AC710 Solution - Chapter 1

Chapter 1.
Economic Environment of Accounting Information

Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses
Difficulty Rating for Exercises and Problems:
Easy: E1.22; E1.23

Medium: E1.24; E1.25; E1.26
P1.30
Difficult: E1.27; E1.28; E1.29
P1.31
QUESTIONS
Q1.1 Financial Statement Data Users.
User-Group Uses of Financial Statement Data
 Board of directors  To decide whether to declare a dividend to

shareholders
 Bondholders  To decide whether to buy (or sell) the bonds of a

given company (i.e., an investment decision)
 Corporate employees  To decide whether to seek a raise or look for

employment elsewhere
 Corporate executives  To decide whether to give a bonus to employees
 Customers  To help decide whether to buy a company’s

products (i.e., will this company be around in the
future to honor the warranty?)
 Investment advisors  To decide whether to recommend the purchase of a

company’s shares to clients (i.e., a portfolio
decision)
 Labor unions  To decide whether to seek a pay increase for union

members
 Loan officers/credit analysts  To decide whether a company merits a new or

continuing loan
 Shareholders  To decide whether to buy, sell, or hold their existing

shares in a company (i.e., an investment decision)
 Suppliers  To decide whether to extend credit to a company

(i.e., to allow the company to buy the supplier’s
products on credit)
©Cambridge Business Publishers, 2017

Solutions Manual, Chapter 1 1-1
Q1.2 GAAP Standards.
Using the analogy presented in Chapter 1 regarding the game of baseball, it is
possible to view the investment decisions of investors as a game; and, in order
to get and retain players in the “game,” there needs to be a set of rules that
establish the guidelines of how the game is played and how to win (or lose) the
game. GAAP is essentially part of that “set of rules” that helps define how the
game is played and how winners and losers will be determined. Since the game
involves making investment decisions – that is, making trade-offs of risk versus
return – GAAP essentially allows the “players” (investors) to make the best
possible trade-off decisions (i.e., the relevance attribute of accounting
information).
How do accounting standards help capital markets be or become efficient?

Recall from the chapter that the qualitative attributes of accounting information
include feedback value and predictive value. Accounting standards allow
investors to evaluate how financially successful their past investment decisions
have been (i.e., feedback value) and assist them in making the best possible
future investment decisions (i.e., predictive value)—in short, they enable
investors, and the capital markets, to behave efficiently.
Q1.3 Corporate Governance.

Corporate governance refers to the process and procedures, usually explicitly
documented in the charter of incorporation of a business, that define how and
what decisions regarding the operations of a business will be made and by
whom (i.e., the board of directors, executives who run the business, or
shareholders). Examples of typical governance issues, and the typical decision-
making group and process followed, include the following:
Governance Issue Decision-Making Group
 Create a stock option or bonus plan  Board of directors with approval of

for executives shareholders
 Issue, or increase, a cash dividend  Executives, with board of directors’

approval
 Execute a merger or acquisition  Executives, with board of directors’

approval and vote of shareholders
Having a well-defined governance program provides transparency to the capital

market that a business is, or will be, run with the least amount of agency costs.
Further, a well-defined governance program clearly delineates what rights
shareholders can expect to exercise in a given business and what
responsibilities will reside with the executives and the board of directors.

1-2 Financial Accounting for Executives & MBAs, 4th Edition
Q1.4 Risk, Return, and Accounting Information.
The return on an investment refers to the income earned on the investment,
whereas risk refers to the uncertainty associated with the expected return. In
general, risk and return are positively correlated – that is, as an investor
assumes increasing risk (i.e., increasing uncertainty about the expected return),
the investor can be expected to demand a higher rate of return.
One of the important qualitative attributes of accounting information is its

predictive value, namely that accounting information helps investors form
predictions about future investment outcomes. Thus, accounting information
helps investors better assess the risk of investing in a given company, and
hence, better assess an investment’s potential return.
Q1.5 Global GAAP.

Impediments to the acceptance of a global set of generally accepted
accounting principles include the following:
 Legal issues: In some countries (e.g., Russia), accounting standards are

set by the government and can only be changed by the passage of
federal legislation.
 Cultural issues: The extent of accounting disclosure is closely linked to
the openness of the local society. In South Korea, for instance, the
limited footnote disclosures found in annual reports from that country
strongly reflect the secretiveness that characterizes South Korean
society. At the other extreme, in the U.K., footnote disclosures are
voluminous and reflect that country’s cultural view of transparency.
 Economic issues: Accounting standards usually reflect the relative
economic development of a country. For example, in lesser-developed
countries where few acquisitions occur, there is little need for (and
hence, often an absence of) consolidation accounting standards.
Similarly, in lesser-developed countries which typically also lack
developed capital markets, the use of such accounting standards as
“mark-to-market” or “lower of cost of market” in the valuation of
marketable securities cannot be implemented.
 Governmental issues: Accounting standards usually reflect the prevailing
form of government. For instance, in Communist and Socialist countries
(e.g., China), accounting standards are heavily influenced by the notion
of centralized planning.
Continued next page

 Social issues: Accounting standards often reflect the dominant
organizational structure of a country. For example, in the U.S.,
accounting standards reflect the dominance of the corporate structure,
whereas in Italy, which is characterized by many small family-run
businesses, the accounting standards reflect the dominance of the small
firm. Although many accounting standards are applicable regardless of
firm size, it can be argued that some are not (e.g., the immediate write-
off of R&D expenditures).
Q1.6 Asymmetric U.S. GAAP.

U.S. GAAP should be changed to allow for the write-up of long-lived assets
when the fair value of the asset appreciates above its book value. This practice
is currently followed in the U.K., which provides a constructive and successful
model for implementation. In the U.K., when the value of a long-lived asset
appreciates above its current value, the increase in value is added to the asset
account, as well as to a shareholders’ equity account called the asset
revaluation reserve. Thus, the appreciation in value is not treated as current
income, but rather as a wealth increase in shareholders’ equity. The asset
revaluation reserve would presumably be reflected as part of Other
Comprehensive Income in the Shareholders’ Equity section of the balance
sheet by U.S. firms.
Under U.S. GAAP, long-term investments classified as available-for-sale may

be marked up to their current market value. Thus, adoption of a write-up
approach for long-term assets in general would put the accounting for all long-
lived assets on a consistent basis under U.S. GAAP.
Under the current circumstances wherein asset value increases are not
recognized, the balance sheets of many U.S. companies do not reflect the
current value of their long-lived assets. Thus, the presence of this asymmetric
treatment reduces the utility of the balance sheet for many investors and
investment professionals.
Q1.7 Human Assets.

Companies that are most adversely affected by the absence of a “human
assets” account on the balance sheet would include:
 Service companies (e.g., American Airlines)

 Technology companies (e.g., Microsoft)
 Pharmaceutical companies (e.g., Pfizer)
Literally, all companies are affected; but, those companies that are highly
automated (Amazon.com) or that require little contact with their customers are
likely to be less adversely affected.

Q1.8 Key Performance Indicators: Amazon.com.
Five key performance indicators (not rank-ordered) presented in the financial
statements of Amazon.com include:
1. Net income (or earnings per share)

2. Revenues
3. Cash flow from operations
4. Return on shareholders’ equity (ROE ratio)
5. Long-term debt-to-equity ratio
Five key performance indicators not presented in the financial statements of

Amazon.com (not rank-ordered):
1. Forecasted revenues
2. Future demand for Internet purchases
3. Pro forma net income (or EPS)
4. Pro forma cash flow from operations
5. Future tax policy of the U.S. government regarding Internet purchases
Q1.9 Audit Reports.

Amazon.com’s audit report was prepared by the firm of Ernst and Young, one
of the “Big Four” audit firms. Audit reports may take one of several forms:
 Unqualified, or “clean”
 Qualified (e.g., the scope of the investigation was limited; there was a
change in accounting principle with which the auditor disagreed; the
statements were prepared using a non-generally-accepted practice; or,
the existence of material uncertainties or potential material future
developments)
 Adverse (e.g., the financial statements “do not fairly present” the firm’s
financial condition or results of operations)
 Disclaimer (i.e., no opinion is issued)
Amazon.com’s audit opinion is an example of an unqualified or clean opinion.

The financial statements “present fairly” the financial position, results of
operations, and cash flows for each of the years covered by the report (i.e.
2013-2014).

Q1.10 Accounting Assumptions and Concepts.
Definitions:
 Accrual basis of accounting: a system of income measurement in which
revenues and expenses may be recognized on the income statement
regardless of whether any cash has been received or paid.
 Cash basis of accounting: a system of income measurement in which
only those amounts received (paid) in cash may be reported on the
income statement as revenue (expense).
 Going concern assumption: an assumption underpinning the accrual
basis of accounting in which a business is presumed to continue
operating for the foreseeable future (i.e., it is not going to be sold or
liquidated).
 Materiality concept: a concept that defines the required financial
statement disclosures to those items that are large or material in
amount, and hence, have decision usefulness for financial statement
users.
 Information role of accounting: a concept suggesting that accounting
information is relevant to investors when making the risk/return trade-off
decision about an investment.
 Contracting role of accounting: a concept suggesting that accounting
information is relevant to investors because accounting information can
be used to monitor and control the behavior of managers whose
preferences may diverge from shareholders.
Q1.11 Basic Financial Statements.

 Income statement: a financial statement describing the operating
performance of a business for a given period of time (e.g., a quarter, six
months, or one year).
 Balance sheet: a financial statement describing the financial health or
condition of a business as of a specific date (e.g. the end of the fiscal year).
 Statement of shareholders’ equity: a financial statement describing the
change in the shareholders’ voluntarily (capital stock) and involuntarily
(retained earnings) contributed capital to a business for a given period of
time (e.g., a quarter, six months, or one year).
 Statement of cash flow: a financial statement summarizing the cash inflows
and outflows of a business entity.
Continued next page

The interconnections, or articulation, of the basic financial statements can be
illustrated with the following diagram.
Balance Sheet Statement of

Cash Flows
Income Assets Investing
Statement Activities
Liabilities Financing
Revenues
-Expenses Activities
Net income Shareholders’ Operating
Equity Activities
Statement of
Shareholders’
Equity
 Net income (loss) results in an increase (decrease) in assets and also an

increase in shareholders’ equity on the balance sheet, with a
corresponding effect on the statement of shareholders’ equity.
 Increases (decreases) in long-term assets are reflected as investing
activities on the statement of cash flow, while changes in the long-term
liabilities and capital stock (from shareholders’ equity) are reflected as
financing activities.
 Net income (loss) results in an increase (decrease) in shareholders’
equity, but is also reflected in the operating activities on the statement of
cash flow.
Q1.12 Debt Covenants.

This is an example of an agency problem between a company’s shareholders
and its creditors. In this instance, American’s creditors are concerned about
constraining the behavior of the American Airlines’ managers and shareholders.
American’s creditors want to ensure that the airline’s managers and
shareholders do not behave in an unconstrained manner - specifically,
undertaking certain decisions or actions that might increase the credit risk of
American Airlines. By placing certain financial and decision constraints on the
company, the creditors ensure that American will have good prospects of
servicing its debt (i.e., making the regular interest payments) and repaying the
principal on a timely basis.
If American Airlines does not agree to these constraints (i.e., debt covenants), it
is unlikely that the financial institutions would be willing to extend or refinance
the loan contract.

Q1.13 Debt Covenants.
This was a classic example of the agency relationship between shareholders
and lenders. TIMET’s U.S. lenders had placed a number of restrictive
covenants on the firm’s behavior in order to keep the company from engaging
in any behavior that might reduce TIMET’s ability to pay its debt servicing or to
repay the debt itself. TIMET had no choice but to agree to these behavioral
constraints, otherwise the company would not likely get the U.S. loan.
A useful discussion here is “What happens when a firm like TIMET violates one
of its debt covenants?” Although the U.S. lender would have the legal right to
demand an immediate repayment of the loan, it is far more likely that the loan
agreement would be renegotiated, with TIMET paying higher interest charges
and fees in return for the lender not immediately calling the loan.
Q1.14 (Appendix 1A) Separation of Ownership and Management.

 Hypothetical conflict between management and shareholders:
o Managers want more income for less work
 Solution:
o Give managers a salary-plus-bonus contract in which the bonus is
linked to increased performance as defined by net income and cash
flow
 Why it works:
o Managers have the incentive to worker harder (assuming they want
more income), which should lead to higher net income, cash flow,
and share price (i.e., shareholder value)
Q1.15 (Appendix 1A) Conflicts Between Shareholders and Debtholders.

 Hypothetical conflict between shareholders and debtholders:
o Shareholders want increasing dividend payouts
 Solution:
o Debtholders lend money to firm to expand operations but covenants
associated with the loan agreement restrict dividends payments to,
for example, 50 percent of net income
 Why it works:
o Shareholders get the investment funds they need to grow the
business, and in return, agree to limit their dividend payments

Q1.16 The Going Concern Assumption.
AMR Corporation is a well-established, U.S.-based airline, and despite recent
problems in the airline industry, Ernst & Young probably assumes that the
company has the capability to survive the current turmoil. Further, with a
number of struggling airlines and mergers (e.g., United and Continental, and at
the time of this writing AMR was in talks with US Airways), the auditor may be
assuming that the merger would make the airline much stronger. Thus, the
cautionary language in the Ernst & Young report seems intended to be “cover
your backside” language for the very unlikely case that AMR Corporation did, in
fact, fail.
Q1.17 Is the Sarbanes-Oxley Act Effective?

Professor Moore’s opinion is based on a 2006 article appearing in the Academy
of Management Review. According to the article, Sarbanes-Oxley failed to
correct a “crucial accounting system weakness – the potential for the ‘moral
seduction’ of the outside auditors.” The moral seduction/corruption is possible
because:
1. Corporate executives retain too much control over the hiring and firing of
outside auditors, consequently discouraging auditors from filing critical
reports about a firm or its management.
2. Sarbanes-Oxley puts only minimal constraints on auditors subsequently
gaining employment with their clients thereby potentially encouraging
auditors to try to curry favor with their clients (i.e., as potential future
employers).
3. Sarbanes-Oxley does not restrict sufficiently the non-audit work that
auditors may do for their clients, thereby increasing the likelihood that an
auditor will yield to client demands due to financial issues.
Q1.18 Should the Sarbanes-Oxley Act Be Revised?

The criticisms leveled at the Sarbanes-Oxley Act have been substantial, and in
many cases, justified—it is unnecessarily costly in its implementation; it is unfair
to foreign and small firms; it fails to provide sufficient guidance in its application.
Nonetheless, given the large number (i.e. over 8 percent of all U.S. publicly-
listed firms) of companies that restated their earnings in the aftermath of the
passage of the Act suggests that whatever the costs, the implementation of the
Act was necessary to achieve the high standard of corporate reporting that is
expected by the capital markets in the U.S. Can the Act be improved upon?
Without doubt, and most observers believe that the Act will be modified, but not
repealed (although a case is pending before the U.S. Supreme Court regarding
the constitutionality of SOX).

Q1.19 (Ethics Perspective) Rules-based versus Principles-based Accounting.
Significant attention has been focused on the debate regarding whether the
U.S. system of GAAP is too “rules-based,” rather than simply allowing more
flexibility within a general principles-based system. An argument against the
current rules-based system is that it allows managers to stay within the letter of
the law and at the same time violate the spirit of the law. By requiring managers
to simply follow the principle of the law, violations such as those experienced at
Enron and WorldCom would be less likely.
A counter argument is that rules-based GAAP is derived from the same

principles that others would recommend. It is further argued that rules or
principles do not make people ethical. Ethics cannot be legislated. At the end
of the day, if people care about the principles, they will care about them under
either rules-based or principles-based systems, and if they choose to take an
unethical path, changing systems will do little to deter them. Ethical behavior is
a choice. Under a principles-based system, the manager will still be required to
make interpretations of the principle, and their ethical standards will still be
challenged.
Rules-based accounting provides individuals and organizations with a technical

road map, not a moral compass. It has been argued that the entire debate is a
waste of time since the law [rules-based] requires adherence to principles-
based accounting. The criminal case “Continental Vending” made principles-
based accounting the law. The case found that “statements are true, correct,
and understandable to non-accountants” is paramount to conformity to GAAP.
In addition, rule 203 of the accountants Code of Professional Conduct requires
accountants to depart from GAAP compliance if compliance would result in
misleading statements.
Finally, consider the language in the auditors’ report that accompanies a

financial statement. The standard language requires the statements to be “fairly
presented [principles-based] … in accordance with generally accepted
accounting principles [rules-based].’
(Note: This answer was based on the writings of Jasper Spencer-Scheurich,

Inez Gonzales, and Sherry Thomas.)

Q1.20. (Appendix 1B)
The preparation of the basic financial statements requires that corporate
managers make a variety of accounting policy decisions, to include (for
example) which depreciation method to utilize to depreciate a company’s
property, plant and equipment, the expected useful lives of those assets, and
their expected salvage value. These policy decisions are subject to review, and
revision, by a company’s independent auditor; and thus, most financial
statement users feel confident that the decisions and estimates adopted have
been properly vetted, and consequently, may be relied upon for purposes of
credit and investing decisions. Because of this inherent system of checks-and-
balances, companies are able to assure their creditors and investors that the
financial statements contain objective, verifiable data that is useful for their
particular decisions needs.
Q1.21. (Appendix 1B)

The historical cost concept asserts that all assets should initially be valued at
their acquisition cost. At the time of acquisition, the purchase price of an asset
clearly satisfies both informational criteria of relevance and reliability. With the
passage of time, however, an asset’s original acquisition cost becomes less
relevant, although it remains a reliable value. Instead, the current market value
of the asset, or even an asset’s liquidation value, assumes greater relevance,
although such values (except for exchange-traded assets like marketable
securities) are frequently unreliable. Thus, for a going concern following the
historical cost concept, we can see that a trade-off occurs over time in which
the informational characteristic of reliability takes precedence over the
characteristic of relevance. From the perspective of a manager with fiduciary
responsibility, and hence legal exposure, making sure that asset values are
reliable may indeed be more important than providing financial statement users
with relevant asset values. Creditors and investors may express a contrary
view.

EXERCISES
E1.22 Account Identification.
See QuestromTools Site.
E1.23 The Balance Sheet Equation.
E1.24 The Balance Sheet Equation.

Since no dividends were declared in Year 2, and since there was no additional
capital investment, the decrease in shareholders’ equity of $5,000 must have
resulted from operations; hence, there must have been a net loss of $5,000.
The increase in liabilities of $20,000 resulted in an equal increase of $20,000 in
assets; however, the net increase in assets of $15,000 reflects the increase of
$20,000 from debt, offset by the decrease of $5,000 in assets from the
operating loss.

E1.25 Key Relationships: Revenues, Expenses, Dividends, and Retained Earnings.
E1.26 Key Relationships: Revenues, Expenses, Dividends, and Retained Earnings.

Shaded figures represent the missing data for the exercise:
2013 2014 2015

Retained earnings (beginning) $(1,746.5) $(1,830.5) $(2,653.0)
Revenues $4,840.5 $5,327.0 $6,009.5

Less: Expenses (4,924.5) (5,628.0) (5,425.0)
Net income (loss) (84.0) (301.0) 584.5
Less Dividends -0- (521.5) (17.5)
Increase (decrease to retained earnings) (84.0) (822.5) 567.0
Retained earnings (end) $(1,830.5) $(2,653.0) $(2,086.0)
Common-size data:
Revenue 100% 100% 100%
Less: Expenses (102)% (106)% (90)%
Net income (2)% (6)% 10%
The company’s revenues increased each year, but it was not until 2015 that
revenues increased faster than costs. Although the modest dividend payment in
2015 appears reasonable, the large dividend in 2014 after two years of losses
appears irrational, especially since the company had paid no dividends in 2013.

E1.27 Financial Statement Results.
 Although GE’s revenues increased slightly, its net income increased at a
faster (percentage) rate. This suggests that GE was able to effectively
control expenses. That is, to increase income faster than sales implies that
costs (from revenues-expenses=net income), were growing at an even
slower rate than revenues (or even decreasing).
 GE’s had modest changes in assets and shareholders’ equity, implying that
liabilities were stable as well. Given we do not know the accounts that
comprise these subtotals, little else can be said of these changes. The
company appears rather stable.
 GE’s cash flow from operations of $27.1 billion and negative cash flow from
investing and financing activities is consistent with the company using cash
flow from operating activities to reinvest back into the company, and to
either pay down debt or return capital to shareholders, or both.
E1.28 Financial Statements Results.

 Johnson and Johnson’s revenues increased by $3.0 (4.2%), its net income
increased by $2.5 (18.1%). This would imply that expenses grow by $0.5,
from $57.5 to $58.0, less that a 1% increase in expenses. This suggests
that the company was able to effectively control expenses. That is, to
increase income faster than sales implies that expenses (from revenues-
expenses=net income), were growing at an even slower rate than revenues
(or even decreasing).
 Johnson and Johnson had modest changes in assets and shareholders’
equity, implying that liabilities were stable as well. Given we do not know the
accounts that comprise these subtotals, little else can be said of these
changes. The company appears rather stable.
 Cash flow from operations of $18.4 billion and negative cash flow from
investing but positive financing activities is consistent with the company
using cash flow from operating activities and new debt or stock issues to
help finance the company’s new investments.

E1.29 Calculating Security Returns.
r eta*
General Electric 10.5% 0.90
Phillips Electronics 2.3% 2.25
Siemens -4.9% 2.11
*(Source: Yahoo. Finance)
Clearly, GE provided the greatest return over the one year period. To evaluate
the return/risk trade off provided by each security, it would be beneficial to know
the historical standard deviation of the return on each of the three companies.

PROBLEMS
P1.30 Key Financial Statement Relations: Balance Sheet, Income Statement,
and Statement of Cash Flow.
Missing Values
2014 2015
Balance sheet:
Cash 10,000
Property, plant, and equipment (net) 140,000*
Land 4,000
Intangible assets 11,000
Wages payable 5,000
Dividends payable 2,000
Long-term debt 52,000
Treasury stock (8,000)
Income statement
Sales revenue 285,000
Interest expense 9,000
Tax expense 35,000
Statement of cash flow
Cash payment for:
Advertising (21,000)
Purchase of marketable securities (2,000)
Issuance of common stock 22,000
Change in cash 15,000
*2014 Property, plant, and equipment (PPE)

= 2015 PPE – 2015 purchase of PPE + 2015 Depreciation expense
= $223,000 - $111,000 + $28,000
= $140,000
During 2015, the company’s financial performance appears to be quite good.

Net income of $53,000 was generated on sales of $285,000, representing a
return on sales of 18.6%. The company also generated cash flows from
operations of $104,000, which more than covered the company’s dividend
payment of $45,000.

P1.31 Key Financial Statement Relations: Balance Sheet, Income Statement,
and Statement of Cash Flow.
Missing Values
2014 2015
Balance sheet:
Cash 15,000
Property, plant and equipment 162,000
Intangible assets 10,000
Accounts payable 21,000
Interest payable 8,000
Long-term debt 52,000
Treasury stock (10,000)
Income statement
Wages expense 6,000
Depreciation expense 11,000
Tax expense 8,000
Statement of cash flow
Cash collections from customers 138,000
Purchase of land (7,000)
The company’s financial performance in 2015 appears to be satisfactory,

generating net income of $18,000 on sales of $140,000, or a return on sales of
nearly 13%. Further, the company generated cash flow from operations of
$9,000, which adequately covered the cash dividends paid of $6,000.

P1.32 Creating Balance Sheets and Income Statements
Balance Sheet as of December 31, 2014 2015

Cash $100 $140
Accounts Receivable 135 230
Inventory 125 300
Other current assets 40 40
Total current assets 400 710
Property. Plant & equipment 650 735

Total assets $1,050 $1,445
Accounts payable $ 80 $90

Current portion of long-term debt 50 70
Total current liabilities 130 160
Long-term debt 490 690

Total liabilities 620 850
Common stock 300 300

Retained earnings 130 295
Total equity 430 595
Total liabilities and equity $1,050 $1,445
Income Statement for

Year ended December 31, 2014 2015
Sales $1,000 $1,500
Cost of goods sold 600 900
Gross profit 400 600
Selling, general, & administrative 175 290
Depreciation 50 60
Operating income 175 250
Interest expense 25 50
Pretax income 150 200
Income taxes 50 70
Net income $ 100 $ 130

CORPORATE ANALYSIS
CA1.33 The Procter and Gamble Company
a. Industry: Consumer goods/cleaning products
Key competitors: Johnson and Johnson
Kimberly-Clark Corporation
Key products: Crest oral care products

Charmin toilet paper
Tide laundry detergent
Bounty paper towels
Pampers diapers
Gillette razorblades
Folgers coffee
b. Financial Performance (in millions)
2015 2014 2013
Net sales $76,279 $80,510 $80,116

Net earnings $7,144 $11,785 $11,402
Return on sales (net earnings ÷ net sales) 9.4% 14.6% 14.2%
Net sales and net earnings decreased in 2015 from 2014, but increased
slightly from 2013 to 2014. This causes a decrease in the return on sales
ratio in 2015 and a slight increase in the return on sales ratio in 2014.
c. Cash Flow Performance (in millions):
2015 2014 2013

Cash flow from operations $14,608 $13,958 $14,873
Operating funds ratio (cash flow from

operations ÷ net earnings) 2.04 1.18 1.30
The trend of the cash flow from operations follows an opposite pattern from
the net earnings and net sales trends. Cash flow from operations decreases
from 2013 to 2014 and increases from 2014 to 2015. The operating funds
ratio reflects a downward trend from 2013 to 2014, but reflects a large
upward trend in 2015 due to an increase in cash flow from operations and a
large decrease in net earnings from the prior year. If the cash flow from
operating activities is consistently greater than net earnings (a ratio >1.0,
which we see here) the company’s earnings are said to be of high quality.
Continued next page

d. Financial Leverage
2015 2014
Total liabilities ÷ total assets 51.3% 51.5%
P & G is principally debt-financed, with just over 50 percent of its asset

financing coming from creditors. The percentage of debt-financing is
decreasing slightly over time.
e. Audit Report
P & G’s auditors are Deloitte & Touche LP, one of the “Big Four” firms. The
audit report indicates that Deloitte & Touche opinion that P & G’s
“…Consolidated Financial Statements present fairly, in all material respects,
the financial position of The Procter & Gamble Company and subsidiaries at
June 30, 2015 and 2014, and the results of their operations and their cash
flows for each of the three years in the period ended June 30, 2015, in
conformity with accounting principles generally accepted in the United
States of America.”
Thus, the audit report contains no exceptions or warnings to financial

statement users.
CA1.34 Internet-based Analysis.

No solution is provided since any solution would be unique to the company
selected.
CA1.35 LVMH Moet Hennessey-Louis Vuitton S.A.

a. The balance sheet equation under IFRS:
A=E+L
NCA + CA = E + (NCL + CL)
Regardless of the particular form of the balance sheet equation, the

informational content of the consolidated balance sheet is exactly the same.
In short, a balance sheet is a balance sheet regardless of the particular
GAAP in use.
Continued next page

b. Under IFRS, the noncurrent assets are listed prior to the current assets, and
noncurrent liabilities are listed before current liabilities. This listing appears
to emphasize the longer-term aspects of a business by drawing attention
first to the long-term revenue-producing assets of a business. Regardless of
the listing sequence, the informational content of the balance sheet remains
unaltered.
c. LVMH’s current assets are listed in reverse order of liquidity, with the least
liquid current assets listed first, followed by the most liquid current assets.
(Cash and cash equivalents are listed last.) Again, this listing appears to
de-emphasize the short-run aspects of a business.
d. Until 2009, U.S. GAAP defined “equity” as shareholders’ equity, to include

the residual interests of both common and preferred shareholders in the
assets and liabilities of a business. IFRS takes a narrower view, on the one
hand, by excluding the residual interest of preferred shareholders from
shareholders’ equity, while also taking a broader view by including what was
formerly called minority interest (now called noncontrolling interest) in
shareholders’ equity. U.S. GAAP has come into compliance with IFRS in
regards to the treatment of noncontrolling interest, which is now also
included in shareholders’ equity, but the treatment of preferred shareholder
capital remains divergent. The IFRS treatment of preferred shareholder
investment is more in line with the treatment afforded preferred stock by the
capital markets, which treat this account as part of a company’s mezzanine
financing, along with the company’s unsecured creditors.


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Chapter 1.

Economic Environment of Accounting Information

Difficulty Rating for Exercises and Problems:

Easy: E1.22; E1.23

User-Group Uses of Financial Statement Data

 Board of directors  To decide whether to declare a dividend to

 Bondholders  To decide whether to buy (or sell) the bonds of a

 Corporate employees  To decide whether to seek a raise or look for

 Corporate executives  To decide whether to give a bonus to employees

 Customers  To help decide whether to buy a company’s

 Investment advisors  To decide whether to recommend the purchase of a

 Labor unions  To decide whether to seek a pay increase for union

 Loan officers/credit analysts  To decide whether a company merits a new or

 Shareholders  To decide whether to buy, sell, or hold their existing

 Suppliers  To decide whether to extend credit to a company

©Cambridge Business Publishers, 2017

How do accounting standards help capital markets be or become efficient?

Q1.3 Corporate Governance.

Governance Issue Decision-Making Group

 Create a stock option or bonus plan  Board of directors with approval of

 Issue, or increase, a cash dividend  Executives, with board of directors’

 Execute a merger or acquisition  Executives, with board of directors’

Having a well-defined governance program provides transparency to the capital

©Cambridge Business Publishers, 2017

One of the important qualitative attributes of accounting information is its

Q1.5 Global GAAP.

 Legal issues: In some countries (e.g., Russia), accounting standards are

Continued next page

©Cambridge Business Publishers, 2017

Q1.6 Asymmetric U.S. GAAP.

Under U.S. GAAP, long-term investments classified as available-for-sale may

Q1.7 Human Assets.

 Service companies (e.g., American Airlines)

©Cambridge Business Publishers, 2017

1. Net income (or earnings per share)

Five key performance indicators not presented in the financial statements of

Q1.9 Audit Reports.

Amazon.com’s audit opinion is an example of an unqualified or clean opinion.

©Cambridge Business Publishers, 2017

Q1.11 Basic Financial Statements.

Continued next page

©Cambridge Business Publishers, 2017

Balance Sheet Statement of

 Net income (loss) results in an increase (decrease) in assets and also an

Q1.12 Debt Covenants.

©Cambridge Business Publishers, 2017

Q1.14 (Appendix 1A) Separation of Ownership and Management.

Q1.15 (Appendix 1A) Conflicts Between Shareholders and Debtholders.

©Cambridge Business Publishers, 2017

Q1.17 Is the Sarbanes-Oxley Act Effective?

Q1.18 Should the Sarbanes-Oxley Act Be Revised?

©Cambridge Business Publishers, 2017

A counter argument is that rules-based GAAP is derived from the same

Rules-based accounting provides individuals and organizations with a technical

Finally, consider the language in the auditors’ report that accompanies a

(Note: This answer was based on the writings of Jasper Spencer-Scheurich,

©Cambridge Business Publishers, 2017

Q1.21. (Appendix 1B)

©Cambridge Business Publishers, 2017