Chapter 1.

Economic Environment of Accounting Information

Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses

Difficulty Rating for Exercises and Problems:

Easy: E1.22; E1.23

Medium: E1.24; E1.25; E1.26; P1.30
Difficult: E1.27; E1.28; E1.29; P1.31

QUESTIONS

Q1.1 Financial Statement Data Users.

User-Group Uses of Financial Statement Data

Board of directors To decide whether to declare a dividend to

shareholders

Bondholders To decide whether to buy (or sell) the bonds of a

given company (i.e., an investment decision)

Corporate employees To decide whether to seek a raise or look for

employment elsewhere

Corporate executives To decide whether to give a bonus to employees

Customers To help decide whether to buy a companys

products (i.e., will this company be around in the
future to honor the warranty?)

Investment advisors To decide whether to recommend the purchase of a

companys shares to clients (i.e., a portfolio
decision)

Labor unions To decide whether to seek a pay increase for union

members

Loan officers/credit analysts To decide whether a company merits a new or

continuing loan

Shareholders To decide whether to buy, sell, or hold their existing

shares in a company (i.e., an investment decision)

Suppliers To decide whether to extend credit to a company

(i.e., to allow the company to buy the suppliers
products on credit)

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Q1.2 GAAP. Using the analogy presented in Chapter 1 regarding the game of
baseball, it is possible to view the investment decisions of investors as a game;
and, in order to get and retain players in the game, there needs to be a set of
rules that establish the guidelines of how the game is played and how to win (or
lose) the game. GAAP is essentially part of that set of rules that helps define
how the game is played and how winners and losers will be determined. Since
the game involves making investment decisions that is, making trade-offs of
risk versus return GAAP essentially allows the players (investors) to make
the best possible trade-off decisions (i.e., the relevance attribute of accounting
information).

How do accounting standards help capital markets be or become efficient?

Recall from the chapter that the qualitative attributes of accounting information
include feedback value and predictive value. Accounting standards allow
investors to evaluate how financially successful their past investment decisions
have been (i.e., feedback value) and assist them in making the best possible
future investment decisions (i.e., predictive value)in short, they enable
investors, and the capital markets, to behave efficiently.

Q1.3 Corporate Governance. Corporate governance refers to the process and

procedures, usually explicitly documented in the charter of incorporation of a
business, that define how and what decisions regarding the operations of a
business will be made and by whom (i.e., the board of directors, executives
who run the business, or shareholders). Examples of typical governance
issues, and the typical decision-making group and process followed, include the
following:

Governance Issue Decision-Making Group

Create a stock option or bonus plan Board of directors with approval of

for executives shareholders

Issue, or increase, a cash dividend Executives, with board of directors

approval

Execute a merger or acquisition Executives, with board of directors

approval and vote of shareholders

Having a well-defined governance program provides transparency to the capital

market that a business is, or will be, run with the least amount of agency costs.
Further, a well-defined governance program clearly delineates what rights
shareholders can expect to exercise in a given business and what
responsibilities will reside with the executives and the board of directors.

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1-2 Financial Accounting for Executives & MBAs, 3 rd Edition
Q1.4 Risk, Return, and Accounting Information. The return on an investment
refers to the income earned on the investment, whereas risk refers to the
uncertainty associated with the expected return. In general, risk and return are
positively correlated that is, as an investor assumes increasing risk (i.e.,
increasing uncertainty about the expected return), the investor can be expected
to demand a higher rate of return.

One of the important qualitative attributes of accounting information is its

predictive value, namely that accounting information helps investors form
predictions about future investment outcomes. Thus, accounting information
helps investors better assess the risk of investing in a given company, and
hence, better assess an investments potential return.

Q1.5 Global GAAP. Impediments to the acceptance of a global set of generally

accepted accounting principles include the following:

Legal issues: In some countries (e.g., Russia), accounting standards are

set by the government and can only be changed by the passage of
federal legislation.
Cultural issues: The extent of accounting disclosure is closely linked to
the openness of the local society. In South Korea, for instance, the
limited footnote disclosures found in annual reports from that country
strongly reflect the secretiveness that characterizes South Korean
society. At the other extreme, in the U.K., footnote disclosures are
voluminous and reflect that countrys cultural view of transparency.
Economic issues: Accounting standards usually reflect the relative
economic development of a country. For example, in lesser-developed
countries where few acquisitions occur, there is little need for (and
hence, often an absence of) consolidation accounting standards.
Similarly, in lesser-developed countries which typically also lack
developed capital markets, the use of such accounting standards as
mark-to-market or lower of cost of market in the valuation of
marketable securities cannot be implemented.
Governmental issues: Accounting standards usually reflect the prevailing
form of government. For instance, in Communist and Socialist countries
(e.g., China), accounting standards are heavily influenced by the notion
of centralized planning.
Social issues: Accounting standards often reflect the dominant
organizational structure of a country. For example, in the U.S.,
accounting standards reflect the dominance of the corporate structure,
whereas in Italy, which is characterized by many small family-run
businesses, the accounting standards reflect the dominance of the small
firm. Although many accounting standards are applicable regardless of
firm size, it can be argued that some are not (e.g., the immediate write-
off of R&D expenditures).

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Q1.6 Asymmetric U.S. GAAP. U.S. GAAP should be changed to allow for the write-
up of long-lived assets when the fair value of the asset appreciates above its
book value. This practice is currently followed in the U.K., which provides a
constructive and successful model for implementation. In the U.K., when the
value of a long-lived asset appreciates above its current value, the increase in
value is added to the asset account, as well as to a shareholders equity
account called the asset revaluation reserve. Thus, the appreciation in value is
not treated as current income, but rather as a wealth increase in shareholders
equity. The asset revaluation reserve would presumably be reflected as part of
Other Comprehensive Income in the Shareholders Equity section of the
balance sheet by U.S. firms.

Under U.S. GAAP, long-term investments classified as available-for-sale may

be marked up to their current market value. Thus, adoption of a write-up
approach for long-term assets in general would put the accounting for all long-
lived assets on a consistent basis under U.S. GAAP.

Under the current circumstances wherein asset value increases are not
recognized, the balance sheets of many U.S. companies do not reflect the
current value of their long-lived assets. Thus, the presence of this asymmetric
treatment reduces the utility of the balance sheet for many investors and
investment professionals.

Q1.7 Human Assets. Companies that are most adversely affected by the absence of
a human assets account on the balance sheet would include:

Service companies (e.g., American Airlines)

Technology companies (e.g., Microsoft)
Pharmaceutical companies (e.g., Pfizer)

Literally, all companies are affected; but, those companies that are highly
automated (Amazon.com) or that require little contact with their customers are
likely to be less adversely affected.

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1-4 Financial Accounting for Executives & MBAs, 3 rd Edition
Q1.8 Key Performance Indicators: Amazon.com. Five key performance indicators
(not rank-ordered) presented in the financial statements of Amazon.com
include:

1. Net income (or earnings per share)

2. Revenues
3. Cash flow from operations
4. Return on shareholders equity (ROE ratio)
5. Long-term debt-to-equity ratio

Five key performance indicators not presented in the financial statements of

Amazon.com (not rank-ordered):

1. Forecasted revenues
2. Future demand for Internet purchases
3. Pro forma net income (or EPS)
4. Pro forma cash flow from operations
5. Future tax policy of the U.S. government regarding Internet purchases

Q1.9 Audit Reports. Amazon.coms audit report was prepared by the firm of Ernst
and Young, one of the Big Four audit firms. Audit reports may take one of
several forms:

Unqualified, or clean
Qualified (e.g., the scope of the investigation was limited; there was a
change in accounting principle with which the auditor disagreed; the
statements were prepared using a non-generally-accepted practice; or,
the existence of material uncertainties or potential material future
developments)
Adverse (e.g., the financial statements do not fairly present the firms
financial condition or results of operations)
Disclaimer (i.e., no opinion is issued)

Amazon.coms audit opinion is an example of an unqualified or clean opinion.

The financial statements present fairly the financial position, results of
operations, and cash flows for each of the years covered by the report (i.e.
2007-2008).

The fourth paragraph of Amazons audit report indicates that the firm adopted a
new accounting standard regarding the accounting for fair value
measurements. This change is problematic for investors since it limits the utility
of prior financial data prepared under the old accounting standard.

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Q1.10 Accounting Assumptions and Concepts. Definitions:
Accrual basis of accounting: a system of income measurement in which
revenues and expenses may be recognized on the income statement
regardless of whether any cash has been received or paid.
Cash basis of accounting: a system of income measurement in which
only those amounts received (paid) in cash may be reported on the
income statement as revenue (expense).
Going concern assumption: an assumption underpinning the accrual
basis of accounting in which a business is presumed to continue
operating for the foreseeable future (i.e., it is not going to be sold or
liquidated).
Materiality concept: a concept that defines the required financial
statement disclosures to those items that are large or material in
amount, and hence, have decision usefulness for financial statement
users.
Information role of accounting: a concept suggesting that accounting
information is relevant to investors when making the risk/return trade-off
decision about an investment.
Contracting role of accounting: a concept suggesting that accounting
information is relevant to investors because accounting information can
be used to monitor and control the behavior of managers whose
preferences may diverge from shareholders.

Q1.11 Basic Financial Statements.

Income statement: a financial statement describing the operating
performance of a business for a given period of time (e.g., a quarter, six
months, or one year).
Balance sheet: a financial statement describing the financial health or
condition of a business as of a specific date (e.g. the end of the fiscal
year).
Statement of shareholders equity: a financial statement describing the
change in the shareholders voluntarily (capital stock) and involuntarily
(retained earnings) contributed capital to a business for a given period of
time (e.g., a quarter, six months, or one year).
Statement of cash flow: a financial statement summarizing the cash
inflows and outflows of a business entity.

Continued next page

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1-6 Financial Accounting for Executives & MBAs, 3 rd Edition
 Continued

The interconnections, or articulation, of the basic financial statements can be

illustrated with the following diagram.

Balance Sheet Statement of

Cash Flows
Income Assets Investing
Statement Activities
Liabilities Financing
Revenues
-Expenses Activities
Net income Shareholders Operating
Equity Activities

Statement of
Shareholders
Equity

Net income (loss) results in an increase (decrease) in assets and also an

increase in shareholders equity on the balance sheet, with a
corresponding effect on the statement of shareholders equity.
Increases (decreases) in assets are reflected as investing activities on
the statement of cash flow, while changes in the liabilities and capital
stock (from shareholders equity) are reflected as financing activities.
Net income (loss) results in an increase (decrease) in shareholders
equity, but is also reflected in the operating activities on the statement of
cash flow.

Q1.12 Debt Covenants. This is an example of an agency problem between a

companys shareholders and its creditors. In this instance, Americans creditors
are concerned about constraining the behavior of the American Airlines
managers and shareholders. Americans creditors want to insure that the
airlines managers and shareholders do not behave in an unconstrained
manner - specifically, undertaking certain decisions or actions that might
increase the credit risk of American Airlines. By placing certain financial and
decision constraints on the company, the creditors insure that American will
have good prospects of servicing its debt (i.e., making the regular interest
payments) and repaying the principal on a timely basis.

If American Airlines does not agree to these constraints (i.e., debt covenants), it
is unlikely that the financial institutions would be willing to extend or refinance
the loan contract.

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Q1.13 Debt Covenants. This was a classic example of the agency relationship
between shareholders and lenders. TIMETs U.S. lenders had placed a number
of restrictive covenants on the firms behavior in order to keep the company
from engaging in any behavior that might reduce TIMETs ability to pay its debt
servicing or to repay the debt itself. TIMET had no choice but to agree to these
behavioral constraints, otherwise the company would not likely get the U.S.
loan.

A useful discussion here is What happens when a firm like TIMET violates one
of its debt covenants? Although the U.S. lender would have the legal right to
demand an immediate repayment of the loan, it is far more likely that the loan
agreement would be renegotiated, with TIMET paying higher interest charges
and fees in return for the lender not immediately calling the loan.

Q1.14 (Appendix 1A) Separation of Ownership and Management.

Hypothetical conflict between management and shareholders:
o Managers want more income for less work
Solution:
o Give managers a salary-plus-bonus contract in which the bonus
is linked to increased performance as defined by net income and
cash flow
Why it works:
o Managers have the incentive to worker harder (assuming they
want more income), which should lead to higher net income, cash
flow, and share price (i.e., shareholder value)

Q1.15 (Appendix 1A) Conflicts between Shareholders and Debtholders.

Hypothetical conflict between shareholders and debtholders:
o Shareholders want increasing dividend payouts
Solution:
o Debtholders lend money to firm to expand operations but
covenants associated with the loan agreement restrict dividends
payments to, for example, 50 percent of net income
Why it works:
o Shareholders get the investment funds they need to grow the
business, and in return, agree to limit their dividend payments

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1-8 Financial Accounting for Executives & MBAs, 3 rd Edition
Q1.16 The Going Concern Assumption. AMR Corporation is a well-established,
U.S.-based airline, and despite recent problems in the airline industry, Ernst &
Young probably assumes that the company has the capability to survive the
current turmoil. Further, with a number of struggling airlines and mergers (e.g.,
United and Continental, and at the time of this writing AMR was in talks with US
Airways), the auditor may be assuming that the merger would make the airline
much stronger. Thus, the cautionary language in the Ernst & Young report
seems intended to be cover your backside language for the very unlikely case
that AMR Corporation did, in fact, fail.

Q1.17 Is the Sarbanes-Oxley Act Effective? Professor Moores opinion is based on

a 2006 article appearing in the Academy of Management Review. According to
the article, Sarbanes-Oxley failed to correct a crucial accounting system
weakness the potential for the moral seduction of the outside auditors. The
moral seduction/corruption is possible because:

1. Corporate executives retain too much control over the hiring and firing of
outside auditors, consequently discouraging auditors from filing critical
reports about a firm or its management.
2. Sarbanes-Oxley puts only minimal constraints on auditors subsequently
gaining employment with their clients thereby potentially encouraging
auditors to try to curry favor with their clients (i.e., as potential future
employers).
3. Sarbanes-Oxley does not restrict sufficiently the non-audit work that
auditors may do for their clients, thereby increasing the likelihood that an
auditor will yield to client demands due to financial issues.

Q1.18 Should the Sarbanes-Oxley Act Be Revised? The criticisms leveled at the
Sarbanes-Oxley Act have been substantial, and in many cases, justifiedit is
unnecessarily costly in its implementation; it is unfair to foreign and small firms;
it fails to provide sufficient guidance in its application. Nonetheless, given the
large number (i.e. over 8 percent of all U.S. publicly-listed firms) of companies
that restated their earnings in the aftermath of the passage of the Act suggests
that whatever the costs, the implementation of the Act was necessary to
achieve the high standard of corporate reporting that is expected by the capital
markets in the U.S. Can the Act be improved upon? Without doubt, and most
observers believe that the Act will be modified, but not repealed (although a
case is pending before the U.S. Supreme Court regarding the constitutionality
of SOX).

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Solutions Manual, Chapter 1 1-9
Q1.19 (Ethics Perspective) Rules-based Versus Principles-based Accounting.
Significant attention has been focused on the debate regarding whether the
U.S. system of GAAP is too rules-based, rather than simply allowing more
flexibility within a general principles-based system. An argument against the
current rules-based system is that it allows managers to stay within the letter of
the law and at the same time violate the spirit of the law. By requiring managers
to simply follow the principle of the law, violations such as those experienced at
Enron and WorldCom would be less likely.

A counter argument is that rules-based GAAP is derived from the same

principles that others would recommend. It is further argued that rules or
principles do not make people ethical. Ethics cannot be legislated. At the end
of the day, if people care about the principles, they will care about them under
either rules-based or principles-based systems, and if they choose to take an
unethical path, changing systems will do little to deter them. Ethical behavior is
a choice. Under a principles-based system, the manager will still be required to
make interpretations of the principle, and their ethical standards will still be
challenged.

Rules-based accounting provides individuals and organizations with a technical

road map, not a moral compass. It has been argued that the entire debate is a
waste of time since the law [rules-based] requires adherence to principles-
based accounting. The criminal case Continental Vending made principles-
based accounting the law. The case found that statements are true, correct,
and understandable to non-accountants is paramount to conformity to GAAP.
In addition, rule 203 of the accountants Code of Professional Conduct requires
accountants to depart from GAAP compliance if compliance would result in
misleading statements.

Finally, consider the language in the auditors report that accompanies a

financial statement. The standard language requires the statements to be fairly
presented [principles-based] in accordance with generally accepted
accounting principles [rules-based].

(Note: This answer was based on the writings of Jasper Spencer-Scheurich,

Inez Gonzales, and Sherry Thomas.)

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1-10 Financial Accounting for Executives & MBAs, 3 rd Edition
Q1.20. (Appendix 1B) The historical cost concept asserts that all assets should
initially be valued at their acquisition cost. At the time of acquisition, the
purchase price of an asset clearly satisfies both informational criteria of
relevance and faithful representation. With the passage of time, however, an
assets original acquisition cost becomes less relevant, although it remains a
faithful representation of value. Instead, the current market value of the asset,
or even an assets liquidation value, assumes greater relevance, although such
values (except for exchange-traded assets like marketable securities) are
frequently unreliable. Thus, for a going concern following the historical cost
concept, we can see that a trade-off occurs over time in which the informational
characteristic of faithful representation takes precedence over the characteristic
of relevance. From the perspective of a manager with fiduciary responsibility,
and hence legal exposure, making sure that asset values are exhibit faithful
representativeness may indeed be more important than providing financial
statement users with relevant asset values. Creditors and investors may
express a contrary view.

Q1.21. (Appendix 1B) The preparation of the basic financial statements requires that
corporate managers make a variety of accounting policy decisions, to include
(for example) which depreciation method to utilize to depreciate a companys
property, plant and equipment, the expected useful lives of those assets, and
their expected salvage value. These policy decisions are subject to review, and
revision, by a companys independent auditor; and thus, most financial
statement users feel confident that the decisions and estimates adopted have
been properly vetted, and consequently, may be relied upon for purposes of
credit and investing decisions. Because of this inherent system of checks-and-
balances, companies are able to assure their creditors and investors that the
financial statements contain objective, verifiable data that is useful for their
particular decisions needs.

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 EXERCISES

E1.22 Account Identification.

1. B/S A 9. I/S E
2. B/S SE 10. B/S L
3. I/S R 11. N/A
4. B/S A 12. B/S A
5. B/S SE 13. I/S E
6. B/S L 14. B/S A
7. N/A 15. I/S E
8. B/S A 16. I/S R

E1.23 The Balance Sheet Equation.

Assets = Liabilities + Shareholders

Equity
Year 2 $70,000 = $40,000 + $30,000
Year 1 80,000 = 60,000 + 20,000
Change in value $(10,000) = $(20,000) + $10,000

Since no dividends were declared and no additional capital was invested, the
increase in shareholders equity from Year 1 to Year 2 must have resulted from
operations; hence, net income must have been $10,000. The decrease in
liabilities of $20,000 suggests that assets in the amount of $20,000 were used
to repay debt. In the absence of the debt reduction, total assets would have
increased by $10,000 (i.e., the amount of net income).

E1.24 The Balance Sheet Equation. Since no dividends were declared in Year 2,
and since there was no additional capital investment, the decrease in
shareholders equity of $5,000 must have resulted from operations; hence,
there must have been a net loss of $5,000. The increase in liabilities of $20,000
resulted in an equal increase of $20,000 in assets; however, the net increase in
assets of $15,000 reflects the increase of $20,000 from debt, offset by the
decrease of $5,000 in assets from the operating loss.

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E1.25 Key Relationships: Revenues, Expenses, Dividends, and Retained
Earnings. Shaded figures represent the missing data for the exercise:

2010 2011 2012

Retained earnings (beginning) $1.2 $ 2.0 $ 2.0

Revenues $8.8 $11.8 $11.8
Less: Expenses (7.4) (11.2) (11.0)
Net income 1.4 0.6 0.8
Dividends declared 0.6 0.6 0.6
Retained earnings (ending) 2.0 2.0 2.2

Common-size data:
Revenues 100% 100% 100%
Less: Expenses (84)% (95)% (93)%
Net income 16% 5% 7%

Dividend pay-out: 43% 100% 75%

Although the level of revenues did increase from 2010 to 2011/2012, costs
increased at a faster rate, suggesting either an absence of economies of scale
or that the benefits of the revenue growth have not yet been realized. But in any
case, the high dividend payout (i.e., 43 percent, 100 percent, and 75 percent in
2010, 2011, and 2012, respectively) appears excessive.

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E1.26 Key Relationships: Revenues, Expenses, Dividends, and Retained
Earnings.

Shaded figures represent the missing data for the exercise:

2010 2011 2012

Retained earnings (beginning) $(1,746.5) $(1,830.5) $(2,653.0)

Revenues $4,840.5 $5,327.0 $6,009.5

Less: Expenses (4,924.5) (5,628.0) (5,425.0)
Net income (loss) (84.0) (301.0) 584.5
Less Dividends -0- (521.5) (17.5)
Increase (decrease to retained
earnings) (84.0) (822.5) 567.0

Retained earnings (end) $(1,830.5) $(2,653.0) $(2,086.0)

Common-size data:
Revenue 100% 100% 100%
Less: Expenses (102)% (106)% (90)%
Net income (2)% (6)% 10%

The companys revenues increased each year, but it was not until 2012 that
revenues increased faster than costs. Although the modest dividend payment in
2012 appears reasonable, the large dividend in 2011 after two years of losses
appears irrational, especially since the company had paid no dividends in 2010.

E1.27 Financial Statement Results.

Although GEs revenues increased slightly, its net income declined by $0.6
billion, suggesting that GEs operating expenses increased at a faster rate
than did revenues. An alternative explanation is that GE took substantial
non-operating write-offs and write-downs during the year.
GEs decrease in total assets of $32.9 billion is consistent with (a) a
significant divestiture or (b) a significant write-off of assets (i.e., a bath).
GEs decrease in shareholders equity of $6.6 billion is consistent with the
company paying out roughly half its net income in dividends.
GEs cash flow from operations of $31.3 billion and positive cash flow from
investing activities of $11.3 billion, along with negative cash flow from
financing activities of $51.1 billion is consistent with the company using
cash flow from operating activities and cash flow from the sale of
investments to pay down existing debt and also drawing down its cash
reserves.

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1-14 Financial Accounting for Executives & MBAs, 3 rd Edition
E1.28 Financial Statements Results.
J&Js $2.2 billion increase in operating revenues resulted in a $1.2 billion
increase in net income, suggesting that while sales were increasing, some
expenses were also increasing.
J&Js $7.7 billion increase in total assets appears to be the result of the
$10.9 billion in net earnings and the acquisition of another company,
Synthes, Inc.
J&Js $7.7 billion increase in shareholders equity resulted in from the $10.9
billion in net earnings and $16.6 billion in additional stock issued, but
partially offset by $6.6 billion paid in cash dividends and $12.9 billion
repurchase of treasury stock.
J&Js cash flow from operations of $15.4 billion was not sufficient to cover
the firms cash flow for investing (negative $4.5 billion) and cash flow for
financing (negative $20.6 billion), requiring that J&J draw down its cash
reserves by nearly $10 billion.

E1.29 Calculating Security Returns.

r eta*

General Electric 10.5% 0.90

Phillips Electronics 2.3% 2.25
Siemens -4.9% 2.11
*(Source: Yahoo. Finance)

Clearly, GE provided the greatest return over the one year period. To evaluate
the return/risk trade off provided by each security, it would be beneficial to know
the historical standard deviation of the return on each of the three companies.

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 PROBLEMS

P1.30 Key Financial Statement Relations: Balance Sheet, Income Statement,

and Statement of Cash Flow.

Missing Values
2011 2012

Balance sheet:
Cash 10,000
Property, plant and equipment (cost) 286,000
Land 4,000
Intangible assets 11,000

Wages payable 5,000

Dividends payable 2,000

Long-term debt 52,000

Treasury stock (8,000)

Income statement
Sales revenue 285,000
Depreciation expense 28,000
Interest expense 9,000
Statement of cash flow
Cash payment for Advertising (21,000)
Purchase of marketable securities (2,000)
Issuance of common stock 22,000
Change in cash 15,000

During 2012, the companys financial performance appears to be quite good.

Net income of $53,000 was generated on sales of $285,000, representing a
return on sales of 18.6%. The company also generated cash flows from
operations of $104,000, which more than covered the companys dividend
payment of $45,000.

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P1.31 Key Financial Statement Relations: Balance Sheet, Income Statement,
and Statement of Cash Flow.

Missing Values
2011 2012

Balance sheet:
Cash 15,000
Property, plant and equipment 162,000
Intangible assets 10,000

Accounts payable 21,000

Interest payable 8,000
Long-term debt 52,000

Treasury stock (10,000)

Income statement
Wages expense 6,000
Depreciation expense 11,000
Tax expense 8,000
Statement of cash flow
Cash collections from customers 138,000
Purchase of land (7,000)

The companys financial performance in 2012 appears to be satisfactory,

generating net income of $18,000 on sales of $140,000, or a return on sales of
nearly 13%. Further, the company generated cash flow from operations of
$9,000, which adequately covered the cash dividends paid of $6,000.

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 CORPORATE ANALYSIS

CA1.32 The Procter and Gamble Company.

a. Industry: Consumer goods/cleaning products

Key competitors: Johnson and Johnson

Kimberly-Clark Corporation

Key products: Secret antiperspirant

Charmin toilet paper
Tide laundry detergent
Bounty paper towels
Pampers diapers
Gillette razorblades
Duracell batteries
Folgers coffee

b. Financial Performance (in millions)

2012 2011 2010

Net sales $83,680 $81,104 $77,567

Net earnings $10,904 $11,927 $12,846

Return on sales
(net earnings net sales) 13.0% 14.7% 16.6%

Net sales are trending upward over the three-year period, while net earnings
are trending downward. This is causing a decrease in the return on sales
ratio.

c. Cash Flow Performance (in millions):

2012 2011 2010

Cash flow from operations $13,28 $13,330 $16,131

4

Operating funds ratio (cash flow from

operations net earnings) 1.22 1.12 1.26

The trend of the cash flow from operations is fairly consistent with the trend
in net earnings, showing a decline over the three year period. The operating
funds ratio, reflects a downward trend from 2010 to 2011, but reflects a very
slight upward trend in 2012 due to only a slight change in cash flow from
operations, despite decreased net earnings from the prior year. If the cash
flow from operating activities is consistently greater than net earnings (a
ratio >1.0, which we see here) the companys earnings are said to be of
high quality.
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 Cambridge Business Publishers, 2014
Solutions Manual, Chapter 1 1-19
 d. Financial Leverage

2012 2011

Total liabilities total assets 51.6% 50.8%

P & G is principally debt-financed, with just over 50 percent of its asset

financing coming from creditors. The percentage of debt-financing is
increasing slightly over time.

e. Audit Report

P & Gs auditors are Deloitte & Touche LP, one of the Big Four firms. The
audit report indicates that Deloitte & Touche opine that P & Gs

Consolidated Financial Statements present fairly, in all material respects,

the financial position of the Company at June 30, 2012 and 2011, and the
results of its operations and cash flows for each of the three years in the
period ended June 30, 2012, in conformity with accounting principles
generally accepted in the United States of America.. and, that the
Company maintained, in all material respects, effective internal control over
financial reporting as of June 30, 2012.

Thus, the audit report contains no exceptions or warnings to financial

statement users.

CA1.33 Internet-based Analysis. No solution is provided since any solution would be

unique to the company selected.

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1-20 Financial Accounting for Executives & MBAs, 3 rd Edition
CA1.34 IFRS Financial Statements. LVMH Moet Hennessey-Louis Vuitton S.A.

a. The balance sheet equation under IFRS: A=E+L

NCA + CA = E + (NCL + CL)

Regardless of the particular form of the balance sheet equation, the

informational content of the consolidated balance sheet is exactly the same.
In short, a balance sheet is a balance sheet regardless of the particular
GAAP in use.

b. Under IFRS, the noncurrent assets are listed prior to the current assets, and
noncurrent liabilities are listed before current liabilities. This listing appears
to emphasize the longer-term aspects of a business by drawing attention
first to the long-term revenue-producing assets of a business. Regardless of
the listing sequence, the informational content of the balance sheet remains
unaltered.

c. LVMHs current assets are listed in reverse order of liquidity, with the least
liquid current assets listed first, followed by the most liquid current assets.
(Cash and cash equivalents are listed last.) Again, this listing appears to
de-emphasize the short-run aspects of a business.

d. Until 2009, U.S. GAAP defined equity as shareholders equity, to include

the residual interests of both common and preferred shareholders in the
assets and liabilities of a business. IFRS takes a narrower view, on the one
hand, by excluding the residual interest of preferred shareholders from
shareholders equity, while also taking a broader view by including what was
formerly called minority interest (now called noncontrolling interest) in
shareholders equity. U.S. GAAP has come into compliance with IFRS in
regards to the treatment of noncontrolling interest, which is now also
included in shareholders equity, but the treatment of preferred shareholder
capital remains divergent. The IFRS treatment of preferred shareholder
investment is more in line with the treatment afforded preferred stock by the
capital markets, which treat this account as part of a companys mezzanine
financing, along with the companys unsecured creditors.

Cambridge Business Publishers, 2014

Solutions Manual, Chapter 1 1-21