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*
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
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
Earnings per share
Net income - Preferred stock dividends
Average common shares outstanding
*Profitability ratio
Price-earnings ratio
_Stock price per share _
Earnings per share
*Profitability ratio
Gross profit rate
Gross profit / Net Sales
*Profitability ratio
Profit margin ratio
Net income / net sales
*Profitability ratio
Return on assets ratio
Net income / Average total assets
Asset turnover ratio
Net sales / Average total assets
*Profitability ratio
Payout ratio
Cash dividends declared on common stock
Net income
*profitability ratio
Return on common stockholders’ equity ratio
Net income - Preferred stock dividends
Average common stockholders’ equity
*Profitability ratio
Quality of earnings
Indicates the level of full and transparent information that is provided to users of the financial statements
Pro forma income
A measure of income that usually excludes items that a company thinks are unusual or non-recurring
Why are analysts and investors critical of using pro forma income?
Because these numbers often make companies look better than they really are
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
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
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
practices of improper recognition
Improper recogntion of revenue - channel stuffing
Improper capitalization of operating expenses
Failing to report all liabilities
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
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
Some factors affecting quality of earnings
Alternative accounting methods
Pro forma income
Improper recognition
Price-earnings ratio
Profitability ratios
Measures of the income or operating success of a company for a given period of time
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
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
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
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)
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
What does a high inventroy turnover ratio suggest?
Suggests inventory is being sold and replenished frequently
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
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
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
The higher the percentage of debt to total assets…
The greater risk that the company may be unable to meet its maturing obligations
What debt to total assets ratio is desirable?
From creditor’s point of view, a low debt to total assets ratio is desirable
When debt to total assets ratio equals 50%
the debt to equity ratio is 1:1
What does the debt to equity ratio show?
Shows the relative use of borrowed funds (total liabilities) compared with resources invested by the owners
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
A cash debt coverage ratio above ________ is acceptable
.20
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
What does a company’s profitability affect?
Its abilityto obtain debt and quity financing, its liquidity position, and its ability to grow
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
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
Two factors that affeect the return on common stockholders’ equity ratio
Return on assets ratio
Degree of leverage
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
Two factors that affect the return on assets ratio
Profit margin ratio
Asset turnover ratio
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
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
Profit Margin x Asset Turnover =
Return on Assets
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
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
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?
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
Extraordinary item treatment is _________ under IFRS
prohibitted
Name for income statement under IFRS
Statement of comprehensive income
IFRS
All components of revenues ane expenses are reported in a traditional income satement except for ______________________________
other comprehensive income or loss
By adpoting _____________, as found in IFRS, many of the earnings quality issues will disappear
principles-based approach
New joint project approach will draw attention away from…
net income
IASB decided to require a ______________
statement of comprehensive income
Presentation of comprehensive income must be reported under IFRS in:
a statement of comprehensive income
Debt to equity ratio
Shows the relative use of borrowed funds (total liabilities) compared with resources invested by the owners
