13-1
13
FINANCIAL ANALYSIS:
THE BIG PICTURE
13-2
Accounting, Fourth Edition
Study Objectives
13-3
1.
Understand the concept of sustainable income.
2.
Indicate how irregular items are presented.
3.
Explain the concept of comprehensive income.
4.
Describe and apply horizontal analysis.
5.
Describe and apply vertical analysis.
6.
Identify and compute ratios used in analyzing a company’s
liquidity, solvency, and profitability.
7.
Understand the concept of quality of earnings.
Financial Analysis: The Big Picture
Sustainable
Income
Irregular items
Changes in
accounting
principles
Comprehensive
income
Comparative
Analysis
Ratio Analysis
Horizontal
analysis
Liquidity ratios
Vertical
analysis
Profitability
ratios
Solvency ratios
Quality of
Earnings
Alternative
accounting
methods
Pro forma
income
Improper
recognition
Price-earnings
ratio
13-4
Sustainable Income
Sustainable Income - Net income adjusted for irregular
items.
Irregular items are separately identified on the income
statement. Two types are:
1. Discontinued operations.
2. Extraordinary items.
These “irregular” items are reported net of income
taxes.
SO 1 Understand the concept of sustainable income.
13-5
SO 2 Indicate how irregular items are presented.
Sustainable Income
Illustration 13-1
Components of
the income
statement
13-6
SO 2 Indicate how irregular items are presented.
Sustainable Income
Discontinued Operations
(a) Disposal of a significant component of a business.
(b) Income statement should report a gain (or loss)
from discontinued operations, net of tax.
13-7
SO 2 Indicate how irregular items are presented.
Sustainable Income
Illustration: Rozek Inc. has revenues of $2.5 million and
expenses of $1.7 million from continuing operations in 2012. The
company therefore has income before income taxes of
$800,000. During 2012 the company discontinued and sold its
unprofitable chemical division at a loss of $210,000 (net of
$90,000 tax savings).
Illustration 13-2
13-8
SO 2
Sustainable Income
Extraordinary items are events and transactions that
meet two conditions:
Both

Unusual in nature and

Infrequent in occurrence
Company must consider the environment in which it
operates.
Amounts reported “net of tax.”
13-9
SO 2 Indicate how irregular items are presented.
Sustainable Income
Illustration: In 2012 a revolutionary foreign government
expropriated property held as an investment by Rozek Inc. If the
loss is $70,000 before applicable income tax savings of $21,000,
how will the loss be presented in the income statement?
Illustration 13-3
13-10
SO 2 Indicate how irregular items are presented.
Sustainable Income
Are these considered Extraordinary Items?
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
Effects of major natural casualties, if rare in
the area.
YES

Effects of major natural casualties, not
uncommon in the area.
NO

Write-down of inventories or write-off of
receivables.
NO

Expropriation (takeover) of property by a
foreign government.
YES
SO 2 Indicate how irregular items are presented.
Sustainable Income
Are these considered Extraordinary Items?

Losses attributable to labor strikes.
NO

Effects of a newly enacted law or regulation,
such as a condemnation action.
YES
Gains or losses from sales of property, plant,
or equipment.
NO

13-12
SO 2 Indicate how irregular items are presented.
13-13
Sustainable Income
Changes in Accounting Principle
13-14

Principle used in the current year is different from
one used in the preceding year.

Example - change from FIFO to average cost.

Permissible when management can show new
principle is preferable.

Most changes are reported retroactively.
SO 2 Indicate how irregular items are presented.
Sustainable Income
Comprehensive Income
All changes in stockholders’ equity except those resulting
from

investments by stockholders and

distributions to stockholders.
Certain gains and losses bypass net income and instead are
reported as direct adjustments to stockholders’ equity.

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Example – Unrealized gain or loss on Available-for-sale
securities
SO 3 Explain the concept of comprehensive income.
Sustainable Income
Illustration of Comprehensive Income
Accounting standards require companies to adjust most
investments in stocks and bonds up or down to their market
value at the end of each accounting period.
Illustration: During 2012 Stassi Company purchased IBM stock
for $10,000 as an investment. At the end of 2012 Stassi was still
holding the investment, but the stock’s market value was now
$8,000.
How should Stassi account for the $2,000 unrealized loss?
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SO 3 Explain the concept of comprehensive income.
Sustainable Income
Illustration of Comprehensive Income
How should Stassi account for the $2,000 unrealized loss?
Answer: Depends on whether Stassi classifies the IBM stock
as a

Trading security or an

Available for-sale security.
Unrealized gains and
losses
(Income Statement)
Unrealized gains and losses
(Comprehensive Income - Stockholders’ Equity)
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SO 3 Explain the concept of comprehensive income.
Sustainable Income
Format One – Comprehensive Income
Combined statement of income and comprehensive income.
Illustration 13-5
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SO 3 Explain the concept of comprehensive income.
Sustainable Income
Format Two - Comprehensive Income
Separate component of Stockholders’ Equity.
Illustration 13-6
13-19
SO 3 Explain the concept of comprehensive income.
Sustainable Income
Format Three Comprehensive
Income
Illustration 13-7
Complete
Income
Statement
13-20
SO 3 Explain the concept of comprehensive income.
Sustainable Income
Illustration: In its draft 2012 income statement,
AIR Corporation reports income before income
taxes $400,000, extraordinary loss due to earthquake $100,000,
income taxes $120,000 (not including irregular items), and loss on
disposal of discontinued flower division $140,000. The income tax
rate is 30%. Prepare a correct income statement, beginning with
income before income taxes.
AIR CORPORATION
Income Statement (partial)
Income before income taxes
Income tax expense
Income before irregular items
Discontinued operations
Loss on disposal of discontinued flower division,
net of $42,000 tax savings
Extraordinary earthquake loss, net of $30,000 tax savings
Net income
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$400,000
120,000
280,000
(98,000)
(70,000)
$112,000
Comparative Analysis
Analyzing financial statements involves:
Comparison
Bases
13-22
Basic Tools

Intracompany

Horizontal analysis

Intercompany

Vertical analysis

Industry averages

Ratio Analysis
Comparative Analysis
Horizontal Analysis
Also called trend analysis, is a technique for evaluating a
series of financial statement data over a period of time.
Purpose - to determine increase or decrease that has
taken place.
Commonly applied to the balance sheet and income
statement.
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SO 4 Describe and apply horizontal analysis.
Comparative Analysis
Illustration 13-11
Horizontal analysis
of balance sheets
Helpful Hint:
When using
horizontal
analysis, be sure
to examine both
dollar amount
changes and
percentage
changes.
13-24
SO 4 Describe and apply horizontal analysis.
Comparative Analysis
Illustration 13-12
Horizontal analysis
of Income statements
Helpful Hint: In horizontal analysis, while the amount column is additive (the
total is $99 million), the percentage column is not additive (9.9% is not a total).
13-25
SO 4 Describe and apply horizontal analysis.
Comparative Analysis
Illustration: Summary financial information for
Rosepatch Company is as follows.
Compute the amount and percentage changes in 2012 using
horizontal analysis, assuming 2011 is the base year.
Solution
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SO 4 Describe and apply horizontal analysis.
Comparative Analysis
Vertical Analysis
Also called common-size analysis, is a technique that
expresses each financial statement item as a percent of a
base amount.
Vertical analysis is commonly applied to the balance sheet
and the income statement.
13-27
SO 5 Describe and apply vertical analysis.
Comparative Analysis
Illustration 13-13
Vertical analysis of
Income statements
These results
indicate the
company shifted
toward equity
financing by relying
less on debt and by
increasing the
amount
of retained
earnings.
13-28
SO 5 Describe and apply vertical analysis.
Comparative Analysis
Illustration 13-14
Vertical analysis of
an income
statements
The increase in net income as a percentage of sales is due primarily to the
decrease in interest expense and income tax expense as a percent of
sales.
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SO 5 Describe and apply vertical analysis.
Comparative Analysis
Illustration 13-15
Intercompany
comparison by vertical
analysis
Vertical analysis
also enables a
comparison of
companies of
different sizes.
Although Chicago Cereal’s net sales are less than those of General Mills,
vertical analysis eliminates the impact of this size difference for our analysis.
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SO 5 Describe and apply vertical analysis.
Ratio Analysis
Ratio analysis expresses the relationship among selected
items of financial statement data.
Financial Ratio Classifications
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Liquidity
Solvency
Profitability
Measures shortterm ability of the
company to pay its
maturing
obligations and to
meet unexpected
needs for cash.
Measures the
ability of the
company to
survive over a long
period of time.
Measures the
income or
operating success
of a company for a
given period of
time.
SO 6 Identify and compute ratios used in analyzing a
company’s liquidity, solvency, and profitability.
Ratio Analysis
Illustration 13-16
Liquidity Ratios
13-32
SO 6 Identify and compute ratios used in analyzing a
company’s liquidity, solvency, and profitability.
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Ratio Analysis
Illustration 13-17
Solvency Ratios
13-34
SO 6 Identify and compute ratios used in analyzing a
company’s liquidity, solvency, and profitability.
Ratio Analysis
Illustration 13-18
Profitability Ratios
13-35
SO 6 Identify and compute ratios used in analyzing a
company’s liquidity, solvency, and profitability.
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Quality of Earnings
A company that has a high quality of earnings provides
full and transparent information that will not confuse or
mislead users of the financial statements.
Recent accounting scandals suggest that some
companies are spending too much time managing their
income and not enough time managing their business.
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SO 7 Understand the concept of quality of earnings.
Quality of Earnings
Alternative Accounting Methods

Variations among companies in the application of GAAP
may hamper comparability and reduce quality of earnings
(FIFO vs. LIFO).
Pro Forma Income
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
Usually excludes items that are unusual or nonrecurring.

Some companies have abused the flexibility that pro
forma numbers allow to put their companies in a more
favorable light.
SO 7 Understand the concept of quality of earnings.
Quality of Earnings
Alternative Accounting Methods
Some managers have felt pressure to continually increase
earnings.
Abuses include:
13-39

Improper recognition of revenue (channel stuffing).

Improper capitalization of operating expenses
(WorldCom).

Failure to report all liabilities (Enron).
SO 7 Understand the concept of quality of earnings.
Quality of Earnings
Price-Earnings Ratio
Reflects investors’ assessment of a company’s future
earnings.

P-E ratio will be higher if investors think that earnings will
increase substantially in the future.

P-E ratio will be lower when there is the belief that a
company has poor-quality earnings.
Illustration 13-19
13-40
SO 7 Understand the concept of quality of earnings.
Quality of Earnings
Price-Earnings Ratio
Illustration 13-19
Illustration 13-20
Earnings per share and P-E
ratios of various companies
13-41
SO 7 Understand the concept of quality of earnings.
13-42
Quality of Earnings
Illustration: Match each of the following terms
with the phrase that it best matches.
Comprehensive income
Quality of earnings
Solvency ratio
Vertical analysis
Pro forma income
Extraordinary items
1. Measures the ability of the company to survive
over a long period of time.
Solvency
2. Usually excludes items that a company thinks are
unusual or non-recurring.
Pro forma
3. Includes all changes in stockholders’ equity during
a period except those resulting from investments
by stockholders and distributions to stockholders.
Comprehensive
income
13-43
SO 7 Understand the concept of quality of earnings.
Quality of Earnings
Illustration: Match each of the following terms
with the phrase that it best matches.
Comprehensive income
Quality of earnings
Solvency ratio
Vertical analysis
Pro forma income
Extraordinary items
4. Indicates the level of full and transparent
information provided to users of the financial
statements.
5. Describes events and transactions that are
unusual in nature and infrequent in occurrence.
6. Expresses each item within a financial statement
as a percent of a base amount.
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Quality of
earnings
Extraordinary
items
Vertical
analysis
SO 7 Understand the concept of quality of earnings.
appendix 13A
Comprehensive
Ratio Analysis
Analyzing financial statements involves:
Comparison
Bases
Characteristics

Liquidity

Intracompany

Profitability

Industry averages

Solvency

Intercompany
The financial information in Illustrations 13A-1 through 13A-4 will be used
to calculate Chicago’s 2009 ratios.
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appendix 13A
Comprehensive
Ratio Analysis
Illustration 13A-1
13-46
appendix 13A
Comprehensive
Ratio Analysis
Illustration 13A-2 & 13A-4
13-47
appendix 13A
Comprehensive
Ratio Analysis
Illustration 13A-3
13-48
appendix 13A
Comprehensive
Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its maturing
obligations and to meet unexpected needs for cash.

Short-term creditors such as bankers and suppliers are
particularly interested in assessing liquidity.

Ratios include the current ratio, the current cash debt
coverage ratio, the receivables turnover ratio, the
average collection period, the inventory turnover ratio,
and average days in inventory.
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appendix 13A
Comprehensive
Ratio Analysis
Current Ratio - Expresses the relationship of current assets to
current liabilities. Calculate the current ratio for 2009 and 2008.
Illustration 13A-5
.67
.60
What do the measures tell us?
A current ratio of .67 means that for every dollar of current
liabilities, the company has $0.67 of current assets.
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appendix 13A
Comprehensive
Ratio Analysis
Cash Debt Coverage Ratio - Because it uses cash provided by
operating activities, it may provide a better representation of
liquidity. Calculate the ratio for 2009 and 2008.
Illustration 13A-6
.37
.39
Is the coverage adequate?
Probably so. Chicago’s coverage is better than that of General
Mills, and it approximates an accepted threshold of .40.
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appendix 13A
Comprehensive
Ratio Analysis
Receivables Turnover Ratio – Measures the number of times,
on average, a company collects receivables during the period.
Calculate the ratio for 2009 and 2008.
Illustration 13A-7
11.9 12.0
How does Chicago’s turnover compare to General Mills’s?
The turnover of 11.9 times is lower than the industry average of
14.0 times, and slightly lower than General Mills’s turnover of 12.8
times.
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appendix 13A
Comprehensive
Ratio Analysis
Average Collection Period – Converts the receivable turnover
ratio into days. Calculate the collection period for 2009 and
2008.
Illustration 13A-8
30.7 30.4
How effective is Chicago’s credit and collection policies?
General rule - collection period should not greatly exceed the
credit term period (i.e., the time allowed for payment).
13-53
appendix 13A
Comprehensive
Ratio Analysis
Inventory Turnover Ratio - Measures the number of times
average inventory was sold during the period. Calculate the ratio
for Chicago for 2009 and 2008.
Illustration 13A-9
7.5
7.9
How does Chicago’s turnover compare to General Mills’s?
The ratio of 7.5 times is higher than the industry average of 6.9
times and better than General Mills’s 6.2 times.
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appendix 13A
Comprehensive
Ratio Analysis
Days in Inventory - Measures the average number of days
inventory is held. Calculate the days for Chicago for 2009 and
2008.
Illustration 13A-10
48.7 46.2
How does Chicago’s days compare to General Mills’s?
An average selling time of 49 days is faster than the industry
average and faster than that of General Mills.
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appendix 13A
Comprehensive
Ratio Analysis
Solvency Ratios
Solvency ratios measure the ability of a company to survive over
a long period of time.


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Debt-Paying Ability
►
Debt to total assets ratio
►
Times interest earned ratio
►
Cash debt coverage ratio
Free cash flow provides information about solvency and
ability to pay additional dividends or invest.
appendix 13A
Comprehensive
Ratio Analysis
Debt to Total Assets Ratio – Indicates the degree of financial
leveraging. Provides some indication of the company’s ability to
withstand losses. Calculate the ratio for 2009 and 2008.
Illustration 13A-11
78% 81%
Has Chicago’s solvency improved during the year?
Yes, slightly. The ratio of 78% says that Chicago would have to
liquidate 78% of its assets at their book value in order to pay off all
of its debts.
13-57
appendix 13A
Comprehensive
Ratio Analysis
Times Interest Earned Ratio - (also called interest coverage)
indicates the company’s ability to meet interest payments as they
come due. Calculate the ratio for Chicago for 2009 and 2008.
Illustration 13A-12
5.8 5.8
Is Chicago better able to service its’ debt?
Yes, the debt to total assets ratio decreased during 2009 and the
times interest earned ratio held constant.
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appendix 13A
Comprehensive
Ratio Analysis
Cash Debt Coverage Ratio - Indicates a company’s ability to
repay its liabilities from cash generated from operating activities
without having to liquidate the assets used in its operations.
Calculate the ratio for Chicago.
Illustration 13A-13
.17
.17
One way of interpreting this ratio is to say that net cash generated
from one year of operations would be sufficient to pay off 17% of
Chicago’s total liabilities.
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appendix 13A
Comprehensive
Ratio Analysis
Free Cash Flow - Ability to pay dividends or expand operations.
Calculate the ratio for Chicago.
Illustration 13A-14
556
507
(in millions)
Cash provided by operations was more than enough to allow
Chicago to acquire additional productive assets and maintain
dividend payments.
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appendix 13A
Comprehensive
Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for
a given period of time.
Illustration 13A-15
Relationships among
profitability measures
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appendix 13A
Comprehensive
Ratio Analysis
Return on Common Stockholders’ Equity Ratio - Shows how
many dollars of net income the company earned for each dollar
invested by the owners. Calculate the ratio for Chicago.
Illustration 13A-16
48% 46%
Chicago’s 2009 rate of return on common stockholders’ equity is
unusually high at 48%, considering an industry average of 30%
and General Mills’s return of 29%.
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appendix 13A
Comprehensive
Ratio Analysis
Return on Assets Ratio - Measures the overall profitability of
assets in terms of the income earned on each dollar invested in
assets. Calculate the ratio.
Illustration 13A-17
10% 9.4%
Note that Chicago’s rate of return on common stockholders’ equity
(48%) is substantially higher than its rate of return on assets
(10%). Chicago has made effective use of leverage.
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appendix 13A
Comprehensive
Ratio Analysis
Profit Margin Ratio - Or rate of return on sales, is a measure of
the percentage of each dollar of sales that results in net income.
Calculate the ratio for Chicago.
Illustration 13A-18
9.4% 9.2%
High-volume (high inventory turnover) businesses such as grocery
stores and pharmacy chains generally have low profit margins.
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appendix 13A
Comprehensive
Ratio Analysis
Asset Turnover Ratio - Measures how efficiently a company
uses its assets to generate sales. Calculate the ratio for
Chicago.
Illustration 13A-19
1.07
1.02
The average asset turnover for utility companies is .45, for
example, while the grocery store industry has an average asset
turnover of 3.49.
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appendix 13A
Comprehensive
Ratio Analysis
You can analyze the combined effects of profit margin and
asset turnover on return on assets for Chicago as shown
Illustration 13A-20
13-66
appendix 13A
Comprehensive
Ratio Analysis
Gross Profit Rate - Indicates a company’s ability to maintain
an adequate selling price above its cost of goods sold.
Calculate the ratio for Chicago.
Illustration 13A-21
44% 44%
As an industry becomes more competitive, this ratio declines.
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appendix 13A
Comprehensive
Ratio Analysis
Earnings Per Share - A measure of the net income earned on
each share of common stock. Calculate the ratio for Chicago.
Illustration 13A-22
$2.63 $2.40
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appendix 13A
Comprehensive
Ratio Analysis
Price-Earnings (P-E) Ratio - Reflects investors’ assessments of
a company’s future earnings. Calculate the ratio for Chicago.
Illustration 13A-23
20.1
20.9
A higher P-E ratio suggests that the market is more optimistic
about Chicago. It might also signal that its stock is overpriced.
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appendix 13A
Comprehensive
Ratio Analysis
Payout Ratio - Measures the percentage of earnings distributed
in the form of cash dividends. Calculate the ratio for Chicago.
Illustration 13A-24
43% 45%
This ratio should be calculated over a longer period of time to
evaluate any trends.
13-70
Key Points
13-71

The tools of financial statement analysis covered in this
chapter are universal and therefore no significant differences
exist in the analysis methods used.

The basic objectives of the income statement are the same
under both GAAP and IFRS. Thus, both the IASB and the FASB
are interested in distinguishing normal levels of income from
irregular items in order to better predict a company’s future
profitability.

The basic accounting for discontinued operations is the same
under IFRS and GAAP.
Key Points
13-72

Under IFRS, there is no classification for extraordinary items. In
other words, extraordinary item treatment is prohibited under
IFRS. All revenue and expense items are considered ordinary in
nature.

The accounting for changes in accounting principles and
changes in accounting estimates are the same for both GAAP
and IFRS.

The income statement under IFRS is referred to as a statement
of comprehensive income. The statement of comprehensive
income can be prepared under the one-statement approach or
the two-statement approach.
Key Points
13-73

GAAP also permits the one-statement or two-statement
approach. In addition, GAAP permits a third alternative, which
is to show the computation of comprehensive income in the
statement of stockholders’ equity.

The issues related to quality of earnings are the same under
both GAAP and IFRS. It is hoped that by adopting a more
principles-based approach, as found in IFRS, many of the
earnings’ quality issues will disappear.
Looking into the Future
The FASB and the IASB are working on a project that would rework the
structure of financial statements. Recently, the IASB decided to require
a statement of comprehensive income, similar to what was required
under GAAP. In addition, another part of this project addresses the
issue of how to classify various items in the income statement. A main
goal of this new approach is to provide information that better
represents how businesses are run. In addition, the approach draws
attention away from one number—net income.
13-74
The basic tools of financial analysis are the same under both
GAAP and IFRS except that:
a) horizontal analysis cannot be done because the format of
the statements is sometimes different.
b) analysis is different because vertical analysis cannot be
done under IFRS.
c) the current ratio cannot be computed because current
liabilities are often reported before current assets in IFRS
statements of position.
d) None of the above.
13-75
Under IFRS:
a) the reporting of discontinued items is different than
GAAP.
b) the reporting of extraordinary items is prohibited.
c) the reporting of changes in accounting principles is
different than under GAAP.
d) None of the above.
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Presentation of comprehensive income must be reported
under IFRS in:
a) the statement of stockholders’ equity.
b) the income statement ending with net income.
c) the notes to the financial statements.
d) a statement of comprehensive income.
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13-78