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Solutions Manual

CHAPTER 11

UNDERSTANDING FINANCIAL STATEMENTS

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. The four financial statements contained in most annual reports are the
balance sheet statement, statement of comprehensive income, statement
of stockholders equity, and statement of cash flows.

2. Bankers and investors use financial statements to make intelligent


decisions about what firms to extend credit or in which to invest,
managers need financial statements to operate their businesses
efficiently, and taxing authorities need them to assess taxes in a
reasonable way.

3. No, because the 20 million of retained earnings would probably not be


held as cash. The retained earnings figure represents the reinvestment of
earnings by the firm over its life. Consequently, the 20 million would
be an investment in all of the firms assets.

4. The balance sheet shows the firms financial position on a specific date,
for example, December 31, 2011. It shows each account balance at that
particular point in time. For example, the cash account shown on the
balance sheet would represent the cash the firm has on hand and in the
bank on December 31, 2011. The income statement, on the other hand,
reports on the firms operations over a period of time, for example, over
the last 12 months. It reports revenues and expenses that the firm has
incurred over that particular time period. For example, the sales figures
reported on the income statement for the period ending December 31,
2011, would represent the firms sales over the period from January 1,
2011, through December 31, 2011, not just sales for December 31, 2011.

5. Investors need to be cautious when they review financial statements.


While companies are required to follow the financial reporting standard,
managers still have quite a lot of discretion in deciding how and when to
report certain transactions. Consequently, two firms in exactly the same
operating situation may report financial statements that convey different

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impressions about their financial strength. Some variations may stem


from legitimate differences of opinion about the correct way to record
transactions. In other cases, managers may choose to report numbers in a
way that helps them present either higher earnings or more stable
earnings over time. As long as they follow the financial reporting
standard, such actions are not illegal, but these differences make it harder
for investors to compare companies and gauge their true performances.

Unfortunately, there have also been cases where managers overstepped


the bounds and reported fraudulent statements. Indeed, a number of
high-profile executives have faced criminal charges because of their
misleading accounting practices.

6. The earnings (less dividends) reported in the income statement is


transferred to the ownership section of the balance sheet as retained
earnings. Thus, what we earn in the income statement becomes part of
the ownership interest in the balance sheet.

7. The balance sheet is based on historical costs. When prices are rising
rapidly, historical cost data may lose much of their meaning particularly
for plant, equipment and inventory.

8. The income statement and balance sheet are based on the accrual method
of accounting, which attempts to match revenues and expenses in the
period in which they occur. However, accrual accounting does not
attempt to properly assess the cash flow position of the firm. The
statement of cash flows fulfills this need.

9. The three primary sections of the statement of cash flows are:

a) Cash flows from operating activities

b) Cash flows from investing activities

c) Cash flows from financing activities

The payment of cash dividends falls into the financing activities


category.

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10. Free cash flow is equal to cash flow from operating activities:

Minus: Capital expenditures required to maintain the productive


capacity of the firm

Minus: Dividends (required to maintain the payout on common


stock and to cover any preferred stock obligation)

The analyst or banker normally looks at free cash flow to determine


whether there are sufficient excess funds to pay back the loan associated
with the leveraged buy-out.

11. Interest expense is a tax deductible item to the corporation, while


dividend payments are not. The net cost to the corporation of interest
expense is the amount paid multiplied by the difference of one minus the
applicable tax rate.

12. CURRENT (C) ; NONCURRENT (NC)

Retained earnings NC Bonds payable NC


Accounts payable C Accrued wages payable C
Prepaid expenses C Accounts receivable C
Plant and equipment NC Capital in excess of par NC
Inventory C Preferred stock NC
Common stock NC Marketable securities C

13. Sales
Cost of Goods Sold
Gross profit
Selling and administrative expense
Depreciation expense
Operating profit
Interest expense
Earnings before taxes
Taxes
Earnings after taxes
Preferred stock dividends
Earnings Available to Common Stockholders
Shares Outstanding
Earnings per share

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14.
Increase in accounts receivable Decreases cash flow (use)
Increase in notes payable Increases cash flow (source)
Depreciation expense Increases cash flow (source)
Increase in investments Decreases cash flow (use)
Decrease in accounts payable Decreases cash flow (use)
Decrease in prepaid expenses Increases cash flow (source)
Increase in inventory Decreases cash flow (use)
Dividend payment Decreases cash flow (use)
Increase in accrued expenses Increases cash flow (source)

15.
1. Balance Sheet (BS) 5. Current Liabilities (CL)
2. Income Statement (IS) 6. Long-term Liabilities (LL)
3. Current Assets (CA) 7. Stockholders Equity (SE)
4. Fixed Assets (FA)

Indicate whether If on Balance Item


Items is on Sheet,
Balance Sheet Designate
(BS) or Income which
Statement (IS) Category
BS SE Retained earnings
IS Income tax expense
BS CA Accounts receivable
BS SE Common stock
BS SE Capital in excess of par value
BS LL Bonds payable
BS CL Notes payable
IS Net income
IS Selling and administrative expenses
BS CA Inventories
BS CL Accrued expenses
BS CA Cash
BS FA Plant and equipment
IS Sales
IS Operating expenses
BS CA Marketable securities
BS CL Accounts payable
IS Interest expense

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BS CL Income tax payable


II. Problems

Problem 1 (Balance Sheet)

From the data given in the problem, we know the following:

Current assets 500,000 Accounts payable and


accruals 100,000
Net plant and Notes payable 150,000
equipment 2,000,000 Current liabilities 250,000
Long-term debt 750,000
Total common equity 1,500,000
Total liabilities and
Total assets 2,500,000 equity 2,500,000

a. We are given that the firms total assets equal 2,500,000. Since
both sides of the balance sheet must equal, total liabilities and equity
must equal total assets = 2,500,000.

b. Total assets = Current assets + Net plant and equipment


2,500,000 = Current assets + 2,000,000
Current assets = 2,500,000 2,000,000
Current assets = 500,000

c. Total liabilities and equity = Current liabilities + Long-term debt +


Total common equity
2,500,000 = Current liabilities + 750,000 + 1,500,000
2,500,000 = Current liabilities + 2,250,000
Current liabilities = 2,500,000 2,250,000
Current liabilities = 250,000

d. Current liabilities = Accounts payable and accruals + Notes payable


250,000 = Accounts payable and accruals + 150,000
Accounts payable and accruals = 250,000 150,000
Accounts payable and accruals = 100,000

e. Net working capital = Current assets Current liabilities


Net working capital = 500,000 250,000
Net working capital = 250,000

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f. Net operating working capital = Current assets (Current liabilities


Notes payable)
Net operating working capital = 500,000 (250,000 150,000)
Net operating working capital = 400,000

Problem 2 (Statement of Stockholders Equity)

NI = 50,000,000; R/EY/E = 810,000,000; R/EB/Y = 780,000,000;


Dividends = ?

R/EB/Y + NI Div = R/EY/E


780,000,000 + 50,000,000 Div = 810,000,000
830,000,000 Div = 810,000,000
20,000,000 = Div.

Problem 3 (Book Value and P/E ratio)

Jennifers Apparel

a. Total assets 800,000


Current liabilities 150,000
Long-term liabilities 120,000
Stockholders equity 530,000
Preferred stock 65,000
Net worth assigned to common 465,000

Common shares outstanding 30,000

Book value (net worth) per share 15.50

b. Earnings available to common 48,000


Shares outstanding 30,000
Earnings per share 1.60

P/E ratio x Earnings per share = Price


15 x 1.60 = 2400

c. Market value per share (price) to Book value per share

24.00 15.50 = 1.55

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d. 2 x Book value per share = Price


2 x 15.50 = 31.00

Price
= P/E
Earnings per share

31.00
= 19.375 P/E ratio round to 19
1.60

Problem 4 (Determination of Profitability)

Red Book Inc.


Statement of Comprehensive Income

Sales (1,300 books at 650 each) 845,000


Cost of goods sold (1,300 books at 450 each) 585,000
Gross Profit 260,000
Selling expense 20,000
Depreciation expense 60,000
Operating profit 180,000
Interest expense 35,000
Earnings before taxes 145,000
Taxes @ 20% 29,000
Earnings after taxes 116,000

Problem 5 (Determination of Profitability)

Toyota Auto Shop


Statement of Comprehensive Income

a. Sales 700,000
Cost of goods sold (70% of sales) 490,000
Gross profit 210,000
Selling and administrative expense
(12% of sales) 84,000
Depreciation 10,000
Operating profit 116,000
Interest expense 8,000
Earnings before taxes 108,000
Taxes @ 30% 32,400

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Earnings after taxes 75,600


b. Sales 750,000
Cost of goods sold (66% of sales) 495,000
Gross profit 255,000
Selling and administrative expense
(14% of sales) 105,000
Depreciation 10,000
Operating profit 140,000
Interest expense 15,000
Earnings before taxes 125,000
Taxes @ 30% 37,500
Earnings after taxes 87,500

Analysis: Ms. Lims idea will increase profitability.

Problem 6 (Determination of Earnings and Earnings per Share)

Angelique Corporation

a. Retained earnings, Dec. 31, 2012 450,000


Less: Retained earnings, Dec. 31, 2011 400,000
Change in retained earnings 50,000
Add: Common stock dividends 25,000
Earnings available to common stockholders 75,000

75,000
b. Earnings per share = = 3.75 per share
20,000 shares

Problem 7 (Construction of Income Statement and Balance Sheet)

Shadow Corporation
2012 Income Statement

a. Sales 220,000
Cost of goods sold (60%) 132,000
Gross profit 88,000
Selling and administrative expense 22,000
Depreciation expense (8%) 20,0001
Operating profit (EBIT) 46,000
Interest expense 8,0002
Earnings before taxes 38,000

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Taxes (20%) 7,600


1
8% x 250,000 = 20,000 Earnings after taxes (EAT) 30,400
2
(10% x 20,000) + (12%Preferred
x 50,000) stock dividends
= 8,000 2,000
Earnings available to common stockholder 24,800

Shares outstanding 10,000

Earnings per share 2.84

Shadow Corporation
2012 Statement of Retained Earnings

b. Retained earnings balance, Jan. 1, 2011 80,000


Add: Earnings available to common
stockholders, 2011 28,400
Deduct: Cash dividend declared in 2011 8,400
Retained earnings balance, Dec. 31, 2012 100,000

Shadow Corporation
2012 Balance Sheet

c. Assets
Current assets
Cash 10,000
Accounts receivable 16,500
Inventory 27,500
Prepaid expenses 12,000
Total current assets 66,000
Fixed assets
Gross plant 285,000
Accumulated depreciation (70,000)3
Net plant 215,000
Total assets 281,000

Liabilities and Owners equity


Liabilities:
Accounts payable 15,000
Notes payable 26,000
Bonds payable 40,000

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Total liabilities 81,000


Owners equity:
3
50,000 + 20,000 = 70,000
Common stock 75,000
Paid in capital in excess of par 25,000
Retained earnings 100,000
Total equity 200,000
Total liabilities and equity 281,000

Problem 8 (Statement of Cash Flows)

Maris Corporation
Statement of Cash Flows
For the Year Ended December 31, 2012

Cash flows from operating activities:


Net income (earnings after taxes) 250,000
Adjustments to determine cash flow
from operating activities:
Add back depreciation 230,000
Increase in accounts receivable (10,000)
Increase in inventory (30,000)
Decrease in prepaid expenses 30,000
Increase in accounts payable 250,000
Decrease in accrued expenses (20,000)
Total adjustments 450,000
Net cash flows from operating activities 700,000

Cash flows from investing activities:


Decrease in investments 10,000
Increase in plant and equipment (600,000)
Net cash flows from investing activities (590,000)

Cash flows from financing activities:


Increase in bonds payable 60,000
Preferred stock dividends paid (10,000)
Common stock dividends paid (140,000)
Net cash flows from financing activities (90,000)

Net increase (decrease) in cash flows 20,000

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Analysis: It should be observe that the increase in cash flows of 20,000


equals the 20,000 change in the cash account on the balance
sheet. This indicates the statement is correct.

a. Cash flows from operating activities far exceeds net income.


This occurs primarily because we add back depreciation of
230,000 and accounts payable increase by 250,000. Thus,
the reader of the cash flow statement gets important insights as
to how much cash flow was developed from daily operations.

b. The buildup in plant and equipment of 600,000 (gross) and


370,000 (net) has been financed, in part, by the large increase
in accounts payable (250,000). This is not a very satisfactory
situation. Short-term sources of funds can always dry up while
fixed asset needs are permanent in nature. The firm may wish
to consider more long-term financing such as a mortgage, to go
along with profits, the increase in bonds payable and the add
back of depreciation.

c. The book value per common share for both 2011 and 2012 are:

Book value Stockholders equity Preferred stock


=
per share Common shares outstanding

Book value per (1,390,000 90,000)


=
share (2011) 150,000

1,300,000
=
150,000

(2011) = 8.67

Book value per (1,490,000 90,000)


=
share (2012) 150,000

1,400,000
=
150,000

(2012) = 9.33

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d. The firms P/E ratio for 2012 is:

Market value = 2.8 x 9.33 = 26.12

P/E ratio = 26.12 1.60 = 16.325 round to 16

Problem 9 (Preparing a Balance Sheet)

SM Farms
Balance Sheet
September 30, 2012

a. Assets
Cash 16,710
Accounts receivable 22,365
Land 550,000
Barns and sheds 78,300
Citrus trees 76,650
Livestock 120,780
Irrigation system 20,125
Farm machinery 42,970
Fences and gates 33,570
Total assets 961,470

Liabilities and Owners equity


Liabilities:
Notes payable 530,000
Accounts payable 77,095
Property taxes payable 9,135
Wages payable 1,820
Total liabilities 618,050
Owners equity:
Share capital 250,000
Retained earnings* 93,420
Total liabilities and equity 961,470

b. The loss of an asset, barns and Sheds, from a typhoon would


cause a decrease in total assets. When total assets are decreased,
the balance sheet total of liabilities and equity must also
decrease. Since there is no change in liabilities as a result of the
*
Total assets, 961,470, minus total liabilities, 618,050, less share capital, 250,000.

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destruction of an asset, the decrease on the right hand side of the


balance sheet must be in the retained earnings account. The
amount of the decrease in Barns and Sheds, in the equity, and in
both balance sheet totals is 23,800.

Problem 10 (Preparing a Balance Sheet and Cash Flow Statement;


Effects of Business Transactions)

The Tasty Bakery


Balance Sheet
August 1, 2012

a. Assets Liabilities and Owners equity


Cash 6,940 Liabilities:
Accounts Notes payable 74,900
receivable 11,260 Accounts
Supplies 7,000 payable 16,200
Land 67,000 Salaries payable 8,900
Building 84,000 Total liabilities 100,000
Equipment Equity:
and fixtures 44,500 Share capital 80,000
Retained earnings 40,700
Total liabilities
Total assets 220,700 and owners equity 220,700

The Tasty Bakery


Balance Sheet
August 3, 2012

b. Assets Liabilities and Owners equity


Cash 14,490 Liabilities:
Accounts Notes payable 74,900
receivable 11,260 Accounts
Supplies 8,250 payable 7,200
Land 67,000 Salaries payable 8,900
Building 84,000 Total liabilities 91,000
Equipment Equity:
and fixtures 51,700 Share capital 105,000
Retained earnings 40,700
Total liabilities
Total assets 236,700 and owners equity 236,700

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Chapter 11 Understanding Financial Statements

The Tasty Bakery


Statement of Cash Flows
For the Period August 1 3, 2012

Cash flows from operating activities:


Cash payment of accounts payable (16,200)
Cash purchase of supplies (1,250)
Cash used in operating activities (17,450)

Cash flows from investing activities:


None

Cash flows from financing activities:


Sale of share capital 25,000

Increase in cash 7,550


Cash balance, August 1, 2012 6,940
Cash balance, August 3, 2012 14,490

c. The Tasty Bakery is in a stronger financial position on August 3 than


it was on August 1.

On August 1, the highly liquid assets (cash and accounts receivable)


total only 18,200 but the company has 25,100 in debts due in the
near future (accounts payable plus salaries payable).

On August 3, after additional infusion of cash from the sale of stock,


the liquid assets total 25,750, and debts due in the near future
amount to 16,100.

Note to Instructor: The analysis of financial position strength in


requirement (c) is based solely upon the balance sheets at August 1
and August 3. Hopefully, students will raise many legitimate issues
regarding necessity of information about operations, rate at which
cash flows into the business, etc. In this problem, the improvement in
financial position results solely from the sale of share capital.

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Problem 11 (Preparing Financial Statements; Effects of Business


Transactions)

The First Malt Shop


Balance Sheet
September 30, 2012

a. Assets Liabilities and Owners equity


Cash 7,400 Liabilities:
Accounts Notes payable* 70,000
receivable 1,250 Accounts
Supplies 3,440 payable 8,500
Land 55,000 Total liabilities 78,500
Building 45,500 Equity:
Furniture Share capital 50,000
and fixtures 20,000 Retained earnings 4,090
Total liabilities
Total assets 132,590 and owners equity 132,590

*Total assets, 132,590, less equity, 54,090, less accounts payable,


8,500, equals notes payable.

The First Malt Shop


Balance Sheet
October 6, 2012

b. Assets Liabilities and Owners equity


Cash 29,400 Liabilities:
Accounts Notes payable 70,000
receivable 1,250 Accounts
Supplies 4,440 payable 18,000
Land 55,000 Total liabilities 88,000
Building 45,500 Equity:
Furniture Share capital 80,000
and fixtures 38,000 Retained earnings 5,590
Total liabilities
Total assets 173,590 and owners equity 173,590

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Chapter 11 Understanding Financial Statements

The First Malt Shop


Income Statement
For the Period October 1 6, 2012

Revenues 5,500
Expenses (4,000)
Net income 1,500

The First Malt Shop


Statement of Cash Flows
For the Period October 1 6, 2012

Cash flows from operating activities:


Cash received from revenues 5,500
Cash paid for expenses (4,000)
Cash paid for accounts payable (8,500)
Cash for paid supplies (1,000)
Cash used in operating activities (8,000)

Cash flows from investing activities:


None

Cash flows from financing activities:


Cash received from sale of share capital 30,000

Increase in cash 22,000


Cash balance, October 1, 2012 7,400
Cash balance, October 6, 2012 29,400

c. The First Malt Shop is in a stronger financial position on October 6


than on September 30. On September 30, the company had highly
liquid assets (cash and accounts receivable) of 8,650, which barely
exceeded the 8,500 in liabilities (accounts payable) due in the near
future. On October 6, after the additional investment of cash by
shareholders, the companys cash alone exceeded its short-term
obligations.

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