Ch05 Merged

© 2013 Cengage Learning. All Rights Reserved.
May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
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Chapter
3
Balance Sheet
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Balance Sheet
• Also called as statement of financial position and
statement of financial condition
• Shows financial condition as of a specific date
• The accounting equation expresses the
relationship among elements of balance sheet
Assets = Liabilities + Stockholders’ Equity
• Format
– Account form (side by side)
– Report form (assets at top and liabilities and
stockholders’ equity at bottom) dominant in the U.S.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for classroom use.
Exhibit 3-1—Quaker Chemical
Corporation
Exhibit 3-1—Quaker Chemical
Corporation
Assets
• Probable future economic benefits obtained or
controlled by an entity as a result of past
transactions or events
• May be physical or intangible
• Major categories
– Current Assets
• Includes cash, and assets that will be realized in cash during
the operating cycle or one year which ever is longer
– Noncurrent or Long-term Assets
• Includes assets that take longer than one year or operating
cycle to convert or to conserve cash
Current Assets
• Cash and assets that will be converted into cash
during the operating cycle or within a year,
whichever is longer
• Presented in order of liquidity
• Cash
– Includes negotiable checks, unrestricted balance in
checking accounts, cash on hand, savings accounts
Current Assets—Continued
• Marketable Securities—readily determinable
market price
– Debt or equity securities
– Carried at fair value
– To be converted into cash during the current period
• Accounts Receivable
– Amounts due from sales or services rendered
– Carried at net realizable value (net of allowances)
– All allowances are carried in one allowance account
– Other receivables due from nontrade sources
• Inventories
– Balance of goods on hand
– Categories
• Merchandise on hand—retail or wholesale firms
• Raw materials
• Work in process Manufacturer
• Finished goods
– Carried at the lower of cost or market
– Supplies could include register tapes, pencils, or
sewing machine needles for the shirt factory
• Prepaids
– Expenditures made in advance of the use of the
service or goods
– Represent future benefits resulting from past
transactions
– Examples
• Insurance
• Advertising
• Taxes
• Promotion costs
• Early payments on long-term contracts
Long-Term Assets: Tangible
• Land
– Carried at acquisition cost
– Not subject to depreciation
– Natural resources are depleted
• Buildings
– Presented at cost plus permanent improvements
– Depreciated over their estimated useful life
Long-Term Assets: Tangible—
Continued
• Machinery
– Historical cost, including costs of delivery, installation,
and material improvements
– Depreciated over its useful life
• Construction in Progress
– Assets under construction
– Costs will be transferred to permanent asset account
upon completion
Continued
• Accumulated Depreciation
– Carries the to-date depreciation of plant assets
– It is subtracted from the cost of the asset to determine
the book value
– Factors used in depreciation calculation
• Asset cost
• Length of the life of the asset
• Estimated salvage (residual) value of asset when retired
Continued
• Depreciation Methods
– Straight-line
– Declining-balance
– Sum-of-the-years’-digits
– Units-of-production
• Balance Sheet Presentation
Cost of the asset
Less: Accumulated depreciation
Net book value
Depreciation: Straight-Line Method
• Cost of asset $10,000
• Estimated salvage $ 2,000
• Estimated life 5 years
Cost  Salvage Value

= Annual Depreciation
Estimated Value
$10,000  $2,000
 $1,600
5 Years
Depreciation: Straight-Line Method
—Continued
• The salvage value is not depreciated and it
equals book value at end of useful life
Accumulated
Depreciation for Depreciation at Book Amount
Year Year End of Year Cost at End of Year
1 $1,600 $1,600 $10,000 $8,400
2 1,600 3,200 10,000 6,800
3 1,600 4,800 10,000 5,200
4 1,600 6,400 10,000 3,600
5 1,600 8,000 10,000 2,000
Depreciation: Declining-Balance
Method
• Cost $10,000
1
× 2 = Double the straight-line rate*
Estimated Life
1
× 2 × Book Value at Beginning of Year = Annual Depreciation
5
*Double the straight-line rate is the maximum rate
Depreciation: Declining-Balance
Method—Continued
• Salvage value is not used in the depreciation
formula but depreciation ends when the book
value equals the salvage value
Accumulated Book Amount Book
Depreciation at at Beginning Depreciation Amount at
Year Cost Beg. of Year of Year for Year End of Year
1 $10,000 — $10,000 $4,000 $6,000
2 10,000 $4,000 6,000 2,400 3,600
3 10,000 6,400 3,600 1,440 2,160
4 10,000 7,840 2,160 160 2,000
5 10,000 8,000 2,000 — 2,000
Depreciation:
Sum-of-the-Years’-Digits Method
• Cost $10,000
Number of Remaining Years
 (Cost  Salvage) = Annual Depreciation
Sum of Digits of Estimated Life
5
 ($10,000  $2,000)  $2,666.67
(5  4  3  2  1) or 15
Depreciation: Sum-of-the-Years’-
Digits Method—Continued
Cost Less Accumulated Book
Depreciation
Year Salvage Fraction Depreciation at End Amount at
for Year
Value of Year End of Year
1 $8,000 5/15 $2,666.67 $2,666.67 $7,333.33
2 8,000 4/15 2,133.33 4,800.00 5,200.00
3 8,000 3/15 1,600.00 6,400.00 3,600.00
4 8,000 2/15 1,066.67 7,466.67 2,533.33
5 8,000 1/15 533.33 8,000.00 2,000.00
Depreciation:
Units-of-Production Method
• Cost $10,000
• Estimated total hours 16,000
• Actual hours of operation 2,000
Cost  Salvage Value
 Per Unit Depreciation
Estimated Life in Capacity
10,000  2,000
= $0.50
16,000 Hours
Depreciation: Units-of-Production
Method—Continued
• Actual Hours of Operation × Rate = Depreciation
• 2,000 hours × $0.50 = $1,000
– Therefore, the depreciation expense for year one is
$1,000
• Asset is depreciated until book value equals
salvage value
Long-Term Assets: Leases
• Capital Lease
– It is in-substance an ownership arrangement
– Classified as long term asset; shown net of
amortization
Long-Term Assets: Investments
• Debt or Equity Securities
– Held to maintain business relationship or to exercise
control
• Debt Securities Classification
– Held-to-maturity securities are carried at amortized
cost
– Available-for-sale securities are carried at fair value
Long-Term Assets: Investments—
Continued
• Equity Securities
– Carried at fair value which have 3 levels for input
• Level 1: Quoted price for identical item in active market
• Level 2: Adjusted quoted price of similar asset (or liability)
• Level 3: Present value of expected cash flows
– Exception- Equity method is used where there is
significant influence
• Cost is adjusted for the proportionate share of the rise/fall in
the retained profits of the subsidiary (investee)
Long-Term Assets: Intangibles
• Intangibles are nonphysical assets
• They are recorded at historical cost
• An intangible asset that has a finite life is
amortized over its useful life
• An intangible asset with an indefinite life are
reviewed for impairment
Long-Term Assets: Intangibles—
Continued
• Goodwill
– Arises form the acquisition of a business where price
paid exceeds the fair value of net assets
– According to U.S. GAAP it is not amortized but tested
annually for impairment
• Patents
– Exclusive legal rights granted to an inventor for a
period of 20 years
– Valued at their acquisition cost
– Amortized over shorter of legal or useful life
Continued
• Trademarks
– Distinctive names or symbols
– Indefinite legal life
– Not amortized but tested for impairment annually
• Franchises
– Legal right to operate under a particular corporate
name, providing trade-name products or services
– Amortize over the life of the franchise
Continued
• Copyrights
– Rights that authors, painters, musicians, sculptors,
and other artists have in their creations and
expressions
– It is granted for life of the creator, plus 70 years
– Amortize over the period of expected benefit
Other Noncurrent Assets
• Few assets do not fit into any of the previously
discussed classification
– Include noncurrent receivables and noncurrent
prepaids
Liabilities
• Probable future sacrifices of economic benefits
arising from present obligations of a particular
entity to transfer assets or provide services to
other entities in the future as a result of past
transactions or events
– Current Liabilities
– Long-term Liabilities
Current Liabilities
• Obligations whose liquidation is reasonably
expected within one year or the operating cycle,
whichever is longer
• Require
– Use of existing current assets
– Creation of other current liabilities
Current Liabilities—Continued
• Payables
– Short-term obligations created by the acquisition of
goods or services
• Unearned Income
– Payments collected in advance of the performance of
services or delivery of goods
• Other Current Liabilities
Long-Term Liabilities
• Due in a period beyond one year or operating
cycle, whichever is longer
• Types
– Financing arrangements of assets
– Operational obligations
Liabilities Relating to Financing
Agreements
• Notes Payable
– Promissory notes
– If secured by property, they are called mortgage
notes
• Credit Agreements
– Ready lines of credit that may require a compensating
balance
– In return for giving a credit agreement, the bank or
insurance company obtains a fee
– Not a liability until funds are drawn
Liabilities Relating to Financing
Agreements—Continued
• Bonds Payable
– Sold at par, premium, or discount
– Premium or discount is amortized into interest
expense
– Bond carrying value is amortized to par value
– Convertible bonds can be converted into common
stock
– Conversion feature enhances the bond’s selling price
Exhibit 3-13—Bonds at Par,
Premium, or Discount
Liabilities Relating to Operational
Obligations
• Deferred Taxes
– Caused by using different accounting methods for tax
and reporting purposes
– It causes tax expense for reporting purposes to be
higher than taxes payable according to the tax return
• The difference is deferred tax
• Warranty Obligations
– Estimated obligations arising out of product
warranties
– Estimated to recognize the obligation at the balance
sheet date and to charge expense
Obligations—Continued
• Noncontrolling Interest
– Previously called “minority interest”
– Reflects the ownership of noncontrolling shareholders
in the equity of consolidated subsidiaries less than
wholly owned
– Reported on consolidated financial statements as
equity, but separate from parents equity
– If material, analysis can be performed twice
• Once as a liability to be conservative and then as
shareholders’ equity item
Obligations—Continued
• Other Noncurrent Liabilities
• Redeemable Preferred Stock
– Excluded from stockholders’ equity
– For analysis, treated as a liability
Stockholders’ Equity
• Also called shareholders’ equity
• The residual ownership interest in the assets of
an entity that remains after deducting its
liabilities
– Paid-in capital
– Retained earnings
Stockholders’ Equity: Paid-In
Capital
• Two basic types of capital stock
– Preferred
– Common
• Par value
– In some states, referred to as “stated value stock”
– Considered “legal capital” by many states
– Established by the articles of incorporation
– Usually a minimal value
• Some states allow the issuance of no-par stock
Stockholders’ Equity:
Paid-in Capital—Continued
• Additional Paid-In Capital
– Issue price in excess of par (stated) value
– Other sources
• Treasury stock transactions
• Stock dividend transactions
• Donated capital
Stockholders’ Equity: Common
Stock
• Shareholder ownership
– Voting rights
• Election of board of directors
• Major corporate decisions
– Liquidation rights secondary to
• Creditors
• Preferred stockholders’
Stockholders’ Equity: Preferred
Stock
• Does not normally convey voting rights
– May carry any or all of these features:
• Preference as to dividends
• Accumulation of dividends
• Participation in excess of stated dividend rate
• Convertibility into common stock at holder’s discretion
• Callability by the corporation
• Redemption at future maturity date
• Preference in liquidation secondary to creditors
Stockholders’ Equity: Donated
Capital
• May be included in the paid-in capital
• Donated by outside entities
• Example: Shareholder surrender of stock
Stockholders’ Equity: Retained
Earnings
• Undistributed earnings of the corporation
– Net income for all prior periods
• Less dividends (both cash and stock) declared to
shareholders
Stockholders’ Equity: Others
• Quasi-Reorganization
– Eliminates a deficit balance of retained earnings and
an equal amount from paid-in-capital
– Retained earnings dated as of the readjustment date
and disclosed in the financial statements for a period
of five to ten years
• Accumulated Other Comprehensive Income
– Represents retained earnings from other
comprehensive income
– Disclosed as a separate component on the face of the
balance sheet or in the notes
Stockholders’ Equity: Others—
Continued
• Employee Stock Ownership Plans (ESOPs)
– A qualified stock-bonus plan, or a combination of
stock-bonus and money-purchase pension plan
– Tax benefits for the employer and employee
– Unearned compensation decreases stockholders’
equity
Stockholders’ Equity: Others—
Continued
• Treasury Stock
– Stock purchased and held by the issuing corporation
– Record treasury stocks in two ways
– Par-value method
• Removes the paid-in capital in excess of par from the original
issue
• Appears as a reduction of paid-in capital
– Cost method
• Records treasury stock at the cost of the stock (presented as
a reduction of stockholders’ equity)
• Most firms record treasury stock at cost
Statement of Stockholders’ Equity
• Reconciles the beginning and ending balances
of stockholders’ equity accounts
• Changes in stockholders’ equity accounts
– Issuance of stock increases paid-in capital
– Acquisition of treasury stock increases treasury stock
– Net income increases retained earnings
– Dividends decreases retained earnings
• This account is related to comprehensive
income
Problems in Balance Sheet
Presentation
• Financial analysis is complicated by
– Many assets recorded at cost rather than fair
(replacement) value
– Varying valuation methods
• Within a firm from product to product
• Within an industry from firm to firm
– Not all items of value are listed as assets
– Certain contingent liabilities may be excluded
International Consolidated Balance
Sheet (IFRS)
• Asset section
– Usually noncurrent assets are presented first,
followed by current assets
• Liabilities and Owner’s Equity section
– “Capital and reserves” are usually listed first, then
noncurrent liabilities, and at last, current liabilities
• The reserves sections of “capital and reserves” would not be
part of U.S. GAAP
Subsequent Events
• Occur during the period between the balance
sheet date and the date statements are issued
• Types
– Events requiring retroactive recognition
• Relates to estimates that were made and subsequent events
indicates estimates were incorrect
– Events requiring disclosure in the notes to the
financial statements
• Does not affect the balance sheet, but is significant to the
users of the financial statement
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
Chapter
4
Income Statement
classroom use.
The Income Statement
• Summarizes revenues and expenses, and gains
and losses
• Ends with the net income for a specific period
• Multiple-step format—presents separately
– Gross profit
– Operating income
– Income before taxes
– Net income
The Income Statement—Continued
• Single-step format
– Totals all revenues and gains
– Deducts total expenses and losses
Multiple-Step Single-Step
Multiple-step Income Statement Single-step Income Statement
For the Year Ended December 31, 2013 For the Year Ended December 31, 2013
Net revenue $37,586 Net revenue $ 37,586

Cost of sales 16,742 Interest income 488
Gross margin 20,844 Other income -
Operating Expenses: 38,074
General & administrative $ 5,458 Costs and Expenses:
Research & development 5,722 Cost of sales $ 16,742
Restructuring charges 710 11,890 General & administrative 5,458
Operating income 8,954 Research & development 5,722
Interest income (expense) 488 Other losses 1,756
Other gains (losses) (net) (1,756) (1,268)
Restructuring charges 710 30,388
Income before taxes 7,686
Income before taxes 7,686
Provision for taxes 2,394
Provision for taxes 2,394
Net Income $ 5,292
Net income $ 5,292
Basic Elements of the Income
Statement
• Net Sales (Revenues)
• Cost of Goods Sold (Cost of Sales)
• Other Operating Revenue
• Operating Expenses
• Other Income or Expense
Net Sales (Revenues)
• Represents revenue from the sale of principal
goods or services sold to customers
• Shown net of
– Discounts
– Returns
– Allowances
Cost of Goods Sold (Cost of Sales)
• The cost of goods that were sold to produce
revenue
Retailer Manufacturer
Beginning Inventory Beginning Inventory
+ Purchases + Cost of Goods Manufactured
− Ending Inventory − Ending Inventory
Cost of Goods Sold Cost of Goods Sold
• A service firm will not have cost of goods sold,

but it will often have cost of services
Other Operating Revenue
• Depends on the operations of the business
• Examples
– Lease revenue
– Royalties
Operating Expenses
• Consist of two types
– Selling expenses
• Result from a company’s effort to create sales
• Advertising. Sales commissions, and Sales supplies used
– Administrative expenses
• Relate to the general administration of a company’s
operation
• Salaries, Insurance, and Bad debt expense
Other Income or Expense
• Secondary activities not directly related to
operations
• Dividend income. Interest income, Gains
(losses) from sale of assets, and Interest
expense
Special Income Statement Items
• Unusual or Infrequent Item Disclosed Separately
– Shown with normal recurring revenues and expenses
– If material, disclosed separately, before tax
– Treatment for analysis
• Included in primary analysis as they relate to operations
• In supplementary analysis, it should be removed net after tax
Special Income Statement Items—
Continued
• Equity Earnings of Nonconsolidated Subsidiaries
– The investor’s proportionate share of the investee’s
net income
– Does not represent cash flow to the investor
• Cash dividends received represent cash flow
– Analysis issues
• Investor’s net income includes revenue of other entity
• May distort ratios
• Presented before tax; tax consequences typically immaterial
Continued
• Income Taxes Related to Operations
– Federal, state, and local taxes
– Includes both paid and deferred taxes
• Discontinued Operations
– Reported net of income tax
– Profitability analysis issues
• Inadequate disclosure of associated assets
• Lack of historical profit and loss information on the
discontinued operations
Special Income Statement Items —
Continued
• Extraordinary Items
– Unusual and infrequent
– Reported net of income tax
– Analysis issues
• Exclude from primary analysis; it is not expected to recur
• Include for supplementary analysis; this approach avoids
disregarding extraordinary items
Continued
• Change in Accounting Principles
– Current GAAP requires retrospective approach,
unless it is impracticable
• Cumulative effect on prior years reported is reflected in
beginning retained earnings in the year of change
– If impracticable
• Determine the difference to the opening balances in the
accounts
– Prior to current GAAP, changes were presented using
the prospective method
Continued
• Net Income—Noncontrolling Interest (prior to
Dec. 31, 2009 it was called minority share of
earnings)
– Earnings of a partially-owned consolidated subsidiary
that would accrue to the minority owners
– Presented net-of-tax
Earnings per Share
• Earnings divided by the number of shares of
outstanding common stock
Net income
EPS =
Outstanding shares of common stock
Retained Earnings
• The accumulated undistributed earnings of the
corporation reported on the balance sheet
• Appropriated
– Restricted by law, contract, or management decision
– Not available for dividends
– Does not represent cash or any other asset
• Unappropriated
– Available for dividends
Reconciliation of Retained
Earnings
• Reported as part of the statement of
stockholders’ equity or combined with the
income statement
Beginning balance of retained earnings
+ Prior period adjustments (net of tax)
Cumulative effect of a change in accounting principle
±
(net of tax)
= Beginning balance as adjusted
+ Net income
– Dividends
= End-of-year balance of retained earnings
Dividends
• Dividends return profits to the owners of a
corporation
• Date of declaration
– Creates liability and reduces retained earnings
• Date of payment
– Eliminates liability and reduces cash
Stock Dividends
• Issuing a percentage of outstanding stock as
new shares to existing shareholders
– Assuming a small distribution (less then 25%)
• Removing the fair market value of the stock from retained
earnings and transferring it to paid-in capital
– If the stock dividend is material
• The amount transferred to paid-in capital is determined by
multiplying the par value by the number of additional shares
• Total equity is unaffected by a stock dividend
– Restate share quantities to reflect stock dividend
activity
Stock Dividend—Example
• 100,000 shares outstanding; $1 par; $5 market
• 10% stock dividend on 100,000 shares, issue
10,000 additional shares recorded at $5 per
share
10% stock dividend
Before Effect of dividend After
Common stock par value $1.00 $1.00
Shares outstanding 100,000 issue 10,000 shares 110,000
Total par value $100,000 10,000 $110,000
Additional paid-in capital 750,000 40,000 790,000
Total paid-in capital 850,000 900,000
Retained earnings 1,000,000 (50,000) 950,000
Total stockholders' equity $1,850,000 $1,850,000
Stock Dividend Example
• 100,000 shares outstanding; $1 par; $5 market
• 40% stock dividend on 100,000 shares, issue
40,000 additional shares recorded at $1 per
share
40% stock dividend
Before Effect of dividend After
Common stock par value $1.00 $1.00
Shares outstanding 100,000 issue 40,000 shares 140,000
Total par value $100,000 40,000 $140,000
Additional paid-in capital 750,000 750,000
Total paid-in capital 850,000 890,000
Retained earnings 1,000,000 (40,000) 960,000
Total stockholders' equity $1,850,000 $1,850,000
Stock Splits
• 2-for-1 split
– Doubles the quantity of stock
– Par or stated value is halved
• No effect on retained earnings, additional paid-in
capital, or capital stock accounts
• Analysis issues
– Restate share quantities to reflect split activity
Legality of Distributions to
Shareholders
• As per various state laws
– Distributions to stockholders are acceptable as long
as the firm has the ability to pay debts as they come
due in the normal course of business
– Distributions to stockholders are acceptable as long
as the firm is solvent and the distributions do not
exceed the fair value of the assets
– Distributions consist of solvency and balance sheet
test of liquidity and risk
Comprehensive Income
• Foreign currency translation adjustments
• Unrealized holding gains and losses on
available-for-sale marketable securities
• Changes to stockholders’ equity resulting from
additional minimum pension liability adjustments
• Unrealized gains and losses from derivative
instruments
Net income
+ The period’s change in accumulated other comprehensive income
= Comprehensive income
Comprehensive Income—
Continued
• Required disclosures
– Comprehensive income
– Each category of other comprehensive income
– Reclassification adjustments for each category of
other comprehensive income
– Tax effects for each category of other comprehensive
income
– Balances for each category of accumulated other
comprehensive income
Continued
• Presentation
– A single income statement reporting net income and
comprehensive income, or
– Report comprehensive income in a separate
statement immediately following the statement of
income
• Analysis issues
– Typically more volatile than net income
• A better indication of long-run profitability
Combined with Income Statement
XYZ Corporation
Statement of Income and Comprehensive Income
For the Year Ended December 31, 2013
Sales $ 230,000
Cost of goods sold 140,000
Gross profit 90,000
Operating expenses 40,000
Operating income 50,000
Other income 4,000
Income before income taxes 54,000
Income taxes 20,000
Net income 34,000
Other comprehensive income
Available-for-sale security adjustment, net of tax 5,500
Minimum pension liability adjustment, net of tax 3,500
Foreign currency transaction adjustment, net of tax (5,000)
Other comprehensive income 4,000
Comprehensive income $ 38,000
Earnings per share (for net income only) $ 2.80

Comprehensive Income—Separate
Statement
XYZ Corporation
Statement of Comprehensive Income
For the Year Ended December 31, 2013
Net income $ 34,000

Other comprehensive income
Available-for-sale security adjustment, net of tax 5,500
Minimum pension liability adjustment, net of tax 3,500
Foreign currency transaction adjustment, net of tax (5,000)
Total other comprehensive income 4,000
Comprehensive income $ 38,000
Income Statement IFRS vs. GAAP
• IFRS and U.S. GAAP for income statements are
similar, with some presentation differences
– IFRS has no required format of the income statement
– IFRS classifies expenses based on their nature or
function
– IFRS equipment may be revalued which result in the
adjustment of depreciation expenses
– IFRS allows for alternative performance measures to
be presented in income statement
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
Chapter
5
Basics of Analysis
classroom use.
Ratio Analysis
• Liquidity ratios
– Measures a firm’s ability to meet its current
obligations
• Borrowing capacity (leverage) ratios
– Measures the degree of protection for long-term
creditors
• Profitability ratios
– Measures the earning ability of a firm
• Cash flow ratios
Ratio Analysis—Continued
• Interpreted in comparison with
– Prior ratios
– Competitor’s ratios
– Industry ratios
– Predetermined standards
• Trend and variability of a ratio are important
considerations
Complexities and Context
• Use of average data from balance sheet
– Necessary when comparing with income statement
data
– Does not
• Eliminate seasonal or cyclical variations
• Reflect changes that occur unevenly throughout the year
• Analysis must be performed and understood
within the context of
– Native accounting principles
– Native business practices and culture
Common-Size Analysis
• The use of percentages is usually preferable to
the use of absolute amounts
• Vertical analysis
– All amounts of a year expressed as a percentage of a
base amount of the same year (e.g., net sales
revenue, total assets)
• Horizontal analysis
– Amounts for comparative years are expressed as a
percentage of the base year amount
Exhibit 5-1: Melcher Company—
Vertical Common Size
Each financial statement element is presented as a percentage of a

designated base which is sales revenue on the income statement
Exhibit 5-1: Melcher Company—
Horizontal Common Size
Each financial statement element is presented as a percentage of a

base amount from a selected year
Year-to-Year Change Analysis
• Use both absolute and percentages
• Guidelines
– When an item has value in the base year and none in
the next period, the decrease is 100%
– A meaningful percent change cannot be computed
when one number is positive and the other number is
negative
– No percent change is computable when there is no
figure for the base year
Industry Variations
• Financial components vary by type of industry
• Merchandising
– Inventory is a principal asset
– Sales may be primarily for cash or on credit
• Service
– Inventory is low or nonexistent
• Manufacturing
– Large inventory holdings
– Substantial investment in plant assets
– Cost of sales often represents the major expense
Descriptive Information
• Narrative data
– Annual report
– Trade periodicals
– Industry reviews
• Further explains the financial position of a firm
• Management Discussion and Analysis (MD&A)
provides an overview of the previous year and of
future goals and new projects
Comparisons
• Provides context for analysis of ratios and
financial data
• Common types
– Trend analysis
– Standard Industrial Classification (SIC) Manual
• The U.S. Department of Labor provides Web site that details
the SIC manual
– North American Industry Classification System
(NAICS)
– Industry Averages and Comparison with Competitors
Comparisons: Trend Analysis
• A study of the financial history of a firm
• It reveals whether the ratio is
– Falling
– Rising
– Relatively constant
• Highlight
– Effective management
– Evidence of problems
Comparisons: SIC
• Classifies business by industry
• Defines industries in accordance with the
composition and structure of the economy
• Coding structure
– Two-digit major group number
– Three-digit industry group number
– Four-digit industry number
Comparisons: NAICS
• Jointly created by the U.S., Canada, and Mexico
• Industry is defined by similar production
processes
• U.S. Census Bureau provides a Web site
(www.census.gov) that that details the NAICS
manual. Go on this site and under “business and
industry” click on NAICS
Comparisons: Industry Averages
• Industry comparison complicated by highly
diversified companies
• Financial services
– Base their analysis on industry placement
– Provide composite industry data
Financial Services’ Publications
Publication Publisher(s) Coverage Data Classification
The Department Economic Manufacturing, Income NAICS
of Commerce Surveys mining, and statement
Financial Report Division, Bureau trade and balance
of the Census corporations sheet data
and ratios
Annual Risk Manufacturing, Common- NAICS or SIC
Statement Management wholesaling, size financial
Studies Association retailing, statements
service, and 16
agriculture, and selected
construction ratios
Standard & Standard & North American Industry NAICS
Poor’s Industry Poor’s and global write-ups
Surveys industries and statistics
Financial Services’ Publications—
Continued
Publication Publisher(s) Coverage Data Classification
Almanac of CCH, Inc. 200 industries Corporate NAICS
Business and tax return
Industrial data
Financial Ratios
Industry Norms Dun & 800 business Condensed SIC

and Key Bradstreet lines financial
Business Ratios statements;
ratios
Value Line The Standard 1 to 97 Longitudinal

Investment Edition and the industries; financial
Survey Small & 1 to 84 information
Mid-Cap Edition industries
Comparisons: Caution in Using
Industry Averages
• Ratios are subject to variance from
– Differing data
– Inconsistent formula construction
– Optional (elective) accounting treatment
– Different fiscal year-ends
– Varying financial policies
– Inconsistent basis (before or after tax)
Relative Size of Firm
• Comparison of disparate size firms
– Capital market access
– Economy of scale (purchasing)
– Wider customer base
• Information
– Absolute numbers amplifies comparison difficulty
– Common-size analysis help to eliminate some of the
difficulty
• Percent of market helps to define relative size
Ward’s Business Directory
• Covers domestic private and public companies
• Up to 20 items of information are provided for
each company listed
• Went digital in 2007 under Gale Directory
Library
Standard & Poor’s Stock Reports
• Companies listed on various stock exchanges
– New York Stock Exchange
– American Stock Exchange
– NASDAQ stock market
– Regional exchanges
• Arranged Alphabetically by stock exchanges
– Contains brief analysis of companies regularly traded
Standard & Poor’s Register Of
Corp., Directors, And Executives
• Contains 2-volumes
– Volume 1
• Alphabetical list of approximately 75,000 corporations
– Volume 2,
• Section 1 contains an alphabetical list of over 70,000
individuals serving as officers, directors, trustees, partners,
and so on
• Section 2 is divided into seven subsections providing
additional details
Standard & Poor’s Analyst’s
Handbook
• Selected income statement and balance sheet
items
• Related ratios
• Applicable to Standard & Poor’s industry group
stock price indexes
• Brief monthly updates for selected industries
supplement the annual editions of the handbook
Standard & Poor’s Standard
Corporation Descriptions
• U.S. corporations
– Background information
– Detailed financial statistics
• The contents and the index are updated
throughout the year
Standard & Poor’s Security
Owner’s Stock Guide
• Covers 5,300 common and preferred stocks
• It contains trading activity, price range,
dividends, and so on, for companies traded on
– New York Stock Exchange
– American Stock Exchange
– Over the Counter
– Regional Exchanges
Standard & Poor’s Statistical
Service
• Industry statistics on industries such as
– Agriculture
– Metals
– Building
– Transportation
• Additional statistics are included such as price
indexes and daily highs, lows, and closes for
stock
Standard & Poor’s Net Advantage
• Available at many academic, public, and
corporate libraries, and information centers
• Other publication available with Net Advantage
– Standard & Poor’s Stock Reports
– Standard & Poor’s Register of Corporations, Directors
and Executives
– Stand and Poor’s Standard Corporation Descriptions
Mergent and Standard & Poor’s
Dividend Record
• Provide a dividend record of payments on
virtually all publicly owned American and some
foreign companies
D&B® Million Dollar Directory®
• Companies must meet at least one of two
inclusion requirements
– $9 million or more in sales volume
– 180 or more employees if company is a headquarters
single location, 900 or more if employees if company
is a branch
• Company listings in Volumes
– Alphabetical
– Geographically
– SIC
Directory Of Corporate Affiliates™
• Gives an in-depth view of companies and their
divisions, subsidiaries, and affiliates
• Contains an alphabetical index, geographical
index, and SIC classifications
• The parent company listing consists of address,
telephone number, stock ticker symbol, stock
exchange(s), approximate sales, number of
employees, type of business, and top corporate
officers
Thomas Register Of American
Manufacturers
• Comprehensive reference
– Products and services
– Company profiles
– Catalog file
Mergent Industrial Manual and
News Reports
• Published in two volumes
• Covers 2000 industrial corporations listed
– On New York and American Stock Exchanges and
other selected exchanges
• Provides information such as history, business,
properties, subsidiaries, financial statements,
and SIC codes
D&B Reference Book of Corporate
Managements
• Contains profile information on over 200,000
principal corporate officers in over 12,000
companies
• This information includes
– Year of birth
– Education
– Military service
– Present business position
– Previous positions
Compact Disclosure
• Database of textual and financial information on
about 12,000 public companies
• Taken from reports filed with the SEC
• Contents
– Major financial statements
– Financial ratios
– Institutional holdings
– Insider ownership
– President’s letter
– Financial notes
Lexis-Nexis
• Provides accounting, legal, newspaper, and
periodical information
• Includes financial statements from annual
reports for thousands of publicly traded
companies
The Users of Financial Statements
• Management
– Analyze information from the perspective of both
investors and creditors
• Investors
– Analysis of past and present information to project the
future prospects of the entity
• Creditors
– Short-term creditor focus on current resources
– Long-term creditors consider the future prospects of
the firm

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© 2013 Cengage Learning. All Rights Reserved.

Cost  Salvage Value

*Double the straight-line rate is the maximum rate

2 8,000 4/15 2,133.33 4,800.00 5,200.00

3 8,000 3/15 1,600.00 6,400.00 3,600.00

4 8,000 2/15 1,066.67 7,466.67 2,533.33

5 8,000 1/15 533.33 8,000.00 2,000.00

Net revenue $37,586 Net revenue $ 37,586

• A service firm will not have cost of goods sold,

Earnings per share (for net income only) $ 2.80

Net income $ 34,000

Each financial statement element is presented as a percentage of a

Each financial statement element is presented as a percentage of a

Industry Norms Dun & 800 business Condensed SIC

Value Line The Standard 1 to 97 Longitudinal

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