Accounting principles 11e kieso kimmel chapter 018

Condensed Balance Sheets For the Years Ended December 31 Illustration 18-12 QUALITY DEPARTMENT STORE INC.. Condensed Income Statements For the Years Ended December 31 LO 5 QUALITY DEPART

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Prepared by Coby Harmon University of California, Santa Barbara

Westmont College

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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,

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Preview of Chapter 18

Accounting Principles Eleventh Edition Weygandt Kimmel Kieso

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LO 1 Discuss the need for comparative analysis.

LO 2 Identify the tools of financial statement analysis.

Basics of Financial Statement Analysis

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18-5 LO 3 Explain and apply horizontal analysis.

Horizontal Analysis

Horizontal analysis , also called trend analysis, is a

technique for evaluating a series of financial statement data

over a period of time

 Purpose is to determine the increase or decrease that has

taken place.

 Commonly applied to the balance sheet, income

statement, and statement of retained earnings.

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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.

Illustration 18-5

Horizontal analysis of balance sheets

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Overall, gross profit and net income were up substantially Gross profit increased17.1%, and net income, 26.5% Quality’s profit trend appears

favorable

Horizontal analysis of Income statements

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In the horizontal analysis of the balance sheet the ending retained earnings increased 38.6% As indicated earlier, the company retained a significant portion of net income to

finance additional plant facilities.

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18-9 LO 4 Describe and apply vertical analysis.

Vertical analysis , also called common-size analysis, is a

technique that expresses each financial statement item as a

percent of a base amount

 On an income statement, we might say that selling

expenses are 16% of net sales.

 Vertical analysis is commonly applied to the balance

sheet and the income statement.

Vertical Analysis

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Vertical analysis of balance sheets

LO 4 Describe and apply vertical analysis.

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Quality appears

to be a profitable enterprise that is becoming even more successful.

Vertical analysis of Income statements

LO 4 Describe and apply vertical analysis.

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18-13 LO 5 Identify and compute ratios used in analyzing a

firm’s liquidity, profitability, and solvency.

Ratio analysis expresses the relationship among selected

items of financial statement data.

Liquidity Profitability Solvency

Measures

short-term ability of the

company to pay its

maturing obligations and to

meet unexpected

needs for cash.

Financial Ratio Classifications

Measures the income or operating success

of a company for a given period of

time.

Measures the ability of the company to survive over a long period of time.

Ratio Analysis

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The discussion of ratios will include the following types of

3 Intercompany comparisons based on Macy’s, Inc as Quality

Department Store’s principal competitor.

A single ratio by itself is not very meaningful

Ratio Analysis

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THE MISSING CONTROLS

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 offs, or in this case, write-offs that were frequently very close to the approval threshold.

write-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 by companies to detect fraud The numeric relationships that can reveal

fraud can be such things as financial ratios that appear abnormal, or statistical abnormalities in the numbers themselves 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.

Advance slide in presentation mode to reveal answer. LO 5

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Liquidity Ratios

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 acid-test ratio ,

accounts receivable turnover , and inventory turnover

Ratio Analysis

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QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets For the Years Ended December 31

Condensed Income Statements For the Years Ended December 31

LO 5 Advance slide in presentation mode to reveal solution.

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Ratio of 2.96:1 means that for every dollar of current liabilities, Quality

has $2.96 of current assets.

Current Ratio

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Ratio Analysis

Acid-Test Ratio

Liquidity Ratios

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LO 5

Balance Sheet (partial) For the Years Ended December 31

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18-22

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LO 5

Balance Sheet (partial)

For the Years Ended December 31

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Measures the number of times, on average, the company collects

receivables during the period.

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A variant of the accounts receivable turnover ratio is to convert it

to an average collection period in terms of days.

Accounts receivable are collected on average every 36 days.

$2,097,000 ($180,000 + $230,000) / 2

= 10.2 times

365 days / 10.2 times = every 35.78 days

Accounts Receivable Turnover

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LO 5

Balance Sheet (partial) For the Years Ended December 31

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Measures the number of times, on average, the inventory is sold

during the period.

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A variant of inventory turnover is the days in inventory.

Inventory turnover ratios vary considerably among industries.

365 days / 2.3 times = every 159 days

$1,281,000 ($500,000 + $620,000) / 2

= 2.3 times

Inventory Turnover

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Profitability Ratios

Measure the income or operating success of a company for a

given period of time

 Income, or the lack of it, affects the company’s ability to obtain

debt and equity financing, liquidity position, and the ability to grow.

 Ratios include the profit margin, asset turnover, return on

assets, return on common stockholders’ equity, earnings per share, price-earnings, and payout ratio.

Ratio Analysis

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LO 5

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LO 5 Identify and compute ratios used in analyzing a

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LO 5

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LO 5

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Ratio Analysis

Return on Asset

An overall measure of profitability.

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LO 5

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Ratio Analysis

Return on Common Stockholders’ Equity

Shows how many dollars of net income the company earned for each dollar invested by the owners.

LO 5

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LO 5

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Ratio Analysis

Earnings Per Share (EPS)

A measure of the net income earned on each share of common stock.

LO 5

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LO 5

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LO 5

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Solvency Ratios

Solvency ratios measure the ability of a company to survive

over a long period of time.

 Debt to Assets and

 Times Interest Earned

are two ratios that provide information about paying ability.

debt-Ratio Analysis

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LO 5

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Ratio Analysis

Debt to Total Assets Ratio

Measures the percentage of the total assets that creditors provide.

LO 5Solvency Ratios

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LO 5

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Ratio Analysis

Times Interest Earned

Provides an indication of the company’s ability to meet interest

payments as they come due.

LO 5Solvency Ratios

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Summary of Ratios

LO 5

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18-51 LO 6 Understand the concept of earning power,

and how irregular items are presented.

Earning power means the normal level of income to be

obtained in the future.

“Irregular” items are separately identified on the income

statement Two types are:

1 Discontinued operations.

2 Extraordinary items.

“Irregular” items are reported net of income taxes.

Earning Power and Irregular Items

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(a) Disposal of a significant component of a business.

(b) Report the income (loss) from discontinued operations in

two parts:

1 income (loss) from operations (net of tax) and

2 gain (loss) on disposal (net of tax).

LO 6 Understand the concept of earning power,

Discontinued Operations

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Illustration: During 2014 BD Inc has income before income

taxes of $79,000,000 During 2014, BD discontinued and sold its unprofitable chemical division The loss in 2014 from chemical

operations (net of $135,000 taxes) was $315,000 The loss on

disposal of the chemical division (net of $81,000 taxes) was

$189,000 Assuming a 30% tax rate on income.

LO 6

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Discontinued

Operations are reported

after “Income from

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Nonrecurring material items that differ significantly from a

company’s typical business activities.

 Must be both of an

► Unusual Nature and

► Occur Infrequently

 Must consider the environment in which it operates.

 Amounts reported “net of tax.”

Extraordinary Items

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Are these considered Extraordinary Items?

(a) A large portion of a tobacco manufacturer’s crops

are destroyed by a hail storm Severe damage from hail storms in the locality where the

manufacturer grows tobacco is rare.

(b) A citrus grower's Florida crop is damaged by

frost

(c) Loss from sale of temporary investments.

(d) Loss attributable to a labor strike.

YES

NO NO

NO

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(e) Loss from flood damage (The nearby Black River

floods every 2 to 3 years.)

(f) An earthquake destroys one of the oil refineries

owned by a large multi-national oil company

Earthquakes are rare in this geographical location.

(g) Write-down of obsolete inventory.

(h) Expropriation of a factory by a foreign

government.

NO

YES

NO

Are these considered Extraordinary Items?

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Extraordinary Items are

reported after “Income

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18-61

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 Occurs when the principle used in the current year is

different from the one used in the preceding year.

 Accounting rules permit a change if justified.

 Changes are reported retroactively.

 Example would include a change in inventory costing

method such as FIFO to average cost.

Change in Accounting Principle

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