1. 13-1

2. 13-2 Financial Analysis: The Big Picture Kimmel ● Weygandt ● Kieso Financial Accounting, Eighth Edition 13

3. 13-3 CHAPTER OUTLINE Apply the concepts of sustainable income and quality of earnings. 1 Apply horizontal analysis and vertical analysis. 2 LEARNING OBJECTIVES Analyze a company’s performance using ratio analysis. 3

4. 13-4 The most likely level of income to be obtained by a company in the future. Unusual Items Separately identified on the income statement.  Discontinued operations.  Other comprehensive income. These “irregular” items are reported net of income tax. LO 1 LEARNING OBJECTIVE Apply the concepts of sustainable income and quality of earnings. 1 SUSTAINABLE INCOME

5. 13-5 SUSTAINABLE INCOME ILLUSTRATION 13-1 Statement of comprehensive income LO 1

6. 13-6 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. SUSTAINABLE INCOME LO 1

7. 13-7 Illustration: Assume that during 2017 Acro Energy Inc. has income before income taxes of $800,000. During 2017, Acro discontinued and sold its unprofitable chemical division. The loss in 2017 from chemical operations (net of $60,000 taxes) was $140,000. The loss on disposal of the chemical division (net of $30,000 taxes) was $70,000. Assuming a 30% tax rate on income. Prepare Acro’s statement of comprehensive income for the year ended December 31, 2017. Discontinued Operations LO 1

8. 13-8 Discontinued Operations ILLUSTRATION 13-2 Statement presentation of discontinued operations LO 1

9. 13-9 INVESTOR INSIGHT What Does “Non-Recurring” Really Mean Many companies incur restructuring charges as they attempt to reduce costs. They often label these items in the income statement as “non- recurring” charges, to suggest that they are isolated events, unlikely to occur in future periods. The question for analysts is, are these costs really one-time, “nonrecurring events” or do they reflect problems that the company will be facing for many periods in the future? If they are one-time events, then they can be largely ignored when trying to predict future earnings. But, some companies report “one-time” restructuring charges over and over again. For example, Procter & Gamble reported a restructuring charge in 12 consecutive quarters, and Motorola had “special” charges in 14 consecutive quarters. On the other hand, other companies have a restructuring charge only once in a 5- or 10-year period. There appears to be no substitute for careful analysis of the numbers that comprise net income. LO 1

10. 13-10 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 SUSTAINABLE INCOME LO 1

11. 13-11 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 2017 Stassi Company purchased IBM stock for $10,000 as an investment. At the end of 2017 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? Comprehensive Income LO 1

12. 13-12 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) ILLUSTRATION OF COMPREHENSIVE INCOME Comprehensive Income LO 1

13. 13-13 Format One Combined statement of income and comprehensive income. Illustration 13-5 Comprehensive Income ILLUSTRATION 13-3 Lower portion of combined statement of income and comprehensive income LO 1

14. 13-14 Format Two Comprehensive Income Separate component of Stockholders’ Equity. ILLUSTRATION 13-4 Unrealized loss in stockholders’ equity section LO 1

15. 13-15 ILLUSTRATION 13-5 Complete statement of comprehensive income

16. 13-16  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 SUSTAINABLE INCOME LO 1

17. 13-17 INVESTOR INSIGHT More Frequent Ups and Downs In the past, U.S. companies used a method to account for their pension plans that smoothed out the gains and losses on their pension portfolios by spreading gains and losses over multiple years. Many felt that this approach was beneficial because it reduced the volatility of reported net income. However, recently some companies have opted to adopt a method that comes closer to recognizing gains and losses in the period in which they occur. Some of the companies that have adopted this approach are United Parcel Service (UPS), Honeywell International, IBM, AT&T, and Verizon Communications. The CFO at UPS said he favored the new approach because “events that occurred in prior years will no longer distort current-year results. It will result in better transparency by eliminating the noise of past plan performance.” When UPS switched, it resulted in a charge of $827 million from the change in accounting principle. Source: Bob Sechler and Doug Cameron, “UPS Alters Pension-Plan Accounting,” Wall Street Journal (January 30, 2012). United Parcel Service (UPS) LO 1

18. 13-18 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. QUALITY OF EARNINGS LO 1

19. 13-19  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 QUALITY OF EARNINGS LO 1

20. 13-20 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). Improper Recognition QUALITY OF EARNINGS LO 1

21. 13-21 In its proposed 2017 income statement, AIR Corporation reports income before income taxes $400,000, unrealized gain on available-for-sale securities $100,000, income taxes $120,000 (not including unusual items), loss from operation of discontinued flower division $50,000, and loss on disposal of discontinued flower division $90,000. The income tax rate is 30%. Prepare a correct statement of comprehensive income, beginning with “Income before income taxes.” Unusual Items DO IT! 1 LO 1

22. 13-22 Unusual Items DO IT! 1 LO 1

23. 13-23 Analyzing financial statements involves: Comparison Bases Basic Tools   Intracompany   Intercompany   Industry averages   Horizontal analysis   Vertical analysis   Ratio Analysis LO 2 LEARNING OBJECTIVE Apply horizontal analysis and vertical analysis. 2

24. 13-24 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 LO 2

25. 13-25 ILLUSTRATION 13-9 Horizontal analysis of balance sheets

26. 13-26 ILLUSTRATION 13-10 Horizontal analysis of income statements LO 2

27. 13-27 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 LO 2

28. 13-28 ILLUSTRATION 13-11 Vertical analysis of balance sheets

29. 13-29 ILLUSTRATION 13-12 Vertical analysis of income statements LO 2

30. 13-30 ILLUSTRATION 13-13 Intercompany comparison by vertical analysis LO 2

31. 13-31 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 to detect fraud. Financial ratios that appear abnormal or statistical abnormalities in the numbers themselves can reveal fraud. 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. LO 2 (continued)

32. 13-32 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. Source: Mark J. Nigrini, “I’ve Got Your Number,” Journal of Accountancy Online (May 1999). Total take: Thousands of dollars ANATOMY OF A FRAUD LO 2

33. 13-33 Summary financial information for Rosepatch Company is as follows. Compute the amount and percentage changes in 2017 using horizontal analysis, assuming 2016 is the base year. Horizontal Analysis DO IT! 2 LO 2

34. 13-34 Reflects investors’ assessment of a company’s future earnings.  Will be higher if investors think that earnings will increase substantially in the future.  Will be lower when there is the belief that a company has poor-quality earnings. PRICE-EARNINGS RATIO LO 3 LEARNING OBJECTIVE Analyze a company’s performance using ratio analysis. 3 ILLUSTRATION 13-14 Formula for price-earnings (P-E) ratio

35. 13-35 ILLUSTRATION 13-14 Formula for price-earnings (P-E) ratio ILLUSTRATION 13-15 Earnings per share and P-E ratios of various companies PRICE-EARNINGS RATIO LO 3

36. 13-36 LIQUIDITY RATIOS ILLUSTRATION 13-16 Summary of liquidity ratios LO 3

37. 13-37 INVESTOR INSIGHT How to Manage the Current Ratio The apparent simplicity of the current ratio can have real-world limitations because adding equal amounts to both the numerator and the denominator causes the ratio to decrease. Assume, for example, that a company has $2,000,000 of current assets and $1,000,000 of current liabilities. Its current ratio is 2:1. If it purchases $1,000,000 of inventory on account, it will have $3,000,000 of current assets and $2,000,000 of current liabilities. Its current ratio decreases to 1.5:1. If, instead, the company pays off $500,000 of its current liabilities, it will have $1,500,000 of current assets and $500,000 of current liabilities. Its current ratio increases to 3:1. Thus, any trend analysis should be done with care because the ratio is susceptible to quick changes and is easily influenced by management. LO 3

38. 13-38 SOLVENCY RATIOS ILLUSTRATION 13-17 Summary of solvency ratios LO 3

39. 13-39 PROFITABILITY RATIOS ILLUSTRATION 13-18 Summary of profitability ratios LO 3

40. 13-40 LO 3 INVESTOR INSIGHT High Ratings Can Bring Low Returns Moody’s, Standard & Poor’s, and Fitch are three big firms that perform financial analysis on publicly traded companies and then publish ratings of the companies’ creditworthiness. Investors and lenders rely heavily on these ratings in making investment and lending decisions. Some people feel that the collapse of the financial markets was worsened by inadequate research reports and ratings provided by the financial rating agencies. Critics contend that the rating agencies were reluctant to give large companies low ratings because they feared that by offending them they would lose out on business opportunities. For example, the rating agencies gave many so-called mortgage-backed securities ratings that suggested that they were low risk. Later, many of these very securities became completely worthless. Steps have been taken to reduce the conflicts of interest that lead to these faulty ratings. Source: Aaron Lucchetti and Judith Burns, “Moody’s CEO Warned Profit Push Posed a Risk to Quality of Ratings,” Wall Street Journal Online (October 23, 2008).

41. 13-41 Analyzing financial statements involves: Characteristics Comparison 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 2014 ratios. LEARNING OBJECTIVE APPENDIX 13A: Evaluate a company comprehensively using ratio analysis. 4 LO 4

42. 13-42 ILLUSTRATION 13A-1 Chicago Cereal Company’s balance sheets LO 4

43. 13-43 ILLUSTRATION 13A-2 Chicago Cereal Company’s income statements LO 4

44. 13-44 LO 4 ILLUSTRATION 13A-3 Chicago Cereal Company’s statements of cash flows

45. 13-45 Profitability Measures the income or operating success of a company for a given period of time. Solvency Measures the ability of the company to survive over a long period of time. Ratio analysis expresses the relationship among selected items of financial statement data. Liquidity Measures short- term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Financial Ratio Classifications RATIO ANALYSIS LO 4

46. 13-46 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. LIQUIDITY RATIOS LO 4

47. 13-47 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. Current Ratio ILLUSTRATION 13A-5 Current ratio LO 4

48. 13-48 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 12.2 times. Accounts Receivable Turnover ILLUSTRATION 13A-6 Accounts receivable turnover LO 4

49. 13-49 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). Average Collection Period ILLUSTRATION 13A-7 Average collection period LO 4

50. 13-50 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 similar to that of General Mills. How does Chicago’s turnover compare to General Mills’s? ILLUSTRATION 13A-8 Inventory turnover Inventory Turnover LO 4

51. 13-51 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? Days in Inventory ILLUSTRATION 13A-9 Days in inventory LO 4

52. 13-52 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 ► Free cash flow SOLVENCY RATIOS LO 4

53. 13-53 Indicates the degree of financial leveraging. Provides some indication of the company’s ability to withstand losses. Yes. 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? Debt to Assets Ratio ILLUSTRATION 13A-10 Debt to assets ratio LO 4

54. 13-54 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 able to service its’ debt? Times Interest Earned ILLUSTRATION 13A-11 Times interest earned LO 4

55. 13-55 Ability to pay dividends or expand operations. Cash provided by operations was more than enough to allow Chicago to acquire additional productive assets and maintain dividend payments. Free Cash Flow ILLUSTRATION 13A-12 Free cash flow LO 4

56. 13-56 Measure the income or operating success of a company for a given period of time. ILLUSTRATION 13A-13 Relationships among profitability measures PROFITABILITY RATIOS LO 4

57. 13-57 Shows how many dollars of net income the company earned for each dollar invested by the owners. Chicago’s 2014 rate of return on common stockholders’ equity is unusually high at 48%, considering an industry average of 19% and General Mills’s return of 25%. Return on Common Stockholders’ Equity ILLUSTRATION 13A-14 Return on common stockholders’ equity LO 4

58. 13-58 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. Return on Assets ILLUSTRATION 13A-15 Return on assets LO 4

59. 13-59 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. Profit Margin ILLUSTRATION 13A-16 Profit margin LO 4

60. 13-60 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. Asset Turnover ILLUSTRATION 13A-17 Asset turnover LO 4

61. 13-61 You can analyze the combined effects of profit margin and asset turnover on return on assets for Chicago as shown. Return on Assets ILLUSTRATION 13A-18 Composition of return on assets LO 4

62. 13-62 Indicates a company’s ability to maintain an adequate selling price above its cost of goods sold. As an industry becomes more competitive, this ratio declines. Gross Profit Rate ILLUSTRATION 13A-19 Gross profit rate LO 4

63. 13-63 A measure of the net income earned on each share of common stock. Earnings Per Share (EPS) ILLUSTRATION 13A-20 Earnings per share LO 4

64. 13-64 Reflects investors’ assessments of a company’s future earnings. A lower P-E ratio suggests that the market is less optimistic about Chicago cereal than about General Mills. It might also signal that its stock is underpriced. Price-Earnings (P-E) Ratio ILLUSTRATION 13A-21 Price-earnings ratio LO 4

65. 13-65 Measures the percentage of earnings distributed in the form of cash dividends. This ratio should be calculated over a longer period of time to evaluate any trends. Payout Ratio ILLUSTRATION 13A-22 Payout ratio LO 4

66. 13-66 RELEVANT FACTS A Look at IFRS LEARNING OBJECTIVE Compare financial statement analysis and income statement presentation under GAAP and IFRS. 5  The tools of financial statement analysis covered in this chapter are universal and therefore no significant differences exist in the analysis methods used.  The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS.  Both GAAP and IFRS follow the same approach in reporting comprehensive income. LO 5

67. 13-67 RELEVANT FACTS  The basic objectives of the income statement are the same under both GAAP and IFRS. A very important objective is to ensure that users of the income statement can evaluate the sustainable income of the company. Thus, both the IASB and the FASB are interested in distinguishing normal levels of income from unusual items in order to better predict a company’s future profitability.  The basic accounting for discontinued operations is the same under IFRS and GAAP. A Look at IFRS LO 5

68. 13-68 A Look at IFRS 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 5

69. 13-69 IFRS Practice 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. A Look at IFRS LO 5

70. 13-70 IFRS Practice 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. A Look at IFRS LO 5

71. 13-71 IFRS Practice In preparing its income statement for 2017, Parmalane assembles the following information. Sales revenue $500,000 Cost of goods sold 300,000 Operating expenses 40,000 Loss on discontinued operations 20,000 Ignoring income taxes, what is Parmalane’s income from continuing operations for 2017 under IFRS? a)$260,000.c)$240,000. b)$250,000.d)$160,000. A Look at IFRS LO 5

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