lib by sample chapter 5

CHAPTER FIVE

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1. Recognize and apply the different financial statement and dis-closure formats used by companies in practice. p. 235

2. Analyze and interpret the return on equity ratio. p. 243

3. Recognize the people involved in the accounting communica-tion process (managers, auditors, information intermediaries,government regulators, and users), their roles in the process,and the guidance they receive from legal and professionalstandards. p. 251

4. Identify the steps in the accounting communication process, including the issuance of press releases, annual reports, quarterly reports, and documents filed with securities commissions, as well as the role of electronic information services in this process. p. 258

5Interpreting andCommunicating AccountingInformation

If you are a skier, you may have visited the Whistler Blackcomb

mountain resort in British Columbia, Panorama in the Canadian

Rockies, Blue Mountain in Ontario, or Tremblant in Québec. You

may have even tried snowboarding at some of these locations.

These mountain resorts have developed into all-season playgrounds that offer a variety of sports activities. What

you may not know is that a number of resorts at these locations and many other locations in Canada, the United

States, and France are owned and operated by Intrawest Corporation.

Intrawest Corporation was formed in the mid-1970s by Joe Houssian as a Vancouver-based real estate

development company. Over time, it evolved into North America’s largest resort real estate company and largest

ski resort operator. Joe’s vision of the company and success in choosing and empowering a superior management

team have resulted in courageous decisions that made Intrawest the leading developer and operator of mountain

resorts across North America. Its destinations feature stylized resort villages with restaurants, retail shops, and

hotels. The company also builds and sells homes and condominiums near its resorts, and has an international

alliance with France’s Compagnie des Alpes, the largest ski company in the world in terms of ski visits.

Intrawest became a public company in 1990 when its shares were listed on the Toronto Stock Exchange. In

preparation for the company’s initial public offering (first issuance of shares to the public, or IPO), its accounting

FOCUS COMPANY:

IntrawestCorporation

COMMUNICATING FINANCIAL

INFORMATION AND

CORPORATE STRATEGY

234 CHAPTER 5 Interpreting and Communicating Accounting Information

staff worked tirelessly with the company’s external auditors and its investment bankersto prepare the detailed financial information necessary for the IPO, in compliance withthe applicable securities regulations in Canada.

In 1995, Intrawest started expanding its operations in the United States by acquiringSnowshoe Mountain in West Virginia in that year and Copper Mountain in Colorado in1996. Access to the U.S. capital markets became important to finance the company’sinvestments in the United States. Hence, in 1997, the company’s shares began tradingon the New York Stock Exchange after meeting the regulatory requirements for listingon that exchange. As a publicly traded company, Intrawest is required to provide morefinancial information than before through regular filings with the Ontario SecuritiesCommission and the Securities and Exchange Commission in the United States.

BUSINESS BACKGROUNDIntrawest’s success formula starts with a resort and then builds an animated village sovisitors stay longer. As more satisfied customers visit the resort more often, they spendmore money and bring their friends. Then Intrawest adds attractions to draw more peo-ple to its destinations. This leads to the expansion of year-round facilities that maxi-mize the use of shops, hotels, convention facilities, and restaurants. As occupancy androom rates climb, so does the demand for resort real estate, which creates a surge inreal estate sales. All of this results in a total resort experience that brings year-rounddestination visitors, increases the company’s revenues, and leads to the development ofmore resorts. Intrawest’s management understands that the company’s financial suc-cess depends on operating actively used resorts that meet the customers’ desire for arange of activities.

Successful companies such as Intrawest learn how to match their financial reportingto their business strategies. Marketing and communication are fundamental to bothstrategies. As Intrawest strives to become a leading integrated leisure company, it con-tinues to seek opportunities to innovate in response to its customers’ needs. Intrawest’sinvestments in new resorts, the results of operating existing resorts, and the company’sfinancial condition are communicated to shareholders, creditors, and other interestedparties through press releases, conference calls with financial analysts, and periodicreporting of financial information. Clear communication with Intrawest’s customers,investors, creditors, and other users of financial statements is essential for the com-pany’s success in implementing its business strategy. The company’s business successmakes Intrawest an excellent example through which we can focus our discussion ofInterpreting and Communicating accounting information.

Chapters 2 through 4 focused on the mechanics of preparing the income statement,balance sheet, statement of retained earnings, and cash flow statement. In this chapter,we discuss the exact statement formats and additional disclosures provided in annualreports and related reports to help you learn how to find relevant information in thesereports. We also focus on the people involved and the sequential process that conveysaccounting information to statement users during a typical year.

CHAPTER 5 Interpreting and Communicating Accounting Information 235

• Players in the AccountingCommunicationProcess

Managers (CEO, CFO,and Accounting Staff)

Auditors

Information Intermediaries:Analysts and Information Services

Government Regulators

• The Disclosure Process

Press Releases

Annual Reports

Quarterly Reports

Reports to SecuritiesCommissions

• A Closer Look at Financial Statement Formats and Notes

Classified Balance Sheet

Classified Income Statement

Statement of Retained Earnings

Cash Flow Statement

Notes to Financial Statements

Voluntary Disclosures

Constraints of AccountingMeasurement

Users: Institutional and Private Investors, Creditors, and Others

Guiding Principles for Communicating Useful Information

ORGANIZATION OF THE CHAPTER

A CLOSER LOOK AT FINANCIAL STATEMENT FORMATS AND NOTESWe have learned in previous chapters that the financial data contained in accountingreports are important factors in decisions made by investors, creditors, and analysts. Tomake financial statements more useful to decision makers, specific classifications ofinformation are included on the statements.

A variety of classifications is used in practice. You should not be confused when younotice different formats used by different companies. You will find that each format isconsistent with the principles discussed in this text. The following is a discussion ofthese classified financial statements.

CLASSIFIED BALANCE SHEETThe June 30, 2001, balance sheet for Intrawest is presented in Exhibit 5.1. First, noticethe title of the statement, Consolidated Balance Sheet. Consolidated means that theaccounts of Intrawest and the accounts of its wholly owned subsidiaries (e.g., WhistlerBlackcomb Resorts Inc.) have been added together through a consolidation processthat results in a single number being reported for each item. (We discuss the consoli-dation process further in Chapter 12.)

Intrawest’s balance sheet is shown in the report format (assets listed first, followedby liabilities and shareholders’ equity accounts); others use an account format (assetson the left side and liabilities and shareholders’ equity on the right side). Like most,Intrawest’s balance sheet is classified. That is, assets and liabilities are listed in a par-ticular order and are separated into current and non-current classifications. As noted inChapter 2, current assets are defined as those that will be turned into cash or expire (beused up) within one year or by the end of the operating cycle, whichever is longer. InChapter 3, we noted that the operating, or cash-to-cash, cycle varies by company and

LEARNING OBJECTIVE 1

Recognize and apply thedifferent financial statement anddisclosure formats used bycompanies in practice.


may be longer than one year. Current liabilities are defined as those obligations thatwill be paid with current assets, normally within one year. Typically a balance sheet isclassified as follows:

A. Assets (by order of liquidity)1. Current assets (short term)

a. Cash and cash equivalentsb. Short-term investments (marketable securities)c. Accounts receivabled. Inventorye. Prepaid expenses (i.e., expenses paid in advance of use)f. Other current assets

2. Non-current assetsa. Long-term investmentsb. Property, plant, and equipment—at cost less accumulated amortizationc. Intangible assetsd. Other (miscellaneous) assets

Total assets

B. Liabilities (by order of time to maturity)1. Current liabilities (short term)

a. Accounts payableb. Accrued expenses payablec. Other short-term liabilities

2. Long-term liabilitiesa. Notes and mortgages payableb. Lease obligationsc. Bonds payabled. Other long-term liabilities

Total liabilities

C. Shareholders’ equity1. Share capital (or capital stock)2. Retained earnings (accumulated earnings that have not been declared as

dividends)a. Total shareholders’ equityb. Total liabilities and shareholders’ equity

It should be emphasized again that each financial statement item is a combinationof a number of accounts used in the company’s accounting system. Under CurrentAssets, Intrawest does not separately report any inventories or prepaid expenses. Anysuch amounts are included in Other Assets in the Current Assets category. Futureincome taxes, depending on the circumstances, can be listed in any of four places onthe balance sheet: as a current asset, current liability, non-current asset, or non-currentliability. The Future Income Taxes account represents the amount of income taxes thatwill most likely be paid or saved in the future, based on differences in the applicationof tax laws and GAAP for recognizing revenues and expenses in the current period. Ifthe amount is an asset (either current or non-current), future tax benefits (reductions)are expected. If the amount is a current or non-current liability, future tax paymentsare expected.

After the Current Assets section, long-term investments are reported. They includeassets that are not used in operating the business. Examples include investments inshares and bonds of other companies. Intrawest does not separately report any long-term investments.

Property, plant, and equipment are often called fixed assets or capital assets. Thisgroup includes tangible (physical) assets that were acquired for use in operating thebusiness rather than for resale as inventory items or held as investments. The assetsincluded are buildings; land on which the buildings sit; and equipment, tools, furni-ture, and fixtures used in operating the business. Property, plant, and equipment, with

the exception of land, are amortized as they are used. As discussed in Chapter 4, theirinitial cost is apportioned to amortization expense over their estimated useful lives.Land is not amortized because it does not wear over time. The amount of amortizationcomputed for each period is reported on the income statement as amortizationexpense. The accumulated amount of amortization expense for all past periods isdeducted from the initial cost of the asset to derive the book value or net book value


EXHIBIT 5.1Balance Sheet of

Intrawest CorporationConsolidated Balance Sheets

June 30, 2001 and 2000(in thousands of U.S. dollars)

2001 2000

AssetsCurrent assets:

Cash and cash equivalents $ 86,430 $ 78,985Amounts receivable (note 7) 82,536 72,233Other assets (note 8[a]) 105,545 78,966Properties (note 6):

Resort 329,177 254,801Discontinued operations — 103

Future income taxes (note 13) 4,168 4,445

607,856 489,533

Ski and resort operations (note 5) 813,741 784,725

Properties (note 6):Resort 371,451 314,481Discontinued operations 7,080 9,521

378,531 324,002

Amounts receivable (note 7) 50,416 35,262

Other assets (note 8[b]) 86,640 67,999

Goodwill 19,128 15,834

$1,956,312 $1,717,355

Liabilities and Shareholders’ EquityCurrent liabilities:

Amounts payable $ 146,464 $ 146,648Deferred revenue (note 10) 81,537 70,832Bank and other indebtedness (note 9):

Resort 201,558 158,144Discontinued operations 82 84

429,641 375,708Bank and other indebtedness (note 9):

Resort 804,912 670,539Discontinued operations 3,363 4,394

808,354 674,933

Due to joint venture partners (note 14) 8,818 16,963Deferred revenue (note 10) 26,750 26,974Future income taxes (note 13) 83,771 82,522Non-controlling interest in subsidiaries 30,616 28,983

1,387,950 1,206,083Shareholders’ equity:

Capital stock (note 12) 414,220 413,719Retained earnings 187,922 131,953Foreign currency translation adjustment (33,780) (34,400)

568,362 511,272

$1,956,312 $1,717,355

REAL WORLD EXCERPT

Intrawest CorporationANNUAL REPORT

reported on the balance sheet (Cost � Accumulated Amortization). To illustrate,assume that Intrawest purchased a new computer system for $23,000. It had an esti-mated useful life of five years and a residual value of $1,000. Amortization expense iscomputed as $22,000 � 5 years � $4,400 per year. If this was the company’s onlyfixed asset, the balance sheets developed during the five-year period would report thefollowing, probably in a note to the financial statements:

20A 20B 20C 20D 20E

Computer system (at cost) $23,000 $23,000 $23,000 $23,000 $23,000

Less: Accumulated amortization 4,400 8,800 13,200 17,600 22,000

Net book value $18,600 $14,200 $ 9,800 $ 5,400 $ 1,000

Intangible assets have no physical existence and have a long life. Their value isderived from the legal rights and privileges that accompany ownership. Examples arepatents, trademarks, copyrights, franchises, and goodwill from purchasing other com-panies. Intangible assets usually are not acquired for resale but are directly related tothe operations of the business. The goodwill that Intrawest reports relates to the pur-chase of a number of companies over the years. As we discussed in Chapter 2,Intrawest’s internally developed intangible assets are not reflected on the balance sheetbecause they do not relate to an identifiable transaction with an external party; onlythose that are material and purchased from others are included. Yet the economic valueof these unrecorded internally developed intangible assets is significant.

Current liabilities are expected to be paid out of the current assets that are convertedto cash, normally within the coming year. Current liabilities include borrowings frombanks and other financial institutions, accounts payable, accrued expenses payable, anddeferred revenue.

Long-term liabilities are a company’s debts that have maturities that extend beyondone year from the balance sheet date. Examples include long-term bank loans, bonds,mortgages, pension liabilities, and lease obligations. At June 30, 2001, Intrawest’s bal-ance sheet showed various types of long-term liabilities that will be covered in futurechapters.

Shareholders’ (Stockholders’) equity represents the residual claim of the owners (i.e.,A � L � SE). This claim results from the initial contributions of the shareholders (sharecapital) plus retained earnings, which is the accumulated earnings of the company lessthe accumulated dividends declared. Retained earnings represents the amount of earningsthat has been left in the company for growth.

Until this chapter, we have identified the financing by investors as share capital. Abroader concept of investing by shareholders is Contributed Capital, which often includestwo components: Share Capital and Contributed Surplus. Share capital reflects the con-tributions for which shareholders receive shares of the corporation’s equity capital. Con-tributed surplus refers to the net result of all other types of capital transactions. The 2001edition of Financial Reporting in Canada indicates that approximately 30 percent of the200 companies surveyed had disclosed contributed surplus in their 2000 financial state-ments.1 Intrawest does not have a contributed surplus component in its shareholders’equity, but it included a foreign currency translation adjustment reflecting the exchangegains or losses arising from Intrawest’s ownership of some of the companies that operateoutside Canada. This topic is discussed in advanced accounting courses.

In note 11 to its financial statements, Intrawest provides details of the type of shares itis authorized to issue and the number of shares that have been issued to shareholders asat the end of its fiscal year. Intrawest is authorized to issue 200 million common shares,


1C. Byrd, I. Chen, and H. Chapman, Financial Reporting in Canada 2001. Toronto: CICA, 2001, p. 340.

50 million non-resort preferred shares, and 20 million preferred shares. By June 30,2001, the company had issued 44,026,394 common shares and 5,513,936 non-resort pre-ferred shares to various shareholders and employees. No preferred shares have ever beenissued, however. Additional discussion about the characteristics of these types of sharesand accounting and reporting issues for shareholders’ equity is presented in Chapter 11.


FINANCIAL ANALYSISBALANCE SHEET RATIOS AND DEBT CONTRACTS

When firms borrow money, they agree to make specific payments of interest and principal in the

future. To provide protection for the creditors, they also often agree to other restrictions on their

activities. For example, Intrawest has issued long-term notes for $125 million payable in the year

2010, along with semi-annual interest payments.The agreement between the company and the

creditors puts some limitations on the company’s issuance of additional debt and the payment of

dividends to shareholders. Other types of debt contracts require companies to maintain a mini-

mum specified current ratio and debt-to-equity ratio, which are defined as follows:

Current Ratio � Debt-to-Equity Ratio �

Maintaining a specified level of the current ratio assures creditors that the company has

sufficient liquidity (liquid assets, after the payment of other current liabilities) to pay its current

debts. The current ratio is discussed in more detail in Chapter 9. The debt-to-equity ratio mea-

sures the portion of the company that is financed with debt as opposed to equity. By limiting

the debt-to-equity ratio, the company agrees to limit the amount of its additional borrowing,

which limits additional demands by these new creditors on the company’s cash. The debt-to-

equity ratio is discussed in more detail in Chapter 10.

Total Liabilities

Shareholders’ EquityCurrent Assets

Current Liabilities

SELF-STUDY QUIZ 5-1Refer to the balance sheet of Intrawest Corporation presented in Exhibit 5.1. Assume that the debtIntrawest owes to the bank is based on an agreement specifying that Intrawest should maintain aminimum current ratio of 1.20 and a maximum debt-to-equity ratio of 2.50.

1. Compute the current ratio and the debt-to-equity ratio at June 30, 2000, and June 30, 2001, toverify if Intrawest violated these conditions of its lending agreement with the bank.

2. Should the company’s management be concerned about the level of these two ratios? Explain.

After you complete the quiz, check your answers with those on page 264.

CLASSIFIED INCOME STATEMENTIntrawest’s 2001 consolidated income statement is reprinted in Exhibit 5.2.2 Othercommon titles include statement of earnings and statement of operations. Incomestatements have up to four major sections:

1. Results of continuing operations.

2. Results of discontinued operations.

3. Extraordinary items.

Net income (sum of 1, 2, and 3)

4. Earnings per share.

2Of the 200 companies surveyed in Financial Reporting in Canada, 2001, 55 companies used the titleIncome Statement, 86 used Statement of Earnings, 41 used Statement of Operations, and 18 used othertitles in their 2000 annual reports. C. Byrd, I. Chen, and H. Chapman, Financial Reporting in Canada2001. Toronto: CICA, 2001, p. 101.

The income statements of all companies have sections 1 (continuing operations) and4 (earnings per share). Some companies report information in sections 2 and/or 3,depending on their particular circumstances. The amounts that are reported for sections1, 2, and 3 are summed to equal the bottom line, Net Income. We first focus on the mostcommon and important section, Continuing Operations.

Continuing Operations This first section of an income statement presents theresults of continuing operations. This section can be presented using one of two com-mon formats:

1. The single-step format, or

2. The multiple-step format, with cost of goods sold deducted from sales to showgross margin (or gross profit) as a subtotal. Other operating expenses are thendeducted to show operating income as a second subtotal.


EXHIBIT 5.2Income Statement of Intrawest Corporation

Consolidated Statements of OperationsFor the years ended June 30, 2001 and 2000

(in thousands of U.S. dollars, except per share amounts)

2001 2000

Revenue:Ski and resort operations $492,202 $447,350Real estate sales 415,336 341,455Rental properties 8,935 6 ,905Interest and other income 3,547 12,449Income from equity accounted investment 2,790 2,333

922,810 810,492

Expenses:Ski and resort operations $383,864 $353,662Real estate costs 338,856 281,845Rental properties 4,426 3,641Interest (note 16) 44,490 35,217Depreciation and amortization 57,934 51,399Corporate general and administrative 9,793 7,985

839,363 733,749

Income before undernoted 83,447 76,743

Provision for income taxes (note 13) 10,014 15,394

Income before non-controlling interest and discontinued operations 73,433 61,349

Non-controlling interest 9,904 9,258

Income from continuing operations 63,529 52,091

Results of discontinued operations (note 4) (2,942) (99)

Net income $ 60,587 $ 51,992

Income per common share:Income from continuing operations $ 1.45 $ 1.20Net income 1.45 1.20

Weighted average number of common sharesoutstanding (in thousands) 43,665 43,362

See accompanying notes to consolidated financial statements.

REAL WORLD EXCERPT


Intrawest’s income statement follows the single-step format in which all revenue,income, and gains are listed first, and then all expenses and losses are subtracted.Only one company in a recent survey of 200 companies used the single-stepapproach.3 A multiple-step income statement would show a subtotal for gross profitand a subtotal for operating income from continuing operations before adding otherincome and gains or subtracting expenses and losses. In Exhibit 5.3, we reorder theaccounts in Intrawest’s income statement to show you how the same data for fiscalyear 2001 would be displayed using the multiple-step format. Some companies alsouse a hybrid approach in which only one subtotal for operating income is presented.

No difference exists in the individual revenue, expense, gain, and loss itemsreported using the different formats. The differences relate only to the use of categoriesand subtotals, such as Gross Profit and Operating Income from Continuing Operations,which are highlighted by shading in Exhibit 5.3. Note that, regardless of format, nearlyall companies separate income tax expense (provision for income taxes) from otherexpenses and report a subtotal before listing the income tax expense.

Cost of goods sold or cost of sales is the cost of inventory sold by a merchandiser (acompany that buys products from manufacturers for resale) or a manufacturer (a com-pany that produces goods for sale to wholesalers or retail merchandisers). Any inven-tory that is purchased or produced but not sold during the period is included in theinventory on the balance sheet. We will present additional discussion of accounting forsales and cost of goods sold for merchandising and manufacturing companies in Chap-ters 6 and 7.

Gross profit (gross margin) is a subtotal, not an account. It is the differencebetween sales revenue and the cost of sales. Given that Intrawest is a developer and


Single Step Multiple Step

Revenue: Revenue:Ski and resort operations $492,202 Ski and resort operations $492,202Real estate sales 415,336 Real estate sales 415,336Rental properties 8,935 Rental properties 8,935Interest and other income 3,547 916,473Interest and equity accounted Cost of revenue:

investment 2,790 Ski and resort operations 383,864Total revenues 922,810 Real estate sales 338,856

Rental properties 4,426Expenses: 727,146

Ski and resort operations 383,864 Gross profit 189,327Real estate sales 338,856 Depreciation and amortization 57,934Rental properties 4,426 Corporate general andInterest 44,490 administrative 9,793Depreciation and amortization 57,934 Operating income fromCorporate general and continuing operations 121,600

administrative 9,793 Non-operating income (expense):Total expenses 839,363 Interest and other income 3,547

Interest from equity accountedinvestment 2,790

Interest expense (44,490)Income before the undernoted 83,447 Income before the undernoted 83,447Provision for income taxes 10,014 Provision for income taxes 10,014Income before non-controlling interest Income before non-controlling interest

and discontinued operations 73,443 and discontinued operations 73,443Non-controlling interest 9,904 Non-controlling interest 9,904Income from continuing operations 63,529 Income from continuing operations 63,529Results of discontinued operations (2,942) Results of discontinued operations (2,942)Net income 60,587 Net income 60,587

3C. Byrd, I. Chen, and H. Chapman, Financial Reporting in Canada 2001. Toronto: CICA, 2001, p. 100.

EXHIBIT 5.3Alternative Income StatementFormats for Results ofContinuing Operations

GROSS PROFIT (GROSSMARGIN) is sales revenue lesscost of sales.

operator of village-centred resorts, which are primarily service activities, the notion ofgross profit is not as applicable to service-oriented companies as it is for merchandis-ing or manufacturing companies. In Exhibit 5.4, we show a much simpler incomestatement of Danier Leather Inc., a leading designer, manufacturer, and retailer of high-quality fashion leather and suede apparel.


Consolidated Statements of EarningsFor the years ended June 30, 2001 and 2000

(thousands of dollars, except per share amounts)

For the Years EndedJune 30, 2001 June 30, 2000

(53 weeks) (52 weeks)

Revenue $165,418 $143,011Cost of sales (Note 7) 82,818 69,865

Gross profit 82,600 73,146Selling, general and administrative expenses (Note 7) 60,902 54,051

Earnings before interest and income taxes 21,698 19,095Interest expense—net 583 33

Earnings before income taxes 21,115 19,062

Provision for income taxes (Note 8)Current 9,090 8,166Future (53) 186

9,037 8,352

Net earnings $12,078 $10,710

Net earnings per share (Notes 1[i] & 9)Basic $1.75 $1.48Fully diluted $1.73 $1.48

REAL WORLD EXCERPT

Danier Leather Inc.ANNUAL REPORT

INCOME FROMCONTINUINGOPERATIONS (OPERATINGINCOME) equals net sales lesscost of goods sold and otheroperating expenses.

INCOME BEFORE INCOMETAXES (PRETAXEARNINGS) is revenues minusall expenses except income taxexpense.

DISCONTINUEDOPERATIONS result from thedisposal of a major segment ofthe business and are reportednet of income tax effects.

EXHIBIT 5.4Income Statement

Operating expenses are the usual expenses incurred in operating a business duringan accounting period. The specific expense and revenue categories reported by compa-nies depend on the nature of each company and industry. Significant unusual or infre-quently occurring items are also often reported separately. Another subtotal—Income from Continuing Operations (also called Operating Income)—is computedafter subtracting operating expenses from gross profit.

Non-operating (other) items are income, expenses, gains, and losses that do not resultfrom the central operations of the business but are not unusual or infrequent in nature.Examples are interest income, interest expense, and gains and losses on the sale of fixedassets. Interest expense on debt is sometimes combined (netted) with interest revenue sothat only a single amount is reported. These non-operating items are added to or sub-tracted from income from operations to obtain Income before Income Taxes, which isalso called Pretax Earnings. In Intrawest’s case, the difference between operatingincome and non-operating items is labelled Income before the Undernoted because addi-tional items are deducted from this subtotal. Non-controlling interest is explained inChapter 12, and the results of discontinued operations are discussed later in this section.

Discontinued Operations Any company that plans to dispose of a major segmentof its business or customer line needs to present separate information on the incomestatement, accompanied by disposal details written in a note. Discontinued operationscan result from abandoning or selling the major segment. Any operating income gen-erated by the discontinued segment is disclosed separately from any gain or loss onthe disposal (the difference between the book value of the net assets being disposed ofand the sale price or the abandonment costs). The disclosure of each can be in a note oron the face of the income statement. Each line is to be reported net of the income tax


Complete the following tabulation, indicating the sign (� for increase, � for decrease, and NE for noeffect) and amount of the effect of each transaction. Consider each item independently.

a. Recorded and paid rent expense of $200.

b. Recorded the sale of goods on account for $400 and cost of goods sold of $300.

Income from Transaction Current Assets Gross Profit Operations

a.

b.

After you complete your work, check your solution with the answer on page 264.

SELF-STUDY QUIZ 5-2

effects. Separate reporting informs users that these results of discontinued operationsare less useful as predictors of the company’s future profitability.

In 1997, Intrawest Corporation decided to separate its non-resort operations from itsresort operations and to dispose of its non-resort assets in an orderly manner. For theyear ended June 30, 2001, these discontinued operations resulted in a loss of $2,942,000as reported in the company’s income statement in Exhibit 5.2. The company includeddetails of the discontinued operations in a note to its financial statements.

Extraordinary Items Extraordinary items are gains or losses incurred by the com-pany that are considered unusual in nature, infrequent in occurrence, and not dependentprimarily on decisions by management or owners. Examples include losses sufferedfrom natural disasters such as floods and hurricanes in geographic areas where such dis-asters rarely occur. These items must be reported separately on the income statement netof income tax effects. Separate reporting informs decision makers that the items are notlikely to recur and for that reason are less relevant to predicting the company’s future.Note disclosure is needed to explain the nature of the extraordinary item.

RETURN ON EQUITY ANALYSISEvaluating company performance is the primary goal of financial statement analysis.Company managers, as well as competitors, use financial statements to better under-stand and evaluate a company’s business strategy. Analysts, investors, and creditors usethese same statements to evaluate performance as part of their stock valuation andcredit evaluation judgements. Our discussion of the financial data contained inaccounting reports has now reached the point where we can evaluate the performanceof the company in relation to the investment made by shareholders.

RETURN ON EQUITYKnow the decision question:

How well has management used the investment by shareholders’ during the period? The return onequity (ROE) ratio helps in answering this question. It is computed as follows:

Return on Equity �

*Average Shareholders’ Equity � (Beginning Shareholders’ Equity � Ending Shareholders’ Equity) � 2

Net IncomeAverage Shareholders’ Equity*

KEY RATIO ANALYSIS:

EXTRAORDINARY ITEMSare gains and losses that areunusual in nature, infrequent inoccurrence, and not dependenton decisions by management orowners. They are reported net oftax on the income statement.


Analyze and interpret the returnon equity ratio.


The 2001 ratio for Intrawest is:

� 0.112 (11.2%)

Examine the ratio using two techniques:

1 Comparisons over Time 2 Comparisons with Competitors

Vail CompagnieIntrawest Resorts des Alpes

1999 2000 2001 2001 2001

7.1% 9.9% 11.2% 3.7% 9.4%

You interpret the results carefully:

IN GENERAL → ROE measures how much the firm earned for each dollar of shareholders’investment. In the long run, firms with higher ROE are expected to have higher stock prices thanfirms with lower ROE, all other things equal. Managers, analysts, and creditors use this ratio toassess the effectiveness of the company’s overall business strategy (its operating, investing, andfinancing strategies).

FOCUS COMPANY ANALYSIS → The preceding computation indicates that Intrawest’s ROEhas increased significantly during the past three years. This is consistent with the company’s keyfinancial objectives of maintaining an earnings growth rate of 20 percent per year, to increaseresort operation revenues and profit margins as villages are built out, and to leverage third-partycapital to carry out business opportunities. Intrawest performed significantly better than VailResorts, North America’s second-ranking ski resort operator, which operates resorts mainly inColorado and Wyoming. Intrawest also outperformed the Compagnie des Alpes, one of thelargest ski-lift operators in Europe, which operates ski resorts in the French and Italian Alps. Theperformance of the Compagnie des Alpes contributed positively to Intrawest’s performance, asIntrawest owns nearly 17 percent of the equity of that company.

A FEW CAUTIONS: An increasing ROE can also indicate that a manufacturing company is fail-ing to invest in research and development or modernization of plant and equipment. While sucha strategy will decrease expenses and thus increase ROE in the short run, it normally results infuture declines in ROE as the company’s products and plant and equipment reach the end oftheir life cycles. As a consequence, experienced decision makers evaluate ROE in the context ofa company’s business strategy.

More detailed analysis of ROE and its relationship to other financial ratios are covered in Chapter 14.

$60,587($568,362 � $511,272) � 2

FINANCIAL ANALYSISACCOUNTING-BASED EXECUTIVE BONUSES

Many companies believe that good performance by executives can be motivated by tying their

compensation to the financial performance of the company. The basic idea is to link the com-

pensation of executives to a measure of income. As a result, the financial interests and moti-

vations of the management team become aligned with those of the company’s shareholders.

Details of a company’s executive compensation are disclosed in the Information Circular or

Management Proxy Circular that is forwarded to shareholders prior to the Aannual Ggeneral

Mmeeting of the corporation’s shareholders.

The annual compensation of key executives consists typically of three components: a base

salary, a bonus, and other compensation. The bonus is usually based on achieving a


predetermined level of performance. For example, Gildan Activewear Inc., the focus company

of Chapter 6, pays its executives a bonus if the actual net earnings exceed the forecasted net

earnings for the year and the actual return on equity exceeds the forecasted return on equity

by 5 percent. For a recent fiscal year, the five executive officers earned $1,621,000 in salaries

and $2,656,000 in bonuses. (Source: Gildan Activewear Inc., Management Proxy Circular,

December 11, 2000, p. 14.)

The connection between performance-based compensation and income measures pro-

vides managers with an incentive to adopt accounting policies that increase the reported

income measures. As reported net income goes up, compensation to the company’s execu-

tives will also increase. Some skceptics also believe that performance-based pay that is tied

to the financial statements gives managers an incentive to distort the amounts reported in the

financial statements in order to increase their total compensation.

SELF-STUDY QUIZ 5-3Assume that Intrawest’s executives receive bonuses if the current year’s net income exceeds theprevious year’s net income by 20 percent. Use Exhibit 5.2 to check whether Intrawest’s executivesearned any bonuses in fiscal year 2001.

Computations __________________________________________________________________

______________________________________________________________________________

Discuss why Intrawest might choose to pay executives based on performance and why it uses thesame accounting numbers in reports to shareholders to measure the executives’ performance.

______________________________________________________________________________

After you complete your work, check your solution with the answer on page 264.

FINANCIAL ANALYSIS

DIFFERENT EARNINGS FOR DIFFERENT PURPOSES

During the high-tech stock market boom of the late 1990s many technology- and Internet-

based companies, started using the term pro forma earnings in addition to net income. The

reported pro forma earnings were always positive and relatively large compared to net income

(or loss). Companies reported these earnings in order to divert investors’ attention away from

the financial results of continuing operations. So how do pro forma earnings differ from net

income? These pro forma earnings often exclude costs that relate to acquisitions of other

companies, non-cash compensation of key executives, research and development, and spe-

cial one-time charges. Companies like Nortel Networks Corp., JDS Uniphase Corp., Cisco

Systems Inc., and Amazon.com Inc. made frequent use of pro forma earnings presentations.

The problems arising from using pro forma earnings for investment decisions is highlighted

below using the amounts reported by Nortel Networks Corp. in the past few years (in millions

of U.S. dollars):

1998 1999 2000 2001

Revenue $17,575 $22,217 $30,275 $17,511

Pro forma earnings 1,065 1,725 2,307 (4,512)

Net earnings (569) (197) (3,470) (27,302)

Nortel’s management focused analysts’ and investors’ attention on pro forma earnings,

which helped Nortel’s stock price reach its peak of $123 in March 2000. In contrast, net earn-

ings calculated in accordance with GAAP showed significant losses when compared to the pro

forma earnings.

Finally, we come to “the bottom line,” Net Income. An income statement is notcomplete, however, without including earnings per share information for corporations.

Earnings per Share As we discussed in Chapter 4, simple computations for earn-ings per share (EPS) are as follows:

EPS �

Intrawest discloses this amount as illustrated in Exhibit 5.2 (called basic EPS). Anycompany that has a complex capital structure (that is, stock options or debt or equitysecurities convertible into common shares) must also compute the effect of these itemsas if they had been converted at the beginning of the period, or when initially issued ifduring the current reporting period (called diluted EPS). The computation of theseamounts is beyond the scope of this textbook and is usually presented in advancedcoursework for accounting majors. Any company that discloses discontinued opera-tions or extraordinary items also must display these effects on a per share basis.

A Note on Taxes One of the features of the first three sections of the income state-ment is that each section shows the amount of income tax expense related to that sec-tion. This is known as intraperiod income tax allocation. Items presented aftercontinuing operations are reported net of the tax effect. For example, an extraordinaryloss of $1,000 is reported as $600 ($1,000 � $400, tax effect based on a tax rate of 40 percent).

Before income from continuing operations is computed, the provision (expense) forincome taxes is calculated and subtracted. For Intrawest, income tax expense is approx-imately 20 percent of pretax income. Income taxes are payable each year (part inadvance in monthly or quarterly estimates).

STATEMENT OF RETAINED EARNINGSThe statement of retained earnings reports the changes in retained earnings during theaccounting period, as indicated in Chapter 1. Two main components of this statementthat affect the balance of retained earnings are net income, which increases retainedearnings, and dividends, which reduce it. Exhibit 5.5 shows that net income of $60,587was added to the balance of retained earnings at the beginning of fiscal year 2001 andthat dividends of $4,618 were deducted. The various types of dividends that can bedeclared by a company are discussed in more detail in Chapter 11.

Occasionally, the statement of retained earnings would include other components,such as the net effect of errors made in prior periods, the cumulative effects of changes

Net Income Available to Common ShareholdersWeighted-Average Number of Shares Outstanding

During the Reporting Period


Securities regulators in the United States (SEC) and Canada (OSC) warned companies

that pro forma earnings represent a departure from GAAP and started to take action against

companies that abused the use of pro forma earnings in order to protect the companies’

shareholders and the investing public.4 But as one issue is resolved, another issue pops up.

The most recent income reporting issue relates to the banking industry. Canadian banks have

disclosed a measure of cash instead of net income in order to attract investors’ attention. Time

will tell if this non-GAAP measure of financial performance is an improvement over net

income.

4For further discussion of pro forma earnings, see A. Rosen, “To make lemonade just add confusion:Companies rush to report earnings minus some costs,” National Post (Financial Post), July 25, 2000,pp. D1, D2; S. Maich, “How many ways are there to say the word earnings?” National Post (FinancialPost), March 26, 2002, p. IN3; M. Lewis, “Pro forma lingo,” CA Magazine, March 2002, pp. 16–24.

in accounting methods, and the effect of transactions related to the repurchase and can-cellation of shares issued by the company.

CASH FLOW STATEMENTWe have introduced the cash flow statement classifications in prior chapters. They arethe following:

Cash Flows from Operating Activities. This section reports cash flows associatedwith earning income.

Cash Flows from Investing Activities. Cash flows in this section are associated withbuying and selling productive assets (other than inventory) and investments in othercompanies.

Cash Flows from Financing Activities. These cash flows are related to financing thebusiness through debt, issuance of shares, and payment of debts or repurchases ofshares.

Intrawest’s consolidated cash flow statement for the year ended June 30, 2001, ispresented in Exhibit 5.6. The cash flows from operations can be calculated using eitherthe direct or indirect method. For Intrawest, the first section (Cash Flows from Oper-ating Activities) is reported using the indirect method as a reconciliation of incomefrom continuing operations on an accrual basis ($63,529) to cash flows from opera-tions (–$47,645). This more common format is different from the presentation made inthe statement prepared for Papa John’s at the end of Chapter 4 that was constructedusing the direct method.


EXHIBIT 5.5Statement of Retained Earnings

Consolidated Statements of Retained EarningsFor the years ended June 30, 2001 and 2000

(in thousands of U.S. dollars)

2001 2000

Retained earnings, beginning of year $131,953 $ 77,088

Net income 60,587 51,992

Reduction in redemption price of non-resort preferred shares (note 12[a]) — 7,588

Dividends (4,618) (4,715)

Retained earnings, end of year $187,922 $131,953

REAL WORLD EXCERPT


FOCUS ON CASH FLOWSOPERATING ACTIVITIES (INDIRECT METHOD)

The computation of cash flows from operations under the indirect method helps the analyst

understand the causes of differences between the income from continuing operations (or net

income if there are no discontinued operations or extraordinary items) and the cash flows of a

business. The income of a company and its cash flows from operating activities can be quite

different. Remember that the income statement is prepared under the accrual concept. Rev-

enues are recorded when earned, without regard to when the related cash flows occur.

Expenses are matched with revenues and recorded in the same period as the revenues, with-

out regard to when the related cash flows occur.


The Operating Activities section starts with the appropriate income number computed

under the accrual concept and converts it to cash flow from operating activities. The items

listed between these two amounts explain the reasons for their difference. For example, since

no cash is paid during the current period for Intrawest’s amortization expense reported on the

income statement, this amount is added back in the conversion process. Similarly, increases

and decreases in current assets and liabilities also account for some of the difference between

income and cash flow from operations.

As we cover different portions of the income statement and balance sheet in more detail in

Chapters 6 through 12, we will also discuss the relevant sections of the cash flow statement.

Then the complete cash flow statement will be discussed in detail in Chapter 13.

EXHIBIT 5.6Cash Flow Statement of Intrawest Corporation

Consolidated Statements of Cash FlowsFor the years ended June 30, 2001 and 2000

(in thousands of U.S. dollars)

2001 2000

Cash provided by (used in):

Operations:Income from continuing operations $ 63,529 $ 52,091Items not affecting cash:

Depreciation and amortization 57,934 51,399Future income taxes 1,027 12,109Income from equity accounted investment (2,790) (2,333)Gain on asset disposals, net of write-offs (2,671) (5,777)Non-controlling interest 9,904 9,258

Funds from continuing operations 126,933 116,747

Recovery of costs through real estate sales 338,856 281,845Acquisition and development of properties held for sale (469,816) (365,249)Increase in amounts receivable, net (13,670) (8,890)Changes in non-cash operating working capital (note 20) (29,948) 34,385

Cash provided by continuing operating activities (47,645) 58,838Cash provided by discontinued operations (note 4) 2,323 10,699

(45,322) 69,537Financing:

Proceeds from bank and other borrowings 994,902 341,373Repayments on bank and other borrowings (810,337) (244,285)Issue of common shares for cash, net of issuance costs 4,467 1,007Redemption and repurchase of non-resort preferred shares (3,966) (19,273)Dividends paid (4,618) (4,715)Distributions to non-controlling interests (5,773) (3,234)

174,675 (70,873)Investments:

Expenditures on:Revenue-producing properties (5,642) 1,315Ski and resort operation assets (93,986) (119,133)Other assets (19,545) (11,026)Business acquisitions, net of cash acquired

of $498 (2000—$207) (10,951) (19,281)Proceeds from asset disposals 8,216 4,243

(121,908) (143,882)

Increase (decrease) in cash and cash equivalents 7,445 (3,472)

Cash and cash equivalents, beginning of year 78,985 82,457

Cash and cash equivalents, end of year $ 86,430 $ 78,985

Supplementary information (note 20)See accompanying notes to consolidated financial statements.

REAL WORLD EXCERPT


NOTES TO FINANCIAL STATEMENTSThe numbers reported on the various financial statements provide important informa-tion to decision makers, but most users require additional details to facilitate theiranalysis. All financial reports include additional information in notes that follow thestatements. Intrawest’s notes to its financial statements for 2001 are categorized in thefollowing discussion by type of note (key accounting policies, additional detail sup-porting reported numbers, and relevant financial information not disclosed on the state-ments). Examples are provided.

Descriptions of Accounting Rules Applied in the Company’s StatementsThe first note typically is a summary of significant accounting policies. As you willsee in your study of subsequent chapters, generally accepted accounting principles(GAAP) permit companies to select alternative methods for measuring the effects oftransactions. The summary of significant accounting policies tells the user whichaccounting methods the company has adopted. It is rather difficult to analyze a com-pany’s financial results effectively without first understanding the various accountingmethods that have been used. Intrawest’s policy for accounting for deferred revenueis as follows:

Note 1Significant Accounting PoliciesDEFERRED REVENUE

Deferred revenue mainly comprises real estate deposits, season pass revenue, golf club initiation

deposits, government grants, and the exchange gains arising on the translation of long-term mone-

tary items that are denominated in foreign currencies (note 2[o]). Deferred revenue that relates to

the sale of season passes is recognized throughout the season based on the number of skier visits.

Deferred revenue that relates to golf club initiation deposits is recognized on a straight-line basis

over the estimated membership terms. Deferred revenue that relates to government grants for ski

and resort operation assets is recognized on the same basis as the related assets are amortized.

Deferred revenue that relates to government grants for properties under development is recognized

as the properties are sold.


FINANCIAL ANALYSISALTERNATIVE ACCOUNTING METHODS AND GAAP

Many people have a mistaken impression concerning the nature of the rules that make up

generally accepted accounting principles (GAAP): that GAAP permit only one accounting

method to be used to compute each value on the financial statements (e.g., inventory). Actu-

ally, GAAP often allow selection of an accounting method from a menu of acceptable methods.

This permits a company to choose the methods that most closely reflect its particular eco-

nomic circumstances (economic reality). This adds an additional complexity to the financial

statement users’ task—they also must understand how the company’s choice of accounting

methods affects its financial statement presentations. As Gabrielle Napolitano and Abby

Joseph Cohen of the investment banking firm of Goldman, Sachs & Co. note in their recent

research report,

There are numerous legitimate ways in which company accounts can be made obscure.Further, investors must be wary of the means by which reported earnings can bemanipulated or smoothed. Users of financial statements (e.g., shareholders, creditors,

REAL WORLD EXCERPT

Goldman, Sachs & Co.ANALYSTS’ REPORT

REAL WORLD EXCERPT


Additional Detail Supporting Reported Numbers The second category of notesprovides supplemental information concerning the data shown on the financial state-ments. Among other information, these notes may show revenues broken out bygeographic region or line of business, descriptions of unusual transactions, and expandeddetail concerning a specific classification. For example, Intrawest’s 2001 financial state-ment notes show detail on such items as acquisitions of other companies, ski and resortoperations, properties, accounts receivable, government assistance, share capital, incometaxes, interest expense, and employee benefits. Note 10, which follows, shows furtherdetails of the deferred revenue items that appear in the balance sheet.


and others) are often forced to wrestle with dramatic differences in reporting practicesbetween firms.*

For example, before analyzing two companies’ statements prepared using different account-

ing methods, one company’s statements must be converted to the other’s methods to make

them comparable. Otherwise, the reader is in a situation similar to comparing distances in kilo-

metres and miles without conversion to a common scale. In later chapters, we will focus on

developing the ability to make these conversions.

*Gabrielle Napolitano and Abby Joseph Cohen, “The Quality of Reported Earnings Has Improved,But . . . Pointers on What to Look for in Company Reports,” U.S. Research (New York: Goldman, Sachs &Co., January 2, 1997).

REAL WORLD EXCERPT


10. DEFERRED REVENUE:

2001 2000

Deposits on real estate sales $66,642 $51,200Government assistance (note 11) 4,974 8,917Exchange gains 14 3,309Golf club initiation deposits 14,935 15,463Season pass revenue 12,864 11,236Other deferred amounts 8,858 7,681

108,287 97,806Current portion 81,537 70,832

$26,750 $25,974

Relevant Financial Information Not Disclosed on the Statements The finalcategory includes information that impacts the company financially but is not specifi-cally indicated on the statements. Examples include information on stock option plans,legal matters, and any material event that occurs subsequent to year-end but before thefinancial statements are published. Note 9 includes the following:

Note 9Bank and Other Indebtedness…. Bank and other indebtedness includes indebtedness in the amount of $342,206,000 (2000—$349,277,000), which is repayable in Canadian dollars of $518,100,000 (2000—$517,140,000).The Company is subject to certain covenants in respect to some bank and other indebtedness, which requirethe Company to maintain certain financial ratios. The Company is in compliance with these covenants atJune 30, 2001.

VOLUNTARY DISCLOSURESGAAP and securities regulations set only a minimum level of required financial disclo-sures. Many companies, including Intrawest, provide important disclosures beyond thoserequired. Such voluntary disclosures may appear in the annual report, in documents filedwith the securities commission, in press releases, or on the company’s Web site.

CONSTRAINTS OF ACCOUNTING MEASUREMENTAccurate interpretation of financial statements requires that the statement readerbe aware of three important constraints of accounting measurement. First, althoughitems and amounts that are of low significance must be accounted for, they do not haveto conform precisely to specified accounting guidelines or be separately reported if theywould not influence reasonable decisions. Accountants usually designate such items andamounts as immaterial. Determining material amounts is often very subjective.

Second, conservatism requires that special care be taken to avoid (1) overstatingassets and revenues and (2) understating liabilities and expenses. Users of financialstatements often want to know about possible sources of trouble for the company. Forexample, creditors need to know how secure their investments will be if the company’sfortunes deteriorate, but they may not be interested in whether the company might doexceptionally well. They care more about the downside risk than the upside potential.For this reason, financial statements that show assets at historical cost, but reduce theseamounts when current values are significantly lower, help satisfy the needs of credi-tors. This lower-of-cost-or-market guideline attempts to offset managers’ natural opti-mism about their business operations, which sometimes creeps into the financialreports that they prepare. More companies have perished through excessive optimismthan through excessive caution.

Finally, the educated financial statement reader must be aware of special industrypractices or industry peculiarities due to long-standing and accepted accounting andreporting practices in various industries. For example, public utilities (an industryregulated by government) often present balance sheet information in what appears to beupside-down order. BC Hydro Corporation lists capital assets first, followed by the moreliquid assets (cash, accounts receivable, and supplies). The reason for this presentation isthat regulatory commissions in many provinces require public utilities to use this format.

PLAYERS IN THE ACCOUNTING COMMUNICATION PROCESSExhibit 5.7 summarizes the accounting communication process in terms of the peopleinvolved, their roles in the process, and the guidance they receive from legal and pro-fessional standards.

MANAGERS (CEO, CFO, AND ACCOUNTING STAFF)As noted in Chapter 1, the primary responsibility for the information in Intrawest’sfinancial statements and related disclosures lies with management as represented by thehighest officer in the company, often called the president and chief executive officer(CEO) and the highest officer associated with the financial and accounting side of thebusiness, often called the chief financial officer (CFO). These two officers normally signthe statement of management responsibility (as discussed in Chapter 1) if one isincluded in the annual report. For public companies, the same officers are responsiblefor the principal reports filed with the provincial securities commissions. At Intrawest,Joe Houssian, president and CEO, and Daniel Jarvis, CFO, have had that responsibilityfor many years. They were responsible for the conformance of the statements andrelated disclosures with GAAP (generally accepted accounting principles). Althoughtheir legal responsibility is smaller, the members of the accounting staff who actuallyprepare the details of the reports also have professional responsibility for the accuracyof this information. Their professional success in the future depends heavily on theirreputations for honesty and competence.

AUDITORSAs we discussed in Chapter 1, the provincial securities commissions require publiclytraded companies to have their statements audited by professional independent accoun-tants following generally accepted auditing standards (GAAS). Many privately ownedcompanies also have their statements audited. By signing a clean audit opinion, the


MATERIAL AMOUNTS areamounts that are large enoughto influence a user’s decision.

CONSERVATISM suggeststhat care should be taken not tooverstate assets and revenuesor understate liabilities andexpenses.


Recognize the people involvedin the accounting communica-tion process (managers,auditors, information inter-mediaries, government regula-tors, and users), their roles in theprocess, and the guidance theyreceive from legal andprofessional standards.

CLEAN AUDIT OPINION.Auditors’ statement that thefinancial statements are fairpresentations in all materialrespects in conformity withGAAP.

audit firm assumes financial responsibility for the fairness of the financial statementsand related presentations. This opinion adds credibility to the statements and often isrequired by agreements with lenders and private investors who are not activelyinvolved in management of the companies.5 Intrawest was initially financed throughinvestments by Mr. Houssian and loans from financial institutions (e.g., banks andcommercial finance companies). By voluntarily subjecting the company’s statementsto independent verification, Intrawest reduced the risk to the private investors andfinancial institutions that the company’s condition was not as represented in the state-ments. As a consequence, rational investors and lenders should lower the rate of return(interest) they charge for providing capital.

KPMG is currently Intrawest’s auditor. KPMG, Deloitte & Touche, Ernst & Young,and PricewaterhouseCoopers are the largest audit firms that employ thousands of profes-sional accountants in offices scattered throughout the world. They audit the great major-ity of publicly traded companies and many privately held companies. Some publiccompanies and most private companies are audited by audit firms of smaller size. A listof well-known companies and their auditors at the time this chapter was written follows.

Company Industry Auditor

Honda Motor Co. Ltd. (Japan) Automobiles KPMGNortel Networks Corporation Computer equipment Deloitte & ToucheSingapore Airlines (Singapore) Airline Ernst & YoungWendy’s (United States) Fast food PricewaterhouseCoopers


EXHIBIT 5.7The Accounting Communication Process Management

Preparation

IndependentAuditors (CAs, CGAs)

Verification

Guided by GAAS

Guided by GAAP

PartnersManagersStaff auditors

UsersAnalysis and Decision

Institutional investorsPrivate investorsLendersOthers (suppliers, etc.)

Chief executive officerChief financial officerAccounting staff

Information Intermediaries

Analysis and Advice

Financial analystsInformation services

Guided by securitiesregulations

GovernmentRegulatorsVerification

Provincial securities commissioners and their staff

(Publiccompaniesonly)

(Publiccompaniesonly)

5In some cases, the auditor may not be satisfied that the company’s financial statements are in compliancewith GAAP. A qualified opinion would then be issued if the company’s management is not willing to modifythe financial reports as per the auditor’s recommendation. Qualified opinions are rarely issued by auditors.

Companies often hire financial managers from their audit firms because of theirbroad financial experience as well as their specific company knowledge gained duringprior years’ audits.


A QUESTION OF ETHICSWHERE WERE THE AUDITORS?

Most professional accountants act in an honest and ethical manner, abiding by the codes of

ethics developed by the professional accounting organizations. Nevertheless, a few accoun-

tants act in their own interest and disregard ethical conduct. They even become accomplices

in spectacular fraud cases and subsequent company bankruptcies. For example, Enron Corp.,

a U.S. energy trading company, intentionally inflated its net earnings by hiding assets and

related debts from 1997 to 2001. Throughout this period, the auditors of Arthur Andersen LLP,

a global accounting services company with revenues in excess of $500 million, endorsed

fraudulent financial statements issued by Enron’s management.

The collapse of Enron, the largest unexpected bankruptcy in U.S. history, caused tremen-

dous losses to the company’s shareholders, creditors, employees, and other stakeholders.

Furthermore, Enron’s bankruptcy in December 2001 caused the breakup of Arthur Andersen.

More than 300 clients left the firm within 90 days, taking with them $250 million of potential

revenue to other audit firms. This audit failure led to calls for improved accountability by man-

agers and auditors. Needless to say, the direct or indirect implication of auditors in such fraud-

ulent actions tarnishes the image and reputation of the accounting profession. This has

generated considerable discussion among securities regulators, financial analysts, investors,

and creditors for stricter regulation of the accounting profession. These discussions will likely

result in far-reaching reforms in the accounting profession and in financial reporting.

INFORMATION INTERMEDIARIES: ANALYSTS AND INFORMATION SERVICES

The Role of Financial Analysts Students often view the communication processbetween companies and financial statement users as involving a simple process ofmailing the report to individual shareholders who read the report and then make invest-ment decisions based on what they have learned. This simple picture is far from today’sreality. Now sophisticated financial analysts use modern information technology togather and analyze information. They receive accounting reports and other informationabout the company from electronic information services (discussed later). They alsogather information through personal phone conversations with company executives andvisits to company facilities. They then combine the results of these analyses with infor-mation about competitors, the overall economy, and even population trends to makepredictions of future earnings and stock price. These predictions form the basis of theirbuy, hold, or sell recommendations for a company’s shares.

Analysts often work in the research departments of brokerage and investmentbanking houses such as RBC Dominion Securities, mutual fund companies such asthe Investors Group, and investment advisory services such as Standard & Poor’s thatsell their advice to others. Individual analysts often specialize in particular industries(such as sporting goods or energy companies) and in particular companies. For exam-ple, Irene Nattel of RBC Dominion Securities and Jill Krutick of Salomon SmithBarney (both brokerage and investment banking companies) are among 15 analystswho follow Intrawest at both Canadian and U.S. brokerage houses. With other ana-lysts at their firms, they write reports that analyze the company’s future prospects.

Analysts’ reports normally include their estimate or forecast of future quarterly and

annual earnings per share for the company.6 In making these earnings forecasts, theanalysts rely heavily on their knowledge of how the accounting system translates busi-ness events into the numbers on a company’s financial statements.7 This knowledgeincludes an understanding of the alternative accounting methods available to compa-nies to account for different transactions and specialized industry practices that may beapplied to a particular industry. Analysts are regularly evaluated based on the accuracyof their forecasts, as well as the profitability of their stock picks.8

Analysts’ employers either use the reports directly or sell them to other investors. Asa consequence, the analyst is transferring his or her knowledge of accounting, the com-pany, and the industry to others who lack this expertise. Many believe that decisionsmade based on analysts’ advice cause stock market prices to react quickly to account-ing information announcements. A quick, unbiased reaction to information is calledmarket efficiency in finance.

It is highly unlikely that unsophisticated investors can glean more information fromfinancial statements than the sophisticated analysts have already learned. Carefulanalysis does not lead all analysts to the same conclusions, however. These differencesof opinion are reflected in the following earnings (per share) forecasts and stock rec-ommendations made by a number of analysts at the time this chapter was written.

Analysts make recommendations to buy, hold, or sell a company’s shares based ontheir earnings forecasts. In the case of Intrawest, seven analysts recommended “strongbuy,” five analysts recommended “buy,” and one analyst recommended “sell.”


6For further discussion of analysts’ forecasts, see K. Schipper, “Analysts’ Forecasts,” AccountingHorizons, December 1991, pp. 105–121.7See G. J. Previts, R. J. Bricker, T. R. Robinson, and S. J. Young, “A Content Analysis of Sell-SideFinancial Analyst Reports,” Accounting Horizons, June 1994, pp. 55–70.8See M. B. Mikhail, B. R. Walther, and R. H. Willis, “Does Forecast Accuracy Matter to SecurityAnalysts?” The Accounting Review, April 1999, pp. 185–200.

REAL WORLD EXCERPT

Yahoo.comINTRAWEST CORORATION

EARNINGS FORECAST

For fiscal 2002 For fiscal 2003

Average forecast $1.63 $1.88Lowest forecast 1.12 1.40Highest forecast 1.80 2.15Number of analysts 14 7

A QUESTION OF ETHICSIT PAYS TO BE A WARY INVESTOR

Occasional unethical behaviour on the part of financial analysts and investment advisors

suggest that savvy investors should apply a healthy dose of scepticism along with their

accounting knowledge when reading or listening to investment advice. Alleged ethical

lapses, questionable business practices, and illegal activity by representatives of some of

the largest, most highly respected brokerage and investment banking houses have recently

made the news. These activities include the rigging of prices in securities auctions, excess

trading of customers’ accounts to generate higher commissions, insider trading, the sale of

securities without full disclosure of their risks, issuance of flattering research recommenda-

tions, and executing trades for some customers at more advantageous prices than others.

Most analysts, brokers, and investment bankers act in an honest and ethical fashion; how-

ever, they earn profits by charging commissions on securities transactions. When brokers let

their need to earn commissions cloud their investment advice, this can lead to questionable

or even unethical behaviour.

EARNINGS FORECASTS arepredictions of earnings for futureaccounting periods.

The information services discussed in the next section allow investors to monitor therecommendations of a variety of analysts.

Information Services Financial analysts obtain much of the information they usefrom the wide variety of electronic information services available today. These servicesare normally either available online (via modem, computer networks, or satellite dish)or on CD-ROM (compact disc, read-only memory). Some of the services provide spe-cialized information. For example, First Call, which has been integrated with I/B/E/SInc., provides consensus (average) and analyst-by-analyst earnings forecasts for morethan 18,000 domestic and foreign companies. More than 800 research analysts con-tribute earnings forecasts to the service. Samples of the consensus forecasts can beaccessed on its Web site: www.firstcall.com.

Services such as Lexis-Nexis, Compustat, and Disclosure provide broader access tofinancial statement and related news information. They also allow users to search thedatabase by key words, including various terms in financial statements. Their Web sitesdescribe their services in more detail:

www.lexis-nexis.com www.compustat.com www.disclosure.com

Canadian companies actually can file financial statements and other securities-related forms electronically with SEDAR (System for Electronic Document Analysisand Retrieval), which is the official site for the filing of documents by public compa-nies as required by securities laws in Canada.9 This information is available to usersthrough SEDAR long before it is available through the mail in hard-copy form.SEDAR is currently a free service available on the Web at www.sedar.com.

To look at SEDAR, just type the address on your Web browser. Select French orEnglish, depending on your preference, then select the letter of the alphabet that cor-responds to the first letter of the company’s name. You will then see a list of compa-nies that includes the selected company. Many of the financial statement examplesused in this book were downloaded (electronically copied) from this Web site.

More general information services include the Dow Jones Interactive andBloomberg Financial Markets and Commodities News, as well as the financial sectionsof national newspapers such as The Globe and Mail and National Post. Dow Jones pro-vides access to news stories about companies, as well as current and historical stockprices and company press releases, including the initial announcements of annual andquarterly financial results. This information also is available electronically through theinformation service long before shareholders and others receive the hard-copy reports.Their Web sites describe their services in more detail:

www.dowjones.com www.bloomberg.com

A growing number of other resources exist on the Web that offer a mixture of freeand fee-based information on many companies. These include

www.marketguide.com www.hoovers.comwww.etrade.com www.yahoo.com

The most interesting new trend in information services is the provision of financialinformation in audio and video form. You can access recordings of conference callsand videos of meetings between financial analysts and company management onYahoo!broadcast. Listening to these recordings is a good way to learn about a com-pany’s business strategy and its expectations for the future, as well as key factors thatanalysts consider when they evaluate a company.

www.broadcast.com/business/


9Canadian companies that have shares traded on U.S. stock exchanges and U.S. companies can file SECforms electronically with EDGAR (Electronic Data Gathering and Retrieval) sponsored by the SEC.

Many companies also provide direct access to their financial statements and otherinformation over the Web. You can contact Intrawest at www.intrawest.com.

Readers should be aware that the definitions used to compute key ratios often differacross these sources.


FINANCIAL ANALYSISINFORMATION SERVICES: USES IN MARKETING,CLASSWORK, AND JOB SEARCHES

Information services have become the primary tools used not only by sophisticated analysts

but also by marketing strategists to analyze competing firms. Sales representatives also use

the services to analyze potential customers. These analyses allow the sales representative to

determine which customers have growing needs for their products and which have the finan-

cial strength necessary to qualify for credit. Such companies are the most profitable targets for

the sales representative’s efforts.

The information services are an important source of information to students for their term

papers and even their job searches. Potential employers expect top job applicants to be

knowledgeable about their company before an interview. We suggest that you contact the

business or reference librarian at your college or university library or visit a local brokerage

house to learn more about these modern electronic information services and the usage fees

they charge.

GOVERNMENT REGULATORSThe Ontario Securities Commission (OSC) and other provincial securities commissionsset additional reporting standards for firms with publicly traded debt or equity securi-ties. We discuss these requirements later in the chapter and throughout the text whenrelevant. The OSC staff reviews these reports for compliance with their standards,investigates irregularities, and punishes violators of their regulations.10

REAL WORLD EXCERPT

Financial Post

“Prerecorded” Revenue Draws Fire

The Ontario Securities Commission expects to release a report by mid-March based on areview of the accounting and revenue recognition practices of 70 unidentified TSX-listedtechnology companies, including telecommunications firms. That review follows a Securitiesand Exchange Commission crackdown on aggressive accounting and revenue booking in theUnited States. ….

SOURCE: Michael Lewis, Financial Post, March 1, 2001, page C1.

USERS: INSTITUTIONAL AND PRIVATE INVESTORS, CREDITORS, AND OTHERSInstitutional investors include the managers of private pension funds (associated withunions and employees of specific companies); public pension funds (for provincial andmunicipal employees); mutual funds; and endowment, charitable foundation, and trustfunds (such as the endowment of your college or university). These institutional

10Research indicates that during a recent 11-year period, the SEC brought enforcement actions againstnearly 300 firms for accounting-related violations. In 72 percent of the cases, the CEO was implicated, andthe company’s auditors were also implicated in 29 percent of the cases. Consequences to the companyincluded bankruptcy or significant changes in ownership as well as financial penalties. These statistics arereported in M. S. Beasley, J. V. Carcello, and D. R. Hermanson, “Fraudulent Financial Reporting:1987–1997: An Analysis of U.S. Public Companies,” The Auditor’s Report, Summer 1999, pp. 15–17. Seealso E. H. Feroz, K. Parke, and V. S. Pastena, “The Financial and Market Effects of the SEC’s Accountingand Auditing Enforcement Releases,” Journal of Accounting Research, Supplement 1991, pp. 107–142.

INSTITUTIONAL INVES-TORS are managers of pensionfunds, mutual funds, endowmentfunds, and other funds thatinvest on behalf of others.

shareholders usually employ their own analysts and use the information intermediariesjust discussed. Institutional shareholders such as these control the majority of publiclytraded shares of Canadian companies. For example, at the end of fiscal year 2001, thefollowing three institutional investors together owned approximately 20 percent ofIntrawest’s outstanding shares:

Institution Approximate Ownership

TAL Global Asset Management Inc. 5.5 million sharesI.G. Investment Management Ltd. 2.1 million sharesCapital Guardian Trust Company 1.6 million shares

Private investors include large individual investors such as Joe Houssian and someof the company’s directors, as well as small retail investors who, like most individuals,buy a small number of shares of publicly traded companies through brokers such asNesbitt Burns and TD Waterhouse. Retail investors normally lack the expertise tounderstand financial statements and the resources to gather other important data effi-ciently. As a consequence, they often rely on the advice of information intermediariesor turn their money over to the management of mutual and pension funds (institutionalinvestors).

Lenders, or creditors, include suppliers, banks, commercial credit companies, andother financial institutions that lend money to companies. Lending officers and finan-cial analysts in these organizations use these same public sources of information intheir analyses. In addition, when companies borrow money from financial institutions,they often agree to provide additional financial information (e.g., monthly statements)as part of the lending contract. Lenders are often the primary external user group forfinancial statements of private companies. Individuals and mutual funds also becomecreditors when they buy publicly traded bonds and debentures issued by a company.11


PRIVATE INVESTORSinclude individuals whopurchase shares in companies.

LENDERS (CREDITORS)include suppliers and financialinstitutions that lend money tocompanies.

11Debentures are debt securities not secured with specific collateral (no specific assets are pledged assecurity for the debt). Bonds normally are secured by specific collateral such as investments in shares ofother companies.

A QUESTION OF ETHICSCONFLICTING INTERESTS OF MANAGERS, SHAREHOLDERS, AND CREDITORS

The economic interests of managers, shareholders, and creditors often differ. For example,

paying dividends to shareholders benefits the shareholders but leaves less money available

to pay creditors; refurnishing the offices occupied by managers benefits the managers but

leaves less money to pay dividends. Expectations of ethical conduct and mutual trust play a

major role in keeping these differing interests in balance.

Accounting and financial statements also play a major role in enforcing these relationships

of trust. Compliance with agreements (contracts) between managers and shareholders and

between shareholders and creditors are monitored with financial statement data.* Applying

the rule “trust but verify” in business practice is prudent.

*Research that examines the use of accounting in contracting is called agency theory.

As noted in Chapter 1, these same financial statements play an important role in therelationships between customers and suppliers. Customers evaluate the financial healthof suppliers to determine whether they will be able to provide a reliable, up-to-datesource of supply. Suppliers evaluate their customers to estimate their future needs andability to pay their debts to the suppliers. Competitors also attempt to learn useful

information about a company from its statements. The potential loss of competitiveadvantage is one of the costs to the preparer of public financial disclosures. Account-ing regulators consider these costs as well as the direct costs of preparation when theyrequire new disclosures. They apply what is called the cost-benefit constraint, whichsuggests that the benefits of accounting for and reporting information should outweighthe costs. Other uses of financial statement information in labour-management rela-tions and in government regulation were discussed in Chapter 1.

GUIDING PRINCIPLES FOR COMMUNICATING USEFUL INFORMATIONFor accounting information to be useful to any of these user groups, it must be relevantand reliable. Relevant information is capable of influencing decisions because it allowsusers to assess past activities (feedback value) and/or predict future activities (predictivevalue). Reliable information must be accurate, unbiased, and verifiable (independentparties can agree on the nature of the transaction and amount). Our discussions of ratioanalysis emphasize the importance of comparing ratios produced by the same companyover time as well as comparing the company’s ratios with those of competitors. Suchcomparisons are valid only if the information is prepared on a consistent and compara-ble basis. Consistent information means that within a company, similar accountingmethods have been applied over time. Comparable information means that similaraccounting methods have been applied. These characteristics of useful information,along with the full-disclosure principle, are defined in the conceptual framework andguide the standard-setters in deciding what financial information should be reported.


The COST-BENEFITCONSTRAINT suggests thatthe benefits of accounting forand reporting information shouldoutweigh the costs.

RELEVANT INFORMATIONcan influence a decision; it istimely and has predictive and/orfeedback value.

RELIABLE INFORMATION isaccurate, unbiased, andverifiable.

CONSISTENTINFORMATION can becompared over time becausesimilar accounting methods havebeen applied.

COMPARABLEINFORMATION can becompared across businessesbecause similar accountingmethods have been applied.

Match the players involved in the accounting communication process with their roles or the guidingprinciples for communicating information with their definitions.

1. Relevant information a. Management primarily responsible for accounting information.

2. CEO and CFO b. An independent party who verifies financial statements.

3. Financial analyst c. Information that influences users’ decisions.

4. External auditor d. Only information that provides benefits in excess of costs shouldbe reported.

5. Cost-benefit constraint e. An individual who analyzes financial information and providesadvice.

After you complete the quiz, check your answers with those on page 264.

SELF-STUDY QUIZ 5-4

THE DISCLOSURE PROCESSAs noted in our discussion of information services and information intermediaries, theaccounting communication process includes more steps and participants than onewould envision in a world in which annual and quarterly reports are simply mailed toshareholders.

PRESS RELEASESIntrawest and most public companies announce quarterly and annual earnings througha press release as soon as the audited annual figures (or reviewed quarterly figures) areavailable, to provide timely information to external users and to limit the possibility ofselective leakage of information. Intrawest normally issues its earnings press releaseswithin six weeks of the end of the accounting period. The announcements are sent elec-tronically to the major print and electronic news services, which make them immedi-ately available to subscribers. An example of a quarterly press release for Intrawest isreprinted in Exhibit 5.8. It includes key financial figures and management’s discussionof the results. Attached to the release are condensed income statements and balance


Identify the steps in theaccounting communicationprocess, including the issuanceof press releases, annualreports, quarterly reports, anddocuments filed with securitiescommissions, as well as the roleof electronic information servicesin this process.

A PRESS RELEASE is awritten public newsannouncement normallydistributed to major newsservices.

For actively traded stocks such as those of Intrawest, most of the stock market reac-tion (stock price increases and decreases from investor trading) to the news in the pressrelease usually occurs quickly. Recall that a number of analysts follow Intrawest andregularly predict the company’s earnings. When the actual earnings are published, themarket reacts not to the amount of earnings but to the difference between expectationsof earnings and actual earnings. This amount is called unexpected earnings. For exam-ple, the Financial Post recently reported the following:


REAL WORLD EXCERPT

IntrawestPRESS RELEASE

EXHIBIT 5.8Earnings Press Release forIntrawest CorporationIntrawest Reports 2002 Second Quarter Results

Real Estate Drives Revenue and EBITDA Growth

All Dollar Amounts Are in U.S. Currency

VANCOUVER, February 19 [2002]—Intrawest Corporation, the leading operator and developer of vil-lage-centered resorts across North America, today announced results for its fiscal 2002 second quarterended December 31, 2001.

Revenue for the second quarter was $231.4 million compared with $207.0 million for the quarter endedDecember 31, 2000. Total company EBITDA (earnings before interest, taxes, non-controlling interest,depreciation and amortization) increased 15 per cent to $40.0 million from $34.7 million in the sameperiod last year. Income from continuing operations for the quarter was $6.0 million or $0.14 per share,on a fully diluted basis, compared with $10.7 million (including a one-time, non-cash income tax recov-ery of $5.3 million) or $0.24 per share in the same quarter fiscal 2001. Excluding this non-recurringincome tax recovery, income from continuing operations would have been $5.4 million or $0.12 pershare in the second quarter last year.

“Contrary to some expectations, the weak North American economy and the events of September 11have not had a dramatic impact on our business,” said Joe Houssian, Intrawest's chairman, presidentand chief executive officer.

Revenue and total company EBITDA for the six months ended December 31, 2001, were $325.1 millionand $47.2 million, respectively, compared with $336.9 million and $50.3 million, respectively, in thesame period last year. Intrawest incurred a loss from continuing operations of $3.7 million for the six months compared with income from continuing operations of $7.5 million ($2.2 million excludingthe one-time income tax recovery) last year.

Ski and resort operation revenue was $87.5 million in the second quarter, down from $94.3 million inthe same quarter of fiscal 2001 due to late season openings at the eastern resorts caused by unusuallywarm weather conditions in November and December. This decline in revenue decreased ski and resortoperations EBITDA for the quarter to $14.1 million from $15.7 million last year. Tight control over costs,and the delayed hiring of seasonal staff as planned, reduced the impact on earnings of the late start tothe season in the East and changes in leisure travel patterns following September 11.

“Solid results at our western resorts tempered the effects of the slow start to the season at our easternresorts,” said Daniel Jarvis, executive vice president and chief financial officer. “Our performance duringthese exceptionally challenging times reflects the success of our early cost-control measures and thestrength of our resort network.”

Real estate revenue was $141.0 million for the second quarter, an increase of 27 per cent from $110.8 million reported in the same quarter last year. Intrawest closed 450 units during the quartercompared with 343 in the same quarter last year. Real estate profit was $21.1 million compared with$14.7 million in the same period last year. Resort Club sales in the quarter were $7.2 million, six percent more than the second quarter last year.

A conference call is scheduled for Tuesday, February 19, 2002, at 4:00 pm ET (3:00 pm CT, 1:00 pm PT)to review Intrawest's fiscal 2002 second quarter results. Access to the call may be obtained by calling1-888-793-1753 (analysts and institutional investors) and 1-888-673-1254 (media and retail investors)before the scheduled start time. A playback version of the conference call will be available through Feb-ruary 25, 2002, at 1-800-558-5253. The password to access the playback version is 20346326. A liveWebcast can be accessed from Intrawest's Web site at www.intrawest.com under InvestorRelations/Webcasts.

sheets (unaudited) that are included in the formal quarterly report to shareholders mailedafter the press release.

Intrawest keeps profit growth streak aliveB.C.-based resort operator’s revenue up 16.5%

VANCOUVER—Intrawest Corp., operator of such major North American mountain resorts asBritish Columbia’s Whistler Blackcomb, yesterday posted a 16.5% rise in profit for the past fiscalyear.

Income hit US$60.59 million or US$1.45 a share compared with US$51.99 million (US$1.20) infiscal 2000, the Vancouver-based company reported.... On the Toronto stock market yesterday,Intrawest shares closed at $28.05, down 30¢.

SOURCE: Financial Post, September 11, 2001, page C7.

Even though Intrawest’s profit increased by 16.5 percent over the previous year’s netearnings, the company’s share price declined, presumably because investors wereexpecting a higher increase in profit. So, the market price reflected investors’ expecta-tions of a certain level of profit, but when the actual profit was below their expecta-tions, the market price adjusted downward to reflect investors’ disappointment. Thefollowing excerpt from an article in Fortune magazine points out the growing impor-tance of meeting or beating the average or consensus analysts’ estimate:

Learn to Play the Earnings Game (and Wall Street Will Love You)The simplest, most visible, most merciless measure of corporate success in the 1990s hasbecome this one: Did you make your earnings last quarter?

This is new . . . it’s only in the past decade with the rise to prominence of the consensus earningsestimates compiled first in the early 1970s by I/B/E/S . . . and now also by competitors Zacks, FirstCall, and Nelson’s, that those expectations have become so explicit.

SOURCE: Fortune, March 31, 1997, p. 77. © 1997 Time Inc. All rights reserved.

In general, financial analysts tend to make optimistic earnings forecasts in order tomaintain a good relationship with the company’s management. The reason is that man-agers provide analysts with vital information for their analysis. Optimistic earningsforecasts, however, put additional pressure on management to meet and even exceedanalysts’ forecasts in order to please investors. The drive to meet analysts’ earningsexpectations has led the management of some companies to adopt accounting policiesthat result in premature recognition of revenue and/or deferral of expenses in order toincrease reported earnings.

Companies such as Intrawest issue press releases concerning other important eventsincluding announcement of new services or development of new resort villages. Thestock market often appears to react to some of these important announcements.

Press releases related to annual earnings and quarterly earnings often precede theissuance of the quarterly or annual report by 15 to 45 days. This time is necessary toprepare the additional detail and to print and distribute those reports.

ANNUAL REPORTSFor privately held companies, annual reports are relatively simple documents photo-copied on white paper. They normally include the following:

1. Four basic financial statements: income statement, balance sheet, statement ofretained earnings, and cash flow statement.

2. Related footnotes or notes as described earlier.3. Report of independent accountants (auditor’s opinion).

The annual reports of public companies are significantly more elaborate, both becauseof additional reporting requirements imposed on these companies by securities com-missions and the fact that many companies use their annual reports as public relationstools to communicate non-accounting information to shareholders, customers, thepress, and others.


REAL WORLD EXCERPT

Financial Post

REAL WORLD EXCERPT

Fortune

The annual reports of public companies are normally split into two sections: the first,“non-financial,” section usually includes a letter to shareholders from the chairman andCEO; descriptions of the company’s management philosophy, products, its successes(and occasionally its failures); and exciting prospects and challenges for the future.Beautiful photographs of products, facilities, and personnel often are included. The sec-ond, “financial,” section, which is often printed on a different colour of paper to makeit easy to find, includes the core of the report. Securities regulators set minimum dis-closure standards for the financial section of the annual reports of public companies.The principal components of the financial section include:

1. Summarized financial data for a 5- or 10-year period.

2. Management’s Discussion and Analysis of Financial Condition and Results ofOperations.

3. The four basic financial statements.

4. Notes (Footnotes).

5. Report of Independent Accountants (Auditor’s Opinion) and sometimes the Reportof Management Responsibility.

6. Recent stock price information.

7. Summaries of the unaudited quarterly financial data (described later).

8. Lists of directors and officers of the company and relevant addresses.

The order of these components varies.Most of these components except for Management’s Discussion and Analysis

(MD&A) have been discussed in earlier chapters. This component includes manage-ment’s discussion and explanation of key figures on the financial statements and futurerisks the company faces. Many companies devote a sizeable portion of their annualreports to the MD&A section, as the chart in the margin shows.12 A complete annualreport from Gildan Activewear Inc., which includes all of these sections, is reprinted inAppendix B of this textbook. As noted earlier, many companies make their annualreports available on the Web. Some companies have stopped producing glossy printcopies of their annual reports in order to save on design, paper, and production costs.For example, Nortel Networks Corporation reduced the cost of creating its annualreport from $6.50 per copy in 1997 to $0.70 per copy in 1999.

QUARTERLY REPORTSQuarterly reports normally begin with a short letter to shareholders. This is followedby a condensed income statement for the quarter, which often shows less detail thanthe annual income statement, and a condensed balance sheet dated at the end of thequarter (e.g., March 31 for the first quarter). These condensed financial statements arenot audited and so are marked unaudited. Also, the cash flow statement, statement ofretained earnings, and some notes to the financial statements often are not included.Private companies also normally prepare quarterly reports for lenders. Intrawest’squarterly reports are issued about seven weeks after the end of each quarter.

REPORTS TO SECURITIES COMMISSIONSPublic companies must also file periodic reports with the OSC and other provincialsecurities commissions. These reports include the annual report, quarterly reports, anannual information form, and an information circular. The annual information formprovides a more detailed description of the business, including such items as the com-pany’s corporate structure, the industry in which it operates, the products and servicesit offers, product and project development, sales and marketing, manufacturing, and


12C. Byrd, I. Chen, and H. Chapman, Financial Reporting in Canada 2001. Toronto: Canadian Institute ofChartered Accountants, 2001, p. 54.

Length of Number ofMD&A Section Companies

1–5 pages 346–10 6311–20 87

21 or more pages 15

competition. The form also lists the properties owned and leased by the company, andsignificant contracts that the company has signed. The information circular is a legaldocument that is forwarded to the company’s shareholders prior to the annual generalor special meeting of shareholders. It provides information about the items that theshareholders will be asked to consider and vote on during the meeting, including elec-tion of new directors, appointment of independent auditors, and other matters of a legalnature. The circular also provides details of the monetary compensation of key man-agement personnel.

In addition to these periodic reports, companies file other types of reports as theneed arises. These include a short-form prospectus that provides details of the equityand/or debt securities that they plan to issue to investors, and press releases concerningnew developments. The SEDAR Web site www.sedar.com lists all of the reports, doc-uments, and news items that Intrawest and other corporations have filed.13


13U.S., Canadian, and international companies that have shares trading on U.S. securities exchangemarkets are required to file a number of reports with the SEC. These are:

• Form 10-K, which provides a more detailed description of the business, and more detailed schedulesconcerning various figures on the income statement and balance sheet, including bad debts, warranties,and inventories. We will discuss some of these disclosures in more detail in later chapters, starting witha discussion of bad debts in Chapter 6.

• Form 10-Q, which includes all of the information provided in the quarterly report to shareholders, alongwith a statement of shareholders’ equity and a cash flow statement for the quarter, a variety of notes,and a management discussion.

• Form 8-K, which is used to report any material event important to investors that has not been previouslyreported in the 10-K or 10-Q forms. An example of an event requiring submission of a Form 8-K is achange of auditors.

DEMONSTRATION CASEGATEWAY, INC.Gateway, Inc., is a leading manufacturer and distributor of computer equipment. It makes desktop andportable personal computers and network servers that it sells to consumers and businesses orderingby telephone and through the company's Web site. It also markets products through its own GatewayCountry stores. Following is a list of financial statement items and amounts adapted from a recentGateway income statement and a recent balance sheet. These items have normal debit and creditbalances, and are reported in millions of dollars.The company has a weighted average of 322 millionshares outstanding during the year. The company closes its books on December 31.

Accrued liabilities $ 556 Net Sales $9,601Accounts payable 785 Other current assets 793Accounts receivable 545 Other current liabilities 289Cash and short-term investments 614 Other income (loss)—debit balance 115Contributed capital 730 Other non-current assets 822Cost of goods sold 7,542 Property, plant, and equipment (net) 897Intangible assets 166 Provision for income taxes 155Inventory 315 Retained earnings, January 1, 20A 1,409Long-term liabilities 141 Selling, general, and administrative

expenses 1,548

Required:1. Prepare in good form a multiple-step income statement for the year (showing both gross profit

and operating income) and a classified balance sheet at December 31.2. Compute the company’s ROE. Briefly explain its meaning. Gateway’s total shareholders’ equity

at the beginning of 20A was $2,290 million.

We strongly recommend that you prepare your own answers to these requirements and thencheck your answer with the suggested solution that follows.

SUGGESTED SOLUTION1. GATEWAY, INC.

Income Statement

For the Period Ended December 31, 20A

(in millions)

Net sales $9,601

Cost of goods sold 7,542

Gross profit 2,059

Operating expenses:

Selling, general, and administrative 1,548

Total operating expenses 1,548

Operating income 511

Non-operating income and expenses:

Other income (loss), net (115)

Income before income taxes 396

Provision for income taxes 155

Net income $ 241

Earnings per share $ 0.75

GATEWAY, INC.

Balance Sheet

December 31, 20A

(in millions)

Assets

Current assets

Cash and short-term investments $ 614

Accounts receivable 545

Inventories 315

Other current assets 793

Total current assets 2,267

Non-current assets

Property, plant, and equipment (net) 897

Intangible assets 165

Other non-current assets 822

Total assets $4,151

Liabilities

Current liabilities

Accounts payable $ 785

Accrued liabilities 556

Other current liabilities 289

Total current liabilities 1,630

Non-current liabilities 141

Shareholders’ equity

Contributed capital 730

Retained earnings 1,650

Total shareholders’ equity 2,380

Total liabilities and shareholders’ equity $4,151

2. Gateway’s ROE at December 31, 20A, is:

Net income $241ROE =

Average Shareholders’ Equity=

($2,290 + $2,380)/2= 0.103 or 10.3%


This ratio indicates that shareholders earned 10.3 percent on the book value oftheir initial investment in the company and subsequent earnings that have beenreinvested in the business. Comparison of this ratio to those of previous yearswould indicate if the company’s performance has improved or deteriorated overtime. Furthermore, comparison to the industry average would also situateGateway’s performance relative to other companies in the same industry.

SOLUTIONS TO SELF-STUDY QUIZZESSelf-Study Quiz 5-11. June 30, 2000 June 30, 2001

Current ratio$489,533

= 1.30$607,856

= 1.42$375,708 $429,641

Debt-to-equity ratio$1,206,083

= 2.36 $1,387,950

= 2.44$511,272 $568,362

The current ratio is above 1.20, and the debt-to-equity ratio is below 2.50 for both years

2. The company’s management should be concerned about the level of the debt-to-equity ratio, as it isapproaching the 2.50 mark. Management should attempt to reduce the amount of bank indebtednessto avoid potential difficulties with the bank. One possibility is to issue additional shares to existing ornew shareholders.

Self-Study Quiz 5-2a. �200, NE, �200; b. �100, �100, �100

Self-Study Quiz 5-3Change in net income = $60,587 – $51,992 = $8,595

Percentage change in net income = $8,595 ÷ $51,992 = 16.5% (less than 20%)

They did not earn their bonuses. Paying Intrawest executives a bonus for increasing earnings helps alignthe interests of the executives with those of the shareholders. In addition, companies often pay executivesbonuses based on the numbers in the annual report because the auditors have independently verified thosenumbers.

Self-Study Quiz 5-41c, 2a, 3e, 4b, 5d.

CHAPTER TAKE-AWAYS1. Recognize and apply the different financial statement and disclosure formats used by

companies in practice. p. 235Most statements are classified and include subtotals that are relevant to analysis. On thebalance sheet, the most important distinctions are between current and non-current assetsand liabilities. On the income statement and cash flow statement, the separation ofoperating and non-operating items is most important. The notes to the statements providedescriptions of the accounting rules applied and more information about items disclosed onthe statements, as well as information about economic events not disclosed in thestatements.

2. Analyze and interpret the return on equity ratio. p. 243ROE measures how well management used the investment by shareholders during theperiod. Its three determinants—net profit margin, asset turnover, and financial leverage—indicate why ROE differs from prior levels or that of competitors; these determinantsprovide insights into strategies to improve ROE in future periods.

3. Recognize the people involved in the accounting communication process (managers,auditors, information intermediaries, government regulators, and users), theirroles in the process, and the guidance they receive from legal and professionalstandards. p. 251Management of the reporting company must decide on the appropriate format (categories)and level of detail to present in its financial reports. Independent audits increase the


credibility of the information. Financial statement announcements from public companiesusually are first transmitted to users through electronic information services. Analysts playa major role in making this and other information available to average investors throughtheir stock recommendations and earnings forecasts.

4. Identify the steps in the accounting communication process, including the issuance ofpress releases, annual reports, quarterly reports, and documents filed with securitiescommissions, as well as the role of electronic information services in this process.p. 258Earnings are first made public in press releases. Companies follow these announcementswith annual and quarterly reports containing statements, notes, and additional information.Public companies must also file additional reports with the securities commissions (e.g.,OSC, SEC), which contain more details about the company. Electronic informationservices are the key source of dissemination of this information to sophisticated users.

In Chapter 6, we begin our in-depth discussion of financial statements. We willbegin with two of the most liquid assets—cash and accounts receivable—andtransactions that involve revenue, adjustments to revenues, and certain selling expensesthat relate to recording cash and accounts receivable. Many analysts and the securitiesregulators believe that accuracy in revenue recognition and the related recognition ofcost of goods sold (discussed in the next chapter) are the most important determinantsof the accuracy—and, thus, the usefulness—of financial statement presentations. Wewill also introduce concepts related to the management and control of cash andreceivables, which is a critical business function. A detailed understanding of thesetopics is crucial to future managers, accountants, and financial analysts.

KEY RATIO

Return on equity (ROE) measures how much the firm earned for each dollar ofshareholders’ investment. It is computed as follows (p. 243):

Return on Equity �Net Income

Average Shareholders’ Equity


FINDINGFINANCIALINFORMATION

BALANCE SHEETKey Classifications

Current and non-current assets and

liabilities

Contributed capital and retained earnings

INCOME STATEMENTKey Subtotals

Gross profit

Income from operations

Net income

Earnings per share

NOTESKey Classifications

Descriptions of accounting rules applied in

the statements

Additional detail supporting reported

numbers

Relevant financial information not

disclosed on the statements

CASH FLOW STATEMENTUnder Operating Activities (indirect method)

Net Income

� Items Not Affecting Cash

� Cash Provided by Operating Activities


KEY TERMSClean Audit Opinion p. 251

Comparable Information p. 258

Conservatism p. 251

Consistent Information p. 258

Cost-Benefit Constraint p. 258

Discontinued Operations p. 243

Earnings Forecasts p. 254

Extraordinary Items p. 243

Gross Profit (Gross Margin) p. 241

Income before Income Taxes(Pretax Earnings) p. 243

Income from Continuing Operations(Operating Income) p. 242

Institutional Investors p. 256

Lenders (Creditors) p. 257

Material Amounts p. 251

Press Release p. 258

Private Investors p. 257

Relevant Information p. 258

Reliable Information p. 258

QUESTIONS1. What are the four major classifications on the income statement?2. Define extraordinary items. Why should they be reported separately on the income

statement?3. List the six major classifications reported on a balance sheet.4. For property, plant, and equipment, as reported on the balance sheet, explain (a) cost,

(b) accumulated amortization, and (c) net book value.5. Briefly explain the major classifications of shareholders’ equity for a corporation.6. What are the three major classifications on a cash flow statement?7. What are the three major categories of notes or footnotes presented in annual reports? Cite

an example of each.8. Briefly define return on equity and what it measures.9. Describe the roles and responsibilities of management and independent auditors in the

financial reporting process.10. Define the following three users of financial accounting disclosures and the relationships

among them: financial analysts, private investors, and institutional investors.11. Briefly describe the role of information services in the communication of financial

information.12. Explain why information must be relevant and reliable to be useful.13. What basis of accounting does GAAP require on the (a) income statement, (b) balance

sheet, and (c) cash flow statement?14. Briefly explain the normal sequence and form of financial reports produced by private com-

panies in a typical year.15. Briefly explain the normal sequence and form of financial reports produced by public com-

panies in a typical year.

MINI-EXERCISES

Determining the Effects of Transactions on Balance Sheet and Income StatementCategoriesComplete the following tabulation, indicating the sign of the effect (� for increase, � fordecrease, and NE for no effect) of each transaction. Consider each item independently.

a. Recorded sales on account of $100 and related cost of goods sold of $60.

b. Recorded advertising expense of $10 incurred but not paid for.

Transaction Current Assets Gross Profit Current Liabilities

(a)

(b)

LO1 M5–1


Determining Financial Statement Effects of Sales and Cost of Goods Sold and Issuanceof SharesUsing the following categories, indicate the effects of the following transactions. Use � forincrease and � for decrease and indicate the accounts affected and the amounts.

a. Sales on account were $500 and related cost of goods sold was $360.

b. Issued 10,000 common shares for $90,000 cash.

Event Assets � Liabilities � Shareholders’ Equity

Recording Sales and Cost of Goods Sold and Issuance of SharesPrepare journal entries for each transaction listed in M5–2.

Computing Net Book Value of Property, Plant, and EquipmentMay’s Diner purchases new tables for $5,000 on January 1, 20A. The tables are expected tohave a useful life of 10 years and a salvage value of $500 . What would be the net book valueof the tables on December 31, 20C?

Computing and Interpreting Return on EquityChen, Inc., recently reported the following amounts in its financial statements (in thousands):

Current Year Prior Year

Gross profit $ 170 $140

Net income 85 70

Total assets 1,000 900

Total shareholders’ equity 800 750

Compute return on equity for the current year. What does this ratio measure?

Matching Players in the Accounting Communication Process with Their DefinitionsMatch each player with the related definition by entering the appropriate letter in the spaceprovided.

Players Definitions

(1) CEO and CFO(2) Independent auditor(3) Users(4) Financial analyst

A. Adviser who analyzes financial and othereconomic information to form forecasts andstock recommendations.

B. Institutional and private investors andcreditors (among others).

C. Chief executive officer and chief financialofficer who have primary responsibility forthe information presented in financialstatements.

D. Independent accountant who examinesfinancial statements and attests to theirfairness.

Identifying the Disclosure SequenceIndicate the order in which the following disclosures or reports are normally issued by publiccompanies.

No. Title

Annual report

Filing of annual financial

information with

securities commissions

Earnings press release

Matching Definitions with Information Releases Made by Public CompaniesThe titles of various information releases follow. Match each definition with the relatedrelease by entering the appropriate letter in the space provided.

LO1

LO3

M5–7

M5–2

M5–3 LO1

LO1M5–4

M5–5

M5–6

LO2

LO4

M5–8 LO4


Information Release Definitions

(1) Annual report(2) Press release(3) Quarterly report

A. Written public news announcement that isnormally distributed to major news services.

B. Report containing the four basic statements forthe year, related notes, and other disclosures bymanagement and auditors.

C. Brief unaudited report for quarter normallycontaining summary income statement andbalance sheet (unaudited).

Finding Financial Information: Matching Financial Statements with the Elements ofFinancial StatementsMatch each financial statement with the items presented on it by entering the appropriate letterin the space provided.

Elements of Financial Statements Financial Statements

(1) Liabilities A. Income statement(2) Cash from operating activities B. Balance sheet(3) Losses C. Cash flow statement(4) Assets D. None of the above(5) Revenues(6) Cash from financing activities(7) Gains(8) Shareholders’ equity(9) Expenses

(10) Assets owned by a shareholder

EXERCISES

Ordering the Classifications on a Typical Balance SheetA list of classifications on the balance sheet is shown below. Number the classifications in theorder in which they normally appear on a balance sheet.

No. Title

Current liabilities

Long-term liabilities

Long-term investments

Intangible assets

Property, plant, and equipment

Current assets

Retained earnings

Share capital

Other non-current assets

Preparing a Classified Balance SheetDell Computer Corporation is the leading direct-sale computer vendor in North America. Thecompany offers its customers a full range of computer systems, including desktop computersystems, notebook computers, workstations, network servers, and storage products, as well asan extended selection of peripheral hardware, computing software and related services. Thecompany sells its products and services to large corporate, government, health care, andeducation customers, small- and medium-sized businesses and individuals. The items listed ona recent balance sheet (in millions) are presented below in alphabetical order.

Accounts payable $ 4,286Accounts receivable, net 2,895Accrued expenses payable 2,257Cash and cash equivalents 5,438

LO1 M5–9

E5–1

LO1 E5–2

LO1

Dell Computer


Inventories 400Investments, long term 2,418Non-current liabilities 1,270Other current assets 758Other non-current assets 530Property, plant, and equipment, net 996Retained earnings 827Share capital 4,795

Required:Prepare in good form a classified balance sheet for Dell Computer as at the end of the currentyear, December 31, 20D, using the categories presented in the chapter.

Preparing and Interpreting a Classified Balance Sheet with Discussion of Terminology (Challenging)Shaw Communications Inc. is a diversified Canadian communications company whose corebusiness is providing broad-band cable television, Internet, and satellite services toapproximately 2.8 million customers. Shaw also has significant interests in telecommunications,Internet infrastructure, and interactive television companies. The following is a list of itemspresented in the company’s recent balance sheet as at August 31, 20A, the end of its fiscal year.The items are listed in alphabetical order and the amounts are in millions of Canadian dollars.

Accounts payable and accrued liabilities $ 335.0Accounts receivable, net 89.5Bank indebtedness 27.0Current portion of long-term debt 187.3Deferred charges (long term) 152.9Deferred credits (long term) 541.6Deferred income taxes (credit balance) 184.9Income taxes payable 2.0Investments and other assets 1,068.4Long-term debt 1,590.3Non-controlling interest 17.8Prepaid expenses and other 9.3Property, plant, and equipment, net 1,683.4Retained earnings (including cumulative translation adjustment) 254.5Share capital 2,136.0Subscriber base and broadcast licences, net 2,318.4Unearned revenue 45.5

Required:

1. Prepare a classified consolidated balance sheet for Shaw Communications Inc. as atAugust 31, 20A, using the categories presented in the chapter.

2. Two of the items end in the term net. Explain what this term means in each case.

Reporting Property, Plant, and Equipment on the Balance SheetOn January 1, 20B, Laura Anne’s Bakery purchased a new oven for $6,800. The oven wasexpected to be used for four years and then to be sold for $2,000 on January 1, 20F. Prepare aschedule showing the amounts that would be reported on the balance sheets prepared at the endof 20B, 20C, 20D, and 20E for the oven (at cost), accumulated amortization, and net book value.

Inferring Share Issuances and Cash Dividends from Changes in Shareholders’ EquityPower Corporation recently reported the following December 31 balances in its shareholders’equity accounts (in millions):


Share capital $ 564 $ 551

Retained earnings 3,392 2,885

Total shareholders’ equity $3,956 $3,436

During the current year, Power Corp. reported net income of $657 million. Assume that theonly other transactions that affected shareholders’ equity during the current year were theissuance of shares and the declaration and payment of cash dividends.

E5–3 LO1Shaw

Communications

E5–4 LO1

E5–5 LO1

Power Corporation


Required:Re-create the two journal entries reflecting the issuance of shares and the declaration andpayment of dividends.

Matching Definitions with Income Statement-Related TermsSelected terms that relate to the income statement follow. Match each definition with itsrelated term by entering the appropriate letter in the space provided.

Terms Definitions

(1) Cost of goods sold(2) Interest expense(3) Extraordinary item(4) Service revenue(5) Income tax expense on operations(6) Income before extraordinary items(7) Net income(8) Gross margin on sales(9) EPS

(10) Operating expenses(11) Income from operations

A. Sales Revenue minus Cost of GoodsSold.

B. Item that is unusual, infrequent, andnot dependent on management’s (orowners’) decisions.

C. Sales of services for cash or on credit.D. Revenues � Gains � Expenses �

Losses, including effects ofdiscontinued operations andextraordinary items (if any).

E. Amount of resources used to purchaseor produce the goods that were soldduring the reporting period.

F. Cost of money (borrowing) over time.G. Net income divided by the average

number of common sharesoutstanding.

H. Total expenses directly related tooperations.

I. Income before all income tax andbefore discontinued operations andextraordinary items (if any).

J. None of the above.

Inferring Income Statement ValuesSupply the missing dollar amounts for the 20B income statement of Ultimate Style Companyfor each of the following independent cases:

Case A Case B Case C Case D Case E

Sales revenue $900 $700 $410 $ ? $ ?

Selling expense ? 150 80 400 250

Cost of goods sold ? 380 ? 500 310

Income tax expense ? 30 20 40 30

Gross margin 400 ? ? ? 440

Income before income tax 200 90 ? 190 ?

Administrative expense 150 ? 60 100 80

Net income 170 ? 50 ? 80

Preparing a Multiple-Step Income StatementThe following data were taken from the records of Village Corporation at December 31, 20B:

Sales revenue $70,000

Gross profit 24,500

Selling (distribution) expense 8,000

Administrative expense ?

Income before income tax 12,000

Income tax rate 30%

Number of shares outstanding 3,000

E5–6

LO1 E5–7

LO1

E5–8LO1


Required:Prepare a complete multiple-step income statement for the company (showing both grossprofit and income from operations). Show all computations. (Hint: Set up the side captionsstarting with sales revenue and ending with earnings per share; use the amounts andpercentages given to infer missing values.)

Preparing Single- and Multiple-Step Income StatementsThe following data were taken from the records of Kimberly Appliances, Incorporated, atDecember 31, 20D:


Administrative expense 10,000

Selling (distribution) expense 18,000

Income tax rate 25%

Gross profit 48,000

Number of shares outstanding 2,000

Required:

1. Prepare a complete single-step income statement for the company. Show all computations.(Hint: Set up the side captions or rows starting with sales revenue and ending withearnings per share; use the amounts and percentages given to infer missing values.)

2. Prepare a complete multiple-step income statement for the company (showing both grossprofit and income from operations).

Determining the Effects of Transactions on Balance Sheet and IncomeStatement CategoriesGildan Activewear Inc. is one of the largest producers of casual wear, selling T-shirts, golfshirts, and sweatshirts. Listed here are selected aggregate transactions from the first quarter of20B (in millions). Complete the following tabulation, indicating the sign (� for increase,� for decrease, and NE for no effect) and amount of the effect of each transaction. Considereach item independently.

a. Recorded sales on account of $153.1 and related cost of goods sold of $110.4.

b. Borrowed $106.5 on line of credit with a bank, payable within one year.

c. Incurred research and development expense of $10, which was paid in cash.

Transaction Current Assets Gross Profit Current Liabilities

a.

b.

c.

Determining the Effects of Transactions on Balance Sheet, Income Statement, and CashFlow Statement CategoriesRowe Furniture Corporation is a Virginia-based manufacturer of furniture. Listed here areselected aggregate transactions from the first quarter of 20B (in millions). Complete thefollowing tabulation, indicating the sign (� for increase, � for decrease, and NE for no effect)and amount of the effect of each additional transaction. Consider each item independently.

a. Recorded $32.2 of cash collections from customers who purchased furniture in 20A.

b. Repaid $2.1 to a local bank for amount borrowed on a line of credit.

Current Gross Current Cash Flow from Transaction Assets Profit Liabilities Operating Activities

a.

b.

E5–9 LO1

E5–10 LO1

Gildan Activewear

E5–11 LO1

Rowe Furniture


Preparing a Simple Cash Flow Statement Using the Indirect MethodBlackwell Corporation is preparing its annual financial statements at December 31, 20A. Theitems listed on the company’s cash flow statement are presented below in alphabetical order.Parentheses indicate that a listed amount should be subtracted on the cash flow statement. Thebeginning balance of cash was $36,000 and the ending balance was $41,000.

Cash borrowed on three-year note $25,000

Decrease in inventory 2,000

Decrease in accounts payable (4,000)

Increase in accounts receivable (10,000)

Net income 18,000

Shares issued for cash 22,000

New delivery truck purchased (12,000)

Land purchased (36,000)

Required:Prepare the 20A cash flow statement for Blackwell Corporation. Use the indirect method forreporting cash flows from operating activities.

Analyzing and Interpreting Return on EquityLands’ End Inc. is a mail-order and Internet-based direct merchant of traditionally styledcasual clothing accessories, shoes, soft luggage, and products for the home. Selected incomestatement and balance sheet amounts (in thousands) for two recent years are presented below.


Net income $ 31,185 $ 64,150

Average shareholders’ equity 349,211 338,092

Required:

Compute the ROE for the current and prior years and explain the meaning of the change.

Analyzing and Evaluating Return on Equity from a Security Analyst’s PerspectivePapa John’s is one of the fastest-growing pizza delivery and carry-out restaurant chains.Selected income statement and balance sheet amounts (in thousands) for two recent years arepresented below.


Net income $ 26,853 $ 18,614

Average shareholders’ equity 232,988 196,352

Required:

1. Compute the ROE for the current and prior years and explain the meaning of the change.

2. Would security analysts more likely increase or decrease their estimates of share value onthe basis of this change? Explain.

Matching Players in the Accounting Communication Process with Their DefinitionsMatch each player with the related definition by entering the appropriate letter in the spaceprovided.

Players Definitions

(1) OSC(2) Independent auditor(3) Institutional investor(4) CEO and CFO(5) Creditor(6) Financial analyst(7) Private investor(8) Information service

A. Adviser who analyzes financial and other economicinformation to form forecasts and stockrecommendations.

B. Financial institution or supplier that lends money tothe company.

C. Chief executive officer and chief financial officerwho have primary responsibility for the informationpresented in financial statements.

E5–12LO1

E5–13LO2

Lands’ End

E5–14LO2

Papa John’s

E5–15LO3


D. Independent accountant who examines financialstatements and attests to their fairness.

E. Ontario Securities Commission, which regulatesfinancial disclosure requirements.

F. A company that gathers, combines, and transmits(paper and electronic) financial and relatedinformation from various sources.

G. Individual who purchases shares in companies.H. Manager of pension, mutual, and endowment funds

that invests funds on behalf of others.

Finding Financial Information: Matching Information Items to Financial ReportsFollowing are information items included in various financial reports. Match each informationitem with the report(s) where it would most likely be found by entering the appropriateletter(s) in the space provided.

Information Item Report

(1) Summarized financial data for 5- or 10-year period.(2) Initial announcement of quarterly earnings.(3) Complete quarterly income statement, balance

sheet, and cash flow statement.(4) The four basic financial statements for the year.(5) Detailed discussion of the company’s competition.(6) Notes to financial statements.(7) Identification of those responsible for the financial

statements.(8) Initial announcement of hiring of new vice-

president for sales.

A. Annual reportB. Annual information

formC. Press releaseD. Quarterly reportE. None of the above

PROBLEMS

Matching Definitions with Balance Sheet–Related TermsSelected terms related to the balance sheet, which were discussed in Chapters 2 through 5, arelisted below. Match each definition with its related term by entering the appropriate letter inthe space provided.

Terms

(1) Retained earnings(2) Current liabilities(3) Liquidity(4) Contra-asset account(5) Accumulated amortization(6) Intangible assets(7) Other assets(8) Shares outstanding(9) Normal operating cycle

(10) Book value(11) Contributed surplus(12) Liabilities(13) Long-term assets(14) Shareholders’ equity(15) Current assets(16) Assets(17) Long-term liabilities

Definitions

A. A miscellaneous category of assets.B. Amount of contributed capital for which

shares were not issued.C. Total assets minus total liabilities.D. Nearness of assets to cash (in time).E. Assets expected to be collected in cash

within one year or the operating cycle, iflonger.

F. Same as carrying value; cost lessaccumulated amortization to date.

G. Accumulated earnings minus accumulateddividends.

H. Asset offset account (subtracted from asset).I. Balance of the Common Shares account

divided by the issue price per share.J. Assets that do not have physical substance.K. Probable future economic benefits owned by

the entity from past transactions.L. Liabilities expected to be paid out of current

assets, normally within the next year.

E5–16 LO4

P5–1 LO1


M. The average cash-to-cash time involved inthe operations of the business.

N. Sum of the annual amortization expense onan asset from the date of its acquisition tothe current date.

O. All liabilities not classified as current liabilities.P. Property, plant, and equipment.Q. Debts or obligations from past transactions to

be paid with assets or services.R. None of the above.

Preparing a Balance Sheet and Analyzing Some of Its Parts (AP5–1)King Jewellers Inc. is developing its annual financial statements for 20C. The followingamounts were correct at December 31, 20C: cash, $42,000; accounts receivable, $51,300;merchandise inventory, $110,000; prepaid insurance, $800; investment in shares of Z Corporation (long term), $26,000; store equipment, $48,000; used store equipment heldfor disposal, $7,000; accumulated amortization, store equipment, $9,600; accounts payable,$42,000; long-term note payable, $30,000; income taxes payable, $7,000; retained earnings,$86,500; and common shares, 100,000 shares outstanding (originally issued at $1.10 pershare).

Required:1. Based on these data, prepare the company’s balance sheet at December 31, 20C. Use the

following major captions (list the individual items under these captions):

a. Assets: Current Assets; Long-Term Investments; Property, Plant and Equipment; andOther Assets.

b. Liabilities: Current Liabilities and Long-Term Liabilities.

c. Shareholders’ Equity: Share Capital and Retained Earnings.

2. What is the net book value of the

a. Inventory?

b. Accounts receivable?

c. Store equipment?

d. Note payable (long term)?

Explain what these values mean.

Reporting Building, Land, and Amortization Expense (AP5–2)Kamel Company is preparing its balance sheet at December 31, 20X. The following assets areto be reported:

a. Building, purchased 15 years ago (including 20X): original cost, $450,000; estimateduseful life, 25 years from date of purchase; and no residual value.

b. Land, purchased 15 years ago (including 20X): original cost, $70,000.

Required:

1. Show how the two assets should be reported on the balance sheet. What is the net bookvalue of the property, plant, and equipment?

2. What amount of amortization expense should be reported on the 20X income statement?Show computations.

Reporting Shareholders’ Equity on a Balance Sheet and Recording the Issuance of Shares (AP5–3)At the end of the 20A annual reporting period, Mesa Corporation’s balance sheet included thefollowing:

MESA CORPORATIONBalance Sheet (Partial)At December 31, 20A

Shareholders’ Equity

Common shares (7,000 shares) $ 70,000

Contributed surplus 10,000


Total shareholders’ equity $130,000

P5–3LO1

P5–4LO1

SP5–2LO1


During 20B, the following selected transactions (summarized) were completed:

a. Sold and issued 1,000 common shares at $15 cash per share (at year-end).

b. Determined net income, $40,000.

c. Declared and paid a cash dividend of $3 per share on the shares outstanding at January 1,20B.

Required:

1. Prepare the shareholders’ equity section of the balance sheet at December 31, 20B.

2. Prepare the journal entry to record the sale and issuance of the 1,000 common shares.

Preparing a Multiple-Step Income Statement and a Statement of Retained Earnings(Challenging)Domtar Inc. is the second-largest integrated manufacturer and marketer of uncoated freesheetpaper in North America and the third-largest worldwide. It produces wood, pulp, and paperproducts, including corrugated containers and linerboard. During the year ended Decem-ber 31, 20B, Domtar changed the methods it used to account for income taxes and employeefuture benefits as recommended by the Accounting Standard Board of the Canadian Instituteof Chartered Accountants. In addition, it purchased shares from its shareholders, paying ahigher price per share than the amount it collected when the shares were originally issued. Theitems reported on the company’s income statement for that year are presented below (inmillions) in alphabetical order.

Amortization expense $ 239Cost of sales 2,703Cumulative effect of changes in accounting policies (debit) 151Dividends 28Financing expenses 96Income tax expense 105Net sales 3,598Premium on repurchase of common shares 43Retained earnings at beginning of year 504Selling, general, and administrative expenses 180

Required:

1. Using appropriate headings and subtotals, prepare a multiple-step consolidated incomestatement (showing both gross profit and operating income) and a statement of retainedearnings for the year ended December 31, 20B.

2. What information does the multiple-step format emphasize that the single-step incomestatement does not?

Preparing Both an Income Statement and Balance Sheet from a Trial Balance (AP5–4)Juan Real Estate Company (organized as a corporation on April 1, 20A) has completed theaccounting cycle for the second year, ended March 31, 20C. Juan also has completed a correcttrial balance as follows:

JUAN REAL ESTATE COMPANYTrial Balance

At March 31, 20CAccount Titles Debit Credit

Cash $ 53,000Accounts receivable 44,800Office supplies inventory 300Automobiles (company cars) 30,000Accumulated amortization, automobiles $ 10,000Office equipment 3,000Accumulated amortization, office equipment 1,000Accounts payable 20,250Salaries and commissions payable 1,500Note payable, long term 30,000Share capital (30,000 shares) 30,000

LO1

Domtar Inc.

P5–5

LO1P5–6

S

S


Contributed surplus 5,000Retained earnings (on April 1, 20B) 7,350Dividends declared 8,000Sales commissions earned 77,000Management fees earned 13,000Operating expenses (detail omitted to conserve your time) 48,000Amortization expense (including $500 on office equipment) 5,500Interest expense 2,500

Totals $195,100 $195,100

Required:

1. Prepare an income statement for the reporting year ended March 31, 20C. Include incometax expense, assuming a 30 percent tax rate. Use the following major captions: Revenues,Expenses, Income before Income Taxes, Income Tax, Net Income, and Earnings per Share(list each item under these captions as appropriate).

2. Prepare the journal entry to record income taxes for the year (not yet paid).

3. Prepare a balance sheet at the end of the reporting year, March 31, 20C. Use the followingcaptions (list each item under these captions as appropriate).

Assets

Current Assets

Non-current Assets

Liabilities

Current Liabilities

Long-Term Liabilities


Share Capital

Retained Earnings

Inferring the Amounts on an Income Statement (Challenging)A partially completed income statement of Reginold Corporation for the year ended Decem-ber 31, 20B, is presented below.

Items Other Data Amounts

Net sales revenue $260,000

Cost of goods sold

Gross margin on sales Gross margin as percent of sales, 35%

Expenses

Selling expense

General and administrative expense $28,000

Interest expense 4,000

Total expenses

Income before income tax

Income tax on operations

Income before extraordinary item

Extraordinary gain 12,000

Income tax effect

Net extraordinary gain

Net income

Earnings per share

Income before extraordinary gain 1.20

Extraordinary gain

Net income

Required:Complete the income statement, assuming (1) a 20 percent income tax rate on all items and (2)25,000 common shares outstanding. Show all computations.

LO1 P5–7


Preparing a Simple Cash Flow Statement Using the Indirect MethodFollowing are the items on Srinivasan Company’s 20B cash flow statement presentedin alphabetical order. Parentheses indicate that a listed amount should be subtracted on thecash flow statement. The beginning balance in cash was $40,000 and the ending balancewas $27,000.

Borrowing on long-term note $20,000

Increase in accounts payable 6,000

Increase in accounts receivable (5,000)

Increase in inventories (10,000)

Net income 55,000

Paid cash dividend (15,000)

Paid long-term note (12,000)

Purchased equipment (80,000)

Purchased land (8,000)

Issuance of share capital (3,000 shares � $12) 36,000

Required:Prepare the 20B cash flow statement for Srinivasan Company using the indirect methodpresented in the chapter.

Determining and Interpreting the Effects of Transactions on Income StatementCategories and Return on Equity (AP5–5)Apple Computer popularized both the personal computer and the easy-to-use graphicinterface. Today it competes against many companies that rely on Intel microprocessors andthe Windows operating system. Presented here is an income statement (in millions).

Net sales $5,941

Costs and expensesCost of sales 4,462 Research and development 310 Selling, general, and administrative 908

Operating income (loss) 261Interest and other income (expenses), net 68

Income (loss) before provision (benefit) for income taxes 329 Provision (benefit) for income taxes 20

Net income (loss) $ 309

Its beginning and ending shareholders’ equity amounts were $1,200 and $1,642, respectively.

Required:

1. Assume that the following hypothetical additional transactions occurred during the fiscalyear. Complete the following tabulation, indicating the sign of the effect of each additionaltransaction (� for increase, � for decrease, and NE for no effect). Consider each itemindependently and ignore income taxes.

a. Recorded sales on account of $500 and related cost of goods sold of $475.

b. Incurred additional research and development expense of $100, which was paid in cash.

c. Issued additional common shares for $200 cash.

d. Declared and paid dividends of $90.

Transaction Gross Profit Operating Income (Loss) Return on Equity

a.

b.

c.

d .

LO1P5–8

P5–9 LO1, 2

Apple Computer


2. Assume that during the next period, Apple does not pay any dividends, does not issue orretire common shares, and earns the same income as during the current period. WillApple’s ROE next period be higher, lower, or the same as the current period? Why?

Matching Transactions with ConceptsThe concepts of accounting covered in Chapters 2 through 5 are shown below. Match eachtransaction with its related concept by entering the appropriate letter in the space provided.Use only one letter for each blank space.

Concepts

(1) Users of financialstatements

(2) Objective offinancialstatements

Qualitative Characteristics

(3) Relevance(4) Reliability

Assumptions

(5) Separate entity(6) Continuity(7) Unit of measure(8) Periodicity

Elements of FinancialStatements

(9) Revenues(10) Expenses(11) Gains(12) Losses(13) Assets(14) Liabilities(15) Shareholders’

equity

Principles

(16) Cost(17) Revenue(18) Matching(19) Full disclosure

Constraints of Accounting

(20) Materialitythreshold

(21) Cost-benefitconstraint

(22) Conservatismconstraint

(23) Industrypeculiarities

Transactions

A. Recorded a $1,000 sale of merchandise on credit.B. Counted (inventoried) the unsold items at the end of the

period and valued them in dollars.C. Acquired a vehicle for use in operating the business.D. Reported the amount of amortization expense because it

likely will affect important decisions of statement users.E. Identified as the investors, creditors, and others interested in

the business.F. Used special accounting approaches because of the

uniqueness of the industry.G. Sold and issued bonds payable of $1 million.H. Paid a contractor for an addition to the building with $10,000

cash and $20,000 market value of the company’s shares($30,000 was deemed to be the cash equivalent price).

I. Engaged an outside independent accountant to audit thefinancial statements.

J. Sold merchandise and rendered services for cash and oncredit during the year; then determined the cost of thosegoods sold and the cost of rendering those services.

K. Established an accounting policy that sales revenue shall berecognized only when ownership of the goods sold passesto the customer.

L. To design and prepare the financial statements to assist theusers in making decisions.

M. Established a policy not to include in the financialstatements the personal financial affairs of the owners of thebusiness.

N. Sold an asset at a loss that was a peripheral or incidentaltransaction.

O. The value to users of a special financial report exceeds thecost of preparing it.

P. Valued an asset, such as inventory, at less than its purchasecost because the replacement cost is less.

Q. Dated the income statement “For the Year Ended December31, 20B.”

R. Used services from outsiders—paid cash for some and theremainder on credit.

S. Acquired an asset (a pencil sharpener that will have a usefullife of five years) and recorded it as an expense whenpurchased for $1.99.

T. Disclosed in the financial statements all relevant financialinformation about the business; necessitated the use ofnotes to the financial statements.

U. Sold an asset at a gain that was a peripheral or incidentaltransaction.

V. Assets of $500,000 � Liabilities of $300,000 �Shareholders’ Equity of $200,000.

W. Accounting and reporting assume a “going concern.”

LO3, 4 P5–10


ALTERNATE PROBLEMSPreparing a Balance Sheet and Analyzing Some of Its Parts (P5–2)Carpet Bazaar is developing its annual financial statements for 20C. The following amountswere correct at December 31, 20C: cash, $35,000; investment in shares of ABC Corporation(long term), $32,000; store equipment, $51,000; accounts receivable, $47,500; carpetinventory, $118,000; prepaid insurance, $1,300; used store equipment held for disposal,$3,500; accumulated amortization, store equipment, $10,200; income taxes payable, $6,000;long-term note payable, $26,000; accounts payable, $45,000; retained earnings, $76,100; andcommon shares, (100,000 shares outstanding, originally sold and issued at $1.25 per share).

Required:

1. Based on these data, prepare the company’s balance sheet at December 31, 20C. Use thefollowing major captions (list the individual items under these captions):

a. Assets: Current Assets; Long-Term Investments; Property, Plant, and Equipment; andOther Assets.

b. Liabilities: Current Liabilities and Long-Term Liabilities.

c. Shareholders’ Equity: Share Capital and Retained Earnings.

2. What is the net book value of the

a. Inventory?

b. Accounts receivable?

c. Store equipment?

d. Note payable (long term)?

Explain what these values mean.

Reporting Building, Land, and Amortization Expense (P5–3)Berczi Inc. is preparing its balance sheet at December 31, 20X. The following assets are to bereported:

a. Building, purchased 12 years ago (including 20X): original cost, $630,000; estimateduseful life, 20 years from date of purchase; no residual value.

b. Land, purchased 12 years ago (including 20X): original cost, $112,000.

Required:

1. Show how the two assets should be reported on the balance sheet. What is the net bookvalue of the property, plant, and equipment?

2. What amount of amortization expense should be reported on the 20X income statement?Show computations.

Reporting Shareholders’ Equity on a Balance Sheet and Recording the Issuance ofShares (P5–4)At the end of its 20A fiscal year, Potamia Corporation’s balance sheet included the following:

POTAMIA CORPORATION

Balance Sheet (Partial)

At December 31, 20A


Common shares (9,500 shares) $ 95,000



Total shareholders’ equity $193,500

During 20B, the following selected transactions (summarized) were completed:

a. Sold and issued 1,500 common shares at $17 cash per share (at year-end).

b. Determined net income, $50,000.

c. Declared and paid a cash dividend of $2 per share on the shares outstanding at January 1,20B.

LO1AP5–1

LO1AP5–2

LO1AP5–3


Required:

1. Prepare the shareholders’ equity section of the balance sheet at December 31, 20B.

2. Prepare the journal entry to record the sale and issuance of the 1,500 common shares.

Preparing Both an Income Statement and Balance Sheet from a Trial Balance (P5–6)ACME Pest Control Services (organized as a corporation on September 1, 20A) has completedthe accounting cycle for the second year, ended August 31, 20C. ACME Pest Control also hascompleted a correct trial balance as follows:

ACME PEST CONTROL SERVICES

Trial Balance

At August 31, 20CAccount Titles Debit Credit

Cash $ 26,000

Accounts receivable 30,800

Supplies inventory 1,300

Service vehicles (company vans) 60,000

Accumulated amortization, automobiles $ 20,000

Equipment 14,000

Accumulated amortization, equipment 4,000

Accounts payable 16,700

Salaries payable 1,100

Note payable, long term 34,000

Share capital (10,000 shares) 10,000


Retained earnings (on September 1, 20B) 4,300

Dividends declared 2,000

Sales revenue 38,000

Maintenance contract revenue 17,000

Operating expenses (detail omitted to conserve your time) 27,000

Amortization expense (including $2,000 on equipment) 12,000

Interest expense 2,000

Totals $175,100 $175,100

Required:

1. Prepare an income statement for the reporting year ended August 31, 20C. Include incometax expense, assuming a 30 percent tax rate. Use the following major captions: Revenues,Expenses, Income before Income Tax, Income Tax, Net Income, and Earnings per Share(list each item under these captions as appropriate).

2. Prepare the journal entry to record income taxes for the year (not yet paid).

3. Prepae a balance sheet at the end of the reporting year, August 31, 20C. Use the followingcaptions (list each item under these captions as appropriate).

Assets

Current Assets

Non-Current Assets

Liabilities

Current Liabilities

Long-Term Liabilities


Share Capital

Retained Earnings

LO1 AP5–4

Determining and Interpreting the Effects of Transactions on Income StatementCategories and Return on Equity (P5–9)Barnes & Noble, Inc., revolutionized bookselling by making its stores public spaces andcommunity institutions where customers may browse, find a book, relax over a cup of coffee,talk with authors, and join discussion groups. Today it is fighting increasing competition notonly from traditional sources but also from online booksellers. Presented here is a recentincome statement (in millions).

Net sales $2,448

Costs and expensesCost of sales 1,785 Selling, general, and administrative 466 Depreciation and amortization 60 Preopening expenses 18

Operating income 119Interest and other income (expenses), net (38)

Income before provision (benefit) for income taxes 81 Provision for income taxes 30

Net income $ 51

Its beginning and ending shareholders’ equity amounts were $400 and $446, respectively.

Required:

1. Assume that the following hypothetical additional transactions occurred during the fiscalyear. Complete the following tabulation, indicating the sign of the effect of each additionaltransaction (� for increase, � for decrease, and NE for no effect). Consider each itemindependently and ignore income taxes.

a. Recorded and received additional interest income of $4.

b. Purchased $25 of additional inventory on open account.

c. Recorded and paid additional advertising expense of $9.

d. Issued additional common shares for $50 cash.

Transaction Operating Income Net Income Return on Equity

a.

b.

c.

d .

2. Assume that during the next period, Barnes & Noble does not pay any dividends, does notissue or retire common shares, and earns 20 percent more than during the current period.Will Barnes & Noble’s ROE next period be higher, lower, or the same as in the currentperiod? Why?

CASES AND PROJECTSFINANCIAL REPORTING AND ANALYSIS CASESFinding Financial InformationRefer to the financial statements of Gildan Activewear Inc., given in Appendix B at the end ofthis book. At the bottom of each statement, the company warns readers to “See accompanyingnotes to consolidated financial statements.” The following questions illustrate the types ofinformation that you can find in the financial statements and accompanying notes.

Required:1. Does the company present a single-step or multiple-step income statement?


AP5–5 LO1, 2

Barnes & Noble

LO1, 4

Gildan Activewear

CP5–1

2. The company spent $46,736,851 on capital expenditures (property, plant, and equipment)this year. Were operating activities or financing activities the major source of cash for theseexpenditures?

3. What was the company’s largest asset (net) at the end of the year?4. What was the amount of interest expense for the most recent year?

Finding Financial InformationRefer to the Online Learning Centre at www.mcgrawhill.ca/college/libby/student/resourcesfor the financial statements of The Forzani Group Ltd. (FGL). The following questions illustratethe types of information that you can find in the financial statements and accompanying notes.(Hint: Use the notes.)

Required:1. What was the highest stock price for the company during the current year?2. How much land did the company own at the end of the current year?3. What was the amortization expense for the current year?4. What amount of goodwill did the company report at the end of the current year?5. Did footwear sales increase or decrease as a percentage of total sales over the previous

year?

Comparing CompaniesRefer to the Online Learning Centre at www.mcgrawhill.ca/college/libby/student/resourcesfor the financial statements of The Forzani Group Ltd. and to Appendix B for the financialstatements of Gildan Activewear Inc..

Required:1. Compute the return on equity for the current year. Which company provided the higher

return to shareholders during the current year?2. How might the ownership versus the rental of property, plant, and equipment affect the

return on equity?

Interpreting the Financial PressThe Committee of Sponsoring Organizations (COSO) published a research studythat examined financial statement fraud occurrences between 1987 and 1997. A summaryof the findings by M. S. Beasley, J. V. Carcello, and D. R. Hermanson, “FraudulentFinancial Reporting: 1987–1997: An Analysis of U.S. Public Companies,” The Auditor’sReport, Summer 1999, pp. 15–17, is available on the Online Learning Centre atwww.mcgrawhill.ca/college/libby/students/resources.* Read the article and then write ashort memo outlining the following:

1. The size of the companies involved.2. The extent of top management involvement.3. The specific accounting fraud techniques involved.4. What might lead managers to introduce misstatements into the income statement near the

end of the accounting period.*Reprinted with permission from The Auditor’s Report, copyright © 1999 by American Institute ofCertified Public Accountants, Inc.

Using Financial Reports: Financial Statement InferencesThe following amounts were selected from the annual financial statements for GenesisCorporation at December 31, 20C (end of the third year of operations):

From the 20C income statement:


Cost of goods sold (170,000)

All other expenses (including income tax) (95,000)

Net income 10,000

From the December 31, 20C, balance sheet:

Current assets $ 90,000

All other assets 212,000

Total assets 302,000

Current liabilities 40,000

Long-term liabilities 66,000


LO1, 4

The Forzani Group

LO2

Gildan Activewearvs. The Forzani

Group

LO3

The Auditor’s Report

LO1, 4

CP5–2

CP5–3

CP5–4

CP5–5

Common shares* 100,000



Total liabilities and shareholders’ equity $302,000

*10,000 shares issued and outstanding throughout the year.

Required:Analyze the data on the 20C financial statements of Genesis by answering the questions thatfollow. Show computations.

1. What was the gross margin on sales?

2. What was the amount of earnings per share?

3. If the income tax rate was 25 percent, what was the amount of pretax income?

4. What was the average issuance price per common share?

5. Assuming that no dividends were declared or paid during 20C, what was the beginningbalance (January 1, 20C) of retained earnings?

Using Financial Reports: Interpreting International Financial Statement Classifications(Challenging)As the economy becomes more international in scope, users of financial statements may beexpected to analyze companies that are not incorporated in Canada. Diageo is a major worldcorporation located in London, England. It is a worldwide consumer goods company thatowns a number of well-known businesses such as Guinness and the Pillsbury Company.

Required:Based on the concepts presented in this book, explain the meaning of the various accountclassifications shown on the portion of the Diageo annual report presented here. (Note: Thereare three reserve accounts and a minority interests account. These accounts are discussed inadvanced accounting courses.)

DIAGEOConsolidated Balance Sheet

At 30th September, 20B and 20A

20B 20A

Notes £m £m £m £m

Fixed assetsIntangible assets 11 2,652 588Tangible assets 12 3,839 3,280Investments 13 144 206

6,635 4,074Current assetsStocks 14 1,269 761Debtors 15 1,451 873Cash at bank and in hand 215 138

2,935 1,772Creditors—due within one yearBorrowings 17 (362) (187)Other creditors 19 (2,316) (1,301)

(2,678) (1,488)Net current assets 15 257 284

Total assets less current liabilities 6,892 4,358Creditors—due after more than one yearBorrowings 17 (3,494) (702)Other creditors 20 (231) (163)

(3,725) (865)Provisions for liabilities and charges 21 (325) (55)

2,842 3,438


LO1

Diageo

CP5–6

Capital and reservesCalled-up share capital 22 506 443Reserves 23Share premium account 436 7Revaluation reserve (944) 649Special reserve — 282Related companies’ reserves 10 16Profit and loss account 2,802 2,010

2,304 2,964

2,810 3,407Minority interests 32 31

2,842 3,438

Using Financial Reports: Analyzing Income Statement-Based Executive BonusesCallaway Golf believes in tying executives’ compensation to the company’s performance as measured by accounting numbers. In a recent year, Callaway had agreed to pay its five executive officers bonuses of up to 200 percent of base salary if sales growth and pretaxearnings as a percentage of sales (computed here) met or exceeded target amounts. Callaway’sincome statements for the relevant years are presented here.

(in thousands, except per share data) Year Ended December 31


Net sales $254,645 100% $132,058 100%Cost of goods sold 115,458 45% 62,970 48%

Gross profit 139,187 55% 69,088 52%Selling expenses 38,485 15% 19,810 15%General and administrative expenses 28,633 11% 14,990 11%Research and development costs 3,653 1% 1,585 1%

Income from operations 68,416 27% 32,703 25%Other income

Interest income, net 1,024 403Other income, net 160 69

Income before income taxes and cumulative effect of accounting change 69,600 27% 33,175 25%

Provision for income taxes 28,396 13,895

Income before cumulative effect of accounting change 41,204 16% 19,280 15%

Cumulative effect of accounting change 1,658

Net income $42,862 17% $19,280 15%

Callaway executives will receive bonuses if sales growth and pretax earnings as a percent ofsales meet or exceed target amounts (35.l percent and 21.1 percent, respectively). Meetingthese goals in the current year would result in bonuses ranging from $400,000 to $700,000 foreach of the five executive officers.

Required:

Use the preceding information to determine whether Callaway executives earned their bonusesin the most recent year presented.


LO3, 4

Callaway Golf

CP5–7

CRITICAL THINKING CASESMaking Decisions as a Manager: Evaluating the Effects of Business Strategy on Return on EquitySony is a world leader in the manufacture of consumer and commercial electronics as well asthe entertainment and insurance industries. Its ROE has increased from 9 percent to 14 percentover the last three years.

Required:

Using the table below, ndicate the most likely effect of each of the following changes inbusiness strategy on Sony’s ROE for the next period and future periods (� for increase, � fordecrease, and NE for no effect), assuming all other things are unchanged. Explain your answerfor each. Treat each item independently.

a. Sony decreases its investment in research and development aimed at products to bebrought to market in more than one year.

b. Sony begins a new advertising campaign for a movie to be released during the next year.

c. Sony issues additional shares for cash, the proceeds to be used to acquire other high-technology companies in future periods.

Strategy Change Current Period ROE Future Periods’ ROE

a.

b.

c.

Making a Decision as an Auditor: Effects of Errors on Income, Assets, and LiabilitiesMegan Company (not a corporation) was careless about its financial records during its first yearof operations, 20A. It is December 31, 20A, the end of the company’s fiscal year. An externalauditor examined the records and discovered numerous errors, all of which are described below.Assume that each error is independent of the others.

Effect On

Net Income Assets Liabilities

Independent Errors 20A 20B 20A 20B 20A 20B

1. Amortization expense for 20A, not recorded in O NE O O NE NE20A, $950. $950 $950 $950

2. Wages earned by employees during 20A not recorded in 20A but will be paid in 20B, $500.

3. Revenue earned during 20A but not collected or recorded until 20B, $600; will be collected in 20B.

4. Amount paid in 20A and recorded as expense in 20A, but it is not an expense until 20B, $200.

5. Revenue collected in 20A and recorded as revenue in 20A, but it is not earned until 20B, $900.

6. Sale of services and cash collection in 20A.Recorded as a debit to Cash and as a credit to Accounts Receivable, $300.

7. On December 31, 20A, bought land on credit for $8,000, but did not record the transaction until payment was made on February 1, 20B.

Required:Analyze each error and indicate its effect on 20A and 20B income, assets, and liabilities if notcorrected. Do not assume any other errors. Use these codes to indicate the effect of each dollaramount: O � overstated, U � understated, and NE � no effect. Write an explanation of youranalysis of each transaction to support your response. (The answer for the first item is given asan example.)


LO2

Sony

CP5–8

CP5–9 LO3

A sample explanation of analysis of errors that are not corrected is provided below, using thefirst error as an example:

1. Failure to record amortization in 20A caused amortization expense to be too low;therefore, income was overstated by $950. Accumulated amortization also is too low by$950, which causes assets to be overstated by $950 until the error is corrected.

Evaluating an Ethical Dilemma: Management Incentives and Fraudulent Financial StatementsMercury Finance Co. was a fast-growing auto-finance and insurance company. In January1997, however, the auditors discovered that recently announced 1996 earnings had beengrossly overstated and prior years’ earnings had been overstated to a lesser extent. Theestimated size of the earnings overstatement for 1996 is described in the following excerpt:

Business Brief—Mercury Finance Co.Estimates for 1996 Revised Again, Now to a Big Loss

04/24/97 p. A8The Wall Street Journal

Mercury Finance Co., which previously warned that it had grossly overstated earlier years’earnings, said it now expects to report up to a $55 million loss for 1996. In January, the LakeForest, Ill., auto-finance company initially reported earnings of $120.7 million for 1996. Soonafterward, however, Mercury disclosed the accounting “irregularities” and estimated that last year’searnings probably would be about $56.7 million.Yesterday, Mercury said in an “update” that 1996results will include an additional $125 million in loss provisions, as well as a $25 million reserve tocover the planned sale of its Lyndon insurance unit. As a result, the company anticipates a 1996net loss of between $48 million and $55 million. In New York Stock Exchange composite trading,Mercury closed down 25 cents, or 13%, at $1.75.

Required:Using more recent news reports (Wall Street Journal Index, Dow Jones Interactive, andBloomberg Business News are good sources), answer the following questions.

1. What were Mercury’s closing stock prices on the day before (January 28, 1997) and theday after (January 30, 1997) the announcement of the misstatement?

2. How might executive compensation plans that tied bonuses to accounting earningsmotivate unethical conduct in this case?

FINANCIAL REPORTING AND ANALYSISPROJECTSComparing Companies over TimeUsing your Web browser, contact Intrawest Corporation at its Web site (www.intrawest.com).Find the latest Intrawest annual report. (Note: The necessary information also can be accessedthrough SEDAR.)

Required:

What was Intrawest’s ROE in the most recent year and how did it compare to the latest figuresprovided in the text? What was management’s explanation for the change (if any)?

Comparing Companies across IndustriesUsing your Web browser, contact the Web sites of Microsoft, the leading computer software company (www.microsoft.com/msft/), and Dell Computer, a leading manufacturer of personal computer hardware (www.dell.com/us/en/gen/corporate/investor/investor.htm).On the basis of information provided in the latest annual reports, determine the return onequity for each company. Write a short memo comparing the companies’ ratios. Indicate whatdifferences in their businesses might account for any difference in the ratios.

Broadening Financial Research Skills: Understanding the Disclosure Process throughthe Intrawest Web siteUsing your Web browser, contact Intrawest at its Web site (www.intrawest.com). Examine themost recent quarterly earnings press release and the related interim report.


LO1

Mercury Finance

LO2

Intrawest Corporation

CP5–11

LO2

Microsoft vs.Dell Computer

CP5–12

CP5–10

LO4

Intrawest

CP5–13

Required:Based on the information provided on the site, answer the following questions.

1. What were the release dates of the quarterly earnings press release and the interim report?

2. What additional information was provided in the interim report that was not reported in theearnings press release?

Broadening Financial Research Skills: Examining Library and Computer ResourcesContact your school reference librarian.

Required:Determine what information resources are available at your school for

1. Business-related news reports and announcements.

2. Company annual reports.

3. Reports to provincial securities commissions (e.g., OSC).

4. Analyst forecasts.

Prepare a brief memo outlining the information available (and the source) for each of theabove four items. Also indicate its format (hard copy, Web site, CD-ROM, etc.).

Broadening Financial Research Skills: Contacting Information Intermediaries on theWebUsing your Web browser, contact one of the information intermediaries at its Web site (listedin the text).

Required:Determine what information that intermediary provides concerning

1. Business-related news reports and announcements.

2. Company annual reports.

3. Analyst forecasts.

Prepare a brief memo outlining the information available from that resource for each of theabove three types of information. Also indicate its format (hard copy, Web site, CD-ROM, etc.).

Broadening Financial Research Skills: Information Provided on Company Web sitesUsing your Web browser, contact Molson Inc. at its Web site(www.molson.com/home/main.ghtml).

Required:Based on the information provided on the site, answer the following questions.

1. Which document(s) provided the most recent information on quarterly earnings?

2. For the most recent quarter, what was the change in sales revenue compared to the samequarter one year earlier? What was management’s explanation for the change (if any)?

3. What was the annual earnings per share, stock price per share, and price-earnings ratio (seeChapter 1) on the day of the most recent fourth-quarter earnings press release?

Ethics Project: Analyzing Irregularities and Management CompensationObtain a recent news story outlining an accounting irregularity (misstatement) in which thereporter linked the motive for the misstatement to management compensation based onreported accounting earnings. (Library files, www.findarticles.com, Dow JonesInteractive, and Bloomberg Business News are good sources. Search for the termsaccounting irregularities and bonus.)

Required:Write a short memo outlining the nature of the irregularity, the size of the necessary correctionof previously reported earnings, the impact of the announcement of the irregularity on thecompany’s stock price, the impact of the irregularity on management compensation, and anyfines or civil penalties against the company and its officers.

Team Project: Analyzing the Accounting Communication ProcessAs a team, select an industry to analyze. MarketGuide provides lists of industries and theirmake-up at www.marketguide.com/mgi/industry/industry.html. Each team member shouldacquire the annual report for one publicly traded company in the industry, with each memberselecting a different company. (Library files, the SEDAR service at www.sedar.com, or thecompany itself are good sources.)


CP5–14

CP5–15

LO3

LO3

LO1, 4

Molson

LO3

CP5–16

CP5–17

CP5–18 LO1, 4

Required:On an individual basis, each team member should write a short report answering the followingquestions about the selected company.

1. What formats are used to present the balance sheet and income statement?

2. Find one note that describes an accounting principle applied in the company’s statements,one note that presents additional detail about a reported financial statement number, andone note that reports financial statement information not listed in the statements. Whatinformation is provided in each case?

3. Using the company’s Web site, the periodicals and newspapers indexes in the library atyour school, or an instructor-assigned resource, find one article reporting the company’sannual earnings announcement. How does the date of the announcement compare with thedate on the annual report? Why is there a difference?

4. Compute return on equity for the current year. Which company provided the highest returnto shareholders during the current year?

Discuss any patterns across the companies that you as a team observe. Then, as a team,write a short report comparing and contrasting your companies using these attributes. Providepotential explanations for any differences discovered.

Comprehensive Project: Understanding Formats of Financial Statements and EarningsAnnouncementsUsing local library resources and company-provided information, your task is to understandthe formats used for financial statements and notes in an annual report and to track the stockprice reaction to the most recent annual earnings announcement for a public company. Yourinstructor may assign a particular company for you to analyze, or you may choose one of thefocus companies in this text, a competitor company in the same industry, or a company inwhich you have career-related interests.

Required:

1. Contact the Web site or investor relations department of the company and obtain a copy ofthe most recent annual report. Both the SEDAR and the SEC EDGAR Web sites providelinks to the Web sites of well-known companies.

a. Describe the formats used to present the balance sheet and the income statement.

b. Outline the information contained in one note that describes an accounting principleapplied in the company’s statements, one note that presents additional detail about areported financial statement number, and one note that reports financial statementinformation not listed in the statements.

2. Using the company’s Web site, or another service listed in the chapter, or an instructor-assigned resource, find one article reporting the company’s annual earnings announcement.Using one of the Web sites shown in the chapter, locate the stock price listing for thecompany.

a. Prepare a graph of the closing stock price for your company for the date of the earningsannouncement and the five days preceding and following the announcement.

b. Describe the apparent effect of the announcement on the company’s stock price.

c. Describe any explanations for the reported earnings or the stock price changes providedin the press article. Discuss whether or not you find the explanations convincing.

Comprehensive Project: Analyzing News Announcements and Financial Reporting (Extended)Using local library resources and company-provided information, track the informationannouncement process for a public company for a three-month period following its mostrecent year-end. Your instructor may assign a particular company for you to analyze, or youmay choose one of the focus companies in this text, a competitor in the same industry, or acompany in which you have career-related interests.

Required:

1. Gathering the necessary information:

a. Contact the investor relations department of the company by mail, phone, or theInternet and obtain copies of the most recent annual report and a recent earnings pressrelease. The SEDAR Web site www.sedar.com provides links to the Web sites of manycompanies.


LO1, 3, 4

LO1, 2, 3, 4 CP5–20

CP5–19

b. Using library resources, another service listed in the chapter, or an instructor-assignedresource, find one article reporting a significant non-earnings-related event (newproduct introduction, merger, etc.) that took place during the quarter following the mostrecent year-end.

c. Using the National Post (Financial Post), The Globe and Mail, or another source,prepare two separate graphs: (1) the closing stock price for your company for the day ofthe earnings press release and the five days preceding and following the earnings pressrelease and (2) the closing stock price for the week of the news article selected in part(b) and the five days preceding and following the news event.

2. Analyzing the information announcements:

a. Based on the annual report, determine the company’s principal lines of business, CEO,CFO, auditors, and major competitors.

b. Determine the format the company used to prepare its income statements and balancesheets in the annual report.

c. Compare the price-earnings ratio, leverage ratio, total asset turnover, net profit margin,and return on equity for the chosen year to the preceding year.

3. Presenting the results of your analysis: Prepare a written report including the followingcomponents:

a. A brief description of the company and its operations, major players, and competitors.

b. The formats used in the income statement and balance sheet.

c. The earnings press release and selected important news announcement, the apparenteffect on the company’s stock price, and any explanations for the reported events or thestock price changes provided in the press.

d. A summary of your comparative analysis of the company’s performance.


lib by sample chapter 5

Documents