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1

Abercrombie and Fitch


Abercrombie and Fitch reports the following balances in Stockholders Equity.
2003
2002
Contributed capital
$140,172
$143,590
Retained earnings
$919,577
$714,475
Total equity
$1,059,749
$858,085
During the year, ANF reported net income of $205,102. Did ANF pay a dividend? If so, what
was the amount of the dividend?
Solution
No dividend was paid. Retained earnings increased the amount of net income. So, no
dividends were paid to shareholders.
Interpreting changes in cash
While analyzing a companys statement of cash flows, you notice that cash decreased over a
period. Is this necessarily bad for this company? Explain.
Solution:
A company is not necessarily worse off because the cash decreased. The important
consideration is how and why it changed. For example, cash can decrease for a growing
because of a build-up of receivables and inventories. Similarly, cash can decrease because
debt is retired or stock repurchased. Neither of these scenarios is necessarily negative.
Book value vs. market value
What is company book value? What is company market value? Why do these values differ?
Solution:
Company book value is the reported stockholders equity as determined by the Generally
Accepted Accounting Principals. Company market value is the number of equity shares
outstanding multiplied by the current per share market price. These two values differ due to
the guidelines (GAAP) surrounding book value. By GAAP, assets and liabilities are recorded
at historical cost, which can be different then market value. Also, any resource that cannot be
reliably measured cannot be recorded in book value, although that resource may have a
market value. GAAP does not factor in external conditions and changes, such as the market
does. Lastly, book value does not project future performance, whereas the market does.

Nike, Inc. and Reebok International Ltd.


Nike, Inc. and Reebok International Ltd. both design and market footwear, apparel and
accessories and are competitors. Key financial figures for these businesses from their most
recent respective Form 10-Ks filed with the SEC are as follows (in millions):
Key Financial Figures
Nike, Inc.
Reebok International
Ltd.
Sales
$12,253
$3,485
Net income
946
157
Average total assets
7,356
1,925
a. Compute the return on assets (ROA) for both Nike, Inc. and Reebok International Ltd.
b. Disaggregate both companies return on assets into profit margin and total asset
turnover.
c. Taking into account the results from part a. and b., which company is more attractive
to you as an investor? Provide reasoning to explain your answer.
Solution
a. ROA = Net income / Average total assets
Nike, Inc.: $946 / $7,356 = 12.86%
Reebok International Ltd.: $157 / $1,925 = 8.16%
b.

ROA = Net income / Average total assets = (Net income / Sales) * (Sales / Average
total assets)
Nike, Inc.:
Profit margin: $946 / $12,253 = 0.0772
Total asset turnover: $12,253 / $7,356 = 1.6657
ROA = 12.86%
Reebok International Ltd.:
Profit margin: $157 / $3,485 = .0451
Total asset turnover: $3,485 / $1,925 = 1.8104
ROA = 8.16%

c.

Based on solely the ROA, profit margin and asset turnover analyses, Nike is more
attractive. It generated more income against the average amount of assets it holds and it
has a higher profit margin (or income compared to total sales). Reebok does show a
faster total asset turnover (amount of sales generated for each dollar of assets held),
however Nikes profit margin and ROA is superior.

Coca-Cola
Selected balance sheet and income statement information for Coca-Cola for fiscal year 2003
follows:
Period
Current
Current
Pretax
Interest
Net
Stock($mil)
operating
operating
income
expense operating
holders
assets
liabilities
assets
equity
2003
$8,396
$4,980
$5,495
$289
$27,342
$11,366
a. Compute the current ratio for each year and discuss any trends. Do you feel that the company
is liquid? Explain.
b. Compute times interest earned and the financial leverage ratio for each year and discuss any
trends. Do you have any concerns about the companys level of financial leverage and its ability
to meet its interest obligations? Explain.

Solution:
a., b.
Period Current ratio
(CA/CL)
2003
1.69
8,398/4,980

Times interest earned


((P-t inc + I) / I)
20.01

Financial leverage ratio


([NOA-SE]/SE)
1.41

(5,495 + 289)/289

(27,342 - 11,366)/11,366

c. The companys current ratio has increased slightly over the 2001-2003 period and reflects
stable liquidity. A significant portion of its current assets is concentrated in cash and inventories
that can be liquidated quickly without significant cost. Its times interest earned ratio has
decreased, but remains at very high levels. The financial leverages ratio has nearly tripled over
this time period, and it much higher than the median value of 0.40 for all publicly traded
companies. The company appears to have sufficient profitability to manage the level of financial
leverage, however.

Liquidity
Explain the concept of liquidity and why is it crucial to company survival.
Solution:
Liquidity refers to available cash and the amount of cash inflow. Liquidity is crucial to a
companys survival because cash is needed in order to pay wages, debts, and shareholder
return on investment. Future investors will also be very critical of entering into investments
with a company that does not show liquidity.

Hewlett Packard
Following are the income statement accounts for a recent Hewlett Packard Company income
statement.

HEWLETT-PACKARD COMPANY AND SUBSIDIARIES


Income Statement
Net revenue
Cost of sales
Gross margin
Research and development
Selling, general and administrative
Amortization of purchased intangible assets and goodwill
Restructuring charges
Acquisition-related charges
In-process research and development charges
Earnings (loss) from operations
Interest and other, net
Net loss on divestitures
Losses on investments and other, net
Litigation settlements
Earnings (loss) before cumulative effect of change in accounting
principle and taxes
Provision for (benefit from) taxes
Net earnings (loss) before cumulative effect of change in accounting
principle
Cumulative effect of change in accounting principle, net of taxes
Net earnings (loss)
Identify the items in its statement that might be considered transitory items.

Solution:
a) Restructuring charges
b) Acquisition-related charges
c) In-process R&D
d) Net loss on divestitures
e) Litigation settlements
f) Cumulative effect of change in accounting principle

Boston Acoustics
The income tax footnote to the financial statements of Boston Acoustics Inc. for 2002-2004 is
as follows.
Years ended
March 27,
2004
Current:
Federal
$921,000
State
82,000
1,003,000
Deferred:
Federal
State

(77,000)
(82,000)
(159,000)
Provision (benefit) for income taxes
$844,000
a.
What is the amount of income tax expense reported in Boston Acoustics 2004 income
statement?
b.
How much of the income tax expense is payable in cash in 2004?
c.
Provide an example to explain how the deferred tax expenses could be negative in
2004?

a.
b.
c.

d.

Solution:
a.$844,000 in 2004 income tax expense
b.$1,003,000 is payable in 2004 computed from the current tax provision ($921,000 +
$82,000).
c. The negative figure indicates that the income reported for tax purposes (taxable
income) is greater than that for financial reporting purposes (GAAP income). A typical
example is the recognition of restructuring costs when the plan is approved, but
these costs are not deductible for tax purposes until paid in the future.

Nordstrom
Discuss when each of the following type of business should likely recognize
revenue:
a. Nordstrom, a large clothing retailer.
b. A company that designs model homes based on lot and then sells
upgrades to each customer specific to the model.
c. An online game company, such as Three Ring, which sells monthly
subscriptions to users for access.
Solution:
Company

Revenue Recognition

Nordstrom

When merchandise is given to the customer, and the


right of return has passed.

Model home
company

When the title of the house is transferred to the


buyers.

Three Ring

When the subscription month has ended.

Revenue recognition
Discuss any revenue recognition issues that arise from the companies above
with the knowledge that:
a.

Nordstrom offers free exchanges (meaning that they pay for shipping if
its for an online purchase) for a period of 60 days after purchase. It also
offers returns, but those are not pre-paid in terms of shipping, for the
same period of time.
b. The company that designs model homes asks for a $10,000 down
payment on a lot, which it keeps for 10 days. At the end of that period,
the customer must sign a contract for the house and also put down
another $25,000. Otherwise, they will lose their right to the lot and have
their $10,000 returned to them.
Solution:
Company

Revenue Recognition

Nordstrom

Record revenue when the 60-day right of return has


passed. Also, estimate potential shipping claims on
exchanges and establish a reserve for them when
revenue is recorded.

Model home
company

Revenue is still recorded when the title of the house is


transferred to the buyers.

Gilman Dairy Products


Gilman Dairy Products is a supplier of ice cream and cheese for many regional grocery outlets.
They are expecting $100,000 in receivables at the end of next year and have estimated that
$4,240 of those receivables will be uncollected. One of Gilmans smaller clients, Langdon
Sundries, has recently declared bankruptcy and will be unable to pay Gilman the $1,000 owed to
them. This amount is going to be written off Gilmans balance sheet.
a. What is the ending allowance for uncollectible accounts?
b. At what amount will accounts receivable be reported on the balance sheet?
Solution:
The ending allowance for uncollectible accounts will be $3,240 ($4,240-$1,000) after the write off.
This will be reflected on the balance sheet in the following manner:
Accounts Receivable, net of $3,240 in allowances.

$95,760

The accounts receivables line item is the same before and after the write off. Accounts
receivable are reduced from $100,000 to $99,000 and the allowance for uncollectible accounts is
reduced from $4,240 to $3,240.
Before Write-OffEffects of Write-Off
Accounts Receivables $100,000
($1000)
Less Allowance for
Uncollectible accounts $4,240
($1000)
$95,760

After Write-off
$99,000
$3,240
$95,760

Confirmative Technology
Confirmative Technology has the following Plant, Property, and Equipment assets on their
balance sheet for 2004:
2004 2003
Land
980
1000
Buildings
324
330
Machinery and equipment
543
555
1,847 1,885
Less Accumulated Depreciation
750
640
Total
1,079 1,245
Determine what percent of the companys depreciable assets are used up for each year? What
does this tell you about the companys future cash flows?
Solution:
Percent Used Up = Accumulated Depreciation/Cost of Depreciable Assets
2004: 0.87= 750/(1,847 980)
Since nearly all of the depreciable assets are used up in 2004 its very likely that Confirmative will
need to increase capital expenditures to replace these assets in the very near future. This will
depress future periods cash flow.

XYZ Company
Summary Inventory Records for Company XYZ
Inventory on January 1, 2004 20 units @ $500 each .. $10,000
Inventory purchased in 2004 . 35 units @ $550 each .. $19,250
Total cost of goods available for sale in 2004 .. 55 units . $29,250
Also assume that 25 units are sold during 2004 @ $700 per unit for total sales revenue of
$17,500
a. Determine the ending inventory balance under LIFO method.
b. Determine the explain the LIFO reserve for Company XYZ

Solution:
a. LIFO method. This method assumes that the last units purchased are the first units sold.
Applying LIFO to the data;
Sales
$17,500
COGS .. 25 units @ $550 $13,750
Gross Profit .
$ 3,750
Inventory Balance: Since $13,750 of inventory cost is removed from beginning inventory, the
remaining inventory cost reported on the 2004 year-end balance sheet is (29,25013,750=15,500) $15,500.
2. FIFO method. This method assumes that the first units purchased are the first units sold.
Applying FIFO to the data;
Sales $17,500
COGS .. 20 units @ $500 $10000
.. 5 unites @ $550 $2750
..
$ 12,750
Gross Profit .
$ 4,750
Inventory Balance: Since $12,750 of inventory cost is removed from beginning inventory, the
remaining inventory cost reported on the 2004 year-end balance sheet is (29,25012,750=16,500) $16,500. Therefore, the LIFO reserve is the difference between LIFO and FIFO
inventory amounts. The reserve for Company XYZ is (16,500-15,500) $1,000. Analysts use this
reserve to compute the amount by which cash flow has been affected both cumulatively and for
the current period from the use of LIFO.

10

Savanna Inc.
Savanna Inc. issues $700,000 of 8% bonds that pay interest semiannually and
mature in 10 years. Assume that the market interest (yield) rate is 10% per
year compounded semiannually.
a) Compute the bond issue price.
N=20, I=10, pmt=28,000, fv=700,000 PV=612,764.53
28,000 x 12.4622 = 348,941.60
700,000 x .3769 = 263,830.00
612,771.60

b) How much interest expense will Savanna recognize at the time of the
first semiannual interest payment?
612,764.53 x .05 = 30,638.23
612,771.60 x .05 = 30,638.58

11. Cover-up Co.


Cover-up Co. invests in window covering stocks and has the following short-term equity
investments in its portfolio at year-end (12/31/01). All securities are readily marketable.
Name

# of shares

Purchase price/Share

Market price/share

Shutters

100

10

12

Wood Blinds

500

15

10

Aluminum Blinds

300

20

Drapes

400

10

20

Assume no cost of selling such as brokerage fees. Also ignore taxes.


A. If Cover-up Co. wishes to maximize current year (2001) net income, circle how
each stock should be classified by circling the appropriate method.
Shutters
Available For Sale
Does Not Matter
Trading
Wood Blinds

Trading

Available For
Sale

Does Not Matter

Aluminum Blinds

Trading

Available For
Sale

Does Not Matter

Drapes

Trading

Available For Sale

Does Not Matter

B. If Cover-up Co. wishes to maximize current year (2001) total assets, circle how
each stock should be classified by circling the appropriate method.
Shutters
Trading
Available For Sale
Does Not Matter
Wood Blinds

Trading

Available For Sale

Does Not Matter

Aluminum Blinds

Trading

Available For Sale

Does Not Matter

Drapes

Trading

Available For Sale

Does Not Matter

C. Assume for part C that Cover-Up classified as trading all investments that
increased in value as trading and all investments that decreased in value as
available for sale. Would Cover-up Co. be able to increase 2001 net income over
the amount they would report if they followed this classification in part A. by
selling any of the stocks? If so, which stocks should they sell?

No, all the stocks that have gone up in price are already recognized on
the income statement since they are considered trading in part a.