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investors, lenders, prospective buyers etc. examine direction, speed, & extent of any trend(s)
Formally, accrual accounting occurs through the process of: Common size analysis: Evaluation of internal makeup of financial
1. Revenue recognition: A firm can recognize revenue statements, and/or financial statement accounts across companies
provided that: Common size income statement as a percentage of revenue
a. It has earned the revenue i.e. it has done what its Common size balance sheet as a percentage of assets / liabilities
supposed to do (i.e. provide product or delivers / stockholders equity
service)
b. The amount of revenue is realizable1, i.e., that the
amount collectible is reasonably assured and is
measurable with a reasonable degree of reliability
2. Matching costs to revenues:
a. Product costs, i.e. those that can be directly
associated with revenues, are recognized as expenses Profitability Ratios
in the period when the firm recognizes the revenue ROE = DuPont Analysis
b. Period costs, i.e. those that are not directly associated
with revenues are, recognized as expenses in the time Profit margin: Measures a firms ability to generate
period benefitted. income from a particular level of sales.
ASSETS = LIABILITIES + SHAREHOLDERS' EQUITY
Asset turnover: Measures a firms ability to generate sales
Common Retained
from a particular investment in assets.
= + + + - -
Assets
Dr. Cr.
Liabilities
Dr. Cr.
Stock
Dr. Cr.
Earnings
Dr. Cr.
Revenues
Dr. Cr.
Expenses
Dr. Cr.
Dividends
Dr. Cr.
Leverage: equity multiplier Magnifying effect
+ - - + - + - + - + + - + -
1 2
When assets received are readily convertible to cash or claims of cash Prepaid Expenses, Unearned Revenues
Activity Ratios LIFO Liquidation
Total asset turnover = Sales / Total assets When the quantity sold exceeds the quantity purchased under LIFO
Measures a firms ability to generate sales from a particular Old inventory costs from the older cost layers are transferred to cost of
investment in assets. goods sold. Creates larger than normal profits because older layers
Fixed asset turnover = Sales / Fixed assets are usually less costly per unit when prices are rising
Decline in ratio the firm is not using its assets efficiently. However, Disclosure of LIFO gain: The amount by which net income would be
a low or decreasing rate of fixed asset turnover may be an indicator increased if the liquidation had not occurred.
of an expanding firm that is preparing for future growth. As the benefits PP&E are expected to extend beyond one year, the
Increase in ratio firm is using its assets efficiently (or a acquisition cost is capitalized when the PP&E is bought. Capitalizing
technological innovation is introduced). However, a firm might cut means the entire amount of the cost is shown as an asset in the balance
back its capital expenditures if the near-term outlook for its products sheet.
is poor. Such an action could lead to an increase in the fixed asset Asset (+A) Dr.
turnover ratio. Cash or Payable (-A or +L) Cr.
Impairment
When market forces or nature may destroy substantial parts of the
assets value, we write down the value of the asset to its current fair
value (i.e., market value) through a process of impairment. The amount
of impairment is charged as an expense during the period when the value
destruction occurred.
Impairment Expense (+E,-SE) Dr.
Provision for impairment or Asset Cr. (+CA or A)
Note that amortization is a periodic charge that occurs every period
over the assets life. Impairment is a one-time event.
If prices are increasing, then following are true (opposite if prices are
decreasing):
LIFO will show lower profit as more recent costs are
matched to sales
LIFO will show lower inventory values because it
reflects older market prices
FIFO Inventory - LIFO Inventory = LIFO reserve.
Companies using LIFO are required to disclose
LIFO reserve can be viewed as an unrealized holding
gain. A gain that results from holding inventory as
prices are rising