To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 24 Presentation and Disclosure in Financial Reporting ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics Brief Questions Exercises * The disclosure principle; type of disclosure 2, 3, 22 * Role of notes that accompany financial statements 1, 4, 1, * Subsequent events 1, 4, 11 * Segment reporting; diversified firms 7, 8, 9, 10, 11 4, 5, 6, 5, * Interim reporting 12, 13, 14, 15, 23 7, * Audit opinions and fraudulent reporting 20, 21 10 * Discussion and analysis 16, 17 * Earnings forecasts 18, 19 Interpretation of ratios 24, 25, 26 *9 Exercises Concepts Problems for Analysis 1, 2, 1, 2, 3, 4, 5, *10 Impact of transactions on ratios *11 Liquidity ratios *12 Profitability ratios *13 Coverage ratios *14 Activity ratios *15 Comprehensive ratio problems *16 Percentage analysis 26, 29 *17 First-time adoption of IFRS 30, 31, 32, 33, 34, 35, 36, 37, 38, 39 28 4, 5, 3, 4, 5, 3, 12 4, 5, 27, 28 8, 10, 11, 12 13, 14, 15 4, 5, 4, 5, 3, 3, 7, *This material is dealt with in an Appendix to the chapter Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-1 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Brief Exercises Exercises Problems Review the full disclosure principle and describe implementation problems Explain the use of notes in financial statement preparation 1, 2, 1, Discuss the disclosure requirements for major business segments 4, 5, 6, Describe the accounting problems associated with interim reporting Identify the major disclosures in the auditor’s report Understand management’s responsibilities for financials Identify issues related to financial forecasts and projections Describe the profession’s response to fraudulent financial reporting *9 Understand the approach to financial statement analysis *10 Identify major analytic ratios and describe their calculation 8, 4, 5, 3, *11 Explain the limitations of ratio analysis *12 Describe techniques of comparative analysis *13 Describe techniques of percentage analysis *14 Describe the guidelines for first-time adoption of IFRS *15 Describe the implementation steps for preparing the opening IFRS statement of financial position 10, 11, 12, 13, 14 7, *16 Describe the exemptions to retrospective application in first-time adoption of IFRS 15 7, *17 Describe the presentation and disclosure requirements of first-time adoption of IFRS 24-2 Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com ASSIGNMENT CHARACTERISTICS TABLE Item Description Level of Difficulty Time (minutes) E24-1 E24-2 E24-3 *E24-4 *E24-5 *E24-6 *E24-7 *E24-8 Subsequent events Subsequent events Segmented reporting Ratio computation and analysis; liquidity Analysis of given ratios Ratio analysis Opening statement of financial position Opening statement of financial position Moderate Moderate Moderate Simple Moderate Moderate Moderate Moderate 10–15 10–15 5–10 20–30 20–30 30–40 10–15 15–20 P24-1 P24-2 *P24-3 *P24-4 *P24-5 Subsequent events Segmented reporting Ratio computations and additional analysis Horizontal and vertical analysis Dividend policy analysis Difficult Moderate Moderate Simple Difficult 40–50 24–30 35–45 40–60 40–50 Simple 10–20 Moderate Simple Moderate Moderate Simple Simple Moderate Moderate Moderate Simple Moderate 20–25 24–30 20–25 30–35 25–30 20–25 30–35 25–30 15–20 10–15 25–35 CA24-1 CA24-2 CA24-3 CA24-4 CA24-5 CA24-6 CA24-7 CA24-8 CA24-9 CA24-10 CA24-11 *CA24-12 General disclosures, inventories, property, plant, and equipment Disclosures required in various situations Disclosures, conditional and contingent liabilities Subsequent events Segment reporting Segment reporting—theory Interim reporting Treatment of various interim reporting situations Financial forecasts Disclosure of estimates—ethics Reporting of subsequent events—ethics Effect of transactions on financial statements and ratios Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-3 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com ANSWERS TO QUESTIONS The major advantages are: (1) additional information pertinent to specific financial statements can be explained in qualitative terms, (2) supplementary data of a quantitative nature can be provided to expand on the information in the financial statements, and (3) restrictions on basic contractual agreements can be explained The types of items normally found in footnotes are: (1) disclosure of accounting policies used, (2) disclosure of contingent assets and liabilities, (3) examination of creditor claims, (4) claims of equity holders, and (5) executory commitments The full disclosure principle in accounting calls for reporting in financial statements any financial facts significant enough to influence the judgment of an informed reader Disclosure has increased because of the complexity of the business environment, the necessity for timely information, and the desire for more information on the enterprise for control and monitoring purposes The benefit of reconciling the effective tax rate and the federal statutory rate is that an investor can determine the actual taxes paid by the enterprise Such a determination is particularly important if the enterprise has substantial fluctuations in its effective tax rate caused by unusual or infrequent transactions In some cases, companies only have income in a given period because of a favorable tax treatment that is not sustainable Such information should be extremely useful to a financial statement reader (a) The increased likelihood that the company will suffer a costly strike requires no disclosure in the financial statements The possibility of a strike is an inherent risk of many businesses It, along with the risks of war, recession, etc., is in the category of general news (b) A note should provide a description of the loss on a discontinued operation in order that the financial statement user has some understanding of the nature of this item (c) Contingent assets which may materially affect a company’s financial position must be disclosed when the surrounding circumstances indicate that, in all likelihood, a valid asset will materialize In most situations, an asset would not be recognized until the court settlement had occurred Transactions between related parties are disclosed to insure that the users of the financial statements understand the basic nature of some of the transactions Because it is often difficult to separate the economic substance from the legal form in related party transactions, disclosure is used extensively in this area Purchase of a substantial block of the company’s ordinary shares by Holland, coupled with the use of a Holland affiliate to act as food broker, suggests that disclosure is needed ―Subsequent events‖ are of two types: (1) Those which affect the financial statements directly and should be recognized therein through appropriate adjustments (2) Those which not affect the financial statements directly and require no adjustment of the account balances but whose effects may be significant enough to be disclosed with appropriate figures or estimates shown (a) (b) (c) (d) (e) (f) (g) (h) 24-4 Probably adjust the financial statements directly Disclosure Disclosure Disclosure Neither adjustment nor disclosure necessary Neither adjustment nor disclosure necessary Probably adjust the financial statements directly Neither adjustment nor disclosure necessary Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Questions Chapter 24 (Continued) Diversified companies are enterprises whose activities are segmented into unrelated industries The accounting problems related to diversified companies are: (1) the problem of defining a segment for financial reporting purposes, (2) the difficulty of allocating common or joint costs to various segments, and (3) the problem of evaluating segment results when a great deal of transfer pricing is involved After the company decides on the segments for possible disclosure, a quantitative test is made to determine whether the segment is significant enough to warrant actual disclosure A segment is identified as a reportable segment if it satisfies one or more of the following tests (a) Its revenue (including both sales to external customers and intersegment sales or transfers) is 10% or more of the combined revenue (sales to external customers and intersegment sales or transfers) of all the company’s operating segments (b) The absolute amount of its operating profit or operating loss is 10% or more of the greater, in absolute amount, of the combined operating profit of all operating segments that did not incur an operating loss, or the combined loss of all operating segments that did incur loss (c) Its identifiable assets are 10% or more of the combined identifiable assets of all segments In applying these tests, two additional factors must be considered First, segment data must explain a significant portion of the company’s business Specifically, the segmented results must equal or exceed 75% of the combined sales to unaffiliated customers for the entire company This test prevents a company from providing limited information on only a few segments and lumping all the rest into one category Second, the profession recognized that reporting too many segments may overwhelm users with detailed information The IASB decided that 10 is a reasonable upper limit for the number of segments that a company must disclose IFRS requires that a company report: (a) (b) (c) (d) General information about its operating segments Segment profit and loss and related information Segment assets and liabilities Reconciliations (reconciliations of total revenues, income before income taxes, and total assets and liabilities) (e) Information about products and services and geographic areas (f) Major customers 10 An operating segment is a component of an enterprise: (a) That engages in business activities from which it earns revenues and incurs expenses (b) Whose operating results are regularly reviewed by the company’s chief operating decision maker to assess segment performance and allocate resources to the segment (c) For which discrete financial information is available that is generated by or based on the internal financial reporting system Information about two operating segments can be aggregated only if the segments have the same basic characteristics related to the: (1) nature of the products and services provided, (2) nature of the production process, (3) type or class of customer, (4) methods of product or service distribution, and (5) nature of the regulatory environment Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-5 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Questions Chapter 24 (Continued) 11 One of the major reasons for not providing segment information is that competitors will then be able to determine the profitable segments and enter that product line themselves If this occurs and the other company is successful, then the present shareholders of Lafayette Inc may suffer This question should illustrate to the student that the answers are not always black and white Disclosure of segments undoubtedly provides some needed information, but some disclosures are confidential 12 Interim reports are unaudited financial statements normally prepared four times a year A complete set of interim financial statements is often not provided because this information is not deemed crucial over a short period of time; the income figure has much more relevance to interim reporting 13 The accounting problems related to the presentation of interim data are as follows: (a) The difficulty of allocating costs, such as income taxes, pensions, etc., to the proper quarter (b) Problems of fixed cost allocation 14 A company records losses from inventory write-downs in an interim period similar to how it would record them in annual financial statements However, if an estimate from a prior interim period changes in a subsequent interim period of that year, the write-down is adjusted in the subsequent interim period 15 One suggestion has been to normalize the fixed nonmanufacturing costs on the basis of seasonal sales The problem with this method is that future sales are unknown and hence a great deal of subjectivity is involved Another approach is to charge as a period charge those costs that are impossible to allocate to any one period Under this approach, reported results for a quarter would only indicate the contribution toward fixed costs and profits, which is essentially a contribution margin approach To alleviate the problem of seasonality, the profession recommends companies subject to material seasonal variations disclose the seasonal nature of their business and consider supplementing their annual reports with information for 12-month periods ended at the interim dates for the current and preceding years 16 The management commentary section covers three financial aspects of an enterprise’s business— liquidity, capital resources, and results of operations It requires management to highlight favorable or unfavorable trends and to identify significant events and uncertainties that affect these three factors 17 Management has the primary responsibility for the preparation, integrity, and objectivity of the company’s financial statements If management wishes to present information in a certain way, it may so If the auditor objects because IFRS is violated, some type of modified opinion is called for 18 Arguments against providing earnings projections: (a) No one can foretell the future Therefore forecasts, while conveying an impression of precision about the future, will nevertheless inevitably be wrong (b) Organizations will not strive to produce results which are in the shareholders’ best interest, but merely to meet their published forecasts (c) When forecasts are not met, there will be recriminations and probably legal actions (d) Disclosure of forecasts will be detrimental to organizations because it will fully inform not only investors but competitors (foreign and domestic) 19 Arguments for providing earnings forecasts are: (a) Investment decisions are based on future expectations; therefore, information about the future facilitates better decisions (b) Forecasts are already circulated informally This situation should be regulated to ensure that forecasts are available to all investors (c) Circumstances now change so rapidly that historical information is no longer adequate for prediction 24-6 Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Questions Chapter 24 (Continued) 20 The auditor expresses a ―clean‖ or unmodified opinion when the client’s financial statements present fairly the client’s financial position and results of operations on the basis of an examination made in accordance with generally accepted auditing standards, and the statements are in conformity with accepted accounting principles and include all informative disclosures necessary to make the statements not misleading The auditor expresses a modified opinion when he/she must take exception to the presentation of one or more components of the financial statements but the exception or exceptions are not serious enough to negate his/her expression of an opinion or to express an ―adverse‖ opinion 21 Fraudulent financial reporting is intentional or reckless conduct, whether by act or omission, that results in materially misleading financial statements Fraudulent financial reporting can involve many factors and take many forms It may entail gross and deliberate distortion of corporate records, such as inventory count tags, or falsified transactions, such as fictitious sales or orders It may entail the misapplication of accounting policies Company employees at any level may be involved, from top to middle management to lower-level personnel If the conduct is intentional, or so reckless that it is the legal equivalent of intentional conduct, and results in fraudulent financial statements, it comes within the operating definition of the term fraudulent financial reporting Fraudulent financial reporting differs from other causes of materially misleading financial statements, such as unintentional errors Fraudulent financial reporting is distinguished from other corporate improprieties, such as employee embezzlements, violations of environmental or product safety regulations, and tax fraud, which not necessarily cause financial statements to be materially inaccurate Fraudulent financial reporting usually occurs as the result of certain environmental, institutional, or individual forces and opportunities These forces and opportunities add pressures and incentives that encourage individuals and companies to engage in fraudulent financial reporting and are present to some degree in all companies If the right combustible mixture of forces and opportunities is present, fraudulent financial reporting may occur A frequent incentive for fraudulent financial reporting that improves the company’s financial appearance is the desire to obtain a higher price from an equity or debt offering or to meet the expectations of investors Another incentive may be the desire to postpone dealing with financial difficulties and thus avoid, for example, violating a restrictive debt covenant Other times the incentive is personal gain: additional compensation, promotion, or escape from penalty for poor performance Situational pressures on the company or an individual manager also may lead to fraudulent financial reporting Examples of these situational pressures include: Sudden decreases in revenue or market share A single company or an entire industry can experience these decreases Unrealistic budget pressures, particularly for short-term results These pressures may occur when a company arbitrarily determines profit objectives and budgets without taking actual conditions into account Financial pressure resulting from bonus plans that depend on short-term economic performance This pressure is particularly acute when the bonus is a significant component of the individual’s total compensation Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-7 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Questions Chapter 24 (Continued) Opportunities for fraudulent financial reporting are present when the fraud is easier to commit and when detection is less likely Frequently these opportunities arise from: The absence of a board of directors or audit committee that vigilantly oversees the financial reporting process Weak or nonexistent internal accounting controls This situation can occur, for example, when a company’s revenue system is overloaded from a rapid expansion of sales, an acquisition of a new division, or the entry into a new, unfamiliar line of business Unusual or complex transactions Examples include the consolidation of two companies, the divestiture or closing of a specific operation, and agreements to buy or sell government securities under a repurchase agreement Accounting estimates requiring significant subjective judgment by company management Examples include allowance for loan losses and the yearly provision for warranty expense 22 U.S GAAP and IFRS have similar standards on subsequent events Subsequent events under IFRS are evaluated through the date that financial statements are ―authorized for issue.‖ U.S GAAP uses the date when financial statements are ―issued.‖ IFRS does not adjust for share dividends and splits in the subsequent period but U.S GAAP does adjust Both IFRS and U.S GAAP use the management approach to identify reportable segments, and similar segment disclosures are required 23 While U.S GAAP has a preference for the integral approach, IFRS leans toward the discrete approach to interim reports Thus, if an IFRS company expenses interim amounts, like advertising expenditures that could benefit later interim periods, it may be difficult to compare to a U.S company that would spread the cost across interim periods *24 It has been said that ―everything is relative,‖ and this is certainly true of financial statement data The chief significance of financial statement data is not so much in the absolute amounts presented but in their relative significance; that is, in the conclusions reached after comparing each item with similar items and after association with related data Financial statements present measures of quantity (this is not to exclude the qualitative aspects of things that dollar quantities reflect), but whether any amount is adequate or not in view of the company’s needs, or whether it represents an amount out of proportion to the company’s other amounts, or whether it represents an improvement over previous years cannot be determined from the absolute amount alone *25 Your friend should be advised that in order to interpret adequately and to evaluate financial statement data, an individual must: (a) (b) (c) (d) Understand the nature and limitations of accounting Understand the terminology of accounting and business Have some knowledge of business Be acquainted with the nature and tools of financial statement analysis *26 Percentage analysis consists of reducing a series of related amounts to a series of percentages of a given base while ratio analysis is the computation of any specific ratio of one figure to another within the reported data Percentage analysis facilitates comparison and is helpful in evaluating the relative size of a series of items Ratio analysis points out the existence of a specific relationship and then proceeds to measure the relationship in terms of either a percentage figure or a single proportion 24-8 Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Questions Chapter 24 (Continued) *27 Cost of goods sold is used for two reasons: first, cost must be used rather than retail value because the average inventory figures are on a cost basis Second, since measurement of the turnover involves determination of the number of times inventory was sold this period in comparison to the total cost incurred, cost of goods sold must be used as representative of total cost incurred An increasing inventory turnover may be an indication of stockouts or inventory shortages *28 The relationship of asset turnover to the rate of return on assets is as follows: Sales Average Total Assets X Net Income Sales = Net Income Average Total Assets An increase in the asset turnover, holding profit margin constant, results in an increase in rate of return on assets and vice versa *29 (a) Common-size analysis is reduction of all dollar amounts in the financial statements to a percentage of a base amount (b) Vertical analysis is the expression percentage-wise of each item on a financial statement in a given period to a base figure (c) Horizontal analysis is the computation of the percentage change over time (d) Percentage analysis consists of reducing a series of related amounts to a series of percentages of a given base This type of analysis facilitates comparisons and is helpful in evaluating the relative size of items such as expenses, current assets, or net income *30 When countries accept IFRS for use as accepted accounting policies, companies need guidance to ensure that their first IFRS financial statements contain high quality information IFRS No requires that information in a company’s first IFRS statements be transparent, provide a suitable starting point, and have a cost that does not exceed the benefits *31 The transition date is the beginning of the earliest period for which full comparative IFRS information is presented The reporting date is the closing statement of financial position date for the first IFRS financial statements *32 The characteristics of high quality information in a company’s first IFRS financial statements are that information be transparent, provide a suitable starting point, and have a cost that does not exceed the benefits *33 The steps in preparing the opening IFRS statement of financial position include the following: Include all assets and liabilities that IFRS requires Exclude any assets and liabilities that IFRS does not permit Classify all assets, liabilities, and equity in accordance with IFRS Measure all assets and liabilities according to IFRS *34 The IASB allows exemptions to retrospective application because in some cases adjustments relating to prior periods cannot be reasonably determined In other cases it is impracticable to provide comparable information because the cost of generating the information exceeds the benefits Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-9 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Questions Chapter 24 (Continued) 35 The IASB identified three required exemptions to retrospective application in first-time adoption of IFRS They are estimates, hedge accounting, and non-controlling interests There exemptions are imposed because implementation of retrospective application in these areas generally requires companies to obtain information that may not be readily available 36 Elective exemptions to retrospective application in first-time adoption of IFRS include all of the following: share-based payment transactions, fair value or revaluation as deemed cost, leases, employee benefits, compound financial instruments, and borrowing costs, (only three exemptions requested) 37 The deemed cost exemption to retrospective application allows companies to measure property, plant, and equipment at fair value at the transition date and use that fair value as their deemed cost in accounting for those assets in subsequent periods Companies avoid recreating depreciation cost records for property, plant and equipment, a costly exercise for many companies, by using this exemption *38 A company that elects the deemed cost exemption is not required to continue using revaluation accounting subsequent to first-time adoption The IASB decided the reconstructed cost data might be less relevant to users compared to fair value information Therefore, companies are permitted to use fair value as deemed cost at firsttime adoption *39 A company must present at least one year of comparative information under IFRS upon first-time adoption of IFRS An entity’s first IFRS financial statements shall include at least three statements of financial position, two statements of comprehensive income, two separate income statements (if presented), two statements of cash flows and two statements of changes in equity and related notes, including comparative information Companies must explain how the transition from previous GAAP to IFRS affected its reported financial position, financial performance, and cash flows 24-10 Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com COMPARATIVE ANALYSIS CASE CADBURY VERSUS NESTLÉ (a) Cadbury commented on the following list of items in its note on accounting policies: Note – Nature of Operations and Accounting Policies Nature of operations and segmental results Accounting convention Preparation of financial statements Basis of consolidation Segmental analysis Foreign currencies Revenue Research and development expenditure Advertising costs Share-based payments Restructuring costs Non-trading items Earnings per ordinary share Goodwill Acquisition intangibles Software intangibles Property, plant and equipment and leases Inventories Cash and cash equivalents Assets held for sale and discontinued operations Taxation Provisions Pensions and other post-retirement benefits Financial instruments Management performance measures Critical accounting policies Nestlé commented on the following list of items in its note on accounting policies: Note - Accounting Policies Accounting convention and accounting standards Consolidated companies Associates Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-45 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com COMPARATIVE ANALYSIS CASE (Continued) Scope of consolidation Venture funds Foreign currencies Segmental information Revenue Net financing cost Expenses Taxes Net other income/(expenses) Classes of financial instruments Financial assets Cash and cash equivalents Loans and receivables Held-to-maturity investments Held-for-trading assets Undesignated derivatives Available-for-sale assets Financial liabilities at amortised cost Derivative financial instruments Hedge accounting Fair value hedges Cash flow hedges Net investment hedges Inventories Prepayments and accrued income Fair values Property, plant and equipment Leased assets Business combinations and related goodwill Intangible assets Research and development Impairment of goodwill and indefinite life intangible assets Impairment of property, plant and equipment and finite life intangible assets Provisions Assets held for sale and discontinued operations Employee benefits Accruals and deferred income Dividends 24-46 Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com COMPARATIVE ANALYSIS CASE (Continued) Share-based payment Contingent assets and liabilities Events occurring after the statement of financial position date (b) Cadbury has four geographic segments – BIMA (Britain, Ireland, Middle East, and Africa), Americas, Europe, and Asia Pacific Nestlé segments are Zone Europe, Zone Americas, Zone Asia, Oceania, and Africa, Nestle Waters, Nestle Nutrition, Other Food & Beverage, and Pharma (c) Both companies received unqualified audit opinions That is, their financial statements give a true and fair view of the financial position, the results of operations and the cash flows in accordance with IFRS Deloitte LLP audited Cadbury, while KPMG audited Nestlé Also, Deloitte audited Cadbury’s Director’s Remuneration Report Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-47 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com *FINANCIAL STATEMENT ANALYSIS CASE RNA INC (a) The calculation of selected financial ratios for RNA for the fiscal year 2011 is as follows: Current ratio = Current assets Current liabilities = $9,900 $6,300 = 1.57 Acid-test ratio Short-term Net = Cash + Investments + Receivables Current liabilities = $3,900 $6,300 = 62 Times interest earned = Income before interest and taxes Interest expense = $7,060 + $900 $900 = 8.84 Profit margin on sales = = Net income Net sales $4,260 $30,500 = 13.97% 24-48 Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com *FINANCIAL STATEMENT ANALYSIS CASE (Continued) Asset turnover = Net sales Average total assets = $30,500 ($17,000 + $16,000) ÷ = 1.85 times Inventory turnover = Cost of goods sold Average inventory = $17,600 ($6,000 + $5,400) ÷ = 3.09 times (b) The analytical use of each of the six ratios presented above and what investors can learn about RNA’s financial stability and operating efficiency are presented below Current ratio Measures the ability to meet short-term obligations using shortterm assets RNA’s current ratio has declined over the last three years from 1.62 to 1.57 This declining trend, coupled with the fact that it is below the industry average, is not yet a major concern; however, the company should watch it in the future as the ratio assumes that non-cash current assets (particularly inventory) can be quickly converted to cash at or close to book value Acid-test ratio Measures the ability to meet short-term debt using the most liquid assets RNA’s acid-test ratio has remained stable over the last three years; however, it is still below the industry average Furthermore, a quick ratio below indicates that RNA may have difficulty meeting its shortterm obligations if inventory does not turn over fast enough Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-49 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com *FINANCIAL STATEMENT ANALYSIS CASE (Continued) Times interest earned Measures the ability to meet interest commitments from current earnings The higher the ratio, the more safety for long-term creditors RNA’s ratio has been improving over the last three years and is above the industry average This provides an indication that RNA has been paying down or refinancing debt and/or increasing sales and profits, which indicates long-term stability Profit margin on sales Measures the net income generated by each dollar of sales It provides some indication of the ability to absorb cost increases or sales declines RNA’s profit margin has been improving and is currently above the industry average, indicating a trend towards marginal operating efficiency Furthermore, it improves the ability to absorb soft economic periods, pay down debt, or take on additional debt for expansion Total asset turnover Measures the efficiency of resource use; i.e., the ability to generate sales through the use of assets RNA’s ratio has been steadily improving and is above the industry average, indicating good use of assets and ability to generate sales Inventory turnover Measures how quickly inventory is sold, as well as how effectively investment in inventory is used It also provides a basis for determining if obsolete inventory is present or pricing problems exist RNA’s ratio has been steadily declining and is below the industry average This slower-than-average situation may indicate a decline in operating efficiency, hidden obsolete inventory, or overpriced stock items 24-50 Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com *FINANCIAL STATEMENT ANALYSIS CASE (Continued) (c) Limitations of ratio analysis include: Difficulty making comparisons among firms in the same industry due to accounting differences Different accounting methods may cause different results in straight-line depreciation versus accelerated methods, Average cost versus FIFO, etc The fact that no one ratio is conclusive Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-51 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com ACCOUNTING, ANALYSIS, AND PRINCIPLES ACCOUNTING (1) Integral Approach 1st Quarter Sales $320,000 Variable manufacturing costs 32,000 Fixed manufacturing costs 64,000 Variable non-manufacturing costs 28,000 Fixed non-manufacturing costs 96,000 Net income $100,000 2nd Quarter $600,000 60,000 120,000 3rd Quarter $2,200,000 220,000 440,000 4th Quarter $480,000 48,000 96,000 52,500 192,500 42,000 180,000 $187,500 660,000 $ 687,500 144,000 $150,000 Sales = (Number of units X $4.00) Variable manufacturing costs = (Number of units X $0.40) Variable non-manufacturing costs = (Number of units X $0.35) Fixed manufacturing costs = Number of units X ($720,000 ÷ 900,000) Fixed non-manufacturing costs = Number of units X ($1,080,000 ÷ 900,000) (2) Discrete Approach Sales Variable manufacturing costs Fixed manufacturing costs Variable non-manufacturing costs *Fixed non-manufacturing costs Net income (Loss) 1st Quarter $320,000 32,000 64,000 2nd Quarter $600,000 60,000 120,000 28,000 270,000 ($ 74,000) 3rd Quarter $2,200,000 220,000 440,000 4th Quarter $480,000 48,000 96,000 52,500 192,500 42,000 270,000 $ 97,500 270,000 $1,077,500 270,000 $ 24,000 *$1,080,000 ÷ 24-52 Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) ANALYSIS Profit margin on sales = Net income ÷ sales (1) Integral approach: Net income (Loss) Sales Profit margin on sales (2) 1st Quarter $100,000 320,000 31.3% 2nd Quarter $187,500 600,000 31.3% 3rd Quarter $687,500 2,200,000 31.3% 4th Quarter $150,000 480,000 31.3% 1st Quarter $(74,000) 320,000 (23.1%) 2nd Quarter $97,500 600,000 16.3% 3rd Quarter $1,077,500 2,200,000 49.0% 4th Quarter $24,000 480,000 5.0% Discrete approach: Net income (Loss) Sales Profit margin on sales The integral approach smoothes variation in profit margin on sales across quarters relative to the discrete approach This smoothing happens because the integral approach allocates fixed costs across quarters according to the sales occurring in the quarter The discrete approach, however, allocates fixed costs across quarters evenly (an equal amount each quarter) Because the sales vary from quarter-to-quarter, an even allocation of fixed costs to the quarters results in more variation in net income Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-53 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) PRINCIPLES IFRS requires companies to follow the discrete approach However, companies should use the same accounting policies for interim reports and for annual reports The concept underlying the integral approach is that an individual quarter is part of a large time interval about which we have more information In this problem, for example, we know that sales are seasonal So, we know that a greater proportion of the revenue generating process occurs in the third quarter than in the other quarters Arguably, then, a greater proportion of the fixed costs for the year should be allocated to the third quarter than to the other quarters Part of the reason we incur fixed costs at the level we is so that we can handle the volume of the third quarter Allocating the same amount of fixed costs to each quarter paints a picture of the firm’s profitability across quarters that is arguably inaccurate 24-54 Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com PROFESSIONAL RESEARCH (a) According to IAS 1, paragraph 117, ―An entity shall disclose in the summary of significant accounting policies: (1) the measurement basis (or bases) used in preparing the financial statements, and (2) the other accounting policies used that are relevant to an understanding of the financial statements (b) (1) A few examples taken from IAS 1: Paragraph 118: It is important for an entity to inform users of the measurement basis or bases used in the financial statements Paragraph 120: Each entity considers the nature of its operations and the policies that the users of its financial statements would expect to be disclosed for that type of entity Paragraph 122: An entity shall disclose, in the summary of significant accounting policies or other notes, the judgements, apart from those involving estimations (see paragraph 125), that management has made in the process of applying the entity’s accounting policies and that have the most significant effect on the amounts recognised in the financial statements Paragraph 124: Some of the disclosures made in accordance with paragraph 122 are required by other IFRSs For example, IAS 27 requires an entity to disclose the reasons why the entity’s ownership interest does not constitute control, in respect of an investee that is not a subsidiary even though more than half of its voting or potential voting power is owned directly or indirectly through subsidiaries IAS 40 Investment Property requires disclosure of the criteria developed by the entity to distinguish investment property from owner-occupied property and from property held for sale in the ordinary course of business, when classification of the property is difficult Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-55 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com PROFESSIONAL SIMULATION Analysis The current-ratio increase is a favorable indication as to solvency, but alone tells little about the going-concern prospects of the client From this ratio change alone, it is impossible to know the amount and direction of the changes in individual accounts, total current assets, and total current liabilities Also unknown are the reasons for the changes The acid-test ratio is an unfavorable indication as to solvency, especially when the current ratio increase is also considered This decline is also unfavorable to the going-concern prospects of the client because it reflects a declining cash position and raises questions as to reasons for the increases in other current assets, such as inventories The increase in the ratio of property, plant, and equipment to equity cannot alone tell anything about either solvency or going-concern prospects There is no way to know the amount and direction of the changes in the two items If assets increased, one must know whether the new assets are immediately productive or need further development A reduction in equity at this point would cause much concern for the creditors of this client The decrease in the ratio of sales to equity is in itself an unfavorable indicator because the most likely reason is a sales decline However, this decline, which is more relevant to going-concern prospects than to solvency, is largely offset by the fact that net income has significantly increased The increase in net income is a favorable indicator for both solvency and going-concern prospects although much depends on the quality of receivables generated from sales and how quickly they can be converted into cash A significant factor here may be that despite a decline in sales, the client’s management has been able to reduce costs to produce this increase Indirectly, the improved income picture may have a favorable impact on solvency and going-concern potential by enabling the client to borrow currently to meet cash requirements 24-56 Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com PROFESSIONAL SIMULATION (Continued) The 32-percent increase in earnings per share, which is identical to the percentage increase in net income, is an indication that there has probably been no change in the number of ordinary shares outstanding This in turn indicates that financing was not obtained through the issuance of ordinary shares It is not possible to reach conclusions about solvency and goingconcern prospects without additional information about the nature and extent of financing The percentage increases in book value per share demonstrate nothing so far as solvency and going-concern potential are concerned It is probable that the smaller percentage increase in the current year only reflects the larger base value created in the preceding year It is not possible to tell from these figures what the dividend policy of the client is or whether there is an increase in net assets which is capable of generating future earnings, thus making it possible to raise capital for current needs by the issue of additional ordinary shares The collective implications of these data alone are that the client entity is about as solvent and as viable as a going concern at the end of the current year as it was at the beginning although there may be a need for short-term operating cash Explanation The creditors will probably ask for the information listed below to overcome the limitations inherent in the ratios discussed above and to obtain more evidence to support the conclusions drawn from them Additional ratios and other comparative data may be requested They are likely to include such items as the following: (a) Changes in current assets other than quick assets (b) Receivables turnover, inventory turnover, and the number of days it takes to complete the cycle from cash to inventories to receivables to cash (c) Liabilities to equity The creditors will probably want explanations for the changes in ratios during the current year The client should be prepared to respond to questions about the age and collectibility of the receivables, the condition and salability of the inventories, the cause of the quickasset position in the current year, the nature of increases in property, plant, and equipment and their potential for providing greater sales or Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual 24-57 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com PROFESSIONAL SIMULATION (Continued) cost reductions in the future, the presence of long-term debt and the dates when it must be repaid, and the manner of controlling costs so that a larger net income was shown in the current year (The comparative financial statements themselves will answer many of these questions and will provide insight into the client’s capability of meeting current obligations as well as continuing profitable operations.) The client may also be expected to provide information about future plans and projections The creditors may also ask for ratios and related information for several recent years These data may demonstrate trends and can be compared to data for other companies and for the industry Although a quick evaluation of a reporting entity can be made using only a few ratios and comparing these with past ratios and industry statistics, the creditors should realize the limitations of such analysis even from the best prepared statements carrying an auditor’s unqualified opinion A limitation on comparisons with industry statistics or other companies within the industry exists because material differences can be created through the use of alternative (but acceptable) accounting methods Further, when evaluating changes in ratios or percentages, the evaluation should be directed to the nature of the item being evaluated because very small differences in ratios or percentages can represent significant changes in dollar amounts or trends The creditors should evaluate conclusions drawn from ratio analysis in the light of the current status of, and expected changes in, such things as general economic conditions, the client’s competitive position, the public’s demand (for the product itself, increased quality of the product, control of noise and pollution, etc.), and the client’s specific plans 24-58 Copyright © 2011 John Wiley & Sons, Inc Kieso Intermediate: IFRS Edition, Solutions Manual To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com ... taxes Amounts Percent Increase (000s omitted) 2 011 2 010 $300 $3,000 $2,700 = 11 .11 % $2,700 $10 5 1, 530 1, 425 = 7.37% $1, 425 $19 5 1, 470 1, 275 = 15 .29% $1, 275 $69 366 297 = 23.23% $297 (b) Other financial... 2 012 2 013 $3,333.3 1, 642.8 1, 690.5 948.2 742.3 296.9 $ 445.4 $3,703.6 1, 763.8 1, 939.8 1, 045.5 894.3 357.7 $ 536.6 10 2.5 (260.0) (6.0) 2 81. 9 (15 0.0) $ 13 1.9 10 2.5 (260.0) 379 .1 (15 0.0) $ 229 .1. .. 24% 13 % 10 0% 45% 27% 28% 10 0% 3.03 to 1. 13 to 4.23 times 1. 14a times 40 to ( $1, 140 ÷ $350) ($320 + $302) ÷ $350 ( $1, 500 ÷ $302) ($320 ÷ $350) 3.26 to 1. 78 to 4.97 times 1. 74b times 91 to b ( $1, 500