Challenge Exercises and Problem
(20 min.) P 11-62
Req. 1
Transaction
Operating
Income
Income
before
Tax
Net
Income
Earnings
per
Share
Beg. Bal.
$655,000
$680,000
$510,000
a.*
NE
NE
NE
NE
b.
+ $70,000
+ $70,000
+ $52,500
+
NE
NE
h.
Req. 2
Operating
Income
Income
before
Net
Earnings
per
Decision Cases
(15-20 min.) Decision Case 1
EPS to use for predicting future profits:
Unaudited EPS …………………………………………………………………. $1.19
Include:
Gain on sale of building ……………………………………………….. .05
Loss on lawsuit settlement …………………………………………… (.12)
Lost income due to employee labor strike …………………….. (.24)
EPS to use for prediction ………………………………………………….. $0.59
Include all the preceding items for your prediction because all are
labeled by GAAP as normal business occurrences and are thus part of
Exclude the following items:
• unrealized loss on investments in AFSS because this is not even part
of net income (it is included in comprehensive income).
(15-20 min.) Decision Case 2
Magid’s earnings are of higher quality than those of Bay Area. Magid
follows more conservative (and more realistic) accounting policies than
Bay Area. Here are some examples:
SALES REVENUE
Magid records sales revenue when it receives an installment sale
contract and a cash down payment from a customer. In contrast, Bay
INSURANCE REVENUE
Magid records insurance revenue over the life of the policy, while Bay
Area records insurance revenue up front when the customer signs the
insurance contract. Magid’s policy is more realistic because both
Overall, Bay Area’s policies for recording revenue suggest that the
company may be overstating its revenue. Magid’s accounting policies
make Magid appear to be the safer investment. The accounts that will
Ethical Issue
Req. 1
The ethical issue: Does it matter how a company reports its operating
results as long as the totals are accurate? May all items of income and
Req. 2 and Req. 3
The stakeholders in this case include the bank, its officers and directors,
shareholders, prospective shareholders, its creditors, and stock
analysts.
Economic analysis: Prospective investors want to predict the level of
net income and cash flows that a company will generate from year to
year. Continuing operations are more predictable than discontinued
operations. This is why discontinued operations are highlighted on the
(continued) Ethical Issue
to Royal Bank and stockholders who buy the company’s stock based on
the second income statement can be hurt. They may lend to the
company on too-favorable terms, or they may pay too high a price for its
Legal analysis: Generally accepted accounting principles as well as the
SEC have legal and regulatory requirements for segregating recurring
items from non-recurring items. To depart from these rules violates
Req. 4
The bank should report their results of operations in a way that
separates the recurring from the non-recurring items. This course of
action is not only the legal and ethical thing to do, but in the long run it
Focus on Financials: Apple Inc.
(30-45 min.)
Req. 1
Apple Inc.’s income statement does not mention income from continuing
operations because there are no special items of income, such as
discontinued operations. All of Apple, Inc.’s net income results from
continuing operations. To evaluate quality of earnings, we reviewed
Measures
of Quality
of Earnings
2014
2013
2012
Cost of
$112,258/$182,795
$106,606/$170,910
$87,846/$156,508
Operating
expenses
to sales
ratio
$18,034/$182,795
= 0.10
$15,305/$170,910
= 0.09
$13,421/$156,508
= 0.09
From this analysis, we see the following trends:
(1) the cost of goods sold to sales ratio increased 6% in 2013 and
declined slightly (1%) in 2014, (2) the gross margin to sales ratio
decreased 6% in 2013 and increased slightly (1%) in 2014, (3) the
operating expenses to sales ratio held steady in 2013 and increased 1%
in 2014, (4) the operating income to sales ratio decreased in 2013 and
held steady in 2014.
(continued) Apple Inc.
Req. 2
Net Income per outstanding share: $39,510,000,000 / 6,085,572 = $6.49.
Investment Capitalization Rates
5%
6%
7%
Req. 3
Student answers will vary depending on when this problem is assigned.
If a student used a price of $112, the approximate cost on October 12,
Focus on Analysis: Under Armour, Inc.
(30 min.)
Req. 1
Measures
of Quality
of Earnings
2014
2013
2012
Cost of
goods sold
$1,572/$3,084
= 0.51
$1,195/$2,332
= 0.51
$956/$1,835
= 0.52
ratio
Operating
income to
revenues
ratio
$354/$3,084
= 0.11
$265/$2,332
= 0.11
$209/$1,835
= 0.11
This table examines four ratios that investigate earnings quality. Cost of
goods sold to revenues have been stable over 2013 and 2014, which is a
favorable sign. The same comment applies to gross margin to revenues
(continued) Under Armour, Inc.
The notes about revenue and expense recognition are also in line with
generally accepted accounting principles, which is favorable for quality
of earnings. The Company presents sales net of sales-related
taxes. We recognize initial fees received from a franchisee or licensee
Req. 2
They define their segments by geographic region either North America
or Foreign. The financial information they provide by segments is for
revenues and operating income. North American segments generate the
Req. 3
Investment Capitalization Rate
4%
6%
8%
10%
(continued) Under Armour, Inc.
Req. 4
Student answers will vary depending on when this problem is assigned.
If a student used the price of $103 on October 12, 2015, this would be
Group Project
1-2 hours
Student responses on this problem will vary.