Chapter 13 Flashcards

1
Q

Sustainable income

A

Net income adjusted for irregular items

*Most likely level of income to be obtained in the future

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2
Q

Two types of irregular items:

A
  1. Discontinued operations
  2. Extraordinary items
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3
Q

Discontinued operations

A

The disposal of a significant component of a business

Ex. elimination of a major class of customers or an entire activity

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4
Q

Extraordinary items

A

Events and transactions that meet two conditions:

  1. Unusual in nature
  2. Infrequent in occurrence
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5
Q

To be considered unusual:

A

The item should be abnormal and only incidentally related to the customary activities of the entity

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6
Q

To be considered infrequent:

A

The event or transaction should not be reasonably expected to recur in the foreseeable future

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7
Q

Where are extraordinary items reported?

A

They are net of taxes in a seperate section of the income statement, immediately below discontinued operations

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8
Q

What if only one criteria for extraordinary items is met?

A

Reported as a seperate line item in the upper portion of the income statement

“Other revenues and gains” or “Other expenses and losses”

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9
Q

Ordinary gains and losses are reported at what?

A

Pretax amounts in arriving at income before income taxes

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10
Q

Change in accounting principle

A

When the principle used in the current year is different from the one used in the preceding year

ex. Change in inventory costing methods

Account rules permit a change when management can show that the new principle is preferable to the old principle

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11
Q

How do companies report most changes in accounting principles?

A

Retroactively

They report both the current period and previous periods using the new principle. => same principle applies in all periods

*Improves the ability to compare results across years*

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12
Q

Why should changes in accounting principles occurr?

A

Should result in financial statements that are more informative for statement users

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13
Q

Comprehensive income

A

Includes all changes in stockholders’ equity during a period except those changes resulting from investments by stockholders and distributions to stockholders

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14
Q

Trading security

A

Bought and held primarily for sale in the near term to generate income on short-term price differences

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15
Q

Where are unrealized losses on trading securities reported?

A

In the “Other expenses and losses” section of the income statement

Rationale: it is likely that the company will realize the unrealized loss (or gain), so the company should report it as a part of net income

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16
Q

Available-for-sale securities

A

Held with the intent of selling them sometime in the future

Report as part of “Other comprehensive income” - direct adjustment to stockholders’ equity

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17
Q

2 important purposes of reporting the unrealized gain or loss in the stockholders’ equity sections:

A
  1. Reduces the volatality of net income due to fluctuations in fair value
  2. Informs the financial statement user of the gain or loss that would occur if the company sold the securities at fair value
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18
Q

Three types of comparisons:

A
  1. Intracompany basis - detect changes in financial relationships and significant trends
  2. Intercompany basis - provide insight into a company’s competitive position
  3. Industry averages - insight on a company’s relative position within the industry
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19
Q

Cross-country comparisons

A

Should improve as more countries adopt international accounting standards

International standards open to widely varying interpretations

Still not as transparent as within-country comparisons

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20
Q

Horizontal analysis

A

A technique for evaluating a series of financial statement data over a period of time to determine the increase (decrease) that has taken place, either an amount of a percentage

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21
Q

Change Since Base Period =

A

Current Year Amount - Base Year Amount

Base Year Amount

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22
Q

Current Results in Relation to Base Period =

A

Current Year Amount

Base Year Amount

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23
Q

The amount of increaes may be ________________, but the percentage change may be __________________

A

the same as or more than the base year;

less because the base is greater each year

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24
Q

Vertical analysis

A

A technique for evaluating financial statement data that expresses each item in a financial statement as a percentage of a base amount

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25
Vertical analysis is meaningful for what?
Comparing companies of different sizes
26
Liquidity ratios
Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash Short-term creditors such as bankers and suppliers are interested
27
Working capital
Current assets - Current liabiliities Liquidity ratio
28
Current ratio
Current assets / Current Liabilities Liquiditiy ratio
29
Current cash debt coverage ratio
Cash provided by operations / average current liabilities liquidity ratio
30
Inventory turnover ratio
Cost of goods sold / average inventory liquidity ratio
31
Days in inventory
365 days / inventory turnover ratio liquidity ratio
32
Receivables turnover ratio
Net credit sales / average net receivables liquidity ratio
33
Average collection period
365 days / receivables turnover ratio liquidity ratio
34
Solvency ratio
Measures the ability of the company to survive over a long period of time Long-term creditors and stockholders are interested in a company's long run solvency, particularly its ability to pay interest as it comes due and to repay the balance of debt at its maturity
35
Debt to total assets ratio
Total liabilties / total assets Solvency ratio
36
Cash debt coverage ratio
Cash provided by operations / Average total liabilities solvency ratio
37
Times interest earned ratio
_Net income + Interest expense + Tax expense_ Interest expense Solvency ratio
38
Free Cash flow
Cash provided by operations - Capital expenditures - Cash Dividends \*Solvency ratio\*
39
Profitability ratios
Measure the income or operating success of a company for a given period of time Creditors and investors are interested Profitability = used as ultimate test of management's operating effectiveness
40
What does a company's profitability affect?
A company's income, or lack of it, affects its ability to obtain debt and equity financing, its liquidity position, and its ability to grow
41
Earnings per share
_Net income - Preferred stock dividends_ Average common shares outstanding \*Profitability ratio
42
Price-earnings ratio
_Stock price per share _ Earnings per share \*Profitability ratio
43
Gross profit rate
Gross profit / Net Sales \*Profitability ratio
44
Profit margin ratio
Net income / net sales \*Profitability ratio
45
Return on assets ratio
Net income / Average total assets
46
Asset turnover ratio
Net sales / Average total assets \*Profitability ratio
47
Payout ratio
_Cash dividends declared on common stock_ Net income \*profitability ratio
48
Return on common stockholders' equity ratio
_Net income - Preferred stock dividends_ Average common stockholders' equity \*Profitability ratio
49
Quality of earnings
Indicates the level of full and transparent information that is provided to users of the financial statements
50
Pro forma income
A measure of income that usually excludes items that a company thinks are unusual or non-recurring
51
Why are analysts and investors critical of using pro forma income?
Because these numbers often make companies look better than they really are
52
Why do companies say in response to critics of pro forma?
Argue that pro forma numbers more clearly indicate sustainable income because they exclude unusual and non-recurring expenses
53
Current dilema with pro forma income
Everyone agrees pro forma numbers can provide insights into determining a company's sustainable income On the other hand, companies have abused the flexibility that pro forma numbers allow and have used it to favor the company
54
Channel stuffing
Offering deep discounts on their prodcuts to customers, companies encourage their customers to buy early rather than later results in poor subsequent periods
55
practices of improper recognition
Improper recogntion of revenue - channel stuffing Improper capitalization of operating expenses Failing to report all liabilities
56
Price-earnings (P-E) ratio
A comparison of the market price of each share of common stock to the earnings per share Computed as the market price of the stock divided by earnings per share
57
What does the P-E ratio reflect?
Investors' assesment of a company's future earnings will be higher if investors think earnigns will increase in the future Lower means investors think the company's future earnings will not be strong
58
Some factors affecting quality of earnings
Alternative accounting methods Pro forma income Improper recognition Price-earnings ratio
59
Profitability ratios
Measures of the income or operating success of a company for a given period of time
60
Why is Current cash debt coverage ratio considered better?
Because it uses cash provided by operating activities rather than a balance at one point in time, it may provide a better representation of liquidity
61
What is a disadvantage of the current ratio?
It uses year-end balances of current asset and current liability accounts and they many not represent to company's current position during most of the year
62
What does the receivables turnover ratio measure?
Measures the number of times, on average, a company collects receivables during the period \*asseses liquidity of the receivables
63
What is the average collection period used for?
Used to asses the effectiveness of a company's credit and collection policies Collection period should not greatly exceed the credit term period (time allowed for payment)
64
Inventory turnover ratio information
Measures the number of times average inventory was sold during the period Measures the liquidity of the inventory The faster the inventory turnover, the less cash is tied up in inventory and the less the chance of inventory becoming obsolete Downside of high inventory turnover is that it sometimes results in lost sales because if a company keeps less inventory on hand, it is more likely to run out of inventory when it is needed
65
What does a high inventroy turnover ratio suggest?
Suggests inventory is being sold and replenished frequently
66
Differences in "Days in inventory"
Differences in product lines across the two companies Grocery stores =\> 37 days Jewlery stores =\> 280 days \*can even vary within a company ex. grocery store produce and detergent
67
What information does free cash flow provide?
Information about the company's solvency and its ability to pay additional dividends or invest in new projects
68
What does debt to total assets ratio indicate?
The degree of financial leveraging The company's ability to withstand losses without impairing the interests of its creditors
69
The higher the percentage of debt to total assets...
The greater risk that the company may be unable to meet its maturing obligations
70
What debt to total assets ratio is desirable?
From creditor's point of view, a low debt to total assets ratio is desirable
71
When debt to total assets ratio equals 50%
the debt to equity ratio is 1:1
72
What does the debt to equity ratio show?
Shows the relative use of borrowed funds (total liabilities) compared with resources invested by the owners
73
Times interest earned ratio info:
(interest coverage) Indicates the company's ability to meet interest payments as they come due \*Uses income before interest expense and income taxes because this amount represents what is available to cover interest
74
A cash debt coverage ratio above ________ is acceptable
.20
75
Cash debt coverage ratio info:
CAsh basis measure of solvency Indicates a company's ability to repay its liabilities from cash generated from operating activities without having to liquidate the assets used in its operations
76
What does a company's profitability affect?
Its abilityto obtain debt and quity financing, its liquidity position, and its ability to grow
77
What does return on common stockholders' equity ratio show?
Shows how many dollars of net income the company earned for each dollar invested by the owners
78
What does the return on assets ratio show?
Measures the overall profitability of assetsin terms of the income earned on each dollar invested in assets
79
Two factors that affeect the return on common stockholders' equity ratio
Return on assets ratio Degree of leverage
80
Leveraging
Borrowing money at a lower rate of interest than can be earned by using the borrowed money "Trading on the equity" Enables management to use money suppllied by nonowners to increase the return to owners
81
Two factors that affect the return on assets ratio
Profit margin ratio Asset turnover ratio
82
Profit margin ratio information:
Rate of return on asales A measure of the percentage of each dollar of sales that results in net income High volume businesses (grocery stores) have low profit margins Low-volume businesses (jewelery stores) have high profit margins
83
Asset turnover ratio information:
Measures how efficiently a company uses its assets to generate sales \*Shows the dollars of sales produced by each dollar invested in assets Utility companies =\> .45 Grocery store =\> 3.49
84
Profit Margin x Asset Turnover =
Return on Assets
85
Gross profit rate
_Gross profit (Net Sales - COGS)_ Net Sales Indicates a company's ability to maintain an adequate selling price above its cost of goods sold As an industry becomes more competive, this ratio dclines
86
Why should earnigns per share not be compared with other companies?
Because of wide variations in the number of shares of outstanding stock among companies
87
Price-Earnings ratio information:
Measures the ratio of the market price of each share of common stock to the earnings per share Reflefcts investors' assessments of a company's future earnings Higher =\> suggests market is more optimistic; or stock is overpriced?
88
Payout rati information:
Measures the percentage of earnigns distributed in the form of cash dividends Companies that have high growth rates often have low payout ratios because they reinvest most of their net income in the business If a company's inet income declines but keeps its total dividend payment the same =\> payout ratio will increase
89
Extraordinary item treatment is _________ under IFRS
prohibitted
90
Name for income statement under IFRS
Statement of comprehensive income
91
IFRS All components of revenues ane expenses are reported in a traditional income satement except for \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_
other comprehensive income or loss
92
By adpoting \_\_\_\_\_\_\_\_\_\_\_\_\_, as found in IFRS, many of the earnings quality issues will disappear
principles-based approach
93
New joint project approach will draw attention away from...
net income
94
IASB decided to require a \_\_\_\_\_\_\_\_\_\_\_\_\_\_
statement of comprehensive income
95
Presentation of comprehensive income must be reported under IFRS in:
a statement of comprehensive income
96
Debt to equity ratio
Shows the relative use of borrowed funds (total liabilities) compared with resources invested by the owners
97