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Chapter 12

BUSI 2160U Chapter Notes - Chapter 12: Financial Statement Analysis, Financial Statement, Earnings Management


School
UOIT
Department
Business
Course Code
BUSI 2160U
Professor
jones
Chapter
12

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Chapter 12 – Analyzing and Interpreting Financial Statements
Why Analyze and Interpret Financial Statement?
People analyze financial statements to help them make decisions
Creditors concerns to ability to pay, value of security and compliance of covenants
(contract agreement)
Covenants are restrictions that impose limits on the actions of borrowers
Covenants may limit or restrict payment of dividends, additional borrowing, some
investments, and sale of certain assets
They may also require that the borrower maintain financial ratios, for example the current
ratio or the debt-to-equity ratio, above or below specified levels
The value of the entity or its shares is extremely important information for people
considering investing in or purchasing a private company
Investors and prospective investors in private and public companies might want to predict
future cash flows and earnings to assess whether the company can pay dividends or if it
will be able to meet upcoming liabilities
Know the Entity
Management discussion and analysis (MD&A) are prepared by an entity's managers, it
provides them the opportunity to discuss its financial results, position, and future
prospects
It is intended to provide readers with a view of the entity through the eyes of management
Private companies aren't required to provide a MD&A
Permanent and Transitory Earnings and Earnings Quality
Permanent versus Transitory Earnings
Permanent earnings is the earnings that are expected in the future
Transitory earnings are earnings that are not expected to be repeated in future periods
An entity's net income can have both permanent and transitory components
Permanent and transitory earnings should be interpreted differently, and financial
statements should provide information that helps stakeholders distinguish them
IFRS provide some help by requiring disclosure of events when they are significant and
necessary for fair presentation
For public companies, a transitory event should have less of an effect on the stock price,
so managers might prefer to classify bad news as unusual

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Earnings Quality
Earnings quality is the usefulness of current earnings for predicting future earnings
Earnings quality is high if current and future earnings are highly correlated and low if
current and future earnings aren't correlated
Earnings quality is low if there are a lot of transitory earnings in the income statement
that can't be easily identified
Earnings quality is high if earnings are mainly permanent or it's easy to separate
permanent and transitory earnings
Managers affect earnings quality with their accounting policies, estimates, and accruals
Earnings quality is affected by earnings management when managers move earnings
among periods to achieve their reporting objectives
Earnings during a period can be thought of as comprising two elements: cash flow and
accruals
Earnings quality can also be affected by an entity's operating decisions—the timing of its
actual transactions
Expenditures on items such as research and development, advertising, and repairs and
maintenance are candidates for van be deferred to a later period
Similar ratios can be calculated for other discretionary expenses
Disclosure is one of the most effective ways of achieving understanding of the effects of
an entity's accounting choices on its financial statements
Disclosure requirements have been improving but isn't practical to disclose every detail
of an entity's economic activity, so there will always be limitations to comprehensive
analyses
Using Ratios to Analyze Accounting Information
Evaluating performance, liquidity, solvency and leverage, and other common ratios
There are no accounting standards for ratio or financial statement analysis; a person can
modify or create any ratios appropriate for the analysis
Vertical and Horizontal Analysis
Vertical Analysis or Common Size Financial Statements
Vertical analysis (common size financial statements) is an analytical tool in which the
amounts in the balance sheet and income statement are expressed as percentages of other
elements in the same year's statements
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On the balance sheet, the amounts are stated as a percentage of total assets and on the
income statement they are a percentage of revenue
This gives a good view of the asset and liability composition of the entity and how it has
changed over time
Income statement amounts are stated as percentages of revenues, the stakeholder can see
what proportion of sales each expense represents
Horizontal Analysis or Trend Statements
Horizontal analysis (trend statements) is an analytical tool in which the amounts in the
balance sheet and income statement are expressed as percentages of a base year set of
financial statements
Evaluating Performance
Accounting measurements are representations of an entity's economic activity and are
subject to the accounting policies and estimates the managers make
Net income represents the net economic benefit or sacrifice of the owners of the entity
over a period
Gross Margin
Percentage of each dollar of sales that is available to cover other costs and return a profit
to the entity's owners
An entity's gross margin percentage can be improved by increasing the price charged for
goods or services or cost control and efficiency
Profit Margin Ratio
The profit margin ratio is a bottom-line measure of performance
It indicates the percentage of each sales dollar that the entity earns in profit
A higher profit margin ratio indicates greater profitability because a larger proportion of
each dollar of sales is profit
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