AC311 Midterm 1 Liu

Classification shifting

-Shifting operating expenses to a nonoperating expense classification to report fewer operating expenses and higher operating income

Income smoothing

-Within rules allowed by GAAP, creates smoother pattern in earnings over time by altering assumptions and estimates -Overestimate expenses in current year to reduce net income, and then reverse those estimates in future years to increase net income

The two primary reasons that a company's book value in the balance sheet does not equal its market value are:

1. Many assets, like land and buildings, are measured at their historical costs rather than amounts for which the assets could be sold (often referred to as the assets' fair values). For example, suppose a company owns land and the amount for which the land could be sold increases. The increase in the land's fair value is not reported in the balance sheet, so it has no effect on the company's book value. However, to the extent the increase in the land's fair value is known by investors, that increase will be reflected in the company's overall market value. 2. Many aspects of a company may represent valuable resources (such as trained employees, experienced management team, loyal customer relationships, and product knowledge). These items, however, are not recorded as assets in the balance sheet and therefore have zero book value. Investors understand the ability of these resources to generate future profits and therefore these resources will be reflected in a company's overall market value.

Asset turnover ratio

A broad measure of asset efficiency is the asset turnover ratio. The ratio is computed by dividing a company's net sales by the average total assets available for use during a period. The denominator, average assets, is determined by adding beginning and ending total assets and dividing by two. The asset turnover ratio provides an indication of how efficiently a company utilizes all of its assets to generate revenue.

Prepaid expenses

A prepaid expense arises when a company incurs a cost of acquiring an asset in one period that won't be expensed until a future period. Examples are supplies, prepaid rent, and prepaid insurance. These assets are not converted to cash, like receivables, collected and inventory sold, but they instead are consumed in the future. Supplies are used, prepaid rent expires over the rental period, and prepaid insurance expires over the period of insurance coverage. Whether a prepaid expense is current or noncurrent depends on the period in which the item is consumed. For example, if rent on an office building were prepaid for one year, then the prepayment is classified as a current asset. However, if rent were prepaid for a period extending beyond the coming year, that portion of the prepayment is classified as a long-term asset. Nike includes prepaid expenses with other current assets. Other current assets could include assets such as nontrade receivables, that, because their amounts are not material, do not warrant separate disclosure.

Times interest earned ratio

A ratio that is commonly used in conjunction with the debt to equity ratio is the times interest earned ratio. This ratio is calculated as income before subtracting interest expense and income taxes, divided by interest expense. To remain solvent or to take on more debt if needed, a company needs to have funds available in the current year to pay interest charges. The ability of a company to "cover" its interest charges commonly is measured by the extent to which income exceeds interest charges in the current period. If income is many times greater than interest expense, creditors' interests are more protected than if income just barely covers this expense. For this purpose, income should be the amount available to pay interest, which is income before subtracting interest and income taxes, calculated by adding back to net income the interest and income taxes that were deducted.

Types of current liabilities

Accounts payable Notes payable Deferred revenues Accrued liabilities

Accounts payable

Accounts payable are obligations to suppliers of merchandise or of services purchased on account, with payment usually due in 30 to 60 days.

Account receivable

Accounts receivable result from the sale of goods or services on account (discussed in Chapter 7). Accounts receivable often are referred to as trade receivables because they arise in the course of a company's normal trade. Nontrade receivables result from loans or advances by the company to individuals and other entities. When receivables are supported by a formal agreement or note that specifies payment terms, they are called notes receivable. Accounts receivable usually are due in 30 to 60 days, depending on the terms offered to customers, and are, therefore, classified as current assets. Any receivable, regardless of the source, not expected to be collected within one year (or operating cycle, if longer) is classified as a long-term investment. In addition, receivables are typically reported at the net amount expected to be collected. The net amount is calculated as total receivables less an allowance for the estimate of uncollectible accounts.

Accrued liabilities

Accrued liabilities represent obligations created when expenses have been incurred, but amounts owed will not be paid until a subsequent reporting period. For example, a company might owe salaries at the end of the fiscal year to be paid some time in the following year. In this case, the company would report salaries payable as an accrued liability in the current year's balance sheet (as well as the related salaries expense in the income statement). Other common examples of accrued liabilities include interest payable, taxes payable, utilities payable, and legal fees payable.

Unqualified Auditors' Reports

An auditor issues an unqualified (or "clean") opinion when the auditor has undertaken professional care to ensure that the financial statements are presented in conformity with generally accepted accounting principles (GAAP). Professional care would include sufficient planning of the audit, understanding the company's internal control procedures, and gathering evidence to attest to the accuracy of the amount reported in the financial statements. In most cases, the auditors will be satisfied that the financial statements "present fairly" the financial position, results of operations, and cash flows and are "in conformity with U.S. generally accepted accounting principles." These situations prompt an unqualified opinion.

Inventory Turnover ratio

An important activity measure for a merchandising company (a retail, wholesale, or manufacturing company) is the inventory turnover ratio. The ratio shows the number of times the average inventory balance is sold during a reporting period. The more frequently a business is able to sell, or turn over, its inventory, the lower its investment in inventory must be for a given level of sales. The ratio is computed by dividing the period's cost of goods sold by the average inventory balance. The denominator, average inventory, is determined by adding beginning and ending inventory and dividing by two. A relatively high ratio, compared to a competitor, usually is desirable. A high ratio indicates comparative strength, perhaps caused by a company's superior sales force or maybe a successful advertising campaign. However, it might also be caused by a relatively low inventory level, which could mean either very efficient inventory management or stockouts and lost sales in the future. On the other hand, a relatively low ratio, or a decrease in the ratio over time, usually is perceived to be unfavorable. Too much capital may be tied up in inventory. A relatively low ratio may result from overstocking, the presence of obsolete items, or poor marketing and sales efforts. Similar to the receivables turnover, we can divide the inventory turnover ratio into 365 days to compute the average days in inventory. This measure indicates the number of days it normally takes to sell inventory.

Annual report disclosures

At the end of each fiscal year, companies with public securities are required to provide shareholders with an annual report. The annual report includes financial statements such as the balance sheet. Financial statements, though, are only part of the information provided in the annual report. Critical to understanding the financial statements and to evaluating a company's performance and financial health are additional disclosures included as part of the financial statements.

Auditors' Report

Auditors examine financial statements and the internal control procedures designed to support the content of those statements. Their role is to attest to the fairness of the financial statements based on that examination. The auditor's attest function for public business entities results in an opinion stated in the auditor's report. There are four basic types of auditor's reports: 1. Unqualified 2. Unqualified with an explanatory or emphasis paragraph 3. Qualified 4. Adverse or disclaimer

Unfavorable financial leverage

Be aware, though, leverage is risky and not always favorable; the cost of borrowing the funds might exceed the returns they provide. If the return on assets invested turned out to be less than expected, the additional debt could result in a lower return on equity for alternative 2. If, for example, the return on assets invested (before interest and income taxes) had been 6% of $50,000,000 (or $3,000,000), rather than 16%, alternative 1 would have provided the better return on equity. That is 4.125% against alternative 2, which generates only 2.25%.

Cash Equivalents

Cash equivalents are defined as short-term investments that have a maturity date no longer than three months from the date of purchase. Examples include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills. These items are listed as cash equivalents because they are highly liquid investments that can be quickly converted into cash with little risk of loss.

Investing activities

Cash flows from investing activities include inflows and outflows of cash related to the acquisition and disposition of long-lived assets used in the operations of the business (such as property, plant, and equipment) and investment assets (except those classified as cash equivalents and trading securities). The purchase and sale of inventory are not considered investing activities. Inventory are purchased for the purpose of being sold as part of the company's operations, so their purchase and sale are included with operating activities rather than investing activities.

Cash inflows

Cash inflows include cash received from: 1. Customers from the sale of goods or services 2. Interest and dividends from investments

Cash outflows from investing activities

Cash outflows from investing activities include cash paid for: 1.The purchase of long-lived assets used in the business 2.The purchase of investment securities like stocks and bonds of other entities (other than those classified as cash equivalents and trading securities) 3.Loans to other entities

Cash outflows

Cash outflows include cash paid for: 1. The purchase of inventory 2. Salaries, wages, and other operating expenses 3. Interest on debt 4. Income taxes

Non-GAAP earnings

Companies are required to report earnings based on Generally Accepted Accounting Principles (GAAP). This number includes all revenues and expenses. Most companies, however, also voluntarily provide non-GAAP earnings when they announce annual or quarterly earnings. Non- GAAP earnings exclude certain expenses and sometimes certain revenues. Common expenses excluded are restructuring costs, acquisition costs, write-downs of impaired assets, and stock-based compensation. Supposedly, non-GAAP earnings are management's view of "permanent earnings," in the sense of being a better long-run measure of its company's performance. Nearly all major companies report non-GAAP earnings. Non-GAAP earnings are controversial because determining which expenses to exclude is at the discretion of management. By removing certain expenses from reported non-GAAP earnings, management has the potential to report misleadingly higher profits. The Sarbanes-Oxley Act addressed non-GAAP earnings in its Section 401. One of the act's important provisions requires that if non-GAAP earnings are included in any periodic or other report filed with the SEC or in any public disclosure or press release, the company also must provide a reconciliation with earnings determined according to GAAP.

Current Assets

Current assets include cash and other assets that are reasonably expected to be converted to cash or consumed within one year from the balance sheet date, or within the normal operating cycle of the business if that's longer than one year. The operating cycle for a typical merchandising or manufacturing company refers to the period of time from the initial outlay of cash for the purchase of inventory until the time the company collects cash from a customer from the sale of inventory.

Current Liabilities

Current liabilities are those obligations that are expected to be satisfied through the use of current assets or the creation of other current liabilities. So, this classification includes all liabilities that are expected to be satisfied within one year from the balance sheet date (or within the operating cycle if that's longer than one year). An exception for the current liability classification is a liability that management intends to refinance on a long-term basis. For example, if management intends to refinance a six-month note payable by substituting a two-year note payable and has the ability to do so, then the six-month note payable would not be classified as current even though it's due within the coming year. The most common current liabilities are accounts payable, notes payable (short-term borrowings), deferred revenues, accrued liabilities, and the currently maturing portion of long-term debt.

Current maturities of long-term debt

Current maturities of long-term debt refer to the portion of long-term notes, loans, mortgages, and bonds payable that is payable within the next year (or operating cycle, if longer). For example, a $1,000,000 note payable requiring $100,000 in principal payments to be made in each of the next 10 years is classified as a $100,000 current liability and a $900,000 long-term liability.

Deferred revenues

Deferred revenues, sometimes called unearned revenues, represent cash received from a customer for goods or services to be provided in a future period. For example, a company records deferred revenue when it sells gift cards. Revenue is not recorded until those gift cards are redeemed by the customer for merchandise or expire without being used.

Diluted EPS

Diluted EPS incorporates the dilutive effect of all potential common shares in the calculation of EPS. Dilution refers to the reduction in EPS that occurs as the number of common shares outstanding increases. Companies may have certain securities outstanding that could be converted into common shares, or they could have stock options outstanding that would create additional common shares if the options were exercised. Because these items could cause the number of shares in the denominator to increase, they potentially decrease EPS.

Cash Flows from Operating Activities Direct method

Direct method: • Presents cash receipts and cash payments by activity. o Easy to understand. • Less common. o Hence, we will focus on the indirect method.

Financing Activities

Financing activities relate to the external financing of the company. Cash inflows occur when cash is borrowed from creditors or invested by owners. Cash outflows occur when cash is paid back to creditors or distributed to owners. The payment of interest to a creditor, however, is classified as an operating activity.

Financing cash inflows

Financing cash inflows include cash received from: 1.Owners when shares are sold to them 2.Creditors when cash is borrowed through notes, loans, mortgages, and bonds

Financing cash outflows

Financing cash outflows include cash paid to: 1.Owners in the form of dividends or other distributions 2.Owners for the reacquisition of shares previously sold 3.Creditors as repayment of the principal amounts of debt (excluding trade payables that relate to operating activities)

Gains and losses

Gains and losses are increases or decreases in equity from peripheral or incidental transactions of an entity. In general, these gains and losses do not reflect normal operating activities of the company, but they nevertheless represent transactions that affect a company's financial position. For example, gains and losses can arise when a company sells investments or property, plant, and equipment for an amount that differs from their recorded amount.

Working capital

Implicit in the definition of a current liability is the relationship between current assets and current liabilities. The difference between current assets and current liabilities is called working capital. By comparing a company's obligations that will shortly become due with the company's cash and other assets that, by definition, will shortly be converted to cash or used to generate cash, the analysis offers some indication of an ability to pay those debts. Although used in a variety of decisions, it is particularly useful to those considering whether to extend short-term credit. Nike's working capital (in millions) at the end of its May 31, 2020, fiscal year is $12,272. This amount is computed as Nike's current assets of $20,556 (Illustration 3-3) minus its current liabilities of $8,284 (Illustration 3-7).

Management's Discussion and Analysis

In addition to the financial statements and accompanying disclosure notes, each annual report of a public company requires a fairly lengthy discussion and analysis provided by the company's management. In this section, which precedes the financial statements and the auditor's report, management provides its views on significant events, trends, and uncertainties pertaining to the company's (1) results of operations, (2) liquidity, (3) capital resources, (4) off-balance sheet arrangements, and (5) critical accounting estimates. Although the management's discussion and analysis (MD&A) section may embody management's biased perspective, it can offer an informed insight that might not be available elsewhere.

Comprehensive income statement

Includes a few types of gains and losses excluded from the Income Statement

Cash Flows from Operating Activities Indirect method

Indirect method: • Reconciles Net Income (NI) to Cash Flows from Operations (CFFO). oIllustrates how and why NI and CFFO are different. oProvides a reality check on the assumptions behind NI. oFirms using the direct method have to disclose this reconciliation in a note (have to do it both ways!)

Inventory

Inventory for a wholesale or retail company consists of finished goods for sale to customers. For example, you buy finished goods such as shoes and athletic wear from Nike, potato chips at Costco, school supplies at Office Depot, and a new shirt at Gap. The inventory of a manufacturer will include not only finished goods, but also goods in the course of production (work in process) and goods to be consumed directly or indirectly in production (raw materials). Manufacturers typically report all three types of inventory either directly in the balance sheet or in a disclosure note. Inventory is reported as a current asset because it normally is sold within the operating cycle. Includes: Finished goods, work in progress, and raw materials

Investments

Investments are assets that are not used directly in the operations of the business. These assets include investments in equity and debt securities of other corporations, land held for speculation, long-term receivables, and cash set aside for special purposes (such as for future plant expansion). These assets are classified as long-term because management does not intend to convert the assets into cash in the next year (or the operating cycle if that's longer). Examples: Investments in equity and debt securities of other corporations Land held for speculation Long-term receivables Cash set aside for special purposes

Short term investments

Investments not classified as cash equivalents that the company has the ability and intent to sell within one year (or operating cycle, if longer) are reported as short-term investments. These investments include items such as equity investments in the common stock of other corporations, as well as debt investments in commercial paper and U.S. Treasury securities. Can be: Held to maturity, trading securities(short term resale), securities available for sale

Using financial statement information

Investors and others use information that companies provide in corporate financial reports to make decisions. Although the financial reports focus primarily on the past performance and the present financial condition of the reporting company, users are most interested in information about the future. Investors want to know a company's default risk. This is the risk that a company won't be able to pay its obligations when they come due. Another aspect of risk is operational risk, which relates more to how adept a company is at withstanding various events and circumstances that might impair its ability to earn profits.

Common current assets

It is common practice for the individual current assets to be listed in the order of their liquidity (the ability to convert the asset to cash). -Cash and cash equivalents -Short-term investments -Accounts receivable -Inventory -Prepaid expenses

Are these liquidity ratios adequate?

It's generally difficult to say without some point of comparison. As indicated previously, common standards for such comparisons are industry averages for similar ratios or ratios of the same company in prior years. Industry averages for the above two ratios are as follows: current ratio is 1.92 and acid-test ratio is 1.10. What if the ratios were lower? Would that indicate a liquidity problem? Not necessarily, but it would raise a red flag that calls for caution in analyzing other areas. Remember that each ratio is but one piece of the entire puzzle. For instance, profitability is perhaps the best indication of liquidity in the long run. Liquidity ratios should be assessed in the context of both profitability and efficiency of managing assets.

Cash inflows from investing activities

Later, when the assets are disposed of, cash inflow from the sale of the assets (or collection of loans and notes) also is reported as cash flows from investing activities. As a result, cash inflows from these transactions are considered investing activities: 1.The sale of long-lived assets used in the business 2.The sale of investment securities (other than cash equivalents and trading securities) 3.The collection of a nontrade receivable (excluding the collection of interest, which is an operating activity)

Liabilities

Liabilities represent obligations to other entities

Liquidity Ratios

Liquidity most often refers to the ability of a company to convert its assets to cash to pay its current obligations. By examining a company's liquidity, we can obtain a general idea of the firm's ability to pay its short-term debts as they come due. Current assets usually are thought of as the most liquid of a company's assets because these assets are easier to convert to cash than long-term assets. Some current assets are more liquid than others, so it's also important to evaluate the specific makeup of current assets. Two common measures of liquidity are (1) the current ratio and (2) the acid-test ratio (or quick ratio). The current ratio can be calculated by dividing current assets by current liabilities. On the other hand, the acid-test ratio can be calculated by dividing quick assets by current liabilities.

Long term liabilities

Long-term liabilities are obligations that are (a) due to be settled or (b) have a contractual right by the borrowing company to be settled in more than one year (or operating cycle, if longer) after the balance sheet date. Examples are long-term notes, bonds, pension obligations, and lease obligations. But simply classifying a liability as long-term doesn't provide complete information to external users. For instance, long-term could mean anything from 2 to 20, 30, or 40 years. Payment terms, interest rates, and other details needed to assess the impact of these obligations on future cash flows and long-term solvency are reported in a disclosure note.

Nonoperating income

Most of the components of earnings in an income statement relate directly to the ordinary, continuing operations of the company. Some, though, such as interest or the gains and losses on the sale of investments, relate only tangentially to normal operations. We refer to these as nonoperating items. Examples: -Interest income or interest expense -Gains or losses on sale of investments

Sustainability Disclosures

Nearly all major public companies provide disclosures that detail their practices and policies related to the sustainability of business operations. These disclosures most often relate to environmental, social, and governance (ESG) factors that shareholders can use to assess factors affecting the company's financial performance, resource efficiency, and operating risks. Sustainability disclosures also provide information more broadly to other stakeholders (creditors, employees, suppliers, governments, and the community from which the business draws its resources) to better understand their unique relationship with the company and the impact of the company on society in general. Environmental disclosures focus on the company's environmental impact. The most common environmental disclosure by most major companies is their greenhouse gas emissions. Many companies disclose their actual emissions and then often compare these actual emissions to planned reductions. Social disclosures focus on issues of interest to broader stakeholders and society at large. For example, the SEC requires companies to disclose the ratio of the compensation of its chief executive officer (CEO) to the median compensation of all full-time employees. Governance disclosures include the company's actions and policies related to the division of power within the company. Most companies disclose the gender diversity and independence of their Board of Directors. Companies also may provide governance disclosures related to their ethical policies and procedures. Another important governance disclosure in recent years is data privacy. With easy access to customer data, many ethical issues have surfaced on how and whether companies should use their customers' data.

Notes payable

Notes payable are written promises to pay cash at some future date (I.O.U.s). Unlike accounts payable, notes usually require the payment of explicit interest in addition to the original obligation amount.

Profitability Analysis—Activity Ratios

One key to profitability is how well a company manages and utilizes its assets •The higher the ratio, the fewer assets are required to maintain a given level of activity (revenue) Asset turnover ratio, Receivables turnover ratio, Inventory turnover ratio

Earnings quality

One meaning of earnings quality is the ability of reported earnings (income) to predict a company's future earnings. The relevance of any historical-based financial statement hinges on its predictive value. To enhance predictive value, analysts try to separate a company's temporary earnings from its permanent earnings. Temporary earnings effects result from transactions or events that are not likely to occur again in the foreseeable future or that are likely to have a different impact on earnings in the future. In contrast, permanent earnings relate to operations that are expected to generate similar profits in the future. Analysts begin their assessment of permanent earnings with income before discontinued operations, that is, income from continuing operations.

Typical Classification of Cash Flows from Interest and Dividends

Operating: Dividends received, interest received, interest paid Financing: Dividends paid

Shareholders equity

Owners' equity is simply total assets minus total liabilities. For that reason, it's sometimes referred to as the net assets or book value of a company. Because owners of a corporation are its shareholders, owners' equity for a corporation typically is referred to as shareholders' equity or stockholders' equity.

Shareholders equity usual components

Paid-in capital Retained earnings

Paid-in capital

Paid-in capital is the amount that shareholders have invested in the company. It most often arises when the company issues stock. Information about the number of shares the company has authorized and how many shares have been issued and are outstanding also must be disclosed either directly in the balance sheet or in a note.

Statement of cash flows

Provides information about cash receipts and cash payments

Income from Continuing Operations

Reports the revenues, expenses, gains, and losses that have occurred during the reporting period

Restructuring costs

Restructuring costs are recognized in the period the exit or disposal cost obligation actually is incurred. Suppose, as part of a restructuring plan, employees to be terminated are offered various benefits but only if they complete a certain period of work for the company. In that case, a liability for termination benefits, and corresponding expense, should be accrued in the required period(s) of work. On the other hand, if future work by the employee is not required to receive the termination benefits, the liability and corresponding expense for benefits are recognized at the time the company communicates the arrangement to employees. Similarly, costs associated with closing facilities and relocating employees are recognized when goods or services associated with those activities are received.

Retained earnings

Retained earnings represents the accumulated net income reported by a company since its inception minus all dividends distributed to shareholders.

Solvency Ratios

Solvency ratios provide some indication of the riskiness of a company with regard to its ability to pay its long-term debts. Investors and creditors, particularly long-term creditors, are vitally interested in long-term solvency, a company's ability to pay its long-term debts. Two common financing ratios are (1) the debt to equity ratio and (2) the times interest earned ratio. Debt to equity ratio is calculated by dividing total liabilities (current and noncurrent) by total shareholders' equity (including retained earnings). Whereas, times interest earned ratio is calculated as income before subtracting interest expense and income taxes divided by interest expense. Since net income is computed by deducting interest expense and income tax expense, we must add them back to compute income before interest expense and income taxes.

Intangible assets

Some assets used in the operations of a business have no physical substance. These are appropriately called intangible assets. Generally, these represent the ownership of an exclusive right to something such as a product, a process, or a name, that can be a valuable resource in generating future revenues. Patents, copyrights, franchises, and trademarks are examples. They are generally reported in the balance sheet at their purchase price less accumulated amortization. Not all intangible assets are purchased; some are developed internally. For example, instead of purchasing a patent granting the exclusive right to manufacture a certain drug, a pharmaceutical company may spend significant amounts in research and development to discover the drug and obtain a patent on its own. Another common type of intangible asset is goodwill. Goodwill isn't associated with any specific identifiable right, but instead arises when one company acquires another company. The amount reported for goodwill equals the acquisition price above the fair value of the identifiable net assets acquired.

Other audit reports

Some audits result in the need to issue other than an unqualified opinion due to exceptions such as (a) nonconformity with generally accepted accounting principles, (b) inadequate disclosures, and (c) a limitation or restriction of the scope of the examination. In these situations the auditor will issue a (an) •Qualified opinion when either the audit process has been limited (scope limitation) or there has been a departure from GAAP, but neither is of sufficient seriousness to invalidate the financial statements as a whole. •Adverse opinion when the auditor has specific knowledge that financial statements or disclosures are seriously misstated or misleading. Adverse opinions are rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report. •Disclaimer when the auditor is not able to gather sufficient information that financial statements are in conformity with GAAP.

Disclosure notes

Some financial statement disclosures are provided by including additional information, often parenthetically, on the face of the statement. Common examples of disclosures included on the face of the balance sheet are the allowance for uncollectible accounts and information about common stock. Information providing details of many financial statement items is provided using disclosure notes. Some examples include: • Pension plans • Leases • Long-term debt • Investments • Income taxes • Property, plant, and equipment • Employee benefit plans Disclosure notes must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions, but many notes are fashioned to suit the disclosure needs of the particular reporting enterprise. Actually, any explanation that contributes to investors' and creditors' understanding of the results of operations, financial position, and cash flows of the company should be included.

Other long term assets

Some long-term assets do not fit clearly in one of the previous categories. These long-term assets can be reported in their own descriptive category or simply in a catchall "Other" category. Two common types of other long-term assets are long-term operating leases and long-term prepaid expenses (sometimes called deferred charges). A key to understanding which category an asset is reported is management intent. For example, management may intend to use land for long-term operating purposes (property, plant, and equipment), hold it for future resale (investment), or sell it in its ordinary course of business (inventory for a real estate company).

Noteworthy events and transactions

Sometimes a company will engage in transactions with owners, management, families of owners or management, affiliated companies, and other parties that can significantly influence or be influenced by the company. The potential problem with related-party transactions is that their economic substance may differ from their legal form. For instance, borrowing or lending money at an interest rate that differs significantly from the market interest rate is an example of a transaction that could result from a related-party involvement. When related-party transactions occur, companies must disclose the nature of the relationship, provide a description of the transactions, and report the dollar amounts of transactions and any amounts due from or to related parties. Less frequent events are errors and fraud. The distinction between these two terms is that errors are unintentional, while fraud is intentional misappropriation of assets or incorrect financial reporting. Errors and fraud may require disclosure (e.g., of assets lost through either errors or fraud). Obviously, the existence of fraud involving management might cause a user to approach financial analysis from an entirely different and more cautious viewpoint. As you might expect, any disclosures of related-party transactions, fraud, and illegal acts can be quite sensitive. Although auditors must be considerate of the privacy of the parties involved, that consideration cannot be subordinate to users' needs for full disclosure

Unqualified with an explanatory paragraph

Sometimes circumstances cause the auditor to issue an opinion that is unqualified with an explanatory paragraph. In these circumstances, the auditor believes the financial statements are in conformity with GAAP (unqualified), but the auditor feels that other important information needs to be emphasized to financial statement users. Most notably, these situations include the following: •Lack of consistency due to a change in accounting principle such that comparability is affected even though the auditor concurs with the desirability of the change. •Going concern when the auditor determines there is significant doubt as to whether the company will be able to pay its debts as they come due. Indicators of a going concern include significant operating losses, loss of a major customer, or legal proceedings that might jeopardize the company's ability to continue operations. •Material misstatement in previously issued financial statements has been corrected. • An audit opinion may also include a paragraph on emphasis of a matter. This discussion would include items such as significant transactions with related parties, important events subsequent to the balance sheet date, or uncertainty relating to the future outcome of significant litigation or regulatory actions.

Property, plant, and equipment

Tangible, long-lived assets used in the operations of the business are classified as property, plant, and equipment. Property, plant, and equipment, along with intangible assets, often are the primary revenue-generating assets of the business. Property, plant, and equipment includes land, buildings, equipment, machinery, and furniture, as well as natural resources, such as mineral mines, timber tracts, and oil wells. These various assets generally are reported as a single amount in the balance sheet, with details provided in a note. They are reported at original cost less accumulated depreciation (or depletion for natural resources) to date. Very often, companies will report only the net amount of property, plant, and equipment in the balance sheet and provide details in a disclosure note. Remember that land often is listed as a separate item in this classification because it has an unlimited useful life and thus is not depreciated.

Acid test or quick ratio

The acid-test ratio provides a more stringent indication of a company's ability to pay its current obligations. Some analysts like to modify the current ratio to consider only current assets that are readily available to pay current liabilities. One such variation in common use is the acid-test ratio. This ratio excludes inventories, prepaid items, and restricted cash from current assets before dividing by current liabilities. The numerator, then, consists of (unrestricted) cash, short-term investments, and accounts receivable, which are referred to as the "quick assets." By eliminating current assets that are less readily convertible into cash, the acid-test ratio provides a more rigorous indication of liquidity than does the current ratio. For example, Nike's quick assets (in millions) at the end of its May 31, 2020, fiscal year total $11,536 ($8,348 + $439 + $2,749). The acid-test ratio can be computed by dividing $11,536 by $8,284 which in this case is 1.39. This can be compared to industry averages.

Balance Sheet

The balance sheet, sometimes referred to as the statement of financial position, presents an organized list of assets, liabilities, and equity at a point in time. It is a freeze frame or snapshot of a company's financial position at the end of a particular day marking the end of an accounting period.

Compensation of Directors and Top Executives

The compensation large U.S. corporations pay their top executives is an issue of considerable public debate and controversy. Shareholders, employees, politicians, and the public in general sometimes question the huge pay packages received by company officials at the same time that more and more rank-and-file employees are being laid off as a result of company cutbacks. A substantial portion of executive pay often is in the form of stock options or restricted stock awards. Executive stock options give their holders the right to buy the company's stock at a set price, regardless of how high the stock price rises. Restricted stock is a unit of stock given to an employee, but that unit of stock is not fully transferable until certain conditions are met. To help shareholders and others sort out the content of executive pay packages and better understand the commitments of the company in this regard, SEC requirements provide for disclosures on compensation to directors and executives. A proxy statement is provided each year and includes compensation information for directors and top executives. The statement also invites shareholders to the annual meeting to elect board members and to vote on issues before the shareholders, or to vote by proxy.

Current ratio

The current ratio is computed by dividing current assets by current liabilities. Nike's current ratio of 2.48 indicates that the company has $2.48 of current assets for each $1 of current liabilities. Care should be taken, however, in assessing liquidity based solely on the current ratio. Liabilities usually are paid with cash, not other types of current assets. A company could have difficulty paying its liabilities even with a current ratio significantly greater than 1.0. For example, if a significant portion of current assets consisted of inventories, and inventories usually are not converted to cash for several months, there could be a problem in paying accounts payable due in 30 days. On the other hand, a current ratio of less than 1.0 doesn't necessarily mean the company will have difficulty meeting its current obligations. A line of credit, for instance, which the company can use to borrow funds, provides financial flexibility. That also must be considered in assessing liquidity.

Debt to equity ratio

The debt to equity ratio compares resources provided by creditors with resources provided by owners. It is calculated by dividing total liabilities (current and long-term) by total shareholders' equity (including retained earnings). Other things being equal, the higher the ratio, the higher the company's risk. The higher the ratio, the greater the creditor claims on assets, so the higher the likelihood an individual creditor would not be paid in full if the company is unable to meet its obligations

Net cash flows from operating activities

The difference between the inflows and outflows is called net cash flows from operating activities. This is equivalent to net income if the income statement had been prepared on a cash basis rather than an accrual basis.

Income statement

The income statement reports a company's profit during a particular reporting period. Profit equals revenues and gains minus expenses and losses.

Operating activites

The inflows and outflows of cash that result from activities reported in the income statement are classified as cash flows from operating activities. In other words, this classification of cash flows includes the elements of net income reported on a cash basis rather than an accrual basis.

Flexibility in reporting

The information in the income statement, as well as other comprehensive income items, can be presented either 1.in a single, continuous statement of comprehensive income or 2.in two separate, but consecutive statements: •an income statement and •a statement of comprehensive income.

Multiple-step income statement

The multiple-step format reports a series of intermediate subtotals such as gross profit, operating income, and income before taxes. Most real-world income statements are in this format. A primary advantage of the multiple-step format is that, by separately classifying operating and nonoperating items, it provides information that might be useful in analyzing trends. Similarly, the classification of expenses by function also provides useful information. It is important to note that the difference between the single-step and multiple-step income statement is one of presentation. The bottom line, net income, is the same regardless of the format used. Most companies use the multiple-step format.

Receivables turnover ratio

The receivables turnover ratio is calculated by dividing a period's net credit sales by the average net accounts receivable. Because income statements seldom distinguish between cash sales and credit sales, this ratio usually is computed using total net sales as the numerator. The denominator, average accounts receivable, is determined by adding beginning and ending net accounts receivable (gross accounts receivable less allowance for uncollectible accounts) and dividing by two.

Single-step income statement

The single-step format first lists all the revenues and gains included in income from continuing operations. Then, expenses and losses are grouped, subtotaled, and subtracted—in a single step—from revenues and gains to derive income from continuing operations. In a departure from that, though, companies usually report income tax expense in a separate line in the statement. In a single-step income statement, operating and nonoperating items are not separately classified.

Specific disclosure notes

The summary of significant accounting policies conveys valuable information about the company's choices from among various alternative accounting methods. For example, management chooses whether to use accelerated or straight-line depreciation, whether to use FIFO, LIFO, or average cost to measure inventories, and whether to measure certain financial investments at fair value or cost. The company also defines which securities it considers to be cash equivalents and its policies regarding the timing of recognizing revenues and the estimated useful lives of its depreciable assets. Studying this note is an essential step in analyzing financial statements. A subsequent event is a significant development that occurs after a company's fiscal year-end but before the financial statements are issued or "available to be issued". Examples are the issuance of debt or equity securities, a business combination or the sale of a business, the sale of assets, an event that sheds light on the outcome of a loss contingency, or any other event having a material effect on operations.

Management's responsibilities

To enhance the awareness of the users of financial statements concerning the relative roles of management and the auditor, annual reports of public companies include a management's responsibilities section that asserts the responsibility of management for the information contained in the annual report as well as an assessment of the company's internal control procedures. Remember that the Sarbanes-Oxley Act of 2002 requires corporate executives to personally certify the financial statements. Submission of false statements carries a penalty of up to 20 years in jail.

Favorable financial leverage

To see how financial leverage works, consider a newly formed corporation attempting to determine the appropriate mix of debt and equity. The initial capitalization goal is $50 million. The capitalization mix alternatives have been narrowed to two: (1) $10 million in debt and $40 million in equity and (2) $30 million in debt and $20 million in equity. Also assume that regardless of the capitalization mix chosen, the corporation will be able to generate a 16% annual return, before payment of interest and income taxes, on the $50 million in assets acquired. In other words, income before interest and taxes will be $8 million (16% × $50 million). If the interest rate on debt is 8% and the income tax rate is 25%, comparative net income for the first year of operations for the two capitalization alternatives will be $5,400,000 and $4,200,000, respectively. We can see that alternative 1 provides a higher net income, $5,400,000. However, we will not choose alternative 1, as the return on the shareholders' equity—that is, net income divided by shareholders' equity—is higher for alternative 2. To explain further, alternative 2 generated a higher return for each dollar invested by shareholders because the company leveraged its $20 million equity investment with additional debt of $30 million. As the cost of the additional debt (8%) is less than the return on assets invested (16%), the return to shareholders is higher. This is the essence of favorable financial leverage.

Financial statement analysis

Trying to gain a glimpse of the future from past and present data entails using various tools and techniques to formulate predictions. This is the goal of financial statement analysis. Common methods for analyzing financial statements include the following: 1. Comparative financial statements. Financial statements that are accompanied by the corresponding financial statement of the preceding year, and often the previous two years. 2. Horizontal analysis. Each item in a financial statement is expressed as a percentage of that same item in the financial statements of another year (base amount). For example, comparing inventory this year to inventory last year would provide the percentage change in inventory. 3. Vertical analysis. Each item in the financial statements is expressed as a percentage of an appropriate corresponding total, or base amount, but within the same year. For example, cash, receivables, and inventory in the current year can be restated as a percentage of total assets in the current year. 4. Ratio analysis. Financial statement items are converted to ratios for evaluating the performance and risk of a company.

Long term assets

When assets are expected to be converted to cash or consumed for more than one year (or operating cycle, if longer), they are reported as long-term (or noncurrent) assets. Typical classifications of long-term assets are as follows: 1. Investments 2. Property, plant, and equipment 3. Intangible assets 4. Other long-term assets

Recognition of revenues

When recognizing expenses, we attempt to establish a causal relationship between revenues and expenses. If causality can be determined, expenses are reported in the same period that the related revenue is recognized. If a causal relationship cannot be established, we relate the expense to a particular period, allocate it over several periods, or expense it as incurred.

Reporting Discontinued Operations—When the Component is Held for Sale

When the discontinued component has not been sold when the reporting period ends, the income effects are reported but modified: Income or loss from operations of the component from the beginning of the reporting period to the end of the reporting period An impairment loss if the fair value of assets of component (minus cost to sell) is less than the book value

Reporting Discontinued Operations—When the Component Has Been Sold

When the discontinued component is sold before the end of the reporting period, the income effects will include: Income or loss from operations of the component from the beginning of the reporting period to the disposal date Gain or loss on disposal of the component's assets

Relationship between risk and profitability

While there are default risks associated with borrowing, a company can use those borrowed funds to provide greater returns to its shareholders. This is referred to as favorable financial leverage and is a very common (but risky) business activity. When a company needs money, the alternatives are debt and equity. Sometimes more debt can mean a higher return on shareholders' equity.

Balance Sheet usefulness

liquidity, solvency, and financial flexibility

Comprehensive income

•Comprehensive income is the total change in equity for a reporting period with nonowners

Stages of business failure

•Four stages of decline —Incubation —Cash shortage —Financial or commercial insolvency —Total insolvency

Horizontal analysis

•Horizontal Analyses provides comparative increases about various line items of each financial statement over time. • •Horizontal Analyses uses percentage change using this formula: • (New - Old)/ Old • where old is the prior year or period and • new is the current year or period.

Discontinued operations

•If a company decides to sell or dispose of a component of their business, profits from these discontinued operations will not continue •Discontinued operations are reported when: 1.A component of an entity or group of components has been sold, disposed of, or is considered held for sale 2.Disposal represents a strategic shift that has, or will have, a major effect on a company's operations and financial results

Financial or Commercial Insolvency

•If additional financing cannot be obtained and the company cannot meet its operational cash flow needs, an out-of-court restructuring or workout may be attempted —Engage a workout or restructuring specialist —Appoint creditors' committees —New financing techniques (e.g., asset-based loan) •If out-of-court restructuring is infeasible —Restructure using legal process (e.g., by filing a chapter 11 petition in the U.S., or CCAA in Canada) •Opportunity for turnaround still exists at this stage if —Underlying operational issues are addressed and/or —Capital structure can be reorganized

Cash shortage

•Liquidity problems: may be "balance sheet" solvent: Assets > Liabilities; decent earnings record; but dire need of cash —Assets are not sufficiently liquid —Capital tied up in inventory and receivables —Upcoming debt maturity wall •Possible to escape the downward trend and survive: Contact key creditors and solicit their support to seek waivers or extensions, or locate additional financing (debt or equity) •Overconfident management: —Denial of the underlying problems —Address only the symptoms and not the causes —Problematic approach à "double-down" on riskier projects after obtaining additional sources of funding

Total Insolvency

•Point of no return à reorganization attempts failed •Company is clearly unable to —Meet its obligations —Operate normally •Total liabilities > Total realizable value of assets •Take legal steps to declare bankruptcy (file Ch 7 in the U.S)

Incubation

•Problematic events may occur unnoticed in businesses without causing much alarm •Various operational and/or financial issues: May individually be insignificant, but collectively material —Change in product demand —Continuing increase in overhead costs —Obsolete production methods —Increase in competition —Incompetent managers in key positions —Acquisition of unprofitable subsidiaries —Overexpansion (or "empire building") —Incompetent credit and collection department —Lack of adequate banking facilities

Earnings per share

•Ratio that indicates the amount of income earned by a company expressed on a per share basis Basic EPS equals total net income (less any dividends to preferred shareholders) divided by the weighted-average number of common shares outstanding. Dividends to preferred shareholders are subtracted from net income in the numerator because those dividends are distributions of the company not available to common shareholders. The denominator is the weighted-average number of common shares outstanding, rather than the number of shares outstanding at the beginning or end of the period, because the goal is to relate performance for the period to the shares that were in place throughout that period. The number of common shares may change over the year from additional issuances or company buybacks, so a weighted average better reflects the number of shares outstanding for the period. The resulting EPS provides a measure of net income generated for each share of common stock during the period•Ratio that indicates the amount of income earned by a company expressed on a per share basis

Vertical analysis

•Vertical Analyses expresses financial information in relation to some relevant figure, or base. • •For example, on an income statement, the relevant base would be net sales revenue. •On a balance sheet, the relevant base for a balance sheet line item would be total assets.

Revenues

••Inflows of resources resulting from providing goods or services to customers

Expenses

••Outflows of resources incurred while generating revenue ••Represent the costs of providing goods and services