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11. Return on common stockholders’ equity ratio is a widely used measure of
profitability from the common stockholder’s viewpoint.
• The ratio shows how many dollars of net income were earned for each dollar
invested by the owners.
12. Return on assets ratio measures the overall profitability of assets in terms of the
income earned on each dollar invested in assets.
• The return on common stockholders’ equity ratio is affected by two factors: the
13. Profit margin, or rate of return on sales, is a measure of the
percentage of each dollar of sales that results in net income.
• The return on assets ratio is affected by two factors, the first of which is the profit
margin ratio.
14. Asset turnover ratio measures how efficiently a company uses its assets to
generate sales.
• The asset turnover ratio is the other factor that affects the return on assets ratio.
• The ratio is determined by dividing net sales by average total assets for the
15. Gross profit rate indicates a company’s ability to maintain an adequate selling price
above its cost of goods sold.
• The profit margin ratio is strongly influenced by the gross profit rate.
16. Earnings per share (EPS) is a measure of the net income earned on each share of
common stock.
• Expressing net income earned on a per share basis provides a useful
perspective for determining profitability.
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17. Price-earnings (P-E) ratio measures the ratio of the market price of each share of
common stock to the earnings per share.
• The price-earnings ratio is a reflection of investors’ assessments of a company’s
future earnings.
18. Payout ratio measures the percentage of earnings distributed in the form of cash
dividends.
• Companies that have high growth rates are characterized by low payout ratios
because they reinvest most of their net income in the business.
Learning Objective – 9 – Compare the accounting for irregular items and the income
statement format under GAAP and IFRS.
A Look at IFRS—The first sections of this chapter dealing with the tools
of financial analysis, are the same through-out the world. Techniques
such as vertical and horizontal analysis, for example, are tools used by
analysis regardless of whether GAAP-or IFRS-related financial
statements are being evaluated. In addition, the ratios provided in the
textbook are the same ones that are used internationally.
KEY POINTS
▪ The tools of financial statement analysis covered in this chapter are universal
and therefore no significant differences exist in the analysis methods used.
▪ The basic objectives of the income statement are the same under both GAAP
and IFRS. As indicated in the textbook, a very important objective is to ensure
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▪ The accounting for changes in accounting principles and changes in accounting
estimates are the same for both GAAP and IFRS.
▪ The income statement under IFRS is referred to as a statement of
comprehensive income. The statement of comprehensive income can be
prepared under the one-statement approach or the two-statement approach.
▪ Under the one-statement approach, all components of revenue and expense are
reported in the income statement. This combined statement of comprehensive
LOOKING TO THE FUTURE
The FASB and the IASB are working on a project that would rework the structure of
financial statements. Recently, the IASB decided to require a statement of comprehensive
income, similar to what was required under GAAP. In addition, another part of this project
addresses the issue of how to classify-various items in the income statement. A main goal
of this new approach is to provide information that better represents how businesses are
run. In addition, the approach draws attention away from one number—net income.
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Chapter 13 Review
✓ What is sustainable income?
✓ What are irregular items on the income statement? How are irregular items presented
on the income statement?
✓ What is comprehensive income?
✓ What is horizontal analysis and how is it used?
✓ What is vertical analysis and how is it used?
✓ Identify the liquidity, solvency, and profitability ratios introduced throughout the text.
Describe how the ratios are used in analyzing a firm’s liquidity, solvency, and
profitability.
✓ Discuss three factors that affect quality of earnings.
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Vocabulary Quiz Name _______________________ Date
____________
Chapter 13
1. The most likely level of income to be obtained in the future.
2. The disposal of a significant component of a business.
3. A technique for evaluating a series of financial statement data over a
period of time to determine the increase (decrease) that has taken
place expressed as either an amount or a percentage.
4. Measures of the ability of the enterprise to survive over a long period of
time.
5. Use of an accounting principle in the current year different from the
one used in the preceding year.
6. Measures the short-term ability of the enterprise to pay its maturing
obligations and to meet unexpected needs for cash.
7. Events and transactions that meet two conditions: (1) unusual in nature
and (2) infrequent in occurrence.
8. Measures the income or operating success of an enterprise for a given
period of time.
9. A measure of income that usually excludes items that the company
thinks are unusual or nonrecurring.
10. Income that includes all changes in stockholders’ equity during a
period except those changes resulting from investments by
stockholders and distributions (dividends) to stockholders.
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Solutions to Vocabulary Quiz
Chapter 13
1. Sustainable income
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10. Multiple Choice Quiz Name _______________________ Date
____________
Chapter 13
1. The most likely level of income to be obtained in the future—that is, to extent this
year’s net income is a good predictor of future years’ net income is
a. sustainable income.
b. net income.
c. net income adjusted for irregular items.
d. both sustainable income and the income adjusted for irregular items.
2. Which of the following would be reported as an irregular item?
a. The gain or loss from the disposal of a significant component of a business.
b. Loss from damages caused by a hurricane.
c. Extraordinary items, net of tax.
d. All of these answer choices are correct.
3. Discontinued operations should be shown in the income statement
a. as “Other revenues and gains.”
b. as “Other expenses and losses.”
c. in a separate section titled “Irregular Item.”
d. net of tax.
4. Extraordinary items are
a. unusual in nature and infrequent in occurrence.
b. unusual in nature or infrequent in occurrence.
c. are reported along with other operating expenses on the income statement.
d. write-downs of inventories or write-offs of receivables.
5. A change in accounting principle is permitted when
a. management can show that the new principle is preferable to the old
principle.
b. the effects of the change are clearly disclosed in the income statement.
c. the effect of the change in accounting principle on net income will not be
significant.
d. both management can show that the new principle is preferable to the old
principle and the effects of the change are clearly disclosed in the income
statement.
6. Comparisons with other companies to provide insight into a company’s competitive
position is an
a. intracompany basis comparison.
b. intercompany basis comparison.
c. industry averages comparison.
d. none of these answer choices are correct.
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7. A technique for evaluating a series of financial statement data over a period of time
is called
a. horizontal analysis.
b. vertical analysis.
c. ratio analysis.
d. none of these answer choices are correct.
8. A technique for evaluating financial statement data that expresses each item in a
financial statement as a percentage of a base amount is called
a. horizontal analysis.
b. vertical analysis.
c. ratio analysis.
d. none of these answer choices are correct.
9. Vertical analysis of comparative income statements would show cost of goods sold
as a percentage of
a. total assets.
b. merchandise inventory.
c. net sales.
d. net income.
10. A measure of the ability of an enterprise to survive over a long period of time is a
a. liquidity ratio.
b. solvency ratio.
c. current ratio.
d. profitability ratio.
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Solutions to Multiple Choice Quiz
Chapter 13
1. d
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Exercise 1 – Irregular Items Accounting Activity
Chapter 13
Indicate which of the following items would be reported as an extraordinary item on the
income statement:
a. Loss from damage caused by the infestation of pine beetles on a timber tract
occurring over a 10-year period.
b. Loss from strike by union employees.
c. Loss from damage to property caused by a volcano eruption. The last eruption was
over 100 years earlier.
d. Decline in the fair market value of land caused by rezoning of property.
e. Loss from damage caused by tornado in an area where tornado damage seldom
occurs.
f. Loss from expropriation of property by a foreign government
g. Gain from sale of plant equipment
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Exercise 2 – Accounts Receivable Turnover Activity
Chapter 13
Mark’s Wine and Spirits is the wholesale supplier of wine and liquor to local package
stores. Most of Mark’s sales are on credit with terms of 1/10, n/45. The receivables turnover
ratio has declined from 11.3 in 2010 to 8.3 in 2014. Mark is concerned about the decline
and is unsure of what steps he should take to improve the ratio.
1. List three potential reasons for such a significant decline.
2. What are three things Mark should consider doing to improve the ratio?
3. How is the receivables turnover ratio used and what does it measure?
Solutions:
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Exercise 3 – World Wide Web Research and Financial Analysis Activity
Chapter 13
In assessing the financial performance of a company, investors are interested in the core or
sustainable earnings of a company. In addition, investors are interested in making
comparisons from period to period. Three basis tools are used in financial statement
analysis: horizontal analysis, vertical analysis, and ratio analysis. Go to
http:/www.marketvolume.com, to find an investing glossary of useful terms. Presently, the
glossary is at the very bottom of the home page. Define the following terms:
1. Accounts receivable turnover
2. Ankle biter
3. Average collection period, or days’ receivable
4. Big uglies
5. Cash flow coverage ratio
6. Common-size analysis
7. Debt-service coverage ratio
8. Fall out of bed
9. Horizontal analysis
10. Inventory turnover
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11. Liquidity ratios
12. Macaroni defense
13. P/E ratio
14. Profitability ratios
15. Vertical analysis
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Exercise 4 – World Wide Web Research and Irregular Items Accounting Activity
Chapter 13
Indicate which of the following items would be reported as a change in accounting principle:
a. Change from FIFO to average cost method of accounting for inventory.
b. Change from ten-year estimated remaining useful life of machinery to two-year
estimated remaining life.
c. Change from straight-line depreciation method to units–of-activity depreciation
method.
d. Change in the market value of an available-for-sale security.
e. Change in the accounting for start-up costs mandated by the FASB.
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Exercise 6 – World Wide Web Accounting Careers Research Activity
Chapter 13
The Office of the Comptroller of the Currency (OCC) is a bureau of the Department of
Treasury that charters, regulates, and supervises national banks. The OCC has a number
of career opportunities for individuals with accounting majors. To learn more about these
career opportunities, go to http://www.occ.treas.gov/. Click on Careers at the OCC and then
Experienced Bank Examiners.
1. Examiners at the OCC work in specialty areas. Summarize the types of activities in
which examiners in each of the following specialty areas would engage:
a. International examiner
b. Asset management specialists
c. Bank information technology specialists
d. Capital markets examiners
e. Compliance specialists
f. Credit examiners
g. Retail credit specialists
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Exercise 7 – Library or World Wide Web Research and Financial Analysis Activity
Chapter 13
Bristol-Myers Squibb and Merck are leaders in the pharmaceutical industry. Conduct
research in your school library or on the Internet to find the annual reports of Bristol-Myers
Squibb and Merck. If researching the web, go to http://www.bms.com to find financial
information on Bristol-Myers Squibb. Merck is located at http://www.merck.com.
1. Using the information in the annual reports, evaluate Bristol-Myers Squibb and
Merck on the basis of liquidity, profitability, and solvency. Identify the measures you
use and comment on the significance of these measures.
2. Assume you have $10,000 to invest. Based on the financial analysis conducted in
part 1, would you invest in Bristol-Myers Squibb or Merck?
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Exercise 8 – Library or World Wide Web Research and Accounting Activity
Chapter 13
Wyeth is a research-based, global pharmaceutical company responsible for the discovery
and development of some of today’s most innovative medicines. Its products are sold in
more than 140 countries, and its product portfolio includes innovative treatments across a
wide range of therapeutic areas. Conduct research in your school library or on the Internet
to find the annual report of Wyeth. If researching the web, go to http://www.wyeth.com/ to
find the latest annual report. One of the notes to the Financial Statements of Wyeth relates
to divestitures and other significant items. Another note relates to special charges. How are
these items reported on the financial statements of Wyeth? Does Wyeth have any items on
the income statement that probably meet one of the requirements for extraordinary
treatment, but not both?