Financial accounting 8e tool for busniess decision making chapter 13

SUSTAINABLE INCOME ILLUSTRATION 13-1Statement of comprehensive income... Prepare Acro’s statement of comprehensive income for the year ended December 31, 2017... Unrealized gains and los

Financial Analysis: The Big Picture

13

Analyze a company’s performance using ratio analysis.

3

The most likely level of income to be obtained by a company

SUSTAINABLE INCOME ILLUSTRATION 13-1

Statement of comprehensive 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.

SUSTAINABLE INCOME

Illustration: Assume that during 2017 Acro Energy Inc has

income before income taxes of $800,000 During 2017, Acro

discontinued and sold its unprofitable chemical division The

loss in 2017 from chemical operations (net of $60,000 taxes)

was $140,000 The loss on disposal of the chemical division

(net of $30,000 taxes) was $70,000 Assuming a 30% tax rate

on income

Prepare Acro’s statement of comprehensive income for the year ended December 31, 2017

Discontinued Operations

Discontinued Operations

ILLUSTRATION 13-2

Statement presentation of discontinued operations

INVESTOR INSIGHT

What Does “Non-Recurring” Really Mean

Many companies incur restructuring charges as they attempt to reduce costs They often label these items in the income statement as “non- recurring” charges, to suggest that they are isolated events, unlikely to occur in future periods The question for analysts is, are these costs really one-time, “nonrecurring events” or do they reflect problems that the company will be facing for many periods in the future? If they are one-time events, then they can be largely ignored when trying to predict future earnings But, some companies report “one-time” restructuring charges over and over again For example, Procter & Gamble reported a restructuring charge in 12 consecutive quarters, and Motorola had “special” charges in 14 consecutive quarters On the other hand, other companies have a restructuring charge only once in

a 5- or 10-year period There appears to be no substitute for careful analysis of the numbers that comprise net 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-Comprehensive Income

SUSTAINABLE INCOME

ILLUSTRATION 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 2017 Stassi Company purchased IBM stock

for $10,000 as an investment At the end of 2017 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?

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

ILLUSTRATION OF COMPREHENSIVE INCOME

Comprehensive Income

Format Two

Comprehensive Income

Separate component of Stockholders’ Equity.

ILLUSTRATION 13-5

Complete statement of comprehensive income

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

SUSTAINABLE INCOME

INVESTOR INSIGHT

More Frequent Ups and Downs

In the past, U.S companies used a method to account for their pension plans that smoothed out the gains and losses on their pension portfolios by spreading gains and losses over multiple years Many felt that this approach was beneficial because it reduced the volatility of reported net income However, recently some companies have opted to adopt a method that comes closer to recognizing gains and losses in the period in which they occur Some of the companies that have adopted this approach are

United Parcel Service (UPS), Honeywell International, IBM, AT&T, and

Verizon Communications The CFO at UPS said he favored the new approach because “events that occurred in prior years will no longer distort current-year results It will result in better transparency by eliminating the noise of past plan performance.” When UPS switched, it resulted in a charge of $827 million from the change in accounting principle.

Source: Bob Sechler and Doug Cameron, “UPS Alters Pension-Plan Accounting,”

United Parcel Service (UPS)

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

Recent accounting scandals suggest that some

companies are spending too much time managing their

income and not enough time managing their

business.

QUALITY OF EARNINGS

Variations among companies in the application of GAAP

may hamper comparability and reduce quality of earnings (FIFO vs LIFO)

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

Alternative Accounting Methods

Pro Forma Income

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)

Improper Recognition

QUALITY OF EARNINGS

In its proposed 2017 income statement, AIR Corporation

reports income before income taxes $400,000, unrealized gain

on available-for-sale securities $100,000, income taxes

$120,000 (not including unusual items), loss from operation of

discontinued flower division $50,000, and loss on disposal of

discontinued flower division $90,000 The income tax rate is

30%

Prepare a correct statement of comprehensive income,

beginning with “Income before income taxes.”

Unusual Items

Unusual Items

Analyzing financial statements involves:

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

HORIZONTAL ANALYSIS

ILLUSTRATION 13-9

Horizontal analysis of balance sheets

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

VERTICAL ANALYSIS

ILLUSTRATION 13-11

Vertical analysis of balance sheets

ILLUSTRATION 13-12

Vertical analysis of income statements

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 to detect fraud Financial ratios that appear abnormal or statistical abnormalities in the numbers themselves can reveal fraud 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.

The Missing Control

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.

Source: Mark J Nigrini, “I’ve Got Your Number,” Journal of Accountancy Online (May 1999).

Total take: Thousands of dollars

ANATOMY OF A FRAUD

Summary financial information for Rosepatch Company is as

follows.

Compute the amount and percentage changes in 2017 using

horizontal analysis, assuming 2016 is the base year.

Horizontal Analysis

Reflects investors’ assessment of a company’s future

earnings

Will be higher if investors think that earnings will increase

substantially in the future

Will be lower when there is the belief that a company has

LIQUIDITY RATIOS

INVESTOR INSIGHT

How to Manage the Current Ratio

The apparent simplicity of the current ratio can have real-world limitations because adding equal amounts to both the numerator and the denominator causes the ratio to decrease

Assume, for example, that a company has $2,000,000 of current assets and $1,000,000 of current liabilities Its current ratio is 2:1 If

it purchases $1,000,000 of inventory on account, it will have

$3,000,000 of current assets and $2,000,000 of current liabilities Its current ratio decreases to 1.5:1 If, instead, the company pays off

$500,000 of its current liabilities, it will have $1,500,000 of current assets and $500,000 of current liabilities Its current ratio increases

to 3:1 Thus, any trend analysis should be done with care because the ratio is susceptible to quick changes and is easily influenced by management.

SOLVENCY RATIOS

ILLUSTRATION 13-17

Summary of solvency ratios

PROFITABILITY RATIOS

ILLUSTRATION 13-18

Summary of profitability ratios

INVESTOR INSIGHT

High Ratings Can Bring Low Returns

Moody’s, Standard & Poor’s, and Fitch are three big firms that perform financial analysis on publicly traded companies and then publish ratings of the companies’ creditworthiness Investors and lenders rely heavily on these ratings in making investment and lending decisions Some people feel that the collapse of the financial markets was worsened by inadequate research reports and ratings provided by the financial rating agencies Critics contend that the rating agencies were reluctant to give large companies low ratings because they feared that by offending them they would lose out on business opportunities For example, the rating agencies gave many so-called mortgage-backed securities ratings that suggested that they were low risk Later, many of these very securities became completely worthless Steps have been taken to reduce the conflicts of interest that lead to these faulty ratings

Analyzing financial statements involves:

ILLUSTRATION 13A-2

Chicago Cereal Company’s income statements

ILLUSTRATION 13A-3

Chicago Cereal Company’s statements of cash flows

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.

Ratio analysis expresses the relationship among selected

items of financial statement data

needs for cash.

Financial Ratio Classifications

RATIO ANALYSIS

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.

LIQUIDITY RATIOS

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

Current Ratio

ILLUSTRATION 13A-5

Current ratio

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

Accounts Receivable Turnover

ILLUSTRATION 13A-6

Accounts receivable turnover

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)

Average Collection Period

ILLUSTRATION 13A-7

Average collection period

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 similar to that of General Mills

How does Chicago’s turnover compare to General Mills’s?

ILLUSTRATION 13A-8

Inventory turnover

Inventory Turnover

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?

Days in Inventory

ILLUSTRATION 13A-9

Days in inventory

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

► Free cash flow

SOLVENCY RATIOS

Indicates the degree of financial leveraging Provides some indication of the company’s ability to withstand losses

Yes The ratio of 78% says that Chicago would have to

liquidate 78% of its assets at their book value in order to pay

Has Chicago’s solvency improved during the year?

Debt to Assets Ratio

ILLUSTRATION 13A-10

Debt to assets ratio

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

Is Chicago able to service its’ debt?

Times Interest Earned

ILLUSTRATION 13A-11

Times interest earned

Ability to pay dividends or expand operations.

Cash provided by operations was more than enough to

allow Chicago to acquire additional productive assets and

maintain dividend payments

Free Cash Flow

ILLUSTRATION 13A-12

Free cash flow

Measure the income or operating success of a company for

a given period of time

PROFITABILITY RATIOS

Shows how many dollars of net income the company

earned for each dollar invested by the owners

Chicago’s 2014 rate of return on common stockholders’ equity is unusually high at 48%, considering an industry average of

Return on Common Stockholders’ Equity

ILLUSTRATION 13A-14

Return on common

stockholders’ equity