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Week 8 – Assignment: Recommend Financial Statement Analysis Techniques

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Consider the following scenario:

Your senior management was very impressed with your assessment of the financial statements and ratios analysis you provided on your competitor

They have asked you to assemble using the information and assessment techniques you demonstrated in Week 7, a presentation for some senior staff and board of directors. You will need to display your corporate position as well as the industry metrics, and then show what your corporation is currently doing to improve your position in the industry and support your projected growth. One key point that your management has asked for is for you to explain your process steps for the analysis of the financial statement and ratios. If you do not have a corporation, choose a corporation and its competitor for your presentation.

In this course, we have discussed many important topics related to Financial Statement Analysis. Taking on the role of a financial statement analyst provide a presentation to senior management and board directors in financial statement and ratio analysis by developing a PowerPoint presentation, based upon the content assignment outcomes from last week, and other outcomes defined within this course.
Support your conclusions with references from a minimum of five (5) journal articles or publications.
Incorporate appropriate animations, transitions, and graphics as well as “speaker notes” for each slide. The speaker notes may be comprised of brief paragraphs or bulleted lists.

Create a PowerPoint slide set. Think about who your target audience is and how your topic affects them.

The required length of the PowerPoint Presentation option for this assignment is 12-15 slides (with a separate reference slide). Your presentation
MUST
include notes that contain 100-150 words per slide (this is your script). Be sure to include citations for quotations and paraphrases with references in APA format and style. Save the file as a PPT file with the correct course code information in the name.

Recent deliberations by both the International
Accounting Standards Board (IASB) and the
Financial Accounting Standard Board (FASB) in
the United States have focused on how fair values
of assets and liabilities should be measured. The
issue of when, rather than how, fair value measure-
ment should be applied is still far from resolved,
however. Fair values have been mandated for
some assets and liabilities under both IASB and
FASB standards, but it is fair to say that principles
governing the applicability of fair values have yet
to be articulated: when is fair value accounting ap-
propriate and when is it not? Or, in terms of my
charge for this paper, under what circumstances is
fair value a plus or a minus?

To prepare for my task, I made a survey of pub-
lic statements made for and against fair value ac-
counting by a variety of standard setters,
regulators, analysts, and preparers. The stated ‘mi-
nuses’ typically point to the dangers of fair value
estimates from marking to model rather than mark-
ing to market, concerns about introducing ‘excess
volatility’ into earnings, and feedback effects (on
banks’ lending practices, for example) that could
damage a business and, indeed, heighten systemat-
ic risk. A few antagonists question whether fair
values (for bank assets and liabilities, for example)
really capture the economics of a business (in fos-
tering core deposits and making loans). In counter-
point, the proponents of fair value argue that fair
value is a superior economic measure to historical
cost. Consider the following arguments, often ad-
vanced as ‘pluses’:
• Investors are concerned with value, not costs, so

report fair values.

• With the passage of time, historical prices be-
come irrelevant in assessing an entity’s current
financial position. Prices provide up-to-date in-
formation about the value of assets.

• Fair value accounting reports assets and liabili-
ties in the way that an economist would look at
them; fair values reflect true economic sub-
stance.

• Fair value accounting reports economic income:
in accordance with the widely accepted Hicksian
definition of income as a change in wealth, the
change in fair value of net assets on the balance
sheet yields income. Fair value accounting is a
solution to the accountant’s problem of income
measurement, and is to be preferred to the hun-
dreds of rules underlying historical cost income.

• Fair value is a market-based measure that is not
affected by factors specific to a particular entity;
accordingly it represents an unbiased measure-
ment that is consistent from period to period and
across entities.
So self-evident do these points seem to be that

fair value accounting is often just presumed to be
‘more relevant’. The words, ‘fair value’ sound
good (who could be against ice-cream and fair
value?!) while ‘historical cost’ sounds, well, passé.
As it turns, out, however, each of these statements
becomes qualified under scrutiny. Can economic
argument lead to constructive arguments for im-
plementing fair value accounting?

1. Some preliminaries
Pluses and minuses can only be evaluated against
an alternative, so I will take the approach of asking
if (or under what conditions) fair value accounting
is an improvement over historical cost accounting.
In discussions about fair value, people often pro-
ceed at cross-purposes, so a few points need to be
clear before we proceed.

1.1. What is fair value?
Three notions of fair value accounting enter the

discussion, and one must be clear which is being
entertained.

Accounting and Business Research Special Issue: International Accounting Policy Forum. pp. 33-44. 2007 33

Financial reporting quality: is fair value
a plus or a minus?
Stephen H. Penman*

*The author is at the Graduate School of Business,
Columbia University, shp38@columbia.edu This paper draws
on some of the themes in a White Paper prepared for the
Center for Excellence in Accounting and Security Analysis
(CEASA) at Columbia Business School. See D. Nissim and S.
Penman, The Boundaries of Fair Value Accounting, White
Paper No. 2 (Center for Excellence in Accounting and
Security Analysis, Columbia University, 2007). Comments re-
ceived at the Information for Better Markets Conference have
been helpful as has a close reading of the manuscript by
Martin Walker and Pauline Weetman.

1. Fair value variously applied in a ‘mixed attrib-
ute model’:
In this treatment, fair value is used alternative-
ly with historical cost for the same asset or lia-
bility but at different times; the accounting is
primarily historical cost accounting, but fair
values are applied under certain conditions.
Examples are fair values applied in fresh-start
accounting (that then proceeds under historical
cost accounting), impairment from historical
cost to fair value (really a form of fresh-start
accounting), using fair values to establish his-
torical cost (for barter transactions and dona-
tions, for example) or in the allocation of
purchase price (between goodwill and tangible
assets, for example), and reference to fair value
to discipline estimates under historical cost ac-
counting.

2. Fair value continually applied as entry value:
Assets are revalued at their replacement cost,
with current costs then recorded in the income
statement, with unrealised (holding) gains and
losses also recognised. Revenue recognition
and matching is maintained but income, based
on current costs, is said to be a better indicator
of the future and not path-dependent.

3. Fair value continually applied as exit value:
Assets and liabilities are remarked each period
to current exit price, with unrealised gains and
losses from the remarking recorded as part of
(comprehensive) income.

The pluses and minuses of fair value in applica-

tions (1) and (2) can be debated, but note that both
are really modified cost accounting; both maintain
standard revenue recognition – applying exit
prices to recognise value from business activity
only on actual exit of the product or service to the
market – but with modifications to the expense
matching.1 Application 3 applies exit values to
continually remark assets and liabilities but with-
out actual exit (realisation).

The FASB, in its recent Statement 157, Fair
Value Measurements endorses fair value as exit
value, with a seeming nod from the IASB subject
to some minor reservations:2

‘Fair value is the price that would be received to
sell an asset or paid to transfer a liability in an
orderly transaction between market participants
at the measurement date.’
While the IASB and FASB presumably envision

exit values being applied to determine fair value in
the mixed attribute model (1), I will limit my com-
ments to fair value applied in (3).3 It is the recog-
nition of exit values without an historical exit
transaction that places this fair value accounting in
such contrast to historical cost accounting. The
top-line notion of revenue disappears, and income
is simply the change in fair values on the balance
sheet. Accordingly, the accounting issues are quite
different. Continually remarking equity invest-
ments to fair value rather than using the equity
method involves different issues from impairing
equity method investments for a permanent loss
under mixed attribute accounting. And so with
marking inventories, core deposits, bank loans, in-
surance contracts, debt, and so on to fair value on
a continual basis. ‘Fair value accounting’ as envi-
sioned in application (3) is a potential shift in par-
adigm.4

1.2. Fair value to whom?
As with any policy issue, prescriptions cannot be

made without an understanding of the objectives
of the exercise. To whom are we reporting? Whose
pluses and whose minuses? Different users may
demand different accounting reports, and confu-
sion reigns if issues are discussed at cross purpos-
es. A shareholder might recognise a gain from a
fall in the market value of debt as creditworthiness
deteriorates, but not the creditor. Bank sharehold-
ers might wish to see bank deposits at fair value,
but not the depositors. A bank regulator would also
be concerned about reporting deposits at less than
face value if such reporting affected depositors’
confidence in the banking system. While an in-
vestor might welcome the information about
volatility that fair value accounting reveals, not so
a central banker who might be concerned about
feedback effects on systematic risk. A bank regula-
tor might be concerned about marking up banks’

34 ACCOUNTING AND BUSINESS RESEARCH

1 For example, impairment to fair value under application
(1) fresh-starts the matching of expenses to future revenues
when there is a downward revision in future revenues antici-
pated, that is, cost have expired. Application (2) matches cur-
rent costs rather than historical costs to (current) revenues.
FASB Statement 33 (now suspended) was an experiment with
application (2), but those issues are not part of the current de-
bate. See Statement of Financial Accounting Standards No.
33, Financial Reporting and Changing Prices (Norwalk,
Conn.: FASB, September 1979).

2 See Statement of Financial Accounting Standards No. 157,
Fair Value Measurements (Norwalk, Conn.: FASB, September
2006), paras 5–15 and Discussion paper, Fair Value
Measurements Part 1: Invitation to Comment (London: IASB,
November 2006).

3 Statement 157 is explicit in stating that the standard deals
with the measurement of fair value (when fair value measure-
ments are applicable), not with the issue of when fair value
measurements are applicable. IASB discussion documents
have the same flavour. However, the application question is
very much open and (presumably) part of the conceptual
framework agenda.

4 Under application (3), some assets or liabilities might be
carried at fair value (continually) while others are carried at
historical cost (continually). So, marketable securities might
be marked to market, with inventories at historical cost. This
form of a ‘mixed attribute model’ differs from moving be-
tween fair value and historical cost for the same asset and lia-
bility.

capital during speculative times with the resulting
incentive for profligate lending.5

In this talk, I take a shareholder perspective:
what are the pluses and minuses of using fair value
accounting (rather than historical cost accounting)
for reporting to shareholders? This, I submit, is
hardly controversial; the shareholders are the own-
ers to whom management and auditors report. But
it does mean that, if standard setters have a broad-
er set of constituents in mind, with an objective of
general purpose financial reporting, then they may
see the issues differently.

1.3. My approach
Normative statements about accounting issues

are often statements of the author’s received wis-
dom combined with some a priori thinking: here is
what I think about the matter, says the author, sup-
ported by some inductive and deductive logic. This
approach, applied in the ‘accounting theory’ era of
the 1950s to the 1970s, gave us numerous prescrip-
tions but little resolution. It would be helpful to
refer to concrete research results for answers, but
theoretical and empirical research has not delivered
a definite resolution either. Recent accounting-
based valuation theory has given us some insight to
which I will refer later. Empirical research (of the
type discussed by Wayne Landsman) documents
correlations between fair value measurements and
stock prices that are useful for understanding
whether fair values are ‘relevant to investors’. But
it does not give us much of a handle on the policy
question of whether fair values should be reported
in place of historical cost accounting (which, re-
search shows, is also relevant to investors).6

My approach, I must confess, is largely a priori.
But I hope to get some bite by taking what might
be referred to as a demand approach. Accounting,
as I see it, is a product and products are a matter of
design. The design – and the quality of the product
– should be judged on how well it serves the cus-
tomer. So, with the customer identified as the
shareholder (above), I ask which product features
– fair value or historical cost – help (or frustrate)
the customer. Unfortunately, inferring demand
from statements made in the current regulatory en-
vironment is difficult, given that regulation affects
behaviour. We do observe the voluntary applica-
tion of fair value accounting (without the coercion
of regulation) in some situations – unregulated
hedge funds use fair value accounting, for example
– and so we can defer to ‘the market’ for lessons.
Such observations are limited, however, so I resort
to a priori analysis. But I do so with an eye to the
shareholder; I presume that shareholders require
accounting information for two purposes:
1. Valuation. Shareholders use accounting infor-

mation to inform them about the (fair) value of
the equity: What is the equity worth?

2. Stewardship. Shareholders use accounting in-
formation to assess the stewardship of manage-
ment, the owners’ employees: How efficient
have managers been in making investments
and conducting operations to add value for
shareholders?

More concretely, I force an orientation to practi-
cal tasks for which information is demanded: To
what extent does fair value accounting aid or frus-
trate the tasks of equity valuation and monitoring
managers’ stewardship? This focus, also, is hardly
controversial. The first task is that of the equity an-
alyst, the second the pursuit of those involved in
corporate governance on behalf of shareholders.

In view of the above, many of the points I make
below are not particularly original. I want to be a
little more analytical than simply listing the stan-
dard litany of complaints about and statements in
favour of fair value accounting. But, in doing so,
some well-worn points come to the surface. By
presenting them in a more organised framework,
my hope is that they will be more imperative.

1.4. Information for better markets
It is often said that financial reporting should have

the objective of providing all relevant information
to capital markets. So (it follows), if both historical
cost information and fair values are relevant, both
should be reported. Nothing here subtracts from that
position (if one wants to adopt it). The issue is
which measurement basis should go through the
discipline of the accounting system to determine the
summary, bottom-line numbers, earnings and book
value on which investors and analysts focus (for
whatever bounded rationality reason). Alternatives
to the accounting information (within the system)
can, of course, be supplied in footnotes, much like
some fair value information is now disclosed.

2. The conceptual merits of fair
value accounting versus historical
cost accounting
As with most accounting issues, it is important to
distinguish conceptual issues from those that have

Special Issue: International Accounting Policy Forum. 2007 35

5 Papers that deal with fair value from the view of the cen-
tral banker and bank regulator include A. Enria et al., Fair
Value and Financial Stability Occasional Paper Series No. 13,
European Central Bank, April 2004; G. Plantin, H. Sapra, and
H. Shin, ‘Marking to market, liquidity, and financial stability’,
Monetary and Economic Studies (Special Edition), October
2005; K. Burkhardt and R. Strausz, ‘The effect of fair vs. book
value accounting on banks’, unpublished paper, Free
University of Berlin, April 2004; and ‘Fair value accounting
for financial instruments: some implications for bank regula-
tion’, BIS Working paper No.209, August 2006.

6 Indeed, inferences from the empirical research are limited
because stock prices, from which ‘relevance’ is inferred, are de-
termined from information under current accounting practices,
and those prices might be different under alternative practices.

to do with measurement. Here I ‘conceptualise’
how both fair value accounting and historical cost
accounting would satisfy the valuation and stew-
ardship goals of shareholder reporting, in principle
(if measurement were no problem). I then overlay
the concepts with measurement in Section 3.

2.1. The concepts behind fair value accounting
Putting aside measurement issues, fair value ac-

counting conveys information about equity value
and managements’ stewardship by stating all as-
sets and liabilities on the balance sheet as their
value to shareholders:7

• the balance sheet becomes the primary vehicle
for conveying information to shareholders;

• with all assets and liabilities recorded on the
balance sheet at fair value, the book value of eq-
uity reports the value of equity (the Price/Book
ratio = 1.0);

• the income (profit and loss) statement reports
‘economic income’ because it is simply the
change in value over a period;

• following the economic principle that current
changes in value do not predict future changes in
value, earnings cannot forecast future earnings.
But this is of no concern for valuation, because
the balance sheet provides the valuation;

• (unexpected) earnings, being a shock to value,
reports on the risk of the equity investment.
Volatility in earnings is informative for value at
risk;

• the P/E ratio is Price/Shock-to-value, that is, a
realisation of value at risk (with a very different
interpretation to that under historical cost);

• income reports the stewardship of management
in adding value for shareholders.
In short, the balance sheet satisfies the valuation

objective and the income statement provides infor-
mation about risk exposure and management per-
formance.

The accounting for investment funds – mutual
funds and hedge funds – applies this strict fair
value accounting, and investors are willing to trade
in and out of these funds at book value (‘net asset
value’) with the presumption that book value
equals value (with no gains and losses between
shareholders). Further, the income (returns) for
these funds is accepted as a comprehensive meas-
ure of the fund managers’ investment perform-
ance, both the investment success and the
volatility to which investors have been subjected.
The accounting is sufficient; one does not require
a balanced scorecard.

2.2. The concepts behind historical cost
accounting

Historical cost accounting is often misinterpret-
ed in the debate, with the criticism that it reports a
balance sheet with old, historical costs rather than
current values. This statement is correct, but belies
an understanding about how historical cost works
for valuation and performance assessment. Under
historical cost accounting,
• the income statement is the primary vehicle for

conveying information about value to sharehold-
ers, not the balance sheet;

• earnings report how well the firm has performed
in arbitraging prices in input (supplier) markets
and output (customer) markets; that is, historical
cost earnings reports the value-added buying in-
puts at one price, transforming them according
to a business model, and selling them at another
price;

• in contrast to fair value accounting, current in-
come forecasts future income on which a valua-
tion can be made;

• the P/B ratio is typically not equal to 1.0 and the
P/E ratio takes current earnings as a base and
multiplies it according to the forecast of future
earnings;

• earnings do not report shocks to value, but
shocks to trading in input and output markets;

• earnings measure the stewardship of manage-
ment in arbitraging input and output markets,
that is, in adding value in markets.
Historical cost accounting views value as gener-

ated in business by purchasing inputs (from suppli-
ers), transforming them according to a business
plan, and selling the consequent product (to cus-
tomers) over cost; in short, value is added by arbi-
traging (entry and exit) prices in input and output
markets for goods and services according to a
business plan. Historical cost accounting does not
report the (present) value of expected outcomes
from the business plan. Rather, it reports on
progress that has been made in executing the plan,

36 ACCOUNTING AND BUSINESS RESEARCH

7 This idea is close to that of ‘value in use’ but with a focus
on the shareholder rather than on the entity. The value-in-use
concept (or its variant, ‘deprival value’) appears (for example)
in Accounting Standards Board, Statement of Principles for
Financial Reporting (London: ASB, 1999), Australian
Accounting Research Foundation, Accounting Theory
Monograph No. 10, Measurement in Financial Accounting
(AARF, 1998) and has long been part of the discussion, for ex-
ample in J. Horton and R. Macve, ‘ ‘Fair value’ for financial
instruments: how erasing theory is leading to unworkable
global accounting standards for performance reporting’,
Australian Accounting Review 10 (July 2000): 26–39 and R.
Macve and G. Serafeim, ‘ “Deprival value” vs “fair value”
measurement for contract liabilities in resolving the “revenue
recognition” conundrum: towards a general solution’.
Unpublished paper, London School of Economics, June 2006.

recognising value added (earnings) from actual
transactions in the input and output markets being
arbitraged. The income statement comes to the
fore with a matching of revenues (value received
from transactional exit prices) with costs (value
surrendered in transactional input prices). The bal-
ance sheet is not a statement of values (for the
large part), by design, but rather a by-product of
this matching, with liabilities such as accrued ex-
penses, deferred revenues, and deferred taxes gain-
ing their legitimacy from the matching process
rather than as representations of the value of obli-
gations.

The term, ‘historical cost’ is unfortunately pejo-
rative. A better term, one that captures the essence,
is ‘historical transactions accounting’, for the ac-
counting reports a history of transactions, and it is
that history of engaging with markets from which
valuations are made and management performance
assessed.

3.3. The demand for fair values
A demand for fair values could be imputed if

historical cost information is shown to be deficient
for valuation and performance evaluation, with
fair values providing the remedy. Here I compare
the two for purposes of valuation.

To separate concepts from measurement issues,
it is helpful to compare fair value accounting and
historical cost accounting implemented in their
ideal form. Ideal fair value accounting reports a
book value that is sufficient to value a firm but
earnings that are useless for the purpose. Ideal his-
torical cost accounting produces a balance sheet
that does not report value, but earnings that are
sufficient to value a firm. Consider the following
equity valuation model based on expected earn-
ings (that is a legitimate one in valuation theory in
the sense that it gives the same value as that based
on expected dividends):

Valuet = Expected Earningst+1 (A)
r

Here r is the required return for the equity holders.
Under ideal fair value accounting, earnings are

forecasted from the current book value:
Expected Earningst+1 = r x Book Valuet (B)
That is, book value (ideally measured at fair

value) is sufficient for forecasting earnings and for
valuation. Under ideal historical cost accounting
earnings are forecasted from current earnings:

Expected Earningst+1 = Earningst (C)
That is, current earnings (ideally measured) are

sufficient for forecasting earnings and for valua-
tion. In the parlance, current earnings indicate per-
manent earnings.8 Accordingly, under historical
cost accounting equity value is determined by cap-
italising current earnings:

Valuet = Earningst (D)
r

The lessons are:
1. It is not necessary to state the balance sheet at

fair value to satisfy the valuation objective.
Valuations can be made from the historical cost
income statement.

2. Assuming that one knows the required equity
return, there is no reason, in principle, to say
that fair value accounting is better than histori-
cal cost accounting. The resolution must turn
on how measurement strays from the ideal.
Historical cost comes with considerable meas-
urement issues; does fair value measurement
provide a solution?

3. If one does not know the required return (and
we don’t!), fair value accounting has a distinct
advantage. Valuation under historical cost ac-
counting requires a required return (to convert
earnings, a value flow, to a stock of value). Fair
value accounting delivers the value directly
from the balance sheet without relying on a re-
quired return (as with the mark-to-market in-
vestment fund). That is, the forecast of earnings
in (B) is not necessary, for book value already
reports the value. As a bonus, realisations on
value at risk are reported in the income state-
ment to give an indication of what the required
return should be.

In short, fair value accounting is a plus, imple-
mentation issues aside. However, historical cost
accounting has features that provide an alternative
should ideal fair value accounting not be attain-
able. Many of the statements about fair value ac-
counting in the bullet points in the introduction to
this paper are misdirected, at least at the conceptu-
al level.

As an illustration of this last statement – and to
focus on the practical valuation task — the appen-
dix carries out a valuation of the Coca-Cola
Company using historical cost numbers. Coke has
a lot of value missing from the balance sheet – its
price-to-book ratio is currently 6.3 – mainly be-
cause US GAAP does not allow its brand asset to
be carried on the balance sheet. Those who com-
plain that accounting is poor because intangible as-
sets are missing from the balance sheet might
argue that brands should be booked (as in the UK

Special Issue: International Accounting Policy Forum. 2007 37

8 One must accommodate retention that yields additional
earnings; the forecast here is for the case of full payout.
Valuation under ideal fair value accounting and ideal histori-
cal cost accounting is modelled in J. Ohlson and X. Zhang,
‘Accrual accounting and equity valuation,’ Journal of
Accounting Research, 36 (Supplement 1998): 85–111.

before IFRS). After reading the Appendix, I hope
you will be impressed by how readily Coke can be
valued without getting the balance sheet straight.
To point (1) above: missing (intangible) assets in
the balance sheet are no problem (for valuation) if
the earnings from those assets are reported in the
income statement. Note that the Coke case is not
one where valuation model (D) with ideal histori-
cal cost accounting applies. That model implies
a forward P/E of 10 (for a 10% required return,
say), but Coke’s P/E is 19.3. Nor is it a case

where

the forecast (C) strictly applies. But the imperfec-
tions of historical cost accounting can be accom-
modated.

A core accounting concept underlies the use of
historical cost accounting in valuation: the can-
celling error property. Provided that earnings are
comprehensive (clean-surplus) earnings, it is al-
ways true that

Stock returnt = Earningst + (Pt – Bt) – (Pt–1 – Bt–1)

where P is equity price and B is the book value of
equity.9 With fair value accounting, P = B at all
points in time, so earnings always equal the stock
return – just like earnings for the mark-to-market
investment fund always equals the market return
on the assets (cum-dividend). However, P = B is
not necessary; provided that the error in the bal-
ance sheet, P – B is the same at the end of the pe-
riod as at the beginning, capitalising earnings still
works. Historical cost reports a balance sheet with
error, but the focus is on earnings. We teach the
cancelling error property to our first-year account-
ing students by pointing out that earnings is the
same whether one expenses R&D immediately or
capitalises it and amortises, provided there is no
growth; that is, balance sheet errors cancel.
Growth changes this (and therefore growth intro-
duces a change in price premium over book value).

But growth can be accommodated in valuation, as
the Coca-Cola example shows.

3. Fair value measurements
Concepts are the place to start, but the rubber hits
the road with measurement. If ideal fair value ac-
counting can be implemented, all is OK, for noth-
ing is lost by abandoning historical cost
accounting, and something is gained; we have a
net plus. However, if fair value measurements do
not achieve the ideal and at the same time we lose
the information provided by historical cost ac-
counting, damage can be done.

After defining fair value as market exit price,
the recent FASB Standard 157, Fair Value
Measurements, then identifies three levels of ‘in-
puts’ to determine market price, distinguished by
increasing levels of subjectivity.10 Levels 2 and 3
refer to estimates of hypothetical market prices.
The criticisms of subjective measurement are well
known, and the FASB’s Level 3, in particular, rais-
es concerns. To sort out the pluses and minuses, it
is worthwhile to focus on Level 1 measurement –
where market prices for identical assets and liabil-
ities are observed in active markets – for, if fair
value accounting is not appropriate in that case,
concerns are just magnified when subjective esti-
mates are made.

3.1. Pluses and minuses of Level 1 fair value
measurements

Implementation of fair value accounting (as pro-
posed by the FASB and IASB) involves two ques-
tions. The first is whether exit value measures
value to shareholders. The second is whether fair
values can be applied at the level of aggregate as-
sets and liabilities that jointly produce value for
shareholders – an issue of matching.
Fair value as exit value

One could envision the implementation of ideal
fair value accounting with subjective estimates of
fair values of assets and liabilities (for sharehold-
ers), but that flies in the face of the idea that ac-
counting information should be based on
objective, reliable evidence. The FASB and IASB
commendably maintain the ‘reliability’ criterion
by requiring that fair value be backed up with an
observed market price (at least in their Level 1 im-
plementation). However, equating fair value to
market value is quite constraining, for it equates
value (to shareholders) to market (exit) price.

Plus: Fair (market) values are a plus when value
to the shareholders is determined solely by expo-
sure to market price; that is, shareholder value is
one-to-one with market prices.

A marketable bond in which a firm invests its
‘excess cash’ is exposed to changes in market price
that determines the amount of cash on liquidation,

38 ACCOUNTING AND BUSINESS RESEARCH

9 I believe this equation first appears in P. Easton, T. Harris,
and J. Ohlson, ‘Accounting earnings can explain most of secu-
rity returns: the case of long event windows,’ Journal of
Accounting and Economics, 15 (June–September 1992):
119–142, but textbooks of old used to discuss the cancelling
error property.

10 Statement 157 defines the three levels as follows:
Level 1inputs are quoted prices (unadjusted) observed in ac-
tive markets for identical assets and liabilities.
Level 2 inputs are inputs other than Level 1 quoted prices that
are observable, directly or indirectly; examples include quot-
ed prices for similar assets or liabilities in active markets,
quoted prices for identical or similar assets or liabilities in
markets that are not active, inputs such as observed interest
rates, credit risks, volatilities, and default rates, and inputs cor-
roborated by observable market data by correlation or other
means.
Level 3 inputs are unobservable inputs for the asset or liabili-
ty, reflecting the firm’s own assumptions about the assump-
tions that market participants would use in pricing the assets
or liability.

and shareholder welfare is tied to the market price,
one-for-one. Accordingly, fair value is appropriate.
It is similarly appropriate for shares held in a trad-
ing portfolio where the investor gets the return,
one-for-one, from the change in market price.

Minus: Fair (market) values are a minus when
the firm arbitrages market prices. That is, fair
value is not appropriate when the firm adds value
(for shareholders) by buying at (input) market
prices and selling at (output) market prices.

Raw material used in manufacturing does not get
its value from a change in its exit market price, but
as an input into a process that adds value to its
market price by producing a product and selling it
to customers; change in shareholder value is not
one-to-one with the change in the market price of
the input. With respect to stewardship, the manag-
er should not be rewarded on the basis of changes
in the market price of the raw material, but for
adding value (earnings) from buying the input
favourably and selling it, transformed, to cus-
tomers with a mark-up.

The one-to-one condition says that fair value is a
minus where firms are involved in (expectational)
arbitrage (of input and output) prices in their busi-
ness model; that is, the business model adds value
to market prices. Or stated differently, fair value is
not appropriate when there is a top-line notion of a
customer from whom value is received in an exit
price, with value added over an input price. Fair
value is appropriate when value comes from prop-
erty rights and obligations, and value is added or
lost (solely) from fluctuations in the market values
of those rights and obligations.11

Here are some cases where the one-to-one con-
dition for fair value applies:
1. Investments in securities in a trading portfolio

and derivative instruments on such securities.
2. Pension assets: The firm has performed by con-

tributing to the fund and has no influence on
the performance of the fund, but shareholder
welfare is affected directly by changes in the
market value of the fund.

3. Investments by an insurance company. In the
business model these securities are value in re-
serve and that value depends on market price.

4. Real estate held for speculation with no plan
for developing or utilising the real estate.

5. Options that give the counter party (but not the

firm) the call rights; the firm is a passive count-
er party. Warrants and call and put options on
the firm’s own stock are an example. Freddie
Mac and Fannie Mae mortgages are of this
type. These are essentially traded put options
on real estate – the right of property owners to
sell property back to these institutions.
Shareholders’ welfare is determined by the
counter party’s call, not the firm’s. The market
value of the instrument reflects the probability
of this call and changes in the market value re-
flect changes in shareholders’ welfare as this
probability changes.

Below are some cases where the one-to-one con-
dition for fair value does not apply:
1. Inventory: the firm adds value by finding a cus-

tomer.
2. Investment in a subsidiary where the firm has

influence.
3. Assets and liabilities whose value changes as

interest rates change but there is also a numer-
ator effect (on future earnings) as well as a de-
nominator effect from change in interest rates.
These typically are instruments that involve
customer relationships. Examples: commercial
loans, mortgages held by originating banks,
and core deposits. Historical cost accounting
allows one to observe the numerator effects.

4. Performance obligations. Fair value accounting
books the liability to perform at the price that
someone else would charge to satisfy the obli-
gation, not at the cost at which the company
can perform (possibly with comparative advan-
tage).

5. Receivable allowances and warranty liabilities.
Value to shareholders is based on firm perform-
ance in servicing these items (through its
credit department and customer service depart-
ment), not what the market would charge for
non-recourse relief from the obligation. (Note:
market values can be information for disciplin-
ing estimates, but as an exercise in improved
historical cost accounting, not as an application
of fair value accounting.)

6. Insurance assets and liabilities, other than in-
vestment assets.

7. Real estate held as input to business enterprise
(for example, real estate development, real es-
tate rentals). For real estate rentals, historical
cost accounting recognises value through rental
income in the income statement.

8. Environmental clean-up liabilities. Fair value
is the amount that someone would charge for
the clean up, not the anticipated cost to the firm
in managing the problem.

Special Issue: International Accounting Policy Forum. 2007 39

11 The perspective is similar to that under Coase’s transac-
tions cost theory of the firm. Firms exist because markets are
not perfect and thus prices do not measure value under all con-
ditions. Firms and their hierarchies are more efficient than
markets in some respect, entrepreneurs exploit those efficien-
cies, and historical cost accounting reports the efficiency of
firms is dealing with imperfect prices.

Fair values are particularly inappropriate when
they replace historical cost accounting from which
(fair) value is assessed:

Minus: Fair market prices are a minus if they
substitute for historical cost information and (effi-
cient) prices depend on historical cost information.

Carrying investments in a subsidiary at market
prices (rather than under the equity method or pro-
portionate consolidation) obscures the profitability
of the subsidiary and the value of the parent which
is based on that profitability. The value of an inter-
mediary function – adding value from the spread
between borrowing and lending rates – is obscured
by fair valuing loans and borrowings if those exit
values do not incorporate the firm-specific ‘intan-
gibles’ in customer and depositor relationships. So
with the insurance business that involves customer
relationships in managing premiums and losses,
along with operating costs.12

The loss of historical cost information can lead
to inefficient prices. The spectre of inefficient
prices raises another issue:

Minus: Fair values bring price bubbles into fi-
nancial statements.

Fair values (as exit prices) come with a caveat.
Provided the one-to-one condition is satisfied, fair
values are value to shareholder if market prices are
‘efficient’. In a price bubble, however, inefficient
prices are booked on the balance sheet, with bub-
ble gains flowing through to the income statement.
For trading portfolios where investments are held
short-term, this may not be a large problem. But
where the portfolio is held for the long-term, it is a
problem. For instance, pension assets marked to
bubble prices may give the appearance of satisfac-
tory funding of future pension obligations and in-
surance assets may give the appearance of
adequate or even excess reserves against future in-
surance losses.
Fair value matching

Fair value accounting is often promoted as a way
to avoid the ‘myriad of rules’ involved in imple-
menting revenue and expense matching in the in-
come statement. But fair value accounting has its
own matching concept that is difficult to implement.

Minus: Fair value accounting fails without asset
and liability matching.

Under a business model, assets and liabilities are
used jointly to generate value for shareholders. If
so, the stand-alone fair value of an asset has little
meaning. To capture value added (from exposure
to market prices), one matches fair values of all the
assets and liabilities that generate the value togeth-
er, leaving none out. A particular danger lies in fair
valuing an asset and not matching the fair value of
an associated liability whose price changes are
negatively correlated with those of the asset.

In the income statement, such fair value mis-
matching results in recognition of gains and not
offsetting losses (or vice versa). The case of nega-
tive correlation produces ‘excess volatility’ in
earnings about which one can indeed complain.
Note further that, even if fair values of individual
assets and liabilities are matched and summed, the
total may not capture the value of the group if they
are used synergistically. (In this case it is difficult
to see that the one-to-one condition would hold
anyway, so the point may be mute.).

Cases where mismatching can occur:
1. Core deposits. These are intangible assets for

banks which represent the ability to obtain rel-
atively inexpensive funds from demand, sav-
ings and small denomination time deposits.
Their value is difficult to estimate but it is neg-
atively related to the value of the loan portfo-
lio: When interest rates rise, the value of the
loan portfolio typically declines but the value
of the core deposits intangible asset typically
increases. If the loan portfolio is marked-to-
market but the value of the core deposits intan-
gible is not recognised, earnings and book
value will be artificially depressed. But the one-
to-one condition says that customer deposits
should not be fair valued. So, if loan portfolios
are fair valued, a mismatching occurs.

2. Borrowings. The decline in the value of a
firm’s assets (due to deteriorating profitability)
is accompanied by an offsetting decline in the
value of its debt obligations (due to deteriorat-
ing credit quality). If the decrease in the value
of liabilities is recognised as a gain in the in-
come statement, but the decrease in asset value
is not recognised (for example, due to difficul-
ties in measuring the value of some intangible
assets such as customer relationships), earnings
will be overstated at times when high quality
information is especially important.

The matching issue is particularly difficult when
an instrument whose value varies with price is
used in conjunction with assets and liabilities
whose value is tied to customer relationships. A
fair value option under IASB standards13 (and pro-
posed in a current FASB exposure draft14), at-

40 ACCOUNTING AND BUSINESS RESEARCH

12 This is not to say that information about the sensitivity of
earnings to changes in interest rates (for banks) or embedded
values (for insurance companies) are not relevant footnote in-
formation.

13 The IASB included a fair value option in International
Accounting Standard No. 39, Financial Instruments:
Recognition and Measurement (London: IASB, December
2003). An IASB amendment restricting the fair value option
was published in June 2005 under the title, The Fair Value
Option. The fair value option must be applied to a group of as-
sets and/or liabilities that is both managed, and it performance
evaluated, on a fair value basis.

14 FASB Proposed Statement of Financial Accounting
Standards, The Fair Value Option for Financial Assets and
Liabilities (Norwalk, Conn.: FASB, January 2006).

tempts to address the matching problem, but not so
if the asset or liability fair valued under the option
does not satisfy the one-to-one condition.

3.2. Pluses and minuses of Level 2 and Level 3
fair value measurements

Levels 2 and 3 admit estimates of hypothetical
market prices. Level 3, while insisting that the fair
value is based on an estimate of market price
(rather than value-in-use), permits ‘unobservable
inputs’ that ‘reflect the reporting entity’s own as-
sumptions about assumptions that market partici-
pants would use in pricing the asset or liability.’

The objections to using subjective estimates are
well understood. However, any accounting beyond
mere cash accounting involves estimates. The
question of where to draw the line on estimates
(Level 2 but not Level 3?) is difficult to handle a
priori, for resolution rides largely on one’s assess-
ment, not only of the integrity of managers but
also of their (honest) subjective biases. The com-
petence and independence of monitors – auditors,
assessors, and corporate boards – must also be
evaluated, along with the effectiveness of controls.
(Honest) managers are naturally optimistic, for it
is their business plan. Accounting, however, serves
as a counterweight to managements’ optimism, so
raising their estimates to the level of accounting
information contaminates. Some argue that such
estimates elicit information from management that
might not otherwise surface. The stewardship per-
spective underscores the downside; rewarding
managers based on their estimates exposes the
shareholder to moral hazard.

Here are a few points to consider when enter-
taining the use of estimated fair values.

First, the restriction in Section 3.1 that fair value
accounting applies only when shareholder value is
solely determined by exposure to market prices
means that, in most cases, there will be an active
market where Level 1 measurements are available.
If a firm has to execute by finding a customer in an
illiquid market, value is usually determined by that
ability to execute, not solely by market prices. So
situations where estimation is required may be
limited (if the one-to-one condition is honoured).

Second, one must question whether Level 3 real-
ly enforces a discipline in estimating market
prices. Using one’s own assumptions could yield
estimates resulting in upfront (day one) estimated
profits.

Third, fair value estimation errors introduce
error into the balance sheet but also the income
statement (which reports the change in fair value).
Indeed, with random errors in both the opening

and closing balance sheet – bias aside – the errors
are compounded in the income statement.15 If one
has a fuzzy balance sheet, fair value is less inform-
ative, but if one also loses the informative histori-
cal cost earnings, mark up a definite minus. In the
extreme, estimated fair values could produce an
uninformative balance sheet and a less uninforma-
tive income statement.

Fourth, it is sometimes said that historical cost
involves estimates and estimated fair values are no
different. But estimates to effect matching under
historical cost are based on, and audited against,
the historical transaction record – like the histori-
cal experience with credit losses, useful lives and
warranty service costs. Level 2, with ‘observable
inputs’, could be interpreted as invoking this no-
tion. But the notion is quite different from specu-
lating about the present value of the cash flows
when marking to model.

Fifth, historical cost estimates true up against the
actual transaction record, and usually fairly quick-
ly. Fair value estimates usually do so but, without
an associated ‘historical transaction accounting’,
estimated fair values settle up against estimated
fair values. So, the fair value of a long-term con-
tract on the output of an energy plant might be re-
estimated each year but, without a reporting on the
actual sales and expenses of running the plant each
year, the subsequent estimated fair values become
elusive. The same can be said about insurance con-
tracts: the fair value of an insurance contract is in-
formed by the historical experience reported in
premiums matched to losses and expenses. Note
that the FASB’s fair value accounting for employ-
ee stock options (at grant date) does not settle up
at all (so, if the option is not exercised, the record-
ed expense is not reversed).

Sixth, I suspect that an analyst will have difficul-
ty in carrying out a quality analysis on fair value
accounting. How would estimation errors, biased
or random, be discovered? Disclosures about the
valuation methodology are required under FASB
Statement 157 and these presumably will help. But
I am not clear on how earnings quality diagnostics
of the type applied under historical cost accounting
(again, with reference with what is normal in the
transaction history) would be developed.

Seventh, observed market behaviour is instruc-
tive. Hedge funds (largely unregulated) apply fair
value accounting and estimate fair values for illiq-
uid assets. They do so under the rigour of formal
valuation committees with oversight of their
boards and auditors. But there is a danger in share-
holders trading in and out of the fund at values
based on estimates. So funds typically limit the
percentage of illiquid assets held or require lock-
ups or transfers to side pockets until realisation.
Private equity funds typically require realisation
before distribution. In short, the tolerance for esti-

Special Issue: International Accounting Policy Forum. 2007 41

15 This effect is demonstrated formally in K. Peasnell,
‘Institution-specific Value’, BIS Working paper No. 210,
August 2006.

mated fair value (by shareholders) is limited.
Eighth, the research reported by Wayne

Landsman at this conference indicates that the in-
formativeness of fair values declines as estimates
are introduced.

4. Conclusion: pluses and minuses
In this paper I have taken a demand approach in
considering the pluses and minuses of fair value
accounting: Do fair values enhance the task of eq-
uity valuation and stewardship assessment? Surely
I have not exhausted this exploration, but some
points have been made. At a conceptual level, fair
value accounting is a plus; equity value is read
from the balance sheet, with no further analysis
needed, and the income statement reports realisa-
tions for determining value at risk. But concepts
are one thing and implementation another. With fair
value defined as exit price, the minuses add up (!).

Fair value accounting works well, for both valu-
ation and stewardship, with investment funds
(where shareholders trade in and out of the fund at
net asset value). This case is instructive for it is the
situation where the one-to-one relationship be-
tween exit prices and fair value to shareholders
holds. That one-to-one condition fails, however,
when a firm holds net assets whose value comes
from execution of a business plan rather than fluc-
tuations in market prices, even when exit prices
are observed in active markets. Asset and liability
matching problems confound the problem further.
Overlay the minuses of estimated fair values when
actual prices are not observed, and the minuses do
add up.

I have spent some time laying out the valuation
properties of historical cost accounting – better re-
ferred to as ‘historical transaction accounting’ –

because I sense that those properties are not al-
ways appreciated in the discussion of fair values.
A balance sheet focus is not necessary for valua-
tion, for we also have an income statement.
Historical cost income statements report earnings
from assets and valuation can be made from earn-
ings even though their fair value is not on the bal-
ance sheet. The Coca-Cola valuation in the
appendix makes the point. I don’t see a plus from
booking an estimate of the market price of Coke’s
brand asset to the balance sheet and then running
the revaluations through the income statement.
This scenario is not on the horizon, one would
think, but there is little difference in principle in
applying exit values to banks’ loans and deposits
that also get their value from brands and other cus-
tomer intangibles.

This having been said, the implementation of
historical cost accounting is not without its prob-
lems, and many criticisms of historical cost ac-
counting under current GAAP are well taken. The
analyst is frustrated by a number of features of
GAAP. I really have not engaged in tallying up the
pluses and minuses of fair values against the plus-
es and minuses of historical cost accounting with
all its measurement issues. But, it is difficult to see
how fair value accounting (with exit prices) solves
the problems with historical cost accounting when
the one-to-one condition is not satisfied. That con-
dition is a necessary condition for fair value ac-
counting. Further, while the implementation
problems with historical cost accounting are due to
difficulties of revenue and expense matching, fair
value accounting also has its own (asset and liabil-
ity) matching problems and these appear to be se-
rious ones.

42 ACCOUNTING AND BUSINESS RESEARCH

Special Issue: International Accounting Policy Forum. 2007 43

Appendix. A valuation of the Coca-Cola Company based on historical cost information

At the close of trading on 8 December 2006, the Coca-Cola Company’s shares traded at $48.91 each. The price-
to-book ratio was 6.3, indicating a lot of value missing from the balance sheet, largely because US GAAP does
not allow Coke’s intangible (brand) assets to be booked to the balance sheet. The forward P/E was 19.3, based
on analysts’ consensus EPS forecast for 2007.
The following valuation yields a value of $49.09 per share using only information available in the historical
cost financial statements. The valuation is crude (and can be refined), but the point is that we get close to the
market price by using historical cost information and, indeed, with three line items.

The historical cost numbers
Here are the relevant line items for years 2002–2005 ($m):

2005 2004 2003 2002
Sales (1) 21,962 21,044 19,656 17,545
Operating income, after tax (2) 5,065 4,427 4,192 3,841
Net operating assets (average) (3) 16,985 16,006 15,220 14,526

The financial statement analysis
From these line items, the following valuation inputs can be calculated:

2005 2004 2003 2002
Operating profit margin (2 ÷ 1) 23.1% 21.0% 21.3% 21.9%
Asset turnover (1 ÷ 3) 1.29 1.31 1.29 1.21
Average operating profit margin 21.8%
Average asset turnover 1.28
Average sales growth rate, on a base
of 2001 sales of $17,354m) 6.6%

The valuation model
We employ a standard residual income valuation model that calculates missing value in the balance sheet from
a forecast of forward (2006) operating income:

Value of Equity2005 = Book Value of Equity2005 + Residual Income from Operations2006
Required Return – Growth Rate

where

Residual Income from Operations2006 = Forecasted Operating Income2006 – (Required
Return x Net Operating Assets2005)

Only the residual income from operations is forecasted because residual earnings from interest on net debt are
usually close to zero.

The forecast
As the book value of equity and net operating assets for 2005 are in the 2005 financial statements, we need
only a forecast of operating income for 2006, the required return, and the growth rate for residual income.

• For the required return, we will use 10% which is approximately the current Treasury rate of 4.6% plus a risk
premium of 5.4%.

• If both the profit margin and the asset turnover are constant, then residual operating income grows at the sales
growth rate.16 The condition is approximately satisfied for Coke, so we set the growth rate at the sales growth
rate of 6.6%.

• The historical financial statements supply a forecast of operating income and residual operating income:

Forecasted sales for 2006 = Sales for 2005 x (1 + Average sales growth rate)
= $21,962 x 1.066
= $23,411

Forecasted operating income for 2006 = Sales for 2006 x Average profit margin
= $23,411 x 0.218
= $5,104

Forecasted residual operating income for 2006 = $5,104 – (0.10 x 17,113)
= $3,392

44 ACCOUNTING AND BUSINESS RESEARCH

Appendix. A valuation of the Coca-Cola Company based on historical cost information (continued)

The valuation
With a 2005 book value of equity of $15,935, the calculated value with these inputs is

Value of Equity2005 = $15,935 + 0003,392

0.10 – 0.066

= $115,700m, or $49.09 per share

The valuation is crude, by design, to make a point. It uses only information in the historical financial statements
(plus as assumed required return). Yet is comes quite close to the market price of $48.91. Adding more infor-
mation (about sales growth rates) and a different required return will change the valuation, but the historical
cost financial statements yield considerable insights. Most importantly, it challenges the notion that one needs
to have fair values on the balance sheet to value equity claims. Indeed, it is hard to see how fair value estimates
of assets and liabilities would enhance the valuation.

In choosing Coca-Cola, I am of course being selective; not all firms are as easy to value as Coke. The histor-
ical cost information for a bio-tech start-up with no product yet out of R&D is not much use for valuation, for
example. The financial reports would report losses and, possibly, negative book values. However, again, it is dif-
ficult to see how exit prices would redeem the accounting. Better for the analyst to get a biochemistry degree.

16 See S. Penman, Financial Statement Analysis and Security Valuation. 3rd ed. (New York: The McGraw-Hill Companies,
2007), p. 523.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.

Summarizes revenues and expenses, and gains and losses
Ends with the net income for a specific period
Multiple-step format—presents separately
Gross profit
Operating income
Income before taxes
Net income
The Income Statement

Single-step format
Totals all revenues and gains
Deducts total expenses and losses
The Income Statement—Continued

Multiple-Step Single-Step

Net Sales (Revenues)
Cost of Goods Sold (Cost of Sales)
Other Operating Revenue
Operating Expenses
Other Income or Expense
Basic Elements of the Income Statement

Represents revenue from the sale of principal goods or services sold to customers
Shown net of
Discounts
Returns
Allowances
Net Sales (Revenues)

The cost of goods that were sold to produce revenue
Cost of Goods Sold (Cost of Sales)

Retailer
Beginning Inventory
+ Purchases
− Ending Inventory
Cost of Goods Sold

Manufacturer
Beginning Inventory
+ Cost of Goods Manufactured
− Ending Inventory
Cost of Goods Sold

A service firm will not have cost of goods sold, but it will often have cost of services

Depends on the operations of the business
Examples
Lease revenue
Royalties
Other Operating Revenue

Consist of two types
Selling expenses
Result from a company’s effort to create sales
Advertising. Sales commissions, and Sales supplies used
Administrative expenses
Relate to the general administration of a company’s operation
Salaries, Insurance, and Bad debt expense
Operating Expenses

Secondary activities not directly related to operations
Dividend income. Interest income, Gains (losses) from sale of assets, and Interest expense
Other Income or Expense

Unusual or Infrequent Item Disclosed Separately
Shown with normal recurring revenues and expenses
If material, disclosed separately, before tax
Treatment for analysis
Included in primary analysis as they relate to operations
In supplementary analysis, it should be removed net after tax
Special Income Statement Items

Equity Earnings of Nonconsolidated Subsidiaries
The investor’s proportionate share of the investee’s net income
Does not represent cash flow to the investor
Cash dividends received represent cash flow
Analysis issues
Investor’s net income includes revenue of other entity
May distort ratios
Presented before tax; tax consequences typically immaterial
Special Income Statement Items—Continued

Income Taxes Related to Operations
Federal, state, and local taxes
Includes both paid and deferred taxes
Discontinued Operations
Reported net of income tax
Profitability analysis issues
Inadequate disclosure of associated assets
Lack of historical profit and loss information on the discontinued operations
Special Income Statement Items—Continued

Extraordinary Items
Unusual and infrequent
Reported net of income tax
Analysis issues
Exclude from primary analysis; it is not expected to recur
Include for supplementary analysis; this approach avoids disregarding extraordinary items
Special Income Statement Items —Continued

Change in Accounting Principles
Current GAAP requires retrospective approach, unless it is impracticable
Cumulative effect on prior years reported is reflected in beginning retained earnings in the year of change
If impracticable
Determine the difference to the opening balances in the accounts
Prior to current GAAP, changes were presented using the prospective method
Special Income Statement Items—Continued

Net Income—Noncontrolling Interest (prior to Dec. 31, 2009 it was called minority share of earnings)
Earnings of a partially-owned consolidated subsidiary that would accrue to the minority owners
Presented net-of-tax
Special Income Statement Items—Continued

Earnings divided by the number of shares of outstanding common stock
Earnings per Share
EPS = Net income
Outstanding shares of common stock

The accumulated undistributed earnings of the corporation reported on the balance sheet
Appropriated
Restricted by law, contract, or management decision
Not available for dividends
Does not represent cash or any other asset
Unappropriated
Available for dividends
Retained Earnings

Reported as part of the statement of stockholders’ equity or combined with the income statement
Reconciliation of Retained Earnings
Beginning balance of retained earnings
+ Prior period adjustments (net of tax)
± Cumulative effect of a change in accounting principle (net of tax)
= Beginning balance as adjusted
+ Net income
– Dividends
= End-of-year balance of retained earnings

Dividends return profits to the owners of a corporation
Date of declaration
Creates liability and reduces retained earnings
Date of payment
Eliminates liability and reduces cash
Dividends

Issuing a percentage of outstanding stock as new shares to existing shareholders
Assuming a small distribution (less then 25%)
Removing the fair market value of the stock from retained earnings and transferring it to paid-in capital
If the stock dividend is material
The amount transferred to paid-in capital is determined by multiplying the par value by the number of additional shares
Total equity is unaffected by a stock dividend
Restate share quantities to reflect stock dividend activity
Stock Dividends

100,000 shares outstanding; $1 par; $5 market
40% stock dividend on 100,000 shares, issue 40,000 additional shares recorded at $1 per share
Stock Dividend Example

As per various state laws
Distributions to stockholders are acceptable as long as the firm has the ability to pay debts as they come due in the normal course of business
Distributions to stockholders are acceptable as long as the firm is solvent and the distributions do not exceed the fair value of the assets
Distributions consist of solvency and balance sheet test of liquidity and risk
Legality of Distributions to Shareholders

Foreign currency translation adjustments
Unrealized holding gains and losses on available-for-sale marketable securities
Changes to stockholders’ equity resulting from additional minimum pension liability adjustments
Unrealized gains and losses from derivative instruments
Comprehensive Income
Net income
+ The period’s change in accumulated other comprehensive income
= Comprehensive income

Required disclosures
Comprehensive income
Each category of other comprehensive income
Reclassification adjustments for each category of other comprehensive income
Tax effects for each category of other comprehensive income
Balances for each category of accumulated other comprehensive income
Comprehensive Income—Continued

Presentation
A single income statement reporting net income and comprehensive income, or
Report comprehensive income in a separate statement immediately following the statement of income
Analysis issues
Typically more volatile than net income
A better indication of long-run profitability
Comprehensive Income—Continued

Comprehensive Income—
Combined with Income Statement

Comprehensive Income—Separate Statement

IFRS and U.S. GAAP for income statements are similar, with some presentation differences
IFRS has no required format of the income statement
IFRS classifies expenses based on their nature or function
IFRS equipment may be revalued which result in the adjustment of depreciation expenses
IFRS allows for alternative performance measures to be presented in income statement
Income Statement IFRS vs. GAAP

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Net revenue$37,586
Cost of sales16,742
Gross margin20,844
Operating Expenses:
General & administrative5,458$
Research & development5,722
Restructuring charges710 11,890
Operating income8,954
Interest income (expense)488
Other gains (losses) (net)(1,756) (1,268)
Income before taxes7,686
Provision for taxes2,394
Net Income5,292$
Multiple-step Income Statement
For the Year Ended December 31, 2013
Net revenue37,586$
Interest income488
Other income-
38,074
Costs and Expenses:
Cost of sales16,742$
General & administrative5,458
Research & development5,722
Other losses1,756
Restructuring charges710 30,388
Income before taxes7,686
Provision for taxes2,394
Net income5,292$
Single-step Income Statement
For the Year Ended December 31, 2013
Sheet1

Multiple-step Income Statement
For the Year Ended December 31, 2013
Net revenue $37,586
Cost of sales 16,742
Gross margin 20,844
Operating Expenses:
General & administrative $ 5,458
Research & development 5,722
Restructuring charges 710 11,890
Operating income 8,954
Interest income (expense) 488
Other gains (losses) (net) (1,756) (1,268)
Income before taxes 7,686
Provision for taxes 2,394
Net Income $ 5,292

Sheet1

Single-step Income Statement
For the Year Ended December 31, 2013
Net revenue $ 37,586
Interest income 488
Other income –
38,074
Costs and Expenses:
Cost of sales $ 16,742
General & administrative 5,458
Research & development 5,722
Other losses 1,756
Restructuring charges 710 30,388
Income before taxes 7,686
Provision for taxes 2,394
Net income $ 5,292

BeforeEffect of dividendAfter
Common stock par value$1.00$1.00
Shares outstanding100,000 issue 10,000 shares110,000
Total par value$100,00010,000 $110,000
Additional paid-in capital750,000 40,000 790,000
Total paid-in capital850,000 900,000
Retained earnings1,000,000 (50,000) 950,000
Total stockholders’ equity$1,850,000$1,850,000
10% stock dividend
Sheet1

10% stock dividend
Before Effect of dividend After
Common stock par value $1.00 $1.00
Shares outstanding 100,000 issue 10,000 shares 110,000
Total par value $100,000 10,000 $110,000
Additional paid-in capital 750,000 40,000 790,000
Total paid-in capital 850,000 900,000
Retained earnings 1,000,000 (50,000) 950,000
Total stockholders’ equity $1,850,000 $1,850,000

BeforeEffect of dividendAfter
Common stock par value$1.00$1.00
Shares outstanding100,000 issue 40,000 shares140,000
Total par value$100,00040,000 $140,000
Additional paid-in capital750,000 750,000
Total paid-in capital850,000 890,000
Retained earnings1,000,000 (40,000) 960,000
Total stockholders’ equity$1,850,000$1,850,000
40% stock dividend
Sheet1

40% stock dividend After 30% stock dividend
Before Effect of dividend After
Common stock par value $1.00 $1.00
Shares outstanding 100,000 issue 40,000 shares 140,000
Total par value $100,000 40,000 $140,000
Additional paid-in capital 750,000 750,000
Total paid-in capital 850,000 890,000
Retained earnings 1,000,000 (40,000) 960,000
Total stockholders’ equity $1,850,000 $1,850,000

Sales230,000$
Cost of goods sold140,000
Gross profit90,000
Operating expenses40,000
Operating income50,000
Other income4,000
Income before income taxes54,000
Income taxes20,000
Net income34,000
Other comprehensive income
Available-for-sale security adjustment, net of tax5,500
Minimum pension liability adjustment, net of tax3,500
Foreign currency transaction adjustment, net of tax(5,000)
Other comprehensive income4,000
Comprehensive income38,000$
Earnings per share (for net income only)2.80$
XYZ Corporation
Statement of Income and Comprehensive Income
For the Year Ended December 31, 2013
Sheet1

XYZ Corporation
Statement of Income and Comprehensive Income
For the Year Ended December 31, 2013
Sales $ 230,000
Cost of goods sold 140,000
Gross profit 90,000
Operating expenses 40,000
Operating income 50,000
Other income 4,000
Income before income taxes 54,000
Income taxes 20,000
Net income 34,000
Other comprehensive income
Available-for-sale security adjustment, net of tax 5,500
Minimum pension liability adjustment, net of tax 3,500
Foreign currency transaction adjustment, net of tax (5,000)
Other comprehensive income 4,000
Comprehensive income $ 38,000
Earnings per share (for net income only) $ 2.80

Net income34,000$
Other comprehensive income
Available-for-sale security adjustment, net of tax5,500
Minimum pension liability adjustment, net of tax3,500
Foreign currency transaction adjustment, net of tax(5,000)
Total other comprehensive income4,000
Comprehensive income38,000$
XYZ Corporation
Statement of Comprehensive Income
For the Year Ended December 31, 2013
Sheet1

XYZ Corporation
Statement of Comprehensive Income
For the Year Ended December 31, 2013
Net income $ 34,000
Other comprehensive income
Available-for-sale security adjustment, net of tax 5,500
Minimum pension liability adjustment, net of tax 3,500
Foreign currency transaction adjustment, net of tax (5,000)
Total other comprehensive income 4,000
Comprehensive income $ 38,000

Also called as statement of financial position and statement of financial condition
Shows financial condition as of a specific date
The accounting equation expresses the relationship among elements of balance sheet
Assets = Liabilities + Stockholders’ Equity
Format
Account form (side by side)
Report form (assets at top and liabilities and stockholders’ equity at bottom) dominant in the U.S.
Balance Sheet

Exhibit 3-1—Quaker Chemical Corporation

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Probable future economic benefits obtained or controlled by an entity as a result of past transactions or events
May be physical or intangible
Major categories
Current Assets
Includes cash, and assets that will be realized in cash during the operating cycle or one year which ever is longer
Noncurrent or Long-term Assets
Includes assets that take longer than one year or operating cycle to convert or to conserve cash
Assets

Cash and assets that will be converted into cash during the operating cycle or within a year, whichever is longer
Presented in order of liquidity
Cash
Includes negotiable checks, unrestricted balance in checking accounts, cash on hand, savings accounts
Current Assets

Marketable Securities—readily determinable market price
Debt or equity securities
Carried at fair value
To be converted into cash during the current period
Accounts Receivable
Amounts due from sales or services rendered
Carried at net realizable value (net of allowances)
All allowances are carried in one allowance account
Other receivables due from nontrade sources
Current Assets—Continued

Inventories
Balance of goods on hand
Categories
Merchandise on hand—retail or wholesale firms
Raw materials
Work in process
Finished goods
Carried at the lower of cost or market
Supplies could include register tapes, pencils, or sewing machine needles for the shirt factory

Current Assets—Continued
Manufacturer

Prepaids
Expenditures made in advance of the use of the service or goods
Represent future benefits resulting from past transactions
Examples
Insurance
Advertising
Taxes
Promotion costs
Early payments on long-term contracts
Current Assets—Continued

Land
Carried at acquisition cost
Not subject to depreciation
Natural resources are depleted
Buildings
Presented at cost plus permanent improvements
Depreciated over their estimated useful life
Long-Term Assets: Tangible

Machinery
Historical cost, including costs of delivery, installation, and material improvements
Depreciated over its useful life
Construction in Progress
Assets under construction
Costs will be transferred to permanent asset account upon completion
Long-Term Assets: Tangible—Continued

Accumulated Depreciation
Carries the to-date depreciation of plant assets
It is subtracted from the cost of the asset to determine the book value
Factors used in depreciation calculation
Asset cost
Length of the life of the asset
Estimated salvage (residual) value of asset when retired
Long-Term Assets: Tangible—Continued

Depreciation Methods
Straight-line
Declining-balance
Sum-of-the-years’-digits
Units-of-production
Balance Sheet Presentation
Long-Term Assets: Tangible—Continued
Cost of the asset
Less: Accumulated depreciation
Net book value

The salvage value is not depreciated and it equals book value at end of useful life
Depreciation: Straight-Line Method —Continued
Year Depreciation for Year Accumulated Depreciation at End of Year Cost Book Amount at End of Year
1 $1,600 $1,600 $10,000 $8,400
2 1,600 3,200 10,000 6,800
3 1,600 4,800 10,000 5,200
4 1,600 6,400 10,000 3,600
5 1,600 8,000 10,000 2,000

Salvage value is not used in the depreciation formula but depreciation ends when the book value equals the salvage value
Depreciation: Declining-Balance Method—Continued
Year Cost Accumulated Depreciation at Beg. of Year Book Amount at Beginning of Year Depreciation for Year Book Amount at End of Year
1 $10,000 — $10,000 $4,000 $6,000
2 10,000 $4,000 6,000 2,400 3,600
3 10,000 6,400 3,600 1,440 2,160
4 10,000 7,840 2,160 160 2,000
5 10,000 8,000 2,000 — 2,000

Depreciation: Sum-of-the-Years’-Digits Method—Continued
Year Cost Less Salvage Value Fraction Depreciation for Year Accumulated Depreciation at End of Year Book Amount at End of Year
1 $8,000 5/15 $2,666.67 $2,666.67 $7,333.33
2 8,000 4/15 2,133.33 4,800.00 5,200.00
3 8,000 3/15 1,600.00 6,400.00 3,600.00
4 8,000 2/15 1,066.67 7,466.67 2,533.33
5 8,000 1/15 533.33 8,000.00 2,000.00

Actual Hours of Operation × Rate = Depreciation
2,000 hours × $0.50 = $1,000
Therefore, the depreciation expense for year one is $1,000
Asset is depreciated until book value equals salvage value
Depreciation: Units-of-Production Method—Continued

Debt or Equity Securities
Held to maintain business relationship or to exercise control
Debt Securities Classification
Held-to-maturity securities are carried at amortized cost
Available-for-sale securities are carried at fair value
Long-Term Assets: Investments

Equity Securities
Carried at fair value which have 3 levels for input
Level 1: Quoted price for identical item in active market
Level 2: Adjusted quoted price of similar asset (or liability)
Level 3: Present value of expected cash flows
Exception- Equity method is used where there is significant influence
Cost is adjusted for the proportionate share of the rise/fall in the retained profits of the subsidiary (investee)
Long-Term Assets: Investments—Continued

Intangibles are nonphysical assets
They are recorded at historical cost
An intangible asset that has a finite life is amortized over its useful life
An intangible asset with an indefinite life are reviewed for impairment
Long-Term Assets: Intangibles

Goodwill
Arises form the acquisition of a business where price paid exceeds the fair value of net assets
According to U.S. GAAP it is not amortized but tested annually for impairment
Patents
Exclusive legal rights granted to an inventor for a period of 20 years
Valued at their acquisition cost
Amortized over shorter of legal or useful life
Long-Term Assets: Intangibles—Continued

Trademarks
Distinctive names or symbols
Indefinite legal life
Not amortized but tested for impairment annually
Franchises
Legal right to operate under a particular corporate name, providing trade-name products or services
Amortize over the life of the franchise
Long-Term Assets: Intangibles—Continued

Copyrights
Rights that authors, painters, musicians, sculptors, and other artists have in their creations and expressions
It is granted for life of the creator, plus 70 years
Amortize over the period of expected benefit
Long-Term Assets: Intangibles—Continued

Few assets do not fit into any of the previously discussed classification
Include noncurrent receivables and noncurrent prepaids
Other Noncurrent Assets

Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events
Current Liabilities
Long-term Liabilities
Liabilities

Obligations whose liquidation is reasonably expected within one year or the operating cycle, whichever is longer
Require
Use of existing current assets
Creation of other current liabilities
Current Liabilities

Payables
Short-term obligations created by the acquisition of goods or services
Unearned Income
Payments collected in advance of the performance of services or delivery of goods
Other Current Liabilities
Current Liabilities—Continued

Due in a period beyond one year or operating cycle, whichever is longer
Types
Financing arrangements of assets
Operational obligations
Long-Term Liabilities

Notes Payable
Promissory notes
If secured by property, they are called mortgage notes
Credit Agreements
Ready lines of credit that may require a compensating balance
In return for giving a credit agreement, the bank or insurance company obtains a fee
Not a liability until funds are drawn
Liabilities Relating to Financing Agreements

Bonds Payable
Sold at par, premium, or discount
Premium or discount is amortized into interest expense
Bond carrying value is amortized to par value
Convertible bonds can be converted into common stock
Conversion feature enhances the bond’s selling price
Liabilities Relating to Financing Agreements—Continued

Exhibit 3-13—Bonds at Par, Premium, or Discount

Deferred Taxes
Caused by using different accounting methods for tax and reporting purposes
It causes tax expense for reporting purposes to be higher than taxes payable according to the tax return
The difference is deferred tax
Warranty Obligations
Estimated obligations arising out of product warranties
Estimated to recognize the obligation at the balance sheet date and to charge expense
Liabilities Relating to Operational Obligations

Noncontrolling Interest
Previously called “minority interest”
Reflects the ownership of noncontrolling shareholders in the equity of consolidated subsidiaries less than wholly owned
Reported on consolidated financial statements as equity, but separate from parents equity
If material, analysis can be performed twice
Once as a liability to be conservative and then as shareholders’ equity item
Liabilities Relating to Operational Obligations—Continued

Other Noncurrent Liabilities
Redeemable Preferred Stock
Excluded from stockholders’ equity
For analysis, treated as a liability
Liabilities Relating to Operational Obligations—Continued

Two basic types of capital stock
Preferred
Common
Par value
In some states, referred to as “stated value stock”
Considered “legal capital” by many states
Established by the articles of incorporation
Usually a minimal value
Some states allow the issuance of no-par stock
Stockholders’ Equity: Paid-In Capital

Additional Paid-In Capital
Issue price in excess of par (stated) value
Other sources
Treasury stock transactions
Stock dividend transactions
Donated capital
Stockholders’ Equity:
Paid-in Capital—Continued

Shareholder ownership
Voting rights
Election of board of directors
Major corporate decisions
Liquidation rights secondary to
Creditors
Preferred stockholders’
Stockholders’ Equity: Common Stock

Does not normally convey voting rights
May carry any or all of these features:
Preference as to dividends
Accumulation of dividends
Participation in excess of stated dividend rate
Convertibility into common stock at holder’s discretion
Callability by the corporation
Redemption at future maturity date
Preference in liquidation secondary to creditors
Stockholders’ Equity: Preferred Stock

May be included in the paid-in capital
Donated by outside entities
Example: Shareholder surrender of stock
Stockholders’ Equity: Donated Capital

Quasi-Reorganization
Eliminates a deficit balance of retained earnings and an equal amount from paid-in-capital
Retained earnings dated as of the readjustment date and disclosed in the financial statements for a period of five to ten years
Accumulated Other Comprehensive Income
Represents retained earnings from other comprehensive income
Disclosed as a separate component on the face of the balance sheet or in the notes
Stockholders’ Equity: Others

Employee Stock Ownership Plans (ESOPs)
A qualified stock-bonus plan, or a combination of stock-bonus and money-purchase pension plan
Tax benefits for the employer and employee
Unearned compensation decreases stockholders’ equity
Stockholders’ Equity: Others—Continued

Treasury Stock
Stock purchased and held by the issuing corporation
Record treasury stocks in two ways
Par-value method
Removes the paid-in capital in excess of par from the original issue
Appears as a reduction of paid-in capital
Cost method
Records treasury stock at the cost of the stock (presented as a reduction of stockholders’ equity)
Most firms record treasury stock at cost
Stockholders’ Equity: Others—Continued

Reconciles the beginning and ending balances of stockholders’ equity accounts
Changes in stockholders’ equity accounts
Issuance of stock increases paid-in capital
Acquisition of treasury stock increases treasury stock
Net income increases retained earnings
Dividends decreases retained earnings
This account is related to comprehensive income
Statement of Stockholders’ Equity

Financial analysis is complicated by
Many assets recorded at cost rather than fair (replacement) value
Varying valuation methods
Within a firm from product to product
Within an industry from firm to firm
Not all items of value are listed as assets
Certain contingent liabilities may be excluded
Problems in Balance Sheet Presentation

Asset section
Usually noncurrent assets are presented first, followed by current assets
Liabilities and Owner’s Equity section
“Capital and reserves” are usually listed first, then noncurrent liabilities, and at last, current liabilities
The reserves sections of “capital and reserves” would not be part of U.S. GAAP
International Consolidated Balance Sheet (IFRS)

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Occur during the period between the balance sheet date and the date statements are issued
Types
Events requiring retroactive recognition
Relates to estimates that were made and subsequent events indicates estimates were incorrect
Events requiring disclosure in the notes to the financial statements
Does not affect the balance sheet, but is significant to the users of the financial statement
Subsequent Events

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© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cost Salvage Value
= Annual Depreciation
Estimated Value
$10,000 $2,000
$1,600
5 Years
–
–
=
1
× 2 = Double the straight-line rate
*
Estimated Life
1
× 2 × Book Value at Beginning of Ye
ar = Annual Depreciation
5
*Double the straight-line rate is the ma
ximum rate
Number of Remaining Years
(Cost Salvage) = Annual Depreciation
Sum of Digits of Estimated Life
5
($10,000$2,000) $2,666.67
(54321) or 15
´-
´-=
++++
–
=
–
Cost Salvage Value
Per Unit Depreciation
Estimated Life in Capacity
10,0002,000
= $0.50
16,000 Hours

Accounting in three dimensions:
a case for momentum

revisited

Eric Melse
Strategy Center, Nyenrode Business Universiteit, Breukelen, The Netherlands

Abstrac

Purpose – This paper aims to extend an earlier analysis of the profitability of an individual firm
operating in the professional services industry from the perspective of the triple-entry framework of
the momentum accounting theory of Yuji Ijiri.

Design/methodology/approach – The paper presents a “common-size-format” model of
balance-sheet momentum, an approach typical of financial statements’ mathematical analysis.

Findings – Common-size-format momentum ratios offer an alternative measurement of (the change
of) business performance. They model stabilizing phenomena that might develop very differently from
ratios like return on total assets or return on equity and thus provide important informational signals
to the analyst of financial statements. The common-size-format ratio of net wealth momentum herein
discussed is proposed as a supplemental measurement for business performance analysis.

Originality/value – The paper discusses a new method for performance measurement and risk
analysis.

Keywords Accounting, Accounting theory, Performance measures, Risk analysis

Paper type Research paper

Introduction
Melse (2004a) explored what meaningful new information the momentum accounting
theory of Yuji Ijiri can disclose in addition to the regularly used performance measures:
profit before income tax (PBIT), profit after tax (PAT), return on equity (ROE) and
return on total assets (ROTA). His conclusion was that financial accounting ratios
should not be calculated from data that are temporally different. Preferably, ratios
should either be calculated from data pertaining to a given time-period, say a year,
quarter or month, or from data measured at a particular time point. The triple-entry
framework of the momentum accounting theory of Yuji Ijiri extends the two dimensions
of the financial accounting system with a third dimension to account for the forces that
drive the momentum, or rate of change, of the creation of new wealth. Accounts can be
identified in this framework by their temporal property which makes it rather easy to
calculate unitless and timeless ratios. This paper discusses the same example firm as
presented by Melse (2004a) but with the time series extended by four more years. The
stability of the profitability of this individual firm is investigated further and how it
recovers after a brief period of serious decline in performance during 2002-2003. A new
accounting measure for financial statement analysis is proposed: the common-size
format of momentum and force ratios. In particular, net wealth momentum is here
investigated as a supplemental method for performance measurement and risk analysis.

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/1526-5943.htm

The author is grateful for the constructive comments of the anonymous reviewer. Participants of
the European Accounting Association’s 2008 Conference are also gratefully acknowledged for
their comments on an earlier version of the paper. Financial assistance was provided by the
Nyenrode Research Group (NRG).

JRF
9,

334

The Journal of Risk Finance
Vol. 9 No. 4, 200

pp. 334-35

q Emerald Group Publishing Limited
1526-5943
DOI 10.1108/15265940810895007

Accounting for disclosure, risk analysis or decision making?
Financial statements supposedly depict the current condition of a company completely
and accurately (McEnroe and Martens, 2004; Haskins and Sack, 2006). Aside
unwittingly made mistakes, technical flaws or fraud, accounting information is by
definition “historic” and therefore “reliable” because financial statements are compiled
from facts, past facts (ex post facto)[1]. At times we may find in the notes to the financial
statements information about the expectations management has for the future (Hutton
et al., 2003). Obviously past results cannot offer any guarantee for results in the future,
such notes are indications only for better or worse. The framework of triple-entry
momentum accounting, or TEMA in short, is seen here as an initiative to innovate
financial accounting so that management or the auditor are better facilitated to disclose
trends that have future bearings. The objective of the TEMA framework is to add a
dynamic perspective to the financial accounting system for the purpose of additional
disclosure, analysis and decision making. The TEMA framework explicitly requires
attention for the causal links in the business model and administers business economic
facts outside the scope of traditional bookkeeping, for example with revenue accounting
(Glover and Ijiri, 2002). This is an ambitious effort that, certainly in the eyes of the critics
of triple-entry accounting strains the boundary between financial and management
accounting (Fraser, 1994; Salvary, 1985; Vaassen, 2002, p. 33; Wagensveld, 1995).

Management by momentum – fasten your seatbelt!
Yuji Ijiri proposes a so-called triple-entry framework with three dimensions to account
for the income capacity of a firm (Ijiri, 1982, 1984, 1986, 1987, 1988, 1989, 1993). The
essential idea is to account for the income capacity of a firm in terms of levels instead of
differences. Ijiri seeks to account for the level of growth instead of net wealth as such at
any particular point in time. He calls this the momentum at which rate net wealth is
accrued. By comparison with car driving, he wants to measure the speed at which the
car travels instead of only measuring the distance traveled so far (Ijiri, 1988, p. 160). His
car driving metaphor can be extended and deepened to further explain the
measurements of the triple-entry framework as well as its managerial use. The two
principal meters in any dashboard are the odometer that measures the mileage driven
during the cars’ life time and the speedometer. Most if not all dashboards also have an
odometer that counts the mileage driven per day and cycles its measurement from 0 to
999 miles or kilometers. While the odometers count the state of the cars mileage, the
speedometer reports the rate of change of the car – its speed. The importance of the
difference between these two meters becomes very clear when we match them against
the balance sheet and the income statement for their explanation of wealth magnitude,
composition and its change:

. Odometer continuous – balance sheet, wealth magnitude and composition as of
“now.”

. Odometer period – income statement, wealth change explained by its “how.”

. Speedometer – the change of wealth change explained by its “why.”

The fundamental notion we have to grasp is that it is impossible to read from any
financial statement the rate of change by which new wealth is created, or the change of
any financial variable for that matter[2]. We should compare the user of financial
statements with a driver in a car with his or her attention focused solely on the

A case for
momentum

revisited

335

revolving number wheels of the odometers. Indeed, it is possible to see wealth increase
and conclude that the company is in business, but without any other reference against
which we can perceive speed, it is impossible to tell by which speed wealth is
increasing[3]. In other words, the financial accounting dashboard is lacking
speedometers: a pretty uncomfortable position to be in[4].

However, we cannot stretch the metaphor too far. Neither financial analysts nor
investors are the “drivers” of the company, therefore, should we be bothered with the
missing speedometer on the financial dashboard? Ijiri feels that we should expect from
management that they are able to “see” at which speed their business is “moving.” How
else can they intervene when momentum is dissipating? The foundational notion
Ijiri puts forward is that the double-entry accounting framework does not exclude the
possibility to include “speed” measurements. He thinks it is feasible to extend the
double-entry bookkeeping framework with a third dimension so that we can account for
the “rate of change” of a firm’s business. He wants to apply the same methodological and
procedural rigor to the administration of facts pertaining to the future as is expected
from the administration of transactions past (Blommaert, 1994).

Dimensions of the accounting measurement
The accounting dimensions are temporally determined sources of information and
concern the substance of information and not its form (Wagensveld, 1995, p. 3; Melse,
2004c). Figure 1 shows the purpose of each dimension as wealth measurements in time.
Through the accounts it should be possible at any point in time to explain the
composition of wealth (1D), i.e. how it was acquired (liabilities and equity) and used
(assets). Next, it should be possible to determine for a given period between points if an
increase of wealth was realized (2D). To this 2D system of accounts, Ijiri adds the
ability to account for the capacity to acquire new wealth in the future (3D) by means of

Figure 1.
The arrow of time in the
framework of triple-entry
and momentum
accounting

Change 2D

PERIOD 2D

Net Wealth Increases

Past

Net Wealth
Unchanged

Capacity 3D

CHANGE RATE 3D

Future

Net Wealth
Decrease

Expensing Forces

Net Wealth
Increase

Earning Forces

C
om

position 1D
P

O
IN

T
IN

T
IM

E
1D

Present

Realisation
t−1

Net Wealth Decreases

Estimation
t+1

JRF
9,4

336

administration of cost and income forces. A framework of three dimensions is proposed
by Ijiri (1986):

(1) Wealth – the first dimension for the administration of the magnitude of wealth
and wealth composition, with accounting variables that are set apart as net
wealth (equity) and liabilities (sources of capital), or as assets (uses of capital).
Accounts of this dimension are on the balance sheet.

(2) Momentum – the second dimension for the administration of the change in
magnitude of wealth (the first dimension), with accounting variables that are set
apart as cost (outflows) and income (inflows). Accounts of this dimension are on
momentum statements that includes the income statement.

(3) Force – the third dimension for the administration of the change of capacity to
acquire new wealth (the second dimension), with accounting variables that are
set apart to administer internal and external forces. Accounts of this dimension
are on force statements that also include impulse and action.

Melse (2004a) discusses these dimensions of momentum accounting theory with more
detail. Figure 2 shows the relations between the three accounting dimensions in Ijiri’s
framework for triple-entry and momentum accounting, TEMA in short. Ijiri introduces
a new set of financial variables he calls momentum accounts that are in the same
vertical column of the framework as income. Although they are also period related,
they have a different temporal position because they explain the rate of (new) income
and their values aggregate dynamically into income in the same manner as income
aggregates into wealth. Suppose a firm realizes net income at a rate of $12 per month,
its “level” of income momentum. Assuming nothing else changes, income realized after
one year should be: $144 (Ijiri, 1987, p. 27). At that time, income is reported as $144
while income momentum is reported as $12/month. The information added to the

Figure 2.
A framework for

triple-entry and
momentum accounting

IMPULSE

FORCE

ACTION

MOMENTUM

INCOMEWEALTH

Momentum
Statement

Wealth
Statement

Force
Statement

CreditDebit Trebit

Force Accounting
Single-Entry
Bookkeeping
in Dollars/Month

Momentum Accounting
Double-Entry
Bookkeeping
in Dollars/Month

Wealth Accounting
Triple-Entry
Bookkeeping
in Dollars

A Derivative Relationship An Integral Relationship

Source: Ijiri (1986)

A Difference Relationship

−

ΣΣ

−
−
−
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income statement is that we now know the rate by which new income is expected to be
created, namely $12 per month. Assuming that this is the firm’s first year of business,
recalling the car driving metaphor discussed before, the odometer is now at $144 and
the speedometer is at $12.

Financial-ratio analysis
Robert Half International Inc., a US based firm, pioneered specialized staffing services
in 1948 and today is recognized as an industry leader. There is no reason to use this
company’s financial statement data other than for the purpose of illustrating how
ratios disclose information for analysis outside and within the TEMA framework of
Yuji Ijiri as an extension of Melse (2004a). No proprietary financial statements data is
used.

Figure 3 shows both ROTA and ROE time series of Table I, like in Melse (2004a),
but now extended with four more years[5]. We derive the ratio ROTA from the division
of the return of PBIT by total assets. Likewise, we get ROE by division of PAT by
shareholder equity. During the period from 1989 to 1992, each ratio shows a sharp
decline reaching a low point in 1991 and 1992, but gradually increases again to reach
high points in 1998 and – after a small drop in 1999 – in 2000. The next two years
again show a dramatic decrease to arrive at almost reaching 0 percent in 2002 and
2003. The last three years show a just as dramatic increase to reach in 2006, about the
same level as in the period 1997-2000. Comparing Figure 3 with Figure 4, which shows
the sales margin during these years, it is obvious that the sales margin displays a trend
similar to both ratios, notably ROE. Indeed, as reported in Table II, the Pearson
correlation coefficient indicates a positive and rather strong association between these
three accounting ratios. As Melse (2004a) showed, the point of interest here is the
observation that ROTA, ROE, and sales margin are exchangeable ratios as far as
the trend in time is concerned also during the last four years (2003-2006). They tell us
the same “business story,” we see similar “ups and downs.”

Walsh (1996, p. 72) sees ROTA as the most important benchmark against which the
performance of business operations can be measured. But, like any other ratio, as a
single figure it is not much more then a target to aim for. It is of more interest to explain

Figure 3.
Robert Half, ROTA
and ROE 0

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ROTA
ROE

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why such a ratio moves up or down when it does. However, using the ratios discussed
above has a disadvantage. Westwick (1981) points at the need to investigate the cause
of the “ups and downs” of a ratio and for this purpose wants to be able to disaggregate
from the “total” to the “parts.” For example, we can calculate the return not only on
total assets but also on the disaggregated current and fixed assets. A brief digression
on the calculation of ROTA as operating performance ratio to support our explanation:

Year

Wealth
(point)

Net wealth
(point)

Sales

(period)

PBIT
(period)

PAT
(period)

ROTA

(ratio)

(percent)

ROE
(ratio)

(percent)

Sales margin
(ratio)

(percent)

1987 155.69 48.13 105.69 13.54 7.25 10.51 14.91 12.81
1988 194.87 61.70 182.05 20.11 12.03 12.91 24.99 11.04
1989 184.41 68.68 234.50 23.62 13.47 12.12 21.83 10.07
1990 188.37 77.29 248.56 14.93 8.87 8.10 12.91 6.01
1991 178.95 84.42 209.46 8.02 4.06 4.26 5.25 3.83
1992 181.76 90.97 220.18 7.91 4.38 4.42 5.19 3.59
1993 204.60 133.60 306.17 21.56 11.72 11.86 12.89 7.04
1994 227.76 177.00 446.33 45.21 26.12 22.10 19.55 10.13
1995 301.14 227.93 628.53 69.09 40.30 30.33 22.77 10.99
1996 416.01 308.45 898.64 103.65 61.10 34.42 26.81 11.53
1997 561.37 418.80 1,302.88 158.83 93.70 38.18 30.38 12.19
1998 703.72 522.47 1,793.04 221.18 131.58 39.40 31.42 12.34
1999 777.19 576.10 2,081.32 234.70 141.44 33.35 27.07 11.28
2000 971.03 718.54 2,699.32 301.63 186.10 38.81 32.30 11.17
2001 994.16 805.70 2,452.85 196.28 121.11 20.21 16.85 8.00
2002 935.67 744.97 1,904.95 3.50 2.17 0.35 0.27 0.18
2003 979.90 788.66 1,974.99 11.72 6.39 1.25 0.86 0.59
2004 1,198.66 911.87 2,675.70 234.67 140.60 23.95 17.83 8.77
2005 1,318.69 970.87 3,338.44 392.17 237.87 32.72 26.09 11.

2006 1,459.02 1,042.67 4,013.55 466.20 283.18 35.35 29.17 11.62

Note: Data scaling factor: millions US$

Source: Compustat/Thomson

Table I.
Robert Half, time series

Figure 4.
Robert Half, sales margin0

2
4

8
10

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We get the following ratios:
. sales margin ¼ PBIT/sales; and
. turn over ¼ sales/total assets.

ROTA can be calculated by the product of sales margin times turn over. Because sales
are the denominator of sales margin as well as the numerator of turn over, it is
cancelled out in the alternatively ROTA calculation of: PBIT/total assets.

Now, following the above method of calculation, Table III gives the return on fixed
assets and on current assets for Robert Half in the first two columns of Panel A.
Figure 5 shows ROTA and the time series of its two disaggregated ratios. Observe how
the ratio return on fixed assets reaches a much higher value in 2006 compared to the
period 1995-2000, or ROTA at that point (1.54). This is somewhat peculiar when we
compare this to the ROTA (0.35). Although these disaggregated ratios are correct, can
we trust them? In the fourth column of Panel A of Table III, with the title check, the
disaggregated return ratios are subtracted from the ROTA. Clearly, in each year, there
is a difference between the sum of the “parts,” the disaggregated return ratios, and

Variables Association

ROTA vs ROE r ¼ 0.918 *

ROTA vs sales margin r ¼ 0.797 *

ROE vs sales margin r ¼ 0.916 *

Note: *Significant at 1 percent level

Table II.
Robert Half, association
between return ratios and
sales margin

A: sales/assets B: assets/sales
Year Fixed Current Total Check Fixed Current Total Check

1987 0.21 0.21 0.11 20.3153 4.76 4.75 9.51 0.0000
1988 0.20 0.36 0.13 20.4294 4.93 2.81 7.74 0.0000
1989 0.18 0.37 0.12 20.4307 5.57 2.69 8.25 0.0000
1990 0.10 0.36 0.08 20.3795 9.54 2.81 12.35 0.0000
1991 0.05 0.21 0.04 20.2228 18.77 4.71 23.48 0.0000
1992 0.05 0.25 0.04 20.2610 18.66 3.97 22.63 0.0000
1993 0.14 0.67 0.12 20.6924 6.93 1.50 8.43 0.0000
1994 0.29 0.95 0.22 21.0192 3.48 1.05 4.53 0.0000
1995 0.43 1.02 0.30 21.1488 2.32 0.98 3.30 0.0000
1996 0.62 0.78 0.34 21.0501 1.62 1.29 2.91 0.0000
1997 0.80 0.73 0.38 21.1487 1.25 1.37 2.62 0.0000
1998 0.97 0.66 0.39 21.2410 1.03 1.51 2.54 0.0000
1999 0.86 0.55 0.33 21.0705 1.16 1.83 3.00 0.0000
2000 1.05 0.61 0.39 21.2790 0.95 1.63 2.58 0.0000
2001 0.66 0.29 0.20 20.7457 1.53 3.42 4.95 0.0000
2002 0.01 0.01 0.00 20.0129 88.12 196.17 284.29 0.0000
2003 0.04 0.02 0.01 20.0457 24.97 54.90 79.87 0.0000
2004 0.83 0.34 0.24 20.9307 1.20 2.98 4.18 0.0000
2005 1.39 0.43 0.33 21.4898 0.72 2.34 3.06 0.0000
2006 1.54 0.46 0.35 21.6498 0.65 2.18 2.83 0.0000

Table III.
Robert Half.
Panel A: return on assets;
Panel B: inverse
calculation

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their “total,”, i.e. ROTA (Figure 5). In other words, disaggregated return ratios
calculated as “sales over assets” do not add up! As an alternative, Westwick (1981)
recommends to inverse the fraction terms as “assets over sales.” Table III, Panel B,
reports these time series and clearly, for each year, the inversed disaggregated ratios
now do add up to their “total:ROTA”.

However, solving one problem introduces another: the return ratios themselves are
now a bit more difficult to understand intuitively. They also tend to become very large
when PBIT is very small, like in 2002 and 2003, respectively, 284.29 and 79.87.
Therefore, for our analysis, the disaggregated return ratios are first multiplied by

100

and then scaled by their natural logarithm to create Figure 6 with the y-axis inversed
(because now, like in Figure 5, when the line “drops” this is “less good”). The
disaggregated analysis of return on assets by inverse calculation reveals in a more
balanced manner the shift in weight over time from fixed to current assets. Figure 6, for
example, shows, from 1997 onwards to 2006, the increasing contribution of the return
on current assets to ROTA. Owing to a poor PBIT, this is particularly difficult to grasp

Figure 5.
Robert Half, return

on assets

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

0605040302010099989796959493929190898887

Fixed Assets
Current Assets
Total Assets

Figure 6.
Robert Half, return on

assets by inverse
calculation (ratios £ 100

and scaled by logN)

10
100

1,000

10,000

1,00,000

0605040302010099989796959493929190898887
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Current Assets
Total Assets
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for the years 2002 and 2003 using the regular return ratios in Figure 5. Hence, we
propose the inverse calculation of disaggregated ratios and subsequent graphing with
a natural logarithm-based scale like in Figure 6.

Unitless and timeless accounting ratios
Of some concern is that accounting ratios are not necessarily timeless as was
concluded before in Melse (2004a). To get ROTA or ROE, we divide period
measurements, respectively, PBIT and PAT, by point measurements, respectively,
total assets and shareholders’ equity (net wealth)[6]. Or, seen from a temporal
perspective, we divide data related to period (p) measurements by data from point (t)
measurements (p?t). In Ijiri’s TEMA framework, this implies that the accounting ratio
is calculated as a momentum measurement (income) divided by a wealth measurement;
PBIT divided by total assets in the example of ROTA.

Ratios become unitless when they relate quantities of the same dimension. Within
the TEMA framework this is clearly not the case for ROTA or ROE. Although the
accounting data are in some way related to the same medium of exchange in use – , i.e.
monetary values – it is their time property we are uncomfortable with. ROTA and
ROE are ratios that express “return by point,” a state at date, which is something
different then a rate of change or “return by period.” A ratio like the sales margin is
unitless and timeless because it relates two period measurements through the division
of PBIT by sales (p?p). In economic accounting terminology, only when we divide
stock accounts by stock accounts, or flow accounts by flow accounts, will we get
unitless ratios.

To obtain unitless and timeless ratios, in the TEMA framework (Figure 2), we have
to divide accounting variables of the same temporal “dimension” wealth, momentum or
force. In other words, unitless ratios are calculated intra-dimensionally, i.e. between
accounting variables with the same temporal dimension. In this approach, an
accounting ratio is a quantity that denotes the proportional amount or magnitude of
one period accounting variable relative to another period accounting variable (p?p), or
of one point relative to another point (t?t). Following this temporal decision rule, we
can calculate ratios between items, like the current ratio, current assets by current
liabilities (two wealth accounts), but not divide a balance sheet account by sales (i.e.
divide a wealth measurement by a momentum measurement). For example, the well
known working capital to sales ratio that tries to capture a dynamic perspective of
short-term liquidity conflicts with this temporal decision rule (Walsh, 1996, p. 118)[7].
This is not to say that such ratios should not be used. The observation here is that such
ratios are calculated extra-dimensionally, and therefore are not timeless, which
possibly leads to less clear interpretations. This is a motivation to investigate what
intra-dimensional ratios might have to offer over and above extra-dimensional ratios.

Common-size-format momentum ratios
In Ijiri’s TEMA framework, momentum accounts are rates per period that measure the
change of a wealth account. Once we divide one such momentum account by another
we get a true ratio that can be expressed as a pure number or as a percentage. For
momentum, such a ratio expresses the proportion of change per period relative to
another change per period. Melse (2004a) presented the momentum ratio of net wealth
composition. In the same manner, a momentum ratio of disaggregated balance sheet

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accounts can be calculated. When the momentum of balance sheet accounts is divided
by total wealth momentum we get common size ratios, or percentages, i.e. a change
fraction of the whole change. However, this requires that the sign of raw data negative
momentum is first inversed to be included in the denominator before the fraction is
calculated[8]. Assuming two disaggregated parts, the following equation gives the
required logic:

For A=BjA=ðifðA , 0 then 2 A else AÞ þ ifðB , 0 then 2 B else BÞÞ:

This equation renders unitless and timeless force or momentum ratios that can be
compared with any other such ratio. Table IV gives the common size momentum ratios
for total liabilities and net wealth and Table V for current and fixed assets. Likewise,
for force accounts, such ratios convey the proportion of the rate of change per period
squared relative to the whole change of momentum per period squared. Thus, we can
compare momentum or force between periods of a single firm or between companies
for panel analysis of markets or sectors. A whole new set of ratios is thus available in
the TEMA framework to investigate business dynamics and possible relationships
between the accounting variables from which they are derived.

Ratio analysis should provide an insight into the financial health of a firm by
looking into its liquidity, solvability, profitability, activity, and capital and market
structure. We limit ourselves here to the comparison of the sales margin and net wealth
momentum of Robert Half. One way to look at sales margin is too see it as a momentum
ratio because the accounting data involved is income-related period measurements (p).

A: raw data B: common size

Year

Wealth
momentum

(period)

Net wealth
momentum

(period)

Liabilities
momentum

(period)
Net wealth
momentum
(ratio)
Liabilities
momentum

(ratio)

Check
(sum)

1987 26.89 20.50 27.38 20.02 0.98 1.0000
1988 39.18 13.57 25.61 0.35 0.65 1.0000
1989 210.46 6.97 217.43 0.29 20.71 1.0000
1990 3.95 8.62 24.66 0.65 20.35 1.0000
1991 29.42 7.13 216.55 0.30 20.70 1.0000
1992 2.81 6.55 23.74 0.64 20.36 1.0000
1993 22.84 42.63 219.79 0.68 20.32 1.0000
1994 23.16 43.39 220.23 0.68 20.32 1.0000
1995 73.38 50.94 22.44 0.69 0.31 1.0000
1996 114.87 80.52 34.36 0.70 0.30 1.0000
1997 145.36 110.36 35.00 0.76 0.24 1.0000
1998 142.35 103.67 38.68 0.73 0.27 1.0000
1999 73.47 53.63 19.84 0.73 0.27 1.0000
2000 193.84 142.44 51.41 0.73 0.27 1.0000
2001 23.13 87.16 264.02 0.58 20.42 1.0000
2002 258.49 260.73 2.24 20.96 0.04 1.0000
2003 44.23 43.69 0.54 0.99 0.01 1.0000
2004 218.75 123.21 95.55 0.56 0.44 1.0000
2005 120.03 59.00 61.03 0.49 0.51 1.0000
2006 140.34 71.80 68.54 0.51 0.49 1.0000

Note: Data scaling factor: millions US$

Table IV.
Robert Half. Panel A: net

wealth and liabilities
momentum; Panel B:

common size momentum
ratios

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PBIT divided by sales; the numerator and the denominator have the time dimension
momentum in Ijiri’s TEMA framework. Both are realized during the period in between
the two moments when financial statements are drawn up; in our case a year.
Consequently, it is more fitting to compare PBIT with net wealth momentum because
both are period measurements (p). Additionally, sales margin can be compared with
the net wealth momentum ratio, each being a period ratio (p?p). Before we discuss this
in more detail, we first turn our attention to PBIT and net wealth momentum as
individual momentum variables.

Analysis of net wealth momentum and its common-size-format ratio
The common-size-format ratio of net wealth momentum is a fraction or percentage of
total wealth momentum. It is calculated for each period by the change of net wealth
(total shareholders’ equity) relative to the change of total wealth of which it is a part.
When we compare the graph of net wealth momentum raw data in Figure 7 with its
common-size-format ratio in Figure 8, it is worthy to note that the net wealth
momentum movement raw data and its common-size-format ratio are similar in 2002
and 2003. However, before 2002 and after 2003, the trend of raw data and the
common-size-format ratio is very different. Notably, the common-size-format ratio is
characterized by a steady rate of change during the periods 1992-2001 and 2004-2006.
On average the ratio is, respectively, 0.63 and 0.52. This implies that although net
wealth momentum itself might fluctuate (Figure 7), relative to the fluctuation of all

A: raw data B: common size
Year
Wealth
momentum
(period)

Current
assets

momentum
(period)

Fixed
assets

momentum
(period)
Current
assets

momentum
(ratio)

Fixed
assets
momentum
(ratio)
Check
(sum)

1987 26.89 27.81 34.70 20.18 0.82 1.0000
1988 39.18 6.94 32.24 0.18 0.82 1.0000
1989 210.46 221.44 10.98 20.66 0.34 1.0000
1990 3.95 24.18 8.13 20.34 0.66 1.0000
1991 29.42 26.40 23.02 20.68 20.32 21.0000
1992 2.81 0.91 1.90 0.32 0.68 1.0000
1993 22.84 15.13 7.71 0.66 0.34 1.0000
1994 23.16 20.24 2.93 0.87 0.13 1.0000
1995 73.38 65.95 7.43 0.90 0.10 1.0000
1996 114.87 84.10 30.77 0.73 0.27 1.0000
1997 145.36 116.26 29.10 0.80 0.20 1.0000
1998 142.35 96.40 45.95 0.68 0.32 1.0000
1999 73.47 60.13 13.34 0.82 0.18 1.0000
2000 193.84 181.07 12.77 0.93 0.07 1.0000
2001 23.13 14.40 8.74 0.62 0.38 1.0000
2002 258.49 242.83 215.66 20.73 20.27 21.0000
2003 44.23 55.45 211.21 0.83 20.17 1.0000
2004 218.75 217.70 1.06 1.00 0.00 1.0000
2005 120.03 100.59 19.44 0.84 0.16 1.0000
2006 140.34 95.45 44.89 0.68 0.32 1.0000

Note: Data scaling factor: millions US$

Table V.
Robert Half. Panel A:
current and fixed assets
momentum; Panel B:
common size momentum
ratios

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accounts it can still be stable (Figure 8). It is this steady rate of change, this momentum
that Ijiri considers to be of great importance in the appraisal of corporate performance.
As far as the creation of net wealth is concerned, Robert Half is shown here to be a
reliable performer from 1992 onwards. Only during 2002 and 2003 the stability is lost.
Indeed, in those years the staffing industry experienced a major downturn in the USA
and in Europe (Fleming, 2002), from which it quickly recovered (Krampf, 2004).

The common-size-format ratio of net wealth momentum can also be seen as a
coefficient. The Robert Half time series provides some evidence that there is a relation
between the growth rate of total wealth and net wealth, and that it holds firm at the
same level over several years (Figure 8). In this, we should not only see an accounting
logic – we can expect that net income is accrued into net wealth – but we should also
read this as an economic phenomenon. That the amount of new wealth gained and
added to the balance sheet is about the same for a certain number of years might not be

Figure 7.
Robert Half, net wealth

momentum, raw data–75

–

–25

0
25
50
75
100

125

150

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Figure 8.
Robert Half, net wealth

momentum, common
size ratio−1.0

− 0.8

− 0.6

− 0.4

− 0.2

0.0
0.2
0.4
0.6
0.8
1.0
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too big a surprise. But, that this firm, after experiencing large shocks during 2002 and
2003 in its business model, drives back (so quickly) to a stable level of momentum is
striking. However, the difference between the new and the previous level of
momentum, on average 0.11 lower, might be somewhat of a disappointment for
analysts and shareholders alike.

That the business model of Robert Half changed after 2003, compared to the period
1993-2001, can also be seen from the stacked bar graph in Figure 9 of the
common-size-format ratios reported as percentages of net wealth momentum and total
liabilities momentum. In Figure 9, each whole stacked bar represents the momentum of
total wealth (of course that is always 100 percent). The lower half of each bar graphs
total liabilities momentum, except for 2002, while the upper half graphs net wealth
momentum. When a momentum is negative, i.e. when the balance sheet account
decreases, the bar is drawn below the 0 percent line which indicates “no change.”
Thus, from Figure 9 it is clear that during the period 1989-1994 Robert Half
successively reduced its debt whereas net wealth showed considerable growth. From
1995 to 2000, Robert Half kept increasing total assets, financing this with about 25
percent of debt. In 2001, the pattern shifts considerably with a substantial decrease of
debt. Therefore, it is not without good reason that, during the market downturn,
Fleming’s (2002) comment was: “Robert Half does have a firm financial foundation,
with $303 million in cash, no debt and [a] healthy cash flow.” At the time, “Robert Half
announced that it would buy back as many as ten million of its own shares” (Id.), which
we see reflected partly in the negative net wealth momentum of 2002 as well as in the
negative current assets momentum (Table V)[9]. But, the recovery from this downturn
is just as remarkable. In 2003 net wealth momentum is about the same as total wealth
momentum, respectively, $43.69 and 44.23 million (Table IV). These changes on the
balance sheet of Robert Half are a good illustration of the use of the net wealth account
as a buffer of funds at the disposal of management to face bad times.

Discussion and conclusions
A great advantage of the TEMA framework is that it allows for the temporal as well as
the categorical analysis of accounting measurements. To this purpose, in this paper

Figure 9.
Robert Half, net wealth
and total liabilities
momentum, common size
percentages

−100

−75

−50

−25

0
25
50
75
100
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Liabilities Momentum Net Wealth Momentum

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ROTA was analyzed both as an aggregated and disaggregated performance
measurement. We proposed to use an inverse method of ratio calculation for
disaggregated ratio analysis. This will allow the comparison of disaggregated
accounting variables relative to their aggregated totals in the TEMA framework.
Preferably, we should not compare time period data with time step data.

Further to Melse (2004a), the extended example of Robert Half demonstrated that
with the TEMA framework new information can be disclosed that is relevant for
performance analysis. It is possibly more meaningful to limit the use of ratios to only
intra-dimensional relations within the TEMA framework for the benefit of temporal
correctness and improved interpretability of the data. Consequently, we should use the
TEMA framework to search for more informative ratios. In our case, we were able to
tell apart years that have a comparable common-size-format ratio of net wealth
momentum but a very different trend of ROTA. This adds new insight to how we
should appreciate the structural aspects of the profitability of a firm. This new method
sheds more light at a desirable stability of the firm’s business model. Vice versa,
observing years that have a comparable ROTA but a different common-size-format
ratio of net wealth momentum might deepen the analysis of balance sheet dynamics,
something of interest to shareholders and analysts alike.

Improving the ability to analyze trends within financial data can benefit all users of
financial statements. It will be worthwhile to broaden this research to larger population
now that it has been shown that common-size-format momentum ratios offer
meaningful insight in the example of Robert Half Inc. By way of additional case
examinations we expect to be able to confirm the findings of this paper. An extension is
to further research the possible association between TEMA variables of a firm and the
market performance of its stock as an alternative to models with balance sheet or
income variables or their ratios (Barniv and Myring, 2006; Biddle et al., 1997; Bird et al.,
2001; Collins et al., 1997; Damant, 2001). A second line of investigation would be to
compare the forecast success rate of TEMA models with that of alternative valuation
models or analysts’ earnings forecasts (Richardson and Tinaikar, 2004). A third line of
investigation could be to investigate if Spectramap factor decomposition of TEMA
variables can be employed in econometric models for investment portfolio
management (Melse, 2004b). Beside the identification of firms that exhibit mean-like
behavior, locating companies that occupy contrasting positions in the decomposed
data space of TEMA variables might be useful to balance investment portfolios
(Haensley, 2003).

We conclude with the contention that implementing momentum accounting might
be beneficial for strategic accounting purposes as well as for the ex post analysis of
financial statements (Bell et al., 1997; Barniv and Myring, 2006; Haskins and Sack,
2006). Possibly, this will prompt a renewed interest in the practical use of the TEMA
framework and Ijiri’s momentum accounting theory as a means to improve
performance measurement and risk analysis.

Notes

1. Misrepresentation of facts in financial statements is a subject that in this study is not
discussed further but nonetheless it is an important and problematic issue. However, we
think that momentum accounting increases transparancy and, as a result, is expected to
reduce the risk of misrepresentation of facts (Blommaert, 1994, p. 230).

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347

2. That is, the rate of change per time unit smaller than the time period in between two financial
statements. As will become clear when the research methodology is discussed in the next
paper, we can count the rate of change per year or quarter with the currently available
financial statements of firms.

3. Or decreasing; whereas the mileage of a car cannot be reduced (something which is illegal to
do) wealth can decrease during the lifetime of the firm when capital is retired or dividend is
paid out. See Melse (2004b) for another example of TEMA balance sheet analysis.

4. To be honest, the items on the cash flow statement can be viewed as “speedometers” when
we set the rate of change equal to one year or one quarter. However, Ijiri’s vision is to provide
much more detailed information with a much shorter time rate of change.

5. Source of non-proprietary data used: Compustat provided by Thomson One Banker
Analytics.

6. It is a matter of taste to choose the point of measurement. One can opt for the period’s closing
balance sheet or the opening balance sheet (that is done in this study). A third alternative is
to average the opening and closing balance sheet to get, in a manner of speaking, a point in
the middle of the period. However, none of this method mitigates the problem of temporal
inconsistency of the ratio.

7. A shortcoming of the current ratio is that point measurements are static data. It is possible to
“window dress” the accounts so that the ratio “looks good” on that day. Possibly, period
measurements and their derived common-size-format momentum ratios make this more
difficult to do.

8. Consequently, the denominator of this division can be larger then the aggregate of the
disaggregated momentum or force accounts.

9. Common shares outstanding were reduced from 174.929 in 2001 to 170.909 in 2002.

References

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Blommaert, A.M.M. (1994), Additional Disclosure. Triple-entry en Momentum Accounting,
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Collins, D.W., Maydew, E.L. and Weiss, I.S. (1997), “Changes in the value-relevance of earnings
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Damant, D. (2001), “The prediction of earnings movements using accounting data: an update and
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A case for
momentum
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349

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Further reading

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Long Range Planning, Vol. 32 No. 3, pp. 311-22.

Corresponding author
Eric Melse can be contacted at: e.melse@nyenrode.nl

JRF
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350

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Uses a concept of cash that includes not only cash but also short-term, highly liquid investments
Referred to as the cash and cash equivalent focus
Explains the changes in focus accounts
Basic Elements of the Statement of Cash Flows

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Uses of the statement of cash flows
Internal (management) users
Determine dividend policy
Evaluate cash generated by operations
Review investing and financing policy
External users
Determine a firm’s ability to increase dividends
Determine a firm’s ability to pay debt from operations
Determine the percentage of cash from operations in relation to the cash from financing
Basic Elements of the Statement of Cash Flows—Continued

Structure of the Statement of Cash Flows
Cash Flows from Operating Activities
Add: Cash Flows from Investing Activities
Add: Cash Flows from Financing Activities
Change in Cash

Beginning Cash Balance
Add: Change in cash
Ending Cash Balance
Supplemental disclosure: Noncash investing and financing activities

Operating Activities
Cash inflows from
Sale of goods or services
Returns on loans (interest)
Return on equity securities (dividends)
Cash outflows for payments
For acquisitions of inventory
To employees
For taxes
For interest expenses
For other expenses
Include the cash effects of events that enter into the determination of net income

Investing Activities
Cash inflows from
Receipts from loans collected
Sales of debt or equity securities of other corporations
Sale of property, plant, and equipment
Cash outflows for
Loans to other entities
Investment in debt or equity securities of other entities
Purchase of property, plant, and equipment
Lending and collecting money and acquiring and selling investments and long-term assets

Financing Activities
Cash inflows from
Sale of equity securities
Sale of bonds, mortgages, notes, and other short- and long-term borrowings
Cash outflows for
Payment of dividends
Reacquisition of capital stock
Payment of amounts borrowed
Include cash flows relating to liability and owners’ equity

Direct method
Converts the income statement from accrual basis to a cash basis
Encouraged by SFAS No. 95
Supplemental information required
Reconciliation of net income to cash provided by operations
Indirect method
Adjusts net income for items that affected net income but did not affect cash
Supplemental information required
Cash paid for income taxes and for interest
Presentation of Cash Flows From Operations

Exhibit 10-1—Statement of Cash Flows: Direct Method

Exhibit 10-1—Statement of Cash Flows: Indirect Method

Traditional ratios related income statement item(s) to a balance sheet item(s)
Statement of cash flows became a required statement in 1987
Cash flow financial ratios were slowly developed
Operating cash flow to current maturities of debt
Operating cash flow to total debt
Operating cash flow per share
Operating cash flow to cash dividends
Financial Ratios and the
Statement of Cash Flows

Indicates a firm’s ability to meet its current maturities of debt
Higher ratio indicates better liquidity
Operating Cash Flow to Current Maturities of Debt

Indicates a firm’s ability to cover total debt with the yearly operating cash flow
The higher the ratio, the better the firm’s ability to carry its total debt
Conservative approach is to include all possible balance sheet debt
Operating Cash Flow to Total Debt

Indicates the funds flow per common share outstanding
Higher than earnings per share as depreciation is not deducted
Operating Cash Flow per Share

A better indication of a firm’s ability to make capital expenditure decisions and pay dividends than is earnings per share
Does not reflect firm’s profitability
Firms are prohibited from reporting this on financial statements
Operating Cash Flow per Share—Continued

Indicates a firm’s ability to cover cash dividends with the yearly operating cash flow
Higher the ratio, the better the firm’s ability to cover cash dividends
Operating Cash Flow to Cash Dividends

No standard definition of cash flow
Alternative definition
Net income plus depreciation expense
Less useful than the net cash flow from operating activities
Alternative Cash Flow

Analyze all balance sheet accounts other than cash and cash equivalents.
Procedures to Develop the Statement of Cash Flows
Increase Decrease
Current assets Operating outflow Operating inflow
Noncurrent assets Investing outflow Investing inflow
Current liabilities Operating inflow Operating outflow
Long-term liabilities Financing inflow Financing outflow
Stockholders’ equity Financing inflow Financing outflow

Three techniques used to prepare the statement of cash flows
The visual method
Determine change in cash and cash equivalents
Compute the net change in all other balance sheet accounts
Classify as operating, investing, and financing
The T-account method
The worksheet method
Procedures to Develop the
Statement of Cash Flows

Operating section describes income statement accounts in terms of receipts or payments
Cash receipts
From customers
From other operating sources
Cash payments
For merchandise
To employees
For other operating expenses
Procedures to Develop Operating Cash Flows: Direct Approach

Begin with net income
Add or deduct adjustments to change accrual basis net income to cash basis net income
Changes in current noncash assets
Changes in noncash assets go in the inverse direction of changes in cash
Changes in current liabilities
Changes in noncash liabilities go in the same direction of changes in cash
Procedures to Develop Operating Cash Flows: Indirect Approach

Adjust net income (loss) for noncash expenses (like depreciation expense) and noncash revenues
Eliminate non cash gains and losses that relate to investing and financing activities
Procedures to Develop Operating Cash Flows: Indirect Approach

Operating Cash Flow
Current Maturities of Long-Term Debt and
Current Note Payable
Operating Cash Flow
Total Debt
Operating Cash
Operating Cash Flow Preferred Dividends
=
Flow per Share
Diluted Weighted Average Common
Shares Outstanding
æö
–
ç÷
èø
Operating Cash Flows
Cash Dividends

DuPont analysis of the return on operating assets:

Common equity = Total Stockholders’ Equity
− Preferred Capital − Noncontrolling Interest

Rate of
return on Measures
return to providers of Typical result
Assets All funds Lowest (includes all assets)
Investment Long-term funds Higher than ROA (relative small amount of short-term funds)
Total equity Equity Higher than ROI (measures return only to shareholders)

The Relationship Between Profitability Ratios

Gross Profit Margin Analysis

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Items not included in net income
Reported as a separate component of shareholders’ equity
Foreign currency translation adjustments
Unrealized holding gains and losses from available-for-sale marketable securities
Changes to stockholders’ equity resulting from additional minimum pension liability adjustments
Unrealized gains and losses from derivative instruments
Comprehensive Income

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Net Income Before Noncontrolling Interes
t,
Equity Income, and Nonrecurring Items
Net Profit Margin =
Net Sales
Net Sales
Total Asset Turnover =
Average Total Assets
Net Income Before Noncontrolling
Interest and Nonrecurring Items
Return on Assets =
Average Total Assets
Return on Assets = Net Profit Margin To
tal Asset Turnover
´
Return on Net Profit Total Asset
Assets = Margin × Turnover
Firm A
Year 1 10% = 4.0% × 2.5
Year 2 8% = 4.0% × 2.0

Firm B
Year 1 10% = 4.0% × 2.5
Year 2 8% = 3.2% × 2.5

Net Income BeforeNet Income Before
Noncontrolling InterestNoncontrolling In
terest
and Nonrecurring Itemsand Nonrecurring I
temsNet Sales
= ×
Average Total AssetsNet salesAverage Tot
al Assets

Return on
Net Profit
Total Asset

Assets
=
Margin
×
Turnover

Firm A
Year 1
10%
=
4.0%
×
2.5
Year 2
8%
=
4.0%
×
2.0
Firm B
Year 1
10%
=
4.0%
×
2.5
Year 2
8%
=
3.2%
×
2.5
Operating Income
Operating Income Margin =
Net Sales
Net Sales
Operating Asset Turnover =
Average Operating Assets
Return on Operating assets =
Operating Income
Average Operating Assets
DuPont ReturnOperatingOperating
On = Income × Asset
Operating AssetsMarginTurnover
æöæöæö
ç÷ç÷ç÷
ç÷ç÷ç÷
ç÷ç÷ç÷
èøèøèø
Net Sales
Sales to Fixed Assets =
Average Net Fixed Assets
(Exclude Construction in Progress)
Net Income Before Noncontrolling
Interest and Nonrecurring Items +
[(Interest Expense) × (1 Tax Rate)]
Return on Investment =
Average (Long-Term Liabilities + Equity)
–
Net Income Before Nonrecurring Items
Dividends on Redeemable Preferred Stock
Return on Equity =
Average Total Equity
–
Net income Before Nonrecurring
Items Preferred Dividends
Return on Common Equity =
Average Common Equity
–
Net Income + Interest Expense
Return on Total Asset Variation =
Average Total Assets
Gross Profit
Gross Profit Margin =
Net Sales

Indicates long-term debt-paying ability
Consider only recurring income
Exclude discontinued operations
Exclude extraordinary items
Exclude (add back) to income
Interest and Income tax expenses
Equity losses (earnings) of nonconsolidated subsidiaries
Net income—Noncontrolling interest
Include interest capitalized
Times Interest Earned

Times Interest Earned—Continued

Comparisons
3 to 5 years of historical data
Lowest value is the primary indicator of interest coverage
Industry competitors and averages
Secondary analysis
Interest coverage on long-term debt
Use only interest on long-term debt
Short-run coverage
Add back noncash expenses to recurring income
Less conservative
Times Interest Earned—Continued

Times Interest Earned- Short-Run Variation

Indicates a firm’s ability to cover fixed charges
Fixed Charge Coverage

Fixed charges include
Interest portion of operating lease payments
General approximation is to include 1/3 of payments
SEC requires specific calculation using lease terms
May also include
Depreciation, depletion, and amortization
Debt principal payments
Pension payments
Substantial preferred stock dividends
The more items included as “fixed charges,” the more conservative the ratio
Fixed Charge Coverage—Continued

Indicates the firm’s long-term debt-paying ability
Total liabilities
Includes short-term liabilities, reserves, deferred tax liability, noncontrolling interests, redeemable preferred stock, and any other non current liability
Indicates the percentage of assets financed by creditors
Debt Ratio

Reserves
Matches an expense but do not represent definite commitments to pay out funds in the future
Infrequently used in U.S. GAAP statements
Include in ratio for conservative application
Debt Ratio and Certain Liabilities

Deferred Income Taxes
Difference between income tax expense and income taxes payable
Recognized as a liability by GAAP; include in ratio
A company reports deferred taxes as
A net current amount
A net noncurrent amount
Referred as soft accounts
Debt Ratio and Certain Liabilities—Continued

Redeemable Preferred Stock
Not disclosed under stockholders’ equity
Exclude from ratio; does not present a normal debt relationship
Included in ratio for conservative application
Debt Ratio and Certain Liabilities—Continued

Determines the entity’s long-term debt payment ability
Indicates how well creditors are protected in case of the firm’s insolvency
More conservative than debt ratio or debt/equity ratio due to exclusion of intangibles
Debt to Tangible Net Worth Ratio

Current debt/net worth ratio
Indicates a relationship between current liabilities and funds contributed by shareholders
The higher the proportion of funds provided by current liabilities, the greater the risk
Total capitalization ratio
Compares long-term debt to total capitalization
Total capitalization consist of long-term debt, preferred stock, and common stockholders’ equity
The lower the ratio, the lower the risk
Other Long-Term Debt-Paying Ability Ratios

Fixed asset/equity ratio
The extent to which shareholders have provided funds in relation to fixed assets
Subtracting intangibles from shareholders’ equity will result in more conservative ratio
The higher the fixed assets in relation to equity, the greater the risk
Other Long-Term Debt-Paying Ability Ratios—Continued

Capital leases
Asset and liability are reported on the balance sheet
Operating leases
Reported as expense on the income statement
Supplemental analysis using future payments
One-third can be estimated as interest
Two-thirds can be added to the fixed assets and long-term liabilities for debt ratio analyses
Long-Term Leasing

Employee Retirement Income Security Act (ERISA)
Includes provisions requiring
Minimum funding of plans
Minimum rights to employees upon termination of their employment
Creation of a special federal agency, the Pension Benefit Guaranty Corporation (PBGC)
Pension Plans

Defines the contributions of the company to the pension plan
Employer bears no risk for future growth of plan
No complexity in estimating company’s pension liability or pension expense
401(k) is a type of defined contribution plan
Trend analysis
Compare three years of pension expense in relationship to operating revenue and income before income taxes; note any balance sheet items
Defined Contribution Plan

Defines the benefits to be received by the participants in the plan
Employer must fund sufficiently to achieve benefit
Note actuarial assumptions inherent in the plan
Interest (discount) rates
Employee turnover
Mortality rates
Compensation
Pension benefits
Defined Benefit Plan

Trend analysis
Compare three years of pension expense in relationship to operating revenue and income before income taxes
Compare benefit obligations to plan assets
Underfunding represents a potential liability
Overfunding represents an opportunity to reduce future pension expense and/or reduce related costs
Note the net balance sheet liability (asset) recognized
Defined Benefit Plan—Continued

Prior to 1993, accrual was not required
Transition costs may be
Amortized over 20 years or
Expensed in the year of adopting the new recognition practice
Analysis is similar to defined benefit plans for pension
Postretirement Benefits
Other than Pensions

An association of two or more businesses established for a special purpose
Consolidation
Done by the parent firm if it has control using a pro-rata share
Carried in an investment account
Analysis
Review footnote that relates to the joint venture
Off-balance sheet commitments represent potential liabilities
Joint Ventures

An existing condition involving uncertainty as to possible gain or loss to an enterprise
Will be resolved when one or more future events occur or fail to occur
Loss contingencies that are not accrued are included in the footnotes
Gain contingencies are not accrued
Review contingency note for possible liabilities and gain contingencies not disclosed on the balance sheet
Contingencies

Disclosure is required of
The face or contract amount
Nature and terms of the instrument
Amount of the potential loss
Entity’s collateral policy and description of the collateral it currently holds
Accounting loss occurs when
The co-party fails to perform the terms of contract
Changes in market make a instrument less valuable or more troublesome
Financial Instruments with
Off-Balance-Sheet Risk

Disclosure is required of the extent of risk from exposures to individuals or groups of counterparties in the same industry or region
Small companies are particularly susceptible to concentration risk
Financial Instruments
with Concentrations of Credit Risk

Disclosure of financial instrument’s fair value is required
On-balance sheet assets and liabilities
Off-balance sheet assets and liabilities
If estimation of fair value is not practicable
Descriptive information pertinent to estimating fair value is provided
Disclosures About
Fair Value of Financial Instruments

Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest
Times Interest Earned =
Interest Expense, Including Capitalized
Interest
(Recurring Earnings + Noncash Expense),
Excluding Interest Expense, Tax Expense,
Equity Earnings, and Noncontrolling Inte
rest
Times Interest Earned =
Interest Expense, Including Capitalized
Interest
Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest + Interest
Portion of Rentals
Fixed Charge Coverage =
Interest Expense, Including Capitalized
In
terest + Interest Portion of Rentals
Total Liabilities
Debt Ratio =
Total Assets
Total Liabilities
Debt/Equity Ratio =
Shareholders’ Equity
Total Liabilitites
Debt to Tangible Net Worth Ratio =
Shareholders’ Equity Intangible Assets
–

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Financial Analysis
Prendergast, Paul
Financial Management; May 2006; ProQuest
pg. 48

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Chapter 6
Liquidity of Short-Term Assets; Related
Debt-Paying Ability

Current assets (1) are in the form of cash, (2) will be realized in cash, or (3) conserve the use of cash
Within the operating cycle of a business or one year, whichever is longer
Typical examples
Cash, marketable securities, receivables, inventories, and prepayments
Current Assets

The time period between the acquisition of goods and the final cash realization from sales
Operating Cycle
Purchase inventory
Cash sale to customer
Purchase material
Produce finished product
Sell to customer on credit
Collect amount due from customer

Retail and Wholesale
Manufacturing

Unrestricted
Available for deposit or to pay creditors
Reported as current asset
Restricted
Maybe reported as current but must disclose restrictions
Eliminate cash and related current liability when measuring short-term debt-paying ability
Current Assets: Cash

Compensating balance
A portion of loan proceeds required to remain on deposit in the bank
Increases effective interest rate
Against short-term borrowings
Separately stated in the current asset section or notes
Against long-term borrowings
Separately stated as noncurrent assets under either investments or other assets
Current Assets: Cash—Continued

The cash account on the balance sheet is usually entitled
Cash
Cash and equivalents, or
Cash and certificates of deposit
Analysis issues
Determining a fair valuation for the asset
Determining the liquidity of the asset
Current Assets: Cash—Continued

To qualify as a marketable security
The investment must be readily marketable
Intention to convert it to cash within the year or the operating cycle, whichever is longer
Examples
Treasury bills, short-term notes of corporations, government bonds, corporate bonds, preferred stock, and common stock
Debt and equity securities are carried at fair value
Current Assets: Marketable Securities

Claims to future cash inflows
Accounts receivables
Notes receivables
Arise from sales to customers
Trade receivables
Valuation problems
The entity incurs costs for the use of the funds, until receivables are collected
Collection might not be made
Current Assets: Receivables

Valuation of receivables
Waiting period is ignored
Assume stipulated rate of interest is fair
Notes that are noninterest-bearing, or carry an unreasonable rate, or are for an amount different from value of transaction are recorded at present value
Causes of impairment
Uncollectibility
Discounts allowed
Allowances given
Sales returns
Current Assets: Receivables—Continued

Impairment—Accrue (allowance method)
Based on estimate of receivables’ realizable value
Set up allowance
Expense recognized on income statement
Asset reduced by “Allowance for Doubtful Debts” account
Charge-off of a specific receivable
Reduces accounts receivable and allowance for doubtful accounts
No impact on income statement or net assets
Current Assets: Receivables—Continued

Impairment—Direct write-off
Alternative to accrual method when
Receivables are not material or
Amount for accrual cannot be reasonably estimated
Charge-off of a specific receivable
Recognize expense
Reduce asset
Bad debt expense likely to be recognized in a year subsequent to the sale
Does not match expense with revenue
Current Assets: Receivables—Continued

Trade receivables
Typically collected within 30 days
Installment receivables
May be carried as a current asset, yet collection may be significantly longer than trade receivables
Usually considered to be lower quality than trade receivables
Current Assets: Receivables—Continued

Customer concentration
May impair the quality of receivables if a large portion of receivables is from a few customers
Liquidity measures
Number of days’ sales in receivables
Accounts receivable turnover
Current Assets: Receivables—Continued

Should mirror the company’s credit terms
Indicates the length of time that the receivables have been outstanding
Use of the natural business year (lower sales at year-end) can understate result
Compare
Firm’s data for several years
Other firms in the industry and industry averages
Days’ Sales in Receivables

Causes for overstatement
Sales volume expands materially late in the year
Uncollectibles should have been written off
A company seasonally dates invoices
Receivables are on the installment basis
Causes for understatement
Sales volume decreases materially late in the year
A material amount of sales are on a cash basis
A company has a factoring arrangement in which a material amount of the receivables is sold
Days’ Sales in Receivables—Continued

Indicates the liquidity of receivables
Determining average gross receivables
End of year and beginning of year base points for average mask seasonal fluctuations
For internal analysis, use monthly or weekly amounts
For external analysis, use quarterly data
Accounts Receivable Turnover

Similar to days’ sales in receivables except average gross receivables are used
Should reflect firm’s credit and collection policies
Accounts Receivable Turnover in Days

Held for sale in the ordinary course of business
Used in the production of goods
Trading concern
Single (merchandise) inventory account
Manufacturing concern
Three distinct inventory accounts
Raw materials inventory
Work-in-process inventory
Finished goods inventory
Current Assets: Inventories

Perpetual
A continuous record of physical quantities is maintained
Inventory and cost of goods sold are updated as sales and purchases take place
Records are verified through physical inventory
Periodic
Periodic physical counts to determine quantity
Attach costs to ending inventory based on selected cost flow assumption(s)
Current Assets: Inventories—Continued

Specific identification
Tracking of specific cost normally impractical
Exceptions to this are large and/or expensive items
If specific costs are used, it is referred to as the specific identification method
Cost flow assumptions
FIFO (first-in, first-out)
LIFO (last-in, first-out)
Averaging
Inventory Cost

First inventory acquired is the first sold
Cost of goods sold includes oldest costs
Current costs are not matched against current revenue
Inflates profits during a time of inflation
Ending inventory reflects latest costs
Approximates replacement cost
Low turnover can distort the approximation of replacement cost
FIFO Cost Flow Assumption

Cost of latest acquired goods are matched against sales revenue
Improves the matching of current costs against current revenue
Profit is reflective of replacement cost
Ending inventory contains oldest costs
Inventory valuation can be based on costs that are years or decades old
LIFO Cost Flow Assumption

Determines a midpoint to calculate cost
Results in an inventory amount and a cost of goods sold amount somewhere between FIFO and LIFO
During times of inflation
Inventory is more than LIFO and less than FIFO
Cost of goods sold is less than LIFO and more than FIFO
Average Cost

Cost Flow Assumption Example

800 units of ending inventory are valued at the most recent costs
800 units of ending inventory are valued at the oldest costs
2,100 units available for sale

Cost Flow Assumption Example

800 units of ending inventory are valued at average unit cost
Ending inventory (800 × $7.95) = $6,360
Cost of goods sold ($16,700 − $6,360) = $10,340
2,100 units available for sale

If LIFO method is being used, short-term debt-paying ability is understated
Understatement is reduced by reported operating expenses that reduce gross profit to net income
Replacement cost of the inventory usually exceeds the reported inventory cost, even if FIFO is used
Analysis Problems and Inventory

Cash flow is higher when LIFO is used for tax reporting
LIFO generally results in a lower profit LIFO profit reflects current costs of sales
FIFO inventory is closer to replacement value of the asset
LIFO reserve
Measures the spread between LIFO and FIFO inventory value
Discloses the approximate FIFO inventory value
Impact on Financial Statements

Cost flow assumptions use historical data
If “utility” (market) is below cost, inventory must be written down to reflect the diminished value
Market is defined in terms of
Replacement cost
Net realizable value
Inventory: Lower-of-Cost-or-Market

Days’ sales in inventory
Inventory turnover in times per year
Inventory turnover in days
Liquidity of Inventory

Indicates the length of time needed to sell all inventory on hand
Use of a natural business year
Understates number of day’s sale in inventory
Overstates liquidity of inventory
Days’ Sales in Inventory

Implications of extremes
A high inventory would result in the number of days’ sales in inventory to be overstated and the liquidity to be understated
A low inventory would result in an unrealistic days’ sales in inventory; lost sales
Days’ Sales in Inventory—Continued

Indicates the liquidity of inventory
Determining average inventory
End of year and beginning of year base points for average mask seasonal fluctuations
For internal analysis use monthly or weekly amounts
For external analysis use quarterly data
Inventory Turnover

Comparison Issues
Use caution when comparing a mix of natural and calendar year companies
Cost flow assumption issues
LIFO yields lower inventory value and higher inventory turnover
Inter-industry comparisons may not be reasonable
Inventory Turnover—Continued Comparison Issues

Inventory Turnover in Days

The period between acquisition of goods and the final cash realization from sales
Current Assets: Operating Cycle
Subject to potential understatement from understatement of turnover measures
Use of LIFO inventory
Use of a natural business year
Averages are computed based on beginning-of-year and end-of-year data

Prepayments
Unexpired costs for which payment has been made
Consumed within an operating cycle or a year, whichever is longer
Have minor influence on short-term debt-paying ability
Valuation is taken as the cost that has been paid
No liquidity computation is needed as prepayment will not result in a receipt of cash
Current Assets: Prepayments

Will be realized in cash or conserve the use of cash within the operating cycle of the business or one year, whichever is longer
If material, and nonrecurring, may distort liquidity
Examples
Property held for sale
Advances or deposits
Current Assets: Other

Obligations whose liquidation is reasonably expected to require
The use of existing resources properly classifiable as current asset
The creation of other current liabilities
Typical Examples
Accounts payable, notes payable, accrued wages, accrued taxes, collections received in advance, and current portions of long-term liabilities
Carried at its face value
Current Liabilities

Liquidity Ratios

Indicates short-run solvency of a business
Subject to understatement if certain assets are understated (i.e., LIFO inventory)
Longitudinal comparison appropriate
Inter-firm comparison is of no value because of their size differences
Working Capital

Determines short-term debt-paying ability
Focus is on the relationship between current assets and current liabilities
Inter-firm comparison is possible and meaningful
Minimum current ratio is 2.00
Decreased current ratio indicates lower liquidity
Industry averages provide contextual benchmarks
Considerations
Quality of inventory and receivables
Inventory cost flow assumptions
Current Ratio

Measures the immediate liquidity of the firm
Relates the most liquid assets to current liabilities
Excludes inventory
A more conservative computation excludes other current assets that do not represent current cash flow
Minimum acid-test ratio is 1.00
Industry averages provide contextual benchmarks
Consideration
Quality of receivables
Acid-Test (Quick) Ratio

Extremely conservative
Unrealistic for a firm to have sufficient cash and securities to cover all its current liabilities
Appropriate context
Firms with naturally slow-moving inventories and receivables
Firms that are highly speculative
Cash Ratio

Measures the turnover of working capital per year
Analyst compare this data with historical data, competitors, and industry averages to determine the adequacy of working capital
Assessment
Low ratio indicates unprofitable use of working capital
High ratio indicates that the firm is undercapitalized

Sales to Working Capital

Liquidity is better than indicated by financial statements
Unused bank credit lines
Long-term assets can be converted to cash quickly
A firm may be in a very good long-term debt position
Liquidity is weaker than indicated by financial statements
Co-signer on debt of another entity
Subject to recourse obligation
Significant contingent (unaccrued) liabilities
Other Liquidity Considerations

Gross Receivables
Days’ Sales in Receivables =
Net Sales365
Net Sales
Accounts Receivable Turnover =
Average Gross Receivables
Average Gross Receivables
Average Receivable Turnover in Days =
Net Sales365
DateDescription
Number
of Units
Cost per
Unit
Total
Cost
Cost of
Goods Sold
01-JanBeginning inventory200 6.00$ 1,200$
01-MarPurchase1,200 7.00 8,400
01-JulPurchase300 9.00 2,700
01-OctPurchase400 11.00 4,400
2,100 16,700$
FIFO
01-OctPurchase400 11.00$ 4,400$
01-JulPurchase300 9.00 2,700
01-MarPurchase100 7.00 700
Ending inventory800 7,800$
Cost of Goods Sold8,900$
LIFO
01-JanBeginning inventory200 6.00$ 1,200$
01-MarPurchase600 7.00 4,200
Ending inventory800 5,400$
Cost of goods sold11,300$
Sheet1

Date Description Number of Units Cost per Unit Total Cost Cost of Goods Sold
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 1,200 7.00 8,400
1-Jul Purchase 300 9.00 2,700
1-Oct Purchase 400 11.00 4,400
2,100 $ 16,700
FIFO
1-Oct Purchase 400 $ 11.00 $ 4,400
1-Jul Purchase 300 9.00 2,700
1-Mar Purchase 100 7.00 700
Ending inventory 800 $ 7,800
Cost of Goods Sold $ 8,900
LIFO
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 600 7.00 4,200
Ending inventory 800 $ 5,400
Cost of goods sold $ 11,300

Sheet2

Sheet3

AVERAGE COST
DateDescription
Number of
Units
Cost per
UnitTotal Cost
01-JanBeginning inventory200 6.00$ 1,200$
01-MarPurchase1,200 7.00 8,400
01-JulPurchase300 9.00 2,700
01-OctPurchase400 11.00 4,400
2,100 16,700$
Total Cost$16,700
Average unit cost = $7.95
Total Units2,100
==
Sheet1

AVERAGE COST
Date Description Number of Units Cost per Unit Total Cost
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 1,200 7.00 8,400
1-Jul Purchase 300 9.00 2,700
1-Oct Purchase 400 11.00 4,400
2,100 $ 16,700
1-Oct Purchase 400 11.00 4,400
1-Jul Purchase 300 9.00 2,700
1-Mar Purchase 100 7.00 700
Ending inventory 800 7,800
Cost of Goods Sold 8,900
LIFO
1-Jan Beginning Inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 600 7.00 4,200
Ending inventory 800 $ 5,400
Cost of Goods Sold $ 11,300

Sheet2

Sheet3

Ending Inventory
Days’ Sales in Inventory
Cost of Goods Sold365
=
Cost of Goods Sold
Inventory Turnover =
Average Inventory
Average Inventory
Inventory Turnover in Days =
Cost of Goods Sold365
365
Inventory Turnover per Year =
Inventory Turnover in Days
Operating Cycle = Accounts Receivable Tu
rnover in Days + Inventory Turnover in D
ays

Current Assets Inventory
Acid-Test (Quick) Ratio =
Current Liabilities
–
Current Assets
Current Ratio =
Current Liabilities
Cash Equivalents
+ Marketable Securities
+ Net Receivables
Acid-Test (Quick) Ratio =
Current Liabilities
æö
ç÷
ç÷
ç÷
èø
Working Capital = Current Assets Curren
t Liabilities
–
Cash Equivalents + Marketable Securities
Cash Ratio =
Current Liabilities
Sales
Sales to Working Capital =
Average Working Capital

The use of financing with a fixed charge is termed financial leverage
Interest as related to debt financing
A contractual obligation
Must be paid regardless of entity’s current profits
Contrast with dividends that are discretionary
Interest is tax deductible
Reduces taxable income
Reduces income tax expense
Financial Leverage

Exhibit 9-1—Dowell Company
Percentage change in net income increase [A] is greater than percentage change in EBIT [B] due to the fixed nature of interest expense

Computation of the Degree of Financial Leverage
The degree of financial leverage is the multiplication factor by which the net income changes in respect to changes in EBIT
A more simple formula for degree of financial leverage

Degree of financial leverage calculations should exclude
Noncontrolling interest
Equity income
Nonrecurring items
Computation of the Degree of Financial Leverage—Continued

The amount of income earned on a share of common stock during an accounting period
Required disclosure for corporate income statements
Pertains only to common stock
Earnings per Common Share

Per share amounts for discontinued operations and extraordinary items must be presented
In the income statement and the notes to the financial statements
Earnings per share for recurring items are significant for primary analysis
Retroactive recognition must be given to events such as stock dividend and stock split
Earnings per Common Share—Continued

Earnings pertain to an entire fiscal period
Average common shares outstanding is used for parity of information
Current guidelines require basic and diluted earnings per share presentation
Diluted earnings per share is calculated the same as basic plus the dilutive effect of potentially dilutive securities
Convertible securities, warrants, or other rights that upon conversion or exercise could in the aggregate dilute earnings per common share are potential dilutive securities
Earnings per Common Share—Continued

Weighted Average Common Outstanding Shares
Months Shares Are Outstanding Shares Outstanding × Fraction of Year Outstanding = Weighted Average
January–June 10,000 6/12 5,000
July–September 12,000 3/12 3,000
October–December 15,000 3/12 3,750
11,750

Measures the relationship between the market price of a share of common stock and that stock’s current earnings per share
Use of diluted earnings per share gives a more conservative price/earnings ratio
Price/Earnings Ratio

Interpretation
High-growth-potential firms have higher P/E ratios
P/E ratio is a function of the market
Compare with
Competitors
Industry average
Exchange averages
Price/Earnings Ratio—Continued

Reflects the proportion of current earnings retained for internal growth
Trend analysis is improved by exclusion of nonrecurring items
Higher percentage typically found in growth firms
Percentage of Earnings Retained

Measures the portion of current earnings per common share being paid out in dividends
A stable dividend policy is developed by consideration of recurring earnings
Lower payout typically found in growth firms
Dividend Payout

Indicates the relationship between the dividends per common share and the market price per common share
The yield depends on a firm’s dividend policy and market price
Dividend Yield

Preferred equity should be measured at liquidation value, if available
Market value and book value
Book value reflects past unrecovered asset costs
Market value reflects the potential of the firm
Book Value per Share

Recognize an expense for all employee services received in share-based payment transactions, using a fair-value-based method
Similar to SFAS No. 123 (R)
Allocate option fair value to the service period
Date of grant through vesting date
Noncompensatory plans
Encourage widespread ownership by employees
Slight discount from fair value
No compensation expense is recognized
Stock Options

Impact of options can be substantial
It may result in lower net income and earnings per share
Following formula is used to determine the materiality of options:
Stock Options—Continued

Sometimes offered to employees in lieu of stock option plans
Restrictions
Employee cannot sell stock for a specified period of time
Employees may forfeit their shares if they leave employer before vesting
Awards may be linked to financial goals
Restricted Stock

Gives the employee right to receive compensation in cash or stock or in a combination of both
Based on the difference between option price and market price
Expense is a function of market price
Year-end spread is measured
Compensation expense is spread minus prior recognition, multiplied by number of shares of stock appreciation rights outstanding
Stock Appreciation Rights

% Change in Net Income
Degree of Financial Leverage =
% Change in EBIT
Earnings Before Interest and Tax
Degree of Financial Leverage =
Earnings Before Tax
æö
ç÷
èø
Earnings Before Interest, Tax,
Noncontrolling Interest,
All-Inclusive Degree
Equity Income, and Nonrecurring Items
=
Earnings Before Tax,
of Financial Leverage
Noncontrolling Interest,
Equity Income,
and Nonrecurring Items
Net Income Preferred Dividend
Earning per Share =
Weighted Average Number of Common
Shares Outstanding
–
Market Price per Share
Price/Earings Ratio =
Diluted Earnings per Share,
Before Nonrecurring Items
æö
–
ç÷
èø
Net Income Before Nonrecurring
Percentage of
Items All Dividends
=
Net Income Before Nonrecurring Items
Earnings Retained
Dividends per Common Share
Dividend Payout ratio =
Diluted Earnings per Share
Before Nonrecurring Items
Dividends per Common Share
Dividend Yield =
Market Price per Common Share
Total Shareholders’ Equity
Preferred Stock Equity
Book Value per Share =
Number of Common Shares
Outstanding
–
Net Income Before Net Income Before
Nonrecurring Items not Nonrecurring It
ems
Including Option ExpenseIncluding Option
Expense
Net Income Before Nonrecurring Items
Not Including O
æöæö
ç÷ç÷
–
ç÷ç÷
ç÷ç÷
èøèø
ption Expense

Liquidity ratios
Measures a firm’s ability to meet its current obligations
Borrowing capacity (leverage) ratios
Measures the degree of protection for long-term creditors
Profitability ratios
Measures the earning ability of a firm
Cash flow ratios
Ratio Analysis

Interpreted in comparison with
Prior ratios
Competitor’s ratios
Industry ratios
Predetermined standards
Trend and variability of a ratio are important considerations
Ratio Analysis—Continued

Use of average data from balance sheet
Necessary when comparing with income statement data
Does not
Eliminate seasonal or cyclical variations
Reflect changes that occur unevenly throughout the year
Analysis must be performed and understood within the context of
Native accounting principles
Native business practices and culture
Complexities and Context

The use of percentages is usually preferable to the use of absolute amounts
Vertical analysis
All amounts of a year expressed as a percentage of a base amount of the same year (e.g., net sales revenue, total assets)
Horizontal analysis
Amounts for comparative years are expressed as a percentage of the base year amount
Common-Size Analysis

Exhibit 5-1: Melcher Company—Vertical Common Size
Each financial statement element is presented as a percentage of a designated base which is sales revenue on the income statement

Financial components vary by type of industry
Merchandising
Inventory is a principal asset
Sales may be primarily for cash or on credit
Service
Inventory is low or nonexistent
Manufacturing
Large inventory holdings
Substantial investment in plant assets
Cost of sales often represents the major expense
Industry Variations

Narrative data
Annual report
Trade periodicals
Industry reviews
Further explains the financial position of a firm
Management Discussion and Analysis (MD&A) provides an overview of the previous year and of future goals and new projects
Descriptive Information

Provides context for analysis of ratios and financial data
Common types
Trend analysis
Standard Industrial Classification (SIC) Manual
The U.S. Department of Labor provides Web site that details the SIC manual
North American Industry Classification System (NAICS)
Industry Averages and Comparison with Competitors
Comparisons

A study of the financial history of a firm
It reveals whether the ratio is
Falling
Rising
Relatively constant
Highlight
Effective management
Evidence of problems
Comparisons: Trend Analysis

Classifies business by industry
Defines industries in accordance with the composition and structure of the economy
Coding structure
Two-digit major group number
Three-digit industry group number
Four-digit industry number
Comparisons: SIC

Jointly created by the U.S., Canada, and Mexico
Industry is defined by similar production processes
U.S. Census Bureau provides a Web site (www.census.gov) that that details the NAICS manual. Go on this site and under “business and industry” click on NAICS
Comparisons: NAICS

Industry comparison complicated by highly diversified companies
Financial services
Base their analysis on industry placement
Provide composite industry data
Comparisons: Industry Averages

Publication Publisher(s) Coverage Data Classification
The Department of Commerce Financial Report Economic Surveys Division, Bureau of the Census Manufacturing, mining, and trade corporations Income statement and balance sheet data and ratios NAICS
Annual Statement Studies Risk Management Association Manufacturing, wholesaling, retailing, service, agriculture, and construction Common-size financial statements and 16 selected ratios NAICS or SIC
Standard & Poor’s Industry Surveys Standard & Poor’s North American and global industries Industry write-ups and statistics NAICS

Financial Services’ Publications

Publication Publisher(s) Coverage Data Classification
Almanac of Business and Industrial Financial Ratios CCH, Inc. 200 industries Corporate tax return data NAICS
Industry Norms and Key Business Ratios Dun & Bradstreet 800 business lines Condensed financial statements; ratios SIC
Value Line Investment Survey The Standard Edition and the Small &
Mid-Cap Edition 1 to 97 industries;
1 to 84 industries Longitudinal financial information

Financial Services’ Publications—Continued

Ratios are subject to variance from
Differing data
Inconsistent formula construction
Optional (elective) accounting treatment
Different fiscal year-ends
Varying financial policies
Inconsistent basis (before or after tax)
Comparisons: Caution in Using Industry Averages

Comparison of disparate size firms
Capital market access
Economy of scale (purchasing)
Wider customer base
Information
Absolute numbers amplifies comparison difficulty
Common-size analysis help to eliminate some of the difficulty
Percent of market helps to define relative size
Relative Size of Firm

Covers domestic private and public companies
Up to 20 items of information are provided for each company listed
Went digital in 2007 under Gale Directory Library
Ward’s Business Directory

Companies listed on various stock exchanges
New York Stock Exchange
American Stock Exchange
NASDAQ stock market
Regional exchanges
Arranged Alphabetically by stock exchanges
Contains brief analysis of companies regularly traded
Standard & Poor’s Stock Reports

Contains 2-volumes
Volume 1
Alphabetical list of approximately 75,000 corporations
Volume 2,
Section 1 contains an alphabetical list of over 70,000 individuals serving as officers, directors, trustees, partners, and so on
Section 2 is divided into seven subsections providing additional details
Standard & Poor’s Register Of Corp., Directors, And Executives

Selected income statement and balance sheet items
Related ratios
Applicable to Standard & Poor’s industry group stock price indexes
Brief monthly updates for selected industries supplement the annual editions of the handbook
Standard & Poor’s Analyst’s Handbook

U.S. corporations
Background information
Detailed financial statistics
The contents and the index are updated throughout the year
Standard & Poor’s Standard Corporation Descriptions

Covers 5,300 common and preferred stocks
It contains trading activity, price range, dividends, and so on, for companies traded on
New York Stock Exchange
American Stock Exchange
Over the Counter
Regional Exchanges
Standard & Poor’s Security Owner’s Stock Guide

Industry statistics on industries such as
Agriculture
Metals
Building
Transportation
Additional statistics are included such as price indexes and daily highs, lows, and closes for stock
Standard & Poor’s Statistical Service

Available at many academic, public, and corporate libraries, and information centers
Other publication available with Net Advantage
Standard & Poor’s Stock Reports
Standard & Poor’s Register of Corporations, Directors and Executives
Stand and Poor’s Standard Corporation Descriptions
Standard & Poor’s Net Advantage

Provide a dividend record of payments on virtually all publicly owned American and some foreign companies
Mergent and Standard & Poor’s Dividend Record

Gives an in-depth view of companies and their divisions, subsidiaries, and affiliates
Contains an alphabetical index, geographical index, and SIC classifications
The parent company listing consists of address, telephone number, stock ticker symbol, stock exchange(s), approximate sales, number of employees, type of business, and top corporate officers
Directory Of Corporate Affiliates™

Comprehensive reference
Products and services
Company profiles
Catalog file
Thomas Register Of American Manufacturers

Published in two volumes
Covers 2000 industrial corporations listed
On New York and American Stock Exchanges and other selected exchanges
Provides information such as history, business, properties, subsidiaries, financial statements, and SIC codes
Mergent Industrial Manual and News Reports

Contains profile information on over 200,000 principal corporate officers in over 12,000 companies
This information includes
Year of birth
Education
Military service
Present business position
Previous positions
D&B Reference Book of Corporate Managements

Database of textual and financial information on about 12,000 public companies
Taken from reports filed with the SEC
Contents
Major financial statements
Financial ratios
Institutional holdings
Insider ownership
President’s letter
Financial notes
Compact Disclosure

Provides accounting, legal, newspaper, and periodical information
Includes financial statements from annual reports for thousands of publicly traded companies
Lexis-Nexis

Management
Analyze information from the perspective of both investors and creditors
Investors
Analysis of past and present information to project the future prospects of the entity
Creditors
Short-term creditor focus on current resources
Long-term creditors consider the future prospects of the firm
The Users of Financial Statements

DuPont analysis of the return on operating assets:

Common equity = Total Stockholders’ Equity
− Preferred Capital − Noncontrolling Interest

The Relationship Between Profitability Ratios

Gross Profit Margin Analysis

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Items not included in net income
Reported as a separate component of shareholders’ equity
Foreign currency translation adjustments
Unrealized holding gains and losses from available-for-sale marketable securities
Changes to stockholders’ equity resulting from additional minimum pension liability adjustments
Unrealized gains and losses from derivative instruments
Comprehensive Income

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Net Income Before Noncontrolling Interes
t,
Equity Income, and Nonrecurring Items
Net Profit Margin =
Net Sales
Net Sales
Total Asset Turnover =
Average Total Assets
Net Income Before Noncontrolling
Interest and Nonrecurring Items
Return on Assets =
Average Total Assets
Return on Assets = Net Profit Margin To
tal Asset Turnover
´
Return on Net Profit Total Asset
Assets = Margin × Turnover
Firm A
Year 1 10% = 4.0% × 2.5
Year 2 8% = 4.0% × 2.0

Firm B
Year 1 10% = 4.0% × 2.5
Year 2 8% = 3.2% × 2.5

Net Income BeforeNet Income Before
Noncontrolling InterestNoncontrolling In
terest
and Nonrecurring Itemsand Nonrecurring I
temsNet Sales
= ×
Average Total AssetsNet salesAverage Tot
al Assets

Return on
Net Profit
Total Asset

Assets
=
Margin
×
Turnover

Times Interest Earned—Continued

Times Interest Earned- Short-Run Variation

Indicates a firm’s ability to cover fixed charges
Fixed Charge Coverage

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