COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Analysis of Financial Statements Chapter 22 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

Learning Objectives 1.Organize a systematic financial ratio analysis using common-size financial statements and the DuPont framework. 2.Recognize the potential impact that differing accounting methods can have on the financial ratios of otherwise essentially identical companies. 3.Understand how foreign companies report their financial results to U.S. investors. 4.Describe the purpose and format of the SEC’s Form 20-F. 5.Convert foreign currency financial statements into U.S. dollars using the translation method.

Framework for Financial Statement Analysis Financial statement analysis- the examination of the relationships among: –Financial statement numbers –The trends of the statement numbers over time. To analyze financial statements, analyst use: –Common sized financial statements –Ratio analysis

Framework for Financial Statement Analysis 1.When the presentations are in good form. 2.When the content of the statements is identical. 3.When accounting principles are not changed, or, if they are changed, the financial effects of the changes are disclosed. 4.When changes in circumstances or in the nature of the underlying transactions are disclosed. The APB stated that comparisons between financial statements are most informative—

Framework for Financial Statement Analysis Common-Size Financial Statements- analysis of a company’s single-year financial statements. Financial statements are standardized by a measure of size, either sales or total assets. All amounts are stated in terms of a percentage of the size measure. Ratio Analysis- Analysis of a company’s financial statements by computing ratios and comparing them against both trends and industry averages.

Ratio Analysis DuPont Framework- Identifying factors that impact return on equity. Efficiency Ratios- How efficiently is the firm utilizing its assets? Leverage Ratios- To what degree is the company using other people’s money to purchase assets? Other Financial Ratios- Other indications of liquidity, cash management, and profitability.

DuPont Framework Developed internally at DuPont around Provides a systematic approach to identifying general factors causing ROE to deviate from normal. Establishes a framework for computing financial ratios to yield more in-depth analysis of a company’s areas of strength and weakness.

DuPont Framework DuPont: ROE can be decomposed into three components: ProfitabilityxEfficiencyxLeverage Return on xAssetxAssets-to- SalesTurnoverEquity Ratio Net IncomexSalesxAssets SalesAssetsEquity

DuPont Framework Net IncomexSalesxAssets SalesAssetsEquity The number of pennies in profits generated from each dollar of sales. The number of dollars in sales generated by each dollar of assets. The number of dollars of assets a company is able to acquire using each dollar invested by stockholders.

Impact of Alternative Accounting Methods If companies are using differing accounting practices, it will impact the ratios. Careful financial statement users should make adjustments for accounting differences among the companies being analyzed.

Foreign Reporting to U.S. Investors Firms such as DaimlerChrysler and Disney must produce financial statements for users not only in their own countries but also in other countries. The significant differences in accounting standards around the world complicate both the preparation of financial statements and the understanding of these statements for users. These divergent national accounting practices can have an extremely significant impact on reported financial statements. The good news is that the demands of international users are forcing companies to provide disclosure so that users can recognize and reconcile the differing accounting standards.

Meeting the Needs of International Users Some multinational firms respond to users in other countries simply by taking their financial statements or annual reports and translating them into the language of the user.

Meeting the Needs of International Users Another response to the international users is to denominate the financial statements in the currency of the country where the financial statements will be used.

Meeting the Needs of International Users Some multinationals partially or completely restate the financial statements to the accounting principles of the financial statement users’ country.

Meeting the Needs of International Users Mutual recognition involves one country accepting the financial statements of another country in return for that country accepting its financial statements for all regulatory purposes.

Form 20-F provides the reconciliation. The SEC’s Form 20-F The SEC requires foreign companies that list shares on U.S. to provide: 1.Complete U.S. GAAP financial statements. 2.Reconcile their reported net income to what income would be according to U.S. GAAP.

Foreign Currency Financial Statements Translation- Used when the foreign subsidiary is a relatively self-contained unit that is independent from the parent company’s operations. Remeasurement- Is appropriate when the subsidiary does not operate independently of the parent company. Functional currency- Currency of the primary economic environment of an entity.

Foreign Currency Financial Statements Assets and liabilities are translated using the current exchange rate prevailing as of the balance sheet date. Income statement items are translated at the average exchange rate for the year. Dividends are translated using the exchange rate prevailing on the date the dividends were declared. Translation

Foreign Currency Financial Statements Capital stock is translated at the historical rate, the rate prevailing on the date the subsidiary was acquired or the stock was issued. Retained earnings is translated in the first year using historical rates. In subsequent years, take the balance in Retained Earnings from the prior period’s translated financial statements and add translated net income and subtracting translated dividends. Translation