978-0078025549 Chapter 12 Lecture Note

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 LO12-1 Perform vertical analysis.

 LO12-2 Perform horizontal analysis.

 LO12-3 Use ratios to analyze a company’s risk.

 LO12-4 Use ratios to analyze a company’s profitability.

 LO12-5 Distinguish persistent earnings from one-time items.

 LO12-6 Explain quality of earnings and distinguish between conservative and aggressive

accounting practices.

Teaching Suggestions

Chapter 12 adopts an underlying sports theme to demonstrate the basic tools used in financial statement

analysis. Part A introduces vertical and horizontal analysis using actual financial statements from Under

Armour and Nike. Vertical analysis controls for differences in company size, making comparisons among

companies of different size possible. Horizontal analysis allows users to analyze trends in financial

statement data for a single company over time. The horizontal analysis of Under Armour’s financial

statements demonstrates the large growth in company operations during the year. The horizontal analysis

of Nike’s financial statements is included in a Let’s Review problem at the end of this section.

Part B uses ratio analysis to provide a detailed assessment of risk and profitability for Under Armour,

comparing the results to the sports apparel industry leader—Nike. We review 14 ratios separated into two

categories: risk ratios and profitability ratios. Ratio analysis is presented in a separate section at the end of

each chapter beginning in Chapter 5 and continuing through Chapter 11. These same ratios are included in

a comprehensive example here in Chapter 12 to allow maximum flexibility to instructors in the coverage

of ratios. Instructors can cover ratios chapter by chapter, save the coverage of ratios until the final chapter,

or combine these two approaches by introducing the ratios in each chapter and then bring all of the ratios

together in this final chapter. Some instructors even save this chapter, including it the following semester

in the managerial accounting class.

Part C addresses earnings persistence and earnings quality. Certain items are part of net income in the

current year but are not expected to persist beyond the current year such as discontinued operations and

extraordinary items. The Decision Maker’s Perspective near the end of this section, entitled “Does

Location in the Income Statement Matter?” helps students see that sometimes it’s not just the final net

income number that’s important, but also the location of the item in the income statement that matters as

well. The final section on earnings quality was written based on reviewer feedback regarding the need to

help students better recognize conservative vs. aggressive accounting practices. Major topics from

Chapters 5, 6, 7, and 8 are used as examples of both conservative accounting practices (as prepared by

Mr. Nadal) and aggressive accounting practices (as prepared by Mr. Djokovic) to help students see the

subjectivity inherent within accounting standards.

Assignment Charts

Questions

Learning

Objective(s) Topic

Time

(Min.)

1 LO12-1,12-2 Identify types of comparisons commonly used in

financial statement analysis

2 LO12-1,12-2 Explain the difference between vertical and horizontal

analysis

3 LO12-1 Describe the base amounts commonly used in vertical

analysis

4 LO12-1 Identify relative age of company based on size of

common stock and retained earnings balances

5 LO12-2 Explain why it is important to look at both the amount

and percentage change in horizontal analysis

6 LO12-3 Explain why some ratios use average rather than ending

balance sheet amounts

7 LO12-3 Describe the difference between liquidity and solvency 5

8 LO12-3 Relate risk ratios with financial questions 5

9 LO12-3 Determine whether each of the following changes in risk

ratios is good news or bad news about a company

10 LO12-3 Describe the effect of a transaction on the current ratio 5

11 LO12-4 Relate profitability ratios with financial questions 5

12 LO12-4 Determine whether each of the following changes in

profitability ratios is good news or bad news about a

company

13 LO12-4 Explain why the return on assets and the return on

equity differ

14 LO12-5 Explain how earnings persistence relate to the reporting

of discontinued operations and extraordinary items

15 LO12-5 Examine a trend in earnings per share before and after

extraordinary items

16 LO12-6 Explain the difference between conservative and

aggressive accounting practices

17 LO12-6 Explain why an accounting practice is conservative 5

18 LO12-6 Explain why an accounting practice is aggressive 5

19 LO12-6 Examine year-end adjustments for a common trend 5

20 LO12-6 Provide an example of a change in accounting practice

that has no effect on cash flows

Brief Exercises

Learning

Objective(s) Topic

Time

(Min.)

BE12-1 LO12-1 Prepare vertical analysis 15

BE12-2 LO12-2 Prepare horizontal analysis 15

BE12-3 LO12-1 Understand vertical analysis 10

BE12-4 LO12-2 Understand horizontal analysis 5

BE12-5 LO12-2 Understand percentage change 5

BE12-6 LO12-3 Calculate receivables turnover 5

BE12-7 LO12-3 Calculate inventory turnover 5

BE12-8 LO12-3 Understand inventory turnover 5

BE12-9 LO12-3 Understand the current ratio 10

BE12-10 LO12-4 Calculate profitability ratios 15

BE12-11 LO12-4 Calculate profitability ratios 10

BE12-12 LO12-5 Record discontinued operations 10

BE12-13 LO12-5 Classify income statement items 10

BE12-14 LO12-6 Distinguish between conservative and aggressive

accounting practices

BE12-15 LO12-6 Distinguish between conservative and aggressive

accounting practices

Exercises

Learning

Objective(s) Topic

Time

(Min.)

E12-1 LO12-1 to 12-6 Match terms with their definitions 20

E12-2 LO12-1 Prepare vertical analysis 15

E12-3 LO12-2 Prepare horizontal analysis 15

E12-4 LO12-1,12-2 Prepare vertical and horizontal analyses 30

E12-5 LO12-3 Evaluate risk ratios 30

E12-6 LO12-4 Evaluate profitability ratios 30

E12-7 LO12-3 Calculate risk ratios 30

E12-8 LO12-4 Calculate profitability ratios 30

E12-9 LO12-4 Calculate profitability ratios 30

E12-10 LO12-4 Calculate profitability ratios 20

E12-11 LO12-5 Classify income statement items 15

E12-12 LO12-5 Record discontinued operations 20

E12-13 LO12-5 Record discontinued operations and extraordinary items 15

E12-14 LO12-6 Distinguish between conservative and aggressive

accounting practices

E12-15 LO12-6 Distinguish between conservative and aggressive

accounting practices

Problems

Learning

Objective(s) Topic

Time

(Min.)

P12-1A LO12-1 Perform vertical analysis 20

P12-2A LO12-2 Perform horizontal analysis 20

P12-3A LO12-1,12-2 Perform vertical and horizontal analyses 30

P12-4A LO12-3 Calculate risk ratios 30

P12-5A LO12-4 Calculate profitability ratios 20

P12-6A LO12-3,12-4 Use ratios to analyze risk and profitability 45

P12-1B LO12-1 Perform vertical analysis 20

P12-2B LO12-2 Perform horizontal analysis 20

P12-3B LO12-1,12-2 Perform vertical and horizontal analyses 30

P12-4B LO12-3 Calculate risk ratios 30

P12-5B LO12-4 Calculate profitability ratios 20

P12-6B LO12-3,12-4 Use ratios to analyze risk and profitability 45

Additional

Perspectives Topic

Time

(Min.)

AP12-1 Continuing Problem: Great Adventures 45

AP12-2 Financial Analysis: American Eagle Outfitters, Inc. 45

AP12-3 Financial Analysis: The Buckle, Inc. 45

AP12-4 Comparative Analysis: American Eagle Outfitters, Inc., vs. The Buckle,

Inc.

AP12-5 Ethics 20

AP12-6 Internet Research 20

AP12-7 Written Communication 20

AP12-8 Earnings Management 20

Chapter Quiz Questions

The following multiple-choice questions are 10 unique quiz questions that correspond to the 10 questions

at the end of each chapter. Each question covers the same learning objective but with a little different

twist. The correct answer is highlighted in bold for each item.

LO12-1

1. Common size analysis is more often referred to as:

a. Vertical analysis.

b. Horizontal analysis.

c. Risk analysis.

d. Profitability analysis.

LO12-1

2. When using vertical analysis, we express balance sheet accounts as a percentage of

a. total assets.

b. total liabilities.

c. total stockholders’ equity.

d. sales.

LO12-2

3. Which of the following is an example of horizontal analysis?

a. Comparing gross profit across companies.

b. Comparing gross profit with operating expenses.

c. Comparing assets with equity.

d. Comparing the change in sales over time.

LO12-2

4. Which of the following is an example of horizontal analysis?

a. Comparing a balance sheet account over time.

b. Comparing a balance sheet account with an income statement account.

c. Comparing a balance sheet account with another balance sheet account at the same point in time.

d. Comparing an income statement account with another income statement account at the same point

in time.

LO12-3

5. Which of the following ratios is not considered to be a liquidity ratio?

a. Receivable turnover ratio.

b. Inventory turnover ratio.

c. Debt to equity ratio.

d. Current ratio.

LO12-3

6. Which of the following is a negative indicator regarding a company’s ability to turn its receivables into

cash?

a. a low receivables turnover ratio.

b. a high receivables turnover ratio.

c. a low average collection period.

d. both a high receivables turnover ratio and a low average collection period.

LO12-4

7. Performance, Inc. reports net income of $100,000, sales of $800,000, and average assets of $500,000.

The profit margin is:

a. 12.5%.

b. 20%.

c. 500%.

d. 800%.

LO12-4

8. Performance, Inc. reports net income of $100,000, sales of $800,000, and average assets of $500,000.

The asset turnover is:

a. 0.20 times.

b. 0.625 times.

c. 5 times.

d. 1.6 times.

LO12-5

9. Power Equipment incurred a material loss, which was not unusual in nature, but was clearly an

infrequent occurrence. This loss should be reported as:

a. An extraordinary item.

b. A discontinued operation.

c. Other revenues and expenses.

d. A separate line item in retained earnings.

LO12-6

10. Which of the following is an example of an aggressive accounting practice in relation to the reporting

of net income?

a. Adjust the allowance for uncollectible accounts to a larger amount.

b. Record a larger expense for warranties.

c. Decrease the estimated useful life in calculating depreciation.

d. Record sales revenue before it is actually earned.

Alternate Let’s Review

Problem #1

The income statements and balance sheets for Incredible Sports are as follows:

Incredible Sports

Income Statements

For the Years Ended December 31

(in millions)

2015 2014

Sales $1,244.0 $1,317.8

Cost of goods sold 719.9 750.0

Gross profit 524.1 567.8

Operating expenses 436.3 449.1

Operating income 87.8 118.7

Other income (expense) 2.1 7.5

Income before tax 89.9 126.2

Income tax expense 22.8 31.2

Net income $67.0 $95.0

Incredible Sports

Balance Sheets

December 31

(in millions)

Assets 2015 2014

Cash $386.7 $230.6

Net receivables 258.1 333.5

Current investments 22.8 22.4

Inventory 222.2 256.3

Other current assets 32.0 29.7

Total current assets 921.8 872.5

Property and equipment 235.4 229.7

Intangible assets 55.8 46.1

Total assets 1,213.0 1,148.3

Liabilities and Stockholders’ Equity

Current liabilities 179.3 173.2

Long-term liabilities 36.5 31.0

Stockholders’ equity 997.2 944.1

Total liabilities and stockholders’ equity 1,213.0 1,148.3

Required:

Calculate the following risk ratios for the year ended December 31, 2015.

Solution:

Risk Ratios Calculations

Liquidity

Receivables turnover ratio $1,244.0

($258.1 + $333.5) / 2 = 4.2 times

Average collection period 365 = 86.9 days

4.2

Inventory turnover ratio $719.9

($222.2 + $256.3) / 2 = 3.0 times

Average days in inventory 365

3.0 = 121.7 days

Current ratio $921.8

$179.3 = 5.1 to 1

Acid-test ratio $386.7 + $22.8 + $258.1

$179.3 = 3.7 to 1

Solvency

Debt to equity ratio $179.3 + $36.5

$997.2 = 21.6%

Problem #2

The income statements and balance sheets for Incredible Sports are as follows:

Incredible Sports

Income Statements

For the Years Ended December 31

(in millions)

2015 2014

Sales $1,244.0 $1,317.8

Cost of goods sold 719.9 750.0

Gross profit 524.1 567.8

Operating expenses 436.3 449.1

Operating income 87.8 118.7

Other income (expense) 2.1 7.5

Income before tax 89.9 126.2

Income tax expense 22.8 31.2

Net income $67.0 $95.0

Incredible Sports

Balance Sheets

December 31

(in millions)

Assets 2015 2014

Cash $386.7 $230.6

Net receivables 258.1 333.5

Current investments 22.8 22.4

Inventory 222.2 256.3

Other current assets 32.0 29.7

Total current assets 921.8 872.5

Property and equipment 235.4 229.7

Intangible assets 55.8 46.1

Total assets $1,213.0 $1,148.3

Liabilities and Stockholders’ Equity

Current liabilities 179.3 173.2

Long-term liabilities 36.5 31.0

Stockholders’ equity 997.2 944.1

Total liabilities and stockholders’ equity $1,213.0 $1,148.3

In addition, the company reported earnings per share for the year ended December 31, 2015 of $2.02, and

the closing stock price on December 31, 2015, was $39.04.

Required:

Calculate the six profitability ratios we’ve discussed for Incredible Sports for the year ended December

31, 2015.

Solution:

Profitability Ratios Calculations

Gross profit ratio $524.1

$1,244.0 = 42.1%

Return on assets $67.0

($1,213.0 +$1,148.3) / 2 = 5.7%

Profit margin $67.0

$1,244.0 = 5.4%

Asset turnover $1,244.0

($1,213.0 +$1,148.3) / 2 = 1.1 times

Return on equity $67.0

($997.2 + $944.1) / 2 = 6.9%

Price-earnings ratio $39.04

$2.02 = 19.3

Problem #3

Classify each of the following accounting practices as conservative or aggressive.

1. Decrease the allowance for uncollectible accounts.

2. Decrease the useful life for calculating depreciation.

3. Reduce the amount of a contingent liability reported for litigation.

4. Record a larger expense for warranties.

5. When costs are going up, change from LIFO to FIFO.

Solution:

1. Aggressive. 2. Conservative. 3. Aggressive. 4. Conservative. 5. Aggressive.

Key Points by Learning Objective

LO12-1 Perform vertical analysis.

For vertical analysis, we express each item as a percentage of the same base amount, such as a percentage

of sales in the income statement or as a percentage of total assets in the balance sheet.

LO12-2 Perform horizontal analysis.

We use horizontal analysis to analyze trends in financial statement data, such as the amount of change and

the percentage change, for one company over time.

LO12-3 Use ratios to analyze a company’s risk.

We divide risk ratios into liquidity ratios and solvency ratios. Liquidity ratios focus on the company’s

ability to pay current liabilities, whereas solvency ratios focus more on long-term liabilities.

LO12-4 Use ratios to analyze a company’s profitability.

Profitability ratios measure the earnings or operating effectiveness of a company over a period of time,

such as a year. Investors view profitability as the number-one measure of company success.

LO12-5 Distinguish persistent earnings from one-time items.

When using a company’s current earnings to estimate future earnings performance, investors normally

should exclude discontinued operations and extraordinary items.

LO12-6 Explain quality of earnings and distinguish between conservative and aggressive

accounting practices.

Changes in accounting estimates and practices alter the appearance of amounts reported in the income

statement and the balance sheet. Changes in accounting estimates and practices usually have no effect on

a company’s underlying cash flows.

Common Mistakes

Common Mistake

In comparing an income statement account with a balance sheet account, some students incorrectly use

the balance sheet account’s ending balance, rather than the average of its beginning and ending balances.

Since income statement accounts are measured over a period of time, comparisons to related balance

sheet accounts also need to be over time by taking the average of the beginning and ending balances.

Decision Points

Question Accounting Information Analysis & Decision

How do we compare

income between

companies of different

size?

Common-size income

statements

A vertical analysis using

common-size income statements

allows for the comparison of

income statement items between

companies of different size.

Question Accounting Information Analysis & Decision

Are any parts of the

company’s earnings not

expected to persist into the

future?

One-time items reported

near the bottom of the

income statement.

Investors should normally

exclude discontinued operations

and extraordinary items in

estimating future earnings

performance.

Career Corner

Investors and creditors, as well as suppliers, customers, employees, and the government among others,

rely heavily on financial accounting information. Who checks big companies like Under Armour and Nike

to make sure they are reporting accurately? Auditors. Many accounting majors begin their career in

auditing. They then use the experience they gained by auditing to obtain management and accounting

positions in private industry, sometimes even with a company they previously audited.

However, auditing is not just for accounting majors. Finance majors are hired as auditors in the

banking and insurance industries. Management information systems (MIS) majors are hired to audit

computer systems. Management majors are hired to audit the effectiveness and efficiency of management

operations. There even are marketing auditors, who identify strengths and weaknesses in marketing

strategy and overall marketing structures.1 Analysis skills, like those covered in this chapter, are the types

of skills necessary for a successful career in auditing, and for that matter, in almost any career in business.

Ethical Dilemma

Michael Hechtner was recently hired as an assistant controller for Athletic Persuasions, a recognized

leader in the promotion of athletic events. However, the past year has been a difficult one for the

company’s operations. In order to help with slowing sales, the company has extended credit to more

customers and accepted payment over longer time periods, resulting in a significant increase in accounts

receivable. Similarly, with slowing sales, its inventory of promotional supplies has increased dramatically.

One afternoon, Michael joined the controller, J.P. Sloan, for a visit with Citizens State Bank. Athletic

Persuasions had used up its line of credit and was looking to borrow additional funds. In meeting with the

loan officer at the bank, Michael was surprised at the positive spin J.P. Sloan put on the company

operations. J.P. exclaimed, “Athletic Persuasions continues to prosper in a difficult environment. Our

current assets have significantly increased in relation to current liabilities, resulting in a much-improved

current ratio over the prior year. It seems wherever I look, the company has been successful.”

Is there anything unethical in the controller’s statement to the banker? What should Michael do in this

situation? Is it acceptable for Michael just to keep quiet?

Key Issues

 When does putting a positive spin on the situation become unethical?

 What action, if any, should Michael take in this situation?

Option 1: Keep quiet and give full support to his boss, J.P. Sloan.

 This is the easiest alternative.

 Maintains a good relationship with his direct supervisor.

1 J. Mylonakis, “Functions and responsibilities of marketing auditors in measuring organizational performance,”

International Journal of Technology Management, 25 (2003), pp. 814–825.

 Increases the likelihood of borrowing additional funds at the bank.

Option 2: Confront J.P. Sloan regarding the “positive spin” given to the loan officer.

 Honesty and transparency is usually the best policy.

 J.P. Sloan was not being completely honest when he said, “It seems wherever I look, the company

has been successful.”

 By confronting his supervisor in the right way, this may reduce the risk of even greater

exaggerations in the future with potentially greater repercussions to the company.