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NAME: STUDENT NUMBER:

FINANCIAL STATEMENT ANALYSIS A7S0 Duration: 180 minutes McMaster University Mid-Term Examination Instructor: E. Bentzen-Bilkvist November 2005

INSTRUCTIONS

1.

This examination is comprised of 17 pages. There are 6 parts, which are to be answered in the space provided for a total of 100 points. Be brief in your answers. You are responsible for ensuring that your copy of the question paper is complete. Bring any discrepancy to the attention ofthe invigilator. On this page, fill in your name and student number. The entire test paper must be returned to have any credit. The use of a calculator is permitted. YOU MUST SHOW ALL COMPUTATIONS TO HAVE ANY CREDIT. Answer the questions to the best of your ability. No questions will be entertained by the invigilators during the examination period. This policy was put in place to assure equal treatment of all students. Reasonable annotated 8 Y2x 11 sheet of paper is allowed in the exam. Points will be awarded as follows: Part I: Part ll: Part ill: Part N Part V: Inventory Income Taxes Analysis and Earnings Cash flow Statement Ratios Attainable 18 17 24 18 15 8 Actual

2.

3.

4.

5.

6. 7.

Part VI: Other areas TOTAL:

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PART I

INVENTORY

(18 marks)

Selected infonnation regarding the inventories and cost of goods sold of Westwood Electrical Supply for Year 5 and Year 6 appears below: Income Statement Sales Cost of Goods Sold Gross Margin Year 6 $17,287 13.134 $ 4.153 Year 5
$14,296 11.080 $ 3.216

Balance Sheet Inventories

December 31 Year 6 Year 5 $1,186 $1,473

Year 4 $1,258

Notes to the Financial Statements

Westwood Electrical Supply uses a last-in, first-out (LIFO) cost-flow assumption for inventories and cost of goods sold. Inventories on a first-in, first-out (FIFO) cost-flow assumption would have exceeded the amounts reported on a LIFO basis by $376 at the end of Year 6, $497 at the end of Year 5, and $338 at the end of Year 4. a) Compute the amount of cost of goods sold and gross margin on a FIFO basis for Year 5 and Year 6. (6 marks)

Continued .....

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b) Compute the gross margin percentage (that is, gross margin as a percent of sales) for Year 5 and Year 6 on a LIFO and on a FIFO basis. (6 marks)

c) During periods of rising prices, LIFO generally results in a higher cost of goods sold and lower gross margin than FIFO. Why does this generalization not describe accurately the experience of Westwood Electrical Supply? (6 marks)

Continued.. ...

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PART II

INCOME TAXES

(17 marks)

The following is the Income Tax disclosure note for Gillette Company's 2002 Financial Statements. Answer the following questions regarding Gillette's tax disclosure. A reconciliation of the statutory Federal income tax rate to the Company's effective tax rate follows.
Yean ended December 31, (percent) 2002 2001 2000

Statutory Federal tax rate Goodwill amortization and :wet impairments Taxes on foreign income Effect of foreign currency translation State taxes (net of Federal t2Xbenefits) Other differences Effective tax rate
The components

35.0016 (3.6) 0.7 (1.1) 31.0016

35.0016

1.5 (5.9) (0.2) 0.9 0.9 32.2%

35.0% 5.0 (7.1) (0.2) 1.2 2.4 36.3%

of deferred t2X assets and deferred tax liabilities are shown belm.v.
2002 Deferred Tax Deferred Tax &seES Liabilities 2001 Deferred Tax Deferred Tax AsseIS Liabilities

At December 31, (millions)

Current Advertising and sales promotion Benefit plans Discontinued operations Inventory Restructuring and :wet impairments Miscellaneous reserves and accruals Operating loss and credit carryforwards Other Total current Net current Noncurrent Benefit plans Currency translation effect of pass-through entities Intangibles Operating loss and credit carryforwards Property, plant and equipment Other Total noncurrent Valuation allowance Net noncurrent

$ 35 46 2 85 15 112 85 380 $380 $77

$ 37 48 41 127 97 103 2 26 481 $481

101 128

$136

151

15 522 27 92 $ (6) $692 $312 778

19 397 58 155 $ (8) $459 $22 606

Toul
Net deferred tax assetsIliabiIities

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QUESTIONS:

1. Was taxable income greater or less than book income before taxes for 2002?

(3 marks)

2. Give the Journal Entry to record the provision for Income tax for 2002. Use deferred tax asset and deferred tax liability accounts in your Journal Entry. (4 marks)

Continued. ....

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3. Assume that depreciation expenses for financial reportingwas $500,000,000 for 2002. Compute the amount of depreciation expenses for tax reporting for 2002. (4 marks)

4. What were the deferred tax liabilities? Pick out one item and explain what it means. (3 marks)

5. Give one example of a permanent difference between Financial Reporting and Tax Reporting for Gillette. (3 marks)

Continued .....

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PART III

ANAL YSIS OF EARNINGS

(24 marks)

International Paper Comp is the largest forest products company in the world. The exhibit below presents. International Paper's income statement for Year 4, Year 5, Year 6 and Year 7. International Paper Income Statements (amounts in millions)

Year Ended December 31

Year 4 Sales $12,960 Cost of Goods Sold. . . . . . . . (9,930) Selling and Administrative Expenses. (1,595) Restructuring charges (212) Interest Expense (277) Income Taxes (377) Income from Continuing $ 569 Extraordinary Loss on Debt...... Changes in Accounting Principles.......... Net Income $ 569

Year 5 $ 12,703 (10,041) (1,649) (60) (315) (239) $ 399 (215)

Year 6 $ 13,598 (10,987) (1,760) (398) (247) J@ $ 142 (6) (50) 1.8.6

Year 7 $ 13,685 (11,089) (1,786) (310)

mu
$ 289

89

The notes to the financial assessments reveal the following information.

RESTRUCTURING CHARGES. In December Year 4, the Company completed a review of operations in the contact of its ongoing programs to emphasize value-added products in growing markets and improve the efficiency of its facilities. As a result, the Company recorded a pretax charge of $212 million ($137 million after taxes); principally related to the planned sale or closure of certain wood products and converting facilities, the estimated cost of remediation, and severance and other personnel expenses associated with the improvement program. In December Year 5, the Company recorded a $60 million ($37 million after taxes) reduction in work charge to cover severance costs associated with the elimination of more than 1,000 positions from its worldwide work force. In November Year 6, the Company recorded a pretax charge of $398 million ($263 million after' taxes) to establish a productivity improvement reserve. Over 80 percent of this charge represents assets write-downs for facility closings or realignments and related severance and relocation costs. The balance covers one-time costs of environmental clean-up, remediation, and legal costs. EXTRAORDINARY ITEM. The Company recorded a loss of$6 million on the early extinguislunent of high-interest rate debt during Year 6.
Continued .....

Page 8 ACCOUNTING CHANGES. The Company adopted the provision of FASB Statement No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions", on January 1, Year 5. The Company recognized a pretax charge of $350 million ($215 million after taxes). The company adopted the provisions of FASB Statement No. 109, "Accounting for Income Taxes", on January 1, Year 6, resulting in a charge of $50 million. a) Discuss the appropriate treatment of: 1) Restructuring Charges (2) Extraordinary Item (3) Accounting Changes, in an assessment of the profitability ofIntemational Paper. (12 marks)

Continued.. ...

Page 9 b) Assume now that you have decided to eliminate each of the items in part a). Indicate the adjustments to the income statement of International Paper to eliminate each of the items in part a). The income tax rate was 35 percent in Year 4, Year 5, Year 6 and Year 7. (12 marks)

Continued .....

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PART IV

CASH FLOW STATEMENT

(18 marks)

Refer to Gillette Company statement of cash flows in the attachments to this midterm exam (see pages 15 to 17 of the Mid-term). 1. Explain the three-year trend in operating cash flows for Gillette Company. (5 marks)

2. What were the free cash flows for 2000,2001 and 2002 for Gillette Company?(3marks)

Continued.. ...

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3. Did the company in the 3 year period generated enough cash ftom operations to finance both additions to capital assets, purchase of company stock and payment of dividends? (6 mark)

4. In 2002, $529 "funding of Company pension plan" appears as a negative item in the operating section ofthe cash flow statement. Why? (3 marks)

Continued.. ...

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PART V

RATIOS

(15 marks)

In the Gillette Company financial statements (see pages 15-17), compute the following ratios for the year ended December 31, 2002. 1.

Return on Assets.

(4 marks)

2.

Current Ratio.

(2 marks)

3.

Fixed assets turnover.

(3 marks)

4.

Return on Common Equity.

(4 marks)

5.

Accounts receivable Turnover

(2 marks)

Continued.. ...

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PART VI

OTHER AREAS

(8 marks)

Answer the following questions in the space provided (each multiple question = 2 marks) I. Why might the use of accelerated depreciation rather than straight-line depreciation produce earnings of higher quality? a) Accelerated depreciation more accurately reflects financial reality because higher depreciation expense would be taken in the early years of its productive period. b) During inflationary periods, rising prices increase replacement costs of most assets, resulting in an understatement of depreciation based on historical cost. c) Both (a) and (b). d) None of the above.

2. Which of the following are methods by which management can manipulate earnings and possibly lower the quality of reported earnings? a) Changing an accounting policy to increase earnings. b) Refusing to take a loss on inventory in an accounting period when the inventory is known to be obsolete. c) Decreasing discretionary expenses. d) All of the above.

3. Which of he following statements is false? a) A negative five cash flow can occur in a year in which net income is positive. b) An increase in accounts receivable represents accounts not yet collected cash. c) An increase in accounts payable represents accounts not yet collected in cash. d) To obtain cash flow from operations, the reported net income must be adjusted.

4. Gains and losses on sales of property, plant and equipment for cash a) are approximately equal to the cash received in the sale b) appear in the investing section of the Statement of Cash Flows, with the label gain or loss c) should be included in the sales, general and administrative costs (SG&A) component of mcome d) all of a, b, c e) none of a, b, c

Continued .....

Page 14

Attachments to
Mid - Term Exam

A750 November, 2005

Financial Statements Analysis

Continued.. ...

Page 15

Consolidated
The Gillette

Balance Sheet
and Subsidiary Companies

Company

At December

31, 2002

(miDiOIU, except per shareamount)

2001

Assets Current Assets Cash and cash equivalents Trade receivables, less allowances: 2002 - $73; 2001 - $69 Other receivables Inventories Deferred income UXes Other current assets Total Current Assets Property, Plant and Equipment, net Goodwill Intangible Assets, net Other Assets

$ 801 1,202 311 928 380 175 3,797 3,565 962 400 1,139 $9,863

$ 947 1,473 313 1,011 481 230 4,455 3,548 935 418 613 $9,969

Liabilities and Stockholders' Current Liabilities Loans payable Current portion of long-tenn debt Accounts payable and accrued liabilities Income taxes Total Current Liabilities Long-Term Debt Deferred Income Taxes Other Long-Term Liabilities Minority Interest Contingent Redemption Value of Common

Equity

$ 673 527 2,054 234 3,488 2,457 692 920 46


Stock Put Options

$2,235 428 1,880 295 4,838 1,654 459 805 42 34

Stockholders' Equity Common stock, par value $ 1 per share Authorized: 2,320 shms Issued 2002 -1,370 shares; 2001 - 1,368 shares Additional paid-in capital Earnings reinvested in the business Accumulated other comprehensive loss Treasury stock. at cost: 2002 326 sh2res; 2001 312 shares

1,370 1,197 6,608 (1,523) (5,392) 2,260 $9,863

1,368 1,094 6,077 (1,437) (4,965) 2,137 $9,969

Total Stockholders' Equity

Continued .....

Consolidated
The Gillette

Statement of Income
Company H,d Sublidiary Companiel

Page 16

Years Ended

December

31,

2002

2001

2000

(milliON. except per Ihan: amounts)

Net Sales Cost of Sales Gross Profit Selling, General and Administrative Expenses Restructuring, Asset Impairment and Other Profit fiom Operations Nonoperating Charges Interest income Interest expense Other charges (income) - net (Income)

$8,453 3,511 4,942 3,172 (39) 1,809

$8,084 3,407 4,677 3,007 172 1,498

$8,310 3,469 4.841 2,757 572 1,512 (5) 223 6 224 1,288 467 821 (428) (1)

(25) 84 (2) 57 1,752 543 1,209 7 $1,216

(4) 145 15 156 1,342 432 910

Income fiom Continuing Operations before Income Taxes Income Taxes Income fiom Continuing Operations Loss on Disposal of Discontinued Operations, net of tax Income (Loss) fiom Discontinued Operations, net of tax Net Income
Net Income (Loss) per Common Share, basic Continuing Operations Disposal of Discontinued Operations Discontinued Operations Net Income Net Income (Loss) per Common assuming full dilution Continuing Operations Disposal of Discontinued Operations Discontinued Operations Net Income Share,

$ 910

$ 392

$ 1.15

.86

.78 (AI) .37

S 1.15

.86

$ 1.14 .01 $ 1.15 $1,216

.86

S .77 (040)
$ .37

.86

Adjusted Net Income, assuming the adoption of SPAS 142 for 2001 and 2000 Adjusted Net Income per Common Sh2re, assuming the adoption of SPAS 142 for 2001 and 2000 Basic Assuming full dilution Weighted average number of common shares outstanding

$ 934

$ 423

S 1.15 S 1.15
1,055 1,059

$ .89 S .88

S $

040 040

Bmc Assumingfulldilution
~ Soc an IIII(-rfac Noca lit Ca 1l1I1i'. . FiaIIICiaI ..

1,055 1,054 1,058 1,063 Continued .....

Consolidated
The Gillelte

Statement of Cash Flows


and Subsidiary Companies

Page 17

Company

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