Solution Manual for
Understanding Financial Statements, 12th edition
Chapter 1
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,Solutions to Study Questions, Problems, and Cases
Chapter 1
1.1 The types of questions that can be answered include the following:
• Would an investment generate attractive returns?
• What is the degree of risk inherent in the investment?
• Should existing investment holdings be liquidated?
• Will cash flows be sufficient to service interest and principal payments to
support the firm’s borrowing needs?
• Does the company provide a good opportunity for employment, future
advancement, and employee benefits?
• How well does this company compete in its operating environment?
• Is this firm a good prospect as a customer?
1.2 The SEC requires regular filing of Annual reports (10-K), quarterly reports
(10-Q) and other reports dependent on particular circumstances, such as a change
in auditor, bankruptcy, financial restatements, or other important events (all filed
as 8-K reports).
1.3 The analyst should use the financial statements: the balance sheet, the
income statement, the statement of stockholders' equity, and the statement of cash
flows; the notes to the financial statements; supplementary information such as
financial reporting by segments; the auditor's report; management's discussion and
analysis of operating performance and financial condition; and the five-year
summary of financial data.
Use the public relations "fluff," such as colored pictures and descriptive material
with caution.
1.4 The SEC has the legal authority to write accounting rules in the United
States, however, they choose to delegate writing rules, for the most part, to the
FASB. The SEC plays a supportive role and at times will encourage FASB to write
particular rules or make changes to policies.
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,1.5 The annual report or Form 10-K includes the following four financial
statements:
1. The balance sheet or statement of financial position shows the financial
position—assets, liabilities, and stockholders’ equity—of the firm on a
particular date, such as the end of a quarter or a year.
2. The statement of comprehensive income presents the results of operations—
revenues, expenses, net profit or loss, and net profit or loss per share—for the
accounting period.
3. The statement of stockholders’ equity reconciles the beginning and ending
balances of all accounts that appear in the stockholders’ equity section of the
balance sheet. Some firms prepare a statement of retained earnings, frequently
combined with the income statement, which reconciles the beginning and
ending balances of the retained earnings account. Companies choosing the
latter format will generally present the statement of stockholders’ equity in a
footnote disclosure.
4. The statement of cash flows provides information about the cash inflows and
outflows from operating, financing, and investing activities during an
accounting period.
1.6 The notes are an integral part of the statements and must be read in order to
understand the presentation on the face of each financial statement. The notes
to the financial statements provide a summary of the firm’s accounting
policies, any changes in accounting policies during the reporting period, details
about particular accounts, such as inventory, property, plant, and equipment,
investments, debt and equity accounts, and information about items such as
acquisitions, divestitures, pension and stock option plans, leases, legal
proceedings, income taxes, contingencies, commitments, and segments,
1.7 A qualified report is issued when the overall financial statements are fairly
presented "except for" items which the auditor discloses; an adverse opinion is
issued when the financial statements have departures from GAAP so numerous that
the statements are not presented fairly. A disclaimer of opinion is caused by a
scope limitation resulting in the auditor being unable to evaluate and express an
opinion on the fairness of the statements. An unqualified opinion with explanatory
language is caused by a consistency departure due to a change in accounting
principle, uncertainty caused by future events such as contract disputes and
lawsuits, or any other events which the auditor believes may present business risk
and going concern problems.
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, 1.8 The Management Discussion and Analysis section is of potential interest to
the analyst because it contains information that cannot be found in the financial
data. The content of this section includes coverage of any favorable or unfavorable
trends and significant events or uncertainties in the areas of liquidity, capital
resources, and results of operations. In particular, the analyst can expect to find a
discussion of the following:
1. The internal and external sources of liquidity
2. Any material deficiencies in liquidity and how they will be remedied
3. Commitments for capital expenditures, the purpose of such commitments, and
expected sources of funding
4. Anticipated changes in the mix and cost of financing resources
5. Unusual or infrequent transactions that affect income from continuing
operations
6. Events that cause material changes in the relationship between costs and
revenues (such as future labor or materials price increases or inventory
adjustments)
7. A breakdown of sales increases into price and volume components
1.9 The proxy statement is a document required by the SEC to solicit
shareholder votes, since many shareholders do not attend shareholder meetings.
The analyst can find important information in the proxy statement such as
background information on the company's nominated directors, director and
executive compensation, any proposed changes to those compensation plans and
the audit and non-audit fees paid to the auditing firm.
1.10 Employee relations with management, employee morale and efficiency, the
reputation of the firm with its customers and in its operating environment, the
quality and effectiveness of management, provisions for management succession,
potential exposure to regulatory changes, "bad publicity" in the media.
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