1. Financial Reporting and Analysis
Chapter 5
Financial Reporting and Analysis
PowerPoint Authors:
Brandy Mackintosh
Lindsay Heiser
Chapter 5: Financial Reporting and Analysis

2. Explain the needs of financial statement users.
Learning Objective 5-1
Explain the needs of financial statement users.
Learning objective 5-1 is to explain the needs of financial statement users.

3. The Needs of Financial Statement Users
Managers at all levels of a company use accounting information to run the business. Based on sales and expense information for each game title, managers at Activision Blizzard decided to discontinue the company’s popular but unprofitable Guitar Hero product line. When accounting information is used to manage the business, it is being used to fulfill a management function.
Directors is the short title used to describe members of the board of directors, who are elected by the company’s stockholders to serve as their representatives. Directors oversee the managers of the company, with the primary goal of ensuring that management and financial decisions aim to benefit stockholders. Directors will use the financial statements to evaluate whether the Chief Executive Officer (CEO), Chief Financial Officer (CFO),
and others have made wise decisions about the amount to invest in assets and have managed to generate sufficient sales and net income from those assets. When accounting information is used to oversee the business, it is being used in a governance role.
All creditors use accounting information. Suppliers, for example, use it to decide whether to enter into contracts to supply other companies, based in part on whether those companies have sufficient assets to pay their liabilities. Bankers use financial statement information to evaluate (and sometimes limit) a company’s activities by measuring the company’s ability to satisfy certain financial targets, such as maintaining specific levels
of assets or stockholders’ equity. These loan covenants help to ensure the company will be able to repay loans owed to the bank. When accounting information is used to administer contract terms such as these, it is being used in a contracting role.
Investors (and their advisers) look to accounting information to help assess the financial strength of a business and, ultimately, to estimate its value. Part of this analysis involves forecasting the company’s future revenues, expenses, and net income. Larger revenues and net income usually lead to higher prices for a company’s stock. When accounting information is used to assess stock prices, it is being used in a valuation role.
Several government agencies look closely at the financial statements prepared by companies. The Securities and Exchange Commission (SEC), for example, is responsible for the functioning of stock markets, so it keeps a close watch on the information that public companies report in financial statements. Also, the Internal Revenue Service (IRS) is interested in financial statements because the income statement provides a starting point for determining the amount of income taxes that should be paid by private and public corporations.

4. Learning Objective 5-2
Describe the environment for financial reporting, including
the Sarbanes-Oxley Act.
Learning objective 5-2 is to describe the environment for financial reporting, including the Sarbanes-Oxley Act.

5. Accounting Fraud
Three things have to exist for accounting fraud to occur. First, there must be an incentive for someone to commit the fraud. Second, an opportunity must exist to commit the fraud. Third, the person committing the fraud must possess personal characteristics that allow the fraud to be rationalized and concealed. Fraud investigators refer to these three elements as the “fraud triangle.”

6. Possible Incentives to Commit Fraud
Financial misreporting is both unethical and illegal, so there must be enormous incentives driving some managers to act this way. These incentives fit into two categories: (1) Creating business opportunities, and (2) Satisfying personal greed. Business opportunities may include pressure to produce pleasing financial results to satisfy loan covenants, increase equity funding, or attract business partners. Personal greed situations include ways members of top management can benefit personally such as enhancing job security, increasing personal wealth, and obtaining a bigger paycheck.

7. Opportunity to Commit Fraud
Internal controls are the methods that a company uses to protect against theft of assets, to enhance the reliability of accounting information, to promote efficient and effective operations, and to ensure compliance with laws and regulations.
Weaknesses in the accounting system create an opportunity for fraudulent information to be entered into it, which increases the risk that the financial statements will be fraudulently misreported. To reduce this risk, certain procedures and policies can be put in place to help ensure that information entered into the accounting system and reported in the financial statements is accurate and complete. These internal controls can’t completely eliminate the opportunity for fraud, but they can limit it if they operate effectively. Internal controls are the methods that a company uses to protect against theft of assets, to enhance the reliability of accounting information, to promote efficient and effective operations, and to ensure compliance with laws and regulations.

8. Character to Rationalize and Conceal Fraud
Most fraudsters have a sense of personal entitlement, which outweighs other moral principles, such as fairness, honesty, and concern for others.
For people to commit fraud and keep it secret, they have to feel “okay” with their actions. Most fraudsters achieve this through a sense of personal entitlement, which outweighs other moral principles, such as fairness, honesty, and concern for others. Recent changes in the financial reporting environment were initiated to begin to counteract these undesirable traits.

9. The Sarbanes-Oxley (SOX) Act
The Sarbanes-Oxley (SOX) Act is one of the most significant changes to financial reporting in the United States since the Securities Exchange Acts were introduced in the 1930s. All companies that trade on the U.S. stock exchanges must comply with the new requirements of SOX, and its impact has been felt by nearly everyone in the business world. SOX was created in response to the many financial frauds and scandals occurring in the late 1990s and early 2000s. Some of the key changes include enforcing counteract incentives for committing fraud such as stiffer fines and prison terms, reducing opportunities for fraud by requiring internal control reports, stronger director oversight, and internal control audits by external auditors, and encouraging good character employees through anonymous tip lines, whistle-blower protection, and codes of ethics.

10. Learning Objective 5-3
Prepare a comparative balance sheet, multistep income statement, and statement of stockholders’ equity.
Learning objective 5-3 is to prepare a comparative balance sheet, multistep income statement, and statement of stockholders’ equity.

11. Financial Reporting in the U.S.
Enhance financial statement format
Obtain independent external audit
Release additional financial information
December 31, 2013
Middle of February, 2014
End of February, 2014
Fiscal Year End
Preliminary Release of Key Results
Final Release of Annual Report
Finalize Financial Statements
Finalize External Audit
Part I
The good news is that the accounting and financial statement preparation processes that you learned in Chapters 1–4 for small, private companies continue to apply for even the largest, publicly traded corporations. To further improve the usefulness of financial statements for their external users, though, all public companies and some private companies take three additional steps: (1) enhance the financial statement format, (2) obtain an independent external audit, and (3) release additional financial information.
Part II
Here is a timeline showing how this financial reporting process typically occurs for a company that ends its year on December 31, From the end of the fiscal year end until the middle of February of the next year, The company’s accounting personnel prepare and finalize the financial statements. Just before this time, the external auditors begin the audit. The company releases the preliminary key results. The annual report is released by the end of February, at the end of the external audit.

12. Comparative Financial Statements
ACTIVISION BLIZZARD, INC.
Balance Sheet
(in millions of U.S. dollars)
Assets
Current Assets
Cash
Short-term Investments
Accounts Receivable
Inventories
Other Current Assets
Total Current Assets
Property and Equipment, net
Other Noncurrent Assets
Goodwill
Total Assets
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts Payable
Unearned Revenue
Accrued and Other Liabilities
Total Current Liabilities
Other Noncurrent Liabilities
Total Liabilities
Stockholders’ Equity
Contributed Capital
Retained Earnings (Accumulated Deficit)
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
December 31,
2009
$ 2,768
477
739
241
1,104
5,329
138
1,121
7,154
$13,742 $
1,426
779
2,507
479
2,986
11,117
(361)
10,756
2010
$ 2,812
696
640
112
1,125
5,385
169
720
7,132
$13,406 $
1,726
818
2,907
296
3,203
10,146 57
10,203
A comparative format reveals changes over time.
To make it easy for financial statement users to compare account balances from one period to the next, most companies report comparative financial statements. Comparative financial statements contain two or more columns of numbers, with each column representing the financial results for different time periods.
For example, Activision’s comparative balance sheets on this slide show one column with account balances at the end of the most recent year (March 31, 2010) and another column with balances at the end of the previous year (March 31, 2009). This allows you to quickly see that Short-Term Investments increased (from $477 million to $696 million) while Activision cut its inventory in half by discontinuing games like Guitar Hero. Note that the balance sheet is still classified, as introduced in Chapter 2. The only difference in a comparative balance sheet is that it uses separate columns to report different points in time.

13. Multistep Income Statements
ACTIVISION BLIZZARD, INC.
Income Statement
(in millions of U.S. dollars)
Sales and Service Revenues
Expenses:
Production
Research and Development
Marketing and Sales
General and Administrative
Total Operating Expenses
Income (Loss) from Operations
Revenue from Investments
Income (Loss) before Income Tax
Income Tax Expense (Recovery)
Net Income (Loss)
2008
$ 3,026
1,839
592
464
364
3,259
(233) 46
(187)
(80)
$ (107)
2009
$ 4,279
2,307
627
544
827
4,305
(26) 18
(8)
(121) $
2010
$ 4,447
2,126
642
520
690
3,978
469 23
492 74 $
Year Ended December 31,
Part I
In earlier chapters our income statements took a more simplified format and were a single-step income statement. A single-step income statement reports net income by subtracting a single group of expenses from a single group of revenues. Both formats end up with the same Net Income at the bottom. However, they differ in how they get there. The purpose of a multistep income statement is to display important measures of profit in addition to net income.
Take a look at Activision’s multistep income statement on this slide. The new subtotals on the multistep income statement are income from operations and income before income taxes.
Part II
Income from operations report the company’s ability to generate income from its core business activities. As an investor or creditor interested in Activision’s long-term success, you probably care most about the company’s ability to generate income from its core business activities like developing, making, and selling video games. Peripheral activities, like earning revenue from investments, aren’t as important in the long-run because they’re not the key reason Activision is in business (and they’re not as likely to recur in the future). To make it easy for you to distinguish core and peripheral results, the top portion of the income statement reports revenues and expenses relating only to core activities.
Part III
Income before income tax expense indicates how much profit the company would have reported had there been no income taxes. This subtotal is useful because not all companies pay the same rate of tax. So, if you’re trying to decide whether to invest in Pfizer or FedEx, which had effective tax rates in 2010 ranging from 12 to 36 percent, you might be interested in comparing their pretax levels of income. Of course, you will also care about Net Income, which is obtained by subtracting Income Tax Expense from Income before Income Tax Expense. Net Income is the same whether a single-step or multistep income statement is presented.

14. Statement of Stockholders’ Equity
ACTIVISION BLIZZARD, INC.
Statement of Stockholders’ Equity
For the Year Ended December 31, 2010
(in millions of U.S. dollars)
Balances at December 31, 2009
Net Income
Dividends Declared
Issued Shares of Stock
Repurchased Shares of Stock
Balances at December 31, 2010
Retained
Earnings (Deficit)
$ (361)
418
(0) $
Contributed
Capital
$ 11,117 73
(1,044)
$ 10,146
Previous chapters indicated that companies report a statement of retained earnings to show how net income increased and dividends decreased the retained earnings balance during the period. While this information is useful, it does not tell the full story because Retained Earnings is only one of the stockholders’ equity accounts. Contributed Capital is another important stockholders’ equity account whose balance increases and decreases during the accounting period. The Statement of Stockholders’ Equity is more comprehensive than the Statement of Retained Earnings because it shows all the changes in both equity accounts, Retained Earnings and Contributed Capital. Notice how the beginning and ending balances correspond to the balance sheet presented earlier.

15. Learning Objective 5-4
Describe other significant aspects of the financial reporting process, including external audits and the distribution of financial information.
Learning objective 5-4 is to describe other significant aspects of the financial reporting process, including external audits and the distribution of financial information.

16. Independent External Audit
Auditors are Certified Public Accountants who are independent of the company.
Unqualified Audit Opinion
Financial statements are presented in accordance with GAAP
Qualified Audit Opinion
Financial statements fail to follow GAAP or not able to complete needed tests
To ensure that the financial statements are prepared properly, the SEC requires all publicly traded companies to have their internal controls and financial statements audited by external auditors. Many privately owned companies also have their financial statements audited, often at the request of lenders or private investors. External audits are conducted by Certified Public Accountants (CPAs) who are independent of the company. These trained professionals examine the company’s financial statements (and its accounting system) with the goal of detecting material misstatements. It is not practical for auditors to check every single business transaction to ensure it was accurately reported, so they can’t be 100 percent sure they have caught every error. Instead, their audits provide reasonable assurance to financial statement users. After completing the audit, external auditors will attach a report to the financial statements that gives a pass/fail type of opinion. An unqualified audit opinion represents a passing grade. If the financial statements fail to follow GAAP or if the auditors were not able to complete the tests needed to determine whether GAAP was followed, the audit opinion will be qualified (like a bad movie review).

17. Preliminary Releases
Most public companies announce quarterly and annual earnings through a press release that is sent to news agencies.
To provide timely information for all external users, public companies announce annual (and quarterly) results through a press release sent to news agencies. This press release is issued three to five weeks after the accounting period ends. The press release typically includes key figures, management’s discussion of the results, and attachments containing a condensed income statement and balance sheet. Many companies follow-up the press release with a conference call broadcast on the Internet that allows analysts to grill the company’s senior executives with questions about the financial results. By listening to these calls, you can learn a lot about a company’s business strategy, its expectations for the future, and the key factors that analysts consider when they evaluate a company.

18. Financial Statement Release
Several weeks after the preliminary press release, public companies release their complete financial statements as part of an annual (or quarterly) report. The typical elements of the financial section include summarized financial data, management’s discussion and analysis, management’s report on internal control, auditor’s report, comparative financial statements, financial statement notes, recent stock price data, unaudited quarterly data, and directors and officers.

19. Securities and Exchange Commission (SEC) Filings
Public companies are required to electronically file certain reports with the SEC, including Form 10-K, Form 10-Q, and Form 8-K.
Public companies are required to electronically file certain reports with the SEC, including an annual report on Form 10-K, quarterly reports on Form 10-Q, and current event reports on Form 8-K. Filings for public companies are available to the public as soon as they are received by the SEC’s Electronic Data Gathering and Retrieval Service (EDGAR). Form 10-K is the annual filing of financial information. Form 10-Q is the quarterly filing of financial information. Form 8 K reports significant business events when they occur.

20. Learning Objective 5-5
Explain the reasons for, and financial statement presentation effects of, adopting IFRS.
Learning objective 5-5 is to explain the reasons for, and financial statement presentation effects of, adopting IFRS.

21. Globalization and IFRS
International Financial Reporting Standards (IFRS) are accounting rules established by the International Accounting Standards Board for use in over 100 countries around the world.
In 2008, the SEC announced a plan to allow some U.S. companies to use IFRS in In 2012, the SEC is still weighing their options as to whether or not they will require mandatory use of IFRS and when.
It’s become an old cliché but business really has gone global. Abercrombie operates in Sweden, and Swedish companies like IKEA and H&M are popular stores throughout the United States. Similar trends are occurring in the investing world, where shares of foreign companies like Benetton and Toyota are traded on the New York Stock Exchange (NYSE). Until recently, investors struggled to compare the financial statements of companies like these because different countries used different accounting rules. All this is changing now with the increasing acceptance of International Financial Reporting Standards (abbreviated IFRS).
IFRS are developed by the International Accounting Standards Board (IASB), which is the international counterpart to the FASB in the United States. Over 100 different countries including Australia, Canada, China, the European Union, South Africa, and New Zealand currently require or permit the use of IFRS, or a local version of IFRS. The United States has not yet switched to IFRS, but it is considering aligning U.S. accounting rules with IFRS. In 2007, the Securities and Exchange Commission (SEC) began moving in this direction by allowing foreign companies to issue stock in the United States without having to convert their IFRS-based accounting numbers to U.S. generally accepted accounting principles (GAAP). In 2008, the SEC announced a plan to allow some U.S. companies, to use IFRS in As of 2012, the SEC was still weighing its options.

22. IFRS Formatting of Financial Statements
Although IFRS differ from GAAP, they do not dramatically alter what you have learned to this point in this course. The most significant differences between IFRS and GAAP relate to technical issues that are typically taught in intermediate and advanced accounting courses. For the topics discussed in this introductory course, differences between IFRS and GAAP are limited. One place where IFRS differ from GAAP is in the formatting of financial statements.
Although financial statements prepared using GAAP and IFRS include the same items (assets, liabilities, revenues, expenses, etc.), a single, consistent format has not been mandated. Consequently, various formats have evolved over time, with those in the United States differing from those typically used internationally. You can gain a good understanding of the main differences by reviewing the information on this slide.
Of the differences listed on this slide, balance sheet order is the most striking. GAAP begins with current items whereas IFRS begins with noncurrent items. Consistent with this, assets are listed in decreasing order of liquidity under GAAP, but internationally are usually in increasing order of liquidity. IFRS similarly emphasize longer-term financing sources by listing equity before liabilities and, within liabilities, by listing noncurrent liabilities before current liabilities (decreasing time to maturity).

23. A side-by-side comparison of a balance sheet prepared using GAAP and a statement of financial position prepared using IFRS.
Activision provides an ideal case for illustrating these differences because its balance sheet is prepared using GAAP, but its main stockholder (a European company named Vivendi) reports a statement of financial position based on IFRS. A side-by-side comparison is shown on this slide. As you can see, Vivendi is a larger company than Activision (one euro is equal to about $1.30 in U.S. dollars) and it reports its assets, liabilities, and stockholders’ equity accounts in the typical IFRS order. But, despite these differences in appearance, the two companies are involved in the same sort of business activities, so the specific items on the financial statements are similar. It may take you a moment or two, but you should be able to find Cash, Short-term Investments, and so on, on both companies’ financial statements.

24. Compare results to common benchmarks.
Learning Objective 5-6
Compare results to common benchmarks.
Learning objective 5-6 is to compare results to common benchmarks.

25. Comparison to Common Benchmarks
To help interpret amounts on the financial statements, it’s useful to have points of comparison or “benchmarks.”
Prior Periods
Competitors
To help interpret amounts on the financial statements, it’s useful to have points of comparison or “benchmarks.” Time series analysis compares a company’s results for one period to its own results over a series of time periods. Cross-sectional analysis compares the results of one company with those of others in the same section of the industry. Let’s see how graphs can help us compare a company with prior periods and competitors.
Time series analysis compares a company’s results for one period to its own results over a series of time periods.
Cross-sectional analysis compares the results of one company with those of others in the same section of the industry.

26. Time Series Analysis Chart
Here is a graph that compares Activision to itself on assets, debt, equity, revenues and net income from 2009 to 2010.
From the chart, we can see that Activision was virtually unchanged between 2009 and To assess Activision’s standing in the video game industry, analysts also would compare Activision to competitors, such as Electronic Arts (maker of The Sims and Madden NFL).

27. Cross-Sectional Analysis
This slide presents a cross-sectional chart that compares Activision to Electronic Arts stock ticker symbol (ERTS) based on financial statement data for the fiscal period from April 1, 2010, to March 31, shows that Activision towers over Electronic Arts in every category. Given these mammoth differences in size, do analysts simply conclude that Activision is the winner and give them a pocketful of investment tokens? In a word, no. This means only that Activision is a bigger company. It says nothing about whether it’s best at using the resources provided to it. In fact, the differences in Net Income suggest that Activision may have been more successful. To reach such a conclusion, analysts rely on financial statement ratio analysis.

28. Learning Objective 5-7
Calculate and interpret the debt-to-assets, asset turnover,
and net profit margin ratios.
Learning objective 5-7 is to calculate and interpret the debt-to-assets, asset turnover, and net profit margin ratios.

29. Most businesses can be broken down into 4 elements:
A Basic Business Model
Most businesses can be broken down into 4 elements:
Obtain financing from lenders and investors, which is used to invest in assets,
Invest in assets, which are used to generate revenues,
Generate revenues, which produce net income,
Produce net income, which is needed to satisfy lenders and investors.
produce
Invested in
generate
Part I
Most businesses can be broken down into four elements:
Part II
First, obtain financing from lenders and investors, which is used to invest in assets.
Part III
Second, invest in assets, which are used to generate revenues.
Part IV
Third, generate revenues, which lead to producing net income.
Part V
Fourth, produce net income, which is needed to comfort lenders, satisfy investors, and provide resources for future expansion.
Part VI
The business model illustrated on this slide provides a framework for understanding the
ratios that we introduce in the next section. As you can see, businesses operate as
a series of interconnected decisions that can be classified as financing, investing and operating.
(2) Assets
(3) Revenues
Investing
Financing
Operating
(1) Debt & Equity Financing
(4) Net Income

30. Financial Statement Ratios
The business model on the previous slide contains three links: (1) debt and equity financing is invested in assets, (2) assets are used to generate revenues, and (3) revenues lead to net income. Using these links, three key financial ratios can be created, as shown in this chart.
In addition to making it possible to compare companies of different sizes, a benefit of ratio analysis is that it enables comparisons between companies reporting in different currencies (dollars vs. euros). Note that, to calculate average total assets in the bottom of the asset turnover ratio, you need amounts from two balance sheets. An average is needed in the asset turnover ratio so that the bottom part spans the entire year, just like the top part.
In addition to making it possible to compare companies of different sizes, a benefit of ratio analysis is that it enables comparisons between companies reporting in different currencies (dollars vs. euros).

31. Financial Statement Ratios
The debt-to-assets ratio provides the percentage of assets financed by debt. A higher ratio means greater financial risk.
The debt-to-assets ratio compares total liabilities to total assets. It is usually calculated to three decimal places, and can be expressed as a percentage by multiplying by 100. This ratio indicates the proportion of total assets that are financed by debt. It’s important to know how much debt is used to finance assets because debt has to be repaid whether or not a company is doing well financially. If assets are financed mainly by debt, rather than equity, then this ratio will be high, which would suggest the company has adopted a risky financing strategy. Ultimately, a company could be forced into bankruptcy if it took on more debt than it ever could repay. A higher ratio means greater financial risk. It is important to know how much debt is used to finance assets because debt has to be repaid whether or not a company is doing well financially.
For all three companies, debt plays a fairly small role in financing the companies’ assets. Activision is the lowest with a debt-to-assets ratio (0.239 or 23.9%) that is lower than either Electronic Arts (0.480 or 48%) or Ubisoft (0.325 or 32.5%). This means that the likelihood of Activision being able to repay its existing liabilities is very high, so the company has little financing risk.

32. Financial Statement Ratios
The asset turnover ratio measures how well assets are used to generate sales. A higher ratio means greater efficiency.
The asset turnover ratio compares total sales revenue to average total assets. It is usually calculated to two decimal places and not expressed as a percentage. This ratio indicates the sales revenue per dollar invested in the assets of the business. The higher the ratio, the more efficiently the company is utilizing its assets. Inefficiently run businesses will have lower ratios because their assets will be more likely to sit around idle and not generate revenue.
As the ratios on this slide show, Activision is generating the lowest revenue per dollar invested in assets (as indicated by the ratio of 0.33). In contrast, Electronic Arts generated 75 cents (0.75) of revenue for each dollar of assets and Ubisoft generated nearly a dollar (0.93). Why is Activision’s ratio so low compared to the others? Its asset base ballooned when it merged with Blizzard in The merger added billions of dollars of assets to its balance sheet at their 2008 market values.

33. Financial Statement Ratios
The net profit margin ratio measures the amount of net income (profit) generated from each dollar of sales revenue. It is usually calculated to three decimal places and can be expressed as a percentage by multiplying by 100. Net profit margin is a key ratio because it indicates how well a company has controlled its expenses. Although it’s important for companies to generate lots of revenue, it’s equally important to control expenses. A company generating tons of revenue will go bankrupt if its expenses are out of control.
As this slide shows, Activision was the leader in controlling its expenses, generating a net profit margin of (or 9.4%). In other words, each dollar in revenue produced $0.09 in profit. In its annual report, Activision explains it was able to attain its strong profit margin during difficult economic times by releasing fewer new game titles, which
reduced production, marketing, and head office expenses. Both Electronic Arts and Ubisoft stumbled, as indicated by their negative net profit margins of (0.077) and (0.050). As world economies struggle, these kinds of financial results have become more typical. A small negative net profit margin (NPM) does not usually cause a company to go out of business; however, large or repeating negative NPMs are definitely cause for concern.
The net profit margin ratio measures the ability to generate sales while controlling expenses. A higher ratio means better performance.

34. How Transactions Affect Ratios
Three-step process:
Analyze the transaction to determine its effects on the accounting equation.
Relate the effects in step 1 to the ratio’s components, to determine whether each component increases, decreases, or stays the same.
Evaluate the combined impact of the effects in step 2 on the overall ratio.
Part I
To properly interpret financial statement ratios, you will find it useful to understand how they are affected by transactions. Apply the following three-step process to determine the impact of each transaction on a particular ratio:
Analyze the transaction to determine its effects on the accounting equation, just as you have learned to do in Chapters 2–4.
Relate the effects in step 1 to the ratio’s components, to determine whether each component increases, decreases, or stays the same.
Evaluate the combined impact of the effects in step 2 on the overall ratio.
Part II
A ratio will increase if (a) its top number increases and the bottom number does not change, (b) its bottom number decreases and its top number does not change, or (c) the top number increases while the bottom number decreases. Changes in the opposite direction have the opposite effect.
When a transaction causes both the top and bottom numbers to change in the same direction, the overall impact on a ratio depends on whether the ratio is greater or less than 1.0 before the transaction. A useful approach for determining the impact of a transaction on a ratio in these cases is to assume some simple numbers for the ratio’s starting point and then recalculate the ratio after taking into account the effects of the transaction. This slide illustrates this approach.
In the first situation, the $5 increases in the top and bottom of the ratio cause the overall ratio to increase from 0.50 to In the second situation, the $5 increases cause the overall ratio to decrease from 2.0 to 1.5. These different outcomes occur because in situation (1), the increase has a greater proportionate effect on the top number than on the bottom, whereas in situation (2), the change has a greater proportionate effect on
the bottom number than on the top.

35. Chapter 5 Solved Exercises
M5-4, M5-5, M5-9, M5-10, E5-8, E5-11
Chapter 5 Solved Exercises: M5-4, M5-5, M5-9, M5-10, E5-8, E5-11

36. M5-4 Preparing and Interpreting a Multistep Income Statement
Nutboy Theater Company reported the following single-step income statement. Prepare a multistep income statement that distinguishes the financial results of the local theater company’s core and peripheral activities. Also, calculate the net profit margin using the company’s core revenues and compare it to the 8 percent earned in In which year did the company generate more profit from each dollar of sales?
M5-4 Preparing and Interpreting a Multistep Income Statement
Nutboy Theater Company reported the single-step income statement as shown on this slide. Prepare a multistep income statement that distinguishes the financial results of the local theater company’s core and peripheral activities. Also, calculate the net profit margin using the company’s core revenues and compare it to the 8 percent earned in In which year did the company generate more profit from each dollar of sales?

37. M5-4 Preparing and Interpreting a Multistep Income Statement
NUTBOY THEATER COMPANY
Income Statement
For the year ended December 31, 2013
Revenues
Ticket Sales
Concession Sales
Total Sales Revenues
Operating Expenses:
Salaries and Wage Expense
Advertising Expense
Utilities Expense
Total Operating Expenses
Income from Operations
Other Revenue (Expense):
Interest Revenue
Other Revenue
Income before Income Tax Expense
Income Tax Expense
Net Income
$ 50,000
2,500
52,500
30,000
8,000
7,000
45,000
7,500
200 50
7,750
$ 5,250
Part I
Nutboy Theater Company’s multistep income statement begins with the revenue section which includes Ticket Sales and Concessions Sales.
Part II
The second section includes the operating expenses such as Salaries and Wage Expense, Advertising Expense, and Utilities Expense.
Part III
Revenues minus operating expenses equals income from operations. The third section includes other income and expense items such as interest revenue, interest expense, and dividend revenue.
Part IV
Finally, Nutboy Theater Company will subtract Income Tax Expense to arrive at Net Income for the period.
Part V
The net profit margin is calculated as net income divided by total sales revenues. For Nutboy Theater Company, net profit margin is 10%, which means that Nutboy produced more net income per dollar of sales (10 cents) than in the previous year (8 cents).
= Net Income/Total Sales Revenues
= $5,250 / $52,500
= 10%
Net Profit Margin

38. M5-5 Preparing a Statement of Stockholders’ Equity
On December 31, 2011, WER Productions reported $100,000 of contributed capital and $20,000 of retained earnings. During 2012, the company had the following transactions. Prepare a statement of stockholders’ equity for the year ended December 31, 2012.
Issued stock for $50,000.
Declared and paid a cash dividend of $5,000.
Reported total revenue of $120,000 and total expenses of $87,000.
M5-5 Preparing a Statement of Stockholders’ Equity
On December 31, 2011, WER Productions reported $100,000 of contributed capital and $20,000 of retained earnings. During 2012, the company had the following transactions. Prepare a statement of stockholders’ equity for the year ended December 31, 2012.
Issued stock for $50,000.
Declared and paid a cash dividend of $5,000.
Reported total revenue of $120,000 and total expenses of $87,000.

39. M5-5 Preparing a Statement of Stockholders’ Equity
WER PRODUCTIONS
Statement of Stockholders’ Equity
For the Year Ended December 31, 2012
Balances at December 31, 2011
Net Income
Dividends Declared
Issued Shares of Stock
Balances at December 31, 2012
Retained
Earnings
$ 20,000
33,000
(5,000)
$ 48,000
Stockholders' Equity
$120,000
50,000
$198,000
Contributed
Capital
$100,000
50,000
$150,000
Part I
Wer Productions’ Statement of Stockholders’ Equity includes a reconciliation of the changes in Contributed Capital. The beginning balance in Contributed Capital was $100,000. It increased by $50,000 for issued shares of stock. The ending balance in Contributed Capital was $150,000.
Part II
The Statement of Stockholders’ Equity also includes a reconciliation of the changes in Retained Earnings. The beginning balance in Retained Earnings was $20,000. It increased by $33,000 for net income ($120,000 in revenue minus $87,000 in expenses). It decreased by $5,000 for dividends declared. The ending balance in Retained Earnings was $48,000.
Part III
The balances in the Contributed Capital account and the Retained Earnings account are added together so we can see the total of Stockholders’ Equity and the changes within this total.

40. M5-9 Determining the Effects of Transactions on Debt-to-Assets, Asset Turnover, and Net Profit Margin
Using the transactions in M5-8, complete the following table by indicating the sign of the effect (+ for increase, - for decrease, NE for no effect, and CD for cannot determine) of each transaction. Consider each item independently.
Transaction
Debt-to-Assets
Asset Turnover
Net Profit Margin a. b. c.
Issued 10,000 shares of stock for $90,000 cash.
Recorded depreciation of $1,000 on the equipment.
Equipment costing $4,000 was purchased by issuing a note payable. - + NE
Part I
M5-9 Determining the Effects of Transactions on Debt-to-Assets, Asset Turnover, and Net Profit Margin
Using the transactions in M5-8, complete the following table by indicating the sign of the effect (+ for increase, - for decrease, NE for no effect, and CD for cannot determine) of each transaction. Consider each item independently.
a. Issued 10,000 shares of stock for $90,000 cash.
Part II
Issuing stock for cash increases equity and total assets. So, the debt-to-assets ratio and the asset turnover ratio decrease. This transaction has no effect on the net profit margin.
b. Equipment costing $4,000 was purchased by issuing a note payable.
Part III
Purchasing equipment by issuing a note increases both assets and liabilities. So, the debt-to-assets ratio increases and the asset turnover ratio decreases. This transaction has no effect on net profit margin.
c. Recorded depreciation of $1,000 on the equipment.
Part IV
Recording depreciation increases expenses which decreases net income and it also decreases assets. So, the debt-to-assets ratio and the asset turnover ratio increase and the net profit margin ratio decreases.

41. M5-10 Preparing Comparative Financial Statements
Complete the blanks in the following comparative income statements, statement of stockholders’ equity, and balance sheets.
Part I
M5-10 Preparing Comparative Financial Statements
Complete the blanks in the following comparative income statements, statement of stockholders’ equity, and balance sheets.
Part II
is titled Income from Operations. Part III
is titled Income before Income Tax Expense. Part IV
is $100.
Income from Operations
Income before Income Tax Expense
100

42. M5-10 Preparing Comparative Financial Statements
Part I
Now, let’s determine the missing amounts on the Statement of Stockholders’ Equity.
Part II
(d) is $480. Part III
is $80 and is found on the December 31, 2012, Balance Sheet. Part IV
is $120.
480
80 (from December 31, 2012, Balance Sheet)
120

43. M5-10 Preparing Comparative Financial Statements
Part I
Now, let’s determine the missing amounts on the Balance Sheet.
Part II
(g) is $480. Part III
is $180.
480
180

44. End of Chapter 5
End of chapter 5.