StIce | StIce |Skousen
Analysis of Financial
Statements
Chapter 22
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Learning Objectives
1.
2.
3.
4.
5.
Organize a systematic financial ratio analysis
using common-size financial statements and the
DuPont framework.
Recognize the potential impact that differing
accounting methods can have on the financial
ratios of otherwise essentially identical
companies.
Understand how foreign companies report their
financial results to U.S. investors.
Describe the purpose and format of the SEC’s
Form 20-F.
Convert foreign currency financial statements
into U.S. dollars using the translation method.
Framework for Financial
Statement Analysis
• Financial statement analysis- the
examination of the relationships
among:
– Financial statement numbers
– The trends of the statement numbers
over time.
• To analyze financial statements,
analyst use:
– Common sized financial statements
– Ratio analysis
Framework for Financial
Statement Analysis
The APB stated that comparisons between
financial statements are most informative—
1. When the presentations are in good
form.
2. When the content of the statements is
identical.
3. When accounting principles are not
changed, or, if they are changed, the
financial effects of the changes are
disclosed.
4. When changes in circumstances or in
the nature of the underlying transactions
are disclosed.
Framework for Financial
Statement Analysis
• Common-Size Financial Statements- analysis
of a company’s single-year financial
statements. Financial statements are
standardized by a measure of size, either
sales or total assets. All amounts are
stated in terms of a percentage of the size
measure.
• Ratio Analysis- Analysis of a company’s
financial statements by computing ratios
and comparing them against both trends
and industry averages.
Ratio Analysis
• DuPont Framework- Identifying factors that
impact return on equity.
• Efficiency Ratios- How efficiently is the firm
utilizing its assets?
• Leverage Ratios- To what degree is the
company using other people’s money to
purchase assets?
• Other Financial Ratios- Other indications of
liquidity, cash management, and
profitability.
DuPont Framework
• Developed internally at DuPont
around 1920.
• Provides a systematic approach to
identifying general factors causing
ROE to deviate from normal.
• Establishes a framework for
computing financial ratios to yield
more in-depth analysis of a company’s
areas of strength and weakness.
DuPont Framework
• DuPont: ROE can be decomposed into
three components:
Profitability x Efficiency
x
Leverage
Return on x
Asset
Sales
Turnover
x
Assets-toEquity Ratio
Net Income x
Sales
x
Assets
Equity
Sales
Assets
DuPont Framework
Net Income x
Sales
Sales
Assets
x
Assets
Equity
The number of
The number of The number of
pennies in dollars in sales dollars of assets a
company is able
profits generated generated by
to acquire using
from each dollar each dollar of
each dollar
of sales.
assets.
invested by
stockholders.
Impact of Alternative
Accounting Methods
• If companies are using differing
accounting practices, it will impact
the ratios.
• Careful financial statement users
should make adjustments for
accounting differences among the
companies being analyzed.
Foreign Reporting to U.S.
Investors
Firms such as
The good news is
DaimlerChrysler and that the demands of
These divergent
Disney
must
producedifferences
The
significant
nationalinternational
accounting users
financial
statementsstandards
in accounting
forcing
practices canare
have
an
for users around
not onlythe
incompanies
world
to provide
extremely
significant
their own
countriesboth
complicate
the
disclosure
so that
impact on
reported
but also
in other of users
preparation
can recognize
financialfinancial
statements.
countries.
statements and
the
and
reconcile the
understandingdiffering
of these accounting
statements for users.
standards.
Meeting the Needs of
International Users
Some multinational
firms respond to users
in other countries
simply by taking their
financial statements or
annual reports and
translating them into
the language of the
user.
Meeting the Needs of
International Users
Another response to the
international users is to
denominate the
financial statements in
the currency of the
country where the
financial statements
will be used.
Meeting the Needs of
International Users
Some multinationals
partially or completely
restate the financial
statements to the
accounting principles of
the financial statement
users’ country.
Meeting the Needs of
International Users
Mutual recognition
involves one country
accepting the financial
statements of another
country in return for that
country accepting its
financial statements for
all regulatory purposes.
The SEC’s Form 20-F
•
The SEC requires foreign companies
that list shares on U.S. to provide:
1. Complete U.S. GAAP financial
statements.
2. Reconcile their reported net income to
what income would be according to U.S.
GAAP.
Form 20-F
provides the
reconciliation.
Foreign Currency Financial
Statements
• Translation- Used when the foreign
subsidiary is a relatively self-contained unit
that is independent from the parent
company’s operations.
• Remeasurement- Is appropriate when the
subsidiary does not operate independently
of the parent company.
• Functional currency- Currency of the
primary economic environment of an entity.
Foreign Currency Financial
Statements
Translation
• Assets and liabilities are translated
using the current exchange rate
prevailing as of the balance sheet
date.
• Income statement items are translated
at the average exchange rate for the
year.
• Dividends are translated using the
exchange rate prevailing on the date
the dividends were declared.
Foreign Currency Financial
Statements
Translation
• Capital stock is translated at the historical
rate, the rate prevailing on the date the
subsidiary was acquired or the stock was
issued.
• Retained earnings is translated in the first year
using historical rates.
• In subsequent years, take the balance in
Retained Earnings from the prior period’s
translated financial statements and add
translated net income and subtracting
translated dividends.