1

STUDY UNIT TEN

ADVANCED FINANCIAL ACCOUNTING
CONCEPTS AND ANALYSIS

10.1 Risk and Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

10.2 Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
10.3 Foreign Currency Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
10.4 Business Combinations and Consolidated Financial Statements . . . . . . . . . . . . . . . . . . 12
10.5 Corporate Equity Accounts and Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
10.6 Financial Statement Analysis -- Liquidity Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
10.7 Financial Statement Analysis -- Activity Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
10.8 Financial Statement Analysis -- Solvency Ratios and Leverage . . . . . . . . . . . . . . . . . . . 26
10.9 Financial Statement Analysis -- ROI and Profitability . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
10.10 Financial Statement Analysis -- Corporate Valuation and Common-Size Financial
Statements Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

This study unit is the second of six covering Domain IV: Financial Management from The IIA’s
CIA Exam Syllabus. This domain makes up 20% of Part 3 of the CIA exam and is tested at the basic
and proficient cognitive levels. Refer to the complete syllabus located in Appendix A to view the
relevant sections covered in Study Unit 10.

The majority of financial management questions on the CIA exam test conceptual
understanding, not the ability to perform calculations. However, many of our financial
management questions require you to perform calculations. They are an effective means of
reinforcing your conceptual understanding.

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2 SU 10: Advanced Financial Accounting Concepts and Analysis

10.1 RISK AND RETURN

1. Rate of Return
a. A return is the amount received by an investor as compensation for taking on the risk of
the investment.
Return = Amount received – Amount invested

EXAMPLE 10-1 Return on Investment

An investor paid US $100,000 for an investment that returned US $112,000. The investor’s return is
US $12,000 ($112,000 – $100,000).

b. The rate of return is the return stated as a percentage of the amount invested.

EXAMPLE 10-2 Rate of Return

The investor’s rate of return is 12% (US $12,000 ÷ $100,000).

Note that the return formula presented above differs from the return on investment (ROI)
formula presented in Subunit 10.9. The return looks at a specific investment’s profitability
relative to the amount invested, whereas the ROI formula indicates how well a business is
using its resources to generate operating income.

2. Residual Income
a. Residual income is calculated as follows:
Residual income = Operating income – Target return on invested capital
1) The target return equals average invested capital times an imputed interest rate.
This rate ordinarily is the weighted-average cost of capital (defined in Study Unit 12,
Subunit 3), but it may be a hurdle rate reflecting the specific risks of a project.
b. Projects with a positive residual income should be accepted, and projects with a negative
residual income should be rejected.
c. Residual income is often considered to be superior to ROI (discussed in Subunit 10.9).
ROI is a percentage measure, and residual income is a monetary measure. Residual
income therefore may be more consistent with maximizing profits.
3. Investment Securities
a. Financial managers may select from many financial instruments for investments and
capital acquisition.

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 SU 10: Advanced Financial Accounting Concepts and Analysis 3

b. The safety of an investment

and its potential return
are inversely related. To
the right is a short list of
widely available investment
securities.

Figure 10-1

c. The reasons for the varying risk and potential return of these securities can be
summarized as follows:
1) Equity securities are necessarily more risky than debt because an entity’s owners
are not contractually guaranteed a return.
2) Issuers of debt securities are contractually obligated to redeem them. Because these
returns are guaranteed, they are lower than those for equity investments.
4. Asset Valuation -- CAPM
a. The capital asset pricing model (CAPM) quantifies the expected return on an equity
security by relating the security’s risk to the average return available in the market.
b. The investor must be compensated for the time value of money and risk.
1) The time value component is the risk-free rate (RF). It is the return provided by the
safest investments, e.g., U.S. Treasury securities.
2) The risk component is determined by the following:
a) The market risk premium (RM – RF) is the return provided by the market
above the risk-free rate.
b) The effect of an individual security on the volatility of a portfolio is measured by
its sensitivity to movements by the overall market. This sensitivity is stated in
terms of a stock’s beta coefficient (β).
i) The beta of the market portfolio equals 1, and the beta of U.S. Treasury
securities is 0.
c) The security risk premium is the market risk premium weighted by beta.
CAPM Formula
Required rate of return = RF + β(RM – RF)
If: RF = Risk-free return
RM = Market return
β = Measure of the systematic risk or volatility of the individual
security in comparison with the market (diversified portfolio)

EXAMPLE 10-3 Required Rate of Return -- CAPM

An investor is considering the purchase of a stock with a beta of 1.2. Treasury bills currently return 8.6%,
and the average return on the market is 10.1%. (U.S. Treasuries are as close to a risk-free investment as
possible.) The return that the investor requires is calculated as follows:
Required rate of return = RF + β(RM – RF)
= 8.6% + 1.2(10.1% – 8.6%)
= 8.6% + 1.8%
= 10.4%

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4 SU 10: Advanced Financial Accounting Concepts and Analysis

5. Two Basic Types of Investment Risk

a. Systematic risk, or market risk, is unavoidable. Changes in the economy as a whole,
such as inflation or the business cycle, affect all market participants.
1) Systematic risk is sometimes called undiversifiable risk. All investments are
affected, and this risk cannot be reduced by diversification.
b. Unsystematic risk, or firm-specific risk, is the risk inherent in a specific investment. This
type of risk is determined by the firm’s industry, products, customer loyalty, degree of
leverage, management competence, etc.
1) Unsystematic risk is diversifiable risk. Because individual investments are
affected by the strengths and weaknesses of the firm, this risk can be reduced by
diversification.
6. Types of Investment Risk
a. Credit default risk is the risk that the borrower will default and will not be able to repay
principal or interest. This risk is estimated by credit-rating agencies.
b. Liquidity risk is the risk that a security cannot be sold on short notice for its market value.
c. Maturity risk, or interest rate risk, is the risk that an investment security will fluctuate
in value between the time it was issued and its maturity date. The longer the time until
maturity, the greater the maturity risk.
d. Inflation risk is the risk that the purchasing power of the currency will decline.
e. Political risk is the probability of loss from actions of governments, such as from changes
in tax laws or environmental regulations or from expropriation of assets.
f. Exchange rate risk is the risk of loss because of fluctuation in the relative value of foreign
currency.
g. Business risk (or operations risk) is the risk of fluctuations in earnings before interest
and taxes or in operating income when the firm has no debt. It is the risk inherent in its
operations that excludes financial risk, which is the risk to the shareholders from the use
of financial leverage. Business risk depends on factors such as the variability of demand,
sales prices, and input prices. It also is affected by operating leverage.
7. Portfolio Management -- Diversification
a. The goal of portfolio management is to hold a group of securities that generates a return
without the risks associated with one security. An investor wants to maximize return and
minimize risk when choosing a portfolio of investments.
1) Portfolio return is the weighted average of the returns on the individual securities.
2) Portfolio risk is usually less than a simple average of the risks of the securities in the
portfolio. One goal of diversification is to offset the unsystematic risk.
b. The coefficient of correlation measures the degree to which the prices of two variables
(e.g., two equity securities) are related. It has a range from 1.0 to –1.0.
1) Perfect positive correlation (1.0) means that the prices of two securities always move
together.
2) Perfect negative correlation (–1.0) means that the prices of two securities always
move in opposite directions.
3) If a pair of securities has a coefficient of correlation of 1.0, the risk of the two
together is the same as the risk of each security by itself. If a pair of securities has
a coefficient of correlation of –1.0, all unsystematic (firm-specific) risk has been
eliminated.
c. The ideal portfolio consists of securities with a wide enough variety of coefficients of
correlation so that only market risk remains.
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 SU 10: Advanced Financial Accounting Concepts and Analysis 5

8. Efficient Markets Hypothesis

a. The efficient markets hypothesis states that current stock prices immediately and fully
reflect all relevant information. Hence, the market is continuously adjusting to new
information and acting to correct pricing errors. The efficient markets hypothesis has
three forms.

Strong Form All public and private information is instantaneously reflected in securities’ prices.
All publicly available data are reflected in security prices, but private or insider
Semistrong Form
data are not immediately reflected.
Weak Form Current securities prices reflect all recent price movement data.

10.2 DERIVATIVES
1. Overview
a. A derivative instrument is an investment in which the parties’ gain or loss is derived from
some other economic event, for example, the price of a given stock, a foreign currency
exchange rate, or the price of a certain commodity.
1) One party enters into the transaction to speculate (incur risk), and the other enters
into it to hedge (avoid risk).
b. Derivatives are a type of financial instrument, along with cash, accounts receivable, notes
receivable, bonds, preferred shares, etc.
2. Options
a. A party who buys an option has bought the right to demand that the counterparty (the
seller or “writer” of the option) buy or sell an underlying asset on or before a specified
future date. The buyer holds all of the rights, and the seller has all of the obligations. The
buyer pays a fee to determine whether the seller buys (sells) the underlying asset from
(to) the buyer.
1) A call option gives the buyer (holder) the right to purchase (i.e., the right to call for)
the underlying asset (stock, currency, commodity, etc.) at a fixed price.
2) A put option gives the buyer (holder) the right to sell (i.e., the right to put onto the
market) the underlying asset (stock, currency, commodity, etc.) at a fixed price.
3) The asset that is subject to being bought or sold under the terms of the option is the
underlying.
4) The party buying an option is the holder. The seller is the writer.
5) The exercise of an option is always at the discretion of the option holder (the buyer)
who has, in effect, bought the right to exercise the option or not.
a) The seller of an option has no choice. (S)he must perform if the holder
chooses to exercise.
6) An option has an expiration date after which it can no longer be exercised.

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6 SU 10: Advanced Financial Accounting Concepts and Analysis

3. Components of the Option Price

a. The price of an option (the option premium) consists of two components: intrinsic value
and the time premium, also called extrinsic value.
Option premium = Intrinsic value + Time premium

b. The exercise price (the strike price) is the price at which the holder can purchase (call
option) or sell (put option) the underlying.
c. The intrinsic value of an option is the value of the option today if it is exercised today.
If intrinsic value is zero, market value would still be positive because of market volatility,
interest rates, and the time value of money.
1) The intrinsic value of a call option is the amount by which the exercise price is
less than the current price of the underlying.
a) If an option has a positive intrinsic value, it is in-the-money.

EXAMPLE 10-4 Intrinsic Value of a Call Option

An investor holds call options for 200 shares of Locksley Corporation with an exercise price of US $48 per
share. Locksley stock is currently trading at US $50 per share. The investor’s options have an intrinsic value
of US $2 each ($50 – $48).

b) If an option has an intrinsic value of US $0, it is out-of-the-money.

EXAMPLE 10-5 Out-of-the-Money Call Option

An investor holds call options for 200 shares of Locksley Corporation with an exercise price of US $48 per
share. Locksley stock is currently trading at US $45 per share. The investor’s options are out-of-the-money.

d. The intrinsic value of a put option is the amount by which the exercise price is greater
than the current price of the underlying.
1) If an option has a positive intrinsic value, it is in-the-money.

EXAMPLE 10-6 Intrinsic Value of a Put Option

An investor holds put options for 200 shares of Locksley Corporation with an exercise price of US $48 per
share. Locksley stock is currently trading at US $45 per share. The investor’s options have an intrinsic value
of US $3 each ($48 – $45).

2) If an option has an intrinsic value of US $0, it is out-of-the-money.

EXAMPLE 10-7 Out-of-the-Money Put Option

An investor holds put options for 200 shares of Locksley Corporation with an exercise price of US $48 per
share. Locksley stock is currently trading at US $50 per share. The investor’s options are out-of-the-money.

e. Time Premium
1) The more time between the writing of an option and its expiration, the greater the
probability that the price of the underlying will change and the option will be in-the-
money. Because the buyer’s loss on an option is limited to the option premium, an
increase in the term of an option (call or put) increases the time premium.

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 SU 10: Advanced Financial Accounting Concepts and Analysis 7

4. Forward Contracts
a. One method of mitigating risk is the simple forward contract. The two parties agree that,
at a set future date, one will perform and the other will pay a specified amount for the
performance.
1) A common example is that of a retailer and a wholesaler who agree in September on
the prices and quantities of merchandise that will be shipped to the retailer’s stores
in time for the winter holiday season. The retailer has locked in a price and a source
of supply, and the wholesaler has locked in a price and a customer.
b. In a forward contract, each party has an obligation, i.e., to deliver merchandise or to pay.
Neither has the option of nonperformance.
1) Forward contracts often are used in foreign currency exchange transactions.
5. Futures Contracts
a. A futures contract is a commitment to buy or sell an asset at a fixed price during a specific
future period. Unlike a forward contract, the counterparty is unknown.
b. Futures contracts are standardized forward contracts with predetermined quantities and
dates. They are essentially commodities that are actively traded on futures exchanges.
1) A clearinghouse randomly matches sellers who will deliver during a given period with
buyers who are seeking delivery during the same period.
c. Because futures contracts are actively traded, the result is a liquid market that permits
buyers and sellers to net their positions.
d. Another aspect of futures contracts is that the market price is posted and netted to each
person’s account at the close of every business day. This practice is called mark-to-
market.
1) A mark-to-market provision minimizes a futures contract’s chance of default.
Profits and losses on the contracts must be received or paid each day through a
clearinghouse that guarantees (underwrites) the transactions to eliminate the risk of
nonperformance.
6. Margin Requirements
a. A margin account is a brokerage account in which the investor borrows money (obtains
credit) from a broker to purchase securities, such as derivatives. The broker charges
interest on the credit provided.
b. A margin requirement (set in the U.S. by the Federal Reserve Board’s Regulation T) is
the minimum down payment that the purchasers of securities must deposit in the margin
account. When the balance is below the margin requirement, the broker notifies the
investor to add funds to the account. This notice is a margin call.

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8 SU 10: Advanced Financial Accounting Concepts and Analysis

7. Hedging
a. Hedging is the process of using offsetting commitments to minimize or avoid the effects
of adverse price movements. Hedging transactions often are used to protect positions in
commodity buying, foreign currency, and future cash flows.
1) The purchase or sale of a derivative or other instrument is a hedge if it is expected to
minimize the risk of loss.
a) In theory, the hedging instrument should be perfectly but negatively correlated
with the hedged items.
2) An example of the hedging approach is financing an asset with a financial instrument
of the same approximate maturity as the life of the asset. The basic concept is that
that entity has the entire life of the asset to recover the amount invested before
having to pay the lender.
b. Long-position hedges are futures contracts that are purchased to protect against price
increases.
1) For example, if a flour company buys and uses 1 million bushels of wheat each
month, it may wish to guard against increases in wheat costs. If so, it will purchase
futures contracts to buy 1 million bushels of wheat at the current price one month
from today. This long position hedge will result in gains if the price of wheat
increases (offsetting the actual increased costs).
c. Short-position hedges are futures contracts that are sold to protect against price
declines.

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 SU 10: Advanced Financial Accounting Concepts and Analysis 9

10.3 FOREIGN CURRENCY TRANSACTIONS

1. Definitions
a. The functional currency is the currency of the primary economic environment in which
the entity operates. Normally, that environment is the one in which it primarily generates
and expends cash.
b. A foreign currency is any currency other than the entity’s functional currency.
c. The reporting currency is the currency in which an entity prepares its financial
statements.
d. Foreign currency transactions are fixed in a currency other than the functional currency.
They result when an entity
1) Buys or sells on credit;
2) Borrows or lends;
3) Is a party to a derivative instrument; or,
4) For other reasons, acquires or disposes of assets, or incurs or settles liabilities, fixed
in a foreign currency.
2. Exchange Rate Exposure
a. When a U.S. firm purchases from, or sells to, an entity in a foreign country, the transaction
is recorded in U.S. dollars (the firm’s domestic currency).
Foreign sale:
Accounts receivable US $100,000
Sales US $100,000
Foreign purchase:
Inventory US $100,000
Accounts payable US $100,000
1) The dollar, however, might not be the currency in which the transaction will have to
be settled (typically 30 days later).
2) If the exchange rate of the two currencies (i.e., the units of one currency required to
purchase a single unit of the other) is fixed, the existence of a foreign-denominated
receivable or payable raises no measurement issue.

EXAMPLE 10-8 Initial Recognition -- Foreign Currency Transaction

On November 15, Year 1, JRF Corporation, a U.S. entity, purchases and receives inventory from Paris
Corporation, a French entity. The transaction is fixed in euros and calls for JRF to pay Paris €500,000 on
January 15, Year 2. On November 15, Year 1, the euro-dollar exchange rate is US $1.2 to €1.
November 15, Year 1:
Inventory US $600,000
Accounts payable (€500,000 × 1.2 exchange rate) US $600,000

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10 SU 10: Advanced Financial Accounting Concepts and Analysis

3. Accounting for Transaction Gains and Losses

a. A transaction gain (loss) results from a change in exchange rates between the functional
currency and the currency in which the transaction is denominated. It is the change in
functional currency cash flows
1) Actually realized on settlement and
2) Expected on unsettled transactions.
b. Transactions are recorded at the spot rate in effect at the transaction date.
c. Transaction gains and losses are recorded at each balance sheet date and at the date the
receivable or payable is settled. The gains or losses ordinarily are included in earnings.
d. When the amount of the functional currency exchangeable for a unit of the currency in
which the transaction is fixed increases, a transaction gain or loss is recognized on
a receivable or payable, respectively. The opposite occurs when the exchange rate
(functional currency to foreign currency) decreases.

EXAMPLE 10-9 Gain or Loss -- Foreign Currency Transaction

In continuation of Example 10-8, the euro-dollar exchange rate was US $1.4 to €1 on December 31, Year 1,
and US $1.55 to €1 on January 15, Year 2.
December 31, Year 1 (financial statements day):
Loss on foreign currency transactions US $100,000
Accounts payable [US $600,000 – (€500,000 × 1.4 year-end
exchange rate)] US $100,000
For the period between the initial recognition of the transaction (November 15, Year 1) and the financial
statements date (December 31, Year 1), the dollar has depreciated against the euro. Now the €500,000 cost
US $700,000 (500,000 × 1.4). On December 31, Year 1, accounts payable are reported at US $700,000, and
loss on foreign currency transaction is reported at US $100,000.
January 15, Year 2 (transaction settlement day):
Accounts payable US $700,000
Loss on foreign currency transactions [500,000 × (1.55 – 1.4)] 75,000
Cash (€500,000 × 1.55 settlement date exchange rate) US $775,000
The loss of US $75,000 on foreign currency transactions is included in the Year 2 income statement.
NOTE: The total loss recognized on the exchange rate difference is US $175,000 [500,000 × (1.2 – 1.55)].

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 SU 10: Advanced Financial Accounting Concepts and Analysis 11

EXAMPLE 10-10 Transaction Gains and Losses

On December 15, Year 1, Boise Co. purchased electronic components from Kinugasa Corporation. Boise
must pay Kinugasa ¥15,000,000 on January 15, Year 2. The exchange rate in effect on December 15,
Year 1, was US $.01015 per yen, giving the transaction a value on Boise’s books of US $152,250
(¥15,000,000 × $.01015).
Transaction Date:
Inventory US $152,250
Accounts payable US $152,250
The exchange rate on December 31, Year 1, Boise’s reporting date, has fallen to US $.01010 per yen. The
balance of the payable must be adjusted in the amount of US $750 [(¥15,000,000 × ($.01015 – $.01010)].
Reporting Date:
Accounts payable US $750
Transaction gain US $750
The exchange rate on January 15, Year 2, has risen to US $.01020 per yen. To settle the payable, the
balance must be adjusted in the amount of US $1,500 [¥15,000,000 × ($.01010 – $.01020)].
Settlement Date:
Accounts payable (US $152,250 – $750) US $151,500
Transaction loss 1,500
Cash US $153,000

e. The occurrence of transaction gains and losses can be summarized as follows:

Effects of Exchange Rate Fluctuations
Transaction That Will Be Results in a Foreign- Foreign Currency Foreign Currency
Settled in a Foreign Currency Denominated Appreciates Depreciates
Sale Receivable Transaction gain Transaction loss
Purchase Payable Transaction loss Transaction gain

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12 SU 10: Advanced Financial Accounting Concepts and Analysis

10.4 BUSINESS COMBINATIONS AND CONSOLIDATED FINANCIAL STATEMENTS

1. Investment in Equity Securities
a. The accounting for an investment in common stock of an investee depends on the
influence that the investor has over the investee.
Voting Presumed
Interest Influence Accounting Method
100%

Control Consolidation

50%
Equity Method or
Significant
Fair Value Option (FVO)
20%
Little or None Fair Value Measurement
0%
b. The fair value option (FVO) may be elected when the investor does not have control over
the investee.
c. When the investor has little or no influence over the investee (holds less than 20% of the
voting interests), the investment is measured at fair value.
1) The changes in its fair value (unrealized holding gains and losses) are recognized in
the income statement.
d. When the investor has significant influence over the investee (holds between 20% and
50% of the voting interests), the investment in equity securities is accounted for using the
equity method if the investor has not elected the FVO.
1) The investment is initially recognized at cost.
2) The investor recognizes in income its share of the investee’s net income or loss for
the period.
3) Dividends from the investee are treated as a return of an investment and decrease
the investment balance.
2. Business Combination
a. A business combination is a transaction or event in which an acquirer obtains control of
one or more businesses.
1) Control (controlling financial interest) is the direct or indirect ability to determine the
direction of management and policies of the investee.
a) An entity is presumed to have control when it acquires more than 50% of the
voting interests (e.g., shares of common stock) of a second entity.
b) However, a controlling financial interest is not deemed to exist when
control does not rest with the majority owner, such as when the entity is in
bankruptcy, in legal reorganization, or under severe governmentally imposed
uncertainties.
2) A parent is an entity that controls one or more subsidiaries.
3) A subsidiary is an entity in which another entity, known as its parent, holds a
controlling financial interest.
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 SU 10: Advanced Financial Accounting Concepts and Analysis 13

3. Acquisition Method
a. A business combination must be accounted for using the acquisition method. This method
involves
1) Identifying the acquirer and
2) Identifying the acquisition date, i.e., the date on which the acquirer obtains control of
the acquiree.
b. At the acquisition date, the acquirer (parent) must recognize and measure
1) Identifiable assets acquired,
2) Liabilities assumed,
3) Any noncontrolling interest, and
4) Goodwill or a gain from bargain purchase.
c. Measurement principle. The identifiable assets acquired, liabilities assumed, and any
noncontrolling interest in the subsidiary are recognized separately from goodwill and
must be measured at acquisition-date fair value.
d. The noncontrolling interest (NCI) is the portion of equity (net assets) in a subsidiary not
attributable, directly or indirectly, to the parent.
1) At the acquisition date, any NCI is measured at fair value.
2) Any NCI is reported in the equity section of the consolidated balance sheet
separately from the parent’s shareholders’ equity.
3) If the parent holds all the subsidiary’s outstanding common stock, no NCI is
recognized.
e. Goodwill recognized in a business combination is an intangible asset reflecting the future
economic benefits resulting from those assets acquired in the combination that are not
individually identified and separately recognized.
1) Goodwill equals the excess of (a) the sum of the acquisition-date fair values of
(1) the consideration transferred, (2) any noncontrolling interest in the acquiree, and
(3) any prior interest held by the acquirer over (b) the acquisition-date fair value of
the net identifiable assets acquired.
2) Goodwill has an indefinite useful life. Thus, it must not be amortized subsequent to
its initial recognition and is instead periodically tested for impairment.
3) The parent presents any goodwill recognized in its consolidated balance sheet as
one amount under noncurrent assets.
4) Goodwill can be recognized only in a business combination. Internally generated
goodwill must not be recognized in the financial statements.

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14 SU 10: Advanced Financial Accounting Concepts and Analysis

5) Goodwill recognized equals the excess of a) over b) below:

a) The sum of the acquisition-date fair value of the consideration transferred, any
NCI recognized, and any previously held equity interest in the acquiree
b) The acquisition-date fair value of identifiable assets acquired and liabilities
assumed (fair value of net assets acquired)

EXAMPLE 10-11 Noncontrolling Interest

Entity C acquired 80% of the outstanding common stock of Entity D for US $192,000. Entity D’s acquisition-
date fair values of identifiable assets and liabilities were US $350,000 and US $140,000, respectively. The
acquisition-date fair value of NCI was US $48,000. The goodwill is calculated as follows:
Consideration transferred US $192,000
Noncontrolling interest 48,000
Acquisition-date fair value of identifiable net assets
(Assets – Liabilities) acquired:
Assets US $350,000
Liabilities (140,000) (210,000)
Goodwill US $ 30,000

6) If b) exceeds a) above, an ordinary gain from a bargain purchase must be

recognized in the parent’s consolidated statement of income.
4. Consolidated Financial Statements
a. When one entity (parent) controls another (subsidiary), consolidated financial statements
must be issued by the parent regardless of the percentages of ownership.
1) Consolidated reporting is required even when majority ownership is indirect, i.e.,
when a subsidiary holds a majority interest in another subsidiary.
b. Consolidated financial statements are the general-purpose financial statements of a
parent with one or more subsidiaries. They present amounts for the parent and all its
subsidiaries as if they were a single economic entity.
c. Required consolidated reporting is an example of substance over form. Even if the two
entities remain legally separate, the financial statements are more meaningful to users if
they see the effects of control by one over the other.
d. Consolidated procedures. The starting point of the consolidation process is the
parent-only and subsidiary-only adjusted trial balances (parent’s and subsidiary’s
separate financial statements). The following steps must be performed when preparing
consolidated financial statements:
1) All line items of assets, liabilities, revenues, expenses, gains, losses, and OCI items
of a subsidiary are added item by item to those of the parent. These items are
reported at the consolidated amounts.
2) The periodic net income or loss of a consolidated subsidiary attributable to NCI
is presented separately from the periodic net income or loss attributable to the
shareholders of the parent.
3) All the equity amounts of the subsidiary are eliminated (not presented in the
consolidated financial statements).
4) The carrying amount of the parent’s investment in the subsidiary as it is presented in
the parent-only financial statements is eliminated (not presented in the consolidated
financial statements).

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 SU 10: Advanced Financial Accounting Concepts and Analysis 15

5) Goodwill recognized at the acquisition date is presented separately as an intangible

asset.
6) Any NCI is reported separately in one line item in the equity section. It must be
adjusted for its proportionate share of (a) the subsidiary’s net income (increase)
or net loss (decrease) for the period, (b) dividends declared by the subsidiary
(decrease), and (c) items of OCI recognized by the subsidiary.
7) Intraentity balances, transactions, income, and expenses must be eliminated in full.
a) Reciprocal balances, such as (1) receivables and payables and (2) interest
income and interest expense, between a parent and a subsidiary are
eliminated in their entirety, regardless of the portion of the subsidiary’s stock
held by the parent.

EXAMPLE 10-12 Intraentity Eliminations -- Reciprocal Balances

Platonic’s separate balance sheet reports a US $12,600 receivable from and a US $8,500 payable to
Socratic. Socratic’s separate balance sheet reports a US $8,500 receivable from and a US $12,600 payable
to Platonic. These balances are not reported on the consolidated balance sheet.

b) Consolidating entities routinely conduct business with each other. The effect of
these intraentity transactions must be eliminated in full during the preparation
of the consolidated financial statements.
c) Consolidated financial statements report the financial position, results of
operations, and cash flows as if the consolidated entities were a single
economic entity. Thus, all line items in the consolidated financial statements
must be presented at the amounts that would have been reported if the
intraentity transactions had never occurred.
d) After adding together all the assets, liabilities, and income statement items of a
parent and a subsidiary, eliminating journal entries for intraentity transactions
must be recorded for proper presentation of the consolidated financial
statements.
e. An example of a full set of consolidated financial statements can be found in Appendix C.

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16 SU 10: Advanced Financial Accounting Concepts and Analysis

10.5 CORPORATE EQUITY ACCOUNTS AND PARTNERSHIPS

1. Corporate Equity
a. The equity accounts of a corporation include contributed capital, treasury stock, retained
earnings, and items included in accumulated other comprehensive income.
2. Corporate Equity -- Contributed Capital
a. Contributed capital represents amounts invested by owners in exchange for stock
(common or preferred).
1) Common stock. The common shareholders are the owners of the entity. They have
voting rights and may receive dividends at the discretion of the board of directors.
2) Preferred stock. Preferred shareholders have the right to receive (a) dividends at a
specified rate (before common shareholders may receive any) and (b) distributions
before common shareholders (but after creditors) upon liquidation. Preferred stock
can be cumulative, callable, or redeemable.
a) The dividends on preferred stock equal the par value of the stock times its
stated rate.
b. Issuance of shares. Cash received is debited, the appropriate class of capital stock
is recognized (credited) for the total par value, and additional paid-in capital is
recognized (credited) for the difference.

EXAMPLE 10-13 Common Stock Issuance

A company issued 50,000 shares of its US $1 par value common stock. The market price was US $17 per
share on the day of issue.
Cash (50,000 shares × US $17 market price) US $850,000
Common stock (50,000 shares × US $1 par value per share) US $ 50,000
Additional paid-in capital (difference) 800,000
A company also issued 10,000 shares of US $50 par value, 6% preferred stock. The market price was
US $62 per share on the day of issue.
Cash (10,000 shares × US $62 market price) US $620,000
6% preferred stock (10,000 shares × US $50 par value per share) US $500,000
Additional paid-in capital (difference) 120,000

c. When an entity reacquires its previously issued and outstanding shares, these shares are
held as treasury stock. The acquisition of treasury shares results in a direct decrease in
equity. This acquisition reduces the shares outstanding but not the shares authorized.
1) Treasury shares are not assets, and dividends are not paid on them.
2) The most common method for recording shares held as treasury stock is the cost
method. Under this method, reacquired shares are recorded at their acquisition cost
(debit treasury stock, credit cash).

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 SU 10: Advanced Financial Accounting Concepts and Analysis 17

3. Corporate Equity -- Retained Earnings and Dividends

a. Retained earnings is accumulated net income or loss. It is increased by net income and
decreased by net loss and dividends.
b. The following entries are recorded when the dividend is declared and paid:
Declaration Payment
Retained earnings US $XXX Dividends payable US $XXX
Dividends payable US $XXX Cash US $XXX
c. The amount of retained earnings (ending balance) as it is reported in the balance sheet
can be calculated as follows:
Beginning retained earnings US $XXX
Plus: Net income for the period (or minus net loss) XXX
Minus: Dividends declared this period (XXX)
Ending retained earnings US $XXX

d. The beginning balance of retained earnings is adjusted for the cumulative effect on the
income statement of (1) changes in accounting principle and (2) corrections of errors in
prior-period financial statements. Accordingly, these items must not be included in the
calculation of current-period net income.
4. Corporate Equity -- Stock Dividends and Splits
a. A stock dividend involves no distribution of cash or other property. Stock dividends are
accounted for as a reclassification of equity (transfer from retained earnings to common
stock), not as liabilities.
1) The recipient does not recognize income. It has the same proportionate interest in
the entity and the same total carrying amount as before the stock dividend.
b. Stock splits are issuance of shares that do not affect the total par or stated value of
shares issued and outstanding or total equity.
1) No entry is made, and no transfer from retained earnings occurs.
5. Partnership Formation
a. A partnership is an association of two or more persons to carry on, as co-owners, a
business for profit.
b. Partners contribute cash and other property as the basis of their equity in a partnership.
Cash is recorded at its nominal amount and property at its fair value.
c. Partnership equity includes only the partners’ capital accounts.
6. Partnership Income or Loss
a. Profit and loss are distributed equally among partners unless the partnership agreement
provides otherwise.
1) If the partnership agreement specifies how profits, but not losses, are to be shared,
losses are shared in the same manner as profits.

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18 SU 10: Advanced Financial Accounting Concepts and Analysis

7. Liquidation of a Partnership -- Process

a. When the partners dissolve their partnership, the process of liquidating noncash assets
and settling liabilities begins. The liquidation process has four steps:
1) Any gain or loss realized from the actual sale of assets is allocated to the partners’
capital accounts in accordance with the profit-and-loss ratio.
2) Remaining noncash assets are assumed to have a fair value of zero, resulting in
an assumed loss equal to their carrying amounts. This amount is allocated to the
partners’ accounts in accordance with the profit-and-loss ratio.
3) If at least one of the partners’ capital accounts has a deficit balance, the deficit is
allocated to the remaining partners’ accounts.
4) The final balances in the partnership accounts equal the amounts of cash, if any, that
may be distributed to the partners.
b. If a partner account has a debit balance after the fourth step, (s)he is liable for that balance.

10.6 FINANCIAL STATEMENT ANALYSIS -- LIQUIDITY RATIOS

1. Liquidity
a. Liquidity is an entity’s ability to pay its current obligations as they come due and remain in
business in the short run.
b. Liquidity depends on the ease with which current assets can be converted to cash.
Liquidity ratios measure this ability by relating an entity’s liquid assets to its current
liabilities at a moment in time.

Figure 10-2

c. Current assets are the most liquid. They are expected to be converted to cash, sold, or
consumed within 1 year or the operating cycle, whichever is longer. Ratios involving
current assets thus measure a firm’s ability to continue operating in the short run.
1) Current assets include, in descending order of liquidity, cash and equivalents;
marketable securities; receivables (net of allowance for credit losses); inventories;
and prepaid items.

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 SU 10: Advanced Financial Accounting Concepts and Analysis 19

d. Current liabilities, by the same token, are ones that must be settled the soonest.
Specifically, they are expected to be settled or converted to other liabilities within 1 year
or the operating cycle, whichever is longer.
1) Current liabilities include accounts payable, notes payable, current maturities of long-
term debt, unearned revenues, taxes payable, wages payable, and other accruals.

EXAMPLE 10-14 Statement of Financial Position

RESOURCES FINANCING
Current Prior Current Prior
CURRENT ASSETS: Year End Year End CURRENT LIABILITIES: Year End Year End
Cash and equivalents US $ 325,000 US $ 275,000 Accounts payable US $ 150,000 US $ 75,000
Available-for-sale securities 165,000 145,000 Notes payable 50,000 50,000
Accounts receivable (net) 120,000 115,000 Accrued interest on note 5,000 5,000
Notes receivable 55,000 40,000 Current maturities of L.T. debt 100,000 100,000
Inventories 85,000 55,000 Accrued salaries and wages 15,000 10,000
Prepaid expenses 10,000 5,000 Income taxes payable 70,000 35,000
Total current assets US $ 760,000 US $ 635,000 Total current liabilities US $ 390,000 US $ 275,000
NONCURRENT ASSETS: NONCURRENT LIABILITIES:
Equity-method investments US $ 120,000 US $ 115,000 Bonds payable US $ 500,000 US $ 600,000
Property, plant, and equip. 1,000,000 900,000 Long-term notes payable 90,000 60,000
Less: Accum. depreciation (85,000) (55,000) Employee-related obligations 15,000 10,000
Goodwill 5,000 5,000 Deferred income taxes 5,000 5,000
Total noncurrent assets US $1,040,000 US $ 965,000 Total noncurrent liabilities US $ 610,000 US $ 675,000
Total liabilities US $1,000,000 US $ 950,000
STOCKHOLDERS’ EQUITY:
Preferred stock, US $50 par US $ 120,000 US $ 0
Common stock, US $1 par 500,000 500,000
Additional paid-in capital 110,000 100,000
Retained earnings 70,000 50,000
Total stockholders’ equity US $ 800,000 US $ 650,000
Total liabilities and
Total assets US $1,800,000 US $1,600,000 stockholders’ equity US $1,800,000 US $1,600,000

2. Working Capital
a. Net working capital consists of the resources the company would have to continue
operating in the short run if it had to settle all of its current liabilities at once.
Working Capital = Current assets – Current liabilities

EXAMPLE 10-15 Change in Working Capital

Current year: US $760,000 – $390,000 = US $370,000
Prior year: US $635,000 – $275,000 = US $360,000
Although the company’s current liabilities increased, its current assets increased by US $10,000 more. The
company has more working capital. If current liabilities had increased by the same amount as current assets,
the working capital balance would not have changed.

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20 SU 10: Advanced Financial Accounting Concepts and Analysis

3. Current Ratio
a. The current ratio, also called the working capital ratio, is the most common measure of
liquidity.

EXAMPLE 10-16 Current Ratio

Current year: US $760,000 ÷ $390,000 = 1.95
Prior year: US $635,000 ÷ $275,000 = 2.31
Although working capital increased in absolute terms (US $10,000), current assets now provide less
proportional coverage of current liabilities than in the prior year.

1) A low ratio indicates a possible solvency problem.

a) A firm with a low current ratio may become insolvent. Therefore, care should
be taken when determining whether to extend credit to a firm with a low ratio.
2) An overly high ratio indicates that management may not be investing idle assets
productively.
3) The quality of accounts receivable and merchandise inventory should be considered
before evaluating the current ratio.
a) Obsolete or overvalued inventory or receivables can artificially inflate the
current ratio.
4) The general principle is that the current ratio should be proportional to the operating
cycle. Thus, a shorter cycle may justify a lower ratio.
a) For example, a grocery store has a short operating cycle and can survive with
a lower current ratio than could a gold mining company, which has a much
longer operating cycle.
4. Quick (Acid-Test) Ratio
a. The quick (acid-test) ratio excludes inventories and prepaid expenses from the numerator
because they are difficult to liquidate at their stated amounts. The quick ratio is therefore
a more conservative measure than the basic current ratio.

EXAMPLE 10-17 Quick (Acid-Test) Ratio

Current year: (US $325,000 + $165,000 + $120,000 + $55,000) ÷ $390,000 = 1.71
Prior year: (US $275,000 + $145,000 + $115,000 + $40,000) ÷ $275,000 = 2.09
Despite its increase in total working capital, the company’s position in its most liquid assets declined.

1) This ratio measures the firm’s ability to easily pay its short-term debts while avoiding
the problem of inventory valuation.

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 SU 10: Advanced Financial Accounting Concepts and Analysis 21

10.7 FINANCIAL STATEMENT ANALYSIS -- ACTIVITY RATIOS

1. Income Statement to Balance Sheet
a. Activity ratios measure how quickly the two major noncash assets are converted to cash.
1) Activity ratios measure results over a period of time and thus draw information from
the firm’s income statement as well as from the balance sheet.

EXAMPLE 10-18 Balance Sheet

RESOURCES FINANCING
Current Prior Current Prior
CURRENT ASSETS: Year End Year End CURRENT LIABILITIES: Year End Year End
Cash and equivalents US $ 325,000 US $ 275,000 Accounts payable US $ 150,000 US $ 75,000
Available-for-sale securities 165,000 145,000 Notes payable 50,000 50,000
Accounts receivable (net) 120,000 115,000 Accrued interest on note 5,000 5,000
Notes receivable 55,000 40,000 Current maturities of L.T. debt 100,000 100,000
Inventories 85,000 55,000 Accrued salaries and wages 15,000 10,000
Prepaid expenses 10,000 5,000 Income taxes payable 70,000 35,000
Total current assets US $ 760,000 US $ 635,000 Total current liabilities US $ 390,000 US $ 275,000
NONCURRENT ASSETS: NONCURRENT LIABILITIES:
Equity-method investments US $ 120,000 US $ 115,000 Bonds payable US $ 500,000 US $ 600,000
Property, plant, and equip. 1,000,000 900,000 Long-term notes payable 90,000 60,000
Less: Accum. depreciation (85,000) (55,000) Employee-related obligations 15,000 10,000
Goodwill 5,000 5,000 Deferred income taxes 5,000 5,000
Total noncurrent assets US $1,040,000 US $ 965,000 Total noncurrent liabilities US $ 610,000 US $ 675,000
Total liabilities US $1,000,000 US $ 950,000
STOCKHOLDERS’ EQUITY:
Preferred stock, US $50 par US $ 120,000 US $ 0
Common stock, US $1 par 500,000 500,000
Additional paid-in capital 110,000 100,000
Retained earnings 70,000 50,000
Total stockholders’ equity US $ 800,000 US $ 650,000
Total liabilities and
Total assets US $1,800,000 US $1,600,000 stockholders’ equity US $1,800,000 US $1,600,000

EXAMPLE 10-19 Income Statement

Current Year Prior Year
Net sales US $ 1,800,000 US $ 1,400,000
Cost of goods sold (1,450,000) (1,170,000)
Gross profit US $ 350,000 US $ 230,000
SG&A expenses (200,000) (160,000)
Operating income US $ 150,000 US $ 70,000
Other income and expenses (65,000) (25,000)
Income before interest and taxes US $ 85,000 US $ 45,000
Interest expense (15,000) (10,000)
Income before taxes US $ 70,000 US $ 35,000
Income taxes (40%) (28,000) (14,000)
Net income US $ 42,000 US $ 21,000

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22 SU 10: Advanced Financial Accounting Concepts and Analysis

2. Receivables Activity Formulas

a. The accounts receivable turnover ratio is the number of times in a year the total
balance of receivables is converted to cash.

1) Average accounts receivable equals beginning accounts receivable plus ending

accounts receivable, divided by two.
a) If a business is highly seasonal, a simple average of beginning and ending
balances is inadequate. The monthly balances should be averaged instead.

EXAMPLE 10-20 Accounts Receivable Turnover

All of the company’s sales are on credit. Net trade receivables at the reporting date of the second prior year
were US $105,000.
Current year: US $1,800,000 ÷ [($120,000 + $115,000) ÷ 2] = 15.3 times
Prior year: US $1,400,000 ÷ [($115,000 + $105,000) ÷ 2] = 12.7 times
The company turned over its trade receivables balance 2.6 more times during the current year, even as
receivables were growing in absolute terms. Thus, the company’s effectiveness at collecting accounts
receivable has improved.

2) A higher turnover implies that customers may be paying their accounts promptly.
a) Because sales are the numerator, higher sales without an increase in
receivables will result in a higher turnover. Because receivables are the
denominator, encouraging customers to pay quickly (thereby lowering the
balance in receivables) also results in a higher turnover ratio.
3) A lower turnover implies that customers are taking longer to pay.
a) If the discount period is extended, customers will be able to wait longer to pay
while still getting the discount.
b. The average collection period, also called the days’ sales in receivables or days’
sales outstanding, measures the average number of days between the time of sale and
receipt of the invoice amount.

EXAMPLE 10-21 Days’ Sales in Receivables

Current year: 365 days ÷ 15.3 times = 23.9 days
Prior year: 365 days ÷ 12.7 times = 28.7 days
The denominator (calculated in Example 10-20) increased, and the numerator is a constant. Accordingly,
days’ sales in receivables must decrease. In addition to improving its collection practices, the company also
may have become better at assessing the creditworthiness of its customers.

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 SU 10: Advanced Financial Accounting Concepts and Analysis 23

3. Inventory Activity Ratios

a. Two ratios measure the efficiency of inventory management.
b. Inventory turnover measures the number of times in a year the total balance of inventory
is converted to cash or receivables.

1) Average inventory equals beginning inventory plus ending inventory, divided by two.
a) If a business is highly seasonal, a simple average of beginning and ending
balances is inadequate. The monthly balances should be averaged instead.

EXAMPLE 10-22 Inventory Turnover

The balance in inventories at the balance sheet date of the second prior year was US $45,000.
Current year: US $1,450,000 ÷ [($85,000 + $55,000) ÷ 2] = 20.7 times
Prior year: US $1,170,000 ÷ [($55,000 + $45,000) ÷ 2] = 23.4 times
The company did not turn over its inventory as often during the current year as in the prior year. A lower
turnover is expected during a period of growing sales (and increasing inventory). It is not necessarily a sign
of poor inventory management.

2) A higher turnover implies strong sales or that the firm may be carrying low levels of
inventory.
3) A lower turnover implies that the firm may be carrying excess levels of inventory or
inventory that is obsolete.
a) Because cost of goods sold is the numerator, higher sales without an increase
in inventory balances result in a higher turnover.
b) Because inventory is the denominator, reducing inventory levels also results in
a higher turnover ratio.
4) The ideal level for inventory turnover is industry specific, with the nature of the
inventory items impacting the ideal ratio. For example, spoilable items such as
meat and dairy products will mandate a higher turnover ratio than would natural
resources such as gold, silver, and coal. Thus, a grocery store should have a much
higher inventory turnover ratio than a uranium mine or a jewelry store.
c. Days’ sales in inventory, also called the inventory conversion period, measures the
average number of days that pass between the acquisition of inventory and its sale.

EXAMPLE 10-23 Days’ Sales in Inventory

Current year: 365 days ÷ 20.7 times = 17.6 days
Prior year: 365 days ÷ 23.4 times = 15.6 days
Because the numerator is a constant, the decreased turnover means that days’ sales in inventory increased.
This is a common phenomenon during a period of increasing sales.

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24 SU 10: Advanced Financial Accounting Concepts and Analysis

4. Operating Cycle
a. A firm’s operating cycle is the amount of time that passes between the acquisition of
inventory and the collection of cash on the sale of that inventory.
Operating cycle = Days’ sales in inventory + Days’ sales in receivables

EXAMPLE 10-24 Operating Cycle

Current year: 17.6 days + 23.9 days = 41.5 days
Prior year: 15.6 days + 28.7 days = 44.3 days
The entity has slightly reduced its operating cycle while increasing sales and inventory.

5. Cash Conversion Cycle

a. A firm’s cash conversion cycle is the amount of time that passes between the actual outlay
of cash for inventory purchases and the collection of cash from the sale of that inventory.
Cash conversion cycle = Average collection period +
Days’ sales in inventory – Average payables period
1) The accounts payable turnover ratio is the number of times during a period that the
firm pays its accounts payable.

a) Average accounts payable equals beginning accounts payable plus ending

accounts payable, divided by two.
i) If a business is highly seasonal, a simple average of beginning and
ending balances is inadequate. The monthly balances should be
averaged instead.

EXAMPLE 10-25 Accounts Payable Turnover

The company had current- and prior-year purchases of US $1,480,000 and US $1,180,000, respectively. Net
accounts payable at the beginning of the prior year was US $65,000.
Current Year: US $1,480,000 ÷ [($150,000 + $75,000) ÷ 2] = 13.2 times
Prior Year: US $1,180,000 ÷ [($75,000 + $65,000) ÷ 2] = 16.9 times
The company is now carrying a much higher balance in payables, so it is not surprising that the balance is
turning over less often. It also may be the case that the company was paying invoices too soon in the prior
year.

b) A higher turnover implies that the firm is taking less time to pay off suppliers
and may indicate that the firm is taking advantage of discounts.
c) A lower turnover implies that the firm is taking more time to pay off suppliers
and forgoing discounts.

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 SU 10: Advanced Financial Accounting Concepts and Analysis 25

2) The average payables period (also called payables turnover in days, or payables
deferral period) is the average time between the purchase of inventories and the
payment of cash.

b. The difference between the operating cycle and the cash conversion cycle is attributable
to credit purchases of inventory. The cash conversion cycle therefore is equal to the
operating cycle minus the average payables period.
6. Other Turnover Ratios
a. The total assets turnover and fixed assets turnover are broader-based ratios that measure
the efficiency with which assets are used to generate revenue.
1) Both cash and credit sales are included in the numerator.

a) Average total net fixed assets equal beginning total net fixed assets plus
ending total net fixed assets, divided by two.

EXAMPLE 10-26 Turnover Ratios for Total Assets and Fixed Assets
Current-year total assets turnover: US $1,800,000 ÷ [($1,800,000 + $1,600,000) ÷ 2] = 1.06 times
Current-year fixed assets turnover: US $1,800,000 ÷ [($915,000 + $845,000) ÷ 2] = 2.04 times
NOTE: The current- and prior-year net carrying amounts of fixed assets are US $915,000 ($1,000,000 –
$85,000) and US $845,000 ($900,000 – $55,000), respectively.

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26 SU 10: Advanced Financial Accounting Concepts and Analysis

10.8 FINANCIAL STATEMENT ANALYSIS -- SOLVENCY RATIOS AND LEVERAGE

1. Solvency
a. Solvency is an entity’s ability to pay its noncurrent obligations as they come due and
remain in business in the long run. The key ingredients of solvency are the entity’s capital
structure and degree of leverage.
1) By contrast, liquidity relates to the ability to remain in business for the short run.
b. A firm’s capital structure includes its sources of financing, both long- and short-term.
These sources can be in the form of debt (external sources) or equity (internal sources).
1) Capital structure decisions affect the risk profile of a firm. For example, a
company with a higher percent of debt capital will be riskier than a firm with a high
percentage of equity capital. Thus, when there is a lot of debt, equity investors
will demand a higher rate of return on their investments to compensate for the risk
brought about by the high use of financial leverage.
2) Alternatively, a company with a high level of equity capital will be able to borrow
at lower rates because debt holders will accept lower interest in exchange for the
lower risk indicated by the equity cushion.

Figure 10-3

2. Debt to Total Assets and Debt to Total Equity

a. The debt to total assets ratio (also called the debt ratio) reports the entity’s debt per
monetary unit of assets.

EXAMPLE 10-27 Debt Ratio

Current year: US $1,000,000 ÷ $1,800,000 = 0.556
Prior year: US $ 950,000 ÷ $1,600,000 = 0.594
The company became slightly less reliant on debt in its capital structure during the current year. The
company is thus less leveraged than before.

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 SU 10: Advanced Financial Accounting Concepts and Analysis 27

b. The debt-to-equity ratio is a direct comparison of the firm’s debt and equity.

EXAMPLE 10-28 Debt-to-Equity Ratio

Current year: US $1,000,000 ÷ $800,000 = 1.25
Prior year: US $ 950,000 ÷ $650,000 = 1.46
The amount by which the company’s debts exceed its equity stake declined in the current year.

1) Like the previous ratio, the debt-to-equity ratio reflects long-term debt-payment
ability. A low ratio means lower relative debt and better debt repayment ability.
3. Earnings Coverage
a. Earnings coverage is a creditor’s best measure of an entity’s ongoing ability to generate
the earnings that will allow it to satisfy its debts and remain solvent.
b. The times-interest-earned ratio is an income statement approach to evaluating the
ongoing ability to meet interest payments on debt obligations.

1) An increased times-interest-earned ratio signifies that more profit is available to pay

interest on debt and solvency has improved.

EXAMPLE 10-29 Times-Interest-Earned Ratio

Current year: US $85,000 ÷ $15,000 = 5.67
Prior year: US $45,000 ÷ $10,000 = 4.50
The entity has improved its ability to pay interest expense. In the prior year, EBIT was only four-and-a-half
times interest expense, but in the current year, it is more than five-and-a-half times.

4. Leverage
a. Leverage is the relative amount of fixed cost in a firm’s overall cost structure. Leverage
creates solvency risk because fixed costs must be covered regardless of the level of
sales.
1) Total costs (TC) equals fixed costs (FC) plus variable costs (VC).
2) A firm’s total leverage consists of an operating leverage component and a financial
leverage component.
b. Operating leverage is the extent to which a firm’s costs of operating are fixed as opposed
to variable. The following ratio is one of the ways to measure operating leverage.
Operating leverage = Fixed costs (FC) ÷ Total costs (FC + VC)
1) High operating leverage means that a high percentage of a firm’s total costs is fixed.
2) A firm with a high percentage of fixed costs is more risky than a firm in the same
industry that relies more on variable costs, but by the same token, it will generate
more earnings by increasing sales.

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28 SU 10: Advanced Financial Accounting Concepts and Analysis

c. Financial leverage is the degree of debt (fixed financial costs) in the firm’s financial
structure. The following ratio is one of the ways to measure financial leverage.
Financial leverage = Total assets ÷ Total equity

EXAMPLE 10-30 Financial Leverage

Current-year financial leverage ratio: US $1,800,000 ÷ $800,000 = 2.25

1) High financial leverage means that a high percentage of a firm’s total assets is
financed by debt.
2) When a firm has a high percentage of fixed financial costs, the firm takes more risk
to increase its earnings per share. (Earnings per share is explained in item 6. in
Subunit 10.9.)

10.9 FINANCIAL STATEMENT ANALYSIS -- ROI AND PROFITABILITY

1. Return on Invested Capital
a. Return on investment, or ROI (also called return on invested capital), is a broad concept
for measures that reflect how efficiently an entity is using the resources contributed by its
shareholders to generate a profit.

NOTE: The examples in this subunit use the statement of financial position on page 19 and the
income statement on page 21.
2. Return on Assets
a. Return on assets, or ROA (also called return on total assets, or ROTA), is the most basic
form of the ROI ratio.

EXAMPLE 10-31 Return on Assets

Current year: US $42,000 ÷ [($1,800,000 + $1,600,000) ÷ 2] = 0.025
During the current year, the company generated US $0.025 in net income for each US $1 invested in the
company’s assets.

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 SU 10: Advanced Financial Accounting Concepts and Analysis 29

3. DuPont Model
a. The original DuPont model treats ROA as the product of a two-component ratio.
ROA Profit Margin Total Assets Turnover
= ×

1) The advantage of this analysis is that it examines both the results of operations and
the efficiency of asset usage in generating sales.

EXAMPLE 10-32 DuPont Model -- ROA

Current-year profit margin: US $42,000 net income ÷ $1,800,000 total sales = 0.0233
1. Profit margin of 0.0233 means that the company generates US $0.0233 of net income from each
US $1 of sales.
2. The total assets turnover is 1.06 (as calculated on page 25).
3. The ROA is 0.025 (0.0233 × 1.06).

4. Return on Equity
a. Return on equity (ROE) is the second version of the ROI ratio.

1) Average total equity equals beginning total equity plus ending total equity, divided by
two.
2) This ratio measures the return available to all shareholders.

EXAMPLE 10-33 Return on Equity

Current-year ROE: US $42,000 net income ÷ [($800,000 + $650,000) ÷ 2] = 0.058

b. The DuPont model has been adapted and expanded. One widely used variation treats
ROE as the product of three components.

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30 SU 10: Advanced Financial Accounting Concepts and Analysis

5. Other Profitability Ratios

a. Three common percentages measure profitability directly from the income statement:

EXAMPLE 10-34 Other Profitability Ratios

Current-year gross profit margin: US $350,000 ÷ $1,800,000 = 19.4%
Current-year operating income margin: US $150,000 ÷ $1,800,000 = 8.3%
Current-year net income margin: US $ 42,000 ÷ $1,800,000 = 2.3%

b. A vertical common-size analysis (discussed in Subunit 10.10) can be useful in

measurement of these ratios.
6. Earnings per Share
a. Basic earnings per share (EPS) is a ratio of particular interest to the corporation’s
common shareholders. It is a profitability ratio that measures the amount of current-
period earnings that can be associated with a single share of a corporation’s common
stock.

1) The numerator often is called income available to common shareholders.

2) EPS is calculated only for common stock because common shareholders are the
residual owners of a corporation.
3) The weighted-average number of common shares outstanding is determined by
relating the portion of the period that the shares were outstanding to the total time
in the period.
b. An entity that has potential common shares (e.g., convertible bonds, convertible
preferred stock, and share options) must report diluted EPS in addition to basic EPS.
The calculation includes the effects of dilutive potential common shares. Dilution is a
reduction in basic EPS resulting from the assumption that potential common shares were
converted to common stock.

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 SU 10: Advanced Financial Accounting Concepts and Analysis 31

10.10 FINANCIAL STATEMENT ANALYSIS -- CORPORATE VALUATION AND COMMON-SIZE

FINANCIAL STATEMENTS RATIOS
1. Book Value per Common Share
a. Book value per common share equals the amount of net assets available to shareholders
divided by the number of shares outstanding.

1) Book value per common share is the amount per share of the company’s net
assets at their book value (carrying amounts) that will be received by the common
shareholders upon the liquidation of the company.
2) The limitation of book value per share is that it is a valuation based solely on the
amounts recorded in the books.
a) Unlike market value, book value does not consider future earnings potential in
determining a company’s valuation.
b) The recorded values of assets on the books are subject to accounting
estimates (e.g., choice of depreciation method) that may vary across
companies within the same industry. Consequently, net assets may be
overstated if estimates are inaccurate.
c) Additionally, those same assets may be pledged as collateral on a loan.
However, a pledge of collateral is not recorded as a liability on the books.
Thus, book value will not account for this potential liability.
d) A well-managed firm’s stock should sell at high multiples of its book value.
2. Price-Earnings (P/E) Ratio
a. The price-earnings ratio measures the amount that investors are willing to pay for US $1 of
the company’s earnings.

1) Growth companies are likely to have high P/E ratios. A high P/E ratio reflects the
stock market’s positive assessment of the firm’s earnings quality and prospects.
2) Because of the widespread use of the P/E ratio and other measures, the relationship
between accounting data and stock prices is crucial. Thus, managers have an
incentive to “manage earnings,” sometimes by fraudulent means.
a) A decrease in investors’ required rate of return will cause share prices to go
up, which will result in a higher P/E ratio.
b) A decline in the rate of dividend growth will cause the share price to decline,
which will result in a lower P/E ratio.
c) An increasing dividend yield indicates that share price is declining, which will
result in a lower P/E ratio.

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32 SU 10: Advanced Financial Accounting Concepts and Analysis

3. Dividend Payout Ratio

a. Increasing shareholder wealth is the fundamental goal of any business. The dividend
payout ratio measures the portion of available earnings the entity actually distributed to
shareholders.

1) Growing entities tend to have a low payout. They prefer to use earnings for
expansion.
4. Dividend Yield Ratio
a. The dividend yield measures the percentage of a share’s market price that was returned
as dividends. This ratio can be applied to both common and preferred stock.

5. Effect of Price Inflation on Financial Ratio Analysis

a. Inflation is the decrease over time of the purchasing power of money. Because statement
of financial position amounts are expressed in terms of money, historical cost amounts
for different periods are measured in units representing different levels of purchasing
power.
b. Net income or loss is also distorted because of inflation’s effect on depreciation expense
and inventory costs.
1) Inflation therefore impairs the comparability of financial statement items, whether for
the same entity over time or for entities of differing ages.
6. Common-Size Financial Statements and Multiple Ratios
a. Common-size financial statements are expressed in percentages.
1) Horizontal common-size analysis focuses on changes in operating results
and financial position during two or more accounting periods. The changes are
expressed in terms of percentages of corresponding amounts in a base period.
2) Vertical common-size analysis relates to the relationships among financial
statement items of a single accounting period expressed in terms of a percentage
relationship to a base item (the base is 100%).
a) For example, income statement items may be expressed as percentages of
sales, and balance sheet items may be expressed as a percentage of total
assets.

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 SU 10: Advanced Financial Accounting Concepts and Analysis 33

EXAMPLE 10-35 Vertical Analysis -- Income Statement

Current Prior
Year Year
Net sales 100.0% 100.0%
Cost of goods sold (80.6%) (83.6%)
Gross profit 19.4% 16.4%
SG&A expenses (11.1%) (11.4%)
Operating income 8.3% 5.0%
Other income and expenses (3.6%) (1.8%)
Income before interest and taxes 4.7% 3.2%
Interest expense (0.8%) (0.7%)
Income before taxes 3.9% 2.5%
Income taxes (40%) (1.6%) (1.0%)
Net income 2.3% 1.5%

b. The income statement above is presented in the common-size format. Line items on
common-size statements are expressed as percentages of net sales (on the income
statement) or total assets (on the statement of financial position).
1) On a common-size income statement, net sales is 100%, and all other amounts are
a percentage of net sales. On the statement of financial position, total assets and
the total of liabilities and equity are each 100%.
2) Each line item can be interpreted in terms of its proportion of the baseline amount.
This process is vertical analysis.
c. Preparing common-size statements makes it easier to analyze differences among
companies of various sizes or comparisons between a similar company and an industry
average.
1) For example, comparing the efficiency of a company with US $1,800,000 of
revenues to a company with US $44 billion in revenues is difficult unless the
numbers are reduced to a common denominator.

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