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II. Solutions to Study Questions, Problems, and Cases Chapter 1 1.1 The annual report is published primarily for shareholders, while the 10-K report is filed with the Securities and Exchange Commission and is used by regulators, analysts, and researchers. The financial statements and much of the financial data are identical in the two documents; but the 10-K report contains more detail (such as schedules showing management remuneration and transactions, a description of material litigation and governmental actions, and elaborations of many financial statement accounts) than the annual report; and the annual report presents additional public relations type material such as colored pictures, charts, graphs, and promotional information about the company. 1.2 The analyst should use the financial statements: the balance sheet, the income statement, the statement of stockholders' equity, and the statement of cash flows; the notes to the financial statements; supplementary information such as financial reporting by segments; the auditor's report; management's discussion and analysis of operating performance and financial condition; and the five-year summary of financial data. Use the public relations "fluff," such as colored pictures and descriptive material with caution. 1.3 A qualified report is issued when the overall financial statements are fairly presented "except for" items which the auditor discloses; an adverse opinion is issued when the financial statements have departures from GAAP so numerous that the statements are not presented fairly. A disclaimer of opinion is caused by a scope limitation resulting in the auditor being unable to evaluate and express an opinion on the fairness of the statements. An unqualified opinion with explanatory language is caused by a consistency departure due to a change in accounting principle, uncertainty caused by future events such as contract disputes and lawsuits, events which the auditor believes may present business risk and going concern problems. 1.4 The proxy statement is a document required by the SEC to solicit shareholder votes, since many shareholders do not attend shareholder meetings. The analyst can find important information in the proxy statement such as background information on the company's nominated directors, director and executive compensation, any proposed changes to those compensation plans and the audit and non-audit fees paid to the auditing firm.

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1.5 Employee relations with management, employee morale and efficiency, the reputation of the firm with its customers and in its operating environment, the quality and effectiveness of management, provisions for management succession, potential exposure to regulatory changes, "bad publicity" in the media. 1.6 Depreciation is a process of cost allocation, which requires estimation of useful life, salvage value, and a choice among depreciation methods affecting the timing of expense recognition. 1.7 Expense and revenue recognition can be different for purposes of calculating taxable income and earnings reported in the financial statements. Thus, companies calculate taxable income taking advantage of every item that will reduce income; and the firm reports the highest possible income to shareholders. Two sets of books (at least!) are kept: one for the I.R.S. and one for the annual report. The financial analyst should be aware of the "deferred taxes" account, which reconciles differences between taxable and reported income. 1.8

(a) Annual Depreciation Expense = Asset cost Dep. period Annual Depreciation Expense = $450,000 15 = $30,000

(b) Accum. Dep. at end of Yr. 1 = $30,000

Accum. Dep. at end of Yr. 2 = Dep. Yr. 1 + Dep. Yr. 2 = $60,000 (c) Year 1 Year 2 Historical Cost $450,000 $450,000 Accum. Dep. 30,000 60,000 Fixed Assets (Net) $420,000 $390,000 (d) Dep. exp. for tax purposes = $45,000 Dep. expense reported in financial statements = $30,000 Amount by which dep. exp. for tax purposes exceeds dep. exp. for reporting purposes = $15,000 (e) Amount by which taxable exp. exceeds reported exp. = $15,000

Tax rate = 0.3 Amount by which reported tax exp. exceeds actual taxes paid = $ 4,500

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1.9 (a) 1. Switch to straight line depreciation if not using. 2. Lengthen depreciation period for depreciable assets. (Items 1 and 2 would lower quality unless made to reflect economic reality.) 3. Sell assets for a gain. 4. Postpone loss recognition on inventory or investments. 5. Reduce advertising and marketing expenditures. 6. Reduce research and development expenditures. 7. Reduce repair and maintenance expenditures. (b) To have a positive "real" impact on the firm's financial position, the company would have to increase revenue from a beneficial policy rather than a cosmetic change or to reduce costs in a manner that would not impair the long-term profitability of the firm. Examples: 1. Have a special end-of-year sale, offer discounts, offer rebates. 2. Invest in plant and equipment at end of year to get tax savings from depreciation. 3. Get employees involved in cost-cutting measures. 4. Sell assets, if for a profit, that the firm had already planned to sell at some point because of inefficiencies.

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1.10 Memorandum

Date: Current Date To: B.R. Neal, Director of Marketing From: Student's Name Subject: Contents of an Annual Report The company's annual report presents financial information about the firm. This information package is published primarily for shareholders and the general public. The major components of an annual report are briefly described in this memo. 1) An annual report contains four financial statements: The balance sheet shows the financial condition (assets, liabilities, stockholders' equity) at end of year; the income or earnings statement presents the results of operations including revenues, expenses, net profit or loss, and net profit or loss per share for the year; the statement of stockholders' equity reconciles beginning and ending balances of accounts in the equity section of the balance sheet; and the statement of cash flows shows inflows and outflows of cash from operating, financing, and investing activities for the year. 2) Notes to the financial statements provide additional detail about particular items in the financial statements. 3) The auditor's report is prepared by an independent accounting firm and attests to the fairness of the information presented. 4) The five year summary shows key financial data including net sales, income/loss from continuing operations on a dollar and per share basis, assets, long term debt, and dividends per common share. 5) Quarterly stock prices record how the company's stock shares have performed over the past two years. 6) Management's Discussion and Analysis provides management's perspective on how the company is doing including favorable or unfavorable trends, and significant events or uncertainties. The remaining material in the annual report is included primarily to provide background information about the company and its management, and to make the document attractive and interesting to read. If staff members would like to learn more about any of the material in the company's annual report, the following book is highly recommended: Understanding Financial Statements by Fraser and Ormiston (Prentice Hall, 2004).

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1.11 (a) Earnings management refers to the practice of using accounting choices and techniques in such a way that earnings reports reflect what management wants the user to see, instead of the true financial performance of the company. (b) Managers are motivated to meet the earnings expectations of analysts on Wall Street. Companies not meeting these expectations have been punished with immediate stock price declines. This in turn negatively impacts the firm's total market capitalization and the value of stock options granted employees. (c) The following five techniques used by companies create illusions according to Levitt: 1. "Big Bath" restructuring charges these charges are taken when a

company reorganizes its businesses. Often companies overestimate the amount of the charges which then results in income being recorded at a later date to correct the error. These supposed one-time charges are usually received on Wall Street favorably since analysts tend to focus on future earnings.

Author's example: An example of restructuring charges which led to

confusion occurred over the ten-year period from 1986 to 1996, when AT&T took four major restructuring charges totaling over $14 billionmore than their reported earnings for that entire period.

2. Creative acquisition accounting classifying part of the acquisition price

when a merger occurs as "in-process" research and development. This item is then written off in the year of acquisition because there is a chance that the research will not result in increased earnings. If, in fact, earnings are increased later, the already written off expense will not negatively impact the earnings number.

Author's example: In 1998, Compaq acquired Digital and immediately

wrote off over $3 billion of "in-process" research and development. 3. Cookie jar reserves overestimating liabilities for such items as sales

returns, loan losses or warranty costs. This results in expenses being recorded in the year of the estimation, but allows a company to reverse these charges in a year when earnings are lower than desired.

Author's example: The W.R. Grace and Co. used cookie jar reserves to stash

away profits to be used in later years to mask declining earnings. The

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former in-house audit chief blew the whistle on the firm in 1999, but the company had been abusing these reserves since the early 1990s.

4. Materiality the concept that insignificant items need not be reported.

Some companies abuse this concept by arguing that items are insignificant when in fact they are meaningful to users.

Author's example: Years ago many firms offered to pay for retirees' medical

costs not covered by Medicare. This was a relatively inexpensive benefit at the time. Severe healthcare inflation quickly made this benefit extremely costly to firms; however, companies used the materiality concept to claim that this liability need not be reported. When FASB forced companies to disclose what they had promised in medical benefits, many companies reported large losses. In 1991, IBM reported an accumulated cost of over $2 billion for postretirement benefits.

5. Revenue recognition recording revenue before the transaction has

actually occurred. Two examples of recognizing revenue erroneously were discussed in

Chapter 1: Waste Management, Inc. and Xerox. (d) Levitt proposes the following steps of action: 1. The SEC must implement rules regarding more detailed disclosures of

changes in accounting assumptions. 2. The AICPA must clarify the rules to auditors of what is acceptable and what is unacceptable with regard to the illusory techniques described above.

3. The SEC must publish better guidance on the concept of materiality. 4. The SEC should consider guidance on the do's and don'ts of revenue recognition. 5. Private sector standard setters need to address areas where current rules are inadequate. FASB needs to promptly resolve current issues which will bring clarity to the definition of a liability. 6. The SEC will formally target companies for review that appear to manage earnings and will aggressively act on abuses of the financial reporting process. 7. The way audits are performed must be assessed. 8. Audit committees must be empowered and function as the ultimate guardian of investors.

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9. Corporate management and Wall Street must embrace a cultural change. Companies should be rewarded for honesty, not for being clever enough to deceive users through financial reporting.

(e) Levitt believes that audit staff are insufficiently trained and supervised. He also believes that audit committees in some firms are severely lacking in financial expertise. Remedies include the investigation and review of the auditing process and the development of recommendations intended to empower audit committees to perform their job correctly. 1.12 (a) Intel supplies the computing and communications industries with chips, boards, systems and software building blocks for computers, servers and networking and communication products. (b) The analyst could learn the following by reading the letter to stockholders:

the significant negative financial impact (21% revenue decrease and 88% decline in net income) of the worldwide recession on Intel.

nearly two-thirds of Intel's sales were outside the Americas. Intel is responding to the recession by looking to the future and is

increasing capital investments and research and development, while also finding ways to increase productivity and cut costs.

(c) Intel received an unqualified audit opinion. The audit report states that the audit was conducted according to generally accepted auditing standards and the financial statements are in conformity with generally accepted accounting principles. (d) The MD&A for Intel discusses the following items:

1. The company expects the key source of liquidity to be internal cash, cash from operating activities and short-term investments and trade assets. A relatively small amount of cash is generated externally from the sale of stock through employee plans. To date, Intel has not used other external sources of cash, but the company has the potential to borrow on sale securities already registered with the SEC in the total amount of $4.4 billion ($3.0 billion in commercial credit plus $1.4 billion in debt, equity, and other financing sources). 2. No material deficiencies of liquidity currently exist. 3. Intel plans to spend $5.5 billion in 2002 for capital expenditures. Specifics are not given with regard to what the funds will be spent on

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or how the funds will be acquired. It is implied that funds will be internally generated and used to increase capacity for future products. 4. No anticipated changes in the mix and cost of financing resources are discussed. 5. The new FASB accounting rule for goodwill will cause amortization expense to decrease, thereby causing operating income to increase in 2002. 6. See 5 above. 7. Sales decreased 21% overall, caused by a combination of lower volume and lower prices.

(e) Intel appears to be doing a good job positioning themselves for an economic recovery, when, and if, that occurs. The company is largely dependent on the worldwide computing industry. As a result, the main concerns are whether the economy will recover in the near future and whether Intel's customers will have also positioned themselves for a recovery.

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CASE 1.1 THE WALT DISNEY COMPANY

1. The audit committee report gives a good summary of the audit committee's responsibilities and the general topics that the committee reviewed and approved in the prior year; however, the report does not offer any information in depth. Items that a shareholder might want to know more about include

how the committee monitors the preparation of financial reports; how the committee determines the independence of auditors; highlights of the seven meetings in 2001; what significant accounting issues were discussed.

2. The Walt Disney Company paid their external auditor a total of $51,610 million in 2001. Of this amount $8,660 million, or less than 17%, was attributed to audit fees. The remaining 83% of fees paid were for consulting services for financial information systems and process improvements ($36,179 million or 70% of total fees) and other audit-related fees and tax services ($6,771 million or 13% of total fees). It appears there may be two conflict-of-interest concerns. First, the audit firm appears to be directly involved in auditing a financial information system they have helped design. How can this be independent? Second, the consulting fees are much larger than the audit fees, creating a potential conflict in that there may be a pressure to render a clean audit opinion in order to retain the consulting revenues the audit firm is receiving. This information is valuable to the shareholder to assess the independence of the audit firm and to determine how much reliance should be put on the auditors' report. 3. Support of Proposal 1 could be defended using items from the "supporting statement" as well as examples of recent scandals of firms that brought the relationship of the audit firm to the company being audited into question. (Waste Management, Xerox and Enron are just three of many possible examples.) Opposition of Proposal 1 could be defended using the items the Board of Directors offers as well as examples of companies who have not been accused of questionable accounting practices but have used their audit firm for consulting services. Instructor's Note: Before the shareholders even voted on this proposal, it was announced that the Board of Directors had voluntarily decided to not use the same firm for both auditing and consulting services.

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CASE 1.2

CYBERONICS, INC. 1. The Management Discussion and Analysis section provides important information that cannot be found anywhere else in the annual report. The section covers trends, events, and uncertainties in the areas of liquidity, capital resources, and operations. Information should include a discussion of:

a. internal and external sources of liquidity; b. any material deficiencies in liquidity and how they will be remedied; c. commitments for capital expenditures and expected sources of

funding; d. anticipated changes in the mix and cost of financing resources; e. unusual or infrequent transactions which affect income from

continuing operations; f. events which cause material changes in the relationship between costs

and revenues; and g. a breakdown of sales increases into price and volume components.

2. The MD&A includes the following discussion of the seven items outlined in (1) above:

a. External sources are used exclusively to finance the company and have mainly been public and private placements of securities. Cyberonics has also used debt in the form of capital leases. In 2001 the company raised $42.5 million from the sale of common stock in a private equity offering.

b. The company believes that the money raised will last through April 30, 2003. After that time it is unclear if the firm will be able to generate internal or external funds. Many factors will determine if cash will become available, such as future FDA approvals for their products resulting in increased sales, the state of the U.S. capital markets and economy and the health care and medical device environment.

c. Cyberonics has no firm commitments but anticipates spending $4.2 million to expand manufacturing capabilities and to enhance business infrastructure and facilities. It is implied that the funding for these capital expenditures will be from the $42.5 million raised through the common stock offering.

d. No changes to the current mix and cost of financing resources were discussed.

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e. There is no indication of unusual or infrequent transactions occurring in the future, however, in 2001 the company incurred nonrecurring charges of $6.5 million to fend off a take-over by Medtronic, Inc.

f. It appears that there may be many items causing changes in the relationship between costs and revenues in the future. Revenues are dependent on future FDA approvals and Cyberonics does not anticipate approval before 2003, so revenues will most likely remain the same or decrease in 2002. On the other hand, as the company pursues its many clinical studies, costs will probably increase. Cost of sales are predicted to fluctuate, significant increases in selling and general and administrative expenses are expected, and based on the past several years, it is likely that research and development expenses will also increase. Since the company will probably not incur changes in 2002 such as the $6.5 million nonrecurring charges it had in 2001, this should help offset some of the other increased costs. As the company uses the cash raised from the common stock offering, interest income will decrease in the future. Currency exchange rates could cause gains or losses in the future. Overall, it appears that Cyberonics will have less revenues and more expenses in 2002.

g. The sales increase of 15% for the ten-month period ended April 27, 2001 was due to a combination of volume and product mix.

3. Cyberonics clearly explained changes in revenues and expenses as well as the sources of funding for the company. In addition, the company shared their expectations with regard to these items for the near future. 4. Answers will vary based on individual students' reactions to the risks involved in Cyberonics. Lack of FDA approval in the future could cause the worst case scenario -- bankruptcy. On the other hand, if Cyberonics can successfully develop treatments for depression, obesity, Alzheimer's or other disorders, the company's stock prices would increase significantly.

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Chapter 2 2.1 The estimation of the allowance for doubtful accounts affects both the valuation of accounts receivable on the balance sheet and the amount of bad debt expense recognized on the income statement. Changes in the allowance account relative to sales level and the amount of accounts receivable outstanding may be an indication that earnings quality is or is not being improved. For example, if a company expands sales by lowering its credit standards, then the allowance account should also be expanded if a quality earnings figure is to be reflected. 2.2 Inventories are a significant proportion of the asset structure for most firms (service firms are an exception). The inventory accounting method used will impact the valuation of inventories on the balance sheet and also the cost of goods sold expense on the income statement. If the valuation method is not realistic, the ending inventory and earnings figure will be distorted. 2.3 Although LIFO generates a larger cost of goods sold expense and lower earnings in a period of inflation, the tax benefits may outweigh the costs of reporting a lower earnings figure. Use of LIFO reduces a firm's taxable income and, thus, the firm saves in terms of actual cash, not just paper figures. 2.4 The straight-line method of depreciation spreads the expense evenly by periods, while the accelerated methods yield higher depreciation expense in the early years of an asset's life and lower expense in the later years. Use of an accelerated method for tax reporting tends to defer tax liabilities for firms which invest heavily in depreciable assets. For reporting purposes, straight-line depreciation will yield a higher earnings figure in the early years and will also distribute expense recognition smoothly. 2.5 The retained earnings account is the measurement of all undistributed earnings. The account does not represent cash in any way. A company can have positive retained earnings and have a zero cash balance. 2.6 A B C

Inventory Assets 28% 65% 43%

Net Fixed Assets

Total Assets 40% 15% 11%

A is a manufacturer, B is a retailer and C is a wholesaler.

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2.7 (a) January

Total Inventory (Beg. Inv. + P) Cost of Goods Sold Ending Inventory (Tot. Inv. - COGS)

FIFO $30,000

+$14,000 $44,000

8,000 x $3.00

$24,000

$44,000 - $24,000

$20,000

LIFO $30,000

+ $14,000 $44,000

4,000 x $3.50 + 4,000 x $3.00

$26,000

$44,000 - $26,000

$18,000

Ave. Cost

$30,000 + $14,000

$44,000

8,000 x ($44,000 14,000)

$25,120

$44,000 - $25,120

$18,880 Beginning Inventory: 10,000 units or $30,000 Purchases (P): 4,000 units x $3.50/unit = $14,000 Total Inventory (units): 14,000 units Sales (units): 8,000 units February

Total Inventory (E. I. for Jan + P) Cost of Goods SoldEnding Inventory

(Tot. Inv. - COGS)

FIFO

$20,000 + $40,000

$60,000

2,000 x $3.004,000 x $3.50

+ 5,000 x $4.00$40,000

$60,000 - $40,000

$20,000

LIFO $18,000

+ $40,000 $58,000

10,000 x $4.00+ 1,000 x $3.00

$43,000

$58,000 - $43,000

$15,000

Ave. Cost

$18,880 + $40,000

$58,880 11,000 x ($58,880 16,000)

$40,480

$58,880 - $40,480

$18,400 Purchases (P): 5,000 x $4.00 + 5,000 x $4.00 = $40,000 Total Inventory (units): 16,000 units Sales (units): 11,000 units

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March

Total Inventory (E.I. for Feb + P) Cost of Goods Sold Ending Inventory (Tot. Inv. - COGS)

FIFO

$20,000 + $67,000

$87,000

5,000 x $4.006,000 x $4.50

+ 1,000 x $5.00$52,000

$87,000 - $52,000

$35,000

LIFO $15,000

+ $67,000 $82,000

8,000 x $5.00+ 4,000 x $4.50

$58,000

$82,000 - $58,000

$24,000

Ave. Cost

$18,400 + $67,000

$85,400 12,000 x ($85,400 19,000)

$54,000

$85,400 - $54,000

$31,400 Purchases (P): 6,000 x $4.50 + 8,000 x $5.00 = $67,000 Total Inventory (units): 19,000 units Sales (units): 12,000 units Totals FIFO LIFO Average Cost*

Total Cost of Goods Sold

$24,000 40,000

+ 52,000 $116,000

$26,000 43,000

+ 58,000 $127,000

$25,12040,480

+ 54,000$119,600

Ending Inventory $35,000 $24,000 $31,400

End. Inv. + COGS $151,000 $151,000 $151,000

*Average Cost may be calculated by combining all three months but answers must be adjusted, so that COGS + Ending Inventory = $151,000 (b) LIFO produces an understated inventory valuation on the balance sheet but a currently valued cost of goods sold on the income statement, matching current costs with current revenues; FIFO results in a currently valued balance sheet inventory but an understated cost of goods sold expense and thus an overstatement

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of net income; average cost falls in between LIFO and FIFO and is a good choice for companies with volatile inventories. 2.8 $150,000 x 0.14 = $21,000 annual interest $21,000

12 = $1,750 monthly interest

$1,750 x 5 months = $8,750 accrued interest for 5 months (July 31 to December 31) 2.9 Tax Purposes Reporting Purposes Revenue $800,000 $800,000Expenses 550,000 480,000Earnings before Taxes $250,000 $320,000Tax Expense (34%) 85,000 108,800Net Income $165,000 $211,200 Reported Tax Expense $108,800Actual Taxes Paid (85,000)Deferred Tax Liability $23,800 2.10 Treasury stock is shown as a reduction of shareholders' equity. (Most companies use the cost method rather than the par value method to account for treasury stock, so the cost of the treasury stock is deducted.) The number of shares acquired for treasury is deducted from the number of shares outstanding used to compute earnings per share; thus a firm can increase earnings per share by purchasing treasury stock. 2.11 Change from

2000 to 2001 Revenues (9.59%) Total Receivables (38.50%) Allowance for doubtful accounts (79.11%)

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Allowance account as a percentage of receivables:

Allowance for doubtful accounts Net Receivables + Allowance

Percentage of Receivables

2001 $244

$20,183 + $244

1.19%

2000 $1,168 $32,045 + $1,168 3.52%

As revenues have declined at Winnebago Industries, Inc., receivables have also declined. This is an expected pattern, however, it appears that the decline in the allowance account is more than one would expect. The downturn in the economy in 2001 could explain the decline in revenues, but generally it would be expected that the allowance for doubtful accounts would at least remain the same or even possibly increase relative to the receivables account if the economy worsens. The management at Winnebago believe that a higher percentage of receivables will be collected compared to prior years as evidenced by the drop in the allowance/receivables ratio from 3.52% to 1.19%. The analyst would want to explore the reason for this change. If no valid explanation can be found, it is possible that the account has been underestimated in order to increase earnings. 2.12 (a) LIFO is probably used for some or all of Maytag's inventories. Companies using LIFO must disclose the value of those inventories as if FIFO had been used, which Maytag has done in this case. (b) The amount closest to current cost would be the FIFO inventory value, $531,695. Under FIFO, the first goods purchased are assumed sold, so the last goods purchased would be included in the inventory valuation and would have been purchased at amounts closest to current costs.

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2.13 Chester Co.

Balance Sheet at December 31, 20XX

Assets Current Assets Cash $1,500 Accounts receivable 6,200 Inventory 12,400 Prepaid expenses 700 Total Current Assets $20,800 Property, plant and equipment 34,000 Less accumulated depreciation (10,500) Property, plant and equipment, net $23,500 Land held for sale 9,200 Total Assets $53,500 Liabilities and stockholders' equity Current liabilities Accounts payable $4,300 Notes payable 8,700 Accrued interest payable 1,400 Current portion of long-term debt 1,700 Total current liabilities $16,100 Deferred taxes payable 1,600 Bonds payable 14,500 Total liabilities $32,200 Stockholders' equity Common stock 2,500 Additional paid-in capital 7,000 Retained earnings 11,800 Total stockholders' equity 21,300 Total liabilities and stockholders' equity $53,500

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2.14 There is no solution presented here for this exercise, but the authors would welcome students' responses. Some possibilities might include Exhibits 2.3 and 2.4 presented in bar or pie chart format; a diagram showing the cost flow assumptions used to value inventory; a pie chart displaying types of depreciation used for financial reporting; a drawing illustrating a distraught reader trying to understand accounting for deferred federal income taxes. 2.15 There is no solution presented here since a variety of companies may be used for this problem. Assigning a single corporation will allow instructors to review answers in the class as a whole. 2.16 (a) INTEL Common Size Balance Sheet 2001 2000 Assets: Current Assets Cash and equivalents 18% 6% Short-term investments 5 22 Trading assets 3 1 A/R 6 9 Inventories 5 5 Deferred tax assets 2 1 Other current assets 1 -- Total current assets 40% 44% Property, plant and equipment 77 59 Less: accumulated depreciation (36) (28) Property, plant and equipment, net 41% 31% Marketable strategic equity securities -- 4 Other long-term investments 3 4 Goodwill, net 10 10 Acquisition-related intangibles, net 2 2 Other assets 4 5 Total Assets 100% 100%

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2001 2000 Liabilities: Current liabilities Short-term debt 1% 1% A/P 4 5 Accrued compensation and benefits 3 4 Deferred income on shipments 1 1 Accrued advertising 1 2 Other accrued liabilities 3 3 Income taxes payable 2 2 Total current liabilities 15% 18% Long-term debt 2 1 Deferred tax liabilities 2 3 Total liabilities 19% 22% Stockholders' equity Common stock 20 18 Acquisition-related unearned stock compensation -- -- Accumulated. other comprehensive income -- -- Retained earnings 61 60 Total stockholders' equity 81% 78% Total liabilities & stockholders' equity 100% 100% (b) The current assets of Intel include cash, short-term investments, trading assets, accounts receivable, inventories, deferred tax assets and other current assets. Long-term assets are composed of property, plant and equipment, marketable strategic equity securities, long-term investments, goodwill, acquisition-related intangibles and an other assets account. The most significant assets to the company are cash and short-term investments, property, plant and equipment and goodwill. Trading assets and available-for-sale investments are reported at fair value. Non-marketable equity securities are accounted for at historical cost, or, if Intel has significant influence over the investee the equity method is used. Inventories are valued using current average or FIFO. Straight-line depreciation is used for depreciating property, plant and equipment for financial reporting purposes. Other items learned from the notes about asset accounts include information about Intel's many investments, derivative financial statements, a break-down of the inventory account into raw materials, work in process and finished goods, the estimated useful lives of plant and equipment and goodwill and other acquisition-related intangibles.

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The asset structure has shifted somewhat. Intel has reduced current assets (short-term investments and accounts receivable) and invested more heavily in fixed assets. Marketable strategic equity securities and other long-term investments have also been reduced. (c) Allowance account as a percentage of accounts receivable:

Allowance for doubtful accounts Net Receivables + Allowance

Percentage of Receivables

2001 $68

$2,607 + $68

2.54%

2000 $84 $4,129 + $84 1.99%

Change from

2000 to 2001 Sales (21.3%) Total Accounts Receivable (36.5%) Allowance for doubtful accounts (19.0%) As sales have decreased so have accounts receivable and the allowance for doubtful accounts. Intel has been conservative in decreasing the allowance account as evidenced by the increase in percentage of estimated bad debts from 1.99% to 2.54%. This appears reasonable given the economic downturn that occurred in 2001. (d) Intel has the typical liabilities found on most companies' balance sheets: short-term debt, accounts payable, accrued liabilities, deferred income, income taxes payable, long-term debt and deferred tax liabilities. No one liability account is significant. In 2001, only 19% of the capital structure is debt, while 81% is equity. There have been no significant changes to the debt and equity structure. (e) Intel has commitments for operating leases and is committed to pay $610 million in the future (2002 and thereafter). The company has also committed to construct or purchase property, plant and equipment of approximately $1.9 billion. Contingencies include a lawsuit filed by Intergraph Corporation regarding patent rights, other various litigation proceedings and a potential liability for environmental clean-up.

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(f) Deferred taxes are included under current assets and noncurrent liabilities. Depreciation is the most significant component of deferred taxes. (g) Intel has the following equity accounts: Preferred stock, Common stock, Acquisition-related unearned stock compensation, Accumulated other comprehensive income and Retained earnings.

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CASE 2.1 US AIRWAYS, INC.

1.

US Airways, Inc. Common Size Balance Sheet

December 31,

ASSETS 2001 2000Current Assets Cash -- -- Cash equivalents 6% 5% Short-term investments 6 9 Receivables, net 4 4 Receivables from related parties, net 2 1 Materials and supplies, net 2 3 Deferred income taxes -- 5 Prepaid expenses and other 2 2 Total Current Assets 22 29 Property and Equipment Flight equipment 91 73 Ground property and equipment 15 12 Less accumulated depreciation and amortization (49) (33) 57 52 Purchase deposits for flight equipment -- -- Total Property and Equipment 57 52 Other Assets Goodwill, net 7 6 Pension assets 5 4 Other intangibles, net 4 4 Receivable from parent company 1 1 Other assets, net 4 4 Total Other Assets 21 19 100% 100%

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LIABILITIES AND STOCKHOLDER'S EQUITY (DEFICIT) Current Liabilities Current maturities of long-term debt 2 % 3% Accounts payable 8 6 Traffic balances payable and unused tickets 10 10 Accrued aircraft rent 3 4 Accrued salaries, wages and vacation 5 3 Other accrued expenses 9 5 Total Current Liabilities 37 31 Noncurrent Liabilities Long-term debt, net of current maturities 44 30 Accrued aircraft rent 4 2 Deferred gains, net 7 7 Postretirement benefits other than pensions 19 15 Employee benefit liabilities and other 22 20 Total Noncurrent Liabilities 96 74 Commitments and Contingencies Stockholder's Equity (Deficit) Common stock, par value $1 per share, authorized,

1,000 shares, issued and outstanding 1,000shares -- --

Paid-in capital 33 29 Retained earnings (deficit) (36 ) (9) Receivable from parent company (28 ) (25) Accumulated other comprehensive income (loss), net

of income tax effect (2 ) --

Total Stockholder's Equity (Deficit) (33 ) (5) 100 % 100% 2. The asset structure of US Airways has shifted from current to noncurrent assets by 7 percentage points. Short-term investments and deferred taxes have decreased as equipment, goodwill and pension assets have increased as a percentage of total assets. Significant changes have occurred in the debt and equity structure of US Airways. Accounts payable and accrued expenses have caused current liabilities to increase. Long-term debt has grown an alarming 14% from 2000 to 2001. In addition, pensions and postretirement benefits have also increased. It appears that US Airways experienced a significant loss in 2001 as the retained earnings deficit increased by 27%. US Airways has more debt than total assets in both 2000 and 2001.

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3. Investors and creditors would be concerned about both the potential profitability of US Airways and the ability of the firm to generate enough cash to pay the large amounts of debt that will ultimately come due. The most immediate concern is that the current assets of the company have declined and are far less than the current liabilities. How will US Airways be able to pay bills in the next year? Most resources are tied up in property, plant and equipment, items not easily saleable if cash is needed immediately. US Airways' total debt is 133% of total assets, therefore, investors and creditors should be concerned about potential bankruptcy of the firm. 4. Investors and creditors would want to look at all other financial statements, the notes to the financial statements, the management discussion and analysis, the auditor's report and stock price information. SEC documents, Form 10-K, Form 10-Q and Form 8-K reports, would be a good source of both financial and nonfinancial information. Financial information of competitors would be useful for comparison purposes. Nonfinancial information from newspapers and periodicals would also be useful. In particular, investors and creditors would want to determine the prospects of US Airways for the future by researching the following:

current trends in the airline industry; security and terrorism issues affecting airlines; possible funding from the Federal government.

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CASE 2.2 Royal Appliance Mfg. Co.

1. 2001 2000

Accounts Receivable

Total Assets 25.6% 30.4%

Inventories Total Assets

36.2% 32.8%

Account Receivable

Net sales 8.4% 10.3%

Inventories

Net sales 11.9% 11.1%

Accounts receivable relative to total assets and net sales have declined, while inventories have been increasing. It is possible that the downturn in the economy has caused this trend. Fewer customers or customers having financial problems could cause a decline in credit sales, leaving Royal with excess inventory. Another explanation could be that Royal tightened their credit policy, thereby causing fewer credit sales and more inventory left in stock. 2. Allowance account as a percentage of accounts receivable: 2001 2000

Allowance for doubtful accounts Net accounts receivable + allowance

7.7% 3.0%

Percent Changes Change from

2000 to 2001 Net sales 4.9%Total accounts receivable (10.2%) Allowance for doubtful accounts 130.8% The trend in the percentage estimate of doubtful accounts relative to accounts receivable and the pattern of growth rates from sales, accounts receivable and the allowance for doubtful accounts is not normal. The decline in accounts receivable as sales are increasing would indicate a possible tightening of credit policy or

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fewer customers buying on credit. Royal has significantly increased the expected amount of bad debts despite the decline in accounts receivable. Note 7 offers a reason for this unusual pattern. Royal's customers are generally mass market retailers. Some of these customers have been experiencing financial difficulties and some, such as Kmart, have filed for protection from creditors under bankruptcy laws. As a result, Royal's bad debt expenses have increased, which in turn, will lower profits and possibly cash collected. 3. Royal is a manufacturing company and therefore carries three types of inventories: component parts (raw materials), work in process and finished goods. Royal combines component parts and work in process in one inventory account. The company uses the FIFO method. FIFO includes the most recently acquired goods in ending inventory, therefore the amounts for inventories on the balance sheet do reflect current costs. 4. The answer to this question depends on the assumption made about the effect of inflation on Royal. If it is assumed that Royal operates in an inflationary environment, then the company has probably paid more in taxes, since the lower priced goods would be changed to cost of goods sold, increasing income and taxes. If it is assumed that Royal operates in a deflationary environment, then the company has probably realized tax savings, since cost of goods sold would include the higher priced goods, causing income and taxes to be lower. 5. Total property, plant and equipment is the most significant noncurrent asset category to Royal, accounting for 59.9% of total assets. The net property, plant and equipment accounts for 26.8% of total assets. The relative proportions of current and noncurrent asset seem reasonable for an appliance manufacturer. Plant and equipment is necessary for the manufacturing of appliances and compared to Exhibit 2.5 in the "Understanding Financial Statements" text book, 26.8% falls in the range given for a variety of manufacturers. Inventories, the most significant current asset for Royal, also falls in the range of inventories to total asset percentages listed in Exhibit 2.4 of the textbook. 6. Royal's current liabilities include accounts payable, accrued liabilities and current portions of capital lease obligations and notes payable. Noncurrent liabilities include a revolving credit agreement, capital lease obligations and deferred income taxes. Total liabilities relative to total assets have declined by about 5% from 2000 to 2001. This overall change was caused by several significant changes in liability

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accounts. Relative to total assets, the revolving credit agreement declined by almost 11%, however current liabilities increased by 6%. In particular accounts payable, accrued salaries, benefits and payroll taxes and income taxes increased the most. 7. Yes, Royal has both commitments and contingencies. Commitments include operating leases with future minimum lease payments in the amount of $26, 640,000, commitments for future advertising and promotional expense of approximately $3,000,000 and other business commitments of approximately $4,300,000. Since operating leases are a form of off-balance-sheet financing, these are significant when looking at the debt structure of the company. Contingencies Royal has include lawsuits filed by Hoover and Bissell charging patent infringement by Royal, as well as a variety of other claims and litigation. in addition, Royal has filed patent infringement suits against Hoover and Bissell. Should Hoover and/or Bissell prevail on their claims, Royal could experience material adverse effects financially. No information is given to determine the probability of this occurrence. 8. Deferred income taxes appear in two classifications: current assets and noncurrent liabilities. Companies are required by GAAP to report one net current and one net noncurrent amount for deferred taxes based on when the temporary differences will reverse in the future. The two principal sources of timing differences for Royal are warranty and customer returns and basis difference in fixed and intangible assets, i.e., depreciation. The warranty and customer returns have caused an expense deduction for financial reporting purposes but not for tax purposes, causing Royal to pay more in taxes now and creating a deferred tax asset. Depreciation has created a deferred tax liability, because less tax has been paid due to a lower depreciation expense on the tax returns compared to higher depreciation expense for financial reporting purposes. 9. Common shares + Additional paid-in-capital

Number of shares issued

$214,000 + $44,167,000 25,829,452 shares = $1.72 per share

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10. Treasury shares, at cost

Number of Treasury shares = $76,248,000 12,365,700 shares = $6.17 per share

The cost of treasury shares causes the shareholders' equity to be less for Royal. it would be helpful to have information on the reasons why the board of directors has embarked on a repurchase program. Is it merely to increase earnings per share, or does the board believe the stock is truly undervalued? Royal has a significant amount of debt, so the board has made a choice to use cash to repurchase stock instead of paying down debt. The future market value of Royal's stock will help answer the question if this was an appropriate investment decision by the board. Instructor's Note: The market value of Royal's common stock ranged from a low of $3.15 per share to a high of $6.61 per share in 2001. 11.

Beginning retained earnings

+ Net income - Dividends = Ending retained earnings

$61,165 + $9,324 - $0 = $70,489

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Chapter 3 3.1 The multiple-step format provides several intermediate profit measures: gross profit, operating profit, and earnings before income taxes. The single-step format groups revenues together and then deducts all categories to arrive at net earnings. The multiple-step format is the most useful for analysis. 3.2 Depreciation, amortization, and depletion are all methods of allocating the costs of long-lived assets over their service lives. The difference among the three methods is the nature of the assets. Depreciation is used for tangible fixed assets such as buildings, machinery, and equipment. Amortization is used for intangible assets such as patents, copyrights, trademarks, licenses, franchises and capitalized leases. Depletion is used for natural resources such as oil and gas, minerals, and timberlands. 3.3 For a business firm to operate successfully it must spend a minimum amount on operating expenses to be competitive. Allowing operating expenses to grow faster than sales growth, however, may indicate a lack of control over expenses, waste or inefficiencies. Decreasing certain expenses such as advertising, research and development or repairs and maintenance may be detrimental to long-term sales growth. 3.4 The beverage and athletic shoes industries are examples of industries that must advertise regularly or risk losing market share (see example of Coca-Cola and Pepsi in Chapter 1). The pharmaceutical and high technology industries are examples of industries that must do extensive research and development to create new and innovative products. 3.5 The statement of stockholders' equity summarizes the changes in all of the equity accounts, including the retained earnings account. 3.6 The net income figure is based on accounting choices and estimates. The inventory valuation and depreciation methods chosen can vary significantly and impact differently on net income. Discretionary items such as advertising and repairs and maintenance can be manipulated to change the net income of a firm. Use of the equity method for investments may also distort net income. Nonrecurring and nonoperating items are included in net income. Net income also incorporates accounting changes and extraordinary items. Finally, net income does not equal cash flow.

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3.7 2002 to 2003 2001 to 2002 Sales growth 21.0% 62.5% Operating expense growth 22.2% 63.6% 2003 2002 2001 Cost of goods sold 78.8 % 76.9 % 70.8 % Gross profit margin 21.2 23.1 29.2Operating profit margin 11.9 13.8 20.0Average tax rate 42.9 42.6 43.8Net profit margin 6.8 7.9 11.3 Sales growth over the three-year period is strong, but the rate of increase decreased 2002-2003 relative to 2001-2002. Sales growth could be the result of price increases, volume increases, or both. The reduction in the gross profit margin indicates problems with inventory cost controls, the pricing of products, or a combination of these factors. The decrease in the operating profit margin is partly a flow-through from the gross profit margin and the result of increasing operating expenses; operating expenses are increasing at a slightly faster rate than sales. Finally, the combination of problems with inventory management, pricing, and control of operating expenses has produced a deteriorating net profit margin. Tax expense has not been a contributing factor because the average tax rate decreased between 2001 and 2003.

3.8 Using the equation from Chapter 2, the calculations to determine dividends are as follows:

Beginning retained earnings + net income - dividends =Ending retained

earnings 1999 $ 760,115 + 328,528 - 62,355 = 1,026,288 2000 1,026,288 + 200,967 - 55,891 = 1,171,364 2001 1,171,364 + 47,736 - 55,079 = 1,164,021

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3.9 Investment Income Investment Account (a) Cost method $12,500* $500,000 (b) Equity method $62,500** $550,000*** * $50,000 cash dividends x 25% ** $250,000 earnings x 25% *** $500,000 + $62,500 - $12,500 3.10

Coyote Inc. Income Statement for the Year

Net sales $1,833,000 Cost of goods sold 1,072,000 Gross profit 761,000 Selling expenses 279,000 General and administrative expenses 175,000 Depreciation expense 14,000 Operating profit 293,000 Other Income (expense) Interest income 13,000 Interest expense (16,000) Pre-tax income 290,000 Income tax expense 116,000 Net income $174,000

3.11 Compare the following paragraphs, one more descriptive and the other more analytical. Have students assess their own writing as to the extent to which they have analyzed rather than described Elf Corporation's profit performance. Descriptive Paragraph Net income for Elf Corporation increased by $15 million in 2001 and 2000. Sales also improvedby $100 million in 2000, but by only $50 million in 2001. The gross profit margin remained constant over the three-year period at 50%, as did the average tax rate. Administrative expenses remained constant at $100 million. Elf Corporation expended $75 million for advertising and marketing in 1999 and 2000 but reduced these expenditures to $50 million in 2001. Interest expense rose by $20 million in 2000 and 2001.

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Analytical Paragraph Net income for Elf Corporation increased in 2000 and 2001, but at a decreasing rate. Sales also improved both years, but at a decreasing rate. Elf Corporation maintained a 50% gross profit margin, reflecting the firm's ability to control the cost of products sold or to pass along price increases to customers. The increase in the rate of profit was impaired in 1995 by slower sales growth and by continued high interest expense. The rise in interest expense could be due to higher interest rates but probably is evidence of increased corporate borrowing, which could signal problems or be the result of expansion. The $50 million increase in operating profit in 2001 has been achieved by reducing expenditures for advertising and marketing, which could help explain the slower sales growth in 2001 and could impair sales in the future. 3.12 There is no solution presented here since the list of technical projects on the FASB agenda is ever-changing. 3.13 (a) INTEL

Common Size Income Statement

2001 2000 1999 Sales 100.0% 100.0% 100.0% Cost of Sales 50.8 37.5 40.3 Gross Profit 49.2 62.5 59.7 Research and development 14.3 11.6 10.6 Marketing, general and administrative 16.8 15.1 13.2 Amortization 8.8 4.7 1.4

Purchased in-process research and development 0.8 0.3 1.3

Operating income 8.5 30.8 33.2

Gains (losses) on equity securities, net (1.8) 11.1 3.0

Interest and other, net 1.5 2.9 2.0 Income before taxes 8.2 44.8 38.2 Provision for taxes 3.4 13.6 13.3 Net Income 4.8% 31.2% 24.9% Effective tax rate 40.9% 30.4% 34.9% Growth rates 2000 - 2001 1999 - 2000 Net revenues (21.3 %) 14.8% Total operating costs 4.1 % 18.9%

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Analysis of Income Statement Volatility exists with regard to revenues and expenses of Intel, as evidenced by the growth rates of revenues and operating costs from 1999 to 2001. From 1999 to 2000, operating expenses grew faster than revenues which negatively impacted operating profits. In 2001, revenue declined, however, expenses increased and therefore, had a significant negative impact on operating profit. While volatility is undesirable, it is expected in the high-tech industry. The Managements Discussion and Analysis (MDA) states that the revenue decline in 2001 is due to lower volume and lower selling prices of microprocessors. In addition, revenues declined in all other product lines. The worldwide economic slowdown negatively impacted Intel, as well as most companies in the technology industry. The gross profit margin decreased significantly from 1999 to 2001. The MDA also explains why this occurred. Lower selling prices and high fixed costs are the main cause of the decline in gross profit. Positive changes in gross profit in 2000 compared to 1999 were the result of higher demand and higher prices for flash memory, as well as greater volume sales of microprocessors without an increase in fixed costs. Operating profit has declined each year, but the drop in 2001 was huge. All expenses with the exception of purchased research and development have increased each year. In raw dollars, research and development and marketing, general and administrative costs actually decreased; the percentage relative to sales is higher because of the large decline in sales. It is important for Intel to maintain research and development in order to gain a competitive edge in new product development. Intel was able to reduce dollars spent in research and development in 2001 by cutting travel-related expenses. Intel is also expanding through acquisitions to remain competitive in an ever-changing technology environment. Over the past three years Intel has acquired forty other companies and this has significantly increased amortization expense. (See notes to the financial statements.) Marketing, general and administrative costs increased due to the Intel Inside ad campaign, as well as profit-dependent bonus expenses and costs related to acquisitions. However, in 2001, Intel reduced spending on the ad campaign and bonuses. In 2000, Intel achieved abnormally high investment gains. These gains were most likely attributed to a booming economy and stock market in that year. The worldwide economic downturn in 2001 caused Intel to incur losses on investments. Interest income and other, net, increased in 2000, again due to favorable economic conditions and higher returns on investments. This number declined in 2001 as

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interest rates cuts were made by the Federal Reserve Bank. The effective tax rate increased by over 10% in 2001 due to the nondeductibility of acquisition related items. Net profits were healthy in 1999 and 2000, but the bleak year of 2001 caused a significant decline in net profit of over 26%. While it is unlikely Intel will be able to achieve net profit margins of 20% and greater in the near future, it does appear that Intel is positioning themselves to achieve greater revenues. If costs are managed well, profits should trend upward. To continue to be successful, Intel must maintain good control of expenses, while continuing to develop cutting edge products. (b) The common stock account has increased over the three-year period due to the issuance of common stock and assumption of stock options in connection with acquisition and also because of sales of common stock through employee stock plans. Accumulated other comprehensive income increased significantly in 1999, but then declined dramatically in 2000. The cause of both changes was from unrealized gains and losses on available-for-sale investments. The retained earnings account increased overall during the three-year period but declined from 2000 to 2001. Increases were generated largely by net income and decreases to this account included the repurchase and retirement of common stock. It appears that the changes to the accumulated other comprehensive income account may reflect the booming economy in 1999 and then the economic downturn (especially of high technology companies) in 2000 and 2001. Net income was substantially lower in 2001 compared to prior years and the result was a decreasing retained earnings account. Intel is repurchasing and retiring common stock each year. Since the amounts repurchased (305 million shares) are close to the amounts sold (309 million shares) through employee stock plans, it is possible that Intel is trying to mitigate the dilutive effects of issuing stock on earnings per share.

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CASE 3.1 THE WALT DISNEY COMPANY

1. The format of the income statements is neither a multiple-step, nor a single-step format. Virtually all operating expenses are lumped together in one account, making it difficult to assess particular areas of strength or weakness of the Walt Disney Company (Disney). It is impossible to calculate gross profit margin, a ratio that is especially helpful to the investor or creditor. Operating profit margin can be calculated, but the analyst would need to decide which items to include in this calculation. A better presentation would include cost of sales, gross profit and operating profit. It would also be helpful for Disney to break out key operating expenses such as advertising and other selling and general and administrative costs. 2. One way to evaluate the income statement would be to reorder the line items and prepare a common size income statement such as the following:

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The Walt Disney Company Common Size Income Statement

Year Ended September 30,

(in percent) 2001 2000 1999 Revenues 100.00 100.00 100.00 Cost and expenses 85.76 85.22 85.40 Amortization of intangible assets 3.04 4.85 1.95 Restructuring and impairment charges

5.75 0.36 0.73

Operating profit 5.45 9.57 11.92 Gain on sale of businesses 0.09 1.92 1.47 Net interest expense and other (1.65) (1.95) (2.61) Equity in the income of investees 1.19 0.82 (0.54) Income before income taxes, minority interests and the cumulative effect of accounting changes: 5.08 10.36 10.24

Income taxes 4.19 6.32 4.32 Minority interests 0.41 0.42 0.38 Income before the cumulative effect of accounting changes 0.48 3.62 5.54

Cumulative effect of accounting changes:

Film accounting (0.90) -- -- Derivative accounting (0.20) -- -- Net (loss) income (0.62) 3.62 5.54 Effective tax rate 82.54% 61.00% 42.20% 2000-2001 1999-2000 Revenue growth (0.59% ) 8.37% Operating expense growth * 3.94% 11.26% *includes cost and expenses, amortization and restructuring and impairment charges Disney's revenues grew from 1999 to 2000 but then declined in 2001. Since the year-end for the company is September 30, most likely the negative effects on revenue from the terrorist attack on September 11, 2001 will not show up until the 2002 financial reports. Of even more concern is that regardless of revenue growth or decline, operating expenses are growing faster than revenues in all years.

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Costs and expenses overall are stable at around 85%, however, more detail is needed to assess the efficiency of Disney with respect to such items as advertising or general and administrative expenses. Operating profit declines each year, probably due to acquisitions and the corresponding amortization charges, as well as the enormous restructuring and impairment charge in 2001. Disney has made some poor investment decisions in the Internet area and is paying the price in 2001. The write-offs related to the GO.com portal business closure and other investments in the Internet area should be a one-time charge. Income before income taxes, minority interests and special items have followed the same overall trend of operating profit, although in 2000, Disney increased this figure slightly, due to an increase on gains on sale of business combined with lower interest expense and other items. On a positive note, it appears that the equity income is increasing and can be attributed to Disney's investment in Euro Disney. Of course, it is now unknown what the effects of terrorist attacks might have on this investment. Disney's exceedingly high effective tax-rate is explained by the lack of deductibility of amortization expense every year. In 2000 and 2001 Disney also had items related to dispositions and the impairment of intangible assets that caused the tax rate to be large. Cumulative effects of accounting changes negatively impacted net profit margin in 2001. Since these items should be one-time charges, 2002 should not be affected. Net profit margin has been on a downward trend for the same reasons prior earnings figures have declined. Even though the one-time charges will disappear for future years, the impact of the economic downturn and possible future terrorist attacks may continue to put downward pressure on Disney's revenues and earnings in the future. 3. The information in Note 15 is useful in assessing future operations of Disney. Investors and creditors could further evaluate the prospects of the purchase of Fox Family Worldwide by analyzing Foxs prior financial statements and researching the company. Interesting information revealed in Note 15 is that Disney paid $5.2 billion for what appears to be $1.1 billion of assets. Without further information, one can only guess that almost 80% of the purchase price may be goodwill. Obviously the programming commitments mentioned in the note have some value, however, given the economic downturn and recent past history of

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Disney's investment choices, more information is needed to determine if the purchase price paid was more than the value Disney will receive. The Pro Forma Results of Operations are not particularly useful. Their main purpose appears to be for Disney to show users of their financial statements positive net income numbers in a poor year. The GAAP-based income statements reflect the prior poor decisions of management, useful information for any user. A more helpful Pro Forma Results of Operations would have been one under the assumption that Fox Family Worldwide had been a part of Disney in 2001.

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CASE 3.2 MICRON TECHNOLOGY, INC.

1. (a)

Micron Technology, Inc.

Common Size Income Statement (Percent)

2001 2000 1999 Net sales 100.0 100.0 100.0 COGS 97.2 48.9 75.6 Gross margin 2.8 51.1 24.4 Selling, general and administrative 13.3 6.9 10.8 Research and development 12.4 6.7 12.4 Other operating expense (income) 1.9 (0.1) 2.0 Operating income (loss) (24.8

) 37.6 (0.8)

Interest income 3.4 1.8 3.2 Interest expense (0.4) (1.5) (5.0) Gain (loss) on issuance of subsidiary stock (0.1) 0.0 0.1 Other non-operating income (expense) (2.5) 0.2 0.0 Income (loss) before taxes and minority interests (24.4

) 38.1 (2.5)

Income tax (provision) benefit 11.3 (13.1)

1.0

Minority interests in net income (0.2) (0.7) (0.8) Income (loss) from continuing operations (13.3

) 24.3 (2.3)

Loss on discontinued PC operations, net of taxes and minority interest:

Loss from operations of PC business (0.9) (0.7) (0.4) Loss on disposal of PC Operations (1.7) 0.0 0.0 Net loss from discontinued PC Operations (2.6) (0.7) (0.4) Net income (loss) (15.9

) 23.6 (2.7)

(b) 2000-2001 1999-2000Sales growth (38.1% ) 147.1%Operating cost growth* 23.7% 53.0%*Includes Cost of goods sold. 2001 2000 1999 Effective tax rate 46.5% 34.2% 39.0%

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2. Volatility in the high technology industry is evident when looking at the past three years of income statement information for Micron Technology. While Micron realized significant sales growth from 1999 to 2000, operating costs did not increase proportionately and the Company realized substantial earnings growth. However, from 2000 to 2001 sales growth declined significantly while operating costs increased at a hefty rate. Sales growth in 2000 was driven by volume increases. Product shipments increased 50% from 2000 to 2001 but this did not translate into higher sales due to the huge decline in selling prices. According to the management discussion and analysis (MDA), average selling prices declined by 60% to 85% probably due to competitive pressures and a weak economy. The gross profit margin reflects the above-mentioned items. From 1999 to 2000 the large increase in gross profit was most likely due to decreases in manufacturing costs since average selling prices only increased 3% according to the MDA. From 2000 to 2001, the 60% to 85% drop in selling prices caused gross profit margin to decline from 51.1% to 2.8%. Operating profit is dismal with the exception of the year 2000. The percentage figures are skewed each year due to the large increases and decreases in the sales numbers. In raw dollars, selling, general and administrative and research and development costs have increased every year. Given the increase in volume in all years, this is not surprising. Unfortunately the small gross profit generated in 2001 could not possibly cover the necessary operating expenses other than cost of goods sold at Micron. The end result has been a substantial decline in operating profit margin from a positive 36.6% to a negative 24.8%. Net profit margin has followed the same trend as operating profit margin for the same reasons. However, the substantial losses in 2001 have generated positive tax benefits for Micron, resulting in a higher net profit margin relative to operating profit margin. In addition, it is noteworthy that interest expense has dropped each year. One reason for this is the conversion of notes into common stock as mentioned in the notes. Micron has disposed of its PC business. This one-time loss will hopefully be beneficial in the future since these operations had been generating losses every year. Micron will need to further reduce manufacturing costs and/or raise prices if the Company is to be successful. No company can continue to exist long-term with results such as Micron experienced in fiscal year 2001.

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Chapter 4 4.1 (a) I (g) F 4.2 (a) O (g) I (b) F (h) I (b) O (h) F (c) F (i) I (c) F (i) F (d) I (j) F (d) C or I (j) O (e) F (k) I (e) O (k) O (f) F (l) F (f) O (l) C 4.3 Luna Enterprises

Statement of Cash Flows for Year Ending December 31, 20X9

Cash flow from operating activities Net income $1,050 Non-cash operating items: Depreciation 100 1,150 Cash provided (used) by current assets and liabilities: Accounts receivable (550) Inventory 300 Accounts payable 300 Accrued wages payable (100) Net cash provided by operating activities 1,100 Cash flows from investing activities Purchase of plant and equipment (600) Sale of long-term investments 250 Net cash used for investing activities (350) Cash flows from financing activities Decrease in bonds payable (300) Payment of dividends (200) Net cash used by financing activities (500) Increase in cash 250

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4.4 (a) Firm A Firm B Cash flow from operating activities Net income $ 75,000 $ 75,000 Depreciation 10,000 30,000 Deferred taxes 3,000 18,000 Accounts receivable (40,000) (5,000) Inventory (40,000) 10,000 Accounts payable (20,000) (5,000) Cash provided (used) by operations ($ 12,000) $ 123,000 Cash flow from investing activities Purchase of plant, property and equipment ($ 20,000) ($ 70,000) Cash flow from financing activities Short-term debt $ 17,000 $ 2,000 Long-term debt 20,000 (10,000) Dividends paid (5,000) (35,000) Net cash flow from financing activities $ 32,000 ($ 43,000) Change in cash $ 0 $ 10,000 (b) Firm A Firm B Inflows $ % $ %Operating activities 0 0 123,000 98Short-term debt 17,000 46 2,000 2Long-term debt 20,000 54 0 0 37,000 100 125,000 100Outflows Operating activities 12,000 32 0 0Purchase of PP&E 20,000 54 70,000 61Reduction of long-term debt 0 0 10,000 9Dividends paid 5,000 14 35,000 30 37,000 100 115,000 100 Change in cash 0 10,000 Both firms reported net income of $75,000, but, in reality, they had an entirely different operating performance, because Firm B had a strong positive operating cash flow, and Firm A had to borrow to finance operations, the purchase of capital assets, and the payment of dividends. Firm B was able to reduce debt while

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expanding capital assets and paying dividends. This problem illustrates the importance of cash flow as a performance measure.

4.5 Little Bit, Inc. Statement of Cash Flows for Year Ended 12-31-X9

Cash flow from operating activities Net income $ 40,000 Non-cash expenses included in net income: Depreciation 60,000 Deferred income taxes 10,000 Cash provided by (used for) current assets and liabilities Accounts receivable (65,000) Inventory (70,000) Prepaid rent (7,000) Accounts payable 25,000 Accrued salaries payable (9,000) Nonoperating items included in net income: Gain on sale of building (5,000) Net cash used by operating activities ($ 21,000) Cash flows from investing activities Purchase of plant and equipment* (150,000) Sale of building 55,000 Purchase of land (15,000) Net cash used by investing activities ($ 110,000) Cash flows from financing activities Additions to short-term debt 118,000 Additions to long-term debt** 40,000 Reductions of long-term debt (20,000) Sale of common stock 20,000 Dividends paid*** (22,000) Net cash provided by financing activities 136,000 Increase in cash $ 5,000

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*Beginning Property and Equipment $450,000- Building sold 100,000+ Acquisitions 150,000Ending Property and Equipment $500,000 **Beginning long-term debt $190,000+ Additions 40,000- Reductions 20,000Ending long-term debt $210,000 ***Beginning Retained Earnings $157,000+ Net income 40,000- Dividends 22,000Ending Retained Earnings $175,000 Analysis Inflows $ % Sale of equipment 55,000 24 Short-term debt 118,000 51 Long-term debt 40,000 17 Sale of common stock 20,000 8 Total 233,000 100 Outflows Operating activities 21,000 9 Purchase of property and equipment 150,000 66 Purchase of land 15,000 7 Reduction of long-term debt 20,000 8 Dividends paid 22,000 10 Total 228,000 100 Little Bit, Inc. failed to generate cash from operating activities due primarily to growth in inventories and receivables. The firm appears to be expanding, as evidenced also by the increase in capital assets. The expansion is being supported primarily by debt (long-term and short- term debt combined contributed 68% of total cash). It would appear that Little Bit is using short-term debt in part for the acquisition of plant and equipment. Ordinarily, this would not be a good matching of debt

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maturity, with the assets being financed, but it could be justified if short- term interest rates are lower than long-term rates and/or if credit is readily available to Little Bit. It is essential that Little Bit generate cash flow in the future to lessen the need for short-term debt, perhaps by controlling the growth of inventories and receivables. 4.6 (a) Cash provided by operations in 20X8 is considerably less than net income. The major reason is the $288.2 million increase in accounts receivable. Inventory also increased substantially ($159.4 million) but the growth in inventory was comparable to what the firm experienced in 20X7. Additions to plant and equipment were about the same in 20X8 as 20X7, so the increase in receivables appears out of line with overall expansion. Techno may be loosening credit to customers in order to stimulate sales and income (note increase in net income between 20X7 and 20X8), but the result of the receivables management is a sharp reduction in operating cash flow. If the firm continues to build receivables at the same pace, Techno will likely experience negative operating cash flow in 20X9. (b) 20X8 20X7 Inflows $ % $ % Operations 24,525 8.2 177,387 78.1 Investment activities 14,408 4.8 0 0 Short-term borrowings 125,248 41.8 45,067 19.9 Add. to long-term borrowings 135,249 45.2 4,610 2.0 299,430 100.0 227,064 100.0 Outflows Add. to plant and equipment 94,176 49.8 93,136 21.2 Investment activities 0 0 34,771 7.9 Purchase of treasury stock 45,854 24.2 39,267 8.9 Dividends 49,290 26.0 22,523 5.1 Repay long-term borrowings 0 0 250,564 56.9 189,320 100.0 440,361 100.0 Change in cash 110,110 (213,197) In 20X7 Techno generated most of its cash (78%) internally through operations. About 20% came from short-term borrowings, apparently to finance working capital. As the result of a strong operating cash flow and a large cash account balance ($291 million) Techno was able to expand plant and equipment while reducing by $250.5 million its long-term borrowings and to add long-term

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investments. A sharply reduced cash flow from operations in 20X8 (see discussion in "a" above) resulted in the need for heavy long-term and short-term borrowings to support growth in receivables, inventory, and plant and equipment. The apparent use of some long-term borrowing for working capital needs could be a problem in the future. Techno also more than doubled its payment of dividends in spite of the decrease in operating cash flow. Given, however, that Techno ended the year with a cash balance of $188.2 million, the firm does not appear to have any immediate liquidity problems. The analyst would want to explore the cause of the buildup in receivables in 20X8. 4.7 Summary analysis of Motorola Inc. statement of cash flows: Inflows (in millions of dollars) 2001 2000 1999Operations 1,976 0 2,140Proceeds from dispositions of investments and business 4,063 1,433 2,556Proceeds from dispositions of property, plant and equipment 14 174 468Sales of short-term investments 233 345 0Net proceeds from issuance of commercial paper and short-term borrowings 0 3,884 0Net proceeds from issuance of debt 4,167 1,190 501Issuance of preferred stock 0 0 484Issuance of common stock 362 383 544Effect of exchange rate changes 148 0 0 Total Inflows 10,963 7,409 6,693Outflows (in millions of dollars) Operations 0 1,164 0Acquisitions and investments, net 512 1,912 632Capital expenditures 1,321 4,131 2,856Purchases of short-term investments 0 0 496Repayment of commercial paper and short-term borrowings 5,688 0 403Repayment of debt 305 5 47Payment of dividends 356 333 291Effect of exchange rate changes 0 100 33 Total Outflows 8,182 7,645 4,758Net increase (decrease) in cash and cash equivalents 2,781 (236) 1,935

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Inflows (in percent of total) 2001 2000 1999Operations 18.0 0.0 32.0Proceeds from dispositions of investments and business 37.1 19.3 38.2Proceeds from dispositions of property, plant and equipment 0.1 2.3 7.0Sales of short-term investments 2.1 4.7 0.0Net proceeds from issuance of commercial paper and short-term borrowings 0.0 52.4 0.0Net proceeds from issuance of debt 38.0 16.1 7.5Issuance of preferred stock 0.0 0.0 7.2Issuance of common stock 3.3 5.2 8.1Effect of exchange rate changes 1.4 0.0 0.0 Total Inflows 100.0 100.0 100.0Outflows (in percent of total) Operations 0.0 15.2 0.0Acquisitions and investments, net 6.3 25.0 13.3Capital expenditures 16.1 54.0 60.0Purchases of short-term investments 0.0 0.0 10.4Repayment of commercial paper and short-term borrowings 69.5 0.0 8.5Repayment of debt 3.7 0.1 1.0Payment of dividends 4.4 4.4 6.1Effect of exchange rate changes 0.0 1.3 0.7 Total Outflows 100.0 100.0 100.0 Analysis of cash flow from operating activities: Cash flow from operations (CFO) has been erratic over the three-year period from 1999 to 2001 for Motorola. In addition, CFO has not corresponded to changes in net earnings. The company generated more CFO than net earnings in 1999 but then had negative CFO in 2000 despite an increase in net earnings. Motorola generated a net loss in 2001 but was once again able to generate positive CFO in that year. An investigation into the causes of this erratic behavior is warranted. In all three years Motorola added back non-cash charges that included depreciation, amortization and reorganization expenses. These items cause CFO to be higher than net earnings. In 2000 the negative CFO was caused by the large increases in accounts receivable and inventories and payment of current liabilities. In addition, the net earnings in 1999 and 2000 occurred because of gains on sales of investments. Without these gains, Motorola would have generated net losses. In 2001 the company decreased accounts receivable and inventories significantly

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and paid off a large amount of accounts payable and other current liabilities. The enormous reorganization charge is the reason the company was still able to generate cash, however, these expenses will have to be paid in the future. Without the other financial statements and notes it is difficult to assess with certainty what Motorolas strategy is for the future, however, it appears that the company is experiencing difficulty in generating positive operating earnings and is, therefore, reorganizing and disposing of segments of the business. Looking at the other cash inflows and outflows will be helpful in further assessing the situation. Analysis of cash inflows: Since Motorola generated 32% or less of CFO each year, the company had to find alternative sources of financing. Disposing of businesses was a key source each year. If the company was eliminating segments operating at losses, then this will probably benefit the firm in the future. On the other hand, if Motorola is selling profitable segments out of a need for cash, this will be detrimental in the future unless new businesses are developed or acquired to generate revenue and cash. Over 68% of Motorolas cash came from borrowed funds in 2000, the year of negative CFO. Of concern is the heavy reliance on short-term borrowings, which need to be repaid in one year. As a result the company had to reborrow, long-term, in 2001. Analysis of Cash Outflows: In 1999 and 2000, Motorola used the majority of cash for acquisitions, investments and capital expenditures. Hopefully this means the company has chosen to replace dispositions of business segments with more profitable alternatives. In 2001, less was spent in these areas as the firm repaid a significant amount of commercial paper and short-term borrowings. To be successful in the future, Motorola needs to be able to focus on core operations that generate profits. Reorganizations should not continue year after year, and this is a red flag raised in the statement of cash flows. In addition, selling off parts of a business year after year to acquire cash will not continue indefinitely nor is it an appropriate way to survive. Future financial information should be evaluated carefully. 4.8 What follows is a sample article. The article should include the following key points: 1) cash flow from operations is different from net income; 2) a brief explanation of why the two measurements differ; and 3) cash is what is needed to

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stay afloat. A good basis for the article is the example of the "Nocash Corporation" in Chapter 4. Your business may be on its way to bankruptcy even though you are showing a healthy profit. Net income, the bottom line of the income statement, is not the same thing as cash flow from operations. As any business owner knows, it is cash that the firm needs to pay its employees, bankers, and suppliers. Net income is an accounting measurement that doesn't actually show cash coming in from the company's business operations. For example, the company's sales may be growing due to the extension of credit to an increasing number of customers who aren't going to pay their bills. Sales are counted in net income, but the cash may not come in at all. The company may be building inventory that will eventually have to be sold at a loss or not sold at allthat problem affects cash flow but isn't showing up on the income statement yet. If suppliers hear about all these problems, they may quit selling goods to the company on credit, so some of the cash outflow that has been in essence delayed (for accounting purposes in calculating net income) will have to be paid out immediately. To get through this patch, the company may have to borrow to cover the cash shortage, which will require future cash for debt service. If the company doesn't turn things around, the problems will compound, leading to potential disaster. The key to avoiding all of this is to keep a close eye on cash flow from operations as well as net income because that is what the bankers and the suppliers and investors are going to be watching. 4.9 There is no solution presented here as the students will be choosing a variety of internet companies.

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4.10 Intel Statement of Cash Flows

2001 2000 1999

Inflows: $ % $ % $ %Operations 8,654 35 12,827 41 12,134 58Sales and maturity of investment 15,398 61 17,124 55 7,987 38Increase in short-term debt 23 0 138 1 69 0Increase in long-term debt 306 1 77 0 118 1Sale of ESOP 762 3 797 3 543 3Put warrants 0 0 0 0 20 0Total Inflows 25,143 100 30,963 100 20,871 100 Outflows: Increase of property, plant and equipment 7,309 36 6,674 21 3,403 18Acquisitions, net 883 4 2,317 7 2,979 16Purchase of investments 7,141 36 17,188 54 7,055 37Other, investing 260 1 980 3 799 4Decrease in short-term debt 0 0 0 0 0 0Decrease in long-term debt 10 0 46 0 0 0Repurchase of stock 4,008 20 4,007 13 4,612 24Cash dividends 538 3 470 2 366 1Total Outflows 20,149 100 31,682 100 19,214 100 Change in cash 4,994 (719) 1,657 Intel generates much cash from operations (CFO). CFO is larger than net income in all three years. This is mainly due to depreciation and amortization (non-cash expenses). Also in 2001 the decrease in accounts receivable also contributed significantly to the larger CFO relative to net income. The low percentage of cash flow from operations is explained by the purchases and ultimate maturities of investments. In all three years, 96% of cash has been generated from operations or maturities of investments. Neither short-term nor long-term debt has been used significantly to generate cash. Some cash has been generated from the sale of stock to employees. The largest use of cash is to purchase available-for-sale investments. Intel has generated so much cash throughout its history that the company has extra cash to invest until it is needed for acquisitions and capital expenditures.

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The company continues to invest yearly in new property, plant and equipment which is an expected expenditure for this type of firm. It is good that Intel is increasing dollars in this area despite the economic downturn. They are positioning themselves well for when the economy recovers. Intel has also begun acquiring other technology companies to expand into related markets and this is another use of cash. Another use of cash is for the repurchase and retirement of common stock. While this may benefit stockholders in the form of capital appreciation of their stock, one must consider whether this is the best use of excess cash for the company. In addition, Intel has increased the dollar and percentage of cash dividends paid each of the past three years. Intels cash position is solid. The company generates good cash flow from operations and as a result should be able to meet future financing needs easily.

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CASE 4.1 HASBRO, INC.

1. Hasbro

Statement of Cash Flows

2000 % 1999 % 1998 %Inflows: CFO 162,556 14.0 391,512 33.8 126,587 14.4Other investing activities 82,863 7.1 30,793 2.7 16,986 1.9Borrowings > 3 months 912,979 78.7 460,333 39.7 407,377 46.2Short-term borrowings 0 0.0 226,103 19.5 271,895 30.9Stock option/warrant transactions 2,523 0.2 50,358 4.3 58,493 6.6 Total Inflows 1,160,921 100.0 1,159,099 100.0 881,338 100.0 Outflows: Additions to PPE 125,055 9.5 107,468 10.2 141,950 13.3Investments/acquisitions 138,518 10.6 352,417 33.3 667,736 62.7Repayments of borrowings > 3 months 291,779 22.2 308,128 29.2 24,925 2.3Repayments of short-term borrowings 341,522 26.0 0 0.0 0 0.0Purchase of common stock 367,548 28.0 237,532 22.5 178,917 16.8Dividends 42,494 3.2 45,526 4.3 42,277 4.0Exchange rate changes 7,049 0.5 5,617 .5 9,570 0.9 Total Outflows 1,313,965 100.0 1,056,688 100.0 1,065,375 100.0 Change in cash (153,044) 102,411 (184,037) Hasbro's earnings have declined over the past three years and the company is now operating at a loss. Despite this downward trend the company has been able to generate cash from operations (CFO). Increases in accounts receivables, inventories and prepaid expenses in 1998 caused CFO to be far less than net earnings. Substantially more CFO than earnings was generated in 1999 due to the large increase in amortization caused by acquisitions and the large increase in current liabilities. CFO was impressive in 2000 despite the net loss. This was due to the significant decreases in accounts receivables and inventories. In addition, Hasbro was able to pay down a large amount of accounts payable and current liabilities.

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Of concern is the large amount of cash inflows derived from borrowing each year. Short and long-term borrowings have contributed 77.1%, 59.2% and 78.7% of cash inflows in 1998, 1999 and 2000 respectively, while CFO contributed most of the balance. CFO has been large enough over the three year period to cover capital expenditures and dividends, but not enough to cover investment and acquisition activity, debt repayments and the purchase of common stock. It appears that Hasbro made a poor decision in its investment in Hasbro Interactive and Games.com. These investments have probably been partly responsible for not only the decline in earnings, but the increase in debt. The disposition of these operations should help improve financial results in the future. Of greater concern is the use of scarce cash for repurchase of common stock with borrowed funds. The repurchases of common stock in at least 1998 and 1999, and maybe 2000, were probably made when stock prices were fairly high. Given the recent economic downturn it is unlikely there is a financial benefit in the near future of this investment. 2. Hasbro is successful in generating positive CFO and has so far been able to make payments on debt. The disposition of a losing operation should help the company