Accounting principles, 13th edition ch18

Accounting Principles
Thirteenth Edition
Weygandt Kimmel Kieso

Chapter 18

Financial Analysis:
The Big Picture
Prepared by

Coby Harmon

University of California, Santa Barbara
Westmont College


Chapter Outline
Learning Objectives
LO 1 Apply the concepts of sustainable income and
quality of earnings.
LO 2 Apply horizontal analysis and vertical analysis.
LO 3 Analyze a company’s performance using ratio
analysis.

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Sustainable Income and Quality of
Earnings

Sustainable income is the most likely level of income
to be obtained by a company in the future. It differs
from actual net income by the amount of unusual
revenues, expenses, gains, and losses included in the
current year’s income.
Information on unusual items such as gains or losses
on discontinued items and components of other
comprehensive income are disclosed.
These unusual items are reported net of income
taxes.

LO 1

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3


Cruz Company
Statement of Comprehensive Income
For the Year Ended 2020
Sales revenue
Cost of goods sold
Gross profit
Operating expenses
Income from operations
Other revenues (expenses) and gains (losses)
Income before income taxes
Income tax expense

Income from continuing operations
Discontinued operations (net of tax)
Net income
Other comprehensive income items (net of tax)
Comprehensive income
LO 1

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ILLUSTRATION 18.1

$900,000
650,000
250,000
100,000
150,000
20,000
170,000
24,000
146,000
30,000
176,000
10,000
$186,000
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Sustainable Income
A statement of comprehensive income includes
net income and

comprehensive income.
The two major unusual items in this statement are


discontinued operations and



other comprehensive income.

Discontinued operations and other comprehensive
income, are reported net of tax.
LO 1

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5


Discontinued Operations
A. Disposal of a significant component of a business.
B. Report 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 1

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Discontinued Operations
Illustration: During 2020 Acro Energy Inc. has income
before income taxes of $800,000. During 2020, Acro
discontinued and sold its unprofitable chemical
division. The loss in 2020 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. Assume a 30% tax rate on
income.

LO 1

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7


Discontinued Operations
Acro Energy Inc.
Statement of Comprehensive Income (partial)
For the Year Ended December 31, 2020
Income before income taxes
Income tax expense
Income from continuing operations
Discontinued operations
Loss from operation of chemical division,
net of $60,000 income tax savings

$140,000
Loss from disposal of chemical division,
net of $30,000 income tax savings
70,000
Net income
LO 1

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ILLUSTRATION 18.2

$800,000
240,000
560,000

210,000
$350,000
8


Comprehensive 0Income
Comprehensive income is the sum of
net income and
other comprehensive income items.


LO 1

Example: Unrealized gains or losses on availablefor-sale debt securities

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Comprehensive Income
Illustration: During 2020 Stassi Corporation purchased IBM bonds
for $10,500 as an investment, which it intends to sell sometime in
the future. At the end of 2020, Stassi was still holding the
investment, but the bonds’ market price was now $8,000. Stassi is
required to reduce the recorded value of its IBM investment by the
unrealized loss of $2,500. Should Stassi include this $2,500
unrealized loss in net income? Assume a tax rate of 20%.
Trading securities: Unrealized gains and losses are reported in the
“Other expenses and losses” section of the income statement.
Available-for-sale securities: Unrealized gains and losses are
reported as “Other comprehensive income” in stockholders’ equity.
LO 1

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10


Comprehensive Income
Stassi did not purchase the investment for trading purposes, it is
classified as available-for-sale.
ILLUSTRATION 18.3
Lower portion of statement of
comprehensive income

Stassi Corporation
Comprehensive Income Statement
For the Year Ended December 31, 2020
Net income
Other comprehensive income
Unrealized loss on available-for-sale
securities, net of $500 tax savings
Comprehensive income
LO 1

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$300,000

2,000
$298,000
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Comprehensive Income
Assume Stassi has common stock of $3,000,000, retained earnings
of $300,000, and accumulated other comprehensive loss of $2,000.
This illustration shows the balance sheet presentation of the
accumulated other comprehensive loss.
Balance Sheet (partial)
Stockholders’ equity
Common stock
Retained earnings
Total paid-in capital and retained earnings

Accumulated other comprehensive loss
Total stockholders’ equity
LO 1

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ILLUSTRATION 18.4
Unrealized loss in
stockholders’ equity section

$3,000,000
300,000
3,300,000
(2,000)
$3,298,000
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Pace Corporation
Statement of Comprehensive Income
For the Year Ended December 31, 2020

Net sales
Cost of goods sold
Gross profit
Operating expenses
Income from operations
Other revenues and gains
Other expenses and losses
Income before income taxes

Income tax expense ($66,000 x 30%)
Income from continuing operations
Discontinued operations
Loss from operation of plastics division, net of income tax
savings $18,000 ($60,000 × 30%)
Gain on disposal of plastics division, net of $15,000 income
taxes ($50,000 × 30%)
Net income
Other comprehensive income
Unrealized gain on available-for-sale securities, net of income
taxes ($15,000 × 30%)
Comprehensive income
LO 1

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ILLUSTRATION 18.5
Complete statement of
comprehensive income

$440,000
260,000
180,000
110,000
70,000
5,600
9,600
66,000
19,800
46,200

$42,000
35,000

7,000
39,200
10,500
$ 49,700
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Changes in Accounting Principle
Occurs when the principle used in the current year is
different from the one used in the preceding year.
Example: Change in inventory costing methods (such
as FIFO to average-cost)
Accounting rules permit a change when management
can show that the new principle is preferable.
Companies report most changes in accounting
principle retroactively.
LO 1

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14


Quality of Earnings
A high quality of earnings provides full and
transparent information that will not confuse or
mislead users.

Alternative Accounting Methods
Variations among companies in the application of
generally accepted accounting principles may hamper
comparability and reduce quality of earnings
FIFO versus LIFO inventory cost flow
Straight-line versus declining balance depreciation
LO 1

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15


Quality of Earnings
Pro Forma Income
Companies whose stock is publicly traded are
required to present their income statement following
GAAP.
Many companies have been also reporting pro forma
income that usually excludes items that the company
thinks are unusual or non-recurring (pro forma
income).
Many analysts and investors are critical of using pro
forma income because these numbers often make

LO 1

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16


Quality of Earnings
Improper Recognition
Most common abuse is improper recognition of
revenue.
Channel stuffing (Bristol-Myers Squibb)
Another practice is improper capitalization of
operating expenses.
Capitalization of operating expenses (WorldCom)
Failure to report liabilities (Enron)
LO 1

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DO IT! 1 Unusual Items
In its proposed 2020 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.”

LO 1

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Statement of Comprehensive Income (partial)
For the Year Ended December 31, 2020
Income before income taxes
Income tax expense
Income from continuing operations
Discontinued operations
Loss from operation of flower division, net of
$15,000 income tax savings
$35,000
Loss on disposal of flower division, net of
$27,000 income tax savings
63,000
Net income
Other comprehensive income
Unrealized gain on available-for-sale securities,
net of $30,000 income taxes
Comprehensive income

LO 1

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$400,000
120,000
280,000

98,000
182,000
70,000
$252,000

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Horizontal Analysis and Vertical
Analysis
Investors are interested in:

Core or sustainable earnings of a company
Making comparisons from period to period


Three types of comparisons:
• Intracompany basis
• Intercompany basis
• Industry averages

LO 2

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Horizontal Analysis and Vertical
Analysis

Three basic tools in financial statement analysis:
1. Horizontal analysis
2. Vertical analysis
3. Ratio analysis

LO 2

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21


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
a. Increase or decrease
b. Expressed as either an amount or a percentage

LO 2

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22


ILLUSTRATION 18.9
Horizontal analysis of
balance sheets

Condensed Balance Sheets
December 31 (in thousands)

Assets
Current assets
Property assets (net)
Other assets
Total assets
Liabilities and Stockholders’ Equity
Current liabilities
Long-term liabilities
Total liabilities
Stockholders’ equity
Common stock
Retained earnings
Treasury stock (cost)
Total stockholders’ equity
Total liabilities and
stockholders' equity
LO 2

2020
$ 2,717

2,990
5,690
$11,397

2019
$ 2,427
2,816
5,471
$10,714

$ 4,044
4,827
8,871

$ 4,020
4,625
8,645

493
3,390
(1,357)
2,526
$11,397

397
2,584
(912)
2,069
$10,714

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Increase (Decrease)
Amount Percent
$ 290
11.9
174
6.2
219
4.0
683
6.4
24
202
226

0.6
4.4
2.6

96
806
(445)
457

24.2
31.2
48.8
22.1

$ 683

6.4
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Horizontal Analysis
The comparative balance sheets show a number of
changes.
In the assets section:
a. current assets increased $290,000, or 11.9% ($290 ÷
$2,427)
b. property assets (net) increased $174,000, or 6.2%
c. other assets increased $219,000, or 4.0%
In the liabilities section:
d. current liabilities increased $24,000, or 0.6%
e. long-term liabilities increased $202,000, or 4.4%
LO 2

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Condensed Income Statements
For the Years Ended December 31 (in thousands)
Increase (Decrease)
2020
2019
Amount Percent

Net sales
$11,776
$10,907
$869
8.0
Cost of goods sold
6,597
6,082
515
8.5
Gross profit
5,179
4,825
354
7.3
Selling and administrative expenses
3,311
3,059
252
8.2
Income from operations
1,868
1,766
102
5.8
Interest expense
321
294
27
9.2

Income before income taxes
1,547
1,472
75
5.1
Income tax expense
444
468
(24)
(5.1)
Net income
$ 1,103
$ 1,004
$ 99
9.9
ILLUSTRATION 18.10
Horizontal analysis of
income statements

LO 2

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