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of cash flows. Dividends, if any, appear in the financing activities section.
Construction firms must make large
capital expenditures for plant assets,
such as the equipment shown here.
These expenditures are a negative
component of free cash flow, which
is the amount of cash that remains
after deducting the funds a company
needs to operate at its planned level.
In 2007, negative free cash flows
forced a number of construction firms
to rely heavily on debt to finance their
capital expenditures, thus increasing
their vulnerability to the economic
downturn of 2008.
Courtesy R, 2009/Used under license
from Shutterstock.com.
Analyzing Cash Flows 667
FOCUS ON BUSINESS PRACTICE
What Do You Mean, ”Free Cash Flow”?
Because the statement of cash flows has been around for income less maintenance-level capital expenditures.”6 The
less than 25 years, no generally accepted analyses have yet definition with which we are most in agreement is the one
been developed. For example, the term free cash flow is com- used in BusinessWeek: free cash flow is net cash flows from
monly used in the business press, but there is no agreement operating activities less net capital expenditures and divi-
on its definition. An article in Forbes defines free cash flow as dends. This “measures truly discretionary funds—company
“cash available after paying out capital expenditures and money that an owner could pocket without harming the
dividends, but before taxes and interest” [emphasis added].5 business.”7
An article in The Wall Street Journal defines it as “operating
Amazon.com is a growing company and does not have material sales of plant
assets and does not pay dividends. The company’s positive free cash flow of
$1,364 million was due primarily to its strong operating cash flow of $1,697 mil-
lion. Consequently, the company does not have to borrow money to expand.
Because cash flows can vary from year to year, analysts should look at trends
in cash flow measures over several years. It is also important to consider the effect
of seasonality on a company’s sales. Because Amazon.com’s sales peak toward the
end of the year, the cash situation at that time may not be representative of the
rest of the year. For example, Amazon.com’s management states that
Our cash, cash equivalents, and marketable securities balances typically reach
their highest level [at the end of each year.] This operating cycle results in a
corresponding increase in accounts payable at December 31. Our accounts
payable balance generally declines during the first three months of the year,
resulting in a corresponding decline in our cash . . .”8
STOP
& APPLY
In 2011, Monfort Corporation had year-end assets of $2,400,000, sales of $2,000,000, net income
of $400,000, net cash flows from operating activities of $360,000, dividends of $100,000, purchases
of plant assets of $200,000, and sales of plant assets of $40,000. In 2010, year-end assets were
$2,200,000. Calculate cash flow yield, cash flows to sales, cash flows to assets, and free cash flow.
SOLUTION
$360,000
Cash Flow Yield (cid:2) _ ________ (cid:2) 0.9 Times
$400,000
$360,000
Cash Flows to Sales (cid:2) ______ _____ (cid:2) 0.18, or 18%
$2,000,000
$360,000
Cash Flows to Assets (cid:2) __________ _________ _ _________ (cid:2) 0.16, or 16% (rounded)
($2,400,000 (cid:3) $2,200,000) (cid:5) 2
Free Cash Flow (cid:2) $360,000 (cid:4) $100,000 (cid:4) $200,000 (cid:3) $40,000 (cid:2) $100,000
668 CHAPTER 15 The Statement of Cash Flows
Operating To demonstrate the preparation of the statement of cash flows, we will work
Activities through an example step-by-step. The data for this example are presented in
Exhibit 15-2, which shows Laguna Corporation’s income statement for 2010,
and in Exhibit 15-3, which shows Laguna’s balance sheets for December 31,
LO3 Use the indirect method to
2010 and 2009. Exhibit 15-3 shows the balance sheet accounts that we use for
determine cash flows from oper-
analysis and whether the change in each account is an increase or a decrease.
ating activities.
The first step in preparing the statement of cash flows is to determine cash
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flows from operating activities. The income statement indicates how successful a
company has been in earning an income from its operating activities, but because
that statement is prepared on an accrual basis, it does not reflect the inflow and
outflow of cash related to operating activities. Revenues are recorded even though
the company may not yet have received the cash, and expenses are recorded even
though the company may not yet have expended the cash. Thus, to ascertain cash
flows from operations, the figures on the income statement must be converted
from an accrual basis to a cash basis.
There are two methods of accomplishing this:
(cid:2)(cid:2) The direct method adjusts each item on the income statement from the
Study Note accrual basis to the cash basis. The result is a statement that begins with
cash receipts from sales and interest and deducts cash payments for purchases,
The direct and indirect methods
operating expenses, interest payments, and income taxes to arrive at net cash
relate only to the operating
flows from operating activities.
activities section of the
statement of cash flows. They (cid:2)(cid:2) The indirect method does not require the adjustment of each item on the
are both acceptable for financial income statement. It lists only the adjustments necessary to convert net
reporting purposes. income to cash flows from operations.
TThe direct and indirect methods always produce the same net figure. The aver-
aage person finds the direct method easier to understand because its presentation
of operating cash flows is more straightforward than that of the indirect method.
However, the indirect method is the overwhelming choice of most companies and
accountants. A survey of large companies shows that 99 percent use this method.9
EXHIBIT 15-2
Laguna Corporation
Income Statement
Income Statement
For the Year Ended December 31, 2010
Sales $698,000
Cost of goods sold 520,000
Gross margin $178,000
Operating expenses (including depreciation
expense of $37,000) 147,000
Operating income $ 31,000
Other income (expenses)
Interest expense ($23,000)
Interest income 6,000
Gain on sale of investments 12,000
Loss on sale of plant assets (3,000) (8,000)
Income before income taxes $ 23,000
Income taxes expense 7,000
Net income $ 16,000
Operating Activities 669
EXHIBIT 15-3 Comparative Balance Sheets Showing Changes in Accounts
Laguna Corporation
Comparative Balance Sheets
December 31, 2010 and 2009
Increase
or
2010 2009 Change Decrease
Assets
Current assets
Cash $ 46,000 $ 15,000 $ 31,000 Increase
Accounts receivable (net) 47,000 55,000 (8,000) Decrease
Inventory 144,000 110,000 34,000 Increase
Prepaid expenses 1,000 5,000 (4,000) Decrease
Total current assets $ 238,000 $185,000 $ 53,000
Investments $ 115,000 $127,000 ($ 12,000) Decrease
Plant assets $ 715,000 $505,000 $210,000 Increase
Less accumulated depreciation (103,000) (68,000) (35,000) Increase
Total plant assets $ 612,000 $437,000 $175,000
Total assets $ 965,000 $749,000 $216,000
Liabilities
Current liabilities
Accounts payable $ 50,000 $ 43,000 $ 7,000 Increase
Accrued liabilities 12,000 9,000 3,000 Increase
Income taxes payable 3,000 5,000 (2,000) Decrease
Total current liabilities $ 65,000 $ 57,000 $ 8,000
Long-term liabilities
Bonds payable 295,000 245,000 50,000 Increase
Total liabilities $ 360,000 $302,000 $ 58,000
Stockholders’ Equity
Common stock, $5 par value $ 276,000 $200,000 $ 76,000 Increase
Additional paid-in capital 214,000 115,000 99,000 Increase
Retained earnings 140,000 132,000 8,000 Increase
Treasury stock (25,000) 0 (25,000) Increase
Total stockholders’ equity $ 605,000 $447,000 $158,000
Total liabilities and stockholders’ equity $ 965,000 $749,000 $216,000
From an analyst’s perspective, the indirect method is superior to the direct method
because it begins with net income and derives cash flows from operations; the ana-
lyst can readily identify the factors that cause cash flows from operations. From a
company’s standpoint, the indirect method is easier and less expensive to prepare.
For these reasons, we use the indirect method in our example.
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As Figure 15-2 shows, the indirect method focuses on adjusting items on
the income statement to reconcile net income to net cash flows from operating
670 CHAPTER 15 The Statement of Cash Flows
FIGURE 15-2 Indirect Method of Determining Net Cash Flows from Operating Activities
ACCRUAL BASIS OF ACCOUNTING CASH BASIS OF ACCOUNTING
EARNED REVENUES NET
ADJUSTMENTS TO RECONCILE CASH FLOWS
NET NET INCOME TO
FROM
INCOME NET CASH FLOWS
OPERATING
INCURRED EXPENSES
FROM OPERATING ACTIVITIES ACTIVITIES
activities. These items include depreciation, amortization, and depletion; gains
and losses; and changes in the balances of current asset and current liability
accounts. The schedule in Exhibit 15-4 shows the reconciliation of Laguna Cor-
poration’s net income to net cash flows from operating activities. We discuss each
adjustment in the sections that follow.
Depreciation
The investing activities section of the statement of cash flows shows the cash
Study Note payments that the company made for plant assets, intangible assets, and natu-
ral resources during the accounting period. Depreciation expense, amortization
Operating expenses on the
expense, and depletion expense for these assets appear on the income statement as
income statement include
allocations of the costs of the original purchases to the current accounting period.
depreciation expense, which
The amount of these expenses can usually be found in the income statement or in
does not require a cash outlay.
a note to the financial statements. As you can see in Exhibit 15-2, Laguna Cor-
poration’s income statement discloses depreciation expense of $37,000, which
would have been recorded as follows:
A (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:4)37,000 (cid:4)37,000
Dr. Cr.
Depreciation Expense 37,000
Accumulated Depreciation 37,000
To record annual depreciation on plant assets
Even though depreciation expense appears on the income statement, it
involves no outlay of cash and so does not affect cash flows in the current period.
Thus, to arrive at cash flows from operations on the statement of cash flows,
FOCUS ON BUSINESS PRACTICE
The Direct Method May Become More Important
At present, the direct method of preparing the operating the use of the direct method, even though it is more costly
section of the statement of cash flows is not important, for companies to prepare. IFRS will continue to require a rec-
but this may change if the International Accounting Stan- onciliation of net income and net cash flows from operating
dards Board (IASB) has its way. As mentioned earlier in the activities similar to what is now done in the indirect method.
text, 99 percent of public companies in the United States CVS’s statement of cash flows, as shown in the Supplement
p resently use the indirect method to show the operating to Chapter 5, is one of the few U.S. companies to use the
activities section of the statement of cash flows. However, direct method with reconciliation. Thus, its approach is very
in the interest of converging U.S. GAAP with international similar to what all companies may do if IFRS are adopted in
financial reporting standards (IFRS), the IASB is promoting the United States.
Operating Activities 671
EXHIBIT 15-4
Laguna Corporation
Schedule of Cash Flows from Operating
Schedule of Cash Flows from Operating Activities
Activities: Indirect Method
For the Year Ended December 31, 2010
Cash flows from operating activities
Net income $16,000
Adjustments to reconcile net income to net cash
flows from operating activities
Depreciation $ 37,000
Gain on sale of investments (12,000)
Loss on sale of plant assets 3,000
Changes in current assets and current liabilities
Decrease in accounts receivable 8,000
Increase in inventory (34,000)
Decrease in prepaid expenses 4,000
Increase in accounts payable 7,000
Increase in accrued liabilities 3,000
Decrease in income taxes payable (2,000) 14,000
Net cash flows from operating activities $30,000
an adjustment is needed to increase net income by the amount of depreciation
expense shown on the income statement.
Gains and Losses
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Like depreciation expense, gains and losses that appear on the income statement
Study Note
do not affect cash flows from operating activities and need to be removed from
this section of the statement of cash flows. The cash receipts generated by the
Gains and losses by themselves
disposal of the assets that resulted in the gains or losses are included in the invest-
do not represent cash flows;
they are merely bookkeeping ing activities section of the statement of cash flows. Thus, to reconcile net income
adjustments. For example, when to cash flows from operating activities (and prevent double counting), gains and
a long-term asset is sold, it is losses must be removed from net income.
the proceeds (cash received), For example, on its income statement, Laguna Corporation shows a $12,000
not the gain or loss, that gain on the sale of investments. This amount is subtracted from net income to
constitute cash flow. reconcile net income to net cash flows from operating activities. The reason for
doing this is that the $12,000 is included in the investing activities section of
the statement of cash flows as part of the cash from the sale of the investment.
Because the gain has already been included in the calculation of net income, the
$12,000 gain must be subtracted to prevent double counting.
Laguna’s income statement also shows a $3,000 loss on the sale of plant
assets. This loss is already reflected in the sale of plant assets in the investing
activities section of the statement of cash flows. Thus, the $3,000 is added to net
income to reconcile net income to net cash flows from operating activities.
Changes in Current Assets
Decreases in current assets other than cash have positive effects on cash flows,
and increases in current assets have negative effects on cash flows. A decrease
in a current asset frees up invested cash, thereby increasing cash flow. An
increase in a current asset consumes cash, thereby decreasing cash flow. For
example, look at Laguna Corporation’s income statement and balance sheets
672 CHAPTER 15 The Statement of Cash Flows
in Exhibits 15-2 and 15-3. Note that net sales in 2010 were $698,000 and
that Accounts Receivable decreased by $8,000. Thus, collections were $8,000
more than sales recorded for the year, and the total cash received from sales
was $706,000 ($698,000 (cid:3) $8,000 (cid:2) $706,000). The effect on Accounts
Receivable can be illustrated as follows:
ACCOUNTS RECEIVABLE
Dr. Cr.
Cash Receipts
Beg. Bal. 55,000 706,000
from
Sales to 698,000
Customers
Customers
End. Bal. 47,000
To reconcile net income to net cash flows from operating activities, the $8,000
decrease in accounts receivable is added to net income.
Inventory can be analyzed in the same way. For example, Exhibit 15-3 shows
that Laguna’s Inventory account increased by $34,000 between 2009 and 2010.
This means that Laguna expended $34,000 more in cash for purchases than it
included in cost of goods sold on its income statement. Because of this expen-
diture, net income is higher than net cash flows from operating activities, so
$34,000 must be deducted from net income. By the same logic, the decrease of
$4,000 in prepaid expenses shown on the balance sheets must be added to net
income to reconcile net income to net cash flows from operating activities.
Changes in Current Liabilities
The effect that changes in current liabilities have on cash flows is the opposite
of the effect of changes in current assets. An increase in a current liability rep-
resents a postponement of a cash payment, which frees up cash and increases
cash flow in the current period. A decrease in a current liability consumes cash,
which decreases cash flow. To reconcile net income to net cash flows from
operating activities, increases in current liabilities are added to net income,
and decreases are deducted. For example, Exhibit 15-3 shows that from 2009
to 2010, Laguna’s accounts payable increased by $7,000. This means that
Laguna paid $7,000 less to creditors than the amount indicated in the cost of
goods sold on its income statement. The following T account illustrates this
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relationship:
ACCOUNTS PAYABLE
Dr. Cr.
Cash
547,000 Beg. Bal. 43,000
Payments to 554,000* Purchases
Suppliers
End. Bal. 50,000
*Purchases (cid:2) Cost of Goods Sold ($520,000) (cid:3) Increase in Inventory ($34,000)
Thus, $7,000 must be added to net income to reconcile net income to net cash
flows from operating activities. By the same logic, the increase of $3,000 in accrued
liabilities shown on the balance sheets must be added to net income, and the
decrease of $2,000 in income taxes payable must be deducted from net income.
Operating Activities 673
Schedule of Cash Flows from Operating Activities
In summary, Exhibit 15-4 shows that by using the indirect method, net income
of $16,000 has been adjusted by reconciling items totaling $14,000 to arrive at
net cash flows from operating activities of $30,000. This means that although
Laguna’s net income was $16,000, the company actually had net cash flows of
$30,000 available from operating activities to use for purchasing assets, reducing
debts, and paying dividends.
The treatment of income statement items that do not affect cash flows can be
summarized as follows:
Add to or Deduct
from Net Income
Depreciation expense Add
Amortization expense Add
Depletion expense Add
Losses Add
Gains Deduct
The following summarizes the adjustments for increases and decreases in current
assets and current liabilities:
Add to Deduct from
Net Income Net Income
Current assets
Accounts receivable (net) Decrease Increase
Inventory Decrease Increase
Prepaid expenses Decrease Increase
Current liabilities
Accounts payable Increase Decrease
Accrued liabilities Increase Decrease
Income taxes payable Increase Decrease
FOCUS ON BUSINESS PRACTICE
What Is EBITDA, and Is It Any Good?
Some companies and analysts like to use EBITDA (an acro- touted its EBITDA, is another reason that analysts have
nym for Earnings Before Interest, Taxes, Depreciation, and had second thoughts about relying on this measure of
Amortization) as a short-cut measure of cash flows from performance.
operations. But recent events have caused many analysts Some analysts are now saying that EBITDA is “to a great
to reconsider this measure of performance. For instance, extent misleading” and that it “is a confusing metric. . . . Some
when WorldCom transferred $3.8 billion from expenses take it for a proxy for profits and some take it for a proxy
to capital expenditures in one year, it touted its EBITDA; at for cash flow, and it’s neither.”10 Cash flows from operations
the time, the firm was, in fact, nearly bankrupt. The demise and free cash flow, both of which take into account interest,
of Vivendi, the big French company that imploded when taxes, and depreciation, are better and more comprehen-
it did not have enough cash to pay its debts and that also sive measures of a company’s cash-generating efficiency.
674 CHAPTER 15 The Statement of Cash Flows
STOP
& APPLY
For the year ended June 30, 2011, Hoffer Corporation’s net income was $7,400. Its deprecia-
tion expense was $2,000. During the year, its Accounts Receivable increased by $4,400, Inven-
tories increased by $7,000, Prepaid Rent decreased by $1,400, Accounts Payable increased by
$14,000, Salaries Payable increased by $1,000, and Income Taxes Payable decreased by $600.
The company also had a gain on the sale of investments of $1,800. Use the indirect method to
prepare a schedule of cash flows from operating activities.
SOLUTION
Hoff er Corporation
Schedule of Cash Flows from Operating Activities
For the Year Ended June 30, 2011
Cash flows from operating activities
Net income $ 7,400
A djustments to reconcile net income to net cash
flows from operating activities
Depreciation $ 2,000
Gain on sale of investments (1,800)
Changes in current assets and current liabilities
Increase in accounts receivable (4,400)
Increase in inventories (7,000)
Decrease in prepaid rent 1,400
Increase in accounts payable 14,000
Increase in salaries payable 1,000
Decrease in income taxes payable (600) 4,600
Net cash flows from operating activities $12,000
Investing To determine cash flows from investing activities, accounts involving cash receipts
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Activities and cash payments from investing activities are examined individually. The objec-
tive is to explain the change in each account balance from one year to the next.
Although investing activities center on the long-term assets shown on the
LO4 Determine cash flows from
balance sheet, they also include any short-term investments shown under current
investing activities.
assets on the balance sheet and any investment gains and losses on the income
statement. The balance sheets in Exhibit 15-3 show that Laguna had no short-
term investments and that its long-term assets consisted of investments and plant
assets. The income statement in Exhibit 15-2 shows that Laguna had a gain on
the sale of investments and a loss on the sale of plant assets.
The following transactions pertain to Laguna’s investing activities in 2010:
Study Note
1. Purchased investments in the amount of $78,000.
Investing activities involve long-
2. Sold for $102,000 investments that cost $90,000.
term assets and short- and long-
term investments. Inflows and 3. Purchased plant assets in the amount of $120,000.
outflows of cash are shown in
4. Sold for $5,000 plant assets that cost $10,000 and that had accumulated
the investing activities section
depreciation of $2,000.
of the statement of cash flows.
5. Issued $100,000 of bonds at face value in a noncash exchange for plant assets.
Investing Activities 675
In the following sections, we analyze the accounts related to investing activi-
ties to determine their effects on Laguna’s cash flows.
Investments
Our objective in this section is to explain Laguna Corporation’s $12,000 decrease
in investments. We do this by analyzing the increases and decreases in Laguna’s
Investments account to determine their effects on the Cash account.
Item 1 in the list of Laguna’s transactions states that its purchases of invest-
ments totaled $78,000 during 2010. This transaction, which caused a $78,000
decrease in cash flows, is recorded as follows:
A (cid:3) L (cid:4) SE Dr. Cr.
(cid:3)78,000
Investments 78,000
(cid:4)78,000
Cash 78,000
Purchase of investments
Item 2 states that Laguna sold for $102,000 investments that cost $90,000.
This transaction resulted in a gain of $12,000. It is recorded as follows:
A (cid:3) L (cid:4) SE Dr. Cr.
(cid:3)102,000 (cid:3) 12,000 Cash 102,000
(cid:4)90,000
Investments 90,000
Gain on Sale of Investments 12,000
Sale of investments for a gain
TThe effect of this transaction is a $102,000 increase in cash flows. Note that the
Study Note gain on the sale is included in the $102,000. This is the reason we excluded it in
computing cash flows from operations. If it had been included in that section, it
The $102,000 price obtained,
wwould have been counted twice. We have now explained the $12,000 decrease in
not the $12,000 gained,
tthe Investments account during 2010, as illustrated in the following T account:
constitutes the cash flow.
INVESTMENTS
Dr. Cr.
Beg. Bal. 127,000 Sales 90,000
Purchases 78,000
End. Bal. 115,000
The cash flow effects of these transactions are shown in the investing activities
section of the statement of cash flows as follows:
Purchase of investments ($ 78,000)
Sale of investments 102,000
Notice that purchases and sales are listed separately as cash outflows and inflows
to give readers of the statement a complete view of investing activity. However,
some companies prefer to list them as a single net amount. If Laguna Corpo-
ration had short-term investments or marketable securities, the analysis of cash
flows would be the same.
Plant Assets
For plant assets, we have to explain changes in both the Plant Assets account and
the related Accumulated Depreciation account. Exhibit 15-3 shows that from
2009 to 2010, Laguna Corporation’s plant assets increased by $210,000 and that
accumulated depreciation increased by $35,000.
676 CHAPTER 15 The Statement of Cash Flows
Item 3 in the list of Laguna’s transactions in 2010 states that the company pur-
chased plant assets totaling $120,000. The following entry records this cash outflow:
A (cid:3) L (cid:4) SE Dr. Cr.
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(cid:3)120,000
Plant Assets 120,000
(cid:4)120,000
Cash 120,000
Purchase of plant assets
Item 4 states that Laguna Corporation sold for $5,000 plant assets that cost
$10,000 and that had accumulated depreciation of $2,000. Thus, this transaction
resulted in a loss of $3,000. The entry to record it is as follows:
A (cid:3) L (cid:4) SE Dr. Cr.
(cid:3)5,000 (cid:4)3,000
Cash 5,000
(cid:3)2,000
Accumulated Depreciation 2,000
(cid:4)10,000
Loss on Sale of Plant Assets 3,000
Plant Assets 10,000
Sale of plant assets at a loss
Note that in this transaction, the positive cash flow is equal to the amount of cash
Study Note received, $5,000. The loss on the sale of plant assets is included in the investing
activities section of the statement of cash flows and excluded from the operating
Even though Laguna had a loss
activities section by adjusting net income for the amount of the loss. The amount
on the sale of plant assets, it
of a loss or gain on the sale of an asset is determined by the amount of cash
realized a positive cash flow of
$5,000, which will be reported received and does not represent a cash outflow or inflow.
in the investing activities section The investing activities section of Laguna’s statement of cash flows reports
of its statement of cash flows. the firm’s purchase and sale of plant assets as follows:
When the indirect method is Purchase of plant assets ($120,000)
used, the loss is eliminated with
Sale of plant assets 5,000
an “add-back” to net income.
Cash outflows and cash inflows are listed separately here, but companies some-
times combine them into a single net amount, as they do the purchase and sale
of investments.
Item 5 in the list of Laguna’s transactions is a noncash exchange that affects
two long-term accounts, Plant Assets and Bonds Payable. It is recorded as follows:
A (cid:3) L (cid:4) SE Dr. Cr.
(cid:3)100,000 (cid:3)100,000
Plant Assets 100,000
Bonds Payable 100,000
Issued bonds at face value for
plant assets
Although this transaction does not involve an inflow or outflow of cash, it is a
significant transaction involving both an investing activity (the purchase of plant
assets) and a financing activity (the issue of bonds payable). Because one purpose
of the statement of cash flows is to show important investing and financing activi-
ties, the transaction is listed at the bottom of the statement of cash flows or in a
separate schedule, as follows:
Schedule of Noncash Investing and Financing Transactions
Issue of bonds payable for plant assets $100,000
We have now accounted for all the changes related to Laguna’s plant asset
accounts. The following T accounts summarize these changes:
Investing Activities 677
PLANT ASSETS
Dr. Cr.
Beg. Bal. 505,000 Sales 10,000
Cash Purchase 120,000
Noncash Purchase 100,000
End. Bal. 715,000
ACCUMULATED DEPRECIATION
Dr. Cr.
Sale 2,000 Beg. Bal. 68,000
Dep. Exp. 37,000
End. Bal. 103,000
Had the balance sheet included specific plant asset accounts (e.g., Equipment and
the related accumulated depreciation account) or other long-term asset accounts
(e.g., Intangibles), the analysis would have been the same.
STOP
& APPLY
The following T accounts show Matiz Company’s plant assets and accumulated depreciation at
the end of 2011:
PLANT ASSETS ACCUMULATED DEPRECIATION
Dr. Cr. Dr. Cr.
Beg. Bal. 65,000 Disposals 23,000 Disposals 14,700 Beg. Bal. 34,500
Purchases 33,600 Depreciation 10,200
End. Bal. 75,600 End. Bal. 30,000
Matiz’s income statement shows a gain on the sale of plant assets of $4,400. Compute the
amounts that should be shown as cash flows from investing activities, and show how they should
appear on Matiz’s 2011 statement of cash flows.
SOLUTION
Cash flows from investing activities:
Purchase of plant assets ($33,600)
Sale of plant assets 12,700
The T accounts show total purchases of plant assets of $33,600, which is an outflow of cash, and disposal of plant
assets that cost $23,000 and that had accumulated depreciation of $14,700. The income statement shows a $4,400
gain on the sale of the plant assets. The cash inflow from the disposal was as follows:
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Plant assets $23,000
Less accumulated depreciation 14,700
Book value $ 8,300
Add gain on sale 4,400
Cash inflow from sale of plant assets $12,700
Because the gain on the sale is included in the $12,700 in the investing activities section of the statement of cash
flows, it should be deducted from net income in the operating activities section.
678 CHAPTER 15 The Statement of Cash Flows
Financing Determining cash flows from financing activities is very similar to determining
Activities cash flows from investing activities, but the accounts analyzed relate to short-
term borrowings, long-term liabilities, and stockholders’ equity. Because Laguna
Corporation does not have short-term borrowings, we deal only with long-term
LO5 Determine cash flows from
liabilities and stockholders’ equity accounts.
financing activities.
The following transactions pertain to Laguna’s financing activities in 2010:
1. Issued $100,000 of bonds at face value in a noncash exchange for plant assets.
2. Repaid $50,000 of bonds at face value at maturity.
3. Issued 15,200 shares of $5 par value common stock for $175,000.
4. Paid cash dividends in the amount of $8,000.
5. Purchased treasury stock for $25,000.
Bonds Payable
Exhibit 15-3 shows that Laguna’s Bonds Payable account increased by $50,000
in 2010. Both items 1 and 2 in the list above affect this account. We analyzed
item 1 in connection with plant assets, but it also pertains to the Bonds Payable
account. As we noted, this transaction is reported on the schedule of noncash
investing and financing transactions. Item 2 results in a cash outflow, which is
recorded as follows:
A (cid:3) L (cid:4) SE Dr. Cr.
(cid:4)50,000 (cid:4)50,000 Bonds Payable 50,000
Cash 50,000
Repayment of bonds at face value at maturity
This appears in the financing activities section of the statement of cash flows as
follows:
Repayment of bonds ($50,000)
The following T account explains the change in Bonds Payable:
BONDS PAYABLE
Dr. Cr.
Repayment 50,000 Beg. Bal. 245,000
Noncash Issue 100,000
End. Bal. 295,000
If Laguna Corporation had any notes payable, the analysis would be the same.
Common Stock
Like the Plant Assets account and its related account, accounts related to stock-
holders’ equity should be analyzed together. For example, the Additional Paid-in
Capital account should be examined along with the Common Stock account. In
2010, Laguna’s Common Stock account increased by $76,000, and its Addi-
tional Paid-in Capital account increased by $99,000. Item 3 in the list of Lagu-
na’s transactions, which states that the company issued 15,200 shares of $5 par
Financing Activities 679
FOCUS ON BUSINESS PRACTICE
How Much Cash Does a Company Need?
Some kinds of industries are more vulnerable to down- companies can lose up to 80 percent of their value in times
turns in the economy than others. Historically, because of of financial stress. In contrast, companies with large amounts
the amount of debt they carry and their large interest and of tangible assets, such as oil companies and railroads, can
loan payments, companies in the airline and automotive lose as little as 10 percent. To survive during economic
industries have been hard hit by economic downturns. But downturns, it is very important for high-tech companies to
research has shown that high-tech companies with large use their cash-generating efficiency to build cash reserves. It
amounts of intangible assets are also hard hit. Biotechnol- makes sense for these companies to hoard cash and not pay
ogy, pharmaceutical, and computer hardware and software dividends to the extent that companies in other industries do.11
value common stock for $175,000, explains these increases. The entry to record
the cash inflow is as follows:
A (cid:3) L (cid:4) SE Dr. Cr.
(cid:3)175,000 (cid:3)76,000 Cash 175,000
(cid:3)99,000
Common Stock 76,000
Additional Paid-in Capital 99,000
Issued 15,200 shares of $5 par value
common stock
This appears in the financing activities section of the statement of cash flows as:
Issuance of common stock $175,000
The following analysis of this transaction is all that is needed to explain the
|
changes in the two accounts during 2010:
COMMON STOCK ADDITIONAL PAID-IN CAPITAL
Dr. Cr. Dr. Cr.
Beg. Bal. 200,000 Beg. Bal. 115,000
Issue 76,000 Issue 99,000
End. Bal. 276,000 End. Bal. 214,000
Retained Earnings
At this point, we have dealt with several items that affect retained earnings. The
only item affecting Laguna’s retained earnings that we have not considered is the
payment of $8,000 in cash dividends (item 4 in the list of Laguna’s transactions).
At the time it declared the dividend, Laguna would have debited its Cash Divi-
dends account. After paying the dividend, it would have closed the Cash Dividends
account to Retained Earnings and recorded the closing with the following entry:
A (cid:3) L (cid:4) SE Dr. Cr.
(cid:4)8,000
Retained Earnings 8,000
(cid:3)8,000
Cash Dividends 8,000
To close the Cash Dividends account
Study Note
Cash dividends would be displayed in the financing activities section of Lagu-
It is dividends paid, not nna’s statement of cash flows as follows:
dividends declared, that appear
Payment of dividends ($8,000)
on the statement of cash flows.
680 CHAPTER 15 The Statement of Cash Flows
The following T account shows the change in the Retained Earnings account:
RETAINED EARNINGS
Dr. Cr.
Cash Dividends 8,000 Beg. Bal. 132,000
Net Income 16,000
End. Bal. 140,000
EXHIBIT 15-5
Statement of Cash Flows: Laguna Corporation
Indirect Method Statement of Cash Flows
For the Year Ended December 31, 2010
Cash flows from operating activities
Net income $ 16,000
Adjustments to reconcile net income to net
cash flows from operating activities
Depreciation $ 37,000
Gain on sale of investments (12,000)
Loss on sale of plant assets 3,000
Changes in current assets and current liabilities
Decrease in accounts receivable 8,000
Increase in inventory (34,000)
Decrease in prepaid expenses 4,000
Increase in accounts payable 7,000
Increase in accrued liabilities 3,000
Decrease in income taxes payable (2,000) 14,000
Net cash flows from operating activities $ 30,000
Cash flows from investing activities
Purchase of investments ($ 78,000)
Sale of investments 102,000
Purchase of plant assets (120,000)
Sale of plant assets 5,000
Net cash flows from investing activities (91,000)
Cash flows from financing activities
Repayment of bonds ($ 50,000)
Issuance of common stock 175,000
Payment of dividends (8,000)
Purchase of treasury stock (25,000)
Net cash flows from financing activities 92,000
Net increase in cash $ 31,000
Cash at beginning of year 15,000
Cash at end of year $ 46,000
Schedule of Noncash Investing and Financing Transactions
Issue of bonds payable for plant assets $100,000
Financing Activities 681
Treasury Stock
As we noted in the chapter on contributed capital, many companies buy back their
own stock on the open market. These buybacks use cash, as this entry shows:
A (cid:3) L (cid:4) SE Dr. Cr.
(cid:4)25,000 (cid:4)25,000
Treasury Stock 25,000
Cash 25,000
Purchased treasury stock
This use of cash is classified in the statement of cash flows as a financing activity:
Study Note
Purchase of treasury stock ($25,000)
The purchase of treasury stock The T account for this transaction is as follows:
qualifies as a financing activity,
but it is also a cash outflow. TREASURY STOCK
Dr. Cr.
Purchase 25,000
We have now analyzed all Laguna Corporation’s income statement items,
explained all balance sheet changes, and taken all additional information into
account. Exhibit 15-5 shows how our data are assembled in Laguna’s statement
of cash flows.
STOP
& APPLY
During 2011, F & K Company issued $1,000,000 in long-term bonds at par, repaid $200,000
of notes payable at face value, issued notes payable of $40,000 for equipment, paid interest of
$40,000, paid dividends of $25,000, and repurchased common stock in the amount of $50,000.
Prepare the cash flows from financing activities section of the statement of cash flows.
SOLUTION
Cash flows from financing activities
Issuance of long-term bonds $1,000,000
Repayment of notes payable (200,000)
Payment of dividends (25,000)
Purchase of treasury stock (50,000)
Net cash flows from financing activities $ 725,000
|
Note: Interest is an operating activity. The exchange of the notes payable for equipment is a noncash investing
and financing transaction.
682 CHAPTER 15 The Statement of Cash Flows
(cid:2) LOPATA CORPORATION: REVIEW PROBLEM
As we pointed out in this chapter’s Decision Point, the managers of Lopata Corporation
were concerned because in 2011, cash flows from operating activities were less than net
income, cash and cash equivalents declined during the year, and the company was hav-
ing trouble paying its bills on time. We asked the following questions:
• Why were Lopata Corporation’s operating cash flows less than its net income, and
why did its cash and cash equivalents decline during the year?
• What measures do managers, stockholders, and potential investors use to evaluate
the strength of a company’s cash flows and liquidity?
Lopata Corporation’s income statement for 2011 appears below. Its comparative bal-
ance sheets for 2011 and 2010 follow. The company’s records for 2011 provide this
additional information:
Statement of Cash
a. Sold long-term investments that cost $35,000 for a gain of $6,250; made other
Flows and Its Analysis long-term investments in the amount of $10,000.
LO2 LO3 b. Purchased 5 acres of land to build a parking lot for $12,500.
LO4 LO5
c. Sold equipment that cost $18,750 and that had accumulated depreciation of
$12,650 at a loss of $1,150; purchased new equipment for $15,000.
d. Repaid notes payable in the amount of $50,000; borrowed $15,000 by signing
new notes payable.
e. Converted $50,000 of bonds payable into 3,000 shares of common stock.
f. Reduced the Mortgage Payable account by $10,000.
g. Declared and paid cash dividends of $25,000.
h. Purchased treasury stock for $5,000.
Lopata Corporation: Review Problem 683
Required
1. Using the indirect method, prepare a statement of cash flows for Lopata
Corporation for the year ended December 31, 2011.
2. User insight: Using data from Lopata’s statement of cash flows, income
statement, and comparative balance sheets, compute the company’s cash flow
yield, cash flows to sales, cash flows to assets, and free cash flow for 2011. What
do your results indicate about the company’s cash-generating efficiency? What
do they indicate about Lopata’s need to sell investments, issue stock, or borrow
money to maintain current operations or finance future growth?
3. User insight: What is the apparent cause of Lopata’s operating cash flow
problem and the decline in its cash and cash equivalents?
684 CHAPTER 15 The Statement of Cash Flows
Answers to 1. Statement of cash flows using the indirect method:
Review Problem
Lopata Corporation: Review Problem 685
2. Cash flow yield, cash flows to sales, cash flows to assets, and free cash flow for
2011:
$58,300
Cash Flow Yield (cid:2) _ _______ (cid:2) 0.7 Times*
$83,200
$58,300
Cash Flows to Sales (cid:2) ________ (cid:2) 7.1%*
$825,000
$58,300
Cash Flows to Assets (cid:2) _ ($_ 7_ 1_ 2_ ,_ 0_ 9_
0
_ (cid:3)__ $_ 7__ 4_
1
_
,
3_ 9_ 0_ )_ (cid:5)__ 2_ (cid:2) 8.0%*
Free Cash Flow (cid:2) $58,300 (cid:4) $25,000 (cid:4) $12,500 (cid:4) $15,000 (cid:3) $4,950 (cid:2) $10,750
Lopata should generate at least $1 of net cash flows from operations for each
$1 of net income. However, its cash flow yield shows that it generated only
70 cents for each $1 of net income. Judging from this result alone, Lopata’s
cash-generating efficiency is weak, and it seems likely that the company will
have to sell investments, borrow money, or issue stock to maintain current
operations or finance future growth.
3. The operating activities section of Lopata’s statement of cash flows shows that
the company reduced its accounts payable by $50,000. This one item more than
offset the effects of all the other items and accounts for Lopata’s operating cash
flow problem and the decline in its cash and cash equivalents. Either Lopata
unnecessarily paid its creditors a large amount, or its creditors have changed
their terms. In the aftermath of the recession of the last few years, it has not
been unusual for creditors to give less favorable terms as credit from banks has
|
tightened.
*Rounded.
686 CHAPTER 15 The Statement of Cash Flows
STOP
& REVIEW
LO1 Describe the principal The statement of cash flows shows how a company’s operating, investing, and
purposes and uses of the financing activities have affected cash during an accounting period. For the state-
statement of cash fl ows, ment of cash flows, cash is defined as including both cash and cash equivalents.
and identify its The primary purpose of the statement is to provide information about a firm’s
cash receipts and cash payments during an accounting period. A secondary pur-
components.
pose is to provide information about a firm’s operating, investing, and financing
activities. Management uses the statement to assess liquidity, determine dividend
policy, and plan investing and financing activities. Investors and creditors use it to
assess the company’s cash-generating ability.
The statement of cash flows has three major classifications: (1) operating
activities, which involve the cash effects of transactions and other events that
enter into the determination of net income; (2) investing activities, which involve
the acquisition and sale of marketable securities and long-term assets and the
making and collecting of loans; and (3) financing activities, which involve obtain-
ing resources from stockholders and creditors and providing the former with a
return on their investments and the latter with repayment. Noncash investing and
financing transactions are also important because they affect future cash flows;
these exchanges of long-term assets or liabilities are of interest to potential inves-
tors and creditors.
LO2 Analyze the statement In examining a firm’s statement of cash flows, analysts tend to focus on cash-
of cash fl ows. generating efficiency and free cash flow. Cash-generating efficiency is a firm’s
ability to generate cash from its current or continuing operations. The ratios used
to measure cash-generating efficiency are cash flow yield, cash flows to sales, and
cash flows to assets. Free cash flow is the cash that remains after deducting the
funds a firm must commit to continue operating at its planned level. These com-
mitments include current and continuing operations, interest, income taxes, divi-
dends, and capital expenditures.
LO3 Use the indirect The indirect method adjusts net income for all items in the income statement that
method to determine do not have cash flow effects (such as depreciation, amortization, and gains and
cash fl ows from operat- losses on sales of assets) and for changes in current assets and current liabilities
ing activities. that affect operating cash flows. Generally, increases in current assets have a nega-
tive effect on cash flows, and decreases have a positive effect. Conversely, increases
in current liabilities have a positive effect on cash flows, and decreases have a
negative effect.
LO4 Determine cash fl ows Investing activities involve the acquisition and sale of property, plant, and equip-
from investing activities. ment and other long-term assets, including long-term investments. They also
involve the acquisition and sale of short-term marketable securities, other than
trading securities, and the making and collecting of loans. Cash flows from invest-
ing activities are determined by analyzing the cash flow effects of changes in each
account related to investing activities. The effects of gains and losses reported on
the income statement must also be considered.
LO5 Determine cash fl ows Determining cash flows from financing activities is almost identical to determining
from fi nancing activities. cash flows from investing activities. The difference is that the accounts analyzed
relate to short-term borrowings, long-term liabilities, and stockholders’ equity.
After the changes in the balance sheet accounts from one accounting period to the
next have been explained, all the cash flow effects should have been identified.
Stop & Review 687
REVIEW of Concepts and Terminology
The following concepts and terms Free cash flow 665 (LO2) Key Ratios
|
were introduced in this chapter:
Indirect method 668 (LO3) Cash flows to assets 664 (L02)
Cash 658 (LO1)
Investing activities 659 (LO1) Cash flows to sales 664 (LO2)
Cash equivalents 658 (LO1)
Noncash investing and financing Cash flow yield 664 (LO2)
Cash-generating transactions 660 (LO1)
efficiency 663 (LO2)
Operating activities 658 (LO1)
Direct method 668 (LO3)
Statement of cash flows 658 (LO1)
Financing activities 660 (LO1)
688 CHAPTER 15 The Statement of Cash Flows
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 Classification of Cash Flow Transactions
SE 1. The list that follows itemizes Furlong Corporation’s transactions. Identify
each as (a) an operating activity, (b) an investing activity, (c) a financing activity,
(d) a noncash transaction, or (e) none of the above.
1. Sold land. 4. Issued common stock for plant assets.
2. Declared and paid a cash dividend. 5. Issued preferred stock.
3. Paid interest. 6. Borrowed cash on a bank loan.
LO2 Cash-Generating Efficiency Ratios and Free Cash Flow
SE 2. In 2011, Ross Corporation had year-end assets of $550,000, sales of
$790,000, net income of $90,000, net cash flows from operating activities
of $180,000, purchases of plant assets of $120,000, and sales of plant assets
of $20,000, and it paid dividends of $40,000. In 2010, year-end assets were
$500,000. Calculate the cash-generating efficiency ratios of cash flow yield, cash
flows to sales, and cash flows to assets. Also calculate free cash flow.
LO2 Cash-Generating Efficiency Ratios and Free Cash Flow
SE 3. Examine the cash flow measures in requirement 2 of the review problem in
this chapter. Discuss the meaning of these ratios.
LO3 Computing Cash Flows from Operating Activities: Indirect Method
SE 4. Wachowski Corporation had a net income of $33,000 during 2010. During
the year, the company had depreciation expense of $14,000. Accounts Receivable
increased by $11,000, and Accounts Payable increased by $5,000. Those were
the company’s only current assets and current liabilities. Use the indirect method
to determine net cash flows from operating activities.
LO3 Computing Cash Flows from Operating Activities: Indirect Method
SE 5. During 2010, Minh Corporation had a net income of $144,000. Included
on its income statement were depreciation expense of $16,000 and amortization
expense of $1,800. During the year, Accounts Receivable decreased by $8,200,
Inventories increased by $5,400, Prepaid Expenses decreased by $1,000, Accounts
Payable decreased by $14,000, and Accrued Liabilities decreased by $1,700. Use
the indirect method to determine net cash flows from operating activities.
LO4 Cash Flows from Investing Activities and Noncash Transactions
SE 6. During 2010, Howard Company purchased land for $375,000. It paid
$125,000 in cash and signed a $250,000 mortgage for the rest. The company
also sold for $95,000 cash a building that originally cost $90,000, on which it
had $70,000 of accumulated depreciation, making a gain of $75,000. Prepare the
cash flows from investing activities section and the schedule of noncash investing
and financing transactions of the statement of cash flows.
LO5 Cash Flows from Financing Activities
SE 7. During 2010, Arizona Company issued $500,000 in long-term bonds
at 96, repaid $75,000 of bonds at face value, paid interest of $40,000, and paid
dividends of $25,000. Prepare the cash flows from the financing activities section
of the statement of cash flows.
Chapter Assignments 689
LO1 LO3 Identifying Components of the Statement of Cash Flows
LO4 LO5 SE 8. Assuming the indirect method is used to prepare the statement of cash
flows, tell whether each of the following items would appear (a) in cash flows from
operating activities, (b) in cash flows from investing activities, (c) in cash flows
from financing activities, (d) in the schedule of noncash investing and financing
transactions, or (e) not on the statement of cash flows at all:
1. Dividends paid 5. Gain on sale of investments
2. Cash receipts from sales 6. Issue of stock for plant assets
|
3. Decrease in accounts receivable 7. Issue of common stock
4. Sale of plant assets 8. Net income
Exercises
LO1 LO2 Discussion Questions
E 1. Develop brief answers to each of the following questions:
1. Which statement is more useful—the income statement or the statement of
cash flows?
2. How would you respond to someone who says that the most important item
on the statement of cash flows is the change in the cash balance for the year?
3. If a company’s cash flow yield is less than 1.0, would its cash flows to sales
and cash flows to assets be greater or less than profit margin and return on
assets, respectively?
LO3 LO4 Discussion Questions
LO5
E 2. Develop brief answers to each of the following questions:
1. If a company has positive earnings, can cash flows from operating activities
ever be negative?
2. Which adjustments to net income in the operating activities section of
the statement of cash flows are directly related to cash flows in other
sections?
3. In computing free cash flow, what is an argument for treating the purchases
of treasury stock like dividend payments?
LO1 Classification of Cash Flow Transactions
E 3. Koral Corporation engaged in the transactions listed below. Identify each
transaction as (a) an operating activity, (b) an investing activity, (c) a financing
activity, (d) a noncash transaction, or (e) not on the statement of cash flows.
(Assume the indirect method is used.)
1. Declared and paid a cash dividend. 7. Increased dividends receivable.
2. Purchased a long-term investment. 8. Issued common stock.
3. Increased accounts receivable. 9. Declared and issued a stock dividend.
4. Paid interest. 10. Repaid notes payable.
5. Sold equipment at a loss. 11. Decreased wages payable.
6. Issued long-term bonds for plant 12. Purchased a 60-day Treasury bill.
assets. 13. Purchased land.
LO2 Cash-Generating Efficiency Ratios and Free Cash Flow
E 4. In 2011, Heart Corporation had year-end assets of $1,200,000, sales of
$1,650,000, net income of $140,000, net cash flows from operating activities of
$195,000, dividends of $60,000, purchases of plant assets of $250,000, and sales
of plant assets of $45,000. In 2010, year-end assets were $1,050,000. Calculate
free cash flow and the cash-generating efficiency ratios of cash flow yield, cash
flows to sales, and cash flows to assets.
690 CHAPTER 15 The Statement of Cash Flows
LO3 Cash Flows from Operating Activities: Indirect Method
E 5. The condensed single-step income statement for the year ended December 31,
2012, of Sunderland Chemical Company, a distributor of farm fertilizers and
herbicides, appears as follows:
Sales $13,000,000
Less: Cost of goods sold $7,600,000
Operating expenses (including
depreciation of $820,000. 3,800,000
Income taxes expense 400,000 11,800,000
Net income $ 1,200,000
Selected accounts from Sunderland Chemical Company’s balance sheets for
2012 and 2011 are as follows:
2012 2011
Accounts receivable $2,400,000 $1,700,000
Inventory 840,000 1,020,000
Prepaid expenses 260,000 180,000
Accounts payable 960,000 720,000
Accrued liabilities 60,000 100,000
Income taxes payable 140,000 120,000
Present in good form a schedule of cash flows from operating activities using the
indirect method.
LO3 Computing Cash Flows from Operating Activities: Indirect Method
E 6. During 2010, Diaz Corporation had net income of $41,000. Included on its
income statement were depreciation expense of $2,300 and amortization expense
of $300. During the year, Accounts Receivable increased by $3,400, Inventories
decreased by $1,900, Prepaid Expenses decreased by $200, Accounts Payable
increased by $5,000, and Accrued Liabilities decreased by $450. Determine net
cash flows from operating activities using the indirect method.
LO3 Preparing a Schedule of Cash Flows from Operating
Activities: Indirect Method
E 7. For the year ended June 30, 2011, net income for Silk Corporation was
$7,400. Depreciation expense was $2,000. During the year, Accounts Receivable
increased by $4,400, Inventories increased by $7,000, Prepaid Rent decreased
by $1,400, Accounts Payable increased by $14,000, Salaries Payable increased by
|
$1,000, and Income Taxes Payable decreased by $600. Use the indirect method
to prepare a schedule of cash flows from operating activities.
LO4 Computing Cash Flows from Investing Activities: Investments
E 8. CUD Company’s T account for long-term available-for-sale investments at
the end of 2010 is as follows:
Investments
Dr. Cr.
Beg. Bal. 152,000 Sales 156,000
Purchases 232,000
End. Bal. 228,000
In addition, CUD Company’s income statement shows a loss on the sale of invest-
ments of $26,000. Compute the amounts to be shown as cash flows from invest-
ing activities, and show how they are to appear in the statement of cash flows.
Chapter Assignments 691
LO4 Computing Cash Flows from Investing Activities: Plant Assets
E 9. The T accounts for plant assets and accumulated depreciation for CUD
Company at the end of 2010 are as follows:
Plant Assets Accumulated Depreciation
Dr. Cr. Dr. Cr.
Beg. Bal. 260,000 Disposals 92,000 Disposals 58,800 Beg. Bal. 138,000
Purchases 134,400 Depreciation 40,800
End. Bal. 302,400 End. Bal. 120,000
In addition, CUD Company’s income statement shows a gain on sale of
plant assets of $17,600. Compute the amounts to be shown as cash flows from invest-
ing activities, and show how they are to appear on the statement of cash flows.
LO5 Determining Cash Flows from Financing Activities: Notes Payable
E 10. All transactions involving Notes Payable and related accounts of Pearl Com-
pany during 2010 are as follows:
Dr. Cr.
Cash 18,000
Notes Payable 18,000
Bank loan
Dr. Cr.
Patent 30,000
Notes Payable 30,000
Purchase of patent by issuing note payable
Dr. Cr.
Notes Payable 5,000
Interest Expense 500
Cash 5,500
Repayment of note payable at maturity
Determine the amounts of the transactions affecting financing activities and show
how they are to appear on the statement of cash flows for 2010.
LO3 LO4 Preparing the Statement of Cash Flows: Indirect Method
LO5
E 11. Olbrot Corporation’s income statement for the year ended June 30, 2012,
and its comparative balance sheets for June 30, 2012 and 2011 appear below and
on the following page.
Olbrot Corporation
Income Statement
For the Year Ended June 30, 2012
Sales $244,000
Cost of goods sold 148,100
Gross margin $ 95,900
Operating expenses 45,000
Operating income $ 50,900
Interest expense 2,800
Income before income taxes $ 48,100
Income taxes expense 12,300
Net income $ 35,800
692 CHAPTER 15 The Statement of Cash Flows
Olbrot Corporation
Comparative Balance Sheets
June 30, 2012 and 2011
2012 2011
Assets
Cash $139,800 $ 25,000
Accounts receivable (net) 42,000 52,000
Inventory 86,800 96,800
Prepaid expenses 6,400 5,200
Furniture 110,000 120,000
Accumulated depreciation–furniture (18,000) (10,000)
Total assets $367,000 $289,000
Liabilities and Stockholders’ Equity
Accounts payable $ 26,000 $ 28,000
Income taxes payable 2,400 3,600
Notes payable (long-term) 74,000 70,000
Common stock, $10 par value 230,000 180,000
Retained earnings 34,600 7,400
Total liabilities and stockholders’ equity $367,000 $289,000
Olbrot issued a $44,000 note payable for purchase of furniture; sold at carry-
ing value furniture that cost $54,000 with accumulated depreciation of $30,600;
recorded depreciation on the furniture for the year, $38,600; repaid a note in
the amount of $40,000; issued $50,000 of common stock at par value; and paid
dividends of $8,600. Prepare Olbrot’s statement of cash flows for the year 2012
using the indirect method.
Problems
LO1 Classification of Cash Flow Transactions
P 1. Analyze each transaction listed in the table that follows and place X’s in the
appropriate columns to indicate the transaction’s classification and its effect on
cash flows using the indirect method.
Cash Flow Classification Effect on Cash Flows
Operating Investing Financing Noncash No
Transaction Activity Activity Activity Transaction Increase Decrease Effect
1. Paid a cash dividend.
2. Decreased accounts
receivable.
3. Increased inventory.
4. Incurred a net loss.
5. Declared and issued a
stock dividend.
6. Retired long-term debt
with cash.
7. Sold available-for-sale
securities at a loss.
(continued)
Chapter Assignments 693
|
Cash Flow Classification Effect on Cash Flows
Operating Investing Financing Noncash No
Transaction Activity Activity Activity Transaction Increase Decrease Effect
8. Issued stock for equipment.
9. Decreased prepaid
insurance.
10. Purchased treasury stock
with cash.
11. Retired a fully depreciated
truck (no gain or loss).
12. I ncreased interest payable.
13. Decreased dividends
receivable on investment.
14. Sold treasury stock.
15. Increased income taxes
payable.
16. Transferred cash to money
market account.
17. Purchased land and
building with a mortgage.
LO1 LO2 Interpreting and Analyzing the Statement of Cash Flows
P 2. The comparative statements of cash flows for Executive Style Corporation, a
manufacturer of high-quality suits for men, appear on the next page. To expand
its markets and familiarity with its brand, the company attempted a new strategic
diversification in 2011 by acquiring a chain of retail men’s stores in outlet malls.
Its plan was to expand in malls around the country, but department stores viewed
the action as infringing on their territory.
Required
Evaluate the success of the company’s strategy by answering the questions that
follow.
1. What are the primary reasons cash flows from operating activities differ from
net income? What is the effect on the acquisition in 2009? What conclusions
can you draw from the changes in 2010?
2. Compute free cash flow for both years. What was the total cost of the acqui-
sition? Was the company able to finance expansion in 2009 by generating
internal cash flow? What was the situation in 2010?
User insight (cid:2) 3. What are the most significant financing activities in 2009? How did the com-
pany finance the acquisition? Do you think this is a good strategy? What
other issues might you question in financing activities?
User insight (cid:2) 4. Based on results in 2010, what actions was the company forced to take and
what is your overall assessment of the company’s diversification strategy?
694 CHAPTER 15 The Statement of Cash Flows
Executive Style Corporation
Statement of Cash Flows
For the Years Ended December 31, 2011 and 2010
(In thousands) 2011 2010
Cash flows from operating activities
Net income (loss) ($ 21,545) $ 38,015
Adjustments to reconcile net income
to net cash flows from operating activities
Depreciation 35,219 25,018
Loss on closure of retail outlets 35,000
Changes in current assets and current liabilities
Decrease (increase) in accounts receivable 50,000 (44,803)
Decrease (increase) in inventory 60,407 (51,145)
Decrease (increase) in prepaid expenses 1,367 2,246
Increase (decrease) in accounts payable 30,579 1,266
Increase (decrease) in accrued liabilities 1,500 (2,788)
Increase (decrease) in income taxes payable (8,300) (6,281)
$205,772 ($ 76,487)
Net cash flows from operating activities $184,227 ($ 38,472)
Cash flows from investing activities
Capital expenditures, net ($ 16,145) ($ 33,112)
Purchase of Retail Division, cash portion — (201,000)
Net cash flows from investing activities ($ 16,145) ($ 234,112)
Cash flows from financing activities
Increase (decrease) in notes payable to banks ($123,500) $228,400
Reduction in long-term debt (9,238) (10,811)
Payment of dividends (22,924) (19,973)
Purchase of treasury stock — (12,500)
Net cash flows from financing activities ($155,662) $185,116
Net increase (decrease) in cash $ 12,420 ($ 87,468)
Cash at beginning of year 16,032 103,500
Cash at end of year $ 28,452 $ 16,032
Schedule of Noncash Investing and Financing Transactions
Issue of bonds payable for retail acquisition $ 50,000
LO2 LO3 Statement of Cash Flows: Indirect Method
LO4 LO5 P 3. The comparative balance sheets for Alvin Arts, Inc., for December 31, 2011
and 2009 appear on the opposite page. Additional information about Alvin Arts’s
operations during 2010 is as follows: (a) net income, $28,000; (b) building and
equipment depreciation expense amounts, $15,000 and $3,000, respectively;
(c) equipment that cost $13,500 with accumulated depreciation of $12,500 sold
at a gain of $5,300; (d) equipment purchases, $12,500; (e) patent a mortization,
|
$3,000; purchase of patent, $1,000; (f) funds borrowed by issuing notes pay-
able, $25,000; notes payable repaid, $15,000; (g) land and building purchased
for $162,000 by signing a mortgage for the total cost; (h) 1,500 shares of
$20 par value common stock issued for a total of $50,000; and (i) paid cash
dividends, $9,000.
Chapter Assignments 695
Alvin Arts, Inc.
Comparative Balance Sheets
December 31, 2010 and 2009
2010 2009
Assets
Cash $ 94,560 $ 27,360
Accounts receivable (net) 102,430 75,430
Inventory 112,890 137,890
Prepaid expenses — 20,000
Land 25,000 —
Building 137,000 —
Accumulated depreciation–building (15,000) —
Equipment 33,000 34,000
Accumulated depreciation–equipment (14,500) (24,000)
Patents 4,000 6,000
Total assets $479,380 $276,680
Liabilities and Stockholders’ Equity
Accounts payable $ 10,750 $ 36,750
Notes payable (current) 10,000 —
Accrued liabilities — 12,300
Mortgage payable 162,000 —
Common stock, $10 par value 180,000 150,000
Additional paid-in capital 57,200 37,200
Retained earnings 59,430 40,430
Total liabilities and stockholders’ equity $479,380 $276,680
Required
1. Using the indirect method, prepare a statement of cash flows for Alvin Arts,
Inc.
User insight (cid:2) 2. Why did Alvin Arts have an increase in cash of $67,200 when it recorded net
income of only $28,000? Discuss and interpret.
User insight (cid:2) 3. Compute and assess cash flow yield and free cash flow for 2010. What is your
assessment of Alvin’s cash-generating ability?
LO2 LO3 Statement of Cash Flows: Indirect Method
LO4 LO5
P 4. The comparative balance sheets for Lopez Tools, Inc., for December 31,
2010 and 2009, are at the top of the next page. During 2010, the company
had net income of $48,000 and building and equipment depreciation expenses
of $40,000 and $30,000, respectively. It amortized intangible assets in the
amount of $10,000; purchased investments for $58,000; sold investments for
$75,000, on which it recorded a gain of $17,000; issued $120,000 of long-
term bonds at face value; purchased land and a warehouse through a $160,000
mortgage; paid $20,000 to reduce the mortgage; borrowed $30,000 by issu-
ing notes payable; repaid notes payable in the amount of $90,000; declared
and paid cash dividends in the amount of $18,000; and purchased treasury
stock in the amount of $10,000.
696 CHAPTER 15 The Statement of Cash Flows
Lopez Tools, Inc.
Comparative Balance Sheets
December 31, 2010 and 2009
2010 2009
Assets
Cash $ 128,800 $ 152,800
Accounts receivable (net) 369,400 379,400
Inventory 480,000 400,000
Prepaid expenses 7,400 13,400
Long-term investments 220,000 220,000
Land 180,600 160,600
Building 600,000 460,000
Accumulated depreciation–building (120,000) (80,000)
Equipment 240,000 240,000
Accumulated depreciation–equipment (58,000) (28,000)
Intangible assets 10,000 20,000
Total assets $2,058,200 $1,938,200
Liabilities and Stockholders’ Equity
Accounts payable $ 235,400 $ 330,400
Notes payable (current) 20,000 80,000
Accrued liabilities 5,400 10,400
Mortgage payable 540,000 400,000
Bonds payable 500,000 380,000
Common stock 650,000 650,000
Additional paid-in capital 40,000 40,000
Retained earnings 127,400 97,400
Treasury stock (60,000) (50,000)
Total liabilities and stockholders’ equity $2,058,200 $1,938,200
Required
1. Using the indirect method, prepare a statement of cash flows for Lopez
Tools, Inc.
User insight (cid:2) 2. Why did Lopez Tools experience a decrease in cash in a year in which it had
a net income of $48,000? Discuss and interpret.
User insight (cid:2) 3. Compute and assess cash flow yield and free cash flow for 2010. Why is each
of these measures important in assessing cash-generating ability?
LO2 LO3 Statement of Cash Flows: Indirect Method
LO4 LO5
P 5. Wu Company’s income statement for the year ended December 31, 2011,
and its comparative balance sheets as of December 31, 2011 and 2010, are
presented on the next page. During 2011, Wu Company engaged in these
transactions:
a. Sold at a gain of $7,000 furniture and fixtures that cost $35,600, on which
it had accumulated depreciation of $28,800.
b. Purchased furniture and fixtures in the amount of $39,600.
|
c. Paid a $20,000 note payable and borrowed $40,000 on a new note.
d. Converted bonds payable in the amount of $100,000 into 4,000 shares of
common stock.
e. Declared and paid $6,000 in cash dividends.
Chapter Assignments 697
Wu Company
Income Statement
For the Year Ended December 31, 2011
Sales $1,609,000
Cost of goods sold 1,127,800
Gross margin $ 481,200
Operating expenses (including depreciation
expense of $46,800) 449,400
Income from operations $ 31,800
Other income (expenses)
Gain on sale of furniture and fixtures $ 7,000
Interest expense (23,200) (16,200)
Income before income taxes $ 15,600
Income taxes expense 4,600
Net income $ 11,000
Wu Company
Comparative Balance Sheets
December 31, 2011 and 2010
2011 2010
Assets
Cash $164,800 $ 50,000
Accounts receivable (net) 165,200 200,000
Merchandise inventory 350,000 450,000
Prepaid rent 2,000 3,000
Furniture and fixtures 148,000 144,000
Accumulated depreciation–furniture and fixtures (42,000) (24,000)
Total assets $788,000 $823,000
Liabilities and Stockholders’ Equity
Accounts payable $143,400 $200,400
Income taxes payable 1,400 4,400
Notes payable (long-term) 40,000 20,000
Bonds payable 100,000 200,000
Common stock, $20 par value 240,000 200,000
Additional paid-in capital 181,440 121,440
Retained earnings 81,760 76,760
Total liabilities and stockholders’ equity $788,000 $823,000
Required
1. Using the indirect method, prepare a statement of cash flows for Wu Com-
pany. Include a supporting schedule of noncash investing transactions and
financing transactions.
User insight (cid:2) 2. What are the primary reasons for Wu Company’s large increase in cash from
2010 to 2011, despite its low net income?
User insight (cid:2) 3. Compute and assess cash flow yield and free cash flow for 2011. Compare
and contrast what these two performance measures tell you about Wu Com-
pany’s cash-generating ability.
698 CHAPTER 15 The Statement of Cash Flows
Alternate Problems
LO1 Classification of Cash Flow Transactions
P 6. Analyze each transaction listed in the table that follows and place X’s in the
appropriate columns to indicate the transaction’s classification and its effect on
cash flows using the indirect method.
Cash Flow Classification Effect on Cash Flows
Operating Investing Financing Noncash No
Transaction Activity Activity Activity Transaction Increase Decrease Effect
1. Increased accounts payable.
2. Decreased inventory.
3. Increased prepaid insurance.
4. Earned a net income.
5. Declared and paid a cash
dividend.
6. Issued stock for cash.
7. Retired long-term debt by
issuing stock.
8. Purchased a long-term
investment with cash.
9. Sold trading securities at
a gain.
10. Sold a machine at a loss.
11. Retired fully depreciated
equipment.
12. Decreased interest payable.
13. Purchased available-for-sale
securities (long-term).
14. Decreased dividends
receivable.
15. Decreased accounts
receivable.
16. Converted bonds to
common stock.
17. Purchased 90-day
Treasury bill.
LO2 LO3 Statement of Cash Flows: Indirect Method
LO4 LO5 P 7. Ortega Corporation’s income statement for the year ended June 30, 2011, and
its comparative balance sheets as of June 30, 2011 and 2010, appear on the next
page. During 2011, the corporation sold at a loss of $4,000 equipment that cost
$24,000, on which it had accumulated depreciation of $17,000. It also purchased
land and a building for $100,000 through an increase of $100,000 in Mortgage
Payable; made a $20,000 payment on the mortgage; repaid $80,000 in notes but
borrowed an additional $30,000 through the issuance of a new note payable; and
declared and paid a $60,000 cash dividend.
Chapter Assignments 699
Ortega Corporation
Income Statement
For the Year Ended June 30, 2011
Sales $4,040,900
Cost of goods sold 3,656,300
Gross margin $ 384,600
Operating expenses (including
depreciation expense of $60,000) 189,200
Income from operations $ 195,400
Other income (expenses)
Loss on sale of equipment ($ 4,000)
Interest expense (37,600) (41,600)
Income before income taxes $ 153,800
Income taxes expense 34,200
Net income $ 119,600
Ortega Corporation
Comparative Balance Sheets
June 30, 2011 and 2010
2011 2010
Assets
|
Cash $ 167,000 $ 20,000
Accounts receivable (net) 100,000 120,000
Inventory 180,000 220,000
Prepaid expenses 600 1,000
Property, plant, and equipment 628,000 552,000
Accumulated depreciation–property,
plant, and equipment (183,000) (140,000)
Total assets $ 892,600 $ 773,000
Liabilities and Stockholders’ Equity
Accounts payable $ 64,000 $ 42,000
Notes payable (due in 90 days) 30,000 80,000
Income taxes payable 26,000 18,000
Mortgage payable 360,000 280,000
Common stock, $5 par value 200,000 200,000
Retained earnings 212,600 153,000
Total liabilities and stockholders’ equity $ 892,600 $ 773,000
Required
1. Using the indirect method, prepare a statement of cash flows. Include a sup-
porting schedule of noncash investing and financing transactions.
User insight (cid:2) 2. What are the primary reasons for Ortega Corporation’s large increase in cash
from 2010 to 2011?
User insight (cid:2) 3. Compute and assess cash flow yield and free cash flow for 2011. How would
you assess the corporation’s cash-generating ability?
LO2 LO3 Statement of Cash Flows: Indirect Method
LO4 LO5
P 8. The comparative balance sheets for Sharma Fabrics, Inc., for December 31,
2011 and 2010, appear on the next page. Additional information about Sharma
Fabrics’ operations during 2011 is as follows: (a) net income, $56,000; (b) b uilding
700 CHAPTER 15 The Statement of Cash Flows
and equipment depreciation expense amounts, $30,000 and $6,000, respectively;
(c) equipment that cost $27,000 with accumulated depreciation of $25,000 sold
at a gain of $10,600; (d) equipment purchases, $25,000; (e) patent amortization,
$6,000; purchase of patent, $2,000; (f) funds borrowed by issuing notes pay-
able, $50,000; notes payable repaid, $30,000; (g) land and building purchased for
$324,000 by signing a mortgage for the total cost; (h) 3,000 shares of $20 par value
common stock issued for a total of $100,000; and (i) paid cash dividend, $18,000.
Sharma Fabrics, Inc.
Comparative Balance Sheets
December 31, 2011 and 2010
2011 2010
Assets
Cash $189,120 $ 54,720
Accounts receivable (net) 204,860 150,860
Inventory 225,780 275,780
Prepaid expenses — 40,000
Land 50,000 —
Building 274,000 —
Accumulated depreciation–building (30,000) —
Equipment 66,000 68,000
Accumulated depreciation–equipment (29,000) (48,000)
Patents 8,000 12,000
Total assets $958,760 $553,360
Liabilities and Stockholders’ Equity
Accounts payable $ 21,500 $ 73,500
Notes payable (current) 20,000 —
Accrued liabilities — 24,600
Mortgage payable 324,000 —
Common stock, $10 par value 360,000 300,000
Additional paid-in capital 114,400 74,400
Retained earnings 118,860 80,860
Total liabilities and stockholders’ equity $958,760 $553,360
Required
1. Using the indirect method, prepare a statement of cash flows for Sharma
Fabrics, Inc.
User insight (cid:2) 2. Why did Sharma Fabrics have an increase in cash of $134,400 when it
recorded net income of only $56,000? Discuss and interpret.
User insight (cid:2) 3. Compute and assess cash flow yield and free cash flow for 2011. What is your
assessment of Sharma’s cash-generating ability?
LO2 LO3 Statement of Cash Flows: Indirect Method
LO4 LO5
P 9. The comparative balance sheets for Karidis Ceramics, Inc., for December
31, 2012 and 2011, are presented on the next page. During 2012, the com-
pany had net income of $96,000 and building and equipment depreciation
expenses of $80,000 and $60,000, respectively. It amortized intangible assets
in the amount of $20,000; purchased investments for $116,000; sold invest-
ments for $150,000, on which it recorded a gain of $34,000; issued $240,000
of long-term bonds at face value; purchased land and a warehouse through a
$320,000 mortgage; paid $40,000 to reduce the mortgage; b orrowed $60,000
Chapter Assignments 701
by issuing notes payable; repaid notes payable in the amount of $180,000;
declared and paid cash dividends in the amount of $36,000; and purchased
treasury stock in the amount of $20,000.
Karidis Ceramics, Inc.
Comparative Balance Sheets
December 31, 2012 and 2011
2012 2011
Assets
Cash $ 257,600 $ 305,600
Accounts receivable (net) 738,800 758,800
|
Inventory 960,000 800,000
Prepaid expenses 14,800 26,800
Long-term investments 440,000 440,000
Land 361,200 321,200
Building 1,200,000 920,000
Accumulated depreciation–building (240,000) (160,000)
Equipment 480,000 480,000
Accumulated depreciation–equipment (116,000) (56,000)
Intangible assets 20,000 40,000
Total assets $4,116,400 $3,876,400
Liabilities and Stockholders’ Equity
Accounts payable $ 470,800 $ 660,800
Notes payable (current) 40,000 160,000
Accrued liabilities 10,800 20,800
Mortgage payable 1,080,000 800,000
Bonds payable 1,000,000 760,000
Common stock 1,300,000 1,300,000
Additional paid-in capital 80,000 80,000
Retained earnings 254,800 194,800
Treasury stock (120,000) (100,000)
Total liabilities and stockholders’ equity $4,116,400 $3,876,400
Required
1. Using the indirect method, prepare a statement of cash flows for Karidis
Ceramics, Inc.
User insight (cid:2) 2. Why did Karidis Ceramics experience a decrease in cash in a year in which it
had a net income of $96,000? Discuss and interpret.
User insight (cid:2) 3. Compute and assess cash flow yield and free cash flow for 2012. Why is each
of these measures important in assessing cash-generating ability?
LO2 LO3 Statement of Cash Flows: Indirect Method
LO4 LO5 P 10. O’Brien Corporation’s income statement for the year ended December 31,
2012, and its comparative balance sheets as of December 31, 2012 and 2011, are
presented on the next page. During 2012, O’Brien Corporation engaged in these
transactions:
a. Sold at a gain of $3,500 furniture and fixtures that cost $17,800, on which it
had accumulated depreciation of $14,400.
b. Purchased furniture and fixtures in the amount of $19,800.
c. Paid a $10,000 note payable and borrowed $20,000 on a new note.
702 CHAPTER 15 The Statement of Cash Flows
d. Converted bonds payable in the amount of $50,000 into 2,000 shares of
common stock.
e. Declared and paid $3,000 in cash dividends.
O’Brien Corporation
Income Statement
For the Year Ended December 31, 2012
Sales $804,500
Cost of goods sold 563,900
Gross margin $240,600
Operating expenses (including
depreciation expense of $23,400) 224,700
Income from operations $ 15,900
Other income (expenses)
Gain on sale of furniture and fixtures $ 3,500
Interest expense (11,600) (8,100)
Income before income taxes $ 7,800
Income taxes expense 2,300
Net income $ 5,500
O’Brien Corporation
Comparative Balance Sheets
December 31, 2012 and 2011
2012 2011
Assets
Cash $ 82,400 $ 25,000
Accounts receivable (net) 82,600 100,000
Merchandise inventory 175,000 225,000
Prepaid rent 1,000 1,500
Furniture and fixtures 74,000 72,000
Accumulated depreciation–
furniture and fixtures (21,000) (12,000)
Total assets $394,000 $411,500
Liabilities and Stockholders’ Equity
Accounts payable $ 71,700 $100,200
Income taxes payable 700 2,200
Notes payable (long-term) 20,000 10,000
Bonds payable 50,000 100,000
Common stock, $20 par value 120,000 100,000
Additional paid-in capital 90,720 60,720
Retained earnings 40,880 38,380
Total liabilities and stockholders’ equity $394,000 $411,500
Required
1. Using the indirect method, prepare a statement of cash flows for O’Brien
Corporation. Include a supporting schedule of noncash investing transac-
tions and financing transactions.
User insight (cid:2) 2. What are the primary reasons for O’Brien Corporation’s large increase in
cash from 2011 to 2012, despite its low net income?
User insight (cid:2) 3. Compute and assess cash flow yield and free cash flow for 2012. Compare
and contrast what these two performance measures tell you about O’Brien’s
cash-generating ability.
Chapter Assignments 703
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO1 LO3 EBITDA and the Statement of Cash Flows
C 1. When Fleetwood Enterprises, Inc., a large producer of recreational vehicles
and manufactured housing, warned that it might not be able to generate enough
cash to satisfy debt requirements and could be in default of a loan agreement, its
cash flow, defined in the financial press as “EBITDA” (earnings before interest,
taxes, depreciation, and amortization), was a negative $2.7 million. The company
|
would have had to generate $17.7 million in the next accounting period to com-
ply with the loan terms.12 To what section of the statement of cash flows does
EBITDA most closely relate? Is EBITDA a good approximation for this section
of the statement of cash flows? Explain your answer, which should include an
identification of the major differences between EBITDA and the section of the
statement of cash flows you chose.
LO2 Anatomy of a Disaster
C 2. On October 16, 2001, Kenneth Lay, chairman and CEO of Enron Corpo-
ration, announced the company’s earnings for the first nine months of 2001 as
follows:
Our 26 percent increase in recurring earnings per diluted share shows
the very strong results of our core wholesale and retail energy busi-
nesses and our natural gas pipelines. The continued excellent pros-
pects in these businesses and Enron’s leading market position make
us very confident in our strong earnings outlook.13
Less than six months later, the company filed for the biggest bankruptcy in U.S.
history. Its stock dropped to less than $1 per share, and a major financial scandal
was underway.
Presented on the next page is Enron’s statement of cash flows for the first nine
months of 2001 and 2000 (restated to correct the previous accounting errors).
Assume you report to an investment analyst who has asked you to analyze this
statement for clues as to why the company went under.
1. For the two time periods shown, compute the cash-generating efficiency ratios of
cash flow yield, cash flows to sales (Enron’s revenues were $133,762 million in
2001 and $55,494 million in 2000), and cash flows to assets (use total assets
of $61,783 million for 2001 and $64,926 million for 2000). Also compute
free cash flows for the two years.
2. Prepare a memorandum to the investment analyst that assesses Enron’s cash-
generating efficiency in light of the chairman’s remarks and that evaluates its
available free cash flow, taking into account its financing activities. Identify
significant changes in Enron’s operating items and any special operating items
that should be considered. Include your computations as an attachment.
LO2 Ethics and Cash Flow Classifications
C 3. Specialty Metals, Inc., a fast-growing company that makes metals for equip-
ment manufacturers, has an $800,000 line of credit at its bank. One section in
the credit agreement says that the ratio of cash flows from operations to interest
expense must exceed 3.0. If this ratio falls below 3.0, the company must reduce
the balance outstanding on its line of credit to one-half the total line if the funds
borrowed against the line of credit exceed one-half of the total line.
After the end of the fiscal year, the company’s controller informs the presi-
dent: “We will not meet the ratio requirements on our line of credit in 2010
704 CHAPTER 15 The Statement of Cash Flows
Enron Corporation
Statement of Cash Flows
For the Nine Months Ended September 30, 2001 and 2000
(In millions) 2001 2000
Cash Flows from Operating Activities
Reconciliation of net income to net
cash provided by operating activities
Net income $ 225 $ 797
Cumulative effect of accounting changes, net of tax (19) 0
Depreciation, depletion and amortization 746 617
Deferred income taxes (134) 8
Gains on sales of non-trading assets (49) (135)
Investment losses 768 0
Changes in components of working capital
Receivables 987 (3,363)
Inventories 1 339
Payables (1,764) 2,899
Other 464 (455)
Trading investments
Net margin deposit activity (2,349) 541
Other trading activities 173 (555)
Other, net 198 (566)
Net Cash Provided by (Used in) Operating Activities $ (753) $ 127
Cash Flows from Investing Activities
Capital expenditures $(1,584) $(1,539)
Equity investments (1,172) (858)
Proceeds from sales of non-trading investments 1,711 222
Acquisition of subsidiary stock 0 (485)
Business acquisitions, net of cash acquired (82) (773)
Other investing activities (239) (147)
Net Cash Used in Investing Activities $(1,366) $(3,580)
Cash Flows from Financing Activities
Issuance of long-term debt $ 4,060 $ 2,725
Repayment of long-term debt (3,903) (579)
|
Net increase in short-term borrowings 2,365 1,694
Issuance of common stock 199 182
Net redemption of company-obligated
preferred securities of subsidiaries 0 (95)
Dividends paid (394) (396)
Net (acquisition) disposition of treasury stock (398) 354
Other financing activities (49) (12)
Net Cash Provided by Financing Activities $ 1,880 $ 3,873
Increase (Decrease) in Cash and Cash Equivalents $ (239) $ 420
Cash and Cash Equivalents, Beginning of Period 1,240 333
Cash and Cash Equivalents, End of Period $ 1,001 $ 753
Source: Adapted from Enron Corporation, SEC filings, 2001.
Chapter Assignments 705
because interest expense was $1.2 million and cash flows from operations were
$3.2 million. Also, we have borrowed 100 percent of our line of credit. We do
not have the cash to reduce the credit line by $400,000.”
The president says, “This is a serious situation. To pay our ongoing bills, we
need our bank to increase our line of credit, not decrease it. What can we do?”
“Do you recall the $500,000 two-year note payable for equipment?” replied
the controller. “It is now classified as ‘Proceeds from Notes Payable’ in cash flows
provided from financing activities in the statement of cash flows. If we move it
to cash flows from operations and call it ‘Increase in Payables,’ it would increase
cash flows from operations to $3.7 million and put us over the limit.”
“Well, do it,” ordered the president. “It surely doesn’t make any difference
where it is on the statement. It is an increase in both places. It would be much worse
for our company in the long term if we failed to meet this ratio requirement.”
What is your opinion of the controller and president’s reasoning? Is the
president’s order ethical? Who benefits and who is harmed if the controller fol-
lows the president’s order? What are management’s alternatives? What would
you do?
LO1 LO2 Alternative Uses of Cash
C 4. Perhaps because of hard times in their start-up years, companies in the high-
tech sector of American industry seem more prone than those in other sectors
to building up cash reserves. For example, companies like Cisco Systems, Intel,
Dell, and Oracle have amassed large cash balances.14
Assume you work for a company in the high-tech industry that has built
up a substantial amount of cash. The company is still growing through devel-
opment of new products, has some debt, and has never paid a dividend or
bought treasury stock. The company is doing better than most companies in
the current financial crisis but the company’s stock price is lagging. Outline
at least four strategies for using the company’s cash to improve the company’s
financial outlook.
LO1 Analysis of the Statement of Cash Flows
C 5. Refer to the statement of cash flows in the CVS Corporation annual report in
the Supplement to Chapter 5 to answer the following questions:
1. Does CVS use the indirect method of reporting cash flows from operating
activities? Other than net earnings, what are the most important factors affect-
ing the company’s cash flows from operating activities? Explain the trend of
each of these factors.
2. Based on the cash flows from investing activities, in 2007 and 2008, would
you say that CVS is a contracting or an expanding company? Explain.
3. Has CVS used external financing during 2007 and 2008? If so, where did it
come from?
LO1 LO2 LO3 Cash Flows Analysis
LO4 LO5
C 6. Refer to the annual report of CVS Corporation and the financial statements
of Southwest Airlines in the Supplement to Chapter 5. Calculate for two years
each company’s cash flow yield, cash flows to sales, cash flows to assets, and free
cash flow. At the end of 2006, Southwest’s total assets were $13,460 million and
CVS’s total assets were $20,574.1 million.
Discuss and compare the trends of the cash-generating ability of CVS and
Southwest. Comment on each company’s change in cash and cash equivalents
over the two-year period.
C H A P T E R
16 Financial Performance
Measurement
T he ultimate purpose of financial reporting is to enable man-
Making a
Statement agers, creditors, investors, and other interested parties to
|
evaluate a company’s financial performance. In earlier chapters, we
INCOME STATEMENT
discussed the various measures used in assessing a company’s finan-
Revenues
cial performance; here, we provide a comprehensive summary of
– Expenses
those measures. Because these measures play a key role in executive
= Net Income
compensation, there is always the risk that they will be manipu-
STATEMENT OF lated. Users of financial statements therefore need to be familiar
RETAINED EARNINGS
with the analytical tools and techniques used in performance mea-
Beginning Balance
+ Net Income surement and the assumptions that underlie them.
– Dividends
= Closing Balance
LEARNING OBJECTIVES
BALANCE SHEET
Assets Liabilities
LO1 Describe the objectives, standards of comparison, sources of
information, and compensation issues in measuring financial
Stockholders’
Equity performance. (pp. 708–714)
A = L + OE
LO2 Apply horizontal analysis, trend analysis, vertical analysis, and
ratio analysis to financial statements. (pp. 715–722)
STATEMENT OF CASH FLOWS
Operating activities
+ Investing activities LO3 Apply ratio analysis to financial statements in a comprehensive
+ Financing activities
= Change in Cash evaluation of a company’s financial performance. (pp. 722–730)
+ Beginning Balance
= Ending Cash Balance
Comparisons within and
across financial statements
help the users of financial
statements assess financial
performance.
706
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) What analytical tools can Maggie
Washington use to measure the
WASHINGTON
financial performance of Quik
INVESTMENTS
Burger and Big Steak?
(cid:2) What standards can she use to
compare the performance of
Having studied the eating habits of Americans for several months,
the two companies?
Maggie Washington, president of Washington Investments, has con-
cluded that there is a trend toward eating out and that the trend will
continue. She is therefore planning to invest in a fast-food restau-
rant chain, and she has narrowed her choice to two companies: Quik
Burger and Big Steak. She is now thinking about how she should
evaluate these companies and thus arrive at her final decision.
In this chapter, we discuss the various analytical tools and stan-
dards that Maggie can use to measure and compare the financial
performance of the two companies.
707
708 CHAPTER 16 Financial Performance Measurement
Foundations
Financial performance measurement, also called financial statement analysis,
of Financial uses all the techniques available to show how important items in a company’s
financial statements relate to the company’s financial objectives. Persons with
Performance
a strong interest in measuring a company’s financial performance fall into two
Measurement groups:
1. A company’s top managers, who set and strive to achieve financial perfor-
LO1 Describe the objectives,
mance objectives; middle-level managers of business processes; and lower-
standards of comparison,
level employees who own stock in the company
sources of information, and com-
pensation issues in measuring 2. Creditors and investors, as well as customers who have cooperative agree-
financial performance. ments with the company
Financial Performance Measurement:
Management’s Objectives
All the strategic and operating plans that management formulates to achieve
a company’s goals must eventually be stated in terms of financial objectives.
A primary objective is to increase the wealth of the company’s stockholders, but
this objective must be divided into categories. A complete financial plan should
have financial objectives and related performance objectives in all the following
categories:
Financial Objective Performance Objective
Liquidity T he company must be able to pay bills when due
and meet unexpected needs for cash.
Profitability It must earn a satisfactory net income.
Long-term solvency It must be able to survive for many years.
Cash flow adequacy I t must generate sufficient cash through operating,
investing, and financing activities.
Market strength I t must be able to increase stockholders’ wealth.
Management’s main responsibility is to carry out its plan to achieve the com-
|
pany’s financial objectives. This requires constant monitoring of key financial per-
formance measures for each objective listed above, determining the cause of any
deviations from the measures, and proposing ways of correcting the deviations.
Management compares actual performance with the key performance measures in
monthly, quarterly, and annual reports. The information in management’s annual
reports provides data for long-term trend analyses.
Financial Performance Measurement:
Creditors’ and Investors’ Objectives
Creditors and investors use financial performance evaluation to judge a company’s
past performance and present position. They also use it to assess a company’s
future potential and the risk connected with acting on that potential. An inves-
tor focuses on a company’s potential earnings ability because that ability will
affect the market price of the company’s stock and the amount of dividends the
company will pay. A creditor focuses on the company’s potential debt-paying
ability.
Past performance is often a good indicator of future performance. To evalu-
ate a company’s past performance, creditors and investors look at trends in past
sales, expenses, net income, cash flow, and return on investment. To evaluate its
Foundations of Financial Performance Measurement 709
current position, they look at its assets, liabilities, cash position, debt in relation
to equity, and levels of inventories and receivables. Knowing a company’s past
performance and current position can be important in judging its future potential
and the related risk.
The risk involved in making an investment or loan depends on how easy it is
to predict future profitability or liquidity. If an investor can predict with confi-
dence that a company’s earnings per share will be between $2.50 and $2.60 in the
next year, the investment is less risky than if the earnings per share are expected
to fall between $2.00 and $3.00. For example, the potential of an investment in
an established electric utility company is relatively easy to predict on the basis of
the company’s past performance and current position. In contrast, the potential
of an investment in a new Internet firm that has not yet established a record of
earnings is very hard to predict. Investing in the Internet firm is therefore riskier
than investing in the electric utility company.
In return for taking a greater risk, investors often look for a higher expected
return (an increase in market price plus dividends). Creditors who take a greater risk
by advancing funds to a company like the new Internet firm mentioned above may
demand a higher interest rate and more assurance of repayment (a secured loan, for
instance). The higher interest rate reimburses them for assuming the higher risk.
Standards of Comparison
When analyzing financial statements, decision makers must judge whether the
relationships they find in the statements are favorable or unfavorable. Three stan-
dards of comparison that they commonly use are rule-of-thumb measures, a com-
pany’s past performance, and industry norms.
Rule-of-Thumb Measures Many financial analysts, investors, and lenders
Study Note
apply general standards, or rule-of-thumb measures, to key financial ratios. For
Rules of thumb evolve and example, most analysts today agree that a current ratio (current assets divided by
change as the business current liabilities) of 2:1 is acceptable.
environment changes. Not long In its Industry Norms and Key Business Ratios, the credit-rating firm of
ago, an acceptable current ratio Dun & Bradstreet offers such rules of thumb as the following:
was higher than today’s 2:1.
Current debt to tangible net worth: A business is usually in trouble when this
relationship exceeds 80 percent.
Inventory to net working capital: Ordinarily, this relationship should not
exceed 80 percent.
Although rule-of thumb measures may suggest areas that need further inves-
tigation, there is no proof that the levels they specify apply to all companies.
A company with a current ratio higher than 2:1 may have a poor credit policy
|
(causing accounts receivable to be too large), too much inventory, or poor cash
management. Another company may have a ratio lower than 2:1 but still have
excellent management in all three of those areas. Thus, rule-of-thumb measures
must be used with caution.
Past Performance Comparing financial measures or ratios of the same com-
pany over time is an improvement over using rule-of-thumb measures. Such a
comparison gives the analyst some basis for judging whether the measure or ratio
is getting better or worse. Thus, it may be helpful in showing future trends. How-
ever, trends reverse at times, so such projections must be made with care.
Another problem with trend analysis is that past performance may not be
enough to meet a company’s present needs. For example, even though a company
710 CHAPTER 16 Financial Performance Measurement
FOCUS ON BUSINESS PRACTICE
Look Carefully at the Numbers
In recent years, companies have increasingly used pro forma c ompanies from giving more prominence to non-GAAP mea-
statements—statements as they would appear without cer- sures and from using terms that are similar to GAAP mea-
tain items—as a way of presenting a better picture of their sures.1 Nevertheless, companies still report pro forma results.
operations than would be the case in reports prepared under A common practice used by such companies as Google,
GAAP. In one quarter, Amazon.com reported a “pro forma eBay, and Starbucks is to provide in the notes to the finan-
net” loss of $76 million; under GAAP, its net loss was $234 cial statements income as it would be without the expense
million. Pro forma statements, which are unaudited, have related to compensation for stock options.2 Analysts should
come to mean whatever a company’s management wants rely exclusively on financial statements that are prepared
them to mean. As a result, the SEC issued rules that prohibit using GAAP and that are audited by an independent CPA.
improves its return on investment from 3 percent in one year to 4 percent the
next year, the 4 percent return may not be adequate for the company’s current
needs. In addition, using a company’s past performance as a standard of compari-
son is not helpful in judging its performance relative to that of other companies.
Industry Norms Using industry norms as a standard of comparison overcomes
some of the limitations of comparing a company’s measures or ratios over time.
Industry norms show how a company compares with other companies in the
same industry. For example, if companies in a particular industry have an average
rate of return on investment of 8 percent, a 3 or 4 percent rate of return is prob-
ably not adequate.
Industry norms can also be used to judge trends. Suppose that because of a
downturn in the economy, a company’s profit margin dropped from 12 percent
to 10 percent, while the average drop in profit margin of other companies in the
same industry was from 12 to 4 percent. By this standard, the company would
have done relatively well. Sometimes, instead of industry averages, data for the
industry leader or a specific competitor are used for analysis.
Using industry norms as standards has three limitations:
1. Companies in the same industry may not be strictly comparable. Consider
two companies in the oil industry. One purchases oil products and markets
them through service stations. The other, an international company, discov-
ers, produces, refines, and markets its own oil products. Because of the dis-
parity in their operations, these two companies cannot be directly compared.
2. Many large companies have multiple segments and operate in more than one
Study Note
industry. Some of these diversified companies, or conglomerates, operate in
many unrelated industries. The individual segments of a diversified company
Each segment of a diversified
company represents an generally have different rates of profitability and different degrees of risk. In
investment that the home office analyzing a diversified company’s consolidated financial statements, it is often
or parent company evaluates impossible to use industry norms as a standard because there simply are no
|
and reviews frequently. comparable companies.
The FASB provides a partial solution to this problem. It requires diver-
sified companies to report profit or loss, certain revenue and expense items,
and assets for each of their segments. Segment information may be reported
for operations in different industries or different geographical areas, or for
Foundations of Financial Performance Measurement 711
EXHIBIT 16-1
(In millions) 2008 2007 2006
Selected Segment Information for
Sales
Goodyear Tire & Rubber Company
North American Tire $ 8,255 $ 8,862 $ 9,089
Europe, Middle East and Africa Tire 7,316 7,217 6,552
Latin American Tire 2,088 1,872 1,607
Asia Pacific Tire 1,829 1,693 1,503
Net Sales $19,488 $19,644 $18,751
Segment Operating Income
North American Tire ($ 156) $ 139 ($ 233)
Europe, Middle East and Africa Tire 425 582 513
Latin American Tire 367 359 326
Asia Pacific Tire 168 150 104
Total Segment Operating Income $ 804 $ 1,230 $ 710
Assets*
North American Tire $ 5,514 $ 5,307 $ 4,798
Europe, Middle East and Africa Tire 5,707 6,020 5,758
Latin American Tire 1,278 1,265 986
Asia Pacific Tire 1,408 1,394 1,236
Total Segment Assets $13,907 $13,986 $12,778
Corporate 1,319 3,205 —
Engineered Products — — 794
Total Assets $15,226 $17,191 $13,572
*2006 assets estimated.
Source: Goodyear Tire & Rubber Company, Annual Report, 2008.
major customers.3 Exhibit 16-1 shows how Goodyear Tire & Rubber Com-
pany reports data on sales, income, and assets for its four business segments.
These data allow the analyst to compute important profitability performance
measures, such as profit margin, asset turnover, and return on assets, for each
segment and to compare them with the appropriate industry norms.
3. Another limitation of industry norms is that even when companies in the
same industry have similar operations, they may use different acceptable
accounting procedures. For example, they may use different methods of valu-
ing inventories and different methods of depreciating assets.
Despite these limitations, if little information about a company’s past perfor-
mance is available, industry norms probably offer the best available standards for
judging current performance—as long as they are used with care.
Sources of Information
The major sources of information about public corporations are reports published
by the corporations themselves, reports filed with the SEC, business periodicals,
and credit and investment advisory services.
Reports Published by the Corporation A public corporation’s annual
report is an important source of financial information. From a financial ana-
lyst’s perspective, the main parts of an annual report are management’s analysis
of the past year’s operations; the financial statements; the notes to the financial
712 CHAPTER 16 Financial Performance Measurement
statements, which include a summary of significant accounting policies; the audi-
tors’ report; and financial highlights for a five- or ten-year period.
Most public corporations also publish interim financial statements each
quarter and sometimes each month. These reports, which present limited infor-
mation in the form of condensed financial statements, are not subject to a full
audit by an independent auditor. The financial community watches interim state-
ments closely for early signs of change in a company’s earnings trend.
Reports Filed with the SEC Public corporations in the United States must
file annual reports, quarterly reports, and current reports with the Securities
and Exchange Commission (SEC). If they have more than $10 million in assets
and more than 500 shareholders, they must file these reports electronically at
www.sec.gov/edgar.shtml, where anyone can access them free of charge.
The SEC requires companies to file their annual reports on a standard form,
called Form 10-K. Form 10-K contains more information than a company’s annual
report and is therefore a valuable source of information. Companies file their
quarterly reports with the SEC on Form 10-Q. This report presents important
facts about interim financial performance. The current report, filed on Form 8-K,
|
must be submitted to the SEC within a few days of the date of certain significant
events, such as the sale or purchase of a division or a change in auditors. The cur-
rent report is often the first indicator of significant changes that will affect a com-
pany’s financial performance in the future.
Business Periodicals and Credit and Investment Advisory Services
Financial analysts must keep up with current events in the financial world. A lead-
ing source of financial news is The Wall Street Journal. It is the most complete
financial newspaper in the United States and is published every business day. Use-
ful periodicals that are published every week or every two weeks include Forbes,
Barron’s, Fortune, and the Financial Times.
Credit and investment advisory services also provide useful information. The pub-
lications of Moody’s Investors Service and Standard & Poor’s provide details about a
company’s financial history. Data on industry norms, average ratios, and credit ratings
are available from agencies like Dun & Bradstreet. Dun & Bradstreet’s Industry Norms
and Key Business Ratios offers an annual analysis of 14 ratios for each of 125 industry
groups, classified as retailing, wholesaling, manufacturing, and construction. Annual
Statement Studies, published by Risk Management Association (formerly Robert
Morris Associates), presents many facts and ratios for 223 different industries. The
publications of a number of other agencies are also available for a yearly fee.
An example of specialized financial reporting readily available to the pub-
lic is Mergent’s Handbook of Dividend Achievers. It profiles companies that have
increased their dividends consistently over the past ten years. A listing from that
publication—for PepsiCo Inc.—is shown in Exhibit 16-2. As you can see, a wealth
of information about the company, including the market action of its stock, its
business operations, recent developments and prospects, and earnings and dividend
data, is summarized on one page. We use the kind of data contained in Mergent’s
summaries in many of the analyses and ratios that we present later in this chapter.
Executive Compensation
As we noted earlier in the text, one intent of the Sarbanes-Oxley Act of 2002 was
to strengthen the corporate governance of public corporations. Under this act,
a public corporation’s board of directors must establish a compensation com-
mittee made up of independent directors to determine how the company’s top
executives will be compensated. The company must disclose the components of
Foundations of Financial Performance Measurement 713
EXHIBIT 16-2 Listing from Mergent’s Dividend Achievers
Source: PepsiCo
listing from
Mergent’s Dividend
Achievers Fall 2007:
Featuring Second-
Quarter Results for
2007. Reprinted by
permission of John
Wiley & Sons Inc.
714 CHAPTER 16 Financial Performance Measurement
compensation and the criteria it uses to remunerate top executives in documents
that it files with the SEC.
Formed in 1985, Starbucks is today a well-known specialty retailer. Star-
bucks provides its executives with incentives to improve the company’s perfor-
mance. Compensation and financial performance are thus linked to increasing
shareholders’ value. The components of Starbucks’ compensation of executive
officers are typical of those used by many companies:
(cid:2) Annual base salary
(cid:2) Incentive bonuses
(cid:2) Stock option awards4
Incentive bonuses are based on financial performance measures that the com-
pensation committee identifies as important to the company’s long-term success.
Many companies tie incentive bonuses to such measures as growth in revenues and
return on assets, or return on equity. Starbucks bases 80 percent of its incentive
bonus on an “earnings per share target approved by the compensation commit-
tee” and 20 percent on the executive’s “specific individual performance.”5
Stock option awards are usually based on how well the company is achieving its
long-term strategic goals. In 2008, a challenging year for Starbucks, the company’s
CEO received a base salary of $1,190,000 and no incentive bonus. In November
|
2007, he received a stock option award of 687,113 shares of common stock.6
From one vantage point, earnings per share is a “bottom-line” number that
encompasses all the other performance measures. However, using a single per-
formance measure as the basis for determining compensation has the potential
of leading to practices that are not in the best interests of the company or its
stockholders. For instance, management could boost earnings per share by reduc-
ing the number of shares outstanding (the denominator in the earnings per share
equation) while not improving earnings. It could accomplish this by using cash to
repurchase shares of the company’s stock (treasury stock), rather than investing
the cash in more profitable operations.
As you study the comprehensive financial analysis of Starbucks in the coming
pages, consider that knowledge of performance measurement not only is impor-
tant for evaluating a company but also leads to an understanding of the criteria by
which a board of directors evaluates and compensates management.
STOP
& APPLY
Identify each of the following as (a) an objective of financial statement analysis, (b) a standard for
financial statement analysis, (c) a source of information for financial statement analysis, or (d) an
executive compensation issue:
1. A company’s past performance 5. Industry norms
2. Investment advisory services 6. Annual report
3. Assessment of a company’s future 7. Creating shareholder value
potential 8. Form 10-K
4. Incentive bonuses
SOLUTION
1. b; 2. c; 3. a; 4. d; 5. b; 6. c; 7. d; 8. c
Tools and Techniques of Financial Analysis 715
Tools and
To gain insight into a company’s financial performance, one must look beyond
Techniques of the individual numbers to the relationship between the numbers and their
change from one period to another. The tools of financial analysis— horizontal
Financial Analysis
analysis, trend analysis, vertical analysis, and ratio analysis—are intended to
show these relationships and changes. To illustrate how these tools are used,
LO2 Apply horizontal analysis,
we devote the rest of this chapter to a comprehensive financial analysis of
trend analysis, vertical analysis,
Starbucks Corporation.
and ratio analysis to financial
statements.
Horizontal Analysis
Comparative financial statements provide financial information for the current
Study Note
year and the previous year. To gain insight into year-to-year changes, analysts use
It is important to ascertain the horizontal analysis, in which changes from the previous year to the current year
base amount used when a are computed in both dollar amounts and percentages. The percentage change
percentage describes an item. relates the size of the change to the size of the dollar amounts involved.
For example, inventory may Exhibits 16-3 and 16-4 present Starbuck Corporation’s comparative balance
be 50 percent of total current sheets and income statements and show both the dollar and percentage changes.
assets but only 10 percent of The percentage change is computed as follows:
total assets.
( )
Amount of Change
Percentage Change (cid:2) 100 (cid:6)
Base Year Amount
The base year is always the first year to be considered in any set of data. For
example, when comparing data for 2007 and 2008, 2007 is the base year. As the
balance sheets in Exhibit 16-3 show, between 2007 and 2008, Starbucks’ total cur-
rent assets increased by $51.5 million, from $1,696.5 million to $1,748.0 million,
or by 3.0 percent. This is computed as follows:
Percentage Change (cid:2) $51.5 million (cid:2) 3.0%
$1,696.5 million
When examining such changes, it is important to consider the dollar amount
of the change as well as the percentage change in each component. For exam-
ple, the percentage increase in accounts receivable, net (14.4 percent) is slightly
greater than the increase in prepaid and other current assets (13.7 percent).
However, the dollar increase in accounts receivable is twice the dollar increase in
prepaid and other current assets ($41.6 million versus $20.4 million). Thus, even
though the percentage changes differ by only 0.7 percent, accounts receivable
|
require much more investment.
Starbucks’ balance sheets for this period, illustrated in Exhibit 16-3, also
show an increase in total assets of $328.7 million, or 6.2 percent. In addition,
shareholders’ equity increased by $206.8 million, or 9.1 percent.
Starbucks’ income statements in Exhibit 16-4 show that net revenues
increased by $971.5 million, or 10.3 percent, while gross margin increased by
$325.3 million, or 6.0 percent. This indicates that cost of sales grew faster than
net revenues. In fact, cost of sales increased 16.2 percent compared with the
10.3 percent increase in net revenues.
Starbucks’ total operating expenses increased by $880.9, or 19.7 percent, also
faster than the 10.3 percent increase in net revenues. As a result, operating income
decreased by $555.6 million, or 58.7 percent, and net income decreased by $357.1,
or 53.1 percent. The primary reason for the decreases in operating income and net
income is that total cost of sales and operating expenses increased at a faster rate
(16.2 and 19.7 percent, respectively) than net revenues (10.3 percent).
716 CHAPTER 16 Financial Performance Measurement
EXHIBIT 16-3 Comparative Balance Sheets with Horizontal Analysis
Starbucks Corporation
Consolidated Balance Sheets
September 28, 2008, and September 30, 2007
Increase (Decrease)
(Dollar amounts in millions) 2008 2007 Amount Percentage
Assets
Current assets:
Cash and cash equivalents $ 269.8 $ 281.3 $(11.5) (4.1)
Short-term investments 52.5 157.4 (104.9) (66.6)
Accounts receivable, net 329.5 287.9 41.6 14.4
Inventories 692.8 691.7 1.1 0.2
Prepaid and other current assets 169.2 148.8 20.4 13.7
Deferred income taxes, net 234.2 129.4 104.8 81.0
Total current assets $1,748.0 $1,696.5 $ 51.5 3.0
Long-term investments 374.0 279.9 94.1 33.6
Property, plant, and equipment, net 2,956.4 2,890.4 66.0 2.3
Other assets 261.1 219.4 41.7 19.0
Other intangible assets 66.6 42.1 24.5 58.2
Goodwill 266.5 215.6 50.9 23.6
Total assets $5,672.6 $5,343.9 $328.7 6.2
Liabilities and Shareholders’ Equity
Current liabilities:
Commercial paper and short-term
borrowings $ 713.0 $ 710.3 $ 2.7 0.4
Accounts payable 324.9 390.8 (65.9) (16.9)
Accrued compensation and related costs 253.6 292.4 (38.8) (13.3)
Accrued occupancy costs 136.1 74.6 61.5 82.4
Accrued taxes 76.1 92.5 (16.4) (17.7)
Insurance reserves 152.5 137.0 15.5 11.3
Other accrued expenses 164.4 160.3 4.1 2.6
Deferred revenue 368.4 296.9 71.5 24.1
Current portion of long-term debt 0.7 0.8 (0.1) (12.5)
Total current liabilities $2,189.7 $2,155.6 $ 34.1 1.6
Long-term debt and other liabilities 992.0 904.2 87.8 9.7
Shareholders’ equity 2,490.9 2,284.1 206.8 9.1
Total liabilities and shareholders’ equity $5,672.6 $5,343.9 $328.7 6.2
Source: Data from Starbucks Corporation, Form 10-K, 2008.
Tools and Techniques of Financial Analysis 717
EXHIBIT 16-4 Comparative Income Statements with Horizontal Analysis
Starbucks Corporation
Consolidated Income Statements
For the Years Ended September 28, 2008, and September 30, 2007
Increase (Decrease)
(Dollar amounts in millions
except per share amounts) 2008 2007 Amount Percentage
Net revenues $10,383.0 $9,411.5 $ 971.5 10.3
Cost of sales, including occupancy costs 4,645.3 3,999.1 646.2 16.2
Gross margin $ 5,737.7 $5,412.4 $ 325.3 6.0
Operating expenses
Store operating expenses $ 3,745.1 $3,215.9 $ 529.2 16.5
Other operating expenses 330.1 294.2 35.9 12.2
Depreciation and amortization expenses 549.3 467.2 82.1 17.6
General and administrative expenses 456.0 489.2 (33.2) (6.8)
Restructuring charges 266.9 — 266.9 100.0
Total operating expenses $ 5,347.4 $4,466.5 $ 880.9 19.7
Operating income $ 390.3 $ 945.9 $(555.6) (58.7)
Other income, net 122.6 148.4 (25.8) (17.4)
Interest expense (53.4) (38.0) (15.4) 40.5
Income before taxes $ 459.5 $1,056.3 $(596.8) (56.5)
Provision for income taxes 144.0 383.7 (239.7) (62.5)
Income before cumulative change for
FIN 47, net of taxes $ 315.5 $ 672.6 $(357.1) (53.1)
Cumulative effect of accounting change
— — — 0.0
for FIN 47, net of taxes
Net income $ 315.5 $ 672.6 $(357.1) (53.1)
Per common share:
Net income per common share before
|
cumulative effect of change in
accounting principle—basic $ 0.43 $ 0.90 $ (0.47) (52.2)
Cumulative effect of accounting change
— — — 0.0
for FIN 47, net of taxes
Net income per common share—basic $ 0.43 $ 0.90 $ (0.47) (52.2)
Net income per common share before
cumulative effect of change in
accounting principle—diluted $ 0.43 $ 0.87 $ (0.44) (50.6)
Cumulative effect of accounting change
— — — 0.0
for FIN 47, net of taxes
Net income per common share—diluted $ 0.43 $ 0.87 $ (0.44) (50.6)
Shares used in calculation of net income
per common share—basic 731.5 749.8 (18.3) (2.4)
Shares used in calculation of net income
per common share—diluted 741.7 770.1 (28.4) (3.7)
Source: Data from Starbucks Corporation, Form 10-K, 2008.
718 CHAPTER 16 Financial Performance Measurement
EXHIBIT 16-5
Starbucks Corporation
Trend Analysis
Net Revenues and Operating Income
Trend Analysis
2008 2007 2006 2005 2004
Dollar values
(In millions)
Net revenues $10,383.0 $9,411.5 $7,786.9 $6,369.3 $5,294.2
Operating income 390.3 945.9 800.0 703.9 549.5
Trend analysis
(In percentages)
Net revenues 196.1 177.8 147.1 120.3 100.0
Operating income 71.0 172.1 145.6 128.1 100.0
Source: Data from Starbucks Corporation, Form 10-K, 2008.
Trend Analysis
Trend analysis is a variation of horizontal analysis. With this tool, the analyst
Study Note
calculates percentage changes for several successive years instead of for just two
To reflect the general five-year yyears. Because of its long-term view, trend analysis can highlight basic changes in
economic cycle of the U.S. the nature of a business.
economy, trend analysis usually In addition to presenting comparative financial statements, many companies
covers a five-year period. Cycles ppresent a summary of key data for five or more years in their annual reports.
of other lengths exist and are Exhibit 16-5 shows a trend analysis of Starbucks’ five-year summary of net rev-
tracked by the National Bureau enues and operating income.
of Economic Research. Trend Trend analysis uses an index number to show changes in related items over
analysis needs to be of sufficient time. For an index number, the base year is set at 100 percent. Other years are
length to show a company’s measured in relation to that amount. For example, the 2008 index for Starbucks’
performance in both up and net revenues is figured as follows (dollar amounts are in millions):
down markets.
( Index Year Amount )
Index (cid:2) 100 (cid:6)
Base Year Amount
( )
$10,383.0
(cid:2) 100 (cid:6) (cid:2) 196.1%
$5,294.2
The trend analysis in Exhibit 16-5 shows that Starbucks’ net revenues increased
over the five-year period. Overall, revenue grew 196.1 percent. However,
operating income grew slower than net revenues in every year except for 2008
when the operating income declined. Figure 16-1 illustrates these trends.
Vertical Analysis
Vertical analysis shows how the different components of a financial statement
relate to a total figure in the statement. The analyst sets the total figure at 100 per-
cent and computes each component’s percentage of that total. The resulting finan-
cial statement, which is expressed entirely in percentages, is called a common-size
statement. Common-size balance sheets and common-size income statements for
Starbucks Corporation are shown in pie-chart form in Figures 16-2 and 16-3 and
in financial statement form in Exhibits 16-6 and 16-7. (On the balance sheet, the
Tools and Techniques of Financial Analysis 719
Operating Income
Net Revenues
250
200
150
100
50
0
2004 2005 2006 2007 2008
figure would be total assets or total liabilities and stockholders’ equity, and on the
income statement, it would be net revenues or net sales.)
Vertical analysis and common-size statements are useful in comparing the
importance of specific components in the operation of a business and in identify-
ing important changes in the components from one year to the next. The main
conclusions to be drawn from our analysis of Starbucks are that the company’s
assets consist largely of current assets and property, plant, and equipment; that
egatnecreP
FIGURE 16-1
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Graph of Trend Analysis Shown in
Exhibit 16-5
FIGURE 16-2 Common-Size Balance Sheets Presented Graphically
2008* 2007*
Property,
Other Property, Other
plant, and
intangible plant, and intangible
equipment, net
assets equipment, net assets
54%
Assets = 100% 1% 52% 1%
Long-term Long-term
investments Current investments Current
7% assets 5% assets
31%
Goodwill Goodwill 32%
5% 4%
Other assets Other assets
5% 4%
Shareholders’ Shareholders’
equity equity
Liabilities and 44% 43%
Shareholders’
Equity = 100% Long-term Current Long-term Current
debt and other liabilities debt and other liabilities
long-term 39% long-term 40%
liabilities liabilities
18% 17%
Deferred income Deferred income
taxes, net taxes, net
0% 0%
*Rounding causes some additions not to total precisely.
720 CHAPTER 16 Financial Performance Measurement
EXHIBIT 16-6
Starbucks Corporation
Common-Size Balance Sheets
Common-Size Balance Sheets
September 28, 2008, and September 30, 2007
2008 2007
Assets
Current assets 30.8% 31.7%
Long-term investments 6.6 5.2
Property, plant, and equipment, net 52.1 54.1
Other assets 4.6 4.1
Other intangible assets 1.2 0.8
Goodwill 4.7 4.0
Total assets 100.0% 100.0%
Liabilities and Shareholders’ Equity
Current liabilities 38.6% 40.3%
Long-term debt and other liabilities 17.5 16.9
Shareholders’ equity 43.9 42.7
Total liabilities and shareholders’ equity 100.0% 100.0%
Note: Amounts do not precisely total 100 percent in all cases due to rounding.
Source: Data from Starbucks Corporation, Form 10-K, 2008.
the company finances assets primarily through equity and current liabilities; and
that it has fewer long-term liabilities.
Looking at the pie charts in Figure 16-2 and the common-size balance sheets
in Exhibit 16-6, you can see that Starbucks’ is gradually shifting assets from cur-
rent assets and long-term investments toward all other categories of long-term
assets. At the same time, it is decreasing its proportion of current liabilities and
increasing both long-term debt and shareholders’ equity. You can also see that
the relationship of liabilities and equity shifted slightly from stockholders’ equity
to current liabilities. The common-size income statements in Exhibit 16-7, illus-
trated in Figure 16-3, show that Starbucks increased its operating expenses from
2007 to 2008 by 4.0 percent of revenues (51.5% (cid:4) 47.5%). In other words, oper-
ating expenses grew faster than revenues.
FIGURE 16-3 2008* Net Revenues = 100% 2007*
Common-Size Income Statements
Presented Graphically
Cost of Cost of
Operating Operating
sales sales
expenses expenses
45% 43%
52% 48%
Net earnings Net earnings
Other income Other income
3% 7%
Provision for 1% Provision for 2%
income taxes income taxes
1% 4%
*Rounding causes some additions not to total precisely.
Note: Not all items are presented.
Tools and Techniques of Financial Analysis 721
EXHIBIT 16-7
Common-Size Income Statements Starbucks Corporation
Common-Size Income Statements
For the Years Ended September 28, 2008 and September 30, 2007
2008 2007
Net revenues 100.0% 100.0%
Cost of sales, including occupancy costs 44.7 42.5
Gross margin 55.3% 57.5%
Operating expenses:
Store operating expenses 36.1% 34.2%
Other operating expenses 3.2 3.1
Depreciation and amortization expenses 5.3 5.0
General and administrative expenses 4.4 5.2
Restructuring charges 2.6 —
Total operating expenses 51.5% 47.5%
Operating income 3.8% 10.1%
Other income, net 1.2 1.6
Interest expense (0.5) (0.4)
Income before taxes 4.4% 11.2%
Provision for income taxes 1.4 4.1
Income before cumulative change for FIN 47,
net of taxes 3.0% 7.1%
Cumulative effect of accounting change for
FIN 47, net of taxes — —
Net income 3.0% 7.1%
Note: Amounts do not precisely total 100 percent in all cases due to rounding.
Source: Data from Starbucks Corporation, Form 10-K, 2008.
Common-size statements are often used to make comparisons between com-
panies. They allow an analyst to compare the operating and financing character-
istics of two companies of different size in the same industry. For example, the
analyst might want to compare Starbucks with other specialty retailers in terms
|
of percentage of total assets financed by debt or in terms of operating expenses
as a percentage of net revenues. Common-size statements would show those and
other relationships. These statements can also be used to compare the character-
istics of companies that report in different currencies.
Ratio Analysis
Ratio analysis is an evaluation technique that identifies key relationships between
the components of the financial statements. Ratios are useful tools for evaluating
a company’s financial position and operations and may reveal areas that need fur-
ther investigation. To interpret ratios correctly, the analyst must have a general
understanding of the company and its environment, financial data for several
years or for several companies, and an understanding of the data underlying the
numerator and denominator.
Ratios can be expressed in several ways. For example, a ratio of net income of
$100,000 to sales of $1,000,000 can be stated as follows:
722 CHAPTER 16 Financial Performance Measurement
1. Net income is 1/10, or 10 percent, of sales.
2. The ratio of sales to net income is 10 to 1 (10:1), or sales are 10 times net
income.
3. For every dollar of sales, the company has an average net income of 10 cents.
STOP
& APPLY
Different types of analysis achieve different objectives for the analyst. Match each of these types
of analysis to their objective: (a) horizontal analysis, (b) trend analysis, (c) vertical analysis, and
(d) ratio analysis.
1. Identifies key relationships among compo- 3. Highlights the composition of assets, liabilities,
nents of the financial statements and equity and changes in the components of
2. Provides a long-term view of key measures the company from one year to the next
as to the direction of the company 4. Provides insight into year-to-year changes
SOLUTION
1. d; 2. b; 3. c; 4. a
Comprehensive
In this section, to illustrate how analysts use ratio analysis in evaluating a com-
Illustration of pany’s financial performance, we perform a comprehensive ratio analysis of
Starbucks’ performance in 2007 and 2008. The following excerpt from the
Ratio Analysis
discussion and analysis section of Starbucks’ 2008 annual report provides the
context for our evaluation of the company’s liquidity, profitability, long-term
LO3 Apply ratio analysis to
solvency, cash flow adequacy, and market strength:
financial statements in a com-
prehensive evaluation of a com- Throughout fiscal 2008, Starbucks continued to experience declining compa-
pany’s financial performance. rable store sales in its U.S. stores, primarily due to lower customer traffic. With
the U.S. segment representing 76 percent of consolidated revenues, the impact
of this decline on the company’s financial results for fiscal 2008 was significant.
For fiscal year 2008 comparable store sales declined 5 percent in the United
States, with a declining trend over the course of the year, ending with a decline
of 8 percent in the fourth quarter. The company also experienced declining
comparable sales in Canada and the UK, its two largest company-operated
international markets, primarily due to lower traffic. The company believes that
the weaker traffic has been caused by a number of ongoing factors in the global
economies that have negatively impacted consumers’ discretionary spending, as
well as factors within the company’s control with respect to the pace of store
openings in the United States and store level execution. In the United States,
the economic factors included the higher cost of such basic consumer staples as
gas and food, rising levels of unemployment and personal debt, reduced access
to consumer credit, and lower home values as well as increased foreclosure
activity in certain areas of the country (California and Florida) where Starbucks
has a high concentration of company-operated stores. These developments,
combined with recent and ongoing unprecedented shocks to the global finan-
cial system and capital markets, have all contributed to sharp declines in con-
sumer confidence in the United States.
Comprehensive Illustration of Ratio Analysis 723
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Evaluating Liquidity
As you know, liquidity is a company’s ability to pay bills when they are due and
to meet unexpected needs for cash. Because debts are paid out of working capital,
all liquidity ratios involve working capital or some part of it. (Cash flow ratios are
also closely related to liquidity.)
Exhibit 16-8 presents Starbucks’ liquidity ratios in 2007 and 2008. The cur-
rent ratio and the quick ratio are measures of short-term debt-paying ability.
Study Note The principal difference between the two ratios is that the numerator of the cur-
rent ratio includes inventories and prepaid expenses. Inventories take longer to
When examining ratios in
convert to cash than the current assets included in the numerator of the quick
published sources, be aware
ratio. Starbucks’ quick ratio was 0.3 times in both years 2007 and 2008. Its cur-
that publishers often redefine
rent ratio was 0.8 times in both years 2007 and 2008. From 2007 to 2008, its
the content of the ratios
provided by the companies. current assets grew at the same rate as current liabilities.
While the general content is Starbucks’ management of receivables and inventories worsened from 2007
similar, variations occur. Be sure to 2008. The receivable turnover, which measures the relative size of accounts
to ascertain and evaluate the receivable and the effectiveness of credit policies, fell from 36.7 times in 2007 to
information that a published 33.6 times in 2008. The related ratio of days’ sales uncollected increased by one
source uses to calculate ratios. day, from 9.9 days in 2007 to 10.9 days in 2008. The number of days is quite low
because the majority of Starbucks’ revenues are from cash sales.
The inventory turnover, which measures the relative size of inventories,
increased from 6.0 times in 2007 to 6.7 times in 2008. This resulted in a favor-
able decrease in days’ inventory on hand, from 60.8 days in 2007 to 54.5 days
in 2008.
Starbucks’ operating cycle, or the time it takes to sell products and col-
lect for them, decreased from 70.7 days in 2007 (9.9 days (cid:3) 60.8 days, or the
days’ sales uncollected plus the days’ inventory on hand) to 65.4 days in 2008
(10.9 days (cid:3) 54.5 days).
Related to the operating cycle is the number of days a company takes to pay
its accounts payable. Starbucks’ payables turnover increased from 11.1 times
in 2007 to 13.0 times in 2008. This resulted in days’ payable of 32.9 days in
2007 and 28.1 days in 2008. If the days’ payable is subtracted from the operating
cycle, Starbucks’ financing period—the number of days of financing required—
was 37.8 days in 2007 and 37.3 days in 2008 (Figure 16-4). Overall, Starbucks’
liquidity declined.
Evaluating Profitability
Investors and creditors are interested in evaluating not only a company’s liquidity
but also its profitability—that is, its ability to earn a satisfactory income. Profit-
ability is closely linked to liquidity because earnings ultimately produce the cash
FIGURE 16-4 Inventory Inventory
Starbucks’ Operating Cycle Purchased Sold
O PERATING CYCLE (65.4 days)
INVENTORY (54.5 days)
RECEIVABLES (10.9 days)
PAYABLES (28.1 days) FINANCING PERIOD (37.3 days)
0 10 20 30 40 50 60 70 80
Days
Cash Paid Cash Received
724 CHAPTER 16 Financial Performance Measurement
EXHIBIT 16-8 Liquidity Ratios of Starbucks Corporation
(Dollar amounts in millions) 2008 2007
Current ratio: Measure of short-term debt-paying ability
Current Assets $1,748.0 (cid:2) 0.8 Times $1,696.5 (cid:2) 0.8 Times
Current Liabilities $2,189.7 $2,155.6
Quick ratio: Measure of short-term debt-paying ability
Cash (cid:3) Marketable $269.8 (cid:3) $52.5 (cid:3) $329.5 $281.3 (cid:3) $157.4 (cid:3) $287.9
Securities (cid:3) Receivables $2,189.7 $2,155.6
Current Liabilities
$651.8 $726.6
(cid:2) (cid:2) 0.3 Times (cid:2) (cid:2) 0.3 Times
$2,189.7 $2,155.6
Receivable turnover: Measure of relative size of accounts receivable and effectiveness of credit policies
Net Sales $10,383.0 $9,411.5
Average Accounts Receivable ($329.5 (cid:3) $287.9) (cid:5) 2 ($287.9 (cid:3) $224.3) (cid:5) 2
|
$10,383.0 $9,411.5
(cid:2) (cid:2) 33.6 Times (cid:2) (cid:2) 36.7 Times
$308.7 $256.1
Days’ sales uncollected: Measure of average days taken to collect receivables
Days in Accounting Period 365 Days 365 Days
(cid:2) 10.9 Days (cid:2) 9.9 Days
Receivable Turnover 33.6 Times 36.7 Times
Inventory turnover: Measure of relative size of inventory
Cost of Goods Sold $4,645.3 $3,999.1
Average Inventory ($692.8 (cid:3) $691.7) (cid:5) 2 ($691.7 (cid:3) $636.2) (cid:5) 2
$4,645.3 $3,999.1
(cid:2) (cid:2) 6.7 Times (cid:2) (cid:2) 6.0 Times
$692.3 $664.0
Days’ inventory on hand: Measure of average days taken to sell inventory
Days in Accounting Period 365 Days 365 Days
(cid:2) 54.5 Days (cid:2) 60.8 Days
Inventory Turnover 6.7 Times 6.0 Times
Payables turnover: Measure of relative size of accounts payable
Cost of Goods Sold (cid:3)/(cid:4) $4,645.3 (cid:3) $1.1 $3,999.1 (cid:3) $55.5*
Change in Inventory ($324.9 (cid:3) $390.8) (cid:5) 2 ($390.8 (cid:3) $340.9) (cid:5) 2
Average Accounts Payable $4,646.4 $4,054.6
(cid:2) (cid:2) 13.0 Times (cid:2) (cid:2) 11.1 Times
$357.9 $365.9
Days’ payable: Measure of average days taken to pay accounts payable
Days in Accounting Period 365 Days 365 Days
(cid:2) 28.1 Days (cid:2) 32.9 Days
Payables Turnover 13.0 Times 11.1 Times
*Figures for 2006 are from the balance sheet in Starbucks’ Form 10-K, 2007.
Source: Data from Starbucks Corporation, Form 10-K, 2008; Form 10-K, 2007.
flow needed for liquidity. Exhibit 16-9 shows Starbucks’ profitability ratios in
2007 and 2008.
Profit margin measures how well a company manages its costs per dollar of
sales. Starbucks’ profit margin decreased from 7.1 to 3.0 percent between 2007
and 2008. Its asset turnover, which measures how efficiently assets are used to
produce sales (or net revenues), was stable at 1.9 times in 2007 and 2008. The
result is a decrease in the company’s earning power, or return on assets, from
Comprehensive Illustration of Ratio Analysis 725
EXHIBIT 16-9 Profitability Ratios of Starbucks Corporation
(Dollar amounts in millions) 2008 2007
Profit margin: Measure of net income produced by each dollar of sales
Net Income $315.5 $672.6
(cid:2) 3.0% (cid:2) 7.1%
Net Sales $10,383.0 $9,411.5
Asset turnover: Measure of how efficiently assets are used to produce sales
Net Sales $10,383.0 $9,411.5
Average Total Assets ($5,672.6 (cid:3) $5,343.9) (cid:5) 2 ($5,343.9 (cid:3) $4,428.9*) (cid:5) 2
$10,383.0 $9,411.5
(cid:2) (cid:2) 1.9 Times (cid:2) (cid:2) 1.9 Times
$5,508.3 $4,886.4
Return on assets: Measure of overall earning power or profitability
Net Income $315.5 $672.6
(cid:2) 5.7% (cid:2) 13.8%
Average Total Assets $5,508.3 $4,886.4
Return on equity: Measure of the profitability of stockholders’ investments
Net Income $315.5 $672.6
Average Stockholders’ Equity ($2,490.9 (cid:3) $2,284.1) (cid:5) 2 ($2,284.1 (cid:3) $2,228.5*) (cid:5) 2
$315.5 $672.6
(cid:2) (cid:2) 13.2% (cid:2) (cid:2) 29.8%
$2,387.5 $2,256.3
*Figures for 2006 are from the five-year selected financial data in Starbucks’ Form 10-K, 2007.
Source: Data from Starbucks Corporation, Form 10-K, 2008; Form 10-K, 2007.
13.8 percent in 2007 to 5.7 percent in 2008. These computations show the rela-
Study Note
ttionships (the small difference in the two sets of return on assets figures results
In accounting literature, ffrom the rounding of the ratios):
profit is expressed in different
Profit Margin Asset Turnover Return on Assets
ways—for example, as income
before income taxes, income Net Income (cid:6) Net Sales (cid:2) Net Income
after income taxes, or operating Net Sales Average Total Assets Average Total Assets
income. To draw appropriate 2007 7.1% (cid:6) 1.9 (cid:2) 13.5%*
conclusions from profitability
2008 3.0% (cid:6) 1.9 (cid:2) 5.7%
ratios, analysts must be aware of
the content of net income data. SStarbucks’ return on equity also declined from 29.8 percent in 2007 to
13.2 percent in 2008.
Although we have used net income in computing profitability ratios for
Starbucks, net income is not always a good indicator of a company’s sustainable
earnings. For instance, if a company has discontinued operations, income from
|
continuing operations may be a better measure of sustainable earnings. For a
company that has one-time items on its income statement—such as restructur-
ings, gains, or losses—income from operations before these items may be a better
measure. Some analysts like to use earnings before interest and taxes, or EBIT,
for the earnings measure because it excludes the effects of the company’s borrow-
ings and the tax rates from the analysis. Whatever figure one uses for earnings,
it is important to try to determine the effects of various components on future
operations.
*Difference from 13.8% above is rounding.
726 CHAPTER 16 Financial Performance Measurement
FOCUS ON BUSINESS PRACTICE
What’s the Best Way to Measure Performance for Management Compensation?
Efforts to link management compensation to performance Better still would be to compare the company’s return on
measures and the creation of shareholder wealth are assets to its cost of debt and equity capital, as does Target.7
increasing. Starbucks uses earning per share (EPS) for this Many analysts believe that this measure, which is called eco-
purpose. Some other companies, including Walgreens, nomic value added (EVA), is superior to EPS. If the return on
use a better approach. This use of return on invested capital, assets exceeds the cost of financing the assets with debt
which is closely related to return on assets, shows whether and equity, then management is indeed creating value for
or not management is employing the assets profitably. the shareholders.
Evaluating Long-Term Solvency
Long-term solvency has to do with a company’s ability to survive for many years.
Study Note
The aim of evaluating long-term solvency is to detect early signs that a company is
Liquidity is a firm’s ability to headed for financial difficulty. Increasing amounts of debt in a company’s capital
meet its current obligations; structure mean that the company is becoming more heavily leveraged. This con-
solvency is its ability to meet dition has a negative effect on long-term solvency because it represents increasing
maturing obligations as they legal obligations to pay interest periodically and the principal at maturity. Failure
come due without losing the to make those payments can result in bankruptcy.
ability to continue operations. Declining profitability and liquidity ratios are key indicators of possible fail-
ure. Two other ratios that analysts consider when assessing long-term solvency
are debt to equity and interest coverage, which are shown in Exhibit 16-10. The
debt to equity ratio measures capital structure and leverage by showing the
amount of a company’s assets provided by creditors in relation to the amount
In addition to using EVA® (Economic
Value Added) to determine executive
compensation, Target uses it to
guide capital investment decisions.
The company uses a benchmark of
9 percent for the estimated after-
tax cost of capital invested in retail
operations and a benchmark of
5 percent for capital invested in credit
card operations. Target believes that
a focus on EVA® fosters its objective
of increasing average annual earnings
per share by 15 percent or more over
time.
Source: Courtesy of Justin Sullivan/
Getty Images.
Comprehensive Illustration of Ratio Analysis 727
EXHIBIT 16-10 Long-term Solvency Ratios of Starbucks Corporation
(Dollar amounts in millions) 2008 2007
Debt to equity ratio: Measure of capital structure and leverage
Total Liabilities $3,181.7 $3,059.8
(cid:2) 1.3 Times (cid:2) 1.3 Times
Stockholders’ Equity $2,490.9 $2,284.1
Interest coverage ratio: Measure of creditors’ protection from default on interest payments
Income Before Income Taxes (cid:3) $459.5 (cid:3) $53.4 $1,056.3 (cid:3) $38.0
Interest Expense $53.4 $38.0
Interest Expense
$512.9 $1,094.3
(cid:2) (cid:2) 9.6 Times (cid:2) (cid:2) 28.8 Times
$53.4 $38.0
Source: Data from Starbucks Corporation, Form 10-K, 2008.
provided by stockholders. Starbucks’ debt to equity ratio was stable at 1.3 times
Study Note
in both 2007 and 2008. Recall from Exhibit 16-3 that the company increased
|
Because of innovative financing both its liabilities and its stockholders’ equity from 2007 to 2008. However,
plans and other means the company’s current ratio is satisfactory and little changed. In sum, Starbucks’
of acquiring assets, lease long-term solvency is not in danger.
payments and similar types If debt is risky, why have any? The answer is that the level of debt is a matter
of fixed obligations should be of balance. Despite its riskiness, debt is a flexible means of financing certain busi-
considered when evaluating ness operations. The interest paid on debt is tax-deductible, whereas dividends
long-term solvency. on stock are not. Because debt usually carries a fixed interest charge, the cost of
financing can be limited, and leverage can be used to advantage. If a company can
earn a return on assets greater than the cost of interest, it makes an overall profit.
In addition, being a debtor in periods of inflation has advantages because the
debt, which is a fixed dollar amount, can be repaid with cheaper dollars. How-
ever, the company runs the risk of not earning a return on assets equal to the cost
of financing the assets, thereby incurring a loss.
The interest coverage ratio measures the degree of protection creditors have
from default on interest payments. Starbucks’ interest coverage declined from
28.8 times to 9.6 times due to almost twice as much interest. Nevertheless, inter-
est coverage is still at a very safe level.
Evaluating the Adequacy of Cash Flows
Because cash flows are needed to pay debts when they are due, cash flow measures
are closely related to liquidity and long-term solvency. Exhibit 16-11 presents
Starbucks’ cash flow adequacy ratios in 2007 and 2008.
Cash flow yield shows the cash-generating ability of a company’s operations;
it is measured by dividing cash flows from operating activities by net income.
Starbucks’ net cash flows from operating activities decreased from $1,331.2 mil-
lion in 2007 to $1,258.7 million in 2008. Its cash flow yield actually increased
from 2.0 to 4.0 times, revealing that net cash provided by operating activities
increased faster than net income.
On the other hand, Starbucks’ ratios for cash flows to sales and cash flows to
assets declined. While the company’s net sales and average total assets increased,
the net cash flows from operating activities declined. Cash flows to sales, or the
cash-generating ability of sales, decreased from 14.1 to 12.1 percent. Cash flows
to assets, or the ability of assets to generate operating cash flows, decreased from
27.2 to 22.9 percent.
728 CHAPTER 16 Financial Performance Measurement
EXHIBIT 16-11 Cash Flow Adequacy Ratios of Starbucks Corporation
(Dollar amounts in millions) 2008 2007
Cash flow yield: Measure of the ability to generate operating cash flows in relation to net income
Net Cash Flows from
Operating Activities $1,258.7* $1,331.2*
(cid:2) 4.0 Times (cid:2) 2.0 Times
Net Income $315.5 $672.6
Cash flows to sales: Measure of the ability of sales to generate operating cash flows
Net Cash Flows from
Operating Activities $1,258.7 $1,331.2
(cid:2) 12.1% (cid:2) 14.1%
Net Sales $10,383.0 $9,411.5
Cash flows to assets: Measure of the ability of assets to generate operating cash flows
Net Cash Flows from $1,258.7 $1,331.2
Operating Activities ($5,672.6 (cid:3) $5,343.9) (cid:5) 2 ($5,343.9 (cid:3) $4,428.9) (cid:5) 2
Average Total Assets
(cid:2) $1,258.7 (cid:2) 22.9% (cid:2) $1,331.2 (cid:2) 27.2%
$5,508.3 $4,886.4
Free cash flow: Measure of cash remaining after providing for commitments
Net Cash Flows from Operating $1,258.7 (cid:4) $0 (cid:4) $984.5* $1,331.2* (cid:4) $0 (cid:4) $1,080.3
Activities (cid:4) Dividends (cid:4)
Net Capital Expenditures (cid:2) $274.2 (cid:2) $250.9
*These figures are from the statement of cash flows in Starbucks’ Form 10-K, 2008.
Source: Data from Starbucks Corporation, Form 10-K, 2008; Form 10-K, 2007.
However, Starbucks’ free cash flow, the cash remaining after providing for
Study Note
commitments, increased. While the company’s net capital expenditures decreased
|
When the computation for by $95.8 million, the net cash flows from operating activities decreased by only
free cash flow uses “net capital $72.5 million. Another factor in Starbucks’ free cash flows is that the company
expenditures” in place of pays no dividends. Management’s comment with regard to liquidity and cash
“purchases of plant assets minus flows in the future is as follows:
sales of plant assets,” it means
The Company’s existing cash and liquid investments were
that the company’s sales of
$322.3 million and $438.7 million as of September 28, 2008 and
plant assets were too small or
September 30, 2007, respectively. The decrease in liquid investments
immaterial to be broken out.
was driven primarily by $59.8 million of auction rate securities, nearly all
of which are held within the Company’s wholly owned captive insurance
company, that are not currently considered liquid and were reclassi-
fied to long-term investments in the second quarter of fiscal 2008. . . .
The Company expects to use its cash and liquid investments, including any
borrowings under its revolving credit facility and commercial paper program
to invest in its core businesses, including new beverage innovations, as well as
other new business opportunities related to its core businesses.8
Comprehensive Illustration of Ratio Analysis 729
EXHIBIT 16-12 Market Strength Ratios of Starbucks Corporation
2008 2007
Price/earnings (P/E) ratio: Measure of investors’ confidence in a company
Market Price per Share $15.25* $27.08*
(cid:2) 35.5 Times (cid:2) 30.1 Times
Earnings per Share $0.43 $0.90
Dividends yield: Measure of a stock’s current return to an investor
Dividends per Share
Starbucks does not pay a dividend.
Market Price per Share
*Market price is the average for the fourth quarter reported in Starbucks’ Form 10-K.
Source: Data from Starbucks Corporation, Form 10-K, 2008.
Evaluating Market Strength
Market price is the price at which a company’s stock is bought and sold. It indi-
cates how investors view the potential return and risk connected with owning the
stock. Market price by itself is not very informative, however, because companies
have different numbers of shares outstanding, different earnings, and different
dividend policies. Thus, market price must be related to earnings by considering
the price/earnings (P/E) ratio and the dividends yield. Those ratios for Star-
bucks appear in Exhibit 16-12. We computed them by using the average market
prices of Starbucks’ stock during the fourth quarters of 2007 and 2008.
The price/earnings (P/E) ratio, which measures investors’ confidence in a
company, is the ratio of the market price per share to earnings per share. The P/E
ratio is useful in comparing the earnings of different companies and the value of
a company’s shares in relation to values in the overall market. With a higher P/E
ratio, the investor obtains less underlying earnings per dollar invested. Despite a
decrease in earnings per share from $0.90 in 2007 to $0.43 in 2008, Starbucks’
P/E ratio increased from 30.1 times in 2007 to 35.5 times in 2008 because the
market value of its stock declined from about $27 to about $15. The implication
is that investors are expecting Starbucks to grow faster in the future than it has in
the past.
The dividends yield measures a stock’s current return to an investor in the
form of dividends. Because Starbucks pays no dividends, its stockholders must
expect their return to come from increases in the stock’s market value.
730 CHAPTER 16 Financial Performance Measurement
STOP
& APPLY
Sasah’s, a retail firm, engaged in the transactions listed below. Opposite each transaction is a ratio
and space to mark the transaction’s effect on the ratio.
Effect
Transaction Ratio Increase Decrease None
a. Accrued salaries. Current ratio
b. Purchased inventory. Quick ratio
c. Increased allowance for Receivable turnover
uncollectible accounts.
d. Purchased inventory on credit. Payables turnover
e. Sold treasury stock. Profit margin
f. Borrowed cash by issuing bond payable. Asset turnover
g. Paid wages expense. Return on assets
|
h. Repaid bond payable. Debt to equity ratio
i. Accrued interest expense. Interest coverage ratio
j. Sold merchandise on account. Return on equity
k. Recorded depreciation expense. Cash flow yield
l. Sold equipment. Free cash flow
Show that you understand the effect of business activities on performance measures by placing
an X in the appropriate column to show whether the transaction increased, decreased, or had no
effect on the ratio.
SOLUTION
Effect
Transaction Ratio Increase Decrease None
a. Accrued salaries. Current ratio X
b. Purchased inventory. Quick ratio X
c. Increased allowance for Receivable turnover X
uncollectible accounts.
d. Purchased inventory on credit. Payables turnover X
e. Sold treasury stock. Profit margin X
f. Borrowed cash by issuing bond payable. Asset turnover X
g. Paid wages expense. Return on assets X
h. Repaid bond payable. Debt to equity ratio X
i. Accrued interest expense. Interest coverage ratio X
j. Sold merchandise on account. Return on equity X
k. Recorded depreciation expense. Cash flow yield X
l. Sold equipment. Free cash flow X
Washington Investments: Review Problem 731
(cid:2) WASHINGTON INVESTMENTS: REVIEW PROBLEM
In the Decision Point at the beginning of this chapter, we noted that Maggie Washington,
President of Washington Investments, was planning to invest in either Quik Burger or
Big Steak. We asked these questions:
• What analytical tools can Maggie Washington use to measure the financial
performance of Quik Burger and Big Steak?
• What standards can she use to compare the performance of the two companies?
The 2010 income statements and balance sheets of the two companies appear
below and on the next page. The following information pertaining to 2010 is also avail-
able to Maggie Washington:
• Quick Burger's statement of cash flows shows that it had net cash flows from
operations of $2,200,000. Big Steak's statement of cash flows shows that its net
cash flows from operations were $3,000,000.
• Net capital expenditures were $2,100,000 for Quik Burger and $1,800,000 for Big Steak.
Comprehensive
Ratio Analysis • Quik Burger paid dividends of $500,000, and Big Steak paid dividends of $600,000.
LO1 LO3 • The market prices of the stocks of Quik Burger and Big Steak were $30 and $20,
respectively.
Maggie Washington does not have financial information pertaining to prior years.
732 CHAPTER 16 Financial Performance Measurement
Required
Perform a comprehensive ratio analysis of both Quik Burger and Big Steak following
the steps outlined below. Assume that all notes payable of these two companies are
current liabilities and that all their bonds payable are long-term liabilities. Show dollar
amounts in thousands, use end-of-year balances for averages, assume no change in
inventory, and round all ratios and percentages to one decimal place.
1. Prepare an analysis of liquidity.
2. Prepare an analysis of profitability.
3. Prepare an analysis of long-term solvency.
4. Prepare an analysis of cash flow adequacy.
5. Prepare an analysis of market strength.
6. In each analysis, indicate the company that apparently had the more favorable
ratio. (Consider differences of 0.1 or less to be neutral.)
7. User insight: In what ways would having access to prior years’ information aid
this analysis?
8. User insight: In addition to the results of your comprehensive ratio analysis,
what other information would be helpful in making the investment decision?
Washington Investments: Review Problem 733
Answers to 1. Liquidity analysis:
Review Problem
2. Profitability analysis:
3. Long-term solvency analysis:
734 CHAPTER 16 Financial Performance Measurement
4. Cash flow adequacy analysis:
5. Market strength analysis:
7. Prior years’ information would be helpful in two ways. First, turnover, return,
and cash flows to assets ratios could be based on average amounts. Second, a
trend analysis could be performed for each company.
8. Using information about industry norms provided by Dun & Bradstreet and
other financial services would be helpful in comparing the performance of Big
Steak and Quik Burger.
|
Stop & Review 735
STOP
& REVIEW
LO1 Describe the objectives, A primary objective in management’s use of financial performance measurement
standards of comparison, is to increase the wealth of the company’s stockholders. Creditors and investors
sources of information, use financial performance measurement to judge a company’s past performance
and compensation issues and current position, as well as its future potential and the risk associated with it.
Creditors use the information gained from their analyses to make reliable loans
in measuring fi nancial
that will be repaid with interest. Investors use the information to make invest-
performance.
ments that will provide a return that is worth the risk.
Three standards of comparison commonly used in evaluating financial perfor-
mance are rule-of-thumb measures, a company’s past performance, and industry
norms. Rule-of-thumb measures are weak because of a lack of evidence that they
can be widely applied. A company’s past performance can offer a guideline for
measuring improvement, but it is not helpful in judging performance relative to
the performance of other companies. Although the use of industry norms over-
comes this last problem, its disadvantage is that firms are not always comparable,
even in the same industry.
The main sources of information about public corporations are reports that
the corporations publish themselves, such as annual reports and interim financial
statements; reports filed with the SEC; business periodicals; and credit and invest-
ment advisory services.
In public corporations, a committee made up of independent directors
appointed by the board of directors determines the compensation of top execu-
tives. Although earnings per share can be regarded as a “bottom-line” number
that encompasses all the other performance measures, using it as the sole basis for
determining executive compensation may lead to management practices that are
not in the best interests of the company or its stockholders.
LO2 Apply horizontal analy- Horizontal analysis involves the computation of changes in both dollar amounts
sis, trend analysis, verti- and percentages from year to year.
cal analysis, and ratio Trend analysis is an extension of horizontal analysis in that it calculates per-
analysis to fi nancial centage changes for several years. The analyst computes the changes by setting a
statements. base year equal to 100 and calculating the results for subsequent years as percent-
ages of the base year.
Vertical analysis uses percentages to show the relationship of the compo-
nent parts of a financial statement to a total figure in the statement. The result-
ing financial statements, which are expressed entirely in percentages, are called
common-size statements.
Ratio analysis is a technique of financial performance evaluation that identifies
key relationships between the components of the financial statements. To inter-
pret ratios correctly, the analyst must have a general understanding of the com-
pany and its environment, financial data for several years or for several companies,
LO3 Apply ratio analysis to
and an understanding of the data underlying the numerators and denominators.
fi nancial statements in
a comprehensive evalu- A comprehensive ratio analysis includes the evaluation of a company’s liquidity, prof-
ation of a company’s itability, long-term solvency, cash flow adequacy, and market strength. The ratios
fi nancial performance. for measuring these characteristics are illustrated in Exhibits 16-8 through 16-12.
736 CHAPTER 16 Financial Performance Measurement
REVIEW of Concepts and Terminology
The following concepts and terms Operating cycle 723 (LO3) Days’ sales uncollected 723 (LO3)
were introduced in this chapter:
Ratio analysis 721 (LO2) Debt to equity ratio 726 (LO3)
Base year 715 (LO2)
Trend analysis 718 (LO2) Dividends yield 729 (LO3)
Common-size statement 718 (LO2)
Vertical analysis 718 (LO2) Interest coverage ratio 727 (LO3)
Compensation committee 712 (LO1)
Inventory turnover 723 (LO3)
Key Ratios
Diversified companies 710 (LO1)
|
Payables turnover 723 (LO3)
Asset turnover 724 (LO3)
Financial performance
Price/earnings (P/E)
measurement 708 (LO1) Cash flows to assets 727 (LO3)
ratio 729 (LO3)
Free cash flow 728 (LO3) Cash flows to sales 727 (LO3)
Profit margin 724 (LO3)
Horizontal analysis 715 (LO2) Cash flow yield 727 (LO3)
Quick ratio 723 (LO3)
Index number 718 (LO2) Current ratio 723 (LO3)
Receivable turnover 723 (LO3)
Interim financial Days’ inventory on hand 723 (LO3)
Return on assets 724 (LO3)
statements 712 (LO1)
Days’ payable 723 (LO3)
Return on equity 725 (LO3)
Chapter Assignments 737
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 Objectives and Standards of Financial Performance Evaluation
SE 1. Indicate whether each of the following items is (a) an objective or (b) a
standard of comparison of financial statement analysis:
1. Industry norms
2. Assessment of a company’s past performance
3. The company’s past performance
4. Assessment of future potential and related risk
5. Rule-of-thumb measures
LO1 Sources of Information
SE 2. For each piece of information in the list that follows, indicate whether the
best source would be (a) reports published by the company, (b) SEC reports,
(c) business periodicals, or (d) credit and investment advisory services.
1. Current market value of a company’s stock
2. Management’s analysis of the past year’s operations
3. Objective assessment of a company’s financial performance
4. Most complete body of financial disclosures
5. Current events affecting the company
LO2 Trend Analysis
SE 3. Using 2010 as the base year, prepare a trend analysis for the following data,
and tell whether the results suggest a favorable or unfavorable trend. (Round
your answers to one decimal place.)
2012 2011 2010
Net sales $158,000 $136,000 $112,000
Accounts receivable (net) 43,000 32,000 21,000
LO2 Horizontal Analysis
SE 4. The comparative income statements and balance sheets of Sarot, Inc.,
appear on the next page. Compute the amount and percentage changes for the
income statements, and comment on the changes from 2011 to 2012. (Round
the percentage changes to one decimal place.)
LO2 Vertical Analysis
SE 5. Express the comparative balance sheets of Sarot, Inc., (shown on the next
page) as common-size statements, and comment on the changes from 2011 to
2012. (Round computations to one decimal place.)
LO3 Liquidity Analysis
SE 6. Using the information for Sarot, Inc. (shown on the next page), in SE 4
and SE 5, compute the current ratio, quick ratio, receivable turnover, days’ sales
uncollected, inventory turnover, days’ inventory on hand, payables turnover, and
days’ payable for 2011 and 2012. Inventories were $16,000 in 2010, $20,000 in
2011, and $28,000 in 2012. Accounts receivable were $24,000 in 2010, $32,000
in 2011, and $40,000 in 2012. Accounts payable were $36,000 in 2010, $40,000
in 2011, and $48,000 in 2012. The company had no marketable securities or pre-
paid assets. Comment on the results. (Round computations to one decimal place.)
738 CHAPTER 16 Financial Performance Measurement
Sarot, Inc.
Comparative Income Statements
For the Years Ended December 31, 2012 and 2011
2012 2011
Net sales $720,000 $580,000
Cost of goods sold 448,000 352,000
Gross margin $272,000 $228,000
Operating expenses 160,000 120,000
Operating income $112,000 $108,000
Interest expense 28,000 20,000
Income before income taxes $ 84,000 $ 88,000
Income taxes expense 28,000 32,000
Net income $ 56,000 $ 56,000
Earnings per share $ 2.80 $ 2.80
Sarot, Inc.
Comparative Balance Sheets
December 31, 2012 and 2011
2012 2011
Assets
Current assets $ 96,000 $ 80,000
Property, plant, and equipment (net) 520,000 400,000
Total assets $616,000 $480,000
Liabilities and Stockholders’ Equity
Current liabilities $ 72,000 $ 88,000
Long-term liabilities 360,000 240,000
Stockholders’ equity 184,000 152,000
Total liabilities and stockholders’ equity $616,000 $480,000
LO3 Profitability Analysis
SE 7. Using the information for Sarot, Inc., in SE 4 and SE 5, compute the profit
margin, asset turnover, return on assets, and return on equity for 2011 and 2012.
|
In 2010, total assets were $400,000 and total stockholders’ equity was $120,000.
Comment on the results. (Round computations to one decimal place.)
LO3 Long-term Solvency Analysis
SE 8. Using the information for Sarot, Inc., in SE 4 and SE 5, compute the debt
to equity ratio and the interest coverage ratio for 2011 and 2012. Comment on
the results. (Round computations to one decimal place.)
LO3 Cash Flow Adequacy Analysis
SE 9. Using the information for Sarot, Inc., in SE 4, SE 5, and SE 7, compute
the cash flow yield, cash flows to sales, cash flows to assets, and free cash flow
for 2011 and 2012. Net cash flows from operating activities were $84,000 in
2011 and $64,000 in 2012. Net capital expenditures were $120,000 in 2011 and
$160,000 in 2012. Cash dividends were $24,000 in both years. Comment on the
results. (Round computations to one decimal place.)
Chapter Assignments 739
LO3 Market Strength Analysis
SE 10. Using the information for Sarot, Inc., in SE 4, SE 5, and SE 9, compute
the price/earnings (P/E) ratio and dividends yield for 2011 and 2012. The com-
pany had 20,000 shares of common stock outstanding in both years. The price
of Sarot’s common stock was $60 in 2011 and $40 in 2012. Comment on the
results. (Round computations to one decimal place.)
Exercises
LO1 LO2 Discussion Questions
E 1. Develop brief answers to each of the following questions:
1. Why is it essential that management compensation, including bonuses, be
linked to financial goals and strategies that achieve shareholder value?
2. How are past performance and industry norms useful in evaluating a com-
pany’s performance? What are their limitations?
3. In a five-year trend analysis, why do the dollar values remain the same for
their respective years while the percentages usually change when a new five-
year period is chosen?
LO3 Discussion Questions
E 2. Develop brief answers to each of the following questions:
1. Why does a decrease in receivable turnover create the need for cash from
operating activities?
2. Why would ratios that include one balance sheet account and one income
statement account, such as receivable turnover or return on assets, be ques-
tionable if they came from quarterly or other interim financial reports?
3. Can you suggest a limitation of free cash flow in comparing one company to
another?
LO1 Issues in Financial Performance Evaluation: Objectives, Standards, Sources
of Information, and Executive Compensation
E 3. Identify each of the following as (a) an objective of financial statement analy-
sis, (b) a standard for financial statement analysis, (c) a source of information for
financial statement analysis, or (d) an executive compensation issue:
1. Average ratios of other companies 5. SEC Form 10-K
in the same industry 6. Assessment of risk
2. Assessment of the future potential 7. A company’s annual report
of an investment 8. Linking performance to
3. Interim financial statements shareholder value
4. Past ratios of the company
LO2 Trend Analysis
E 4. Using 2008 as the base year, prepare a trend analysis of the following data,
and tell whether the situation shown by the trends is favorable or unfavorable.
(Round your answers to one decimal place.)
2012 2011 2010 2009 2008
Net sales $25,520 $23,980 $24,200 $22,880 $22,000
Cost of goods sold 17,220 15,400 15,540 14,700 14,000
General and administrative 5,280 5,184 5,088 4,896 4,800
expenses
Operating income 3,020 3,396 3,572 3,284 3,200
740 CHAPTER 16 Financial Performance Measurement
LO2 Horizontal Analysis
E 5. Compute the amount and percentage changes for the comparative balance
sheets for Davis Company below, and comment on the changes from 2010 to
2011. (Round the percentage changes to one decimal place.)
Davis Company
Comparative Balance Sheets
December 31, 2011 and 2010
2011 2010
Assets
Current assets $ 18,600 $ 12,800
Property, plant, and equipment (net) 109,464 97,200
Total assets $128,064 $110,000
Liabilities and Stockholders’ Equity
Current liabilities $ 11,200 $ 3,200
Long-term liabilities 35,000 40,000
Stockholders’ equity 81,864 66,800
Total liabilities and stockholders’ equity $128,064 $110,000
|
LO2 Vertical Analysis
E 6. Express the partial comparative income statements for Davis Company that
follow as common-size statements, and comment on the changes from 2010 to
2011. (Round computations to one decimal place.)
Davis Company
Partial Comparative Income Statements
For the Years Ended December 31, 2011 and 2010
2011 2010
Net sales $212,000 $184,000
Cost of goods sold 127,200 119,600
Gross margin $ 84,800 $ 64,400
Selling expenses $ 53,000 $ 36,800
General expenses 25,440 18,400
Total operating expenses $ 78,440 $ 55,200
Operating income $ 6,360 $ 9,200
LO3 Liquidity Analysis
E 7. Partial comparative balance sheet and income statement information for
Smith Company is as follows:
Chapter Assignments 741
2012 2011
Cash $ 27,200 $ 20,800
Marketable securities 14,400 34,400
Accounts receivable (net) 89,600 71,200
Inventory 108,800 99,200
Total current assets $240,000 $225,600
Accounts payable $ 80,000 $ 56,400
Net sales $645,120 $441,440
Cost of goods sold 435,200 406,720
Gross margin $209,920 $ 34,720
In 2010, the year-end balances for Accounts Receivable and Inventory were
$64,800 and $102,400, respectively. Accounts Payable was $61,200 in 2010 and
is the only current liability. Compute the current ratio, quick ratio, receivable
turnover, days’ sales uncollected, inventory turnover, days’ inventory on hand,
payables turnover, and days’ payable for each year. (Round c omputations to one
decimal place.) Comment on the change in the company’s liquidity position,
including its operating cycle and required days of financing from 2011 to 2012.
LO3 Turnover Analysis
E 8. Modern Suits Rental has been in business for four years. Because the com-
pany has recently had a cash flow problem, management wonders whether there
is a problem with receivables or inventories. Here are selected figures from the
company’s financial statements (in thousands):
2011 2010 2009 2008
Net sales $288.0 $224.0 $192.0 $160.0
Cost of goods sold 180.0 144.0 120.0 96.0
Accounts receivable (net) 48.0 40.0 32.0 24.0
Merchandise inventory 56.0 44.0 32.0 20.0
Accounts payable 26.0 20.0 16.0 10.0
Compute the receivable turnover, inventory turnover, and payables turnover for
each of the four years, and comment on the results relative to the cash flow prob-
lem that the firm has been experiencing. Merchandise inventory was $22,000,
accounts receivable were $22,000, and accounts payable were $8,000 in 2007.
(Round computations to one decimal place.)
LO3 Profitability Analysis
E 9. Barr Company had total assets of $320,000 in 2010, $340,000 in 2011,
and $380,000 in 2012. Its debt to equity ratio was 0.67 times in all three years.
In 2011, Barr had net income of $38,556 on revenues of $612,000. In 2012,
it had net income of $49,476 on revenues of $798,000. Compute the profit
margin, asset turnover, return on assets, and return on equity for 2011 and
2012. Comment on the apparent cause of the increase or decrease in profitabil-
ity. (Round the percentages and other ratios to one decimal place.)
LO3 Long-term Solvency and Market Strength Ratios
E 10. An investor is considering investing in the long-term bonds and common
stock of Companies P and R. Both firms operate in the same industry. Both also
pay a dividend per share of $8 and have a yield of 10 percent on their long-term
bonds. Other data for the two firms are as follows:
742 CHAPTER 16 Financial Performance Measurement
Company P Company R
Total assets $2,400,000 $1,080,000
Total liabilities 1,080,000 594,000
Income before income taxes 288,000 129,600
Interest expense 97,200 53,460
Earnings per share 3.20 5.00
Market price of common stock 40.00 47.50
Compute the debt to equity ratio, interest coverage ratio, and price/earnings
(P/E) ratio, as well as the dividends yield, and comment on the results. (Round
computations to one decimal place.)
LO3 Cash Flow Adequacy Analysis
E 11. Using the data below from the financial statements of Bali, Inc., compute
the company’s cash flow yield, cash flows to sales, cash flows to assets, and free
cash flow. (Round computations to one decimal place.)
Net sales $1,600,000
|
Net income 176,000
Net cash flows from operating activities 228,000
Total assets, beginning of year 1,445,000
Total assets, end of year 1,560,000
Cash dividends 60,000
Net capital expenditures 149,000
Problems
LO2 Horizontal and Vertical Analysis
P 1. Robert Corporation’s condensed comparative income statements and com-
parative balance sheets for 2011 and 2010 follow.
Robert Corporation
Comparative Income Statements
For the Years Ended December 31, 2011 and 2010
2011 2010
Net sales $1,638,400 $1,573,200
Cost of goods sold 1,044,400 1,004,200
Gross margin $ 594,000 $ 569,000
Operating expenses
Selling expenses $ 238,400 $ 259,000
Administrative expenses 223,600 211,600
Total operating expenses $ 462,000 $ 470,600
Income from operations $ 132,000 $ 98,400
Interest expense 32,800 19,600
Income before income taxes $ 99,200 $ 78,800
Income taxes expense 31,200 28,400
Net income $ 68,000 $ 50,400
Earnings per share $ 3.40 $ 2.52
Chapter Assignments 743
Robert Corporation
Comparative Balance Sheets
December 31, 2011 and 2010
2011 2010
Assets
Cash $ 40,600 $ 20,400
Accounts receivable (net) 117,800 114,600
Inventory 287,400 297,400
Property, plant, and equipment (net) 375,000 360,000
Total assets $820,800 $792,400
Liabilities and Stockholders’ Equity
Accounts payable $133,800 $238,600
Notes payable (short-term) 100,000 200,000
Bonds payable 200,000 —
Common stock, $10 par value 200,000 200,000
Retained earnings 187,000 153,800
Total liabilities and stockholders’ equity $820,800 $792,400
Required
1. Prepare schedules showing the amount and percentage changes from 2010
to 2011 for the comparative income statements and the balance sheets.
2. Prepare common-size income statements and balance sheets for 2010 and 2011.
User insight (cid:2) 3. Comment on the results in requirements 1 and 2 by identifying favorable and
unfavorable changes in the components and composition of the statements.
LO3 Effects of Transactions on Ratios
P 2. Sung Corporation, a clothing retailer, engaged in the transactions listed in
the first column of the table below. Opposite each transaction is a ratio and space
to mark the effect of each transaction on the ratio.
Effect
Transaction Ratio Increase Decrease None
a. Issued common stock for cash. Asset turnover
b. Declared cash dividend. Current ratio
c. Sold treasury stock. Return on equity
d. Borrowed cash by issuing note payable. Debt to equity ratio
e. Paid salaries expense. Inventory turnover
f. Purchased merchandise for cash. Current ratio
g. Sold equipment for cash. Receivable turnover
h. S old merchandise on account. Quick ratio
i. P aid current portion of long-term debt. Return on assets
j. Gave sales discount. Profit margin
k. P urchased marketable securities for cash. Quick ratio
l. D eclared 5% stock dividend. Current ratio
m. Purchased a building. Free cash flow
744 CHAPTER 16 Financial Performance Measurement
Required
User insight (cid:2) Show that you understand the effect of business activities on performance mea-
sures by placing an X in the appropriate column to show whether the transaction
increased, decreased, or had no effect on the indicated ratio.
LO3 Comprehensive Ratio Analysis
P 3. The condensed comparative income statements and balance sheets of Tola
Corporation appear below and on the next page. All figures are given in thou-
sands of dollars, except earnings per share. Additional data for Tola Corporation
in 2011 and 2010 are as follows:
2011 2010
Net cash flows from operating activities $32,000 $49,500
Net capital expenditures $59,500 $19,000
Dividends paid $15,700 $17,500
Number of common shares 15,000 15,000
Market price per share $40 $60
Balances of selected accounts at the end of 2009 were accounts receivable (net),
$26,350; inventory, $49,700; accounts payable, $32,400; total assets, $323,900;
and stockholders’ equity, $188,300. All of the bonds payable were long-term
liabilities.
Tola Corporation
Comparative Income Statements
For the Years Ended December 31, 2011 and 2010
2011 2010
Net sales $400,200 $371,300
Cost of goods sold 227,050 198,100
Gross margin $173,150 $173,200
Operating expenses
|
Selling expenses $ 65,050 $ 52,300
Administrative expenses 70,150 57,750
Total operating expenses $135,200 $110,050
Income from operations $ 37,950 $ 63,150
Interest expense 12,500 10,000
Income before income taxes $ 25,450 $ 53,150
Income taxes expense 7,000 17,500
Net income $ 18,450 $ 35,650
Earnings per share $ 1.23 $ 2.38
Chapter Assignments 745
Tola Corporation
Comparative Balance Sheets
December 31, 2011 and 2010
2011 2010
Assets
Cash $ 15,550 $ 13,600
Accounts receivable (net) 36,250 21,350
Inventory 61,300 53,900
Property, plant, and equipment (net) 288,850 253,750
Total assets $401,950 $342,600
Liabilities and Stockholders’ Equity
Accounts payable $ 52,350 $ 36,150
Notes payable 25,000 25,000
Bonds payable 100,000 55,000
Common stock, $10 par value 150,000 150,000
Retained earnings 74,600 76,450
Total liabilities and stockholders’ equity $401,950 $342,600
Required
Perform the following analyses. Round percentages and ratios to one decimal place.
1. Prepare a liquidity analysis by calculating for each year the (a) current ratio, (b) quick
ratio, (c) receivable turnover, (d) days’ sales uncollected, (e) inventory turnover,
(f) days’ inventory on hand, (g) payables turnover, and (h) days’ payable.
2. Prepare a profitability analysis by calculating for each year the (a) profit mar-
gin, (b) asset turnover, (c) return on assets, and (d) return on equity.
3. Prepare a long-term solvency analysis by calculating for each year the (a) debt
to equity ratio and (b) interest coverage ratio.
4. Prepare a cash flow adequacy analysis by calculating for each year the (a) cash
flow yield, (b) cash flows to sales, (c) cash flows to assets, and (d) free cash flow.
5. Prepare an analysis of market strength by calculating for each year the
(a) price/earnings (P/E) ratio and (b) dividends yield.
User insight (cid:2) 6. After making the calculations, indicate whether each ratio improved or dete-
riorated from 2010 to 2011 (use F for favorable and U for unfavorable and
consider changes of 0.1 or less to be neutral).
LO3 Comprehensive Ratio Analysis of Two Companies
P 4. Agnes Ball is considering an investment in the common stock of a chain of
retail department stores. She has narrowed her choice to two retail companies,
Fast Corporation and Style Corporation, whose income statements and balance
sheets are presented on the next page.
During the year, Fast Corporation paid a total of $50,000 in dividends. The
market price per share of its stock is currently $60. In comparison, Style Corporation
paid a total of $114,000 in dividends, and the current market price of its stock is $76
per share. Fast Corporation had net cash flows from operations of $271,500 and net
capital expenditures of $625,000. Style Corporation had net cash flows from opera-
tions of $492,500 and net capital expenditures of $1,050,000. Information for prior
years is not readily available. Assume that all notes payable are current liabilities and
all bonds payable are long-term liabilities and that there is no change in inventory.
746 CHAPTER 16 Financial Performance Measurement
Income Statements
Fast Style
Net sales $12,560,000 $25,210,000
Costs and expenses
Cost of goods sold $ 6,142,000 $14,834,000
Selling expenses 4,822,600 7,108,200
Administrative expenses 986,000 2,434,000
Total costs and expenses $11,950,600 $24,376,200
Income from operations $ 609,400 $ 833,800
Interest expense 194,000 228,000
Income before income taxes $ 415,400 $ 605,800
Income taxes expense 200,000 300,000
Net income $ 215,400 $ 305,800
Earnings per share $ 4.31 $ 10.19
Balance Sheets
Fast Style
Assets
Cash $ 80,000 $ 192,400
Marketable securities (at cost) 203,400 84,600
Accounts receivable (net) 552,800 985,400
Inventory 629,800 1,253,400
Prepaid expenses 54,400 114,000
Property, plant, and equipment (net) 2,913,600 6,552,000
Intangibles and other assets 553,200 144,800
Total assets $4,987,200 $9,326,600
Liabilities and Stockholders’ Equity
Accounts payable $ 344,000 $ 572,600
Notes payable 150,000 400,000
Income taxes payable 50,200 73,400
Bonds payable 2,000,000 2,000,000
Common stock, $20 par value 1,000,000 600,000
|
Additional paid-in capital 609,800 3,568,600
Retained earnings 833,200 2,112,000
Total liabilities and stockholders’ equity $4,987,200 $9,326,600
Required
Conduct a comprehensive ratio analysis for each company, using the available
information. Compare the results. Round percentages and ratios to one decimal
place, and consider changes of 0.1 or less to be indeterminate.
1. Prepare a liquidity analysis by calculating for each company the (a) current
ratio, (b) quick ratio, (c) receivable turnover, (d) days’ sales uncollected,
(e) inventory turnover, (f) days’ inventory on hand, (g) payables turnover,
and (h) days’ payable.
2. Prepare a profitability analysis by calculating for each company the (a) profit
margin, (b) asset turnover, (c) return on assets, and (d) return on equity.
Chapter Assignments 747
3. Prepare a long-term solvency analysis by calculating for each company the
(a) debt to equity ratio and (b) interest coverage ratio.
4. Prepare a cash flow adequacy analysis by calculating for each company the
(a) cash flow yield, (b) cash flows to sales, (c) cash flows to assets, and
(d) free cash flow.
5. Prepare an analysis of market strength by calculating for each company the
(a) price/earnings (P/E) ratio and (b) dividends yield.
User insight (cid:2) 6. Compare the two companies by inserting the ratio calculations from 1
through 5 in a table with the following column headings: Ratio Name, Fast,
Style, and Company with More Favorable Ratio. Indicate in the last column
which company had the more favorable ratio in each case.
User insight (cid:2) 7. How could the analysis be improved if information about these companies’
prior years were available?
Alternate Problems
LO3 Effects of Transactions on Ratios
P 5. Lim Corporation engaged in the transactions listed in the first column of
the following table. Opposite each transaction is a ratio and space to indicate the
effect of each transaction on the ratio.
Effect
Transaction Ratio Increase Decrease None
a. Sold merchandise on account. Current ratio
b. Sold merchandise on account. Inventory turnover
c. Collected on accounts receivable. Quick ratio
d. Wrote off an uncollectible account. Receivable turnover
e. Paid on accounts payable. Current ratio
f. Declared cash dividend. Return on equity
g. Incurred advertising expense. Profit margin
h. Issued stock dividend. Debt to equity ratio
i. Issued bonds payable. Asset turnover
j. Accrued interest expense. Current ratio
k. Paid previously declared cash dividend. Dividends yield
l. Purchased treasury stock. Return on assets
m. Recorded depreciation expense. Cash flow yield
Required
User insight (cid:2) Show that you understand the effect of business activities on performance mea-
sures by placing an X in the appropriate column to show whether the transaction
increased, decreased, or had no effect on the indicated ratio.
LO3 Comprehensive Ratio Analysis
P 6. Data for Robert Company in 2011 and 2010 follow. These data should be
used in conjunction with the data in P 1.
748 CHAPTER 16 Financial Performance Measurement
2011 2010
Net cash flows from operating activities ($98,000) $72,000
Net capital expenditures $20,000 $32,500
Dividends paid $22,000 $17,200
Number of common shares 20,000 20,000
Market price per share $18 $30
Selected balances at the end of 2009 were accounts receivable (net), $103,400;
inventory, $273,600; total assets, $732,800; accounts payable, $193,300; and
stockholders’ equity, $320,600. All Robert’s notes payable were current liabili-
ties; all its bonds payable were long-term liabilities.
Required
Perform a comprehensive ratio analysis following the steps outlined below. Round
all answers to one decimal place.
1. Prepare a liquidity analysis by calculating for each year the (a) current
ratio, (b) quick ratio, (c) receivable turnover, (d) days’ sales uncollected,
(e) inventory turnover, (f) days’ inventory on hand, (g) payables turnover, and
(h) days’ payable.
2. Prepare a profitability analysis by calculating for each year the (a) profit mar-
gin, (b) asset turnover, (c) return on assets, and (d) return on equity.
|
3. Prepare a long-term solvency analysis by calculating for each year the (a) debt
to equity ratio and (b) interest coverage ratio.
4. Prepare a cash flow adequacy analysis by calculating for each year the (a) cash
flow yield, (b) cash flows to sales, (c) cash flows to assets, and (d) free cash
flow.
5. Prepare a market strength analysis by calculating for each year the (a) price/
earnings (P/E) ratio and (b) dividends yield.
User insight (cid:2) 6. After making the calculations, indicate whether each ratio improved or dete-
riorated from 2010 to 2011 (use F for favorable and U for unfavorable and
consider changes of 0.1 or less to be neutral).
LO2 Horizontal and Vertical Analysis
P 7. Sanborn Corporation’s condensed comparative income statements for 2012
and 2011 appear below. The corporation’s condensed comparative balance sheets
for 2012 and 2011 appear on the next page.
Sanborn Corporation
Comparative Income Statements
For the Years Ended December 31, 2012 and 2011
2012 2011
Net sales $3,276,800 $3,146,400
Cost of goods sold 2,088,800 2,008,400
Gross margin $1,188,000 $1,138,000
Operating expenses
Selling expenses $ 476,800 $ 518,000
Administrative expenses 447,200 423,200
Total operating expenses $ 924,000 $ 941,200
Income from operations $ 264,000 $ 196,800
Interest expense 65,600 39,200
Income before income taxes $ 198,400 $ 157,600
Income taxes expense 62,400 56,800
Net income $ 136,000 $ 100,800
Earnings per share $ 3.40 $ 2.52
Chapter Assignments 749
Sanborn Corporation
Comparative Balance Sheets
December 31, 2012 and 2011
2012 2011
Assets
Cash $ 81,200 $ 40,800
Accounts receivable (net) 235,600 229,200
Inventory 574,800 594,800
Property, plant, and equipment (net) 750,000 720,000
Total assets $1,641,600 $1,584,800
Liabilities and Stockholders’ Equity
Accounts payable $ 267,600 $ 477,200
Notes payable (short-term) 200,000 400,000
Bonds payable 400,000 —
Common stock, $10 par value 400,000 400,000
Retained earnings 374,000 307,600
Total liabilities and stockholders’ equity $1,641,600 $1,584,800
Required
1. Prepare schedules showing the amount and percentage changes from 2011
to 2012 for the comparative income statements and the balance sheets.
2. Prepare common-size income statements and balance sheets for 2011 and
2012.
User insight (cid:2) 3. Comment on the results in requirements 1 and 2 by identifying favorable and
unfavorable changes in the components and composition of the statements.
LO3 Comprehensive Ratio Analysis of Two Companies
P 8. Ginger Adair is considering an investment in the common stock of a chain
of retail department stores. She has narrowed her choice to two retail companies,
Lewis Corporation and Ramsey Corporation, whose income statements and bal-
ance sheets are presented on the next page.
During the year, Lewis Corporation paid a total of $100,000 in dividends.
The market price per share of its stock is currently $60. In comparison, Ramsey
Corporation paid a total of $228,000 in dividends, and the current market price
of its stock is $76 per share. Lewis Corporation had net cash flows from opera-
tions of $543,000 and net capital expenditures of $1,250,000. Ramsey Corpora-
tion had net cash flows from operations of $985,000 and net capital expenditures
of $2,100,000. Information for prior years is not readily available. Assume that all
notes payable are current liabilities and all bonds payable are long-term liabilities
and that there is no change in inventory.
750 CHAPTER 16 Financial Performance Measurement
Income Statements
Lewis Ramsey
Net sales $25,120,000 $50,420,000
Costs and expenses
Cost of goods sold $12,284,000 $29,668,000
Selling expenses 9,645,200 14,216,400
Administrative expenses 1,972,000 4,868,000
Total costs and expenses $23,901,200 $48,752,400
Income from operations $ 1,218,800 $ 1,667,600
Interest expense 388,000 456,000
Income before income taxes $ 830,800 $ 1,211,600
Income taxes expense 400,000 600,000
Net income $ 430,800 $ 611,600
Earnings per share $ 4.31 $ 10.19
Balance Sheets
Lewis Ramsey
Assets
Cash $ 160,000 $ 384,800
Marketable securities (at cost) 406,800 169,200
|
Accounts receivable (net) 1,105,600 1,970,800
Inventory 1,259,600 2,506,800
Prepaid expenses 108,800 228,000
Property, plant, and equipment (net) 5,827,200 13,104,000
Intangibles and other assets 1,106,400 289,600
Total assets $9,974,400 $18,653,200
Liabilities and Stockholders’ Equity
Accounts payable $ 688,000 $ 1,145,200
Notes payable 300,000 800,000
Income taxes payable 100,400 146,800
Bonds payable 4,000,000 4,000,000
Common stock, $20 par value 2,000,000 1,200,000
Additional paid-in capital 1,219,600 7,137,200
Retained earnings 1,666,400 4,224,000
Total liabilities and stockholders’ equity $9,974,400 $18,653,200
Required
Conduct a comprehensive ratio analysis for each company, following the steps
below. Compare the results. Round percentages and ratios to one decimal place,
and consider changes of 0.1 or less to be indeterminate.
1. Prepare a liquidity analysis by calculating for each company the (a) current
ratio, (b) quick ratio, (c) receivable turnover, (d) days’ sales uncollected,
(e) inventory turnover, (f) days’ inventory on hand, (g) payables turnover,
and (h) days’ payable.
2. Prepare a profitability analysis by calculating for each company the (a) profit
margin, (b) asset turnover, (c) return on assets, and (d) return on equity.
Chapter Assignments 751
3. Prepare a long-term solvency analysis by calculating for each company the
(a) debt to equity ratio and (b) interest coverage ratio.
4. Prepare a cash flow adequacy analysis by calculating for each company the (a) cash
flow yield, (b) cash flows to sales, (c) cash flows to assets, and (d) free cash flow.
5. Prepare an analysis of market strength by calculating for each company the
(a) price/earnings (P/E) ratio and (b) dividends yield.
User insight (cid:2) 6. Compare the two companies by inserting the ratio calculations from 1
through 5 in a table with the following column headings: Ratio Name, Lewis,
Ramsey, and Company with More Favorable Ratio. Indicate in the last col-
umn which company had the more favorable ratio in each case.
User insight (cid:2) 7. How could the analysis be improved if information about these companies’
prior years were available?
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO1 LO3 Standards for Financial Performance Evaluation
C 1. In 2005, in a dramatic move, Standard & Poor’s Ratings Group, the large
financial company that evaluates the riskiness of companies’ debt, downgraded
its rating of General Motors and Ford Motor Co. debt to “junk” bond status
because of concerns about the companies’ profitability and cash flows. Despite
aggressive cost cutting, both companies still face substantial future liabilities for
health care and pension obligations. They are losing money or barely breaking
even on auto operations that concentrate on slow-selling SUVs. High gas prices
and competition force them to sell the cars at a discount.9 What standards do you
think Standard & Poor’s would use to evaluate General Motors' progress? What
performance measures would Standard & Poor’s most likely use in making its
evaluation? In light of the fortunes of these companies during the recent financial
crisis, did Standard & Poor’s deserve the criticism the company received?
LO1 Using Segment Information
C 2. Refer to Exhibit 16-1, which shows the segment information of Goodyear
Tire & Rubber Company. In what business segments does Goodyear operate?
What is the relative size of its business segments in terms of sales and income in
the most recent year shown? Which segment is most profitable in terms of return
on assets? Which segment is largest, and which segment is most profitable in
terms of return on assets?
LO1 Using Investors’ Services
C 3. Refer to Exhibit 16-2, which contains the PepsiCo Inc. listing from Mer-
gent’s Handbook of Dividend Achievers. Assume that an investor has asked you to
assess PepsiCo’s recent history and prospects. Write a memorandum to the inves-
tor that addresses the following points:
1. PepsiCo’s earnings history. What has been the general relationship between
PepsiCo’s return on assets and its return on equity over the last seven years?
|
What does this tell you about the way the company is financed? What figures
back up your conclusion?
2. The trend of PepsiCo’s stock price and price/earnings (P/E) ratio for the
seven years shown.
3. PepsiCo’s prospects, including developments likely to affect the company’s
future.
752 CHAPTER 16 Financial Performance Measurement
LO2 LO3 Effect of a One-Time Item on a Loan Decision
C 4. Apple a Day, Inc., and Unforgettable Edibles, Inc., are food catering busi-
nesses that operate in the same metropolitan area. Their customers include
Fortune 500 companies, regional firms, and individuals. The two firms reported
similar profit margins for the current year, and both base bonuses for managers
on the achievement of a target profit margin and return on equity. Each firm has
submitted a loan request to you, a loan officer for City National Bank. They have
provided you with the following information:
Unforgettable
Apple a Day Edibles
Net sales $625,348 $717,900
Cost of goods sold 225,125 287,080
Gross margin $400,223 $430,820
Operating expenses 281,300 371,565
Operating income $118,923 $ 59,255
Gain on sale of real estate — 81,923
Interest expense (9,333) (15,338)
Income before income taxes $109,590 $125,840
Income taxes expense 25,990 29,525
Net income $ 83,600 $ 96,315
Average stockholders’ equity $312,700 $390,560
1. Perform a vertical analysis and prepare a common-size income statement for
each firm. Compute profit margin and return on equity.
2. Discuss these results, the bonus plan for management, and loan consider-
ations. Identify the company that is the better loan risk.
LO3 Comprehensive Ratio Analysis
C 5. Using data from the CVS Corporation annual report in the Supplement to
Chapter 5, conduct a comprehensive ratio analysis that compares the company’s
performance in 2008 and 2007. If you have computed ratios for CVS in previous
chapters, you may prepare a table that summarizes the ratios and show calculations
only for the ratios not previously calculated. If this is the first ratio analysis you
have done for CVS, show all your computations. In either case, after each group
of ratios, comment on the performance of CVS. Round your calculations to one
decimal place. Prepare and comment on the following categories of ratios:
Liquidity analysis: current ratio, quick ratio, receivable turnover, days’ sales
uncollected, inventory turnover, days’ inventory on hand, payables turnover,
and days’ payable. (Accounts Receivable, Inventories, and Accounts Payable
were [in millions] $2,381.7, $7,108.9, and $2,521.5, respectively, in 2006.)
Profitability analysis: profit margin, asset turnover, return on assets, and return
on equity. (Total assets and total shareholders’ equity were [in millions]
$20,574,1 and $9,917.6, respectively, in 2006.)
Long-term solvency analysis: debt to equity ratio and interest coverage ratio.
Cash flow adequacy analysis: cash flow yield, cash flows to sales, cash flows to
assets, and free cash flow.
Market strength analysis: price/earnings (P/E) ratio and dividends yield.
Chapter Assignments 753
LO3 Comparison of Key Financial Performance Measures
C 6. Refer to the annual report of CVS Corporation and the financial statements
of Southwest Airlines Co. in the Supplement to Chapter 5. Prepare a table for
the following key financial performance measures for the two most recent years
for both companies. Use your computations in C 5 or perform those analyses if
you have not done so. Total assets for Southwest in 2006 were $13,460 million.
Profitability: profit margin
asset turnover
return on assets
Long-term solvency: debt to equity ratio
Cash flow adequacy: cash flow yield
free cash flow
Evaluate and comment on the relative performance of the two companies with
respect to each of the above categories.
C H A P T E R
17
Partnerships
T his chapter discusses the characteristics of the partnership
Making a
Statement form of business and examines accounting issues relating
to the formation, dissolution, and liquidation of partnerships, as
INCOME STATEMENT
well as the division of income among partners.
Revenues
|
– Expenses
LEARNING OBJECTIVES
= Net Income
LO1 Identify the principal characteristics, advantages, and
disadvantages of the partnership form of business. (pp. 756–759)
STATEMENT OF
PARTNERS’ EQUITY LO2 Record partners’ investments of cash and other assets when a
partnership is formed. (pp. 759–760)
Opening Balance
+ Net Income LO3 Compute and record the income or losses that partners share,
– Withdrawals based on stated ratios, capital balance ratios, and partners’
salaries and interest. (pp. 761–766)
= Partners’ EQUITY
LO4 Record a person’s admission to or withdrawal from a
BALANCE SHEET partnership. (pp. 767–772)
Assets Liabilities
LO5 Compute and record the distribution of assets to partners
when they liquidate their partnership. (pp. 772–778)
Partners’
Equity
STATEMENT OF CASH FLOWS
Operating activities
+ Investing activities
+ Financing activities
= Change in Cash
+ Starting Balance
= Ending Cash Balance
754
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) What details should be included
in a partnership agreement?
HOLDER AND WILLIAMS
PARTNERSHIP (cid:2) How would Jack Holder and Dan
Williams share the income or
losses of their business?
Jack Holder and Dan Williams reached an agreement in 2010 to (cid:2) How would they handle any
pool their resources and form a partnership to manufacture and changes in ownership that
sell u niversity T-shirts. To form the partnership, Jack contributed might occur?
$100,000, and Dan contributed $150,000. As they were preparing
their partnership agreement, they had to make a number of impor-
tant decisions, including how they would share the income or losses
of the business and how they would handle both the admission of
new partners and the withdrawal of partners. In this chapter, we dis-
cuss these issues, as well as several other accounting issues that part-
nerships entail.
755
756 CHAPTER 17 Partnerships
Partnership
The Uniform Partnership Act, which has been adopted by most states, defines a
Characteristics partnership as “an association of two or more persons to carry on as co-owners
of a business for profit.” Partnerships are treated as separate entities in account-
ing, but legally there is no economic separation between them and their owners.
LO1 Identify the principal
They differ in many ways from the other forms of business. Here we describe
characteristics, advantages, and
some of their important characteristics.
disadvantages of the partnership
form of business.
Characteristics of Partnerships
Study Note AA partnership is a voluntary association of individuals rather than a legal entity
iin itself. Therefore, a partner is responsible under the law for his or her partners’
Partnerships and sole
aactions within the scope of the business. A partner also has unlimited liability for
proprietorships are not legal
tthe debts of the partnership. Because of these potential liabilities, a partner must
entities; corporations are. All
bbe allowed to choose the people who join the partnership. A person should select
three, however, are considered
aas partners individuals who share his or her business objectives.
accounting entities.
PPartnership Agreement A partnership is easy to form. Two or more com-
petent people simply agree to be partners in a common business purpose. Their
agreement is known as a partnership agreement. The partnership agreement
does not have to be in writing. However, good business practice calls for a writ-
ten document that clearly states the details of the arrangement, including the
name, location, and purpose of the business; the names of the partners and their
respective duties; the investments of each partner; the method of distributing
income and losses; and the procedures for the admission and withdrawal of part-
ners, the withdrawal of assets allowed each partner, and the liquidation (termina-
tion) of the business.
Limited Life Because a partnership is formed by an agreement between part-
ners, it has a limited life. It may be dissolved when a new partner is admitted;
when a partner withdraws, goes bankrupt, is incapacitated (to the point that he
|
or she cannot perform as obligated), retires, or dies; or when the terms of the
partnership agreement are met (e.g., when the project for which the partner-
ship was formed is completed). However, if the partners want the partnership to
continue legally, the partnership agreement can be written to cover each of these
situations. For example, the partnership agreement can state that if a partner dies,
the remaining partner or partners must purchase the deceased partner’s capital at
book value from the heirs.
Mutual Agency Each partner is an agent of the partnership within the scope
of the business. Because of this mutual agency, any partner can bind the part-
nership to a business agreement as long as he or she acts within the scope of the
company’s normal operations. For example, a partner in a used-car business can
bind the partnership through the purchase or sale of used cars. But this partner
cannot bind the partnership to a contract to buy men’s clothing or any other
goods that are not related to the used-car business. Because of mutual agency, it
is very important for an individual to choose business partners who have integrity
and who share his or her business objectives.
Unlimited Liability All partners have unlimited liability for their compa-
ny’s debt, which means that each partner is personally liable for all the debts of
the partnership. If a partnership cannot pay its debts, creditors must first satisfy
their claims from the assets of the business. If these assets are not enough to
Partnership Characteristics 757
ppay all debts, the creditors can seek payment from the personal assets of each
Study Note
ppartner. If one partner’s personal assets are used up before the debts are paid,
tthe creditors can claim additional assets from the remaining partners who are
Unlimited liability means
aable to pay. Each partner, then, can be required by law to pay all the debts of
that potential responsibility
for debts is not limited by tthe partnership.
one’s investment, as it is in a
corporation. Each person is
Co-Ownership of Partnership Property When individuals invest prop-
personally liable for all debts
eerty in a partnership, they give up the right to their separate use of the prop-
of the partnership, including
eerty. The property becomes an asset of the partnership and is owned jointly by
those arising from contingent
tthe partners.
liabilities such as lawsuits.
Liability can be avoided only by
filing for personal bankruptcy. Participation in Partnership Income Each partner has the right to share in
tthe company’s income and the responsibility to share in its losses. The partner-
sship agreement should state the method of distributing income and losses to each
partner. If the agreement describes how income should be shared but does not
mention losses, losses are distributed in the same way as income. If the agreement
does not describe the method of income and loss distribution, the partners must
by law share income and losses equally.
Advantages and Disadvantages of Partnerships
Study Note
Partnerships have both advantages and disadvantages. One advantage is that a
There is no federal income tax partnership is easy to form, change, and dissolve. Also, a partnership facilitates the
on partnerships; partners are
pooling of capital resources and individual talents; it has no corporate tax bur-
taxed at their personal rates.
den (because a partnership is not a legal entity for tax purposes, it does not have
However, partnerships must file
to pay a federal income tax, as do corporations, but must file an informational
an informational return with
return); and it gives the partners a certain amount of freedom and flexibility.
the IRS, and some state and
On the other hand, partnerships have the following disadvantages: the life
local governments levy a tax on
of a partnership is limited; one partner can bind the partnership to a contract
them. An example of this is the
(mutual agency); the partners have unlimited personal liability; and it is more dif-
Michigan Single Business Tax.
ficult for a partnership to raise large amounts of capital and to transfer ownership
|
interests than it is for a corporation.
Limited Partnerships and Joint Ventures
Two other common forms of association that are a type of partnership or similar
to a partnership are limited partnerships and joint ventures.
FOCUS ON BUSINESS PRACTICE
Why Are Limited Partnerships Used to Finance Big Projects?
Limited partnerships resemble corporations in that the shopping centers, office buildings, and apartment com-
liability of the partners is restricted to the amount of plexes). For example, Alliance Capital Management
their investment in the business. Because limited part- Limited Partnership, a large investment advisor, man-
nerships curtail an investor’s risk, they are sometimes ages more than $90 billion in assets for corporate and
used in place of corporations to raise funds from the individual investors in various projects. The company’s
public to finance large projects, such as the exploration partnership units, or shares of ownership, sell on the
and drilling of oil and gas wells, the manufacture of air- New York Stock Exchange and can be purchased by the
planes, and the development of real estate (including individual investor.
758 CHAPTER 17 Partnerships
FOCUS ON BUSINESS PRACTICE
How Do Partnerships Facilitate International Investment?
When U.S. companies make investments abroad, they often need for outside capital and operational know-how with
find it wise to partner with a local company. Because many investors’ interest in business expansion and profitability.
countries require that local investors own a substantial per- Joint ventures frequently take the form of partnerships
centage of a newly formed business, partnering with a local among two or more corporations and other investors. Any
company is often a necessary step. One way of accomplish- income or losses from operations are divided among the
ing this is to form a joint venture, which matches a country’s participants according to a predetermined agreement.
Limited Partnerships A limited partnership is a special type of partnership
that, like corporations, confines the limited partner’s potential loss to the amount
of his or her investment. Under this type of partnership the unlimited liability
disadvantage of a partnership can be overcome. Usually, the limited partnership
has a general partner who has unlimited liability but allows other partners to limit
their potential loss. The potential loss of all partners in an ordinary partnership is
limited only by personal bankruptcy laws.
Joint Ventures In today’s global environment, more companies are looking to
ffoorm alliances similar to partnerships, called joint ventures, with other companies
Study Note
rraather than to venture out on their own. A joint venture is an association of two
Many types of organizations oorr more entities for the purpose of achieving a specific goal, such as the manu-
have been created by law. ffaacture of a product in a new market. Many joint ventures have an agreed-upon
They include S corporations lliimmited life. The entities forming joint ventures usually involve companies but
and limited partnerships. Each ccaan sometimes involve governments, especially in emerging economies. A joint
provides legal (especially tax) vveenture brings together the resources, technical skills, political ties, and other
advantages and disadvantages. aasssets of each of the parties for a common goal. Profits and losses are shared on
aann agreed-upon basis.
FOCUS ON BUSINESS PRACTICE
Corporations That Look Like Partnerships
Some types of corporations mimic the characteristics of in the business. LLCs are used mainly by accounting and
partnerships. S corporations are corporations that U.S. consultancy firms.
tax laws treat as partnerships. Unlike normal corpora- Special-purpose entities (SPEs), which gained notoriety
tions, S corporations do not pay federal income taxes. because of the Enron case, are firms with limited lives that
They have a limited number of stockholders, who report a company creates to achieve a specific objective, such as
the income or losses on their investments in the business raising money by selling receivables. By meeting certain
|
on their personal tax returns. This avoids the problem of conditions, a company that sets up an SPE can legitimately
double taxation. avoid including the debt of the SPE on its balance sheet.
In a limited liability corporation (LLC), the stockholders Enron used SPEs extensively and fraudulently to hide debt
are partners, and their liability is limited to their investment and other commitments.
Accounting for Partners’ Equity 759
STOP
& APPLY
Indicate whether each statement below is a reflection of (a) voluntary association, (b) a partnership
agreement, (c) limited life, (d) mutual agency, or (e) unlimited liability.
1. W hen a partner is admitted, withdraws, retires, 4. A written contract specifies details of the
or dies, the partnership must be dissolved. arrangements among partners.
2. A partner may be required to pay the debts 5. A ny partner can bind the partnership to a
of the partnership out of personal assets. business agreement.
3. A partner does not have to remain a partner
if he or she does not want to.
SOLUTION
1. c; 2. e; 3. a; 4. b; 5. d
Accounting
Although accounting for a partnership is very similar to accounting for a sole
for Partners’ proprietorship, there are differences. One is that the owner’s equity in a partner-
ship is called partners’ equity. In accounting for partners’ equity, it is necessary
Equity
to maintain separate Capital and Withdrawals accounts for each partner and to
divide the income and losses of the company among the partners.
LO2 Record partners’ invest-
The differences in the Capital accounts of a sole proprietorship and a partner-
ments of cash and other assets
ship are as follows:
when a partnership is formed.
SOLE PROPRIETORSHIP PARTNERSHIP
BLAKE, CAPITAL DESMOND, CAPITAL FRANK, CAPITAL
Dr. Cr. Dr. Cr. Dr. Cr.
50,000 30,000 40,000
BLAKE, WITHDRAWALS DESMOND, WITHDRAWALS FRANK, WITHDRAWALS
Dr. Cr. Dr. Cr. Dr. Cr.
12,000 5,000 6,000
In the partners’ equity section of the balance sheet, the balance of each partner’s
Capital account is listed separately:
Liabilities and Partners’ Equity
Dr. Cr.
Total liabilities $28,000
Partners’ equity
Desmond, capital $25,000
Frank, capital 34,000
Total partners’ equity 59,000
Total liabilities and partners’ equity $87,000
Each partner invests cash, other assets, or both in the partnership according
to the partnership agreement. Noncash assets should be valued at their fair mar-
ket value on the date they are transferred to the partnership. The assets invested
by a partner are debited to the proper account, and the total amount is credited
to the partner’s Capital account.
To show how partners’ investments are recorded, let’s assume that Jerry
Adcock and Rose Villa have agreed to combine their capital and equipment in a
760 CHAPTER 17 Partnerships
partnership to operate a jewelry store. According to their partnership agreement,
Adcock will invest $28,000 in cash and $37,000 worth of furniture and displays,
and Villa will invest $40,000 in cash and $30,000 worth of equipment. Related
to the equipment is a note payable for $10,000, which the partnership assumes.
The entries to record the partners’ initial investments are as follows:
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:3)28,000 (cid:3)65,000 2010 Dr. Cr.
(cid:3)37,000
July 1 Cash 28,000
Furniture and Displays 37,000
Jerry Adcock, Capital 65,000
Initial investment of Jerry
Adcock in Adcock and Villa
1 Cash 40,000
A (cid:3) L (cid:4) OE Equipment 30,000
(cid:3)30,000 (cid:3)10,000 (cid:3)60,000 Notes Payable 10,000
(cid:3)40,000
Rose Villa, Capital 60,000
Initial investment of Rose
Villa in Adcock and Villa
The values assigned to the assets would be included in the partnership agree-
Study Note ment. These values can differ from those carried on the partners’ personal books.
For example, the equipment that Rose Villa contributed had a value of only
Villa’s noncash contribution is $22,000 on her books, but its market value had increased considerably after she
equal to the fair market value of
purchased it. The book value of Villa’s equipment is not important. The fair mar-
|
the equipment less the amount
ket value of the equipment at the time of transfer is important, however, because
owed on the equipment.
that value represents the amount of money Villa has invested in the partnership.
Later investments are recorded in the same way.
STOP
& APPLY
On June 1, Sarah and Alma form a partnership to operate a fitness center. Sara contributes cash of
$24,000, and Alma contributes exercise equipment that cost $20,000 but is valued at $16,000.
Prepare the entry in journal form to record the partners’ initial investments.
SOLUTION
Dr. Cr.
June 1 Cash 24,000
Exercise Equipment 16,000
Sara, Capital 24,000
Alma, Capital 16,000
Formation of partnership
Distribution of Partnership Income and Losses 761
Distribution
A partnership’s income and losses can be distributed according to whatever
of Partnership method the partners specify in the partnership agreement. Income in this form
of business normally has three components: return to the partners for the use of
Income and Losses
their capital (called interest on partners’ capital), compensation for services the
partners have rendered (partners’ salaries), and other income for any special con-
LO3 Compute and record the
tributions individual partners may make to the partnership or risks they may take.
income or losses that partners
The breakdown of total income into its three components helps clarify how much
share, based on stated ratios,
each partner has contributed to the firm.
capital balance ratios, and part-
If all partners contribute equal capital, have similar talents, and spend the
ners’ salaries and interest.
same amount of time in the business, then an equal distribution of income and
losses would be fair. However, if one partner works full-time in the firm and
another devotes only a fourth of his or her time, then the distribution of income
Study Note or losses should reflect the difference. (This concept would apply to any situation
in which the partners contribute unequally to the business.)
The division of income is one
Distributing income and losses among partners can be accomplished by
area in which a partnership
using stated ratios or capital balance ratios or by paying the partners’ sala-
differs from a corporation. In
corporations, each common ries and interest on their capital and sharing the remaining income according
share receives an equal to stated ratios. Salaries and interest here are not salaries expense or interest
dividend. Partners can use any expense in the ordinary sense of the terms. They do not affect the amount of
method they agree on to divide reported net income. Instead, they refer to ways of determining each partner’s
partnership income. share of net income or net loss on the basis of time spent and money invested
in the partnership.
Stated Ratios
One method of distributing income and losses is to give each partner a stated
ratio of the total income or loss. If each partner is making an equal contribution
to the firm, each can assume the same share of income and losses. It is important
to understand that an equal contribution to the firm does not necessarily mean an
equal capital investment in the firm. One partner may be devoting more time and
talent to the firm, whereas another may have made a larger capital investment.
And if the partners contribute unequally to the firm, unequal stated ratios can be
appropriate.
Let’s assume that Adcock and Villa had a net income last year of $140,000.
Study Note Their partnership agreement states that the percentages of income and losses dis-
tributed to Jerry Adcock and Rose Villa should be 60 percent and 40 percent,
The computations of each
respectively. The computation of each partner’s share of the income and the entry
partner’s share of net income
to show the distribution are as follows:
are relevant to the closing
entries in which the Income Adcock ($140,000 (cid:6) 0.60) $ 84,000
Summary account is closed to Villa ($140,000 (cid:6) 0.40) 56,000
the partners’ Capital accounts.
Net income $140,000
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:4)140,000 2011 Dr. Cr.
|
(cid:3)84,000
(cid:3)56,000 June 30 Income Summary 140,000
Jerry Adcock, Capital 84,000
Rose Villa, Capital 56,000
Distribution of income for the year
to the partners’ Capital accounts
762 CHAPTER 17 Partnerships
Capital Balance Ratios
If invested capital produces the most income for the partnership, then income
and losses may be distributed according to capital balances. The ratio used to dis-
tribute income and losses here may be based on each partner’s capital balance at
the beginning of the year or on the average capital balance of each partner during
the year. The partnership agreement must describe the method to be used.
Ratios Based on Beginning Capital Balances To show how the first
method works, let’s look at the beginning capital balances of the partners in Adcock
and Villa. At the start of the fiscal year, July 1, 2010, Jerry Adcock, Capital showed
a $65,000 balance and Rose Villa, Capital showed a $60,000 balance. (Actually,
these balances reflect the partners’ initial investment; the partnership was formed
on July 1, 2010.) The total partners’ equity in the firm, then, was $125,000. Each
partner’s capital balance at the beginning of the year divided by the total partners’
equity at the beginning of the year is that partner’s beginning capital balance ratio:
Beginning Capital Beginning Capital
Balance Balance Ratio
Jerry Adcock $ 65,000 65,000 (cid:5) 125,000 (cid:2) 0.52 (cid:2) 52%
Rose Villa 60,000 60,000 (cid:5) 125,000 (cid:2) 0.48 (cid:2) 48%
$125,000
The income that each partner should receive when distribution is based on begin-
ning capital balance ratios is determined by multiplying the total income by each
partner’s capital ratio. If we assume that income for the year was $140,000, Jerry
Adcock’s share of that income was $72,800, and Rose Villa’s share was $67,200.
Jerry Adcock $140,000 (cid:6) 0.52 (cid:2) $ 72,800
Rose Villa $140,000 (cid:6) 0.48 (cid:2) 67,200
$140,000
Ratios Based on Average Capital Balances If Adcock and Villa use
beginning capital balance ratios to determine the distribution of income, they do
not consider any investments or withdrawals made during the year. But investments
and withdrawals usually change the partners’ capital ratios. If the partners believe
their capital balances will change dramatically during the year, they can choose aver-
age capital balance ratios as a fairer means of distributing income and losses.
The following T accounts show the activity over the year in Adcock and Villa’s
partners’ Capital and Withdrawals accounts:
JERRY ADCOCK, CAPITAL JERRY ADCOCK, WITHDRAWALS
Dr. Cr. Dr. Cr.
7/1/2010 65,000 1/1/ 2011 10,000
ROSE VILLA, CAPITAL ROSE VILLA, WITHDRAWALS
Dr. Cr. Dr. Cr.
7/1/2010 60,000 11/1/2010 10,000
2/1/2011 8,000
Jerry Adcock withdrew $10,000 on January 1, 2011, and Rose Villa withdrew
$10,000 on November 1, 2010, and invested an additional $8,000 of equipment
on February 1, 2011. Again, the income for the year’s operation (July 1, 2010, to
June 30, 2011) was $140,000. The calculations for the average capital balances
and the distribution of income are as follows:
Distribution of Partnership Income and Losses 763
AVERAGE CAPITAL BALANCES
AVERAGE
CAPITAL MONTHS CAPITAL
PARTNER DATE BALANCE (cid:5) UNCHANGED (cid:3) TOTAL BALANCE
Adcock July–Dec. $65,000 (cid:6) 6 (cid:2) $390,000
Jan.–June $55,000 (cid:6) 6 (cid:2) 330,000
12 $720,000 (cid:5) 12 (cid:2) $ 60,000
Villa July–Oct. $60,000 (cid:6) 4 (cid:2) $240,000
Nov.–Jan. $50,000 (cid:6) 3 (cid:2) 150,000
Feb.–June $58,000 (cid:6) 5 (cid:2) 290,000
12 $680,000 (cid:5) 12 (cid:2) 56,667
Total average capital $116,667
AVERAGE CAPITAL BALANCE RATIOS
Adcock (cid:2) A __d _c _o _c _k _’s _ A _v _ e _r _a _g _e _ _C _a _p _i t _a _ l _B _a _ la _n __ce _ (cid:2) _ $_6_0_,_0_0_0_ (cid:2) 0.514 (cid:2) 51.4%
Total Average Capital $116,667
Villa (cid:2) V _i _ll _a _’s _ _A _v _e _r _a _g _e _ C _a _p __it _a _l _B _a _la _ n _c _e _ (cid:2) _$_5_6_,_6_6_7_ (cid:2) 0.486 (cid:2) 48.6%
Total Average Capital $116,667
DISTRIBUTION OF INCOME
SHARE OF
PARTNER INCOME (cid:5) RATIO (cid:3) INCOME
|
Adcock $140,000 (cid:6) 0.514 (cid:2) $ 71,960
Villa $140,000 (cid:6) 0.486 (cid:2) 68,040
Total income $140,000
Notice that to determine the distribution of income (or loss), you must
determine the average capital balances, the average capital balance ratios, and
each partner’s share of income or loss. To compute each partner’s average capital
balance, you must examine the changes that have occurred during the year in
each partner’s capital balance, changes that are the product of further investments
and withdrawals. The partner’s beginning capital is multiplied by the number of
months the balance remains unchanged. After the balance changes, the new bal-
ance is multiplied by the number of months it remains unchanged. The process
continues until the end of the year. The totals of these computations are added,
and then they are divided by 12 to determine the average capital balances. Once
the average capital balances are determined, the method of figuring capital bal-
ance ratios for sharing income and losses is the same as the method used for
beginning capital balances.
Salaries, Interest, and Stated Ratios
PPartners’ contributions to a firm are usually not equal. To make up for the inequal-
Study Note iity, a partnership agreement can allow for partners’ salaries, interest on partners’
ccapital balances, or both in the distribution of income. Again, salaries and inter-
Partnership income or losses
eest of this kind are not deducted as expenses before the partnership income is
cannot be divided solely on the
ddetermined. They represent a method of arriving at an equitable distribution of
basis of salaries or interest. An
iincome or losses.
additional component, such as
To illustrate an allowance for partners’ salaries, we assume that Adcock and
stated ratios, is needed.
VVilla agree to annual salaries of $8,000 and $7,000, respectively, and to divide any
rremaining income equally between them. Each salary is charged to the appropriate
764 CHAPTER 17 Partnerships
partner’s Withdrawals account when paid. Assuming the same $140,000 income
for the first year, the calculations for Adcock and Villa are as follows:
INCOME OF PARTNER INCOME
ADCOCK VILLA DISTRIBUTED
Total income for distribution $140,000
Distribution of salaries
Adcock $ 8,000
Villa $ 7,000 (15,000)
Remaining income after salaries $125,000
Equal distribution of remaining
income
Adcock ($125,000 (cid:6) 0.50) 62,500
Villa ($125,000 (cid:6) 0.50) 62,500 (125,000)
Remaining income —
Income of partners $70,500 $69,500 $140,000
Salaries allow for differences in the services that partners provide the business.
However, they do not take into account differences in invested capital. To allow for
capital differences, each partner can receive, in addition to salary, a stated interest
on his or her invested capital. Suppose that Jerry Adcock and Rose Villa agree to
annual salaries of $8,000 and $7,000, respectively, as well as 10 percent interest on
their beginning capital balances, and to share any remaining income equally. The
calculations for Adcock and Villa, assuming income of $140,000, are as follows:
INCOME OF PARTNER INCOME
ADCOCK VILLA DISTRIBUTED
Total income for distribution $140,000
Distribution of salaries
Adcock $ 8,000
Villa $ 7,000 (15,000)
Remaining income after salaries $125,000
Distribution of interest
Adcock ($65,000 (cid:6) 0.10) 6,500
Villa ($60,000 (cid:6) 0.10) 6,000 (12,500)
Remaining income after salaries
and interest $112,500
Equal distribution of
remaining income
Adcock ($112,500 (cid:6) 0.50) 56,250
Villa ($112,500 (cid:6) 0.50) 56,250 (112,500)
Remaining income —
Income of partners $70,750 $69,250 $140,000
Study Note
When negotiating a partnership If the partnership agreement allows for the distribution of salaries or inter-
agreement, be sure to look at eesst or both, the amounts must be allocated to the partners even if profits are not
(and negotiate) the impact of eennough to cover the salaries and interest. In fact, even if the company has a loss,
both profits (net income) and tthhese allocations must still be made. The negative balance, or loss, after the alloca-
|
losses. ttiioon of salaries and interest must be distributed according to the stated ratio in the
ppaartnership agreement, or equally if the agreement does not mention a ratio.
Distribution of Partnership Income and Losses 765
FOCUS ON BUSINESS PRACTICE
What Are the Risks of Being a Partner in an Accounting Firm?
Partners in large accounting firms can make over $250,000 partnership. Also, each partner is required to make a
per year, with top partners drawing over $800,000. How- substantial investment of capital in the partnership. This
ever, consideration of those incomes should take into capital remains at risk for as long as the partner chooses
account the risks that partners take and the fact that the to stay in the partnership. For instance, in one notable
incomes of partners in small accounting firms are often case, when a large firm was convicted of destroying evi-
much lower. dence in the Enron case, the partners lost their total
Partners are not compensated in the same way as investments as well as their income when their firm was
managers in corporations. Partners’ income is not guar- subjected to lawsuits and other losses. The firm was
anteed, but rather is based on the performance of the eventually liquidated.
For example, let’s assume that Adcock and Villa agreed to the following
conditions, with much higher annual salaries, for the distribution of income
and losses:
Beginning
Salaries Interest Capital Balance
Adcock $70,000 10 percent of beginning $65,000
Villa $60,000 capital balance $60,000
The computations for the distribution of the income and losses, again assuming
income of $140,000, are as follows:
INCOME OF PARTNER INCOME
ADCOCK VILLA DISTRIBUTED
Total income for distribution $140,000
Distribution of salaries
Adcock $70,000
Villa $60,000 (130,000)
Remaining income after salaries $ 10,000
Distribution of interest
Adcock ($65,000 (cid:6) 0.10) 6,500
Villa ($60,000 (cid:6) 0.10) 6,000 (12,500)
Negative balance after salaries
and interest ($ 2,500)
Equal distribution of negative
Balance*
Adcock ($2,500 (cid:6) 0.50) (1,250)
Villa ($2,500 (cid:6) 0.50) (1,250) 2,500
Remaining income —
Income of partners $75,250 $64,750 $140,000
*Notice that the negative balance is distributed equally because the agreement does not
indicate how income and losses should be distributed after salaries and interest are paid.
766 CHAPTER 17 Partnerships
EXHIBIT 17-1
Adcock and Villa
Partial Income Statement for Adcock
Partial Income Statement
and Villa
For the Year Ended June 30, 2011
Net income $140,000
Distribution to the partners
Adcock
Salary distribution $70,000
Interest on beginning capital balance 6,500
Total $76,500
One-half of remaining negative amount (1,250)
Study Note
Share of net income $ 75,250
Using salaries and interest to Villa
divide income or losses among
Salary distribution $60,000
partners has no effect on the
Interest on beginning capital balance 6,000
income statement. They are not
Total $66,000
expenses. Partners’ salaries and
interest are used only to allow One-half of remaining negative amount (1,250)
the equitable division of the Share of net income 64,750
partnership’s net income. Net income distributed $140,000
On the income statement for the partnership, the distribution of income or
losses is shown below the net income figure. Exhibit 17-1 shows how this is done.
STOP
& APPLY
Kathy and Roger share income in their partnership in a 1:4 ratio. Kathy and Roger receive salaries of
$16,000 and $10,000, respectively. How would they share a net income of $22,000 before salaries?
SOLUTION
Income of Partner
Income
Kathy Roger Distributed
Total income for distribution $22,000
Distribution of salaries
Kathy $16,000
Roger $10,000 (26,000)
Negative balance after salaries ($ 4,000)
Distribution of negative balance
Kathy ($4,000 (cid:6) 0.20) (800)
Roger ($4,000 (cid:6) 0.80) (3,200) 4,000
Remaining income —
Income of partners $15,200 $ 6,800 $22,000
Dissolution of a Partnership 767
Dissolution
Dissolution of a partnership occurs whenever there is a change in the original
of a Partnership association of partners. When a partnership is dissolved, the partners lose their
|
authority to continue the business as a going concern. The fact that the part-
ners lose this authority does not necessarily mean that the business operation
LO4 Record a person’s admis-
is ended or interrupted. However, it does mean—from a legal and accounting
sion to or withdrawal from a
standpoint—that the separate entity ceases to exist. The remaining partners can
partnership.
act for the partnership in finishing the affairs of the business or in forming a new
partnership that will be a new accounting entity. The dissolution of a partnership
takes place through, among other events, the admission of a new partner, the
withdrawal of a partner, or the death of a partner.
Admission of a New Partner
The admission of a new partner dissolves the old partnership because a new asso-
Study Note ciation has been formed. Dissolving the old partnership and creating a new one
requires the consent of all the original partners and the ratification of a new part-
Admission of a new partner
nership agreement. When a new partner is admitted, a new partnership agree-
never has an impact on net
ment should be in place.
income. Regardless of the price
a new partner pays, there are An individual can be admitted to a partnership in one of two ways: by pur-
never any income statement chasing an interest in the partnership from one or more of the original partners or
accounts in the entry to admit a by investing assets in the partnership.
new partner.
Purchasing an Interest from a Partner When a person purchases an inter-
est in a partnership from an original partner, the transaction is a personal one
between these two people. However, the interest purchased must be transferred
from the Capital account of the selling partner to the Capital account of the new
partner.
Suppose that Jerry Adcock decides to sell his interest of $70,000 in Adcock
and Villa to Richard Davis for $100,000 on August 31, 2012, and that Rose Villa
agrees to the sale. The entry to record the sale on the partnership books looks
like this:
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:4) 70,000 2012 Dr. Cr.
(cid:3) 70,000
Aug. 31 Jerry Adcock, Capital 70,000
Richard Davis, Capital 70,000
Transfer of Jerry Adcock’s equity
to Richard Davis
Notice that the entry records the book value of the equity, not the amount Davis
pays. The amount Davis pays is a personal matter between Adcock and him.
Because the amount paid does not affect the assets or liabilities of the firm, it is
not entered in the records.
Here’s another example of a purchase. Assume that Richard Davis purchases
half of Jerry Adcock’s $70,000 interest in the partnership and half of Rose Villa’s
interest, assumed to be $80,000, by paying a total of $100,000 to the two part-
ners on August 31, 2012. The entry to record this transaction on the partnership
books would be as follows:
768 CHAPTER 17 Partnerships
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:4)35,000 2012 Dr. Cr.
(cid:4)40,000
(cid:3)75,000 Aug. 31 Jerry Adcock, Capital 35,000
Rose Villa, Capital 40,000
Richard Davis, Capital 75,000
Transfer of half of Jerry Adcock’s
and Rose Villa’s equity to Richard Davis
Investing Assets in a Partnership When a new partner is admitted through
Study Note
an investment in the partnership, both the assets and the partners’ equity in the firm
If the asset accounts did not increase. The increase occurs because the assets the new partner invests become
reflect their current values, the partnership assets, and as partnership assets increase, partners’ equity increases. For
asset accounts (and Capital example, assume that Jerry Adcock and Rose Villa have agreed to allow Richard
accounts) would need to be Davis to invest $75,000 in return for a one-third interest in their partnership. The
adjusted before admitting the Capital accounts of Jerry Adcock and Rose Villa are $70,000 and $80,000, respec-
new partner. tively. Davis’s $75,000 investment equals a one-third interest in the firm after the
investment is added to the previously existing capital of the partnership.
Jerry Adcock, Capital $ 70,000
|
Rose Villa, Capital 80,000
Davis’s investment 75,000
Total capital after Davis’s investment $225,000
One-third interest (cid:2) $225,000 (cid:5) 3 (cid:2) $ 75,000
The entry to record Davis’s investment is as follows:
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:3)75,000 (cid:3)75,000 2012 Dr. Cr.
Aug. 31 Cash 75,000
Richard Davis, Capital 75,000
Admission of Richard Davis for a
one-third interest in the company
Bonus to the Old Partners A partnership is sometimes so profitable or oth-
Study Note
erwise advantageous that a new investor is willing to pay more than the actual
The original partners receive dollar interest he or she receives in the partnership. For instance, suppose an
a bonus because the entity is individual pays $100,000 for an $80,000 interest in a partnership. The $20,000
worth more as a going concern excess of the payment over the interest purchased is a bonus to the original part-
than the fair market value of ners. The bonus must be distributed to the original partners according to the
the net assets would otherwise partnership agreement. When the agreement does not cover the distribution of
indicate. That is, the new bonuses, a bonus should be distributed to the original partners in accordance
partner is paying for unrecorded with the method for distributing income and losses.
partnership value. Assume that the Adcock and Villa Company has operated for several years
and that the partners’ capital balances and the stated ratios for distribution of
income and loss are as follows:
Partners Capital Balances Stated Ratios
Adcock $160,000 55%
Villa 140,000 45
$300,000 100%
Dissolution of a Partnership 769
Richard Davis wants to join the firm. He offers to invest $100,000 on
December 1 for a one-fifth interest in the business and income. The origi-
nal partners agree to the offer. This is the computation of the bonus to the
original partners:
Partners’ equity in the original partnership $300,000
Cash investment by Richard Davis 100,000
Partners’ equity in the new partnership $400,000
Partners’ equity assigned to Richard Davis
($400,000 (cid:6) 1⁄5) $ 80,000
Bonus to the original partners
Investment by Richard Davis $100,000
Less equity assigned to Richard Davis 80,000 $ 20,000
Distribution of bonus to original partners
Jerry Adcock ($20,000 (cid:6) 0.55) $ 11,000
Rose Villa ($20,000 (cid:6) 0.45) 9,000 $ 20,000
This is the entry that records Davis’s admission to the partnership:
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:3)100,000 (cid:3)11,000 2012 Dr. Cr.
(cid:3)9,000
(cid:3)80,000 Dec. 1 Cash 100,000
Jerry Adcock, Capital 11,000
Rose Villa, Capital 9,000
Richard Davis, Capital 80,000
Investment by Richard Davis for a one-
fifth interest in the firm, and the bonus
distributed to the original partners
Bonus to the New Partner There are several reasons that a partnership
might want a new partner. A partnership in financial trouble might need addi-
tional cash. Or the partners might want to expand the firm’s markets and need
more capital for this purpose than they themselves can provide. Also, the partners
might know a person who would bring a unique talent to the firm. Under these
conditions, a new partner may be admitted to the partnership with the under-
standing that part of the original partners’ capital will be transferred (credited) to
the new partner’s Capital account as a bonus.
For example, suppose that Jerry Adcock and Rose Villa have invited Richard
Davis to join the firm. Davis is going to invest $60,000 on December 1 for a
one-fourth interest in the company. The stated ratios for distribution of income
or loss for Adcock and Villa are 55 percent and 45 percent, respectively. If Davis
is to receive a one-fourth interest in the firm, the interest of the original partners
represents a three-fourths interest in the business. The computation of Davis’s
bonus is as follows:
770 CHAPTER 17 Partnerships
Total equity in partnership
Jerry Adcock, Capital $160,000
Rose Villa, Capital 140,000
Investment by Richard Davis 60,000
Partners’ equity in the new partnership $360,000
|
Partners’ equity assigned to Richard Davis
($360,000 (cid:6) ¼) $ 90,000
Bonus to new partner
Equity assigned to Richard Davis $90,000
Less cash investment by Richard Davis 60,000 $ 30,000
Distribution of bonus from original partners
Jerry Adcock ($30,000 (cid:6) 0.55) $16,500
Rose Villa ($30,000 (cid:6) 0.45) 13,500 $ 30,000
The entry to record the admission of Richard Davis to the partnership is shown
below:
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:3)60,000 (cid:4)16,500 2012 Dr. Cr.
(cid:4)13,500
(cid:3)90,000 Dec. 1 Cash 60,000
Jerry Adcock, Capital 16,500
Rose Villa, Capital 13,500
Richard Davis, Capital 90,000
To record the investment by
Richard Davis of cash and a
bonus from Adcock and Villa
WWithdrawal of a Partner
Study Note
SSince a partnership is a voluntary association, a partner usually has the right to
There is no impact on the
wwithdraw at any time. However, to avoid disputes when a partner does decide to
income statement of a
wwithdraw or retire, a partnership agreement should describe the procedures to be
partnership when a partner
ffollowed. The agreement should specify (1) whether an audit will be performed,
withdraws. The only change is
(2) how the assets will be reappraised, (3) how a bonus will be determined, and
on the balance sheet.
(4) by what method the withdrawing partner will be paid.
A partner who wants to withdraw from a partnership can do so in one of
sseveral ways. The partner can sell his or her interest to another partner or to an
outsider with the consent of the remaining partners, or the partner can withdraw
assets equal to his or her capital balance, less than his or her capital balance (in
Study Note
this case, the remaining partners receive a bonus), or greater than his or her capi-
Selling a partnership interest tal balance (in this case, the withdrawing partner receives a bonus). These alterna-
does not affect the assets and tives are illustrated in Figure 17-1.
liabilities of the partnership.
Therefore, total equity remains Withdrawal by Selling Interest When a partner sells his or her interest
unchanged. The only effect to another partner or to an outsider with the consent of the other partners,
of a partner’s selling his or the transaction is personal; it does not change the partnership assets or the
her interest to the existing partners’ equity. For example, let’s assume that the capital balances of Adcock,
partners or to a new partner
Villa, and Davis are $140,000, $100,000, and $60,000, respectively, for a total
is the change of names in the
of $300,000.
partners’ equity section of the
Villa wants to withdraw from the partnership and is reviewing two offers for
balance sheet.
her interest. The offers are (1) to sell her interest to Davis for $110,000 or (2) to
Dissolution of a Partnership 771
Figure 17-1
Alternative Ways for a Partner
Sells to remaining
to Withdraw
partners
Sells interest
Sells to new partner
Partner withdraws Withdraws assets equal
to interest
Withdraws interest Withdraws assets less
in partnership than interest; bonus to
assets remaining partners
Withdraws assets greater
than interest; bonus to
departing partner
sell her interest to Judy Jones for $120,000. The remaining partners have agreed
to either potential transaction. Because Davis and Jones would pay for Villa’s
interest from their personal assets, the partnership accounting records would
show only the transfer of Villa’s interest to Davis or Jones. The entries to record
these possible transfers are as follows:
A (cid:3) L (cid:4) OE 1. If Villa’s interest is purchased by Davis:
(cid:4)100,000
Rose Villa, Capital 100,000
(cid:3)100,000
Richard Davis, Capital 100,000
Sale of Villa’s partnership interest to Davis
A (cid:3) L (cid:4) OE 2. If Villa’s interest is purchased by Jones:
(cid:4)100,000
Rose Villa, Capital 100,000
(cid:3)100,000
Judy Jones, Capital 100,000
Sale of Villa’s partnership interest to Jones
Withdrawal by Removing Assets A partnership agreement can allow a
withdrawing partner to remove assets from the firm equal to his or her capital bal-
ance. Assume that Richard Davis decides to withdraw from Adcock, Villa, Davis &
|
Company on January 21, 2012. Davis’s capital balance is $60,000. The partner-
ship agreement states that he can withdraw cash from the firm equal to his capital
balance. If there is not enough cash, he must accept a promissory note from the
new partnership for the balance. The remaining partners ask that Davis take only
$50,000 in cash because of a cash shortage at the time of his withdrawal; he agrees
to this request. The following entry records Davis’s withdrawal:
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:4)50,000 (cid:3) 10,000 (cid:4) 60,000 2013 Dr. Cr.
Jan. 21 Richard Davis, Capital 60,000
Cash 50,000
Notes Payable, Richard Davis 10,000
Withdrawal of Richard Davis
from the partnership
772 CHAPTER 17 Partnerships
When a withdrawing partner removes assets that represent less than his or her
capital balance, the equity that the partner leaves in the business is divided among the
remaining partners according to their stated ratios. This distribution is considered a
bonus to the remaining partners. When a withdrawing partner takes out assets that
are greater than his or her capital balance, the excess is treated as a bonus to the with-
drawing partner. The remaining partners absorb the bonus according to their stated
ratios. Alternative arrangements can be spelled out in the partnership agreement.
Death of a Partner
When a partner dies, the partnership is dissolved because the original association
has changed. The partnership agreement should state the actions to be taken.
Normally, the books are closed, and financial statements are prepared. Those
actions are necessary to determine the capital balance of each partner on the
date of the death. The agreement may also indicate whether an audit should be
conducted, assets appraised, and a bonus recorded, as well as the procedures for
settling with the deceased partner’s heirs. The remaining partners may purchase
the deceased’s equity, sell it to outsiders, or deliver specified business assets to
the estate. If the firm intends to continue, a new partnership must be formed.
STOP
& APPLY
Dan and Augie each own a $50,000 interest in a partnership. They agree to admit Bea as a partner by
selling her a one-third interest for $80,000. How large a bonus will be distributed to Dan and Augie?
SOLUTION
Partners’ equity in the original partnership $100,000
Cash investment by Bea 80,000
Partners’ equity in the new partnership $180,000
Partners’ equity assigned to Bea ($180,000 (cid:6) 1/3) $ 60,000
Bonus to the original partners
Investment by Bea $ 80,000
Less equity assigned to Bea 60,000
$ 20,000
Distribution of bonus to original partners
Dan ($20,000 (cid:6) 0.50) $10,000
Augie ($20,000 (cid:6) 0.50) 10,000 $ 20,000
Liquidation
The liquidation of a partnership is the process of ending the business—of selling
of a Partnership enough assets to pay the partnership’s liabilities and distributing any remaining
assets among the partners. Liquidation is a special form of dissolution. When a
LO5 Compute and record the partnership is liquidated, the business will not continue.
The partnership agreement should indicate the procedures to be followed
distribution of assets to partners
in the case of liquidation. Usually, the books are adjusted and closed, with the
when they liquidate their part-
income or losses distributed to the partners. As the assets of the business are sold,
nership.
any gain or losses should be distributed to the partners according to the stated
ratios. As cash becomes available, it must be applied first to outside creditors,
then to loans from partners, and finally to the partners’ capital balances.
The process of liquidation can have a variety of financial outcomes. We look at
two: (1) assets sold for a gain and (2) assets sold for a loss. For both alternatives, we
Liquidation of a Partnership 773
make the assumptions that the books have been closed for Adcock, Villa, Davis &
Company and that the following balance sheet exists before liquidation:
Adcock, Villa, Davis & Company
Balance Sheet
February 2, 2013
ASSETS LIABILITIES
Cash $ 60,000 Accounts payable $120,000
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Accounts receivable 40,000
Merchandise inventory 100,000 PARTNERS’ EQUITY
Plant assets (net) 200,000
Adcock, Capital $ 85,000
Villa, Capital 95,000
Davis, Capital 100,000
Total partners’ equity $280,000
Total liabilities and
Total assets $400,000 partners’ equity $400,000
The stated ratios of Adcock, Villa, and Davis are 3:3:4, or 30, 30, and
40 percent, respectively.
Gain on Sale of Assets
Suppose that the following transactions took place in the liquidation of Adcock,
Villa, Davis & Company:
1. The accounts receivable were collected for $35,000.
2. The inventory was sold for $110,000.
3. The plant assets were sold for $200,000.
4. The accounts payable of $120,000 were paid.
Study Note
5. The gain of $5,000 from the realization of the assets was distributed accord-
Notice the proper use of the term ing to the partners’ stated ratios.
realization in the February 13
6. The partners received cash equivalent to the balances of their Capital accounts.
and 14 entries. Realization means
“conversion into cash.” These transactions are summarized in the statement of liquidation in Exhibit 17-2.
The entries in journal form with their assumed transaction dates are as follows:
Explanation on Statement of Liquidation
Entry in Journal Form:
A (cid:3) L (cid:4) OE
(cid:3)5,000 (cid:4)35,000 2013 Dr. Cr.
(cid:4)40,000
Feb. 13 Cash 35,000 1.
Gain or Loss from Realization 5,000
Accounts Receivable 40,000
Collection of accounts
receivable
A (cid:3) L (cid:4) OE 14 Cash 110,000 2.
(cid:3)110,000 (cid:3)100,000
Merchandise Inventory 100,000
(cid:4)10,000
Gain or Loss from Realization 10,000
Sale of inventory
774 CHAPTER 17 Partnerships
Explanation on Statement of Liquidation
Dr. Cr.
A (cid:3) L (cid:4) OE Feb. 15 Cash 200,000 3.
(cid:3)200,000 Plant Assets 200,000
(cid:4)200,000 Sale of plant assets
A (cid:3) L (cid:4) OE 16 Accounts Payable 120,000 4.
(cid:4)120,000 (cid:4)120,000 Cash 120,000
Payment of accounts payable
A (cid:3) L (cid:4) OE 20 Gain or Loss from Realization 5,000 5.
(cid:4)5,000 Jerry Adcock, Capital 1,500
(cid:3)1,500 Rose Villa, Capital 1,500
(cid:3)1,500
Richard Davis, Capital 2,000
(cid:3)2,000
Distribution of the net gain
on assets ($10,000 gain
minus $5,000 loss) to the partners
A (cid:3) L (cid:4) OE 20 Jerry Adcock, Capital 86,500 6.
(cid:4)285,000 (cid:4)86,500 Rose Villa, Capital 96,500
(cid:4)96,500 Richard Davis, Capital 102,000
(cid:4)102,000
Cash 285,000
Distribution of cashto the partners
EXHIBIT 17-2 Statement of Liquidation Showing Gain on Sale of Assets
Adcock, Villa, Davis & Company
Statement of Liquidation
February 2–20, 2013
Gain
Adcock, Villa, Davis, (or Loss)
Other Accounts Capital Capital Capital from
Explanation Cash Assets Payable (30%) (30%) (40%) Realization
Balance 2/2/13 $ 60,000 $340,000 $120,000 $85,000 $95,000 $100,000
1. Collection of
Accounts
Receivable 35,000 (40,000) ($ 5,000)
$ 95,000 $300,000 $120,000 $85,000 $95,000 $100,000 ($ 5,000)
2. Sale of Inventory 110,000 (100,000) 10,000
$205,000 $200,000 $120,000 $85,000 $95,000 $100,000 $ 5,000
3. Sale of Plant
Assets 200,000 (200,000)
$405,000 — $120,000 $85,000 $95,000 $100,000 $ 5,000
4. Payment of
Liabilities (120,000) (120,000)
$285,000 — $85,000 $95,000 $100,000 $ 5,000
5. Distribution of
Gain (or Loss)
from Realization 1,500 1,500 2,000 (5,000)
$285,000 $86,500 $96,500 $102,000 —
6. Distribution
of Cash to Partners (285,000) (86,500) (96,500) (102,000)
— — — —
Liquidation of a Partnership 775
Notice that the cash distributed to the partners is the balance in their respec-
tive Capital accounts. Cash is not distributed according to the partners’ stated
ratios.
Loss on Sale of Assets
Study Note
We discuss two cases involving losses on the sale of a company’s assets. In the
Because losses are allocated
first, the losses are small enough to be absorbed by the partners’ capital balances.
on the same basis as gains, the
In the second, one partner’s share of the losses is too large for his capital balance
only difference in accounting for
them is that debits and credits to absorb.
are switched. When a firm’s assets are sold at a loss, the partners share the loss on liq-
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uidation according to their stated ratios. For example, assume that during the
liquidation of Adcock, Villa, Davis & Company, the total cash received from the
collection of accounts receivable and the sale of inventory and plant assets was
$140,000. The statement of liquidation appears in Exhibit 17-3.
EXHIBIT 17-3 Statement of Liquidation Showing Loss on Sale of Assets
Adcock, Villa, Davis & Company
Statement of Liquidation
February 2–20, 2013
Gain
Adcock, Villa, Davis, (or Loss)
Other Accounts Capital Capital Capital from
Explanation Cash Assets Payable (30%) (30%) (40%) Realization
Balance 2/2/13 $ 60,000 $340,000 $120,000 $85,000 $95,000 $100,000
1. Collection of
Accounts
Receivable
and Sale of
Inventory and
Plant Assets 140,000 (340,000) ($200,000)
$200,000 — $120,000 $85,000 $95,000 $100,000 ($200,000)
2. Payment of
Liabilities (120,000) (120,000)
$ 80,000 — $85,000 $95,000 $100,000 ($200,000)
3. Distribution of
Gain (or Loss)
from Realization (60,000) (60,000) (80,000) 200,000
$ 80,000 $25,000 $35,000 $ 20,000 —
4. Distribution of
Cash to Partners (80,000) (25,000) (35,000) (20,000)
— — — —
776 CHAPTER 17 Partnerships
The entries in journal form for the transactions summarized in the statement
of liquidation in Exhibit 17-3 are as follows:
Explanation on Statement of Liquidation
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:3)140,000 (cid:4)200,000 2013 Dr. Cr.
(cid:4)40,000
Feb. 15 Cash 140,000 1.
(cid:4)100,000
Gain or Loss from Realization 200,000
(cid:4)200,000
Accounts Receivable 40,000
Merchandise Inventory 100,000
Plant Assets 200,000
Collection of accounts receivable
and the sale of inventory and
plant assets.
A (cid:3) L (cid:4) OE 16 Accounts Payable 120,000 2.
(cid:4)120,000 (cid:4)120,000 Cash 120,000
Payment of accounts payable
A (cid:3) L (cid:4) OE 20 Jerry Adcock, Capital 60,000 3.
(cid:4)60,000 Rose Villa, Capital 60,000
(cid:4)60,000
Richard Davis, Capital 80,000
(cid:4)80,000
Gain or Loss from Realization 200,000
(cid:3)200,000
Distribution of the loss on
assets to the partners
A (cid:3) L (cid:4) OE 20 Jerry Adcock, Capital 25,000 4.
(cid:4)80,000 (cid:4)25,000 Rose Villa, Capital 35,000
(cid:4)35,000
Richard Davis, Capital 20,000
(cid:4)20,000
Cash 80,000
Distribution of cash to
the partners
In some liquidations, a partner’s share of the loss is greater than his or her
capital balance. In such a situation, because partners are subject to unlimited
liability, the partner must make up the deficit in his or her Capital account from
personal assets. For example, suppose that after the sale of assets and the payment
of liabilities, the remaining assets and partners’ equity of Adcock, Villa, Davis &
Company look like this:
Assets
Cash $ 30,000
Partners’ equity
Adcock, Capital $ 25,000
Villa, Capital 20,000
Davis, Capital (15,000) $ 30,000
Richard Davis must pay $15,000 into the partnership from personal funds to
cover his deficit. If he pays cash to the partnership, the following entry would
record the cash contribution:
Liquidation of a Partnership 777
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:3)15,000 (cid:3)15,000
2013 Dr. Cr.
Feb. 20 Cash 15,000
Richard Davis, Capital 15,000
Additional investment of
Richard Davis to cover the
negative balance in his
Capital account
After Davis pays $15,000, there is enough cash to pay Adcock and Villa their
capital balances and, thus, to complete the liquidation. The transaction is recorded
in the following way:
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:4)45,000 (cid:4)25,000 2013 Dr. Cr.
(cid:4)20,000
Feb. 20 Jerry Adcock, Capital 25,000
Rose Villa, Capital 20,000
Cash 45,000
Distribution of cash to the partners
If a partner does not have the cash to cover his or her obligations to the
partnership, the remaining partners share the loss according to their established
stated ratios. Remember that all partners have unlimited liability. As a result, if
Richard Davis cannot pay the $15,000 deficit in his Capital account, Adcock and
Villa must share the deficit according to their stated ratios. Each has a 30 percent
stated ratio, so each must pay 50 percent of the losses that Davis cannot pay. The
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new stated ratios are computed as follows:
Old Ratios New Ratios
Adcock 30% 30 (cid:5) 60 (cid:2) 0.50 (cid:2) 50%
Villa 30% 30 (cid:5) 60 (cid:2) 0.50 (cid:2) 50
60% 100%
And the entries to record the transactions are as follows:
A (cid:3) L (cid:4) OE Entry in Journal Form:
(cid:4)7,500
2013 Dr. Cr.
(cid:4)7,500
(cid:3)15,000 Feb. 20 Jerry Adcock, Capital 7,500
Rose Villa, Capital 7,500
Richard Davis, Capital 15,000
Transfer of Davis’s deficit
to Adcock and Villa
A (cid:3) L (cid:4) OE 20 Jerry Adcock, Capital 17,500
(cid:4)30,000 (cid:4)17,500 Rose Villa, Capital 12,500
(cid:4)12,500
Cash 30,000
Distribution of cash to the partners
778 CHAPTER 17 Partnerships
Davis’s inability to meet his obligations at the time of liquidation does not
relieve him of his liabilities to Adcock and Villa. If he is able to pay his liabilities
at some time in the future, Adcock and Villa can collect the amount of Davis’s
deficit that they absorbed.
STOP
& APPLY
After the partnership between Joanna and Andrew has been operating for a year, their Capital
accounts are $30,000 and $20,000, respectively. The firm has cash of $24,000 and inventory of
$26,000. The partners decide to liquidate the partnership. The inventory is liquidated for only
$8,000. Assuming the partners share income and losses in the ratio of one-third to Joanna and two-
thirds to Andrew, how much cash will be distributed to each partner in liquidation?
SOLUTION
Loss on inventory computed:
$26,000 (cid:4) $8,000 (cid:2) $18,000
Joanna Andrew
Distribution of cash to partners:
Capital balances $30,000 $ 20,000
Distribution of loss
Joanna ($18,000 (cid:6) 1/3) (6,000)
Andrew ($18,000 (cid:6) 2/3) (12,000)
Cash to partners $24,000 $ 8,000
(cid:2) HOLDER AND WILLIAMS PARTNERSHIP: REVIEW
PROBLEM
In the Decision Point at the beginning of the chapter, we noted that when Jack Holder
and Dan Williams were forming their partnership in 2010, they were faced with a num-
ber of important decisions. We asked these questions:
• What details should be included in a partnership agreement?
• How would Jack Holder and Dan Williams share the income or losses of their
business?
• How would they handle any changes in ownership that might occur?
Jack and Dan drafted a written partnership agreement that clearly stated the details
of the arrangement, including the name, location, and purpose of the business; their
names and respective duties; the investments each of them had made; the method of
distributing income and losses; and the procedures for the admission and withdrawal
Distribution of Income
of partners, the withdrawal of assets allowed each partner, and the liquidation (termi-
and Admission
nation) of the business. They decided that Jack, who had contributed $100,000 to the
of a Partner partnership, was to receive an annual salary of $6,000 and that Dan was to receive 3
LO3 LO4 percent interest annually on his original investment of $150,000. They were to share
income and losses after salary and interest in a 2:3 ratio.
Holder and Williams Partnership: Review Problem 779
Required
1. In 2010, the partnership had an income of $27,000, and in 2011, it had a
loss of $2,000 (before salaries and interest). Compute Jack Holder and Dan
William’s share of the income and loss, and prepare the required entries in
journal form.
2. On January 1, 2012, Jean Ratcliffe offers Jack and Dan $60,000 for a 15 percent
interest in the partnership. They agree to Ratcliffe’s offer because they need
her resources to expand the business. On January 1, 2012, the balance in
Jack’s Capital account is $113,600, and the balance in Dan’s Capital account is
$161,400. Record the admission of Jean Ratcliffe to the partnership, assuming
that her investment represents a 15 percent interest in the total partners’ capital
and that a bonus will be distributed to Jack and Dan in the ratio of 2:3.
Answers to
1. Income and loss shared by the partners:
Review Problem
780 CHAPTER 17 Partnerships
Entry in Journal Form:
2010 Dr. Cr.
Income Summary 27,000
Jack Holder, Capital 12,600
Dan Williams, Capital 14,400
Distribution of income for the year to the
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partners’ Capital accounts
Entry in Journal Form:
2011 Dr. Cr.
Dan Williams, Capital 3,000
Income Summary 2,000
Jack Holder, Capital 1,000
Distribution of the loss for the year
to the partners’ Capital accounts
2. Admission of the new partner:
Capital Balance and Bonus Computation
Ratcliff e, Capital (cid:2) (Original Partners’ Capital (cid:3) New Partner’s Investment) (cid:6) 15%
(cid:2) ($113,600 (cid:3) $161,400 (cid:3) $60,000) (cid:6) 0.15 (cid:2) $50,250
Bonus (cid:2) New Partner’s Investment (cid:4) Ratcliff e, Capital
(cid:2) $60,000 (cid:4) $50,250
(cid:2) $9,750
Distribution of Bonus
Holder (cid:2) $9,750 (cid:6) 2/ (cid:2) $3,900
5
Williams (cid:2) $9,750 (cid:6) 3/ (cid:2) 5,850
5
Total bonus $9,750
Entry in Journal Form:
2012 Dr. Cr.
Jan. 1 Cash 60,000
Jack Holder, Capital 3,900
Dan Williams, Capital 5,850
Jean Ratcliff e, Capital 50,250
Sale of a 15 percent interest in the
partnership to Jean Ratcliff e and the
bonus paid to the original partners
Stop & Review 781
STOP
& REVIEW
LO1 Identify the principal A partnership has several major characteristics that distinguish it from the other
characteristics, advan- forms of business. It is a voluntary association of two or more people who com-
tages, and disadvan- bine their talents and resources to carry on a business. Their joint effort should be
tages of the partnership supported by a partnership agreement that spells out the venture’s operating pro-
cedures. A partnership is dissolved by a partner’s admission, withdrawal, or death
form of business.
and therefore has a limited life. Each partner acts as an agent of the partnership
within the scope of normal operations and is personally liable for the partnership’s
debts. Property invested in the partnership becomes an asset of the partnership,
owned jointly by all the partners. And, finally, each partner has the right to share
in the company’s income and the responsibility to share in its losses.
The advantages of a partnership are the ease of its formation and dissolution,
the opportunity to pool several individuals’ talents and resources, the lack of a
corporate tax burden, and the freedom of action each partner enjoys. The disad-
vantages are the limited life of a partnership, mutual agency, the unlimited per-
sonal liability of the partners, and the difficulty of raising large amounts of capital
and transferring partners’ interest. Two other common forms of association that
are a type of partnership or similar to a partnership are limited partnerships and
joint ventures.
LO2 Record partners’ A partnership is formed when the partners contribute cash, other assets, or a
investments of cash and combination of both to the business. The details are stated in the partnership
other assets when a agreement. Initial investments are recorded with a debit to Cash or another asset
partnership is formed. account and a credit to the investing partner’s Capital account. The recorded
amount of the other assets should be their fair market value on the date of trans-
fer to the partnership. In addition, a partnership can assume an investing partner’s
liabilities. When this occurs, the partner’s Capital account is credited with the dif-
ference between the assets invested and the liabilities assumed.
LO3 Compute and record the The partners must share income and losses in accordance with the partnership
income or losses that agreement. If the agreement says nothing about the distribution of income and
partners share, based on losses, the partners share them equally. Common methods used for distributing
stated ratios, capital bal- income and losses include stated ratios, capital balance ratios, and salaries and
ance ratios, and partners’ interest on capital investments. Each method tries to measure the individual part-
salaries and interest. ner’s contribution to the operations of the business.
Stated ratios usually are based on the partners’ relative contributions to the
partnership. When capital balance ratios are used, income or losses are divided
strictly on the basis of each partner’s capital balance. The use of salaries and
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interest on capital investment takes into account both efforts (salary) and capital
investment (interest) in dividing income or losses among the partners.
LO4 Record a person’s admis- An individual is admitted to a partnership by purchasing a partner’s interest or
sion to or withdrawal by contributing additional assets. When an interest is purchased, the withdrawing
from a partnership. partner’s capital is transferred to the new partner. When the new partner contrib-
utes assets to the partnership, it may be necessary to recognize a bonus shared or
borne by the original partners or by the new partner.
A person can withdraw from a partnership by selling his or her interest in the
business to the remaining partners or a new partner or by withdrawing company
assets. When assets are withdrawn, the amount can be equal to, less than, or
782 CHAPTER 17 Partnerships
greater than the partner’s capital interest. When assets that have a value less than
or greater than the partner’s interest are withdrawn, a bonus is recognized and
distributed among the remaining partners or to the departing partner.
LO5 Compute and record the The liquidation of a partnership entails selling the assets necessary to pay the
distribution of assets to company’s liabilities and then distributing any remaining assets to the partners.
partners when they liqui- Any gain or loss on the sale of the assets is shared by the partners according to
date their partnership. their stated ratios. When a partner has a deficit balance in a Capital account, that
partner must contribute personal assets equal to the deficit. When a partner does
not have personal assets to cover a capital deficit, the deficit must be absorbed
by the solvent partners according to their stated ratios.
REVIEW of Concepts and Terminology
The following concepts and terms Limited life 756 (LO1) Partnership 756 (LO1)
were introduced in this chapter:
Limited partnership 758 (LO1) Partnership agreement 756 (LO1)
Bonus 768 (LO4)
Liquidation 772 (LO5) Unlimited liability 756 (LO1)
Dissolution 767 (LO4)
Mutual agency 756 (LO1)
Joint venture 758 (LO1)
Partners’ equity 759 (LO2)
Chapter Assignments 783
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 Partnership Characteristics
SE 1. Indicate whether each statement below is a reflection of (a) voluntary
association, (b) a partnership agreement, (c) limited life, (d) mutual agency, or
(e) unlimited liability.
1. A partner may be required to pay the debts of the partnership out of personal
assets.
2. A partnership must be dissolved when a partner is admitted, withdraws,
retires, or dies.
3. Any partner can bind the partnership to a business agreement.
4. A partner does not have to remain a partner if he or she does not want to.
5. Details of the arrangements among partners are specified in a written contract.
LO2 Partnership Formation
SE 2. Bob contributes cash of $12,000, and Kim contributes office equipment
that cost $10,000 but is valued at $8,000 to the formation of a new partnership.
Prepare the entry in journal form to form the partnership.
LO3 Distribution of Partnership Income
SE 3. During the first year, the Bob and Kim partnership in SE 2 earned an
income of $5,000. Assume the partners agreed to share income and losses in
the ratio of the beginning balances of their capital accounts. How much income
should be transferred to each Capital account?
LO3 Distribution of Partnership Income
SE 4. During the first year, the Bob and Kim partnership in SE 2 earned an income of
$5,000. Assume the partners agreed to share income and losses by figuring interest
on the beginning capital balances at 10 percent and dividing the remainder equally.
How much income should be transferred to each Capital account?
LO3 Distribution of Partnership Income
SE 5. During the first year, the Bob and Kim partnership in SE 2 earned an
income of $5,000. Assume the partners agreed to share income and losses by fig-
uring interest on the beginning capital balances at 10 percent, allowing a salary of
$6,000 to Bob, and dividing the remainder equally. How much income (or loss)
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should be transferred to each Capital account?
LO4 Withdrawal of a Partner
SE 6. After the partnership has been operating for a year, the Capital accounts of Bob
and Kim are $15,000 and $10,000, respectively. Kim withdraws from the partnership
by selling her interest in the business to Sonia for $8,000. What will be the Capital
account balances of the partners in the new Bob and Sonia partnership? Prepare the
entry in journal form to record the transfer of ownership on the partnership books.
LO4 Admission of a New Partner
SE 7. After the partnership has been operating for a year, the Capital accounts
of Bob and Kim are $15,000 and $10,000, respectively. Sonia buys a one-sixth
interest in the partnership by investing cash of $11,000. What will be the Capital
784 CHAPTER 17 Partnerships
account balances of the partners in the new Bob, Kim, and Sonia partnership,
assuming a bonus to the old partners, who share income and losses equally? Pre-
pare the entry in journal form to record the transfer of ownership on the partner-
ship books.
LO4 Admission of a New Partner
SE 8. After the partnership has been operating for a year, the Capital accounts of
Bob and Kim are $15,000 and $10,000, respectively. Sonia buys a one-fourth
interest in the partnership by investing cash of $5,000. What will be the Capital
account balances of the partners in the new Bob, Kim, and Sonia partnership,
assuming that the new partner receives a bonus and that Bob and Kim share
income and losses equally? Prepare the entry in journal form to record the trans-
fer of ownership on the partnership books.
LO4 Withdrawal of a New Partner
SE 9. After the partnership has been operating for several years, the Capital
accounts of Bob, Kim, and Sonia are $25,000, $16,000, and $9,000, respec-
tively. Sonia decides to leave the partnership and is allowed to withdraw $9,000
in cash. Prepare the entry in journal form to record the withdrawal on the part-
nership books.
LO5 Liquidation of a Partnership
SE 10. After the partnership has been operating for a year, the Capital accounts
of Bob and Kim are $15,000 and $10,000, respectively. The firm has cash of
$12,000 and office equipment of $13,000. The partners decide to liquidate the
partnership. The office equipment is sold for only $4,000. Assuming the partners
share income and losses in the ratio of one-third to Bob and two-thirds to Kim,
how much cash will be distributed to each partner in liquidation?
Exercises
LO1 LO2 Discussion Questions
LO3
E 1. Develop brief answers to each of the following questions:
1. Why is it important for people to form partnerships with people they can trust?
2. When accounts receivable are transferred into a partnership, at what amount
should they be recorded?
3. What is a disadvantage of receiving a large salary as part of a partner’s
distribution?
LO4 LO5 Discussion Questions
E 2. Develop brief answers to each of the following questions:
1. If the value of a partnership is worth far more than the book value of the assets on
the balance sheet, would a new partner entering the partnership be more likely to
pay a bonus to the old partners or receive a bonus from the old partners?
2. When a partnership is dissolved, what is an alternate approach to selling all
the assets and distributing the proceeds, and what decisions will have to be
made if this approach is taken?
LO2 Partnership Formation
E 3. Henri Mikels and Alex Jamison are watch repairmen who want to form a part-
nership and open a jewelry store. They have an attorney prepare their partnership
agreement, which indicates that assets invested in the partnership will be recorded at
their fair market value and that liabilities will be assumed at book value.
Chapter Assignments 785
The assets contributed by each partner and the liabilities assumed by the part-
nership are as follows:
Assets Henri Mikels Alex Jamison Total
Cash $40,000 $30,000 $70,000
Accounts receivable 52,000 20,000 72,000
Allowance for uncollectible
accounts 4,000 3,000 7,000
Supplies 1,000 500 1,500
Equipment 20,000 10,000 30,000
Liabilities
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Accounts payable 32,000 9,000 41,000
Prepare the entry in journal form necessary to record the original investments
of Mikels and Jamison in the partnership.
LO3 Distribution of Income
E 4. Elijah Samuels and Tony Winslow agreed to form a partnership. Samuels
contributed $200,000 in cash, and Winslow contributed assets with a fair market
value of $400,000. The partnership, in its initial year, reported net income of
$120,000. Calculate the distribution of the first year’s income to the partners
under each of the following conditions:
1. Samuels and Winslow failed to include stated ratios in the partnership
agreement.
2. Samuels and Winslow agreed to share income and losses in a 3:2 ratio.
3. Samuels and Winslow agreed to share income and losses in the ratio of their
original investments.
4. Samuels and Winslow agreed to share income and losses by allowing 10 p ercent
interest on original investments and sharing any remainder equally.
LO3 Distribution of Income or Losses: Salaries and Interest
E 5. Assume that the partnership agreement of Samuels and Winslow in E 4 states
that Samuels and Winslow are to receive salaries of $20,000 and $24,000, respec-
tively; that Samuels is to receive 6 percent interest on his capital balance at the
beginning of the year; and that the remainder of income and losses are to be
shared equally. Calculate the distribution of the income or losses under the fol-
lowing conditions:
1. Income totaled $120,000 before deductions for salaries and interest.
2. Income totaled $48,000 before deductions for salaries and interest.
3. There was a loss of $2,000.
4. There was a loss of $40,000.
LO3 Distribution of Income: Average Capital Balance
E 6. Barbara and Karen operate a furniture rental business. Their capital bal-
ances on January 1, 2010, were $160,000 and $240,000, respectively. Barbara
withdrew cash of $32,000 from the business on April 1, 2010. Karen withdrew
$60,000 cash on October 1, 2010. Barbara and Karen distribute partnership
income based on their average capital balances each year. Income for 2010 was
$160,000. Compute the income to be distributed to Barbara and Karen using
their average capital balances in 2010.
LO4 Admission of a New Partner: Recording a Bonus
E 7. Ernie, Ron, and Denis have equity in a partnership of $40,000, $40,000,
and $60,000, respectively, and they share income and losses in a ratio of 1:1:3.
The partners have agreed to admit Henry to the partnership. Prepare entries in
786 CHAPTER 17 Partnerships
journal form to record the admission of Henry to the partnership under the fol-
lowing conditions:
1. Henry invests $60,000 for a 20 percent interest in the partnership, and a
bonus is recorded for the original partners.
2. Henry invests $60,000 for a 40 percent interest in the partnership, and a
bonus is recorded for Henry.
LO4 Withdrawal of a Partner
E 8. Danny, Steve, and Luis are partners. They share income and losses in the
ratio of 3:2:1. Luis’s Capital account has a $120,000 balance. Danny and Steve
have agreed to let Luis take $160,000 of the company’s cash when he retires
from the business. What entry in journal form must be made on the partner-
ship’s books when Luis retires, assuming that a bonus to Luis is recognized and
absorbed by the remaining partners?
LO5 Partnership Liquidation
E 9. Assume the following assets, liabilities, and partners’ equity in the Ming and
Demmick partnership on December 31, 2011:
Assets (cid:3) Liabilities (cid:4) Ming, Capital (cid:4) Demmick, Capital
$160,000 (cid:2) $10,000 (cid:3) $90,000 (cid:3) $60,000
The partnership has no cash. When the partners agree to liquidate the business,
the assets are sold for $120,000, and the liabilities are paid. Ming and Demmick
share income and losses in a ratio of 3:1.
1. Prepare a statement of liquidation.
2. Prepare entries in journal form for the sale of assets, payment of liabilities,
distribution of loss from realization, and final distribution of cash to Ming
and Demmick.
LO5 Partnership Liquidation
E 10. Ariel, Mandy, and Tisha are partners in a tanning salon. The assets, liabili-
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ties, and capital balances as of July 1, 2010, are as follows:
Assets $480,000
Liabilities 160,000
Ariel, Capital 140,000
Mandy, Capital 40,000
Tisha, Capital 140,000
Because competition is strong, business is declining, and the partnership has
no cash, the partners have decided to sell the business. Ariel, Mandy, and Tisha
share income and losses in a ratio of 3:1:1, respectively. The assets were sold for
$260,000, and the liabilities were paid. Mandy has no other assets and will not be
able to cover any deficits in her Capital account. How will the ending cash bal-
ance be distributed to the partners?
Problems
LO2 LO3 Partnership Formation and Distribution of Income
P 1. In January 2010, Edie Rivera and Babs Bacon agreed to produce and sell
chocolate candies. Rivera contributed $240,000 in cash to the business. Bacon
contributed the building and equipment, valued at $220,000 and $140,000,
respectively. The partnership had an income of $84,000 during 2010 but was less
successful during 2011, when income was only $40,000.
Chapter Assignments 787
Required
1. Prepare the entry in journal form to record the investment of both partners in
the partnership.
2. Determine the share of income for each partner in 2010 and 2011 under
each of the following conditions:
a. The partners agreed to share income equally.
b. The partners failed to agree on an income-sharing arrangement.
c. T he partners agreed to share income according to the ratio of their
original investments.
d. T he partners agreed to share income by allowing interest of 10 percent
on their original investments and dividing the remainder equally.
e. T he partners agreed to share income by allowing salaries of $40,000 for
Rivera and $28,000 for Bacon, and dividing the remainder equally.
f. T he partners agreed to share income by paying salaries of $40,000 to
Rivera and $28,000 to Bacon, allowing interest of 9 percent on their
original investments, and dividing the remainder equally.
User insight (cid:2) 3. What are some of the factors that need to be considered in choosing the plan
of partners’ income sharing among the options shown in requirement 2?
LO3 Distribution of Income: Salaries and Interest
P 2. Naomi and Petri are partners in a tennis shop. They have agreed that Naomi will
operate the store and receive a salary of $104,000 per year. Petri will receive 10 per-
cent interest on his average capital balance during the year of $500,000. The remain-
ing income or losses are to be shared by Naomi and Petri in a 2:3 ratio.
Required
Determine each partner’s share of income and losses under each of the following
conditions. In each case, the income or loss is stated before the distribution of
salary and interest.
1. Income was $168,000.
2. Income was $88,000.
3. The loss was $25,600.
LO4 Admission and Withdrawal of a Partner
P 3. M arnie, Stacie, and Samantha are partners in Woodware Company. Their
capital balances as of July 31, 2011, are as follows:
MARNIE, CAPITAL STACIE, CAPITAL SAMANTHA, CAPITAL
Dr. Cr. Dr. Cr. Dr. Cr.
45,000 15,000 30,000
Each partner has agreed to admit Connie to the partnership.
Required
1. Prepare the entries in journal form to record Connie’s admission to or
Marnie’s withdrawal from the partnership under each of the following
conditions:
a. C onnie pays Marnie $12,500 for 20 percent of Marnie’s interest in the
partnership.
b. C onnie invests $20,000 cash in the partnership and receives an interest
equal to her investment.
c. C onnie invests $30,000 cash in the partnership for a 20 percent interest
in the business. A bonus is to be recorded for the original partners on
the basis of their capital balances.
788 CHAPTER 17 Partnerships
d. C onnie invests $30,000 cash in the partnership for a 40 percent interest
in the business. The original partners give Connie a bonus according to
the ratio of their capital balances on July 31, 2011.
e. Marnie withdraws from the partnership, taking $52,500. The excess of
withdrawn assets over Marnie’s partnership interest is distributed accord-
ing to the balances of the Capital accounts.
f. Marnie withdraws by selling her interest directly to Connie for $60,000.
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User insight (cid:2) 2. When a new partner enters a partnership, why would the new partner pay a
bonus to the old partners, or why would the old partners pay a bonus to the
new partner?
LO5 Partnership Liquidation
P 4. Caruso, Evans, and Weisman are partners in a retail lighting store. They share
income and losses in the ratio of 2:2:1, respectively. The partners have agreed to liq-
uidate the partnership. Here is the partnership balance sheet before the liquidation:
Caruso, Evans, and Weisman Partnership
Balance Sheet
August 31, 2010
ASSETS LIABILITIES
Cash $ 280,000 Accounts payable $ 360,000
Other assets 880,000
PARTNERS’ EQUITY
Caruso, Capital $ 400,000
Evans, Capital 240,000
Weisman, Capital 160,000
Total partners’ equity $ 800,000
Total liabilities and
Total assets $1,160,000 partners’ equity $1,160,000
The other assets were sold on September 1, 2010, for $720,000. Accounts pay-
able were paid on September 4, 2010. The remaining cash was distributed to the
partners on September 11, 2010.
Required
1. Prepare a statement of liquidation.
2. Prepare the following entries in journal form:
a. the sale of the other assets,
b. payment of the accounts payable,
c. the distribution of the loss from realization, and
d. the distribution to the partners of the remaining cash.
Alternate Problems
LO3 Distribution of Income: Salaries and Interest
P 5. Jacob, Deric, and Jason are partners in the South Central Company. The part-
nership agreement states that Jacob is to receive 8 percent interest on his capital
balance at the beginning of the year, Deric is to receive a salary of $100,000 a year,
and Jason will be paid interest of 6 percent on his average capital balance during the
year. Jacob, Deric, and Jason will share any income or loss after salary and interest in
Chapter Assignments 789
a 5:3:2 ratio. Jacob’s capital balance at the beginning of the year was $600,000, and
Jason’s average capital balance for the year was $720,000.
Required
Determine each partner’s share of income and losses under the following condi-
tions. In each case, the income or loss is stated before the distribution of salary
and interest.
1. Income was $545,200.
2. Income was $155,600.
3. The loss was $56,800.
LO4 Admission and Withdrawal of a Partner
P 6. Peter, Mara, and Vanessa are partners in the Image Gallery. As of November 30,
2011, the balance in Peter’s Capital account was $50,000, the balance in Mara’s was
$60,000, and the balance in Vanessa’s was $90,000. Peter, Mara, and Vanessa share
income and losses in a ratio of 2:3:5.
Required
1. Prepare entries in journal form for each of the following independent
conditions:
a. Bob pays Vanessa $100,000 for four-fifths of Vanessa’s interest.
b. B ob is to be admitted to the partnership with a one-third interest for a
$100,000 cash investment.
c. B ob is to be admitted to the partnership with a one-third interest for
a $160,000 cash investment. A bonus, based on the partners’ ratio for
income and losses, is to be distributed to the original partners when
Bob is admitted.
d. B ob is to be admitted to the partnership with a one-third interest for an
$82,000 cash investment. A bonus is to be given to Bob on admission.
e. Peter withdraws from the partnership, taking $66,000 in cash.
f. P eter withdraws from the partnership by selling his interest directly to
Bob for $70,000.
User insight (cid:2) 2. In general, when a new partner enters a partnership, why would the new
partner pay a bonus to the old partners, or why would the old partners pay a
bonus to the new partner?
LO5 Partnership Liquidation
P 7. The balance sheet of the Rose Partnership as of July 31, 2011, follows.
Rose Partnership
Balance Sheet
July 31, 2011
ASSETS LIABILITIES
Cash $ 6,000 Accounts payable $480,000
Accounts receivable 120,000
PARTNERS’ EQUITY
Inventory 264,000
Equipment (net) 462,000 Gerri, Capital $ 72,000
Susi, Capital 180,000
Mari, Capital 120,000
Total partners’ equity $372,000
Total liabilities and
Total assets $852,000 partners’ equity $852,000
790 CHAPTER 17 Partnerships
The partners—Gerri, Susi, and Mari—share income and losses in the ratio of
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5:3:2. Because of a mutual disagreement, Gerri, Susi, and Mari have decided to
liquidate the business.
Assume that Gerri cannot contribute any additional personal assets to the
company during liquidation and that the following transactions occurred during
liquidation: (a) Accounts receivable were sold for 60 percent of their book value.
(b) Inventory was sold for $276,000. (c) Equipment was sold for $300,000.
(d) Accounts payable were paid in full. (e) Gain or loss from realization was dis-
tributed to the partners’ Capital accounts. (f) Gerri’s deficit was transferred to the
remaining partners in their new income and loss ratio. (g) The remaining cash
was distributed to Susi and Mari.
Required
1. Prepare a statement of liquidation.
2. Prepare entries in journal form to liquidate the partnership and distribute any
remaining cash.
LO2 LO3 Comprehensive Partnership Transactions
LO4 LO5
P 8. The following events pertain to a partnership formed by Mark Raymond and
Stan Bryden to operate a floor-cleaning company:
2011
Feb. 14 The partnership was formed. Raymond transferred to the partnership
$80,000 cash, land worth $80,000, a building worth $480,000, and
a mortgage on the building of $240,000. Bryden transferred to the
partnership $40,000 cash and equipment worth $160,000.
Dec. 31 During 2011, the partnership earned income of just $84,000.
The partnership agreement specifies that income and losses are
to be divided by paying salaries of $40,000 to Raymond and
$60,000 to Bryden, allowing 8 percent interest on beginning
capital investments, and dividing any remainder equally.
2012
Jan. 1 To improve the prospects for the company, the partners decided
to take in a new partner, Chuck Menzer, who had experience in
the floor-cleaning business. Menzer invested $156,000 for a
25 percent interest in the business. A bonus was transferred in
equal amounts from the original partners’ Capital accounts to
Menzer’s Capital account.
Dec. 31 During 2012, the company earned income of $87,200. The new
partnership agreement specified that income and losses would be
divided by paying salaries of $60,000 to Bryden and $80,000 to
Menzer (no salary to Raymond), allowing 8 percent interest on
beginning capital balances after Menzer’s admission, and dividing
the remainder equally.
2013
Jan. 1 Because it appeared that the business could not support the three
partners, the partners decided to liquidate the partnership. The
asset and liability accounts of the partnership were as follows: Cash,
$407,200; Accounts Receivable (net), $68,000; Land, $80,000;
Building (net), $448,000; Equipment (net), $236,000; Accounts
Payable, $88,000; and Mortgage Payable, $224,000. The equip-
ment was sold for $200,000. The accounts payable were paid.
The loss was distributed equally to the partners’ Capital accounts.
A statement of liquidation was prepared, and the remaining assets
Chapter Assignments 791
and liabilities were distributed. Raymond agreed to accept cash
plus the land and building at book value and the mortgage payable
as payment for his share. Bryden accepted cash and the accounts
receivable for his share. Menzer was paid in cash.
Required
Prepare entries in journal form to record all of the facts above. Support your com-
putations with schedules, and prepare a statement of liquidation in connection
with the January 1, 2013, entries.
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO3 Distribution of Partnership Income and Losses
C 1. Landow, Donovan, and Hansa, who are forming a partnership to operate
an antiques gallery, are discussing how income and losses should be distributed.
Among the facts they are considering are the following:
a. Landow will contribute cash for operations of $100,000, Donovan will con-
tribute a collection of antiques that is valued at $300,000, and Hansa will
not contribute any assets.
b. Landow and Hansa will handle day-to-day business operations. Hansa will
work full-time, and Landow will devote about half-time to the partnership.
Donovan will not devote time to day-to-day operations. A full-time clerk in
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a retail store would make about $20,000 in a year, and a full-time manager
would receive about $30,000.
c. The current interest rate on long-term bonds is 8 percent.
Landow, Donovan, and Hansa have just hired you as the partnership’s accoun-
tant. Write a memorandum describing an equitable plan for distributing income
and losses. Outline the reasons why you believe this plan is equitable. According
to your plan, which partner will gain the most if the partnership is very profitable,
and which will lose the most if the partnership has large losses?
LO1 Partnership Agreement
C 2. Form a partnership with one or two of your classmates. Assume that the two
or three of you are forming a small service business. For example, you might form
a company that hires college students to paint houses during the summer or to
provide landscaping services.
Working together, draft a partnership agreement for your business. The
agreement can be a simple one, with just a sentence or two for each provision.
However, it should include the name, location, and purpose of the business; the
names of the partners and their respective duties; the investments of each partner;
methods for distributing profits and losses; and procedures for dealing with the
admission or withdrawal of partners, the withdrawal of assets, the death of a part-
ner, and liquidation of the business. Include a title, date, and signature lines.
LO1 LO2 Death of a Partner
LO4
C 3. South Shore Realty was started 20 years ago when T. S. Tyler, R. C. Strong,
and A. J. Hibbert established a partnership to sell real estate near Galveston, Texas.
The partnership has been extremely successful. In 2011, Tyler, the senior partner,
who in recent years had not been very active in the partnership, died. Unfortu-
nately, the partnership agreement is vague about how the partnership interest of a
792 CHAPTER 17 Partnerships
partner who dies should be valued. It simply states that “the estate of a deceased
partner shall receive compensation for his or her interest in the partnership in
a reasonable time after death.” The attorney for Tyler’s family believes that the
estate should receive one-third of the assets of the partnership based on the fair
market value of the net assets (total assets less total liabilities). The total assets of
the partnership are $10 million in the accounting records, but the assets are worth
at least $20 million. Because the firm’s total liabilities are $4 million, the attorney
is asking for $5.3 million (one-third of $16 million). Strong and Hibbert do not
agree, but all parties want to avoid a protracted, expensive lawsuit. They have
decided to put the question to an arbitrator, who will make a determination of the
settlement.
Here are some other facts that may or may not be relevant. The current bal-
ances in the partners’ Capital accounts are $1.5 million for Tyler, $2.5 million for
Strong, and $2.0 million for Hibbert. Net income in 2011 is to be distributed
to the Capital accounts in the ratio of 1:4:3. Before Tyler’s semiretirement, the
distribution ratio was 3:3:2. Assume you or your group is the arbitrator, and
develop what you would consider a fair distribution of assets to Tyler’s estate.
Defend your solution.
LO1 LO3 Effects of a Lawsuit on Partnership
C 4. The Springfield Clinic is owned and operated by ten local doctors as a part-
nership. Recently, a paralyzed patient sued the clinic for malpractice, for a total
of $20 million. The clinic carries malpractice liability insurance in the amount of
$10 million. There is no provision for the possible loss from this type of lawsuit
in the partnership’s financial statements. The condensed balance sheet for 2011
is as follows:
Springfield Clinic
Condensed Balance Sheet
December 31, 2011
Assets
Current assets $246,000
Property, plant, and equipment (net) 750,000
Total assets $996,000
Liabilities and Partners’ Equity
Current liabilities $180,000
Long-term debt 675,000
Total liabilities $855,000
Partners’ equity 141,000
Total liabilities and partners’ equity $996,000
1. How should information about the lawsuit be disclosed in the December 31,
|
2011, financial statements of the partnership?
2. Assume that the clinic and its insurance company settle out of court by agree-
ing to pay a total of $10.1 million, of which $100,000 must be paid by the
partnership. What effect will the payment have on the clinic’s December 31,
2011, financial statements? Discuss the effect of the settlement on the Spring-
field Clinic doctors’ personal financial situations.
Chapter Assignments 793
LO1 International Joint Ventures
C 5. Nokia (www.nokia.com), the Finnish telecommunications company, has
formed an equally owned joint venture with Capital Corporation, a state-owned
Chinese company, to develop a center for the manufacture and development of tele-
communications equipment in China, the world’s fastest-growing market for this
kind of equipment. The main aim of the development is to persuade Nokia’s sup-
pliers to move close to the company’s main plant. The Chinese government looks
favorably on companies that involve local suppliers.1 What advantages does a joint
venture have over a single company in entering a new market in another country?
What are the potential disadvantages? Divide into groups. One-half of the groups
will make a strong argument for the joint venture. The other half will make a strong
case against the joint venture. Engage in a class debate over the joint venture.
LO1 Comparison of Career Opportunities in Partnerships and Corporations
C 6. Accounting firms are among the world’s largest partnerships and provide a wide
range of attractive careers for business and accounting majors. Through the Needles
Website at http://www.cengage.com/accounting/needles, you can explore careers
in public accounting by linking to the website of one of the Big Four accounting
firms: Deloitte & Touche, Ernst & Young, KPMG International, and Pricewater-
houseCoopers. Each firm’s home page has a career opportunity section. For the
firm you choose, compile a list of facts about the firm—size, locations, services, and
career opportunities. Do you have the interest and background for a career in public
accounting? Why or why not? How do you think working for a large partnership
would differ from or be the same as working for a large corporation? Be prepared to
discuss your findings in class.
C H A P T E R
The Changing Business
18
Environment:
A Manager’s Perspective
M anagement is expected to ensure that the organization uses
The Management
Process its resources wisely, operates profitably, pays its debts, and
abides by laws and regulations. To fulfill these expectations, man-
PLAN
agers establish the goals, objectives, and strategic plans that guide
Formulate mission statement
and control the organization’s operating, investing, and financing
Set strategic, tactical, and
operating performance activities. In this chapter, we describe the approaches that managers
objectives and measures
have developed to meet the challenges of today’s changing busi-
ness environment and the role that management accounting plays
in meeting those challenges in an ethical manner.
PERFORM
Manage ethically
Measure value chain and
LEARNING OBJECTIVES
supply chain performance
LO1 Distinguish management accounting from financial
accounting and explain how management accounting
supports the management process. (pp. 796–803)
EVALUATE
LO2 Describe the value chain and its usefulness in analyzing a
Compare actual performance business. (pp. 803–807)
with performance levels
established in planning stage
LO3 Identify the management tools used for continuous
Use tools of continuous improvement. (pp. 807–811)
improvement
LO4 Explain the balanced scorecard and its relationship to
performance measures. (pp. 811–814)
COMMUNICATE
LO5 Identify the standards of ethical conduct for management
Prepare business plan
accountants. (pp. 814–816)
Prepare accurate financial
statements
Communicate information
clearly and ethically
794
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∇
∇
∇
∇
∇
∇
∇
∇
How managers plan, perform,
evaluate, and report business
can affect us all.
DECISION POINT (cid:2) A MANAGER’S FOCUS (cid:2) What is Good Food Store’s
strategic plan?
GOOD FOODS STORE
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(cid:2) What management accounting
tools does the company use to
Vanna Lang is about to open a retail grocery store called Good Foods stay ahead of its competitors?
Store. She has assembled a team of store managers, and in a recent (cid:2) What role does management
meeting, she and the managers discussed the factors they should accounting play in Good Foods
concentrate on to ensure the store’s success. They agreed that their Store’s endeavors?
company, like any other company, should aim to satisfy customer
needs, develop efficient operating processes, foster career paths for
employees, and become an innovative leader in marketing products
and services. In this chapter, we follow Vanna Lang and her manag-
ers as they try to balance these factors while mapping out a strategic
plan, performing their managerial duties, evaluating the results of
their efforts, and communicating about the company’s progress.
779955
796 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
The Role of
To plan and control an organization’s operations, to measure its performance,
Management and to make decisions about products or services and many other internal control
and governance matters, managers need accurate and timely accounting informa-
Accounting
tion. The role of management accounting is to provide an information system
that enables managers and persons throughout an organization:
LO1 Distinguish manage-
(cid:2) to make informed decisions,
ment accounting from financial
accounting and explain how (cid:2) to be more effective at their jobs, and
management accounting sup-
(cid:2) to improve the organization’s performance.
ports the management process.
In 2008, the Institute of Management Accountants (IMA) updated the defi-
nition of management accounting as follows:
Management accounting is a profession that involves partnering
in management decision making, devising planning and perfor-
mance management systems, and providing expertise in financial
reporting and control to assist management in the formulation and
implementation of an organization’s strategy.1
This definition recognizes that regulation, globalization, and technology changes
have redefined the management accountant’s role from a traditional compliance,
number-focused one to that of a strategic business partner within an organiza-
tion. Thus, the importance of nonfinancial information has increased significantly.
Today, management accounting information includes nonfinancial data as well as
financial data in performance management, planning and budgeting, corporate
governance, risk management, and internal controls.
Management Accounting and Financial Accounting:
A Comparison
Both management accounting and financial accounting assist decision makers by
Study Note
identifying, measuring, and processing relevant information and communicating this
Management accounting is information through reports. Both provide managers with key measures of a com-
not a subordinate activity to pany’s performance and with cost information for valuing inventories on the balance
financial accounting. Rather, it is sheet. Despite the overlap in their functions, management accounting and financial
a process that includes financial accounting differ in a number of ways. Table 18-1 summarizes these differences.
accounting, tax accounting,
The primary users of management accounting information are people inside
information analysis, and other
the organization, whereas financial accounting takes the actual results of manage-
accounting activities.
ment decisions about operating, investing, and financing activities and prepares
financial statements for parties outside the organization—owners or stockhold-
ers, lenders, customers, and governmental agencies. Although these reports are
Study Note prepared primarily for external use, managers also rely on them in evaluating an
organization’s performance.
Financial accounting must
Because management accounting reports are for internal use, their format can
adhere to the conventions of
be flexible, driven by the user’s needs. They may report either historical or future-
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consistency and comparability
oriented information without any formal guidelines or restrictions. In contrast,
to ensure the usefulness
financial accounting reports, which focus on past performance, must follow gen-
of information to parties
erally accepted accounting principles as specified by the Securities and Exchange
outside the firm. Management
Commission (SEC).
accounting, on the other hand,
The information in management accounting reports may be objective and
can use innovative analyses
verifiable, expressed in monetary terms or in physical measures of time or objects;
and presentation techniques
to enhance the usefulness of the information may be based on estimates, and in such cases, it will be more
information to people within subjective. In contrast, the statements that financial accounting provides must
the firm. be based on objective and verifiable information, which is generally historical in
nature and measured in monetary terms. Management accounting reports are
The Role of Management Accounting 797
TABLE 18-1 Comparison of Management Accounting and Financial Accounting
Areas of Comparison Management Accounting Financial Accounting
Primary users Managers, employees, supply-chain Owners or stockholders, lenders,
partners customers, governmental agencies
Report format Flexible, driven by user’s needs Based on generally accepted
accounting principles
Purpose of reports Provide information for planning, Report on past performance
control, performance measurement,
and decision making
Nature of information Objective and verifiable for decision Objective and verifiable; publicly
making; more subjective for planning available
(relies on estimates); confidential and
private
Units of measure Monetary at historical or current Monetary at historical and current
market or projected values; physical market values
measures of time or number of objects
Frequency of reports Prepared as needed; may or may not Prepared on a periodic basis
be on a periodic basis
prepared as often as needed—annually, quarterly, monthly, or even daily. Finan-
cial statements, on the other hand, are prepared and distributed periodically, usu-
ally on a quarterly and annual basis.
Management Accounting and the
Management Process
Although management actions differ from organization to organization, they
generally follow a four-stage management process. As illustrated at the beginning
of this chapter and in the chapters that follow, the four stages of this process are:
(cid:2) planning,
(cid:2) performing,
(cid:2) evaluating, and
(cid:2) communicating.
Management accounting is essential in each stage of the process as managers
make business decisions.
Planning Figure 18-1 shows the overall framework in which planning takes
place. The overriding goal of a business is to increase the value of the stake-
holders’ interest in the business. The goal specifies the business’s end point, or
ideal state.
A company’s mission statement describes the fundamental way in which the
company will achieve its goal of increasing stakeholders’ value. It also expresses
the company’s identity and unique character. For example, in its mission state-
ment, Wal-Mart, the world’s leading retailer and grocery chain, says that it wants
“to give ordinary folk the chance to buy the same things as rich people.”
The mission statement is essential to the planning process, which must con-
sider how to add value through strategic objectives, tactical objectives, and oper-
ating objectives.
798 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
FIGURE 18-1
GOAL/VISION: To increase the value of stakeholders’ interest in
Overview of the Planning Framework
the business
MISSION: Fundamental way in which the company will achieve the
goal of increasing stakeholders’ value
STRATEGIC OBJECTIVES: Broad, long-term goals that determine the
fundamental nature and direction of the business and that serve as
a guide for decision making
TACTICAL OBJECTIVES: Mid-term goals for positioning the business
to achieve its long-term strategies
O PERATING OBJECTIVES: Short-term goals that outline expectations
|
for performance of day-to-day operations
BUSINESS PLAN: A comprehensive statement of how the company will
achieve its objectives
BUDGETS: Expressions of the business plan in financial terms
(cid:2) Strategic objectives are broad, long-term goals that determine the f undamental
nature and direction of a business and that serve as a guide for decision making.
Strategic objectives involve such basic issues as what a c ompany’s main products
or services will be, who its primary customers will be, and where it will oper-
ate. They stake out the strategic position that a company will occupy in the
market—whether it will be a cost leader, quality leader, or niche satisfier.
(cid:2) Tactical objectives are mid-term goals that position an organization to
achieve its long-term strategies. These objectives, which usually cover a three-
to five-year period, lay the groundwork for attaining the company’s strategic
objectives.
(cid:2) Operating objectives are short-term goals that outline expectations for the
performance of day-to-day operations. Operating objectives link to perfor-
mance targets and specify how success will be measured.
To develop strategic, tactical, and operating objectives, managers must for-
mulate a business plan. A business plan is a comprehensive statement of how a
company will achieve its objectives. It is usually expressed in financial terms in the
form of budgets, and it often includes performance goals for individuals, teams,
products, or services.
EXAMPLE. As we noted in the Decision Point at the start of the chapter, Vanna
Lang is about to open a retail grocery store called Good Foods Store. Lang’s goal
is to obtain an income from the business and to increase the value of her invest-
ment in it. After reading about how traditional grocers are being squeezed out by
low-cost competitors like Wal-Mart and quality-focused stores like Whole Foods
Market, Lang has made the following decisions about Good Foods Store:
The Role of Management Accounting 799
(cid:2) Good Foods Store’s mission is to attract upscale customers and retain them
by selling high-quality foods and providing excellent service in a pleasant
atmosphere.
(cid:2) Lang’s strategic objectives call for buying high-quality fresh foods from local
growers and international distributors and reselling these items to c onsumers.
(cid:2) Her tactical objectives include implementing a stable supply chain of high-
quality suppliers and a database to track customers’ preferences.
(cid:2) Her operating objectives call for courteous and efficient customer service. To
measure performance in this area, she decides to keep a record of the number
and type of complaints about poor customer service.
Before Lang can open her store, she needs to apply to a local bank for a
start-up loan. To do so, she must have a business plan that provides a full descrip-
tion of the business, including a complete operating budget for the first two years
of operations. The budget must include a forecasted income statement, a fore-
casted statement of cash flows, and a forecasted balance sheet for both years.
Because Lang does not have a financial background, she consults a local
accounting firm for help in developing her business plan. To provide relevant
input for the plan, she has to determine the types of products she wants to sell;
the volume of sales she anticipates; the selling price for each product; the monthly
costs of leasing or purchasing facilities, employing personnel, and maintaining
the facilities; and the number of display counters, storage units, and cash registers
that she will need.
Performing Planning alone does not guarantee satisfactory operating results.
Management must implement the business plan in ways that make optimal use of
available resources in an ethical manner. Smooth operations require one or more
of the following:
(cid:2) Hiring and training personnel
(cid:2) Matching human and technical resources to the work that must be done
(cid:2) Purchasing or leasing facilities
(cid:2) Maintaining an inventory of products for sale
|
(cid:2) Identifying operating activities, or tasks, that minimize waste and improve
the quality of products or services
FOCUS ON BUSINESS PRACTICE
What’s Going on in the Grocery Business?
Sales at large supermarket chains, such as Kroger, Safe- strategy to combat its flat sales and profits was to sell itself
way, and Albertson’s, have been flat and profits weak to other retailers, like Supervalu and CVS, to form larger
because both ends of their customer market are being businesses. Other grocery chains are reconsidering their
squeezed. Large-scale retailers like Wal-Mart and Costco company’s mission and strategic options by adding new
are attracting cost-conscious grocery shoppers, and upscale products and services, such as walk-in medical clinics, clos-
grocery customers are being lured to specialty grocers ing stores and downsizing, or entering new geographic
like Trader Joe’s and Whole Foods Market. Albertson’s markets.2
800 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
FIGURE 18-2 The Supply Chain
GROWERS
MANUFACTURERS DISTRIBUTORS RETAILERS CONSUMERS
SUPPLIERS
Managers execute the business plan by overseeing the company’s daily opera-
tions. In small companies like Vanna Lang’s, managers generally have frequent
direct contact with their employees. They supervise them and interact with them
to help them learn a task or improve their performance. In larger, more complex
organizations, there is usually less direct contact between managers and employ-
ees. Instead of directly observing employees, managers in large companies like
Wal-Mart monitor their employees’ performance by measuring the time taken to
complete an activity (such as how long it takes to process customer sales) or the
frequency of an activity (such as the number of customers served per hour).
Critical to managing any retail business is a thorough understanding of their
supply chain. As Figure 18-2 shows, the supply chain (also called the supply
network) is the path that leads from the suppliers of the materials from which a
product is made to the final consumer. In the supply chain for grocery stores,
food and other items flow from growers and suppliers to manufacturers or dis-
tributors to retailers to consumers. The supply chain expresses the links between
businesses—growers to vendors to the business to their customers.
EXAMPLE. Let’s assume that Good Foods Store is now open for business. The
budget prepared for the store’s first two years of operation expresses in mon-
etary terms how the business plan should be executed. Items that relate to the
business plan appear in the budget and become authorizations for expenditures.
They include such matters as spending on store fixtures, hiring employees, devel-
oping advertising campaigns, and pricing items for special sales. Lang’s knowl-
edge of her supply chain allows her to coordinate deliveries from local growers
The supply chain is the path that
links producers to stores to the final
consumer. In the supply chain for
grocery stores, fruits and vegetables
flow from growers and suppliers to
manufacturers or distributors to retail-
ers to consumers. The supply chain for
this farmer’s market is much shorter:
grower to consumer.
Courtesy of Vasiliki/iStockphoto.
The Role of Management Accounting 801
and international distributors so that she meets the demands of her customers
without having too much or too little inventory on hand.
Evaluating When managers evaluate operating results, they compare the orga-
nization’s actual performance with the performance levels they established in the
planning stage. They earmark any significant variations for further analysis so
that they can correct the problems. If the problems are the result of a change in
the organization’s operating environment, the managers may revise the original
objectives. Ideally, the adjustments made in the evaluation stage will improve the
company’s performance.
EXAMPLE. To evaluate how well Good Foods Store is doing, Vanna Lang will
compare the amounts estimated in the budget with actual results. If any differ-
|
ences appear, she will analyze why they have occurred. The reasons for these dif-
ferences may lead Lang to change parts of her original business plan. In a ddition
to reviewing employees’ performance with regard to financial goals, such as avoid-
ing waste, Lang will want to review how well her employees served customers. As
noted earlier, she decided to monitor service quality by keeping a record of the
number and type of complaints about poor customer service. Her review of this
record may help her develop new and better strategies.
Communicating Whether accounting reports are prepared for internal or
external use, they must provide accurate information and clearly communicate
this information to the reader. Inaccurate or confusing internal reports can have
a negative effect on a company’s operations. Full disclosure and transparency
in financial statements issued to external parties is a basic concept of generally
accepted accounting principles, and violation of this principle can result in stiff
penalties. After the reporting violations by Enron, WorldCom, and other com-
panies, Congress passed legislation that requires the top management of compa-
nies that file financial statements with the Securities and Exchange Commission
to certify that these statements are accurate. The penalty for issuing false public
reports can be loss of compensation, fines, and jail time.
The key to producing accurate and useful internal and external reports
whose meaning is transparent to the reader is to apply the four w’s: why, who,
what, and when.
(cid:2) Why? Know the purpose of the report. Focus on it as you write.
(cid:2) Who? Identify the audience for your report. Communicate at a level that
matches your readers’ understanding of the issue and their familiarity with
accounting information. A detailed, informal report may be appropriate for
FOCUS ON BUSINESS PRACTICE
What Is Management’s Responsibility for the Financial Statements?
Top-level managers have not only an ethical responsibil- c ompanies filing reports with the SEC to certify that those
ity to ensure that the financial statements issued by their reports contain no untrue statements and include all facts
companies adhere to the principles of full disclosure and needed to ensure that the reports are not misleading. In
transparency; today, they have a legal responsibility as well. addition, the SEC requires managers to ensure that the
The Securities and Exchange Commission (SEC) requires information in reports filed with the SEC “is recorded, pro-
the chief executive officers and chief financial officers of cessed, summarized and reported on a timely basis.”3
802 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
your manager, but a more concise summary may be necessary for other audi-
ences, such as the president or board of directors of your organization.
(cid:2) What? What information is needed, and what method of presentation is best?
Select relevant information from reliable sources. You may draw information
from pertinent documents or from interviews with knowledgeable managers
and employees. The information should be not only relevant but also easy to
read and understand. You may need to include visual aids, such as bar charts
or graphs, to present the information clearly.
(cid:2) When? Know the due date for the report. Strive to prepare an accurate report
on a timely basis. If the report is urgently needed, you may have to sacrifice
some accuracy in the interest of timeliness.
EXAMPLE. Assume that Vanna Lang has asked her company’s accountant, Sal
Chavez, to prepare financial statements and internal reports. In the financial state-
ments that are prepared:
(cid:2) The purpose—or why—is to report on the financial health of Good Foods
Store.
(cid:2) Lang, her bank and other creditors, and potential investors are the who.
(cid:2) The what consists of disclosures about assets, liabilities, product costs, and sales.
(cid:2) The required reporting deadline for the accounting period answers the ques-
tion of when.
|
Lang will also want periodic internal reports on various aspects of her store’s
operations. For example, a monthly report may summarize the costs of order-
ing products from international distributors and the related shipping charges. If
the costs in the monthly reports appear to be too high, she may ask for a special
study. The results of such a study might result in a memorandum report like the
one shown in Exhibit 18-1.
EXHIBIT 18-1 A Management
Accounting Report Memorandum
When: Today’s Date
Who: To: V. Lang, Good Foods Store
From: Sal Chavez, Accountant
Why: Re: International Distributors Ordering and Shipping Costs—Analysis
and Recommendations
What: As you requested, I have analyzed the ordering and shipping costs
incurred when buying from international distributors. I found that
during the past year, these costs were 9 percent of sales, or $36,000.
On average, we are placing about two orders per week, or eight
orders per month. Placing each order requires about two and one-half
hours of an employee’s time. Further, the international distributors
charge a service fee for each order, and shippers charge high rates for
orders as small as ours.
My recommendations are (1) to reduce orders to four per month
(the products’ freshness will not be affected if we order at least once
a week) and (2) to begin placing orders through the international
distributors’ websites (our international distributors do not charge a
service fee for online orders). If we follow these recommendations,
I project that the costs of receiving products will be reduced to
4 percent of sales, or $16,000, annually—a savings of $20,000.
Value Chain Analysis 803
In summary, management accounting can provide a constant stream of rel-
evant information. Compare Lang’s activities and information needs with the
plan, perform, evaluate, and communicate steps of the management process.
She started with a business plan, implemented the plan, and evaluated the results.
Accounting information helped her develop her business plan, communicate that
plan to her bank and employees, evaluate the performance of her employees, and
report the results of operations. As you can see, accounting plays a critical role in
managing the operations of any organization.
STOP
& APPLY
Indicate whether each of the following characteristics relates to management accounting (MA)
or financial accounting (FA):
1. Focuses on various segments of the 5. Reports information on a regular basis
business entity 6. Uses only monetary measures for
2. Demands objectivity reports
3. Relies on the criterion of usefulness 7. Adheres to generally accepted account-
rather than formal guidelines in report- ing principles
ing information 8. Prepares reports whenever needed
4. Measures units in historical dollars
SOLUTION
1. MA; 2. FA; 3. MA; 4. FA; 5. FA; 6. FA; 7. FA; 8. MA
Value Chain
Each step in the making of a product or the delivery of a service can be thought
Analysis of as a link in a chain that adds value to the product or service. This concept of
how a business fulfills its mission and objectives is known as the value chain.
As shown in Figure 18-3, the steps that add value to a product or service—
LO2 Describe the value chain
which range from research and development to customer service—are known
and its usefulness in analyzing
as primary processes. The value chain also includes support services, such
a business.
as legal services and management accounting. These services facilitate the pri-
mary processes but do not add value to the final product or service. Their
roles are critical, however, to making the primary processes as efficient and
effective as possible.
Primary Processes and Support Services
EXAMPLE. Let’s assume that Good Foods Store has had some success, and Vanna
Lang now wants to determine the feasibility of making and selling her own brand of
candy. The primary processes that will add value to the new candy are as follows:
(cid:2) Research and development: developing new and better products or services.
Lang plans to add value by developing a candy that has less sugar content
|
than similar confections.
(cid:2) Design: creating improved and distinctive shapes, labels, or packages for
products. For example, a package that is attractive and that describes the
desirable features of Lang’s new candy will add value to the product.
804 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
FIGURE 18-3 The Value Chain
MISSION
STRATEGIC OBJECTIVES
TACTICAL OBJECTIVES
OPERATING OBJECTIVES
SUPPORT SERVICES IN THE VALUE CHAIN
• Human Resources
• Legal Services
• Information Systems
• Management Accounting
PRIMARY PROCESSES IN THE VALUE CHAIN
Research and Customer
Design Supply Production Marketing Distribution
Development Service
VALUE CREATION
(cid:2) Supply: purchasing materials for products or services. Lang will want to pur-
chase high-quality sugar, chocolate, and other ingredients for the candy, as
well as high-quality packaging.
(cid:2) Production: manufacturing the product or service. To add value to the new
candy, Lang will want to implement efficient manufacturing and packaging
processes.
(cid:2) Marketing: communicating information about the products or services and
selling them. Attractive advertisements will facilitate sale of the new candy to
customers.
(cid:2) Distribution: delivering the product or service to the customer. Courteous
and efficient service for in-store customers will add value to the product. Lang
may also want to accommodate Internet customers by providing shipping.
(cid:2) Customer service: following up with service after sales or providing warranty
service. For example, Lang may offer free replacement of any candy that does
not satisfy the customer. She could also use questionnaires to measure cus-
tomer satisfaction.
The support services that provide the infrastructure for the primary processes
are as follows:
(cid:2) Human resources: hiring and training employees to carry out all the functions of
the business. Lang will need to hire and train personnel to make the new candy.
Value Chain Analysis 805
(cid:2) Legal services: maintaining and monitoring all contracts, agreements, obliga-
tions, and other relationships with outside parties. For example, Lang will
want legal advice when applying for a trademark for the new candy’s name
and when signing contracts with suppliers.
(cid:2) Information systems: establishing and maintaining technological means of
controlling and communicating within the organization. Lang will want a
computerized accounting system that keeps not only financial records but
customer information as well.
(cid:2) Management accounting: provides essential information in any business.
Advantages of Value Chain Analysis
An advantage of value chain analysis is that it allows a company to focus on its
Study Note
core competencies. A core competency is the thing that a company does best.
A company cannot succeed by It is what gives a company an advantage over its competitors. For example,
trying to do everything at the Wal-Mart is known for having the lowest prices; that is its core competency.
highest level. It has to focus on A common result of value chain analysis is outsourcing, which can also be
its core competencies to give of benefit to a business. Outsourcing is the engagement of other companies
customers the best value. to perform a process or service in the value chain that is not among an orga-
nization’s core competencies. For instance, Wal-Mart outsources its inventory
management to its vendors, who monitor and stock Wal-Mart’s stores and
warehouses.
Managers and Value Chain Analysis
In today’s competitive global business environment, analysis of the value chain
is critical to most companies’ survival. Managers at Good Foods Store and other
organizations must provide the highest value to customers at the lowest cost, and
low cost often equates with the speed at which the primary processes of the value
chain are executed. Time to market is very important.
Managers must also make the services that support the primary processes
as efficient as possible. These services are essential and cannot be eliminated,
but because they do not add value to the final product, they must be imple-
|
mented as economically as possible. Businesses have been making progress in
this area. For example, over the past ten years, the cost of the accounting func-
tion in many companies as a percentage of total revenue has declined from
6 percent to 2 percent. Technology has played a big role in making this
economy possible.
EXAMPLE. To determine whether manufacturing and selling her own brand
of candy will be profitable, Vanna Lang will need accurate information about
the cost of the candy. She knows that if her candy is to be competitive, she can-
not sell it for more than $10 per pound. Further, she has an idea of how much
candy she can sell in the first year. Based on this information, her accountant,
Sal Chavez, analyzes the value chain and projects the initial costs per pound
shown in Exhibit 18-2. The total cost of $8 per pound worries Lang because
with a selling price of $10, it leaves only $2, or 20 percent of revenue, to cover
all the support services and provide a profit. Lang believes that if the enterprise
is to be successful, this percentage, called the margin, must be at least 35 per-
cent. Since the selling price is constrained by the competition, she must find a
way to reduce costs.
(cid:2) Option 1: Chavez tells her that the company could achieve a lower total cost
per pound by selling a higher volume of candy, but that is not realistic for
806 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
EXHIBIT 18-2
Value Chain Analysis Good Foods Store
Projected Costs of New Candy
June
Initial Revised
Primary Process Costs per Pound Costs per Pound
Research and development $0.25 $0.25
Design 0.10 0.10
Supply 1.10 0.60
Production 4.50 3.50
Marketing 0.50 0.50
Distribution 0.90 0.90
Customer service 0.65 0.65
Total cost $8.00 $6.50
the new product. He also points out that the largest projected costs in the
store’s value chain are for supply and production. Because Lang plans to
order ingredients from a number of suppliers, her orders would not be large
enough to qualify for quantity discounts and savings on shipping. Using a
single supplier could reduce the supply cost by $0.50 per unit.
(cid:2) Option 2: Another way of reducing the cost of production would be to out-
source this process to a candy manufacturer, whose high volume of products
would allow it to produce the candy at a much lower cost than could be
done at Good Foods Store. Outsourcing would reduce the production cost
to $3.50 per unit. Thus, the total unit cost would be reduced to $6.50, as
shown in Exhibit 18-2. This per unit cost would enable the company to sell
the candy at a competitive $10 per pound and make the targeted margin of
35 percent ($3.50 (cid:5) $10.00).
This value chain analysis illustrates two important points. First, Good Food
Store’s mission is as a retailer. The company has no experience in making candy.
Manufacturing candy would require a change in the company’s mission and major
changes in the way it does business.
Second, outsourcing portions of the value chain that are not part of a busi-
ness’s core competency is often the best business policy. Since Good Foods Store
does not have a core competency in manufacturing candy, it would not be com-
petitive in this field. Vanna Lang would be better off having an experienced candy
manufacturer produce the candy according to her specifications and then selling
the candy under her store’s label. As Lang’s business grows, increased volume
may allow her to reconsider undertaking the manufacture of candy.
STOP
& APPLY
The following unit costs were determined by dividing the total costs of each component by the num-
ber of products produced. From these unit costs, determine the total cost per unit of primary pro-
cesses and the total cost per unit of support services.
Continuous Improvement 807
Research and development $ 1.25
Human resources 1.35
Design 0.15
Supply 1.10
Legal services 0.40
Production 4.00
Marketing 0.80
Distribution 0.90
Customer service 0.65
Information systems 0.75
Management accounting 0.10
Total cost per unit $11.45
SOLUTION
Primary Processes:
|
Research and development $1.25
Design 0.15
Supply 1.10
Production 4.00
Marketing 0.80
Distribution 0.90
Customer service 0.65
Total cost per unit $8.85
Support Services:
Human resources $1.35
Legal services 0.40
Information systems 0.75
Management accounting 0.10
Total cost per unit $2.60
Continuous
Today managers in all parts of the world have ready access to international
Improvement markets and to current information for informed decision making. As a result,
global competition has increased significantly. One of the most valuable lessons
gained from this increase in competition is that management cannot afford to
LO3 Identify the manage-
become complacent. The concept of continuous improvement evolved to avoid
ment tools used for continuous
such complacency. Organizations that adhere to continuous improvement are
improvement.
never satisfied with what is; they constantly seek improved quality and lower cost
through better methods, products, services, processes, or resources. In response
to this concept, several important management tools have emerged. These tools
help companies remain competitive by focusing on continuous improvement of
business methods.
Management Tools for Continuous Improvement
Among the management tools that companies use are the just-in-time operat-
ing philosophy, total quality management, activity-based management, and the
theory of constraints.
808 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
Just-in-Time Operating Philosophy The just-in-time (JIT) operating
philosophy requires that all resources—materials, personnel, and facilities—be
acquired and used only when they are needed. Its objectives are to improve pro-
ductivity and eliminate waste.
In a JIT environment, production processes are consolidated and workers
are trained to be multiskilled so that they can operate several different machines.
Materials and supplies are delivered just at the time they are needed in the pro-
duction process, which significantly reduces inventories of materials. Produc-
tion is usually started only when an order is received, and the ordered goods are
shipped when completed, which reduces the inventories of finished goods.
When manufacturing companies adopt the JIT operating philosophy, the man-
agement system is called lean production since it reduces production time and
costs, investment in materials inventory, and materials waste, and it results in high-
er-quality goods. Funds that are no longer invested in inventory can be redirected
according to the goals of the company’s business plan. JIT methods help retailers like
Wal-Mart and manufacturers like Harley-Davidson assign more accurate costs
to their products and identify the costs of waste and inefficient operation. Good
Foods Store is considering following Wal-Mart’s example, which requires ven-
dors to restock inventory often and pays them only when the goods sell. This
minimizes the funds invested in inventory and allows the retailer to focus on
offering high-demand merchandise at attractive prices.
Total Quality Management Total quality management (TQM) requires that
all parts of a business focus on quality. TQM’s goal is the improved quality of prod-
ucts or services and the work environment. Workers are empowered to make oper-
ating decisions that improve quality in both areas. All employees are tasked to spot
possible causes of poor quality, use resources efficiently and effectively to improve
quality, and reduce the time needed to complete a task or provide a service.
TQM, like the JIT operating philosophy, focuses on improving product or
service quality by identifying and reducing or eliminating the causes of waste.
Like JIT, TQM results in reduced waste of materials, higher-quality goods, and
lower production costs in manufacturing environments.
To determine the impact of poor quality on profits, TQM managers use
accounting information about the costs of quality. The costs of quality include
both the costs of achieving quality (such as training costs and inspection costs)
and the costs of poor quality (such as the costs of rework and of handling cus-
|
tomer complaints). Managers use information about the costs of quality:
(cid:2) to relate their organization’s business plan to its daily operating activities,
(cid:2) to stimulate improvement by sharing this information with all employees,
(cid:2) to identify opportunities for reducing costs and customer dissatisfaction, and
(cid:2) to determine the costs of quality relative to net income.
For retailers like Wal-Mart and Good Foods Store, TQM results in a quality cus-
tomer experience before, during, and after the sale.
Activity-Based Management Activity-based management (ABM) is an
approach to managing an organization that identifies all major activities or tasks
involved in making a product or service, determines the resources consumed by
each of those activities and why the resources are used, and categorizes the activi-
ties as either adding value to a product or service or not adding value.
Activities that add value to a product or service, as perceived by the cus-
tomer, are known as value-adding activities. All other activities are called
Continuous Improvement 809
nonvalue-adding activities; they add cost to a product or service but do not
increase its market value. ABM eliminates nonvalue-adding activities that do not
support the organization; those that do support the organization are focal points
for cost r eduction. ABM results in reduced costs, reduced waste of resources,
increased efficiency, and increased customer satisfaction.
ABM includes a management accounting practice called activity-based cost-
ing. Activity-based costing (ABC):
(cid:2) identifies all of an organization’s major operating activities (both production
and nonproduction),
(cid:2) traces costs to those activities or cost pools, and
(cid:2) assigns costs to the products or services that use the resources supplied by
those activities.
The advantage to using ABC is that ABC produces more accurate costs than tra-
ditional cost allocation methods, which leads to improved decision making.
Theory of Constraints According to the theory of constraints (TOC), limit-
ing factors, or bottlenecks, occur during the production of any product or service,
but once managers identify such a constraint, they can focus their attention and
resources on it and achieve significant improvements. TOC thus helps managers
set priorities for how they spend their time and resources. In identifying con-
straints, managers rely on the information that management accounting provides.
EXAMPLE. Suppose Vanna Lang wants to increase sales of store-roasted cof-
fees. After reviewing management accounting reports, she concludes that the
limited production capacity of her equipment—a roaster that can roast only
100 pounds of coffee beans per hour—limits the sales of the store’s coffee.
To overcome this constraint, she can rent or purchase a second roaster. The
increase in production will enable her to increase coffee sales.
Achieving Continuous Improvement
JIT, TQM, ABM, and TOC all make a contribution to continuous improvement,
as shown in Figure 18-4. In the just-in-time operating environment, management
wages war on wasted time, wasted resources, and wasted space. All employees
are encouraged to look for ways of improving processes and saving time. Total
quality management focuses on improving the quality of the product or service
and the work environment. It pursues continuous improvement by reducing the
number of defective products and the time needed to complete a task or provide
a service. Activity-based management seeks continuous improvement by empha-
sizing the ongoing reduction or elimination of nonvalue-adding activities. The
theory of constraints helps managers focus resources on efforts that will produce
the most effective improvements.
Each of these management tools can be used individually, or parts of them
can be combined to create a new operating environment. They are applicable in
service businesses, such as banking, as well as in manufacturing and retail busi-
nesses. By focusing attention on continuous improvement and fine-tuning of
|
operations, they contribute to the same results in any organization:
(cid:2) a reduction in product or service costs and delivery time,
(cid:2) an improvement in the quality of the product or service, and
(cid:2) an increase in customer satisfaction.
810 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
FIGURE 18-4 The Continuous Improvement Environment
JUST-IN-TIME
MANAGEMENT OPERATING TOTAL QUALITY ACTIVITY-BASED THEORY OF
TOOL PHILOSOPHY MANAGEMENT MANAGEMENT CONSTRAINTS
Reduces or Reduces or
Identifies
eliminates eliminates Reduces or
constraints
PROCESS/ wasted time, wasted resources eliminates
and manages
PRODUCT wasted resources, caused by defects, nonvalue-adding
resources to
CHANGES and wasted poor materials, activities
overcome them
space and wasted time
Product/service
costs and
time reduced
RESULTS Product/service
quality and
customer
satisfaction
increased
GOAL CONTINUOUS IMPROVEMENT
STOP
& APPLY
Recently, you dined with four chief financial officers (CFOs) who were attending a seminar on
management tools and approaches to improving operations. During dinner, the CFOs shared
information about their organizations’ current operating environments. Excerpts from the dinner
conversation appear below. Indicate whether each excerpt describes activity-based management
(ABM), the just-in-time (JIT) operating philosophy, total quality management (TQM), or the
theory of constraints (TOC).
CFO 1: We think quality can be achieved through CFO 2: Your approach is good. But we’re more
carefully designed production processes. We concerned with our total operating environment,
focus on minimizing the time needed to move, so we have a strategy that asks all employees to
store, queue, and inspect our materials and contribute to the quality of both our products and
products. We’ve reduced inventories by pur- our work environment. We focus on eliminating
chasing and using materials only when they’re poor product quality by reducing waste and inef-
needed. ficiencies in our current operating methods.
Performance Measures: A Key to Achieving Organizational Objectives 811
CFO 3: Our organization has adopted a strat- CFO 4: All of your approaches are good, but
egy for producing high-quality products that how do you set priorities for your management
incorporates many of your approaches. We also efforts? We find that we achieve the great-
want to manage our resources effectively, and est improvements by focusing our time and
we do it by monitoring operating activities. We resources on the bottlenecks in our production
analyze all activities to eliminate or reduce the processes.
ones that don’t add value to products.
SOLUTION
CFO 1: JIT; CFO 2: TQM; CFO 3: ABM; CFO 4: TOC
Performance
Performance measures are quantitative tools that gauge an organization’s
Measures: A Key performance in relation to a specific goal or an expected outcome. Performance
measures may be financial or nonfinancial.
to Achieving
(cid:2) Financial performance measures include return on investment, net income
Organizational
as a percentage of sales, and the costs of poor quality as a percentage of
Objectives
sales. Such measures use monetary information to gauge the performance of
a profit-generating organization or its segments—its divisions, departments,
LO4 Explain the balanced product lines, sales territories, or operating activities.
scorecard and its relationship to (cid:2) Nonfinancial performance measures include the number of times an activity
performance measures.
occurs or the time taken to perform a task. Examples are number of customer
complaints, number of orders shipped the same day, and the time taken to
fill an order. Such performance measures are useful in reducing or eliminating
waste and inefficiencies in operating activities.
Using Performance Measures
in the Management Process
Managers use performance measures in all stages of the management process.
(cid:2) In the planning stage, they establish performance measures that will support
the organization’s mission and the objectives of its business plan, such as
|
reducing costs and increasing quality, efficiency, timeliness, and customer sat-
isfaction. As you will recall from earlier in the chapter, Vanna Lang selected
the number of customer complaints as a performance measure to monitor the
quality of service at Good Foods Store.
(cid:2) As managers perform their duties, they use the performance measures they
established in the planning stage to guide and motivate employees and to
assign costs to products, departments, and operating activities. Vanna Lang
will record the number of customer complaints during the year. She can
group the information by type of complaint or by the employee involved in
the service.
(cid:2) When evaluating performance, managers use the information that perfor-
mance measures have provided to analyze significant differences between
actual and planned performance and to identify ways of improving perfor-
mance. By comparing the actual and planned number of customer com-
plaints, Lang can identify problem areas and develop solutions.
812 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
(cid:2) When communicating with stakeholders, managers use information derived
from performance measurement to report results and develop new budgets.
If Lang needed formal reports, she could prepare performance evaluations
based on this information.
The Balanced Scorecard
If an organization is to achieve its mission and objectives, it must identify the
Study Note areas in which it needs to excel and establish measures of performance in these
critical areas. As we have indicated, effective performance measurement requires
The balanced scorecard focuses
an approach that uses both financial and nonfinancial measures that are tied to
all perspectives of a business on
a company’s mission and objectives. One such approach that has gained wide
accomplishing the business’s
acceptance is the balanced scorecard.
mission.
The balanced scorecard is a framework that links the perspectives of an
organization’s four stakeholder groups to the organization’s mission, objectives,
resources, and performance measures. The four stakeholder groups are as
Study Note follows:
(cid:2) Stakeholders with a financial perspective (owners, investors, and creditors)
The balanced scorecard
value improvements in financial measures, such as net income and return on
provides a way of linking the
lead performance indicators of investment.
employees, internal business (cid:2) Stakeholders with a learning and growth perspective (employees) value high
processes, and customer needs
wages, job satisfaction, and opportunities to fulfill their potential.
to the lag performance
indicator of external financial (cid:2) Stakeholders who focus on the business’s internal processes value the safe and
results. In other words, if cost-effective production of high-quality products.
managers can foster excellent
(cid:2) Stakeholders with a customer perspective value high-quality products that are
performance for three of the
low in cost.
stakeholder groups, good
financial results will occur for Although their perspectives differ, these stakeholder groups may be interested in
the investor stakeholder group. the same measurable performance goals. For example, holders of both the cus-
tomer and internal business processes perspectives are interested in performance
that results in high-quality products.
EXAMPLE. Figure 18-5 applies the balanced scorecard to Good Foods Store.
The company’s mission is to be the food store of choice in the community. This
mission is at the center of the company’s balanced scorecard. Surrounding it are
the four interrelated perspectives.
(cid:2) Learning and Growth: At the base of the scorecard is the learning and
growth perspective. Here, part of the objective, or performance goal, is to
provide courteous service. Because training employees in customer service
should result in courteous service, performance related to this objective can
be measured in terms of how many employees have received training. The
number of customer complaints is another measure of courteous service.
|
(cid:2) Internal Business Processes: From the perspective of internal business pro-
cesses, the objective is to help achieve the company’s mission by managing
the supply chain efficiently, which should contribute to customer satisfaction.
Efficiency in the ordering process can be measured by recording the number
of orders placed with distributors each month and the number of times per
month that customers ask for items that are not in stock.
(cid:2) Customer: If the objectives of the learning and growth and internal business
processes perspectives are met, this should result in attracting customers and
Performance Measures: A Key to Achieving Organizational Objectives 813
FIGURE 18-5 The Balanced Scorecard for Good Foods Store
Financial (Investors’) Perspective
Objective
Pe Mrfo earm sua rn ece
To have profitable Growth in sales,
growth profit margin,
return on assets
Customer Perspective
Internal Business Processes Perspective
Objective
Pe Mrfo earm sua rn ece Objective
Pe Mrfo earm sua rn ece
To attract and Number of new MISSION: To be the food store of choice To manage the Number of orders
retain customers customers, in the community supply chain placed with
efficiently distributors per
number of repeat
month, number of
customers
times per month
each item is out
of stock
Learning and Growth
(Employees’) Perspective
Objective
Pe Mrfo earm sua rn ece
To give courteous Number of
service employees trained
in customer service,
number of customer
complaints
Source: Adapted from Robert S. Kaplan and David P. Norton, “The Balanced Scorecard: Measures That Drive Performance,” Harvard
Business Review, July–August 2005.
retaining them, which is the objective of the customer perspective. Perfor-
mance related to this objective is measured by tracking the number of new
customers and the number of repeat customers.
(cid:2) Financial: Satisfied customers should help achieve the objective of the finan-
cial perspective, which is profitable growth. Profitable growth is measured by
growth in sales, profit margin, and return on assets.
FOCUS ON BUSINESS PRACTICE
How Does the Balanced Scorecard Measure Success at Futura Industries?
Futura Industries is not a famous company, but it is one (cid:2) Percentage of sales from new products and total pro-
of the best. Based in Utah, it is rated as that state’s top pri- duction cost per standard hour are measures of the
vately owned employer and serves a high-end niche in such company’s internal processes.
diverse markets as floor coverings, electronics, transporta-
(cid:2) Number of customers’ complaints and percentage of
tion, and shower doors. In achieving its success, Futura uses
materials returned are the measures of customer satis-
the balanced scorecard. Futura has developed the follow-
faction.
ing performance measures:
(cid:2) Income and gross margin are among the measures of
(cid:2) Employee turnover is a measure of learning and
financial performance.4
growth.
814 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
Benchmarking
The balanced scorecard enables a company to determine whether it is making
continuous improvement in its operations. But to ensure its success, a company
must also compare its performance with that of similar companies in the same
industry. Benchmarking is a technique for determining a company’s competi-
tive advantage by comparing its performance with that of its closest competitors.
Benchmarks are measures of the best practices in an industry.
EXAMPLE. To obtain information about benchmarks in the retail grocery indus-
try, Vanna Lang might join a trade association for small retail shops or food stores.
Information about these benchmarks would be useful to her in setting targets for
the performance measures in Good Foods Store’s balanced scorecard.
STOP
& APPLY
Connie’s Takeout caters to young professionals who want a good meal at home but do not have
time to prepare it. Connie’s has developed the following business objectives:
1. To provide fast, courteous service 3. To have repeat customers
2. To manage the inventory of food 4. To be profitable and grow
carefully
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Connie’s has also developed the following performance measures:
5. Growth in revenues per quarter and 7. Average customer time at the coun-
net income ter before being waited on
6. Average unsold food at the end of 8. Percentage of customers who have
the business day as a percentage of shopped in the store before
the total food purchased that day
Match each of these objectives and performance measures with the four perspectives of the bal-
anced scorecard: financial perspective, learning and growth perspective, internal business processes
perspective, and customer perspective.
SOLUTION
Financial perspective: 4, 5; learning and growth perspective: 1, 7; internal business processes perspective: 2, 6;
customer perspective: 3, 8
Standards Managers balance the interests of external parties (e.g., customers, owners, sup-
of Ethical Conduct pliers, governmental agencies, and the local community) when they make deci-
sions about the proper use of organizational resources and the financial reporting
of their actions. When ethical conflicts arise, management accountants have a
LO5 Identify the standards of
responsibility to help managers balance those interests.
ethical conduct for management
To be viewed credibly by the various parties who rely on the information they
accountants.
provide, management accountants must adhere to the highest standards of per-
formance. To provide guidance, the Institute of Management Accountants has
issued standards of ethical conduct for practitioners of management accounting
and financial management. Those standards, presented in Exhibit 18-3, empha-
size that management accountants have responsibilities in the areas of compe-
tence, confidentiality, integrity, and credibility.
Standards of Ethical Conduct 815
EXHIBIT 18-3 Statement of Ethical Professional Practice
Members of IMA shall behave ethically. A commitment to ethical professional practice includes: overarching principles that
express our values, and standards that guide our conduct.
PRINCIPLES
IMA’s overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility. Members shall act in accordance
with these principles and shall encourage others within their organizations to adhere to them.
STANDARDS
A member’s failure to comply with the following standards may result in disciplinary action.
I. COMPETENCE
Each member has a responsibility to:
1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills.
2. Perform professional duties in accordance with relevant laws, regulations, and technical standards.
3. Provide decision support information and recommendations that are accurate, clear, concise, and timely.
4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or
successful performance of an activity.
II. CONFIDENTIALITY
Each member has a responsibility to:
1. Keep information confidential except when disclosure is authorized or legally required.
2. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates’ activities to ensure
compliance.
3. Refrain from using confidential information for unethical or illegal advantage.
III. INTEGRITY
Each member has a responsibility to:
1. Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of interest.
Advise all parties of any potential conflicts.
2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically.
3. Abstain from engaging in or supporting any activity that might discredit the profession.
IV. CREDIBILITY
Each member has a responsibility to:
1. Communicate information fairly and objectively.
2. Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the
reports, analyses, or recommendations.
3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy
and/or applicable law.
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RESOLUTION OF ETHICAL CONFLICT
In applying the Standards of Ethical Professional Practice, you may encounter problems identifying unethical behavior or
resolving an ethical conflict. When faced with ethical issues, you should follow your organization’s established policies on the
resolution of such conflict. If these policies do not resolve the ethical conflict, you should consider the following courses of action:
Discuss the issue with your immediate supervisor except when it appears that the supervisor is involved. In that case, present
the issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next management level. If your
immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the
audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate
superior should be initiated only with your superior’s knowledge, assuming he or she is not involved. Communication of such
problems to authorities or individuals not employed or engaged by the organization is not considered appropriate, unless you
believe there is a clear violation of the law.
Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics Counselor or other impartial advisor to
obtain a better understanding of possible courses of action.
Consult your own attorney as to legal obligations and rights concerning the ethical conflict.
Source: IMA Statement of Ethical Professional Practice, Institute of Management Accountants, www.imanet.org. Reprinted by
permission.
816 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
FOCUS ON BUSINESS PRACTICE
How to Blow the Whistle on Fraud
According to PricewaterhouseCoopers’s fourth bien- reporting system. Such a system can help prevent fraud,
nial survey of more than 5,400 companies in 40 countries, as can hotlines that provide guidance on ethical dilem-
eradicating fraud is extremely difficult. Despite increased mas involved in reporting fraud. An example of such an
attention to fraud detection systems and stronger inter- ethics hotline is the one that the Institute of Management
nal controls, half of the companies interviewed had fallen Accountants instituted in 2002. However, Pricewater-
victim to some type of fraud in the previous two years. The houseCoopers’s study found that the best fraud deter-
average cost of the fraud was about $3.2 million per com- rents were a company-wide risk management system
pany. Fraud appeared most likely to happen in Africa, North with a continuous proactive fraud-monitoring compo-
America, and Central-Eastern Europe. nent and a strong ethical culture to which all employees
The Sarbanes-Oxley Act of 2002 requires that all pub- subscribe.5
licly traded companies have an anonymous incident
STOP
& APPLY
Rank in order of importance the management accountant’s four areas of responsibility: compe-
tence, confidentiality, integrity, and credibility. Explain the reasons for your ranking.
SOLUTION
Rankings will vary depending on the reasoning used concerning the four areas of responsibility. Ranking differences
between individuals also reinforces the fact that we approach ethical behavior in a variety of ways and why a code of
ethics is necessary.
(cid:2) GOOD FOODS STORE: REVIEW PROBLEM
The Decision Point at the beginning of this chapter focused on Good Foods Store, a
company whose mission is to attract upscale customers and retain them by selling
high-quality foods and providing excellent service in a pleasant atmosphere. It posed
these questions:
• What is Good Foods Store’s strategic plan?
• What management accounting tools does the company use to stay ahead of its
competitors?
• What role does management accounting play in Good Foods Store’s endeavors?
Good Foods Store’s strategic plan focuses on achieving the company’s objective of
being the upscale retailer of choice for the foods and services it offers. This strategy
drives the way Good Foods Store’s managers address stakeholder perspectives, as well
|
as how they formulate tactical and operating plans. To stay agile, flexible, and ahead
Supply Chain and of its competitors, Good Foods Store uses management tools like supply and value
chains to standardize requirements and procedures to ensure a high-quality shopping
Value Chain Analysis
experience.
LO2
Management accounting provides the information necessary for effective deci-
sion making. Good Foods Store’s managers use management accounting information
Good Foods Store: Review Problem 817
in making decisions about everything from selecting vendors and products, to devel-
oping and implementing new supply-chain processes, to pricing and marketing its
goods.
Management accounting also provides Good Foods Store managers with objec-
tive data that they can use to measure the company’s performance in terms of its
key success factor—quality. Among the management accounting tools used are
budgets, which set daily operating goals and provide targets for evaluating the
store’s performance. As Good Foods Store strives to improve its sales, earnings per
share, and profitability, it will continue to rely on the information that management
accounting provides.
As a convenience to customers, Good Foods Store wants to sell a variety of generic
prescription drugs for $ 4.00 for a 30-day supply. To do so, Good Foods Store cannot
pay its vendor, Medicine for All, more than $2.00 for a 30-day supply. Managers at Medi-
cine for All and the Good Foods Store work together to analyze their value chains and
supply chain to determine if the total cost of primary processes per 30-day supply can
be reduced to less than $1.60. If it can, then the Good Foods Store deal is acceptable.
A joint study by the management accountants has determined the following current
per unit costs for primary processes:
Primary Process Cost per Unit
Research and development $0.50
Design 0.25
Supply 0.35
Production 0.50
Advertising and marketing 0.55
Distribution 0.20
Customer service 0.05
Total cost $2.40
After analyzing operations, management at both companies believe the following
proposals for cost reduction of primary processes are possible:
• Research and development and design are critical functions because the market
and competition require constant development of new, safe packaging features
and higher quality at lower cost. Nevertheless, management feels that the cost of
these processes must be reduced by 20 percent.
• Five different suppliers currently provide the components for the generic
medicines. Ordering these components from just two suppliers and negotiating
lower prices could result in a savings of 30 percent.
• The generic drugs are currently manufactured in Mexico. By shifting production to
China, the unit cost of production can be lowered by 40 percent.
• Management believes that by working with Good Foods Store they can cut their
advertising and marketing budgets by 70 percent.
• Distribution costs are already very low, but management will set a target of
reducing the cost by 10 percent.
• Customer support and service has been a weakness of the company and has
resulted in lost sales. Management therefore proposes increasing the cost per unit
of customer support to Good Foods Store by 50 percent.
Required
1. Prepare a table showing Medicine for All’s current cost of primary processes and
the projected cost per 30-days’ supply based on management’s proposals for
cost reduction.
818 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
2. Will management’s proposals for cost reduction achieve the targeted total cost
of less than $1.60 per 30-day supply?
3. Manager insight: What are the company’s support services? What role should
these services play in the value chain analysis?
Answers to
1.
Review Problem
Current Percentage Projected
Cost per 30-Day (Decrease) Cost per 30-Day
Supply Increase Supply*
Research and
development $0.50 (20%) $0.400
Design 0.25 (20%) 0.200
Supply 0.35 (30%) 0.245
Production 0.50 (40%) 0.300
Advertising
and marketing 0.55 (70%) 0.165
Distribution 0.20 (10%) 0.180
Customer service 0.05 50% 0.075
|
Total $2.40 $1.565
*Computations: $0.50 (cid:6) (100% (cid:4) 20%) (cid:2) $0.40; $0.25 (cid:6) (100% (cid:4) 20%) (cid:2) $0.20;
$0.35 (cid:6) (100% (cid:4) 30%) (cid:2) $0.245; $0.50 (cid:6) (100% (cid:4) 40%) (cid:2) $0.30; $0.55 (cid:6)
(100% (cid:4) 70%) (cid:2) $0.165; $0.20 (cid:6) (100% (cid:4) 10%) (cid:2) $0.18; and $0.05 (cid:6)
(100% (cid:3) 50%) (cid:2) $0.075.
2. Yes, $1.565 is lower than $1.60. Medicine for All and Good Foods Store have a
mutually beneficial deal.
3. The support services are human resources, legal services, information systems, and
management accounting. The analysis has not mentioned these services, which are
necessary but do not provide direct value to the final product. Management should
analyze these functions carefully to see if they can be reduced.
Stop & Review 819
STOP
& REVIEW
LO1 Distinguish manage- Management accounting involves partnering with management in decision making,
ment accounting from devising planning and performance management systems, and providing expertise
fi nancial accounting and in financial reporting and control to assist management in the formulation and
explain how manage- implementation of an organization’s strategy.
Management accounting reports provide information for planning, control,
ment accounting sup-
performance measurement, and decision making to managers and employees when
ports the management
they need such information. These reports have a flexible format; they can pre-
process.
sent either historical or future-oriented information expressed in dollar amounts
or physical measures. In contrast, financial accounting reports provide informa-
tion about an organization’s past performance to owners, lenders, customers, and
governmental agencies on a periodic basis. Financial accounting reports follow
strict guidelines defined by generally accepted accounting principles.
Management accounting supports each stage of the management p rocess.
When managers plan, they work with management accounting to establish
strategic, tactical, and operating objectives that reflect their company’s mission
and to formulate a comprehensive business plan for achieving those objectives.
The plan is usually expressed in financial terms in the form of budgets. When
managers implement the plan, they use the information provided in the bud-
gets to manage the business in the context of its supply chain. In e valuating
performance, managers compare actual performance with planned performance
and take steps to correct any problems. Reports reflect the results of plan-
ning, executing, and evaluating operations and may be prepared for external
or internal use.
LO2 Describe the value chain The value chain conceives of each step in the production of a product or the
and its usefulness in ana- delivery of a service as a link in a chain that adds value to the product or ser-
lyzing a business. vice. These value-adding steps—research and development, design, supply,
production, marketing, distribution, and customer service—are known as pri-
mary processes. The value chain also includes support services—human
resources, legal services, information services, and management accounting.
Support services facilitate the primary processes but do not add value to the
final product. Value chain analysis enables a company to focus on its core com-
petencies. Parts of the value chain that are not core competencies are frequently
outsourced.
LO3 Identify the manage- Management tools for continuous improvement include the just-in-time (JIT)
ment tools used for con- operating philosophy, total quality management (TQM), activity-based manage-
tinuous improvement. ment (ABM), and the theory of constraints (TOC). These tools are designed to
help businesses meet the demands of global competition by reducing resource
waste and costs and by improving product or service quality, thereby increasing
customer satisfaction.
Management accounting responds to a just-in-time operating environment
by providing an information system that is sensitive to changes in production
|
processes. In a total quality management environment, management accounting
provides information about the costs of quality. Activity-based management’s
assignment of overhead costs to products or services relies on the account-
ing practice known as activity-based costing (ABC). In businesses that use the
theory of constraints, management accounting identifies process or product
constraints.
820 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
LO4 Explain the balanced The balanced scorecard links the perspectives of an organization’s stakeholder
scorecard and its groups—financial (investors and owners), learning and growth (employees),
relationship to perfor- internal business processes, and customers—to the organization’s mission, objec-
mance measures. tives, resources, and performance measures. Performance measures are used to
assess whether the objectives of each of the four perspectives are being met.
Benchmarking is a technique for determining a company’s competitive advantage
by comparing its performance with that of its industry peers.
LO5 Identify the standards The Statement of Ethical Professional Practice emphasizes the Institute of
of ethical conduct Management Accounting members’ responsibilities in the areas of compe-
for management tence, confidentiality, integrity, and credibility. These standards of conduct
accountants. help management accountants recognize and avoid situations that could
compromise their ability to supply management with accurate and relevant
information.
REVIEW of Concepts and Terminology
The following concepts and terms were introduced in this chapter:
Activity-based costing Just-in-time (JIT) operating Strategic objectives 798 (LO1)
(ABC) 809 (LO3) philosophy 808 (LO3)
Supply chain 800 (LO1)
Activity-based management Lean production 808 (LO3)
Support services 803 (LO2)
(ABM) 808 (LO3)
Management accounting 796 (LO1)
Tactical objectives 798 (LO1)
Balanced scorecard 812 (LO4)
Mission statement 797 (LO1)
Theory of constraints
Benchmarking 814 (LO4)
Nonvalue-adding (TOC) 809 (LO3)
Benchmarks 814 (LO4) activities 809 (LO3)
Total quality management
Business plan 798 (LO1) Operating objectives 798 (LO1) (TQM) 808 (LO3)
Continuous improvement 807 (LO3) Outsourcing 805 (LO2) Value-adding activities 808 (LO3)
Core competency 805 (LO2) Performance measures 811 (LO4) Value chain 803 (LO2)
Costs of quality 808 (LO3) Primary processes 803 (LO2)
Chapter Assignments 821
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 Management Accounting Versus Financial Accounting
SE 1. Management accounting differs from financial accounting in a number of
ways. Indicate whether each of the following characteristics relates to manage-
ment accounting (MA) or financial accounting (FA):
1. Publically reported
2. Forward looking
3. Usually confidential
4. Complies with accounting standards
5. Reports past performance
6. Uses physical measures as well as monetary ones for reports
7. Focus on business decision making
8. Driven by user needs
LO1 Strategic Positioning
SE 2. Organizations stake out different strategic positions to add value and achieve
success. Some strive to be low-cost leaders like Wal-Mart, while others become
the high-end quality leaders like Whole Foods Market. Identify which of the fol-
lowing organizations are low-cost leaders (C) and which are quality leaders (Q):
1. Tiffany & Co. 6. Rent-a-Wreck
2. Yale University 7. Hertz Rental Cars
3. Local community college 8. Pepsi-Cola
4. Lexus 9. Store-brand soda
5. Kia
LO1 The Management Process
SE 3. Indicate whether each of the following management activities in a depart-
ment store is part of planning (PL), performing (PE), evaluating (E), or com-
municating (C):
1. Completing a balance sheet and income statement at the end of the year
2. Training a clerk to complete a cash sale
3. Meeting with department managers to develop performance measures for
sales personnel
4. Renting a local warehouse to store excess inventory of clothing
5. Evaluating the performance of the shoe department by examining the signifi-
|
cant differences between its actual and planned expenses for the month
6. Preparing an annual budget of anticipated sales for each department and the
entire store
LO1 Report Preparation
SE 4. Molly Metz, president of Metz Industries, asked controller Rick Caputo to
prepare a report on the use of electricity by each of the organization’s five divisions.
Increases in electricity costs in the divisions ranged from 20 to 35 percent over the
past year. What questions should Rick ask before he begins his analysis?
822 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
LO1 LO2 The Supply Chain and the Value Chain
SE 5. Indicate whether each of the following is part of the supply chain (SC), a pri-
mary process (PP) in the value chain, or a support service (SS) in the value chain:
1. Human resources
2. Research and development
3. Supplier
4. Management accounting
5. Customer service
6. Retailer
LO2 The Value Chain
SE 6. The following unit costs were determined by dividing the total costs of
each component by the number of products produced. From these unit costs,
determine the total cost per unit of primary processes and the total cost per unit
of support services.
Research and development $ 1.40
Human resources 1.45
Design 0.15
Supply 1.10
Legal services 0.50
Production 4.00
Marketing 0.80
Distribution 0.90
Customer service 0.65
Information systems 0.85
Management accounting 0.20
Total cost per unit $12.00
LO3 JIT and Continuous Improvement
SE 7. The just-in-time operating environment focuses on reducing or eliminat-
ing the waste of resources. Resources include physical assets such as machinery
and buildings, labor time, and materials and parts used in the production pro-
cess. Choose one of those resources and describe how it could be wasted. How
can an organization prevent the waste of that resource? How can the concept of
continuous improvement be implemented to reduce the waste of that resource?
LO3 TQM and Value
SE 8. DUDs Dry Cleaners recently adopted total quality management. Dee
Mathias, the owner, has hired you as a consultant. Classify each of the following
activities as either value-adding (V) or nonvalue-adding (NV):
1. Providing same-day service
2. Closing the store on weekends
3. Providing free delivery service
4. Having a seamstress on site
5. Making customers pay for parking
LO4 The Balanced Scorecard: Stakeholder Values
SE 9. In the balanced scorecard approach, stakeholder groups with different per-
spectives value different performance goals. Sometimes, however, they may be
interested in the same goal. Indicate which stakeholder groups—financial (F),
learning and growth (L), internal business processes (P), and customers (C)—
value the following performance goals:
1. High wages
2. Safe products
Chapter Assignments 823
3. Low-priced products
4. Improved return on investment
5. Job security
6. Cost-effective production processes
LO5 Ethical Conduct
SE 10. Topher Sones, a management accountant for Beauty Cosmetics Company,
has lunch every day with his friend Joel Saikle, who is a management accountant
for Glowy Cosmetics, Inc., a competitor of Beauty Cosmetics. Last week, Topher
couldn’t decide how to treat some information in a report he was preparing, so
he discussed it with Joel. Is Topher adhering to the ethical standards of manage-
ment accountants? Defend your answer.
Exercises
LO1 Management Accounting Versus Financial Accounting
E 1. Explain this statement: “It is impossible to distinguish the point at which
financial accounting ends and management accounting begins.”
LO1 Management Accounting
E 2. In 1982, the IMA defined management accounting as follows:
The process of identification, measurement, accumulation, analysis,
preparation, interpretation, and communication of financial infor-
mation used by management to plan, evaluate, and control within
the organization and to assure appropriate use of and accountability
for its resources.6
Compare this definition with the updated one that appears in LO 1. How has the
emphasis changed?
LO1 The Management Process
E 3. Indicate whether each of the following management activities in a com-
|
munity hospital is part of planning (PL), performing (PE), evaluating (E), or
communicating (C):
1. Leasing five ambulances for the current year
2. Comparing the actual number with the planned number of patient days in
the hospital for the year
3. Developing a strategic plan for a new pediatric wing
4. Preparing a report showing the past performance of the emergency room
5. Developing standards, or expectations, for performance in the hospital admit-
tance area for next year
6. Preparing the hospital’s balance sheet and income statement and distributing
them to the board of directors
7. Maintaining an inventory of bed linens and bath towels
8. Formulating a corporate policy for the treatment and final disposition of haz-
ardous waste materials
9. Preparing a report on the types and amounts of hazardous waste materials
removed from the hospital in the last three months
10. Recording the time taken to deliver food trays to patients
LO1 Report Preparation
E 4. John Jefferson is the sales manager for Sunny Greeting Cards, Inc. At the
beginning of the year, the organization introduced a new line of humorous birth-
day cards to the U.S. market. Management held a strategic planning meeting on
August 31 to discuss next year’s operating activities. One item on the agenda was
to review the success of the new line of cards and decide if there was a need to
824 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
change the selling price or to stimulate sales volume in the five sales territories.
Jefferson was asked to prepare a report addressing those issues and to present it at
the meeting. His report was to include the profits generated in each sales territory
by the new card line only.
On August 31, Jefferson arrived at the meeting late and immediately distrib-
uted his report to the strategic planning team. The report consisted of comments
made by seven of Jefferson’s leading sales representatives. The comments were
broad in scope and touched only lightly on the success of the new card line.
Jefferson was pleased that he had met the deadline for distributing the report, but
the other team members were disappointed in the information he provided.
Using the four w’s for report presentation, comment on Jefferson’s effective-
ness in preparing his report.
LO1 The Supply Chain
E 5. In recent years, United Parcel Service (UPS) (www.ups-scs.com/solutions/
casestudies.html) has been positioning itself as a solver of supply-chain issues. Visit its
website and read one of the case studies related to its supply-chain solutions. Explain
how UPS helped improve the supply chain of the business featured in the case.
LO1 The Planning Framework
E 6. Edward Ortez has just opened a company that imports fine ceramic gifts
from Mexico and sells them over the Internet. In planning his business, Ortez did
the following:
1. Listed his expected expenses and revenues for the first six months of operations
2. Decided that he wanted the company to provide him with income for a good
lifestyle and funds for retirement
3. Determined that he would keep his expenses low and generate enough rev-
enues during the first two months of operations so that he would have a posi-
tive cash flow by the third month
4. Decided to focus his business on providing customers with the finest
Mexican ceramics at a favorable price
5. Developed a complete list of goals, objectives, procedures, and policies relating
to how he would find, buy, store, sell, and ship goods and collect payment
6. Decided not to have a retail operation but to rely solely on the Internet to
market the products
7. Decided to expand his website to include ceramics from other Central
American countries over the next five years
Match each of Ortez’s actions to the components of the planning framework:
goal, mission, strategic objectives, tactical objectives, operating objectives, busi-
ness plan, and budget.
LO2 The Value Chain
E 7. As mentioned in E 6, Edward Ortez recently opened his own company. He
has been thinking of ways to improve the business. Here is a list of the actions
|
that he will be undertaking:
1. Engaging an accountant to help analyze progress in meeting the objectives
of the company
2. Hiring a company to handle payroll records and employee benefits
3. Developing a logo for labeling and packaging the ceramics
4. Making gift packages by placing gourmet food products in ceramic pots and
wrapping them in plastic
5. Engaging an attorney to write contracts
6. Traveling to Mexico himself to arrange for the purchase of products and
their shipment back to the company
Chapter Assignments 825
7. Arranging new ways of taking orders over the Internet and shipping the
products
8. Keeping track of the characteristics of customers and the number and types
of products they buy
9. Following up with customers to see if they received the products and if they
are happy with them
10. Arranging for an outside firm to keep the accounting records
11. Distributing brochures that display the ceramics and refer to the website
Classify each of Ortez’s actions as one of the value chain’s primary processes—
research and development, design, supply, production, marketing, distribution, or
customer service—or as a support service—human resources, legal services, infor-
mation systems, or management accounting. Of the 11 actions, which are the
most likely candidates for outsourcing? Why?
LO1 LO2 The Supply Chain and Value Chain
E 8. The items in the following list are associated with a hotel. Indicate which are
part of the supply chain (S) and which are part of the value chain (V).
1. Travel agency
2. Housekeeping supplies
3. Special events and promotions
4. Customer service
5. Travel bureau website
6. Tour agencies
LO1 LO3 Management Reports
E 9. The reports that follow are from a grocery store. Which report would be
used for financial purposes, and which would be used for activity-based decision
making? Why?
Salaries $ 1,000 Scan grocery purchases $ 3,000
Equipment 2,200 Stock fruit 1,000
Freight 5,000 Bake rye bread 500
Supplies 800 Operate salad bar 2,500
Use and occupancy 1,000 Stock can goods 2,000
Collapse cardboard boxes 1,000
Total $10,000 Total $10,000
LO2 The Value Chain
E 10. As shown in the data that follow, a producer of ceiling fans has determined
the unit cost of its most popular model. From these unit costs, determine the total
cost per unit of primary processes and the total cost per unit of support services.
Research and development $ 5.00
Human resources 4.50
Design 1.50
Supply 1.00
Legal services 0.50
Production 4.50
Marketing 2.00
Distribution 2.50
Customer service 6.50
Information systems 1.80
Management accounting 0.20
Total cost per unit $30.00
826 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
LO3 Comparison of ABM and JIT
E 11. The following are excerpts from a conversation between two managers
about their companies’ management systems. Identify the manager who works
for a company that emphasizes ABM and the one who works for a company that
emphasizes a JIT system.
Manager 1: We try to manage our resources effectively by monitoring oper-
ating activities. We analyze all major operating activities, and we focus on
reducing or eliminating the ones that don’t add value to our products.
Manager 2: We’re very concerned with eliminating waste. We’ve designed
our operations to reduce the time it takes to move, store, queue, and inspect
materials. We’ve also reduced our inventories by buying and using materials
only when we need them.
LO4 The Balanced Scorecard
E 12. Tim’s Bargain Basement sells used goods at very low prices. Tim has devel-
oped the following business objectives:
1. To buy only the inventory that sells
2. To have repeat customers
3. To be profitable and grow
4. To keep employee turnover low
Tim also developed the following performance measures:
5. Growth in revenues and net income per quarter
6. Average unsold goods at the end of the business day as a percentage of the
total goods purchased that day
7. Number of unemployment claims
8. Percentage of customers who have shopped in the store before
Match each of these objectives and performance measures with the four per-
|
spectives of the balanced scorecard: financial perspective, learning and growth
perspective, internal business processes perspective, and customer perspective.
LO4 The Balanced Scorecard
E 13. Your college’s overall goal is to add value to the communities it serves. In
light of that goal, match each of the following stakeholders’ perspectives with the
appropriate objective:
Perspective Objective
1. Financial (investors) a. A dding value means that the faculty
engages in meaningful teaching and
research.
2. Learning and growth (employees) b. Adding value means that students
receive their degrees in four years.
3. Internal business processes c. A dding value means that the college
has winning sports teams.
4. Customers d. Adding value means that fund-raising
campaigns are successful.
LO5 Ethical Conduct
E 14. Katrina Storm went to work for NOLA Industries five years ago. She was
recently promoted to cost accounting manager and now has a new boss, Vickery
Chapter Assignments 827
Howe, the corporate controller. Last week, Storm and Howe went to a two-
day professional development program on international accounting standards
changes. During the first hour of the first day’s program, Howe disappeared and
Storm didn’t see her again until the cocktail hour. The same thing happened on
the second day. During the trip home, Storm asked Howe if she had enjoyed the
conference. She replied: “Katrina, the golf course was excellent. You play golf.
Why don’t you join me during the next conference? I haven’t sat in on one of
those sessions in ten years. This is my R&R time. Those sessions are for the new
people. My experience is enough to keep me current. Plus, I have excellent peo-
ple to help me as we adjust our accounting system to the international changes
being implemented.”
Does Katrina Storm have an ethical dilemma? If so, what is it? What are
her options? How would you solve her problem? Be prepared to defend your
answer.
LO5 Corporate Ethics
E 15. To answer the following questions, conduct a search of several companies’
websites: (1) Does the company have an ethics statement? (2) Does it express a
commitment to environmental or social issues? (3) In your opinion, is the com-
pany ethically responsible? Select one of the companies you researched and write
a brief description of your findings.
Problems
LO1 Report Preparation
P 1. Clothing Industries, Inc. is deciding whether to expand its line of women’s
clothing called Sami Pants. Sales in units of this product were 22,500, 28,900,
and 36,200 in 2010, 2011, and 2012, respectively. The product has been very
profitable, averaging 35 percent profit (above cost) over the three-year period.
The company has 10 sales representatives covering seven states in the North.
Production capacity at present is about 40,000 pants per year. There is adequate
plant space for additional equipment, and the labor needed can be easily hired
and trained.
The organization’s management is made up of four vice presidents: the vice
president of marketing, the vice president of production, the vice president of
finance, and the vice president of management information systems. Each vice
president is directly responsible to the president, Jefferson Henry.
Required
1. What types of information will Henry need before he can decide whether to
expand the Sami Pants line?
2. Assume that one report needed to support Henry’s decision is an analysis of
sales, broken down by sales representative, over the past three years. How
would each of the four w’s pertain to this report?
3. Design a format for the report described in 2.
LO2 The Value Chain
P 2. Reigle Electronics is a manufacturer of cell phones, a highly competitive busi-
ness. Reigle’s phones carry a price of $99, but competition forces the company to
offer significant discounts and rebates. As a result, the average price of Reigle’s cell
phones has dropped to around $50, and the company is losing money. Manage-
ment is applying value chain analysis to the company’s operations in an effort to
828 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
|
reduce costs and improve product quality. A study by the company’s management
accountant has determined the following per unit costs for primary processes:
Primary Process Cost per Unit
Research and development $ 2.50
Design 3.50
Supply 4.50
Production 6.70
Marketing 8.00
Distribution 1.90
Customer service 0.50
Total cost $27.60
To generate a gross margin large enough for the company to cover its over-
head costs and earn a profit, Reigle must lower its total cost per unit for primary
processes to no more than $20. After analyzing operations, management reached
the following conclusions about primary processes:
• Research and development and design are critical functions because the
market and competition require constant development of new features
with “cool” designs at lower cost. Nevertheless, management feels that
the cost per unit of these processes must be reduced by 10 percent.
• Six different suppliers currently provide the components for the cell
phones. Ordering these components from just two suppliers and negoti-
ating lower prices could result in a savings of 15 percent.
• T he cell phones are currently manufactured in Mexico. By shifting produc-
tion to China, the unit cost of production can be lowered by 20 percent.
• M ost cell phones are sold through wireless communication companies
that are trying to attract new customers with low-priced cell phones.
Management believes that these companies should bear more of the
marketing costs and that it is feasible to renegotiate its marketing arrange-
ments with them so that they will bear 35 percent of the current market-
ing costs.
• D istribution costs are already very low, but management will set a target
of reducing the cost per unit by 10 percent.
• C ustomer service is a weakness of the company and has resulted in lost
sales. Management therefore proposes increasing the cost per unit of cus-
tomer service by 50 percent.
Required
1. Prepare a table showing the current cost per unit of primary processes and the
projected cost per unit based on management’s proposals for cost reduction.
Manager insight (cid:2) 2. Will management’s proposals for cost reduction achieve the targeted total
cost per unit? What further steps should management take to reduce costs?
Which steps that management is proposing do you believe will be the most
difficult to accomplish?
Manager insight (cid:2) 3. What are the company’s support services? What role should these services
play in the value chain analysis?
LO2 The Value Chain and Core Competency
P 3. Medic Products Company (MPC) is known for developing innovative and
high-quality products for use in hospitals and medical and dental offices. Its lat-
est product is a nonporous, tough, and very thin disposable glove that will not
leak or split and molds tightly to the hand, making it ideal for use in medical
and dental procedures. MPC buys the material it uses in making the gloves from
another company, which manufactures it according to MPC’s exact specifications
Chapter Assignments 829
and quality standards. MPC makes two models of the glove—one white and one
transparent—in its own plant and sells them through independent agents who
represent various manufacturers. When an agent informs MPC of a sale, MPC
ships the order directly to the buyer. MPC advertises the gloves in professional
journals and gives free samples to physicians and dentists. It provides a product
warranty and periodically surveys users about the product’s quality.
Required
1. Briefly explain how MPC accomplishes each of the primary processes in the
value chain.
2. What is a core competency? Which one of the primary processes would you
say is MPC’s core competency? Explain your choice.
LO4 The Balanced Scorecard and Benchmarking
P 4. Howski Associates is an independent insurance agency that sells business,
automobile, home, and life insurance. Maya Howski, senior partner of the agency,
recently attended a workshop at the local university in which the balanced score-
card was presented as a way of focusing all of a company’s functions on its mis-
|
sion. After the workshop, she met with her managers in a weekend brainstorming
session. The group determined that Howski Associates’ mission was to provide
high-quality, innovative, risk-protection services to individuals and businesses. To
ensure that the agency would fulfill this mission, the group established the fol-
lowing objectives:
• T o provide a sufficient return on investment by increasing sales and
maintaining the liquidity needed to support operations
• T o add value to the agency’s services by training employees to be knowl-
edgeable and competent
• To retain customers and attract new customers
• T o operate an efficient and cost-effective office support system for
customer agents
To determine the agency’s progress in meeting these objectives, the group
established the following performance measures:
• Number of new ideas for customer insurance
• Percentage of customers who rate services as excellent
• Average time for processing insurance applications
• Number of dollars spent on training
• Growth in revenues for each type of insurance
• Average time for processing claims
• P ercentage of employees who complete 40 hours of training during the year
• Percentage of new customer leads that result in sales
• Cash flow
• Number of customer complaints
• Return on assets
• Percentage of customers who renew policies
• P ercentage of revenue devoted to office support system (information sys-
tems, accounting, orders, and claims processing)
Required
1. Prepare a balanced scorecard for Howski Associates by stating the agency’s
mission and matching its four objectives to the four stakeholder perspectives:
the financial, learning and growth, internal business processes, and customer
perspectives. Indicate which of the agency’s performance measures would be
appropriate for each objective.
830 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
Manager insight (cid:2) 2. Howski Associates is a member of an association of independent insurance
agents that provides industry statistics about many aspects of operating an
insurance agency. What is benchmarking, and in what ways would the indus-
try statistics assist Howski Associates in further developing its balanced
scorecard?
LO5 Professional Ethics
P 5. Taylor Zimmer is the controller for Value Corporation. He has been with
the company for 17 years and is being considered for the job of chief financial
officer. His boss, who is the current chief financial officer and former company
controller, will be Value Corporation’s new president. Zimmer has just discussed
the year-end closing with his boss, who made the following statement during
their conversation: “Taylor, why are you being so inflexible? I’m only asking you
to postpone the $2,500,000 write-off of obsolete inventory for 10 days so that it
won’t appear on this year’s financial statements. Ten days! Do it. Your promotion
is coming up, you know. Make sure you keep all the possible outcomes in mind as
you complete your year-end work. Oh, and keep this conversation confidential—
just between you and me. Okay?”
Required
1. Identify the ethical issue or issues involved.
2. What do you believe is the appropriate solution to the problem? Be prepared
to defend your answer.
Alternate Problems
LO1 Report Preparation
P 6. Daisy Flowers recently purchased Yardworks, Inc., a wholesale distributor
of equipment and supplies for lawn and garden care. The organization, which is
headquartered in Baltimore, has four distribution centers that service 14 eastern
states. The centers are located in Boston, Massachusetts; Rye, New York; Reston,
Virginia; and Lawrenceville, New Jersey. The company’s profits for 2010, 2011,
and 2012 were $225,400, $337,980, and $467,200, respectively.
Shortly after purchasing the organization, Flowers appointed people to the
following positions: vice president, marketing; vice president, distribution; cor-
porate controller; and vice president, research and development. Flowers called a
meeting of this management group. She wants to create a deluxe retail lawn and
|
garden center that would include a large, fully landscaped plant and tree nursery.
The purposes of the retail center would be (1) to test equipment and supplies
before selecting them for sales and distribution and (2) to showcase the effects of
using the company’s products. The retail center must also make a profit on sales.
Required
1. What types of information will Flowers need before deciding whether to cre-
ate the retail lawn and garden center?
2. To support her decision, Flowers will need a report from the vice president
of research and development analyzing all possible plants and trees that could
be planted and their ability to grow in the places where the new retail center
might be located. How would each of the four w’s pertain to this report?
3. Design a format for the report in 2.
LO2 The Value Chain
P 7. Soft Spot is a manufacturer of futon mattresses. Soft Spot’s mattresses are
priced at $60, but competition forces the company to offer significant discounts
Chapter Assignments 831
and rebates. As a result, the average price of the futon mattress has dropped to
around $50, and the company is losing money. Management is applying value
chain analysis to the company’s operations in an effort to reduce costs and improve
product quality. A study by the company’s management accountant has deter-
mined the following per unit costs for primary processes and support services:
Primary Process Cost per Unit
Research and development $ 5.00
Design 3.00
Supply 4.00
Production 16.00
Marketing 6.00
Distribution 7.00
Customer service 1.00
Total cost per unit $42.00
Support Service
Human resources $ 2.00
Information services 5.00
Management accounting 1.00
Total cost per unit $ 8.00
To generate a gross margin large enough for the company to cover its over-
head costs and earn a profit, Soft Spot must lower its total cost per unit for
primary processes to no more than $32.00 and its support services to no more
than $5.00. After analyzing operations, management reached the following con-
clusions about primary processes and support services:
• R esearch and development and design are critical functions because the
market and competition require constant development of new features
with “cool” designs at lower cost. Nevertheless, management feels that
the cost per unit of these processes must be reduced by 20 percent.
• T en different suppliers currently provide the components for the futons.
Ordering these components from just two suppliers and negotiating
lower prices could result in a savings of 15 percent.
• T he futons are currently manufactured in Mali. By shifting production to
China, the unit cost of production can be lowered by 40 percent.
• M anagement believes that by selling to large retailers like Wal-Mart it is
feasible to lower current marketing costs by 25 percent.
• D istribution costs are already very low, but management will set a target
of reducing the cost per unit by 10 percent.
• C ustomer service and support to large customers are key to keeping their
business. Management therefore proposes increasing the cost per unit of
customer service by 20 percent.
• B y outsourcing its support services, management projects a 20 percent
drop in these costs.
Required
1. Prepare a table showing the current cost per unit of primary processes and
support services and the projected cost per unit based on management’s
proposals.
Manager insight (cid:2) 2. Will management’s proposals achieve the targeted total cost per unit? What
further steps should management take to reduce costs?
Manager insight (cid:2) 3. What role should the company’s support services play in the value chain analysis?
832 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
LO2 The Value Chain and Core Competency
P 8. Sports Products Company (SPC) is known for developing innovative high-
quality shoes for lacrosse. Its latest patented product is a tough, all-weather,
and very flexible shoe. SPC buys the material it uses in making the shoes from
another company, which manufactures it according to SPC’s exact specifications
|
and quality standards. SPC makes two models of the shoe—one white and one
black—in its own plant. SPC sells them through independent distributors who
represent various manufacturers. When a distributor informs SPC of a sale, SPC
ships the order directly to the buyer. SPC advertises the shoes in sports magazines
and gives free samples to well-known lacrosse players who endorse its products.
It provides a product warranty and periodically surveys users about the product’s
quality.
Required
1. Briefly explain how SPC accomplishes each of the primary processes in the
value chain.
2. What is a core competency? Which one of the primary processes would you
say is SPC’s core competency? Explain your choice.
LO4 The Balanced Scorecard and Benchmarking
P 9. Resource College is a liberal arts school that provides local residents the
opportunity to take college courses and earn bachelor’s degrees. Yolanda How-
ard, the school’s provost, recently attended a workshop in which the balanced
scorecard was presented as a way of focusing all of an organization’s functions on
its mission. After the workshop, she met with her administrative staff and college
deans in a weekend brainstorming session. The group determined that the col-
lege’s mission was to provide high-quality courses and degrees to individuals to
add value to their lives. To ensure that the college would fulfill this mission, the
group established the following objectives:
• T o provide a sufficient return on investment by increasing tuition rev-
enues and maintaining the liquidity needed to support operations
• T o add value to the college’s courses by encouraging faculty to be life-
long learners
• T o retain students and attract new students
• To operate efficient and cost-effective student support systems
To determine the college’s progress in meeting these objectives, the group
established the following performance measures:
• Number of faculty publications
• Percentage of students who rate college as excellent
• Average time for processing student applications
• Number of dollars spent on professional development
• Growth in revenues for each department
• Average time for processing transcript requests
• P ercentage of faculty who annually do 40 hours of professional development
• Percentage of new student leads that result in enrollment
• Cash flow
• Number of student complaints
• Return on assets
• Percentage of returning students
• P ercentage of revenue devoted to student services systems (registrar,
computer services, financial aid, and student health)
Chapter Assignments 833
Required
1. Prepare a balanced scorecard for Resource College by stating the college’s
mission and matching its four objectives to the four stakeholder perspectives:
the financial, learning and growth, internal business processes, and customer
perspectives.
2. Indicate which of the college’s performance measures would be appropriate
for each objective.
LO3 LO5 Ethics and JIT Implementation
P 10. For almost a year, WEST Company has been changing its manufacturing
process from a traditional to a JIT approach. Management has asked for employ-
ees’ assistance in the transition and has offered bonuses for suggestions that cut
time from the production operation. Don Hanley and Jerome Obbo each identi-
fied a time-saving opportunity and turned in their suggestions to their manager,
Sam Knightly.
Knightly sent the suggestions to the committee charged with reviewing
employees’ suggestions, which inadvertently identified them as being Knightly’s
own. The committee decided that the two suggestions were worthy of reward
and voted a large bonus for Knightly. When notified of this, Knightly could not
bring himself to identify the true authors of the suggestions.
When Hanley and Obbo heard about Knightly’s bonus, they confronted
him with his fraudulent act and expressed their grievances. He told them that
he needed the recognition to be eligible for an upcoming promotion and prom-
ised that if they kept quiet about the matter, he would make sure that they both
received significant raises.
Required
|
1. Should Hanley and Obbo keep quiet? What other options are open to them?
2. How should Knightly have dealt with Hanley’s and Obbo’s complaints?
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO1 Management Information
C 1. Obtain a copy of a recent annual report of a publicly held organization in
which you have a particular interest. (Copies of annual reports are available at
your campus library, at a local public library, on the Internet, or by direct request
to an organization.) Assume that you have just been appointed to a middle-
management position in a division of the organization you have chosen. You are
interested in obtaining information that will help you better manage the activities
of your division, and you have decided to study the contents of the annual report
in an attempt to learn as much as possible.
You particularly want to know about the following: (1) size of inventory
maintained; (2) ability to earn income; (3) reliance on debt financing; (4) types,
volume, and prices of products or services sold; (5) type of production process
used; (6) management’s long-range strategies; (7) success (profitability) of the
division’s various product lines; (8) efficiency of operations; and (9) operating
details of your division.
1. Write a brief description of the organization and its products or services and
activities.
2. Based on a review of the financial statements and the accompanying disclo-
sure notes, prepare a written summary of information pertaining to items 1
through 9 above.
834 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective
3. Can you find any of the information in which you are interested in other sec-
tions of the annual report? If so, which information, and in which sections of
the report is it?
4. The annual report also includes other types of information that you may
find helpful in your new position. In outline form, summarize this additional
information.
LO1 Management Information Needs
C 2. In C 1, you examined your new employer’s annual report and found some
useful information. However, you are interested in knowing whether your divi-
sion’s products or services are competitive, and you were unable to find the nec-
essary information in the annual report.
1. What kinds of information about your competition do you want to find?
2. Why is this information relevant? (Link your response to a particular decision
about your organization’s products or services. For example, you might seek
information to help you determine a new selling price.)
3. From what sources could you obtain the information you need?
4. When would you want to obtain this information?
5. Create a report that will communicate your findings to your superior.
LO1 Report Preparation
C 3. The registrar’s office of Mainland College is responsible for maintaining a
record of each student’s grades and credits for use by students, instructors, and
administrators.
1. Assume that you are a manager in the registrar’s office and that you recently
joined a team of managers to review the grade-reporting process. Explain
how you would prepare a report of grades for students’ use and the same
report for instructors’ use by answering the following questions:
a. Who will read the grade report?
b. Why is the grade report necessary?
c. What information should the grade report contain?
d. When is the grade report due?
2. Why does the information in a grade report for students’ use and in a grade
report for instructors’ use differ?
3. Visit the registrar’s office of your school in person or through your school’s
website. Obtain a copy of your grade report and a copy of the form that the
registrar’s office uses to report grades to instructors. Compare the informa-
tion that these reports supply with the information you listed in requirement
1. Explain any differences.
4. What can the registrar’s office do to make sure that its grade reports are effec-
tive in communicating all necessary information to readers?
LO4 Management Information Needs
C 4. McDonald’s is a leading competitor in the fast-food restaurant business. One
|
component of McDonald’s marketing strategy is to increase sales by expanding its
foreign markets. At present, McDonald’s restaurants operate in over 100 coun-
tries. In making decisions about opening restaurants in foreign markets, the com-
pany uses quantitative and qualitative financial and nonfinancial information. The
following types of information would be important to such a decision: the cost
of a new building (quantitative financial information), the estimated number of
hamburgers to be sold in the first year (quantitative nonfinancial information),
and site desirability (qualitative information).
Suppose you are a member of McDonald’s management team that must
decide whether to open a new restaurant in England. Identify at least two exam-
ples each of the (a) quantitative financial, (b) quantitative nonfinancial, and (c)
qualitative information that you will need before you can make a decision.
Chapter Assignments 835
LO1 LO4 Performance Measures and the Balanced Scorecard
C 5. Working in a group of four to six students, select a local business. The group
should become familiar with the background of the business by interviewing its
manager or accountant. Each group member should identify several performance
objectives for the business and link each objective with a specific stakeholder’s
perspective from the balanced scorecard. (Select at least one performance objec-
tive for each perspective.) For each objective, ask yourself, “If I were the man-
ager of the business, how would I set performance measures for each objective?”
Then prepare an email stating the business’s name, location, and activities and
your linked performance objective and perspectives. Also list possible measures
for each performance objective.
In class, members of the group should compare their individual emails and
compile them into a group report by having each group member assume a differ-
ent stakeholder perspective (add government and community if you want more
than four perspectives). Each group should be ready to present all perspectives
and the group’s report on performance objectives and measures in class.
LO1 LO3 Cookie Company (Continuing Case)
C 6. Each of the rest of the chapters in this text includes a “cookie company” case
that shows how you could operate your own cookie business. In this chapter, you
will express your company’s mission statement; set strategic, tactical, and oper-
ating objectives; decide on a name for your business; and identify management
tools you might consider using to run your business.
1. In researching how to start and run a cookie business, you found the follow-
ing three examples of cookie company mission statements:
• To provide cheap cookies that taste great and fast courteous service!
• O ur mission is to make the best chocolate chip cookies that you have ever
tasted.
• Handmaking the best in custom cookie creations.
a. C onsider which of the mission statements most closely expresses what
you want your company’s identity and unique character to be. Why?
b. Will your business focus on cost, quality, or satisfying a specific need?
c. Write your company’s mission statement.
2. Based on your mission statement, describe your broad long-term strategic
objectives:
• What will be your main products?
• Who will be your primary customers?
• Where will you operate your business?
3. You made the following decisions about your business:
• T o list expected expenses and revenues for the first six months of operations
• T o keep expenses low and generate enough revenues during the first two
months of operations to have a positive cash flow by the third month
• T o develop a complete list of goals, objectives, procedures, and policies relat-
ing to how to find, buy, store, sell, and ship goods and collect payment
• T o rely solely on the Internet to market products
• T o expand the ecommerce website to include 20 varieties of cookies over
the next five years
Match each of the above to the following components of the planning frame-
work: strategic objectives, tactical objectives, operating objectives, business
|
plan, and budget.
4. What will be the name of your cookie company?
5. Which of the management tools listed in the chapter might you consider
using to operate your business? Why?
C H A P T E R
19 Cost Concepts
and Cost Allocation
PLAN
Classify costs
Compute predetermined
overhead rates
PERFORM
EVALUATE
COMMUNICATE
836
∇
∇
Flow service and product-
related costs throught
the inventory accounts
∇
Allocate overhead using either
the traditional or ABC approach
∇
Compute the unit cost of a
product or service
∇
Compare actual and allocated
overhead amounts
∇
Dispose of the under/over-
applied overhead into Cost of
Goods Sold account
∇
Prepare external reports,
i.e., service, retail, and
manufacturing income
statements
∇
Prepare internal management
reports to monitor and manage
costs
∇
The Management
I n this chapter, we describe how managers use information
Process
about costs, classify costs, compile product unit costs, and allo-
cate overhead costs using the traditional method.
LEARNING OBJECTIVES
LO1 Explain how managers classify costs and how they use these
cost classifications. (pp. 838–842)
LO2 Compare how service, retail, and manufacturing organizations
report costs on their financial statements and how they
account for inventories. (pp. 842–846)
LO3 Describe the flow of costs through a manufacturer’s inventory
accounts. (pp. 846–850)
LO4 Define product unit cost, and compute the unit cost of a
product or service. (pp. 850–854)
LO5 Define cost allocation, and explain how the traditional
method of allocating overhead costs figure into calculating
product or service unit cost. (pp. 855–860)
How managers use cost
information to solve, “How
much does it cost?” can
result in differing answers.
DECISION POINT (cid:2) A MANAGER’S FOCUS (cid:2) How do managers at The Choice
Candy Company determine the
THE CHOICE CANDY
cost of a candy bar?
COMPANY
(cid:2) How do they use cost
information?
The Choice Candy Company’s mission is to make the world’s best-
tasting chocolate candy bars. As in any other company, a primary
goal for The Choice Candy Company is to make a profit and thereby
increase the value of its stakeholders’ interest in the business. Mak-
ing top-quality products requires top-quality ingredients and skilled
employees—both of which can be costly. If The Choice Candy Com-
pany is to achieve the goal of profitability and at the same time pro-
duce top-quality products, its managers have to be familiar with the
cost concepts and cost allocation methods discussed in this chapter.
883377
838 CHAPTER 19 Cost Concepts and Cost Allocation
Cost Information
One of a company’s primary goals is to be profitable. Because a company’s own-
ers expect to earn profits, managers have a responsibility to use the company’s
LO1 Explain how managers resources wisely and to generate revenues that will exceed the costs of the com-
classify costs and how they use pany’s operating, investing, and financing activities. In this chapter, we focus on
these cost classifications. costs related to the operating activities of manufacturing, retail, and service orga-
nizations. We begin by looking at how managers in these different organizations
use information about costs.
Managers’ Use of Cost Information
Managers use information about operating costs to plan, perform, evaluate, and
communicate the results of operating activities.
(cid:2) Service organization managers find the estimated cost of services helpful in moni-
toring profitability and making decisions about such matters as bidding on future
business, lowering or negotiating their fees, or dropping one of their services.
(cid:2) In retail organizations, such as Good Foods Store, which we used as an exam-
ple in the last chapter, managers work with the estimated cost of merchandise
purchases to predict gross margin, operating income, and value of merchan-
dise sold. They also use this information to make decisions about matters
like reducing selling prices for clearance sales, lowering selling prices for bulk
sales, or dropping a product line.
(cid:2) Managers at manufacturing companies like Hershey’s use estimated prod-
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