Accounting tools for business decision making 7 kieo ch13
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Accounting: Tools for Business Decision Making
Seventh Edition
Kimmel; Weygandt; Kieso
Chapter 13
Financial Analysis: The Big Picture
Prepared by
COBY HARMON
University of California, Santa Barbara
Westmont College
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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.
Copyright ©2019 John Wiley & Sons, Inc.
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Learning Objective 1
Apply the Concepts of Sustainable Income and Quality of
Earnings
LO 1
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3
Sustainable Income (1 of 3)
•
•
The most likely level of income to be obtained by a company in the future
•
Income statements provide information on sustainable income by separating operating
transactions from nonoperating transactions
LO 1
Differs from actual net income by the amount of unusual revenues, expenses, gains, and losses
included in the current year’s income
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Sustainable Income (2 of 3)
Cruz Company
Statement of Comprehensive Income
For the Year Ended 2022
Sales revenue
$900,000
Cost of goods sold
650,000
Gross profit
250,000
Operating expenses
100,000
Income from operations
150,000
Other revenues (expenses) and gains (losses)
20,000
Income before income taxes
170,000
Income tax expense
24,000
Income from continuing operations
146,000
Discontinued operations (net of tax)
30,000
Net income
176,000
Other comprehensive income items (net of tax)
10,000
Comprehensive income
LO 1
$186,000
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Sustainable Income (3 of 3)
•
•
A statement of comprehensive income includes
•
Net income and
•
Comprehensive income
Two major unusual items in this statement are
•
Discontinued operations and
•
Other comprehensive income
•
•
LO 1
Example: Unrealized gains or losses on available-for-sale debt securities
Unusual items reported net of taxes
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Discontinued Operations (1 of 3)
•
Disposal of a significant component of a business
•
Report income (loss) from discontinued operations in two parts
LO 1
•
Income (loss) from operations, net of tax, and
•
Gain (loss) on disposal, net of tax
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Discontinued Operations (2 of 3)
Illustration: During 2022 Acro Energy Inc. has income before income taxes of $800,000. During
2022, Acro discontinued and sold its unprofitable chemical division. The loss in 2022 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.
Prepare a statement of comprehensive income for ACRO for the year ended December 31, 2022.
LO 1
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Discontinued Operations (3 of 3)
Acro Energy Inc.
Statement of Comprehensive Income (partial)
For the Year Ended December 31, 2022
Income before income taxes
$800,000
Income tax expense
240,000
Income from continuing operations
560,000
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
210,000
$350,000
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Comprehensive Income (1 of 3)
Illustration: During 2022, Stassi Corporation purchased IBM bonds for $10,500 as an investment, which it intends
to sell sometime in the future. At the end of 2022, 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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Comprehensive Income (2 of 3)
Classified as available-for-sale
→ Stassi did not purchase the investment for trading purposes
Stassi Corporation
Comprehensive Income Statement
For the Year Ended December 31, 2022
Net income
$300,000
Other comprehensive income
Unrealized loss on available-for-sale securities,
net of $500 tax savings
2,000
Comprehensive income
LO 1
$298,000
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Comprehensive Income (3 of 3)
Stassi has common stock of $3,000,000, retained earnings of $300,000, and an accumulated other comprehensive loss
of $2,000.
Stassi Corporation
Balance Sheet (partial)
Stockholders’ equity
Common stock
$3,000,000
Retained earnings
300,000
Total paid-in capital and retained earnings
Accumulated other comprehensive loss
Total stockholders’ equity
LO 1
3,300,000
(2,000)
$3,298,000
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Complete Statement of Comprehensive Income
Pace Corporation
Statement of Comprehensive Income
For the Year Ended December 31, 2022
Net sales
$440,000
Cost of goods sold
260,000
Gross profit
180,000
Operating expenses
110,000
Income from operations
70,000
Other revenues and gains
5,600
Other expenses and losses
9,600
Income before income taxes
66,000
Income tax expense ($66,000 × 30%)
19,800
Income from continuing operations
46,200
Discontinued operations
Loss from operation of plastics division, net of
income tax savings $18,000 ($60,000 × 30%)
LO 1
Gain on disposal of plastics division, net of
$15,000 income taxes ($50,000 ì 30%)
$42,000
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35,000
7,000
Changes in Accounting Principle
•
•
•
LO 1
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
Changes permitted when management can show that the new principle is preferable
Most changes in accounting principle reported retroactively
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Quality of Earnings
•
A high quality of earnings provides full and transparent information that will not confuse
or mislead users
•
Reduction of quality of earnings
•
Caused by variations in alternative accounting methods used among companies which
hampers comparability
•
Examples
•
•
LO 1
FIFO versus LIFO inventory cost flow
Straight-line versus declining-balance depreciation
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Pro Forma Income
•
Companies whose stock is publicly-traded are required to present their income statement
following GAAP
•
Companies often report pro forma income
•
LO 1
•
Excludes items that the company thinks are unusual or non-recurring
Analysts and investors are often critical of using pro forma income because these numbers often
make companies look better than they really are
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Improper Recognition
•
•
•
LO 1
Improper recognition of revenue
•
•
Most common abuse of manipulating earnings numbers to meet expectations
Such as channel stuffing (Bristol-Myers Squibb)
Improper capitalization of operating expenses
ã
WorldCom
Failure to report liabilities
ã
Enron
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Do It! 1: Unusual Items (1 of 2)
In its proposed 2022 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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Do It! 1: Unusual Items (2 of 2)
AIR Corporation
Statement of Comprehensive Income (partial)
For the Year Ended December 31, 2022
Income before income taxes
$400,000
Income tax expense
120,000
Income from continuing operations
280,000
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
98,000
182,000
Other comprehensive income
Unrealized gain on available-for-sale
securities, net of $30,000 income taxes
70,000
Comprehensive income
LO 1
$252,000
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Learning Objective 2
Apply Horizontal Analysis and Vertical Analysis
LO 2
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Assessing Financial Performance
Investors are interested in
•
•
Core or sustainable earnings of a company
Making comparisons from period to period
•
Three types of comparisons
•
•
•
LO 2
Intracompany basis
Intercompany basis
Industry averages
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Tools of Financial Statement Analysis
Three basic tools in financial statement analysis:
1.
Horizontal analysis
2.
Vertical analysis
3.
Ratio analysis
LO 2
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Horizontal Analysis
•
Technique for evaluating a series of financial statement data over a period of time
•
Also called trend analysis
•
Purpose is to determine
LO 2
•
Increase or decrease
•
Expressed as either an amount or a percentage
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Balance Sheet Horizontal Analysis (1 of 2)
Chicago Cereal Company
Condensed Balance Sheets
December 31 (in thousands)
Assets
2022
Current assets
2021
Increase (Decrease)
Increase (Decrease)
during 2022 Amount
during 2022 Percent
$ 2,717
$ 2,427
$ 290
11.9
Property assets (net)
2,990
2,816
174
6.2
Other assets
5,690
5,471
219
4.0
$11,397
$10,714
$ 683
6.4
$ 4,044
$ 4,020
$ 24
0.6
4,827
4,625
202
4.4
8,871
8,645
226
2.6
493
397
96
24.2
3,390
2,584
806
31.2
(1,357)
(912)
445
48.8
2,526
2,069
457
22.1
$11,397
$10,714
$ 683
6.4
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
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Balance Sheet Horizontal Analysis (2 of 2)
a. Changes in the assets section
b.Current assets increased $290,000, or 11.9% ($290 ÷ $2,427)
c. Property assets (net) increased $174,000, or 6.2%
d.Other assets increased $219,000, or 4.0%
e. Changes in the liabilities section
f.
Current liabilities increased $24,000, or 0.6%
g. Long-term liabilities increased $202,000, or 4.4%
h.Changes in the stockholders’ equity section
LO 2
i.
Retained earnings increased $806,000,
or 31.2%
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