Additional Aspects of Financial Reporting and Financial Analysis C hapter 6 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition Nikolai Bazley Jones

2 The prices of securities traded in the capital market fully reflect all publicly available information. Evidence from research on an efficient market hypothesis tends to show-- These prices are adjusted almost immediately based on new information and in an unbiased manner. Market Efficiency

3 1. The auditor is independent. 2. The audit was performed on specified financial statements. 3. The financial statements are the responsibility of the company’s management; the opinion is the responsibility of the auditors. 4. The audit was conducted according to generally accepted auditing standards. ContinuedContinued An auditor’s standard report includes these statements... Auditor’s Report (Opinion)

4 5. The audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatements. 6. The audit included examination, assessment, and evaluation stages. 7. The audit provides a reasonable basis for an opinion. 8. An opinion is expressed concerning the fair presentation. Auditor’s Report (Opinion)

5 The first (introductory) paragraph lists the financial statements that were audited, declares that management is responsible for those statements, and asserts that the auditor is responsible for expressing an opinion on them. The second (scope) paragraph describes what the auditor has done. The third (opinion) paragraph gives the auditor’s opinion. An unqualified opinion contains 3 paragraphs. Auditor’s Report (Opinion)

6 1. An unqualified opinion is not a “clean bill of health.” 2. An unqualified opinion provides no assurance of the future success of the company. 3. An audit report does not provide an assurance that fraud has not been committed by a member, or members, of the company unless such fraud would cause a material misstatement in the financial statements. Auditor’s Report (Opinion)

7 The MD&A provides a narrative explanation of the financial statements so that investors can judge the “quality” of earnings and the likelihood that past performance is indicative of future performance in regard to cash flows. Management’s Discussion and Analysis

8 The MD&A provides a narrative explanation of the financial statements so that investors can judge the “quality” of earnings and the likelihood that past performance is indicative of future performance in regard to cash flows. The MD&A provides information regarding liquidity, capital resources, and the results of operations, as well as other information necessary to understand its financial condition and changes in financial condition. Where knowledge of segment information is useful to understanding a company’s business, the discussion is to focus on each relevant, reportable operating segment, as well as on the whole company. Management’s Discussion and Analysis

9 Disaggregation of Financial Information  Although investors and creditors know the importance of consolidated statements in evaluating overall company performance, the disaggregation of total financial data also can be important in their financial analysis.  A company improves the financial analysis information on risk and return by presenting disaggregated information on its operating segments.

10 1. that engages in business activities to earn revenues and incur expenses, 2. whose operating results are regularly reviewed by the company’s chief operating officer to make decisions about resources to be allocated to the segment and to assess its performance, and 3. for which financial information is available. An operating segment is a component of a company-- Segment Reporting

11 An operating segment is considered significant and is a reportable segment if it satisfies at least one of the following tests: 1.Revenue Test. Its reported revenues are 10% or more of the combined revenues of all the company’s reported operating segments. Segment Reporting

12 An operating segment is considered significant and is a reportable segment if it satisfies at least one of the following tests: 2.Profit Test. The absolute amount of its profit (loss) is 10% or more of the combined reported profits of all operating segments that did not report a loss. Segment Reporting

13 An operating segment is considered significant and is a reportable segment if it satisfies at least one of the following tests: 3.Asset Test. Its segment assets are 10% or more of the combined assets of all operating segments. Segment Reporting

14 Interim Income Taxes To fairly present the results of operations, at the end of each interim period a company must make its best estimate of the effective income tax rate to be applicable for the entire year.

15 1.Estimated Annual Income: First quarter$ 20,000actual income Second quarter26,000actual income Third quarter25,000estimated income Fourth quarter 29,000estimated income $100,000estimated annual income ContinuedContinued Interim Income Taxes The tax rates are 15% on the first $20,000 and 30% on income over $20,000

16 2.Estimated Effective Income Tax Rate: 15% x $20,000 = $ 3,000 30% x ($100,000 – $20,000) = 24,000 Estimated total tax for the year = $27,000 27% Effective tax rate = $27,000 Estimated income tax $100,000 Estimated IncomeContinuedContinued Interim Income Taxes

17 4.Estimated Income Tax for Second Quarter: $12,420 estimated income tax on first six months of income (5,220)estimated income tax on first-quarter income (using annual estimate at that time) $ 7,200 estimated income tax on second-quarter income 3.Estimated Income Tax for First Six Months: $46,000 x 27% = $12,420 estimated income tax on first six months’ income Interim Income Taxes

18 For interim income statements for the second and third quarters: 1.Present the “year to date” income statement, 2.Deduct the amounts for each account from the previous quarter’s statement, 3.Present an income statement for the current quarter in the adjoining column Interim Statements

19 Two SEC forms that are important to accountants are-- Form 10-K Form 10-Q SEC Reports

20 Financial Analysis Comparisons Intracompany Intercompany Percentage Analyses Horizontal Vertical Ratio Financial Analysis Comparison

21 In horizontal analysis, changes in a company’s operating results and financial position over time are shown in percentages as well as in dollars. In horizontal analysis, changes in a company’s operating results and financial position over time are shown in percentages as well as in dollars. Horizontal Analysis

22 In vertical analysis, the monetary relationships between items on the financial statements are shown in percentages as well as in dollars. Vertical Analysis- Income Statement

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, Sales, $138,000 Sales, net, $130,000 = Vertical Analysis- Income Statement

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, (6.2)% Sales returns, ($8,000) Sales, net, $130,000 = (6.2) Vertical Analysis- Income Statement

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, (57.0)% Cost of goods sold, ($74,100) Sales, net, $130,000 = (6.2) (57.0) Vertical Analysis- Income Statement

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, % Gross profit, $55,900 Sales, net, $130,000 = (6.2) (57.0) 43.0 Vertical Analysis- Income Statement

Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129, % Cash, $3,900 Total Assets, $129,200 = 3.0 Total Assets $129, Vertical Analysis- Balance Sheet

Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129, Total Assets $129, % Receivables (net), $7,600 Total Assets, $129,200 = 5.9 Vertical Analysis- Balance Sheet

29 Using this approach on the rest of the assets, this section can be completed. Vertical Analysis- Balance Sheet

Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129, Total Assets $129, Vertical Analysis- Balance Sheet

31 In calculating vertical analysis amounts for liabilities and stockholders’ equity, all items are divided by “total liabilities and stockholders’ equity.” 3.9% Accounts Payable, $5,000 Total L& SE, $129,200 = Vertical Analysis- Balance Sheet

32 Continue using Cooper Company information on previous slides and on pages

33 Earnings per share is probably the most frequently cited ratio in a financial analysis. Net Income - Preferred Dividends Average Common Shares Outstanding Ratio Analysis Stockholders’ Profitability Ratios

34 Earnings per share is probably the most frequently cited ratio in a financial analysis. $11,000- $1,200 5,400 = $1.81 Ratio Analysis Stockholders’ Profitability Ratios

35 Price/earnings is used by actual and potential stockholders to evaluate the attractiveness of an investment in the stock of a company. Market Price per Common Share Earnings per Share Ratio Analysis Stockholders’ Profitability Ratios

36 Price/earnings is used by actual and potential stockholders to evaluate the attractiveness of an investment in the stock of a company. $14.25 $1.81 = 7.9 times Ratio Analysis Stockholders’ Profitability Ratios

37 Stockholders’ Profitability Ratios Dividend yield provides the stockholders’ their individual rates of return based on the actual dividends received as compared with the ending market price of the stock. Dividends per Common Share Market Price per Common Share $1.00 $14.25 = 7.0% Ratio Analysis

38 Profit margin is used to evaluate a company’s efficiency in controlling costs and expenses in relation to sales. Net Income Net Sales Ratio Analysis Company Profitability Ratios

39 Profit margin is used to evaluate a company’s efficiency in controlling costs and expenses in relation to sales. $11,000 $130,000 = 8.5% Ratio Analysis Company Profitability Ratios

40 Return on total assets indicates how efficiently a company uses its economic resources. Net Income + Interest Expense (net of tax) Average Total Assets Ratio Analysis Company Profitability Ratios

41 $11,000 + ($3,000 x 0.7) ($129,200 + $112,000)/2 = 10.9% Ratio Analysis Company Profitability Ratios Return on total assets indicates how efficiently a company uses its economic resources.

42 Return on stockholders’ equity shows the residual returns on the owners’ equity. Net Income Average Stockholders’ Equity Ratio Analysis Company Profitability Ratios

43 Return on stockholders’ equity shows the residual returns on the owners’ equity. Company Profitability Ratios $11,000 ($93,000 + $79,000)/2 = 12.8% Ratio Analysis

44 The current ratio is used to evaluate a company’s short-run liquidity. Current Assets Current Liabilities Ratio Analysis Liquidity Ratios 1.Cash 2.Short-term investments 3.Accounts receivable 4.Inventory 5.Prepaid expenses/supplies

45 The current ratio is used to evaluate a company’s short-run liquidity. $21,400 $11,200 = 1.91 times Ratio Analysis Liquidity Ratios

46 Ratio Analysis The acid-test ratio is a more severe test of a company’s short-term debt-paying abilities. Quick Assets Current Liabilities Liquidity Ratios 1.Cash 2.Short-term investments 3.Accounts receivable

47 Ratio Analysis The acid-test ratio is a more severe test of a company’s short-term debt-paying abilities. Liquidity Ratios $11,500 $11,200 = 1.03 times

48 Inventory turnover indicates the number of times the inventory is “turned over” or sold during that period. Cost of Goods Sold Average Inventory Ratio Analysis Activity Ratios

49 Activity Ratios $74,100 ($8,900 + $10,100)/2 = 7.8 times or 47 days Ratio Analysis Inventory turnover indicates the number of times the inventory is “turned over” or sold during that period.

50 Net Credit Sales Average Net Receivables Receivables turnover indicates how many times receivables are “turned over” or collected each period. Activity Ratios Ratio Analysis

51 Net Credit Sales Average Net Receivables $130,000 x 0.70 Activity Ratios ($7,600 + $8,600)/2 = 11.2 times or 33 days Ratio Analysis Receivables turnover indicates how many times receivables are “turned over” or collected each period.

52 Activity Ratios Cost of Goods Sold Average Accounts Payable Ratio Analysis The payables turnover ratio measures the number of times accounts payable turns over during the year.

53 The payables turnover ratio measures the number of times accounts payable turns over during the year. Activity Ratios Cost of Goods Sold Average Accounts Payable $74,100 ($5,000 + $6,600)/2 = 12.8 times or 29 days Ratio Analysis

54 The debt ratio indicates the percentage of total assets contributed by creditors. Stability Ratios Total Liabilities Total Assets Ratio Analysis

55 The debt ratio indicates the percentage of total assets contributed by creditors. Stability Ratios Total Liabilities Total Assets $36,200 $129,200 = 28% Ratio Analysis

56 Times interest earned is used to evaluate the ability of a company to cover its interest obligations through its annual earnings. Stability Ratios Pretax Operating Income Interest Expense Ratio Analysis

57 Stability Ratios $15,700 + $3,000 $3,000 = 6.2 times Ratio Analysis Times interest earned is used to evaluate the ability of a company to cover its interest obligations through its annual earnings.

58 Book value per common share shows the net assets per share of stock. Stability Ratios Common Stockholders’ Equity Outstanding Common Shares Ratio Analysis

59 Stability Ratios $93,000 - ($140 x 150) 5,400 =$ per common share Ratio Analysis Book value per common share shows the net assets per share of stock.

60 C hapter 6 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.