Accounting FundamentalsAccounting Fundamentals

Dr. Yan XiongDr. Yan XiongDepartment of AccountancyDepartment of Accountancy

CSU SacramentoCSU SacramentoThe lecture notes are primarily based on Reimers The lecture notes are primarily based on Reimers

(2003). (2003).

7/11/037/11/03

Chapter 11: Financial Statement Chapter 11: Financial Statement AnalysisAnalysis

AgendaAgenda Purpose of a Business and Purpose of a Business and

Types of BusinessesTypes of Businesses Ownership Structure of Ownership Structure of

BusinessesBusinesses Business ProcessesBusiness Processes The Accounting EquationThe Accounting Equation Four Basic Financial Four Basic Financial

StatementsStatements

Analyzing Financial StatementsAnalyzing Financial Statements Before we discuss financial Before we discuss financial

statement analysis, let’s take a closer statement analysis, let’s take a closer look at some of the elements of the look at some of the elements of the income statement.income statement.

Then, we’ll talk about several ways to Then, we’ll talk about several ways to analyze financial statements.analyze financial statements.

More About The Income StatementMore About The Income Statement To make the information on the income To make the information on the income

statement clearer, there are several statement clearer, there are several special items that are separated from the special items that are separated from the regular earnings of a business:regular earnings of a business: Gains and losses from discontinued Gains and losses from discontinued

operations,operations, Extraordinary items, andExtraordinary items, and Cumulative effect of a change in Cumulative effect of a change in

accounting principleaccounting principle

Discontinued OperationsDiscontinued Operations If a segment or division of a If a segment or division of a

business is eliminated, the business is eliminated, the gain or loss from the gain or loss from the disposal must be shown disposal must be shown after income from continuing after income from continuing operations, net of taxes.operations, net of taxes.

Any current gain or loss Any current gain or loss from the operations of that from the operations of that discontinued segment must discontinued segment must also be shown separately.also be shown separately.

How Discontinued How Discontinued Operations Are ShownOperations Are Shown

Containers, Inc. Income Statement

For the year ended December 31, 2003

Income before taxes $400,000 Income tax expense 160,000 Income from continuing operations 240,000 Discontinued operations

Income from discontinued operations net of taxes of $2,300

$ 10,100

Gain on disposal of mailing packages segment net of taxes of $25,000

35,000 45,100

Net Income $ 285,100

Extraordinary Items Extraordinary Items Events that are Events that are unusualunusual in nature and in nature and

infrequentinfrequent in occurrence are called in occurrence are called extraordinary items.extraordinary items.

The accounting rules are very strict The accounting rules are very strict about what types of events may be about what types of events may be classified as extraordinary.classified as extraordinary.

Any gain or loss from these events are Any gain or loss from these events are shown, net of taxes, after income from shown, net of taxes, after income from continuing operations and after income continuing operations and after income from discontinued operations.from discontinued operations.

Examples Of Actual Examples Of Actual Extraordinary OccurrencesExtraordinary Occurrences

Volcano eruptionsVolcano eruptions Take-over of foreign operations by the Take-over of foreign operations by the

foreign governmentforeign government Effects of new laws or regulations that Effects of new laws or regulations that

result in a one-time cost to complyresult in a one-time cost to comply

EEach situation is unique and must ach situation is unique and must be considered in the environment be considered in the environment in which the business operates.in which the business operates.

How Extraordinary Items Are ShownHow Extraordinary Items Are ShownContainers, Inc.

Income Statement For the year ended December 31, 2003

Income before taxes $400,000 Income tax expense 160,000 Income from continuing operations 240,000 Discontinued operations Income less taxes of $2,500 $ 10,100 Gain on disposal less taxes of $20,000 35,000

45,100 Income before extraordinary item $ 285,100 Extraordinary item Expropriation of foreign operation net of tax

savings of $35,000

70,000 Net Income $215,100

Cumulative Effect Cumulative Effect Of A Change In Accounting PrincipalOf A Change In Accounting Principal

The The cumulative effectcumulative effect of a change in of a change in accounting principle is the amount of accounting principle is the amount of gain or loss from changing accounting gain or loss from changing accounting methods.methods.

It must be shown separately on the It must be shown separately on the income statement, net of taxes, after income statement, net of taxes, after income from continuing operations, income from continuing operations, discontinued operations, and any discontinued operations, and any extraordinary items.extraordinary items.

ExampleExample Suppose the company changed from Suppose the company changed from

depreciating equipment using the depreciating equipment using the straight-line method to depreciating straight-line method to depreciating the equipment using the double the equipment using the double declining balance method. declining balance method.

The equipment was purchased on The equipment was purchased on January 1, 2001, at a cost of $10,000, January 1, 2001, at a cost of $10,000, has a useful life of 10 years, with no has a useful life of 10 years, with no salvage value. salvage value.

Depreciation SchedulesDepreciation SchedulesMethod Straight-line Double-declining

balance Year ended: December 31, 2001

$1,000

$2,000

December 31, 2002 $1,000 $1,600 Total for two years $2,000 $3,600

The income for Containers, Inc. would have been The income for Containers, Inc. would have been lower by $1,600 if double-declining balance had been lower by $1,600 if double-declining balance had been used from the beginning.used from the beginning.

A switch now means the company will have to A switch now means the company will have to subtract $1,600, net of any tax effect, as a cumulative subtract $1,600, net of any tax effect, as a cumulative effect of a change in accounting principle. effect of a change in accounting principle.

Cumulative EffectCumulative Effect The income for Containers, Inc. The income for Containers, Inc.

would have been lower by $1,600 would have been lower by $1,600 if double-declining balance had if double-declining balance had been used from the beginning.been used from the beginning.

A switch now means the company A switch now means the company will have to subtract $1,600, net of will have to subtract $1,600, net of any tax effect, as a cumulative any tax effect, as a cumulative effect of a change in accounting effect of a change in accounting principle. principle.

How The Cumulative Effect Is Shown On How The Cumulative Effect Is Shown On The Income StatementThe Income Statement

Containers, Inc. Income Statement

For the year ended December 31, 2003 Income before taxes $400,000 Income tax expense 160,000 Income from continuing operations 240,000 Discontinued operations Income less taxes of $2,500 $ 10,100 Gain on disposal less taxes of $20,000 35,000

45,100 Income before extraordinary item and cumulative effect of change in accounting principle

$ 285,100

Extraordinary item Expropriation of foreign operation net of tax

saving of $35,000

70,000 Cumulative effect of a change in accounting principle

Effect on prior years of change in depreciation method, net of $400 tax savings

1,200 Net Income $213,900

Comprehensive IncomeComprehensive Income

The income statement shows all of the effects The income statement shows all of the effects of revenues, expenses, gains, and losses on net of revenues, expenses, gains, and losses on net income. income.

Net income, in turn, affects owners’ equity.Net income, in turn, affects owners’ equity. Other items, Other items, notnot included on the income included on the income

statement, may affect owners’ equity.statement, may affect owners’ equity. The total of all items that affect owners’ equity, The total of all items that affect owners’ equity,

not including contributions from owners and not including contributions from owners and dividends, is called dividends, is called comprehensive income.comprehensive income.

Items that effect Shareholders’ Equity

Owners’ contributions

Paid-in Capital (Contributed

Capital)

Net income

Retained Earnings

Dividends

Other comprehensive income: A few other items including unrealized gains and losses from foreign currency translation and from available for sale securities

Cumulative other comprehensive income (may be labeled as a single item if it has only one component, e.g. foreign currency translation)

Comprehensive income

Diagram Showing the Items that Affect Owners’ EquityDiagram Showing the Items that Affect Owners’ Equity

OtherOther Comprehensive Income Comprehensive Income

Total Total comprehensive incomecomprehensive income = = net net incomeincome plus plus other comprehensive other comprehensive incomeincome

Items included in Items included in other other comprehensive incomecomprehensive income include: include: unrealized gains and losses from unrealized gains and losses from

foreign currency translationforeign currency translation unrealized gains and losses on unrealized gains and losses on

certain types of investments.certain types of investments.

One More New Financial Statement One More New Financial Statement Item: Investments In SecuritiesItem: Investments In Securities

A company may use some of its extra cash to A company may use some of its extra cash to invest in the debt or equity securities of invest in the debt or equity securities of another company.another company.

These investments must be classified as one These investments must be classified as one of three types:of three types: Securities held to maturitySecurities held to maturity Trading securitiesTrading securities Securities available for saleSecurities available for sale

A company may use some of its extra cash to A company may use some of its extra cash to invest in the debt or equity securities of invest in the debt or equity securities of another company.another company.

These investments must be classified as one These investments must be classified as one of three types:of three types: Securities held to maturitySecurities held to maturity Trading securitiesTrading securities Securities available for saleSecurities available for sale

Securities Held To MaturitySecurities Held To Maturity Debt securities Debt securities Intent and ability to Intent and ability to

hold to maturityhold to maturity Must not be sold in Must not be sold in

response to changes in response to changes in interest rates, funding interest rates, funding sources, etc.sources, etc.

Measured at cost on Measured at cost on the balance sheetthe balance sheet

Trading SecuritiesTrading Securities Debt and equity securitiesDebt and equity securities Readily determinable fair valuesReadily determinable fair values Bought and held to sell in the Bought and held to sell in the

near termnear term Actively and frequently traded Actively and frequently traded

(profit!)(profit!) Measured at fair value and Measured at fair value and

classified as a current assetclassified as a current asset Unrealized gains and losses, Unrealized gains and losses,

included in determination of net included in determination of net incomeincome

Securities Available For SaleSecurities Available For Sale Debt and equity securitiesDebt and equity securities Readily determinable fair valuesReadily determinable fair values Not classified as either securities held Not classified as either securities held

to maturity or trading securitiesto maturity or trading securities Measured at fair value on Measured at fair value on

balance sheetbalance sheet May be either current or noncurrentMay be either current or noncurrent May have holding gains or losses, to be May have holding gains or losses, to be

reported net as a separate component of reported net as a separate component of owners’ equity, usually as part of owners’ equity, usually as part of other other comprehensive income.comprehensive income.

In addition to the financial statements, In addition to the financial statements, annual reports contain the following:annual reports contain the following: Notes to the financial statements, Notes to the financial statements,

including a summary of the accounting including a summary of the accounting methods usedmethods used

Management’s discussion and analysis Management’s discussion and analysis (MD&A) of the financial results(MD&A) of the financial results

The auditor’s reportThe auditor’s report Comparative financial data for a series of Comparative financial data for a series of

yearsyears

Financial Statement AnalysisFinancial Statement Analysis

Financial Statement AnalysisFinancial Statement Analysis

Now that you’ll be able to recognize Now that you’ll be able to recognize these new items we’ve just discussed, these new items we’ve just discussed, you’re ready to do some analysis of the you’re ready to do some analysis of the financial statements.financial statements.

First, we’ll talk about First, we’ll talk about horizontalhorizontal and and verticalvertical analysisanalysis. .

Then, we’ll discussThen, we’ll discuss financial ratios financial ratios -- --standard measures that enable analysts standard measures that enable analysts to compare companies of different sizesto compare companies of different sizes

Horizontal AnalysisHorizontal Analysis

2003 2002 2001 2000Sales $41,500 $37,850 $36,300 $35,000

Horizontal analysis compares one value across severalperiods. First, a base year must be chosen as the basisfor comparison.

The difference between each year and the base year is expressed as a percentage of the base year.

Horizontal AnalysisHorizontal Analysis

2003 2002 2001 2000Sales $41,500 $37,850 $36,300 $35,000

18.6% 8.1% 3.7%

This shows 2000 as the base year. The base year’s sales are subtracted from each year’s sales. Then, this difference is expressed as a percentage of the base year’s sales.

Base year

Horizontal AnalysisHorizontal Analysis

2003 2002 2001 2000Sales $41,500 $37,850 $36,300 $35,000

18.6% 8.1% 3.7%

For example, the sales for 2003 represent an increaseof 18.6% over the base year 2000.

Base year

Vertical AnalysisVertical Analysis

– compares each item in a financial compares each item in a financial statement to a base number set to statement to a base number set to 100%.100%.

Every item on the financial statement Every item on the financial statement is then reported as a percentage of is then reported as a percentage of that base.that base.

Vertical AnalysisVertical Analysis 2002 %

Sales $38,303 100.0Cost of goods sold 19,688 51.4Gross margin $18,615 48.6Total operating expenses 13,209 34.5Operating income $ 5,406 14.1Other income 2,187 5.7Income before taxes $ 7,593 19.8Income taxes 2,827 7.4Net income $ 4,766 12.4

Ratio AnalysisRatio AnalysisRatios are Ratios are standard standard measures that measures that enable analysts enable analysts to compare to compare companies of companies of different sizes.different sizes.

Ratio ClassificationRatio Classification

LiquidityLiquidity: Can a company pay the bills : Can a company pay the bills as they come due? as they come due?

Solvency: Solvency: Can the company survive over Can the company survive over a long period of time?a long period of time?

ProfitabilityProfitability: Can a company earn a : Can a company earn a satisfactory rate of return?satisfactory rate of return?

Market indicatorsMarket indicators: Is the stock a good : Is the stock a good investment?investment?

Current ratio =Total current assets ÷ Total current liabilities

Liquidity: Measuring Ability to Liquidity: Measuring Ability to Pay Current LiabilitiesPay Current LiabilitiesThis ratio measures a company’s ability to pay current liabilities with current assets.

Acid-test ratio =(Cash + Short-term investments

+ Net current receivables)÷ Total current liabilities

Liquidity: Measuring Ability to Liquidity: Measuring Ability to Pay Current LiabilitiesPay Current Liabilities

The acid-test ratio shows the company’s ability to pay all current liabilities if they come due immediately.

Working capital =Total current assets

Total current liabilities

Liquidity: Measuring Ability to Liquidity: Measuring Ability to Pay Current LiabilitiesPay Current Liabilities

Working capital is not a ratio, but it is often computed to evaluate a the company’s ability to pay its current liabilities.

Inventory turnover = Cost of goods sold÷ Average inventory

Liquidity: Measuring Ability Liquidity: Measuring Ability to Sell Inventoryto Sell Inventory

This ratio measures how quickly a company is turning over its inventory. A high number indicates an ability to quickly sell inventory.

Accounts receivable turnover =Net credit sales

÷ Average accounts receivable

Liquidity: Measuring Ability to Liquidity: Measuring Ability to Collect ReceivablesCollect ReceivablesThis ratio measure’s a company’s ability to collect the cash from its credit customers.

Solvency: Measuring Ability to Solvency: Measuring Ability to Pay Long-term DebtPay Long-term DebtThe debt to equity ratio compares the The debt to equity ratio compares the amount of debt a company has with the amount of debt a company has with the amount the owners have invested in the amount the owners have invested in the company. company.

Debt-to-equity ratio =Total liabilities ÷ Total equity

Solvency: Times interest earnedSolvency: Times interest earned

This ratio compares the amount of This ratio compares the amount of income that has been earned in an income that has been earned in an accounting period to the interest accounting period to the interest obligation for the same period.obligation for the same period.

Times interest earned ratio =Net income + interest expense

÷ Interest expense

Return on assets =Net income + interest expense

÷ Average total assets

Measuring Profitability: Measuring Profitability: Return on assetsReturn on assets

This ratio measures a company’s success in using its assets to earn income for the persons who are financing the business.

Rate of return on common stockholders’ equity= (Net income – preferred dividends)

÷ Average common stockholders’ equity

Measuring Profitability: Measuring Profitability: Return on EquityReturn on Equity

This ratio measures how much income is earned with the common shareholders’ investment in the company.

Gross margin ratio = Gross margin ÷ Sales

Measuring Profitability: Gross Measuring Profitability: Gross Margin RatioMargin Ratio

This ratio measures percentage of sales price that is gross profit. A small shift usually indicates a big change in the profitability of the company’s sales.

Measuring Profitability: Measuring Profitability: Earnings Per ShareEarnings Per Share

Earnings per share of common stock= (Net income – Preferred dividends)

÷ Number of shares of common stock outstanding

This ratio gives the amount of net income per share of common stock. It is one of the most widely-used measures of a company’s profitability.

Market Indicators: PE RatioMarket Indicators: PE Ratio

Price/earning ratio is the ratio of market Price/earning ratio is the ratio of market price per share to earnings per share. price per share to earnings per share. This ratio indicates the market price for This ratio indicates the market price for $1 of earnings.$1 of earnings.

Price/Earnings Ratio =Market price per share of common

stock ÷ Earnings per share

Dividend per share of common(or preferred) stock ÷ Market price per share

of common (or preferred) stock

Market Indicators: Dividend Yield Market Indicators: Dividend Yield

Dividend yield gives the percentage of a stock’s market value returned as dividends to stockholders each period.

Making Ratios UsefulMaking Ratios Useful A ratio by itself does not give much A ratio by itself does not give much

information. information. To be useful, a ratio must be compared To be useful, a ratio must be compared

to other ratios from previous periods, to other ratios from previous periods, compared to ratios of other companies compared to ratios of other companies in the industry, or compared to industry in the industry, or compared to industry averages.averages.