Preview of Chapter Financial Accounting Ninth Edition Weygandt Kimmel Kieso 14-1 Preview of Chapter 14 Financial Accounting Ninth Edition Weygandt Kimmel Kieso 14-2 14 Financial Statement Analysis 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 14-3 Basics of Financial Statement Analysis Analyzing financial statements involves: Comparison Bases Characteristics Liquidity Intracompany Horizontal Profitability Vertical Solvency Industry averages Ratio 14-4 Tools of Analysis Intercompany LO & LO 14 Financial Statement Analysis 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 14-5 Horizontal Analysis Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time 14-6 Purpose is to determine the increase or decrease Commonly applied to the ► balance sheet, ► income statement, and ► statement of retained earnings LO Horizontal Analysis Illustration 14-5 Horizontal analysis of balance sheets 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 14-7 LO Horizontal Analysis Illustration 14-6 Horizontal analysis of Income statements 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 14-8 LO Horizontal Analysis Illustration 14-7 Horizontal analysis of retained earnings statements 14-9 The ending retained earnings increased 38.6% As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities LO 14 Financial Statement Analysis 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 14-10 Earning Power and Irregular Items Change in Accounting Principle 14-67 When the principle used is different from the one used in the preceding year Accounting rules permit a change if justified Changes are reported retroactively Example: Change from FIFO to average cost LO Earning Power and Irregular Items Comprehensive Income All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders Reported in Stockholders’ Equity + Unrealized gains and losses on available-forsale securities Plus other items 14-68 LO Earning Power and Irregular Items Comprehensive Income Why are gains and losses on available-for-sale securities excluded from net income? Disclosing them separately 1) reduces the volatility of net income due to fluctuations in fair value, yet 2) informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value 14-69 LO 14 Financial Statement Analysis 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 14-70 Quality of Earnings 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 14-71 LO Quality of Earnings Alternative Accounting Methods Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings Pro Forma Income 14-72 Pro forma income usually excludes items that the company thinks are unusual or non-recurring Many companies have abused the flexibility that pro forma numbers allow LO Quality of Earnings Improper Recognition Due to pressure from Wall Street some managers have manipulated the earnings numbers to meet expectations Abuses include: 14-73 Channel stuffing, improper recognition of revenue (BristolMyers Squibb) Improper capitalization of operating expenses (WorldCom) Failure to report all liabilities (Enron) LO Key Points 14-74 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 As indicated in the textbook, a very important objective is to ensure that users of the income statement can evaluate the earning power of the company Earning power is the normal level of income to be obtained in the future 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 LO Compare financial statement analysis and income statement presentation under GAAP and IFRS Key Points 14-75 The basic accounting for discontinued operations is the same under IFRS and GAAP 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 Disclosure, however, is extensive for items that are considered material to the financial results Examples are write-downs of inventory or plant assets, or gains and losses on the sale of plant assets The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS LO Key Points 14-76 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 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, that many of the earning quality issues will disappear LO 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 14-77 LO IFRS Self-Test Questions The basic tools of financial analysis are the same under both GAAP and IFRS except that: 14-78 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 IFRS Self-Test Questions Under IFRS: 14-79 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 IFRS Self-Test Questions Presentation of comprehensive income must be reported under IFRS in: 14-80 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 Copyright “Copyright © 2014 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.” 14-81 ...Preview of Chapter 14 Financial Accounting Ninth Edition Weygandt Kimmel Kieso 14- 2 14 Financial Statement Analysis Learning Objectives After studying this chapter, you should be... December 31 Illustration 14- 12 14- 23 LO Ratio Analysis Liquidity Ratios Acid-Test Ratio Illustration 14- 14 Acid-test ratio measures immediate liquidity 14- 24 LO 14- 25 LO 14- 26 QUALITY DEPARTMENT... of different sizes Illustration 14- 10 Intercompany income statement comparison 14- 14 LO 14 Financial Statement Analysis Learning Objectives After studying this chapter, you should be able to: