The document discusses various techniques for analyzing financial statements including horizontal analysis, vertical analysis, and ratio analysis. It provides examples of applying these techniques to analyze a company's liquidity, profitability, and solvency using ratios such as the current ratio, profit margin, return on assets, and debt to total assets ratio. The chapter aims to help readers understand how to use financial statement analysis tools to evaluate a company's performance and financial condition.

1. 18-1

2. 18-2
Learning Objectives
After studying this chapter, you should be able to:
[1] Discuss the need for comparative analysis.
[2] Identify the tools of financial statement analysis.
[3] Explain and apply horizontal analysis.
[4] Describe and apply vertical analysis.
[5] Identify and compute ratios used in analyzing a firm’s liquidity,
profitability, and solvency.
[6] Understand the concept of earning power, and how irregular items are
presented.
[7] Understand the concept of quality of earnings.
18 Financial Statement
Analysis

3. 18-3
Preview of Chapter 18
Accounting Principles
Eleventh Edition
Weygandt Kimmel Kieso

4. 18-4
Analyzing financial statements involves:
Characteristics
Comparison
Bases
Tools of
Analysis
 Liquidity
 Profitability
 Solvency
 Intracompany
 Industry
averages
 Intercompany
 Horizontal
 Vertical
 Ratio
Basics of Financial Statement Analysis

5. 18-5 LO 3 Explain and apply horizontal analysis.
Horizontal Analysis
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 the increase or decrease that has
taken place.
 Commonly applied to the balance sheet, income
statement, and statement of retained earnings.

6. 18-6 LO 3 Explain and apply horizontal analysis.
Changes suggest
that the company
expanded its asset
base during 2011
and financed this
expansion primarily
by retaining income
rather than assuming
additional long-term
debt.
Illustration 18-5
Horizontal analysis of
balance sheets
Horizontal Analysis

7. 18-7 LO 3 Explain and apply horizontal analysis.
Overall, gross profit and
net income were up
substantially. Gross
profit increased
17.1%, and net income,
26.5%. Quality’s profit
trend appears
favorable.
Illustration 18-6
Horizontal analysis of
Income statements
Horizontal Analysis

8. 18-8 LO 3 Explain and apply horizontal analysis.
In the horizontal analysis of the balance sheet the ending
retained earnings increased 38.6%. As indicated earlier, the
company retained a significant portion of net income to
finance additional plant facilities.
Illustration 18-7
Horizontal analysis of
retained earnings
statements
Horizontal Analysis

9. 18-9 LO 4 Describe and apply vertical analysis.
Vertical analysis, also called common-size analysis, is a
technique that expresses each financial statement item as a
percent of a base amount.
 On an income statement, we might say that selling
expenses are 16% of net sales.
 Vertical analysis is commonly applied to the balance
sheet and the income statement.
Vertical Analysis

10. 18-10
These results reinforce
the earlier observations
that Quality is
choosing to finance
its growth through
retention of earnings
rather than through
issuing additional
debt.
Illustration 18-8
Vertical analysis of
balance sheets
LO 4 Describe and apply vertical analysis.
Vertical Analysis

11. 18-11
Quality appears
to be a profitable
enterprise that is
becoming even more
successful.
Illustration 18-9
Vertical analysis of
Income statements
LO 4 Describe and apply vertical analysis.
Vertical Analysis

12. 18-12
Enables a comparison of companies of different sizes.
Illustration 18-10
Intercompany income
statement comparison
LO 4 Describe and apply vertical analysis.
Vertical Analysis

13. 18-13
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio analysis expresses the relationship among selected
items of financial statement data.
Liquidity Profitability Solvency
Measures short-
term ability of the
company to pay its
maturing
obligations and to
meet unexpected
needs for cash.
Financial Ratio Classifications
Measures the
income or
operating success
of a company for a
given period of
time.
Measures the
ability of the
company to
survive over a long
period of time.
Ratio Analysis

14. 18-14
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
The discussion of ratios will include the following types of
comparisons.
1. Intracompany comparisons for two years for Quality
Department Store.
2. Industry average comparisons based on median ratios for
department stores.
3. Intercompany comparisons based on Macy’s, Inc. as Quality
Department Store’s principal competitor.
A single ratio by itself is not very meaningful.
Ratio Analysis

15. 18-15
THE MISSING CONTROLS
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.
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 by companies to detect fraud. The numeric relationships that can reveal
fraud can be such things as financial ratios that appear abnormal, or statistical abnormalities in
the numbers themselves. 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.
Advance slide in presentation mode to reveal answer. LO 5

16. 18-16
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Liquidity 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 acid-test ratio,
accounts receivable turnover, and inventory turnover.
Ratio Analysis

17. 18-17
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 18-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
Advance slide in presentation mode to reveal solution.

18. 18-18
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio of 2.96:1 means that for every dollar of current liabilities, Quality
has $2.96 of current assets.
Ratio Analysis Liquidity Ratios
Current Ratio Illustration 18-12

19. 18-19
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Illustration 18-13
Ratio Analysis
Acid-Test Ratio
Liquidity Ratios

20. 18-20
Illustration 18-12
LO 5
QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)
For the Years Ended December 31
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31

21. 18-21
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Illustration 18-14
Ratio Analysis
Acid-Test Ratio
Liquidity Ratios
Acid-test ratio measures immediate liquidity.

22. 18-22

23. 18-23 LO 5
QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)
For the Years Ended December 31
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31

24. 18-24 LO 5
Illustration 18-15
Ratio Analysis
Accounts Receivable Turnover
Liquidity Ratios
Measures the number of times, on average, the company collects
receivables during the period.

25. 18-25
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
A variant of the accounts receivable turnover ratio is to convert it
to an average collection period in terms of days.
Accounts receivable are collected on average every 36 days.
$2,097,000
($180,000 + $230,000) / 2
= 10.2 times
365 days / 10.2 times = every 35.78 days
Accounts Receivable Turnover
Ratio Analysis Liquidity Ratios

26. 18-26
Illustration 18-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)
For the Years Ended December 31

27. 18-27 LO 5
Illustration 18-16
Ratio Analysis
Inventory Turnover
Liquidity Ratios
Measures the number of times, on average, the inventory is sold
during the period.

28. 18-28
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
A variant of inventory turnover is the days in inventory.
Inventory turnover ratios vary considerably among industries.
365 days / 2.3 times = every 159 days
$1,281,000
($500,000 + $620,000) / 2
= 2.3 times
Inventory Turnover
Ratio Analysis Liquidity Ratios

29. 18-29
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Profitability Ratios
Measure the income or operating success of a company for a
given period of time.
 Income, or the lack of it, affects the company’s ability to obtain
debt and equity financing, liquidity position, and the ability to
grow.
 Ratios include the profit margin, asset turnover, return on
assets, return on common stockholders’ equity, earnings
per share, price-earnings, and payout ratio.
Ratio Analysis

30. 18-30
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5

31. 18-31
Illustration 18-17
Ratio Analysis
Profit Margin
Measures the percentage of each dollar of sales that results in net
income.
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Profitability Ratios

32. 18-32
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 18-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5

33. 18-33
Illustration 18-18
Ratio Analysis
Asset Turnover
Measures how efficiently a company uses its assets to generate
sales.
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Profitability Ratios

34. 18-34
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 18-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5

35. 18-35
Ratio Analysis
Return on Asset
An overall measure of profitability.
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Profitability Ratios
Illustration 18-19

36. 18-36
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 18-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5

37. 18-37
Ratio Analysis
Return on Common Stockholders’ Equity
Shows how many dollars of net income the company earned for each
dollar invested by the owners.
Profitability Ratios
LO 5
Illustration 18-20

38. 18-38
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 18-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5

39. 18-39
Ratio Analysis
Earnings Per Share (EPS)
A measure of the net income earned on each share of common stock.
Profitability Ratios
LO 5
Illustration 18-22

40. 18-40
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 18-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5

41. 18-41
Ratio Analysis
Price-Earnings Ratio
Measures the net income earned on each share of common stock.
Profitability Ratios
LO 5
Illustration 18-23

42. 18-42
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 18-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5

43. 18-43
Ratio Analysis
Payout Ratio
Measures the percentage of earnings distributed in the form of cash
dividends.
Profitability Ratios
LO 5
Illustration 18-24

44. 18-44
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Solvency Ratios
Solvency ratios measure the ability of a company to survive
over a long period of time.
 Debt to Assets and
 Times Interest Earned
are two ratios that provide information about debt-paying
ability.
Ratio Analysis

45. 18-45
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 18-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5

46. 18-46
Ratio Analysis
Debt to Total Assets Ratio
Measures the percentage of the total assets that creditors provide.
LO 5
Solvency Ratios
Illustration 18-25

47. 18-47
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 18-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5

48. 18-48
Ratio Analysis
Times Interest Earned
Provides an indication of the company’s ability to meet interest
payments as they come due.
LO 5
Solvency Ratios
Illustration 18-25

49. 18-49
Illustration 18-27
Ratio Analysis
LO 5
Summary of Ratios

50. 18-50
Illustration 18-27
Summary of Ratios
LO 5

51. 18-51
LO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning power means the normal level of income to be
obtained in the future.
“Irregular” items are separately identified on the income
statement. Two types are:
1. Discontinued operations.
2. Extraordinary items.
“Irregular” items are reported net of income taxes.
Earning Power and Irregular Items

52. 18-52
(a) Disposal of a significant component of a business.
(b) Report the income (loss) from discontinued operations in
two parts:
1. income (loss) from operations (net of tax) and
2. gain (loss) on disposal (net of tax).
LO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
Discontinued Operations

53. 18-53
Illustration: During 2014 BD Inc. has income before income
taxes of $79,000,000. During 2014, BD discontinued and sold
its unprofitable chemical division. The loss in 2014 from
chemical operations (net of $135,000 taxes) was $315,000. The
loss on disposal of the chemical division (net of $81,000 taxes)
was $189,000. Assuming a 30% tax rate on income.
LO 6
Earning Power and Irregular Items

54. 18-54
Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations 55,000
Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Net income 54,496
$
Income Statement (in thousands)
Sales 285,000
$
Cost of goods sold 149,000
Discontinued
Operations are reported
after “Income from
continuing operations.”
Previously labeled as
“Net Income”.
Moved to
LO 6
Earning Power and Irregular Items

55. 18-55
Nonrecurring material items that differ significantly from a
company’s typical business activities.
 Must be both of an
► Unusual Nature and
► Occur Infrequently.
 Must consider the environment in which it operates.
 Amounts reported “net of tax.”
LO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
Extraordinary Items

56. 18-56
Are these considered Extraordinary Items?
(a) A large portion of a tobacco manufacturer’s crops
are destroyed by a hail storm. Severe damage
from hail storms in the locality where the
manufacturer grows tobacco is rare.
(b) A citrus grower's Florida crop is damaged by
frost.
(c) Loss from sale of temporary investments.
(d) Loss attributable to a labor strike.
YES
NO
NO
LO 6 Understand the concept of earning power,
and how irregular items are presented.
NO
Earning Power and Irregular Items

57. 18-57
(e) Loss from flood damage. (The nearby Black River
floods every 2 to 3 years.)
(f) An earthquake destroys one of the oil refineries
owned by a large multi-national oil company.
Earthquakes are rare in this geographical location.
(g) Write-down of obsolete inventory.
(h) Expropriation of a factory by a foreign
government.
NO
YES
YES
LO 6 Understand the concept of earning power,
and how irregular items are presented.
NO
Are these considered Extraordinary Items?
Earning Power and Irregular Items

58. 18-58
Illustration: In 2014 a foreign government expropriated property
held as an investment by DB Inc. If the loss is $770,000 before
applicable income taxes of $231,000, the income statement will
report a deduction of $539,000.
Earning Power and Irregular Items
LO 6 Understand the concept of earning power,
and how irregular items are presented.

59. 18-59
Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations 55,000
Extraordinary loss, net of tax 539
Net income 54,461
$
Extraordinary Items are
reported after “Income
from continuing
operations.”
Previously labeled as
“Net Income”.
Moved to
LO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
Income Statement (in thousands)
Sales 285,000
$
Cost of goods sold 149,000

60. 18-60
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations 55,000
Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Income before extraordinary item 54,496
Extraordinary loss, net of tax 539
Net income 53,957
$
Reporting when both
Discontinued
Operations and
Extraordinary Items
are present.
Discontinued
Operations
Extraordinary Item
LO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
Income Statement (in thousands)
Sales 285,000
$
Cost of goods sold 149,000

61. 18-61

62. 18-62
 Occurs when the principle used in the current year is
different from the one used in the preceding year.
 Accounting rules permit a change if justified.
 Changes are reported retroactively.
 Example would include a change in inventory costing
method such as FIFO to average cost.
LO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
Change in Accounting Principle

63. 18-63
Unrealized gains and
losses on available-for-
sale securities.
Plus other items
+
Reported in Stockholders’
Equity
Comprehensive Income
LO 6 Understand the concept of earning power,
and how irregular items are presented.
All changes in stockholders’
equity except those resulting
from investments by
stockholders and distributions
to stockholders.
Earning Power and Irregular Items
Income Statement (in thousands)
Sales 285,000
$
Cost of goods sold 149,000
Gross profit 136,000
Operating expenses:
Advertising expense 10,000
Depreciation expense 43,000
Total operating expense 53,000
Income from operations 83,000
Other revenue:
Interest revenue 17,000
Total other 17,000
Income before taxes 100,000
Income tax expense 24,000
Net income 76,000
$

64. 18-64
Why are gains and losses on available-for-sale securities
excluded from net income?
Because disclosing them separately
1) reduces the volatility of net income due to fluctuations in fair
value,
2) yet informs the financial statement user of the gain or loss
that would be incurred if the securities were sold at fair value.
LO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
Comprehensive Income

65. 18-65
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.
The issue of quality of earnings has taken on increasing
importance because recent accounting scandals suggest that
some companies are spending too much time managing their
income and not enough time managing their business.
LO 7 Understand the concept of quality of earnings.
Quality of Earnings

66. 18-66
 Variations among companies in the application of GAAP may
hamper comparability and reduce quality of earnings.
LO 7 Understand the concept of quality of earnings.
 Pro forma income usually excludes items that the company
thinks are unusual or nonrecurring.
 Some companies have abused the flexibility that pro forma
numbers allow.
Quality of Earnings
Alternative Accounting Methods
Pro Forma Income

67. 18-67
Some managers have felt pressure to continually increase
earnings and have manipulated the earnings numbers to meet
these expectations.
Abuses include:
 Improper recognition of revenue (channel stuffing).
 Improper capitalization of operating expenses (WorldCom).
 Failure to report all liabilities (Enron).
LO 7 Understand the concept of quality of earnings.
Quality of Earnings
Improper Recognition

68. 18-68
 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.
LO 8 Compare financial statement analysis and income
statement presentation under GAAP and IFRS..
A Look at IFRS
Key Points

69. 18-69
 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.
 Both GAAP and IFRS follow the same approach in reporting
comprehensive income. The statement of comprehensive income can be
prepared under the one-statement approach or the two-statement
approach.
LO 8 Compare financial statement analysis and income
statement presentation under GAAP and IFRS..
A Look at IFRS
Key Points

70. 18-70
 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.
LO 8 Compare financial statement analysis and income
statement presentation under GAAP and IFRS..
A Look at IFRS
Key Points

71. 18-71
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 8 Compare financial statement analysis and income
statement presentation under GAAP and IFRS..
A Look at IFRS
Looking to the Future

72. 18-72
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.
LO 8 Compare financial statement analysis and income
statement presentation under GAAP and IFRS..
A Look at IFRS
IFRS Self-Test Questions

73. 18-73
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.
LO 8 Compare financial statement analysis and income
statement presentation under GAAP and IFRS..
A Look at IFRS
IFRS Self-Test Questions

74. 18-74
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.
LO 8 Compare financial statement analysis and income
statement presentation under GAAP and IFRS..
A Look at IFRS
IFRS Self-Test Questions

75. 18-75
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