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

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

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

13-5 LO 2 Indicate how irregular items are presented. Sustainable 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 Sustainable Income Components of the income statement Illustration 13-1 LO 2 Indicate how irregular items are presented.

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. Sustainable Income LO 2 Indicate how irregular items are presented.

13-8 Illustration: Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in 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). Sustainable Income 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.” Sustainable Income LO 2 Indicate how irregular items are presented.

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? Sustainable Income Advance slide in presentation mode to reveal solution. Illustration 13-3 LO 2 Indicate how irregular items are presented. ROZEK INC. Income Statement (partial) For the Year Ended December 31, 2014

13-11 Are these considered Extraordinary Items? YES NO NO YES Sustainable Income  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. LO 2 Indicate how irregular items are presented.

13-12 NO YES NO Sustainable Income  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. LO 2 Indicate how irregular items are presented. Are these considered Extraordinary Items?

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13-14 Sustainable Income LO 2 Indicate how irregular items are presented.  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

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13-16 Sustainable Income 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 Sustainable Income LO 3 Explain the concept 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 Sustainable Income LO 3 Explain the concept 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 Sustainable Income LO 3 Explain the concept of comprehensive income. Combined statement of income and comprehensive income. Illustration 13-5

13-20 Format Two - Comprehensive Income Sustainable Income LO 3 Explain the concept of comprehensive income. Separate component of Stockholders’ Equity. Illustration 13-6

13-21 Complete Income Statement Sustainable Income LO 3 Explain the concept of comprehensive income. 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 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. Comparative Analysis Horizontal Analysis

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

13-26 Illustration Horizontal analysis of Income statements Comparative Analysis 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). LO 4 Describe and apply horizontal analysis.

13-27 Summary financial information for Rosepatch Company is as follows. Solution LO 4 Describe and apply horizontal analysis. 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. Comparative Analysis Vertical Analysis

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

13-31 Illustration 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. Comparative Analysis Vertical analysis also enables a comparison of companies of different sizes.

13-32 Profitability Measures the income or operating success of a company for a given period of time. Solvency 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 Analysis Ratio analysis expresses the relationship among selected items of financial statement data. Liquidity Measures short- term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Financial Ratio Classifications

13-33 Ratio Analysis Illustration LO 6 Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability. Liquidity Ratios

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13-35 Ratio Analysis Illustration LO 6 Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability. Solvency Ratios

13-36 Ratio Analysis Illustration LO 6 Profitability Ratios

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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 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). LO 7 Understand the concept of quality of earnings.  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. Quality of Earnings Alternative Accounting Methods Pro Forma Income

13-40 Quality of Earnings LO 7 Understand the concept of quality of earnings. 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 Quality of Earnings LO 7 Understand the concept of quality of earnings. 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 Price-Earnings Ratio

13-42 Quality of Earnings LO 7 Understand the concept of quality of earnings. Illustration Illustration 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 LO 7 Understand the concept of quality of earnings. 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 LO 7 Understand the concept of 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 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using ratio analysis.

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

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

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

13-49 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 current cash debt coverage, the accounts receivables turnover, the average collection period, the inventory turnover, and days in inventory. Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using ratio analysis.

13-56 Solvency 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. Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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) Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using ratio analysis.

13-61 Profitability Ratios Measure the income or operating success of a company for a given period of time. Appendix 13A Comprehensive Ratio Analysis Illustration 13A-15 Relationships among profitability measures LO 8 Evaluate a company comprehensively using ratio analysis.

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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Illustration 13A-19 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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. Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using ratio analysis.

13-68 Earnings Per Share - A measure of the net income earned on each share of common stock. Illustration 13A-22 Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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. Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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. Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using 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 LO 9 Compare the accounting for Irregular items and the income statement format under GAAP and IFRS.

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 LO 9 Compare the accounting for Irregular items and the income statement format under GAAP and IFRS.

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. LO 9 Compare the accounting for Irregular items and the income statement format under GAAP and IFRS.

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 LO 9 Compare the accounting for Irregular items and the income statement format under GAAP and IFRS.

13-76 IFRS Practice LO 9 Compare the accounting for Irregular items and the income statement format under GAAP and IFRS. 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 LO 9 Compare the accounting for Irregular items and the income statement format under GAAP and IFRS.

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