GAAP: AN ANALYTICAL STUDY OF FINANCIAL ACCOUNTING STANDARDS. By: William Mayo. Oxford May 2017

Transcription

1 GAAP: AN ANALYTICAL STUDY OF FINANCIAL ACCOUNTING STANDARDS By: William Mayo A thesis submitted to the faculty of The University of Mississippi in partial fulfillment of the requirements of the Sally McDonnell Barksdale Honors College. Oxford May 2017 Approved by Advisor: Professor Victoria Dickinson Reader: Dean Mark Wilder

2 ABSTRACT WILLIAM MAYO: GAAP: AN ANALYTICAL STUDY OF FINANCIAL ACCOUNTING STANDARDS This thesis is comprised of a series of case studies covering various principles and standards of financial accounting. The thesis was created throughout a single academic year and the case studies are ordered to follow the basic elements of a balance sheet. These case studies include financial statement analysis, income and asset ratios, statement of cash flows, accounts receivable, revenue and inventory recognition, depreciation and fraud, GAAP standards compared to IFRS standards, debt, stockholders equity, securities, revenue growth and regulatory issues, tax liabilities, and pensions and retirement plans. The purpose of this thesis format is to provide analysis for and within multiple areas of financial accounting. Most of the cases studies begin with an overview of the main topic of the study, followed by questions to be analyzed and answered. These questions ranged from creating journal entries to comparing companies financial performances. Many of the case studies involved a heavy usage of Excel for creating tables, financial statements, and comparisons. Usually, the case studies also contained an analysis section of questions, which left more space for user interpretation in the answers to be provided. Because these case studies are based on established financial accounting standards, there are not necessarily any new findings. Rather, each case study is a reinforcement of individual accounting principles. The case studies confirm that there is a ii

3 necessity to the existence of these principles, and their usage is based on logical thought and established facts that have become commonplace in the field of financial accounting. The thesis was also a tool to hone critical thinking and research skills. It allowed users to gain proficiency in Excel, among other technologies, such as the accounting codification website. It reinforced the basic concepts of theoretical accounting while allowing users to apply this knowledge to contextualized problems. In summary, this thesis, as well as the corresponding class taught by Dr. Victoria Dickinson, was an extremely valuable experience for those of us entering the accounting world. We were able to strengthen our learning in other accounting courses because this class subjected us to different types of studies, analyses, and concepts. iii

4 TABLE OF CONTENTS LIST OF TABLES v FINANCIAL STATEMENT ANALYSIS 1 INCOME AND ASSET RATIOS 22 STATEMENT OF CASH FLOWS 32 ACCOUNTS RECEIVABLE 39 REVENUE AND INVENTORY RECOGNITION 47 DEPRECIATION AND FRAUD 57 GAAP VS. IFRS 61 DEBT 64 STOCKHOLDERS EQUITY 73 SECURITIES 79 REVENUE GROWTH AND REGULATORY ISSUES 87 TAX LIABILITIES 93 PENSIONS AND RETIREMENT PLANS 102 iv

5 LIST OF TABLES CHAPTER 1: FINANCIAL STATEMENT ANALYSIS Table 1.1 Glenwood Chart of Accounts 4 Table 1.2 Glenwood Multistep Income Statement 9 Table 1.3 Glenwood Statement of Retained Earnings 9 Table 1.4 Glenwood Classified Balance Sheet 10 Table 1.5 Glenwood Statement of Cash Flows 11 Table 1.6 Glenwood Financial Ratios 12 Table 1.7 Eads Chart of Accounts 13 Table 1.8 Eads Multistep Income Statement 18 Table 1.9 Eads Statement of Retained Earnings 18 Table 1.10 Eads Classified Balance Sheet 19 Table 1.11 Eads Statement of Cash Flows 20 Table 1.12 Eads Financial Ratios 21 CHAPTER 2: INCOME AND ASSET RATIOS Table 2.1 Molson Coors Income Statement 28 Table 2.2 Molson Coors Comparison of Non-Operating Items 29 Table 2.3 Molson Coors Comparison of Net Operating Assets 29 CHAPTER 3: STATEMENT OF CASH FLOWS Table 3.1 Golden Enterprises Statement of Cash Flows 34 CHAPTER 4: ACCOUNTS RECEIVABLE Table 4.1 Provision for Bad and Doubtful Debts T-Account 41 Table 4.2 Provision for Sale Returns T-Account 42 Table 4.3 Gross Trade Receivables T-Account 44 v

6 LIST OF TABLES (CONTINUED 1) Table 4.4 Estimation of Uncollectible Accounts 45 Table 4.5 Average Collection Period 46 CHAPTER 6: DEPRECIATION AND FRAUD Table 6.1 Estimated Gain (Loss) on Sale 57 CHAPTER 8: DEBT Table 8.1 Rite Aid Amortization Schedule 68 Table 8.2 Rite Aid Amortization Interest Expense Comparison 69 Table 8.3 Rite Aid Ratio Table 71 CHAPTER 9: STOCKHOLDERS EQUITY Table 9.1 Merck & GlaxoSmithKline Equity Comparison 78 CHAPTER 11: REVENUE GROWTH AND REGULATORY ISSUES Table 11.1 Amazon Revenue, Income, and Stock Price Comparison 88 Table 11.2 Groupon Common Size Income Statement Comparison 89 CHAPTER 13: PENSIONS AND RETIREMENT PLANS Table 13.1 Johnson & Johnson Return Comparison 106 Table 13.2 Johnson & Johnson Contributions Comparison 107 Table 13.3 Johnson & Johnson Pension Obligation Benefit Comparison 108 vi

7 CASE 1: FINANCIAL STATEMENT ANALYSIS It can be difficult to search through the accounting records of these two similar companies and find many glaring differences. Many of the financial statements and ratios show very close comparisons. However, each company made a few different business decisions that shed light on which company is a smarter, safer, and more profitable investment. Glenwood Heating, Inc. reports financial ratios that are better than Eads, but largely due to the fact that Glenwood reported a higher net income. At first glance, it may appear that Glenwood is the obvious choice to invest in, but further analysis into their business practices will scare away investors. The most alarming numbers come from their Statement of Cash Flows, where they lost $16,374 to operating activities and only had a cash balance of $426 at the end of the year. There is major uncertainty in regards to how Glenwood will continue to operate, especially due to the fact that next year they will have to fund another piece of important equipment that could cost upwards of $16,000. The owner of this piece of equipment refused to promise Glenwood the same price; therefore they could be in limbo if the price rises drastically. Eads Heater, Inc. capitalizes in the areas that Glenwood fails in. The differences in the financial ratios are a product of Eads accounting decisions, not a reflection of their poor business values. They chose to sacrifice numbers in the first year of operations in order to solidify their ability to operate and profit in the future. In fact, Eads decision to

8 FINANCIAL STATEMENT ANALYSIS 2 lease an important piece of equipment will prove vital to their continued operations as a company. It is also important to note that Eads collects cash from their inventory sales over a month faster than Glenwood is able to. Eads was almost able to break-even in operating activities and managed to end the year with a cash balance of $7,835. Eads is primed to perform well in the future, as they will be able to turn this cash into investments that will benefit their business. Ultimately, Eads appears to be the better investment of the two, because of their decision to lease an important piece of equipment for multiple years, and because their cash balance will allow them to fund projects, investments, and perform research that will only increase the value of the company. Net income is a critical number for potential investors to consider when deciding whether or not to invest in a specific company. Multiple accounting decisions led Glenwood to report a higher net income than Eads (over $20,000 difference). Both companies reported the same sales revenues, but Glenwood s use of FIFO allowed them to report a lower cost of goods sold, because the price of inventory rose throughout the year. Glenwood also estimated only one percent of receivables unable to be collected compared to five percent estimation from Eads. The biggest difference is obviously in the depreciation expense account. Eads decision to use the double-declining method of depreciation and to lease a piece of equipment that Glenwood is renting caused their depreciation expense to be $22,500 higher than Glenwood s. While in the first year it appears that Glenwood is headed for a greater net income, their decision to rent the piece of equipment will likely come back to harm them in the future.

9 FINANCIAL STATEMENT ANALYSIS 3 Both companies have the same activity in their equity accounts. They have 3,200 shares outstanding and paid $23,200 in dividends. Glenwood has a higher reported total stockholder s equity simply because they reported a higher net income. Eads and Glenwood also share similar balance sheets. Eads reports higher total assets and liabilities largely due to the lease agreement they signed for a piece of equipment. This gives them an asset account of Leased equipment, and a liability account of Lease payable that Glenwood is not able to report because they chose to rent the equipment for a single year as opposed to signing a capital lease agreement. This is the most important statement to analyze in the comparison of these two companies. In the first year, Eads lost only $325 to operating activities compared to Glenwood s massive loss of $16,374. Glenwood s cash balance at the end of the year is only $426 while Eads is $7,835. This is important because Glenwood must be able to find cash to pay for the important piece of equipment that Eads has leased for eight years. If Glenwood is unable to find the cash to fund this equipment, the entire operation of the company could be at risk. Eads sacrificed in the short term, but is better suited to continue to operate in the next few years.

10 FINANCIAL STATEMENT ANALYSIS 4 Accounts Receivable Glenwood Heating, Inc. Chart of Accounts Allowance for Bad Debts Inventory Land Building Part A Cash A1 $160,000 A2 $400,000 A3 -$420,000 $70,000 $350,000 A4 -$80,000 A5 $239,800 A6 $398,500 A7 $299,100 $299,100 A8 -$213,360 A9 -$41,000 A10 -$34,200 A11 -$23,200 A12 Totals $47,340 $99,400 $0 $239,800 $70,000 $350,000 Part B B1 $994 B2 -$177,000 B3 B4 -$16,000 B5 -$30,914 Totals $426 $99,400 $994 $62,800 $70,000 $350,000 Table 1.1 Glenwood Chart of Accounts

11 FINANCIAL STATEMENT ANALYSIS 5 Part A Accumulated Depreciation- Building Equipment A1 A2 A3 A4 $80,000 A5 A6 A7 A8 Glenwood Heating, Inc. Chart of Accounts Accumulated Depreciation- Equipment Leased Equipment Accumulated Depreciation- Leased Equipment A9 A10 A11 A12 Totals $0 $80,000 $0 $0 $0 Part B B1 B2 B3 $10,000 $9,000 B4 B5 Totals $10,000 $80,000 $9,000 $0 $0 Table 1.1 (continued 1) Glenwood Chart of Accounts

12 FINANCIAL STATEMENT ANALYSIS 6 Glenwood Heating, Inc. Chart of Accounts Accounts Interest Notes Lease Common Part A Payable Payable Payable Payable Stock A1 $160,000 A2 $400,000 A3 A4 Retained Earnings Dividends A5 $239,800 A6 A7 A8 $213,360 A9 $20,000 A10 A11 $23,200 A12 $6,650 Totals $26,440 $6,650 $380,000 $0 $160,000 $0 $23,200 Part B B1 B2 B3 B4 B5 Totals $26,440 $6,650 $380,000 $0 $160,000 $0 $23,200 Table 1.1 (continued 2) Glenwood Chart of Accounts

13 FINANCIAL STATEMENT ANALYSIS 7 Cost of Goods Sold Glenwood Heating, Inc. Chart of Accounts Bad Debt Expense Depreciation Expense Interest Expense Other Operating Expense Part A Sales A1 A2 A3 A4 A5 A6 $398,500 A7 A8 A9 $21,000 A10 $34,200 A11 A12 $6,650 Totals $398,500 $0 $0 $0 $27,650 $34,200 Part B B1 $994 B2 $177,000 B3 $19,000 B4 B5 Totals $398,500 $177,000 $994 $19,000 $27,650 $34,200 Table 1.1 (continued 3) Glenwood Chart of Accounts

14 FINANCIAL STATEMENT ANALYSIS 8 Part A A1 A2 A3 A4 Glenwood Heating, Inc. Chart of Accounts Rent Expense Provisions for Income Taxes A5 A6 A7 A8 A9 A10 A11 A12 Totals $0 $0 Part B B1 B2 B3 B4 $16,000 B5 $34,914 Totals $16,000 $34,914 Table 1.1 (continued 4) Glenwood Chart of Accounts

15 FINANCIAL STATEMENT ANALYSIS 9 Glenwood Heating, Inc. Multistep Income Statement Sales Revenue $398,500 Cost of Goods Sold $177,000 Gross Profit $221,500 Selling and Administrative Expenses $70,194 Income from Operations $151,306 Interest Expense $27,650 Income before Taxes $123,656 Income Tax $30,914 Net Income $92,742 Table 1.2 Glenwood Multistep Income Statement Glenwood Heating, Inc. Statement of Retained Earnings Retained Earnings, January 1 $0 Add: Net Income $92,742 $92,742 Less: Dividends -$23,200 Retained Earnings, December 31 $69,542 Table 1.3 Glenwood Statement of Retained Earnings

16 FINANCIAL STATEMENT ANALYSIS 10 Glenwood Heating, Inc. Classified Balance Sheet Assets Current Assets Cash $426 Accounts Receivable $99,400 Less: Allowance for doubtful accounts $994 $98,406 Inventory $62,800 Total Current Assets $161,632 Property, Plant, Equipment Land $70,000 Building $350,000 Less: Accumulated Depreciation- Building $10,000 $340,000 Equipment $80,000 Less: Accumulated Depreciation- Equipment $9,000 $71,000 Total Property, Plant, and Equipment $481,000 Total Assets $642,632 Liabilities and Stockholders' Equity Current Liabilities Accounts Payable $26,440 Interest Payable $6,650 Lease Payable $0 Total Current Liabilities $33,090 Long-Term Debt Twenty-year 7% Debentures, due September 30, 20X1 $380,000 Total Liabilities $413,090 Stockholders' Equity Common Stock $160,000 Retained Earnings $69,542 Total Stockholders' Equity $229,542 Total Liabilities and Equity $642,632 Table 1.4 Glenwood Classified Balance Sheet

17 FINANCIAL STATEMENT ANALYSIS 11 Glenwood Heating, Inc. Statement of Cash Flows Cash Flows from Operating Activities Net Income $92,742 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Depreciation Expense $19,000 Increase in Accounts Receivable -$98,406 Increase in Inventory -$62,800 Increase in Accounts Payable $26,440 Increase in Interest Payable $6,650 Net Cash Used by Operating Activities $16,374 Cash Flows from Investing Activities Purchase of Equipment -$80,000 Purchase of Land -$70,000 Purchase of Building -$350,000 Net Cash Used by Investing Activities $500,000 Cash Flows from Financing Activities Payment of Cash Dividends -$23,200 Issuance of Common Stock $160,000 Redemption of Bonds -$380,000 Net Cash Used by Financing Activities $243,200 Net Decrease in Cash $759,574 Table 1.5 Glenwood Statement of Cash Flows

18 FINANCIAL STATEMENT ANALYSIS 12 Glenwood Heating, Inc. Financial Ratios Liquid Ratios Current Ratio 3.04 Acid-Test Ratio 1.88 Accounts Receivable Turnover 4.01 Days to Collect Receivables Inventory Turnover 2.82 Days to Sell Inventory Operating Cycle Profitability Ratios Gross Profit Margin 56% Profit Margins 23% Return on Assets (ROA) 14% Return on Owners' Equity (ROE) 40% Earnings per Share (EPS) Long-Term Solvency Ratios Debt Ratio 64% Times Interest Earned 5.47 Table 1.6 Glenwood Financial Ratios

19 FINANCIAL STATEMENT ANALYSIS 13 Part A Cash A1 $160,000 A2 $400,000 Eads Heaters, Inc. Chart of Accounts Allowance Accounts for Bad Receivable Debts Inventory Land Building A3 -$420,000 $70,000 $350,000 A4 -$80,000 A5 $239,800 A6 $398,500 A7 $299,100 -$299,100 A8 -$213,360 A9 -$41,000 A10 -$34,200 A11 -$23,200 A12 Totals $47,340 $99,400 $0 $239,800 $70,000 $350,000 Part B B1 $4,970 B2 -$188,800 B3 B4 -$16,000 B5 -$23,505 Totals $7,835 $99,400 $4,970 $51,000 $70,000 $350,000 Table 1.7 Eads Chart of Accounts

20 FINANCIAL STATEMENT ANALYSIS 14 Part A Accumulated Depreciation- Building Eads Heaters, Inc. Chart of Accounts Accumulated Depreciation- Equipment Leased Equipment Accumulated Depreciation- Leased Equipment Equipment A1 A2 A3 A4 $80,000 A5 A6 A7 A8 A9 A10 A11 A12 Totals $0 $80,000 $0 $0 $0 Part B B1 B2 B3 $10,000 $20,000 B4 $92,000 $11,500 B5 Totals $10,000 $80,000 $20,000 $92,000 $11,500 Table 1.7 (continued 1) Chart of Accounts

21 FINANCIAL STATEMENT ANALYSIS 15 Eads Heaters, Inc. Chart of Accounts Part A Accounts Payable Interest Payable Notes Payable Lease Payable Common Stock Retained Earnings Dividends A1 $160,000 A2 $400,000 A3 A4 A5 $239,800 A6 A7 A8 -$213,360 A9 -$20,000 A10 A11 $23,200 A12 $6,650 Totals $26,440 $6,650 $380,000 $0 $160,000 $0 $23,200 Part B B1 B2 B3 B4 $83,360 B5 Totals $26,440 $6,650 $380,000 $83,360 $160,000 $0 $23,200 Table 1.7 (continued 2) Eads Chart of Accounts

22 FINANCIAL STATEMENT ANALYSIS 16 Part A Cost of Goods Sold Eads Heater, Inc. Chart of Accounts Bad Debt Depreciation Expense Expense Interest Expense Other Operating Expense Sales A1 A2 A3 A4 A5 A6 $398,500 A7 A8 A9 $21,000 A10 $34,200 A11 A12 $6,650 Totals $398,500 $0 $0 $0 $27,650 $34,200 Part B B1 $4,970 B2 $188,800 B3 $30,000 B4 $11,500 $7,360 B5 Totals $398,500 $188,800 $4,970 $41,500 $35,010 $34,200 Table 1.7 (continued 3) Eads Chart of Accounts

23 FINANCIAL STATEMENT ANALYSIS 17 Eads Heater, Inc. Chart of Accounts Part A Rent Expense Provisions for Income Taxes A1 A2 A3 A4 A5 A6 A7 A8 A9 A10 A11 A12 Totals $0 $0 Part B B1 B2 B3 B4 B5 $23,505 Totals $0 $23,505 Table 1.7 (continued 4) Eads Chart of Accounts

24 FINANCIAL STATEMENT ANALYSIS 18 Eads Heaters, Inc. Multistep Income Statement Sales Revenue $398,500 Cost of Goods Sold $188,800 Gross Profit $209,700 Selling and Administrative Expenses $80,670 Income from Operations $129,030 Interest Expense $35,010 Income before Taxes $94,020 Income Tax $23,505 Net Income $70,515 Table 1.8 Eads Multistep Income Statement Eads Heaters, Inc. Statement of Retained Earnings Retained Earnings, January 1 $0 Add: Net Income $70,515 $70,515 Less: Dividends $23,200 Retained Earnings, December 31 $47,315 Table 1.9 Eads Statement of Retained Earnings

25 FINANCIAL STATEMENT ANALYSIS 19 Eads Heaters, Inc. Classified Balance Sheet Assets Current Assets Cash $7,835 Accounts Receivable $99,400 Less: Allowance for Doubtful Accounts $4,970 $94,430 Inventory $51,000 Total current assets $153,265 Property, Plant, Equipment Land $70,000 Building $350,000 Less: Accumulated Depreciation- Building $10,000 $340,000 Equipment $80,000 Less: Accumulated Depreciation- Equipment $20,000 $60,000 Leased Equipment $92,000 Less: Accumulated Depreciation- Leased Equipment $11,500 $80,500 Total Property, Plant, and Equipment $550,500 Total Assets $703,765 Liabilities and Stockholders' Equity Current Liabilities Accounts Payable $26,440 Interest Payable $6,650 Lease Payable $83,360 Total Current Liabilities $116,450 Long-Term Debt Twenty-year 7% Debentures, due September 30 20X1 $380,000 Total Liabilities $496,450 Stockholders' Equity Common Stock $160,000 Retained Earnings $47,315 Total Stockholders' Equity $207,315 Total Liabilities and Equity $703,765 Table 1.10 Eads Classified Balance Sheet

26 FINANCIAL STATEMENT ANALYSIS 20 Eads Heaters, Inc. Statement of Cash Flows Cash Flows from Operating Activities Net Income $70,515 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Depreciation Expense $41,500 Increase in Accounts Receivable -$94,430 Increase in Inventory -$51,000 Increase in Accounts Payable $26,440 Increase in Interest Payable $6,650 Net Cash Used by Operating Activities $325 Cash Flows From Investing Activities Purchase of Equipment -$80,000 Purchase of Land -$70,000 Purchase of Building -$350,000 Net Cash Used by Investing Activities $500,000 Cash Flows from Financing Activities Payment of Cash Dividends -$23,200 Issuance of Common Stock $160,000 Lease payable $83,360 Redemption of Bonds -$380,000 Net Cash Used by Financing Activities $159,840 Net Increase in Cash $660,165 Table 1.11 Eads Statement of Cash Flows

27 FINANCIAL STATEMENT ANALYSIS 21 Eads Heaters, Inc. Financial Ratios Liquid Ratios Current Ratio 2.48 Acid-Test Ratio 1.65 Accounts Receivable Turnover 4.22 Days to Collect Receivables Inventory Turnover 3.70 Days to Sell Inventory Operating Cycle Profitability Ratios Gross Profit Margin 53% Profit Margins 18% Return on Assets (ROA) 10% Return on Owners' Equity (ROE) 34% Earnings per Share (EPS) Long-Term Solvency Ratios Debt Ratio 71% Times Interest Earned 3.69 Table 1.12 Eads Financial Ratios

28 INCOME AND ASSET RATIOS 22 CASE 2: INCOME AND ASSET RATIOS Molson Coors is a brewing company that was established in 2005 after the merger of Adolph Coors Co. and Molson, Inc. Its largest markets are the United States, Canada, and the United Kingdom. Molson Coors aspires to appeal to a multitude of consumer tastes, styles, and price preferences. Although the production of quality beer is the staple of Molson Coors Brewing Co., they engage in a variety of business transactions that can make it difficult to find and understand the important information in their financial statements. This analysis will extract the useful information from Molson Coors financial statements and notes, especially as it relates to the future profitability and stock expectations of the company. The main focus of this analysis deals with the core business aspects of Molson Coors, their operations. Operations have the greatest effect on the cash flows, which is important in predicting Molson Coors stock value in the future. Throughout this analysis, there are new calculation values for net operating assets, persistent income, and net operating income after tax. These calculations removed items from Molson Coors financial statements that are not recurring, operating items. These calculations also allow potential investors to gain insight of the meat of Molson Coors operations, and they provide better indicators of future operations, profitability, and future cash flows. Molson Coors, like other public companies, is required by law to be taxed at a statutory tax rate. However, Molson Coors engages in a variety of foreign business operations that provide tax breaks. In an effort to find a persistent income for Molson

29 INCOME AND ASSET RATIOS 23 Coors, a new effective tax rate was calculated by averaging the separate tax items for each year and totaling the sum of those averages. Persistent income is an important measure for investors to use in future profitability predictions. Persistent income for Molson Coors removes nonrecurring, non-operating items from its income statement including discontinued operations, special items, and other income. All three of these are considered nonrecurring because they cannot be reasonably expected to occur in the future at predictable levels. These items are not valuable indicators of the core operations of Molson Coors, and therefore they are not valuable to any analysis of Molson Coors future operations. Arguably the most important step of our analysis was determining items from Molson Coors balance sheet that are non-operating. These items only cloud investors from the actual operations numbers. Non-operating assets such as affiliates, goodwill, other intangibles, and an investment in Miller Coors were all removed from the balance sheet simply because these assets do not provide any indication of Molson Coors actual operations. Liabilities including discontinued operations, debts, pension payments, and derivative hedging instruments were all removed from the opposite side of Molson Coors balance sheet for the same reason as stated above. This calculation of net operating assets provides a critical figure in determining future operations predictions. After analysis (see appendix), it was confirmed that Molson Coors can be reasonably predicted to give investors a positive return.

30 INCOME AND ASSET RATIOS 24 Appendix a. The major classifications on an income statement are: sales, gross profit, expenses (controllable and fixed), profit, and loss. b. Classified income statements permit users to assess the amounts, timing and uncertainty of future cash flows. GAAP requires companies to submit classified income statements because its subsections can be more informative than a simple income statement. c. Financial statement users would be interested in persistent income because it is the portion of a company s income that can be reasonably expected to reoccur the following year. Obviously, users want this measurement to determine future profitability of a company and to determine whether or not to invest. d. Comprehensive income includes all changes in equity during a period except those resulting from an investment by an owner or a distribution to owners. Net income includes all changes in owner s equity. e. Net sales=sales-excise Taxes. Excise taxes, which in this case are taxes on beer, inflate the total sales number. Molson Coors reports these items separately to show the effect of excise taxes on their total sales revenue.

31 INCOME AND ASSET RATIOS 25 f. i. Special items are unusual gains or expenses that a company believes are not indicative of its core operations. In Molson Coors case, some of these items include: - Expenses from restructuring employee severance programs - Flood losses - Asset impairment - Termination fees ii. Molson Coors reports these special items on a separate line because they are largely unpredictable. However, they are classified as operating expenses because these items have a great impact on the ability of Molson Coors to operate normally. g. Other income related expenses and gains are unrelated to operations, whereas special items are nonrecurring operations-related items. h. i. Comprehensive income totals $760.2 million for the year compared to $572.5 million in net income. ii. The million in additional income attributed to comprehensive income stems entirely from non-operating gains, such as foreign currency adjustments, pension adjustments, and unrealized gains.

32 INCOME AND ASSET RATIOS 26 i. There are 3 statements on Molson Coors income statement that we considered non-persistent: 1. Special Items- they may still exist in the future, but the amounts of these items are undeterminable. 2. Income/losses from discontinued operations- discontinued operations will not persist in the future. 3. Income/losses from non-controllable interests- like special items, noncontrollable interests may affect the company next year, but there is no accurate way to determine these amounts. j. i. Molson Coors effective tax rate in 2013 is 12.8 percent. That is calculated as income tax expense (84) divided by pretax income (654.5). Source: ii. Unrecognized tax benefit, change in valuation allowance, and other taxes are unpredictable both in amount and existence for future years. We considered eliminating the unpredictable taxes from our effective tax rate but ultimately determined that eliminating these elements would probably result in an undervaluation of tax expenses for the company. Instead, we averaged the amounts of each item for each year (predictable and unpredictable) and summed the totals to create a new effective tax rate of percent.

33 INCOME AND ASSET RATIOS 27 Note: Foreign tax law was not averaged because its 2012 total was not indicative of future rates due to a change in foreign policy that resulted in an abnormally high rate. k. Our calculation of Molson Coors persistent income can be found in the chart below. We used our effective tax rate calculated in j.) to tax these items. Also, we determined that discontinued operations, special items, and other income are all nonrecurring items, and therefore not necessary to calculate persistent income.

34 INCOME AND ASSET RATIOS 28 Molson Coors Income Statement Persistent Income (in millions) Sales Excise Tax (1793.5) Net Sales Cost of Goods Sold (2545.6) Gross Profit General and Admin (1193.8) Expenses Equity Income Other Income Interest Expense (183.8) Interest Income 13.7 Income from cont operations Income Tax Expense Net Income Less: non-controlling (5.2) interests Net (persistent) income Table 2.1 Molson Coors Income Statement The persistent income figure is an average of NI from Continuing Operations from 2011 to l.) i. We determined that special items, discontinued operations, and other income are all non-operating items, because their financial contributions to the income statement are not related to Molson Coors brewing operations. ii. Note: Other income and special items are both listed at before tax on the income statement; for these items, we will apply the company s three-year marginal tax rate of 12 percent. Discontinued operations are listed as after tax and remain the same as previously listed on the income statement.

35 INCOME AND ASSET RATIOS 29 Molson Coors Comparison of Non-Operating Items for the Years 2012 and 2013 Non-operating Items Special items, net (200) (81.4) Equity income in MillerCoors Other income (expense), net 18.9 (90.3) Income from discontinued Operations Income attributable to non-controlling interests (4.576) 3.43 Total non-operating items $ $ Table 2.2 Molson Coors Comparison of Non-Operating Items iii. Net operating assets for 2013 and 2012 are respectively $13, and $13, Molson Coors Comparison of Total Net Operating Assets for 2012 and 2013 Net Operating Assets Total Assets 15, ,212.2 Affiliates Investment in MillerCoors 2, ,431.8 Total net operating assets (in millions) $13, $13, Table 2.3 Molson Coors Comparison of Net Operating Assets

36 INCOME AND ASSET RATIOS 30 m.) i. Non-operating Assets: 1. Investment in Miller Coors- investment in another company may provide Molson Coors with cash, but it is not a part of operations. 2. Affiliate- like the investment in Miller Coors, affiliates provide return on investments but do not relate to operations. 3. Goodwill & other intangibles- intangible assets produce long-term value and may derive from operations in some cases; however, they are not essential to operations. Non-operating liabilities: 1. Hedging instruments- hedging instruments are used for equity related purposes (bonds, stocks, etc.). 2. Discontinued Operations- discontinued operations will have no effect on the present and future operations of Molson Coors. 3. Long-term debt- the obligation to pay off long-term debt does not affect the operations of Molson Coors. 4. Pension- post-retirement payments, while important to employees, are 5. Derivative Hedging- see: hedging instruments 7. Short & long-term debt- see: long-term debt

37 INCOME AND ASSET RATIOS 31 n. RNOA= Net Operating Profit After Tax/ Average Net Operating Assets 2013: /1246.2= 70.2% 2012: /1576.9= 47.9% o. Operating Profit Margin= Net Operating Profit After Tax/Sales 2013: /5999.6=14.6% 2012: /5615.0=13.5% Net Operating Asset Turnover= Sales/Average Net Operating Assets 2013: /1246.2= 4.8x 2012: 5615/1576.9= 3.6x The increase in NOPAT along with the decrease in net operating assets from 2012 to 2013 are the factors that contribute to 2013 s significantly larger RNOA. p RNOA using Persistent Income from j.): /1246.2= 64.0% This RNOA is a better future profitability predictor than the RNOA in item n.) because our persistent income figure is a more accurate prediction of future net operating profit after tax.

38 STATEMENT OF CASH FLOWS 32 CASE 3: STATEMENT OF CASH FLOWS The primary purpose of the statement of cash flows is to provide relevant information about the cash receipts and payments of a company during a period. The statement of cash flows helps users evaluate a company s liquidity, solvency, and financial flexibility. On the other hand, an income statement is a measure of financial performance, specifically a company s profit or loss from revenues and expenses. The two different methods for preparing the statement of cash flows are the direct method and the indirect method. Golden Enterprises, like most companies, uses the indirect method. We know this by examining their 2012 statement of cash flows from their 2013 Form 10-K. Golden Enterprises converts their net income from accrual to cash basis in the operating activities section of their statement of cash flows. They add back non-cash expenses that would appear on the income statement and adjust net income for changes in current assets and current liabilities. Most companies choose to prepare their statement of cash flows using the indirect method because the information required is readily available whereas the direct method requires data for items that most companies normally do not record using accrual accounting. The three sections of the statement of cash flows are the cash effects from (1)

39 STATEMENT OF CASH FLOWS 33 operating activities, (2) investing activities, and (3) financing activities during a period. The operating activities section of the statement of cash flows is related to the balance sheet in many ways. Increases in current liabilities are subtracted from net income (decreases in CA are added), while increases in current liabilities are added to net income (decreases in CL are subtracted). The investing activities section of the statement usually deals with property, plant, and equipment purchases and/or sales from the PPE portion of the balance sheet. The last section of the statement of cash flows, the financing activities section, usually pulls information from the equity section of the balance sheet such as common stock issuances and treasury stock purchases. Cash equivalents are liquid investments that mature in three months or less. Examples include commercial paper, marketable securities, and treasury bills. The apparent inconsistency between net income being determined on an accrual basis and also appearing first on the statement of cash flows is critical to understand the process of the indirect method for preparing the statement of cash flows. The entire purpose is to convert the accrual basis net income figure to a cash basis. Therefore, net income is the first item on the statement of cash flows, but it is subsequently adjusted for non-cash expenses that are listed on the income statement, changes in current assets such as receivables, and changes in current liabilities such as accounts payable.

40 STATEMENT OF CASH FLOWS 34 Analysis: a. Golden Enterprises Statement of Cash Flows (Indirect) For the Year Ended May 31, 2013 Net Income 1,134,037 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense 3,538,740 Deferred income taxes (185,939) Gain on sale of property and equipment (61,040) Decrease in accounts receivable, net 106,367 Decrease in inventory 200,985 Decrease in prepaid expenses 200,137 Decrease in cash surrender value of 62,906 insurance Increase in other assets (191,298) Decrease in accounts payable (1,216,399) Increase in accrued expenses 954,938 Decrease in salary continuation plan (49,774) Decrease in accrued income taxes 113,369 Net cash provided by operating activities 4,607,029 Cash flows from investing activities Cash received from sale of plant assets 74,514 Cash paid for purchase of plant assets (4,149,678) Net cash used in investing activities (4,075,164) Cash flows from financing activities Debt proceeds 38,361,200 Debt repayments (38,287,529) Change in checks outstanding in excess of (267,502) bank balance Purchases of treasury shares (6,860) Cash dividends paid (1,467,879) Net cash used in financing activities (1,668,570) Net decrease in cash and cash equivalents (1,136,705) Cash and cash equivalents at beginning of 1,893,816 year Cash and cash equivalents at end of year 757,111 Table 3.1 Golden Enterprises Statement of Cash Flows Explanation of construction of the 2013 statement of cash flows on the following page.

41 STATEMENT OF CASH FLOWS 35 Operating Activities: Net cash provided from operating activities is a critical figure for users to measure how the core business aspects of a company are performing. As discussed in item b., Golden Enterprises uses the indirect method when preparing their cash flows. This requires them to adjust their net income in order to convert it to a cash basis. As listed in order: i. Depreciation expense is added back to net income because it is a non-cash expense listed on the income statement. ii. The decrease in deferred income taxes is subtracted from net income. iii. A gain on sale of a fixed asset is subtracted from net income. It is important to note here that while the actual sale of the asset was for $74,514, only $61,040 is recognized as a gain due to the net book value of the fixed asset. iv. The next 5 items listed in the operating sections are additions or deductions due to changes in current assets and current liabilities. The fiscal year decreases in receivables, inventories, prepaid expenses, and the cash surrender value of life insurance are all added back to net income, because decreases in these accounts work positively towards generating more cash. (In other words, a decrease in accounts receivables means Golden Enterprises is collecting more cash from its sales.) The increase in other assets is

42 STATEMENT OF CASH FLOWS 36 deducted from net income for the same reason as stated above. v. The last 4 items are the adjustments due to changes in current liabilities. Increases in accrued expenses and accrued income taxes are added to net income because Golden Enterprises is not paying these liabilities off with cash as fast as they are increasing. Decreases in accounts payable and the salary continuation plan are deducted from net income. These decreases signify that Golden Enterprises is paying cash to lessen these liabilities. Investing Activities: The investing activities section of the statement of cash flows is the shortest and easiest to construct, in Golden Enterprises case. It is simply the $4,149,678 cash payment for purchase of new property, plant, and equipment and the sale of old equipment, which provided cash receipt of nearly $75,000. Financing Activities: The net cash outflow from financing activities includes debt issuances and debt repayments as disclosed in the additional information provided in the case packet. Purchase of treasury stock and cash dividends paid are also listed as cash outflows in the financing section of the statement of cash flows. Of particular importance, and as noted in the case packet, the item change in checks outstanding in excess of bank balances must also be listed in the financing section.

43 STATEMENT OF CASH FLOWS 37 b. Depreciation expenses does not generate cash for Golden Enterprises, but it is added back to net income because it is a non-cash expense listed on the income statement. In other words, depreciation expense and amortization are expensed on the income statement, but since they do not actually require cash payments from the company, they are added back to reconcile net income to net cash provided from operating activities. c. Fiscal 2013 saw a drop in Golden Enterprises ability to generate cash as well as their net income. Net income dropped nearly 49% from $2,207,623 to $1,134,037. Golden Enterprises also lost over $300,000 more in cash and cash equivalents in fiscal 2013 compared to fiscal These trends should be alarming for all of Golden Enterprises stakeholders (especially if they are considering funding $5,000,000 worth of capital expenditures in item k.). While net sales increased in 2013, Golden Enterprise also experienced a near $3,000,000 increase in SGA expenses, which is a major contributor to their loss of income. Managers at Golden Enterprise must regain that lost income in order to bring their cash flows back to adequate operating standards. d. Based on the statement of cash flows for 2012 and 2013, Golden Enterprises productive capacity has seen a significant decrease over the last three years. Despite less cash lost from investing activities and only a slight increase in cash lost due to financing activities, Golden Enterprises operations saw over a $1,000,000 decrease in net cash provided. This loss of cash will harm Golden Enterprises ability to fund projects and investments, ultimately decreasing their productive capacity. This is further evident in Golden Enterprises lost of net income in 2013 as well. There appears to be a direct

44 STATEMENT OF CASH FLOWS 38 correlation between Golden Enterprises ability to generate cash and their ability to provide a net income at a consistent level. e. Fiscal 2014 may not be the best year for Golden Enterprises to spend $5,000,000 on property, plant, and equipment. As detailed in their 2013 statement of cash flows, Golden Enterprises net cash provided from operating activities is already substantially smaller than it was in However, if Golden Enterprises deems that these capital expenditures are critical to the future operations of the company, then these purchases will be funded in large part by the cash flow from operations. Golden Enterprises covered their $4,149,678 purchase of new property, plant, and equipment in 2013 with their net cash provided from operations, but if 2014 continues to see a decline in cash provided from operating activities, Golden Enterprises might consider issuing stock to cover the entirety of the $5,000,000 capital expenditures.

45 ACCOUNTS RECEIVABLE 39 CASE 4: ACCOUNTS RECEIVABLE Accounts receivable are oral promises of the purchaser to pay for goods and services sold. Receivables are defined as claims held against customers for money, goods, or other services. They are normally collected within 30 to 60 days. Accounts receivable are often referred to as invoices, bills, or even debts. Notes receivable are written promises to pay a certain sum of money on a specified future date, while accounts receivable are oral promises that must be collected within a certain time frame. Notes receivable can be both short-term and long-term. A contra account is a general ledger account, which is intended to have its balance be the opposite of the normal balance for that account classification. A common contra account is accumulated depreciation, which accounts for depreciation on noncurrent assets such as equipment. Pearson s trade receivables have two contra accounts associated with them: provisions for bad and doubtful debts (contra asset) and anticipated future sales returns (contra revenue). Provision for bad and doubtful debts captures the amount of accounts receivable that companies can estimate will not be collected from customers. Managers will use historical data along with knowledge of customer behavior to reasonably estimate a percentage of accounts receivable that will not be paid by customers.

46 ACCOUNTS RECEIVABLE 40 Provision for sales returns captures the effect of Pearson s goods and services that a customer may return for any number of reasons. Managers will again use past data to anticipate a percentage of sales that companies can reasonably expect to be returned. In the percentage-of-sales procedure for estimating uncollectible accounts receivable, otherwise known as the income statement approach, managers estimate a percentage of credit sales that will be uncollectible based on past experience and their current credit policies. For example, if a manager estimates one percent of credit sales ($100,000) are going to be uncollectible, then $1000 is predicted as bad debt expense. The journal entry is a debit to Bad Debt Expense and a credit to Allowance for Doubtful Accounts each for $1000. The aging-of-accounts approach requires managers to set up an aging schedule, which applies a different uncollectible estimate to different age categories of accounts receivable. The aging-of-accounts procedure falls under the percentage-of-receivables approach, which produces a more accurate estimate of net accounts receivable, but it does not match cost and revenues as well as the percentage-of-sales procedure. Pearson is taking a calculated risk by extending credit to customers that it may believe to be uncollectible. They are most likely more than willing to accept an increase in their sales revenue even if there s a chance the account is uncollectible, because managers typically want their bottom line to be impressive. However, in the long run loose credit policies can harm the future cash flows of Pearson if they are not collecting on enough accounts.

47 ACCOUNTS RECEIVABLE 41 Appendix: A. i. T-account for Bad and doubtful debts : Provision for Bad and Doubtful Debts in 2009 T-Account All figures in millions Table 4.1 Provision for Bad and Doubtful Debts T-Account 76 The debited line items in the Bad and Doubtful Debts account are as follows: 5 million for exchange differences that was gained in currency exchanges, and 20 million for accounts that were written off (or utilised ). This amount is debited to the Bad and Doubtful Debts account and it should no longer count against Pearson s bad debt expense, because those accounts have also been credited to accounts receivable, removing them from the books. The credited items include 26 million for income statement movements, or bad debt expense that was estimated for this period. There is also a 3 million credit for new bad debt that was attained through a business acquisition.

48 ACCOUNTS RECEIVABLE 42 ii. Journal Entries: Journal Entries for the Provision for Bad and Doubtful Debts Account Activities for 2009 All figures in millions Provision for Bad and Doubtful Debts 5 Gain on Exchange 5 Bad and Doubtful Debt Expense 26 Provision for Bad and Doubtful Debts 26 Provision for Bad and Doubtful Debts 20 Trade Receivable 20 Loss on Business Acquisition 3 Provision for Bad and Doubtful Debts 3 iii. The provision for bad and doubtful debts is not directly reported on the income statement. However, income statement movements (bad debt expense) is reported as an operating expense. b. i. T-account for Provision for Sales Return : Provision for Sale Returns in 2009 T-Account All figures in millions Table 4.2 Provision for Sale Returns T-Account

49 ACCOUNTS RECEIVABLE 43 ii. Journal Entries: Journal Entries for the Provision for Sales Returns Account Activities for 2009 All figures in millions Sales Returns and Allowances 425 Provision for Sales Returns 425 Provision for Sales Returns 443 Trade Receivable 443 iii. The 425 million estimated sales returns appears in the sales line item of the income statement, which reflects the net amount Pearson expects to sale after returns.

50 ACCOUNTS RECEIVABLE 44 c. i. T-account for Total Trade Receivables : ii. Gross Trade Receivables in 2009 T-Account All figures in millions 1, ,049 5,641 1,419 Table 4.3 Gross Trade Receivables T-Account Journal Entries to Record Trade Receivables Activity in 2009 All figures in millions Trade Receivable 6,049 Sales 6,049 Cash 5,641 Trade Receivable 5,641

51 ACCOUNTS RECEIVABLE 45 d. Aging Schedule of Pearson s 2009 Trade Receivables: Estimation of Total Uncollectible Accounts at December 31, 2009 All figures in millions All figures in millions Balance Estimated % Uncollectible Accounts Estimated Uncollectible Within due date % months past 228 4% months past 51 25% months past 20 50% months past 4 60% months past 20 90% 18 Total 1, Table 4.4 Estimation of Uncollectible Accounts Based on this estimate, an auditor can be comfortable that the balance of the provision for bad and doubtful debt account reported in Note 22 ( 76 million) is adequate, although the estimates do not match exactly.

52 ACCOUNTS RECEIVABLE 46 e. Average Collection Period Average Collection Period Credit sales, net (in millions) 5,624 4,811 Average gross trade receivables (in millions) 1,447 1,283 Account receivable turnover Average collection period (in days) Table 4.5 Average Collection Period The average collection on accounts receivable decreased nearly three and a half days from 2008 to Any number of factors could have contributed to this decrease. Pearson may have enacted stricter credit policies and credit checks, or they may have stopped selling to customers that had a history of bad debt. f. Pearson s CFO can do many things to reduce their average collection period, ultimately aligning it more closely to McGraw Hill s. Pearson can create stricter credit policies, such as shortening the payment period. Pearson can stop selling to specific customers that they know from past experience will most likely not pay their debts. Pearson can also do a better job of expediting their internal invoice/check process.

53 REVENUE AND INVENTORY RECOGNITION 47 CASE 5: REVENUE AND INVENTORY RECOGNITION GAC s new owner, Nicki, is overseeing a couple of major changes and challenges during this fiscal year. First, Nicki altered the look of GAC s graphic shirts to create an edgier look. However, this has made it difficult for her to maintain sales levels because the new shirts drove away GAC s conservative retail base. GAC was also forced to deal with a warehouse leak that caused about half of their plain shirts to be stained or damaged in some form. Financially, GAC made the decision to move from equity financing to debt financing, which now requires it to submit annual financial statements to its bank. Nicki owns GAC. She was offered ownership after the original owner became seriously ill. Before Nicki took over ownership, the only external user of the financial statements was the IRS. However, now GAC is required to submit annual financial statements to its bank within 60 days of year-end. GAC s new loan agreement with the bank includes a covenant that requires GAC to maintain a minimum current ratio of 1.0. Violation of this covenant could force GAC to be externally audited. GAC had a couple of significant events in 2014 that could potentially affect its future operations. There is new ownership and a new financing strategy. GAC also had to deal with an inventory warehouse leak that could have caused irreparable damage to its inventory. Instead, Nicki turned this negative event into a positive by using the stained shirts to complement her new design looks.

54 REVENUE AND INVENTORY RECOGNITION 48 The custom shirt business is doing well for GAC. Because of Nicki s efforts, GAC started production of $10,000 of custom shirt orders in late August. Compared to the previous year s custom orders of only $100, it is obvious GAC and Nicki have begun to capitalize on the custom shirt market for local teams and organizations. GAC s customer base was full of conservative retailers. These retailers were not very excited about Nicki s new graphic shirt designs, and many of them cut back orders for Nicki replaced many of these customers with start-up clothing stores that were eager to offer the new designs. As mentioned above, Nicki had to work tirelessly to replace GAC s old customers with ones that were excited to sell her new designs. While she is looking forward to working with these new retailers and eager to establish her reputation as a designer with her new shirts, Nicki is worried about the management of her new customers compared to the reliability of her old customers. It was discovered in May that the warehouse where GAC s inventory is stored had a roof leak. The damage to the building was minimal, but the water did stain over half of GAC s plain shirts. While the majority of the stains could be removed, some permanently remained. Nicki was forced to market the stained look as a gritty complement to her new designs, but so far it is too early to determine the final effect of the leak on sales.