Cases
of net income. The auditors may become concerned if the loss is greater in the future or
if management does not take action to try to reduce it.
decisions of users of financial statements. The $120,000 inventory loss represents 4 per-
cent of net income ($120,000 / $3,000,000). Whether or not this loss is material depends
on who is using the financial statements. To management, it represents a loss of income
C2. Conceptual Understanding: Materiality
Materiality refers to the relative importance of an item or event. In general, an item is
material if there is a reasonable expectation that knowledge of it would influence the
that impairs the company’s ability to improve operations and results. To the auditors, the
loss is reflected in the financial statements and thus is not misstated. In most retail oper-
ations, some inventory loss is expected. It is unlikely that external users of financial state-
ments would change their decisions because of an item that represents only 4 percent
should disclose the nature of the change, the justification for making it, and its probable
effect on net income. Thus, readers of the financial statements will know that a change
has been made and can assess its effects.
to decision makers. So this is a material effect, and the change in accounting method
should be disclosed. (An adjustment may also be made to the beginning of the year,
which could mitigate the year-end effect on the financial statements.)
decisions of users of financial statements. In this case, the change from the cash to the
accrual method would have a 5 percent ($62,500 / $1,250,000) effect on net income.
Many people consider 5 percent to be the point at which an amount starts to matter
to another. In this case, a change from cash method to the accrual method would violate
the consistency convention if the change is not disclosed in the financial statements.
Materiality refers to the relative importance of an item or event. In general, an item is
Full disclosure requires that financial statements and accompanying notes present all in-
formation relevant to the user’s understanding of the statements. In this case, the notes
material if there is a reasonable expectation that knowledge of it would influence the
C1. Conceptual Understanding: Consistency, Full Disclosure, and Materiality
Consistency requires that an accounting procedure, once adopted by a company, remain
in use from one accounting period to another unless management decides that a new
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1.
C3. Interpreting Financial Reports: Comparison of Profitability
2.
*
**
3.
The higher profit margin and asset turnover at The Gap makes it more profitable
The figures may differ slightly from the previous page because of rounding.
Industry figures are provided in Figures 4 through 9 of the text.
The Gap has more debt than equity; the debt to equity ratio was 169.4 percent for
The Gap, which is considerably higher than the industry average, and 63.7 percent
C3. Interpreting Financial Reports: Comparison of Profitability (Concluded)
Return on assets is a combination of profit margin and asset turnover. The grocery
industry has low profit margins. The profit margins of the two companies are 5.7 and
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1.
2.
3.
earnings were $22,090 million.
$38,051 $37,700 =2011: $26,492
Contributed capital for 2011 was $28,126 million. (Note: CVS has no preferred stock
Total Stockholders’ Equity
Yes. The debt to equity ratio increased from 64.9% in 2010 to 69.6% in 2011.
Debt to Equity Ratio = Total Liabilities
C4. Annual Report Case: Classified Balance Sheet
Yes, the company uses a classified balance sheet with current assets, property and
*Rounded
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(+ /2
$14,866
$16,765.5
2010: $12,104
=$12,104 = 0.8 times*
$15,463 $14,269 )
=$15,658 = 0.9 times*
2010: $95,778
CVS
Asset turnover = Net Sales
Average Total Assets
Asset turnover
= 3.8%
Southwest
2011: $178 = 1.1% 2010: $459
CVS
C5. Comparison Case: Financial Performance
Profit margin
Profit Margin
=
*Rounded
Net Income (Loss)
Net Sales or Total Operating Revenue
**
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( $15,463 + ) 2
$459
$14,866
= = 3.1%
$14,269 /
Return on assets
Return on Assets = Net Income
*Rounded
C5. Comparison Case: Financial Performance (Continued)
Average Total Assets
CVS
*
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CVS
C5. Comparison Case: Financial Performance (Concluded)
Return on equity
Return on Equity = Net Income
Average Stockholders’ Equity
issue. Some students may say that the first report is tentative and that a reevaluation
C6. Ethical Dilemma: Ethics and Financial Reporting
This situation is framed so that the difference between 75 percent and 90 percent is ma-
terial but also falls within the range of judgment. Thus, one can take either side of the
Note to Instructor: Answers will vary depending on the company selected by the students.
C7. Continuing Case: Annual Report Project
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