Homework Problems - Accounting and Finance Problems
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2
A Further Look at Financial Statements
CHAPTER PREVIEW
If you are thinking of purchasing Best Buy stock, or any stock, how can you decide what the shares are worth? If you manage Columbia Sportswear's credit department, how should you determine whether to extend credit to a new customer? If you are a �inancial executive at Google, how do you decide whether your company is generating adequate cash to expand operations without borrowing? Your decision in each of these situations will be in�luenced by a variety of considerations. One of them should be your careful analysis of a company's �inancial statements. The reason: Financial statements offer relevant and reliable information, which will help you in your decision-making.
In this chapter, we take a closer look at the balance sheet and introduce some useful ways for evaluating the information provided by the �inancial statements. We also examine the �inancial reporting concepts underlying the �inancial statements. We begin by introducing the classi�ied balance sheet.
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Just Fooling Around?
Few people could have predicted how dramatically the Internet would change the investment world. One of the most interesting results is how it has changed the way ordinary people invest their savings. More and more people are striking out on their own, making their own investment decisions.
Two early pioneers in providing investment information to the masses were Tom and David Gardner, brothers who created an online investor website called The Motley Fool. The name comes from Shakespeare's As You Like It. The fool in Shakespeare's play was the only one who could speak unpleasant truths to kings and queens without being killed. Tom and David view themselves as 21st-century “fools,” revealing the “truths” of the stock market to the small investor, who they feel has been taken advantage of by Wall Street insiders. The Motley Fool's online bulletin board enables investors to exchange information and insights about companies.
Critics of these bulletin boards contend that they are simply high-tech rumor mills that cause investors to bid up stock prices to unreasonable levels. For example, the stock of PairGain Technologies jumped 32% in a single day as a result of a bogus takeover rumor on an investment bulletin board. Some observers are concerned that small investors—ironically, the very people the Gardner brothers are trying to help—will be hurt the most by misinformation and intentional scams.
To show how these bulletin boards work, suppose that you had $10,000 to invest. You were considering Best Buy Company, the largest seller of electronics equipment in the United States. You scanned the Internet investment bulletin boards and found messages posted by two different investors. Here are excerpts from actual postings:
TMPVenus: “Where are the prospects for positive movement for this company? Poor margins, poor management, astronomical P/E!”
broachman: “I believe that this is a LONG TERM winner, and presently at a good price.”
One says sell, and one says buy. Whom should you believe? If you had taken “broachman's” advice and purchased the stock, the $10,000 you invested would have been worth over $300,000 �ive years later. Best Buy was one of America's best-performing stocks during that period of time.
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Rather than getting swept away by rumors, investors must sort out the good information from the bad. One thing is certain—as information services such as The Motley Fool increase in number, gathering information will become even easier. Evaluating it will be the harder task.
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LEARNING OBJECTIVE 1
Identify the sections of a classi�ied balance sheet.
In Chapter 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) , you learned that a balance sheet presents a snapshot of a company's �inancial position at a point in time. It lists individual asset, liability, and stockholders' equity items. However, to improve users' understanding of a company's �inancial position, companies often use a classi�ied balance sheet instead. A classi�ied balance sheet groups together similar assets and similar liabilities, using a number of standard classi�ications and sections. This is useful because items within a group have similar economic characteristics. A classi�ied balance sheet generally contains the standard classi�ications listed in Illustration 2-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0001) .
ILLUSTRATION 2-1 Standard balance sheet classi�ications
These groupings help �inancial statement readers determine such things as (1) whether the company has enough assets to pay its debts as they come due, and (2) the claims of short- and long-term creditors on the company's total assets. Many of these groupings can be seen in the balance sheet of Franklin Corporation shown in Illustration 2-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) on the next page. In the sections that follow, we explain each of these groupings.
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ILLUSTRATION 2-2 Classi�ied balance sheet
▼ HELPFUL HINT
Recall that the accounting equation is Assets=Liabilities+Stockholders' Equity.
CURRENT ASSETS Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 2-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) , Franklin
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Corporation had current assets of $22,100. For most businesses, the cutoff for classi�ication as current assets is one year from the balance sheet date. For example, accounts receivable are current assets because the company will collect them and convert them to cash within one year. Supplies is a current asset because the company expects to use the supplies in operations within one year.
Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year. The operating cycle of a company is the average time required to go from cash to cash in producing revenue—to purchase inventory, sell it on account, and then collect cash from customers. For most businesses, this cycle takes less than a year, so they use a one-year cutoff. But for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year. Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long-term.
Common types of current assets are (1) cash, (2) investments (such as short-term U.S. government securities), (3) receivables (accounts receivable, notes receivable, and interest receivable), (4) inventories, and (5) prepaid expenses (insurance and supplies). Companies list current assets in the order in which they expect to convert them into cash. Follow this rule when doing your homework.
Illustration 2-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0003) presents the current assets of Southwest Airlines Co. in a recent year.
ILLUSTRATION 2-3 Current assets section
As explained later in the chapter, a company's current assets are important in assessing its short-term debt-paying ability.
LONG-TERM INVESTMENTS Long-term investments are generally (1) investments in stocks and bonds of other corporations that are held for more than one year, (2) long-term assets such as land or buildings that a company is not currently using in its operating activities, and (3) long-term notes receivable. In Illustration 2-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) , Franklin Corporation reported total long-term investments of $7,200 on its balance sheet.
Google Inc. reported long-term investments on its balance sheet in a recent year as shown in Illustration 2-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0004) .
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ILLUSTRATION 2-4 Long-term investments section
ALTERNATIVE TERMINOLOGY
Long-term investments are often referred to simply as investments.
PROPERTY, PLANT, AND EQUIPMENT Property, plant, and equipment are assets with relatively long useful lives that are currently used in operating the business. This category includes land, buildings, equipment, delivery vehicles, and furniture. In Illustration 2-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig- 0002) , Franklin Corporation reported property, plant, and equipment of $29,000.
Depreciation is the allocation of the cost of an asset to a number of years. Companies do this by systematically assigning a portion of an asset's cost as an expense each year (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset's life. In Illustration 2-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) , Franklin Corporation reported accumulated depreciation of $5,000.
Illustration 2-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0005) presents the property, plant, and equipment of Tesla Motors, Inc. in a recent year.
ILLUSTRATION 2-5 Property, plant, and equipment section
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ALTERNATIVE TERMINOLOGY
Property, plant, and equipment is sometimes called �ixed assets or plant assets.
INTANGIBLE ASSETS Many companies have assets that do not have physical substance and yet often are very valuable. We call these assets intangible assets. One common intangible is goodwill. Others include patents, copyrights, and trademarks or trade names that give the company exclusive right of use for a speci�ied period of time. In Illustration 2-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02- �ig-0002) , Franklin Corporation reported intangible assets of $3,100.
Illustration 2-6 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0006) shows the intangible assets of media and theme park giant The Walt Disney Company in a recent year.
ILLUSTRATION 2-6 Intangible assets section
DO IT! 1a
Assets Section of Classi�ied Balance Sheet
Baxter Hoffman recently received the following information related to Hoffman Corporation's December 31, 2017, balance sheet.
Prepaid insurance $ 2,300 Inventory $3,400 Cash 800 Accumulated depreciation—equipment 2,700
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Equipment 10,700 Accounts receivable 1,100
Prepare the assets section of Hoffman Corporation's classi�ied balance sheet.
Action Plan ✓ Present current assets �irst. Current assets are cash and other
resources that the company expects to convert to cash or use up within one year.
✓ Present current assets in the order in which the company expects to convert them into cash.
✓ Subtract accumulated depreciation—equipment from equipment to determine net equipment.
SOLUTION
Related exercise material: BE2-2, DO IT! 2-1a, E2-3, and E2-4.
▼ HELPFUL HINT
Sometimes intangible assets are reported under a broader heading called “Other assets.”
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CURRENT LIABILITIES In the liabilities and stockholders' equity section of the balance sheet, the �irst grouping is current liabilities. Current liabilities are obligations that the company is to pay within the next year or operating cycle, whichever is longer. Common examples are accounts payable, salaries and wages payable, notes payable, interest payable, and income taxes payable. Also included as current liabilities are current maturities of long-term obligations—payments to be made within the next year on long-term obligations. In Illustration 2-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig- 0002) , Franklin Corporation reported �ive different types of current liabilities, for a total of $16,050.
Illustration 2-7 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0007) shows the current liabilities section adapted from the balance sheet of Google Inc. in a recent year.
ILLUSTRATION 2-7 Current liabilities section
LONG-TERM LIABILITIES Long-term liabilities (long-term debt) are obligations that a company expects to pay after one year. Liabilities in this category include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities. Many companies report long-term debt maturing after one year as a single amount in the balance sheet and show the details of the debt in notes that accompany the �inancial statements. Others list the various types of long-term liabilities. In Illustration 2-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) , Franklin Corporation reported long-term liabilities of $11,300.
Illustration 2-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0008) shows the long-term liabilities that Nike, Inc. reported in its balance sheet in a recent year.
ILLUSTRATION 2-8 Long-term liabilities section
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STOCKHOLDERS' EQUITY Stockholders' equity consists of two parts: common stock and retained earnings. Companies record as common stock the investments of assets into the business by the stockholders. They record as retained earnings the income retained for use in the business. These two parts, combined, make up stockholders' equity on the balance sheet. In Illustration 2-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) , Franklin Corporation reported common stock of $14,000 and retained earnings of $20,050.
DO IT! 1b
Balance Sheet Classi�ications
The following �inancial statement items were taken from the �inancial statements of Callahan Corp.
_______ Salaries and wages payable
_______ Service revenue
_______ Interest payable
_______ Goodwill
_______ Debt investments (short-term)
_______ Mortgage payable (due in 3 years)
_______ Investment in real estate
_______ Equipment
_______ Accumulated depreciation—equipment
_______ Depreciation expense
_______ Retained earnings
_______ Unearned service revenue
Match each of the items to its proper balance sheet classi�ication, shown below. If the item would not appear on a balance sheet, use “NA.”
Current assets (CA)
Long-term investments (LTI)
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Property, plant, and equipment (PPE)
Intangible assets (IA)
Current liabilities (CL)
Long-term liabilities (LTL)
Stockholders' equity (SE)
Action Plan ✓ Analyze whether each �inancial statement item is an asset,
liability, or stockholders' equity item.
✓ Determine if asset and liability items are current or long-term.
SOLUTION
CL Salaries and wages payable
NA Service revenue
CL Interest payable
IA Goodwill
CA Debt investments (short-term)
LTL Mortgage payable (due in 3 years)
LTI Investment in real estate
PPE Equipment
PPE Accumulated depreciation—equipment
NA Depreciation expense
SE Retained earnings
CL Unearned service revenue
Related exercise material: BE2-1, DO IT! 2-1b, E2-1, E2-2, E2-3, E2-5, and E2-6.
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ALTERNATIVE TERMINOLOGY
Common stock is sometimes called capital stock.
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LEARNING OBJECTIVE 2
Use ratios to evaluate a company's pro�itability, liquidity, and solvency.
In Chapter 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) , we introduced the four �inancial statements. We discussed how these statements provide information about a company's performance and �inancial position. In this chapter, we extend this discussion by showing you speci�ic tools that you can use to analyze �inancial statements in order to make a more meaningful evaluation of a company.
RATIO ANALYSIS Ratio analysis expresses the relationship among selected items of �inancial statement data. A ratio expresses the mathematical relationship between one quantity and another. For analysis of the primary �inancial statements, we classify ratios as shown in Illustration 2-9 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0009) (page 52).
ILLUSTRATION 2-9 Financial ratio classi�ications
A single ratio by itself is not very meaningful. Accordingly, in this and the following chapters, we will use various comparisons to shed light on company performance:
1. Intracompany comparisons covering two years for the same company.
2. Industry-average comparisons based on average ratios for particular industries.
3. Intercompany comparisons based on comparisons with a competitor in the same industry.
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Next, we use some ratios and comparisons to analyze the �inancial statements of Best Buy.
USING THE INCOME STATEMENT Best Buy generates pro�its for its stockholders by selling electronics. The income statement reveals how successful the company is at generating a pro�it from its sales. The income statement reports the amount earned during the period (revenues) and the costs incurred during the period (expenses). Illustration 2- 10 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0010) shows a simpli�ied income statement for Best Buy.
ILLUSTRATION 2-10 Best Buy's income statement
From this income statement, we can see that Best Buy's sales and net income increased during the period. Net income increased from a $441 million loss to a positive $532 million. One extremely unusual aspect of Best Buy's income statement is that the 2013 comparative column only covers 11 months. This occurred because Best Buy changed its year-end from “the Saturday nearest the end of February to the Saturday nearest the end of January.” Such a change is very uncommon and complicates efforts to compare performance across years.
A much smaller competitor of Best Buy is hhgregg. hhgregg operates 228 stores in 20 states and is headquartered in Indianapolis, Indiana. It reported net income of $228,000 for the year ended March 31, 2014.
To evaluate the pro�itability of Best Buy, we will use ratio analysis. Pro�itability ratios, such as earnings per share, measure the operating success of a company for a given period of time.
Earnings per Share
Earnings per share (EPS) measures the net income earned on each share of common stock. Stockholders usually think in terms of the number of shares they own or plan to buy or sell, so stating net income earned as a per share amount provides a useful perspective for determining the investment return. Advanced accounting courses present more re�ined techniques for calculating earnings per share.
For now, a basic approach for calculating earnings per share is to divide earnings available to common stockholders by weighted-average common shares outstanding during the year. What is “earnings
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available to common stockholders”? It is an earnings amount calculated as net income less dividends paid on another type of stock, called preferred stock (Net income−Preferred dividends).
By comparing earnings per share of a single company over time, we can evaluate its relative earnings performance from the perspective of a stockholder—that is, on a per share basis. It is very important to note that comparisons of earnings per share across companies are not meaningful because of the wide variations in the numbers of shares of outstanding stock among companies.
Illustration 2-11 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0011) shows the earnings per share calculation for Best Buy in 2014 and 2013, based on the information presented below. Recall that Best Buy's 2013 income is based on 11 months of results. Further, to simplify our calculations, we assumed that any change in the number of shares for Best Buy occurred in the middle of the year.
ILLUSTRATION 2-11 Best Buy's earnings per share
DECISION TOOLS
Earnings per share helps users compare a company's performance with that of previous years.
USING A CLASSIFIED BALANCE SHEET You can learn a lot about a company's �inancial health by also evaluating the relationship between its various assets and liabilities. Illustration 2-12 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0012) (page 54) provides a simpli�ied balance sheet for Best Buy.
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ILLUSTRATION 2-12 Best Buy's balance sheet
Liquidity
Suppose you are a banker at CitiGroup considering lending money to Best Buy, or you are a sales manager at Hewlett-Packard interested in selling computers to Best Buy on credit. You would be concerned about Best Buy's liquidity—its ability to pay obligations expected to become due within the next year or operating cycle. You would look closely at the relationship of its current assets to current liabilities.
WORKING CAPITAL
One measure of liquidity is working capital, which is the difference between the amounts of current assets and current liabilities:
ILLUSTRATION 2-13 Working capital
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When current assets exceed current liabilities, working capital is positive. When this occurs, there is a greater likelihood that the company will pay its liabilities. When working capital is negative, a company might not be able to pay short-term creditors, and the company might ultimately be forced into bankruptcy. Best Buy had working capital in 2014 of $3,049 million ($10,485 million−$7,436 million).
CURRENT RATIO
Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. One liquidity ratio is the current ratio, computed as current assets divided by current liabilities.
The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have signi�icantly different current ratios. Illustration 2-14 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0014) shows the 2014 and 2013 current ratios for Best Buy and for hhgregg, along with the 2014 industry average.
ILLUSTRATION 2-14 Current ratio
What does the ratio actually mean? Best Buy's 2014 current ratio of 1.41:1 means that for every dollar of current liabilities, Best Buy has $1.41 of current assets. Best Buy's current ratio increased in 2014. When compared to the industry average of .88:1, Best Buy's liquidity seems strong. It is lower than hhgregg's but not signi�icantly so.
One potential weakness of the current ratio is that it does not take into account the composition of the current assets. For example, a satisfactory current ratio does not disclose whether a portion of the current assets is tied up in slow-moving inventory. The composition of the current assets matters because a dollar of cash is more readily available to pay the bills than is a dollar of inventory. For example, suppose a company's cash balance declined while its merchandise inventory increased substantially. If inventory increased because the company is having dif�iculty selling its products, then the current ratio might not fully re�lect the reduction in the company's liquidity.
ACCOUNTING ACROSS THE ORGANIZATION
REL Consultancy Group
Can a Company Be Too Liquid?
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There actually is a point where a company can be too liquid—that is, it can have too much working capital. While it is important to be liquid enough to be able to pay short-term bills as they come due, a company does not want to tie up its cash in extra inventory or receivables that are not earning the company money.
By one estimate from the REL Consultancy Group, the thousand largest U.S. companies had cumulative excess working capital of $1.017 trillion in a recent year. This was an 18% increase, which REL said represented a “deterioration in the management of operations.” Given that managers throughout a company are interested in improving pro�itability, it is clear that they should have an eye toward managing working capital. They need to aim for a “Goldilocks solution”—not too much, not too little, but just right.
Source: Maxwell Murphy, “The Big Number,” Wall Street Journal (November 9, 2011).
What can various company managers do to ensure that working capital is managed ef�iciently to maximize net income? (Go to WileyPLUS for this answer and additional questions.)
DECISION TOOLS
The current ratio helps users determine if a company can meet its near-term obligations.
ETHICS NOTE
A company that has more current assets than current liabilities can increase the ratio of current assets to current liabilities by using cash to pay off some current liabilities. This gives the appearance of being more liquid. Do you think this move is ethical?
Solvency
Now suppose that instead of being a short-term creditor, you are interested in either buying Best Buy's stock or extending the company a long-term loan. Long-term creditors and stockholders are interested in a company's solvency—its ability to pay interest as it comes due and to repay the balance of a debt due at its maturity. Solvency ratios measure the ability of the company to survive over a long period of time.
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DEBT TO ASSETS RATIO
The debt to assets ratio is one measure of solvency. It is calculated by dividing total liabilities (both current and long-term) by total assets. It measures the percentage of total �inancing provided by creditors rather than stockholders. Debt �inancing is more risky than equity �inancing because debt must be repaid at speci�ic points in time, whether the company is performing well or not. Thus, the higher the percentage of debt �inancing, the riskier the company.
The higher the percentage of total liabilities (debt) to total assets, the greater the risk that the company may be unable to pay its debts as they come due. Illustration 2-15 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0015) shows the debt to assets ratios for Best Buy and hhgregg, along with the industry average.
ILLUSTRATION 2-15 Debt to assets ratio
The 2014 ratio of 72% means that every dollar of assets was �inanced by 72 cents of debt. Best Buy's ratio is less than the industry average of 88% and is signi�icantly higher than hhgregg's ratio of 51%. The higher the ratio, the more reliant the company is on debt �inancing. This means that Best Buy has a lower equity “buffer” available to creditors if the company becomes insolvent when compared to hhgregg. Thus, from the creditors' point of view, a high ratio of debt to assets is undesirable. Best Buy's solvency appears lower than hhgregg's and higher than the average company in the industry.
The adequacy of this ratio is often judged in light of the company's earnings. Generally, companies with relatively stable earnings, such as public utilities, can support higher debt to assets ratios than can cyclical companies with widely �luctuating earnings, such as many high-tech companies. In later chapters, you will learn additional ways to evaluate solvency.
INVESTOR INSIGHT When Debt Is Good
Debt �inancing differs greatly across industries and companies. Here are some debt to assets ratios for selected companies in a recent year:
Debt to Assets Ratio Google 23%
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Debt to Assets Ratio
Nike 41% Microsoft 48% ExxonMobil 48% General Motors 74%
Discuss the difference in the debt to assets ratio of Microsoft and General Motors. (Go to WileyPLUS for this answer and additional questions.)
▼ HELPFUL HINT
Some users evaluate solvency using a ratio of liabilities divided by stockholders' equity. The higher this “debt to equity” ratio, the lower is a company's solvency.
DECISION TOOLS
The debt to assets ratio helps users determine if a company can meet its long-term obligations.
USING THE STATEMENT OF CASH FLOWS In the statement of cash �lows, net cash provided by operating activities is intended to indicate the cash- generating capability of the company. Analysts have noted, however, that net cash provided by operating activities fails to take into account that a company must invest in new property, plant, and equipment (capital expenditures) just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. A measurement to provide additional insight regarding a company's cash-generating ability is free cash �low. Free cash �low describes the net cash provided by operating activities after adjusting for capital expenditures and dividends paid.
Consider the following example. Suppose that MPC produced and sold 10,000 personal computers this year. It reported $100,000 net cash provided by operating activities. In order to maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in dividends. Its free cash �low was $80,000 ($100,000−$15,000−$5,000). The company could use this $80,000 to purchase new assets to expand the business, pay off debts, or increase its dividend distribution. In practice, analysts often calculate free cash �low with the formula shown in Illustration 2-16
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(http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0016) . (Alternative de�initions also exist.)
ILLUSTRATION 2-16 Free cash �low
We can calculate Best Buy's 2014 free cash �low as shown in Illustration 2-17 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0017) (dollars in millions).
ILLUSTRATION 2-17 Best Buy's free cash �low
Best Buy generated free cash �low of $314 million, which is available for the acquisition of new assets, the retirement of stock or debt, or the payment of additional dividends. Long-term creditors consider a high free cash �low amount an indication of solvency. hhgregg's free cash �low for 2014 is $60 million. Given that hhgregg is considerably smaller than Best Buy, we would expect its free cash �low to be much lower.
DECISION TOOLS
Free cash �low helps users determine the amount of cash a company generated to expand operations, pay off debts, or increase dividends.
DO IT! 2
Ratio Analysis
The following information is available for Ozone Inc.
2017 2016 Current assets $ 88,000 $ 60,800
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2017 2016
Total assets 400,000 341,000 Current liabilities 40,000 38,000 Total liabilities 120,000 150,000 Net income 100,000 50,000 Net cash provided by operating activities 110,000 70,000 Preferred dividends 10,000 10,000 Common dividends 5,000 2,500 Expenditures on property, plant, and equipment 45,000 20,000 Shares outstanding at beginning of year 60,000 40,000 Shares outstanding at end of year 120,000 60,000
(a) Compute earnings per share for 2017 and 2016 for Ozone, and comment on the change. Ozone's primary competitor, Frost Corporation, had earnings per share of $2 in 2017. Comment on the difference in the ratios of the two companies.
(b) Compute the current ratio and debt to assets ratio for each year, and comment on the changes.
(c) Compute free cash �low for each year, and comment on the changes.
Action Plan ✓ Use the formula for earnings per share (EPS): (Net
income−Preferred dividends)÷Weighted-average common shares outstanding.
✓ Use the formula for the current ratio: Current assets÷Current liabilities.
✓ Use the formula for the debt to assets ratio: Total liabilities÷Total assets.
✓ Use the formula for free cash �low: Net cash provided by operating activities – Capital expenditures – Cash dividends.
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Related exercise material: BE2-3, BE2-4, BE2-5, DO IT! 2-2, E2-7, E2-9, E2-10, and E2- 11.
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LEARNING OBJECTIVE 3
Discuss �inancial reporting concepts.
You have now learned about the four �inancial statements and some basic ways to interpret those statements. In this last section, we will discuss concepts that underlie these �inancial statements. It would be unwise to make business decisions based on �inancial statements without understanding the implications of these concepts.
THE STANDARD-SETTING ENVIRONMENT How does Best Buy decide on the type of �inancial information to disclose? What format should it use? How should it measure assets, liabilities, revenues, and expenses? Accounting professionals at Best Buy and all other U.S. companies get guidance from a set of accounting standards that have authoritative support, referred to as generally accepted accounting principles (GAAP). Standard-setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards.
The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. �inancial markets and accounting standard-setting bodies. The Financial Accounting Standards Board (FASB) is the primary accounting standard-setting body in the United States. The International Accounting Standards Board (IASB) issues standards called International Financial Reporting Standards (IFRS), which have been adopted by many countries outside of the United States. Today, the FASB and IASB are working closely together to minimize the differences in their standards. Recently, the SEC announced that foreign companies that wish to have their shares traded on U.S stock exchanges no longer have to prepare reports that conform with GAAP, as long as their reports conform with IFRS. The SEC is currently evaluating whether the United States should eventually adopt IFRS as the required set of standards for U.S. publicly traded companies. Another relatively recent change to the �inancial reporting environment was that, as a result of the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (PCAOB) was created. Its job is to determine auditing standards and review the performance of auditing �irms. If the United States adopts IFRS for its accounting standards, it will also have to coordinate its auditing regulations with those of other countries.
INTERNATIONAL INSIGHT The Korean Discount
If you think that accounting standards don't matter, consider recent events in South Korea. For many years, international investors complained that the �inancial reports of South Korean companies were inadequate and inaccurate. Accounting practices there often resulted in huge differences between stated revenues
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and actual revenues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of comparable companies in different countries. This difference in share price was often referred to as the “Korean discount.”
In response, Korean regulators decided that companies would have to comply with international accounting standards. This change was motivated by a desire to “make the country's businesses more transparent” in order to build investor con�idence and spur economic growth. Many other Asian countries, including China, India, Japan, and Hong Kong, have also decided either to adopt international standards or to create standards that are based on the international standards.
Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007).
What is meant by the phrase “make the country's businesses more transparent”? Why would increasing transparency spur economic growth? (Go to WileyPLUS for this answer and additional questions.)
INTERNATIONAL NOTE Over 115 countries use international standards (called IFRS). For example, all companies in the European Union follow IFRS. In this textbook, we highlight any signi�icant differences using International Notes like this one, as well as a more in-depth discussion in the A Look at IFRS section at the end of each chapter.
QUALITIES OF USEFUL INFORMATION Recently, the FASB and IASB completed the �irst phase of a joint project in which they developed a conceptual framework to serve as the basis for future accounting standards. The framework begins by stating that the primary objective of �inancial reporting is to provide �inancial information that is useful to investors and creditors for making decisions about providing capital. According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 2-18 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo3#c02-�ig-0018) (page 60)..
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ILLUSTRATION 2-18 Fundamental qualities of useful information
Enhancing Qualities
In addition to the two fundamental qualities, the FASB and IASB also describe a number of enhancing qualities of useful information. These include comparability, veri�iability, timeliness, and understandability. In accounting, comparability results when different companies use the same accounting principles. Another type of comparability is consistency. Consistency means that a company uses the same accounting principles and methods from year to year. Information is veri�iable if independent observers, using the same methods, obtain similar results. As noted in Chapter 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) , certi�ied public accountants (CPAs) perform audits of �inancial statements to verify their accuracy. For accounting information to have relevance, it must be timely. That is, it must be available to decision-makers before it loses its capacity to in�luence decisions. The SEC requires that large public companies provide their annual reports to investors within 60 days of their year-end. Information has the quality of understandability if it is presented in a clear and concise fashion, so that reasonably informed users of that information can interpret it and comprehend its meaning.
ACCOUNTING ACROSS THE ORGANIZATION
What Do These Companies Have in Common?
Another issue related to comparability is the accounting time period. An accounting period that is one-year long is called a �iscal year. But a �iscal year need not match the calendar year. For example, a company could end its �iscal year on April 30 rather than on December 31.
Why do companies choose the particular year-ends that they do? For example, why doesn't every company use December 31 as its accounting year-end? Many companies choose to end their accounting year when inventory or operations are at a low point. This is advantageous because compiling accounting information requires much time and effort by managers, so
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they would rather do it when they aren't as busy operating the business. Also, inventory is easier and less costly to count when its volume is low.
Some companies whose year-ends differ from December 31 are Delta Air Lines, June 30; The Walt Disney Company, September 30; and Dunkin' Donuts, Inc., October 31. In the notes to its �inancial statements, Best Buy states that its accounting year-end is the Saturday nearest the end of January.
What problems might Best Buy's year-end create for analysts? (Go to WileyPLUS for this answer and additional questions.)
ASSUMPTIONS IN FINANCIAL REPORTING To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 2-19 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo3#c02-�ig-0019) . These include assumptions about the monetary unit, economic entity, periodicity, and going concern.
ILLUSTRATION 2-19 Key assumptions in �inancial reporting
ETHICS NOTE
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The importance of the economic entity assumption is illustrated by scandals involving Adelphia. In this case, senior company employees entered into transactions that blurred the line between the employees' �inancial interests and those of the company. For example, Adelphia guaranteed over $2 billion of loans to the founding family.
PRINCIPLES IN FINANCIAL REPORTING
Measurement Principles
GAAP generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.
HISTORICAL COST PRINCIPLE
The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held. For example, if land that was purchased for $30,000 increases in value to $40,000, it continues to be reported at $30,000.
FAIR VALUE PRINCIPLE
The fair value principle indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily available for these types of assets. In choosing between cost and fair value, the FASB uses two qualities that make accounting information useful for decision-making—relevance and faithful representation. In determining which measurement principle to use, the FASB weighs the factual nature of cost �igures versus the relevance of fair value. In general, the FASB indicates that most assets must follow the historical cost principle because market values may not be representationally faithful. Only in situations where assets are actively traded, such as investment securities, is the fair value principle applied.
Full Disclosure Principle
The full disclosure principle requires that companies disclose all circumstances and events that would make a difference to �inancial statement users. If an important item cannot reasonably be reported directly in one of the four types of �inancial statements, then it should be discussed in notes that accompany the statements.
COST CONSTRAINT
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Providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard-setters consider the cost constraint. It weighs the cost that companies will incur to provide the information against the bene�it that �inancial statement users will gain from having the information available.
DO IT! 3
Financial Accounting Concepts and Principles
The following items guide the FASB when it creates accounting standards.
Relevance Periodicity assumption Faithful representation Going concern assumption Comparability Historical cost principle Consistency Full disclosure principle Monetary unit assumption Materiality Economic entity assumption
Match each item above with a description below.
1. _______ Ability to easily evaluate one company's results relative to another's.
2. _______ Belief that a company will continue to operate for the foreseeable future.
3. _______ The judgment concerning whether an item is large enough to matter to decision-makers.
4. _______ The reporting of all information that would make a difference to �inancial statement users.
5. _______ The practice of preparing �inancial statements at regular intervals.
6. _______ The quality of information that indicates the information makes a difference in a decision.
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7. _______ A belief that items should be reported on the balance sheet at the price that was paid to acquire the item.
8. _______ A company's use of the same accounting principles and methods from year to year.
9. _______ Tracing accounting events to particular companies.
10. _______ The desire to minimize errors and bias in �inancial statements.
11. _______ Reporting only those things that can be measured in dollars.
Action Plan ✓ Understand the need for conceptual guidelines in accounting.
✓ List the characteristics of useful �inancial information.
✓ Review the assumptions, principles, and constraint that comprise the guidelines in accounting.
SOLUTION
1. Comparability
2. Going concern assumption
3. Materiality
4. Full disclosure principle
5. Periodicity assumption
6. Relevance
7. Historical cost principle
8. Consistency
9. Economic entity assumption
10. Faithful representation
11. Monetary unit assumption
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Related exercise material: BE2-8, BE2-9, BE2-10, DO IT! 2-3, E2-12, and E2-13.
USING DECISION TOOLS—TWEETER HOME ENTERTAINMENT In this chapter, we evaluated a home electronics giant, Best Buy. Tweeter Home Entertainment sold consumer electronics products from 154 stores on the East Coast under various names. It specialized in products with high-end features. Tweeter �iled for bankruptcy in June 2007 and was acquired by another company in July 2007. Financial data for Tweeter, prior to its bankruptcy, are provided below.
September 30 (amounts in millions) 2006 2005 Current assets $146.4 $158.2 Total assets 258.6 284.0 Current liabilities 107.1 119.0 Total liabilities 190.4 201.1 Total common stockholders' equity 68.2 82.9 Net income (loss) (16.5) (74.4) Net cash provided (used) by operating activities 15.6 (26.7) Capital expenditures (net) 17.4 22.2 Dividends paid 0 0 Weighted-average shares of common stock (millions) 25.2 24.6
INSTRUCTIONS
Using the data provided, answer the following questions and discuss how these results might have provided an indication of Tweeter's �inancial troubles.
1. Calculate the current ratio for Tweeter for 2006 and 2005 and discuss its liquidity position.
2. Calculate the debt to assets ratio and free cash �low for Tweeter for 2006 and 2005 and discuss its solvency.
3. Calculate the earnings per share for Tweeter for 2006 and 2005, and discuss its change in pro�itability.
4. Best Buy's accounting year-end was February 28, 2006; Tweeter's was September 30, 2006. How does this difference affect your ability to compare their pro�itability?
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SOLUTION
1. Current ratio:
2006:$146.4÷$107.1=1.37:12005:$158.2÷$119.0=1.33:1
Tweeter's liquidity improved slightly from 2005 to 2006, but in both years it would most likely have been considered inadequate. In 2006, Tweeter had only $1.37 in current assets for every dollar of current liabilities. Sometimes larger companies, such as Best Buy, can function with lower current ratios because they have alternative sources of working capital. But a company of Tweeter's size would normally want a higher ratio.
2. Debt to assets ratio:
2006:$190.4÷$258.6=73.6%2005:$201.1÷$284.0=70.8%
Tweeter's solvency, as measured by its debt to assets ratio, declined from 2005 to 2006. Its ratio of 73.6% meant that every dollar of assets was �inanced by 73.6 cents of debt. For a retailer, this is extremely high reliance on debt. This low solvency suggests Tweeter's ability to meet its debt payments was questionable.
Free cash �low:
2006:$15.6−$17.4−$0=−$1.8 million2005:−$26.7−$22.2−$0=− $48.9 million
Tweeter's free cash �low was negative in both years. The company did not generate enough net cash provided by operating activities even to cover its capital expenditures, and it was not paying a dividend. While this is not unusual for new companies in their early years, it is also not sustainable for very long. Part of the reason that its debt to assets ratio, discussed above, was so high was that it had to borrow money to make up for its de�icient free cash �low.
3. Loss per share:
2006:−$16.5÷$25.2=−$0.65 per share2005:−$74.4÷$24.6=− $3.02 per share
Tweeter's loss per share declined substantially. However, this was little consolation for its shareholders, who experienced losses in previous years as well. The company's lack of pro�itability, combined with its poor liquidity and solvency, increased the likelihood that it would eventually �ile for bankruptcy.
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4. Tweeter's income statement covers 7 months not covered by Best Buy's. Suppose that the economy changed dramatically during this 7-month period, either improving or declining. This change in the economy would be re�lected in Tweeter's income statement but would not be re�lected in Best Buy's income statement until the following March, thus reducing the usefulness of a comparison of the income statements of the two companies.
REVIEW AND PRACTICE
LEARNING OBJECTIVES REVIEW 1. Identify the sections of a classi�ied balance sheet. In a classi�ied balance sheet,
companies classify assets as current assets; long-term investments; property, plant, and equipment; and intangibles. They classify liabilities as either current or long-term. A stockholders' equity section shows common stock and retained earnings.
2. Use ratios to evaluate a company's pro�itability, liquidity, and solvency. Ratio analysis expresses the relationship among selected items of �inancial statement data. Pro�itability ratios, such as earnings per share (EPS), measure aspects of the operating success of a company for a given period of time.
Liquidity ratios, such as the current ratio, measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. Solvency ratios, such as the debt to assets ratio, measure the ability of a company to survive over a long period. Free cash �low indicates a company's ability to generate net cash provided by operating activities that is suf�icient to pay debts, acquire assets, and distribute dividends.
3. Discuss �inancial reporting concepts. Generally accepted accounting principles are a set of rules and practices recognized as a general guide for �inancial reporting purposes. The basic objective of �inancial reporting is to provide information that is useful for decision-making.
To be judged useful, information should have the primary characteristics of relevance and faithful representation. In addition, useful information is comparable, consistent, veri�iable, timely, and understandable.
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The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money. The economic entity assumption states that economic events can be identi�ied with a particular unit of accountability. The periodicity assumption states that the economic life of a business can be divided into arti�icial time periods and that meaningful accounting reports can be prepared for each period. The going concern assumption states that the company will continue in operation long enough to carry out its existing objectives and commitments.
The historical cost principle states that companies should record assets at their cost. The fair value principle indicates that assets and liabilities should be reported at fair value. The full disclosure principle requires that companies disclose circumstances and events that matter to �inancial statement users.
The cost constraint weighs the cost that companies incur to provide a type of information against its bene�it to �inancial statement users.
DECISION TOOLS REVIEW
GLOSSARY REVIEW Classi�ied balance sheet A balance sheet that groups together similar assets and similar
liabilities, using a number of standard classi�ications and sections.
Comparability Ability to compare the accounting information of different companies because they use the same accounting principles.
Consistency Use of the same accounting principles and methods from year to year within a company.
Cost constraint Constraint that weighs the cost that companies will incur to provide the information against the bene�it that �inancial statement users will gain from having the information available.
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Current assets Assets that companies expect to convert to cash or use up within one year or the operating cycle, whichever is longer.
Current liabilities Obligations that a company expects to pay within the next year or operating cycle, whichever is longer.
Current ratio A measure of liquidity computed as current assets divided by current liabilities.
Debt to assets ratio A measure of solvency calculated as total liabilities divided by total assets. It measures the percentage of total �inancing provided by creditors.
Earnings per share (EPS) A measure of the net income earned on each share of common stock; computed as net income minus preferred dividends divided by the weighted- average number of common shares outstanding during the year.
Economic entity assumption An assumption that every economic entity can be separately identi�ied and accounted for.
Fair value principle Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).
Faithful representation Information that is complete, neutral, and free from error.
Financial Accounting Standards Board (FASB) The primary accounting standard- setting body in the United States.
Free cash �low Net cash provided by operating activities after adjusting for capital expenditures and cash dividends paid.
Full disclosure principle Accounting principle that dictates that companies disclose circumstances and events that make a difference to �inancial statement users.
Generally accepted accounting principles (GAAP) A set of accounting standards that have substantial authoritative support and which guide accounting professionals.
Going concern assumption The assumption that the company will continue in operation for the foreseeable future.
Historical cost principle An accounting principle that states that companies should record assets at their cost.
Intangible assets Assets that do not have physical substance.
International Accounting Standards Board (IASB) An accounting standard-setting body that issues standards adopted by many countries outside of the United States.
International Financial Reporting Standards (IFRS) Accounting standards, issued by the IASB, that have been adopted by many countries outside of the United States.
Liquidity The ability of a company to pay obligations that are expected to become due within the next year or operating cycle.
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Liquidity ratios Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Long-term investments Generally, (1) investments in stocks and bonds of other corporations that companies hold for more than one year; (2) long-term assets, such as land and buildings, not currently being used in the company's operations; and (3) long- term notes receivable.
Long-term liabilities Obligations that a company expects to pay after one year.
Materiality Whether an item is large enough to likely in�luence the decision of an investor or creditor.
Monetary unit assumption An assumption that requires that only those things that can be expressed in money are included in the accounting records.
Operating cycle The average time required to purchase inventory, sell it on account, and then collect cash from customers—that is, go from cash to cash.
Periodicity assumption An assumption that the life of a business can be divided into arti�icial time periods and that useful reports covering those periods can be prepared for the business.
Pro�itability ratios Measures of the operating success of a company for a given period of time.
Property, plant, and equipment Assets with relatively long useful lives that are currently used in operating the business.
Public Company Accounting Oversight Board (PCAOB) The group charged with determining auditing standards and reviewing the performance of auditing �irms.
Ratio analysis A technique that expresses the relationship among selected items of �inancial statement data.
Ratio An expression of the mathematical relationship between one quantity and another.
Relevance The quality of information that indicates the information makes a difference in a decision.
Securities and Exchange Commission (SEC) The agency of the U.S. government that oversees U.S. �inancial markets and accounting standard-setting bodies.
Solvency ratios Measures of the ability of the company to survive over a long period of time.
Solvency The ability of a company to pay interest as it comes due and to repay the balance of debt due at its maturity.
Timely Information that is available to decision-makers before it loses its capacity to in�luence decisions.
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Understandability Information presented in a clear and concise fashion so that users can interpret it and comprehend its meaning.
Veri�iable The quality of information that occurs when independent observers, using the same methods, obtain similar results.
Working capital The difference between the amounts of current assets and current liabilities.
PRACTICE MULTIPLE-CHOICE QUESTIONS (LO 1)
1. In a classi�ied balance sheet, assets are usually classi�ied as:
(a) current assets; long-term assets; property, plant, and equipment; and intangible assets.
(b) current assets; long-term investments; property, plant, and equipment; and common stock.
(c) current assets; long-term investments; tangible assets; and intangible assets.
(d) current assets; long-term investments; property, plant, and equipment; and intangible assets.
(LO 1)
2. Current assets are listed:
(a) by order of expected conversion to cash.
(b) by importance.
(c) by longevity.
(d) alphabetically.
(LO 1)
3. The correct order of presentation in a classi�ied balance sheet for the following current assets is:
(a) accounts receivable, cash, prepaid insurance, inventory.
(b) cash, inventory, accounts receivable, prepaid insurance.
(c) cash, accounts receivable, inventory, prepaid insurance.
(d) inventory, cash, accounts receivable, prepaid insurance.
(LO 1)
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4. A company has purchased a tract of land. It expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. The land should be reported as:
(a) property, plant, and equipment.
(b) land expense.
(c) a long-term investment.
(d) an intangible asset.
(LO 1)
5. The balance in retained earnings is not affected by:
(a) net income.
(b) net loss.
(c) issuance of common stock.
(d) dividends.
(LO 2)
6. Which is an indicator of pro�itability?
(a) Current ratio.
(b) Earnings per share.
(c) Debt to assets ratio.
(d) Free cash �low.
(LO 2)
7. For 2017, Spanos Corporation reported net income $26,000, net sales $400,000, and weighted-average shares outstanding 4,000. There were preferred dividends of $2,000. What was the 2017 earnings per share?
(a) $6.00.
(b) $6.50.
(c) $99.50.
(d) $100.00.
(LO 2)
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8. Which of these measures is an evaluation of a company's ability to pay current liabilities?
(a) Earnings per share.
(b) Current ratio.
(c) Both (a) and (b).
(d) None of the above.
(LO 2)
9. The following ratios are available for Reilly Inc. and O'Hare Inc.
Current Ratio
Debt to Assets Ratio
Earnings per Share
Reilly Inc. 2:1 75% $3.50
O'Hare Inc. 1.5:1 40% $2.75
Compared to O'Hare Inc., Reilly Inc. has:
(a) higher liquidity, higher solvency, and higher pro�itability.
(b) lower liquidity, higher solvency, and higher pro�itability.
(c) higher liquidity, lower solvency, and higher pro�itability.
(d) higher liquidity and lower solvency, but pro�itability cannot be compared based on information provided.
(LO 2)
10. Companies can use free cash �low to:
(a) pay additional dividends.
(b) acquire property, plant, and equipment.
(c) pay off debts.
(d) All of the above.
(LO 3)
11. Generally accepted accounting principles are:
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(a) a set of standards and rules that are recognized as a general guide for �inancial reporting.
(b) usually established by the Internal Revenue Service.
(c) the guidelines used to resolve ethical dilemmas.
(d) fundamental truths that can be derived from the laws of nature.
(LO 3)
12. What organization issues U.S. accounting standards?
(a) Financial Accounting Standards Board.
(b) International Accounting Standards Committee.
(c) International Auditing Standards Committee.
(d) None of the above.
(LO 3)
13. What is the primary criterion by which accounting information can be judged?
(a) Consistency.
(b) Predictive value.
(c) Usefulness for decision-making.
(d) Comparability.
(LO 3)
14. Neutrality is an ingredient of:
Faithful Representation Relevance (a) Yes Yes (b) No No (c) Yes No (d) No Yes
(LO 3)
15. The characteristic of information that evaluates whether it is large enough to impact a decision.
(a) Comparability.
(b) Materiality.
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(c) Cost.
(d) Consistency.
SOLUTIONS
1. (b) Assets are classi�ied as current assets; long-term investmens; property, plant and equipment; and intangible assets. The other choices are incorrect because (a) long-term assets includes long-term investments; property, plant, and equipment; and intangible assets; (b) common stock refers to the equity of the �irm and is not an asset; and (c) while tangible assets describes property, plant, and equipment, it is better to use the more common terminology of property, plant, and equipment.
2. (a) Current assets should be listed by order of expected conversion to cash (liquidity), not (b) by importance, (c) by longevity, or (d) alphabetically.
3. (c) The correct order of presentation for current assets is cash, accounts receivable, inventory, and then prepaid insurance. The other choices are therefore incorrect.
4. (c) Land or buildings that are currently not used in operations are considered to be long-term investments. The other choices are incorrect because (a) this classi�ication is for property, plant, and equipment used in operations; (b) land is never expensed; and (d) intangible assets have no physical existence and are used in the production of income.
5. (c) Issuance of common stock has no impact on retained earnings. The other choices are incorrect because (a) net income increases retained earnings, (b) net loss decreases retained earnings, and (d) dividends decrease retained earnings.
6. (b) Earnings per share is a measure of pro�itability. The other choices are incorrect because (a) the current ratio is a measure of liquidity, (c) the debt to assets ratio is a measure of solvency, and (d) free cash �low is a measure of solvency.
7. (a) Earnings per share = Net income ($26,000) less Preferred dividends ($2,000) divided by Weighted-average shares outstanding (4,000) = $6.00/share, not (b) $6.50, (c) $99.50, or (d) $100.00.
8. (b) The current ratio measures liquidity. Higher current ratios indicate higher liquidity. The other choices are incorrect because (a) earnings per share is a measure of a �irm's pro�itability, not its ability to pay its current liabilities; (c) one of these answers is incorrect; and (d) there is a correct answer.
9. (d) Reilly Inc. has higher liquidity as it has a higher current ratio, and lower solvency due to its higher debt to assets ratio. However, pro�itability cannot be compared across companies using earnings per share because of the wide variations in the number of shares of common stock of different companies. The other choices are therefore incorrect.
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10. (d) Free cash �low can be used to pay dividends; acquire more property, plant, and equipment; and pay off debts. Although choices (a), (b), and (c) are correct, choice (d) is the better answer.
11. (a) All U.S. companies get guidance from a set of rules and practices that have authoritative support, referred to as generally accepted accounting principles (GAAP). Standard-setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards. The other choices are incorrect because GAAP is (b) not established by the Internal Revenue Service, (c) not intended to provide guidance in resolving ethical dilemmas, or (d) created by people and can evolve over time, unlike laws of nature, such as those in physics and chemistry.
12. (a) The Financial Accounting Standards Board (FASB) is the organization that issues U.S. accounting standards, not the (b) International Accounting Standards Committee or (c) International Auditing Standards Committee. Choice (d) is wrong as there is a correct answer.
13. (c) Usefulness for decision-making is the primary criterion by which accounting information can be judged. The other choices are incorrect because (a) consistency, (b) predictive value, and (d) comparability all help to make accounting information more useful but are not the primary criterion by which accounting information is judged.
14. (c) Neutrality is an ingredient of faithful representation but not relevance. The other choices are therefore incorrect.
15. (b) Materiality evaluates whether information is large enough to impact a decision, not (a) comparability, (c) cost, or (d) consistency.
PRACTICE EXERCISES
Prepare assets section of a classi�ied balance sheet.
(LO 1)
1. Suppose the following information (in thousands of dollars) is available for H. J. Heinz Company—famous for ketchup and other �ine food products—for the year ended April 30, 2017.
Prepaid insurance $ 168,182 Buildings $4,344,269 Land 56,007 Cash 617,687 Goodwill 4,411,521 Accounts receivable 1,161,481 Trademarks 723,243 Accumulated depreciation—buildings 2,295,563
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Inventory 1,378,216
INSTRUCTIONS
Prepare the assets section of a classi�ied balance sheet, listing the items in proper sequence and including a statement heading.
SOLUTION
Compute and interpret various ratios.
(LO 2)
2. Suppose the following data were taken from the 2017 and 2016 �inancial statements of American Eagle Out�itters. (All dollars are in thousands.)
2017 2016 Current assets $1,020,834 $1,189,108 Total assets 1,867,680 1,979,558 Current liabilities 376,178 464,618 Total liabilities 527,216 562,246 Net income 400,019 387,359 Net cash provided by operating activities 464,270 749,268 Capital expenditures 250,407 225,939 Dividends paid on common stock 80,796 61,521
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2017 2016 Weighted-average shares outstanding 216,119 222,662
INSTRUCTIONS
Perform each of the following.
(a) Calculate the current ratio for each year.
(b) Calculate earnings per share for each year.
(c) Calculate the debt to assets ratio for each year.
(d) Calculate the free cash �low for each year.
(e) Discuss American Eagle's solvency in 2017 versus 2016.
SOLUTION
1.
PRACTICE PROBLEM
Prepare �inancial statements.
(LO 1)
Listed here are items taken from the income statement and balance sheet of Bargain Electronics, Inc. for the year ended December 31, 2017. Certain items have been combined for simpli�ication. (Amounts are given in thousands.)
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Notes payable (due in 3 years) $ 50.5 Cash 141.1 Salaries and wages expense 2,933.6 Common stock 454.9 Accounts payable 922.2 Accounts receivable 723.3 Equipment, net 921.0 Cost of goods sold 9,501.4 Income taxes payable 7.2 Interest expense 1.5 Mortgage payable 451.5 Retained earnings 1,336.3 Inventory 1,636.5 Sales revenue 12,456.9 Debt investments (short-term) 382.6 Income tax expense 30.5 Goodwill 202.7 Notes payable (due in 6 months) 784.6
INSTRUCTIONS
Prepare an income statement and a classi�ied balance sheet using the items listed. Do not use any item more than once.
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SOLUTION
WileyPLUS Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.
QUESTIONS 1. What is meant by the term operating cycle?
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2. De�ine current assets. What basis is used for ordering individual items within the current assets section?
3. Distinguish between long-term investments and property, plant, and equipment.
4. How do current liabilities differ from long-term liabilities?
5. Identify the two parts of stockholders' equity in a corporation and indicate the purpose of each.
6. (a) Geena Lowe believes that the analysis of �inancial statements is directed at two characteristics
of a company: liquidity and pro�itability. Is Geena correct? Explain.
(b) Are short-term creditors, long-term creditors, and stockholders primarily interested in the same characteristics of a company? Explain.
7. Name ratios useful in assessing (a) liquidity, (b) solvency, and (c) pro�itability.
8. Tom Dawes, the founder of Footwear Inc., needs to raise $500,000 to expand his company's operations. He has been told that raising the money through debt will increase the riskiness of his company much more than issuing stock. He doesn't understand why this is true. Explain it to him.
9. What do these classes of ratios measure? (a) Liquidity ratios.
(b) Pro�itability ratios.
(c) Solvency ratios.
10. Holding all other factors constant, indicate whether each of the following signals generally good or bad news about a company. (a) Increase in earnings per share.
(b) Increase in the current ratio.
(c) Increase in the debt to assets ratio.
(d) Decrease in free cash �low.
11. Which ratio or ratios from this chapter do you think should be of greatest interest to: (a) a pension fund considering investing in a corporation's 20-year bonds?
(b) a bank contemplating a short-term loan?
(c) an investor in common stock?
12. (a) What are generally accepted accounting principles (GAAP)?
(b) What body provides authoritative support for GAAP?
13. (a) What is the primary objective of �inancial reporting?
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(b) Identify the characteristics of useful accounting information.
14. Merle Hawkins, the president of Pathway Company, is pleased. Pathway substantially increased its net income in 2017 while keeping its unit inventory relatively the same. Jon Dietz, chief accountant, cautions Merle, however. Dietz says that since Pathway changed its method of inventory valuation, there is a consistency problem and it is dif�icult to determine whether Pathway is better off. Is Dietz correct? Why or why not?
15. What is the distinction between comparability and consistency?
16. Describe the constraint inherent in the presentation of accounting information.
17. Your roommate believes that accounting standards are uniform throughout the world. Is your roommate correct? Explain.
18. Wanda Roberts is president of Best Texts. She has no accounting background. Wanda cannot understand why fair value is not used as the basis for all accounting measurement and reporting. Discuss.
19. What is the economic entity assumption? Give an example of its violation.
20. What was Apple's largest current asset, largest current liability, and largest item under “Assets” at September 27, 2014?
BRIEF EXERCISES
Classify accounts on balance sheet.
(LO 1), K
BE2-1 The following are the major balance sheet classi�ications:
Current assets (CA) Current liabilities (CL) Long-term investments (LTI) Long-term liabilities (LTL) Property, plant, and equipment (PPE) Common stock (CS) Intangible assets (IA) Retained earnings (RE)
Match each of the following accounts to its proper balance sheet classi�ication.
_______ Accounts payable
_______ Accounts receivable
_______ Accumulated depreciation
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_______ Buildings
_______ Cash
_______ Goodwill
_______ Income taxes payable
_______ Investment in long-term bonds
_______ Land
_______ Inventory
_______ Patent
_______ Supplies
Prepare the current assets section of a balance sheet.
(LO 1), AP
BE2-2 A list of �inancial statement items for Chin Company includes the following: accounts receivable $14,000; prepaid insurance $2,600, cash $10,400, supplies $3,800, and debt investments (short-term) $8,200. Prepare the current assets section of the balance sheet listing the items in the proper sequence.
Compute earnings per share.
(LO 2), AP
BE2-3 The following information (in millions of dollars) is available for Limited Brands for a recent year: sales revenue $9,043, net income $220, preferred dividend $0, and weighted-average shares outstanding 333 million. Compute the earnings per share for Limited Brands.
Calculate liquidity ratios.
(LO 2), AP
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BE2-4 These selected condensed data are taken from a recent balance sheet of Bob Evans Farms (in millions of dollars).
Cash $ 29.3 Accounts receivable 20.5 Inventory 28.7 Other current assets 24.0 Total current assets $102.5 Total current liabilities $201.2
Compute working capital and the current ratio.
Calculate liquidity and solvency ratios.
(LO 2), AP
BE2-5 Ross Music Inc. reported the following selected information at March 31.
2017 Total current assets $262,787 Total assets 439,832 Total current liabilities 293,625 Total liabilities 376,002 Net cash provided by operating activities 62,300
Calculate (a) the current ratio, (b) the debt to assets ratio, and (c) free cash �low for March 31, 2017. The company paid dividends of $12,000 and spent $24,787 on capital expenditures.
Recognize generally accepted accounting principles.
(LO 3), K
BE2-6 Indicate whether each statement is true or false.
(a) GAAP is a set of rules and practices established by accounting standard-setting bodies to serve as a general guide for �inancial reporting purposes.
(b) Substantial authoritative support for GAAP usually comes from two standards-setting bodies: the FASB and the IRS.
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Identify characteristics of useful information.
(LO 3), K
BE2-7 The accompanying chart shows the qualitative characteristics of useful accounting information. Fill in the blanks.
Identify characteristics of useful information.
(LO 3), K
BE2-8 Given the characteristics of useful accounting information, complete each of the following statements.
(a) For information to be _______, it should have predictive and con�irmatory value.
(b) _______ means that information accurately depicts what really happened.
(c) _______ means using the same accounting principles and methods from year to year within a company.
Identify characteristics of useful information.
(LO 3), K
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BE2-9 Here are some qualitative characteristics of useful accounting information:
1. Predictive value
2. Neutral
3. Veri�iable
4. Timely
Match each qualitative characteristic to one of the following statements.
______ (a) Accounting information should help provide accurate expectations about future events.
______ (b) Accounting information cannot be selected, prepared, or presented to favor one set of interested users over another.
______ (c) The quality of information that occurs when independent observers, using the same methods, obtain similar results.
______ (d) Accounting information must be available to decision-makers before it loses its capacity to in�luence their decisions.
De�ine full disclosure principle.
(LO 3), K
BE2-10 The full disclosure principle dictates that:
(a) �inancial statements should disclose all assets at their cost.
(b) �inancial statements should disclose only those events that can be measured in dollars.
(c) �inancial statements should disclose all events and circumstances that would matter to users of �inancial statements.
(d) �inancial statements should not be relied on unless an auditor has expressed an unquali�ied opinion on them.
DO IT! EXERCISES
Prepare assets section of balance sheet.
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(LO 1), AP
DO IT! 2-1a Mylar Corporation has collected the following information related to its December 31, 2017, balance sheet.
Accounts receivable $22,000 Equipment $180,000 Accumulated depreciation—equipment 50,000 Inventory 58,000 Cash 13,000 Supplies 7,000
Prepare the assets section of Mylar Corporation's balance sheet.
Classify �inancial statement items by balance sheet classi�ication.
(LO 1), AP
DO IT! 2-1b The following �inancial statement items were taken from the �inancial statements of Gomez Corp.
_______ Trademarks
_______ Notes payable (current)
_______ Interest revenue
_______ Income taxes payable
_______ Debt investments (long-term)
_______ Unearned sales revenue
_______ Inventory
_______ Accumulated depreciation
_______ Land
_______ Common stock
_______ Advertising expense
_______ Mortgage payable (due in 3 years)
Match each of the �inancial statement items to its proper balance sheet classi�ication. (See E2-1, on page 74, for a list of the balance sheet classi�ications.) If the item would not
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appear on a balance sheet, use “NA.”
Compute ratios and analyze.
(LO 2), AP
DO IT! 2-2 The following information is available for Nguoi Corporation.
2017 2016 Current assets $ 54,000 $ 36,000 Total assets 240,000 205,000 Current liabilities 22,000 30,000 Total liabilities 72,000 100,000 Net income 80,000 40,000 Net cash provided by operating activities 90,000 56,000 Preferred dividends 6,000 6,000 Common dividends 3,000 1,500 Expenditures on property, plant, and equipment 27,000 12,000 Shares outstanding at beginning of year 40,000 30,000 Shares outstanding at end of year 75,000 40,000
(a) Compute earnings per share for 2017 and 2016 for Nguoi, and comment on the change. Nguoi's primary competitor, Matisse Corporation, had earnings per share of $1 per share in 2017. Comment on the difference in the ratios of the two companies.
(b) Compute the current ratio and debt to assets ratio for each year, and comment on the changes.
(c) Compute free cash �low for each year, and comment on the changes.
Identify �inancial accounting concepts and principles.
(LO 3), K
DO IT! 2-3 The following characteristics, assumptions, principles, and constraint guide the FASB when it creates accounting standards.
Relevance
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Faithful representation
Comparability
Consistency
Monetary unit assumption
Economic entity assumption
Periodicity assumption
Going concern assumption
Historical cost principle
Full disclosure principle
Materiality
Cost constraint
Match each item above with a description below.
1. _______ Items not easily quanti�ied in dollar terms are not reported in the �inancial statements.
2. _______ Accounting information must be complete, neutral, and free from error.
3. _______ Personal transactions are not mixed with the company's transactions.
4. _______ The cost to provide information should be weighed against the bene�it that users will gain from having the information available.
5. _______ A company's use of the same accounting principles from year to year.
6. _______ Assets are recorded and reported at original purchase price.
7. _______ Accounting information should help users predict future events, and should con�irm or correct prior expectations.
8. _______ The life of a business can be divided into arti�icial segments of time.
9. _______ The reporting of all information that would make a difference to �inancial statement users.
10. _______ The judgment concerning whether an item's size makes it likely to in�luence a decision-maker.
11. _______ Assumes a business will remain in operation for the foreseeable future.
12. _______ Different companies use the same accounting principles.
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EXERCISES
Classify accounts on balance sheet.
(LO 1), AP
E2-1 The following are the major balance sheet classi�ications.
Current assets (CA)
Long-term investments (LTI)
Property, plant, and equipment (PPE)
Intangible assets (IA)
Current liabilities (CL)
Long-term liabilities (LTL)
Stockholders' equity (SE)
Instructions
Classify each of the following �inancial statement items taken from Ming Corporation's balance sheet.
_______ Accounts payable
_______ Accounts receivable
_______ Accumulated depreciation—equipment
_______ Buildings
_______ Cash
_______ Interest payable
_______ Goodwill
_______ Income taxes payable
_______ Inventory
_______ Stock investments (to be sold in 7 months)
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_______ Land (in use)
_______ Mortgage payable
_______ Supplies
_______ Equipment
_______ Prepaid rent
Classify �inancial statement items by balance sheet classi�ication.
(LO 1), AP
E2-2 The major balance sheet classi�ications are listed in E2-1.
Instructions
Classify each of the following �inancial statement items based upon the major balance sheet classi�ications listed in E2-1.
_______ Prepaid advertising
_______ Equipment
_______ Trademarks
_______ Salaries and wages payable
_______ Income taxes payable
_______ Retained earnings
_______ Accounts receivable
_______ Land (held for future use)
_______ Patents
_______ Bonds payable
_______ Common stock
_______ Accumulated depreciation—equipment
_______ Unearned sales revenue
_______ Inventory
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Classify items as current or noncurrent, and prepare assets section of balance sheet.
(LO 1), AP
E2-3 Suppose the following items were taken from the December 31, 2017, assets section of the Boeing Company balance sheet. (All dollars are in millions.)
Inventory $16,933 Patents $12,528 Notes receivable—due after December 31, 2018 5,466 Buildings 21,579 Notes receivable—due before December 31, 2018 368 Cash 9,215 Accumulated depreciation—buildings 12,795 Accounts receivable 5,785 Debt investments (short-term) 2,008
Instructions
Prepare the assets section of a classi�ied balance sheet, listing the current assets in order of their liquidity.
Prepare assets section of a classi�ied balance sheet.
(LO 1), AP
E2-4 Suppose the following information (in thousands of dollars) is available for H. J. Heinz Company— famous for ketchup and other �ine food products—for the year ended April 30, 2017.
Prepaid insurance $ 125,765 Buildings $4,033,369 Land 76,193 Cash 373,145 Goodwill 3,982,954 Accounts receivable 1,171,797 Trademarks 757,907 Accumulated depreciation—buildings 2,131,260 Inventory 1,237,613
Instructions
Prepare the assets section of a classi�ied balance sheet, listing the items in proper sequence and including a statement heading.
Prepare a classi�ied balance sheet.
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(LO 1), AP
E2-5 These items are taken from the �inancial statements of Longhorn Co. at December 31, 2017.
Buildings $105,800 Accounts receivable 12,600 Prepaid insurance 3,200 Cash 11,840 Equipment 82,400 Land 61,200 Insurance expense 780 Depreciation expense 5,300 Interest expense 2,600 Common stock 60,000 Retained earnings (January 1, 2017) 40,000 Accumulated depreciation—buildings 45,600 Accounts payable 9,500 Notes payable 93,600 Accumulated depreciation—equipment 18,720 Interest payable 3,600 Service revenue 14,700
Instructions
Prepare a classi�ied balance sheet. Assume that $13,600 of the note payable will be paid in 2018.
Prepare a classi�ied balance sheet.
(LO 1), AP
E2-6 Suppose the following items were taken from the 2017 �inancial statements of Texas Instruments, Inc. (All dollars are in millions.)
Common stock $2,826 Accumulated depreciation—equipment $3,547 Prepaid rent 164 Accounts payable 1,459 Equipment 6,705 Patents 2,210 Stock investments (long-term) 637 Notes payable (long-term) 810
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Debt investments (short-term) 1,743 Retained earnings 6,896 Income taxes payable 128 Accounts receivable 1,823 Cash 1,182 Inventory 1,202
Instructions
Prepare a classi�ied balance sheet in good form as of December 31, 2017.
Compute and interpret pro�itability ratio.
(LO 2), AP
E2-7 Suppose the following information is available for Callaway Golf Company for the years 2017 and 2016. (Dollars are in thousands, except share information.)
2017 2016 Net sales $1,117,204 $1,124,591 Net income (loss) 66,176 54,587 Total assets 855,338 838,078 Share information Shares outstanding at year-end 64,507,000 66,282,000 Preferred dividends -0- -0-
There were 73,139,000 shares outstanding at the end of 2015.
Instructions (a) What was the company's earnings per share for each year?
(b) Based on your �indings above, how did the company's pro�itability change from 2016 to 2017?
(c) Suppose the company had paid dividends on preferred stock and on common stock during the year. How would this affect your calculation in part (a)?
Prepare �inancial statements.
(LO 1, 2), AP
E2-8 These �inancial statement items are for Fairview Corporation at year-end, July 31, 2017.
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Salaries and wages payable $ 2,080 Salaries and wages expense 57,500 Supplies expense 15,600 Equipment 18,500 Accounts payable 4,100 Service revenue 66,100 Rent revenue 8,500 Notes payable (due in 2020) 1,800 Common stock 16,000 Cash 29,200 Accounts receivable 9,780 Accumulated depreciation—equipment 6,000 Dividends 4,000 Depreciation expense 4,000 Retained earnings (beginning of the year) 34,000
Instructions (a) Prepare an income statement and a retained earnings statement for the year. Fairview Corporation did
not issue any new stock during the year.
(b) Prepare a classi�ied balance sheet at July 31.
(c) Compute the current ratio and debt to assets ratio.
(d) Suppose that you are the president of Lunar Equipment. Your sales manager has approached you with a proposal to sell $20,000 of equipment to Fairview. He would like to provide a loan to Fairview in the form of a 10%, 5-year note payable. Evaluate how this loan would change Fairview's current ratio and debt to assets ratio, and discuss whether you would make the sale.
Compute liquidity ratios and compare results.
(LO 2), AP
E2-9 Nordstrom, Inc. operates department stores in numerous states. Selected �inancial statement data (in millions of dollars) for a recent year follow.
End of Year Beginning of Year Cash and cash equivalents $ 72 $ 358 Receivables (net) 1,942 1,788 Merchandise inventory 900 956
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End of Year Beginning of Year Other current assets 303 259 Total current assets $3,217 $3,361 Total current liabilities $1,601 $1,635
Instructions (a) Compute working capital and the current ratio at the beginning of the year and at the end of the year.
(b) Did Nordstrom's liquidity improve or worsen during the year?
(c) Using the data in the chapter, compare Nordstrom's liquidity with Best Buy's (see page 55).
Compute liquidity measures and discuss �indings.
(LO 2), AP
E2-10 The chief �inancial of�icer (CFO) of Myeneke Corporation requested that the accounting department prepare a preliminary balance sheet on December 30, 2017, so that the CFO could get an idea of how the company stood. He knows that certain debt agreements with its creditors require the company to maintain a current ratio of at least 2:1. The preliminary balance sheet is as follows.
Instructions (a) Calculate the current ratio and working capital based on the preliminary balance sheet.
(b) Based on the results in (a), the CFO requested that $20,000 of cash be used to pay off the balance of the Accounts Payable account on December 31, 2017. Calculate the new current ratio and working capital after the company takes these actions.
(c) Discuss the pros and cons of the current ratio and working capital as measures of liquidity.
(d) Was it unethical for the CFO to take these steps?
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Compute and interpret solvency ratios.
(LO 2), AP
E2-11 Suppose the following data were taken from the 2017 and 2016 �inancial statements of American Eagle Out�itters. (All dollars, are in thousands.)
2017 2016 Current assets $ 925,359 $1,020,834 Total assets 1,963,676 1,867,680 Current liabilities 401,763 376,178 Total liabilities 554,645 527,216 Net income 179,061 400,019 Net cash provided by operating activities 302,193 464,270 Capital expenditures 265,335 250,407 Dividends paid on common stock 82,394 80,796 Weighted-average shares outstanding 205,169 216,119
Instructions
Perform each of the following.
(a) Calculate the current ratio for each year.
(b) Calculate earnings per share for each year.
(c) Calculate the debt to assets ratio for each year.
(d) Calculate the free cash �low for each year.
(e) Discuss American Eagle's solvency in 2017 versus 2016.
(f ) Discuss American Eagle's ability to �inance its investment activities with net cash provided by operating activities, and how any de�iciency would be met.
Identify accounting assumptions and principles.
(LO 3), K
E2-12 Presented below are the assumptions and principles discussed in this chapter.
1. Full disclosure principle
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2. Going concern assumption
3. Monetary unit assumption
4. Periodicity assumption
5. Historical cost principle
6. Economic entity assumption
Instructions
Identify by number the accounting assumption or principle that is described below. Do not use a number more than once.
______ (a) Is the rationale for why plant assets are not reported at liquidation value. (Note: Do not use the historical cost principle.)
______ (b) Indicates that personal and business recordkeeping should be separately maintained.
______ (c) Assumes that the dollar is the “measuring stick” used to report on �inancial performance.
______ (d) Separates �inancial information into time periods for reporting purposes.
______ (e) Measurement basis used when a reliable estimate of fair value is not available.
______ (f ) Dictates that companies should disclose all circumstances and events that make a difference to �inancial statement users.
Identify the assumption or principle that has been violated.
(LO 3), C
E2-13 Lopez Co. had three major business transactions during 2017.
(a) Reported at its fair value of $260,000 merchandise inventory with a cost of $208,000.
(b) The president of Lopez Co., Victor Lopez, purchased a truck for personal use and charged it to his expense account.
(c) Lopez Co. wanted to make its 2017 income look better, so it added 2 more weeks to its income statement reporting period (a 54-week year). Previous years were 52 weeks.
Instructions
In each situation, identify the assumption or principle that has been violated, if any, and discuss what the company should have done.
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EXERCISES: SET B AND CHALLENGE EXERCISES Visit the book's companion website, at www.wiley.com/college/kimmel (http://www.wiley.com/college/kimmel) , and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.
PROBLEMS: SET A
Prepare a classi�ied balance sheet.
(LO 1), AP
P2-1A Suppose the following items are taken from the 2017 balance sheet of Yahoo! Inc. (All dollars are in millions.)
Goodwill $3,927 Common stock 6,283 Equipment 1,737 Accounts payable 152 Patents 234 Stock investments (long-term) 3,247 Accounts receivable 1,061 Prepaid rent 233 Debt investments (short-term) 1,160 Retained earnings 6,108 Cash 2,292 Notes payable (long-term) 734 Unearned sales revenue 413 Accumulated depreciation—equipment 201
Instructions
Prepare a classi�ied balance sheet for Yahoo! Inc. as of December 31, 2017.
Tot. current assets $4,746 Tot. assets $13,690
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Prepare �inancial statements.
(LO 1), AP
P2-2A These items are taken from the �inancial statements of Martin Corporation for 2017.
Retained earnings (beginning of year) $31,000 Utilities expense 2,000 Equipment 66,000 Accounts payable 18,300 Cash 10,100 Salaries and wages payable 3,000 Common stock 12,000 Dividends 12,000 Service revenue 68,000 Prepaid insurance 3,500 Maintenance and repairs expense 1,800 Depreciation expense 3,600 Accounts receivable 11,700 Insurance expense 2,200 Salaries and wages expense 37,000 Accumulated depreciation—equipment 17,600
Instructions
Prepare an income statement, a retained earnings statement, and a classi�ied balance sheet as of December 31, 2017.
Net income $21,400 Tot. assets $73,700
Prepare �inancial statements.
(LO 1), AP
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P2-3A You are provided with the following information for Lazuris Enterprises, effective as of its April 30, 2017, year-end.
Accounts payable $ 834 Accounts receivable 810 Accumulated depreciation—equipment 670 Cash 1,270 Common stock 900 Cost of goods sold 1,060 Depreciation expense 335 Dividends 325 Equipment 2,420 Income tax expense 165 Income taxes payable 135 Insurance expense 210 Interest expense 400 Inventory 967 Land 3,100 Mortgage payable 3,500 Notes payable 61 Prepaid insurance 60 Retained earnings (beginning) 1,600 Salaries and wages expense 700 Salaries and wages payable 222 Sales revenue 5,100 Stock investments (short-term) 1,200
Instructions (a) Prepare an income statement and a retained earnings statement for Lazuris Enterprises for the year
ended April 30, 2017.
(b) Prepare a classi�ied balance sheet for Lazuris Enterprises as of April 30, 2017.
(a) Net income $2,230 (b) Tot. current assets $4,307 Tot. assets $9,157
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Compute ratios; comment on relative pro�itability, liquidity, and solvency.
(LO 2), AN
P2-4A Comparative �inancial statement data for Loeb Corporation and Bowsh Corporation, two competitors, appear below. All balance sheet data are as of December 31, 2017.
Loeb Corporation Bowsh Corporation 2017 2017 Net sales $1,800,000 $620,000 Cost of goods sold 1,175,000 340,000 Operating expenses 283,000 98,000 Interest expense 9,000 3,800 Income tax expense 85,000 36,000 Current assets 407,200 190,336 Plant assets (net) 532,000 139,728 Current liabilities 66,325 33,716 Long-term liabilities 108,500 40,684 Net cash provided by operating activities 138,000 36,000 Capital expenditures 90,000 20,000 Dividends paid on common stock 36,000 15,000 Weighted-average number of shares outstanding 80,000 50,000
Instructions (a) Comment on the relative pro�itability of the companies by computing the net income and earnings per
share for each company for 2017.
(b) Comment on the relative liquidity of the companies by computing working capital and the current ratio for each company for 2017.
(c) Comment on the relative solvency of the companies by computing the debt to assets ratio and the free cash �low for each company for 2017.
Compute and interpret liquidity, solvency, and pro�itability ratios.
(LO 2), AP
P2-5A The following are �inancial statements of Ohara Company.
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Additional information: The net cash provided by operating activities for 2017 was $190,800. The cash used for capital expenditures was $92,000. The cash used for dividends was $31,000. The weighted- average number of shares outstanding during the year was 50,000.
Instructions (a) Compute the following values and ratios for 2017. (We provide the results from 2016 for comparative
purposes.)
(i) Working capital. (2016: $160,500)
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(ii) Current ratio. (2016: 1.65:1)
(iii) Free cash �low. (2016: $48,700)
(iv) Debt to assets ratio. (2016: 31%)
(v) Earnings per share. (2016: $3.15)
(b) Using your calculations from part (a), discuss changes from 2016 in liquidity, solvency, and pro�itability.
Compute and interpret liquidity, solvency, and pro�itability ratios.
(LO 2), AP
P2-6A Condensed balance sheet and income statement data for Danke Corporation are presented as follows.
Instructions
Compute these values and ratios for 2016 and 2017.
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(a) Earnings per share.
(b) Working capital.
(c) Current ratio.
(d) Debt to assets ratio.
(e) Free cash �low.
(f ) Based on the ratios calculated, discuss brie�ly the improvement or lack thereof in �inancial position and operating results from 2016 to 2017 of Danke Corporation.
Compute ratios and compare liquidity, solvency, and pro�itability for two companies.
(LO 2), AP
P2-7A Selected �inancial data of two competitors, Target and Wal-Mart, are presented here. (All dollars are in millions.) Suppose the data were taken from the 2017 �inancial statements of each company.
Instructions
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For each company, compute these values and ratios.
(a) Working capital.
(b) Current ratio.
(c) Debt to assets ratio.
(d) Free cash �low.
(e) Earnings per share.
(f ) Compare the liquidity and solvency of the two companies.
Comment on the objectives and qualitative characteristics of �inancial reporting.
(LO 3), E
P2-8A A friend of yours, Saira Ortiz, recently completed an undergraduate degree in science and has just started working with a biotechnology company. Saira tells you that the owners of the business are trying to secure new sources of �inancing which are needed in order for the company to proceed with development of a new healthcare product. Saira said that her boss told her that the company must put together a report to present to potential investors.
Saira thought that the company should include in this package the detailed scienti�ic �indings related to the Phase I clinical trials for this product. She said, “I know that the biotech industry sometimes has only a 10% success rate with new products, but if we report all the scienti�ic �indings, everyone will see what a sure success this is going to be! The president was talking about the importance of following some set of accounting principles. Why do we need to look at some accounting rules? What they need to realize is that we have scienti�ic results that are quite encouraging, some of the most talented employees around, and the start of some really great customer relationships. We haven't made any sales yet, but we will. We just need the funds to get through all the clinical testing and get government approval for our product. Then these investors will be quite happy that they bought in to our company early!”
Instructions (a) What is accounting information? Explain to Saira what is meant by generally accepted accounting
principles.
(b) Comment on how Saira's suggestions for what should be reported to prospective investors conforms to the qualitative characteristics of accounting information. Do you think that the things that Saira wants to include in the information for investors will conform to �inancial reporting guidelines?
PROBLEMS: SET B AND SET C
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Visit the book's companion website, at www.wiley.com/college/kimmel (http://www.wiley.com/college/kimmel) , and choose the Student Companion site to access Problems: Set B and Set C.
CONTINUING PROBLEM Cookie Creations
(Note: This is a continuation of the Cookie Creations problem from Chapter 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) .)
CC2 After investigating the different forms of business organization, Natalie Koebel decides to operate her business as a corporation, Cookie Creations Inc. She then begins the process of getting her business running.
Go to the book's companion website, www.wiley.com/college/kimmel (http://www.wiley.com/college/kimmel) , to see the completion of this problem.
EXPAND YOUR | CRITICAL THINKING
FINANCIAL REPORTING PROBLEM: Apple Inc.
CT2-1 The �inancial statements of Apple Inc., are presented in Appendix A (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a01#a01) at the end of this textbook.
Instructions
Answer the following questions using the �inancial statements and the notes to the �inancial statements.
(a) What were Apple's total current assets at September 27, 2014, and September 28, 2013?
(b) Are the assets included in current assets listed in the proper order? Explain.
(c) How are Apple's assets classi�ied?
(d) What were Apple's current liabilities at September 27, 2014, and September 28, 2013?
COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation
CT2-2 The �inancial statements of Columbia Sportswear Company are presented in Appendix B (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a02#a02) . Financial
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statements of VF Corporation are presented in Appendix C
(http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a03#a03) . Assume Columbia's weighted-average number of shares outstanding was 227,514,000, and VF's was 56,997,000.
Instructions (a) For each company, calculate the following values for 2014.
(1) Working capital.
(2) Current ratio.
(3) Debt to assets ratio.
(4) Free cash �low.
(Hint: When calculating free cash �low, do not consider business acquisitions to be part of capital expenditures.)
(b) Based on your �indings above, discuss the relative liquidity and solvency of the two companies.
COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.
CT2-3 Amazon.com, Inc.'s �inancial statements are presented in Appendix D
(http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a04#a04) . Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a05#a05) .
Instructions (a) For each company, calculate the following values for 2014.
(1) Working capital.
(2) Current ratio.
(3) Debt to assets ratio.
(4) Free cash �low.
(b) Based on your �indings above, discuss the relative liquidity and solvency of the two companies.
INTERPRETING FINANCIAL STATEMENTS
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CT2-4 Suppose the following information was reported by Gap, Inc.
2017 2016 2015 2014 2013 Total assets (millions) $7,065 $7,985 $7,564 $7,838 $8,544 Working capital $1,831 $2,533 $1,847 $1,653 $2,757 Current ratio 1.87:1 2.19:1 1.86:1 1.68:1 2.21:1 Debt to assets ratio .42:1 .39:1 .42:1 .45:1 .39:1 Earnings per share $1.89 $1.59 $1.35 $1.05 $0.94
(a) Determine the overall percentage decrease in Gap's total assets from 2013 to 2017. What was the average decrease per year?
(b) Comment on the change in Gap's liquidity. Does working capital or the current ratio appear to provide a better indication of Gap's liquidity? What might explain the change in Gap's liquidity during this period?
(c) Comment on the change in Gap's solvency during this period.
(d) Comment on the change in Gap's pro�itability during this period. How might this affect your prediction about Gap's future pro�itability?
REAL-WORLD FOCUS
CT2-5 Purpose: Identify summary liquidity, solvency, and pro�itability information about companies, and compare this information across companies in the same industry.
Address: http://biz.yahoo.com/i (http://biz.yahoo.com/i)
Steps
1. Type in a company name, or use the index to �ind a company name. Choose Pro�ile. Choose Key Statistics. Perform instruction (a) below.
2. Go back to Pro�ile. Click on the company's particular industry behind the heading “Industry.” Perform instructions (b), (c), and (d).
Instructions
Answer the following questions.
(a) What is the company's name? What was the company's current ratio and debt to equity ratio (a variation of the debt to assets ratio)?
(b) What is the company's industry?
(c) What is the name of a competitor? What is the competitor's current ratio and its debt to equity ratio?
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(d) Based on these measures, which company is more liquid? Which company is more solvent?
CT2-6 The Feature Story described the dramatic effect that investment bulletin boards are having on the investment world. This exercise will allow you to evaluate a bulletin board discussing a company of your choice.
Address: http://biz.yahoo.com/i (http://biz.yahoo.com/i)
Steps
1. Type in a company name, or use the index to �ind a company name.
2. Choose Msgs or Message Board. (for messages).
3. Read the 10 most recent messages.
Instructions
Answer the following questions.
(a) State the nature of each of these messages (e.g., offering advice, criticizing company, predicting future results, ridiculing other people who have posted messages).
(b) For those messages that expressed an opinion about the company, was evidence provided to support the opinion?
(c) What effect do you think it would have on bulletin board discussions if the participants provided their actual names? Do you think this would be a good policy?
CT2-7 The July 6, 2011, edition of the Wall Street Journal Online includes an article by Michael Rapoport entitled “U.S. Firms Clash Over Accounting Rules.” The article discusses why some U.S. companies favored adoption of International Financial Reporting Standards (IFRS) while other companies opposed it.
Instructions
Read the article and answer the following questions.
(a) The articles says that the switch to IFRS tends to be favored by “larger companies, big accounting �irms, and rule makers.” What reasons are given for favoring the switch?
(b) What two reasons are given by many smaller companies that oppose the switch?
(c) What criticism of IFRS is raised with regard to regulated companies?
(d) Explain what is meant by “condorsement.”
DECISION-MAKING ACROSS THE ORGANIZATION
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CT2-8 As a �inancial analyst in the planning department for Erin Industries, Inc., you must develop ratios from the comparative �inancial statements. This information is to be used to convince creditors that, despite a slight decline in sales, Erin Industries, Inc. is liquid, solvent, and pro�itable, and that it deserves their continued support. Lenders are particularly concerned about the company's ability to continue as a going concern.
Here are the data requested and the computations developed from the �inancial statements:
2017 2016 Current ratio 3.1 2.1 Working capital Up 22% Down 7% Free cash �low Up 25% Up 18% Debt to assets ratio 0.60 0.70 Net income Up 32% Down 8% Earnings per share $2.40 $1.15
Instructions
Erin Industries, Inc. asks you to prepare brief comments stating how each of these items supports the argument that its �inancial health is improving. The company wishes to use these comments to support presentation of data to its creditors. With the class divided into groups, prepare the comments as requested, giving the implications and the limitations of each item regarding Erin's �inancial well-being.
COMMUNICATION ACTIVITY
CT2-9 B. P. Palmer is the chief executive of�icer of Future Products. Palmer is an expert engineer but a novice in accounting.
Instructions
Write a letter to B. P. Palmer that explains (a) the three main types of ratios; (b) examples of each, how they are calculated, and what they measure; and (c) the bases for comparison in analyzing Future Products' �inancial statements.
ETHICS CASE
CT2-10 At one time, Boeing closed a giant deal to acquire another manufacturer, McDonnell Douglas. Boeing paid for the acquisition by issuing shares of its own stock to the stockholders of McDonnell Douglas. In order for the deal not to be revoked, the value of Boeing's stock could not decline below a certain level for a number of months after the deal.
During the �irst half of the year, Boeing suffered signi�icant cost overruns because of inef�iciencies in its production methods. Had these problems been disclosed in the quarterly �inancial statements during the �irst and second quarters of the year, the company's stock most
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likely would have plummeted, and the deal would have been revoked. Company managers spent considerable time debating when the bad news should be disclosed. One public relations manager suggested that the company's problems be revealed on the date of either Princess Diana's or Mother Teresa's funeral, in the hope that it would be lost among those big stories that day. Instead, the company waited until October 22 of that year to announce a $2.6 billion write-off due to cost overruns. Within one week, the company's stock price had fallen 20%, but by this time the McDonnell Douglas deal could not be reversed.
Instructions
Answer the following questions.
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues?
(c) What assumptions or principles of accounting are relevant to this case?
(d) Do you think it is ethical to try to “time” the release of a story so as to diminish its effect?
(e) What would you have done if you were the chief executive of�icer of Boeing?
(f ) Boeing's top management maintains that it did not have an obligation to reveal its problems during the �irst half of the year. What implications does this have for investors and analysts who follow Boeing's stock?
ALL ABOUT YOU
CT2-11 Every company needs to plan in order to move forward. Its top management must consider where it wants the company to be in three to �ive years. Like a company, you need to think about where you want to be three to �ive years from now, and you need to start taking steps now in order to get there.
Instructions
Provide responses to each of the following items.
(a) Where would you like to be working in three to �ive years? Describe your plan for getting there by identifying between �ive and 10 speci�ic steps that you need to take in order to get there.
(b) In order to get the job you want, you will need a résumé. Your résumé is the equivalent of a company's annual report. It needs to provide relevant and reliable information about your past accomplishments so that employers can decide whether to “invest” in you. Do a search on the Internet to �ind a good résumé format. What are the basic elements of a résumé?
(c) A company's annual report provides information about a company's accomplishments. In order for investors to use the annual report, the information must be reliable; that is, users must have faith that the information is accurate and believable. How can you provide assurance that the information on your résumé is reliable?
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(d) Prepare a résumé assuming that you have accomplished the �ive to 10 speci�ic steps you identi�ied in part (a). Also, provide evidence that would give assurance that the information is reliable.
FASB CODIFICATION ACTIVITY
CT2-12 If your school has a subscription to the FASB Codi�ication, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following.
Instructions (a) Access the glossary (“Master Glossary”) at the FASB Codi�ication website to answer the
following.
(1) What is the de�inition of current assets?
(2) What is the de�inition of current liabilities?
(b) A company wants to offset its accounts payable against its cash account and show a cash amount net of accounts payable on its balance sheet. Identify the criteria (found in the FASB Codi�ication) under which a company has the right of set off. Does the company have the right to offset accounts payable against the cash account?
CONSIDERING PEOPLE, PLANET, AND PROFIT
CT2-13 Auditors provide a type of certi�ication of corporate �inancial statements. Certi�ication is used in many other aspects of business as well. For example, it plays a critical role in the sustainability movement. The February 7, 2012, issue of the New York Times contained an article by S. Amanda Caudill entitled “Better Lives in Better Coffee,” which discusses the role of certi�ication in the coffee business.
Address: http://scientistatwork.blogs.nytimes.com/2012/02/07/better-lives-in-better- coffee/ (http://scientistatwork.blogs.nytimes.com/2012/02/07/better-lives-in-better-coffee/)
Instructions
Read the article and answer the following questions.
(a) The article mentions three different certi�ication types that coffee growers can obtain from three different certi�ication bodies. Using �inancial reporting as an example, what potential problems might the existence of multiple certi�ication types present to coffee purchasers?
(b) According to the author, which certi�ication is most common among coffee growers? What are the possible reasons for this?
(c) What social and environmental bene�its are coffee certi�ications trying to achieve? Are there also potential �inancial bene�its to the parties involved?
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LEARNING OBJECTIVE 4
Compare the classi�ied balance sheet format under GAAP and IFRS.
The classi�ied balance sheet, although generally required internationally, contains certain variations in format when reporting under IFRS.
KEY POINTS
Following are the key similarities and differences between GAAP and IFRS related to the �inancial statements.
Similarities
IFRS generally requires a classi�ied statement of �inancial position similar to the classi�ied balance sheet under GAAP.
IFRS follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities.
Differences
IFRS recommends but does not require the use of the title “statement of �inancial position” rather than balance sheet.
The format of statement of �inancial position information is often presented differently under IFRS. Although no speci�ic format is required, many companies that follow IFRS present statement of �inancial position information in this order:
Non-current assets
Current assets
Equity
Non-current liabilities
Current liabilities
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Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed �irst, but under IFRS it is listed last.
IFRS has many differences in terminology from what are shown in your textbook. For example, in the sample statement of �inancial position illustrated on the next page, notice in the investment category that stock is called shares.
Both GAAP and IFRS are increasing the use of fair value to report assets. However, at this point IFRS has adopted it more broadly. As examples, under IFRS companies can apply fair value to property, plant, and equipment, and in some cases intangible assets.
LOOKING TO THE FUTURE
The IASB and the FASB are working on a project to converge their standards related to �inancial statement presentation. A key feature of the proposed framework is that each of the statements will be organized in the same format, to separate an entity's �inancing activities from its operating and investing activities and, further, to separate �inancing activities into transactions with owners and creditors. Thus, the same classi�ications used in the statement of �inancial position would also be used in the income statement and the statement of cash �lows. The project has three phases. You can follow the joint �inancial presentation project at the following link: http://www.fasb.org/project/-�inancial_statement_presentation.shtml.
IFRS Practice
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IFRS SELF-TEST QUESTIONS
1. A company has purchased a tract of land and expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. Under IFRS, the land should be reported as: (a) land expense.
(b) property, plant, and equipment.
(c) an intangible asset.
(d) a long-term investment.
2. Current assets under IFRS are listed generally: (a) by importance.
(b) in the reverse order of their expected conversion to cash.
(c) by longevity.
(d) alphabetically.
3. Companies that use IFRS: (a) may report all their assets on the statement of �inancial position at fair value.
(b) may offset assets against liabilities and show net assets and net liabilities on their statements of �inancial position, rather than the underlying detailed line items.
(c) may report non-current assets before current assets on the statement of �inancial position.
(d) do not have any guidelines as to what should be reported on the statement of �inancial position.
4. Companies that follow IFRS to prepare a statement of �inancial position generally use the following order of classi�ication: (a) current assets, current liabilities, non-current assets, non-current liabilities, equity.
(b) non-current assets, non-current liabilities, current assets, current liabilities, equity.
(c) non-current assets, current assets, equity, non-current liabilities, current liabilities.
(d) equity, non-current assets, current assets, non-current liabilities, current liabilities.
IFRS EXERCISES
IFRS2-1 In what ways does the format of a statement of �inancial of position under IFRS often differ from a balance sheet presented under GAAP?
IFRS2-2 What term is commonly used under IFRS in reference to the balance sheet?
IFRS2-3 The statement of �inancial position for Sundell Company includes the following accounts (in British pounds): Accounts Receivable £12,500, Prepaid Insurance £3,600, Cash £15,400, Supplies £5,200,
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and Debt Investments (short-term) £6,700. Prepare the current assets section of the statement of �inancial position, listing the accounts in proper sequence.
IFRS2-4 The following information is available for Lessila Bowling Alley at December 31, 2017.
Buildings $128,800 Share Capital $100,000 Accounts Receivable 14,520 Retained Earnings (beginning) 15,000 Prepaid Insurance 4,680 Accumulated Depreciation—Buildings 42,600 Cash 18,040 Accounts Payable 12,300 Equipment 62,400 Notes Payable 97,780 Land 64,000 Accumulated Depreciation—Equipment 18,720 Insurance Expense 780 Interest Payable 2,600 Depreciation Expense 7,360 Bowling Revenues 14,180 Interest Expense 2,600
Prepare a classi�ied statement of �inancial position. Assume that $13,900 of the notes payable will be paid in 2018.
INTERNATIONAL COMPARATIVE ANALYSIS PROBLEM: Apple vs. Louis Vuitton
The �inancial statements of Louis Vuitton are presented in Appendix E (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a05#a05) . Instructions for accessing and using the company's complete annual report, including the notes to its �inancial statements, are also provided in Appendix F (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a05#a05) .
Instructions
Identify �ive differences in the format of the statement of �inancial position used by Louis Vuitton compared to a company, such as Apple, that follows GAAP. (Apple's �inancial statements are available in Appendix A (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a01#a01) .)
Answers to IFRS Self-Test Questions
1. d 2. b 3. c 4. c
