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Financial Statement Analysis

Reading 29 Financial Statement Analysis: An introduction

497

Financial Statement Analysis 1-Which of the following statements about financial statement analysis and reporting is least accurate? A) Deciding whether to recommend a companys securities to investors is a role of financial statement analysis. B) Financial statement analysis uses financial statement data to form opinions about the companys ability to generate cash flow in the future. C) Providing information about changes in a companys financial position is a role of financial reporting.

D) Financial statement analysis focuses on the way companies show their financial performance to investors by preparing and presenting financial statements.
498

Financial Statement Analysis Financial reporting refers to the way companies show their financial performance to investors, creditors, and other interested parties by preparing and presenting financial statements, including information about changes in a companys financial position. The role of financial statement analysis is to use the information in a companys financial statements, along with other relevant information, to make economic decisions, such as whether to invest in the companys securities or recommend them to other investors. Analysts use financial statement data to evaluate a companys past performance and current financial position in order to form opinions about the companys ability to earn profits and generate cash flow in the future.

499

Financial Statement Analysis 2-Which of the following best describes financial reporting and financial statement analysis? A) Financial reporting is performed by investors, creditors, and other interested parties. B) Financial reports assess a companys past performance in order to draw conclusions about the companys ability to generate cash and profits in the future. C) The objective of financial analysis is to provide information about the financial position of an entity that is useful to a wide range of users. D) Financial reporting refers to how companies show their financial performance and financial analysis refers to using the information to make economic decisions.
500

Financial Statement Analysis

Financial reporting refers to the way companies show their financial performance to investors, creditors, and other interested parties by preparing and presenting financial statements. The objective of financial statements, not analysis, is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. The role of financial statement analysis, not reporting, is to use the information in a companys financial statements, along with other relevant information, to make economic decisions.

501

Financial Statement Analysis 3-Which of the following is least likely to be considered a role of financial statement analysis? A) B) C) D) Determining whether to invest in the companys securities. Deciding whether to extend trade credit to the company. To make economic decisions. Assessing the management skill of the companys executives.

502

Financial Statement Analysis The role of financial statement analysis is to use the information in a companys financial statements, along with other relevant information, to make economic decisions. Examples of such decisions include whether to invest in the companys securities or recommend them to other investors, or whether to extend trade or bank credit to the company. Although the financial statements might provide indirect evidence about the management skill of the companys executives, that is not generally considered the role of

financial statement analysis.

503

Financial Statement Analysis 4-According to the IASB, which of the following least accurately describes financial reporting? A) provides information about changes in financial position of an entity. B) is useful to a wide range of users.

C) uses the information in a companys financial statements to make economic decisions. D) provides information about the financial performance of an entity.

504

Financial Statement Analysis The role of financial reporting is described by the International Accounting Standards Board (IASB) in its Framework for the Preparation and Presentation of Financial Statements: The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. Using the information in a companys financial statements to make economic decisions is financial analysis, not financial reporting.

505

Financial Statement Analysis 5-Which of the following statements represents information at a specific point in time? A) B) C) D) The income statement. The statement of cash flows. The income statement and the balance sheet. The balance sheet.

506

Financial Statement Analysis

The balance sheet represents information at a specific point in time. The income statement represents information over a period of time. The statement of cash flows also represents information over a period of time.

507

Financial Statement Analysis 6- Which of the following statements regarding footnotes to the financial statements is FALSE? A) Footnotes provide information about assumptions and estimates used by management. B) Some supplementary schedules are audited whereas footnotes are not audited. C) Footnotes may disclose what types of accounting methods are being used. D) Footnotes may contain information regarding contingent losses.

508

Financial Statement Analysis Some supplementary schedules are not audited whereas footnotes are audited. The financial statements and footnotes in the annual report and the SEC 10-k filings are all audited. The other statements

are true.

509

Financial Statement Analysis 7-The Management Discussion and Analysis (MD&A) portion of the financial disclosure is required to discuss all of the following EXCEPT: A) B) capital resources and liquidity. results of operations.

C)
D)

expected effects of marketplace events.


a general business overview based on known trends.

510

Financial Statement Analysis The MD&A portion of the financial disclosure is required to discuss results of operations, capital resources and liquidity and a general business overview based on known trends. A discussion of expected effects of marketplace events may voluntarily be included by a firm, but is not required in the MD&A portion.

511

Financial Statement Analysis 8-The standard auditor's report is most likely required to: A) provide an "unqualified" opinion if material uncertainties exist.

B) provide reasonable assurance that the financial statements contain no material errors. C) mention any significant deficiencies in the internal control structure. D) provide reasonable assurance that management is reliable.

512

Financial Statement Analysis

The standard auditor's report contains three parts: 1. The financial statements are prepared by management and are their responsibility and the auditor has performed an independent review. 2. The audit was conducted using generally accepted auditing standards, which provides reasonable assurance that there are no material errors in the financial statements. 3. The auditor is satisfied the statements were prepared in accordance with accepted accounting principles, and the principles chosen and estimates are reasonable. Under U.S. GAAP, the auditor is required to state an opinion on the company's internal controls. The auditor may add this opinion as a fourth element of the auditor's report or provide it separately.

513

Financial Statement Analysis 9-Which of the following would NOT require an explanatory paragraph added to the auditors report? A) Doubt regarding the "going concern" assumption.

B) Uncertainty regarding the valuation or realization of assets and payment of liabilities. C) Uncertainty due to litigation.

D) Statements that the financial information was prepared according to GAAP.

514

Financial Statement Analysis The statements that the financial information was prepared according to GAAP should be included in the regular part of the auditors' report and not as an explanatory paragraph. The other information would be contained in explanatory paragraphs added to the auditors report.

515

Financial Statement Analysis 10-Which of the following is an independent auditor least likely to do with respect to a companys financial statements? A) B) C) D) Provide an opinion concerning their fairness and reliability. Prepare and accept responsibility for them. Perform an independent review of them. Confirm assets and liabilities contained in them.

516

Financial Statement Analysis Auditors make an independent review of financial statements, which are prepared by company management and are managements responsibility. It is the responsibility of auditors to confirm the assets, liabilities, and other items included in the statements and then issue an opinion concerning their fairness and reliability.

517

Financial Statement Analysis 11-Which of the following is the best description of the financial statement analysis framework? A) Gather data, analyze and interpret the data, determine the context, report the conclusions, update the analysis. B) State the objective and context, gather data, process the data, analyze and interpret the data, report the conclusions or recommendations, update the analysis. C) Process and analyze the data, interpret the context, determine the objective, report the recommendations. D) Gather data, analyze and interpret the data, process the conclusions, assess the context, report the recommendations, update the analysis.

518

Financial Statement Analysis The financial statement analysis framework consists of six steps: 1. State the objective and context. 2. Gather data. 3. Process the data. 4. Analyze and interpret the data. 5. Report the conclusions or recommendations. 6. Update the analysis.

519

Financial Statement Analysis

READING 32 UNDERSTANDING THE INCOME STATEMENT

520

Financial Statement Analysis 35- Do gains and losses, and do expenses appear on the income statement? Gains and Losses Yes Yes Expenses Yes No

A) B)

C)
D)

No
No

Yes
No

521

Financial Statement Analysis Gains and losses result from, transactions that are not a part of the firms normal business operations. Expenses are amounts that are incurred to generate revenue; thus, expenses result from the firms ongoing operations. Both are included on the income statement.

522

Financial Statement Analysis 36- Would an increase in the cost of raw materials used in the production of inventory and would an increase in marketing expenses result in lower gross profit? Increase in raw materials cost A) B) C) D) Yes No No Yes Increase in marketing expense Yes No Yes No

523

Financial Statement Analysis Gross profit is equal to sales minus cost of goods sold. Cost of goods sold includes the direct costs of producing a product or service such as raw materials, direct labor, and overhead (fixed costs). Thus, an increase in raw materials costs will result in higher cost of goods sold and lower gross profit. Marketing expenses are considered operating expenses (SG&A), not in cost of goods sold.

524

Financial Statement Analysis 37- CPP Corporation has a contract to build a custom test chamber for a client for $100,000. CPP Corporation uses the percentage-ofcompletion method for accounting and estimates the total costs for the project to be equal to $80,000. CPP Corporation has promised to complete the project within three years. At year-end the customer has paid $60,000, equaling the total amount billed for the year, and total costs incurred to date are $40,000. On the income statement, net income for the year-end will be: A) B) $10,000. $20,000.

C)
D)

$6,667.
-$10,000.
525

Financial Statement Analysis Under the percentage-of-completion method, one-half of the total revenue is recognized because one-half of the costs have been incurred ($40,000 / $80,000). Therefore, revenue will be equal to $50,000, expenses are $40,000, and net income will be $10,000.

526

Financial Statement Analysis 38- According to the installment method of accounting, gross profit on an installment sale is recognized: A) B) C) on the date of sale. on the date the final cash collection is received. in proportion to the cash collection.

D) after cash collections equal to the cost of sales have been received.

527

Financial Statement Analysis The installment sales method recognizes sales and COGS in proportion to cash collections

528

Financial Statement Analysis An analyst has gathered the following data pertaining to Hegel Companys construction projects, which began during 2002: Project 1 Project 2 Contract price $420,000 $300,000 Costs incurred in 2002 240,000 280,000 Estimated costs to complete 120,000 40,000 Billed to customers during 2002 150,000 270,000 Received from customers during 2002 90,000 250,000 39 -If Hengel used the completed contract method, what amount of gross profit (loss) would Hengel report in its 2002 income statement for: Project 1 Project 2 A) ($20,000) $0 B) C) $0 ($20,000) ($20,000) ($20,000)

D)

$0

$0

529

Financial Statement Analysis No profit is recognized until the completion of the project, however losses are recognized. Project 2 has an expected loss of $20,000.

530

Financial Statement Analysis 40- If Hengel used the percentage-of-completion method, what amount of gross profit (loss) would Hengel report in its 2002 income statement?

A)
B) C) D)

$20,000.
$(20,000). $22,500. $40,000.

531

Financial Statement Analysis Under the percentage of completion method, $40,000 of profit is recognized for project 1. 120,000 + 240,000 = 360,000 total costs; 240,000 / 360,000 60,000 estimated profit = $40,000 profit. Project 2 is running at a $20,000 loss. If the loss can be estimated the loss must be recognized at the time it is estimated. Total revenue for project 2 = 300,000 contract price 320,000 total costs = -$20,000 estimated loss 40,000 (project 1) 20,000 (project 2) = $20,000 gross profit in 2002

532

Financial Statement Analysis 41- An analyst has gathered the following data pertaining to Hegel Companys construction projects, which began during 2002: Project 1 Project 2 Contract price $420,000 $300,000 Costs incurred in 2002 240,000 280,000 Estimated costs to complete 120,000 40,000 Billed to customers during 2002 150,000 270,000 Received from customers during 2002 90,000 250,000 If Hengel used the completed contract method, what amount of gross profit (loss) would Hengel report in its 2002 income statement for: Project 1 Project 2 A) $0 ($20,000) B) C) D) ($20,000) ($20,000) $0 $0 ($20,000) $0
533

Financial Statement Analysis No profit is recognized until the completion of the project, however losses are recognized. Project 2 has an expected loss of $20,000.

534

Financial Statement Analysis 42-Cash collection is a critical event for income recognition under the: Cost-Recovery Method Installment Method A) Yes Yes B) C) No No Yes No

D)

Yes

No

535

Financial Statement Analysis Recognition of income depends on cash collected under both methods.

536

Financial Statement Analysis 43 -Lee Ann Company collected the following amounts for subscriptions to the magazine it publishes during the past year: Date Amount Collected Subscription April 1 $60,000 one year July 1 $30,000 two years October 1 $36,000 three years What amount of subscription revenue should Lee Ann Co recognize for the year? A) B) $45,000. $55,500.

C)
D)

$60,000.
$126,000.

537

Financial Statement Analysis The subscriptions earned is the sum of $45,000 ($60,000 9/12), $7,500 [($30,000 x 6/24)] and $3,000 ($36,000 x 3/36).

538

Financial Statement Analysis 44-Under the cost recovery method, profit is recognized: A) B) C) D) as collection occurs. at time of delivery. after the amount of cost has been collected. at time of sale.

539

Financial Statement Analysis The cost recovery method is used when the costs to provide goods or services are not known. Under this method, sales are recognized when cash is received, but no gross profit is recognized until all of the cost of goods sold is collected.

540

Financial Statement Analysis 45-If a reliable estimate of total costs of the contract does not exist, which of the following revenue recognition methods should be used?

A)
B) C) D)

Completed contract method.


Percentage-of-completion method. Installment sales method. Cost recovery method.

541

Financial Statement Analysis

The installment sales method is used when the assurance of payment and estimated bad debts does not exist before cash is collected. Sales revenue and COGS are recognized only when cash is received. The cost recovery method is used when future cash collections are not assured even after receipt of partial payments. Gross profit is not recognized until all of the cost of goods sold is collected. The percentage-of-completion method is used when ultimate payment is assured and revenue is earned as costs are incurred. Profit is recognized corresponding to the percentage of costs incurred to the total estimated.

542

Financial Statement Analysis 46-Which revenue recognition method is used when the payment is assured and revenue is earned as costs are incurred? A) B) C) D) Installment sales method. Completed contract method. Cost recovery method. Percentage-of-completion method.

543

Financial Statement Analysis

The installment sales method is used when the assurance of payment and estimated bad debts does not exist before cash is collected. Sales revenue and COGS are recognized only when cash is received. The completed contract method is used when a reliable estimate of the total costs does not exist and the amount of revenue cannot be determined until the contract is finished. Revenue is recognized only when the contract is completed and the title is transferred. The cost recovery method is used when future cash collections are not assured even after receipt of partial payments. Gross profit is not recognized until all of the cost of goods sold is collected.

544

Financial Statement Analysis 47-As a general rule, revenue is normally recognized when it is: A) B) C) earned. measurable and received. realized and earned.

D)

measurable.

545

Financial Statement Analysis

Under the accrual concept, revenue is recognized when the earnings process is completed (earned) and ultimate realization (cash receipt) is assured.

546

Financial Statement Analysis 48-Which of the following statements regarding revenue recognition is least accurate? A) The completed contract method does not recognize revenue and expenses until the contract is completed and title is transferred. B) Revenues should be recognized when the earnings process is complete and payment is assured. C) The installment sales method recognizes revenue and associated cost of goods sold only when cash is received. D) sale. The cost recovery method recognizes revenues at the time of

547

Financial Statement Analysis The cost recovery method recognizes sales when cash is received, but no gross profit is recognized until all the cost of goods sold is collected.

548

Financial Statement Analysis 49- When a reliable estimate of costs exists, ultimate payment is assured, and revenue is earned as costs are incurred, which of the following revenue recognition methods should be used? A) B) C) D) Installment sales method. Completed contract method. Percentage-of-completion method. Cost recovery method.

549

Financial Statement Analysis The completed contract method doesnt recognize revenue and expense until the contract is completed and title is transferred. All profit is recognized when the contract is completed. The completed contract method is used when selling price or cost estimates are unreliable. The installment sales method recognizes revenue and associated cost of goods sold only when cash is received. Gross profit (sales cost of goods sold) reflects the proportion of cash received. The cost recovery method is similar to the installment sales method but is more conservative. Sales are recognized when cash is received, but no gross profit is recognized until all of the cost of goods sold is collected.

550

Financial Statement Analysis 50-The Kammel Building Company has a contract to build a building for $100 million. The estimate of the cost of the project is $75 million. In the first year of the project, Kammel had costs of $30 million. Kammels reported profit for the first year of the contract, using the completed contract method, is: A) B) C) D) $10 million. $15 million. $20 million. $0.

551

Financial Statement Analysis Under the completed contract method, profit is only reported upon completion of the contract.

552

Financial Statement Analysis 51- Which of the following statements regarding the methods of revenue recognition is most accurate? A) The completed contract method, in comparison to the percentage-of-completion method, will generally result in higher net income. B) The completed contract method is used when the selling price or cost estimates are unreliable. C) The percentage-of-completion method is primarily used in contracts that have short lives.

D) The percentage-of-completion method generally results in lower retained earnings than the completed contract method.

553

Financial Statement Analysis The completed contract method compared to the percentage-ofcompletion method will result in lower net income since revenue is recognized later. Hence, retained earnings will also be lower than the percentage-of-completion method.

554

Financial Statement Analysis 52- When the cost of goods and services used are recognized as an expense in the same period that its generated revenue is recognized, which of the following principle(s) is/are being described? A) B) The matching principle for revenue and expense recognition. The accrual and expense recognition principles.

C)
D)

The depreciation and accrual principles.


The matching and accrual principles.

555

Financial Statement Analysis The accrual concept states that revenue is recognized when the earnings process is completed and cash receipt is assured.

556

Financial Statement Analysis

53- Extraordinary items are: A) B) C) D) reported above the line. unusual or infrequent. unusual and infrequent. reported on the balance sheet.

557

Financial Statement Analysis 54- Which of the following is least likely reported net of tax on the income statement under U.S. GAAP? A) B) C) D) Income from discontinued operations. Extraordinary items. Interest expense. Uninsured losses from natural disasters.

558

Financial Statement Analysis Interest expense would be considered an expense that is incurred from continuing operations and, therefore, is listed prior to subtracting the income tax expense on the income statement. Income from discontinued operations and extraordinary items are included on the income statement after the net income from continuing operations is reported and after the income tax expense from continuing operations is reported. Therefore, these latter accounts are reported net of tax.

559

Financial Statement Analysis 55- All the following items are reported net of taxes below net income from continuing operations on the income statement EXCEPT: A) B) C) D) extraordinary items. income from discontinued operations. expropriations by foreign governments. unusual or infrequent items.

560

Financial Statement Analysis Unusual or infrequent items appear as a component of net income from continuing operations and are reported "above the line." Extraordinary items, such as expropriations, are unusual and infrequent and appear "below the line."

561

Financial Statement Analysis 56- Zichron, Inc., had the following equity accounts on December 31: Common stock: 20,000 shares Preferred stock A: 10,000 shares convertible into common on a 2 for 1 basis, dividend of $40,000 was declared during the year Preferred stock B: 10,000 shares, convertible to common on a 4 for 1 basis, dividend of $5,000 was declared during the year The company reported net income of $120,000 and paid a $20,000 dividend to its common shareholders. What are the basic earnings per share reported for the year? A) B) C) D) $2.75. $3.75. $1.36. $2.00.
562

Financial Statement Analysis ($120,000 40,000 5,000) / 20,000 shares = $3.75.

563

Financial Statement Analysis 57-What are the diluted earnings per share reported for the year? A) B) C) D) $3.00. $1.50. $1.33. $2.00.

564

Financial Statement Analysis ($120,000) / (20,000 + 20,000 + 40,000) = $1.50.

565

Financial Statement Analysis 58- A firm has a weighted average number of 20,000 common shares selling at an average of $10 throughout the year and 11,000, 10 percent, $100 par value preferred shares. If the firm earns $210,000 after taxes, what is its Basic EPS? A) B) C) D) $7.50 / share. $10.00 / share. $10.50 / share. $5.00 / share.

566

Financial Statement Analysis (210,000 - 110,000)/20,000 = $5 share

567

Financial Statement Analysis 59- For a firm with a simple capital structure, all of the following are necessary to measure basic earnings per share (EPS) EXCEPT: A) B) dividends paid to preferred shareholders. number of shares outstanding at the beginning of the year.

C) the timing and number of shares issued or repurchased during the year. D) dividends paid to common shareholders.

568

Financial Statement Analysis Basic EPS = earnings available to common shareholders divided by the weighted average number of common shares outstanding. Earnings available to common shareholders equals net income preferred dividends. The weighted number of common shares outstanding equals the number of shares outstanding during the year weighted by the proportion of the year they were outstanding.

569

Financial Statement Analysis 60- The standard equation for computing basic earnings per share (EPS) is: A) [Sales - Cost of Goods Sold] / Number of Preferred Shares Outstanding. B) [Net Income - Common Dividends] / Weighted Average Number of Common Shares Outstanding. C) [Net Income Preferred Dividends]/Weighted Average Number of Common Shares Outstanding. D) Total Assets Total Liabilities + Stockholders Equity.

570

Financial Statement Analysis The basic EPS calculation does not consider the effects of any dilutive securities in the computation. Basic EPS = [Net Income Preferred Dividends]/Weighted Average Number of Common Shares Outstanding.

571

Financial Statement Analysis 61- A complex capital structure would typically contain: A) B) C) D) bank notes. callable bonds. convertible bonds. variable rate notes.

572

Financial Statement Analysis A complex capital structure is one that contains securities that have the potential to dilute a firms earnings per share. For example, convertible bonds, convertible preferred stock, options, and warrants have the potential to dilute earnings per share upon conversion or exercise.

573

Financial Statement Analysis 62- Which type of a capital structure contains no dilutive securities? A) B) C) D) Complex. Functional. Basic. Simple.

574

Financial Statement Analysis A complex capital structure contains potentially dilutive securities such as options, warrants, or convertible securities. There is no basic capital structure but there are basic earnings per share which does NOT consider the effects of any dilutive securities in the computation of EPS.

575

Financial Statement Analysis 63- The following information pertains the QRK Company: One million shares of common stock outstanding at the beginning of 2005. 200,000 shares issued on the last day of March. 500,000 shares issued on the last day of June. 800,000 shares issued on the last day of September. What is the number of shares that should be used to compute 2005 earnings per share for the QRK Company? A) B) 2.5 million. 1.9 million.

C)
D)

1.6 million.
1.5 million.
576

Financial Statement Analysis The weighted average number of common shares outstanding is the number of shares outstanding during the year weighted by the portion of the year they were outstanding. For the QRK Company, the weighted number of shares outstanding is the original one million shares plus 150,000 shares for the end-of-March issue (= 200,000 * 9/12), plus 250,000 shares for the end-of-June issue (= 500,000 * 6/12), plus 200,000 shares for the end-of-September issue (= 800,000 * 3/12), or 1.6 million shares.

577

Financial Statement Analysis

A Diluted EPS Calculation Using the if-Converted Method for Preferred Stock. For the year ended 31 December 2006, Bright-Warm Utility Company had net income of $ 1,750,000. The company had an average of 500,000 shares of common stock outstanding, 20,000 shares of convertible preferred, and no other potentially dilutive securities. Each share of preferred pays a dividend of $10 per share, and each is convertible into five shares of the companys common stock.

Calculate the companys basic and diluted EPS.

578

Financial Statement Analysis

Solution If the 20,000 shares of convertible preferred had each converted into 5 shares of the companys common stock, the company would have had an additional 100,000 shares of common stock (5 shares of common for each of the 20,000 shares of preferred). If the conversion had taken place, the company would not have paid preferred dividends of $200,000 ($10 per share for each of the 20,000 shares of preferred).

579

Financial Statement Analysis

Basic EPS Net income Preferred Dividend Numerator Weighted average number of shares outstanding If converted Denominator EPS $ 1,750,000 200,000 $ 1,550,000

Diluted EPS $1,750,000 0 $1,750,000

500,000 0 500,000 3.10

500,000 100,000 600,000 2.92

580

Financial Statement Analysis

A Diluted EPS Calculation Using the if Converted Method for Convertible Debt Oppnox Company reported net income of $ 750 000 for the year ended 31 December 2005. The company had an average of 690 000 shares of common stock outstanding. In addition the company has only one potentially dilutive security: $ 50 000 of 6% convertible bonds, convertible into a total of 10 000 shares. Assuming a tax rate of 30 percent, calculate Oppnoxs basic and diluted EPS.

581

Financial Statement Analysis

Solution If the convertible debt had been converted, the debt securities would no longer be outstanding; instead, an additional 10 000 shares of common stock would be outstanding. Also, if such a conversion had taken place, the company would not have paid interest on the convertible debt of $ 3 000, equivalent 3 000 (1 0.30) = 2 100 on an after tax basis. To calculate diluted EPS using the if converted method for convertible debt, the amount of net income available to common shareholders is increased by $ 2 100. Also the weighted average number of shares in the denominator increase by 10 000 shares
582

Financial Statement Analysis

Solution EPS 750 000 750 000 Diluted EPS 750 000 2 100 752 100

Net income After tax cost of interest Numerator Weighted average number of shares outstanding If converted

690 000 0

690 000 10 000

Denominator
EPS

690 000
1.09

700 000
1.07
583

Financial Statement Analysis

A Diluted EPS Calculation Using the Treasury Stock Method for Options. Hihotech Company reported net income of $2.3 million for the year ended 30 June 2005 and had an average of 800 000 common shares outstanding. The company has outstanding 30 000 options with an exercise price of $35 and no other potentially dilutive securities. Over the year, the companys market price has averaged $55 per share. Calculated the companys basic and diluted EPS.

584

Financial Statement Analysis

Solution: Using the treasury stock method, we first calculate that the company would have received $ 1 050 ($35 for each of the 30 000 options exercised) if all the options had been exercised. The options would no longer be outstanding, instead 30 000 new shares of common stock would be outstanding. Under the treasury stock method we reduce the number of new shares by the number of shares that could have been purchased with the cash received upon exercise of the options. At an average market price of $55 per share, the $1 050 000 proceeds from option exercise could have purchased 19 091 shares of treasury stock. Therefore, the net new shares issued would have been 10,909 (calculated as 30,000 minus 19, 091). No change is 585 made to the numerator.

Financial Statement Analysis

Solution EPS 2,300,000 2,300,000 800,000 0 800,000 2.88 Diluted EPS 2,300,000 2,300,000 800,000 10,909 810,909 2.84
586

Net income Numerator Weighted average number of shares outstanding


If converted Denominator EPS

Financial Statement Analysis

An Antidilutive Security. For the year ended 31 December 2006, Dim-Cool Utility Company had net income of $1,750,000. The company had an average of 500,000 shares of common stock outstanding, 20,000 shares of convertible preferred, and no other potencially dilutive securities. Each share of preferred pays a dividend of $10 per share, and each is convertible into three shares of the companys common stock. What was the companys basic and diluted EPS.

587

Financial Statement Analysis

An Antidilutive Security. Basic EPS. $1,750,000 200,000 $1,550,000 Diluted EPS. $1,750,000 0 $1,750,000

Net income Preferred Dividend Numerator Weighted average number of shares outstanding If converted EPS

500,000 0 $3.10

500,000 60,000 $3.13

Exceeds basic EPS; security is antidilutive and therefore, not included


588

Financial Statement Analysis

64- The following data pertains to the Sapphire Company: Net income equals $15,000 5,000 shares of common stock issued on January 1st 10% stock dividend issued on June 1st 1,000 shares of common stock were repurchased on July 1st 1,000 shares of 10%, $100 par preferred stock each $2.50 . convertible into 8 shares of common were $1.15 . outstanding the whole year $1.20 What is the companys diluted earnings per share . (EPS)? A)$1.00. B)$2.50. C)$1.15. D)$1.20.
589

B ) C ) D )

Financial Statement Analysis


Number of average common shares: 1/1 5,500 shares issued (includes 10% stock dividend on 6/1) 12 = 66,000 7/1 1,000 shares repurchased 6 months = -6,000 = 60,000 60,000 shares / 12 months = 5,000 average shares Preferred dividends = ($10)(1,000) = $10,000 Number of shares from the conversion of the preferred shares = (1,000 preferred shares)(8 shares of common/share of preferred) = 8,000 common Diluted EPS = [$15,000(NI) $10,000(pfd) + $10,000(pfd)] / 5000(common shares) + 8000(shares from the conv. pfd. shares) = $15,000 / 13,000 shares = $1.15/share This number needs to be compared to basic EPS to see if the preferred shares are antidilutive. Basic EPS = [$15,000(NI) $10,000(preferred dividends)] / 5,000 shares = $5,000 / 5,000 shares = $1/share Since the EPS after the conversion of the preferred shares is greater than before the conversion the preferred shares are antidilutive and they should not be treated as common in computing diluted EPS. Therefore diluted EPS is the same as basic EPS or $1/share. 590

Financial Statement Analysis

65- Assume that the exercise price of an option is $11, and the average market price of the stock is $16. Assuming 1,039 options are outstanding during the entire year, what is the number of shares to be added to the denominator of the Diluted EPS?

A)289.
B)1,039.

C)714.
D)325.
591

Financial Statement Analysis

(1,039 options)($11) = $11,429 $11,429/$16 per share =714 shares 1039-714 = 325 shares or [(16-11)/16]1,039 =325.

592

Financial Statement Analysis

66- Assume that the exercise price of an option is $10, and the average market price of the stock is $13. Assuming 999 options are outstanding during the entire year, what is the number of shares to be added to the denominator of the diluted earnings per share (EPS)? A)231. B)999. C)768. D)206.
593

Financial Statement Analysis

(999)(10) = 9,990
9,990 / 13 = 768

999 768 = 231

or (13 10) / 13 0.23(999)

= 231
594

Financial Statement Analysis

67- The Gaffe Company had net income of $1,500,000. Gaffe paid preferred dividends of $5 on each of the 100,000 preferred shares. Each preferred share is convertible into 20 common shares. There are 1 million Gaffe common shares outstanding. In addition to the common and preferred stock, Gaffe has $25 million of 4% bonds outstanding. If Gaffe's tax rate is 40%, what is it's diluted earnings per share? A)$0.33. B)$0.50. C)$1.00. D)$1.50.
595

Financial Statement Analysis

Basic EPS (1 500 000 500 000) / 500 000

=1
Diluted EPS. 1 500 000 / ( 2 000 000 + 1 000 000)

= 0.5

596

Financial Statement Analysis

68- The Widget Company had net income of $1 million for the period. There were 1 million shares of weighted common stock outstanding for the entire period. If there are 100,000 options outstanding with an exercise price of $40, what is the diluted earnings per share for Widget common stock if the average price per share over the period was $50? A)$0.99. B)$1.00. C)$0.98. D)$1.01.
597

Financial Statement Analysis

Use the Treasury stock method Proceeds = 100,000 ($40) = $4,000,000 Shares assumed purchased with proceeds= $4,000,000/$50 = 80,000 shares Potential dilution = 100,000 80,000 = 20,000 shares
OR

(50 - 40) / 50 = 0.20


0.20 * 100000

=20 000
Basic EPS = $1/share Diluted EPS = $1,000,000 / 1,020,000 = $0.98/share

598

Financial Statement Analysis

69- An analyst has gathered the following information about Zany Corp. Net income of $200,000 for the year ended December 31, 2004. During 2004, 50,000 common shares were outstanding. Zany has 10,000 shares of 7%, $50 par convertible preferred stock outstanding, each convertible into two shares of common. 5,000 warrants are outstanding with an exercise price of $24. Each warrant is convertible into one common share. The average market price per common share during 2004 was $20. Calculate Zany's basic and diluted earnings per share (EPS) for 2004. Basic EPSDiluted EPS 599 A)$3.30 $2.00 B)$4.00 $2.86 C)$4.00 $2.00D)$3.30$2.86

Financial Statement Analysis

Basic EPS = (net income preferred dividends) / number of common shares = (200,000 35,000) / 50,000 = $3.30 per share

The preferred shares are converted into 20,000 common shares, the firm does not pay preferred dividends. Diluted EPS = 200,000 / (50,000 + 20,000) = $2.86 per share. The warrants are out of the money at a stock price of $20.

600

Financial Statement Analysis

Basic EPS = (net income preferred dividends) / number of common shares = (200,000 35,000) / 50,000 = $3.30 per share

The preferred shares are converted into 20,000 common shares, the firm does not pay preferred dividends. Diluted EPS = 200,000 / (50,000 + 20,000) = $2.86 per share. The warrants are out of the money at a stock price of $20.

601