Fae3e SM ch02

Chapter 2.
From Business Events to Financial Statements
Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses

Difficulty Rating for Exercises and Problems:
Easy: E2.15; E2.16

Medium: E2.17; E2.18; E2.19
P2.22; P2.23; P2.24; P2.26; P2.27; P2.30; P2.32; P2.33
Difficult: E2.20; E2.21
P2.25; P2.28; P2.29; P2.31
QUESTIONS
Q2.1 Accounting Terminology

Asset: an economic resource of a business that can be used to
generate operating revenue, earnings, and cash flow.
Liability: an economic claim on the assets of a business.
Shareholders Equity: an ownership claim on the net assets of a
business (i.e., a residual claim after the creditor claims have first been
satisfied).
Revenue: an inflow of assets resulting from a firms primary operations.
Expense: the outflow of assets necessary to generate operating
revenue.
When a firm generates operating revenue, this leads initially to an increase in

assets (i.e., cash or accounts receivable) but also a decrease in assets (e.g.,
inventory) representing the cost (expense) of doing business. Thus, assets and
shareholders equity increase or decrease depending upon whether a business
is producing net income or a net loss. Not only are a firms operating assets
frequently financed with debt, but liabilities also arise as part of the ongoing
operations of a business (e.g., accounts payable for inventory, wages payable
for employee salaries, and interest payable for any unpaid cost of debt
financing).
Cambridge Business Publishers, 2014

Solutions Manual, Chapter 2 2-1
Q2.2 Historical versus Forecasted Financial Statements. Historical financial
statements reflect the past, whereas forecasted (or pro forma) financial
statements reflect the future. Other than the time period that they relate to,
these financial statements are essentially quite similar, having identical format
and structure.
Managers and shareholders use historical financial statements to evaluate a

firms past performance, as well as to predict a firms likely future performance.
Managers use forecasted financial statements as a road map to help guide a
business to a desired financial position. They also use forecasted financial
statements (sometimes referred to as budgeted financial statements) as a
benchmark to help evaluate whether a firm is on track to meet its stated goals
and objectives. Shareholders, on the other hand, use forecasted financial
statements to determine what a firm is worth (i.e., what a share of stock is
worth), and thus, to determine whether to buy more shares, sell, or hold their
existing shares.
Q2.3 Accounting Principles. The entity principle stipulates that the financial
statements of a business must reflect only the financial affairs of the business
entity and should not reflect the financial affairs of the entitys owners. The
revenue recognition principle suggests that an entity should report as revenue
only those revenue-producing transactions that have been substantially
completed and for which cash collection is relatively certain. Finally, the
matching principle stipulates that once an entity determines the appropriate
amount of revenue to be recognized, it should recognize all business costs
incurred to generate the recognized operating revenue.
The three principles are related in that one stipulates the unit of business (i.e.,
the entity principle), whereas the others stipulate when, and how much,
revenue and expenses should be disclosed by the entity when reporting its
periodic performance.
Q2.4 Balance Sheet Classifications. The classification of assets into current assets
and noncurrent assets is important because it enables financial statement
users to distinguish between those assets that will be consumed or used up as
part of current operations versus those assets whose productivity is expected to
last beyond the current operating cycle. This information is relevant to both
managers and shareholders by establishing which assets will need to be
replaced before the end of the current cycle and those that will not, thereby
facilitating an assessment of the short-term cash flow needs of the business.
The delineation of liabilities into current liabilities and noncurrent liabilities is
also important from a cash flow perspective. This dichotomy allows managers
and shareholders to know what the cash demands from creditors will be in the
short term versus the long term.

2-2 Financial Accounting for Executives & MBAs, 3 rd Edition
Q2.5 Key Performance Indicators: The Income Statement. Operating revenues
measure the inflow of assets (e.g., cash and accounts receivable) from a firms
primary business activity. Gross profit, on the other hand, measures the amount
of operating asset inflows remaining after deducting the cost of sales (or cost of
goods sold). Operating income measures a firms operating inflows after all
operating expenses (e.g., cost of goods sold, selling and administrative
expenses, etc.) have been deducted from revenue. And, net income measures
a firms operating inflows after considering both operating and nonoperating
expenses.
All four of these performance indicators are considered by investment

professionals as they evaluate the performance of alternative businesses to
add to their clients portfolios of securities. In an ideal setting, financial analysts
will look for those firms with outstanding performance on all for of the income
statement KPIs.
Q2.6 Key Performance Indicators: The Statement of Cash Flow. The cash flow
from operating activities (CFFO) reports a firms net cash flow from its primary
business activity. This KPI is the cash-basis equivalent of net income. The cash
flow from investing activities (CFFI) reports a firms net cash flow from its
investing decisions; it is a reflection of a firms investment strategy. The cash
flow from financing activities (CFFF) reports a firms net cash flow from its
financing decisions; it is a reflection of a firms financing strategy.
The CFFO informs financial statement users as to whether a firm is a net

positive (or negative) generator of cash flow from its principal business activity.
Firms that do not generate positive CFFO must raise cash to support their
operations in other ways (e.g., dis-investing, borrowing, selling equity). The
CFFI informs financial statement users as to whether a firm is a net positive (or
negative) generator of cash from its investment strategy. In general,
shareholders expect (and prefer) to see a negative CFFI, which usually
indicates that a firm is reinvesting in long-term, revenue-generating assets. The
CFFF informs financial statement users as to whether a firm is financing its
long-term investments with debt or with equity. In general, debt financing is
preferred to equity financing because it is cheaper.

Q2.7 Return on Shareholders Equity. Return on Equity = Return on Sales x Total
Asset Turnover x Financial Leverage
Return on Equity (ROE): Net Income divided by Shareholders Equity
Return on Sales (ROS): Net Income divided by Net Sales
Total Asset Turnover (TAT): Net Sales divided by Total Assets
Financial Leverage (LEV): Total Assets divided by Shareholders Equity
A manager can increase a firms ROE by:
1. Increasing ROS (i.e., by selling more units at a profit or by raising its

selling prices, assuming no loss in sales volume).
2. Increasing TAT (i.e., by selling more product given the same
investment in assets, or by selling the same volume of product with a
smaller investment in assets).
3. Increasing LEV (i.e., by financing more of its asset purchases and
operations with debt, assuming that the cost of debt financing is less
than the return generated from those borrowed assets).
4. Some combination of 1, 2, and 3.
Q2.8 Evaluating Financial Risk.

Long-term-debt-to-total-assets: The percentage of total assets
financed by long-term debt (i.e., a measure of the extent that a firm uses
leverage).
Interest coverage ratio: Net income before income taxes plus interest
expense, divided by interest expense (i.e. a measure of the extent to
which operating income covers existing debt services charges).
Assuming that a firm can use leverage effectively (i.e., that the return on any
borrowed assets exceeds the cost of borrowing), a firm can improve its
financial riskiness by using larger quantities of debt to finance both asset
purchases and operations. Another interpretation of the phrase improve a
firms financial riskiness may mean to reduce the level of leverage (or debt)
used to finance a business. Whether a firm uses leverage is a strategic
decision, but in general, many firms can build shareholder value through
increased debt financing (depending, of course, on firm profitability).

Q2.9 Managing Operating Revenue. Front-end loading of operating revenue refers
to the act of recognizing revenue on the income statement before the revenue
has been earned (i.e., realized) see the B.J.s Wholesale Club example in
Chapter Two. An example of front-end loading is the practice of channel
stuffing that is, selling large quantities of inventory to customers at year-end
with the promise of accepting any unsold inventory back without cost to the
buyer. Rear-end loading of operating revenue refers to the delayed recognition
of earned revenue on the income statement. Rear-end loaded revenues are
reported on the balance sheet as a liability, usually labeled Deferred Revenue
or Unearned Revenue. Managers that use front-end loading of revenue are
trying to make the firm look more profitable than it really is, whereas managers
that use rear-end loading are trying to make a firm look less profitable.
One approach used by some analysts to identify the possibility of revenue

management is to calculate the cash conversion ratio, or cash sales divided by
net sales. This ratio indicates the extent to which cash is collected relative to
the amount of recognized revenue. By calculating this ratio over several periods
and examining the trend in this ratio, it is possible to identify whether or not
front-end or rear-end loading is likely to be present. As the cash conversion
ratio declines below one and approaches zero, it often indicates the use of
front-end loading. As the cash conversion ratio increases above one, it may
indicate the use of rear-end loading. The cash conversion ratio is discussed in
Chapter Three.
Q2.10 Net Income, Cash Flow from Operations, and Dividend Policy. Because
accrual accounting is used to measure net income, it is possible for net income
to be positive and the cash flow from operations to be negative. This situation
would be characteristic of a firm going through a significant growth spurt, with
many credit sales (and hence, higher net income) that had not yet been
collected (and hence, little or no cash flow from operations). If the negative
cash flow from operations is the result of significant new sales growth,
maintaining a firms dividend policy would be quite reasonable, especially given
the very negative equity market reaction associated with dividend reductions. If
however, the negative cash flow from operations is attributable to other less
favorable factors (i.e., the rear-end loading of expenses see the America
Online example in the Chapter Two), then a change in dividend policy may be
warranted.

Q2.11 Debt Covenants. The net debt-to-capital ratio is defined as:
(Total debt Liquid assets) Shareholders equity.
The Bristol-Myers Squibb (BMS) syndicate of lenders imposed this constraint

on the company to insure that the firms overall financial riskiness never
reached a level as to place in jeopardy BMS ability to repay its line of credit or
to pay the debt servicing on the line of credit. Notice that the net debt-to-capital
ratio is a modification of the debt-to-equity ratio discussed in Chapter 2. BMS
was willing to agree to the covenant constraint to insure that it had access to
the line of credit. Given BMS current net debt-to-capital ratio of only 14
percent, the company does not appear likely to fall in violation of the constraint
in the near term.
Q2.12 Managing Operating Expenses. Rear-end loading of expenses (e.g., see

America Online example in Chapter 2) refers to a failure to properly recognize
operating expenses in the current period income statement. Expenses that are
rear end loaded are reported as assets on the balance sheet. Front-end loading
of expenses refers to reporting as current period expenses expenditures that
would be more appropriately treated as assets on the balance sheet. Rear-end
loading of expenses is adopted to make a firm look more profitable than it really
is, whereas front-end loading of expenses is employed to make a firm look less
profitable than it actually is. Identifying rear-end loading is usually possible in
cases like America Online by carefully reviewing a firms asset capitalization
policy as reported in its Summary of Significant Accounting Principles (i.e. in its
footnotes). However, identifying the existence of front-end loading is more
problematic. Some analysts calculate what are known as expense realization
ratios for this purpose. For example, an expense realization ratio for selling,
general and administrative expenses (SG&A) would be calculated as follows:
Cash SG&A outlays SG&A expense
If this ratio grows over time (i.e. the ratio approaches and/or exceeds one), it
may be indicative of front-end loading of SG&A (which is where managers often
attempt to hide these excess expenditures).

Q2.13 Net Loss, Cash Flow from Operations, and Dividend Policy. Because
accrual accounting is used to measure net income, it is possible for a firm to
have negative net income yet a positive cash flow from operations. One
explanation for this situation is the presence of such noncash expenses as
depreciation and amortization, which are subtracted from operating revenue to
measure net income but are added back to net income in the calculation of the
cash flow from operations.
Whether or not a firms dividend policy should be altered for a net loss depends
largely upon the expected future performance of the firm. If a firm is expected to
report net losses for the foreseeable future, a dividend reduction may indeed be
appropriate. On the other hand, if the current net loss is expected to be short-
lived, followed by recurring operating profits, then a dividend policy change
would be unnecessary, especially given the markets negative reaction to
dividend reductions.
Q2.14 (Ethics Perspective) Corporate Social Responsibility and Ethics. It is not

surprising to see a strong correlation between financial performance and ethical
behavior. After all, profits are not something that results without any cause. It
has long been argued that while shareholders are the residual claimants of the
corporation, all other stakeholders are still important to a corporations well-
being. Consider the following three items:
1. If you treat your employees ethically and fairly, they will be happy to
come to work, enthusiastic about the company and its vision.
Consequently, they will be more inclined to work harder to move the
company in the direction it needs to go. Simply look at Fortunes Top
100 Companies to Work For and notice how many of these companies
are also successful financially.
2. If you treat your customers ethically and fairly, they will be more inclined
to continue to buy from you. Reputation and word of mouth marketing
are powerful drivers of financial performance.
3. If you treat your financial reporting ethically and fairly, those that use
them, both internally and externally, will respect your business position.
Trust is crucial in gaining financing in order to further a companys
growth needs, ultimately translating into financial well-being.
Continued next page

Continued
An excellent example of ethics and good business practice is The Johnson &
Johnson Company, whose vision is incorporated into a credo of social
responsibility in the pursuit of reasonable profits. The following represents this
credo, written in order of importance.
1. We believe our first responsibility is to the doctors, nurses, and patients,

to mothers and all others who use our products and services.
2. We are responsible to our employees.
3. We are responsible to the communities in which we live and work and
to the world community as well.
4. Our final responsibility is to our stockholders.
Such a credo has served The Johnson & Johnson Company, along with its
shareholders, well. J&J is consistently a leader in Fortune magazines rankings
of management excellence of the 200 largest U.S. Corporations, as well as
being regarded as one of the most successful healthcare companies in the
world.
(Note: This answer was based on the writings of Paul Pope and Douglas Barry.)

EXERCISES
E2.15 The Balance Sheet Equation.
Fernandez & Co.

1 2 3 4 5 6 Summary
Assets
Cash 5,000,000 10,000,000 (500,000) (100,000) 2,000,000 16,400,000
Inventory 500,000 500,000
Equipment 700,000 700,000
Total assets 17,600,000
Liabilities
Taxes payable (100,000) (100,000)
Notes payable 700,000 700,000
Bonds payable 10,000,000 10,000,000
Total Liabilities 10,600,000
Shareholders Equity
Common stock 5,000,000 5,000,000
Retained earnings 2,000,000 2,000,000
Total Shareholders
Equity 7,000,000
E2.16 Account Classification.

a. I/S E j. I/S E
b. B/S A k. B/S A
c. I/S E l. B/S L
d. B/S A m. I/S E
e. I/S E n. B/S A
f. B/S A o. B/S SE
g. I/S R p. I/S E
h. B/S L q. I/S E
i. B/S A r. B/S - A

E2.17 Asset or Expense.
1. Because of the immaterial amount involved ($250,000), most companies
would expense the cost of resurfacing. Another argument for expensing is
that the resurfacing is a necessary activity (like changing the oil in your cars
engine) to enable the company to receive the expected normal use from the
parking lot. Thus, resurfacing is like regular maintenance and should not be
considered an asset.
2. Because the expenditure of $500,000 was mandated by a governmental
agency, the cost is best treated as an asset. The magnitude of the
expenditure is material (i.e., five percent of total revenues), which also
suggests treatment as an asset.
3. While the $900,000 could legitimately have been capitalized to the
balance sheet as an asset initially, once the decision is made to shelve the
project, the expenditure should be immediately expensed.
4. Since the development effort appears to relate to an existing asset (i.e.,
the order entry system), a sound argument can be made to capitalize this
cost as an asset to the balance sheet. Once the system is operational, the
cost can then be amortized, probably over a five-year period.
5. Both of these expenditures are commonly understood to be period costs
that should be expensed in the period when incurred.
E2.18 The Statement of Cash Flow.

Year 3 Year 2 Year 1
Cash, beginning balance -- $5,377 --
Cash flow from operating activities -- $11,131 --
Cash flow from investing activities -- -- $(4,526)
Cash flow from financing activities $(4,556) -- --
Cash, ending balance -- $9,013 --
J&J has a healthy cash flow from operations, and thus, finances its operations
and asset purchases using its operating cash flow.
E2.19 The Statement of Cash Flow.

Year 3 Year 2 Year 1
Cash, beginning balance $15,328 -- $8,910
Cash flow from operating activities -- -- --
Cash flow from investing activities $(35,049) -- --
Cash flow from financing activities -- $4,594 --
Cash, ending balance -- -- $12,664
GE generates a very strong cash flow from operations and annually makes
significant investments into new assets and in acquiring new businesses.

E2.20 Preparing the Basic Financial Statements.
Purcha
Borro se Pay
Issue w Pay Fresh Utilitie Floral Balanc
Transaction: Stock Cash Rent Flowers s Sales e Sheet
Assets
15,0 (4,200 (2,500 (1,200 12,00
Cash 5,000 00 ) ) ) 0 24,100
Total assets 24,100
Liabilities
15,00
Loan payable 0 15,000
Total liabilities 15,000
Shareholders
Equity
Common stock 5,000 5,000
Retained earnings 4,100
12,00
Revenue 0
(4,20
Lease Expense 0)
(2,500
Floral Expense )
(1,200
Utilities Expense )
Total
shareholders'
equity 9,100
Floral Shop
Income Statement
For Year 1
Revenue $12,000
Less: Lease expense (4,200)
Floral expense (2,500)
Utilities expense (1,200)
Net income $4,100
Floral Shop
Statement of Shareholders Equity
For Year 1
Common Retained
Stock Earnings Total
Beginning balance $0- $0- $0-
Net income -- 4,100 4,100
Dividends paid -- -0- -0-
Issuance of Common stock 5,000 -- 5,000
Balance at year-end $5,000 $4,100 $9,100
NOTE: Statement of Shareholders Equity not required in text question
Continued next page

Continued
Floral Shop
Balance Sheet
At End of Year 1
Assets Equities
Cash $24,100 Liabilities
Loan payable $15,000
Total 15,000
Shareholders equity
Common stock 5,000
Total 9,100
Total $24,100 Total $24,100
Floral Shop
Statement of Cash Flow
For Year 1
Operating activities
Revenues $12,000
Lease expense (4,200)
Floral expense (2,500)
Utilities expense (1,200)
Cash flow from operations 4,100
Investing activities
Cash flow from investing -0-
Financing activities
Common stock issuance 5,000
Loan payable 15,000
Cash flow from financing 20,000
Change in cash 24,100
Cash, beginning of year 0
Cash, end of year $24,100
Although Marilyns net income and cash flow from operations are both positive
($4,100), it would probably be unwise as a start-up business to try to pay half
($7,500) of her parents loan back at the end of the first year. A more realistic
payment might be $3,000, although that amount is also arbitrary.

E2.21 Preparing Cash Flow Data.
Floral Shop
For Year 2
Operating activities
Revenues $15,000
Operating expenses (7,000)
Investing activities
Purchase of equipment (2,500)
Cash flow from investing (2,500)
Financing activities
Sale of equity interest 13,000
Dividend payment (2,800)
Cash flow from financing 10,200
Cash, beginning of year 12,000
Marilyns cash management strategy appears solid. The dividend payment of

$2,800 appears quite reasonable given her net income of $11,000 and cash
flow from operations of $8,000.

PROBLEMS
P2.22 Accounting Event Analysis and Financial Statement Preparation.
Smith & Co.

Balanc
e
Transaction: 1 2 3 4 5 6 Sheet
Assets
60,00 18,0 (11,00 (1,00
Cash 0 (40,000) 00 0) 0) 26,000
16,0
Accounts receivable 00 16,000
Land 40,000 40,000
82,00
Total assets 0
Liabilities
18,00
Total liabilities 18,000
Shareholders Equity
60,0
Common stock 00 60,000
16,0
Revenue 00
(11,00
Operating expense 0)
(1,00
Dividends 0)
Total shareholders' equity 64,000
Smith & Co.

Income Statement
For Year 1
Revenues $16,000
Less: Expenses (11,000)
Net income $5,000
Smith & Co.

For Year 1
Retained Commo
Earning n Total
s Stock

Net income 5,000 -- 5,000
Dividends (1,000) -- (1,000)
Stock sales 60,000 60,000
Continued next page

Continued
Smith & Co.

Balance Sheet
At End of Year 1
Assets Liabilities
Cash $26,000 Loan payable $18,000
Accounts receivable 16,000 Shareholders equity
Land 40,000 Common stock 60,000
Total $82,000 Total $82,000
Smith & Co.

For Year 1
Cash flow from operations
Operating expenses ($11,000)
Cash flow from investing (40,000)
Cash flow from financing

Bank loan $18,000
Common stock 60,000
Dividends paid (1,000)
77,000
Increase in cash 26,000
Smith & Co. generated positive net income of $5,000 during its first year of
operations, but its cash flow from operations was ($11,000) since none of its
revenues were received in cash. This situation will presumably rectify itself in
the second year when the uncollected sales are collected. Considering that it is
the companys first year of operations and that its cash flow from operations
was negative, the decision to pay a dividend of $1,000 was ill-conceived.

P2.23 Accounting Event Analysis and Financial Statement Preparation
Wilmot Real Estate Co.

Balan
ce
Transaction: 1 2 3 4 5 6 7 8 Sheet
Assets
50,0 40,0 (30,0
(10,000 20,0 (11,00 22,00 (5,000
Cash 00 00 00) ) 00 0) 0 ) 76,000
5,00
Accounts receivable 0 5,000
30,0 (15,00 15,00
Land 00 0) 0
96,00
Total assets 0
Liabilities
40,0
40,00
Total liabilities 0
Shareholders
Equity
50,0
Common stock 00 50,000
25,0
Revenue 00
(10,000
Lease expense )
(11,00
Misc. expenses 0)
Gain on sale 7,000
(5,00
Dividends 0)
Total stockholders' 56,00
equity 0

Income Statement
For Year 1
Revenues $25,000
Less:
Lease expense (10,000)
Misc. expenses (11,000)
Operating income 4,000
Gain on land sale 7,000
Net income $11,000
Continued next page

Continued

For Year 1
Common Retained
Stock Earnings Total

Net income -- 11,000 11,000
Dividends -- (5,000) (5,000)
Stock sales 50,000 -- 50,000

Balance Sheet
At End of Year 1
Assets Liabilities & Shareholders Equity

Cash $76,000 Bank loan $40,000
Accounts receivable 5,000 Common stock 50,000
Land 15,000 Retained earnings 6,000
Total $96,000 Total $96,000

For Year 1
Lease payments $(10,000)
Cash from customers 20,000
Miscellaneous cash payments (11,000) $(1,000)
Cash flow from investing
Purchase of land (30,000)
Proceeds from land sale 22,000 (8,000)
Bank loan 40,000
Common stock 50,000
85,000
The company generated positive net income of $11,000 during its first of
operations, but its cash flow from operations was ($1,000). The decision to pay
a dividend of $5,000 at this early stage and in the face of negative cash flows
from operations was ill-conceived.

P2.24 Accounting Event Analysis and the Balance Sheet. The December 1, 2013
balance sheet of the Mayfair Company would appear as follows:
1.
Mayfair Company
Balance Sheet
December 1, 2013
Assets Liabilities and Shareholders Equity
Current Assets: Liabilities:

Cash $10,000 Accounts Payable $10,000
Accounts Receivable 15,000 Notes Payable 9,500
Notes Receivable 2,000 Bank Loan 10,500
Inventory 3,000 Total Liabilities 30,000
30,000
Noncurrent Assets: Shareholders Equity:
Land 40,000 Common Stock 5,000
Building (net) 30,000 Addl Paid-in-capital 76,000
Machinery & Equip. (net) 15,000 Retained Earnings 12,000
Goodwill 8,000
93,000 93,000
Total Liabilities and
Total Assets $123,000 Shareholders Equity $123,000
2.
Mayfair Company
Bal.
Bal. Sheet
Sheet Dec.
Dec. 1, 31,
Transaction: 2013 1 2 3* 4 5 6 2013
Assets
(8,000 (3,000
Cash 10,000 2,000 ) ) 1,000
Accounts
receivable 15,000 15,000
Notes (2,00
receivable 2,000 0)
3,00
Inventory 3,000 0 6,000
Land 40,000 25,000 65,000
Building (net) 30,000 no 30,000
Machinery & 12,00
equip. 15,000 0 entry 27,000
Goodwill 8,000 8,000
152,00
Total assets 123,000 0
Liabilities
Accounts 10,000 3,00 (8,000 5,000
payable 0 )
22,00
Notes payable 9,500 0 31,500
Bank loan 10,500 10,500
Total
liabilities 30,000 47,000
Continued next page

2. Continued
Table continued
Mayfair Company
Bal. Bal.
Sheet Sheet
Dec. 1, Dec. 31,
Transaction: 2013 1 2 3* 4 5 6 2013
Shareholders
Equity
12,0
Common stock 5,000 00 17,000
APIC 76,000 76,000
Retained earnings 12,000 12,000
Total
shareholders 105,00
equity 93,000
*No entry under U.S. GAAP. Under IASB GAAP, increase Building Asset Revaluation Reserve by $15,000
3.
Mayfair Company
Balance Sheet
December 31, 2013
Assets Liabilities and Shareholders Equity
Current assets: Liabilities:
Cash $ 1,000 Accounts payable $ 5,000
Accounts receivable 15,000 Notes payable 31,500
Notes receivable 0 Bank loan 10,500
Inventory 6,000 Total liabilities 47,000
22,000
Noncurrent assets: Shareholders equity:
Land 65,000 Common stock 17,000
Building (net) 30,000 Addl Paid-in-capital 76,000
Mach. & Equip. (net) 27,000 Retained earnings 12,000
Goodwill 8,000 Total shareholders equity 105,000
130,000
Total liabilities &
Total assets $152,000 shareholders equity $152,000
4. The Mayfair Companys use of financial leverage increased from the

beginning to the end of the year. Assuming notes payable and the bank loan
are both long-term debt, the companys long-term debt-to-total assets ratio
increased from 16% to 28%, suggesting that the company became more
reliant on debt financing during the year. Most of this increase in financial
leverage is reflected in the notes payable account, which was used to
partially finance the purchase of land (see transaction number 6).

P2.25 Preparing a Balance Sheet.
Pfizer, Inc.
Balance Sheet
12/31
Current assets Current liabilities

$
Cash and cash equivalents 2,247 Accounts payable $ 2,226
Short-term investments 19,979 Accrued expenses payable 14,633
Accounts receivable (net) 9,765 Short-term borrowings 11,589
Inventory 6,709 Total 28,448
Prepaid expenses 3,196 Noncurrent
Total 41,896 Long-term debt 6,347
Noncurrent Post-retirement obligations 17,143
Property, plant and equipment
(net) 19,587 Total liabilities 51,938
Goodwill and other intangible
assets (net) 56,082 Shareholders Equity
Contributed capital 67,307
Other comprehensive income 479
Treasury stock (39,767)
Total 65,627
Total liabilities and
Total assets $117,565 Shareholders equity $117,565
Financial risk:
Quick ratio = $31,991 $28,448 =1.12
Current ratio = $41,896 $28,448 = 1.47
Total debt Total assets =$51,938 $117,565 = 44.2%
Long-term debt-to-equity = $6,347 $65,627 = 9.7%
Pfizer has excellent liquidity and solvency, and hence, little financial risk.

P2.26 Analysis of Financial Statement Data.
1. Ratios
2012 2013
a. Return on equity 24.3% 23.4%
b. Return on assets 14.5% 14.7%
c. Return on sales 17.0% 17.5%
d. Financial leverage 1.68 1.59
e. Total asset turnover 0.85 0.84
2. The companys small decline in ROE (from 24.3 percent to 23.4 percent)
resulted from a reduction in the use of financial leverage (from 1.68 to 1.59).
This is apparent because the companys ROA increased modestly from 14.5
percent to 14.7 percent. Further, the slight increase in ROA resulted from an
increase in the firms ROS from 17.0 percent to 17.5 percent. Total asset
turnover declined slightly from 0.85 to 0.84.
This is a case where the firm could have increased shareholder value by
increasing its use of financial leverage.
P2.27 Analysis of Financial Statement Data.

1. Ratios
2012 2013
a. Return on equity 33.0% 59.2%
b. Return on assets 17.9% 24.6%
c. Return on sales 7.7% 9.5%
d. Financial leverage 1.84x 2.41x
e. Total asset turnover 2.33x 2.59x
2. The companys increase in ROE (from 33 percent to 59.2 percent) resulted

from an increase in both the firms ROA (from 17.9 percent to 24.6 percent)
and from its increasing use of financial leverage (from 1.84 to 2.41).
Similarly, the companys increase in ROA resulted from an increase in both
its ROS (from 7.7 percent to 9.5 percent) and its total asset turnover (from
2.33x to 2.59x). In summary, all of the ratios represent positive
improvements in the firms financial performance.

P2.28 Analyzing Financial Statement Information.
Profitability
2013 2012
Return on sales 34.3% 18.8%

Return on assets 18.8% 10.9%
Return on equity 38.7% 21.4%
Thunderbirds profitability is excellent and has improved significantly.
Financial risk
Financial leverage 2.06 1.96

Total-debt-to-total-assets 51.6% 49.1%
Long-term debt-to-equity 83.9% 75%
Thunderbirds assets are about equally financed with debt and equity,
although the use of financial leverage is up marginally.
Cash flow
Cash flow from operations $52,500 $31,500
Thunderbirds cash flow from operations is positive and growing.
Overall assessment
Given Thunderbirds profitability and solid cash flow, the Biltmore National
Bank is likely to extend the loan even though Thunderbird is already
somewhat levered. An important indicator that cannot be calculated given
the available data is the interest coverage ratio, which indicates the ability of
a companys operations to sustain the cost of additional debt. If this ratio is
favorable, then the Biltmore National Bank is likely to extend the loan.

P2.29 The Operating Cycle and Financial Statements.
1.
The Little Corporation

2.
Income Statement
For Year Ended 12/31/13
Sales $2,000,00
0
Less: Cost of goods sold (800,000)
Gross profit 1,200,000
Less: Wage expense $447,000

Miscellaneous expense 98,000
Rent expense 180,000
Deprec. expense-Equipment 144,000
Deprec. expense-Machinery 124,000
Amortization expense 22,500
(1,015,500
)
Operating income (loss) 184,500
Interest expense (240,000)
Loss on sale of machinery (40,000)
Net income (loss) $(95,500)

3.
Retained Common
Earnings Stock Total
Beginning balance $1,548,000 $1,200,00 $2,748,00

0 0
Net loss (95,500) -- (95,500)
Dividends declared (100,000) -- (100,000)
Common stock issued 450,000 450,000
Ending balance $1,352,500 $1,650,00 $3,002,50
0 0

Balance Sheet
12/31/13
Cash $752,000 Liabilities
Marketable securities 200,000 Accounts payable $150,000
Accounts receivable 414,000 Wages payable -0-
Inventory 620,000 Interest payable 36,000
Prepaid rent 42,000 Bank loan 450,000
Total current assets 2,028,000 Bonds payable 1,950,000
Long-term investments 496,500 Total liabilities 2,586,000
Equipment 1,440,000 Shareholders equity
Less: Accum deprec. (432,000) Common stock 1,650,000
1,008,000 Retained earnings 1,352,500
Machinery 2,480,000 Total shareholders equity $3,002,500
Less: Accum deprec. (626,500)
1,853,500
Intangible assets (net) 202,500
Total liabilities and
Total assets 5,588,500 shareholders equity $5,588,500
Continued next page

3. Continued

Net loss $
(95,500)
Amortization expense 22,500
Depreciation expense (144,000 + 124,000) 268,000
Loss on sale of machinery 40,000
Accounts receivable 150,000
Inventory 100,000
Prepaid rent 180,000
Accounts payable (500,000
)
Wages payable (173,000
)
Interest payable (20,000)
(28,000)
Cash flow from investing
Sale of machinery 120,000
Marketable securities (200,000
)
(80,000)
Sale of common stock 450,000
Dividends paid (100,000
)
350,000
0
Instructor note: The indirect method format is presented above although

it is not introduced to students until Chapter 3. The direct method format
can be readily prepared from the cash column of the companys
spreadsheet.
4. Financial leverage
2012: $6,027,000 / $2,748,000 = 2.19
2013: $5,588,500 / $3,002,500 = 1.86
Financial leverage declined from 2012 to 2013 for The Little Corporation.

P2.30
1.
Photovoltaics, Inc.
Opening Balance
Transaction (in thousands): 1 2 3 3 4 Balance 5 6 6 7 8 8 9 10 11 12 13 12/ 31/13
$548,487.
Cash 500 (27) 8,125 (121.875) (8,000) 476.125 384 (70) (2.7) (72) (9.6) (40) (130) (100) 435.83
Solutions Manual, Chapter 2

Accounts Receivable - 96 96
Inventory 1,300 1,300 70 (215) 1,155
Land 750 750 750
Building 4,500 4,500 (225) 4,275
Equipment 2,750 2,750 (275) 2,475
Patent 500 500 (29.412) 470.588
Start-up Costs 27 27.000 (5.4) 21.6
Total Assets 1,000 10,303 9,679.013
Notes Payable 1,300 1,300 1,300

Total Liabilities - 1,300 1,300
Common Stock 1,000 2,500 3,500 3,500

APIC 5,625 (121.875) 5,503.125 5,503.125
Retained Earnings (624.112)
Revenue 480
Cost of goods sold (215)
Insurance expense (2.7)
Wages expense (72)
Executive compensation (40)
Selling & admin exp. (9.6)
Depreciation exp. (500)
Preparing Financial Statements from Accounting Events.
Amortization expense (29.412)

Start-up costs (5.4)
Interest expense (130)
Dividends (100)
Total Shareholders' Equity 1,000 9,003 8,379.013
Note. Start-ups costs (Transaction #2) were capitalized, although Codification Topic 720-15 requires that they be
expensed. No income tax payable is required due to the presence of a net operating loss carryforward of

2-31
a. Opening balance sheet
Photovoltaics, Inc.
Balance Sheet
Beginning of Year 1

Cash $ 476,125 Notes payable $1,300,000
Inventory 1,300,000 Shareholders equity:
Equipment 2,750,000 Common stock 3,500,000
Building 4,500,000 Additional paid-in-capital 5,503,125
Land 750,000 Retained earnings --
Patent 500,000
Start-up costs 27,000
Total $10,303,125 Total $10,303,125
b. Income statement
Photovoltaics, Inc.
Statement of Earnings
For Year 1
Revenues $480,000
Less: Cost of goods sold (215,000)
Gross profit 265,000
Less: Employee wages $72,000
Insurance expense 2,700
Selling & administrative expense 9,600
Depreciation expense 500,000
Amortization of Patent 29,412
Start-up costs 5,400
Executive compensation 40,000
Interest expense 130,000
(789,112)
Net loss $(524,112)

c. Balance sheet at end of first year
Photovoltaics, Inc.
Balance Sheet
End of Year 1
Current: Liabilities
$1,300,00
Cash $435,825 Notes payable 0
Accounts receivable 96,000
Inventory 1,155,000
Total 1,686,825 Shareholders equity
Noncurrent Common stock 3,500,000
Land $750,000 Additional paid-in-capital 5,503,125
Equipment (net) 2,475,000 Retained earnings (624,112)
Building (net) 4,275,000
Patent (net) 470,588
Start-up costs (net) 21,600
Total 7,992,188
Total liabilities & $9,679,01
Total assets $9,679,013 shareholders equity 3
d. Statement of Cash Flows
Photovoltaics, Inc.
For Year 1
Cash sales $384,000
Cash cost of goods sold (70,000)
Cash wages (72,000 + 40,000) (112,000)
Cash selling, general and administrative expense
(2,700 + 9,600) (12,300)
Cash interest (130,000)
59,700
Cash flow from investing 0
(100,000)
Decrease in cash (40,300)

2. A prospective investor would probably want to consider the following issues:
a. Although sales were forecasted to be $480,000 in the first year,

what is the demand for the photovoltaic arrays thereafter?
b. At what level of sales will the company be at breakeven?
c. Although there is not much debt on the balance sheet, the cash
balance is very small. Is the small but positive cash flow from operations
sufficient to sustain the business through the start-up phase?
Clearly, the decision to pay a dividend (especially a large one) at this early
stage is unwise. The dividend of $100,000 exceeded the cash flow from
operations of $59,700, thus eating away at the firms small cash balance.
This decision should be reconsidered.
P2.31 Preparing Financial Statements from Accounting Events.
Spreadsheet at March 31, 2003:
Island Foods, Inc.

Bal.
Sheet
Transaction: 1 2 3 4 5 6 7 3/31/13
120,00 (26,00 (12,00 (1,20 (2,700 (68,00
Cash 10,000 0 0) 0) 0) ) 0) 20,100
Kitchen equipment 26,000 26,000
12,00
Computer equipment 0 12,000
Food prep equipment 1,200 1,200
Furniture and fixtures 2,700 2,700
Equipment --
Leasehold
improvements 68,000 68,000
10,00 130,00
Total assets 0 0
120,00 120,00
Loan payable 0 0
120,00
Total liabilities -- 0
Common stock 10,000 10,000
Retained earnings --
Total
shareholders 10,00
equity 0 10,000

1.
Island Foods, Inc.
Balance Sheet
As of March 31, 2003
Cash $20,100 Liabilities:

Kitchen equipment 26,000 Loan payable $120,000
Computer system 12,000
Food prep equipment 1,200 Shareholders equity:
Furniture and fixtures 2,700 Common stock 10,000
Leasehold improvements 68,000
Total liabilities & shareholders
Total assets $130,000 equity $130,000
2. Financial Statements for 2003.
Island Foods, Inc.

Balance Sheet
As of December 31, 2003
Current Liabilities
Cash $63,000 Accounts payable $9,000
Accounts receivable 3,000 Utilities payable 1,000
Prepaid insurance 13,500 Employee wages payable 1,100
Total 79,500 Accrued interest payable 6,750
Income taxes payable 7,496
Noncurrent: Loan payable-current 12,000
Kitchen equipment (net) 22,100 37,346
Computer system (net) 10,500 Loan payable-noncurrent 108,000
Food preparation equipment (net) 900 Total liabilities 145,346
Furniture and equipment (net) 2,025 Shareholders Equity:
Leasehold improvements (net) 57,800 Common stock 10,000
Total 27,479
Total Liabilities & Shareholders
Total Assets $172,825 Equity $172,825
Continued next page

2. Continued
Island Foods, Inc.

Income Statement
For the 9 months ended December 31, 2003
Sales revenue $215,000
Less:
Food costs $69,000
Supply costs 4,800
Utility charges 9,000
Employee wage expense 45,100
Business license fee 900
Lease expense 8,400
Depreciation expense* 16,575
Interest expense 6,750
(165,025)
Net income before tax 49,975
Income taxes (15%) (7,496)
Net income after tax $42,479
*(3,900 + 1,500 + 975 + 10,200); ($68,000/5 years) x 9/12 = $10,200.
Island Foods, Inc.

For 9 months ended 12/31/03
Operations
Net income $42,479
Depreciation 16,575
Accounts receivable (3,000)
Prepaid insurance (13,500)
Accounts payable 9,000
Utilities payable 1,000
Employee wages payable 1,100
Accrued interest payable 6,750
Investing
-- --
Financing
Dividends (25,000)
Cash flow from financing (25,000)

3. Financial Statements for 2004.
Island Foods, Inc.

Balance Sheet
As of December 31, 2004
Current Liabilities
Cash $105,504 Current
Accounts receivable 5,000 Accounts payable $12,000
Prepaid insurance 7,500 Utilities payable 1,000
Total 118,004 Employee wages payable 1,400
Interest payable 6,075
Noncurrent Loan payable-current 12,000
Kitchen equipment (net) 16,900 43,466
Computer system (net) 8,500 Noncurrent
Food preparation Loan payable 96,000
equipment (net) 500 Total liabilities 139,466
Furniture and equipment
(net) 1,125 Shareholders Equity
Leasehold improvements Common stock 10,000
(net) 44,200 Retained earnings 39,763
71,225 Total 49,763
Total Liabilities & Shareholders
Total Assets $189,229 Equity $189,229
Island Foods, Inc.

Income Statement
For the year ended December 31, 2004
Sales revenue $329,000

Less:
$108,00
Food costs 0
Supply costs 6,200
Utility charges 12,000
Employee wage expense 76,300
Lease expense 16,800
Interest expense* 8,325
Depreciation expense 22,100
(255,725)
Net income before tax 73,275
Income taxes (15%) (10,991)
Net income after tax $62,284
*[($120,000 x 7.5% x 3/12) + ($108,000 x 7.5% x 9/12)]
Continued next page

3. Continued
Island Foods, Inc.
Operations
Net income $62,284
Depreciation 22,100
Accounts receivable (2,000)
Prepaid insurance 6,000
Accounts payable 3,000
Utilities payable --
Employee wages payable 300
Interest payable (675)
Investing
-- --
Financing
Loan payable (12,000)
Dividends (40,000)
Cash flow from financing (52,000)
4. Financial Analysis.
2003 2004
ROE 154.6% 125.2%
ROA (levered) 24.6% 32.9%
ROA (unlevered) 27.9% 36.7%
ROS 19.8% 18.9%
Financial leverage 6.29 3.80
Long-term-debt-to-equity 4.37 2.17
Interest coverage 8.4 9.8
Total asset turnover 1.24x 1.74x
Why do Island Foods profitability ratios (i.e., ROE, ROS, and ROA) look so
positive? Clark and Susan treated their salary withdrawal as a dividend (i.e.,
after calculating net income) rather than as compensation expense (i.e., before
calculating net income). Thus, the restaurants profitability ratios are artificially
high and should be recalculated after treating the dividends as an operating
expense.
Given the strength of the first two years of operations, a bank would most likely
extend Susan and Clark the loan for expansion purposes.
CORPORATE ANALYSIS
CA2.32 The Procter and Gamble Company.

a. Common-size income statements
2012 2011 2010
Net sales 100% 100% 100%

Cost of products sold (50.7) (49.1) (47.8)
Selling, general and administrative
expense (31.6) (31.7)
Goodwill and intangibles
impairment (1.9) -- (32.0)
Interest expense (0.9) (1.0) (1.2)
Other nonoperating income 0.3 0.4 0.1
Income taxes (4.1) (4.1) (5.2)
Net earnings from discontinued op. 1.9 0.3 2.6
Net earnings 13.0% 14.7% 16.6%
(Note: All columns may not total exactly due to rounding.)
P & Gs net sales are increasing, but some of the companys operating
expenses are growing at a faster rate, causing P&Gs net income to
decrease each year. Cost of products sold as a percent of net sales
increased each year over the three year period and the goodwill and
intangibles impairment existed only in 2012. While SG&A expense, interest
expense, and income taxes fell slightly over the period, it was not enough to
offset the increase in cost of goods sold and the intangibles impairment.

b. Common-size balance sheets
2012 2011
Cash and cash equivalents 3.4 2.0
Accounts receivable 4.6 4.5

Inventories 5.1 5.3
Deferred income taxes 0.8 0.8
Prepaid expenses and other current assets 2.8 3.2
Property, plant and equipment (net) 15.4 15.4
Goodwill and other intangible assets (net) 64.1 65.2
Other noncurrent assets 3.9 3.5
Total assets 100% 100%
(Note: All columns may not total exactly due to rounding.)
P&Gs asset decrease was principally accounted for by a 1.1% decline

(calculated as a percentage of total assets) in net goodwill and other
intangible assets from 2011 to 2012. Goodwill declined as a result of the
elimination of the snack and pet care segments. Goodwill was also
impacted from a change in the timing of the goodwill impairment calculation.
The calculation identified a required $1.3 billion reduction to goodwill
attributable to the Appliances and Salon Professionals reporting units.
Assets also decreased because, prepaid expenses and other current assets
declined 0.4% (calculated as a percentage of total assets) over the same
period. The decline in prepaid expenses is not a problem since it would
mean there is more cash available for P&Gs short term use or to make
longer term investments.

c. Financial strategy
2012 2011
Accounts payable 6.0 5.8
Accrued and other liabilities 6.3 6.7
Debt due within one year 6.6 7.2

Long-term debt 15.9 15.9
Deferred income taxes 7.7 8.0
Other noncurrent liabilities 9.1 7.2
Shareholders equity 48.4 49.2
Total liabilities and shareholders equity 100% 100%
The decrease in assets had no impact on long-term debt, which remained

constant, but debt due within one year declined 0.6%. Shareholder equity
declined by 0.8% due in large part to the impact of the decline in goodwill.
2012 2011
Total debt total assets 51.6% 50.8%
Long-term debt shareholders equity 46.5% 47.1%
While P&Gs debt-to-total assets ratio has slightly increased, 0.8% over the
two year period, the change in ratio could be attributed to the decline in
assets, primarily goodwill, over the same period. The long-term-debt-to-
equity ratio has decreased from 2011 to 2012.
Footnote 4 in P & Gs annual report reveals that the firms weighted average
cost of debt was as follows:
2012 2011
Short-term 0.6% 0.9%
Long-term 3.3% 3.4%
Given that P & Gs unlevered ROA in 2012 is 8.6 percent, they may want to
take advantage of their low cost of debt to finance its operations.

d. Cash Flow Analysis (2012)
Major Outflows Amount
Treasury stock purchases 4,024
Dividends paid to shareholders 6,139
Capital expenditures (net ) 1,071
Reductions in short-term debt 3,412
Reductions to long-term debt 2,549
Total $17,195
Major Inflows
Operations $13,284
Long-term borrowings 3,985
Impact of stock options and other 1,729
Total $18,998
P&Gs principal uses of cash were the repurchase of common shares, the
payment of dividends to shareholders, capital investments, and debt
reduction. P&G financed these outflows using cash generated from
operations, new borrowings, and cash generated from the exercise of stock
options.
e. Dividend Policy.
Using dividends paid to common shareholders and net earnings attributable
to P&G, we calculate the following:
Dividend Payout Ratio
2012 2011 2010
P&G 54.7% 46.9% 41.1%
Johnson & Johnson 60.9% 63.6% 43.5%
Kimberly-Clark 66.5% 69.6% 58.9%
P & G, and its key competitors, all maintain relatively high dividend payout
policies, although P & Gs dividend payout is lower than that for Johnson &
Johnson and for Kimberly-Clark.
A high dividend payout usually indicates a firm (and, in this case, an

industry) that is relatively mature and lacking in significant growth
opportunities. Firms that return a high percentage of their earnings do so
because they believe that this is a good way to retain their shareholders. In
this case, the presumption is that P & Gs shareholders have better
investment opportunities than does P & G itself and hence, the high
dividend payout policy.
CA2.33.Internet-based Analysis.
No solution is provided as any solution would be unique to the company
selected.

Fae3e SM ch02

Uploaded by

Copyright:

Available Formats

Fae3e SM ch02

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Fae3e SM ch02

Uploaded by

Copyright:

Available Formats

Chapter 2.

From Business Events to Financial Statements

Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses

Easy: E2.15; E2.16

Q2.1 Accounting Terminology

When a firm generates operating revenue, this leads initially to an increase in

Cambridge Business Publishers, 2014

Managers and shareholders use historical financial statements to evaluate a

Cambridge Business Publishers, 2014

All four of these performance indicators are considered by investment

The CFFO informs financial statement users as to whether a firm is a net

Cambridge Business Publishers, 2014

Return on Equity (ROE): Net Income divided by Shareholders Equity

Return on Sales (ROS): Net Income divided by Net Sales

Total Asset Turnover (TAT): Net Sales divided by Total Assets

Financial Leverage (LEV): Total Assets divided by Shareholders Equity

A manager can increase a firms ROE by:

1. Increasing ROS (i.e., by selling more units at a profit or by raising its

Q2.8 Evaluating Financial Risk.

Cambridge Business Publishers, 2014

One approach used by some analysts to identify the possibility of revenue

Cambridge Business Publishers, 2014

(Total debt Liquid assets) Shareholders equity.

The Bristol-Myers Squibb (BMS) syndicate of lenders imposed this constraint

Q2.12 Managing Operating Expenses. Rear-end loading of expenses (e.g., see

Cash SG&A outlays SG&A expense

Cambridge Business Publishers, 2014

Q2.14 (Ethics Perspective) Corporate Social Responsibility and Ethics. It is not

Continued next page

Cambridge Business Publishers, 2014

1. We believe our first responsibility is to the doctors, nurses, and patients,

Cambridge Business Publishers, 2014

E2.15 The Balance Sheet Equation.

Fernandez & Co.

E2.16 Account Classification.

Cambridge Business Publishers, 2014

E2.18 The Statement of Cash Flow.

E2.19 The Statement of Cash Flow.

Cambridge Business Publishers, 2014

NOTE: Statement of Shareholders Equity not required in text question

Continued next page

Cambridge Business Publishers, 2014

Cambridge Business Publishers, 2014

Marilyns cash management strategy appears solid. The dividend payment of

Cambridge Business Publishers, 2014

P2.22 Accounting Event Analysis and Financial Statement Preparation.

Smith & Co.

Smith & Co.

Smith & Co.

Beginning balance $0- $0- $0-

Continued next page

Cambridge Business Publishers, 2014

Smith & Co.

Smith & Co.

Cash flow from investing (40,000)

Cash flow from financing

Cambridge Business Publishers, 2014

Wilmot Real Estate Co.

Wilmot Real Estate Co.