Accounting 202 Final

6. Describe a common-size statement and how it might be helpful in evaluating a company.

A common-size statement reports only percentages—the same percentages that appear in a vertical analysis. By only reporting percentages, it removes dollar value bias when comparing one company to another company.

8. If a company experienced a loss on disposal of long-term assets, how would this be reported in the operating activities section of the statement of cash flows when using the indirect method? Why?

A loss on disposal of long-term assets would be removed from the net income on the statement of cash flows by adding it back in the operating section. The loss was originally included in net income, but the cash from the sale needs to be shown in the investing section of the statement of cash flows.

2. What is an annual report? Briefly describe the key parts of the annual report.

An annual report (10-K) is a report required by the Securities and Exchange Commission that provides information about a company's financial condition. The annual report includes the following: • An overview of the business • Management's discussion and analysis of financial conditions and operations • The report of an independent registered public accounting firm • Financial statements • Notes to financial statements

9. If current assets other than cash increase, what is the effect on cash? What about a decrease in current assets other than cash?

An increase in a current asset other than cash causes a decrease adjustment to net income in the operating activities section of the statement of cash flows. A decrease in a current asset other than cash causes an increase adjustment to net income.

10. If current liabilities increase, what is the effect on cash? What about a decrease in current liabilities?

An increase in current liabilities causes an increase adjustment to net income in the operating activities section of the statement of cash flows. A decrease in current liabilities causes a decrease adjustment to net income.

7. What is benchmarking, and what are the two main types of benchmarks in financial statement analysis?

Benchmarking is the practice of comparing a company's performance with its prior performance or with best practices from other companies. The two main types of benchmarking in financial statement analysis are: benchmarking against a key competitor and benchmarking against the industry average.

7. Explain why depreciation expense, depletion expense, and amortization expense are added to net income in the operating activities section of the statement of cash flows when using the indirect method.

Depreciation expense, depletion expense, and amortization expense all impact the income statement decreasing net income. None of these use cash at the time they are expensed, these expenses occurred when the asset was purchased. Therefore, to go from net income to cash flows, depreciation must be removed by adding it back to net income.

14. How does the direct method differ from the indirect method when preparing the operating activities section of the statement of cash flows?

In the indirect method, start with net income and then adjust it to cash basis through a series of adjusting items. When calculating the direct method, take each line item of the income statement and convert it from accrual to cash basis.

4. What types of transactions are reported in the non-cash investing and financing activities section of the statement of cash flows?

Investing and financing transactions that do not involve cash are called non-cash investing and financing activities. Examples of these non-cash investing and financing activities include issuing stock in exchange for plant assets, retirement of debt by issuing stock, or purchasing plant assets with long-term notes payable.

3. What is horizontal analysis, and how is a percentage change computed?

The horizontal analysis is the study of percentage changes in line items from comparative financial statements. The percentage change is calculated using this formula: (Dollar amount of change / Base period amount) × 100.

11. What accounts on the balance sheet must be evaluated when completing the investing activities section of the statement of cash flows?

The long-term asset accounts must be evaluated when completing the investing activities section of the statement of cash flows.

12. What accounts on the balance sheet must be evaluated when completing the financing activities section of the statement of cash flows?

The long-term liability accounts and the equity accounts must be evaluated when completing the financing activities section of the statement of cash flows.

13. What should the net change in cash section of the statement of cash flows always reconcile with?

The net change in the cash section of the statement of cash flows reconciles the statement of cash flows. It is computed by combining the cash provided for or used by operating, investing, and financing activities. This amount should equal the change in cash on the balance sheet.

1. What does the statement of cash flows report?

The statement of cash flows reports on a business's cash receipts and cash payments for a specific period.

3. Describe the three basic types of cash flow activities.

The three basic types of cash flow activities are: operating, investing, and financing. Operating activities are ones that create revenue or expenses in the entity's business. Investing activities increase or decrease long-term assets. Financing activities include cash inflows and outflows involved with long-term liabilities and equity.

1. What are the three main ways to analyze financial statements?

The three main ways to analyze financial statements are horizontal analysis, vertical analysis, and ratio analysis.

4. What is trend analysis, and how does it differ from horizontal analysis?

The trend analysis is a form of horizontal analysis in which percentages are computed for line items by selecting a base period as 100% and expressing amounts for following periods as a percentage of the base period amount. (Any period amount / Base period amount) × 100.

5. Describe the two formats for reporting operating activities on the statement of cash flows.

The two formats for reporting the operating activities section are the indirect and direct methods. The indirect method starts with net income and adjusts it to net cash provided by operating activities. The direct method restates the income statement in terms of cash. It shows all the cash receipts and cash payments from operating activities.

5. What is vertical analysis? What item is used as the base for the income statement? What item is used as the base for the balance sheet?

The vertical analysis of a financial statement shows the relationship of each line item to its base amount, which is the 100% figure. Every other item on the statement is then reported as a percentage of the base. For the income statement, net sales revenue is the base. For the balance sheet, total assets is the base.

10. Briefly describe the ratios that can be used to evaluate a company's ability to pay long-term debt.

• Debt ratio—Shows the proportion of assets financed by debt: Total liabilities / Total assets. • Debt to Equity ratio—Shows the proportion of total debt to equity: Total liabilities / Total equity. • Times-Interest-Earned ratio—Evaluates the business's ability to pay interest expense. It is calculated as: EBIT (Net income + Income tax expense + Interest expense) / interest expense.

9. Briefly describe the ratios that can be used to evaluate a company's ability to sell merchandise inventory and collect receivables.

• Inventory turnover—measures the number of times a company sells its average level of merchandise inventory during a period. Cost of goods sold/ Average merchandise inventory. • Days' sales in inventory measures the average number of days merchandise inventory is held by the company: 365 days / Inventory turnover • Gross profit percentage measures the profitability of each net sales dollar above the cost of goods sold and is computed as: Gross profit / Net sales revenue. • Accounts receivable turnover measures the number of times the company collects the average receivables balance in a year: Net credit sales / Average net accounts receivable. • Days' sales in receivables is also called the collection period. This ratio indicates how many days it takes to collect the average level of receivables: 365 days / Accounts receivable turnover.

2. How does the statement of cash flows help users of financial statements?

• Predict future cash flows. • Evaluate management decisions. • Predict ability to pay debts and dividends.

12. Briefly describe the ratios that can be used to evaluate a company's stock as an investment.

• Price / earnings ratio—The market price of a share of common stock in relation to the company's earnings per share. It measures the value that the stock market places on $1 of a company's earnings: Market price per share of common stock / Earnings per share. • Dividend yield—The ratio of annual dividends per share of stock to the stock's market price per share. It measures the percentage of a stock's market value that is returned annually as dividends to stockholders: Annual dividend per share / Market price per share. • Dividend payout—The ratio of dividends declared per common share relative to the earnings per share of the company: Annual dividend per share / Earnings per share.

11. Briefly describe the ratios that can be used to evaluate a company's profitability.

• Profit margin ratio—Shows how much net income is earned on every dollar of sales: Net income / Net sales revenue. • Rate of return on total assets—Measures the success a company has in using its assets to earn income: (Net income + Interest expense) / Average total assets. • Asset turnover ratio—Measures how efficiently a business uses its average total assets to generate sales: Net sales revenue / Average total assets. • Rate of return on common stockholder's equity—Shows the relationship between net income available to common stockholders and their average common equity invested in the company: (Net income - Preferred dividends) / Average common stockholder's equity. • Earnings per share—Measures the amount of a company's net income (loss) for each share of its outstanding common stock: (Net income - Preferred dividends) / Weighted average number of common shares outstanding.

6. Describe the five steps used to prepare the statement of cash flows by the indirect method.

• STEP 1: Complete the cash flows from operating activities section using net income and adjusting for increases or decreases in current assets (other than cash) and current liabilities. Also, adjust for gains or losses on long-term assets and non-cash expenses such as depreciation expense. • STEP 2: Complete the cash flows from investing activities section by reviewing the long-term assets section of the balance sheet. • STEP 3: Complete the cash flows from financing activities section by reviewing the long-term liabilities and equity sections of the balance sheet. • STEP 4: Compute the net increase or decrease in cash during the year. The change in cash is the key reconciling figure for the statement of cash flows and must match the change in cash reported on the comparative balance sheet. • STEP 5: Prepare a separate schedule reporting any non-cash investing and financing activities.

13. What are some common red flags in financial statement analysis?

• Unexpected or inconsistent movements among sales, merchandise inventory, and receivables • Earnings problems • Decreased cash flow • Too much debt • Inability to collect receivables • Buildup of merchandise inventory

8. Briefly describe the ratios that can be used to evaluate a company's ability to pay current liabilities.

• Working capital: Current assets - Current liabilities • Cash ratio: (Cash + Cash equivalents) / Total current liabilities • Acid-Test (or Quick) ratio: (Cash + Short-term investments + Net current receivables) / Total current liabilities • Current ratio: Current assets / Total current liabilities