how to read and interpret financial statements: a guide to understanding what the numbers really

How to Read and Interpret Financial Statements

Second Edition

A Guide to Understanding What the Numbers Really Mean

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How to Read and Interpret Financial Statements

Second Edition

A Guide to Understanding What the Numbers Really Mean

Michael P.Griffin

How to Read and Interpret Financial Statements, Second EditionA Guide to Understanding What the Numbers Really Mean© 2015 American Management Association. All rights reserved. This material may not be reproduced, stored in a retrieval system,or transmitted in whole or in part, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise,without the prior written permission of the publisher.

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ISBN 13: 978-0-7612-1559-2

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About This Course ixHow to Take This Course xiPre-Test xiii

1 Understanding Financial Statements 1IntroductionAccounting Is More an Art Than a ScienceInternal UsersExternal UsersBasic Concepts and Principles of Financial Accounting and Financial StatementsGenerally Accepted Accounting Principles (GAAP)Auditor’s ReportsLimitations of Financial StatementsRecapReview QuestionsAnswers to “Think About It…” Questions from This Chapter

2 Types of Financial Statements 19IntroductionElements of Financial StatementsAssetsLiabilitiesEquityInvestments by OwnersDistributions to OwnersRevenuesExpensesGainsLossesThe Balance SheetAssetsLiabilitiesOwners’ EquityIncome StatementSales

Contents

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Cost of Goods SoldStatement of Retained EarningsStatement of Cash FlowsNotes to the Financial Statements and Supplemental InformationManagement’s Discussion and Analysis of Financial Condition andResults of Operation

RecapReview QuestionsAnswers to “Think About It…” Questions from This Chapter

3 The Balance Sheet: Assets 41IntroductionCurrent AssetsCashMarketable SecuritiesReceivablesInventoriesPrepaid Expenses Long-Term InvestmentsCost Method of ValuationEquity Method of Valuation Property, Plant, and EquipmentTangible Fixed AssetsIntangible AssetsWasting AssetsOther AssetsRecapReview QuestionsAnswers to “Think About It…” Questions from This Chapter

4 The Balance Sheet: Liabilities and 57Owners’ EquityIntroductionLiabilitiesCurrent LiabilitiesLong-Term LiabilitiesOff-Balance-Sheet FinancingOwners’ (or Shareholders’) EquityCapital StockAdditional Paid-In CapitalRetained Earnings Treasury Stock


vi HOW TO READ AND INTERPRET FINANCIAL STATEMENTS


5 The Income Statement 71IntroductionIncome Statement FormatComponents of an Income StatementComprehensive IncomeCash Versus Accrual Basis of AccountingCash BasisAccrual BasisApportionment of Revenues and ExpensesPrepaid Expenses Requiring ApportionmentUnearned and Recorded Revenues Requiring ApportionmentUnrecorded Accrued RevenuesUnrecorded Accrued ExpensesValuation of Accounts Receivable and InvestmentsValuation of Marketable Securities


6 The Statement of Cash Flows 83IntroductionThe Usefulness of the Statement of Cash FlowsThe Nature of the Statement of Cash FlowsSignificant Noncash Financing and Investing ActivitiesStatement of Cash Flows: Format AlternativesThe Direct MethodThe Indirect Method

Free Cash FlowRecapReview QuestionsAnswers to “Think About It…” Questions from This Chapter

7 Balance Sheet Analysis 93IntroductionRatios in Financial-Statement AnalysisLimitations of Financial RatiosCategories of Financial RatiosLiquidity RatiosActivity RatiosLeverage RatiosVertical and Horizontal AnalysisRecapReview QuestionsAnswers to “Think About It…” Questions from This Chapter

8 Income Statement Analysis 111Sales

CONTENTS vii



Cost of Goods SoldGross ProfitOperating ExpensesOperating IncomeProfitability RatiosGross Profit MarginOperating Profit MarginProfit MarginReturn on AssetsReturn on EquityEarnings Per ShareLimitations of Financial Ratios Horizontal and Vertical AnalysisRecapReview QuestionsAnswers to “Think About It…” Questions from This Chapter

9 Analysis of Operational Results 123IntroductionCost BehaviorFixed CostsVariable CostsMixed CostsCost-Volume-Profit AnalysisBreak-Even PointThe Graphic Presentation of Break-EvenUsing Break-Even AnalysisContribution MarginAdvantages of Cost-Volume-Profit AnalysisLimitations of Cost-Volume-Profit AnalysisThe Profit-Volume GraphPlotting a Profit Line


Bibliography 137Glossary 139Online Resources 147Post-Test 149Index 155

viii HOW TO READ AND INTERPRET FINANCIAL STATEMENTS


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About This Course

The ability to read and interpret financial statements is a critical skill for anymanager. How to Read and Interpret Financial Statements, Second Edition, teachesreaders to read, understand, and analyze the financial reports that are funda-mental to understanding the overall health of a business. Readers will learn tointerpret balance sheets, income statements, and statements of cash flows froma management perspective. They’ll gain insights into how to view financialstatements in the context of external economic conditions. Readers will learnhow to uncover critical information by applying the right type of analysis—ratio, vertical, horizontal—to the right statement. Written for today’s practi-tioner, How to Read and Interpret Financial Statements, Second Edition, highlightsnew legislation, rules, and standards of practice that affect accounting and fi-nance and thereby the interpretation of financial statements. In each chapter,exhibits, examples, and exercises reinforce the learning and give readers thechance to apply new concepts and practice new skills.

Michael P. Griffin is an instructor of accounting and finance at theCharlton College of Business at the University of Massachusetts Dartmouth.Mr. Griffin received his B.S. in business administration from Providence Col-lege and an M.B.A. from Bryant College. He is a Certified Public Accountant,a Certified Management Accountant, a Certified Financial Manager (Instituteof Management Accountants), and a Chartered Financial Consultant (Amer-ican College). In addition to his teaching experience, Mr. Griffin has held avariety of positions in the areas of auditing, accounting, and finance and is anactive consultant. He is the author of many books and articles on accountingand finance topics, including MBA Fundamentals: Accounting and Finance, pub-lished by Kaplan Publishing. He has also been a content developer for financeand accounting learning systems (software) for publishers such as McGraw-Hill and Pearson Education. In addition to his teaching responsibilities at theCharlton College of Business, Professor Griffin has held the position of As-sistant Dean and is currently the internship director.

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How to Take This Course

This course consists of text material for you to read and three types of activ-ities (the Pre- and Post-Test, in-text exercises, and end-of-chapter ReviewQuestions) for you to complete. These activities are designed to reinforce theconcepts brought out in the text portion of the course and to enable you toevaluate your progress.

Pre- and Post-TestsBoth a pre-test and a post-test are included in this course. Take the pre-testbefore you study any of the course material to determine your existing knowl-edge of the subject matter. To get instructions on taking the test and havingit graded, please email [email protected], and you will receive anemail back with details on taking your test and getting your grade. This emailwill also include instructions on taking your post-test, which you should doupon completion of the course material.

CertificateOnce you have taken your post-test, you will receive an email with your gradeand a certificate if you have passed the course successfully (70% or higher).All tests are reviewed thoroughly by our instructors, and your grade and acertificate will be returned to you promptly.

The TextThe most important component of this course is the text, for it is here thatthe concepts and methods are first presented. Reading each chapter twice willincrease the likelihood of your understanding the text fully.

We recommend that you work on this course in a systematic way. Onlyby reading the text and working through the exercises at a regular and steadypace will you get the most out of this course and retain what you have learned.



In your first reading, concentrate on getting an overview of the chapter’s con-tents. Read the learning objectives at the beginning of each chapter first. Theyserve as guidelines to the major topics of the chapter and enumerate the skillsyou should master as you study the text. As you read the chapter, pay attentionto the heading and subheadings. Find the general theme of the section andsee how that theme relates to others. Don’t let yourself get bogged down withdetails during the first reading; simply concentrate on remembering and un-derstanding the major themes.

In your second reading, look for the details that underlie the themes.Read the entire chapter carefully and methodically, underlining key points,working out the details of the examples, and making marginal notations asyou go. Complete the exercises.

Exercises and ActivitiesInterspersed with the text in each chapter you will find exercises that take avariety of forms. In some cases, no specific or formal answers are provided.Where appropriate, suggested responses or commentary follow the exercises.

The Review QuestionsAfter reading a chapter and before going on to the next, work through the re-view questions. By answering the questions and comparing your own answersto the answers provided, you will find it easier to grasp the major ideas of thatchapter. If you perform these self-check exercises conscientiously, you willdevelop a framework in which to place material presented in later chapters.

Questions About Grading/Retaking the TestIf you have questions regarding the tests, the grading, or the courses itself,please email Self Study at [email protected] .

If you fail the Post-Test, you have one year to retake the test for one yearafter the course’s purchase date.

xii HOW TO READ AND INTERPRET FINANCIAL STATEMENTS




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Pre-Test

How to Read and Interpret Financial Statements Second Edition

Course Code 98002

INSTRUCTIONS: To take this test and have it graded, please email [email protected]. You will receive an email back with details on taking your test and get-ting your grade.

FORQUESTIONS ANDCOMMENTS: You can also contact Self Study at 1-800-225-3215or visit the website at www.amaselfstudy.org.

Costs that do not change within a workable range of activity are:1.variable.(a)mixed.(b)fixed.(c)direct.(d)

Based on the following facts, what is the break-even point? 2.A company has a fixed cost of $28,000 and a variable cost per unit of $30. The unit’s selling price is $100.300 units(a)200 units(b)400 units(c)500 units(d)

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Based on the following facts, how many units must be sold to earn a3.profit of $700? A company has a fixed cost of $28,000 and a variablecost per unit of $30. The unit’s selling price is $100.410 units(a)401 units(b)400 units(c)470 units(d)

Which of the following ratios is calculated by dividing current assets by4.current liabilities?Quick(a)Current(b)Time interest earned(c)None of the above(d)

Which of the following ratios gives the most conservative indication of5.liquidity?Quick(a)Current(b)Time interest earned(c)None of the above(d)

Which of the following categories of ratios answers the question: 6.How well does the company manage its resources?Liquidity(a)Activity(b)Profitability(c)Leverage(d)

What does the following formula measure?7.Cost of Beginning Inventory + Net Purchases − Cost of Ending Inventory

Cost of goods sold(a)Gross margin(b)Cost of goods available for sale(c)Cost of manufactured goods(d)

Complete the following formula: 8.Gross Profit – Operating Expenses = ____________________________.

Net income(a)Operating income(b)Gross profit(c)Contribution margin(d)

xiv HOW TO READ AND INTERPRET FINANCIAL STATEMENTS



Which is the lowest level of report issued by a Certified Public9.Accountant after developing a working knowledge of the entity andreading the financial statements to confirm that they are in the correctform and free from obvious material errors?Compilation(a)Review(b)Standard Audit(c)Qualified Opinion(d)

One metric that management can calculate to see if there was adequate10.cash flow during the period to keep productive capacity at currentlevels is Free Cash Flow (FCF). FCF is calculated by taking valuesfrom the __________________.balance sheet(a)statement of cash flows(b)retained earnings statement(c)income statement(d)

Which of the following is the organization that is empowered to issue11.statements of financial accounting standards and interpretations?AAA(a)PCAOB(b)FASB(c)IMA(d)

Which of the following is not a current asset of a business?12.Fixed assets(a)Accounts receivable(b)Inventories(c)None of the above, since all are current assets(d)

Which of the following are assets?13.Inventories(a)Accounts receivable(b)Land(c)All of the above(d)

Additional paid-in capital is:14.the same as treasury stock.(a)a type of equity account.(b)always preferred stock.(c)a long-term liability.(d)


PRE-TEST xv


Which of the following is the asset name for amounts due from15.customers for sales made or services rendered on account?Promissory notes(a)Accounts receivable(b)Accruals(c)Interest receivable(d)

Which of the following is not one of the inventory accounts related to16.the products that the company sells?Raw materials(a)Supplies(b)Work-in-process(c)Finished goods(d)

Which of the following inventory methods would result in maximizing17.net income during times of rising prices?Last in, first out(a)First in, first out(b)Average cost(c)Specific identification(d)

Which of the following inventory methods would result in minimizing18.net income during times of rising prices?Last in, first out(a)First in, first out(b)Average cost(c)Specific identification(d)

Which of the following is not a current liability?19.Accounts payable(a)Notes payable (due in six months)(b)Dividends payable(c)Bond due in ten years(d)

Which of the following long-term liabilities creates a lien on company20.property?Bond payable(a)Mortgage payable(b)Zero coupon bond(c)Debenture(d)

Which of the following liabilities rarely carries an interest charge?21.Accounts payable(a)Notes payable(b)Bonds payable(c)Mortgage payable(d)

xvi HOW TO READ AND INTERPRET FINANCIAL STATEMENTS



Which of the following income statement formats shows the most22.detail?Single step(a)Multi-step(b)Cost-of-goods-sold step(c)Contribution margin income statement(d)

The source of payment of current liabilities usually is derived from23.__________________ assets.long-term(a)net (b)current(c)permanent(d)

Under accrual accounting rules, generally, a revenue:24.is any cash inflow into a business during the accounting period.(a)is the result of delivering or producing goods and rendering(b)services.can include an increase in equity from transactions that are not(c)central to the purpose of the firm.is shown on the statement of cash flows.(d)

__________________ income is a company’s change in total25.stockholders’ equity from all sources other than the owners of the firm.Net(a)Extraordinary(b)Comprehensive(c)Interest(d)


PRE-TEST xvii


1Understanding Financial

Statements

Learning Objectives

By the end of this chapter, you should be ableto:

• Identify the two major users of accounting in-formation and explain their specific needs.• List the various entities that influence the de-velopment of Generally Accepted Account-ing Principles (GAAP).• Describe the basic principles of accountingand financial statement preparation.• Explain the differences between financialstatements that have been audited as opposedto those that are only reviewed or compiled.• Identify and explain the limitations of finan-cial statements.

INTRODUCTION

The goal of this course is to help you work with financial statements and tohave a better understanding of what these critical reports convey to managers,creditors, investors, and regulators. Whether you look to invest, to lend, orsimply to manage the resources of a business, you will benefit from delvingdeeper into the underlying assumptions and the pointed messages found infinancial statements.

Financial statements communicate important facts about a firm. Usersof financial statements rely on these facts to make decisions that affect thewell-being of enterprises and the general health of the economy. Therefore,it is essential that financial statements be both reliable and useful for decisionmaking. Useful accounting and finance data is information that makes man-agers more intelligent—it makes managers better decision makers. Reliability

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and usefulness are critical for informed decision making. The concept of usefulinformation is particularly important. Accounting principles and practices haveat their origins the weighty goal of usefulness, and management accounting(to be discussed in a subsequent section of this chapter) is almost exclusivelyguided by the need for management to have information that is useful in thecontext of decision making. For the management accountant, the objective ofusefulness serves as the primary guiding light.

ACCOUNTING ISMORE ANARTTHANASCIENCE

Accounting is a system that collects and processes (analyzes, measures, andrecords) financial information about an organization and reports that infor-mation to decision makers (Libby, Libby, and Short, 2011).

Accounting is often called an art because it is never completely defined;it is in a state of constant flux. This state of change is necessary because of:

The changing needs of financial statement users•The pressures of regulatory bodies•The internal needs of management•Users of financial information fall into two primary groups: internal and

external. The next two sections of this chapter elaborate on the different needsof these two types of users.

Internal UsersInternal users are managers who use financial information to make decisionsthat affect day-to-day operations and to plan future operations. Managerialaccounting systems meet the needs of internal users. Managerial accountingprovides information that enables better internal decision making and can in-clude:

The cost of a product or service•The price to charge for a product or service•The contribution margin of a product or service•Budgets•Variances•Whether to lease or purchase an asset•Whether to make or buy a product•Investment analysis•Capital rationing•Internal users’ needs are often quite different from those of external

users. Whereas the guiding principle of managerial accounting (for internalusers) is simply usefulness, the rules that dictate the reporting of financial ac-counting information to external users are much more specific and compli-cated.

2 HOW TO READ AND INTERPRET FINANCIAL STATEMENTS



External UsersExternal users are not involved in day-to-day operations of the firm, althoughthey do have an interest in the results of those operations. They typically needfinancial information and receive it in the form of annual reports (i.e., reportsto stockholders), quarterly reports (filed with the U.S. Securities and ExchangeCommission), and audited financial statements (balance sheet, income state-ment, and statement of cash flows). External users may be one or more of thefollowing:

Common stock investors•Bondholders•Vendors•Banks•Financial analysts•Potential vendors•Creditors•Credit agencies•Union and trade representatives•Customers•Government regulatory agencies, such as the Securities and Exchange•Commission (SEC)The Public Company Accounting and Oversight Board (PCAOB) •External users work with information generated by the firm’s financial

accounting system and especially the output of that system: the financial state-ments. Financial accounting is the process that results in the preparation offinancial statements for use by external users. Financial accounting is gov-erned by specific rules and procedures, principles, and accepted concepts. Wecall the rules of financial accounting Generally Accepted Accounting Prin-ciples (GAAP). This course does not attempt to educate the student on thedetails of GAAP; however, it is valuable for the financial statement user toknow that the rules of GAAP are guiding lights helping the accountant pre-pare reliable reports. GAAP helps increase the confidence that readers of fi-nancial statements have in the values that are reported.

GAAP has not always been in place. As American industry grew in sizeand complexity and state and federal tax laws evolved, it became necessaryto develop a set of guidelines to regulate the preparation of financial state-ments so that shareholders (nonmanagement owners), taxing authorities, cred-itors, and other interested parties could assess the financial condition ofcompanies consistently. It also would guarantee that users of financial infor-mation would have statements that were reliable. Various organizations re-sponded favorably to this need for generally accepted accounting principles.

Although accounting has been around since around the time of Colum-bus (late 1500s), it is an ever-evolving practice, and through the years, variousorganizations have taken the lead in developing a theory base for accounting.In 1973, a degree of stability was achieved with the establishment of the Fi-nancial Accounting Standards Board (FASB). The goal of the FASB was, andstill is, to develop a constitution or broad conceptual framework for financialaccounting. However, for a principle or concept of accounting to be consid-

UNDERSTANDING FINANCIAL STATEMENTS 3



ered “generally accepted,” it must have substantial support from several in-terest groups. One important group is the Securities and Exchange Commis-sion (SEC), whose role is explained in a later section of this chapter.

FASB is an independent organization consisting of seven full-time membersfrom both the accounting profession and the business sector. The major objectiveof FASB is to review and research accounting issues and to establish accountingstandards. The standard-setting process of FASB is open to the public, and publicparticipation is strongly encouraged. The process of establishing a standard canbe time-consuming; some standards have taken more than a decade to establish.

FASB is independent of the AICPA and is empowered to issue statementsof financial accounting standards as well as interpretations of those statementsor the statements of other bodies. FASB may issue new statements, modify orrevoke existing standards of proceeding boards, and interpret any existingprinciple.

Major accounting research projects are undertaken by a FASB task forceof outside experts. This task force studies existing literature related to themajor project and then issues a discussion memorandum that identifies thebasic premises of the topic. The discussion memorandum is available to thegeneral public, and interested parties are encouraged to comment either inwriting or verbally at a public hearing. Once comments from interested partieshave been considered by FASB, FASB meets to resolve pending issues. (Onceagain, these FASB meetings are open to the public.)

The meeting results in an exposure draft, which is a statement of specificrecommendations. An exposure draft requires a majority approval from FASB inorder for it to be issued to the public. The accounting profession and the businesscommunity have the opportunity to respond to the exposure draft; at the end ofthe exposure period (usually at least 60 days), all comments from interested par-ties are reviewed by FASB. FASB’s review of reactions and comments is analyzed,and the end result is either the issuance of a statement of financial accountingstandards or, in some cases, the abandonment of the project.

FASB statements can create a new standard or re-examine an old one. AFASB interpretation clarifies existing FASB opinions or those of FASB’s pred-ecessors. This prolific body reflects both the rapidly changing profession ofaccounting and the profession’s need to police itself. FASB would rather policethe profession than respond to threats of regulatory action by the government.

Despite a very effective self-regulatory role played by the accountingprofession and FASB, the federal government does influence accounting prac-tices through the SEC. With legislation in 1934, Congress formed the SEC toregulate the issuance and trading of securities by public corporations. TheSEC issues Accounting Series Releases (ASRs) on accounting matters affect-ing the financial reporting by publicly held companies. The primary aim ofthe SEC is to provide potential investors with accurate, consistent informationand to protect them from abuses and false or misleading information.

As a result of the Sarbanes–Oxley Act of 2002, the Public Company Ac-counting Oversight Board (PCAOB) was created. The PCAOB website(pcaobus.org) states that “the PCAOB is a nonprofit corporation establishedby Congress to oversee the audits of public companies in order to protect theinterests of investors and further the public interest in the preparation of in-




formative, accurate, and independent audit reports.” Since the PCAOB issuesauditing standards, it has an impact on the quality of information reported inthe audited financial statements of publicly held corporations.

Several other groups and organizations are also influential in the devel-opment of accounting standards.

The American Accounting Association (AAA) is composed of accounting pro-fessors and practicing accountants. The AAA serves as a critic in apprais-ing accounting practice and recommends improvements through itsquarterly publication, The Accounting Review.

The Institute of Management Accountants (IMA) provides accounting re-search and education for the internal accountant. In addition, the IMAawards the Certificate in Management Accounting (CMA), a well-rec-ognized professional accounting designation.

The state societies of CPAs provide forums and boards for the discussion ofFASB pronouncements and other matters of importance to the profession.

The Internal Revenue Service (IRS) has a strong influence over the use ofaccounting methods. Since tax and financial accounting often have dif-ferent objectives, managers must decide which policies will minimize taxeffects while maximizing income. These conflicts often lead to tax-to-book differences in income.

There is no end to the evolutionary process involved in the developmentof generally accepted accounting principles, as the needs and requirementsof business and government are always changing.

Answers appear at the end of this chapter.

1. Why is accounting more an art than a science? ___________________________________

_________________________________________________________________________

_________________________________________________________________________

2. What dictates the standards to be used by management accountants when preparinginformation for internal use?___________________________________________________

_________________________________________________________________________

_________________________________________________________________________

3. Why is it necessary that financial information to be used by external users be reported inaccordance with GAAP? _____________________________________________________

_________________________________________________________________________

_________________________________________________________________________

Think About It . . .



“Think About It” continues on next page.


4. Match the financial information with the typical user of that information.

A = Internal User B = External User C = Both

___ Analysis of cost components of a product

___ Budget

___ Annual report to stockholders

___ Lease versus purchase analysis

___ Balance sheet

___ Income statement

BASICCONCEPTS ANDPRINCIPLES OFFINANCIALACCOUNTINGANDFINANCIALSTATEMENTS

The various bodies discussed previously exist to ensure that different financialstatements will be uniformly useful. To this end, accountants make severalbasic assumptions. They are:

There exists an accounting entity whose activity can be kept separate from•that of its owners or other business units (separate-entity assumption).The enterprise is assumed to have a life that will continue beyond the cur-•rent accounting cycle (going-concern assumption). Unless stated or dis-closed as otherwise, when a user reads financial statements, he or she is toassume that the business is to operate indefinitely into the future. That iswhy liquidation values of assets are not important. Liquidation values areirrelevant as of the balance sheet date as a going-concern enterprise is noton the verge of liquidation. On the other hand, if the going-concern as-sumption cannot be made, that fact must be disclosed in the financial state-ments, and auditors must also add a “going-concern” explanatory paragraphto their audit reports to call attention to the doubts they might expressabout business continuity.Money is used as a unit of measurement. Accounting records are kept in•monetary units and therefore in the United States, items revealed on thebalance sheet, income statement, and cash flow statement are all in dollarsand cents. The measurement of the activity of a firm is broken down into accounting•cycles of short duration, such as a year. This is to allow information to becollected and reported in a timely manner. This is called the periodicityor time period assumption.



Think About It continued from previous page.


Along with the underlying assumptions used by accountants whenpreparing financial statements, several basic financial accounting principlescan be summarized as follows:

Historical cost is used to record the activities and transactions of a firm. His-•torical cost is a verifiable item and provides an objective basis for valuation.Revenue recognition is made when the earnings process is complete and an•exchange transaction has occurred.Attempts are made to match related costs to recognized revenues (matching•principle). There are generally two types of cost: product and period. Productcosts are usually included as part of inventory and will be recognized in fu-ture periods after the sale of inventory. Period costs are those that are chargedto current operations, such as rent.Full disclosure requires that the information provided be of sufficient detail•and comprehensive enough to allow the user to make adequate decisions.There are conflicting forces at work in this principle that cause trade-offsamong the need for detail, the ability of the accountant to condense detailand keep it understandable, and the need to do this in a cost-effective man-ner. Notes to the financial statements provide additional information be-yond the numbers of the financial statements. For example, a note to afinancial statement can describe the particular inventory method used tovalue the ending inventory and cost of goods sold. Methods such as last in,first out; first in, first out; and average cost are all possible ways of valuinginventory and all give different results. Someone analyzing the financialstatements who wants to understand how the inventory was valued can de-termine that by reading the disclosures in the notes. Other examples ofcommon notes to financial statements include disclosures regarding depre-ciation methods, leases, fair value reporting, and related party transactions.Conservatism prevails; it is the method least likely to overstate assets or in-•flate income. This underscores the general rule that unfavorable events arerecorded immediately. The recording of apparently favorable events mustwait until the favorable outcome is assured. This also leads to the practicethat if alternative accounting methods are available, the accountant shouldchoose the one having the least favorable effect on net income and totalassets. Materiality requires that judgment be used in determining how some trans-•actions are handled. It is similar to the concept of an order of significance;an adjustment for depreciation, for example, may be immaterial (insignif-icant) for a large company. Therefore, the adjustment may not be made. Ifa small company chooses not to make the entry, however, the financial state-ment could be seriously distorted. It is also required that all material dis-closures be made to readers of financial statements. This includes alladditional information that if known by an investor or creditor could in-fluence those parties deciding to invest in or grant credit to the companyrepresented by the financial statements.




Accrual accounting is used as the basis for recording transactions under gen-•erally accepted accounting principles (GAAP). That is, an expense isrecorded when incurred regardless of when the cash payment for the ex-pense is made. Revenues are recorded when a sale is made, not necessarilywhen cash flows occur.


For each of the following, identify with a C (Conservatism) or an F (Full Disclosure) the related ac-counting principle or assumption that underlies the procedure.

5. ___ Inventory should be stated at the lower of cost or market value on the balance sheet.

6. ___ Land is worth (market value) $1,000,000. It was acquired by the company 10 years ago for$300,000 and is still listed on the balance sheet at $300,000.

7. ___ A company’s management believes that it will soon lose a law suit and that the settlementcould be substantial. However, it (management) has not been able to develop a reasonableestimate of the settlement amount. The company’s auditors require that these facts be dis-closed in footnotes to the financial statements.

GENERALLYACCEPTEDACCOUNTINGPRINCIPLES (GAAP)As was previously stated, the combination of basic assumptions and principlesmake up a body of knowledge known as generally accepted accounting prin-ciples (GAAP). These principles reflect the consensus of the accounting pro-fessions at any given point in time. They determine:

What should be recorded as assets and liabilities.1.What changes in asset values and liability balances should be recorded,2.and when they should be recorded.What information needs to be revealed, and how it should be revealed.3.How the financial accounting systems should operate.4.How the financial statements should be prepared and what statements5.should be prepared.

When an accountant performs an audit of a firm’s financial statements,he or she determines whether the statements were prepared according toGAAP. An audit is an investigation conducted by accountants employed by apublic accounting firm. In an audit, the accountants carefully examine a com-pany’s accounting systems, records, and internal controls. This examination





enables the accounting firm to issue an opinion as to the fairness and reliabil-ity of the company’s financial statements.

There are also international standards that companies operating globallymust adhere to when reporting financial position and results of operations.International Financial Reporting Standards (IFRS) are accounting rules forglobal businesses. They have been developed because it is common for share-holders to own companies that deal in international trade and have operationsin many countries. They are particularly important for companies that havedealings in several countries. Investors have been challenged when trying toanalyze global companies and compare financial statements of entities fromdifferent countries with different financial reporting standards.

In the recent past, major economies such as those of the United States,the United Kingdom, Japan, and Germany have had their own standards (ver-sions of GAAP). The difficulty for international investors has been trying torestate or convert accounting information from one country to another tomake financial statements comparable and more easily interpreted. The IFRShas as its goal to harmonize or converge accounting standards used across theglobe into one set of rules. By 2015, U.S. GAAP is expected to be in harmonywith IFRS. In other words, once GAAP is aligned with IFRS, publicly tradedcorporations based in the United States will be issuing financial statementsthat comply with the principles of IFRS.

Auditor’s ReportsThe auditor’s opinion is the result of a process of audit, analysis, and investigation.The opinion deals with the fairness of the financial statements and their con-formity with GAAP, and should disclose any material changes in accountingprinciples. When performing financial audits of public corporations, auditingfirms also issue an audit report on internal controls. Internal controls areprocesses affected by an organization’s structure, work and authority flows, peo-ple, and accounting information systems designed to help the organization ac-complish specific goals or objectives. One important objective of internal controlsis to help promote accurate and reliable financial reporting. Internal controlshave existed in businesses for decades but there has been greater emphasis oninternal controls in recent years with the enactment of the Sarbanes–Oxley Actof 2002, which required improvements in internal controls along with carefuldocumentation of such controls by auditors in U.S. public corporations.

There are two other lower-level reports that an auditor can issue: compi-lation and review. The financial statement user should be aware of the level ofinvolvement contained in each report (audit, compilation, and review). Thisawareness allows the analyst to form a judgment on how much reliance canbe placed on the financial statements that accompany these reports.

AuditThe greatest level of assurance of GAAP compliance is attained when an auditis performed. In an audit, the accountant performs extensive tests of transac-tions and internal controls in order to be reasonably certain that accountingsystems perform as required by GAAP.




According to AU 150 section paragraph .07 of the Generally AcceptedAuditing Standards, an independent auditor “plans, conducts, and reports theresults of an audit in accordance with generally accepted auditing standards.Auditing standards provide a measure of audit quality and the objectives tobe achieved in an audit.” An audit is critical to providing users of financialstatements with the confidence they need to “trust the numbers.”

During an audit, external auditors conduct an extensive investigation(auditing procedures) into many aspects of the business and accounting sys-tems. Confirmation letters are mailed by the accountant to verify such itemsas cash, receivables, and major liabilities.

In an audit, extensive verification work is done on balance sheet itemsand their valuations. In addition, auditing standards call for full disclosure ofmajor nonfinancial items and events, and the auditor works to verify that thesemajor items are revealed as footnotes to the statements.

The audit process concludes with the issuance of an auditor’s opinion.The second paragraph (opinion paragraph) in the unqualified, short-formaudit report used by independent auditors contains the attestation to the in-tegrity of the financial statement. Standard audit reports contain a statement(opinion paragraph) very similar to the following:

In our opinion, the financial statements referred to above presentfairly, in all material respects, the financial position of XYZ, Inc., atDecember 31, 20XX, and the results of its operations and its cashflows for the year then ended, in conformity with accounting prin-ciples generally accepted in the United States of America.

ReviewThe next level of report is the review. In doing a review, the accountant per-forms inquiry and analytical procedures. An inquiry involves asking manage-ment about the company’s accounting methods for recording, classifying, andsummarizing transactions as well as those methods used for accumulating in-formation for disclosure in the financial statements, and reading the minutesthat detail actions taken at meetings of stockholders, boards of directors, etc.

The analysis performed by an accountant when conducting a review ismuch less extensive than auditing procedures and consists of:

Comparison of prior years’ results and balances with current year results•and balancesComparison of budgets and forecasts with actual results•Financial statement analysis, including ratio analysis•Financial statement analysis is done to see whether the current financial

balances and results meet the accountant’s requirement for reasonableness. Itis hoped that the comparisons and analytical techniques will disclose any grosserrors made in recording assets, liabilities, revenues, and expenses.

With a review, the analyst has a greater degree of assurance that the state-ments are materially correct than that obtained with a compilation. However,since an audit is not performed in a review, the accountant cannot express the






opinion that the statements are prepared in accordance with GAAP.Compilation

The lowest level of report is the compilation. When doing a compilation, theaccountant is required only to have a working knowledge of the industry andto read the financial statements to see if they are in the correct form and freefrom obvious material errors. The compilation is a service provided by ac-countants that meets the objective of helping management present financialinformation without performing auditing procedures or providing any assur-ance about the quality of the information being reported. For example, a com-pilation involves no testing of underlying accounting records, no inspectionof source documents, no confirmation of account balances (such as accountsreceivable) and no observation of accounting procedures (such as the countingof merchandise inventory).

The compilation report is issued only for nonpublic entities and it clearlystates that the accountant has “not audited or reviewed the accompanying fi-nancial statements” and stresses that the accountant is not expressing an opin-ion or providing any assurance about whether the financial statements areaccurate.

With a compilation, a reader of the financial statements is assured onlythat the form is correct, that the math is correct, and that nothing appears un-usual. With a compilation report the accountant (CPA) does not render anopinion about the financial statements’ compliance with GAAP. A GAAPopinion is the result of an audit, and an audit is not performed in a compilationengagement.


8. How is compilation of financial statements different from an audit of financial statementsfrom the standpoint of the user (reader, financial analyst, credit analyst, etc.)?

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9. As an external statement user, explain why you would be correct in asking for auditedfinancial statements as opposed to those that were compiled or reviewed by an accountant.

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LIMITATIONS OFFINANCIAL STATEMENTS

The information contained in financial statements should not be seen as acomplete picture. Although the statements may have the appearance of ex-actness, certain limitations exist, and many important factors, including qual-itative variables, are not captured within the financial statements and theirrelated disclosures. For example, a balance sheet provides no way to quantifythe morale of employees or the creative and innovative approaches taken bymanagement. The depth of experience of management and the competitiveadvantages that a firm enjoys because of the knowledge and skills of its em-ployees also do not show up in the financial statements.

Information resources (including the company’s information processingcapabilities), the valuable strategic information contained in its files andservers, and the value of its website with its “hits and unique visitors” cannotbe measured in terms of debits and credits. Nor can the value of the humanresources of a company be represented on a balance sheet.

Many measures of competitiveness are not reflected in financial state-ments. A company’s brand equity and its competitive standing vis-à-vis othercompanies in its industry are hard to judge by examining financial statements.Even when comparing similar firms, difficulties can arise as a result of compa-nies using acceptable but different methods of accounting for similar transac-tions. And despite all the rules, conservative approaches, and accuracy builtinto generally accepted accounting principles, management uses many esti-mates when preparing financial statements. Although much accounting infor-mation is based on objective evidence, some accounts, including receivables,inventory, and depreciation, are estimates and therefore subject to error.

Nonmonetary yet important facts are not disclosed in financial state-ments. In some businesses, management has supplemented the internal re-porting of financial results with what is called the balanced scorecard. Thebalanced scorecard not only reports the traditional measures of financial per-formance—data and metrics gleaned from the financial statements—but alsoreports measures related to customer satisfaction and competitiveness. A com-plete discussion of the balanced scorecard is beyond the focus of this text;however, its use and popularity in the 21st century attest to the limitations ofthe messages of financial statements when it comes to monitoring strategicperformance.

Another limitation of financial statements is that they are not presentedin real time—they are, in fact, historic. Financial statement information canbe stale. The balance sheet is only a snapshot of a very dynamic situation thatwas a reality some time ago. Balance sheet values can change from minute tominute, and although much internal reporting is done in real time, externalreporting (financial statements) cannot be done in real time. Audited state-ments take many months to be issued. An income statement is only a reflectionof the revenues and expenses of a period that has already passed. Markettrends and other changes in the market place are rapid and can change manyassumptions after financial statements have been issued.

Historical costs, which provide the basis for most of the assets reportedon a balance sheet, may not bear any resemblance to and are not usually




correlated to current market values (with a few exceptions, such as inventoryand marketable securities). In addition, historical costs may seem irrelevantonce inflation is considered. The inflationary trend in this country has weak-ened the reliability of financial statements because conventional reportinghas not accounted for the changing dollar value. Since the 1930s, the purchas-ing power of the U.S. dollar has declined significantly as a result of inflation.

On the liability side of things, contingent liabilities (obligations that willoccur if some other event happens) are not reflected on the balance sheet.Some obligations, such as certain leases, are also kept off the balance sheet.

Increases in sales volume near the current end of the price spiral may bethe result of a greater number of units sold. But if the unit volume equals that ofmany previous years, the selling price would have to be increased to keep abreastof the rising level of costs. Therefore, comparison of information over an ex-tended period, without allowing for cyclical trends in the economy, can lead toinconsistent, misleading conclusions. In addition, assets that are recorded andreported at historical cost can be grossly undervalued in terms of today’s dollars.

The list of items not disclosed in financial statements but having an im-portant impact on decision makers is long. Credit ratings, future contractualcommitments, some contingent liabilities, the effectiveness of research anddevelopment, the loyalty of customers, the loyalty and integrity of employees,and the quality of the products are all considerations. When a user does athorough analysis of a company, many of these factors must be taken into ac-count, even though the accounting records will not reveal them. Therefore,there are always some supplemental sources of relevant data that must begathered (beyond the ledgers and statements) and considered when trying toget a holistic picture of an entity.


10. List five events that would not be reflected in the “numbers’’ of financial statements but couldhave a significant impact on the future operation and condition of a firm.

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11. The Purple T-Shirt Company sells its entire product online. Its CPA prepares annual financialstatements showing its cash flows, assets, liabilities, equity, revenues, expenses, and netincome. The financials are done in accordance with GAAP and management analyzes thestatements using traditional methods (such as financial ratios). However, because thebusiness is so dependent on its web business, management would like to see moremeasures of performance, especially those related to the website. What do you thinkmanagement wants to track and analyze beyond what is disclosed by and asserted to in thefinancial statements?








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Accounting is art rather than a science because it is never fullydefined; it is always in a state of change. Managerial account-ing systems meet the needs of internal users, whereas externalusers’ needs are met by financial accounting systems. The sin-gle guiding principle of managerial accounting is usefulness,while financial accounting is governed by generally acceptedaccounting principles (GAAP).

Many organizations have an impact on the development of accountingprinciples, but no organization has more influence than the Financial Ac-counting Standards Board (FASB). Other groups, including the American In-stitute of Certified Public Accountants and the Institute of ManagementAccountants, are also influential in the development of accounting standards.

This chapter summarized some of the basic concepts and principles ofaccounting used in the preparation of financial statements. It is critical thatusers of financial statements understand these concepts to make the analysisof such statements most meaningful. Accounting information users also needto understand the different levels of auditor’s reports, including the stan-dard/unqualified (clean opinion) report, qualified report, compilation, andreview. Unqualified and qualified auditor’s reports and an auditor’s reviewgive some level of assurance about the fairness and accuracy of reports (al-though some are quite limited). A compilation is the lowest level of an ac-countant’s report and only assures that correct form was used and that theunaudited financial statements are free from obvious material errors. No au-diting procedures are performed in the case of a compilation.

Nonaccounting considerations and limitations that affect the analysis andinterpretation of financial statements need to be understood by financial state-ment users and the disclosures made within the notes to the financial state-ments must also be reviewed and understood to get a clear picture of thefinancial health of a company.



INSTRUCTIONS: Here is the first set of review questions in this course. Answering the questions fol-lowing each chapter will give you a chance to check your comprehension of the concepts as they are presentedand will reinforce your understanding of them.

As you can see below, the answer to each numbered question is printed to the side of the question.Before beginning, you should conceal the answers in some way, either by folding the page vertically or byplacing a sheet of paper over the answers. Then read and answer each question. Compare your answerswith those given. For any questions you answer incorrectly, make an effort to understand why the answergiven is the correct one. You may find it helpful to turn back to the appropriate section of the chapter andreview the material of which you are unsure. At any rate, be sure you understand all the review questionsbefore going on to the next chapter.

Accounting as a profession and as a way of reporting financial 1. (d)1.information experiences changes over time. Accounting principles, rules, and procedures change over time as a result of all of the following except:

the changing needs of financial statement users.(a)pressures from regulatory bodies such as the SEC.(b)the needs of management.(c)the U.S. Congress, which requires revisions of accounting rules (d)every five years.

External users of financial statements have access to all of the 2. (d)2.following reports except:

the balance sheet.(a)the income statement.(b)the statement of cash flows.(c)budgets.(d)

Which of the following organizations has as its objective to 3. (b)3.review and research accounting issues and to establish accounting standards in the United States?

PCAOB(a)FASB(b)GAAP(c)SEC(d)

Which accounting principle or assumption would guide a 4. (c)4.bookkeeper or accountant to record a sale of a product because the “earnings process is complete and an exchange has taken place”?

Going concern(a)Historical cost(b)Revenue recognition(c)Full disclosure(d)

Review Questions






Which of the following is an assumption that the company reflected 5. (a)5.in the set of financial statements would be viable and carry on its business indefinitely into the future?

Going concern(a)Historical cost(b)Revenue recognition(c)Full disclosure(d)

ANSWERS TO “THINKABOUT IT . . . ” QUESTIONS FROMTHISCHAPTER

It is never completely defined; it is ever-changing because the needs of financial1.statement users, regulatory bodies, and others are always changing.

Managerial accounting provides financial information that is useful in making2.decisions. Since usefulness is the only guiding light, no standards are necessary.Management accountants prepare internal reports such as budgets, variances, pricingreports, and capital expenditure analyses.

GAAP is a set of guidelines that enables external financial users to assess financial3.conditions consistently. GAAP also assures that these users will be confident thatfinancial statements are reliable.

A4.ABACC

C5.

C6.

F7.

The user of a financial statement that has been audited by external auditors has a much8.higher confidence level that the statements have been prepared in accordance withgenerally accepted accounting principles (GAAP). If it is a clean opinion (unqualifiedopinion), there is also an assumption that the statements are reasonably free from errorsand material misstatements. A qualified opinion will tell the reader that except forcertain issues, the statements are in good shape, whereas an adverse opinion willdisclose serious problems with the financial statements. With a compilation report, theaccountant does not render an opinion about the financial statements’ compliance withGAAP. The accountant performs limited procedures and relies very heavily onmanagement when “compiling” financial statements. A GAAP opinion is the result ofan audit, and an audit is not performed in a compilation engagement.




Audited statements: You can be confident that the statements were reviewed by an9.independent third party (CPA) and an opinion stating whether the statements werepresented fairly and in conformance with GAAP has been made. More extensiveprocedures have been used by the auditor/accountant in issuing an audit report asopposed to a review or compilation. A review does involve more extensive proceduresthan a compilation; however, only inquiries of management and analytical proceduresare done in a review whereas a compilation only assures that the form of the financialstatements is correct, the math is correct, and that nothing appears unusual, but noopinion is issued by the accountant as to compliance with GAAP.

There can be any number of correct answers, but examples could include:10.management expertise, product quality, trade secrets, valuable patents, companyreputation and goodwill, product quality, credit rating, effectiveness of R&D (researchand development), and the loyalty and integrity of employees.

With a website, profitability is important (net income); however, other measures are11.also critical success factors such as page views, unique visitors, bounce rates, andwebsite conversion rates. Those types of metrics cannot be generated or derived froma set of financial statements.


2Types of Financial

Statements

Learning Objectives


• Identify the four key financial statements.• Describe what each type of financial state-ment presents to the reader.• Identify the major components of each typeof financial statement.• State the basic accounting equation.• State the formula for the statement of re-tained earnings.• List the things to look for in the notes to thefinancial statements.

INTRODUCTIONChapter 2 will familiarize you with the four key financial statements: the bal-ance sheet, the income statement, the statement of retained earnings, and thestatement of cash flows. The accounting profession strives to provide the fi-nancial statement user with a consistent, informative document that disclosesmajor revenue, expense, asset, liability, and equity balances in an accuratemanner. This consistent disclosure is especially important to people outsidea firm, such as an outside financial analyst, because the financial statementmay be one of the few sources of company information available.

To meet generally accepted accounting principles, all financial state-ments contain the following:

The auditor’s opinion1.Balance sheet2.Income statement3.



Statement of retained earnings4.Statement of cash flows5.Notes to the financial statements6.

In addition to these six items, the financial statements may contain op-tional supplementary schedules for further information.

ELEMENTS OFFINANCIAL STATEMENTSThe Financial Accounting Standards Board (FASB), in its Statement of Fi-nancial Accounting No. 3, defined the elements of financial statements as fol-lows (FASB, 1980):

AssetsAssets are probable future economic benefits obtained or controlled by a par-ticular entity as a result of past transactions or events.

LiabilitiesLiabilities are probable future sacrifices of economic benefits arising frompresent obligations of a particular entity to transfer assets or provide servicesto other entities in the future as a result of past transactions or events.

EquityEquity is residual interest in the assets of an entity that remains after deduct-ing its liabilities. In a business enterprise, the equity is the ownership inter-est.

Investments by OwnersInvestments by owners are increases in net assets of a particular enterpriseresulting from transfers to it from other entities of something of value to ob-tain or increase ownership interests (or equity) in it. Assets are most com-monly received as investments by owners, but that which is received may alsoinclude services, or satisfaction, or conversion of liabilities of the enterprise.In corporations, investments by an owner can take various forms, includingthe purchase of common stock and preferred stock.

Distributions to OwnersDistributions to owners are decreases in net assets of a particular enterpriseresulting from transferring assets, rendering services, or incurring liabilitiesby the enterprise to owners. Distributions to owners decrease ownership in-terests (or equity) in an enterprise. In a corporation, distribution to owners isusually in the form of a cash dividend.




RevenuesRevenues are inflows or other enhancements of assets of an entity or settle-ment of liabilities (or a combination of both) during a period resulting fromdelivering or producing goods, rendering services, or other activities that con-stitute the entity’s ongoing major or central operations.

ExpensesExpenses are outflows or other using-up of assets or incurrence of liabilities(or a combination of both) during a period resulting from delivering or pro-ducing goods, rendering services, or carrying out other activities that consti-tute the entity’s ongoing major or central operations.

GainsGains are increases in equity (net assets) from peripheral or incidental trans-actions of an entity and from all other transactions and other events and cir-cumstances affecting the entity during a period, except those that result fromrevenues or investments by owners.

LossesLosses are decreases in equity (net assets) resulting from peripheral or inci-dental transactions of an entity and from all other transactions and otherevents and circumstances affecting the entity during a period, except thosethat result from expenses or distributions to owners.

These definitions are formal, somewhat difficult to understand, and all-encompassing. To simplify the definitions of the financial statement elementswe will explore first in this chapter—assets, liabilities, and equity—we willuse the following definitions:

Assets are things of value owned by a business.•Liabilities are debts owed by a business.•Equity represents the interest or rights due the owners or shareholders after•all liabilities have been settled.

Assets, liabilities, and equity are presented on the balance sheet and representbalances at a certain point in time. The balance of the elements at that pointin time is the cumulative balance of all transactions since the inception of thebusiness.

The balance sheet elements are affected by other account balances thatare not reported on the balance sheet, such as distributions (dividends) toowners, revenues, expenses, gains, and losses. These items—specifically rev-enues and expenses—summarize transactions over a period of time, for in-stance, from January 1 to December 31 of a particular year, and are presentedon the income statement and the changes in equity statement. Revenue, ex-pense, gains, and loss accounts are often called temporary accounts since theirbalances are closed into the equity account at the end of the period and areset to zero to begin summarizing a new period. The process of closing

TYPES OF FINANCIAL STATEMENTS 21



accounts is similar to resetting a scoreboard back to zero at the end of a game.To this point we have briefly explored the elements of financial state-

ments. The following sections review the components of the various state-ments and their major groupings. We begin exploring the components offinancial statements by first looking at the balance sheet.

THEBALANCE SHEETThe balance sheet is a snapshot of a business at a given date. Also called astatement of financial position or a statement of financial condition, the bal-ance sheet identifies a business’ assets, liabilities, and owners’ equity as of acertain date. An example of a comparative balance sheet is shown in Exhibit2–1. A comparative balance sheet shows balances of accounts as of two dates.The balance sheet is a cumulative document representing the current balancesof the various accounts since the inception of the business to a given point intime.

The balance sheet is the line-by-line version of the basic accountingequation:

Assets = Liabilities + Owners’ Equity

The balance sheet is subdivided into subsections of types of assets, liabilities,and owners’ equity.

AssetsAssets can be subdivided into four major categories:

Current assets1.Long-term investments2.Property, plant, and equipment, including fixed assets (tangible and intan-3.gible) and wasting assets (natural resources)Other assets4.

Current AssetsCurrent assets are those that will most likely be converted into cash, be sold,or be consumed within a period of one year or within the normal operatingcycle of the business. Under the general classification of assets, they form thefirst subcategory in that they are listed first on the balance sheet. Examplesof current assets include:

Cash•Accounts receivable (money owed to the company from customers)•Inventories•






xhibit 2–1Example Company Balance Sheets, Years Ended December 31, 20X1and December 31, 20X2

20X2 20X1

Assets Current Assets:

Cash $ 50,000 $

Marketable Securities 116,006 50,000Accounts Receivable 247,856 224,659 Inventories 1,343,670 1,308,100 Prepaid Expenses 2,247 0

Total Current Assets 1,759,779 1,620,747

Fixed Assets: Property, Plant, and Equipment 860,307 803,518 Less: Accumulated Depreciation 543,426 477,994

Total Fixed Assets 316,881 325,524

Other Assets 6,537 8,537 Total Assets $2,083,197 $1,954,808

Liabilities and Owners’ Equity Current Liabilities:

Notes Payable—Bank $ 55,000 $ 85,000 Current Portion of Long-Term Debt 1,850 5,553 Accounts Payable—Other 642,237 535,610 Notes Payable—Other 134,692 144,692 Accrued Expenses 46,980 47,913 Accrued Income Taxes 10,743 16,064

Total Current Liabilities 891,502 834,832

Long-Term Debt: Notes Payable—Bank 22,818 10,488 Less: Current Portion 1,850 5,553

Net Long-Term Debt 20,968 4,935 Total Liabilities 912,470 839,767

Owners’ Equity Common Stock, issued and Outstanding: 10,000 Shares $10 Par 100,000 100,000 Additional Paid-In Capital 22,643 22,643 Retained Earnings 1,070,584 992,398

1,193,227 1,115,041 Less: Treasury Stock 22,500

Total Owners’ Equity 1,170,727 1,115,041

Total Liabilities and Owners, Equity $2,083,197 $1,954,808


Long-Term InvestmentsLong-term investments include such assets as:

Stocks and bonds owned by the business•Land held for future use or speculative purposes•The cash surrender value of life insurance policies•Investments set aside in special funds, such as pension or plant-expansion•funds

Property, Plant, and EquipmentProperty, plant, and equipment, also called fixed assets, are used in the oper-ation of the business and have a useful life of more than one year. They maybe broken down further into:

Tangible fixed assets•Intangible fixed assets•Natural resources•Property, plant, and equipment can be thought of as assets that businesses

use to produce and distribute goods and services.

Other AssetsThis is a catch-all for assets that cannot be classified properly elsewhere. Ex-amples include:

Long-term, prepaid expenses•Refundable deposits on long-term leases•Organization costs•


1. Match the following accounts with the section of the balance sheet in which they appear. Usethe letters CA to signify current asset, LTI to signify long-term investment, and PPE to signifyproperty, plant, and equipment.

A. _____ Stocks owned by the firmB. _____ Natural resources owned by the companyC. _____ Cash surrender value of life insurance policiesD. _____ CashE. _____ Accounts receivableF. _____ Intangible fixed assetsG. _____ Tangible fixed assetsH. _____ Land held for speculationI. _____ InventoriesJ. _____ Investment set aside for plant expansion





LiabilitiesLiabilities are usually classified in the following major subcategories:

Current•Long-term•Let’s first look at the current liabilities, which, like the current assets, are

listed prior to long-term items.

Current LiabilitiesCurrent liabilities are debts and other liabilities owed by the company thatwill be satisfied within one year. Cash flow from the sale or liquidation of cur-rent assets will, under ordinary circumstances, be used to satisfy the currentliabilities. Current liabilities include:

Accounts payable•Wages payable•Taxes payable•

Long-Term LiabilitiesLiabilities that will not be satisfied within one year are classified as long term.To be more descriptive and therefore disclose more information for the state-ment user, information concerning interest rates, maturity dates, and the na-ture of any security pledged for a long-term debt is usually included on thebalance sheet or in the notes to the financial statements. Examples of long-term liabilities are:

Unsecured bank loans that are payable over a period greater than one year•Bonds that are issued by the firm and that will mature on a date more than•one year into the futureLong-term mortgages•


2. Match the following accounts with the section of the balance sheet in which they appear. Usethe letters CL to signify current liabilities and LTL to signify long-term liabilities.

A. _____ Accounts payableB. _____ Taxes payableC. _____ 30-year mortgageD. _____ Unsecured bank loan due in 30 yearsE. _____ Salaries payable





Owners’ EquityOwners’ equity for a corporation is usually divided into four subcategories:

Capital stock at the par or stated value1.Additional paid-in capital or amounts paid over par2.Retained earnings (representing the undistributed earnings of the entity)3.Treasury stock4.

Capital StockCapital stock is a broad description for the ownership interest in a corporation.The true ownership interest in a corporation is called common stock. Com-mon stock normally carries full ownership rights, including:

The right to receive dividends•The right to vote for directors•The right to receive assets upon the dissolution of the company•The right to maintain proportionate percentage of ownership in the com-•pany through the pre-emptive right to buy new shares of common stockprior to their sale to the general publicThe right to examine the company’s books•There are also many types of nonvoting common stock and classes of

preferred stock. Preferred stock, which is also an ownership interest, may bevoting or nonvoting and usually has preference in the receipt of dividends;thus the term preferred. This preference with respect to dividends means thatthe preferred stockholder will receive the preferred stock cash dividend priorto the common stockholder receiving a common stock cash dividend. How-ever, unlike common stock, preferred dividends are usually fixed; for instance,at a certain percentage of par value. A complete discussion of the various typesof stock is beyond the scope of this course, but the analyst should be aware ofthe types presented in the equity section of a balance sheet. The footnotes toa balance sheet usually contain details concerning capital stocks.

Additional Paid-In CapitalAnother possible equity account is called additional paid-in capital. Additionalpaid-in capital is capital contributed by stockholders and other outsiders. Inother words, it is the total in excess of the par, or stated value of the stock,and is kept separate from retained earnings and capital stock balances. Thepar or stated value is the stated amount of value per share specified in thecorporate charter. Par value is an arbitrary monetary figure that is not to beconfused with the market value of the stock. For example, if the par value ofa common stock was $100 and the company issued 1,000 shares at $150 pershare, there would be $50 per share of paid-in capital, for a total of $50,000of additional paid-in capital. The results of this sale of stock are shown below:

Common Stock (1,000 shares, $100 par) $100,000

Additional Paid-In Capital $50,000

Total Capital $150,000




Some balance sheets, like the one shown in Exhibit 2–1, do not show anamount for additional paid-in capital. This is because some companies do notassign a par value to the stock; rather, the company issues no-par stock. Forexample, assuming the same facts as in the previous example, with the excep-tion that the stock being issued is no par, the total value of the stock being is-sued, $150,000 (1,000 shares × $150 per share), would be recorded as commonstock.

Retained EarningsOnly two things can happen to a company’s earnings: They can be paid to thestockholders in the form of dividends, or they can be reinvested in the com-pany in the form of retained earnings. Retained earnings are accumulatedearnings that are not distributed to the shareholders; they have been retainedto provide for future growth. Retained earnings can be restricted or unre-stricted. Restricted retained earnings do not constitute a pool of resources;they are unavailable for disbursement as dividends.

Treasury StockTreasury stock is the company’s own stock that has been reacquired by thefirm. Shares of stock acquired as treasury stock have not been cancelled orretired, but are being held by the company for possible future resale or reis-suance. There are several reasons why a firm might repurchase its own stock.They include:

The company may wish to change its capital structure and may use the•proceeds from debt or another class of stock to buy back stock.The company may be trying to fight an unfriendly corporate takeover by•buying up the excess shares a suitor would need to gain a controlling in-terest.The stock may be needed to make awards for employee stock plans or stock•option plans.The company may be trying to boost earnings per share.•One misconception is that treasury stock is an asset of the company. As

Exhibit 2–1 shows in the 20X2 column, treasury stock is a negative equity ac-count—it is stock that was once issued but is no longer outstanding. Its balanceis a debit balance, and it is therefore subtracted from owners’ equity.


3. Using the following information, prepare the equity section of the balance sheet. A corpora -tion issues 10,000 shares of $10 par value stock for $35 per share. During the year, it buysback 2,000 shares at $35. The retained earnings balance at year end is $55,000.






Equity section of the balance sheet:

Common stock $_____Additional paid-in capital _____Less: Treasury stock _____Retained earnings _____Total equity $_____


4. Match the following descriptions with the owners’ equity account name:

A. _____ Common or preferred stock issued by the company to raise capitalB. _____ Capital contributed by owners in excess of the par value of the stock

purchased by the ownersC. _____ Accumulated earnings that provide for future growthD. _____ CashE. _____ The company’s own stock that has been reacquired by the company

1. Additional paid-in capital2. Capital stock3. Treasury stock4. Retained earnings

INCOMESTATEMENTThe terms income statement, profit and loss statement, and statement of op-erations all refer to the financial statement that discloses a company’s profitor loss during a specified period of time. The income statement shows rev-enues earned during a period of time, the expenses incurred to produce thatrevenue, and the income or loss for that period.

In a previous section of this chapter, the formal definitions of the termsrevenue and expense were presented. A more informal and possibly easier setof definitions for revenue and expense are as follows:

Revenue—the price of goods sold and services rendered during a given ac-•counting periodExpense—the cost of the goods and services used in the process of earning•revenue








When income statements are prepared, management or its accountantsextract revenues from internal records, sales, and other income totals. Therevenue-recognition principle provides that revenue is recognized when:

The earning process is complete or virtually complete.1.An exchange transaction has taken place.2.

Revenue is usually recognized at the point of sale or transfer of rights tothe goods from the seller to the buyer, i.e., at the time of shipping.

Expenses are subtracted from revenues to arrive at net income or loss forthe period. An accounting principle called the matching concept gives guid-ance on how expenses are to be recognized. The matching concept comparesincurred costs and expenses of a specific accounting period against revenueearned during the same period in order to determine net income earned forthat period. This does not mean that an exact matching must occur. Some-times this precision may be difficult to achieve. Matching means that the pe-riodically recognized revenues presented in the income statement areproperly matched with the identified expenses for the same period.

An illustration of the matching concept is the handling of the cost of ma-chinery acquired by a company. Ordinarily, a machine provides benefits to acompany for more than the period in which it was purchased. Under thematching concept, an apportioning of the cost over the periods benefited isessential for the correct calculation of income. A proper allocation of the costto these periods could be achieved by taking the cost of the asset, reduced byany estimated scrap or residual value, and then dividing it by the number ofaccounting periods served. This allocation of asset cost is called straight-linedepreciation. Exhibit 2–2 shows a comparative example income statementwith net incomes of $78,186 and $117,037 for the years 20X1 and 20X2, re-spectively. It also shows the key components of the income statements as:

Sales•Cost of goods sold•Operating expenses•Other income (other expenses)•Net income (loss)•

SalesThe sales figure on the income statement represents the total of invoices billedto customers during the period covered by the income statement. Therefore,the sales figure usually represents both cash and credit sales. Often, the salesfigure represents net sales. Net sales are defined as the total of invoices billedto customers during the period, less sales discounts and returns and allowances.

The net sales formula is:

Gross Sales – Sales Discounts – Sales Returns and Allowances

Sales discounts are granted to customers who pay bills early. Sales returnsrepresent merchandise that was sold and then returned by the customer. Salesallowances are discounts granted to the customer because the product wasdefective or not up to the quality level expected by the customer.



5. During 20X1, a company had gross sales of $10 million. Of that $10 million in sales, 60percent were cash sales that were granted a 5 percent discount. In addition, $250,000 ofmerchandise that was sold was returned to the company for various reasons, and another$100,000 of allowances were granted to customers after the sale, because the merchandisewas found to be defective. What are the corporation’s net sales for 20X1?

Cost of Goods SoldThe cost of goods sold is composed of those expenses incurred to manufactureor purchase merchandise that has been sold. The cost of goods sold takes intoaccount material costs as well as labor and factory expenses. Often a separatereport, such as the one shown in Exhibit 2–3, called the cost of goods sold, isprepared. The cost of goods sold report shows how the cost of goods sold ex-pense, shown on the income statement, was computed. Sometimes, the costof goods sold calculation is included on the income statement; in that case, acost of goods sold report separate from the income statement is not necessary.The cost of goods sold is found by using the following formula.




xhibit 2–2Example Statement of Income for the 12 Months Ended December 31

20X1 20X2 Sales $8,173,780 $7,341,704

Cost of Goods Sold 5,963,510 5,189,315 Gross Profit 2,210,270 2,152,389

Operating Expenses: Selling and Administrative Expenses 1,994,054 1,887,420 Depreciation 67,933 66,575 Interest 13,026 29,966

Total Operating Expenses 2,075,013 1,983,961

Profit from Operations 135,257 168,428 Other Income 6,429 35,609 Earnings Before Taxes 141,686 204,037 Provision for Income Taxes 63,500 87,000 Net Income $ 78,186 $ 117,037


Beginning Inventory + Purchases and Freight In

− Purchase Returns and Allowances and Discounts on Purchases

− Ending Inventory

By subtracting the cost of goods sold from sales, you derive gross profit.Gross profit is a preliminary indication of profitability. Also called gross profiton sales or gross margin, this profit is called gross because operating expensesmust be subtracted from it.


6. Using the following financial data, calculate the cost of goods sold and gross profit.

Net Sales $1,200,000

Purchases and Freight In $700,00

Purchase Returns and Allowances and Discounts $25,000on Purchases

Ending Inventory $625,000

Beginning Inventory $600,000




xhibit 2–3Cost of Goods Sold Report

Cost of Goods Sold:

Beginning Inventory $1,000 Purchases $500

Freight In 100

Cost of Purchases 600

Less: Purchase Returns and Allowances 50 Discount on Purchases 25 75 525

Cost of Goods Available for Sale 1,525

Ending Inventory 500

Cost of Goods Sold $1,025




Operating ExpensesOperating expenses are the day-to-day expenses incurred in running a firm.Falling into the category of operating expenses are:

Selling and administrative expenses•Depreciation•Interest•If operating expenses are less than gross income, as is the case in Exhibit

2–2, then the result is a profit from operations. If the opposite is true, withoperating expenses greater than gross profit, then the result would be a lossfrom operations.

Other Income (Other Expenses)Revenues from sources other than the principal activity of the business arecalled other income. This type of income is also called non-operating income.Examples of other income include income from investments (such as dividendor interest income), rent, and capital gains from the sale of plant assets. Ex-penses that are not incurred in normal operations are called other expenses.Examples of other expenses could include the loss incurred from the damagescaused by a hurricane.

Net Income (Loss)The bottom-line figure on the income statement is net income (loss). Net in-come increases owners’ equity, whereas net loss decreases owners’ equity. Aswas mentioned in the balance sheet section earlier, only two things can happento net income:

It can be reinvested in the firm (retained earnings).1.All or a portion of it can be paid out to the owners of the firm in the form2.of dividends.

With the income statement completed, the statement of retained earningscan be prepared. In fact, the income statement and statement of retained earn-ings are often combined into one statement.

STATEMENTOFRETAINEDEARNINGSThis statement details the changes in the retained earnings accounts for thesame period as the income statement. The statement consists of the beginningbalance of retained earnings, the net income (loss), any dividends paid out,and the ending balance of retained earnings. The example statement of re-tained earnings shown in Exhibit 2–4 is based on the information given in thefinancial statements shown in Exhibits 2–1 and 2–2. The formula for the state-ment of retained earnings is as follows:

Beginning Retained Earnings + Net Income – Dividends

= Ending Retained Earnings



7. Match the items shown below with the financial statement on which they appear. Use theletters IS for the income statement, SRE for the statement of retained earnings, or BOTH, ifthe account appears on both the statement of retained earnings and the income statement.

a. ____ Net incomeb. ____ Dividendsc. ____ Beginning retained earningsd. ____ Net salese. ____ Ending retained earnings

8. Match the following accounts with the statement where they appear. Use the letters BS tosignify balance sheet, IS for income statement, and SRE for statement of retained earnings.

a. ____ Dividends paid by the corporation to stockholdersb. ____ Current liabilitiesc. ____ Cost of goods soldd. ____ Additional paid-in capitale. ____ Mortgage payablef. ____ Net salesg. ____ Sales returns and allowancesh. ____ Other incomei. ____ Long-term investmentsj. ____ Selling and administrative expenses

9. Assume a company had beginning retained earnings of $100,000. Calculate ending retainedearnings under each of the following independent scenarios.

a. Net income of $50,000, dividend of $20,000 Ending Retained Earnings $________

b. Net loss of $30,000, dividend of $20,000Ending Retained Earnings $________

c. Break-even (no net income or net loss), dividend of $70,000Ending Retained Earnings $________

d. Net income of $30,000, no dividends declared or paidEnding Retained Earnings $________




xhibit 2–4Example Statement of Retained Earnings for the 12 Months Ended Dec. 31

20X1

Retained Earnings, Beginning $ 992,398

Net Income 78,186

Retained Earnings, Ending $1,070,584


STATEMENTOFCASHFLOWSThe statement of cash flows originated as a management tool. Its purpose wasto show where the cash came from and where it went during a particular pe-riod. In 1987, the FASB made the statement of cash flows mandatory withOpinion No. 95. What this means is that the statement of cash flows becamea required part of the basic set of financial statements.

The statement of cash flows provides the user with a detailed summaryof all the cash provided during the period and the uses to which the cash wasput. It is extremely important because it reflects the operating, financing, andinvestment activities of an organization. The statement is useful for managersin evaluating past financing and investing activities and in planning future fi-nancing and investing activities. The statement is also useful to creditors andinvestors in their analysis of a firm’s financial condition. Chapter 6 discussesthis important statement in greater detail. Exhibit 2–5 presents one of the twoalternative formats for this report: the indirect method.

NOTES TOTHEFINANCIAL STATEMENTSANDSUPPLEMENTAL INFORMATIONNotes to the financial statements are a very important source of informationfor the analyst. Notes provide additional information about a company’s oper-ations and financial position and are considered an integral part of the financialstatements. They can amplify or explain information in the financial statementsor add supplemental information that might be of interest to decision-makerswho will read the statements.

The full-disclosure principle requires that information that could influ-ence a financial statement reader’s judgment must be disclosed in the financialstatements. Since some variables cannot be reflected in the numbers, they canbe disclosed in the notes. Many contingent liabilities and material events sub-sequent to the balance sheet date are disclosed in the notes to the financialstatements. In addition, details on accounting policies, debt, future commit-ments, other material transactions including those with related parties (suchas transactions between a parent company and its subsidiaries or transactionsbetween management and principal owners), as well as many nonfinancialevents that may affect future operations should be presented in the notes.

Notes to financial statements cover such issues as:

Significant accounting policies and practices—The accounting policies that•are most important to the portrayal of the company’s financial conditionand results must be disclosed in the notes to the financial statements. Income taxes—Detailed information about the company’s current and de-•ferred income taxes. The information is broken down by level—federal,state, local, and/or foreign.Pension plans and other retirement programs—The notes contain specific•information about the assets and costs of these programs, and indicatewhether and by how much the plans are over- or under-funded.




Stock options—Stock options granted to officers and employees, including•the method of accounting for stock-based compensation and the effect ofthe method on reported results.Property, plant, and equipment holdings•Maturity patterns of bond issues•Significant uncertainties—i.e., any pending litigation•Details of capital stock issues•



xhibit 2–5Example Statement of Cash Flows (Indirect Method)

Cash Flows from Operating Activities:

Net Income per Income Statement $ 78,186

Add:

Depreciation $ 67,933

Decrease in Other Assets 2,000

Increase in Accounts Payable 106,627 176,560

Deduct:

Increase in Accounts Receivable 23,197

Increase in Inventories 35,570

Increase in Prepaid Expenses 2,247

Decrease in Accrued Expenses 933

Decrease in Accrued Income Taxes 5,321 67,268

Net Cash Flow from Operating Activities $187,478

Cash Flows from Investing Activities:

Purchase of Marketable Securities $ 66,006

Cash Paid for Equipment 59,290

Net Cash Flow Used for Investing Activities ($125,296)

Cash Flows from Financing Activities:

Cash Paid to Retire Debt 27,670

Cash Paid to Purchase Treasury Stock 22,500

Net Cash Flow Used for Financing Activities ($ 50,170)

Increase in Cash $ 12,012

Cash at the Beginning of the Year 37,988

Cash at the End of the Year $ 50,000


Financial statement users need to understand all the significant risks ofan entity, and therefore disclosures should be made as of the balance sheetdate about items and events that could significantly affect the reportedamounts in the near term (within one year). Possible significant risks relatedto products, markets, locations, and the industry within which the business isoperating should be revealed through supplemental notes.

Analysis of financial statements is not complete until the notes to the fi-nancial statements are read and analyzed for any transactions or informationthat will affect the future operations of the enterprise. Notes help give thecomplete picture.

MANAGEMENT’SDISCUSSION ANDANALYSIS OF FINANCIALCONDITION ANDRESULTS OFOPERATIONSThe Management Discussion and Analysis (MD&A) is a section of a com-pany’s annual report in which management discusses numerous aspects of thecompany, both past and present. The MD&A provides an overview of the pre-vious year of operations. Management will also write about the upcomingyear, outlining future goals and approaches to new projects. The MD&A is avery important section of an annual report, especially for those analyzing thefundamentals of a company. It contains useful information. However, investorsshould keep in mind that the section is unaudited.

The content in a MD&A can include a discussion of the business envi-ronment and risks that the company operates within, segment-wise perform-ance, liquidity and capital sources, environmental matters (potential liabilitiesrelated to environmental obligations), market risk, inflation and other uncer-tainties, and critical accounting estimates.

This chapter introduced the four financial statements: the bal-ance sheet, the income statement, the statement of retainedearnings, and the statement of cash flows. The financial state-ment user must understand the components of each of thesestatements. Each section of a financial statement reportssomething unique, and classifications (current versus long-term) within the balance sheet help users analyze such issuesas liquidity and debt burden.

The balance sheet is the line-by-line version of the basic accountingequation:

Assets = Liabilities + Owners’ Equity

The income statement shows revenues earned during a period of time,the expenses incurred to produce that revenue, and the income or loss for that




period. The statement of retained earnings details the changes in the retainedearnings accounts for the same period as the income statement. The statementconsists of the beginning balance of retained earnings, the net income (loss),any dividends paid out, and the ending balance of retained earnings. The for-mula for the statement of retained earnings is as follows:

Beginning Retained Earnings + Net Income − Dividends

= Ending Retained Earnings

The statement of cash flows was also introduced in this chapter with anexample of the statement prepared under the indirect method. The statementcan also be prepared using the direct method, but the mechanics of thatmethod are beyond the scope of this course. The statement of cash flows showsthe sources and uses of cash during the period covered by the financial state-ments. It is an important financial statement since it is the only one preparedon a cash basis (under GAAP rules), and since a company’s obligations are al-most exclusively settled with cash, the statement of cash flows is of great in-terest to investors and creditors.

The notes to the financial statements are important sources of informa-tion for analysts. Accounting procedures, accounting policies, estimates andsignificant near-term risks should be disclosed by management as supplemen-tary notes that need to be read and analyzed by statement users to get thewhole picture.




If total assets are $1,000,000, total liabilities are $300,000, capital 1. (b)1.stock totals $100,000, and there are no other equity accounts other than retained earnings, what is the retained earnings balance?$700,000(a)$600,000(b)$500,000(c)$400,000(d)

ABC Corporation buys $35,000 of merchandise inventory from 2. (b)2.XYZ Company and will pay for the inventory in one month. Which of the following statements is true about the nature of that transaction?Assets (inventory) are increased by $35,000 and notes payable (a)(a liability) is increased by the same amount.Assets (inventory) are increased by $35,000 and accounts payable (b)(a liability) is increased by the same amount.Cost of goods sold (an expense) is recognized.(c)The transaction has no impact on the financial statements.(d)

All of the following increase equity except: 3. (c)3.Purchase of common stock by investors who purchase it directly (a)from the company as a first time issuance.Net income greater than dividends for the period.(b)The acquisition of treasury stock by the corporation that initially(c)issued the stock (acquiring its own stock).Initial public offering of preferred stock (a type of capital stock.)(d)

A company issues 10,000 shares of $20 par value stock and raises a 4. (a)4.total of $300,000 of capital. How much is the additional paid-in capital as a result of this transaction?$100,000(a)$200,000(b)$300,000(c)$400,000(d)

Review Questions




A company sells one product—a wrist watch with a colorful silicon 5. (d)5.band. The watch has a list price of $25. For an entire year the product is on sale at 20% off and the company sold 10,000 units (watches), all on credit. About 40% of the customers paid their bills early to take advantage of a 5% discount for early payment, while watches with a sales value of $12,000 were returned by customers for various reasons. Which of the following is an estimate of net sales?$250,000(a)$233,000(b)$200,000(c)$184,000(d)

ANSWERS TO “THINKABOUT IT…” QUESTIONS FROMTHISCHAPTER

1. A. LTIB. PPEC. LTID. CAE. CAF. PPEG. PPEH. LTII. CAJ. LTI

2. A. CLB. CLC. LTLD. LTLE. CL

3. Common stock $100,000Additional paid-in capital 250,000Less: Treasury stock (70,000)Retained earnings 55,000Total equity $335,000

4. A. 2B. 1C. 4D. 3E. 3




5. Gross Sales $10,000,000Sales Discounts (300,000)Sales Returns and Allowances (350,000)Net Sales $9,350,000

6. Cost of Goods SoldBeginning Inventory $600,000Add: Purchases and Freight In 700,000Less: Purchase Returns and Allowances and Discounts on Purchases 25,000

Less: Ending Inventory 625,000Cost of Goods Sold $650,000Gross Profit:Net Sales $1,200,000Less: Cost of Goods Sold 650,000Gross Profit $550,000

7. A. BOTHB. SREC. SRED. ISE. SRE

8. A. SREB. BSC. ISD. BSE. BSF. ISG. ISH. ISI. BSJ. IS

9. a. $130,000b. $50,000c. $30,000d. $130,000




3The Balance Sheet: Assets

Learning Objectives


• Identify the components of each asset group.• Identify the valuation methods for each asset

group.

INTRODUCTIONAn asset is a probable future economic benefit obtained or controlled by aparticular entity as a result of past transactions or events (FASB, 1980). A sim-plified definition of an asset would be: a thing of value, physical or otherwise, thatwill probably give future economic value to the entity. Future may be taken to meanany time from now until the end of the entity’s existence. Assets are subdividedinto four major categories:

Current assets1.Long-term investments2.Property, plant, and equipment, including fixed assets (tangible and intan-3.gible) and wasting assets (natural resources)Other assets4.



CURRENTASSETSCurrent assets are those that will most likely be converted into cash, sold, orconsumed within a period of one year. Under the general classification of as-sets, current assets are the first subcategory and appear in the order of theirliquidity, with the most liquid of the current assets listed first. The list of cur-rent assets includes:

Cash•Marketable securities•Receivables•Inventories•Prepaid expenses•

CashOn the balance sheet, current assets appear in order of their liquidity. Themost liquid of these, cash, is listed first, followed by the less-liquid assets. Be-sides currency and coin, cash includes personal checks, bank drafts, moneyorders, cashier’s checks, and money on deposit in banks.

Marketable SecuritiesMarketable securities, otherwise called short-term investments, involve thetemporary use of excess cash in order to earn interest or dividends until thecash is needed.

Short-term investments are the closest thing to cash on the balance sheet.They are reported in three possible categories according to generally acceptedaccounting principles: trading securities, available-for-sale securities, andheld-to-maturity securities.

Trading securities are marketable securities that are to be held for a shorttime and sold for more than their cost. In other words, the intent of manage-ment is to sell trading securities soon at a gain. Therefore, trading securitiesare always reported in the current asset section of the balance sheet. Tradingsecurities are typically in the form of equity (stock) or debt (bonds or notes).For example, ABC Corporation could own shares of Apple Inc. as a way ofutilizing its cash effectively (hoping for dividends and capital gains to providea good yield on the investment).

Trading securities are recorded at cost (what the firm pays for the in-vestment), and any income (dividends or interest) is recognized as incurred.In a departure from the cost principle, the value of trading securities on thebalance sheet can be increased if the fair market value of the investment risesabove its cost. That is called an unrealized gain (it is unrealized because theinvestment has not been sold.)

The accounting for fair market value of trading securities is beyond thescope of this course; however, understanding that marketable securities aresubject to price fluctuations (unrealized gains and unrealized losses) gives thefinancial statement user additional insight into how to read and interpret in-formation related to current assets and liquidity.




Held-to-maturity and available-for-sale securities can also be classifiedas current assets. They can be shown as part of short-term investments, de-pending on if they are readily converted to cash and if it is management’s in-tent and ability to hold them until they mature. Held-to-maturity securitiesare debt instruments (bonds) that management intends to hold until they ma-ture. If the maturity date is beyond one year, the investment is classified onthe balance sheet as a long-term investment. If the held-to-maturity invest-ments will mature within the year, they are classified as a current asset. Held-to-maturity investments are listed at what is called the amortized cost, amethod that takes into account any discounts or premiums paid when thebond was purchased.

Available-for-sale securities may be debt investments (bonds) that man-agement does not intend to hold until maturity or equity (stock not classifiedas trading securities.) Under GAAP rules, if the company owns less than 20%of the issuer of equity available-for-sale securities, then those securities areshown at their fair market values on the balance sheet. This means that theirvalue is most likely derived from quoted prices (stock market or bond market)and therefore is subject to fluctuations similar to those described with tradingsecurities. If the company owns more than 20% of the issuer of equity secu-rities, a method of valuation called the equity method is used. There is moreon the equity method in a subsequent section of this chapter. Available-for-sale securities are considered long-term investments.

ReceivablesThere are three main categories of receivables:

Amounts due from customers for sales made or services rendered on ac-1.count, commonly called trade receivables or accounts receivablePromissory notes, commonly called notes receivable2.Accruals due for such items as rents and interests, or obligations due from3.employees, etc., commonly called other receivables

Receivables are valued at the amount due from the entity owing the debt.Often a provision for losses is made and set up in a contra-asset account called“allowance for doubtful accounts.” A contra-asset account’s balance is sub-tracted from an associated account on the balance sheet. In the case of a re-serve for bad debts, the allowance for doubtful accounts balance, which is anestimate of the dollar amount of receivables that will become uncollectible,is subtracted from the receivables value on the balance sheet to derive thebook value of receivables. For example, if the total amount owed from cus-tomers is $1,000,000, and it is estimated that of that $1,000,000, $50,000 willnot be collected, then the book value of receivables would be $950,000. Con-tra-asset accounts are further discussed later in this chapter since they areused to compute the book value of various other assets.

Receivables can also be written off; a process that removes the receivablesbalance from the balance sheet. When it is determined that an amount owedfrom a specific customer will not be collected, as is often the case when thecustomer is bankrupt or is deceased with few or no net assets remaining in

THE BALANCE SHEET: ASSETS 43



the estate, the account is written off (often called a write-off). A write-off si-multaneously reduces the asset value of the receivable and the balance of theallowance for doubtful accounts.

InventoriesInventory is acquired for resale or used to produce goods that will eventuallybe sold. Retailing firms have one inventory account called merchandise. Man-ufacturing firms usually have three inventory accounts:

Raw materials1.Work in process2.Finished goods3.

Inventories are recorded at the lower of market or cost. The market valueis also referred to as net realizable value. The accounting profession has devel-oped guidelines for determining this value. The net realizable value is theamount that is expected to be realized on the eventual sale of the inventory,plus a normal profit margin. Costs to be included in inventory include:

Purchase price of inventory, or in the case of manufacturing, the cost of•the materials, labor, and overhead factored into the final cost of the finishedproductCosts to bring the inventory items to the concern’s location, such as freight•chargesDirect labor and manufacturing overhead incurred in preparing the raw•materials for final sale (these costs would, of course, not exist for a retail-type operation)Manufacturing overhead, including such costs as indirect material, indirect•labor, depreciation, taxes, utilities, and insurance

Once the total cost has been assigned to inventory, the final step is to de-cide on the cost-flow assumption to be used in valuing the inventory. Themost common methods of valuation are:

Specific identification1.Average cost2.First in, first out (FIFO)3.Last in, first out (LIFO)4.

Specific IdentificationThis method requires that each unit on hand be specifically identified. Spe-cific identification is usually only cost effective in situations of high-value in-ventory, such as those involving automobiles or jewelry. Specific identificationis either impossible or not cost effective in situations where inventory consistsof low-value items.

Average CostThis method uses the simple average cost of all purchases to value the inven-tory. A weighted average or a moving average may also be used. Since the




average-cost method is relatively simple and easy to apply, it is popular. Asits name implies, the cost here is determined by dividing the total cost by thetotal units purchased to arrive at an average cost per unit. This average costis then multiplied by the units on hand to arrive at an inventory value. Thismethod works well with products that are largely homogeneous and, in timesof stable prices, tends to give a good approximation of the replacement valueof inventory and an accurate cost of goods sold.

First In, First Out (FIFO)The FIFO method assumes that the first items into the business are the firstitems sold. The cost of the inventory is valued as the sum of the costs of themost recent purchases. In most situations, especially retail environments, thismethod probably closely approximates the true cost of the inventory on handsince it matches typical inventory flow. With the FIFO method, inventoryvalue is often close to a replacement cost because the value is of the most re-cent purchases. In times of rapidly rising prices, however, income is maxi-mized, as older costs (the first items purchased) would be matched to newerrevenues.

Last In, First Out (LIFO)The LIFO method makes an assumption that is the exact opposite of FIFO.LIFO assumes that the costs of the most recently acquired goods are allocatedto the latest sales and that the costs of the earliest units purchased are allocatedto inventory. When LIFO is used in times of sharply rising prices, net incomeis minimized because the higher recent costs are used to compute the cost ofgoods sold and are matched against the most recent sales.

The valuation methods mentioned above are the most commonly used.These discussions are brief and merely scratch the surface of the study of in-ventory. A financial analyst needs to be aware of the valuation method usedby the company under examination in order to determine whether the valueof the inventory is materially correct and how closely it reflects the true valueof the inventory. The method of valuation is usually in the form of disclosednotes to the financial statements.


1. Identify the inventory valuation method that would yield the following results in an environmentof rising prices:

___ Highest net income

___ Greatest ending inventory value

___ Lowest income tax liability






2. Identify the inventory valuation method that would yield the following results in an environmentof falling prices:

___ Highest net income

___ Greatest ending inventory value

___ Lowest income tax liability

3. Why are short-term (trading securities) marketable securities carried on the balance sheet atfair market value?

Prepaid ExpensesA prepaid expense is an expenditure that will benefit a future period. Exam-ples are: prepaid rent, taxes, royalties, commission, prepaid office supplies,and insurance. Prepaid items are allocated to a future period based on a meas-urable benefit, use, or a time or period cost. For example, if a lease were pre-paid for a year, each month would expense one-twelfth of the prepaid amount.

LONG-TERM INVESTMENTSLong-term investments include such assets as:

Stocks and bonds•Land held for future use or speculative purposes•The cash surrender value of life insurance policies•Investments set aside in special funds, such as pension or plant-expansion•fundsInvestment in other companies•Loans made to other companies•Real estate unrelated to ordinary operations of the business•Joint ventures with other entities that will be carried on for more than one•year





Each of these investments may be evaluated in terms of the rate of returnit generates. The size of the return depends on numerous variables. Some ofthe variables that should be analyzed, if possible, are:

The marketability of the asset1.The availability of the asset, if the company wishes to use it as collateral2.for loans, either short or long termThe current fair market value of the asset3.The profitability of investment in subsidiaries4.

Special attention must be paid to valuation of long-term investments.The methods of valuation used for long-term investments depend on the typeof investment.

Cost Method of ValuationWhen the investment is in nonequity securities, it is recorded and reportedat cost. It remains at the original cost until such time as it is wholly or partiallydisposed of, some verifiable permanent change causes the value of the assetto drop, or a liquidating dividend is received.

The historical cost of an investment consists of the costs of acquiring it,including commissions to brokers, taxes, and other transaction costs. The his-torical cost principle restricts the write-up of investments to their marketvalue, which can sometimes result in an undervalued balance sheet. The fi-nancial analyst must know about this restriction and interpret the informationon the balance sheet accordingly.

Some companies address the undervaluation of investments by disclosingtheir market value, as of the statement date, as a supplementary schedule orin a footnote.

Equity Method of ValuationWhen an investment exceeds 20% of the ownership in another company (butless than 50%), the equity method of valuation is used.

The equity method of accounting for long-term investments records theacquisition cost as of the date of purchase. This figure is adjusted accordingto the investor’s proportionate share of the company’s earnings or losses afterthe date of acquisition. The offset is reflected as recognized earnings or lossesin income. Dividends received reduce the carrying value of the investmentaccount.

If an investment in another company exceeds 50% ownership interest,the “parent company” prepares consolidated financial statements. Consoli-dation is a topic that is beyond the scope of this course, but in summary, con-solidated statements are combined financial statements of a parent companyand its subsidiaries. There are accounting rules on how consolidation is to bedone but in essence those rules attempt to give a financial picture of an entityso that users can gauge the overall health of an entire group of companies.




Answers appear at the end of the chapter.

4. ABC Corporation purchased 500,000 shares of XYZ’s common stock at $30 per share. XYZhad 2,000,000 shares of common stock issued and outstanding. Net income for the most recentyear ending December 31, 20X1 was $3,000,000 and there was a dividend declared during theyear of $.50 per share.

Calculate the following:

a. The amount at which ABC will list the stock of XYZ on the balance sheet upon itsacquisition $___________

b. ABC’s share of XYZ’s net income for the year $__________

c. The balance for ABC’s investment in XYZ as reported on the December 31, 20X1 $________

PROPERTY, PLANT, ANDEQUIPMENTProperty, plant, and equipment (fixed assets), the third category of assets, areused in the operation of the business and have a useful life of more than oneyear. They may be broken down further into:

Tangible fixed assets1.Intangible fixed assets2.Wasting assets (natural resources)3.

Included in property, plant, and equipment are assets that businesses useto produce and distribute goods and services. For example, land, buildings,machinery, equipment, furniture, fixtures, automobiles, and trucks are tangiblefixed assets. Notice how the assets noted above meet the definition of fixedassets. These assets are not intended for resale and are not readily convertibleinto cash. Their expected useful life is more than one year. The expense recog-nition of fixed assets, with the exception of land, is recognized through peri-odic, systematic write-offs to the company’s income, called depreciation.

Tangible Fixed AssetsTangible assets have a physical existence and include such items as land,buildings, equipment, machinery, furniture, fixtures, and carpeting. These as-sets fall into groupings of either real property or personal property. When atangible asset is not used in the firm’s ongoing operations, it is not classifiedas property, plant, and equipment but is under a separate heading such asother assets. Historical cost is the basis normally used for recording the ac-quisition of tangible assets. Historical cost is the price paid for the asset on





the date of acquisition, plus other costs, such as freight, installation, and setup.With the exception of land, the historical cost of most tangible fixed assets isrecognized (using a method of depreciation) as an expense over the useful lifeof the asset. Depreciation occurs when an asset loses its utility (usefulness).Regardless of the money spent for repairs and maintenance, eventually thetime comes when all property, plant, and equipment can no longer favorablycontribute to business activities and must therefore be retired.

Accounting for depreciation is a process of cost allocation and not valu-ation. Depreciation is a way of allocating the cost of a tangible asset in a sys-tematic and rational way over the useful life of the asset. Here’s how theAICPA has defined depreciation:

A system of accounting which aims to distribute the cost of otherbasic values of tangible capital assets, less salvage (if any), over theestimated useful life of the unit (which may be a group of assets) ina systematic and rational manner. It is a process of allocation, not ofvaluation. Depreciation for the year is the portion of the total chargeunder such a system that is allocated to the year. Although the allo-cation may properly take into account occurrences during the year,it is not intended to be a measurement of the effect of all such oc-currences (AICPA, 1961).

Although depreciation represents a business expense and is therefore re-flected on the income statement, depreciation also affects the balance sheet.A balance sheet account, called accumulated depreciation, is used to accumulatethe depreciation expense that is recognized on fixed assets. Accumulated de-preciation is a contra-asset account. As was mentioned in the discussion ofreceivables, a contra-asset account’s balance is subtracted from an associatedaccount on the balance sheet. In the case of fixed assets, the balance of accu-mulated depreciation is subtracted from the cost of fixed assets to derive thenet fixed asset (net book value). In Exhibit 3–1, the book value of the buildingis shown at $52,000.

A common depreciation method is straight-line depreciation, where thecost of the asset less any predicted residual value (the estimated value at theend of the useful life) is divided by the number of years of useful life. Othermethods of depreciation are allowed, including those that recognize a variableamount of depreciation based on use (units of production) and acceleratedmethods that produce larger depreciation expense in early years and smalleramounts in later years (when compared to straight-line).

Appreciation of a long-lived, tangible asset constitutes an increase in thecurrent value of property; in other words, the appreciation is the excess of thepresent value of property over its book value. Appreciation should not beviewed as the opposite of depreciation.

Depreciation is lost usefulness, whereas appreciation is not necessarilyan increase in usefulness but rather an increase in the current market value.Increases in the value of assets are not recognized in the accounting recordsuntil they become realized through sale or exchange. Land is never depreci-ated because it ordinarily doesn’t lose its usefulness. Some companies show




the appreciated value parenthetically in the balance, as is the case in Exhibit3–1, where the building has a historical cost of $83,000, a book value of$52,000, and a current value of $127,000.

The current, or appreciated, value can be included in the footnotes tothe financial statements instead of including it in the property, plant, andequipment section of the balance sheet, and reliable, independent appraisersshould determine the new values.


5. Explain why this statement is false: “Depreciation recognizes that the market value of a long-term asset has fallen due to wear and tear and obsolescence.”

6. Machinery was bought at the beginning of year 1 for a purchase price of $50,000 plus $10,000installation charges. The machinery is depreciated over a useful life of 10 years (straight-linedepreciation, which means an equal amount of depreciation each year). If you assume no resid-ual (terminal value) of the equipment, what would be the net book value after the third year?

Cost $_____ less Accumulated Depreciation $_____ = Net Book Value _____

Intangible AssetsIntangible assets are those that have no physical existence. Their value de-pends on the rights and benefits enjoyed by the owner. Some of the more im-portant intangible assets are:

Patents, copyrights, and trademarks•Leases and leaseholds•Licenses and franchises•Goodwill•




xhibit 3–1Appreciation

Building (Current Appraised Value, December 31,1991: $127,000)

At Cost $83,000 Less: Accumulated Depreciation 31,000 $52,000 !




Intangible assets are carried at their cost and, like tangible fixed assets,should be a periodic write-off of the costs. The periodic recognition of thecost of intangible assets is called amortization. The time period or useful lifeof an intangible asset is dependent upon the expected years of usefulness tothe acquiring company, or the useful life may be dictated by government reg-ulations. The next several paragraphs describe some of the typical intangibleassets found on company balance sheets.

Patents have a limited life span of 20 years granted by the federal gov-ernment. A patent gives the holder exclusive rights to control the manufactureand sale of the protected product. However, if the company feels that theproduct will become obsolete or be superseded by another prior to the endof its legal life, a shorter time period for amortization may be estimated.

Copyrights grant the holder control over “original works of authorship”fixed in tangible form. The basic term of copyright for such works createdafter January 1, 1978 (pursuant to the Copyright Act of 1976) is the life of theauthor plus 70 years after his or her death. Like patents, the useful life of copy-rights may be reduced from the 70 years.

Trademarks, which represent the right to exclusive use of a symbol orname, are amortized over a period not to exceed 40 years. The registration ofa trademark may be renewed every 20 years for an unlimited period of time,but the cost will not go beyond the amortization period.

A lease is a contract between two parties—a lessor and a lessee—thatgrants the lessee exclusive use of some property for an extended period oftime. Also known as a leasehold, the most common type of lease calls formonthly lease payments that are expensed as incurred. There is one situationthat may create an intangible asset, which occurs when there are prepaid leasepayments. This type of payment is usually classified as an intangible asset.

Licenses and franchises award rights to be operative for a specified timeperiod that is negotiable between the company and the issuing agent. A fran-chise grants the right to an exclusive territory or market, whereas a licensegives its holder official or legal permission to do or own a specific thing. Aswith other intangible assets, a license and franchise are recorded at cost, whichis spread over the life of the licence or franchise.

Goodwill results from such factors as good customer relations, efficiencyof operation, reputation for dependability, quality of products, location of op-eration, and credit rating. It is recorded on the books when purchased in con-nection with the acquisition of a business. It represents the potential of abusiness to earn above-normal profits and may be referred to as the presentvalue of expected future earnings that are anticipated to be above normal.Even though all of the factors listed above may be in existence, they cannotbe recorded under the heading of goodwill because there is no verifiable costbasis. At one time, goodwill was amortized over a period of 40 years. That isno longer the rule under GAAP (FASB 142). Now companies that carry good-will on the balance sheet are required to determine the fair value of the re-porting units, using present value of future cash flow, and compare it to theircarrying value (book value of assets plus goodwill minus liabilities.) If the fairvalue is less than carrying value, the goodwill value is considered “impaired.”Simply put, impairment means that goodwill’s value on the balance sheet


needs to be reduced. The specifics of goodwill impairment are beyond thescope of this course, but it is another example of how some assets producelosses. The impairment loss is reported as a separate line item on the incomestatement, and new adjusted value of goodwill is reported in the balance sheet.

Intangibles carry with them a mark of uncertainty. Caution and clear un-derstanding of the nature of these assets are required to correctly evaluatetheir worth to a company. Some companies, in an attempt at conservatism,follow the practice of writing their intangibles down to one dollar, which saysthat intangibles exist but that there is uncertainty about their value.

Wasting AssetsThe third group of fixed assets consists of wasting assets, or natural resources.The chief difference between tangible and intangible fixed assets and wastingassets is that the latter cannot be replaced easily. For example, lumber is awasting asset. It takes approximately 35 years for a new crop of trees to reachthe age of harvest.

A material amount of economic activity can be attributed to the discov-ery, development, extraction, processing, and sale of these natural resources.Natural resources are subject to exhaustion through extraction. Examples ofwasting assets are mineral deposits (coal, sulphur, iron, copper, and other typesof ore), oil and gas deposits, and standing timber. With the exception of timber,which can be replenished by planned cutting and reseeding, other natural re-sources become exhausted, losing most of their value.

Generally accepted accounting principles require that natural resourcesbe recorded at their original cost, plus costs incurred for discovery, explo-ration, and development. Once the cost has been determined, the write-offpolicy is established. Write-off of natural resources to income is called depletionand is usually calculated on the basis of estimated units available for extrac-tion. To illustrate, assume land containing natural resources was purchasedat a cost of $7.2 million (see Exhibit 3–2). After extraction and removal of theresources, the land is reclaimed and has an estimated fair market value of$600,000. Natural resources underground are set at 1.2 million tons. The cal-culation for depletion per unit of extraction is shown in Exhibit 3–2.



xhibit 3–2Depletion of Natural Resources

Building (Current Appraised Value, December 31,1991: $127,000)

At Cost $83,000 Less: Accumulated Depreciation 31,000 $52,000 !


Depletion cost per ton is $5.50. An accounting rule of thumb is that thedepletion cost per unit follows the unit after it is extracted. For example, whena ton of resource is sold, the unit depletion cost becomes part of the cost ofgoods sold. The extracted resources that remain unsold become an inventorywith a $5.50 per ton cost for depletion.

A financial analyst must be aware that, although write-off of natural re-source cost is relatively easy to calculate, it is not necessarily precise. Numer-ous complications may arise. For example, the original estimate of the numberof units of natural resource available may be erroneous. Because of these com-plications, periodic adjustments should be made according to new informationreceived. In spite of these complications, though, the fact that estimates arenot precise does not mean that periodic depletion charges should be ignored.


7. Match the asset with the method used to allocate its cost:

A. Building ______B. Land ______C. Patent ______D. Mineral deposits ______E. Oil and gas reserves ______F. Computers ______G. Franchise rights ______H. Accounts receivable ______

Cost-Allocation Methods:

1. Depreciation2. Amortization3. Depletion4. Asset’s cost is not allocated under any method

OTHERASSETSThis is a catch-all for assets that cannot be classified properly elsewhere. Ex-amples of other assets include some long-term, prepaid expenses; refundabledeposits on term leases; and organization costs.





Assets are things of value that will probably give the companysome measurable future benefit. Assets are subdivided intofour major categories: current assets; long-term investments;property, plant, and equipment; and other assets. Receivables,inventory, and investments may need to be revalued periodi-cally, as their fair market value can fluctuate based on a varietyof factors. Receivables can be written off because of noncol-lection, and accounting rules also dictate that an allowance for

doubtful accounts (a contra-asset account) must be established to properlyreflect the book value of receivables. Inventory is reported at the lower of costor market value. Investments are shown at fair market value—as determinedby the price that would be received to sell the investment in a transaction be-tween market participants. Investments can be classified as either short-termor long-term depending on management’s intention and the nature of the in-vestment.

Fixed assets such as such as buildings and equipment are recorded at costand that cost is allocated over periods of useful life by a process called depre-ciation. In other words, a portion of the cost of all fixed assets (with the ex-ception of land) is recognized as an expense (depreciation expense) over theperiod of time that the asset will provide benefits to the firm.

Natural resources and some intangible long-term assets are also expensedover a period of useful life by the processes of depletion (natural resources)and amortization (intangible long-term assets).




Which of the following categories of assets is most likely be converted 1. (a)1.to cash, sold, or consumed within one year?

Current Assets(a)Long-Term Investments(b)Property, Plant, And Equipment [Fixed Assets (Tangible And(c)Intangible), Natural Resources (Wasting Assets)]Other Assets(d)

Which of the following is not a category of investments under GAAP? 2. (a)2.Plant and equipment(a)Trading securities(b)Available-for-sale securities(c)Held-to-maturity securities(d)

Which of the following should be included in the cost of inventory 3. (c)3.on the balance sheet?

The projected cost of a salesperson’s commission(a)Costs to bring the inventory items to the customer’s location(b)Direct labor and direct manufacturing overhead incurred in (c)preparing the raw materialsDirect labor and overhead of a retail operation(d)

Which of the following is not a long-term intangible investment? 4. (a)4.Patents, copyrights, and trademarks(a)Leases and leaseholds(b)Accounts and notes receivable(c)Goodwill(d)

Natural resources and some intangible long-term assets are expensed 5. (d)5.over a period of useful life by the processes of ___ (natural resources) and ___ (intangible long-term assets).

depreciation / amortization(a)depreciation / depletion(b)depletion / depreciation(c)depletion / amortization(d)

Review Questions





1. FIFO, FIFO, LIFO

2. LIFO, LIFO, FIFO

3. Short-term securities will be redeemed or sold at close to their fair market value.Take the example of a bond that is close to its maturity (redemption) date. Since itis close to the date when it will be worth its face value, the current fair market valueis the best indication of value. Short-term debt securities do not fluctuate greatly invalue. On the other hand, equity securities (which do not have a maturity date) aresubject to much greater price fluctuation, but even in those cases, if management’sintention is to sell them within the next 12 months, current fair market value is thebest indication of value.

4. ABC’s share of XYZ’s common stock = 500,000 shares / 2,000,000 shares, whichequals 25%. Therefore the equity method is used.

a. ABC’s initial investment in XYZ’s common stock = 500,000 shares x $30 = $15,000,000

b. Company ABC’s share of XYZ’s net income = $3,000,000 x 25% = $750,000

c. ABC’s share of XYZ’s dividend declared = $.50 per share x 500,000 shares = $250,000

5. Depreciation has nothing to do with market value. An asset’s historical cost—not itscurrent market value—is depreciated. In fact, an asset can be depreciated to thepoint where it has a substantial market value while its net book value (cost lessaccumulated depreciation) is zero. Depreciation is not a valuation method. It is asystematic way of allocating the tangible asset’s cost over its useful life. The estimateof the useful life takes into account variables such as obsolescence and wear and tear,all of which do impact an asset over time, but depreciation really has no bearing onmaking the net book value (cost less accumulated depreciation) approximate thefair market value of the asset.

6. The cost is $60,000 and the depreciation each year is $6,000 ($60,000 / 10 = $6,000).Therefore, after 3 years the accumulated depreciation would be $18,000 and thusthe net book value would be $42,000 ($60,000 – $18,000)

7. A. 1B. 4C. 2E. 3F. 3G. 1H. 2I. 4




4The Balance Sheet:

Liabilities and Owners’ Equity

Learning Objectives


• Distinguish between current and long-termliabilities.• Identify various types of liabilities.• Identify the various components of equity onthe balance sheet.

INTRODUCTIONThe assets of a company are financed by liabilities and owners’ equity. In otherwords, assets are acquired with funds generated via debts or with owners’ in-vestment. Current liabilities provide some of the working capital necessaryto run a business day to day. Long-term liabilities and owners’ equity providethe permanent base of asset financing. In the sections that follow, you willlearn more about the specific accounts that are classified under liabilities andowners’ equity. Much of this chapter entails definitions of terms. Knowledgeof these terms forms a foundation for analysis of a company’s financial struc-ture; eventually, these terms will come in handy when performing financialanalysis using ratios and other quantitative techniques.

LIABILITIESLiabilities are obligations resulting from past transactions requiring paymentby conveyance of assets or the rendering of future services. Liability amounts



must be definite or reasonably estimated. Liabilities are usually classifiedunder the following major subheadings:

Current liabilities•Long-term liabilities•

Current LiabilitiesCurrent liabilities are debts that will be satisfied within one year or withinthe operating cycle, whichever is longer. The source of payment of currentliabilities usually is derived from current assets. A typical scenario is thatgoods or services are sold on credit, an accounts receivable is created, cash iscollected from customers, and that cash is used to meet payments on the cur-rent liabilities. Some typical current liabilities include:

Accounts payable•Notes payable•Current maturities of long-term debt•Cash dividends•Accrued liabilities•Revenues collected in advance•Taxes payable•Income taxes payable•Guarantee and warranty costs•Deferred income taxes•

Accounts PayableAccounts payable are obligations that arise from the purchase of stock-in-trade items, supplies, or services on open account. These may also be calledtrade accounts payable in order to differentiate them from amounts payable topartners, officers, stockholders, employees, or affiliated companies, whichshould be shown separately on the balance sheet. Rarely is interest chargedon accounts payable, and they are a more informal arrangement than a notespayable, the topic of the next section.

Notes PayableA note payable is a written promise signed by the maker of the note to pay acertain sum of money, either on demand or at a future date. The negotiableinstrument (the note) may or may not bear a rate of interest although mostnotes payables are evidenced by a promissory note that calls for interest. Itmay be a trade note to suppliers of stock-in-trade items or services, or a short-term loan note payable to financial institutions or other lenders. The advan-tage to the holder of a note is that it is a written formal contract.

Current Maturities of Long-Term DebtThe portion of bonds, notes payable, and other long-term debts that matureor are payable within the next fiscal year are reported as current liabilities,with the balance shown as long-term debt.




Cash Dividends PayableUnpaid cash dividends that have been declared by the board of directors butnot paid as of the financial statement date are called dividends payable. Divi-dends do not accrue; the liability materializes only upon declaration by theboard of directors.

Accrued LiabilitiesAlso known as accrued expenses, these represent expenses, such as wages, intereston note obligations, property taxes, and rent that accrue (or accumulate) ona daily basis. As a result, the amount of the specific accrual must be deter-mined as of the end of the accounting period and is listed in the liability sec-tion of the balance sheet. If the amount cannot be determined exactly, areasonable estimate must be made when the financial statements are prepared.Not only is this estimate necessary for proper presentation of the liability, italso generates a charge to an expense account that must be recorded and usedin arriving at an income figure to properly match expenses to revenues.

Unearned Revenue Any revenues collected before a service is actually performed must be shownas liabilities. This type of liability is often called revenues collected in advance.When the revenue becomes earned (as a result of performing a service or de-livering a product), the unearned revenue account is reduced.

Taxes PayableSales taxes and employer portions of payroll taxes, such as social security, in-come taxes withheld, and other payroll deductions, are examples of taxes col-lected that will be remitted to a third party—such as a state department ofrevenue and the IRS—sometime in the future. Income taxes payable, whichis a liability that results from the company’s earnings, are shown in a differentaccount, called income taxes payable.

Income Taxes PayableCorporations are income-tax-paying entities. As the accounting period pro-gresses, a provision for estimated income taxes is made and the expense is ac-crued. The balance in the income taxes payable account represents theseaccruals, less payments made to the IRS. The IRS requires that corporationspay estimated taxes at various times during the year.

Due to the differences between taxable income as computed under taxlaws and accounting income computed under generally accepted accountingprinciples, there arises the potential for differences between the reported in-come on the financial statements and taxable income on the tax return. Theseinterperiod income tax allocations are reported on the income statement asdeferred income taxes payable as well as in the notes to the financial state-ments.

Guarantee and Warranty CostsA warranty is a commitment by a seller to make good on deficiencies in aproduct. It entails future costs that could be material but are indefinite in

THE BALANCE SHEET: LIABILITIES AND OWNERS’ EQUITY 59



terms of amount, payee, or due date. (The costs of guarantees and warrantiesshould, however, be recognized if they can be reasonably estimated.)

These charges represent an estimate of all costs expected to result fromproducts sold with warranties and guarantees, and are recognized in accor-dance with the matching principle.

There are two methods of recording these costs. The first is the cash basis,in which warranties are charged to current operations as incurred. The cashmethod is not an acceptable method under generally accepted accounting prin-ciples. The second is the accrualmethod, where an estimated amount is chargedto current operations. For example, a company may sell 500 units and estimatethat each unit will incur $100 in warranty costs. The company would chargean expense account for $50,000 and record a liability for $50,000. This liabilityis usually current, unless there are long-term, extended warranties.


1. Match the description of each of the following obligations of a company to the liability account name.


Obligation description Liabilities

1. ____ $1,500 of interest hasaccumulated in the truck loan accountas of the balance sheet of 12/31/20X1date and will be paid on January 15,20X2.

A. Accounts Payable

B. Notes Payable

C. Current Maturity of Long-term Debt

D. Accrued Liability

2. ____ Supplier of a manufacturer isowed $10,000 for raw materialspurchased. The amount is due in 30 days.

3. ____ $1,000 of rent is due from lastmonth’s use of an office.

4. ____ Electric bill from last month’selectricity usage is due in 20 days.

5. ____ 12 payments ($2,200 each) aredue this year on a 30-year mortgagethat has about 10 years remaining. The12 payments represent $21,500 ofprincipal that is shown on the balancesheet as a current liability.





2. During 20X1, a company sells 1,000 units that cost $50 each and retail for $115. The companyestimates that 5 percent of the units will involve a claim under the warranty. The company esti-mates that the average warranty claim will cost the company $25. Under the accrual basis ofaccounting, the estimated warranty expense for the 20X1 sales must be recognized andmatched against these sales. Based on this information, how much warranty expense shouldbe recorded for 20X1?

Long-Term LiabilitiesA debt that takes the company longer than one year to satisfy is classified inthe balance sheet as a long-term liability. If the time period of a long-term lia-bility is reduced to one year or less, the debt should then be moved into thecurrent liability section. Since most long-term debts carry an interest obliga-tion, the interest accumulation should be shown as a current liability.

Debts are sometimes payable in installments. When the year begins, theamount to be paid during the ensuing year should be moved from the long-term to the current liability section. Examples are mortgages, bonds, deben-tures, and notes payable with maturity dates later than one year.

Long-term debt is often used as a permanent source of funds for financ-ing growth, since the cost (interest) of long-term debt is usually fixed. Theuse of long-term debt can leverage earnings, which means that the fixed costof long-term debt can mean that greater earnings in high-revenue years canbe achieved than could be realized with variable-cost financing. In addition,the interest paid on long-term debt is tax deductible as a business expense;therefore, the real cost of long-term-debt financing is less than the cost of eq-uity financing (dividends), which is not tax deductible.

Long-term debt may be subject to various restrictions or covenants. Sincethese may include working capital ratios, debt levels, dividend restrictions, etc.,the financial statement user should review the notes to the financial statementsto determine whether there are covenants that may affect the ability of the com-pany to repay other obligations. Two popular types of long-term liabilities—mortgage payable and bonds payable—are detailed in the sections that follow.

Mortgage PayableA mortgage payable comes into existence when real property is pledged assecurity for a loan. The mortgage creates a lien on the property to secure pay-ment so that should the borrower default, the pledged assets can be sold bythe lender, and the proceeds from the foreclosure sale used to satisfy the debt.If the pledged asset’s value is less than the total amount of the mortgage ob-ligation, the mortgage holder becomes a general creditor for the difference.

Bonds PayableBonds payable are long-term promissory contracts, called indentures, thatpromise to pay a specific amount of money at a specified time as well as topay periodic interest on the outstanding principal. The following are descrip-tions of several types of bonds.





Debenture Bonds. This is an obligation protected not by collateral or tan-gible assets, but only by the general credit rating of the issuer. There maybe requirements included to protect the buyer. Requirements for suchprotective measures may include maintenance of a specified workingcapital ratio, immediate maturity of the issue in case of default in interestpayments, and restrictions on dividends to stockholders.

Guaranteed Bonds. A bond is guaranteed if the payment of principal andinterest is guaranteed by a person or company other than the issuer.

Income Bonds. With income bonds, the payment of interest income de-pends on the issuing company’s earnings. If earnings are sufficient, theinterest payments will be made. If the earnings are not sufficient, interestpayments may be skipped or deferred to a future date. If the interest pay-ments are deferred to a future date, the income bond is called cumulative.If the bond interest is cumulative, interest that cannot be paid in one pe-riod will be carried forward as a lien against future income.

Corporate bonds may be classified in more detail than income bonds ac-cording to such factors as the way the bonds are registered, pay interest,make payments, or mature.

Registered Bonds. These bonds are issued in the name of the owner. Whena registered bond is sold, the seller must surrender the certificate. A newcertificate is issued to the buyer. Periodically, the bondholders of recordwill receive interest checks.

Bearer Bonds. Also known as coupon bonds, these bonds are not recorded inthe name of the owner; ownership may be transferred by delivery withoutendorsement of the bond showing the transfer of ownership by a formerowner. Interest coupons are attached to the bond. Periodic interest is paidby presenting the appropriate coupon at a bank. Bearer bonds eliminatethe need for recording changes in ownership and preparation and mailingof the interest checks. However, since they are not registered, the bond-holder does not have the protection that registered bonds offer.

Term Bonds. These bonds are an issue that has the same maturity date.

Serial Bonds. These bonds are an issue that matures in installments.

Convertible Bonds.These bonds are convertible into another security, usu-ally equity.

Deep Discount or Zero Coupon Bonds.These are issues that are sold at a dis-count and provide that all the interest is earned by paying the full facevalue at maturity.

Bonds should be presented on the balance sheet in a manner detailedenough for the reader to understand. Disclosure of only the face value of out-standing bonds is not sufficient. The preferred method is to give a descriptionof the security, the interest rate it bears, and its maturity date. This informa-tion is usually presented in the footnotes.





3. Match the type of bond with its definition.A. _____ Serial bondB. _____ Convertible bondC. _____ Debenture bondD. _____ Registered bondE. _____ Guaranteed bond

Definitions:

1. A bond with interest and principal payments guaranteed by a third party2. A bond that can be exchanged for another security, such as shares of common stock of the

issuing company3. A bond that matures in installments4. A bond that is backed by only the issuer’s promise to pay5. A bond issued in the name of the owner

4. Identify the following liabilities as being either CL (current liabilities) or LTL (long-term liabilities).

A. Accounts payable _____B. Current portion of long-term debt _____C. Mortgage payable _____D. Dividend payable _____E. 30-year bond payable _____F. Zero coupon bond maturing in 5 years _____G. Wages payable _____

OFF-BALANCE-SHEETFINANCINGOff-balance-sheet financing is a form of utilizing resources without showingthe source of funding for those resources (which often is debt or equity). Onecommon example of off-balance-sheet financing is operating leases. Generallyaccepted accounting principles in the United States have set numerous rulesfor companies to follow in determining whether a lease should be capitalized(included on the balance sheet) or expensed (and kept off the balance sheet).Significant forms of off-balance-sheet financing should be disclosed in thenotes to the financial statements. The term “off-balance-sheet financing” cameinto use during the Enron bankruptcy.

OWNERS’ (OR SHAREHOLDERS’) EQUITYOwners’ equity is defined as the amount of right or interest investors have inthe assets of an enterprise after all liabilities owed to the company’s creditorsare satisfied.





There is no guarantee, however, that the amounts shown under the own-ers’ equity section of the balance sheet will be received by the owners. A com-pany that is a going concern may not liquidate its assets in the near future,and even if liquidation occurs, management may not be able to generateenough cash to pay off the liabilities and cover the owners’ investment.

Owners’ equity is usually divided into four parts:

Capital stock at the par or stated value1.Additional paid-in capital or amounts paid over par2.Retained earnings representing the undistributed earnings of the entity3.Treasury stock4.

Capital StockOften, the ownership interest of a corporation is described in terms of capitalstock. Owners of a corporation buy shares of capital stock; the stock certifi-cates are evidence of ownership. Four basic rights are inherent in the owner-ship of stock. If only one class of stock exists, these rights are shared by thestockholders in proportion to the number of shares of stock they each own.These rights are:

The right to vote for corporate directors and thereby be represented in1.the company’s managementThe right to share in the profits of the business by receipt of dividends de-2.clared by the directorsThe right to share in the distribution of cash or other assets in the event3.of corporate liquidationThe preemptive right to purchase additional shares, in proportion to one’s4.present holdings, in the event that the corporation elects to increase thenumber of shares of outstanding capital stock

Additional Paid-In CapitalPaid-in surplus is capital paid in excess of par or contributed by stockholdersor outsiders. In other words, it is the total in excess of the par, or stated valueof the stock, and is separated from retained earnings and capital stock on thebalance sheet. To illustrate the concept of additional paid-in capital, assumea sale was made of $100,000 of par value, common stock for $115,000. The$115,000 is debited to the cash account. However, because the stock had a parvalue of $100,000, only $100,000 would be added to the capital stock account.The excess ($15,000) of the capital received ($115,000) over the par value ofthe capital stock ($100,000) should be entered into an account called additionalpaid-in capital.





5. If a company issues 20,000 shares of common stock with a $40 par value at an issue price of $45:

A. How much total capital would be raised?B. How much of the capital would be classified as capital stock?C. How much capital would be classified as additional paid-in capital?

Retained EarningsRetained earnings are the accumulated profits that have not been distributedto the shareholders through payment of dividends. A portion of the retainedearnings can be earmarked for purposes other than dividend distribution.These are labeled restricted earnings. This appropriation reduces the amountof retained earnings that are free and available for dividends. When the needfor the appropriation passes, the dollar amount set aside is returned to theregular account, again available for dividends. Appropriations should be dis-closed clearly in the equity section of the statement and are often footnotedto provide full disclosure. Among the types of restricted earnings are appro-priations for plant expansion and contingencies.

Treasury StockThis is a corporation’s own stock that has been issued or reacquired. Treasurystock can be resold, but the purchase of treasury stock by the company createsa temporary reduction in paid-in capital. As shown in the example balancesheet in Exhibit 4–1, treasury stock is negative equity; the amount paid forthe stock ($22,500 on the December 31, 20X2 balance sheet) must be deductedfrom stockholders’ equity. Shares of stock in the company’s treasury are noteligible for dividends, nor do they grant voting rights.

Treasury stock is never classified as an asset. It is contradictory to implythat a corporation can invest in itself, although treasury stock may be sold toobtain needed funds. Treasury stock is also used by corporations to award sharesto employees under certain benefit plans such as stock bonuses or pension.


6. A corporation that currently has no treasury stock has a net income of $1,000,000 and out-standing common stock shares of 200,000. Based on this information, the earnings per share(EPS) for the common stock is $5.00 per share, which is computed as follows:







Net Income, $1,000,000, divided by 200,000 shares equals $5.00 EPS

A. The stock is selling for $10 per share in the market. Based on the facts, if the company wantsto boost EPS to $6.00 per share, how many shares of stock would it need to repurchase?

B. How much treasury stock (in dollars) does the repurchase represent?C. Assume that the common stock was purchased to achieve the $6.00 EPS goal and that im-

mediately prior to the purchase of the treasury stock, the equity section of the corporation’sbalance sheet was as follows:

Capital Stock (200,000 Shares Issued at $10 Par)

$2,000,000 Additional Paid-in Capital $10,000

Retained Earnings $100,000

What would the total equity of the corporation be immediately after the repurchase of stock?

Exhibit 4–1 presents the liability and equity section of a company’s bal-ance sheets.



xhibit 4–1Example Company Liabilities and Owners’ Equity, Years Ended December 31

D 20X2 20X1 Current Liabilities:

Notes Payable—Bank $ 55,000 $ 85,000 Current Portion of Long-Term Debt 1,850 5,583 Accounts Payable 642,237 535,610

Notes Payable—Other 134,692 144,692 Accrued Expenses 46,980 47,913 Accrued Income Taxes 10,743 16,064

Total Current Liabilities 891,502 834,832 Long-Term Debt:

Notes Payable—Bank 22,818 10,488 Less: Current Portion 1,850 5,553

Net Long-Term Debt 20,968 4,935 Total Liabilities 912,470 839,767 Owners’ Equity

Common Stock, Issued and Outstanding: 10,000 Shares $10 Par 100,000 100,000 Additional Paid-in Capital 22,643 22,643 Retained Earnings 1,070,584 992,398

1,193,227 1,115,041 Less: Treasury Stock 22,500

Total Owners’ Equity 1,170,727 1,115,041 Total Liabilities and Owners’ Equity $2,083,197 $1,955,808

!





Liabilities fall into one of two broad categories: current orlong-term. Current liabilities are obligations that are to be sat-isfied or paid within one year, and the source of their paymentis usually current assets. Long-term liabilities are obligationsthat mature in a future period beyond one year. Liabilities areone type of claim (claim by creditors) against the assets of acompany. The owners also have a claim against the assets. Thisis called owners’ equity.

Owners’ equity is the book value of the owners’ interest in a company.Owners’ equity usually includes a number of components, including commonand preferred stock and retained earnings. Common stock is the purest formof ownership in a corporation and entitles the holder to dividends when de-clared by the board of directors. Those dividends are paid from retained earn-ings and therefore are linked to both the corporation’s cash position and itsprofits. Preferred stock is also an ownership interest but its dividends are dis-tinct from common stock dividends in that preferred stock gives the holderpriority when dividends are paid. This means that if there is enough cash andprofits to pay dividends, the preferred stockholders must receive their divi-dends first.

Sometimes a portion of retained earnings can be re-allocated to a sepa-rate restricted account. Such a move limits the amount of retained earningsthat can be paid out of the balance of the main retained earnings account.


The source of payment for current liabilities is usually: 1. (b)1.long-term borrowing.(a)current cash flow from normal business operations.(b)capital raised as a result of a common stock issue.(c)capital raised from floating long-term bonds.(d)

Which of the following statements best describes accounts payable? 2. (c)2.It is a short-term obligation evidenced by a promissory note.(a)It is a current liability that also involves accrued interest.(b)It is a current liability that comes about from purchasing goods and(c)services from suppliers on account.It is for such obligations as dividends payable and interest payable.(d)

A dividend payable is the result of: 3. (a)3.the declaration of a cash dividend (positive vote) by the board of(a)directors.an accrual that takes place over time; similar to accrued interest.(b)the declaration of a stock dividend by the board of directors.(c)owning another corporation’s bond.(d)

Which of the following statements is true with respect to mortgage 4. (c)4.payable and bond payable?

A mortgage payable is a long-term obligation whereas a bond payable(a)is a short-term one.A bond payable amount is usually secured by company property such(b)as real estate whereas a mortgage payable is an unsecured debt.A bond payable is usually an unsecured long-term debt whereas a(c)mortgage payable amount is a secured long-term debt.A bond payable is a government obligation whereas a mortgage payable(d)is usually owed to a bank.

Which of the following statements best describes the purpose of 5. (b)5.restricted retained earnings?

They are required by state law.(a)They are an appropriation that reduces the amount of retained(b)earnings available for dividends.They are restricted to pay federal or state income taxes.(c)They are an appropriation that increases the corporation’s ability to(d)pay future dividends.

Review Questions




ANSWERS TO “THINKABOUT IT...” QUESTIONS FROMTHISCHAPTER

1. 1. D, 2. A, 3. D, 4. A, 5. C

2. 1,000 × .05 × $25 = $1,250

3. A. 3B. 2C. 4D 5E. 1

4. A. CLB. CLC. LTLD. CLE. LTLF. LTLG. CL

5. A. 20,000 × $45 = $900,000B. $40 × 20,000 = $800,000C. ($45 − 40) × 20,000 = $100,000

6. A. At $166,667 outstanding shares, EPS = $6.00; therefore, 33,333 shares needto be repurchased (200,000 − 166,667).

B. 33,333 shares × $10 = $333,330 C. Equity of $2,110,000 prior to the treasury stock purchase, less the value of

the treasury stock purchased, which is $333,330, equals equity of $1,776,670.




5The Income Statement

Learning Objectives


• Identify income and expense accounts.• Identify the various income statement for-mats.• Prepare the single-step income statement.• List the five types of revenue and expense ad-justments.

INTRODUCTIONThe income statement serves three key functions. First, it is a summary of therevenues and expenses of an entity for a specified period of time. Second, itsummarizes the company’s operational activity. Finally, the income statementaccount balances reflect the cumulative activity in the revenue and expenseaccounts for the period being reported. This statement is also referred to asthe statement of income, the operating statement, the statement of operations, or the profitand loss statement.

INCOMESTATEMENTFORMATAn income statement may take one of several forms. The single-step income state-ment has no provision for intermediate income measurement. It merely deductsthe total of all costs and expenses from the total of all revenues to arrive at anet income figure. No recognition is given to gross profit or nonoperating in-come and expenses. Exhibit 5–1 shows an example of the single-step format.



The multi-step income statement provides for intermediate income meas-urement of such items as gross profit, net operating income, and net income.A distinction is made between operating and nonoperating revenues and ex-penses. For example, if the company earns revenues from an extraordinaryevent, such as the sale of a subsidiary, the revenue is shown separately fromthe operating income. The amount of income before taxes reflects pre-taxearnings and emphasizes the special nature of the income tax levy. The multi-step income statement is more likely to be found in the more detailed financialstatements prepared for use by management, bankers, and other creditors. Ex-hibit 5–2 is an example of the multi-step income statement.


1. On a separate peice of paper use the following account balances to prepare a single-step in-come statement for the XYZ Company. Use the format shown in Exhibit 5–1 as a guide. (CAUTION: There may be one or two figures that you do not need to prepare the single-stepstatement.)




xhibit 5–1Example of a Single-Step Income Statement

ABC Corporation Income Statement For Year Ended December 31, 20X2

Revenues: Net Sales $708,000 Interest Income 3,600 Total Revenues $711,600

Expenses: Cost of Merchandise Sold $525,000 Selling Expenses 75,000 General Expenses 35,000 Interest Expense 2,400 Total Expenses 637,400 Net Income $ 74,200



Cost of Merchandise Sold $500,000

Net Sales $850,000

Selling Expenses $70,000

Interest Income $3,000

General Expenses $30,000

Gross Profit $350,000

Components of an Income StatementWhatever the format, every income statement details the activity of four typesof economic variables. These variables are:

Revenues1.Expenses2.Gains3.Losses4.

RevenuesRevenues are earned from providing services and selling goods. Under theaccrual basis of accounting, revenues are recorded at the time of providingthe service or delivering the goods, even if cash is not received at the point ofpurchase. Examples of revenue accounts include sales, service revenues, feesearned, and interest earned. The nature of the business operation dictates themain revenue sources of the entity. Typical revenues of a law firm are fromfees earned; for Walmart, they are from sales (merchandise); for Bank ofAmerica, they are from interest paid on loans made to its customers. A keyquality of revenue is that it is the result of activities that constitute the entity’songoing major or central operations.

ExpensesExpenses are outflows (or other using-up of assets) or incurrences of liabilities(or both) during a period from delivering or producing goods, rendering serv-ices, or carrying out other activities that constitute the entity’s ongoing majoror central operations. Expenses are often categorized as cost of goods sold (thecost of the merchandise or product sold) and operating expenses. Operatingexpenses are incurred in carrying out an organization’s day-to-day activitiesand include payroll, sales commissions, employee benefits and pension con-tributions, transportation and travel, rent, amortization and depreciation, re-pairs, and various types of taxes. Operating expenses are usually subdividedinto selling expenses and administrative and general expenses.

THE INCOME STATEMENT 73






xhibit 5–2Example of a Multi-Step Income Statement

ABC Corporation Income Statement For Year Ended December 31, 20X2

Revenues from Sales: Sales $720,000 Less: Sales Returns and Allowances $ 6,100

Sales Discounts 5,900 12,000 Net Sales $708,000

Cost of Merchandise Sold: Merchandise Inventory,

January 1, 20X2 $ 60,000 Purchases $520,000 Less: Purchase Returns and Allowances $ 9,100 Purchase Discounts 2,500 11,600 Net Purchases $508,400 Add in Transportation 17,400 Cost of Merchandise Purchased 525,800 Merchandise Available for Sale $585,800 Less: Merchandise Inventory,

December 31, 20X2 60,800 Cost of Merchandise Sold 525,000 Gross Profit $183,000

Operating Expenses: Selling Expenses: Sales Salaries Expense $ 60,000 Advertising Expense 11,000 Depreciation Expense 3,100 Miscellaneous Selling Expense 600 Total Selling Expenses $ 74,700

General Expenses: Office Salaries Expense $ 21,000 Rent Expense 8,100 Depreciation Expense 2,500 Insurance Expense 1,900 Office Supplies Expense 600 Merchandise General Expense 700 Total General Expenses 34,800

Total Operating Expenses 109,500 Income from Operations $ 73,500 Other Income: Interest Income $ 3,600 Other Expense: Interest Expense 2,900 700 Net Income $ 74,200


GainsGains are increases in equity (net assets) from peripheral or incidental trans-actions of an entity and from all other transactions and other events and cir-cumstances, except those resulting from revenues or investments by owners,affecting the entity during a period. For example, if a manufacturing companyowns a vacant lot at a cost of $100,000 and sells it for $150,000, it will have a$50,000 gain (ignoring taxes). That gain is a peripheral or incidental eventwith regard to its normal operating activities (manufacturing and selling prod-ucts) and is therefore not classified as a revenue item, as it is not from normal(day-to-day) operations.

LossesLosses are decreases in equity (net assets) from peripheral or incidental trans-actions on an entity and from all other transactions and other events and cir-cumstances, except those that result from expenses or distributions to owners,affecting the entity during a period.

Gains and losses can be widely varied, but the key is that they are of anon-normal type of transaction, i.e., sale of investments, theft, sale or closingof a plant, etc. If the gain or loss is of an unusual and infrequent nature, it isusually classified as an extraordinary item and is presented below the incomefrom operations. The purpose is to separate nonrecurring items from normaloperations in order to make the components of income clear to the reader.

To summarize: Revenues and expenses are the recording of transactionsthat are the normally occurring types of business in which an enterprise isengaged. The result of these transactions represents the income or loss fromoperations. Gains and losses are the result of transactions that are outside thenormal realm of operations; for example, the closing of a plant is usually pre-sented as an extraordinary item.

Comprehensive IncomeComprehensive income is a company’s change in total stockholders’ equityfrom all sources other than the owners’ of the firm. It is calculated as follows:

Net income (or net loss) plus unrealized gains (losses) on available-for-sale invest-ments and foreign-currency translation adjustments

Net income, not comprehensive income, is used to calculate the earningsper share of a company. Exhibit 5–3 shows an example of a statement of com-prehensive income.





2. Match the revenue or expense described with the type of company.


Type of Revenue or Expense Type of Company

1. ___ Legal fees earned A. Landscaping company

B. Insurance company

C. Bank

D. Law firm

E. Retailer

F. Manufacturer

2. ___ Interest income

3. ___ Premiums

4. ___ Sales of merchandise

5. ___ Interest expense on time depositaccounts

6. ___ Cost of materials, labor, andoverhead of products sold

7. ___ Depreciation expense on trucksand lawn mowers



xhibit 5–3Example of a Statement of Comprehensive Income

For the year ended December 31, 20X1Amounts are in thousands (000s)

Net Sales $15,000Cost of goods sold 9,000Gross profit $6,000Operating expenses 4,000Operating income $2,000Interest income 15Income before taxes $2,015Income taxes 800Net income $1,215Other comprehensive income:Unrealized gains on available-for-sale investments 500Loss on foreign currency translation 100Comprehensive income $1,615

Statement of Comprehensive Income


CASHVERSUSACCRUALBASIS OFACCOUNTINGThe analyst must be aware of the accounting basis, cash or accrual, used bythe company whose statements he or she is examining. The cash basis is gen-erally used by small businesses in which inventories, receivables, and payablesare not a material factor.

Cash BasisA rule for the cash basis of accounting for revenues and expenses is:

Revenue is recorded as earned when it is received or collected.1.Expense is recorded as incurred when it is paid.2.

Objections to the cash basis are numerous. The primary objection con-cerns the difficulty of matching current costs with current revenues. The timeelapsed between the production of revenue and its ultimate recognition affectsthe financial and managerial position of a company. If expenses are prepaid(for example, prepaid rent), they are taken entirely as an expense at the timeof a payment and will produce a calculated income. The calculated incomewill be understated in the period of payment and overstated in the subsequentperiod or periods that received the benefit of the expenditure.

Accrual BasisThe accrual basis of accounting is used by larger firms and is an acceptablemethod for reporting revenue. On the accrual basis, revenue is allocated tothe period or periods it is earned, regardless of when it is collected. Expensesare applied to the period in which they are incurred rather than the period oftheir payment or satisfaction. The summarizing rule for the accrual basis ofaccounting is:

Revenue is recorded as such in the period it is earned, regardless of when1.it is received.Expense is recorded as such in the period it is incurred, regardless of when2.it is paid.

Since an important goal of the accrual basis of accounting is to matchcosts and revenues for a particular period, adjustment of account balances isnecessary at year’s end.

APPORTIONMENTOFREVENUES ANDEXPENSESIn its operations during an accounting period, a company is affected by accruedand deferred expenses and revenues. Transactions that were recorded in ac-counts affecting the balance sheet and income statement during one periodmay influence other accounting periods. Therefore, end-of-period adjustments




are necessary. Financial transactions or events that have not been recorded asof year’s end will have to be recorded in order to bring all accounts to theirproper balances as of the statement date.

The diversity of year-end adjustments fits into five categories:

Prepaid expenses requiring apportionment1.Unearned and recorded revenues requiring apportionment2.Unrecorded accrued revenues3.Unrecorded accrued expenses4.Valuation of accounts receivable and investments5.

Prepaid Expenses Requiring ApportionmentOutlays that contribute to revenues of a particular period are called expenses.For example, prepaid or unexpired insurance for a three-year coverage is anasset at the time of the cash outlay. However, this cost eventually expires andrequires an entry that would move the expired portion of insurance from anasset account to an expense account. This periodic matching of the use of anasset with the period in which it is used is an excellent example of the conceptof matching of revenue and expense.

Unearned and Recorded Revenues Requiring ApportionmentSuppose $24,000 was received in advance for the 24-month rental of a ware-house unused by the company. Revenue income, if recorded as $24,000, wouldproduce an overstated figure, with the resulting income and income tax over-stated. The later period or periods would receive the benefit of the rent pre-payment but would not be charged with any of the expense. Matching of costsand revenues would not occur. In this case, a liability for the unearned portionwould be set up and the revenue account credited for the amount earned. Theliability account of unearned revenue may need to be split between a currentand noncurrent liability, depending on how many months are unearned andthe fiscal year of the company. For example, if 18 months were unearned, 12months would be current and 6 months would be noncurrent as of that balancesheet date.

Unrecorded Accrued RevenuesAccrued revenues occur when revenue is earned but not yet collected. At theend of an accounting period, some accrued revenues may need to be recorded.Examples of unrecorded revenues are interest revenue owed to the companyfor completed services or delivered goods that, for a variety of reasons, havenot been billed (invoiced) to the customer. For example, assume a bank’s cus-tomer owes 12% interest on a three-year, $10,000 note (loan) receivable buthas not yet made a payment; still, one month of interest has accrued. Thatwould mean that $100 ($10,000 x .12/12 months) of accrued interest wouldneed to be recorded. Another example: A service worth $1,000 was performedfor a customer on the last day of the year but the customer won’t pay untilnext month and an invoice has not yet been mailed out. Under accrual ac-counting rules, the revenue is earned when the service has been provided or




the goods have been delivered and so the $1,000 should be recognized as ac-crued revenue.

Unrecorded Accrued ExpensesAccrued salaries serve as an illustration here. If payroll accrued at a daily rateof $20,000 and was not recorded for three days at year’s end, the expense forpayroll would be understated, income overstated, and income tax computedthereon too high. The accounting period that followed would be affected con-versely. To correct this balance, a current liability would be recorded and thecorrect expense accounts would be charged for $60,000. This reasoning is thesame for any other expense incurred but not paid during the accounting pe-riod.

Valuation of Accounts Receivable and InvestmentsWhenever a business makes sales on account, some accounts receivable provewholly or partially uncollectible. In order to effect a proper matching of costsand revenues, the estimated loss arising from a credit sale should be recog-nized in the period the sale was made. This requires an evaluation of the re-ceivables to determine the approximate amount of the loss. Once the estimateis established, it should be reflected on the accounts receivable balance atyear’s end. An account for bad debts expense (also often called the allowancefor doubtful accounts) contains the total of the periodic expense to be usedin the income statement; a contra-valuation account follows the accounts re-ceivable account to the balance sheet. Income is reduced by the bad debts es-timate, and accounts receivable is reduced by the contra account. The balancesheet equation will be in balance. Here is an example. Management estimatesthat 2 percent of its credit sales will be uncollectible. Sales for the past yearwere $1,000,000, and $600,000 of that amount was on credit. Therefore, theestimate for bad debts is $12,000. If the company has $50,000 of accounts re-ceivable at the end of the year, the net book value of the accounts receivablereported on the balance sheet as of the end of the year would be $38,000($50,000 less $12,000).

Valuation of Marketable SecuritiesThe valuation accounts for adjusting marketable securities for changes in mar-ket values (also called fair market value) are covered in Chapter 3.


3. Match the description of an apportionment of a revenue or expense with one of the four appor-tionment descriptions.








___ A. During the year 20X1, a civic center sells a three-concert ticket package for a price of$60 to 10,000 customers. By year end 20X1, two of the concerts had been performed.Therefore, two-thirds of the $600,000 revenue ($400,000) was recognized as revenuefor 20X1, and $200,000 (the remaining unearned revenue) is shown on the 20X1 year-end balance sheet as an unearned revenue (liability).

___ B. A company rents a warehouse. The company makes a rental payment covering the next24 months on April 1, 20X1. At year end, the remaining unexpired rent, which represents15 months, is shown on the balance sheet as an asset.

___ C. At the end of the year, the balance of accounts receivable is $150,000. However, it isestimated that $20,000 of the receivables will not be collected. The book value of thereceivables is adjusted to show $130,000 as the amount of net receivables.

Apportionment Descriptions

1. Prepaid expenses requiring apportionment2. Unearned and recorded revenues requiring apportionment3. Unrecorded accrued expenses4. Valuation of accounts receivable and investments

The income statement is a summary of the revenues and ex-penses of an entity for a specific period of time. It shows thecalculation of net income (revenues less expenses). Two for-mats are used to present the income statement: the single stepand multi-step formats.

When accountants prepare an income statement usingaccrual accounting principles, adjusting entries are necessaryto assure that revenues and expenses are properly reflected.

There are five categories of adjustments: prepaid expenses requiring appor-tionment, unearned and recorded revenues requiring apportionment, un-recorded accrued revenues, unrecorded accrued expenses, and valuation ofaccounts receivable and investments. Adjustments are performed at end ofthe accounting period, just before the financial statements are prepared.



The multi-step income statement provides for intermediate income 1. (d)1.measurement of such items as ______, net operating income, and net income.

cost of goods sold(a)earnings before interest(b)depreciation(c)gross profit(d)

A manufacturing company owns a truck with a net book value of 2. (a)2.$14,000. It sells the truck for $10,000 and therefore incurs a $4,000 loss. Which of the following best describes how the loss will be reported on the company’s income statement?

It will be shown as a loss, separated from expenses since it is not(a)incurred in the normal course of operating activities.The $4,000 loss will be shown as depreciation expense (for the truck)(b)for the period in which the sale occurs.It will not be shown separately as it is a type of revenue ($10,000)(c)because the truck was sold.It will be part of cost of goods sold reported for the same period of the(d)sale.

A company purchases supplies for $5,000 on January 2, 20X1 and 3. (b)3.initially records the purchase as an asset. During the year, another $2,000 of supplies are purchased and are also added to the supplies account. On December 31, 20X1 in anticipation of preparing a balance sheet and income statement, the staff takes a count of the supplies that remain on hand. The count reveals that $2,500 of supplies have not yet been used. Which of the following best describes the adjusting entry that is needed?

No adjusting entry is needed because the company still owns some of(a)the supplies and therefore won’t need to write them off until they areused.The supplies account needs to be reduced by $4,500 and the supplies(b)expense account needs to be increased by $4,500 to recognize the useof the asset during the year.The cash account needs to be reduced by $7,000 for the cost of the(c)supplies.The cash account needs to be reduced by $7,000 and increased by(d)$2,500 by the end of the year.

Review Questions






If a professional sports team sells season tickets during the summer 4. (b)4.months (games will be played in the time period of September through February), what will the team most likely need to do at the end of the fiscal year (December 31)?

Increase cash for the sale of the tickets and recognize revenue for all(a)the tickets sold.Determine what percentage of all games for the season have been(b)played by year end and recognize a proportional amount as revenueand reduce its related liability (unearned revenue) for the sameamount.Determine what percentage of all games for the season has been played(c)by year end and increase cash by a proportional amount.Adjust (reduce) operating expenses for the year by a proportion equal(d)to the number of games played by December 31 divided by the totalnumber of games on the schedule.

Management estimates that 4% of its credit sales will be uncollectible. 5. (c)5.Sales for the past year were $2,000,000 and $1,600,000 of that amount was on credit. The end of year balance for accounts receivable is $120,000. Which of the following is correct?

There are about $80,000 of bad debts that most likely exist as of (a)year end.The net receivables are $40,000 as of year end.(b)The net receivables are $56,000 as of year end.(c)The bad debt expense for the year will be $56,000.(d)

ANSWERS TO “THINKABOUT IT...” QUESTIONS FROMTHISCHAPTER

1. Revenues:Net Sales $850,000Interest Income $3,000Total Revenues $853,000Expenses:Cost of Merchandise $500,000Selling Expenses $70,000General Expenses $30,000Total Expenses $600,000Net Income $253,000

2. 1. D, 2. C, 3. B, 4. E, 5. C, 6. F, 7. A

3. A. 2B. 1C. 4


6The Statement of Cash Flows

Learning Objectives


• Describe the kinds of information disclosedby the statement of cash flows.

• List the three key areas of cash flows dis-closed in a statement of cash flows.

• Identify and describe the two accepted state-ment of cash flows formats.

• Explain the free cash flow concept

INTRODUCTIONA balance sheet (or statement of financial position, as it is often called) is a snap-shot of the amounts of assets, liabilities, and owners’ equity at a specific mo-ment in time. Balance sheets are prepared at least annually, often quarterly,and even perhaps as often as monthly. An income statement is a summary ofrevenues and expenses that covers a period of time, such as a year, a quarter,or a month.

Although the balance sheet and income statement are prepared period-ically and do disclose much about the condition of a company and its recentearnings history, they do not tell the statement user much about how the com-pany manages cash. Since cash flow is what companies use to pay bills and re-ward the owners with dividends, cash activity is very important and issummarized in the statement of cash flows, a statement that is required to beissued along with the balance sheet and income statement.

This chapter explains the format and objectives of the statement of cashflows, as required by FASB 95. FASB 95 was issued in 1987 by the FinancialAccounting Standards Board and superseded APB 19, which had been in place



for many years and stipulated how to prepare cash flows statements (previ-ously called statement of sources and uses of cash). Please note that FASB 95was subsequently amended by SFAS No. 102 and 104.

In the sections that follow, we examine the two ways of preparing thestatement of cash flows.

THEUSEFULNESS OF THE STATEMENTOFCASHFLOWSAn investor, creditor, or other interested person needs to know how an or-ganization got where it is and to predict what its prospects are for the reason-ably near future. There are two reasons why an income statement does notrepresent an adequate source of data for this purpose. First, an income state-ment contains estimates and assumptions that are of a noncash nature. Suchestimates tend to be mixed in with the actual cash-generating and cash-dis-bursing activities of the business; this mixture is not readily apparent whensimply examining the income statement.

Second, an income statement is most often prepared on an accrual basis.As such, many of the figures (perhaps significant percentages of various ac-counts) are far removed from actual cash flow.

The statement of cash flows provides the statement user with an insight intothe planning, decision making, and success of management in handling manyof the actions relating to cash. It also helps answer these important questions:

What amount of cash was generated and used by operations?1.What was the source of cash invested in new plant and equipment?2.How was the cash raised? From issuing stock or floating a bond?3.Why, despite a healthy net income, was the cash balance lower than the4.previous period?How was the company able to pay dividends?5.

The purpose of the statement of cash flows is to summarize the resultsof the other interrelated financial statements for the current period and topresent reasons for the inflows and outflows of cash.

THENATUREOF THE STATEMENTOFCASHFLOWSThe statement of cash flows summarizes the firm’s many sources and majoruses of cash in three key areas during a period of time:

Cash flows from operating activities. These are cash flows from day-to-day,1.income-producing activities. They include the activities that are not in thecategories of investing and financing, described in the following section.Cash flows from financing activities. These include issuance of capital stock,2.debt securities, dividend payments, repayment of debt, and purchase oftreasury stock.

84 HOW TO READ AND INTERPRET FINANCIAL STATEMENTS, SECOND EDITION



Cash flows from investing activities. These include purchases and sales of pro-3.ductive assets and other companies’ debts (bonds and notes) and equity(common and preferred stocks issued by other companies).Each of these three key areas is presented in a different section of the

statement of cash flows. The following outline details the major items in eachof the three sections. Please note that the outline contains examples of itemsto be found in each section (operating, financing, and investing) but is not in-tended to be all-inclusive.

A. Cash Flows from Operating Activities (covers all transactions not detailedin the specifics of investing or financing activities)

Cash Inflows1.Sales of goods and services for cash and the collection of accounts(a)receivableInterest and dividends received on investments(b)

Cash Outflows2.Purchases of materials and supplies(a)Employee compensation(b)Taxes(c)Interest on borrowed money(d)

B. Cash Flows from Financing ActivitiesCash Inflows1.

Issuing (selling) more common or preferred stock(a)Issuing bonds, notes, and mortgages(b)

Cash Outflows2.Dividends of common or preferred stock paid to owners(a)Principal payments on bonds, notes, and mortgages(b)Buying of stock for treasury purposes(c)

C. Cash Flows from Investing ActivitiesCash Inflows1.

Sale of property, plant, and equipment(a)Sale of a portion of the business, such as a division(b)Sale of securities (investments)(c)

Cash Outflows2.Acquisition of property, plant, and equipment(a)Making loans to another organization(b)Purchase of securities (investments)(c)

Significant Noncash Financing and Investing ActivitiesIn addition to the financing and investing activities, noncash financing

and investing activities, if significant, must be disclosed in a supplementalschedule or reported in the footnotes to the statement of cash flows. For ex-ample, the exchange of shares of $100,000 of stock for land valued at$100,000, although not a cash transaction, could have a significant effect onfuture cash flows and thus is a noncash financing and investing activity that

THE STATEMENT OF CASH FLOWS 85



should be disclosed in the statement of cash flows. Other examples of signif-icant noncash financing and investing activities include:

Conversions of debt to equity•Exchanges of assets for other assets•Receipt of donated property•


1. Classify each of the following as either:

O. Operating ActivityF. Financing ActivityI. Investing ActivityN. Noncash Financing or Investing Activity

A. ____ A company sold $100,000 of common stock to investors.B. ____ A company used $150,000 to acquire 10,000 shares of its own stock.C. ____ A company collected cash from its customers for goods sold and services provided.D. ____ A company purchased a factory for $1.5 million in cash.E. ____ A company purchased a factory for $1.5 million worth of its preferred stock.F. ____ A publishing company paid $50,000 cash for a copyright.

STATEMENTOFCASHFLOWS: FORMATALTERNATIVESFASB allows two alternative formats for the statement of cash flows. Onemethod is called the direct method; the other is called indirect. Although FASBallows either method, it recommends the direct method.

The Direct MethodThe direct method reports the major classes of net cash flows from operatingactivities by listing all major operating cash receipts and payments. The directformat must disclose at least the following categories of cash flows:

Cash collected from customers•Interest and dividends received•Other operating receipts•Cash paid to employees and suppliers•Interest payments•Income tax payments•





The advantage of the direct method is that it gives the details of operatingcash flows. The main disadvantage is that it can be costly to collect the de-tailed cashflow data. An example statement of cash flows is shown in Exhibit6–1.

The Indirect MethodThe indirect method requires that net income and net cash flow from oper-ating activities be reconciled through a series of adjustments. These adjust-ments include reducing net income for noncash revenues, increasing netincome for noncash expenses (such as depreciation), and adjusting net in-come for changes in working capital accounts. These adjustments (reconcilingnet income to net cash flow) may appear in the body of the statement, asshown in Exhibit 6–2, or they may appear in a supplemental schedule. Theadjustments should at least include:



xhibit 6–1Example Statement of Cash Flows (Direct Method)

Cash Flows from Operating Activities

Cash Received from Customers $8,150,583 Other Income 6,429 $8,157,012

Deduct: Cash Paid to Suppliers and Employees $ 7,887,687 Interest Paid 13,026 Income Taxes Paid 68,821 7,969,534 Net Cash Flow from Operating Activities $187,478

Cash Flows from Financing Activities Cash from Notes Payable—Bank $ 16,033 Deduct: Payment of Notes Payable—Bank $ 33,703 Payment of Notes Payable—Other 10,000 Purchase of Treasury Stock 22,500 66,203 Net Cash Flow from Financing Activities ($ 50,170)

Cash Flows from Investing Activities Purchase of Marketable Securities $ 66,006 Purchase of Property, Plant, and Equipment 59,290 Net Cash Flow from Investing Activities ($125,296)

Net Cash Increase $ 12,012 Beginning Cash Balance 37,988 Ending Cash Balance $ 50,000


Deferrals of past operating receipts and payments•Accruals of expected future operating receipts and payments•Changes in receivables, inventories, payables, and other operating current•assets and liabilitiesOther classes of reconciling items•Noncash gains and losses•

The indirect method, in contrast to the direct method, does not providea list of operating cash flows.



xhibit 6–2Example Statement of Cash Flows (Indirect Method)

Cash Flows from Operating Activities

Net Income $ 78,186 Add: Depreciation $ 67,933 Increase in Accounts Payable 106,627 Reduction in Other Assets 2,000 176,560

$254,746

Deduct: Increase in Accounts Receivable $ 23,197 Increase in Inventory 35,570 Increase in Prepaid Expenses 2,247 Reduction in Accrued Expenses 933 Reduction in Accrued Taxes 5,321 67,268 Net Cash Flow from Operating Activities $ 187,478

Cash Flows from Financing Activities Cash from Notes Payable—Bank $ 16,033

Deduct: Payment of Notes Payable—Bank $ 33,703 Payment of Notes Payable—Other 10,000 Purchase of Treasury Stock 22,500 66,203 Net Cash Flow from Financing Activities ($ 50,170)

Cash Flows from Investing Activities Purchase of Marketable Securities $ 66,006 Purchase of Property, Plant, and Equipment

59,290

Net Cash Flows from Investing Activities ($125,296)

Net Cash Increase $ 12,012

Beginning Cash Balance 37,988 Ending Cash Balance $ 50,000


FREECASHFLOWThere is a growing body of analytical techniques that utilize information fromthe statement of cash flows. One such technique is the free cash flow (FCF)calculation. The following is the formula for calculating one version of FCF:

Cash Flow from Operations – Capital Expenditures Required to Maintain Productive Capacity Used in the Production of Income – Dividends

= Free Cash Flow (FCF) (version 1)

One major difficulty in calculating FCF (version 1) is determining thecapital expenditures required to maintain productive capacity used in the pro-duction of income. Very few companies disclose the amount of capital expen-ditures needed to maintain productive capacity. However, there are situationsin which the amount of capital expenditures needed to maintain productivecapacity is known. Version 2 of the FCF calculation is:

EBIT (1 – Tax Rate) + Depreciation & Amortization – Change in Net WorkingCapital – Capital Expenditure = Free Cash Flow (FCF) (version 2)

EBIT is earnings before interest and taxes and can be derived from the com-pany’s income statement. This version (version 2) does not subtract dividendsand therefore produces a free cash flow amount that is available to pay divi-dends and other costs of capital.

If a company has positive FCF, it had adequate cash flow during the pe-riod to keep productive capacity at current levels. Positive FCF is crucial forlong-term growth. Think of it this way: adequate free cash flow allows a com-pany to pay dividends (and therefore reward stockholders) and do the thingsthat help growth, such as make acquisitions, develop new products, and investin new property, plant, and equipment.


2. Using the information from Exhibit 6–1 and the version 1 formula of FCF, calculate:

A. the free cash flow, assuming that the capital expenditures required to maintain productivecapacity used in the production of income are exactly equal to the amount of cash flow spenton property, plant, and equipment.

B. the FCF if the company paid $20,000 in dividends.

3. Assume that a company has EBIT of $1,000,000 and the following facts also exist:Tax rate: 35%Depreciation for the year: $100,000 Change in WC: +$50,000Capital expenditures for the year: $150,000






A. Calculate the Free Cash Flow (FCF) using the version 2 method.

FCF = $___________

B. If a similar cash flow projection is made for next year and management is contemplating another$600,000 of capital spending above current year levels, what do you think would have to happento carry out management’s plans?

Under generally accepted accounting principles (GAAP), afull set of financial statements includes the balance sheet, in-come statement, and statement of cash flows, as required byFASB. The statement of cash flows must cover the same periodas the income statement. The statement of cash flows providesinsight into how cash has been generated and how it has beenused by a company. In addition, the statement of cash flowsallows interested parties to understand how cash inflows mightbe generated and used in the future.

There are two acceptable formats for the statement of cash flows: directand indirect. Both the direct and indirect methods classify cash flows accord-ing to operating, investing, and financing activities. The different presentationsaffect the operating section only. The investing and financing sections do notdiffer between the two presentations. Some experts believe that the directmethod is more revealing of a company’s ability to generate sufficient cashfrom operations to pay debts, reinvest in operations, and make distributionsto owners. The indirect method focuses on the difference between net incomeand net cash flow from operations and provides useful links among the state-ment of cash flows, the income statement, and the balance sheet.

One metric that can be calculated using the statement of cash flows isfree cash flow (FCF). This chapter shows how FCF is calculated using thestatement of cash flows and how it is a useful measurement to be consideredby management and external parties such as investors and creditors.





FASB 95 established standards for: 1. (b)1.how to prepare the balance sheet on a cash basis.(a)cash flow reporting.(b)the sources and uses of funds statement.(c)preparing the income statement on a cash basis.(d)

Which of the following cannot be determined from the statement 2. (d)2.of cash flows?

The amount of cash generated and used by operations(a)The source of cash invested in new plant and equipment(b)The amount of cash raised from issuing stock or floating a bond(c)The amount of stock awarded in a stock split during the period(d)

Which of the following entries would be found in the operating 3. (c)3.activities section of the statement of cash flows?

Cash received from selling the firm’s common stock(a)Cash received from dividends on marketable securities(b)Cash received from the sale of goods and services(c)Cash paid to acquire property, plant, and equipment(d)

Which of the following statements describes the direct method of the 4. (a)4.statement of cash flows?

It reports the major classes of net cash flows from operating activities(a)by listing all major operating cash receipts and payments.It requires that net income and net cash flow from operating activities(b)be reconciled through a series of adjustments.It shows all cash and noncash activities that impact the ability to pay(c)interest and dividends on corporate capital.It only shows cash flows from operating activities and excludes cash(d)flows from financing and investing activities.

Which of the following statements describes the indirect method of the 5. (b)5.statement of cash flows?

It reports the major classes of net cash flows from operating activities(a)by listing all major operating cash receipts and payments.It requires that net income and net cash flow from operating activities(b)be reconciled through a series of adjustments.It shows all cash and noncash activities that impact the ability to pay(c)interest and dividends on corporate capital.It only shows cash flows from operating activities and excludes cash(d)flows from financing and investing activities.

Review Questions







1. A. FB. FC. OD. IE. NF. I

2. A. $128,188B. $108,188

3. A. $450,000B. Another $600,000 of capital spending will not be possible

without additional financing from outside the company.


7Balance Sheet Analysis

Learning Objectives


• List the liquidity, activity, and leverage ratiosused to analyze a balance sheet.

• Explain the purpose of horizontal and verti-cal analysis.

INTRODUCTIONThe prior chapters have presented background on the preparation of financialstatements, their components, and the efforts of the accounting profession toprovide consistent financial statements that are materially correct. The assur-ance that we have financial statements that present each balance in a consistentmanner from year to year allows us to analyze financial statements on a com-parative basis for a single company and for others in the same industry.

The aim of financial statement analysis depends on the user. Banks andcreditors are interested in the business entity’s ability to meet liabilities in theshort run. Bondholders and shareholders, both current and potential, are in-terested in the capital structure, earnings, and how efficiently the entity usesits resources. Management is interested in analysis and trends that disclosestrengths, weaknesses, and potential problems.



RATIOS INFINANCIAL STATEMENTANALYSISWhen analyzing financial statements, the first task is to determine what in-formation is being sought. Many analytical techniques can disclose informa-tion about a company. Once the financial statement analyst knows whatinformation is being sought, the proper technique can be used. Financial ratiosare the primary analytical tool of the analyst. Ratios are easy to compute, ver-ifiable, and allow for period-to-period and company-to-industry comparisons.

Limitations of Financial RatiosThere are some disadvantages to ratio analysis, and caution should be exer-cised when using ratios. Ratios should not be considered as the only answerto complex questions. Ratios are only as good as the information contained infinancial statements, which in part consist of historical costs that may not bein line with reality and estimates and allocations that are somewhat subjective.In addition, with the possibility of the existence of financial statement errorsand omissions, the financial statement analyst should know that a ratio can bemisleading.

Ratio analysis must be considered as only one step in the complete analy-sis of a company. Additional avenues of approach should be taken, includingexamination of footnotes to the financial statements, review of the nonfinan-cial material of an annual report, comparison of industry statistics with thoseof the company being analyzed, and matching the company’s ratios againstthose of a leading competitor.

Finally, a ratio by itself is not of much use. To give ratios some basis forcomparison, the analyst should review one or more of the reference materialsthat list industry ratios and averages. Two excellent sources for industry ratiosare Dun & Bradstreet’s Industry Norms and Business Ratios and Robert MorrisAssociates’ Annual Statement Studies (for 340 lines of business). Another goodsource is the Almanac of Business and Industrial Financial Ratios published byPrentice-Hall. These volumes are often available at corporate libraries andbusiness school libraries.

Many libraries, especially those associated with business schools, haveweb resources to help students do research on corporate entities. One suchsource is Thomson ONE, which provides access to real-time and historicalSEC EDGAR filings. Thomson ONE also includes thousands of research re-ports. Thomson ONE is published by Thomson Reuters, a leading source ofintelligent corporate financial information.

Another source of financial data and ratios is Mergent Online (www.mer-gentonline.com). Mergent provides Internet-based access to a detailed andcomprehensive database of global companies. One feature of Mergent Onlineis FactSheets Express, which is available for 10,000 U.S. and Canadian com-panies. It covers essential facts and figures, including a fifteen-year stock priceand volume chart, summary of annual financials, recent quarterly earnings,and key financial ratios.



http://www.mer-gentonline.com

http://www.mer-gentonline.com


CATEGORIES OF FINANCIALRATIOSFinancial ratios can be classified into the following categories: liquidity, ac-tivity, leverage, and profitability. In this chapter, you will learn about liquidity,activity, and leverage ratios. Chapter 8 presents profitability ratios.

Liquidity RatiosLiquidity ratios attempt to measure a company’s ability to meet its short- termobligations. There are two popular liquidity ratios: the current ratio and thequick (or acid-test) ratio.

Current RatioThe current ratio expresses how many times the current assets of a company“cover” current liabilities. For example, using 20X1 figures from Exhibit 7–1,the company has a current ratio of 1.97, calculated as follows:

A current ratio of greater than 1 means that the book value of the currentassets is greater than the amount of current liabilities. A current ratio of lessthan 1 means that the company does not have sufficient liquid assets to payoff the current liabilities.

At one time, the rule of thumb was that a current ratio of 2 or greater wasconsidered adequate. However, that rule of thumb became outdated as analystsrealized that much depends on the industry in which the firm operates. Thebest way to evaluate a current ratio of a specific company is to compare it toan industry average. Thus, if the industry average is 2.5, then the current ratioof 1.97 is below the industry average and could be a cause for concern.

The current ratio is only one measure of determining liquidity. It doesnot answer the questions that better determine true liquidity, such as: Howliquid (good) are the receivables, or how liquid (current) is the inventory?

Quick (Acid-Test) RatioIn the current ratio formula (current assets/current liabilities), the value ofinventories is included in current assets. That inclusion is a potential draw-back. Inventories, although technically a member of the current asset family,could be slow-moving or obsolete and therefore not truly liquid. Current as-sets also can include prepaid expenses that are of value to the company in theaccounting sense but do not represent an asset available to satisfy current ob-ligations. The quick ratio, also known as the acid-test ratio, attempts to meas-ure the firm’s ability to meet its obligations without having to convertinventories to cash and without considering prepaid expenses.

Using Exhibit 7–1 as an example, the quick ratio for 20X1 is computedas follows:

Current Assets ($1,759,779) = 1.97

Current Liabilities ($891,502)

Cash and Marketable Securities and Net Receivables ($413,862) = 0.46

Current Liabilities ($891,502)

BALANCE SHEET ANALYSIS 95



As was the case with the current ratio, the quick ratio of a company hasanalytical usefulness when compared to an industry average. If the quick ratioindustry average is 0.95, and the company quick ratio is 0.46, then the com-pany is only about half as liquid as the industry average and may be very de-pendent on the quick turnover of inventories to meet obligations.



xhibit 7–1A Company’s Comparative Balance Sheet, Years Ended December 31

Assets 20X1 20X0 Current Assets:

Cash $ 50,000 $ 37,989 Marketable Securities 116,006 50,000 Accounts Receivable 247,856 224,659 Inventories 1,343,670 1,308,100 Prepaid Expenses 2,247 0



316,881 325,524 Other Assets 6,537 8,537

Total Assets $2,083,197 $1,954,808


Notes Payable—Bank $ 55,000 $ 85,000 Current Portion of Long-Term Debt 1,850 5,553 Accounts Payable 642,237 535,610 Notes Payable—Other 134,692 144,692 Accrued Expenses 46,980 47,913 Accrued Income Taxes 10,743 16,064


Long-Term Debt Notes Payable—Bank 22,818 10,488 Less: Current Portion (1,850) (5,553)

Net Long-Term Debt 20,968 4,935 Owners’ Equity

Common Stock, Issued and Outstanding: 10,000 Shares 122,643 122,643 Retained Earnings 1,070,584 992,398

1,193,227 1,115,041 Less Treasury Stock (At Cost) 22,500 0

1,170,727 1,115,041 Total Liabilities and Owners’ Equity $2,083,197 $1,954,808

!



1. Using the balance sheet shown in Exhibit 7–2, compute and evaluate the following for 20X1:

Current Ratio _______ (Industry Average = 2 times)

Evaluation: ________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

2. Current Ratio _______ (Industry Average = 2 times)

Evaluation: ________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

Limitations of the Current and Quick RatiosThe current ratio and quick ratio do not constitute an entire liquidity analysis.These ratios are merely a starting point. Other factors to be considered in-clude:

The nature of the business•The composition of the current assets•The seasonal nature of the business and how it affects liquidity•The quality of management•The probability of real current asset values (market values) deviating•greatly from the book valuesThe company’s credit rating and ability to refinance short-term debts•

Activity RatiosActivity ratios measure how efficiently the company manages its assets. Ac-tivity ratios help answer these questions:

How well does the company manage accounts receivable?•How well does the company manage inventory?•How well does the company generate revenues from its base of assets?•







xhibit 7–2A Company’s Comparative Balance Sheet, Years Ended December 31

Assets 20X1 220X0 Current Assets:

Cash $ 40,000 $ 37,988 Marketable Securities 200,000 50,000 Accounts Receivable 247,856 224,659 Inventories 1,132,559 1,308,100 Prepaid Expenses 7,247 0



Total Fixed Assets 314,659 325,524

Other Assets 6,648 8,537

Total Assets $1,948,969 $1,954,808


Notes Payable—Bank $ 65,000 $ 85,000 Current Portion of Long-Term Debt 2,850 5,553 Accounts Payable 543,348 535,610 Notes Payable—Other 134,692 144,692 Accrued Expenses 46,980 47,913 Accrued Income Taxes 10,743 16,064


Long-Term Debt Notes Payable—Bank 22,818 10,488 Less: Current Portion (2,850) (5,553)

Net Long-Term Debt 19,968 4,935 Total Liabilities 823,581 839,767

Owners’ Equity Common Stock, Issued and Outstanding: 10,000 Shares 122,643 122,643 Retained Earnings 1,025,245 992,398

1,147,888 1,115,041

Less Treasury Stock (At Cost) 22,500 0 Total Owners’ Equity 1,125,388 1,115,041

Total Liabilities and Owners’ Equity $1,948,969 $1,954,808 !


There are many activity ratios. The sections that follow present five ac-tivity ratios:

Accounts receivable turnover1.Average collection period2.Inventory turnover3.Number of days’ inventory4.Total asset turnover5.

Accounts Receivable TurnoverThe accounts receivable turnover, along with the average collection period,gives an indication as to how well the company is managing its accounts re-ceivable. The trend of a rising accounts receivable turnover is favorable, sinceit means that the company is becoming more effective at collecting the re-ceivable balances—more effective at “turning over” these balances. The for-mula for the accounts receivable turnover is as follows:

Net Credit Sales

Average Accounts Receivable

Average accounts receivable, the denominator in the accounts receivableturnover formula, is determined by a simple average as follows:

Beginning Balance of Accounts Receivables + Ending Receivables

2

Using the example comparative balance sheet and income statement inExhibits 7–3 and 7–4, the accounts receivables turnover as of 12/31/20X1 is34.6, computed as follows:

Net Sales

Accounts Receivable

$8,173,780

$247,856 + 224,657 ÷ 2

The larger the turnover number, the better. If the industry average forthis example is 25, then the company, with an accounts receivable turnoverof 34.6, is more effective at collecting its receivables.

Average Collection PeriodThe average collection period is the average time it takes to collect a creditsale. A trend of a falling average collection period means that a company isprobably becoming better at collecting receivables or at judging credit risk. Arising average collection period means trouble—customers are stretchingtheir payments. The average collection period is calculated as follows:




365 Days

Accounts Receivable Turnover Ratio

For example, using the previous example of an accounts receivable turnoverof 34.6, the average collection period is 10.55 days, computed as follows:

When the average collection period of this example is compared to theindustry average of 14.6 days, the company is collecting receivables faster(10.54 days versus 14.6 days) than is the industry.

Inventory TurnoverThe inventory turnover ratio monitors how effective a company is at manag-ing its inventory. The ratio represents the number of times during the year(or period) that a company replaces (“turns over”) its inventory. A rising trendshows an improving efficiency in managing inventory. This is an indicationthat the firm is squeezing more and more sales from a proportionately smallerinventory investment. The inventory turnover is calculated using the follow-ing formula:

Cost of Goods Sold

Average Inventory

365= 1.97

34.6



xhibit 7–3Statement of Income, Years Ended December 31

20X1 20X0 Sales $8,173,780 $7,341,704 Cost of Goods Sold 5,963,510 5,189,315

Gross Profit 2,210,270 2,152,389

Operating Expenses Selling and Administrative 1,994,054 1,887,420 Depreciation 67,933 66,575 Interest 13,026 29,966


Profit from Operations 135,257 168,428

Other Income 6,429 35,609 Profit Before Taxes 141,686 204,037 Provision for Taxes 63,500 87,000

Net Income 78,186 117,037 !


with the average inventory computed as follows:

Beginning Inventory + Ending Inventory

2



xhibit 7–4Balance Sheet, Years Ended December 31, Vertical and Horizontal Analysis

Assets 20X1 % 20X0 % Current Assets:

Cash $ 50,000 2.40% $ 37,989 1.94% Marketable Securities 116,006 5.57% 50,000 2.56% Accounts Receivable 247,856 11.90% 224,659 11.49% Inventories 1,343,670 64.50% 1,308,100 66.92% Prepaid Expenses 2,247 0.11% 0 0.00%

Total Current Assets 1,759,779 84.47% 1,620,747 82.91%

Fixed Assets: Property, Plant, and Equipment 860,307 41.30% 803,518 41.10% Less: Accumulated Depreciation 543,426 26.09% 477,994 24.45%

316,881 15.21% 325,524 16.65% Other Assets 6,537 0.31% 8,537 0.44%

Total Assets $2,083,197 100.00% $1,954,808 100.00%


Notes Payable—Bank $ 55,000 2.64% $ 85,000 4.35% Current Portion of

Long-Term Debt 1,850 0.09% 5,553 0.28% Accounts Payable 642,237 30.83% 535,610 27.40% Notes Payable—Other 134,692 6.47% 144,692 7.40% Accrued Expenses 46,980 2.26% 47,913 2.45% Accrued Income Taxes 10,743 0.52% 16,064 0.82%

Total Current Liabilities 891,502 42.79% 834,832 42.71%

Long-term Debt Notes Payable—Bank 22,818 1.10% 10,488 0.54% Less: Current Portion (1,850) 0.09% (5,553) 0.28%

Net Long-Term Debt 20,968 1.01% 4,935 0.25% Owners’ Equity

Common Stock, Issued and Outstanding: 10,000 Shares 122,643 5.89% 122,643 6.27% Retained Earnings 1,070,584 51.39% 992,398 50.77%

1,193,227 57.28% 1,115,041 57.04% Less Treasury Stock (At Cost) 22,500 1.08% 0 0.00%

1,170,727 56.20% 1,115,041 57.04% Total Liabilities and

Owners’ Equity $2,083,197 100.00% $1,954,808 100.00%




For example, using the numbers from Exhibits 7–3 and 7–4, the com-pany’s inventory turnover for 20X1 is 4.5 times, calculated as follows:

Cost of Goods Sold

Average Inventory

If the industry average for the inventory turnover is 6 times, then thecompany, with a turnover of 4.5 times, is not moving its inventory as fast asthe industry average.

Number of Days’ InventoryThe “number of days inventory” ratio is the average number of days a unit isin inventory. It is computed using the following formula:

365

Inventory Turnover

For example, if a company’s inventory turnover is 4.5 times, then thenumber of days in inventory is 81.11 days. If the industry average for the num-ber of days inventory is 75 days, then the company is holding items in inven-tory longer than the industry average.

Total Asset TurnoverThe total asset turnover ratio reveals how effective a company is at generatingsales from its base of assets. It is an indication of general company efficiencyand is calculated using the following formula:

Net Sales

Total Assets

Exhibit 7–3 shows that the company had net sales of $8,173,780 in 20X1,and Exhibit 7–1 shows total assets (for 20X1) of $2,083,197, for a total assetturnover of 3.92 times, calculated as follows:

If the industry average for the total asset turnover is 2.9, then the com-pany is squeezing relatively more sales out of its base of assets than the in-dustry does on average.

$5,963,510 = 4.5

($1,343,670 + 1,308,100) ÷2

$8,173,780 ÷ 3.92

$2,083,197



3. Using Exhibits 7–2 and 7–5, calculate and evaluate the following for 20X1:

Average Collection Period __________ (Industry Average = 19 days)

Evaluation: ________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

4. Inventory Turnover __________ (Industry Average = 3 times)

Evaluation: ________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________




xhibit 7–5Statement of Income, Years Ended December 31 !

20X1 20X0 Sales $8,172,669 $7,341,704 Cost of Goods Sold 5,961,288 5,189,315

Gross Profit 2,211,381 2,152,389

Operating Expenses Selling and Administrative 1,990,721 1,887,420 Depreciation 67,489 66,575 Interest 12,915 29,966


Profit from Operations 140,256 168,428 Other Income 6,540 35,609 Profit Before Taxes 146,796 204,037 Provision for Taxes 62,500 87,000

Net Income 84,296 117,037 !


Leverage RatiosManagement has a choice between two sources of financing for the company—debt and equity. Of the two choices, debt carries the greatest risk, since its costis fixed and contractual. However, debt financing has an important advantage;in good times (rising revenues), the cost of debt is limited to the interest pay-ments, whereas the cost of equity is variable. The use of debt to finance a firmis called leverage because of the potential to “leverage” earnings by using debt.

Leverage ratios help the analyst forecast the solvency of the firm in thelong run. They give long-term debt-holders an indication of the protectionavailable to them, as well as indicating to equity holders/investors how securetheir returns may be. If more debt is added to a firm’s structure, the return oncommon stock may be reduced or less certain.

The following ratios may be used by analysts in their examination of acompany’s use of leverage:

Debt ratio•Debt-to-equity ratio•Times interest earned•

Debt RatioThe debt ratio is also called the total-debt-to-total-assets ratio. It is a measure ofthe degree to which assets would be needed to settle claims by creditors if acompany had to liquidate its assets. It could also be viewed as the percentageof assets financed by debt. The debt ratio is calculated as follows:

Total Debt

Total Assets

Using the 20X1 figures from Exhibit 7–1, the company’s debt ratio is 43.80percent ($912,470 ÷ $2,083,197). If the industry debt ratio is 45 percent, youcould say that the company is using comparable levels of debt to finance assets.

Debt-to-Equity RatioThe debt-to-equity ratio shows the stake that creditors have in the businessin relation to the owners’ investment. If a company has a debt-to-equity ratiothat is comparatively lower than the industry average, that company’s credi-tors’ demands are probably not of great concern to management. However, acomparatively high debt-to-equity ratio is of great concern to management,since it means that creditors’ demands could impact its freedom. The debt-to-equity ratio is computed as follows:

Total Liabilities

Total Owners’ Equity

Using Exhibit 7–1 as an example, the company’s debt-to-equity ratio for20X1 is 77.94 percent, calculated as follows:

$912,470 = 77.94 percent$1,170,727




If the industry average for debt-to-equity ratio is 80 percent, then thecompany is feeling about the same amount of debt pressure as does the in-dustry on average. A very small debt-to-equity ratio may not be good for acompany, since prudent use of debt, with its fixed cost, can help a companyachieve a greater rate of return than when the debt is not used.

Times Interest EarnedThe times-interest-earned ratio measures the company’s ability to meet in-terest payments. It is an indication of the company’s margin of safety, showingthe ability of earnings to pay interest on debts. The ratio discloses the numberof times that earnings could cover the interest expense of the company. A rel-atively high times-interest-earned ratio is preferable to a low ratio. Using the20X1 numbers from Exhibit 7–3 as an example, the times-interest-earnedratio is 11.88 times, calculated as follows:

Income Before Taxes and Interest Charges

Interest Charges

If the industry average is 10, then the company with an 11.88 times in-terest earned ratio is in good shape.


5. Using Exhibits 7–2 and 7–5, calculate and evaluate the following for 20X1:

Debt-to-Equity Ratio __________ (Industry Average = 65 percent)

Evaluation: ________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

6. Times-Interest-Earned Ratio __________ (Industry Average = 10 times)

Evaluation: ________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

$154,712 = 11.88$13,026





VERTICAL ANDHORIZONTALANALYSISAnother useful tool for spotting trends is vertical and horizontal analysis. Thisis accomplished by determining what each item on the financial statement isas a percentage of a given base. The base is usually total assets in the case ofthe balance sheet, and net sales in the case of the income statement. Horizontalanalysis compares percentages across periods, whereas vertical analysis com-pares them within the period. We can use the data set out in Exhibit 7–4 toillustrate vertical and horizontal analysis. For example, a horizontal analysisof inventories shows that inventory was 66.92 percent of total assets in 20X0,but only 64.50 percent in 20X1. This comparison is made by looking horizon-tally across the years of the balance sheet. Vertical analysis is just the opposite.It involves looking up and down the columns of the balance sheet and makingcomparisons. For example, in 20X1, inventory at 64.5 percent of total assetsis by far the greatest component of assets, with accounts receivable (at 11.90percent) being the next-largest asset element.

A further horizontal and vertical analysis of Exhibit 7–4 reveals that thecompany has apparently improved in a few areas. The cash and marketablesecurities have increased, while inventories have gone down. This makes thecompany more liquid, which is also seen in the increase in current assets as apercentage of the total.

On the liability side, the decrease in notes payable has been offset by theincrease in the accounts payable. The company has switched bank debt fortrade debt.


7. What trends do you spot by examining the balance sheet in Exhibit 7–6?

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________







xhibit 7–6Balance Sheet, Years Ended December 31

Assets 20X1 % 20X0 % Current Assets:

Cash 100,000 5.26% 37,989 1.94% Marketable Securities 75,000 3.94% 50,000 2.56% Accounts Receivable 257,856 13.56% 224,659 11.49% Inventories 1,143,670 60.12% 1,308,100 66.92% Prepaid Expenses 2,247 0.12% 0 0.00%

Total Current Assets 1,578,773 83.00% 1,620,747 82.91%

Fixed Assets: Property, Plant, and

Equipment 860,307 45.23% 803,518 41.10% Less: Accumulated

Depreciation 543,426 28.57% 477,994 24.45%

316,881 16.66% 325,524 16.65% Other Assets 6,537 0.34% 8,537 0.44%

Total Assets $1,902,191 100.00% $1,954,808 100.00%


Notes Payable—Bank 25,000 1.31% 85,000 4.35% Current Portion of

Long-Term Debt 1,850 0.10% 5,553 0.28% Accounts Payable 542,237 28.51% 535,610 27.40% Notes Payable—Other 104,692 5.50% 144,692 7.40% Accrued Expenses 46,980 2.47% 47,913 2.45% Accrued Income Taxes 10,743 0.56% 16,064 0.82%

Total Current Liabilities 731,502 38.46% 834,832 42.71%

Long-term Debt Notes Payable—Bank 122,818 6.46% 10,488 0.54% Less: Current Portion (1,850) !0.10% (5,553) !0.28%

Net Long-Term Debt 120,968 6.36% 4,935 0.25% Owners’ Equity

Common Stock, Issued and Outstanding: 10,000 Shares 122,643 6.45% 122,643 6.27% Retained Earnings 949,578 49.92% 992,398 50.77%

1,072,221 56.37% 1,115,041 57.04% Less Treasury Stock

(At Cost) 22,500 1.18% 0 0.00% 1,049,721 55.18% 1,115,041 57.04%

Total Liabilities and Owners’ Equity $1,902,191 100.00% $1,954,808 100.00%

!


Financial analysis can help you gain a better understandingof the financial strengths and weaknesses of a firm. Althoughfinancial analysis can take many forms, financial ratio analysisis one of the tools most commonly used.

Three categories of financial ratios were examined in thischapter: liquidity, activity, and leverage. Liquidity ratios helpthe user understand the company’s ability to pay its bills. Thecurrent ratio and the quick (acid-test) ratio are commonlyused to judge liquidity. Activity ratios measure how efficiently

the company manages its assets. Examples of activity ratios include accountsreceivable and inventory turnover, average collection period, number of daysinventory, and total asset turnover. Leverage ratios measure debt burden. Thedebt ratio, debt-to-equity ratio, and times-interest-earned ratio are three pop-ular leverage ratios that help financial statement users monitor the long-termsolvency of a business.

Another technique to analyze the balance sheet is using vertical and hor-izontal analysis. By calculating balance sheet items as a percentage of assetsand comparing results from year to year, trends can be recognized that can’talways be seen from a first glance at the numbers.




The following formula is for the ____ ratio: 1. (b)1.(Cash + Marketable Securities + Net Receivables)

Current Liabilitiescurrent ratio(a)quick ratio(b)debt ratio(c)solvency ratio(d)

Which of the following best describes the difference between the 2. (c)2.current ratio and the quick ratio?The current ratio allows one-half of fixed assets to be considered (a)as a liquid asset whereas the quick ratio only considers current assets as liquid.The current ratio uses current fair market values whereas the (b)quick ratio uses liquidation values for current assets.The quick ratio does not include inventory in the nominator of (c)the ratio whereas the current ratio does.The quick ratio includes long-term investments at their fair (d)market value whereas the current ratio does not.

Which ratio is this? 3. (c)3.Cost of Goods

Sold Average InventoryNumber of days inventory(a)Average collection period(b)Inventory turnover(c)Total asset turnover(d)

Which of the following ratios measures the stake that creditors have 4. (a)4.in the business in relation to the owners’ investment?Debt-to-equity ratio(a)Debt ratio(b)Times interest earned(c)Total asset turnover(d)

If you are using a form of financial analysis that uses a base of total assets 5. (d)5.in the case of the balance sheet, and net sales as a basis of comparison in the case of the income statement, you would most likely be working with:the current ratio.(a)the quick ratio.(b)the acid test ratio.(c)vertical and horizontal analysis.(d)

Review Questions





1&2. Current Ratio = 2, which is equal to the industry average and therefore anacceptable ratio. Quick Ratio = 0.6, which is below the industry average. Thismeans that the firm’s liquidity is less than that of its peers in the industry (onaverage) and therefore needs improvement. The lower-than-average quick ratio,in tandem with an average current ratio, may point to a relatively large investment(in relation to industry averages) in inventory.

3&4. Average collection period = 10.5 days, as compared to the industry average of 19days, means that the firm is collecting receivables faster than does its peers in theindustry. Inventory turnover of 4.88 times, as opposed to an industry average of 3times, is favorable, since it means that the firm is “turning over” its inventory fasterthan does its peers in the industry.

5&6. A debt-to-equity ratio of 73 percent, as compared to the industry average of 65percent, means that the firm uses relatively more debt to finance its operationsthan do its peers in the industry. A times-interest-earned ratio of 12.36 times isfavorable, in comparison with the industry average of 10 times. Because the firm’stimes-interest-earned ratio is greater than the industry average, you can concludethat the firm has a larger safety cushion to cover its interest charges with earningsthan its peers.

7. The liquidity position of the company has improved with cash, marketablesecurities, and accounts receivable equaling 22.75 percent of assets in 20X1, asopposed to 15.99 percent in 20X0. In addition, the company’s current assets as apercentage of total liabilities and equity decreased from 42.75 percent in 20X0 to38.46 percent in 20X1. However, long-term debt increased from .25 percent to 6.36percent during that same period.




8Income Statement Analysis

Learning Objectives


• List the three elements of every sales dollar.• Identify the elements to be analyzed in thegross profit ratio.• List the profitability ratios.• Discern income trends using vertical andhorizontal analysis.

SALESAnalysis of the income statement begins with sales, or more specifically, netsales. Net sales are equal to gross sales, less returns and allowances or discounts.Gross sales must not be used as the basis for percentage and ratio calculationsbecause the amount of sales returns and allowances may be significant.

Every sales dollar is made up of three basic components: cost of goods sold,operating expenses, and net income or loss. Note: If net income is zero (break-even),then the sales dollar will have two elements—cost of goods sold and operatingexpenses.

COSTOFGOODS SOLDThe cost of goods sold, sometimes called cost of sales, is generally the most sig-nificant cost as a percentage of sales in the income statement. Cost of goodssold is a relatively simple computation. The following formula shows the



calculation for a merchant—a retailer or wholesaler:

Cost of Beginning Inventory + Net Purchases −

the Cost of the Ending Inventory = Cost of Goods Sold

Net purchases are calculated this way:

(Purchases for the Period − Purchase Discounts) −

Purchase Returns and Allowances] + Freight Charges = Net Purchases

The cost of goods sold in a manufacturing company is a bit more complex.Instead of net purchases, another calculation is performed called cost of goodsmanufactured. That calculation takes into account the purchases during theperiod and the changes in the work-in-process account. Here is the basic for-mula for cost of goods sold for a manufacturing company:

Beginning Finished Goods Inventory + Cost of Goods Manufactured

During the Period − Ending Finished Goods Inventory


1. Use the following numbers to compute the cost of goods sold for 20X1 for a retailer:

Inventory, January 1, 20X1 $200,000Inventory, December 31, 20X1 $250,000Purchases During 20X1 $300,000Purchase Returns and Allowances During 20X1 $20,000Purchase Discounts During 20X1 $10,000Freight Charges on Purchases During 20X1 $11,000

Cost of Goods Sold $ _______

2. Use the following information to calculate the cost of goods sold for 20X1 for a manufacturer:

Finished Goods Inventory, January 1, 20X1 $200,000Finished Goods Inventory, December 31, 20X1 $250,000Cost of goods Manufactured During 20X1 $300,000Purchases $20,000

Cost of Goods Sold $ _______

Gross ProfitThe excess of sales over cost of goods sold is called gross profit. The calculatedpercentage (amount of gross profit divided by net sales) is often used as anoperating ratio, called gross-profit-margin ratio or gross profit ratio.





Changes in the gross profit ratio should be analyzed in detail for:

The quantity of units of product sold•The changes in selling prices•The cost of goods sold in terms of units of the different types of product•(product mix)Changes in costs•In multi-product companies, sales mix is very important in calculating a

gross profit amount or ratio. Variations in gross profit between the periodsunder study may occur because of increases or decreases in sales volume, unitcost, unit selling price, or a combination of these factors.

Analysis of Trends of Net Sales, Cost of Goods Sold, and Gross ProfitThe gross profit and the gross profit ratio can give an early indication of acompany’s profitability. Analysis of trends in net sales, cost of goods sold, andgross profit can provide additional information. Exhibit 8–1 shows an exampleof how trends can tell a story about the profitability of a company.

Exhibit 8–1 shows a four-year trend of sales, cost of sales, and gross profitfor a company. With 20X1 as a base period, the following have been com-puted:

Net sales trend percentage•Cost of goods sold trend percentage•Cost of goods sold as a percentage of sales•Gross profit ratio•Notice in Exhibit 8–1 that although the net sales trend percentage for

20X4 is up 46 percent from the 20X1 level (20X4 is 146 percent of the 20X1level), the cost-of-goods-sold-trend percentage is also up—57 percent (20X4level is 157 percent of 20X1), resulting in a shrinking gross profit ratio of 40.9percent in 20X4, down from its 20X1 level of 45 percent. This means that al-though the gross profit dollar amount is moving upward, the company is lessprofitable because cost of goods sold is increasing relative to sales, and thegross profit ratio is in a downward trend.

Operating ExpensesThe gross profit is a preliminary profit from which operating expenses are sub-tracted. If management exercises any significant control over costs and expenses,it is usually in the area of operations. Operating management is mainly respon-sible for the day-to-day activities that produce revenue, and results should re-flect the company’s ability to adjust expenses to the fluctuation of sales.

Analysis of operating expense components and trends may be of somevalue to financial management. Exhibit 8–2 shows an analysis of the compo-nents and trends of the operating expenses of a company. The individual op-erating expense ratios are shown as percentages of net sales, and reflect howmuch of the revenue has been consumed by various operating expenses. Theseratios and percentages can also gain greater meaning when compared withthose of similar businesses or the industry as a whole.

INCOME STATEMENT ANALYSIS 113



In Exhibit 8–2, the four-year sales trend shows a 42 percent increase,while expenses increased by 93 percent.

OPERATING INCOMEOperating income is the end result of the buying, manufacturing, and sellingactivity of a business. It is the total profit available after normal operating ex-penses have been deducted from gross profit but before interest income, div-idend income, interest expense, and extraordinary and nonrecurring incomeand expenses have been added or deducted. Operating income is the basis forevaluating the profitability of operations. It is calculated as follows:

Operating Income = Gross Profit – Operating Expenses



xhibit 8–1Trends: Comparison of Net Sales, Cost of Goods Sold, and Gross Profit

20X1 20X2 20X3 20X4

Net Sales $119,600 $144,100 $161,700 $174,400 Trend Percentage 100 120 135 146

Cost of Goods Sold $ 65,700 $ 83,600 $ 95,100 $103,000 Trend Percentage 100 127 145 157

Gross Profit $ 53,900 $ 60,500 $ 66,600 $ 71,400 Trend Percentage 100 112 124 132

Gross Profit Ratio 45.07% 41.98% 41.19% 40.94%

!

xhibit 8–2Comparative Statement of Operating Expenses

20X1 20X2 20X3 20X4 $ % $ % $ % $ % Sales Salaries 32.4 5.1 35.0 5.2 36.5 4.9 46.1 5.1 Salesperson Travel 7.0 1.1 8.1 1.2 12.7 1.7 19.0 2.1 Advertising 14.7 2.3 20.9 3.1 26.8 3.6 38.0 4.2 Depreciation: Equipment 12.1 1.9 14.9 2.2 20.1 2.7 29.0 3.2

Maintenance and Repair 14.0 2.2 18.2 2.7 23.8 3.2 35.3 3.9 Office Salaries 23.6 3.7 27.7 4.1 29.1 3.9 32.6 3.6

Total Expenses 103.8 16.3 124.8 18.5 149.0 20.0 200.0 22.1 Expense Trend 100.0 120.2 143.5 192.7 Net Sales 637.0 675.0 745.0 905.0 Sales Trend 100.0 106.0 117.0 142.0 !


PROFITABILITYRATIOSProfitability ratios can be used to assess a company’s ability to control ex-penses and to convert sales into profits. In addition, profitability ratios helpdetermine how effectively the company produces profits from its resources.We present six profitability ratios in the sections that follow:

Gross profit margin•Operating profit margin•Profit margin•Return on assets•Return on equity•Earnings per share•We will use the 20X1 numbers from the balance sheet and income state-

ments in Exhibits 7–1 and 7–3 to explain each of the profitability ratios.

Gross Profit MarginThe gross profit margin shows the percentage of revenue or sales left aftersubtracting the cost of goods sold. A company that boasts a higher gross profitmargin than its competitors and the industry average is doing a good job pric-ing its product and controlling its cost of goods (or cost of goods manufac-tured). It is calculated as follows:

Gross Profit Margin = Gross Profit ÷ Net Sales (Revenues)

.27 or 27% = $2,210,270 ÷ $8,173,780

Operating Profit MarginThe operating profit margin shows the percentage of revenue or sales leftafter subtracting cost of goods sold and operating expenses. A company thathas a higher operating profit margin than its competitors and the industry av-erage is doing a good job controlling operating costs and/or maintaining asolid gross profit margin. It is calculated as follows:

Operating Profit Margin = Profit from Operations ÷ Net Sales (Revenues)

.0165 or 1.65% = $135,257 ÷ $8,173,780

Profit MarginThe profit margin shows the percentage of net income produced by each salesdollar. Using the income statement from Exhibit 7–3, the profit margin for-mula is:

Profit Margin = Net Income after Taxes ÷ Net Sales =

$78,186 ÷ $8,173,780 = 0.96 percent

The industry profit margin is 1.20 percent. The company profit marginof .96 percent means that the company is less profitable than its peers.




Return on AssetsThe return on assets ratio measures how efficiently the company uses its totalresources (total assets) to produce net income. Using Exhibits 7–1 and 7–3,return on assets is computed as:

Return on Assets = Net Income after Taxes ÷ Average

Total Assets = $78,186 ÷ $2,019,002 = 3.87 percent

If the industry average is 3.5 percent, then the company is more efficientthan its peers in squeezing profits from its resources.

Return on EquityThe return on equity measures the rate of return earned on the owners’ in-vestment in the company (as measured by equity). It is a ratio that an investorwould be interested in watching, since the value of the investment could in-crease if the return on equity improves. Again using Exhibits 7–1 and 7–3,the return on assets is computed as:

Return on Equity = Net Income after Taxes ÷ Average

Owners’ Equity = $78,186 ÷ $1,142,884 = 6.84 percent

If the industry average is 6.3 percent, then the company is, on average,providing a greater return on owners’ equity than its peers.

Earnings per ShareEarnings per share is also a measure of profitability that is important to theowners. It is a simple computation used when there is a single class of stock:net income divided by the number of outstanding shares. (Care must be takenwhen more than one class of stock is authorized and issued because the exis-tence of preferred stock will dilute the earnings per share of common stock.Other items that might reduce earnings per share of common stock are: con-vertible securities, stock options, and warrants. The example given here coversonly common stock.) Earnings per share tells you how much income “standsbehind” each share of stock—an important concept, since it is from earningsthat dividends are paid to owners.

Earnings per Share = Income Available to Common Stockholders

Weighted-Average Number of Common Shares Outstanding for the Period

If you assume that a company has net income of $98,186 and pays its pre-ferred stockholders $20,000, the income available to common stockholderswould be $78,186. If the weighted-average number of shares is 10,000, thenthe earnings per share would be $7.82, as shown below.

EPS = $78,186 ÷ 10,000 = $7.82

Diluted EPS reflects the potential dilution that could occur if securitiesor other contracts to issue common stock were exercised or converted into




common stock or resulted in the issuance of common stock that then sharedin the earnings of the entity. Diluted EPS is a more advanced topic that is be-yond the scope of this course, but it should be recognized as a more conser-vative indication of the earnings that “stand behind” each share of a company’scommon stock.


3. Using Exhibits 7–2 and 7–5, calculate and evaluate the following:

Profit Margin _____________ (Industry Average = .85 percent)

Evaluation:

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

Return on Assets _____________ (Industry Average = 5.0 percent)

Evaluation:

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

Return on Equity _____________ (Industry Average = 7.5 percent)

Evaluation:

_________________________________________________________________________

_________________________________________________________________________

_________________________________________________________________________

4. Using the net income for 20X0 from the income statement in Exhibit 7–5, and assuming 10,000shares of outstanding common stock, what are the earnings per share for 20X0?

Limitations of Financial RatiosRatio analysis has its limitations. It doesn’t measure nonfinancial factors suchas the “value” of human resources, a firm’s reputation, or any competitive ad-vantages the company enjoys. Ratios can be easily calculated from financialstatements, but even though accounting rules (GAAP) promote consistencyfrom period to period, assumptions and methods can be changed, and ratios





are sensitive to those changes. Companies that have been accused of “windowdressing” make their ratios look better than they should look. Differences inaccounting assumptions used by competitors may make it difficult to compareratios from different organizations. Keep in mind that accounting assumptionsinclude the choice of inventory methods such as last in, first out or first in,first out and depreciation methods like straight-line or double-declining bal-ance. Ratios that show significant deviations from industry norms might pointto a company’s strengths or weaknesses, but they also might be indicative offinancial statement fraud or mistakes in the accounting system. However, ra-tios cannot definitively tell the user whether there is fraud or point to signif-icant errors, and in some of the largest financial statement fraud cases inhistory, financial ratios were not the red flags that brought the fraud to thesurface. In fact, it is usually a “whistle blower” who calls the fraud to the at-tention of management or the authorities.

HORIZONTAL ANDVERTICALANALYSISHorizontal and vertical analysis is useful for analyzing income statements. Forincome statements, this represents setting net sales equal to 100 percent andthen calculating the percentage of net sales for each cost, expense, or othercategory.

Exhibit 8–3 shows vertical and horizontal analysis comparing two years.The results of the analysis show that although sales are up, the gross profitpercentage has dropped by more than two points. Selling and administrativeexpenses as a percentage have been reduced, as has interest. Other income



xhibit 8–3Income Statement

' '

20X1 20X0 $ % $ % Sales $8,173,780 100.00% $7,341,704 100.00%

Cost of Goods Sold 5,963,510 72.96% 5,189,315 70.68% Gross Profit 2,210,270 27.04% 2,152,389 29.32% Operating Expenses;

Selling and Administrative 1,994,054 24.40% 1,887,420 25.71% Depreciation 67,933 0.83% 66,575 0.91% Interest 13,026 0.16% 29,966 0.41% Total Operating Expenses 2,075,013 25.39% 1,983,961 27.02%

Profit from Operations 135,257 1.65% 168,428 2.29% Other Income 6,429 0.08% 35,609 0.49%

Profit Before Taxes on Income 141,686 1.73% 204,037 2.78% Provision for Taxes on Income 63,500 0.78% 87,000 1.19% Net Income $ 78,186 0.96% $ 117,037 1.59% '


was reduced sharply. The net result of all these changes is that the percentageof sales of income before taxes was reduced from 2.78 percent to 1.73 percent,and the percentage of sales of income after taxes was reduced from 1.59 per-cent to 0.96 percent. This is lower than the average and may be cause for con-cern. The outside analyst, especially one who represents a lending institution,will want to be very clear as to why these ratios are performing this way. Is ita single-year problem, or is it industry wide?


5. Complete the following report by calculating the percentages for both years, then answer thequestions.

a. Has the gross profit percentage improved or deteriorated over the two periods?

Improved Why? ____________________________________________________

Deteriorated Why? ____________________________________________________

b. Within operating expenses, what components have increased proportionally from period 1 to period 2?

c. 20X1 results do show that the company has produced greater profits over 20X0. How does20X1 compare to 20X0 based on the profit margin of the two periods?


20X1 20X0

$ % $ %Sales $13,200,000 100.00% $12,500,000 100.00%

Cost of Goods Sold 9,768,000 74.00% 9,750,000 78.00%

Gross Profit 3,432,000 26.00% 2,750,000 22.00%

Operating Expenses;Selling and Administrative 2,244,000 17.00% 1,900,000 15.20%

Depreciation 91,000 0.69% 89,000 0.71%Interest 28,000 0.21% 19,000 0.15%

Total Operating Expenses 2,363,000 17.90% 2,008,000 16.06%

Profit from Operations 1,069,000 8.10% 742,000 5.62%

Other Income 35,000 0.27% 9,000 0.07%Profit Before Taxes on Income 1,104,000 8.36% 751,000 5.69%

Provision for Taxes on Income 331,200 2.51% 150,200 1.14%

Net Income $772,800 5.85% $600,800 4.55%




The analysis of the income statement begins with an under-standing of sales. Every sales dollar comprises three basiccomponents: cost of goods sold, operating expenses, and netincome or loss. Net sales are the true sales for the period, sincenet sales take into account returns of product by customers,allowances (reductions of price or adjustments to invoices)granted for various reasons, and all discounts granted to creditcustomers for early payments.

Financial analysis of the income statement can be facili-tated by the use of profitability ratios such as the operating ratio, more com-monly called the gross profit ratio, and the profit margin. Other ratios, suchas return on assets, return on equity, and earnings per share, give additionalinsight into how well a company is producing profits from its base of assetsand investor’s equity. All these profit-related ratios need to be monitored overtime by interested parties such as owners, managers, and creditors.

The firm as a profit generator is a complex entity and sometimes difficultto understand—even when financial ratios are used. Many other considera-tions come into play when reviewing the profit performance of a company.Variables such as the quantity of units of product sold, changes in sellingprices, product mix, and cost changes have an effect on the profits of a busi-ness, and of course, on its profitability ratios.

Vertical and horizontal analysis of income statements can provide addi-tional information about a company’s profitability. A vertical analysis of fi-nancial statements shows you the relationships among components measuredas percentages. On a balance sheet, each asset is shown as a percentage of totalassets; each liability or equity item is shown as a percentage of total liabilitiesand equity. On the income statement, each line item is shown as a percentageof net sales.

A horizontal analysis provides you with a way to compare numbers fromone period to the next. Each line item has an entry in a current period columnand a prior period column; and again, percentages help give significance todifferences (changes) between two or more reporting periods.




Which expense is generally the most significant cost as a percentage 1. (a)1.of sales in the income statement?Cost of goods sold (a)Selling expense(b)Administrative expense(c)Income tax expense(d)

The excess of sales over cost of goods sold is called: 2. (c)2.net income.(a)operating income.(b)gross profit.(c)net profit.(d)

Profit margin, return on assets, return on equity, and earnings per 3. (b)3.share are all:liquidity ratios.(a)profitability ratios.(b)quick ratios.(c)measures of efficiency.(d)

Net Income after Taxes ÷ Net Sales =: 4. (d)4.Return on Assets(a)Return on Equity(b)Earnings per Share(c)Profit Margin(d)

In performing vertical analysis of an income statement, you 5. (b)5.calculate the percentage of ______ for each expense on the income statement.assets(a)net sales(b)cost of goods sold(c)net income(d)

Review Questions





$ % $ %Sales $13,200,000 100.00% $12,500,000 100.00%

Cost of Goods Sold 9,768,000 74.00% 9,750,000 78.00%Gross Profit 3,432,000 26.00% 2,750,000 22.00%

Operating Expenses;Selling and Administrative 2,244,000 17.00% 1,900,000 15.20%Depreciation 91,000 0.69% 89,000 0.71%Interest 28,000 0.21% 19,000 0.15%

Total Operating Expenses 2,363,000 17.90% 2,008,000 16.06%

Profit from Operations 1,069,000 8.10% 742,000 5.62%Other Income 35,000 0.27% 9,000 0.07%Profit Before Taxes on Income 1,104,000 8.36% 751,000 5.69%Provision for Taxes on Income 331,200 2.51% 150,200 1.14%Net Income $772,800 5.85% $600,800 4.55%

20X1 20X0

122 UNDERSTANDING FINANCIAL STATEMENTS


1. $231,000

2. $250,000 (beginning finished goods plus cost of goods manufactured less endingfinished goods). Do not use the value for purchases, as that would be taken intoaccount in the cost of goods manufactured.

3. A profit margin of 1.03 percent, as opposed to an industry average of .85 percent, isfavorable. A return on assets of 4.3 percent, as opposed to an industry average of 5percent, is unfavorable. It appears that the industry is able to squeeze relativelymore profit out of its assets. A return on equity of 7.5 percent is equal to theindustry average.

4. $11.70

5.

a. It has improved as the cost of goods sold as a percentage of sales have fallen.

b. Selling and administrative expenses and interest expense have increasedproportionately to sales whereas depreciation expense has decreased as apercentage of sales.

c. The profit margin has also increased (20X1 is 5.85% versus 20X0 of 4.55%).


9Analysis of

Operational Results

Learning Objectives


• List the three kinds of costs.• Explain the term break-even point.• List three uses of break-even analysis.• Define the term contribution margin.• Identify the five factors that influence cost-volume-profit analysis.

INTRODUCTIONOne’s objective in managing a business is described simply in this way: to assurethat the benefits achieved exceed the sacrifices made.Managers are constantly facedwith decisions about selling prices, variable and fixed costs, choice of productlines, market strategy, utilization of production facilities, and acquisition andemployment of economic resources in pursuit of some goal or objective. Thebases for financial planning and control include cost-behavior analysis, eval-uation of cost-volume-profit relationships, and flexible budgeting. Flexiblebudgeting allows the effect of changes in anticipated volume to be taken intoaccount and involves a series of budgets for varying levels of activity. Manymanagers are interested in cost behavior, cost control, and cost measurement.This chapter presents information that will aid in their planning and control.



COSTBEHAVIORThe first basis for planning and control, cost behavior, refers to the degree ofresponsiveness a cost has at various activity levels. There are fixed costs, vari-able costs, and mixed costs.

Fixed CostsFixed costs remain unchanged within a relevant range of activity. If straight-line depreciation is used for fixed-asset write-off, the cost is fixed and un-changing for a specific, short time period. Reference to a particular timeperiod is essential to the concept of a fixed cost because all costs tend to bevariable over a long period of time. For consistency, the time frame used inthis text is one year.

Although the fixed cost will have the same total, the unit rate changesinversely with volume. For example, assume annual depreciation of $100,000,using the straight-line method. This amount is charged as a cost, regardlessof the level of production or sales. At the 100,000-unit level of production,the depreciation rate per unit is one dollar. If 200,000 units were produced,the rate would reduce to 50 cents per unit. Since the fixed cost depends on aparticular volume, these amounts will remain constant within a workablerange. Supervisors’ salaries provide a good illustration. A supervisor’s salaryis fixed, regardless of whether the group of people he or she supervises con-sists of 20 or 40 people (or any number in between).

Variable CostsVariable costs, in total, change in direct proportion to an activity level. Totalvariable costs of a particular cost object (something that you are tracking thecost of) increase with increases in the volume level related activity and de-crease with decreases in the volume level of the related activity. For instance,the total cost of raw material used in production varies in relation to the num-ber of units produced. Thus, if a unit of material costs $5, this rate will notchange, regardless of the number of units used in production; but the totalcost increases directly with the number of material units used in production.

Mixed CostsMixed costs are a hybrid cost—part fixed and part variable. For example, a cellphone bill could be a mixed cost if it has a fixed monthly fee plus a rate perminute of usage. Operating company vehicles is a classic example of a mixedcost involving certain fixed costs such as annual insurance and variable costs suchas changing fuel prices and differing amounts of use from one month to another.

The algebraic formula for a mixed cost is y = a + bx, where:

y is the total cost

a is the fixed cost per period

b is the variable rate per unit of activity

and x is the number of units of activity




For example, the annual expense of operating a truck might be foundusing the following formula:

$5,000 + .30x

Where x is the number of miles driven (the activity).If the truck is driven 20,000 miles in a particular year, the cost would be:

$5,000 + .3(20,000) = $11,000

COST-VOLUME-PROFITANALYSISThe cost-volume-profit (CVP) analysis in this chapter covers only variableand fixed expenses. Exhibit 9–1 shows the relationship of total costs to unitcosts at various levels of production. If the total fixed cost remains the same,the cost per unit decreases as volume increases. The total variable cost in-creases directly with an increase in production, but the rate of increase is con-stant.

Five important factors influence cost-volume-profit analysis. They are:

Fixed costs1.Variable costs2.Selling prices of products3.Volume of sales or level of sales activity4.Mixture of the types of products sold5.

All of these factors must be weighed by management when engaging inprofit planning and cost control.

Break-Even PointThe study of cost-volume-profit analysis, often called break-even analysis,stresses the relationship among the five elements listed above. The break-evenpoint is the point where the volume of sales or level of operations producesneither a net income nor a net loss. In other words, the break-even point iswhere revenues will just cover costs. This point can be found mathematically

ANALYSIS OF OPERATIONAL RESULTS 125


xhibit 9–1A Comparison of Total Costs with Unit Costs at Various Levels of Production

Production in Units 1,000 2,000 3,000 4,000 Total Cost:

Fixed $5,000 $ 5,000 $ 5,000 $ 5,000 Variable 7,000 14,000 21,000 28,000

Unit Cost: Fixed $5.00 $2.50 $1.67 $1.25 Variable 7.00 7.00 7.00 7.00


or by preparing a graph. Whichever method is used, all costs are separatedinto fixed and variable categories.

Working with an example is the best way to understand the break-evenpoint calculation. For example, John Smith is a college student who earns histuition by doing odd jobs and taking on small business ventures. He plans onselling historical plaques during a Fourth of July picnic. He purchases theplaques for $2 each, retaining the option to return all unsold items. The rentalof his booth costs $150. If the plaques sold for $5 each, how many would Johnhave to sell in order to break even? (Ignore income taxes.)

In determining the break-even point using a mathematical computation,you must understand the most elementary formula for computing a break-even point:

Break-Even Sales = Variable Cost + Fixed Cost

If you let X = sales at break-even (units of dollars), you can plug JohnSmith’s data into the equation as follows:

$5X = $2X + $150

3X = 150

X = 50 plaques

Proof:

Sales = 50 plaques @ $5 each = $250

Cost and Expenses—Variable:

50 Plaques @ $2 each = $100

Fixed:

Rent: $150 $250

Profit: $0

What would John’s profit be if he sold 51 plaques? Quite often, peopleassume the answer is $5. But calculation is necessary to be sure.

Sales = 51 plaques @ $5 each = $255


51 Plaques @ $2 each = $102

Fixed:

Rent: $150 $252

Profit: $3




The cost of the plaques fluctuates directly with the quantity purchased—a variable cost. Fixed cost is recovered with the sale of the first 50 plaques.Thereafter, the sale of each plaque contributes to profit, after covering thevariable cost per unit.

By expanding on the basic formula, it can be determined how manyplaques must be sold to earn a particular profit. Suppose John Smith wantedto earn $75 for the period of time he spends in his booth. The formula wouldbe expanded to solve for the $75 profit as follows:

Sales = Variable Cost + Fixed Cost + Profit

$5X = $2X + $150 + $75

3X = 225

X = 75 plaques

Proof:

Sales = 75 plaques @ $5 = $375


75 plaques @ $2 = $150

Fixed:

Rent: $150 $300

Profit: $75


1. Compute the monthly break-even point for a company that has variable cost of $4 per unit andmonthly fixed costs of $600. The company’s sales are $10 per unit.

2. Using the facts in question 1, what would the volume of sales need to be to achieve a profit of$1,000 in one month?

THEGRAPHICPRESENTATIONOFBREAK-EVENA break-even point graph can be used to determine the dollar or unit amountat which there will be no profit or loss. Exhibit 9–2 plots John Smith’s infor-mation. Although the graph is not accurate decimally, it is adequate for thelimited range used here.





The sales and total expense lines cannot be plotted ad infinitum with thehope of maximizing profit to the nth degree. A saturation point will be reachedwhere sales begin to drop or where both fixed and variable costs begin to in-crease. Here the lines on the graph cross each other again; the area beyondthe second juncture is a loss area.

Sales may begin to slow down because there are fewer buyers in the mar-ket who want to purchase. On the other hand, costs and expenses may beginto climb because the scarcity of material may cause prices to rise, or becausethe labor supply may have been reduced to a level that necessitates offeringa monetary incentive to obtain the required work force.

USINGBREAK-EVENANALYSISThe break-even point is helpful to management for forecasting, evaluatingmanagerial efficiency, and decision making. As a forecasting tool, the break-even point can aid in determining the following:

The requirements of the sales department that justify a proposed invest-•ment in plant expansionThe effect of increases and decreases in sales volume•



xhibit 9–2John Smith’s Break-Even Point Graph, July 4, 20X0


The probable cost per unit of manufactured goods at various production•levelsThe evaluation of changes in production methods•The planning of profit objectives•Managerial efficiency may be evaluated by comparing actual break-even

results with predetermined levels. If properly considered by management, thebreak-even point and the analysis of cost-volume-profit can be valuable toolswhen used in conjunction with the analysis of sales mix and the conversionof variable costs to fixed costs. For example, management may be consideringa capital expenditure in order to automate equipment. This decision wouldshift some costs from variable to fixed, thus changing the break-even point.

CONTRIBUTIONMARGIN

The contribution margin is most easily defined as the difference between salesand variable costs. The excess of sales over variable costs can be used to con-tribute toward meeting fixed costs and achieving a profit for the period. Acomparison of contribution margin and the traditional income statement, andhow they each arrive at net income, is shown in Exhibit 9–3. The contributionmargin is employed by management because costs are classified by behavior(variable or fixed) rather than by function (production, sales, or administra-



xhibit 9–3The Traditional Format Income Statement versus the ContributionMargin Format (000’s omitted)

Traditional Format: Sales $650 Cost of Goods Manufactured 193 Gross Profit $457 Selling Expenses 224 Administrative Expenses 193 Net Income $ 40

Contribution Margin Format: Sales $650 Variable Costs and Expenses: Manufacturing 130 Selling 148 Administrative 112 Contribution Margin $260 Fixed Costs and Expenses: Manufacturing 63 Selling 76 Administrative 81 Net Income $ 40


tion). It should be noted, however, that contribution margin is not the sameas gross margin or gross profit, which is computed in the traditional format.

Once again, the John Smith venture can illustrate the contribution marginapproach.

Sale price per plaque ($5) − Variable cost per plaque ($2) = Unit Contribution Margin ($3)

Since the contribution margin of $3 will cover fixed costs, the next ques-tion is: How many units must be sold to cover the $150 rental with no antic-ipated profit?

The calculation for the break-even point in dollars, using the contribu-tion margin, requires a contribution percentage. In Smith’s venture, 60 percent($3 out of $5) of the total selling price is contributed toward fixed costs andprofit. Since profit does not enter into the calculation of the break-even point,the dollars of sales needed are:

The contribution margin computation for the $75 profit desired by Smithis:

Fixed Costs ($150) + Desired Profit ($75) = $375 Contribution MarginRatio (0.60)


3. Based on the following facts, what is the contribution margin per unit?

A company has variable cost of $5 per unit and monthly fixed costs of $800. Its sales are $15per unit.

Fixed Costs ($150) = 50 Units

Unit Contribution Margin in Dollars ($3)

Fixed Costs ($150) = $250

Contribution Margin Ratio (0.60)

Fixed Costs ($150) + Desired Profit ($75) = $375

Contribution Margin Ratio (0.60)






4. Using the contribution-margin approach, compute the monthly break-even point for a companythat has variable cost of $7 per unit and monthly fixed costs of $4,900. The company’s salesare $14 per unit.

5. Using the same facts as in question 4, what level of sales are needed to produce a $500 profitin one month?

Advantages of Cost-Volume-Profit AnalysisCost behavior patterns offer valuable insights into planning and controllinglong-term and short-term operations. It is obligatory that management be-come fully cognizant of cost-volume-profit analysis. Management’s duty is todiscover the combination of fixed and variable costs that will be most benefi-cial to the company. A firm that has a large and highly salaried sales force(fixed cost) may discover through the contribution margin that, after deduct-ing variable costs from sales, there is an insufficient remainder to contributetoward fixed costs and profit. It may be less costly for the company to employmanufacturers’ representatives and compensate them using commission, avariable cost. Remuneration would then vary directly with sales.

When management sets a profit goal for a specific period of time (annual,semi-annual, quarterly), it is easy to compute the number of units that mustbe sold in order to reach the goal; this is done simply by dividing the fixedcosts plus desired profit by the contribution margin per unit. When the con-tribution margin is low, a large increase in sales must occur in order to producea significant increase in profit. Another look at Exhibit 9–2 reveals that, assales move beyond the break-even point, the contribution margin ratio in-creases and thus profits also increase at a faster rate.

The external analyst may be unable to project future break-even pointsat various sales volumes because he or she does not ordinarily have access todata that are exact enough. Nevertheless, the analyst’s conclusions, althoughrough at best, are meaningful. The variable costs may be difficult to project,but conclusions on fixed costs should be within the limits of company toler-ance. Although shortcomings in cost-volume-profit analysis do exist, and theanalysis does require laborious effort, performance evaluation is less difficultgiven the results of such an analysis.





Limitations of Cost-Volume-Profit AnalysisThe function of profit projection is vitally important to financial analysts, butit is not without its shortcomings. Clear assignment of costs to either a fixedor variable category is not always possible. The interpretations of several an-alysts will probably differ. For example, machinery rent that is based on unitsproduced can be classified as a variable cost when production fluctuates. How-ever, if production is steady for a period of time beyond the predeterminedrange, some analysts may think of the rent as a fixed cost. This differentiationis often difficult for the internal analyst to determine. For the outside analyst,categorization is an almost impossible task if he or she does not possess a con-siderable amount of internal data.

Direct labor is usually classified as a variable cost. Any change in pro-duction volume will have a direct effect on labor in the same direction. Ifmanagement decides on a temporary shutdown of operations, the effect onthe variability of labor cost may not correspond directly. If, for example, thecompany wishes to retain its highly experienced and skilled personnel duringthe shutdown period so as not to lose them, the fluctuating nature of directlabor is changed.

Another major weakness of cost-volume-profit analysis as a planning orcontrolling device occurs in a manufacturing business. The assumption bythe analyst that sales and production volumes will always be the same may bevalid in theory but not in fact. Business is dynamic, and qualifying a specificcost analysis with the prefatory statement, “other things being equal,” will notnecessarily produce a valid result because “other things” will not be equal.

Analysis covering an extended period of time requires a common de-nominator for all component periods so that data examined will be equivalent.Where costs and prices have changed drastically, adjustments based on currentcosts and prices produce a more uniform result. Many outside factors mustalso be kept in mind, such as strikes, lateral and vertical competition, domesticand foreign political developments, and natural disasters.

THEPROFIT-VOLUMEGRAPHThe profit-volume graph may be used in place of, or along with, the break-even graph. This form is preferred by many managers who are interestedmainly in a clearer representation of the effect of volume, since only the neteffect of revenue and cost is shown. The graph has a break-even line insteadof a break-even point. Exhibit 9–4 shows the vertical axis, calibrated was profitabove and loss below the break-even line. The horizontal axis shows units ofproduct.

Plotting a Profit LineAssume the following data: selling price per unit is $10; variable cost per unitis $6; and fixed expense amounts to $150,000.




The following steps are necessary to plot a profit line on the graph:

Fixed expense exists even at zero level of activity; therefore, the fixed-1.expense point is located on the vertical axis below the break-even line.A point should now be plotted to indicate the amount of profit at a chosen2.level of sales. The level used in Exhibit 9–4 is 100,000 units, or $1,000,000.Expected profits at this level are:3.

Sales (100,000 units @ $10 each) $1,000,000

Less Variable Costs (100,000 × $6) 600,000

Contribution Margin 400,000

Less Fixed Costs 150,000

Net Profit$ 250,000

This point is plotted on the graph at the intersection of $1,000,000 of salesand $250,000 of profit. A line is then drawn from this point to connect thefixed-expense point of $150,000 on the vertical axis. The point at which theprofit line crosses the horizontal break-even line is the break-even point—37,500 units, or $375,000. The vertical distance between the profit line and thebreak-even line reflects the expected profit or loss at a specific volume of sales.

The profit-volume graph is often preferred by management because thedata are presented more simply than those of a break-even chart. It is a con-venient device that quickly outlines the effect on expected profits caused bysuch changing factors as fixed and variable costs, selling prices, and volumeof sales.



xhibit 9–4Profit-Volume Graph


The basis of profit planning and control is knowledge of costbehavior. You must know the difference between a fixed andvariable cost and how to recognize semi-variable or mixedcosts and how they behave with respect to changes in a par-ticular key activity level, such as sales or production. Companycost structures are a complex entanglement of fixed and vari-able costs, and sometimes it is difficult to sort those costs out.Fixed costs remain unchanged within a relevant range of ac-tivity. Variable costs increase with increases in the volume

level of related activity and decrease with decreases in the volume level ofthe related activity, while semi-variable costs are a combination that fallssomewhere between fixed and variable cost elements.

Cost-volume-profit (CVP) analysis, which has its origins in break-evenanalysis, is useful for predicting cost behavior for a company and for planningproduction levels to produce a desired profit. It is a decision-making tool formanagement and allows you to ask “what-if ” questions and to see the bot-tom-line impact of changes in prices, volume, and costs. Management canconsider altering any or all of the five factors of CVP when planning. Thosefactors are fixed costs, variable costs, selling prices, sales volume (units), andthe sales mix.

The break-even point can be used either in a formula form or a chart todetermine what revenue level is needed to cover all costs exactly. Break-evenpoints are often shown in business plans, as investors and creditors like to seewhat it will take to cover costs.

Break-even analysis can be modified so that the level of revenue neededto achieve a profit target can be known. Management can set target profit lev-els and then use the break-even model to determine what volume of sales willbe necessary and what level of costs will need to be incurred to meet profitgoals.

The contribution margin is another useful tool. It is found on a per unitbasis by subtracting variable costs per unit from the price of a product. Totalcontribution margin is the difference between total revenue (or sales) andvariable costs. Knowing the contribution margin allows you to quickly com-pute break-even and “back solve” for the production levels needed to producea desired profit.




Which of the following statements is generally true about costs? 1. (b)1.Fixed costs will increase on a per-unit basis when sales volume(a)increases.Total fixed costs will remain the same regardless of changes in sales(b)volume within a moderate range of activity.Variable costs will vary on a per-unit cost basis.(c)Fixed costs per unit will decrease as volume also decreases.(d)

If a particular cost element of a company can be estimated using 2. (c)2.the following formula it is a ______ cost.

$100 + $4x where x is sales volume in unitsfixed(a)variable(b)mixed(c)sunk(d)

Sales price less variable cost per unit is: 3. (d)3.gross profit.(a)profit margin.(b)mark-up.(c)contribution margin.(d)

Direct labor and direct materials are considered: 4. (b)4.fixed costs.(a)variable costs.(b)manufacturing overhead costs.(c)sunk costs.(d)

If fixed costs are $200,000, contribution margin per unit is $6, and 5. (a)5.the target profit is $100,000, which of the following is the sales volume needed to achieve the target profit?

50,000 units(a)60,000 units(b)70,000 units(c)100,000 units(d)

Review Questions





1. 100 units

2. 267 units

3. $10

4. 700 units

5. 771 units




Bibliography

Brealey, Richard A., Franklin Allen, and Steward C. Myers. Principles ofCorporate Finance, McGraw-Hill (2011)

Fridson, Martin S. and Fernando Alvarez. Financial Statement Analysis: APractitioner’s Guide, Wiley Finance (2002)

Gibson, Charles K. Financial Reporting & Analysis, South-Western CengageLearning (2012)

Horgren, Charles T. and George Foster. Cost Accounting: A Managerial Em-phasis,Pearson Education (2012)

Hoover’s Company Information (www.hoovers.com)

Kieso, Donald E., Jerry J. Weygandt, and Terry D. Warfield. IntermediateAccounting, Wiley (2012)

Libby, Robert, Patricia Libby, and Daniel Short. Financial Accounting, McGraw-Hill (2011)

Subramanyam, K.R. and John L. Wild. Financial Statement Analysis, McGraw-Hill (2009)

Try, Leo. Almanac of Business and Industrial Financial Ratios, CCH Inc. (2012)

Van Horn, James C. and John M. Wachowicz Jr., Fundamentals of FinancialManagement, Prentice Hall (2012)

137© American Management Association. All rights reserved.


http://www.hoovers.com




Glossary

Accounting A system that collects and processes (analyzes, measures,and records) financial information about an organization and reports that in-formation to decision makers.

Accounts receivable Money owed to the company from customers as aresult from credit sales.

Accounts payable Obligations that arise from the purchase of stock-in-trade items, supplies, or services on open account.

Accrual accounting The basis for recording transactions under Gener-ally Accepted Accounting Principles (GAAP). That is, an expense is recordedwhen incurred regardless of when the cash payment for the expense is made.Revenues are recorded when a sale is made, not necessarily when cash flowsoccur.

Activity ratios Ratios that measure how efficiently the company man-ages its assets.

Additional paid-in capital Capital paid into the corporation from thepurchase of capital stock by shareholders for a value in excess of the par valueof the capital stock.

Adjusting entries Certain accounts need adjustment at the end of a pe-riod so that both the balance sheet and income statement will be accurate atthe end of a period. Adjusting entries fall into five categories: prepaid expensesrequiring apportionment, recorded revenues requiring apportionment, un-recorded accrued revenues, unrecorded accrued expenses, and valuation ofaccounts receivable and investments.

139


Allowance for doubtful accounts A contra-asset account’s balance thatis subtracted from the accounts receivable account balance on the balancesheet. It is a reserve for bad debts, an estimate of the dollar amount of receiv-ables that will become uncollectible.

American Accounting Association (AAA) An organization composedof accounting professors and practicing accountants. The AAA serves as acritic in appraising accounting practice and recommends improvementsthrough its quarterly publication, The Accounting Review.

American Institute of Certified Public Accountants (AICPA) The na-tional professional organization of Certified Public Accountants (CPAs) inthe United States that sets ethical standards for the profession and U.S. audit-ing standards for audits of private companies, nonprofit organizations, andfederal, state, and local governments.

Accrual accounting Revenue is allocated to the period or periods it isearned, regardless of when it is collected. Expenses are applied to the periodin which they are incurred rather than the period of their payment or satis-faction. Accrual accounting is a GAAP method.

Accrued liabilities Expenses, such as wages, interest on note obligations,property taxes, and rent that accrue (or accumulate) on a daily basis.

Audit A series of procedures carried out by an accountant including per-forming extensive tests of transactions and internal controls. These procedureshelp the accountant be reasonably certain that accounting systems performas required by GAAP.

Assets Probable future economic benefits obtained or controlled by aparticular entity as a result of past transactions or events.

Balance sheet Financial statement that identifies a business’s assets, lia-bilities, and owners’ equity as of a certain date.

Bond A debt investment in which an investor loans money to an entity(corporate or governmental) for a defined period of time at usually a fixedinterest rate. Bonds are issued by corporations, municipalities, states, and U.S.and foreign governments to finance a variety of projects.

Break-even point The sales level where revenues are exactly equal tototal costs (fixed plus variable costs).

Capital stock A broad description for the ownership interest in a corpo-ration. The true ownership interest in a corporation is called common stock,which is a type of capital stock.




Cash basis of accounting A type of accounting where revenue isrecorded as earned when received or collected and expense is recorded as in-curred when paid. The cash basis of accounting is not a GAAP method.

Cash flows from financing activities Cash flows from the issuance ofcapital stock, debt securities, dividend payments, repayment of debt, and pur-chase of treasury stock.

Cash flows from investing activities Cash flows from the purchases andsales of productive assets and other companies’ debts (bonds and notes) andequity (common and preferred stocks issued by other companies).

Cash flows from operating activities Cash flows from day-to-day, in-come-producing activities. They include the activities that are not in the cat-egories of investing and financing.

Conservatism A underlying assumption of financial statements and aguiding principle of accounting that requires accountants to choose account-ing methods that are least likely to overstate assets or inflate income. Thisleads to the general rule that unfavorable events are recorded immediately.The recording of apparently favorable events must wait until the favorableoutcome is assured.

Contribution margin On a per-unit basis the contribution margin isprice minus variable cost per unit. On a company-wide basis it is sales minustotal variable costs.

Cost of goods sold An expense of companies that sell products that iscomprised of those expenses incurred to manufacture or purchase merchan-dise that has been sold.

Current assets Assets that will most likely be converted into cash, besold, or be consumed within a period of one year or within the normal oper-ating cycle of the business.

Current liabilities Debts and other obligations owed by the companythat will be satisfied within one year.

Debenture An obligation (bond) protected, not by collateral or tangibleassets, but only by the general credit rating of the issuer.

Depletion The allocation (expense) of the cost of a natural resource suchas timber, minerals, and oil as it is extracted from the earth.

Depreciation Allocation (expense) of the cost of a long-term, tangibleasset over the useful life of that asset.


GLOSSARY 141


Dividends Income paid to stockholders from the retained earnings ofthe business. Dividends are declared (voted) by the board of directors.

Earnings per share A measure of profitability that is important to theowners of the company (shareholders). In its simple form it is found by di-viding net income by the number of outstanding shares.

EBIT Earnings before interest and taxes, is caluculated as follows: (I –Tax Rates) + Depreciation and Amortization – Change in Net WorkingCapital – Capital.

Equity Residual interest in the assets of an entity that remains after de-ducting its liabilities. In a business enterprise, the equity is the ownership in-terest.

Expenses Outflows or other using-up of assets or incurrence of liabilities(or a combination of both) during a period resulting from delivering or pro-ducing goods, rendering services, or carrying out other activities that consti-tute the entity’s ongoing major or central operations.

FASB 95 The rules that guides the accountant in the preparation of thestatement of cash flows.

Financial Accounting Standards Board (FASB) A nonprofit corporationthat develops the broad conceptual framework for financial accounting andGenerally Accepted Accounting Principles (GAAP).

Financial accounting The type of accounting that serves the needs ofexternal users such as prospective and current investors, creditors, and regu-lators. It is guided by General Accepted Accounting Principles (GAAP).

Financial analyst A person who reads and interprets financial statementsso as to make a particular decision. For example, a financial analyst might re-view financial statements so as to recommend the entity as an investment toprospective investors or to recommend to a loan officer that the entity begranted or denied a loan.

Free Cash Flow (FCF) Free cash flow is calculated as follows: Cash Flowfrom Operations – Capital Expenditures Required to Maintain ProductiveCapacity Used in the Production of Income – Dividends = Free Cash Flow(FCF)

Fixed costs A cost that does not vary depending on production or saleslevels, such as rent, property tax, insurance, or interest expense.

Full disclosure An accounting principle that requires that the informa-tion provided in the financial statements and the notes to the financial state-ments be of sufficient detail to allow the user to make adequate decisions.




Gains Increases in equity (net assets) from peripheral or incidental trans-actions of an entity and from all other transactions and other events and cir-cumstances affecting the entity during a period, except those that result fromrevenues or investments by owners.

Generally Accepted Accounting Principles The combination of basicassumptions and principles that make up a body of knowledge known as Gen-erally Accepted Accounting Principles (GAAP).

Going-concern assumption The assumption that the entity will con-tinue in existence into the foreseeable future. This assumption is part of thereason why asset values are not liquidation values but mostly historical cost(with a few exceptions where lower of cost or market value or fair marketvalue is used).

Historical cost The cost used to record the activities and transactions ofa company. Historical cost is a verifiable item and provides an objective basisfor valuation.

Income statement Also called the profit and loss statement or the state-ment of operations, it is the financial statement that discloses a company’sprofit or loss during a specified period of time. The income statement showsrevenues earned during a period of time, the expenses incurred to producethat revenue, and the income or loss for that same period.

Institute of Management Accountants (IMA) An association of man-agement accounting professionals that provides accounting research and ed-ucation for the internal accountant. In addition, the IMA awards theCertificate in Management Accounting (CMA).

Internal Revenue Code (IRC) United States law that governs the taxingof income and the collection of those taxes.

Internal Revenue Service (IRS) A bureau of the Department of theTreasury responsible for collecting taxes and the interpretation and enforce-ment of the Internal Revenue Code (IRC).

Inventory Stock of goods available for sale, the merchandise or stockthat a store or company has on hand, or in the case of a manufacturer, rawmaterials, work-in-process, and finished goods.

Investments Stocks and bonds owned by the business, land held for fu-ture use or speculative purposes, and investments set aside in special funds,such as pension or plant-expansion funds.

Leverage ratios Ratios that help the analyst measure the debt burden ofthe company and forecast the solvency of the firm in the long run.

GLOSSARY 143



Liabilities Probable future sacrifices of economic benefits arising frompresent obligations of a particular entity to transfer assets or provide servicesto other entities in the future as a result of past transactions or events.

Liquidity ratios Ratios that attempt to measure a company’s ability tomeet its short-term obligations. There are two popular liquidity ratios: currentratio and quick (or acid-test) ratio.

Long-term liabilities Liabilities that will not be satisfied within one yearare classified as long term.

Losses Decreases in equity (net assets) resulting from peripheral or in-cidental transactions of an entity and from all other transactions and otherevents and circumstances affecting the entity during a period, except thosethat result from expenses or distributions to owners.

Management accounting The type of accounting that serves the infor-mation needs of staff and management. Its guiding principle is usefulness.

Marketable securities Otherwise called short-term investments, a safehaven involving the temporary use of excess cash in order to earn interest ordividends until the cash is needed.

Matching principle Requires a company to match expenses with relatedrevenues in order to report a company’s net income or loss during a specifiedtime interval (such as one year).

Materiality A judgment call made by accountants on how some trans-actions are to be handled. It is similar to the concept of an order of signifi-cance. The threshold of materiality can allow an accountant to violate anotheraccounting principle if the amount is so small that the reader of the financialstatements will not be misled. For example, an insignificant asset can be com-pletely written off as opposed to capitalized if its value is insignificant.

Mixed cost A hybrid cost—part fixed and part variable.

Mortgage payable A long-term loan securing real property. In otherwords, real estate is pledged as security for a loan.

Net income The bottom-line figure on the income statement. It is thedifference between revenues and expenses. Net income increases owners’ eq-uity (whereas net loss decreases owners’ equity).

Net loss The bottom-line figure on the income statement. It is the dif-ference between revenues and expenses. Net loss decreases owners’ equity(whereas net income increases owners’ equity).




Notes payable A written promise signed by the maker of the note to paya certain sum of money, either on demand or at a future date. The negotiableinstrument (the note) may or may not bear a rate of interest, although mostnotes payable are evidenced by a promissory note that calls for interest.

Operating expenses Costs incurred in carrying out an organization’s day-to-day activities that include payroll, sales commissions, employee benefits andpension contributions, transportation and travel, rent, amortization and depre-ciation, repairs, and various types of taxes. Operating expenses are usually sub-divided into selling expenses and administrative and general expenses.

Owners’ equity Owners’ investment in a company. For a corporation,owners’ equity is usually divided into four sub-categories: capital stock at thepar or stated value, additional paid-in capital or amounts paid over par, re-tained earnings, and treasury stock (negative equity).

Pre-emptive right The right of current shareholders to maintain theirproportional ownership of a company by buying a proportional number ofshares of any future issue of common stock.

Preferred stock A type of capital stock that provides a dividend that ispaid before any dividends are paid to common stockholders and takes prece-dence over common stock in the event of liquidation.

Prepaid expense An expenditure that is initially recorded as an asset(current) that will benefit a future period. Examples are: prepaid rent, taxes,royalties, commission, prepaid office supplies, and insurance.

Profitability ratios Financial ratios that can be used to assess a com-pany’s ability to control expenses and convert sales into profits.

Profit margin A ratio that shows the percentage of net income producedby each sales dollar. It is found by dividing net income by sales.

Property, plant, and equipment Also called fixed assets. They are usedin the operation of the business and have a useful life of more than one year.

Public Company Accounting and Oversight Board (PCAOB) A non-profit corporation created by the Sarbanes–Oxley Act, a 2002 United Statesfederal law, to oversee and regulate the work of the auditors of the financialstatements of corporations that issue their stock to the public.

Retained earnings Accumulated earnings that are not distributed to theshareholders. The change in retained earnings equals net income or net lossless dividends.

GLOSSARY 145



Revenues Inflows or other enhancements of assets of an entity or settle-ment of liabilities (or a combination of both) during a period resulting fromdelivering or producing goods, rendering services, or other activities that con-stitute the entity’s ongoing major or central operations.

Revenue recognition This occurs when the earnings process is completeand an exchange transaction has occurred.

Sarbanes–Oxley Act of 2002 A United States federal law that set stan-dards for all U.S. public company boards, management, and public accountingfirms. It was passed in response to a series of large corporate frauds and scan-dals involving misleading financial reporting. The act established the PublicCompany Accounting and Oversight Board (PCAOB).

Securities and Exchange Commission (SEC) Federal regulatory agencyfor the securities industry. The SEC is responsible for helping assure thatthere is full disclosure of significant financial information and facts and toprotect investors against fraud and manipulative practices in the securitiesmarkets. The SEC enforces the Securities Act of 1933 and the Securities Ex-change Act of 1934.

Statement of cash flows Provides the user with a detailed summary ofall the cash provided during the period and the uses of the cash.

Statement of retained earnings The financial statement that details thechanges in the retained earning accounts for the same period as the incomestatement. The formula for the statement of retained earnings is as follows:Beginning Retained Earnings + Net Income − Dividends = Ending RetainedEarnings.

Treasury stock The company’s own stock that has been re-acquired bythe company.

Variable costs Costs that vary with some activity level such as productionoutput or sales volume. For example, variable costs rise as production in-creases and fall as production decreases.

Unearned revenue Revenues collected before a service is actually per-formed must be shown as liabilities.

Zero coupon bonds Bonds that are sold at a discount and provide thatall the interest is earned by paying the full face value at maturity.





Online Resources

147

American Accounting Association (aaahq.org)

American Institute of Public Accountants (www.aicpa.org)

Financial Accounting Standards Board (www.fasb.org)

Institute of Management Accountants (www.imanet.org)

International Financial Reporting Standards Foundation (www.ifrs.org)

Mergent Online (www.mergentonline.com)

Public Company Accounting Oversight Board (pcaobus.org)

Standard and Poor's Industry Surveys Ratios (www.standardandpoors.com)

United States Securities and Exchange Commission (www.sec.gov)

Value Line Investment Survey (valueline.com)


http://www.aicpa.org

http://www.fasb.org

http://www.imanet.org

http://www.ifrs.org

http://www.mergentonline.com

http://www.standardandpoors.com

http://www.sec.gov



Post-Test

How to Read and Interpret Financial Statements Second Edition

Course Code 98002

INSTRUCTIONS: To take this test and have it graded, please email [email protected]. You will receive an email back with details on taking your test and get-ting your grade.

FORQUESTIONS ANDCOMMENTS: You can also contact Self Study at 1-800-225-3215or visit the website at www.amaselfstudy.org.

Costs that do not change within a workable range of activity are:1.variable.(a)mixed.(b)fixed.(c)direct.(d)

Based on the following facts, what is the break-even point? 2.A company has a fixed cost of $28,000 and a variable cost per unit of $30. The unit’s selling price is $100.

300 units(a)200 units(b)400 units(c)500 units(d)

mailto:@amanet.org



Based on the following facts, how many units must be sold to earn a3.profit of $700? A company has a fixed cost of $28,000 and a variablecost per unit of $30. The unit’s selling price is $100.

410 units(a)401 units(b)400 units(c)470 units(d)

Which of the following ratios is calculated by dividing current assets by4.current liabilities?

Quick(a)Current(b)Time interest earned(c)None of the above(d)

Which of the following ratios gives the most conservative indication of5.liquidity?

Quick(a)Current(b)Time interest earned(c)None of the above(d)

Which of the following categories of ratios answers the question: 6.How well does the company manage its resources?

Liquidity(a)Activity(b)Profitability(c)Leverage(d)

What does the following formula measure?7.Cost of Beginning Inventory + Net Purchases − Cost of Ending Inventory

Cost of goods sold(a)Gross margin(b)Cost of goods available for sale(c)Cost of manufactured goods(d)

Complete the following formula: 8.Gross Profit – Operating Expenses = ____________________________.

Net income(a)Operating income(b)Gross profit(c)Contribution margin(d)




Which is the lowest level of report issued by a Certified Public9.Accountant after developing a working knowledge of the entity andreading the financial statements to confirm that they are in the correctform and free from obvious material errors?

Compilation(a)Review(b)Standard Audit(c)Qualified Opinion(d)

One metric that management can calculate to see if there was adequate10.cash flow during the period to keep productive capacity at currentlevels is Free Cash Flow (FCF). FCF is calculated by taking valuesfrom the __________________.

balance sheet(a)statement of cash flows(b)retained earnings statement(c)income statement(d)

Which of the following is the organization that is empowered to issue11.statements of financial accounting standards and interpretations?

AAA(a)PCAOB(b)FASB(c)IMA(d)

Which of the following is not a current asset of a business?12.Fixed assets(a)Accounts receivable(b)Inventories(c)None of the above, since all are current assets(d)

Which of the following are assets?13.Inventories(a)Accounts receivable(b)Land(c)All of the above(d)

Additional paid-in capital is:14.the same as treasury stock.(a)a type of equity account.(b)always preferred stock.(c)a long-term liability.(d)

POST-TEST 151



Which of the following is the asset name for amounts due from15.customers for sales made or services rendered on account?

Promissory notes(a)Accounts receivable(b)Accruals(c)Interest receivable(d)

Which of the following is not one of the inventory accounts related to16.the products that the company sells?

Raw materials(a)Supplies(b)Work-in-process(c)Finished goods(d)

Which of the following inventory methods would result in maximizing17.net income during times of rising prices?

Last in, first out(a)First in, first out(b)Average cost(c)Specific identification(d)

Which of the following inventory methods would result in minimizing18.net income during times of rising prices?

Last in, first out(a)First in, first out(b)Average cost(c)Specific identification(d)

Which of the following is not a current liability?19.Accounts payable(a)Notes payable (due in six months)(b)Dividends payable(c)Bond due in ten years(d)

Which of the following long-term liabilities creates a lien on company20.property?

Bond payable(a)Mortgage payable(b)Zero coupon bond(c)Debenture(d)

Which of the following liabilities rarely carries an interest charge?21.Accounts payable(a)Notes payable(b)Bonds payable(c)Mortgage payable(d)




Which of the following income statement formats shows the most22.detail?

Single step(a)Multi-step(b)Cost-of-goods-sold step(c)Contribution margin income statement(d)

The source of payment of current liabilities usually is derived from23.__________________ assets.

long-term(a)net (b)current(c)permanent(d)

Under accrual accounting rules, generally, a revenue:24.is any cash inflow into a business during the accounting period.(a)is the result of delivering or producing goods and rendering(b)services.can include an increase in equity from transactions that are not(c)central to the purpose of the firm.is shown on the statement of cash flows.(d)

__________________ income is a company’s change in total25.stockholders’ equity from all sources other than the owners of the firm.

Net(a)Extraordinary(b)Comprehensive(c)Interest(d)

POST-TEST 153




Index

AAA, see American AccountingAssociation

accounting, 2 – 6accrual, 8, 60, 77, 139, 140assumptions made in, 6 – 7cash basis, 60, 77, 141definition of, 139and external users, 3 – 5GAAP for, 8 – 9and internal users, 2management, 144managerial, 2see also financial accounting

accounting cycles, 6accounting policies and

practices, in notes tofinancial statements, 34

The Accounting Review, 5Accounting Series Releases

(ASRs), 4accounting standardsFASB’s review andestablishment of, 4

groups and organizationsinfluencing, 5

accounts payableas current liabilities, 25, 58definition of, 139

accounts receivable, 43definition of, 139requiring valuationadjustment, 79

accounts receivable turnoverratio, 99

accrual accounting, 8

cash basis accounting vs., 77definition of, 139, 140for guarantee and warrantycosts, 60

accrued expenses, 59, 79accrued liabilitiesas current liabilities, 59definition of, 140

accrued revenues, 78 – 79accumulated depreciation, 49acid-test (quick) ratio, 95 – 97activity ratiosdefinition of, 139types of, 97 – 103

additional paid-in capitalon balance sheet, 26 – 27definition of, 139as part of owners’ equity, 64

adjusting entries, 139AICPA, see American Institute of

Certified PublicAccountants

allowance for doubtful accounts,43, 140

Almanac of Business and IndustrialFinancial Ratios, 94

American AccountingAssociation (AAA), 147

accounting standardsinfluenced by, 5

definition of, 140American Institute of Certified

Public Accountants(AICPA), 147

definition of, 140

depreciation defined by, 49amortization, 51annual reports, 3Annual Statement Studies (Robert

Morris Associates), 94appreciation, 49, 50ASRs (Accounting Series

Releases), 4assets, 20on balance sheet, 21, 41 – 54categories of, 41current, 22, 42 – 46, 141definition of, 21, 41, 140intangible, 50 – 52long-term investments as, 24,46 – 48

other, 53property, plant and equipmentas, 24, 48 – 53

tangible fixed, 48 – 50wasting, 52 – 53

assumptions, 6 – 7auditdefinition of, 8, 140purpose of, 8 – 9

audited financial statements, 3, 5auditor’s opinion, 9, 10auditors’ reports, 9 – 11available-for-sale securities, 43average collection period ratio,

99, 100average cost method, 44 – 45

Balanced scorecard, 12balance sheet, 22 – 28





assets on, 21, 41 – 54definition of, 140elements of, 21 – 22equity on, 21expenses on, 21liabilities on, 21, 57 – 63limitations of, 12and off-balance-sheetfinancing, 63

owners’ equity on, 26, 63 – 66revenue on, 21

balance sheet analysis, 93 – 108ratios in, 94 – 105vertical and horizontal,106 – 107

bank loans, 25bearer bonds, 62bond(s), 25definition of, 140as long-term investment, 46maturity patterns of, 35as trading securities, 42types of, 62

bonds payable, 61 – 63brand equity, 12break-even analysis, see cost-

volume-profit analysisbreak-even pointcalculation of, 125 – 127definition of, 140graphic presentation of,127 – 128

uses of, 128 – 129

Capital stockon balance sheet, 26 – 27definition of, 140in notes to financialstatements, 35

as part of owners’ equity, 64cash, as current asset, 42cash basis of accountingaccrual accounting vs., 77definition of, 141for guarantee and warrantycosts, 60

cash dividends payable, 59cash flows from financing

activities, 84definition of, 141examples of, 85

cash flows from investingactivities, 85

definition of, 141examples of, 85


cash flows from operatingactivities, 84

definition of, 141examples of, 85

Certificate in ManagementAccounting (CMA), 5

closing accounts, 21 – 22common stock, 26 – 27competitiveness, measures of, 12compilation reports, 9, 11comprehensive income, 75, 76conservatism, 7, 141consolidation, 47contingent liabilities, 13, 34contra-asset accounts, 43contribution margin, 129 – 131,

141convertible bonds, 62copyrights, 51cost allocation, 29cost behavior, 124 – 125cost method of valuation, 47cost of goods solddefinition of, 141on income statement, 30 – 31in income statement analysis,111 – 112

cost of sales, see cost of goodssold

cost-volume-profit (CVP)analysis, 125 – 132

advantages of, 131break-even graph in, 127 – 128break-even point calculationin, 125 – 127

contribution margin in,129 – 131

limitations of, 132using, 128 – 129

coupon bonds, 62CPAs, state societies of, 4cumulative bond interest, 62current asset(s), 22, 42 – 46cash as, 42definition of, 141inventories as, 44 – 46marketable securities as,42 – 43

prepaid expenses as, 46receivables as, 43 – 44

current liabilities, 25, 58 – 61definition of, 141types of, 58 – 61

current maturities of long-termdebt, 58

current ratio, 95, 97

CVP analysis, see cost-volume-profit analysis

Debenture (bond), 62, 141debtinstallment, 61long-term, see long-termliabilities

as trading securities, 42debt ratio, 104debt-to-equity ratio, 104 – 105deep discount bonds, 62depletion, 52, 53, 141depreciation, 49accumulated, 49definition of, 141straight-line, 29, 49

diluted EPS (earnings per share),116

direct labor, 44, 132direct method, 86 – 87disclosure, 7discussion memorandum

(FASB), 4distributions to owners, 20dividends, 142dividends payable, 59Dun & Bradstreet, 94

Earningsrestricted, 65retained, 27, 65, 145

earnings per share, 116, 142EBIT, 89, 142end-of-period adjustments,

77 – 78equity, 20on balance sheet, 21definition of, 21, 142as trading securities, 42see also owners’ equity

equity method of valuation, 47expense recognition, 29expense(s), 21in accrual accounting, 8accrued, 59, 79on balance sheet, 21definition of, 28, 142on income statement, 73,77 – 80

operating, 32, 73, 113, 114, 145other, 32prepaid, 46, 78, 145

external users, 3 – 5


INDEX 157

FactSheets Express, 94fair market value, 42FASB, see Financial

Accounting StandardsBoard

FASB 95, 34definition of, 142for statement of cashflows, 83 – 86

FASB interpretations, 4FASB standards, 4FCF, see free cash flowFIFO (first in, first out), 45financial accountingbasic principles of, 7definition of, 3, 142for external users, 3

Financial AccountingStandards Board(FASB), 3 – 4, 147

definition of, 142goal of, 3 – 4task force of, 4

financial analyst, 142financial informationexternal users of, 3 – 5historic, 12internal users of, 2reliability and usefulnessof, 1 – 2

financial ratios, 94 – 105activity, 97 – 103leverage, 104 – 105limitations of, 94, 117, 118liquidity, 95 – 97

financial statement analysisaim of, 93notes in, 36purpose of, 10ratios in, 94 – 106see also balance sheetanalysis; incomestatement analysis

financial statement(s), 1 – 3,19 – 37

assumptions used increating, 6 – 8

balance sheet as, 22 – 28elements of, 20 – 22income statement as,28 – 32

limitations of, 12 – 13and MD&A, 36notes to, 34 – 36statement of cash flows as,34, 35


statement of retained earningsas, 32 – 33

supplemental information for,34 – 36

see also individual types ofstatements

financing activitiescash flows from, 84, 85, 141noncash, 85 – 86

finished goods account, 44first in, first out (FIFO), 45fixed assets, see property, plant

and equipmentfixed costscost behavior of, 124definition of, 142

franchises, 51free cash flow (FCF), 89 – 90calculating, 89definition of, 142

full disclosure, 7, 34, 142

GAAP, see generally acceptedaccounting principles

GAAP opinion, 11gain(s), 21definition of, 143on income statement, 75unrealized, 42, 75

generally accepted accountingprinciples (GAAP), 8 – 9

and audits, 9 – 10definition of, 143statement users’ knowledge of,3

Generally Accepted AuditingStandards, 10

going-concern assumption, 6,143

goodwill, 51 – 52goodwill impairment, 51 – 52grading policy, xiigross profit, 31, 112 – 114gross profit margin, 115gross-profit-margin ratio, 112gross profit ratio, 112 – 113guarantee costs, 59 – 60guaranteed bonds, 62

Held-to-maturity securities, 43historical cost, 7, 12 – 13definition of, 143of investments, 47of tangible assets, 48 – 49

horizontal analysis, 106

of balance sheets, 101,106 – 107

of income statements, 101,118 – 119

human resources measures, 12

IFRS (International FinancialReporting Standards), 9

IMA, see Institute ofManagement Accountants

incomecomprehensive, 75, 76net, 32, 75, 144operating, 114other, 32

income bonds, 62income statement, 28 – 32, 71 – 80apportionment of revenuesand expenses on, 77 – 80

and cash vs. accrual basis ofaccounting, 77

components of, 73, 75 – 76cost of goods sold on, 30 – 31definition of, 143format for, 71 – 74information not availablefrom, 84

multi-step, 72, 74net income on, 32operating expenses on, 32other income (other expenses)on, 32

sales on, 29single-step, 71 – 73

income statement analysis,111 – 120

cost of goods sold in, 111 – 112gross profit in, 112 – 114horizontal and vertical, 101,118 – 119

operating expenses in, 113,114

operating income in, 114profitability ratios in, 115 – 118sales in, 111

income taxes, 34, 59income taxes payable, 59indentures, 61indirect method, 87 – 88Industry Norms and Business Ratios

(Dun & Bradstreet), 94inflation, 13Institute of Management

Accountants (IMA), 147accounting standardsinfluenced by, 5



definition of, 143intangible assets, 50 – 52internal controls, 9Internal Revenue Code (IRC),

143Internal Revenue Service (IRS)accounting standardsinfluenced by, 5

definition of, 143internal users, 2International Financial

Reporting Standards(IFRS), 9

International FinancialReporting StandardsFoundation, 147

international standards, 9inventory(-ies)as current asset, 44 – 46definition of, 143vertical and horizontalanalysis of, 106

inventory turnover ratio,100 – 102

investing activitiescash flows from, 85, 141noncash, 85 – 86

investmentsdefinition of, 143long-term, 24, 46 – 48by owners, 20requiring valuationadjustment, 79

short-term, see marketablesecurities

IRC (Internal Revenue Code),143

IRS, see Internal RevenueService

Joint ventures, 46Landand depreciation, 49as long-term investment, 46

last in, first out (LIFO), 45leases/leaseholdsas intangible assets, 51operating, 63

leverage ratios, 104 – 105, 143liabilities, 20accrued, 59, 140on balance sheet, 21, 25,57 – 63

contingent, 13, 34current, 25, 58 – 61, 141


definition of, 21, 144long-term, 25, 58, 61 – 63, 144

licenses, 51life insurance policies, 46LIFO (last in, first out), 45limitations of financial

statements, 12 – 13liquidity, 42liquidity ratios, 95 – 97, 144loans, 25, 46long-term investments, 24,

46 – 48on balance sheet, 24cost method of valuing, 47equity method of valuing, 47

long-term liabilities, 25current maturities of, 58definition of, 144types of, 61 – 63

losses, 21definition of, 144on income statement, 75

Management accounting, 144Management Discussion and

Analysis (MD&A), 36managerial accounting, internal

users of, 2manufacturing overhead, 44marketable securitiesas current asset, 42 – 43definition of, 144requiring valuationadjustment, 79

matching concept, 29matching principle, 7, 144material events, in notes to

financial statements, 34materiality, 7, 144MD&A (Management

Discussion and Analysis),36

Mergent Online, 94, 147mixed cost(s)cost behavior of, 124 – 125definition of, 144

monetary units, 6mortgages, 25mortgage(s) payabledefinition of, 144as long-term liabilities, 61

multi-step income statement, 72,74

Natural resources, 52 – 53net income, 75

definition of, 144on income statement, 32

net loss, 75, 144net realizable value, 44net sales, 29, 111noncash financing activities,

85 – 86noncash investing activities,

85 – 86nonmonetary facts, 12notes payableas current liabilities, 58definition of, 145as trading securities, 42

notes receivable, 43notes to financial statements, 7,

34 – 36number of days’ inventory ratio,

102

Off-balance-sheet financing, 63online resources, 94, 147operating activities, cash flows

from, 84, 85, 141operating expenses, 73definition of, 145on income statement, 32in income statement analysis,113, 114

operating income, 114operating leases, 63operating profit margin, 115operational results analysis,

123 – 134contribution margin in,129 – 131

cost behavior in, 124 – 125cost-volume-profit analysis in,125 – 132

graphic presentation of break-even in, 127 – 128

profit-volume graph in,132 – 133

using break-even analysis in,128 – 129

other assets, 53other income (other expenses),

32other receivables, 43owners, distributions to, 20owners’ equity, 20on balance sheet, 26, 63 – 66definition of, 145parts of, 64 – 66


INDEX 159

Par value, 26patents, 51PCAOB, see Public

Company Accountingand Oversight Board

pension plans, 34period costs, 7periodicity assumption, 6 – 7Post-Test, xi, 149 – 150pre-emptive right, 145preferred stock, 145prepaid expense(s)as current asset, 46definition of, 145requiring adjustment, 78

Pre-Test, xi, xiii – xviiproduct costs, 7profitability, evaluating, 114profitability ratiosdefinition of, 145in income statementanalysis, 115 – 118

profit line, plotting, 132 – 133profit margin, 115, 145profit-volume graph,

132 – 133property, plant and

equipment, 48 – 53on balance sheet, 24definition of, 145intangible assets as, 50 – 52in notes to financialstatements, 35

tangible fixed assets as,48 – 50

wasting assets as, 52 – 53Public Company

Accounting andOversight Board(PCAOB), 147

creation of, 4definition of, 145purpose of, 4 – 5

purchase price of inventory,44

Qualitative variables, 12quarterly reports, 3quick (acid-test) ratio, 95 – 97

Ratios, see financial ratiosraw materials account, 44real estate, as long-term

investment, 46receivables, 43 – 44, see also

specific types of receivables


registered bonds, 62restricted earnings, 65retained earningson balance sheet, 27definition of, 145as part of owners’ equity, 65

retirement programs, 34return on assets, 116return on equity, 116revenue recognition, 7, 29, 146revenue(s), 21in accrual accounting, 8accrued, 78 – 79on balance sheet, 21definition of, 28, 146on income statement, 73,77 – 80

requiring adjustment, 78 – 79unearned, 59, 146

review questions, xiireview reports, 9 – 11risks, in notes to financial

statements, 36Robert Morris Associates, 94

Salescomponents of, 111on income statement, 29in income statement analysis,111

sales allowances, 29sales discounts, 29sales returns, 29Sarbanes – Oxley Act of 2002, 4,

9, 146Securities and Exchange

Commission (SEC), 147definition of, 146FASB support from, 4role of, 4

separate-entity assumption, 6serial bonds, 62shareholders’ equity, see owner’s

equityshort-term investments, see

marketable securitiessingle-step income statement,

71 – 73specific identification method,

44Standard and Poor’s Industry

Surveys Ratios, 147standardsaccounting, 4auditing, 5international, 9

statement of cash flows, 34, 35,83 – 90

definition of, 146format alternatives for, 86 – 88and free cash flow calculation,89 – 90

nature of, 84 – 86usefulness of, 84

Statement of FinancialAccounting No. 3, 20

statement of financial position,see balance sheet

statement of retained earnings,32 – 33, 146

state societies of CPAs, 4stockcapital, 26 – 27, 35, 64, 140as long-term investment, 46preferred, 145as trading securities, 42treasury, 27, 65, 146

stock options, 35straight-line depreciation, 29, 49supplemental information, for

financial statements, 34 – 36

Tangible fixed assets, 48 – 50taxes payable, 25, 59temporary accounts, 21term bonds, 62“Think About It...” exercises, xiiThomson ONE, 94time period assumption, 6 – 7times interest earned ratio, 105total asset turnover ratio, 102total-debt-to-total-assets ratio,

104trade accounts pay, see accounts

payabletrademarks, 51trade receivables, 43trading securities, 42treasury stockon balance sheet, 27definition of, 146as part of owners’ equity, 65

trends, on income statements,113, 114

Uncertaintieswith intangibles, 52in notes to financialstatements, 35

unearned revenueas current liability, 59definition of, 146



unrealized gain, 42, 75unrealized losses, 75unrecorded accrued expenses, 79unrecorded accrued revenues,

78 – 79U.S. GAAP, 9

Value Line Investment Survey,147

variable costscost behavior of, 124definition of, 146

vertical analysis, 106of balance sheets, 101,106 – 107

of income statements, 101,118 – 119

Wages payable, 25warranty costs, 59 – 60wasting assets, 52 – 53work in process account, 44write-offsof natural resources, 52 – 53of receivables, 43 – 44

Year-end adjustments, 78 – 79Zero coupon bonds, 62, 146



how to read and interpret financial statements: a guide to understanding what the numbers really

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