FINANCIAL STATEMENT ANALYSIS

7.1.A. ACCOUNTING INCOME AND ASSETS: THE

ACCRUAL CONCEPT
INCOME STATEMENT AND NET INCOME
The income statement reports both the revenues and the costs incurred or allocated for a given
period. The net of revenue and expenses is earnings before tax. Thus, once the tax expense is
accounted for, the result will be the net income for the period.
Question:
Which of the following calculations cannot be performed using income statements alone?
A) How liquid the company is relative to its interest expenses.
B) How profitable a company is relative to its overall sales.
C) The volatility of a company's earnings.
D) Cost structure of the company's operations.
Answer:
A
Explanation:
The income statement calculates net income, however this is not the same thing as cash. Cash,
and near cash items, can only be observed in the balance sheet. Mind you, interest expenses can
be found in the income statement, however, that alone is not enough to calculate a company's
liquidity.

REVENUE RECOGNITION
In general, a company may recognize revenue if:
a) payment is fairly certain,
b) it is measurable (i.e. there's no ambiguity with respect to its amount), and
c) the service or the good has to a large extend, been completed or delivered.
Question:
Which one of the following conditions would not constitute the realization of revenue?
A) Ownership of the good is effectively transferred from the seller over to the buyer even though
delivery has not occurred yet.
B) The customer has paid for a full year's worth of products with the first shipment going out
immediately.

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C) The resulting sales and expenses associated with the good being sold can be measured fairly
accurately.
D) The selling company has substantially fulfilled its obligations to produce and deliver the
goods.
Answer:
B
Explanation:
When a customer pays in advance for goods and services to be received at a later date, it does not
constitute revenue to the selling firm. In fact, this advance payment becomes a liability to the firm
until it performs its task as required by the buyer-seller agreement. Only then can the company
realize revenue.

THE MATCHING PRINCIPLE

Why do companies incur expenses? Obviously, these expenses (such as cost of goods or wages)
are incurred so that the firm may generate an even higher amount in revenue. Consequently,
expenses must therefore be matched to the revenue that they ultimately generated. This is why
the cost of equipment is depreciated over many periods, because the asset is expected to
contribute to the revenue generation process for that number of periods.
Question:
Under the matching principal, a company that acquires an asset this year and estimates that it will
be used for only a couple of years, should:
A) Adopt an accelerated form of depreciation in order to expense the asset.
B) Expense the entire amount of the asset in the year that it was acquired in order to match the
expense with the year that it was acquired.
C) Simply employ a straight-line depreciation method so that the impact on earnings will be
moderated.
D) Expense the asset in the year that it is disposed, since at that point in time, it will become very
clear what the disposal value of the asset is and therefore what its true market depreciation should
be.
Answer:
A
Explanation:
By adopting an accelerated form of depreciation, a greater proportion of the asset's value will be
depreciated in the earlier years. This fulfills the matching principal since it is in those early years
that the asset is most heavily used and thus most heavily contributing to the revenue generating
process.

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Also note that the cost of inventory is not recognized until the item is sold. This too is a result of
the matching principle rule.
REVENUE RECOGNITION METHODS
In general, three methods may be used to recognize revenue:
a) accrual method: recognizes an expense in the period in which its associated revenue was
generated
b) installment method: recognizes that proportion of expense which is equal to the
proportion of the total payment that is received for the period.
c) cost recovery method: all initial revenue is used to offset the cost of the project. In other
words, until all the costs have been accounted for, the company has a profit of nil.
Afterwards, profit will equal revenue.
MANIPULATING EARNINGS
Accounting rules allow management to choose among the various acceptable accounting
practices. Consequently, by choosing among the various accounting policies, management will
have an impact on reported financial statements. In addition to the choice of accounting policy,
management may also time certain expenditures or time the recognition of certain revenues so as
to "smooth" out reported earnings.
Question:
Which of the following is not a common method used by management in order to manipulate
earnings?
A) Increase expenditures into research and development during abnormally good years and
reduce those expenditures during bad years.
B) Increase or decrease the number of shares outstanding so that earnings per share data can seem
more stable.
C) Increase provisions for uncollectable receivables during good years.
D) Classify gains and losses either as an extra-ordinary event or as a recurring event, so that
operating income seems more stable.
Answer:
B
Explanation:
Manipulative techniques are those that are not easily observable. Changing the number of shares
outstanding would be very visible event and would therefore not be able to fool most investors.
On the other hand, the remaining answers illustrate how difficult it is to distinguish between
management decisions that are taken in the best interests of shareholders and those that are

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simply made in order to benefit the managers personally.

UNUSUAL OR INFREQUENT ITEMS

Another technique that management may use to have an impact on "basic" net income is how to
account for unusual or infrequent items. For instance, if the sale of some assets is deemed as
"part" of a segment, then any subsequent gains or losses are included in basic earnings (or above
the line). However, if the sale of these assets are deemed as the disposal of an "entire" segment,
then any gains or losses are treated as part of "discontinued operations", which is reported below
basic net income.
Consequently, management has an incentive to treat asset sales that result in a gain as part of
basic earnings, and asset sales that result in a loss as something that is separate from basic
earnings.
Question:
Which of the following is not an example of an unusual or an infrequent item?
A) Gains or losses arising from the sale of a subsidiary.
B) Losses resulting from the expropriation of company property by a foreign government.
C) Gains or losses arising from the disposal of a portion of a business division.
D) Losses arising from strikes or lawsuits.
Answer:
B
Explanation:
When a foreign government expropriates a company's assets, it is viewed as an extraordinary
event. Consequently, any losses arising from such a seizure is shown net of taxes as a separate
item on an income statement.

THE BALANCE SHEET

In essence, the balance sheet illustrates what the company owns (the assets), and how the
purchase of those assets were financed. In particular:
Assets = Liabilities + Owners Equity
Question:
The shareholder equity of the firm is equal to:
A) Total assets less total liabilities.
B) Total assets less total liabilities and dividends earmarked for preferred shareholders.

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C) Current assets less current liabilities.

D) Long term assets less long-term liabilities.
Answer:
A
Explanation:
Another expression for shareholder's equity is net assets. In either case, it is found by subtracting
total liabilities from total assets.
While the market value of the firm's assets, liabilities, and therefore equity may change, the
balance sheet always records these items at their historical values. For instance, owner's equity is
the amount which the owners contributed into the firm either through capital infusion or by
foregoing earnings. This recorded value for equity will not change, regardless of how the stock
price behaves.
Question:
Which of the following steps is inaccurate with respect to calculating a figure for shareholder's
equity?
A) All dividends, be it for preferred or common shares, must be deducted from net income before
it is added to the retained earnings component of shareholder's equity.
B) Total liabilities must be subtracted from total assets.
C) All the capital that equity holders have invested into the firm must be added to the earnings
that have been retained by the company over time.
D) Depreciation must be added back to net income before it is added on the retained earnings
portion of shareholder's equity.
Answer:
D
Explanation:
Depreciation is added back to net income only when calculating for cash flow. In the case of
shareholder's equity, all figures are derived using accrual methods. Therefore, even though net
income is at best only an estimate of the true economic profit of the firm, only dividends are
deducted from it before it is added to retained earnings.

PERCENTAGE-OF-COMPLETION vs. COMPLETED CONTRACT

When it comes to longer term projects, quantifying expected revenues, costs, and therefore profits
becomes much more difficult and ambiguous. Consequently, the previous revenue recognition
methods would not be appropriate. Instead, for such long term projects, either of two methods
may be used to account for revenues and costs.

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The "Percentage of Completion" method requires an upfront estimation of the total costs and thus
total profits expected from a project. Therefore, every year of the project, the amount of profit
that is recognized is equal to the proportion of the total project cost that is recognized in that year.
The "Completed Contract" method does not recognize any revenues, costs, or profits until the
project has been completed. As a result, all receipts are regarded as unearned revenues (or
advances), which is a liability account, and all cost incurred are regarded as work-in-process, an
inventory like account. Once the project is completed, the net of these cumulative advances and
work-in-process will determine the income that will be reported at that point.
Question:
Which of the following are not motives for managers to prefer the Percentage-of-Completion to
the Completed Contract Method?
A) The Percentage of Completion method results in higher asset values, which helps to strengthen
the balance sheet position of the company.
B) Earnings fluctuations tend to be smoother over time by using the Percentage of Completion
method.
C) Equity figures are higher under the Percentage of Completion method, thus resulting in lower
debt-to-equity ratios.
D) Since income is higher during the earlier periods under the Percentage of Completion method,
profitability ratios will seem higher.
Answer:
A
Explanation:
It is the completed contract method that results in the higher asset values. This is so because all
costs incurred in the production process are capitalized.

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