Acc102 chap13 publisher_power_point

13-2
FINANCIAL
ANALYSIS:
THE BIG PICTURE
Accounting, Fifth Edition
13

13-3
After studying this chapter, you should be able to:
1. Understand the concept of sustainable income.
2. Indicate how irregular items are presented.
3. Explain the concept of comprehensive income.
4. Describe and apply horizontal analysis.
5. Describe and apply vertical analysis.
6. Identify and compute ratios used in analyzing a company’s
liquidity, solvency, and profitability.
7. Understand the concept of quality of earnings.
Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

13-4
Preview of Chapter 13
Accounting
Fifth Edition
Kimmel Weygandt Kieso

13-5
LO 2 Indicate how irregular items are presented.
Sustainable IncomeSustainable IncomeSustainable IncomeSustainable Income
Sustainable Income - Net income adjusted for irregular
items.
Irregular Items
Irregular items are separately identified on the income
statement. Two types are:
1. Discontinued operations.
2. Extraordinary items.
These “irregular” items are reported net of income taxes.
LO 1 Understand the concept of sustainable income.

13-6
Components of
the income
statement
Illustration 13-1

13-7
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.

13-8
Illustration: Rozek Inc. has revenues of $2.5 million and expenses
of $1.7 million from continuing operations in 2014. The company
therefore has income before income taxes of $800,000. During
2014 the company discontinued and sold its unprofitable chemical
division at a loss of $210,000 (net of $90,000 tax savings).
LO 2
Illustration 13-2

13-9
Extraordinary items are events and transactions that
meet two conditions:
Both
 Unusual in nature and
 Infrequent in occurrence
Company must consider the environment in which it operates.
Amounts reported “net of tax.”

13-10
Illustration: In 2014 a revolutionary foreign government
expropriated property held as an investment by Rozek Inc. If the
loss is $70,000 before applicable income tax savings of $21,000,
how will the loss be presented in the income statement?
Advance slide in presentation mode to reveal solution.
Illustration 13-3
ROZEK INC.
Income Statement (partial)
For the Year Ended December 31, 2014

13-11
Are these considered Extraordinary Items?
YESYES
NONO
NONO
YESYES
 Effects of major natural casualties, if rare in
the area.
 Effects of major natural casualties, not
uncommon in the area.
 Write-down of inventories or write-off of
receivables.
 Expropriation (takeover) of property by a
foreign government.

13-12
NONO
YESYES
NONO
 Losses attributable to labor strikes.
 Effects of a newly enacted law or regulation,
such as a condemnation action.
 Gains or losses from sales of property, plant,
or equipment.
Are these considered Extraordinary Items?

13-14
 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

13-16
LO 3 Explain the concept of comprehensive income.
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

13-17
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 2014 Stassi Company purchased IBM stock
for $10,000 as an investment. At the end of 2014 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?

13-18
Illustration of Comprehensive Income
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)

13-19
Format One – Comprehensive Income
Combined statement of income and comprehensive income.
Illustration 13-5

13-20
Format Two - Comprehensive Income
Separate component of Stockholders’ Equity.
Illustration 13-6

13-21
Complete
Income
Statement
Illustration 13-7
Format Three -
Comprehensive
Income
PACE CORPORATION
Income Statement and
Statement of Comprehensive Income
For the Year Ended December 31, 2014

13-22
AIR CORPORATION
Income Statement (partial)
Income before income taxes $400,000
Income tax expense 120,000
Income before irregular items 280,000
Discontinued operations
Loss on disposal of discontinued flower division,
net of $42,000 tax savings (98,000)
Extraordinary earthquake loss, net of $30,000 tax savings (70,000)
Net income $112,000
Illustration: In its draft 2014 income statement,
AIR Corporation reports income before income taxes
$400,000, extraordinary loss due to earthquake $100,000, income
taxes $120,000 (not including irregular items), and loss on disposal of
discontinued flower division $140,000. The income tax rate is 30%.
Prepare a correct income statement, beginning with income before
income taxes.
Advance slide in presentation mode to reveal solution. LO 3

13-23
Analyzing financial statements involves:
Comparative AnalysisComparative AnalysisComparative AnalysisComparative Analysis
Comparison
Bases
Basic Tools
 Intracompany
 Intercompany
 Industry averages
 Horizontal analysis
 Vertical analysis
 Ratio Analysis

13-24 LO 4 Describe and apply horizontal analysis.
Also called trend analysis, is a technique for evaluating a
series of financial statement data over a period of time.
 Purpose is to determine increase or decrease that has taken
place.
 Commonly applied to the balance sheet and income
statement.
Horizontal Analysis

13-25
Helpful Hint:
When using
horizontal
analysis, be sure
to examine both
dollar amount
changes and
percentage
changes.
Illustration 13-11
Horizontal analysis
of balance sheets
LO 4 Describe and apply horizontal analysis.

13-26
Illustration 13-12
Horizontal analysis
of Income statements
Helpful Hint: In horizontal analysis, while the amount column is additive (the
total is $99 million), the percentage column is not additive (9.9% is not a total).

13-27
Summary financial information for Rosepatch Company
is as follows.
Solution
Compute the amount and percentage changes in 2012 using horizontal
analysis, assuming 2011 is the base year.
Advance slide in presentation
mode to reveal solution.

13-28 LO 5 Describe and apply vertical analysis.
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

13-29 LO 5 Describe and apply vertical analysis.
These results
indicate the
company shifted
toward equity
financing by relying
less on debt and by
increasing the
amount
of retained
earnings.
Illustration 13-13
Vertical analysis of
Income statements

13-30
The increase in net income as a percentage of net sales is due primarily to the
decrease in interest expense and income tax expense as a percentage of
sales.
LO 5 Describe and apply vertical analysis.
Illustration 13-14
Vertical analysis of
an income
statements

13-31
Illustration 13-15
Intercompany
comparison by vertical
analysis
LO 5 Describe and apply vertical analysis.
Although Chicago Cereal’s net sales are less than those of General Mills,
vertical analysis eliminates the impact of this size difference for our analysis.
Vertical analysis
also enables a
comparison of
companies of
different sizes.

13-32
ProfitabilityProfitability
Measures the
income or
operating success
of a company for a
given period of
time.
SolvencySolvency
Measures the
ability of the
company to
survive over a long
period of time.
LO 6 Identify and compute ratios used in analyzing a
company’s liquidity, solvency, and profitability.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Ratio analysis expresses the relationship among selected
items of financial statement data.
LiquidityLiquidity
Measures short-
term ability of the
company to pay its
maturing
obligations and to
meet unexpected
needs for cash.
Financial Ratio Classifications

13-33
Illustration 13-16
Liquidity Ratios

13-35
Illustration 13-17
Solvency Ratios

13-36
Illustration 13-18
LO 6
Profitability Ratios

13-38
Recent accounting scandals suggest that some companies
are spending too much time managing their income and
not enough time managing their business.
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.
Quality of EarningsQuality of EarningsQuality of EarningsQuality of Earnings
LO 7 Understand the concept of quality of earnings.

13-39
 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

13-40
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).
Alternative Accounting Methods

13-41
Reflects investors’ assessment of a company’s future
earnings.
 P-E ratio will be higher if investors think that earnings will
increase substantially in the future.
 P-E ratio will be lower when there is the belief that a company
has poor-quality earnings.
Illustration 13-19
Price-Earnings Ratio

13-42
Illustration 13-19
Illustration 13-20
Earnings per share and P-E
ratios of various companies
Price-Earnings Ratio

13-43
Match each of the following terms with the phrase that
it best matches.
1. Measures the ability of the company to survive
over a long period of time.
2. Usually excludes items that a company thinks are
unusual or non-recurring.
3. Includes all changes in stockholders’ equity during
a period except those resulting from investments
by stockholders and distributions to stockholders.
Solvency
Pro forma
Comprehensive
income
Comprehensive income Vertical analysis
Quality of earnings Pro forma income
Solvency ratio Extraordinary items

13-44
Match each of the following terms with the phrase that
it best matches.
4. Indicates the level of full and transparent
information provided to users of the financial
statements.
5. Describes events and transactions that are
unusual in nature and infrequent in occurrence.
6. Expresses each item within a financial statement
as a percent of a base amount.
Quality of
Earnings
Extraordinary
Items
Vertical Analysis
Comprehensive income Vertical analysis
Quality of earnings Pro forma income
Solvency ratio Extraordinary items

13-45
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 2011 ratios.
Appendix 13AAppendix 13AAppendix 13AAppendix 13A
Comprehensive
Ratio Analysis
LO 8 Evaluate a company comprehensively using ratio analysis.

13-46
Illustration 13A-1
Comprehensive
Ratio Analysis
LO 8

13-47
Illustration 13A-2 & 13A-4
Comprehensive
Ratio Analysis
LO 8

13-48
Illustration 13A-3
Comprehensive
Ratio Analysis
LO 8

13-49
Liquidity RatiosLiquidity Ratios
Measure the short-term ability of the company to pay its maturing
obligations and to meet unexpected needs for cash.
 Short-term creditors such as bankers and suppliers are
particularly interested in assessing liquidity.
 Ratios include the current ratio, the current cash debt
coverage, the accounts receivables turnover, the average
collection period, the inventory turnover, and days in
inventory.
Comprehensive
Ratio Analysis

13-50
Current Ratio - 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.
Illustration 13A-5
Comprehensive
Ratio Analysis

13-51
Current Cash Debt Coverage - Because it uses cash provided by
operating activities, it may provide a better representation of
liquidity.
Is the coverage adequate?
Probably so. Chicago’s coverage is better than that of General
Mills, and it approximates an accepted threshold of .40.
Illustration 13A-6
Comprehensive
Ratio Analysis

13-52
Accounts Receivables Turnover – 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 12.4
times.
Illustration 13A-7
Comprehensive
Ratio Analysis

13-53
Average Collection Period – 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).
Illustration 13A-8
Comprehensive
Ratio Analysis

13-54
Inventory Turnover - 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 better than General Mills’s 6.5 times.
How does Chicago’s turnover compare to General Mills’s?
Illustration 13A-9
Comprehensive
Ratio Analysis

13-55
Days in Inventory - 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?
Illustration 13A-10
Comprehensive
Ratio Analysis

13-56
Solvency RatiosSolvency Ratios
Solvency ratios 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
► Cash debt coverage
 Free cash flow provides information about solvency and
ability to pay additional dividends or invest.
Comprehensive
Ratio Analysis

13-57
Debt to Assets Ratio – Indicates the degree of financial
leveraging. Provides some indication of the company’s ability to
withstand losses.
Yes, slightly. 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?
Illustration 13A-11
Comprehensive
Ratio Analysis

13-58
Times Interest Earned - (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 better able to service its’ debt?
Illustration 13A-12
Comprehensive
Ratio Analysis

13-59
Cash Debt Coverage - Indicates a company’s ability to repay its
liabilities from cash generated from operating activities without
having to liquidate the assets used in its operations.
One way of interpreting this ratio is to say that net cash generated
from one year of operations would be sufficient to pay off 17% of
Chicago’s total liabilities.
Illustration 13A-13
Comprehensive
Ratio Analysis

13-60
Free Cash Flow - Ability to pay dividends or expand operations.
Calculate the ratio for Chicago.
Cash provided by operations was more than enough to allow
Chicago to acquire additional productive assets and maintain
dividend payments.
Illustration 13A-14
(in millions)
Comprehensive
Ratio Analysis

13-61
Profitability RatiosProfitability Ratios
Measure the income or operating success of a company for a
given period of time.
Comprehensive
Ratio Analysis
Illustration 13A-15
Relationships among
profitability measures

13-62
Return on Common Stockholders’ Equity (ROE) - Shows how
many dollars of net income the company earned for each dollar
invested by the owners.
Chicago’s 2011 rate of return on common stockholders’ equity is
unusually high at 48%, considering an industry average of 24%
and General Mills’s return of 24%.
Illustration 13A-16
Comprehensive
Ratio Analysis

13-63
Return on Assets - 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.
Illustration 13A-17
Comprehensive
Ratio Analysis

13-64
Profit Margin - 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.
Illustration 13A-18
Comprehensive
Ratio Analysis

13-65
Asset Turnover - 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.
Illustration 13A-19
Comprehensive
Ratio Analysis

13-66
You can analyze the combined effects of profit margin and
asset turnover on return on assets for Chicago as shown
Illustration 13A-20
Comprehensive
Ratio Analysis

13-67
Gross Profit Rate - Indicates a company’s ability to maintain
an adequate selling price above its cost of goods sold.
Illustration 13A-21
As an industry becomes more competitive, this ratio declines.
Comprehensive
Ratio Analysis

13-68
Earnings Per Share - A measure of the net income earned on
each share of common stock.
Illustration 13A-22
Comprehensive
Ratio Analysis

13-69
Price-Earnings (P-E) Ratio - Reflects investors’ assessments of
a company’s future earnings.
Illustration 13A-23
A higher P-E ratio suggests that the market is more optimistic
about Chicago. It might also signal that its stock is overpriced.
Comprehensive
Ratio Analysis

13-70
Payout Ratio - Measures the percentage of earnings distributed
in the form of cash dividends.
Illustration 13A-24
This ratio should be calculated over a longer period of time to
evaluate any trends.
Comprehensive
Ratio Analysis

13-71
 The tools of financial statement analysis covered in this chapter are
universal and therefore no significant differences exist in the analysis
methods used.
 The basic objectives of the income statement are the same under
both GAAP and IFRS. Thus, both the IASB and the FASB are
interested in distinguishing normal levels of income from irregular
items in order to better predict a company’s future profitability.
 The basic accounting for discontinued operations is the same under
IFRS and GAAP.
Key Points
LO 9 Compare the accounting for Irregular items and the
income statement format under GAAP and IFRS.

13-72
 Under IFRS, there is no classification for extraordinary items. In
other words, extraordinary item treatment is prohibited under IFRS.
All revenue and expense items are considered ordinary in nature.
 The accounting for changes in accounting principles and changes in
accounting estimates are the same for both GAAP and IFRS.
 The income statement under IFRS is referred to as a statement of
comprehensive income. The statement of comprehensive income
can be prepared under the one-statement approach or the two-
statement approach.
Key Points

13-73
 GAAP also permits the one-statement or two-statement approach. In
addition, GAAP permits a third alternative, which is to show the
computation of comprehensive income in the statement of
stockholders’ equity.
 The issues related to quality of earnings are the same under both
GAAP and IFRS. It is hoped that by adopting a more principles-based
approach, as found in IFRS, many of the earnings’ quality issues will
disappear.
Key Points

13-74
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.

13-75
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.
IFRS Practice

13-76
IFRS Practice
Under IFRS:
a) the reporting of discontinued items is different than GAAP.
b) the reporting of extraordinary items is prohibited.
c) the reporting of changes in accounting principles is different
than under GAAP.
d) None of the above.

13-77
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.
IFRS Practice

13-78
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