2
A FURTHER LOOK AT
FINANCIAL STATEMENTS
2-1
Study Objectives
1. Identify the sections of a classified balance sheet.
2. Identify and compute ratios for analyzing a company’s
profitability.
3. Explain the relationship between a retained earnings statement
and a statement of stockholders’ equity.
4. Identify and compute ratios for analyzing a company’s liquidity
and solvency using a balance sheet.
5. Use the statement of cash flows to evaluate solvency.
6. Explain the meaning of generally accepted accounting
principles.
7. Discuss financial reporting concepts.
2-2
A Further Look At Financial Statements
The Classified Using the Financial Financial Reporting
Balance Sheet Statements Concepts
Current assets Ratio analysis The standard-setting
Using the income environment
Long-term
investments statement Qualities of useful
Property, plant, and Using the statement of information
equipment stockholders’ equity Assumptions
Intangible assets Using a classified Principles
balance sheet
Current liabilities Constraints
Using the statement of
Long-term liabilities
cash flows
Stockholders’ equity
2-3
The Classified Balance Sheet
The difference between traditional and classified BS
Presents a snapshot at a point in time.
To improve understanding, companies group similar
assets and similar liabilities together.
Standard Classifications Illustration 2-1
2-4
The Classified Balance Sheet
Illustration 2-2
2-5 SO 1
The Classified Balance Sheet
Illustration 2-2
2-6 SO 1
The Classified Balance Sheet
Current Assets
Assets that a company expects to convert to cash or
use up within one year or the operating cycle,
whichever is longer.
Operating cycle is the average time it takes from the
purchase of inventory to the collection of cash from
customers.
2-7
The Classified Balance Sheet
Current Assets
Illustration 2-3
Companies list current asset accounts in the order they expect to
convert them into cash.
2-8
The Classified Balance Sheet
Current assets
1.Cash and cash equivalents: the most liquid assets. # short term
investment (within 12 month, risk to convert to cash),
(marketable securities, commercial paper, short term
government bond,..).
2.Short-term investment: expire within one year (stocks and
bonds,…). Ex: Microsoft, which is always in a strong cash
position, had short-term investments totaling approximately $32
billion at the end of 2005.
3.Account receivables: Money owed by individuals and corp.
(relatively short time period).
2-9
The Classified Balance Sheet
Current assets
4. Inventories: A company's merchandise, raw materials,
and finished and unfinished products which have not yet
been sold. The cost of inventory should include all costs
necessary to acquire the items and to get them ready for
sale…
5.Prepaid expenses: as a result of business
making payments for goods and services to be received in
the near future. Ex: a company had a one-year insurance policy
cost of $1200. As each month elapses, $100 of prepaid
insurance would be expensed to the income statement until the
account is empty at the end of the year.
2-10
The Classified Balance Sheet
Review Question
Cash, and other resources that are reasonably expected to
be realized in cash or sold or consumed in the business
within one year or the operating cycle, are called:
a. Current assets.
b. Intangible assets.
c. Long-term investments.
d. Property, plant, and equipment.
2-11
The Classified Balance Sheet
Long-Term Investments
Investments in stocks and bonds of other companies that
are held for more than one year.
Investments in long-term assets such as land or buildings
not currently being used in operating activities.
Illustration 2-4
2-12
The Classified Balance Sheet
Property, Plant, and Equipment
Long useful lives.
Currently used in operations.
Depreciation - allocating the cost of assets to a number
of years.
Accumulated depreciation - total amount of
depreciation expensed thus far in the asset’s life.
2-13
The Classified Balance Sheet
Property, Plant, and Equipment
Illustration 2-5
2-14
The Classified Balance Sheet
Intangible Assets
Assets that do not have physical substance.
Illustration 2-6
2-15
The Classified Balance Sheet
Intangeble assets
Intellectual property (patents, trademarks, copyrights,
business methodologies), goodwill and brand recognition,
…
Valuable for a firm and can be critical to its long-term
success or failure. Ex: Coca-Cola , its positive effects on
bottom-line profits can prove extremely valuable to firms
such as Coca-Cola, whose brand strength drives global
sales year after year.
2-16
The Classified Balance Sheet
Review Question
Patents and copyrights are
a. Current assets.
b. Intangible assets.
c. Long-term investments.
d. Property, plant, and equipment.
2-17
The Classified Balance Sheet
Current Liabilities
Obligations the company is to pay within the coming year.
Usually list notes payable first, followed by accounts
payable.
Other items follow in order of magnitude.
2-18
The Classified Balance Sheet
Current Liabilities
Illustration 2-7
2-19
The Classified Balance Sheet
Current Liabilities
1.Note payables: A written promissory note, in which a
borrower borrows a specific amount of money and
promises to pay it back with interest over a
predetermined time period (shor –term/long term)
2.Account payables: represents an entity's obligation
to pay off a short-term debt to its creditors. Ex: the
phone company, the gas company and the cable
company are types of creditors. Each one of these
creditors provide a service first and then bills the
customer after the fact.
2-20
The Classified Balance Sheet
3. Tax payable
4. Wage and salary payable
5. Unearned revenue: Company receives money for a
service or product that has yet to be fulfilled. The early
cash flow to the firm is advantageous for any number of
activities, such as paying interest on debt to purchasing
more inventory.
6. Mortgage payable: The long-term financing used to
purchase property. The property itself serves as
collateral for the mortgage until it is paid off. A
mortgage usually requires equal payments, consisting of
principal and interest, throughout its term.
2-21 SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Long-Term Liabilities
Obligations a company expects to pay after one year.
Illustration 2-8
2-22 SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Review Question
Which of the following is not a long-term liability?
a. Bonds payable
b. Current maturities of long-term obligations
c. Long-term notes payable
d. Mortgages payable
2-23 SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Stockholders’ Equity
Illustration 2-2
Paid-in capital: is the amount invested in the corporation by its
owners. The basic component of paid-in capital is common
stock.
Common stock - investments of assets into the business by
the stockholders.
Retained earnings - income retained for use in the business.
2-24
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
2-25 SO 1 Identify the sections of a classified balance sheet.
Using the Financial Statements
Ratio Analysis
Ratio analysis expresses the relationship among
selected items of financial statement data.
A ratio expresses the mathematical relationship
between one quantity and another.
2-26
Using the Financial Statements
2-27
Using the Financial Statements
Using the Income Statement
Illustration 2-10
Profitability ratios measure the operating success of a company for a given period of time.
2-28
SO 2 Identify and compute ratios for analyzing a company’s profitability.
Profitability
Using the Financial Statements Ratio
Illustration: Earnings per share (EPS) measures the net
income earned on each share of common stock.
Best Buy
Illustration 2-11
$1,003 - $0 $1,407 - $0
= =
(414 + 411) 2 (411 + 481) 2
2-29 $2.43 $3.15
Using the Financial Statements
Review Question
For 2010 Stoneland Corporation reported net
income $26,000; net sales $400,000; and average shares
outstanding 6,000. There were preferred stock dividends of
$2,000. What was the 2010 earnings per share?
a. $4.00
b. $0.06 $26,000 - $2,000
= $4.00
c. $16.67 6,000
d. $66.67
2-30
SO 2 Identify and compute ratios for analyzing a company’s profitability.
Using the Illustration 2-13
Financial
Statements
Using a
Classified
Balance Sheet
2-31
Using the Financial Statements
Using a Classified Balance Sheet
Liquidity—the ability to pay obligations expected to
become due within the next year or operating cycle.
Illustration 2-14
When working capital is positive, there is greater likelihood that
the company will pay its liabilities.
Video: http://www.investopedia.com/video/play/working-
capital/
SO 4 Identify and compute ratios for analyzing a company’s
liquidity and solvency using a balance sheet.
2-32
Liquidity
Using the Financial Statements Ratio
Liquidity ratios measure the short-term ability to pay maturing
obligations and to meet unexpected needs for cash.
Illustration 2-15
For every dollar of current liabilities, Best Buy has $.97 of current assets
2-33
SO 4 Identify and compute ratios for analyzing a company’s
liquidity and solvency using a balance sheet.
Using the Financial Statements
Using a Classified Balance Sheet
Solvency—the ability to pay interest as it comes due and to
repay the balance of a debt due at its maturity.
Solvency ratios measure the ability of the company to
survive over a long period of time.
2-34
SO 4 Identify and compute ratios for analyzing a company’s
liquidity and solvency using a balance sheet.
Solvency
Using the Financial Statements Ratio
Debt to total assets ratio measures the percentage of total
financing provided by creditors rather than stockholders.
Illustration 2-16
The 2009 ratio means that every dollar of assets was financed by 71 cents of debt.
2-35
SO 4 Identify and compute ratios for analyzing a company’s
liquidity and solvency using a balance sheet.
Using the Financial Statements
Review Question
The following ratios are available for Leer Inc. and Stable Inc.
Compared to Stable Inc., Leer Inc. has:
a. higher liquidity, higher solvency, and higher profitability.
b. lower liquidity, higher solvency, and higher profitability.
c. higher liquidity, lower solvency, and higher profitability.
d. higher liquidity and lower solvency, but profitability cannot be
compared based on information provided.
2-36 SO 4
2-37
Using the Financial Statements
In the Statement of Cash Flows, cash
provided by operating activities fails to
take into account that a company must
invest in new PP&E and must maintain dividends at current levels to
satisfy investors.
Free cash flow is a measurement to provide additional insight
regarding a company’s cash-generating ability.
2-38
SO 5 Use the statement of cash flows to evaluate solvency.
Using the Financial Statements
Illustration: MPC produced and sold
10,000 personal computers this year. It
reported $100,000 cash provided by
operating activities. In order to maintain production at 10,000
computers, MPC invested $15,000 in equipment. It chose to pay
$5,000 in dividends. Calculate free cash flow.
Cash provided by operating activities $100,000
Less: Expenditures on property, plant, and equipment -15,000
Dividends paid 5,000
Free cash flow $ 80,000
2-39
SO 5 Use the statement of cash flows to evaluate solvency.
Using the Financial Statements
Using the Statement of Stockholders’ Equity
Illustration 2-12
Most companies use
a statement of
stockholders’
equity, rather than a
retained earnings
statement, so that
they can report all
changes in
stockholders’ equity
accounts.
2-40
SO 3 Explain the relationship between a retained earnings
statement and a statement of stockholders’ equity.
Using the Financial Statements
Using the Statement of Stockholders’ Equity
Observations from this financial statement of Best Buy:
► Common stock decreased during the first year because the
stock issuance was much smaller than the stock repurchase.
► Common stock increased in the second year as the result of
an issuance of shares..
► Best Buy paid dividends each year.
► Prior to 2003, Best Buy did not pay dividends, even though it
was profitable and could do so.
Why didn’t Best Buy pay dividends prior to 2003? Read Page 57
2-41
SO 3 Explain the relationship between a retained earnings
statement and a statement of stockholders’ equity.
Using the Financial Statements
Review Question
The balance in retained earnings is not affected by:
a. net income
b. net loss
c. issuance of common stock
d. dividends
2-42
SO 3 Explain the relationship between a retained earnings
statement and a statement of stockholders’ equity.
Financial Reports Concepts
The Standard-Setting Environment
Generally Accepted Accounting Principles (GAAP) - A set of
rules and practices, having substantial authoritative support, that
the accounting profession recognizes as a general guide for
financial reporting purposes.
Standard-setting bodies determine these guidelines:
► Securities and Exchange Commission (SEC)
► Financial Accounting Standards Board (FASB)
► International Accounting Standards Board (IASB)
► Public Company Accounting Oversight Board (PCAOB)
2-43 SO 6 Explain the meaning of generally accepted accounting principles.
Financial Reports Concepts
Review Question
Generally accepted accounting principles are:
a. a set of standards and rules that are recognized
as a general guide for financial reporting.
b. usually established by the Internal Revenue
Service.
c. the guidelines used to resolve ethical dilemmas.
d. fundamental truths that can be derived from the
laws of nature.
2-44 SO 6 Explain the meaning of generally accepted accounting principles.
Financial Reports Concepts
Qualities of Useful Information
According to the FASB, useful information should possess two
fundamental qualities, relevance and faithful representation.
Illustration 2-17
2-45 SO 7
Financial Reports Concepts
Qualities of Useful Information
Enhancing Qualities
Comparability Information has the
results when Information is quality of
different companies verifiable if we are understandability
use the same able to prove that it if it is presented in a
accounting is free from error. clear and concise
principles. fashion.
Consistency means
that a company uses
For accounting information to be
the same accounting
relevant, it must be timely.
principles and methods
from year to year.
2-46 SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
Assumptions in Financial Reporting
Illustration 2-18
Economic Entity
States that every
economic entity can be
separately identified
and accounted for.
Monetary Unit Periodicity
Requires that only States that the life of a
those things that can business can be
be expressed in divided into artificial
money are included in time periods.
the accounting
records.
2-47 SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
Assumptions in Financial Reporting
Illustration 2-18
Going Concern Accrual-Basis
The business will Transactions are
remain in operation recorded in the
for the foreseeable periods in which the
future. events occur.
2-48 SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
Principles in Financial Reporting
Measurement Principles
Cost Fair Value Full disclosure
Or historical cost Indicates that assets Requires that
principle, dictates and liabilities should companies disclose
that companies be reported at fair all circumstances
value (the price
record assets at and events that
received to sell an
their cost. would make a
Ex: If land that purchased
asset or settle
a liability). difference to
for $30.000 increase in
value to 40.000, it Ex:Investment financial statement
continued to report at securities users.
$30.000
2-49 SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
Match each item above with a description below.
1. Ability to easily evaluate one company’s results Comparability
relative to another’s.
2. Belief that a company will continue to operate
Going concern
for the foreseeable future.
3. The judgment concerning whether an item is
Materiality
large enough to matter to decision makers.
2-50 SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
Constraints in Financial Reporting
Illustration 2-19
Materiality Constraint
An item is material when its size makes it
likely to influence the decision of an
investor or creditor.
Cost Constraint
Accounting standard-setters weigh the cost
that companies will incur to provide the
information against the benefit that
financial statement users will gain.
2-51 SO 7
Financial Reports Concepts
4. The reporting of all information that would Full disclosure
make a difference to financial statement users.
5. The practice of preparing financial statements Periodicity
at regular intervals.
6. The quality of information that indicates the Relevance
information makes a difference in a decision.
2-52 SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
7. Belief that items should be reported on the
balance sheet at the price that was paid to Cost
acquire the item.
8. A company’s use of the same accounting
Consistency
principles and methods from year to year.
9. Tracing accounting events to particular Economic entity
companies.
2-53 SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
10. The desire to minimize errors and bias in Faithful representation
financial statements.
11. Reporting only those things that can be Monetary unit
measured in dollars.
2-54 SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
Review Question
What is the primary criterion by which accounting
information can be judged?
a. Consistency.
b. Predictive value.
c. Usefulness for decision making.
d. Comparability.
2-55 SO 7 Discuss financial reporting concepts.
Self test
Notes payable (due in 3 years) 50.5
Listed here are items Cash 141.1
($1000) taken from Salaries and wages expense 2,933.6
Common stock 454.9
Bargain Electronics,
Accounts payable 922.2
Inc. for the year ended Accounts receivable 723.3
December 31, 2012. Equipment, net 921.0
Instructions Cost of goods sold 9,501.4
Prepare an income Income taxes payable 7.2
statement and a Interest expense 1.5
classified balance sheet Mortgage payable 451.5
using the items listed. Retained earnings 1,336.3
Do not use any item Inventory 1,636.5
Sales revenue 12,456.9
more than once.
Short-term investments 382.6
Income tax expense 30.5
Goodwill 202.7
Notes payable (due in 6 months) 784.6
2-56
