BA 270 - Mid Term Exam Fall, 2003

TENTATIVE SOLUTION

Name: ______(Please Print) PID: ______

Scheduled Class Time: 8:00 9:30 11:00 2:00 (Circle One)

Question Suggested Time Points

I. 1 ¾ hours 60

II. 1 ¼ hour 37 Because of Isabel and Saturday exams +3 Total 3 hours 100

Show your work for partial credit—close counts in horseshoes, hand grenades and BA270, but only if you show your work. If you feel that you need to make an assumption on a problem, please state it. If you are really confused by a question, I will be in the hall to answer questions. Attached are the UK GAAP financial statements for Manchester United. Assume that, although the format of their financial statements differs from US GAAP, the basic accounting principles are consistent with those we’ve discussed in class. All amounts are in thousand of pounds (£’000) unless noted otherwise—please round to £’000s. (In some cases columns will not add up exactly because of rounding—don’t worry about it). Note that Manchester United’s year ends on July 31, so 2003 refers to the year ending July 31, 2003. Assume that the 2003 soccer season also runs from August 1, 2002 to July 31, 2003. Assume a 25% tax rate throughout.

Part I:

Your goal is to forecast an income statement, statement of cash flows and balance sheet for Manchester United for 2003. For the purposes of this part, refer only to the attached summary financial statements and the following assumptions. If at all possible, please provide journal entries in the space provided below. If you really hate journal entries, indicate which accounts go up or down in the space below the description of the transaction, but don’t leave that space blank if you want partial credit. Do not worry if your accounts temporarily have negative balances (the transactions below are not sequential; they are aggregations over the period).

Manchester United has three primary lines of revenue—ticket sales, media sales (e.g., the television rights to the games) and merchandise sales.

1. You forecast that Manchester United will earn £56,321 from tickets to games during the 2003 season. Assume that Manchester United sells some of the 2003 seats through game-day sales (£10,844) and that the remainder (£45,477) will be for season tickets sold in 2002 covering the 2003 season (“unearned revenue” on the balance sheet). Assume further that Manchester United sells (for cash) £48,976 of tickets during 2003 for the 2004 season. (6 points)

Deferred Income 45,477 Ticket Turnover 45,477

Cash 10,844 Ticket Turnover 10,844 Cash 48,976 Deferred Income 48,976

2. Manchester United also derives revenue from media sales (broadcasters paying for the rights to televise games). Assume that contracts for media coverage are signed prior to the start of the season (e.g., contracts covering the 2003 season were signed in 2002), but the cash is received both during and after the end of the season (e.g., cash for the 2003 season media rights is received in 2003 and 2004). You forecast that Manchester United will earn £80,544 from media sales for the 2003 season, of which £49,863 will be paid in cash during 2003 and £30,681 will remain uncollected (“debtors” on the balance sheet) at year end 2003. In addition, Manchester United will collect any amounts due it as of the beginning of 2003 during 2003. Finally, during 2003, Manchester United will sign a contract for £82,332 for rights to the 2004 season, payment to be received in 2004 and 2005. (8 points)

Cash 49,863 Media Turnover 49,863

Debtors 30,681 Media Turnover 30,681

Cash 32,279 Debtors 32,279

3. Finally, Manchester United derives revenue from merchandise sales (hats, t-shirts and the like). In general, they charge royalties on the merchandise rather than taking delivery themselves. Assume that Manchester United will receive £12,136 in cash during 2003 for merchandise sold in 2003. (2 points)

Cash 12,136 Merchandise Turnover 12,136 4. An unusual aspect of Manchester United’s business is that they buy and sell player registrations (contracts) for cash. Basically, the idea is analogous to property, plant and equipment—when they buy a player registration, they depreciate it straightline over its life and record a sale if the player’s contract is ultimately sold. Assume that in 2003 they buy additional player registrations of £40,150 and record amortization totaling £22,700 on all player registrations. Assume further, that player registrations have a life of 5 years and that during 2003 they sell player registrations with a historical cost of £20,500 which are three years through their life at the time of sale and receive £20,800 of cash on the sale. (10 points)

Cost of Player Registration 40,150 Cash 40,150

Amortization of Player Registrations 22,700 Accumulated Amortization 22,700

Cash 20,800 Accumulated Amortization 12,300 Cost of Player Registrations 20,500 Profit on Disposal of Players 12,600

5. In addition, they buy tangible fixed assets (property, plant and equipment) for cash of £18,023 and record depreciation of £10,234. No tangible fixed assets will be sold during 2003. (5 points)

Cost of Tangible Assets 18,023 Cash 18,023

Depreciation of Tangible Fixed Assets 10,234 Accum. Depr. on Tangible Assets 10,234

6. Employees (including players) will earn £73,442 for services rendered in 2003. The ending balance in the accrued salaries account will be £12,377 (5 points)

Compensation Expense 73,442 Accrued Salaries 73,442

Accrued Salaries 75,626 Cash 75,626

7. Administrative expenses will be £21,289, all paid during 2003. (2 points)

Administrative Expense 21,289 Cash 21,289 8. Taxes are paid in the first quarter of the year on the previous year’s profits. New taxes payable are recorded at year-end at 25% of pre-tax income. (6 points)

Corporation Tax 7,308 Cash 7,308

Taxation 8484 Corporation Tax 8484

9. The ending cash balance will be £1,010. Any excess cash is paid out as a dividend and any shortfall is made up by issuing stock. (3 points)

Profit and Loss Account 12,425 Cash 12,425

Ticket Turnover 56,321 Media Turnover 80,544 Merchandise Turnover 12,136 Profit on Disposal of Players 12,600 Administrative Expense 21,289 Compensation Expense 73,442 Amortization of Player Reg. 22,700 Depreciation of Tang. Assets 10,234 Taxation 8,484 Profit and Loss Account 25,452

Prepare Manchester United’s forecasted 2003 balance sheet (4 points), income statement (3 points) and cash flow statement (5 points). Cost of Player Accumulated Amort. Cost of Tangible Assets Registrations of Player Registrations 108,427 26,218 160,121 (4) 40,150 (4) 20,500 (4) 12,300 (4) 22,700 (5) 18,023

128,077 36,618 178144

Accumulated Deprec. Debtors Cash of Tangible Assets 31,792 32,279 933 (5) 10,234 (2) 30,681 (2) 32,279 (1) 10,844 (4) 40,150 (1) 48,976 (5) 18,023 (2) 49,863 (6) 75,626 (2) 32,279 (7) 21,289 (3) 12,136 (8) 7,308 (4) 20,800 (9) 12,425 42,026 30,681 1,010

Accrued Salaries Corporation Tax Deferred Income 14,561 7308 45,477 75,626 (6) (6) 73,442 (8) 7308 (8) 8484 (1) 45,477 (1) 48,976

12,377 8484 48,976 Profit and Loss Account Ticket Turnover Media Turnover 110,966 45,477 (1) 49,863 (2) 12,425 25,452 10,844 (1) 30,681 (2)

123,993 (9) 56,321 56,321 (9) 80,544 80,544

Merchandising Turnover Administration Expense Compensation Expense 12,136 (3) (7) 21,289 (6) 73,442

(9) 12,136 12,136 21,289 21,289 (9) 73,442 73,442 (9)

Amortization of Player Depreciation of Tangible Profit on Disposal of Registrations Fixed Assets Players (4) 22,700 (5) 10,234 (4) 12,600

22,700 22,700 (9) 10,234 10,234 (9) (9) 12,600 12,600

Taxation (8) 8,484

8,484 8,484 (9) CONSOLIDATED PROFIT AND LOSS ACCOUNT

Turnover Tickets 56253 56321 Media and Commercials 78441 80544 Merchandising 11368 12136 Total Turnover 146062 149001

Administration Expenses 35940 21289 Compensation Expense 69999 73442 Amortization of Player Registrations 17647 22700 Depreciation of Tangible Assets 7685 10234 Operating Profit 14791 21336 Profit on Disposal of Players 17406 12600 Profit on Disposal of Tangible Fixed Assets 150 0 Profit Before Taxation 32347 33936 Taxation 7308 8484 Profit for the Year 25039 25452 Dividends 8053 12426 Retained Profit for the Year 16986 13026

CONSOLIDATED BALANCE SHEET

Fixed Assets Intangible Assets Cost of Player Registrations 108427 128077 Accumulated Amortisation of Player Registrations 26218 36618 Net Book Value of Player Registrations 82209 91459 Tangible Assets Cost of Tangible Assets 160121 178144 Accumulated Depreciation of Tangible Assets 31792 42026 Net Book Value of Tangible Assets 128329 136118 Investments in Associates 1789 1789 Total Fixed Assets 212327 229366

Current Assets Debtors 32279 30681 Cash 933 1,010 Other 196 196 Total Current Assets 33408 31887 Creditors--amounts falling due within one year Accrued Salaries 14561 12377 Corporation Tax 7308 8484 Other 31590 31590 Total Current Liabilities 53459 52451 Net Current Liabilities -20051 -20564

Creditors--amounts falling due after one year Deferred Taxation 9356 9356 Deferred Income 45477 48976 Total Noncurrent Liabilities 54833 58332 Net Assets 137443 150470

Share Capital 26477 26477 Profit and Loss Account 110966 123993 Shareholders' Funds 137443 150470

CONSOLIDATED CASH FLOW STATEMENT

Profit for the Year 25039 25452 Depreciation Charges 7685 10234 Amortization of Player Registrations 17647 22700 Profit on Disposal of Tangible Fixed Assets -150 0 Profit on Disposal of Players -17406 -12600 Decrease/(increase) in stocks 2013 0 Decrease/(increase) in debtors 1470 1598 (Decrease)/increase in accrued salaries -1060 -2184 (Decrease)/increase in corporation tax -91 1176 (Decrease)/increase in deferred income 2789 3499 Other -4486 0 Net Cash Inflow from Operaitons 33450 49875 33450 Cash from Investing Proceeds from Sale of Player Registrations 13,006 20800 Purchase of Player Registrations -25089 -40150 Proceeds from Sale of Tangible Fixed Assets 1165 0 Purchase of Tangible Fixed Assets -15088 -18023 Net Cash from Investing -26,006 -37,373

Cash from Financing Equity Dividends Paid -8053 -12425 Other 2779 0 Net Cash from Financing -5274 -12425

Change in Cash 2170 77 Part II

This section uses the information provided here as well as the some of the information in financial statements for 2002, but don’t use your forecasted numbers for 2003.

1. In June 2003, Manchester United sold Beckham’s registration to Real Madrid. The selling price of 27.5 million Euro had two main components (based on the Manchester United Press Release). Manchester United had the choice between an unconditional 17.5 million Euro divided equally over the next four years or 16.3 million Euro in September 2003, the difference reflecting the time value of money. In addition, Manchester United is to receive 10 million Euro conditional on Real Madrid's performances in the UEFA Champions League, 1.25 million Euro of it payable in each of the next four seasons if Real Madrid qualifies for the Champions League, and a further 1.25 million Euro each season if Real Madrid reaches the quarter-finals.

a. Should Real Madrid record any liability to Manchester United in June 2003 related to the purchase of Beckham? Explain (briefly) your reasoning. (2 points)

Yes. All conditions are met. In particular, unavoidable obligation, past transaction or event, reasonably estimable. It is not an executory contract because Manchester United has satisfied all of its obligations—it is like selling PP&E. If Beckham were to break a leg, Real Madrid would still be out the money.

b. Assuming a liability is recorded for some portion of the 27.5 million Euro total potential payment, what amount (if any) should Real Madrid record for the unconditional portion of the payment? Explain your reasoning. (2 points)

16.3 million—present value of the future cash flows. The unconditional nature of the obligation makes it a liability. c. Assuming a liability is recorded for some portion of the 27.5 million Euro total potential payment, what amount (if any) do you think Real Madrid should record for the conditional portion? Why? (I’m not sure there is a clear right answer here, but I am looking for your reasoning. (2 points)

The obligation is contingent, but the nature of the contingency is unusual because it is not contingent on anything that Manchester United has control over. The answer really comes down to whether it is deemed reasonably estimable, which it may or may not be.

2. What journal entries did Manchester United record in 2002 on the player contracts (your answer should explain the change in the cost of player registration and accumulated amortization of player registration accounts—the Beckham transaction is not included since that occurred in 2003). The beginning of 2002 balances were £104,075 for cost of player registrations and £23,708 for accumulated amortization of player registrations. Hint: this problem has multiple parts—break it down into its parts and solve each part separately. (14 points).

Cost of player registrations (SCF) 25,089 Cash 25,089

Amortization Expense (SCF) 17,647 Accumulated Amortization 17,647

Cash (SCF) 23,006 Accumulated Amortization (plug t-account) 15,137 Cost of player registration (plug t-acct.) 20,737 Profit on Disposal (SCF) 17,406 3. One of the areas for which Manchester United is best known is developing young talent and selling the player registrations. Beckham, for example, signed up with a Manchester United club team as a teenager and was developed internally. In exchange for training, a player like Beckham commits to a long term contract with no upfront payment. Suppose that Manchester United spent £500 developing Beckham to the point where he was ready to play for a professional club. Would they recognize an asset for the £500? Explain briefly. (2 points)

No. That is just training costs (Beckham is an internally developed intangible). Real Madrid would book him as an asset at purchase price because they purchased his contract.

4. What was Manchester United’s return on equity in 2002? Assume a beginning balance in shareholders’ equity of £85,840 and in total assets of £218,409. (4 points)

Average shareholders’ equity 85,840+137,443/2 = 111,642 Net Income 25039 ROE = 25,039/111,642 = 0.224

Decompose their return on equity into three pieces as we did in class. (4 points)

Average total assets (218,409+245,735)/2 = 232,072 Sales 146,062

Net Income/Sales x Sales/Average Total Assets x ATA/Average SH Equity

25,039/146,062 x 146,062/232,072 x 232,072/111,642 .171 x .629 x 2.08 = .224 5. Suppose that Manchester United’s CEO is evaluated based on return on equity.

a. Suggest a way that he could increase the third term in the decomposition (leverage). Which of the other three terms is most likely to be reduced and why? (2 points)

Take on more debt. Reduce net income/sales because of interest..

b. Suppose he decided to increase advertising and suppose that changed two of the three terms. Which two terms would be most likely to change, in what direction and why? (2 points)

Profit margin would drop because of advertising expense and total asset turnover would increase because of increased sales..

c. Suppose the CEO decided to issue long term debt and use the proceeds to pay a dividend. Would that change return on assets? If so, would it go up or down? Explain (you don’t need to compute it). (2 points).

There would be no effect on ROA—it is before financing. Income is before interest and assets are before financing.

6. Note that Manchester United’s owners’ equity consists of “Share Capital” (contributed capital) and “Profit and Loss Account” (retained earnings). What does that tell you about their international subsidiaries? (1 point)

Manchester United has no foreign currency translation adjustment, implying no international subsidiaries keeping their books in foreign currencies. Manchester United has foreign sales, but they are probably through the U.K. parent.