Ch. 11 Exercises

Chapter 11

Using the Income Statement and the Financial Statement Notes: Additional Corporate Reporting Issues

3Questions

1. Income from continuing operations is the result of the entity’s central operations. It is more predictable from period to period than income from discontinued operations and extraordinary items. To provide stockholders and creditors with information useful for predicting the corporation’s future income, income from continuing operations is reported separately from other elements of net income.

2. Investors can estimate the value of a stock by computing the present value of the company’s stream of future income from continuing operations. The equation (using assumed amounts) is:

Chapter 11 Using the Income Statement and the Financial Statement Notes: Additional Corporate Reporting Issues 645

Estimated annualEstimated value of income in the future $200,000

the company’s = = = $2,000,000common stock Investment capital- 0.10

ization rate

3. Extraordinary items include losses arising from natural disasters (like earthquakes, floods, and tornadoes) and the taking of assets by a foreign government. Gains and losses due to employee strikes, the settlement of lawsuits, discontinued operations, and the sale of plant assets are not extraordinary items because they are normal business occurrences.

4. An accounting change makes it difficult to compare one period’s financial statements with the statements of preceding periods. Without detailed information, investors and creditors can be led to believe that the current year is better or worse than the preceding year when, in fact, the only difference is a change in accounting method. To help investors separate the effects of business operations from those effects generated by a change in accounting method, companies report the effect of the accounting change in a special section of the income statement. It is called the cumulative effect of an accounting change, and it usually appears after extraordinary items.

5. Earnings per share (EPS) is the most widely used of all accounting statistics; it is the amount of a company’s net income per share of its outstanding common stock. A company’s price-to-earnings ratio is the ratio of the market price of its common stock to its EPS. The price-to-earnings ratio for the company given is 6 ($12 / $2).

6. EPS is $0.50 [$5,500 / (12,000 shares – 1,000 shares = 11,000 shares)].

7. Three items on the income statements that generate income tax expense are (1) income from continuing operations, (2) income from discontinued operations, and (3) extraordinary items. An income tax saving is a reduction in income tax. It is caused by a loss.


8. Income tax expense is based on pretax accounting income on the income statement; it is an expense used to measure net income and is reported on the income statement. Income tax payable is based on taxable income from the income tax return filed with the Internal Revenue Service. Income tax payable is a liability reported on the balance sheet.

9. Creditors seek to restrict dividends and treasury stock purchases because outlays for these transactions decrease the corporation’s assets available to pay liabilities.

10. The statement of stockholders’ equity reports:

Other financial statement that reports on these transactions:

a. Net income Income statement

b. Details about the company’s issuance of stock

Statement of cash flows

c. Declaration of cash dividends None

d. Distribution of stock dividends None

e. Purchase and sale of treasury stock Statement of cash flows

f. Unrealized gains and losses on available-for-sale investments

None

g. Cumulative translation adjustment None

11. Major components of the Summary of Significant Policies:

a. Consolidation policy e. Inventoryb. Revenues f. Depreciationc. Expenses g. Capitalization of costsd. Earnings per share

This information is important because it reports how the company accounted for the item in question. It tells how the company prepared its financial statements. Investors and creditors can use this information to evaluate companies in light of the accounting methods they use, especially in comparison with other companies.

Other financial statement notes report on:

•1Acquisitions and dispositions of other companies. This note reveals to the company’s stockholders what other entities the business is buying and selling and how the business financed the acquisitions.

•2Pensions. This note reports the accumulated benefit obligations to retired employees, the fair market value of the pension plan assets, and whether the pension plan is overfunded or underfunded.

•3Long-term debt. This note gives details on the principal amounts, interest rates, and maturity dates of the company’s long-term notes payable and bonds payable.

12. Top management bears primary responsibility for the company’s financial statements. The auditors audit the financial statements to express a professional opinion whether the statements conform to GAAP, are free from material misstatement, and can be relied upon. The independent audit lends credibility to the financial statements and to consistency in the financial statements from one company to another.


13. A business segment is a clearly defined unit within a company. It is an entity within an entity that managers and investors wish to evaluate separately. Segment data are important because they indicate which parts of the business are most successful and which parts need improvement.

14. An interim period is a reporting period shorter than a year. Interim reports include an income statement, sometimes a balance sheet, and rarely a statement of cash flows. The interim reports are important because investors need information for decision making on a continuous basis. They cannot wait until after year-end to make all their decisions. Interim reports are not as reliable as annual reports because annual reports are audited by independent accountants. Interim reports are not audited.

3 Exercises

(20-30 min.) E 11-1Req. 1

Texaco, Inc.Income StatementFor the Year 19X5

MillionsTotal revenues............................................................... $36,787 Total operating expenses............................................... 35,801Income from continuing operations before income tax.................................................................. 986 Income tax expense....................................................... 258Income from continuing operations.............................. 728 Discontinued operations: Net loss from operations, $19, less income tax saving of $2............................................................. $ (17) Net loss on disposal, $223, less income tax saving of $49........................................................... (174) (191)Income before cumulative effect of accounting change 537 Cumulative effect of accounting change, $147, less income tax expense of $26.................................. 121Net income.................................................................... $ 658

Req. 2

Income fromEstimated annual continuing operations

Estimated value income in the future $728 millionof Texaco = = = $12,133.3 million

common stock Investment 0.06capitalization rate

Analysts can compare this estimated value to the actual market price of the company’s stock to decide whether to buy, hold, or sell the stock.


(10-15 min.) E 11-2

Graz CorporationIncome StatementFor the year 19X4

Sales revenue................................................................. $130,000

Cost of goods sold......................................................... 45,000

Gross margin.................................................................. 85,000

Operating expenses........................................................ 43,000

Income from continuing operations............................... 42,000

Loss on discontinued operations, $50,000,

less income tax saving of $20,000.............................. (30,000)

Income before extraordinary item and cumulative

effect of change in depreciation method..................... 12,000

Extraordinary gain, $12,000, less

income tax of $4,800.................................................. 7,200

Cumulative effect of change in depreciation

method, $6,000, less income tax saving of $2,000..... (4,000)

Net income..................................................................... $ 15,200

19X4 was a good year. Income from continuing operations, the best predictor of annual income, was $42,000 on sales of $130,000. The company sold an unprofitable segment, and removal of this drain on profits should help operations in 19X5. Many investors ignore the extraordinary gain and the cumulative effect of the accounting change for the purpose of predicting the company’s future income.

(10-15 min.) E 11-3

1. Continuing operations produced income of $698 million during

19X2, so operations were profitable.

2. The company’s stock price probably did not drop to near zero during

19X2 as a result of the net loss for the year. The net loss occurred as

a result of an accounting change that was required by a new

accounting standard, not because of the company’s main operations,

so investors probably did not stop buying McDonnell Douglas stock.

3. McDonnell Douglas was able to declare cash dividends during a loss

year because of retained earnings built up in prior years. The

company paid dividends from cash, which is not necessarily low

because of the net loss.


(10-15 min.) E 11-4

EPS forValue of continuing operations

one share of =PepsiCo. stock Investment

capitalization rate

$36.25 = $2.22i

i = $2.22 = 6.1%$36.25

6.1% ‘ Low risk

PepsiCo.’s line of business is relatively low risk because people will probably continue buying soft drinks and fast food during both bad times and good times.

(5-10 min.) E 11-5

EPS = [$56,000 – (1,600 x $1.75 x 1/4)] / (52,000 shares – 2,000 shares) = $55,300 / 50,000 shares = $1.11

(10-15 min.) E 11-6Earnings per share:

Income from continuing operations

[($115,400 – $5,000) / 46,000] $2.40

Loss on discontinued operations ($8,280 / 46,000) (0.18)

Income before extraordinary items

[($107,120 – $5,000) / 46,000] 2.22

Extraordinary loss ($55,200 / 46,000) (1.20)

Net income [($51,920 – $5,000) / 46,000] $1.02

Computations:Preferred dividends: 10,000 x $10 x 0.05 = $5,000

Weighted-average shares of common stock outstanding:

Number of Common Shares

OutstandingFraction of

Year

Weighted-AverageNumber of Common Shares Outstanding

40,000 x 4/12 = 13,33349,000 x 8/12 = 32,667

Weighted-average number of common shares outstanding...................................................... 46,000


(10-15 min.) E 11-7

19X6 Income Tax Expense ($420,000 x 0.35) 147,000 Income Tax Payable ($380,000 x 0.35) 133,000 Deferred Tax Liability ($40,000 x 0.35) 14,000

19X7 Income Tax Expense ($470,000 x 0.35) 164,500Deferred Tax Liability ($40,000 x 0.35) 14,000 Income Tax Payable ($510,000 x 0.35) 178,500

Deferred Tax Liability19X6 Bal. 14,000

19X7 14,00019X7 Bal. 0

Income statement: 19X6 19X7

Income before tax............................... $420,000 $470,000

Income tax expense............................ 147,000 164,500

Net income......................................... $273,000 $305,500

Balance sheet:

Current liabilities:

Income tax payable.......................... $133,000 $178,500

Long-term liabilities:

Deferred tax liability........................ 14,000 -0-

(5-10 min.) E 11-8Req. 1

Boeing either paid its 1994 balance of deferred tax liability during 1995,

or the 1994 deferred taxes shifted into Income taxes payable during 1995.

Either event would cause the 1994 deferred tax liability to decrease.

Req. 2

Boeing must have earned income during 1995 that caused its Income taxes

payable to increase during the year.


(10 min.) E 11-9

Big Red, Inc.Statement of Retained Earnings

For the Year Ended December 31, 19X9

(Millions)

Retained earnings balance, December 31, 19X8,

as originally reported............................................................ $395.3

Prior-period adjustment (debit)................................................ (3.8)

Retained earnings balance, December 31, 19X8, as adjusted. . 391.5

Net income for 19X9................................................................ 92.1

483.6

Dividends for 19X9.................................................................. (39.8)

Retained earnings balance, December 31, 19X9...................... $443.8

(10-15 min.) E 11-10Req. a

Stockholders’ equity

Total paid-in capital...................................................... $ 820,000

Retained earnings — Note X........................................ 270,000

Total stockholders’ equity............................................ $1,090,000

Note X — Long-term debt (or Restriction of retained earnings).The company’s long-term debt agreement restricts retained earnings in the amount of $250,000.

Req. b

Yung’s maximum dividend declaration could be $20,000, the unrestricted amount of retained earnings.


(10 min.) E 11-11

The Kroger Co.Statement of Retained Earnings


(Millions)

Retained earnings, December 31, 19X6................................... $792.6

Net income for 19X7................................................................ 127.1

919.7

Dividends for 19X7 ($2.3 + $85.2).......................................... (87.5)

Retirement of preferred stock................................................... (11.3)

Retained earnings, December 31, 19X7................................... $820.9

The $11.3 million debit to Retained Earnings arose from retiring preferred stock at a price greater than the price at which the company issued the stock. Apparently, the carrying value of the preferred stock was $70.3 million, computed as follows:

MillionsPrice paid to retire preferred stock...................... $81.6Less: Carrying value of preferred stock.............. (70.3)“Loss” on retirement, debited to

Retained Earnings ................................$11.3

The journal entry to record the retirement of preferred stock was:Millions

Preferred Stock.................................................... 70.3Retained Earnings............................................... 11.3

Cash................................................................ 81.6

(15-25 min.) E 11-12

NOVA Corp.Statement of Stockholders’ Equity


CommonStock

AdditionalPaid-inCapital

RetainedEarnings

TreasuryStock Total

Balance, Dec. 31, 19X5 $600,000 $3,100,000 $1,700,000 $(78,000) $5,322,000

Stock dividend 300,000 (300,000) —

Sale of treasury stock 5,000 31,000 36,000

Issuance of common stock 2,500 11,500 14,000

Net income 340,000 340,000

Cash dividends (180,000) (180,000)

Balance, Dec. 31, 19X6 $902,500 $3,116,500 $1,560,000 $(47,000) $5,532,000

1. NOVA’s retained earnings decreased by $140,000 during 1996 because total dividends exceeded net income during the year.

2. The stock dividend had no effect on total stockholders’ equity, total assets, or total liabilities.

3. Creditors would look with favor on the sale of treasury stock and on the issuance of stock. These transactions increased stockholders’ equity and assets and thereby strengthened the positions of NOVA’s creditors.


(10-15 min.) E 11-13

The Coca-Cola Company reported:Millions

1994 19951. Retained earnings..................... $11,006 $12,882

Retained earnings is also reported on the balance sheet. 1995 was

profitable. Net income was $2,986 million.

2. Assets (probably cash) received from issuance of stock:

$86 million ($1 + $85)

The statement of cash flows reports the $86 million received from the

issuance of stock.

3. The U.S. dollar was strong (the foreign currencies were weak) during

1995. The company had a negative cumulative translation adjustment

that grew during the year.

4. The market value of the available-for-sale investments increased by

$34 million during the year.

(15-20 min.) E 11-14Req. 1

Ford’s affiliated companies operated at a loss during 1995. Ford’s share of these losses was $154 million.

Req. 2

Ford’s equity in net lossof affiliated companies = $154 million

$154 million = 25% of the affiliates’ net losses

Affiliates’ net losses = $154 million = $616 million 0.25

Req. 3

A majority-owned subsidiary is another company in which the parent company (Ford) owns greater than 50% of the stock. The parent company can thus control the subsidiary.

Ford accounts for its majority-owned subsidiaries by the consolidation method, which means that Ford’s reported totals for income, assets, liabilities, and cash flows include the figures of the subsidiary companies.

The consolidation method requires management to use estimates and assumptions, as indicated in the last paragraph of Note 1, under Principles of Consolidation. Therefore, consolidation accounting may not be perfectly accurate.


(15-20 min.) E 11-15Req. 1Ford records revenue on automobile sales when Ford ships the cars to dealers. This policy seems reasonable because at the point of shipment the cars belong to the dealer and Ford has a receivable that it expects to collect from the dealer.

Req. 2Selling, administrative, and other expenses........................ $6,044 million

Req. 3Hertz, Avis, Alamo, Budget, National

Ford records revenue for sales to the auto rental companies over the “period of daily rental service” because “the daily rental company has an option to require [Ford] to repurchase [the] vehicles.” Ford’s sales to Hertz and Avis are not finalized at the time Ford ships automobiles to the rental companies. Therefore, it is appropriate for Ford to wait until later to record the sales revenue.

Req. 4Ford earns interest revenue “over the term of [its finance] receivables.”Financial Services Revenue for 1995................................ $26,641 millionFinancial Services’ largest expense for 1995: Interest expense.............................................................. 9,424 million

Ford borrowed money in order to lend it to Ford customers. Ford’s cost of the borrowed money was $9,424 million, and Ford earned $26,641 million of interest revenue by lending the money out to others. This is how financial services operate: borrowing at one rate and lending at a higher rate.

(20-25 min.) E 11-16Req. 1LIFO is Ford’s main inventory costing method.Ford also uses FIFO.

Req. 2Millions

Raw materials, work in process and supplies.......................... $3,717Finished products.................................................................... 3,445Total inventories..................................................................... $7,162

U.S. inventories....................................................................... $2,662Inventories held in foreign countries...................................... 4,500Total inventories..................................................................... $7,162

Req. 3Inventories, some at LIFO cost, some at FIFO cost, as reported.......................................................... $7,162Increase if all inventories were reported at FIFO cost............. 1,406Inventories, if all were reported at FIFO cost......................... $8,568

The increase from LIFO cost to FIFO cost can occur only when inventory costs are increasing.

Req. 4

Inventory turnover Cost of goods sold $101,171for finished products = Average finished

product inventory= ($3,445 + $3,295) / 2

= 30 times during the year

Average holding period = 365 days = 12 days30 times

A completed automobile sits at an assembly plant about 12 days.


(15-20 min.) E 11-17Req. 1

(Millions)

Long-term debt payable: AutomotiveFinancial Services Total

During 1996.................... $1,832 $ 73,058 $ 74,890 After 1996....................... 5,475 68,259 73,734 Total................................ $7,307 $141,317 $148,624

The balance sheet for Financial Services reports only one amount for Debt. It does not separate current liabilities from long-term liabilities. This breakdown is available only in the note.

Req. 2Ford’s managers would care about the breakdown of debts payable next year and the debts payable after one year because the managers must have the cash ready to pay the debts when they come due. Ford’s creditors care about the breakdown because they expect to receive the cash from Ford when the debts come due.

Two ratios that depend upon the level of current liabilities are:

Current ratio = Total current assets Total current liabilities

Acid-test Cash + Short-term investments + Net receivables(Quick) ratio = Total current liabilities

Req. 3(Millions)

AutomotiveFinancial Services Total

Fair value of debt................. $8,160 $144,730 $152,890

(15-20 min.) E 11-18Req. 1

Internal controls are designed to:1. Safeguard assets2. Encourage adherence to company policies3. Promote operational efficiency, and4. Ensure accurate and reliable accounting records.

Ford’s statement of management’s responsibility indicates that the company’s internal control structure is:

1. Intended to provide protection against...misuse or loss of company assets

2. Supported by written policies and procedures that communicate details of the internal control structure to the company’s worldwide activities

3. Aided by a staff of internal auditors4. Intended to provide...reasonable assurance that its records include

the transactions of its operations....

Req. 2

The Audit Committee takes responsibility “for determining that [Ford’s] management fulfills its responsibilities in the financial control of operations and the preparation of the financial statements.” In effect, the Audit Committee audits management, so it is important for the Audit Committee to be independent of management.


(continued) E 11-18Req. 3

Coopers & Lybrand L.L.P. (Limited Liability Partnership) is Ford’s

independent auditing firm. The Detroit, Michigan, office of Coopers &

Lybrand performed the audit. These auditors are not employees of Ford or

any other company. They work for themselves, and that makes them

independent of Ford Motor Company.

Req. 4

Coopers & Lybrand states that they audited Ford’s financial statements.

They expressed a clean, or unqualified, opinion on Ford’s financial

statements. Investors and creditors place more reliance on audited

financial statements than on unaudited statements. The auditor’s

independent examination of a company’s financial statements makes the

statements more credible because the auditors assure the public that the

statements conform to GAAP.

(15-20 min.) E 11-19

Case A 19X1 19X21. Net income [$25,000 – ($25,000 x 0.40)] $15,000

[$30,000 – ($30,000 x 0.40)] $18,000

2. Income Tax Payable ($25,000 x 0.40) $10,000($30,000 x 0.40) $12,000

Case B 19X1 19X21. Net income — same as Case A $15,000 $18,000

2. Income Tax Payable ($25,000 – $6,000) x 0.40 7,600 ($30,000 – $4,000) x 0.40 10,400

3. Deferred Tax Liability — Cr. bal. ($6,000 x 0.40) 2,400 19X1 balance of $2,400 + ($4,000 x 0.40) 4,000

The desirable feature of the deferred tax liability is that it need not be paid immediately. Payment can be delayed, which conserves cash for other business uses.


(30-40 min.) E 11-20Req. 1

(Millions)

= Higher AutomotiveFinancialServices

Revenues................................. $110,496 $ 26,641Net income.............................. 2,056 2,083Total assets.............................. 72,772 170,511

Financial Services use revenues more profitably.Automotive uses assets more profitably.

Req. 2

(Millions of Dollars)United States Foreign Countries

Net income: Automotive............. $1,843 44.5% $116 + $97 = $213 5.2% Financial Services 1,718 41.5 321 + 44 = 365 8.8 Total....................... $3,561 86.0% $578 14.0%

This analysis suggests that Ford would least like to keep its foreign automotive business because that is the least profitable segment. Ford probably keeps its foreign automotive business because the auto sales spawn loans that enable Ford to earn the higher amount of net income on financial services.

3 Problems

Group A

(40-50 min.) P 11-1AReq. 1

Mainframe Manufacturing CorporationIncome Statement

For the Year Ended June 30, 19X5

Revenues and gains: Net sales revenue ($589,000 less returns of $15,000 and discounts of $7,000)................................. $567,000 Dividend revenue............................................................ 11,000 Gain on lawsuit settlement.............................................. 8,000 Total revenues and gains.............................................. 586,000

Expenses and losses: Cost of goods sold........................................................... $319,000 Selling expenses.............................................................. 87,000 General expenses............................................................ 71,000 Interest expense............................................................... 23,000 Loss on sale of plant assets............................................. 10,000 Income tax expense......................................................... 28,000 Total expenses and losses............................................. 538,000Income from continuing operations.................................... 48,000Discontinued operations: Operating income, $9,000, less income tax of $3,600..... 5,400 Loss on sale of discontinued operations, $8,000 less income tax saving of $3,200.................................. (4,800) Income from discontinued operations.............................. 600Income before extraordinary items and cumulative effect of change in depreciation method.......................... 48,600Extraordinary gain, $27,000, less income tax of $10,800. . . 16,200Cumulative effect of change in depreciation method, $7,000, less income tax of $3,000...................... 4,000


Net income......................................................................... $ 68,800

(continued) P 11-1AReq. 1

Earnings per share:


[($48,000 – $6,000) / 20,000]........................................ $2.10

Income from discontinued operations ($600 / 20,000)...... 0.03

Income before extraordinary gain and

cumulative effect of change in depreciation method

[($48,600 – $6,000) / 20,000]........................................ 2.13

Extraordinary gain ($16,200 / 20,000).............................. 0.81

Cumulative effect of change in depreciation method

($4,000 / 20,000)............................................................ 0.20

Net income [($68,800 – $6,000) / 20,000]........................ $3.14

Computations:Preferred dividends: 4,000 x $25 x 0.06 = $6,000Common shares outstanding: 22,000 shares issued minus

2,000 treasury shares = 20,000 shares outstanding

Req. 2Evaluation: The year ended June 30, 19X5 was not a very good year. Most importantly, income from continuing operations was only $48,000 (8.5% of net sales) which was less than the target earnings of 10%. For predictive purposes, managers and investors often ignore discontinued operations, extraordinary items, and cumulative effects of accounting changes, because these gains and losses cannot be expected to recur in the future.



Stockholders’ EquityPaid-in capital: Preferred stock, 6%, $25 par, 20,000 shares authorized, 4,000 shares issued................................... $100,000 Common stock, no-par, 22,000 shares authorized and issued... 350,000 Paid-in capital from retirement of preferred stock.................... 16,000 Total paid-in capital............................................................... 466,000 Retained earnings......................................................................... 109,800* Subtotal.................................................................................. 575,800 Less treasury stock, common (2,000 shares at cost)..................... (28,000) Total stockholders’ equity...................................................... $547,800

*See the statement of retained earnings (not required) for the ending balance of retained earnings.

Req. 4

Preparing this income statement and statement of retained earnings will help students learn the components of income from continuing operations (ICO). Many investors use ICO as the major predictor of a company’s future income. Students will learn to omit discontinued operations, extraordinary gains and losses, the cumulative effects of accounting changes, and prior-period adjustments from ICO. Students will thus be better prepared to make investment decisions on the basis of a prediction of a company’s future income.

(continued) P 11-1A

Mainframe Manufacturing CorporationStatement of Retained Earnings (Not required)


Retained earnings balance, June 30, 19X4,

as originally reported....................................................... $ 63,000

Prior-period adjustment (debit)........................................... (4,000)

Retained earnings balance, June 30, 19X4, as adjusted...... 59,000

Net income for 19X5.......................................................... 68,800

127,800

Dividends for 19X5 — preferred....................... $ 6,000

common.......................... 12,000 (18,000)

Retained earnings balance, June 30, 19X5......................... $109,800


(10-15 min. — after working P 11-1A) P 11-2A

Estimated annual Income from continuingEstimated value income in the future operations ($48,000)of Mainframe = = = $960,000common stock Investment 0.05

capitalization rate

Current market value ofMainframe Manufacturing = $1,040,000 (20,000 shares x $52 per share)outstanding common stock

The investors would offer approximately $960,000.

The owners of Mainframe would probably not accept $960,000 because

their outstanding stock is now worth around $1,040,000 (20,000 shares

outstanding x $52 each).

(25-35 min.) P 11-3AReq. 1

Earnings per share:


[($371,885 – $12,500) / 123,500]....................................... $2.91

Gain on discontinued operations ($69,160 / 123,500).............. 0.56


[($441,045 – $12,500) / 123,500].......................................... 3.47

Extraordinary gain ($49,510 / 123,500)................................... 0.40

Net income [($490,555 – $12,500) / 123,500]......................... $3.87

Computations:Preferred dividends: 5,000 x $2.50 = $12,500


Number ofCommon Shares

Outstanding Fraction of Year


130,000 x 2/12 = 21,667119,000 x 1/12 = 9,917 121,000 x 7/12 = 70,583128,000 x 2/12 = 21,333

Weighted-average number of common shares outstanding 123,500



Investment Capitalization Rates 8% 10% 12%

Estimated value $2.91 $2.91 $2.91of Pellegrini =

common stock 0.08 0.10 0.12

= $36.375 = $29.10 = $24.25

The final estimate ($24.25 at 12%) presumes the investment is the most

risky. That is why the investor is willing to pay the least for Pellegrini

stock.

(30-40 min.) P 11-4A

The Software Connection, Inc.Statement of Income and Retained Earnings


Revenues: Net sales revenue ($733,000 less returns of $22,000 and discounts of $10,000)................... $701,000 Expenses: Cost of goods sold................................................ $383,000 Selling expenses................................................... 103,000 General expenses.................................................. 74,000 Income tax expense.............................................. 56,400 Total expenses................................................... 616,400Income from continuing operations........................ 84,600 Discontinued operations: Operating income, $25,000, less income tax of $10,000....................................... $ 15,000 Loss on sale of discontinued operations, $40,000, less income tax saving of $16,000..... (24,000) Loss from discontinued operations...................... (9,000)Income before extraordinary item........................... 75,600 Extraordinary gain, $30,000, less income tax of $12,000................................... 18,000Net income.............................................................. $ 93,600 Retained earnings balance, June 30, 19X3, as originally reported........................................... $209,000 Prior-period adjustment (debit)............................... (4,000)Retained earnings, June 30, 19X3, as adjusted....... 205,000

298,600 Dividends................................................................ (15,000)Retained earnings balance, June 30, 19X4.............. $283,600


(continued) P 11-4A

Earnings per share:

Income from continuing operations ($84,600 / 20,000)........ $4.23

Loss from discontinued operations ($9,000 / 20,000)........... (0.45)

Income before extraordinary item ($75,600 / 20,000)........... 3.78

Extraordinary gain ($18,000 / 20,000).................................. 0.90

Net income ($93,600 / 20,000)............................................. $4.68

Computation of common shares outstanding:

24,000 shares issued – 4,000 treasury shares = 20,000 shares outstanding


(25-35 min.) P 11-5AReq. 1 (taxable income)

19X3 19X4Total revenue: $680,000 + $10,000............................... $690,000 $720,000 – $10,000............................... $710,000 Cost of goods sold.................................... (290,000) (310,000)Operating expenses: $180,000 + ($60,000 – $40,000)........... (200,000) $190,000 + ($20,000 – $40,000)........... (170,000)Taxable income........................................ $200,000 $230,000

Req. 2 (income tax entries)

JournalDATE ACCOUNT TITLES AND EXPLANATION DEBIT CREDIT

19X3 Income Tax Expense ($210,000 x 0.35).................................... 73,500 Income Tax Payable ($200,000 x 0.35).............................. 70,000 Deferred Tax Liability ($10,000 x 0.35)................................ 3,500

19X4 Income Tax Expense ($220,000 x 0.35).................................... 77,000Deferred Tax Liability ($10,000 x 0.35)...................................... 3,500 Income Tax Payable ($230,000 x 0.35).............................. 80,500


Waterhouse Microfilms, Inc.Income Statement

For 19X3 and 19X4

19X3 19X4

Total revenue................................... $680,000 $720,000

Expenses:

Cost of goods sold........................ $290,000 $310,000

Operating expenses....................... 180,000 190,000

Income tax expense....................... 73,500 77,000

Total expenses.............................. 543,500 577,000

Net income....................................... $136,500 $143,000


(15-20 min.) P 11-6AReq. 1

Income before income tax: $520 million = $520 million = $800 million1 – Tax rate 1 – 0.35

Req. 2

Par value of common stock: $3,000,000 = $0.60 per share5,000,000 shares

Req. 3

Price per share of stock issuance: $49,000,000 = $9.80 per share5,000,000 shares

Req. 4

Cost of treasury stock sold: $11,000,000Selling price of treasury stock sold: $16,000,000Increase in total stockholders’ equity: $16,000,000

Reg. 5

Stock dividend percentage: $18,000,000 = 10%173,000,000 + $3,000,000

(30-40 min.) P 11-7AReq. 1

Receivables are sold to investors or pledged as collateral to long-term lenders.

At June 30, 1996, Clayton expected to collect $154,270,000 during fiscal year 1997. This amount is reported in Note 1, under Installment Contract Receivables.

Req. 2

Held-to-Maturity securities (reported at amortized cost)

Trading securities (reported at fair market value)

Available-for-Sale securities (reported at fair market value)

These accounting methods agree with Chapter 10.Amortized cost of held-to-maturity securities................... $20,361,000Market value of held-to-maturity securities...................... $19,774,000

Req. 3

Cost.............................................................. $228,841,000Less: Accumulated depreciation.................. (44,570,000)Book value.................................................... $184,271,000

Req. 4

Note Payable........................... 4,866,000 Cash..................................... 4,866,000Paid off note.


(continued) P 11-7A

Req. 5Net worth is another name for stockholders’ equity. Lenders want their borrowers to keep a certain minimum level of net worth because that means the business has that much more in assets than it owes in liabilities. The higher a business’s net worth, the better able it is to pay its debts.

Req. 6Manufactured Financial

Housing Services

Operating income $89,504 $62,600Identifiable assets = $197,938 = 45.2% $493,622 = 12.7%

Manufactured Housing looks more profitable on this measure. Clayton probably keeps Financial Services because that segment generates a large amount of operating income each year.

Req. 7Clayton’s management bears primary responsibility for the company’s financial statements.

Coopers & Lybrand audits Clayton’s financial statements. The auditors take responsibility for the professional opinion that they express on the financial statements.

The audit does not examine all transactions of the client. The second paragraph of the audit report states that the auditors examined evidence “on a test basis.”

3 Problems

Group B

(40-50 min.) P 11-1BReq. 1

CPI Manufacturing, Inc.Income Statement

For the Year Ended September 30, 19X6Revenues: Net sales revenue ($860,000 less discounts of $18,000 and returns of $9,000).................................. $833,000 Interest revenue............................................................ 4,000 Total revenues........................................................... 837,000 Expenses and losses: Cost of goods sold........................................................ $424,000 Selling expenses........................................................... 136,000 General expenses.......................................................... 113,000 Interest expense............................................................ 11,000 Loss on insurance settlement........................................ 12,000 Loss on sale of plant assets........................................... 8,000 Income tax expense...................................................... 72,000 Total expenses and losses.......................................... 776,000Income from continuing operations.................................. 61,000 Discontinued operations: Operating loss, $15,000, less income tax saving of $6,000............................... $ (9,000) Gain on sale of discontinued operations, $20,000, less income tax expense of $8,000............................. 12,000 Gain from discontinued operations............................... 3,000Income before extraordinary item and cumulative effect of change in depreciation method........................ 64,000 Extraordinary loss, $30,000, less income tax saving of $12,000................................ (18,000)Cumulative effect of change in depreciation method, $3,000, less income tax saving of $1,000........ (2,000)


Net income...................................................................... $ 44,000

(continued) P 11-1BReq. 1

Earnings per share:


[($61,000 – $10,000) / 24,000]........................................... $2.13

Income from discontinued operations ($3,000 / 24,000)....... 0.12

Income before extraordinary item and cumulative

effect of change in depreciation method

[($64,000 – $10,000) / 24,000]........................................... 2.25

Extraordinary loss ($18,000 / 24,000)................................... (0.75)

Cumulative effect of change in depreciation method

($2,000 / 24,000)................................................................ (0.08)

Net income [($44,000 – $10,000) / 24,000].......................... $1.42

Computations:Preferred dividends: 5,000 x $40 x 0.05 = $10,000Common shares outstanding: 25,000 shares issued minus

1,000 treasury shares = 24,000 shares outstanding

Req. 2Evaluation: The year ended Sept. 30, 19X6 was a bad year. CPI managers fell short of their goal of earning income from continuing operations — the best predictor of annual income — of 10% of net sales ($61,000 / $833,000 = 0.073). For predictive purposes, managers and investors often ignore discontinued operations, extraordinary items, and cumulative effects of accounting changes because these gains and losses cannot be expected to recur in the future.



Stockholders’ Equity

Paid-in capital:

Preferred stock, 5%, $40 par, 10,000 shares authorized,

5,000 shares issued.............................................................. $200,000

Common stock, $10 par, 25,000 shares authorized

and issued............................................................................. 250,000

Paid-in capital in excess of par — common............................ 20,000

Contributed (paid-in) capital from treasury stock transactions 7,000

Total paid-in capital.......................................................... 477,000

Retained earnings....................................................................... 91,000*

Subtotal............................................................................. 568,000

Less treasury stock, common (1,000 shares at cost).................. (11,000)

Total stockholders’ equity................................................. $557,000

*See the statement of retained earnings (not required) for the ending balance of retained earnings.

Req. 4Preparing this income statement and statement of retained earnings will help students learn the components of income from continuing operations (ICO). Many investors use ICO as the major predictor of a company’s future income. Students will learn to omit discontinued operations, extraordinary gains and losses, the cumulative effects of accounting changes, and prior-period adjustments from ICO. Students will thus be better prepared to make investment decisions on the basis of a prediction of a company’s future income.

(continued) P 11-1B

CPI Manufacturing, Inc.Statement of Retained Earnings (Not required)

For the Year Ended September 30, 19X6

Retained earnings balance, September 30, 19X5,

as originally reported............................................................ $ 88,000

Prior-period adjustment (debit)................................................ (6,000)

Retained earnings balance, September 30, 19X5, as adjusted. 82,000

Net income for 19X6................................................................ 44,000

126,000

Dividends for 19X6.................................................................. (35,000)

Retained earnings balance, September 30, 19X6..................... $ 91,000


(10-15 min. — after working P 11-1B) P 11-2B

Estimated annual Income from continuingEstimated value of income in the future operations ($61,000) CPI Manufacturing = = = $871,429

common stock Investment 0.07capitalization rate

Current market value ofCPI Manufacturing = $996,000 (24,000 shares x $41.50 per share)

common stock

The investors would offer approximately $870,000.

The owners of CPI Manufacturing would probably not accept $870,000

because their outstanding stock is now worth over $996,000 (24,000

shares x $41.50).

(20-25 min.) P 11-3BReq. 1

Earnings per share:


[($81,100 – $25,000) / 51,000]........................................ $1.10

Gain on discontinued operations ($6,630 / 51,000)............... 0.13


[($87,730 – $25,000) / 51,000]........................................... 1.23

Extraordinary loss ($33,660 / 51,000)................................... (0.66)

Net income [($54,070 – $25,000) / 51,000].......................... $ 0.57

Computations:Preferred dividends: 20,000 x $1.25 = $25,000


Number ofCommon Shares Outstanding Fraction of Year


44,000 x 5/12 = 18,33350,000 x 3/12 = 12,500 60,500 x 4/12 = 20,167

Weighted-average number of common shares outstanding 51,000



Investment Capitalization Rates 8% 10% 12%

Estimated valueof Priest = $1.10 $1.10 $1.10

common stock 0.08 0.10 0.12

= $13.75 = $11.00 = $9.17

The final estimate ($9.17 at 12%) presumes the investment is the most

risky. That is why the investor is willing to pay the least for Priest stock.

(30-40 min.) P 11-4B

Santa Rosa Book DistributorsStatement of Income and Retained Earnings

For the Year Ended December 31, 19X3Revenues: Net sales revenue ($362,000 less returns of $11,000 and discounts of $6,000).................. $345,000

Expenses: Cost of goods sold............................................. $103,000 Selling expenses................................................ 56,000 General expenses............................................... 61,000 Income tax expense........................................... 50,000 Total expenses................................................ 270,000Income from continuing operations..................... 75,000 Discontinued operations: Operating loss, $13,000, less income tax saving of $5,200................... $ (7,800) Gain on sale of discontinued operations, $10,000, less income tax of $4,000................ 6,000 Loss from discontinued operations.................... (1,800)Income before extraordinary item........................ 73,200 Extraordinary flood loss, $20,000, less income tax saving $8,000........................... (12,000)Net income........................................................... $ 61,200 Retained earnings balance, December 31, 19X2, as originally reported......................................... $111,000 Prior-period adjustment (debit)............................ (14,000)Retained earnings balance, December 31, 19X2, as adjusted....................... 97,000

158,200 Dividends............................................................. (7,000)


Retained earnings balance, December 31, 19X3. . $151,200

(continued) P 11-4B

Earnings per share:

Income from continuing operations ($75,000 / 50,000) .... $1.50

Loss from discontinued operations ($1,800 / 50,000)...... (0.04)

Income before extraordinary item ($73,200 / 50,000)...... 1.46

Extraordinary loss ($12,000 / 50,000) ........................ (0.24)

Net income ($61,200 / 50,000)................................. $1.22

Computation of common shares outstanding:

52,000 shares issued – 2,000 treasury shares = 50,000 shares outstanding


(25-35 min.) P 11-5BReq. 1 (taxable income)

19X7 19X8Total revenue: $930,000 + $15,000................................... $945,000 $990,000 – $15,000................................... $975,000 Cost of goods sold........................................ (430,000) (460,000)Operating expenses: $270,000 + ($80,000 – $50,000)............... (300,000) $280,000 + ($20,000 – $50,000)............... (250,000)Taxable income............................................ $215,000 $265,000

Req. 2 (income tax entries)

JournalDATE ACCOUNT TITLES AND EXPLANATION DEBIT CREDIT

19X7 Income Tax Expense ($230,000 x 0.35).............................. 80,500 Income Tax Payable ($215,000 x 0.35)........................ 75,250 Deferred Tax Liability ($15,000 x 0.35).......................... 5,250

19X8 Income Tax Expense ($250,000 x 0.35).............................. 87,500Deferred Tax Liability ($15,000 x 0.35)................................ 5,250 Income Tax Payable ($265,000 x 0.35)........................ 92,750


Vista Petroleum CorporationIncome Statement

For 19X7 and 19X8

19X7 19X8Total revenue................................ $930,000 $990,000

Expenses: Cost of goods sold..................... $430,000 $460,000 Operating expenses.................... 270,000 280,000 Income tax expense................... 80,500 87,500 Total expenses........................... 780,500 827,500Net income................................... $149,500 $162,500


(15-20 min.) P 11-6BReq. 1

$336 million $336 millionIncome before income tax: = = $560

million1– Tax rate 1 – 0.40

$336 million $336 milliontax: = = $560

million1– Tax rate 1 – 0.40

Req. 2$8,000,000

Par value of common stock: = $0.80 per share10,000,000 shares

Req. 3$49,000,000

Price per share of stock issuance: = $4.90 per share10,000,000 shares

Req. 4

Cost of treasury stock sold: $19 millionSelling price of treasury stock sold: $28 millionIncrease in total stockholders’ equity: $28 million

Reg. 5$22 million

Stock dividend percentage: = 5%$427 million + $8 million


(30-40 min.) P 11-7BReq. 1

Clayton expects to collect its receivables over a period ranging from 3 years (36 months) to 15 years (180 months). This revenue is called financial services revenue, reported on the income statement as follows:

ThousandsFinancial Services Revenue (interest revenue).......................... $115,987

Req. 2

The income statement reports no depreciation expense. Note 4 reports depreciation expense of $11,163,000. Depreciation is included in selling, general, and administrative expense (and also in cost of sales, because Clayton is a manufacturing company. However, students should not be held responsible for cost of sales).

Req. 3

Interest expense avoided ($4,866,000 x 0.10)........................... $486,600

Req. 4

Current ratio and debt ratio may be restricted by lenders because lenders do not want their borrowers’ liabilities to get too high. The lower a borrower’s liabilities in relation to its assets, the better able the borrower is to pay its debts.


Rent expense for fiscal year 1996............................................. $2,722,000Rent payments scheduled for fiscal year 1997.......................... $2,551,000

Req. 6Manufactured Financial

Housing Services

Operating income $89,504 $62,600 = = 11.8% = 63.0%

Revenues $761,111 $99,443

Financial Services look more profitable by this measure. Clayton probably keeps Manufactured Housing for two reasons: (1) Manufactured Housing is quite profitable, and (2) The sales of manufactured houses bring the receivables to Clayton, which enables the company to earn the financial service revenue.

Req. 7

Coopers & Lybrand audits the financial statements of Clayton Homes.

The audit was performed in accordance with generally accepted auditing standards. Clayton’s accounting was evaluated in comparison with generally accepted accounting principles.

The auditors believe Clayton’s financial statements are reliable, as indicated by the clean audit opinion, which states, “...in conformity with generally accepted accounting principles.”


3 Decision Case

(15-20 min.)

Clayton’s accounting policies are better than those of Magnuson. Clayton follows more conservative (and more realistic) accounting policies than Magnuson. Here are some examples.

Sales Revenue

Clayton records sales revenue when it receives a sale contract and a cash down payment from a customer. In contrast, Magnuson records revenue when it receives a sale contract. Magnuson rarely receives a customer down payment. Therefore, Clayton’s receivables appear to be more collectible than Magnuson’s receivables, and as a result, Clayton’s revenues look stronger.

Premium Revenue

Clayton records premium revenue on insurance policies over the life of the policy, while Magnuson records insurance premium revenue up front when the customer signs the insurance contract. Clayton’s policy is more realistic because both companies earn the insurance premium revenue over the life of the contract as they provide insurance coverage for policyholders. They do not earn the revenue at the beginning of the contract period, which is when Magnuson records the revenue.

Overall, Magnuson’s policies for recording revenue suggest that the company may be overstating its revenue on the income statement. Clayton’s accounting policies make Clayton appear to be the safer investment.

3 Ethical Issue

1. It does matter how a company reports its operating results because different sources of income or loss can be expected to recur with different frequency. Investors and creditors want to predict the level of net income and cash flows that a company can expect to generate from year to year. Continuing operations are more predictable than extraordinary items and accounting changes. This is why extraordinary gains and losses and the effects of accounting changes are highlighted on the income statement — to alert investors and creditors of their nonrecurring, special nature.

In this case, the company and its existing stockholders could be helped by management’s action. By hiding the extraordinary gain, the second income statement makes the company look better than it really is. By burying the extraordinary gain in income from continuing operations, the second income statement makes it appear that General Cinema can earn more income each year than it really can. Projecting this rosy picture of operations may enable the company to borrow on better terms, and its stock price may temporarily perform better than it should.

Lenders who loan money to General Cinema and stockholders who buy the company’s stock based on the second income statement can be hurt. They may lend to the company on too-favorable terms, or they may pay too high a price for its stock. When the truth comes out — in terms of actual results — General Cinema may be unable to pay its loans. Or the company’s stock price may fall, leaving the new stockholders with stock worth less than they paid for it.

2. Management’s ethics look bad if top managers intentionally reported the second income statement — for the reasons given in requirement 1.


3 Financial Statement Case

(20-25 min.)Req. 1

The trends of net sales and gross profit are up. The trends of income from operations and net income are down. The main reason for the difference in the trends is that selling, general, and administrative (SG&A) expenses have increased faster than sales.

An investor would probably regard the trend of income from operations as most important because it includes sales revenue and all operating expenses, but excludes the effects of any discontinued operations, extraordinary gains and losses, and accounting changes. Income from operations thus measure the company’s success in its main, ongoing business activities.

Req. 2

Lands’ End’s stock prices dropped throughout fiscal years 1995 and 1996, following the path of net income, which also dropped.

(continued)Req. 3

Fourth Quarter 1996

Estimated year-end Market high + Market low $15.50 + $12.875market price = =

2 2

= $14.19

Estimated price of Net income per share $0.89*= =

Investment icapitalization rate (i)

$0.89i = = 6.3% ‘ Low risk

$14.19

*From Income Statement


(continued)Req. 4

Total return on your Price change + Dividendsstock investment =

Beginning stock price

= ($15.50 – $22.625) + $0*$22.625

= – 31.5%

*From Statement of Shareholders’ Investment

This investment return tracks the decline in Lands’ End’s net income from fiscal year 1994 through fiscal year 1996 rather closely, as follows:

Percentage decreasein Lands’ End

net income from1994 to 1996

= $30,555 – $43,729$43,729

= – 30.1%

Note: Student responses need not be so precise to show that the declines in net income and stock price are moving together.

Solutions to Internet Exercises

May Department Stores

(Answers based on 1996 fiscal year financial statements)

a. May’s fiscal year-end is at the end of January. Because of the flurry of holiday shopping during December, having a December fiscal year-end would spread the results of one shopping period over two years of accounting reports.

b. Items following Income from Continuing Operations include Net Earnings from Discontinued Operations and Extraordinary Loss.

c. The answer depends on the objective of the financial statement user. Most equity analysts prefer to focus on income from continuing operations, because it yields information regarding the firm’s core economic activities. Items following income from continuing operations are, typically, one-time events that occur infrequently. However, some firms seem to have one-time events every year.

d. May’s sales increased from $9.759 billion to $10.507 billion during fiscal 1996, a 7.7% increase. Same-store sales during 1996 increased 2.5 percent. The majority of May’s sales increases came from expanding the number of stores as opposed to increasing store sales.

e. The largest assets on May’s balance sheet are accounts receivable, inventory, and property and equipment. The retail industry requires that stores (property and equipment) hold significant levels of inventory for resale. To encourage sales, stores provide credit terms to shoppers. Thus, the operating cycle of a retailer is readily apparent in the balance sheet.


f. May Department Stores clearly shows seasonal sales patterns. The fourth quarter (November – January), which encompasses the Christmas season, has the largest level of sales. The winter quarter (February – April) has the lowest level of sales.

Business

Ch. 11 Exercises