Fundamentals of Financial Accounting 3e by Phillips, Libby, and Libby.

Fundamentals of Financial Accounting 3e by Phillips, Libby, and Libby.
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Measuring and Evaluating Financial Performance
Chapter 13 Measuring and Evaluating Financial Performance PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Fred Phillips, Ph.D., CA Chapter 13: Measuring and Evaluating Financial Performance.

Learning Objective 1 Describe the purpose and uses of horizontal, vertical, and ratio analyses. Learning objective 1 is to describe the purpose and uses of horizontal, vertical, and ratio analyses. 13-3

Horizontal, Vertical, and Ratio Analyses
Horizontal (trend) analyses are conducted to help financial statement users recognize important financial changes that unfold over time. 12/31/09 12/31/10 Gross Profit in 2009 Gross Profit in 2010 Δ in Gross Profit $ and/or % from 2009 Trend Analysis Vertical analyses focus on important relationships between items on the same financial statement. Part I Horizontal (trend) analyses are conducted to help financial statement users recognize important financial changes that unfold over time. Part II A company will report gross profit each year on its income statement. In Horizontal or trend analysis, we might calculate the change in gross profit from one year to the next. We could do this for all accounts on the financial statements. Part III Vertical analyses focus on important relationships between items on the same financial statement. Part IV Here is a partial income statement showing sales, cost of goods sold, and gross profit for the fiscal year While we know that the number amounts will appear on the income statement, we gain insights the values on the income statement by doing a vertical, or common size, analysis. Here we have calculated the percentages for each amount by expressing sales as 100 percent. Sales Cost of Goods Sold Gross Profit $200, % 150, % $ 50, % Amount Percent 2010 13-4

Horizontal, Vertical, and Ratio Analyses
Ratio analyses are conducted to understand relationships among various items reported in one or more of the financial statements. Receivable Turnover Ratio = Net Sales Revenue Average Net Receivables Part I Ratio analyses are conducted to understand relationships among various items reported in one or more of the financial statements. Part II Recall the calculation of the Receivable Turnover Ratio. By calculating this ratio we were able to determine the number of times per year receivable are collected. Part III It is essential to understand that no analysis is complete unless it leads to an interpretation that helps financial statement users understand and evaluate a company’s financial results It is essential to understand that no analysis is complete unless it leads to an interpretation that helps financial statement users understand and evaluate a company’s financial results 13-5

Learning Objective 2 Use horizontal (trend) analysis to recognize financial changes that unfold over time. Learning objective 2 is to use horizontal (trend) analysis to recognize financial changes that unfold over time. 13-6

Horizontal (Trend) Computations
Trend analyses are usually calculated in terms of year-to-year dollar and percentage changes. (Current Year’s Total – Prior Year’s Total) Year-to-Year Change (%) = Change This Year Prior Year’s Total × 100 Part I Trend analyses are usually calculated in terms of year-to-year dollar and percentage changes. Part II Calculating the dollar change from one year to the next is relatively easy. However, calculating the year-to-year percentage change can be a challenge. We begin the process by subtracting the prior year’s total dollar amount from the current year’s total dollar amount. This is referred to as the “current year change.” We divide the current year change by the prior year’s total amount and multiply that amount by 100 to convert it to a percentage that is easy to read. Part III Let’s look at an example of trend computation. Let’s look at an example 13-7

Horizontal (Trend) Computations
$48,230 – $48,283 $48,283 × 100 Part I Here is the income statement of Lowe’s for the fiscal years 2009 and See if you can calculate the dollar change in net sales revenue between 2009 and 2008. Part II There was a $53 million decrease in Net Sales Revenue between the two years ($48,283 – $48,230). How did you do? Part III Now let’s calculate the percentage change in Net Sales Revenue between 2009 and 2008. Part IV The decrease in Net Sales Revenue between the two years is one-tenth of 1 percent decrease. How did you do? Part V You can see that we calculate the percentage by subtracting $48,283 (2008 amount) from $48,230 (2009 amount) and dividing the difference by $48,283 (2008 amount) and multiply the total times 100 to express the percent in a readable form of one-tenth of 1 percent decrease. Part VI Why don’t you calculate the dollar and percentage change for Cost of Sales between 2009 and Don’t proceed until you have finished the computations. Part VII I hope you were able to get these answers. Between 2008 and 2009, Cost of Sales increased by $173 million, which means it increased by one-half of one percent. Here is the rest of the trend analysis for the Income Statement. We could apply the same techniques to the balance sheet to do a trend analysis of that financial statement. Calculate the change in dollars for Net Sales Revenue between 2009 and 2008. Now let’s calculate the percentage change in Net Sales Revenue between 2009 and 2008. Now let’s look at the remainder of the trend analysis of the Income Statement. Can you calculate the dollar and percentage change for Cost of Sales? 13-8

Learning Objective 3 Use vertical (common size) analysis to understand important relationships within financial statements. Learning objective 3 is to use vertical (common size) analysis to understand important relationships within financial statements. 13-9

Vertical (Common Size) Computations
Vertical, or common size, analysis focuses on important relationships within financial statements. Income Statement Sales = 100% Balance Sheet Total Assets = 100% Cost of Sales Net Sales Revenue × 100 Part I Vertical, or common size, analysis focuses on important relationships within financial statements. We usually pick a value on the financial statement and express all other values on that statement as a percent of the selected amount. Part II When preparing a common size income statement we normally let net sales equal 100 percent and express all other items on the income statement as a percent of net sales. When preparing a common size balance sheet we normally let total assets equal 100 percent and express all other balance sheet accounts as a percent of total assets. Let’s look at an example. Part III Here is the income statement of Lowe’s for the fiscal years 2008 and Notice, we have set Net Sales Revenue equal to 100 percent. Now, calculate Cost of Sales as a percent of Net Credit Sales. Part IV Here is the equation we will use to calculate the percentage. Part V Cost of Sales is equal to 65.8 percent of Net Sales Revenue in 2008, and 65.4 percent in There as been a slight increase in Cost of Sales as a percent of Net Sales Revenue. Part VI Why don’t you complete the common size income statements for the two years? Part VII How did you do? Can you explain why there was a fairly significant decrease in net income from 2007 (5.8 percent) to 2008 (4.6 percent)? 13-10

Learning Objective 4 Calculate financial ratios to assess profitability, liquidity, and solvency. Learning objective 4 is to calculate financial ratios to assess profitability, liquidity, and solvency. 13-11

Ratio Computations Ratio analysis compares the amounts for one or more line items to the amounts for other line items in the same year. Ratios are classified into three categories Profitability ratios examine a company’s ability to generate income. Solvency ratios examine a company’s ability to pay interest and repay debt when due. Ratio analysis compares the amounts for one or more line items to the amounts for other line items in the same year. Most analysts classify ratios into three categories: Profitability ratios, which relate to the company’s performance in the current period—in particular, the company’s ability to generate income. Liquidity ratios, which relate to the company’s short-term survival—in particular, the company’s ability to use current assets to repay liabilities as they become due. Solvency ratios, which relate to the company’s long-run survival—in particular, the company’s ability to repay lenders when debt matures and to make the required interest payments prior to the date of maturity. Liquidity ratios help us determine if a company has sufficient current assets to repay liabilities when due. 13-12

Common Profitability Ratios
We have listed some common profitability ratios. These ratios relate to the company’s performance in the current period—in particular, the company’s ability to generate income. We will calculate each of these ratios later in this presentation. Note that we are going to cover in detail eight common profitability ratios. 13-13

Common Liquidity Ratios
Here is a list of four common liquidity ratios. These ratios relate to the company’s short-term survival—in particular, the company’s ability to use current assets to repay liabilities as they become due. 13-14

Common Solvency Ratios
We are going to compute three common solvency ratios. Solvency ratios relate to the company’s long-run survival—in particular, the company’s ability to repay lenders when debt matures and to make the required interest payments prior to the date of maturity. 13-15

Interpret the results of financial analyses.
Learning Objective 5 Interpret the results of financial analyses. Learning objective 5 is to interpret the results of financial analyses. 13-16

Interpreting Horizontal and Vertical Analyses
With 60 new stores opened, Lowe’s had a 7.9% increase in inventory, and a 6.4% increase in Property and Equipment. Lowe’s grew by 5.9% in fiscal 2009. Part I Financial statement analyses are not complete unless they lead to interpretations that help users understand and evaluate a company’s financial results. Part II Horizontal (trend) analysis of Lowe’s balance sheet shows that the company grew in fiscal Overall, total assets increased approximately 5.9 percent. Part III In fiscal 2008, Lowe’s opened 60 new stores, resulting in significant increases in Inventories (7.9 percent) and Property and Equipment (6.4 percent). 13-17

The Company’s cash position weakened significantly between fiscal 2007 and 2008. There was a large increase in the inventory carried by the company. The accumulation of inventory is a sign of a weakening business outlook. Part I Let’s see if we can identify some of the warning signs facing Lowe’s. Part II Lowe’s cash position weakened between fiscal 2007 and The weakening hurt the liquidity of the company. As a general rule, retail companies are in business to sell, not hold, inventory. When we see a build-up in inventory we know that the company is facing a soft business environment. We cannot generate cash unless we sell inventory. 13-18

Cost of sales and operating expenses are the most important determinants of the company’s profitability. Much of the decline in fiscal 2008 Net Income is explained by the increase in Cost of Sales and Operating Expenses. Part I Vertical analysis of Lowe’s income statement shows that Cost of Sales and Operating Expenses are the most important determinants of the company’s profitability. Part II Cost of sales and operating expenses are the most important determinant of the company’s profitability. Cost of Sales consumed 65.8 percent of Sales in fiscal 2008 and Operating Expenses consumed an additional 26.3 percent. Part III Much of the reduction in the company’s Net Income (from 5.8 percent of Sales in 2007 to 4.6 percent in 2008) is explained by these two categories of expenses. 13-19

Lowe’s has experienced a 0.4% increase in its cost of goods sold from fiscal 2007 to Increasing cost of sales means lower gross profit. Lowe’s did not do a good job of controlling its operating expenses between 2007 and The company is faced with lower gross profit and poor operating expense control. Part I Lowe’s is facing some serious problems relating to its ability to generate future income. Let’s see where the current problems can be located. Part II Cost of sales increased by four-tenths of one percent from fiscal 2007 to fiscal Higher cost of goods sold, given relatively stable sales, results in a lower gross profit. This can be a disturbing trend in a retail business. Part III The management at Lowe’s was unable to effectively control operating expenses from 2007 to Operating expenses increased by one point 4 percent during the period. One piece of data to help a financial statement reader evaluate the effectiveness of management is to see how well the management controls operating expense. Control of operating expenses is extremely important in periods of slow or no economic growth. 13-20

Ratio Calculations Here is the balance sheet information that we will use in the calculation of our ratios. It is a good idea to print this slide and the next as we compute the various ratios. An alternative is to look at Exhibits 13-1 and 13-2 in your textbook. 13-21

Ratio Calculations We will use Lowe’s Income Statement for many of the ratio calculations we will complete in the following slides. Let’s get started with the calculation of profitability ratios. 13-22

Profitability Ratios Net Profit Margin – Lowe’s faced a challenging economic environment in 2008 as shown by the decline in Net Profit Margin. Gross Profit Percentage – Lowe’s gross profit percentage indicates how much profit was made on each dollar of sales after deducting the Cost of Goods Sold. Part I Profitability ratios focus on the level of profits the company generated during the period. In our analyses, we compare Lowe’s financial ratios to the prior year and in some cases to those for The Home Depot. (Lowe’s and The Home Depot’s annual reports are printed in Appendix A and B.) The Net Profit Margin Ratio represents the percentage of sales revenues that ultimately make it into net income, after deducting expenses. In 2008, Lowe’s generated 4.6 cents in net profit margin for each dollar of sales, down from 5.8 cents the previous year. Part II The decrease in the gross profit percentage from 2007 to 2008 (34.2% %) means that Lowe’s made 0.4 cents less gross profit on each dollar of sales in 2008 than in This decline means that Lowe’s charged lower selling prices without experiencing a decrease in the cost of merchandise or Lowe’s paid a higher unit cost for merchandise purchased. 13-23

Profitability Ratios Asset Turnover Ratio – indicates the amount of sales revenue generated for each dollar invested in assets during the period. Fixed Asset Turnover – indicates how much revenue the company generates in sales for each dollar invested in fixed assets, Part I The asset turnover ratio suggests that Lowe’s assets did not generate sales as efficiently in 2008 as in the prior year. To understand why, it is helpful to focus on the key assets used to generate sales. For a retailer such as Lowe’s, the key asset is store properties, which we can compare to sales using the fixed asset turnover ratio discussed next. Part II The fixed asset turnover ratio shows that Lowe’s had $2.19 of sales in 2008 for each dollar invested in fixed assets. Although the decline from 2007 was not good, it is understandable because 2008 was a difficult year for retailers. Lowe’s 2008 fixed asset turnover also suffered because the company added stores during the year. Those stores will likely need some time to establish a strong customer base and begin generating sales at full capacity. Part III The Home Depot reported a fixed asset turnover ratio of 2.65 in In terms of using fixed assets to generate sales revenue, The Home Depot has a competitive advantage over Lowe’s. In other words, Lowe’s is operating less efficiently than its major competitor. Home Depot 2008 fixed asset turnover ratio was 2.65 13-24

Profitability Ratios Return on Equity (ROE) – Compares the amount of net income to average stockholders’ equity. ROE reports the net amount earned during the period as a percentage of each dollar contributed by stockholders and retained in the business. Part I Return on Equity (ROE) compares the amount of net income to average stockholders’ equity. ROE reports the net amount earned during the period as a percentage of each dollar contributed by stockholders and retained in the business. Lower ROE was predictable because the company had increased its stockholders’ equity to finance store expansion. But store expansion failed to increase sales in Lower sales resulted in lower net income. Lower income and the increase in the stockholders’ equity results in a lower ROE. Part II Earnings Per Share (EPS) shows the amount of earnings generated for each share of outstanding common stock. Lowe’s was bound to experience a decline in EPS because lower sales resulted in lower net income. In addition, Lowes issued more shares of stock to finance the new stores that were opened in But these stores have yet to increase sales revenue. As a result of these two factors, Lowes experiences a rather significant decline in EPS. Earnings Per Share (EPS) – Shows the amount of earnings generated for each share of outstanding common stock. 13-25

Profitability Ratios Quality of Income – Quality of income ratio relates operating cash flows (from the Statement of Cash Flows) to net income. Home Depot 2008 Quality of Income Ratio was 2.45 Price /Earnings (P/E) Ratio – Shows the relationship between EPS and the market price of one share of the company’s stock. Part I Quality of Income – quality of income ratio relates operating cash flows (from the Statement of Cash Flows) to net income. in 2008, Lowe’s generated $1.88 of operating cash flow for every dollar of net income. Because the ratio is much greater than 1.0, it is interpreted as “high quality” income. Part II In 2008, The Home Depot reported Quality of Income Ratio was 2.45. Part III Using the going price for Lowe’s stock, $18.25 in 2008 and $23.00 in 2007, the P/E ratio was 12.1 in both years. This means investors were willing to pay 12.1 times earnings to buy a share of Lowe’s stock. The Home Depot’s P/E ratio at that time was around 18.5, suggesting that investors were less willing to buy stock in Lowe’s than in The Home Depot. 13-26

Average Net Receivables
Liquidity Ratios Let’s change our attention to an examination of liquidity ratios. The analyses in this section focus on the company’s ability to survive in the short term, by converting assets to cash that can be used to pay current liabilities as they come due. Receivable Turnover Ratio = Net Sales Revenue Average Net Receivables Receivable Turnover Ratio – Most retail home improvement companies have low levels of accounts receivable relative to sales revenue because they collect the majority of their sales immediately in cash. Part I Let’s change our attention to an examination of liquidity ratios. The analyses in this section focus on the company’s ability to survive in the short term, by converting assets to cash that can be used to pay current liabilities as they come due. Part II We will begin with the Receivable Turnover Ratio. Most home improvement companies have low levels of accounts receivable relative to sales revenue because they collect the majority of their sales immediately in cash. As a consequence, the receivable turnover ratio has little meaning to the financial statement reader. 13-27

Liquidity Ratios Inventory Turnover Ratio – The inventory turnover ratio indicates how frequently inventory is bought and sold. The “days to sell” indicates the average number of days needed to sell each purchase of inventory. Home Depot sells its inventory in an average of 87 days in 2008. Current Ratio – The current ratio measures the company’s ability to pay its current liabilities Part I The inventory turnover ratio indicates how frequently inventory is bought and sold during the year. The measure “days to sell” converts the inventory turnover ratio into the average number of days needed to sell each purchase of inventory. Because of the weaker economy in 2008, Lowe’s inventory turned over less frequently. On average, its inventory took an additional 5.7 days to sell (91.0 – 85.3). Part II Although most retailers experienced a decline in inventory turnover in 2008, Lowe’s decline was disappointing because it prevented the company from catching up to The Home Depot (where inventory takes an average of 87 days to sell). Part III The current ratio measures the company’s ability to pay its current liabilities. Lowe’s ratio increased slightly from 2007 to 2008, ending the year with a ratio of In this industry, a current ratio greater than 1.0 is deemed acceptable. 13-28

Liquidity Ratios Let’s examine some Solvency Ratios
Quick Ratio – The quick ratio is a much more stringent test of short-term liquidity than is the current ratio. Lowe’s quick ratio increased slightly in 2008, just as its current ratio did. Referred to as “quick assets.” Part I The quick ratio compares the sum of cash, short-term investments, and accounts receivable to current liabilities. The low quick ratio shown here is typical for industries where most customers buy with cash or credit card. Part II These assets are referred to as quick assets because they may be converted into cash on short notice. The quick ratio is a much more stringent test of short-term liquidity than is the current ratio. Lowe’s quick ratio increased slightly in 2008, just as its current ratio did. The average quick ratio in 2008 for the homebuilding industry was 0.66. Now, let’s move on and examine the Solvency Ratios which focus on a company’s ability to survive over the long term, that is, to repay debt when it matures, pay interest until that time, and finance the replacement and/or expansion of long-term assets. Let’s examine some Solvency Ratios Solvency ratios focus on a company’s ability to survive over the long term, that is, to repay debt when it matures, pay interest until that time, and finance the replacement and/or expansion of long-term assets. 13-29

In 2008, The Home Depot had a debt-to-assets ratio of 57 percent.
Solvency Ratios Debt to Assets Ratio – indicates the proportion of total assets that creditors finance. In 2008, The Home Depot had a debt-to-assets ratio of 57 percent. Times Interest Earned – indicates how many times the company’s interest expense was covered by its operating results. Part I Debt to Assets Ratio indicates the proportion of total assets that creditors finance. Lowe’s ratio of 0.45 in 2008 indicates that creditors contributed 45 cents per $1.00 of the company’s total assets, implying that stockholders’ equity was the company’s main source of financing at 55 cents for each $1.00 of total assets. Part II In 2008, The Home Depot has a debt-to-asset ratio of 57 percent. The Home Depot relies much more on debt financing. Part III Times Interest Earned indicates how many times the company’s interest expense was covered by its operating results. This ratio is calculated using accrual-based interest expense and net income before interest and income taxes. Lowe’s ratio of 13.5 indicates the company is generating more than enough profit to cover its interest expense. A ratio of 1.0 means that the company is able to cover its interest expense for the period. 13-30

Solvency Ratio Capital Acquisition Ratio – compares cash flows from operations with cash paid for property and equipment. Capital Acquisition Ratio compares cash flows from operations with cash paid for property and equipment. The 1.26 capital acquisitions ratio in 2008 indicates that Lowe’s was able to pay for all its store expansion using cash generated from operating activities. Lowe’s is financially well-positioned. 13-31

Describe how analyses depend on key accounting decisions and concepts.
Learning Objective 6 Describe how analyses depend on key accounting decisions and concepts. Learning objective 6 is to describe how analyses depend on key accounting decisions and concepts. 13-32

Underlying Accounting Decisions and Concepts
Difference in Strategies, e.g. type of financing. Difference in Operations, e.g. quality of items sold. Difference in Accounting Methods, e.g. FIFO vs. LIFO. In any analysis you prepare it is essential that you understand the underlying accounting decisions and concepts. When comparing two companies we must understand each company’s strategy. One company may have decided to increase revenue by expanding into new locations, while the other company may attempt to increase revenue by upgrading its existing locations and spending more resources to understand customer needs. We also need to understand the differences in operation between the two companies. One company may elect to be the low cost provider in its market while the other company may concentrate on upscale products and heavy customer assistance. Finally, we must be aware of any differences in the accounting methods employed by the two companies. For example, one company may elect to use accelerated depreciation method for financial accounting and reporting while the other company uses straight-line depreciation. The choices made in these three areas will impact the values we produce from our analysis. 13-33

Accounting Concepts Companies may elect to use any acceptable generally accepted accounting principle (GAAP) as long as they apply the principle consistently. Companies may elect to use any acceptable generally accepted accounting principle (GAAP) as long as they apply the principle consistently. This table shows the differences in inventory and depreciation principles for Lowe’s, The Home Depot, and Builder’s FirstSource, all companies in the home improvement industry. Notice how much more quickly Builder’s FirstSource depreciated its equipment when compared to Lowe’s and The Home Depot. 13-34

Conceptual Framework for Financial Accounting and Reporting
Objective of External Financial Reporting To provide useful financial information to external users for decision making (Ch. 1) It must be relevant and a faithful representation of the business. It is more useful if it is comparable, verifiable, timely, and understandable. Elements to be Measured and Reported Assets, Liabilities, Stockholders’ Equity, Revenue, Expenses (Ch. 1) Concepts for Measuring and Reporting Information Assumptions: Unit of Measure (Ch. 1), Separate Entity (Ch. 1) Going Concern, Time Period (Ch. 3) Principles: Cost (Ch. 2), Revenue Recognition (Ch. 3), Matching (Ch. 3), Full Disclosure Exceptions Cost-Benefit, Materiality (Ch. 5), Industry Practices The concepts that you have already studied in prior chapters are highlighted in red. The appropriate chapter reference is shown. The primary objective of financial accounting and reporting is to provide useful financial information for people external to a company to use in making decisions about the company. To be useful, this information must be relevant and faithfully represent the underlying business. We will discuss some of the concepts previously omitted. The going concern concept is an assumption that underlies accounting rules. It is the belief that the business will be capable of continuing its operations long enough to realize its recorded assets and meet its obligations in the normal course of business. If a company runs into severe financial difficulty (such as bankruptcy), this assumption may no longer be appropriate and we will be faced with a going concern problem. Simply put, the principle of full disclosure is that financial reports should present all information that is needed to properly interpret the results of the company’s business activities. The industry practices constraint is that companies in some industries, such as financial services, oil and gas, and agricultural production, have such unique circumstances that they need to use accounting rules that differ somewhat from what companies in most other industries use. The cost-benefit constraint recognizes that it is costly for companies to gather all the financial information that could possibly be reported. Accounting rules need to be implemented only to the extent that the benefits outweigh the costs of doing so. 13-35

Factors Contributing to Going-Concern Problems
Factors that commonly contribute to going-concern problems are listed below. If ever a company encounters a going-concern problem, it may need to adjust the amount and classification of items in its financial statements, which would be explained in the financial statement notes and to which the auditor’s report would draw attention. Financial and other types of analyses often call to our attention a potential going-concern issue. 13-36

Nonrecurring and Other Special Items
Chapter 13 Supplement 13A Nonrecurring and Other Special Items Chapter 13, Supplement 13A: Nonrecurring and Other Special Items.

  Nonrecurring Items Extraordinary Items
Very few events qualify as extraordinary items.  Cumulative Effect of Changes in Accounting Methods Direct adjustment to Retained Earnings rather than income reporting.  Part I The definition of extraordinary has become so restricted that few events—not even the losses that arose from Hurricane Katrina—qualify as extraordinary. Part II The cumulative effect of an accounting change is reported as a direct adjustment to the beginning balance in Retained Earnings rather than as part of the income statement in the period when the change is made. Part III Discontinued operations result from abandoning or selling a major business component. Because an abandoned or sold business unit will not affect financial results in future years, its results for the current year are reported on a separate line of the income statement immediately after Income Tax Expense. In the year of disposal, any gain or loss of the discontinued unit will be in the reporting company’s income statement as well as the operating income from the beginning of the year until the date of disposal. Discontinued Operations For discontinued component two items are reported: Operating income prior to the date of disposal. Gain or loss on sale or disposal of net assets.  13-38

Discontinued Operations.
Nonrecurring Items NONRECURING ITEM Discontinued Operations. Here is an example of the reporting of nonrecurring items. In our example, we are reporting a loss from discontinued operations. Nonrecurring items are not considered part of normal income from operations and is reported net of applicable taxes. In this case because the loss is deductible on our tax return, we will experience a tax savings. This tax savings is the result of a loss lowering our income tax expense. 13-39

Other Special Items Comprehensive Income includes:
Gains or losses from certain foreign currency exchange rate changes. Gains or losses resulting from the change in value of certain types of investments. Excluded from net income because they are likely to disappear before they are ever realized. Items included in comprehensive income are excluded from net income and reported in the equity section of the balance sheet. The main reason for excluding these gains and losses from net income is that the changes in value that created them may well disappear before they are ever realized (when the company sells the related assets or liabilities). 13-40

Reviewing and Contrasting IFRS and GAAP
Chapter 13 Supplement 13B Reviewing and Contrasting IFRS and GAAP Chapter 13, Supplement 13B: Reviewing and Contrasting IFRS and GAAP .

Overview At a basic level both IFRS and GAAP are concerned with accounting rules that describe when an item should be recognized in the accounting system, how that item should be classified (asset , liability, equity, expense, or revenue), and the amount at which each item should be measured. Reverse inventory Lower of Cost or Market write-down. IFRS GAAP Yes No Part I At a basic level both IFRS and GAAP are concerned with accounting rules that describe (1) when an item should be recognized in the accounting system, (2) how that item should be classified (asset, liability, equity, revenue, or expense), and (3) the amount at which each item should be measured. Both systems require that items be recorded only after an exchange between the company and another party. Initially, these items are recorded at the value they enter the company. Part II There are differences between IFRS and GAAP. For example, IFRS requires or allows companies to report items using values that differ from those required or allowed by GAAP. IFRS permits companies to report fixed assets at fair values. Report fixed assets at fair value. IFRS Yes GAAP No 13-42

Chapter 13 Solved Exercises
M13-1, M13-2, M13-6, E13-1, E13-3, E13-4, E13-10, E13-13 Chapter 13 Solved Exercises: M13-1, M13-2, M13-6, E13-1, E13-3, E13-4, E13-10, E13-13.

M13-1 Calculations for Horizontal Analyses
Using the following income statements, perform the calculations needed for horizontal analyses. Round percentages to one decimal place. M13-1 Calculations for Horizontal Analyses Using the income statements shown, perform the calculations needed for horizontal analyses. Round percentages to one decimal place. 13-44

M13-1 Calculations for Horizontal Analyses
How did you do on this assignment? As you can see, Net Sales increased by $25,000 or 33.3 percent. ($100,000 – $75,000) $75,000 × = 33.3% 13-45

M13-2 Calculations for Vertical Analyses
Refer to M Perform the calculations needed for vertical analyses. Round percentages to one decimal place. $21,000 $100,000 × = 21.0% Part I M13-2 Calculations for Vertical Analyses Refer to M Perform the calculations needed for vertical analyses. Round percentages to one decimal place. Part II In the year ended December 31, 2010, Net Income is 21.0 percent of Net Sales. We determine this by dividing Net Sales into Net Income and multiplying the results by 100. 13-46

M13-6 Inferring Financial Information Using Gross Profit Percentage and Year-over-Year Comparisons
A consumer products company reported a 25 percent increase in sales from 2009 to Sales in 2009 were $200,000. In 2010, the company reported Cost of Goods Sold in the amount of $150,000. What was the gross profit percentage in 2010? Round to one decimal place. $100,000 $250,000 × = 40.0% Part I M13-6 Inferring Financial Information Using Gross Profit Percentage and Year-over-Year Comparisons A consumer products company reported a 25 percent increase in sales from 2009 to Sales in 2009 were $200,000. In 2010, the company reported Cost of Goods Sold in the amount of $150,000. What was the gross profit percentage in 2010? Round to one decimal place. Part II Sales increased by 25 percent from 2009 to Sales in 2009 were $200,000, so Sales in 2010, must be $250,000 ($200,000 times 1.25). So, in 2010, Gross Profit was $100,000. Part III With Sales of $250,000 and Gross Profit of $100,000, the Gross Profit Percentage is 40 percent in 2010. 13-47

E13-1 Preparing and Interpreting a Schedule for Horizontal
and Vertical Analyses The average price of a gallon of gas in 2008 jumped $0.45 (16 percent) from $2.81 in 2007 (to $3.26 in 2008). Let’s see whether these changes are reflected in the income statement of Chevron Corporation for the year ended December 31, 2008 (amounts in billions). Required: 1. Conduct a horizontal analysis by calculating the year-over-year changes in each line item, expressed in dollars and in percentages (rounded to one decimal place). How did the change in gas prices compare to the changes in Chevron Corp.’s total revenues and costs of crude oil and products? 2. Conduct a vertical analysis by expressing each line as a percentage of total revenues (round to one decimal place). Excluding income tax and other operating costs, did Chevron earn more profit per dollar of revenue in 2008 compared to 2007? E13-1 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses The average price of a gallon of gas in 2008 jumped $0.45 (16 percent) from $2.81 in 2007 (to $3.26 in 2008). Let’s see whether these changes are reflected in the income statement of Chevron Corporation for the year ended December 31, 2008 (amounts in billions). Required: Conduct a horizontal analysis by calculating the year-over-year changes in each line item, expressed in dollars and in percentages (rounded to one decimal place). How did the change in gas prices compare to the changes in Chevron Corp.’s total revenues and costs of crude oil and products? Conduct a vertical analysis by expressing each line as a percentage of total revenues (round to one decimal place). Excluding income tax and other operating costs, did Chevron earn more profit per dollar of revenue in 2008 compared to 2007? 13-48

and Vertical Analyses Req. 1 The 16% increase in the average gas price was less than the 23.5% increase in total revenues and the 28.6% increase in cost of crude oil and products. It appears from this analysis that the increase in gas prices explains only part of Chevron’s increase in total revenues. Note that the percentage increase in total revenues was less than the percentage increase in the cost of crude oil and products, suggesting the costs of crude oil really did increase a lot in 2008, necessitating the increase in gas prices. Part I Compare your analysis to the one shown above. If you had any problems, make sure you check your math before moving on to answer the questions posed. Part II The 16% increase in the average gas price was less than the 23.5% increase in total revenues and the 28.6% increase in cost of crude oil and products. It appears from this analysis that the increase in gas prices explains only part of Chevron’s increase in total revenues. Note that the percentage increase in total revenues was less than the percentage increase in the cost of crude oil and products, suggesting the costs of crude oil really did increase a lot in 2008, necessitating the increase in gas prices. 13-49

and Vertical Analyses Req. 2 Part I Compare your analysis to the one shown above. If you had any problems, make sure you check your math before moving on to answer the questions posed. Part II As a percent of total revenues, Chevron’s cost of crude oil and products was higher in 2008 (62.6%) than in 2007 (60.2%). This implies that Chevron earned less profit (excluding income tax and other operating costs) per dollar of revenues in 2008 than in 2007. As a percent of total revenues, Chevron’s cost of crude oil and products was higher in 2008 (62.6%) than in 2007 (60.2%). This implies that Chevron earned less profit (excluding income tax and other operating costs) per dollar of revenues in 2008 than in 2007. 13-50

E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses
According to the producer price index database maintained by the Bureau of Labor Statistics, the average cost of computer equipment fell 20.9 percent between 2007 and Let’s see whether these changes are reflected in the income statement of Computer Tycoon Inc. for the year ended December 31, 2008. Required: 1. Conduct a horizontal analysis by calculating the year-over-year changes in each line item, expressed in dollars and in percentages (rounded to one decimal place). How did the change in computer prices compare to the changes in Computer Tycoon’s sales revenues? 2. Conduct a vertical analysis by expressing each line as a percentage of total revenues (round to one decimal place). Excluding income tax, interest, and operating expenses, did Computer Tycoon earn more profit per dollar of sales in 2008 compared to 2007? E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses According to the producer price index database maintained by the Bureau of Labor Statistics, the average cost of computer equipment fell 20.9 percent between 2007 and Let’s see whether these changes are reflected in the income statement of Computer Tycoon Inc. for the year ended December 31, 2008. Required: Conduct a horizontal analysis by calculating the year-over-year changes in each line item, expressed in dollars and in percentages (rounded to one decimal place). How did the change in computer prices compare to the changes in Computer Tycoon’s sales revenues? Conduct a vertical analysis by expressing each line as a percentage of total revenues (round to one decimal place). Excluding income tax, interest, and operating expenses, did Computer Tycoon earn more profit per dollar of sales in 2008 compared to 2007? 13-51

Req. 1 Part I Compare your analysis to the one shown above. If you had any problems, make sure you check your math before moving on to answer the questions posed. Part II The 20.9% decrease in the average price of computer equipment was more than the 18.8% decrease in total revenues. It appears from this analysis that the 20.9% decrease in computer prices was partially offset by an increase in Computer Tycoon’s sales volumes, leaving an overall decrease in sales revenues of 18.8%. The 20.9% decrease in the average price of computer equipment was more than the 18.8% decrease in total revenues. It appears from this analysis that the 20.9% decrease in computer prices was partially offset by an increase in Computer Tycoon’s sales volumes, leaving an overall decrease in sales revenues of 18.8%. 13-52

Req. 2 Part I Compare your analysis to the one shown above. If you had any problems, make sure you check your math before moving on to answer the questions posed. Part II Excluding income tax, interest, and operating expenses (i.e., looking at gross profit), we see that Computer Tycoon earned 40.1% gross profit in 2008, which is down from 41.2% in In other words, Computer Tycoon earned 1.1 cents less (40.1 – 41.2) per dollar of revenues in 2008 than in 2007. Excluding income tax, interest, and operating expenses (i.e., looking at gross profit), we see that Computer Tycoon earned 40.1% gross profit in 2008, which is down from 41.2% in In other words, Computer Tycoon earned 1.1 cents less (40.1 – 41.2) per dollar of revenues in 2008 than in 2007. 13-53

E13-4 Computing Profitability Ratios
Use the information in E13-3 to complete the following requirements. Required: Compute the gross profit percentage for each year (one decimal place). Assuming that the change for 2007 to 2008 is the beginning of a sustained trend, is Computer Tycoon likely to earn more or less gross profit from each dollar of sales in 2009? Compute the net profit margin for each year (expressed as a percentage with one decimal place). Given your calculations here and in requirement 1, explain whether Computer Tycoon did a better or worse job of controlling operating expenses in 2008 relative to 2007. Computer Tycoon reported average net fixed assets of $54,200 in 2008 and $45,100 in Compute the fixed asset turnover ratios for both years (round to two decimal places). Did the company better utilize its investment in fixed assets to generate revenues in 2008 or 2007? Computer Tycoon reported average stockholders’ equity of $54,000 in 2008 and $40,800 in Compute the return on equity ratios for both years (expressed as a percentage with one decimal place). Did the company generate greater returns for stockholders in 2008 or 2007? E13-4 Computing Profitability Ratios Use the information in E13-3 to complete the following requirements. Required: Compute the gross profit percentage for each year (one decimal place). Assuming that the change for 2007 to 2008 is the beginning of a sustained trend, is Computer Tycoon likely to earn more or less gross profit from each dollar of sales in 2009? Compute the net profit margin for each year (expressed as a percentage with one decimal place). Given your calculations here and in requirement 1, explain whether Computer Tycoon did a better or worse job of controlling operating expenses in 2008 relative to 2007. Computer Tycoon reported average net fixed assets of $54,200 in 2008 and $45,100 in Compute the fixed asset turnover ratios for both years (round to two decimal places). Did the company better utilize its investment in fixed assets to generate revenues in 2008 or 2007? Computer Tycoon reported average stockholders’ equity of $54,000 in 2008 and $40,800 in Compute the return on equity ratios for both years (expressed as a percentage with one decimal place). Did the company generate greater returns for stockholders in 2008 or 2007? 13-54

Req. 1 If these results are the beginning of a sustained trend, then it is likely that Computer Tycoon will have lower total revenues in 2009, and a slight decline in gross profit percentage. The gross profit percentage of 40.1% means that the company generated 40.1 cents of gross profit on each dollar of sales in 2008, which was down a little more than one cent from If this continues, the company could be expected to generate even less gross profit from each dollar of sales in 2009. Part I Requirement 1 – We have provided you with the equation for the computation of the Gross Profit Percentage. Part II The Gross Profit Percentage for 2007 is 41.2 percent. Part III The Gross Profit Percentage for 2008 is 40.1 percent. Part IV If these results are the beginning of a sustained trend, then it is likely that Computer Tycoon will have lower total revenues in 2009, and a slight decline in gross profit percentage. The gross profit percentage of 40.1% means that the company generated 40.1 cents of gross profit on each dollar of sales in 2008, which was down a little more than one cent from If this continues, the company could be expected to generate even less gross profit from each dollar of sales in 2009. 13-55

Req. 2 Computer Tycoon did a worse job of controlling expenses (other than the cost of goods sold) in 2008 relative to 2007 because the net profit margin decreased 4.8% (5.9 – 1.1) at the same time that the gross profit percentage decreased only 1.1% (from 41.2% to 40.1%). This also is evident from the horizontal analysis in E13-3, which indicates that while sales and cost of sales decreased by 18.8% and 17.2%, operating expenses actually increased slightly (by less than 0.1%). Part I Requirement 2 – We have provided you with the equation to compute the net profit margin. Part II The Net Profit Margin for 2007 was 5.9 percent. The company was able to produce 5.9 cents of profit for each dollar of sales it generated. Part III The Net Profit Margin for 2008 was only 1.1 percent. Part IV Computer Tycoon did a worse job of controlling expenses (other than the cost of goods sold) in 2008 relative to 2007 because the net profit margin decreased 4.8% (5.9 – 1.1) at the same time that the gross profit percentage decreased only 1.1% (from 41.2% to 40.1%). This also is evident from the horizontal analysis in E13-3, which indicates that while sales and cost of sales decreased by 18.8% and 17.2%, operating expenses actually increased slightly (by less than 0.1%). 13-56

Req. 3 The company did not better utilize its investment in fixed assets in Its fixed asset turnover ratio fell from 2.70 in 2007 to 1.82 in The 2008 ratio means that the company generated $1.82 of sales revenue for every dollar invested in fixed assets. Part I You are required to calculate the Fixed Asset Turnover for 2007 and We have provided you with the equation needed to calculate the ratio. Part II The Fixed Asset Turnover was 2.70 in 2007. Part III The Fixed Asset Turnover dropped to 1.82 in 2008. Part IV The company did not better utilize its investment in fixed assets in Its fixed asset turnover ratio fell from 2.70 in 2007 to 1.82 in The 2008 ratio means that the company generated $1.82 of sales revenue for every dollar invested in fixed assets. 13-57

Req. 4 No, the company did not generate better returns for stockholders in 2008 (2.1%) than in 2007 (17.7%). This decline in ROE is caused by the significant decrease in net income (over 84% as shown in E13-3) coupled with an increase in stockholders’ equity of 32.4% [($54,000 – 40,800) ÷ 40,800 x 100]. Part I In Requirement number 4 you are to calculate the Return on Equity, or ROE, for 2007 and We have provided you with the equation you will need to calculate the return. Part II The ROE in 2007 was 17.7 percent. Part III In 2008 the ROE dropped all the way down to 2.1 percent, a very significant drop. Part IV No, the company did not generate better returns for stockholders in 2008 (2.1%) than in 2007 (17.7%). This decline in ROE is caused by the significant decrease in net income (over 84% as shown in E13-3) coupled with an increase in stockholders’ equity of 32.4% [($54,000 – 40,800) ÷ 40,800 x 100]. 13-58

E13-10 Inferring Financial Information from Profitability and Liquidity Ratios
Dollar General Corporation operates approximately 8,400 general merchandise stores that feature quality merchandise at low prices to meet the needs of middle-, low-, and fixed-income families in southern, eastern, and mid-western states. For the year ended January 30, 2009, the company reported average inventories of $1,352 (in millions) and an inventory turnover of Average total fixed assets were $1,272 (million), and the fixed asset turnover ratio was 8.22. Required: Calculate Dollar General’s gross profit percentage (expressed as a percentage with one decimal place). What does this imply about the amount of gross profit made from each dollar of sales? TIP: Work backward from the fixed asset turnover and inventory turnover ratios to compute the amounts needed for the gross profit percentage. Is this an improvement from the gross profit percentage of 28.2 percent earned during the previous year? E13-10 Inferring Financial Information from Profitability and Liquidity Ratios Dollar General Corporation operates approximately 8,400 general merchandise stores that feature quality merchandise at low prices to meet the needs of middle-, low-, and fixed-income families in southern, eastern, and mid-western states. For the year ended January 30, 2009, the company reported average inventories of $1,352 (in millions) and an inventory turnover of Average total fixed assets were $1,272 (million), and the fixed asset turnover ratio was 8.22. Required: Calculate Dollar General’s gross profit percentage (expressed as a percentage with one decimal place). What does this imply about the amount of gross profit made from each dollar of sales? TIP: Work backward from the fixed asset turnover and inventory turnover ratios to compute the amounts needed for the gross profit percentage. Is this an improvement from the gross profit percentage of 28.2 percent earned during the previous year? 13-59

Fixed asset turnover = Net sales ÷ Average fixed assets
E13-10 Inferring Financial Information from Profitability and Liquidity Ratios Req. 1 We can get the net sales number from the fixed assets turnover ratio and the cost of goods sold number from the inventory turnover ratio, as shown below. Fixed asset turnover = Net sales ÷ Average fixed assets 8.22 = Net sales ÷ $1,272,000,000 8.22 x $1,272,000,000 = Net sales $10,455,840,000 = Net sales Inventory turnover = Cost of goods sold ÷ Average inventory 5.47 = Cost of goods sold ÷ $1,352,000,000 5.47x $1,352,000,000 = Cost of goods sold $7,395,440,000 = Cost of goods sold Part I For Requirement number 1, We can get the net sales number from the fixed assets turnover ratio and the cost of goods sold number from the inventory turnover ratio, as shown below. Let’s do the math. Part II The Fixed Asset Turnover is equal to Net Sales divided by Average Fixed assets. Part III The Turnover of 8.22 is equal to the Net Sales divided by $1,272,000,000, the Net Sales. Part IV Next, we want to get Net Sales on one side of the equation, so the equation now reads 8.22 times $1,272,000,000 is equal to Net Sales. Part V Finally, we solve for Net Sales and get $10,455,840,000. Part VI We conduct a similar analysis for the Inventory Turnover. Part VII The Inventory Turnover is 5.47 and Average Inventory is $1,352,000,000. Now we need to solved for Cost of Goods Sold. Part VIII By rearranging the equation, we determine the Cost of Goods Sold is equal to 5.47 times $1,352,000,000. Part IX So, Cost of Goods Sold is $7,395,440,000. Part X By using the values needed to solve for Gross Profit Percentage, we find that the percentage is 29.3 percent. The gross profit percentage of 29.3 percent means that the company generates 29.3 cents of gross profit on each dollar of sales. This is an improvement over the previous year. So, Gross profit percentage = (Net sales – cost of goods sold) ÷ Net sales = or 29.3% 13-60

E13-13 Analyzing the Impact of Selected Transactions on the
Current Ratio The Sports Authority, Inc., is the country’s largest private full-line sporting goods retailer. Stores are operated under four brand names: Sports Authority, Gart Sports, Oshman’s, and Sportmart. Assume one of the Sports Authority stores reported current assets of $88,000 and its current ratio was Assume that the following transactions were completed: paid $6,000 on accounts payable, purchased a delivery truck for $10,000 cash, wrote off a bad account receivable for $2,000, and paid previously declared dividends in the amount of $25,000. Required: Compute the updated current ratio rounded to two decimal places, after each transaction. E13-13 Analyzing the Impact of Selected Transactions on the Current Ratio The Sports Authority, Inc., is the country’s largest private full-line sporting goods retailer. Stores are operated under four brand names: Sports Authority, Gart Sports, Oshman’s, and Sportmart. Assume one of the Sports Authority stores reported current assets of $88,000 and its current ratio was Assume that the following transactions were completed: paid $6,000 on accounts payable, purchased a delivery truck for $10,000 cash, wrote off a bad account receivable for $2,000, and paid previously declared dividends in the amount of $25,000. Required: Compute the updated current ratio rounded to two decimal places, after each transaction. 13-61

E13-13 Analyzing the Impact of Selected Transactions on the
Current Ratio Part I The payment of the account payable results in a decrease in the asset, Cash, and a decrease in the liability, Accounts Payable for $6,000. As you can see from this table, the new current ratio is Were you surprised? The current and current liabilities both decreased by the same amount, but the Current Ratio increase from 1.75 to 1.85. Part II In the second transaction we purchase a truck for cash of $10,000. The truck is a noncurrent asset and as such will not impact the current ratio. The current ratio after recording transactions 2 is You would expect a drop in the current ratio resulting from this transaction because current assets decreased and current liabilities were unchanged. Part III In the next transaction we wrote-off an account receivable. We know from out past studies that the write-off of an account receivable has no impact on the net accounts receivable and so, it will have no impact on the current ratio. Part IV Our last transaction is the payment of a previously declared cash dividend of $25,000. Notice that there is a decrease in both the current assets and current liabilities by $25,000, but the current ratio increased to 2.44. 13-62

End of Chapter 13 End of chapter 13.

Fundamentals of Financial Accounting 3e by Phillips, Libby, and Libby.

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