13-1 13 FINANCIAL ANALYSIS: THE BIG PICTURE 13-2 Financial Accounting, Seventh Edition Learning Learning Objectives Objectives After studying this chapter, you should be able to: 13-3 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 Preview of Chapter 13 Financial Accounting Seventh Edition Kimmel Weygandt Kieso 13-4 Sustainable Sustainable Income Income Sustainable Income - Net income adjusted for irregular items Irregular Items Irregular items are separately identified on the income statement Two types are: Discontinued operations Extraordinary items These “irregular” items are reported net of income taxes 13-5 LO Understand the concept of sustainable income LO Indicate how irregular items are presented Sustainable Sustainable Income Income Illustration 13-1 Components of the income statement 13-6 LO Indicate how irregular items are presented Sustainable Sustainable Income Income 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 13-7 LO Indicate how irregular items are presented Sustainable Sustainable Income Income Illustration: Rozek Inc has revenues of $2.5 million and expenses of $1.7 million from continuing operations in 2014 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) Illustration 13-2 13-8 LO Sustainable Sustainable Income Income 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.” 13-9 LO Indicate how irregular items are presented Sustainable Sustainable Income Income 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? ROZEK INC Illustration 13-3 Income Statement (partial) For the Year Ended December 31, 2014 Advance slide in presentation mode to reveal solution 13-10 LO Indicate how irregular items are presented Appendix Appendix 13A 13A Comprehensive Ratio Analysis Profit Margin - Or rate of return on sales, is a measure of the percentage of each dollar of sales that results in net income Illustration 13A-18 High-volume (high inventory turnover) businesses such as grocery stores and pharmacy chains generally have low profit margins 13-64 LO Evaluate a company comprehensively using ratio analysis Appendix Appendix 13A 13A Comprehensive Ratio Analysis Asset Turnover - Measures how efficiently a company uses its assets to generate sales Illustration 13A-19 The average asset turnover for utility companies is 45, for example, while the grocery store industry has an average asset turnover of 3.49 13-65 LO Evaluate a company comprehensively using ratio analysis Appendix Appendix 13A 13A Comprehensive Ratio Analysis You can analyze the combined effects of profit margin and asset turnover on return on assets for Chicago as shown Illustration 13A-20 13-66 LO Evaluate a company comprehensively using ratio analysis Appendix Appendix 13A 13A Comprehensive Ratio Analysis 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 13-67 LO Evaluate a company comprehensively using ratio analysis Appendix Appendix 13A 13A Comprehensive Ratio Analysis Earnings Per Share - A measure of the net income earned on each share of common stock Illustration 13A-22 EPS is not compared between companies because of the wide variations in the number shares outstanding among companies 13-68 LO Evaluate a company comprehensively using ratio analysis Appendix Appendix 13A 13A Comprehensive Ratio Analysis 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 13-69 LO Evaluate a company comprehensively using ratio analysis Appendix Appendix 13A 13A Comprehensive Ratio Analysis 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 13-70 LO Evaluate a company comprehensively using ratio analysis Key Points 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 LO Compare the accounting for Irregular items and the income statement format under GAAP and IFRS Key Points 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 twostatement approach LO Compare the accounting for Irregular items and the income statement format under GAAP and IFRS Key Points 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 LO Compare the accounting for Irregular items and the income statement format under GAAP and IFRS 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 13-74 LO Compare the accounting for Irregular items and the income statement format under GAAP and IFRS IFRS Practice 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 13-75 LO Compare the accounting for Irregular items and the income statement format under GAAP and IFRS IFRS Practice 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 13-76 LO Compare the accounting for Irregular items and the income statement format under GAAP and IFRS IFRS Practice 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 13-77 LO Compare the accounting for Irregular items and the income statement format under GAAP and IFRS Copyright Copyright “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.” 13-78 [...]... apply vertical analysis Comparative Comparative Analysis Analysis Illustration 13-13 Vertical analysis of Income statements These results indicate the company shifted toward equity financing by relying less on debt and by increasing the amount of retained earnings 13-29 LO 5 Describe and apply vertical analysis Comparative Comparative Analysis Analysis Illustration 13 -14 Vertical analysis of an income... (70,000) LO 3 Comparative Comparative Analysis Analysis Analyzing financial statements involves: Comparison Bases 13-23 Basic Tools Intracompany Horizontal analysis Intercompany Vertical analysis Industry averages Ratio Analysis Comparative Comparative Analysis Analysis Horizontal Analysis Also called trend analysis, is a technique for evaluating a series of financial statement data over a period... those of General Mills, vertical analysis eliminates the impact of this size difference for our analysis 13-31 LO 5 Describe and apply vertical analysis Ratio Ratio Analysis Analysis Ratio analysis expresses the relationship among selected items of financial statement data Financial Ratio Classifications 13-32 Liquidity Solvency Profitability Measures shortterm ability of the company to pay its maturing... assuming 2011 is the base year Solution 13-27 Advance slide in presentation mode to reveal solution LO 4 Describe and apply horizontal analysis Comparative Comparative Analysis Analysis 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... 13-12 Horizontal analysis of Income statements 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) 13-26 LO 4 Describe and apply horizontal analysis Summary financial information for Rosepatch Company is as follows Compute the amount and percentage changes in 2012 using horizontal analysis, assuming... applied to the balance sheet and income statement LO 4 Describe and apply horizontal analysis Comparative Comparative Analysis Analysis Illustration 13-11 Horizontal analysis of balance sheets Helpful Hint: When using horizontal analysis, be sure to examine both dollar amount changes and percentage changes 13-25 LO 4 Describe and apply horizontal analysis Comparative Comparative Analysis Analysis Illustration... LO 3 Explain the concept of comprehensive income Sustainable Sustainable Income Income Illustration of Comprehensive Income Accounting standards require companies to adjust most investments in stocks and bonds up or down to their market price at the end of each accounting period Illustration: During 2 014 Stassi Company purchased IBM stock for $10,000 as an investment At the end of 2 014 Stassi was... Vertical analysis of an income statements 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 13-30 LO 5 Describe and apply vertical analysis Comparative Comparative Analysis Analysis Illustration 13-15 Intercompany comparison by vertical analysis Vertical analysis also enables a comparison of companies... 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? 13-17 LO 3 Explain the concept of comprehensive income Sustainable Sustainable Income Income Illustration 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... Income For the Year Ended December 31, 2 014 Complete Income Statement 13-21 LO 3 Explain the concept of comprehensive income Illustration: In its draft 2 014 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