Preview of Chapter 1 Financial Accounting Ninth Edition

Preview of Chapter 1 Financial Accounting Ninth Edition
Weygandt Kimmel Kieso

Preview of Chapter 14 Financial Accounting Ninth Edition
Weygandt Kimmel Kieso

14 Financial Statement Analysis Learning Objectives
After studying this chapter, you should be able to: [1] Discuss the need for comparative analysis. [2] Identify the tools of financial statement analysis. [3] Explain and apply horizontal analysis. [4] Describe and apply vertical analysis. [5] Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. [6] Understand the concept of earning power, and how irregular items are presented. [7] Understand the concept of quality of earnings.

Basics of Financial Statement Analysis
Analyzing financial statements involves: Characteristics Comparison Bases Tools of Analysis Liquidity Profitability Solvency Intracompany Industry averages Intercompany Horizontal Vertical Ratio LO 1 & LO 2

Horizontal Analysis 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 the increase or decrease. Commonly applied to the balance sheet, income statement, and statement of retained earnings. LO 3

Horizontal Analysis Illustration 14-5 Horizontal analysis of balance sheets Changes suggest that the company expanded its asset base during 2011 and financed this expansion primarily by retaining income rather than assuming additional long-term debt. LO 3

Horizontal Analysis Illustration 14-6 Horizontal analysis of Income statements Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality’s profit trend appears favorable. LO 3

Horizontal Analysis Illustration 14-7 Horizontal analysis of retained earnings statements The ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities. LO 3

Vertical Analysis Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount. On an income statement, we might say that selling expenses are 16% of net sales. Vertical analysis is commonly applied to the balance sheet and income statement. LO 4

Vertical Analysis Illustration 14-8 Vertical analysis of balance sheets Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt. LO 4

Vertical Analysis Quality appears
Illustration 14-9 Vertical analysis of Income statements Quality appears to be a profitable enterprise that is becoming even more successful. LO 4

Vertical Analysis Enables a comparison of companies of different sizes. Illustration 14-10 Intercompany income statement comparison LO 4

Financial Ratio Classifications
Ratio Analysis Ratio analysis expresses the relationship among selected items of financial statement data. Financial Ratio Classifications Liquidity Profitability Solvency Measures short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Measures the income or operating success of a company for a given period of time. Measures the ability of the company to survive over a long period of time. LO 5

Ratio Analysis A single ratio by itself is not very meaningful.
The discussion of ratios include the following types of comparisons. Intracompany comparisons for two years for Quality Department Store. Industry average comparisons based on median ratios for department stores. Intercompany comparisons based on Macy’s, Inc. as Quality Department Store’s principal competitor. LO 5

Total take: Thousands of dollars
ANATOMY OF A FRAUD This final Anatomy of a Fraud box demonstrates that sometimes relationships between numbers can be used by companies to detect fraud. The numeric relationships that can reveal fraud can be such things as financial ratios that appear abnormal, or statistical abnormalities in the numbers themselves. For example, the fact that WorldCom’s line costs, as a percentage of either total expenses or revenues, differed very significantly from its competitors should have alerted people to the possibility of fraud. Or, consider the case of a bank manager, who cooperated with a group of his friends to defraud the bank’s credit card department. The manager’s friends would apply for credit cards and then run up balances of slightly less than $5,000. The bank had a policy of allowing bank personnel to write-off balances of less than $5,000 without seeking supervisor approval. The fraud was detected by applying statistical analysis based on Benford’s Law. Benford’s Law states that in a random collection of numbers, the frequency of lower digits (e.g., 1, 2, or 3) should be much higher than higher digits (e.g., 7, 8, or 9). In this case, bank auditors analyzed the first two digits of amounts written off. There was a spike at 48 and 49, which was not consistent with what would be expected if the numbers were random. Total take: Thousands of dollars THE MISSING CONTROL Independent internal verification. While it might be efficient to allow employees to write off accounts below a certain level, it is important that these write-offs be reviewed and verified periodically. Such a review would likely call attention to an employee with large amounts of write-offs, or in this case, write-offs that were frequently very close to the approval threshold. Advance slide in presentation mode to reveal missing control. LO 5

Ratio Analysis Liquidity 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 acid-test ratio, accounts receivable turnover, and inventory turnover. LO 5

LO 5 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets For the Years Ended December 31 QUALITY DEPARTMENT STORE INC. Condensed Income Statements For the Years Ended December 31 Illustration 14-12 Advance slide in presentation mode to reveal solution. LO 5

Ratio Analysis 1. Current Ratio Liquidity Ratios
Illustration 14-12 Ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets. LO 5

Ratio Analysis 2. Acid-Test Ratio Liquidity Ratios LO 5
Illustration 14-13 LO 5

Condensed Balance Sheets For the Years Ended December 31 QUALITY DEPARTMENT STORE INC. Balance Sheet (partial) For the Years Ended December 31 Illustration 14-12 LO 5

Ratio Analysis 2. Acid-Test Ratio Liquidity Ratios
Illustration 14-14 Acid-test ratio measures immediate liquidity. LO 5

Balance Sheet (partial) For the Years Ended December 31 QUALITY DEPARTMENT STORE INC. Condensed Income Statements For the Years Ended December 31 LO 5

Ratio Analysis 3. Accounts Receivable Turnover Liquidity Ratios
Illustration 14-15 Measures the number of times, on average, the company collects receivables during the period. LO 5

365 days / 10.2 times = every 35.78 days
Liquidity Ratios Ratio Analysis 3. Accounts Receivable Turnover $2,097,000 = times ($180,000 + $230,000) / 2 A variant of the accounts receivable turnover ratio is to convert it to an average collection period in terms of days. 365 days / 10.2 times = every days Accounts receivable are collected on average every 36 days. LO 5

Balance Sheet (partial) For the Years Ended December 31 QUALITY DEPARTMENT STORE INC. Condensed Income Statements For the Years Ended December 31 Illustration 14-12 LO 5

Ratio Analysis 4. Inventory Turnover Liquidity Ratios
Illustration 14-16 Measures the number of times, on average, the inventory is sold during the period. LO 5

365 days / 2.3 times = every 159 days
Liquidity Ratios Ratio Analysis 4. Inventory Turnover $1,281,000 = 2.3 times ($500,000 + $620,000) / 2 A variant of inventory turnover is the days in inventory. 365 days / 2.3 times = every 159 days Inventory turnover ratios vary considerably among industries. LO 5

Ratio Analysis Profitability Ratios
Measure the income or operating success of a company for a given period of time. Income affects the company’s ability to obtain debt and equity financing, their liquidity position, and their ability to grow. Ratios include the profit margin, asset turnover, return on assets, return on common stockholders’ equity, earnings per share, price-earnings ratio, and payout ratio. LO 5

Condensed Balance Sheets For the Years Ended December 31 QUALITY DEPARTMENT STORE INC. Condensed Income Statements For the Years Ended December 31 LO 5

Ratio Analysis 5. Profit Margin Profitability Ratios
Illustration 14-17 Measures the percentage of each dollar of sales that results in net income. LO 5

Condensed Balance Sheets For the Years Ended December 31 QUALITY DEPARTMENT STORE INC. Condensed Income Statements For the Years Ended December 31 Illustration 14-12 LO 5

Ratio Analysis 6. Asset Turnover Profitability Ratios
Illustration 14-18 Measures how efficiently a company uses its assets to generate sales. LO 5

Ratio Analysis 7. Return on Asset Profitability Ratios
Illustration 14-19 An overall measure of profitability. LO 5

Ratio Analysis 8. Return on Common Stockholders’ Equity
Profitability Ratios Ratio Analysis 8. Return on Common Stockholders’ Equity Illustration 14-20 Shows how many dollars of net income the company earned for each dollar invested by the owners. LO 5

Ratio Analysis 8. Return on Common Stockholders’ Equity
Profitability Ratios Ratio Analysis 8. Return on Common Stockholders’ Equity With Preferred Stock Deduct preferred dividend from net income. Illustration 14-21 Return on common stockholders’ equity with preferred stock LO 5

Ratio Analysis 9. Earnings Per Share (EPS) Profitability Ratios
Illustration 14-22 A measure of the net income earned on each share of common stock. LO 5

Ratio Analysis 10. Price-Earnings Ratio Profitability Ratios
Illustration 14-23 Reflects investors’ assessments of a company’s future earnings. LO 5

Ratio Analysis 11. Payout Ratio Profitability Ratios
Illustration 14-24 Measures the percentage of earnings distributed in the form of cash dividends. LO 5

Ratio Analysis Solvency Ratios
Solvency ratios measure the ability of a company to survive over a long period of time. Debt to Assets and Times Interest Earned are two ratios that provide information about debt-paying ability. LO 5

Ratio Analysis 12. Debt to Total Assets Ratio Solvency Ratios
Illustration 14-25 Measures the percentage of the total assets that creditors provide. LO 5

Ratio Analysis 13. Times Interest Earned Solvency Ratios
Illustration 14-25 Provides an indication of the company’s ability to meet interest payments as they come due. LO 5

Ratio Analysis Summary of Ratios Illustration 14-27 LO 5

Summary of Ratios Illustration 14-27 LO 5

Earning Power and Irregular Items
Earning power means the normal level of income to be obtained in the future. “Irregular” items are separately identified on the income statement. Two types are: Discontinued operations. Extraordinary items. “Irregular” items are reported net of income taxes. LO 6

Discontinued Operations Disposal of a significant component of a business. Report the income (loss) from discontinued operations in two parts: income (loss) from operations (net of tax) and gain (loss) on disposal (net of tax). LO 6

Illustration: During 2015 AE Inc. has income before income taxes of $79,000,000. During 2015, AE Inc. discontinued and sold its unprofitable chemical division. The loss in 2015 from chemical operations (net of $135,000 taxes) was $315,000. The loss on disposal of the chemical division (net of $81,000 taxes) was $189,000. Assuming a 30% tax rate on income. LO 6

Previously labeled as “Net Income”.
Earning Power and Irregular Items Discontinued Operations are reported after “Income from continuing operations.” Previously labeled as “Net Income”. Moved to LO 6

Extraordinary Items Nonrecurring material items that differ significantly from a company’s typical business activities. Must be both of an Unusual Nature and Occur Infrequently. Must consider the environment in which it operates. Amounts reported “net of tax.” LO 6

Are these considered Extraordinary Items? (a) A large portion of a tobacco manufacturer’s crops are destroyed by a hail storm. Severe damage from hail storms in the locality where the manufacturer grows tobacco is rare. A citrus grower's Florida crop is damaged by frost. Loss from sale of temporary investments. Loss attributable to a labor strike. YES NO NO NO LO 6

Are these considered Extraordinary Items? Loss from flood damage. (The nearby Black River floods every 2 to 3 years.) An earthquake destroys one of the oil refineries owned by a large multi-national oil company. Earthquakes are rare in this geographical location. Write-down of obsolete inventory. Expropriation of a property by a foreign government. NO YES NO YES LO 6

Illustration: In 2015 a foreign government expropriated property held as an investment by AE Inc. If the loss is $770,000 before applicable income taxes of $231,000, the income statement will report a deduction of $539,000. LO 6

Previously labeled as “Net Income”.
Earning Power and Irregular Items Extraordinary Items are reported after “Income from continuing operations.” Previously labeled as “Net Income”. Moved to LO 6

Discontinued Operations
Earning Power and Irregular Items Reporting when both Discontinued Operations and Extraordinary Items are present. Discontinued Operations Extraordinary Item LO 6

Change in Accounting Principle When the principle used is different from the one used in the preceding year. Accounting rules permit a change if justified. Changes are reported retroactively. Example: Change from FIFO to average cost. LO 6

+ Earning Power and Irregular Items Comprehensive Income
All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders. Reported in Stockholders’ Equity Unrealized gains and losses on available-for-sale securities. Plus other items + LO 6

Comprehensive Income Why are gains and losses on available-for-sale securities excluded from net income? Disclosing them separately reduces the volatility of net income due to fluctuations in fair value, yet informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value. LO 6

Quality of Earnings 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. Recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business. LO 7

Quality of Earnings Alternative Accounting Methods Pro Forma Income
Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings. Pro Forma Income Pro forma income usually excludes items that the company thinks are unusual or non-recurring. Many companies have abused the flexibility that pro forma numbers allow. LO 7

Quality of Earnings Improper Recognition
Due to pressure from Wall Street some managers have manipulated the earnings numbers to meet expectations. Abuses include: Channel stuffing, improper recognition of revenue (Bristol- Myers Squibb). Improper capitalization of operating expenses (WorldCom). Failure to report all liabilities (Enron). LO 7

Key Points 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. As indicated in the textbook, a very important objective is to ensure that users of the income statement can evaluate the earning power of the company. Earning power is the normal level of income to be obtained in the future. 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. LO 8 Compare financial statement analysis and income statement presentation under GAAP and IFRS..

Key Points The basic accounting for discontinued operations is the same under IFRS and GAAP. 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. Disclosure, however, is extensive for items that are considered material to the financial results. Examples are write-downs of inventory or plant assets, or gains and losses on the sale of plant assets. The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS. LO 8

Key Points Both GAAP and IFRS follow the same approach in reporting comprehensive income. The statement of comprehensive income can be prepared under the one-statement approach or the two-statement approach. 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, that many of the earning quality issues will disappear. LO 8

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. LO 8

IFRS Self-Test Questions
The basic tools of financial analysis are the same under both GAAP and IFRS except that: horizontal analysis cannot be done because the format of the statements is sometimes different. analysis is different because vertical analysis cannot be done under IFRS. the current ratio cannot be computed because current liabilities are often reported before current assets in IFRS statements of position. None of the above. LO 8

Under IFRS: the reporting of discontinued items is different than GAAP. the reporting of extraordinary items is prohibited. the reporting of changes in accounting principles is different than under GAAP. None of the above. LO 8

Presentation of comprehensive income must be reported under IFRS in: the statement of stockholders’ equity. the income statement ending with net income. the notes to the financial statements. a statement of comprehensive income. LO 8

Copyright “Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”

Preview of Chapter 1 Financial Accounting Ninth Edition

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