c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Learning Objectives
1.
Describe basic financial statement analytical methods.
2.
Use financial statement analysis to assess the solvency of a business.
3.
Use financial statement analysis to assess the profitability of a business.
4.
Describe the contents of corporate annual reports.

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Basic Analytical Methods o Users analyze a company’s financial statements using a variety of analytical methods. Three such methods are as follows:



Horizontal analysis
Vertical analysis
Common-sized statements c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Horizontal Analysis o The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis .
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

H ORIZONTAL
A NALYSIS

H ORIZONTAL
A NALYSIS
Horizontal
Analysis:
Difference
Base year (2013)
$17,000
$533,000
= 3.2%

H ORIZONTAL
A NALYSIS

H ORIZONTAL
A NALYSIS
Horizontal
Analysis:
Difference
Base year (2013)
$25,800
$64,700
= 39.9%

H ORIZONTAL
A NALYSIS

H ORIZONTAL
A NALYSIS
Horizontal
Analysis:
Difference $296,500
Base year (2013) $1,234,000
= 24.0%

H ORIZONTAL
A NALYSIS

H ORIZONTAL
A NALYSIS
Horizontal
Analysis:
Difference $37,500
Base year (2013) $ 100,000
= 37.5%

Vertical Analysis o A percentage analysis used to show the relationship of each component to the total within a single financial statement is called vertical analysis .
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Vertical Analysis o In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. o Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

V ERTICAL A NALYSIS

V ERTICAL A NALYSIS
Vertical
Analysis:
Current Assets $550,000
Total Assets $ 1,139,500
= 48.3%

Vertical Analysis o In a vertical analysis of the income statement, each item is stated as a percent of net sales.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

V ERTICAL A NALYSIS

V ERTICAL A NALYSIS
Vertical Analysis:
Selling expenses $191,000
Net sales $1,498,000
= 12.8%

Common-Sized Statements o In a common-sized statement , all items are expressed as percentages with no dollar amounts shown.
o Common-sized statements are useful for comparing the current period with prior periods, individual businesses with one another, or one business with industry averages.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

C OMMON -S IZED
S TATEMENTS

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Solvency Analysis o All users of financial statements are interested in the ability of a company to do the following:
 Meet its financial obligations (debts), called solvency .
 Earn income, called profitability .
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Solvency Analysis o Solvency analysis focuses on the ability of a business to pay its current and noncurrent liabilities.
o Solvency and profitability are interrelated. A company that cannot pay its debts will have difficulty obtaining credit, which can decrease its profitability.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Current Position Analysis o A company’s ability to pay its current liabilities is called current position analysis . It is of special interest to short-term creditors.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Working Capital o The excess of current assets over current liabilities is called working capital . Working capital is often used to evaluate a company’s ability to pay current liabilities.
o Working capital is computed as follows:
Working Capital = Current Assets – Current Liabilities c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Current Ratio o The current ratio , sometimes called the
working capital ratio, also measures a company’s ability to pay its current liabilities.
o The current ratio is computed as follows:
Current Ratio =
Current Assets
Current Liabilities c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Current Ratio o The current ratio for Lincoln Company is computed below.
Current assets
Current liabilities
2014 2013
$550,000
$210,000
$533,000
$243,000
Current ratio 2.6 2.2
$550,000
$210,000
$533,000
$243,000 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Quick Ratio o A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio , or acid-test ratio. It is computed as follows:
Quick Ratio =
Quick Assets
Current Liabilities
Quick assets are cash and other assets that can be easily converted to cash.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Quick Assets o The quick ratio for Lincoln Company is computed below.
Quick assets:
Cash
Temporary Investments
Accounts receivable (net)
Total quick assets
Current liabilities
Quick ratio
2014 2013
$280,500
$210,000
$ 90,500 $ 64,700
75,000 60,000
115,000 120,000
$280,500 $244,700
$210,000 $243,000
1.3 1.0
$244,700
$243,000 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounts Receivable Turnover o The relationship between sales and accounts receivable may be stated as accounts receivable turnover . Collecting accounts receivable as quickly as possible improves a company’s solvency.
o The accounts receivable turnover is computed as follows:
Accounts Receivable Turnover
=
Net Sales
Average Accounts
Receivable c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounts Receivable Turnover o The accounts receivable turnover for Lincoln
Company is computed below.
2014 2013
Net sales
Accounts receivable (net):
Beginning of year
End of year
Total
Average (Total ÷ 2)
$1,498,000 $1,200,000
$ 120,000 $ 140,000
115,000 120,000
$ 235,000 $ 260,000
$ 117,500 $ 130,000
Accounts receivable turnover 12.7 9.2
$1,498,000
$117,500
$1,200,000
$130,000 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Number of Days’ Sales in Receivables o The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. It is computed as follows:
Number of Days’
Sales in Receivables
=
Net
Sales
365
Average Accounts
Receivable
Average Daily
Sales c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Number of Days’ Sales in Receivables o The number of days’ sales in receivables for
Lincoln Company is computed below.
2014 2013
Average accounts receivable
(Total accounts receivable ÷ 2) $ 117,500 $ 130,000
Net sales $1,498,000 $1,200,000
Average daily sales
(Net sales ÷ 365) $ 4,104 $ 3,288
Number of days’ sales in receivables 28.6 39.5
$117,500
$4,104
$130,000
$3,288 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Inventory Turnover o The relationship between the volume of goods
(merchandise) sold and inventory may be stated as the inventory turnover . The purpose of this ratio is to assess the efficiency of a firm in managing its inventory.
o The inventory turnover is computed as follows:
Inventory Turnover =
Cost of Goods Sold
Average Inventory c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Inventory Turnover o Lincoln’s inventory balance at the beginning of
2013 is $311,000.
2014 2013
Cost of goods sold
Inventories:
Beginning of year
End of year
Total
Average (Total ÷ 2)
$1,043,000
$ 283,000
264,000
$ 547,000
$ 273,500
$820,000
$311,000
283,000
$594,000
$297,000
Inventory turnover
$1,043,000
$273,500
3.8 2.8
$820,000
$297,000 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Number of Days’ Sales in Inventory o The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory.
o The number of days’ sales in inventory is computed as follows:
Number of Days’
Sales in Inventory
=
Average Inventory
Average Daily Cost of
Goods Sold
Cost of Goods Sold
365 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Number of Days’ Sales in Inventory o The number of days’ sales in inventory for
Lincoln Company is computed below.
2014 2013
Average Inventory $273,500 $297,000
$547,000 ÷ 2 $594,000 ÷ 2
(continued) c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Number of Days’ Sales in Inventory o The number of days’ sales in inventory for
Lincoln Company is computed below.
2014 2013
Average Inventory
Average daily cost of goods sold
$273,500
$2,858
$297,000
$2,247
$1,043,000 ÷
365
$820,000 ÷
365
Number of days’ sales in inventory 95.7 132.2
$273,500
$2,858
$297,000
$2,247 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Ratio of Fixed Assets to Long-Term Liabilities o The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the note-holders or bondholders. It also indicates the ability of the business to borrow additional funds on a longterm basis.
o The ratio is computed as follows:
Ratio of Fixed Assets to
Long-Term Liabilities
=
Fixed Assets (net)
Long-Term
Liabilities c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Ratio of Fixed Assets to Long-Term Liabilities o To illustrate, the ratio of fixed assets to longterm liabilities for Lincoln Company is computed below.
2014 2013
Fixed assets (net)
Long-term liabilities
$444,500
$100,000
$470,000
$200,000
Ratio of fixed assets to long-term liabilities
$444,500
$100,000
4.4 2.4
$470,000
$200,000 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Ratio of Liabilities to Stockholders’ Equity o The relationship between the total claims of the creditors and the owners— the ratio of liabilities to stockholders’ equity —is a solvency measure that indicates the margin of safety for creditors.
o The ratio is computed as follows:
Ratio of Liabilities to
Stockholders’ Equity
=
Total Liabilities
Total Stockholders’
Equity c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Ratio of Liabilities to Stockholders’ Equity o The ratio of liabilities to stockholders’ equity for Lincoln Company is computed below.
Total liabilities
Total stockholders’ equity
Ratio of liabilities to stockholders’ equity
$310,000
$829,500
2014
$310,000
$829,500
2013
$443,000
$787,500
0.4 0.6
$443,000
$787,500 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Number of Times Interest Charges Earned o Corporations in some industries normally have high ratios of debt to stockholders’ equity. For such corporations, the relative risk of the debtholders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge
coverage ratio.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Number of Times Interest Charges Earned o It is computed as follows:
Number of Times Interest
Charges Are Earned
=
Income Before Income Tax
+ Interest Expense
Interest Expense c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Number of Times Interest Charges Earned o The number of times interest charges are earned for Lincoln Company is computed below.
2014 2013
Income before income tax
Add interest expense
Amount available to meet interest charges
$162,500
6,000
$168,500
$134,600
12,000
$146,600
Number of times interest charges earned 28.1 12.2
$168,500
$6,000
$146,600
$12,000 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Number of Times Interest Charges Earned o The number of times interest charges are earned can be adapted for use with dividends on preferred stock.
o The number of times preferred dividends are earned is computed as follows:
Number of Times
Preferred Dividends
Are Earned
=
Net Income
Preferred Dividends c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Profitability Analysis o Profitability analysis focuses primarily on the relationship between operating results and the resources available to a business.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Ratio of Net Sales to Assets o The ratio of net sales to assets is a profitability measure that shows how effectively a company utilizes its assets.
o The ratio is computed as follows:
Ratio of Net Sales to Assets =
Net Sales
Average Total
Assets
(excluding longterm investments) c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Ratio of Net Sales to Assets o The ratio of net sales to assets for Lincoln
Company is computed below.
Net sales
Total assets:
Beginning of year
End of year
Total
Average (Total ÷ 2)
2014
$1,498,000
$1,053,000
1,044,500
$2,097,500
$1,048,750
2013
$1,200,000
$1,010,000
1,053,000
$2,063,000
$1,031,500
Excludes long-term investments
(continued) c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Ratio of Net Sales to Assets o The ratio of net sales to assets for Lincoln
Company is computed below.
Net sales
Total assets:
Beginning of year
End of year
Total
Average (Total ÷ 2)
2014
$1,498,000
$1,053,000
1,044,500
$2,097,500
$1,048,750
2013
$1,200,000
$1,010,000
1,053,000
$2,063,000
$1,031,500
Ratio of net sales to assets 1.4 1.2
$1,498,000
$1,048,750
$1,200,000
$1,031,500 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Rate Earned on Total Assets o The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed.
o It is computed as follows:
Rate Earned on Total Assets =
Net Income +
Interest Expense
Average Total Assets c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Rate Earned on Total Assets o This ratio for Lincoln Company is computed below. Total assets are $1,187,500 at the beginning of 2013.
2014 2013
Net income
Plus interest expense
Total
Total assets:
Beginning of year
End of year
Total
Average (Total ÷ 2)
$ 91,000
6,000
$ 97,000
$1,230,500
1,139,500
$2,370,000
$1,185,000
$ 76,500
12,000
$ 88,500
$1,187,500
1,230,500
$2,418,000
$1,209,000
Rate earned on total assets 8.2% 7.3%
$97,000
$88,500
$1,185,000
$1,209,000 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Rate Earned on Stockholders’ Equity o The rate earned on stockholders’ equity measures the rate of income earned on the amount invested by the stockholders.
o It is computed as follows:
Rate Earned on
Stockholders’ Equity
=
Net Income
Average Total
Stockholders’ Equity c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Rate Earned on Stockholders’ Equity o The rate for Lincoln Company is computed below. Total stockholders’ equity is $750,000 at the beginning of 2013.
Net income
Stockholders’ equity:
Beginning of year
End of year
Total
Average (Total ÷ 2)
2014
$ 91,000
$ 787,500
829,500
$1,617,000
$ 808,500
2013
$ 76,500
$ 750,000
787,500
$1,537,500
$ 768,750
Rate earned on stockholders’ equity 11.3% 10.0%
$91,000
$808,500
$76,500
$768,750 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Rate Earned on Stockholders’ Equity o The difference between the rate earned on stockholders’ equity and the rate earned on total assets is called leverage .
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Rate Earned on Stockholders’ Equity o For Lincoln Company, the effect of leverage is computed as follows:
Rate earned on stockholders’ equity
Less rate earned on total assets
Effect of leverage
2014 2013
11.3% 10.0%
8.2
7.3
3.1% 2.7% c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

R ATE E ARNED ON
S TOCKHOLDERS ’
E QUITY

Rate Earned on Common Stockholders’ Equity o The rate earned on common stockholders’ equity measures the rate of profits earned on the amount invested by the common stockholders.
o It is computed as follows:
Rate Earned on Common
Stockholders’ Equity
=
Net Income –
Preferred Dividends
Average Common
Stockholders’ Equity c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Rate Earned on Common Stockholders’ Equity o Lincoln Company had $150,000 of 6% preferred stock outstanding on December 31,
2014 and 2013. Thus, preferred dividends of
$9,000 ($150,000 x 6%) are deducted from net income. Lincoln’s common stockholders’ equity is determined as follows:
(continued) c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Rate Earned on Common Stockholders’ Equity
Net income
Less preferred dividends
Total
Common stockholders’ equity:
Beginning of year
End of year
Total
Average (Total ÷ 2)
2014
$ 91,000
9,000
$ 82,000
2013
$ 76,500
9,000
$ 67,500
$ 637,500 $ 600,000
679,500 637,500
$1,317,000 $1,237,500
$ 658,500 $ 618,750
Rate earned on common stockholders’ equity 12.5% 10.9%
$82,000
$658,500
$67,500
$618,750 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Earnings per Share on Common Stock o Earnings per share (EPS) on common stock measures the share of profits that are earned by a share of common stock. GAAP requires the reporting of earnings per share in the income statement.
o It is computed as follows:
Earnings per Share (EPS) on Common Stock
=
Net Income –
Preferred Dividends
Shares of Common Stock
Outstanding c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Earnings per Share on Common Stock o EPS for Lincoln Company is computed below.
Net income
Less preferred dividends
Total
Shares of common stock
2014
$91,000
9,000
$82,000
50,000
2013
$76,500
9,000
$67,500
50,000
Earnings per share on common stock $1.64 $1.35
$82,000
50,000
$67,500
50,000 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Price-Earnings Ratio o Another profitability measure quoted by the financial press is the price-earnings (P/E) ratio on common stock. The price-earnings ratio on common stock measures a company’s future earnings prospects.
o The price-earnings ratio is computed as follows:
Price-earnings (P/E) ratio =
Market Price per Share of
Common Stock
Earnings per Share on
Common Stock c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Price-Earnings Ratio o The P/E ratio for Lincoln Company is computed below.
2014 2013
Market price per share of common stock
Earnings per share on common stock
$41.00
$27.00
÷ $1.64
÷ $1.35
Price-earnings ratio on common stock 25 20 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Dividends per Share o Dividends per share can be reported with earnings per share to indicate the relationship between dividends and earnings. o Comparing these two per-share amounts measures the extent to which earnings are being distributed to common shareholders.
The ratio for dividends per share is at the top of the next slide.
(continued) c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Dividends per Share o The dividends per share for Lincoln Company are computed below.
Dividends per Share =
Dividends
Shares of Common Stock
Outstanding
2014 2013
Dividends on common stock $40,000 $30,000
Shares of common stock outstanding ÷ 50,000 ÷ 50,000
Dividends per share of common stock $0.80 $0.60
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

D IVIDENDS AND
E ARNINGS PER
S HARE

Dividend Yield o The dividend yield on common stock measures the rate of return to common stockholders from cash dividends.
o It is of special interest to investors whose objective is to earn dividends from their investment. It is computed as follows:
Dividend Yield =
Dividends per Share of
Common Stock
Market Price per Share of
Common Stock c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Dividend Yield o The dividend yield for Lincoln Company is computed below.
2014 2013
Dividends per share of common stock
Market price per share of common stock
$ 0.80
$41.00
$ 0.60
$27.00
Dividend yield on common stock 2.0% 2.2%
$0.80
$41
$0.60
$27 c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

S UMMARY OF
A NALYTICAL M EASURES
(continued)

S UMMARY OF
A NALYTICAL M EASURES
(concluded)

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Corporate Annual Reports o In addition to the financial statements and the accompanying notes, corporate annual reports usually include the following sections:
 Management discussion and analysis
 Report on internal control
 Report on fairness of the financial statements c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Management Discussion and Analysis o Management’s Discussion and Analysis
(MD&A) is required in annual reports filed with the SEC.
o It contains management’s analysis of current operations and its plans for the future.
o Typical items included in the MD&A are:
 Management’s analysis and explanations of any significant changes between the current and prior year’s financial statements.
(continued) c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Management Discussion and Analysis
 Important accounting principles or policies that could affect interpretation of the financial statements.
 Management’s assessment of the company’s liquidity and the availability of capital to the company.
 Significant risk exposures that might affect the company.
 Any “off-balance-sheet” arrangements such as leases not included directly in the financial statements.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Report on Internal Control o The Sarbanes-Oxley Act of 2002 requires a report stating management’s responsibility for establishing and maintaining internal control.
In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report.
o It also requires a public accounting firm to verify management’s conclusions on internal control.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Report on Fairness of Financial Statements o All publicly held corporations are required by the Sarbanes-Oxley Act of 2002 to have an independent audit (examination) of their financial statements. The CPA firm that conducts the audit renders an opinion on the fairness of the statements.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Unusual Items on the Income Statement o Unusual items affecting the current period’s income statement include the following:
 Discontinued operations
 Extraordinary items c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Discontinued Operations o A company may discontinue a segment of its operations by selling or abandoning the segment’s operations.
o A note accompanying the income statement should describe the operations sold, including such details as the date operations were discontinued, the assets sold, and the effect (if any) on current and future operations.
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Discontinued Operations o Jones Corporation produces and sells electrical products, hardware supplies, and lawn equipment. Because of lack of profits,
Jones discontinues its electrical products operation and sells the remaining inventory and other assets at a loss of $100,000. Exhibit
11 (next slide) illustrates the reporting of the loss on the discontinued operations.
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D ISCONTINUED
O PERATIONS

Extraordinary Items o An extraordinary item is defined as an event or transaction with both of the following characteristics:
 Unusual in nature
 Infrequent in occurrence c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

E XTRAORDINARY
I TEMS

R EPORTING
E ARNINGS PER
S HARE

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.