Financial Accounting: Chapter 13

Tools for Business Decision Making, 4th Edition

Kimmel, Weygandt, Kieso After studying Chapter 13, you should be
able to:
 Understand the concept of “CONTINUING”

CHAPTER 13 operations and the importance of a multiple-

step income statement presentation.
 Explain the concept of comprehensive
FINANCIAL income.
ANALYSIS:  Interpret financial statements, including the

use of ratio analysis.

The Big Picture
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KEEPIN’ IT REAL: 1
11 Sustainable Income...
A strong analytic includes first developing an “CONTINUING OPERATIONS”
expectation.
REMEMBER: FINANCIAL STATEMENTS TELL WHAT HAPPENED
Also, can we use financial statements to prove/ (PAST TENSE) TO USERS WHO WANT TO DEVELOP
disprove some of the “economics” you are EXPECTATIONS ABOUT WHAT IS GOING TO HAPPEN. Thus a
learning? need for a MULTIPLE STEP INCOME STATEMENT, which:
 Segregates the continuing operations from two principle items
 How’s the economy been doing? which are NOT continuing::
 What sort of effect do you suppose that may have on  Discontinued Pperations and
financial statements?  Extraordinary Items

 “Price elasticity” and “law of demand”… how about

WalMart? Have a look: http://sec.gov/cgi-bin/browse- WHY DO POTENTIAL NEW INVESTORS AND CREDITORS CARE
edgar?company=&match=&CIK=wal&filenum=&State=& ABOUT WHAT ALREADY HAPPENED?
Country=&SIC=&owner=exclude&Find=Find+Companies THE PAST IS A STRONG INDICATOR OF THE FUTURE.
&action=getcompany
 What economic principle is that?
“GIffen Goods” 13-3 13-4

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 Components of the MULTIPLE 2
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Irregular Items
STEP Income Statement
Revenue X
COGS Y Typical examples:
Two types of irregular items are
Gross Profit x-y=GP •SG&A
•Depreciation exp.
reported -- (all net of taxes)
Operating expenses A •Rent
•Etc.  discontinued operations
Income before taxes GP-A=IBT
Taxes Tax rate*IBT=T  extraordinary items
Inc. from continuing Op’s ICO=IBT-T
Discontinued op’s (Net of Tax!) D
Extraordinary items (Net of Tax!) E
Net Income ICO+-D+-E
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Discontinued Operations... Discontinued Operations

Rozek net income of $800,000 from continuing
operations in 2007.
Refers to the disposal of a significant During 2007 the company discontinued and sold its
segment of a business... unprofitable chemical division. The loss in 2007 from
chemical operations (net of $90,000 taxes) was
 the elimination of a major class of $210,000. The tax rate is 30%.
customers or
 an entire activity.

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 Extraordinary Items... Extraordinary Items

Are events and  In 2007 a revolutionary foreign

transactions that
meet two conditions:
government expropriated property
 Unusual in nature held as an investment by Rozek Inc.
 Infrequent in  The loss is $70,000 before applicable
occurrence income taxes of $21,000, the income
HELP FROM BOB: (1) statement presentation will show a
Has not happened deduction of $49,000.
before
(2) is not expected to
happen again.
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Presentation of Extraordinary Extraordinary Items

Items...

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 Change in
Estimating Sustainable Income Accounting Principle

I DON’T COVER, EVEN THOUGH IT IS IN YOUR TEXT.

When evaluating a company,


it generally makes sense to

eliminate all irregular items in
estimating future sustainable
income.

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Comprehensive Income Comprehensive Income

 Most revenues, expenses, gains, and  The FASB now requires that, in
losses recognized during the period addition to reporting net income, a
are included in net income. company must also report
 Specific exceptions to this practice comprehensive income.
have developed - these items bypass
income and are reported directly in
stockholders’ equity as “other
comprehensive income” (aka OCI).

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Comprehensive Income Complete Income Statement
Includes all changes in
stockholders' equity during a
period except those resulting from
investments by stockholders and
distributions to stockholders. Other
Comprehensive
Income
(aka “OCI”)
EASIER TO UNDERSTAND:
Comprehensive income= Net Income + Other Comprehensive Income.

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Comparative Analysis Financial Statement Analysis

Three basic tools are used in financial
statement analysis :
There are three types of comparisons to 1. Horizontal analysis
Comparison over time
improve decision usefulness of financial


 Expressed as a % of a base year

information: 2. Vertical analysis
Relational analysis within a statement
 Intracompany basis:


 Expressed as a % of:
 Compare a company to itself (usually over  Assets if analyzing the balance sheet;
Revenues if analyzing the income statement;
time)


3. Ratio analysis
 Intercompany basis  Relational analysis among statements;
Allows comparing various sized
Compare a company to its competitors

 entities to one another (“right
sizing”)
 Industry averages
 Compare a company to the average of the
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 Horizontal Analysis Horizontal Analysis- Balance Sheet

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Horizontal Analysis – Review

Income Statement
In horizontal analysis, each item is
expressed as a percentage of the:

a. net income amount.

b. stockholders’ equity amount.
c. total assets amount.
d. base-year amount.

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 Review Vertical Analysis - Balance Sheet

In horizontal analysis, each item is

expressed as a percentage of the:

a. net income amount.

b. stockholders’ equity amount.
c. total assets amount.
d. base-year amount.

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Intercompany Comparison by Review

Vertical Analysis
In vertical analysis, the base amount for
depreciation expense is generally:

a. net sales.
b. depreciation expense in a previous year.
c. gross profit.
d. fixed assets.

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 Review 6
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Ratio Analysis

In vertical analysis, the base amount for

depreciation expense is generally:

a. net sales.
b. depreciation expense in a previous year.
c. gross profit.
d. fixed assets.

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Ratios Liquidity Ratios

 Three types:
 Liquidity ratios Measure the short-term ability
 Solvency ratios of the enterprise to pay its
 Profitability ratios maturing obligations and to
 Can provide clues to underlying conditions that may meet unexpected needs for
not be apparent from an inspection of the individual cash.
components.
 Single ratio by itself is not very meaningful. WHO CARES?
Short-term creditors such as
bankers and suppliers

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Liquidity Ratios Solvency Ratios
Measure the ability of the
enterprise to survive over a
long period of time
WHO CARES?
Long-term creditors and
stockholders- particularly with
respect to ability to make
principle and interest
payments.

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Solvency Ratios Profitability Ratios

Measure the income or operating
success of an enterprise for a given
period of time
WHO CARES? Everybody
WHY? A company’s income affects:
 its ability to obtain debt and equity
financing
 its liquidity position
 its ability to grow
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PER SHARE Profitability Ratios
Why does it make sense to convert items on
the statements to “per share” amounts?

Unless you own all the stock of a company,

you would like to see activity converted to
the basis at which you made your purchase

What about a lender, would they be interested

in net income per share or net income?

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Price Earnings Ratio Earnings Per Share and

Price Earnings Ratio

The P/E ratio reflects the investors’

assessment of a company’s future
earnings.

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 Limitations Of Estimates
Financial Analysis
 Financial statements are based on
 Horizontal, vertical, and ratio analysis are estimates.
frequently used in making significant  allowance for uncollectible accounts
business decisions.  depreciation
 One should be aware  costs of warranties
of the limitations of  contingent losses
these tools and the To the extent that these estimates are inaccurate,
financial statements. the financial ratios and percentages are also
inaccurate.

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Quality of Earnings Pro Forma Income

A company that has a high quality of earnings A measure of the net income generated
provides full and transparent information that that usually excludes items that the
will not confuse or mislead users of the financial company thinks are unusual or
statements. nonrecurring.

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 Improper Recognition LAST BUT CERTAINLY NOT
LEAST
 Offering big discounts (channel stuffing) Financial statements display what
to companies to get them to buy early- happened (past tense)
Often leads to disaster in subsequent
 Will the past always repeat itself?
periods.
 Improper capitalization of operating
expenses

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