Chapter01Sol 6e2005f

Chapter 1
Overview of Financial Reporting, Financial

Statement Analysis, and Valuation
CHAPTER 1
OVERVIEW OF FINANCIAL REPORTING, FINANCIAL

STATEMENT ANALYSIS, AND VALUATION
Solutions to Questions, Exercises and Problems, and Teaching Notes to Cases
1.1 Value Chain Analysis Applied to Timber and Timber Products Industry.
Schedule 1.1 of this Instructor’s/Solutions Manual contains a depiction of the value
chain. The links in the value chain are as follows:
1. Timber Tracts: Plants and maintains timber tracts (Weyerhauser).

2. Logging: Harvests timber (Weyerhauser).
3a. Sawmills: Cuts timber into various grades of wood (Weyerhauser).
3b. Pulp and Paper Manufacturing: Grinds timber into pulp and converts the pulp
into various grades of paper and cardboard (International Paper).
4a. Intermediate Users of Wood: Engage in construction, furniture manufacturing,
etc. (Masco).
4b. Intermediate Users of Paper: Manufacture containers and packaging (Owens-
Illinois) and various commodity and specialty papers (Georgia-Pacific).
5a. Retailers of Lumber and Wood Products: Sells such products to the final
consumer (Home Depot).
5b. Retailers of Paper Products: Sells such products to the final consumer (Office
Depot).
Schedule 1.1
Value Chain for the Timber and Timber Products Industry
Retailers of
Sawmills Intermediate Users Lumber and
of Wood Wood Products
Timber Logging
Tracts
Pulp and Paper Intermediate Retailers of Paper

Manufacturing Users of Paper Products
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1.2 Porter’s Five Forces Applied to Air Courier Industry.
Buyer Power. Air courier services are a commodity. Firms in the industry offer
similar overnight or two-day deliveries. Firms also provide opportunities to track
shipments. Business customers can negotiate favorable shipping terms based on the
volume of shipments. Thus, buyer power is high.
Supplier Power. The principal inputs are labor services, equipment, and
information systems. Except for pilots and some information processing
specialists, the skill required to offer air courier services is relatively low.
Competition for jobs, therefore, reduces supplier power. The principal items of
equipment are airplanes and trucks. The number of suppliers of this equipment is
relatively small, but the equipment offered is largely a commodity. Thus, supplier
power is relatively low. Information systems are critical to scheduling, tracking, and
delivery of parcels. Hiring individuals with the skills needed to design and maintain
this information system is somewhat difficult only because of the high level of
competition in the economy for such individuals. Thus, supplier power is low to
moderate.
Rivalry Among Existing Firms. Seven air couriers now carry a 90 percent market
share. Fed Ex and UPS have the largest market shares and compete heavily. Smaller
firms compete more in particular geographical or customer markets. Thus, rivalry is
relatively high.
Threat of New Entrants. The cost of equipment, developing national and

international delivery networks, and overcoming entrenched firms in an already
crowded market makes the threat of new entrants low.
Threat of Substitutes. The main threat to transportation of letter parcels is digital

transmission. The threat of substitutes for transportation of packages is low.
1.3 Economic Attributes Framework Applied to Specialty Retailing Apparel

Industry.
Demand. Firms attempt to compete on design, colors, and other product

attributes, but apparel is largely a commodity. Demand is somewhat cyclical with
economic conditions; customers tend to either delay purchases or trade down during
economic downturns. Demand is seasonal within the year. Demand grows at the
growth rate in population, which suggests that apparel retailing is a relatively
mature market. To the extent that retailers can generate customer loyalty, demand is
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not highly price sensitive. However, given the similarity of product offerings across
firms, firms cannot price their goods too much out of line with competitors.
Supply. There are many firms selling similar apparel in most markets. The barriers
to entry are not particularly high, since an apparel line and retail space are the most
important ingredients.
Manufacturing. The manufacturing process is labor intensive. The manufacturing

process is relatively simply and firms source their apparel from Asia, which has low
wage rates.
Marketing. Because of the large number of suppliers selling similar products,

apparel-retailing firms must stimulate demand with attractive store layouts, colorful
product offerings, and various sales promotions.
Investing and Financing. Firms must finance inventory, usually with a

combination of supplier and bank financing. The risk of inventory obsolescence is
somewhat high if the product offerings in a particular season do not catch on. Firms
tend to rent retail space in shopping malls, so they need to engage in extensive long-
term borrowing.
1.4 Identification of Commodity Businesses.

Dell. The products of Dell, computers, servers and printers, are commodities. Dell
tends not to develop the technologies underlying these products. Instead, it
purchases the components from firms that develop the technologies
(semiconductors, computer software). Dell’s direct-to-customer marketing strategy
is not unique, but the extent to which Dell performs this strategy better than anyone
else in the industry gives it a competitive advantage. Its size, purchasing power,
quality control, and efficiency permit it to operate as a low-cost provider.
Southwest Airlines. Airline transportation services are a commodity product in

the sense that one cannot differentiate seats on one airline from another. Southwest
Airlines’ strategy is to be the lowest cost provider of such services, thereby
differentiating itself on low prices.
Microsoft. The basic idea of a commodity product is that the product offerings of
one firm are so similar to those of other firms that customers can easily switch to
competitors’ products if price becomes an issue. The technological attributes of
computer software are duplicated relatively easily, a commodity attribute.
However, Microsoft’s size permits it to invest in new technology development and
keep it on the leading edge of new technologies. Microsoft also has a huge
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advantage in terms of installed base that most customers are almost forced to
purchase its software to be able to use application programs and communicate with
other computer users. Thus, its products are inherently commodities but Microsoft
is able to overcome some of the disadvantages of commodity status.
Johnson & Johnson. Johnson & Johnson operates in three business segments:
consumer healthcare, pharmaceuticals, and medical equipment. It derives the
majority of its revenue and profits from the latter two industries. Patents protect
the products of these two industries, which give the firm a degree of market power.
Until another firm creates a new product that dominates the patented product of
Johnson & Johnson, its products are not commodities. Rapid technological change,
however, makes most products obsolete earlier than the end of the patent’s life.
The products of Johnson & Johnson probably have fewer commodity attributes
than the other three firms in this question.
One of the purposes of this question is to illustrate that firms can pursue both
product differentiation strategies and low cost leadership strategies and, if
performed well, can gain “most admired status”.
1.5 Identification of Company Strategies. The strategies of Home Depot and

Lowe’s Companies are marked more by their similarities than by their differences.
Both firms sell to the do-it-yourself homeowner and the professional builder,
plumber, or electrician at competitively low prices. Their in-store product offerings
are similar, roughly evenly split between building materials, electrical and plumbing
supplies, hardware, paint, and floor coverings. Their store sizes are approximately
the same. They both use sales personnel with expertise in a particular home
improvement area to offer advice to customers. They both rely on third party
credit cards for a large portion of their sales to customers. Home Depot is slightly
less than twice the size of Lowe’s in terms of number of stores. Home Depot’s
stores span the United States, whereas Lowe’s tends to locate in the eastern United
States. Lowe’s, however, is expanding westward.
1.6 Researching the FASB Web Site. The answer to this question will change over
time as the FASB updates its activities. The purpose of the question is to
familiarize students with the FASB web site and the kinds of information they can
find there.
1.7 Researching the IASB Web Site. The answer to this question will change over
time as the IASB updates its activities. The purpose of the question is to
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familiarize students with the IASB web site and the kinds of information they can
find there.
1.8 Effect of Industry Economics on Balance Sheet. Intel faces the greatest risk of
technological change for its products among the three firms. Although the
manufacture of semi-conductors is capital intensive, Intel does not add financial risk
to its already high business risk. Thus, Firm B is Intel. The revenues of both
American Airlines and Walt Disney change with changes in economic conditions,
subjecting them to cyclical risk and thereby reducing their use of long-term debt.
Walt Disney produces movies, in addition to operating theme parks, which the firm
does not include in property, plant and equipment. This will reduce its property,
plant and equipment to total assets percentage. American Airlines has few assets
other then its flight and ground support equipment. Thus, Firm A is Walt Disney
and Firm C is American Airlines. It may seem strange that Walt Disney has such
smaller proportions of long-term debt in its capital structure than American
Airlines. One possible explanation is that the assets of American Airlines have a
more ready market in case a lender repossessed and sold them than the more unique
assets of Walt Disney. The more ready market reduces the borrowing cost. In this
case, however, the explanation lies in the fact that American Airlines has operated at
a net loss for several years and has negative shareholders’ equity. The result is a
higher long-term debt to assets ratio for American Airlines than for Walt Disney.
1.9 Effect of Business Strategy on Common-Size Income Statement. Firm A is

Dell and Firm B is Apple Computer. The clues appear below.
Cost of Goods Sold to Sales Percentages. One would expect Dell to have a
higher cost of goods sold to sales percentage because it adds less value, essentially
following an assembly strategy, and competes based on low prices. Apple
Computer can obtain a higher markup on its manufacturing costs because it creates
more unique products with somewhat of a unique consumer following.
Selling and Administrative Expense to Sales Percentages. Apple Computer

engages in more promotion to market its somewhat unique products to consumers;
thereby increasing its selling expenses. Apple Computer is also considerably
smaller than Dell, which creates some diseconomies of scale with respect to
administrative expenses.
Research and Development Expense to Sales Percentages. Apple Computer is

more of a technology innovator than Dell, thereby giving Apple Computer a high
research and development expense to sales percentage.
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Net Income to Sales Percentages. These percentages do not appear consistent

with the strategies of these firms. One would expect Apple Computer to have a
higher profit margin, given its product innovations. Dell appears to execute its
strategy more effectively, at least in this particular year.
1.10 Effect of Business Strategy on Common-Size Income Statements. Firm A is

Dollar General and Firm B is Federated Department Stores (Federated).
Department stores sell branded products for which the stores can obtain a higher
markup on their acquisition cost. Discount stores price low in an effort to gain
volume. Thus, the cost of goods sold to sales percentage of Federated should be
lower than that of Dollar General. Department stores engage in advertising and
other promotions to stimulate demand. They also have higher cost of space. These
factors should increase their selling and administrative expense to sales percentage.
One would expect that the department stores should have a higher net income to
sales percentage. In this case, the profit margin percentages are the same.
1.11 Effect of Industry Characteristics on Financial Statement Relationships.

There are various strategies for approaching this problem. One strategy begins with
a particular company, identifies unique financial characteristics (for example, hotel
and casino companies have a high proportion of property, plant and equipment
among their assets), and then searches the common-size data in Exhibit 1.15 to
identify the company with that unique characteristic. Another approach begins
with the common-size data in Exhibit 1.15, identifies unusual financial statement
relationships (for example, Firm (12) has a high proportion of receivables), and then
looks over the list of companies to identify the one most likely to have substantial
receivables among its assets. We follow both strategies here.
The two financial services firms will have balance sheets dominated by cash,
securities, and loans receivable. Firms (11) and (12) meet this description. Cash
and securities present 75.5 percent (= 1,507.2/1,996.0) of the assets of Firm (12),
typical of a securities firm, suggesting that it is Merrill Lynch. Receivables
comprise a higher percent of total assets for Firm (11) than for Firm (12) (36.2
percent for Firm (11) versus 19.3 percent for Firm (12)), suggesting that Firm (11)
is Citigroup. Firm (11) also has a high percentage of its assets in cash and securities,
consistent within Citigroup’s involvement in a wide range of financial services.
Firm (11) has a much higher percentage of revenues in selling and administrative
expenses than firm (12). Citigroup’s involvement in a wider range of financial
services likely increases its administrative expenses. In addition, managing its
branch-banking network likely increases administrative costs. Firm (11) has a lower
percentage of revenues for interest expense, consistent with using low-interest
yielding customer deposits as a main source of funds. Neither firm is fixed-asset
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intensive, although Citigroup’s branch network of banks increases its fixed asset
intensity relative to Firm (12).
Three firms have high percentages of property, plant and equipment relative to
sales, Firms (7), (8), and (10). These firms in some order are Carnival Corporation,
Harrah’s Entertainment, and Verizon Communications. Firm (10) has the highest
percentage of property, plant and equipment to revenues, yet Firm (8) has the
highest depreciation and amortization expense to revenues percentage. The
percentage of accumulated depreciation to the cost of property, plant and
equipment is higher for Firm (8) than for Firm (10), so Firm (8)’s higher
depreciation and amortization expense to revenues percentage is not likely due to
new, more expensive depreciable assets. The likely explanation is that Firm (8) has
a shorter depreciable life for its depreciable assets than Firm (10). Due to
technological obsolescence, the depreciable assets of Verizon likely have a shorter
life then either the casinos and hotels of Harrah’s or the ships of Carnival. Thus,
Firm (8) is Verizon. Note that Verizon does not amortize its wireless licenses, so
that amortization of these licenses will not explain the higher depreciation and
amortization expense to revenues percentage for Firm (8). Another distinguishing
characteristic of Firm (8) is that it has a lower cost of sales to revenue percentage
than Firm (7) or Firm (10). Verizon’s services are more capital, instead of labor,
intensive compared to those of Carnival or Harrah’s, which lowers Verizon’s
operating expense line. Also, Carnival and Harrah’s sell meals as part of its
services, the cost of which they include in cost of sales. Firm (8) has the highest
selling and administrative expense to revenues percentage of the three firms.
Telecommunication services are more competitive than luxury entertainment, which
both increases marketing expenses and lowers revenues for Verizon.
This leaves Firm (7) and Firm (10) to be Carnival and Harrah’s in some order.
Firm (10) is more fixed-asset intensive. Firm (7) on the other hand finances more
heavily with long-term debt. Firm (7) has a higher selling and administrative
expense to revenues percentage and thereby a lower net income to revenues
percentage. Distinguishing these two firms is a close call. The land-based services
of Harrah’s are probably more competitive because of the direct competition located
physically nearby and the low switching costs for customers. Once customers
commit to a cruise, their switching costs are higher. Thus, one would expect
Harrah’s to have higher marketing costs and a lower net income to revenues
percentage. This reasoning suggests that Firm (7) is Harrah’s and Firm (10) is
Carnival. One wonders though why Carnival would be twice as fixed-asset
intensive as Harrah. One possible explanation is that the cost per square foot of a
ship is larger than that of hotels and casinos. Another possibility is that the
capacity utilization of ships is less on average than that of hotels and casinos. The
problem does not provide information to assess these possibilities. Firm (7)’s
higher proportion of long-term debt might suggest that hotels and casinos serve as
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better collateral for loans than ships. Another possibility is that Harrah’s simply
chose to use debt more extensively than Carnival.
Three firms have research and development expenses, Firms (5), (6), and (9).
These firms are likely to be ebay, Johnson & Johnson, and Cisco Systems. All
three numbered firms have high profit margins, high proportions of cash and
marketable securities, low proportions of property, plant and equipment, and low
long-term debt, consistent with technology-based firms. These firms differ on their
R&D to revenues percentages, with Firm (9) having the lowest percentage. Both
Johnson & Johnson and Cisco invest in R&D to create new products, whereas ebay
invests in technology to support the offering of its online services. The clue
suggests that ebay is Firm (9). Firm (9) differs from Firm (5) and Firm (6) in the
amount of intangibles. Intangibles dominate the balance sheet of Firm (9). The
problem indicates that ebay has grown its network of online services largely by
acquiring other firms, which increases goodwill and other intangibles. Thus, Firm
(9) is ebay. Note that ebay amortizes some of its intangibles, which increases it
depreciation and amortization expense to revenues percentage relative to Firm (5)
and Firm (6).
Firm (5) and Firm (6) are Johnson & Johnson and Cisco in some combination.
The principal difference between the percentages for these two firms is in the other
noncurrent assets to revenues percentage. The problem states that Cisco has
expanded by making minority equity investments in emerging technology firms,
which it would include in other noncurrent assets. Cisco would realize equity
earnings from such investments, which increases its other revenues percentage,
relative to Johnson & Johnson. This suggests that Johnson & Johnson is Firm (5)
and Cisco is Firm (6). One would expect that R&D to revenues for a
pharmaceutical company would be higher than for a computer company, which runs
counter to the conclusion that Firm (5) is Johnson & Johnson. Johnson & Johnson,
however, generates revenues from branded, over-the-counter consumer health
products, which do not require as much R&D investment.
This leaves four firms, Firms (1) to (4). The four remaining firms are
Amazon.com, Anheuser-Busch, Kellogg, and Yum Brands. Amazon.com is likely
the least fixed asset intensive of these firms. It must invest in information systems,
but does not need either manufacturing or retailing assets, as does the other three.
This suggests that Firm (1) is Amazon.com. Also consistent with the conclusion
that Firm (1) is Amazon.com is that its shareholders’ equity is negative.
Amazon.com is a relatively new firm with a record of startup losses. Note that its
income taxes percentage is negative, indicating a tax savings instead of a tax expense.
Amazon.com likely benefited from the carryforward of net operating losses. Firm
(1) has the highest cost of sales to revenue percentage of the four firms, consistent
with Amazon.com’s low value added for its online services. It is interesting to
compare the cost of sales to revenues percentages for Amazon.com and ebay [Firm
(9)]. Amazon.com includes the full selling price of goods sold in its revenues
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whenever it takes product risk and the cost of the product sold in the cost of sales.
On the other hand, ebay does not assume product risk, so its revenue includes only
customer posting and transaction fees and advertising fees. Its cost of sales
percentage primarily includes compensation of personnel maintaining its auction
sites. One other item to note for Firm (1) is its heavy use of long-term debt. The
lack of collateral for borrowing would seem to dictate low long-term debt. The debt
in this case is mostly convertible debt, which permits the holder to convert into
shares of common stock if the firm does well, but provides greater protection to the
investor in the event of bankruptcy than investing in the firm’s common stock.
This leaves Firm (2), Firm (3) and Firm (4). Firm (2) has the smallest
inventories to revenues percentage, consistent with a restaurant selling perishable
foods. The cost of sales to revenues percentage for Firm (2) is the highest of these
three remaining firms. The extent of competition in the restaurant business is likely
higher than that for the branded food products of Anheuser-Busch and Kellogg,
consistent with a perceived lower value added (higher cost of sales to revenues
percentage) for Firm (2). Thus, Firm (2) is Yum Brands.
Firm (3) has a significantly higher property, plant and equipment to revenues
percentage than Firm (4), consistent with the theme parks of Anheuser-Busch.
Firm (4) has a significantly higher intangibles to revenues percentage than Firm (3),
consistent with Kellogg’s strategy of acquiring other branded foods companies and
recognizing goodwill. Thus, Firm (3) is Anheuser-Busch and Firm (4) is Kellogg.
Note that Anheuser-Busch uses long-term debt to a greater extent, with its theme
parks serving as collateral. Kellogg has a significantly higher percentage of selling
and administrative expense to revenues percentage than Anheuser-Busch. Both
firms advertise heavily. One possible explanation is that Anheuser-Busch has a
more narrow range of products to advertise than Kellogg does.
1.12 Effect of Industry Characteristics on Financial Statement Relationships.

There are various strategies for approaching this problem. One strategy begins with
a particular company, identifies unique financial characteristics (for example, electric
utilities have a high proportion of property, plant and equipment among their
assets), and then searches the common-size data in Exhibit 1.16 to identify the
company with that unique characteristic. Another approach begins with the
common-size data in Exhibit 1.16, identifies unusual financial statement
relationships (for example, Firm (10) has a high proportion of receivables), and then
looks over the list of companies to identify the one most likely to have substantial
receivables among its assets. We follow both strategies here.
Firm (10) has a high proportion of receivables among its assets and substantial
borrowing in its capital structure. This balance sheet structure is typical of the
finance company, HSBC Finance. We ask students why the capital markets allow a
finance company to have such a high proportion of borrowing in its capital
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structure. The answer is threefold: (1) finance companies have contractual rights to
receive cash flows in the future from borrowers; the cash flow tends to be highly
predictable, (2) finance companies lend to many different individuals, which
diversifies their risk, and (3) borrowers often pledge collateral to back up the loan,
which provides the finance companies with an alternative for collecting cash if
borrowers default on their loans. Thus, the low risk in the asset structure allows the
firm to assume high risk on the financing side. We use this opportunity to ask
students how this firm can justify recognizing interest revenue on its loans as it
accrues each period when it has an uncollectible loan provision of 27.1 percent of
revenues. Two points are noteworthy: (1) the concern with uncollectibles is not
with the size of the provision but with how much uncertainty there is in the amount
of the provision (a high mean with a low standard deviation is not a concern but a
high mean with a high standard deviation is a concern), and (2) revenues represent
interest revenues on loans whereas the provision for uncollectibles includes both
unpaid principal and interest; thus, the 27.1 percent provision does not mean that
the firm experiences defaults on 27.1 percent of its customers each year. The
percentage for depreciation and amortization includes the amortization of the cost of
establishing loans. HSBC Finance capitalizes these costs (included in Other Assets)
and amortizes them over the term of the loan. The cash flow from operations to
capital expenditures ratio is high because of the low capital intensity of this firm.
Firm (12) has a high proportion of cash and marketable securities among its
assets and a high proportion of liabilities in its capital structure. This balance sheet
structure is typical of the insurance company, Allstate Insurance. Allstate receives
cash from policyholders each period as premium revenues. It pays out the cash to
policyholders as they make insurance claims. There is a lag between the receipt and
disbursement of cash, which for a property and casualty insurance company can
span periods up to several years. Allstate invests the cash in the interim to generate
a return. The high proportion of current liabilities represents Allstate’s estimate of
the amount of future claims arising from insurance coverage in force in the current
and previous periods. We ask students at this point to comment on the quality of
earnings of an insurance company. Our objective is to get students to see the extent
of estimates that go into recognizing claims expenses in a particular period. Claims
made from accidents or injuries during the current year related to insurance in force
during that year require relatively little estimation. However, policyholders may
sustain a loss during the current period but not file a claim immediately. Also,
estimating the cost of a claim may present difficulties if the policyholders contest
the amount Allstate is willing to pay and the case goes through adjudication. Thus,
the potential for low quality earnings is present with insurance companies. We then
point out that the amount shown for other assets represents the unamortized
portion of the cost of writing a new policy (costs of investigating new policyholders
to assess risk levels, commissions paid to insurance agents for writing the new
policy, filing fees with state insurance regulators). We ask why insurance
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companies do not write this amount off in the year of initiating the policy. The
explanation is one of matching. Insurance companies recognize premium revenues
over several future periods and should match both policy initiation costs and claims
costs against these revenues. The cash flow from operations to capital expenditures
ratio is high because of the low capital intensity of this firm.
Four firms report research and development (R&D) expenditures, Firm (4), Firm
(5), Firm (6), and Firm (9). Dupont, Hewlett-Packard, Merck and Procter &
Gamble will all incur costs to discover new technologies or develop new products.
Firm (9) has the highest R&D expense to revenues percentage, the most fixed assets
per dollar of sales, and the highest profit margin. This firm is Merck.
Pharmaceutical companies must invest heavily in new drugs to remain competitive.
The drug development process is also lengthy, which increases R&D costs.
Pharmaceutical companies have patents on most of their drugs, providing such firms
with a degree of monopoly power. The demand for most pharmaceuticals is also
relatively price inelastic, both because customers need the drugs and because the
cost of the drugs is often covered by insurance. The manufacturing process for
pharmaceuticals is capital-intensive, in part because of the need for precise
measurement of ingredients and in part because of the need for purity. Note that
Merck has a relatively high selling and administrative expenses to revenues
percentage. This high percentage reflects both the cost of maintaining a sales staff
to market products to physicians and hospitals and heavy advertising outlays to
stimulate demand from consumers.
Hewlett-Packard, on the other hand, outsources many of its computer
components and will therefore not have as much property, plant and equipment.
Thus, Firm (4) is Hewlett-Packard. We ask students why Hewlett-Packard has
such a small proportion of long-term debt in its capital structure. Computer firms
experience considerable technological risk related to the introduction of new
products by competitors. Products life cycles are short, approximately one to two
years. Hewlett-Packard does not want to add financial risk to its already high
business (asset side) risk. Also, computer firms have relatively few assets (other
than property, plant and equipment) that can serve as collateral for borrowing.
Their most important resources, their technologies and their people, do not show up
on the balance sheet. The relatively low profit margin evidences the increasingly
commodity nature of most computer products and the intense competition in the
industry.
This leaves Firm (5) and Firm (6) as being Dupont and Procter & Gamble in
some combination. Firm (5) has a lower cost of sales to revenues percentage and a
higher selling and administrative expense to revenues percentage. It also has a higher
profit margin than Firm (6). Firm (5) is Procter & Gamble. The high profit margin
reflects the brand names of Procter & Gamble’s products. The high selling and
administrative expense percentage results from advertising and other expenditures to
stimulate demand and to maintain and enhance brand names. The low cost of sales
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percentage reflects the relatively low cost of ingredients in most of its products and
the high selling prices it can charge. One final clue is that investments in R&D are
less critical for a consumer products company than for firms where technology
development is important. Note that Procter & Gamble shows a high percentage for
intangibles, the result of goodwill and other intangibles from companies it has
acquired.
This leaves Firm (6) as Dupont. Its income statement percentages are similar to
those for Hewlett-Packard. It carries more debt than Hewlett-Packard, related to
Dupont’s borrowing to finance its more capital-intensive operations.
We move next to Pacific Gas & Electric. Utilities are very capital intensive and
carry high levels of debt. Firm (11) displays these characteristics. Note that
depreciation and amortization as a percentage of revenues is the highest for this
firm, reflective of its capital intensity. Its interest expense to revenues percentage is
also the second highest among these firms, which one would expect from the high
levels of debt.
We move next to the two service firms, Kelly Services and Omnicom Group.
Neither firm will have a high proportion of property, plant and equipment. Thus,
Firms (1), (2), and (8) are possibilities. Kelly Services should have no inventories
and inventories for Omnicom Group should be small, representing advertising work
in process. This suggests that Firm (1) and Firm (8) are the most likely candidates.
One would expect the value added by employees of Kelly (temporary help services)
would be less than that of Omnicom (creative advertising services). Thus, Firm (1)
is Kelly and Firm (8) is Omnicom. Another clue that Firm (1) is Kelly is that
receivables relative to operating revenues indicate a turnover of 6.8 (=
100.0%/14.6%) times per year and current liabilities relative to operating expenses
indicate a turnover of 8.7 (= 84.0%/9.7%) times per year. The corresponding
turnovers for Firm (8) are 2.0 (= 100.0%/50.4%) and .8 (= 70.2%/89.7%). One
would expect faster turnovers for a temporary help business that pays its
employees more regularly for temporary work done. One would expect even higher
turnovers for Kelly Services than those above for Firm (1). The turnovers for
Omnicom are difficult to interpret because its operating revenues represent the
commission and fee earned on advertising work whereas accounts receivable
represent the full amount (media time plus commission or fee) billed to clients and
accounts payable represent the full amount payable to various media. The higher
percentages for receivables and current liabilities for Firm (8) indicate the agency
nature of advertising firms. Firm (8) shows a relatively high proportion for
intangibles, consistent with recognizing goodwill in the acquisition of other
marketing services firms by Omnicom in recent years. Neither firm has much long-
term debt, consistent with the low collateral value of its assets (primarily
employees). The surprising result is that the cash flow from operations to capital
expenditures ratio for Kelly is so low. Given its low capital intensive, one would
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expect a high ratio. The explanation relates to its very low profitability, which leads
to low cash flow from operations.
We move next to the fast-food restaurant, McDonalds. The firm should have
inventories but its inventories should turn over rapidly. The remaining firm with
the lowest inventory percentage is Firm (7), representing McDonalds. Note that
the firm has a high proportion of its assets in property, plant and equipment.
McDonalds owns its company-operated restaurants and owns but leases other
restaurants to its franchisees. The relatively high profit margin percentage results
from McDonalds dominance in its market and its brand name.
We are left with two unidentified firms in Exhibit 1.16, Firm (2) and Firm (3)
and they are Abercrombie & Fitch and Best Buy in some combination. Both of
these firms have inventories. Firm (3) has substantially more property, plant and
equipment per dollar of sales and a much higher profit margin than Firm (2).
Abercrombie & Fitch sells brand name clothing products with a degree of fashion
emphasis, whereas Best Buy sells electronic products with near-commodity status
at low prices. One would expect the cost of store space for Best Buy to be less
than that of Abercrombie & Fitch, since the latter firm tends to locate in malls.
Thus, Firm (2) is Best Buy and Firm (3) is Abercrombie & Fitch.
1.13 Effect of Industry Characteristics on Financial Statement Relationships

—Global Perspective. There are various approaches to this problem. One
approach begins with a particular company and identifies unique financial
characteristics (for example, steel companies have a high proportion of property,
plant, and equipment among their assets), and then searches the common-size
financial data to identify the company with that unique characteristic.
Another approach begins with the common-size data and identifies unusual
financial statement relationships (for example, Firm (12) has a high proportion of
cash, marketable securities, and receivables among its assets), and then looks over
the list of companies to identify the one most likely to have that unusual financial
statement relationship. This teaching note employs both approaches.
The high proportions of cash, marketable securities, and receivables for Firm
(12) suggest that it is Fortis, the Dutch insurance and banking company. Insurance
companies receive cash from premiums each year and invest the funds in various
investment vehicles until needed to pay insurance claims. They recognize premium
revenue from the cash received and investment income from investments each year.
They must match against this revenue an appropriate portion of the expected cost
of insurance claims from policies in force during the year. Fortis includes this
amount on the line labeled Operating Expenses in Exhibit 1.17. Operating revenues
also include interest revenue on loans made. One might ask: why does Fortis have
such a high proportion of financing in the form of current liabilities? This balance
sheet category includes the estimated cost of claims not yet paid from insurance in
1-13
Chapter 1
force. It also includes deposits by customers in its banks. One might also ask:
What types of quality of earnings issues arise for a company like Fortis? One issue
relates to the measurement of insurance claims expense each period. The ultimate
cost of claims will not be known with certainty until customers make claims and
settlement is made. Prior to that time, Fortis must estimate what that cost will be.
The need to make such estimates creates the opportunity to manage earnings and
lowers the quality of earnings. Another issue relates to estimated uncollectible
loans. Fortis recognizes interest revenue from loans each year and must match
against this revenue the cost of any loans that will not be repaid. The need to make
such estimates also provides management with an opportunity to manage earnings
and therefore lowers the quality of earnings.
There are four firms with research and development (R&D) expenses, Firms (2),
(3), (5), and (9). These are likely to be Nestle, Roche Holding, Sun Microsystems,
and Toyota Motor in some combination.
Roche Holding and Sun Microsystems are more technology-oriented and
therefore likely to have a higher percentage of R&D to sales. This suggests that
they are Firms (2) and (9) in some combination. The inventories of Firm (9) turn
over more slowly at 1.4 times per year (= 27.2/20) than those of Firm (2) at 16.1
times per year (= 45.2/2.8). Firm (9) is also more capital intensive than Firm (2).
This suggests that Firm (2) is Sun Microsystems and Firm (9) is Roche Holdings.
Sun uses only 11.8 cents in fixed assets for each dollar of sales generated. These
ratios are consistent with Sun's strategy of outsourcing most of its manufacturing
operations. The inventory turnover of Roche is consistent with the making of fewer
production runs on each pharmaceutical product to gain production efficiencies.
The manufacture of pharmaceuticals is highly automated, consistent with the slower
fixed asset turnover of Roche. These two firms have the highest profit margins of
the 12 firms studied. Sun is a technology leader in engineering workstations and
servers. Roche sells products protected by patents. These advantages permit the
firms to achieve high profit margins. Roche has a very high proportion of its assets
in cash and marketable securities. It generates interest revenue from these
investments, which it includes in other revenues. It is interesting to observe the
relatively small cost of goods sold to sales percentage for Roche. The manufacturing
cost of pharmaceutical products primarily includes the cost of the chemical raw
materials, which machines combine into various drugs. Pharmaceutical firms must
price their products significantly above manufacturing costs to recoup their
investments in R&D. Note also that Sun has very little long-term debt in its capital
structure. Computer products have short product life cycles. Lenders are reluctant
to lend for a long period because of the concern for technological obsolescence.
Computer companies that outsource their production also have few assets that can
serve as collateral for long-term borrowing.
This leaves Firms (3) and (5) as Nestle and Toyota Motor in some combination.
Firm (5) has a larger amount of receivables relative to sales than Firm (3), consistent
1-14
Chapter 1
with Toyota Motor providing financing for its customers' purchases of automobiles.
Nestle will have receivables from wholesales and distributors of its food products as
well, but not to the extent of the multi-year financing of automobiles. The
inventory turnover of Firm (3) is 4.5 times a year (= 44.5%/9.9%), whereas the
inventory turnover of Firm (5) is 10.6 times a year (= 68%/6.4%). One might at
first expect a food processor to have a much higher inventory turnover than an
automobile manufacturer, suggesting that Firm (3) is Toyota Motor and Firm (5) is
Nestle. Toyota Motor, however, has implemented just-in-time inventory systems,
which speeds its inventory turnover. Nestle tends to manufacture chocolates to
meet seasonal demands, and therefore carries inventory somewhat longer than one
might expect. Firm (3) has a much higher percentage of selling and administrative
expense to sales than Firm (5). Both of these firms advertise their products heavily.
It is difficult to know why one would have a substantially different percentage than
the other. The profit margin of Firm (3) is substantially higher than that of Firm
(5). The auto industry is more competitive than at least the chocolate side of the
food industry. However, other food products encounter extensive competition.
Firm (5) has a high proportion of intercorporate investments. Japanese companies
tend to operate within groups, called kieretsu. The members of the group make
investments in the securities of other firms within the group. This would suggest
that Firm (5) is Toyota Motor. Another characteristic of Japanese companies is
their heavier use of debt in their capital structures. One of the members of these
Japanese corporate groups is typically a bank, which lends to group members as
needed. With this more-or-less assured source of funds, Japanese firms tend to take
on more debt. Although the ratios give somewhat confusing signals, Firm (3) is
Nestle and Firm (5) is Toyota Motor.
Firms (10) and (11) are unique in that they are both very fixed intensive.
Electric utilities and telecommunication firms both utilize fixed assets in the delivery
of their services. Firm (11) is the most fixed-asset intensive of the two firms and
carries a higher proportion of long-term debt. Electric-generating plants are more
fixed asset intensive than the infrastructure needed for distribution of
telecommunication services. This would suggest that Firm (10) is Deutsche
Telekom and Firm (11) is Tokyo Electric Power. The telecommunication industry
is going through deregulation whereas Tokyo Electric Power still has a monopoly
position in Japan. Thus, the selling and administrative expense to operating
revenues percentage for Deutsche Telekom is substantially higher than for Tokyo
Electric Power. The difference in the accounts receivable turnovers is somewhat
surprising, given that both firms bill their customers monthly. One would expect an
accounts receivable turnover of approximately 12 times a year for each firm. The
accounts receivable turnover for Deutsche Telekom is in this ballpark, but not for
Tokyo Electric Power. Japan was in a recession during the period studied and this
factor may account for its slower receivables turnover. Payment policies in Japan
may also be more lenient than in other countries.
1-15
Chapter 1
Firms (6) and (8) represent two of the remaining industries that are also capital
intensive, but not to the extent of Deutsche Telekom and Tokyo Electric Power.
These firms are Accor, a hotel group, and Arbed-Acier, a steel manufacturer. Firms
(6) and (8) require the next highest fixed assets per dollar of sales after Firms (10)
and (11). Thus, Firms (6) and (8) are Accor and Arbed-Acier in some combination.
Firm (8) has virtually no inventories, whereas Firm (6) has substantial inventories.
This suggests that Firm (6) is Arbed-Acier, the steel company, and Firm (8) is
Accor, the hotel group. Accor has grown in recent year by acquiring established
hotel chains. Accor allocates a portion of the purchase price to goodwill in their
acquisitions, which accounts for its higher percentage for Other Assets. Steel
products are commodities, whereas hotels have some brand recognition appeal.
These factors may explain the higher profit margin for Firm (8) than for Firm (6).
Firm (7) has an unusually high proportion of its assets in receivables and in
current liabilities. Although this pattern would be typical for a commercial bank, we
identified Firm (12) earlier as the financial institution. The pattern is also typical
for an advertising agency, which creates and sells advertising copy for clients (for
which it has a receivable) and purchasing time and space from various media to
display it (for which it has a current liability). Additional evidence that Firm (7) is
Interpublic Group is the high percentage for Other Assets, representing goodwill
from acquisitions. Firm (7) also has a relatively high profit margin percentage,
reflective of its ability to differentiate its creative services.
Firm (1) is distinguished by its high cost of goods sold to sales and small profit
margin percentages. This pattern suggests commodity products with low value
added. Of the remaining firms, this characterizes a grocery business. Firm (1) is
Carrefour. Its combination of a rapid receivables turnover of 11.8 times per year
(=100/8.5) and rapid inventory turnover of 8.9 times per year (=87.8/9.9) are also
consistent with a grocery business. Current liabilities comprise more than half of its
financing. Current assets make up a similarly high proportion of its current assets.
The remaining firm is Firm (4), which is Marks & Spencer, the department store
chain. Firm (4) has substantial receivables, consistent with having a credit card.
1.14 Value Chain Analysis and Financial Statement Relationships. Four Firms
(1), (2), (3), and (5) incur research and development (R&D) expenditures and three
do not. Wyeth, Amgen, Mylan, and Johnson & Johnson engage in research to
develop new products. Thus, they represent these four numbered firms in some
combination. One would expect that the firms enjoying patent protection (Wyeth
and Amgen) would have the highest profit margins (that is, net income divided by
sales). This would suggest that Firms (1) and (2) are Wyeth and Amgen in some
order and that Firms (3) and (5) are Mylan and Johnson & Johnson in some order.
The perplexing aspect of this logic, however, is the common-size income statement
percentages for Firm (1). Its cost of goods sold percentage is the highest of the four
1-16
Chapter 1
companies and its R&D percentage is the lowest, which are inconsistent with this
being either Wyeth OR Amgen. Products with patent protection should have the
lowest cost of goods sold percentages (resulting from high markups on cost to arrive
at selling prices). Thus, following another line of logic, the need to continually
discover new drugs should lead Wyeth and Amgen to have the highest R&D
percentages, which would be either Firm (2) or Firm (3) as discussed below.
With this being the case, the other two firms—Firm (1) and Firm (5) are Mylan
and Johnson & Johnson in some combination. The brand recognition of Johnson &
Johnson’s products should give it a high profit margin and competition among
generic firms, which compete on the basis of low prices, should give Mylan a lower
profit margin. This reasoning would suggest that Johnson & Johnson is Firm (1)
and Mylan is Firm (5). The contradictory aspect of this conclusion is the low
selling and administrative expenses for Firm (1) versus Firm (5). Mylan will not
need to advertise its products, although it will use a sales force. Johnson &
Johnson, on the other hand, advertises extensively. Thus, Firm (1) is Mylan and
Firm (5) is Johnson & Johnson. The high profit margin of Mylan results from
offering generic drugs for ethical drugs that have recently come off patent and more
aggressive management of drug cost by health care plans (that is, requiring
pharmacists to substitute generic drugs for ethical drugs whenever possible). Note
that Mylan has a high proportion of cash, relatively small current liabilities, and
minimal long-term debt. With the major ethical drug firms now competing
aggressively in the generic market, one might expect the profit margin of Mylan to
decrease in the future.
This leaves Firms (2) and (3) as Wyeth and Amgen in some order. The
biotechnology industry is significantly less mature than the ethical drug industry.
Few biotechnology drugs have received FDA approval and research to develop new
drugs is intensive. Given the few biotechnology drugs available on the markets,
Amgen’s profit margin should be higher and its R&D expense percentage should
also be higher than those of Wyeth. Thus, Firm (2) is Amgen and Firm (3) is
Wyeth. Amgen has a higher proportion of cash on the balance sheet than Wyeth,
reflecting its growth phase and the need to fund R&D. Wyeth’s higher selling and
administrative expense percentage results from it need to maintain a sales force. The
biotechnology products of Amgen are fewer in number and are essentially pulled
through the distribution process by customer demand at this point. Thus, it has
less need for a sales force.
We are now left with Quintiles, Cardinal Health, and Walgreen and Firms (4),
(6), and (7). Quintiles will have no inventories, whereas both Cardinal Health
(wholesaler) and Walgreen (retailer) will have inventories. Thus, Firm (4) is
Quintiles. This firm will need property, plant, and equipment to conduct the
testing of new drugs. Of the remaining two firms, Cardinal Health and Walgreen,
Walgreen will likely have a higher proportion of its assets in property, plant and
equipment for retail space. Cardinal Health needs only warehousing facilities for its
1-17
Chapter 1
drug wholesaling activities. Thus, Firm (6) is Walgreen and Firm (7) is Cardinal
Health. Advertising expenditures by Walgreen drive up its selling and
administrative expense percentage relative to that of Cardinal Health. Walgreen sells
for cash or third party credit cards and will therefore have less receivables than
Cardinal Health, which sells to businesses on credit.
It is interesting to note that the highest profit margins in the pharmaceutical
industry occur with the upstream activities (discovery of new drugs) instead of the
downstream activities (wholesaling and retailing). It is also interesting to note that
the profit margin of Quintiles lies between the high profit margins of the creators of
new drugs and the low profit margins of those firms involved in distribution.
Quintiles must possess some technical expertise in order to offer drug-testing
services, thus providing the rationale for a higher profit margin than those achieved
by the wholesalers and retailers. The higher profit margin for Walgreen over
Cardinal Health is probably attributable to brand name recognition and the large
number of retail stores nationwide. The wholesaling function of Cardinal is low
value added. The pharmaceutical benefit management services are somewhat
differentiable but quickly copied by competitors.
It is also interesting to note the extent that these firms use long-term debt
financing. The firms involved in upstream activities must invest in research and
manufacturing facilities, which can serve as collateral for borrowing. These firms,
however, have high profit margins (which should enhance cash flow from
operations) and high product risks (introduction of superior products by
competitors, legal liability exposure). Thus, these firms tend not to add financial
risk to their already high asset-side risk. However, note that all the firms operating
in the various sectors of the pharmaceutical industry generally carry relatively low
amounts of debt.
1.15 Recasting the Financial Statements of a U.K. Company into U.S. Formats,
Terminology, and Accounting Principles. The recast consolidated balance sheet
is presented below. The instructor may wish to ask if there are any unusual
relationships between the structure of the assets and the structure of the financing
of WPP Group. One unusual feature is the excess of current liabilities over current
assets. WPP Group serves as an intermediary between its clients desiring media
time or space and the providers of that space. Accounts receivable includes the
amounts receivable from clients and accounts payable includes amounts payable to
media providers. The excess liability suggests a degree of short-term credit risk for
WPP Group. A second issue is the amount of long-term debt. WPP Group has few
tangible assets to serve as collateral for this borrowing. Most of its long-term assets
are in the form of goodwill. This debt, coupled with the excess of current liabilities
over current assets, suggest considerable financial risk. However, profitability did
1-18
Chapter 1
improve between Year 10 and Year 11. In addition, the WPP Group is one of the
most established advertising groups in the world.
The recast consolidated income statement follows the balance sheet. An
interesting issue to discuss is the classification of operating expenses. Common
practice in the U.K. classifies expenses by their nature. The largest expense for a
marketing services firm like WPP Group is compensation. The firm includes this
expense in operating expenses rather than cost of goods sold. For WPP Group, the
amount for cost of goods sold is only the cost of materials used in preparing
advertising copy for clients. Students will likely use a variety of single-step and
multiple-step income statement formats.
The recast consolidated statement of cash flows follows the income statement.
The statement of cash flows in the U.K. uses five types of activities instead of the
usual three categories in the U.S. Cash inflows from investments and cash outflows
for interest and dividends appear as a separate category, as does cash outflows for
income taxes. The cash inflows from investments and the cash outflows for income
taxes are part of cash flow from operations in the U.S. The cash outflow for
dividends is a financing activity in the U.S. The calculation of cash flow from
operations appears at the bottom of the consolidated statement of cash flows
reported here.
Note that the WPP Group made significant acquisitions in both Year 11 and
Year 10. It appears that the acquisitions in Year 11 were financed by mainly bank
loans and to a lesser extent issuance of stock. The large swings in accounts
receivable and accounts payable during this two-year period is probably related to
these acquisitions made by WPP Group. The firm also increased its investment in
property, plant and equipment during the year.
Students will often ask why the changes in various accounts on the balance sheet
(for example accounts receivable, inventories) do not precisely equal the changes on
the statement of cash flows. The usual reason for this difference is that a firm has
acquired or sold another firm during the year. The purchase or sale causes individual
accounts to change (for example, accounts receivable, inventories). Such changes,
however, appear as an investing activity on the statement of cash flows. Thus, part
of the change in accounts receivable is an operating activity and part is an investing
activity.
1-19
Chapter 1
WPP Group
Consolidated Balance Sheet
(amounts in millions of pounds)
(Problem 1.15)
December 31
Assets Year 10 Year 11
Cash..................................................................................... £ 1,086 £ 586
Marketable Securities.......................................................... -- 77
Accounts Receivable ........................................................... 2,181 2,392
Other Receivables................................................................ 233 248
Inventories........................................................................... 223 237
Total Current Assets.................................................. £ 3,723 £ 3,540
Investments in Securities..................................................... 552 553
Property, Plant and Equipment (net).................................. 390 432
Corporate Brands (a)........................................................... 950 950
Goodwill (a) ........................................................................ 3,497 4,439
Total Assets............................................................... £ 9,112 £ 9,914
Liabilities and Shareholders' Equity

Accounts Payable................................................................ £ 2,575 £ 2,506
Bank Loans.......................................................................... 298 319
Taxes Payable...................................................................... 164 166
Other Current Liabilities ..................................................... 1,215 1,331
Total Current Liabilities............................................. £ 4,252 £ 4,322
Long-term Debt................................................................... 1,280 1,712
Deferred Taxes .................................................................... 30 41
Pension Liability (b)............................................................ 99 153
Other Noncurrent Liabilities ............................................... 57 46
Total Liabilities .......................................................... £ 5,718 £ 6,274
Shareholders' Equity
Minority Interest ................................................................ £ 24 £ 41
Common Stock.................................................................... 111 115
Additional Paid-in Capital (c) ............................................. 3,310 3,407
Retained Earnings................................................................ (211) (48)
Accumulated Other Comprehensive Income....................... 160 125
Total Shareholders' Equity......................................... £ 3,394 £ 3,640
Total Liabilities and Shareholders' Equity.................. £ 9,112 £ 9,914
(a) See Note 1 to the WPP Group financial statements.

(b) Year 11 = £ 18 + 135; Year 10 = £ 11 + 88.
(c) Year 11 = £ 1,044 + 2,363; Year 10 = £ 1,096 + 2,214.
1-20
Chapter 1
WPP Group
Consolidated Income Statement
(Problem 1.15)
Year 10 Year 11
Sales..................................................................................... £ 13,949 £ 20,887
Cost of Goods Sold............................................................. (245) (232)
Gross Profit......................................................................... £ 13,704 £ 20,655
Selling, General, and Administrative Expenses ................... (13,325) (20,149)
Operating Income................................................................ £ 379 £ 506
Other Income (Expense)...................................................... 38 (24)
Interest Expense.................................................................. (52) (71)
Income before Income Taxes and Minority Interest........... £ 365 £ 411
Income Taxes....................................................................... (110) (126)
Income before Minority Interest......................................... £ 255 £ 285
Minority Interest in Earnings.............................................. (11) (14)
Net Income (Loss)............................................................... £ 244 £ 271
WPP Group
Consolidated Statement of Cash Flows
(Problem 1.15)
Operations Year 10 Year 11

Net Income (Loss)............................................................... £ 244 £ 271
Depreciation........................................................................ 79 125
Increase in Provisions.......................................................... 74 27
Other Adjustmentsa ............................................................ 3 138
(Increase) Decrease in Receivables and Prepayments......... (434) (5)
(Increase) Decrease in Inventories....................................... (15) (18)
Increase (Decrease) in Trade Creditors ............................... 539 (473)
Cash Flow from Operationsb ..................................... £ 490 £ 65
Investing
Acquisition of Fixed Assets................................................ £ (112) £ (218)
Acquisitions ........................................................................ (230) (696)
Other Investing Activities................................................... (51) (125)
Cash Flow from Investing.......................................... £ (393) £ (1,039)
1-21
Chapter 1
Financing
Increase (Decrease) in Bank Loans...................................... £ 128 £ 439
Issue of Capital Stock ......................................................... 78 69
Dividends ............................................................................ (26) (44)
Cash Flow from Financing ......................................... £ 180 £ 464
Effect of Exchange Rate Changes on Cash and Cash
Equivalents........................................................................ £ 35 £ 10
Net Change in Cash and Cash Equivalents.......................... 312 (500)
Cash and Cash Equivalents—Beginning of Year................. 774 1,086
Cash and Cash Equivalents—End of Year .......................... £ 1,086 £ 586
aThe amount for "Other Adjustments" is a plug amount.

bCash flow from operations includes the following from WPP Group's cash flow
statement:
Year 10 Year 11
Net Cash Flow from Operating Activities.......................... £ 624 £ 174
Net Cash Flow from Investments and Servicing
of Finance (excluding dividends paid) ............................... (53) (31)
Taxation............................................................................... (81) (78)
Cash Flow from Operations....................................... £ 490 £ 65
1-22
Chapter 1
1.16 Comprehensive Income.

a. Changes in the recognition and valuation of assets and liabilities that do not
immediately affect net income and retained earnings—but will at some point in
the future—are reported as part of comprehensive income. Stated differently,
comprehensive income equals net income for a period plus or minus the change
in shareholders’ equity accounts other than changes from net income and
transactions with owners. For WPP Group, comprehensive income for Year 11
is £236 as reported in the statement below.
WPP Group
Consolidated Statement of Comprehensive Income
(Problem 1.16)
Year 11
Net income .................................................................................................. £ 271
Foreign currency translation adjustment (a)................................................ (53)
Pension benefit reserve (b).......................................................................... 18
Comprehensive income ............................................................................... £ 236
(a) £133 – £80 as reported in Note 5 of WPP Group’s financial statements.

(b) £27 – £45 as reported in Note 5 of WPP Group’s financial statements.
b Net income as a percent of turnover, or revenues, for Year 11 is 1.3 percent (=

£271/£20,887). Comprehensive income as a percent of turnover for Year 11 is
1.1 percent (= £236/£20,887). Although the ratio is lower using comprehensive
income, the difference between the two is not significant. Furthermore, as you
will learn in subsequent chapters, analyzing the appropriate level for the ratio
involves assessing the trend of the ratio over time, as well as comparing it to
ratios of other firms operating in similar industries. The difference between net
income and comprehensive income varies across firms, but regardless, to date it
appears that analysts have not embraced the concept of comprehensive income.
In addition, very few databases report comprehensive income and none of the
credit rating agencies (S&P, for example) emphasize comprehensive income in
their assessment of a firm’s profitability and risk.
1-23
Chapter 1
1.17 Recasting the Financial Statements of a German Company into U.S.

Reporting Formats and Terminology.
a. The recast balance sheet appears below. Several items on the balance sheet
require elaboration.
Leased Vehicles Note 2 indicates that this account captures the vehicles
leased to customers by Volkswagen. The leases are for a short duration and thus,
the vehicle remains on the balance sheet of the company. An alternative
disclosure could be to include the leased vehicles in a separate category under
property, plant and equipment.
Provisions Note 6 indicates that this account includes pension, warranties,
restructuring, taxes and other provisions. With the exception of taxes payable, it
is unclear whether these provisions should appear as current or as noncurrent
liabilities. Pensions clearly are noncurrent. Warranties and restructuring
provisions likely have at least some current portion. Given the limited disclosures
made by Volkswagen, we cannot delve any more deeply into this question. We
classified all the provisions as noncurrent liabilities except for the taxes payable
which we classify as current.
Deferred Income Volkswagen likewise does not disclose the term over which
it will recognize deferred income. Some of the amounts will almost certainly be
current. We classify the entire amount as current.
Retained Earnings U.S. firms do not separate earnings available versus
unavailable for dividends. Thus, retained earnings at the end of each year is a
combination of Accumulated Profits and Revenue Reserves.
The instructor may wish to point out certain aspects of the assets and
financing of Volkswagen. Accounts receivable and property, plant and equipment
dominate the asset side of the balance sheet. The accounts receivable relate to
amounts due from both dealers and customers for assets leased. Note also the
heavy proportion of debt in the capital structure. A large portion of current
liabilities represents bank borrowing. Industrial companies in Germany work
closely with their banks and tend to have higher proportions of their financing
come from this source. Other noncurrent liabilities also comprise a major portion
of total financing. Included here are obligations to employees for pensions,
warranty estimates, and other provisions unspecified by Volkswagen (see Note
6).
1-24
Chapter 1
Balance Sheet for Volkswagen Group AG

(in millions of €)
(Problem 1.17)
December 31
Year 9 Year 10
Assets
Cash............................................................................... € 2,156 € 4,285
Marketable Securities.................................................... 3,886 3,610
Accounts Receivable ..................................................... 41,432 45,166
Inventories..................................................................... 9,335 9,945
Prepayments ................................................................. 299 378
Total Current Assets............................................... € 57,108 € 63,384
Investments in Securities............................................... 4,216 3,999
Leased Vehicles ............................................................. 4,783 7,284
Property, Plant, and Equipment (net)........................... 19,726 21,735
Deferred Tax Assets...................................................... 1,377 1,426
Goodwill and Other Intangibles .................................... 5,355 6,596
Total Assets............................................................ € 92,565 € 104,424
Liabilities and Shareholders’ Equity
Accounts Payable.......................................................... € 7,435 € 7,055
Bank Loans Payable...................................................... 26,201 30,044
Advances from Customers............................................ 204 285
Other Current Liabilities ............................................... 5,699 6,161
Taxes Payable................................................................ 1,424 1,418
Total Current Liabilities.......................................... € 40,963 € 44,963
Long-term Debt............................................................. 8,383 12,750
Deferred Tax Liabilities................................................. 2,095 2,299
Other Noncurrent Liabilities ......................................... 19,704 20,364
Total Liabilities ....................................................... € 71,145 € 80,376
Shareholders’ Equity
Minority Interest .......................................................... € 49 € 53
Preferred Stock.............................................................. 268 272
Common Stock.............................................................. 803 815
Additional Paid-in Capital............................................. 4,296 4,415
Retained Earnings.......................................................... 16,004 18,493
Total Shareholders’ Equity ..................................... € 21,420 € 24,048
Total Liabilities and Shareholders’ Equity.............. € 92,565 € 104,424
1-25
Chapter 1
b. The recast income statement appears below. Different income statement

formats are followed by U.S. companies that engage in both the manufacturing
and sales financing of passenger and commercial vehicles. The format presented
below is similar to that followed by Ford Motor Company. However, Ford
breaks out selling and administrative expenses separately for its automotive and
financial services division, whereas Volkswagen Group AG does not provide
this breakdown.
Income Statement for Volkswagen Group AG

(in millions of €)
(Problem 1.17)
December 31
Year 9 Year 10
Automotive
Revenues ....................................................................... € 83,127 € 88,540
Cost of Goods Sold....................................................... (71,130) (75,586)
Gross profit—automotive....................................... € 11,997 € 12,954
Financial Services
Revenues ....................................................................... € 3,025 € 3,208
Interest Expense............................................................ (1,812) (1,880)
Gross profit—financial services.............................. € 1,213 € 1,328
Selling and Administrative Expense (a)......................... € (9,820) € (10,593)
Other Operating Items (net) (b).................................... (105) 850
Operating Income.......................................................... € 3,285 € 4,539
Equity in Earnings of Affiliates..................................... 335 289
Other Income (expense) ................................................ 99 (419)
Income before Taxes and Minority Interest.................. € 3,719 € 4,409
Income Tax Expense...................................................... (1,105) (1,483)
Income before Minority Interest................................... € 2,614 € 2,926
Minority Interest in Earnings........................................ (7) (11)
Net Income.................................................................... € 2,607 € 2,915
(a) Consists of €7,554 + €2,154 + €885 for Year 10, and €7,080 + €2,001 + €739 for
Year 9.
(b) Consists of €4,118 – €3,268 for Year 10, and €3,656 – €3,761 for Year 9.
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Integrative Case 1.1: Starbucks
I. Objectives
A. Identify the economics characteristics of the specialty coffee retail industry

and Starbucks’ strategy for competing in this industry as background for the
integrative case on Starbucks used throughout the book.
B. Review the purpose, format, terminology and accounting principles

underlying the balance sheet, income statement, and statement of cash flows.
C. Introduce common-size and percentage-change income statements and

balance sheets and the insights such statements provide.
II. Teaching Strategy—We have taught this case with two approaches. If an
opportunity exists to assign students to prepare this case prior to the first class,
we give students the solutions to the questions involving the balance sheet, income
statement, statement of cash flows, and relations between financial statements. We
ask them to review these parts on their own and then prepare solutions to the
questions under the sections labeled industry and strategy analysis and interpreting
financial statement relationships. We devote the first class period to discussing
these two sections of the case. If students do not have access to the case prior to
the first class session, we devote approximately three hours of class to discuss the
entire case. Alternatively, the instructor can choose to emphasize particular
questions based on the amount of time available and refer students to the solution
for the remaining parts.
Industry and Strategy Analysis

a. Porter’s five forces applied to the specialty coffee retail industry:
1. Buyer Power: Buyer power for specialty coffees is less than for commodity
coffees because consumers view specialty coffees as higher quality and more
unique. These characteristics of specialty coffees increase consumers’
willingness to pay more for such coffees and make them less price sensitive.
Combining the specialty coffee with a unique setting (the “Starbucks
experience”) in which consumers purchase and enjoy the coffee decreases still
further consumers’ price sensitivity. Thus, buyer power appears to be
relatively low.
2. Supplier Power: Suppliers of the high-quality coffee beans used in specialty

coffees have a degree of power over their customers because of their customers’
needs for such coffee beans. Commodity coffee beans are not an attractive
alternative for such customers. Starbucks indicates that it sources its coffee
beans from suppliers around the world. It is not clear though whether this
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worldwide sourcing means that there are many suppliers of similar specialty
coffee beans, which would give firms like Starbucks an ability to switch
suppliers to gain an advantage, or because there are few suppliers of a variety
of specialty coffee beans, which give these suppliers more pricing power. The
fact that Starbucks negotiates annually with its suppliers at a fixed price
suggests that both the availability of the specialty coffee beans and the
volatility of their prices puts the firm at risk. Thus, supplier power is
moderate.
3. Rivalry Among Existing Firms: There are few direct competitors in the
specialty coffee retail industry. However, firms such as Panera Bread
Company, Krispy Kreme, and others combine specialty coffees with other
offerings (sandwiches, donuts) and therefore compete with Starbucks. The
issue for Starbucks is whether the “Starbucks experience” sufficiently
differentiates the firm from competitors whose specialty coffees might be of
equal quality. Rivalry among firms appears to be moderate.
4. Threat of New Entrants: Brand name and the number and location of retail
stores appear to be the main barriers to entry. Starbucks certainly has the
advantage of an established brand name. It has also saturated the United States
with retail stores and is growing its business in other countries. The threat of
new entrants offering a similar retail concept as Starbucks appears low.
However, other established retail food chains have the ability to add specialty
coffees. Whether they could add the equivalent of the Starbucks experience”
remains an open question. Thus, the threat of new entrants appears to be low
to moderate.
5. Threat of Substitutes: There are numerous beverage substitutes to specialty

coffee, which would tend to make the threat of substitutes high. However,
there are fewer substitutes for the “Starbucks experience”, which lower the
threat of substitutes. Thus, the threat of substitutes appears to be low to
moderate.
b. Starbucks combines the sale of specialty coffees and other high-quality beverages
with a unique setting in which to enjoy the beverages. This combination has
allowed the firm to differentiate itself from direct competitors. Its market
saturation in the United States has permitted the firm to establish a brand name,
which it is now exporting to other countries. Its use of licensing arrangements has
fostered the rapid growth. Starbucks is now leveraging its brand name by selling
coffee beans and ground coffees through grocery stores, warehouse clubs, and food
distributors. It is also leveraging its brand name by forming partnerships with
other established, brand name firms to sell various high-quality beverages.
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Starbucks appears to be aggressively pursuing multiple avenues to maintain its

growth, discourage new entrants, and leverage its brand name.
Balance Sheet
c. Cash includes cash on hand and in checking accounts. Cash equivalents include
amounts that a firm can easily convert into cash. Cash equivalents usually have a
maturity date of less than three months at the time of purchase, so that changes in
interest rates have an insignificant affect on their market value. Cash equivalents
might include investments in United States Treasury bills, commercial paper, and
money market funds.
d. Securities that are marketable and that a firm intends to sell within one year of the
balance sheet date appear in Marketable Securities. Securities for which there is
not a ready market in which to sell them and securities that a firm expects to hold
for more than one year appear in the noncurrent asset, Investment in Securities.
e. The allowance of uncollectible accounts account arises because Starbucks

recognizes revenue earlier than the time when it collects cash. Because Starbucks is
not likely to collect 100 percent of the amount reported as revenue, it must
recognize an expense for estimated uncollectible accounts and reduce gross
accounts receivable to the amount it expects to collect in cash. Starbucks increases
the balance in the allowance account for estimated uncollectible accounts arising
from revenue each year. It reduces the balance in the allowance account for actual
customers’ accounts deemed uncollectible. Starbucks reports the balance in the
allowance account as a subtraction from gross accounts receivable on the balance
sheet.
f. The Accumulated Deprecation accounts reports the cumulative depreciation

recognized since the firm acquired depreciable assets that appear on the balance
sheet. Depreciation Expense reports only the amount of depreciation recognized
for a particular accounting period.
g. Deferred tax assets arise when a temporary difference between net income and
taxable income provides a future tax benefit to the firm. This occurs either (1)
when a firm recognizes revenue earlier of tax reporting than for financial reporting
(subsequent recognition of the revenue for financial reporting will not give rise to a
tax payment), or (2) when a firm recognizes expenses earlier for financial reporting
than for tax reporting (subsequent recognition of the expense for tax reporting will
reduce income tax payments). Deferred tax liabilities arise when a temporary
difference will require a firm to make a tax payment in the future. This occurs
either (1) when a firm recognizes revenue earlier for financial reporting than for tax
reporting (subsequent recognition of the revenue for tax reporting will require the
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Chapter 1
firm to pay taxes), or (2) when a firm recognizes an expense earlier for tax reporting
than for financial reporting (subsequent recognition of the expense for financial
reporting does not give rise to a tax deduction, thereby increasing taxable income
and taxes payable). Note that the classification of deferred taxes on the balance
sheet for a particular revenue or expense depends on (1) whether temporary
differences give rise to a deferred tax asset or a deferred tax liability, and (2) the
timing of the likely reversal of the temporary difference (less than one year or
longer than one year).
h. Generally accepted accounting principles (GAAP) require firms to report

marketable securities and investments in securities at market value at the end of
each accounting period. GAAP also requires firms in some circumstances to
translate the assets and liabilities of their foreign subsidiaries and branches into
U.S. dollars using the current exchange rate. Changes in the valuations of assets
and liabilities from these accounting principles give rise to unrealized gains and
losses that firms will not realize until they convert the assets into cash or settle
their liabilities with cash. The ultimate realized gain or loss depends on the market
prices of securities and the exchange rate at the time of sale or settlement. GAAP
does not permit firms to include the unrealized gains or losses in net income, but
instead must include them in accumulated other comprehensive income. At the
time of sale or settlement, the amount of the gain or losses becomes established and
realized. At that time, the firm includes the realized gain or loss in net income.
Income Statement
i. Revenues from company-owned stores represent the revenues from sale of
specialty coffees and other products in the retail stores that they own and manage.
Revenues from licensing represent various fees Starbucks receives from retail stores
that it does not own or manage. Starbucks likely receives a fee based on revenues
of these stores. It also likely receives fees for paper products sold to the licensees
and for various services provided. Revenues from foodservice represent amounts
received from the sale of products to grocery stores, warehouse clubs, and food
service distributors. Note the Starbucks’ income from its partnerships ventures
with PepsiCo and Dreyer’s Grand Ice Cream, Inc.
j. Cost of sales likely includes the cost of the raw materials, such as coffee beans,
teas, milk, and similar items, that make up its products. Occupancy costs includes
rent, property taxes, insurance, utilities and maintenance costs of its company-
owned stores. Store operating expenses include compensation of its employees
working in the company-owned stores, as well as advertising and other marketing
expenses.
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k. As indicated in the answer to Part i. above, the Income of Equity Investees

represents Starbucks’ share of the earnings of partnerships with PepsiCo and
Dreyer’s Grand Ice Cream, Inc. Note that this amount is a revenue to Starbucks,
but its represents Starbucks’ share of the bottom line of the income statements of
the partnerships, not the top line (that is, the partnerships’ revenue). Starbucks
reports its investments in these partnerships under Investments in Securities in the
noncurrent assets section of the balance sheet.
Statement of Cash Flows

l. Firms use the accrual basis of accounting in measuring net income. Firms usually
recognize revenue at the time of sale of goods and services, not necessarily when
they receive cash from customers. Firms attempt to match expenses with
associated revenues, regardless of when they expend cash. The accrual basis gives
a better indication of a firm’s operating performance than the cash basis because of
the matching of inputs and outputs. The statement of cash flows reports the
amount of cash received from customers net of amounts paid to suppliers of goods
and services.
m. Depreciation and amortization reduces net income but does not require a cash
expenditure in the year of their recognition (the cash effect occurred in the year a
firm acquired the depreciable or amortizable asset; the firm classified the cash
outflow as an investing activity in the statement of cash flows at that time). The
addition adds back to net income the amount subtracted in calculating earnings for
the year, in effect zeroing out its effect on cash flow from operations.
n. Net income on the first line of the statement of cash flows includes revenues
recognized each year. Starbucks does not necessarily collect cash each year in an
amount exactly equal to revenues. The subtraction for the increase in accounts
receivable means that Starbucks received less cash than it recognized as revenue.
o. Net income on the first line of the statement of cash flows includes a subtraction
for the cost of sales during each year. Starbucks likely purchases a different
amount of inventory than it uses or sells. An increase in inventories means that
Starbucks purchased more than it used or sold. Thus, the cash outflow for
purchases potentially exceeds cost of sales and requires a subtraction from net
income for the additional cash required. Whether additional cash was in fact
required in any year depends on the change in accounts payable, discussed next.
p. Accounts payable reflects amounts owed to suppliers for inventory items

purchased. Purchases of inventory items increase this liability and cash payments
reduce it. The adjustment for inventory in Part o. above converts cost of sales to
purchases. The adjustment for accounts payable converts purchases to cash
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payments to suppliers. An increase in accounts payable means that Starbucks

purchased more than its cash expenditure for purchases. Thus, the adjustments for
the change in inventories and the change in accounts payable convert cost of sales
included in net income to cash payments to suppliers of inventory items.
q. The Financial Accounting Standards Board requires firms to report most changes in
marketable securities as an investing activity, not an operating activity. The
rationale is that firms derive operating cash flows by selling goods or services to
customers, not from selling marketable securities.
r. The Financial Accounting Standards Board requires firms to report changes in

short-term borrowing as a financing activity, not an operating activity. The
rationale is that firms derive operating cash flows by selling goods or services to
customers, not by borrowing cash.
Relations Between Financial Statements

s. Retained Earnings, September 30, Year 3............................................ $ 1,058.3
Net Income for Fiscal Year 4............................................................... 390.6
Retained Earnings, September 30, Year 4............................................ $ 1,448.9
The fact that net income fully explains the change in retained earnings means that
Starbucks did not declare a dividend. The absence of a dividend in the financing
section of the statement of cash flows tends to confirm this conclusion.
t. Property, Plant and Equipment, September 30, Year 3 ...................... $ 2,516.3

Plus Acquisition of Property, Plant and Equipment during Year 4
(See Statement of Cash Flows) .................................................... 412.5
Less Acquisition Cost of Property, Plant and Equipment Sold or
Retired during Year 4 (Plug)......................................................... (51.1)
Property, Plant and Equipment, September 30, Year 4 ...................... $ 2,877.7
We cannot determine the amount of accumulated depreciation on the property,

plant and equipment sold because Starbucks does not report depreciation
separately from amortization.
Interpreting Financial Statement Relations

u. The difficulty with interpreting common-size percentages is that the amounts for a
particular account are not independent of the amounts for all other accounts. Note
in Exhibit 1.27 that property, plant and equipment, net increased 11.2 percent
between fiscal Year 2 and fiscal Year 3 and 7.2 percent between fiscal Year 3 and
fiscal Year 4. Other assets, particularly cash and cash equivalents, investments in
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Chapter 1
securities, and other noncurrent assets increased at a faster rate, thereby causing the
common-size percentages for property, plant and equipment, net to decline.
v. The increased percentage for liabilities between fiscal Year 2 and fiscal Year 3
results from an increase in the amount of other noncurrent liabilities and the
increase between fiscal Year 3 and fiscal Year 4 results from an increase in other
current liabilities. Although the amount of total shareholders’ equity increased
between these years, the amount of total liabilities increased even more.
w. Starbucks issued and repurchased common stock in each year. The net change in
common stock and additional paid-in capital was a 7.3 percent increase between
fiscal Year 2 and fiscal Year 3 and a decline between fiscal Year 3 and fiscal Year 4.
Retained earnings increased each year by the amount of net income, since Starbucks
did not pay a dividend. The rapid growth in net income led to a significant increase
in the amount and thereby the common-size percentage for retained earnings.
x. The proportion of revenue from company-operated stores and foodservice declined

while the proportion from licensing increased, although the dollar amounts of
revenue from these three sources all increased. Starbucks has licensed more new
stores than it has opened new company-operated stores in recent years in an effort
to expand quickly, leading to an increase in the common-size percentage of
revenues for licensing.
y. The main contributing factors for the increase in the net income to revenues
percentage are the decline in the percentages for depreciation and amortization
expense and general and administrative expense. The costs for these items tend to
be more fixed than for other operating expenses. As Starbucks has grown its
revenues, it has spread these relatively fixed costs over a larger revenue base,
resulting in declining expense percentage for these two expense items. The expense
percentages for cost of sales including occupancy costs increased, suggesting that
Starbucks has not passed along increases in the cost of raw materials or occupancy
to its customers in the company-operated stores.
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Chapter 1
Case 1.2: Nike: Somewhere Between a Swoosh and a Slam Dunk
I. Objectives
A. Review the purpose, format, terminology and accounting principles
underlying the balance sheet, income statement, and statement of cash flows.
B. Introduce common-size and percentage-change income statements and

balance sheets and the insights such statements provide.
II. Teaching Strategy—We have taught this case with two approaches. If an
opportunity exists to distribute the case prior to the first class session, we give
students the solution to the questions involving the income statement, balance
sheet, statement of cash flows, and relations between financial statement items.
We ask them to review these parts on their own and then prepare the questions
under the section labeled interpreting financial statement relationships. We devote
the first class session to discussing this last section of the case. If we cannot
distribute the case ahead of time, we devote approximately three hours of class to
discussing the case. Alternatively, the instructor can choose to emphasize certain
questions based on the amount of time available and refer students to the solution
for the remaining parts.
Income Statement
a. Nike apparently recognizes revenues from the sale of products at the time of sale.
It recognizes revenue from license fees as earned, which is probably at the time of
delivery of products to licensees. The criteria for revenue recognition are (1)
substantial performance of services to be provided, and (2) receipt of cash or a
receivable whose cash-equivalent value a firm can measure with reasonable
accuracy. The sale of products to retailers constitutes substantial performance
unless Nike is required to take back unsold items. There is no indication that
returns are substantial, and furthermore, Nike recognizes a reduction for return
sales at the time of sales. The “futures” ordering program likely matches products
to specific customer needs. Nike carries substantial accounts receivable from its
customers. The allowance for uncollectible accounts had a balance equal to 4.3
percent of gross accounts receivable [$95/($2,120 + $95)] at the end of Year 4 and
3.8 percent [$82/($2,084 + $82)] at the end of Year 3. Thus, Nike’s revenue
recognition appears appropriate.
b. The Notes indicate that Nike uses FIFO for domestic and international inventories.
Firms are free to select their inventory cost-flow assumption from the set deemed
acceptable by standard-setting bodies. These bodies do not provide a set of criteria
that firms must apply to determine which inventory cost-flow assumption is
“appropriate”. The Financial Accounting Standards Board permits firms in the
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United States to use FIFO, LIFO, weighted average, and several other methods.
Nike probably uses FIFO because the physical flow of its inventory is FIFO.
Also, Nike saves record keeping costs by using FIFO for both reporting to foreign
governments and reporting to its shareholders in the U.S.
c. Nike does not conduct any of its own manufacturing. Thus, depreciation expense
relates to buildings and equipment used in selling and administrative activities.
Nike’s income statement classifies expenses by their function instead of by their
nature. Thus, Nike includes depreciation expense in selling and administrative
expenses.
d. The Notes indicate that income tax expense of $504 includes $495 payable
currently and a decrease in deferred tax assets or an increase in deferred tax
liabilities of $9. Firms recognize deferred taxes for temporary differences between
taxable income and income for financial reporting. The taxable income of Nike for
Year 4 is less than its income before taxes for financial reporting. This probably
occurred because Nike recognized revenues for financial reporting in Year 4 that it
will recognize in later years for tax reporting and because it recognized expenses
during Year 4 for tax reporting that it will not recognize for financial reporting until
later years. The basis for measuring the amount of income tax expense is the
amount of revenues and expenses recognized during the year for financial reporting.
The basis for measuring income tax payable is the amount of revenues and expenses
recognized during the year for tax reporting. Because these amounts are usually
different, firms are required to recognize deferred tax assets and deferred tax
liabilities on their balance sheets. Governmental laws dictate the manner of
measuring taxable income. As long as firms apply these laws correctly in
measuring their taxable income each year and pay the required taxes, they have no
additional obligation to governmental entities at this time. The presence of a
deferred tax asset or a deferred tax liability on the balance sheet is not an indication
that governmental bodies have permitted firms to delay paying taxes. Rather, it
indicates the desire of standard-setters to match income tax expense with income
before taxes for financial reporting.
Balance Sheet
a. The allowance for uncollectible accounts account arises because Nike recognizes
revenue earlier than the time when it collects cash. Because Nike is not likely to
collect 100 percent of the amount reported as sales revenue, it must recognize an
expense for estimated uncollectible accounts and reduce gross accounts receivable
to the amount it expects to collect in cash. Nike increases the balance in the
allowance account for estimated uncollectible accounts arising from sales each year.
It reduces the balance in the allowance account for actual customers’ accounts
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Chapter 1
deemed uncollectible. Nike reports the balance in the allowance account as a

subtraction from gross accounts receivable.
b. The Notes indicate that Nike uses the straight-line method for buildings and
leasehold improvements and the declining balance method for machinery and
equipment. As with the inventory cost-flow assumption, standard-setting bodies
give firms freedom to select any depreciation method from the set deemed
acceptable. These bodies do not provide criteria as to which method is more
“appropriate” for a particular firm. The methods that Nike uses for financial
reporting closely coincide with the methods it uses for tax reporting. Thus, Nike
saves record-keeping costs by using similar depreciation methods for financial and
tax reporting.
c. Generally accepted accounting principles in the United States require firms to

expense in the year incurred any expenditures (for example, advertising, promotion,
quality control) to develop intangibles (patents, trademarks, goodwill). Thus,
expenditures made to develop the Nike name or its trademarks will not appear on
the balance sheet as assets. Expenditures made to purchase intangibles from other
firms will appear on the balance sheet as assets (in some cases subject to
amortization). Most of the identifiable intangible assets and goodwill appearing on
Nike’s balance sheet arose from the acquisition of Converse, Inc. during Year 4 and
Bauer, Inc. several years ago.
d. Deferred tax assets arise when a temporary difference provides a future tax benefit
for a firm. This occurs either (1) when a firm recognizes revenue earlier for tax
reporting than for financial reporting (subsequent recognition of the revenue for
financial reporting will not give rise to a tax payment), or (2) when a firm
recognizes expenses earlier for financial reporting than for tax reporting
(subsequent recognition of the expense for tax reporting will reduce income tax
payments). Deferred tax liabilities arise when a temporary difference will require a
firm to make a tax payment in the future. This occurs either (1) when a firm
recognizes revenue earlier for financial reporting than for tax reporting (subsequent
recognition of the revenue for tax reporting will require the firm to pay taxes), or
(2) when a firm recognizes an expense earlier for tax reporting than for financial
reporting (subsequent recognition of the expense for financial reporting does not
give rise to a tax deduction, thereby increasing taxable income and taxes payable).
Note that the classification of deferred taxes on the balance sheet depends on (1)
whether temporary differences give rise to a deferred tax asset or deferred tax
liability, and (2) the timing of the likely reversal of the temporary difference (less
than one year or longer than one year).
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Chapter 1
e. The Financial Accounting Standards Board concluded that firms should report
changes in assets and liabilities that do not immediately affect net income and
retained earnings—but may affect them in the future—as a separate component of
shareholders’ equity in the account Accumulated Other Comprehensive Income. In
this case, Nike’s “losses” relate to foreign currency translation and derivatives.
Statement of Cash Flows

a. Firms use the accrual basis of accounting in measuring net income. Firms usually
recognize revenue at the time of sale of goods and services, not necessarily when
they receive cash from customers. Firms attempt to match expenses with
associated revenues, regardless of when they expend cash. The accrual basis gives
a better indication of a firm’s operating performance than the cash basis because of
the matching of inputs and outputs. The statement of cash flows reports the
amount of cash received from customers net of amounts paid to suppliers of goods
and services.
b. Depreciation expense reduces net income but does not require a cash expenditure in
the year of their recognition (the cash effect occurred in the year a firm acquired the
property, plant, equipment; the firm classified the cash outflow as an investing
activity in the statement of cash flows at that time). The addition adds back to net
income the amount subtracted in calculating earnings for the year.
c. Question d. in the Income Statement questions indicated that NIKE paid less
income taxes during Year 4 than it recognized as income tax expense. Net income
on the first line of the statement of cash flows reflects a subtraction for the
TOTAL amount of income tax expense, whereas only a portion of it was paid out
in cash in Year 2, Year 3 and Year 4. The difference is added back to net income in
calculating cash from operation to correct for the portion of income tax expense
that did not use cash.
d. Net income on the first line of the statement of cash flows includes revenues
recognized each year. Nike does not necessarily collect cash each year in an
amount exactly equal to revenues. It may collect cash during Year 4 from sales
made in prior years and it may not collect cash on some sales made in Year 4 until
later years. The addition for the decrease in accounts receivable means that Nike
received more cash than it recognized as sales revenue.
e. Net income on the first line of the statement of cash flows includes a subtraction
for the cost of goods sold during each year. Nike will likely purchase a different
amount of inventory than it sells. An increase in inventories means that Nike
purchased more than it sold. Thus, the cash outflow for purchases potentially
exceeds cost of goods sold and requires a subtraction from net income for the
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additional cash required. Whether additional cash was in fact required in any year
depends on the change in accounts payable, discussed next.
f. Accounts payable reflects amounts owed to suppliers for inventory items

purchased. Purchases of inventory items increase this liability and cash payments
reduce it. The adjustment for inventory in Part e. above converted cost of goods
sold to purchases. The adjustment for accounts payable converts purchases to
cash payments to suppliers. An increase in accounts payable means that Nike
purchased more than its cash expenditure for purchases. Thus, the adjustments for
the change in inventories and the change in accounts payable convert cost of goods
sold included in net income to cash payments to suppliers for inventory items.
The accrued liabilities and income tax payable accounts reflect amounts owed to
suppliers of various services. Purchases of these services increase these liabilities
and cash payments reduce them. Net income on the first line of the statement of
cash flows includes an expense for the cost of these services consumed during the
year. An increase in the liability for these items means that the cash expenditure
during the year was less than the amount recognized as an expense. The addition
to net income indicates that the cash outflow was less than the expense. Cash flow
from operations did not decrease by the full amount of the expense.
g. The Financial Accounting Standard Board requires firms to report the proceeds
from selling property, plant and equipment as an investing activity. Their rationale
for this classification is two-fold: (1) selling such noncurrent assets is not the
primary operating activity of most companies, and (2) cash expenditures to
purchase these assets appear as investing activities. If a firm sells such assets at a
gain or loss, it must subtract the gain from net income or add back the loss to net
income when computing cash flow from operations. This subtraction or addition
nets the effect of the gain or loss to zero in the operating section of the statement
of cash flows and shows the full cash proceeds as an investing activity. Any gains
or losses for Nike were sufficiently small that it did not disclose them separately.
h. The Financial Accounting Standards Board requires firms to report changes in

short-term bank borrowing as a financing activity. Their rationale for not including
such borrowing as an operating activity, which is the classification of changes in
other current liabilities, is that a firm does not generate operating cash flows by
borrowing from banks. Operating cash flows come from selling goods and services
to customers. Changes in other current liabilities on the other hand relate directly
to purchases of goods and services used in operations, justifying their inclusion in
the operating section of the statement of cash flows.
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Relations between Financial Statement Items (amounts in millions)

a. Sales Revenue ................................................................................ $ 12,253
Decrease in Accounts Receivable* ................................................ 83
Cash Collected from Customers.................................................... $ 12,336
b. Cost of Goods Sold ....................................................................... $ 7,001

Increase in Inventories*................................................................. 56
Cost of Inventories Purchased....................................................... $ 7,057
Increase in Accounts Payable**.................................................... (191)
Cash Paid for Purchases of Inventory........................................... $ 6,866
*Amount taken from the Consolidated Statement of Cash Flows.

**Amount taken from the Consolidated Balance Sheet. It represents an approximation
because Nike combines the change in Accounts Payable with the change in Other
Current Liabilities. The change in Accounts Payable on the balance sheet includes
the effect of both operating activities and a corporate acquisition during the year.
c. Property, Plant and Equipment (at cost):

Balance, May 31, Year 3 ($1,621 + $1,368) ................................. $ 2,989
Purchases of Property, Plant and Equipment ............................... 224
Book Value of Property, Plant and Equipment Disposed (plug).. (81)
Balance, May 31, Year 4 ($1,587 + $1,545) ................................. $ 3,132
Accumulated Depreciation:
Balance, May 31, Year 3 ............................................................... $ 1,368
Depreciation Expense for fiscal Year 4.......................................... 252
Accumulated Depreciation of Property, Plant and Equipment
Disposed for fiscal Year 4 (plug)................................................ (75)
Balance, May 31, Year 4 ............................................................... $ 1,545
Cash Proceeds from Disposal of Property, Plant and

Equipment .................................................................................. $ 12
Book Value of Property, Plant and Equipment Disposed:
($81 – $75) .................................................................................. (6)
Gain on Sale of Property, Plant and Equipment ........................... $ 6
Nike likely includes the gain in Other Income (Expenses), net on the income
statement. It subtracted the gain from net income in calculating cash flow from
operations, probably on its line labeled “other”.
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Chapter 1
d. Retained earnings increased during Year 4 by $338 million (= $3,977 – $3,639).

Net income increased retained earnings by $946 million, dividends reduced retained
earnings by $179 million, for a net increase of $767 million (= $946 – $179). The
repurchase and retirement of Nike common stock must have resulted in a charge
against retained earnings of $429 million (= $338 – $767). Note that most
companies report the cost of treasury stock purchased on a separate line in the
shareholders’ equity section of the balance sheet. Nike chooses to report such
repurchases as the retirement of the stock. The charge against retained earnings
reflects the increases in the stock price in previous years resulting from the
retention of earnings.
Interpreting Financial Statement Relationships

a. The improved net income/sales percentage over the three-year period results from
the net effect of a decrease in the cost of goods sold to sales percentage and an
increase in the selling and administrative expenses to sales percentage.
b. The move to apparel changes the product mix and could result in sales of more
higher-margin products. The move to Europe and other countries may also result
in higher margin sales. The introduction of more upscale shoes would also likely
increase the gross margin, although there is no evidence in the case that this
occurred. Another factor may be favorable exchange rate changes. This in fact
occurred, but most students will not likely have the background to understand this
explanation. During this period, the Euro increased in value relative to the U.S.
dollar. Nike denominates its purchases in U.S. dollars. It denominates sales in
Europe in Euros. A higher gross margin results from an increase in the value of the
Euro.
c. The increase in selling and administrative expense to sales percentages between

Year 2 and Year 4 likely results from the need to increase marketing efforts
(advertising and celebrity endorsements) in a period of slower growth in sales.
d. Nike outsources its manufacturing and also outsources most of the retailing of its
products. Thus, the principal fixed assets are corporate headquarters, research
facilities, warehouses, and transportation equipment. One might think of Nike as
serving essentially a wholesaling function along with product development and
promotion.
e. Nike has few fixed assets to serve as collateral for borrowing. Also, Nike generates
more than sufficient cash flow from operations to finance the small amount of
investments in fixed assets. Thus, Nike does not need significant long-term debt
financing.
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Chapter 1
f. As discussed in Question d., Nike outsources the production of its products to

manufacturers located in Asia. The property, plant and equipment needs of Nike
are minimal, and probably represent warehouses and distribution facilities. As
such, one might expect minimal increases or even decreases in property, plant and
equipment each year.
g. Nike experienced a substantial increase in accounts receivable and inventories that

exceeded the increase in sales and net income. Cash flow from operations therefore
declined between the two years.
h. In each year, Nike reported a significant addback for depreciation. Although

depreciation is not a source of cash, it is deducted as an expense on the income
statement to arrive at net income. For firms that have depreciation charges,
inevitably cash flows from operations will be greater than net income because net
income includes this expense, whereas it is excluded (added back) as a cash flow
from operations.
i. Cash flow from operations exceeded expenditures on property, plant and

equipment each year, so Nike did not need to rely on external financing for its
capital expenditures.
j. The repurchases of common stock substantially exceeded the issue of new stock
under stock option plans and other stock issues in all three years. Thus,
repurchasing shares to maintain a level number of shares outstanding to avoid
dilution does not appear to be the primary reason for the stock repurchases. It is
likely that Nike had excess cash and felt that its stock price was undervalued. Such
stock repurchases often result in an increase in the market price of the stock.
k. In fact, Nike approximately maintained its dividend payout rate (dividends as a

percentage of net income) during this three-year period. The total amount of
dividends paid out each year increased with the increase of net income. Note that
the dividend rate per outstanding share of common stock had to increase as a result.
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Chapter 1

Overview of Financial Reporting, Financial

OVERVIEW OF FINANCIAL REPORTING, FINANCIAL

1. Timber Tracts: Plants and maintains timber tracts (Weyerhauser).

Pulp and Paper Intermediate Retailers of Paper

1.2 Porter’s Five Forces Applied to Air Courier Industry.

Threat of New Entrants. The cost of equipment, developing national and

Threat of Substitutes. The main threat to transportation of letter parcels is digital

1.3 Economic Attributes Framework Applied to Specialty Retailing Apparel

Demand. Firms attempt to compete on design, colors, and other product

Manufacturing. The manufacturing process is labor intensive. The manufacturing

Marketing. Because of the large number of suppliers selling similar products,

Investing and Financing. Firms must finance inventory, usually with a

1.4 Identification of Commodity Businesses.

Southwest Airlines. Airline transportation services are a commodity product in

1.5 Identification of Company Strategies. The strategies of Home Depot and

1.9 Effect of Business Strategy on Common-Size Income Statement. Firm A is

Selling and Administrative Expense to Sales Percentages. Apple Computer

Research and Development Expense to Sales Percentages. Apple Computer is

Net Income to Sales Percentages. These percentages do not appear consistent

1.10 Effect of Business Strategy on Common-Size Income Statements. Firm A is

1.11 Effect of Industry Characteristics on Financial Statement Relationships.

1.12 Effect of Industry Characteristics on Financial Statement Relationships.

1.13 Effect of Industry Characteristics on Financial Statement Relationships

Liabilities and Shareholders' Equity

(a) See Note 1 to the WPP Group financial statements.

Operations Year 10 Year 11

aThe amount for "Other Adjustments" is a plug amount.

1.16 Comprehensive Income.

(a) £133 – £80 as reported in Note 5 of WPP Group’s financial statements.

b Net income as a percent of turnover, or revenues, for Year 11 is 1.3 percent (=

1.17 Recasting the Financial Statements of a German Company into U.S.

Balance Sheet for Volkswagen Group AG

b. The recast income statement appears below. Different income statement

Income Statement for Volkswagen Group AG

Integrative Case 1.1: Starbucks

A. Identify the economics characteristics of the specialty coffee retail industry

B. Review the purpose, format, terminology and accounting principles

C. Introduce common-size and percentage-change income statements and

Industry and Strategy Analysis

2. Supplier Power: Suppliers of the high-quality coffee beans used in specialty

5. Threat of Substitutes: There are numerous beverage substitutes to specialty

Starbucks appears to be aggressively pursuing multiple avenues to maintain its

e. The allowance of uncollectible accounts account arises because Starbucks

f. The Accumulated Deprecation accounts reports the cumulative depreciation

h. Generally accepted accounting principles (GAAP) require firms to report

k. As indicated in the answer to Part i. above, the Income of Equity Investees

Statement of Cash Flows

p. Accounts payable reflects amounts owed to suppliers for inventory items

payments to suppliers. An increase in accounts payable means that Starbucks

r. The Financial Accounting Standards Board requires firms to report changes in

Relations Between Financial Statements

t. Property, Plant and Equipment, September 30, Year 3 ...................... $ 2,516.3

We cannot determine the amount of accumulated depreciation on the property,

Interpreting Financial Statement Relations

x. The proportion of revenue from company-operated stores and foodservice declined

Case 1.2: Nike: Somewhere Between a Swoosh and a Slam Dunk

B. Introduce common-size and percentage-change income statements and

deemed uncollectible. Nike reports the balance in the allowance account as a

c. Generally accepted accounting principles in the United States require firms to

Statement of Cash Flows

f. Accounts payable reflects amounts owed to suppliers for inventory items