This is generally considered (favorable / unfavorable) to stockholders. Q8 DineEquity (does / does not) pay dividends. Year 9. DineEquity purchased property and equipment for $__________ thousand in cash and sold property and equipment for $__________ thousand in cash. Q2 In Year 8. which could indicate this business is (expanding / down-sizing). the company (purchased / sold) more property and equipment. This disparity was primarily caused by (Depreciation and amortization / Payment of dividends / Impairment and closure charges). Q5 DineEquity issued preferred stock during Year (9 / 8 / 7). Q11 DineEquity reports a (strengthening / weakening) cash position. This acquisition was primarily financed by (operating cash flow / the issuance of debt / the issuance of stock). indicating the assumption of (more / less) financial risk. Why? Q7 DineEquity reissued treasury stock during Year (9 / 8 / 7). Q6 DineEquity purchased treasury stock during Year (9 / 8 / 7). which typically indicates a (strong / weak) cash position. 969 (660) (1.867) 79 100 1.333 (440) 44 (176) 177 Cash flows from financing activities: Repurchase of common stock Issuance of common stock under employee plans Issuance (payment) of commercial paper.085) (183) (225) 2.635 $ (77) 588 7.809) (1.519 (237) (1.360) 1.358 (444) 18 (376) (361) (1. net of effects from acquisitions: Accounts receivable Financing receivables Inventories Other assets Accounts payable Deferred service revenue Accrued and other liabilities Change in cash from operating activities January 28.406) Effect of exchange rate changes on cash and cash equivalents Change in cash and cash equivalents Cash and cash equivalents at beginning of the year Cash and cash equivalents at end of the year (3) 3.433 2.635 $ 13.913 174 2.894 Cash flows from investing activities: Investments: Purchases Maturities and sales Capital expenditures Proceeds from sale of facility and land Acquisition of business.635 970 332 382 1. 2009 $ $ $ 2. 2010 January 30.833 135 (44) 3.764 8.630) 2 477 2 76 2. net Proceeds from issuance of debt Repayments of debt Other Change in cash from financing activities (800) 12 (176) 3.278 10.058 (122) (2) 2.117) 663 (13) 1.069 (1.352 $ 10.538 (367) 16 (3. Dell (DELL) STATEMENT OF CASH FLOWS ($ in millions) Fiscal Year Ended Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Stock-based compensation Provision for doubtful accounts Effects of exchange rate changes on monetary assets and liabilities denominated in foreign currencies Deferred income taxes Other Changes in operating assets and liabilities.012 (2.165) (1.383) 1.906 480 (302) 309 (106) (3. net of cash received Purchase of financing receivables Change in cash from investing activities (1.352 Income tax paid Interest paid $ $ $ $ $ $ 800 74 Statement of Cash Flows Page 152 435 188 434 151 Chapter 5 .478 852 312 429 769 418 310 (4) 59 (115) (45) 26 (52) 102 86 34 (707) (709) (248) 516 (151) 551 421 3.ACTIVITY 53 Purpose: ANALYSIS OF DELL • Understand and interpret amounts reported on the statement of cash flows.283 8.584) 2.613) (3. 2011 January 29. Q1 Review operating activities and comment on your observations. Q2 Review investing activities and comment on your observations. How can you tell? Support your response with at least five observations. Q4 Dell reports a (strengthening / weakening) cash position. Q3 Review financing activities and comment on your observations. Statement of Cash Flows Page 153 Chapter 5 . Of the following accounts. it is preferable to report the same account information on both the income statement and the operating activity section of the statement of cash flows. whereas paying the interest is a(n) (operating / investing / financing) activity. circle those that are used to compute net income: (interest revenue / interest expense / dividend revenue / dividends paid). LTL long-term liability. the cash received/paid for these items is reported in the (operating / investing / financing) activity section on the statement of cash flows. (Circle all that apply) Key: CA current asset. FINANCING ACTIVITIES report cash transactions that typically affect (CA / LTA / CL / LTL / SE) accounts. b. Q2 a. c. OPERATING ACTIVITIES report cash transactions that typically affect (CA / LTA / CL / LTL / SE) accounts. For a note receivable. b. whereas receiving an interest payment is a(n) (operating / investing / financing) activity. are reported in the (operating / investing / financing) activity section of the statement of cash flows. Because dividends paid are NOT reported on the income statement. 1. Issuing common stock to shareholders is a(n) (operating / investing / financing) activity and paying cash dividends to those shareholders is a(n) (operating / investing / financing) activity. interest expense. Because interest revenue. Q3 Q4 a. CL current liability. but instead.” To make these two amounts more comparable. they are also NOT reported on the statement of cash flows in the (operating / investing / financing) activity section. paying the principal is a(n) (operating / investing / financing) activity. 2. (Circle all that apply) c. Statement of Cash Flows Page 154 Chapter 5 . LTA long-term asset. receiving repayment of principal is a(n) (operating / investing / financing) activity. For a loan payment. Decision makers compare “net income” to “net cash from operating activities. Q1 The primary source of cash for an established company with a strong cash position should be (operating / investing / financing) activities. a. INVESTING ACTIVITIES report cash transactions that typically affect (CA / LTA / CL / LTL / SE) accounts. and dividend revenue are reported on the income statement. (Circle all that apply) b.ACTIVITY 54 Purpose: TEST YOUR UNDERSTANDING • Understand and interpret amounts reported on the statement of cash flows. SE stockholders’ equity. b. The company that appears to be borrowing money to expand and grow is (Ford / Royal Caribbean / United Airlines).976) $ $ 1.700 (160) 2.169) $ (1. and pay dividends is (Ford / Royal Caribbean / United Airlines). and equipment.138 a. repay debt. c. plant. The company that appears to have (Ford / Royal Caribbean / United Airlines). List three transactions that result in a cash outflow from financing activities. d. Why? a. List three transactions that result in a cash inflow for investing activities. The company that appears to be using amounts from operating activities to purchase property.764 $ United Airlines (UAL) Net cash from Operating $ 634 $ Net cash from Investing $ (17.969) Net cash from Financing $ (2. b.Q5 Answer the questions that follow by referring to the statement of cash flow information below. The company that appears to be borrowing money to finance operating activities is (Ford / Royal Caribbean / United Airlines).784) $ (1. the weakest cash position is Q7 What does the statement of cash flows reveal about a company that the income statement does not? Q8 Who can use the information on the statement of cash flows? For what purpose? Statement of Cash Flows Page 155 Chapter 5 . COMPANY ($ in millions) Q6 Ford (F) Royal Caribbean Cruises (RCL) 22. and equipment? Should it be measured at cost or an appraised value? How would you appraise the value of equipment? In this chapter. the RIM Wireless Handheld™ product line. and embedded technologies are used by thousands of organizations and millions of consumers around the world and include the BlackBerry» wireless solution. We learn that. 4. and other software and hardware. Understand accounting for property. Understand the nature of cash and cash equivalents. 3. services. Canada. plant. accountants often measure assets and liabilities at historical costs. RIM announced approval of the BlackBerry 7 smartphone for U. Understand accounts receivable and the accounting for bad debts. Headquartered in Waterloo. 5. But how? How do you measure the value of investments in stocks and bonds? Should they be measured at their cost or most recent stock price? How do you measure the value of inventory as prices change? How do you measure the value of property. 6. you must measure the value of a company’s assets and liabilities. INTRODUCTION In order to understand a company’s liquidity or solvency. we will use the financial statements of Research in Motion Limited (“RIM” or ticker “RIMM”). including the straight-line and double-declining-balance methods. we explore how accountants measure the value of different items on the balance sheet. To demonstrate the concepts in this chapter. or other values. Specific Accounts Page 156 Chapter 6 . to be practical. RIM produces and sells the BlackBerry® device: Research In Motion Limited introduced the BlackBerry® solution in 1999 and quickly became the global leader in wireless innovation. RIM’s portfolio of award-winning products. software development tools. plant. Ontario. Learn to account for inventory. Recently. which don’t necessarily reflect their true value. 2. Learn how companies account for current and noncurrent liabilities. Department of Defense Networks. including the FIFO and LIFO methods. Learn how companies report short-term and long-term investments.CHAPTER 6 SPECIFIC ACCOUNTS LEARNING OBJECTIVES 1. and equipment.S. 274 51 7. 2010—1. Class A common shares and unlimited number of voting common shares.488 577 2. plant.458.798 508 12.205 $ See notes to the consolidated financial statements.326 151 10.432 141 29 2.328. Issued—523.813 958 1.752. retractable.511 179 108 3.551 361 2.875 (94) 5. RIMM’s Consolidated Balance Sheet was prepared using United States GAAP.957 1.890 (February 27.603 10. in millions) CONSOLIDATED BALANCE SHEETS February 26. Specific Accounts Page 157 Chapter 6 . and equipment.749 (10) 8.868.359 2.504 1. 2011 As at Assets Current Cash and cash equivalents Short-term investments Accounts receivables Other receivables Inventories Other current assets Deferred income tax asset $ Long-term investments Property.630 276 31 3.394) Treasury stock February 26. cumulative.As shown here.638 96 68 15 2.955 324 618 241 229 7. net Intangible assets Goodwill $ Liabilities Current Accounts payable Accrued liabilities Income taxes payable Deferred revenue Deferred income tax liability $ Long-term debt Income taxes payable Commitments and contingencies Shareholders’ Equity Capital stock and additional paid-in capital: Preferred shares. redeemable. authorized unlimited number of non-voting. Research In Motion Limited (RIMM) Incorporated under the Laws of Ontario (United States dollars.602 - - 2.875 832 2. 2010 $ $ $ 1.791 330 3.950) Retained earnings Accumulated other comprehensive income (loss) $ 1.938 12. 2011—2.594 206 660 247 194 5.205 615 1.372 (160) 6.937 February 27.644 voting common shares (February 27. 2010—557. redeemable and retractable Common shares. authorized unlimited number of non-voting. coins. Specific Accounts Page 158 Chapter 6 . here is how RIMM describes its cash and cash equivalents: Cash and cash equivalents consist of balances with banks and liquid investments with maturities of three months or less at the date of acquisition. the investment must be classified as a long-term Investment. the “investments in stock” listed as an asset on one company’s balance sheet is “common stock” listed in stockholders’ equity on the other company’s balance sheet. They are almost always classified as current assets. suppliers. cash produces little or no investment return for companies. the investment must be classified on the balance sheet as a short-term investment.CASH AND CASH EQUIVALENTS Cash usually refers to physical currency (such as dollar bills.S. An investor’s acquisition of stock represents an ownership share in an investee.” Trading securities are bought and held principally for the purpose of selling them in the near term (thus held for only a short period of time). a company will move its entire cash balance to short-term investments at the end of the day and sell those investments for cash the next morning. a current asset. U. commercial paper. Interestingly. Accordingly. INVESTMENTS Companies often make investments by purchasing other companies’ stock and bonds. Companies also must decide whether investments are “trading securities” or “available-for-sale. Because many commercial checking accounts today pay no interest. a noncurrent asset. Companies need cash to pay for expenses and liabilities. Companies must classify their investments as short term or long term.” Cash equivalents are highly liquid investments with maturities of 90 days or less. or other securities that are relatively safe and can be sold quickly. GAAP. However. Typically. cash makes a bad investment for companies. Trading securities are generally bought and sold with the objective of generating profits on short-term differences in price. if a company intends to sell the investment after one year.S. government discount notes. cash will be available to pay checks outstanding. etc. For example.) or bank deposits. part of the investee’s stockholders’ equity. If a company purchases an investment intending to sell it within one year. based on when they intend to sell the securities. mutual funds. They may make these investments to store excess cash until they need it or to provide a long-term return. One way to compensate for this problem is to make overnight investments in money market accounts or other highly liquid investments. Cash not needed for a company’s immediate cash needs is often invested in other highly liquid investments. companies list cash and all of these investments together as “cash and cash equivalents. Companies usually define exactly how they measure cash and cash equivalents in the notes to the financial statements. They may also make these investments to strategically buy other companies. Short-term investments are often called marketable securities. such as competitors. such as time deposits in banks. International Financial Reporting Standards for cash and cash equivalents are essentially equivalent to U. This way. On their balance sheets. or customers. or total. the closing price on the balance sheet date. or the Allowance for doubtful accounts. such as their credit ratings. Large increases or decreases may be temporary. misleading investors into thinking that assets are more valuable or less valuable than they really are. Whether they are trading securities or available-for-sale. the Allowance for uncollectibles. because they reflect the actual value for which assets can be sold on the balance sheet date. part of stockholders’ equity. the gains and losses on changes in the market price are listed on the income statement and included in net income. Companies must estimate how much accounts receivable they will not be able to collect and deduct that estimate from Accounts Receivable. current or long term.” This means reporting the investments on the balance sheet at their most recent stock market price. suppose that an available-for-sale stock costing $15 was worth $19 on the balance sheet date. Mark-to-market has been criticized because market prices can fluctuate widely.Investments in stocks not classified as trading securities are classified as available-for-sale. For example. accounts receivable on the balance sheet. “Older” accounts receivable—items sold a long time ago but not yet collected—are less likely to be collected than “newer” accounts receivable. if a stock costing $15 was worth $19 on the balance sheet date. Therefore. if these large increases or decreases are on trading securities. the next year. This is called the Allowance for bad debts. a technique known as “mark-to-market. However. Unrealized gains and losses are the change in market price during an accounting period. It is based on the company’s history and especially the “age” of the accounts receivable. investments are usually recorded at market value. if companies presented their gross. unrealized gains and losses reflecting changes in market price are placed in accumulated other comprehensive income (“AOCI”). the company sold the stock for $25. many accounting standard-setters consider mark-to-market accounting to be the ideal measure of value. Then. the company will not be able to collect some portion of accounts receivable from customers. gains and losses are not included on the income statement until the securities are actually sold. The $4 unrealized gain would be removed from AOCI and a $10 realized gain would be recorded on the income statement. When developing its estimate. ACCOUNTS RECEIVABLE Accounts Receivable is monies to be received by the company from previous sales to customers. part of stockholders’ equity. The $4 appreciation would be placed in AOCI as an unrealized gain. For example. The most challenging issue in accounts receivable is collection. However. a company can also use economic data and information about specific companies. Furthermore. Until the sales date. they would mislead investors into thinking that the entire accounts receivable will be collected. for available-for-sale securities. and a $4 unrealized gain would be placed on the income statement and included in net income. the gains and losses recorded in the income statement may overstate or understate income. Available-forsale securities may be classified as current or noncurrent assets. Specific Accounts Page 159 Chapter 6 . the stock would be listed on the balance sheet as a $19 asset. For trading securities. Realized gains and losses result when the security is actually sold and the proceeds have been realized. This is the difference between the $25 proceeds and the $15 cost of the available-for-sale security. Inevitably. GAAP. it will write off the account—taking it off the company’s books—by subtracting the amount owed from accounts receivable and from the allowance. This is just a bookkeeping entry to avoid misleading investors. consider that a company has $1. The allowance against gross accounts receivables reflect the best estimate of probable losses inherent in the receivables portfolio determined on the basis of historical experience.000.S. Specific Accounts Page 160 Chapter 6 . For example. the company decides to write it off.000 in accounts receivable and a $50. and other currently available information. A typical note regarding accounting policy for accounts receivable and bad debts reads: Accounts receivable Accounts receivable are stated at their net realizable value. It should be noted that writing off a bad debt does not mean that the company loses its right to collect the receivable from the customer. NOTES to the Financial Statements.In the course of business. International Financial Reporting Standards for accounts receivable are essentially the same as U. For example. a company will identify individual accounts receivables that are uncollectible. The allowance for bad debts at December 31.000 and the allowance for bad debts to $40.000 allowance for bad debts. 2010—$2 million). including the allowance for future bad debts. 2011 is $2 million (December 31. When the company identifies this customer account as uncollectible. It will reduce accounts receivable to $990.000. specific allowances for known troubled accounts. a customer might declare bankruptcy and have no assets to pay off creditors. When it fails to collect a $10.000 receivable. 907 3.” By dividing the number of days in the year by Accounts Receivable Turnover.2 in 2008.2 50 50 45 A B A/B 365/AR Turnover Chapter 6 . It took RIMM much longer to collect receivables.0 to 12. on average.955 5. 1 Accounts Receivable Turnover and Accounts Receivable Days are computed as follows: Fiscal year ending in… Sales revenue AR AR Turnover AR Days Specific Accounts 2010 $19.3 in 2010.3 in 2009.ACCOUNTS RECEIVABLE TURNOVER A chief concern about accounts receivable is how quickly a company collects its accounts receivable. on average. Accounts Receivable Days = 365 days in the year Accounts receivable turnover This measure is much more intuitive than Accounts Receivable Turnover. Below are Accounts Receivable Days for RIMM and MMI.3 times 50 2010 7. on average.2 times per year in 2008.0 RIMM 2009 $14. ACCOUNTS RECEIVABLE DAYS Because the concept of turnover can be difficult to visualize.065 2. By 2010.594 5.460 1.0 indicates that. The efficiency associated with speedy collection of accounts receivable indicates that bad debts are not excessive and that accounts receivable assets are being used productively. 7.2 73 63 70 Page 161 2010 $13.050 1. On the other hand. and more quickly. RIMM collected its accounts receivable 5. and 5. specifically. in 50 days. Here are accounts receivable turnover ratios for RIMM and Motorola Mobility Holdings (MMI)1: AR Turnover AR Days 2010 5.2 times 45 For example.3 times 50 2008 8. MMI collects its accounts receivable.3 2008 $11. A ratio of 12. on average. on average. Here we can see more clearly how quickly MMI collects its accounts receivable.3 MMI 2009 $11. analysts sometimes convert it into “days. Accounts Receivable Turnover measures how quickly a company collects accounts receivable.0 times per year in 2010.064 1. Sales revenue Accounts receivable Accounts Receivable Turnover = In general.570 7.8 times 63 2008 5.8 2008 $11. MMI was collecting its accounts receivable.112 5. the company makes 12 collections of accounts receivable every year. MMI’s collections were 8. a company makes a sale on a receivable and collects it.341 8. 73 days on average. the accounts receivable turnover ranges from 6. more often. 5.0 times 73 RIMM 2009 5. and 7. you can compute the average number of days it takes for a company to collect accounts receivable. than RIMM. how many times a year.780 7.2 times 70 MMI 2009 7.8 times per year in 2009.953 2. A company usually starts with beginning inventory and then adds to it inventory purchased during the period. and what are the costs of units kept in inventory? SPECIFIC IDENTIFICATION To avoid this assumption. and you are encouraged to take the older milk from the front of the shelf. It is classified as inventory based on the company’s intention to sell the item. One lot cost $100 each to make. how much did it cost? What was the cost of goods sold? $100? $110? $115? And what is the cost of the lots that remained in RIMM’s stock? This requires the company to make an inventory cost flow assumption. consider an example where RIMM buys and sells leather cases. To illustrate. When accounting for inventory. suppose that RIMM assembles three lots of BlackBerry® units. employees move the old inventory up to the front of the shelf. The same model computer. To illustrate. many companies follow FIFO.INVENTORY Inventory. Specific Accounts Page 162 Chapter 6 . the total pool of inventory available during the period. almost all companies use a system of inventory rotation called First-In. suppose that RIMM started the year with inventory of 10 units that cost $10 each. the older milk at the back of the shelf would eventually spoil. This method is usually used when dealing with unique and expensive inventory items such as fine jewelry. equals goods available for sale. the Specific Identification inventory method. Computers in boxes on the shelf. custom-built homes. and the newest units are sold last. a current asset. After a customer purchases a single lot. plant. would be classified as property. the second cost $110. If the grocer stocked the new milk from the front (so that you can take the freshest milk). some companies keep track of when each and every inventory item was purchased and sold. Subtract from this the units sold to customers. is merchandise held for sale to customers. FIRST-IN. ready for sale to customers. and you get ending inventory. The cost of inventory units inevitably changes—what are the costs of units sold. When restocking shelves. the accountants know exactly which lot of BlackBerry® units the customer purchased and its cost. This prevents spoilage of the old inventory at the back of the shelf. Beginning inventory. In our example above. are inventory. This can be visualized as follows: Beginning Inventory Ending Inventory Goods Available for Sale Purchases Units Sold When accounting for inventory. and the third cost $115. sitting on the sales manager’s desk. Consider how inventory flows through a company. added to purchases. The grocer stocks the new milk at the back of the shelf. As shown below. or automobiles. Think about the milk case in your supermarket. companies must select a cost flow assumption. assuming that the oldest units are sold first. and place the new inventory in the back. and equipment. FirstOut or FIFO. FIRST-OUT When managing inventory. they account for the inventory in the opposite direction (assuming that savvy customers reach to the back of the case to get their milk). of units 10 units 20 units 15 units 45 units Cost per unit @$10 each = @$20 each = @$30 each = Total cost $ 100 400 450 $ 950 How much did the remaining ending inventory of 15 units cost? This can be calculated by computing the cost of the last 15 units purchased. and so on. of units 0 units 0 units 15 units 15 units Cost per unit @$10 each = @$20 each = @$30 each = Total cost $ -0-0450 $ 450 Because we are allocating the cost of goods available for sale among the units sold (cost of goods sold) and the units remaining in ending inventory. FIRST-OUT When accounting for inventory. First-Out. because presumably these were the items sold: Date Event January 1 Beginning inventory February 1 Purchase #1 March 1 Purchase #2 Cost of goods sold No. many U. To summarize: Date Event January 1 Beginning inventory February 1 Purchase #1 March 1 Purchase #2 Goods available for sale No. ending inventory equals cost of goods available for sale minus cost of goods sold: $1400 .300 Units Sold $950 LAST-IN. while the oldest items remain on the shelf.On February 1. RIMM purchased 20 units that cost $20 each. Here is a list of the beginning inventory and purchases during the year: Specific Accounts Page 163 Chapter 6 . placing the new milk at the back of the dairy case. Let’s use the same case to illustrate. The cost of goods sold would be calculated by computing the cost of the first 45 units purchased. Beginning Inventory $100 FIFO Ending Inventory $450 Goods Available for Sale $1. These same companies would use standard inventory management practices. On March 1.$950 = $450. of units 10 units 20 units 30 units 60 units Cost per unit @$10 each = @$20 each = @$30 each = Total cost $ 100 400 900 $ 1. companies use the opposite of FIFO. However.400 Assume that RIMM sold 45 of these inventory units during the year.400 Purchases $1. or LIFO. RIMM purchased 30 more units that cost $30 each. This means that they assume that the most recently purchased items are the first to be sold.S. called Last-In. because presumably these were the items still on hand: Date Event January 1 Beginning inventory February 1 Purchase #1 March 1 Purchase #2 Ending inventory No. 200 Note that. to $20 in February. of units 0 units 15 units 30 units 45 units Cost per unit @$10 each = @$20 each = @$30 each = Total cost $ -0300 900 $1. the most recent inventory costs (the newest units purchased) are allocated to inventory. Suppose that RIMM sold the 45 units for $100 each. take the cost of the oldest 15 units (the spoiled milk still sitting on the shelf): Date Event January 1 Beginning inventory February 1 Purchase #1 March 1 Purchase #2 Ending inventory No. (In a decreasing-prices scenario. resulting in a lower inventory value. Compare RIMM’s income statements under the FIFO and LIFO assumptions: Specific Accounts Page 164 Chapter 6 . of units 10 units 20 units 30 units 60 units Cost per unit @$10 each = @$20 each = @$30 each = Total cost $ 100 400 900 $1.400 Again assume that RIMM sold 45 of these inventory units during the year.400 Purchases $1. FIFO also results in a lower cost of goods sold amount than LIFO.200 To calculate the cost of the remaining ending inventory of 15 units cost.300 Units Sold $1. (which assumes that customers grab the freshest milk): Date Event January 1 Beginning inventory February 1 Purchase #1 March 1 Purchase #2 Cost of goods sold No. Under LIFO. the oldest inventory costs (units purchased a long time ago) are allocated to inventory.) The difference between FIFO and LIFO can significantly affect net income. of units 10 units 5 units 0 units 15 units Cost per unit @$10 each = @$20 each = @$30 each = Total cost $ 100 100 -0$ 200 To summarize the flow of inventory for LIFO: Beginning Inventory $100 LIFO Ending Inventory $200 Goods Available for Sale $1. FIFO providing a lower inventory value than LIFO and higher cost of goods sold. these effects will reverse. in this example. As prices increase.000 in operating expenses. because under FIFO. and incurred $3. The cost of goods sold would be calculated by computing the cost of the last 45 units purchased. prices are increasing from $10 in January.Date Event January 1 Beginning inventory February 1 Purchase #1 March 1 Purchase #2 Goods available for sale No. and to $30 in March. FIFO provides a higher inventory value than LIFO. FIFO $4,500 950 3,550 3,000 $ 550 Sales Cost of goods sold Gross profit Operating expense Net income LIFO $4,500 1,200 3,300 3,000 $ 300 As prices increase, FIFO results in higher net income than LIFO. This raises a simple question: why use LIFO? LIFO depresses the balance sheet value of inventory because it allocates the cost of the oldest inventory value to ending inventory. Furthermore, it inflates the value of cost of goods sold, thereby depressing net income—LIFO lowers net income. Making matters worse, LIFO doesn’t reflect reality. Companies actually manage their inventory using FIFO, first-in, first-out. They always stock their shelves from the back. Why use LIFO accounting? Companies use LIFO in order to reduce their income tax provision. By reporting lower net income under LIFO, companies pay lower income taxes. The U.S. Internal Revenue Service permits companies to base income tax payments on LIFO accounting as long as they use LIFO for external reporting, their financial statements. As can be seen in the notes to the financial statements, RIMM uses the FIFO method to account for its inventory. It also provides a breakdown of inventory in the manufacturing process. Raw materials are materials to be used in the manufacturing process, such as plastic and individual electronic components. Work in process are partially completed units, that have entered the assembly line, but have not yet been completed. Finished goods are completed and ready for sale. Inventories Raw materials are stated at the lower of cost and replacement cost. Work in process and finished goods inventories are stated at the lower of cost and net realizable value. Cost includes the cost of materials plus direct labour applied to the product and the applicable share of manufacturing overhead. Cost is determined on a first-in-first-out basis. 5. INVENTORIES—Inventories were comprised as follows: (US$ in thousands) February 26, 2011 Raw materials Work in process Finished goods Provision for excess and obsolete inventories Specific Accounts Page 165 $ 552 222 94 (250) $ 618 February 27, 2011 $ 490 232 55 (117) $ 660 Chapter 6 The Provision for excess and obsolete inventories is a subtraction from inventories, similar to the allowance for bad debts that is subtracted from accounts receivable. Recall that the allowance for bad debts was subtracted from accounts receivable because it represented management’s estimate of how much accounts receivable would not be collected. Similarly, the provision for excess and obsolete inventories is management’s estimate of the cost of inventories that will not be sold. These could be damaged items or old models that customers are no longer interested in. INTERNATIONAL FINANCIAL REPORTING STANDARDS Although U.S. GAAP permits the use of LIFO, IFRS does not. Therefore, international companies that use LIFO in the United States typically use FIFO in other countries. As we noted before, the Internal Revenue Service (IRS) permits companies to base income tax payments on LIFO accounting as long as they use LIFO for external reporting, their financial statements. However, IFRS prohibits LIFO. Therefore, companies adopting IFRS would not be able to comply with this IRS requirement. They would have to give up LIFO and the tax benefit that it offers. To resolve this issue, either (1) companies need to give up LIFO tax benefits, (2) IFRS needs to permit LIFO usage, or (3) U.S. lawmakers need to eliminate the requirement that companies using LIFO for their tax returns also use LIFO for their financial statements. GROSS PROFIT MARGIN The Gross Profit Margin, gross profit divided by sales revenue, expresses gross profit as a percentage of sales revenue. Gross Profit Margin = Gross profit Sales revenue After paying for the cost of purchasing or manufacturing the products sold, how much profit did the company earn? This ratio is the first measure of profitability reported on the income statement. Here we compare RIMM’s gross profit percentage with Motorola Mobility Holdings (MMI). MMI offers RAZR smartphones and Motorola Xoom, among many other mobile technology products. Sales revenue 2010 $19,907 RIMM 2009 $14,953 2008 $11,065 2010 $13,064 MMI 2009 $11,460 2008 $11,050 RIMM’s revenues from 2008 to 2010 increased dramatically, from $11,065 million in 2008, to $14,953 million in 2009, and to $19,907 million in 2010. This is an average increase of 40% per year.2 During the same period, MMI’s sales increased from $11,050 million in 2008 to $13,064 million in 2010. 2 Total increase from 2008 to 2010 is 74.4% [= (19,907 - 11,065) / 11,065]. 79.9% / 2 = 40.0% per year. Specific Accounts Page 166 Chapter 6 Here are the gross profit margins for RIMM and MMI3: Gross profit margin 2010 44.3% RIMM 2009 44.0% 2008 46.1% 2010 25.4% MMI 2009 25.9% 2008 19.5% Not only is RIMM growing a lot faster than MMI, but it is much more profitable. RIMM’s gross profit margin was 44.3% in 2010, 44.0% in 2009, and 46.1% in 2008. For every $100 of sales, RIMM earns $44.30 of gross profit, and incurs $55.70 of cost of goods sold ($100.00 - $44.30). RIMM’s products appear to be very profitable. Although the gross profit margin decreased, it is still much higher than MMI’s. INVENTORY TURNOVER Inventory management requires that companies keep just enough merchandise in stock to satisfy customers’ needs. If they keep too much inventory in stock, items may become obsolete or spoiled. Excessive inventory also soaks up financing costs because companies often borrow money to pay for inventory. However, companies that keep too little merchandise inventory in stock might not be able to satisfy customer demand, losing sales as customers shop elsewhere to find the goods they need. The trend has been for companies to use technology and careful coordination with suppliers to keep inventory levels as low as possible. Inventory turnover indicates the number of times a company sells its average inventory level during the year. It measures how efficiently a company uses its investment in inventory. It is computed by dividing cost of goods sold by inventory: Inventory Turnover = Cost of goods gold Inventory For example, the department store industry reports an average inventory turnover of 6.3, meaning that department stores typically sell their average inventory level about six times per year. Department stores generally restock their shelves four times a year, for four seasons: Spring, Summer, Back-to-School, and Holiday. At the beginning of the season, new clothes are brought out to the front of each department, and clothes from the prior season, are put on sale, with increasing discounts until they are sold. The industry’s inventory turnover, however, is higher than 4.0 because certain items (such as cosmetics and accessories) sell more quickly. 3 Computed as follows. Fiscal year ending in… Sales revenue Gross profit Gross profit margin Specific Accounts 2010 $16,416 8,825 53.7% RIMM 2009 $12,536 6,584 52.5% 2008 $9,411 5,097 54.2% Page 167 2010 $13,064 3,317 25.4% MMI 2009 $11,460 2,965 25.9% 2008 $11,050 2,153 19.5% A B B/A Chapter 6 Here is the Inventory Turnover for RIMM and MMI4: Inventory turnover 2010 6.9 times RIMM 2009 5.4 times 2008 7.3 times 2010 18.2 times MMI 2009 25.1 times 2008 13.6 times When it comes to efficiency in handling inventory, MMI performs much better than RIMM. At 18.2 in 2010, MMI’s inventory turnover is much higher than RIMM’s 6.9. Meanwhile, RIMM’s inventory turnover dropped from 7.3 in 2008 to just 6.9 in 2010. INVENTORY DAYS As with accounts receivable turnover, analysts can convert inventory turnover into “days.” By dividing the number of days in the year by the Inventory Turnover, you can compute the average number of days it takes for a company to sell inventory. Inventory Days = 365 days in the year Inventory turnover This measure is easier to understand than Inventory Turnover. Here are Inventory Days for RIMM and MMI: Inventory days 2010 20 days RIMM 2009 29 days 2008 41 days 2010 26 days MMI 2009 36 days 2008 28 days Here we can see more clearly how quickly the companies sell their inventory. In 2010, RIMM needed just 20 days, on average, to sell inventory. MMI, on the other hand, was selling each unit of inventory within 26 days. RIMM now manages its inventory more efficiently than MMI. 4 Inventory Turnover and inventory Days are computed as follows. COGS Inventory Inventory turnover Inventory days Specific Accounts 2010 $11,082 618 17.9 20 RIMM 2009 $8,369 660 12.7 29 2008 $5,968 682 8.8 41 Page 168 2010 $9,747 701 13.9 26 MMI 2009 $8,495 843 10.1 36 2008 $8,897 688 12.9 28 A B A/B 365/Inv TO Chapter 6 PROPERTY, PLANT, AND EQUIPMENT Property, plant, and equipment are long-term assets expected to benefit future years. This asset category is also called PPE, fixed assets, or capital assets. Land, buildings, machines, computers, and vehicles, when used in a company’s business, are all classified as property, plant, and equipment. As with inventory, a company’s intent and use are very important. For example, dairy cattle—cows that produce milk—are PPE. Beef cattle—cows raised for consumption—would be classified as inventory. PPE is recorded at acquisition cost, also called original cost or historical cost. This includes all costs necessary to prepare the asset for use, including the purchase price, delivery, and set-up costs. Depreciation expense is the systematic allocation of the cost of an asset over the expected useful life of the asset. To illustrate, suppose a company buys a truck costing $20,000 with a five-year life. Recording the whole cost of the truck as an expense of $20,000 in one year would make little sense because the truck will run for four more years. Therefore, the company could record $4,000 depreciation expense in each of five years. This simplifies matters, and a few other considerations need to be made. Land is not depreciated because it is considered to have an indefinite life. Before an asset can be depreciated, a company must estimate the residual value, also known as the salvage value or scrap value. This is the estimated value of the asset at the end of its estimated useful life. The depreciable base, computed as acquisition cost less residual value, is the total amount of depreciation that will be recorded over an asset’s life. On the balance sheet, the account accumulated depreciation appears as a subtraction from the asset’s cost. Accumulated depreciation is the total amount of depreciation expensed since acquisition. Book value is the acquisition cost less accumulated depreciation, the value at which the asset is recorded on the balance sheet. It is also called carrying value; PPE, net; or the cost not yet depreciated. The two most widely used depreciation methods are called Straight-Line (SL) and Double-DecliningBalance (DDB). Straight-line spreads depreciation out equally over all periods. Double-declining-balance is an accelerated method, meaning that it records more depreciation early in the life of an asset, when it is new, and less depreciation when the asset is old. STRAIGHT-LINE DEPRECIATION Straight-line depreciation divides the depreciable base by the life of the asset, recording equal amounts of depreciation expense each year: Depreciation Expense = Depreciable base Expected useful life = Acquisition cost - Residual value Expected useful life To illustrate, suppose that RIMM purchased equipment costing $500,000, with an estimated useful life of five years and residual value of $50,000. Annual depreciation expense would be computed as: Depreciation Expense Specific Accounts = $500,000 - $50,000 5 years Page 169 = $90,000 / year Chapter 6 Over the life of the asset, depreciation expense would be recorded at $90,000 per year, increasing accumulated depreciation, and decreasing book value down to the residual value: SL Year 1 Year 2 Year 3 Year 4 Year 5 Total Depreciation Expense $ 90,000 90,000 90,000 90,000 90,000 $450,000 Accumulated Depreciation $ 90,000 180,000 270,000 360,000 450,000 Book Value (Acq Cost - Acc Dep) = Book Value ($500,000 - 90,000 =) $410,000 ($500,000 - 180,000 =) 320,000 ($500,000 - 270,000 =) 230,000 ($500,000 - 360,000 =) 140,000 ($500,000 - 450,000 =) 50,000 After Year 5, when the asset has been fully depreciated, there is no more need to record depreciation expense; there is no depreciable base left to depreciate. The asset will be reported on the balance sheet at its acquisition cost, less accumulated depreciation, with a book value of $50,000. On the income statement, annual depreciation expense is reported. On the balance sheet, the company will report the acquisition cost, accumulated depreciation, and book value. Our Company BALANCE SHEET (excerpt) December 31, Year 3 Property, plant, and equipment $500,000 Less: Accumulated Depreciation (270,000) Property, plant, and equipment, net $230,000 DOUBLE-DECLINING-BALANCE DEPRECIATION Double-declining-balance is an accelerated depreciation method that records more depreciation expense when an asset is new, and less when the asset is older. It is computed by multiplying the asset’s book value by two times (double) the straight-line depreciation rate: Depreciation Expense = Book value x 2 x 1 Expected useful life As the book value decreases each year, depreciation expense will also decrease. To illustrate, again suppose that RIMM purchased equipment costing $500,000, with an estimated useful life of five years and residual value of $50,000. The first year’s depreciation expense would be computed as: Year 1 Depreciation Expense = 500,000 x 2 x 1 = 200,000 5 This would reduce the book value to $300,000 (= $500,000 - $200,000), so that the second year’s depreciation expense would be computed as: Specific Accounts Page 170 Chapter 6 Year 2 Depreciation Expense = 300,000 x 2 x 1 = 120,000 5 After recording this depreciation expense, book value would decline to $180,000 (= $300,000 - 120,000). The third year’s depreciation expense would be: Year 3 Depreciation Expense = 180,000 x 2 x 1 = 72,000 5 For the Year 4 computation, book value equals $108,000 (= $180,000 - $72,000). Fourth-year depreciation expense would be: Year 4 Depreciation Expense = 108,000 x 2 x 1 = 43,200 5 However, this creates a problem. Year 5 depreciation would be $25,920 (64,800 x 2 x 1/5) and the new book value would equal $38,800 ($64,800 - 25,920). This is below the $50,000 residual value. Therefore, we would stop using DDB depreciation in Year 5, and decrease the book value until it hit the $50,000 residual value. Depreciation in Year 5 would equal $14,800 ($64,800, the Year 4 book value, less the $50,000 residual value). Year 5 Year 4 Book Value – Residual Value = $64,800 - $50,000 = $14,800 The following amounts will be reported in each year’s income statement and balance sheet: DDB Year 1 Year 2 Year 3 Year 4 Year 5 Total Depreciation Expense $200,000 120,000 72,000 43,200 14,800 $450,000 Accumulated Depreciation $200,000 320,000 392,000 435,200 450,000 Book Value Acq. Cost – Acc. Dep. = Book Value ($500,000 - 200,000 =) $300,000 ($500,000 - 320,000 =) 180,000 ($500,000 - 392,000 =) 108,000 ($500,000 - 435,200 =) 64,800 ($500,000 - 450,000 =) 50,000 Our Company BALANCE SHEET (excerpt) December 31, Year 3 Property, plant, and equipment $500,000 Less: Accumulated Depreciation (392,000) Property, plant, and equipment, net $108,000 By Year 5, the asset has been fully depreciated. No depreciation expense will be recorded in subsequent years. Specific Accounts Page 171 Chapter 6 $50. suppose that the company sold this asset for $30. and therefore lower total assets. On the other hand. It would record a gain of $10.800 50.000 in DDB depreciation. A gain or loss on disposal would be reported on the income statement as part of nonoperating revenues and expenses. suppose that the company sells the asset for $60.000 180.000 $410. however. and less productive when old. it will equal the depreciable base. versus $410.000 90. Now. $25. a company using DDB would report lower net income than under SL.$50. DDB reports lower depreciation expense than SL. and lower income under SL. it will equal the residual value.000 120.800 14. under DDB.000 90. would be better depreciated under Double-declining-balance.000 (= $60. the company reports $300. Then.000 230. In Year 1.000.200 64. DDB reports much higher depreciation expense when the asset is new: In Year 1. Therefore. Companies can choose among Straight-Line. In Year 4. For example. assets that provide fairly stable levels of productivity over their useful lives would be better depreciated under Straight-line.000 50. it is a gain. the accounting method used for depreciation has tremendous effect on both net income and total assets.000). or that are more productive when new.000 in DDB book value. If the difference is positive. Specific Accounts Page 172 Chapter 6 . Year 1 Year 2 Year 3 Year 4 Year 5 Total Straight-Line Depreciation Book Value Expense $ 90. or other depreciation methods. its book value will be the same under either method.000 versus $140. after the asset is fully depreciated. the trend reverses.000 43.000 90. Double-declining-balance.COMPARING STRAIGHT-LINE WITH DOUBLE-DECLINING-BALANCE Comparing Straight-line (SL) to Double-declining-balance (DDB) depreciation illustrates the differences between these two depreciation methods.000 108.000 $450. suppose a company acquires an asset for $500. assets that rapidly become obsolete.000 90.000 In short. book value is lower when the asset is new. This means that in Year 1. and then depreciates it down to its residual value. If it’s negative.000 $300. It would record a loss of $20. GAAP requires them to select the method that appropriately allocates costs to the periods benefited. For example. However.000 in SL book value.000 320. Most companies use one method or the other for all of their assets. total depreciation over the life of the asset will be the same.000. To illustrate.000 versus $90. it’s a loss.000. total assets will be lower than under SL. This means that under DDB. GAINS AND LOSSES ON SALE OF PPE The gain or loss on the sale of PPE is computed as the selling price less the book value. this decision is made very carefully. This would mean higher income under DDB.000 140. the company records $200.000 $450. Furthermore.000.000. in Year 4. As the asset ages. $50.000. and $90.000 72.000 .000 Double-Declining-Balance Depreciation Book Value Expense $200. as shown above.000. Furthermore. regardless of which depreciation method is used.000 in SL depreciation. DDB also reports lower book value than SL. 200 300 300 2.000 original cost of the asset). as would be recorded when a company buys a stock one day for $50 a share and sells it for $75. and equipment.000 for the asset. and other Cloud operations and other information technology Manufacturing equipment.000 on the asset (= the $60.000 proceeds less the $500. and equipment We state property. This means that the company really lost $440. and would report a $25 gain. If it recorded too much depreciation. NOTES to the Financial Statements. However.” the company means that book value is multiplied by 20% each year to determine depreciation expense. In the first example. Rather. Depreciation and amortization are recorded using the following rates and methods: Buildings.000 1. We do not amortize construction in progress until the assets are ready for use. however. 2010 $ 100 900 1.000) and the book value ($50. where it uses declining balance. plant. recall that the company paid $500. net Property.800 900 $ 1.400 $ 2.000.000 gain. book value would exceed the fair value of the asset. A typical note regarding accounting policy for PPE reads: Property. the gain or loss on the sale of PPE is not a true gain or loss. book value would be below the fair value of the asset. and the company would report a gain on disposal.000.000 gain.800 400 500 4. the company sold the asset for $60. the difference between the proceeds ($60.200 1. research and development equipment Furniture and fixtures Straight-line between 5 and 40 years Straight-line between 3 and 5 years Straight-line between 2 and 8 years Declining balance at 20% per annum This company uses straight-line depreciation for all categories of PPE except for furniture and fixtures. and equipment at cost less accumulated amortization. accountants would actually report a $10.900 Chapter 6 . and the company would report a loss on disposal. 2011 $ 100 1. By “Declining balance at 20% per annum. plant.600 December 31. Accordingly. the gain or loss on the sale of PPE indicates whether the company recorded too much or too little depreciation on the asset. After considering depreciation of $450. NOTES to the Financial Statements continue for PPE: Property. leaseholds. plant. If the company recorded too little depreciation on the asset. research and development equipment Furniture and fixtures Accumulated depreciation and amortization Net book value Specific Accounts Page 173 December 31. recording a $10. leaseholds and other Cloud operations and other information technology Manufacturing equipment. plant. and equipment comprised the following: Cost Land Buildings.000).Consider the nature of this gain or loss. If RIMM received a loan from the bank. INTERNATIONAL FINANCIAL REPORTING STANDARDS Under U. How long are employees expected to live? How much will employees’ last years’ salaries be? If the company invests money now to cover this liability. it would have a liability to pay for the shipment. These occur when companies promise employees payments or other benefits after they retire. for the rest of their lives after they retire. a current liability. All other liabilities are classified as noncurrent. For example. A single debt can be split up between these categories. This postretirement benefit liability requires careful estimation. For example. Most companies record some kind of accounts payable. and the cost of parts and labor needed to repair or replace defective units. They arise from transactions that occurred in the past. warranty payable.At December 31. and $20 million (December 31. Companies choosing to revalue their assets must revalue all assets within a class of PPE on a regular basis. Any new amounts added to the warranty payable would be recorded as warranty expense. Current liabilities are those due within a year. 2010— $100 million) was included in Cloud operations and other information technology. 2011. Employee pensions. suppose that RIMM provides a free 90-day warranty for parts and services on all of its products. companies record assets at historical cost. called post-retirement benefits.S. These are amounts due to suppliers in the future for the purchase of inventory. If the assets decline in value. companies have the option to revalue PPE to market value on their financial statements. if RIMM purchased and received a shipment of raw materials. But how can it be estimated? RIMM will need to look at sales and past payments made because of the warranty program. 2010—$250 million). Of this amount. For example. As such. it would now have a liability to the bank. and the remaining payments would be classified as noncurrent. For example. leaseholds and other. 2010—$50 million) was included in manufacturing equipment. research and development equipment. companies need to update the warranty payable balance every year. $130 million (December 31. Many liabilities require careful estimates. they may be deemed “impaired. However. GAAP. how much return will it earn on these investments? Specific Accounts Page 174 Chapter 6 . the carrying amount of assets under construction was $300 million (December 31.” and written down to a lower book value. if a company has a long-term debt requiring monthly payments for the next 30 years. the next 12 months’ payments would be classified as current. based on their best estimates of the amounts likely to be paid. CURRENT AND NONCURRENT LIABILITIES Liabilities are amounts owed to creditors. require many estimates. a company might offer employees 50% of their last year’s salary. 2010—$100 million) was included in buildings. creates a liability. This. $150 million (December 31. under International Financial Reporting Standards. of course. Most companies use legal “tax planning” strategies to put off paying taxes until future periods or to avoid paying them completely. Here.The most difficult estimates involve contingent liabilities. DDB delivers lower depreciation expense. However. In June 2011. This means lower taxes when the asset is new. every three months. If it paid less. “Estimable” means that it is possible to estimate how much the company will have to pay. NOTES to the Financial Statements. results of operations. resulting in higher taxes. The Company is confident in the merits of its case and believes that it will prevail on appeal. the Company does not expect that the ultimate costs to resolve these matters will have a material adverse effect on its financial position. accountants may need to predict that outcome—and estimate the payments as a liability—before the lawsuit even goes to trial. companies usually owe some form of income taxes. For example. For example. When the asset is older. and whether or not to record a liability on its balance sheet. This is one strategy companies may use to push tax payments off to future years. IFRS uses the lower standard of “more likely than not. For example. and litigation arising in the ordinary course of business. then it will have to pay the remainder. accountants record a liability when the payment is probable and estimable. For such lawsuits. ABC Company filed a lawsuit. These are for potential liabilities from lawsuits and especially for environmental cleanups. When accounting for contingent liabilities. the Company is subject to legal proceedings. an income tax payable. including intellectual property litigation.000 payment with the tax return. In April 2010. if a company is a defendant in a lawsuit. and then computed total income taxes of $1. The Company has appealed the jury’s verdict. Specific Accounts Page 175 Chapter 6 . Then. In addition. after the end of the year. In most countries. it would owe an additional $150. no reserves have been recorded in this case. If the company paid more than that amount during the year. As they say. Needless to say. Inevitably. While the outcome of these matters is currently not determinable. it has to consider whether it will have to pay damages. Similarly. and higher net income. companies periodically pay estimated taxes during each year. if a company paid $1 million in estimated taxes during the year.000 for the year. this effect reverses when the asset is older. a company can continue to adjust the liability as the situation develops. a jury found the Company had willfully infringed the patent and awarded approximately $2 billion in past compensation damages. the company prepares a tax return to compute the exact amount of taxes owed. accelerated depreciation methods (such as an IRS-sanctioned version of double-declining-balance) can help a company to put off taxes until a future period. DDB delivers higher depreciation and lower net income than straight-line. claims. it will receive a refund. when an asset is new.” meaning that there is a greater than 50% chance that a company will have to make a payment. Recall that. For loss contingences. for an environmental clean-up site. only two things in life are certain: death and taxes.150. However. even before it can fully determine the damage or cost of cleanup. A typical note regarding litigation reads: Litigation There are a number of patent disputes with third parties who claim the Company’s products infringed on patents. a company needs to estimate the liability. these estimates may turn out to be incorrect. say. If so. it can be extremely difficult to predict a jury’s outcome. As a result. or cash flows. “probable” means that the company will most likely have to make a payment. On the balance sheet. One issue is that investors often expect a higher or lower interest rate than that printed on the face of the bond certificate. the company is required only to pay the principal amount. back to the creditor. If so.We know the company will have to pay the taxes—it has just managed to legally defer them to future periods. On the other hand. suppose that RIMM issued $1 billion bonds payable with a rate of 8% printed on the bond. the premium or discount is amortized as an adjustment to interest expense. However. bonds payable are reported as liabilities. the coming year’s payments would be classified as “current portion of long-term debt. semi-annually. RIMM would collect more than the $1 billion principal of the bonds. not the discount or premium. in a fashion similar to how long-lived assets are depreciated. with premiums added to the principal. Over the life of the bond. Discounts would be subtracted from the principal. debtors must pay the principal. called a deferred tax liability. They may require annual or monthly payments. when a bond matures. Companies must make two types of payments for bonds payable. The creditors would be willing to pay a premium on the bond. These strategies create a liability. Then. Second. or the amount due when the loan matures. companies must pay interest. less than the 8% rate printed on the face of the bond. called the market interest rate. Therefore. One specific type of long-term debt is called bonds payable. a premium or discount is reduced to zero. creditors were expecting a rate of 10%. Specific Accounts Page 176 Chapter 6 . First. usually a rate printed on the face of the bond certificate. investors holding the bonds can sell them on bond markets. These are loans with certificates that can be traded among investors. as we stated before. When issuing bonds. suppose that creditors were expecting a rate of 7%.” a current liability. For example. or comes due. Any payments due after that would be classified with noncurrent liabilities. or upon maturity. when the bond becomes due. Interest payments may be due monthly. creditors would require RIMM to sell the bonds at a discount. companies usually receive a premium (because the face rate was higher than the market was expecting) or accept a discount (because the face rate was lower than the market expected). Long-term debt usually refers to bank loans that are due over more than one year. When it prepared to sell the bond to creditors. the face rate of 8% was too low. A company issues bonds to raise large amounts of capital (money). Accordingly. and RIMM would collect less than the $1 billion principal of the bonds. the ratio formulas used may differ from the formulas in the text. The allowance for bad debts records an estimate of the total receivables that are unlikely to be collected. are recorded as part of net income on the income statement. They are recorded on the balance sheet at their market value. are classified as short term.0 times 12 days S&P 500 (2) 14.com (2) There are no official rules governing how these ratios are calculated. Companies’ investments are typically in the stocks and bonds of other companies.4 times 35 days 60% 31.9 times Efficiency 365 / Inventory Turnover 20 days 2009 5. Accounts receivable are moneys to be received by the company from customers. Therefore. investments.0 times Accounts Receivable Days Efficiency 365 / AR Turnover 73 days Gross Profit Margin Inventory Turnover Inventory Days Profitability Gross Profit / Sales Revenue 44% Efficiency Cost of Goods Sold / Inventory 6.msn. Investments intended to be held for only a short time.0 times 37 days (1) Industry: Diversified Communications Services. Any gains or losses on trading securities. bank deposits. Cash and cash equivalents includes physical currency. First-In.8 times 63 days 44% 5. Trading securities are bought and held principally for the purpose of selling them in the near term. This is usually a company’s most liquid asset. For available-for-sale securities.Research in Motion Limited (RIMM) RATIO Type Formula 2010 Accounts Receivable Turnover Efficiency Sales Revenue / AR 5. Industry and S&P 500 ratio averages from moneycentral.3 times 41 days Industry (1) (2) 10. Companies must classify investments in two ways: as short term or long term. Investments intended to be held for longer periods of time are classified as long term. Investments in stock not classified as trading securities are classified as available-for-sale securities. but unrealized gains and losses are recorded as part of stockholders’ equity. This will be subtracted in arriving at net accounts receivable on the balance sheet. accounts receivable. and as trading securities or available-for-sale securities. property. and liabilities. realized gains and losses are recorded on the income statement. whether realized on sale or unrealized (as the investments increase or decrease in market value). and highly-liquid investments with short maturities.2 times 70 days 46% 7. Accounts Receivable Turnover and Accounts Receivable Days measure the speed with which a company collects accounts receivable. SUMMARY This chapter reviews the accounting for cash. Companies can use different cost-flow assumptions to measure the value of inventory. IFRS does not permit use of LIFO. and equipment (PPE).2 times 26 days 39% 10. These are also recorded at market value on the balance sheet.4 times 29 days 2008 5. First-Out (FIFO). Last-Out (LIFO). The Gross Profit Margin measures Specific Accounts Page 177 Chapter 6 . Inventory is merchandise held for sale to customers. usually within a year. plant. and Last-In. inventory. These assumptions include Specific Identification. Specific Accounts Page 178 Chapter 6 . PPE are noncurrent assets expected to benefit future years. among others. on average. Post-retirement benefits are owed to workers when they retire. Long-term debt refers to bank loans due over more than one year. factories. Inventory Turnover and Inventory Days measure how quickly a company sells inventory. Accounts payable are due to suppliers.the profitability on sales of inventory items. Gains and losses on PPE are recorded as the difference between the selling price and the book value. Warranty payable is an estimate of warranty repairs owed to customers for items that they purchased. Liabilities are amounts owed to creditors. Companies list many types of liabilities on their balance sheets. and vehicles. Contingent liabilities are estimated liabilities for lawsuits and environmental clean-ups. such as land. Income taxes payable are owed for tax payments on income earned during the year. Companies can choose between the straight-line and double-declining-balance methods of depreciation. Historical cost is also referred to as _____ cost 24. How long it takes to sell merchandise (2 words) 30. Investments intended to be held for more than one year (2 words) 28. delivery. Inventory cost-flow assumption used to reduce tax liabilities in a period of inflation (abbreviation) 26. Estimate of accounts receivable that may go bad in the future is the _____ for Uncollectibles 4. Bank loans due in more than one year (3 words) 19. Physical currency (such as dollar bills. Valuing investments at the closing stock price (3 words) 10. Another companies’ stock or bond used to store excess cash or provide a long-term return 29. Marketable Securities are _____ investments (2 words) 7. Measures the number of times a company sells its average inventory level during the year (2 words) 18. coins.) and bank deposits 13. Huge amount of debt that can be traded in smaller denominations (2 words) 22. Subtotal that is the first indication of profitability (2 words) 14. Gains and losses recorded when a security is sold and cash received 25. Keeping track of each inventory item purchased and sold (2 words) 27.ACTIVITY 55 CHAPTER 6 CROSSWORD PUZZLE Across 3. Salvage value or scrap value or _____ value 20. Tangible long-term assets whose cost includes the purchase price. Gains and losses reflecting changes in market price 9. Depreciation method spreading cost equally over all periods (2 words) 16. Cost-flow assumption reporting recently purchased inventory on the balance sheet (4 words) 5. Take uncollectible accounts receivable off the company books (2 words) 12. Asset cost not yet depreciated (2 words) 8. Beginning inventory + Purchases = Goods _____ for Sale 6. When sold is reported as COGS on the income statement Specific Accounts Down 1. Report when sales proceeds exceed book value Page 179 Chapter 6 . Securities bought and sold for profit in the near term 11. 360 divided by AR Turnover = AR _____ 17. AR _____ measures how quickly a company collects amounts from customers 23. and set-up costs (4 words) 2. Double-declining balance is an _____ method of depreciation 15. Highly-liquid investments with maturities of 90 days or less (2 words) 21. Not trading securities (3 words) 31. etc. and equipment and dividends.685 6. net Other noncurrent assets TOTAL Assets 05/31/11 05/31/10 05/31/09 $ 16.504 $73. Cash Equivalents.763 31. plant.995 3.629 4.163 12. time deposits. and Short-term Investments. which include marketable equity securities. Q3 One measure of cash flow adequacy is (free cash flow / the debt ratio / return on sales). and Short-term Investments reads: Cash. equipment.913 $47.628 3. Cash Equivalents. Refer to the information presented above to answer the following questions: Q1 Highly-liquid investments with maturities of 3 months or less are classified as (cash and cash equivalents / short-term investments / long-term investments) and investments with maturities of greater than 3 months but less than one year are classified as (cash and cash equivalents / short-term investments / long-term investments).578 $ 8.950 2. which seems like a (high / low) percentage.914 8.811 $61.416 NOTES to the Financial Statements.535 $ 9. The definition of cash equivalents is reported (on the balance sheet / on the income statement / in the notes to the financial statements).922 26. A typical note regarding accounting policy for Cash. cash and cash equivalents plus short-term investments total $__________ million on 5/31/11 that is __________% of total assets. plant. are classified as available-for-sale and are recorded at fair value using the specific identification method.698 2. Q4 Can a company ever have too much cash? (Yes / No) Why? Too little cash? (Yes / No) Why? Specific Accounts Page 180 Chapter 6 .527 1.585 2. Short-term investments.555 5. ORACLE CORPORATION (ORCL) ($ in millions) Cash and cash equivalents Short-term investments Receivables Other current assets Property. which is the amount of cash available from operations after paying for planned investments in property. Cash and cash equivalents primarily consist of highly-liquid investments in time deposits and certificates of deposit with original maturities of 3 months or less.430 1. and government and corporate bonds with original maturities of greater than 3 months but less than one year when purchased.ACTIVITY 56 Purpose: CASH AND CASH EQUIVALENTS • Reinforce understanding of cash and cash equivalents. Q2 For Oracle.857 31. The fair market value of the trading securities reported above is $__________.ACTIVITY 57 Purpose: SHORT-TERM INVESTMENTS • Reinforce understanding of amounts reported for short-term investments. Q5 The income statement accounts listed above would be reported on a multi-step income statement as (operating / nonoperating) revenues and expenses.000 12. During this accounting period the market value of these trading securities has (increased / decreased / can’t tell) by $__________. $__________ was collected in cash during this accounting period and $__________ is the amount of cash to be received in the future. Q1 Investments classified as short term are intended to be sold or liquidated in (one year or less / more than one year). these securities must have been originally purchased for $__________.000 200. Specific Accounts Page 181 Chapter 6 .000 Refer to the information presented above to answer the following questions. Assume this is the first year of operation.) Q6 As a result of the financial statement information listed above. Q3 If these securities were sold next year.000 5. indicating these are revenues and expenses from (operating / investing / financing). Year 1 net income will (increase / decrease) by $__________. Because this is the first year of operation. Q2 Trading securities are reported on the balance sheet at their (acquisition cost / market value). (Circle all that apply.000 INCOME STATEMENT ACCOUNTS—Year 1 Interest revenue Dividend revenue Unrealized loss on trading securities $ 4. Q4 The amount of interest earned during this accounting period was $__________.000 $ 231.000 1. a(n) (realized / unrealized) loss would be reported if the selling price was less than the (acquisition cost / market value at the end of last year / current market value). Of this amount. BALANCE SHEET ACCOUNTS—December 31. Year 1 Cash Short-term investments—Trading securities Interest receivable Total current assets $ 30. After the write-off. Specific Accounts Page 182 Chapter 6 .000 INCOME STATEMENT ACCOUNTS—Year 5 Sales revenue Bad debt expense $ 800. and Accounts receivable. the accounts would report: Accounts receivable ($88. The write-off of an uncollectible account changes (total assets / net income / both / neither). This is an application of the (cost / matching / historical cost) principle.000). Using the above amounts. net ($84. Year 5 Accounts receivable Allowance for bad debts Accounts receivable.000 owed by Customer Ryan was written off as uncollectible.000 / $86.000 / $6. total assets will increase by $__________. Q2 The total amount customers owe the company on account on December 31.000 / $4.000 15. and of that amount. Above. Q3 Bad debt expense is the portion of (accounts receivable / sales revenue) that is estimated as uncollectible and reported as a(n) (operating /nonoperating) expenses on a multi-step income statement. Q4 Bad debt expense is a(n) (estimated / known) amount calculated (at the end of / during) each accounting period and recorded as an adjustment. Allowance for bad debts ($2.000 / $90. Nonoperating revenues and expenses are also referred to as other gains and losses. assume that $2. BALANCE SHEET ACCOUNTS—December 31. the (allowance / direct write-off) method is used to report uncollectible accounts.000 (4.000 / $88.000). net is also referred to as net realizable value. Bad debt expense is also referred to as doubtful-account expense or uncollectible account expense. $__________ is estimated to be uncollectible. As a result of the financial statement information listed above.ACTIVITY 58 Purpose: ACCOUNTS RECEIVABLE • Reinforce understanding of amounts reported on the financial statements for accounts receivable.000 Refer to the information presented above to answer the following questions: Q1 The allowance for bad debts is the portion of (accounts receivable / sales revenue) that is estimated as uncollectible and is reported on the balance sheet as a (current asset / noncurrent asset / current liability / noncurrent liability / stockholders’ equity).000) 86. $__________ is estimated to be uncollectible and $__________ is estimated to be collectible. net $ 90. The adjustment to record bad debt expense changes (total assets / net income / both / neither).000 / $92. sales revenue earned during Year 5 totals $__________. Why? Q5 Above. Year 5 is $__________. Why? Note: Accounts receivable. Of this amount.000). Specific Accounts Page 183 Chapter 6 . has come to you seeking a loan of $350. Q4 Would you feel comfortable granting a loan based on the information above? (Yes / No). d. and then in Year 7 it (increased / decreased). what additional information would you request before granting a loan? Explain. Cost of goods sold: In Year 6 it (increased / decreased). He proposes to use his accounts receivable as collateral for the loan and has provided you with the following financial statements. Accounts receivable: In Year 6 it (increased / decreased). and then in Year 7 it (increased / decreased). b. Q2 Compute the Accounts Receivable Turnover ratio and the Allowance as a Percentage of Sales ratio for each of the three years. and then in Year 7 it (increased / decreased). Comment on any unexpected or suspicious observations. owner of CI Manufacturing. f. e.ACTIVITY 59 Purpose: EVALUATING ACCOUNTS RECEIVABLE • Analyze trends in Accounts Receivable and the Allowance for Bad Debt accounts.475 876 599 518 $ 81 $1. c.000 for new manufacturing equipment to expand his operations. Chris Ives. What information do these ratios reveal? Q3 The amount reported for the allowance for bad debts is a(n) (known / estimated) amount so this amount (can / cannot) be manipulated. Inc. If not. Record in the chart above. and then in Year 7 it (increased / decreased). Sales revenue: In Year 6 it (increased / decreased). Operating income: In Year 6 it (increased / decreased). ($ in thousands) Year 7 Year 6 Year 5 $1.502 905 597 453 $ 144 $ 458 23 $ 387 31 $ 374 29 Income Statement Sales revenue Cost of goods sold Gross profit Operating expenses Operating income Balance Sheet Accounts receivable Allowance for bad debts Ratio Analysis Accounts receivable turnover ratio Allowance as a percentage of sales revenue Q1 Examine the trend in each of the following accounts. Assume you work in the corporate loan office of Lanford Bank. Allowance for bad debts: In Year 6 it (increased / decreased). a.589 947 642 487 $ 155 $1. and then in Year 7 it (increased / decreased). The manager knows net income for this year is lower than what is needed to qualify for additional financing at his current bank. Q3 To qualify for the bank loan. but may result in huge (short-term / long-term) costs. The manager also realizes some of the estimates used to calculate net income could be adjusted to make net income come within the qualifying range for an additional loan. overestimating bad debt expense will result in (understating / having no affect on / overstating) the allowance for bad debts and (understating / having no affect on / overstating) accounts receivable. unethical decisions make the (short term / long term) appear better. Q1 On the income statement. Specific Accounts Page 184 expense will result in operating expenses and Chapter 6 . Q7 Discuss some ways the misstatement of bad debt expense could be detected by bank officials. Q2 On the balance sheet. Q8 In general.ACTIVITY 60 Purpose: ETHICS AFFECTING FINANCIAL STATEMENT AMOUNTS • Understand the effect ethical decisions have on amounts reported for accounts receivable. the manager should (over / under) estimate bad debt expense. net. A manager of a small electronics store would like to expand and also sell computers. Why? Q4 Is intentionally misstating an estimate ethical? (Yes / No / Maybe) Why? Q5 Is intentionally misstating an estimate legal? (Yes / No / Maybe) Why? Q6 List some possible consequences if bank officials detect the misstatement of the estimate. overestimating bad debt (understating / having no affect on / overstating) (understating / having no affect on / overstating) net income. The expansion would require seeking a loan from a local bank. As a result of using LIFO.) Q2 Does the answer for Q1 comply with the Consistency Principle? (Yes / No) Explain.039) million if the first-in. first-out (FIFO) method had been used to value all inventories and ($9.951 312 8. Q1 General Electric uses the (FIFO / Weighted Average / LIFO) inventory cost-flow assumption(s). Refer to Note 11 above to answer Q3 through Q7. Year 6. This tax benefit is achieved by allocating the higher.894 Finished goods 4. Note 11: GE Inventories (Adapted) ($ in millions) December 31. Q4 Circle the effect the LIFO cost-flow assumption has had on reported financial statement amounts since GE began operations. $606 million (more / less) in ending inventory.645 Less revaluation to LIFO (606) $9. (Circle all that apply. Q7 General Electric would appear more profitable if it used (FIFO / LIFO) to determine the value of all inventories. $606 million (more / less) in income before income tax.ACTIVITY 61 Purpose: INVENTORY • Reinforce understanding of amounts reported for inventory from using different cost-flow assumption. first-out (LIFO) basis. All inventories are stated at the lower of cost or realizable values. $242 million ($606 million x 40%) (more / less) in tax expense. Cost for substantially all of GE’s U.971 (676) $8. inventories is determined on a last-in.295 Refer to Note 1 above to answer Q1 and Q2. b.379 Unbilled shipments 372 9. LIFO or FIFO. $606 million (more / less) in cost of goods sold (COGS). first-out (FIFO) basis.645 / $9. first-out (LIFO) method were used to value the domestic portion of inventories. assuming a 40% tax rate. GENERAL ELECTRIC COMPANY (GE) Note 1: Summary of Significant Accounting Policies Inventories.S. Would it really be more profitable? (Yes / No) Explain. the balance sheet would have reported inventories of ($9.708 3.039 Year 5 $4. c. Q6 In a period of inflation. d. Cost of other GE inventories is primarily determined on a first-in. Q3 On December 31. Specific Accounts Page 185 Chapter 6 . GE has reported: a.645 / $9.039) million if the last-in. more current inventory costs to (COGS / Ending Inventory). which indicates there probably (was / was not) a LIFO liquidation. Q5 The revaluation to LIFO (decreased / increased) from Year 5 to Year 6. the cost-flow assumption resulting in the lowest taxable income is (FIFO / Weighted Average / LIFO). Year 6 Raw material and work in process $4. FIFO assumes the first units purchased are the first units sold during the accounting period. (FIFO / LIFO) allocates the higher. (FIFO / LIFO) reports the greatest amount for COGS (Cost of goods sold).600 Goods available for sale Q1 90 units $2. b. Two commonly used cost-flow assumptions are first-in.900 Assume 60 units were sold. In a craft store. more recent costs to the balance sheet.ACTIVITY 62 Purpose: INVENTORY: LIFO AND FIFO CALCULATIONS • Compute COGS and Ending Inventory when using the LIFO and FIFO cost-flow assumptions. custom-built homes. This method is used when dealing with unique and expensive inventory items such as jewelry. first-out (LIFO). Jan 1 Beg inventory 20 units @ $20 per unit = $ 400 Feb 1 Purchase #1 30 units @ $30 per unit = 900 Mar 1 Purchase #2 40 units @ $40 per unit = 1. first-out (FIFO) and last-in. The specific identification inventory method tracks when each inventory item is purchased and sold. and GAAP allows companies to select an inventory cost-flow assumption to allocate costs between cost of goods sold and ending inventory. In a period of inflation: a. Which 60 units were really sold? Specific Accounts Page 186 Chapter 6 . FIFO LIFO COGS $ $ ENDING INVENTORY $ $ Q2 Examine the results above. whereas LIFO assumes the last units purchased are the first units sold during the accounting period. Use the information in the chart immediately below to answer the following questions. c. Many times tracking individual units is not cost effective. Using FIFO and LIFO. imagine trying to track when each wooden bead or Styrofoam cone is purchased and then sold. At the end of the accounting period inventory costs must be assigned to either cost of goods sold or ending inventory so the financial statements can be prepared. calculate the cost allocated to cost of goods sold (COGS) and ending inventory in the space provided below. or automobiles. Q3 Assume the 60 units in Q1 sold for $100 each and operating expenses total $3. b. which results in (lower / higher) COGS and. c. (FIFO / LIFO) results in less income tax expense. complete the income statement in the space provided below. In a period of inflation: a. 3. therefore. but do not allow (FIFO / LIFO) Specific Accounts Page 187 Chapter 6 . (lower / higher) operating income. therefore. Using FIFO and LIFO.500 $ Examine the income statement above. FIFO allocates the (recent / older) inventory costs to COGS. (lower / higher) operating income. which results in (lower / higher) COGS and.500.500 $ 3. INCOME STATEMENT—Sell 60 units for $100 each FIFO Sales revenue $ LIFO $ COGS Gross profit Operating expenses Operating income Q4 Q5 . International Financial Reporting Standards allow (FIFO / LIFO). LIFO allocates the (recent / older) inventory costs to COGS. does it have cans of Coca-Cola that have been sitting in the warehouse since the company started business? (Yes / No) Summarize the effects of using the FIFO and LIFO cost-flow assumptions on COGS and Ending Inventory by circling the type of costs allocated to each below.000 a. Q2 Q3 What costs remain in ending inventory? The Coca-Cola Company is more than 100 years old.000 units.000 Purchase #2 1. How much is goods available for sale? $_________ Sell 1. YEAR 2: What costs remain in ending inventory? Beginning inventory ________ units @ $_____ per unit = $_________ $_________ Purchase 2.000 a. How much is goods available for sale? $_________ Sell 2. YEAR 3: What costs remain in ending inventory? Beginning inventory ________ units @ $_____ per unit = $_________ $_________ Purchase 3.000 units @ $1 = $1. b. Coca-Cola uses the LIFO cost-flow assumption. So how old are those inventory costs on the balance sheet? b.000 units @ $2 = $4.000 units @ $3 = $9.ACTIVITY 63 Purpose: Q1 INVENTORY: THE EFFECTS OF LIFO • Understand if recent or older costs are allocated to the income statement or the balance sheet when using LIFO and FIFO.000 a. FIFO Q4 $_________ LIFO COGS (Recent / Older / Ancient) (Recent / Older / Ancient) Ending inventory (Recent / Older / Ancient) (Recent / Older / Ancient) May a company use LIFO for tax purposes and FIFO for external reporting to shareholders? (Yes / No) Why would a company want to do this? Specific Accounts Page 188 Chapter 6 .000 units @ $1 = $1.000 units. b. b. How much is goods available for sale? $_________ Sell 3. YEAR 1: Purchase #1 1. When will Coca-Cola get those “ancient” LIFO inventory costs off of the balance sheet? c. a. Use the LIFO cost-flow assumption to answer the following questions. Because Coca-Cola uses LIFO.000 units. Kroger (KR) (grocery) (70% / 40% / 20%) (25% /20% / 2%) d. INVENTORY TURNOVER RATIO = Q2 Cost of goods sold Inventory Guess the inventory turnover ratio for each of the following companies: a. What do the above ratios reveal about each of the companies? e. The gross profit margin (GP%) compares gross profit to sales revenue. Kroger—(grocery) (4 / 8 / 12 / 35) c. f. This ratio is the first measure of profitability reported on the income statement. INVENTORY TURNOVER RATIO The inventory turnover ratio indicates the number of times a company sells its average inventory level during the year. It expresses gross profit as a percentage of sales. The information for both the numerator and denominator of the ratios above come from the (balance sheet / income statement / statement of cash flows). ROS. Wal-Mart—(discount retailer) (4 / 8 / 12 / 35) b. Dell Computer—(computer) (4 / 8 / 12 / 35) d. Apple (AAPL) (computers) (70% / 40% / 20%) (25% /20% / 2%) c. JC Penney—(department store) (4 / 8 / 12 / 35) Q3 What does the inventory turnover ratio reveal about each of the companies? Q4 What are some of the costs of holding inventory? Specific Accounts Page 189 Chapter 6 . Gross profit margin is the (first / second / last) indication of profitability on the income statement.ACTIVITY 64 Purpose: GROSS PROFIT MARGIN • Understanding that gross profit margin. Bristol-Myers Squibb (BMY) (pharmaceuticals) (70% / 40% / 20%) (25% /20% / 2%) b. It measures how efficiently a company uses its investment in inventory. GROSS PROFIT MARGIN = Q1 Gross profit Sales revenue Guess the GP% and ROS for each of the following companies: GP% ROS a. It is a measure of efficiency. and inventory turnover ratios vary by industry. double counting a portion of ending inventory will result in (understating / having no affect on / overstating) cost of goods sold (COGS) and (understating / having no affect on / overstating) gross profit. Q7 Discuss some ways the double counting of inventory could be detected by management. and Q2 On the income statement. Q1 On the balance sheet. Why? Q4 Is intentionally double counting ending inventory ethical? (Yes / No / Maybe) Why? Q5 Is intentionally double counting ending inventory legal? (Yes / No / Maybe) Why? Q6 List some possible consequences if upper management detects double counting of ending inventory. This year the manager is only two thousand dollars short from qualifying for a sizable yearend bonus. double counting a portion of ending inventory will result in (understating / having no affect on / overstating) ending inventory (understating / having no affect on / overstating) total assets. The manager is in a position to have a portion of the inventory counted twice in the year-end physical inventory count. the manager (should / should not) double count over two thousand dollars of ending inventory. Q3 To qualify for the year-end bonus.ACTIVITY 65 Purpose: ETHICS AFFECTING FINANCIAL STATEMENT AMOUNTS • Understand the effect ethical decisions have on amounts reported for inventory. Cost of goods sold is adjusted for any changes to year-end inventory. Specific Accounts Page 190 Chapter 6 . A manager of a men’s clothing store receives a bonus based on the amount of gross profit earned by the department. On a multi-step income statement. Q2 The portion of the equipment’s original cost expensed since it was purchased is $__________. Assuming straight-line depreciation is used. Q5 Book value (is / is not) the same as current value. Specific Accounts Page 191 Chapter 6 . Q8 By purchasing additional property. $__________ will be added into total assets and Year 5 net income will (increase / decrease) by $__________. which is an application of the (cost / matching / consistency) principle.000 Loss on sale of land (3. Q3 Depreciation expense is a(n) (estimated / known) amount recorded (at the end of / during) each accounting period as an adjustment. depreciation expense is reported as an (operating expense / nonoperating revenues and expenses). Explain. Explain what this means.000) Refer to the financial statement information presented above to answer the following questions. Q4 The (straight-line / double-declining-balance / neither) method(s) of depreciation will result in greater depreciation the first year of an asset’s useful life and the (straight-line / double-decliningbalance / neither) method(s) will result in greater total depreciation over the asset’s useful life.000 Accumulated depreciation (150. it appears the equipment was purchased __________ years ago. PLANT. BALANCE SHEET ACCOUNTS—12/31/Year 5 Equipment $ 400.000 INCOME STATEMENT ACCOUNTS—Year 5 Depreciation expense $ (50. plant.000) Gain on sale of equipment 7.000) Book value $ 250. equipment was sold for $__________ more than (acquisition cost / book value / market value) whereas land was sold for $__________ less than (acquisition cost / market value). plant. the company is investing in (short-term / long-term) income-producing assets that are expected to (increase / decrease) future revenues. The primary purpose of depreciation is (cost allocation / current valuation). AND EQUIPMENT • Reinforce understanding of property. Q6 During the year. The company got a better deal on the sale of the (equipment / land / can’t tell).ACTIVITY 66 Purpose: PROPERTY. and equipment. Q1 The amount originally paid (acquisition cost) to purchase the equipment was $__________. Q7 As a result of the financial statement information above. The cost allocated to Year 5 for use of the equipment is $__________. and equipment amounts reported on the financial statements. which was capitalized and recorded as a(n) (noncurrent asset / expense). 000 $260.000_ Year 3 ___________ ___________ ___________ Year 4 ___________ ___________ ___________ Year 5 ___________ ___________ ___________ Total ======== Q2 Record amounts reported on the income statement and the balance sheet over a six-year period in the chart below. Accumulated Depreciation is the total amount of depreciation expensed since acquisition. and set-up costs. accumulated depreciation. Property.000 has an estimated useful life of five years and a residual value of $50.000 140. Two widely used depreciation methods include straight-line (SL) and double-declining balance (DDB).000 _260. Record depreciation expense. Double-Declining-Balance (DDB) depreciation is an accelerated method. net = Cost not yet depreciated = Amount reported on the balance sheet and added to arrive at total assets STRAIGHT-LINE DEPRECIATION Q1 Equipment costing $400. and book value in the chart below for each year of the five-year useful life using the straight-line method of depreciation. Residual Value = salvage value = scrap value The estimated value of the asset at the end of the estimated useful life.000 Page 192 Year 3 Year 4 Year 5 Year 6 $ $ $ $ $ $ $ $ $ $ $ $ Chapter 6 . Book value = Acquisition Cost minus Accumulated Depreciation = Carrying value = PPE. delivery.ACTIVITY 67 Purpose: PPE: STRAIGHT-LINE DEPRECIATION • Compute depreciation using the straight-line method. Plant. SL Depreciation Expense Accumulated Depreciation Book Value = Acquisition Cost – Accumulated Dep Year 1 ___________ ___________ ___________ Year 2 ___________ __140.Residual Value Depreciation is the allocation of the Depreciable Base over the expected useful life of the asset. StraightLine (SL) depreciation allocates an equal amount of expense to each year of the asset’s expected useful life. Year 1 Income Statement Depreciation Expense Balance Sheet Acquisition Cost Accumulated Dep Book Value Specific Accounts $ $ $ Year 2 $ $400. • Understand what amounts are reported for depreciation on the financial statements. which allocates more expense to the early years of the asset’s useful life.000. Depreciable Base = Acquisition Cost . and Equipment = PPE = fixed assets = capital assets Acquisition Cost = Original cost = Historical cost = The amount reported as the acquisition cost of PPE includes all costs to make the asset operational including purchase. 000 400. Equipment costing $400.000 400.000 Year 2 ___________ _________ ___________ Year 3 ___________ _________ ___________ Year 4 ___________ _________ ___________ Year 5 ___________ _________ ___________ Total =========== Record the amounts reported on the income statement and the balance sheet over a six-year period.000.000 has an estimated useful life of five years and a residual value of $50. Straight-Line Rate = (1 / Useful Life) DDB Rate = Straight-Line Rate x 2 = Double the Straight-line Rate SL Rate Double It = DDB Rate a. Compute the Double-Declining-Balance (DDB) Rate for each useful life below.160. • Understand what amounts are reported for depreciation on the financial statements. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Income Statement Depreciation Expense $ $ $ $ $ $ $ $ $ $ $ $ $ $ Balance Sheet Acquisition Cost $ Accumulated Dep Book Value Specific Accounts $400.000 * 40% = 160. Complete the table below for Years 2–5 using the DDB method of depreciation. 3 year life ___________ x2 ___________ Q2 .000 - 0 = 400. 10 year life ___________ x2 ___________ c.ACTIVITY 68 PPE: DOUBLE-DECLINING-BALANCE DEPRECIATION Purpose: Q1 • Compute depreciation using the double-declining-balance method.000 Page 193 Chapter 6 .000 256.000 $ $144.000 = 240.000 Year 1 160. Beginning Book Value x DDB Rate = DDB Depreciation Expense Depreciation Expense DDB Acquisition Q3 Accumulated Depreciation Book Value = Acquisition Cost – Accumulated Dep 400. 5 year life 1/5 = 20% x2 ___40% b.000 . net income that is (higher / equal / lower) than the SL depreciation method. the (SL / DDB / either) method can be used. the DDB depreciation method reports: a. depreciation expense that is (higher / lower) than the SL depreciation method. In the first year of an asset’s useful life. In the final year of an asset’s useful life. accumulated depreciation of $10. Q5 If an asset has an acquisition cost of $20. d. then on average. and no residual value. the DDB depreciation method reports: a. Chapter 6 . depreciation expense that is (higher / equal / lower) than the SL depreciation method. total assets that are (higher / lower) than the SL depreciation method. (SL / DDB) is usually preferred. Why? Q11 May a company choose one depreciation method for reporting to shareholders and a different depreciation method for tax purposes? (Yes / No) Specific Accounts generally appears better to Page 194 shareholders when using (SL / DDB). Q3 Book value (does / does not) depend on the depreciation method used. Q9 The company Why? Q10 For tax purposes. b. net income that is (higher / lower) than the SL depreciation method. the (SL / DDB / either) method can be used. Q7 If a building is being depreciated.ACTIVITY 69 Purpose: Q1 Q2 PPE: COMPARING SL AND DDB • Understand how SL and DDB depreciation methods affect the financial statements. the assets are (recently purchased / about half way through their useful lives / old and ready to be disposed of / can’t tell). total assets that are (higher / equal / lower) than the SL depreciation method. Q8 Land (is / is not) depreciated because it has an indefinite life.000. c. accumulated depreciation that is (higher / lower) than the SL depreciation method. which means that a greater amount of depreciation expense is reported at the (beginning / end) of the asset’s useful life. If an auto is being depreciated. accumulated depreciation that is (higher / equal / lower) than the SL depreciation method.000. Q6 An accelerated depreciation method is (SL / DDB). Q4 Book value (is / is not) the same as the current selling price of the asset. b. d. c. $ _______________ DDB $ _______________ At the end of Year 2.000 $ 22. (Gain / Loss) of $____________ c. 3. a.000.000 and a selling price of $10.000. • Understand that the effect on net income equals the cost of using the asset over the useful life of the asset.000 with a 10-year estimated useful life and no estimated residual value is sold at the end of Year 2 for $22.000 and a selling price of $10.000. Record in the chart below. (Gain / Loss) of $____________ b. Q3 SL 1. book value of $10. Straight-line Double-declining-balance Selling Price $ 22. Why? Specific Accounts Page 195 Chapter 6 . Why? Compute the gain (loss) on the sale for the SL and DDB depreciation methods. book value of $8. Over the life of this asset.000 . Gain (Loss) = Selling Price . Compute the book value at the time of sale (at the end of Year 2). the effect on net income is the (same / different) for SL and DDB.Book Value Revenues are earned when engaging in the primary business activity and reported at their gross amount. The market value and the book value are (the same / different) for SL. Gains (Losses) are reported when a peripheral asset is sold and the selling price is reported net of book value as of the date of sale. the market value of the equipment is $ _______________. (Gain / Loss) of $____________ Q2 Equipment purchased for $30. Compute the effect on net income for SL and DDB from purchase to sale of the asset.Book Value $ ________________ $ ________________ = Gain (Loss) on the Sale $ ________________ $ ________________ Q4 a. 4. b.000.000 and a selling price of $10. 2.ACTIVITY 70 Purpose: PPE: GAINS AND LOSSES • Compute gains and losses on the sale of PPE. The market value and the book value are (the same / different) for DDB. Straight-line Double-declining-balance Year 1 Depreciation Expense $ ________________ $ ________________ Year 2 Depreciation Expense $ ________________ $ ________________ Gain (Loss) on the Sale $ ________________ $ ________________ = Increase (Decrease) in Net Income $ ________________ $ ________________ b. Q1 Compute the gain (loss) for Fancy Florist on the sale of a van with a: a. book value of $11. Is intentionally choosing one depreciation method for financial purposes and a different method for income tax ethical? (Yes / No / Maybe) Legal? (Yes / No / Maybe) Q7 a depreciation method that reports Legal? (Yes / No / Maybe) Explain. plant. Q3 Is intentionally choosing ethical? (Yes / No / Maybe) Q4 Depreciation expense is based on estimates of useful life and residual value. the controller would (shorten / lengthen) the useful life and (raise / lower) the residual value of the asset.ACTIVITY 71 Purpose: ETHICS AFFECTING FINANCIAL STATEMENT AMOUNTS • Understand the effect ethical decisions have on amounts reported for property. Q1 GAAP allows choices with regard to depreciation methods. higher net income statement purposes Identify at least three items that the controller could use to make net income appear more favorable with regard to the depreciation of assets placed in service during the current year that are both ethical and legal. In the first year of an asset’s useful life. if the straight-line rather than the double-declining-balance depreciation method is used then: a. Specific Accounts Page 196 Chapter 6 . For financial statement purposes. Q6 a. which leads to (lower / higher) book value and (lower / higher) total assets. Q2 To make net income appear as favorable as possible. For income tax purposes. Q5 Is intentionally choosing an estimated useful life and residual value that report higher net income ethical? (Yes / No / Maybe) Legal? (Yes / No / Maybe) Explain. Financial analysts have predicted that net income will increase by 5% for a major corporation. a company generally prefers to report (lower / higher) net income and therefore would choose the (straight-line / double-declining-balance) depreciation method. and equipment. which leads to (lower / higher) net income. To make net income appear as favorable as possible. b. a company generally prefers to report (lower / higher) taxable income and therefore would choose the (straight-line / double-declining-balance) depreciation method. reported accumulated depreciation will be (lower / higher). c. the controller would choose the (straight-line / double-declining-balance) depreciation method for assets placed in service during the current year. b. Corporate management has suggested that the controller do what is necessary to meet these predictions. reported depreciation expense will be (lower / higher). The controller decides to examine depreciation expense because the amount is based on estimates of useful life and residual value and GAAP allows choices with regard to depreciation methods. 400 11. and d. Year 2 Dec 31. As a result. (increase / decrease / depends) net income.500 6.500 $ 4. b.900 Jan 2. (increase / decrease / depends) total assets. Year 2 Dec 31. Year 1 $ 4. Refer to the related financial information below to answer the following questions. (increase / decrease / depends) comprehensive income. and d. Q4 Assume the 100 shares of Coca-Cola stock were sold for $76 per share during Year 4. BALANCE SHEET ASSETS: Long-term investments SE: Accumulated other comprehensive income—Unrealized gain/(loss) on investments INCOME STATEMENT Other comprehensive income— Unrealized gain/(loss) on investments STATEMENT OF CASH FLOWS INVESTING ACTIVITIES: Cash inflows (outflows) Q3 Dec 31.600 Complete the chart below to reflect how the above information would be reported on the financial statements. (increase / decrease / have no effect on) total assets.400 $ 18. Specific Accounts Page 197 Chapter 6 . Q5 When available-for-sale securities are sold at a gain. c. Year 3 COCA-COLA (100 shares) IBM (100 shares) Total Q2 $ 7.000 $ 10. (increase / decrease / have no effect on) comprehensive income. c. (increase / decrease / depends) stockholders’ equity. These equity securities are classified as available-for-sale because the intent is to hold them for several years. Fair Market Value Dec 31.800 Cost Dec 31. (increase / decrease / have no effect on) stockholders’ equity.300 7.ACTIVITY 72 Purpose: Q1 LONG-TERM INVESTMENTS • Reinforce understanding of investments classified as available-for-sale securities Assume Winfield Corporation purchased 100 shares of Coca-Cola stock and 100 shares of IBM stock on January 2.600 10. b.000 $ 14. this event will: a. Year 3 Dec 31. Year 1. this event will: a.600 $ 12. (increase / decrease / have no effect on) net income. Year 1 $ $ $ $ $ $ Year 3 $ Year 2 $ Year 3 $ Year 1 $ Year 2 $ Year 1 $ When available-for-sale securities increase in value. Year 1 $ 5. the Year 4 income statement would report a (realized / unrealized) gain of $__________ as an (operating / nonoperating) revenue and the Year 4 statement of cash flows would report a cash (inflow / outflow) of $__________ in the (operating / investing / financing) activity section. they are recorded at their (face / present) value.245 510 389 271 7. mature in 2030 Bond discount Long-term debt INCOME STATEMENT ACCOUNTS—Year 5 Sales revenue Post-retirement benefit expense Warranty expense Interest expense (related to the bond payable) ($ in millions) $ 6. Of this amount.000 698 275 220 Refer to the information presented above to answer the following questions. After issuance.415 51 2. Q3 Warranty costs related to Year 5 sales total ($275 / $510 / $785) million and warranty costs expected to be incurred in the future total ($275 / $510 / $785) million. These amounts are (known / estimated). Year 5 Accounts payable Warranty liability Income taxes payable Current portion of long-term debt Total current liabilities Deferred income taxes Post-retirement benefit liabilities Bonds payable. and therefore.ACTIVITY 73 Purpose: • CURRENT AND NONCURRENT LIABILITIES Reinforce understanding of amounts reported on the financial statements for current and noncurrent liabilities. BALANCE SHEET ACCOUNTS—Dec 31. Specific Accounts Page 198 Chapter 6 . the actual cost of borrowing is (greater than / equal to / less than) 8%. This is an application of the (matching / cost / reliability) principle. The above bond has a current carrying value of $__________ million that will continue to (increase / decrease) until maturity. Q2 The purchase of inventory will usually increase the (accounts / notes / mortgage) payable account. Q4 There is ($271 / $631 / $902) million of total debt outstanding (not including bonds). Q1 (Current / Noncurrent) liabilities are obligations due within one year or within the company’s normal operating cycle if longer. At maturity. Obligations due beyond that time are classified as (current / noncurrent) liabilities.500 (156) 2. 8%. the issuing corporation will pay $__________ million to the holder of the bond. they are reported at their (present / fair market / amortized) value.344 631 $ 50. Q7 Post-retirement benefits are expensed and recorded as a liability in the year of (employment / retirement). the company plans to pay ($271 / $631 / $902) million during the following year and pay ($271 / $631 / $902) million in later years. Q5 When bonds payable are issued. Q6 The bond payable was issued at a discount because the market interest rates were (higher than / equal to / lower than) 8%. This year’s interest payment totaled ($156 / $200 / $220 / $250) million while this year’s cost of borrowing totaled ($156 / $200 / $220 / $250) million.390 2. Q6 Explain the prime lending rate and its importance with regard to other lending rates. __________% for a 30-year fixed-rate mortgage with no points. Q4 Explain why the reported interest rates differ between (b) and (c) above.) ___________________________________ Q2 The current prime-lending rate is __________%. __________% for a traditional savings account. These rates are available on the Internet and at a local bank or credit union. c. newspaper. Please note the source of your information: (financial institution. Q5 Explain why the reported interest rates differ between (c) and (d) above. Please note the source of your information: (financial institution. b. The current rates banks/credit unions are offering/asking are: a. etc. etc. d. __________% for a one-year certificate of deposit (CD). Website.ACTIVITY 74 Purpose: Q1 CURRENT MARKET INTEREST RATES • Benchmark current market rates and understand why they differ among various financial instruments. newspaper. __________% for a standard credit card. Research the following current interest rates. Website.) ______________________________________________ Q3 Explain why the reported interest rates differ between (a) and (b) above. Specific Accounts Page 199 Chapter 6 . which is the interest rate charged by banks to their most creditworthy customers (usually the most prominent and stable business customers). A $50.000 / $10. A Bond Issuance raises large amounts of capital ($$$) by issuing many bonds of small denominations (e. Bond Prices For example.000 / $20.000) in interest payments and repay ($1.000) annually to the holder of this bond.000 / $10. which is $__________. a.000.000 / $20.000 bond issued at 103 will sell for ______% of the face value. Over the life of the bond.000 Stated rate 10% Matures in 10 years Q2 The issuing corporation makes interest payments of ($1. • Compute interest payments on a bond payable.000 bond issued at 99 will sell for ______% of the face value. b. par. for a total cash outflow of ($1.000) over the life of the bond.000 / $10.000 / $10. if a $100.g. which is $__________.000).000) of principal at maturity. Principal = Maturity Value = Face Value = the amount the issuing corporation pays to the holder of the bond at maturity Stated Rate = Coupon Rate = the rate of the required annual interest payment Principal x Stated Rate = Annual Interest Payment Use the information on the bond payable below to answer the following question.ACTIVITY 75 Purpose: Q1 BONDS PAYABLE • Reinforce understanding of bonds payable amounts reported on the financial statements. • Understand why a bond sells at a premium. or a discount.000 bond is issued at 102 the bond will sell for 102% of the face value or for $102.000 / $20. Bond Payable Principal $10. $1. Specific Accounts Page 200 Chapter 6 . the corporation will pay out ($1.000 / $20. A $100. Q5 The corporation paid out $_______________ in total interest payments + paid out $_______________ of principal at maturity = total amounts paid of $____________ This bond was issued at (a premium / par / a discount) because the market rate of interest was (less than 10% / 10% / more than 10%). At issuance the corporation received from the investor (____________) c. The difference is the cost of borrowing over the ten years = $____________ d. T his bond was issued at (a premium / par / a discount) because the market rate of interest was (less than 10% / 10% / more than 10%). Q7 When will a bond be issued at a premium? Par? A discount? Q8 A corporation would prefer to issue bonds at a (premium / par / discount). The difference is the cost of borrowing over the ten years = $____________ d. Q4 Assume the bond was originally issued for $8. The difference is the cost of borrowing over the ten years = $____________ d. At issuance the corporation received from the investor (____________) c. a. This bond was issued at (a premium / par / a discount) because the market rate of interest was (less than 10% / 10% / more than 10%). The corporation paid out $_______________ in total interest payments + paid out $_______________ of principal at maturity = total amounts paid of $____________ b.Q3 Assume the bond was originally issued for $10. Assume the bond was originally issued for $12. a. At issuance the corporation received from the investor (____________) c. whereas an investor would prefer a (4% / 8% / 12%) market. a. Why? Specific Accounts Page 201 Chapter 6 .000 and held to maturity. b.000 and held to maturity.000 and held to maturity. Q6 The issuing corporation would prefer to borrow money in a (4% / 8% / 12%) market. The corporation paid out $_______________ in total interest payments + paid out $_______________ of principal at maturity = total amounts paid of $____________ b. Explain why one yield is higher than the other for these two types of bonds. Explain why one yield is higher than the other for these two types of corporate bonds. b. Record the yield of a high-quality corporate bond that matures in 1–10 years. Record the yield of a high-quality corporate bond that matures in 10+ years. _________% Record the yield of a high-quality corporate bond that matures in more than 10 years. A rating of AAA indicates very low risk and a rating of C indicates very high risk. Explain why one yield is higher than the other for these two types of corporate bonds. (AA) Medium quality 10+ years 5. _________% b. a.19% 4. (AA) Medium quality 1–10 years 3.23% Yield 3.O. Q1 Yield is the cost to the issuing entity for borrowing and the return to the investor/creditor for lending the money.95% (A-BBB/Baa) All years High yield (BB/Ba-C) 9. Q2 Q3 Q4 __________% Ratings are a measure of risk. Record the yield of a high-quality tax-exempt bond that matures in 7–12 years.ACTIVITY 76 Purpose: EXAMINING BOND YIELDS • Understand why bond yields differ.O. Specific Accounts Page 202 Chapter 6 . __________% c.95% 7–12 years G. __________% Record the yield of a high-yield corporate bond.92% 2–22 years G. YIELD COMPARISONS CORPORATE BONDS NEW TAX-EXEMPT BONDS Maturity Rating Yield Maturity Rating 1–10 years High quality (AAA-AA) 2. _________% c. whereas bonds issued by municipalities usually are tax-exempt.O. b. a. Record the yield of a high-quality corporate bond that matures in 1–10 years.70% Refer to the information in the table above to answer the following questions. _________% c. Record the yield of a high-quality corporate bond that matures in 1–10 years. Bonds issued by corporations are usually not tax-exempt. a. Bonds have different lengths of time to maturity.30% 4. Explain the advantage of tax-exempt bonds to the investor/creditor. d. Standard & Poor’s and Moody’s are two companies that assess the amount of risk.34% 22+years G. (AA) (A-BBB/Baa) 10+ years High quality (AAA-AA) 5. Yield is also referred to as the market rate and the effective rate of borrowing. Assuming investments with the same amount of risk. whereas the Trump AC bond is rated ___________ and returning a __________% yield. effective rate) for this investment. This bond is selling at a (premium / par / discount).71% 21. effective rate) for this investment. the Bid Price of the Allied Waste bond is 104. Refer to the information in the table above to answer the following questions. ($100.500. Q5 The Allied Waste bond is selling at a premium because the coupon rate (stated rate.50. face rate) is (greater than / less than) the yield (market rate. at par. the par value.000 x 104. Q2 The Allied Waste bond is currently rated a B+ and returning a __________% yield. Q4 The amount paid by the issuing corporation at maturity is referred to as the face value. the investor/creditor pays the issuing corporation an additional amount (premium) at the beginning of the investment. This indicates an investor/creditor could purchase or sell a $100.000 Allied Waste bond for $104. A $100.13% * Yield is the lower of yield to maturity and yield to call. This bond is selling at a (premium / par / discount). an investor/creditor would prefer a (high / low) yield whereas the issuing corporation would prefer a (high / low) yield.000 Trump AC bond would sell for $__________. Q1 The Allied Waste bond has a _______% coupon rate (also referred to as the stated rate or the face rate) that determines the (cash interest payment / effective interest rate). An investor/creditor holding a $100. Q6 Would you prefer to invest in the Allied Waste or the Trump AC bond? Why? Specific Accounts Page 203 Chapter 6 . The Trump AC bond is selling at a discount because the coupon rate (stated rate. For example.00% 8/2014 11. Bond bid (selling) price is quoted as a percentage of par. Name Allied Waste Trump AC Rating B+ CCC+ HIGH-YIELD BONDS Coupon Rate Maturity 10. and the maturity value.50%).25% 5/2011 Bid Price 104. the initial investment of the investor/creditor is less than face value (discount) and at maturity the higher face value is received. To achieve the (higher / lower) yield. To achieve the (higher / lower) yield. The CCC+ rating indicates (more / less) financial risk than a B+ rating. to attract investors/creditors the Trump AC bond must offer a (higher / lower) rate of return (yield). or at a discount. Q3 An investor/creditor purchasing the Allied Waste bond is expecting a(n) __________ % annual return. Therefore.00 Yield* 8.ACTIVITY 77 Purpose: EXAMINING THE BOND MARKET • Understand why bonds sell at a premium. face rate) is (greater than / less than) the yield (market rate.50 79.000 Allied Waste bond will receive $__________ in interest payments each year. Q3 The amount of net income retained in the business and not yet distributed as dividends to the shareholders is $__________ million.550 (2. Q7 The number of common shares currently outstanding is #__________ million shares. Common stock of the Coca-Cola Company was originally issued (above / at / below / can’t tell) par at an average price of $__________ per share. (increase / decrease / have no effect on) earnings per share. The COCA-COLA COMPANY Shareowners’ Equity December 31. and d. Specific Accounts Page 204 Chapter 6 . b. which represents 100% ownership of the company. 2011 Common stock. Q8 Total stockholders’ equity is $__________ million. Refer to the financial information above to answer the following questions.212 53. (increase / decrease / have no effect on) stockholders’ equity. (increase / decrease / have no effect on) stockholders’ equity.257 shares) $ in millions $ 880 11.600 shares Issued: 3. (increase / decrease / have no effect on) total assets. (increase / decrease / have no effect on) net income. which is the amount of business assets owned by shareholders. Q4 Retained earnings (is / is not) a reservoir of cash available for dividends. The average price paid for treasury stock is approximately $__________ per share.520 shares Capital surplus* Reinvested earnings Accumulated other comprehensive income (loss) Treasury shares. this event will: a. Q9 List several factors that would attract you to purchase shares of stock in a particular corporation. this event will: a. (increase / decrease / have no effect on) net income. Q1 The total amount of financing received from shareholders since incorporation is $__________ million and is generally referred to as ____________________. at cost (1. c. Q6 When a company buys back its own stock.703) (31. which is generally referred to as ____________________. b. Q5 Treasury stock is considered (issued / outstanding / retired) but no longer (issued / outstanding retired). Q2 When additional shares of common stock are issued. (increase / decrease / have no effect on) earnings per share.ACTIVITY 78 Purpose: STOCKHOLDERS’ EQUITY • Reinforce understanding of amounts reported on the financial statements for stockholders’ equity.302) * Assume capital surplus is all from issuing common stock above par value. and d. (increase / decrease / have no effect on) total assets.25 par value Authorized: 5. c. $. On May 31..... 3. the average computation needed to be adjusted for stock splits and stock dividends...000 | 8...547 2011 ...... Q6 Over the years the DJIA has had its ups and downs. However. 14...54 divided by a divisor of 0. When the DJIA increases in value.000 | 6...8....... 11.... On October 1.... What is the significance of the trend to investors? b... Q5 In the chart above. draw a line graph of the DJIA using the historical data above and the current DJIA information you just found.....000 |_____________________________________ 1928 '38 '48 '58 '68 '81 '91 2001 2006 2011 Q4 Use the Internet to find the current DJIA........ each DJIA company would have increased in value by $__________ per share. complete the graph outlined below. 200 1981 .. 12...000 1995 ...........393 points. 1.....000 / 30 stocks = 200 DJIA points....... but since 1928 the general direction of the DJIA has been (increasing / decreasing).... On May 31... a.. 2.. …………...ACTIVITY 79 EXAMINING THE DOW JONES INDUSTRIAL AVERAGE Using the Internet Purpose: • Understand how the DJIA is computed. DJIA closed at __________ points on __________ (date).132129493 = DJIA of 12...... 2012 if each of the 30 DJIA stocks increased in value by one dollar per share then the DJIA would increase by approximately 227 points (30/0..000 I DJIA 12..000 1997 ...164 2008 .. What stocks currently comprise the DJIA? Use the Internet to find out and list 6 of the 30 companies that currently comprise the DJIA. 2012 assume the DJIA increased by approximately 450 points.... On May 31....... Date DJIA 1928 . 4....000 | 10... To the corporations issuing the stock? Specific Accounts Page 205 Chapter 6 .... 7... 8.......000 14....000 | 2.... Q3 Historical Summary of the DJIA.....000 1996 ... 6... Q1 Companies comprising the Dow Jones Industrial Average (DJIA)...000 2002… ...... 2012 the market values added together totaled $1..000 2007 Oct 9...637.. Using the information presented in the chart.... 6..000 2004 ...... The DJIA is the most quoted stock market index..000 1999 ............ the sum of the market values of the each of the 30 stocks totaled $6. then the majority of stocks traded on the New York Stock Exchange would also be expected to (increase / decrease) in value. 1928 the first DJIA was computed using (10 / 20 / 30) industrial stocks traded on the New York Stock Exchange...000 | 4..000 2009 March 9 . 132129493 = 227)..... In 1928... • Understand the information provided by the DJIA average.. ___________ ___________ ___________ ___________ ___________ ___________ Q2 Computing the DJIA.000 1991 .. This means that on average... Since then the corporations comprising the index have changed many times to reflect the changing economy.... ……10.. The following chart summarizes the DJIA at various points in history....000 1986 .. The index started as a true average of the market values of the stocks comprising the index... yahoo.ACTIVITY 80 FOLLOWING THE STOCK MARKET Using the Internet Purpose: Q1 • Follow the stock market quotes for three companies and the Dow Jones Industrial Average (DJIA) for four weeks.(a) Four week % change in market price (b .com. For each of the next four weeks record in the chart below the (a) date of the stock information. Over the four weeks you observed the DJIA (increased / stayed the same / decreased). Specific Accounts Page 206 Chapter 6 . Did the stocks you selected move in the same direction as the Dow Jones Industrial Average? (Yes / No) d. (b) the closing stock price of the three companies you selected. and (c) the DJIA as of the close (end) of that business day. Comment on at least two interesting results you noted while following the stock market. and other sites. finance.a) / (a) Q2 % % % % At the end of the four weeks complete the following: a. c. b. • Understand market value per share. Compute the information requested in the bottom two rows of the above chart. Select three publicly traded corporations.msn.com. Would you expect your stocks to move in the same direction as the DJIA? (Yes / No) Why? e. Corporation Name Company #1 Company #2 Company #3 DJIA WEEK ONE: Closing Market Price on ______________ (a) WEEK TWO: Closing Market Price on ______________ WEEK THREE: Closing Market Price on ______________ WEEK FOUR: Closing Market Price on ______________ (b) Four week change in market price (b) . Free stock quote information can be found on the Internet at money. 6 5.72% 2.922 Revenue Cost of goods sold Net income $ $ Circuit City (CC) SIC #5731 Retail—Radio TV and Consumer Electronics Stores Best Buy (BBY) SIC #5731 Retail—Radio TV and Consumer Electronics Stores Wal-Mart (WMT) SIC #5331 Retail—Variety Stores Dell (DELL) SIC #3571 Electronic Computers Apple (AAPL) SIC #3571 Electronic Computers * CC amounts from 2007.28% 2.91% 39.404 776 Total assets 3.16% CC* BBY WMT DELL AAPL 2/28/2008 2/1/11 1/31/11 1/1/12 9/29/11 5.88% 63.83% Debt Ratio 59.272 421.0 4.54% 3.744 50.574 5.7 2.249 9.602 68.0 Asset turnover 3.492 $25.319 37.4 0.16% 33.503 6.54% 7.84% 22.2 Inventory turnover 5. and solvency ratios of various companies.15% 9.3 1.06% 79.348 Inventory 1.4 38.616 39.07% 7.0 10. the year before the company filed for bankruptcy.4 82.533 116.635 315. Specific Accounts Page 207 Chapter 6 .089 $ 6.849 62.4 0.318 1. Where’s the Cash? 2011 CC* BBY WMT DELL AAPL Accounts receivable (A/R) days 10.897 36.95% 3.9 -8.369 Efficiency Ratios DuPont Analysis of ROE Asset turnover ROA Financial leverage Selected Accounts ($ in Millions) Accounts receivable 331 $ 2.071 108.89% 5.1 Inventory days 61.0 1.917 76.01% 62.2 42.8 2.849 180.431 $ (320) $ 1. efficiency.34% 23.4 8.0 18.277 $ 16.756 Stockholders’ equity 1.63% 23.6 20.8 2.4 2011 CC* BBY WMT DELL AAPL A/R turnover 35.542 8.5 2.746 17.6 4.1 2.ACTIVITY 81 Purpose: RATIO ANALYSIS • Analyze profitability.9 6.98% 34.7 57.260 64.3 17.287 48.1 2.243 11.371 Total liabilities 2.663 44.7 34.29% 19.389 $ 3.5 21.9 2011 CC* BBY WMT DELL AAPL ROS -2.4 83.121 35.476 $ 5.5 ROE -21.9 9.615 11.3 1.247 112. The primary driver of ROA for BBY is (ROS / asset turnover) whereas for AAPL it is (ROS / asset turnover). as ROA contributes _______% to ROE. Impending signs of bankruptcy include weak (efficiency / profitability / both). Q2 Inventory turnover is faster for (BBY / DELL) because it assembles the product after the order is received from the customer. The driver of ROE for Dell is (ROA / financial leverage). Q4 The company with the greatest financial leverage is (CC / BBY / WMT / DELL / AAPL). Best Buy (BBY). (do / do not) have ownership rights. Creditors. Dell (DELL). Which company is managing its cash most efficiently? (CC / BBY / WMT / DELL / AAPL) How can you tell? Q8 Overall the company with the greatest profitability is (CC / BBY / WMT / DELL / AAPL). How can you tell? Q9 Of the 5 companies. Q1 Wal-Mart generates profits from a (high mark up / high volume of sales). Whereas inventory turnover is slower for (BBY / DELL) because inventory sits on the shelf an average of ______ days. thereby needing very little inventory on hand. How can you tell? Q7 Best Buy has its cash tied up in (accounts receivable / inventory). Wal-Mart (WMT). resulting in a higher (ROS / asset turnover). What other companies have a low-cost high-volume strategy? (CC / BBY / DELL / AAPL) Contributing to CC and BBY’s high asset turnover is their high (accounts receivable / inventory) turnover. whereas financial leverage contributes _______% to ROE. Specific Accounts Page 208 Chapter 6 . who (do / do not) have ownership rights. whereas Dell has its cash tied up in (accounts receivable / inventory). Q5 The company with the highest ROE is (CC / BBY / WMT / DELL / AAPL). almost _____ months before it is sold. which one would you choose to invest in? (CC / BBY / WMT / DELL / AAPL) Why? Support your choice by discussing at least 3 good reasons. 2008. there are (more / less) profits for the shareholders. Q6 The company with the weakest ROE is (CC / BBY / WMT / DELL / AAPL). Therefore. and Apple (AAPL) to answer the following questions. those who finance debt. indicating it relies primarily on (debt / equity) to finance assets. Branding of AAPL allows it to charge (more / less) for its products. Q3 The company with the strongest ROA is (CC / BBY / WMT / DELL / AAPL).Use the information on the previous page regarding Circuit City (CC). Circuit City filed for bankruptcy on November 10. .000 Page 209 Chapter 6 . $220..000 $220.............. $300..........compute Other than depreciation .....................000 60..........000 units at $4 = units at $5 = units at $6 = units at $7 = $ 40...000 COGS ....... both companies began operations at the beginning of the current year and during the year purchased inventory as follows: Jan 4 Apr 6 Aug 9 Nov 3 10............000 70.....000 During the first year...... In early January both companies purchased equipment costing $200. Frasco uses the first-in.......ACTIVITY 82 Purpose: TEST YOUR UNDERSTANDING • Compare effects of the inventory cost-flow assumptions FIFO and LIFO on the financial statements....000 10...000 Purchases (see above)...000 10.... • Compare effects of the depreciation method (SL or DDB) on the financial statements..000 units of inventory............................... • Understand how the choice of different accounting methods affects cash and accrual accounting.. both companies sold 25...................... • Prepare the income statement................... 80.......compute Operating expenses: Depreciation expense ...... first-out (LIFO) method for inventory.. Frasco uses straight-line depreciation............000 10.............. and Lasco uses last-in..... Frasco and Lasco are virtually identical........ first-out (FIFO) method....000 with a 10-year estimated useful life and no residual value.. and Lasco uses double-decliningbalance depreciation for equipment. INCOME STATEMENT FRASCO LASCO Sales revenue COGS Operating expenses: Depreciation expense Other Net income Specific Accounts $80............ balance sheet.000 40.....000 50..... and the statement of cash flows using different accounting methods......... Both companies’ trial balances at December 31st include the following: Sales revenue..........000 Use the above information to answer the following questions.. Q1 Prepare a multi-step Income Statement for both companies in the space provided below........ BALANCE SHEET Cash Inventory Equipment Total assets FRASCO $ $ Long-term debt Retained earnings 350.000 350.000 $ Chapter 6 .000 0 0 $ $ Supplemental Schedule—Indirect Method Net Income + Depreciation expense (Increase) decrease in inventory Net cash from operating activities LASCO FRASCO LASCO $ $ $ $ Prepare a Balance Sheet for both companies in the space provided below. STATEMENT OF CASH FLOWS FRASCO Net cash from operating activities Cash from customers Cash paid to suppliers Cash paid for operating expenses Total net cash from operating activities Net cash from investing activities Cash paid for equipment Net cash from financing activities Issued long-term debt Net change in cash + Beginning cash = Ending cash $ $ Q3 350. prepare a Statement of Cash Flows.000 Total liabilities and stockholders’ equity Specific Accounts LASCO $ Page 210 430.000 350.Q2 Assuming all transactions are cash transactions. Also prepare the Supplement Schedule—Indirect Method that reconciles net income and net cash from operating activities. Q4 a. Specific Accounts Page 211 Chapter 6 . affect (cash. why is net income different for Frasco and Lasco? Q6 On the balance sheet. Which company generated more cash during the year? (Frasco / Lasco / the same) c. which accounts report different amounts? (Cash / Inventory / Equipment / Notes payable / Retained earnings) Why? Q7 On the Statement of Cash Flows./ accrual.) basis accounting. which totals differ between Frasco and Lasco? Net cash from (operating / investing / financing / none) What conclusions can you draw from this Activity? Q8 Different accounting methods. such as FIFO or LIFO and SL or DDB. Which company appears to be more profitable? (Frasco / Lasco / the same) b. Which company presents a stronger balance sheet? (Frasco / Lasco / the same) Why? Q5 On the Income Statement. and whether each account is increased or decreased. 2. 4.” and “income tax expense. THE 10-STEP ACCOUNTING CYCLE How does the accounting system gather data and convert this data into useful information? Through the use of accounts. A financial statement line item can be broken down into several accounts. A Chart of Accounts is a list of all accounts used by a company. it is a database of transactions.” “accounts payable. 3. Egyptian hieroglyphics recount the collection and distribution of grain. explaining how to record. 8. In a computer program. classify. journals. and report transactions. the Franciscan friar Luca Pacioli authored Summa de Arithmetica. accountants have been recording. such as “cash. Analyze transactions using the accounting equation.” “accounts receivable.” “sales revenue. The Biblical book of Exodus accounts for items donated to and used for the building of the tabernacle in the desert. but also for all business people who will one day work with accountants. 7. Post journal entries to the general ledger. and reporting transactions. Proportioni et Proportionalita. To record a journal entry. INTRODUCTION For literally thousands of years.” Accountants typically number accounts. 5. This chapter was written with you in mind—it was designed not only for the future accountant. a mathematical treatise that explains how to keep financial records and prepare an income statement and balance sheet. classifying. Prepare closing journal entries and understand the closing process. Prepare a trial balance. in Renaissance Venice. Prepare adjusting journal entries and understand why they are made. 6. The Accounting Cycle Page 212 Chapter 7 . By 1494. Prepare journal entries using debits and credits. Describe the 10 steps of the accounting cycle. Geometria. and ledgers. we will give a brief introduction to the accounting cycle. in order to keep more detailed records.CHAPTER 7 THE ACCOUNTING CYCLE LEARNING OBJECTIVES 1. Accounts appear in financial statements as line items. Understand how specific events and transactions affect the financial statements. A Journal is a book listing the accounts affected by each transaction recorded by a company. Accounts are used to classify and record economic events and transactions. In this chapter. simply list the accounts affected. A computer program would typically set up a general ledger as a database. keeping track of the balance or amount in each account. THE ACCOUNTING CYCLE Step 1: Analyze and prepare transaction journal entries (TJEs) Step 2: Post TJEs to the ledger Step 3: Prepare the unadjusted trial balance Step 4: Prepare adjusting journal entries (AJEs) Step 5: Post AJEs to the ledger Step 6: Prepare the adjusted trial balance Step 7: Prepare the financial statements Step 8: Prepare closing journal entries (CJEs) The Accounting Cycle Step 9: Post CJEs to the ledger Page 213 Step 10: Prepare the post-closing trial balance Chapter 7 . The goal of the accounting system is to transform a list of transactions into financial statements. THE GOAL Transactions Financial Statements This is accomplished through the 10-Step Accounting Cycle.A Ledger is a book with one page for each account. with their balances. and usually consists of “give and take” with an outside party. this method is referred to as double-entry accounting.” at least two accounts must always be affected. This transaction would affect cash and common stock.STEP 1: ANALYZE AND PREPARE TRANSACTION JOURNAL ENTRIES (TJES) A transaction is an event that affects the financial position of an enterprise. or stockholders’ equity accounts (until he or she was paid).000. and/or stockholders’ equity accounts. paying employees. Then determine which accounts the transaction will affect.000. Go to the common stock page and add $100.000. To record a journal entry. simply list the accounts affected. liability. In our example.000 and increase common stock by $100. For example. Hiring a new employee would not be a transaction because it would have no effect on asset. the above transaction would increase cash by $100. it changes asset. For example. Examples of transactions include sales to customers. First. suppose investors contribute $100. The Accounting Cycle Page 214 Chapter 7 . Because a transaction consists of “give and take. and whether each account is increased or decreased.000 and common stock of $100. a book with one page for each account. which keeps track of the balance or amount in each account. Journal entries are used to record transactions. go to the cash page in the ledger and add $100. determine if a transaction took place. STEP 2: POST TJES TO THE LEDGER Copy the journal entries from the journal to the ledger. Therefore. The trial balance would report cash of $100. STEP 3: PREPARE THE UNADJUSTED TRIAL BALANCE A trial balance is a list of all accounts in the ledger.000 of cash in exchange for the common stock of a company. and receiving cash investments from shareholders. liability.000. It would also list all other accounts in the general ledger along with their balances. accountants adjust accounts to reflect accrued amounts and unrecorded transactions. STEP 9: POST CJES TO THE LEDGER As in Steps 2 and 5. new amounts for that year can accumulate. closing entries need to be posted to the ledger. and posting them to the ledger. as in Step 3. the company’s bookkeeper did not record the transaction.000 to employees at the end of the month. • Statement of Stockholders’ Equity. at the beginning of the year. suppose that a company owed salaries of $40. STEP 7: PREPARE THE FINANCIAL STATEMENTS Using the adjusted trial balance from Step 6. employees have not yet received their paychecks. The adjusted trial balance includes an additional $40. in two days. with their balances.” or zeroed out so that. list all accounts in the ledger.STEP 4: PREPARE ADJUSTING JOURNAL ENTRIES (AJES) STEP 5: POST AJES TO THE LEDGER At the end of the accounting period.000. and • Balance Sheet. STEP 8: PREPARE CLOSING JOURNAL ENTRIES (CJES) Record closing journal entries to zero out temporary accounts. These need to be “closed. The accountant would record a journal entry that increases wage expense and increases wages payable by $40. This entails recording more journal entries. the accountant transcribes the accounts listed into an: • Income Statement. STEP 6: PREPARE THE ADJUSTED TRIAL BALANCE Just as in Step 3. Therefore. The Accounting Cycle Page 215 Chapter 7 . For example.000 in wage expense and wages payable recorded in Step 5. but because pay day is Friday. The accountant also uses information from the financial statements and general ledger to prepare a Statement of Cash Flows. Temporary accounts are dividends and all accounts appearing on the income statement. The difference is that the adjusted trial balance includes the adjustments in Step 4. like in Step 2. This trial balance will take us to the beginning of next year. these transactions will be organized using the accounting equation. Revenue. and later recorded using debits and credits in an accounting journal. are reported at their correct ending balances. and permanent accounts (balance sheet accounts). ANALYZE TRANSACTIONS USING THE ACCOUNTING EQUATION This section uses the transactions of Lincoln’s Tax Accounting Corporation (LTAC) to explain how accounting data goes through the accounting cycle.Expenses) increases retained earnings and dividends decrease retained earnings. A chart of accounts is a list of all accounts used by a company. and dividend account data appear in the retained earnings column as Net Income (Revenues .STEP 10: PREPARE THE POST-CLOSING TRIAL BALANCE The final trial balance indicates that all temporary accounts (accounts appearing on the income statement and dividends) have been brought down to zero. Initially. expense. returning the company to Step 1. LTAC uses accrual accounting. For example: Lincoln’s Tax Accounting Corporation Chart of Accounts 100 110 200 210 300 310 320 400 500 510 520 600 The Accounting Cycle Cash Accounts receivable Notes payable Interest payable Common stock Retained earnings Dividends Revenue Rent expense Salary expense Interest expense Income Summary Page 216 Chapter 7 . therefore. one year from now. Assets Cash Other Assets = Liabilities Notes Payable +80. The signing of a note for cash affects the company’s assets (cash) and its liabilities (notes payable). which in turn. 2010. 2011. This transaction would increase cash by $20.000. The earning of revenue for cash affects assets (cash) and retained earnings (revenue). increases retained earnings and stockholders’ equity.000 TRANSACTION #3: During January.000 in cash payments from clients for preparing tax returns. The signed promissory note states that the amount borrowed is due January 1. This transaction would increase cash by $80. The issuance of stock for cash affects the company’s assets (cash) and its stockholders’ equity (common stock). LTAC received $80.000.000 from the bank.000 in cash in exchange for the common stock of LTAC.000 Stockholders’ Equity Retained Common Stock Earnings +20.000 in revenue. This transaction would increase cash by $10.000 and increase common stock by $20.000. Assets Cash = Other Assets Liabilities Notes Payable + Other Liabilities +20. when investors contributed $20.000 The Accounting Cycle Page 217 Other Liabilities + Stockholders’ Equity Retained Common Stock Earnings +80. Assets Cash = Other Assets Liabilities Notes Payable +10.TRANSACTION #1: Lincoln’s Tax Accounting Corporation started on January 1.000. The preparation of tax returns is the primary business activity of Lincoln’s Tax Accounting Corporation. thus increasing net income by $80. the company has earned $80.000 and increase notes payable by $10.000 + Other Liabilities Stockholders’ Equity Retained Common Stock Earnings +10.000 TRANSACTION #2: LTAC borrowed $10.000 and increase revenue by $80.000 Chapter 7 . because expenses decrease net income. Assets Cash = Other Assets Liabilities Notes Payable + Other Liabilities Accounts Receivable +25.000 for the preparation of tax returns but has not received payment. (Note that the parentheses indicate negative amounts.000 in salaries. The payment of expenses affects assets (cash) and retained earnings (expenses).000.) Assets Cash = Other Assets Liabilities Notes Payable + Other Liabilities (62.000. This transaction would decrease cash by $3.000 and paid employees $60.000. The payment of a cash dividend affects the company’s assets (cash) and retained earnings (dividends).000) Other Liabilities + Stockholders’ Equity Retained Common Stock Earnings Dividends (3. as retained earnings is increased by revenues and decreased by expenses and dividends. This transaction would increase accounts receivable by $25. expense.TRANSACTION #4: During January.000 and decrease retained earnings by $62.000.000) TRANSACTION SUMMARY: The business transactions of Lincoln’s Tax Accounting Corporation (LTAC) for January are summarized below. LTAC paid January rent of $2.000 cash dividend to stockholders. Again. therefore.000 in revenue. LTAC billed clients for $25. Assets Cash Other Assets = Liabilities Notes Payable (3. and dividend account data appear in the retained earnings column.000 and decrease retained earnings by $3. Revenue. The earning of revenue on account affects assets (accounts receivable) and retained earnings (revenue).000 Stockholders’ Equity Retained Common Stock Earnings Revenue +25.000) TRANSACTION #6: LTAC paid a $3. which in turn decreases retained earnings and stockholders’ equity. LTAC has paid expenses totaling $62. The Accounting Cycle Page 218 Chapter 7 . Here.000 and increase revenue by $25.000 TRANSACTION #5: During the month.000) Stockholders’ Equity Retained Common Stock Earnings Rent expense (2. the preparation of tax returns is the primary business activity of Lincoln’s Tax Accounting Corporation. The costs incurred to earn revenues are referred to as expenses. the company has earned $25. This transaction would decrease cash by $62.000) Salary expense (60. 000 #2 LTAC borrowed $10. (62.000) Rent Expense (2. In his treatise on accounting. (3.000 +20.000 + Retained Earnings $40.000 in cash in exchange for the common stock of LTAC.000 $40.000 + A/R $25.Assets = Liabilities + Stockholders’ Equity Other Retained Cash Other Assets Notes Payable Common Stock Liabilities Earnings #1 Investors contributed $20.000 Cash $45.000) #6 LTAC paid a $3.000 +10. but have not received payment.000 in salaries.000 #3 LTAC received cash payments totaling $80. The Accounting Cycle Page 219 Chapter 7 .000 +25.000 Note that within each transaction the accounting equation is in balance.000) BALANCE in each account at the end of January. Luca Pacioli said that a person should never go to sleep until their accounts balance.000 cash dividend to stockholders.000 from clients for preparing tax returns.000 + Common stock $20.000 Revenue +80. +20. $45.000 $20.000 from the bank and signed a promissory note.000) Dividends (3.000 #5 LTAC paid January rent of $2.000 and paid employees $60. +80. +10.000 $25. at the end of January the accounting equation is also in balance.000) Salary Expense (60.000 = Liabilities $10.000 + Stockholders’ Equity $60.000 #4 LTAC billed clients for $25.000 $10. Accounts Revenue Receivable +25.000 for the preparation of tax returns.000 = N/P $10. and therefore.000 Assets $70. credit it.PREPARE JOURNAL ENTRIES USING DEBITS AND CREDITS To record a large volume of accounts. debit it. debit it. To decrease a debit account. debit it. we use the debit/credit system. However. debit it. expenses could be subtracted from the credit side. As an example of a credit account. to record an increase in cash (an asset). To record a decrease in cash (an asset). ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY DEBITS = CREDITS Debit Accounts Credit Accounts Assets Liabilities Stockholders’ Equity DEBIT ACCOUNTS CREDIT ACCOUNTS Debit Credit Debit Credit Increase Decrease Decrease Increase To increase a debit account. To increase a credit account. credit it. to avoid subtraction. In theory. to record an increase in notes payable (a liability account). To record a decrease. The Accounting Cycle Page 220 Chapter 7 . which builds off of the accounting equation. credit it. To decrease a credit account. credit it. DEBIT ACCOUNTS CREDIT ACCOUNTS Assets Liabilities Expenses Stockholders’ Equity Dividends Revenues Therefore. we add them to the left side. Forget any notions that “credits are good. A more useful intuition is that credits tend to be sources of funds. Common stock is increased by $20. but they also represent increases in liabilities.000 from the bank. STEP 1: ANALYZE AND PREPARE TRANSACTION JOURNAL ENTRIES (TJES) We will again use the transactions of Lincoln’s Tax Accounting Corporation to explain the accounting cycle. 2010.000 … notes payable is a liability … liabilities are credit accounts … increased with a credit.000 in cash in exchange for the common stock of LTAC. The signed promissory note states that the amount borrowed is due January 1. but also represent increases in assets. assets are debit accounts … increased by a debit. Revenue is increased by a credit. The account that is credited should be indented and listed second.000 … cash is an asset … assets are debit accounts … increased with a debit.” Credits represent increases in revenues. 2011. Cash is increased by $20. Date Accounts Jan 1 Cash Common stock Debit Credit 20. Expenses. we will instead use debits and credits.Retained Earnings is increased by revenues and decreased by expenses and dividends. Similarly.000 10.000 20. Debits represent increases in expenses. to record transactions.000 TRANSACTION #2: LTAC borrowed $10.. Because retained earnings is a stockholders’ equity account (a credit account). which reduce stockholders’ equity. Cash is increased by $10.000 … cash is an asset . are increased by debits.000 … common stock is a stockholders’ equity (SE) account … SE are a credit accounts … increased with a credit. Continue to use the same Chart of Accounts for Lincoln’s Tax Accounting Corporation. Date Accounts Jan 1 Cash Notes Payable The Accounting Cycle Debit Credit 10. Notes payable is increased by $10. are increased by debits. debits are bad. we used the accounting equation. revenue is also a credit account. when investors contributed $20. TRANSACTION #1: Lincoln’s Tax Accounting Corporation started on January 1. whereas debits usually represent uses of funds. In the last section. dividends. one year from now. In this section. The account that is debited should always be listed first. which reduce net income and stockholders’ equity..000 Page 221 Chapter 7 . 000 80. Accounts receivable is increased by $25. Rent Expense and Salary Expense decrease retained earnings by $62.000 Page 222 Chapter 7 . but has not received payment. Date Accounts January Cash Revenue Debit Credit 80.000 in cash payments from clients for the preparing tax returns. LTAC paid January rent of $2. Date January Accounts Debit Rent Expense Salary Expense Cash The Accounting Cycle Credit 2.TRANSACTION #3: During January.000 60.000 25. Revenue is increased by $80.000 in salaries. Date Accounts January Accounts Receivable Revenue Debit Credit 25. LTAC billed clients for $25. LTAC received $80. Revenue is increased by $25.000 TRANSACTION #5: During the month.000 … cash is an asset … assets are debit accounts … increased with a debit.000 … cash is an asset account … assets are debit accounts … decreased with a credit.000 … retained earnings is an SE account … decreased with a debit. Cash is decreased by $62. Cash is increased by $80.000 … revenues increase retained earnings … retained earnings is an SE account … increased with a credit.000 for the preparation of tax returns.000 … accounts receivable is an asset account … assets are debit accounts … increased with a debit.000 … revenues increase retained earnings … retained earnings is an SE account … increased with a credit.000 and paid employees $60.000 62.000 TRANSACTION #4: During January. 000 110 Accounts Receivable 200 Notes Payable 300 Common Stock (2)10. Transactions #1 through #6 have been posted from the journal to the ledger. to keep track of the balance or amount in each account.000 (1)20. noting whether the account is debited or credited.000 (5)62.TRANSACTION #6: LTAC paid a $3. Dividends decrease retained earnings by $3. each account from the Chart of Accounts for Lincoln’s Tax Accounting Corporation.000 (3)80. Date Accounts Jan 31 Dividends Cash Debit Credit 3. Cash is decreased by $3. Lincoln’s Tax Accounting Corporation—January 31. Posting is copying each of the journal entries to the appropriate ledger account.000 (2)10. A T-account is used to represent each account in the general ledger.000 3.000 500 Rent Expense (5) 2.000 … cash is an asset … assets are debit accounts … decreased with a credit.000 cash dividend to stockholders.000 STEP 2: POST TJES TO THE LEDGER Recall that a ledger is a book with one page for each account.000 210 Interest Payable 310 Retained Earnings (4)25.000 (8)80. 2010 GENERAL LEDGER 100 Cash (1)20.000 (6) 3.000 520 Interest Expense Chapter 7 .000 320 Dividends (6)3.000 600 Income Summary The Accounting Cycle 400 Revenue Page 223 510 Salary Expense (5)60.000 … retained earnings is an SE account … SE accounts are credit accounts … decreased with a debit.000 (4)25. Lincoln’s Tax Accounting Corporation—January 31.STEP 3: PREPARE THE UNADJUSTED TRIAL BALANCE Recall that a trial balance is a list of all accounts in the general ledger. like in Step 2. Account Debit 100 110 200 210 300 310 320 400 500 510 520 600 Cash Accounts receivable Notes payable Interest payable Common stock Retained earnings Dividends Revenue Rent expense Salary expense Interest expense Income summary $ 45.000 Credit $ 10.000 2. This amount has not yet been accrued.000 $135. with their balances. make certain that total debits equal total credits. which includes recording accrued amounts and unrecorded transactions. To check the accuracy of the postings. 2010 UNADJUSTED TRIAL BALANCE No.000 105. accountants must review the unadjusted trial balance for accounts that have not yet been updated (adjusted) to the correct ending balance.000 STEP 4: PREPARE ADJUSTING JOURNAL ENTRIES (AJES) At the end of the accounting period.000 60.000 20.000 3. This entails recording more journal entries. The Accounting Cycle Page 224 Chapter 7 . After reviewing LTAC’s unadjusted trial balance it is determined that notes payable bears interest of 12% per year. Below is the unadjusted trial balance for Lincoln’s Tax Accounting Corporation.000 25.000 Total $135. 000 x 1% = $100 of accrued interest.AJE #1: LTAC borrowed $10.. signed a promissory note due January 1. 2010. (If 12 months of interest totals 12%. one month of accrued interest totals $100..000 110 Accounts Receivable 210 Interest Payable 310 Retained Earnings (4)25.000 320 Dividends The Accounting Cycle 400 Revenue 510 Salary Expense (5)60. 2010 GENERAL LEDGER 100 Cash (1)20. At the end of January.000 (2)10. Principal x Rate x Time = Interest) Interest expense is increased by $100 … interest expense decreases retained earnings … retained earnings is an SE account … SE accounts are credit accounts … decreased with a debit. increased with a credit. One month of accrued interest needs to be recorded. 2011) is increased … liabilities are credit accounts .000 (6) 3.000 (4)25.000 (2)10. $10.000 (3)80. Interest payable (not due until January 1. 2011.000 520 Interest Expense (A1)100 Chapter 7 . Date Accounts Debit Jan 31 Interest expense Interest payable Credit 100 100 STEP 5: POST AJES TO THE LEDGER As in Step 2. bearing 12% interest annually.000 (1)20. post amounts from the journal to the ledger.000 (A1)100 (6)3. Lincoln’s Tax Accounting Corporation—January 31.000 600 Income Summary Page 225 (8)80.000 from the bank on January 1. then one month of interest is 1%.000 500 Rent Expense (5) 2.000 200 Notes Payable 300 Common Stock (5)62. 000 100 20.STEP 6: PREPARE THE ADJUSTED TRIAL BALANCE As in Step 3.000 2.000 100 Total $ 135.000 105. 2010 ADJUSTED TRIAL BALANCE No.100 $ 135. the accountant transcribes the accounts listed into the following financial statements.000 25. with all amounts correctly updated. list all accounts in the general ledger.000 3. Account Debit 100 110 200 210 300 310 320 400 500 510 520 600 Cash Accounts receivable Notes payable Interest payable Common stock Retained earnings Dividends Revenue Rent expense Salary expense Interest expense Income summary $ Credit 45.000 60. an additional $100 in interest expense and interest payable. (1) Income Statement (2) Statement of Stockholders’ Equity (3) Balance Sheet The accountant also uses information from the financial statements and general ledger to prepare a Statement of Cash Flows. with their balances. Lincoln’s Tax Accounting Corporation—January 31.100 STEP 7: PREPARE THE FINANCIAL STATEMENTS Using the adjusted trial balance from Step 6.000 $ 10. The difference here is that the adjusted trial balance includes the adjustments in Step 4. The Accounting Cycle Page 226 Chapter 7 . 100 20.900 Lincoln’s Tax Accounting Corporation—January 2010 STATEMENT OF STOCKHOLDERS’ EQUITY Retained Common Stock Earnings Balance.000 Page 227 Chapter 7 .Lincoln’s Tax Accounting Corporation—January 2010 INCOME STATEMENT Revenue Operating expenses: Rent expense Salary expense Total operating expense Operating income Nonoperating revenues and expenses: Interest expense $ 105. January 1.000 25. January 31.000 (100) Net income $ 42. 2010 BALANCE SHEET ASSETS Cash Accounts receivable Total assets $ 45.000 60.000 100 10.000 39.000 62.900 Lincoln’s Tax Accounting Corporation—January 31.000 43.900 Total liabilities & stockholders’ equity The Accounting Cycle $ 70.000) Total SEquity $ 0 20.900 Dividends (3.000 Net income 42.000 42.900 $ 20. 2010 $59.000 $ 70. 2010 $ 0 $ 0 Stock issued 20.000 2.000 $39.900 (3.000 LIABILITIES Notes payable Interest payable Total liabilities STOCKHOLDERS’ EQUITY Common stock Retained earnings Total stockholders’ equity 10.900 59.000) Balance. 000 Rent paid (2. so they are ready to start accumulating amounts during the next accounting period. these accounts must be credited. to close it (zero it out). This means that all temporary accounts (income statement accounts and dividends) must be closed.000) Net cash from financing activities 27. to close them (zero them out).000 100 Page 228 Chapter 7 . this account must be debited.Lincoln’s Tax Accounting Corporation—January 2010 STATEMENT OF CASH FLOWS CASH FROM OPERATING ACTIVITIES Cash from customers $ 80.000 (3. 31 Revenue Income Summary Debit Credit 105.100 2.000) Net cash from operating activities $ 18.000) Salaries paid (60.000 CASH FROM FINANCING ACTIVITIES Cash from issuing a note payable Cash from issuing common stock Dividends paid 10. Date Accounts Jan. Permanent (balance sheet) accounts have already been updated to their correct ending balances.000 CJE #2: Close all expense and loss accounts to income summary.000 STEP 8: PREPARE CLOSING JOURNAL ENTRIES (CJES) After the financial statements are prepared. therefore.000 20. which become the beginning balances of the next accounting period. brought to zero balances. All revenue and gain accounts are closed to income summary. All expense and loss accounts are closed to income summary. Revenue has a credit balance.000 105. Date Accounts Jan. CJE #1: Close all revenue and gain accounts to income summary. the accounts must be made ready for the next accounting period. therefore.000 60.000 -0- Ending cash balance $ 45. 31 Income summary Rent expense Salary expense Interest expense The Accounting Cycle Debit Credit 62.000 Net change in cash Beginning cash balance 45. Expenses have a debit balance. therefore. Date Accounts Jan. Dividends have a debit balance.000 3. Dividends are closed and Retained Earnings updated and reduced by the amount of dividends declared during the accounting period. 31 Income Summary Retained earnings Debit Credit 42. to close Income Summary (zero it out). Income Summary has a credit balance equal to net income. this account must be credited. to close dividends (zero it out). Therefore.000 Page 229 Chapter 7 . this account must be debited. Date Accounts Jan. 31 Retained earnings Dividends The Accounting Cycle Debit Credit 3. After closing all revenue and gain accounts and expenses and loss accounts. Income Summary is closed and Retained Earnings increased by net income.900 CJE #4: Close the dividends account to retained earnings.900 42.CJE #3: Close the income summary account to retained earnings. 0 600 Income Summary (C2)62.900 520 Interest Expense (A1)100 (C2)100 Bal.000 (8)80.000 Bal.000 (5)62. 0 510 Salary Expense (6)3.000 Bal.000 200 Notes Payable 300 Common Stock (2)10. 0 210 Interest Payable (A1)100 310 Retained Earnings (C4)3.000 Bal. 39. 0 The Accounting Cycle Page 230 Chapter 7 .000 400 Revenue (1)20.000 (C1)105. 0 (5)60.STEP 9: POST CJES TO THE LEDGER Lincoln’s Tax Accounting Corporation—January 31.000 Bal.900 Bal.000 (C3)42.000 Bal.000 (C4)3.000 110 Accounts Receivable (4)25. 42.000 (2)10. 0 (C3)42.000 Bal.900 500 Rent Expense (5) 2.000 (C1)105.000 (3)80.000 Bal.000 (4)25.000 (6) 3.000 (C2)60. 45. 2010 GENERAL LEDGER 100 Cash (1)20.300 320 Dividends (C2)2. 000 3. Date Accounts Feb 1 Cash Sales revenue Cost of goods sold Merchandise inventory The Accounting Cycle Debit Credit 5. cost of goods sold and merchandise inventory. the amount of profit or markup on the goods sold. record the amount paid by the customer at retail. was a service corporation. What about the transactions of a retailer. a costume retailer. The other two accounts record the amount paid by the retailer to the supplier. sold merchandise that cost $3. Lincoln’s Tax Accounting Corporation. 100 110 200 210 300 310 320 400 500 510 520 600 Lincoln’s Tax Accounting Corporation—January 31.900 -0- $ 70.000 39.000 Notes payable Interest payable Common stock Retained earnings Dividends -0Revenue Rent expense -0Salary expense -0Interest expense -0Income summary -0Total $ 70.STEP 10: PREPARE THE POST-CLOSING TRIAL BALANCE The post-closing trial balance shows all temporary accounts with zero balances and permanent accounts with the correct ending balances. sales revenue and cash (or accounts receivable).000 100 20. 2010 POST-CLOSING TRIAL BALANCE Account Debit Cash $ 45.000 Credit $ 10. The difference between sales revenue (amount at retail) and cost of goods sold (amount at wholesale) is gross profit. Pirate Company. No. The accounts of LTAC are ready to start the next accounting period. Two of the accounts.000 Accounts receivable 25.000 3.000 5.000 for cash of $5. which buys and sells inventory? Recording the sale of merchandise involves four different accounts.000 TRANSACTION JOURNAL ENTRIES OF A MERCHANDISE RETAILER Our example.000 Page 231 Chapter 7 .000. 000 Cost of Goods Sold 3. The Accounting Cycle Credit Salary Expense 5. 2. Review the unadjusted trial balance for accounts that need to be updated. The ending balance in salaries payable should be $600 (3 days x $200 per day. MORE ADJUSTING JOURNAL ENTRIES Adjusting journal entries (AJEs) are made at the end of the accounting period to update account balances before preparing the financial statements. 31 Salary expense Salaries payable 600 600 Salaries Payable -0600 (A2) 600 Bal.000 3.200 Page 232 Chapter 7 .000 5. 17. prior to this entry. an asset is reduced (merchandise inventory) and an expense (cost of goods sold) is increased. Make the adjusting journal entry. Employees earn $200 per day.000 5.000 When assets are used to produce revenue. 3. Date Accounts Debit Jan. 10. The adjusting process consists of four steps: 1.000 in cash and $17. 4. The reduction in the asset indicates the asset has been used to help produce revenue. This reduction will equal the amount of the expense. 30. AJE #2: The company did not pay its employees until February 3 for their work on January 29. Determine the required increase or decrease to achieve the appropriate ending balance.000 in merchandise inventory.000 Merchandise Inventory Bal. Determine the appropriate ending balance for each account that needs to be updated. and 31. Cash Sales Revenue Bal.Suppose that. The asset is “moved” to the income statement. 6. Pirate Company had $12.600 (A2) 600 Bal. AJE #3: The company’s $3. Page 233 (A4) 310 Bal.1. January has now passed and only 11 months remain. or 60-month life. The company has consumed one month’s worth of insurance. and a residual value of $1.300 represents the remaining 11 months (11 months x $300 per month) of prepaid insurance premiums. 31 Insurance expense Prepaid insurance Debit Credit 300 300 Prepaid Insurance 3.400.000 .400) / 60 = $310 The journal entry to record depreciation expense is always the same: Date Accounts Jan.000 Bal. costing $20. This $300 asset is moved to the income statement.600 300 (A3) Bal.600 insurance policy covers a 12-month time period. 300 AJE #4: Pirate Company’s truck. 310 Chapter 7 .Residual value) / Estimated useful life = Depreciation Expense (20.000.300 Insurance Expense (A3) 300 Bal.600 / 12 months). 31 Depreciation expense Accumulated depreciation Truck Debit Credit 310 310 Accumulated Depreciation Depreciation Expense 60. has a five-year. The ending balance of $3. because it is a “negative asset. as an expense. costing $300 ($3. Depreciate one month using straight-line depreciation. 3. Date Accounts Jan.” (Cost . Accumulated depreciation is called a contra-asset account. 60.000 The Accounting Cycle 310 (A4) 310 Bal. so that amounts for coming year can accumulate. zero out or close the temporary accounts. The company has used $700 ($1. Liabilities. The difference between sales revenue (amount at retail) and cost of goods sold (amount at wholesale) is gross profit. Step 8: Prepare Closing Journal Entries (CJEs)—After the financial statements are prepared. Step 7: Prepare the Financial Statements using amounts from the Adjusted Trial Balance.AJE #5: The company counted $500 worth of unused office supplies in its supply closet. If it did. and Dividends are debit accounts. increased with a credit and decreased with a debit. 500 Office Supplies Expense (A5) 700 Bal. list each account balance in a trial balance. The Accounting Cycle Page 234 Chapter 7 . Date Accounts Debit Jan. Stockholders’ Equity. Step 9: Post CJEs to the Ledger—Like in Step 2.500) worth of supplies. Step 4: Prepare Adjusting Journal Entries (AJEs)—At the end of the accounting period. increased with a debit and decreased with a credit. Step 10: Prepare the Post-Closing Trial Balance—Like in Step 3. it is a transaction that is recorded in the journal. Expenses. a book with one page for each account. Step 6: Prepare the Adjusted Trial Balance—Like in Step 3.200 . or stockholders’ equity account. accountants adjust accounts to reflect accrues amounts and unrecorded transactions. Step 2: Post TJEs to the Ledger—Copy the journal entries from the journal to the ledger. determine if the event changed an asset. post amounts from the journal to the ledger. Recording the sale of merchandise involves four different accounts: Sales Revenue and Cash (or accounts receivable) to record the price paid by the customer and Cost of Goods Sold and Merchandise Inventory to record the amount paid to the supplier.200 700 (A5) Bal. all income statement accounts and dividends. 31 Office supplies expense Office supplies Credit 700 700 Office Supplies 1. list each account balance in a trial balance. which tracks the balance. liability. post amounts from the journal to the ledger. Step 5: Post AJEs to the Ledger—Like in Step 2. Step 1: Analyze and Prepare Transaction Journal Entries (TJEs)—First. a book listing transactions in chronological order using debits and credits. The company had originally purchased $1.200 in supplies. and Revenues are credit accounts. Step 3: Prepare the Unadjusted Trial Balance—The trial balance is a list of all accounts in the general ledger with their balances. Assets. 700 SUMMARY The accounting system gathers data and converts it into financial statements through the 10-step accounting cycle. Event changing an asset. Step _____ Preparing Closing Journal Entries (CJEs) that zero out all temporary accounts 26. List of all accounts used by a company (3 words) 5. Step _____ Preparing the Post-Closing Trial Balance 11. Journal entries generally affecting one income statement account and one balance sheet account. Copying journal entries to the ledger. Step _____ Preparing Adjusting Journal Entries (AJEs) at the end of the accounting period 24. noting debit or credit 9. usually representing a use of funds 3. Step _____ Preparing the Unadjusted Trial Balance 8.ACTIVITY 83 CHAPTER 7 CROSSWORD PUZZLE Across 2. Accounts including all income statement accounts and dividends 25. Account increased by revenues and decreased by expenses and dividends (2 words) 19. Left-side entries. Step _____ Analyzing and Preparing Transaction Journal Entries (TJEs) 12. List of all ledger accounts and their balances (2 words) 7. The sales revenue account is closed using a _____ 22. Chronological listing of all transactions 20. keeping track of the balance in each 21. Goal of the accounting system is to transform transactions into _____ (2 words) 4. Used to classify and record economic events and transactions 6. Step _____ Preparing the Financial Statements using amounts from the Adjusted Trial Balance 23. Accounts where ending balances become beginning balances of the next accounting period 10. The inventory account is decreased with a _____ 15. Step _____ Preparing the Adjusted Trial Balance Page 235 Chapter 7 . Database of accounts. Step _____ Posting TJEs to the Ledger The Accounting Cycle Down 1. Journal entries bringing all temporary accounts to a zero balance 17. liability. Step _____ Posting AJEs to the Ledger 14. never cash 16. Debits must always equal _____ 13. Step _____ Posting CJEs to the Ledger 6. or stockholders’ equity account 18. .. (A)sset accounts..start with (100 / 200 / 300 / 400 / 500) c.. A chart of accounts is a list of all accounts used by a company. account numbers for: a.start with (100 / 200 / 300 / 400 / 500) Q4 Within Doogie’s Chart of Accounts the account numbers increase by (ones / tens) so that additional accounts can be easily added. Doogie’s Dog Grooming Corporation Chart of Accounts 100 110 120 130 140 150 200 210 220 300 350 360 400 500 510 520 530 540 Cash Accounts receivable Supply inventory Equipment Accumulated depreciation Prepaid insurance Accounts payable Rent payable Wages payable Common stock Retained earnings Dividends Revenue Depreciation expense Insurance expense Rent expense Supply expense Wage expense (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) (A / L / SE / Rev / Exp) Q1 Identify each of the above accounts as either a(n) (A)sset. (SE)quity accounts....... (L)iability accounts ..start with (100 / 200 / 300 / 400 / 500) d. The Accounting Cycle Page 236 Chapter 7 ..start with (100 / 200 / 300 / 400 / 500) b. the most appropriate account number for utilities payable would be (201 / 230) and for utilities expense would be (160 / 230 / 370 / 410 / 550).. (Rev)enue.. if the company received a utility bill. or (Exp)ense account by circling the appropriate response. (S)tockholders’ (E)quity... For example. (Rev)enue accounts ... Following is the chart of accounts for Doogie’s Dog Grooming Corporation.start with (100 / 200 / 300 / 400 / 500) e. (Exp)ense accounts ....ACTIVITY 84 THE CHART OF ACCOUNTS Purpose: • Understand the chart of accounts.. (L)iability. Q2 In what order are the accounts within a chart of accounts organized? First (A / L / SE / Rev / Exp) Second (A / L / SE / Rev / Exp) Third (A / L / SE / Rev / Exp) Fourth (A / L / SE / Rev / Exp) Last (A / L / SE / Rev / Exp) Q3 Within Doogie’s Chart of Accounts. or stockholders’ equity (SE) account. expense. The chart on the following page lists eight events that occurred during July for Doogie’s. liability (L). Therefore. Q1 A transaction is an event that affects the financial position of an enterprise. it changes an asset (A). Q2 Because a transaction consists of “give and take. Total liabilities $__________ c.000.000 of cash in exchange for the common stock of a company” (is / is not) a transaction that affects (cash / accounts receivable) and (retained earnings / common stock). and dividend account data are recorded in the Retained Earnings column. Retained earnings is increased by (net income / dividends) and decreased by (net income / dividends). Total stockholders’ equity $__________ Is the accounting equation in balance at the end of July? (Yes / No) The Accounting Cycle Page 237 Chapter 7 . Q7 For each balance sheet classification listed below. compute the ending balance for July and record in the bottom row of the chart.” at least (one / two / three) accounts are always affected. Total assets $__________ b. Q8 a. and dividend account data. the revenue portion of this transaction is listed under the Retained Earnings column. compute the ending balance for July. A company is not liable for payment of supplies until the supplies (are ordered / arrive). “Doogie’s provided dog grooming services for $20. Q3 “Investors contribute $30. indicate which accounts increased or decreased and identify the amount and account title under the appropriate heading.000.ACTIVITY 85 Purpose: ANALYZE TRANSACTIONS AND EVENTS • Analyze transactions and events using the accounting equation. an order (is / is not) a transaction and (is / is not) recorded. Q4 Revenue. Because the arrival of supplies increases an asset and creates a liability this event (is / is not) a transaction and (is / is not) recorded. Q5 Doogie’s Dog Grooming Corporation started business in July. Transaction #1 is completed for you.000 cash” is a transaction that affects (cash / accounts receivable) and (revenue / expense). this method is referred to as (the give-’n-take method / double-entry accounting). Q6 For each of the six columns in the chart. Because revenue (increases / decreases) net income and net income (increases / decreases) (retained earnings / common stock). record “No Transaction. expense.” In the Retained Earnings column record revenue. Common stock is a(n) (A / L / SE) account that would (increase / decrease) by $30. For each transaction. Therefore. Cash is a(n) (A / L / SE) account that would (increase / decrease) by $30. Use the Chart of Accounts on the previous page. If an event is not a transaction. Therefore. #3 July 1 Doogie purchased a one-year insurance policy for $2.000 + 30. Revenue + 20.000 cash.000 Q9 Transaction #6 affects (1 / 2 / 3) accounts and is referred to as a (double / compound) entry. #8 July 31 Doogie paid a $400 cash dividend to shareholders.Doogie’s Dog Grooming Corporation TRANSACTIONS—July ASSETS Cash #1 July 1 = LIABILITIES + STOCKHOLDERS’ EQUITY Other Accounts Common Retained Assets Payable Stock Earnings Doogie’s Dog Grooming Corporation began by issuing 1. #4 July 1 Prepaid insurance + 2.400 Doogie ordered doggie treats and other supplies totaling $1.000 and rent of $1. Compute the BALANCE in each account at the end of July. The Accounting Cycle Page 238 Chapter 7 .000 #2 July 1 Doogie purchased a grooming table and other equipment for $18.400 cash. whereas Transaction #7 affects (1 / 2 / 3) accounts and is referred to as a (double / compound) entry.200.000 cash. #6 July Doogie’s provided dog grooming services for $20. 30.000 cash.500 for July.000 shares of common stock in exchange for $30.200. + 30.000 #7 July 31 Doogie paid employee wages of $2. #5 July 6 The doggie treats and other supplies arrived along with a bill for $1. Assets = Liabilities + Stockholders’ Equity. To decrease a credit account. AND 3 USING DEBITS AND CREDITS Purpose: • • • Prepare journal entries using debits and credits. Post transaction journal entries to the general ledger. to record an increase of $30. (will / will not) always be in balance. the accounting equation. revenues (increase / decrease) retained earnings whereas expenses and dividends (increase / decrease) retained earnings. Whereas liabilities and stockholders’ equity are (debit / credit) accounts.ACTIVITY 86 DOOGIE’S … STEPS 1. the journal entry should (debit / credit) stockholders’ equity. which builds off of the accounting equation. Therefore.expenses) and decreased by dividends. we use the debit/credit system.000 in common stock. which is a (debit / credit) account. Q2 Assets are (debit / credit) accounts. credit it. to record an increase of $30. which is increased with a (debit / credit). ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY DEBITS = CREDITS Debit Accounts Assets Credit Accounts Liabilities Stockholders’ Equity DEBIT ACCOUNTS Debit Credit Increase CREDIT ACCOUNTS Debit Credit Decrease Decrease To increase a debit account.DIVIDENDS = Ending RETAINED EARNINGS Beginning R/E + (REVENUE .000 in cash. Therefore.EXPENSES) . debit it. ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY STOCKHOLDERS’ EQUITY = COMMON STOCK + RETAINED EARNINGS Beginning RETAINED EARNINGS + NET INCOME . Q4 Common stock is a(n) (A / L / SE) account. 2. Prepare an unadjusted trial balance. Debits (will / will not) always equal Credits. credit it. which is a (debit / credit) account. the journal entry should (debit / credit) cash. Q3 Cash is a(n) (A / L / SE) account. which is increased with a (debit / credit). debit it. which are increased with a (debit / credit) and decreased with a (debit / credit). which are increased with a (debit / credit) and decreased with a (debit / credit). Q1 When amounts are correct. Increase To increase a credit account. Hence. The Accounting Cycle Page 239 Chapter 7 . To record a large volume of accounts. Similarly. To decrease a debit account.DIVIDENDS = Ending RETAINED EARNINGS Debit Accounts Expenses Dividends Q5 Credit Accounts Stockholders’ Equity Revenue Retained Earnings is increased by net income (revenues . revenue is recorded with a (debit / credit).200.000 Doogie purchased a grooming table and other equipment for $18.000 Common stock 30. Cash 30. If an event is not a transaction. record “No Transaction.000 cash.000 shares of common stock in exchange for $30.000 cash. Doogie’s Dog Grooming Corporation GENERAL JOURNAL—JULY Date TJE #1 July 1 TJE #2 July 1 Accounts Debit Credit Doogie’s Dog Grooming Corporation began by issuing 1. Rent expense 1. revenue is increased with a credit and expenses and dividends are increased with a debit. record the appropriate journal entry. TJE #5 July 6 The doggie treats and other supplies arrived along with a bill for $1.000 cash.400 cash. Debit Accounts Credit Accounts Assets Expenses Dividends Liabilities Stockholders’ Equity Revenues STEP 1: ANALYZE AND PREPARE TRANSACTION JOURNAL ENTRIES (TJES) Q7 The events below occurred during July for Doogie’s Dog Grooming Corporation. TJE #4 July 1 Doogie ordered doggie treats and other supplies totaling $1.500 for July.” Use the Chart of Accounts introduced in the previous Activity. July 1 18. For each transaction.000 and rent of $1.500 TJE #8 July 31 Doogie paid a $400 cash dividend to shareholders. TJE #6 July July Doogie’s provided dog grooming services for $20. Because expenses and dividends decrease stockholders’ equity. Because revenue increases stockholders’ equity. The Accounting Cycle Page 240 Chapter 7 . In summary. TJE #3 July 1 Cash Doogie purchased a one-year insurance policy for $2.000 TJE #7 July 31 Doogie paid employee wages of $2.200. Transaction #1 is completed for you.Q6 Retained Earnings is a Stockholders’ Equity account. they are recorded with a (debit / credit). keeping track of the balance or amount in each account. Posting is copying each of the journal entries to the appropriate ledger account.000(T1) 110 Accounts Receivable 210 Rent Payable 350 Retained Earnings 510 Insurance Expense 120 Supply Inventory 220 Wages Payable 360 Dividends 520 Rent Expense Income Summary 530 Supply Expense 400 Revenue 540 Wage Expense 130 Equipment 140 Accumulated Depreciation The Accounting Cycle 150 Prepaid Insurance Page 241 Chapter 7 . noting whether the account is debited or credited. each account from the Chart of Accounts for Doogie’s Dog Grooming Corporation. A T-account is used to represent each account in the general ledger. Transaction #1 is completed for you. Doogie’s Dog Grooming Corporation GENERAL LEDGER—JULY 100 Cash 200 Accounts Payable 300 Common Stock (T1)30. noting whether the account is debited or credited.STEP 2: POST TJES TO THE LEDGER Recall that a ledger is a book with one page for each account. noting whether the balance is debited or credited. Q9 Compute the ending balance of the cash account below. Q8 Post each transaction recorded in the General Journal on the previous page to the General Ledger below.000 500 Depreciation Expense 30. Account 100 Cash 110 Accounts receivable 120 Supply inventory 130 Equipment 140 Accumulated depreciation 150 Prepaid insurance 200 Accounts payable 210 Rent payable -0- 220 Wages payable -0- 300 Common stock 350 Retained earnings 360 Dividends 400 Revenue 500 Depreciation expense -0- 510 Insurance expense -0- 520 Rent expense 530 Supply expense 540 Wage expense $25. with their debit or credit balances.STEP 3: PREPARE THE UNADJUSTED TRIAL BALANCE A trial balance is a list of all accounts in the general ledger.200 Total The Accounting Cycle Page 242 Chapter 7 . Q10 In the unadjusted trial balance below. record the ending balance of each account in the General Ledger of Doogie’s Dog Grooming Corporation on the previous page. Do total debits equal total credits? (Yes / No) Doogie’s Dog Grooming Corporation UNADJUSTED TRIAL BALANCE—July 31 Debit Credit No. The ending balance in cash is completed for you. make certain that total debits equal total credits. Q11 Compute total debits and total credits and record in the last row below. Total debits are completed for you. Q12 As a check to the accuracy of the postings.700 -0- -0- -0- -0- $51. please find the error and correct. If not. Q2 Use the information below to prepare general journal entries needed to record the adjustments for Doogie’s Dog Grooming Corporation on July 31. accountants adjust accounts to reflect accrued amounts and unrecorded transactions. Prepare an adjusted trial balance. July 31 AJE #3 Doggie treats and other supplies arrived along with a bill for $1. July 31 The Accounting Cycle Page 243 Chapter 7 . like in Step 2. Review the accounts in Doogie’s unadjusted trial balance on the previous page. Straight-line depreciation is used. which are (revenue / depreciation expense / insurance expense / rent expense / supply expense).200 on July 6. On July 31.ACTIVITY 87 Purpose: DOOGIE’S … STEPS 4. Record insurance expense for July. like in Step 3. What amount of supplies was used during July? Record supply expense for July. This equipment has a five-year life with no residual value. July 31 AJE #2 Doogie purchased a one-year insurance policy for $2. Doogie’s Dog Grooming Corporation GENERAL JOURNAL—July Date Accounts Debit Credit AJE #1 Doogie purchased a grooming table and other equipment for $18. There are (1 / 2 / 3 / 4) income statement accounts that need to be adjusted. which are (cash / supply inventory / accumulated depreciation / prepaid insurance / common stock). Record depreciation expense for July. one month of insurance coverage has been used. This entails recording more journal entries. AND 6 USING DEBITS AND CREDITS • • • Prepare adjusting journal entries using debits and credits. 5. and posting them. STEP 4: PREPARE ADJUSTING JOURNAL ENTRIES (AJES) Q1 At the end of the accounting period. There are three balance sheet accounts that need to be adjusted (updated to the correct ending balance). On July 31 there were $500 of doggie treats and other supplies remaining.400 cash on July 1. The Chart of Accounts for Doogie’s is presented in a previous activity. Post adjusting journal entries to the general ledger.000 cash on July 1. Q4 After posting adjustments compute the ending balance for Supply Inventory and Prepaid Insurance. record the ending balance of each account in the General Ledger of Doogie’s Dog Grooming Corporation (Question 4). please find the error and correct. The ending balance in cash is completed for you. make certain that total debits equal total credits. with their balances. list all accounts in the general ledger.700 -0- -0-0-0- $51. recording it as a debit or credit balance in the General Ledger on Page 241.STEP 5: POST AJES TO THE LEDGER Q3 Post each adjusting journal entry recorded in the General Journal on July 31 for Doogie’s Dog Grooming Corporation (on the previous page) to the General Ledger on Page 241. Q5 In the adjusted trial balance below. The difference is that the adjusted trial balance includes the adjustments in Step 4. STEP 6: PREPARE THE ADJUSTED TRIAL BALANCE A trial balance is a list of all accounts in the general ledger. Just like in Step 3. 100 110 120 130 140 150 200 210 220 300 350 360 400 500 510 520 530 540 Account Cash Accounts receivable Supply inventory Equipment Accumulated depreciation Prepaid insurance Accounts payable Rent payable Wages payable Common stock Retained earnings Dividends Revenue Depreciation expense Insurance expense Rent expense Supply expense Wage expense Debit $25. noting whether the account is debited or credited.500 Total The Accounting Cycle Credit Page 244 Chapter 7 . As a check to the accuracy of the postings. If not. Q6 Compute total debits and total credits and record below. Do total debits equal total credits? (Yes / No) Doogie’s Dog Grooming Corporation ADJUSTED TRIAL BALANCE—July 31 No. with their debit or credit balances. ACTIVITY 88 DOOGIE’S … STEP 7 USING DEBITS AND CREDITS Purpose: • • • Prepare the financial statements. Post transaction journal entries to the general ledger. Prepare an unadjusted trial balance. STEP 7: PREPARE THE FINANCIAL STATEMENTS Q1 Use the information from Activities 86 and 87 and prepare the: a. Income Statement b. Statement of Stockholders’ Equity c. Balance Sheet d. Statement of Cash Flows Doogie’s Dog Grooming Corporation INCOME STATEMENT—July $ Revenue Operating expenses: Wage Expense Rent Expense Supply Expense Depreciation Expense Insurance Expense $ 2,000 ______ 4,700 Total operating expense $ Net income Doogie’s Dog Grooming Corporation STATEMENT OF STOCKHOLDERS’ EQUITY—July Common Stock Balance, July 1 Stock issued Net income Dividends $ Balance, July 31 $ The Accounting Cycle Page 245 -0- Retained Earnings $ -0- Total SEquity $ -0- $ $ 44,900 Chapter 7 Doogie’s Dog Grooming Corporation BALANCE SHEET—July 31 ASSETS Cash Supply Inventory Equipment Accumulated Depreciation Prepaid Insurance $ $18,000 ( ) Total assets LIABILITIES Accounts Payable STOCKHOLDERS’ EQUITY Common Stock Retained Earnings $ $ 46,100 Total liabilities & stockholders’ equity Doogie’s Dog Grooming Corporation STATEMENT OF CASH FLOWS—July CASH FROM OPERATING ACTIVITIES Cash from customers Insurance paid Rent paid Wages paid $20,000 ( ) ( ) ( ) Net cash from operating activities CASH FROM INVESTING ACTIVITIES Cash used to purchase equipment CASH FROM FINANCING ACTIVITIES Cash from issuing common stock Dividends paid $ 14,100 ( ) 30,000 ( ) $ Net cash from financing activities 25,700 -0- Net change in cash Beginning cash balance $ Ending cash balance The Accounting Cycle Page 246 Chapter 7 ACTIVITY 89 Purpose: DOOGIE’S … STEPS 8, 9, AND 10 USING DEBITS AND CREDITS • • • Prepare closing journal entries using debits and credits. Post closing journal entries to the general ledger. Prepare a post-closing trial balance. STEP 8: PREPARE CLOSING JOURNAL ENTRIES (CJES) Q1 Record closing journal entries that zero out temporary accounts. Temporary accounts include all income statement accounts and dividends. These need to be zeroed out or closed so that, at the beginning of the year, new amounts for that year can accumulated. Doogie’s Dog Grooming Corporation GENERAL JOURNAL—July Date Accounts CJE #1 Close all revenue and gain accounts to income summary. July 31 Revenue 20,000 Income Summary Close all expense and loss accounts to income summary. CJE #2 Debit Credit 20,000 July 31 Rent Expense 1,500 CJE #3 Close the income summary account to retained earnings. July 31 Income Summary CJE #4 Close the dividends account to retained earnings. 15,300 July 31 STEP 9: POST CJES TO THE LEDGER Closing Entries are journal entries, like in Steps 2 and 5, which need to be posted to the general ledger. Q2 Post each closing journal entry recorded in the General Journal on July 31 for Doogie’s Dog Grooming Corporation (on the previous page) to the General Ledger on Page 241, noting whether the account is debited or credited. Q3 After posting closing entries compute the ending balances, recording as a debit or credit balance in the General Ledger on Page 241. The Accounting Cycle Page 247 Chapter 7 STEP 10: PREPARE THE POST-CLOSING TRIAL BALANCE One last trial balance, this one shows that all temporary accounts (accounts appearing on the income statement and dividends) have been brought down to zero, and permanent accounts (balance sheet accounts), are reported at their correct ending balances. This trial balance will start the next year, returning the company to Step 1. Doogie’s Dog Grooming Corporation POST-CLOSING TRIAL BALANCE—July 31 No. 100 110 120 130 140 150 200 210 220 300 350 360 400 500 510 520 530 540 Account Cash Accounts receivable Supply inventory Equipment Accumulated depreciation Prepaid insurance Accounts payable Rent payable Wages payable Common stock Retained earnings Dividends Revenue Depreciation expense Insurance expense Rent expense Supply expense Wage expense Debit $25,700 -0- -0-0- $ Total The Accounting Cycle Credit $ Page 248 $ 46,400 Chapter 7 ACTIVITY 90 ANALYZE MERCHANDISING TRANSACTIONS Purpose: Analyze merchandising transactions. Prepare journal entries using debits and credits. Understand how merchandising transactions affect the income statement and the balance sheet. Recording the sale of merchandise involves four different accounts. Two of the accounts, sales revenue and cash (or accounts receivable), record the amount paid by the customer at retail. The other two accounts record the amount paid by the retailer to the supplier, cost of goods sold and merchandise inventory. The difference between sales revenue (amount at retail) and cost of goods sold (amount at wholesale) is gross profit, the amount of profit or markup on the goods sold. Q1 • • • Prepare general journal entries for the following transactions. Scott King’s Sporting Goods Retailer GENERAL JOURNAL—AUGUST Date Accounts Debit TJE #1 Aug 1 Sold 2,000 shares of no-par common stock for cash of $12,000. Aug 1 Cash Credit 12,000 Common stock TJE #2 Aug 3 Purchased store equipment for $3,000 cash. 12,000 TJE #3 Aug 3 Purchased merchandise inventory on account for $9,000. TJE #4 Aug 10 Sold merchandise that cost $3,000 for $5,000 in cash. Merchandise Inventory TJE #5 Aug 30 Sold merchandise that cost $2,000 for $4,000 on account. 3,000 TJE #6 Aug 30 Paid August salaries of $1,500. Q2 The general ledger reported $10,000 as the August 1 balance for cash. On August 31, the general ledger would report cash of $_________. Q3 The August Income Statement would report Sales Revenue of $(4,000 / 5,000 / 9,000), Cost of Goods Sold of $(2,000 / 3,000 / 5,000), and Operating Expenses totaling $(1,500 / 3,500 / 6,500). Q3 The August income statement would report gross profit of $_________ and net income of $_________. The Accounting Cycle Page 249 Chapter 7 ACTIVITY 91 ADJUSTING JOURNAL ENTRIES Purpose: Q1 • • Analyze adjusting journal entries. Prepare adjusting journal entries using debits and credits. Prepare general journal entries to record the adjustments below as of December 31, 2012 for the Perry Corporation. Perry Corporation GENERAL JOURNAL—2012 Date Accounts Debit Credit AJE #1 The accountant completed the depreciation schedule for 2012, which showed total depreciation expense of $10,520 for the year. The depreciation expense account already has a balance of $8,500. Record the remaining depreciation expense for the year. Dec 31 AJE #2 Commissions for December of $22,000 will be paid to Perry’s sales staff on January 5, 2013. The commissions payable account has a zero balance. Record commission expense for December. AJE #3 The company loaned $20,000 to a customer on July 1, 2012 for one year at 8% interest. The customer will pay the principal and interest on the loan on June 30 of next year. No interest in connection with this loan has been recorded. Record interest revenue for the year. AJE #4 On July 1, 2012 Perry paid an entire year’s rent of $14,000 for a warehouse, which the bookkeeper recorded as Prepaid Rent. Record rent expense for 2012. Q2 Review the adjusting journal entries (AJEs) above. Identify each journal entry account as either a balance sheet account or an income statement account. In total there are (3 / 4 / 5 ) balance sheet accounts and (3 / 4 / 5 ) income statement accounts. Each AJE includes (1 / 2 / 3) balance sheet accounts and (1 / 2 / 3) income statement account and (always / sometimes / never) includes the cash account. Q3 Prepare part of the December 31, 2012 adjusted trial balance for the expense accounts below. ADJUSTED TRIAL BALANCE—Dec 31, 2012 No. Account 400 500 510 520 Interest revenue Depreciation expense Commission expense Rent expense The Accounting Cycle Debit Page 250 Credit Chapter 7 ACTIVITY 92 PREPARE AN ADJUSTED TRIAL BALANCE Purpose: • Prepare an adjusted trial balance. The following account information from Lelescu Corporation’s adjusted trial balance at December 31 is arranged in alphabetical order by account: Accounts Receivable Accounts Payable Accumulated Depreciation, Equipment Additional Paid-in Capital Cash Common Stock Cost of Goods Sold Dividends Equipment Loss on Sale of Equipment Interest Expense Inventory Notes Payable Retained Earnings, beginning Sales Revenue Supply Expense $18,000 7,000 3,000 31,000 9,000 5,000 11,000 2,000 22,000 5,800 100 5,000 4,100 4,000 20,000 1,200 Required: Prepare an adjusted trial balance in proper form using the above information. Lelescu Corporation ADJUSTED TRIAL BALANCE—December 31 Account Cash $ Debit 9,000 Accounts Payable $ 7,000 Sales Revenue 20,000 Total The Accounting Cycle Credit $ 74,100 Page 251 Chapter 7 900 CJE #4 Close the dividends account to retained earnings.000 / 5.000 31.100 4.000 20.800 Income Summary 1.000 9.000 Loss on Sale of Equipment CJE #3 Close the income summary account to retained earnings.000 5.000 100 5.000 3.200 Prepare closing entries for year-end.000 5. Q2 Retained earnings on the December 31 Balance Sheet will report $[(100) / 3. beginning Sales Revenue Supply Expense Q1 $18.000 22.900 / 4. Equipment Additional Paid-in Capital Cash Common Stock Cost of Goods Sold Dividends Equipment Interest Expense Inventory Loss on Sale of Equipment Notes Payable Retained Earnings. The Accounting Cycle Page 252 Chapter 7 .000 2. Oza Corporation GENERAL JOURNAL Date Accounts Debit Credit CJE #1 Close all revenue and gain accounts to income summary. 5. Dec 31 Income Summary CJE #2 Close all expense and loss accounts to income summary.900].000 11.000 7.800 4. The following account information from Oza Corporation’s adjusted trial balance at December 31 is arranged in alphabetical order by account: Accounts Receivable Accounts Payable Accumulated Depreciation.ACTIVITY 93 Purpose: PREPARE CLOSING ENTRIES • Prepare closing entries. 20.000 1. The Accounting Cycle Page 253 Chapter 7 . Nancy Nanny opened a child-care facility on January 1. NANCY NANNY CHILD CARE CHART OF ACCOUNTS 110 120 130 135 140 150 170 171 Cash Accounts receivable Note receivable Interest receivable Supply inventory Prepaid rent Property. and equipment Accumulated depreciation—PPE 210 220 230 240 Accounts payable Notes payable Interest payable Unearned revenue 310 320 330 Common stock Retained earnings Dividends 410 420 Revenue Interest revenue 510 520 530 540 550 560 Cost of goods sold Depreciation expense Rent expense Supply expense Wage expense Interest expense Note: Add other accounts if needed. plant. Use the Chart of Accounts below to complete the requirements on the following pages for Nancy Nanny Child Care. Year 1.ACTIVITY 94 COMPREHENSIVE REVIEW OF THE ACCOUNTING CYCLE—YEAR 1 Purpose: • Comprehensive review the 10-step accounting cycle—Year 1. Paid cash. Nancy Nanny paid $30. Record each transaction in proper journal entry format below using debits and credits.000 Common stock 100. paid employees $70. Nancy Nanny purchased tables. Feb 1 TJE #5 During Year 1. Jan 2 Cash 100.NANCY NANNY CHILD CARE—Year 1 Q1 The following transactions occurred during Year 1. The prepaid rent account was used to record this entry. Nancy Nanny Child Care GENERAL JOURNAL—Year 1 Date Accounts Debit Credit TJE #1 On January 2. collections from receivable customers totaled $146. cots. for Nancy Nanny Child Care.000.000. and other furniture for $18. Nancy Nanny purchased supplies at a cost of $40.000 in cash from investors in exchange for shares of Nancy Nanny common stock. Nancy Nanny received $100.000 was paid in cash with the balance on a note payable due in one year bearing 12% annual interest. chairs.000 TJE #2 On January 2. $5. the first year of business. Year 1 The Accounting Cycle Page 254 Chapter 7 . Jan 2 TJE #3 On February 1. Nancy Nanny provided child-care services on account totaling $150. Year 1 TJE #7 During Year 1.000. This furniture has an estimated useful life of five years and is depreciated monthly using the straight-line method with no expected residual value.000.000. Year 1 TJE #6 During Year 1. Feb 1 TJE #4 On February 1.000 for a two-year lease of the building. (Refer to TJE #2. Nancy Nanny made the following adjusting journal entries. Nancy Nanny had $6.) Debit Credit Dec 31 AJE #2 Record depreciation expense for the year.) AJE #4 At the end of the first year. (Refer to TJE #3.000 of supplies still on hand that had not been used. Nancy Nanny Child Care GENERAL JOURNAL—Year 1 Date Accounts AJE #1 Record rent expense for the year.) The Accounting Cycle Page 255 Chapter 7 .) AJE #3 Record interest expense for the year. (Refer to TJE #4.NANCY NANNY CHILD CARE—Year 1 Q2 At the end of Year 1. Record each adjusting entry in proper journal entry format below using debits and credits. (Refer to TJE #3. Nancy Nanny Child Care GENERAL LEDGER—Year 1 520 Depreciation Expense 110 Cash 220 Notes Payable 310 Common Stock 120 Accounts Receivable 230 Interest Payable 320 Retained Earnings 530 Rent Expense 140 Supply Inventory 330 Dividends 540 Supply Expense 150 Prepaid Rent Income Summary 550 Wage Expense 410 Revenue 560 Interest Expense 170 PPE The Accounting Cycle 171 Accumulated Depreciation—PPE Page 256 Chapter 7 .NANCY NANNY CHILD CARE—Year 1 Q3 Post the Transaction Journal Entries from Q1 and the Adjusting Journal Entries from Q2 to the General Ledger below. Q4 Compute the ending balance for each account. NANCY NANNY CHILD CARE—Year 1 Q5 Use the ending balances computed in the General Ledger to prepare the Adjusted Trial Balance below.000 $267. and equipment Accumulated depreciation—PPE Notes payable Interest payable Common stock Revenue Depreciation expense Rent expense Supply expense Wage expense Interest expense Credit $ 101.730 Total The Accounting Cycle Debit Page 257 Chapter 7 . 110 120 140 150 170 171 220 230 310 410 520 530 540 550 560 Account Cash Accounts receivable Supply inventory Prepaid rent Property. Nancy Nanny Child Care ADJUSTED TRIAL BALANCE—Year 1 No. plant. Year 1 Stock issued Net income Dividends $ -0- Retained Earnings $ -0- Total SEquity $ -0- Balance. January 1. Use the forms provided below.300 Net income $ 26. Year 1 The Accounting Cycle Page 258 Chapter 7 .NANCY NANNY CHILD CARE—Year 1 Q6 Use amounts from the Adjusted Trial Balance to prepare the Income Statement and the Statement of Stockholders’ Equity.270 Nancy Nanny Child Care STATEMENT OF STOCKHOLDERS’ EQUITY—Year 1 Common Stock Balance. Nancy Nanny Child Care INCOME STATEMENT—Year 1 Revenue Operating expenses: $ $ ________ Total operating expense Operating income Nonoperating expenses: 122. December 31. 700 140.000 ( ) ( ) ( ) $ Net cash from operating activities CASH FROM INVESTING ACTIVITIES Cash paid for property. and equipment Accumulated depreciation—PPE $ ( ) 14. and the Statement of Stockholders’ Equity to prepare the Balance Sheet and the Statement of Cash Flows.NANCY NANNY CHILD CARE—Year 1 Q7 Use amounts from the General Ledger.000 The Accounting Cycle -0- Page 259 Chapter 7 . Adjusted Trial Balance.000 Property. plant. Use the forms provided below.700 Total assets LIABILITIES _______ Total liabilities STOCKHOLDERS’ EQUITY _______ _______ Total stockholders’ equity $ Total liabilities and stockholders’ equity Nancy Nanny Child Care STATEMENT OF CASH FLOWS—Year 1 CASH FROM OPERATING ACTIVITIES Cash from customers Rent paid Cash paid for supplies Wages paid $ 146. plant. Nancy Nanny Child Care BALANCE SHEET—Year 1 ASSETS Cash $ 101. and equipment ( CASH FROM FINANCING ACTIVITIES Cash from issuing common stock $ _______ ) Net change in cash Beginning cash balance $ Ending cash balance $ 101. plant. Use the forms provided below. Retained earnings Dividends -0-0- Nancy Nanny Child Care—POST-CLOSING TRIAL BALANCE—Year 1 No.730 CJE #3 Close the income summary account to retained earnings.NANCY NANNY CHILD CARE—Year 1 Q8 Use amounts from the Adjusted Trial Balance to prepare Closing Journal Entries and the PostClosing Trial Balance. Nancy Nanny Child Care—GENERAL JOURNAL—Year 1 Date Accounts CJE #1 Close all revenue and gain accounts to income summary.000 Income summary 123. 150. CJE #4 Close the dividends account to retained earnings. 110 120 140 150 170 171 220 230 310 320 Account Cash Accounts receivable Supply inventory Prepaid rent Property.000 Credit Chapter 7 . and equipment Accumulated depreciation—PPE Note payable Interest payable Common stock Retained earnings Total The Accounting Cycle Page 260 $ Debit 101. Debit Credit Dec 31 Income summary CJE #2 Close all expense and loss accounts to income summary.000 $ 144. paid employees $80. Q1 The following transactions occurred during Year 2.000. Nancy Nanny purchased supplies at a cost of $45. TJE #4 On December 8.000 TJE #2 On February 1. server. Jan 2 Property. the second year of business for Nancy Nanny Child Care. Paid cash. printer. collections from customer receivables totaled $182. and related accessories for $10. a child who regularly attends Nancy Nanny’s. plant.000 Cash 10. This activity covers the accounting cycle for Year 2. Nancy Nanny decided to use the doubledeclining method of depreciation over a five-year life with no expected residual value. Nancy Nanny purchased a computer. his grandson.000 of dividends to her investors.000 toward next year’s child care costs for Jason.000.ACTIVITY 95 COMPREHENSIVE REVIEW OF THE ACCOUNTING CYCLE—YEAR 2 Purpose: • Comprehensive review of the 10-step accounting cycle—Year 2. and equipment 10. Year 2 The Accounting Cycle Page 261 Chapter 7 . Nancy Nanny Child Care GENERAL JOURNAL—Year 2 Date Accounts Debit Credit TJE #1 On January 2. Continue to use the chart of accounts for Nancy Nanny Child Care provided in the previous Activity. TJE #6 During Year 2. Nancy Nanny provided child care services on account totaling $180. Year 2 TJE #7 During Year 2. Year 1.000 cash. Nancy Nanny repaid the note payable from Year 1 plus interest. NANCY NANNY CHILD CARE—Year 2 Nancy Nanny opened a child-care facility on January 1. Record each transaction in proper journal entry format below using debits and credits. Due to fast changing computer technologies. TJE #5 On December 14. Nancy Nanny declares and distributes $20. The previous Activity covered the accounting cycle for Year 1. Year 2 TJE #8 During Year 2. Interest expense 130 TJE #3 On February 1.000. Grandpa Meyer prepaid $6.000. 000 of supplies on hand that had not been used. Nancy Nanny made the following adjusting journal entries.) Debit Credit Dec 31 AJE #2 Record depreciation expense for the year. (Refer to Year 1 TJE #2. Nancy Nanny had $5. Record each adjusting entry in proper journal entry format below using debits and credits.NANCY NANNY CHILD CARE—Year 2 Q2 At the end of Year 2.) Dec 31 AJE #3 At the end of the second year. Nancy Nanny Child Care GENERAL JOURNAL—Year 2 Date Accounts AJE #1 Record rent expense for the year. (Refer to Year 1 TJE #3 and Year 2 TJE #1. (What amount of supplies did Nancy Nanny use during Year 2?) Dec 31 The Accounting Cycle Page 262 Chapter 7 . 000 The Accounting Cycle Page 263 Chapter 7 . Q5 Compute the ending balance for each account. Q4 Post the Transaction Journal Entries from Q1 Year 2 and the Adjusting Journal Entries from Q2 Year 2 to the General Ledger below. Record below.NANCY NANNY CHILD CARE—Year 2 Q3 Use the Post-Closing Trial Balance amounts of Year 1 (from the previous Activity) as the beginning balances of Year 2.000 Beg 100.000 (T1)10. Nancy Nanny Child Care GENERAL LEDGER—Year 2 110 Cash Beg 101.000 10.000 Beg Beg -0- 120 Accounts Receivable 230 Interest Payable 320 Retained Earnings 530 Rent Expense 140 Supply Inventory 240 Unearned Revenue 330 Dividends 540 Supply Expense Bal 119.440 150 Prepaid Rent 170 PPE 550 Wage Expense 171 Accumulated Depreciation—PPE 410 Revenue 560 Interest Expense Beg 18.000(T1) 220 Notes Payable 310 Common Stock 520 Depreciation Expense 13. 110 120 140 170 171 240 310 320 330 410 520 530 540 550 560 Account Cash Accounts receivable Supply inventory Property. plant.NANCY NANNY CHILD CARE—Year 2 Q6 Use the ending balances from the General Ledger to prepare the Adjusted Trial Balance below. and equipment Accumulated depreciation—PPE Unearned revenue Common stock Retained earnings (Beginning) Dividends Revenue Depreciation expense Rent expense Supply expense Wage expense Interest expense Credit $ 323.440 Page 264 Chapter 7 .170 Total The Accounting Cycle Debit $ 119. Nancy Nanny Child Care ADJUSTED TRIAL BALANCE—Year 2 No. January 1. December 31.NANCY NANNY CHILD CARE—Year 2 Q7 Use amounts from the Adjusted Trial Balance to prepare the Income Statement and the Statement of Stockholders’ Equity.600 Total operating expense Operating income Nonoperating expenses: ________ $ Net income Nancy Nanny Child Care STATEMENT OF STOCKHOLDERS’ EQUITY—Year 2 Retained Earnings Common Stock Balance. Use the forms provided below. Year 2 Stock issued Net income Dividends $ Balance. Nancy Nanny Child Care INCOME STATEMENT—Year 2 $ Revenue Operating expenses: $ ________ 148.270 0 $ 0 ( Page 265 $ ) ( ) $ Chapter 7 . Year 2 $ The Accounting Cycle $ Total SEquity 126. Nancy Nanny Child Care BALANCE SHEET—Year 2 ASSETS $ $ ( ) ________ $ Total assets LIABILITIES STOCKHOLDERS’ EQUITY ________ $ 143. and equipment CASH FROM FINANCING ACTIVITIES Paid note payable Dividends paid ( ( ) ) ) ) 18. Adjusted Trial Balance. and the Statement of Stockholders’ Equity to prepare the Balance Sheet and the Statement of Cash Flows. plant.440 Page 266 Chapter 7 .540 Total liabilities & stockholders’ equity Nancy Nanny Child Care STATEMENT OF CASH FLOWS—Year 2 CASH FROM OPERATING ACTIVITIES Cash from customers Cash paid for supplies Wages paid Interest paid $ ( ( ) ) (1.NANCY NANNY CHILD CARE—Year 2 Q8 Use amounts from the General Ledger.440 ________ Net change in cash Beginning cash balance $ Ending cash balance The Accounting Cycle ( ( Net cash used for financing activities 61. Use the forms provided below.560) $ Net cash from operating activities CASH FROM INVESTING ACTIVITIES Cash paid for property. Debit Dec 31 Income Summary 148. Use the forms provided below.270 Dec 31 Nancy Nanny Child Care—POST-CLOSING TRIAL BALANCE—Year 2 No. Nancy Nanny Child Care—GENERAL JOURNAL—Year 2 Date CJE #1 Accounts Close all revenue and gain accounts to income summary.NANCY NANNY CHILD CARE—Year 2 Q9 Use amounts from the Adjusted Trial Balance to prepare the Closing Journal Entries and the PostClosing Trial Balance. plant. Dec 31 Income Summary CJE #4 Close the dividends account to retained earnings. Credit Dec 31 31. 110 120 140 170 171 240 310 320 Account Cash Accounts receivable Supply inventory Property. and equipment Accumulated depreciation—PPE Unearned revenue Common stock Retained earnings $ $ Total The Accounting Cycle Debit Page 267 Credit $ 154.730 CJE #3 Close the income summary account to retained earnings.440 $ Chapter 7 . ACTIVITY 96 TEST YOUR UNDERSTANDING Purpose: • • • • Post journal entries directly into T-accounts. -0- 510 Salary Expense Beg. Q3 Compute the ending balance for each account. using straight-line depreciation.000 during September. -0- 110 Accounts Receivable Beg.000 Q1 Q2 300 Common Stock 30. These ending balances would appear on the (unadjusted / adjusted / postclosing) trial balance and (be / not be) reported on the financial statements. 400 Revenue Beg. Prepare the Statement of Cash Flows using the indirect method.000 Beg. which has a four-year (48month) life. 6. -0- 130 Delivery Van Beg. What amounts would be recorded on the September balance sheet? REarnings $________ Total Assets $________ Total Liabilities $________ SEquity $________ The Accounting Cycle Page 268 Chapter 7 . Record the adjusting journal entry for September directly into the T-accounts above: AJE #1 Record September depreciation expense for the delivery van.000. TJE #3 Employees earn $700 in salaries during September. -0- Record the following transaction journal entries for September directly into the T-accounts above. recording it as a debit or credit balance in the General Ledger above. -0- 350 Retained Earnings -0Beg. -0- 140 Accumulated Depreciation Beg. Prepare the Statement of Cash Flows using the direct method. 24. TJE #4 For Salaries Payable. TJE #1 Bill customers for deliveries that total $2. Prepare the TJE for cash paid to employees. the ending balance on September 30 is $100. Brian was ready to start business on September 1 after issuing common stock for $30. Record as Salaries Payable. 500 Depreciation Expense Beg. the ending balance on September 30 is $150.000 and purchasing a delivery van for $24. Brian Nelson’s Delivery Service Corporation GENERAL LEDGER—September 100 Cash Beg. Prepare the TJE for cash received from customers.000 200 Salaries Payable Beg. TJE #2 For accounts receivable. Prepare financial statements. / cash-) based “Cash received from customers” reported on the (Income Statement / Statement of Cash Flows) is $___________./ cash-) based “Salaries paid” reported on the (Income Statement / Statement of Cash Flows) is $___________. e. Record in the Adjustments Column above. (A) prepare the Income Statement and (B) prepare the Operating Activity section of the Statement of Cash Flows below. The Accounting Cycle Page 269 Chapter 7 .000 Salary expense ( Depreciation expense ( Net income $ $ Total $ 550 What adjustments are needed to get from accrual-based net income to cash-based Net Cash from Operating Activities? a. Complete the Adjustments Column for Depreciation in the chart above. This difference will (always / sometimes) be the same as the amount in the Adjustments Column. During September. a difference of $___________. Statement of Cash Flows (Indirect Method) Net income Add depreciation expense (Increase) decrease in accounts receivable Increase (decrease) in salaries payable Net cash from operating activities (NCOA) Amounts $ $ 1. The difference between (accrual. Salaries Payable had a beginning balance of $___________ and an ending balance of $___________. Use amounts from the Adjustments Column above to prepare the Operating Activities section of the Statement of Cash Flows below. During September. This adjustment is (added / subtracted). and financing activities may be reported using the (direct / indirect / either) method. Q8 In the Statement of Cash Flows. operating activities may be reported using the (direct / indirect / either) method.350 Q7 Amounts from the Adjustments Column are used to reconcile accrual-based Net Income with cashbased Net Cash from Operating Activities. a difference of $___________. b. This difference will (always / sometimes) be the same as the amount in the Adjustments Column. The indirect method of preparing the Statement of Cash Flows reconciles accrual-based Net Income with cash-based Net Cash from Operating Activities (NCOA). which is the purpose of the (direct / indirect) method. d./ cash-) based “Salary expense” reported on the (Income Statement / Statement of Cash Flows) and (accrual. The difference between (accrual. Accounts Receivable had a beginning balance of $___________ and an ending balance of $___________. c. This adjustment is (added / subtracted). investing activities may be reported using the (direct / indirect / either) method. INCOME STATEMENT Q5 Q6 ADJUSTMENTS STATEMENT OF CASH FLOWS Cash received from customers $ ) Salaries paid ( ) ) Depreciation paid ( ) Net cash from operating activities $ 1.350 Revenue $ 2. Record in the Adjustments Column.Q4 Using amounts from the General Ledger on the previous page./ cash-) based “Revenue” reported on the (Income Statement / Statement of Cash Flows) and (accrual. Chapter 9. and may spell trouble later on. and ratios measured over time. the additional financial leverage is increasing financial risk. So even though ROE is increasing. it is important to track financial risk. This chapter emphasizes how important it is to look at the whole picture. or liquidity. liquidity. It would be relatively easy to look at one aspect of a company. research has shown that some investors only look at net income. profitability is generally considered the most important factor. the Capstone Project. and solvency. First of all. That said. They focus almost exclusively on net income. under the indirect method. ending all future opportunities of returns. describes how net income (reported on the income statement) increases cash and cash equivalents (reported on the balance sheet). When considering a company’s investment potential. as a company grows.CHAPTER 8 COMPREHENSIVE REVIEW INTRODUCTION This chapter presents a series of activities designed to review and integrate the concepts learned throughout the course. provides further comprehensive review. changes in financial statements. or solvency. Remember that efficiency and solvency can also boost losses. to the exclusion of others. Solvency indicates a company’s ability to pay back debts in the long term. or even how net income was calculated. to review all of the financial statements. The operating cash flows section of the Statement of Cash Flows. the DuPont Model demonstrates how efficiency (as measured by asset turnover) and solvency (as measured by financial leverage) can be multiplied by return on sales to increase return on equity. These measures change over time. The Statement of Stockholders’ Equity describes how net income (reported on the income statement) increases retained earnings (reported on the balance sheet). In addition to profitability and efficiency. efficiency and solvency can boost returns. it could close. For example. using a company of your choice. efficiency. its return on equity could be increasing. and to jointly assess a company’s profitability. but due to increased financial leverage rather than increased profitability. Solvency and liquidity indicate financial risk. They don’t care about revenue. This is why it’s especially important to consider trends. Well-run companies earn profits that grow reliably at a steady pace. whereas liquidity indicates a company’s ability to pay back debts in the short term. A company must eventually pay back its debts. The financial statements link with and explain one another. consider how the financial statements interact with one another. If a company can’t pay back debts. For example. Comprehensive Review Page 270 Chapter 8 . Purchase short-term trading securities for cash. (I / D / No) i. Pay cash dividends. The current market value of high-tech inventory is less than acquisition cost. (I / D / No) d. (I / D / No) Comprehensive Review Page 271 Chapter 8 . Record depreciation for the equipment. Issue a bond payable at a discount for cash. (I / D / No) g. (I / D / No) f. (I / D / No) c. (I / D / No) m. b. Record the receipt of cash from Customer Casey in (b). (I / D / No) j. Land purchased ten years ago has increased in market value. or have (No) effect on total assets. Record a cash sale to Customer Grant.ACTIVITY 97 Purpose: TRANSACTIONS AFFECTING TOTAL ASSETS • Review the effect of various transactions on total assets. Sell equipment at a gain for cash. Purchase supplies for cash. (I / D / No) n. Purchase equipment on account. Record a sale on account to Customer Casey. Circle whether each of the following events/transactions will (I)ncrease. At the end of the accounting period. the short-term trading securities purchased in (h) have increased in market value. (I / D / No) k. (D)ecrease. TOTAL ASSETS (Circle the answer) (I / D / No) a. (I / D / No) h. (I / D / No) e. (I / D / No) l. Purchase treasury stock for cash. Company lawyers evaluate the case and estimate the company will probably win a substantial amount for damages. These costs will not be paid until an employee retires in a future accounting period. Circle whether each of the following events/transactions will (I)ncrease. (I / D / No) h. estimate the amount of income taxes owed for the fiscal year. (I / D / No) d.000. (I / D / No) e. Issue bond payable at a discount. (D)ecrease. (I / D / No) f. (I / D / No) At the end of the accounting period. (I / D / No) A lawsuit is filed against Company ABC. Comprehensive Review Page 272 Chapter 8 . j. Bond payable matures and is paid in full. (I / D / No) b. (I / D / No) c. (I / D / No) Retirement costs for current employees are recorded. Company lawyers evaluate the case and estimate the company will probably lose and owe a substantial amount for damages. The case will be tried in a future accounting period. TOTAL LIABILITIES (Circle the answer) a. At the end of the accounting period. (I / D / No) g. l. The employee will start next Monday.ACTIVITY 98 Purpose: TRANSACTIONS AFFECTING TOTAL LIABILITIES • Review the effect of various transactions on total liabilities. or have (No) effect on total liabilities. Employees get paid on Friday. The case will be tried in a future accounting period. k. Pay for the inventory purchased in (a). (I / D / No) The end of the accounting period is on Wednesday. i. Sell inventory to customers for cash. (I / D / No) Company ABC files a lawsuit. Purchase inventory on account. Record accrued employee wage expense. Hire a new employee for an annual salary of $20. record accrued interest expense on the bond payable. (D)ecrease.ACTIVITY 99 Purpose: TRANSACTIONS AFFECTING STOCKHOLDERS’ EQUITY • Review the effect of various transactions on stockholders’ equity. Record net income for the accounting period. the market price of the company’s common stock increases. Declare and issue a stock dividend. Issue preferred stock at par value. (I / D / No) e. (I / D / No) b. Correct an error that understated depreciation expense in the previous accounting period. (I / D / No) f. Issue common stock at more than par value. Issue bonds payable at a premium. Purchase inventory on account. Circle whether each of the following events/transactions will (I)ncrease. (I / D / No) g. (I / D / No) c. (I / D / No) d. Purchase treasury stock. (I / D / No) i. Comprehensive Review Page 273 (I / D / No) Chapter 8 . During the accounting period. Declare and issue a cash dividend. STOCKHOLDERS’ EQUITY (Circle the answer) a. (I / D / No) j. (I / D / No) h. or have (No) effect on stockholders’ equity. 000 from the bank and sign a note. Borrow $10. Record a loss on the sale of equipment. (I / D / No) f.000 note. Record a sale for Customer Ewa on account. At the end of the accounting period. Issue common stock for more than the par value. (I / D / No) e. (I / D / No) b2. Record cash received from Customer Ewa for the sale recorded in (b1). record the portion of sales estimated as uncollectible. (I / D / No) d3. (I / D / No) d1. Comprehensive Review Page 274 (I / D / No) Chapter 8 . (I / D / No) i. make the adjusting entry to record accrued interest expense on the note in (d1).ACTIVITY 100 Purpose: • TRANSACTIONS AFFECTING NET INCOME Review the effect of various transactions on net income. Circle whether each of the following events/transactions will (I)ncrease. Repay the $10. Record a sale for Customer Ashley paying cash. (I / D / No) c2. Record an extraordinary gain. record an unrealized gain on the short-term trading securities portfolio. (D)ecrease. At the end of the accounting period. (I / D / No) d2. (I / D / No) At the end of the accounting period. (I / D / No) g. At the end of the accounting period. (I / D / No) c1. j. Purchase equipment. or have (No) effect on net income. make the adjusting entry to record depreciation for the equipment. (I / D / No) h. (I / D / No) c3. (I / D / No) b1. NET INCOME (Circle the answer) a. Declare and issue a cash dividend. Pay rent for this accounting period. Market value of the common stock issued by the corporation.ACTIVITY 101 Purpose: WHICH FINANCIAL STATEMENT? • Reinforce understanding of the information provided by each financial statement. BS IS SE CF Not = Balance sheet = Income statement = Statement of stockholders’ equity = Statement of cash flows = Not found on any of the financial statements FINANCIAL STATEMENTS (Circle only one correct answer) a. (BS / IS / SE / CF / Not) f. Rental costs incurred this year. (BS / IS / SE / CF / Not) g. (BS / IS / SE / CF / Not) q. (BS / IS / SE / CF / Not) o. Market value of equipment purchased ten years ago. (BS / IS / SE / CF / Not) i. Equipment book value (carrying value). (BS / IS / SE / CF / Not) Comprehensive Review Page 275 Chapter 8 . (BS / IS / SE / CF / Not) e. Noncash investing and financing activities. Rental costs still owed. (BS / IS / SE / CF / Not) j. Cost of inventory sold during the accounting period. (BS / IS / SE / CF / Not) d. Evaluate how assets are currently being financed. Cash-basis accounting used to compute operating results. Amounts contributed by common shareholders this year. (BS / IS / SE / CF / Not) c. Cost of equipment allocated to this accounting period. Market value of investments in the short-term trading portfolio. (BS / IS / SE / CF / Not) b. Rental costs paid this year. (BS / IS / SE / CF / Not) p. Inventory remaining unsold at the end of the accounting period. (BS / IS / SE / CF / Not) m. (BS / IS / SE / CF / Not) l. (BS / IS / SE / CF / Not) h. the most recent inventory costs will end up on this statement. If we use the FIFO inventory cost flow assumption. (BS / IS / SE / CF / Not) n. Financial statement reporting amounts as of a certain date. (BS / IS / SE / CF / Not) k. Circle the financial statement you would consult to find the following information. Accrual-basis accounting used to compute operating results. Year 1. Straight-line depreciation is used. g. a classified balance sheet. a.000 remains unpaid at the end of the year. Paid cash.000 in cash (for a total of $100. purchased new equipment costing $70.000 in cash.000 of books. Later in the year. January 1. All purchases have been paid for.000 with a 10-year useful life and no residual value.000. At the end of the year. Yonghong and her friend each invested $50. the statement of retained earnings.000 for a two-year property insurance policy. the company paid shareholders cash dividends totaling $8. Rental costs for the year total $48. January 1. Yonghong opened Books Galore. $4. $250. On January 1. • Differentiate between accrual accounting and cash accounting. Principal and interest are due on June 30. e. Inc. the December 31. 10% note payable. During Year 1. the land was sold to another small business owner for $30. f. j. Inventory purchases totaled $200. • Prepare a multi-step income statement.000 of those purchases remain in inventory at the end of the year. Year 1. and the Year 1 statement of cash flows in the space provided. Year 1. Use these items to prepare the Year 1 multi-step income statement. Of that amount.000. customers purchased $300. i. h. Of that amount.000) in exchange for shares of common stock in Books Galore. borrowed $25. Year 1. Year 2. d. December 31.. and $18. the Year 1 statement of stockholders’ equity. The following financial items summarize the first year of operations.000 from a local bank and signed a one-year.ACTIVITY 102 Purpose: FINANCIAL STATEMENT PREPARATION • Apply the revenue recognition and the matching principles. Inc. During Year 1. On July 1. Multi-Step Income Statement Year 1 Sales revenue Cost of goods sold Gross profit Operating expenses: Nonoperating revenues (expenses): Net income Comprehensive Review Page 276 Chapter 8 . and the statement of cash flows.000 for the year. purchased a piece of land next to the store for $20. b. purchased and paid $2. Year 1.000 has been collected from customers in cash and the remaining amounts will be collected next year. c. for business on January 1. adjusting entries were recorded for depreciation expense and interest expense. Year 1 classified balance sheet. Year 1.000 in cash. Beginning balances Additions: STATEMENT OF STOCKHOLDERS’ EQUITY Year 1 Contributed Retained Capital Earnings $ -0$ -0- Total SE $ -0- Deductions: Ending balances $ $ $ CLASSIFIED BALANCE SHEET December 31. and Equipment: Stockholders’ Equity: STATEMENT OF CASH FLOWS Year 1 (Prepared using the Direct Method) Cash from operating activities: Cash from investing activities: Cash from financing activities: Net change in cash + Beginning cash =Ending cash Comprehensive Review Page 277 Chapter 8 . Year 1 Current Assets: Liabilities: Property. Plant. 9% 20.9% 39.2% 2.8% 10.9% 35. solvency. Therefore.8 $579 1.96 11.4 NA $53 1.6 days 4.85 1.1 days 1.58 1.5% 9.9% XXXXX NA 5.8% 1.7% 1.2% 4. the ratio formulas used may differ from the formulas in the text.3 NA 14. 2012 PROFITABILITY Return on sales (ROS) Return on assets (ROA) Return on equity (ROE) Gross profit margin (GP%) Earnings per share (EPS) Quality of income EFFICIENCY Asset turnover (A TO) Accounts receivable turnover Accounts receivable days Inventory turnover Inventory days LIQUIDITY Current ratio Cash flow liquidity SOLVENCY Debt ratio Financial leverage (LEV) Times interest earned Free cash flow (in millions) Cash flow adequacy INVESTMENT Price earnings ratio (PE) Dividend rate Market value per share: Close March.96 --5.64 4.43 $15.10 $16.7% 11.7 64 days 1. Understand that meaning is added to a ratio by comparing that ratio to industry norms or to a company within the same industry because norms may vary by industry.43 52% 2.4 10.43 $10.57 1.53 55 6. 2012 52-week high 52-week low DUPONT ANALYSIS OF ROE Return on sales (ROS) Asset turnover (A TO) Return on assets (ROA) Financial leverage (LEV) Return on equity (ROE) Industry Average* The GAP (GPS) American Eagle Outfitters (AEO) 6.28 **19.7 30. Analyze profitability. liquidity.msn.00 $25.2 2.53 9.4 $0.40 16.9% 5.ACTIVITY 103 Purpose: • • • RATIO ANALYSIS Understand that reviewing many ratios helps give an overall impression of corporate financial strength.0 1.5 81.9% NA = Not available XXXXX = Not comparable among companies * Industry: Apparel Stores—Industry averages from money.9 $0.62 7. efficiency.5% 1.1 117 XXXXX NA 63% 2.1 20. Comprehensive Review Page 278 Chapter 8 .4 _______ days 2.8% 7.9% 2.7 20.1 NA 2.8% 1.7% $0.2% 30.00 6.3% $1. RATIOS As of January 28.43 NA NA NA $25.08 $16.2% 36.74 27% 1.com There are no official rules governing how these ratios are calculated.53 3.com ** Industry: Apparel Stores—Industry ratio averages from morningstar. and investment ratios.62 78 _______ days 5. Is American Eagle Outfitters efficiently managing its assets? (Yes / No) How can you tell? c. a. dividends.Refer to the ratio information on the previous page to answer the following questions. and other assets. Q2 Compare The GAP and American Eagle Outfitters. Q4 Review the DUPONT ANALYSIS of ROE for American Eagle Outfitters. Q1 For American Eagle Outfitters. the most significant influence can be attributed to (ROA / Financial Leverage / both contribute about equally). Is American Eagle Outfitters effectively managing its debt? (Yes / No) Able to adequately cover capital expenditures and pay dividends? (Yes / No) How can you tell? e. PROFITABILITY RATIOS measure the overall performance of a firm. EFFICIENCY RATIOS measure the effectiveness of managing cash. b. Q6 a. Q5 Analyze American Eagle Outfitters by reviewing each category of ratio information presented on the previous page to answer the following questions. Regarding ROE. the most significant influence can be attributed to (ROS / Asset Turnover / both contribute about equally). accounts receivable. For liquidity and solvency ratios … Cross out any company ratio reporting higher risk. compute account receivable days _______ and inventory days _______. PPE. Does American Eagle Outfitters have the ability to make payments as they come due? (Yes / No) How can you tell? d. capital expenditures. SOLVENCY RATIOS measure the extent of debt relative to equity. Regarding overall profitability (ROA). Is American Eagle Outfitters earning sufficient profits? (Yes / No) How can you tell? b. For profitability and efficiency ratios … Cross out any company ratio weaker than the industry average. Compared to the industry average. AEO collects accounts receivable (quicker / slower) and sells inventory (quicker / slower). and the ability to cover required payments for interest. b. a. would you recommend investing in American Eagle Outfitters? (Yes / No) Why? Comprehensive Review Page 279 Chapter 8 . and other fixed payments. For profitability and efficiency ratios … Circle the stronger ratio. b. For liquidity and solvency ratios … Circle the ratio reporting the least amount of risk. LIQUIDITY RATIOS measure a firm’s ability to meet cash needs as they arise. if financial leverage is being used effectively. Q3 Compare The GAP and American Eagle Outfitters to industry averages. Enter these amounts in the appropriate location in the ratio chart on the previous page. Is American Eagle Outfitters providing an adequate return to shareholders? (Yes / No) How can you tell? Based on all of the information presented on the previous page. a. INVESTMENT RATIOS compare the market value per share to other per share amounts and the level of dividend payment. inventory. For ratio formulas and explanations refer to Appendix B—Ratios. 996 0 0 1.610 $ 216 0 2.239 31.903 775 808 $ 8.614 1.983 34.289 $ 13.851 $ 40.004 40.603 7. the balance sheet. and the statement of cash flows.759 6.745 1.178 5.562 7.356 2.643 5. plant.214 1.167 4.768 Chapter 8 .252 0 750 41.690 20.429 $ 483 3.497 12/31/2008 $ 0 14.427 0 2705 52.574 Page 280 $ 0 18.346 1. and equipment.256 1.824 300 2.792 9.562 227 0 28.465 3.574 $ 57.044 1.235 27.223 $ 10.189 2.497 $ 31. net Goodwill Intangibles Other noncurrent assets TOTAL Assets LIABILITIES Accounts payable Short-term debt Accrued expenses Other current liabilities TOTAL Current liabilities Long-term debt Deferred income taxes Other noncurrent liabilities TOTAL Noncurrent liabilities TOTAL Liabilities STOCKHOLDERS’ EQUITY Preferred stock Common stock Retained earnings Other stockholders’ equity Treasury stock TOTAL Stockholders’ equity TOTAL L & SE Comprehensive Review BALANCE SHEET ($ in millions) 12/31/2011 12/31/2010 $ 9.745 4.913 2986 287 2.145 72.243 5.751 8.504 29.198 14.657 7.345 4.227 3.516 14.450 13.868 138 0 46.630 21.845 4.302 0 13 1.287 3.264 37.178 0 1.817 20.758 9. • Prepare a statement of retained earnings.493 $ 178 0 1.234 4.614 11.840 997 519 $ 72.642 0 1.256 2.082 105 0 36.ACTIVITY 104 Purpose: TEST YOUR UNDERSTANDING—GOOGLE • Analyze the income statement. Google (GOOG) ASSETS Cash and cash equivalents Short-term investments Accounts receivable Inventories Other current assets TOTAL Current assets Property.247 285 2.241 57.748 0 0 1.851 12/31/2009 $ 0 15.605 276 0 58.768 $ 588 1.218 4.578 1.529 $ 0 20. 336 883 3.270 1.946 1.396 1.294 (108) Net cash (for) investing activities (NCIA) (19.807 2.127 7.668 3.737 $ 8.254) 1.984 1.316 Cash flows from (for) investing activities Sale of investments 48.004 1.724 5.905 $ 13.853 15.326 2.803 2.321) (5.541 + Beginning cash and cash equivalents 13.024 327 7.227 1.162 500 12.589 $ 9.358) (15.050 233 Effect of exchange rate changes 22 (19) 11 Net change in cash (3.438) (4.861 8.647) 3.291 1.081 9.523 6.575 6.627 $ 4. net 0 (801) 0 Cash dividends paid 0 0 0 Other financing cash flow items 81 388 233 Net cash from financing activities (NCFA) 807 3.227 314 $ 2008 For the years ended December 31.500 (225) 2.054 Changes in working capital 630 (99) 486 Net cash from operating activities (NCOA) 14.983 $ 13.373 Chapter 8 .796 8.103 Purchase of PPE.312 +415 +69 10.854 1.188 24.041) (10.793 0 6.082 8. Revenue Cost of goods sold (COGS) Gross profit Sales and marketing General and administrative Research and development Unusual expense Total operating expenses Operating income Other revenues and expenses.463 0 Issuance (repurchase) of capital stock.962 1.630 $ 10.018) (810) Purchase of investments (62.063 8.506 Free cash flow 2008 21.717 4.565 11.321 $ 23.657 = Ending cash and cash equivalents $ 9.762 2.381 2.632 (778) 5.763 (2.204) Other investing cash flow items (2.520 319 316 Google (GOOG) STATEMENT OF CASH FLOWS ($ in millions) 2011 2010 2009 Cash flows from (for) operating activities Net income (loss) $ 9.844 18.520 Depreciation and amortization 1.851 1.524 Deferred income tax 343 9 (268) Operating (gains) losses 2.589 2.019) Cash flows from (for) financing activities Issuance (repayment) of debt. net 726 3.198 Supplemental information 795 959 $ 243 Cash interest paid $ $ 731 102 217 Cash taxes paid 11.055) (29.843 0 0 8.542 6.746 37.742 +584 12.381 8.495 10.198 8. net (3.Google (GOOG) For the years ended December 31.403) (3.680) (8.799 1.319) $ $ 0 (72) 0 160 88 (46) 2.622 13. Comprehensive Review Page 281 $ 4.174 1.737 $ 323 ($ in millions) 2010 2009 29.651 10.417 8.796 8. net Income before income tax Provision for income tax Net income Outstanding Shares (in millions) INCOME STATEMENT 2011 $ 37.505 $ 6.630 10.505 $ 6.432 1.095) (45.657 1.904 14.975 11.099 22. b. Compute the ratios requested in the chart below. Q2 a. c... Cash and short-term investments … more than doubled from 12/31/2008 to 12/31/2011. Google Current ratio Debt ratio * Industry Norm* 5. A response is given for Cash and Short-term Investments to help with understanding. (a) compare the two years of company ratios and circle the ratio indicating lower financial risk. comprising more than 80% of total assets on 12/31/2011.63 14. Total assets… d. Contributed capital… e. INCOME STATEMENT Q4 Compute the ratios requested in the chart below.4% 0. Google DUPONT ANALYSIS of ROE ROS Asset turnover ROA Financial leverage ROE * Industry Norm* 22. the balance sheet and related ratios indicate a (strengthening / steady / weakening) financial position. and totals. Goodwill.24 17. and then (2) identify what your observations indicate. For ratio formulas and explanation refer to Appendix B—Ratios. Q3 Overall.0 29% 12/31/2011 12/31/2008 % % Industry: Internet Information Provider—Industry ratio averages from money.msn. indicating a company that is rich in cash.com Comprehensive Review Page 282 Chapter 8 . Why? List observations that support your conclusion and explain why.Refer to the financial statements presented for Google on the previous two pages to answer the following questions.5% 2011 2008 % % % % % % Industry: Internet Information Provider—Industry ratio averages from money. (1) describe your observations.com For each ratio. Retained earnings.. BALANCE SHEET Q1 Review the following accounts. subtotals..msn. and (c) comment on the results. (b) cross out any company ratio indicating greater financial risk than the industry norm. For ratio formulas and explanation refer to Appendix B—Ratios.1% 1. indicating profitability is (down / up). Google RATIOS Free cash flow ($ in millions) Cash flow adequacy Cash flow liquidity Quality of income Industry Norm NA NA NA NA 2011 $ 2008 $ For each ratio. the most significant influence can be attributed to (ROS / Asset Turnover / both contribute about equally). Since 2009. Comprehensive Review Page 283 Chapter 8 . ROS has been (increasing / decreasing). (Circle all that apply. indicating that (sales and marketing / general and administrative / R&D / interest income / provision for income tax) has been increasing as a percentage of revenue. (a) circle the stronger ratio.7% 100% 36% 29% +1% 8% 29% 2009 100% 37% 29% +0% 8% 28% 2008 100% 40% 30% -4% 8% 19% Operating expenses have been (increasing / decreasing). and (c) comment on the results. For ratio formulas and explanation refer to Appendix B—Ratios. Q7 2011 2010 __________% __________% __________% __________% __________% 25. b. c. (b) cross out any ratio that is weaker than the industry norm. The income statement and related information indicate (strengthening / mixed / weakening) earnings potential. b. indicating that more investments were (purchased / sold). Q6 Compute the missing information for 2011 in Google’s common-size income statements below. Regarding overall profitability (ROA). STATEMENT OF CASH FLOWS Q8 The primary source of cash was (operating activities / issuing debt / issuing capital stock) and the primary use of cash was (purchasing PPE / purchasing investments /paying dividends). the most significant influence can be attributed to (ROA / Financial Leverage / both contribute about equally). Google Common-Size INCOME STATEMENT Revenue Cost of goods sold Operating expenses Nonoperating revenues (expense) Provision for income tax Net income a. (a) circle the company ratio indicating the strongest cash position and (b) comment on the results. For investments. there was a net cash outflow during (2011 / 2010 / 2009 / 2008).Q5 Review the DUPONT ANALYSIS of ROE for Google on the previous page. For each ratio. Regarding ROE. a. c. Q9 Compute the ratios requested in the chart below.) Provision for income tax has been (increasing / decreasing) as a percentage of revenue. Why? List observations that support your conclusion and explain why. Google STATEMENT OF RETAINED EARNINGS For the years ended December 31. since incorporation Google has earned profits and losses totaling $______ million. Google STATEMENT OF CASH FLOWS Common-Size 2011 Net cash from operating activities Sale of investments Purchase of investments Purchase of PPE.335 4. c. Q11 b. net Cash dividends paid Net change in cash ___________% ___________% ___________% ___________% ___________% ___________% -25% ($ in millions) 2010 2009 2008 100% 335% -407% 36% 31% 0% 31% 100% 237% -313% -9% 0% 0% 17% 100% 201% -196% -30% 0% 0% 33% * Only select amounts are listed above so will not sum to the total. beginning Net income Dividends paid Other adjustments Retained earnings. Why? List observations that support your conclusion and explain why. In what year did Google report a net decrease in cash? (2011 / 2010 / 2009 / 2008) What was the cause of the decrease? The statement of cash flows and related information report a (strengthening / steady / weakening) cash position. net Issuance (repayment) of debt. In what year did Google issue a significant amount of debt? c. Complete the statement of retained earnings below. As of 12/31/2011. would you invest in this company? (Yes / No) Why? Support your response with at least five good observations.Q10 a. Complete the missing information in the common-sized statement of cash flows for 2011.227 0 0 $ 13. Comprehensive Review Page 284 Chapter 8 . Retained earnings. ending 2011 2010 $ $ 0 $ ($ in millions) 2009 $ (719) $ 2008 0 $ $ 9. Does Google pay dividends? (Yes / No) What might be the reason for this? OTHER Q13 Based on the financial statements presented for Google. STATEMENT OF RETAINED EARNINGS Q12 a.562 b. the balance sheet.122 -370 12/31/2010 $ 225 125 6 7 43 406 982 -305 752 22 0 150 924 ($ in millions) 12/31/2009 $ 220 50 5 6 17 298 882 -246 677 22 0 17 716 12/31/2008 $ 88 100 4 5 14 211 777 -191 636 22 0 6 664 586 22 0 6 614 $ 1.122 $ 0 540 278 (114) 704 962 $ 0 502 151 (30) 623 825 Chapter 8 . and the statement of cash flows • Prepare a statement of retained earnings Chipotle Mexican Grill (CMG) ASSETS Cash and cash equivalents Short-term investments Accounts receivable Inventories Other current assets TOTAL Current assets Property. and equipment Accumulated depreciation PPE. net Goodwill and other intangibles Long-term investments Other noncurrent assets TOTAL Noncurrent assets TOTAL Assets LIABILITIES Accounts payable Short-term debt Current portion of long-term debt Accrued expenses Other current liabilities TOTAL Current liabilities Long-term debt Deferred income taxes Other noncurrent liabilities TOTAL Noncurrent liabilities TOTAL Liabilities STOCKHOLDERS' EQUITY Preferred stock Common stock Retained earnings Other stockholders' equity TOTAL Stockholders’ equity TOTAL L & SE Comprehensive Review BALANCE SHEET 12/31/2011 $ 401 55 8 9 28 501 1.ACTIVITY 105 Purpose: TEST YOUR UNDERSTANDING – CHIPOTLE • Analyze the income statement.425 Page 285 $ 0 594 457 (240) 811 1.425 $ 1.122 $ 962 $ 825 $ 46 0 0 77 34 157 0 64 160 224 381 $ 34 0 0 89 0 123 4 51 133 188 311 $ 25 0 0 73 4 102 4 39 113 156 258 $ 24 0 0 53 0 77 4 30 92 126 202 $ 0 677 671 (304) 1044 1. plant. 045 287 101 53 9 163 124 3 127 49 0 0 78 $ Chipotle Mexican Grill (CMG) STATEMENT OF CASH FLOWS ($ in millions) For the years ended December 31.518 1.Chipotle Mexican Grill (CMG) INCOME STATEMENT For the years ended December 31.347 489 126 69 6 201 288 1 289 110 0 0 179 2009 $ $ 1.332 1.270 1. and equipment Sale of investments Purchase of property.140 379 108 61 6 175 204 0 204 77 0 0 127 2008 $ 1.836 1. and admin expense (SGA) Depreciation and amortization expense Other operating expenses Total operating expenses Operating income Interest income (expense) and other Income before income tax Provision for income tax Income from continuing operations Nonrecurring items / Minority interest Net income 2011 $ $ 2. general. and equipment Purchase of investments Other investing cash flow items Net cash from (for) investing activities Cash flows from (for) financing activities Issuance of debt Issuance of capital stock Repayment of debt Repurchase of capital stock Cash dividends paid Other financing cash flow items Net cash (for) financing activities Effect of exchange rate changes Net change in cash + Beginning cash and cash equivalents = Ending cash and cash equivalents Supplemental information Free cash flow Comprehensive Review 2011 $ 215 75 11 12 98 411 2010 $ 179 69 10 13 18 289 2009 $ 127 61 8 21 43 261 2008 $ 78 53 13 21 33 199 0 125 (151) (183) (1) (210) 0 50 (113) (127) 0 (190) 0 100 (117) (50) 0 (67) 0 20 (152) (100) 0 (232) $ 0 0 0 (64) 0 40 (24) 0 176 225 401 $ 0 0 0 (109) 0 14 (95) 0 5 220 225 $ 0 0 0 (72) 0 10 (62) 0 132 88 220 0 0 0 (30) 0 0 (30) 0 (63) 151 88 $ 260 $ 176 $ 144 Page 286 $ $ 47 Chapter 8 . Revenue Cost of goods sold (COGS) Gross profit Selling. Cash flows from (for) operating activities Net income (loss) Depreciation and amortization Deferred income tax Operating (gains) losses Changes in working capital Net cash from (for) operating activities Cash flows from (for) investing activities Sale of property.680 590 158 75 6 239 351 (1) 350 135 215 0 215 ($ in millions) 2010 $ $ 1. plant. plant. which is a __________% (increase / decrease). (a) compare the two years of ratios and circle the ratio indicating lower financial risk. Cash and Cash Equivalents … more than tripled from $88 million in 2008 to $401 million in 2011. this account has changed by $__________ million. Retained earnings. and (c) comment on the results.com For each ratio. f. For ratio formulas and explanation refer to Appendix B – Ratios. Why? List observations that support your conclusion and explain why... BALANCE SHEET Q1 Review the following accounts.Refer to the financial statements presented for Chipotle on the previous two pages to answer the following questions. Stockholders’ equity. and totals. During the same time period. (1) describe your observations. and then (2) identify what your observations indicate. Since the earliest year reported.msn. Chipotle Current ratio Debt ratio * Industry Norm* 1.3 66% 12/31/2011 12/31/2008 Industry: Restaurants —Industry ratio averages from money.. resulting in net income (increasing / decreasing) by _____%. cash and cash equivalents moved from being 10% of total assets in 2008 up to more than 25% of total assets in 2011. COGS (increased / decreased) by __________%. (b) cross out any ratio indicating greater financial risk than the industry norm. the balance sheet and related ratios indicate a (strengthening / steady / weakening) financial position. Comprehensive Review Page 287 Chapter 8 . subtotals.. Total assets… d. Total liabilities… e. Noncurrent assets… c. indicating this company is cash rich! b. Q3 Overall. INCOME STATEMENT Q4 Revenues were $__________ million for the earliest year reported and $__________ million for the most recent year reported. Q2 a. A response is given for Cash and Cash Equivalents to help with understanding. total operating expenses (other than COGS) (increased / decreased) by __________%. Also. Compute the ratios requested in the chart below. Repurchased common stock is referred to as (common / preferred / treasury) stock. and (c) comment on the results. (b) cross out any company ratio that is weaker than the industry norm. indicating that more investments were (purchased / sold). Chipotle RATIOS Free cash flow Cash flow adequacy Cash flow liquidity Quality of income Industry Norm NA NA NA NA 2011 $ 2008 $ For each ratio. For investments. A net cash outflow for capital stock occurred during (2011 / 2010 / 2009 / 2008).0 % 37. For ratio formulas and explanation refer to Appendix B – Ratios. Comprehensive Review Page 288 Chapter 8 . Why? List observations that support your conclusion and explain why. (a) circle the stronger company ratio. which is (favorable / unfavorable) for shareholders because earnings per share (increases / decreases).0 % 14. Q8 Compute the ratios requested in the chart below.Q5 Compute the ratios requested in the chart below. STATEMENT OF CASH FLOWS Q7 During 2011. the primary source of cash was (operating activities / issuing debt / issuing capital stock) and the primary use of cash was (purchasing PPE / purchasing investments /paying dividends).2 99 1. Q6 The income statement and related ratios indicate (strengthening / steady / weakening) earnings potential.com For each ratio. For ratio formulas and explanation refer to Appendix B – Ratios.2 12/31/2011 12/31/2008 Industry: Restaurants —Industry ratio averages from money. Treasury stock (increases / decreases) total stockholders’ equity on the balance sheet and decreases total shares outstanding. Chipotle ROS ROA ROE Gross profit margin Accounts receivable turnover Inventory turnover Asset turnover * Industry Norm* 14. meaning more capital stock was (issued / repurchased). there was a net cash outflow during (2011 / 2010 / 2009 / 2008). (a) circle the company ratio indicating the strongest cash position and (b) comment on the results.8 % 33.5 % 71.msn. would you invest in this company? (Yes / No) Why? Support your response with at least five good observations. ending $ $ $ b. Retained earnings increased during (2011 / 2010 / 2009).Q9 The statement of cash flows reports a net increase in cash during (2011 / 2010 / 2009 / 2008). The statement of cash flows and related information report a (strengthening / steady / weakening) cash position. Why? List observations that support your conclusion and explain why. Chipotle STATEMENT OF RETAINED EARNINGS ($ in millions) 2008 2011 2010 2009 For the years ended December 31. Why? OTHER Q11 Based on the financial statements presented for Chipotle. STATEMENT OF RETAINED EARNINGS Q10 a. beginning $ $ $ $ 78 Net income 0 Dividends paid (1) 0 0 0 Other adjustments $ 151 Retained earnings. Comprehensive Review Page 289 Chapter 8 . Complete the statement of retained earnings below. 73 Retained earnings. 823 4. Carnival Corporation (CCL) ASSETS Cash and cash equivalents Short-term investments Accounts receivable Inventories Other current assets TOTAL Current assets Property.312 4.522 4.291 0 551 6.488 0 417 TOTAL Liabilities STOCKHOLDERS’ EQUITY Preferred stock Common stock.623 525 (1.297 $ $ 11/30/Year 3 643 17 409 240 419 1.381 10.019) 21.335 $ 690 583 1. the balance sheet.020 5.987) 10.388 $ 269 0 155 290 906 1.326 (3) 0 16.103 (1.622 3.876 10.418 28.233 143 (1.842 $ 634 94 392 568 1.045 5.918 0 470 7. • Prepare a statement of retained earnings.432 Page 290 $ 27.116 681 0 406 $ 28.620 3.760 13.311 8.491 $ 12. and the statement of cash flows.184 (3.268 $ 631 981 681 721 2.636 $ 24.132 20.014 0 283 3. plant.361) 20.551) 17.310 6. and equipment Accumulated depreciation PPE.460 11.191 142 (1.ACTIVITY 106 Purpose: TEST YOUR UNDERSTANDING—CARNIVAL CORPORATION • Analyze the income statement.042 832 2.335 Chapter 8 . net Goodwill and other intangibles Long-term investments Other noncurrent assets TOTAL Assets LIABILITIES Accounts payable Short-term debt Current portion of long-term debt Accrued expenses Other current liabilities TOTAL Current liabilities Long-term debt Deferred income taxes Other noncurrent liabilities TOTAL Noncurrent liabilities 11/30/Year 5 $ $ 11/30/Year 2 610 461 403 171 487 2.073 (2.636 $ 24.058) 0 355 7.627 0 458 TOTAL Stockholders’ equity Comprehensive Review 11/30/Year 4 ($ in millions) 1.144) 0 359 7.178 9 408 250 370 2.215 25.491 $ 12. par Additional paid-in capital Retained earnings Other stockholders’ equity Treasury stock TOTAL L & SE BALANCE SHEET $ 11.793 7.163 7.331 (4.192 5.698 4.972 15.355 0 482 667 39 108 91 227 1.728 24.089 6.058) 0 6 1.917 0 359 7.132 12.034 6.727 0 541 6.432 $ 27. and admin expense (SGA) Depreciation and amortization expense Other operating expenses Total operating expenses Operating income Interest income (expense) and other Total nonoperating revenue (expense) Income before income tax Provision for income tax Income from continuing operations Nonrecurring items / Minority interest Net income Outstanding shares (in millions) Carnival Corporation(CCL) Year 5 $ $ Comprehensive Review Year 4 $ $ 9.735 4.274 2.016 382 54 17 1.042 (111) 28 959 (57) 1.854 812 28 522 3. Cash flows from (for) operating activities Net income (loss) Depreciation and amortization Operating (gains) losses Changes in working capital Net cash from operating activities Cash flows from (for) investing activities Sale of property.194 0 1.427 4.288 812 (90) 3. and equipment Sale of investments Purchase of property. and equipment Purchase of investments Other investing cash flow items Net cash (for) investing activities Cash flows from (for) financing activities Issuance of debt Issuance of capital stock Repayment of debt Repurchase of capital stock Cash dividends paid Other financing cash flow items Net cash from (for) financing activities Effect of exchange rate changes Net change in cash + Beginning cash and cash equivalents = Ending cash and cash equivalents Supplemental information Cash interest paid Cash taxes paid Free cash flow 10.183 2.257 0 2.010 2.438 1.223 29 1. plant.586) 0 497 (3.854 802 STATEMENT OF CASH FLOWS Year 5 For the years ended November 30.196 2.680 585 (69) 2.880 3.579 1.901 47 1.173 (284) 12 1.016 0 1.913 2.173 (195) 35 1.977) 0 7 (1.Carnival Corporation (CCL) INCOME STATEMENT For the years ended November 30. plant.433) 0 0 (1.244 5.986) 0 (75) (2.474 902 (102) 3. general.516) 0 83 (2.194 585 22 132 1.854 0 1.061) 910 50 (912) (305) (566) (69) (892) (13) 535 643 1.970) 0 0 (3.933 Year 2 $ 1.178 881 112 (736) 0 (400) 64 (79) (15) 33 610 643 1.257 806 ($ in millions) $ $ 2.016 587 ($ in millions) Year 4 $ Year 2 $ Year 3 $ 1.410 Year 3 $ 6.244 1.330 73 2.216 $ 4.459 2.089) 0 0 (2.421 667 $ Page 291 314 15 867 $ $ 250 8 (770) $ $ 156 20 (875) $ $ 110 0 (763) Chapter 8 .257 902 45 206 3. Revenue Cost of goods sold (COGS) Gross profit Selling.469 0 0 (1.480 1.822 5.067 382 (11) 1.639 (330) 21 2.751 42 (898) 0 (292) (137) 466 (23) (57) 667 610 232 7 (190) 0 (246) (1) (198) (5) (795) 1.194 718 $ 1.764 2. when PPE increased by more than 50%. BALANCE SHEET Q1 Review the following accounts. Property. Retained earnings. Long-term debt… d. and net income (increased / decreased) by __________%. indicating purchases of additional cruise ships for expansion. and totals. For ratio formulas and explanation refer to Appendix B—Ratios. and then (2) identify what your observations indicate. net to help with understanding. (a) compare the two years of ratios and circle the ratio indicating lower financial risk. Q3 Overall. plant. which is a(n) __________% (increase / decrease). Comprehensive Review Page 292 Chapter 8 . During the same time period. Contributed capital totals $__________ million on Year 5… e. The greatest increase was in Year 3.com For each ratio. COGS (increased / decreased) by __________%. b. (1) describe your observations.Refer to the financial statements presented for Carnival Corporation on the previous two pages to answer the following questions. INCOME STATEMENT Q4 Revenues were $__________ million for the earliest year reported and $__________ million for the most recent year reported. Carnival Corporation Current ratio Debt ratio Times Interest Earned * Industry Norm* 0. Compute the ratios requested in the chart below. net … increased from $10.312 million in Year 5.50 63% 8. Why? List observations that support your conclusion and explain why.. subtotals. A response is given for PPE. an increase of 111%. and (c) comment on the results. (b) cross out any ratio indicating greater financial risk than the industry norm.00 Year 5 Year 3 Industry: Resorts and Casinos—Industry and S&P 500 ratio averages from money. Since the earliest year reported. the balance sheet and related ratios indicate a (strengthening / steady / weakening) financial position. Q2 a. and equipment. this account has changed by $__________ million. Goodwill and other intangibles… c. operating expenses (other than COGS) (increased / decreased) by __________%.msn.116 million in Year 2 to $21.. dividends paid (increased / decreased) by __________%. Q9 Compute the ratios requested in the chart below.msn. and equipment a net cash (inflow / outflow) was reported in the (operating / investing / financing) activity section so PPE was (purchased / sold). indicating more debt was (borrowed / repaid). Carnival Corporation Free cash flow ($ in millions) Cash flow adequacy ratio Cash flow liquidity ratio Quality of income ratio Industry Norm NA NA NA NA Year 5 $ Year 3 $ For each ratio. Why? List observations that support your conclusion and explain why. STATEMENT OF CASH FLOWS Q7 The primary source of cash was (operating / investing / financing).com For each ratio. For ratio formulas and explanation refer to Appendix B—Ratios. For ratio formulas and explanation refer to Appendix B—Ratios.8% 6. For property. Carnival Corporation Gross profit margin ROS ROA ROE Asset turnover * Industry Norm* 50. (a) circle the stronger company ratio. This is a(n) (favorable / unfavorable) sign indicating… Q8 Net cash from operating activities (increased / decreased) by $__________ million or __________%. During the same time period. These amounts appear to have primarily financed (operations / the purchase of PPE / the repurchase of common stock). indicating more capital stock was (issued / repurchased).2% 0. Q6 The income statement and related ratios indicate (strengthening / steady / weakening) earnings potential. (b) cross out any company ratio that is weaker than the industry norm. plant. Comprehensive Review Page 293 Chapter 8 . which is a(n) (favorable / unfavorable) sign.7% 12.40 Year 5 Year 3 Industry: Resorts and Casinos—Industry and S&P 500 ratio averages from money. A net cash inflow for capital stock occurred during FYE (5 / 4 / 3 / 2). which is a(n) (favorable / unfavorable) sign indicating… A net cash inflow for debt occurred during FYE ( 5 / 4 / 3 / 2).8% 16. (a) circle the company ratio indicating the strongest cash position and (b) comment on the results. and (c) comment on the results.Q5 Compute the ratios requested in the chart below. the primary use of cash was (purchasing PPE / repaying debt / paying dividends) using _____% of NCOA.516) 1. whereas in Year 5. Carnival Corporation STATEMENT OF RETAINED EARNINGS ($ in millions) For the years ended November 30. ending Year 5 $ Year 4 $ (81) $ Year 3 $ (22) $ $ Year 2 $ 5. Year 5 Net cash from operating activities Purchase of PPE Issuance of debt Issuance of capital stock Repayment of debt Repurchase of capital stock Cash dividends paid Net change in cash Year 5 $_____________ ______________ ______________ ______________ ______________ ______________ ______________ $ 535 100. Why? Comment on your observations.933 (2.326 Net income is initially reported on the (balance sheet / income statement / statement of cash flows) and dividends paid are initially reported on the (balance sheet / income statement / statement of cash flows).46% 0.751 42 (898) 0 (292) $ (57) 100.Q10 Complete the common-size Statement of Cash Flows for Year 5.00% -15. would you invest in this company? (Yes / No) Why? Support your response by listing at least five significant observations. Carnival Corporation STATEMENT OF CASH FLOWS Common-Size ($ in millions) For the years ended November 30. Only select accounts are reported.58% 2. Comprehensive Review Page 294 Chapter 8 . OTHER Q13 Based on the financial statements presented for Carnival Corporation. STATEMENT OF RETAINED EARNINGS Q12 Complete the statement of retained earnings below. In Year 3. beginning Net income Dividends Other adjustments Retained earnings. the primary use of cash was (purchasing PPE / repaying debt / paying dividends) using _____% of NCOA.50% * Only select amounts are listed above and will not necessarily sum to the total.17% -46. Retained earnings.016 (246) (37) (0) $ 6.11% -1.556 1.16% 90.00% -130. Q11 The statement of cash flows indicates a (strengthening / steady / weakening) cash position.00% ________% ________% ________% ________% ________% ________% ________% Year 3 $ Year 3 1. 007 $ 0 87 459 1.019 (1.622 52 0 440 492 2. and the statement of cash flows.833 2. • Prepare a statement of retained earnings.069 $ 3.713 50 0 453 503 2.607 57 36 542 635 2.069 $ 0 94 720 1.840 $ 912 0 12 318 365 1.216 $ 850 22 7 287 456 1.007 $ 4.037 136 0 132 1.095 $ 3.448) 1.300) 920 141 0 62 1.745 1.305 141 600 424 1. plant.820 (1. net Goodwill and other intangibles Long-term investments Other noncurrent assets TOTAL Noncurrent assets TOTAL Assets LIABILITIES Accounts payable Short-term debt Current portion of long-term debt Accrued expenses Other current liabilities TOTAL Current liabilities Long-term debt Deferred income taxes Other noncurrent liabilities TOTAL Noncurrent liabilities TOTAL Liabilities STOCKHOLDERS’ EQUITY Preferred stock Common stock.440 2.840 Chapter 8 .179) 840 254 0 142 1.236 880 125 231 1.745 $ 4.316 20 0 425 445 1.114 $ 636 0 1 171 508 1.240 25 2.698 76 2.574 80 2.242 $ 922 0 7 380 404 1. Circuit City Stores (CCYTQ) ASSETS Cash and cash equivalents Short-term investments Accounts receivable Inventories Other current assets TOTAL Current assets Property.761 $ 0 84 320 981 118 1.503 3.ACTIVITY 107 Purpose: TEST YOUR UNDERSTANDING—CIRCUIT CITY • Analyze the income statement.791 4.123 316 522 221 1.336 25 1. the balance sheet.955 4.455 54 2.745 Page 295 $ 0 86 344 1.637 82 2.884 2.220 (1.079 3.365 44 1. and equipment Accumulated depreciation PPE. par Additional paid-in capital Retained earnings Other stockholders’ equity TOTAL Stockholders’ equity TOTAL L & SE Comprehensive Review BALANCE SHEET 2/28/Year 7 $ ($ in millions) 2/28/Year 6 2/28/Year 5 2/28/Year 4 $ $ $ 296 1 489 1.093) 727 247 0 121 1.485 (1. 248 880 $ (382) $ 13 $ 89 $ 219 Page 296 Chapter 8 .322 154 (15) 2. and equipment Purchase of investments Other investing cash flow items Net cash from (for) investing activities Cash flows from (for) financing activities Issuance of debt Issuance of capital stock Repayment of debt Repurchase of capital stock Cash dividends paid Other financing cash flow items Net cash (for) financing activities Effect of exchange rate changes Net change in cash + Beginning cash and cash equivalents = Ending cash and cash equivalents Supplemental information Free cash flow Comprehensive Review Year 7 $ (320) 187 28 71 4 (30) Year 6 $ (9) 182 72 120 (46) 319 Year 5 $ 136 164 (14) 27 43 356 Year 4 $ 62 154 (116) 10 274 384 71 3.514 8.926 (286) (2.664 178 92 2934 (6) 26 20 31 (11) 2 (9) Year 5 Year 4 $ 11.461 108 (5) 103 38 65 (3) $ 62 Circuit City (CCYTQ) STATEMENT OF CASH FLOWS ($ in millions) For the years ended February 28.002) (12) (335) 55 1.015 (254) (1.470 7.596 214 19 233 86 147 (11) $ 136 $ 10.704 2. and equipment Sale of investments Purchase of property. Revenue Cost of goods sold (COGS) Gross profit Selling. Cash flows from (for) operating activities Net income (loss) Depreciation and amortization Deferred income tax Operating (gains) losses Changes in working capital Net cash from (for) operating activities Cash flows from (for) investing activities Sale of property. plant.435 161 0 2. general.810 2.Circuit City Stores (CCYTQ) INCOME STATEMENT For the years ended February 28.318 2.928 2.587 183 26 2796 (370) 17 (353) (32) (321) 1 $ (320) ($ in millions) Year 6 $ $ 12.901 2.569 2. and admin expense (SGA) Depreciation and amortization expense Other operating expenses Total operating expenses Operating income Interest income (expense) and other Income before income tax Provision for income tax Income from continuing operations Nonrecurring items / Minority interest Net income Year 7 $ 11. plant.650) (1) 341 39 1.501 2.430 9.246 (325) (2.744 9.426 2.410) -(594) 61 -(151) --(90) $ 256 5 (295) (47) (27) (49) (157) 1 155 141 296 $ 37 90 (64) (237) (20) 36 (158) (1) (175) 316 141 $ 19 38 (58) (339) (13) 25 (328) 2 (564) 880 316 $ -9 (25) -(14) (632) (662) -(368) 1. which is a __________% (increase / decrease). BALANCE SHEET Q1 Review the following accounts.com For each ratio. Comprehensive Review Page 297 Chapter 8 . COGS (increased / decreased) by __________%. and (c) comment on the results.3 29% Year 7 Year 4 Industry: Electronics Stores—Industry ratio averages from money.. indicating credit terms might be too lax. During the same time period. For ratio formulas and explanation refer to Appendix B—Ratios. the balance sheet and related ratios indicate a (strengthening / steady / weakening) financial position. INCOME STATEMENT Q4 Revenues were $__________ million for the earliest year reported and $__________ million for the most recent year reported.. (1) describe your observations. Why? List observations that support your conclusion and explain why. (b) cross out any company ratio indicating greater financial risk than the industry norm. and net income (increased / decreased). Compute the ratios requested in the chart below. Since the earliest year reported. subtotals. Total assets… d. total operating expenses (other than COGS) (increased / decreased) by __________%.. b. and totals. A response is given for Current Assets to help with understanding. f. Noncurrent assets… c. Stockholders’ equity. Total liabilities… e. The buildup of accounts receivable accompanied by a decrease in inventory is cause for concern. Q3 Overall.. Q2 a. Circuit City Current ratio Debt ratio * Industry Norm* 1. and then (2) identify what your observations indicate. Current assets… decreased in Year 7 due to a sharp decline in short-term investments and a dip in inventory. this account has changed by $__________ million. Retained earnings.Refer to the financial statements presented for Circuit City on the previous two pages to answer the following questions. (a) compare the two years of company ratios and circle the ratio indicating lower financial risk.msn. msn.Q5 Compute the ratios requested in the chart below.5% 63 6.8% 21. Circuit City RATIOS Free cash flow ($ in millions) Cash flow adequacy Cash flow liquidity Quality of income Industry Norm NA NA NA NA Year 7 $ Year 4 $ For each ratio. which is (favorable / unfavorable) for shareholders because earnings per share (increases / decreases). (b) cross out any ratio that is weaker than the industry norm. For ratio formulas and explanation refer to Appendix B—Ratios. For ratio formulas and explanation refer to Appendix B—Ratios. Repurchased common stock is referred to as (common / preferred / treasury) stock. Investing activities provided a source of cash during Year (7 / 6 / 5 / 4). Comprehensive Review Page 298 Chapter 8 . Circuit City ROS ROA ROE Gross profit margin Accounts receivable turnover Inventory turnover Asset turnover * Industry Norm* 2. and (c) comment on the results.8 Year 7 Year 4 Industry: Electronics Stores—Industry ratio averages from money. indicating … A net cash outflow for capital stock occurred during Year (7 / 6 / 5 / 4). Q8 Compute the ratios requested in the chart below.com For each ratio.9% 7.3 2.3% 27. (a) circle the stronger ratio. Treasury stock (increases / decreases) total stockholders’ equity on the balance sheet and decreases total shares outstanding. (a) circle the company ratio indicating the strongest cash position and (b) comment on the results. STATEMENT OF CASH FLOWS Q7 The primary source of cash was operating activities during Year (7 / 6 / 5 / 4). Why? List observations that support your conclusion and explain why. meaning more capital stock was (issued / repurchased). Q6 The income statement and related ratios indicate (strengthening / steady / weakening) earnings potential. A net loss was reported during Year (7 / 6 / 5 / 4) and dividends increased during Year (7 / 6 / 5 / 4). Retained earnings decreased during Year ( 7 / 6 / 5 ). beginning $ $ $ Net income Dividends paid Other adjustments (8) 0 2 Retained earnings.Q9 The statement of cash flows and related information report a (strengthening / steady / weakening) cash position. What signs of this impending bankruptcy do you find in these financial statements? When did these signs start to appear? Comprehensive Review Page 299 Chapter 8 . Why? List observations that support your conclusion and explain why. ending $ $ $ a. What might be one reason that dividends paid increased? b. Why? Year 4 $ 1. Retained earnings. STATEMENT OF RETAINED EARNINGS Q10 Complete the statement of retained earnings below.240 OTHER Q11 Circuit City filed for bankruptcy 6 months into Year 8.199 62 (14) (7) $ 1. Circuit City STATEMENT OF RETAINED EARNINGS ($ in millions) Year 7 Year 6 Year 5 For the years ended February 28. technology. Tell Me About Your Company: Choose a company to research. its products. PART 2 – PRESENTATION AND POWERPOINT SLIDES (Activity 109) Would you advise a friend to invest in this company? Prepare and deliver a short presentation highlighting information that supports your investment recommendation. C. its industry. trend. and communication skills. Capstone Project Page 300 Chapter 9 . you will use your understanding of financial accounting to analyze a company’s financial statements. Write a brief description of your company. You will be responsible for the following parts of this project: PART 1 – WRITTEN REPORT AND COMPANY RESEARCH (Activity 108) A. this project will help you build your critical thinking. liquidity. efficiency.CHAPTER 9 CAPSTONE PROJECT WOULD YOU ADVISE A FRIEND TO INVEST IN THIS COMPANY? PURPOSE: This chapter outlines a capstone project that includes researching and analyzing a publicly-traded corporation of your choice. and other items to enhance the overall project. and solvency. Compare to industry norms. Financial Statement Analysis: Prepare and analyze condensed. and common-size financial statements for your company. Stock Market Activity: Summarize your company’s market activity over the past 10 years. Then. you will use data from the Internet and organize it using 5 worksheets. Ratio Analysis: Compute financial statement ratios for your company to analyze its profitability. B. E. F. To prepare this analysis. Accordingly. charts. Research Summary: Would You Advise a Friend to Invest in This Company? Prepare a 2-page written summary of your analysis and investment recommendation. In this project. Company News: Search for at least 2 major events that have affected your company or its industry over the past year. Have fun with this project! Be creative! Include graphs. D. and its markets. you will communicate the results of your analysis in a detailed written report and highlight the results in a presentation. sec. Compare company ratios to industry averages. and sound reasoning.gov/edgar/searchedgar/companysearch. The instructor must approve the company. analysis. which summarizes the past year and highlights future opportunities. Prepare a well-written report analyzing your corporation using appropriate business and accounting vocabulary.html. Explore the corporate website. its products. If you are undecided about which company to select. marketing strategy. Compute financial statement ratios and analyze. Prepare a financial statement analysis using condensed. “30 INDUSTRIAL” STOCKS that currently comprise the DOW JONES INDUSTRIAL AVERAGE 3M (MMM) Alcoa (AA) American Express (AXP) AT&T (T) Bank of America (BAC) Boeing (BA) Caterpillar (CAT) Chevron Corporation (CVX) Cisco Systems (CSCO) DuPont (DD) ExxonMobil (XOM) General Electric (GE) Hewlett-Packard (HPQ) Home Depot (HD) Intel (INTC) IBM (IBM) Johnson & Johnson (JNJ) JPMorgan Chase (JPM) Kraft Foods (KFT) McDonald’s (MCD) Merck (MRK) Microsoft (MSFT) Pfizer (PFE) Procter & Gamble (PG) The Coca-Cola Company (KO) Travelers Companies (TRV) United Technologies (UTX) Verizon Communications (VZ) Wal-Mart Stores (WMT) Walt Disney (DIS) Research your company using a variety of resources. competition. Form 10-K information is available at http://www. Research the current stock quote of your company and analyze past market activity. Consult the Form 10-K filed with the SEC. Review the Annual Report. 3. trend. which usually provides updated comprehensive information including links to current news items and financial information. Support your investing advice with three to five significant points based on previous research. The company must be publicly traded but not regulated. Note that the company provides the information posted on the website and. Each student will select a different company. Tell me about your company … its industry. therefore. product offerings. especially the Letter to Shareholders and Management’s Discussion & Analysis. choose one of the 30 corporations comprising the Dow Jones Industrial Average (DJIA) listed below or one of the companies used in this text. may be biased in favor of the company. 2. which can be found in Appendix A. This form contains a wealth of information. and its market (1-3 pages) Choose a company to research. Business to find information regarding the business. Read through PART 1 Item 1. 1. Links to the Annual Report are usually found on the company website under Investor Relations.ACTIVITY 108 Purpose: • • • • • • • A. and common-size financial statements. and market share. Capstone Project Page 301 Chapter 9 . WRITTEN REPORT AND COMPANY RESEARCH Use a variety of resources to research a corporation. com http://finance. Stock Market Activity (1-2 pages) Summarize the market activity of your company’s stock.yahoo.msn. Financial Statement information can be found at: http://money. Appropriately cite all sources and include a print-out of each cited page in Appendix 3. explain trends and events influencing the stock chart. and its markets. its products.Summarize your research in a 1-3 page written report of your company … its industry. Income Statement: Prepare the trend analysis and common-size income statement using the amounts from the condensed balance sheet. Financial Statement Analysis (4 pages) Collect three years of financial statement information to prepare the condensed balance sheet. including the current stock quote and market activity over the most recent 10 years. Briefly describe each event. discuss how this event will affect the company’s operations and the financial ratios.msn.google.com http://www. and the condensed statement of cash flows. In addition. Company News (1-2 pages) Search for at least two significant news items or events that have affected your company or its industry over the past year. Next.com/finance Appropriately cite all sources and include a print-out of each cited page in Appendix 3. Enter the results in Worksheet A on page 306. Enter the results in Worksheet B on page 307. the announcement of a dividend is not newsworthy unless it is a major surprise. Include your company’s 10-year stock chart. C.com http://finance. For example. Use the three most recent years available. B.com http://www. Find stock market activity information and charts at: http://money. the condensed income statement. Make certain that the item is truly newsworthy. This should be a well-written paper with introductory and concluding paragraphs. B. Appropriately cite all sources and include a print-out of each cited page in Appendix 3. Capstone Project Page 302 Chapter 9 . Organize your information using Worksheets A.yahoo. D.com/finance Prepare Trend Analyses and Common-Size Financial Statements Balance Sheet: Prepare a trend analysis and common-size balance sheet using the amounts from the condensed balance sheet.google. and C found on pages 306 to 308. include a copy of the company’s financial statements. In Appendix 2. and common-size balance sheet. and stockholders’ equity. trend. Capstone Project Page 303 Chapter 9 . Summarize your analysis in a one-page written report. Summarize your analysis in a one-page written report. and overall financial risk. include a print-out of each cited page. and common-size balance sheet. and C. income statement. Appropriately cite all sources. In Appendix 1. Review the information reported on Worksheets A. Accounts receivable Inventory Interest expense Capital expenditures Dividends paid Record this information on Worksheet D – Ratio Analysis (page 309). Summarize your results in a 1-page written report. and net income. include a copy of Worksheets A. Create the trend and common-size financial statements using Excel formulas that reference the condensed financial statement. and the overall cash position. expenses. Create a separate worksheet tab for the balance sheet. Comment on trends in the growth of revenues. trend. B. and common-size balance sheet. (Optional) Create a Microsoft Excel workbook based on the tables provided on the following pages. E. Enter the results in Worksheet C on page 308. and statement of cash flows. and C.Statement of Cash Flows: Prepare the trend analysis and common-size income statement using the amounts from the condensed statement of cash flows. Analyze each Financial Statement (1-page each) Balance Sheet: Review the condensed. Write a report summarizing the overall story of the financial statements (1 page). liabilities. Income Statement: Review the condensed. Ratio Analysis (2-4 pages) Collect the additional data needed for ratio computations listed below. Comment on trends in the growth of assets. and overall profitability. In Appendix 3. Statement of Cash Flows: Review the condensed. B. trend. and financing activities. Summarize your analysis in a one-page written report. Use Excel formulas for all computations within the condensed financial statements. Comment on trends in the growth of operating. investing. yahoo. 3. Indicate whether each ratio is stronger/weaker. 4.com to find industry average ratios: (1) Type in the Ticker Symbol or Company Name in the Get Quotes box. no industry average is available. Record the industry averages in the first column of Worksheet D – Ratio Analysis. In Appendix 1.com. more/less liquid. liquidity. 10. (Optional) Add a Ratios tab to your Microsoft Excel workbook formatted similar to Worksheet D – Ratio Analysis. efficiency. then (2) in the left-hand column menu under COMPANY click on Competitors. Summarize your results in a 1-3 page written report. and solvency. Your company’s profitability. include a copy of Worksheet D – Ratio Analysis. Compare the two years of ratio information. Write a 1-3 page report discussing: What information each ratio reveals about your company.msn.Compute two years of ratios for each ratio listed below. 1. and noting whether they are improving or deteriorating.) * At money. Analyze ratio trends. 12. Note that all ratios may not apply to your company.** Note the industry and record at the top of Worksheet D – Ratio Analysis.yahoo.com* and finance.com to find industry average ratios: (1) Type in the Ticker Symbol or Company Name in the GET QUOTE box. quicker/slower. Your company’s profitability. or more/less risk on Worksheet D – Ratio Analysis. 2. Refer to the information reported on Worksheet D – Ratio Analysis. Obtain industry averages. then (2) in the left-hand column menu under Fundamentals click on Key Ratios. 6. ** At finance. 8. Appropriately cite all sources and include a print-out of each cited page in Appendix 3. Record your results on Worksheet D – Ratio Analysis found on page 309. Return on Sales Return on Assets Return on Equity Gross Profit Margin Accounts Receivable Turnover Inventory Turnover 7. and solvency. Capstone Project Page 304 Chapter 9 . Asset Turnover Current Ratio Debt Ratio Financial Leverage Times Interest Earned Free Cash Flow Ratio formulas can be found in Appendix B. 11. Note: Because free cash flow is not comparable among companies. 5. efficiency. 9. Industry average information can be found at money. liquidity. are noting whether they are better than or worse than its peers. (page 309.msn. 2. Capstone Project Page 305 Chapter 9 . C. Indicate whether the overall profitability. using a 12-point Times New Roman font. including a title page. Place your Written Report. Prepare your report as a professional-looking document for which you were paid a great deal of money. in a binder. Prepare the DuPont Analysis of ROE for your company and its industry. include a copy of Worksheet E – Research Summary. In the body of the paper. Proper Referencing. Use Microsoft Word. use of a clear and concise writing style that is easy to understand and professional in appearance. Briefly explain why you came to this conclusion. average. B. with a complete page of sources used. business leaders have a “zero tolerance” policy regarding basic spelling and grammar mistakes. include proper references to all written materials and internet sources. identifying three to five significant points that justify your conclusion. and E • Appendix 2 – Copies of your company’s financial statements • Appendix 3 – Printouts of materials cited in report (such as company information and news events) Written reports will be graded on comprehensive coverage. Set apart the following sections. Be careful with grammar and spelling. and solvency of the company are strong. Indicate whether you would invest in your company. in this order: • Title Page • Research Summary (Part F) • Tell Me About Your Company (Part A) • Company News (Part B) • Stock Market Activity (Part C) • Financial Statement Analysis (Part D) • Ratio Analysis (Part E) • Sources Used • Appendix 1 – Copies of Worksheets A. Professional Quality. doublespace the paper and leave one-inch margins. liquidity. Indicate the primary driver of ROA and ROE for your company.F. 4. Summarize current events and other items of importance. Format: Typed. Copying or rewording another report without proper citation and quotation is considered plagiarism. D. accuracy of the analysis. 3. In Appendix 1. As a part of this analysis: 1. efficiency. This conclusion should summarize your research in a clear and concise manner. Include printouts from cited sources in Appendix 3. double-spaced with one-inch margins. Research Summary (2 pages) Use the format shown in Worksheet E – Research Summary (page 310) to prepare a two-page summary of your analysis. or weak. WORKSHEET A: ($ in millions) Current assets PPE.0% % % % % % 100.0% _________ 100 100 100 100 100 100 100 100 100 100 100 _________ % % % % 100. net Goodwill and intangibles Other assets TOTAL ASSETS Current liabilities Noncurrent liabilities Contributed capital Retained earnings Treasury stock and other SE TOTAL L & SE (Your Company Name) CONDENSED COMMON-SIZE BALANCE SHEET (Month) (Day) ______________ Year-End (Most recent) Current assets PPE. net Goodwill and intangibles Other assets TOTAL ASSETS Current liabilities Noncurrent liabilities Contributed capital Retained earnings Treasury stock and other SE TOTAL L & SE Capstone Project _________ $ % % % % 100.0% Page 306 _________ % % % % 100. net Goodwill and intangibles Other assets TOTAL ASSETS Current liabilities Noncurrent liabilities Contributed capital Retained earnings Treasury stock and other SE TOTAL L & SE BALANCE SHEET ANALYSIS (Your Company Name) CONDENSED CLASSIFIED BALANCE SHEET (Month) (Day) ______________ Year-End (Most recent) _________ $ $ $ $ $ $ $ $ $ $ $ (Your Company Name) CONDENSED TREND ANALYSIS BALANCE SHEET (Month) (Day) ______________ Year-End _________ (Most recent) Current assets PPE.0% % % % % % 100.0% % % % % % 100.0% Chapter 9 . 0% Cost of goods sold % % Gross profit % % Operating expenses % % Operating income % % Nonoperating revenues and expenses % % Income before income tax % % Provision for income tax % % Income from continuing operations % % Nonrecurring items % % Capstone Project _________ $ Page 307 _________ 100.WORKSHEET B: ($ in millions) INCOME STATEMENT ANALYSIS (Your Company Name) CONDENSED MULTISTEP INCOME STATEMENT Fiscal Year Ended (Month) (Day) _______________ Year-End _________ (Most recent) $ $ Sales revenue Cost of goods sold Gross profit Operating expenses Operating income Nonoperating revenues and expenses Income before income tax Provision for income tax Income from continuing operations Nonrecurring items NET INCOME Earnings per share $ $ $ $ (Your Company Name) CONDENSED TREND ANALYSIS INCOME STATEMENT Fiscal Year Ended (Month) (Day) _______________ Year-End _________ (Most recent) Sales revenue Cost of goods sold Gross profit Operating expenses Operating income Nonoperating revenues and expenses Income before income tax Provision for income tax Income from continuing operations Nonrecurring items NET INCOME $ $ _________ 100 100 100 100 100 100 100 100 100 100 100 100 Earnings per share (Your Company Name) CONDENSED COMMON-SIZE INCOME STATEMENT Fiscal Year Ended (Month) (Day) _______________ Year-End _________ (Most recent) 100.0% Sales revenue 100.0% % % % % % % % % % Chapter 9 . WORKSHEET C: STATEMENT OF CASH FLOWS ANALYSIS (Your Company Name) CONDENSED STATEMENT OF CASH FLOWS Fiscal Year Ended (Month) (Day) ______________ Year-End ($ in millions) _________ (Most recent) Net cash from operating activities _________ $ $ $ $ $ $ Net cash from investing activities Net cash from financing activities Effect of exchange rate on cash Net change in cash Cash. ending (Your Company Name) CONDENSED TREND ANALYSIS STATEMENT OF CASH FLOWS Fiscal Year Ended (Month) (Day) ______________ Year-End _________ (Most recent) _________ Net cash from operating activities 100 Net cash from investing activities 100 Net cash from financing activities 100 Effect of exchange rate on cash 100 Net change in cash 100 (Your Company Name) CONDENSED COMMON-SIZE STATEMENT OF CASH FLOWS Fiscal Year Ended (Month) (Day) ______________ Year-End _________ (Most recent) 100.0% _________ 100.0% Net cash from operating activities 100. beginning Cash.0% Net cash from investing activities % % % Net cash from financing activities % % % Effect of exchange rate on cash % % % Net change in cash % % % Capstone Project Page 308 Chapter 9 . WORKSHEET D: Company Name: Industry Name: RATIO ANALYSIS ____________________________________________________________ ____________________________________________________________ Title of Ratio Industry Ratios Average Company Ratios Change Current Year Prior Year Profitability Ratios Return on sales (ROS) % Stronger / Weaker % % Return on assets (ROA) % Stronger / Weaker % % Return on equity (ROE) % Stronger / Weaker % % Gross profit margin % Stronger / Weaker % % % % Efficiency Ratios Accounts receivable turnover Quicker / Slower Inventory turnover Quicker / Slower Asset turnover Quicker / Slower Liquidity Ratios Current ratio More / Less Liquid Solvency Ratios Debt ratio % More / Less Risk Financial leverage More / Less Risk Times interest earned More / Less Risk Free cash flow ($ in millions) XXXXX More / Less Risk $ $ Additional data needed for ratio computations: ($ in millions) Accounts receivable ______________ Year… _________ (Most recent) $ $ _________ $ Inventory Interest expense Capital expenditures Dividends paid Capstone Project Page 309 Chapter 9 . DuPont Analysis of ROE Ratio ROS x Asset Turnover Type Profitability Efficiency NI / Rev Rev / A Formula Your Company Your Industry % % x Financial Leverage = ROA = ROE Solvency NI / A A / SE NI / SE % % % % For your company. SIGNIFICANT current events and other information of importance: 4. the primary driver of ROA is [ROS (mark-up) / Asset Turnover (volume)] For your company. the primary driver of ROE is [ROA (profit) / Financial Leverage (use of debt)] 3.WORKSHEET E: RESEARCH SUMMARY Company Name: Industry Name: 1. INVESTMENT DECISION Your Company: (Invest / Not invest) Why? 1– 2– 3– 4– 5– Capstone Project Page 310 Chapter 9 . ____________________________________________________________ ____________________________________________________________ FINANCIAL ANALYSIS of your company: Profitability (Strong / Average / Weak) Explain: Efficiency (Strong / Average / Weak) Explain: Liquidity (Strong / Average / Weak) Explain: Solvency (Strong / Average / Weak) Explain: 2. Financial Statement Analysis (4 pages) 20 Prepare the condensed. Your company…Invest? Not invest? Why? A. Ratio Analysis (1-3 pages) 20 Compute ratios … 2 years Collect industry averages for each ratio Aanalyze your company’s a. Tell Me About Your Company (1-3 pages) 5 Description of company … its industry. Significant current events….WRITTEN REPORT — GRADING RUBRIC Student Name ______________________________________________ Company Name _____________________________________________ Industry Name_______________________________________________ Maximum Item Score CONTENT F. and common-size statements BS … Analyze the Balance Sheet and RISK (1 page) IS … Analyze the Income Statement and PROFITABILITY (1 page) CF … Analyze the Stmt of CFlows and CASH Position (1 page) Summarize your analysis in a written report … What’s the Story? E. Financial analysis…Profitability. Research Summary (2 pages) 10 1. DuPont Analysis of ROE…primary drivers 3. other significant information 4. accuracy. Profitability b. Liquidity. Stock Market Activity (1-2 pages) 5 10-year stock chart with explanation of trends Use a variety of sources D. grammar Proper referencing … sources used page TOTAL POINTS Capstone Project Improve Average Great 70 Page 311 Chapter 9 . Efficiency. and markets B. trend. products. D. Efficiency c. Company News (1-2 pages) 5 Search for 2-3 major items/events occurring over the past year Discuss how each affects the company’s operations and the financial ratios C. Solvency Summarize your analysis in a written report Appendices 5 App 1: Copies of Worksheets A. Liquidity d. Solvency 2. C. B. E App 2: Copy of company financial statements App 3: Copies of cited materials App 4: PowerPoint slides Professional quality … comprehensive coverage. During each class of presentations. Focus on the financial information and key ratios. The presentation should be well delivered with a strong opening and a closing that is evident.ACTIVITY 109 Purpose: PRESENTATION AND POWERPOINT SLIDES • • Prepare and deliver a presentation titled “Would You Advise a Friend to Invest in This Company?” that is based on research. Present the highlights of your research. Another rule of thumb is no more than 7 items across and 7 items down. Each student should listen attentively to the other presentations and jot down questions. not sentences or paragraphs. Use PowerPoint slides as your visual aid. Prepare PowerPoint slides as a visual aid using at least 2 graphs Prepare and deliver a presentation titled “Would You Advise a Friend to Invest in This Company?” based upon your research and analysis of this company’s financial information. Capstone Project Page 312 Chapter 9 . Make your presentation interesting. Please support your fellow students by being attentive and courteous during their presentations. not a broad summary. Convince the audience to invest or not invest in your company. In Appendix 4. include a copy of your PowerPoint slides. Provide hard-copy of your PowerPoint slides to the instructor on the day of presentation. including at least 2 graphs. A rule of thumb is one slide per minute. Include: • • • • • • • Use the Research Summary to help organize your presentation. • • • • Remember that PowerPoint slides are visual aids. and sound reasoning. Slides should contain bullet points. Conduct a Q&A session at the conclusion of your presentation. analysis. every student is expected to ask at least one question. For encouragement. Closing is evident and leaves a definite impression. stating an interesting fact. Audience. Capstone Project As yourself As a boss With just sound—Listen (turn your back to the screen so that you cannot see the video) With no sound—Just the visual With someone else Page 313 Chapter 9 . Practice your opening and closing—as these are critical. each time using one of the following techniques. Benefits. Achieve eye contact with your audience. Keep aids uncluttered and readable—no more than seven items across and seven items down. Context 13. 4. Introduction. If using PowerPoint—no more than one slide per minute (maximum eight). d. Talk to your audience. View it … a. A visual aid is just that—an aid that supports the presentation. say it. The story could be about an incident that led you to choose this company to research. If your presentation is videotaped. You may use note cards with key points and key statistics. and Conclusion: State what you are going to say. Information.PRESENTATION — TIPS 1. 7. Objections. Opening should grab the audience’s attention. Consider: Purpose. 2. If you look at the last row your voice will project to the last row. 10. e. 9. Body. and then summarize what you just said. Stand with your feet planted squarely on the ground. Opening techniques include asking a question. Please be courteous and attentive during other student presentations. Do not read your presentation. 12. look at foreheads. review the video five different times. plant a smiling friend at the back of the audience for you to look at during the presentation. not leaning against the podium or swaying back and forth. 8. If eye contact is intimidating. 6. Support these points with good explanation and examples. 11. or telling a story. Speak slowly and clearly. 3. Identify three to five main points that you want the audience to remember. b. c. 5. tone.” and “likes” Note cards may be used. its industry. not full sentences Not more than one PowerPoint slide per minute Not cluttered—not more than seven items across and seven items down GROUP COORDINATION (if applicable) Presentation is well-coordinated among members All members speak Provide hard-copy of PowerPoint slides to your instructor to follow during the presentation TOTAL POINTS Capstone Project Improve Average Great 30 Page 314 Chapter 9 . and delivery rate are used Appropriate eye contact with the audience Voice is projected to the back row Delivery is energetic Conversational voice style is used Professional language and few “ums. its markets Include several innovative or interesting facts about the company Focus on the financials and key ratios INVESTING ADVICE is clearly stated and well supported Explain amounts and ratios Information is accurate CLOSING is evident and leaves a definite impression of investment advice Question & Answer … answers questions thoughtfully PRESENTATION 10 Presenter is confident. volume. its products. but not read Professional appearance … business casual attire Adheres to time limits POWERPOINT 10 Helps to clarify and emphasize content Includes at least two graphs to highlight significant financial results Slides are attractive Uses key words.“ “okays. and in control Appropriate gestures. relaxed.PRESENTATION — GRADING RUBRIC Student Name ______________________________________________ Company Name _____________________________________________ Industry Name_______________________________________________ Maximum Item Score CONTENT 10 Strong OPENING … vivid and compelling … should grab the audience’s attention BODY is well organized Information is appealing to the audience and can be easily followed Include a description of the company. and the pioneering spirit of the Anheuser & Co brewery established in 1860 in St. www. the company is now focusing on profits. Each brand specializes in a certain area. romance. and a website. www. www.com Barnes & Noble (BKS NYSE) is a bookseller. Belgium. CDs. cafe products and services. and training.abinbev. videos. American Eagle operates over 800 stores in the United States and Canada and also distributes merchandise via its ecommerce operation. footwear. and apparel. DVDs. and the corporate website follow for each corporation used in the text. Other products include servers (Xserve). After years of expansion. Inc. music.com Amazon. wireless networking equipment (Airport). and personal entertainment devices. and publishing and multimedia software. The TaylorMade Adidas Golf brand covers a range of golf clubs. dating back to 1366. The Company's principal business is the sale of trade books (such as mystery. Adidas focuses on running. for performance athletes.com. www.to 25-year-olds in the United States and Canada. (AAPL NASDAQ) designs.APPENDIX A – FEATURED CORPORATIONS A brief description of the company. Stella Artois®.com Apple Computer. in an attempt to capture a larger ebook market share. www. (AMZN NASDAQ) is the world’s largest online bookstore offering millions of books.barnesandnoble. bargain books. Belgium. and other products at its website.apple. Anheuser-Busch InBev manages a portfolio of nearly 300 brands that includes global flagship brands Budweiser®. A true consumer-centric. and TaylorMade. Louis. As of October 2011. manufactures.adidasgroup. and movies. It is the leading global brewer and one of the world’s top five consumer products companies. football. and other fiction). its stock symbol. Inc. Adidas AG (ADDYY OTC) is a global producer of sportswear and sports equipment. Barnes and Noble are aggressively marketing their eReader.com Anheuser-Busch InBev NV/SA (ABI EBR) is a publicly traded company based in Leuven. accessories. the Nook. Missouri. personal computers. the Company operated 703 bookstores. gifts. children's books. science fiction. The company now also offers an online music store (iTunes). The Reebok brand covers sports and lifestyle products. and Beck’s®. markets. magazines. Reebok. and markets mobile communication devices. basketball.ae. Founder Jeff Bezos and his family own about one-third of the company.com American Eagle Outfitters. www.amazon. AnheuserBusch InBev’s dedication to heritage and quality is rooted in brewing traditions that originate from the Den Hoorn brewery in Leuven. and sells its own brand of clothing targeting 15.com Featured Corporations Page 315 Appendix A . The Company offers its products through three main brands: Adidas. (AEO NYSE) is a retailer that designs. Inc. 637 college bookstores. USA. tennis. sales-driven company. licensing.com Caterpillar Inc.com Carnival Corporation (CCL NYSE) (previously Carnival Cruise Lines Inc. Engines. operates. the company is acquiring businesses and acquiring licensing for next generation technologies.Best Buy (BBY NYSE) is a specialty retailer of consumer electronics. Carowinds. Canada. www. and related services. They have announced plans to increase capacity. Europe.cedarfair. (FUN NYSE) is one of the largest regional amusement park operators in the world. motor coaches for sightseeing and charters. Of that. company owned and franchisee restaurants totaled 1. L. and related services. Kings Island. The Company operates retail stores and websites under the brand name Best Buy. domed rail cars.” www.579.com Bristol-Myers Squibb (BMY NYSE) is engaged in the discovery. one indoor water park. Germany. and Financial Products. The Partnership owns and operates Cedar Point. The Company operates 1. www. and franchises the Chili’s Grill & Bar (Chili’s) and Maggiano’s Little Italy (Maggiano’s) restaurant brands.chipotle. The Company sold off all non-pharmaceutical brands to focus their efforts on next generation products. and engines. Canada’s Wonderland. home office products.com Brinker International (EAT NYSE) owns. The Company is focusing on growth initiatives for mining. and London. increase production. the Company’s international franchisees opened 37 Chili’s restaurants. entertainment software. Valleyfair. six outdoor water parks. Ohio.000 passenger capacity in North America.P. As of December 2010.) provides cruises to major vacation destinations outside the Far East.com Chipotle Mexican Grill (CMG NYSE) develops and operates fast-casual. 2008. To that end. The company operates 99 cruise ships with about 196.cat. (CAT NYSE) operates in three principal lines of business: Machinery. The company filed for bankruptcy on November 10. Michigan’s Adventure. Dorney Park and Wildwater Kingdom (Dorney Park). Worlds of Fun. It owns eleven amusement parks. CitiGroup (CIT NYSE) provides a range of financial services to consumers and corporate customers. The company is guided by the idea of “Food with Integrity.carnivalcorp. As of June 2011. and six separate-gated outdoor water parks.com Cedar Fair. home office products. the United Kingdom.084 restaurants as of December 2010. www. entertainment software. fresh Mexican food restaurants in 33 states throughout the United States. Castaway Bay Indoor Waterpark Resort in Sandusky.com Featured Corporations Page 316 Appendix A . rail. Citigroup has more than 200 million customer accounts and does business in more than 160 countries primarily through its two operating units.bestbuy.citigroup. They currently operate domestically and internationally. It also markets and operates hotels and lodges. The company is no longer operating and all assets have been liquidated. www. Kings Dominion. and New Zealand. www. develops. Australia. and five hotels. During fiscal year 2011. England. and luxury day boats.brinker.com Circuit City Stores (CCTYQ NYSE) was a specialty retailer of consumer electronics. www. Citicorp and Citi Holdings. appliances. development. distribution. and make acquisitions in those growth areas. manufacturing. Knott’s Berry Farm. 868 are Company operated. and sale of biopharmaceutical products. www. California’s Great America. marketing.bms. Barq’s. The Media Networks segment consists of a domestic broadcast television network. manufacturers.com platform and eBay’s other online platforms. domestic television stations.com eBay (EBAY NASDAQ) provides online marketplaces for the sale of goods and services. Parks and Resorts. sells about 300 drink brands. The Consumer Products segment engages with licensees. Costco operates 598 membership warehouses.corporate. eBay’s Payments segment comprises its online payment solutions PayPal and Bill Me Later. Inc. The Walt (DIS NYSE) together with its subsidiaries. Sprite. (DIN NYSE) franchises and owns restaurants under the IHOP and Applebee’s brands. Many consumable products are offered for sale in case. Inc. the company owns and operates 309 Applebee’s and 11 IHOPs. and retailers globally to design.com Dell (DELL NASDAQ) has four main operating segments: Large Enterprise. is a global entertainment company. The business segments of the Company are Media Networks.com Costco (COST NASDAQ) operates international membership warehouses offering its members products in a range of merchandise categories.Coca-Cola Company.disney. Smokey Bones Barbeque & Grill. and Consumer Products. and Dasani and Evian water. As of December 10. or multiple-pack quantities. and sell a range of products based on Disney characters. www.ebay. including the traditional eBay. As of December 2010. develop. It buys the majority of its merchandise directly from manufacturers and routes it to a cross-docking consolidation point (depot) or directly to its warehouses.dell. Olive Garden. which enables voice over Internet protocol (VoIP) calls between Skype users and provides connectivity to traditional fixed-line and mobile telephones. Bahama Breeze. as well as other online commerce or ecommerce platforms. The firm. www. www.com Darden Restaurants. publishers. and Consumer.A.. musical recordings. and Communications. and online communications offerings to a diverse community of individuals and businesses.701 Applebee’s and 1. and live stage plays.com Featured Corporations Page 317 Appendix A . carton. which does no bottling. www. (DRI NYSE) is a dining restaurant company that operates over 1. www. The (KO NYSE) was established in 1886 and is now the world’s largest soft drink company operating in approximately 200 countries and commanding approximately 50% of the global soft-drink market. Payments. cable networks. direct-to-video programming. 2011. including Red Lobster. television production and distribution operations. including CocaCola.go. Studio Entertainment.493 IHOP restaurants.894 restaurants in the United States and Canada. Small & Medium Business. The Company has three business segments: Marketplaces. Public.darden.com DineEquity. The Company acquired Perot Systems in 2010 and made additional acquisitions in 2011. Its Marketplaces segment provides the infrastructure to enable global online commerce through a variety of platforms. and Three Seasons. The Company is moving from a consumer focus to an enterprise focus. publish. promote.costco. www.com Disney Company. Minute Maid.dineeqeuity. www.cocacola. whereas franchisees operate 1. and Internet and mobile operations. The Communications segment consists of Skype Technologies S. online payment services. The Studio Entertainment segment produces and acquires live-action and animated motion pictures. domestic broadcast radio networks and stations. consolidated recoverable proven and probable reserves totaled 120.generalmills. Canada. shelf stable and frozen vegetables.gap. fruit and savory snacks. Phelps Dodge Corporation (Phelps Dodge). Ford operates in two sectors: Automotive and Financial Services.com General Mills (GIS NYSE) is a supplier of branded and unbranded food products to the foodservice and commercial baking industries.com Freeport McMoRan Copper & Gold Inc. The Motorcycles and Related Products segment engages in the design. (HDI NYSE) produces heavyweight motorcycles.5 billion pounds of copper.75 billion pounds of cobalt.com General Electric Company (GE NYSE) is one of the top players in a vast array of markets including: aircraft engines. Retail. the Company issued an IPO for $20. 35. the Company sold 5. electric distribution and control equipment. and marketing of cars. www. Other operations include the NBC television network.com General Motors Corporation (GM NYSE) is engaged primarily in the development.fcx. and Land Rover. medical imaging equipment. microwave popcorn. (GOOG NASDAQ) maintains an index of websites and its search technology enables people to obtain nearly instant access to relevant information online. generators and turbines. ready-to-serve soup.S.. As of December 2010. Its joint ventures manufacture and market products in more than 130 countries and republics worldwide. dessert and baking mixes. Piperlime. Recently.5 million ounces of gold. The (GPS NYSE) is a global retailer focusing on apparel and accessories. production. Jaguar. Japan. www. www. Its financial arm accounts for nearly half of the company's revenues. www. is a copper. manufacture. dry dinners. (FCX NYSE) through its wholly owned subsidiary. Banana Republic. and sale of Featured Corporations Page 318 Appendix A . The Company operates stores in the United States. refrigerated yogurt. and a variety of organic products including soup. 3. International. and molybdenum mining company. www.com Google Inc. General Mills operates in three operating segments: U. and 0. During 2010. and Bakeries and Foodservice.S. Ireland. 325 million ounces of silver. In November 2010.com Gap Inc. Old Navy. and markets vehicles worldwide. frozen pizza and pizza snacks. gold. manufactures. grain. the Company filed for bankruptcy. www. trucks.39 billion pounds of molybdenum.google. appliances (kitchen and laundry equipment). Aston Martin. motorcycle parts. making GE one of the largest financial services companies in the U. Motorcycles and Related Products and Financial Services. Google offers its services and products free of charge and generates revenue primarily by delivering online advertising.ge. The Company develops. the company sold off or discontinued many operating segments such as: Mercury. and related accessories. Volvo. granola bars. China and Italy.1 billion. It operates in two segments.Ford Motor Company (F NYSE) is a producer of cars and trucks. Mazda. and plastics. and Athleta. and cereal. locomotives and other transportation equipment. The Company’s finance and insurance operations are primarily conducted through GM Financial. nuclear reactors. lighting. www. the United Kingdom. France. refrigerated and frozen dough products. The Company has a line of brands including: Gap. and parts.com Harley-Davidson Inc. In June 2009. The Company’s major product categories in the United States are ready-to-eat cereals.5 million vehicles world wide. General Mills manufactures its products in 15 countries and markets them in more than 100 countries. GM Financial provides a range of financial services.ford.gm. com Intel Corporation (INTC NASDAQ) is the largest chipmaker in the world.ibm. Software. Worthington. and computer-related services. Penney Company Inc. The Company operates 1.intel. and markets technology products and services worldwide. www. www.jcpenney. Intel also makes flash memories and is #1 globally in this market. multi-brand. either directly or through its subsidiaries. and consulting services. east5th. Ferrar. Article 365. www. Dell and HP are the company's largest customers. and convenience stores throughout the United States. procurement agency.000 restaurants in 121 countries worldwide. group treasury.n.lenovo.com McDonald’s Corporation (MCD NYSE) is the world's #1 fast-food chain.a.com Hewlett-Packard Company (HPQ NYSE) is a provider of computing and imaging solutions for business and home. portrait photography. Intel’s most notable products include its Pentium and Celeron microprocessors. and performance motorcycles. currently possessing 80% of the market share. she said. St. servers. Okie Dokie. (JCP NYSE) provides merchandise and services to consumers through its department stores and Direct (catalog/Internet). It manufactures and processes some of the food for sale in its supermarkets.com J. its J. manufactures. custom. property holding and property management. J. clothing. supply chain management.harley-davidson.Crew catalog. the department stores provide customers with additional services such as salon. multidepartment stores. as well as a line of motorcycle parts. The Company offers complete assortments of women’s. operating more than 32. intellectual property rights management. is engaged in manufacturing and distribution of information technology (IT) products and provision of IT services. Global Business Services. www. including personal computers. The Company. and provision of repair services for computer hardware and software systems. a.460 supermarkets and multidepartment stores. As of January 2011.106 department stores.jcrew. through its subsidiaries. Their brands include jcpenney. The Company has five main operating segments: Global Technology Services. optical. Decree. jewelry.com Kroger (KR NYSE) is a publicly owned supermarket that operates retail food and drug stores. specialty retailer. accessories.C. Linden Street. www. The company provides enterprise and consumer customers a full range of hightech products. jcpenney Home Collection and Studio by jcpenney Home Collection. The Original Arizona Jean Company.com Lenovo Group Limited (LNVGY OTC. printers. IBM also provides business. storage products. touring. Featured Corporations Page 319 Appendix A . HKG) develops. www. 2.com International Business Machines (IBM NYSE) is an information technology (IT) company. and custom decorating. www. In addition to the familiar freestanding locations. software. technology. www. and the Internet. and children’s apparel and accessories. The Company conducts its business through two primary sales channels: Stores and Direct. and collectibles. Ambrielle. and home furnishings. accessories.014 of which had fuel centers. 1. jewelry stores. Stafford. the Company operated. Every Day Matters.primarily heavyweight. The Company markets family apparel.com J. John's Bay.hp. shoes.Crew products are distributed through its retail and factory stores. In addition. Systems & Technology and Global Financing. Crew Group (JCG NYSE) is an integrated multi-channel. men’s.kroger. J. Oracle also provides consulting. and embedded Featured Corporations Page 320 Appendix A . the world's #1 maker of snacks such as corn chips (Doritos. RIM provides platforms and solutions for access to information. Ruffles. Direct Broadcast Satellite Television. Its international divisions operate in over 200 countries. NIKE sells athletic footwear and apparel. workstations. It sells its products to retail accounts. Aquafina bottled water. Dole juices.newscorp.com Microsoft Corporation (MSFT NASDAQ) is the world's #1 software company that develops. Middle East and Africa. Beverages include Pepsi (the #2 soft drink). and Lipton tea. skateboarding. The Company sells the Xbox video game console and has expanded into interactive television. Its products include running. Television. volleyball. manufactures. www. PepsiCo Europe. services. and accessory products. with its largest operations in Mexico and the United Kingdom. and supports a variety of products and services.com Oracle Corporation (ORCL NASDAQ) is a leading provider of systems software. and worldwide marketing of footwear. Inc. laptops. golf. development. and Book Publishing. Magazines and Inserts. www. offering a variety of business applications that include software for data warehousing. customer relationship management. support. and recreational uses. Through the development of integrated hardware. outdoor activities. sport-inspired urban shoes. and Internet access. It is also targeting services for growth. manufacturer. desktops. and marketer of wireless solutions for the worldwide mobile communications market. bicycling. and through a mix of independent distributors and licensees.McDonald's has mini-restaurants at locations within Wal-Mart and Chevron stores. baseball. equipment.oracle. Tropicana Juices (the world’s leading juice manufacturer). It also markets shoes designed for aquatic activities. www. WOW!). (NKE NYSE) is engaged in the design. short message service (SMS). training. and PepsiCo Asia. and supply chain management. Newspapers and Information Services. phone. cheerleading. lacrosse.com Research in Motion (RIMM NASDAQ) is a designer. wrestling. and services that support multiple wireless network standards. basketball.nike. including its Windows operating systems and Office software suite. Microsoft has reached a tentative settlement to end an ongoing antitrust investigation. Slice. production. and distribution of network and television programming. www. through NIKE-owned retail. football. PepsiCo Americas Beverages. Internet. (PEP NYSE) is the world's #2 soft-drink maker and the world’s #1 maker of snacks. and training services. including Filmed Entertainment.com Nike Inc.com PepsiCo. software. including e-mail.mcdonalds. licenses. apparel. All-Sport. Mountain Dew. Fritos) and potato chips (Lay's. Oracle's software runs on a broad range of computers including mainframes.pepsico. and children’s shoes. and intranet-based applications. It is engaged in the operation of broadcast television stations and the development. agreeing to uniformly license its operating systems and allow manufacturers to include competing software with Windows. PepsiCo also owns Frito-Lay. looking to transform its software applications into web-based services for enterprises and consumers. Much of the company’s new growth is in foreign markets that now generate over 60% of sales. www.com News Corporation (NWS NASDAQ) is a diversified entertainment company with operations in eight industry segments. and handheld devices. www. walking. tennis. RIM’s portfolio of products. soccer. The Company is organized into four business units: PepsiCo Americas Foods. Cable Network Programming.microsoft. 354 specialty retail stores in the United States along with 483 full-line and specialty retail stores in Canada. and CDF Croisières de France. the Company merged with Continental. www. Azamara Club Cruises. coffee makers. (RCL NYSE) is the world's second-largest cruise line (behind Carnival) providing cruises to Alaska. Southwest currently operates 559 Boeing 737 jets (as of September 30. In May 2010. The Trump Organization is privately owned by Donald Trump and controls several New York real estate pieces including Trump International Hotel. Free People. Roebuck and Co. and youth.com.003 coffee shops positioned throughout 50 countries in office buildings.com United Airlines Corporation (UAUA NASDAQ) transports persons. www. www.southwest. (LUV NYSE) has expanded its low-cost. Its three segments include Kmart.rim. www. The Company’s products are sold in North America. and other locations.com Time Warner (TWX NYSE) operates in three business segments: Cable Television Networks. and 50% of the General Motors Building. In addition to coffee. 2011). and Germany in approximately 23.underarmour.trump. marketing. and Sears Canada. women.united.com Starbucks Corporation (SBUX NASDAQ) is the leading specialty coffee retailer with 17. Leifsdottir and BHLDN brands.S.com Royal Caribbean Cruises Ltd. and even coffee ice cream. United is a passenger airline that operates more than 5. www.rccl. Trump also has a 42% stake in Trump Hotels & Casino Resorts. the Caribbean. www. Celebrity Cruises. pastries. the RIM Wireless Handheld product line. Sears Domestic. Miss Teen USA. Filmed Entertainment.com Southwest Airlines Co.000 retail stores. The Company had 420 destinations in 2010 and had more than 4. Sears Holdings Corporation has over 2.5 million passengers. the United Kingdom. www. coffee grinders. and Europe on 40 different cruise ships.800 flights a day to more than 375 destinations in 28 countries and two United States territories. www. The Company offers point-to-point transportation rather than using a hub-and-spoke method. and software. and distributing branded performance apparel.timewarner. and Magazine Publishing. to service over 69 cities in 35 states. airports. and accessories for men. no-frills approach to air travel throughout the U. Starbucks offers coffee beans. malls.com Under Armour (UA NYSE) is engaged in the business of developing. www. The cable television segment is the largest of the three segments. The Company has many brands such as: Royal Caribbean International. This business approach has resulted in 38 profitable years in a row. which operate three casinos in Atlantic City and a 50% stake in the Miss USA. Trump Tower (26 floors). property. Anthropologies. Pullmantur. mugs.starbucks.searsholdings. and Miss Universe beauty pageants. Terrain.com Urban Outfitters (URBN NASDAQ) is a lifestyle specialty retail company that operates under the Urban Outfitters.com Sears Holdings Corporation (SHLD NASDAQ) is a retailing company that owns Kmart Holding Corporation and Sears. and mail throughout the United States and abroad.technologies are used by organizations worldwide and include the BlackBerry wireless solution. footwear. 40 Wall Street.201 full-line stores and 1. software development tools. France. The Company Featured Corporations Page 321 Appendix A . Pizza Hut. www.361 stores.also operates a wholesale segment under the Free People and Leifsdottir brands. Asia.000 units in more than 110 countries. (YUM NYSE) is the largest restaurant operator in terms of number of locations (second to McDonald’s in sales) with over 37. Its stores include Wal-Mart discount stores. www. Long John Silver's (LJS). It also offers online properties and services to users. Yum consists of three operating segments: the U.com Wal-Mart Stores. but international expansion has made it the #1 retailer in Canada and Mexico. and A&W All-American Food Restaurants (A&W).com Yahoo! Incorporated (YHOO NASDAQ) is a global Internet brand.com Featured Corporations Page 322 Appendix A .yum. and Yum! Restaurants China. Wal-Mart also has operations in South America. Target’s. segment consisting of KFC.walmartstores. and Sam’s Club membershiponly warehouse stores. Most Wal-Mart stores are in the United States. Wal-Mart Supercenters (combined discount and grocery stores). www. Taco Bell.com Yum! Brands. Search and Marketplaces. Yum! Restaurants International. www. Inc. (WMT NYSE) is the largest retailer in the world with over 8.urbanoutfittersinc. and Media. Inc. the Company offers its products directly to the consumer through its e-commerce websites. Its sales are greater than Sears’. The Company generates revenues by providing marketing services to advertisers across a majority of Yahoo! Its offerings to users on Yahoo! Properties fall into three categories: Communications and Communities. In addition to its retail stores. and Kroger’s combined.457 stores in 2011. and Europe.S. those markets were comprised of 4.yahoo. they should be used in combination with other elements of financial analysis. but do not provide answers. industry. PROFITABILITY EFFICIENCY LIQUIDITY SOLVENCY INVESTMENT Return on Sales (ROS) Asset Turnover Current Ratio Debt Ratio Price Earnings (P/E) Return on Assets (ROA) Accounts Receivable Turnover Cash Flow Liquidity Financial Leverage Dividend Rate per share Return on Equity (ROE) Accounts Receivable Days Times-InterestEarned DuPont Analysis of ROE Inventory Turnover Free Cash Flow Gross Profit Margin (GP%) Inventory Days Cash Flow Adequacy Earnings Per Share (EPS) Quality of Income * Shaded ratios are included in the Capstone Project – Chapter 9 Ratios Page 323 Appendix B . and economic environment. Each situation should be evaluated within the context of the particular firm. please note that there is not one definitive set of key financial ratios. and no standard which should be met for each ratio.APPENDIX B – RATIOS Ratios are extremely valuable as analytical tools. Also. Categories and ratios are described on the following pages. but they also have limitations. no uniform definition for all ratios. To be most effective. There are five major categories of ratios listed to help analyze a particular aspect of the financial condition. They can indicate areas of strength and weakness. RATIOS CONCEPTUAL FORMULAS Profitability Ratios Are we generating enough returns on revenues and investments? Return on sales (ROS).Preferred dividends) / Average number of common shares outstanding = Net cash from operating activities / Net income Efficiency Ratios Are we using the firm’s resources efficiently? Asset turnover = Sales revenue / Total assets Accounts receivable turnover = Sales revenue / Accounts receivable Accounts receivable days = 365 / Accounts receivable turnover Inventory turnover = Cost of goods sold / Inventory Inventory days = 365 / Inventory turnover Liquidity Ratios Are we meeting our current obligations? Current ratio = Current assets / Current liabilities Cash flow liquidity = (Cash + Marketable securities + NCOA) / Current liabilities Solvency Ratios Are we handling debt appropriately? Debt ratio = Total liabilities / Total assets Financial leverage Times interest earned. also = Total assets / Stockholders’ equity Earnings per share known as Interest Coverage Ratio Free cash flow Cash flow adequacy Investment Ratios Price earnings ratio (P/E) Dividends rate per share Ratios = Operating income / Interest expense = Net cash from operating activities (NCOA) – (Capital expenditures + Dividends paid) = Net cash from operating activities / (Capital expenditures + Dividends paid) How do we appear to our shareholders? = Market value per share / Earnings per share = Annual common stock dividends paid / Average number of common shares outstanding Page 324 Appendix B . also known as Net profit margin = Net income / Sales revenue Return on assets (ROA) = Net income / Total assets Return on equity (ROE) = Net income / Stockholders' equity DuPont Analysis of ROE = ROS x Asset turnover = ROA x Financial leverage = ROE ROS = Net income / Sales revenue x Asset turnover = Sales revenue / Total assets x Financial leverage = Total assets / Stockholders' equity Gross profit margin Quality of income = Gross profit / Sales revenue = (Net income . EFFICIENCY measures the efficiency of managing the assets. A = L + SE. which reflects a firm’s ability to translate revenue into profits. ROA is the most comprehensive measure of profitability since it takes into account both the profitability of each dollar of revenue (ROS) and sales volume (Asset Turnover). control expenses. Net income ROS = Sales revenue Return on Assets (ROA) **measures how productively a company uses its assets to generate profits. inventory. This is a more complex formula that incorporates interest expense as the return on liabilities to creditors and net income as the return to shareholders. investing activity. the overall performance of a firm. It expresses net income as a percentage of revenue. SOLVENCY measures the extent of debt relative to equity. accounts receivable. also known as Net Profit Margin. measures the profitability from each dollar of revenue.RATIO CATEGORIES PROFITABILITY measures the ability to generate profits. A high ROA depends on managing asset investments to produce the greatest amount of revenue and controlling expenses to keep net income high. and property. within the next 12 months. Page 325 Appendix B . cash. if financial leverage is being used effectively. ROS x Asset Turnover = ROA Net income ROA = Total assets * * ** Ratios Average amounts may be used to calculate the formula to better represent the balance in the account over the entire year. and equipment. financing activity. and the ability to cover interest. INVESTMENT compares the market value per share to other per share amounts and indicates the level of dividend payment. resources of the firm. LIQUIDITY measures a firm's ability to meet cash needs as they arise. Alternate formula for ROA = [Net income before nonrecurring items + Interest expense (net of tax)] / Average total assets. PROFITABILITY RATIOS Return on Sales (ROS). and other fixed payment requirements. plant. Net income .Preferred dividends EPS = Average number of common shares outstanding The Quality-of-Income ratio compares cash flows from operating activities to net income. It is cash (not accrual-based net income) that is needed to pay suppliers. The third component.0 indicates high-quality income because each dollar of net income is supported by one dollar or more of cash. Page 326 Appendix B . to invest in income-producing assets.The Return on Equity (ROE) measures how effectively stockholders’ equity is used to produce net income. etc. (2) The low-cost strategy relies on efficient management of assets to produce high Asset Turnover. is the effective use of debt in a capital structure. (ROS x Asset Turnover = ROA). expressing gross profit as a percentage of sales revenue. It measures how successfully a company buys and sells merchandise at a profit. A ratio higher than 1. Net cash from operating activities (NCOA) Quality of Income = Net income * Ratios Average amounts may be used to calculate the formula to better represent the balance in the account over the entire year. To summarize. The first two components. employees. compares gross profit to revenue. Return on Sales and Asset Turnover. This allows charging higher prices and thus earning greater ROS. ROA x Financial Leverage = ROE Net income ROE = Stockholders’ equity * The DuPont Analysis of ROE divides Return on Equity into components that help to better assess company performance and indicate ways that management can improve ROE.. Financial Leverage. also known as Gross Margin. ROE increases when ROA is higher than the average cost of debt because the excess return accrues to the benefit of the shareholders. ROS x Asset Turnover = ROA x Financial Leverage = ROE DuPont Analysis of ROE ROE = Net income SE = = ROS x Asset Turnover x Financial Leverage Net income x Sales revenue x Sales revenue Total assets Total assets SE Gross Profit Margin (GP%). Gross profit GP% = Sales revenue Earnings per Share (EPS) is the amount of net income (loss) earned by each individual common share of stock held by investors. Improving ROA also results in increasing ROE. reflect the use of two business strategies: (1) The high-value or product-differentiation strategy relies on the superiority or distinctiveness of the products. and to ensure long-term success. Inventory is costly in terms of financing and storage. Accounts Receivable Sales revenue = Turnover Accounts receivable * Accounts Receivable Days indicate the average number of days required to convert receivables into cash. 365 Inventory Days = Inventory turnover * Ratios Average amounts may be used to calculate the formula to better represent the balance in the account over the entire year. It is a measure of efficiency that leads to greater profitability. Accounts Receivable 365 = Days Accounts receivable turnover Inventory Turnover indicates the number of times a company sells its average inventory level during the year. but presents it in a different format.EFFICIENCY RATIOS Asset Turnover measures how productively a company uses its assets to produce revenue. It offers the same information as the accounts receivable turnover ratio. It offers the same information as the inventory turnover ratio. Page 327 Appendix B . so companies want enough inventory to meet customer demand without stock-outs. Cost of goods sold Inventory Turnover = Inventory * Inventory Days indicate the average length of time that inventories are available for sale. Sales revenue Asset Turnover = Total assets * Accounts Receivable Turnover indicates how many times average accounts receivable are collected annually. The longer receivables are outstanding. but presents it in a different format. the higher the collection risk and the greater the cost of financing those receivables. Regrettably. It is a measure of liquidity. This ratio uses cash and marketable securities (truly liquid current assets) and net cash from operating activities to evaluate whether adequate cash is generated from selling inventory and offering services to pay current liabilities when they come due. It compares current assets to current liabilities as current assets are generally used to meet current liability obligations. It is a cash-basis measure of short-term liquidity. Annual common stock dividends paid Dividend Rate = Average number of common shares outstanding Ratios Page 328 Appendix B . (Cash + Marketable securities + NCOA) Cash Flow Liquidity = Current liabilities INVESTMENT RATIOS Investors use the Price Earnings (P/E) ratio to measure how “expensive” a company’s stock is compared to EPS. a company's ability to pay amounts due within the next 12 months.LIQUIDITY RATIOS The Current Ratio measures the ability to pay current payables as they come due. Even a profitable business will fail without sufficient cash. it does not explain why a stock is expensive or cheap. Market price per share P/E Ratio = EPS The Dividend Rate is the amount of dividends paid annually for each common share of stock held by investors. Current assets Current Ratio = Current liabilities The Cash-Flow-Liquidity ratio compares cash resources to current liabilities. is used by credit-rating agencies to identify if there is adequate cash coverage of capital expenditures. with modifications in the denominator. It presents free cash flow information in a ratio format. which helps analysts more easily evaluate the trade-offs between risk and return. the higher the financial leverage. and other annual payments. Debt-to-equity ratio (Total liabilities / Stockholders’ equity) = Debt ratio / (1 – Debt Ratio) Debt ratio = Debt-to-Equity ratio / (1 + Debt-to-Equity ratio) Total liabilities Debt Ratio = Total assets Financial Leverage is similar to the debt ratio. Adequate free cash flow allows for growth and financial flexibility. Net cash from operating activities Free Cash Flow = . dividends. The following formulas convert the Debt-to-Equity ratio to the Debt Ratio and vice versa.SOLVENCY RATIOS Debt Ratio indicates the percentage of the company financed with debt (liabilities). It is used to measure solvency. Operating income Times Interest Earned = Interest expense Free Cash Flow reflects the amount of cash available for business activities after allowances for investing and financing activity requirements to maintain productive capacity at current levels. Total assets Financial Leverage = Stockholders’ equity Times Interest Earned.(Capital expenditures + Dividends paid) The Cash-Flow-Adequacy ratio evaluates whether net cash from operating activities (NCOA) is adequate to maintain productive capacity at current levels. debt. The Debt-to-Equity ratio and the Financial Leverage ratio offer the same information as the debt ratio. indicates a company’s ability to earn (cover) its periodic interest payments. This ratio. Net cash from operating activities (NCOA) Cash Flow Adequacy = (Capital expenditures + Dividends paid) Ratios Page 329 Appendix B . there is less financial risk and stronger solvency. but present it in a different format. in the sense that the more debt a company has. a company's ability to pay back long-term debt when due. It measures how debt “boosts” return on assets to increase return on equity. When the debt ratio is lower. also referred to as the Interest Coverage Ratio. and set-up costs Additional paid-in capital Amount received in excess of par when stock is issued AICPA (American Institute of Certified Public Accountants) A professional organization of accountants that prints a Code of Professional Conduct that holds CPAs accountable for serving the public interest Allowance for bad debts Estimate of uncollectible accounts receivable. classifying. Typical asset accounts include cash. not necessarily when cash is received or paid Accumulated depreciation The total amount of depreciation expensed since the assets’ date of purchase Accumulated other comprehensive income (loss) Adjustments to stockholders’ equity resulting from three specific types of items that are not recorded on the income statement Acquisition cost All costs necessary to prepare the asset for use. and land. buildings. inventory. plant. Basic earnings per share Earnings per share calculated based on the actual number of shares outstanding. the amount of receivables estimated as collectible Allowance for doubtful accounts See allowance for bad debts Allowance for uncollectibles See allowance for bad debtsAssets Items of value that a corporation has a right to use. Assets = Liabilities + Stockholders’ Equity Asset turnover ratio Measures how efficiently the company uses assets to generate revenue Audits CPAs attest to whether a company’s financial statements comply with GAAP Authorized The maximum number of shares that a corporation is permitted to print. Accounts Receivable minus the Allowance for Bad Debts equals Net Accounts Receivable. Available-for-sale securities Investments in stocks not classified as trading securities Balance sheet One of the four primary financial statements.GLOSSARY Accounting A system for recording. delivery. and reporting transactions Accounts Used to classify and record economic events and transactions Accounts payable Amounts that a corporation must pay to suppliers in the future Accounts receivable Amounts to be received in the future from customers Accounts receivable days The average number of days it takes for a company to collect accounts receivable Accounts receivable turnover ratio Measures how quickly a company collects accounts receivable Accrual accounting Method of accounting that records transactions when they occur. Bonds payable Loans with certificates that can be traded among investors Book value Cost of a long-term asset that a company can still depreciate (expense on the income statement) Borrowings Loans or other payables due over the long term Capital assets See property. and equipment Carrying value See book value. equipment. including the purchase price. accounts receivable. Glossary Page 330 Glosssary . It p rovides a snapshot of a company’s financial position as of a certain date. coins. sold. and their amounts set by the company’s board of directors Consolidated A financial statement that combines the results of all a company’s subsidiaries Contingent liabilities Potential liabilities from lawsuits and especially for environmental cleanups Contributed capital Amounts paid-in (contributed) to the company by stockholders to purchase common stock and preferred stock Cost flow assumption The assumption used to measure cost of sales. or consumed within the next 12 months Current liabilities Liabilities due within 12 months Current portion of borrowings The portion of long-term debt due within the next 12 months Current ratio Measures the ability to pay current liabilities as they come due. etc. the cost of inventory sold to customers during the accounting period. according to the profitability of the company. a debt Deferred income tax liabilities Liabilities for tax rules that allow companies to earn income now but pay taxes later Depreciable base Total amount of depreciation that will be recorded over an asset’s life Depreciation expense The cost allocated to each year of the asset’s useful life Diluted earnings per share Earnings per share calculated based on the number of shares likely to be outstanding under certain circumstances. Discontinued operations The segment of a business that is closed or sold Dividend rate Amount of dividends paid annually for each share of stock held by investors Glossary Page 331 Glosssary . Also referred to as cost of goods sold CPAs (Certified Public Accountants) Accountants certified by the state to conduct audits Creditor A person to whom money is owed by a debtor Current assets Assets which are converted into cash. It is a measure of solvency Debtor Someone who has the obligation of paying back money owed.Cash Physical currency (such as dollar bills. Cost flow assumptions include First-in first-out and Lastin first-out Cost net yet depreciated See book value Cost of goods sold See cost of sales Cost of sales Reports the wholesale costs of inventory sold to customers during the accounting period. and investments that can be liquidated immediately Cash-basis accounting Method of accounting that records transactions when cash is received or paid Cash flow adequacy ratio Evaluates whether cash flow from operating activities is sufficient to cover annual payment requirements Cash flow liquidity ratio Uses cash and marketable securities (truly liquid current assets) and net cash from operating activities to evaluate whether adequate cash is generated from selling inventory and offering services Certified Public Accountants (CPAs) Accountants certified by the state to conduct audits Chart of accounts List of all accounts used by a company Commitments and contingencies Reminds investors that lawsuits and other events could create new liabilities for the company Common-size balance sheet Compares all amounts within one year to total assets of that same year Common-size income statement Compares all amounts within one year to revenue of that same year Common stock A portion of the ownership of the company. Common stock dividends vary. Debt ratio Indicates the percentage of the company financed with debt (liabilities). bank accounts.) or bank deposits Cash and cash equivalents Actual currency. Current assets are usually used to pay current liabilities. management team. and other intangible value Gross Total amount Gross profit Difference between revenues and cost of sales Gross profit margin (GP%) Also known as gross margin.Dividends Distributions of a company’s profit paid out to common and/or preferred shareholders Double-declining balance (DDB) depreciation method An accelerated depreciation method that records more depreciation early in the life of an asset. They are computed as the excess of the selling price over the book value of any asset sold Goodwill Extra value that is recorded when buying another company.Income tax benefit Benefit that reduces a company’s loss as a result of federal. It r eports a company’s profitability during an accounting period by adding revenues and gains and subtracting expenses and losses. but not any physical presence Glossary Page 332 Glosssary . and copyrights that have value. or foreign governments issuing tax refunds to the company Income tax payable Amounts owed for income taxes Income tax provision See provision for income tax Initial Public Offering When a company sells stock to the public for the first time as a publicly traded corporation Intangible assets Include patents. trademarks. representing its reputation. distribution system. compares gross profit to revenue. Financial leverage ratio Measures how effectively a company uses debt to increase the return to shareholders. expressing gross profit as a percentage of net revenue Historical cost See acquisition cost Income before income tax Income from operations plus or minus nonoperating items Income from continuing operations before income tax See income before income tax Income from operations A company’s profit from its primary business operations Income statement One of the four primary financial statements. to cost of goods sold Fixed assets See property. first-out (FIFO) An inventory cost-flow assumption that allocates the cost of units purchased first. The difference between Return on Assets and Return on Equity Financing activities A section of the statement of cash flows that reports cash transactions involving stockholders and creditors Finished goods Inventory items completed and ready for sale First-in. the older units. plant. and less depreciation when the asset is old Earnings Net income Earnings per share (EPS) Amount of net income (loss) earned by each individual share of stock held by investors Expenses The costs incurred to produce revenues Extraordinary items Highly unusual transactions that are considered unusual in nature and infrequent in occurrence Financial Accounting Standards Board (FASB) An organization that sets most standards for United States GAAP. state. customer base. when it is new. and equipment Free cash flow ratio Amount of cash available for business activities after allowances for investing and financing activity requirements to maintain productive capacity at current levels GAAP (Generally Accepted Accounting Principles) Rules that management must follow when preparing financial statements available to investors Gains These income statement items arise from the sale of long-lived assets or investments. keeping track of the balance or amount in each account Liabilities A mounts owed to creditors. and nonrecurring Items. plant. a book with one page for each account. the provision for income tax. notes payable. Net income is also referred to as profit (loss). and equipment and investments in securities offered by other companies Investments Purchasing stock. Net income T he difference between revenues and expenses. They are computed as the shortfall of the selling price less the book value of any asset sold Mark-to-market Current or long-term investments reported on the balance sheet at their most recent stock market price Market value per share The stock market trading price of the company’s common stock Matching principle Recording expenses in the period they help generate revenues. or the bottom line Net sales Revenues minus total discounts and other deductions Noncurrent assets All assets not listed as current Noncurrent liabilities Liabilities due after 12 months Nonrecurring items Items that accountants deem unusual and infrequent Notes to the financial statements Detailed disclosures reported after the financial statements in the annual report Glossary Page 333 Glosssary . first-out (LIFO) An inventory cost-flow assumption that allocates the last (most recent) units purchased to cost of goods sold Ledger In an accounting system. which are deemed most important. Typical liability accounts include accounts payable. revenues and cost of sales. are listed at the top. wages payable. the amount of debt owed to third parties. These are followed by operating expenses. These standards are set by the International Accounting Standards Board Inventories Merchandise held for sale to customers Inventory days The average number of days it takes for a company to sell inventory Inventory turnover ratio Indicates the number of times a company sells its average inventory level during the year Investing activities A section of the statement of cash flows that reports cash used to purchase and sell property. usually cash Journal A book listing the accounts affected by each transaction recorded by a company Last-in. and other types of securities of other companies Issue Selling stock shares to investors in exchange for assets.International Accounting Standards Board (IASB) The organization that establishes International Financial Reporting Standards International Financial Reporting Standards (IFRS) A set of global accounting standards adopted in many countries throughout the world. A basic principle of accrual accounting Multistep income statement Income statement format that lists items in order of importance. bonds. nonoperating items. earnings. and bonds payable Limited partnership A type of business organization that issues limited partnership units rather than stock Liquidity Describes a company’s ability to pay liabilities as they come due in the next year Long-term debt Bank loans that are due over more than one year Long-term investment An investment that the company intends to sell after one year Losses These income statement items arise from the sale of long-lived assets or investments. selling products or services to earn net income Operating expenses Costs of generating sales besides cost of sales Operating income Gross profit minus operating expenses Original cost See acquisition cost Other comprehensive income (loss) Additions to or subtractions from net income. consisting primarily of three specific types of items that are not recorded on the income statement. Preferred stock Provides a specific dividend that is paid before any dividends are paid to common stock holders. or saleable for less than its historical cost. Provision for income tax Income tax expense Public offering. plant. and equipment Attractions. and which takes precedence over common stock in the event of a liquidation Price earnings (P/E) ratio Measure how “expensive” a company’s stock is compared to EPS Principal Amount due when a loan matures Productivity Measures how efficiently you can generate desired outputs from given inputs Projects in progress Fixed assets that are being constructed Property. Par value Legal value assigned to each share of stock PCAOB (Public Company Accounting Oversight Board) Establishes auditing standards and conducts inspections of the public accounting firms that perform audits Permanent accounts Balance sheet accounts Post-retirement benefit liability Estimate of amount owed for pensions and health-care benefits expected to be paid to workers after they retire Post-retirement benefits Pensions and health-care benefits given to workers after they retire Posting Copying each of the journal entries to the appropriate ledger account. long-term assets expected to benefit future years Provision for excess and obsolete inventories Estimate of the value of inventory no longer saleable.Operating activities A section of the statement of cash flows that reports cash transactions related to a company’s main business. and land. how well expenses are kept under control Glossary Page 334 Glosssary . noting whether the account is debited or credited PP&E. initial (IPO) A company who sells stock to the public for the first time as a publicly traded corporation Publicly traded Shares bought and sold on stock exchanges Quality of income ratio Compares cash flows from operating activities to net income Raw materials Materials to be used in the manufacturing process Realized gains and losses When a security is actually sold and the proceeds have been realized Receivables Monies to be received by the company from customers Residual value Estimated value of a long-term asset being depreciated at the end of its estimated useful life Retained earnings Net income earned by the company since its incorporation and not yet distributed as dividends Return on asset (ROA) ratio Re veals how efficiently assets are used to generate profit (net income) Return on equity (ROE) ratio Measures how effectively stockholders’ equity is used to produce net income Return on sales (ROS) M easures the profitability of each dollar of revenue. buildings. equipment. net See book value. including contributed capital and retained earnings. It provides information about changes in a company’s stockholders’ equity. not necessarily in the period that the company collects the money. also referred to as shareholders Stockholders’ equity The portion of assets the owners own free and clear of any liabilities. which equals the number of shares issued less the number of shares of treasury stock that were bought back by the company Short-term investment An investment intended to be sold within one year Single-step income statement Combines all revenues and gains at the top of the income statement and then subtracts all expenses and losses below Solvency Describes a company’s ability to pay liabilities back long-term debt when due. for example common stock or preferred stock Stock dividends Shares of common stock issued that proportionately increase the number of shares outstanding. It reports cash inflows and cash outflows during an accounting period Statement of earnings See income statement Statement of financial position See balance sheet Statement of income See income statement Statement of operations See income statement Statement of profit and loss See income statement Statement of stockholders’ equity One of the four primary financial statements.Revenue recognition principle Revenues are recorded in the period earned. may also be referred to as shareholders’ equity or owners’ equity Straight-line (SL) depreciation method Depreciates out equally over all periods Temporary accounts All income statement accounts and dividends Times-interest-earned ratio Measures a company’s ability to earn (cover) its periodic interest payments Glossary Page 335 Glosssary . It helps investors understand the structure of a company’s ownership. Revenues Amounts received from customers for products sold or services provided Sales Revenues from the sale of merchandise. Specific identification inventory method Inventory method used to track when each and every inventory item was purchased and sold Statement of cash flows One of the four primary financial statements. common way of referring to sales revenue Sales revenue Amounts earned engaging in the primary business activity Salvage value See residual value Scrap value See residual value SEC (Securities and Exchange Commission) Holds legislative authority to set the reporting rules for accounting information of publicly-held corporations Service revenue Amounts earned engaging in the primary business activity that involves providing services Shareholders’ equity See stockholders’ equity Shares authorized The maximum number of shares that a corporation is permitted to print Shares outstanding Total number of shares actually held by investors at a given time. Stock options Contracts that give their holders the right to buy or sell shares of stock at a certain price Stock splits Proportional increases in the number of shares outstanding Stockholders Entities owning shares of stock. A basic principle of accrual accounting. owners of a corporation. Stock Represents a portion of the ownership of a corporation. Sometimes issued in lieu of a cash dividend. a list of all accounts in the ledger. the earliest year being studied. divide the amount reported for each account by the amount reported for the base year and multiply by 100 Trial balance Within an accounting system. To compute the trend index. but have not yet been completed Write-off Taking bad debt off of a company’s books Glossary Page 336 Glosssary .Trading securities Securities bought and sold with the objective of generating profits on short-term differences in price Transaction An event that affects the financial position of an enterprise Treasury stock When corporations buy back shares of stock from investors Trend analysis An analysis that compares amounts of a more recent year to a base year. The analysis measures the percentage of change from the base year and indicates growth trends for a company. with their balances Unearned royalties Includes prepaid amounts from subscribers and advance sales Unrealized gains and losses Change in market price during an accounting period Warranty payable Estimate of amounts that will be owed to customers for product warranties Work in process Partially completed units of inventory that have entered the assembly line. 63 Cost of sales 5. 63 Cost not yet depreciated 169 Index 337 Index . 3. 40 Deferred income tax liabilities 37. 216 Commitments and contingencies 38 Common stock 95 Common-size balance sheet 13. 34 Asset turnover ratio 10. 75 Consolidated statements 33 Contingent liabilities 175 Contributed capital 4.CPAs (Certified Public Accountants) 7 Creditor 39 Current assets 34 Current liabilities 34. 124. 174 Accounts receivable 3. 169 Borrowings 37 Capital assets 169 Capital in excess of par 95 Carrying value 169 Cash and cash equivalents 35. 169 Accumulated other comprehensive income 100 Accrual accounting 63 Acquisition cost 169 Additional paid-in capital 95 AICPA (American Institute of Certified Public Accountants) 7 Allowance for bad debts 159 Allowance for uncollectibles 159 Allowance for doubtful accounts 159 Assets 2. 71 Audits 7 Authorized 95 Available-for-sale securities 159 Balance sheet 2. 69 Income tax benefit 67 Income tax expense 67 Income tax payable 175 Income tax provision 67 Intangible assets 36 International Accounting Standards Board (IASB) 8 International Accounting Standards Committee (IASC) 8 INDEX Accounting 1 Accounts 212 Accounting equation 3 Accounts payable 4. 42 Common-size income statement 13. 60. 169 Depreciable base 169 Diluted earnings per share 104 Discontinued operations 68 Dividends 2 Dividend rate 105 Double-declining balance (DDB) depreciation 169. 5. 37 Current portion of borrowings 37 Current ratio 39 Debtor 39 Debt ratio 8. 37. 125 Financial leverage ratio 102 Finished goods 165 First-in. 166 Historical Cost 169 Historical cost principle 7. 32 Basic earnings per share 104 Bonds payable 176 Book value 36. 159 Accounts receivable days 161 Accounts receivable turnover ratio 161 Accumulated depreciation 36. 6 Cost flow assumption 162 Cost of goods sold 5. 169 Free cash flow 132 GAAP (Generally Accepted Accounting Principles) 7 Gains and losses 66. 175 Depreciation expense 36. first-out (FIFO) 162 Fixed assets 36. 172 Goodwill 37 Gross 159 Gross margin 73 Gross profit 64 Gross profit margin (GP%) 73. 158 Cash-basis accounting 63Cash flow adequacy ratio 133 Cash flow liquidity ratio 133 Chart of accounts 212. 3. 5. 63 Extraordinary items 68 Financial Accounting Standards Board (FASB) 7 Financing activities 6. 167Income from continuing operations before income tax 67 Income from operations 65 Income before income tax 67 Income statement 2. 170 Earnings 2 Earnings per share (EPS) 104 Expenses 2. direct method 127 Operating activities. 99 Trend analysis 12 Trend analysis. 62 Revenue recognition principle 62 Sales 62 Sales revenue 5 Salvage value 169 Scrap value 169 SEC (Securities and Exchange Commission) 7 Service revenue 5 Shareholders 39 Shares outstanding 95 Shareholders’ equity 34 Short-term investment 158 Single-step income statement 60 Solvency 33. 174 Limited partnership 122 Liquidity 32. 169 Provision for income tax 67Provision for excess and obsolete inventory 166 Public offering. income statement 74 Trend index 41 Trial balance 214. 34. balance sheet 96 Straight-line (SL) depreciation method 169 Temporary accounts 215 Times-interest-earned ratio 103 Trading securities 158 Transaction 214 Treasury stock 95. 70 Revenues 2. 72 Return on equity (ROE) ratio 101 Return on sales (ROS) ratio 10. 34 Stockholders’ equity. 124. 162 Inventory days 168 Inventory turnover ratio 167 Investments 158 Investing activities 6. initial (IPO) 95 Publicly traded 94 Index Quality of income ratio 134 Ratio analysis 8 Raw materials inventory 165 Realized gains and losses 159 Receivables 35 Residual value 169 Retained earnings 2. 40 Specific identification inventory method 162 Statement of cash flows 2. 124. 68 Net profit margin 10. 4.International Financial Reporting Standards (IFRS) 8 Inventories 35. 39 Long-term debt 175 Long-term Investment 158 Mark-to-market 159 Marketable Securities 158 Matching principle 63 Multistep income statement 60 Net income 2. 6. 70 Net sales 62 Noncurrent assets 34. 100 Return on assets (ROA) ratio 11. 34. 4. net 169 Preferred stock 95 Price earnings (P/E) ratio 105 Principal 176 Productivity 69 Projects in progress 36 Property. and equipment 36. 97 Stock 94 Stock dividends 101 Stock options 104 Stock splits 101 Stockholders 39 Stockholders’ equity 2. balance sheet 41 Trend analysis. plant.121 Statement of earnings 60 Statement of financial position 32 Statement of income 60 Statement of operations 60 Statement of profit and loss 60 Statement of stockholders’ equity 2. 5. 36 Noncurrent liabilities 34. 37 Nonrecurring Items 68 Notes to the financial statements 99 Other comprehensive income (loss) 100 Operating activities 6. 5. 4. 126 Issue 95 Journal 212 Ledger 213. 127 Operating activities. 224 Unearned royalties 37 338 Index . indirect method 129 Operating expenses 65 Operating income 65 Original cost 169 Par value 95 PCAOB (Public Company Accounting Oversight Board) 7 Permanent accounts 216 Posting 223 Post-retirement benefit liability 174 Post-retirement benefits 174 PPE. 6. 6. 223 Last-in first-out (LIFO) 163 Liabilities 2. 94. Unrealized gains and losses 159 Warranty payable 174 Work in process inventory 165 Write off 160 Index 339 Index .
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