Chapter 21Analysis of Financial Statements

MULTIPLE CHOICE 1. A useful tool in financial statement analysis is the common-size financial statement. What does this tool enable the financial analyst to do? a Evaluate financial statements of companies within a given industry of approximately the . same value. b Determine which companies in the same industry are at approximately the same stage of . development. c Ascertain the relative potential of companies of similar size in different industries. . d Compare the mix of assets, liabilities, capital, revenue, and expenses within a company . over time or between companies within a given industry without respect to relative size.

ANS: D

OBJ: LO 1

2. When using common-size statements a data may be selected for the same business as of different dates, or for two or more . businesses as of the same date. b relationships should be stated in terms of ratios. . c dollar changes are reported over a period of at least three years. . d All of the above are correct. .

ANS: A

OBJ: LO 1

3. Which of the following statements best describes the use of financial statement analysis? a Financial statement analysis techniques are merely guides to interpretation of financial . data. b Financial statement analysis can eliminate the risk in investment decisions. . c Measurements for a specific company should be compared only with data from past . periods. d All of the above are correct. .

ANS: A

OBJ: LO 1

4. Rauh Corporation had a current ratio of 2.0 at the end of 2004. Current assets and current liabilities increased by equal amounts during 2005. The effects on net working capital and on the current ratio, respectively, were a no effect; increase. . b no effect; decrease.

. c increase; increase. . d decrease; decrease. .

ANS: B

OBJ: LO 1

5. Which of the following ratios measures short-term solvency? a Current ratio . b Creditors' equity to total assets . c Return on investment . d Total asset turnover .

ANS: A

OBJ: LO 1

6. If a firm changes its inventory method from FIFO to LIFO just prior to a period of rising prices, the effect in the next period will be Current Ratio a . b . c . d .
No effect No effect Increase Decrease

Inventory Turnover
Increase Decrease Decrease Increase

ANS: D

OBJ: LO 2

7. Which of the following transactions would increase a firm's current ratio? a Purchase of inventory on account . b Payment of accounts payable . c Collection of accounts receivable . d Purchase of temporary investments for cash .

ANS: B

OBJ: LO 1

8. How are trade receivables used in the calculation of each of the following? Current Ratio Inventory Turnover a . b . c . d .
Not used Numerator Numerator Denominator Numerator Numerator Not used Numerator

ANS: C

OBJ: LO 1

9. In comparing the current ratios of two companies, why is it invalid to assume that the company with the higher current ratio is the better company? a A high current ratio may indicate inadequate inventory on hand. . b A high current ratio may indicate inefficient use of various assets and liabilities. . c The two companies may define working capital in different terms. . d The two companies may be different sizes. .

ANS: B

OBJ: LO 1

10. Which of the following is the primary factor in determining the functional currency of a foreign subsidiary? a How the costs for the foreign entity's product are determined . b The denomination of the foreign entity's financing . c The location of the primary sales market that influences the price of the foreign entity's . product d Management's assessment of all relevant factors .

ANS: D

OBJ: LO 5

11. A translation adjustment resulting from the translation process is disclosed on the financial statements a as a separate component of stockholders' equity. . b as a below-the-line item on the income statement. . c as an adjustment to retained earnings. . d as a part of income from operations on the income statement. .

ANS: A OBJ: LO 5 12. Which of the following is the least likely means a company might choose to meet the needs of international investors? a Translation of financial statements or annual reports into the language of the user. . b Denomination of the financial statements in the currency of the country where the . financial statements will be used. c Partial or complete restatement of financial statements to the accounting principles of the . financial statement users' country. d Mutual recognition in which one country accepts the financial statements of another . country for regulatory purposes such as listing on stock exchanges or filing annual reports.

ANS: D

OBJ: LO 3

13. Information from Blain Company's balance sheet is as follows: Current assets:
Cash Marketable securities ............................... Accounts receivable ................................. Inventories ......................................... Prepaid expenses .................................... Total current assets Current liabilities: .................................. Notes payable ....................................... Accounts payable .................................... Accrued expenses .................................... Income taxes payable ................................ Payments due within one year on long-term debt ...... Total current liabilities ........................... $ 1,200,000 3,750,000 28,800,000 33,150,000 600,000 $67,500,000 $ 750,000 9,750,000 6,250,000 250,000 1,750,000 $18,750,000

What is Blain's current ratio? a 0.26 to 1 . b 0.30 to 1 . c 1.80 to 1 . d 3.60 to 1 .

ANS: D

OBJ: LO 1

14. Millward Corporation's books disclosed the following information for the year ended December 31, 2005:
Net credit sales ...................................... Net cash sales ........................................ Accounts receivable at beginning of year .............. Accounts receivable at end of year .................... $1,500,000 240,000 200,000 400,000

Millward's accounts receivable turnover is a 3.75 times. . b 4.35 times. . c 5.00 times. . d 5.80 times. .

ANS: C

OBJ: LO 1

15. Selected information from the accounting records of Thorne Company is as follows:
Net sales for 2005 .................................... Cost of goods sold for 2002 ........................... Inventory at December 31, 2004 ........................ Inventory at December 31, 2005 ........................ $900,000 600,000 180,000 156,000

Thorne's inventory turnover for 2005 is a 5.36 times. . b 3.85 times. . c 3.67 times. . d 3.57 times. .

ANS: D

OBJ: LO 1

16. Selected information from the accounting records of the Vassar Company is as follows:
Net accounts receivable at December 31, 2004 .......... Net accounts receivable at December 31, 2005 .......... Accounts receivable turnover .......................... Inventories at December 31, 2004 ...................... Inventories at December 31, 2005 ...................... Inventory turnover .................................... $ 900,000 1,000,000 5 to 1 $1,100,000 1,200,000 4 to 1

What was Vassar's gross margin for 2005? a $150,000 . b $200,000 . c $400,000 . d $500,000 .

ANS: A

OBJ: LO 1

17. The following data were abstracted from the records of Johnson Corporation for the year:
Sales ................................................. Bond interest expense ................................. Income taxes .......................................... Net income ............................................ $1,800,000 60,000 300,000 400,000

How many times was bond interest earned? a 7.67 . b 11.67 . c 12.67 . d 13.67 .

ANS: C

OBJ: LO 1

18. Selected information for Henry Company is as follows: December 31 2004 2005
Common stock ................................ Additional paid-in capital .................. Retained earnings ........................... Net income for year ......................... $600,000 250,000 170,000 120,000 $600,000 250,000 370,000 240,000

Henry's return on common stockholder's equity, rounded to the nearest percentage point, for 2005 is a 20 percent. . b 21 percent. . c 28 percent. . d 40 percent. .

ANS: B OBJ: LO 1 19. Selected information from the accounting records of Ellison Manufacturing lows:
Net sales ............................................. Cost of goods sold .................................... Inventories at January 1 ............................. Inventories at December 31 ............................ $3,600,000 2,400,000 672,000 576,000

What is the number of days' sales in average inventories for the year? a 102.2 .

b 94.9 . c 87.6 . d 68.1 .

ANS: B

OBJ: LO 1

20. Orchard Corporation's capital stock at December 31 consisted of the following: (a) Common stock, $2 par value; 100,000 shares authorized, issued, and outstanding. (b) 10% noncumulative, nonconvertible preferred stock, $100 par value; 1,000 shares authorized, issued, and outstanding. Orchard's common stock, which is listed on a major stock exchange, was quoted at $4 per share on December 31. Orchard's net income for the year ended December 31 was $50,000. The yearly preferred dividend was declared. No capital stock transactions occurred. What was the priceearnings ratio on Orchard's common stock at December 31? a 6 to 1 . b 8 to 1 . c 10 to 1 . d 16 to 1 .

ANS: C

OBJ: LO 1

21. Selected financial data of Alexander Corporation for the year ended December 31, 2005, is presented below:
Operating income ...................................... Interest expense ...................................... Income before income tax .............................. Income tax expense .................................... Net income ............................................ Preferred stock dividends ............................. Net income available to common stockholders ........... $900,000 (100,000) $800,000 (320,000) $480,000 (200,000) $280,000

Common stock dividends were $120,000. The times-interest-earned ratio is a 2.8 to 1. . b 4.8 to 1. . c 6.0 to 1. . d 9.0 to 1. .

ANS: D

OBJ: LO 1

22. During the year, The Grap Company purchased $1,920,000 of inventory. The cost of goods sold for the year was $1,800,000 and the ending inventory at December 31 was $360,000. What was the inventory turnover for the year? a 5.0 . b 5.3 . c 6.0 . d 6.4 .

ANS: C OBJ: LO 1 23. On December 31, 2004 and 2005, Taft Corporation had 100,000 shares of common stock and 50,000 shares of noncumulative and nonconvertible preferred stock issued and outstanding. Additional information:
Stockholders' equity at 12/31/2005 .................... Net income year ended 12/31/2005 ...................... Dividends on preferred stock year ended 12/31/2005 .... Market price per share of common stock at 12/31/2005 .. $4,500,000 1,200,000 300,000 144

The price-earnings ratio on common stock at December 31, 2005, was a 10 to 1. . b 12 to 1. . c 14 to 1. . d 16 to 1. .

ANS: D

OBJ: LO 1

24. Albright Distributing Inc. converts its foreign subsidiary financial statements using the translation process. Their German subsidiary reported the following for 2005: revenues and expenses of 10,050,000 and 7,800,000 marks, respectively, earned or incurred evenly throughout the year, dividends of 2,000,000 marks were paid during the year. The following exchange rates are available:
On January 1, 2005 .................................... On December 31, 2005 .................................. Average rate for 2005 ................................. Rate when dividends were declared and paid ............ $.250 .285 .270 .255

Translated net income for 2005 is a $641,250. . b $607,500. .

c $131,250. . d $97,500. .

ANS: B

OBJ: LO 5

25. Tokyo Enterprises, a subsidiary of Worldwide Enterprises based in Dallas, reported the following information at the end of its first year of operations (all in yen): assets--110,000,000; expenses-41,000,000; liabilities--97,500,000; capital stock--5,500,000; revenues--48,000,000. Relevant exchange rates are as follows:
On date subsidiary stock was purchased ................ Average rate for the year ............................. At year end ........................................... $.085 .078 .075

As a result of the translation process, what amount is recorded on the financial statements as the translation adjustment? a $21,000 debit adjustment . b $76,000 debit adjustment . c $21,000 credit adjustment . d $76,000 credit adjustment .

ANS: B

OBJ: LO 5

26. What is the effect of the collection of accounts receivable on the current ratio and net working capital, respectively? a . b . c . d . Current Ratio No effect Increase Increase No effect Net Working Captial No effect Increase No effect Increase

ANS: A

OBJ: LO 1

27. Which of the following is an appropriate computation for return on investment? a Net income divided by total assets . b Net income divided by sales . c Sales divided by total assets . d Sales divided by stockholders' equity .

ANS: A

OBJ: LO 1

28. Which of the following is included in the calculation of the acid-test (quick) ratio? Accounts Receivable a No . b No . c Yes . d Yes . Inventories No Yes No Yes

ANS: C

OBJ: LO 1

29. A measure of profitability analysis is a times interest earned . b cash flow per share . c quick ratio . d dividend payout ratio .

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ANS: D

OBJ: LO 1

30. Selected information from the 2005 and 2004 financial statements of SCL Corporation is presented below: (in thousands) As of December 31 2005 $ 21 27 60 105 5 247 57 10 8 52 (in thousands) As of December 31 2005 $750 82% 60% $ 30 6 6

Cash ................................... Marketable securities (current) ........... Accounts receivable (net) .... Inventory ............................ Prepaid expenses ................. Land and building (net) ......... Accounts payable ................ Accrued expenses ............... Notes payable (shortterm) ... Bonds payable .....................

2004 $ 35 22 98 142 3 315 75 14 4 66

Cash sales ........................... Credit sales (percent of cash sales) ............. Cost of goods sold (percent of total sales) ...... Net income .......................... Interest expense .................. Income tax expense .............

2004 $675 85% 58% $ 38 9 7

SCL's current ratio as of December 31, 2005, is a . b . c . d . 2.84 to 1. 3.37 to 1. 2.91 to 1. 3.33 to 1.

ANS: C

OBJ: LO 1

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31. Refer to the SCL Corporation information above. SCL's quick (acid test) ratio as December 31, 2005, is a 1.44 to 1. . b 1.50 to 1. . c 1.67 to 1. . d 1.66 to 1. .

ANS: A

OBJ: LO 1

32. Refer to the SCL Corporation information above. SCL's account receivable turnover for 2005 is a 13.85. . b 10.00. . c 9.49. . d 7.78. .

ANS: D

OBJ: LO 1

33. Refer to the SCL Corporation information above. SCL's merchandise inventory turnover for 2005 is a 3.43. . b 5.68. . c 6.63. . d 6.79. .

ANS: C

OBJ: LO 1

34. Refer to the SCL Corporation information above. SCL's turnover of assets and number of times interest earned for 2005 are respectively a . b . c . d . Asset Turnover 2.97 2.94 2.94 2.94 Times Interest Earned 5.0 5.0 6.0 7.0

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ANS: D OBJ: LO 1 35. The primary purpose of the Security and Exchange Commission's Form 20-F is a to explain in detail the differences between the internal controls established under the . accounting and auditing principles of a foreign country and those of the United States. b to determine the fee a foreign company must pay to register its financial statements with . the Securities and Exchange Commission.. c to explain in detail the differences between net income computed under the accounting . principles of a foreign country and U.S. GAAP. d to explain in detail the differences between total assets measured using the accounting . principles of a foreign country and U.S. GAAP.

ANS: C PROBLEMS

OBJ: LO 4

1. Comparative balance sheet data for the Addyson Co. at the end of 2004 and 2005 follows: Addyson Company Condensed Comparative Balance Sheet December 31, 2005 and 2004 Assets
Current assets ............................... Long-term investments ........................ Land, buildings, and equipment (net) ......... Intangible assets ............................ Other assets ................................. Total assets .................................

2005
$ 71,000 67,000 195,000 9,400 5,000 $347,400

2004
$ 68,000 43,000 162,000 11,300 8,000 $292,300

Liabilities
Current liabilities .......................... Long-term liabilities--8% bonds .............. Total liabilities ............................ $ 37,100 23,500 $ 60,600 $ 34,000 17,900 $ 51,900

Stockholders' Equity
6% preferred stock ........................... Common stock ................................. Additional paid-in capital ................... Retained earnings ............................ Total stockholders' equity ................... Total liabilities and stockholders' equity ... $ 7,500 50,000 46,000 183,300 $286,800 $347,400 $ 7,500 50,000 46,000 136,900 $240,400 $292,300

Prepare a common-size balance sheet comparing financial structure percentages for the two-year period. Use total assets to standardize.

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ANS: Addyson Company Condensed Common-Size Balance Sheet For Years Ended December 31, 2005 and 2004 Assets
Current assets .............................. Long-term investments ....................... Land, buildings, and equipment (net) ........ Intangible assets ........................... Other assets ................................ Total assets ................................

2005
20% 19 57 3 1 100%

2004
23% 15 55 4 3 100%

Liabilities
Current liabilities ......................... Long-term liabilities--8% bonds ............. Total liabilities ........................... 11% 7 18% 12% 6 18%

Stockholders' Equity
6% preferred stock .......................... Common stock ................................ Additional paid-in capital .................. Retained earnings ........................... Total stockholders' equity .................. Total liabilities and stockholders' equity .. 2% 14 13 53 82% 100% 2% 17 16 47 82% 100%

OBJ:

LO 1

2. The inventory of Brett Company averages $1,255,002 at cost. During 2005, sales of $7,341,750 were made at 30 percent above cost. Using the given data, compute the following: (1) (2) Inventory turnover rate for 2005. Number of days' sales in inventory.

ANS: (1) $7,341,750 / 1.30 = $5,647,500 $5,647,500 / $1,255,002 = 4.50 times (rounded) (2) 365 / 4.50 = 81.1 days OBJ: LO 1

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3.

Comparative data for Kerry Inc. for the two-year period 2004-2005 are given as follows: Income Statement Data 2005
Net sales ................................... Cost of goods sold .......................... Gross profit on sales ....................... Selling, general, and other expenses ........ Income tax expense .......................... Net income .................................. Dividends paid .............................. Net increase in retained earnings ........... $1,400,000 840,000 $ 560,000 400,000 40,000 $ 120,000 80,000 $ 40,000

2004
$800,000 440,000 $360,000 130,000 30,000 $200,000 80,000 $120,000

Balance Sheet Data 2005 Assets

Current assets .............................. Land, buildings, and equipment .............. Total assets ................................ $ 540,000 800,000 $1,340,000 $ 440,000 720,000 $1,160,000

2004

Liabilities and Stockholders' Equity

Current liabilities ......................... Bonds payable (8%) .......................... Common stock ($5 par) ....................... Retained earnings ........................... Total liabilities and stockholders' equity .. $ 300,000 320,000 480,000 240,000 $1,340,000 $ 240,000 320,000 400,000 200,000 $1,160,000

From the given data, compute the following for 2004 and 2005: (1) Current ratio. (2) Net profit margin on sales. (3) Gross profit margin on sales. (4) Debt-to-equity ratio. (5) Times interest earned.

ANS: (1) 2005: 2004: (2) 2005: 2004: (3) 2005: 2004: (4) 2005: 2004: $540,000 / $300,000 = 1.80 to 1 $440,000 / $240,000 = 1.83 to 1 $120,000 / $1,400,000 = 8.57% $200,000 / $800,000 = 25% $560,000 / $1,400,000 = 40% $360,000 / $800,000 = 45% $620,000 / $720,000 = 0.86 to 1 $560,000 / $600,000 = 0.93 to 1

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(5) 2005: 2004:

($120,000 + $40,000 + $25,600*) / $25,600 = 7.25 times ($200,000 + $30,000 + $25,600*) / $25,600 = 9.98 times * (8% $320,000)

OBJ:

LO 1

4. Income statements for LaRue Co. show the following: 2005

Sales (net) ..................... Cost of goods sold: Beginning inventory ............. Purchases ....................... Ending inventory ................ Gross profit .................... $500,000 110,000 420,000 $530,000 170,000 360,000 $140,000

2004
$400,000 90,000 330,000 $420,000 110,000 310,000 $ 90,000

2003
$350,000 20,000 370,000 $390,000 90,000 300,000 $ 50,000

From the data presented, calculate the following ratios for 2005 and 2004: (1) Inventory turnover rate. (2) Number of days' sales in inventories. (3) Gross profit margin on sales.

ANS: (1) 2005

Cost of goods sold .................... Inventory: Beginning of year ..................... End of year ........................... Average inventory ..................... Inventory turnover .................... $360,000 110,000 170,000 140,000 2.57 times

2004
$310,000 90,000 110,000 100,000 3.10 times

(2)
Inventory turnover for year ........... Number of days' sales in average inventory ............................. 2.57 365/2.57 = 142.0 days 3.10 365/3.10 = 117.7 days

(3)
Gross profit .......................... Sales (net) ........................... Gross profit margin on sales .......... $140,000 500,000 28% $ 90,000 400,000 22.5%

OBJ:

LO 1

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5. The following are comparative data for Gates Company for the three-year period 2003-2005: Income Statement Data 2005
Net sales (80% are on credit each period) ......................... Net purchases ................... $900,000 480,000

2004
$720,000 390,000

2003
$840,000 330,000

Balance Sheet Data

Accounts receivable, December 31 $150,000 $132,000 $126,000

Compute the following measurements for 2005 and 2004: (1) The receivables turnover rate. (2) The average collection period for accounts receivable.

ANS: (1) 2005

Net credit sales ............................. Net receivables: Beginning of year ............................ End of year .................................. Average receivables .......................... Receivables turnover ......................... $720,000 132,000 150,000 141,000 5.11 times

2004
$576,000 126,000 132,000 129,000 4.47 times

(2)
Average receivables .......................... Net credit sales ............................. Average daily credit sales ................... Average collection period (average receivables average daily credit sales) ................ * ** ($900,000 .80)/365 = $1,973 ($720,000 .80)/365 = $1,578 $141,000 $720,000 1,973* 71.5 days $129,000 $576,000 1,578** 81.7 days

OBJ:

LO 1

6. The balance sheet for the Byrne Dareed Corp. showed liabilities and stockholders' equity balances at the end of each year as given below: 2005
Current liabilities .......................... 12% Bonds payable ............................ Preferred 10% stock, $100 par ................ Common stock, $20 par ........................ Additional paid-in capital ................... Retained earnings ............................ Net income ................................... Market price per share, December 31 .......... $ 750,000 1,200,000 900,000 2,250,000 450,000 750,000 375,000 65 $

2004
600,000 1,200,000 750,000 1,875,000 375,000 540,000 300,000 60

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Common stock dividends .......................

75,000

45,000

Based on the data provided, compute the following ratios for 2005: (1) The rate of earnings on average total stockholders' equity. (2) The number of times bond interest requirements were earned. (3) The earnings per share on common stock. (4) The price-earnings ratio. (5) Debt-to-equity ratio.

ANS: (1) $375,000 / [($4,350,000 + $3,540,000)/2] = $375,000 / $3,945,000 = 9.51% (2) ($375,000 + $144,000) / $144,000 = 3.6 times (3) ($375,000 - $90,000) / 112,500 shares = $2.53 per share (4) $65 / $2.53 = 25.69 times (5) $1,950,000 / $4,350,000 = 0.45 to 1 OBJ: LO 1

7. The following partial balance sheet information is for Ollie Company: 12/31/05
Dividends Payable ........................... Deferred Income Taxes (Liability) ........... Equipment ................................... Accumulated Depreciation--Equipment ......... Unappropriated Retained Earnings ............ Appropriated Retained Earnings .............. Cash ........................................ Income Tax Refund Receivable ................ $ 3,400 46,000 92,500 28,300 71,000 2,000 670 1,750

12/31/04
$ 2,200 41,500 78,000 30,000 50,000 0 350 1,400

The following additional information relates to 2005: (a) Net income for the year, $100,000. (b) Depreciation expense for the year, $7,400. (c) Income tax expense for the year, $35,000. (d) During the year, equipment was overhauled at a cost of $2,500. The cost was debited to accumulated depreciation. (e) During the year, equipment with a book value of $10,000 was sold. A loss of $1,100 was realized on the sale. Compute the following:

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(1) (2) (3)

Total equipment purchases during the year. Cash paid for income taxes during the year. Cash paid for dividends during the year.

ANS: (1) Accumulated Depreciation--Equipment Beginning balance

30,000

Depreciation expense Equipment overhaul Accumulated depreciation of equipment sold Ending balance Equipment
78,000 2,500 6,600

7,400

28,300

Beginning balance Cost of equipment sold Purchase of new equipment Ending balance Total equipment purchases = $31,100 (2)
31,100 92,500 16,600

Deferred Income Taxes Beginning balance Total income tax expense Current portion of income tax Ending balance Income Tax Refund Receivable Beginning balance Current portion of income tax
1,400 30,500 30,500 46,000 41,500 35,000

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Cash payments for income tax Ending balance Cash payments for income tax = $30,850 (3)

30,850 1,750

Unappropriated Retained Earnings Beginning balance Appropriation Net income Dividends declared Ending balance Dividends Payable Beginning balance Dividends declared Dividends paid Ending balance Cash payments for dividends = $75,800 OBJ: LO 6
75,800 3,400 2,200 77,000 77,000 71,000 2,000 100,000 50,000

8. On July 15, 2005, United Manufacturing Inc., a New York based conglomerate, purchased, Sky Inc., a Korean-based company. Sky Inc.'s balance sheet on the date of purchase is as follows: In Korean Won (in thousands)
Cash .............................................. Accounts receivable ............................... Inventory ......................................... Plant assets (net) ................................ Accounts payable .................................. Non-current liabilities ........................... Capital stock ..................................... Retained earnings ................................. 11,250 62,500 57,250 48,900 179,900 64,000 74,900 12,500 28,500 179,900

The exchange rate for Korean won on July 15, 2005, is $.007.

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Prepare a translated balance sheet as of July 15, 2005. ANS: In Korean Won (in thousands)
Cash ......................... Accounts receivable .......... Inventory .................... Plant assets (net) ........... Accounts payable ............. Non-current liabilities ...... Capital stock ................ Retained earnings ............ 11,250 62,500 57,250 48,900 179,900 64,000 74,900 12,500 28,500 179,900

Exchange Rate
$0.007 0.007 0.007 0.007 0.007 0.007 0.007 0.007 $

In U.S. $
78,750 437,500 400,750 342,300 $1,259,300 $ 448,000 524,300 87,500 199,500 $1,259,300

OBJ: LO 5 9. Financial information for Toro Enterprises at the end of 2005 is as follows: French Francs
Current assets ........................................ Equipment ............................................. Current liabilities ................................... Long-term debt ........................................ Capital stock ......................................... Retained earnings (January 1, 2005) ................... Revenues .............................................. Expenses .............................................. 14,500,000 9,750,000 6,500,000 3,200,000 1,600,000 9,250,000 10,450,000 6,750,000

Relevant exchange rates are as follows:

When Toro was purchased ............................... Current exchange rate ................................. Average rate for the year ............................. $0.20 0.32 0.28

In addition, the computed retained earnings balance from the prior year's translated financial statements is $2,405,000 at the end of 2005. Prepare a translated trial balance for Toro Enterprises. ANS: In Francs (in thousands)
Current assets .............. Equipment .................. . Expenses ................... . 14,500 9,750 6,750 31,000

Exchange Rate
0.32 0.32 0.28

In U.S. $ (in thousands)

$4,640 3,120 1,890 $9,650

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Current liabilities ......... Long-term debt .............. Capital stock ............... Retained earnings (January 1, 2005) ........... Revenues ................... . Translation adjustment ......

6,500 3,200 1,600

0.32 0.32 0.20

$2,080 1,024 320

9,250 10,450

computed 0.28

2,405 2,926 895

31,000

$9,650

OBJ:

LO 5

10. The following financial information is available for Paul Company, a hypothetical non-U.S. firm with shares listed on a U.S. stock exchange:
Net income computed according to home country GAAP ...... Stockholders' equity computed according to home country GAAP ............................................ Possible obligation for severance benefits to be paid to employees in future years; recognized this year ...... Development costs capitalized at the end of the year .... 800,000 8,000,000 3,000,000 3,200,000

If Paul were following U.S. GAAP, development costs would be expensed when incurred.. According to U.S. GAAP, the possible obligation for severance benefits would not be recognized until it had become probable. Prepare a reconciliation of Paul's reported stockholders' equity and net income to the amounts of these items under U.S. GAAP. ANS: Paul Company Reconciliation of Stockholders' Equity to U.S. GAAP
Stockholders' equity computed according to homecountry GAAP .................................................. Adjustments required to conform to U.S. GAAP: Development costs capitalized at the end of the year Possible obligation for severance benefits ........... Stockholders' equity in accordance with U.S. GAAP ..... $8,000,000 (3,200,000) 3,000,000 $ 7,800,000

Paul Company Reconciliation of Net Income to U.S. GAAP

Net income according to home country GAAP ............. Adjustments required to conform to U.S. GAAP: Possible obligation for severance benefits .......... Development costs capitalized at the end of the year Net income in accordance with U.S. GAAP ............... $ 800,000

3,000,000 (3,200,000) $ 600,000

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OBJ:

LO 3, LO 4

11. The following schedule shows the net changes in the balance sheet accounts at December 31, 2004, as compared to December 31, 2005, for the Williams Company. The statement of cash flows for the year ended December 31, 2005, has not been prepared. Assets
Cash and cash equivalents .............................. Accounts receivable (net) .............................. Inventories ............................................ Prepaid expenses ....................................... Property, plant, and equipment (net) ................... Total assets ...........................................

Increase (Decrease)
$ 60,000 66,000 37,000 2,000 63,000 $228,000

Liabilities
Accounts payable ....................................... Short-term notes payable ............................... Accrued liabilities .................................... Bonds payable .......................................... Less: Amortized bond discount .......................... Total liabilities ...................................... $(46,000) (20,000) 28,500 (28,000) 1,200 $(64,300)

Stockholders' Equity
Common stock ........................................... Paid-in capital in excess of par ....................... Retained earnings ...................................... Appropriation of retained earnings for possible plant expansion ........................................ Total stockholders' equity ............................. $500,000 200,000 (437,700) 30,000 $292,300

The following additional information has been gathered: (a) (b) (c) The net income for the year ended December 31, 2005, was $172,300. During the year ended December 31, 2005, uncollectible accounts receivable of $26,400 were written off by a debit to Allowance for Doubtful Accounts. A comparison of Property, Plant, and Equipment, as of the end of each year follows: December 31 2005 2004
Property, plant, and equipment ... Less: Accumulated depreciation ... $570,500 225,500 $345,000 $510,000 228,000 $282,000

Increase (Decrease)
$60,500 (2,500) $63,000

During 2005, machinery was purchased at a cost of $45,000. In addition, machinery that was acquired in 1998 at a cost of $48,000 was sold for $3,600. At the date of sale, the machinery had an undepreciated cost of $4,200. The remaining increase in property, plant, and equipment resulted from the acquisition of a tract of land for a new plant site.

23

(d) (e)

(f) (g)

The bonds payable mature at the rate of $28,000 every year. In January 2005, the company issued an additional 10,000 shares of common stock at $14 per share upon exercise of outstanding stock options held by key employees. In May 2005, the company declared and issued a 5% stock dividend on its outstanding stock. During the year, a cash dividend was paid on the common stock. On December 31, 2005, there were 840,000 shares of common stock outstanding. The appropriation of retained earnings was made in anticipation of the construction of a new plant. The notes payable relate to operating activities.

Prepare a statement of cash flows for the year ended December 31, 2005, using the indirect method. ANS: Williams Company Statement of Cash Flows For the Year Ended December 31, 2005
Cash flows from operating activities: Net income ................................ Adjustments: Depreciation .............................. Amortization of bond discount ............. Loss on sale of machinery ................. Increase in accounts receivable ........... Increase in inventory ..................... Increase in prepaid expenses .............. Decrease in accounts payable .............. Decrease in short-term notes payable ...... Increase in accrued liabilities ........... Net cash flow provided by operations ........ Cash flows from investing activities: Sale of machinery ......................... Purchase of machinery ..................... Purchase of land .......................... Net cash flow used by investing activities .. Cash flows from financing activities: Issuance of common stock 4 ................. Retirement of bonds ....................... Payment of dividends ...................... Net cash flow provided by financing activities Net increase in cash and cash equivalents ... $172,300 41,300 1 1,200 600 2 (66,000) (37,000) (2,000) (46,000) (20,000) 28,500

$ 72,900

$ 3,600 (45,000) (63,500) 3

(104,900)

$140,000 (28,000) (20,000)5

92,000 $ 60,000

Note: Completion of the formal statement of cash flows would require disclosure of the beginning and ending cash and cash equivalents. Computations:
1 Accumulated depreciation--beginning balance ............ Accumulated depreciation--machine sold

$(228,000)

24

($48,000 $4,200) ..................................... Accumulated depreciation--ending balance ............... Depreciation expense for the year 2002 .................
2 Book value of machine sold ($48,000 $43,800) ......... Proceeds on sale ....................................... Loss on sale ...........................................

43,800 225,500 $ $ 41,300 4,200 (3,600) $ 600

Property, plant, and equipment--beginning balance ...... Purchase of machine .................................... Sale of machine ........................................ Property, plant, and equipment--ending balance ......... Purchase of land .......................................
4

$(510,000) (45,000) 48,000 570,500 $ 63,500

Additional stock issued as a result of 5% stock dividend: 800,000 shares .05 = 40,000 shares. $ 437,700 (30,000) (560,000) 172,300 $ 20,000

Net decrease in retained earnings ...................... Appropriation of retained earnings ..................... Stock dividend (40,000 shares $14) ................... Net income ............................................. Dividends declared and paid ............................

OBJ:

LO 6

12. The following 3 ratios have been computed using the financial statements for the year ended December 31, 2005, for James Company: Current ratio Debt-to-equity ratio = (Current assets/Current liabilities) = $70,000 $40,000 = 1.75 = (Total liabilities/ Stockholders' equity) = $100,000 $120,000 = .83 =(Net income/Sales) = $40,000 $390,000 = .10

Return on sales

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The following additional information has been assembled: (a) James uses the LIFO method of inventory valuation. Beginning inventory was $30,000 and ending inventory was $40,000. If James had used FIFO, beginning inventory would have been $40,000 and ending inventory would have been $55,000. (b) James' sole depreciable asset was purchased on January 1, 2002. The asset cost $110,000 and is being depreciated over 10 years with no estimated salvage value. Although the 10-year life is within the acceptable range, most firms in James' industry depreciate similar assets over 8 years. (c) For 2005, James decided to recognize a $15,000 liability for future environmental cleanup costs. Most other firms in James' industry have similar environmental cleanup obligations but have decided that the amounts of the obligations are not reasonably estimable at this time; on average, these firms recognized only 5% of their total environmental cleanup obligation.

Show how the values for the 3 ratios computed above differ if James had used FIFO, depreciated the asset over 8 years, and recognized only 5% of its environmental cleanup obligation. Compute how the financial statements would differ if the alternative accounting methods had been used. Do not treat the use of these alternative methods as accounting changes. Ignore any income tax effects. ANS: Adjustments: (a) Using FIFO: Ending inventory increases by $15,000 ($55,000 - $40,000). Net income for 2005 increases by $5,000 [($55,000 - $40,000) - ($40,000 - $30,000)]. Beginning retained earnings increases by $10,000 ($40,000 - $30,000). (b) 8-year useful life: Book value at December 31, 2005: 10-year life: $110,000 - [($110,000 10) 4 years] = $66,000 8-year life: $110,000 - [($110,000 8) 4 years] = $55,000 Book value decreases by $11,000 ($66,000 - $55,000). Net income for 2002 decreases by $2,750 [($130,000 8) - ($130,000 10)] Beginning retained earnings decreases by $8,250 [($110,000 8) 3 years] - [($110,000 10) 3 years]. (c) Environmental cleanup obligation: Net income for 2005 increases by $14,250 [($15,000 - ($15,000 .05)]. Environmental cleanup obligation decreases by $14,250. Adjusted current ratio: ($70,000 + $15,000) $40,000 = 2.13 Adjusted debt-to-equity ratio: ($100,000 - $14,250) ($120,000 + $5,000 + $10,000 - $2,750 $8,250 + $14,250) = .62 Adjusted return on sales ratio: ($40,000 + $5,000 - $2,750 + $14,250) $390,000 = 0.145 OBJ: LO 2

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13. The following 3 ratios have been computed using the financial statements for the year ended December 31, 2005, for Arthur Company: Current ratio Debt-to-equity ratio = (Current assets/Current liabilities) = $85,000 $55,000 = 1.55 = (Total liabilities/ Stockholders' equity) = $150,000 $130,000 = 1.15 = (Net income/Sales) = $50,000 $410,000 = .12

Return on sales

The following additional information has been assembled: (a) Arthur uses the LIFO method of inventory valuation. Beginning inventory was $25,000 and ending inventory was $35,000. If Arthur had used FIFO, beginning inventory would have been $50,000 and ending inventory would have been $65,000. (b) Arthur's sole depreciable asset was purchased on January 1, 2002. The asset cost $130,000 and is being depreciated over 15 years with no estimated salvage value. Although the 15-year life is within the acceptable range, most firms in Arthur's industry depreciate similar assets over 10 years. (c) For 2005, Arthur decided to recognize a $22,000 liability for future environmental cleanup costs. Most other firms in Arthur's industry have similar environmental cleanup obligations but have decided that the amounts of the obligations are not reasonably estimable at this time; on average, these firms recognized only 5% of their total environmental cleanup obligation. Show how the values for the 3 ratios computed above differ if Arthur had used FIFO, depreciated the asset over 8 years, and recognized only 5% of its environmental cleanup obligation. Compute how the financial statements would differ if the alternative accounting methods had been used. Do not treat the use of these alternative methods as accounting changes. Ignore any income tax effects. ANS: Adjustments: (a) Using FIFO: Ending inventory increases by $30,000 ($65,000 - $35,000). Net income for 2005 increases by $5,000 [($65,000 - $35,000) - ($50,000 - $25,000)]. Beginning retained earnings increases by $25,000 ($50,000 - $25,000). (b) 10-year useful life: Book value at December 31, 2005: 15-year life: $130,000 - [($130,000 15) 4 years] = $95,333 10-year life: $130,000 - [($130,000 10) 4 years] = $78,000 Book value decreases by $17,333 ($95,333 - $78,000). Net income for 2005 decreases by $4,333 [($130,000 10) - ($130,000 15)] Beginning retained earnings decreases by $13,000 [($130,000 10) 3 years] - [($130,000 15) 3 years].

27

(c) Environmental cleanup obligation: Net income for 2005 increases by $20,900 [($22,000 - ($22,000 .05)]. Environmental cleanup obligation decreases by $20,900. Adjusted current ratio: ($85,000 + $30,000) $55,000 = 2.09 Adjusted debt-to-equity ratio: ($150,000 - $20,900) ($130,000 + $5,000 + $25,000 - $4,333 $13,000 + $20,900) = .78 Adjusted return on sales ratio: ($50,000 + $5,000 - $4,333 + $20,900) $410,000 = 0.18 OBJ: LO 2

14. The following 3 ratios have been computed using the financial statements for the year ended December 31, 2005, for CR Company: Current ratio Debt-to-equity ratio = (Current assets/Current liabilities) = $80,000 $43,000 = 1.86 = (Total liabilities/ Stockholders' equity) = $110,000 $125,000 = .88 = (Net income/Sales) = $45,000 $400,000 = .11

Return on sales

The following additional information has been assembled: (a) CR uses the FIFO method of inventory valuation. Beginning inventory was $48,000 and ending inventory was $58,500. If CR had used LIFO, beginning inventory would have been $36,000 and ending inventory would have been $43,000. (b) CR's sole depreciable asset was purchased on January 1, 2002. The asset cost $120,000 and is being depreciated over 7 years with no estimated salvage value. Although the 7-year life is within the acceptable range, most firms in CR's industry depreciate similar assets over 12 years. (c) For 2005, CR decided to recognize only 5% of an $18,000 liability for future environmental cleanup costs. Most other firms in CR's industry have similar environmental cleanup obligations but have decided that the amounts of the obligations are reasonably estimable and have recognized the full amount of the liability.

Show how the values for the 3 ratios computed above differ if CR had used LIFO, depreciated the asset over 12 years, and recognized the full amount of its, environmental cleanup obligation. Compute how the financial statements would differ if the alternative accounting methods had been used. Do not treat the use of these alternative methods as accounting changes. Ignore any income tax effects. ANS: Adjustments: (a) Using LIFO:

28

Ending inventory decreases by $15,500 ($43,000 - $58,500). Net income for 2005 decreases by $3,500 [($43,000 - $36,000) - ($58,500 - $48,000)]. Beginning retained earnings decreases by $12,000 ($36,000 - $48,000). (b) 12-year useful life: Book value at December 31, 2005: 7-year life: $120,000 - [($120,000 7) 4 years] = $51,429 12-year life: $120,000 - [($120,000 12) 4 years] = $80,000 Book value increases by $28,571 ($51,429 - $80,000). Net income for 2005 increases by $7,143 [($120,000 7) - ($120,000 12)] Beginning retained earnings increases by $21,428 [($120,000 7) 3 years] - [($130,000 12) 3 years]. (c) Environmental cleanup obligation: Net income for 2005 decreases by $17,100 [($18,000 .05) - $18,000]. Environmental cleanup obligation increases by $17,100. Adjusted current ratio: ($80,000 - $15,500) $43,000 = 1.5 Adjusted debt-to-equity ratio: ($110,000 + $17,100) ($125,000 - $3,500 - $12,000 + $7,143 + $21,428 - $17,100) = 1.05 Adjusted return on sales ratio: ($45,000 - $3,500 + $7,143 - $17,100) $400,000 = 0.079 OBJ: LO 2

15. The following financial information is for DC Company, a non-U.S. firm with shares listed on a U.S. stock exchange:
Net income computed according to home country GAAP ........ Stockholders' equity, computed according to home country GAAP ..................................................... . Minority interest, recorded as an addition to stockholders' equity ................................................... . Market value of investment securities acquired this year that were reported at cost of $4,000 ...................... Interest on the financing of self-constructed assets ...... $ 40,000

170,000 35,000

5,000 6,000

If DC Company were following U.S. GAAP, the minority interest would have been classified as a liability instead of as part of stockholders' equity. In addition, minority interest income of $4,000 for the year would have been excluded from the computation of net income. Under U.S. GAAP the investment securities would have been classified as trading securities and the interest on financing of self-constructed assets would have been capitalized rather than expensed. Prepare reconciliations of DC's reported stockholders' equity and net income to U.S. GAAP.

29

ANS:
Reconciliation of stockholders' equity: Stockholders' equity computed according to home country GAAP .................................................... Adjustments required to conform to U.S. GAAP: Minority interest included in stockholders' equity ...... Unrealized gain on trading securities ($5,000 - $4,000) . Interest on financing of self-constructed assets ........ Stockholders' equity according to U.S. GAAP .............

$170,000 (35,000) 1,000 6,000 $142,000

Reconciliation of net income: Net income computed according to home country GAAP ...... Minority interest income ................................ Unrealized gain on trading securities ($5,000 - $4,000) . Interest on financing of self-constructed assets ........ Net income in accordance with U.S. GAAP .................

$ 40,000 (4,000) 1,000 6,000 $ 43,000

OBJ:

LO 3

16. The following financial information is for Olaf Company, a non-U.S. firm with shares listed on a U.S. stock exchange:
Net income computed according to home country GAAP ...... Stockholders' equity, computed according to home country GAAP .................................................... Possible obligation for severance benefits to be paid to employees in future years, recognized this year ......... Minority interest, recorded as an addition to stockholders' equity .................................... Market value of investment securities acquired this year that were reported at cost of $2,000 .................... Interest on the financing of self-constructed assets .... $ 350,000 4,100,000 1,000,000 30,000 $ 3,200 4,000

If Olaf Company were following U.S. GAAP, the minority interest would have been classified as a liability instead of as part of stockholders' equity. In addition, minority interest income of $3,000 for the year would have been excluded from the computation of net income. Under U.S. GAAP the investment securities would have been classified as trading securities and the interest on financing of self-constructed assets would have been capitalized rather than expensed. Prepare reconciliations of Olaf's reported stockholders' equity and net income to U.S. GAAP. ANS:
Reconciliation of stockholders' equity: Stockholders' equity computed according to home country GAAP .................................................. Adjustments required to conform to U.S. GAAP: Possible obligation for severance benefits ............ Minority interest included in stockholders' equity .... Unrealized gain on trading securities ($3,200 - $2,000) Interest on financing of self-constructed assets ...... Stockholders' equity according to U.S. GAAP ...........

$4,100,000 1,000,000 (30,000) 1,200 4,000 $5,075,200

30

Reconciliation of net income: Net income computed according to home country GAAP .... Possible obligation for severance benefits ............ Minority interest income .............................. Unrealized gain on trading securities ($3,200 - $2,000) Interest on financing of self-constructed assets ...... Net income in accordance with U.S. GAAP ...............

350,000 1,000,000 (3,000) 1,200 4,000 $1,352,200

OBJ:

LO 3

17. Assume that you have just been hired as the controller of the Trent Manufacturing Company. In order to be fully apprised of the financial and operating condition of the company, you have decided to analyze several of the key accounts appearing on the company's financial statements. An account of obvious interest to you is the company's trade accounts receivable. Identify specific attributes of the accounts receivable that you would examine as well as any ratios that might be useful to you in your analysis. ANS: An analysis of the accounts receivable of the company might include the following: 1. Identify receivables with the following characteristics and assess their effect on the company's financial health generally: a. b. Receivables from customers having severe financial difficulties. Receivables from customers in economically unstable foreign countries.

2. Determine if the receivables are concentrated in just a few customers or are diversified among many customers. 3. Nothing is said in the facts of the problem about whether Trent's trade receivables are from other business enterprises or consumers. Trade receivables from consumers would be riskier than those from other enterprises. 4. Calculate the accounts receivable turnover. A high turnover rate usually shows that the company is collecting quickly from customers. An excessively high turnover might indicate a credit policy that is too stringent with the result that sales are lost. A low ratio may indicate that large amounts of receivables are uncollectible as a result of weak collection policies or credit terms that are too lenient. Quarterly or monthly sales figures may be required for use in the turnover ratio if sales vary greatly during the year. 5. Calculate the accounts receivable-to-total-assets and accounts-receivable-to sales ratios to determine if receivables are accumulating beyond what would reasonable be expected. 6. Calculate the sales-returns-to-sales and sales-returns-to-accounts receivable ratios. An upward trend in these ratios may indicate errors in filling orders or problems with the quality of merchandise sold. 7. Calculate the-bad-debts-to-accounts-receivable and bad-debts-to-net-sales ratios. These ratios give some indication as to the adequacy of the bad debt provision the company is making in its financial statements.

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OBJ:

LO 1

18. Laura Anderson has just been assigned as the senior accountant on the audit of Larsen Manufacturing Company. Laura currently is planning the audit and has been considering what procedures to perform in examining the company's inventories of raw materials, work-in-process, and finished goods. She has determined that the calculation of certain ratios and other financial analysis techniques will prove useful to her in deciding how to approach the audit of the company's inventory accounts. Identify the ratios to be calculated and the factors to be considered in Laura's analysis of the company's inventory accounts.

32

ANS: Laura should consider the following in her analysis of the company's inventory accounts: 1. The increase in inventory should be compared to the increase in sales. If the inventory is increasing at a faster rate, then the company may accumulating inventory it cannot sell. Unsaleable inventory likely will adversely affect future cash flows. Inquiries should be made of management regarding the potential for implementing just-in-time inventory procedures to minimize the investment in inventory and to provide greater assurance of the production of high quality products. The balances in the raw materials, work-in-process, and finished goods accounts should be reviewed. A decrease in raw materials accompanied by an increase in work-in-process and finished goods may indicate a possible future production slowdown. The inventory turnover ratio should be calculated for each major inventory category and by department. Low turnover ratios may result from overstocking, obsolescence, or a weak marketing effort. Low turnover may be acceptable for a new product that has just begun to be marketed. A rate of turnover that is too high may indicate that inventories are not adequate to serve customer needs resulting in a loss of valuable business. The number of days inventory is held should be calculated and compared to industry figures and prior years. The trend for the ratio of inventory to sales also should be examined. A determination should be made regarding any inventories that might pose a health or environmental hazard that such inventories have not been banned by a regulatory agency. Such a ban could result in the need to write off large amounts of inventory. The nature of the inventory should be evaluated to determine if the items in inventory are susceptible to price variability or fads. Inventory items also may be specialized, perishable, highly technological, or luxury items. All of these factors can affect future demand and salability. A determination should be made as to whether any inventory is pledged as collateral for a loan. Appropriate insurance coverage should be evidenced for inventory. Storage sites for inventory should be evaluated for security that is adequate to protect the inventory. Pricing and quantity errors as well as appropriate costing of the inventory should be considered. LO 1

2.

3.

4.

5.

6.

7.

8. 9. 10 11. OBJ:

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