Solution manual intermediate accounting 9e by nicolai ch05

Dividend yield, price/earnings, profit margin, return on total assets, return on stockholders' equity, current, acid-test, inventory turnover, receivables turnover, average operating cyc

CHAPTER 5

ADDITIONAL ASPECTS OF FINANCIAL REPORTING

AND FINANCIAL ANALYSIS

CONTENT ANALYSIS OF EXERCISES AND PROBLEMS

Time Range (minutes) E5-1 Segment Reporting Schedule showing segment revenues,

E5-2 Segment Reporting Schedule showing segment revenues,

E5-3 Segment Reporting Schedule showing segment revenues and

E5-4 Determination of Reportable Segments Schedule showing

E5-5 Interim Reporting First quarter income statement, balance

sheet Gross profit method for inventory Trial balance, additional information given

10-15

E5-6 Interim Reporting First quarter income statement, balance

sheet Gross profit method for inventory Trial balance, additional information given

10-15

E5-7 Interim Reporting Year-to-date, 6-month income statement

Second-quarter income statement

10-15

E5-8 Interim Taxes Schedule to compute the income tax expense

to be listed on each quarterly income statement

5-15

E5-9 (Appendix) Horizontal Analyses Of comparative income

statements, balance sheets Year-to-year and date approaches

base-year-to-10-15

E5-10 (Appendix) Vertical Analyses Of comparative income

E5-11 (Appendix) Ratios Price/earnings, profit margin, return on

total assets, return on stockholders' equity, current, inventory turnover, payables turnover, debt

10-20

Number Content

Time Range (minutes) E5-12 (Appendix) Ratios Earnings per share, dividend yield, return

on stockholders' equity, current, acid-test, receivables turnover, times interest earned, book value per common share

10-20

E5-13 (Appendix) (AICPA adapted) Ratio Analysis Current,

inventory turnover, and debt ratios Determine effects on ratios

of various transactions and events

10-20

P5-1 Income Statement and Segment Reporting Single-step

income statement Allocation of revenues, expenses, assets to segments Schedule Related notes Compute profit margin (Appendix)

45-75

P5-2 Income Statement and Segment Reporting Multiple-step

income statement Allocation of revenues, expenses, assets to segments Schedule Related notes Compute return on identifiable assets (Appendix)

45-75

P5-3 Interim Reporting Income statements for first six months,

second quarter Balance sheet, retained earnings statement

Gross profit method for inventory Worksheet

60-80

P5-4 Interim Reporting Income statements for first six months,

second quarter Balance sheet, retained earnings statement

Retail inventory method Worksheet

60-80

P5-5 (AICPA adapted) Interim Reporting Identification of

standards of disclosure, weaknesses in form and content of the given report Indication of preferable treatment

40-45

P5-6 (AICPA adapted) Financial Statement Presentation and

Ratios Identification of appropriate and inappropriate disclosures Justification Description of ratio significance

Ratio computations

20-40

P5-7 (AICPA adapted) Multiple-Step Income Statement

Preparation of income statement, including extraordinary item and deferred taxes Reconciliation of net income and taxable income

45-60

P5-8 (Appendix A) The Coca-Cola Company Disclosures

Numerous questions relating to the financial report in Appendix

A at the end of the book

25-45

P5-9 (Appendix) Horizontal Analysis and Ratios Year-to-year

approach Current, acid-test, inventory turnover, receivables turnover, earnings per share, dividend yield, return on total assets, return on stockholders' equity, debt

60-75

Number Content

Time Range (minutes) P5-10 (Appendix) Vertical Analysis and Ratios Current, acid-test,

inventory turnover, receivables turnover, payables turnover, return on total assets, return on stockholders' equity, debt, times interest earned

60-75

P5-11 (Appendix) Horizontal and Vertical Analyses

Base-year-to-date approach Two year analyses

45-60

P5-12 (Appendix) Ratio Analysis Dividend yield, price/earnings,

profit margin, return on total assets, return on stockholders' equity, current, acid-test, inventory turnover, receivables turnover, average operating cycle, debt, times interest earned, book value per common share

30-45

P5-13 (Appendix) (AICPA adapted) Ratio Analysis Current,

acid-test, number of days sales in average receivables, inventory turnover, book value per share, earnings per share,

price/earnings, dividend yield

30-40

ANSWERS TO QUESTIONS

Q5-1 A standard auditor's report includes the following statements:

1 The auditor is independent,

2 An audit was performed on specified financial statements,

3 The financial statements are the responsibility of the company's management; the opinion is the responsibility of the auditors,

4 The audit was conducted according to generally accepted auditing standards,

5 The audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatement,

6 The audit included examination, assessment, and evaluation stages,

7 The audit provides a reasonable basis for an opinion, and

8 An expression of an opinion concerning the fair presentation

The report is also signed and dated by the auditing firm

Q5-2 An audit committee is a group that has oversight over the financial reporting process

of a company A management report is a report in which management

acknowledges that it is responsible for the preparation and presentation of the financial statements This report frequently includes a discussion of internal control, references to the audit committee's responsibilities, and may identify the

independent auditor's responsibilities

Q5-3 Management's discussion and analysis (MD&A) is a narrative explanation of the

financial statements so that investors can judge the quality of earnings and the likelihood that past performance is indicative of future performance in regard to cash flows from operations and from outside sources The MD&A is included in the

company's annual report to give investors the opportunity to look at the company

"through the eyes of management" by providing both a short-term and long-term analysis of the company's business

Q5-4 Investors and creditors desire operating segment information about a company in

order to evaluate both risk and return in their investment and credit decisions Risk involves uncertainty or unpredictability that results from the way in which the

company is organized and how its divisions are operated, the nature and current status of the economy(ies) within which a company operates, the changing

conditions in the geographic areas within which the company operates, and the characteristics of its major customers Similarly, the return (profitability) generated by

a company is also affected by the same factors Disclosure of financial information concerning the operating segments of a company leads to insights about risk and return and improves the predictive value and feedback value of the accounting information that may not be discernible from the consolidated financial statements Q5-5 An operating segment is considered a reportable segment if it satisfies one of three

tests The three tests are the revenue test, operating profit test, and asset test

1 Revenue test Its reported revenues (including sales to external customers and intersegment sales) are 10% or more of the combined revenues of all the company's reported operating segments

2 Profit test The absolute amount of its profit (loss) is 10% or more of the combined reported profits of all the operating segments that did not report an operating loss (If the combined losses of all operating segments that reported a loss exceed the combined profits as calculated, the combined loss amount would be used for this 10% test.)

3 Asset test Its segment assets are 10% or more of the combined assets of all operating segments

Q5-6 1 Information about profit (or loss) A company must report a measure of the profit

(or loss) for each reportable segment It must also disclose certain amounts used

in computing each segment's profit (or loss), as long as these amounts are included in the reports reviewed by the chief operating officer These amounts are the segment's: (a) revenues (separated into sales to external customers and intersegment sales), (b) interest revenue and interest expense, and (c)

depreciation, depletion, and amortization expense

2 Information about assets A company must report a measure of the total assets

of each reportable segment Only those segment assets that are included in the reports reviewed by the chief operating officer are included For these assets, a company also must disclose the total capital expenditures for additions to long-lived assets for each reportable segment

Q5-7 A company (even one with only a single operating segment) must disclose (a) its

revenue from external customers for each product and service, and (b) information about geographic areas including (1) revenues from external customers in the U.S., and revenues from customers in individual foreign countries, and (2) total long-lived assets located in the U.S., and total long-lived assets located in all foreign countries If

a company's revenues from transactions with a single external customer are 10% or more of the company's total revenues, then the company must disclose this fact and identify the segment(s) reporting the revenues

Q5-8 Interim financial statements are financial reports for periods of less than one year

(usually by quarters) These interim reports are issued because many external users desire information on a more timely basis than once a year Furthermore, these reports are required to be issued by all publicly-held companies

Q5-9 In regard to the reporting of its inventories in interim reports, a company using an

estimation technique must report the method used and any significant adjustments resulting from the reconciliation with the annual physical inventory A company using LIFO and encountering a temporary partial liquidation of its base inventory that is expected to be replaced by year end must not give effect to the liquidation in its interim cost of goods sold A permanent loss (and any subsequent recovery) due to inventory decline must be recognized in accordance with lower of cost or market procedures Finally, when a company uses a standard cost accounting system, the accounting for all variances must follow routine annual procedures and any

significant unexpected purchase price or volume variances should be disclosed Q5-10 A company matches its expenses not directly associated with product sales during

an interim period against its revenues using a variety of bases In this regard,

(a) expenses affecting more than one interim period are allocated to the interim periods on the basis of time expired, benefits received, or activity associated with the periods; (b) expenses identified only with activities of the current interim period are allocated to that period; and (c) gains and losses incurred in an interim period are recognized in that period

Q5-11 (a) The accounting procedures used in the preparation of a company's interim

reports are similar to those for its annual reports in that a year-to-date trial balance is taken, the trial balance is entered on a worksheet or other working paper, year-to-date adjusting entries are recorded on the worksheet, and financial statements are prepared (b) The interim accounting procedures differ in that the determination of the interim ending inventory is based on an estimate rather than a physical inventory, the interim adjusting entries are usually not entered into the accounts, and closing entries are not usually made at the end of each interim period

Q5-12 The minimum interim report disclosures include:

1 Sales or gross revenues, income taxes, extraordinary items (net of tax), the

cumulative effect of a change in accounting principle, and net income

2 Earnings per share for each period presented

3 Seasonal revenues, costs, and expenses

4 Significant changes in estimates of income taxes

Q5-12 (continued)

5 Results of discontinued operations and material unusual or infrequent items

6 Contingent items

7 Changes in accounting principles or estimates

8 Significant changes in financial position (i.e., cash flows)

Q5-13 The Chief Accountant of the SEC helps in the establishment of administrative policies

regarding accounting matters, is directly responsible for Regulation S-X, and is

primarily responsible for the Financial Reporting Releases

The Division of Corporation Finance of the SEC is responsible for the establishment of SEC reporting standards (except those delegated to the Chief Accountant) and the requirements for adherence to these standards by regulated companies It is also responsible for reviewing the financial reports submitted to the SEC by these

companies

Q5-14 The two SEC reports that are important to accountants are:

1 Form 10-K An annual report

2 Form 10-Q A quarterly report of operations

Q5-15 External users may make comparisons of a company's current financial performance

and financial position with its financial performance and position during previous accounting periods These are referred to as intracompany comparisons External users may also compare a company's performance and position with those of

competitors, the average for the industry in which it operates, or with results in related industries This is referred to as intercompany comparison It is important for

accountants to be knowledgeable about these comparisons because they are the preparers of the financial statements used Accountants must present information that is consistent across time, and, to the extent possible, consistent across

companies Furthermore, a better understanding may also lead to insights on how to improve the information contained in the financial statements

Q5-16 In horizontal analysis, changes in a company's operating results and financial position

over time are shown in percentages as well as in dollars When a 2-year comparison

is made, the earlier year is used as the base year and the amount of change in each item is shown as a percentage of that item's base-year amount When a horizontal analysis of more than 2 years is made, two alternative approaches may be used In the "year-to-year"approach, the preceding year is used as the base year in

developing the percentage changes In the "base-year-to-date" approach, the initial year is used as the base year and the cumulative results from the later years are compared with this base year to determine the percentage changes

Q5-17 In vertical analysis, percentages are developed that show the monetary relationships

between items on the financial statements of a company for a particular period These percentages are shown in addition to the dollar amounts for each item In horizontal analysis, changes in the items on a company's financial statements over time are shown as a percentage as well as in dollars Thus, vertical analysis develops

"within period" percentage relationships whereas horizontal analysis develops "across period" percentage changes

Q5-18 Ratio analysis is a form of percentage analysis in which one or more items on a

company's financial statements are divided by another related item or items The various ratios computed for a company in a particular year are compared with that company's ratio results from previous years (intracompany comparison) or with the ratio results from other companies (intercompany comparison) in order to evaluate the financial aspects (i.e., return, risk, financial flexibility, liquidity, and operating capability) of the company

Q5-19 The stockholder profitability ratios are the earnings per share, price/earnings, and

dividend yield They are computed as follows:

Earnings per share: Average common shares outstanding Net income – Preferred dividends

Price/earnings: Market price per common share Earnings per share

Dividend yield: Market price per common share Dividends per common share

Q5-20 The company profitability ratios are the profit margin, return on total assets, and

return on stockholders' equity They are computed as follows:

Profit margin: Net income Net sales

Return on total assets: Net income + Interest expense (net of tax) Average total assets

Return on stockholders’ equity: Average stockholders’ equity Net income

Q5-21 The ratios that may be applied in regard to a company's reportable operating

segments include the profit margin, return on total assets, and return on stockholders' equity

Q5-22 The liquidity ratios include the current ratio and acid-test ratio They are computed

Q5-23 The activity ratios include the inventory turnover, the accounts receivable turnover,

and the accounts payable turnover They are computed as follows:

Inventory turnover: Cost of goods sold Average inventory

Receivables turnover: Net credit sales

Average net receivables

Payables turnover: Cost of goods sold

Average accounts payable Q5-24 The stability ratios include the debt ratio, times interest earned, and book value per

common share They are computed as follows:

Debt: Total liabilities

Total assets

Times interest earned: Pretax operating income

Interest expense

Book value per common share: Common stockholders’ equity

Outstanding common shares

ANSWERS TO CASES

C5-1

In an audit, the certified public accountant conducts an examination of the accounting system, records, and financial statements in accordance with generally accepted

auditing standards Based on the examination, the auditor expresses an opinion

concerning the fairness of the financial statements in conformity with generally accepted accounting principles

An unqualified opinion includes three paragraphs The first paragraph, known as the introductory paragraph, lists the financial statements that were audited, states that the management of the company is responsible for those statements, and that the auditor is responsible for expressing an opinion on them The second paragraph, known as the scope paragraph, describes what the auditor has done Specifically, it states that the auditor has examined the financial statements in accordance with generally accepted auditing standards and has performed appropriate tests The third paragraph, known as the opinion paragraph, gives the auditor's opinion When the opinion is unqualified, the auditor states that the financial statements present fairly the financial position, results of operations, and cash flows of the company in conformity with generally accepted accounting principles

C5-2 (CMA adapted solution)

Note to Instructor: This case is slightly more advanced than the text explanation, but is useful for class discussion

1 The general purposes of the management report are to communicate management's responsibility for the financial statements, the adequacy of the company's internal

controls, the role of the board of directors, the role of the corporation's audit committee, and the role and responsibilities of the external auditors

2 Five subject areas or topics that have been recommended for inclusion in the

management report include the following:

management's responsibility for the financial statements and other financial

information

management's responsibility for the system of internal accounting controls and its response to material weaknesses identified by the independent auditor

a description of the role of the company's internal auditors

an assertion regarding the board of directors' role in overseeing and reviewing management's preparation of the financial statements

a reference to the company's code of conduct or ethical and legal policies

C5-2 (continued)

3 The management report itself does not create any new audit requirements However, the content of the management report probably will influence the activities of the external auditor during the audit engagement Therefore, the external auditor should read the management report but has no obligation to corroborate the information contained therein Additionally, the external auditor should consider whether the report by

management is consistent with information appearing in the financial statements and also should consider whether the report contains a material misstatement of fact

C5-3 (CMA adapted solution)

Note to Instructor: This case is slightly more advanced than the text explanation, but is useful for class discussion

1 The SEC is an independent federal agency that receives its authority from federal

legislation The Securities Exchange Act of 1934 created the SEC and empowered it to administer compliance with provisions of that Act and the Securities Act of 1933

2 a The SEC supports fair securities markets by regulating brokers, exchanges, and the

publicly held companies themselves The Commission monitors the trading practices and financial condition of brokers The Commission oversees the activities and trading rules of securities exchanges Finally, the Commission requires registration and

continuing public disclosure of financial and other information by publicly held

companies

b The SEC fosters enlightened shareholder participation in major corporate decisions by requiring corporate management to keep stockholders informed by various means Management is required to issue proxy solicitations, file periodic reports with the SEC, hold annual stockholders' meetings, and issue annual reports to stockholders that include audited financial statements

3 The SEC requires publicly held companies to file audited financial statements and other disclosures in accordance with its regulations The Commission relies primarily on the integrity and legal responsibility of the reporting entities and the external auditors for the material accuracy and completeness of the filings The Commission reviews filings on a selective basis in an attempt to discover untrue, incomplete, or misleading information C5-4

1 An operating segment is a component of a company:

(a) that engages in business activities to earn revenues and incur expenses,

(b) whose operating results are regularly reviewed by the company's chief operating officer to make decisions about resources to be allocated to the segment and to assess its performance, and

(c) for which financial information is available

Not all departments in a company are operating segments For instance, a corporate headquarters normally does not earn revenues directly and is not an operating segment Generally, an operating segment has a segment manager who is directly accountable for

C 5-4 (continued)

2 There are three basic tests to be applied to operating segments to determine if they are significant enough to be separately reportable If a segment meets any one of the tests it

is significant and is a reportable segment

The first test is based upon revenue If an operating segment's reported revenues from sales to external customers and intersegment sales are equal to 10 percent or more of the company's combined revenues of all the company's operating segments, the segment is reportable

The second test is based upon profits or losses There are two subtests in this category based upon absolute amounts of profits or losses An operating segment is reportable if the profit or loss reported by the segment is equal to or greater than 10 percent of the higher of the following two absolute amounts:

(a) Sum of the reported profits for all operating segments' reporting profits

(b) Sum of the reported losses for all operating segments' reporting losses

Third, an operating segment is reportable if the assets of the segment equal or exceed 10 percent of the combined assets of all of the operating segments within the company

3 A company must disclose the following information about its reportable operating

segments:

(a) Information about profit (or loss) The company must report a measure of the profit (or loss) for each reportable segment It must also disclose certain amounts used in computing each segment's profit (or loss), as long as these amounts are included in the reports reviewed by the chief operating officer These amounts are the

segment's: (1) revenues (separated into sales to external customers and

intersegment sales), (2) interest revenue and interest expense, and (3) depreciation, depletion, and amortization expense

(b) Information about assets The company must report a measure of the total assets of each reportable segment Only those segment assets that are included in the reports reviewed by the chief operating officer are included For these assets, the company also must disclose the total capital expenditures for additions to long-lived assets for each reportable segment

(c) Reconciliations The company must provide reconciliations of: (1) the total of the reportable segments' revenues to its total revenues, (2) the total of the reportable segments' measures of profit (or loss) to its pretax income from continuing operations, and (3) the total of the reportable segments' assets to its total assets The revenues, profit (or loss), and segment assets of the "all other" segment category must be included in these respective reconciliations

C5-5 (AICPA adapted solution)

1 Sales and other revenues should be recognized for interim financial statement purposes in the same manner as revenues are recognized for annual reporting purposes This means normally at the point of sale or, in the case of services, at completion of the earnings process

In the case of industries whose sales vary greatly due to the seasonal nature of business, revenues should still be recognized as earned, but a disclosure should be made of the seasonal nature of the business in the notes

In the case of long-term contracts recognizing earnings on the percentage-of-completion basis, the current state of completion of the contract should be estimated and revenue recognized at interim dates in the same manner as at the normal year end

2 For interim reporting purposes, product costs (costs directly attributable to the production

of goods or services) should be matched with the product and associated revenues in the same manner as for annual reporting purposes

Period costs (costs not directly associated with the production of a particular good or service) should be charged to earnings as incurred or allocated among interim periods based on an estimate of time expired, benefit received, or other activity associated with the particular interim period(s) Also, if a gain or loss occurs during an interim period and is

a type that would not be deferred at year end, the gain or loss should be recognized in full in the interim period in which it occurs Finally, in allocating period costs among interim periods, the basis for allocation must be supportable and may not be based on merely an arbitrary assignment of costs between interim periods

The AICPA Accounting Principles Board allowed for some variances from the normal method of determining cost of goods sold and valuation of inventories at interim dates in APB Opinion No 28, but these methods are allowable only at interim dates and must be fully disclosed in a note to the financial statements Some companies use the gross profit method of estimating cost of goods sold and ending inventory at interim dates instead of taking a complete physical inventory This is an allowable procedure at interim dates, but the company must disclose the method used and any significant variances that

subsequently result from reconciliation of the results obtained using the gross profit method and the results obtained after taking the annual physical inventory

At interim dates, companies using the LIFO cost-flow assumption may temporarily have a reduction in inventory level that results in a liquidation of base period tiers of inventory If this liquidation is considered temporary and is expected to be replaced prior to year end, the company should charge cost of goods sold at current prices The difference between the carrying value of the inventory and the current replacement cost of the inventory is a current liability for replacement of LIFO base inventory temporarily depleted When the temporary liquidation is replaced, inventory is debited for the original LIFO value and the liability is removed

Inventory losses from a decline in market value at interim dates should not be deferred but should be recognized in the period in which they occur However, if in a subsequent interim period the market price of the written-down inventory increases, a gain should be

C5-5 (continued)

2 (continued)

Finally, if a company uses a standard costing system to compute cost of goods sold and

to value inventories, variances from standard should be treated at interim dates in the same manner as at year end However, if variances occur at an interim date that are expected to be absorbed prior to year end, the variances should be deferred instead of being immediately recognized

3 The AICPA Accounting Principles Board stated that the provision for income taxes shown in interim financial statements must be based upon the effective tax rate expected for the entire annual period for ordinary earnings The effective tax rate is, in accordance with previous APB Opinions, based on earnings for financial statement purposes as opposed to taxable income which may consider timing differences This effective tax rate is the

combined federal and state(s) income tax rate applied to expected annual earnings, taking into consideration all the various anticipated tax credits, foreign tax rates,

percentage depletion capital gains rates, and other available tax planning alternatives Ordinary earnings do not include unusual or extraordinary items, discontinued operations,

or cumulative effects of changes in accounting principles, all of which will be separately reported or reported net of their related tax effect in reports for the interim period or for the fiscal year The amount shown as the provision for income taxes at interim dates should be computed on a year-to-date basis For example, the provision for income taxes for the second quarter of a company's fiscal year is the result of applying the expected rate to year-to-date earnings and subtracting the provision recorded for the first quarter There are several variables in this computation (expected earnings may change, tax rates may change), and the year-to-date method of computation provides the only continuous method of approximating the provision for income taxes at interim dates However, if the effective rate or expected annual earnings change between interim periods, the change

is not reflected retroactively but the effect of the change is absorbed in the current interim period

C5-6 (AICPA adapted solution)

1 Financial reporting for operating segments of a business enterprise involves reporting financial information on a less-than-total-enterprise basis These segments are defined along organizational lines, such as divisions, branches, or subsidiaries Segmentation could

be based on areas of common activity, such as industries in which the enterprise operates, product lines, types of services rendered, markets, types of customers, or geographical areas It also could be based on critical "drivers" of the enterprise's risks and opportunities

In addition to these possible individual definitions of an enterprise's segments, a company may use more than one of the above-cited bases of segmentation Guidelines have been established by the Securities and Exchange Commission to guide management in selecting a basis of segmentation

2 The reasons for requiring financial data to be reported by operating segments include the following:

They would provide more detailed disclosure of information needed by investors, creditors, and other users of financial statements

Appraisers can evaluate major operating segments of a business enterprise before

considering the business in its entirety

C5-6 (continued)

2 (continued)

In addition to being useful and desirable, such information is practical to compute

The growth potential of an enterprise can be evaluated by reviewing the growth potential

of its major operating segments

Users can better assess management decisions to drop or add an operating segment Projection of future earning power is made more effective when approached on an operating segment basis, because different segments may have differing rates of growth, profitability, and degrees of risk

Managerial ability is better assessed with operating segment data because managerial responsibility within the enterprise is frequently decentralized

3 The possible disadvantages of requiring financial data to be reported by operating

segments include the following:

They could be misinterpreted due to the public's general lack of appreciation of the limitations of the somewhat arbitrary bases for most allocations of common costs

They may disguise the interdependence of all the operating segments

They might result in misleading comparisons of operating segments of different enterprises Confidential information would be revealed to competitors about profitable or

unprofitable products, plans for new products or entries into new markets, apparent weaknesses that might induce competitors to increase their own efforts to take

advantage of the weakness, and the existence of advantages not otherwise indicated Information thus made available might cause customers to challenge prices to the

disadvantage of the company

Operating data reported by operating segments might be misleading to those who read them Segment data prepared for internal management purposes often include arbitrary judgments that are known to those using the data and taken into account in making evaluations The difficulty of making such background information available and

understandable to outside users is considered by many to be great

C5-7 (AICPA adapted solution)

Note to Instructor: This case is slightly advanced for students but provides a good basis for class discussion

1 If a corporation's activity could be expected to be the same in all quarters, there would

be no problems in using quarterly statements to predict annual results, providing one recognized that the normal activities of any corporation could be disrupted by unforeseen events such as strikes, fires, floods, actions of governmental authorities, and unusual

changes in demand for goods or supply of raw materials Most businesses, however, can

be expected to have variations in activity among quarters Any user of the financial statements who is not also a member of management would probably have great

difficulty in making accurate predictions

A basis cause of fluctuating quarterly activity is seasonality Sales often show a seasonal pattern Expenses also may show a seasonal pattern, but the pattern for any expense may differ from the patterns for sales or for the other expenses Production, expressed in physical units, may show still another pattern The more product lines a business has, the greater the number of varying seasonal patterns that may be present

2 Repairs and Maintenance of Factory Machinery is an example of an item which may show substantial variations that are not proportionate to either sales or production In fact, it would not be unusual for many repair and maintenance projects to be performed during the time when production is lowest, thus causing high unit costs (high costs divided by few units) for the quarter The effect on income would be spread between the quarter of incurrence and later quarters, depending on inventory levels and costing methods Use of predetermined overhead rates would have the same effect (if variances were allocated between inventories and cost of goods sold) or else would confine the effect of the high costs to the current quarter (if variances were included in cost of goods sold) Low costs in periods of high production would result in low unit costs, the effects of which would be spread among quarters as described above

3 Such quarterly statements do give management opportunities to manipulate the results of operations for a quarter; for instance, through the timing of expenses Management can defer some expenses in an attempt to make the results of earlier quarters look very

profitable, thus delaying discovery of conditions that could reflect on management's performance On the other hand, management can incur heavy expenses in the earlier quarters in an attempt to show a favorable trend in the later quarters For example, the time at which maintenance work is undertaken is somewhat discretionary

C5-8

1 The purpose of a MD&A is to give investors the opportunity to look at a company's

"forward looking" information "through the eyes of management" by providing both a short-term and long-term analysis of the company's business Thus, a MD&A provides a narrative explanation of the financial statements so that investors can judge the "quality"

of earnings and the likelihood that past performance is indicative of future performance in regard to cash flows from operations and from outside sources

C5-8 (continued)

1 (continued)

In its MD&A, a company must provide information regarding liquidity, capital resources, and the results of operations, as well as other information necessary to understand its financial position and changes in financial position This disclosure includes descriptions and amounts of items that would have an impact on future operations but that did not affect past operations, as well as amounts of items that affected past operations but are not expected to have an impact on future operations Furthermore, where knowledge of segment information is useful for understanding a company's business, the discussion is to focus on each relevant, reportable operating segment as well as the whole company

2 (a) The company is the largest manufacturer, marketer, and distributor of nonalcoholic

beverage concentrates and syrups The company manufactures beverage

concentrates and syrups and, in certain instances, finished beverages, which it sells

to bottling and canning operations, authorized fountain wholesalers, and some fountain retailers It also markets and distributes juice and juice-drink products In addition, it has ownership interests in numerous bottling and canning operations The company measures sales volume in two ways: (1) gallons and (2) unit cases of

finished product (p 46)

(b) Net operating revenues increased 1 percent in 2001 This growth was primarily due to

an increase in gallon shipments, price increases in selected countries, and the

consolidation of the Nordic and Brazilian bottling operations (p 47)

(c) Selling expenses were $6,930 million in 2001, and they increased over 2000 primarily due to higher marketing in line with the company's unit case volume growth,

incremental marketing expenses, and the consolidation in 2001 of the Nordic and Brazilian bottling operations (p 48)

(d) In regard to liquidity, the company believes that its ability to generate cash from operations to reinvest into its business is one of its fundamental financial strengths (p 52)

(e) The company's "free cash flow" is the cash remaining from operations after it has satisfied its business reinvestment opportunities Free cash flow, along with

borrowings, is used to pay dividends, make share repurchases, and make acquisitions (p 52)

(f) The cash provided by operations for 2001 was $4,110 million, and it increased in 2001 primarily as a result of solid 2001 business results (p 52)

3 While management cannot predict future performance, it believes considerable

opportunities exist for sustained, profitable growth, not only in the developing population centers of the world, but also in the company's most established markets It firmly believes the strength of the company's brands, its unparalleled distribution system, its global

presence, its strong financial condition, and the diversity and skills of its people gives it the flexibility to capitalize on growth opportunities as it continues to pursue its goal of

increasing share-owner value over time (p 55)

C5-9

Note to Instructor: This case does not have a definitive answer From a financial reporting perspective, GAAP is identified and summarized From an ethical perspective, various issues are raised for discussion purposes

From a financial reporting perspective, for interim reporting purposes expenses that are not directly associated with product sales are matched against revenues in various ways Expenses that can be identified as affecting the operating activities of more than one interim period are allocated among the interim periods based on an estimate of the time expired, benefit received, or activity associated with the periods Expenses that cannot

be identified with activities other than those of the current interim period are allocated to that period No arbitrary allocations are allowed

From an ethical perspective, the issue is when to report the repair and maintenance expense, given that all the costs are incurred in the first quarter Allocation of the expense

to incorrect interim periods will cause the net income of each interim period to be under-

or overstated This may have an impact on the predictive value and timeliness of the information It may also affect the perceived return on investment, risk, and operating capability of Tallas The timing of the reporting will have an impact on the rights of, and fairness to the stakeholders The stakeholders include the controller and the accountant,

as well as the creditors and stockholders of Tallas

A judgment must be made as to whether the repairs and maintenance costs incurred affect the operating activities of all interim periods If so, then it would be appropriate from a financial reporting and ethical perspective to record the costs as an asset and allocate the costs across the interim periods, perhaps on the basis of the units produced each period However, it would be unethical to allocate the costs simply on an arbitrary basis (as the company currently does) On the other hand, if it is judged that the costs incurred only affect the operating activities of the first interim period, then the costs should

be reported as repair and maintenance expense for that period

ANSWERS TO MULTIPLE CHOICE

SOLUTIONS TO EXERCISES

E5-1

YORK DRUG COMPANY Industry Segment Financial Results For Year Ended December 31, 2004

General corporate expenses

Income before income taxes

(4,000)

$ 23,400

General corporate assets

Total assets at December 31, 2004

E5-3

PARKS CONGLOMERATE COMPANY Working Paper for Segment Reporting For Year Ended December 31, 2004

(not required)

All Operating Segments Segment

A B Other Totals Unallocated Totals Total revenues (sales) $120,000 $138,000 $42,000 $300,000 $ 0 $300,000 Operating expenses:

Cost of goods sold

$ 82,880

$ 37,120

$ 70,000 12,600 21,600

$104,200

$ 33,800

$21,000 4,200 9,720

$34,920

$ 7,080

$140,000 28,000 54,000

$222,000

$ 78,000

$ 0 2,000 6,000

$ 8,000

$(8,000)

$140,000 30,000 60,000

$230,000

$ 70,000

PARKS CONGLOMERATE COMPANY Industry Segment Financial Results For Year Ended December 31, 2004

General corporate expenses

Note: Of the $30,000 total depreciation expense, $2,000 is related to general

corporate activities The remaining depreciation expense is allocated to Segments

A and B and the other operating segments in the amounts of $11,200, $12,600, and

$4,200 respectively

Segment profit is total revenues less operating expenses Income taxes,

depreciation expense, and other operating expenses related to general corporate activities have not been deducted in the computation of operating profits

E5-4

1 Determination of reportable segments (see the working paper that follows)

a Revenue test Since the sales of Segment 4 ($63,900) are more than 10% ($100,000 x 0.10 = $10,000) of the sales for all industry segments, Segment 4 is considered to be a reportable segment

b Profit test Since the profits of Segment 4 ($21,500) and Segment 5 ($3,600) are more than 10% ($35,000 x 0.10 = $3,500) of the total profit for all industry segments, both Segment 4 and Segment 5 are reportable segments

c Asset test Since the assets of Segment 1 ($15,100) and Segment 4 ($87,900) are more than 10% ($145,000 x 0.10 = $14,500) of the combined assets of all operating segments, Segment 1 and Segment 4 are reportable segments

d The combined revenues of Segments 1, 4, and 5 are $82,200, which is more than 75% of the company revenues ($100,000 x 0.75 = $75,000)

Based on the above tests, Segments 1, 4, and 5 are the reportable segments and Segments 2 and 3 should be combined for reporting purposes

STRAUB DIVERSIFIED COMPANY Working Paper for Segment Reporting For Year Ended December 31, 2004

a$28,000 pretax income + $7,000 general corporate expenses (not allocated so segment profit is increased)

b$155,000 total assets - $10,000 general corporate assets (not allocated)

cSegment 4 meets the revenue test

dSegments 4 and 5 meet the profit test

eSegments 1 and 4 meet the asset test

E5-4 (continued)

Industry Segment Financial Results For Year Ended December 31, 2004

Reportable Operating

Note to Instructor: Students must use the gross profit method of estimating inventory to solve this exercise Most elementary accounting books discuss this method; it is also explained in Chapter 8

JERSEY COMPANY Interim Income Statement For Quarter Ended March 31, 2004

Cost of goods sold

Operating expenses

E5-5 (continued)

Other items

JERSEY COMPANY Interim Balance Sheet March 31, 2004 Assets

Total liabilities and stockholders' equity $61,580

Note to Instructor: The following adjustments have been made to the Selling Expenses and General and Administrative Expenses control accounts as well as to certain other income statement and balance sheet accounts These would not be recorded in the general journal, but are shown in journal entry form for illustrative purposes

General and Administrative Expenses ($50,000 x 0.01) 500

To record bad debts

General and Administrative Expenses ($900 x 2/3) 600

Buildings and Equipment (net) ($36,000 10 x 1/4) 900

To record depreciation expense

To record accrued interest on note receivable

Income Tax Expense ($11,000 pretax income x 0.30) 3,300

To record estimated income taxes

HOWARD CORPORATION Interim Income Statement For Quarter Ended March 31, 2004

Cost of goods sold

Cost of goods available for sale $69,000

Less: Inventory, March 31, 2004 (12,000)

Operating expenses

General and administrative expenses 11,650

E5-6 (continued)

HOWARD CORPORATION Interim Balance Sheet March 31, 2004 Assets

Less: Accumulated depreciation (37,800) 70,200

Liabilities and Stockholders' Equity

Total liabilities and stockholders' equity $130,000

Note to Instructor: The following adjustments have been made to the Selling Expenses and General and Administrative Expenses control accounts as well as to certain other income statement and balance sheet accounts These would not be recorded in the general journal, but are shown in journal entry form for illustrative purposes

General and Administrative Expenses 600

Selling Expenses ($1,800 x 1/4) 450

General and Administrative Expenses ($1,800 x ¾) 1,350

Accumulated Depreciation ($108,000 15 x 1/4) 1,800

Income Tax Expense ($18,900 pretax income x 0.30) 5,670

Totals:

Selling expenses = $12,000 + $450 = $12,450

General and administrative expenses = $9,700 + $600 + $1,350 = $11,650

E5-7

HILL COMPANY Interim Income Statement

(1) For 6-Month Period Ended June 30, 2004

(2) For Second Quarter Ended June 30, 2004 Sales (net)

Cost of goods sold

Income before income taxes

Income tax expense

Net income

$50,000 20,000 16,000

$ 1,000

500 (2,100)

$ 340,000 (190,000)

$ 44,200

$32,000 9,400 8,000

$ 400

500 (1,100)

$190,000 (100,000)

$ 28,200 Earnings per share (20,000 shares) $2.21 $1.41 E5-8

FARRIS COMPANY Schedule of Computed Income Tax Expense For Quarters Ended March 31, June 30, September 30, and December 31

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

1 Estimation of annual pretax income (as shown in exercise)

Actual income (year-to-date)

Estimated remaining income

Estimated annual income

$20,000 60,000

$80,000

$42,000 44,000

$86,000

$60,000 21,000

$81,000

$82,000

$82,000

Estimated total income tax

Effective income tax rate:

$10,000 10,500

$20,500

$10,000 12,600

$22,600

$10,000

10,850 $20,850

4 Estimated income tax expense for each quarter:

(Horizontal Analysis)

(1)

Year-to-Year Increase (Decrease)

(2) Base-Year-to-Date Increase (Decrease)

Income before income taxes

Income tax expense

Net income

Number of common shares

Earnings per share

$120,000 (72,000)

$ 48,000 (22,000)

$ 26,000

400 (1,200)

$ 25,200 (8,200)

$ 17,000 6,000 $2.83

$100,000 (55,000)

$ 45,000 (20,000)

$ 25,000

500 (1,000)

$ 24,500 (8,000)

$ 16,500 6,000 $2.75

$85,000 (45,000)

$40,000 (18,000)

$22,000

200 (500)

$21,700 (6,000)

$15,700 5,000 $3.14

$20,000 17,000

$ 3,000 2,000

$ 1,000 (100)

20.0 30.9 6.7 10.0 4.0 (20.0) 20.0 2.9 2.5 3.0

0 2.9

$15,000 10,000

$ 5,000 2,000

$ 3,000

300

500

$ 2,800 2,000

$ 800 1,000 $(0.39)

17.6 22.2 12.5 11.1 13.6 150.0 100.0 12.9 33.3 5.1 20.0 (12.4)

$35,000 27,000

$ 8,000 4,000

$ 4,000

200

700

$ 3,500 2,200

$ 1,300 1,000 $(0.31)

41.2 60.0 20.0 22.2 18.2 100.0 140.0 16.1 36.7 8.3 20.0 (9.9)

The analyses reveal that the company has experienced a significant percentage increase (41.2%) in sales over the 2-year period, but that greater percentage increases in cost of goods sold (60.0%) and income taxes (36.7%) and a substantial increase in operating expenses (22.2%) substantially moderated the increase in net income Similar observations may be made on a year-to-year basis from

2003 to 2004 and 2004 to 2005, with the percentage increase in cost of goods sold between 2004 and 2005 being particularly

depressive on net income Although the percentage increase in net income was greater from 2003 to 2004 than it was from 2004 to

E5-10 SAMUELS COMPANY

Comparative Income Statements

(Vertical Analysis) For Years Ended December 31,

Income before income taxes

Income tax expense

Net income

Earnings per share

$100,000 (60,000)

$ 40,000 (21,300) 1,500 (3,700)

$ 16,500 (5,000)

$ 11,500 $1.92

100.0 (60.0) 40.0 (21.3) 1.5 (3.7) 16.5 (5.0) 11.5

$90,000 (51,000)

$39,000 (21,900) 1,400 (2,500)

$16,000 (4,700)

$11,300 $1.95

100.0 (56.7) 43.3 (24.3) 1.6 (2.8) 17.8 (5.2) 12.6

SAMUELS COMPANY Comparative Balance Sheets (Vertical Analysis) December 31,

Long-term investments (bonds)

Property and equipment (net)

Total assets

Current liabilities

Bonds payable, 10%

Common stock, $2 par

Premium on common stock

Retained earnings

Total liabilities and

stockholders' equity

$ 3,000 7,000 11,000 20,000 79,000

$120,000

$ 10,000 37,000 12,000 21,000 40,000

$120,000

2.5 5.8 9.2 16.7 65.8 100.0 8.3 30.9*

10.0 17.5 33.3 100.0

$ 2,000 8,000 12,000 15,000 63,000

$100,000

$ 11,400 25,000 11,600 19,500 32,500

$100,000

2.0 8.0 12.0 15.0 63.0 100.0 11.4 25.0 11.6 19.5 32.5 100.0

*Rounded to balance

Cost of goods sold as a percentage of sales has increased from 2004 to 2005 This

unfavorable trend has been offset by a decrease in the percentage of operating expenses

to sales The combination of these two changes accounts for most of the small percentage decrease in net income

The company has decreased its current assets as a percentage of total assets and its

current liabilities as a percentage of total liabilities and stockholders' equity, perhaps

indicating an acceleration of its operating cycle The percentage of long-term debt has

per Earnigns

price Market

$304,400

$21,800 sales

Net

income Net

$231,000

$26,630 2

$238,000)/

($224,000

69*) ($7,000x0.

$21,800 assets

total Average

(net) expense Interest

income Net

rate) tax (after 0.69

0.31 1

rate;

tax income estimated

0.31 31,800

$143,200)/

($138,800

$21,800 equity

rs' stockholde Average

income Net

liabilitie Current

assets Current

$19,300)/2 ($21,500

$183,600 inventory

Average

sold goods of

Cost

$18,000)/2 ($18,800

$183,600 payable

accounts Average

sold goods of

Cost

$238,000

$94,800 assets

Total

s liabilitie Total

$24,000 g

outstandin shares

common Average

dividends Preferred

income Net

$20

$1.70 price

Market

share common

per Dividends

2

$246,000)/

($250,000

$24,000 equity

rs' stockholde Average

income Net

$40,000

$56,000

$22,000

$10,000 s

liabilitie Current

assets Current

$40,000

$22,000

$10,000 s

liabilitie Current

assets Quick

$22,000)/2 ($24,000

0.78 x

$267,000 s

receivable net

Average

sales credit Net

$11,000

$11,000

$10,000

$24,000 expense

Interest

income operating

Pretax

8 Book value per common share =

$10,000

($110x500) -

$55,000

$45,000

$50,000

$100,000 shares

common g

Outstandin

equity rs'

stockholde Common

= 10,000

$195,000

= $19,500 per common share Although the current ratio is greater than 2.0, the acid-test ratio is less than 1, thus indicating possible liquidity problems

Expenses

Administrative and office salaries 43,000

Miscellaneous office expenses 2,300

Extraordinary loss due to tornado

Earnings per share (10,000 shares of common stock):