True or False

1. The income statement measures the changes in the assets and liabilities that occurred
during the period. False
2. The income statement measures the results of operations for a period. True
3. The income statement measures the financial position of a firm for a period. False
4. Common size income statement provides intermediate profit measures. False
5. Common size income statement groups revenues together and then deducts all categories
to arrive at net earnings. False
6. Common size income statement expresses each item on an income statement as a
percentage of net sales. True
7. Common size income statement includes all changes of equity during a period. False
8. The gross profit margin and cost of goods sold percentage are complements of each
other. False
9. Repairs and maintenance expenses are depreciated in the same manner as depreciation
expense. False
10. The operating profit figure includes all operating revenues and expenses as well as
interest and taxes related to operation. False
11. Gross profit is the difference between net sales and cost of goods sold. True
12. Operating profit is the difference between net sales and expenses associated with
generating sales including interest expenses. False
13. Earnings per share figure calculated by dividing the average number of common stock
shares outstanding into the net earnings available to common stockholders. True

MCQS:

1)
Why is it important to evaluate the operating expenses?
a. increases in operating expenses may indicate inefficiencies, and decreases in operating
expenses may be detrimental to long-term sales growth.
b. it is important to determine whether companies are spending at least 10 cents of every sales
dollar on advertising expenses.
c. Increases in operating expenses are always an indication that a firm will increase sales in the
future.
d. None of the above.

2)
Which of the following assets will not be depreciated over its service life?
a. Buildings.
b. Furniture
c. Land
d. Equipment

3)
Why is the figure for operating profit important?
a. Because it is used for calculating federal income tax expense.
b. Because it provides a basis for assessing the success of a company apart from its financing and
investment activities and separate from its tax.
c. Because it provides a basis for assessing the wealth of a firm.
d. All of the above.

4)
Which of the following causes(s) a change in the retained earnings account balance?
a. Prior earning adjustment
b. payment of dividends
c. Net profit or loss
d. All of the above

5)
Which of the following statements is correct in regard to the stockholders’ equity statement?
a. it is the same as retained earnings statement.
b. it is the statement that only reconciles only the treasury stock account.
c. it is a statement that summarizes changes in the entire stockholders’ equity section of the
balance sheet.
d. None of the above

6)
Sales allowances are categorized in the net income statement under:
a. Cost of sales
b. Other revenue
c. Net Sales
d. None of the above

7)
Sales will increase or decrease if:
a. The amount of units sold increases or decreases
b. The price at which the product or service is sold increases or decreases.
c. A and B
d. None of the above

8)
Gross profit margin can increase or decrease as a result of:
a. A change in sales prices,
b. A change in cost of goods sold,
c. A change in volume.
d. All of the above
Question One:
Consider the following items from the net income. Prepare the multiple-step income statement
for Segma Company.

What are the ratios of profit margins?

Net Sales $1,840,000

Interest expense 16,000
Equity losses 9,000
Gain on sale of equipment 15,000
Depreciation expense 24,000
Selling expenses 270,000
Insurance 60,000
Rent 40,000
Cost of goods sold 1,072,000
Salaries 55,000
Interest income 13,000
Income tax expense 96,000

Answer Question one:

Net sales $1,840,000

Cost of goods sold 1,072,000
Gross profit 768,000
Selling expenses 270,000
General and administrative expenses 155,000
Depreciation expense 24,000
Operating profit 319,000
Other Income (expense)
Gain on sale of equipment 15,000
Equity losses (9,000)
Interest income 13,000
Interest expense (16,000)
Pre-tax income 322,000
Income tax expense 96,000
Net income $226,000

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Question Two:
You have given the Moon Company’s annual report, calculate any profit measures deemed
necessary and discuss the implications of the profitability of the company.

Answer Question Two:

2015 to 2016 2014 to 2015

Sales growth 12.2% 30.7%

2016 2015 2014

Cost of goods sold 76.8% 75.0 % 72.0 %

Gross profit margin 23.2 25.0 28.0
Operating profit margin 11.4 12.2 14.7

Average tax rate 31.2 31.3 31.8

Net profit margin 7.8 8.4 10.0

Sales growth over the three-year period is strong, but the rate of increase decreased from 2015-
2016 relative to 2014-2015. Sales growth could be the result of price increases, volume
increases, or both. The reduction in the gross profit margin indicates problems with inventory
cost controls, the pricing of products, or a combination of these factors. The decrease in the
operating profit margin is partly a flow-through from the gross profit margin and the result of
increasing operating expenses. Finally, the combination of problems with inventory
management, pricing, and control of operating expenses has produced a deteriorating net profit
margin. Tax expense has not been a contributing factor because the effective tax rate decreased
slightly between 2014 and 2016.

Question Three:
Assume that company A acquires exactly 20% of the voting common stock of Company B for
$400,000 at 1 January 2016. Company B reports $100,000 earnings for the year and pays
$25,000 in cash dividends at 31 Dec 2016.
Solution:

$25,000 x 0.20 = $5,000

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Question Four:
Solution of Question Four:
Yarrick Company
Common Size Income Statement (in percent)
For the Years Ended December 31, 2016, 2015, and 2014
2016 2015 2014
Net sales 100.0 100.0 100.0
Cost of goods sold 58.2 54.2 53.7
Gross profit margin 41.8 45.8 46.3
Selling, gen. & admin. 17.7 20.0 29.1
Research & develop. 16.0 21.3 40.3
Operating profit margin 8.1 4.5 (23.1)
Income tax expense 3.0 1.3 (8.2)
Net profit margin 5.1 3.2 (14.9)

It is noticed that sales have increased 15.7 percent from 2014 to 2015 and 52.9 percent from
2015 to 2016 for Yarrick Company. This increase is the result of volume or price increases. The
gross profit margin has declined each year. Yarrick has either lowered selling prices or costs of
goods sold have risen and the company has not passed on those increases to their customers.
Operating profit margin has surprisingly increased despite the decline in gross profit margin.
This has been achieved by significant reductions in selling, general, and administrative and
research and development expenses in 2015. In dollars these expenses increased in 2016, but
from a percentage standpoint decreased due to the large sales growth. The reduction in these
expenses is concerning. To stay on the cutting edge of their industry it is important for Yarrick to
spend enough in research and development. Cuts in this area may be detrimental to sales growth
in the long-run. If advertising is being reduced or key productive, personnel are being laid off to
achieve the cost reductions in selling, general and administrative expenses, this, too, can
negatively impact the company's sales and profits. If Yarrick has been able to reduce costs
through the elimination of waste, this would be a quality change.

Net profit has increased from a loss of $20 million to a profit of $12 million from 2014 to 2016
due to the above mentioned changes in operating expenses. Tax expense has not had a significant
impact on the net profit of the firm.
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Question Five:

Answer Question Five:

a)
Gross profit margin: 2016 2015 2014
Tickets 45.1% 48.0% 51.0%
Concessions 91.2% 90.0% 88.3%
Total 59.5% 60.4% 61.0%

(b) The overall gross profit margin of LA Theaters is declining. The cause of this decline is the
result of tickets rather than concessions. If the cost of acquiring films is increasing, then ticket
prices have not been raised proportionately, otherwise ticket prices have been reduced without a
corresponding decrease in cost of films. Concessions gross profit margin is increasing each year
which has mitigated the decline in overall gross profit margin. Concessions prices have been
raised without corresponding increases in costs or the costs of concessions have been declining
without a change in prices.
LA Theaters should focus on selling as many concessions as possible since the profit margin is
quite high on these items. If ticket prices cannot be raised to compensate for increased costs, the
management should be sure that the theaters are filled to capacity as volume increases in ticket
revenues will result in higher gross profit margins. The cost of acquiring films is fixed, but does
not change proportionately with the volume of ticket sales.
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Question Six:
Answer Question Six:
Net income for Elf Corporation increased by $15 million in 2016 and 2015. Sales also improved
—by $100 million in 2015, but by only $50 million in 2016. The gross profit margin remained
constant over the three-year period at 50%, as did the average tax rate. Administrative expenses
remained constant at $100 million. Elf Corporation expended $75 million for advertising and
marketing in 2014 and 2015 but reduced these expenditures to $50 million in 2016. Interest
expense rose by $20 million in 2015 and 2016.

Net income for Elf Corporation increased in 2015 and 2016, but at a decreasing rate. Sales also
improved both years, but at a decreasing rate. Elf Corporation maintained a 50% gross profit
margin, reflecting the firm's ability to control the cost of products sold or to pass along price
increases to customers. The increase in the rate of profit was reduced in 2014 by slower sales
growth and by continued high interest expense. The rise in interest expense could be due to
higher interest rates but probably is evidence of increased corporate borrowing, which could
signal problems or be the result of expansion. The $50 million increase in operating profit in
2016 has been achieved by reducing expenditures for advertising and marketing, which could
help explain the slower sales growth in 2016 and could impair sales in the future.
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Question Seven:
Consider this income statement common size:
INTEL
Common Size Income Statement

2013 2012 2011

Sales 100.0% 100.0% 100.0%
Cost of Sales 40.2 37.9 37.5
Gross Profit 59.8% 62.1% 62.5%
Research and development 20.1 19.0 15.5
Marketing, general and administrative 15.3 15.1 14.2
Restructuring and asset impairment .5 -- --
Amortization of acquisition-related
intangibles .6 0.6 0.5
Operating income 23.3% 27.4% 32.3%
Gains (losses) on equity investments, net 0.9 0.3 0.2
Interest and other, net (0.3) 0.2 0.4
Income before taxes 23.9% 27.9% 32.9%
Provision for taxes 5.7 7.3 9.0
Net Income 18.2% 20.6% 23.9%

Effective tax rate 23.7% 26.0% 27.2%

Growth rates 2012 - 2013 2011- 2012
Net revenues (1.2)% (1.2)%
Operating costs 3.9% 13.7%
Operating costs + COGS 4.4% 6.0%

Calculate the Growth rates of Revenues and operating costs, then analyze the profitability of the
company?
Answer Question Seven:
Revenues for Intel decreased in both 2013 and 2012 by 1.2%. Operating costs increased in both
years resulting in decreasing operating profit. Intel has four segments for reporting purposes: the
PC Client Group (PCCG), the Data Center Group (DCG), the Other Intel Architecture segment
(OIA) and the Software and Services segment (SSG).
The decrease in revenues in 2013 was overall a result of less volume offset by higher average
selling prices in the PCCG. PCCG sales were down 4% while the DCG increased sales by 7%
due to both higher volume and higher prices. The shift from PCCG to DCG is expected as the
market for PC sales declines and growth occurs in the Internet cloud computing and high
performance computing market segments. The revenue for the OIA segment, including ISG,
Multi-Comm, the Tablet Group, the Phone Group, the Service Provider Group, the Netbook
Group, and the New Devices Group decreased 7% in 2013. The decrease was primarily due to
lower netbook platform, feature and entry phone components, and Multi-Comm unit sales. To a
lesser extent, lower Multi-Comm average selling prices contributed to the decrease. These
decreases were partially offset by higher ISG revenue on increased platform average selling
prices. Revenues for the SSG increased as a result of the McAfee acquisition.

The decrease in revenues in 2012 was partially due to the fact that 2012 was a 52 week year and
2011 was a 53 week year. In addition, volume was decreasing due to the shift away from PCs to
consumer demand for tablets. Desktop platform selling prices increased, however, to somewhat
offset the decline in unit sales. Notebook platform sales increased, but the average selling price
decreased. Net revenue for the OIA segment decreased by 13% in 2012. The decrease was
primarily due to lower netbook platform unit sales and lower Multi-Comm average selling
prices. To a lesser extent, lower netbook platform average selling prices contributed to the
decrease. These decreases were partially offset by higher ISG platform average selling prices.
Revenues for the SSG increased as a result of the McAfee acquisition.
The gross profit margin, stable in 2011 and 2012, decreased in 2013. The Management
Discussion and Analysis (MDA) explain that the decrease in gross profit margin was a result of
higher factory start-up costs primarily for the next-generation 14nm process technology. To a
lesser extent, lower overall revenue from the OIA segment, primarily in the phone and mobile
component businesses and netbook group, as well as lower PCCG and DCG platform revenue
contributed to the decrease. These decreases were partially offset by higher ISG platform
revenue, lower PCCG and DCG platform unit costs, and lower excess capacity charges. Higher
(or lower) revenues caused by volume increases (or decreases) result in higher (lower) gross
profit margins when firms have fixed costs. As a manufacturer Intel would have significant fixed
costs included in their cost of sales. The stable gross profit margin in 2012 was a result of higher
excess capacity charges and higher unit costs on the PCCG and DCG platform offset by lower
factory start-up costs.

Operating profit has decreased significantly from 2011 to 2013 due to the decline in revenues
and gross profit margin combined with increases in all other operating expenses.

Intel is spending more on research and development costs (R&D) in 2012 and 2013 as they
transition to new markets. Investments are being made primarily in smartphones and tablets, as
well as rewarding employees with higher salaries in 2013, while in 2012 investments focused on
not only smartphones and tablets, but also, Ultrabook devices, and data centers. Higher process
development costs for 14nm process technology, higher compensation expenses, costs of
acquisitions, and higher costs related to the development of 450mm wafer technology
contributed to the 2012 R&D increases.
Marketing, general and administrative expenses barely increased in 2013, and have only
increased about 1% since 2011 as a result of acquisition expenses of McAfee and higher
compensation expenses.

Restructuring and asset impairment charges were incurred in 2013, as Intel responded to the
changing business environment by reducing the workforce and exiting certain businesses and
facilities such as the 200mm wafer fabrication facility in Massachusetts, which will cease
production by the end of 2014.

Intel has net overall gains from equity investments in all three years. Although the amounts are
insignificant they are growing each year as market conditions improve. Interest and other, net, is
a combination of miscellaneous items including interest income and interest expense. Interest
income is stable year to year; however, interest expense has increased all years as a result of the
long-term debt taken out to repurchase the firm’s common stock.
Intel's effective tax rate is relatively low compared to the statutory rate of 35 percent. The firm
has benefited from lower foreign tax rates, domestic manufacturing benefits deductions and
R&D tax credits.
Net profit margin followed the downward trend of operating profit margin. To continue to be
successful, Intel must maintain good control of expenses, while continuing to develop cutting
edge products. In addition, Intel must be prepared to transition quickly when changes in the
technology market occur. With PCs and older technology becoming obsolete, Intel, who has
relied on PC sales, must be competitive in newer markets. The increase in investments in R&D is
warranted at this point. Intel has been successful in controlling marketing, general and
administrative costs and plans for restructuring are also positive moves by the company. If Intel
can move more quickly into new markets they have the potential to increase revenues in future
years and reverse the downward trend of profits. The change in CEO and recognition by the firm
that they have not performed as well as they should are positive signs that Intel is on track to
improve their performance.

The common stock account has increased in dollars (not shares) over the three-year period due to
the proceeds from sales of common stock and share-based compensation. Repurchases of stock
has caused the number of shares to decrease because Intel chooses to retire the stock rather than
recording the purchase in a treasury stock account. It appears that Intel is decreasing the amount
of stock repurchases each year.

Accumulated other comprehensive income has varied each year as a result of changes in pension
liabilities, investment related items, and foreign currency translation.

The retained earnings account has increased in 2012 and 2013, after a decrease in 2011. A large
amount of net income in all years increased the retained earnings account; however, charges for
the repurchase of common stock caused the account to decrease, especially in 2011. Dividends
paid all years also cause a decrease to retained earnings.

According to the chairman of Intel the purpose of the repurchase of Intel’s common stock is to
increase stockholder value. Intel’s stock price ranged from a high of $29.18 in the second quarter
of 2012 to a low of $19.36 in the fourth quarter of 2012. While the stock peaked at a high of
$25.70 per share in 2013, one must consider if the large amount of cash used to repurchase
common stock would have been more valuable if used elsewhere.

Cash dividends have been increased each year to reward Intel's stockholders. This is a positive
sign that the firm is doing well and as was seen on the balance sheet, Intel has enough cash to
support the increased dividends.
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Question Eight:
You have given this common size Net income statement, Analyze the profitably of AMAT
company.
Applied Materials (AMAT / NASDAQ)
Annual Common Size Income Statement
S u m m ary p e rc e n tag e s in ita lic s will n o t f o o t d u e to rou n d in g

Results for the Years Ending

Oct 27, 2013 Oct 28, 2012 Oct 30, 2011

Net sales 100.0% 100.0% 100.0%

Less: Cost of goods sold 60.2% 62.0% 58.5%
Gross profit 39.8% 38.0% 41.5%
Sales, general and administrative 12.0% 12.3% 8.6%
Research and development (R&D) 17.6% 14.2% 10.6%
Restructuring, impairment, and amortization 4.5% 6.8% 0.0%
Purchased in-process R&D 0.0% 0.0% 0.0%
Other operating expenses (0.1%) 0.0% (0.5%)
Total operating expenses 34.1% 33.3% 18.7%
Operating profit (loss) 5.8% 4.7% 22.8%
Other income (expenses), net excluding interest expense 0.2% 0.0% 0.4%
Earnings (loss) before interest and taxes 5.9% 4.7% 23.2%
Interest expense 1.3% 1.1% 0.6%
Earnings (loss) before taxes 4.7% 3.6% 22.6%
Provision for (benefit from) income taxes 1.3% 2.4% 4.3%
Earnings (loss) after taxes 3.4% 1.3% 18.3%
Extraordinary items, net 0.0% 0.0% 0.0%
Discontinued operations, net 0.0% 0.0% 0.0%
Cumulative effect of changes in accounting principles, net 0.0% 0.0% 0.0%
Other after-tax income (loss), net 0.0% 0.0% 0.0%

Net profit (loss) 3.4% 1.3% 18.3%

Effective tax rate 26.9% 65.5% 19.0%

Answer Question Eight:

Applied Materials’ (AMAT) sales decreased 14% from 2012 to 2013, and 17% from 2011 to
2012. AMAT has four distinct segments: Silicon Systems Group, Applied Global Services,
Display and Energy and Environmental Solutions. The only segment with increasing sales in
2013 was the Display segment which reflected the recovery of the TV manufacturing equipment
investment. The decreases in other segments were caused by excess manufacturing capacity in
the solar industry and lower investments in semiconductor equipment, spares and services. The
Silicon Systems Group was the only segment with increasing sales in 2012. The decreasing sales
were a result of lower investments in c-Si solar and LCD TV equipment, partially offset by sales
attributable to the Varian acquisition.

Gross profit margin decreased in 2012, but recovered somewhat in 2013. Despite lower sales in
2013, gross profit margin increased due to lower costs, lower inventory charges and a favorable
product mix. The decrease in gross profit margin in 2012 was a result of lower sales (AMAT has
fixed costs), higher inventory charges and costs associated with the Varian acquisition.

Operating profit margin dropped significantly in 2012 and increased only slightly in 2013. Gross
profit margin caused operating profit to decrease and then increase, but does not explain the
entire change in operating profit. All other operating expenses increased and in 2012 and 2013,
AMAT incurred restructuring and asset impairment charges.

AMAT has increased research and development (R&D) expenditures in order to maintain a
competitive advantage. In 2013 the firm increased their investments in 300mm product
development, developed new applications to enable chip makers to build faster devices and
deliver next-generation mobile computing power, released next-generation defect review and
classification technology, and continued to invest in 450 mm wafer fabrication equipment. The
increases in R&D in 2012 were mainly related to the Varian acquisition, partially offset by lower
investments in solar R&D and the cessation of LED equipment.

Selling, general and administrative (SG&A) expenses increased in dollars in 2012 and then
returned to dollar levels comparable to 2011 in 2013; however in percentage terms the change in
percentage in 2013 was minimal due to the large decrease in sales without a proportional
decrease in expenses. The increased costs in 2012 were a result of the Varian acquisition. In
2013, those costs did not occur again and the firm was able to reduce costs through their
restructuring programs along with a reduction in bad debt expense as a result of lower risk
exposure in display and solar customers.

The deteriorating market in the solar industry presented challenges for AMAT in both 2012 and
2013, resulting in goodwill impairment charges in the Energy and Environmental Solutions
segment and implementation of a restructuring plan. Under the plan AMAT implemented a
voluntary retirement program and other workforce reduction programs.

Other income and expense items include gains and losses on sales of facilities, impairments of
equity investments and interest income and overall have increased profits by a small amount.
Interest expense increased as a percentage of sales, but was flat from 2012 to 2013, with an
increase in 2012 relatively to 2011 as a result of counting a full year’s interest on unsecured
notes.

AMAT’s effective tax rate has been volatile. The non-deductibility of the goodwill impairment
charges in 2012 caused the rate to be 65.5%. The effective tax rate for the firm, with no goodwill
impairment charges, was 19% in 2011. AMAT benefits from lower tax rates to a great extent and
realized a much lower tax rate as a result of global business in 2013. This was offset, however,
by more non-deductible goodwill impairment charges resulting in an effective tax rate of 26.9%
instead of a rate of 4.4% had impairment charges not been taken.

Net profit margin has followed the trend of operating profit margin. The past two years have
been especially poor for AMAT. The firm will need to continue to work toward cost reduction
while also innovating. According to the annual report, the firm hopes to merge with Tokyo
Electron Limited in 2014. If this merger is successful, AMAT may be able to move more quickly
toward higher profitability as they gain more market share in both the semiconductor and display
markets.