Solutions to Study Questions, Problems, and Cases
Chapter 1
1.1 The annual report is published primarily for shareholders, while the 10-K
report is filed with the Securities and Exchange Commission and is used by
regulators, analysts, and researchers. The financial statements and much of the
financial data are identical in the two documents; but the 10-K report contains
more detail (such as schedules showing management remuneration and
transactions, a description of material litigation and governmental actions, and
elaborations of many financial statement accounts) than the annual report; and the
annual report presents additional public relations type material such as colored
pictures, charts, graphs, and promotional information about the company.
1.2 The analyst should use the financial statements: the balance sheet, the
income statement, the statement of stockholders' equity, and the statement of cash
flows; the notes to the financial statements; supplementary information such as
financial reporting by segments; the auditor's report; management's discussion and
analysis of operating performance and financial condition; and the five-year
summary of financial data.
Use the public relations "fluff," such as colored pictures and descriptive material
with caution.
1.3 A qualified report is issued when the overall financial statements are fairly
presented "except for" items which the auditor discloses; an adverse opinion is
issued when the financial statements have departures from GAAP so numerous that
the statements are not presented fairly. A disclaimer of opinion is caused by a
scope limitation resulting in the auditor being unable to evaluate and express an
opinion on the fairness of the statements. An unqualified opinion with explanatory
language is caused by a consistency departure due to a change in accounting
principle, uncertainty caused by future events such as contract disputes and
lawsuits, events which the auditor believes may present business risk and going
concern problems.
1.4 The proxy statement is a document required by the SEC to solicit
shareholder votes, since many shareholders do not attend shareholder meetings.
The analyst can find important information in the proxy statement such as
background information on the company's nominated directors, director and
executive compensation, any proposed changes to those compensation plans and
the audit and nonaudit fees paid to the auditing firm.
1
,1.5 Employee relations with management, employee morale and efficiency, the
reputation of the firm with its customers and in its operating environment, the
quality and effectiveness of management, provisions for management succession,
potential exposure to regulatory changes, "bad publicity" in the media.
1.6 Depreciation is a process of cost allocation, which requires estimation of
useful life, salvage value, and a choice among depreciation methods affecting the
timing of expense recognition.
1.7 Expense and revenue recognition can be different for purposes of calculating
taxable income and earnings reported in the financial statements. Thus, companies
calculate taxable income taking advantage of every item that will reduce income;
and the firm reports the highest possible income to shareholders. Two sets of
books (at least!) are kept: one for the IRS and one for the annual report. The
financial analyst should be aware of the "Deferred Taxes" account, which
reconciles differences between taxable and reported income.
1.8
Asset cost
(a) Annual Depreciation Expense =
Dep. period
$450,000
Annual Depreciation Expense = = $30,000
15
(b) Accum. Dep. at end of Yr. 1 = $30,000
Accum. Dep. at end of Yr. 2 = Dep. Yr. 1 + Dep. Yr. 2 = $60,000
(c) Year 1 Year 2
Historical Cost $450,000 $450,000
Accum. Dep. 30,000 60,000
Fixed Assets (Net) $420,000 $390,000
(d) Dep. exp. for tax purposes = $45,000
Dep. expense reported in financial statements = $30,000
Amount by which dep. exp. for tax purposes
exceeds dep. exp. for reporting purposes = $15,000
(e) Amount by which taxable exp. exceeds reported exp. = $15,000
Tax rate = 0.3
Amount by which reported tax exp. exceeds actual
taxes paid = $ 4,500
2
,1.9
(a) 1. Switch to straight-line depreciation if not using.
2. Lengthen depreciation period for depreciable assets.
(Items 1 and 2 would lower quality unless made to reflect economic reality.)
3. Sell assets for a gain.
4. Postpone loss recognition on inventory or investments.
5. Reduce advertising and marketing expenditures.
6. Reduce research and development expenditures.
7. Reduce repair and maintenance expenditures.
(b) To have a positive "real" impact on the firm's financial position, the
company would have to increase revenue from a beneficial policy rather than a
cosmetic change or to reduce costs in a manner that would not impair the long-term
profitability of the firm.
Examples:
1. Have a special end-of-year sale, offer discounts, offer rebates.
2. Invest in plant and equipment at end of year to get tax savings
from depreciation.
3. Get employees involved in cost-cutting measures.
4. Sell assets, if for a profit, that the firm had already planned to
sell at some point because of inefficiencies.
3
, 1.10
Memorandum
Date: Current Date
To: B.R. Neal, Director of Marketing
From: Student's Name
Subject: Contents of an Annual Report
The company's annual report presents financial information about the firm.
This information package is published primarily for shareholders and the general
public. The major components of an annual report are briefly described in this
memo.
1) An annual report contains four financial statements: The balance sheet
shows the financial condition (assets, liabilities, stockholders' equity) at end of
year; the income or earnings statement presents the results of operations
including revenues, expenses, net profit or loss, and net profit or loss per share for
the year; the statement of stockholders' equity reconciles beginning and ending
balances of accounts in the equity section of the balance sheet; and the statement
of cash flows shows inflows and outflows of cash from operating, financing, and
investing activities for the year.
2) Notes to the financial statements provide additional detail about
particular items in the financial statements. 3) The auditor's report is prepared by
an independent accounting firm and attests to the fairness of the information
presented. 4) The five-year summary shows key financial data including net sales,
income/loss from continuing operations on a dollar and per share basis, assets,
long-term debt, and dividends per common share. 5) Quarterly stock prices record
how the company's stock shares have performed over the past two years. 6)
Management's Discussion and Analysis provides management's perspective on
how the company is doing including favorable or unfavorable trends, and
significant events or uncertainties.
The remaining material in the annual report is included primarily to provide
background information about the company and its management, and to make the
document attractive and interesting to read.
If staff members would like to learn more about any of the material in the
company's annual report, the following book is highly recommended:
Understanding Financial Statements by Fraser and Ormiston (Prentice Hall, 2007).
4
Chapter 1
1.1 The annual report is published primarily for shareholders, while the 10-K
report is filed with the Securities and Exchange Commission and is used by
regulators, analysts, and researchers. The financial statements and much of the
financial data are identical in the two documents; but the 10-K report contains
more detail (such as schedules showing management remuneration and
transactions, a description of material litigation and governmental actions, and
elaborations of many financial statement accounts) than the annual report; and the
annual report presents additional public relations type material such as colored
pictures, charts, graphs, and promotional information about the company.
1.2 The analyst should use the financial statements: the balance sheet, the
income statement, the statement of stockholders' equity, and the statement of cash
flows; the notes to the financial statements; supplementary information such as
financial reporting by segments; the auditor's report; management's discussion and
analysis of operating performance and financial condition; and the five-year
summary of financial data.
Use the public relations "fluff," such as colored pictures and descriptive material
with caution.
1.3 A qualified report is issued when the overall financial statements are fairly
presented "except for" items which the auditor discloses; an adverse opinion is
issued when the financial statements have departures from GAAP so numerous that
the statements are not presented fairly. A disclaimer of opinion is caused by a
scope limitation resulting in the auditor being unable to evaluate and express an
opinion on the fairness of the statements. An unqualified opinion with explanatory
language is caused by a consistency departure due to a change in accounting
principle, uncertainty caused by future events such as contract disputes and
lawsuits, events which the auditor believes may present business risk and going
concern problems.
1.4 The proxy statement is a document required by the SEC to solicit
shareholder votes, since many shareholders do not attend shareholder meetings.
The analyst can find important information in the proxy statement such as
background information on the company's nominated directors, director and
executive compensation, any proposed changes to those compensation plans and
the audit and nonaudit fees paid to the auditing firm.
1
,1.5 Employee relations with management, employee morale and efficiency, the
reputation of the firm with its customers and in its operating environment, the
quality and effectiveness of management, provisions for management succession,
potential exposure to regulatory changes, "bad publicity" in the media.
1.6 Depreciation is a process of cost allocation, which requires estimation of
useful life, salvage value, and a choice among depreciation methods affecting the
timing of expense recognition.
1.7 Expense and revenue recognition can be different for purposes of calculating
taxable income and earnings reported in the financial statements. Thus, companies
calculate taxable income taking advantage of every item that will reduce income;
and the firm reports the highest possible income to shareholders. Two sets of
books (at least!) are kept: one for the IRS and one for the annual report. The
financial analyst should be aware of the "Deferred Taxes" account, which
reconciles differences between taxable and reported income.
1.8
Asset cost
(a) Annual Depreciation Expense =
Dep. period
$450,000
Annual Depreciation Expense = = $30,000
15
(b) Accum. Dep. at end of Yr. 1 = $30,000
Accum. Dep. at end of Yr. 2 = Dep. Yr. 1 + Dep. Yr. 2 = $60,000
(c) Year 1 Year 2
Historical Cost $450,000 $450,000
Accum. Dep. 30,000 60,000
Fixed Assets (Net) $420,000 $390,000
(d) Dep. exp. for tax purposes = $45,000
Dep. expense reported in financial statements = $30,000
Amount by which dep. exp. for tax purposes
exceeds dep. exp. for reporting purposes = $15,000
(e) Amount by which taxable exp. exceeds reported exp. = $15,000
Tax rate = 0.3
Amount by which reported tax exp. exceeds actual
taxes paid = $ 4,500
2
,1.9
(a) 1. Switch to straight-line depreciation if not using.
2. Lengthen depreciation period for depreciable assets.
(Items 1 and 2 would lower quality unless made to reflect economic reality.)
3. Sell assets for a gain.
4. Postpone loss recognition on inventory or investments.
5. Reduce advertising and marketing expenditures.
6. Reduce research and development expenditures.
7. Reduce repair and maintenance expenditures.
(b) To have a positive "real" impact on the firm's financial position, the
company would have to increase revenue from a beneficial policy rather than a
cosmetic change or to reduce costs in a manner that would not impair the long-term
profitability of the firm.
Examples:
1. Have a special end-of-year sale, offer discounts, offer rebates.
2. Invest in plant and equipment at end of year to get tax savings
from depreciation.
3. Get employees involved in cost-cutting measures.
4. Sell assets, if for a profit, that the firm had already planned to
sell at some point because of inefficiencies.
3
, 1.10
Memorandum
Date: Current Date
To: B.R. Neal, Director of Marketing
From: Student's Name
Subject: Contents of an Annual Report
The company's annual report presents financial information about the firm.
This information package is published primarily for shareholders and the general
public. The major components of an annual report are briefly described in this
memo.
1) An annual report contains four financial statements: The balance sheet
shows the financial condition (assets, liabilities, stockholders' equity) at end of
year; the income or earnings statement presents the results of operations
including revenues, expenses, net profit or loss, and net profit or loss per share for
the year; the statement of stockholders' equity reconciles beginning and ending
balances of accounts in the equity section of the balance sheet; and the statement
of cash flows shows inflows and outflows of cash from operating, financing, and
investing activities for the year.
2) Notes to the financial statements provide additional detail about
particular items in the financial statements. 3) The auditor's report is prepared by
an independent accounting firm and attests to the fairness of the information
presented. 4) The five-year summary shows key financial data including net sales,
income/loss from continuing operations on a dollar and per share basis, assets,
long-term debt, and dividends per common share. 5) Quarterly stock prices record
how the company's stock shares have performed over the past two years. 6)
Management's Discussion and Analysis provides management's perspective on
how the company is doing including favorable or unfavorable trends, and
significant events or uncertainties.
The remaining material in the annual report is included primarily to provide
background information about the company and its management, and to make the
document attractive and interesting to read.
If staff members would like to learn more about any of the material in the
company's annual report, the following book is highly recommended:
Understanding Financial Statements by Fraser and Ormiston (Prentice Hall, 2007).
4
