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MBA Module 2 SM
Module 2
Constructing and Reporting Financial StatementsQUESTIONS
Q2-1.An asset is something that we own that is expected to provide future benefits. A Liability is a current obligation that will require a future sacrifice. Equity is the difference between assets and liabilities. It represents the claims of the companys owners to its income and assets. The following are some examples of each:Assets Cash
Receivables
Inventories
Plant, property and equipment
Liabilities Accounts payable
Accrued liabilities
Notes payable
Long-term debt
Equity Contributed capital (common and preferred stock)
Additional paid-in capital
Earned capital (retained earnings)
Treasury stock
Q2-2.The Revenue Recognition Principle stipulates that revenue should be recorded when it is earned. The Matching Principle tells us that expenses should be recorded when they are incurred. Neither the recognition of revenue nor that of expense necessarily involve the receipt or payment of cash. Revenue are recognized first. Then, the expenses incurred in order to generate those revenues are recognized in the same accounting period. That way, profit is correctly reported (e.g., not overstated nor understated).Q2-3.Accrual accounting entails the recognition of revenue under the Revenue Recognition Principle (record revenues when earned), and the recognition of expenses using the Matching Principle (record expenses when incurred). Q2-4.Transitory items are those that are not expected to reoccur. The objective of financial statement analysis is, generally, to predict future performance. Given that perspective, transitory (nonrecurring) items are not relevant except to the extent that they convey information about future financial performance. Q2-5.The Statement of Stockholders Equity provides information relating to all events which impact stockholders equity during the period. It contains information relating to stock sales and repurchases, dividends and other comprehensive income. Q2-6.The Statement of Cash Flows reports on cash inflows and outflows recognized during the period and categorizes them as operating, investing and financing activities. The income statement reports profit earned under accrual accounting, but does not provide sufficient information concerning cash flows. The Statement of Cash Flows fills that void. Q2-7.Articulation refers to the updating of the balance sheet (retained earnings) to reflect the profit earned during the period less the portion of that profit that is paid out to shareholders in the form of dividends. We can see clearly that all of the financial statements are linked and not separate.Q2-8.When a machine is purchased, its cost is recorded as an asset since it is owned and will provide future benefits. As the machine is used up, a portion of this cost is transferred from the balance sheet and into the income statement as (depreciation) expense. Assets are, thus, reduced (via the increase in accumulated depreciation (a contra-asset that reduces the carrying amount of the asset on the balance sheet), and Equity is reduced as the expense reduces net income and, therefore, Retained Earnings. This is the Matching Principle. It is critical to the proper recognition of profit. If the costs of the machine were expensed rather than capitalized, profit would be reduced considerably in the year of acquisition, and an inaccurately higher level of profit would be recorded in subsequent years as none of the machines cost would be matched against its revenues.
Q2-9.An asset must be owned and it must provide future benefits. Owning means we have title to the asset (some leased assets are also recorded on the balance sheet as we will discuss in our Module 9 entitled, Reporting and Analyzing Off-Balance-Sheet Financing). Future benefits may mean the future inflows of cash. Or, it could relate to some other benefit, like an increase in another asset or reduction of a liability.
Q2-10.Liquidity generally refers to cash. That is, how much cash do we have, how much cash is being generated, and how much cash can we raise quickly. Liquidity is essential to the survival of the business. After all, we can only pay our loans with cash and our employees will only accept cash for their wages.
Q2-11.Current means that the asset will be liquidated (converted to cash) or the liability is expected to be paid within the next year (or the operating cycle if longer than 1 year).
Q2-12.Historical costs are used by accountants because they are less subjective than using market values. Market values can be biased for two reasons: first, we may not be able to measure them accurately (consider our inability to accurately measure the market value of a production facility, for example), and second, managers may intervene in the reporting process to intentionally bias the results in order to achieve a particular objective (like enhancing the stock price).
Q2-13.Generally, unrecorded assets are those that contribute to our sustainable competitive advantage, but that cannot be measured accurately. Some examples include the value of a brand, the management of a company, employee morale, a strong supply chain, credibility with the financial markets, and so forth.
Q2-14.An intangible asset is an asset that we cannot touch. It has to meet the tests of an asset (e.g., we own it, and it will provide future benefits). Intangible assets are always acquired. Internally generated intangible assets are not recorded on the balance sheet. Some examples are goodwill, patents and trademarks, contractual agreements like royalties, leases, and franchise agreements. All of the intangible assets, though not recorded if internally generated, are recorded if purchased, as in an acquisition of another company, for example.
Q2-15.An accrued liability is a liability that generally has arisen without a transaction. Examples include wages that have been earned by employees and not yet paid, interest that has accrued on a bank loan, an environmental liability that has arisen because of our actions, and warranties we have given customers on the products that they have purchased. Generally, when the liability is recognized on the balance sheet, a corresponding expense is recognized in the income statement.
Q2-16.Accrued liabilities are recorded on the face of the balance sheet when they are deemed to be probable and can be estimated. If only one of these criteria is met, they are referenced in the footnotes only, and if neither is met they are not disclosed at all.
Q2-17.Net working capital = current assets current liabilities. Increasing the amount of trade credit (e.g., accounts payable to suppliers) increases current liabilities and reduces net working capital. As trade credit increases, we are using someone elses cash rather than our own. As a business grows, its net working capital grows as the growth of inventories and receivables are generally greater than that of accounts payable and accrued liabilities. Net working capital is an asset category that must be financed just like fixed assets.
Q2-18.Book value is the amount at which an asset (or liability) is carried on the balance sheet. The book value of the company is the sum of the book values of all of its assets and liabilities, that is, its stockholders equity. Book values are determined in accordance with GAAP. Market value is the sale price of an asset or liability. Markets are not constrained by GAAP standards and, therefore, can consider a number of factors that accountants cannot. Market values, therefore, generally differ significantly from book values.
MINI-EXERCISES
M2-19 (15 minutes)
a. Income statement
b. Balance sheet
c. Income statement
d. Balance sheet
e. Income statement
f. Balance sheet
g. Income statement
h. Balance sheet
i. Balance sheet
M2-20 (15 minutes)
a.Balance sheet
b.Income statementc.Balance sheetd.Income statemente.Balance sheetf.Balance sheetg.Balance sheet
h.Balance sheeti.Income statement
j.Income statement
k.Balance sheet
l.Balance sheet
M2-21 (20 minutes)
Net income computationService revenue (record when earned)
$100,000
Wage expense (record when incurred, even if unpaid)
(40,000) ($25,000 + $15,000)
Net income
$ 60,000
Net cash flow computationCash inflow from services rendered
$50,000 ($30,000 + $20,000)
Cash outflow for wages paid
(25,000)
Net cash inflow
$25,000
Cash inflow will be $50,000 less than net income less because only $50,000 of revenues were collected in cash. Cash inflow will be $15,000 more than net income because $15,000 less was spent for expenses than was incurred. The combined effects of these two items (less $50,000 and plus $15,000) yields an overall reduction of $35,000 net income to arrive at cash inflow of $25,000 ($60,000 net income - $35,000 net reduction = $25,000 cash inflows).
M2-22 (15 minutes)
a. A
b. L
c. E
d. A
e. A (referred to as contra asset)f. E
g. E
M2-23 (15 minutes)
20042005
Beginning retained earnings
$143,292$176,893
Add: Net income (loss)
83,601201,347
Less: Dividends
50,000 50,000
Ending retained earnings
$176,893$328,240
M2-24 (10 minutes)Kasznik Corporation
Statement of Retained Earnings
For Year Ended December 31, 2005Retained earnings, December 31, 2004
$100,000
Add: Net income
85,000
Less: Dividends
(30,000)
Retained earnings, December 31, 2005
$155,000
M2-25 (15 minutes)
20042005
Revenues
$350,000$ 0
Expenses
200,000 0
Net income
$150,000$ 0
Explanation: All of the revenue is reported in 2004 when it is earnedper the revenue recognition principle. Likewise, the expense is reported in 2004 when it is incurredper application of the matching principle. The receipt or payment of cash does not affect the recording of revenues, expenses, and net income.
M2-26 (15 minutes)
TransactionBalance SheetIncome Statement
Cash Asset+Noncash Assets=Liabi-lities+Contrib. capital+Retained EarningsRevenues Expenses
a. Issue stock for $1,000 cash1,0001,000(Common stock)
b. Purchase inventory for $500 cash-500500
(Inventory)
c. Sell inventory from b for $2,000 on credit2,000
(Accts Rec)
-500
(Inventory)2,000-5002,000
(Sales)-500
(COGS)
d. Receive $2,000 cash on receivable from c2,000-2,000
(Accts Rec)
EXERCISES
E2-27 (20 minutes)Barth Corporation
Income Statement
For Year Ended December 31, 2005
Sales revenue
$400,000
Expenses
Cost of goods sold
$180,000
Wages expense
40,000
Supplies expense
6,000
Total expenses
226,000
Net income
$174,000
Barth Corporation
Balance Sheet
December 31, 2005
AssetsLiabilities and equity
Cash
$48,000Accounts payable
$ 16,000
Accounts receivable
30,000Bonds payable
200,000
Supplies
3,000Total liabilities
216,000
Inventory
36,000
Land
80,000Common stock
150,000
Equipment
70,000Retained earnings
60,000
Patents
8,000Total equity
210,000
Buildings
151,000
Total assets
$426,000Total liabilities and equity
$426,000
E2-28 (15 minutes)
Income statementBalance sheet
Sales
$30,000Cash
$ 0
Wage expense
12,000Accounts receivable
30,000
Net income (loss)
$18,000Total assets
$30,000
Wages payable
$12,000
Retained earnings
18,000
Total liabilities and equity
$30,000
E2-29 (30 minutes)
Demers Company
Income Statement
For Month Ended March 31
Sales revenue
$18,000($4,000 + $14,000)
Expenses
Rent expense
$3,200
Wage expense
4,800 8,000
Net income
$10,000
E2-30 (15 minutes)
The personal balance sheet will be unique to each individual student.The personal balance sheet will most noticeably differ from those in the Module in the area of equity. That is, the Module presented corporations that involved contributed capital and earned capital accounts. However, a personal balance sheet simply reports owners equity.
E2-31 (15 minutes)Proctor & Gamble ($ millions)AmountClassification
Sales
$ 43,373I
Accumulated depreciation
10,438B
Depreciation expense
1,703I
Retained earnings
11,686B
Net income
5,186I
Property, plant and equipment
13,104B
Selling, general and admin expense
13,009I
Accounts receivable
3,038B
Total liabilities
27,520B
Stockholders' equity
16,186B
E2-32 (15 minutes)
Target Corp ($ millions)AmountClassification
Sales
$ 48,163I
Accumulated depreciation
6,178B
Depreciation expense
1,320I
Retained earnings
9,648B
Net income
1,841I
Property, plant & equipment
16,969B
Selling, general & admin expense
11,534I
Accounts receivable
5,776B
Total liabilities
20,327B
Stockholders' equity
11,065B
E2-33 (15 minutes)
Briggs & Stratton ($ millions)AmountClassification
Sales
$ 1,658I
Accumulated depreciation
506B
Depreciation expense
64I
Retained earnings
821B
Net income
81I
Property, plant & equipment
371B
Selling, general & admin expense
178I
Accounts receivable
202B
Total liabilities
960B
Stockholders' equity
515B
E2-34 (15 minutes)
Kimberly Clark ($ millions)AmountClassification
Sales
14,348I
Accumulated depreciation
6,916B
Depreciation expense
759I
Retained earnings
9,494B
Net income
1,694I
Property, plant & equipment
8,263B
Selling, general & admin expense
2,376I
Accounts receivable
1,955B
Total liabilities
10,014B
Stockholders' equity
6,766B
E2-35 (15 minutes)
YUM Brands ($ millions)AmountClassification
Sales
8,380I
Accumulated depreciation
2,326B
Depreciation expense
401I
Retained earnings
204B
Net income
617I
Property, plant & equipment
3,280B
Selling, general & admin expense
973I
Accounts receivable
169B
Total liabilities
4,500B
Stockholders' equity
1,120B
Exercise 2-36 (15 minutes)
TransactionBalance SheetIncome Statement
Cash Asset+Noncash Assets=Liabi-lities+Contrib capital+Retained EarningsRevenues- Expenses
a. $500 of employee wages are earned but not yet paid+500
(wages payable)-500 - 500
(wage expense)
b. $2,000 of inventory is purchased on credit+2,000
(inventory)+2,000
(accounts payable)
c. The inventory purchase in b is sold for $3,000 on credit+3,000
(accounts receivable)
-2,000
(inventory)+3,000
-2,000+3,000
(sales)
- 2,000
(cost of goods sold)
d. Collected $3,000 cash from the transaction c+3,000-3,000
(accounts receivable)
e. $5,000 of equipment is acquired for cash-5,000+5,000
(Equipment)
f. Record depreciation of $1,000 on equipment from transaction e-1,000
Equipment, net*-1,000 - 1,000
(depreciation expense)
g. Paid $10,000 on a note payable that came due-10,000-10,000
(note payable)
h. Paid $2,000 cash interest on borrowings-2,000-2,000 - 2,000
(interest expense)
*Equipment, net is Equipment, gross less Accumulated Depreciation.
PROBLEMS
P2-37 (20 minutes)
a.
ANFJWN
Total assets
$1,199$4,466
Total expenses (sales net income)
1,4011,503
Total expenses as percent of sales
87.8%
($1,401/$1,596)88.0%
(1,503/$1,708)
b.
ANFJWN
Return on average assets
$195/[($1,199+$995)/2
=17.8%$205/[($4,466+4,096)/2]
=4.8%
c.
ANFJWN
Profit margin$195/$1,596=12.2%$205/$1,708=12.0%
Asset turnover$1,596/[($1,199+$995)/2=1.46$205/[($4,466+4,096)/2]=0.40
Interpretation. Although the net profit margins of the two companies are comparable, JWNs asset turnover rate is markedly less than ANFs and this is the primary reason for its lower return on average assets. P2-38 (30 minutes)a.
3MCurrent AssetsLong-term AssetsTotal AssetsCurrent LiabilitiesLong-term LiabilitiesTotal LiabilitiesStockholders' Equity
1999$6,066 $7,830 $13,896 $3,819 $3,788 $7,607 $6,289
20006,379 8,143 14,522 4,754 3,237 7,991 6,531
20016,296 8,310 14,606 4,509 4,011 8,520 6,086
20026,059 9,270 15,329 4,457 4,879 9,336 5,993
20037,720 9,880 17,600 5,082 4,633 9,715 7,885
b.3Ms current assets most likely include cash, accounts receivable, inventories, and prepaid assets.Its long-term assets most likely include property, plant and equipment (PPE), goodwill, and other intangible assets that have arisen from acquisitions.P2-39 (30 minutes)a.Abercrombie & FitchCurrent AssetsLong-term AssetsTotal AssetsCurrent LiabilitiesLong-term LiabilitiesTotal LiabilitiesStockholders' Equity
2000$300 $158 $ 458 $138 $ 9 $147 $311
2001304 284 588 155 10 165 423
2002405 365 770 163 12 175 595
2003601 394 995 211 34 245 750
2004753 446 1,199 280 48 328 871
b.We might reasonably predict inventories to comprise the bulk of its current assets. In reality, ANFs largest current asset is cash and short-term investmentssuggesting that the company is very liquid. c.In fiscal year 2000, current assets comprised 66% ($300/$458) of total assets. In fiscal year 2004, current assets comprised 63% ($753/$1,199). Thus, the company has slightly less (more) current (long-term) assets as a percentage of total assets than it did 5 years ago.
d.Yes, the company is conservatively financed. Specifically, stockholders equity comprises 73% ($871/$1,199) of its total capitalization.P2-40 (30 minutes)
a.Albertsons Inc.Current AssetsLong-term AssetsTotal AssetsCurrent LiabilitiesLong-term LiabilitiesTotal LiabilitiesStockholders' Equity
2000$4,582 $11,119 $15,701 $4,055 $5,944 $ 9,999 $5,702
20014,300 11,778 16,078 3,395 6,989 10,384 5,694
20024,609 11,358 15,967 3,582 6,470 10,052 5,915
20034,268 10,943 15,211 3,448 6,566 10,014 5,197
20044,419 10,975 15,394 3,685 6,328 10,013 5,381
b. For a grocery chain like Albertsons we would reasonably predict that inventories and cash to be the predominant items in current assets, with minimal receivables. The reality is that is that inventories is not a large dollar amount as the companys business model depends on high inventory turnoverthat is, it works diligently to minimize the quantity of inventory so as to keep it fresh. Long-term assets are primarily concentrated in property, plant and equipment (PPE). c. No, its stockholders equity represents 35% ($5,381/$15,394) of its total capitalization. Although its dependence on debt financing is not extreme, its equity capital does not represent a large proportion of total capitalization relative to many other companies (see P2-39, for example).P2-41 (30 minutes)
a.Harley-Davidson, Inc.Current AssetsLong-term AssetsTotal AssetsCurrent LiabilitiesLong-term LiabilitiesTotal LiabilitiesStockholders' Equity
1999$ 949 $1,163 $2,112 $518 $ 433 $ 951 $1,161
20001,297 1,139 2,436 498 533 1,031 1,405
20011,665 1,453 3,118 716 646 1,362 1,756
20022,067 1,794 3,861 990 638 1,628 2,233
20032,729 2,194 4,923 956 1,009 1,965 2,958
b.Harleys current assets are likely to be comprised of cash, accounts receivable, inventories and prepaid expenses.
Its long-term assets will likely be comprised of property, plant and equipment (PPE) for its manufacturing operations and goodwill and other intangible assets arising from acquisitions.c.Yes, stockholders equity represents 60% of total capitalization and the company utilizes somewhat less debt financing than the average publicly traded company (that being about 50% of equity).P2-42 (30 minutes)
a.Microsoft, Inc.Current AssetsLong-term AssetsTotal AssetsCurrent LiabilitiesLong-term LiabilitiesTotal LiabilitiesStockholders' Equity
1999$20,233 $16,923 $37,156 $ 8,718 $ 0 $ 8,718 $28,438
200030,308 21,842 52,150 9,755 1,027 10,782 41,368
200139,637 19,620 59,257 11,132 836 11,968 47,289
200248,576 19,070 67,646 12,744 2,722 15,466 52,180
200358,973 20,598 79,571 13,974 4,577 18,551 61,020
b.Microsoft has a considerable amount of current assets in marketable securities. In fact, nearly $50 billion of its current assets in 2003 is comprised of marketable securities. The company paid out much of that investment balance as a special dividend and stock repurchase in 2004.c.Microsoft is very conservatively financed with 77% ($61,020/$79,571) of its total capitalization (assets) financed by equity. The high proportion of equity financing is due to Microsofts high level of profitability and consequent retained earnings.P2-43 (30 minutes)
a.Nike, Inc.SalesCost of Goods SoldGross ProfitOperating ExpensesOperating IncomeNonoperating ExpensesNet
Income
1999$ 8,777 $5,295 $3,482 $2,645 $ 837 $386 $451
20008,995 5,216 3,779 2,813 966 387 579
20019,489 5,588 3,901 2,903 998 408 590
20029,893 5,781 4,112 3,060 1,052 389 663
200310,697 6,074 4,623 3,377 1,246 772 474
b.The gross profit percentage (also called gross profit margin) for each year follows:Nike, Inc.Gross Profit Percentage
19990.397
20000.420
20010.411
20020.416
20030.432
Nikes gross profit has fluctuated over this period and it somewhat higher in 2003 than it has been in earlier yearswhich may reflect a slight upward trend.c.Cost of goods sold, wages, and advertising expenses are likely to be the major cost categories for Nike.
P2-44 (30 minutes)
a.Starbucks, Inc.SalesCost of Goods SoldGross ProfitOperating ExpensesOperating IncomeNonoperating ExpensesNet
Income
1999$1,680 $1,336 $344 $187 $157 $ 55 $102
20002,169 1,737 432 240 192 97 95
20012,649 2,082 567 315 252 71 181
20023,289 2,598 691 390 301 86 215
20034,075 3,207 868 482 386 118 268
b.The gross profit percentage (also called gross profit margin) for each year follows:
Starbucks, Inc.Gross Profit Percentage
19990.205
20000.199
20010.214
20020.210
20030.213
SBUX gross profit percentage has been fairly constant, with a possible slightly increasing trend, over the past five years.c.Cost of goods sold, wages, and advertising expenses are likely to be major cost categories for SBUX.
P2-45 (30 minutes)
a.Target CorporationSalesCost of Goods SoldGross ProfitOperating ExpensesOperating IncomeNonoperating ExpensesNet
Income
2000$33,702 $23,029 $10,673 $ 8,344 $2,329 $1,185 $1,144
200136,903 25,295 11,608 9,130 2,478 1,214 1,264
200239,888 27,246 12,642 9,895 2,747 1,379 1,368
200343,917 29,260 14,657 11,393 3,264 1,610 1,654
200448,163 31,790 16,373 12,854 3,519 1,678 1,841
b.The gross profit percentage (also called gross profit margin) for each year follows:
Target CorporationGross Profit Percentage
20000.317
20010.315
20020.317
20030.334
20040.340
TGTs gross profit percentage has increased substantially over the past five years.c.Cost of goods sold, wages, and advertising expenses are likely to be the major cost categories for Target Corporation.
P2-46 (25 minutes)
TransactionBalance SheetIncome Statement
Cash Asset+Noncash Assets=Liabi-lities+Contrib capital+Retained EarningsRevenues- Expenses
a. Received $100,000 cash for common stock and borrowed $50,000 cash+150,000+50,000
Note Payable+100,000
Common Stock
b. Purchased $50,000 of equipment, paying $10,000 cash and $40,000 note payable10,000+50,000
Equipment+40,000
Note Payable
c. $80,000 of inventory is purchased for cash80,000+80,000
Inventory
d. $70,000 of inventory purchased in c is sold for $60,000 in cash sales and $40,000 in credit sales+60,000+40,000
Accounts Receivable
70,000
Inventory+100,000
70,000+100,000
Sales
70,000
Cost ofGoods Sold
e. Paid $10,000 cash for future advertising time10,000+10,000
Prepaid Advertising
f. $7,500 of the advertising time in e is aired7,500
Prepaid Advertising7,500 7,500
Advertising Expense
g. Employees paid $15,000 cash in wages15,00015,000 15,000
Wages
Expense
h. Employees earn $1,000 in wages not yet paid+1,000
Wages
Payable1,000 1,000
Wages
Expense
i. Record depreciation of $2,000 on equipment2,000
Equipment, net*2,000 2,000
Depreciation Expense
Totals+95,000+100,500+91,000+100,000+4,500+100,000 95,500
*Equipment, gross less Accumulated Depreciation.P2-47 (20 minutes)
AniFoods, Inc.
Income Statement
For Month Ended March 31
Sales
$100,000
Cost of goods sold
(70,000)
Gross profit
30,000
Advertising expense
(7,500)
Wage expense
(16,000)
Depreciation expense
(2,000)
Net income
$ 4,500
AniFoods, Inc.
Balance Sheet
March 31
Cash
$ 95,000Wages payable
$ 1,000
Accounts receivable
40,000Note payable (to owner)
50,000
Inventory
10,000Note payable (to vendor)
40,000
Prepaid advertising
2,500Total liabilities
91,000
Equipment, gross
50,000
Accumulated deprec
(2,000)Common stock
100,000
Equipment, net
48,000Retained earnings
4,500
Total assets
$195,500Total liabilities and equity
$195,500
P2-48A (30 minutes)
a.Cash
100,000
Common Stock
100,000
Cash
50,000
Note Payable
50,000
Note: It is also acceptable to record these two entries as one entry.
b.Equipment
50,000
Cash
10,000
Note Payable
40,000
c.Inventory
80,000
Cash
80,000
d.Cash
60,000
Accounts Receivable
40,000
Sales
100,000
Cost of Goods Sold
70,000
Inventory
70,000
e.Prepaid Advertising
10,000
Cash
10,000
f.Advertising Expense
7,500
Prepaid Advertising
7,500
g.Wages Expense
15,000
Cash
15,000
h.Wages Expense
1,000
Wages Payable
1,000
i.Depreciation Expense
2,000
Accumulated Depreciation--Equipment
2,000
P2-49B (20 minutes)
Cash flows from operating activities
Net income
$135,000
Adjustments to reconcile net income to operating cash flow
Depreciation
$25,000
Accounts receivable increase
(10,000)
Prepaid expense decrease
3,000
Accounts payable increase
6,000
Wages payable decrease
(4,000)
Gain on sale of assets
(5,000) 15,000
Net cash provided from operating activities
$150,000
Cambridge Business Publishers, 2006
2Financial Accounting for MBAs, 2nd Edition
Cambridge Business Publishers, 2006
1Solutions Manual, Module 2
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