CHAPTER 2

ACCOUNTING INFORMATION AND

REGRESSION ANALYSIS
1. Accounting information generally consists of the four basic financial statements:
balance sheet, income statement, statement of retained earnings, and statement of
changes in financial position. The balance sheet is useful because it depicts the
firm’s financing and investment policies. Comparative balance sheets can be use
to detect trends and possible future problems. However, the balance sheet is static
by definition and thus must be analyzed with caution in financial analysis and
planning. The income statement is more dynamic than the balance sheet because it
reflects changes for the period. Moreover, it provides an analyst with an overview
of a firm’s operations and the profitability of the firm on a gross, an operating, and
a net income basis. The retained earnings statement is easily understood if it is
viewed as a bridge between the balance sheet and the income statement. It
presents a summary of the firm’s dividend policy and shows how net income is
allocated to cash dividends and reinvestment. Finally, the statement of changes in
financial position is very helpful in evaluating a firm’s use of its funds and in
determining how these funds were raised. Therefore it is an important tool for
financial planning and analysis.

Quarterly, data are composed of trend-cycle, seasonal, and random components.

A disadvantage of quarterly data is their large irregular or random component,
which introduces noise into the analysis. Annual data are composed of the trend-
cycle and irregular components, but no seasonal component. While it may seem
that annual data would be most useful for long-term financial planning and
analysis, seasonal data reveal important permanent patterns which underlie the
short-term time series in financial analysis and planning. This particular type of
information can be valuable to a firm’s short-run financial decisions, such as those
related to cash flows and inventory.

Major problems with the use of accounting information arise from (1)
classification errors, (2) the choice of depreciation methods, (3) the choice of
inventory evaluation methods, and (4) the use of historical costs. Classification
errors occur when transactions are classified into individual ledger accounts. The
choice of a depreciation method can cause a wide variation in net income,
depending on the method used. Reliance on historical cost is particularly
troublesome in times of high inflation, because historical cost values are no longer
 representative of the underlying values of the assets and liabilities of the firm.

The difference between accounting and financial information is that an

accountant defines income as the change in shareholder’s wealth due to the
operations of the firm, whereas the finance (or economic) discipline defines a
firm’s income as cash income, or the difference between cash revenues and cash
expenses. Due to accruals and the difference in timing, accounting income is
numerically different from cash income.

Three possible methods for improving the representativeness or accuracy of

accounting information in financial analysis and planning are the use of
alternative information, the use of statistical tools, and the use of finance and
economic theories. Alternative information includes market information such as
stock prices and replacement costs. Statistical tools such as time-series
decomposition techniques can be used to divide quarterly earnings into the trend
cyclical, seasonal, and irregular components. Finally, by applying these theories
one can adjust accounting income measurement- i.e., finance income. In addition,
various earnings estimates can shed additional light on the firm’s value
determination.

2. Define the following terms:

a. Real markets are the product markets while financial markets are the markets
for capital.

b. M1 is the traditional definition of the money supply and is defined as currency

and coin plus demand deposits at commercial banks, NOW accounts, share
draft accounts, and savings accounts that automatically transfer funds into a
checking account when the checking account is overdrawn. M2 is M1 plus
most forms of savings account balances plus shares in money market mutual
funds.

c. Leading Economic Indicators are economic variables whose time series reach
peaks and troughs before aggregate economic activity does.

d. NYSE and AMEX are organized exchanges located in New York City where
OTC represents the Over the Counter market which is in reality a
communication network and does not have a specific geographic location.
 e. The primary market for corporate stock offerings is the market in which issues
of preferred stock or common stock are initially sold to investors by the firm
to acquire new capital for internal uses. The secondary market for securities is
where outstanding issues are traded among investors.

f. The (secondary) bond market can be divided into a corporate bond market and
the government bond market. While corporate bonds can be traded on one of
the organized exchanges or in the OTC market, government bonds are traded
only in the latter market.

g. The Option market consists of option trading on the Chicago Board of Options
Exchange, the American Stock Exchange, the Philadelphia Stock Exchange,
the Pacific Stock Exchange and the New York Stock Exchange.
Commodities and financial futures are traded on the NYSE, the CBOT, and
the CME.

3. Using accounting information may cause several types of classification errors. One
classification error occurs when a bookkeeper enters an item in the wrong
account. The difference between accountancy and finance theory is another case
of classification error. An accountanat defines income as the change in
shareholder’s wealth due to operations of the firm. This includes the use of
accruals in wealth determination. However, the finance discipline defines a firm’s
income as cash income, or the difference between cash revenue and cash
expenses. Due to the accruals used in accounting, accounting income is
numerically different from cash income because of a difference in timing.
Moreover, different ways in dealing with depreciation and the use of historical
costs for pricing an asset acquisition also cause some problems in using
accounting information.

There are three possible methods to improve the representativeness or accuracy of

accounting information in financial analysis and planning, the use of alternative
information, the use of statistical tools, and the use of finance and economic
theories.

4. The major difference between linear and nonlinear breakeven analysis is that
linear analysis implies that the firm operates in a perfect product market for its
outputs and that the cost of material and labor is constant. If economies of scale
 are nonlinear, then nonlinear breakeven analysis should be used. (See Figure 2-2
and 2-3 on pages 33 and 34, respectively, of the text.)

5. Ratio analysis puts together different pieces of data on an equivalent base, which
increases the usefulness of the data. Analysis of a series of ratios can give us a
clear picture of a firm’s financial condition and performance. There are two types
of ratio analysis. According to one method, the analyst can compare the ratio of
one firm with those of similar firms or with industry averages at a specific point in
time. The other ration analysis method involves the comparison of a firm’s present
ratio with its historical and expected ratios. This form of time-series analysis will
indicate whether the firm’s financial condition has improved or deteriorated. Both
types of ration analysis can take on two forms: static determination and analysis,
or dynamic adjustment and its analysis.

The dynamic adjustment process can improve our ability to compare

companies with one another and forecast future ratios. It involves regressing
current ratios against past ratios to help one analyze the dynamic nature and the
adjustment process of a firm’s financial ratio. This regression postulates that at
any time, t, only a fixed fraction of a desired adjustment (toward a target ratio) is
achieved in that period. Two conflicting costs can be attributed with inducing such
gradualism into the adjustment process; (1) the cost of adjustment, and, (2) the
cost of being out of equilibrium.

Target ratios are often determined by using an industry average as proxy for the
target ratio. Individual ratios can be weighted according to equal weights, asset
weights, or sales weights. The extent to which firm size, as measured by asset
base or market share, affects the relative level of a firm’s ratios and the tendency
for other firms in the industry to adjust toward the target level must be
determined. Calculating coefficients of variation for a number of ratios under each
of the weighting schemes and choosing the scheme the consistently has the lowest
coefficients of variation is one such method. The most appropriate weighting
scheme can then be used to calculate the target ratio.

6. CVP is a synthesized analysis of the income statement. Technically, ratio variable

inputs are required for performing these analyses. Conceptually, CVP is designed
to analyze the income statement in terms of an aggregated ratio indicator. Hence it
can be regarded as one kind of financial ratio analysis.
 The basic type of CVP analysis if break-even analysis, which can be
extended to operating and financial leverage analysis. Both CVP and break-even
analysis can be integrated with the NPV method of capital budgeting decisions to
do financial analysis (see Chapter 9 for detail).

7. There are three ways of describing income: accounting earnings, finance income,
and economic income. Accounting earnings are based on recorded transactions
according to generally accepted accounting principles using accruals and
deferrals, rather than cash flows. Whereas accounting earnings measure only the
change in wealth due to realized gains and obvious losses, economic income
measures the change in wealth based on both realized and unrealized gains and
losses. Finance income is based on cash flow changes in wealth, that is, cash
revenues less cash expenses. Technically, economic and (or finance) income
rather than accounting earnings should be used to determine the value of a firm;
but because it is not directly observable, accounting earnings are generally used as
a proxy for them.

8. To obtain estimates of Aj and Bj, we want to find the equation that minimizes the
errors sum of squares (ESS) as defined as

. In order to minimize the value of

ESS, we take the derivative of ESS with respect to A j and Bj and set the results
equal to zero, as:

and

Solving for Aj and Bj by formulating a two-equation simultaneous system and by

using Cramer’s Rule, we have

and
.

9. To solve this question, we first define the related formulae as

1)
 2)

3)

4)

5) Growth rate = (retention rate)(IRR)

For these formula and related income statement, procedure, and concept, we can
obtain:
a) I = $33,333

b) F= $66,667

c) DOL = 1.5

d) Break-even quantity (Q*) = 33,333 units

e) EAIT = $20,000

f) TAX = $80,000

g) Return on NW = ROE = .05 or 5%

h) Return on total asset = NI/TA = .033 or 3.3%

i) EPS = 20,000/10,000 = $2.00

j) P/E = 40/2 = 20

k) Pay-out ratio = 1/2 or .50

l) g = br = 1/2 (IRR) = 4%

m) Required rate of return =

n) Asset turnover = Sales/TA = .667 or 2/3

o) Using results of a) － n), finance theory discussed in later chapters and other

related concepts, the financial position of this firm can be analyzed.

p) An interval inference approach can be used to analyze some of the important

financial variables and do related analysis for the XYZ company.

10. Using 1952-79 yearly data and the partial adjustment model as defined in equation
 (2.4) on page 30, we can obtain two partial ratio adjustment models:

Current .14318 .37066

Ratio (1.967073)* (2.32609)* .14504
Leverage .17514 －1.8242
Ratio (1.998433)* (－2.229759) .13252

These results can be used either to forecast or to analyze the financial ratio
behavior.

= adjusted coefficient of determination (multiple R2)

* Indicates that the coefficient is statistically significant at 95% level.

11.

a. EAIT = [(P-V)(Q)-F](1-T)
= [(20 - 10)(10,000) - 50,000] (1 - .5) = 25,000

b. Breakeven quantity:

c.

d. Yes, ABC Company should produce more if price is greater than variable
cost. The DOL of 2 means that for a 1% increase in sales, profits should
increase by 2%.

12.
Expected Net Income = (0.3)[(1000)(10-5){1-.5)]
+ (0.4)[(2000)(20-10)(1-.5)]
+ (0.3)[(3000)(30-15)(1-.5)]
- (15,000) (1-.5)
= $4,000
13. Depreciation example:

A piece of capital equipment has a 5 year life which is estimated to be worth

50,000 hours of productive capacity. It originally cost $160,000. Its salvage value
in 5 years is $10,000.

Straight Line

Sum of the Years Digit

Sum of the years = 5 + 4 + 3 + 2 + 1 = 15

Yr 1 depreciation = (5/15)(160,000 - 10,000) = 50,000

Yr 2 depreciation = (4/15)(160,000 - 10,000) = 40,000
Yr 3 depreciation = (3/15)(160,000 - 10,000) = 30,000
Yr 4 depreciation = (2/15)(160,000 - 10,000) = 20,000
Yr 5 depreciation = (1/15)(160,000 - 10,000) = 10,000

NOTE: As a check students can add the depreciation amounts for the five years
and find that they total $150,000 which is the total amount of the depreciation for
the asset.

Double Declining Balance

Since the straight line rate is (1/n years) or (1/5), the double declining balance rate
is 2(1/5) or (2/5).
Further, while total depreciation over 5 years should equal $150,000 or cost less
salvage value, the method uses calculations based on cost of $160,000. Note how
this is dealt with in year 5 in the following example.

Year Calculation Annual Accumulated

 Depreciation Depreciation
1 (2/5)(160,000) $64,000 $64,000

2 (2/5)(160,000 - 64,000) 38,400 102,400

3 (2/5)(160,000 - 102,400) 23,040 125,440

4 (2/5)(160,000 - 125,440) 13,824 139,264

5 150,000 – 139,264 10,736 150,000

NOTE: Students may attempt to calculate depreciation for year 5 as follows:

(2/5)(160,000- 139,264) = 8295.60
The problem with this is that the accumulated depreciation in year 5 will only be
147,559.60 which is less than the needed $150,000.

Units of Production
The 50,000 hours of productive capacity are assumed to be distributed as follows:

Year 1 12,000 hours

Year 2 13,000 hours

Year 3 11,000 hours

Year 4 10,000 hours

Year 5 4,000 hours

Annual
Year Calculation
Depreciation

1 $3,00(12,000) 36,000

2 $3,00(13,000) 39,000

3 $3,00(11,000) 33,000
 4 $3,00(10,000) 30,000

5 $3,00(4,000) 12,000

NOTE: Annual depreciation totals $150,000 which is the difference between cost
and salvage value.

14.

a.

b.

15.

a.

b.

16. The total asset utilization ratio is low indicating an overinvestment in total assets
relative to sales. The average collection period and inventory turnover ratios are
satisfactory indicating that the firm’s investment in accounts receivable and
inventory, respectively are in line. However, the fixed asset utilization ratio
indicates that the firm does have an overinvestment in fixed assets to which the
low total asset utilization ratio could be attributed.

17.
a. Liquidity Ratios
 The current ratio of Wallace ranges from 1.31 in 1987 to 1.47 in 1988
compared to the industry average of 1.2. Thus, Wallace is in a slightly better
position in terms of liquidity. However, the drop in 1987 should be
investigated to find out whether the sharp decrease can be explained by some
extraordinary circumstances or if the firm’s liquidity is deteriorating,

b. Asset Management Ratios

The average collection period increases from 33 days in 1986 to 37 days in
1987 but then drops to 32 days in 1988. The industry average is 34 days.
There is a similar trend in the inventory turnover ratio. This indicates that the
company’s working capital management is comparable with the average
industry performance. However, the same can not be said about the fixed asset
utilization. After dropping from 2.60 in 1986 to 2.44 in 1987, it improves to
2.56 in 1988, however, the 1988 figure is still below the industry average of
2.80. If we consider the fact that the liquidity and working capital turnover
ratios are better than the industry ratios, then it seems that the company has
excess capacity. This is further supported by the total asset turnover ratio of
1.40 in 1988 which is better than the industry average of 1.20.

c. Capital Structure Ratios

There has been a questionable trend in various leverage ratios over the three
year period. The leverage ratios are above the norm and the interest coverage
ratio is below the industry average in 1986. But the continuous decline makes
these ratios comparable with the industry ratios. Although Wallace is about
average in terms of financial leverage, the interest coverage ratio is
substantially higher than the norm indicating that the company has excellent
debt servicing capacity.

d. Profitability ratios
The profitability of Wallace has improved over the years. While the
company is in poor shape in 1986, profitability subsequently improves and is
comparable to the industry standards in 1987 and 1988. The company’s ROE
of 12% in 1987 and 1988 is still lower than the industry average of 13% but is
still substantially improved from its 1986 level of 6%.

18.
a. The ratios for 1985 and 1986 for Nelson are given below:
 Nelson Industry
1) Current Ratio 2.33 3.40
2) Quick Ratio 1.41 2.43
3) Average Collection Period 107.55 88.65
4) Inventory Turnover 3.56 6.46
5) Fixed Asset Turnover 2.00 4.41
6) Total Asset Utilization 0.80 1.12
7) Debt to Total Equity 0.92 0.34
8) Debt to Total Assets 0.48 0.25
9) Times Interest Earned 10.08 12.00
10) Return on Total Assets 10.87% 12.00%
11) Return on Equity 20.87% 18.00%
12) Net Profit Margin 13.59% 12.00%

b. Nelson’s ROE and net profit margin are better, though only slightly, than the
industry averages. Elsewhere, the company’s ratios are below the industry
standards. The company’s liquidity, turnover and leverage ratios are especially
weak compared to those of the industry.