Chapter 13 Flashcards
Sustainable income
Net income adjusted for irregular items
*Most likely level of income to be obtained in the future
Two types of irregular items:
- Discontinued operations
- Extraordinary items
Discontinued operations
The disposal of a significant component of a business
Ex. elimination of a major class of customers or an entire activity
Extraordinary items
Events and transactions that meet two conditions:
- Unusual in nature
- Infrequent in occurrence
To be considered unusual:
The item should be abnormal and only incidentally related to the customary activities of the entity
To be considered infrequent:
The event or transaction should not be reasonably expected to recur in the foreseeable future
Where are extraordinary items reported?
They are net of taxes in a seperate section of the income statement, immediately below discontinued operations
What if only one criteria for extraordinary items is met?
Reported as a seperate line item in the upper portion of the income statement
“Other revenues and gains” or “Other expenses and losses”
Ordinary gains and losses are reported at what?
Pretax amounts in arriving at income before income taxes
Change in accounting principle
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
How do companies report most changes in accounting principles?
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*
Why should changes in accounting principles occurr?
Should result in financial statements that are more informative for statement users
Comprehensive income
Includes all changes in stockholders’ equity during a period except those changes resulting from investments by stockholders and distributions to stockholders
Trading security
Bought and held primarily for sale in the near term to generate income on short-term price differences
Where are unrealized losses on trading securities reported?
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
Available-for-sale securities
Held with the intent of selling them sometime in the future
Report as part of “Other comprehensive income” - direct adjustment to stockholders’ equity
2 important purposes of reporting the unrealized gain or loss in the stockholders’ equity sections:
- Reduces the volatality of net income due to fluctuations in fair value
- Informs the financial statement user of the gain or loss that would occur if the company sold the securities at fair value
Three types of comparisons:
- Intracompany basis - detect changes in financial relationships and significant trends
- Intercompany basis - provide insight into a company’s competitive position
- Industry averages - insight on a company’s relative position within the industry
Cross-country comparisons
Should improve as more countries adopt international accounting standards
International standards open to widely varying interpretations
Still not as transparent as within-country comparisons
Horizontal analysis
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
Change Since Base Period =
Current Year Amount - Base Year Amount
Base Year Amount
Current Results in Relation to Base Period =
Current Year Amount
Base Year Amount
The amount of increaes may be ________________, but the percentage change may be __________________
the same as or more than the base year;
less because the base is greater each year
Vertical analysis
A technique for evaluating financial statement data that expresses each item in a financial statement as a percentage of a base amount
Vertical analysis is meaningful for what?
Comparing companies of different sizes
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
Working capital
Current assets - Current liabiliities
Liquidity ratio
Current ratio
Current assets / Current Liabilities
Liquiditiy ratio
Current cash debt coverage ratio
Cash provided by operations / average current liabilities
liquidity ratio
Inventory turnover ratio
Cost of goods sold / average inventory
liquidity ratio
Days in inventory
365 days / inventory turnover ratio
liquidity ratio
Receivables turnover ratio
Net credit sales / average net receivables
liquidity ratio
Average collection period
365 days / receivables turnover ratio
liquidity ratio
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
Debt to total assets ratio
Total liabilties / total assets
Solvency ratio
Cash debt coverage ratio
Cash provided by operations / Average total liabilities
solvency ratio
Times interest earned ratio
Net income + Interest expense + Tax expense
Interest expense
Solvency ratio
Free Cash flow
Cash provided by operations - Capital expenditures - Cash Dividends
*Solvency ratio*
