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The Effect of Accounting Choices
P13-17
Objs. 2, 4, 5 Ginsberg Company is a recently formed, publicly traded company. At the end of its most re-
cent fiscal year, the company reported the following information.
a. Sales revenues were $13,680,000, and 360,000 units were sold. Credit sales were
$10,000,000. Uncollectible accounts associated with credit sales are estimated to be be-
tween 3% and 4%.
b. At the beginning of the year, 140,000 units of inventory were on hand at a unit cost of
$10 per unit; during the year, 250,000 units were purchased at $10.50, and, later,
150,000 units were purchased at $11.50 per unit.
c. Plant assets included equipment with a book value of $3,375,000 and buildings with a
book value of $8,260,000. The equipment has an estimated remaining useful life of be-
tween four and seven years. The buildings have an estimated remaining useful life of
between 25 and 35 years.
d. Intangible assets (excluding goodwill) cost $1,200,000 and have a remaining useful life
of no less than 10 years.
e. The company has the option of adopting a new accounting standard for the fiscal year.
If the standard is adopted, the cumulative effect of the accounting change, before the
tax effect, will be a loss of $1,100,000.
f. The company’s tax rate is 34%. Other operating expenses were $6,245,000. Interest ex-
pense was $460,000. There were 500,000 shares of common stock outstanding through-
out the year.
Management has not yet made decisions about how to treat items a through e. A choice is
necessary in each instance. The chief financial officer has asked you to determine the range of
net income that might be reported depending on the choices that are made.

Required Prepare two different pro forma (projected) income statements for the year.
A. With the first income statement, show the minimum net income the company could
report under GAAP.
B. With the second income statement, show the maximum net income that could be re-
ported under GAAP.
C. What does this suggest to you about comparing the reported net income of one firm
versus the others?
F523
CHAPTER F13: Operating Activities
527
Operating Activities

P13-18 Identifying Operating Activities from Entries to the Accounting
System
Objs. 2, 3, 4, 5
Goose Hollow Company had the following entries to its account system during a recent week.


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Event Accounts Cash Assets Capital Earnings
a. Accounts Receivable 18,000
Sales Revenue 18,000
Merchandise Inventory 14,600
Cost of Goods Sold 14,600
b. Merchandise Inventory 33,000
Accounts Payable 33,000
c. Cash 4,365
Accounts Receivable 4,500
Sales Discount 135
d. Allowance for Doubtful Accounts 1,100
Accounts Receivable 1,100
e. Cash 2,500
Accounts Payable 2,500
f. Accounts Receivable 6,000
Allowance for Returns 6,000
Merchandise Inventory 4,200
Cost of Goods Sold 4,200
g. Finished Goods Inventory 13,000
Work-in-Process Inventory 13,000
h. Warranty Expense 15,750
Warranty Obligations 15,750
i. Allowance for Returns 8,300
Sales Returns 8,300
j. Doubtful Accounts Expense 3,740
Allowance for Doubtful Accounts 3,740
k. Merchandise Inventory 800
Loss on Inventory 800




Required Study each entry and write a short description of the event that occurred to cause
the entry.
F524 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
528 Activities

P13-19 Reporting Equity Income, Noncontrolling Interest, and Pension Infor-
mation
(Based on the Other Topics section.) A partial income statement for Half Moon, Inc. is reported
below.



Half Moon, Inc.
Partial Income Statement
For Year Ending December 31, 2004

Sales revenue $3,504,600
•
•
•
Operating income $ 587,300
Equity income in related company (Able Co.) 40,000
Income before income taxes $ 627,300
Provision for income taxes 219,500
Income before noncontrolling interests $ 407,800
Noncontrolling interest in net income of subsidiary (Baker Co.) (2,466)
Net income $ 405,334




In addition, the following disclosure was found in the notes to the financial statements.

Note 7: Projected benefit obligation $1,500,000
Fair value of plan assets 1,300,000
Pension liability $ 200,000
Service cost $ 103,400
Return on plan assets 100,100
Net pension expense $ 3,300

Required Explain each of the following.
A. What information is conveyed by the line labeled “Equity income in related com-
pany”? Describe the situation that must prevail for this line to appear on an income
statement.
B. What information is conveyed by the line labeled “Noncontrolling interest in net in-
come of subsidiary”? Describe the situation that must prevail for this line to appear on
an income statement. Why is this amount subtracted in this case?
C. What information is conveyed by each of the first three lines of Note 7?
D. What information is conveyed by each of the second set of three lines of Note 7?


Excel in Action
P13-20
The Book Wermz purchases books for all of its stores through a central purchasing depart-
ment. Books are then shipped to different stores for sale. One of the company’s largest sell-
ing items is an edition of Webster’s dictionary. A large volume of sales occurs in August and
September each year to students returning to school. At the beginning of August 2004, the
company’s inventory of dictionaries included 245 units purchased on April 12, 2004 at $27.00
per unit, 360 units purchased on May 3, 2004 at $29.00 per unit, and 1,000 units purchased
SPREADSHEET on July 24, 2004 at $32.00 per unit. No purchases were made in August. The Book Wermz
sold 1,447 units of the dictionary during August.

Required Use a spreadsheet to prepare a schedule of Cost of Goods Sold and Ending In-
ventory for the dictionary for August. Show both FIFO and LIFO inventory numbers.
Enter the captions illustrated on the next page at the top of the spreadsheet.
F525
CHAPTER F13: Operating Activities
529
Operating Activities




Beginning in row 8, enter data in each column for each of the purchase dates. In the Cost of
Goods Sold columns, enter the number of units sold and the cost of these units (units sold
cost per unit) from each inventory layer1 using the FIFO method. In the Ending Inventory
columns, provide the same data for units remaining in inventory at the end of August. Use
formulas for all calculations so that if the units available or cost per unit numbers changed,
these changes would automatically be updated in columns D–G.
In row 11, sum columns B and D–G, using the Summation button.
Beginning in row 13, repeat the captions, data, and calculations using the LIFO method.
You can copy the data from the FIFO section, select cell A13, and paste the data. Then make
any needed changes for the LIFO calculations.
Beginning in row 21, provide a calculation of the amount of income taxes the company
would save if it used the LIFO method in August. The company’s income tax rate was 35%.
Place captions in column A and calculations in column B. The calculations should report the
amount of LIFO cost, FIFO cost, the excess of LIFO over FIFO costs, the company’s income
tax rate, and the tax savings.
Format the schedule using underlines, commas, and appropriate alignment so that it is
easy to read and has a formal appearance.
Suppose the number of units available from the April purchase was 545 and the cost of
the May purchase was $31.00 per unit. What would cost of goods sold be for August for the
dictionaries? What would the ending inventory be at the end of August?

Multiple-Choice Overview of the Chapter
P13-21
1. The excess of sales revenues over cost of goods sold for a fiscal period is
a. net income.
b. income before taxes.
c. operating income.
d. gross profit.
2. Timing differences between sales revenues recognized during a fiscal period and cash
collected from customers during the period affects the change in the balance of
a. accounts receivable.
b. unearned revenue.
c. gross profit.
d. allowance for doubtful accounts.
3. A transaction to estimate the amount of doubtful accounts expense for a fiscal period
would affect the
a. accounts receivable and doubtful accounts expense accounts.
b. allowance for doubtful accounts and doubtful accounts expense accounts.
c. allowance for doubtful accounts and accounts receivable accounts.
d. allowance for doubtful accounts and sales revenue accounts.
4. Universal Joint Company publishes a monthly periodical, Grease Today. At the begin-
ning of March, the company’s unearned revenues included 1,200 one-year subscrip-

1
Each purchase represents an inventory layer. For example, Book Wermz has a beginning inven-
tory layer of 245 units at $27.00 per unit. The company acquired additional inventory layers at
$29.00 and $32.00 per unit.
(Continued)
F526 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
530 Activities

tions at $36 each. During March, the company received 200 new subscriptions. The
March issue was shipped to all subscribers on March 25. The amount of subscription
revenue the company should recognize in March is
a. $7,200.
b. $4,200.
c. $3,600.
d. $600.
5. Inventory prices on the balance sheet are closest to current costs for a company that es-
timates its inventories using
a. FIFO.
b. LIFO.
c. weighted-average.
d. a method that cannot be determined from the information given.
6. A company will report the highest net income if
a. it uses LIFO inventory, with rising prices and increasing inventory levels.
b. it uses LIFO inventory estimating, under all conditions.
c. it uses FIFO inventory, with rising prices and increasing inventory levels.
d. it uses FIFO inventory estimating, under all conditions.
7. Warranty expense should appear in the income statement in the period when
a. the product is manufactured.
b. the product is sold.
c. a defective item is repaired or replaced.
d. the warranty period ends and all expense is known.
8. Merchandise in transit at the end of the accounting period that has been shipped FOB
shipping point should be included in the ending inventory of
a. the buyer.
b. the seller.
c. both the buyer and the seller.
d. the freight company.
9. Redford Company reported net income of $40 million for its most recent fiscal year.
The company recorded interest expense of $10 million for the year. Also, it paid pre-
ferred dividends of $2 million and common dividends of $5 million. The average num-
ber of common shares outstanding for the year was 10 million. The company would
report earnings per share of common stock for the year of
a. $4.00.
b. $3.80.
c. $3.30.
d. $2.30.
10. Given the following information, determine Cost of Goods Sold for the month using
the perpetual LIFO method.

Date Event Units Unit Cost
May 1 Beginning inventory 100 $5
5 Purchase of inventory 10 6
12 Sale of inventory 20
18 Purchase of inventory 10 7
23 Purchase of inventory 10 8
28 Sale of inventory 25

a. $225
b. $285
c. $325
d. $425
11. When a periodic inventory system is used, cost of goods sold is calculated as
a. beginning inventory purchases ending inventory.
b. beginning inventory purchases ending inventory.
c. ending inventory purchases beginning inventory.
d. beginning inventory ending inventory purchases.
F527
CHAPTER F13: Operating Activities
531
Operating Activities

12. A major disadvantage of a periodic inventory system is
a. the added expense of applying it.
b. the required technology for applying it.
c. the lesser degree of control and information it provides.
d. the requirement for an inventory count, which is never necessary with a perpetual
system.
13. (Based on the Other Topics section.) Deferred compensation, such as pension benefits
and health care for retirees, should be expensed
a. when a plan is adopted.
b. while employees are working.
c. when employees retire.
d. when paid to retirees.




Projects
CASES
Examining Operating Activities
C13-1
Objs. 2, 4, 5 Appendix B of this book contains a copy of the 2002 annual report of General Mills, Inc.

Required Review the annual report and answer each of the following questions.
A. What was the primary inventory estimation method used by General Mills? What is the
effect on the company’s cost of goods sold and operating income of using this primary
method as compared to other methods? (Hint: Look at Notes 1c and 6. The “Reserve
for LIFO” is an estimate of the difference between FIFO and LIFO values.)
B. What was the amount of General Mills’ allowance for doubtful accounts for 2002? Did
the relationship between estimated doubtful accounts and net sales change from 2000
to 2002?
C. How much income tax expense did General Mills recognize as expense for 2002? How
much income tax did the company owe for 2002? What were the primary causes of the
difference between income tax expense and income tax payable? How much income tax
did General Mills pay in 2002? (Hint: See Note 16 as well as the statement of earnings.
The total to be paid for 2002 is “Total Current.”)
D. How much did General Mills report for depreciation and amortization and for interest
expense in 2002? How much cash did General Mills pay for depreciation, amortization,
and interest in 2002? (Hint: See the income statement and Note 13.)

The Effect of Accounting Choices on Reported Results
C13-2
Objs. 2, 3, 4 Sunlight Incorporated and Moonbeam Enterprises both began operations on the first day of
2004. Both operate in the same industry, sell the same products, and have many of the same
customers. Both companies have just reported financial results at the end of 2004. By a re-
markable coincidence, the sales revenue reported by both companies was exactly the same.
Overall, however, Moonbeam’s net income was approximately 75% greater than Sunlight’s.
You are a little surprised by this because it was generally thought by those in the industry that
Sunbeam had been the better managed and more successful firm.




(Continued)
F528 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
532 Activities

Sunlight Moonbeam
Income Statements for Year 2004 Incorporated Enterprises
Sales revenue $31,000 $31,000
Cost of goods sold 20,000 18,600
Gross profit $11,000 $12,400
Operating expenses:
Depreciation 1,100 1,100
Insurance 550 610
Supplies 1,300 1,300
Uncollectible accounts 1,240 310
Warranties 620 0
Wages 1,500 1,570
Total operating expenses 6,310 4,890
Operating income 4,690 7,510
Interest expense 900 900
Pretax income 3,790 6,610
Income tax expense 1,298 2,314
Net income $ 2,492 $ 4,296
Earnings per share $ 1.25 $ 2.15

Upon reviewing the notes that accompany the financial statements, however, you observe the
following.
1. At year-end, Sunlight recorded allowances in its accounting system for expected sales
discounts (of $113) and expected sales returns ($1,345). Moonbeam, while having the
same types of products and customers, did not believe it had enough information to
record estimates after only one year in business.
2. Both companies reported sales totaling 1,200 units. Sunlight recognizes revenue when
goods are shipped to customers. Moonbeam recognizes revenue when the order is re-
ceived. As of year-end, the last 100 units that Moonbeam has reported as sales have not
yet been shipped to customers because Moonbeam is temporarily out of stock. An em-
ployee forgot to re-order the item on time and now the manufacturer’s plant is down
for annual maintenance at year-end. Production is scheduled to resume on January 15.
As soon as these units are received at Moonbeam’s warehouse, they will be shipped to
the customers who ordered them.
3. Moonbeam used the perpetual FIFO method of inventory estimation, but Sunlight
used perpetual LIFO. Both companies had the same inventory costs and reported in-
ventory transactions as follows.

Event Units Cost per Unit Total Cost
Beginning inventory 0 $0 $ 0
Purchase 200 12 2,400
Purchase 500 15 7,500
Sales 300
Purchase 400 17 6,800
Sales 500
Purchase 300 19 5,700
Sales 300
Sales* 100

*As the wholesale cost of goods increased during the year, both firms increased selling prices, too.
This last batch of sales (as reported by each firm) was sold at $30 per unit. Unlike other sales,
this batch of goods was sold for cash and no returns were allowed.

4. At year-end, both companies were concerned about uncollectible accounts. Being new
in the business, neither firm had much history upon which to base an estimate. Never-
theless, Sunlight estimated that approximately 4% of sales would be uncollectible.
Moonbeam was more optimistic and estimated the rate at only 1%.
5. The companies differ in how they account for warranty expenses. Sunlight’s manage-
ment estimated the cost of future warranty claims (for goods sold during the year just
F529
CHAPTER F13: Operating Activities
533
Operating Activities

ended) and recorded an expense for that amount. Moonbeam decided that the amount
would be immaterial and it would just charge these claims to expense in the later years
when they were paid.

Required Which firm had the better financial results for its first year of operation? Why?
Prepare any tables or schedules that you think would support your conclusion or be helpful
to illustrate the basis for your conclusion.
F14 14 F14
ANALYSIS OF OPERATING
ACTIVITIES
How do operations create value for our business?

A goal of operating activities is to create value for customers who purchase a com-
pany’s products. By creating value for customers, a company also can create value
for its owners. To do this, a company must produce and sell its products efficiently and
effectively. The opportunities, challenges, and uncertainties that arise from operating ac-
tivities require managers to make operating decisions. Accounting information describes
the results of operating activities. It can be used to identify and evaluate management deci-
sions. Also, it can help decision makers form expectations about a company’s economic future
and make decisions that will affect that future.

Company managers like Stan, Maria, and Ellen make strategic decisions that determine how a
company will compete in its product markets. The managers, investors, creditors, and other stake-
holders must then evaluate how successful the strategy has been.


FOOD FOR THOUGHT
As an advisor to the managers of Mom’s Cookie Company, what issues do you think they should consider
when deciding on the strategy the company will use to compete? How can managers and other decision
makers evaluate how well the strategy is working?


Maria, Stan, and Ellen are meeting to decide on an operating strategy for Mom’s Cookie Company.

Our company operates in a very competitive industry. We need to determine how we are going to price our
Maria:
products and what competitive strategy we will use to create sales and profits.
Stan: We have to sell our products at a relatively high price to make a profit. I realize that our sales volume will
decrease if our prices are too high, but I was hoping we could depend on the high quality of our products
to create sales.
Ellen: I think we should focus on the quality of our products. Our cookies appeal to customers who are willing to
pay for the added flavor and consistent quality. Our operating strategy should focus on what makes our
products special.
Maria: Okay, let’s figure out how we can make that strategy work and the effect the strategy should have on the
performance of the company.
F531
CHAPTER F14: Analysis of Operating Activities
536 Analysis of Operating Activities


OBJECTIVES

Once you have completed this chapter, you 4 Evaluate operating performance by using
should be able to: accrual and cash flow measures.
1 Explain the relationship between product 5 Examine return on equity and explain how
pricing and sales volume in creating operating, investing, and financing
revenues and profits. activities are interconnected.
2 Explain how operating strategy affects a 6 Describe the primary components of an
company’s return on assets. accounting system and how they are useful
for understanding business activities.
3 Define cost leadership and product
differentiation, and explain how companies
use these strategies to create profits.




OPERATING DECISIONS
After their discussions of financing and investing activities described in previous chap-
OBJECTIVE 1
ters, Maria, president, Stan, vice president of operations, and Ellen, chief financial of-
Explain the relationship ficer of Mom’s Cookie Company, met to discuss operating activities of their company.
between product pricing “In our previous discussions, we decided to finance our company primarily with com-
and sales volume in mon stock and to invest in automated equipment for our production process,” Maria
creating revenues and began. “Now, we need to make some operating decisions. In particular, we need to de-
profits.
termine how to price our products so that they continue to be competitive and prof-
itable. First, let’s think about the basic factors that affect profitability. Net income is
revenues minus expenses. Return on assets is net income divided by total assets.

Net income revenues expenses
Return on assets net income total assets

“Return on assets provides a simple measure for evaluating how well we use our
assets to create profits. We need to determine how to create a return on assets that will
satisfy our stockholders. We have already decided on an automated production process
that will require an initial investment in assets of $5 million. Also, expenses created by
this process are mostly fixed. Exhibit 1 summarizes, from our prior discussions, our ex-
pected initial investment and expected operating results for the next two years.




Exhibit 1 (In thousands)
Summary of Expected Assets Initial Investment Operating Results Year 1 Year 2
Assets and Expected
Current assets $1,000 Sales revenues $ 3,000 $ 3,600
Operating Results for
Plant assets 4,000 Cost of ingredients (800) (960)
Mom’s Cookie Company
Total assets $5,000 Depreciation (300) (300)
Wages and benefits (700) (700)
Other operating expenses (1,000) (1,000)
Operating income 200 640
Interest expense (20) (20)
Pretax income 180 620
Income taxes (54) (186)
Net income $ 126 $ 434
F532 SECTION F2: Analysis and Interpretation of Financial Accounting Information
537
Analysis of Operating Activities

Maria continued: “We expect our return on assets to be only 2.5% ($126 $5,000)
in the first year. By the second year, we expect to be earning a higher profit, and we be-
lieve our future profitability will be much higher. If our investment in assets remains
at approximately $5 million, our return on assets should increase to 8.7% in year two.
What we can see from Exhibit 1 is that assets and expenses are pretty well determined
by our production process and will not increase much until we can sell more of our
product than we can produce. The real issue, then, is how to generate as much revenue
as possible from our product.”
Stan observed, “What I hear you saying is this: The major purpose of our company
is to earn a satisfactory return for our stockholders by creating value for our customers.
We have a valuable product, and we can produce it efficiently. Though these are nec-
essary attributes of a successful business, they do not guarantee our success. We have
to develop a strategy for creating profits by competing with other producers.”
“Right,” Maria said. “And, again, the basics are pretty straightforward. Revenue de-
pends on two factors, number of units sold (generally referred to as sales volume) and
price per unit.

Sales revenues sales volume price per unit

The more units we sell at a given price, the more revenue we earn. More revenue means
higher net income and higher return on assets.”
“Also, we know that sales volume and price are indirectly related,” Ellen noted. “As
price goes up, sales volume goes down. Therefore, we need to determine a price that
will allow us to maximize our revenues. What we can charge is affected by the prices
charged by our competitors and what our customers are willing to pay. You’ve looked
at the competition, Stan. What are your thoughts on this matter?”
“The industry is dominated by a few major producers,” Stan replied. “All of these
companies produce very similar products. Consequently, competition is based largely
on price. Each company attempts to sell its products at as low a price as possible. All
of the companies charge about the same amount. One company cannot raise its prices
without losing customers. If a company’s prices get much higher than those of other
companies, customers simply will buy from a competitor who sells at a lower price.
Producers, then, must set prices that are close to their competitors’ and that allow them
to earn a reasonable profit. The most efficient producers earn the most money because
they keep their production and marketing costs low. To keep these costs low, it is usu-
ally necessary to produce in high volume because so many of the costs are fixed, as we
have seen for our company. Companies have to invest a lot in plant assets to get into
this business. Therefore, they have to sell a lot of product to cover the costs of their in-
vestment and earn a reasonable return on assets.”



DEVELOPING OPERATING STRATEGY
AN
“Companies in our industry don’t earn a huge profit on each item sold,” Ellen contin-
OBJECTIVE 2
ued. “A commonly used measure of profitability relative to amount of sales is profit
Explain how operating margin, or return on sales. Profit margin is the ratio of net income to sales, or oper-
strategy affects a ating, revenues and is a measure of a company’s ability to create profit from its sales.
company’s return on
assets. Profit margin net income sales revenues

Average profit margin in our industry is about 7%. A practical way of thinking about
this measure is that companies earn 7¢ for each $1 of revenue they earn.
“Because profit margin is fairly low,” Ellen went on, “companies must sell a lot of
product to earn a reasonable profit. A commonly used measure of sales volume rela-
tive to total investment is asset turnover. Asset turnover is the ratio of sales, or oper-
F533
CHAPTER F14: Analysis of Operating Activities
538 Analysis of Operating Activities

ating, revenues, to total assets and is a measure of a company’s ability to generate sales
from its investment in assets.

Asset turnover sales revenues total assets

“Average asset turnover in our industry is 1.2. A practical way of thinking about this
measure is that companies generate $1.20 of sales revenue for each $1 invested in assets.
“You can see that return on assets is a combination of profit margin and asset
turnover.

Return on assets profit margin asset turnover
Net income net income sales revenues
Total assets sales revenues total assets

Therefore, average return on assets in our industry is 8.4% 7% profit margin 1.2
asset turnover. This should be our target for the second year of operations.”
“Our products are different from most competing products, however,” Maria in-
terjected. “We can compete by offering quality and taste that are not available from our
competitors. Our marketing research has demonstrated that our customers are willing
to pay more for our products than for those of our competitors.”
“That’s what we’re counting on,” Stan replied. “We can’t price our products too
much above those of our competitors, but we can command a premium because of the
distinct quality and taste we offer. Thus, we can expect customers to pay a bit more for
our products than for those of our competitors.
“Exhibit 2 contains some estimated sales figures for years 1 and 2. Scenario 1 esti-
mates revenues using average industry prices and expected unit sales for Mom’s Cookie
Company. Scenario 2 estimates revenues using a 10% premium over the average in-
dustry price. Expected unit sales will be lower in scenario 2 than in scenario 1 because
of the higher price. I don’t expect the decrease in sales volume to be very large, how-
ever, because of the added value of our products. I think most customers will pay a
higher price if we can make them aware of the higher quality.


Exhibit 2 Units Revenues
Estimated Sales Volume
Unit Price Year 1 Year 2 Year 1 Year 2
at Different Price Levels
for Mom’s Cookie Scenario 1: Sell at average industry price
Company $27 108,000 130,000 $2,916,000 $3,510,000
Scenario 2: Sell at premium price (10% above industry average)
$30 100,000 120,000 $3,000,000 $3,600,000




“As you can see from the first scenario, if we charge average industry prices, we will
fall below our expected total sales revenues of $3 million in year 1 and $3.6 million in
year 2. The 10% premium gets us to our target sales revenue levels each year.”
Maria asked, “If the higher price produces more revenue, why not use a higher pre-
mium, say 20%? Why should we be content with a 10% premium? Surely our quality
justifies the higher price.”
“We have to be careful,” Stan answered. “We are marketing a new product, and cus-
tomers will have to determine for themselves that it is a better product than they can get
from our competitors. We expect sales to increase each year as more customers discover
our product. If we start out with too high a price, however, customers will be discour-
aged from trying our product. Our marketing people have done some market tests, and
they believe a premium of much above 10% will slow sales considerably over the first
F534 SECTION F2: Analysis and Interpretation of Financial Accounting Information
539
Analysis of Operating Activities

few years. Our primary challenge in the first couple of years is to get the product into
the hands of customers. Once they are sold on its value, we can consider higher prices.
“Also, a 10% premium earns us a competitive return in the second year. Exhibit 3
computes our expected profit margin, asset turnover, and return on assets in year 2. At
estimated sales of $3.6 million, we expect to earn a profit of $434,000 (from Exhibit 1).
Assuming that we maintain a total investment in assets of $5 million, we will earn a re-
turn on assets of 8.68% in year 2, which is slightly above the industry average of 8.4%.”



Exhibit 3 Estimated sales revenues $3,600,000
Expected Return on Estimated net income 434,000
Assets for Mom’s Estimated assets 5,000,000
Cookie Company in Profit margin 12.06% $434,000 $3,600,000
Year 2 Asset turnover 0.720 $3,600,000 $5,000,000
Return on assets 8.68% 12.06% 0.720




“Is it reasonable to expect our total assets to stay at $5 million, Ellen?” Maria asked.
“I think so,” Ellen responded. “We won’t need much additional plant investment,
and I think we can keep current assets fairly constant. I don’t see anything wrong with
Stan’s estimates.”
Stan continued, “You can see that our asset turnover is lower than average—0.72
(Exhibit 3), compared with 1.2 for the industry. We are not going to sell enough prod-
uct, even if we sell at the industry average price, to generate a high asset turnover. Our
product is too new. It will take several years for us to build sales volume. Our asset
turnover should increase over time.
“We make up for the low asset turnover with a high profit margin, however. Our
expected profit margin is a little over 12% (Exhibit 3), compared with 7% for the in-
dustry. As asset turnover increases, a high profit margin will earn us a much higher re-
turn than the industry average. A key to our success is sales volume. If we can increase
sales each year without incurring a lot of additional expenses, we should make a lot of
money.”
Maria and Ellen nodded in agreement. “Now let’s see if we can make our plans
work,” Maria said, closing the meeting.




1 SELF-STUDY PROBLEM Information is presented below for two appliance companies.

(In thousands) Ardmore Bellwood
Sales revenues $ 800 $800
Net income 100 80
Total assets 1,000 800

Required
A. Compute profit margin, asset turnover, and return on assets for each company.
B. Compare the operating strategies of the two companies and explain which com-
pany is doing the better job with its strategy.
C. Using the information presented, discuss how each company could improve its
profits and return on assets.
The solution to Self-Study Problem 1 appears at the end of the chapter.
F535
CHAPTER F14: Analysis of Operating Activities
540 Analysis of Operating Activities


INTERPRETATION OPERATING ACTIVITIES
OF
To create profits and value for stockholders, a company must use its assets effectively
OBJECTIVE 3
to create and sell products demanded by customers. Also, it must operate efficiently so
Define cost leadership that revenues exceed expenses. Companies that are more effective and efficient earn
and product higher profits and are more valuable than less effective and less efficient companies. As-
differentiation, and set turnover is a measure of effectiveness. A company that sells more of its products
explain how companies will have a higher asset turnover than a company with the same amount of assets that
use these strategies to
sells less of its product. Profit margin is a measure of efficiency. A company that is ef-
create profits.
ficient in controlling costs and converting resources into products will have a higher
profit margin than a company with the same amount of sales that is less efficient.
Asset turnover and profit margin are not the same for all companies, even those
that are highly profitable and create high value. Among highly profitable companies,
asset turnover is higher for some and profit margin is higher for others. These compo-
nents of return on assets provide useful information about companies’ operating ac-
tivities. To illustrate, consider the information in Exhibit 4.


Exhibit 4 Profit Margin, Asset Turnover, and Return on Assets for Krispy Kreme and Starbucks

Krispy Kreme Starbucks
(In thousands) 2001 2000 2001 2000

Net income $ 14,725 $ 5,956 $ 181,210 $ 94,564
Sales revenues 300,715 220,243 2,648,980 2,177,614
Total assets 171,493 104,958 1,851,039 1,491,546
Profit margin (net income sales revenues) 4.9% 2.7% 6.8% 4.3%
Asset turnover (sales revenues assets) 1.75 2.10 1.43 1.46
Return on assets (margin turnover) 8.6% 5.7% 9.8% 6.3%




This exhibit provides information for Krispy Kreme Doughnuts, Inc. and Star-
bucks Corporation. It compares profit margin, asset turnover, and return on assets for
the companies. Starbucks is a much larger company than Krispy Kreme. Though the
numbers vary a bit from 2000 to 2001, Krispy Kreme has a smaller profit margin but
a higher asset turnover than Starbucks in both years.


Cost Leadership and Product Differentiation Strategies
Differences in profit margin and asset turnover among companies are not accidents.
The strategies companies use to create profits differ. To generate high returns, compa-
nies with lower asset turnovers, like Starbucks, must generate high profit margins. Thus,
they must carefully control production and selling costs to make sure they earn a rea-
sonable profit on each dollar of product sold. Observe from Exhibit 4 that Starbucks
earned 6.8¢ on each dollar of sales in 2001, compared with 4.9¢ for Krispy Kreme.
Companies like Starbucks can earn higher profit margins because they sell prod-
ucts that are differentiated from their competitors’ products. These products offer cer-
tain qualities or features that build a customer following. Starbucks is known world
wide as a premium coffee company. It offers a variety of coffee products that customers
demand because of their taste. These customers are willing to pay more for Starbucks’
products than for more ordinary or generic coffee products offered by many restau-
rants and fast food companies.
Krispy Kreme also has a specialized product, but its products are less distinct from
competitors than Starbucks’ products. Its products command less of a premium. Con-
sequently, Krispy Kreme depends more on asset turnover to generate a return than does
F536 SECTION F2: Analysis and Interpretation of Financial Accounting Information
541
Analysis of Operating Activities

Starbucks. Low profit margin companies must sell in high volumes to make a profit.
Therefore, high asset turnover is essential to their success.
Because they must keep their prices low to generate high sales volume, low profit
margin companies must keep their operating expenses low so they can earn a profit.
These companies use a cost leadership strategy to generate profits. They lead their com-
petitors in selling high quantities of products by keeping the prices of these products
low. High profit margin companies use a product differentiation strategy. They com-
pete by offering products with special features or qualities that customers are willing to
buy.
Exhibit 5 illustrates these operating strategies. Cost leadership and product dif-
ferentiation are two ends of a competitive spectrum. Krispy Kreme and Starbucks are
not at either end of the spectrum. However, Starbucks falls closer toward the product
differentiation end than Krispy Kreme does. Most companies fall somewhere between
the two ends of the spectrum. In fact, many companies offer several products or prod-
uct lines of the same type to compete across the spectrum. For example, manufactur-
ers of TVs and other electronic equipment offer products in various sizes and with
various features to appeal to customers who want a low-cost product and to those who
want special features. Most automobile companies offer brands and models of various
sizes and with various features. Some of these brands or models are targeted toward
customers who are looking primarily for economical transportation. Others are tar-
geted toward customers who are looking primarily for style or comfort.


Exhibit 5 Operating Strategy Profit Margin Asset Turnover
Cost Leadership and
Cost Leadership Low High
Product Differentiation
Product Differentiation High Low
as Alternative Operating
Strategies



Both asset turnover and profit margin are important for all companies. A company
using a cost leadership strategy relies on high sales volume. It cannot ignore profit mar-
gin, however. Because this type of company earns a relatively low profit margin, a small
drop in this margin can make a big difference in the company’s profitability. As we can
see in Exhibit 4, Krispy Kreme’s return on assets was lower in 2000 than in 2001 be-
cause of its lower profit margin. Similarly, asset turnover is important for a product
differentiation company. If Starbucks permits its asset turnover to drop, it will earn a
lower return on assets.
Cost leadership and product differentiation describe different ways in which com-
panies compete to earn a profit. Both Krispy Kreme and Starbucks have gained success
by effectively selling products and efficiently controlling costs. The companies use dif-
ferent strategies to create success, however. A company’s operating strategy determines
the types of decisions that are important for the company’s success.
Cost leadership companies typically buy and sell in high volume. They keep their
operations streamlined to keep costs low. Usually, few specialized customer services are
offered. Sales facilities typically are not elaborate. Advertising often emphasizes low
prices and convenient “one-stop” shopping. Little research and development activity
takes place.
Product differentiation companies produce and sell specialized products. They em-
phasize service quality and often use elaborate selling facilities—compare the facilities of
brand-name stores in a typical mall with those of discount stores like Wal-Mart, for ex-
ample. Advertising emphasizes the high quality or special features of their products and
how these products are better than products offered by competitors. An attempt is made
to build brand loyalty. Research and development activities often are critical for these
companies. For example, Microsoft has become one of the most profitable software com-
panies by continuing to develop products that are not available from other producers.
F537
CHAPTER F14: Analysis of Operating Activities
542 Analysis of Operating Activities

Comparing Accrual and Cash Flow Measures of Operating
Performance
Return on assets measures performance using accrual-based net income. Operating cash
OBJECTIVE 4
flow is also an important measure of operating activities. If a company does not con-
vert its profits into cash, the profits are a misleading performance indicator. The ratio
Evaluate operating
performance by using of operating cash flow to total assets is useful for comparing the operating cash flows
accrual and cash flow of different companies. It is a measure of cash flow generated during a period through
measures. the use of assets to produce and sell goods and services.
Exhibit 6 provides operating cash flow to total assets information for Krispy Kreme
and Starbucks. Consistent with its return on assets, Krispy Kreme’s operating cash flows
were lower than those of Starbucks in both years. Starbucks was converting a larger
portion of its earnings into cash than was Krispy Kreme in these years.


Exhibit 6 Krispy Kreme Starbucks
A Comparison of
(In thousands) 2001 2000 2001 2000
Operating Cash Flows
for Krispy Kreme and Net income (loss) $14,725 $ 5,956 $181,210 $ 94,564
Starbucks Depreciation and amortization 6,457 4,546 177,087 142,171
Receivables (3,434) (4,760) (17,177) (25,013)
Inventories (2,052) (93) (19,704) (19,495)
Prepaid expenses 1,239 (1,619) (10,919) (700)
Income taxes, net 902 (2,016) 34,548 5,026
Accounts payable 1,591 1,570 54,117 15,561
Other current liabilities 8,956 4,966 38,622 38,849
Other 2,192 430 23,042 70,833
Net cash provided by operating activities $30,576 $ 8,980 $460,826 $321,796
Operating cash flows to total assets 17.83% 8.56% 24.90% 21.57%




The operating activities sections of the statements of cash flows shown in Exhibit
6 provides information about the changes in cash flows from 2000 to 2001. Both com-
panies show increases in operating cash flows. Part of the increase was associated with
higher net income. Net cash flow was substantially higher than net income because of
depreciation and amortization expenses that did not require cash payments and in-
creases in accounts payable and other current liabilities. Both companies were incur-
ring higher costs that were not paid for in 2001. These higher costs were associated with
growth; receivables and inventories increased.
The statement of cash flows is useful for identifying the amount of cash a company
is generating from its operating activities. It provides a means of determining why this
cash flow is greater or less than a company’s net income.


Further Evaluation of Operating Strategy
As we have discussed, profit margin and asset turnover are useful measures for under-
standing and evaluating a company’s operating strategy. Each of these ratios can be sep-
arated into other ratios for more detailed analysis of a company’s operating activities.
For example, assets can be divided into individual asset categories for a more detailed
examination of turnover. The categories that are most often examined are inventory
and receivables. Inventory turnover and receivables turnover compare income state-
ment numbers with balance sheet numbers.
Inventory turnover is the ratio of cost of goods sold (from the income statement)
to inventory (from the balance sheet); it measures the success of a company in con-
verting its investment in inventory into sales. Though inventory is necessary for many
F538 SECTION F2: Analysis and Interpretation of Financial Accounting Information
543
Analysis of Operating Activities

companies, it is expensive for a company to maintain large amounts of inventory. If
the amount of inventory increases relative to selling activities, as measured by cost of
goods sold, a company is less effective in using its resources. A major decrease in in-
ventory turnover or a ratio that is lower than that of similar companies indicates that
a company is investing too heavily in inventory for the amount of product it is selling.
Exhibit 7 provides selected financial statement information for Krispy Kreme and
Starbucks. The exhibit provides several financial ratios for the two companies. Inven-
tory turnover was higher for Krispy Kreme than for Starbucks in both years. The higher
ratio indicates that Krispy Kreme was selling its inventory faster than Starbucks, con-
sistent with the companies’ overall asset turnover ratios.


Exhibit 7 Selected Financial Statement Information and Ratios for Krispy Kreme and Starbucks

Krispy Kreme Starbucks
(In thousands) 2001 2000 2001 2000

Sales revenues $300,715 $220,243 $2,648,980 $2,177,614
Cost of goods sold 150,414 114,000 1,175,787 1,047,138
Gross profit 150,301 106,243 1,473,193 1,130,476
Income from operations 23,507 10,838 281,094 212,252
Interest expense 607 1,525 2,087 2,104
Net income 14,725 5,956 181,210 94,564
Accounts receivable 19,855 17,965 90,425 76,385
Inventories 12,031 9,979 221,253 201,656
Property and equipment 78,340 60,584 1,135,784 930,759
Total assets 171,493 104,958 1,851,039 1,491,546
Total liabilities 45,814 57,203 480,041 346,735
Total shareholders’ equity 125,679 47,755 1,375,927 1,148,399
Total liabilities and shareholders’ equity 171,493 104,958 1,851,039 1,491,546
Market value 482,430 173,605 3,209,064 2,686,807
Inventory turnover (cost of sales inventory) 12.50 11.42 5.31 5.19
Days’ sales in inventories (inventory (cost of sales 365)) 29.19 31.95 68.68 70.29
Accounts receivable turnover (sales receivables) 15.15 12.26 29.29 28.51
Average collection period (receivables (sales 365)) 24.10 29.77 12.46 12.80
Fixed asset turnover (sales fixed assets) 3.84 3.64 2.33 2.34
Gross profit margin (gross profit sales) 50.0% 48.2% 55.6% 51.9%
Operating profit margin (operating income sales) 7.8% 4.9% 10.6% 9.7%
Financial leverage 1.36 2.20 1.35 1.30
Times interest earned 38.73 7.11 134.71 100.87
Return on equity (ROA financial leverage) 12% 12% 13% 8%
Market to book value (market value equity) 3.52 0.98 6.08 3.93




A ratio related to inventory turnover is day’s sales in inventories, the ratio of in-
ventory to average daily cost of goods sold. Average daily cost of goods sold is com-
puted by dividing cost of goods sold by 365. This ratio measures the average number
of days for a company to sell its total inventory, or how many days’ supply of inven-
tory it keeps on hand. Inventories for both Krispy Kreme and Starbucks consist pri-
marily of ingredients, not finished goods. Starbucks maintains higher inventory levels
than Krispy Kreme. These ratios did not change much for either company from 2000
to 2001. An increase in day’s sales in inventories signals that a company is not selling
its products as quickly and often is a sign that the company is likely to become less
profitable.
Accounts receivable turnover is the ratio of sales revenues (from the income state-
ment) to accounts receivable (from the balance sheet); it measures a company’s abil-
ity to convert revenues into cash. A higher ratio indicates that a greater portion of sales
F539
CHAPTER F14: Analysis of Operating Activities
544 Analysis of Operating Activities

is being collected in cash during a period. Krispy Kreme had higher amounts of re-
ceivables relative to sales in both years. Therefore, its accounts receivable turnover was
lower in both years.
A ratio related to accounts receivable turnover is average collection period, the ra-
tio of accounts receivable to average daily sales. Average daily sales are computed by
dividing sales revenue by 365. This ratio measures how long it takes a company, on av-
erage, to collect its receivables. The ratio was higher in both years for Krispy Kreme.
An increase in the ratio may signal that a company is having difficulty collecting cash
from its customers.
Another turnover ratio is fixed asset turnover, the ratio of sales revenues to fixed
assets (property and equipment). The ratio measures the effectiveness of a company
in using its investment in fixed assets to create sales. The ratio was higher for Krispy
Kreme than Starbucks in both years. Krispy Kreme generates higher sales relative to its
investment in fixed assets than Starbucks. This higher ratio is associated with a cost
leadership strategy that requires less elaborate stores than companies using the prod-
uct differentiation strategy. Starbucks’ stores are often located in high-cost facilities such
as in airports and urban areas. Starbucks’ operating strategy involves selling to high-in-
come customers who are willing to pay for premium products. Krispy Kreme sells to
average-income consumers, particularly to families with children. Many of its stores are
in smaller cities and towns.
Asset turnover, inventory turnover, day’s sales in inventories, accounts receivable
turnover, average collection period, and fixed asset turnover are primarily effectiveness
measures. They indicate how well a company is using its assets to sell its products and
collect cash from its customers. These ratios improved slightly for Krispy Kreme and
Starbucks from 2000 to 2001.
In addition to examining turnover ratios to evaluate effectiveness, we can examine
changes in the components of profit margin to provide additional information about
a company’s efficiency. Two commonly used components are gross profit margin and
operating profit margin. Both ratios compare income statement numbers with other
income statement numbers.
Gross profit margin is the ratio of gross profit (sales revenues minus cost of goods
sold) to sales revenues; it measures efficiency in the production or purchase of goods
for sale. A high gross profit margin indicates that a company is controlling its product
costs. Product costs are the costs of merchandise for merchandising companies and pro-
duction costs for manufacturing companies. A decrease in gross profit margin or a mar-
gin lower than that of similar companies indicates that a company is not efficient in
producing or purchasing goods for sale. Exhibit 7 indicates that Krispy Kreme’s gross
profit margins were lower than those of Starbucks. Starbucks’ gross profit margin in-
creased from 2000 to 2001, explaining much of the increase in the company’s return
on assets during this period (see Exhibit 4).
Operating profit margin is the ratio of operating income (sales revenues minus
operating expenses) to sales revenues. When compared with gross profit margin, op-
erating profit margin is an indicator of a company’s efficiency in controlling operating
costs other than product costs. These costs are primarily period expenses associated
with selling and administrative activities. Consequently, operating profit margin can be
used to evaluate a company’s efficiency in controlling its selling and administrative costs.
Krispy Kreme’s operating profit margin increased from 4.9% in 2000 to 7.8% in
2001 (Exhibit 7). However, Krsipy Kreme’s operating profit margin was much lower
in both years than was Starbucks’. Krispy Kreme’s overall lower profit margin is asso-
ciated with its lower operating profit margin. The low operating profit margin had a
major effect on Krispy Kreme’s return on assets. When a company’s profit margin is
low, consistent with a cost leadership strategy, a small increase in profit margin usu-
ally has a significant effect on net income and return on assets. Cost control is espe-
cially important for these companies. Accordingly, Krispy Kreme’s increase in
operating profit margin results in an increase in return on assets from 2000 to 2001
(see Exhibit 4).
F540 SECTION F2: Analysis and Interpretation of Financial Accounting Information
545
Analysis of Operating Activities

Linking Operating and Investing Activities with Financing Activities
Return on assets (and operating cash flow to assets) links a company’s operating activ-
OBJECTIVE 5 ities (profits or operating cash flows) with its investing activities (total assets). Thus, re-
turn on assets measures the ability of a company to use its investments to generate
Examine return on equity
and explain how operating results. Completing the link among operating, investing, and financing ac-
operating, investing, and tivities requires that we examine financial leverage and return on equity.
financing activities are Recall from Chapter F10 that return on equity is return on assets times financial
interconnected. leverage as measured by the assets to equity ratio. Thus, return on equity is a summary
measure of the success of a company’s financing, investing, and operating activities. We
can separate return on equity into three components.



Financial Leverage
Asset Turnover
Profit Margin
Return on Equity




Sales
Net Income Net Income Total Assets
Revenues
Equity Sales Equity
Total Assets
Revenues




Profit margin measures the ability of a company to operate efficiently to produce
profits (operating activities). Asset turnover measures the ability of a company to cre-
ate sales (operating activities) from investments in assets (investing activities). Assets
to equity measures the capital structure (financing activities) used by a company to pay
for its assets (investing activities). Companies can use each of these components to im-
prove their returns to stockholders and their company value.
Exhibit 7 includes return on equity and market to book value ratios for Krispy
Kreme and Starbucks. Krispy Kreme had higher financial leverage than Starbucks did
in 2001. This leverage worked in favor of Krispy Kreme. Financial leverage resulted in
higher return on equity than in return on assets. Krispy Kreme and Starbucks had sim-
ilar amounts of financial leverage in 2001. Because Starbucks’ return on assets was a lit-
tle higher than Krispy Kreme’s, its return on equity also was a bit higher.
Financial leverage can result in higher return for a company’s stockholders. How-
ever, the higher return is associated with greater financial risk because debt and inter-
est must be paid. Another ratio that is used to measure financial risk is times interest
earned, the ratio of operating income (income before interest and taxes) to interest
expense. The ratio is larger when a company incurs relatively small amounts of inter-
est. From Exhibit 7, we can see that Krispy Kreme was incurring much higher interest
expense and a lower times interest earned than Starbucks. Krispy Kreme’s ratio im-
proved from 2000 to 2001 but was still lower than Starbucks’ ratio. Though the com-
panies’ financial leverages were similar in 2001, Krispy Kreme was using more debt that
required interest payments than Starbucks. Much of Starbucks’ liabilities were payables
that did not incur interest.
Krispy Kreme’s low market to book value in 2000 was attributable to its poor per-
formance. As that performance improved in 2001, the market value increased. Star-
bucks’ market to book value was higher in both years. The company was growing rapidly
and had relatively low amounts of debt. The times interest earned ratio is particularly
informative because it indicates the higher level of financial risk associated with Krispy
Kreme that is evident in the company’s lower market to book value.
Thus, a company’s value depends on its operating activities in relation to its in-
vesting and financing activities. All of these activities are interrelated and must be con-
sidered together to understand a company’s performance. Financial statements are a
F541
CHAPTER F14: Analysis of Operating Activities
546 Analysis of Operating Activities

major source of information for measuring and eval-
LEARNING NOTE
uating these activities. They provide information
In this book, we have discussed some major issues that are im-
about both the results of activities for a period and
portant for understanding financial accounting information and
changes in results from one period to the next. Thus,
using this information to evaluate performance. We have focused
both return on assets and equity and the amount of
on those issues that we believe are most important. Our discus-
change in return on assets and equity from one pe-
sion has not included many other issues that are relevant for un-
riod to the next are important for evaluating perfor-
derstanding and using accounting information because space
mance. Companies with high and increasing returns
prohibits coverage of all relevant topics. Other topics are covered
usually are more valuable than companies with low
in more advanced accounting and business courses.
and decreasing returns.



2 SELF-STUDY PROBLEM Information is provided below for two companies that produce
and sell plastic containers.

Caseopia Dragoon
(In thousands) 2004 2003 2004 2003
Sales revenues $750 $700 $320 $300
Cost of goods sold 450 420 208 180
Gross profit 300 280 112 120
Operating expenses 120 135 50 43
Operating income 180 145 62 77
Net income 100 87 37 46
Accounts receivable 46 43 23 20
Inventories 82 80 50 42
Total assets 960 900 500 450

Required
A. Compute profit margin, gross profit margin, operating profit margin, asset
turnover, accounts receivable turnover, inventory turnover, and return on assets
for each company.
B. Use these ratios to evaluate the operating activities of each company and to com-
pare the companies’ performance.
The solution to Self-Study Problem 2 appears at the end of the chapter.




THE BIG PICTURE
In this final section, we summarize the primary topics covered in this book. It is im-
OBJECTIVE 6
portant to see how each topic fits into the overall story in order to understand the im-
Describe the primary portance of accounting as a business tool.
components of an Exhibit 8 illustrates the role of accounting in the business decision process. A busi-
accounting system and ness is a transformation process in which (1) financial resources are obtained through
how they are useful for financing activities, (2) financial resources are used to acquire other resources through
understanding business
investing activities, and (3) resources are used to produce and sell goods and services
activities.
through operating activities. Accounting is an information system for measuring and
reporting the transformation of resources into goods and services and the sale or trans-
fer of these goods and services to customers. Thus, the accounting system provides in-
formation about activities that have occurred in the transformation process. This
information is used by decision makers both to evaluate past activities and to plan for
future activities that are part of the transformation process. Accordingly, the account-
ing system links past events to future events.
Accounting information plays a crucial role in business decisions. Accounting in-
formation, like any other information, tells only a partial story. Certain aspects of a
company’s activities are measured, summarized, and reported. Other aspects are ig-
nored. Assumptions and estimations are necessary to measure certain activities for
F542 SECTION F2: Analysis and Interpretation of Financial Accounting Information
547
Analysis of Operating Activities

Exhibit 8 Transformation Process Accounting System
Accounting and
Business Decisions Activities Information
Investing Investing

Financing Operating Financing Operating



Decision Makers

Decisions
Investing

Financing Operating




which more specific, timely information is not available. Thus, the picture of a com-
pany provided by accounting information is incomplete and does not fully represent
the actual company. The picture that is presented depends on the particular set of rules
used to measure and report the company’s activities. Organizations that set accounting
standards, like the FASB, influence the type of picture that is presented.
Accounting information provides a representation of a company. The company is
too complex to be represented completely. An information system identifies certain at-
tributes of the company and summarizes a large amount of complex data to make them
useful to decision makers. As a result, the representation of the company is only an ap-
proximation of the company. Rules used by the system affect how the company is rep-
resented. A different set of rules would result in a different representation. Accordingly,
if decision makers are to use the representation provided by the system, they need to
understand the system so that they are not misled by differences between the repre-
sentation and the actual company. Consequently, it is essential for those who use ac-
counting information to make business decisions to understand major components of
the accounting system.
Exhibit 9 provides a more detailed description of the accounting system. The pri-
mary components of the system include measurement rules, processing and storage
procedures, reporting rules, and reports.



Exhibit 9 Transformation Process
The Accounting
Information System
Measurement Rules



Decisions




Processing
Reports
& Storage




Reporting Rules
F543
CHAPTER F14: Analysis of Operating Activities
548 Analysis of Operating Activities

Measurement rules determine which attributes of the transformation process en-
ter the accounting system. Measurement units used to measure activities in the trans-
formation process are primarily dollar values, based on the historical costs of resources
acquired or used in the transformation process. Transactions (primarily exchanges of
resources) are measured on an accrual basis. This basis recognizes events in the trans-
formation process when they cause resources to increase or decrease, rather than when
cash is received or paid. These events are recognized in specific fiscal periods so that
activities in the transformation process can be determined and evaluated on a timely
basis. Expenses are matched with revenues in the period in which resources are con-
sumed. The matching of expenses with revenues in particular fiscal periods requires es-
timation of the financial effects of some events. For example, depreciation and inventory
estimation are used to allocate asset costs to specific periods. Accounting measurement
rules often are conservative. These rules recognize expenses or losses in the period in
which an asset is likely to have been consumed or impaired or in which a liability is
likely to have been incurred. Revenues or gains often are deferred, however, until all
events that created the revenue or gain have been completed. Conservatism recognizes
that the financial effects of events often are estimates and attempts to ensure that rev-
enues and profits are not overstated by optimistic managers. The values of certain re-
sources that are difficult to measure objectively, such as management or employee skills
and brand names, are excluded from accounting measurement.
Processing and storage procedures determine how information from the transfor-
mation process enters the accounting system and how this information is summarized
and stored so that it can be provided to decision makers. Double-entry bookkeeping
has been the traditional method of recording transactions in an accounting system. Each
transaction is recorded in two or more accounts, which are information categories that
can be classified into five types: assets, liabilities, owners’ equity, revenues, and expenses.
The accounting cycle is a process for entering, processing, and summarizing account-
ing information. The process involves (1) examining business activities, (2) recording
transactions, (3) updating account balances, (4) making end-of-period adjustments, (5)
preparing financial statements, and (6) closing revenue and expense accounts. In most
businesses, many of these steps are performed by computer programs. Internal control
procedures ensure the accuracy of information in the accounting system.
Reporting rules determine the type and format of information reported by an ac-
counting system. Reporting rules govern the separation of accounting information into
individual financial statements. The rules specify the order of accounts or activities and
the amount of detail reported in financial statements and accompanying notes. Direct
and indirect formats for reporting the statement of cash flows are examples of report-
ing rules. Other examples include requirements that companies report their account-
ing policies and certain measurement rules in notes to financial statements. In general,
reporting rules require companies to provide sufficient information in their financial
statements or accompanying notes so that users are fully informed about the compa-
nies’ financial activities. Reporting rules also specify the timing of reports. For exam-
ple, most corporations are required to provide annual reports and quarterly updates to
their stockholders. In addition to general reports such as financial statements, specific
reporting rules may be used to design reports for special uses, such as those for man-
agers and taxing authorities.
Accounting reports are the summary documents provided to decision makers. Fi-
nancial statements (income statement, balance sheet, statement of cash flows, and state-
ment of stockholders’ equity) are the primary financial accounting reports. These
statements usually are accompanied by notes that explain numbers or activities in the
statements. Financial statements reported to external decision makers usually are ac-
companied by an audit report that expresses the auditor’s opinion about whether the
statements fairly present the company’s financial position and results of operations. Ac-
counting reports also may contain explanations by company management about events
reported in the financial statements.
Decisions of managers, owners, creditors, and others depend, in part, on their un-
derstanding of the information reported by a company’s accounting system. Managers
F544 SECTION F2: Analysis and Interpretation of Financial Accounting Information
549
Analysis of Operating Activities

make financing, investing, and operating decisions that determine the future of a com-
pany. These decisions rely on information about past financing, investing, and operat-
ing activities, and on estimation of the effects of decisions on future activities. Owners,
creditors, and other users evaluate managers’ financing, investing, and operating activ-
ities. They use accounting information to assess how well a company has performed
and how well it is likely to perform in the future.
Information about financing activities identifies a company’s capital structure and
the particular types of debt and equity a company uses to finance its assets. Financial
statements help users determine the effects of financial leverage on profitability and the
ability of a company to meet its debt obligations. They provide information about when
obligations will become due and about changes in financing, such as new borrowing,
repaying debt, and selling and repurchasing stock.
Information about investing activities identifies both the types of assets a company
has acquired and the changes in these assets over time. Financial statement users can
assess whether a company is growing (by acquiring additional assets) and whether those
assets are being used productively to generate additional sales and profits. Information
about assets also is useful for evaluating uncertainty about future profits if a company’s
sales are lower than expected. Companies with high operating leverage (high fixed to
total costs) are sensitive to sales volatility because they cannot reduce many of their
costs—for example, those associated with production facilities—in the short run.
Information about operating activities identifies how well a company is able to use
its assets to create sales and to control production and selling costs so that it earns a
profit. This information also is useful for assessing a company’s ability to convert prof-
its to cash and its ability to pay dividends or invest in growth opportunities. Separate
reporting of unusual or nonrecurring events helps users distinguish ordinary events
from those requiring special analysis.
Exhibit 10 summarizes information derived from financial statements for evaluat-
ing a company’s performance and assessing its value. Company value is depicted on the



Exhibit 10 Using Accounting Information to Make Decisions About Company Value


Revenues Debt &
Value Profits Assets
& Expenses Equity




Asset
Profit
Turnover
Margin




Assets/
Return on
Equity
Assets




Return on
Equity




Market to
Book Value
F545
CHAPTER F14: Analysis of Operating Activities
550 Analysis of Operating Activities

top line of the illustration as being derived primarily from a company’s ability to earn
profits. Profits, in turn, depend on a company’s ability to sell goods and services (rev-
enues) and its ability to use resources efficiently in producing and selling those prod-
ucts (expenses). Revenues and expenses depend on a company’s investment in assets
that can be used to produce and sell its products. A larger investment in assets should
permit a company to generate higher revenues, but it also results in higher expenses.
The ability of a company to invest in assets depends on financing available from debt
and equity. The amounts of debt and equity and the mix of debt relative to equity af-
fect investment decisions and operating results. Profits from operating results also are
a source of equity through retained earnings.
Accounting measures such as profit margin and asset turnover summarize relation-
ships among the various activities that create company value. Profit margin links prof-
its to revenues. Asset turnover links revenues to assets. Return on assets links profits to
assets. Return on equity links revenues to equity and encompasses all of the accounting
relationships from profits through revenues and expenses, assets, debt, and equity. There-
fore, it incorporates all of the activities in a company’s transformation process: financ-
ing, investing, and operating. Finally, market to book value links company value (market
value of stockholders’ equity) to accounting numbers. When the accounting performance
measures depicted in the exhibit are high, company value typically is high.
Consequently, understanding accounting information is important for under-
standing company value. Understanding the accounting system, including the rules used
to measure and report information and the procedures used to capture and summa-
rize this information, is critical to understanding accounting information. The primary
goal of this book has been to help you understand the components of the accounting
system, how they work, and how they can be used to understand business activities.




3 SELF-STUDY PROBLEM To understand a company’s operating activities, it is important
to understand the relationships among operating, investing, and
financing activities and to understand the accounting system that provides information
about these activities.

Required Explain why.

The solution to Self-Study Problem 3 appears at the end of the chapter.




REVIEW SUMMARY of IMPORTANT CONCEPTS


1. Operating decisions involve choices about how a company will produce and sell prod-
ucts to earn revenues and make a profit.
a. Sales revenue depends on sales volume and price per unit, which are indirectly re-
lated. An increase in price usually results in a decrease in volume.
b. The prices a company can charge for its products depend on what customers are
willing to pay based on the value of the products to them and the prices charged by
competitors.
c. If a market is highly competitive and companies in the market produce very similar
products, the companies usually will compete on the basis of price. They will keep
their prices low to attract customers and will depend on high sales volume to earn a
profit.
d. If a company can distinguish its products from competitors’ products by special fea-
tures or qualities, it can charge a higher price and earn more per unit from cus-
tomers who are willing to pay for these features or qualities.
e. Asset turnover measures the volume of sales (in dollars) relative to a company’s in-
vestment in assets. Companies that compete using low prices require high asset
turnover to earn a high profit and return on assets.
F546 SECTION F2: Analysis and Interpretation of Financial Accounting Information
551
Analysis of Operating Activities

f. Profit margin measures the amount of income a company can earn on its sales.
Companies that compete using special product features use high profit margin to
earn a high profit and return on assets.

2. The operating strategies that companies select depend on the types of products they
produce and sell.
a. Companies that rely on low costs use a cost leadership strategy and require high as-
set turnover.
b. Companies that rely on product features use a product differentiation strategy and
require high profit margin.
c. Product differentiation companies normally rely on brand-name identification, ad-
vertising of product features, and research and development activities to a greater
extent than cost leadership companies.
d. Many companies provide different products and product lines to compete in both
cost leadership and product differentiation markets.

3. Various measures can be used to evaluate the success of a company’s operating
strategy.
a. Profit margin, asset turnover, and return on assets are commonly used measures.
b. The ratio of operating cash flow to assets measures a company’s ability to convert
its profits into cash.
c. Inventory turnover measures a company’s ability to convert its investment in inven-
tory into sales.
d. Day’s sales in inventories measures the average number of days for a company to
sell its total inventory, or how many days’ supply of inventory it keeps on hand.
e. Accounts receivable turnover measures a company’s ability to convert its credit sales
into cash.
f. Average collection period measures how long it takes a company to collect its re-
ceivables.
g. Fixed asset turnover measures the effectiveness of a company in using its investment
in fixed assets to create sales.
h. Gross profit margin measures a company’s efficiency in the production or purchase
of goods for sale.
i. Operating profit margin measures a company’s efficiency in controlling selling and
administrative expenses in addition to its efficiency in controlling product costs.
j. Return on equity includes the effect of financing in evaluating overall company per-
formance and links operating, investing, and financing activities.
k. Times interest earned measures the ability of a company to meet its interest require-
ments.

4. Accounting provides information about a company’s transformation process to help
decision makers identify and evaluate past activities and plan for and form expectations
about future activities.
a. To use accounting information effectively, decision makers must understand the ac-
counting system that provides the information.
b. The system consists of measurement rules, processing and storage procedures, re-
porting rules, and reports that provide particular types of information about a com-
pany’s activities.
c. Decision makers who understand how information is produced by the accounting
system can use this information to assess performance and company value.




DEFINE TERMS and CONCEPTS DEFINED in this CHAPTER


accounts receivable turnover (F538) gross profit margin (F539)
average collection period (F539) inventory turnover (F537)
day’s sales in inventories (F538) operating profit margin (F539)
fixed asset turnover (F539) times interest earned (F540)
F547
CHAPTER F14: Analysis of Operating Activities
552 Analysis of Operating Activities


SELF-STUDY PROBLEM SOLUTIONS
SSP14-1 A. Profit margin net income sales revenues

Ardmore: $100 $800 12.5%
Bellwood: $80 $800 10%

Asset turnover sales revenues total assets

Ardmore: $800 $1,000 0.8
Bellwood: $800 $800 1.0

Return on assets profit margin asset turnover

Ardmore: 12.5% 0.8 10%
Bellwood: 10.0% 1.0 10%

B. Ardmore appears to charge higher prices for its products than Bellwood. It earns more
for each dollar of sales (12.5¢ for Ardmore versus 10¢ for Bellwood). Bellwood sells
more of its product than Ardmore, however. It sells $1 of product for each $1 invested
in assets, whereas Ardmore sells 80¢ for each $1 invested. By charging lower prices,
Bellwood is able to sell more product.
Ardmore earns a higher net income than Bellwood, but each company earns the
same return on assets. Therefore, neither company is more profitable than the other
relative to their investments in assets. We can conclude that each company is prof-
itable, but the companies use different strategies to create their profits. Ardmore appar-
ently sells products with features or quality that are more desirable than those of
Bellwood. Customers are willing to pay more for these products, though they purchase
fewer of them. Bellwood competes by selling lower-price products and by selling a
higher volume than Ardmore.
C. The primary factors involved in creating a high return on assets are revenues, expenses,
and assets. Revenues depend on sales price and volume. Companies are more effective
if they can sell more of their products to earn higher revenues without increasing ex-
penses. Companies increase revenues by increasing sales prices if they sell the same
number of units. Also, they increase revenues by increasing sales volume if they sell at
the same price. They earn higher net income if they reduce expenses without decreas-
ing sales revenues. Finally, companies increase return on assets by reducing the amount
of assets they need to earn a given amount of net income. Companies are more effi-
cient if they reduce assets or expenses without reducing revenues. Thus, companies be-

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