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Chapter 17 - Understanding Accounting and Financial Information
17-76
lecture
enhancers
“In the business world, the rearview mirror is always clearer than the windshield.”
Warren Buffett
“There is no job so simple that it can’t be done wrong.”
Perrussel’s Law
“It comes from saying no to 1,000 things to make sure we don’t get on the wrong
track or try to do too much.”
Steve Jobs
lecture enhancer 17-1
INNOVATING WITH OPEN BOOKS AND SHARED PROFITS
During a recessionary economy, cutting costs becomes the primary focus of most companies.
Anything that detracts from a business’s bottom line is excised and nothing that could burden the books is
added. But with all their penny-pinching, many managers fail to heed one of the simplest maxims in busi-
ness: You have to spend money to make money. In most cases, a little investment in a company’s em-
ployees through open accounting and profit sharing can go a long way toward improving efficiency and,
ultimately, profit margins.
By opening the books to employees and cutting them in on profits, staffers become more motivat-
ed to do a good job since they can see how their salary is tied to their performance. But most importantly,
open-book management spurs innovation in every level of the company. For instance, at the small pack-
aging business Great Little Box, employees equally split 15% of the company’s pretax earnings. Thanks
to the staff’s level playing field, a maintenance worker suggested to upper management that they trim a
quarter-inch of cardboard off some boxes. The employee’s recommendation resulted in thousands of dol-
lars in savings each month for Great Little Box. Also, each employee acts as a sort of mini-manager by
keeping tabs on their colleagues’ productivity, since any amount of slacking could result in less money
for everybody.
A recent study by the Institute for Health and Social Policy at McGill University found compre-
hensive employee empowerment to be a common thread in successful companies both big and small. In
fact, a survey by Inc. magazine revealed that 40% of the 500 fastest-growing companies in the United
States use open-book management. Nevertheless, only 1% of American companies grant employees ac-
cess to accounting records. And those few that employ profit sharing usually reserve it only for managers.
In the end, most companies feel they can’t afford to include their staff in their already slim profit margins.
But as the recession wears on, businesses could find that short-term cost-cutting measures could come
back to bite them in the long term.i
Chapter 17 - Understanding Accounting and Financial Information
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lecture enhancer 17-2
THE RISE IN FAIR VALUE ACCOUNTING
To many businesses the process of accounting is simple: keep track of costs and weigh them
against revenue to determine profit. But some of the world’s largest companies prefer to figure out their
financial well being by using a more complicated, predictive method. Known as fair value accounting,
this technique measures a company’s assets by valuing them on estimates and projections rather than hard
data. Its proponents argue that it makes accounting information more relevant for day-to-day operations.
Critics of fair value, on the other hand, accuse the system of obscuring important facts that are necessary
in determining a company’s financial health.
Fair value accounting was banned for much of the 20th century after it was blamed for contrib-
uting to the 1929 stock market crash. By the 1980s, though, financial theory had changed to a point where
many experts assumed that financial markets were efficient and their prices reflected real-world values.
As economists argued in favor of this notion, the government repealed their ban on fair value accounting.
The practice went on unfettered until 2008 when the nation experienced another stock market crash. Once
again critics condemned fair value, especially for the role it played in overvaluing derivatives and mort-
gage-backed securities.
But unlike their Depression-era predecessors, regulators didn’t ban fair value accounting. In fact,
the world’s two major accounting principles and standards organizations continue to champion the meth-
od. Fair value has also grown in popularity with financial services companies that suggest the technique
for businesses both big and small. Regardless of fair value’s ubiquity, however, evidence shows that his-
torical accounting is far more accurate and valuable to both companies and shareholders in the long run.
After all, it makes more sense to value an asset based on the data available to the accountant rather than to
place an assumption on its future worth. But as long as fair value remains in vogue, it will only get more
and more difficult to gauge the true value of a company and its holdings.ii
lecture enhancer 17-3
MANAGERIAL ACCOUNTING AND THE BUDGET PROCESS
In addition to the balance sheet, income statement, and cash flow statement, managers need other
forms of financial information—especially for the budgeting process. They also need this information to
help make decisions such as when to replace a machine, whether to hire extra people, how much wages
can be raised, and if advertising should be increased or decreased. Detailed reports are needed on such
things as departmental costs, special projects, cash flow, financial analyses, taxes, and labor costs. These
reports, which are a part of managerial accounting, do not have to be standardized but can be tailored to
the firm’s individual needs.
Budgeting and Budgetary Control
Two of the primary functions of management are planning and control. When these two functions
are combined with the accounting techniques we have studied, they provide one of management’s most
useful tools: the budgeting process. This process, in turn, involves both budgeting and budgetary control.
Budgeting is simply stating in dollars-and-cents terms what the firm wants to accomplish in a
given period of time. Most individuals have some informal plan at the beginning of the month as to how
they are going to spend their money. They know, in general, what their expected income is and what ex-
penses they must use that money for.
Chapter 17 - Understanding Accounting and Financial Information
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Businesses must use more formal plans, but they follow the same procedure an individual does—
determine how much revenue will come into the firm, divide that revenue among the expenses, and de-
termine the expected profit or loss from operations. In essence, the firm is preparing a “planned” income
statement when it sets up a budget.
The starting point in budgeting is estimating expected revenue, which is the total amount of goods
or services that company expects to sell. For management to get an accurate figure, the firm’s sales de-
partment must give a realistic estimate of probable sales. This figure will be a blend of past sales figures,
expected business conditions, and company objectives. For example, if 1,200,000 units are to be sold, and
the expected price per unit is $7, the total revenue should be $8,400,000.
Next, expected expenses are calculated by the departments in the firm that will be involved. The
production department should submit a plan showing how much it will cost to produce those items, in-
cluding such costs as raw materials, wages, electricity, and maintenance. The marketing department
should develop a plan for sales activities such as advertising, personal selling, and sales promotion. Then
administrative, depreciation, and other costs must be computed.
After all the firm’s departments have submitted their estimates, management can calculate the
projected net income by subtracting total expected expenses from expected revenues.
At this point, management adds its plans and projections to the raw figures and begins “fine-
tuning” the budget. The departmental budgets may be sent back for further work and the first few steps
repeated until a comprehensive budget acceptable to all is created. Each department then develops a de-
partmental budget based on the figures in the comprehensive budget.
The budgeting process does not end here. The only thing you have at this point is a plan, stated in
monetary terms, of what you expect to do during the next year. Unless budgetary control is added, the
budget becomes useless. Budgetary control involves comparing actual performance against planned per-
formance and taking corrective action if differences are found.
For instance, the production department budget may call for spending $490,000 each month to
produce one month’s output of 100,000 units. If, at the end of the month, the chief accountant finds that
$505,000 has been spent, he or she knows that actual expenses are exceeding planned expenses by
$15,000 and can notify the production manager to take corrective action.
With this information, the manager can investigate the problem. Are raw materials being wasted?
Was there an increase in the cost of these materials? On the basis of the results of this investigation, a
change may be made in production methods or a new supplier may be found. If it is found that the origi-
nal budget was not realistic, the budget itself may be changed to show realistic goals. In this way, man-
agement makes adjustments in order to meet the goals it has set. Budgets and budgetary control are excel-
lent planning and control tools.
Determining Costs and Setting Prices
The income statement shows an item called “cost of sales” or “cost of goods sold,” which in-
cludes various costs—material, labor, and overhead. Analyses that are more detailed can be made to relate
these costs to each product, and costs can be compared with the income from the sales of that product.
This shows what the present cost–profit situation is at a given level of sales. Another study is usually
made to find out what the situation would be if sales increased or decreased.
Each company has its own approach to cost accounting. Some emphasize quality, others price.
Cost analysis provides a basis for determining which approach to follow. All involve a trade-off of value
against cost.
Deciding on Capital Investments
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Managers must make daily and long-term capital investment decisions. Daily decisions may be
made on whether to use machine A or machine B for a given operation. Should a salesperson visit cus-
tomer X on this trip or the next? Should Jones’s order be produced today to ensure on-time delivery, or
can it wait?
Capital investment decisions are concerned with changes in fixed assets that affect longer periods
of time. Should a manual operation be replaced with a machine? Should a piece of equipment be replaced,
rebuilt, or discarded? Many of these decisions involve large sums of money and have long-term effects on
the company. Special consideration must therefore be given to such decisions, including such factors as
interest charges and the unavailability of money for other purposes, called opportunity cost.
These and other capital investment studies consume much time and involve many people. They
also involve the use of detailed accounting records to obtain costs for their analysis.
lecture enhancer 17-4
COMING SOON—THE WIDE WORLD OF ACCOUNTING
It would be nearly impossible to make it through a day in the United States using only products
that were “Made in America” or owned by American companies. Globalization is a fact of life we have
come to accept in the 21st century. Nevertheless, there is one last vestige of Made in America that has
persisted. The U.S. accounting system is still based on generally accepted accounting principles (GAAP)
under the oversight of the Financial Accounting Standards Board (FASB). However, this lone ranger of
U.S. financial leadership may soon give way to the unstoppable surge of globalization much like other
industries before it.
The move from GAAP to International Financial Reporting Standards (IFRS) seems to be an in-
evitable conclusion. Accountants no longer talk about if GAAP and IFRS will converge but when the
transformation will take place. The U.S. Securities and Exchange Commission has even devised a
roadmap for the incorporation of IFRS with a whisper date of 2013 for implementation. Many account-
ants, however, believe that certain changes in the international standards need to be met first and U.S.
companies won’t make the switch to IFRS until 2016.
At one time, many felt GAAP would become the gold standard worldwide as many European and
Asian companies rolled out accounting numbers in the preferred U.S. style as well as their own. However,
support for GAAP seemed to collapse globally as it became more and more bloated (25,000 pages versus
2,500 for the IFRS) and heavily rules-riddled. Even Robert H. Herz, chair of FASB, admitted GAAP was
better suited to a different era, one that was not global. One concern that does bother many accountants
about IFRS is its relative youth. The International Accounting Standards Board (IASB), the body that
regulates IFRS, has been in existence only since 2001. Still Europe adopted IFRS early, and nations such
as Japan, China, India, Brazil, and Canada have announced their intention to move toward IFRS adoption
as well.
The change to IFRS is far from a done deal. Many questions persist about the implementation and
what it would mean for American companies and investors. Jeffrey Mahoney, general counsel of the
Council of Institutional Investors, says IASB needs to answer six questions before U.S. companies switch
to IFRS:
• Do international standards produce the same quality of reporting as GAAP?
• Will the application and enforcement of international standards in the United States be as rigorous
as they are in the case of GAAP?
• Does IASB have an adequate and stable source of funding that’s not dependent on private do-
nors?
• Does IASB have a competent, full-time, capable staff?
Chapter 17 - Understanding Accounting and Financial Information
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• Does IASB pay the most attention to the views of customers of financial reports—in other words,
investors?
• Does IASB have a structure, process, and adequate governmental support to keep its standards
work from “being overridden by the political process”?
Others have questions about the membership of the board, whether it should be based on exper-
tise, geography, or some other measure. Needless to say, the banking and financial crisis of 2008–2009
did little to help the transition to global accounting standards and will most likely stall its implementation.
Still, accountants ranging from academia, the Big Four, not-for-profits, and so on agree that global change
is in the air.iii
lecture enhancer 17-5
NEW REGULATIONS HIT WALL STREET
More than two years after the near collapse of America’s financial system, President Obama
signed the Dodd-Frank Financial Reform and Consumer Protection Act into law in 2010. Although the
bill took awhile to run through the congressional wringer, the provisions included in it will have a dra-
matic effect on the future of American commerce. First of all, the new legislation gives the government
power to seize and shutter large financial institutions on the verge of collapse in an effort to prevent fur-
ther bailouts. It also subjects derivatives, the complicated financial deals that fueled the crisis, to strict
governmental oversight.
Perhaps most important to the general public, though, is the law’s formation of an independent
consumer protection agency housed within the Federal Reserve. The new agency protects borrowers
against a host of financial abuses ranging from payday loans to mortgages and credit cards. As Harvard
law professor and consumer protection pioneer Elizabeth Warren said: “For the first time, there will be a
financial regulator in Washington watching out for families instead of banks.” Still, the agency is not
without its critics. Some consumer advocates worry about the agency’s location within the Federal Re-
serve, an institution that has done little to protect consumers in the past. Also, a number of entities are
exempt from regulation by the agency. For example, car dealers, originators of nearly 80% of auto loans,
are not liable to the agency’s jurisdiction.
In its most controversial move, the reform act does nothing to restructure the government-owned
Fannie Mae and Freddie Mac. In fact, it leaves all of the nation’s biggest financial institutions almost
completely intact. Loopholes litter the nearly 2,000-page measure as well, potentially setting the stage for
future economic meltdowns. For all its faults, though, the reform act represents the most sweeping change
in financial regulation since the Great Depression. It may not be a miracle cure, but at least it resolves
some of the most pressing issues facing our economy today while setting the stage for a stronger financial
future.iv
lecture enhancer 17-6
CONSUMER PROTECTION AGENCY GAINS STEAM
The Dodd-Frank financial reform bill had its fair share of critics before Congress even passed it.
While many anti-regulation advocates rejected it outright, reformers slammed the law for tangling many
of its key provisions in red tape. Nevertheless, at least one aspect of the 2010 legislation appears to be
working at full capacity. In 2013, just a year and a half in existence, the Consumer Financial Protection
Bureau (CFPB) collected 90,000 consumers’ complaints and fined banks hundreds of millions of dollars.
Chapter 17 - Understanding Accounting and Financial Information
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With a staff of more than 1,000, the agency’s to-do list includes writing 44 specific rules, publish-
ing 11 reports, and conducting four in depth studies. The CFPB’s research focuses on the various ways
consumers interact with financial institutions and incur debt. For instance, one report examined thousands
of credit scores to discover how they fluctuated under various factors. One interesting piece of data
showed that credit-card payments affect a person’s score more than their mortgage. Information like this
could prove indispensible for educating consumers about financial responsibility.
The CFPB does far more than simply raise awareness, though. Not only does the agency keep a
close eye on the actions of 153 banks, it also oversees payday lenders, debt collectors, private student
lenders and credit reporting firms. None of these services has previously been subject to government
oversight, causing a certain amount of friction within the industry. Much of the ire has been born out of
the agency’s first enforcement actions. Three credit card providers were fined a combined $101.5 million
along with $435 million in restitution for misleading consumers with hidden fees and needless add-ons.
Although financial firms may balk at such expensive penalties, the tough love appears to be working.
Banks like JPMorgan Chase, Bank of America and American Express have dropped similar add-on fees
after the CFPB’s crackdown.”v
lecture enhancer 17-7
USING THE STATEMENT OF CASH FLOWS
Rather than studying the income statement, many investors are choosing to look beyond that list
of a company’s revenues and expenses to the cash flow statement. And because cash flow is key to fi-
nancing many takeovers and leveraged buyouts, understanding and profiting from acquisitions often
means understanding figures such as “operating cash flow” and “free cash flow.”
Companies do not go out of business because they report net losses. They fade away because they
run out of cash. Monitoring your ability to generate cash flow is critical to success. To maximize long-
term value, a company must continually evaluate its consistent capacity for generating cash. Commercial
lenders realize that it is cash flow, not net income, which will repay their loans.
The true definition of cash flow is unclear. It is one of the most overused and least agreed upon
terms in corporate finance. Cash flows can be divided into three primary categories:
• Cash flows from operating activities
• Cash flows from investing activities
• Cash flows from financing activities
Investors have been coming in more contact with cash flow statements recently. Since November
1987, public companies have been required to include cash flow statements when presenting full financial
statements. Cash flow is simply how much money a company spends, and where it has gone; and how
much is received, and from whom. The cash flow statement is a hard-nosed and pragmatic financial
statement.
Cash flow is often a better measure of company health than earnings, analysts say, because earn-
ings can be puffed up or hidden through accounting changes or other manipulations that don’t reflect the
true state of a company’s business. When times are tough, companies can fool around with tax rates and
make timing adjustments. Due to such manipulations, many analysts rate the usefulness of cash flow
statements far above earnings statements.
Chapter 17 - Understanding Accounting and Financial Information
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In today’s competitive environment, it is vital for the owner/operator to monitor current and fu-
ture cash flow requirements. Careful tracking of cash flow is especially important for industries facing
seasonal fluctuations, such as the retail industry. These companies must prepare projections of cash in-
flows and outflows, preferably on a monthly basis, but certainly no less than on a quarterly basis. A fore-
cast of the company’s monthly balance sheet is also important to show its financial position and available
assets, such as accounts receivable and inventory, which can be used as collateral for working capital
loans.
Based on these projections, periods of negative cash flow will be highlighted and anticipated. To
lessen the effect of periods of negative cash flow, many factors should be considered, including the com-
pany’s business cycle and its ability to fund the negative cash flow period.
In anticipation of these down times, it’s necessary to pay particular attention to cash-producing
assets, such as accounts receivable, and cash flow–draining liabilities, such as accounts payable. Steps to
speed up time for collections of receivables might include reducing the time between the sale and mailing
the invoice to the customer or changing sales terms to cash on delivery. It may also be worthwhile to meet
with the company’s banker to review the cash flow requirements of the company and obtain a seasonal
line of credit to cover the negative cash flow periods.
Cash flow can be used in different ways for different types of companies:
• For developing companies, cash flow and free cash flow are usually negative because the
company is burdened with low sales and one-time expenses necessary to build the business.
Matching the cash being lost in a cash flow statement to the assets on hand to pay bills can
predict how long the company can survive.
• Minding cash flow is especially crucial in energy and real estate companies, whose bottom
line often is obscured by heavy depreciation and depletion allowances.
• Companies that recently have made takeovers often have depressed earnings because they
must write off massive amounts of goodwill carried on their balance sheet. The goodwill
comes from paying a premium over a company’s book value to buy the company.
Monitoring cash flows is crucial to a company’s success. As owners and financial statement users
become more familiar with the concept and use of cash flow ratios, their decision-making process will
improve greatly and become more focused on the cash flow impact of their decisions.
Chapter 17 - Understanding Accounting and Financial Information
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critical
thinking exercises
Name: ___________________________
Date: ___________________________
critical thinking exercise 17-1
ANNUAL REPORTS ONLINE
Locating corporate annual reports is easier than it has ever been. AnnualReports.com hosts a
website (www.reportgallery.com)vi containing annual reports for hundreds of corporations. The site is
comprehensive and easy to use.
Go to the website (www.reportgallery.com) and choose one company to research. Use the infor-
mation given in this report to answer the following questions. (Sometimes the Web address for a location
changes. You might need to search to find the exact location mentioned.)
Company Name ________________________________ Financial Year ______________________
1. Locate the report of the independent auditors.
a. Who are the auditors?
b. Are there any auditor reservations—anything that the auditors flag with the term “ex-
cept”? Give details.
2. Locate the report of management. Since the passage of the Sarbanes-Oxley Act in 2002, corporate
management has to certify these financial results. Who signed the management report?
3. Which intangible assets are listed on the balance sheet?
4. How much income tax did the company pay?
Chapter 17 - Understanding Accounting and Financial Information
17-84
critical thinking exercise 17-1 (continued)
5. Using the financial ratios discussed in this chapter, answer the following:
a. What is the current ratio?
b. What is the debt-to-equity ratio?
6. What is the basic earnings per share? Diluted earnings per share.
Chapter 17 - Understanding Accounting and Financial Information
17-85
Name: ___________________________
Date: ___________________________
critical thinking exercise 17-2
THE PIZZA STAND
A student organization has been given permission to operate a pizza stand during the upcoming
homecoming weekend. The stand will be located just outside the football stadium, making it accessible
during the ballgame. The location is also convenient for visitors as they tour the campus at other times
during the weekend. An estimated 2,500 visitors will be on campus, in addition to the campus population
of 1,500.
Each pizza requires:
1/2 lb. pizza flour
2 oz. pizza sauce
1/8 lb. pepperoni
1/2 lb. cheese
Pizza flour costs $8.00 per 10-lb. bag; pizza sauce, $4.80 per 64-oz. jar; pepperoni, $18.00 per 5-
lb. package; and cheese, $15.00 per 5-lb. package. Club members will cook the pizzas and staff the stand
on a volunteer basis. The university requires each vendor to pay a $25.00 permit fee and a $50.00 refund-
able deposit on the building. Your club plans to donate the profits from the pizza sales to a local chil-
dren’s hospital.
1. How many pizzas can you anticipate selling?
2. What price should you charge per pizza?
3. How much of each raw material do you need to buy?
4. What will be your probable profit?
5. Develop a financial plan for your weekend enterprise.
Chapter 17 - Understanding Accounting and Financial Information
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notes on critical thinking exercise 17-2
I have used this exercise several times in my classes. Below are two of the potential solutions,
one conservative and one very optimistic.
ALTERNATIVE 1
1. How many pizzas can you anticipate selling?
On homecoming weekend, there will be about 4,000 people on campus. The first step in develop-
2. What price should you charge per pizza?
You could consider several pricing strategies. Chapter 14 covered several possibilities: demand-
based pricing, competition-based pricing, cost-based pricing, and break-even analysis. What is the price
people are willing to pay? What price is our competition charging? What is the break-even point? To
Ingredient
Amount per
Pizza
Ounces
Cost of
Ingredient
Cost per
Ounce
Cost per Piz-
za
Pizza flour
1/2 lb.
8 oz.
$8.00 per 10 lb.
$0.05
$0.40
Pizza sauce
2 oz.
2 oz.
$4.80 per 64 oz.
$0.075
$0.15
Pepperoni
1/8 lb.
2 oz.
$18.00 per 5 lb.
$0.225
$0.45
Cheese
1/2 lb.
8 oz.
$15.00 per 5 lb.
$0.1875
$1.50
Total
$2.50
After determining the cost of raw materials, a price can be set that covers these costs and provides
the desired profit. Possible prices: $5.00, $7.00, or $9.00.
Chapter 17 - Understanding Accounting and Financial Information
17-87
3. How much of each raw material do you need to buy?
Ingredient
Amount per
Pizza
Ounces
Potential Sales
Units
Total Ounc-
es Needed
Total Pounds
Pizza flour
1/2 lb.
8 oz.
400
3,200 oz.
200 lb.
Pizza sauce
2 oz.
2 oz.
400
800 oz.
Pepperoni
1/8 lb.
2 oz.
400
800 oz.
50 lb.
Cheese
1/2 lb.
8 oz.
400
3,200 oz.
200 lb.
Supplies Needed
Pizza flour 20 10-lb. bags 20 x $8.00 $160.00
Pizza sauce 12 1/2 64-oz. jars 13 x $4.80 $62.40
Pepperoni 10 5-lb. packages 10 x $18.00 $180.00
Cheese 40 5-lb. packages 40 x $15.00 $600.00
Total cost $1,002.40
4. What will be your probable profit?
Your profit will depend on the price you charge. Using $7.00:
Price $7.00
Revenue $2,800.00 (400 x $7.00)
5. Develop a financial plan for your weekend enterprise.
Project Costs
Buy permit $25.00
Purchase raw materials
Pizza flour 20 10-lb. bags 20 x $8.00 $160.00
Pizza sauce 12 1/2 64-oz. jars 13 x $4.80 $62.40
Chapter 17 - Understanding Accounting and Financial Information
17-88
Project Net Profit
Revenue $2,800.00
Cost of goods $1,002.40
ALTERNATIVE 2
1. How many pizzas can you anticipate selling?
2. What price should you charge per pizza?
3. How much of each raw material do you need to buy?
Ingredient
Amount per
Pizza
Ounces
Potential Sales
Units
Total Ounc-
es Needed
Total Pounds
Pizza flour
1/2 lb.
8 oz.
3,000
24,000 oz.
1,500 lb.
Pizza sauce
2 oz.
2 oz.
3,000
6,000 oz.
Pepperoni
1/8 lb.
2 oz.
3,000
6,000 oz.
375 lb.
Cheese
1/2 lb.
8 oz.
3,000
24,000 oz.
1,500 lb.
4. What will be your probable profit?
Price is $10.00
Revenue $30,000.00 (3,000 x $10.00)
Variable costs $7,501.20
5. Develop a financial plan for your weekend enterprise.
Purchase enough raw materials to make 3,000 pizzas and market aggressively. If sales don’t meet
Name: ___________________________
Chapter 17 - Understanding Accounting and Financial Information
17-89
Date: ___________________________
critical thinking exercise 17-3
PREPARING FINANCIAL STATEMENTS
As the accountant for Wheatley International, it is your job to prepare the company’s income
statement and balance sheet. Use the accounts listed below to construct the statements. Assume that the
tax rate is 25%.
List of Accounts for
Wheatley International
Accounts Receivable $ 120,600
Land 1,500,000
Notes Receivable 61,200
Insurance Expenses 54,000
Accounts Payable 45,000
Interest Expenses 24,600
Common Stock 1,896,000
Depreciation 400,000
Net Sales 1,053,000
Ending Inventory 126,600
Notes Payable (Long-Term) 210,000
Beginning Inventory 154,800
Retained Earnings 1,459,800
Advertising Expense 90,000
Cash 72,000
Salaries 180,000
Short-Term Notes Payable 15,600
Merchandise Purchased (for Inventory) 316,800
Buildings 1,050,000
Rent 13,800
Utilities 8,400
Equipment & Vehicles 1,066,000
Goodwill 90,000
Bonds Payable 60,000
Chapter 17 - Understanding Accounting and Financial Information
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notes on critical thinking exercise 17-3
The formula for the balance sheet is assets equal liabilities plus stockholders’ equity. To prepare a
balance sheet, add the assets and liabilities. The difference between the two is stockholders’ equity. For
the income statement, you subtract cost of goods sold from net sales (revenue). Then you subtract expens-
es to get gross income. From that, you subtract the income tax of 25% to get net income.
(Note: The format of these statements may be slightly different from the format taught in stu-
dents’ accounting courses. The exact format is less important than understanding the overall concepts.)
Wheatley International
Income Statement
FY 201X
REVENUES
Net Sales $1,053,000
COST OF GOODS SOLD
Beginning Inventory $154,800
Merchandise Purchased + 316,800
Cost of Goods Available for Sale 471,600
Less: Ending Inventory −126,600
Cost of Goods Sold $345,000
GROSS PROFIT (GROSS MARGIN) $708,000
OPERATING EXPENSES
Selling Expenses
Salaries $180,000
Advertising 90,000
Total Selling Expenses $270,000
General Expenses
Insurance $54,000
Interest Expense 24,600
Rent 13,800
Utilities 8,400
Total General Expenses $100,800
Total Operating Expenses $370,800
NET PROFIT (INCOME) BEFORE TAXES $337,200
Less: Income Tax Expenses (25%) $ 84,300
NET INCOME (PROFIT) AFTER TAXES $252,900
.
