CHAPTER Accounting as a Form of Communication QUESTIONS Business is concerned with all the activities necessary to provide the members of an economic system with goods and services Some businesses are organized to earn a profit, whereas others are organized for some other purpose Regardless, all businesses are organized to provide goods and/or services to their customers An asset is a future economic benefit to a business Cash, accounts receivable, merchandise inventories, and property and equipment are all examples of assets They are located on the left side of the accounting equation A liability is an obligation of a business Assets and liabilities are related in that most liabilities are satisfied by using assets, most often in the form of cash They are located on the right side of the equation along with owners’ equity The three forms of business entities are sole proprietorships, partnerships, and corporations The types of activities in which companies engage are financing, investing, and operating To start a new business, such as renting bicycles and skis, requires initial financing, such as initial contributions by the owners and loans by a bank Next, the business would need to invest in the assets it will rent—that is, bicycles and skis Once investments in assets are made, the business would earn revenue by renting out bicycles and skis The business would also incur various operating expenses, such as wages, advertising, and taxes Accounting is a communication process Its purpose is to provide economic information about an organization that will be useful to those who need to make decisions regarding that entity For example, information provided by an accountant about an entity is useful to a banker in reaching a decision about whether to loan money to a business Financial accounting and management accounting differ with regard to the users of the information provided by the two branches of the discipline Management accounting is the branch of accounting that provides management with information to facilitate the planning and control functions The information provided by a management accounting system can be tailored to meet the needs of managers 1-1 © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 1-2 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL Alternatively, financial accounting is concerned with the preparation of general-purpose financial statements for use by both management and outsiders Because the information provided by financial accounting must meet the needs of many different groups, it is necessary to rely on a set of generally accepted accounting principles in preparing the financial statements © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER • ACCOUNTING AS A FORM OF COMMUNICATION 1-3 Many different groups rely on accounting information in making decisions For example, investors and potential investors rely on financial statements and related disclosures in deciding whether to sell or buy stock in a company This group is particularly concerned with the recent profitability of the company as shown on the income statement Bankers and other creditors need information to decide whether to loan money to a company or whether to extend an existing loan Many different government agencies have information needs that are specified by law The Internal Revenue Service needs to know about a company’s profitability in levying taxes on it The Securities and Exchange Commission, the Interstate Commerce Commission, and the Federal Trade Commission also depend on the information provided by accountants in making decisions Labor unions need information about a company’s profitability and financial position in negotiating contracts with the company for the employees Trade associations rely on the information provided in financial statements in compiling information for use by their members Stockholders’ equity or owners’ equity is the difference between the assets of an entity and its liabilities Thus, it represents the claims of the owners to the assets of the business Therefore, it includes the contributions of the owners (e.g., capital stock) and retained earnings 10 The two distinct elements of owners’ equity in a corporation are contributed capital and retained earnings Contributed capital, as represented by capital stock, is the original contribution to the company by the owners Retained earnings represents the claims of the owners to the assets of the business These claims result from the earnings of the company that have not been paid out in dividends 11 The purpose of a balance sheet is to show the financial position of an entity as of a particular point in time It consists of three distinct elements: assets, liabilities, and owners’ equity 12 A balance sheet should be dated as of a particular day It is a statement of financial position and shows the assets, liabilities, and owners’ equity of a business at a particular point in time Unlike an income statement, it is not a flow statement and therefore is not dated for a particular period of time Balance sheets are typically prepared to coincide with the end of an accounting period, such as the end of the month or the end of the year 13 The cost principle is an accounting requirement to record an asset at the cost to acquire it and report it on subsequent balance sheets at this amount 14 The purpose of an income statement is to summarize the revenues and expenses of a company for a period of time It is an indicator of the profitability of an entity 15 An income statement should be dated for a particular period of time: for example, for the month of June or for the year ended December 31, 2014 The income statement is a flow statement because it summarizes revenues and expenses for a period of time Unlike a balance sheet, it is not an indication of position at any one particular point in time © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 1-4 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL 16 If Rogers has $55,000 in Retained Earnings to begin the year and net income for the year of $27,000, the ending balance in Retained Earnings would be $82,000 if no dividends were paid during the year Because the ending balance in Retained Earnings is $70,000, the company must have paid $12,000 in dividends 17 Various groups are involved in determining the rules companies must follow in preparing their financial statements In the United States, the Securities and Exchange Commission (SEC) has ultimate authority for companies whose securities are sold to the general public However, the SEC has relegated much of the standard setting to the private sector in the form of the Financial Accounting Standards Board (FASB) Standard setters in the United States continue to work closely with those in the international community For instance, at one time, foreign companies that filed their financial statements with the SEC were required to adjust those statements to conform to U.S accounting standards The SEC dropped this requirement, as long as foreign companies follow the standards of the IASB However, there are significant differences between U.S and international standards; it may be some time before all differences are eliminated 18 In 2002, Congress passed the Sarbanes-Oxley Act The act was a direct response to corporate scandals and was an attempt to bring about major reforms in corporate accountability and stewardship, given the vast numbers of stockholders, creditors, employees, and others affected in one way or another by these scandals Among the most important provisions in the act are the following: (1) the establishment of a new Public Company Accounting Oversight Board, (2) a requirement that the external auditors report directly to the company’s audit committee, and (3) a clause to prohibit public accounting firms who audit a company from providing any other services that could impair their ability to act independently in the course of their audit 19 The auditors may be in an excellent position to evaluate a company, but not because they have prepared the financial statements The preparation of the statements is the responsibility of management The role of the auditor is to perform various tests and procedures as a basis for rendering an opinion on the fairness of the presentation of the statements 20 We assume in the absence of evidence to the contrary that a business will continue indefinitely This assumption, known as the going concern assumption, helps to justify the use of historical costs in the statements For example, if we knew that a company was in the process of liquidation, it would not be appropriate to use historical costs in assigning an amount to such assets as land and buildings Instead, the current or market values of the assets would be more meaningful to a user of the balance sheet Because the normal assumption is that a business will continue indefinitely, the objectivity of historical cost makes it more attractive as a basis for valuation © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER • ACCOUNTING AS A FORM OF COMMUNICATION 1-5 21 Inflation, as evidenced by the changing value of the dollar, poses a problem for the accountant Accountants make the assumption in preparing a set of financial statements that the dollar is a stable measuring unit This assumption, called the monetary unit assumption, may or may not be accurate, depending on the level of inflation in the economy The higher the rate of inflation, the less reliable is the dollar as a measuring unit 22 Any profession must have a set of standards that govern the practice of the profession In accounting, generally accepted accounting principles, or GAAP, are those methods, rules, practices, and other procedures that have evolved over time and that govern the preparation of financial statements Two important points are worth noting about GAAP First, these principles are not static but rather change in response to changes in the ways companies conduct business Second, there is not a single, identifiable source of GAAP Both the private and public sectors have contributed to the development of generally accepted accounting principles 23 Although the Securities and Exchange Commission has the ultimate authority to determine the rules in preparing financial statements, it has to a large extent allowed the accounting profession, through the Financial Accounting Standards Board, to establish its own rules The SEC has at times taken an active role in the setting of accounting standards It has stepped in when it has believed that the profession has not acted quickly enough or in the correct manner Since its inception in 1934, the commission has been more involved in the enforcement of GAAP as a means of protecting the rights of investors than it has been in setting standards BRIEF EXERCISES LO BRIEF EXERCISE 1-1 TYPES OF BUSINESSES Students will provide a number of different examples of real companies that are manufacturers, retailers, and service providers LO BRIEF EXERCISE 1-2 FORMS OF ORGANIZATION When you own a share of stock in a corporation, you are part owner of that business In contrast, if you own one of the corporation’s bonds, you have made a loan to the company and you are one of its creditors © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 1-6 LO USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL BRIEF EXERCISE 1-3 BUSINESS ACTIVITIES The first activity for a new business is to secure financing Next, investing activities are needed to secure the necessary assets to then begin operating the business The order of the activities is financing, investing, and operating LO BRIEF EXERCISE 1-4 USERS OF ACCOUNTING INFORMATION Stockholders, creditors (including banks, bondholders, and suppliers), and government agencies are all examples of external users LO BRIEF EXERCISE 1-5 THE ACCOUNTING EQUATION AND THE BALANCE SHEET Assets = Liabilities + Stockholders’ Equity The two parts that make up stockholders’ equity are capital stock and retained earnings LO BRIEF EXERCISE 1-6 MONETARY UNIT The dollar is the monetary unit used in the United States, and the yen is used in Japan LO BRIEF EXERCISE 1-7 THE ROLE OF AUDITORS The external auditors not prepare the financial statements Management of the company is responsible for preparation of the statements The auditors provide an opinion as to the fairness of the financial statements LO BRIEF EXERCISE 1-8 MAKING ETHICAL DECISIONS The four steps in the model presented in the chapter to help in making ethical decisions are: Recognize an ethical dilemma Analyze the key elements in the situation List alternatives and evaluate the impact of each on those affected Select the best alternative © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER • ACCOUNTING AS A FORM OF COMMUNICATION 1-7 © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER Financial Statements and the Annual Report QUESTIONS The primary concern to an investor is the future cash to be received from the invest- ment However, this does not mean that the cash flows of the company that has been invested in are not relevant A relationship exists between the cash flows to the investor and those to the company For example, a company that does not consistently generate sufficient cash flows from its operations will not be able to pay cash dividends to the investors over a sustained time The understandability characteristic does not imply that someone must have an extensive accounting background to be able to use financial statements However, accounting information should be understandable to those who are willing to learn to use it properly In other words, the information should make sense to someone who spends the time required to have a basic understanding of accounting Relevance is the capacity of accounting information to make a difference in a financial decision For example, an income statement is relevant when the use of it has at least the potential to make a difference in an investment decision Comparability is the quality of accounting information that allows comparisons to be made between or among companies Without it, financial statements would be very limited in their value Financial decisions require choices to be made about the investment of limited resources Investors need assurance that the financial statements of companies that they are considering as investments are comparable Comparability is the quality of information that allows for comparisons to be made between two or more companies, whereas consistency is the quality that allows for comparisons to be made within a single entity from one accounting period to the next The concept of materiality is closely related to the size of a company For example, assume that a company must decide whether a $500 expenditure that will benefit future periods should be expensed immediately or capitalized (i.e., recorded as an asset) The decision cannot be made without considering the amount in relation to the size of the company An amount that is immaterial for a large multinational corporation may be material for a smaller business The IASB recognizes the same qualitative characteristics for useful information as does the FASB The two groups are working together on a joint conceptual framework project, of which the chapter on qualitative characteristics is completed A current asset is an asset that a company expects to realize in cash, sell, or consume during its normal operating cycle Therefore, accounts receivable, inventory, and supplies all meet this definition and are classified as current assets By their nature, the benefits from each of these assets will be realized during the normal operating cycle of the business The note payable will be classified on the balance sheet as long term until one year from its maturity date At that time, it should be reclassified from long term to current because it will be paid within the next year Any liability that will mature within one year of the date of the balance sheet should be classified as current, regardless of the original term of the loan (five years in this case) 10 Both capital stock and retained earnings represent claims of the stockholders on the assets of the business They differ, however, in the source of those claims Capital stock represents the claims of the stockholders that arise from their contributions of cash and other assets to the business Retained earnings represent the accumulated earnings, or net income, of the business since its inception less all dividends declared during that time 11 Working capital is an absolute measure of liquidity That is, it is the total dollar amount of current assets minus current liabilities One of the problems with working capital as a measure of liquidity is that it does not allow someone to compare the relative liquidity of two companies of different sizes Even within a single company, it may be difficult to compare the relative liquidity of the company over time if the company has grown The current ratio (current assets divided by current liabilities) overcomes these deficiencies by focusing attention on the relative size of the current assets and current liabilities 12 Capital structure refers to the right side of a balance sheet All items on the right side of the balance sheet represent claims against the assets of the business: liabilities are the claims of outsiders, and stockholders’ equity is the claim of the owners on the assets of the business The capital structures of all companies differ in that some companies rely more on outsiders to provide assets, whereas others rely more on the owners to provide the necessary assets to run the business 13 The single-step income statement shows a subtotal for all expenses and deducts this amount from total revenues The weakness of the single-step form for the income statement is that relationships between key items on the statement are not highlighted For example, the relationship between sales revenue and the cost of the products sold is very important for a product-oriented company The difference between the two amounts is called gross profit and would appear on a multiple-step statement but not in the single-step form 14 A statement of retained earnings links the income statement and the balance sheet in the following way A statement of retained earnings shows the beginning balance in the account, the addition (deduction) to the account for the net income (loss) of the period, and any deduction from the account for dividends The beginning balance in Retained Earnings is taken from the balance sheet at the end of the prior period The income statement indicates the net income for the period The ending balance in Retained Earnings appears on the balance sheet at the end of the period 15 An audit of a set of financial statements does not ensure that the statements contain no errors Because of the sheer number of transactions entered into during a period of time, it would be impossible for an auditor to check every single transaction to determine that it was correctly recorded Instead, through various types of tests, the auditor renders an opinion as to whether the statements are free of material misstatement 16 The first note is the summary of significant accounting policies As the name implies, the purpose of this note is to summarize all of the company’s important accounting policies, such as those relating to the method of depreciating assets and the method for valuing inventories BRIEF EXERCISES LO BRIEF EXERCISE 2-1 OBJECTIVES OF FINANCIAL REPORTING The overriding objective of financial reporting is to provide financial information to permit users of the information to make informed decisions Financial statements not report the value of the reporting entity, but should provide useful information to allow users to make estimates of the value of the entity LO BRIEF EXERCISE 2-2 QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION The two fundamental qualities that make accounting information useful are relevance and faithful representation Financial information is enhanced when it is understandable, comparable, and consistent CHAPTER 12 The Statement of Cash Flows QUESTIONS The purpose of the statement of cash flows is to summarize an entity’s cash flows from operating, investing, and financing activities during a period Because it is concerned with activity for a specific period of time, the statement is similar to the income statement However, they differ in two important respects First, with a few exceptions, the income statement deals only with operating activities Second, the income statement is on an accrual basis, while the statement of cash flows reports operating activities on a cash basis A cash equivalent is an item that is readily convertible to a known amount of cash and has an original maturity of three months or less These items, such as Treasury bills and money market funds, present very little risk to the holder; therefore, they are included with cash for the purpose of preparing the statement of cash flows That is, purchases and sales of cash equivalents are not considered significant activities to be separately reported on the statement The down payment of $20,000 is a cash outflow that would be reported in the Investing Activities section of the statement of cash flows The issuance of the promissory note for $60,000 would appear in a supplemental schedule of noncash investing and financing activities A 60-day Treasury bill would be classified as a cash equivalent and combined with cash on the balance sheet Therefore, the purchase of the Treasury bill would not be reported as an investing activity However, the purchase of Motorola stock would appear as a cash outflow in the Investing Activities section of the statement of cash flows Companies cannot continue in business if they not generate positive cash flows from operating activities Also, over a period of years, a company cannot continue to borrow more than it repays, nor can it issue capital stock indefinitely Thus, you would not expect a net cash outflow from financing activities over a sustained period of time However, many companies regularly experience a net cash outflow from investing activities A company must at a minimum replace existing assets and in many cases acquire additional plant and equipment to remain competitive At the same time, disposals of long-term assets may be fairly common, but usually they will not generate significant amounts of cash inflow 12-1 © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 12-2 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL The student is correct in that it is simple enough to find the net inflow or outflow of cash during the period But this is only the starting point in preparing the statement of cash flows First, all of the balance sheet accounts must be analyzed to find the explanations for the increases and decreases in cash during the period Second, each of these inflows and outflows must be classified as either operating, investing, or financing activities © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER 12 • THE STATEMENT OF CASH FLOWS 12-3 The only accurate part of these statements is that depreciation is often one of the largest items in the Operating Activities section of the statement However, this is merely a result of using the indirect method to prepare this section In computing net income, depreciation is deducted Therefore, under the indirect method, it must be added back to net income because it is a noncash expense Depreciation does not in any way generate cash There is considerable debate over which method is most useful Many accountants, as well as users of the statements, believe that the direct method, with its emphasis on cash receipts and cash payments, provides the most information Others believe that the indirect method is better because it focuses attention on the differences between net income and net cash provided by operations Accounting standards allow the use of either method, but companies are strongly encouraged to use the direct method Under the indirect method, net income is reported at the top of the Operating Activities section, and adjustments are made to convert income to a cash basis Sales revenue is included in net income However, on a cash basis, we are interested in cash collections from sales, not the sales on an accrual basis A decrease in accounts receivable indicates that cash collections exceeded sales revenue Therefore, the excess is added back to the net income of the period 10 Inventory is analyzed to determine the purchases of the period Cost of goods sold decreases the Inventory account, and purchases increase it After the purchases of the period are found, they are added to the beginning balance in the Accounts Payable account The difference between the addition of these amounts and the ending balance in Accounts Payable is the amount of cash payments 11 A profitable year does not guarantee a large cash balance at the end of the year A large share of the profits may be returned to the stockholders in the form of cash dividends Investments in new plant and equipment require significant amounts of cash, as does the repayment of various forms of borrowing Likewise, a substantial increase in sales on account results in an increase in sales and net income for the year but not necessarily an increase to cash if cash is not collected on a timely basis 12 Yes, it is possible to report a net loss and still experience a net increase in cash First, a company could report large noncash charges against net income, such as depreciation and various types of losses Thus, it is possible that net cash provided by operating activities is positive even though a net loss is reported Second, the net loss deals only with operating activities It is possible that a net cash inflow was provided by either investing or financing activities, or both © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 12-4 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL 13 Regardless of which method is used, a decrease in income taxes payable means that cash paid to the government during the period exceeded income tax expense on the income statement Under the direct method, the amount of cash paid is reported as a cash outflow in the Operating Activities section of the statement If the indirect method is used, the decrease in taxes payable is deducted from net income to arrive at net cash flow from operations 14 The requirement to separately disclose income taxes paid and interest paid when the indirect method is used is a compromise Accounting standards strongly encourage companies to use the direct method because each major operating cash receipt and payment is reported in the Operating Activities section of the statement However, if a company chooses to use the indirect approach, it is still required to report separately how much cash was actually paid to the government in taxes and to creditors in interest 15 An argument can be made that it is inconsistent to report interest paid in the Operating section and dividends paid in the Financing section Both represent returns to providers of capital: interest to creditors and dividends to stockholders Furthermore, the cash raised from each of these sources—the amounts borrowed from creditors and the amounts contributed by stockholders—is classified as an inflow in the Financing section of the statement The rationale normally given for this treatment is that interest enters into the determination of net income; thus, the cash expended in interest should appear in the Operating section Many believe that this is illogical and that both interest paid and dividends paid belong in the Financing section 16 An analysis of the Prepaid Rent account can be used to find the amount of cash paid for rent: Beginning prepaid rent + Cash payments – Rent expense = Ending prepaid rent $ 9,600 X (45,900) $ 7,300 $9,600 + X – $45,900 = $7,300 X = $43,600 17 The purchase of 2,000 shares of treasury stock at $20 per share would be reflected on the statement of cash flows as a cash outflow of $40,000 in the Financing Activities section of the statement © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER 12 • THE STATEMENT OF CASH FLOWS 12-5 18 The effect of the sale of the truck can be identified and analyzed as follows: Identify and Analyze ACTIVITY: ACCOUNTS: Investing Cash Increase Delivery Truck Decrease Accumulated Depreciation Decrease Loss on Sale Increase Balance Sheet and Income Statement STATEMENT[S]: Balance Sheet ASSETS Cash 9,000 Accumulated Depreciation* 14,000** Delivery Truck (25,000) = LIABILITIES Income Statement + STOCKHOLDERS’ EQUITY (2,000) REVENUES – EXPENSES Loss on Sale 2,000*** = NET INCOME (2,000) *The Accumulated Depreciation account has decreased It is shown as an increase in the equation above because it is a contra account and causes total assets to increase **$25,000 - $11,000 = $14,000 ***$11,000 - $9,000 = $2,000 Two items would be reported on a statement of cash flows using the indirect method First, the loss of $2,000 would be added back to net income in the Operating Activities section Second, the cash received of $9,000 would be reported as a cash inflow in the Investing Activities section 19 Since the company neither bought nor sold any patents during the year, the decrease in the balance in the account of $4,000 represents the amortization of the patent for the year Amortization is a noncash expense, as is depreciation, and is added back to net income under the indirect method 20 A stock dividend does not involve the inflow or outflow of cash and therefore is not reported on a statement of cash flows It is questionable whether it is even a significant noncash activity that should be reported in the supplemental schedule It could be argued that the issuance of stock in connection with a stock dividend is a financing activity and that it should be included on the schedule If a 10% stock dividend is included on the schedule, it would be reported at the market value of the shares issued 21 The information needed to determine a company’s cash flow adequacy comes from two sources The numbers in the numerator of the ratio, net cash provided by operating activities and capital expenditures, appear on the statement of cash flows The amount of average annual debt maturing over the next five years in the denominator can be found in a note to the financial statements © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 12-6 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL BRIEF EXERCISES LO BRIEF EXERCISE 12-1 PURPOSE OF THE STATEMENT OF CASH FLOWS A statement of cash flows is needed to explain why cash changed during the period and to categorize the explanations for the change in cash into operating, investing, and financing activities The income statement summarizes performance on an accrual basis The statement of cash flows complements the accrual-based income statement by allowing users to assess a company’s performance on a cash basis LO BRIEF EXERCISE 12-2 CASH EQUIVALENTS A 60-day certificate of deposit is a cash equivalent and is included with cash on the balance sheet Therefore, buying a CD is not considered an investing activity as the company is just using cash to buy a cash equivalent LO BRIEF EXERCISE 12-3 THREE TYPES OF ACTIVITIES F O I O I F F I LO BRIEF EXERCISE 12-4 DIRECT VERSUS INDIRECT METHOD I D I I I D I D LO BRIEF EXERCISE 12-5 DIRECT METHOD $12,000 $(17,000) $(6,000) $(27,000) © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER 12 • THE STATEMENT OF CASH FLOWS LO BRIEF EXERCISE 12-6 INDIRECT METHOD D A A D A D A A LO 12-7 BRIEF EXERCISE 12-7 CASH FLOW ADEQUACY Cash flow adequacy = (Cash from operating activities – Capital expenditures)/ Average amount of debt maturing over next five years ($1,500,000 – $900,000)/($750,000/5) = $600,000/$150,000 = 4.0 LO BRIEF EXERCISE 12-8 WORK SHEET Operating: D Operating: A Operating: A Investing: D Operating: D Financing: A © 2015 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER 13 Financial Statement Analysis QUESTIONS The inventory valuation method used by a company will have a significant effect on many ratios Depending on the relative movement of prices, the choice between LIFO and FIFO will result in significantly different amounts reported for inventory For example, in a period of rising prices, the use of LIFO will reduce inventory (relative to what it would have been under FIFO) and thus reduce the current ratio and the acidtest ratio The inventory turnover ratio will differ as well, because LIFO will result in more cost of goods sold expense Thus, all other things being equal, in a period of rising prices, a LIFO company will report a higher turnover of inventory than a FIFO company The LIFO company’s cash flow will be better because it will pay less in taxes Thus, the various ratios that involve cash from operations will be affected Finally, the profitability ratios will be affected by the choice of an inventory method For example, the LIFO company will report lower profits and thus have a lower profit margin One of the difficulties in comparing a company’s ratios with industry standards is that the standards are an average for all companies surveyed First, your company may be much larger or smaller than the average company in the survey Second, many large companies today are conglomerates, and their operations cross over the traditional boundaries of any one industry This makes comparison with industry standards difficult Finally, your company may use different accounting methods than most others in the survey If your company uses straight-line depreciation but a majority of the sample companies use accelerated depreciation, comparisons can be difficult Companies should use caution when comparing industry averages and use this technique as one of several possible methods of analysis Published financial statements, as well as those often used by management, are based on historical costs and have not been adjusted for inflation Trend analysis is one type of analysis that must be performed with particular caution if inflation is significant An increase in sales, for example, may be due to an increase in prices, rather than to an increase in the number of units sold Inflation affects the various financial statements differently Some period expenses, such as advertising, are usually not seriously misstated in historical cost terms However, depreciation based on costs paid for assets that are 30 years old will be much different from depreciation adjusted for the effects of inflation The analysis of financial statements over a series of years is called horizontal analysis For example, by looking for trends in certain costs over a series of years (thus, the name trend analysis), the analyst is able to more accurately predict future costs Common-size financial statements are statements in which all amounts are stated as a percentage of one selected item on the statement, such as net sales Thus, vertical analysis of a single year’s income statement will help the analyst discern the relative amounts incurred for various costs Rising costs to either manufacture or purchase inventory could be responsible for a decline in gross profit in the face of an increase in sales Assume that 1,000 units of a product are sold with a unit cost of $80 and a selling price of $100 Sales total $100,000, and gross profit is $20,000 Assume that in the following year, the company raises the selling price to $115 because of rising costs If the cost to make a unit goes up to $96 and the company sells another 1,000 units, sales will increase by 15% to $115,000, but gross profit will decrease to 1,000 × ($115 – $96), or $19,000—a decrease in gross profit of 5% The composition of current assets indicates the relative size of cash, accounts receivable, inventory, and other short-term assets A relatively large balance in inventory may indicate that a company is not turning over its products quickly enough Similarly, a large accounts receivable balance could signal a problem in the collection department Finally, a large cash balance may be a sign that the company is not taking advantage of short-term investment opportunities Ratios can be categorized according to their use in performing three types of analysis: (1) liquidity analysis, (2) solvency analysis, and (3) profitability analysis The first stage in the operating cycle for a manufacturer is the purchase of raw material and its transformation into a final product The second step is the sale of the product, and the third is the collection of any receivable from credit granted to the customer The operating cycle differs for a retailer in that a finished product is purchased from a wholesaler and there is not the time involved in production Current assets are reported on a balance sheet in the order of their nearness to cash, or liquidity Cash is obviously presented first, followed by short-term investments Accounts receivable, one step removed from cash, are shown next, and then inventory Because prepaid assets, such as supplies or insurance paid for in advance, will not be converted into cash, they are normally reported last in the Current Assets section of the balance sheet 10 A relatively low acid-test, or quick, ratio compared with the current ratio probably indicates a large inventory balance Large amounts of inventory may be normal for a company; on the other hand, they could signal problems in moving obsolete items The inventory turnover ratio for the most recent period should be compared with those of prior periods to determine whether there has been a decrease in the number of turns per year A less likely explanation for a low quick ratio compared with the current ratio would be large balances in various prepayments, such as supplies and insurance 11 All turnover ratios are a measure of the activity for a period compared with the investment necessary to carry on that activity For example, the inventory turnover ratio measures the relationship between inventory sold, on a cost basis, and the average amount of inventory on hand during that time period The base is the average inventory because it is divided into an activity measure for the entire period— that is, cost of goods sold 12 An accounts receivable turnover of nine times translates to an average number of days in receivables of 40 (360/9) If the credit department extends terms of 2/10, n/30, investigation of the company’s actual credit policies is warranted For example, the department may routinely give customers up to 40 or 50 days to pay If this policy does not create any cash flow problems, why have terms of 2/10, n/30? Alternatively, the average time to collect may be an indication that the credit department is extending credit to customers who are not good credit risks 13 One possible explanation for a decrease in inventory turnover is slow-moving items Caution must be used, however, because a low inventory turnover may simply be a seasonal phenomenon For example, the ratio for the third quarter of the year should be compared with that of the third quarter of the prior year Problems in the sales department may also partially explain a low turnover of inventory Or, the company may be pricing itself out of the market and need to consider lowering its prices to meet the competition 14 A manufacturer’s operating cycle runs from the purchase of raw materials, to the transformation of the materials into a final product, to sale, to the collection of any receivable This differs from the operating cycle of a service business because the latter does not technically sell a product Service businesses must look for alternative measures of efficiency For example, an airline would be interested in the average amount of time elapsed between the sale of a ticket and collection from the passenger A public accounting firm might want to know the average length of time that passes after an audit is finished before the client pays the bill 15 Liquidity analysis is concerned with the ability of the company to pay its debts as they are due and thus focuses on the current assets and liabilities Solvency is the ability to stay in business over the long run The debt-to-equity ratio and the debt service coverage ratio are two measures of the firm’s solvency 16 The debt service coverage ratio is superior to the times interest earned ratio as a measure of solvency for two reasons First, the ratio considers the need to pay both interest and principal, whereas the times interest earned ratio deals only with interest Second, the necessary payments to service debt are compared with the cash available to pay the debt, while the times interest earned ratio uses an accrual income number in its numerator 17 Both are right Many different ratios are used to assess the relative mix of a company’s capital structure The debt-to-equity ratio measures the amount of outstanding debt relative to the amount of stockholders’ equity An alternative measure is to divide the same debt by the total assets of the company A different ratio will obviously result, but as long as the same measure is used consistently, either ratio is an indicator of solvency 18 The debt service coverage ratio measures the amount of cash generated from operating activities that is available to repay the interest and any maturing debt A loan officer is primarily concerned with the company’s ability to meet interest and principal payments on time and, therefore, would be very interested in this ratio 19 Dividends are not a legal obligation, but they often become an expectation on the part of stockholders Therefore, when computing the cash available to make capital acquisitions, it is helpful to take into account the normal dividend requirements 20 The numerator in any rate of return ratio must match the investment or base in the denominator If total assets is the base, the numerator must be a measure of the income available to all providers of capital Interest expense, net of tax, is added back to net income because the creditors are one of the sources of capital, and we want to consider the income available before any of the sources of funds are given a distribution Interest must be on a net or after-tax basis to be consistent with net income, which is on an after-tax basis 21 A return on stockholders’ equity that is lower than the return on assets means that the company is not successfully using borrowed funds Return on assets measures the return to all providers of capital, whereas return on equity is concerned only with common stockholders The company has not been able to earn an overall return that is as high as what is being paid to creditors and preferred stockholders Leverage deals with the use of someone else’s money to earn a favorable return Presently, this company is not successfully employing financial leverage 22 The price/earnings ratio is sometimes used as an indicator of the quality of a company’s earnings because it combines a measure of the company’s performance, based on its earnings, and the company’s worth as measured by the market price of its stock The ratio of price to earnings is an indication of the market’s assessment of the company’s performance For example, the use of different accounting methods can cause the market to value the price of one company’s stock higher than another company’s stock, even though they report similar earnings This could be the case if in a period of rising prices one defers taxes by using LIFO whereas the other uses FIFO This differing treatment of the two stocks is a statement by the market about the “quality” of the two companies’ earnings 23 Most of the liquidity ratios are primarily suited to use by management For example, the investor would not normally place major emphasis on the turnover of either inventory or receivables On the other hand, turnover ratios must be constantly monitored by management The stockholder will be very interested in both the dividend payout ratio and the dividend yield A banker would rely partially on a company’s debt service coverage in the past as an indication of its ability to repay a potential loan in the future 24 The inventory turnover ratio is meaningless to a service business such as a law firm or a public accounting firm These firms not sell a tangible product; instead, they sell their professional expertise and thus must rely on alternative measures of their efficiency in marketing their services An accounting firm, for example, might keep detailed records on the number of clients served, the average annual billings to each client, and the ratio of these billings to the average costs incurred on each audit 25 Separate reporting of discontinued operations and extraordinary items assists the reader of the statements in making predictions about the future profitability of the business For example, users of the income statement may want to ignore these items when assessing the future prospects for the company because these items by their nature are not likely to reoccur in the future BRIEF EXERCISES LO BRIEF EXERCISE 13-1 LIMITATIONS IN RATIO ANALYSIS Although a current ratio of 0.50 is certainly low, other factors need to be considered before making a decision on whether to extend credit Has the company operated successfully in the past with a low current ratio? How does this ratio compare with other companies in the same industry? What is the composition of the company’s current assets? LO BRIEF EXERCISE 13-2 HORIZONTAL ANALYSIS A comparison of financial statement items within a single period is called vertical analysis A comparison of financial statement items over a period of time is called horizontal analysis LO BRIEF EXERCISE 13-3 VERTICAL ANALYSIS Accounts on the balance sheet should be stated as a percentage of total assets All accounts on the income statement should be stated as a percentage of net sales LO BRIEF EXERCISE 13-4 LIQUIDITY ANALYSIS Current ratio: Current Assets Acid-Test ratio: Cash + Marketable Securities + Current Receivables Accounts Receivable Turnover ratio: Net Credit Sales Inventory Turnover ratio: Cost of Goods Sold LO BRIEF EXERCISE 13-5 SOLVENCY ANALYSIS Meet its interest and principal payments: Debt service coverage ratio Finance long-term asset acquisitions with cash from operations: Cash flow from operations to capital expenditures ratio Meet its interest payments: Times interest earned ratio LO BRIEF EXERCISE 13-6 PROFITABILITY ANALYSIS Return on assets: Interest Expense, Net of Tax (A) Return on common stockholders’ equity: Preferred Dividends (D) Earnings per share: Preferred Dividends (D) Return on sales: Interest Expense, Net of Tax (A) LO BRIEF EXERCISE 13-7 OTHER INCOME STATEMENT ITEMS (APPENDIX) Disposed of a segment of the business: Discontinued operations Incurred a loss from an event that was unusual and infrequently occurring: Extraordinary item ... sense to close the Equipment account at the end of the period The account should stay on the books as long as the company keeps the asset On the other hand, Depreciation Expense on the equipment... assumption, called the monetary unit assumption, may or may not be accurate, depending on the level of inflation in the economy The higher the rate of inflation, the less reliable is the dollar... balance per the bank, it is because the company is reconciling the balance on the bank statement to the balance on the books The bank has deducted the charge from the balance it shows Because the company