Solutions to Final Exam, BA 202A, Fall 1999

Solutions to Final Exam, BA 202A, Fall 1999 Solution for Marketable Securities Question: a. Since A is a trading security, its unrealized gain or loss appears in income. Since it is the only trading security left at the end of 1998, the unrealized gain of $3,000 is entirely attributed to that security. Its market value at the end of 1998 is $12,000; therefore, it was purchased for $9,000. b. Since B was the only security sold during 1998, the realized gain on the income statement for 1998, $1,000, is attributable to it. Since it was sold for $8,000, it must have been purchased for $7,000. c. Since C is a security available for sale, its unrealized gain or loss appears in the owners equity section of the balance sheet. Since it is the only such security, its unrealized loss for 1998 is $3,000. Since its market value at the end of 1998 is $5,000, it must have been purchased for $8,000. d. At the end of 1999 the only security left is C. Since the unrealized gain at that time is $1,000, its market value is $9,000. This is the amount that appears on the balance sheet. e. Since the firm had no trading securities in its portfolio at the end of 1999, there was no unrealized gain or loss for that year. f. Security A was sold for $14,000. At the end of 1998 its market value was $12,000. Therefore, the realized gain for 1999 is $2,000. Solution for Shareholders Equity Question: a. Retained earnings decreases by 10% x 100,000 shares x $20 = $200,000. There is no effect on total owners' equity. b. There is no effect on either retained earnings or total owners' equity. c. Retained earnings is not affected. Total owners' equity increases by 400 x $15 = $6,000. d. Retained earnings is not affected. Total owners' equity decreases by 4,000 x $18 = $72,000. e. Retained earnings is not affected. Total owners' equity increases by 3,000 x $19 = $57,000. f. Retained earnings is not affected. Total owners' equity increases by 10,000 x $8 = $80,000. 1

g. Retained earnings and owners' equity decrease by $5,000. h. Retained earnings and owners' equity are not affected. 2

Solution for Inventory Question: a. efifo elifo ROE= 120/500=.24 135/320=.42 ROA= 120/700=.17 135/640=.21 b. NI(FIFO) = 135000-9000 - 3000 = 123000 SHE(FIFO) = 320000-12000 = 308000 TA(FIFO) = 640000-3000 = 637000 ROE = 123 / 308 =.40 ROA = 123 / 637 =.19 c. efifo NI = 12000 + 8000 + 1000 = 129000 SHE = 500000 + 9000 = 509000 TA= 700000 + 1000 = 701000 ROE = 129 / 509 =.25 ROA = 129 / 701 =.18 3

Lease Question: If lease treated as Operating Lease: 1/1/2000 - no entry 12/31/2000: DR Operating Lease Expense 5000 (E) CR Cash 5000 (A) If lease treated as Capital Lease: 1/1/2000 - DR Leased Equipment 18024 (=5000*3.60478) (A) CR Lease Obligation 18024 (L) 12/31/2000: DR Depreciation Expense 3605 (=18024/5) (E) CR Accumulated. Dep 3605 (A) DR Interest Expense 2163 (=18024*.12) (E) CR Lease Obligation 2834 (L) CR Cash 5000 (A) a. 30000/40000 =.75 b. Assets decrease by 5000 Equity decrease by 5000 c. (30000+18024 ) / 40000 = 1.2 d. Assets decrease by 3605 + 5000 Liabilities decrease by 2834 Equity decreases by 3605 + 2163 4

Question 5: Cash Flow Statement Suppose that before you came to Haas, you were a financial manager at America Online, Inc. (AOL). Your boss, the CFO (who had never taken accounting before), had asked you to compute some cash flow measures. AOL s accounting staff just finished AOL's 1999 income statement and balance sheet (see last two pages), but was still working on the cash flow statement. In addition to the income statement and balance sheet, they provided you with the following data: 1. Depreciation expense (of property and equipment) of $300 million are included in the Cost of Revenue, 2. All merger-related charges are non-cash expenses, and 3. Net capital expenditure (cash used cash provided) amounted to $1,000 million. Required: Compute AOL s (a) operating cash flow and (b) free cash flow for the year ended June 30, 1999. (a) We compute CFO using the same method you used for the capstone project. Hence, the answer differs from the number you would find from AOL s 1999 cash flow statement. CFO = NI + non-cash expenses - Working capital (non-cash) Non-cash expenses = Dep. exp. + Amort. exp. + merger-related costs = 300 + 65 + 95 = 460 Working capital (non-cash) = (Non-cash current assets current liabilities) = (1979 887 1725) (1263 677 1155) = -64 Hence, CFO = 762 (I/S) + 460 (-64) = 1286 (b) FCF = CFO net capital expenditure = 1286 1000 = 286. 5

Question 6: Accounts Receivables You were working late reviewing AOL s trade accounts receivables. You had a few questions to ask the accounting folks, but they were all gone by 5 PM. Luckily, you found the following Note from the company s 1999 preliminary financial statements (i.e., it had not been released to the public). Excerpt from Note 2: Trade Accounts Receivables. The carrying amount of the Company's trade accounts receivables approximate fair value. The Company recorded provisions of $33 and $25 million and write-offs of $x and $y million during the fiscal years ended June 30, 1999 and 1998, respectively. Required: Use the information in the Note and the attached financial statements to answer the following questions. (a) Assume that the accounting staff used the percentage of sales approach to estimate allowance for uncollectibles. What percentage point did they use to estimate bad debt expense for fiscal 1999? Assume that all of AOL's total revenues are on credit. Provisions for bad debts = Sales * Percentage 33 (Note 2) = 4777 (I/S) * Percentage Percentage = 0.69% (b) What percentage of the gross trade accounts receivables at the end of fiscal 1999 is deemed uncollectible? Percentage deemed uncollectible = Allowance for bad debts / Gross accounts receivables = 54 / (323 + 54) (all numbers from the B/S) = 14.3% 6

Question 6 (...continued) (c) How much of the trade accounts receivables were written off in fiscal 1999? Consider the allowance account: End. Bal. = Beg. Bal. + Provisions Write-off 54 (B/S) = 34 (B/S) + 33 (Note 2) Write-off Hence, Write-off = 13. (d) You wanted to "clean up" the balance sheet by writing off an additional $10 million of uncollectible accounts. However, you knew that your boss, the CFO, would not be happy if it would have an adverse impact on the company s reported income and the tax bill. To find out if the CFO would like your idea, compute the effects of an additional $10 million write-off on the company s: Recall, the journal entry for writing off bad debts is: Dr. Allowance for bad debts 10 million Cr. Accounts Receivables 10 million (i) No effect on total current assets. A/R decreases by $10 million, but Allowance also decreases by $10 million. Hence, net A/R remains unchanged the same is true for Total current assets. (ii) No effect on income from operations. Write-off does not hit the income statement, as shown in the journal entry. (iii) Tax payment to the IRS decreases by $4 million. Write-offs are tax deductible. Hence, taxable income decreases by $10 million and tax payment decreases by $10 million * 40%. 7

Question 7: Capitalization vs. Expensing Suppose your CFO boss was a true believer that AOL's subscriber acquisition costs have future benefits, and should therefore be capitalized and amortized over their useful life (instead of the current practice of immediate expensing). In fact, you can vividly recall his annoyance when AOL changed its accounting practice from capitalizing and amortizing to immediate expensing back in July 1, 1996. For the purposes of providing additional information to the security analysts, he asked you to compute the company s fiscal 1999 income from operations as if it had never changed its accounting estimate on July 1, 1996 (as described below). Once again, the accounting folks had gone home and all you had were the attached financial statements and the following Note. Excerpt from Note 2: Subscriber Acquisition Costs and Advertising. The Company accounts for subscriber acquisition costs pursuant to Statement of Position 93-7, "Reporting on Advertising Costs" ("SOP 93-7"). As a result of the Company's change in accounting estimate, effective July 1, 1996, the Company began expensing all costs of advertising as incurred. Included in sales and marketing expense is both brand and acquisition advertising across the Company's multiple brands and was $599 million, $476 million and $453 million for the fiscal years ended June 30, 1999, 1998 and 1997, respectively. Required: Compute AOL s fiscal 1999 income from operations had AOL continued its practice of capitalizing and amortizing subscriber acquisition costs. Assume that: 1. Subscriber acquisition costs are always incurred on the first day of the fiscal year. 2. Capitalized costs are amortized over a period of two years, using the straight-line method. 3. Unamortized subscriber acquisition costs (reported under Other Assets ) amounted to $314 million on June 30, 1996 (the end of fiscal 1996). Since the capitalized costs are amortized over 2 years, the subscriber costs incurred in 1997 would be amortized equally in 1997 and 1998. The costs incurred before 1998 (including the $314 million unamortized costs on 6/30/1996) would have no impact on 1999 s amortization expenses. Thus the amortization expenses for 1999 are related to the amortization of acquisition costs incurred in 1998 and 1999 only = 476/2 + 599/2 = $538 million To compute the adjusted income from operations, you need to (i) back out the immediate expensing of $599 acquisition costs in 1999 from reported income and (ii) subtract the amortization expenses of $538. i.e., Income from operation (under capitalization) = 458 (I/S) + 599 (Note 2) 538 (above) = $519 million. 8

Question 8: Long-term Liabilities Finally, the CFO asked you to review the company s long-term liabilities, especially the convertible notes. He was concerned about the company s ability to pay interest and the effect of future conversions on the company s balance sheet. To prevent any potential problems, the CFO was considering buying back the entire outstanding convertible notes from the holders (at market prices). He asked you to help him form a decision. Once again, you picked up the financial statements and found Note 12 regarding the convertible notes (yes, the accounting folks were gone for the day): Excerpt from Note 12 (modified):... On November 17, 1997, the Company sold $350 million of 4% Convertible Subordinated Notes due November 15, 2002 (the Notes ). The Notes are convertible into the Company s common stock at a conversion rate of 76,000 shares of common stock for each $1 million principal amount of the Notes... During fiscal 1999, 6.8 million shares of common stock were issued related to conversions... At June 30, 1999, the fair value of the Notes exceeded the book value by $2 billion as estimated by using quoted market prices... As of June 30, 1999, the book value of the Notes was $256 million,... You also found that: (i) Interest on the notes is payable semiannually on June 30 and December 31. (ii) The notes were issued at a time when the effective interest rate was 4% Required: (a) What are the interest expense and interest payment for the 6-month period from July 1, 1999 to December 31, 1999 (for part (a), assume there are no conversions/repurchase of Notes in this period). Since coupon rate = effective rate at issuance of the notes, therefore the notes are issued at par. Book value = face value over the entire life of the notes. Interest expense = interest payment = book value * semi-annual interest rate = 256 * (4% / 2) = $5.12 million 9

Question 8 (...continued) (b) According to Note 12, during fiscal 1999, 6.8 million shares of common stock were issued related to conversion of notes. Which balance sheet accounts were affected by the conversion and by how much? 6.8 million shares of common stock is issued for the conversion of about $89 million (= 6,800,000 / 76,000) principal amount of notes. Recall that the notes are issued at par. Hence, the book value of the notes converted is also equal to $89 million. The journal entry for the conversion: Dr. Bond payable 89,000,000 Cr. Common Stock (0.01 par value) 68,000 Cr. Additional paid-in capital 88,932,000 Hence, Bond payable (liability) decreases by $89 million and shareholders equity (common stock and additional paid-in capital) increases by $89 million. (c) Suppose that AOL repurchased the entire outstanding convertible notes on July 1, 1999 (i.e., the first day of fiscal 2000). Compute the effect of this transaction on the company s fiscal 2000 income statement. Assume that AOL can purchase the notes at the closing market prices on June 30, 1999 and that the tax rate is 0%. Note 12 states that the fair value of the Notes exceed the book value by $2 billion. Hence, if AOL repurchased the notes on July 1, 1999, it would have to recognize a book loss of $2 billion. This loss is reported in the income statement (under Extraordinary loss on the early retirement of debt). (d) Which balance sheet accounts would be affected by the repurchase of the notes and by how much? Journal entry for the notes repurchase (dollar figures in millions): Dr. Bond payable 256 Dr. Extraordinary loss on the early retirement of debt 2,000 Cr. Cash 2,256 Bond payable (liability) decrease by $256 million and cash (asset) decreases by $2,256 million. Moreover, retained earnings (S/E) decrease by $2,000 million, as the extraordinary loss passes through income. 10

Attachments for Questions 5-8: Selected portions of America Online s 1999 financial statements. AMERICA ONLINE INC Income Statement Year ended (Amounts in millions, except per share data) June 30, 1999 Revenues: Subscription services $3,321 Advertising, commerce and other 1,000 Enterprise solutions 456 Total revenues 4,777 Costs and expenses: Cost of revenues 2,657 Sales and marketing 808 Product development 286 General and administrative 408 Amortization of goodwill and other intangible assets 65 Merger-related charges 95 Total costs and expenses 4,319 Income from operations 458 Other income, net 638 Income before provision for income taxes 1,096 Provision for income taxes (334) Net income $762 Earnings per share: Earnings per share-diluted $0.60 Earnings per share-basic $0.73 Weighted average shares outstanding-diluted 1,277 Weighted average shares outstanding-basic 1,041 11

AMERICA ONLINE INC Balance Sheet (Amounts in millions, except per share data) June 30, 1999 June 30, 1998 ASSETS Current assets: Cash and cash equivalents $887 $677 Short-term investments 537 146 Trade accounts receivable, less allowances of $54 323 192 and $34, respectively Other receivables 79 93 Prepaid expenses and other current assets 153 155 Total current assets 1,979 1,263 Long-term assets: Property and equipment at cost, net 657 503 Investments including available-for-sale securities 2,151 531 Product development costs, net 100 88 Goodwill and other intangible assets, net 454 472 Other assets 7 17 Total assets $5,348 $2,874 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Trade accounts payable $74 $120 Other accrued expenses and liabilities 795 461 Deferred revenue 646 420 Accrued personnel costs 134 78 Deferred network services credit 76 76 Total current liabilities 1,725 1,155 Long-term liabilities: Notes payable 348 372 Deferred revenue 30 71 Other liabilities 15 7 Deferred network services credit 197 273 Total liabilities 2,315 1,878 Stockholders' equity: Common stock, $.01 par value; 1,800,000,000 shares authorized, 1,100,893,933 and 973,150,052 shares issued and outstanding at June 30, 1999 and 1998, respectively 11 10 Additional paid-in capital 2,703 1,431 Unrealized gain on available-for-sale securities, net 168 145 Retained earnings (accumulated deficit) 151 (590) Total stockholders' equity 3,033 996 $5,348 $2,874 12

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