# Components of annual report

Components of annual report

For each item, indicate the portion of the annual report in which it would be found. Preparing a statement of retained earnings
Diaz Company has the following information from its accounting records on December 31.

Required:Prepare a statement of retained earnings on December 31.

The statement of retained earnings starts with beginning retained earnings and lists all the changes in Retained Earnings for the period.

Let’s examine each item in this problem individually:

Correction of error:
Revenue and expense items are closed into Retained Earnings during the closing process. Thus, any errors related to revenue and expense items from a prior period(s) will have to be adjusted through Retained Earnings.

The effect of these errors is shown net of tax and adjusts beginning retained earnings on the retained earnings statement.

To compute the amount of the correction (of the error), net of tax, first calculate the tax effect of the error. An increase in income will also increase tax. Thus, there is additional tax associated with this error.

 Additional tax = Error × Tax rate = \$25,500 × 47% = \$11,985

Note: There is another way to compute the gain net of tax.

 Gain net of tax = Gain × (1 – Income tax rate) = \$25,500 × (1 – 47%) = \$25,500 × 0.53 = \$13,515

Net income:
Net income increases Retained Earnings and will be listed in the retained earnings statement after adjusted beginning retained earnings.

Cash dividends declared
When dividends are declared, Retained Earnings is reduced. Cash dividends declared will reduce Retained Earnings and will follow net income on the retained earnings statement.

Cash Dividends Paid:
When cash dividends are paid, Dividends Payable is reduced and Cash is reduced. However, this transaction does not affect Retained Earnings. Retained Earnings is decreased when dividends are declared, not paid.

Accumulated depreciation:
Accumulated depreciation is a contra-asset that is reported on the balance sheet in the property, plant, and equipment section. It does not affect Retained Earnings, and it will not be found on the retained earnings statement.

Note: Make sure to add ( ) into Dividends or answer will be wrong.

Ratio analysis: Liquidity ratios
The financial statements of Flores Company include the following data: Required:

Compute the inventory turnover ratio for 2015. Round your answer to two decimal places. (If necessary, consult a list of formulas.)

The inventory turnover ratio measures how many times an entity sells its inventory during the year. Differences across inventories, companies, and industries are too great to allow a general statement on what is a good inventory turnover ratio. However, if the inventory turnover ratio for a business is lower than that of its competitors or lower than the industry average, this could be an indication that inventory is not being managed properly.

The inventory turnover ratio is computed by dividing cost of goods sold by average merchandise inventory (beginning inventory plus ending inventory, all divided by two):

 Inventory turnover ratio = Cost of Goods SoldAverage merchandise inventory = \$465,300(\$75,200 + \$79,900) / 2 = 6 Ratio analysis: Profitability ratios
The financial statements of Edwards Company include the following data:

Required:

Compute the operating expenses to sales ratio for 2015. Round your answer to the nearest percentage. (If necessary, consult a list of formulas.)

Required:

Compute the payout ratio for 2015. Round your answer to the nearest percentage. (If necessary, consult a list of formulas.)

= 0.1060

= 11%

Required:

Compute the asset turnover ratio for 2015. Round your answer to the nearest percentage. (If necessary, consult a list of formulas.)

Financial statement analysis: Horizontal analysis

Torres Company had the following income statement to be used in horizontal analysis:

Required:

Examine operating expenses and compute the following. Indicate for each whether the change is an increase or a decrease:

Compute the change in dollar amount from 2014 to 2015.

Compute the percentage change from 2014 to 2015.

Horizontal analysis of financial statements compares values in a certain period to values in prior periods and computes the dollar and percentage change horizontally on each line. For example, on the income statement, net sales or cost of goods sold for the current period may be compared to those in the previous period or periods in various ways. Below are two examples of horizontal analysis.

Find the change in the dollar amount and the percentage change calculated with the earlier year’s value (2014) as the base year. The base year is the year used for comparison purposes and is given a value of 100%. If the change is a decrease, it is placed in parentheses.

Horizontal analysis compares the values from a number of periods and computes the value of each year as a percentage of the base year. This is often called trend analysis. In this example, 2013 is the base year.

Horizontal analysis can be used with any financial statement. Business decision-makers use horizontal analysis to assess the soundness and performance of a company based on detected trends of increase and decrease. These trends are also used to project future performance and financial position.

The change in dollar amount of operating expenses is computed by subtracting the amount of operating expenses for 2014 from the amount of operating expenses from 2015.

 Change in operating expenses = 2015 operating expenses – 2014 operating expenses = \$221,400 – \$280,000 = \$-58,600

Since 2015 operating expenses are less than 2014 operating expenses, there is a decrease of \$58,600 in operating expenses.

The percentage change in operating expenses is computed by dividing the change in operating expenses by the amount of operating expenses from 2014.

To convert 0.2093 to a percentage, multiply 0.2093 × 100% = 20.93%.

Normally a company tries to maximize profit by reducing its expenses and increasing its revenue. As a company expands its operations and sales revenue, its operating expenses normally increase too. So, a dollar increase in operating expenses is not bad when it is accompanied by increased sales revenue. What is important is the percentage change in operating expenses as compared to the percentage change in sales and gross profit.

Wal-mart, the number one retailer, has a lower percentage operating expenses to sales ratio than its competition due to an extremely efficient distribution system. This permits the retail giant to offer its customers lower prices, which in turn increases its sales and net income.

In horizontal analysis, the percentage change from one period to another is watched very carefully and compared with other companies’ percentages and with industry averages. It is important to show increased net income, and it is also important to show results that compare favorably with competitors.

Examine income before taxes and compute the following. Indicate for each whether the change is an increase or a decrease:

Compute the change in dollar amount from 2014 to 2015.

Compute the percentage change from 2014 to 2015.

 Change in income before taxes = 2015 income before taxes – 2014 income before taxes = \$235,700 – \$210,000 = \$25,700 = Change in income before taxes2014 income before taxes = \$25,700\$210,000 = 0.12238… = 0.1224     (Rounded to four decimal places.)

To convert 0.1224 to a percentage, multiply 0.1224 × 100% = 12.24%.

Financial statement analysis: Vertical analysis

The following information was obtained from the income statements of Turner Company and Wood Company to be used in vertical analysis.

Required:

1. Compute Turner Company’s Gross profit as a percentage of sales.

2. Compute Wood Company’s Gross profit as a percentage of sales.

Round your responses to two decimal places.

Vertical analysis of financial statements is used to show the relationship of each individual component as a percentage of the total within a single statement. In a vertical analysis of an income statement, each item is typically stated as a percentage of net sales. In a vertical analysis of a balance sheet, each item is typically stated as a percentage of total assets.

Vertical analysis, also called common size analysis, uses percentages to compare the financial statements of two or more companies of any size. In the income statement, the comparison then focuses on each income statement item as a percentage of net sales.

Vertical analysis is also useful in comparing the current period percentages with those of prior periods for the same company to discern a trend.

1. Turner Company can express its gross profit as a percentage of sales by dividing gross profit by sales.

To convert 0.50 to a percentage, multiply 0.50 × 100% = 50%.

Wood Company can express its gross profit as a percentage of sales by dividing gross profit by sales.

To convert 0.525 to a percentage, multiply 0.525 × 100% = 52.50%.

A percentage increase in gross profit is desirable if it leads to higher net income. Gross profit as a percentage of sales will increase if the sales price of the company’s products increases while the cost of goods sold remains unchanged. This may not be desirable if it makes the company less price competitive and the company loses sales as a result. Or, an increase in gross profit may be desirable if it is the result of smarter buying that reduces the COGS.