BA213: Chapter 15—Financial Statement Analysis

Study Objectives:1. Discuss the need for comparative analysis.2. Identify the tools of financial statement analysis.3. Explain and apply horizontal analysis.4. Describe and apply vertical analysis.5. Identify and compute ratios and describe their purpose and use in analyzing a

firm’s liquidity, profitability, and solvency.6. Understand the concept of earning power, and how irregular items are presented. 7. Understand the concept of quality of earnings.

1. BASIC OF FINANCIAL STATEMENT ANALYSISA. Introduction: The definition of accounting which is introduced in the first chapter

of the accounting textbook accounting process involves identifying and analyzing business transactions; classifying the transactions according to the section(s) of the accounting equation involved and if a particular account is increased or decreased; recording transactions in the permanent record; summarizing the transactions in the form of financial statements; and finally interpreting where conclusions and decisions are made from the financial statements. Throughout the chapters in the textbook, ratios have been computed to analyze financial statements or sections of the financial statements. This chapter brings the entire process together of “Financial Statement Analysis” where we look for relationships among the many figures on the financial statements.

B. Analyzing financial statements involves evaluating three characteristics of a company: its liquidity, its solvency, and its profitability.

1. Define liquidity: the ability of a business to pay its debts when they fall due. It is the ability of a business to convert its assets into cash, which is the most liquid asset. In this chapter, this topic will be covered under the heading RATIO ANALYSIS and under the subheading LIQUIDITY RATIOS.

2. Define solvency: the ability of a business to survive over a long period of time. In this chapter, this topic will be covered under the heading RATIO ANALYSIS and under the subheading SOLVENCY RATIOS.

3. Define profitability: the ability of a business to earn a reasonable return on the owners’ investments. It measures the income or operating success of an enterprise for a given period of time. Income, or the lack of it, affects the company’s ability to obtain debt and equity financing. In this chapter, this topic will be covered under the heading RATIO ANALYSIS and the subheading PROFITABILITY RATIOS.

C. NEED FOR COMPARATIVE ANALYSIS1. Financial statements are analyzed to gain greater insights into the firm to

provide information from which the users of that information can make good judgments and decisions. The accounting process involves transforming the

data into useful information for decision-making and communicating information to users. Users include owners and managers of the business, creditors, tax agencies, governmental bodies, and others.

2. Users of the financial statements are interested in the characteristics of a company’s liquidity, its solvency, and its profitability.

a) A short-term creditor, such as a bank, is primarily interested in the ability of the borrower to pay obligations when they come due. The liquidity of the borrower is extremely important is evaluating the safety of a loan.

b) A long-term creditor, such as a bondholder, however looks to profitability and solvency measures that indicate the company’s ability to survive over a long period of time. Long-term creditors consider such measures as the amount of debt in the company’s capital structure and its ability to meet interest payments.

c) Owners/stockholders are interested in profitability and solvency of the company. They want to access the likelihood of dividends and the growth potential of the stock.

3. In order to obtain information as to whether the amount of cash a company reports such as Sears, Roebuck and Co. (1) represents an increase over prior years or (2) is adequate in relation to the company’s need for cash, the amount of cash must be compared with other financial statement data. Comparisons can be made on a number of different bases such as the following:

4. Intracompany basis compares an item or financial relationship within a company in the current year with the same item or relationship in one or more prior years. Intracompany comparisons are useful in detecting changes in financial relationships and significant trends.

5. Industry averages compares an item or financial relationship of a company with industry averages (or norms) published by financial ratings. Industry averages comparisons are useful to provide information as to a company’s relative performance within the industry.

6. Intercompany basis compares an item or financial relationship of one company with the same item or relationship in one or more competing companies. Intercompany comparisons are useful in determining a company’s competitive position.

D. TOOLS OF FINANCIAL STATEMENT ANALYSIS1. Three commonly used tools are utilized to evaluate the significance of

financial statement data.a) Horizontal analysis (trend analysis) evaluates a series of financial

statement data over a period of time.b) Vertical analysis evaluates financial statement data expressing each item in

a financial statement as a percent of a base amount.

c) Ratio analysis expresses the relationship among selected items of financial statement data.

2. Horizontal analysis is used primarily in intracompany comparisons. Published financial statements facilitate this type of comparison because:a) Each of the basic financial statements shows a minimum of 2

years.b) Summary of selected data will show 5 – 10 years or more.

3. Vertical analysis is used in both intra- and intercompany comparisons.

4. Ratio analysis is used in all three types of comparisons.

II. HORIZONTAL ANALYSISA. Horizontal analysis is the comparison of each item in a company’s financial

statements in the current period with the same item from a previous accounting period or periods. Horizontal analysis compares one year to another and is also called trend analysis.

B. The purpose of horizontal analysis is to determine the increase or decrease that has taken place this change may be expressed as either an amount or a percentage. The recent net sales figures of J.C. Penney Company.1. Given that 2013 is the base year, we can measure all percentage

increases or decreases from this base period amount as follows where CY is Current Year and BY is Base Year or can use PY for Prior year:

CY - BY or PY ÷ BY or PY = “CHANGE” since BY or PY

An easy way to remember how to calculate change is using IS and WAS as follows:IS - WAS ÷ WAS = “CHANGE” since WAS

Applying the formula to JC. Penney’s net sales from 2013 to 2014:$18,096 - $17,513 ÷ $17,513 = 3.3% increase from 2013 to 2014

HORIZONTAL ANALYSIS example:$150,000 - $100,000 ÷ $100,000 = 50% increase in 2013 from 2015

CY - BY ÷ BY “CHANGE” since BYIS - WAS ÷ WAS “CHANGE” since WAS

2. Alternatively, we can express current year sales as a percentage of the base period. This is done by dividing the current year amount. Part of horizontal analysis is determining, “Trend Percentages” which are measures used to compare financial data over a period of years, in which one year is selected as the base year, and every other year’s amount is expressed as a percent of the base year’s amount. In horizontal analysis, the earlier year is always the base year in calculating percent increase or percent decrease. Percentage expressions are more meaningful than dollar amounts.

CY Amount ÷ BY Amount = CY results in relation to BY

3. The percentage of the base period for each of the 3 years, assuming 2013 as the base period, is shown where 2015 is calculated as follows:

CY Amount ÷ BY Amount = CY results in relation to BY$18,781 ÷ $`17,513 = 107.24% for 7.24% inc. (change)

C. BALANCE SHEET1. The two-year condensed balance sheet of Quality Department Store Inc. for 2015

and 2014 would show dollar and percentage changes.2. The comparative balance sheets show a number of significant changes that

occurred in Quality Department Store’s financial structure from 2014 to 2015:a) In the asset section, plant assets (net) increased $167,500 or 26.5%.b) In the liabilities section, current liabilities increased $41,500 or 13.7%.c) In the stockholders’ equity section, retained earnings increased

$202,600 or 38.6%.d) ANALYSIS: It appears the company expanded its asset base during

2015 and financed the expansion by retaining income in the firm.

D. INCOME STATEMENT1. The two-year comparative income statements of Quality Department Store Inc.

for 2015 and 2014. 2. HORIZONTAL ANALYSIS of the comparative income statement shows the

following changes:a) Net sales increased $260,000, or 14.2% ($260,000 ÷ $1,837,000).b) Cost of goods sold increased $141,000, or 12.4% ($141,000 ÷ $1,140,000).c) Total operating expenses increased $37,000, or 11.6% ($37,000 ÷ $320,000).d) ANALYSIS: Overall, gross profit and net income were up

substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality’s profit trend appears favorably.

E. RETAINED EARNINGS STATEMENT1. A horizontal analysis of Quality Department Store’s comparative retained

earnings statements.2. Analyzed horizontally:

a) Net income increased $55,300, or 26.5%.b) Common dividends increased only $1,200, or 2%.c) Ending retained earnings increased 38.6%.

3. ANALYSIS: As indicated above the company retained a significant portion of net income to finance additional plant facilities.

F. COMMENTS ON HORIZONTAL ANALYSIS:1. When using horizontal analysis, both dollar amount changes and

percentage changes need to be examined.a) It is not necessarily bad if a company’s earnings are growing at a

declining rate.

b) The amount of increase may be the same as or more than the base year.

c) The percentage change may be less because the base is greater each year.

2. Complications can occur in making the computations:a) If an item has no value in a base year and a value in the next year, no

percentage change can be computed.b) If a negative amount appears in the base or preceding period, and a

positive amount exists the following year (or vice versa), no percentage change can be computed

III. VERTICAL ANALYSISA. Describe and apply vertical analysis, also called common size analysis.

Vertical analysis compares each item on the statement to an item considered to be the base. VERTICAL ANALYSIS of the income statement reflects the size of each item relative to a base amount (Net Sales) where each item is divided by Net Sales. The COMMON SIZE ANALYSIS restates each item on a financial statement in terms of percentage of a base amount which enables the comparison of companies of different sizes (BIG COMPANY vs. SMALL COMPANY).1. For the income statement, net sales is the base. 2. For the balance sheet, total assets (or total liabilities and owner’s

equity) is the base. 3. Once percents are calculated for one year, they can be compared to

the same calculations for another year to see if the relative importance of an item has changed.

B. BALANCE SHEET1. The two-year comparative balance sheet of Quality Department Store Inc.

for 2015 and 2014.2. The base for asset items is total assets and the base for the liability and

stockholders’ equity items are total liabilities and owner’s equity. Vertical analysis shows the relative size of each category in the balance sheet as well as percentage change in the individual asset, liability, and stockholders’ equity items.a) The formula to compute the percentage with Vertical Analysis:

Asset item ÷ Total Assets = “PERCENT” of Base for relative importance or Asset section ÷ Total Assets = “PERCENT” of Base for relative importance

For Quality Department stores:Current Assets ÷ Total Assets = “PERCENT” of Base for relative importance

$945,000 ÷ $1,595,000 = 59.25%$1,020,000 ÷ $1,835,000 = 55.59%

b) Current assets increased $75,000 from 2014 to 2015; but they decreased from 59.2% to 55.6% of total assets.

c) Plant assets (net) increased from 39.7% to 43.6% of total assets.d) Retained earnings increased from 32.9% to 39.7% of total liabilities and

stockholders’ equity.e) ANALYSIS: These results reinforce earlier observations that Quality is

financing its growth through retention of earnings rather than from issuing additional debt.

C. INCOME STATEMENT1. Vertical analysis of the two-year comparative income statement of Quality

Department Store Inc. for 2015 and 2014.2. For the income statement, net sales is the base.

a) of goods sold as a percentage of net sales declined 1% (62.1% versus 61.1%).

b) Total operating expenses declined 0.4% (17.4% versus 17.0%).c) Net income as a percent of net sales therefore increased from 11.4% to

12.6%.3. ANALYSIS: Quality appears to be a profitable enterprise that is

becoming more successful.4. An associated benefit of vertical analysis is that Vertical analysis

enables you to compare companies of different sizes. a) Quality’s major competitor is a JC Penney store in a nearby town. b) Using vertical analysis, the small Quality Department Store Inc. can be

meaningfully compared to the much larger J.C. Penney.Intercompany income statement comparison where Vertical Analysis eliminates this difference in size:1) Gross profit rates were somewhat comparable at 38.9% and

39.3%.2) Income from operations percentages were significantly different at

21.9% and 8.4%.3) Quality’s selling and administrative expense percentage (17%) is

much lower than JC Penney’s (30.9%).4) JC Penney’s net income as a percentage of sales (percent of each

sales dollar) was much lower than Quality’s (5.8% to 12.6 %.)

IV. RATIO ANALYSISA. INTRODUCTION—Ratio analysis expresses the relationship among

selected items of the financial statement data. A ratio expresses a mathematical relationship between one quantity and another. The relationship is expressed in terms of either a percentage, a rate, or a simple proportion. A single ratio by itself is not very meaningful, in the illustrations that will be used. Therefore the following types of comparisons will be used:1. Intracompany comparisons for two years for the Quality Department

Store.2. Industry average comparisons based on median ratios for department

stores from Dun & Bradstreet and Robert Morris Associates’ median ratios.3. Intercompany comparisons based on the J.C. Penney Company, as

Quality Department Store’s principal competitor.4. The three financial ratio classifications: Liquidity Ratios;

Profitability Ratios; and Solvency Ratios.

B. LIQUIDITY RATIOS.1. Introduction : Liquidity is the ability of a business to pay its debts

when they fall due Liquidity ratios measure the short-term ability of the enterprise to pay its maturity obligations and to meet unexpected needs for cash.

2. Current Ratio a) The current ratio (working capital ratio) is a widely used measure

for evaluating a company’s liquidity and short-term debt-paying ability. Working capital = current assets - current liabilities. The current ratio is a more dependable indicator of liquidity than working capital.

b) A standard or benchmark for this ratio is 2 to 1 or $2.00 in current assets for every $1.00 in current liabilities.

c) It is computed by dividing current assets by current liabilities and is a more dependable indicator of liquidity than working capital where formula shown below applying it to Quality and compared to the Industry average and to J.C. Penney (NOTE: the ratio is taken two places which indicated in dollars and cents the amount of current assets to current liabilities):

Current Assets ÷ Current Liabilities = Current RatioQuality Department Store for 2015

$1,020,000 ÷ $344,500 = 2.96:1J.C. Penney Company = 5.72:1

Industry average = 1.28:1

d) ANALYSIS: 1) For 2015, the current ratio of 2.96:1 means that there is $2.96

of current assets for every $1.00 of current liabilities.2) The current ratio for 2015 has decreased from 2014.3) But compared to the benchmark of 2:1 and the industry

average, Quality appears to be reasonably liquid. J.C. Penney has an unusually high current ratio which means it has considerable current assets to current liabilities.

3. Acid-Test Ratio a) A disadvantage of the current ratio is that it does not take into

account the composition of the current assets. For example, a satisfactory current ratio does not disclose the fact that a portion of the current assets may be tied up in slow-moving inventory.

b) The acid-test ratio (quick ratio) is a measure of a company’s short-term liquidity. Since the current ratio does not deal with the composition of current assets, the quick ratio shows the ability of the firm to convert current assets to cash to pay the current liabilities so this ratio shows the immediate debt-paying ability of the company.

c) A standard or benchmark for this ratio is 1 to 1 or $1.00 of quick assets to every $1.00 of current liabilities.

d) It is computed by dividing the sum of cash, marketable securities, and net receivables by current liabilities:

Cash + S/T Investments +”Net” Rec. ÷ C. Liabilities = Acid-Test Ratio

e) The acid-test ratios for Quality Department Store and comparative data shows this ANALYSIS:1) The ratio has declined in 2015.2) But when compared with the industry average and JC

Penney’s, Quality’s acid-test ratio seems adequate.

4. Receivables Turnover a) The receivables turnover ratio is used to assess the liquidity of the

receivables. It measures the number of times, on average; receivables are collected during the period.

b) The ratio is computed by dividing net credit sales by average net receivables shown as follows for Quality Department Store for 2015:

Net Credit Sales ÷ Average “NET” Receivables = Receivables Turnover

$2,097,000 ÷ $180,000 + $230,000 = 10.2 Times2

c) The receivables turnover for Quality Department Store and comparative data shows this ANALYSIS: 1) The ratio has increased from 2014 to 2015.2) Even though it is substantially lower than JC Penney’s

ratio, it is similar to the department store’s industry’s average of 10.8 times.

d) The average collection period converts the receivables turnover in terms of days by dividing the receivables turnover ratio into 365 days.For example the above receivables turnover of 10.2 times is

converted into the average collection period as follows:365 days. ÷ Receivables Turnover = Average Collection Period

365 ÷ 10.2 = 35.8 days or 36 daysThe average collection period is frequently used to assess the

effectiveness of a company’s credit and collection policies. The general rule is that the collection period should NOT greatly exceed the credit term period (the time allowed for payment).

5. Inventory Turnover a) The inventory turnover ratio measures the number of times, on

average; the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory.

b) It is computed by dividing cost of goods sold by average inventory during the year shown as follows for Quality Department Store for 2015:

COGS ÷ Average Inventory = Inventory Turnover$1,281,000 ÷ $500,000 + $620,000 = 2.3 Times2

c) The inventory turnover is showing forQuality Department Store and comparative data this ANALYSIS:1) The ratio has declined slightly in 2015.2) It is relatively low compared to the industry average and JC

Penney’s.

3) Generally, the faster the inventory turnover, the less cash that is tied up in inventory and the less chance of inventory obsolescence.

d) The average days to sell inventory converts the inventory turnover in term of days and is calculated by dividing the inventory turnover into 365 days.1) For example the above receivables turnover of 10.2 days is

converted into the average collection period as follows:365 days. ÷ Inventory Turnover = Ave. Days to Sell Inventory

365 ÷ 2.3 = 158.7 days or 159 days2) ANALYSIS: This is relatively high compared to the

industry average of 54.5 days and Sears’s of 79.3 days.

C. PROFITABILITY RATIOS:1. Introduction —Profitability ratios measure the income and

operating success of an enterprise for a given period of time.a) Without income (profit), the company’s ability to obtain debt

and equity financing.b) The company’s liquidity position and the company’s ability to

grow is also affected by the amount of income or profit.c) Therefore, both creditors and investors are interested in

evaluating earning power—profitability and often used as the ultimate test of management’s operating effectiveness.

2. Profit Margin a) The profit margin ratio is a measure of the percentage of each

dollar of sales that results in net income.b) It is computed by dividing net income by net sales shown as

follows for Quality Department Store for 2015:

Net Income ÷ Net Sales = Profit Margin on Sales$263,800 ÷ $2,097,000 = 12.6%

c) The profit margin on sales is showing for Quality Department Store and comparative data this ANALYSIS: Quality experienced an increase in its profit margin from 2014

to 2015.Its profit margin is unusually high in comparison with the

industry average of 3.6% and JC Penney’s 3.7%.

3. Asset Turnover a) Asset turnover measures how efficiently a company uses its

assets to generate sales.b) It is determined by dividing net sales by average assets shown as

follows for Quality Department Store for 2015.Net Sales ÷ Average Assets = Asset Turnover$2,097,000 ÷ $1,595,000 + $1,835,000 = 1.22 Times2

c) The asset turnover is showing for Quality Department Store and comparative data this ANALYSIS:Asset turnover shows that in 2015 Quality generated sales of

$1.22 for each dollar it had invested in assets. The ratio changed little from 2014 to 2015.

Quality’s asset turnover is below the industry average and JC Penney’s ratio.

4. Return on Assets a) An overall measure of profitability is return on assets. b) It is computed by dividing net income by average assets for the

period shown as follows for Quality Department Store for 2015:Net Income ÷ Average Assets = Return on Assets

$263,800 ÷ $1,595,000 + $1,835,000 = 15.4% Times2

c) The return on assets is showing in for Quality Department Store and comparative data this ANALYSIS:Quality’s return on assets improved from 2014 to 2015.Its return is very high compared with the department store

industry average and JC Penney’s.5. Return on Common Stockholders’ Equity

a) A ratio that measures profitability from the viewpoint of the common stockholder is return on common stockholders’ equity.

b) It is computed by dividing net income by average common stockholders’ equity period shown as follows for Quality Department Store for 2015.

Net Income ÷ Average Common S/H’s Equity =Return on Common

S/H’s Equity

$263,800 ÷ $795,000 + $1,003,000 = 29.3% Times2

c) When preferred stock is present, preferred dividend requirements are deducted from net income to compute income available to common stockholders.

d) The par value of preferred stock (or call price – if applicable) must be deducted from total stockholders’ equity to determine the amount of common stockholders’ equity used in this ratio. The ratio then appears as shown below:

Net Income – Preferred Div. ÷ Average Common S/H’s Equity =

Rate of Return on Common S/H’s Equity

e) The return on common stockholders’ equity is showing for Quality Department Store and comparative data this ANALYSIS:1) Quality’s return on common stockholder’s equity improved

from 2014 to 2015.2) Quality’s rate of return is higher than both the industry

average and JC Penney’s.3) Quality’s rate of return on stockholder’s equity (29.3%) is

substantially higher that its rate of return on assets (15.4%). This is because Quality has made effective use of leverage or trading on the equity at a gain which means that the company has borrowed money at a lower rate of interest than it is able to earn by using the borrowed money.a. Leverage enables Quality to use money supplied by

nonowners (creditors) to increase the return to its owners.

b. A comparison of the rate of return on total assets with the rate of interest paid for borrowed money indicates the profitability of trading on the equity. Quality earns more on its borrowed funds than it has to pay in interest.

6. Earnings per Share (EPS) a) Earnings per share (EPS) is a measure of net income earned on

each share of common stock.b) It is calculated by dividing net income by the number of

weighted average common shares outstanding during the year shown as follows for Quality Department Store for 2005:

Net Income ÷ Wt. Average Common S/H’s O/S = Earnings per Share

$263,800 ÷ 270,000 + 275,400 = $.97/ share2

c) The earnings per share is showing for Quality Department Store and comparative data this ANALYSIS:1) Quality’s EPS increased 20 cents per share in 2015 which

represents a 26% increase over the 2014 EPS.2) Note that no industry or JC Penney’s data presented as

such comparisons are not meaningful because of the wide variations in the number of shares outstanding stock among companies. The only meaningful EPS is an intracompany trend comparison.

3) In computing EPS, preferred dividends declared for the period, must be deducted from net income to determine income available to the “common” stockholders.

7. Price-Earnings Ratio a) The price-earnings (PE) ratio measures the ratio of the market

price of each share of common stock to the earnings per share.b) It is computed by dividing the market price per share of

common stock by earnings per share shown as follows for Quality Department Store for 2015.

Mkt Price/Share of Stock ÷ EPS = Price-Earnings Ratio$12.00 ÷ $.97 = 12.4 times

c) The price-earnings ratio is showing for Quality Department Store and comparative data this ANALYSIS:1) In 2015 each share of Quality’s stock sold for 12.4 times the

amount that was earned on each share which was higher than the 2014 of 10.4 times.

2) Quality’s PE ratio is lower than the industry average and the ratio for JC Penney.

8. Payout Ratio a) The payout ratio measures the percentage of earnings

distributed in the form of cash dividends.b) It is computed by dividing cash dividends by net income shown

as follows for Quality Department Store for 2015.Cash Dividends ÷ Net Income = Payout Ratio

$61,200 ÷ $263,800 = 23.2%

c) The payout ratio is showing for Quality Department Store and comparative data this ANALYSIS:

1) Quality’s payout ratio was lower in 2015 than in 2014.2) It is much higher than the industry average and JC Penney.

D. SOLVENCY RATIOS:1. Introduction —Solvency ratios measure the ability of the company

to survive over a long period of time. Long-term creditors and stockholders are particularly interested in the company’s ability to pay interest as it comes due and to repay the face value of debt at maturity.

2. Debt to Total Assets Ratio a) The debt to total assets ratio measures the percentage of total

assets provided by creditors. This ratio indicates the company’s degree of leverage and provides some indication of the company’s ability to withstand losses without impairing the interests of creditors. The higher the percentage the greater the risk that the company may be unable to meet its maturity obligations.

b) The prudent range for the debt to total assets is considered to be 50 percent or less.

c) It is computed by dividing total debt by total assets shown as follows for Quality Department Store for 2015.

TOTAL DEBT ÷ TOTAL ASSETS = Debt to Total Assets$832,000 ÷ $1,835,000 = 45.3%

d) The debt to total assets ratio is showing for Quality Department Store and comparative data this ANALYSIS:1) Quality’s 2015 debt to total assets ratio is lower than the

2014 which means that it is improving and below the prudent range.

2) Quality’s ratio is above the industry average but much lower that JC Penney’s. The lower the ratio, the more equity buffer there is available to creditors.

3. Times Interest Earned a) Times interest earned provides an indication of the company’s

ability to meet interest payments as they come due. The higher this ratio the better.

b) It is computed by dividing income before income taxes and interest expense by interest expense shown as follows for Quality Department Store for 2015:

Income Before Income Taxes and Interest Expense

÷ Interest Expense = Times Interest Earned

$468,000 ÷ $36,000 = 13 times

c) The times interest earned is showing for Quality Department Store and comparative data this ANALYSIS:1) Quality times interest earned improved from 2014 to 2015

as it is covering its interest more times.2) Quality’s ratio is above the industry average and JC Penney’s.

V. EARNING POWER AND IRREGULAR ITEMSA. Users of financial statements are interested in the concept of

“earning power.”1. Earning power differs from actual net income by the amount of

irregular revenues, expenses, gains, and losses.2. Users are interested in earning power because it helps them derive an

estimate of future earnings without irregular items.B. For users of financial statements to determine “earning power” or

regular income, the “irregular” items are separately identified on the income statement. Three types of “irregular” items are reported:1. In studying financial statements, users may ask: (1) Are the results typical of

the company? (2) Are the results a reasonable indicator of the company’s future earnings? Therefore accountants have concluded that material items not typical of regular operations should also be reported through additional sections should be added to the income statement to report material items not typical of regular operations.a) Non-typical “irregular” items include:

1) Discontinued operations2) Extraordinary items3) Changes in accounting principle

b) Each item should be carefully explained in footnotes to financial statements, and the income statement should report the income tax expense or savings applicable to each item.

C. DISCONTINUED OPERATIONS1. Discontinued operations refer to the disposal of a significant segment of a

business. Examples are the cessation of an entire activity or the elimination of a major class of customers.

2. Following the disposal, the income statement should report both income from continuing operations and income (loss) from discontinued operations.

3. The income (loss) from discontinued operations consists of:a) (1) income (loss) from operations and b) (2) gain (loss) on disposal of the segment.

4. Both components are reported net of applicable taxes in a section entitled Discontinued Operations, which follows Income from Continuing Operations.

5. Examples will show the caption, “Income from continued operations” is used and that a new section “Discontinued operations” is added. Within the new section, the two subsections presentation which clearly indicates the separate effects of the discontinued operations from the continuing operations:

a) Operating income or loss that occurred during the year from the discontinued operation net of applicable taxes.

b) The income or the loss on from disposing of the operation net of applicable taxes.

D. EXTRAORDINARY ITEMS:1. Extraordinary items are events and transactions that meet two conditions:

a) unusual in nature andb) infrequent in occurrence .

2. To be unusual, the item should be: a) abnormal and b) be only incidentally related to customary activities of the entity.

3. To be infrequent, the item should not be reasonably expected to recur in the foreseeable future.

4. Extraordinary items are reported net of taxes in a separate section of the income statement immediately below discontinued operations.

5. Examples of extraordinary and ordinary items Illustration: Assume that in 2018 a revolutionary foreign government expropriated property held as an investment by Acro Energy Inc. If the loss is $70,000, before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000 ($70,000 loss - $21,000 applicable tax savings as the loss will reduce income that would be taxable).

E. CHANGE IN ACCOUNTING PRINCIPLE1. A change in accounting principle occurs when the principle used in the

current year is different from the one used in the preceding year. When a change has occurred:a) The new principle should be used in reporting the results of operations of

the current year and prior years.b) Companies report most changes in accounting principle retroactively.

1) They report both the current period and previous periods using the new principle.

2) As a result the same principle applies to all periods. This treatment improves the ability to compare results across years.

2. A change in accounting principle is permitted when two conditions are met:a) Management can show that the new principle is preferable to the old

principle, andb) The effects of the change are clearly disclosed in the income statement.

3. Examples include a change in depreciation methods or inventory costing methods.

F. COMPREHENSIVE INCOME1. Comprehensive Income includes all changes in stockholders’ equity

during a period except those resulting from investments by stockholders and distributions to stockholders.

2. Unrealized gains and losses on available-for-sale securities are not included in income but instead are reported in the balance sheet as adjustments to stockholders’ equity. These are excluded from net income because disclosing them separately:a) (1) reduces the volatility of net income due to fluctuations in fair value,

yetb) (2) informs the financial statement user of the gain or loss that would be

incurred if the securities were sold at fair value.3. Many analysts have expressed concern over the significant increase in the

number of items that bypass the income statement and have reduced the usefulness of the income statement. Therefore, the FASB now requires that, in addition to reporting net income, a company must also report comprehensive income.

VI. QUALITY OF EARNINGSa) Study Objective 7: Understanding the concept of quality of earnings.b) You should be aware of some of the limitations of the three analytical tools

illustrated in the chapter and of the financial statements on which they are based:1. ESTIMATES : Financial statements contain numerous estimates; to the

extent that these estimates are inaccurate, the financial ratios and percentages are inaccurate.

2. COST : Traditional financial statements are based on cost and are not adjusted for price-level changes. Comparisons of unadjusted financial data from different periods may be rendered invalid by significant inflation or deflation.

3. ALTERNATIVE ACCOUNTING METHODS : Variations among companies in the application of GAAP may hamper comparability. Example are:a) Inventory cost methods such as FIFO vs. LIFO. For example if

GM Corporation had used FIFO instead of LIFO in valuing its inventories, its inventories would have been 26% higher which would have significantly affected the current ratio as well as other ratios.

b) Differences in depreciation methods used (straight-line vs. declining-balance or units or activity or production, etc.), and reporting of depletion and amortization expense.

c) Differences in accounting methods might be detectable from reading the notes to the financial statements.

d) But adjusting the financial data to compensate for the different methods is difficult, if not impossible, in some cases.

4. A TYPICAL DATA : Fiscal year-end data may not be typical of the financial condition during the year. Firms often establish a fiscal year-end that coincides with the low point in operating activity or in inventory levels. Thus, certain account balances may not be representative of the account balances during the year.

5. DIVERSIFICATION OF FIRMS : Diversification in U.S. industry also restricts the usefulness of financial analysis. Many firms today are too diversified to be classified by industry, while others appear to be comparable when they are not.

6. PRO FORMA INCOME a) Excludes items that the company thinks are unusual or

nonrecurring.b) To compute pro forma income, companies generally can exclude

any items they deem inappropriate for measuring their performance.

c) Many companies have abused the flexibility that pro forma numbers allow and have used the measure as a way to put their companies in good light.

7. IMPROPER RECOGNITION a) The most common abuse is improper recognition of revenue where

one practice is using channel stuffing: Offering deep discounts on their products to customers to encourage them to buy early.

b) Another is improper capitalization of operating expenses.

VI. CORPORATION INCOME STATEMENTS with income taxes:A. Introduction

2. Income statements for corporations are the same as the statements for proprietorships or partnerships except for one thing: the reporting of income taxes.

3. For income tax purposes, corporations are a separate legal entity. As a result, income tax expense is reported in a separate section of the corporation income statement before net income.

4. Income statement with income taxes showing the Income tax expense after the Income before income taxes line item.

5. Income tax expense and the related liability for income taxes payable are recorded as part of the adjusting process where the adjusting for Leads, Inc. would be entered as followed:

General Journal Page 1Date Account Title P.R Debit Credit20-- Adjusting Entry

Dec. 31 Income Tax Expense 46,800Income taxes Payable 46,800

VII. EARNINGS PER SHARE (EPS)A. Earnings per share (EPS) indicate the net income earned by each share of

outstanding common stock.B. Most companies are required to report earnings per share on the income

statement.C. EARNINGS PER SHARE CALCULATION:

Net Income – Preferred Dividends ÷

“Weighted” Average of Common Shares Outstanding = Earnings per Share

D. To illustrate, assume Rally Inc. reports net income of $211,000 on its 102,500 weighted average common shares (calculation of weighted average is covered in advanced accounting courses dealing with days during the year with the number of shares outstanding) and that during the year it also declares a $6,000 dividend on its preferred stock is calculated as follows:

Net Income – Preferred Dividends ÷

“Weighted” Average of Common Shares Outstanding = Earnings per Share

$211,000 - $6,000 ÷ 102,500 = $2.00E. Basic earnings per share disclosure which is simply reported below the net income

on the income statement.F. Additional earnings per share disclosures are required when the income statement

contains any irregular (non-recurring) items; EPS should be disclosed for each component. Assuming that Arco Energy had 100,000 shares of common stock outstanding during the year, the additional EPS disclosures on the income statement would be shown as follows noting that the dollar amount in parenthesis are coming from the main part of the income statement:

ARCO ENERGY INC.Income Statement (partial)

For the Year Ended December 31, 20--Net income $284,200Earnings per share:

Income from continuing operations ($560,000 ÷ 100,000) $5.60Loss from discontinued operations ($210,000 ÷ 100,000) (2.10)Income before extraordinary item and cumulative

Effect of change in accounting principle ($350,000 ÷ 100,000) 3.50Extraordinary loss ($49,000 ÷ 100,000) (.49)Cumulative effect of change in accounting principle ($16,800÷100,000) (.17)Net income $2.84