Chapter 14 - Understanding Financial Statements

CHAPTER 14
UNDERSTANDING FINANCIAL STATEMENTS
Changes from Twelfth Edition
Updated from the Twelfth Edition. A new case Tokyo AFM has been added. Two cases
Scientific Instruments and Limited Editions have been dropped.
Approach
Some pulling together and review of financial accounting seems to be desirable at this point. When
the basic concepts were first introduced in Chapters 2 and 3, their full meaning, and especially the
qualifications relating to them, was undoubtedly not entirely clear. This chapter reviews these
concepts in the light of the additional information that the student has acquired in intervening
chapters.
There is no way of ensuring, of course, that students will come away with just the right balance
between appreciating the value of accounting information and recognizing its limitations. We have
tried to strike such a balance as best we can, but instructors may lean more in one direction or the
other, according to their own opinion.
Cases
Quick Lunch is a complete accounting cycle, requiring the construction of financial statements from a
narrative explanation of events.
Accounting at MacCloud Winery requires decisions on a number of accounting issues. This case is
new to this edition.
PolyMedica Corporation exercises a companys decision to capitalize direct response advertising
costs. This case is new to this edition.
Tokyo AFM requires students to decide how a property casualty insurance company should account
for a number of transactions and events with income statement and balance sheet consequences.

Problems
Problem 14-1
The auditors decide what audit procedures are necessary to provide reasonable assurance that the
financial statements do not include material misstatements. The auditors fee should not play a role in
setting the scope of an audit.

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In making their examination, auditors do not rely primarily on a detailed rechecking of the analysis,
journalizing, and posting of each transaction. Rather, they satisfy themselves that the accounting
system is designed to ensure that the data are processed properly. The auditors (1) make test checks of
how well the system is working, (2) verify the existence of assets (for example, they must observe the
taking of physical inventory), (3) ask a sample of customers to confirm, or verify, the accuracy of the
accounts receivable, (4) check bank balances and investment securities, and (5) make sure that
especially important or non-routine transactions are recorded in conformity with generally accepted
accounting principles (GAAP).
These checks provide reasonable assurance that material errors have not been committed through
oversight or carelessness and that there has been no misstatement of financial statements due to
fraudulent activity. They do not provide absolute assurance, however; almost any system can be
beaten by someone intent on doing so. Although spectacular frauds receive much publicity, they are
infrequent relative to the number of companies audited every year.
The word fairly should be contrasted with the word accurately. The auditors do not say that the
reported net income is the only, or even the most accurate, number that could have been reported.
Rather, they say that of the many alternative principles that could have been used, those actually
selected by management do give a fair picture in the circumstances relevant to the particular
company. This contrast between fairness and accuracy is further emphasized by the fact that the
auditors report is called an opinion. Auditors do not certify the accuracy of the statements; instead,
they give their professional opinion that the presentation is fair.
If a company uses an accounting principles that is inconsistent with an FASB pronouncement, the
auditors will write an adverse opinion. Qualification may occur for any of three reasons: (1) a lack of
consistency, (2) existence of a major uncertainty, or (3) doubt as to the entitys ability to continue as a
going concern.
Problem 14-2
a. Typically, accounting does not recognize these changes in value. The cost of assets shown on
financial statements seldom reflects the assets current market value. Some believe that the
historical cost convention flows from the going concern concept, which implies that since the
business is not going to sell its fixed assets as such, there is little point in revaluing assets to
reflect current values. For practical reasons, the accountant prefers the reporting of actual original
costs to less certain estimates, which are more difficult to verify. By using historical costs, the
accountants already difficult task is not further complicated by the need to keep additional
records of changing market values.
b.

dr. Property Plant and Equipment....................................................................................................................................

1,750,000
cr. Revaluation Reserve...............................................................................................................................................
1,750,000

The credit to a revaluation reserve is to an equity account. Depreciation would be based on the new
carrying value of the asset. The revaluation gain should not be included as income.

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Problem 14-3
The principal exceptions to the historical cost concept are the lower of cost or market rule, the
recording at market of trading and available-for-sale securities and the accounting for derivatives at
fair value. Pension plan assets are also reported at their market values. Another departure from the
cost concept is the reporting of foreign exchange denominated payables and receivables at current
exchange rates.
Problem 14-4
a. The company lists a number of sources of deferred tax assets. Deferred tax assets arise when the
company records expenses for book purposes before it does for tax purposes or records revenue
for tax purposes before it does for book purposes.
The company lists several sources of deferred tax liabilities. Deferred tax liabilities arise when a
company recognizes expenses for tax purposes before it does for book purposes or records
revenue for book purposes before it does for tax purposes.
The different treatment of revenue and expense items for book and tax purposes leads to
differences between its book carrying values of assets and liabilities and their tax basis. These
differences and the changes in them are used to measure deferred tax balances.
b. The actual tax payments (cash outflow) are disclosed along with the reasons why the companys
book tax rate is considerably lower than the federal statutory rate. The deferred tax asset and
liability disclosure indicates the sources of the deferred tax credits that result in its companys
low book tax rate.
c. In measuring deferred taxes, management can assume possible future feasible tax strategies. The
treatment of the valuation allowance requires a probability determination by management (more
likely or not).
The tax note provides detailed tax information beyond that communicated in the primary
financial statements. These data help readers to understand better the companys tax accounting
practices, tax policies and tax position and its role of management judgment in measuring
deferred taxes.
Problem 14-5
The factors not captured in financial statements that are vitally important in evaluating the health and
prospects of a company might include the health of its chief executive officer; the morale of the work
force; the intellectual capital of the company; the market prospects for its products and services; the
companys competitive strengths and weaknesses; the state of the economy; the soundness of the
companys strategy; and the companys access to funding sources.

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Cases
Case 14-1: Quick Lunch*
Note: Unchanged from the Twelfth Edition.
Approach
This is a good review case in which the student must exercise judgment in the treatment of some
items. As a result, students will come up with more than one net income figure, which seems to be
within the framework of generally accepted accounting principles. If he or she wishes, the instructor
can use the discussion on these specific matters in Quick Lunch as a springboard for a broader
discussion of the meaning and usefulness of financial statements prepared under GAAP. (Statements
appear on the next two pages of this manual.)
Notes
1. This treatment shows the redeemed coupons at their net value (27.5/30 of face value). An
acceptable alternative is to charge off the full amount of the discount in 2002 and show $1,500 as
a liability. This makes for simpler accounting and could be defended on the grounds that the
discount was given to acquire cash in advance of eating, the full benefit of which has been
obtained in 2002.
2. The withdrawal could have been regarded as a labor expense, although it is less than the value of
Binghams services as measured by his earnings previously. Alternatively, an estimate of the
value of these services could have been shown as wages. It is important that the Binghams
understand whatever method is used, or they will misinterpret their net income.

QUICK LUNCH
Income Statement for the Four Months Ended December 31, 2002
Cash sales.............................................................................................................................................................................
$29,315
Coupon sales (Note 1)..........................................................................................................................................................
$ 2,475
Net sales...............................................................................................................................................................................
31,790
Expenses..............................................................................................................................................................................
Food..................................................................................................................................................................................
14,415
Rent...................................................................................................................................................................................
4,975
Depreciation of equipment (Note 4)..................................................................................................................................
440
Amortization of leasehold.................................................................................................................................................
1,900
License fee........................................................................................................................................................................
75
Other expenses..................................................................................................................................................................
90
Total expenses...............................................................................................................................................................
21,895
Net income...........................................................................................................................................................................
9,895
Less: Withdrawals (Note 2)..............................................................................................................................................
3,800
Addition to capital................................................................................................................................................................
$ 6,095

This teaching note was prepared by Robert N. Anthony. Copyright Robert N. Anthony.
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QUICK LUNCH
Balance Sheet as of December 31,2002
Assets

Current assets:
Cash............................................................................................................................................................................
$12,265
Merchandise inventory...............................................................................................................................................
750
Prepaid license fee......................................................................................................................................................
150
Total current assets..................................................................................................................................................
$13,165
Plant and equipment:
Equipment (Note 3)....................................................................................................................................................
8,800
Less: Accumulated depreciation (Note 4)................................................................................................................
440
8,360
Leasehold (or goodwill) (Note 5)............................................................................................................................
3,800
Total assets...........................................................................................................................................................
$25,325

Liabilities and Owners Equity

Current liabilities:..........................................................................................................................................................
Accounts payable........................................................................................................................................................
$ 2,405
Coupons payable.........................................................................................................................................................
1,375
Total current liabilities.............................................................................................................................................
3,780
Owners equity:
Original capital...........................................................................................................................................................
$15,450
Plus: Addition from operations...................................................................................................................................
6,095
Total owners equity................................................................................................................................................
21,545
Total liabilities and owners equity......................................................................................................................
$25,325
3. The installation cost of $600 has been included as a fixed asset. Since the value of the installation
is lost if the lease is terminated, an argument can be made for setting up the installation separately
and writing it off over one year or four years, the life of the lease without or with extensions.

QUICK LUNCH
Statement of Cash Flows
For the Four Months Ended December 31, 2002
Net cash flow from operating activities:
Net income......................................................................................................................................................................
$ 9,895
Noncash items included in net income:
Depreciation.................................................................................................................................................................
440
Amortization of leasehold............................................................................................................................................
1,900
Increase in inventory....................................................................................................................................................
(750)
Increase in prepaid fee.................................................................................................................................................
(150)
Increase in accounts payable........................................................................................................................................
2,405
Increase in coupons payable........................................................................................................................................
1,375
Net cash from operating activities............................................................................................................................
15,115

Cash flows from investing activities:

Acquisition of equipment................................................................................................................................................
(4,600)
Proceeds from disposal of old equipment.......................................................................................................................
400
Net cash used for investing activities...........................................................................................................................
(4,200)
Cash flows from financing activities:
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Chapter 14 - Understanding Financial Statements

Withdrawals by owner..........................................................................................................................................................
(3,800)
Net increase in cash..................................................................................................................................................................
7,115
Cash at beginning of the period................................................................................................................................................
5,150
Cash at the end of the period....................................................................................................................................................
$12,265
Notes:
A. This statement has been prepared for the period starting with the commencement of
operations. An alternative would be to prepare it for the period starting with the owners
initial investment of capital (a $15,450 financing activity, $10,300 investing activity, and
additional cash increase of $5,150 from the beginning cash balance of zero).
B. The cash flow from operations could also have been developed using the direct method,
instead of the indirect (reconciliation) method. The data come right out of the cash receipts
and disbursements table in the case: $33,165 - $14,275 - $225 - $3,460 - $90 = $15,115.
4. Depreciation could be estimated on the basis of one year (on assumption that equipment is
worthless if lease is not renewed), 4 years (assuming that lease will be renewed once), 10 years
(useful life of equipment), or any other reasonable estimate of life. The solution uses straight-line
over 10 years and follows the convention (not necessarily valid) of taking one-half-years
depreciation in the first year. Arguments can, of course, also be made for accelerated depreciation
and for including an estimate of salvage value.
5. The solution takes the very conservative route of writing off the leasehold over one year. Four
years can easily be defended. $10,300 4,600 = $5,700 excess of amount paid over value of
assets received. $5,700 x 4/12 = $1,900 amortization; $3,800 unamortized cost.
6. The coffee urn repairs are disregarded although an argument can be made for showing the value
of Mr. Binghams labor (at Sunday rates?) as an expense. The amount should not be capitalized.
7. No provision is made for income taxes on the grounds that these are a personal matter.
Question 2
At his old job, Mr. Bingham made perhaps $390 per week, or $6,630 for 17 weeks. This is less than
the income for the venture, but does not allow anything for Mrs. Binghams services or for a return on
the $15,450 investment. On the other hand, the business is just getting started, and the stated profit is
conservative because of the large write-off of fixed assets.
Case 14-2: Accounting at MacCloud Winery*
Note: This is unchanged from the Twelfth Edition. Please see the printed Instructors Resource
Manual for the Harvard Teaching Notes.
Case 14-3: PolyMedica Corporation (A)
Note: This case is unchanged with the Twelfth Edition. Please see the printed Instructors Resource
Manual for the Harvard Teaching Notes.

This note was prepared by Professors David F. Hawkins and Gregory S. Miller. Copyright 2005 by its
President and Fellows of Harvard College. Harvard Business School Teaching Note 106-008.
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Chapter 14 - Understanding Financial Statements

Case 14-4: Tokyo*

Note: A new case with the Thirteenth Edition. Please see the printed Instructors Resource Manual
for the Harvard Teaching Notes.

This note was prepared by Professor Francois Brochet. Copyright 2009 President and Fellows of Harvard College.
Harvard Business School Teaching Note 109-091.

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