Chapter 16 - Financial Statement Analysis PDF

16 CHAPTER Financial Statement Analysis Principles of Accounting 12e Needles Powers Crosson © human/iStockphoto LEARNING OBJECTIVES  LO1: Describe the concepts, standards of comparison, and sources of information used in meas...

16 CHAPTER Financial Statement Analysis Principles of Accounting 12e Needles Powers Crosson © human/iStockphoto LEARNING OBJECTIVES  LO1: Describe the concepts, standards of comparison, and sources of information used in measuring financial performance.  LO2: Apply horizontal analysis, trend analysis, vertical analysis, and ratio analysis to financial statements.  LO3: Apply financial ratio analysis in a comprehensive evaluation of a company’s financial performance.  LO4: Define quality of earnings, and identify the factors that affect quality of earnings and related management compensation issues. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SECTION 1: CONCEPTS  Relevance: information that has a direct effect on a decision or makes a difference in the analysis of a company’s performance  Predictive value: information that helps users make decisions about future actions  Comparability: presenting information in a way that enables users to recognize similarities, differences, and trends over different periods in the same company and among different companies  Timeliness: receiving information in time to influence a decision ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Concepts Underlying Financial Performance Measurement (slide 1 of 2)  Financial statement analysis (or financial performance measurement) is used to show how items in a company’s financial statements relate to the company’s financial performance objectives. – Users want measures of financial performance that meet these underlying concepts:  Relevance: The measures need to make a difference in the analysis of a company’s performance.  Predictive value: The measures need to help users make decisions about future actions.  Comparability: The measures need to make useful comparisons of one period of the company’s performance with another and of the company’s performance to other companies.  Timeliness: The measures need to enable users to make decisions in time to have the desired effects. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Concepts Underlying Financial Performance Measurement (slide 2 of 2) – In the analysis of accounting information, managers, creditors, and investors want measures that relate to the following objectives:  Profitability: To continue operating, a company must earn a satisfactory net income.  Total Asset Management: To maximize net income, management must use all of the company’s assets in a way that maximizes revenues while minimizing the investment in these assets.  Liquidity: A company must be able to pay its bills when they come due and meet unexpected needs for cash.  Financial risk: Management must use debt and stockholders’ investments effectively without jeopardizing the company’s future. The more difficult it is to predict future profitability and liquidity, the greater the risk.  Operating Asset Management: Managers must use current assets and current liabilities in a way that supports revenue growth and minimizes investment. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Rule-of-Thumb Measures  When analyzing financial statements, decision makers must judge whether the relationships they find in the statements are favorable or unfavorable.  Many financial analysts, investors, and lenders apply general standards, or rule-of-thumb measures, to key financial ratios. – Current ratio: The higher the ratio, the more likely the company will be able to meet its liabilities. A ratio of 2 to 1 (2.0) or higher is desirable. – Current liabilities to net worth ratio (%): Normally a business starts to have trouble when this relationship exceeds 80%. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Past Performance  Comparing financial measures or ratios of the same company over time is an improvement over using rule-of-thumb measures.  Such a comparison gives the analyst some basis for judging whether the measure or ratio is getting better or worse, which can be helpful in showing future trends.  However, such projections must be made with care because trends reverse over time, and a company’s needs may change.  In addition, using a company’s past performance as a standard of comparison is not helpful in judging its performance relative to that of other companies. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Industry Norms  Industry norms show how a company compares with other companies in the same industry, which overcomes some of the limitations of comparing a company’s measures over time.  Using industry norms has the following limitations: – Comparability: Companies in the same industry may not be strictly comparable. – Accounting differences: Companies in the same industry with similar operations may use different accounting procedures, such as different methods of valuing inventory and depreciating assets. – Diversity: Diversified companies (or conglomerates) are large companies that have multiple segments and operate in more than one industry. They may not be comparable to any other company. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Segment Information  The FASB requires a diversified company to report profit or loss, certain revenue and expense items, and assets for each of its segments, as shown below for Goodyear. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sources of Information  The major sources of information about public corporations include: – Reports published by a corporation  Annual reports  Interim financial statements—condensed financial statements published each quarter and sometimes each month – Reports filed with the Securities and Exchange Commission (SEC)  Annual reports (Form 10-K)  Quarterly reports (Form 10-Q)  Current reports (Form 8-K) – Business periodicals and credit and investment advisory services  The Wall Street Journal  Moody’s, Standard & Poor’s, and Dun and Bradstreet ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SECTION 2: ACCOUNTING APPLICATIONS (slide 1 of 2)  Analyzing financial  Evaluating Liquidity statements – Cash flow yield – Horizontal analysis – Cash flows to sales – Trend analysis – Cash flows to assets – Vertical analysis – Free cash flow – Ratio analysis  Evaluating financial  Evaluating risk profitability and total – Debt to equity ratio asset management – Return on equity – Profit margin – Interest coverage – Asset turnover ratio – Return on assets ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SECTION 2: ACCOUNTING APPLICATIONS (slide 2 of 2)  Evaluating operating  Evaluating market asset management strength – Inventory turnover – Price/earnings (P/E) – Days’ inventory on – Dividend yield hand – Receivable turnover – Days’ sales uncollected – Payables turnover – Days’ payable – Financing period – Current ratio – Quick ratio ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Horizontal Analysis  To gain insight into year-to-year changes, analysts use horizontal analysis, in which changes from the previous year to the current year are computed in both dollar amounts and percentages. – The percentage change is computed as follows: Percentage Change = 100 X Comparative Year Amount − Base Year Amount Base Year Amount - The base year is the first year considered in any set of data. - As shown on the next slide, Starbucks’ total current assets increased from $2,756.4 million in 2010 to $3,794.9 million in 2011, or by 37.7 percent, as computed below: 100 X ($3,794.9 million − $2,756.4 million) = 37.7% $2,756.4 million ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Comparative Balance Sheets with Horizontal Analysis (slide 1 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Comparative Balance Sheets with Horizontal Analysis (slide 2 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Comparative Income Statements with Horizontal Analysis ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Horizontal Analysis  Starbucks’ balance sheets for 2010 and 2011 also show the following:  Starbucks’ income statements show the following: ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Trend Analysis  Trend analysis is a variation of horizontal analysis that calculates percentage changes for several successive years instead of for just two years. – It uses an index number to show changes in related items over time.  For an index number, the base year is set at 100 percent. Other years are measured in relation to that number. – A trend analysis of Starbucks’ five-year summary of net revenues and operating income is shown on the next slide. It shows that: ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Trend Analysis ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Graph of Trend Analysis ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Vertical Analysis  Vertical analysis shows how the different components of a financial statement relate to a total figure in the statement. – The analyst sets the total figure at 100 percent and computes each component’s percentage of that total. – The resulting financial statement, which is expressed entirely in percentages, is called a common-size statement.  Vertical analysis and common-size statements are useful in comparing the importance of specific components in the operation of a business and in identifying important changes in the components from one year to the next. They are often used to make comparisons between companies. – Common-size balance sheets and income statements for Starbucks, in both pie-chart and financial statement form, are shown on the next four slides. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Common-Size Balance Sheets Presented Graphically ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Common-Size Balance Sheets ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Common-Size Income Statements Presented Graphically ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Common-Size Income Statements ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Financial Ratio Analysis  Financial ratio analysis identifies key relationships between the components of the financial statements. – To interpret ratios correctly, the analyst must have:  A general understanding of the company and its environment  Financial data for several years or for several companies  An understanding of the data underlying the numerator and denominator – Ratios can be expressed in several ways. For example, a ratio of net income of $100,000 to sales of $1,000,000 can be stated as:  Net income is 1/10, or 10 percent, of sales.  The ratio of sales to net income is 10 to 1 (10:1).  For every dollar of sales, the company has an average net income of 10 cents. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Evaluating Profitability and Total Asset Management  Investors and creditors use profit margin to evaluate a company’s ability to earn a satisfactory income (profitability).  They use asset turnover to determine whether the company uses assets in a way that maximizes revenue (total asset management).  The combined effect of these two ratios is overall earning power—that is, return on assets.  Starbucks’ profit margins, asset turnover, and return on assets in 2010 and 2011 are computed on the next three slides. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Profit Margin  Profit margin measures the net income produced by each dollar of sales. Income Statement Statement of Cash Numbers Flows Numbers Cash Net Flows from Total Total Total Revenues Income Operating Assets Liabilities Equity Activities Net Income Profit Margin = Net Revenue 2011 2010 Net Income $1,248.0 948.3 = 10.7% = 8.9% Net Revenue $11,700.4 10,707.4 ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Asset Turnover  Asset turnover measures how efficiently assets are used to produce sales. Income Statement Statement of Cash Numbers Flows Numbers Cash Net Flows from Total Total Total Revenues Income Operating Assets Liabilities Equity Activities Net Revenue Asset Turnover = Average Total Assets 2011 2010 $11,700.4 $10,707.4 = 1.7 = 1.8 ($7,360.4 + $6,385.9) ÷ 2 Times ($6,385.9 + $5,576.8) ÷ 2 Times ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Assets  Return on assets measures a company’s overall earning power, or profitability. Income Statement Statement of Cash Numbers Flows Numbers Cash Net Flows from Total Total Total Revenues Income Operating Assets Liabilities Equity Activities Return on Assets = Net Income Average Total Assets 2011 2010 $1,248.0 $948.3 = 18.2% = 15.9% ($7,360.4 + $6,385.9) ÷ 2 ($6,385.9 + $5,576.8) ÷ 2 ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Profitability Ratio Relationships  The relationships of the three financial ratios for profitability are as follows. – If a company has one-time items on its income statement, such as gains or losses on the sale or disposal of discontinued operations, income from continuing operations may be a better measure of sustainable earnings than net income. – Some analysts like to use earnings before interest and taxes (EBIT) for the earnings measure because it excludes the effects of the company’s borrowings and the tax rates from the analysis. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Evaluating Liquidity  Liquidity is a company’s ability to pay bills when they are due and to meet unexpected needs for cash. – To evaluate a company’s liquidity, analysts compute:  Cash flow yield  Cash flows to sales  Cash flows to assets  Free cash flow – Starbucks’ cash flow yields, cash flows to sales ratios, cash flows to assets ratios, and free cash flows in 2010 and 2011 are computed on the next four slides. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cash Flow Yield  Cash flow yield measures a company’s ability to generate operating cash flows in relation to net income. Income Statement Statement of Cash Numbers Flows Numbers Cash Net Flows from Total Total Total Revenues Income Operating Assets Liabilities Equity Activities Net Cash Flows from Operating Activities Cash Flow Yield = Net Income 2011 2010 $1,612.4 $1,704.9 = 1.3 Times = 1.8 $1,248.0 $948.3 Times ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cash Flows to Sales  Cash flows to sales refers to the ability of sales to generate operating cash flows. Income Statement Statement of Cash Numbers Flows Numbers Cash Net Flows from Total Total Total Revenues Income Operating Assets Liabilities Equity Activities Net Cash Flows from Operating Activities Cash Flows to Sales = Net Revenues 2011 2010 $1,612.4 $1,704.9 = 13.8% = 15.9% $11,700.4 $10,707.4 ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cash Flows to Assets  Cash flows to assets measures the ability of assets to generate operating cash flows. Income Statement Statement of Cash Numbers Flows Numbers Cash Net Flows from Total Total Total Revenues Income Operating Assets Liabilities Equity Activities Net Cash Flows from Operating Activities Cash Flows to Assets = Average Total Assets 2011 2010 $1,612.4 $1,704.9 = 28.5% = 23.5% ($7,360.4 + $6,385.9) ÷ 2 ($6,385.9 + 5,576.8) ÷ 2 ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Free Cash Flow  Free cash flow is a measure of the cash remaining after providing for commitments. – Starbucks’ free cash flows in 2010 and 2011 are computed as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Evaluating Financial Risk  Financial risk refers to a company’s ability to survive in good times and bad. – The aim of evaluating financial risk is to detect early signs that a company is headed for financial difficulty through its use of debt, or financial leverage, to finance part of the company. – Increasing amounts of debt in a company’s capital structure can mean that the company is becoming heavily leveraged and runs the risk of not earning a return on assets equal to the cost of financing the assets. – Ratios related to financial risk include debt to equity, return on equity, and interest coverage. – Starbucks’ debt to equity, return on equity, and interest coverage ratios in 2010 and 2011 are computed on the next three slides. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Debt to Equity Ratio  The debt to equity ratio shows the amount of assets provided by creditors in relation to the amount provided by stockholders. Income Statement Statement of Cash Numbers Flows Numbers Cash Net Flows from Total Total Total Revenues Income Operating Assets Liabilities Equity Activities Total Liabilities Debt to Equity = Stockholders’ Equity 2011 2010 $2,973.1 $2,703.6 = 0.7 Times = 0.7 $4,384.9 $3,674.7 Times ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Equity  Return on equity measures the return to stockholders, or the profitability of stockholders’ investments. Income Statement Statement of Cash Numbers Flows Numbers Cash Net Flows from Total Total Total Revenues Income Operating Assets Liabilities Equity Activities Net Income Return on Equity = Average Stockholders’ Equity 2011 2010 $1,248.0 $948.3 = 31.0% = 28.2% ($4,384.9 + $3,674.7) ÷ 2 ($3,674.7 + $3,045.7) ÷ 2 ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Interest Coverage  The interest coverage ratio is a supplementary ratio that measures the degree of protection creditors have from default on interest payments. – Starbucks’ interest coverage ratios in 2010 and 2011 are computed as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Evaluating Operating Asset Management  The operating cycle spans the time it takes to purchase inventory, sell it, and collect for it.  The financing cycle—the period between the time a supplier must be paid and the end of the operating cycle—defines how much additional financing the company must have to support its operations. – Because additional debt increases a company’s financial risk, it is important to keep the financing period at a manageable level.  The financial ratios that measure operating asset management include inventory turnover, days’ inventory on hand, receivables turnover, days’ sales uncollected, payables turnover, and days’ payable. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inventory Turnover  Inventory turnover measures the relative size of inventories. – Starbucks’ inventory turnover ratios in 2010 and 2011 are computed as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Days’ Inventory on Hand  Day’s inventory on hand measures the average number of days that it takes to sell inventory. – Starbucks’ days’ inventory on hand ratios in 2010 and 2011 are computed as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Receivables Turnover  Receivables turnover measures the relative size of accounts receivable and the effectiveness of credit policies. – Starbucks’ receivables turnover ratios in 2010 and 2011 are computed as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Days’ Sales Uncollected  Days’ sales uncollected measures the average number of days it takes to collect receivables. – Starbucks’ days’ sales uncollected ratios in 2010 and 2011 are computed as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Payables Turnover  Payables turnover measures the relative size of accounts payable and the credit terms extended to a company. – Starbucks’ payables turnover ratios in 2010 and 2011 are computed as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Day’s Payable  Days’ payable measures the average number of days it takes to pay accounts payable. – Starbucks’ days’ payable ratios in 2010 and 2011 are computed as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Financing Period  The financing period is computed by deducting the days’ payable from the operating cycle (days’ inventory on hand + days’ sales uncollected). – Starbucks’ financing periods in 2010 and 2011 are computed as follows: 2011: 55.3 Days + 10.7 Days − 27.9 Days = 38.1 Days 2010: 49.3 Days + 9.8 Days − 23.1 Days = 36.0 Days ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Current Ratio  The current ratio measures short-term debt- paying ability by comparing current assets with current Income liabilities. Statement Statement of Cash Numbers Flows Numbers Cash Net Flows from Total Total Total Revenues Income Operating Assets Liabilities Equity Activities Current Assets Current Ratio = Current Liabilities 2011 2010 $3,794.9 $2,756.4 = 1.8 Times = 1.5 $2,075.8 $1,779.1 Times ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Quick Ratio  The quick ratio differs from the current ratio in that the numerator of the quick ratio excludes inventories and prepaid expenses. – Starbucks’ quick ratios in 2010 and 2011 are computed as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Evaluating Market Strength with Financial Ratios  Market price is the price at which a company’s stock is bought and sold. It indicates how investors view the potential return and risk connected with owning the stock. – Market price by itself is not very informative because companies have different numbers of shares outstanding, different earnings, and different dividend policies. – Thus, market price must be related to earnings by considering the price/earnings (P/E) ratio and the dividend yield. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Price/Earnings (P/E)  Price/earnings (P/E), which measures investors’ confidence in a company, is the ratio of the market price per share to earnings per share. – Starbucks’ P/E ratios in 2010 and 2011 are computed as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Dividend Yield  Dividend yield measures a stock’s current return to an investor in the form of dividends. – Starbucks’ dividend yields in 2010 and 2011 are computed as follows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Relationships of Financial Ratios ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  (slide 1 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  (slide 2 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. SECTION 3: BUSINESS APPLICATIONS  Evaluating quality of earnings – Accounting methods – Accounting estimates – One-time items  Determining management compensation ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Evaluating Quality of Earnings  Net income (net earnings) is the measure most commonly used to evaluate a company’s profitability.  Because of the importance of net income, or the “bottom line,” in measuring a company’s prospects, there is significant interest in evaluating the quality of net income.  The quality of earnings refers to the substance of earnings and their sustainability into future periods. It is affected by: – Accounting methods – Accounting estimates – One-time items ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Accounting Methods  The accounting methods a firm uses affect its operating income. Generally accepted accounting methods include: – Uncollectible receivables methods (percentage of net sales and aging of accounts receivable) – Inventory methods (LIFO, FIFO, and average cost) – Depreciation methods (accelerated, production, straight- line) – Revenue recognition methods  Different accounting methods have different effects on net income, as illustrated by the income statements of the two companies on the next slide. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Effects of Different Accounting Methods ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Impact of Different Accounting Methods on Income  The income from continuing operations before income taxes for the firm that uses LIFO and DDB (double-declining-balance) is lower because in periods of rising prices, the LIFO method produces a higher cost of goods sold.  Also, in the early years of an asset’s useful life, accelerated depreciation yields a higher depreciation expense.  The result is lower operating income. However, future operating income should be higher. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Impact of Different Accounting Methods on Cash Flows  Although the choice of accounting method does not affect cash flows except for possible differences in income taxes, the $25,000 difference in operating income stems solely from the choice of accounting methods.  Estimates of the useful lives and residual values of plant assets could lead to an even greater difference.  In general, an accounting method or estimate that results in lower current earnings produces a better quality of operating income. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Impact of Different Accounting Methods on Financial Statements  The latitude that companies have in their choice of accounting method could cause problems in the interpretation of financial statements were it not for the conventions of full disclosure and consistency. – Full disclosure requires management to explain, in a note to the financial statements, the significant accounting policies used. – Consistency requires that the same accounting procedures be used from year to year. If a company changes its accounting procedure, it must explain the nature of the change and its monetary effect in a note to the financial statements. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Accounting Estimates  In allocating expenses among the periods that benefit from them, accountants must make estimates and exercise judgment, which will affect net income.  Areas that require accounting estimates include: – Useful life of assets – Residual value of assets – Uncollectible accounts receivable – Sales returns – Total units of production – Total recoverable units of natural resources – Amortization periods – Warranty claims – Environmental cleanup costs ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. One-Time Items  If earnings increase because of one-time items, that portion of earnings will not be sustained in the future.  Examples of one-time items include: – Gains and losses – Write-downs and restructurings – Nonoperating items  Because management has choices in the content and positioning of these income statement components, there is a potential for managing earnings to achieve specific income targets. – The next slide shows the components of a typical income statement. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Corporate Income Statement ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Gains and Losses  When a company sells or otherwise disposes of operating assets or marketable securities, a gain or loss generally results.  These gains or losses appear in the operating section of the income statement, but they usually represent one-time events, and management often has some choice as to their timing.  Thus, from an analyst’s standpoint, they should be ignored when considering operating income. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Write-Downs and Restructurings  A write-down (or write-off) is a reduction in the value of an asset below its carrying value on the balance sheet.  A restructuring is the estimated cost of a change in a company’s operations. It usually involves the closing of facilities and the laying off of personnel.  Both write-downs and restructurings reduce current operating income and boost future income by shifting future costs to the current period. – Companies sometimes take all possible losses in the current year so that future years will be “clean” of these costs. Such “big baths” commonly occur when a company is having a bad year or when there is a change in management. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Nonoperating Items  The nonoperating items that appear on the income statement include discontinued operations—segments that are no longer part of a company’s operations—and gains or losses on the sale or disposal of these segments.  These items can significantly affect net income.  To make it easier to evaluate a company’s ongoing operations, GAAP requires that gains and losses from discontinued operations be reported separately on the income statement. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Management Compensation  Under the Sarbanes-Oxley Act, a public corporation’s board of directors must establish a compensation committee made up of independent directors to determine how the company’s top executives will be compensated. – Typical components of the compensation of executive officers include:  Annual base salary  Annual incentive bonuses—based on financial performance measures that the compensation committee identifies as important to the company’s long-term success  Long-term incentive compensation (stock option awards)— usually based on how well the company is achieving its long- term strategic goals ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.