1. 18-1 Prepared by Coby Harmon University of California, Santa Barbara Westmont College

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

60. 18-60 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

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

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

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