FAE4e - SM - Ch02 120216 - Excluding Assignment Questions

Chapter 2.
From Accounting 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
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 firm’s 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 firm’s 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, 2017

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

firm’s past performance, as well as to predict a firm’s 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 entity’s 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 concept 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.

2-2 Financial Accounting for Executives & MBAs, 4th Edition
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.
Q2.5 Key Performance Indicators: The Income Statement.

Operating revenues measure the inflow of assets (e.g., cash and accounts
receivable) from a firm’s 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 firm’s
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 firm’s 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 firm’s 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 firm’s net cash flow from
its investing decisions; it is a reflection of a firm’s investment strategy. The cash
flow from financing activities (CFFF) reports a firm’s net cash flow from its
financing decisions; it is a reflection of a firm’s 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
Asset Turnover (AT): Net Sales divided by Total Assets
Financial Leverage (LEV): Total Assets divided by Shareholders’ Equity
A manager can increase a firm’s 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-equity: The relative size of financing from creditors (long-
term debt) versus financing from shareholders (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 firm’s 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 3.

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
firm’s 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 2), 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 ensure that the firm’s 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 ensure 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 firm’s 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 firm’s 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 market’s 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
corporation’s 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 Fortune’s “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 company’s growth needs,
ultimately translating into financial well-being.
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 magazine’s 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.
See QuestromTools Site.
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 car’s
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.
Continued next page

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.

2015 2014 2013
Cash, beginning balance -- $20,927 --

Cash flow from operating activities -- $18,471 --
Cash flow from investing activities -- -- $(5,103)
Cash flow from financing activities $(12,335) -- --
Cash, ending balance -- $14,523 --
JNJ 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.

2015 2014 2013
Cash, beginning balance $91,017 -- $77,533

Cash flow from operating activities -- -- --
Cash flow from investing activities $59,488 -- --
Cash flow from financing activities -- $(20,450) --
Cash, ending balance -- -- $88,792
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.
Balance
Cash 5,000 15,000 (4,200) (2,500) (1,200) 12,000 24,100
Total assets 24,100
Loan payable 15,000 15,000

Total liabilities 15,000
Common stock 5,000 5,000

Retained earnings 4,100
Revenue 12,000
Lease Expense (4,200)
Floral Expense (2,500)
Utilities Expense (1,200)
Total stockholders' 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
Continued next page

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 Marilyn’s 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 parent’s 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.

PROBLEMS
P2.22 Accounting Event Analysis and Financial Statement Preparation.
1 2 3 4 5 6 Balance
Cash 60,000 (40,000) 18,000 (11,000) (1,000) 26,000
Accounts receivable 16,000 16,000
Land 40,000 40,000
Total assets 82,000


Revenue 16,000
Operating expense (11,000)
Dividends (1,000)
Total stockholders' 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 Common
Earnings Stock Total

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

Smith & Co.
Balance Sheet
At End of Year 1
Assets Liabilities
Cash $26,000 Loan payable $18,000
Accounts 16,000 Shareholders’ equity
receivable
Land 40,000 Common stock 60,000
Total $82,000 Retained earnings 4,000
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
company’s 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.
1 2 3 4 5 6 7 8 Balance
(30,000 (11,00
Cash 50,000 40,000 ) (10,000) 20,000 0
) 22,000 (5,000) 76,000
Accts. receivable 5,000 5,000
(15,00
Land 30,000 0) 15,000
Total assets 96,000


Revenue 25,000
(11,00
Misc. expenses 0
)
Gain on sale 7,000
Dividends (5,000)
Total stockholders'
equity 56,000
Wilmot Real Estate Co.

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

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

Continued next page

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

Equity
Cash $76,000 Bank loan $40,000
Accounts 5,000 Common stock 50,000
receivable
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
Increase in cash 76,000

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, 2017 balance sheet of the Mayfair Company would appear as
follows:
Mayfair Company
Balance Sheet
December 1, 2017
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 Additional Paid-in-capital 76,000
Machinery & Equipment (net) 15,000 Retained Earnings 12,000
Other long-term investments 8,000 93,000
93,000
Total Liabilities and
Total Assets $123,000 Shareholders’ Equity $123,000
12/1/2017 1 2 3* 4 5 6 12/31/2017
Cash 10,000 2,000 (8,000) (3,000) 1,000
Accounts receivable 15,000 15,000
Notes receivable 2,000 (2,000)
Inventory 3,000 3,000 6,000
Land 40,000 25,000 65,000
Building (net) 30,000 30,000
12,00
Machinery & equip 15,000 0 27,000
Other long-term
investments 8,000 8,000
Total assets 123,000 152,000
Accounts payable 10,000 3,000 (8,000) 5,000

Notes payable 9,500 22,000 31,500
Bank loan 10,500 10,500
Total liabilities 30,000 47,000
12,00
Common stock 5,000 0 17,000
APIC 76,000 76,000
Retained earnings 12,000 12,000
Total equity 93,000 105,000
* No entry under U.S. GAAP. Under IASB GAAP, increase Building Asset Revaluation Reserve by $15,000

Continued next page

Mayfair Company
Balance Sheet
December 31, 2017
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 Additional Paid-in-capital 76,000
Machinery & Equipment (net) 27,000 Retained Earnings 12,000
Other long-term investments 8,000 Total Shareholders’ Equity 105,000
130,000
Total Liabilities and
The Mayfair Company’s 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 company’s 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
12/31/15
Current assets Current liabilities

Cash and cash equivalents $3,641 Accounts payable $3,620
Short-term investments 19,649 Accrued expenses payable 15,619
Accounts receivable (net) 8,176 Short-term borrowings 10,160
Inventory 7,513 Total 29,399
Current tax assets 2,662
Other current assets 2,163 Noncurrent
Total 43,804 Long-term debt 28,818
Pension and post-retirement
benefit obligations 8,119
Noncurrent deferred tax
Noncurrent assets liabilities 26,877
Other taxes payable and other
Long-term investments 15,999 noncurrent liabilities 9,249
Property, plant & equipment, (net) 13,766 Total liabilities 102,462
Identifiable intangible assets (net) 40,356 Shareholders’ Equity
Goodwill 48,242 Contributed capital 81,501
Noncurrent deferred tax assets,
other noncurrent tax assets, and
other noncurrent assets 5,293 Retained earnings 71,993
Other comprehensive
income (loss) (9,522)
Treasury stock (79,252)
Total shareholders’ equity 64,720
Equity attributable to
noncontrolling interests 278
Total equity 64,998
Total liabilities and
Total assets $167,460 Shareholders’ equity $167,460
Financial risk:
 Total debt ÷ Total assets =$102,462 ÷$167,460 = 61.2%
 Long-term debt-to-shareholders’ equity = $28,818 ÷ $64,720= 44.5%
Pfizer has reasonable ratios related to debt.

P2.26 Analysis of Financial Statement Data.
1. Ratios
2016 2017
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. Asset turnover 0.85 0.84
2. The company’s 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 company’s ROA increased modestly from 14.5
percent to 14.7 percent. Further, the slight increase in ROA resulted from an
increase in the firm’s ROS from 17.0 percent to 17.5 percent. 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
2016 2017
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. Asset turnover 2.33x 2.59x
2. The company’s increase in ROE (from 33 percent to 59.2 percent) resulted

from an increase in both the firm’s 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 company’s increase in ROA resulted from an increase in both its ROS
(from 7.7 percent to 9.5 percent) and its asset turnover (from 2.33x to 2.59x).
In summary, all of the ratios represent positive improvements in the firm’s
financial performance.

P2.28 Analyzing Financial Statement Information.
 Profitability
2017 2016
Return on sales 34.3% 18.8%

Return on assets 18.8% 10.9%
Return on equity 38.7% 21.4%
Thunderbird’s 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%
Thunderbird’s 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
Thunderbird’s cash flow from operations is positive and growing.
 Overall assessment
Given Thunderbird’s 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
company’s 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.

P2.30 Preparing Financial Statements from Accounting Events.
1.
Photovoltaics, Inc.
1 2 3 3 4 Opening Bal. 5 6 6 7 8 8 9 10 11 12 13 12/31/17
Cash 500,000 (27,000) 8,125,000 (121,875) (8,000,000) 476,125 384,000 (70,000) (2,700) (72,000) (9,600) (40,000) (130,000) (100,000) 911,950
Accounts receivable ― 96,000 96,000
Inventory 1,300,000 1,300,000 70,000 (215,000) 2,455,000
Land 750,000 750,000 1,500,000
Building 4,500,000 4,500,000 (225,000) 8,775,000
Equipment 2,750,000 2,750,000 (275,000) 5,225,000
Patent 500,000 500,000 (29,412) 970,588
Start-up costs 27,000 121,875 148,875 (29,775) 267,975
Total assets 1,000,000 10,425,000 20,201,513
Notes payable 1,300,000 1,300,000 2,600,000

Total liabilities ― 1,300,000 2,600,000
Common stock 1,000,000 2,500,000 3,500,000 7,000,000

APIC 5,625,000 5,625,000
Retained earnings (648,487)
Revenue 480,000
Cost of goods sold (215,000)
Insurance expense (2,700)
Wages expense (72,000)
Executive comp. (40,000)
Selling & admin exp. (9,600)
Depreciation exp. (500,000)
Amortization exp. (29,412)
Start-up costs (29,775)
Interest expense (130,000)
Dividends (100,000)
Total equity 1,000,000 9,125,000 6,351,513
Note. Start-ups costs (Transaction #2) were capitalized, although Codification Topic 720-15 requires that they be expensed.
12. No Income tax payable is required due to the presence of a net operating loss carryforward of $548,487.

a. Opening balance sheet
Photovoltaics, Inc.
Balance Sheet
Beginning of 2015
Assets Liabilities & Shareholders’ Equity
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 5,625,000
Land 750,000 Retained earnings --
Patent 500,000
Start-up costs 148,875
Total $10,425,000 Total $10,425,000
b. Income statement
Photovoltaics, Inc.
Statement of Earnings
For Year Ended 2015
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 29,775
Executive compensation 40,000
Interest expense 130,000
(813,487)
Net loss $(548,487)

c. Balance sheet at end of first year
Photovoltaics, Inc.
Balance Sheet
End of 2015
Current: Liabilities
Cash $435,825 Notes payable $1,300,000
Accounts receivable 96,000 Shareholders’ equity
Inventory 1,155,000 Common stock 3,500,000
Total 1,686,825 Additional paid-in-capital 5,625,000
Noncurrent Retained earnings (648,487)
Land $750,000
Equipment (net) 2,475,000
Building (net) 4,275,000
Total liabilities & shareholders’
Patent (net) 470,588 equity $9,776,513
Start-up costs (net) 119,100
Total 8,089,688
Total assets $9,776,513
d. Statement of Cash Flows
Photovoltaics, Inc.
For Year Ended 2015
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)
Cash, beginning of year 476,125

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 firm’s small cash balance. This
decision should be reconsidered.
P2.31 Preparing Financial Statements from Accounting Events.
a. Spreadsheet at March 31, 2015:
Island Foods, Inc.

3/31/15
Cash 10,000 120,000 (26,000) (12,000) (1,200) (2,700) 68,000 20,100
Kitchen equipment 26,000 26,000
Computer equipment 12,000 12,000
Food prep equipment 1,200 1,200
Furniture & fixtures 2,700 2,700
Equipment ―
Leasehold improvements 68,000 68,000
Total assets 10,000 130,000
Loan payable 120,000 120,000

Total liabilities ― 120,000

Retained earnings
Total equity 10,000 10,000
Continued next page

Island Foods, Inc.
Balance Sheet
As of March 31, 2015
Cash $20,100 Liabilities:
Kitchen equipment 26,000 Loan payable $120,000
Computer system 12,000 Shareholders’ equity
Food prep equipment 1,200 Common stock 10,000
Furniture and fixtures 2,700
Leasehold improvements 68,000
Total liabilities & shareholders’
Total assets $130,000 equity $130,000
b. Financial Statements for 2015.
Island Foods, Inc.

Income Statement
For the 9 months ended December 31, 2015
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.

**$120,000 x 0.075 x 9/12
Continued next page

Island Foods, Inc.
Balance Sheet
As of December 31, 2015
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 prep 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 &
Island Foods, Inc.

For 9 months ended 12/31/15
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)

c. Financial Statements for 2016.
Island Foods, Inc.

Income Statement
For the year ended December 31, 2016
Sales revenue $329,000

Less:
Food costs $108,000
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)]
Island Foods, Inc.

Balance Sheet
As of December 31, 2016
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 prep equipment (net) 500 Loan payable 96,000
Furniture and equipment (net) 1,125 Total liabilities 139,466
Leasehold improvements (net) 44,200
71,225 Shareholders’ Equity
Common stock 10,000
Total 49,763
Total Liabilities &

Continued next page

Island Foods, Inc.
For Year Ended 12/31/16
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)
d. Financial Analysis.
2015 2016
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
Asset turnover 1.24x 1.74x
Why do Island Food’s 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 restaurant’s 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.
2015 2014 2013

Net sales 76,279 80,510 80,116
% change in net sales (5.26%) 0.49% --
Net Income 7,144 11,785 11,402
% change in net income (39.38%) 3.36% --
Net income declined at a much faster rate from 2014 to 2015. This calculation
indicates that costs increased dramatically from 2014 to 2015 and P&G has
difficulty controlling costs.
b. Common-size balance sheets
2015 2014
Cash and cash equivalents 5.3 5.9
Available for sale investment securities 3.7 1.5
Accounts receivable 3.8 4.4
Inventories 4.2 4.7
Deferred income taxes 1.0 0.8
Prepaid expenses and other current assets 2.2 2.7
Assets held for sale 2.7 2.0
Property, plant and equipment (net) 15.7 15.5
Goodwill and other intangible assets (net) 57.3 58.6
Other noncurrent assets 4.2 4.0
Total assets 100% 100%
(Note: All columns may not total exactly due to rounding.)
P&G’s asset decrease was principally accounted for by a 1.3% decline

(calculated as a percentage of total assets) in net goodwill and other
intangible assets from 2014 to 2015. Goodwill declined as a result of the
company’s exit from the Batteries business. The company incurred
impairment charges totaling $1.2 billion.
Assets also decreased because cash and cash equivalents, accounts

receivable, inventories, prepaid expenses and other current 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&G’s short term use or to make longer
term investments. Furthermore, the decrease in accounts receivable could
indicate that customers are paying for goods in cash in lieu of credit.
However, the decline in cash and cash equivalents contradicts this idea.

c. Financial strategy
2015 2014
Accounts payable 6.4 5.9
Accrued and other liabilities 6.4 6.2
Liabilities held for sale 0.9 0.5
Debt due within one year 9.3 10.8
Long-term debt 14.2 13.7
Deferred income taxes 7.4 7.1
Other noncurrent liabilities 6.8 7.3
Shareholders’ equity 48.7 48.5
Total liabilities and shareholder equity 100% 100%
The decrease in assets resulted in an increase in long-term debt of 0.5% and

debt due within one year declined 1.5%. Shareholder equity declined by 0.2%
due in large part to the impact of the decline in goodwill.
2015 2014
Total debt ÷ total assets 51.3% 51.5%
Long-term debt ÷ shareholders’ equity 29.1% 28.3%
While P&G’s debt-to-total assets ratio has slightly decreased, 0.2% over the
two year period, the change in ratio could be attributed to the decline in total
debt, primarily debt due within one year. The long-term-debt-to-equity ratio
has increased from 2014 to 2015.
Footnote 4 in P & G’s annual report reveals that the firm’s weighted average
cost of debt was as follows:
2015 2014
Short-term 0.3% 0.7%
Long-term 3.2% 3.2%
Given that P & G’s unlevered ROA in 2015 is 5.5 percent, they may want to
take advantage of their low cost of debt to finance its operations.

d. Cash Flow Analysis (2015)
Major Outflows Amount

Treasury stock purchases 4,604
Dividends paid to shareholders 7,287
Capital expenditures (net) 3,736
Change in short-term debt 2,580
Reductions to long-term debt 3,512
Purchases of short-term investments 3,647
Total $25,366
Major Inflows
Operations $14,608
Long-term borrowings 2,138
Impact of stock options and other 2,826
Proceeds from asset sales 4,497
Proceeds from sales of short-term investments 1,203
Total $25,272
P&G’s principal uses of cash were the payment of dividends to shareholders,

treasury stock purchases, purchases of short-term investments, reductions
to long-term debt, and capital expenditures. P&G financed these outflows
using cash generated from operations, new borrowings, and cash generated
from the exercise of stock options and proceeds from asset sales and short-
term investments.
e. Dividend Policy.
Using dividends paid to common shareholders and net earnings attributable

to P&G, we calculate the following:
Dividend Payout Ratio

2015 2014
P&G 102% 58.6%
Johnson & Johnson 55% 47.6%
Kimberly-Clark 125.6% 82.3%
Continued next page

P&G, and its key competitors, all maintain relatively high dividend payout
policies, although P&G’s dividend payout is lower than Kimberly-Clark in 2014
and 2015 and higher than Johnson & Johnson in 2014 and 2015. In 2015,
both P&G and Kimberly-Clark had dividend payout ratios over 100% returned
more money to shareholders than the company earned. This high ratio is
likely caused by a decrease in earnings in both cases. Moving forward, it’s
possible that the companies will be forced to lower dividends unless the
companies are positive about future earnings
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&G’s shareholders have better investment opportunities
than does P&G itself – and hence, the high dividend payout policy. However,
in the case of dividend ratios over 100%,
CA2.33. Internet-based Analysis.

No solution is provided as any solution would be unique to the company selected


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Chapter 2.

From Accounting Events to Financial Statements

Difficulty Rating for Exercises and Problems:

Easy: E2.15; E2.16

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

©Cambridge Business Publishers, 2017

Managers and shareholders use historical financial statements to evaluate a

Q2.3 Accounting Principles.

©Cambridge Business Publishers, 2017

Q2.5 Key Performance Indicators: The Income Statement.

All four of these performance indicators are considered by investment

©Cambridge Business Publishers, 2017

Q2.7 Return on Shareholders’ Equity.

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

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

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

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

A manager can increase a firm’s ROE by:

©Cambridge Business Publishers, 2017

Q2.9 Managing Operating Revenue.

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

©Cambridge Business Publishers, 2017

Q2.11 Debt Covenants.

(Total debt – Liquid assets) ÷ Shareholders’ equity

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

©Cambridge Business Publishers, 2017

Cash SG&A outlays ÷ SG&A expense

©Cambridge Business Publishers, 2017

©Cambridge Business Publishers, 2017

E2.15 The Balance Sheet Equation.

See QuestromTools Site.

E2.16 Account Classification.

E2.17 Asset or Expense.

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E2.18 The Statement of Cash Flow.

Cash, beginning balance -- $20,927 --

E2.19 The Statement of Cash Flow.

Cash, beginning balance $91,017 -- $77,533

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Loan payable 15,000 15,000

Common stock 5,000 5,000

Net income $4,100

Beginning balance $0- $0- $0-

Continued next page

©Cambridge Business Publishers, 2017

Change in cash 24,100

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See QuestromTools Site.

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Loan payable 18,000 18,000

Common stock 60,000 60,000

Smith & Co.

Smith & Co.

Beginning balance $0- $0- $0-

Continued next page

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Smith & Co.

Cash flow from operations

Cash flow from investing (40,000)

Cash flow from financing

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Loan payable 40,000 40,000

Common stock 50,000 50,000