Managerial Accounting Weygandt, Kieso, & Kimmel John Wiley & Sons, Inc. Prepared by Karleen Nordquist .. The College of St. Benedict ... and St. John’s University .. . with contributions by Dr. Jessica J. Frazier .. and Philip Li ... Eastern Kentucky University ….
To illustrate, assume that Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in 1999.
The company therefore has income before income taxes of $800,000.
During 1999 the company discontinued and sold its unprofitable chemical division. The loss in 1999 from chemical operations (net of $60,000 taxes) was $140,000, and the loss on disposal of the chemical division (net of $30,000 taxes) was $70,000.
Assuming a 30% tax rate on income before taxes, the income statement presentation would be as follows:
Income before income taxes $800,000 Income tax expense 240,000 Income from continuing operations 560,000 Discontinued operations Loss from operations of chemical division, net of $60,000 income tax savings $140,000 Loss from disposal of chemical division, net of $30,000 income tax savings 70,000 210,000 Net income $350,000 Rozek Inc. Partial Income Statement For the Year Ended December 31, 1999 Illustration 12-1
Extraordinary items are events and transactions that meet two conditions:
They are unusual in nature.
They are infrequent in occurrence.
Extraordinary items are reported net of taxes in a separate section of the income statement immediately below discontinued operations.
If a transaction or event meets one, but not both, of the criteria for an extraordinary item, it should be reported as a separate line item in the upper portion of the income statement, usually in the “other revenues and gains” or “other expenses and losses” section at its gross amount.
Classification of Extraordinary and Ordinary Items
Effects of major casualties (acts of God), if rare in the area.
Expropriation (takeover of property by a foreign government.
Effects of a newly enacted law or regulation, such as a condemnation action.
Effects of major casualties (acts of God), frequent in the area.
Write-down of inventories or write-off of receivables.
Assume that in 1999 a revolutionary foreign government expropriated property held as an investment by Rozek Inc.
If the loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000.
Income before income taxes $800,000 Income tax expense 240,000 Income from continuing operations 560,000 Discontinued operations Loss from operations of chemical division, net of $60,000 income tax savings $140,000 Loss from disposal of chemical division, net of $30,000 income tax savings 70,000 210,000 Income before extraordinary item 350,000 Extraordinary item Expropriation of investment, net of $21,000 income tax savings 49,000 Net income $301,000 Rozek Inc. Partial Income Statement For the Year Ended December 31, 1999 Illustration 12-3
Assume at the beginning of 1999, Rozek Inc. changes from the straight-line method to the declining-balance method for equipment purchased on January 1, 1996.
The cumulative effect on prior-year income statements (statements for 1996-1998) is to increase depreciation expense and decrease income before income taxes by $24,000.
If there is a 30% tax rate, the net-of-tax effect of the change is $16,800 ($24,000 x 70%).
The income statement is presented on the next slide.
Changes in Accounting Principle Income before income taxes $800,000 Income tax expense 240,000 Income from continuing operations 560,000 Discontinued operations Loss from operations of chemical division, net of $60,000 income tax savings $140,000 Loss from disposal of chemical division, net of $30,000 income tax savings 70,000 210,000 Income before extraordinary item 350,000 Extraordinary item Expropriation of investment, net of $21,000 income tax savings 49,000 Cumulative effect of change in accounting principle Effect on prior years of change in depreciation method, net of $7,200 income tax savings 16,800 Net income $284,200 Rozek Inc. Partial Income Statement For the Year Ended December 31, 1999 Illustration 12-4
Although most revenues, expenses, gains, and losses recognized during the period are included in net income, specific exceptions to this practice have developed.
Certain items, such as unrealized gains and losses on available-for-sale securities, now bypass income and are reported directly in stockholders’ equity.
(Unrealized gains and losses on available-for-sale securities are excluded from net income because 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.)
The comparative balance sheets show that a number of changes occurred in Kellogg’s financial position from 1996 to 1997.
In the assets section, current assets decreased $60.9 million, or 4.0% ($60.9 $1,528.6), plant assets (net) decreased $159.6, or 5.4%, and other assets increased 8.2%.
In the liabilities section, current liabilities decreased $541.7, or 24.6%, while long-term liabilities increased $654.2, or 41.7%.
In the stockholders’ equity section, retained earnings decreased $3,025.5, or 75.9%. The decrease in retained earnings and treasury stock is due to a retirement of a significant number of shares of treasury stock.
Horizontal analysis of the income statements shows these changes:
Net sales increased $153.5, or 2.3% ($153.5 $6.676.6).
Cost of goods sold increased $147.2, or 4.7%.
Selling and administrative expenses decreased $91.9, or 3.7%.
Overall, gross profit increased $6.2 million, or less than 1%, and net income increased 2.8%. The increase in net income can be primarily attributed to the decrease in selling and administrative expenses.
As shown from the preceding example, vertical analysis shows the relative size of each category on the financial statements.
Vertical analysis also enables the comparison of companies of different sizes. This benefit of vertical analysis is evident from its alternative name: common-size analysis .
As an example, see the following vertical analysis comparing Kellogg’s income statement with that of General Mills, Inc., one of Kellogg’s competitors.
Condensed Income Statements For the Year Ended December 31, 1997 (in millions) Kellogg Company General Mills, Inc. Amount Percent Amount Percent Net sales $6,830.1 100.0% $5,609.3 100.0% Cost of goods sold 3,270.1 47.9 2,328.4 41.5 Gross profit 3,560.0 52.1 3,280.9 58.5 Selling & administrative expense 2,366.8 34.6 2,422.0 43.2 Nonrecurring charges 184.1 2.7 48.4 .9 Income from operations 1,009.1 14.8 810.5 14.4 Interest expense 108.3 1.6 100.5 1.8 Other income(expense), net 3.7 .1 (6.3 ) (.1) Income before income taxes and cumulative effect of accounting change 904.5 13.3 703.7 12.5 Income taxes 340.5 5.0 258.3 4.6 Income before cumulative effect of accounting change 564.0 8.3 445.4 7.9 Cumulative effect of accounting change (net) (18.0 ) (.3) — — Net income $ 546.0 8.0% $ 445.4 7.9% Illustration 12-10
Although Kellogg’s net sales are $1,220.8 million (22%) greater than the net sales of General Mills, vertical analysis eliminates this difference and the companies can be compared to each other.
Kellogg’s gross profit is 52.1% as a percentage of net sales, versus 58.5% for General Mills. This is due to Kellogg’s cost of goods sold being 6.4% higher (47.9% to 41.5%) than General Mills’.
Yet net income as a percent of sales is very close (8% for Kellogg and 7.9% for General Mills). Kellogg achieves this in spite of its lower gross profit percentage because its selling and administrative expenses are 8.6% lower than General Mills’.
The acid-test ratio is an important complement to the current ratio .
The ratio does not include inventory or prepaid expenses.
Cash, marketable securities, and receivables are highly liquid compared with inventory and prepaid expenses. Inventory may not be readily salable, and the prepaid expenses may not be transferable to others.
A disadvantage of the current and acid-test ratios is that they use year-end balances of current assets and liabilities. These year-end balances may not be representative of the company’s position during most of the year.
The current cash debt coverage ratio partially corrects for this problem.
Because it uses net cash provided by operating activities rather than a balance at one point in time, it may provide a better representation of liquidity.
Current Cash Debt Coverage Ratio Net Cash Provided by Operating Activities Average Current Liabilities =
A popular variant of the receivables turnover ratio converts it into an average collection period in days.
Analysts frequently use the average collection period to assess the effectiveness of a company’s credit and collection policies. The general rule is that the collection period should not greatly exceed the credit term period.
Average Collection Period 365 days Receivables turnover ratio =
One indication of a company’s solvency, as well as of its ability to pay dividends or expand operations, is the amount of excess cash it generated after investing to maintain its current productive capacity and paying dividends.
This measure is referred to as free cash flow .
This ratio was introduced in Chapter 11.
Dividends paid Capital expenditures Net cash provided by operating activities Free Cash Flow – – =
In addition to the measures shown on the next slide (in order to illustrate the relationships among them), some profitability measures include:
cash return on sales ratio,
earnings per share,
price-earnings ratio, and
Relationships Among Profitability Measures Gross profit rate Operating expenses to sales ratio Profit margin ratio Asset turnover ratio Return on assets ratio Leverage (debt to total asset ratio) Return on common stockholders’ equity Illustration 12-23
A widely used measure of profitability from the common stockholders’ viewpoint is the return on common stockholders’ equity ratio ( ROE ). This ratio shows how many dollars of net income were earned for each dollar invested by the owners.
Income available to common stockholders is net income minus any preferred stock dividends.
Return on Common Stockholders’ Equity Income available to common stockholders Average common stockholders’ equity =
Leveraging or trading on the equity at a gain means that the company has borrowed money by issuing bonds or notes at a lower rate of interest than it is able to earn by using the borrowed money. Leverage is simply trying to use money supplied by nonowners to increase the return to owners.
Leverage is a two-way street, however. A company can earn less than it pays on its borrowed funds, i.e., trade on the equity at a loss.
The profit margin ratio discussed earlier is an accrual-based ratio using net income as a numerator. The cash-basis counterpart to that ratio is the cash return on sales ratio , which uses net cash provided by operating activities as the numerator.
The difference between these two ratios should be explainable as differences between accrual accounting and cash-basis accounting, such as differences in the timing of revenue and expense recognition.
Cash Return on Sales Ratio Net cash provided by operating activities Net sales =
Notice when the term “net income per share” or “earnings per share” is used it refers to the amount of net income applicable to each share of common stock. Therefore, if there are preferred dividends declared for the period, they must be deducted from net income to arrive at income available to the common stockholders.
Intercompany and industry comparisons are not normally meaningful for EPS because of the wide variations in the number of shares outstanding among companies.
In terms of the types of financial information available and the ratios used by various industries, what this textbook has covered is just the “tip of the iceberg” compared to the vast databases and types of ratio analysis that are available.
The availability is not a problem. The real trick is to be discriminating enough to perform relevant analysis and select pertinent comparative data.
Variations among companies in the application of GAAP may hamper comparability.
For example, one company may use the FIFO method of inventory costing, while another company in the same industry may use LIFO. If the inventory is significant for both companies, it is unlikely that their current ratios are comparable.
In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization.
Although these differences in accounting methods might be detectable from reading the notes to the financial statements, adjusting the financial data to compensate for the different methods is difficult, if not impossible, in some cases.
Diversification in American industry also limits the usefulness of financial analysis.
Many firms are so diverse they cannot be classified by industry.
When companies have significant operations in different lines of business, they are required to report additional disclosures in a segmental data note to their financial statements. Many analysts say the segmental information is the most important data in the financial statements because without it, comparison of diversified companies is very difficult.