Link download solutions manuals accounting concepts and applications 10th edition by albrecht

CHAPTER DISCUSSION QUESTIONS inspect the company by, among other things, reviewing the financial statements Investors, creditors, and other external users need to know a company's financial status For example, what assets does the company own? Are the assets still productive? How hard would it be to sell the assets, if needed? Also, what debts must be paid? Are the owners' interests in the business increasing or decreasing and why? External users also need information on the profitability of the company Is the company making or losing money? In addition, external users need to know what the total inflows and outflows of cash are—those from operations as well as those from investing and financing activities This information is provided in the primary financial statements consisting of a balance sheet, an income statement, and a statement of cash flows By researching the past and current financial statements of the company, you can determine (1) if past and present stock performances are indicative of the projected 150% return; (2) if the company has a history of positive or negative cash flows; (3) if sales have been steadily increasing or decreasing over time; and (4) if the company historically has had net earnings or losses These are but a few of the many reasons why it is important to the research yourself before immediately jumping into an investment just on your friends' advice Readers of annual reports need to compare the financial status and results of operations of a company with other companies and with the same company's results for previous periods In this way, users can judge the relative progress of a company toward its goals Statements covering more than one accounting period and those statements that classify and highlight key relationships assist in this comparative analysis a A balance sheet shows a company's financial status (the relationships among assets, liabilities, and owners' equity) at a particular date b An income statement shows the results of an entity's operations during a period of time c A statement of cash flows shows the major inflows and outflows of cash during a period of time There are three ways that economic resources can be brought into a business: borrowing from others, owner contributions, and earnings The first is a liability, whereas the latter two are included in the owners' equity section Together these two balance sheet sections (liabilities and owners' equity) inform readers of the ―sources'' of assets The answer might seem obvious to you, but you would be surprised at how often people get so caught up in dreaming of the ―guaranteed‖ return that they forget to research the company's financial situation before investing Owners' equity is a residual value showing the amount of net assets (assets minus liabilities) that are claimed by the owners of the business If a business were to sell all its assets, then pay all its creditors, the remaining amount would go to the owners The amount of owners' equity reported on a balance sheet generally will not be equal to Would you buy a home on your friends' advice without seeing the home yourself? No, you would view the home and most likely hire an inspector to check it for problems before deciding if it would be a good investment Just as you would inspect a home before investing, so should you 15 16 Chapter the current worth of a business since the assets generally are reported at their historical costs, not at their current values The amount of owners' equity is represented by all assets (after deducting liabilities), not just cash operations is a key figure that should be highlighted 11 When financial statements are prepared in accordance with generally accepted accounting principles (GAAP), certain guidelines or rules have been followed in measuring and reporting the yearly financial activities In expressing an opinion, an auditor attests and affirms that the guidelines followed are commonly accepted by the accounting profession Thus, the auditor's opinion gives assurance that the results of operations have not been distorted because a firm uses different or incorrect accounting principles and procedures The auditor's opinion also gives some assurance that management's financial statements fairly represent what actually occurred during the year Without such assurances, misleading or ill-prepared financial statements could cause substantial losses to unwary investors 12 Auditors cannot assure that the financial statements are accurate, because their examination is not based on a test of every item and every transaction Time and fee constraints require that an audit be based on a sample of items Auditors review a sufficient sample of evidential material to form a professional opinion, but accuracy is still the responsibility of the preparer of the statements—management The auditor's function is to express an opinion about the financial statements 13 The four types of financial statement notes typically included in an annual report are (1) summary of significant accounting policies, (2) additional information about summary totals, (3) disclosure of information not recognized, and (4) supplementary information 14 The importance of the basic accounting concepts or assumptions is as follows: The balance sheet has two main limitations First, assets are initially recorded at their purchase cost and subsequent changes in value may or may not be recorded on the books The second limitation is that some important economic assets, called intangible assets, are not reported at all, although they may be the most valuable assets to the company It is important to be aware of these limitations when evaluating a company's growth potential because the company may be worth much more (or less) than its book value shows Some people feel that the income statement is more important than the balance sheet because it shows the profitability of a company In turn, profitability relates to future cash-generating ability, which is of prime interest to most users of financial reports Others feel that the balance sheet is more important than the income statement because cash flow is eventually translated into the asset and equity balances reported on the balance sheet Properly informed people realize that all three primary financial statements are equally important and complementary By looking only at the net income or EPS number, an investor might not see the important relationships of various categories on an income statement For example, revenues less operating expenses equals operating income If an unusual gain or loss on some nonoperating item is added to or subtracted from operating income, net income and the EPS number may be distorted and would not reflect the results of normal operations for the period 10 Cash flows should be classified according to operating, investing, and financing activities in order to help investors and others see the sources and uses of cash by major activity For example, if a company is not providing a net cash inflow from operations and instead has to borrow cash to keep the business running, it may not stay in business long Thus, the amount of net cash provided from a The separate entity concept identifies the particular organizational unit for which accounting data are compiled The entity is the focal point for accumulating, measuring, and communicating accounting data b Arm's-length transactions are those in which the buyer and seller are rational and free to act independently Accounting for and analyzing economic Chapter transactions enable the accountant to measure the successes and failures of a reporting entity If transactions between entities involve any favoritism or irregularity, the data measured by the accountant will lose validity; that is, the data will not accurately measure the success of the reporting entity c The cost principle requires transactions to be recorded at historical costs, the amounts originally paid in an arm'slength transaction This ensures that accounting data are objective, since the exchange price (historical cost) at the date of the transaction is presumed to reflect the fair market value of an item at that date d Monetary measurement provides a quantitive means of measuring transactions and comparing the results of operations for various reporting entities 17 e The going concern assumption states that, unless there is evidence to the contrary, the entity will continue in operation for the foreseeable future If the opposite assumption were made— that the entity was about to go out of business—accountants would record liquidation values on the books of the entity 18 Chapter PRACTICE EXERCISES PE 2–1 (LO1) Total Assets Computation of total assets: $ Cash Accounts receivable Inventory Equipment Total assets PE 2–2 (LO1) 800 1,000 3,500 10,000 $15,300 Total Liabilities Computation of total liabilities: Accounts payable Wages payable Loan payable Total liabilities PE 2–3 (LO1) $ 900 500 9,000 $10,400 Total Owners’ Equity Computation of total owners’ equity: Capital stock Retained earnings Total owners’ equity $ 1,500 3,400 $ 4,900 Refer to the solutions for PE 2–1, 2–2, and 2–3 To confirm the accuracy of the solutions, we can verify assets are equal to liabilities plus owners’ equity: Total assets $15,300 Total liabilities Total owners’ equity Total liabilities and owners’ equity $10,400 4,900 $15,300 PE 2–4 (LO1) The Accounting Equation Case A $10,000 – $4,000 = $6,000 Owners’ equity Case B $8,000 – $3,500 = $4,500 Liabilities Case C $5,500 + $7,000 = $12,500 Assets Case D $13,000 – $15,000 = ($2,000) Owners’ equity Note that in this case, total owners’ equity is negative because liabilities are greater than assets 19 Chapter PE 2–5 (LO1) Balance Sheet Assets Cash Accounts receivable Inventory Equipment Total assets $ 800 1,000 3,500 10,000 $15,300 Liabilities Accounts payable Wages payable Loan payable Total liabilities 900 500 9,000 $10,400 Owners’ Equity Capital stock Retained earnings Total owners’ equity Total liabilities and owners’ equity $ 1,500 3,400 $ 4,900 $15,300 PE 2–6 (LO1) $ Current Assets Computation of total current assets: Cash Accounts receivable Inventory Total current assets PE 2–7 (LO1) $ 625 800 2,100 $3,525 Current Liabilities Computation of total current liabilities: Accounts payable Loan payable (due in months) Total current assets $700 250 $950 For simplicity, the entire $10,000 amount of the mortgage payable is assumed to be a long-term liability However, if monthly payments are to be made on the mortgage during the next year, some part of the liability is current This portion might be labeled as ―current portion of mortgage payable.‖ 20 Chapter PE 2–8 (LO1) Book value of equity: Case A Case B Case C Case D Book Value and Market Value of Equity Assets $ 10,000 8,000 13,500 100,000 = Liabilities $ 4,000 7,000 5,500 150,000 Owners’ Equity $ 6,000 1,000 8,000 (50,000) + Market value of equity: Case A Case B Case C Case D Shares of Stock Outstanding 1,000 500 300 1,000  Price per Share $15 10 20 = Market Value $15,000 5,000 6,000 7,000 Cases A and B illustrate the normal case in which the accounting book value understates the actual value of the company In Case C, the market value is actually less than the book value; this can occur when a company makes unwise investment and operating decisions after the owners have invested their money Case D illustrates that a company can have positive market value even when the book value of equity is negative Surprisingly, about 5% of publicly-traded U.S companies have negative equity book values PE 2–9 (LO2) Total Revenues Computation of total revenues: Sales Consulting revenue Interest revenue Total revenues PE 2–10 (LO2) $13,600 2,700 900 $17,200 Total Expenses Computation of total expenses: Cost of goods sold Advertising expense Total expenses $10,200 2,150 $12,350 21 Chapter PE 2–11 (LO2) Computation of Net Income Computation of net income (or net loss): Sales Rent revenue Cost of goods sold Interest expense Net income (loss) PE 2–12 (LO2) Case A $ 100,000 5,000 (60,000) (18,000) $ 27,000 Case B $150,000 1,000 (30,000) (47,000) $ 74,000 Case C $ 70,000 12,000 (60,000) (25,000) $ (3,000) Case D $ 200,000 10,000 (110,000) (31,000) $ 69,000 Income Statement Income statement: $12,000 Sales Expenses: Cost of goods sold Wage expense Interest expense Income tax expense Totalexpenses $7,300 900 1,200 800 10,200 $ 1,800 Net income PE 2–13 (LO2) Computation of Ending Retained Earnings Computation of ending retained earnings: Beginning retained earnings Net income (loss) Less: Dividends Ending retained earnings PE 2–14 (LO2) Case A $50,000 5,000 $55,000 3,000 $52,000 Case B $15,000 1,000 $16,000 4,500 $11,500 Case C $31,000 12,000 $43,000 2,100 $40,900 Case D $ 70,000 (10,000) $ 60,000 6,000 $ 54,000 Expanded Accounting Equation Case A $23,000 – $11,000 – $4,500 = $7,500 Capital stock Case B $17,500 – $4,500 – $3,600 = $9,400 Liabilities Case C $14,000 + $11,000 + $27,000 = $52,000 Assets Case D $45,000 – $29,000 – $18,000 = ($2,000) Retained earnings Note that in this case, retained earnings is negative indicating that either the company has reported a cumulative loss over its history or cumulative dividends have exceeded cumulative income 22 PE 2–15 (LO3) Chapter Computing Cash from Operating Activities Computation of cash flow from operating activities: Cash collected from customers Cash received from tenants renting part of a building Cash paid for interest Cash paid for income taxes Cash flow from operating activities PE 2–16 (LO3) $10,000 600 (450) (1,320) $ 8,830 Computing Cash from Investing Activities Computation of cash flow from investing activities: Cash received from sale of a building Cash paid to purchase land Cash flow used by investing activities PE 2–17 (LO3) $ 5,600 (12,000) $ (6,400) Computing Cash from Financing Activities Computation of cash flow from financing activities: Cash paid to repay a loan Cash paid for dividends Cash received upon the issuance of new shares of stock Cash flow from financing activities $(1,000) (780) 3,000 $ 1,220 23 Chapter PE 2–18 (LO3) Preparing a Statement of Cash Flows Statement of Cash Flows OPERATING ACTIVITIES: Cash collected from customers Cash received from tenants renting part of a building Cash paid for interest Cash paid for income taxes $ 10,000 600 (450) (1,320) Cashflowfromoperatingacti vities $ 8,830 INVESTING ACTIVITIES: Cash received from sale of a building $ 5,600 (12,000) Cash paid to purchase land Cashflowusedbyinvestingactiv ities (6,400) FINANCING ACTIVITIES: $ (1,000) (780) Cash received upon the issuance of new shares of stock 3,000 .Cashflowfromfinancingacti vities Cash paid to repay a loan Cash paid for dividends Net increase in cash Cash balance, beginning of year Cash balance, end of year PE 2–19 (LO3) 1,220 $ 3,650 2,000 $ 5,650 Financial Statement Articulation Case A Cash, beginning $13,000 Net increase (decrease) in cash 8,200 Cash, ending $21,200B Beginning retained earnings Net income (loss) Less: Dividends Ending retained earnings Case A $41,000 18,000 $59,000 6,500 $52,500A Case B $15,700 C 5,300 $21,000 Case B $ (1,700) 25,000 $ 23,300 7,300 $ 16,000 D Case C $ 4,200 (2,600)E $ 1,600 Case D $ 22,000 (6,300) $ 15,700 H Case C $22,000 (5,700)F $16,300 800 $15,500 Case D $ 51,000 (11,000) $ 40,000 5,000G $ 35,000 24 Chapter EXERCISES E 2–20 (LO1) BS/L IS BS/A IS BS/A BS/A E 2–21 (LO1) Classification of Financial Statement Elements 10 11 12 IS BS/A BS/OE IS BS/A BS/A 13 14 15 16 17 18 BS/L BS/L BS/A IS BS/OE IS Accounting Equation A Cash Accounts receivable Land and buildings Accounts payable Mortgage payable Owners' equity B $31,000 14,000 95,000 15,000 80,000 45,000 $ 8,400 13,000 42,600 16,000 31,000 17,000 C $13,000 16,500 67,000 23,000 41,500 32,000 E 2–22 (LO1, LO2) Comprehensive Accounting Equation X Assets: January 1, 2009 Liabilities: January 1, 2009 Owners' equity: January 1, 2009 Assets: December 31, 2009 Liabilities: December 31, 2009 Owners' equity: December 31, 2009 Revenues in 2009 Expenses in 2009 $360 280 80 380 320 60 80 100 Y $1,080 460 620 1,240 520 720 216 116 Z $230 80 150 310 90 220 400 330 36 Chapter P 2–42 (LO2) Income Statement Preparation Wadley’s Car Wash Income Statement For the Year Ended December 31, 2009 Service revenues Expenses: Rent expense $ 6,000 Salaries expense 41,000 Utilities expense 4,300 Supplies expense 10,300 Miscellaneous expense 970 Income before taxes Income taxes Net income Earnings per share ($102,430/3,000 shares) $210,000 62,570 $ 147,430 45,000 $ 102,430 $ 34.14 (rounded) P 2–43 (LO1, LO2) Expanded Accounting Equation Compute net increase in assets: Cash Interest receivable Inventory Accounts receivable Building Net increase in assets Compute net increase in liabilities: Accounts payable Mortgage payable Wages payable Net increase in liabilities $ 12,500 (7,500) 50,000 (11,750) 157,500 $200,750 $ 22,500 137,500 (35,250) $124,750 Figure overall increase in owners' equity from net increases in assets and liabilities: Net increase in assets Less: Net increase in liabilities Net increase in owners' equity $200,750 124,750 $ 76,000 37 Chapter P 2–43 (LO1, LO2) (Concluded) Compute known net increase in owners' equity: Capital stock Retained earnings (dividends paid) Known net increase in owners' equity $ 26,250 (25,000) $ 1,250 Net increase of $76,000 in owners' equity resulted from changes in (1) the known net increase in owners' equity and (2) net income Thus, net income can be figured by: Overall net increase in owners' equity Less: Known net increase in owners' equity Net income for 2009 P 2–44 (LO2) $ 76,000 (1,250) $ 74,750 Income Statement Preparation Precision Corporation Income Statement For the Year Ended December 31, 2009 Sales revenue Expenses: Advertising expense Delivery expense Packaging expense Salaries expense Supplies expense Income before taxes Income taxes Net income Earnings per share 10,000 shares  *Rounded  $34,515  $3.45   10,004 shares *   $68,000 $ 1,530 480 355 18,350 8,410 29,125 $38,875 4,360 $34,515 $ 3.45 38 Chapter P 2–45 (LO2) Net Income Streuling Company Income Statement For the Year Ended May 31, 2009 Consulting fees $115,100 Expenses: Advertising expense Supplies expense Rent expense Salaries expense Miscellaneous expense Administrative expense Income before taxes Income taxes Net income 71,650 $ 43,450 21,180 $ 22,270 Earnings per share ($22,270/3,000 shares) $ 7.42 (rounded) If Streuling Company had a loss, it may or may not be a good idea to pay dividends It would depend on the amount of cash available, whether the loss is considered only a temporary situation, and the expectations of the shareholders Many large companies continue to pay dividends, even though they have a loss, in order to satisfy both perceived and real shareholder expectations P 2–46 (LO2) $ 2,760 37,820 1,500 18,150 4,170 7,250 Net Income and Statement of Retained Earnings Quincy Company Income Statement For the Year Ended May 31, 2009 Consulting fees Expenses: Advertising expense $ 4,650 Supplies expense 38,410 Rent expense 2,400 Salaries expense 25,340 Miscellaneous expense 10,200 Administrative expense 13,900 Income before taxes Income taxes Net income Earnings per share ($60,740/8,000 shares) $176,400 94,900 $ 81,500 20,760 $ 60,740 $ 7.59 (rounded) 39 Chapter P 2–46 (LO2) (Concluded) Quincy Company Statement of Retained Earnings For the Year Ended May 31, 2009 Retained earnings, June 1, 2008 Add net income for the year Less dividends Retained earnings, May 31, 2009 Quincy Company Statement of Retained Earnings For the Year Ended May 31, 2009 Retained earnings, June 1, 2008 Less: Net loss for year Dividends Retained earnings, May 31, 2009 $175,670 60,740 $236,410 19,500 $216,910 $175,670 $38,000 19,500 57,500 $118,170 If Quincy Company had a loss, as in (3) above, it may or may not be a good idea to pay dividends It would depend on the amount of cash available, whether the loss is considered only a temporary situation, and the expectations of the shareholders Many large companies continue to pay dividends, even though they have a loss, in order to satisfy both perceived and real shareholder expectations P 2–47 (LO1, LO2) Comprehensive Financial Statement Preparation Wilcox, Inc Income Statement For the Year Ended December 31, 2009 Revenues Expenses: Salaries expense Utilities expense Supplies expense Rent expense Other expenses Income before taxes Income taxes Net income Earnings per share ($81,300/2,000 shares) $389,950 $125,350 5,250 110,600 21,200 11,250 273,650 $116,300 35,000 $ 81,300 $ 40.65 40 Chapter P 2–47 (LO1, LO2) (Concluded) Wilcox, Inc Balance Sheet December 31, 2009 Assets Current assets: Cash Accounts receivable Supplies Total current assets Long-term assets: Land Buildings Total long-term assets Total assets Liabilities and Owners' Equity Current liabilities: Accounts payable Long-term liabilities: Notes payable Total liabilities Owners' equity: Capital stock Retained earnings Total owners' equity Total liabilities and owners' equity $ 61,100* 90,000 72,500 $223,600 $ 42,500 197,550 240,050 $463,650 $ 38,050 63,800 $101,850 $ 65,000 296,800* 361,800 $463,650 *Computations: Retained earnings, December 31, 2009 ($296,800) = Retained earnings, January 1, 2009 ($311,000) + Net income ($81,300) – Dividends ($95,500) Total current assets ($223,600) = Total assets ($463,650) – Total long-term assets ($240,050) Cash ($61,100) = Total current assets ($223,600) – Accounts receivable ($90,000) – Supplies ($72,500) The company has been profitable over the past several years, even though more was paid out in dividends this year than was earned The company apparently has retained most of the past years' earnings in the business Chapter 41 P 2–48 (LO1, LO2) Elements of Comparative Financial Statements Utilities expense Salaries and commissions expense Miscellaneous expenses Income tax expense Total expenses $ 5,700 38,700 2,200 4,500 $51,100 Retained earnings, December 31, 2009 Less retained earnings, December 31, 2008 Net increase for 2009 Add dividends paid Net income for 2009 $35,000 18,000 $17,000 8,000 $25,000 Total expenses (item 1) Add net income (item 2) Total revenue $51,100 25,000 $76,100 Comparative financial statements enable users to compare operating results and the financial position of the company for more than one year Often, trends in a company's financial position are more important than absolute figures 42 Chapter P 2–49 (LO3) Statement of Cash Flows Pratt & Jordan Development, Inc Statement of Cash Flows For the Year Ended December 31, 2009 Cash Flows from Operating Activities Cash inflows from: Customer sales Cash outflows from: Payment of operating expenses Payment of wages and salaries Payment of taxes Other expenses Net cash provided by operating activities $ 215,000 135,000 43,000 32,000 Cash Flows from Investing Activities Investments in securities Net cash used by investing activities $(245,000) Cash Flows from Financing Activities Proceeds from land loans Payment of building loan Distributions to owners Netcashusedbyfinancingactivities $ 75,000 (50,000) (60,000) Net increase in cash Cash at beginning of year Cash at end of year $ 750,000 425,000 $ 325,000 (245,000) (35,000) $ 45,000 130,000 $ 175,000 Yes, Pratt & Jordan Development, Inc., appears to be in good shape from a cash flow standpoint It generated $325,000 in cash flows from operating activities, which was used for investing and financing activities Pratt & Jordan Development, Inc., was able to distribute an amount to its owners and still add $45,000 toward its end-of-year cash balance It would help to have comparative statements of cash flows, as well as the other financial statements, to see the trends and relationships of the information 43 Chapter P 2–50 (LO3) Statement of Cash Flows Esplin Enterprises Statement of Cash Flows For the Year Ended December 31, 2009 Cash Flows from Operating Activities Cash receipts from: Services $2,214,000 Cash payments for: Operating expenses $1,735,000 Taxes 207,000 1,942,000 Net cash provided by operating activities $ 272,000 Cash Flows from Investing Activities Cash receipts from sale of land $ 194,000 Cash payment to purchase building (352,000) Netcashusedbyinvestingactivities Cash Flows from Financing Activities Cash receipts from investments by owners $ Cash payments for distributions to owners Netcashprovidedbyfinancingactivities Net increase in cash Cash at beginning of year Cash at end of year *X + $139,000 = X= $815,000 $676,000 (158,000) 93,000 (68,000) 25,000 $ 139,000 676,000* $ 815,000 44 Chapter ANALYTICAL ASSIGNMENTS AA 2–51 Creditor and Investor Information Needs Discussion As the bank's loan officer, you would want to see comparative balance sheets, income statements, and statements of cash flows The profitability of a company is a major factor in determining whether a company will have sufficient future cash flows to repay its loans as well as to pay the interest on those loans In analyzing the liquidity, solvency, and overall financial position of the company, you also would be interested in the relationships disclosed on the balance sheet and the cash flow statement As a potential investor, you would want to determine Ink Spot's cash flow position and its operating profitability during its first two years of existence These factors will affect the value of the company's stock (and therefore its resale value) as well as the company's ability to pay dividends to its stockholders AA 2–52 Analyzing Trends and Key Financial Relationships Discussion Net income and earnings per share (EPS) increased in 2008 and again in 2009 The cause of this increase, however, was the reduction in selling and advertising expenses Revenues actually decreased during the three-year period Revenues in 2008 were approximately 3% less than in 2007 In 2009 there was a further decline of more than 8% Another significant trend was the increase in interest expense A potential investor would be very concerned about the declining revenues and the increasing interest expense The increase in interest expense from 2007 to 2009 could indicate that the company has been forced to rely more and more on borrowed funds to meet its operating expenses Also, the significant decrease in selling and advertising expenses suggests that the company may be cutting back on sales staff and promotional efforts in an attempt to show increasing income and EPS Administrative and other expenses have remained fairly stable, indicating that they are relatively ―fixed'' costs Future decreases in selling and advertising expenses may accelerate the downward trend in revenues This case illustrates the danger in looking only at the ―bottom line'' results, such as net income and EPS In addition to the income statement data presented, a prospective investor would want to analyze comparative balance sheet and cash flow data The balance sheet and statement of cash flows, combined with the notes to the financial statements and the independent auditor's report, would help the investor determine the significance of the trends reflected in the income statement This information considered collectively provides the basis for an informed investment decision AA 2–53 How Many Accounting Equations Are There? Discussion Congratulations to your friend for remembering a few important terms from his accounting class However, you might want to ask your friend what grade he got in the class because his ―equations‖ are all wrong His mistakes are as follows: Revenues = Assets It is common for introductory students to mistakenly think that revenues and assets are one and the same thing Assets are items of value owned or controlled by a company Those assets can arise from a number of sources—the cash to buy the assets can be borrowed, can be invested, or can be generated through business operations When describing the source of assets, ―revenue‖ is the 45 Chapter AA 2–53 (Concluded) label given to the source of assets that are generated through business operations, just as ―loan payable‖ is the label used when the source of assets is a bank loan and ―paid-in capital‖ is the label used when the source of the assets is owner investment Net Income = Cash from Operating Activities As explained in the chapter, accountants make many adjustments, assumptions, and estimates in the computation of net income These adjustments are made in order to convert the raw cash from operating activities number, computed simply as the difference between cash inflows and cash outflows from operating activities, into a better measure of the company’s economic performance, net income Retained Earnings = Cash Net income represents the amount of assets generated through profitable operations Some of these assets are used to pay dividends to investors The difference between the assets generated (net income) and the assets paid out to investors (dividends) is called retained earnings Once these excess assets are generated, they can be converted into any form the company desires They can be turned into cash in order to increase the cash balance They can be turned into inventory, into land, or into buildings The point is that there is no reason to think that all of a company’s retained earnings will be used to increase the company’s cash balance AA 2–54Can Financial Statement Information Be Used to Successfully Pick Stocks? Discussion This is an extremely controversial question For some stock traders, the answer is unequivocally ―yes.‖ These stock traders believe in the usefulness of fundamental analysis which involves using existing information, including financial statement information, to determine the fundamental underlying value of a company Using this approach, if a stock’s current price is below its computed fundamental value, then shares of that stock should be purchased An alternate view is based on the belief in an efficient market In an efficient stock market, stock prices respond very quickly (within a few minutes or hours) to any information contained in a company’s financial statements This means that potential investors who come along a week or a month later cannot use those financial statements to identify winning and losing stocks because stock prices have already moved to reflect the financial statement information For example, it seems foolish to think that an investor can use the fact that Wal-Mart’s net income, announced six weeks ago, had increased 25% over the preceding year in order to predict that Wal-Mart’s stock price will jump in the future Any jump that was going to occur would have occurred six weeks ago when the big-money investors in New York City first got the news about the net income increase Some academic research has indicated that financial models using accounting information can be used to identify, in advance, winning and losing stocks However, one must have a little skepticism about these models because we typically don’t observe accounting professors getting rich on their ability to pick stocks AA 2–55 Who Audits American Companies? Discussion Your sister is completely correct about the importance of financial statement reliability to the ability of U.S companies to compete in the global marketplace However, she is mistaken about who pays audit fees Auditors are not hired by the U.S federal government; instead, each company chooses and pays its own 46 AA 2–55 Chapter (Concluded) auditor As explained in the chapter, this market for auditors works because auditors want to maintain their reputations and because they want to avoid lawsuits As explained in the chapter, the Sarbanes-Oxley Act of 2002 increased the federal government oversight of the auditing profession However, auditors are still hired and paid by the companies they audit, not by the federal government AA 2–56 Accounting for the Proper Entity Discussion You would need to explain to Mr Masters that the financial reports you have been asked to prepare are for the company, which is a separate and distinct reporting entity Mixing personal and business transactions will not accurately reflect the financial results of the business The payments should be classified as personal expenses, not business expenses The entity concept of reporting is an important consideration in this situation Of equal or greater importance is the fact that deducting personal expenditures on the tax return as business expenses is not only improper, but illegal You should encourage Mr Masters to what is right, not what he might get away with If he insists on including the payments as business expenses, you should decline to provide further services for him AA 2–57You Decide: What is the most important number in the financial statements—net income or EPS? Judgment Call Issues to be discussed are: There is an almost fixated focus on EPS these days And, instead of annual EPS, the focus seems to be on quarterly EPS and whether or not the company has met Wall Street’s estimate of the EPS EPS is only a summary of much more information Sometimes, focusing on EPS doesn’t allow you to see why things changed the way they did Net income by itself isn’t much more useful than EPS because it is a net number that, when looked at alone, obscures the reasons why it increased or decreased The best thing to is to study the detail of the income statement (and the other financial statements) and not just look at one number It is only when you have a complete financial picture by looking at all the financial statements and the way and reasons they changed that you really understand what went on AA 2–58 You Decide: Is the cash flow statement necessary? Judgment Call Issues to be discussed are: Many companies focus on EBITDA these days and pay much more attention to EBITDA than to cash flows 47 Chapter AA 2–58 (Concluded) Most of the information on the statement of cash flows can be derived from looking at successive balance sheets and income statements, although it is much harder to obtain In the end, it is cash flows, much more than earnings or EBITDA, that really matters If a company doesn’t have sufficient cash, it cannot pay its obligations and will have liquidity problems It is important to see how much of cash flows comes from the three activities of operations, financing, and investments EBITDA is often used as a surrogate for cash flows It adjusts earnings for depreciation and amortization, which is also done on the statement of cash flows AA 2–59You Decide: Should Wall Street place so much importance on the EPS figure or not? Judgment Call Issues to be discussed are: There is a huge penalty for missing expected EPS The stock market is built and based on expectations When those expectations are not met, it often doesn’t matter by how much Rather, the ―bad news‖ often results in a stock price dropping considerably It is the EPS number that Wall Street focuses on—usually quarterly EPS If she diversifies enough, unless the entire market drops, the stocks that go up should compensate for the stocks that go down In fact, in a market where gains are unlimited and losses are limited (by the amount of the investment), in a portfolio, often one or two stocks increase enough to more than compensate for all the losers People care about EPS because it is a nice, easy-to-understand summary of the financial statements and the performance of a company AA 2–60 You Decide: Are the notes to the financial statements necessary? Judgment Call Issues to be discussed are: It is impossible to completely understand the financial statements without reading and understanding the notes There are many estimates and assumptions involved in preparing financial statements and those estimates and assumptions must be explained in the notes The notes also provide additional detail that helps explain many of the changes in the financial statements from year to year The notes help readers understand the risk posture of the company—is it using aggressive accounting principles or conservative accounting principles? Without notes, it would be difficult to know whether or not GAAP is being followed 48 Chapter AA 2–61 Wal-Mart Real Company Analysis On January 31, 2006, Wal-Mart had $6.414 billion in cash and cash equivalents This amount comprised 4.6% of Wal-Mart's total assets Wal-Mart had $31.024 billion in long-term debt, including the current portion Wal-Mart typically has a large amount of long-term debt because of the large amount of property it finances Revenues increased 9.5% [($312,427 – $285,222)/$285,222] over the previous year Compared to the prior year, when sales increased by 11.3%, the company's rate of increase in sales has decreased slightly Wal-Mart paid a dividend of $2.511 billion in 2005 Wal-Mart both issued shares under its stock option plan and purchased shares of its own stock in 2005 The amount of stock repurchased ($3,580) during the year exceeded the amount of stock issued under its stock option plan during the year ($276) Wal-Mart generates most of its cash from operations The company uses that cash to repurchase its own stock, pay dividends, make long-term debt payments, invest in other companies, and invest in other operating assets like property and equipment AA 2–62 Safeway Real Company Analysis Current assets as a percentage of total assets increased slightly from 23.4% in 2004 to 23.5% in 2005 The primary reason for the increase was a slight increase in all of the current asset accounts The gross profit ratio was slightly higher for 2004 (29.6% vs 28.9%) The slight increase indicates that groceries (and other products sold by Safeway) were being sold with a slightly higher margin in 2004 For 2005, Safeway generated more cash from operations than was spent through investing activities ($1.9 billion from operations compared to $1.3 billion spent relating to investing) Safeway borrowed $0.8 billion in long-term financing and paid $1.2 billion to reduce the company’s long-term debt It would be reasonable to expect that Safeway’s long-term debt decreased during the year AA 2–63 Diageo International The first major difference students should notice on Diageo's balance sheet is the listing of fixed assets first Most companies in the United States list current assets first and fixed assets second Another thing students will notice is that there is no easy way to conclude that the balance sheet does balance As indicated in the next question, there is no total for assets or for liabilities and stockholders' equity Diageo does not provide a number indicating total assets The company nets current assets and liabilities and then adds that net figure to its fixed assets In the United States, a number indicating total assets is always provided Companies around the world use different terms than we might be accustomed to, but we can unravel the meaning of the words For example, stocks is included in the current assets section The most common current assets include cash, inventory, and accounts receivable By a process of elimination we can conclude that Stocks means Inventory Likewise, Debtors represents Accounts Receivable Called-up Share Capital is the same as Common Stock, and Profit and Loss Account is the English equivalent of Retained Earnings 49 Chapter AA 2–64 Violating a Covenant Ethics There are many ways to change the current ratio Some of them have a legitimate business purpose and some don't For example, selling a product or service at a profit will cause the current ratio to increase, as will selling equipment The difference is that selling a product or service is a long-term solution to the current problem, while selling equipment that the company will need is a short-term solution Would investors want management deciding on short-term, quick-fix solutions to avoid violating debt covenants? Management might argue that it is in the best interest of shareholders to keep the bank out of the company's business Thus, manipulating the current ratio is the proper thing to The lender would counter that selling equipment to inflate the current ratio violates the spirit of the debt covenant What's the right answer? As is often the case in gray areas, it is probably not clear But one thing is certain: you must always be careful when making business decisions that not have a clear business purpose AA 2–65 The Most Important Financial Statement Writing Obviously, there is no one most important financial statement Each is used for a different purpose While students may disagree on how well the individual financial statements fulfill the objectives for which they were designed, each financial statement provides valuable information Although it is a good exercise for students to be able to provide support for their most important financial statement, it is equally important for them to be able to identify the limitations of each of the financial statements Thus, make sure students also focus on identifying why they determined the other statements are not as important AA 2–66 Creating a Balance Sheet and Income Statement Cumulative Spreadsheet Project The solutions to the Cumulative Spreadsheet Project are in the Solutions Manual files in the Instructor’s Resource section of the Albrecht Web site at http://www.thomsonedu.com/accounting/albrecht In addition, the solutions can be found on the Instructor’s Resource CD-ROM, ISBN 0-324-64578-3 ... in order to help investors and others see the sources and uses of cash by major activity For example, if a company is not providing a net cash inflow from operations and instead has to borrow... which accounting data are compiled The entity is the focal point for accumulating, measuring, and communicating accounting data b Arm's-length transactions are those in which the buyer and seller... buyer and seller are rational and free to act independently Accounting for and analyzing economic Chapter transactions enable the accountant to measure the successes and failures of a reporting