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Ryerson University
ACC 110
Marla Spergel

CHAPTER 12 Analyzing and Interpreting Financial Statements EXERCISES E12-1. a. This is a transitory element since reorganizations are infrequent events. b. The increase will apply in future periods so this is a permanent element. c. Could be either. Inventory writedowns are common in many industries. Whether its permanent or transitory depends on the nature of the business and the size of the writedown. (Even in a business where inventory writedowns are expected, an usually large one would be considered transitory. d. Losses on the sale of land are generally transitory since they wont likely be recurring events, unless the entity is a real estate company. E12-3. a. The income of the new business isnt included in the years financial statements (because it was purchased near the end of the year) so predicting the next years income based on those statements would be difficult. It would be necessary to include an estimate of the new divisions income into the IFRS statements. b. By expanding into a new market revenues and expenses will increase. Because the expansion occurred late in the year the full impact isnt reflected in the financial statements and so they arent fully useful to predict the next years income. c. There is no established track record of past performance and the rapid change ensures that the insights that can be gained from the historical IFRS financial statements are very limited. d. The earnings in the future may be greater or less than in the past since the closing of the plants will eliminate costs, but the market is shrinking and competitors will likely drive down prices to maintain market share. The impact of the contraction wont appear in the financial statements until later, after the company has operated for a period under the new situation. e. Software products tend to have very short life cycles and new products can easily displace existing ones. The predictive value of financial statements in industries where change is rapid is limited. Copyright 2010 McGraw-Hill Ryerson Ltd. 1 E12-5. a. Amqui Inc. Trend Balance Sheets As of December 31, 2014 2013 2012 Cash 0.900 1.200 1.000 Accounts receivable 1.503 1.326 1.000 Inventory 1.317 1.022 1.000 Other current assets 1.500 1.375 1.000 Total current assets 1.356 1.178 1.000 Property, plant, and equipment (net of depreciatio1.378 1.135 1.000 Total assets 1.370 1.150 1.000 Bank loans 2.100 1.191 1.000 Accounts payable and accrued liabilities 1.208 1.079 1.000 Total current liabilities 1.544 1.121 1.000 Long-term liabilities 1.400 1.240 1.000 Capital shares 1.000 1.000 1.000 Retained earnings 2.099 1.489 1.000 Total liabilities and shareholders' equity 1.370 1.150 1.000 Amqui Inc. Trend Income Statements For the years ended December 31, 2014 2013 2012 Revenue 1.210 1.120 1.000 Cost of sales 1.172 1.090 1.000 Gross margin 1.246 1.149 1.000 Selling and marketing expenses 1.145 1.050 1.000 General and administrative expenses 1.145 1.050 1.000 Depreciation 1.304 1.217 1.000 Miscellaneous expenses 1.318 1.220 1.000 Interest expense 1.875 1.500 1.000 Income before taxes 1.288 1.246 1.000 Income tax expense 1.098 1.250 1.000 Net income 1.354 1.245 1.000 b. Copyright 2010 McGraw-Hill Ryerson Ltd. 2 From the trend financial statements, we see that cost of sales is increasing more slowly than sales and, as a result, the gross margin has increased over the three year period. Also, selling, general, and administrative expenses are growing slightly more slowly than revenues but interest expense, depreciation and other expenses are growing more rapidly. The overall effect is that net income has increased over 35% over the three years while sales have increased 21%. This indicates that the company has managed its costs effectively. The major reason that net income has increased faster than revenues is that cost of goods sold and selling, general, and administrative expenses have increased at a slower rate than sales. On the trend balance sheets, we see that liabilities are increasing faster than assets, which is related to the fact that capital assets are increasing faster than revenues. We might suppose that the increased capital expenditure has brought efficiencies that have increased gross margins but that has been at the cost of higher interest expense. The amount of bank loans has increased sharply, as has long-term debt, which could be related purchases of capital assets. Also, inventory has increased faster than cost of sales (you would expect them to grow at about the same rate) and accounts receivable have grown much faster than sales, which is a cause for concern because this indicates difficulty collecting receivables (or perhaps a relaxing of credit terms to boost sales). c. These financial statements enable us to see the trends in various accounts without the absolute size of the numbers obscuring the changes. The trend statements also make it possible to compare changes in the individual accounts over time. Its more difficult to infer changes from the original statements. d. Without the original financial statements, the trends have little explanatory power. When we try to rely on the trend statements alone to understand what is happening, we can easily draw faulty conclusions. So while eliminating absolute size from the statements makes trends and changes clearer, without perspective on the significance of each of the numbers, the ability to draw conclusions is impaired. For example, from the trend statements alone, one could become very concerned about a large percentage increase when the absolute dollar amount makes the concern unimportant. E12-7. a. Lameque Corp. Common Size Income Statements For the Years Ended March 31 2015 2014 2013 Sales 1.000 1.000 1.000 Cost of sales 0.548 0.526 0.528 Gross margin 0.452 0.474 0.472 Expenses Selling and marketing 0.070 0.064 0.071 Copyright 2010 McGraw-Hill Ryerson Ltd. 3 Advertising and promotion 0.106 0.095 0.099 General and administrative 0.045 0.040 0.039 Depreciation 0.052 0.053 0.054 Interest 0.070 0.064 0.071 Unusual income (0.087) n/a n/a Income before income taxes 0.196 0.158 0.138 Income tax expense 0.035 0.031 0.031 Net income 0.161 0.127 0.107 Lameque Corp. Trend Income Statements For the Years Ended March 31 2015 2014 2013 Sales 1.186 1.077 1.00 Cost of sales 1.230 1.074 1.00 Gross margin 1.136 1.081 1.00 Expenses Selling and marketing 1.176 0.968 1.00 Advertising and promotion 1.272 1.035 1.00 General and administrative 1.358 1.105 1.00 Depreciation 1.154 1.058 1.00 Interest 1.176 0.968 1.00 Unusual income n/a n/a n/a Income before income taxes 1.672 1.232 1.00 Income tax expense 1.333 1.067 1.00 Net income 1.770 1.280 1.00 b. Lameque Corp. has generally performed quite well over the three year period. Gross margin has increased over the three-year period, although we cant tell how that compares to other firms in the industry. From the common-sized financial statements, we observe that the cost of sales was approximately constant in 2013 and 2014, but increased as a percentage of sales by almost 2% in 2015, which suggests that the company has experienced cost increases that it isnt able to pass on to customers. Most other expenses increased as a percentage of sales in 2015 versus 2014 (the exception is depreciation). The increased profit margin is due to the unusual income, which at 8.7% to the bottom line. As a result the improvement should be interpreted carefully since ongoing costs have increased on a proportional basis over the three years for almost all accounts. The trend statements reinforce this analysis, with cost of sales, selling and marketing expenses, and advertising and promotion expenses increases more quickly than sales. This suggests that costs in these categories arent being well controlled. Without more details, it isnt possible to arrive at a definite conclusion about the performance of the company. However, all the trends are consistent with a company that is Copyright 2010 McGraw-Hill Ryerson Ltd. 4
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