Solution Manual for Financial Accounting in an Economic Context, 9th Edition

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1CHAPTER 1FINANCIAL ACCOUNTINGINANECONOMIC CONTEXTISSUES FOR DISCUSSIONID1–1Security analysts and stockholders: These users would use financial statements to try to estimate thefuture earnings and cash flow potential of the company, which would be used to project a value for thecompany’s stock.Bank loan officers:These users would use the financial statements to determine the ability of acompany to repay loans to the bank.A company’s customers and suppliers:These users would use financial statements to determinewhether to extend credit to the company (suppliers) or whether to rely upon the company to be asupplier (customers). Both suppliers and customers would also use the financial statements to monitorthe company’s profit margins.Public utilities: This group would use the financial statements to determine the company’s growth rateand how that might impact upon the company’s utility needs. Also, they would evaluate the company’sability to pay its bills.Labor unions:These groups would use the financial statements to monitor the profitability of thecompany to help determine the amount of pay raises and benefits that it will negotiate for from thecompany.A company’s managers:The company’s managers will use the financial statements to assess theoverall financial health of the company. This could impact the managers in a number of ways: raises,promotion opportunities, performance of other departments, etc.ID1–2The board of directors serves various functions for a company.One is to represent and protect theinterests of the stockholders who are not on the board.Another is to provide oversight and input tomanagement.The managers are involved in running the business on a day to day basis whereas theboard is more focused on the bigger, long term picture. A weak board may not ask probing questionsof management but instead may take everything at face value and believe anything that managementsays to them. A healthy management team would want a strong board that delivers valuable input. Amanagementteamthatwantsaweakboardofdirectorsmaybetryingtohidesomething(management fraud).Auditors are concerned with management fraud because, if there is a problem, in many cases theauditors will be sued by the stockholders on the basis that the auditors should have detected the fraud.

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2ID1–3The function of the audit committee is to provide a channel whereby the auditors report their findingsand concerns, if any, to the board of directors. Typically there are outside members of the board thatare on the audit committee so that if the auditors have concerns about management’s financialstatements or activities, then the auditors have a way to speak directly to the board of directors.The auditors are in a sensitive position because the financial statements and activities that they areauditing are prepared by the same people who hire and pay the auditors.Therefore, they may bereluctant to jeopardize their relationship with the company by being too negative.ID1–4Banks make loans to customers and depend on those customers to repay the loans (called the“principal”) plus interest for the banks to earn a profit.If customers are not able to pay the interest,the banks cannot make a profit; further, if the customers are not able to repay the principal the bankswill show a loss that reduces the equity on the balance sheet. Banks look at a number of factors, both“macro” and “micro” in nature.Banks will look at the overall strength of the economy and thelikelihood for future growth; these are the macro issues a bank considers. Banks will also examine thespecifics of a company’s individual performance within the economy; these micro issues often are seenin the financial statements of companies. Issues such as the amount of debt, the level of profits, theamount of cash on hand and the amount of cash generated by the business, and the quality and size ofthe assets can all be seen from the financial reporting system.Banks require borrowers to submitfinancial statements to show these performance measures.During the 2008-2009 recession andrelated credit crunch, banks were concerned about the macro issues shown in general economic data,as well as the micro issues shown in companies’ individual financial reports.The reluctance of banks tolend has been cited as one of the reasons for the length of the economic downturn.ID1–5Sales for Home Depotincreasedduring the time periodbecause of theslow rebound of theeconomyafter the worst of the “Great Recession”.As conditions improved, home owners and to a lesser extenthome builderspurchasedmorematerials from Home Depot toimprove andconstruct houses. Profitsincreasedbecause thebumpin sales was not offset with an equalincreasein expenses, probably due tosome economies of scale experienced by the large hardware retailer.Assetsincreased as the companyboosted inventory in stores to meet the higher sales, as well as the company increasing its totalnumber of stores.Equity remained flat because the companyrewarded its owners by paying outdividendsequal to itsprofits.Finally, the cash balance slightly increased due tothe fact that theimproved operations (from the stronger economy) generated more cash than what was needed toinvest in new storesand pay out to the providers of capital.ID1–6Creditors would impose these types of restrictions onUnitedContinental so that the creditors would beprotected for their loans. These types of restrictions are fairly common and act as a trip wire to warnthe creditors that business may not be going well. The cash restriction would forceUnitedContinentalto have enough cash to pay the interest on the debtandthe minimumcash flow coverage assuresthattheairline’s operations arefunctioning well enough to generate sufficient cash flow to meetobligations..These restrictions act as trip wires in that as soon as a restriction is violated the creditors can call thedebt and force the company to pay back the loans.What is more typical is for the loans to be

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3restructured. This usually means higher interest rates and fees to do the restructuring. These all putthe creditors in a better position to protect their loans.ID1–7Companies would usually engage in this type of behavior to try to improve their stock price.Byshowing higher revenues or lower expenses investors are more likely to reward the company with ahigher stock price.Companies that have negative cash flow are under a lot of pressure to maintain ahigh stock price since selling stock is the only way to fund the business. This type of incentive can leadto questionable behavior.The ethical implications are significant because if investors lose faith in the financial statements thatare reported this would severely impact the stock market.A strong driver to a robust economy isaccess to capital (stock markets). If this source is reduced because investors don’t believe the numbersthat are reported, a very bad impact on the overall economy would result.ID1–8This is the normal statement that an auditor would make about a companywhose books it had audited and found no significant problems. This would bepart of what is called a “non-qualified opinion”. If there was a particular itemthat the auditors did not agree with they would issue a “qualified opinion”–they would agree with everything except the qualified item that would beidentified.“In our opinion”,shows that the statement represents the auditor’sopinionand not a fact;“fairly, in all material respects” means that the auditors can not saythat every single number is exactly accurate to the penny but that the numbers aregenerallyaccurate. This reflects the concept of materiality; the auditors believethat all material items have been presented accurately.Finally,“in conformitywith accounting principles generally accepted in the United States of America”means that the financial statements have been compiled in a way that meets all ofthe accounting principles that are called GAAPin the U.S but not necessarily inconformance with international standards.ID1–9Corporate governance describes the relationship among the stakeholders of a company, mainly : theshareholders, the Board of Directors, management and the company’s auditors. Corporate governancemechanisms encourage management and the Board of Directors to act in the best interest of theshareholders and to provide the shareholders with accurate and timely financial information.TheSarbanes-Oxley Act was passed to upgrade the financial transparency of corporate operations,requiring increased financial disclosures and management responsibilities for the intergrity of thefinancial statements.Improved information provided to shareholders and other providers of capital

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4will strenghten the confidence in the financial system, ultimately benefitting both providers and usersof capital.ID1–10Management is charged with the responsibility to benefit the shareholders’ investment in thecompany.Choosing investments that will boost the short-term results of the company in lieu oflong-term gains does not meet this requirement.While satisfying the needs of Wall Streetanalysts for short term results, a management decision to forego larger long term returns violatesthe relationship between the owners of the company and the management of the company.Many observers feel that short term profit pressures from analysts have caused management toignore its responsibility to work for the long term benefit of the shareholder.ID1–11Financial analysts are charged with the task of following companies in specified industries andevaluating the past financial performance of those companies, as well as providing guidance forexpectations for future financial performance. Until financial reporting is consistent across globallines, analysts must be in a position to understand, interpret, analyze and forecast financialperformance using different financial systems.An analyst following the pharmaceutical industryneeds to understand how companies compare against each other, how Novartis stacks up againstJohnson & Johnson.Now, not only does an analyst have to understand two sets of financialreporting systems (IFRS and GAAP), but that analyst then has to perform some type of conversion,so the companies can be compared under the same (“apples to apples”) basis. Fluency in GAAP isnot sufficient; an analyst must also speak the language of IFRS and be able to translate back andforth between the two systems.ID1–12Accounting guidelines that are established based on a number of generalprincipleshave the advantageof being simplified and easier to understand and document.On the other hand, guidelines that areprinciple-based are more ripe to be exploited by companies desiring to present their financialstatements in good light. Guidelines that are based on a detailed set ofrulesare, by definition, lengthyand complicated, trying to anticipate every possible business situation. However, some argue that themore detailed rules-based approach allows the users of financial statements to review companies’financial performance from a consistent perspective.ID1–13Managerialaccounting is the accounting system that generates information that is used exclusively bythe managers of the company.Financial accounting refers to the financial statements that areprepared and distributed outside of the company.So in many cases management accountinginformation is the operational information used by the managers of the company.This can be veryproprietary to the company and so is not made public.Management accounting numbers are notsubject to audit and therefore are prepared in whatever form is helpful to the manager.

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5Financial accounting information is audited and therefore has to follow GAAP.Its primarypurpose is to be used by people outside of the company.ID1-14a.Google is primarily a service business, providing internet search functions and selling targeted onlineadvertising.However, due to a recent acquisition of part of Motorola’s cell phone business, thecompany alsois a manufacturing company.b.The firm ofErnst & Youngaudits the financial statements ofGoogle. The audit report states what yearsand financial statements were audited and therefore being commented upon by theauditor.Thesecond paragraph explains what an audit is intended to do and how the company has gone about doingthis audit.The company’s internal control procedures are discussed.Finally, the reportstates theauditors’ opinion regarding the financial statements that have been audited. Theauditors do notevaluate the financial strength of the company; the auditor states that the financial statements“present fairly” the position ofGoogle; it is up to the user of the financial statements to analyze thecompany’s performance.c.Net income in 2010was $8,505,000,000, for 2011net income was $9,737,000,000 and for 2012netincome was $10,737,000,000.d.The amounts shown below are in millions:20122011.Totalliabilities$22,083$14,429Total assets$93,798$72,574TL/TA (%)23.54%19.88%Total liabilities include both Current and Long Term liabilities.From 20111to 2012 Googleincreasedthe percentage of its assets that were financed by liabilities.This fact, of course, means that thecompanydecreased the percentage of its assets that were financed by equity.e.Cash from operating activities was $11,081,000,000 in 2010, in 2011it was $14,565,000,000 and in2012itwas $16,619,000,000.f.Googleincreased its profitability (in both raw dollars) but asa percentage of revenuethe company wasslightly less profitable, 2012 versus 2010.The addition of the Motorola business might be anexplanation behind the margin shift.As noted above, the company used slightly more leverage thanpreviously, but debt levels are still quite low in comparison to other companies.Finally, the cashgenerated by the company’s core operations grew significantly from 2010 to 2012.The company isquite strong and well-positioned for the future.

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1CHAPTER 2THE FINANCIAL STATEMENTSBRIEF EXERCISESBE2–1201220122012BeginningEndingRetained201220122012RetainedEarnings+Revenues–Expenses–Dividends=Earnings$40.3+$65.5–$59.3–X=$43.2X=$3.32012Dividends as a percentage of 2012net income:2012Dividends=$3.3=53.2%2012Net income ($65.5-$59.3)$6.2BE2–2(1)Current Liabilities financed $45billion of the assets.Current Liabilities divided by Total assets = $45/$89=50.6%(2)Long-term debt financed $38billion of the assets.Long-term debt divided by total assets = $38/$89=42.7%(3)Stockholders’ equity financed $6billion of the assets.Stockholders’ equity divided by total assets = $6/$89=6.7%BE2–3(a)Working capital = current assets–current liabilities.Boeing’s current assets total $57billion, less$45billion of current liabilities, gives the company working capital of $12billion. Another measureof solvency would be the current ratio.The current ratio is current assets divided by currentliabilities or $57billion divided by $45billion =1.27.Both measures indicate that Boeing appears tohavereasonablesolvency. Current assets are sufficient to cover current liabilities.(b)No, Boeing has $19.1billion of liquidcurrentassets (cash, short term investments, and accountsreceivable) but it has $45billion of current liabilities.(c)Boeing would bemoresolvent if accounts receivable were $37.8billion and inventory was $5.6billion.Accounts receivable are closer to cash than inventory. This means that accounts receivableare expected to be converted to cash in a shorter period of time than inventory.

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BE2-4201220112010Net cash flow from operating activities.........................$36,100$34,743$35,222Net cash flow from investing activities..........................(19,680)(21,250)(21,449)Net cash flow from financing activities..........................(17,673)(11,649)(15,849)Net change in cash.........................................................$(1,253)$1,844$(2,076)Cash at beginning of period...........................................3,0451,2013,277Cash at end of period………………………………....................$1,792$3,045$1,201AT & T’s cash management activities over the three-year period of 2010-2012appear to be extremelystrong.The company isgenerating significant amounts of cash flow from operating activities,withall threeyears in excess of $34.5 billion.AT & Tis then able to reinvest substantial amounts in its asset base.At thesame timeAT & Tis also able to fund its financing activities from its operating cash flow. The large amountof funds being used in investing activities indicatesthatAT & Tis growing itscapital-intensivebusiness.BE2–5IFRS FormatNon-current assets154,073Current assets115,397Less: Current liabilities(94,384)Total175,086Non-current liabilities49,118Equity125,968Total175,086GAAP FormatNon-current assets154,073Current assets115,397Total269,470Current liabilities94,384Non-current liabilities49,118Equity125,968Total269,470Many non-US companies begin with non-current assets, add current assets, and then subtract currentliabilities to reflect the resourcesavailable togenerate revenues and profits. TheIFRSbalance sheet thenlists non-current liabilities and shareholders’ equity, which represent the financing sources ofcompanyresources; this amountis oftenlabeled“capital employed.”GAAP balance sheets, on the other hand, list all assets owned (current and long-term) and then categorizesthe financing sources (current and long-term liabilities, as well as shareholder equity) for those assets.

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EXERCISESE2–1Operating,Investing,orFinancingBalance SheetIncomeStatementStatementofCash FlowsStatementofStockholdersEquity1FinancingYesNoYesYes2OperatingYesYesCannot tellYes3OperatingYesYesYesYes4InvestingYesNoCannot tellNo5FinancingYesNoYesNo6FinancingYesNoYesYes7InvestingYesNoYesNo8OperatingYesNoYesNoE2–2Operating,Investing,orFinancingBalance SheetIncomeStatementStatementofCash FlowsStatementofShareholdersEquity1FinancingYesNoYesNo2OperatingYesNoNoNo3OperatingYesYesYesYes4OperatingYesYesNoYes5InvestingYesNoYesNo6InvestingYesCannot tellYesCannot tell7FinancingYesNoYesNo8OperatingYesNoYesNoE2–3a.Balance sheetg.Balance sheetm.Balance sheetb.Income statementh.Balance sheetn.Balance sheetc.Balance sheeti.Balance sheeto.Balance sheetd.Income statementj.Balance sheetp.Income statemente.Balance sheetk.Income statementq.Balance sheetf.Income statementl.Income statementr.Balance sheetE2–4

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1.Statement of Stockholders’ Equity (Retained Earnings); Statement of Cash Flow, Income Statement2. Income Statement3. Balance Sheet4. Statement of Cash Flow, Balance Sheet5. Statement of Stockholders’ Equity; Statement of Cash Flow6. Income Statement, Balance Sheet7. Income Statement8. Balance Sheet, Income StatementE2–5201020102010BeginningEndingRetained201020102010RetainedEarnings+Revenues–Expenses–Dividends=Earnings$1.5+$14.3–$13.0–X=$1.5X=$1.32011*20112011BeginningEndingRetained201120112011RetainedEarnings+Revenues–Expenses–Dividends=Earnings$1.5+$14.5–X–$1.3=$1.9X=$12.8201220122012BeginningEndingRetained201220122012RetainedEarnings+Revenues–Expenses–Dividends=EarningsX+$19.6–17.8–$1.8=$1.9X=$1.9*you must calculate the 2012equation before you can calculate the 2011equation201220112010Sales growth ($)$5.1$0.2N/ASales growth (%)35.2%1.4%N/AProfits ($)$1.8$1.7$1.3Profits (% of sales)9.2%11.7%9.1%Dividends (% of net income)100%76.5%100%The companysaw significant sales growth, but profitsgrewrelativelyless.Dividends are a consistently highpercentage of profits, which is common in the utility industry.

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E2–620102010Ending Retained Earnings2010Beginning Retained Earningsor=+Revenues for 20102011Beginning Retained Earnings–Expenses for 2010–Dividends for 2010($523)=($499)+$1,383–X–$0X=$1,407Expenses for 2010are $1,407.2011($758)=($523)+$1,522–$1,608–XX=$149Dividends declared for 2011are $149.2012($596)=($758)+X–$1,550–$5X=$1,717Revenue for 2012is $1,717.201020112012Salesgrowth (%)..........................................................N/A10.0%12.8%Profits............................................................................($24)($86)$167Profits as a percentage of sales......................................(1.7%)(5.7%)9.7%Dividends........................................................................$0$149$5Dividends as a percentage of net income......................N/AN/A3.0%The advertising agency had modest sales growth from 2010to 2012. However, from 2011to 2012, theCompany was able to go from losses to a profit. Even though the Company had a loss in 2011the Companypaid a healthy dividend.Then in 2012, when the Company showed a profit, it virtually eliminated thedividend.There is reason to be optimistic going forward. In 2012the Company was able to show a nicegrowth in its sales while at the same time showing a reduction in its expenses.

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E2–7Solvency primarily indicates a company’s ability to meet its debt payments as they come due. Currentliabilities are obligations that will be settled within one year or the company’s operating cycle, whichever islonger, through the use of current assets or the creation of new current liabilities. Current assets are thoseassets that will be consumed or converted to cash within one year or the company’s operating cycle,whichever is longer. Consequently, comparing current assets to current liabilities provides an indication of acompany’s ability to meet its short-term debts. In this case, current assets were3.33($500/$150)and3.27($432/$132)times greater than current liabilities as of December 31, 2012and December 31, 2011,respectively.Although comparing current assets to current liabilities provides a measure of a company’s solvency, thismeasure is not perfect. A true test of a company’s short-term solvency would be to compare the cash valueof its current assets to the cash value of its current liabilities. For current liabilities, the book value is usuallya good approximation of the cash value, since a company cannot, from a legal viewpoint, unilaterallychange its debts. The situation is different for current assets though. The book value may or may not bearany relation to the cash value. Consequently, comparing the book value of current assets to currentliabilities may not give an accurate measure of a company’s solvency.E2–8Method 1Method 2Working capital as of 12/31/2012($500–$150).................................................................$350$350Impact of method on current assets..............................00Impact of method on current liabilities.........................(200)0New working capital as of January 2013........................$150$350It seems thatonly the secondmethod would be acceptable to the company in terms of maintainingcompliance with theminimumworking capital covenant.E2–9201220112010Beginning cash balance..................................................$7,662$Y*$5,718Net cash flow from operating activities.........................11,491X10,173Net cash flow from investing activities..........................(3,815)(2,934)XNet cash flow from financing activities..........................X(4,064)621Ending cash balance.......................................................$9,799$7,662$4,581X equals.................................................................$(5,539)$10,079$(11,931)*Beginning cash balance for 2011= Ending cash balance for 2010.Cisco Systems’ cash management activities over the three-year period of 2010, 2011, and 2012appear tobe strong. The Company is generating a significant amount of net cash flow from operations each yearandthen is investing in its business.Financing activities (including dividends and/or share repurchases) reducedcash in 2012and 2011, butwerepositive in 2010.

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E2–10201220112010Beginning cash balance..................................................$829**$1,261$XNet cash flow from operating activities.........................2,0641,3561,561Net cash flow from investing activities..........................X(1,022)(1,265)Net cash flow from financing activities..........................(947)X(149)Ending cash balance.......................................................$1,113$829$1,261*X equals.................................................................$(833)$(766)$1,114*2011Beginning balance = 2010Ending balance**2012Beginning balance = 2011Ending balance.Southwest Airlines’ cash management activities appear to be very good for the years 2010and2011, buteven betterin2012(due to the economic recovery). The company generateda net cash inflow from itsoperating activitiesfor the years shown. A look at its investing activities reveals that the company isexpanding its asset base,as necessary in such a capital intensive industry. During 2011 and 2012, thecompanyincreased itscashoutflowsdue to financing activities. Overall, Southwest Airlinesis a strongcompanyemerging froma difficult time in its cyclical business.E2–11Lana & SonsStatement of Cash FlowsFor the Year EndedCash flows from operating activities:Cash collection from services provided..................................................$4,000Cash payment for expenses...................................................................(3,000)Net cash increase (decrease) from operating activities..................$1,000Cash flows from investing activities:Purchase of machinery...........................................................................$(3,000)Net cash increase (decrease) from investing activities...................(3,000)Cash flows from financing activities:Proceeds from stockholders’ contributions...........................................$7,000Payment of dividends.............................................................................(1,500)Net cash increase (decrease) from financing activities...................5,500Increase (decrease) in cash balance..............................................................$3,500Beginning cash balance.................................................................................13,000Ending cash balance......................................................................................$16,500Based on just one year’s statement of cash flows it is difficult to comment adequately on Lana & Son’s cashmanagement activities. However, one can observe that most of the cash during the year was generated as aresult of issuing equity. The company seems to be investing in its asset base. That will certainly help it growin the future. Cash flows from operations is positive, which certainly is a good sign.

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E2–12Emory Inc.Statement of Cash FlowsFor the Year EndedCash flows from operating activities:Cash collection from services provided..................................................$40,000Cash payment for expenses...................................................................(23,000)Net cash increase (decrease) from operating activities..................$17,000Cash flows from investing activities:Purchase of equipment..........................................................................$(23,000)Net cash increase (decrease) from investing activities...................(23,000)Cash flows from financing activities:Proceeds from the bank loan.................................................................$30,000Payment of dividends(24,000)Net cash increase (decrease) from financing activities...................6,000Increase (decrease) in cash balance..............................................................$0Beginning cash balance.................................................................................25,000Ending cash balance......................................................................................$25,000Based on just one year’s statement of cash flows, it is difficult to comment adequately on Emory’s cashmanagement activities. However, it seems that the company is generating a substantial portion of its cashflows from operating activities. The company is taking some loans to finance its asset base which would behelpful in the future. Return on total assets and return on equity would probably increase.E2–13George’s BusinessIncome StatementFor the Year EndedLease revenue...................................................................................................$3,000Expenses...........................................................................................................2,500Net income.......................................................................................................$500George’s BusinessStatement of Stockholders’ EquityFor the Year EndedContributedRetainedCapitalEarningsBeginning Balance$0$0Stock Issue6,000Net Income500Cash Dividends_____(800)Ending Balance$6,000$ (300)

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E2–13ConcludedGeorge’s BusinessBalance SheetAs ofAssetsCash................................................................................................................$2,700Land................................................................................................................8,000Total assets.......................................................................................................$10,700Liabilities & Stockholders’ EquityNote payable....................................................................................................$5,000Contributed capital...........................................................................................6,000Retained earnings.............................................................................................(300)Total liabilities & stockholders’ equity.............................................................$10,700George’s BusinessStatement of Cash FlowsFor the Year EndedCash flows from operating activities:Cash collections from customers..................................................$3,000Cash payments for expenses.........................................................(2,500)Net cash flow from operating activities...................................$500Cash flows from investing activities:Purchase of land............................................................................$(8,000)Net cash flow from investing activities....................................(8,000)Cash flows from financing activities:Proceeds from equity investor......................................................$6,000Proceeds from borrowing..............................................................5,000Cash payments for dividends........................................................(800)Net cash flow from financing activities....................................10,200Increase in cash..................................................................................$2,700Beginning cash balance......................................................................0Ending cash balance...........................................................................$2,700Upon examining George’s financial statements the bank would certainly be concerned because George paidout more in dividends than the net income he realized during the year. George’s statement of retainedearnings shows a negative balance, which means that the payment to equity investors which was disguisedas returnoncapital was in fact a returnofcapital. Generally, dividend payments cannot exceed theRetained Earnings balance.

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E2–14Mary’s BusinessIncome StatementFor the Year EndedLease revenue...................................................................................................$12,000Expenses...........................................................................................................14,000Net income.......................................................................................................$(2,000)Mary’s BusinessStatement of Stockholders’ EquityFor the Year EndedContributedRetainedCapitalEarningsBeginning Balance$0$0Stock Issue30,000Net Income (Loss)(2,000)Cash Dividends______(1,000)Ending Balance$30,000$ (3,000)Mary’s BusinessBalance SheetAs ofAssetsCash................................................................................................................$2,000Land................................................................................................................40,000Total assets.......................................................................................................$42,000Liabilities & Stockholders’ EquityNote payable....................................................................................................$15,000Contributed capital...........................................................................................30,000Retained earnings.............................................................................................(3,000)Total liabilities & stockholders’ equity.............................................................$42,000

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