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Flashcards in Chapter 13 Deck (97):

Sustainable income

Net income adjusted for irregular items

*Most likely level of income to be obtained in the future


Two types of irregular items:

1. Discontinued operations

2. Extraordinary items


Discontinued operations

The disposal of a significant component of a business

Ex. elimination of a major class of customers or an entire activity


Extraordinary items

Events and transactions that meet two conditions:

1. Unusual in nature

2. Infrequent in occurrence


To be considered unusual:

The item should be abnormal and only incidentally related to the customary activities of the entity



To be considered infrequent:

The event or transaction should not be reasonably expected to recur in the foreseeable future


Where are extraordinary items reported?

They are net of taxes in a seperate section of the income statement, immediately below discontinued operations


What if only one criteria for extraordinary items is met?

Reported as a seperate line item in the upper portion of the income statement

"Other revenues and gains" or "Other expenses and losses"


Ordinary gains and losses are reported at what?

Pretax amounts in arriving at income before income taxes


Change in accounting principle

When the principle used in the current year is different from the one used in the preceding year

ex. Change in inventory costing methods

Account rules permit a change when management can show that the new principle is preferable to the old principle



How do companies report most changes in accounting principles?


They report both the current period and previous periods using the new principle. => same principle applies in all periods

*Improves the ability to compare results across years*


Why should changes in accounting principles occurr?

Should result in financial statements that are more informative for statement users


Comprehensive income

Includes all changes in stockholders' equity during a period except those changes resulting from investments by stockholders and distributions to stockholders


Trading security

Bought and held primarily for sale in the near term to generate income on short-term price differences


Where are unrealized losses on trading securities reported?

In the "Other expenses and losses" section of the income statement

Rationale: it is likely that the company will realize the unrealized loss (or gain), so the company should report it as a part of net income


Available-for-sale securities

Held with the intent of selling them sometime in the future

Report as part of "Other comprehensive income" - direct adjustment to stockholders' equity


2 important purposes of reporting the unrealized gain or loss in the stockholders' equity sections:

1. Reduces the volatality of net income due to fluctuations in fair value

2. Informs the financial statement user of the gain or loss that would occur if the company sold the securities at fair value


Three types of comparisons:

1. Intracompany basis - detect changes in financial relationships and significant trends

2. Intercompany basis - provide insight into a company's competitive position

3. Industry averages - insight on a company's relative position within the industry


Cross-country comparisons

Should improve as more countries adopt international accounting standards

International standards open to widely varying interpretations

Still not as transparent as within-country comparisons



Horizontal analysis

A technique for evaluating a series of financial statement data over a period of time to determine the increase (decrease) that has taken place, either an amount of a percentage


Change Since Base Period = 

Current Year Amount - Base Year Amount

Base Year Amount


Current Results in Relation to Base Period = 

Current Year Amount

Base Year Amount


The amount of increaes may be ________________, but the percentage change may be __________________

the same as or more than the base year;

less because the base is greater each year


Vertical analysis

A technique for evaluating financial statement data that expresses each item in a financial statement as a percentage of a base amount


Vertical analysis is meaningful for what?

Comparing companies of different sizes


Liquidity ratios

Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash

Short-term creditors such as bankers and suppliers are interested


Working capital

Current assets - Current liabiliities

Liquidity ratio


Current ratio

Current assets / Current Liabilities

Liquiditiy ratio


Current cash debt coverage ratio

Cash provided by operations / average current liabilities

liquidity ratio


Inventory turnover ratio

Cost of goods sold / average inventory

liquidity ratio


Days in inventory

365 days / inventory turnover ratio

liquidity ratio


Receivables turnover ratio

Net credit sales / average net receivables

liquidity ratio


Average collection period

365 days / receivables turnover ratio

liquidity ratio


Solvency ratio

Measures the ability of the company to survive over a long period of time

Long-term creditors and stockholders are interested in a company's long run solvency, particularly its ability to pay interest as it comes due and to repay the balance of debt at its maturity


Debt to total assets ratio

Total liabilties / total assets

Solvency ratio


Cash debt coverage ratio

Cash provided by operations / Average total liabilities

solvency ratio


Times interest earned ratio

Net income + Interest expense + Tax expense

Interest expense

Solvency ratio


Free Cash flow

Cash provided by operations - Capital expenditures - Cash Dividends

*Solvency ratio*


Profitability ratios

Measure the income or operating success of a company for a given period of time

Creditors and investors are interested

Profitability = used as ultimate test of management's operating effectiveness


What does a company's profitability affect?

A company's income, or lack of it, affects its ability to obtain debt and equity financing, its liquidity position, and its ability to grow


Earnings per share

Net income - Preferred stock dividends

Average common shares outstanding

*Profitability ratio


Price-earnings ratio

Stock price per share 

Earnings per share

*Profitability ratio


Gross profit rate

Gross profit / Net Sales

*Profitability ratio


Profit margin ratio

Net income / net sales

*Profitability ratio


Return on assets ratio

Net income / Average total assets


Asset turnover ratio

Net sales / Average total assets

*Profitability ratio


Payout ratio

Cash dividends declared on common stock

Net income

*profitability ratio


Return on common stockholders' equity ratio

Net income - Preferred stock dividends

Average common stockholders' equity

*Profitability ratio


Quality of earnings

Indicates the level of full and transparent information that is provided to users of the financial statements


Pro forma income

A measure of income that usually excludes items that a company thinks are unusual or non-recurring


Why are analysts and investors critical of using pro forma income?

Because these numbers often make companies look better than they really are


Why do companies say in response to critics of pro forma?

Argue that pro forma numbers more clearly indicate sustainable income because they exclude unusual and non-recurring expenses


Current dilema with pro forma income

Everyone agrees pro forma numbers can provide insights into determining a company's sustainable income

On the other hand, companies have abused the flexibility that pro forma numbers allow and have used it to favor the company


Channel stuffing

Offering deep discounts on their prodcuts to customers, companies encourage their customers to buy early rather than later

results in poor subsequent periods


practices of improper recognition

Improper recogntion of revenue - channel stuffing

Improper capitalization of operating expenses

Failing to report all liabilities


Price-earnings (P-E) ratio

A comparison of the market price of each share of common stock to the earnings per share

Computed as the market price of the stock divided by earnings per share


What does the P-E ratio reflect?

Investors' assesment of a company's future earnings

will be higher if investors think earnigns will increase in the future

Lower means investors think the company's future earnings will not be strong


Some factors affecting quality of earnings

Alternative accounting methods

Pro forma income

Improper recognition

Price-earnings ratio


Profitability ratios

Measures of the income or operating success of a company for a given period of time


Why is Current cash debt coverage ratio considered better?

Because it uses cash provided by operating activities rather than a balance at one point in time, it may provide a better representation of liquidity


What is a disadvantage of the current ratio?

It uses year-end balances of current asset and current liability accounts and they many not represent to company's current position during most of the year


What does the receivables turnover ratio measure?

Measures the number of times, on average, a company collects receivables during the period

*asseses liquidity of the receivables


What is the average collection period  used for?

Used to asses the effectiveness of a company's credit and collection policies

Collection period should not greatly exceed the credit term period (time allowed for payment)


Inventory turnover ratio information

Measures the number of times average inventory was sold during the period

Measures the liquidity of the inventory

The faster the inventory turnover, the less cash is tied up in inventory and the less the chance of inventory becoming obsolete

Downside of high inventory turnover is that it sometimes results in lost sales because if a company keeps less inventory on hand, it is more likely to run out of inventory when it is needed


What does a high inventroy turnover ratio suggest?

Suggests inventory is being sold and replenished frequently


Differences in "Days in inventory"

Differences in product lines across the two companies

Grocery stores => 37 days

Jewlery stores => 280 days

*can even vary within a company

ex. grocery store produce and detergent


What information does free cash flow provide?

Information about the company's solvency and its ability to pay additional dividends or invest in new projects


What does debt to total assets ratio indicate?

The degree of financial leveraging

The company's ability to withstand losses without impairing the interests of its creditors


The higher the percentage of debt to total assets...

The greater risk that the company may be unable to meet its maturing obligations


 What debt to total assets ratio is desirable?

From creditor's point of view, a low debt to total assets ratio is desirable


When debt to total assets ratio equals 50%

the debt to equity ratio is 1:1


What does the debt to equity ratio show?

Shows the relative use of borrowed funds (total liabilities) compared with resources invested by the owners


Times interest earned ratio info:

(interest coverage)

Indicates the company's ability to meet interest payments as they come due

*Uses income before interest expense and income taxes because this amount represents what is available to cover interest


 A cash debt coverage ratio above ________ is acceptable



Cash debt coverage ratio info:

CAsh basis measure of solvency

Indicates a company's ability to repay its liabilities from cash generated from operating activities without having to liquidate the assets used in its operations


What does a company's profitability affect?

Its abilityto obtain debt and quity financing, its liquidity position, and its ability to grow


What does return on common stockholders' equity ratio show?

Shows how many dollars of net income the company earned for each dollar invested by the owners


What does the return on assets ratio show?

Measures the overall profitability of assetsin terms of the income earned on each dollar invested in assets


Two factors that affeect the return on common stockholders' equity ratio

Return on assets ratio

Degree of leverage



Borrowing money at a lower rate of interest than can be earned by using the borrowed money

"Trading on the equity"

Enables management to use money suppllied by nonowners to increase the return to owners


Two factors that affect the return on assets ratio

Profit margin ratio

Asset turnover ratio


Profit margin ratio information:

Rate of return on asales

A measure of the percentage of each dollar of sales that results in net income

High volume businesses (grocery stores) have low profit margins

Low-volume businesses (jewelery stores) have high profit margins


Asset turnover ratio information:

Measures how efficiently a company uses its assets to generate sales

*Shows the dollars of sales produced by each dollar invested in assets

Utility companies => .45

Grocery store => 3.49


Profit Margin x Asset Turnover =

Return on Assets


Gross profit rate

Gross profit (Net Sales - COGS)

Net Sales

Indicates a company's ability to maintain an adequate selling price above its cost of goods sold

As an industry becomes more competive, this ratio dclines


Why should earnigns per share not be compared with other companies?

Because of wide variations in the number of shares of outstanding stock among companies


Price-Earnings ratio information:

Measures the ratio of the market price of each share of common stock to the earnings per share

Reflefcts investors' assessments of a company's future earnings

Higher => suggests market is more optimistic; or stock is overpriced?


Payout rati information:

Measures the percentage of earnigns distributed in the form of cash dividends

Companies that have high growth rates often have low payout ratios because they reinvest most of their net income in the business

If a company's inet income declines but keeps its total dividend payment the same => payout ratio will increase


Extraordinary item treatment is _________ under IFRS




Name for income statement under IFRS

Statement of comprehensive income



All components of revenues ane expenses are reported in a traditional income satement except for  ______________________________

other comprehensive income or loss


By adpoting _____________, as found in IFRS, many of the earnings quality issues will disappear

principles-based approach


New joint project approach will draw attention away from...

net income


IASB decided to require a ______________

statement of comprehensive income


Presentation of comprehensive income must be reported under IFRS in:

a statement of comprehensive income


Debt to equity ratio

Shows the relative use of borrowed funds (total liabilities) compared with resources invested by the owners