Chapter 7 Accounting for Financial Management Answers to Beginning-of-Chapter Questions
Chapter 7
Accounting for Financial Management
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
7-1 The balance sheet shows the assets, along with the sources of funds used to acquire the assets, at a point in time, say 12/31/07. The income statement shows the sales and profits that were produced during an interval of time, say the year 2007. An individual would have assets, and a net worth, and a balance sheet would detail these holdings. The individual would also have income and expenses, and his or her income statement would detail these flows. For a business, the most important number—the “bottom line”—is generally thought to be the net income. However, the firm’s net cash flow is also quite important, especially if one distrusts management and thinks the accounting statements might be misleading.
7-2 a. WorldCom understated costs. This had the effect of increasing its reported profits and its net worth. Also, since assets were not reduced by the correct amounts, reported assets were too high. This caused the reported debt ratio (debt/assets) to be too low, making the company look stronger than it actually was. Enron essentially transferred and got off its books debt that it was responsible for, along with assets that were actually worth less than had been paid for them. Enron “sold” the transferred assets to sham companies at inflated prices, thus allowing it to inflate its reported profits. Since both companies were able to report high profits and to look stronger than they actually were, their stock prices were much higher than they would have been had proper accounting been used. b. When the deceptions were revealed, both Enron’s and WorldCom’s stock prices collapsed. Investors then became worried that other companies might have been doing the same thing (they were), so the prices of other stocks, including companies that were playing entirely by the rules, also fell. c. The stock market collapse had serious
Accounting for Financial Management
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
7-1 The balance sheet shows the assets, along with the sources of funds used to acquire the assets, at a point in time, say 12/31/07. The income statement shows the sales and profits that were produced during an interval of time, say the year 2007. An individual would have assets, and a net worth, and a balance sheet would detail these holdings. The individual would also have income and expenses, and his or her income statement would detail these flows. For a business, the most important number—the “bottom line”—is generally thought to be the net income. However, the firm’s net cash flow is also quite important, especially if one distrusts management and thinks the accounting statements might be misleading.
7-2 a. WorldCom understated costs. This had the effect of increasing its reported profits and its net worth. Also, since assets were not reduced by the correct amounts, reported assets were too high. This caused the reported debt ratio (debt/assets) to be too low, making the company look stronger than it actually was. Enron essentially transferred and got off its books debt that it was responsible for, along with assets that were actually worth less than had been paid for them. Enron “sold” the transferred assets to sham companies at inflated prices, thus allowing it to inflate its reported profits. Since both companies were able to report high profits and to look stronger than they actually were, their stock prices were much higher than they would have been had proper accounting been used. b. When the deceptions were revealed, both Enron’s and WorldCom’s stock prices collapsed. Investors then became worried that other companies might have been doing the same thing (they were), so the prices of other stocks, including companies that were playing entirely by the rules, also fell. c. The stock market collapse had serious