Università Bocconi | Financial Reporting and Analysis (20214)
Solution to Question 1 (Financial Statements)
a. Inserting the 2018 balance sheet numbers of Citi Trends into the accounting equation
yields:
297,989 of assets = 110,564 of liabilities + 187,425 of equity
Assets are defined as resources under the entity’s control. Liabilities are outsiders’ (non-
owners’) claims on these resources, whereas equity reflects the owners’ claims.
b. The asset with the highest reported value is inventory, carried at $139,841. One cannot,
however, conclude that inventory is the company’s most valuable resource because not all
resources are recognized on the balance sheet and because the balance sheet amounts are
determined by accounting rules and do not necessarily reflect the assets’ current
economic values.
c. Equity consists of paid-in capital, defined as the total amount of funds contributed by the
owners, and of retained earnings, defined as the cumulative amount of income (profit)
that the entity has earned since its founding date, less the cumulative amount of
distributions (dividends) paid out to the owners. The retained earnings balance of Citi
Trends is $176,094, and the paid-in capital balance, consisting of common stock at par,
additional paid-in capital and treasury stock, is $11,331. (One could also associate the
treasury stock with the retained earnings instead, but most companies would only do this
for treasury stock in excess of paid-in capital.)
d. Net income is $21,374. This amount can be found on the income statement, the cash flow
statement, and the statement of changes in owners’ equity.
e. Net income flows into the retained earnings account on the balance sheet. Since net
income and dividends are not shown on the balance sheet and retained earnings amounts
are not shown on the income statement, the connection only becomes apparent if one
consults the statement of changes in owners’ equity, which shows the reconciliation:
retained earnings, 2/3/2018 $158,927
net income 21,374
dividends (4,207)
retained earnings, 2/2/2019 176,094
f. The three main categories of cash flows are operating, investing and financing activities.
Their sum total explains the change between the beginning and ending amounts of cash
reported on the balance sheet. For Citi Trends, the numbers are:
cash balance, 2/3/2018 $48,451
operating cash flow 30,410
investing cash flow (15,343)
financing cash flow (45,655)
cash balance, 2/2/2019 17,863
Università Bocconi | Financial Reporting and Analysis (20214)
Solution to Question 2 (Balance Sheet)
a. The difference between assets and liabilities is, by definition, the company’s equity.
Equity can, broadly, be split into paid-in capital (funds contributed by the owners) and
retained earnings (funds earned by the company by doing business). All amounts except
retained earnings are given, and so retained earnings must be:
retained earnings = assets – liabilities – paid-in capital
= 1990 – 3343 – 1654 = –3007
The negative retained earnings balance indicates that Amazon has been accumulating
losses since it started operations. In fact, even equity in total (including paid-in capital) is
negative. Since the company has been in business for eight years (since 1995) and has
incurred cumulative losses of $3,007 million since then (recall that no dividends have
been paid), the average loss per year must have been:
average net income (loss) per year = –3007 ÷ 8 = –376
b. The market value of equity of $5,500 million substantially exceeds the balance sheet
value of equity, which is the sum of paid-in capital and retained earnings, or negative
$1,353 million. One possibility is that stock market participants do not assess the value of
the company correctly and that the $5,500 million therefore does not reflect the
company’s actual value. (Whether this could be the case is not an accounting problem, so
we will assume here that Amazon’s equity investors have priced the company properly.)
The second possibility is that the balance sheet does not reflect the equity value
completely. First, recall that accounting rules assign values to assets and liabilities and
that these accounting values often do not correspond to fair market values. Second, recall
that assets and liabilities are only included in the balance sheet if they meet the
accounting definitions. In the case of Amazon, many of the company’s internally
developed intangible assets, such as its brand value, customer loyalty, reputation for
service quality, employees’ skill and motivation etc., fail the definition of an asset under
accounting rules because their valuation is too uncertain. These assets likely underlie the
future profits that investors anticipate when they price Amazon at $5,500 million. The
income statement does not immediately reflect the value appreciation in these assets, and
hence Amazon reports losses despite generating profitable future opportunities by
building its brand and expanding its market share. The difference between the market
value of equity and the book value of equity thus provides an indication of the uncertainty
of a business’ assets. The larger the gap, the more value derives from assets whose value
is too uncertain to qualify for recognition under accounting rules.
Università Bocconi | Financial Reporting and Analysis (20214)
Solution to Question 3 (Income Statement)
We have information about two metrics: the current gross profit and the gross profit margin
last year. Gross profit is defined as the difference between sales revenue and cost of sales:
cost of sales (current) = revenue (current) – gross profit (current) = revenue (current) – 118
Next, the gross profit margin is defined as gross profit divided by sales revenue. Last year,
we can thus infer:
gross profit margin (prior) = gross profit (prior) ÷ revenue (prior)
= [ revenue (prior) – cost of sales (prior) ] ÷ revenue (prior) = 20%
which, given the percentage increases between last year and this year, is equivalent to:
[ revenue (current) ÷ 110% – cost of sales (current) ÷ 108% ] ÷ [ revenue (current) ÷ 110% ] = 20%
Rearranging yields:
cost of sales (current) = revenue (current) × 80% × 108% ÷ 110%
We can now equate the two expressions for the current cost of sales to obtain:
revenue (current) – 118 = revenue (current) × 80% × 108% ÷ 110%
which has a unique solution value of $550 for this year’s sales revenue.
Università Bocconi | Financial Reporting and Analysis (20214)
Solution to Question 4 (Accrual Accounting)
Part A. The journal entries are:
1. DR cash 2,145,100
CR long-term debt 2,145,100
DR long-term debt 2,129,600
CR cash 2,129,600
2. DR dividends 2,330
CR dividends payable 2,330
DR dividends payable 2,269
CR cash 2,269
3. DR common stock 5,600
DR retained earnings 61,322
CR cash 66,922
4. DR depreciation expense 68,665
CR accumulated depreciation 68,665
5. DR property and equipment, at cost 66,127
CR accounts payable 3,876
CR cash 62,251
6. DR cash 17,905
DR loss on sale of equipment 4,775
DR accumulated depreciation 7,320
CR property and equipment, at cost 30,000
Università Bocconi | Financial Reporting and Analysis (20214)
Part B. The journal entries and explanations are:
1. DR cash 1,031,782
CR sales revenue 1,031,782
2. DR credit card receivables 1,031,782
CR sales revenue 1,031,782
DR cash 1,031,782
CR credit card receivables 1,031,782
The balance sheet and income statement are the same as in item 1 above
because cash receipts and sales revenue are the same, while the increase and
decrease in credit card receivables net to zero between the two journal entries.
3. DR cash 1,031,331
DR credit card receivables 451
CR sales revenue 1,031,782
Since the net increase in receivables by $451 is fixed and given, assuming one
dollar more in credit card sales (and thus one dollar less in cash sales)
automatically also means an extra dollar in credit card receivables collected, so
that the total amount of cash received during the period stays the same.
4. DR deferred revenue from gift cards 1,031,782
CR sales revenue 1,031,782
By the revenue recognition principle, revenue can only recognized on the
income statement when earned, and hence gift card sales only count as revenue
once the customer has used the gift card for a meal at the restaurant.
5. DR cash 1,033,318
DR credit card receivables 451
CR deferred revenue from gift cards 1,987
CR sales revenue 1,031,782
Given the net change in deferred revenue, assuming one dollar more in revenue
from gift card redemptions implies one dollar more in cash received from gift
card sales and a one-dollar decrease in both revenue and cash collections from
either cash or credit card sales, so that total revenue and cash collections remain
unchanged.
6. DR cash 1,032,665
DR credit card receivables 451
DR third party gift card sales receivables 653
CR deferred revenue from gift cards 1,987
CR sales revenue 1,031,782
The increase in third party gift card sales receivables by $653 implies that third
Università Bocconi | Financial Reporting and Analysis (20214)
party gift card vendors sold $653 worth of gift cards more than they remitted to
BJ’s Restaurants by the end of the year, and hence, compared to item 5 above,
the company’s cash flow is lower.
Università Bocconi | Financial Reporting and Analysis (20214)
Part C. The journal entries and explanations are:
1. DR cost of sales 268,707
CR inventory 268,707
2. DR inventory 269,314
CR accounts payable 269,314
The inventory balance has increased by $607 between 2016 and 2017. Hence,
inventory purchases must have been $607 higher than cost of sales.
3. DR labor expense 371,220
CR cash 371,220
4. DR labor expense 371,220
DR accrued labor-related expenses 2,321
CR cash 373,541
Cash paid for labor costs is higher than in item 3 because, as evidenced by the
decrease in the accrued expense balance, the company has paid for some labor-
related expenses accrued in prior periods, in addition to current labor costs.
5. DR labor expense 371,220
DR accrued labor-related expenses 2,321
CR paid-in capital 1,877
CR cash 371,664
Università Bocconi | Financial Reporting and Analysis (20214)
Part D. The journal entries and explanations are:
1. DR rent expense 44,700
CR cash 44,700
2. DR rent expense 44,700
CR deferred rent 44,700
The deferred rent is a liability because the company owes a future payment to
its landlords for services (the use of the restaurant property during the current
year) that have already been provided.
3. DR rent expense 44,700
CR deferred rent 2,063
CR cash 42,637
The increase in deferred rent liabilities means that BJ’s Restaurants is paying
less currently than it would if the rent payments were allocated evenly over the
lease term, and hence rent payments will, for the average lease contract, have to
increase over time.
4. Landlords pay the improvement allowance because they want their tenants’
businesses to turn into reliable future rent payers for the duration of the lease
term. The improvement allowance is thus meant to help the tenant (in this case,
BJ’s Restaurants) generate revenues during the lease term, and so the matching
principle requires that the allowance be allocated over this period.
5. DR rent expense 44,700
DR deferred lease incentives 1,249
CR deferred rent 2,063
CR cash 43,886
6. DR rent expense 44,700
DR deferred lease incentives 1,249
DR tenant improvement allowances receivable 1,565
CR deferred rent 2,063
CR cash 45,451
Rent-related net cash payments are higher than in item 5 above because
improvement allowances received in cash (which partly offset the company’s
rent payments) have been less than what the company is entitled to under the
new leases signed in 2017, as evidenced by the net increase in the receivables
balance by $1,565.
