530Mod2a

Session 2 - Financial Statements, Cash Flow, and Taxes, Chapter 2

All page numbers are references to Corporate Finance: A Focused Approach 7th edition by Ehrhardt and Brigham (Cengage South-Western, 2020)

In Chapter 2, we learn the structure and terms of financial statements. In Chapter 3, we analyze financial statements using ratio analysis. The more important, and difficult, material is Chapter 2. Major changes are occurring in Accounting; our textbooks are often years behind these changes. In my videos, I will discuss some of these changes.

Chapter 2

Things to Absorb

In Chapter 2, we learn the structure and terms of financial statements. In Chapter 3, we analyze financial statements using ratio analysis. The more important, and difficult, material is Chapter 2. Major changes are occurring in Accounting; our textbook is years behind these changes.
For Chapter 2, the main focus is on the format and purpose of balance sheet and income statement, and the names of items that might appear in these statements (e.g., depreciation is on income statement and accumulated depreciation may be on balance sheet), names of four required financial statements, the basics of tax calculations, understand how to identify/calculate cash flow, scrambled income statement/ balance sheet problems, Municipal (tax free) versus Corporate (Taxable) bond yields, (Not testable but important) Tax Cuts and Jobs Act of 2017, most companies are not optimizing.

Things to Read

  • You will need to read Chapter 2.
  • You will need to search for account names using a search engine.

Things to Do

Make 100 on the quiz. Be able to answer End of Chapter Questions 1-4, 6, and 7 and Problems 1, 2, 4, 6, and 9-11. Note, I will ask you to know the names of many financial accounts that are not listed in the chapter, so expect to do some Internet searches. Many account names in financial statements vary by company (Income Statement = Profit and Loss Statement = Statement of Income = Statement of Operations), thus part of learning this chapter is learning potential account names. When solving problems for this chapter, use the Internet to look up terms with which you are unfamiliar. This is especially applicable when solving the scrambled income statement/ balance sheet problems. On our D2L course page, under Chapter 2 Content, I have placed a ToolKit.  These are Excel spreadsheet solutions to various end of chapter problems.

Here is a structured study guide for this chapter.

  • 1. Watch the Chapter 2 Overview. You can download the PowerPoint slides from these videos from here.
  • Read pages 55-63.
  • Watch this video on the Income Statement and Balance Sheet (Minicase letter a, page 98). Most people find this video to be very useful in identifying the various accounts for these two statements.
  • Be able to answer end of Chapter 2 Questions 1-4 and Problems 4 and 6.
  • Read pages 63-77.
  • Watch this video on the Statement of Cash Flows and Calculating Cash Flows (minicase b-e). There is nothing from this video that is commonly tested on the mid-term exam.  In online classes, I sometimes ask about calculating operating cash flows.
  • Be able to answer end of Chapter 2 Questions 6, 7 and Problems 10 and 11.
  • Read pages 77-82.
  • If you would like a review of a bunch of accounting terms and Economic Value Added, watch the Economic Value Added (minicase f-h) video. Hint, unless your company uses EVA, you can probably skip most of this video and learn the terms/concepts by doing the Chapter quiz multiple times.  Economic Value Added is unlikely to be on the Exam.  Consider watching the video on the 2017 Tax Cut and Jobs Act (minicase i-k).  While this will not be on the exam, many companies have not adjusted their operations to maximize the benefits of this law. Do not focus on the tax code details as these often change.
  • Do be able to use the equation that Pretax return (1- tax rate) = After tax return (similar to end of chapter problems 1, 2 and 9 and slides 15-18 of this video), as there is often an exam question on this topic.  This relationship is covered in this Taxes (minicase l) video.
  • Read the rest of the chapter.
  • Since the main focus is the on the format of statements, the most complex quiz problems require you to unscramble and solve for missing numbers in the income statement and balance sheet. To solve these big problems, you must be able to solve smaller segments of the statements. Here are audio solutions that focus on the smaller components:
    1. In its recent income statement, Smith Software Inc. reported $26 million of net income, and in its year-end balance sheet, Smith reported $353 million of retained earnings. The previous year, its balance sheet showed $339 million of retained earnings. What were the total dividends paid to shareholders during the most recent year? (Answers are in $ millions.) | Audio solution
    2. In its recent income statement, Smith Software Inc. reported paying $10 million in dividends to common shareholders, and in its year-end balance sheet, Smith reported $365 million of retained earnings. The previous year, its balance sheet showed $354 million of retained earnings. What was the firm's net income during the most recent year? (Answers are in $ millions.) | Audio solution
    3. Cox Corporation recently reported an EBITDA of $66 million and $8 million of net income. The company has $11 million interest expense and the corporate tax rate is 40.0% percent. What was the company's depreciation and amortization expense? (Answers are in $ millions.) | Audio solution
    4. Brooks Sisters' operating income (EBIT) is $140 million. The company's tax rate is 40.0%, and its operating cash flow is $115.3 million. The company's interest expense is $28 million. What is the company's net cash flow? (Assume that depreciation is the only non-cash item in the firm's financial statements.) (Answers are in $ millions.) | Audio solution
    5. The Happy Auto Shop has the following annual information: Gross Sales, $700,000; Net Sales, $696,000; Gross Profit, $448,000. What are the shop's returns and allowances and cost of goods sold?  Review Audio Solution
    6. Construct an income statement using the following information: net sales, $500,000; salaries, $100,000; rent, $24,000; COGS, $250,000; utilities, $25,000; payroll taxes, $25,000; insurance, $12,000; and interest expense, $5,450. Make sure that you include gross profit, operating expenses, and net profit.  Review Audio Solution
    7. State the stockholder’s equity of the Alphabet Corporation if it has a current net profit of $1,500,000, beginning of-the-period retained earnings of $3,675,000, 1 million shares of common stock issued at a par value of $1 per share, and paid-in capital in excess of par of $12.50 per share?  Review Audio Solution
    8. State your current cash balance if you have the following information: total cash receipts of $624,000; a cash balance at the end of last year of $60,000; total cash payments of $540,000; cash outflow from investing activities of $100,000; and cash inflows from financial activities of $172,000.  Review Audio Solution
    9. A complex scramble/unscramble Balance Sheet Income Statement Problem: Fill in the missing numbers. Prepaid expenses _________ Additional paid-in capital _______ Property, plant and equipment, net ________ Total Liabilities and Equity ________ Net income _______ Tax payable _______ Interest expense ________ Net sales __________ Deferred (Long term) income tax liabilities ________ Operating expenses _________ Change in Retained Earnings 177 Total current assets 2495 Cash 660 Trade Receivables 749 Operating income 557 Income before provision for income taxes 538 Inventories 872 Income taxes receivable 100 Other long term assets 384 Accounts payable 407 Deferred revenue 38 Accrued program costs 536 Total Assets 4474 Other long term Liabilities 43 Retained earnings 1945 Total liabilities 1896 Cost of sales 2097 Gross profit 1713 Intangible assets, net 1071 Income taxes expense 199 Dividends 162 Total current liabilities 1104 Long-term debt 516 Accrued expenses 101 Common stock 31 | Audio solution
    10. For the below Income Statement and Balance Sheet, you are to match the Available Choices with the Accounts that are missing numbers. Total Revenue 27,625; Common Stock 16; Retained Earnings ________; Long Term Bonds (Liability) 742; Capital Leases (Long Term Liability) 965; Research & Development Expense 1,055; Other Long Term Assets 4,420; Total Long Term Assets 5,174; Total Assets 24,342; General and Administrative Expenses 14,502; Labor Expense __________; Accounts Payable 2,010; Current Portion of Long Term Debt _________; Other Long Term Liabilities 1,049: Interest Expense 923; Total Current Liabilities 3,936; Income Before Tax __________; Short Term Investments 51; Net Receivables ___________; Inventory 3,000; Other Current Assets 748; Net Income -12,288; Cash And Cash Equivalents 10,301; Total Current Assets _________; Long Term Investments 45; Total Liab. and Equity _________; Cost of Revenue 20,730; Other Current Liabilities 1,006; Bank Loans (Long Term) _________; Gross Profit ________; Depreciation 65; Selling Expense 760; Operating Income -11,362; Property Plant and Equipment 505; Goodwill 0 Other Long Term Investments 204; Total Liabilities 6,692; Redeemable Preferred Stock 74; Preferred Stock 150; Income Tax Expense ___________; Capital Surplus 38,624. | Audio solution
  • Be prepared for a difficult quiz over the Chapter 2 material.

updated August 18,2020

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