Chapter 05 - Financial Reporting and Analysis

Chapter 5
Financial Reporting and Analysis

ANSWERS TO QUESTIONS

1. Managers at all levels within a company use accounting information to run the
business by making decisions, such as obtaining debt versus issuing more stock.

Directors use accounting information to oversee the business. One decision the
directors make is the CEO’s pay.

Creditors use accounting information to administer business contracts by evaluating

loan covenant compliance.

Investors value the business by using accounting information to estimate future

earnings and stock price.

Government agencies regulate businesses, relying on accounting information to

determine income taxes for example.

2. The three points of the fraud triangle are incentive (which answers the question,
“Why would someone commit fraud?”), opportunity (which answers the question
“How would someone commit a fraud?”) and personality (which answers the
question, “Who would commit a fraud?”). If any one of the elements is missing,
(the person lacks the incentive, lacks the opportunity, or does not possess a
questionable personality), the chances are less likely that a fraud will be
committed.

3. Managers can be motivated to misreport financial results to create business

opportunities (by satisfying loan covenants, increasing equity financing, and
attracting business partners) and to satisfy personal greed (enhancing job security,
increasing personal wealth, and obtaining a bigger paycheck).

4. The Sarbanes-Oxley Act counteracts the incentive to commit fraud by stipulating

steeper fines and longer jail terms for those who willfully misrepresent financial data.

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Chapter 05 - Financial Reporting and Analysis

5. The Sarbanes-Oxley Act reduces the opportunity to commit fraud by requiring that
management monitor their internal controls and submit a report that indicates
whether the controls over financial reporting operated effectively. The board of
directors must appoint an audit committee to oversee the financial matters of the
company. External auditors must test the effectiveness of the company’s internal
controls and submit a report stating whether they agree with the internal control
report issued by management.

6. The Sarbanes-Oxley Act attempts to encourage good personality in employees by

mandating the creation of confidential tip lines whereby employees can report
potentially fraudulent conduct. It also offers protection to whistle-blowers.

7. Auditors provide quality assurance by reporting on the effectiveness of a company’s

internal controls over financial reporting and by providing an independent opinion
about whether the company’s financial statements are prepared in accordance with
GAAP.

8. Like fraudulent financial reporting, academic dishonesty will occur only if an

individual has incentives, opportunities, and the personality to cheat. Like the impact
of bonuses and stock options on managers, the impact of potentially higher grades
on assignments and exams may heighten the incentive to cheat. The opportunity to
cheat depends on how closely managers (and students) are audited (watched) and
how much subjectivity is involved in determining whether fraud (academic
dishonesty) has been committed. Finally, whether someone will act on these
incentives and opportunities depends on the personality of the individual involved.
We’d like to believe that most students possess a personality to “do the right thing”
and not succumb to the temptation to cheat.

9. Interactive data (reported in XBRL) promises the benefits of more efficient and
accurate comparisons of companies’ financial data.

10. The financial statements of companies in the United States may differ from what was
shown in Chapters 1-4 in the following three ways:
 A company may present comparative financial statements, which show account
balances for more than one period in order to facilitate comparison of a
company’s past performance from one period to the next.
 A company may present multistep income statements, which divide income and
expenses into subtotals for core and peripheral activities.
 Finally, a company may present a more comprehensive version of the statement
of retained earnings called the statement of stockholders’ equity.

11. Countries are adopting IFRS to reduce or eliminate differences in accounting rules
that have developed previously on a country-by-country basis. As well, these
improvements in comparability are needed as a result of increasing globalization in
corporate operations and investing.

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Chapter 05 - Financial Reporting and Analysis
12. Three main differences between GAAP and IFRS financial statements are:
 Financial Statement Titles: the financial statements report similar items but under
different titles.
 Presentation of Expenses: similar expenses are reported, but they may be
grouped in different ways.
 Balance Sheet Order: similar accounts are shown, but they are presented in
different order of liquidity (for assets) and order of maturity (for liabilities).

13. Two commonly used benchmarks are:

 Prior periods - By comparing a company’s current period results to its own results
in prior periods, we can gain a sense of how the company’s performance is
changing over time.
 Competitors - Although an analysis focused on one company is useful, it doesn’t
show what’s happening in the industry. To get this industry-wide perspective,
most analysts will compare competitors within a particular industry.

14. The goal of ratio analysis is to get to the heart of how a company performed given
the resources it had available.

15. There are four parts to the business model:

 Obtain financing from lenders and investors, which is used to invest in assets.
 Invest in assets, which are used to generate revenues.
 Generate revenues, which produce net income.
 Produce net income, which is needed to satisfy lenders and investors.

16. The key to understanding why averages are included in some ratios but not others is
to remember that the income statement reports the results of an entire period of
time, whereas the balance sheet reports the results at a single point in time. Some
ratios are calculated by combining information from both the income statement and
balance sheet. The asset turnover ratio, for example, takes sales revenue from the
income statement for the top part of the ratio and total assets from the balance sheet
for the bottom. To allow the bottom part of the ratio to represent the same time
period as the top, we need to calculate the average of the beginning and ending
balance sheet amounts.

17. The debt-to-assets ratio assesses the sources of financing of the company’s assets.
The asset turnover ratio evaluates how well assets are used to generate sales. The
net profit margin ratio determines the ability of the company to control expenses
incurred to generate revenues.

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Chapter 05 - Financial Reporting and Analysis
Authors' Recommended Solution Time
(Time in minutes)

Skills Continuing
Mini-exercises Exercises Problems Development Case
Cases*
No. Time No. Time No. Time No. Time No. Time
1 5 1 10 CP5-1 10 1 20 1 30
2 3 2 10 CP5-2 10 2 20
3 1 3 10 CP5-3 10 3 30
4 3 4 5 CP5-4 20 4 40
5 5 5 10 PA5-1 10 5 20
6 3 6 10 PA5-2 10 6 20
7 5 7 10 PA5-3 10 7 40
8 5 8 5 PA5-4 20
9 5 9 5 PB5-1 10
10 5 10 10 PB5-2 10
11 5 11 15 PB5-3 10
12 5 12 5 PB5-4 20
13 5 13 5
14 5 14 20
15 5 15 15
16 5

* Due to the nature of cases, it is very difficult to estimate the amount of time students
will need to complete them. As with any open-ended project, it is possible for students
to devote a large amount of time to these assignments. While students often benefit
from the extra effort, we find that some become frustrated by the perceived difficulty of
the task. You can reduce student frustration and anxiety by making your expectations
clear, and by offering suggestions (about how to research topics or what companies to
select). The skills developed by these cases are indicated below.

Financial Ethical Critical

Case Research Technology Writing Teamwork
Analysis Reasoning Thinking
1 x
2 x
3 x x x x x
4 x x x
5 x x x x
6 x x x
7 x x

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Chapter 05 - Financial Reporting and Analysis
ANSWERS TO MINI-EXERCISES

M5-1
Players Definitions
____C____ (1) Independent auditors A. Investors and creditors (among others).
____A____ (2) External users B. People who are elected by stockholders to oversee a
____B____ (3) Directors company’s management.
C. CPAs who examine financial statements and attest to their
fairness.

M5-2

1. C 2. A 3. B 4. C 5. B

M5-3
No. Title
_____2__ Form 10-K
_____3__ Annual Report
_____1__ Press release announcing annual earnings

M5-4
NUTBOY THEATER COMPANY
Income Statement
For the Year Ended December 31, 2010
Revenues:
Ticket Sales $ 50,000
Concession Sales 2,500
Total Sales Revenues 52,500
Operating Expenses:
Salaries and Wage Expense 30,000
Advertising Expense 8,000
Utilities Expense 7,000
Total Operating Expenses 45,000
Income from Operations 7,500
Other Revenue (Expense):
Interest Revenue 200
Other Revenue 50
Income before Income Tax Expense 7,750
Income Tax Expense 2,500
Net Income $ 5,250

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Chapter 05 - Financial Reporting and Analysis
M5-4 (continued)

Net Profit Margin = Net Income / Total Sales Revenues

= $5,250 / $52,500
= 10%

Nutboy produced more net income per dollar of sales (ten cents) than in the previous
year (8 cents).

M5-5

WER PRODUCTIONS
Statement of Stockholders’ Equity
For the Year Ended December 31, 2009

Contributed Retained
Capital Earnings

Balances at December 31, 2008 $ 100,000 $ 20,000

Net Income 33,000

Dividends Declared (5,000)
Issuance of Shares of Stock 50,000
Balances at December 31, 2009 $ 150,000 $ 48,000

M5-6

Transaction Assets Liabilities Stockholders’ Equity

a. +500 NE Services Revenue (+R) +500
b. +50 +50 NE
c. NE +1,000 Advertising Expense (+E) –1,000

The effects of the transactions can be seen by making the related journal entries.

a. dr Accounts Receivable (+A) .................................... 500

cr Services Revenue (+R, +SE)....................... 500

b. dr Supplies (+A)........................................................... 50
cr Accounts Payable (+L) ................................ 50

c. dr Advertising Expense (+E, –SE) ............................ 1,000

cr Accounts Payable (+L) ............................... 1,000

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Chapter 05 - Financial Reporting and Analysis
M5-7

Transaction Debt-to-Assets Asset Turnover Net Profit Margin

a. – CD +
b. + − NE
c. + NE –

M5-8

Transaction Assets Liabilities Stockholders’ Equity

a. +90,000 NE Contributed Capital +90,000
b. +4,000 +4,000 NE
c. -1,000 NE Depreciation Expense (+E) –1,000

The effects of the transactions can be seen by making the related journal entries.

a. dr Cash (+A) ............................................................. 90,000

cr Contributed Capital (+SE) .......................... 90,000

b. dr Equipment (+A) .................................................... 4,000

cr Note Payable (+L)........................................ 4,000

c. dr Depreciation Expense (+E, –SE) .......................... 1,000

cr Accumulated Depreciation (+xA,-A)............. 1,000

M5-9

Transaction Debt-to-Assets Asset Turnover Net Profit Margin

a. – – NE
b. + – NE
c. + + –

M5-10

a) Income from Operations

b) Income before Income Tax Expense
c) 100
d) 480
e) 80 (from December 31, 2009 Balance Sheet)
f) 120
g) 480
h) 180

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Chapter 05 - Financial Reporting and Analysis

M5-11
STARBOOKS CORPORATION
Statement of Financial Position
At December 31
2010 2009
Assets
$60
Total Assets $800 0
Stockholders’ Equity and Liabilities
Stockholders’ Equity
Contributed Capital $480 $400
Retained Earnings 180 80
Total Stockholders’ Equity 660 480
Total Liabilities 140 120
Total Stockholders’ Equity and Liabilities $800 $600

M5-12

Prior Year
Net profit margin = Net Income = $850 = .094 = 9.4%
Sales Revenue $9,000

Current Year
Net profit margin = Net Income = $700 = .10 = 10%
Sales Revenue $7,000

Happy’s has increased its net profit margin to 10% in the current year from 9.4% in the
prior year. This means that, in the current year, Happy’s made about 10 cents of profit
for each dollar of sales. The increase in net profit margin indicates that Happy’s has
improved its control of expenses incurred to generate revenues.

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Chapter 05 - Financial Reporting and Analysis
M5-13

Prior Year
Debt-to-assets = Total Liabilities = $10,000 – $8,000 = .20 = 20%
Total Assets $10,000

Current Year
Debt-to-assets = Total Liabilities = $9,000 – $7,500 = .167 = 16.7%
Total Assets $9,000

The debt-to-assets ratio indicates the percentage of assets financed by debt. This is a
sign of the company’s financing risk. This analysis indicates that Happy’s has moved
towards less debt financing with a decrease in debt-to-assets from 20% in the prior year
to 16.7% in the current year, making the company less risky.

M5-14

Current Year
Asset turnover = Sales Revenue = $7,000 = $7,000 = 0.737
Average Total ($10,000 + $9,000)/2 $9,500
Assets

The asset turnover ratio determines how efficiently assets are used to generate sales.
Happy’s generated less sales per dollar invested in assets in the current year (0.737)
than in the prior year (0.852), which means the company decreased its efficiency in
using assets to generate sales.

M5-15

a. Generating Sales from Assets

Columbia

Asset turnover = Sales Revenue = $1,318 = $1,318 = 1.14

Average Total Assets ($1,166 + $1,148)/2 $1,157

Levi Strauss

Asset turnover = Sales Revenue = $4,303 = $4,303 = 1.53

Average Total Assets ($2,851 + $2,777)/2 $2,814

Levi Strauss appears to be more efficient at generating sales from assets. It generates
$1.53 for every dollar of assets, versus $1.14 for Columbia.

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Chapter 05 - Financial Reporting and Analysis
M5-15 (continued)

b. Generating Net Income from Sales

Columbia

Net profit margin = Net Income = $95 = .072 = 7.2%

Sales Revenue $1,318

Levi Strauss

Net profit margin = Net Income = $229 = .053 = 5.3%

Sales Revenue $4,303

Columbia is more effective at generating net income from sales. For every dollar of
sales, Columbia generates just over 7 cents in net income, versus about 5 cents per
dollar for Levi Strauss.

ANSWERS TO EXERCISES

E5-1

Components Definitions
E (1) Investor A. Individual who purchases stock in companies for
information personal ownership or for pension funds or mutual
Web site funds.
C (2) External B. Financial institution or supplier that lends money to the
auditor company.
A (3) Investor C. Independent CPA who examines financial statements
B (4) Creditor and attests to their fairness.
D (5) SEC D. Securities and Exchange Commission, which regulates
financial disclosure requirements.
E. Gathers, combines, and transmits financial and related
information from various sources.

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Chapter 05 - Financial Reporting and Analysis
E5-2

Information Release Definitions

A (1) Annual report A. Comprehensive report containing the four basic
F (2) Form 8-K financial statements and related notes,
D (3) Press release statements by management and auditors, and
C (4) Form 10-Q other descriptions of the company’s activities.
E (5) Quarterly report B. Annual report filed by public companies with the
B (6) Form 10-K SEC that contains detailed financial
information.
C. Quarterly report filed by public companies with
the SEC that contains unaudited financial
information.
D. A company-prepared news announcement that
is normally distributed to major news agencies.
E. Brief unaudited report for the quarter, normally
containing condensed income statement and
balance sheet (unaudited).
F. Report of special events (e.g., auditor changes,
mergers and acquisitions) filed by public
companies with the SEC.

E5-3
Information Item Report
C (1) Initial announcement of hiring of new vice president A. Annual Report
for sales. B. Form 8-K
C (2) Initial announcement of quarterly earnings. C. Press Release
B (3) Initial announcement of a change in auditors. D. Form 10-Q
D (4) Complete quarterly income statement, balance sheet E. Quarterly Report
and cash flow statement. F. Form 10-K
A,F (5) The four basic financial statements for the year. G. None of the above
E (6) Summarized income statement information for the
quarter.
A,F (7) Detailed discussion of the company’s business risks
and strategies.
A,F (8) Detailed notes to financial statements.
A,F (9) Summarized financial data for 5- or 10-year period.

E5-4
Date Filed/Issued Report
D (1) March 31, 2007 A. Issued annual earnings press release
A (2) June 5, 2007 B. Filed form 8-K announcing press release
B (3) June 5, 2007 C. Filed form 10-K
C (4) June 29, 2007 D. Completed fiscal year

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Chapter 05 - Financial Reporting and Analysis

E5-5
Answers Events
C (1) Users of financial statements
A. Counted unused supplies at the end of the period
E (2) Objective of financial statements
H (3) Faithful representation and valued them in U.S. dollars.
G (4) Comparability B. Valued an asset at the amount paid to acquire it,
F (5) Separate entity even though its market value has increased
A (6) Unit of measure
considerably.
J (7) Cost principle
D (8) Revenue principle C. Analyzed the financial statements to assess the
I (9) Matching principle company’s performance.
B (10) Conservatism D. Established an accounting policy that sales
revenue shall be recognized only when services
have been provided to the customer.
E. Prepared and distributed financial statements that
provide useful financial information for creditors
and investors.
F. Established a policy not to include in the financial
statements the personal financial affairs of the
owners of the business.
G. Used the same accounting policies over several
years to facilitate analyses.
H. Established policies to report the company’s
business activities in a way that depicts their
economic substance.
I. Adjusted the rent accounts to show the cost of
rent relating to the current period.
J. Acquired a vehicle for use in the business,
reporting it at the agreed-upon purchase price
rather than its higher sticker price.

E5-6

Req. 1

The company is referring to the characteristic of comparability. By changing the year-

end date, the company allows more meaningful cross-sectional analysis with other firms
in the industry.

Req. 2

The change in year-end would be reported on the Form 8-K.

Req. 3

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Chapter 05 - Financial Reporting and Analysis
Yes, all the ratios will be meaningful in 2003. The debt-to-assets ratio will not be
affected by the change since it looks at a specific point in time. The asset turnover is
meaningful if it is compared to other nine-month periods or “scaled” to a full year by
multiplying by 12/9. The net profit margin ratio is still meaningful since both the top and
the bottom of the ratio are for the same time period.

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Chapter 05 - Financial Reporting and Analysis

E5-7

Req. 1
The reason given seems to be internal to THQ since it will make it easier for THQ to
provide “financial guidance” (ie. earnings forecasts). The change in year-end may be
more useful to users if it enhances comparability with other companies.

Req. 2
The change in year-end would be reported on the Form 8-K.

Req. 3
Yes, all the ratios will be meaningful for the period. The debt-to-assets ratio will not be
affected by the change since it looks at a specific point in time. The asset turnover is
meaningful if it is compared to other three month periods or “scaled” to a full year by
multiplying by 12/3. The net profit margin ratio is still meaningful since both the top and
the bottom of the ratio are for the same time period.

E5-8

2005
Net profit margin = Net Income = $1,341 = .074 = 7.4%
Sales Revenue $18,236

2004
Net profit margin = Net Income = $2,082 = .125 = 12.5%
Sales Revenue $16,689

Cendant Corporation’s net profit margin has decreased from 12.5% in 2004 to 7.4% in 2005.
This means that in 2005, Cendant made about 7 cents of profit for each dollar of sales. The
decrease in net profit margin indicates that Cendant’s performance of controlling expenses
while generating sales deteriorated.

E5-9

Req. 1
The company waited so long to issue the press release because it needed that time to
determine the adjusting journal entries.

Req. 2
The 10-K is not filed at the same time as the press release because it takes time to
determine the extra financial disclosures that are needed in the 10-K.

Req. 3
The annual report will be issued after the 10-K to allow time for printing.

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Chapter 05 - Financial Reporting and Analysis
E5-10

Req. 1

2008
Asset turnover = Total Revenues = $1,132 = 2.87
Average Total Assets ($402 + $386)/2

2007
Asset turnover = Total Revenues = $1,064 = 2.72
Average Total Assets ($380 + $402)/2

2008
Net profit margin = Net Income = $37 = .033 = 3.3%
Total Revenues $1,132

2007
Net profit margin = Net Income = $33 = .031 = 3.1%
Total Revenues $1,064

Req. 2

The asset turnover ratio determines how well assets are used to generate sales. This
analysis indicates that the company has increased its efficiency in using assets to
generate sales, from 2.72 to 2.87.

Net profit margin measures a company’s ability to control expenses while generating
sales. This analysis indicates the company’s performance in this area has improved
from 3.1% to 3.3%.

Analysts would most likely increase their estimates of share value, since there was an
increase in the net profit margin and the asset turnover ratio.

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Chapter 05 - Financial Reporting and Analysis
E5-11
Req. 1
2008
Asset turnover = Sales Revenue = $4,225 = 1.98
Average Total Assets ($2,284 + $1,990)/2

2007
Asset turnover = Sales Revenue = $4,252 = 2.09
Average Total Assets ($1,990 + $2,070)/2

2008
Net profit margin = Net Income = $192 = .045 = 4.5%
Sales Revenue $4,225

2007
Net profit margin = Net Income = $237 = .056 = 5.6%
Sales Revenue $4,252

Req. 2
The asset turnover ratio determines how well assets are used to generate sales. This
analysis indicates that the company has decreased its efficiency in using assets to
generate sales from 2.09 in 2007 to 1.98 in 2008.

Net profit margin measures a company’s ability to control expenses while generating
sales. This analysis indicates that the company’s performance in this regard has
declined from 5.6% in 2007 to 4.5% in 2008.

Analysts would be concerned with the decrease in asset turnover (decreased sales per
dollar invested in assets) and the declining net profit margin (less profit per dollar of
sales). This would cause stock analysts to decrease their estimates of stock value.

Req. 3
2008
Debt-to-assets = Total Liabilities = $1,466 = .642 = 64.2%
Total Assets $2,284

2007
Debt-to-assets = Total Liabilities = $1,220 = .613 = 61.3%
Total Assets $1,990

Req. 4
The debt-to-assets ratio indicates the percentage of assets financed by debt as a sign
of the company’s financing risk. This analysis indicates that the company has increased
its debt financing from 61.3% in 2007 to 64.2% in 2008. Analysts would likely decrease
their estimates of RadioShack’s ability to repay lenders because the company increased
its relative reliance on debt financing, making the company more risky.

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Chapter 05 - Financial Reporting and Analysis
E5-12

Transaction Assets Liabilities Stockholders’ Equity

a. –10 –10 NE
b. +/–32 NE NE

The effects of the transactions can be seen by making the related journal entries.

a. dr Notes Payable (–L) ............................................... 10

cr Cash (–A) ................................................... 10

b. dr Cash (+A) ............................................................. 32

cr Accounts Receivable (–A)............................ 32

E5-13

Transaction Debt-to-Assets Asset Turnover Net Profit Margin

a. – + NE
b. NE NE NE

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Chapter 05 - Financial Reporting and Analysis

E5-14

Req. 1

SPORTLIFE GYM CORPORATION

Income Statement
For the Years Ended December 31

2010 2009

Membership Revenue $ 399,000 $ 398,000

Coaching Revenue 11,000 10,000
Total Revenues 410,000 408,000
Expenses:
Coaching Expenses 221,000 219,400
Facilities Expenses 22,000 22,000
General Expenses 106,150 107,700
Total Operating Expenses 349,150 349,100
Income from Operations 60,850 58,900
Other Revenues (Expenses)
Interest Revenue 750 700
Interest Expense (600) (15,000)
Income before Income Tax Expense 61,000 44,600
Income Tax Expense 20,000 14,000
Net Income $ 41,000 $ 30,600

Note: Facilities Expenses includes rent and depreciation, and General Expenses
includes management salaries and general operating expenses.

SPORTLIFE GYM CORPORATION

Statement of Stockholders’ Equity
For the Year Ended December 31, 2010

Contributed Retained
Capital Earnings

Balances at December 31, 2009 $ 50,000 $ 50,000

Net Income 41,000

Dividends Declared (5,000)
Issuance of Shares of Stock 164,000
Buyback of Shares of Stock 0
Balances at December 31, 2010 $ 214,000 $ 86,000

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Chapter 05 - Financial Reporting and Analysis
E5-14 (continued)

Req. 1 (continued)

SPORTLIFE GYM CORPORATION

Balance Sheet
At December 31

Assets 2010 2009

Current Assets:
Cash $ 31,500 $ 30,000
Accounts Receivable 2,500 2,000
Supplies 13,000 13,000
Prepaid Rent 3,000 3,000
Total Current Assets 50,000 48,000
Equipment, net of accumulated depreciation of 330
$20,000 and $10,000, respectively ,000 340,000
20,
Other Noncurrent Assets 000 12,000
Total Assets $ 400,000 $ 400,000
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts Payable $ 5,000 $ 6,000
Unearned Revenue 72,000 80,000
Income Taxes Payable 13,000 14,000
Total Current Liabilities 90,000 100,000
Long-term Debt 10,000 200,000

Total Liabilities 100,000 300,000

Stockholders’ Equity:
Contributed Capital 214,000 50,000
Retained Earnings 86,000 50,000
Total Stockholders’ Equity 300,000 100,000
Total Liabilities and Stockholders’ Equity $ 400,000 $ 400,000
Req. 2

Two balance sheet accounts that changed significantly are Long-term Debt ($190,000
decrease) and Contributed Capital ($164,000 increase). These changes might be
related in the sense that the cash contribution from stockholders ($164,000) was used
to pay down the long-term debt.

Two income statement accounts that changed significantly were Interest Expense and
Income Tax Expense. Interest Expense decreased from $15,000 to $600, consistent
with the reduction in long-term debt. The decreased Interest Expense contributed to a

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Chapter 05 - Financial Reporting and Analysis
much greater pre-tax income. Because of this, Income Tax Expense rose from $14,000
to $20,000.
E5-14 (continued)

Req. 3

2009
Debt-to-assets = Total Liabilities = $300,000 = .750 = 75%
Total Assets $400,000

2010
Debt-to-assets = Total Liabilities = $100,000 = .250 = 25%
Total Assets $400,000

The company’s debt-to-assets ratio fell from 75% in 2009 to 25% in 2010, indicating
less financing risk for creditors (and investors).

2009
Asset turnover = Total Revenue = $408,000 = 1.02
Average Total Assets ($400,000 + $400,000)/2

2010
Asset turnover = Total Revenue = $410,000 = 1.03
Average Total Assets ($400,000 + $400,000)/2

The company’s asset turnover ratio improved by a very small amount. Using these
rounded ratios, we see that the company is generating about one extra cent of sales per
dollar of assets in 2010 as compared to 2009.

2009
Net profit margin = Net Income = $30,600 = .075 = 7.5%
Total Revenue $408,000

2010
Net profit margin = Net Income = $41,000 = .100 = 10.0%
Total Revenue $410,000

The company has grown its net profit margin to 10.0% in 2010, indicating better
management of expenses leading to a higher net income.

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Chapter 05 - Financial Reporting and Analysis
E5-15

Req. 1

SPORTLIFE GYM CORPORATION

Statement of Financial Position
At December 31

2010 2009
Assets
Other Noncurrent Assets $ 20,000 $ 12,000
Equipment, net of accumulated depreciation
of $20,000 and $10,000, respectively 330,000 340,000
Total Noncurrent Assets 350,000 352,000
Current Assets:
Prepaid Rent 3,000 3,000
Supplies 13,000 13,000
Accounts Receivable 2,500 2,000
Cash 31,500 30,000
Total Current Assets 50,000 48,000
Total Assets $ 400,000 $ 400,000

Equity and Liabilities

Stockholders’ Equity:
Contributed Capital $ 214,000 $ 50,000
Retained Earnings 86,000 50,000
Total Stockholders’ Equity 300,000 100,000

Long-term Debt 10,000 200,000

Total Noncurrent Liabilities 10,000 200,000

Current Liabilities:
Income Taxes Payable 13,000 14,000
Unearned Revenue 72,000 80,000
Accounts Payable 5,000 6,000
Total Current Liabilities 90,000 100,000
Total Liabilities 100,000 300,000
Total Liabilities and Stockholders’ Equity $ 400,000 $ 400,000

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Chapter 05 - Financial Reporting and Analysis
E5-15 (continued)

Req. 2
SPORTLIFE GYM CORPORATION
Statement of Comprehensive Income
For the Years Ended December 31

2010 2009

Membership Revenue $ 399,000 $ 398,000

Coaching Revenue 11,000 10,000
Total Revenues 410,000 408,000
Expenses:
Wages and Salaries Expenses 321,000 319,400
Facilities Rent Expense 12,000 12,000
Depreciation Expense 10,000 10,000
General Operating Expenses 6,150 7,700
Total Operating Expenses 349,150 349,100
Income from Operations 60,850 58,900
Other Revenues (Expenses)
Interest Revenue 750 700
Interest Expense (600) (15,000)
Income before Income Tax Expense 61,000 44,600
Income Tax Expense 20,000 14,000
Net Income $ 41,000 $ 30,600

Note: Wages and Salaries Expenses includes coaching and assistants wages and
management salaries.

E5-16

1. Insurance costs paid this year, to expire next year. B/S

2. Insurance costs expired this year. I/S
3. Insurance costs still owed. B/S
4. Cost of equipment used up this accounting year. I/S
5. Equipment book value (carrying value). B/S
6. Amounts contributed by stockholders during the year. SSE
7. Cost of supplies unused at the end of the year. B/S
8. Cost of supplies used during the accounting year. I/S
9. Amount of unpaid loans at end of year. B/S
10. Dividends declared and paid during this year. SSE

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Chapter 05 - Financial Reporting and Analysis
ANSWERS TO COACHED PROBLEMS

CP5-1

Transaction Assets Liabilities Stockholders’ Equity

a. +7,208 NE Marketing Revenue (+R) +7,208
b. +363 NE Contributed Capital +363
c. –1,222 NE Research & Development Expense (+E) –1,222

The effects of the transactions can be seen by making the related journal entries.

a. dr Accounts Receivable (+A) .................................... 7,208

cr Marketing Revenue (+R,+SE)...................... 7,208

b. dr Cash (+A) ............................................................. 363

cr Contributed Capital (+SE) .......................... 363

c. dr Research and Development Expense (+E, –SE) . 1,222

cr Cash (–A)..................................................... 1,222

CP5-2

Transaction Debt-to-Assets Asset Turnover Net Profit Margin

a. – CD +
b. – – NE
c. + + –

CP5-3

Req. 1

Best Buy appears to rely more on debt financing, as indicated by its higher debt-to-
assets ratio. This ratio indicates that 42 percent of Best Buy’s assets were financed by
liabilities, which suggests the company has a slightly higher risk of defaulting on its
payments.

Req. 2

Best Buy is slightly more efficient in using its assets to generate sales, as suggested by
the asset turnover ratio of 2.42, which is higher than GameStop Corp.’s ratio of 2.10.
These ratios indicate that Best Buy generates about $2.42 in sales for each dollar
invested in assets, while GameStop Corp. generates $2.10.

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Chapter 05 - Financial Reporting and Analysis
CP5-3 (continued)

Req. 3

GameStop Corp. appears to better control its expenses than Best Buy, as suggested by
its higher net profit margin ratio. This ratio indicates that 4.35 percent of GameStop
Corp.’s revenues ultimately are included as net income (suggesting that expenses make
up 95.65 percent of revenues). In contrast, Best Buy’s net income is only 2.69 percent
of revenues, suggesting that its expenses make up 97.31 percent of revenues.

CP5-4

Req. 1
H&M
Statement
(in millions of Swedish of Financial Position
Krona)
At November 30, 2008
Assets
Goodwill and Intangible Assets 1,656
Other Non-current Assets 1,775
Land 68
Buildings and Equipment 21,616
Less: Accumulated Depreciation (9,243)
Total Non-current Assets 15,872
Current Assets:
Prepaid Expenses 948
Stock–in–Trade (Inventory) 8,500
Accounts Receivable 3,197
Liquid Funds (Cash) 22,726
Total Current Assets 35,371
Total Assets 51,243

Equity and Liabilities

Stockholders’ Equity:
Contributed Capital 1,617
Retained Earnings 35,333
Total Stockholders’ Equity 36,950

Long-term Liabilities 2,414

Total Non-current Liabilities 2,414

Current Liabilities:
Accrued Liabilities 3,687
Other Current Liabilities 4,534
Accounts Payable 3,658

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Chapter 05 - Financial Reporting and Analysis

Total Current Liabilities 11,879

Total Liabilities 14,293
Total Liabilities and Stockholders’ Equity 51,243

5-25
Chapter 05 - Financial Reporting and Analysis
CP5-4 (continued)

Req. 2

2008
Debt-to-assets = Total Liabilities = 14,293 = .279 = 27.9%
Total Assets 51,243

H&M’s debt-to-assets ratio is 0.279, which is higher than Volcom’s ratio of 0.126. This
indicates that Volcom has less financing risk for creditors (and investors) and is more
likely to pay its liabilities.

Req. 3

2008
Net profit margin = Net Income = 15,294 = .079 = 7.9%
Total Sales Revenue 192,573

H&M’s net profit margin shows a profit equal to 7.9 percent of sales, which is higher
than Volcom’s ratio that shows a profit of 6.5 cents for each dollar of sales. It appears
that H&M better controls its expenses.

Req. 4

2008
Asset turnover = Total Sales Revenue = 192,573 = 4.14
Average Total Assets (51,243+ 41,734)/2

H&M’s asset turnover ratio of 4.14 is considerably higher than Volcom’s ratio of 1.58.
This analysis indicates that H&M is very efficient in using its investment in assets to
generate sales revenues.

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Chapter 05 - Financial Reporting and Analysis
ANSWERS TO GROUP A PROBLEMS

PA5-1

Transaction Assets Liabilities Stockholders’ Equity

a. –7 –7 NE
b. +/–6 NE NE
c. +2 +2 NE
d. +20 NE Franchise Royalty Revenues (+R) +20

The effects of the transactions can be seen by making the related journal entries.

a. dr Loan Payable (–L) ................................................ 7

cr Cash (–A)..................................................... 7

b. dr Property and Equipment (+A) ............................... 6

cr Cash (–A) ................................................... 6

c. dr Property and Equipment (+A) ............................... 2

cr Note Payable (+L)........................................ 2

d. dr Accounts Receivable (+A) .................................... 20

cr Franchise Royalty Revenues (+R,+SE)....... 20

PA5-2

Transaction Debt-to-Assets Asset Turnover Net Profit Margin

a. – + NE
b. NE NE NE
c. + – NE
d. – CD +

PA5-3

Req. 1

Dillard’s appears to rely more on debt than Kohl’s, as suggested by its higher debt-to-
assets ratio. This ratio indicates that 35 percent of Dillard’s assets were financed by
liabilities, as opposed to 24 percent for Kohl’s.

Req. 2

Kohl’s appears to be more efficient in using its assets to generate sales, as suggested
by its higher asset turnover ratio. This ratio indicates that Kohl’s generates about $1.50
in sales for each dollar invested in assets, whereas Dillard’s generates only $1.39 in
sales for each dollar of assets.

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Chapter 05 - Financial Reporting and Analysis
PA5-3 (continued)

Req. 3

Kohl’s appears to better control its expenses than Dillard’s, as suggested by its higher
net profit margin ratio. This ratio indicates that 5.4 percent of Kohl’s revenues ultimately
are included as net income (suggesting that expenses make up 94.6 percent of
revenues). In contrast, Dillards’ net income is -3.4% of revenues, suggesting that its
expenses make up 103.4 percent of revenues.

PA5-4

Req. 1
GLŰCKLICH GOLFSPIELER
Statement of Financial Position
At December 31, 2010 Assets
(in thousands of euro) Goodwill and Intangible Assets 450
Other Non-current Assets 400
Land 100
Buildings and Equipment 5,500
Less: Accumulated Depreciation (2,500)
Total Non-current Assets 3,950
Current Assets:
Prepaid Expenses 250
Inventory 2,500
Accounts Receivable 500
Cash 5,800
Total Current Assets 9,050
Total Assets 13,000

Equity and Liabilities

Stockholders’ Equity:
Contributed Capital 400
Retained Earnings 9,000
Total Stockholders’ Equity 9,400

Other Long-term Liabilities 1,100

Notes Payable 600

Total Non-current Liabilities 1,700

Current Liabilities:
Accrued Liabilities 900

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Chapter 05 - Financial Reporting and Analysis

5-29
Chapter 05 - Financial Reporting and Analysis

Accounts Payable 1,000

Total Current Liabilities 1,900
Total Liabilities 3,600
Total Liabilities and Stockholders’ Equity 13,000

PA5-4 (continued)

Req. 2

2010
Debt-to-assets = Total Liabilities = €3,600 = .277 = 27.7%
Total Assets €13,000

Glücklich Golfspieler’s debt-to-assets ratio is 0.277, which is higher than the

competitor’s ratio of 0.20. This indicates that the competitor has less financing risk for
creditors (and investors) and is more likely to pay its liabilities.

Req. 3

2010
Net profit margin = Net Income = €4,000 = .091 = 9.1%
Total Revenue €44,000

Glücklich Golfspieler’s net profit margin shows a profit of 9.1 percent for each euro of
sales, which is higher than the competitor’s ratio that shows a profit of 5.0 percent.
Glücklich Golfspieler is better able to control its expenses.

Req. 4

2010
Asset turnover = Total Revenue = €44,000 = 3.83
Average Total Assets (€10,000 + €13,000)/2

Glücklich Golfspieler’s asset turnover ratio of 3.83 is higher than the competitor’s ratio of
2.60. This analysis indicates that Glücklich Golfspieler is more efficient in using assets
to generate sales.

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Chapter 05 - Financial Reporting and Analysis
ANSWERS TO GROUP B PROBLEMS

PB5-1

Transaction Assets Liabilities Stockholders’ Equity

a. +/–30 NE NE
b. –40 NE Dividends (+D) –40
c. –78 NE Depreciation Expense (+E) –78
d. +450 NE Admissions Revenue (+R) +450

The effects of the transactions can be seen by making the related journal entries.

a. dr Property and Equipment (+A) ............................... 30

cr Cash (–A) ................................................... 30

b. dr Dividends Declared (+D, –SE) ............................. 40

cr Cash (–A)..................................................... 40

c. dr Depreciation Expense (+E, –SE) .......................... 78

cr Accumulated Depreciation (+xA, –A)........... 78

d. dr Cash (+A) ............................................................. 450

cr Admissions Revenue (+R,+SE)................... 450

PB5-2

Transaction Debt-to-Assets Asset Turnover Net Profit Margin

a. NE NE NE
b. + + NE
c. + + –
d. – CD +

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Chapter 05 - Financial Reporting and Analysis
PB5-3

Req. 1

YUM Brands appears to rely more on debt than stockholders’ equity for financing, as
suggested by its higher debt-to-assets ratio. This ratio indicates that 99 percent of the
company’s assets were financed by liabilities, as opposed to 43 percent for McDonald’s.
This suggests that YUM Brands has a higher risk of defaulting on its payments when
compared to McDonald’s.

Req. 2

YUM Brands appears to be more efficient in using its assets to generate sales, as
suggested by its higher asset turnover ratio. This ratio indicates that YUM generates
about $1.64 in revenues for each dollar invested in assets, whereas McDonald’s
generates only $0.81 in revenues for each dollar of assets.

Req. 3

McDonald’s appears to better control its expenses when compared to YUM Brands, as
suggested by its higher net profit margin ratio. This ratio indicates that 18.34 percent of
McDonald’s revenues ultimately are included as net income (suggesting that expenses
make up 81.66 percent of revenues). In contrast, YUM’s net income is 8.6 percent of
revenues, suggesting that its expenses make up 91.4 percent of revenues.

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Chapter 05 - Financial Reporting and Analysis
PB 5-4

Req. 1
LATTERIA LIMITED
Statement of Financial Position
At December 31, 2010 Assets
(in thousands of euro) Land 5,550
Buildings and Equipment 6,600
Less: Accumulated Depreciation (3,600)
Total Non-Current Assets 8,550
Current Assets:
Prepaid Expenses 250
Inventory 2,500
Accounts Receivable 500
Cash 1,200
Total Current Assets 4,450
Total Assets 13,000

Equity and Liabilities

Stockholders’ Equity:
Contributed Capital 400
Retained Earnings 9,000
Total Stockholders’ Equity 9,400

Notes Payable 1,700

Total Non-current Liabilities 1,700

Current Liabilities:
Accrued Liabilities 600
Accounts Payable 1,300
Total Current Liabilities 1,900
Total Liabilities 3,600
Total Liabilities and Stockholders’ Equity 13,000

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Chapter 05 - Financial Reporting and Analysis

5-34
Chapter 05 - Financial Reporting and Analysis
PB 5-4 (continued)

Req. 2

2010
Debt-to-assets = Total Liabilities = €3,600 = .277 = 27.7%
Total Assets €13,000

Latteria Limited’s debt-to-assets ratio is 0.277, which is lower than Saputo’s ratio of
0.40. This indicates that Latteria Limited has less financing risk for creditors (and
investors) and is more likely to pay its liabilities.

Req. 3

2010
Net profit margin = Net Income = €2,200 = .10 = 10.0%
Total Revenue €22,000

Latteria Limited’s net profit margin shows a profit of 10.0 percent on each euro of sales,
which is higher than Saputo’s ratio that shows 6.0 percent. Latteria is better able to
control its expenses.

Req. 4

2010
Asset turnover = Total Revenue = €22,000 = 2.00
Average Total Assets (€9,000 + €13,000)/2

Latteria Limited’s asset turnover ratio of 2.00 is slightly higher than Saputo’s ratio of
1.94. This analysis indicates that Latteria Limited is more efficient in using its
investment in assets to generate sales.

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Chapter 05 - Financial Reporting and Analysis
ANSWERS TO SKILLS DEVELOPMENT CASES

S5-1

Req.1

2/1/2009
Debt-to-assets = Total Liabilities = $23,387 = 0.568 = 56.8%
Total Assets $41,164

2/3/2008
Debt-to-assets = Total Liabilities = $26,610 = 0.600 = 60.0%
Total Assets $44,324

The Home Depot’s financing has become less risky with the debt-to-assets ratio
decreasing from 60.0% on February 2, 008, to 56.8% on February 1, 2009.

Req. 2

2008-09
Asset turnover = Sales Revenues = $71,288 = 1.67
Average Total Assets ($41,164 + $44,324)/2

2007-08
Asset turnover = Sales Revenues = $77,349 = 1.60
Average Total Assets ($44,324 + $52,263)/2

The Home Depot has been more efficient in using its investment in assets to generate
sales in 2008-09, with the asset turnover ratio increasing from 1.60 in 2007-08 to 1.67 in
2008-09.

Req. 3

2008-09
Net profit margin = Net Income = $2,260 = .032 = 3.2%
Sales Revenues $71,288

2007-08
Net profit margin = Net Income = $4,395 = .057 = 5.7%
Sales Revenues $77,349

The Home Depot has made less profit per dollar of sales in 2008-09 because net profit
margin decreased from 5.7% in 2007-08 to 3.2% in 2008-09.

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Chapter 05 - Financial Reporting and Analysis
S5-2

Req. 1

Total Liabilities $14,631

Debt-to-assets = = = .448 = 44.8%
Total Assets $32,686

Based on this calculation Lowe’s is less risky, with a debt-to-assets ratio of 44.8%,
compared to The Home Depot’s debt-to-assets ratio of 56.8% (as calculated in S5-1).

Req. 2

Total Sales Revenues $48,230

Asset turnover = = = 1.52
Average Total Assets ($32,686 + $30,869)/2

Based on this calculation, Lowe’s investment in assets was used less efficiently in
generating sales in 2008-09, with a turnover ratio of 1.52 compared to The Home
Depot’s asset turnover ratio of 1.67.

Req. 3

Net Income $2,195

Net profit margin = = = .046 = 4.6%
Total Revenues $48,230

Based on this calculation, Lowe’s generated more profit per dollar of sales revenue in
2008-09, with a net profit margin of 4.6% compared to The Home Depot’s net profit
margin ratio of 3.2%.

S5-3

The solutions to this project will depend on the company and/or accounting period
selected for analysis.

S5-4
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Chapter 05 - Financial Reporting and Analysis

Req. 1

1998 Q3
Debt-to-assets = Total Liabilities = $869 = .596 = 59.6%
Total Assets $1,457

1998 Q4
Debt-to-assets = Total Liabilities = $830 = .579 = 57.9%
Total Assets $1,434

1999 Q1
Debt-to-assets = Total Liabilities = $862 = .585 = 58.5%
Total Assets $1,474

1999 Q2
Debt-to-assets = Total Liabilities = $937 = .601 = 60.1%
Total Assets $1,558

1999 Q3
Debt-to-assets = Total Liabilities = $983 = .609 = 60.9%
Total Assets $1,614

1998 Q4
Asset turnover = Sales Revenues = $280 = .194
Average Total Assets ($1,457 + $1,434)/2

1999 Q1
Asset turnover = Sales Revenues = $261 = .180
Average Total Assets ($1,434 + $1,474)/2

1999 Q2
Asset turnover = Sales Revenues = $222 = .146
Average Total Assets ($1,474 + $1,558)/2

1999 Q3
Asset turnover = Sales Revenues = $238 = .150
Average Total Assets ($1,558 + $1,614)/2

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Chapter 05 - Financial Reporting and Analysis
S5-4 (continued)

Req. 1 (continued)

1998 Q3
Net profit margin = Net Income = $1 = 0.5%
Sales Revenues $220

1998 Q4
Net profit margin = Net Income = $16 = 5.7%
Sales Revenues $280

1999 Q1
Net profit margin = Net Income = $8 = 3.1%
Sales Revenues $261

1999 Q2
Net profit margin = Net Income = $8 = 3.6%
Sales Revenues $222

1999 Q3
Net profit margin = Net Income = $11 = 4.6%
Sales Revenues $238

Req. 2

1998 Q3
Debt-to-assets = Total Liabilities = $879 = .604 = 60.4%
Total Assets $1,455

1998 Q4
Debt-to-assets = Total Liabilities = $868 = .599 = 59.9%
Total Assets $1,448

1999 Q1
Debt-to-assets = Total Liabilities = $882 = .603 = 60.3%
Total Assets $1,463

1999 Q2
Debt-to-assets = Total Liabilities = $944 = .621 = 62.1%
Total Assets $1,521

1999 Q3
Debt-to-assets = Total Liabilities = $972 = .626 = 62.6%
Total Assets $1,553

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Chapter 05 - Financial Reporting and Analysis
S5-4 (continued)

Req. 2 (continued)

1998 Q4
Asset turnover = Sales Revenues = $277 = .191
Average Total Assets ($1,455 + $1,448)/2

1999 Q1
Asset turnover = Sales Revenues = $254 = .175
Average Total Assets ($1,448 + $1,463)/2

1999 Q2
Asset turnover = Sales Revenues = $214 = .143
Average Total Assets ($1,463 + $1,521)/2

1999 Q3
Asset turnover = Sales Revenues = $231 = .150
Average Total Assets ($1,521 + $1,553)/2

1998 Q3
Net profit margin = Net Income = ($12) = –5.5%
Sales Revenues $219

1998 Q4
Net profit margin = Net Income = $5 = 1.8%
Sales Revenues $277

1999 Q1
Net profit margin = Net Income = $0 = 0%
Sales Revenues $254

1999 Q2
Net profit margin = Net Income = ($4) = –1.9%
Sales Revenues $214

1999 Q3
Net profit margin = Net Income = $4 = 1.7%
Sales Revenues $231

Req. 3

Overall, the initially reported numbers suggested less financing risk than the restated
numbers. It could be argued that the impact of this change could affect any of the four
users, but the group most directly influenced is arguably the creditors. Specifically the
lenders assessing the financing risk and monitoring compliance with loan covenants
would be directly affected.

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Chapter 05 - Financial Reporting and Analysis
S5-4 (continued)

Req. 4

Overall, the initially reported numbers present Aurora’s efficiency in generating sales in
a better light. Again, it could be any of the user groups affected but arguably the
directors and investors are most directly affected. Directors use the asset turnover ratio
to gauge appropriateness of investments in assets and whether some should be added
or disposed of. Investors are affected because sales are a driver of profit which impacts
stock price.

Req. 5

Overall, the initially reported numbers present Aurora’s profitability in a better light than
the revised numbers. Arguably investors would be most influenced by the impact in the
net profit margin ratio because net income drives stock prices.

Note: Although not a requirement of this case, the three ratios can be compared using
graphs similar to the following (initially reported results are shaded, restated results are
not).

Debt-to-Assets Ratio Asset Turnover Ratio Net Profit Margin Ratio

63.0%
0.20 6.0%
62.0% 0.18

0.16 4.0%
61.0%

0.14
60.0%
2.0%
0.12
59.0%
0.10
0.0%
58.0%
0.08

57.0% 0.06 -2.0%

56.0% 0.04

0.02 -4.0%
55.0%
1998 Q3 1998 Q4 1999 Q1 1999 Q2 1999 Q3 0.00
Qu a r t e r 1998 Q3 1998 Q4 1999 Q1 1999 Q2 -6.0%
Qu a r t e r
1998 Q3 1998 Q4 1999 Q1 1999 Q2 1999 Q3

Qu a r t e r

Req. 6
Aurora’s auditors detected the problem and brought it the attention of the directors,
which was the appropriate level. Fraud can be difficult to detect when management
conceals it with falsified documents. For this reason, it is not surprising that the 1998
audit did not reveal the fraud.

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Chapter 05 - Financial Reporting and Analysis
S5-4 (continued)

Req. 7
Case Fact Incentive/Goal Goal Fulfilled?
a. Obtained loans from 1. Attract business partners by No; bank found out
Chase and other presenting lower financing risk. and renegotiated loan
lenders. 2. Satisfy loan covenants. and the other lenders
left.
b. Barred for life from 3. Enhance job security. No; forced to resign
serving as an and jailed. Career
executive. ended at age 36.
c. Returned stock and 4. Increase personal wealth. No; forced to return all
bonuses. 5. Obtain bigger paycheck. the money.

Had the Sarbanes-Oxley Act existed prior to 1998, the harsh penalties for intentionally
misstating financial statement items (fines up to $5 million and up to 20 years in prison)
may have deterred the CFO from ordering her staff to make false journal entries and
prepare misleading financial statements. Other factors that could have prevented the
CFO’s fraud are the independent internal auditing committees required by the act, and
the fraud-reporting hotlines set up to allow employees to contact authorities regarding
questionable accounting practices.

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Chapter 05 - Financial Reporting and Analysis
S5-5

Req. 1

All of the ratios discussed in the chapter will be affected by the decision of the CFO.
Both the debt-to-assets and asset turnover ratios would decrease and the net profit
margin ratio would increase.

Req. 2

There are several issues in this case that may make you feel uncomfortable. First of all,
the change affects two important ratios in directions that enhance the apparent financial
strength of the company. The change in these ratios will affect lenders and investors as
they rely on the financial statements to make their decisions. The question needs to be
asked as to whether these costs actually provide future economic benefits. The answer
would be yes if the costs were for the initial installation of the machinery or were needed
to get the machinery working initially but would be no if the costs were incurred for
routine maintenance. It’s not clear whether costs of “tinkering” with the line relate to
pre-production installation or post-installation maintenance. You also might feel
uncomfortable with the urgency of this change and may even wonder why it wasn’t done
earlier. Also, why was the last clerk being replaced? Was he/she fired? Was he/she
incompetent?

Req. 3

You should view this encounter as an opportunity to learn from the CFO. Ask the CFO
to explain where GAAP says this is okay. If you are still dissatisfied after listening to the
explanation, you need to report it to the appropriate level in the organization. The
company may have an anonymous tip line or you could raise the issue with a member
of the board of directors.

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Chapter 05 - Financial Reporting and Analysis
S5-6

Req.1

Asset turnover = Net Sales = $1,117 = 1.32

Average Total Assets ($855 + $838)/2

Net profit margin = Net Income = $66 = 5.9%

Net Sales $1,117

The Callaway executives met the lower bonus targets, as asset turnover exceeded 0.8
and net profit margin exceeded 5%. However, the above ratios were too low to meet the
higher bonus targets of a 1.6 asset turnover and 7% net profit margin.

Req. 2

Asset turnover ensures the volume of sales and net profit margin ensures the
profitability on each sale. The bonus is based on both ratios because they are both
important factors to the company’s success. One factor cannot be focused on to the
exclusion of the other. This prevents management from simply cutting expenses
without regard to growing sales in order to boost profit margin, or from slashing prices to
increase the volume of sales without regard to the profitability of each sale.

S5-7

Data Used in Analyses

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Chapter 05 - Financial Reporting and Analysis
S5-7 (continued)

Req. 1

5-45
Chapter 05 - Financial Reporting and Analysis
S5-7 (continued)

Req. 2

5-46
Chapter 05 - Financial Reporting and Analysis
S5-7 (continued)

Req. 3

5-47
Chapter 05 - Financial Reporting and Analysis
ANSWERS TO CONTINUING CASE

CC-5

Req. 1

Trans. Assets Liabilities Stockholders’ Equity

Accounts
a Equipment +320 NE
Payable +320
Accounts Receivable Spa Service Revenue (+R)
b NE
+1,500 +1,500
Advertising Expense (+E) -
c Cash -40 NE
40
Accrued
d NE Utilities Expense (+E) -750
Liabilities +750
e Cash +50,000 NE Contributed Capital +50,000
Note Payable
f Cash +2,500 NE
+2,500
Accumulated Depreciation Depreciation Expense (+E) -
g NE
(+xA) -1,800 1,800
Unearned Spa Service Revenue (+R)
h NE
Revenue -200 +200

Req. 2

Transaction Debt-to-Assets Asset Turnover Net Profit Margin

a + - NE
b - - +
c + + -
d + NE -
e - - NE
f + - NE
g + + -
h - + +

5-48