Understanding Financial Statements 69

.R,E VIEW QUESTIONS AND ,P ROBLEMS

Questions

J. What four financial statements

. ;
are.contained in .most·annual reports?

2. Who are some of the basic users of financial statements, and how do they
use them? , , ,,

3. If a typical firm reports P20 million of retained earnings on its statement

of financial pos_ition, could its directors declare a P20 million cash
dividend without having any qualms about what they are doing? Explain
your answer.

4. Explain the following statement: "While the statement of financial

position cart be .thought of as~ snapshot of a firm's financial position at a
· point in time, the income statement reports on operations over a period of
time." ·

5. Financial statements are based on financial reporting standards ancLare

audited by CPA firms. Do investors.need to worry about the validity of
tho~e statements? Explain your answer. .

6. How is the income statement related to the statement of financial position?

7. Comment on why inflation may restrict the usefulness of the statement of

financial position as normally presented.

8. Explain why the statement of cash flows provides useful information that
goes beyond incolT)e statement and statement of financial position data.

9. · What are the three primary sectiors of the statement of cash flows? In what
section would the payment of a cash dividend be shown?

I 0. What is free cash flo.w? Why is it il1,'lportant to leveraged buyouts?

11. Why is interest ~xpense said to cost 'ihe firm substantially less than the
actual expense, while dividends cost it 100 percent·ofthe Qutlay?
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70 , Chapter 5

12. Classify' the foll9wing statement of financial position items as current or

noncurrent. • 1

Reta'ined earnings Bonds payable

Accounts payable Accrued .wages payable
Prepaid expenses · Accounts receivable
Plant and equipment . Capital in·excess of par
Inventqry ·Pref~rr~ stock ,
Common stock · Marketable securities

13. Arrange.the following in~nte_statement items so they. are in the proper

order of an income statement.

Taxes Earnings per share

;-- ,
Gross profit shares outstai:iding Earnings before taxes
Cost of goods sold
I
Interest-expense I t

Depreciation expense Earnings ~fter taxes

SFlling an~ administrative Earnings available tq comm'on
expense stockholders
Sales Preferred stock dividends
Gross profit Operating profit
I
i '"'

14. Identify wheth~r each of the following items ircreases or decre~ses cash \

flow. · · l

Increase in accounts receivable Decre~e in prep~id expense,s

Increase in notes payable · Increase in inventory
Depreciinion expense ' . · Dividend payment ·
Increase in investments :Increase in accr~ed expenses
Decrease in accounts payable ·

.15. Fi"II in the b'lank spaces with categories I through 7helow.

I. Statement ofFinancial Position 5. ·current Liab11ities (Cl'...)

2. Income Statement (IS) 6. Long-term Liabilities (LL)
3. Current Assets (CA) 7. Stockholders' :Equity (SE)
4: Fixed Assets (FA) I

.!

J
 {/nderstanding_ Financial Statements 71
Indicate
( If on Item
whether Items is Statement of ·
on ·Statement of Financial
Financial Position,
.. Position .or Designate
In<;OT[le · which ./

. Statement ([SJ Category

· Retained earnings ·
_ Income tax expense
Accounts receivable
Common stock
Capital in excess of par value
Bonds payable
,· Notes payable
Net income
Selling and administrative expenses
Inventories
Accrued expenses
Cash
- Plant and equipment
Sales
Operating.expenses
Marketable securities
Accounts payable
Interest expense
Income tax payable .

·,
-~ - _..H"'V"lf""'f WIUM a:at -m . . ... , . C I 15 ....---..
 11 Chapter 5

Problems

Problem 1 (Statement of Financial Position)

The {lSsets of J&R Associates consist entirely of current assets and net plant and
equipment. The firm has total assets of P2.5 million, and net plant and equipment
of P2 million. It has notes payable of Pl 50,000," long-term debt of P750,000, and
total common equity of p 1.5 million·. The firm does have accounts payable and
accl'\lals on its statement of financial position. The firm only finances •with debt
and common equity, so it has no preferred stock on its statement of financi~I
position.

Require.d:

a. What is the.amount oftotaniabilities and equity that appears on the firm's ·

. stat~ment oftinancial position? . · .
b. What is the balance of current assets on the firm's statement of financial ' .
position? ·
c. What is the balance of current liabilities on the firm's statement of financial ' 1
position?
d. What is the amount of accounts payable, and accruals on its statement of
financial position? ·
e. ,What is the firm's net wor~ing capital?
) f. What is the firm's net operating working capital?

Problem 2 (Statement of Stockholders' Equity)

In its most recent financial statements, Newhouse Inc. reported PSO million of net
income and P810 million of retained earnings. Jhe' previous retained earnings were '. ·
P780 million.

Required:

How much in dividends were paid to shareholders during the year? Assume that ·
all dividends declared were actually paid.

Problem 3 (Book Value and PIE ratio)

Jennifer',s App~rel has total assets of P8Q0,00.0, current liabilities of Pl 50,000, and ·
long-tenn liabilities ·ofp.120,000 ..rhere is P65,000 in preferred stock outstanding.
Thirty thousand shares of common stock have been isslied. · '
 llnderstandir,g Financial StaJemenJs 13
Required:

a. Compute_ book value (net worth) per share. . ,

b. If thefe5
is P48,000 in earnings available to common stockholders and the
finn ' stock
.of the stock? , has a .
P IE of IS times earnings per share, what is the current price

c. What is the.ratio of market value per share to book value per share? (Round
off to .two places to the right of the decimal point.) .
d. If the firm sells at two times book value per share, what will the PIE ratio be?
(Round off to the nearest whole number.) . ·

Problem 4 (Determination of Profitability)

The Red ~ook Inc. sold J,300 finance textbooks for P6S0 each to Brilliant ·
University in 20XS. These books cost Red Book Inc. P4S0 to produce .. Book
Inc. spent P20,000 (selling expense) to convince the university to buy its books. In
addition, Re~ Book Inc. bc>rrowed P3S0,00O on January 1 20XS_, on which the
1
company paid IO .percent interest. Both interest and principal were paid on
December 31, 20XS. Red ~ook Inc. tax rate is 20 percent. Depreciation expense
for the year was P6,_000 .

Required:

Did Red Book Inc. make a profit in 20X5? Verify your answer with an income
statement.

Problem 5 (Determination of Profitability)

. . .

Toyota Auto Shop had sales of P?00,000 in 20XS and cost of goods sold
represented 70 percent of sales. Selling and administrative expenses were 12
percent of sales. Depreciation expense was Pl 0,000 and interest expense for the
year was P8,000. The firm's tax rate is 30 percent.

Require<f:

a. Compute earnings after taxes. .

b. Assume the firm hire~ Ms. Lim, an expert consultant. She suggests that by
in~reasing selling and administrative expens~s to 14 percent of sales, sale can.
be expanded to P750,000. The extra sales effort ~ill also reduce.cost of goods
sold,to 66 percent of sales (there will be a larger makeup_in prices as a result
of more aggressive selling). Depreciation. expense .will remain at PI0,000.
. -
'1.4 .ohapter j

Howev.er., roc;ire automobiles wil.l have to be can-ied in inventory to satisfy

-custoi:ners, and 1,11terest expense will g9 u_p to Pl 5,000. The finn's tax l'ate will 5
remain .at 30 percent. Compute revised ea,rnings after tax.es b.ased on M.~. Um, s :
suggestiQDS for ~O}'Ota Auto Sho.p. Will · her ,ideas jncrease or decrease.
prptita'bi1.ity? .
I,
·1
PJpbieAD .(D,et.e,mj.aation .o f Earnings and Earpil)gs Per Share)
Ange)ique CoIJ>or:ation has t-450,000 of retained earnings on December 31, 20X5.
The company paid common dividends of P25,000 in 20X5 _and had retained
eaJil)ings of P40S);000 on December 31, 20X4. · ·· ' ··
Required: I•·'

a. How much did Angelique Corporation earn during 20X5?

b. What iWould its earnings per share be if20,000 shares of common stock wet~
outstanding? · ·· ·

Pr()blem 7 ,(Constmction of Income Statement .and Statement of Finitncial

P.osition) · · ·1
For ~cember 31, 20X4, the statement · of financial po_si.tion of Shadow ·
Corpo_ration i_s as fo_llows:

Assets ' Liabi11ties and Owners' equity

ewren,. assets Wabilities
Cash ,- 10,000 Accounts payable ,- 12,000
Accounts receivable 15,000 ' Notes payable 20,000
Inventory 25,POO . 8Q11ds payable , 50,000
Prepaid expenses 12,000 Total Liabilities 82,000
Toi.al Current assets 62,000 .
Owners' -.equity
Fixed ,assets Common stock . 75,000
Plant qnd equipment (gross) 250,000 Pa.id-in capital 25,000 -
less: Accumulated Retained earnings 80,000-
.depreciati<;>n 50,000 Total equity 180,000
Netpl~tand I
. i
.
eq!Jipment 200,000
Total liabilities and
Total assets ~262,000 · Owners' equity 1'262;000

\.

_ ,.(
 c.indentandinG_ Financial StaJernenL!S 75

, Sales for 20X5 were P220,000, and the cost of goods sold was 60 percent of~-
- Selling and administrative expense was P22,000. Depreciation expense was 8
percent of plant and equipment (gross) at the beginn'ing of the year. .Interest
expense for the notes payable was IO percent, and interest expense on the bonds
payable was 12 ,percent. These, interest expenses are based on December 31, 201.4
balances. The tax rate averaged 20 percent. Two thousand pesos in preferred stock
dividends were paid and P8,400 in_dividends were paid to common stockholders.
There were 1_0 ,000 shares of common stock outstanding. Darin$ 2015, the cash
balance and prepaid expenses balance were unchanged. Accounts receivable and·
invento_ry increased by IO percent. A new machine was purchased on ~ b e r
· 31, 2015 at a cost of P35,000 . .Accounts payable increased by 25 percent. Notes
payable "increased by P6,000 and bonds payable decreased by P 10,000, both at the
end of the year. The common· s~ock and paid-in capital in exces!t ·o f par accounts
did not change . .

Required:
a. Prepare an incolJ}e state111ent for 20X5 .
b. Prepare a statement of retained ~irigs for 20X5 _
c. Prepare a s~ement offinancia_l position as of December 31 , 20X5.

Problem
J
8 (Statement of Cash Flows)

Prepare a statement ·of cash flo\.Vs for Maris Corporation.

Maris Co_rporation _
Income Statement
Foi-the Year Ended _December 31, 20X1 ·
Sales t-3,300,000
Cost of goods sold 1,950,000 -
Gross profits 1,350,000
Selling and administrative expense 650,000
, Depreciation expense 230,000
O~rating income 470,000
Interest expense 80,000
Earnings before taxes 390,000
Taxes 140,000
Earnings after taxes 250,000
Preferred stock dividends · 10,000
Earnings available_to common stockholders - r24o,ooo
Shares outstanding · ·
Earnings per share ·
16 CnapJer 5 . ..__

Maris Corporation
Comparative s._tatements_of Fmancial Position
for the Years Ended 20XO and 20X1 ·
,
20XO 20X1 ,
Assets
Current assets
,,. 100,000 ,- 120,000
Cash
Accounts receivable (net) 500,000 s10,ooo
. 610,000 . 640,000
Inventory ,
Prepaid expenses 60,000 30,000
,1 1 ·,270,000 1,300,000.
Total Current.assets
IR~ents {long-ter.m-securities) 90,000 80,000
Plant and equipment 2,000,000 2,600,000.
Less: Accumulated Depreciation 1,000,000 1,230,000
Net -plant and equipment 1,000,000 1,370,000
Total assets n,3so,ooo P2.750;00Q ,,,
Liabilities and Owners' equity
Current liabilities .......
Accounls payable ,- 300,000 ,- 550,000
Notes payable - 500,000 soo;ooo :. ·
Accrued expenses 70,000 50,000
Total current liabilities 870;000 . 1,100,000 ,
Long-term liabilities
Bonds payable, 20YJ 100,000 160,000
Total liabilities ,- 970,000 . P1, 126,000 ·

Owneis' equity
Pref~ stock, f!i100 par value ., . 90,000 ,- 90,000"
Common -stock, ,-1 par value 150,000 150,000
Capital paid in excess of par - 350,000 _! 350,000
Retained earnings 800,000 ~. 900,000
Total9wners' equity ,.1,390,000 ft1,490;-000
Tota~ liabilities and owners' equity 1!2,360000 r 2,zso.00

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 Understanding Financial SlaJements 11

Maris Corporation
Statement of Retained
For the Year Emed December 31, 20X1
Retained earnings balance, January 1, 20X1
Nl0,000
Acid: Earnings avaiable to common stockholders, 20x1 - 240,000
.Less: Cash~ declared and paid il 20X1 140,<XX>
Retained ,eamingsbalance, December 31, 20X1 ,-000,000
Additional questions:

a: Describe the general relationship between net income and net cash flows from
operatin~ activities for the ti~ ·
b. Has , the buildup .in plant and · equipment been financed in a satisfactory
manner? Briefly discuss.
c. Compute the book value per common ~are for both 20X0 and 20X I.
d. If the market value of a share of comm_on stock is 2.8 times book value for
20X I; what is the firm ' s PIE ratio for 20XJ? (Round of to the nearest whole.)

Problem 9 (Preparing a Statement of Financial Positi~o)

, Shown below in random order is a list of statement of financial position items for
SM Farms at September 30. 20X5:

Land ..............:..................,....t-550,000 Fences and Gates .............. t- 33,570

Barns and Sheds.................. 78,300 Irrigation System 20,125
Notes Payable ...................... 530,000 Cash ................................... . 16,710
Accounts Receivable ... ......... 22,365 Livestock 120,780
Citrus Trees ...........:.............. 76,650 · Farm Machinery ................. . 42,970
· Accounts Payable.,.,............. 77,0~5 Retained Earnings .............. . ?
Property Taxes payable ....... 9,135 Wages Payable .................. . 1,820
Share Capital ... '..................... •250,000

Required:
-a. Prepare a statement of financial position by using these items and computing
the amount for retained earnings. (After .. Barns and Sheds" you may list the
remaining assets in any order.) Include a proper heading for your statement of
financial position. -
b. Assume that on September 30, immediately after this statement of financial
position was prepared, typhoon completely destroyed one of the barns. This
barn had a cost of P23,800, and was not insured against this type of disaster.
 •

'"l8 C hapter .J.

Explain w.hat .changes would be required in your "September 30 statement of .

finan.c:iit11positio.n to irefiect the 1oss of th is barn. ·

Problem il'O(Pmparing :a Statement of Financial Position and Cash Flow

Statement; Effects of Business Transactions) ·

The -staterne.at ;0f iiinanc:iaJ position items for The Tasty · Bakery (arranged in
1alphab.etical order} w.ere as follows at August 1, 20X5. (You are to,eompute the
niissi)'.\g fi gure for iretained eamihgs.) · ,

Accounts rP.ayable................J•16 ,200 Share·Capltal_ ...•.:... ·-'···., .......1980,oo·o

~ccounts Receivable ..•.,.......... . 1-1,260· land ......,..... ............................ 67,000
'Building .................................... 84,000 Notes Payable .................,: ...... 74,900
' Cash...................... .................. 6,940 Salaries Payable ......:.. :........... · 8,900
:~
-Equipment and Fixtures ........... 44,500 Supplies ................ :::...:........... 7,000

During the next two days, the following transactions occurred:

••- ,
Aug. 2 Additional. share capital was sold for P25,000. The accounts
· payable were paid in ·full, (No payment was tnade on .the· notes
pay.able or income taxes payable.)

Aug. 3 Equipment was purchased at a cost of P? ,200 to be paid within 10

days. Supplies were purchased foi P 1,250 .cash from a restaurant .
supply center that was going out'.o fbtisiness. rhese ·supplies would
have-cost Pl ,890 if purchased through normal channels.

Required:
·.\
a. P1epare a statement of financiiil position at August I, 20X5 .
,'
b. Prepare .a statement of financial position at August 3, 20X5, and a cash flow
s.tatem~nt _for August 1-3. Classify the payment of accounts payable and the
purchase of suppJies as operating activities.
' J • ' I

c. Assume th~ note paya~le does riot come due for several years . . Is The Tasty
B.akery in a stronger financial position on August 1 or on August 3? Explain
.briefly.

1·
...
_...
 Understanding_ Financial Statements 19·
Problem 11 (Preparing Financiai Statements;
Transactions) - I·
Effects ·or ·sos.niess
,

o(
The stat.emen~ fin;..,; iat position .items of The First Malt Shop (arranged in
,.alphabeti~al or.der) wei:e as follo~s at the close ,of busin~ss on September 30,
20X5: ' . . ' . - ··

Accounts Payable................. 8,500 Land , · ~5 ooo

A tsRecerva . ble ............... 1,250 . ····································· '
Share.Capital .......................... · 50,000
Bu1ld1ng
C , ..........................
. '. ......... 45,500
. Notes Payable• ...........:............. ?
asn :...............................,..:...., 7,400 Retained Earnings.................... 4,090
Equip,:nent and Fixtures ........... 20,000 Supplies ........................:......... 3,440

1'he transaction·s occuri-ing.~uring die first-week of October were:

Oct. 3 Additj9na( share capital • was soil for P;,0,000. • The accounts
payable were paid i,n full. (No payment was made on the notes
.payabl1r.)_..
Oct. 6 More furniture was purchased on account at a cost of Pl 8,000, to be
paid within ·JO days. Supplies were purchased fortt'l,0,00 cash from
a restaurant supply.center that was·going out of- business. These
supplies would have cost Pl ,875 if purchased under normal
circumstance's-. . '' r . . ,

Oct. 1-6 Reyenues · of PS,500 were earned and paid in cash. Expenses
re,q!lited to earn the revenues of P4,000 were incurred and paid in
cash. . . . . -
·. /'

Required:

a. Prepare a .statement of financial position at September 30, 20X5. (You will

need to compute the rnissing'figure for Notes Payable.) . . ·
b. Prepare a s~tement of financial -~sition at.October 6, 20X5. Also prepare an .
income statement·and a cash flow statemenrforthe period October 1-6, 20X5.
In your c3;5h, flow statement, ~t the purchase of supplies and tht? payment of
accounts payable as operating activities. • . · . l
· c. Assume the note payable does not come due for several years. ls .The First
Malt Shop in a stronger financial position on September 30 or on October 6?
· Explain briefly. ·

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