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  • 1. Chapter 15: Accounting and Financial Analysis Outline Introduction A. The Learning Goals of this chapter are to: 1. Explain how firms use accounting. 2. Explain how firms can ensure proper financial reporting. 3. Explain how to interpret financial statements. 4. Explain how to evaluate a firm’s financial condition. B. Accounting is the summary and analysis of a firm’s financial condition. Accounting information enables managers to make business decisions that increase the value of the firm. I. How Firms Use Accounting A. Reporting accurate data regarding the firm’s financial transactions is the purpose of financial accounting. The first step in the reporting process is the recording of the firm’s financial activities, which is called bookkeeping. 1. Publicly owned firms are regularly involved in reporting to shareholders financial information regarding the performance of the firm. 2. Firms also report their financial condition to creditors. Lending institutions often require a firm’s most recent financial statements. These provide the creditors with information about the creditworthiness of the firm. 3. A common activity of public accountants is certifying of the accuracy of the firm’s financial statements. The accountant’s stamp of approval indicates that the financial records have been kept in accordance with generally accepted accounting principles. Public accountants provide accounting services for clients for a fee. Public accountants who meet specific educational requirements and pass a national examination are referred to as certified public accountants (CPAs). B. Decision support data, the type of information provided to help managers make good decisions, are provided by managerial accounting. C. By reviewing financial information, managers can monitor and control the performance of individuals, divisions, and products. This will allow the manager to identify the firm’s strengths and weaknesses. 1. Auditing refers to the assessment of the records that were used to prepare the firm’s financial statements. 2. Internal auditors specialize in evaluating the various divisions of a business to ensure that they are operating efficiently. 1
  • 2. II. Responsible Financial Reporting A. Companies like Enron and WorldCom that used accounting gimmicks to appear more profitable than they were, were exposed as frauds in late 2001 and early 2002. Both companies went bankrupt. Firms should use whatever method of accounting provides the most accurate measure of its financial condition. B. Auditors play an important role in ensuring proper reporting. Auditors ensure that all information in a financial statement is accurate. C. A firm’s board of director’s job is to represent the shareholders. In order to discourage any temptation to misrepresent the firm’s earnings in order to inflate the sale of their own stock, board members are often held to an agreement that they cannot sell stock while they are serving on the board. D. In light of the accounting fraud problems that have arisen in the past few years, regulators have attempted to exert more control over firms that list on the exchange. The Securities and Exchange Commission has been granted more power under the Sarbanes-Oxley Act of 2002. The provisions of the act are: 1. An auditing firm is allowed to provide nonaudit services when auditing a client only if the client’s audit committee pre-approves the services. 2. Auditing firms may not audit companies whose CEO, CFO, or other managers in similar roles were employed by the auditing firm in the one-year prior to the audit. 3. The board members of a firm who are assigned to oversee the audit should not receive consulting or advising fees from the auditing firm. 4. The CFO and other managers of the firm must file an internal control report along with each annual report. 5. The CEO and CFO must certify that the audited statements fairly represent the operations and financial condition of a firm. 6. Major fines or prison terms are imposed on employees who mislead investors or hide evidence. III. Interpreting Financial Statements A. An income statement, which indicates the revenue, expenses, and profits (or losses) of a firm over a period of time, is presented in Exhibit 15.1. Exhibit 15.2 presents the income statement as a percentage of net sales. The components of an income statement are as follow: 1. Net sales reflect total sales adjusted for any discounts. 2. Cost of goods sold is the cost of all materials that were used to produce the goods that were sold. 3. Gross profit is equal to net sales minus the cost of goods sold. 4. Operating expenses are composed of selling expenses as well as general and administrative expenses. 5. Earnings before interest and taxes (EBIT) are calculated by subtracting a firm’s operating expenses from its gross profits. 2
  • 3. 6. Earnings before taxes are earnings before interest and taxes minus interest expenses. 7. Earnings after taxes, sometimes referred to as net income, equal earnings before taxes minus taxes. B. A balance sheet, presented in Exhibit 15.3, reports the book value of all assets, liabilities, and owner’s equity of a firm at a given point in time. Exhibit 15.4 presents a percentage breakdown of a balance sheet. The relationship between the items on a balance sheet is described by the basic accounting equation: Assets = Liabilities + Owner’s Equity 1. Assets represent anything of value owned by the firm. a. Current assets are assets that will be converted into cash within one year. Examples include cash, marketable securities, accounts receivable, and inventories. b. Fixed assets are assets that will be used by the firm for more than one year. Examples include the firm’s plant and equipment. These assets are subject to depreciation, which represents a reduction in the value of a fixed asset to reflect wear and tear, as well as obsolescence. 2. Liabilities represent the debts or obligations of the firm. a. Current liabilities are debts that come due in a year or less. Accounts payable are current liabilities. Accounts payable are short-term debts incurred for the purchase of materials and supplies. Another current liability is notes payable, which are short-term loans from creditors. b. Long-term liabilities represent debts that are due in a time period of greater than one year. Examples include long-term loans and bond issues. 3. Owner’s equity represents the investment made by the owners plus profits that have been retained in the firm. Specifically, owner’s equity includes the par value of all common stock issued, additional paid-in capital, and retained earnings. IV. Ratio Analysis A. An evaluation of the relationships between financial statement variables is called a ratio analysis. The purpose of a financial ratio analysis is to identify the strengths and weaknesses of the firm. B. Measures of liquidity report a firm’s short-term debt-paying ability. 1. The current ratio reflects the relationship between current assets and current liabilities. The larger the number, the greater the liquidity. 2. The quick ratio is similar to the current ratio, with one exception. Inventory is excluded in the calculation of current assets. This is done because inventory investments may not be as easily liquidated as other current assets. As with the current ratio, the larger the firm’s quick ratio, the greater its liquidity. 3
  • 4. C. Measures of efficiency indicate how well management is employing the firm’s assets to generate revenue. 1. Inventory turnover reflects the number of times per year that inventory is acquired and then sold. Ideally, management is holding just enough inventory to satisfy consumer demand. A declining inventory turnover indicates slowing sales and/or excess inventory. 2. Asset turnover focuses on management’s use of total assets in supporting sales. Ideally, the firm’s asset turnover is larger than that of its competitors. D. Measures of financial leverage report the percentage of assets that is financed with debt. A firm with a high degree of financial leverage will incur the risk of greater variation in profits. Leverage is a two-edged sword that can benefit or injure a firm depending upon the growth rate in sales. A small increase (decrease) in sales will result in a much larger increase (decrease) in earnings. 1. The debt-to-equity ratio compares long-term liabilities to total funds invested by owners (i.e., owner’s equity). 2. The times interest earned ratio measures the ability of the firm to cover its interest payments. A declining ratio indicates a debt level that is increasing faster than earnings. However, if sales are decreasing, then a declining time interest earned ratio indicates that debt is decreasing at an even slower rate. E. Measures of profitability indicate management’s ability to generate profits for owners of the firm. 1. Net profit margin is a measure of net income as a percentage of sales. 2. Return on assets (ROA) measures the net income of the firm as a percentage of the total assets utilized by the firm. 3. Return on equity (ROE) expresses the net income as a percentage of the owner’s investment in the business. F. Comparison of Ratios with Those of Other Firms 1. One way to interpret the results of a financial analysis is to compare the ratios with other firms in the same industry or with an industry average for a specific ratio. 2. Exhibits 15.5 and 15.6 provide formulas and interpretations of the most commonly utilized ratios. A meaningful evaluation requires both an intra-industry comparison and a trend analysis, comparing a firm’s ratios from one year to the next. Exhibit 15.7 illustrates how a financial analysis can identify different business functions that need improvement. G. Limitations of Ratio Analysis 1. Comparing a firm with an industry average can be troublesome because many firms operate in more than one industry. For example, Anheuser-Busch produces beer and owns theme parks. 4
  • 5. 2. Accounting practices vary among firms, which may cause differences in the ratios of one firm to another. 3. Firms with seasonal variations in sales may show large deviations from the industry norm at certain times but not at others. H. Sources of Information for Ratio Analysis 1. The booklet Annual Statement Studies, published by Robert Morris Associates, provides financial ratios for many different industries. 2. Dun and Bradstreet also publish a series of financial ratios for selected industries, classified by size. Solutions to End-of-Chapter Materials Answers to Review & Critical Thinking Questions (1) What is accounting? Why is accounting important for a firm? Accounting is the summary and analysis of a firm’s financial condition. Firms use accounting to report their financial condition, support decisions, and control business operations. Managers of all types of businesses use accounting information to make better decisions. Financial analysis resulting from accounting can detect deficiencies in the firm’s operations, which can allow managers to revise those operations and thereby enhance the firm’s value. (2) List the parties that would be interested in a firm’s financial condition. How would each use financial information about the firm? The parties that would be interested in the financial condition of a firm would include managers as well as the current and potential creditors and stockholders of the firm. Managers use accounting information to plan for the future and control current operations. Managers evaluate the firm in order to detect weaknesses that can be corrected and strengths that can be exploited. Creditors assess the financial statements of a firm to determine the probability that the firm will default on loans. Creditors that plan to provide short-term loans assess financial statements to determine the level of the firm’s liquidity (the ability to sell existing assets in order to pay current liabilities). Creditors that plan to provide long-term loans may assess the financial statements to determine whether the firm is capable of generating sufficient income in future years to make interest and principal payments on the loan far in the future. Shareholders assess financial statements to evaluate the performance of a firm in which they have invested. If the analysis determines that the firm has performed poorly, 5
  • 6. existing shareholders may attempt to replace the board of directors or may sell their stock. (3) What is a public accountant? What is an important job of public accountants? Public accountants are individuals who provide accounting services to a variety of firms for a fee. A license is required to practice public accounting. To qualify for the license, one must meet specific educational requirements and pass a national examination. A common job for a public accountant is auditing to ensure that a firm’s financial statements are accurate. All publicly owned firms must have their financial statements audited by an independent accounting firm. (4) What is the difference between a balance sheet and an income statement? One difference between the two financial statements is the time covered by the statement. The income statement summarizes the performance of a company over a certain time period, while the balance sheet provides a snapshot of the firm’s financial condition at any given time. The income statement indicates the revenue, expenses, and earnings (profits or net income) of a firm over a period of time (such as a quarter or year). The balance sheet reports the book value of all assets, liabilities, and owner’s equity of a firm at a given point in time. Because the two statements reveal different financial characteristics, both financial statements must be analyzed along with other information to perform a complete evaluation of the firm. (5) What is the difference between current assets and fixed assets? Provide examples of each type of asset. Current assets are assets that will be converted into cash within one year. They include cash, marketable securities, accounts receivable, and inventories. Fixed assets are assets that will be used by a firm for more than one year. They include the firm’s plant and equipment. (6) Discuss how assets can be financed by a firm. Assets can be financed through liabilities, which include accounts payable and notes payable. Accounts payable represent money owed by the firm for the purchase of current assets, such as materials or supplies. Notes payable represent short-term loans to the firm made by creditors such as banks. Long-term liabilities are liabilities that will not be repaid within one year. These liabilities are commonly used to finance fixed assets. Long-term liabilities include long-term loans provided by banks and the issuance of bonds. A firm could also issue additional stock to finance its assets, resulting in owner’s equity. 6
  • 7. (7) Why is responsible financial reporting important? Responsible financial reporting is important because firms have some flexibility when accounting for their financial condition. Some firms tend to use whatever method of accounting will inflate the earnings, because they know that their stockholders will be more satisfied if earnings are high. Using responsible financial reporting will earn the firm some credibility with existing and prospective stockholders by providing clear and consistent reports that are easily understood. Furthermore, the managers who work for the firm may be more able to detect and correct deficiencies if an understandable and logical accounting method is used. (8) What is the role does a firm’s board of directors play in ensuring proper financial reporting? If board members are being compensated with shares of the firm’s stock, how could they be forced to act in the long-term interests of the company? A firm’s board of directors represents the shareholders and should try to prevent the firm from providing misleading financial reports. Board members who hold company stock may be motivated to sell their holdings of stock while the stock price is artificially high. By being forced to hold on to their shares for a long-term period, they would make decisions to affect the long-term performance of the firm. (9) Discuss the pros and cons of financial leverage for a firm. Financial leverage represents the degree to which a firm uses borrowed funds to finance its assets. Firms that borrow a large proportion of their funds have a high degree of financial leverage. This can have a favorable effect on the firm’s owners when the firm performs well, because the earnings generated by the firm can be spread among a relatively small group of owners. However, when the firm experiences poor performance, a high degree of financial leverage is dangerous. Firms with a high degree of financial leverage incur higher fixed financial costs (interest expenses) that must be paid regardless of their levels of sales. These firms may experience debt repayment problems and have more risk. Firms with a high degree of financial leverage increase the volatility of their earnings. Firms that obtain a larger proportion of funds from equity financing incur smaller debt repayments and therefore have less risk. (10) Why is profitability relevant for a firm? How can profitability be measured? Profitability indicates the performance of a firm’s operations during a given period of time. The overall goal of a business is to increase the value of the firm for the owners. Increasing the profitability of the firm is important because it is the only way to increase the value of the firm. The income statement, provided by the accounting function, identifies the profit, or net income, of the firm’s operations. The dollar amount of profit generated by the firm can 7
  • 8. be expressed as a ratio relative to the firm’s level of sales (net profit margin), assets (return on assets), or equity (return on equity). (11) What are the limitations of ratio analysis? Ratio analysis has some major limitations. First, comparing some firms to an industry average can be difficult because the firms operate in more than one industry. Second, the industry used as a benchmark for comparison may include firms that are involved in a variety of other businesses. This distorts the average ratios for the industry. Third, accounting practices vary among firms. Fourth, firms with seasonal swings in sales may show large deviations from the norm at certain times but not at other times. Normally, however, the seasonal swings should not distort annual financial statements. (12) Discuss the effect of exchange rates on the earnings of a foreign subsidiary whose parent corporation is located in the United States. A U.S. firm that has subsidiaries in foreign countries typically generates earnings in the local currencies of the countries where those subsidiaries are located. Any firm with foreign subsidiaries must consolidate the financial data from all subsidiaries when preparing its financial statements. The consolidation process requires that foreign earnings be reported in the currency of the parent company. Changes in exchange rates can have a major impact on the firm’s reported earnings. (13) Why do firms have to follow GAAP, SEC regulations, and IRS regulations when they report financial information? They have to follow these guidelines so that all firms report standardized financial information to shareholders and potential creditors. In this way, financial statements for two or more companies can be compared. (14) Why do publicly owned firms have to hire public accountants when reporting their financial statements? The audit by public accountants is supposed to certify that financial statements are accurately reported in a standardized format, so that shareholders can be confident that financial statements are accurately reported. (15) How did the Sarbanes-Oxley Act of 2002 affect auditors’ relationships with the firms they audit? Auditors now must be independent of the management of the firm. This means that they are limited in terms of non-audit services they can provide to the firm, and that managers of the firm cannot have worked for the auditing firm in the year prior to the audit. (16) What kinds of disincentives does the Sarbanes-Oxley Act impose to discourage managers from falsifying financial statements? Employees who falsify information face major fines or imprisonment. 8
  • 9. (17) What is the difference between assets and liabilities? Assets are anything owned by a firm, whereas liabilities are anything owed by a firm. (18) How do current assets differ from fixed assets? Current assets are assets that will be converted into cash within one year. Fixed assets are those that the firm will use for more than one year. (19) Why do manufacturing firms hold relatively little cash compared to net fixed assets? Manufacturing firms hold little cash because they do not earn a rate of return on cash, and because fixed assets are used in the production process. (20) What is meant by “responsible” financial reporting? Responsible financial reporting involves reporting financial information fairly, and providing shareholders with trustworthy data rather than engaging in accounting gimmicks, which mislead investors. Answers to Discussion Questions (1) Discuss the concept of short-term financing for short-term assets and long-term financing for long-term assets. The concept of short-term financing for purchasing short-term assets means that accounts payable or trade credit will be used to finance inventory. The concept of long-term financing to purchase long-term assets requires the firm to use long-term liabilities (such as notes payable or corporate bonds) or equity financing through the issuance of corporate stock to finance the firm’s plant and equipment. (2) How can a firm use the Internet to provide information about its financial performance? Answers to this question may vary. However, a firm could use the Internet to provide information about its financial performance by using its website to either display its recent financial performance or to provide links to downloadable files. Furthermore, a firm could provide information about its future plans to improve its financial performance. (3) Indicate the ratio that measures each of the following and classify it as a measure of liquidity, efficiency, financial leverage, or profitability: (a) the return of profits to owners, (b) the amount of debt financing relative to the owner’s investment, and (c) the ratio of the firm’s short-term assets to its short-term liabilities. a. Return on equity (ROE) or profitability ratio b. Debt-to-Equity or leverage ratio 9
  • 10. c. Current ratio or liquidity ratio (4) Discuss the difference between gross profit and earnings before interest and taxes. The earnings before interest and taxes are equal to gross profit minus operating expenses. (5) Assume that you are planning to invest in a corporation. Before you do this, however, you would like to examine its financial statements. Which statements would you want to review and why? The would-be investor would want to review the income statement to assess sales revenues, operating expenses, and net income. The balance sheet would be of interest to assess the financial health of the business. This investigation would determine the asset structure and how the assets were financed. If the firm’s balance sheet shows greater equity investment than debt financing, less risk will be associated with the investment. (6) You are ready to invest in a company, primarily because its financial statements have recently been audited by a reputable accounting firm. Those statements show that the company had a very strong financial performance recently. Why might you conduct some additional research before investing in this firm? There is some evidence that auditors will certify financial reports that are misleading. Sometimes, if the auditor will not certify the financial statements, the company will hire another auditor that will. Given these conflicts of interest, auditors can not always be trusted to ensure that a firm provides proper disclosure of financial information to its stockholders. (7) Why is financial reporting important for firms? What impact might financial reporting have on the firm’s stock price? Financial reporting provides information to shareholders so that they can make decisions about whether they want to hold the stock. If managers report information in compliance with accounting standards, then shareholders will be able to monitor the performance of the firm. (8) Describe the Sarbanes-Oxley Act of 2002. How did it affect auditors and managers of publicly owned firms? Sarbanes-Oxley required that auditors be independent of management of the firm. It requires the CFO and CEO of the firm to certify that the financial statements are correct. (9) Explain the basic accounting equation. What does each component represent? What is owner’s equity? Assets = Liabilities + Shareholders’ Equity Assets represent investments made by the firm Liabilities represent funds provided by creditors Shareholders’ equity represents funds provided by owners of the firm. 10
  • 11. (10) Describe the interaction between (a) auditors, (b) managers, and (c) the board of directors in ensuring accurate financial reporting. Auditors examine the financial statements of the firm to make sure they are in compliance with accounting regulations and are accurate. Managers select the auditor and put together the audit committee, which provides oversight over financial reporting. The board of directors is supposed to oversee and discipline managers in order to make sure that they are reporting the financial operations of the firm accurately. It’s Your Decision: Financial Management at CHC (1) Explain why the current ratio is important to CHC. CHC needs to maintain enough liquidity so that it can pay its future liabilities such as rent and wages. (2) Explain how CHC’s financial leverage can be measured. If the leverage is too high, what is the danger to CHC? The financial leverage can be measured as the debt-to-equity ratio. If the financial leverage is too high, CHC will have a relatively high amount of interest payments, and may not be able to cover those payments. (3) Explain how Sue Kramer can monitor CHC’s performance by comparing its net income to the amount of equity invested in CHC. CHC can use the return on equity (ROE) to measure performance, which is equal to net income over a time period to the equity invested in CHC. A high ROE implies a high level of income for the given amount of equity invested, or a high return on investment. (4) If Sue decides to expand CHC’s existing facilities, explain why its earnings may be lower initially. If CHC expands its facilities, it would need additional funds to cover the higher rent expense. Its revenue will not increase until it generates extra revenue. It might not generate extra revenue to cover the extra expenses. (5) A health club differs from manufacturing firms in that it produces a service rather than products. Manufacturing firms tend to require more machinery than service firms. Explain why manufacturing firms may need more financing than service firms. Manufacturing firms need financing to cover the expense associated with the machinery that is purchased. Case: Using an Accounting System (1) If Sue wants to assess her firm’s performance, what type of firms should she use for purposes of comparison? Sue should compare her firm’s performance to those of other artists with similar small businesses. 11
  • 12. (2) Explain how the two notebooks that Sue uses could be used to develop an income statement. The first notebook represents the revenue generated by her firm. The second notebook represents expenses that are incurred. The revenue and expenses of the firm are all that is needed to construct the income statement of her business. (3) Sue notices that her asset turnover is low. Interpret this situation. Her net sales were low, relative to the investment of assets. Therefore, she did not generate a high level of sales with those assets. (4) How will a low asset turnover ratio affect the profits at Sue’s firm? Since a low asset turnover ratio implies low sales generated by the assets, the revenue will not be as high as is desirable. Because the costs of using the relatively large amount of assets are high, profits will be low. (5) Considering this is a sole proprietorship without shareholders, do you think responsible financial reporting still applies to Sue’s business? Why or why not? Yes, responsible financial reporting still applies to Sue’s business. Even though there are no shareholders, Sue may be tempted to deflate her earnings in order to avoid income taxes on her business. Sue should use whatever method of accounting provides the most accurate indication of her financial condition. Video Case: Reporting Information at Archway (1) Why was Archway’s management concerned about its old information system? Archway’s management could not obtain cost information quickly due to manual recording of information. (2) What kinds of problems was Archway having with coordinating information? Archway’s information systems were not integrated, so it could not obtain cost information quickly. (3) Why do Archway’s higher level managers need a global, summarized set of information rather than specific details about the company’s production and stores? Archway’s management needs to be able to identify information at a macro level in order to examine cost information for all operations. (4)What kinds of problems may Archway encounter as it implements the new information system? Archway may face substantial costs of implementing the new system and in training employees to use the new system. 12
  • 13. Dell’s Secret to Success (1) Based on Dell’s focus, what items on the income statement would Dell closely monitor to ensure that it was achieving its goals? Dell relies on efficient production so that it can still make profits even though its prices are low. So it would closely monitor its expenses. It would also assess its sales (revenue) over time. (2) What balance sheet items would be very important to Dell? Dell would pay close attention to the amount of cash that it has, its long-term assets, and its debt. (3) Review Dell’s comments on its website about its financial reporting. Notice how it emphasizes the integrity of its reporting process, and how it implements systems, controls, and processes so that it can summarize timely and accurate information. Why do you think that Dell emphasizes its integrity when discussing financial reporting? Dell recognizes that investors can not always trust financial statements because some firms have distorted their reports in the past. Dell wants to convince investors that its financial statements are accurate. 13