Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CHAPTER 14 PERFORMANCE MEASUREMENT LEARNING OBJECTIVES Explain and apply comparative analysis Calculate and interpret ratios that are used to analyze liquidity Calculate and interpret ratios that are used to analyze solvency Calculate and interpret ratios that are used to analyze profitability Understand the limitations of financial analysis SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES AND BLOOM’S TAXONOMY Item LO BT 1 C C C Item LO BT Item LO BT Questions Item LO BT Item LO 1,2 C C C 11 12 13 3 C C C 16 17 18 4 2,3,4 C C C 21 22 23 C C 14 C 19 C K 10 C 15 C 20 C 10 11 12 3,4 4 AN AN AN 13 14 15 16 2,3,4 5 AN AN AN AN 2,3,4 2,3,4 AN AN 2,3,4 E BT 5 C K C 24 C 25 4,5 C 13 14 15 4,5 AN AN AN AN Brief Exercises 1 AP AN AP 1 AP AN AN 1 2,3,4 AN AN AN C 2 AN AN AN AN 10 11 12 2 AN AN AN Exercises 3 4 AN AN AN AN Problems: Set A and B 1 AN AN 2,3,4 AN AN 2,3,4 2,3,4 AN AN Accounting Cycle Review 1,2,3,4 AN Cases 1,2,3,4 AN 2,3,4 E 2,3,4,5 AN 1,2,3,4 AN 1,2,3,5 C AN Solutions Manual 14-1 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition Legend: The following abbreviations will appear throughout the solutions manual file LO Learning objective BT Bloom's Taxonomy K Knowledge C Comprehension AP Application AN Analysis S Synthesis E Evaluation Level of difficulty S Simple M Moderate C Complex Estimated time to prepare in minutes Difficulty: Time: AACSB CPA CM cpa-e001 cpa-e002 cpa-e003 cpa-e004 cpa-e005 cpa-t001 cpa-t002 cpa-t003 cpa-t004 cpa-t005 cpa-t006 Association to Advance Collegiate Schools of Business Communication Communication Ethics Ethics Analytic Analytic Technology Tech Diversity Diversity Reflective Thinking Reflec Thinking CPA Canada Competency Ethics Professional and Ethical Behaviour PS and DM Problem-Solving and Decision-Making Comm Communication Self-Mgt Self-Management Team & Lead Teamwork and Leadership Reporting Financial Reporting Stat & Gov Strategy and Governance Mgt Accounting Management Accounting Audit Audit and Assurance Finance Finance Tax Taxation Solutions Manual 14-2 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition ANSWERS TO QUESTIONS (a) An answer cannot be calculated for the percentage change when there is no value in a base year, because division by is mathematically impossible However, the absolute dollar value of the change from the base year can be determined (b) An answer cannot be calculated for the percentage change when there is a negative value in a base year and a positive value in the next year However, the absolute dollar value of the change from the base year can be determined LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Horizontal analysis (also called trend analysis) measures the dollar and percentage increase or decrease of an item over a period of time In this approach, the amount of the item on one statement is compared with the amount of that same item on one or more earlier statements Horizontal analysis measures items across years (or periods) Vertical analysis (also called common size analysis) expresses each item within a financial statement in terms of a percent of a relevant total, usually the largest item within the same statement Vertical analysis measures items within the same year (or period) LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-3 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition (a) Horizontal percentage of a base-period amount is accomplished by using a base year for comparative purposes, which is assumed to be 100 The results of any subsequent year are compared to the base year by dividing the results from the year in question by the results from the base year For example, assume that XYZ Inc reported net income of $200,000 and $220,000 for 2017 and 2018, respectively If 2017 is assumed to be the base year, the percent of base period amount is calculated as follows: $220,000 ÷ $200,000 = 110%, and expressed as a percentage (b) Horizontal percentage change for a period is calculated by dividing the dollar amount of the change between the specific year under analysis and the base year by the base-year amount In calculating the percentage change for a period, each prior year is set as the base year in order to assess trends in changes between years In the above example discussed in (a), the horizontal percentage change for the period would be 10% (($220,000-$200,000)/$200,000) (c) In vertical percentage of a base amount, each item in a financial statement is expressed as a percentage of a base amount in the same financial statement, providing analysis of data within the same year The base amount commonly used for the statement of financial position is total assets and the base amount commonly used for the income statement is net sales or revenues For example, assume that XYZ Inc reported merchandise inventory of $200,000 and total assets of $5,000,000 for 2017 The percent of base amount is calculated as $200,000 ÷ $5,000,000 = 4%, and expressed as a percentage LO BT: C Difficulty: M Time: 10 AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-4 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition Trend analysis is made difficult when a limited amount of information is available to the general public concerning a business In the case of David’s Tea, quarterly reports could be used Horizontal analysis of 2015 and 2016 would not be particularly useful because of the limited number of years that are being analyzed Vertical analysis may be less problematic because it is based on percentages determined with reference to a base amount in the current year LO BT: C Difficulty: C Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance (a) The base amount assigned a 100% value in a vertical analysis of a statement of financial position is usually total assets (b) The base amount assigned a 100% value in a vertical analysis of an income statement is usually net sales LO BT: K Difficulty: S Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Yes Companies competing in the same industry that are different sizes and in different countries with different currencies can be compared For instance, a company may want to know whether its gross profit margin percentage is in line with that of its competition Vertical analysis uses percentages to place the results of both companies side by side, which allows for a comparison despite differences such as size and currency LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-5 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley (a) Financial Accounting, Seventh Canadian Edition Comparison of financial information can be made on an intracompany basis, intercompany basis, and industry average basis (using predetermined norms) • • • The intracompany basis compares an item or financial relationship within the current year or with one or more prior periods, within the same company The intercompany basis compares the same item or relationship with one or more competing companies The industry average basis compares an item or relationship with that of the industry These three bases of comparison should be used together (b) Horizontal analysis is useful in detecting significant trends within a company and in assessing the impact of economic changes that affect the industry It is best used in intracompany comparisons, although it can also be used to compare with one or more competing companies Vertical analysis is useful in detecting changes in financial relationships between years, with competitors and between companies in the same industry It is best used in intercompany comparisons, although it can also be used to compare the company’s data on an intracompany basis Ratio analysis is useful to evaluate the significance of financial data within the same company across different years and to provide insight into a company's position relative to other companies and to the industry Ratio analysis can be used with all three bases of comparisons—intracompany, intercompany, and industry averages LO 1,2 BT: C Difficulty: C Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-6 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition A high current ratio is usually a good indicator of a company’s liquidity However, it might be hiding liquidity problems with inventory or accounts receivable For example, a high level of inventory will cause the current ratio to increase Increases in inventory can be because inventory is not selling and may be obsolete Increases in the current ratio will also occur if the company’s accounts receivable increase An increase in accounts receivable could indicate the company is having trouble collecting its overdue accounts, which again would mean liquidity problems for the business LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance A lower result is better in the case of the following liquidity ratios: average collection period and days in inventory The longer assets are held before they are converted to cash, the longer the business needs to finance these assets LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance 10 Increasing the inventory turnover will reduce the amount of inventory reported at cost on the statement of financial position, because the inventory is being sold more quickly The accounts receivable are increased at the selling price of the inventory being turned over more quickly Independent of the above, if the accounts receivable turnover increases, the cash will be increased more quickly and the accounts receivable will reduce more quickly from earlier collections Taken together, total current assets should increase, by the amount of the additional gross profit that is being recorded more quickly Consequently, the current ratio will improve (increase) LO BT: C Difficulty: M Time: 10 AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-7 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley 11 Financial Accounting, Seventh Canadian Edition A lower result is better in the case of the debt to total assets solvency ratio because debt gives rise to servicing charges such as interest and also requires principal repayments, which will have to be paid with the use of cash For the remaining solvency ratios, including times interest earned and free cash flow, a higher result is better LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance 12 Magna has a lower (better) debt to total assets ratio than the industry average and a much higher (better) times interest earned ratio than the industry average As a result, Magna’s solvency is better than other businesses in the same auto parts industry LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance 13 Amber has likely used the additional debt for investments in long-lived assets which in turn have increased income from operations Although Amber would have incurred more interest expense from the increased debt, this additional debt (leverage) was used to produce a greater amount of income than the additional interest costs Baxter on the other hand did not invest the additional debt in a way that increased net income as much as the additional interest expense incurred which caused the times interest earned ratio to fall For example, the additional debt may have been used to buy unproductive assets or to pay dividends LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance 14 The profit margin and the asset turnover ratio combine mathematically (when multiplied) to equal the return on assets ratio To increase its return on assets, a company can increase its profit margin or increase its asset turnover, or both at the same time LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-8 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley 15 Financial Accounting, Seventh Canadian Edition The return on common shareholders’ equity is affected by both the return on assets and the debt to total assets ratio To increase its return on common shareholders’ equity, a company can increase its return on assets or increase its leverage (as measured by the debt to total assets ratio) Leverage, however, should only be increased if the increased interest expense on the increased level of debt can be covered by higher income LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance 16 The difference between CIBC’s return on assets of 0.8% and the return on common shareholders’ equity of 18.7% means that the company must be using a substantial amount of debt to finance their assets and is using leverage effectively This debt is likely in the form of customers’ bank accounts, which are in turn lent out to others to earn a higher rate of interest than the one paid to customers on their deposits LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance 17 (a) To consider how investors view a company’s growth potential, investors would focus primarily on the price-earnings ratio If this ratio is high, it means that the market expects the company to grow rapidly (b) To consider income potential, this generally refers to receiving dividends from the company Investors would focus on the payout ratio to determine the extent to which the company pays dividends from the income earned and consider the dividend yield to measure the rate of return that a dividend gives the investor relative to the share’s price LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-9 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley 18 (a) (b) (c) (d) (e) (f) (g) Financial Accounting, Seventh Canadian Edition Asset turnover Inventory turnover, days in inventory Return on common shareholders’ equity Times interest earned Current ratio Payout ratio Price-earnings ratio LO 2,3,4 BT: C Difficulty: M Time: 10 AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance 19 The factors that can limit the usefulness of financial analysis are the use of alternative accounting policies, professional judgement, comprehensive income, diversification, inflation, and economic factors The use of different accounting policies can impact a company’s results and, therefore, lessen comparability The use of professional judgement may introduce the possibility of bias and impacts the many estimates made in preparing financial statements Significant sources of comprehensive income should be considered in assessing a company’s profitability, even though OCI is not typically used in ratios Many companies are diversified, which makes it difficult to compare them since they cannot be classified to a single industry Inflation is not considered in the preparation of financial statements so assessment of growth rates and trends may not be accurate if inflation is significant Understanding the effect of the economy is also important in correctly interpreting financial information LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-10 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT14-1 (CONTINUED) (2) THE NORTH WEST COMPANY INC Vertical Analysis of Statement of Financial Position (thousands) 2016 2015 $ % $ % Current assets Non-current assets Total assets Current liabilities Non-current liabilities Total liabilities Shareholders' equity Liabilities and shareholders' equity 2014 $ % 335,581 458,214 793,795 155,501 42.3 57.7 100.0 19.6 315,840 408,459 724,299 146,275 43.6 56.4 100.0 20.2 299,071 371,441 670,512 209,738 44.6 55.4 100.0 31.3 280,682 436,183 357,612 35.4 54.9 45.1 248,741 395,016 329,283 34.3 54.5 45.5 138,334 348,072 322,440 20.6 51.9 48.1 793,795 100.0 724,299 100.0 670,512 100.0 Note: The percentages shown in the above table not add perfectly because of discrepancies that occur from rounding the results to one decimal place (c) The horizontal analysis of part (a) highlights how increases in sales over the two years are outpaced slightly by increases in cost of goods sold and selling, operating, and administrative expenses in 2016 On the statement of financial position, we can see liquidity improving with increases in current assets while at the same time decreases in current liabilities To some extent the vertical analysis of part (b) echoes the highlights of part (a) Whereas the gross profit ratio declined in 2015, income from operations is holding constant and the profit margin has declined due to the reduced gross profit in 2015 and increases in operating expenses in 2016 Similarly, the dollar increase in current assets and decrease of current liabilities is demonstrated in the vertical analysis In spite of the steady increase in noncurrent liabilities, North West is enjoying strong solvency with debt to equity proportions remaining close to a 55:45 split by the end of 2015 and 2016 LO 1,2,3,4 BT: AN Difficulty: M Time: 50 AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-99 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley CT14-2 (a) Financial Accounting, Seventh Canadian Edition FINANCIAL ANALYSIS CASE Liquidity ratios: NORTH WEST (thousands) SOBEYS (millions) $335,581 = 2.2 :1 $155,501 $2,581.4 = 1.0 :1 $2,707.4 Receivables turnover $1,796,035 = 23.7 times ($79,373 + $72,506) [ ] $24,618.8 = 49.8 times ($489.4 + $499.7) [ ] Average collection period 365 = 15 days 23.7 365 = days 49.8 Inventory turnover $1,273,421 = 6.1 times $211,736 + $204,812 ( ) $18,661.2 = 14.7 times $1,287.3 + $1,260.3 ( ) Days in inventory 365 = 60 days 6.1 365 = 25 days 14.7 Current ratio Liquidity: Comparing the current ratios, North West is far more liquid than Sobeys Sobeys sells products to consumers in larger population centres while North West sells products in remote regions and has more commercial customers so it has more credit sales and higher receivables In addition, the nature of the inventory of Sobeys, which could include a higher proportion of perishable goods, may explain why the inventory turns over more quickly at Sobeys along with the fact that it takes longer for North West to move inventory through its distribution channels given the remote locations that it operates in Overall North West is more liquid because Sobeys has more current liabilities than current assets Solutions Manual 14-100 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT14-2 (CONTINUED) (b) Solvency ratios: NORTH WEST (thousands) SOBEYS (millions) Debt to total assets $436,183 = 54.9% $793,795 $5,230.9 = 65.7 % $7,960.6 Free cash flow $132,987 – $63,179 – $58,210 = $11,598 (thousands) $837.7 - $616.2 - $130.3 = $91.2 million Times interest earned $69,779 + $6,210 + $31,332 $6,210 = 17.3 times Not applicable due to loss Solvency: The higher a company’s percentage of debt to total assets is, the greater the risk that this company may be unable to meet its maturing obligations North West’s debt to total assets ratio of 54.9% is lower than Sobeys’ at 65.7% For North West, there is sufficient income before income tax and interest expense to service the interest on its debt, as evidenced by its high times interest earned ratio of 17.3 The solvency ratio of times interest earned cannot be calculated for Sobeys due to the operating loss and negative earnings North West is the more solvent of the two companies Both companies generate free cash flow which means that cash is available to pay down debt or expand operations Solutions Manual 14-101 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT14-2 (CONTINUED) (c) Profitability ratios: (1) In spite of the reporting of a loss from operations and a net loss for Sobeys, it is appropriate to calculate and compare some of the profitability ratios that can be calculated NORTH WEST (thousands) SOBEYS (millions) Gross profit margin $522,614 = 29.1 % $1,796,035 $24,618.8 – $18,661.2 = 24.2% $24,618.8 Profit margin $69,779 = 3.9 % $1,796,035 Not applicable due to loss Asset turnover $1,796,035 $793,795 + $724,299 ( ) = 2.4 times $24,618.8 $7,960.6 + $10,261.0 ( ) = 2.7 times Return on assets $69,779 $793,795 + $724,299 ( ) = 9.2% Not applicable due to loss Return on common shareholders’ equity $69,779 $357,612 + $329,283 ( ) Not applicable due to loss = = 20.3% Solutions Manual 14-102 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT14-2 (CONTINUED) Profitability: Although we only have two ratios to compare, we see that Sobey’s gross profit margin is lower (worse) than that of North West On the other hand, Sobey’s asset turnover is higher (better) than that of North West (2) (d) In order to complete the comparison and perform further analysis, it would be possible to make an assumption ignoring the impairment loss recorded by Sobeys in 2016 This is a non-recurring item that was extremely large North West had no non-recurring items that could be excluded Other useful information would include the industry averages to determine each company’s performance in relation to other companies in the same industry In addition, previous years’ financial results would show any trends that are affecting the company’s performance Other useful information contained in the annual report, but not the financial statements, would indicate management’s assessment of financial performance, discussion of economic conditions, and discussion of strategies that would explain the reasons behind some of the changes in the financial ratios LO 2,3,4 BT: E Difficulty: C Time: 40 AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-103 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley CT14-3 Financial Accounting, Seventh Canadian Edition FINANCIAL ANALYSIS CASE (a) FLL is reporting under IFRS because it uses the Other Comprehensive Income account, which is not used under ASPE It also reversed an impairment loss and revalued equipment to fair value, both of which are allowed only under IFRS Lastly, the company recorded a “provision,” which is a term used only under IFRS DLL has recorded none of these items allowed under IFRS and reports using ASPE (b) Not all of the differences that are described relate to the use of IFRS and ASPE The choice of inventory cost formulas is available under both sets of standards (c) Current ratio: Due to the rising cost of inventory, FIFO will yield a higher value in inventory and so FLL will have a higher current ratio than DLL Inventory turnover: Cost of goods sold will be lower under FIFO in times of rising prices and ending inventory will be higher Therefore, FLL will likely experience a lower inventory turnover ratio Debt to total assets ratio: FLL will likely have a lower debt to total assets ratio because the equipment value has been increased to fair value, and because the reversal of the impairment loss on some of the equipment has caused assets to increase Offsetting this increase in property, plant, and equipment may be the reduction of those assets involved in the other comprehensive loss recorded during the year which might not be triggered under ASPE Profit margin: FLL will have a higher profit margin because of its choice to use FIFO, as explained in the inventory turnover ratio above As well the reversal of the impairment loss on some of the equipment will increase net income Asset turnover: FLL will have higher total assets as explained in the debt to total assets ratio above Consequently, its asset turnover ratio can be LO 2,3,4,5 BT: AN Difficulty: M Time: 30 AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-104 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley CT14-4 Financial Accounting, Seventh Canadian Edition PROFESSIONAL JUDGEMENT CASE Company A is WestJet Airlines Ltd – clues to its identity include: • Discount airline would have a low gross profit • Administrative costs would be minimal as most employees would work on the airplanes or in maintenance – salaries for pilots, attendants, mechanics etc would be included in cost of goods sold • WestJet has a December 31 year-end, which is right after the very busy Christmas travel season so cash levels are very high • Accounts receivable would be very low as most customers pay with credit cards • Inventories would be minimal as products are not sold to customers except food on airplanes, and there may be some spare parts inventory for planes and equipment • Property, plant, and equipment would be high as the company operates airplanes • Current liabilities would be high because a large portion of this would be unearned revenue as tickets are sold in advance Company B is BlackBerry Limited – clues to its identity include: • The only company with research and development costs • Products are not sold to consumers but retailers, and these types of sales are more likely to be on credit so accounts receivable would be fairly high • This is the company most likely to have intangible assets for the patents on its products • High tech companies usually not rely as much on bank financing as other companies because they tend to have less tangible collateral, so we would expect to see lower levels of non-current liabilities Solutions Manual 14-105 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT14-4 (CONTINUED) Company C is Loblaw Companies Ltd – clues to its identity include: • The grocery industry is competitive so we would expect a lower gross profit margin and a lower profit margin ratio • Despite lower margins, such a company is less likely to be unprofitable given the predictability of revenues and expenses and the constant demand for its products • Selling costs should be a higher percentage of sales compared to other companies because grocery stores advertise (so furniture companies but they would have higher gross profits) • Inventory would be high but not the highest of the five companies as inventory turnover would have to be high enough to prevent too much spoilage • Because it has private labels, it should have some intangible assets Company D is Canadian Natural Resources Limited – clues to its identity include: • Oil prices are high this year so a high gross profit margin is expected along with a high profit margin • Depreciation is the largest expense because the business is so capital intensive – oil sands plants are very expensive – this correlates with the large percentage of assets represented by property, plant, and equipment • Due to the large proportion of non-current assets, one would expect to see a correspondingly larger proportion of non-current liabilities compared to current liabilities • Due to the riskiness of oil prices it is more likely for an oil and gas company to have lower debt relative to liabilities than companies with more stable revenue streams like an airline or grocery chain Solutions Manual 14-106 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT14-4 (CONTINUED) Company E is Leon’s Furniture – clues to its identity include: • Large selling expenses due to significant advertising that occurs in this industry • This company should have a reasonably high level of inventory as its turnover would be slower than the grocery chain • Accounts receivable would be low as sales are made to individuals and any special sales where payment is not needed for a certain period of time give rise to receivables that are often sold to financial institutions • A company that has operated for over 100 years may be more likely to have a higher level of retained earnings and equity and be less in need of bank financing than the other companies and would not need as many noncurrent liabilities LO 1,2,3,4 BT: AN Difficulty: M Time: 40 AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-107 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley CT14-5 (a) Financial Accounting, Seventh Canadian Edition ETHICS CASE The stakeholders in this case are: Vern Fairly, president of Flex Industries Anne Saint-Onge, vice-president of communications You, as controller of Flex Industries Shareholders of Flex Industries Potential investors in Flex Industries Any readers of the press release (b) The president’s press release is deceptive and incomplete and to that extent, his actions are unethical (c) As controller, you should at least inform Anne Saint-Onge, the vicepresident of communications, about the biased content of the release She should be aware that the information she is about to release, while factually accurate, is deceptive and incomplete Both the controller and the vicepresident of communications (if she agrees) have the responsibility to inform the president of the bias in the about-to-be-released information LO 1,2,3,5 BT: C Difficulty: M Time: 20 AACSB: Ethics CPA: cpa-t001, cpa-e001, cpa-t005 CM: Reporting, Ethics, and Finance Solutions Manual 14-108 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley CT14-6 Financial Accounting, Seventh Canadian Edition STUDENT VIEW CASE (a) The software company should have a higher price-earnings ratio because the market expects this company to have opportunities to grow faster than a more established company (b) More established companies like this bank tend to have stable income and cash flows and are not in the same growth phase that a newly public company would be Consequently, such a company can distribute some of its cash flows to shareholders by paying out a dividend A newly public company typically obtains a listing on a stock exchange to raise capital from investors to expand their operations and would therefore, be using all available cash for expansion and would not want to diminish available cash by returning any to shareholders through dividends (c) The software company has yet to reach its normal levels of activity and profitability so one would expect such a company to have low income (and perhaps even losses), which in turn will make any ratio based on profitability, such as return on common shareholders’ equity or return on assets, lower than more established companies with a record of profitability (d) A bank uses leverage (borrowed funds) extensively Every savings account that a bank has is a liability on the bank’s statement of financial position Therefore, the debt that a bank has is usually much larger than its equity Normally, the bank will earn a higher return on the borrowed money than it pays to its customers in interest Because of this, the return on common shareholders’ equity will be higher than the return on assets Solutions Manual 14-109 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT14-6 (CONTINUED) (e) There really is no “right” answer to this question It really depends on how much risk an investor is willing to undertake The bank may provide a nice dividend and its share price may rise in the future but not at a very fast rate because the ability of a bank to grow rapidly is limited due to the large number of competing banks that exist On the other hand, if the software company makes a very good game and there exists a large demand for that game, then the software company’s share price will rise dramatically However, there is a risk that the game may not be popular and the share price may then collapse Such a drop in share price may not occur for the bank’s shares given the steady demand that exists for its services So, if you feel comfortable with the risk implicit in buying the software company’s shares and believe that their games will indeed be popular, buy those shares If you are more conservative and don’t mind earning a more modest income or incurring a modest rather than severe loss, you may want to buy the bank shares Your aversion to risk may also be a function of age For example, a senior should probably not invest extensively in software company shares because if the price falls dramatically, that lost income can’t be replaced because the senior may be unable to work Furthermore, the senior may need dividend income to meet living expenses, whereas a younger person can take on more risk with their investments because they have alternative sources of income LO BT: AN Difficulty: M Time: 45 AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-110 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley CT14-7 Financial Accounting, Seventh Canadian Edition SERIAL CASE (a) At first glance, Software Solutions appears to be more liquid than Micro Inc Its current ratio is significantly higher than the industry ratio However, the current ratio may be artificially high because its receivables turnover and inventory turnover are both lower than those of Micro and the industry average This indicates that Software Solutions is collecting its accounts receivable and turning over its inventory less quickly than its competitor It would be important to look at the composition of Software Solutions’ current assets and current liabilities It could be that it is the stronger of the two companies—it depends on what other types of assets, besides receivables and inventory, make up its total current assets and how liquid they are (b) It appears that Software Solutions is the less solvent of the two companies Micro has a lower debt to total assets ratio, which is indicative of greater solvency and has a higher times interest earned ratio Micro’s higher times interest earned ratio indicates that it can service its debt load Micro’s and Software Solutions’ times interest earned ratio fall short of the industry average Nonetheless, Software Solutions debt to total assets ratio is not far off that of the industry and it is still able to handle its interest with a strong times interest earned ratio of 10.8 times (c) Software Solutions is clearly the more profitable of the two companies, as all of its profitability ratios are superior to those of Micro and of the industry (d) Investors who are interested in receiving dividend income rather than appreciation in the share price would favour Software Solutions as indicated by its higher dividend yield ratio Their dividend yield ratio is also higher than the industry average (e) Investors who are interested in appreciation in the share price rather than receiving dividend income would favour Micro as indicated by its higher price-earnings ratio This means that investors have positive expectations of Micro’s performance in the future Solutions Manual 14-111 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT14-7 (CONTINUED) (f) Emily and Daniel should be aware that financial statements prepared under IFRS can contain accounting policy choices and financial statement items (such as other comprehensive income) that may be different from those applied by companies using ASPE Consequently, some of the above ratios might not be comparable They should also inquire whether the industry averages are applicable given that they likely relate only to publicly-traded competitors In preparing their analysis, they should also be aware of what items under IFRS may be subject to additional volatility and how they will interpret the change in the trends for the ratios affected (g) Emily and Daniel should consider some of the following factors related to making an investment in Software Solutions: - their risk tolerance (can they tolerate the fluctuations inherent in share investments) their profile as investors (are they investing for growth or income) their goals for this investment (are they investing for short-term appreciation or long-term growth) is this the right time to be purchasing the shares (are they currently overvalued by other investors)? In addition, before concluding their analysis, Emily and Daniel should obtain additional information to supplement the ratio analysis This could include detailed financial statements, a horizontal and vertical analysis, as well as relevant non-financial information They likely already have a very good understanding of the business and the economy from their involvement with Anthony Business Company Ltd (ABC) LO 2,3,4 BT: E Difficulty: M Time: 45 AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14-112 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition Legal Notice Copyright © 2017 by John Wiley & Sons Canada, Ltd or related companies All rights reserved The data contained in these files are protected by copyright This manual is furnished under licence and may be used only in accordance with the terms of such licence The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd (MMXVII vi F2) Solutions Manual 14-113 Chapter 14 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited ... correctly interpreting financial information LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 14- 10 Chapter 14 Copyright © 2017 John... 120 10.0% Interest expense Income before income tax Income tax expense Net income EXERCISE 14- 3 (CONTINUED) (b) (continued) Solutions Manual 14- 29 Chapter 14 Copyright © 2017 John Wiley & Sons... and Decision- Making Comm Communication Self-Mgt Self-Management Team & Lead Teamwork and Leadership Reporting Financial Reporting Stat & Gov Strategy and Governance Mgt Accounting Management Accounting