18-1 prepared by coby harmon university of california, santa barbara westmont college

18-1

Prepared byCoby Harmon

University of California, Santa BarbaraWestmont College

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

18-3

Preview of Chapter 18

Accounting PrinciplesEleventh Edition

Weygandt Kimmel Kieso

18-4

Analyzing financial statements involves:

CharacteristicsComparison

BasesTools of Analysis

Liquidity

Profitability

Solvency

Intracompany

Industry averages

Intercompany

Horizontal

Vertical

Ratio

LO 1 Discuss the need for comparative analysis.LO 2 Identify the tools of financial statement analysis.

Basics of Financial Statement Analysis

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.


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 18-5Horizontal analysis ofbalance sheets

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 18-6Horizontal analysis ofIncome statements

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 18-7Horizontal analysis ofretained earnings statements

Horizontal Analysis

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

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 18-8Vertical analysis ofbalance sheets

LO 4 Describe and apply vertical analysis.

Vertical Analysis

18-11

Quality appearsto be a profitable enterprise that is becoming even more successful.

Illustration 18-9Vertical analysis ofIncome statements


Vertical Analysis

18-12

Enables a comparison of companies of different sizes.

Illustration 18-10Intercompany income statement comparison


Vertical Analysis

18-13LO 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.

LiquidityLiquidity ProfitabilityProfitability SolvencySolvency

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



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

18-15

THE MISSING CONTROLSIndependent 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 betweennumbers 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 statisticalanalysis based on Benford’s Law. Benford’s Law states that in a random collection ofnumbers, 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



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 acid-test ratio,

accounts receivable turnover, and inventory turnover.

Ratio Analysis

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


LO 5Advance slide in presentation mode to reveal solution.



Ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets.

Ratio Analysis Liquidity RatiosLiquidity Ratios

Current RatioIllustration 18-12



Illustration 18-13

Ratio Analysis

Acid-Test Ratio


18-20

Illustration 18-12

LO 5

QUALITY DEPARTMENT STORE INC.Balance Sheet (partial)






Illustration 18-14

Ratio Analysis

Acid-Test Ratio


Acid-test ratio measures immediate liquidity.

18-23 LO 5





18-24 LO 5

Illustration 18-15

Ratio Analysis

Accounts Receivable Turnover


Measures the number of times, on average, the company collects receivables during the period.



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


18-26

Illustration 18-12



LO 5



18-27 LO 5

Illustration 18-16

Ratio Analysis

Inventory Turnover


Measures the number of times, on average, the inventory is sold during the period.



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




Profitability RatiosProfitability 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

18-30





LO 5

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.


18-32



Illustration 18-12



LO 5

18-33

Illustration 18-18

Ratio Analysis

Asset Turnover

Measures how efficiently a company uses its assets to generate sales.



18-34



Illustration 18-12



LO 5

18-35

Ratio Analysis

Return on Asset

An overall measure of profitability.



Illustration 18-19

18-36



Illustration 18-12



LO 5

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.


LO 5

Illustration 18-20

18-38



Illustration 18-12



LO 5

18-39

Ratio Analysis

Earnings Per Share (EPS)

A measure of the net income earned on each share of common stock.


LO 5

Illustration 18-22

18-40



Illustration 18-12



LO 5

18-41

Ratio Analysis

Price-Earnings Ratio

Measures the net income earned on each share of common stock.


LO 5

Illustration 18-23

18-42



Illustration 18-12



LO 5

18-43

Ratio Analysis

Payout Ratio

Measures the percentage of earnings distributed in the form of cash dividends.


LO 5

Illustration 18-24



Solvency RatiosSolvency 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

18-45



Illustration 18-12



LO 5

18-46

Ratio Analysis

Debt to Total Assets Ratio

Measures the percentage of the total assets that creditors provide.

LO 5


Illustration 18-25

18-47



Illustration 18-12



LO 5

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


Illustration 18-25

18-49

Illustration 18-27

Ratio Analysis

LO 5

Summary of Ratios

18-50

Illustration 18-27

Summary of Ratios

LO 5

18-51LO 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

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.


Discontinued Operations

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


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


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.”



Extraordinary Items

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.

YESYES

NONO

NONO


NONO


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.

NONO

YESYES

YESYES


NONO

Are these considered Extraordinary Items?


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.



18-59

Other revenue (expense):



Total other (4,000)




Extraordinary loss, net of tax 539 Net income 54,461$

Extraordinary Items are reported after “Income

from continuing operations.”



Moved to




Sales 285,000$

Cost of goods sold 149,000

18-60


Total other (4,000)




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.



Extraordinary ItemExtraordinary Item




Sales 285,000$


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.



Change in Accounting Principle

18-63

Unrealized gains and losses on available-for-sale securities.

Plus other items

+

Reported in Stockholders’ Equity

Comprehensive Income


All changes in stockholders’

equity except those resulting

from investments by

stockholders and distributions

to stockholders.



Sales 285,000$


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:


Total other 17,000



Net income 76,000$

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.



Comprehensive Income

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

18-66

Variations among companies in the application of GAAP

may hamper comparability and reduce 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

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).


Quality of Earnings

Improper Recognition

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

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.


A Look at IFRS

Key Points

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.


A Look at IFRS

Key Points

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.


A Look at IFRS

Looking to the Future

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.


A Look at IFRS

IFRS Self-Test Questions

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.


A Look at IFRS


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.


A Look at IFRS


18-75

“Copyright © 2013 John Wiley & Sons, Inc. All rights reserved.

Reproduction or translation of this work beyond that permitted in

Section 117 of the 1976 United States Copyright Act without the

express written permission of the copyright owner is unlawful.

Request for further information should be addressed to the

Permissions Department, John Wiley & Sons, Inc. The purchaser

may make back-up copies for his/her own use only and not for

distribution or resale. The Publisher assumes no responsibility for

errors, omissions, or damages, caused by the use of these

programs or from the use of the information contained herein.”

Copyright

18-1 prepared by coby harmon university of california, santa barbara westmont college

Documents

vertical analysis slide

trend analysis

comparative analysis

commonsize analysis

financial statement

financial statements

retention of earnings

net sales