acc102 chap13 publisher_power_point

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FINANCIAL ANALYSIS: THE BIG PICTURE

Accounting, Fifth Edition

13

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After studying this chapter, you should be able to:

1. Understand the concept of sustainable income.

2. Indicate how irregular items are presented.

3. Explain the concept of comprehensive income.

4. Describe and apply horizontal analysis.

5. Describe and apply vertical analysis.

6. Identify and compute ratios used in analyzing a company’s

liquidity, solvency, and profitability.

7. Understand the concept of quality of earnings.

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

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Preview of Chapter 13

AccountingFifth Edition

Kimmel Weygandt Kieso

13-5 LO 2 Indicate how irregular items are presented.

Sustainable IncomeSustainable IncomeSustainable IncomeSustainable Income

Sustainable Income - Net income adjusted for irregular

items.

Irregular Items

Irregular items are separately identified on the income

statement. Two types are:

1. Discontinued operations.

2. Extraordinary items.

These “irregular” items are reported net of income taxes.

LO 1 Understand the concept of sustainable income.

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Components of the income statement

Illustration 13-1

LO 2 Indicate how irregular items are presented.

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Discontinued Operations

(a) Disposal of a significant component of a business.

(b) Income statement should report a gain (or loss) from

discontinued operations, net of tax.



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Illustration: Rozek Inc. has revenues of $2.5 million and expenses

of $1.7 million from continuing operations in 2014. The company

therefore has income before income taxes of $800,000. During

2014 the company discontinued and sold its unprofitable chemical

division at a loss of $210,000 (net of $90,000 tax savings).


LO 2

Illustration 13-2

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Extraordinary items are events and transactions that

meet two conditions:

Both

Unusual in nature and

Infrequent in occurrence

Company must consider the environment in which it operates.

Amounts reported “net of tax.”



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Illustration: In 2014 a revolutionary foreign government expropriated property held as an investment by Rozek Inc. If the loss is $70,000 before applicable income tax savings of $21,000, how will the loss be presented in the income statement?


Advance slide in presentation mode to reveal solution.

Illustration 13-3


ROZEK INC.Income Statement (partial)

For the Year Ended December 31, 2014

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Are these considered Extraordinary Items?

YESYES

NONO

NONO

YESYES


Effects of major natural casualties, if rare in

the area.

Effects of major natural casualties, not

uncommon in the area.

Write-down of inventories or write-off of

receivables.

Expropriation (takeover) of property by a

foreign government.


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NONO

YESYES

NONO


Losses attributable to labor strikes.

Effects of a newly enacted law or regulation,

such as a condemnation action.

Gains or losses from sales of property, plant,

or equipment.


Are these considered Extraordinary Items?

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Principle used in the current year is different from one

used in the preceding year.

Example - change from FIFO to average cost.

Permissible when management can show new principle is

preferable.

Most changes are reported retroactively.

Changes in Accounting Principle

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LO 3 Explain the concept of comprehensive income.

All changes in stockholders’ equity except those resulting

from

investments by stockholders and

distributions to stockholders.

Certain gains and losses bypass net income and instead are

reported as direct adjustments to stockholders’ equity.

Example – Unrealized gain or loss on Available-for-sale

securities

Comprehensive Income

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Illustration of Comprehensive Income



Accounting standards require companies to adjust most

investments in stocks and bonds up or down to their market

value at the end of each accounting period.

Illustration: During 2014 Stassi Company purchased IBM stock

for $10,000 as an investment. At the end of 2014 Stassi was still

holding the investment, but the stock’s market value was now

$8,000.

How should Stassi account for the $2,000 unrealized loss?

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Illustration of Comprehensive Income



How should Stassi account for the $2,000 unrealized loss?

Answer: Depends on whether Stassi classifies the IBM stock as a

Trading security or an

Available for-sale security.

Unrealized gains and losses

(Income Statement)

Unrealized gains and losses (Comprehensive Income - Stockholders’ Equity)

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Format One – Comprehensive Income



Combined statement of income and comprehensive income.

Illustration 13-5

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Format Two - Comprehensive Income



Separate component of Stockholders’ Equity.Illustration 13-6

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Complete Income Statement



Illustration 13-7

Format Three - Comprehensive Income

PACE CORPORATIONIncome Statement and

Statement of Comprehensive IncomeFor the Year Ended December 31, 2014

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AIR CORPORATIONIncome Statement (partial)

Income before income taxes $400,000Income tax expense 120,000Income before irregular items 280,000Discontinued operations

Loss on disposal of discontinued flower division, net of $42,000 tax savings (98,000)

Extraordinary earthquake loss, net of $30,000 tax savings (70,000)Net income $112,000

Illustration: In its draft 2014 income statement,

AIR Corporation reports income before income taxes

$400,000, extraordinary loss due to earthquake $100,000, income

taxes $120,000 (not including irregular items), and loss on disposal of

discontinued flower division $140,000. The income tax rate is 30%.

Prepare a correct income statement, beginning with income before

income taxes.

Advance slide in presentation mode to reveal solution. LO 3

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Analyzing financial statements involves:

Comparative AnalysisComparative AnalysisComparative AnalysisComparative Analysis

Comparison Bases

Basic Tools

Intracompany

Intercompany

Industry averages

Horizontal analysis

Vertical analysis

Ratio Analysis

13-24 LO 4 Describe and apply horizontal analysis.

Also called trend analysis, is a technique for evaluating a

series of financial statement data over a period of time.

Purpose is to determine increase or decrease that has taken

place.

Commonly applied to the balance sheet and income

statement.


Horizontal Analysis

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Helpful Hint: When using horizontal

analysis, be sure to examine both dollar amountchanges and percentage changes.

Illustration 13-11Horizontal analysis of balance sheets


LO 4 Describe and apply horizontal analysis.

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Illustration 13-12Horizontal analysis of Income statements


Helpful Hint: In horizontal analysis, while the amount column is additive (the total is $99 million), the percentage column is not additive (9.9% is not a total).


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Summary financial information for Rosepatch Company

is as follows.

Solution


Compute the amount and percentage changes in 2012 using horizontal analysis, assuming 2011 is the base year.

Advance slide in presentation mode to reveal solution.

13-28 LO 5 Describe and apply vertical analysis.

Also called common-size analysis, is a technique that

expresses each financial statement item as a percent of a

base amount.

Vertical analysis is commonly applied to the balance sheet

and the income statement.


Vertical Analysis

13-29 LO 5 Describe and apply vertical analysis.


These results indicate the

company shiftedtoward equity

financing by relying less on debt and by

increasing the amount

of retained earnings.

Illustration 13-13Vertical analysis of Income statements

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The increase in net income as a percentage of net sales is due primarily to the

decrease in interest expense and income tax expense as a percentage of

sales.

LO 5 Describe and apply vertical analysis.


Illustration 13-14Vertical analysis of an income statements

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Illustration 13-15Intercompany comparison by vertical analysis

LO 5 Describe and apply vertical analysis.

Although Chicago Cereal’s net sales are less than those of General Mills, vertical analysis eliminates the impact of this size difference for our analysis.


Vertical analysis

also enables a

comparison of

companies of

different sizes.

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ProfitabilityProfitability

Measures the income or

operating success of a company for a

given period of time.

SolvencySolvency

Measures the ability of the company to

survive over a long period of time.

LO 6 Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis

Ratio analysis expresses the relationship among selected items of financial statement data.

LiquidityLiquidity

Measures short-term ability of the

company to pay its maturing

obligations and to meet unexpected needs for cash.

Financial Ratio Classifications

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Illustration 13-16


Liquidity Ratios

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Illustration 13-17


Solvency Ratios

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Illustration 13-18

LO 6

Profitability Ratios

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Recent accounting scandals suggest that some companies

are spending too much time managing their income and

not enough time managing their business.

A company that has a high quality of earnings provides

full and transparent information that will not confuse or

mislead users of the financial statements.

Quality of EarningsQuality of EarningsQuality of EarningsQuality of Earnings

LO 7 Understand the concept of quality of earnings.

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Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings (FIFO vs. LIFO).


Usually excludes items that are unusual or nonrecurring.

Some companies have abused the flexibility that pro forma numbers allow to put their companies in a more favorable light.


Alternative Accounting Methods

Pro Forma Income

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Some managers have felt pressure to continually increase

earnings.

Abuses include:

Improper recognition of revenue (channel stuffing).

Improper capitalization of operating expenses (WorldCom).

Failure to report all liabilities (Enron).

Alternative Accounting Methods

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Reflects investors’ assessment of a company’s future earnings.

P-E ratio will be higher if investors think that earnings will increase substantially in the future.

P-E ratio will be lower when there is the belief that a company has poor-quality earnings.

Illustration 13-19

Price-Earnings Ratio

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Illustration 13-19

Illustration 13-20Earnings per share and P-Eratios of various companies

Price-Earnings Ratio

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Match each of the following terms with the phrase that it best matches.

1. Measures the ability of the company to survive over a long period of time.

2. Usually excludes items that a company thinks are unusual or non-recurring.

3. Includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.

Solvency


Pro forma

Comprehensive income

Comprehensive income Vertical analysisQuality of earnings Pro forma incomeSolvency ratio Extraordinary items

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Match each of the following terms with the phrase that it best matches.

4. Indicates the level of full and transparent information provided to users of the financial statements.

5. Describes events and transactions that are unusual in nature and infrequent in occurrence.

6. Expresses each item within a financial statement as a percent of a base amount.

Quality of Earnings


Extraordinary Items

Vertical Analysis

Comprehensive income Vertical analysisQuality of earnings Pro forma incomeSolvency ratio Extraordinary items

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Analyzing financial statements involves:

CharacteristicsComparison

Bases

Liquidity

Profitability

Solvency

Intracompany

Industry averages

Intercompany

The financial information in Illustrations 13A-1 through 13A-4 will be used to calculate Chicago’s 2011 ratios.

Appendix 13AAppendix 13AAppendix 13AAppendix 13A Comprehensive Ratio Analysis

LO 8 Evaluate a company comprehensively using ratio analysis.

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Illustration 13A-1


LO 8

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Illustration 13A-2 & 13A-4


LO 8

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Illustration 13A-3


LO 8

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Liquidity RatiosLiquidity Ratios

Measure the short-term ability of the company to pay its maturing

obligations and to meet unexpected needs for cash.

Short-term creditors such as bankers and suppliers are

particularly interested in assessing liquidity.

Ratios include the current ratio, the current cash debt

coverage, the accounts receivables turnover, the average

collection period, the inventory turnover, and days in

inventory.



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Current Ratio - Expresses the relationship of current assets to

current liabilities.

What do the measures tell us?

A current ratio of .67 means that for every dollar of current

liabilities, the company has $0.67 of current assets.

Illustration 13A-5



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Current Cash Debt Coverage - Because it uses cash provided by

operating activities, it may provide a better representation of

liquidity.

Is the coverage adequate?

Probably so. Chicago’s coverage is better than that of General

Mills, and it approximates an accepted threshold of .40.

Illustration 13A-6



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Accounts Receivables Turnover – Measures the number of

times, on average, a company collects receivables during the

period.

How does Chicago’s turnover compare to General Mills’s?

The turnover of 11.9 times is higher than the industry average of

11.2 times, and slightly lower than General Mills’ turnover of 12.4

times.

Illustration 13A-7



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Average Collection Period – Converts the receivable turnover

ratio into days.

How effective is Chicago’s credit and collection policies?

General rule - collection period should not greatly exceed the

credit term period (i.e., the time allowed for payment).

Illustration 13A-8



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Inventory Turnover - Measures the number of times average

inventory was sold during the period.

The ratio of 7.5 times is higher than the industry average of 6.7 times and better than General Mills’s 6.5 times.

How does Chicago’s turnover compare to General Mills’s?

Illustration 13A-9



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Days in Inventory - Measures the average number of days

inventory is held.

An average selling time of 49 days is faster than the industry average and faster than that of General Mills.

How does Chicago’s days compare to General Mills’s?

Illustration 13A-10



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Solvency RatiosSolvency Ratios

Solvency ratios measure the ability of a company to survive over

a long period of time.

Debt-Paying Ability

► Debt to total assets ratio

► Times interest earned

► Cash debt coverage

Free cash flow provides information about solvency and

ability to pay additional dividends or invest.



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Debt to Assets Ratio – Indicates the degree of financial

leveraging. Provides some indication of the company’s ability to

withstand losses.

Yes, slightly. The ratio of 78% says that Chicago would have to

liquidate 78% of its assets at their book value in order to pay off

all of its debts.

Has Chicago’s solvency improved during the year?

Illustration 13A-11



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Times Interest Earned - (also called interest coverage) indicates

the company’s ability to meet interest payments as they come

due.

Yes, the ratio indicates that income before interest and taxes was

5.8 times the amount needed for interest expense.

Is Chicago better able to service its’ debt?

Illustration 13A-12



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Cash Debt Coverage - Indicates a company’s ability to repay its

liabilities from cash generated from operating activities without

having to liquidate the assets used in its operations.

One way of interpreting this ratio is to say that net cash generated

from one year of operations would be sufficient to pay off 17% of

Chicago’s total liabilities.

Illustration 13A-13



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Free Cash Flow - Ability to pay dividends or expand operations.

Calculate the ratio for Chicago.

Cash provided by operations was more than enough to allow

Chicago to acquire additional productive assets and maintain

dividend payments.

Illustration 13A-14

(in millions)



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Profitability RatiosProfitability Ratios

Measure the income or operating success of a company for a given period of time.


Illustration 13A-15Relationships amongprofitability measures


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Return on Common Stockholders’ Equity (ROE) - Shows how

many dollars of net income the company earned for each dollar

invested by the owners.

Chicago’s 2011 rate of return on common stockholders’ equity is

unusually high at 48%, considering an industry average of 24%

and General Mills’s return of 24%.

Illustration 13A-16



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Return on Assets - Measures the overall profitability of assets in

terms of the income earned on each dollar invested in assets.

Note that Chicago’s rate of return on common stockholders’ equity

(48%) is substantially higher than its rate of return on assets

(10%). Chicago has made effective use of leverage.

Illustration 13A-17



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Profit Margin - Or rate of return on sales, is a measure of the

percentage of each dollar of sales that results in net income.

High-volume (high inventory turnover) businesses such as grocery

stores and pharmacy chains generally have low profit margins.

Illustration 13A-18



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Asset Turnover - Measures how efficiently a company uses its

assets to generate sales.

The average asset turnover for utility companies is .45, for

example, while the grocery store industry has an average asset

turnover of 3.49.

Illustration 13A-19



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You can analyze the combined effects of profit margin and

asset turnover on return on assets for Chicago as shown

Illustration 13A-20



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Gross Profit Rate - Indicates a company’s ability to maintain

an adequate selling price above its cost of goods sold.

Illustration 13A-21

As an industry becomes more competitive, this ratio declines.



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Earnings Per Share - A measure of the net income earned on

each share of common stock. Illustration 13A-22



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Price-Earnings (P-E) Ratio - Reflects investors’ assessments of

a company’s future earnings. Illustration 13A-23

A higher P-E ratio suggests that the market is more optimistic

about Chicago. It might also signal that its stock is overpriced.



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Payout Ratio - Measures the percentage of earnings distributed

in the form of cash dividends.

Illustration 13A-24

This ratio should be calculated over a longer period of time to

evaluate any trends.



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The tools of financial statement analysis covered in this chapter are

universal and therefore no significant differences exist in the analysis

methods used.

The basic objectives of the income statement are the same under

both GAAP and IFRS. Thus, both the IASB and the FASB are

interested in distinguishing normal levels of income from irregular

items in order to better predict a company’s future profitability.

The basic accounting for discontinued operations is the same under

IFRS and GAAP.

Key Points

LO 9 Compare the accounting for Irregular items and the income statement format under GAAP and IFRS.

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Under IFRS, there is no classification for extraordinary items. In

other words, extraordinary item treatment is prohibited under IFRS.

All revenue and expense items are considered ordinary in nature.

The accounting for changes in accounting principles and changes in

accounting estimates are the same for both GAAP and IFRS.

The income statement under IFRS is referred to as a statement of

comprehensive income. The statement of comprehensive income

can be prepared under the one-statement approach or the two-

statement approach.

Key Points


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GAAP also permits the one-statement or two-statement approach. In

addition, GAAP permits a third alternative, which is to show the

computation of comprehensive income in the statement of

stockholders’ equity.

The issues related to quality of earnings are the same under both

GAAP and IFRS. It is hoped that by adopting a more principles-based

approach, as found in IFRS, many of the earnings’ quality issues will

disappear.

Key Points


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Looking to the Future

The FASB and the IASB are working on a project that would rework the

structure of financial statements. Recently, the IASB decided to require a

statement of comprehensive income, similar to what was required under

GAAP. In addition, another part of this project addresses the issue of how to

classify various items in the income statement. A main goal of this new

approach is to provide information that better represents how businesses

are run. In addition, the approach draws attention away from one number—net income.


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The basic tools of financial analysis are the same under both GAAP

and IFRS except that:

a) horizontal analysis cannot be done because the format of the

statements is sometimes different.

b) analysis is different because vertical analysis cannot be done

under IFRS.

c) the current ratio cannot be computed because current

liabilities are often reported before current assets in IFRS

statements of position.

d) None of the above.

IFRS Practice


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IFRS Practice


Under IFRS:

a) the reporting of discontinued items is different than GAAP.

b) the reporting of extraordinary items is prohibited.

c) the reporting of changes in accounting principles is different

than under GAAP.

d) None of the above.

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Presentation of comprehensive income must be reported under

IFRS in:

a) the statement of stockholders’ equity.

b) the income statement ending with net income.

c) the notes to the financial statements.

d) a statement of comprehensive income.

IFRS Practice


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acc102 chap13 publisher_power_point

Education

concept of sustainable

income statementillustration

extraordinary items

net of income taxes

irregular itemsirregular

b income statement

income statement partialfor

applicable income tax