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5

Interpreting and
Communicating Accounting
Information

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 professional
standards. 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
FOCUS COMPANY:

Intrawest
Corporation
If you are a skier, you may have visited the Whistler Blackcomb
COMMUNICATING FINANCIAL
mountain resort in British Columbia, Panorama in the Canadian
INFORMATION AND
Rockies, Blue Mountain in Ontario, or Tremblant in Québec. You
CORPORATE STRATEGY
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
234 CHAPTER 5 Interpreting and Communicating Accounting Information

staff worked tirelessly with the company’s external auditors and its investment bankers
to prepare the detailed financial information necessary for the IPO, in compliance with
the applicable securities regulations in Canada.
In 1995, Intrawest started expanding its operations in the United States by acquiring
Snowshoe Mountain in West Virginia in that year and Copper Mountain in Colorado in
1996. Access to the U.S. capital markets became important to finance the company’s
investments in the United States. Hence, in 1997, the company’s shares began trading
on the New York Stock Exchange after meeting the regulatory requirements for listing
on that exchange. As a publicly traded company, Intrawest is required to provide more
financial information than before through regular filings with the Ontario Securities
Commission and the Securities and Exchange Commission in the United States.

BUSINESS BACKGROUND
Intrawest’s success formula starts with a resort and then builds an animated village so
visitors stay longer. As more satisfied customers visit the resort more often, they spend
more 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 and
room rates climb, so does the demand for resort real estate, which creates a surge in
real estate sales. All of this results in a total resort experience that brings year-round
destination visitors, increases the company’s revenues, and leads to the development of
more resorts. Intrawest’s management understands that the company’s financial suc-
cess depends on operating actively used resorts that meet the customers’ desire for a
range of activities.
Successful companies such as Intrawest learn how to match their financial reporting
to their business strategies. Marketing and communication are fundamental to both
strategies. 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’s
investments in new resorts, the results of operating existing resorts, and the company’s
financial condition are communicated to shareholders, creditors, and other interested
parties through press releases, conference calls with financial analysts, and periodic
reporting 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 success
makes Intrawest an excellent example through which we can focus our discussion of
Interpreting 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 annual
reports and related reports to help you learn how to find relevant information in these
reports. We also focus on the people involved and the sequential process that conveys
accounting information to statement users during a typical year.
CHAPTER 5 Interpreting and Communicating Accounting Information 235

ORGANIZATION OF THE CHAPTER

• A Closer Look at • Players in the • The Disclosure


Financial Statement Accounting Process
Formats and Notes Communication
Process

Classified Balance Sheet Managers (CEO, CFO, Press Releases


and Accounting Staff)

Classified Income Auditors Annual Reports


Statement

Statement of Information Intermediaries: Quarterly Reports


Retained Earnings Analysts and Information
Services

Cash Flow Statement Government Regulators Reports to Securities


Commissions
Notes to Financial Users: Institutional and
Statements Private Investors,
Creditors, and Others

Voluntary Disclosures Guiding Principles for


Communicating Useful
Information

Constraints of Accounting
Measurement

A CLOSER LOOK AT FINANCIAL STATEMENT


FORMATS AND NOTES
We have learned in previous chapters that the financial data contained in accounting LEARNING OBJECTIVE 1
reports are important factors in decisions made by investors, creditors, and analysts. To Recognize and apply the
make financial statements more useful to decision makers, specific classifications of different financial statement and
information are included on the statements. disclosure formats used by
companies in practice.
A variety of classifications is used in practice. You should not be confused when you
notice different formats used by different companies. You will find that each format is
consistent with the principles discussed in this text. The following is a discussion of
these classified financial statements.

CLASSIFIED BALANCE SHEET


The June 30, 2001, balance sheet for Intrawest is presented in Exhibit 5.1. First, notice
the title of the statement, Consolidated Balance Sheet. Consolidated means that the
accounts of Intrawest and the accounts of its wholly owned subsidiaries (e.g., Whistler
Blackcomb Resorts Inc.) have been added together through a consolidation process
that 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, followed
by liabilities and shareholders’ equity accounts); others use an account format (assets
on 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 in
Chapter 2, current assets are defined as those that will be turned into cash or expire (be
used up) within one year or by the end of the operating cycle, whichever is longer. In
Chapter 3, we noted that the operating, or cash-to-cash, cycle varies by company and
236 CHAPTER 5 Interpreting and Communicating Accounting Information

may be longer than one year. Current liabilities are defined as those obligations that
will be paid with current assets, normally within one year. Typically a balance sheet is
classified as follows:
A. Assets (by order of liquidity)
1. Current assets (short term)
a. Cash and cash equivalents
b. Short-term investments (marketable securities)
c. Accounts receivable
d. Inventory
e. Prepaid expenses (i.e., expenses paid in advance of use)
f. Other current assets
2. Non-current assets
a. Long-term investments
b. Property, plant, and equipment—at cost less accumulated amortization
c. Intangible assets
d. Other (miscellaneous) assets
Total assets
B. Liabilities (by order of time to maturity)
1. Current liabilities (short term)
a. Accounts payable
b. Accrued expenses payable
c. Other short-term liabilities
2. Long-term liabilities
a. Notes and mortgages payable
b. Lease obligations
c. Bonds payable
d. Other long-term liabilities
Total liabilities
C. Shareholders’ equity
1. Share capital (or capital stock)
2. Retained earnings (accumulated earnings that have not been declared as
dividends)
a. Total shareholders’ equity
b. Total liabilities and shareholders’ equity
It should be emphasized again that each financial statement item is a combination
of a number of accounts used in the company’s accounting system. Under Current
Assets, Intrawest does not separately report any inventories or prepaid expenses. Any
such amounts are included in Other Assets in the Current Assets category. Future
income taxes, depending on the circumstances, can be listed in any of four places on
the balance sheet: as a current asset, current liability, non-current asset, or non-current
liability. The Future Income Taxes account represents the amount of income taxes that
will most likely be paid or saved in the future, based on differences in the application
of tax laws and GAAP for recognizing revenues and expenses in the current period. If
the 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 payments
are expected.
After the Current Assets section, long-term investments are reported. They include
assets that are not used in operating the business. Examples include investments in
shares 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. This
group includes tangible (physical) assets that were acquired for use in operating the
business rather than for resale as inventory items or held as investments. The assets
included 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
CHAPTER 5 Interpreting and Communicating Accounting Information 237

EXHIBIT 5.1
Balance Sheet of
Consolidated Balance Sheets
Intrawest Corporation
June 30, 2001 and 2000
(in thousands of U.S. dollars)

2001 2000
REAL WORLD EXCERPT

Assets
Intrawest Corporation
Current assets:
Cash and cash equivalents $ 86,430 $ 78,985 ANNUAL REPORT
Amounts receivable (note 7) 82,536 72,233
Other assets (note 8[a]) 105,545 78,966
Properties (note 6):
Resort 329,177 254,801
Discontinued 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 371,451 314,481
Discontinued 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’ Equity


Current liabilities:
Amounts payable $ 146,464 $ 146,648
Deferred revenue (note 10) 81,537 70,832
Bank and other indebtedness (note 9):
Resort 201,558 158,144
Discontinued operations 82 84
429,641 375,708
Bank and other indebtedness (note 9):
Resort 804,912 670,539
Discontinued operations 3,363 4,394
808,354 674,933

Due to joint venture partners (note 14) 8,818 16,963


Deferred revenue (note 10) 26,750 26,974
Future income taxes (note 13) 83,771 82,522
Non-controlling interest in subsidiaries 30,616 28,983
1,387,950 1,206,083
Shareholders’ equity:
Capital stock (note 12) 414,220 413,719
Retained earnings 187,922 131,953
Foreign currency translation adjustment (33,780) (34,400)
568,362 511,272
$1,956,312 $1,717,355

the exception of land, are amortized as they are used. As discussed in Chapter 4, their
initial 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 amortization
computed for each period is reported on the income statement as amortization
expense. The accumulated amount of amortization expense for all past periods is
deducted from the initial cost of the asset to derive the book value or net book value
238 CHAPTER 5 Interpreting and Communicating Accounting Information

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 is
computed as $22,000  5 years  $4,400 per year. If this was the company’s only
fixed asset, the balance sheets developed during the five-year period would report the
following, 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 is
derived from the legal rights and privileges that accompany ownership. Examples are
patents, trademarks, copyrights, franchises, and goodwill from purchasing other com-
panies. Intangible assets usually are not acquired for resale but are directly related to
the 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 sheet
because they do not relate to an identifiable transaction with an external party; only
those that are material and purchased from others are included. Yet the economic value
of these unrecorded internally developed intangible assets is significant.
Current liabilities are expected to be paid out of the current assets that are converted
to cash, normally within the coming year. Current liabilities include borrowings from
banks and other financial institutions, accounts payable, accrued expenses payable, and
deferred revenue.
Long-term liabilities are a company’s debts that have maturities that extend beyond
one 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 future
chapters.
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 (share
capital) plus retained earnings, which is the accumulated earnings of the company less
the accumulated dividends declared. Retained earnings represents the amount of earnings
that has been left in the company for growth.
Until this chapter, we have identified the financing by investors as share capital. A
broader concept of investing by shareholders is Contributed Capital, which often includes
two 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 2001
edition of Financial Reporting in Canada indicates that approximately 30 percent of the
200 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 exchange
gains or losses arising from Intrawest’s ownership of some of the companies that operate
outside Canada. This topic is discussed in advanced accounting courses.
In note 11 to its financial statements, Intrawest provides details of the type of shares it
is authorized to issue and the number of shares that have been issued to shareholders as
at the end of its fiscal year. Intrawest is authorized to issue 200 million common shares,

1
C. Byrd, I. Chen, and H. Chapman, Financial Reporting in Canada 2001. Toronto: CICA, 2001, p. 340.
CHAPTER 5 Interpreting and Communicating Accounting Information 239

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 been
issued, however. Additional discussion about the characteristics of these types of shares
and accounting and reporting issues for shareholders’ equity is presented in Chapter 11.

FINANCIAL ANALYSIS
BALANCE 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 Assets Total Liabilities


Current Ratio  Debt-to-Equity Ratio  Shareholders’ Equity
Current Liabilities

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.

SELF-STUDY QUIZ 5-1


Refer to the balance sheet of Intrawest Corporation presented in Exhibit 5.1. Assume that the debt
Intrawest owes to the bank is based on an agreement specifying that Intrawest should maintain a
minimum 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, to
verify 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 STATEMENT


Intrawest’s 2001 consolidated income statement is reprinted in Exhibit 5.2.2 Other
common titles include statement of earnings and statement of operations. Income
statements 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.
2
Of the 200 companies surveyed in Financial Reporting in Canada, 2001, 55 companies used the title
Income Statement, 86 used Statement of Earnings, 41 used Statement of Operations, and 18 used other
titles in their 2000 annual reports. C. Byrd, I. Chen, and H. Chapman, Financial Reporting in Canada
2001. Toronto: CICA, 2001, p. 101.
240 CHAPTER 5 Interpreting and Communicating Accounting Information

EXHIBIT 5.2
Income Statement of
Consolidated Statements of Operations
Intrawest Corporation
For the years ended June 30, 2001 and 2000
(in thousands of U.S. dollars, except per share amounts)

2001 2000
REAL WORLD EXCERPT

Revenue:
Intrawest Corporation
Ski and resort operations $492,202 $447,350
ANNUAL REPORT Real estate sales 415,336 341,455
Rental properties 8,935 6 ,905
Interest and other income 3,547 12,449
Income from equity accounted investment 2,790 2,333
922,810 810,492
Expenses:
Ski and resort operations $383,864 $353,662
Real estate costs 338,856 281,845
Rental properties 4,426 3,641
Interest (note 16) 44,490 35,217
Depreciation and amortization 57,934 51,399
Corporate 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 $ 1.20
Net income 1.45 1.20

Weighted average number of common shares


outstanding (in thousands) 43,665 43,362

See accompanying notes to consolidated financial statements.

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

Continuing Operations This first section of an income statement presents the


results 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 show
gross margin (or gross profit) as a subtotal. Other operating expenses are then
deducted to show operating income as a second subtotal.
CHAPTER 5 Interpreting and Communicating Accounting Information 241

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-step
approach.3 A multiple-step income statement would show a subtotal for gross profit
and a subtotal for operating income from continuing operations before adding other
income and gains or subtracting expenses and losses. In Exhibit 5.3, we reorder the
accounts in Intrawest’s income statement to show you how the same data for fiscal
year 2001 would be displayed using the multiple-step format. Some companies also
use a hybrid approach in which only one subtotal for operating income is presented.
No difference exists in the individual revenue, expense, gain, and loss items
reported using the different formats. The differences relate only to the use of categories
and 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, nearly
all companies separate income tax expense (provision for income taxes) from other
expenses 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 (a
company 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 the
inventory on the balance sheet. We will present additional discussion of accounting for
sales and cost of goods sold for merchandising and manufacturing companies in Chap-
ters 6 and 7. GROSS PROFIT (GROSS
Gross profit (gross margin) is a subtotal, not an account. It is the difference MARGIN) is sales revenue less
between sales revenue and the cost of sales. Given that Intrawest is a developer and cost of sales.

EXHIBIT 5.3
Alternative Income Statement
Single Step Multiple Step
Formats for Results of
Revenue: Revenue: Continuing Operations
Ski and resort operations $492,202 Ski and resort operations $492,202
Real estate sales 415,336 Real estate sales 415,336
Rental properties 8,935 Rental properties 8,935
Interest and other income 3,547 916,473
Interest and equity accounted Cost of revenue:
investment 2,790 Ski and resort operations 383,864
Total revenues 922,810 Real estate sales 338,856
Rental properties 4,426
Expenses: 727,146
Ski and resort operations 383,864 Gross profit 189,327
Real estate sales 338,856 Depreciation and amortization 57,934
Rental properties 4,426 Corporate general and
Interest 44,490 administrative 9,793
Depreciation and amortization 57,934 Operating income from
Corporate 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 accounted
investment 2,790
Interest expense (44,490)
Income before the undernoted 83,447 Income before the undernoted 83,447
Provision for income taxes 10,014 Provision for income taxes 10,014
Income before non-controlling interest Income before non-controlling interest
and discontinued operations 73,443 and discontinued operations 73,443
Non-controlling interest 9,904 Non-controlling interest 9,904
Income from continuing operations 63,529 Income from continuing operations 63,529
Results of discontinued operations (2,942) Results of discontinued operations (2,942)
Net income 60,587 Net income 60,587

3
C. Byrd, I. Chen, and H. Chapman, Financial Reporting in Canada 2001. Toronto: CICA, 2001, p. 100.
242 CHAPTER 5 Interpreting and Communicating Accounting Information

operator of village-centred resorts, which are primarily service activities, the notion of
gross 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 income
statement of Danier Leather Inc., a leading designer, manufacturer, and retailer of high-
quality fashion leather and suede apparel.

EXHIBIT 5.4
Income Statement
Consolidated Statements of Earnings
For the years ended June 30, 2001 and 2000
REAL WORLD EXCERPT
(thousands of dollars, except per share amounts)
Danier Leather Inc. For the Years Ended
June 30, 2001 June 30, 2000
ANNUAL REPORT
(53 weeks) (52 weeks)

Revenue $165,418 $143,011


Cost of sales (Note 7) 82,818 69,865
Gross profit 82,600 73,146
Selling, general and administrative expenses (Note 7) 60,902 54,051

Earnings before interest and income taxes 21,698 19,095


Interest expense—net 583 33
Earnings before income taxes 21,115 19,062

Provision for income taxes (Note 8)


Current 9,090 8,166
Future (53) 186
9,037 8,352
Net earnings $12,078 $10,710
Net earnings per share (Notes 1[i] & 9)
Basic $1.75 $1.48
Fully diluted $1.73 $1.48

Operating expenses are the usual expenses incurred in operating a business during
an 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 Income from Continuing Operations (also called Operating Income)—is computed
CONTINUING after subtracting operating expenses from gross profit.
OPERATIONS (OPERATING
INCOME) equals net sales less
Non-operating (other) items are income, expenses, gains, and losses that do not result
cost of goods sold and other from the central operations of the business but are not unusual or infrequent in nature.
operating expenses. Examples are interest income, interest expense, and gains and losses on the sale of fixed
assets. Interest expense on debt is sometimes combined (netted) with interest revenue so
that only a single amount is reported. These non-operating items are added to or sub-
INCOME BEFORE INCOME tracted from income from operations to obtain Income before Income Taxes, which is
TAXES (PRETAX
also called Pretax Earnings. In Intrawest’s case, the difference between operating
EARNINGS) is revenues minus
all expenses except income tax income and non-operating items is labelled Income before the Undernoted because addi-
expense. tional items are deducted from this subtotal. Non-controlling interest is explained in
Chapter 12, and the results of discontinued operations are discussed later in this section.

Discontinued Operations Any company that plans to dispose of a major segment


of its business or customer line needs to present separate information on the income
DISCONTINUED statement, accompanied by disposal details written in a note. Discontinued operations
OPERATIONS result from the can result from abandoning or selling the major segment. Any operating income gen-
disposal of a major segment of
the business and are reported
erated by the discontinued segment is disclosed separately from any gain or loss on
net of income tax effects. the disposal (the difference between the book value of the net assets being disposed of
and the sale price or the abandonment costs). The disclosure of each can be in a note or
on the face of the income statement. Each line is to be reported net of the income tax
CHAPTER 5 Interpreting and Communicating Accounting Information 243

SELF-STUDY QUIZ 5-2


Complete the following tabulation, indicating the sign ( for increase,  for decrease, and NE for no
effect) 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.

effects. Separate reporting informs users that these results of discontinued operations
are less useful as predictors of the company’s future profitability.
In 1997, Intrawest Corporation decided to separate its non-resort operations from its
resort operations and to dispose of its non-resort assets in an orderly manner. For the
year ended June 30, 2001, these discontinued operations resulted in a loss of $2,942,000
as reported in the company’s income statement in Exhibit 5.2. The company included
details of the discontinued operations in a note to its financial statements.

Extraordinary Items Extraordinary items are gains or losses incurred by the com- EXTRAORDINARY ITEMS
pany that are considered unusual in nature, infrequent in occurrence, and not dependent are gains and losses that are
unusual in nature, infrequent in
primarily on decisions by management or owners. Examples include losses suffered occurrence, and not dependent
from natural disasters such as floods and hurricanes in geographic areas where such dis- on decisions by management or
asters rarely occur. These items must be reported separately on the income statement net owners. They are reported net of
of income tax effects. Separate reporting informs decision makers that the items are not tax on the income statement.
likely 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 ANALYSIS


Evaluating company performance is the primary goal of financial statement analysis. LEARNING OBJECTIVE 2
Company managers, as well as competitors, use financial statements to better under- Analyze and interpret the return
stand and evaluate a company’s business strategy. Analysts, investors, and creditors use on equity ratio.
these same statements to evaluate performance as part of their stock valuation and
credit evaluation judgements. Our discussion of the financial data contained in
accounting reports has now reached the point where we can evaluate the performance
of the company in relation to the investment made by shareholders.

KEY RATIO ANALYSIS:


RETURN ON EQUITY
Know the decision question:
How well has management used the investment by shareholders’ during the period? The return on
equity (ROE) ratio helps in answering this question. It is computed as follows:

Net Income
Return on Equity ⴝ
Average Shareholders’ Equity*

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


244 CHAPTER 5 Interpreting and Communicating Accounting Information

The 2001 ratio for Intrawest is:

$60,587
ⴝ 0.112 (11.2%)
($568,362 ⴙ $511,272) ⴜ 2

Examine the ratio using two techniques:

1 Comparisons over Time 2 Comparisons with Competitors

Vail Compagnie
Intrawest 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 than
firms with lower ROE, all other things equal. Managers, analysts, and creditors use this ratio to
assess the effectiveness of the company’s overall business strategy (its operating, investing, and
financing strategies).

FOCUS COMPANY ANALYSIS → The preceding computation indicates that Intrawest’s ROE
has increased significantly during the past three years. This is consistent with the company’s key
financial objectives of maintaining an earnings growth rate of 20 percent per year, to increase
resort operation revenues and profit margins as villages are built out, and to leverage third-party
capital to carry out business opportunities. Intrawest performed significantly better than Vail
Resorts, North America’s second-ranking ski resort operator, which operates resorts mainly in
Colorado and Wyoming. Intrawest also outperformed the Compagnie des Alpes, one of the
largest ski-lift operators in Europe, which operates ski resorts in the French and Italian Alps. The
performance of the Compagnie des Alpes contributed positively to Intrawest’s performance, as
Intrawest 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 such
a strategy will decrease expenses and thus increase ROE in the short run, it normally results in
future declines in ROE as the company’s products and plant and equipment reach the end of
their life cycles. As a consequence, experienced decision makers evaluate ROE in the context of
a company’s business strategy.

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

FINANCIAL ANALYSIS
ACCOUNTING-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
CHAPTER 5 Interpreting and Communicating Accounting Information 245

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 5-3


Assume that Intrawest’s executives receive bonuses if the current year’s net income exceeds the
previous year’s net income by 20 percent. Use Exhibit 5.2 to check whether Intrawest’s executives
earned any bonuses in fiscal year 2001.

Computations __________________________________________________________________

______________________________________________________________________________
Discuss why Intrawest might choose to pay executives based on performance and why it uses the
same 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.
246 CHAPTER 5 Interpreting and Communicating Accounting Information

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.

Finally, we come to “the bottom line,” Net Income. An income statement is not
complete, 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:

Net Income Available to Common Shareholders


EPS ⴝ
Weighted-Average Number of Shares Outstanding
During the Reporting Period

Intrawest discloses this amount as illustrated in Exhibit 5.2 (called basic EPS). Any
company that has a complex capital structure (that is, stock options or debt or equity
securities convertible into common shares) must also compute the effect of these items
as if they had been converted at the beginning of the period, or when initially issued if
during the current reporting period (called diluted EPS). The computation of these
amounts is beyond the scope of this textbook and is usually presented in advanced
coursework 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 after
continuing operations are reported net of the tax effect. For example, an extraordinary
loss 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) for
income 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 in
advance in monthly or quarterly estimates).

STATEMENT OF RETAINED EARNINGS


The statement of retained earnings reports the changes in retained earnings during the
accounting period, as indicated in Chapter 1. Two main components of this statement
that affect the balance of retained earnings are net income, which increases retained
earnings, and dividends, which reduce it. Exhibit 5.5 shows that net income of $60,587
was added to the balance of retained earnings at the beginning of fiscal year 2001 and
that dividends of $4,618 were deducted. The various types of dividends that can be
declared 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

4
For 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 (Financial
Post), March 26, 2002, p. IN3; M. Lewis, “Pro forma lingo,” CA Magazine, March 2002, pp. 16–24.
CHAPTER 5 Interpreting and Communicating Accounting Information 247

EXHIBIT 5.5
Statement of Retained Earnings
Consolidated Statements of Retained Earnings
For the years ended June 30, 2001 and 2000
(in thousands of U.S. dollars)

2001 2000
REAL WORLD EXCERPT
Retained earnings, beginning of year $131,953 $ 77,088
Intrawest Corporation
Net income 60,587 51,992
ANNUAL REPORT
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

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

CASH FLOW STATEMENT


We have introduced the cash flow statement classifications in prior chapters. They are
the following:
Cash Flows from Operating Activities. This section reports cash flows associated
with earning income.
Cash Flows from Investing Activities. Cash flows in this section are associated with
buying and selling productive assets (other than inventory) and investments in other
companies.
Cash Flows from Financing Activities. These cash flows are related to financing the
business through debt, issuance of shares, and payment of debts or repurchases of
shares.
Intrawest’s consolidated cash flow statement for the year ended June 30, 2001, is
presented in Exhibit 5.6. The cash flows from operations can be calculated using either
the 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 income
from 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 in
the statement prepared for Papa John’s at the end of Chapter 4 that was constructed
using the direct method.

FOCUS ON CASH FLOWS


OPERATING 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.
248 CHAPTER 5 Interpreting and Communicating Accounting Information

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 5.6
Cash Flow Statement of
Consolidated Statements of Cash Flows
Intrawest Corporation
For the years ended June 30, 2001 and 2000
(in thousands of U.S. dollars)
2001 2000
REAL WORLD EXCERPT
Cash provided by (used in):
Intrawest Corporation Operations:
ANNUAL REPORT Income from continuing operations $ 63,529 $ 52,091
Items not affecting cash:
Depreciation and amortization 57,934 51,399
Future income taxes 1,027 12,109
Income 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 338,856 281,845
Acquisition 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) 58,838
Cash provided by discontinued operations (note 4) 2,323 10,699
(45,322) 69,537
Financing:
Proceeds from bank and other borrowings 994,902 341,373
Repayments on bank and other borrowings (810,337) (244,285)
Issue of common shares for cash, net of issuance costs 4,467 1,007
Redemption 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) 1,315
Ski 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.
CHAPTER 5 Interpreting and Communicating Accounting Information 249

NOTES TO FINANCIAL STATEMENTS


The numbers reported on the various financial statements provide important informa-
tion to decision makers, but most users require additional details to facilitate their
analysis. All financial reports include additional information in notes that follow the
statements. Intrawest’s notes to its financial statements for 2001 are categorized in the
following 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 Statements


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

Note 1
Significant Accounting Policies REAL WORLD EXCERPT
DEFERRED REVENUE
Deferred revenue mainly comprises real estate deposits, season pass revenue, golf club initiation
Intrawest Corporation
deposits, government grants, and the exchange gains arising on the translation of long-term mone- ANNUAL REPORT
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 ANALYSIS
ALTERNATIVE 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 REAL WORLD EXCERPT
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
Goldman, Sachs & Co.
ANALYSTS’ REPORT
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 be
manipulated or smoothed. Users of financial statements (e.g., shareholders, creditors,
250 CHAPTER 5 Interpreting and Communicating Accounting Information

and others) are often forced to wrestle with dramatic differences in reporting practices
between 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).

Additional Detail Supporting Reported Numbers The second category of notes


provides supplemental information concerning the data shown on the financial state-
ments. Among other information, these notes may show revenues broken out by
geographic region or line of business, descriptions of unusual transactions, and expanded
detail 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 resort
operations, properties, accounts receivable, government assistance, share capital, income
taxes, interest expense, and employee benefits. Note 10, which follows, shows further
details of the deferred revenue items that appear in the balance sheet.

10. DEFERRED REVENUE:

2001 2000

Deposits on real estate sales $66,642 $51,200


Government assistance (note 11) 4,974 8,917
Exchange gains 14 3,309
Golf club initiation deposits 14,935 15,463
Season pass revenue 12,864 11,236
Other deferred amounts 8,858 7,681
108,287 97,806
Current portion 81,537 70,832
$26,750 $25,974

Relevant Financial Information Not Disclosed on the Statements The final


category 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 the
financial statements are published. Note 9 includes the following:
Note 9
REAL WORLD EXCERPT
Bank and Other Indebtedness
…. Bank and other indebtedness includes indebtedness in the amount of $342,206,000 (2000—
Intrawest Corporation $349,277,000), which is repayable in Canadian dollars of $518,100,000 (2000—$517,140,000).
ANNUAL REPORT The Company is subject to certain covenants in respect to some bank and other indebtedness, which require
the Company to maintain certain financial ratios. The Company is in compliance with these covenants at
June 30, 2001.

VOLUNTARY DISCLOSURES
GAAP and securities regulations set only a minimum level of required financial disclo-
sures. Many companies, including Intrawest, provide important disclosures beyond those
required. Such voluntary disclosures may appear in the annual report, in documents filed
with the securities commission, in press releases, or on the company’s Web site.
CHAPTER 5 Interpreting and Communicating Accounting Information 251

CONSTRAINTS OF ACCOUNTING MEASUREMENT


Accurate interpretation of financial statements requires that the statement reader
be aware of three important constraints of accounting measurement. First, although
items and amounts that are of low significance must be accounted for, they do not have
to conform precisely to specified accounting guidelines or be separately reported if they
would not influence reasonable decisions. Accountants usually designate such items and
amounts as immaterial. Determining material amounts is often very subjective. MATERIAL AMOUNTS are
Second, conservatism requires that special care be taken to avoid (1) overstating amounts that are large enough
to influence a user’s decision.
assets and revenues and (2) understating liabilities and expenses. Users of financial
statements often want to know about possible sources of trouble for the company. For
example, creditors need to know how secure their investments will be if the company’s CONSERVATISM suggests
fortunes deteriorate, but they may not be interested in whether the company might do that care should be taken not to
exceptionally well. They care more about the downside risk than the upside potential. overstate assets and revenues
or understate liabilities and
For this reason, financial statements that show assets at historical cost, but reduce these expenses.
amounts 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 financial
reports that they prepare. More companies have perished through excessive optimism
than through excessive caution.
Finally, the educated financial statement reader must be aware of special industry
practices or industry peculiarities due to long-standing and accepted accounting and
reporting practices in various industries. For example, public utilities (an industry
regulated by government) often present balance sheet information in what appears to be
upside-down order. BC Hydro Corporation lists capital assets first, followed by the more
liquid assets (cash, accounts receivable, and supplies). The reason for this presentation is
that regulatory commissions in many provinces require public utilities to use this format.

PLAYERS IN THE
ACCOUNTING COMMUNICATION PROCESS
Exhibit 5.7 summarizes the accounting communication process in terms of the people LEARNING OBJECTIVE 3
involved, their roles in the process, and the guidance they receive from legal and pro- Recognize the people involved
fessional standards. in the accounting communica-
tion process (managers,
auditors, information inter-
MANAGERS (CEO, CFO, AND ACCOUNTING STAFF) mediaries, government regula-
As noted in Chapter 1, the primary responsibility for the information in Intrawest’s tors, and users), their roles in the
financial statements and related disclosures lies with management as represented by the process, and the guidance they
highest officer in the company, often called the president and chief executive officer receive from legal and
(CEO) and the highest officer associated with the financial and accounting side of the professional standards.
business, often called the chief financial officer (CFO). These two officers normally sign
the statement of management responsibility (as discussed in Chapter 1) if one is
included in the annual report. For public companies, the same officers are responsible
for the principal reports filed with the provincial securities commissions. At Intrawest,
Joe Houssian, president and CEO, and Daniel Jarvis, CFO, have had that responsibility
for many years. They were responsible for the conformance of the statements and
related disclosures with GAAP (generally accepted accounting principles). Although
their legal responsibility is smaller, the members of the accounting staff who actually
prepare the details of the reports also have professional responsibility for the accuracy
of this information. Their professional success in the future depends heavily on their
reputations for honesty and competence.

AUDITORS CLEAN AUDIT OPINION.


As we discussed in Chapter 1, the provincial securities commissions require publicly Auditors’ statement that the
financial statements are fair
traded companies to have their statements audited by professional independent accoun- presentations in all material
tants following generally accepted auditing standards (GAAS). Many privately owned respects in conformity with
companies also have their statements audited. By signing a clean audit opinion, the GAAP.
252 CHAPTER 5 Interpreting and Communicating Accounting Information

EXHIBIT 5.7
The Accounting
Communication Process Management
Preparation
Chief executive officer
Chief financial officer
Accounting staff
Guided by GAAP

Independent
Auditors (CAs, CGAs)
Verification
Partners
Managers
Staff auditors
Guided by GAAS (Public
Government
companies
Information Regulators
only)
Intermediaries Verification
Analysis and Advice Provincial securities
Financial analysts commissioners and
Information services (Public their staff
companies Guided by securities
Users only) regulations
Analysis and Decision
Institutional investors
Private investors
Lenders
Others (suppliers, etc.)

audit firm assumes financial responsibility for the fairness of the financial statements
and related presentations. This opinion adds credibility to the statements and often is
required by agreements with lenders and private investors who are not actively
involved in management of the companies.5 Intrawest was initially financed through
investments by Mr. Houssian and loans from financial institutions (e.g., banks and
commercial finance companies). By voluntarily subjecting the company’s statements
to independent verification, Intrawest reduced the risk to the private investors and
financial 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 public
companies and most private companies are audited by audit firms of smaller size. A list
of well-known companies and their auditors at the time this chapter was written follows.

Company Industry Auditor

Honda Motor Co. Ltd. (Japan) Automobiles KPMG


Nortel Networks Corporation Computer equipment Deloitte & Touche
Singapore Airlines (Singapore) Airline Ernst & Young
Wendy’s (United States) Fast food PricewaterhouseCoopers

5
In some cases, the auditor may not be satisfied that the company’s financial statements are in compliance
with GAAP. A qualified opinion would then be issued if the company’s management is not willing to modify
the financial reports as per the auditor’s recommendation. Qualified opinions are rarely issued by auditors.
CHAPTER 5 Interpreting and Communicating Accounting Information 253

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

A QUESTION OF ETHICS
WHERE 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 process
between companies and financial statement users as involving a simple process of
mailing 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’s
reality. Now sophisticated financial analysts use modern information technology to
gather and analyze information. They receive accounting reports and other information
about the company from electronic information services (discussed later). They also
gather information through personal phone conversations with company executives and
visits to company facilities. They then combine the results of these analyses with infor-
mation about competitors, the overall economy, and even population trends to make
predictions of future earnings and stock price. These predictions form the basis of their
buy, hold, or sell recommendations for a company’s shares.
Analysts often work in the research departments of brokerage and investment
banking houses such as RBC Dominion Securities, mutual fund companies such as
the Investors Group, and investment advisory services such as Standard & Poor’s that
sell 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 Smith
Barney (both brokerage and investment banking companies) are among 15 analysts
who 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
254 CHAPTER 5 Interpreting and Communicating Accounting Information

EARNINGS FORECASTS are annual earnings per share for the company.6 In making these earnings forecasts, the
predictions of earnings for future analysts rely heavily on their knowledge of how the accounting system translates busi-
accounting periods. ness events into the numbers on a company’s financial statements.7 This knowledge
includes an understanding of the alternative accounting methods available to compa-
nies to account for different transactions and specialized industry practices that may be
applied to a particular industry. Analysts are regularly evaluated based on the accuracy
of 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. As
a 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 decisions
made based on analysts’ advice cause stock market prices to react quickly to account-
ing information announcements. A quick, unbiased reaction to information is called
market efficiency in finance.
It is highly unlikely that unsophisticated investors can glean more information from
financial statements than the sophisticated analysts have already learned. Careful
analysis does not lead all analysts to the same conclusions, however. These differences
of 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.
REAL WORLD EXCERPT
INTRAWEST CORORATION
Yahoo.com EARNINGS FORECAST
For fiscal 2002 For fiscal 2003

Average forecast $1.63 $1.88


Lowest forecast 1.12 1.40
Highest forecast 1.80 2.15
Number of analysts 14 7

Analysts make recommendations to buy, hold, or sell a company’s shares based on


their earnings forecasts. In the case of Intrawest, seven analysts recommended “strong
buy,” five analysts recommended “buy,” and one analyst recommended “sell.”

A QUESTION OF ETHICS
IT 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.

6
For further discussion of analysts’ forecasts, see K. Schipper, “Analysts’ Forecasts,” Accounting
Horizons, December 1991, pp. 105–121.
7
See G. J. Previts, R. J. Bricker, T. R. Robinson, and S. J. Young, “A Content Analysis of Sell-Side
Financial Analyst Reports,” Accounting Horizons, June 1994, pp. 55–70.
8
See M. B. Mikhail, B. R. Walther, and R. H. Willis, “Does Forecast Accuracy Matter to Security
Analysts?” The Accounting Review, April 1999, pp. 185–200.
CHAPTER 5 Interpreting and Communicating Accounting Information 255

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

Information Services Financial analysts obtain much of the information they use
from the wide variety of electronic information services available today. These services
are 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/S
Inc., provides consensus (average) and analyst-by-analyst earnings forecasts for more
than 18,000 domestic and foreign companies. More than 800 research analysts con-
tribute earnings forecasts to the service. Samples of the consensus forecasts can be
accessed on its Web site: www.firstcall.com.
Services such as Lexis-Nexis, Compustat, and Disclosure provide broader access to
financial statement and related news information. They also allow users to search the
database by key words, including various terms in financial statements. Their Web sites
describe 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 Analysis
and 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 users
through 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 or
English, 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 examples
used in this book were downloaded (electronically copied) from this Web site.
More general information services include the Dow Jones Interactive and
Bloomberg Financial Markets and Commodities News, as well as the financial sections
of 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 stock
prices and company press releases, including the initial announcements of annual and
quarterly financial results. This information also is available electronically through the
information 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 free
and fee-based information on many companies. These include
www.marketguide.com www.hoovers.com
www.etrade.com www.yahoo.com
The most interesting new trend in information services is the provision of financial
information in audio and video form. You can access recordings of conference calls
and videos of meetings between financial analysts and company management on
Yahoo!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 that
analysts consider when they evaluate a company.
www.broadcast.com/business/

9
Canadian companies that have shares traded on U.S. stock exchanges and U.S. companies can file SEC
forms electronically with EDGAR (Electronic Data Gathering and Retrieval) sponsored by the SEC.
256 CHAPTER 5 Interpreting and Communicating Accounting Information

Many companies also provide direct access to their financial statements and other
information over the Web. You can contact Intrawest at www.intrawest.com.
Readers should be aware that the definitions used to compute key ratios often differ
across these sources.

FINANCIAL ANALYSIS
INFORMATION 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 REGULATORS
The Ontario Securities Commission (OSC) and other provincial securities commissions
set 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 when
relevant. The OSC staff reviews these reports for compliance with their standards,
investigates irregularities, and punishes violators of their regulations.10

“Prerecorded” Revenue Draws Fire


REAL WORLD EXCERPT The Ontario Securities Commission expects to release a report by mid-March based on a
review of the accounting and revenue recognition practices of 70 unidentified TSX-listed
Financial Post technology companies, including telecommunications firms. That review follows a Securities
and Exchange Commission crackdown on aggressive accounting and revenue booking in the
United States. ….

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

USERS: INSTITUTIONAL AND PRIVATE INVESTORS,


CREDITORS, AND OTHERS
INSTITUTIONAL INVES- Institutional investors include the managers of private pension funds (associated with
TORS are managers of pension unions and employees of specific companies); public pension funds (for provincial and
funds, mutual funds, endowment
funds, and other funds that
municipal employees); mutual funds; and endowment, charitable foundation, and trust
invest on behalf of others. funds (such as the endowment of your college or university). These institutional
10
Research indicates that during a recent 11-year period, the SEC brought enforcement actions against
nearly 300 firms for accounting-related violations. In 72 percent of the cases, the CEO was implicated, and
the company’s auditors were also implicated in 29 percent of the cases. Consequences to the company
included bankruptcy or significant changes in ownership as well as financial penalties. These statistics are
reported 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. See
also E. H. Feroz, K. Parke, and V. S. Pastena, “The Financial and Market Effects of the SEC’s Accounting
and Auditing Enforcement Releases,” Journal of Accounting Research, Supplement 1991, pp. 107–142.
CHAPTER 5 Interpreting and Communicating Accounting Information 257

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

Institution Approximate Ownership

TAL Global Asset Management Inc. 5.5 million shares


I.G. Investment Management Ltd. 2.1 million shares
Capital Guardian Trust Company 1.6 million shares

Private investors include large individual investors such as Joe Houssian and some PRIVATE INVESTORS
include individuals who
of the company’s directors, as well as small retail investors who, like most individuals, purchase shares in companies.
buy a small number of shares of publicly traded companies through brokers such as
Nesbitt Burns and TD Waterhouse. Retail investors normally lack the expertise to
understand financial statements and the resources to gather other important data effi-
ciently. As a consequence, they often rely on the advice of information intermediaries
or turn their money over to the management of mutual and pension funds (institutional
investors).
Lenders, or creditors, include suppliers, banks, commercial credit companies, and LENDERS (CREDITORS)
other financial institutions that lend money to companies. Lending officers and finan- include suppliers and financial
institutions that lend money to
cial analysts in these organizations use these same public sources of information in
companies.
their 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 for
financial statements of private companies. Individuals and mutual funds also become
creditors when they buy publicly traded bonds and debentures issued by a company.11

A QUESTION OF ETHICS
CONFLICTING 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 the
relationships between customers and suppliers. Customers evaluate the financial health
of suppliers to determine whether they will be able to provide a reliable, up-to-date
source of supply. Suppliers evaluate their customers to estimate their future needs and
ability to pay their debts to the suppliers. Competitors also attempt to learn useful

11
Debentures are debt securities not secured with specific collateral (no specific assets are pledged as
security for the debt). Bonds normally are secured by specific collateral such as investments in shares of
other companies.
258 CHAPTER 5 Interpreting and Communicating Accounting Information

The COST-BENEFIT information about a company from its statements. The potential loss of competitive
CONSTRAINT suggests that advantage is one of the costs to the preparer of public financial disclosures. Account-
the benefits of accounting for ing regulators consider these costs as well as the direct costs of preparation when they
and reporting information should
outweigh the costs.
require new disclosures. They apply what is called the cost-benefit constraint, which
suggests that the benefits of accounting for and reporting information should outweigh
the costs. Other uses of financial statement information in labour-management rela-
tions and in government regulation were discussed in Chapter 1.
RELEVANT INFORMATION
can influence a decision; it is GUIDING PRINCIPLES FOR
timely and has predictive and/or COMMUNICATING USEFUL INFORMATION
feedback value. For accounting information to be useful to any of these user groups, it must be relevant
RELIABLE INFORMATION is and reliable. Relevant information is capable of influencing decisions because it allows
accurate, unbiased, and users to assess past activities (feedback value) and/or predict future activities (predictive
verifiable. value). Reliable information must be accurate, unbiased, and verifiable (independent
CONSISTENT parties can agree on the nature of the transaction and amount). Our discussions of ratio
INFORMATION can be analysis emphasize the importance of comparing ratios produced by the same company
compared over time because over time as well as comparing the company’s ratios with those of competitors. Such
similar accounting methods have
been applied.
comparisons are valid only if the information is prepared on a consistent and compara-
ble basis. Consistent information means that within a company, similar accounting
COMPARABLE methods have been applied over time. Comparable information means that similar
INFORMATION can be
compared across businesses
accounting methods have been applied. These characteristics of useful information,
because similar accounting along with the full-disclosure principle, are defined in the conceptual framework and
methods have been applied. guide the standard-setters in deciding what financial information should be reported.

SELF-STUDY QUIZ 5-4


Match the players involved in the accounting communication process with their roles or the guiding
principles 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 should
be reported.
5. Cost-benefit constraint e. An individual who analyzes financial information and provides
advice.
After you complete the quiz, check your answers with those on page 264.

THE DISCLOSURE PROCESS


LEARNING OBJECTIVE 4
Identify the steps in the
As noted in our discussion of information services and information intermediaries, the
accounting communication accounting communication process includes more steps and participants than one
process, including the issuance would envision in a world in which annual and quarterly reports are simply mailed to
of press releases, annual shareholders.
reports, quarterly reports, and
documents filed with securities
commissions, as well as the role
PRESS RELEASES
of electronic information services Intrawest and most public companies announce quarterly and annual earnings through
in this process. a press release as soon as the audited annual figures (or reviewed quarterly figures) are
available, to provide timely information to external users and to limit the possibility of
selective leakage of information. Intrawest normally issues its earnings press releases
A PRESS RELEASE is a
written public news
within six weeks of the end of the accounting period. The announcements are sent elec-
announcement normally tronically to the major print and electronic news services, which make them immedi-
distributed to major news ately available to subscribers. An example of a quarterly press release for Intrawest is
services. reprinted in Exhibit 5.8. It includes key financial figures and management’s discussion
of the results. Attached to the release are condensed income statements and balance
CHAPTER 5 Interpreting and Communicating Accounting Information 259

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

EXHIBIT 5.8
Earnings Press Release for
Intrawest Reports 2002 Second Quarter Results Intrawest Corporation
Real Estate Drives Revenue and EBITDA Growth
All Dollar Amounts Are in U.S. Currency
REAL WORLD EXCERPT
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 quarter
ended December 31, 2001.
Intrawest
PRESS RELEASE
Revenue for the second quarter was $231.4 million compared with $207.0 million for the quarter ended
December 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 same
period 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-recurring
income tax recovery, income from continuing operations would have been $5.4 million or $0.12 per
share in the second quarter last year.
“Contrary to some expectations, the weak North American economy and the events of September 11
have not had a dramatic impact on our business,” said Joe Houssian, Intrawest's chairman, president
and chief executive officer.
Revenue and total company EBITDA for the six months ended December 31, 2001, were $325.1 million
and $47.2 million, respectively, compared with $336.9 million and $50.3 million, respectively, in the
same 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 excluding
the 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 in
the same quarter of fiscal 2001 due to late season openings at the eastern resorts caused by unusually
warm weather conditions in November and December. This decline in revenue decreased ski and resort
operations 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 to
the 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 eastern
resorts,” said Daniel Jarvis, executive vice president and chief financial officer. “Our performance during
these exceptionally challenging times reflects the success of our early cost-control measures and the
strength 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 quarter
compared 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 per
cent 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 calling
1-888-793-1753 (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 live
Webcast can be accessed from Intrawest's Web site at www.intrawest.com under Investor
Relations/Webcasts.

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 press
release usually occurs quickly. Recall that a number of analysts follow Intrawest and
regularly predict the company’s earnings. When the actual earnings are published, the
market reacts not to the amount of earnings but to the difference between expectations
of earnings and actual earnings. This amount is called unexpected earnings. For exam-
ple, the Financial Post recently reported the following:
260 CHAPTER 5 Interpreting and Communicating Accounting Information

REAL WORLD EXCERPT Intrawest keeps profit growth streak alive


B.C.-based resort operator’s revenue up 16.5%
Financial Post VANCOUVER—Intrawest Corp., operator of such major North American mountain resorts as
British Columbia’s Whistler Blackcomb, yesterday posted a 16.5% rise in profit for the past fiscal
year.
Income hit US$60.59 million or US$1.45 a share compared with US$51.99 million (US$1.20) in
fiscal 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 net
earnings, the company’s share price declined, presumably because investors were
expecting 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. The
following excerpt from an article in Fortune magazine points out the growing impor-
tance of meeting or beating the average or consensus analysts’ estimate:
REAL WORLD EXCERPT
Learn to Play the Earnings Game (and Wall Street Will Love You)
Fortune The simplest, most visible, most merciless measure of corporate success in the 1990s has
become 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 earnings
estimates compiled first in the early 1970s by I/B/E/S . . . and now also by competitors Zacks, First
Call, 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 to


maintain a good relationship with the company’s management. The reason is that man-
agers provide analysts with vital information for their analysis. Optimistic earnings
forecasts, however, put additional pressure on management to meet and even exceed
analysts’ forecasts in order to please investors. The drive to meet analysts’ earnings
expectations has led the management of some companies to adopt accounting policies
that result in premature recognition of revenue and/or deferral of expenses in order to
increase reported earnings.
Companies such as Intrawest issue press releases concerning other important events
including announcement of new services or development of new resort villages. The
stock market often appears to react to some of these important announcements.
Press releases related to annual earnings and quarterly earnings often precede the
issuance of the quarterly or annual report by 15 to 45 days. This time is necessary to
prepare the additional detail and to print and distribute those reports.

ANNUAL REPORTS
For 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 of
retained 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 because
of additional reporting requirements imposed on these companies by securities com-
missions and the fact that many companies use their annual reports as public relations
tools to communicate non-accounting information to shareholders, customers, the
press, and others.
CHAPTER 5 Interpreting and Communicating Accounting Information 261

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 and
CEO; 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 make
it 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 of
Operations.
3. The four basic financial statements.
4. Notes (Footnotes).
5. Report of Independent Accountants (Auditor’s Opinion) and sometimes the Report
of 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. Length of Number of
Most of these components except for Management’s Discussion and Analysis MD&A Section Companies
(MD&A) have been discussed in earlier chapters. This component includes manage- 1–5 pages 34
ment’s discussion and explanation of key figures on the financial statements and future 6–10 63
risks the company faces. Many companies devote a sizeable portion of their annual 11–20 87
21 or more pages 15
reports to the MD&A section, as the chart in the margin shows.12 A complete annual
report from Gildan Activewear Inc., which includes all of these sections, is reprinted in
Appendix B of this textbook. As noted earlier, many companies make their annual
reports available on the Web. Some companies have stopped producing glossy print
copies 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 annual
report from $6.50 per copy in 1997 to $0.70 per copy in 1999.

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

REPORTS TO SECURITIES COMMISSIONS


Public companies must also file periodic reports with the OSC and other provincial
securities commissions. These reports include the annual report, quarterly reports, an
annual information form, and an information circular. The annual information form
provides 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 services
it offers, product and project development, sales and marketing, manufacturing, and

12
C. Byrd, I. Chen, and H. Chapman, Financial Reporting in Canada 2001. Toronto: Canadian Institute of
Chartered Accountants, 2001, p. 54.
262 CHAPTER 5 Interpreting and Communicating Accounting Information

competition. The form also lists the properties owned and leased by the company, and
significant contracts that the company has signed. The information circular is a legal
document that is forwarded to the company’s shareholders prior to the annual general
or special meeting of shareholders. It provides information about the items that the
shareholders 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 legal
nature. 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 the
need arises. These include a short-form prospectus that provides details of the equity
and/or debt securities that they plan to issue to investors, and press releases concerning
new 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

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

Accrued liabilities $ 556 Net Sales $9,601


Accounts payable 785 Other current assets 793
Accounts receivable 545 Other current liabilities 289
Cash and short-term investments 614 Other income (loss)—debit balance 115
Contributed capital 730 Other non-current assets 822
Cost of goods sold 7,542 Property, plant, and equipment (net) 897
Intangible assets 166 Provision for income taxes 155
Inventory 315 Retained earnings, January 1, 20A 1,409
Long-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 then
check your answer with the suggested solution that follows.

13
U.S., Canadian, and international companies that have shares trading on U.S. securities exchange
markets 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 schedules
concerning 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 with
a discussion of bad debts in Chapter 6.
• Form 10-Q, which includes all of the information provided in the quarterly report to shareholders, along
with 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 previously
reported in the 10-K or 10-Q forms. An example of an event requiring submission of a Form 8-K is a
change of auditors.
CHAPTER 5 Interpreting and Communicating Accounting Information 263

SUGGESTED SOLUTION
1. 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 $241


ROE = = = 0.103 or 10.3%
Average Shareholders’ Equity ($2,290 + $2,380)/2
264 CHAPTER 5 Interpreting and Communicating Accounting Information

This ratio indicates that shareholders earned 10.3 percent on the book value of
their initial investment in the company and subsequent earnings that have been
reinvested in the business. Comparison of this ratio to those of previous years
would indicate if the company’s performance has improved or deteriorated over
time. Furthermore, comparison to the industry average would also situate
Gateway’s performance relative to other companies in the same industry.

SOLUTIONS TO SELF-STUDY QUIZZES


Self-Study Quiz 5-1
1. June 30, 2000 June 30, 2001
$489,533 $607,856
Current ratio = 1.30 = 1.42
$375,708 $429,641
$1,206,083 $1,387,950
Debt-to-equity ratio = 2.36 = 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 is
approaching the 2.50 mark. Management should attempt to reduce the amount of bank indebtedness
to avoid potential difficulties with the bank. One possibility is to issue additional shares to existing or
new shareholders.
Self-Study Quiz 5-2
a. 200, NE, 200; b. 100, 100, 100
Self-Study Quiz 5-3
Change 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 align
the interests of the executives with those of the shareholders. In addition, companies often pay executives
bonuses based on the numbers in the annual report because the auditors have independently verified those
numbers.
Self-Study Quiz 5-4
1c, 2a, 3e, 4b, 5d.

CHAPTER TAKE-AWAYS
1. Recognize and apply the different financial statement and disclosure formats used by
companies in practice. p. 235
Most statements are classified and include subtotals that are relevant to analysis. On the
balance sheet, the most important distinctions are between current and non-current assets
and liabilities. On the income statement and cash flow statement, the separation of
operating and non-operating items is most important. The notes to the statements provide
descriptions of the accounting rules applied and more information about items disclosed on
the statements, as well as information about economic events not disclosed in the
statements.
2. Analyze and interpret the return on equity ratio. p. 243
ROE measures how well management used the investment by shareholders during the
period. Its three determinants—net profit margin, asset turnover, and financial leverage—
indicate why ROE differs from prior levels or that of competitors; these determinants
provide 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), their
roles in the process, and the guidance they receive from legal and professional
standards. p. 251
Management 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
CHAPTER 5 Interpreting and Communicating Accounting Information 265

credibility of the information. Financial statement announcements from public companies


usually are first transmitted to users through electronic information services. Analysts play
a major role in making this and other information available to average investors through
their stock recommendations and earnings forecasts.
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
Earnings are first made public in press releases. Companies follow these announcements
with 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 information
services 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 will
begin with two of the most liquid assets—cash and accounts receivable—and
transactions that involve revenue, adjustments to revenues, and certain selling expenses
that relate to recording cash and accounts receivable. Many analysts and the securities
regulators believe that accuracy in revenue recognition and the related recognition of
cost of goods sold (discussed in the next chapter) are the most important determinants
of the accuracy—and, thus, the usefulness—of financial statement presentations. We
will also introduce concepts related to the management and control of cash and
receivables, which is a critical business function. A detailed understanding of these
topics is crucial to future managers, accountants, and financial analysts.

KEY RATIO

Return on equity (ROE) measures how much the firm earned for each dollar of
shareholders’ investment. It is computed as follows (p. 243):
Net Income
Return on Equity ⴝ
Average Shareholders’ Equity

FINDING
BALANCE SHEET INCOME STATEMENT
Key Classifications Key Subtotals
FINANCIAL
Current and non-current assets and Gross profit INFORMATION
liabilities Income from operations
Contributed capital and retained earnings Net income
Earnings per share

CASH FLOW STATEMENT NOTES


Under Operating Activities (indirect method) Key Classifications
Net Income Descriptions of accounting rules applied in
 Items Not Affecting Cash the statements
 Cash Provided by Operating Activities Additional detail supporting reported
numbers
Relevant financial information not
disclosed on the statements
266 CHAPTER 5 Interpreting and Communicating Accounting Information

KEY TERMS
Clean Audit Opinion p. 251 Income from Continuing Operations
Comparable Information p. 258 (Operating Income) p. 242
Conservatism p. 251 Institutional Investors p. 256
Consistent Information p. 258 Lenders (Creditors) p. 257
Cost-Benefit Constraint p. 258 Material Amounts p. 251
Discontinued Operations p. 243 Press Release p. 258
Earnings Forecasts p. 254 Private Investors p. 257
Extraordinary Items p. 243 Relevant Information p. 258
Gross Profit (Gross Margin) p. 241 Reliable Information p. 258
Income before Income Taxes
(Pretax Earnings) p. 243

QUESTIONS
1. 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
LO1 M5–1 Determining the Effects of Transactions on Balance Sheet and Income Statement
Categories
Complete the following tabulation, indicating the sign of the effect ( for increase,  for
decrease, 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)
CHAPTER 5 Interpreting and Communicating Accounting Information 267

M5–2 Determining Financial Statement Effects of Sales and Cost of Goods Sold and Issuance LO1
of Shares
Using the following categories, indicate the effects of the following transactions. Use  for
increase 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

M5–3 Recording Sales and Cost of Goods Sold and Issuance of Shares LO1
Prepare journal entries for each transaction listed in M5–2.
M5–4 Computing Net Book Value of Property, Plant, and Equipment LO1
May’s Diner purchases new tables for $5,000 on January 1, 20A. The tables are expected to
have a useful life of 10 years and a salvage value of $500 . What would be the net book value
of the tables on December 31, 20C?
M5–5 Computing and Interpreting Return on Equity LO2
Chen, 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?
M5–6 Matching Players in the Accounting Communication Process with Their Definitions LO3
Match each player with the related definition by entering the appropriate letter in the space
provided.
Players Definitions

(1) CEO and CFO


(2) Independent auditor A. Adviser who analyzes financial and other
(3) Users economic information to form forecasts and
(4) Financial analyst stock recommendations.
B. Institutional and private investors and
creditors (among others).
C. Chief executive officer and chief financial
officer who have primary responsibility for
the information presented in financial
statements.
D. Independent accountant who examines
financial statements and attests to their
fairness.

M5–7 Identifying the Disclosure Sequence LO4


Indicate the order in which the following disclosures or reports are normally issued by public
companies.
No. Title

Annual report
Filing of annual financial
information with
securities commissions
Earnings press release

M5–8 Matching Definitions with Information Releases Made by Public Companies LO4
The titles of various information releases follow. Match each definition with the related
release by entering the appropriate letter in the space provided.
268 CHAPTER 5 Interpreting and Communicating Accounting Information

Information Release Definitions

(1) Annual report A. Written public news announcement that is


(2) Press release normally distributed to major news services.
(3) Quarterly report B. Report containing the four basic statements for
the year, related notes, and other disclosures by
management and auditors.
C. Brief unaudited report for quarter normally
containing summary income statement and
balance sheet (unaudited).

LO1 M5–9 Finding Financial Information: Matching Financial Statements with the Elements of
Financial Statements
Match each financial statement with the items presented on it by entering the appropriate letter
in 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
LO1 E5–1 Ordering the Classifications on a Typical Balance Sheet
A list of classifications on the balance sheet is shown below. Number the classifications in the
order 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

LO1 E5–2 Preparing a Classified Balance Sheet


Dell Computer Dell Computer Corporation is the leading direct-sale computer vendor in North America. The
company offers its customers a full range of computer systems, including desktop computer
systems, notebook computers, workstations, network servers, and storage products, as well as
an extended selection of peripheral hardware, computing software and related services. The
company sells its products and services to large corporate, government, health care, and
education customers, small- and medium-sized businesses and individuals. The items listed on
a recent balance sheet (in millions) are presented below in alphabetical order.
Accounts payable $ 4,286
Accounts receivable, net 2,895
Accrued expenses payable 2,257
Cash and cash equivalents 5,438
CHAPTER 5 Interpreting and Communicating Accounting Information 269

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

Required:
Prepare in good form a classified balance sheet for Dell Computer as at the end of the current
year, December 31, 20D, using the categories presented in the chapter.
E5–3 Preparing and Interpreting a Classified Balance Sheet with LO1
Discussion of Terminology (Challenging) Shaw
Shaw Communications Inc. is a diversified Canadian communications company whose core Communications
business is providing broad-band cable television, Internet, and satellite services to
approximately 2.8 million customers. Shaw also has significant interests in telecommunications,
Internet infrastructure, and interactive television companies. The following is a list of items
presented 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 $ 335.0
Accounts receivable, net 89.5
Bank indebtedness 27.0
Current portion of long-term debt 187.3
Deferred charges (long term) 152.9
Deferred credits (long term) 541.6
Deferred income taxes (credit balance) 184.9
Income taxes payable 2.0
Investments and other assets 1,068.4
Long-term debt 1,590.3
Non-controlling interest 17.8
Prepaid expenses and other 9.3
Property, plant, and equipment, net 1,683.4
Retained earnings (including cumulative translation adjustment) 254.5
Share capital 2,136.0
Subscriber base and broadcast licences, net 2,318.4
Unearned revenue 45.5

Required:
1. Prepare a classified consolidated balance sheet for Shaw Communications Inc. as at
August 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.
E5–4 Reporting Property, Plant, and Equipment on the Balance Sheet LO1
On January 1, 20B, Laura Anne’s Bakery purchased a new oven for $6,800. The oven was
expected to be used for four years and then to be sold for $2,000 on January 1, 20F. Prepare a
schedule showing the amounts that would be reported on the balance sheets prepared at the end
of 20B, 20C, 20D, and 20E for the oven (at cost), accumulated amortization, and net book value.

E5–5 Inferring Share Issuances and Cash Dividends from Changes in Shareholders’ Equity LO1
Power Corporation recently reported the following December 31 balances in its shareholders’ Power Corporation
equity accounts (in millions):
Current Year Prior Year
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 the
only other transactions that affected shareholders’ equity during the current year were the
issuance of shares and the declaration and payment of cash dividends.
270 CHAPTER 5 Interpreting and Communicating Accounting Information

Required:
Re-create the two journal entries reflecting the issuance of shares and the declaration and
payment of dividends.
LO1 E5–6 Matching Definitions with Income Statement-Related Terms
Selected terms that relate to the income statement follow. Match each definition with its
related term by entering the appropriate letter in the space provided.

Terms Definitions

(1) Cost of goods sold A. Sales Revenue minus Cost of Goods


(2) Interest expense Sold.
(3) Extraordinary item B. Item that is unusual, infrequent, and
(4) Service revenue not dependent on management’s (or
(5) Income tax expense on operations owners’) decisions.
(6) Income before extraordinary items C. Sales of services for cash or on credit.
(7) Net income D. Revenues  Gains  Expenses 
(8) Gross margin on sales Losses, including effects of
(9) EPS discontinued operations and
(10) Operating expenses extraordinary items (if any).
(11) Income from operations E. Amount of resources used to purchase
or produce the goods that were sold
during the reporting period.
F. Cost of money (borrowing) over time.
G. Net income divided by the average
number of common shares
outstanding.
H. Total expenses directly related to
operations.
I. Income before all income tax and
before discontinued operations and
extraordinary items (if any).
J. None of the above.

LO1 E5–7 Inferring Income Statement Values


Supply the missing dollar amounts for the 20B income statement of Ultimate Style Company
for 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

LO1 E5–8 Preparing a Multiple-Step Income Statement


The 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
CHAPTER 5 Interpreting and Communicating Accounting Information 271

Required:
Prepare a complete multiple-step income statement for the company (showing both gross
profit and income from operations). Show all computations. (Hint: Set up the side captions
starting with sales revenue and ending with earnings per share; use the amounts and
percentages given to infer missing values.)
E5–9 Preparing Single- and Multiple-Step Income Statements LO1
The following data were taken from the records of Kimberly Appliances, Incorporated, at
December 31, 20D:

Sales revenue $120,000


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 with
earnings 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 gross
profit and income from operations).
E5–10 Determining the Effects of Transactions on Balance Sheet and Income LO1
Statement Categories Gildan Activewear
Gildan Activewear Inc. is one of the largest producers of casual wear, selling T-shirts, golf
shirts, and sweatshirts. Listed here are selected aggregate transactions from the first quarter of
20B (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. Consider
each 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.

E5–11 Determining the Effects of Transactions on Balance Sheet, Income Statement, and Cash LO1
Flow Statement Categories Rowe Furniture
Rowe Furniture Corporation is a Virginia-based manufacturer of furniture. Listed here are
selected aggregate transactions from the first quarter of 20B (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 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.
272 CHAPTER 5 Interpreting and Communicating Accounting Information

LO1 E5–12 Preparing a Simple Cash Flow Statement Using the Indirect Method
Blackwell Corporation is preparing its annual financial statements at December 31, 20A. The
items 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. The
beginning 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 for
reporting cash flows from operating activities.
LO2 E5–13 Analyzing and Interpreting Return on Equity
Lands’ End Lands’ End Inc. is a mail-order and Internet-based direct merchant of traditionally styled
casual clothing accessories, shoes, soft luggage, and products for the home. Selected income
statement and balance sheet amounts (in thousands) for two recent years are presented below.

Current Year Prior Year

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.
LO2 E5–14 Analyzing and Evaluating Return on Equity from a Security Analyst’s Perspective
Papa John’s Papa 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 are
presented below.
Current Year Prior Year

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 on
the basis of this change? Explain.
LO3 E5–15 Matching Players in the Accounting Communication Process with Their Definitions
Match each player with the related definition by entering the appropriate letter in the space
provided.
Players Definitions

(1) OSC A. Adviser who analyzes financial and other economic


(2) Independent auditor information to form forecasts and stock
(3) Institutional investor recommendations.
(4) CEO and CFO B. Financial institution or supplier that lends money to
(5) Creditor the company.
(6) Financial analyst C. Chief executive officer and chief financial officer
(7) Private investor who have primary responsibility for the information
(8) Information service presented in financial statements.
CHAPTER 5 Interpreting and Communicating Accounting Information 273

D. Independent accountant who examines financial


statements and attests to their fairness.
E. Ontario Securities Commission, which regulates
financial disclosure requirements.
F. A company that gathers, combines, and transmits
(paper and electronic) financial and related
information 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.
E5–16 Finding Financial Information: Matching Information Items to Financial Reports LO4
Following are information items included in various financial reports. Match each information
item with the report(s) where it would most likely be found by entering the appropriate
letter(s) in the space provided.

Information Item Report

(1) Summarized financial data for 5- or 10-year period. A. Annual report


(2) Initial announcement of quarterly earnings. B. Annual information
(3) Complete quarterly income statement, balance form
sheet, and cash flow statement. C. Press release
(4) The four basic financial statements for the year. D. Quarterly report
(5) Detailed discussion of the company’s competition. E. None of the above
(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.

PROBLEMS
P5–1 Matching Definitions with Balance Sheet–Related Terms LO1
Selected terms related to the balance sheet, which were discussed in Chapters 2 through 5, are
listed below. Match each definition with its related term by entering the appropriate letter in
the space provided.
Terms

(1) Retained earnings (10) Book value


(2) Current liabilities (11) Contributed surplus
(3) Liquidity (12) Liabilities
(4) Contra-asset account (13) Long-term assets
(5) Accumulated amortization (14) Shareholders’ equity
(6) Intangible assets (15) Current assets
(7) Other assets (16) Assets
(8) Shares outstanding (17) Long-term liabilities
(9) Normal operating cycle

Definitions

A. A miscellaneous category of assets. G. Accumulated earnings minus accumulated


B. Amount of contributed capital for which dividends.
shares were not issued. H. Asset offset account (subtracted from asset).
C. Total assets minus total liabilities. I. Balance of the Common Shares account
D. Nearness of assets to cash (in time). divided by the issue price per share.
E. Assets expected to be collected in cash J. Assets that do not have physical substance.
within one year or the operating cycle, if K. Probable future economic benefits owned by
longer. the entity from past transactions.
F. Same as carrying value; cost less L. Liabilities expected to be paid out of current
accumulated amortization to date. assets, normally within the next year.
274 CHAPTER 5 Interpreting and Communicating Accounting Information

M. The average cash-to-cash time involved in O. All liabilities not classified as current liabilities.
the operations of the business. P. Property, plant, and equipment.
N. Sum of the annual amortization expense on Q. Debts or obligations from past transactions to
an asset from the date of its acquisition to be paid with assets or services.
the current date. R. None of the above.

LO1 P5–2 Preparing a Balance Sheet and Analyzing Some of Its Parts (AP5–1)
King Jewellers Inc. is developing its annual financial statements for 20C. The following

S amounts 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 held
for 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 per
share).
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; and
Other 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.
LO1 P5–3 Reporting Building, Land, and Amortization Expense (AP5–2)
Kamel Company is preparing its balance sheet at December 31, 20X. The following assets are
to be reported:
a. Building, purchased 15 years ago (including 20X): original cost, $450,000; estimated
useful 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 book
value of the property, plant, and equipment?
2. What amount of amortization expense should be reported on the 20X income statement?
Show computations.
LO1 P5–4 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 the
following:
MESA CORPORATION
Balance Sheet (Partial)
At December 31, 20A
Shareholders’ Equity

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


Contributed surplus 10,000
Retained earnings 50,000
Total shareholders’ equity $130,000
CHAPTER 5 Interpreting and Communicating Accounting Information 275

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.
P5–5 Preparing a Multiple-Step Income Statement and a Statement of Retained Earnings LO1
(Challenging) Domtar Inc.
Domtar Inc. is the second-largest integrated manufacturer and marketer of uncoated freesheet
paper in North America and the third-largest worldwide. It produces wood, pulp, and paper
products, 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 employee
future benefits as recommended by the Accounting Standard Board of the Canadian Institute
S
of Chartered Accountants. In addition, it purchased shares from its shareholders, paying a
higher price per share than the amount it collected when the shares were originally issued. The
items reported on the company’s income statement for that year are presented below (in
millions) in alphabetical order.
Amortization expense $ 239
Cost of sales 2,703
Cumulative effect of changes in accounting policies (debit) 151
Dividends 28
Financing expenses 96
Income tax expense 105
Net sales 3,598
Premium on repurchase of common shares 43
Retained earnings at beginning of year 504
Selling, general, and administrative expenses 180

Required:
1. Using appropriate headings and subtotals, prepare a multiple-step consolidated income
statement (showing both gross profit and operating income) and a statement of retained
earnings for the year ended December 31, 20B.
2. What information does the multiple-step format emphasize that the single-step income
statement does not?
P5–6 Preparing Both an Income Statement and Balance Sheet from a Trial Balance (AP5–4) LO1
Juan Real Estate Company (organized as a corporation on April 1, 20A) has completed the
accounting cycle for the second year, ended March 31, 20C. Juan also has completed a correct
trial balance as follows:
JUAN REAL ESTATE COMPANY
Trial Balance
S
At March 31, 20C
Account Titles Debit Credit

Cash $ 53,000
Accounts receivable 44,800
Office supplies inventory 300
Automobiles (company cars) 30,000
Accumulated amortization, automobiles $ 10,000
Office equipment 3,000
Accumulated amortization, office equipment 1,000
Accounts payable 20,250
Salaries and commissions payable 1,500
Note payable, long term 30,000
Share capital (30,000 shares) 30,000
276 CHAPTER 5 Interpreting and Communicating Accounting Information

Contributed surplus 5,000


Retained earnings (on April 1, 20B) 7,350
Dividends declared 8,000
Sales commissions earned 77,000
Management fees earned 13,000
Operating expenses (detail omitted to conserve your time) 48,000
Amortization expense (including $500 on office equipment) 5,500
Interest expense 2,500
Totals $195,100 $195,100

Required:
1. Prepare an income statement for the reporting year ended March 31, 20C. Include income
tax 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 following
captions (list each item under these captions as appropriate).
Assets
Current Assets
Non-current Assets

Liabilities
Current Liabilities
Long-Term Liabilities
Shareholders’ Equity
Share Capital
Retained Earnings

LO1 P5–7 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.
CHAPTER 5 Interpreting and Communicating Accounting Information 277

P5–8 Preparing a Simple Cash Flow Statement Using the Indirect Method LO1
Following are the items on Srinivasan Company’s 20B cash flow statement presented
in alphabetical order. Parentheses indicate that a listed amount should be subtracted on the
cash flow statement. The beginning balance in cash was $40,000 and the ending balance
was $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 method
presented in the chapter.
P5–9 Determining and Interpreting the Effects of Transactions on Income Statement LO1, 2
Categories and Return on Equity (AP5–5) Apple Computer
Apple Computer popularized both the personal computer and the easy-to-use graphic
interface. Today it competes against many companies that rely on Intel microprocessors and
the Windows operating system. Presented here is an income statement (in millions).

Net sales $5,941


Costs and expenses
Cost of sales 4,462
Research and development 310
Selling, general, and administrative 908
Operating income (loss) 261
Interest 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 fiscal
year. Complete the following tabulation, indicating the sign of the effect of each additional
transaction ( for increase,  for decrease, and NE for no effect). Consider each item
independently 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.
278 CHAPTER 5 Interpreting and Communicating Accounting Information

2. Assume that during the next period, Apple does not pay any dividends, does not issue or
retire common shares, and earns the same income as during the current period. Will
Apple’s ROE next period be higher, lower, or the same as the current period? Why?
LO3, 4 P5–10 Matching Transactions with Concepts
The concepts of accounting covered in Chapters 2 through 5 are shown below. Match each
transaction with its related concept by entering the appropriate letter in the space provided.
Use only one letter for each blank space.
Concepts Transactions
(1) Users of financial A. Recorded a $1,000 sale of merchandise on credit.
statements B. Counted (inventoried) the unsold items at the end of the
(2) Objective of period and valued them in dollars.
financial C. Acquired a vehicle for use in operating the business.
statements D. Reported the amount of amortization expense because it
Qualitative Characteristics likely will affect important decisions of statement users.
(3) Relevance E. Identified as the investors, creditors, and others interested in
(4) Reliability the business.
Assumptions F. Used special accounting approaches because of the
uniqueness of the industry.
(5) Separate entity
G. Sold and issued bonds payable of $1 million.
(6) Continuity
H. Paid a contractor for an addition to the building with $10,000
(7) Unit of measure
cash and $20,000 market value of the company’s shares
(8) Periodicity ($30,000 was deemed to be the cash equivalent price).
Elements of Financial I. Engaged an outside independent accountant to audit the
Statements financial statements.
(9) Revenues J. Sold merchandise and rendered services for cash and on
(10) Expenses credit during the year; then determined the cost of those
(11) Gains goods sold and the cost of rendering those services.
(12) Losses K. Established an accounting policy that sales revenue shall be
(13) Assets recognized only when ownership of the goods sold passes
(14) Liabilities to the customer.
(15) Shareholders’ L. To design and prepare the financial statements to assist the
equity users in making decisions.
Principles M. Established a policy not to include in the financial
statements the personal financial affairs of the owners of the
(16) Cost
business.
(17) Revenue
N. Sold an asset at a loss that was a peripheral or incidental
(18) Matching transaction.
(19) Full disclosure O. The value to users of a special financial report exceeds the
Constraints of Accounting cost of preparing it.
(20) Materiality P. Valued an asset, such as inventory, at less than its purchase
threshold cost because the replacement cost is less.
(21) Cost-benefit Q. Dated the income statement “For the Year Ended December
constraint 31, 20B.”
(22) Conservatism R. Used services from outsiders—paid cash for some and the
constraint remainder on credit.
(23) Industry S. Acquired an asset (a pencil sharpener that will have a useful
peculiarities life of five years) and recorded it as an expense when
purchased for $1.99.
T. Disclosed in the financial statements all relevant financial
information about the business; necessitated the use of
notes to the financial statements.
U. Sold an asset at a gain that was a peripheral or incidental
transaction.
V. Assets of $500,000  Liabilities of $300,000 
Shareholders’ Equity of $200,000.
W. Accounting and reporting assume a “going concern.”
CHAPTER 5 Interpreting and Communicating Accounting Information 279

ALTERNATE PROBLEMS
AP5–1 Preparing a Balance Sheet and Analyzing Some of Its Parts (P5–2) LO1
Carpet Bazaar is developing its annual financial statements for 20C. The following amounts
were 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; carpet
inventory, $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; and
common 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 the
following major captions (list the individual items under these captions):
a. Assets: Current Assets; Long-Term Investments; Property, Plant, and Equipment; and
Other 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.
AP5–2 Reporting Building, Land, and Amortization Expense (P5–3) LO1
Berczi Inc. is preparing its balance sheet at December 31, 20X. The following assets are to be
reported:
a. Building, purchased 12 years ago (including 20X): original cost, $630,000; estimated
useful 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 book
value of the property, plant, and equipment?
2. What amount of amortization expense should be reported on the 20X income statement?
Show computations.
AP5–3 Reporting Shareholders’ Equity on a Balance Sheet and Recording the Issuance of LO1
Shares (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

Shareholders’ Equity

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


Contributed surplus 28,500
Retained earnings 70,000

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.
280 CHAPTER 5 Interpreting and Communicating Accounting Information

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.
LO1 AP5–4 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 completed
the accounting cycle for the second year, ended August 31, 20C. ACME Pest Control also has
completed a correct trial balance as follows:

ACME PEST CONTROL SERVICES


Trial Balance
At August 31, 20C
Account 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
Contributed surplus 30,000
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 income
tax 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 following
captions (list each item under these captions as appropriate).
Assets

Current Assets
Non-Current Assets

Liabilities

Current Liabilities
Long-Term Liabilities
Shareholders’ Equity

Share Capital
Retained Earnings
CHAPTER 5 Interpreting and Communicating Accounting Information 281

AP5–5 Determining and Interpreting the Effects of Transactions on Income Statement LO1, 2
Categories and Return on Equity (P5–9) Barnes & Noble
Barnes & Noble, Inc., revolutionized bookselling by making its stores public spaces and
community 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 not
only from traditional sources but also from online booksellers. Presented here is a recent
income statement (in millions).

Net sales $2,448


Costs and expenses
Cost of sales 1,785
Selling, general, and administrative 466
Depreciation and amortization 60
Preopening expenses 18
Operating income 119
Interest 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 fiscal
year. Complete the following tabulation, indicating the sign of the effect of each additional
transaction ( for increase,  for decrease, and NE for no effect). Consider each item
independently 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 not
issue 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 current
period? Why?

CASES AND PROJECTS


FINANCIAL REPORTING AND ANALYSIS CASES
CP5–1 Finding Financial Information LO1, 4
Refer to the financial statements of Gildan Activewear Inc., given in Appendix B at the end of Gildan Activewear
this book. At the bottom of each statement, the company warns readers to “See accompanying
notes to consolidated financial statements.” The following questions illustrate the types of
information 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?
282 CHAPTER 5 Interpreting and Communicating Accounting Information

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 these
expenditures?
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?
LO1, 4 CP5–2 Finding Financial Information
The Forzani Group Refer to the Online Learning Centre at www.mcgrawhill.ca/college/libby/student/resources
for the financial statements of The Forzani Group Ltd. (FGL). The following questions illustrate
the 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?
LO2 CP5–3 Comparing Companies
Gildan Activewear Refer to the Online Learning Centre at www.mcgrawhill.ca/college/libby/student/resources
vs. The Forzani for the financial statements of The Forzani Group Ltd. and to Appendix B for the financial
Group statements 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?
LO3 CP5–4 Interpreting the Financial Press
The Auditor’s Report The Committee of Sponsoring Organizations (COSO) published a research study
that examined financial statement fraud occurrences between 1987 and 1997. A summary
of the findings by 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, is available on the Online Learning Centre at
www.mcgrawhill.ca/college/libby/students/resources.* Read the article and then write a
short 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 of
Certified Public Accountants, Inc.
LO1, 4 CP5–5 Using Financial Reports: Financial Statement Inferences
The following amounts were selected from the annual financial statements for Genesis
Corporation at December 31, 20C (end of the third year of operations):

From the 20C income statement:


Sales revenue $275,000
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
CHAPTER 5 Interpreting and Communicating Accounting Information 283

Common shares* 100,000


Contributed surplus 16,000
Retained earnings 80,000
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 that
follow. 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 beginning
balance (January 1, 20C) of retained earnings?
CP5–6 Using Financial Reports: Interpreting International Financial Statement Classifications LO1
(Challenging) Diageo
As the economy becomes more international in scope, users of financial statements may be
expected to analyze companies that are not incorporated in Canada. Diageo is a major world
corporation located in London, England. It is a worldwide consumer goods company that
owns 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 account
classifications shown on the portion of the Diageo annual report presented here. (Note: There
are three reserve accounts and a minority interests account. These accounts are discussed in
advanced accounting courses.)

DIAGEO
Consolidated Balance Sheet
At 30th September, 20B and 20A
20B 20A

Notes £m £m £m £m

Fixed assets
Intangible assets 11 2,652 588
Tangible assets 12 3,839 3,280
Investments 13 144 206
6,635 4,074
Current assets
Stocks 14 1,269 761
Debtors 15 1,451 873
Cash at bank and in hand 215 138
2,935 1,772
Creditors—due within one year
Borrowings 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 4,358
Creditors—due after more than one year
Borrowings 17 (3,494) (702)
Other creditors 20 (231) (163)
(3,725) (865)
Provisions for liabilities and charges 21 (325) (55)
2,842 3,438
284 CHAPTER 5 Interpreting and Communicating Accounting Information

Capital and reserves


Called-up share capital 22 506 443
Reserves 23
Share premium account 436 7
Revaluation reserve (944) 649
Special reserve — 282
Related companies’ reserves 10 16
Profit and loss account 2,802 2,010
2,304 2,964
2,810 3,407
Minority interests 32 31
2,842 3,438

LO3, 4 CP5–7 Using Financial Reports: Analyzing Income Statement-Based Executive Bonuses
Callaway Golf Callaway 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 pretax
earnings as a percentage of sales (computed here) met or exceeded target amounts. Callaway’s
income statements for the relevant years are presented here.

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

Current Year Prior Year

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 1,024 403
Other 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 of
sales meet or exceed target amounts (35.l percent and 21.1 percent, respectively). Meeting
these goals in the current year would result in bonuses ranging from $400,000 to $700,000 for
each of the five executive officers.
Required:
Use the preceding information to determine whether Callaway executives earned their bonuses
in the most recent year presented.
CHAPTER 5 Interpreting and Communicating Accounting Information 285

CRITICAL THINKING CASES


CP5–8 Making Decisions as a Manager: Evaluating the Effects of Business Strategy on LO2
Return on Equity Sony
Sony is a world leader in the manufacture of consumer and commercial electronics as well as
the entertainment and insurance industries. Its ROE has increased from 9 percent to 14 percent
over the last three years.
Required:
Using the table below, ndicate the most likely effect of each of the following changes in
business strategy on Sony’s ROE for the next period and future periods ( for increase,  for
decrease, and NE for no effect), assuming all other things are unchanged. Explain your answer
for each. Treat each item independently.
a. Sony decreases its investment in research and development aimed at products to be
brought 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.

CP5–9 Making a Decision as an Auditor: Effects of Errors on Income, Assets, and Liabilities LO3
Megan Company (not a corporation) was careless about its financial records during its first year
of operations, 20A. It is December 31, 20A, the end of the company’s fiscal year. An external
auditor 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 NE


20A, $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 not
corrected. Do not assume any other errors. Use these codes to indicate the effect of each dollar
amount: O  overstated, U  understated, and NE  no effect. Write an explanation of your
analysis of each transaction to support your response. (The answer for the first item is given as
an example.)
286 CHAPTER 5 Interpreting and Communicating Accounting Information

A sample explanation of analysis of errors that are not corrected is provided below, using the
first 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.
LO1 CP5–10 Evaluating an Ethical Dilemma: Management Incentives and Fraudulent
Mercury Finance Financial Statements
Mercury Finance Co. was a fast-growing auto-finance and insurance company. In January
1997, however, the auditors discovered that recently announced 1996 earnings had been
grossly overstated and prior years’ earnings had been overstated to a lesser extent. The
estimated 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. A8
The 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 Lake
Forest, Ill., auto-finance company initially reported earnings of $120.7 million for 1996. Soon
afterward, however, Mercury disclosed the accounting “irregularities” and estimated that last year’s
earnings probably would be about $56.7 million. Yesterday, Mercury said in an “update” that 1996
results will include an additional $125 million in loss provisions, as well as a $25 million reserve to
cover the planned sale of its Lyndon insurance unit. As a result, the company anticipates a 1996
net 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, and
Bloomberg 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 the
day after (January 30, 1997) the announcement of the misstatement?
2. How might executive compensation plans that tied bonuses to accounting earnings
motivate unethical conduct in this case?

FINANCIAL REPORTING AND ANALYSIS


PROJECTS
LO2 CP5–11 Comparing Companies over Time
Intrawest Corporation Using 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 accessed
through SEDAR.)
Required:
What was Intrawest’s ROE in the most recent year and how did it compare to the latest figures
provided in the text? What was management’s explanation for the change (if any)?
LO2 CP5–12 Comparing Companies across Industries
Microsoft vs. Using your Web browser, contact the Web sites of Microsoft, the leading computer
Dell 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 on
equity for each company. Write a short memo comparing the companies’ ratios. Indicate what
differences in their businesses might account for any difference in the ratios.
LO4 CP5–13 Broadening Financial Research Skills: Understanding the Disclosure Process through
Intrawest the Intrawest Web site
Using your Web browser, contact Intrawest at its Web site (www.intrawest.com). Examine the
most recent quarterly earnings press release and the related interim report.
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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 the
earnings press release?
CP5–14 Broadening Financial Research Skills: Examining Library and Computer Resources LO3
Contact 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 the
above four items. Also indicate its format (hard copy, Web site, CD-ROM, etc.).
CP5–15 Broadening Financial Research Skills: Contacting Information Intermediaries on the LO3
Web
Using your Web browser, contact one of the information intermediaries at its Web site (listed
in 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 the
above three types of information. Also indicate its format (hard copy, Web site, CD-ROM, etc.).
CP5–16 Broadening Financial Research Skills: Information Provided on Company Web sites LO1, 4
Using your Web browser, contact Molson Inc. at its Web site Molson
(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 same
quarter 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 (see
Chapter 1) on the day of the most recent fourth-quarter earnings press release?
CP5–17 Ethics Project: Analyzing Irregularities and Management Compensation LO3
Obtain a recent news story outlining an accounting irregularity (misstatement) in which the
reporter linked the motive for the misstatement to management compensation based on
reported accounting earnings. (Library files, www.findarticles.com, Dow Jones
Interactive, and Bloomberg Business News are good sources. Search for the terms
accounting irregularities and bonus.)
Required:
Write a short memo outlining the nature of the irregularity, the size of the necessary correction
of previously reported earnings, the impact of the announcement of the irregularity on the
company’s stock price, the impact of the irregularity on management compensation, and any
fines or civil penalties against the company and its officers.
CP5–18 Team Project: Analyzing the Accounting Communication Process LO1, 4
As a team, select an industry to analyze. MarketGuide provides lists of industries and their
make-up at www.marketguide.com/mgi/industry/industry.html. Each team member should
acquire the annual report for one publicly traded company in the industry, with each member
selecting a different company. (Library files, the SEDAR service at www.sedar.com, or the
company itself are good sources.)
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Required:
On an individual basis, each team member should write a short report answering the following
questions 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, and
one note that reports financial statement information not listed in the statements. What
information is provided in each case?
3. Using the company’s Web site, the periodicals and newspapers indexes in the library at
your school, or an instructor-assigned resource, find one article reporting the company’s
annual earnings announcement. How does the date of the announcement compare with the
date on the annual report? Why is there a difference?
4. Compute return on equity for the current year. Which company provided the highest return
to 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. Provide
potential explanations for any differences discovered.
LO1, 3, 4 CP5–19 Comprehensive Project: Understanding Formats of Financial Statements and Earnings
Announcements
Using local library resources and company-provided information, your task is to understand
the formats used for financial statements and notes in an annual report and to track the stock
price reaction to the most recent annual earnings announcement for a public company. Your
instructor may assign a particular company for you to analyze, or you may choose one of the
focus companies in this text, a competitor company in the same industry, or a company in
which you have career-related interests.
Required:
1. Contact the Web site or investor relations department of the company and obtain a copy of
the most recent annual report. Both the SEDAR and the SEC EDGAR Web sites provide
links 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 principle
applied in the company’s statements, one note that presents additional detail about a
reported financial statement number, and one note that reports financial statement
information 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 the
company.
a. Prepare a graph of the closing stock price for your company for the date of the earnings
announcement 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 provided
in 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 information
announcement process for a public company for a three-month period following its most
recent year-end. Your instructor may assign a particular company for you to analyze, or you
may choose one of the focus companies in this text, a competitor in the same industry, or a
company in which you have career-related interests.
LO1, 2, 3, 4 CP5–20
Required:
1. Gathering the necessary information:
a. Contact the investor relations department of the company by mail, phone, or the
Internet and obtain copies of the most recent annual report and a recent earnings press
release. The SEDAR Web site www.sedar.com provides links to the Web sites of many
companies.
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b. Using library resources, another service listed in the chapter, or an instructor-assigned


resource, find one article reporting a significant non-earnings-related event (new
product introduction, merger, etc.) that took place during the quarter following the most
recent 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 of
the earnings press release and the five days preceding and following the earnings press
release 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 balance
sheets 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 following
components:
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 apparent
effect on the company’s stock price, and any explanations for the reported events or the
stock price changes provided in the press.
d. A summary of your comparative analysis of the company’s performance.