2-1 a further look at financial statements accounting, fifth edition 2

2-1

A FURTHER LOOK AT FINANCIAL STATEMENTS

Accounting, Fifth Edition

2

2-2

After studying this chapter, you should be able to:After studying this chapter, you should be able to:

1. Identify the sections of a classified balance sheet.

2. Identify tools for analyzing financial statements and ratios for

computing a company’s profitability.

3. Identify and compute ratios for analyzing a company’s liquidity and

solvency using a balance sheet.

4. Explain the meaning of generally accepted accounting principles.

5. Discuss financial reporting concepts.

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

2-3

Communicating with UsersCommunicating with UsersCommunicating with UsersCommunicating with Users

Balance Sheet Reports assets and claims

to assets at a specific

point in time.

Assets = Liabilities +

Stockholders’ Equity.

Lists assets first, followed

by liabilities and

stockholders’ equity.

Illustration 1-7

Helpful Hint The heading of a balance sheet must identify the

company, the statement, and the date.

2-4

The The ClassifiedClassified Balance Sheet Balance SheetThe The ClassifiedClassified Balance Sheet Balance Sheet

LO 1 Identify the sections of a classified balance sheet.

Presents a snapshot at a point in time.

To improve understanding, companies group similar

assets and similar liabilities together.

Illustration 2-1Standard Classifications

2-5

Illustration 2-2

The Classified Balance Sheet - AssetsThe Classified Balance Sheet - AssetsThe Classified Balance Sheet - AssetsThe Classified Balance Sheet - Assets

LO 1

2-6

Classified Balance Sheet – Current AssetsClassified Balance Sheet – Current AssetsClassified Balance Sheet – Current AssetsClassified Balance Sheet – Current Assets


Assets that a company expects to convert to cash or use

up within one year or the operating cycle, whichever is

longer.

Operating cycle is the average time it takes from the

purchase of inventory to the collection of cash from

customers.

Common types of current assets are (1) cash, (2)

investments, (3) receivables, (4) inventories, and (5)

prepaid expenses.

Current Assets

2-7

Classified Balance Sheet – Current AssetsClassified Balance Sheet – Current AssetsClassified Balance Sheet – Current AssetsClassified Balance Sheet – Current Assets


Companies list current asset accounts in the order they expect to convert them into cash.

Current AssetsIllustration 2-3

2-8

Classified Balance Sheet – LT InvestmentsClassified Balance Sheet – LT InvestmentsClassified Balance Sheet – LT InvestmentsClassified Balance Sheet – LT Investments

LO 1

Investments in stocks and bonds of other corporations that

are held for more than one year.

Long-term assets such as land or buildings that a company

is not currently using in its operating activities.

Long-term notes receivable.

Long-Term Investments

Illustration 2-4

Alternative TerminologyLong-term investments are often referred to simply as investments.

2-9

Property, Plant, and Equipment

Classified Balance Sheet – PP&EClassified Balance Sheet – PP&EClassified Balance Sheet – PP&EClassified Balance Sheet – PP&E


Long useful lives.

Currently used in operations.

Includes land, buildings, equipment, delivery vehicles, and

furniture.

Depreciation - allocating the cost of assets to a number of

years.

Accumulated depreciation - total amount of depreciation

expensed thus far in the asset’s life.

Alternative TerminologyProperty, plant, and equipment is sometimes called fixed assets or plant assets.

2-10

Classified Balance Sheet – PP&EClassified Balance Sheet – PP&EClassified Balance Sheet – PP&EClassified Balance Sheet – PP&E


Illustration 2-5

Property, Plant, and Equipment

2-11

Intangible Assets

Classified Balance Sheet – Intang AssetsClassified Balance Sheet – Intang AssetsClassified Balance Sheet – Intang AssetsClassified Balance Sheet – Intang Assets

LO 1

Assets that do not have physical substance.

Includes goodwill, patents, copyrights, and trademarks or trade names.

Illustration 2-6

Helpful Hint Sometimes intangible assets are reportedunder a broader heading called “Other assets.”

2-12

Ex 2-4Ex 2-4Ex 2-4Ex 2-4

2-13

Illustration 2-2

Classified Balance Sheet - LiabilitiesClassified Balance Sheet - LiabilitiesClassified Balance Sheet - LiabilitiesClassified Balance Sheet - Liabilities

LO 1

2-14

Classified Balance Sheet – Current LiabsClassified Balance Sheet – Current LiabsClassified Balance Sheet – Current LiabsClassified Balance Sheet – Current Liabs


Obligations the company is to pay within the next year or

operating cycle, whichever is longer.

Common examples are accounts payable, salaries and

wages payable, notes payable, interest payable, and income

taxes payable.

Also included as current liabilities are current maturities

of long-term obligations—payments to be made within the

next year on long-term obligations.

Current Liabilities

2-15

Classified Balance Sheet – Current LiabsClassified Balance Sheet – Current LiabsClassified Balance Sheet – Current LiabsClassified Balance Sheet – Current Liabs


Illustration 2-7

Current Liabilities

2-16

Classified Balance Sheet – LT LiabsClassified Balance Sheet – LT LiabsClassified Balance Sheet – LT LiabsClassified Balance Sheet – LT Liabs


Obligations a company expects to pay after one year.

Include bonds payable, mortgages payable, long-term

notes payable, lease liabilities, and pension liabilities.Illustration 2-8

Long-Term Liabilities

2-17

Classified Balance Sheet - EquityClassified Balance Sheet - EquityClassified Balance Sheet - EquityClassified Balance Sheet - Equity


Illustration 2-2

Common stock - investments of assets into the business by

the stockholders.

Retained earnings - income retained for use in the business.

Stockholders’ Equity

2-18

CL Salaries and wages payable LTI Investment in real estate

NA Service revenue PPE Equipment

CL Interest payable PPE Accumulated depreciation

IA Goodwill CA Debt investments (short-term)

NA Depreciation expense SE Retained earnings

LTL Mortgage payable CL Unearned service revenue

(due in 3 years)

Match each of the items to its proper balance sheet classification,

shown below. If the item would not appear on a balance sheet, use “NA.”

Current assets (CA) Current liabilities (CL)

Long-term investments (LTI) Long-term liabilities (LTL)

Property, plant, and equipment (PPE) Stockholders’ equity (SE)

Intangible assets (IA)

Solution

LO 1

2-19

Using the Financial StatementsUsing the Financial StatementsUsing the Financial StatementsUsing the Financial Statements

Ratio Analysis – Tells the real story

Ratio analysis expresses the relationship among selected

items of financial statement data.

A ratio expresses the mathematical relationship between

one quantity and another.

A single ratio by itself is not very meaningful.

LO 2 Identify tools for analyzing financial statements and ratios for computing a company’s profitability.

2-20

Using the Financial StatementsUsing the Financial StatementsUsing the Financial StatementsUsing the Financial Statements

LO 2 Identify tools for analyzing financial statements and ratios for computing a company’s profitability.

Illustration 2-9 Financial ratio classifications

2-21

Financial Ratios for Ch 2Financial Ratios for Ch 2Financial Ratios for Ch 2Financial Ratios for Ch 2

Earnings per Share Earnings per Share (Profitability ratio)(Profitability ratio)

Net Income – Preferred DividendsNet Income – Preferred Dividends

AverageAverage Common Shares Outstanding Common Shares Outstanding

Working Capital Working Capital (Liquidity ratio)(Liquidity ratio)

Current Assets – Current LiabilitiesCurrent Assets – Current Liabilities

Debt to Assets Debt to Assets (Solvency ratio)(Solvency ratio)

Total LiabilitiesTotal Liabilities

Total AssetsTotal Assets

2-22LO 2

Using the Income StatementUsing the Income StatementUsing the Income StatementUsing the Income Statement

Illustration: Earnings per share (EPS) measures the net income earned on each share of common stock.

$1,277

(393

- $0

+ 419) 2=

$3.14

$1,317

(419

- $0

+ 414) 2=

$3.16

Illustration 2-11

Best Buy

Profitability Ratio

2-23

Using the Using the Financial Financial StatementsStatements

Using the Using the Financial Financial StatementsStatements

Using a

Classified

Balance Sheet

Illustration 2-13

2-24

Using a Classified Balance SheetUsing a Classified Balance SheetUsing a Classified Balance SheetUsing a Classified Balance Sheet

LO 4 Identify and compute ratios for analyzing a company’s liquidity and solvency using a balance sheet.

Liquidity—the ability to pay obligations expected to become

due within the next year or operating cycle.Illustration 2-14

Working capital is the difference between the amounts of current assets and current liabilities.

Best Buy had working capital in 2011 of $1,810 million ($10,473 million - $8,663 million).

2-25


Liquidity ratios measure the short-term ability to pay maturing

obligations and to meet unexpected needs for cash.Illustration 2-15

For every dollar of current liabilities, Best Buy has $1.21 of current assets.


Liquidity Ratio

2-26

Solvency—the ability to pay interest as it comes due and to

repay the balance of a debt due at its maturity.

Solvency ratios measure the ability of the company to

survive over a long period of time.



Helpful Hint Some users evaluate solvency using a ratio of liabilities divided by stockholders’ equity. The higher this “debt to equity” ratio, the lower is a company’s solvency.

2-27

The 2011 ratio means that every dollar of assets was financed by 59 cents of debt.


Debt to assets ratio measures the percentage of total financing

provided by creditors rather than stockholders.Illustration 2-16


Solvency Ratio

2-28

Do it! Review 2-3 (a-b) page 76Do it! Review 2-3 (a-b) page 76Do it! Review 2-3 (a-b) page 76Do it! Review 2-3 (a-b) page 76

2-30

Financial Reporting ConceptsFinancial Reporting ConceptsFinancial Reporting ConceptsFinancial Reporting Concepts

The Standard-Setting Environment

International Note Over 115 countries use international standards (called IFRS).

LO 6 Explain the meaning of generally

accepted accounting principles.

U.S. Global

Rule Maker FASB (Fin’l Acctg Stds Board) issues broad & specific US accounting principles.

IASB (Int’l Acctg Stds Board ) issues preferred accounting practices in other countries.

Rules GAAP (Generally Accepted Accounting Principles)

IFRS (Int’l Financial Reporting Standards)

Police/Enforcers SEC (Securities & Exchange Commission)

IFRS not enforceable BUT recommended.

US Reqm’ts US GAAP req’d for US SEC Registrants

IFRS or GAAP for non-US SEC Registrants

It seems unlikely that IFRS will be mandated soon given the new SEC Chairman’s focus on investor

protections & securities law enforcement. However US GAAP & IFRS accounting standards continue to converge SO US companies are being impacted by

IFRS. (Apr 2013)

2-31

IdentifiesIdentifies

RecordsRecords

CommunicatesCommunicatesRelevantRelevant

ReliableReliable

ComparableComparable

AccountingAccountingis a

system that

information

that is

to help users make better decisions.

to help users make better decisions.

GAAP

Importance of AccountingImportance of AccountingImportance of AccountingImportance of Accounting

2-32


Qualities of Useful Information

LO 7

According to the FASB, useful information should possess two

fundamental qualities, relevance and faithful representation.

Relevance Accounting information has relevance if it would

make a difference in a business decision. Information is

considered relevant if it provides information that has

predictive value, that is, helps provide accurate expectations

about the future, and has confirmatory value, that is,

confirms or corrects prior expectations. Materiality is a

company-specific aspect of relevance. An item is material

when its size makes it likely to influence the decision of an

investor or creditor.

2-33



According to the FASB, useful information should possess two

fundamental qualities, relevance and faithful representation.

Faithful Representation Faithful representation means

that information accurately depicts what really happened. To

provide a faithful representation, information must be

complete (nothing important has been omitted), neutral (is

not biased toward one position or another), and free from

error.

LO 7 Discuss financial reporting concepts.

2-34


Enhancing Qualities

Comparability results when

different companies use the same

accounting principles.

Consistency means that a company uses the same accounting

principles and methods from year to year.

Information is verifiable if independent

observers, using the same methods, obtain

similar results.

For accounting information to have relevance, it must be

timely.

Information has the quality of

understandabilityif it is presented in a clear and concise

fashion.



2-36


Assumptions in Financial Reporting


Monetary Unit Economic Entity

Illustration 2-18

Requires that only those things that can be expressed in money are included in the

accounting records.

States that every economic entity can be separately

identified and accounted for.

2-37


Assumptions in Financial Reporting


Illustration 2-18

Going Concern

The business will remain in operation for the

foreseeable future.

Periodicity

States that the life of a business can be divided into

artificial time periods.

2-38


Principles in Financial Reporting


Measurement Principles

Historical Cost Fair Value Full disclosure

Or cost principle, dictates that

companies record assets at their

cost.

Indicates that assets and

liabilities should be reported at fair value (the price

received to sell an asset or settle

a liability).

Requires that companies disclose all circumstancesand events that would make a difference to

financial statement users.

2-39


Cost Constraint

Cost Constraint

Accounting standard-setters weigh the cost that companies will incur to provide the information against the

benefit that financial statement users will gain from having the

information available.


2-1 a further look at financial statements accounting, fifth edition 2

Documents