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Chapter 02: Review of Accounting
Chapter 2
Review of Accounting
Discussion Questions
2-1.
Discuss some financial variables that affect the price-earnings ratio.
The price-earnings ratio will be influenced by the earnings and sales growth of
the firm, the risk or volatility in performance, the debt-equity structure of the
firm, the dividend payment policy, the quality of management, and a number of
other factors. The ratio tends to be future-oriented, and the more positive the
outlook, the higher it will be.
2-2.
What is the difference between book value per share of common stock and
market value per share? Why does this disparity occur?
Book value per share is arrived at by taking the cost of the assets and
subtracting out liabilities and preferred stock and dividing by the number of
common shares outstanding. It is based on the historical cost of the assets.
Market value per share is based on current assessed value of the firm in the
marketplace and may bear little relationship to original cost. Besides the
disparity between book and market value caused by the historical cost approach,
other contributing factors are the growth prospects for the firm, the quality of
management, and the industry outlook. To the extent these are quite negative or
positive; market value may differ widely from book value.
2-3.
Explain how depreciation generates actual cash flows for the company.
The only way depreciation generates cash flows for the company is by serving
as a tax shield against reported income. This non-cash deduction may provide
cash flow equal to the tax rate times the depreciation charged. This much in
taxes will be saved, while no cash payments occur.
2-4.
What is the difference between accumulated depreciation and depreciation
expense? How are they related?
Accumulated depreciation is the sum of all past and present depreciation
charges, while depreciation expense is the current year’s charge. They are
related in that the sum of all prior depreciation expense should be equal to
accumulated depreciation (subject to some differential related to asset
write-offs).
Chapter 02: Review of Accounting
2-5.
How is the income statement related to the balance sheet?
The earnings (less dividends) reported in the income statement is transferred to
the ownership section of the balance sheet as retained earnings. Thus, what we
earn in the income statement becomes part of the ownership interest in the
balance sheet.
2-6.
Comment on why inflation may restrict the usefulness of the balance sheet as
normally presented.
The balance sheet is based on historical costs. When prices are rising rapidly,
historical cost data may lose much of their meaning–particularly for plant and
equipment and inventory.
2-7.
Explain why the statement of cash flows provides useful information that goes
beyond income statement and balance sheet data.
The income statement and balance sheet are based on the accrual method of
accounting, which attempts to match revenues and expenses in the period in
which they occur. However, accrual accounting does not attempt to properly
assess the cash flow position of the firm. The statement of cash flows fulfills
this need.
2-8.
What are the three primary sections of the statement of cash flows? In what
section would the payment of a cash dividend be shown?
The sections of the statement of cash flows are:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
The payment of cash dividends falls into the financing activities category.
Chapter 02: Review of Accounting
2-9.
What is free cash flow? Why is it important to leveraged buyouts?
Free cash flow is equal to cash flow from operating activities:
Minus: Capital expenditures required to maintain the productive capacity
of the firm.
Minus: Dividends (required to maintain the payout on common stock and
to cover any preferred stock obligation).
The analyst or banker normally looks at free cash flow to determine whether
there are sufficient excess funds to pay back the loan associated with the
leveraged buy-out.
2-10.
Why is interest expense said to cost the firm substantially less than the actual
expense, while dividends cost it 100 percent of the outlay?
Interest expense is a tax deductible item to the corporation, while dividend
payments are not. The net cost to the corporation of interest expense is the
amount paid multiplied by the difference of one minus the applicable tax rate.
For example, $100 of interest expense costs the company $65 after taxes when
the corporate tax rate is 35 percent; for example, $100 × (1 – .35) = $65.
Chapter 2
Problems
1. Income Statement (LO1) Frantic Fast Foods had earnings after taxes of $390,000 in the
year 2009 with 300,000 shares outstanding. On January 1, 2010, the firm issued 25,000
new shares. Because of the proceeds from these new shares and other operating
improvements, earnings after taxes increased by 20 percent.
a. Compute earnings per share for the year 2009.
b. Compute earnings per share for the year 2010.
2-1. Solution:
Chapter 02: Review of Accounting
Frantic Fast Foods
a. Year 2009
=
=
Earnings after taxes
Earnings per share Shares outstanding
$390,000
= $1.30
300,000
b. Year 2010
Earnings after taxes $390,000 1.20 $468,000
Shares outstanding 300,000 25,000 325,000
$468,000
Earnings per share $1.44
325,000
= =
= + =
==
2. Income Statement (LO1) Bettis Bus Company had earnings after taxes of $600,000 in the
year 2009 with 300,000 shares of stock outstanding. On January 1, 2010, the firm issued
40,000 new shares. Because of the proceeds from these new shares and other operating
improvements, earnings after taxes increased by 25 percent.
a. Compute earnings per share for the year 2009.
b. Compute earnings per share for the year 2010.
2-2. Solution:
Bettis Bus Company
a. Year 2009
Earnings after taxes
Earnings per share = Shares outstanding
$600,000
= = $2.00
300,000
b. Year 2010
Chapter 02: Review of Accounting
Earnings after taxes $600,000 1.25 $750,000
Shares outstanding 300,000 40,000 340,000
$750,000
Earning per share $2.21
340,000
= =
= + =
==
3. a. Gross profit (LO1) Hillary Swank Clothiers had sales of $360,000 and cost of goods
sold of $244,800. What is the gross profit margin (ratio of gross profit to sales)?
b. If the average firm in the clothing industry had a gross profit of 35 percent, how is the
firm doing?
2-3. Solution:
Hillary Swank Clothiers
a. Sales ........................................................... $360,000
4. Operating Profit (LO1) A-Rod Fishing Supplies had sales of $2,000,000 and cost of
goods sold of $1,250,000. Selling and administrative expenses represented 8 percent of
sales. Depreciation was 5 percent of the total assets of $4,000,000. What was the firm’s
operating profit?
2-4. Solution:
Chapter 02: Review of Accounting
2-6
A-Rod Fishing Supplies
Sales.............................................................. $2,000,000
5. Income statement (LO1) Arrange the following income statement items so they are in the
proper order of an income statement:
Taxes Earnings per share
Shares outstanding Earnings before taxes
Interest expense Cost of goods sold
Depreciation expense Earnings after taxes
Preferred stock dividends Earnings available to common
Operating profit stockholders
Sales Selling and administrative expense
Gross profit
2-5. Solution:
Sales
Chapter 02: Review of Accounting
2-7
6. Income statement (LO1) Given the following information prepare in good form an
income statement for the Dental Drilling Company.
Selling and administrative expense ..................................... $ 60,000
Depreciation expense .......................................................... 70,000
Sales ................................................................................... 470,000
Interest expense .................................................................. 40,000
Cost of goods sold .............................................................. 140,000
Taxes .................................................................................. 45,000
2-6. Solution:
Dental Drilling Company
Income Statement
Sales.............................................................. $ 470,000
Cost of goods sold......................................... $ 140,000
Chapter 02: Review of Accounting
2-8
7. Income Statement (LO1) Given the following information, prepare in good form an
income statement for Jonas Brothers Cough Drops.
Selling and administrative expense ..................................... $250,000
Depreciation expense .......................................................... 190,000
Sales ................................................................................... 1,600,000
Interest expense .................................................................. 120,000
Cost of goods sold .............................................................. 480,000
Taxes .................................................................................. 165,000
2-7. Solution:
Jonas Brothers Cough Drops
Income Statement
Sales.............................................................. $1,600,000
Chapter 02: Review of Accounting
2-9
8. Determination of profitability (LO1) Prepare in good form an income statement for ATM
Cards, Inc. Take your calculations all the way to computing earnings per share.
Sales ................................................................................... $800,000
Shares outstanding .............................................................. 100,000
Cost of goods sold .............................................................. 300,000
Interest expense .................................................................. 20,000
Selling and administrative expense ..................................... 40,000
Depreciation expense .......................................................... 30,000
Preferred stock dividends .................................................... 80,000
Taxes .................................................................................. 110,000
2-8. Solution:
ATM Cards, Inc.
Income Statement
Sales.............................................................. $ 800,000
Cost of goods sold......................................... 300,000
Chapter 02: Review of Accounting
2-10
9. Determination of profitability (LO1) Prepare in good form an income statement for
Virginia Slim Wear. Take your calculations all the way to computing earnings per share.
Sales ................................................................................... $600,000
Shares outstanding .............................................................. 100,000
Cost of goods sold .............................................................. 200,000
Interest expense .................................................................. 30,000
Selling and administrative expense ..................................... 40,000
Depreciation expense .......................................................... 20,000
Preferred stock dividends .................................................... 80,000
Taxes .................................................................................. 100,000
2-9. Solution:
Virginia Slim Wear
Income Statement
Sales.............................................................. $600,000
Cost of goods sold......................................... 200,000
Gross profit ............................................... 400,000
10. Income Statement (LO1) Precision Systems had sales of $800,000, cost of goods of
$500,000, selling and administrative expense of $60,000 and operating profit of $100,000.
What was the value of depreciation expense? Set this problem up as a partial income
statement, and determine depreciation expense as the plug figure.
