Chapter 1

Introduction to Financial Reporting

PROBLEMS

PROBLEM 1-1

1. b 6. i

PROBLEM 1-2

1. o 6. e 11. h

PROBLEM 1-3

a. 2 Typically, much judgment and estimates go into

the preparation of financial statements.

b. 4 Financial accounting is not designed to measure

directly the value of a business enterprise.

The end result statements can be used as part of

the data to aid in estimating the value of the

business.

c. 4 FASB Statement of Concepts No. 2 lists

timeliness, predictive value, and feedback value

as ingredients of the quality of relevance.

d. 2 The Securities and Exchange Commission has the

primary right and responsibility for generally

accepted accounting principles. They have

primarily elected to have the private sector

develop generally accepted accounting principles

and have designated the Financial Accounting

Standards Board as the primary source.

e. 4 The concept of conservatism directs that the

measurement with the least favorable effect on

net income and financial position in the current

period be selected.

f. 3 The Internal Revenue Service deals with Federal

tax law, not generally accepted accounting

principles.

g. 5 Opinions were issued by The Accounting Principles Board.

 

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Chapter 7

Long-Term Debt-Paying Ability

PROBLEMS

PROBLEM 7?1

     Earnings before interest and tax:

       Net sales                              $1,079,143

       Cost of sales                         (   792,755)

       Selling and administration            (   264,566)

                                              $   21,822

a.  

b.   Cash basis times interest earned:

    

PROBLEM 7?2

                          Recurring Earnings Excluding Interest

                          Expense, Tax Expense, Equity Earnings,

a. Times Interest Earned = and Minority Earnings               

                          Interest Expense, Including

                          Capitalized Interest

   Income before income taxes         $675

   Plus interest                    60

   Adjusted income                $735

   Interest expense               $ 60

     Times Interest Earned = $735 = 12.25 times per year

                             $60

b.  

   Adjusted income from (part a)        $735

   1/3 of operating lease payments

     (1/3 x $150)                         50

   Adjusted income, including rentals   $785

   Interest expense                     $ 60

   1/3 of operating lease payments        50

                                        $110

   Fixed Charge Coverage = $785 = 7.14 times per year

                           $110

PROBLEM 7?3

                           Recurring Earnings, Excluding Interest

                           Expense, Tax Expense, Equity Earning,

a. Times Interest Earned = and Minority Earnings________________              

                           Interest Expense, Including

                           Capitalized Interest

   Income before income taxes and

     extraordinary charges              $36

   Plus interest                           16

   (1) Adjusted income                     52

   (2) Interest expense                 $16

   Times Interest Earned: (1) divided by (2) = 3.25 times per year

                           Recurring Earnings, Excluding Interest

                           Expense, Tax Expense, Equity Earnings,

                           and Minority Earnings + Interest Portion

b. Fixed Charge Coverage = Of Rentals______________________________                       

                           Interest Expense, Including Capitalized

                           Interest + Interest Portion Of Rentals

   Adjusted income (part a)             $ 52

   1/3 of operating lease payments

     (1/3 x $60)                         20

   (l) Adjusted income, including rentals      $72

  

   Interest expense                     $16

   1/3 of operating lease payments       20

   (2) Adjusted interest expense        $36

   Fixed charge coverage: (1) divided by (2) = 2.00 times per year

PROBLEM 7?4

a. Debt Ratio =

b. Debt/Equity Ratio =

c. Ratio of Total Debt to Tangible Net Worth =

   Total Liabilities  =      $174,979     = $174,979 = 70.9%

   Tangible Net Worth   $249,222 ? $2,324   $246,898

d. Kaufman Company has financed over 41% of its assets by the use of funds from outside creditors. The Debt/Equity Ratio and the Debt to Tangible Net Worth Ratio are over 70%. Whether these ratios are reasonable depends upon the stability of earnings.

PROBLEM 7-5

PROBLEM 7?6

a. Times Interest Earned:

Times interest earned relates earnings before interest expense, tax, minority earnings, and equity income to interest expense. The higher this ratio, the better the interest coverage. The times interest earned has improved materially in strengthening the long?term debt position. Considering that the debt ratio and the debt to tangible net worth have remained fairly constant, the probable reason for the improvement is an increase in profits.

The times interest earned only indicates the interest coverage. It is limited in that it does not consider other possible fixed charges, and it does not indicate the proportion of the firms resources that have come from debt.

Debt Ratio:

The debt ratio relates the total liabilities to the total assets.

The lower this ratio, the lower the proportion of assets that have been financed by creditors.

For Arodex Company, this ratio has been steady for the past three years. This ratio indicates that about 40% of the total assets have been financed by creditors. For most firms, a 40% debt ratio would be considered to be reasonable.

The debt ratio is limited in that it relates liabilities to the book value of total assets. Many assets would have a value greater than book value. This tends to overstate the debt ratio and, therefore, usually results in a conservative ratio. The debt ratio does not consider immediate profitability and, therefore, can be misleading as to the firm¡¯s ability to handle long?term debt.

Debt to Tangible Net Worth:

The debt to tangible net worth relates total liabilities to shareholders' equity less intangible assets. The lower this ratio, the lower the proportion of tangible assets that has been financed by creditors.

Arodex Company has had a stable ratio of approximately 81% for the past three years. This indicates that creditors have financed 81% as much as the shareholders after eliminating intangibles from the shareholders contribution??for most firms, this would be considered to be reasonable. The debt to tangible net worth ratio is more conservative than the debt ratio because of the elimination of intangible items. It is also conservative for the same reason that the debt ratio was conservative, in that book value is used for the assets and many assets have a value greater than book value. The debt to tangible net worth ratio also does not consider immediate profitability and, therefore, can be misleading as to the firm's ability to handle long?term debt.

Collective inferences one may draw from the ratios of Arodex, Company:

Overall it appears that Arodex Company has a reasonable and improving long?term debt position. The debt ratio and the debt to tangible net worth ratios indicate that the proportion of debt appears to be reasonable. The times interest earned appears to be reasonable and improving.

The stability of earnings and comparison with industry ratios will be important in reaching a conclusion on the long?term debt position of Arodex Company.

b. Ratios are based on past data. The future is what is important, and uncertainties of the future cannot be accurately determined by ratios based upon past data.

Ratios provide only one aspect of a firm's long-term debt-paying ability.  Other information, such as information about management and products, is also important.

A comparison of this firm's ratios with ratios of other firms in the same industry would be helpful in order to decide if the ratios are reasonable.

PROBLEM 7?7

                       Recurring Earnings, Excluding Interest

a. 1. Times Interest   Expense, Tax Expense, Equity Earnings,

        Earned       = and Minority Earnings_________________                  

                       Interest Expense, Including

                       Capitalized Interest

         $162,000 = 8.1 times per year

         $ 20,000

2. Debt Ratio =  Total Liabilities

                    Total Assets

                    $193,000 = 32.2%

                    $600,000

3. Debt/Equity Ratio = Total Liabilities  

                          Stockholders' Equity

                    $193,000 = 47.4%

                    $407,000

   4. Debt to Tangible Net Worth Ratio = Total Liabilities

                                         Tangible Net Worth

                        $193,000        = 49.9%

                    $407,000 ? $20,000

b. New asset structure for all plans:

                    Assets

          Current assets                $226,000

          Property, plant, and

             equipment                  554,000

          Intangibles                     20,000

          Total assets                  $800,000

   Liabilities and Equity

   Plan A

   Current Liabilities         $ 93,000  $200,000,000/100 =

   Long?term debt              100,000  2,000,000 shares

   Preferred stock             250,000

   Common equity               357,000  No change in net income

                               $800,000

   Plan B

   Current liabilities         $ 93,000  $200,000,000/10 =

   Long?term debt              100,000  20,000,000 shares

   Preferred stock               50,000

   Common stock                120,000

   Premium on common stock     300,000

   Retained earnings           137,000  No change in net income

                               $800,000

   Plan C

   Current liabilities         $ 93,000  Operating Income  $162,000

   Long?term debt               300,000  Interest expense    52,000*

   Preferred stock               50,000                     110,000

   Common equity                357,000  Taxes (40%)         44,000

                                $800,000  Net Income        $ 66,000

   *  $20,000 + 16% ($200,000) = $52,000

1.               Recurring Earnings, Excluding Interest Expense,

   Times Interest  Tax Expense, Equity Earnings, and Minority Earnings

       Earned   =  Interest Expense, Including Capitalized Interest

  

      Plan A         Plan B          Plan C

         

2. Debt   = Total Liabilities 

   Ratio       Total Assets

      Plan A             Plan B        Plan C

                

3. Debt/Equity Ratio =

      Plan A         Plan B          Plan C

          

4. Debt to Tangible Net Worth =

   Plan A                 Plan B                Plan C

     

c. Preferred Stock Alternative:

   Advantages:

1. Lesser drop in earnings per share than under the common stock alternative.

2. Not the absolute reduction in earnings that accompanied the debt alternative.

   3. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and Total Debt to Tangible Net Worth Ratio.

4. Does not have the reduced times interest earned that accompanied alternative of issuing long?term debt.

Disadvantages:

1. An increase in the fixed preferred dividend charge that the firm must pay before any dividends can be paid to common stockholders.

Common Stock Alternative:

   Advantages:

   1. No increase in fixed obligations.

   2. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and the Total Debt to Tangible Net Worth Ratio.

   3. Not the absolute reduction in earnings that accompanied the debt alternative.

   4. Does not have the reduced times interest earned that accompanied alternative of issuing long?term debt.

Disadvantages:

1. Maximum dilution in earnings per share of the three alternatives.

   Long-Term Bonds Alternative:

   Advantages:

   1. Higher earnings per share than with common stock.

Disadvantages:

   1. Material decline in Times Interest Earned.

   2. A material increase in the Debt Ratio, Debt/Equity Ratio,

      and Total Debt to Tangible Net Worth Ratio.

   3. Absolute reduction in earnings.

   4. Increase in the interest fixed charge that must be paid.

d. The 10% preferred stock increased the preferred dividends which are not tax deductible; therefore, the cost of these funds is the 10% amount. The 16% bonds are tax deductible and, therefore, the after-tax cost is 9.6% (16% x (1?.40).

Note to Instructor: You may want to take this opportunity to point out to the students that the alternative that should be selected is greatly influenced by the change in earnings and the specific debt structure. The conclusions in this problem would not necessarily be true with changed assumptions.

PROBLEM 7?8

a. Times Interest Earned =

   Earnings from continuing operations before

   income taxes and equity earnings

   (1) Add back interest expense        (1)  $ 74,780,000

   (2) Adjusted earnings                (2)  $ 37,646,000

                                             $112,426,000

   Times interest earned: [(2) divided by (1)]  1.99 times

                                                   per year

b. Earnings from continuing operations

   Plus:

   (1) Interest                         $ 65,135,000

       Income taxes                        37,394,000

   (2) Adjusted earnings                $140,175,000

   Times interest earned: [(2) divided by (1)]  3.72 times

                                                   per year

c. Removing equity earnings gives a more conservative times interest earned ratio.  The equity income is usually substantially more than the cash dividend received from the related investments.  Therefore, the firm cannot depend on this income to cover interest payments.

PROBLEM 7?9

a. 1. Times Interest Earned =

                

   2. Debt Ratio =

   3. Debt Equity =  

   4. Debt to Tangible Net Worth =

     

                  

b. No, Barker Company has a times interest earned of 5.3 times while the industry average is 7.2 times.  This indicates that Barker Company has less than average coverage of its interest.  Also, Barker Company has a much higher than average debt/equity, and debt to tangible net worth ratio.

c. Allen Company has a better times interest earned, debt ratio, debt/equity, and debt to tangible net worth.

PROBLEM 7-10

a. 1. Times Interest Earned =

      2004:    $280,000 - $156,000     = 7.29 times per year

                    $17,000

      2003:    $302,000 - $157,000     = 9.06 times per year

                    $16,000

      2002:    $286,000 - $154,000     = 8.80 times per year

                    $15,000

      2001:    $270,000 - $150,000     = 8.28 times per year

                    $14,500

      2000:    $248,000 - $147,000     = 4.39 times per year

                    $23,000

                             Recurring Earnings, Excluding

                             Interest, Tax Expense, Equity

                             Earnings, and Minority Earnings +

   2. Fixed Charge Coverage = Interest Portion of Rentals    

                             Interest Expense, Including

                             Capitalized Interest + Interest

                             Portion of Rentals

      2004:    $280,000 - $156,000 + $10,000     = 4.96 times per year

                    $17,000 + $10,000

      2003:    $302,000 - $157,000 + $9,000 = 6.16 times per year

                    $16,000 + $9,000   

  

      2002:    $286,000 - $154,000 + $9,500 = 5.78 times per year

                    $15,000 + $9,500

      2001:    $270,000 - $150,000 + $10,000     = 5.31 times per year

                    $14,500 + $10,000

      2000:    $248,000 - $147,000 + $9,000 = 3.44 times per year

                    $23,000 + $9,000

   3. Debt Ratio = Total Liabilities

                   Total Assets

      2004:    $88,000 + $170,000           = 46.07%

                   $560,000

      2003:    $89,500 + $168,000           = 46.48%

                   $554,000

      2002:    $90,500 + $165,000           = 46.14%

                   $553,800

      2001:    $90,000 + $164,000           = 46.31%

                   $548,500

      2000:    $91,500 + $262,000           = 65.83%

                   $537,000

   4. Debt/Equity =  Total Liabilities

                   Shareholders' Equity

      2004:    $88,000 + $170,000           = 85.43%

                   $302,000

      2003:    $89,500 + $168,000           = 86.85%

                   $296,500

      2002:    $90,500 + $165,000           = 85.65%

                   $298,300

      2001:    $90,000 + $164,000           = 86.25%

                   $294,500

      2000:    $91,500 + $262,000           = 192.64%

                   $183,500

   5. Debt to Tangible Net Worth =   Total Liabilities 

                                  Shareholders' Equity -

                                  Intangible Assets

      2004:    $88,000 + $170,000           = 91.49%

              $302,000 - $20,000

      2003:    $89,500 + $168,000           = 92.46%

              $296,500 - $18,000

      2002:    $90,500 + $165,000           = 90.83%

              $298,300 - $17,000

      2001:    $90,000 + $164,000           = 91.20%

              $294,500 - $16,000

      2000:    $91,500 + $262,000           = 209.79%

              $183,500 - $15,000

b. Both the times interest earned and the fixed charge coverage are good.  The times interest earned is substantially better than the fixed charge coverage because of the operating leases.  Both of these ratios materially declined in 2004.

   The debt ratio, debt/equity, and debt to tangible net worth materially improved between 20## and 2001.  During the period 20##-2004, these ratios were relatively steady and appeared to be good.  The debt to tangible net worth ratio is not as good as the debt/equity ratio because of the influence of intangibles.