Financial accounting 7e harmon chapter 14 financial analysis the big picture

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13

FINANCIAL
ANALYSIS:
THE BIG PICTURE

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Financial Accounting, Seventh Edition


Learning
Learning Objectives
Objectives
After studying this chapter, you should be able to:

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1.

Understand the concept of sustainable income.

2.

Indicate how irregular items are presented.

3.

Explain the concept of comprehensive income.

4.

Describe and apply horizontal analysis.

5.

Describe and apply vertical analysis.

6.

Identify and compute ratios used in analyzing a company’s
liquidity, solvency, and profitability.

7.

Understand the concept of quality of earnings.


Preview of Chapter 13

Financial Accounting
Seventh Edition
Kimmel Weygandt Kieso
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Sustainable
Sustainable Income

Income
Sustainable Income - Net income adjusted for irregular
items.

Irregular Items
Irregular items are separately identified on the income
statement. Two types are:
1. Discontinued operations.
2. Extraordinary items.

These “irregular” items are reported net of income taxes.
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LO 1 Understand the concept of sustainable income.
LO 2 Indicate how irregular items are presented.


Sustainable
Sustainable Income
Income
Illustration 13-1

Components of
the income
statement

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LO 2 Indicate how irregular items are presented.

Sustainable
Sustainable Income
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.

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LO 2 Indicate how irregular items are presented.


Sustainable
Sustainable Income
Income
Illustration: Rozek Inc. has revenues of $2.5 million and expenses
of $1.7 million from continuing operations in 2014. The company
therefore has income before income taxes of $800,000. During
2014 the company discontinued and sold its unprofitable chemical
division at a loss of $210,000 (net of $90,000 tax savings).
Illustration 13-2

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LO 2


Sustainable

Sustainable Income
Income
Extraordinary items are events and transactions that
meet two conditions:
Both


Unusual in nature and



Infrequent in occurrence

Company must consider the environment in which it operates.
Amounts reported “net of tax.”

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LO 2 Indicate how irregular items are presented.


Sustainable
Sustainable Income
Income
Illustration: In 2014 a revolutionary foreign government
expropriated property held as an investment by Rozek Inc. If the
loss is $70,000 before applicable income tax savings of $21,000,
how will the loss be presented in the income statement?
ROZEK INC.

Illustration 13-3

Income Statement (partial)
For the Year Ended December 31, 2014

Advance slide in presentation mode to reveal solution.

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LO 2 Indicate how irregular items are presented.


Sustainable
Sustainable Income
Income
Are these considered Extraordinary Items?

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

Effects of major natural casualties, if rare in
the area.

YES



Effects of major natural casualties, not
uncommon in the area.

NO



Write-down of inventories or write-off of
receivables.

NO



Expropriation (takeover) of property by a
foreign government.

YES

LO 2 Indicate how irregular items are presented.


Sustainable
Sustainable Income
Income
Are these considered Extraordinary Items?

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

Losses attributable to labor strikes.

NO



Effects of a newly enacted law or regulation,
such as a condemnation action.

YES



Gains or losses from sales of property, plant,
or equipment.

NO

LO 2 Indicate how irregular items are presented.


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Sustainable
Sustainable Income
Income
Changes in Accounting Principle

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

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.

LO 2 Indicate how irregular items are presented.


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Sustainable
Sustainable Income
Income
Comprehensive 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.


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Example – Unrealized gain or loss on Available-for-sale
securities
LO 3 Explain the concept of comprehensive income.


Sustainable
Sustainable Income
Income
Illustration of Comprehensive Income
Accounting standards require companies to adjust most
investments in stocks and bonds up or down to their market
price at the end of each accounting period.
Illustration: During 2014 Stassi Company purchased IBM stock
for $10,000 as an investment. At the end of 2014 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?

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LO 3 Explain the concept of comprehensive income.


Sustainable
Sustainable Income
Income
Illustration of 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
(Comprehensive Income - Stockholders’ Equity)
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LO 3 Explain the concept of comprehensive income.


Sustainable
Sustainable Income
Income
Format One – Comprehensive Income
Combined statement of income and comprehensive income.
Illustration 13-5

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LO 3 Explain the concept of comprehensive income.


Sustainable
Sustainable Income
Income
Format Two - Comprehensive Income
Separate component of Stockholders’ Equity.
Illustration 13-6

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LO 3 Explain the concept of comprehensive income.


Sustainable
Sustainable Income
Income

Format Three Comprehensive
Income

Illustration 13-7
PACE CORPORATION
Income Statement and
Statement of Comprehensive Income
For the Year Ended December 31, 2014

Complete
Income
Statement

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LO 3 Explain the concept of comprehensive income.


Illustration: In its draft 2014 income statement,
AIR Corporation reports income before income taxes
$400,000, extraordinary loss due to earthquake $100,000, income
taxes $120,000 (not including irregular items), and loss on disposal of
discontinued flower division $140,000. The income tax rate is 30%.
Prepare a correct income statement, beginning with income before
income taxes.

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AIR CORPORATION
Income Statement (partial)

Income before income taxes
$400,000
Income tax expense
120,000
Income before irregular items
280,000
Discontinued operations
Loss on disposal of discontinued flower division,
net of $42,000 tax savings
(98,000)
ExtraordinaryAdvance
earthquake
net of $30,000
savings
slide loss,
in presentation
mode totax
reveal
solution.
(70,000)

LO 3


Comparative
Comparative Analysis
Analysis
Analyzing financial statements involves:
Comparison
Bases

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Basic Tools



Intracompany



Horizontal analysis



Intercompany



Vertical analysis



Industry averages



Ratio Analysis

Comparative
Comparative Analysis
Analysis
Horizontal Analysis
Also called trend analysis, is a technique for evaluating a
series of financial statement data over a period of time.

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

Purpose is to determine increase or decrease that has taken
place.



Commonly applied to the balance sheet and income
statement.

LO 4 Describe and apply horizontal analysis.


Comparative
Comparative Analysis
Analysis
Illustration 13-11
Horizontal analysis
of balance sheets

Helpful Hint:

When using
horizontal
analysis, be sure
to examine both
dollar amount
changes and
percentage
changes.

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LO 4 Describe and apply horizontal analysis.