Financial accounting tools for business decision making 9 KIeso ppt ch13

Financial Accounting: Tools for Business
Decision Making
Ninth Edition
Kimmel ● Weygandt ● Kieso

Chapter 13
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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Learning Objective 1
Apply the Concepts of Sustainable
Income and Quality of Earnings

LO1

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3


Sustainable Income
The most likely level of income to be obtained by a
company in the future
Differs from actual net income by the amount of
unusual revenues, expenses, gains, and losses
included in the current year’s income
Income statements provide information on
sustainable income by separating operating
transactions from nonoperating transactions
LO1

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Statement of Comprehensive
Income
(1 of 2)
Cruz Company
Statement of Comprehensive Income
For the Year Ended 2022

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

LO1

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$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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Statement of Comprehensive Income (2 of 2)
A statement of comprehensive income includes
a. Net income and
b. Comprehensive income

Two major unusual items in this statement are
c. Discontinued operations and
d. Other comprehensive income
 Example: Unrealized gains or losses on availablefor-sale debt securities

LO1

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
• Income (loss) from operations, net of tax, and
• Gain (loss) on disposal, net of tax

LO1

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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.
LO1

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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
Income tax expense
Income from continuing operations
Discontinued operations
Loss from operation of chemical division,
net of $60,000 income tax savings
Loss from disposal of chemical division,
net of $30,000 income tax savings
Net income

LO1

$800,000
240,000
560,000

$140,000

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70,000

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.
LO1

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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
Other comprehensive income
Unrealized loss on available-for-sale
securities, net of $500 tax savings
Comprehensive income

LO1

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$300,000
2,000
$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.
Balance Sheet (partial)
Stockholders’ equity
Common stock
Retained earnings
Total paid-in capital and retained earnings
Accumulated other comprehensive loss
Total stockholders’ equity

LO1

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$3,000,000
300,000
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
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

LO1

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$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

a. 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
LO1

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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
a. Caused by variations in alternative accounting
methods used among companies which hampers
comparability
b. Examples
• FIFO versus LIFO inventory cost flow
LO1

• 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
a. 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
LO1

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Improper Recognition
Improper recognition of revenue
a. Most common abuse of manipulating earnings
numbers to meet expectations
b. Such as channel stuffing (Bristol-Myers Squibb)

Improper capitalization of operating expenses
c. WorldCom

Failure to report liabilities

d. Enron
LO1

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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.”
LO1

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Do It! 1: Unusual Items (2 of 2)
Statement of Comprehensive Income (partial)
For the Year Ended December 31, 2022

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

LO1

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$400,000
120,000
280,000

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

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Learning Objective 2
Apply Horizontal Analysis and Vertical
Analysis

LO2

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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
• Intracompany basis
ã Intercompany basis
ã Industry averages

LO2

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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

LO2

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

LO2

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Balance SheetCondensed

Horizontal
Analysis
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

LO2

(1 of 2)

Increase (Decrease)
Amount Percent
$290
11.9

174
6.2
219
4.0
$683
6.4

2022
$ 2,717
2,990
5,690
$11,397

2021
$ 2,427
2,816
5,471
$10,714

$ 4,044
4,827
8,871

$ 4,020
4,625
8,645

$ 24
202
226

0.6
4.4
2.6

493
3,390
(1,357)
2,526

397
2,584
(912)
2,069

96
806
(445)
457

24.2
31.2
48.8
22.1

$11,397

$10,714

$683

6.4

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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
i. Retained earnings increased $806,000, or 31.2%
LO2

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