Financial accounting 10th by harmin ch13

Prepared by
Coby Harmon
University of California, Santa Barbara
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Westmont College


13

Financial Analysis:
The Big Picture

Learning Objectives

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1

Apply the concepts of sustainable income and quality of earnings.

2

Apply horizontal analysis and vertical analysis.

3

Analyze a company’s performance using ration analysis.


LEARNING

1

OBJECTIVE

Apply the concepts of sustainable income and quality of
earnings.

Sustainable Income
The most likely level of income to be obtained by a company in the future .

Unusual Items
Separately disclosed.



Discontinued operations.



Other comprehensive income.

These unusual items are reported net of income tax.

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LO 1


Sustainable Income

Illustration 13-1
Statement of comprehensive
income

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LO 1


Sustainable Income

DISCONTINUED OPERATIONS

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(a)

Disposal of a significant component of a business.

(b)

The income (loss) from discontinued operations consists of two parts:

1.

the income (loss) from operations and

2.

the gain (loss) on disposal of the component.

LO 1


DISCONTINUED OPERATIONS

Illustration: Assume that during 2019 Acro Energy Inc. has income before income taxes of $800,000. During
2019, Acro discontinued and sold its unprofitable chemical division. The loss in 2019 from chemical operations
(net of $60,000 taxes) was $140,000. The loss on disposal of the chemical division (net of $30,000 taxes) was
$70,000. Assuming a 30% tax rate on income.
Prepare Acro’s statement of comprehensive income for the year ended December 31, 2019.

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LO 1


DISCONTINUED OPERATIONS

Illustration 13-2
Statement presentation of discontinued operations

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LO 1


INVESTOR INSIGHT

What Does “Non-Recurring” Really Mean
Many companies incur restructuring charges as they attempt to reduce costs. They often label these items in the income
statement as “non-recurring” charges, to suggest that they are isolated events, unlikely to occur in future periods. The
question for analysts is, are these costs really one-time, “nonrecurring events” or do they reflect problems that the
company will be facing for many periods in the future? If they are one-time events, then they can be largely ignored when
trying to predict future earnings. But, some companies report “one-time” restructuring charges over and over again. For
example, Procter & Gamble reported a restructuring charge in 12 consecutive quarters, and Motorola had “special”
charges in 14 consecutive quarters. On the other hand, other companies have a restructuring charge only once in a 5- or
10-year period. There appears to be no substitute for careful analysis of the numbers that comprise net income.

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LO 1


Sustainable 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 1


COMPREHENSIVE INCOME

ILLUSTRATION OF COMPREHENSIVE INCOME
Accounting standards require companies to adjust most investments in stocks and bonds up or down to their
market value at the end of each accounting period.
Illustration: During 2019 Stassi Company purchased IBM bonds for $10,000 as an investment. At the end of 2019
Stassi was still holding the investment, but the bonds’ market value was now $8,000.
How should Stassi account for the $2,000 unrealized loss?

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LO 1


COMPREHENSIVE INCOME

ILLUSTRATION OF COMPREHENSIVE INCOME
How should Stassi account for the $2,000 unrealized loss?
Answer: Depends on whether Stassi classifies the IBM bonds as a



Trading security or an
Unrealized gains and losses



Available for-sale security.

(Income Statement)

Unrealized gains and losses
(Other Comprehensive Income - Stockholders’ Equity)

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LO 1


COMPREHENSIVE INCOME

Format One
Combined statement of income and comprehensive income.

Illustration 13-5

Illustration 13-3
Lower portion of combined statement of income and comprehensive income

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COMPREHENSIVE INCOME

Format Two
Separate component of Stockholders’ Equity.

Illustration 13-4
Unrealized loss in stockholders’ equity section
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LO 1


Illustration 13-5
Complete statement of
comprehensive income

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SUSTAINABLE 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 1


INVESTOR INSIGHT

United Parcel Service (UPS)

More Frequent Ups and Downs
In the past, U.S. companies used a method to account for their pension plans that smoothed out the gains and losses on their
pension portfolios by spreading gains and losses over multiple years. Many felt that this approach was beneficial because it
reduced the volatility of reported net income. However, recently some companies have opted to adopt a method that comes
closer to recognizing gains and losses in the period in which they occur. Some of the companies that have adopted this approach
are United Parcel Service (UPS), Honeywell International, IBM, AT&T, and Verizon Communications. The CFO at UPS said
he favored the new approach because “events that occurred in prior years will no longer distort current-year results. It will result in
better transparency by eliminating the noise of past plan performance.” When UPS switched, it resulted in a charge of $827

million from the change in accounting principle.
Source: Bob Sechler and Doug Cameron, “UPS Alters Pension-Plan Accounting,” Wall Street Journal (January 30, 2012).

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LO 1


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.

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LO 1


Quality of Earnings

ALTERNATIVE ACCOUNTING METHODS



Variations among companies in the application of GAAP may hamper comparability and reduce
quality of earnings (FIFO vs. LIFO).

PRO FORMA INCOME



Usually excludes items that are unusual or nonrecurring.



Some companies have abused the flexibility that pro forma numbers allow to put their companies in a
more favorable light.

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LO 1


Quality of Earnings

IMPROPER RECOGNITION
Some managers have felt pressure to continually increase earnings.
Abuses include:

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

Improper recognition of revenue (channel stuffing).



Improper capitalization of operating expenses (WorldCom).



Failure to report all liabilities (Enron).

LO 1


DO IT!

1

Unusual Items

In its proposed 2019 income statement, AIR Corporation reports income before income taxes $400,000,
unrealized gain on available-for-sale securities $100,000, income taxes $120,000 (not including unusual
items), loss from operation of discontinued flower division $50,000, and loss on disposal of discontinued flower
division $90,000. The income tax rate is 30%.
Prepare a correct statement of comprehensive income, beginning with “Income before income taxes.”

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LO 1


DO IT!

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1

Unusual Items

LO 1


LEARNING

2

OBJECTIVE

Apply horizontal analysis and vertical analysis.

Analyzing financial statements involves:

Comparison

Basic Tools

Bases

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

Intracompany



Horizontal analysis



Intercompany



Vertical analysis



Industry averages



Ratio Analysis

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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 2


Illustration 13-9
Horizontal analysis of balance sheets

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Illustration 13-10
Horizontal analysis of income statements

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LO 2