CHAPTER 14 FINANCIAL STATEMENT ANALYSIS: THE BIG PICTURE SUMMARY OF QUESTIONS BY STUDY OBJECTIVES AND BLOOM’S TAXONOMY Item SO BT Item SO BT Item SO BT Item SO BT 5 6 7 C C K K K K K K 5 5 5 5 5 5 5 5 5 5 5 6 6 AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP K Item SO BT 33 34 sg 35 sg 36 5 K K K K 141 142 143 144 145 146 147 148 149 150 151 sg 152 sg 153 st 154 sg 155 sg 156 sg 157 sg 158 sg 159 sg 160 sg 161 sg 162 6 6 6 6 1 4 5 5 6 K AP AP C K K K C K C True-False Statements 1 1 2 C K K K K K K K 10 11 12 13 14 15 16 3 4 4 K AP C K C C C C 17 18 19 20 21 22 23 24 5 5 5 K K K K K C C C 25 26 27 28 29 30 sg 31 sg 32 sg sg Multiple Choice Questions 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 sg st 1 1 1 1 2 2 2 3 3 3 3 3 4 K K C C C C C K K K K K K K K K K AP K C C C AP AP AP AP 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 4 4 4 5 5 5 5 5 5 5 5 5 K K C C C C C C C K K K AP AP AP AP K C C K AP AP AP C K AP 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 5 5 5 5 5 5 5 5 5 5 5 5 5 K C C C C C C AP C C K C AP AP C K AP C C AP K C K K K AP 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 This question also appears in the Study Guide This question also appears in a self-test at the student companion website 14 - Test Bank for ISV Managerial Accounting, Fourth Edition SUMMARY OF QUESTIONS BY STUDY OBJECTIVES AND BLOOM’S TAXONOMY Brief Exercises 163 164 165 3 AP AP AN 166 167 168 4 AP AP AP 169 170 171 5 K AP AP 172 173 AP AP 192 193 194 195 196 197 5 6 AN AP AP AP AP AP 198 199 6 AP AP 6 K K K 212 K Exercises 174 175 176 177 178 179 3 3 3,4 3,4 AP AP AP AN AP AP 180 181 182 183 184 185 4 5 5 AP AN AP AP AP AN 186 187 188 189 190 191 5 5 5 AP AP AP AP AP E Completion Statements 200 201 202 K K K 203 204 205 5 K K AP 206 207 208 5 AP K K 209 210 211 SUMMARY OF STUDY OBJECTIVES BY QUESTION TYPE Item Type Item Type Item TF TF TF 37 TF TF MC 38 39 40 TF TF 31 45 TF MC 46 47 10 11 TF TF TF TF 32 51 52 53 TF MC MC MC 54 55 56 57 12 13 14 15 TF TF TF TF 16 17 33 61 TF TF TF MC 62 63 64 65 18 19 20 21 22 23 24 25 TF TF TF TF TF TF TF TF 75 76 77 78 79 80 81 82 MC MC MC MC MC MC MC MC 91 92 93 94 95 96 97 98 Type Item Type Item Study Objective MC 41 MC 44 MC 42 MC 151 MC 43 MC 152 Study Objective MC 48 MC 50 MC 49 MC Study Objective MC 58 MC 163 MC 59 MC 164 MC 60 MC 165 MC 153 MC 166 Study Objective MC 66 MC 154 MC 67 MC 155 MC 68 MC 167 MC 69 MC 168 Study Objective MC 107 MC 123 MC 108 MC 124 MC 109 MC 125 MC 110 MC 126 MC 111 MC 127 MC 112 MC 128 MC 113 MC 129 MC 114 MC 130 Type Item Type Item Type MC MC MC 200 C BE BE BE BE 174 175 176 177 Ex Ex Ex Ex 178 179 201 Ex Ex C MC MC BE BE 178 179 180 181 Ex Ex Ex Ex 202 C MC MC MC MC MC MC MC MC 158 159 169 170 171 172 182 183 MC MC BE BE BE BE Ex Ex 188 193 194 203 204 205 206 207 Ex Ex Ex C C C C C MC Financial Statement Analysis: The Big Picture 26 34 35 70 71 72 73 74 TF TF TF MC MC MC MC MC 83 84 85 86 87 88 89 90 MC MC MC MC MC MC MC MC 99 100 101 102 103 104 105 106 27 28 36 137 TF TF TF MC 138 139 140 141 MC MC MC MC 142 143 144 145 29 TF 30 TF 150 Study Objective (cont.) MC 115 MC 131 MC 116 MC 132 MC 117 MC 133 MC 118 MC 134 MC 119 MC 135 MC 120 MC 136 MC 121 MC 156 MC 122 MC 157 Study Objective MC 146 MC 160 MC 147 MC 161 MC 148 MC 162 MC 149 MC 173 Study Objective7 MC 14 - MC MC MC MC MC MC MC MC 184 185 186 187 189 190 191 192 Ex Ex Ex Ex Ex Ex Ex Ex 208 209 C C MC MC MC BE 195 196 197 198 Ex Ex Ex Ex 199 210 211 212 Ex C C C Note: TF = True-False BE = Brief Exercise C = Completion MC = Multiple Choice Ex = Exercise The chapter also contains two sets of ten Matching questions and four Short-Answer Essay questions CHAPTER STUDY OBJECTIVES Discuss the need for comparative analysis There are three bases of comparison: (1) Intracompany, which compares an item or financial relationship with other data within a company (2) Industry, which compares company data with industry averages (3) Intercompany, which compares an item or financial relationship of a company with data of one or more competing companies Identify the tools of financial statement analysis Financial statements can be analyzed horizontally, vertically, and with ratios Explain and apply horizontal analysis Horizontal analysis is a technique for evaluating a series of data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage Describe and apply vertical analysis Vertical analysis is a technique that expresses each item within a financial statement in terms of a percentage of a relevant total or a base amount Identify and compute ratios used in analyzing a firm's liquidity, profitability, and solvency The formula and purpose of each ratio is presented in Illustration 14-27 Understand the concept of earning power, and how irregular items are presented Earning power refers to a company’s ability to sustain its profits from operations “Irregular items”—discontinued operations and extraordinary items—are presented net of tax below income from continuing operations to highlight their unusual nature Understand the concept of quality of earnings A high quality of earnings provides full and transparent information that will not confuse or mislead users of financial statements Issues related to quality of earnings are (1) alternative accounting methods, (2) pro forma income, and (3) improper recognition 14 - Test Bank for ISV Managerial Accounting, Fourth Edition TRUE-FALSE STATEMENTS Intracompany comparisons of the same financial statement items can often detect changes in financial relationships and significant trends Calculating financial ratios is a financial reporting requirement under generally accepted accounting principles Measures of a company's liquidity are concerned with the frequency and amounts of dividend payments Analysis of financial statements is enhanced with the use of comparative data Comparisons of company data with industry averages can provide some insight into the company's relative position in the industry Vertical and horizontal analyses are concerned with the format used to prepare financial statements Horizontal, vertical, and circular analyses are the most common tools of financial statement analysis Horizontal analysis is a technique for evaluating a financial statement item in the current year with other items in the current year Another name for trend analysis is horizontal analysis 10 If a company has sales of $110 in 2008 and $154 in 2009, the percentage increase in sales from 2008 to 2009 is 140% 11 In horizontal analysis, if an item has a negative amount in the base year, and a positive amount in the following year, no percentage change for that item can be computed 12 Common size analysis expresses each item within a financial statement in terms of a percent of a base amount 13 Vertical analysis is a more sophisticated analytical tool than horizontal analysis 14 Vertical analysis is useful in making comparisons of companies of different sizes 15 Meaningful analysis of financial statements will include either horizontal or vertical analysis, but not both 16 Using vertical analysis of the income statement, a company's net income as a percentage of net sales is 10%; therefore, the cost of goods sold as a percentage of sales must be 90% 17 In the vertical analysis of the income statement, each item is generally stated as a percentage of net income 18 A ratio can be expressed as a percentage, a rate, or a proportion Financial Statement Analysis: The Big Picture 14 - 19 A solvency ratio measures the income or operating success of an enterprise for a given period of time 20 The current ratio is a measure of all the ratios calculated for the current year 21 Inventory turnover measures the number of times on average the inventory was sold during the period 22 Profitability ratios are frequently used as a basis for evaluating management's operating effectiveness 23 The rate of return on total assets will be greater than the rate of return on common stockholders' equity if the company has been successful in trading on the equity at a gain 24 From a creditor's point of view, the higher the total debt to total assets ratio, the lower the risk that the company may be unable to pay its obligations 25 A current ratio of 1.2 to indicates that a company's current assets exceed its current liabilities 26 Using borrowed money to increase the rate of return on common stockholders' equity is called "trading on the equity." 27 When the disposal of a significant segment occurs, the income statement should report both income from continuing operations and income (loss) from discontinued operations 28 An event or transaction should be classified as an extraordinary item if it is unusual in nature or if it occurs infrequently 29 Variations among companies in the application of generally accepted accounting principles may reduce quality of earnings 30 Pro forma income usually excludes items that the company thinks are unusual or nonrecurring Additional True-False Questions 31 The three basic tools of analysis are horizontal analysis, vertical analysis, and ratio analysis 32 A percentage change can be computed only if the base amount is zero or positive 33 In vertical analysis, the base amount in an income statement is usually net sales 34 Profitability ratios measure the ability of the enterprise to survive over a long period of time 35 The days in inventory is computed by multiplying inventory turnover by 365 36 Extraordinary items are reported net of applicable taxes in a separate section of the income statement 14 - Test Bank for ISV Managerial Accounting, Fourth Edition Answers to True-False Statements Item Ans T F F T T F Item 10 11 12 Ans F F T F T T Item 13 14 15 16 17 18 Ans F T F F F T Item 19 20 21 22 23 24 Ans F F T T F F Item 25 26 27 28 29 30 Ans T F T F T T Item 31 32 33 34 35 36 Ans T F T F F T MULTIPLE CHOICE QUESTIONS 37 Which one of the following is primarily interested in the liquidity of a company? a Federal government b Stockholders c Long-term creditors d Short-term creditors 38 Which one of the following is not a characteristic generally evaluated in analyzing financial statements? a Liquidity b Profitability c Marketability d Solvency 39 In analyzing the financial statements of a company, a single item on the financial statements a should be reported in bold-face type b is more meaningful if compared to other financial information c is significant only if it is large d should be accompanied by a footnote 40 Short-term creditors are usually most interested in evaluating a solvency b liquidity c marketability d profitability 41 Long-term creditors are usually most interested in evaluating a liquidity and solvency b solvency and marketability c liquidity and profitability d profitability and solvency 42 Stockholders are most interested in evaluating a liquidity and solvency b profitability and solvency c liquidity and profitability d marketability and solvency Financial Statement Analysis: The Big Picture 14 - 43 A stockholder is interested in the ability of a firm to a pay consistent dividends b appreciate in share price c survive over a long period d all of these 44 Comparisons of financial data made within a company are called a intracompany comparisons b interior comparisons c intercompany comparisons d intramural comparisons 45 A technique for evaluating financial statements that expresses the relationship among selected items of financial statement data is a common size analysis b horizontal analysis c ratio analysis d vertical analysis 46 Which one of the following is not a tool in financial statement analysis? a Horizontal analysis b Circular analysis c Vertical analysis d Ratio analysis 47 In analyzing financial statements, horizontal analysis is a a requirement b tool c principle d theory 48 Horizontal analysis is also called a linear analysis b vertical analysis c trend analysis d common size analysis 49 Vertical analysis is also known as a perpendicular analysis b common size analysis c trend analysis d straight-line analysis 50 In ratio analysis, the ratios are never expressed as a a rate b negative figure c percentage d simple proportion 14 - Test Bank for ISV Managerial Accounting, Fourth Edition 51 The formula for horizontal analysis of changes since the base period is the current year amount a divided by the base year amount b minus the base year amount divided by the base year amount c minus the base year amount divided by the current year amount d plus the base year amount divided by the base year amount 52 Horizontal analysis evaluates a series of financial statement data over a period of time a that has been arranged from the highest number to the lowest number b that has been arranged from the lowest number to the highest number c to determine which items are in error d to determine the amount and/or percentage increase or decrease that has taken place 53 Horizontal analysis evaluates financial statement data a within a period of time b over a period of time c on a certain date d as it may appear in the future 54 Assume the following sales data for a company: 2010 2009 2008 2007 $1,000,000 900,000 750,000 600,000 If 2007 is the base year, what is the percentage increase in sales from 2007 to 2009? a 100% b 150% c 50% d 66.7% 55 Comparative balance sheets are usually prepared for a one year b two years c three years d four years 56 Horizontal analysis is appropriately performed a only on the income statement b only on the balance sheet c only on the statement of retained earnings d on all three of these statements 57 A horizontal analysis performed on a statement of retained earnings would not show a percentage change in a dividends paid b net income c expenses d beginning retained earnings Financial Statement Analysis: The Big Picture 14 - 58 Under which of the following cases may a percentage change be computed? a The trend of the balances is decreasing but all balances are positive b There is no balance in the base year c There is a positive balance in the base year and a negative balance in the subsequent year d There is a negative balance in the base year and a positive balance in the subsequent year 59 Assume the following sales data for a company: 2009 2008 2007 $945,000 780,000 650,000 If 2007 is the base year, what is the percentage increase in sales from 2007 to 2008? a 25% b 20% c 125% d 143% 60 Assume the following cost of goods sold data for a company: 2009 2008 2007 $1,500,000 1,200,000 900,000 If 2007 is the base year, what is the percentage increase in cost of goods sold from 2007 to 2009? a 167% b 67% c 60% d 40% Use the following information for questions 61–62: Moon Beam, Inc has the following income statement (in millions): MOON BEAM, INC Income Statement For the Year Ended December 31, 2008 Net Sales Cost of Goods Sold Gross Profit Operating Expenses Net Income 61 $180 120 60 33 $ 27 Using vertical analysis, what percentage is assigned to Cost of Goods Sold? a 67% b 33% c 100% d None of the above 14 - 10 Test Bank for ISV Managerial Accounting, Fourth Edition 62 Using vertical analysis, what percentage is assigned to Net Income? a 100% b 85% c 15% d None of the above 63 Vertical analysis is also called a common size analysis b horizontal analysis c ratio analysis d trend analysis 64 Vertical analysis is a technique which expresses each item within a financial statement a in dollars and cents b in terms of a percentage of the item in the previous year c in terms of a percent of a base amount d starting with the highest value down to the lowest value 65 In common size analysis, a a base amount is required b a base amount is optional c the same base is used across all financial statements analyzed d the results of the horizontal analysis are necessary inputs for performing the analysis 66 In performing a vertical analysis, the base for prepaid expenses is a total current assets b total assets c total liabilities and stockholders' equity d prepaid expenses 67 In performing a vertical analysis, the base for sales revenues on the income statement is a net sales b sales c net income d cost of goods available for sale 68 In performing a vertical analysis, the base for sales returns and allowances is a sales b sales discounts c net sales d total revenues 69 In performing a vertical analysis, the base for cost of goods sold is a total selling expenses b net sales c total revenues d total expenses 14 - 44 Test Bank for ISV Managerial Accounting, Fourth Edition Ex 188 Winter Corporation has issued common stock only The company has been successful and has a gross profit rate of 20% The information shown below was taken from the company's financial statements Beginning inventory Purchases Ending inventory Average accounts receivable Average common stockholders' equity Sales (all on credit) Net income $ 482,000 5,636,000 ? 700,000 3,500,000 7,000,000 525,000 Instructions Compute the following: (a) Receivables turnover and the average collection period (b) Inventory turnover and the days in inventory (c) Return on common stockholders' equity Solution 188 (a) (13–18 min.) Receivables turnover = = = Average collection period Credit sales ————————————— Average accounts receivable $7,000,000 ÷ $700,000 10 times = = = (b) 365 days ————————— Receivables turnover 365 ÷ 10 times 36.5 days Inventory turnover = Cost of goods sold ÷ Average inventory First calculate ending inventory Beginning Inventory $ 482,000 + Purchases 5,636,000 – Cost of Goods Sold (5,600,000)* Ending Inventory $ 518,000 *Since the gross profit ratio is 20%, the cost of goods sold ratio is 80% 80% × $7,000,000 (net sales) = $5,600,000 Ending Inventory = $518,000 (per above) Average Inventory = ($482,000 + $518,000) ÷ = $500,000 Inventory Turnover = $5,600,000 ÷ $500,000 = 11.2 times Days in Inventory = 365 days ÷ 11.2 times = 32.6 days (c) Net income Return on common stockholders' equity = ————————————————— Average common stockholders' equity $525,000 ÷ $3,500,000 = 15% Financial Statement Analysis: The Big Picture 14 - 45 Ex 189 Boyle Corporation had the following comparative current assets and current liabilities: Dec 31, 2009 Dec 31, 2008 Current assets Cash $ 20,000 $ 30,000 Short-term investments 40,000 10,000 Accounts receivable 55,000 95,000 Inventory 110,000 90,000 Prepaid expenses 35,000 20,000 Total current assets $260,000 $245,000 Current liabilities Accounts payable $140,000 $110,000 Salaries payable 40,000 30,000 Income tax payable 20,000 15,000 Total current liabilities $200,000 $155,000 During 2009, credit sales and cost of goods sold were $600,000 and $350,000, respectively Instructions Compute the following liquidity measures for 2009: Current ratio Working capital Acid-test ratio Receivables turnover Inventory turnover Solution 189 (10–15 min.) Current ratio = Current assets ÷ Current liabilities = $260,000 ÷ $200,000 = 1.3 : Working capital = $260,000 – $200,000 = $60,000 Cash + Short-term investments + Accounts receivable Acid-test ratio = ———————————————————————— Current liabilities $20,000 + $40,000 + $55,000 = ————————————— = 58 : $200,000 Receivables turnover = Net credit sales ————————————— Average accounts receivables = $600,000 ———— = times $75,000 Cost of goods sold Inventory turnover = ————————— Average inventory $350,000 = ———— = 3.5 times $100,000 14 - 46 Test Bank for ISV Managerial Accounting, Fourth Edition Ex 190 Selected data from Oates Company are presented below: Total assets Average assets Net income Net sales Average common stockholders' equity $1,600,000 1,750,000 175,000 1,225,000 1,000,000 Instructions Calculate the profitability ratios that can be computed from the above information Solution 190 (9–13 min.) With the information provided, the profitability ratios that can be calculated are as follows: Profit margin = Net income ÷ Net sales = $175,000 ÷ $1,225,000 = 14.3% Asset turnover = Net sales ÷ Average assets = $1,225,000 ÷ $1,750,000 = 70% Return on assets = Net income ÷ Average assets = $175,000 ÷ $1,750,000 = 10% Net income Return on common stockholders' equity = ————————————————— Average common stockholders' equity = $175,000 ÷ $1,000,000 = 17.5% Ex 191 The following data are taken from the financial statements of Doyle Company: Monthly average accounts receivable Net sales on account Terms for all sales are 2/10, n/30 2009 $ 520,000 5,460,000 2008 $ 500,000 4,500,000 Instructions (a) Compute the receivables turnover and the average collection period for both years (b) What conclusion can an analyst draw about the management of the accounts receivable? Financial Statement Analysis: The Big Picture Solution 191 (8–12 min.) (a) Receivables turnover Average collection period (b) 14 - 47 2009 2008 $5,460,000 ————— 520,000 $4,500,000 ————— 500,000 10.5 times 9.0 times 365 days ————– 10.5 times 365 days ———— 9.0 times 34.8 days 40.6 days The receivables are turning faster in 2009 than they did in 2008 There is still a problem since the normal credit period is 30 days, and the average collection period for both years exceeds this target Therefore, improvement in the management of the receivables would appear to be desirable Ex 192 State the effect of the following transactions on the current ratio Use increase, decrease, or no effect for your answer (a) Collection of an accounts receivable (b) Declaration of cash dividends (c) Additional stock is sold for cash (d) Short-term investments are purchased for cash (e) Equipment is purchased for cash (f) Inventory purchases are made for cash (g) Accounts payable are paid Solution 192 (a) (b) (c) (d) (e) (f) (g) no effect decrease increase no effect decrease no effect increase (7–11 min.) 14 - 48 Test Bank for ISV Managerial Accounting, Fourth Edition Ex 193 The balance sheet for Farley Corporation at the end of the current year indicates the following: Bonds payable, 7% 6% Preferred stock, $100 par Common stock, $10 par $4,000,000 1,000,000 3,000,000 Income before income taxes was $1,120,000 and income taxes expense for the current year amounted to $336,000 Cash dividends paid on common stock were $300,000, and the common stock was selling for $45 per share at the end of the year There were no ownership changes during the year Instructions Determine each of the following: (a) times that bond interest was earned (b) earnings per share for common stock (c) price-earnings ratio Solution 193 (a) (9–14 min.) Times interest earned = Income before income taxes and interest expense —————————————————————— Interest expense $1,120,000 + $280,000 —————————— = times $280,000 (b) Net income – Preferred dividends Earnings per share = ————————————————————— Weighted average common shares outstanding $784,000 – $60,000 ————————— = $2.41 per share 300,000 shares (c) Market price per share Price-earnings ratio = —————————— Earnings per share $45.00 ——— = 18.67 $2.41 Ex 194 The income statement for Stoval Company for the year ended December 31, 2008 appears below Sales Cost of goods sold Gross profit Expenses Net income $610,000 380,000 230,000 170,000* $ 60,000 *Includes $30,000 of interest expense and $18,000 of income tax expense Financial Statement Analysis: The Big Picture Ex 194 14 - 49 (cont.) Additional information: Common stock outstanding on January 1, 2008 was 40,000 shares On July 1, 2008, 10,000 more shares were issued The market price of Stoval's stock was $15 at the end of 2008 Cash dividends of $30,000 were paid, $6,000 of which were paid to preferred stockholders Instructions Compute the following ratios for 2008: (a) earnings per share (b) price-earnings (c) times interest earned Solution 194 (a) (8–13 min.) Earnings per share $60,000 – $6,000 $54,000 —————————— = ———— = $1.20 [40,000 + (10,000 ÷ 2)] 45,000 (b) Price-earnings $15.00 ——— = 12.5 times 1.20 (c) Times interest earned $60,000 + $30,000 + $18,000 ————————————— = 3.6 times $30,000 Ex 195 Gumble Corporation had income from continuing operations of $300,000 for the year ended December 31, 2008 It also had the following items (before income taxes): Extraordinary flood loss of $150,000 Loss of $60,000 on discontinuance of a division All items are subject to income taxes at a 30% tax rate Instructions Prepare a partial income statement, beginning with income from continuing operations 14 - 50 Test Bank for ISV Managerial Accounting, Fourth Edition Solution 195 (9–12 min.) Income from continuing operations Discontinued operations Loss on discontinued division, net of $18,000 income tax savings Income before extraordinary item and cumulative effect of change in accounting principle Extraordinary item Flood loss, net of $45,000 income tax savings Net income $300,000 (42,000) 258,000 (105,000) $153,000 Ex 196 Lawrenz Corporation gathered the following information for the fiscal year ended December 31, 2008: Sales $1,400,000 Extraordinary fire loss 140,000 Selling and administrative expenses 160,000 Cost of goods sold 900,000 Loss on sale of equipment 40,000 Lawrenz Corporation is subject to a 30% income tax rate Instructions Prepare a partial income statement, beginning with income before income taxes Solution 196 (8–12 min.) LAWRENZ CORPORATION Partial Income Statement For the Fiscal Year Ended December 31, 2008 Income before income taxes ($1,400,000 – $900,000 – $160,000 – $40,000) Income tax expense ($300,000 × 30%) Income before extraordinary item Extraordinary fire loss, net of $42,000 tax saving ($140,000 × 30%) Net income $300,000 90,000 210,000 (98,000) $112,000 Ex 197 Dennehy Corporation had the information listed below available in preparing an income statement for the year ended December 31, 2008 All amounts are before income taxes Assume a 30% income tax rate for all items Sales Expropriation of property by a foreign government (loss) Income from operation of discontinued cement division Loss from disposal of cement division Operating expenses Gain on sale of equipment Cost of goods sold $ 600,000 $(120,000) $ 100,000 $ (80,000) $ 125,000 $ 85,000 $ 360,000 Financial Statement Analysis: The Big Picture Ex 197 14 - 51 (cont.) Instructions Prepare a multiple-step income statement in good form which takes into account intraperiod income tax allocation Ignore EPS computations Solution 197 (17–22 min.) DENNEHY CORPORATION Income Statement For the Year Ended December 31, 2008 ——————————————————————————————————————————— Sales Cost of goods sold Gross profit Operating expenses Operating income Other revenues and gains Gain on sale of equipment Income before income taxes Income taxes Income from continuing operations Discontinued operations Income from operation of discontinued cement division, net of $30,000 income taxes $70,000 Loss from disposal of cement division, net of $24,000 income tax savings (56,000) Income before extraordinary item Extraordinary item Loss on expropriation of property, net of $36,000 income tax saving Net income $600,000 360,000 240,000 125,000 115,000 85,000 200,000 60,000 140,000 14,000 154,000 (84,000) $ 70,000 Ex 198 Indicate whether the following items would be reported as an ordinary or an extraordinary item in Logan Corporation's income statement (a) Loss attributable to labor strike (b) Gain on sale of fixed assets (c) Loss from fire Logan is a chemical company (d) Loss from sale of short-term investments (e) Expropriation of property by a foreign government (f) Loss from tornado damage Logan Corporation is located in the Midwest's tornado alley (g) Loss from government condemnation of property through newly enacted law 14 - 52 Test Bank for ISV Managerial Accounting, Fourth Edition Solution 198 (a) (b) (c) (d) (6–9 min.) ordinary ordinary ordinary ordinary (e) (f) (g) extraordinary ordinary extraordinary Ex 199 Potter Company has income from continuing operations of $480,000 for the year ended December 31, 2008 It also has the following items (before considering income taxes): (1) An extraordinary fire loss of $180,000 (2) A gain of $110,000 on the discontinuance of a major segment (3) A correction of an error in last year's financial statement that resulted in a $100,000 overstatement of 2007 net income Assume all items are subject to income taxes at a 30% tax rate Instructions (a) Prepare an income statement, beginning with income from continuing operations (b) Indicate the statement presentation of any item not included in (a) above Solution 199 (a) (10–15 min.) POTTER COMPANY Partial Income Statement For the Year Ended December 31, 2008 Income from continuing operations Discontinued operations Gain on discontinued segment, net of $33,000 income taxes Income before extraordinary item and cumulative effect of change in accounting principle Extraordinary item Fire loss, net of $54,000 tax saving Net income (b) $480,000 77,000 557,000 (126,000) $431,000 The correction of an error in last year's financial statements is a prior period adjustment The correction is reported in the 2008 retained earnings statement as an adjustment that decreases the reported beginning balance of retained earnings by $70,000 [$100,000 – ($100,000 × 30%)] Financial Statement Analysis: The Big Picture 14 - 53 COMPLETION STATEMENTS 200 In analyzing and interpreting financial statement information, three major characteristics are generally evaluated: (1) , (2) _, and (3) _ 201 analysis, also called trend analysis, is a technique for evaluating a percentage increase or decrease for a financial statement item over a period of time 202 Expressing each item within a financial statement as a percentage of a base amount is called analysis 203 The ratios used in evaluating a company's liquidity and short-term debt paying ability that complement each other are the ratio and the ratio 204 The receivables turnover is calculated by dividing _ by average _ 205 If inventory turnover is times, and the average inventory was $400,000, the cost of goods sold during the year was $ and the days in inventory was days 206 Hansen Corporation had net income for the year of $300,000 and a profit margin of 25% If total average assets were $400,000, the asset turnover ratio was times 207 The ratio measures the percentage of earnings distributed in the form of cash dividends 208 The lower the to ratio, the more equity "buffer" there is available to the creditors 209 Times interest earned is calculated by dividing _ before _ and by interest expense 210 Discontinued operations refers to the disposal of a of a business 211 The two criteria necessary for an item to be classified as an extraordinary item are that the transaction or event must be (1) and (2) _ 212 A change in inventory methods during the year would be classified as a change in Answers to Completion Statements 200 201 202 203 204 205 206 liquidity, profitability, solvency Horizontal vertical (common size) current, acid-test (quick) net credit sales, gross receivables 2,000,000, 73 207 208 209 210 211 payout debt, total assets income, income taxes, interest expense significant segment unusual in nature, infrequent in occurrence 212 accounting principle 14 - 54 Test Bank for ISV Managerial Accounting, Fourth Edition MATCHING SET A 213 For each of the ratios listed below, indicate by the appropriate code letter, whether it is a liquidity ratio, a profitability ratio, or a solvency ratio Code: L = P = S = Liquidity ratio Profitability ratio Solvency ratio Price-earnings ratio Asset turnover Receivables turnover Earnings per share Payout ratio Current ratio Acid-test ratio Debt to total assets ratio Times interest earned 10 Inventory turnover Answers to Matching P Price-earnings ratio P Asset turnover L Receivables turnover P Earnings per share P Payout ratio L Current ratio L Acid-test ratio S Debt to total assets ratio S Times interest earned L 10 Inventory turnover Financial Statement Analysis: The Big Picture 14 - 55 SET B 214 Match the ratios with the appropriate ratio computation by entering the appropriate letter in the space provided A B C D E Current ratio Acid-test ratio Profit margin Asset turnover Price-earnings ratio F G H I J Times interest earned Inventory turnover Average collection period Days in inventory Payout ratio Cost of goods sold ————————— Average inventory Net income ————— Net sales Cash dividends ——————— Net income Net sales ——————— Average assets Current assets ———————— Current liabilities 365 days —————————— Receivables turnover Market price per share of stock —————————————— Earnings per share 365 days ———————— Inventory turnover Income before income taxes and interest expense —————————————————————— Interest expense Cash + short-term investments + receivables (net) 10 ——————————————————————— Current liabilities Answers to Matching G C J D A 10 H E I F B 14 - 56 Test Bank for ISV Managerial Accounting, Fourth Edition SHORT-ANSWER ESSAY QUESTIONS S-A E 215 Horizontal and vertical analyses are analytical tools frequently used to analyze financial statements What type of information or insights can be obtained by using these two techniques? Explain how the output of horizontal analysis and vertical analysis can be compared to industry averages and/or competitive companies Solution 215 Horizontal analysis allows an analyst to develop a picture of current trends in a company's operations The analyst can see whether the accounts are increasing or decreasing and how large these changes actually are Vertical analysis allows an analyst to evaluate financial statement items within a single financial statement This technique helps the analyst to evaluate the relative size of the financial statement items and how the items relate to the financial statement as a whole An example would be if current liabilities were a very large percentage of total liabilities and stockholders' equity Both techniques allow the company to evaluate their performance and position relative to their competitors and their industry as a whole For example, the company could evaluate its current trend in sales and see how favorably its sales performance compared to the sales performance of other companies in the industry Another example would be comparing the relative size of longterm liabilities or retained earnings This would show which companies have taken on a large amount of debt and which companies have invested in themselves S-A E 216 Manuel Mentirosa, the CEO of Mystical Products, is a successful entrepreneur but a poor student of accounting He asks you to explain to him, in a memo, the bases of comparison for ratio analysis Solution 216 To: Manuel Mentirosa From: Student name Re: Bases of Comparison for Ratio Analysis There are three bases of comparison for ratio analysis They include: Intracompany: This basis compares a ratio for the current year to the same ratio for one or more prior years Intercompany: This basis compares a ratio for one company with the same ratio for one or more competing companies Industry averages: This basis compares a ratio for a company with the industry average for the same ratio (Signed) Financial Statement Analysis: The Big Picture 14 - 57 S-A E 217 (Ethics) A trusted employee of Wilderness Tours was caught in the act of embezzling funds He confessed to earlier embezzlements, but retracted the confession on the advice of his attorney Over the course of the most recent quarter, it has been determined that $20,000 was embezzled Wilderness Tours has suffered adverse publicity in the recent past because of serious injury to five tourists that occurred during a two week "Winter Wilds Adventure" tour The company has therefore decided to avoid publicity and has agreed to drop all charges against the embezzling employee In return, the employee has agreed to a notation of "Terminated—Not to be Rehired" to be appended to his personnel file Required: Who are the stakeholders in the decision not to prosecute? Was it ethical for the company to decide not to prosecute? Explain Solution 217 The stakeholders include • The embezzling employee • The other employees • Company management • Other companies who might hire the embezzling employee The company was certainly within its legal rights not to prosecute the embezzling employee However, the decision not to prosecute may not be ethical First, it does not serve public justice The embezzling employee could find a job elsewhere, and harm someone else financially Second, to the extent that other employees know of the act and of the decision, morale may be harmed The decision is also not the best one for the employee Having never been forced to face the consequences of his dishonest acts, he is not deterred from (and may even feel encouraged to) commit similar acts in the future The one argument that would support the premise that the decision was ethical is that the public disclosure would cause harm greater than that caused by keeping silent Even this argument lacks force, because it implies a lack of moral courageousness S-A E 218 (Communication) Kwik Express specializes in the overnight transportation of medical equipment and laboratory specimens The company has selected the following information from its most recent annual report to be the subject of an immediate press release • The financial statements are being released • Net income this year was $2.2 million Last year's net income had been $2.0 million • The current ratio has changed to 2:1 from last year's 1.5:1 • The debt/total assets ratio has changed to 4:5 from last year's 3:5 • The company expanded its truck fleet substantially by purchasing ten new delivery vans The company already had twelve delivery vans • The company is now the largest medical courier in the mid-Atlantic region Required: Prepare a brief press release incorporating the information above Include all information Think carefully which information (if any) is good news for the company, and which (if any) is bad news 14 - 58 Test Bank for ISV Managerial Accounting, Fourth Edition Solution 218 Press Release Kwik Express released its financial statements today, disclosing a 10% increase in earnings, to $2.2 million from $2 million last year The company also improved its short-term liquidity Its current ratio improved to 2:1 from last year's 1.5:1 Part of the improved performance is no doubt due to the addition of ten new delivery vans to its fleet, allowing it to become the largest medical courier in the mid-Atlantic region The purchase of the vans, however, caused the debt/total asset ratio to decline There are now $4 of debt for every $5 in assets, while last year, there were only $3 of debt to $5 in assets ... computed by multiplying inventory turnover by 365 36 Extraordinary items are reported net of applicable taxes in a separate section of the income statement 14 - Test Bank for ISV Managerial Accounting, ... to quality of earnings are (1) alternative accounting methods, (2) pro forma income, and (3) improper recognition 14 - Test Bank for ISV Managerial Accounting, Fourth Edition TRUE-FALSE STATEMENTS...14 - Test Bank for ISV Managerial Accounting, Fourth Edition SUMMARY OF QUESTIONS BY STUDY OBJECTIVES AND BLOOM’S TAXONOMY Brief Exercises