Solutions Mod2

MBA Module 2 SM

Module 2

Constructing and Reporting Financial StatementsQUESTIONS

Q2-1.An asset is something that we own that is expected to provide future benefits. A Liability is a current obligation that will require a future sacrifice. Equity is the difference between assets and liabilities. It represents the claims of the companys owners to its income and assets. The following are some examples of each:Assets Cash

Receivables

Inventories

Plant, property and equipment

Liabilities Accounts payable

Accrued liabilities

Notes payable

Long-term debt

Equity Contributed capital (common and preferred stock)

Additional paid-in capital

Earned capital (retained earnings)

Treasury stock

Q2-2.The Revenue Recognition Principle stipulates that revenue should be recorded when it is earned. The Matching Principle tells us that expenses should be recorded when they are incurred. Neither the recognition of revenue nor that of expense necessarily involve the receipt or payment of cash. Revenue are recognized first. Then, the expenses incurred in order to generate those revenues are recognized in the same accounting period. That way, profit is correctly reported (e.g., not overstated nor understated).Q2-3.Accrual accounting entails the recognition of revenue under the Revenue Recognition Principle (record revenues when earned), and the recognition of expenses using the Matching Principle (record expenses when incurred). Q2-4.Transitory items are those that are not expected to reoccur. The objective of financial statement analysis is, generally, to predict future performance. Given that perspective, transitory (nonrecurring) items are not relevant except to the extent that they convey information about future financial performance. Q2-5.The Statement of Stockholders Equity provides information relating to all events which impact stockholders equity during the period. It contains information relating to stock sales and repurchases, dividends and other comprehensive income. Q2-6.The Statement of Cash Flows reports on cash inflows and outflows recognized during the period and categorizes them as operating, investing and financing activities. The income statement reports profit earned under accrual accounting, but does not provide sufficient information concerning cash flows. The Statement of Cash Flows fills that void. Q2-7.Articulation refers to the updating of the balance sheet (retained earnings) to reflect the profit earned during the period less the portion of that profit that is paid out to shareholders in the form of dividends. We can see clearly that all of the financial statements are linked and not separate.Q2-8.When a machine is purchased, its cost is recorded as an asset since it is owned and will provide future benefits. As the machine is used up, a portion of this cost is transferred from the balance sheet and into the income statement as (depreciation) expense. Assets are, thus, reduced (via the increase in accumulated depreciation (a contra-asset that reduces the carrying amount of the asset on the balance sheet), and Equity is reduced as the expense reduces net income and, therefore, Retained Earnings. This is the Matching Principle. It is critical to the proper recognition of profit. If the costs of the machine were expensed rather than capitalized, profit would be reduced considerably in the year of acquisition, and an inaccurately higher level of profit would be recorded in subsequent years as none of the machines cost would be matched against its revenues.

Q2-9.An asset must be owned and it must provide future benefits. Owning means we have title to the asset (some leased assets are also recorded on the balance sheet as we will discuss in our Module 9 entitled, Reporting and Analyzing Off-Balance-Sheet Financing). Future benefits may mean the future inflows of cash. Or, it could relate to some other benefit, like an increase in another asset or reduction of a liability.

Q2-10.Liquidity generally refers to cash. That is, how much cash do we have, how much cash is being generated, and how much cash can we raise quickly. Liquidity is essential to the survival of the business. After all, we can only pay our loans with cash and our employees will only accept cash for their wages.

Q2-11.Current means that the asset will be liquidated (converted to cash) or the liability is expected to be paid within the next year (or the operating cycle if longer than 1 year).

Q2-12.Historical costs are used by accountants because they are less subjective than using market values. Market values can be biased for two reasons: first, we may not be able to measure them accurately (consider our inability to accurately measure the market value of a production facility, for example), and second, managers may intervene in the reporting process to intentionally bias the results in order to achieve a particular objective (like enhancing the stock price).

Q2-13.Generally, unrecorded assets are those that contribute to our sustainable competitive advantage, but that cannot be measured accurately. Some examples include the value of a brand, the management of a company, employee morale, a strong supply chain, credibility with the financial markets, and so forth.

Q2-14.An intangible asset is an asset that we cannot touch. It has to meet the tests of an asset (e.g., we own it, and it will provide future benefits). Intangible assets are always acquired. Internally generated intangible assets are not recorded on the balance sheet. Some examples are goodwill, patents and trademarks, contractual agreements like royalties, leases, and franchise agreements. All of the intangible assets, though not recorded if internally generated, are recorded if purchased, as in an acquisition of another company, for example.

Q2-15.An accrued liability is a liability that generally has arisen without a transaction. Examples include wages that have been earned by employees and not yet paid, interest that has accrued on a bank loan, an environmental liability that has arisen because of our actions, and warranties we have given customers on the products that they have purchased. Generally, when the liability is recognized on the balance sheet, a corresponding expense is recognized in the income statement.

Q2-16.Accrued liabilities are recorded on the face of the balance sheet when they are deemed to be probable and can be estimated. If only one of these criteria is met, they are referenced in the footnotes only, and if neither is met they are not disclosed at all.

Q2-17.Net working capital = current assets current liabilities. Increasing the amount of trade credit (e.g., accounts payable to suppliers) increases current liabilities and reduces net working capital. As trade credit increases, we are using someone elses cash rather than our own. As a business grows, its net working capital grows as the growth of inventories and receivables are generally greater than that of accounts payable and accrued liabilities. Net working capital is an asset category that must be financed just like fixed assets.

Q2-18.Book value is the amount at which an asset (or liability) is carried on the balance sheet. The book value of the company is the sum of the book values of all of its assets and liabilities, that is, its stockholders equity. Book values are determined in accordance with GAAP. Market value is the sale price of an asset or liability. Markets are not constrained by GAAP standards and, therefore, can consider a number of factors that accountants cannot. Market values, therefore, generally differ significantly from book values.

MINI-EXERCISES

M2-19 (15 minutes)

a. Income statement

b. Balance sheet

c. Income statement

d. Balance sheet

e. Income statement

f. Balance sheet

g. Income statement

h. Balance sheet

i. Balance sheet

M2-20 (15 minutes)

a.Balance sheet

b.Income statementc.Balance sheetd.Income statemente.Balance sheetf.Balance sheetg.Balance sheet

h.Balance sheeti.Income statement

j.Income statement

k.Balance sheet

l.Balance sheet

M2-21 (20 minutes)

Net income computationService revenue (record when earned)

$100,000

Wage expense (record when incurred, even if unpaid)

(40,000) ($25,000 + $15,000)

Net income

$ 60,000

Net cash flow computationCash inflow from services rendered

$50,000 ($30,000 + $20,000)

Cash outflow for wages paid

(25,000)

Net cash inflow

$25,000

Cash inflow will be $50,000 less than net income less because only $50,000 of revenues were collected in cash. Cash inflow will be $15,000 more than net income because $15,000 less was spent for expenses than was incurred. The combined effects of these two items (less $50,000 and plus $15,000) yields an overall reduction of $35,000 net income to arrive at cash inflow of $25,000 ($60,000 net income - $35,000 net reduction = $25,000 cash inflows).

M2-22 (15 minutes)

a. A

b. L

c. E

d. A

e. A (referred to as contra asset)f. E

g. E

M2-23 (15 minutes)

20042005

Beginning retained earnings

$143,292$176,893

Add: Net income (loss)

83,601201,347

Less: Dividends

50,000 50,000

Ending retained earnings

$176,893$328,240

M2-24 (10 minutes)Kasznik Corporation

Statement of Retained Earnings

For Year Ended December 31, 2005Retained earnings, December 31, 2004

$100,000

Add: Net income

85,000

Less: Dividends

(30,000)

Retained earnings, December 31, 2005

$155,000

M2-25 (15 minutes)

20042005

Revenues

$350,000$ 0

Expenses

200,000 0

Net income

$150,000$ 0

Explanation: All of the revenue is reported in 2004 when it is earnedper the revenue recognition principle. Likewise, the expense is reported in 2004 when it is incurredper application of the matching principle. The receipt or payment of cash does not affect the recording of revenues, expenses, and net income.

M2-26 (15 minutes)

TransactionBalance SheetIncome Statement

Cash Asset+Noncash Assets=Liabi-lities+Contrib. capital+Retained EarningsRevenues Expenses

a. Issue stock for $1,000 cash1,0001,000(Common stock)

b. Purchase inventory for $500 cash-500500

(Inventory)

c. Sell inventory from b for $2,000 on credit2,000

(Accts Rec)

-500

(Inventory)2,000-5002,000

(Sales)-500

(COGS)

d. Receive $2,000 cash on receivable from c2,000-2,000

(Accts Rec)

EXERCISES

E2-27 (20 minutes)Barth Corporation

Income Statement

For Year Ended December 31, 2005

Sales revenue

$400,000

Expenses

Cost of goods sold

$180,000

Wages expense

40,000

Supplies expense

6,000

Total expenses

226,000

Net income

$174,000

Barth Corporation

Balance Sheet

December 31, 2005

AssetsLiabilities and equity

Cash

$48,000Accounts payable

$ 16,000

Accounts receivable

30,000Bonds payable

200,000

Supplies

3,000Total liabilities

216,000

Inventory

36,000

Land

80,000Common stock

150,000

Equipment

70,000Retained earnings

60,000

Patents

8,000Total equity

210,000

Buildings

151,000

Total assets

$426,000Total liabilities and equity

$426,000

E2-28 (15 minutes)

Income statementBalance sheet

Sales

$30,000Cash

$ 0

Wage expense

12,000Accounts receivable

30,000

Net income (loss)

$18,000Total assets

$30,000

Wages payable

$12,000

Retained earnings

18,000

Total liabilities and equity

$30,000

E2-29 (30 minutes)

Demers Company

Income Statement

For Month Ended March 31

Sales revenue

$18,000($4,000 + $14,000)

Expenses

Rent expense

$3,200

Wage expense

4,800 8,000

Net income

$10,000

E2-30 (15 minutes)

The personal balance sheet will be unique to each individual student.The personal balance sheet will most noticeably differ from those in the Module in the area of equity. That is, the Module presented corporations that involved contributed capital and earned capital accounts. However, a personal balance sheet simply reports owners equity.

E2-31 (15 minutes)Proctor & Gamble ($ millions)AmountClassification

Sales

$ 43,373I

Accumulated depreciation

10,438B

Depreciation expense

1,703I

Retained earnings

11,686B

Net income

5,186I

Property, plant and equipment

13,104B

Selling, general and admin expense

13,009I

Accounts receivable

3,038B

Total liabilities

27,520B

Stockholders' equity

16,186B

E2-32 (15 minutes)

Target Corp ($ millions)AmountClassification

Sales

$ 48,163I


6,178B


1,320I

Retained earnings

9,648B

Net income

1,841I

Property, plant & equipment

16,969B

Selling, general & admin expense

11,534I

Accounts receivable

5,776B

Total liabilities

20,327B


11,065B

E2-33 (15 minutes)

Briggs & Stratton ($ millions)AmountClassification

Sales

$ 1,658I


506B


64I

Retained earnings

821B

Net income

81I


371B


178I

Accounts receivable

202B

Total liabilities

960B


515B

E2-34 (15 minutes)

Kimberly Clark ($ millions)AmountClassification

Sales

14,348I


6,916B


759I

Retained earnings

9,494B

Net income

1,694I


8,263B


2,376I

Accounts receivable

1,955B

Total liabilities

10,014B


6,766B

E2-35 (15 minutes)

YUM Brands ($ millions)AmountClassification

Sales

8,380I


2,326B


401I

Retained earnings

204B

Net income

617I


3,280B


973I

Accounts receivable

169B

Total liabilities

4,500B


1,120B

Exercise 2-36 (15 minutes)


Cash Asset+Noncash Assets=Liabi-lities+Contrib capital+Retained EarningsRevenues- Expenses

a. $500 of employee wages are earned but not yet paid+500

(wages payable)-500 - 500

(wage expense)

b. $2,000 of inventory is purchased on credit+2,000

(inventory)+2,000

(accounts payable)

c. The inventory purchase in b is sold for $3,000 on credit+3,000

(accounts receivable)

-2,000

(inventory)+3,000

-2,000+3,000

(sales)

- 2,000

(cost of goods sold)

d. Collected $3,000 cash from the transaction c+3,000-3,000

(accounts receivable)

e. $5,000 of equipment is acquired for cash-5,000+5,000

(Equipment)

f. Record depreciation of $1,000 on equipment from transaction e-1,000

Equipment, net*-1,000 - 1,000

(depreciation expense)

g. Paid $10,000 on a note payable that came due-10,000-10,000

(note payable)

h. Paid $2,000 cash interest on borrowings-2,000-2,000 - 2,000

(interest expense)

*Equipment, net is Equipment, gross less Accumulated Depreciation.

PROBLEMS

P2-37 (20 minutes)

a.

ANFJWN

Total assets

$1,199$4,466

Total expenses (sales net income)

1,4011,503

Total expenses as percent of sales

87.8%

($1,401/$1,596)88.0%

(1,503/$1,708)

b.

ANFJWN

Return on average assets

$195/[($1,199+$995)/2

=17.8%$205/[($4,466+4,096)/2]

=4.8%

c.

ANFJWN

Profit margin$195/$1,596=12.2%$205/$1,708=12.0%

Asset turnover$1,596/[($1,199+$995)/2=1.46$205/[($4,466+4,096)/2]=0.40

Interpretation. Although the net profit margins of the two companies are comparable, JWNs asset turnover rate is markedly less than ANFs and this is the primary reason for its lower return on average assets. P2-38 (30 minutes)a.

3MCurrent AssetsLong-term AssetsTotal AssetsCurrent LiabilitiesLong-term LiabilitiesTotal LiabilitiesStockholders' Equity

1999$6,066 $7,830 $13,896 $3,819 $3,788 $7,607 $6,289

20006,379 8,143 14,522 4,754 3,237 7,991 6,531

20016,296 8,310 14,606 4,509 4,011 8,520 6,086

20026,059 9,270 15,329 4,457 4,879 9,336 5,993

20037,720 9,880 17,600 5,082 4,633 9,715 7,885

b.3Ms current assets most likely include cash, accounts receivable, inventories, and prepaid assets.Its long-term assets most likely include property, plant and equipment (PPE), goodwill, and other intangible assets that have arisen from acquisitions.P2-39 (30 minutes)a.Abercrombie & FitchCurrent AssetsLong-term AssetsTotal AssetsCurrent LiabilitiesLong-term LiabilitiesTotal LiabilitiesStockholders' Equity

2000$300 $158 $ 458 $138 $ 9 $147 $311

2001304 284 588 155 10 165 423

2002405 365 770 163 12 175 595

2003601 394 995 211 34 245 750

2004753 446 1,199 280 48 328 871

b.We might reasonably predict inventories to comprise the bulk of its current assets. In reality, ANFs largest current asset is cash and short-term investmentssuggesting that the company is very liquid. c.In fiscal year 2000, current assets comprised 66% ($300/$458) of total assets. In fiscal year 2004, current assets comprised 63% ($753/$1,199). Thus, the company has slightly less (more) current (long-term) assets as a percentage of total assets than it did 5 years ago.

d.Yes, the company is conservatively financed. Specifically, stockholders equity comprises 73% ($871/$1,199) of its total capitalization.P2-40 (30 minutes)

a.Albertsons Inc.Current AssetsLong-term AssetsTotal AssetsCurrent LiabilitiesLong-term LiabilitiesTotal LiabilitiesStockholders' Equity

2000$4,582 $11,119 $15,701 $4,055 $5,944 $ 9,999 $5,702

20014,300 11,778 16,078 3,395 6,989 10,384 5,694

20024,609 11,358 15,967 3,582 6,470 10,052 5,915

20034,268 10,943 15,211 3,448 6,566 10,014 5,197

20044,419 10,975 15,394 3,685 6,328 10,013 5,381

b. For a grocery chain like Albertsons we would reasonably predict that inventories and cash to be the predominant items in current assets, with minimal receivables. The reality is that is that inventories is not a large dollar amount as the companys business model depends on high inventory turnoverthat is, it works diligently to minimize the quantity of inventory so as to keep it fresh. Long-term assets are primarily concentrated in property, plant and equipment (PPE). c. No, its stockholders equity represents 35% ($5,381/$15,394) of its total capitalization. Although its dependence on debt financing is not extreme, its equity capital does not represent a large proportion of total capitalization relative to many other companies (see P2-39, for example).P2-41 (30 minutes)

a.Harley-Davidson, Inc.Current AssetsLong-term AssetsTotal AssetsCurrent LiabilitiesLong-term LiabilitiesTotal LiabilitiesStockholders' Equity

1999$ 949 $1,163 $2,112 $518 $ 433 $ 951 $1,161

20001,297 1,139 2,436 498 533 1,031 1,405

20011,665 1,453 3,118 716 646 1,362 1,756

20022,067 1,794 3,861 990 638 1,628 2,233

20032,729 2,194 4,923 956 1,009 1,965 2,958

b.Harleys current assets are likely to be comprised of cash, accounts receivable, inventories and prepaid expenses.

Its long-term assets will likely be comprised of property, plant and equipment (PPE) for its manufacturing operations and goodwill and other intangible assets arising from acquisitions.c.Yes, stockholders equity represents 60% of total capitalization and the company utilizes somewhat less debt financing than the average publicly traded company (that being about 50% of equity).P2-42 (30 minutes)

a.Microsoft, Inc.Current AssetsLong-term AssetsTotal AssetsCurrent LiabilitiesLong-term LiabilitiesTotal LiabilitiesStockholders' Equity

1999$20,233 $16,923 $37,156 $ 8,718 $ 0 $ 8,718 $28,438

200030,308 21,842 52,150 9,755 1,027 10,782 41,368

200139,637 19,620 59,257 11,132 836 11,968 47,289

200248,576 19,070 67,646 12,744 2,722 15,466 52,180

200358,973 20,598 79,571 13,974 4,577 18,551 61,020

b.Microsoft has a considerable amount of current assets in marketable securities. In fact, nearly $50 billion of its current assets in 2003 is comprised of marketable securities. The company paid out much of that investment balance as a special dividend and stock repurchase in 2004.c.Microsoft is very conservatively financed with 77% ($61,020/$79,571) of its total capitalization (assets) financed by equity. The high proportion of equity financing is due to Microsofts high level of profitability and consequent retained earnings.P2-43 (30 minutes)

a.Nike, Inc.SalesCost of Goods SoldGross ProfitOperating ExpensesOperating IncomeNonoperating ExpensesNet

Income

1999$ 8,777 $5,295 $3,482 $2,645 $ 837 $386 $451

20008,995 5,216 3,779 2,813 966 387 579

20019,489 5,588 3,901 2,903 998 408 590

20029,893 5,781 4,112 3,060 1,052 389 663

200310,697 6,074 4,623 3,377 1,246 772 474

b.The gross profit percentage (also called gross profit margin) for each year follows:Nike, Inc.Gross Profit Percentage

19990.397

20000.420

20010.411

20020.416

20030.432

Nikes gross profit has fluctuated over this period and it somewhat higher in 2003 than it has been in earlier yearswhich may reflect a slight upward trend.c.Cost of goods sold, wages, and advertising expenses are likely to be the major cost categories for Nike.

P2-44 (30 minutes)

a.Starbucks, Inc.SalesCost of Goods SoldGross ProfitOperating ExpensesOperating IncomeNonoperating ExpensesNet

Income

1999$1,680 $1,336 $344 $187 $157 $ 55 $102

20002,169 1,737 432 240 192 97 95

20012,649 2,082 567 315 252 71 181

20023,289 2,598 691 390 301 86 215

20034,075 3,207 868 482 386 118 268

b.The gross profit percentage (also called gross profit margin) for each year follows:

Starbucks, Inc.Gross Profit Percentage

19990.205

20000.199

20010.214

20020.210

20030.213

SBUX gross profit percentage has been fairly constant, with a possible slightly increasing trend, over the past five years.c.Cost of goods sold, wages, and advertising expenses are likely to be major cost categories for SBUX.

P2-45 (30 minutes)

a.Target CorporationSalesCost of Goods SoldGross ProfitOperating ExpensesOperating IncomeNonoperating ExpensesNet

Income

2000$33,702 $23,029 $10,673 $ 8,344 $2,329 $1,185 $1,144

200136,903 25,295 11,608 9,130 2,478 1,214 1,264

200239,888 27,246 12,642 9,895 2,747 1,379 1,368

200343,917 29,260 14,657 11,393 3,264 1,610 1,654

200448,163 31,790 16,373 12,854 3,519 1,678 1,841

b.The gross profit percentage (also called gross profit margin) for each year follows:

Target CorporationGross Profit Percentage

20000.317

20010.315

20020.317

20030.334

20040.340

TGTs gross profit percentage has increased substantially over the past five years.c.Cost of goods sold, wages, and advertising expenses are likely to be the major cost categories for Target Corporation.

P2-46 (25 minutes)


Cash Asset+Noncash Assets=Liabi-lities+Contrib capital+Retained EarningsRevenues- Expenses

a. Received $100,000 cash for common stock and borrowed $50,000 cash+150,000+50,000

Note Payable+100,000

Common Stock

b. Purchased $50,000 of equipment, paying $10,000 cash and $40,000 note payable10,000+50,000

Equipment+40,000

Note Payable

c. $80,000 of inventory is purchased for cash80,000+80,000

Inventory

d. $70,000 of inventory purchased in c is sold for $60,000 in cash sales and $40,000 in credit sales+60,000+40,000

Accounts Receivable

70,000

Inventory+100,000

70,000+100,000

Sales

70,000

Cost ofGoods Sold

e. Paid $10,000 cash for future advertising time10,000+10,000

Prepaid Advertising

f. $7,500 of the advertising time in e is aired7,500

Prepaid Advertising7,500 7,500

Advertising Expense

g. Employees paid $15,000 cash in wages15,00015,000 15,000

Wages

Expense

h. Employees earn $1,000 in wages not yet paid+1,000

Wages

Payable1,000 1,000

Wages

Expense

i. Record depreciation of $2,000 on equipment2,000

Equipment, net*2,000 2,000

Depreciation Expense

Totals+95,000+100,500+91,000+100,000+4,500+100,000 95,500

*Equipment, gross less Accumulated Depreciation.P2-47 (20 minutes)

AniFoods, Inc.

Income Statement

For Month Ended March 31

Sales

$100,000

Cost of goods sold

(70,000)

Gross profit

30,000

Advertising expense

(7,500)

Wage expense

(16,000)


(2,000)

Net income

$ 4,500

AniFoods, Inc.

Balance Sheet

March 31

Cash

$ 95,000Wages payable

$ 1,000

Accounts receivable

40,000Note payable (to owner)

50,000

Inventory

10,000Note payable (to vendor)

40,000

Prepaid advertising

2,500Total liabilities

91,000

Equipment, gross

50,000

Accumulated deprec

(2,000)Common stock

100,000

Equipment, net

48,000Retained earnings

4,500

Total assets

$195,500Total liabilities and equity

$195,500

P2-48A (30 minutes)

a.Cash

100,000

Common Stock

100,000

Cash

50,000

Note Payable

50,000

Note: It is also acceptable to record these two entries as one entry.

b.Equipment

50,000

Cash

10,000

Note Payable

40,000

c.Inventory

80,000

Cash

80,000

d.Cash

60,000

Accounts Receivable

40,000

Sales

100,000

Cost of Goods Sold

70,000

Inventory

70,000

e.Prepaid Advertising

10,000

Cash

10,000

f.Advertising Expense

7,500

Prepaid Advertising

7,500

g.Wages Expense

15,000

Cash

15,000

h.Wages Expense

1,000

Wages Payable

1,000

i.Depreciation Expense

2,000

Accumulated Depreciation--Equipment

2,000

P2-49B (20 minutes)

Cash flows from operating activities

Net income

$135,000

Adjustments to reconcile net income to operating cash flow

Depreciation

$25,000

Accounts receivable increase

(10,000)

Prepaid expense decrease

3,000

Accounts payable increase

6,000

Wages payable decrease

(4,000)

Gain on sale of assets

(5,000) 15,000

Net cash provided from operating activities

$150,000

Cambridge Business Publishers, 2006

2Financial Accounting for MBAs, 2nd Edition

Cambridge Business Publishers, 2006

1Solutions Manual, Module 2

Documents

Solutions Mod2