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Chapter 14

MGAB02H3 Chapter Notes - Chapter 14: Profit Margin

Financial Accounting
Course Code
Liang Chen

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Chapter 14 Performance Measurement Notes
Sustainable Earnings
x sustainable earnings Æ likely level of earnings to be obtained in future, determined by adjusting net earnings for irregular items
x differ from actual net earnings by amount of irregular (non-typical) revenues, expenses, gains, losses included in net earnings
x users are interested in sustainable earnings because amount helps estimate future earnings without “noise” of irregular items
x to help determine sustainable earnings, irregular items are reported separately on the financial statements
Discontinued Operations
x discontinued operations Æ the disposal, or availability for sale, of an identifiable operating segment of the business
x operating segment can be subsidiary company or operating division within company, as long as it is separate business unit with
its own financial elements (e.g., revenues, expenses, and cash flows) that can be clearly distinguished from rest of company
x whether operating segment has been disposed of (sale, abandonment, spin-off), or classified as held for sale, it is expected that:
1. operations and cash flows have been eliminated from ongoing operations of company as result of disposal transaction
2. the company will have no continuing involvement after the disposal transaction
Balance Sheet
x assets (net of any related liabilities) that are held for sale as discontinued operations are valued and reported on the balance sheet
at the lower of their carrying amount and fair value (less any anticipated costs of selling)
x they retain their original classification as assets or liabilities, and are reported as current or noncurrent
x once an asset has been classified as held for sale, no additional depreciation is recognized
x of course, assets that have already been disposed of are no longer recorded or reported on the balance sheet
Statement of Earnings
x when a company disposes of one of its operating segments, the disposal is reported separately on the statement of earnings as an
irregular item called discontinued operations
x the discontinued operations item consists of two parts: the earnings (loss) from the discontinued operations and the gain (loss) on
the disposal of the segment; of course, if the segment has not yet been disposed of and is being held for sale, only the first part
(earnings or loss from discontinued operations) will be segregated and reported on statement until the actual disposal occurs
x like all irregular items, discontinued operations are reported net of income tax, that is, the applicable income tax expense or tax
savings is shown for earnings before income tax and for each component that is reported for discontinued operations
x in addition, on its statement of earnings, earnings per share are reported separately for continuing operations and for discontinued
operations so that investors can clearly see the impact of this decision on the company
x the impact of the discontinued operations on cash flow must also be reported separately on the cash flow statement
x in general, in evaluating a company it makes sense to eliminate irregular items such as discontinued operations from the analysis
Change in Accounting Principle
x change in accounting principle Æ use of unlike accounting principle in current year compared to what was used in past year
x to ensure the comparability of financial statements from year to year, accounting principles should be applied consistently from
period to period, however, this does not mean that changes can never be made
x when a change is made, it is classified as either voluntary or mandatory
x a voluntary change in accounting principle is allowed when management can show that the new accounting principle results in a
more reliable and relevant presentation of events or transactions in the financial statements
x a mandatory change in accounting principle is one that is required by standard-setters
x changes in accounting principles affect financial reporting in four ways:
1. The cumulative effect of the change in accounting principle should be reported (net of income tax) as an adjustment to
opening retained earnings. Since prior-period earnings are affected, a change in accounting principle must be reported in the
retained earnings section of the statement of shareholdersequity (or in the statement of retained earnings), rather than in
the current period’s statement of earnings.
2. The new principle should be used for reporting the results of operations in the current year.
3. All prior-period financial statements should be restated to make comparisons easier.
4. The effects of the change should be detailed and disclosed in a note.
x ideally, all accounting changes are applied retrospectively—this means that a financial statement from any prior year that is
represented for comparative purposes must be restated as if the new accounting principle had been used in the past
Comparative Analysis
x in assessing financial performance, investors and creditors are interested in the sustainable earnings of a company
x in addition to this, they are also interested in making comparisons from period to period
x there are three types of comparisons to improve the usefulness of financial information for decision-making:
1. Intracompany basis: This basis compares an item or financial relationship inside a company within the current year or
with one or more prior years. Comparisons within a company are often useful to detect changes in financial relationships
and significant trends.
2. Intercompany basis: This basis compares an item or financial relationship of one company with the same item or
relationship in one or more competing companies. Comparisons with other companies give insight into a company’s
competitive position.
3. Industry averages: This basis compares an item or financial relationship of a company. Comparisons with industry give
information about a company’s relative position within the industry.

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x other financial information includes a management discussion and analysis (MD & A) of the company’s financial position and a
summary of historical key financial figures and ratios
x non-financial information includes discussion of company’s mission, goals and objectives, market position, people, and products
x understanding a company’s goals and objectives is important when interpreting financial performance
x economic circumstances that a company is operating in must also be considered
x economic measures such as the rate of interest, inflation, unemployment, and changes in demand and supply can have a
significant impact on a company’s performance
x other non-financial information includes corporate governance, customer satisfaction, employee satisfaction, product reputation,
innovation, knowledge resources, sustainable development, and so on
x various tools are used to evaluate the significance of financial data for a company; three commonly used tools follow:
1. Horizontal analysis: This tool evaluates a series of financial statement data over time, expressing changes between periods
as either an amount or a percentage. Horizontal analysis is used in intracompany comparisons.
2. Vertical analysis: This tool evaluates financial statement data by expressing each item in financial statement as percentage
of base amount for the same period of time. Vertical analysis is used in both intracompany and intercompany comparisons.
3. Ratio analysis: This tool expresses relationships among selected items of financial statement data. Ratio analysis is used in
all three types of comparisons (intracompany, intercompany, and industry averages).
Horizontal Analysis
x horizontal analysis Æ technique for evaluating a series of financial statement data over a period of time to determine the increase
(decrease) that has taken place; this increase (decrease) is expressed as either an amount or a percentage; known as trend analysis
x two features in annual reports make this type of comparison easier: (1) each of financial statements is presented on a comparative
basis for one or more previous years; (2) a summary of selected financial data is presented for a series of 5 to 10 years or more
x percentage of base-period amount = Analysis-period amount ÷ Base-period amount
x percentage change for period = Dollar amount of change since base period ÷ Base-period amount
Statement of Earnings
x the measurements of changes from period to period in percentages is fairly straightforward and quite useful; however, the
calculations can be affected by complications
Vertical Analysis
x vertical analysis Æ a technique for evaluating financial statement data that expresses each item in a financial statement as a
percentage of a base amount; also known as common-size analysis
Balance Sheet
x the base for the assets items is total assets, and the base for the liability and shareholders’ equity items is total liabilities and
shareholders’ equity, which equals total assets
x vertical analysis shows the relative size of each item in the balance sheet compared to a base amount
x it is useful to compare vertically prepared information for multiple periods or just one period
Ratio Analysis
x ratios are generally classified into 3 types:
1. Liquidity ratios: Measure short-term ability of firm to pay its maturing obligations and to meet unexpected needs for cash.
2. Solvency ratios: These measure the ability of the company to survive over a long period of time.
3. Profitability ratios: These measure the earnings or operating success of a company for a specific period of time.
Liquidity Ratios
x liquidity ratios measure the short-term ability of a firm to pay its maturing obligations and to meet unexpected needs for cash
x short-term creditors, such as bankers and suppliers, are particularly interested in assessing liquidity
Ratio Formula Purpose
Working capital Current assets – Current liabilities Measures short-term debt-paying ability
Current ratio Measures short-term debt-paying ability
Inventory 1Measures liquidity of inventory
Days in inventory 1
Measures number of days inventory is on
Receivables turnover 1Measures liquidity of receivables
Average collection period 1
Measures number of days receivables are
Cash current debt coverage Measures short-term debt-paying ability
(cash basis)
Solvency Ratios
x solvency ratios measure the ability of a company to survive over a long period of time
x long-term creditors and shareholders are interested in a companys long-run solvency, particularly its ability to pay interest as it
comes due and to repay the face value of debt at maturity
Ratio Formula Purpose
Debt to total assets
Measures percentage of total
assets provided by creditors
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