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    Interpret Southwest Airlines' Balance Sheet

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    1. Reading and Interpreting Southwest Airlines' Balance Sheet

    The following items appear in the current liabilities section of Southwest Airlines' balance sheet at December 31, 2006.

    Air traffic liability $799 million

    In addition, one of Southwest Airlines' notes reads as follows: "Tickets sold are initially deferred as air traffic liability. Passenger revenue is recognized when transportation is provided. Air traffic liability primarily represents tickets sold for future travel dates and estimated refunds and exchanges of tickets sold for past travel dates".


    1. What economic event caused Southwest Airlines to incur this liability? Was it an external or internal event?
    2. Describe the effect on the accounting equation from the transaction to record the air traffic liability?
    3. Assume that one customer purchases a $500 ticket in advance. Determine the effect on the accounting equation from this transaction.
    4. What economic event will cause Southwest Airlines to reduce its air traffic liability? Is this an external or internal event?

    2. Cash and Accrual Income Statements for a Manufacturer

    Drysdale Company was established to manufacture companies for the auto industry. The components are shipped the same day they are purchased. The following events took place during the first year of operations:

    a. Issued common stock for a $50,000 cash investment.
    b. Purchased delivery truck at the beginning of the year at a cost of $10,000 cash. The truck is expected to last five years and will be worthless at the end of that time.
    c. Manufactured and sold 500,000 components the first year. The costs incurred to manufacture the components are (1) $1,000 monthly rent on a facility that included utilities and insurance, (2) $400,000 of raw materials purchased on account ($100,000 is still unpaid as of year-end, but all materials were used in manufacturing), and (3) $190,000 paid in salaries and wages to employees and supervisors.
    d. Paid $100,000 to sales and office staff for salaries and wages.
    e. Sold all components on account for $2 each. As of year-end, $150,000 is due from customers.


    1. How much revenue will Drysdale recognize under the cash basis and under the accrual basis?
    2. Describe how Drysdale should apply the matching principle to recognize expenses.
    3. Prepare an income statement under the accrual basis. Ignore income taxes.

    3. The Use of Net Income and Cash Flow to Evaluate a Company

    After you have gained five years of experience with a large CPA firm, one of your clients, Duke Inc., asks you to take over as chief financial officer for the business. Duke advises its client on the purchase of software products and assists them in installing the programs on their computer systems. Because the business is relatively new (it began servicing clients in January 2008), its accounting records are somewhat limited. In fact, the only statement available is the following income statement for the first year:

    Duke Inc.,
    Statement of Income
    For the Year Ended December 31, 2008

    Revenue $1,250,000
    Expense $480,000
    Salaries and wages 65,000
    Supplies 30,000
    Utilities 120,000
    Rent 345,000
    Depreciation 138,000
    Total Expense $1,178,000
    Net Income $ 72,000

    Based on its relatively modest profit margin of 5.76% (net income of $72,000 divided by revenues of $1,250,000) you are concerned about joining the new business. To alleviate your concern the president of the company is able to give you the following additional information.

    a. Clients are given 90 days to pay their bills for consulting services provided by Duke. On December 31, 2008, $230,000 of the revenues is yet to be collected in cash.
    b. Employees are paid on a monthly basis. Salaries and wages of $480,000 include the December payroll of $40,000, which will be paid on January 5, 2009.
    c. The company purchased $100,000 of operating supplies when it began operations in January. The balance of supplies on hand at December 31 amounts to $35,000.
    d. Office space is rented in a downtown high-rise building at a monthly cost of $10,000. When the company moved into the office January, it prepaid its rent for the next 18 months beginning January 1, 2008.
    e. On January 1, 2008, Duke purchased a computer system and related accessories at a cost of $1,725,000. The estimated useful life of the system is five years.
    f. The computer system was purchased by signing a three-year, 8% note payable for $1,725,000 on the date of purchase. The principal amount of the note and interest for the three years are due on January 1, 2011.


    1. Based on the income statement and the additional information given, prepare a statement of cash flows for Duke for 2008. (Simply list all of the cash inflows and outflows that relate to operations).
    2. On the basis of the income statement given and the statement of cash flows prepared in (1), do you think it would be a wise decision to join the company as its chief financial officer? Include in your response any additional questions that you believe are appropriate to ask before joining the company.

    4. Inventory Turnover for Apple Computer and Hewlett Packard
    The following information was summarized from the 2006 annual report of Apple Computers Inc.

    (in millions)
    Cost of sales for the year ended:
    September 30, 2006 $13,717
    September 24, 2005 (as restated) 9,889
    September 30, 2006 270
    September 24, 2005 (as restated) 165

    Net sales for the year ended:
    September 30, 2006 19,315
    September 24, 2006 (as restated) 13,931

    The following information was summarized from the fiscal year 2006 annual report of Hewlett Packard Company:
    (in millions)
    Cost of sales for the year ended:
    October 31, 2006 $55,248
    October 31, 2005 52,550
    October 31, 2006 7,750
    October 31, 2005 6,877

    Net revenue for the year ended:
    October 31, 2006 91,658
    October 31, 2006 86,696


    1. Calculate the gross profit ratios for Apple Computer and Hewlett Packard for each of the two years presented.
    2. Calculate the inventory turnover ratios for both companies for the most recent year.
    3. Which company appears to be performing better? What other information should you consider to determine how these companies are performing in this regard?

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    Solution Summary

    The solution explains some accounting questions relating to Southwest Airlines' Balance Sheet including topics like cash vs accrual, cash flow, inventory turncash vs accrual, cash flow and inventory turn in an attached Word document.