CHAPTER
5
Foundations of Financial
Reporting and the
Classified Balance Sheet
Principles of
Accounting
12e
Needles
Powers
Crosson
© human/iStockphoto
LEARNING OBJECTIVES
 LO1: Describe the objective of financial reporting,
and identify the conceptual framework underlying
accounting information.
 LO2: Identify and define the basic components of
financial reporting, and prepare a classified
balance sheet
 LO3: Use classified financial statements to
evaluate liquidity and profitability.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
SECTION 1: CONCEPTS
(slide 1 of 3)
 Relevance: information has a direct bearing on a decision
– Predictive value: information helps capital providers make decisions
about future actions
– Confirmative value: information confirms or changes previous evaluations
– Materiality: the omission or misstatement of information could influence the
user’s economic decisions taken on the basis of the financial statements
 Faithful representation: information is complete, neutral, and free
from material error
– Completeness: all information necessary for a reliable decision is
provided
– Neutrality: information is free from bias intended to achieve a certain
result or bring about a particular behavior
– Free from material error: information meets a minimum level of accuracy
so it does not distort what is being reported
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
SECTION 1: CONCEPTS
(slide 2 of 3)
 Enhancing qualitative characteristics
– Comparability: the quality that enables users to identify
similarities and differences between two sets of financial data
– Verifiability: the quality that different knowledgeable and
independent observers could reach consensus, although not
necessarily complete agreement, that a particular depiction is a
faithful representation
– Timeliness: the quality that enables users to receive information in
time to influence their decisions
– Understandability: the quality that enables users to comprehend
the meaning of information
– Cost constraint (cost-benefit): the benefits to be gained from
providing accounting information should be greater than the costs
of providing it
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
SECTION 1: CONCEPTS
(slide 3 of 3)
 Accounting conventions: constraints used in preparing
financial statements
– Consistency: once a company has adopted an accounting
procedure, it must use it from one period to the next unless a note
to the financial statements informs users of a change
– Full disclosure (transparency): financial statements must present all
the information relevant to users’ understanding of the statements
– Conservatism: when faced with choosing between two equally
acceptable procedures or estimates, accountants should choose the
one that is least likely to overstate assets and income
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Objective of Financial Reporting
 To be useful for decision making, financial reporting must
enable the user to
– Assess cash flow prospects
– Assess management’s stewardship
 Financial reporting includes the financial statements
(balance sheet, income statement, statement of owner’s
equity, and statement of cash flows) that are prepared
periodically.
– Management’s underlying assumptions and methods
and estimates used in the financial statements are also
important components of financial reporting.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Qualitative Characteristics of
Accounting Information
 To facilitate interpretation of accounting
information, the FASB has established standards,
or qualitative characteristics, by which to judge
the information.
 The most fundamental of these characteristics are:
– Relevance
– Faithful representation
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Relevance
(slide 1 of 2)
 Relevance means that the information has a direct
bearing on a decision. In other words, if the
information were not available, a different
decision would be made.
– To be relevant, information must have one or both of the
following:
 Predictive value—Information has predictive value if it helps
capital providers make decisions about future actions.
 Confirmative value—Information has confirmative value if it
confirms or changes previous evaluations.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Relevance
(slide 2 of 2)
 Relevant information is also subject to materiality.
– Information is material if its omission or misstatement
could influence the user’s economic decisions taken on
the basis of the specific entity’s financial statements.
– Materiality is related to both the nature of an item and its size or
misstatement.
 The materiality of an item normally is determined by relating its
dollar value to an element of the financial statements, such as
net income or total assets.
 As a rule, when an item is worth 5 percent or more of net
income, accountants treat it as material.
 However, many small errors can add up to a material amount.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Faithful Representation
 Faithful representation means that the financial
information is complete, neutral, and free from
material errors.
– Complete information provides all information
necessary for a reliable decision.
– Neutral information is free from bias intended to
achieve a certain result or to bring about a particular
behavior.
– To be free from material error means information
meets a minimum level of accuracy so it does not distort
what is being reported.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Enhancing Qualitative Characteristics
(slide 1 of 2)
 Other characteristics that the FASB has established for
interpreting accounting information include:
– Comparability—enables users to identify similarities
and differences between two sets of financial data.
– Verifiability—different knowledgeable and
independent observers could reach consensus that a
particular depiction is a faithful representation.
– Timeliness—enables users to receive information in
time to influence their decisions.
– Understandability—enables users to comprehend the
meaning of the information.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Enhancing Qualitative Characteristics
(slide 2 of 2)
 These enhancing characteristics are subject to the
cost constraint (or cost-benefit), which holds that
the benefits to be gained from providing
accounting information should be greater than the
costs of providing it.
– Minimum levels of relevance and faithful representation
must be reached if accounting information is to be
useful.
– Beyond the minimum levels, it is up to the FASB, the
SEC, and the accountant who provides the information
to judge the costs and benefits in each case.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accounting Conventions
(slide 1 of 2)
 Accounting conventions, or constraints, used in preparing
financial statements include:
– Consistency—requires that once a company has
adopted an accounting procedure, it must use it from
one period to the next unless a note to the financial
statements informs users of a change.
– Full disclosure (or transparency)—requires that
financial statements present all the information relevant
to users’ understanding of the statements, including:
 any explanation needed to keep them from being misleading.
 the disclosure of significant events arising after the balance
sheet date.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accounting Conventions
(slide 2 of 2)
– Conservatism—holds that, when faced with
choosing between two equally acceptable
procedures or estimates, the accountant should
choose the one that is least likely to overstate
assets and income.
 Conservatism can be a useful tool, but if abused,
can lead to incorrect or misleading financial
statements.
 Accountants should apply the conservatism
convention only when they are uncertain about which
accounting procedure or estimate to use.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Ethical Financial Reporting
 Under the Sarbanes-Oxley Act, chief executive
officers and chief financial officers of all publicly
traded companies must certify that, to their
knowledge, their quarterly and annual statements
are accurate and complete.
 Fraudulent financial reporting can have high costs
for investors, lenders, employees, and customers—
as well as for the people who condone, authorize,
or prepare misleading reports.
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Classified Balance Sheet
 General-purpose external financial statements that are
divided into subcategories are called classified financial
statements.
 The subcategories into which assets, liabilities, and owner’s
equity are broken down are shown below.
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Assets
 The classified balance sheet typically divides
assets into four categories: current assets;
investments; property, plant, and equipment; and
intangible assets.
 These categories are listed in the order of how
easily they can be converted to cash.
 Some companies group investments, intangible
assets, and other miscellaneous assets into a
category called other assets.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Current Assets
 Current assets include cash and other assets that a
company can reasonably expect to convert to cash, sell, or
consume within one year or its normal operating cycle,
whichever is longer.
– A company’s normal operating cycle is the average time it needs
to go from spending to receiving cash.
– Current assets include: cash; short-term investments; notes and
accounts receivable; inventory that a company expects to convert
to cash (by selling it) within the next year or the normal operating
cycle; prepaid expenses; and supplies bought for use.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Investments

Investments include assets, usually long-term, that are
not used in normal business operations and that
management does not plan to convert to cash within the
next year. Examples include:
– Securities held for long-term
investment
– Long-term notes receivable
– Land held for future use
– Plant or equipment not used
in business
– Special funds established to
pay off a debt or buy a
building
– Large permanent investments
made in another company for
the purpose of controlling that
company
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Property, Plant, and Equipment
 Property, plant, and equipment include tangible longterm assets used in a business’s day-to-day operations.
– They are also called operating assets, fixed assets, tangible assets,
long-lived assets, or plant assets.
– Through depreciation, the costs of these assets (except land) are
spread over the periods they benefit.
– To reduce clutter on the balance sheet, property, plant, and
equipment and related accumulated depreciation accounts are
often combined—for example:
Property, plant, and equipment (net) $116,240
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Intangible Assets
 Intangible assets are long-term assets with no
physical substance. Their value stems from the
rights or privileges accruing to their owners.
Examples include:
–
–
–
–
–
Patents
Copyrights
Franchises
Trademarks
Goodwill—arises in an acquisition of another company
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Liabilities

Liabilities are divided into two categories:
- Current liabilities—
obligations that must be
satisfied within one year or
within the company’s normal
operating cycle, whichever is
longer.
 Notes payable
 Accounts payable
 Current portion of long-term
debt
 Salaries and wages payable
 Customer advances
- Long-term liabilities—
debts that fall due more
than one year in the future
or beyond the normal
operating cycle.
 Mortgages payable
 Long-term notes
 Bonds payable
 Employee pension
obligations
 Long-term lease liabilities
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Owner’s Equity
 The terms owner’s equity, proprietorship, owner’s
capital, and net worth are all used to refer to the
owner’s interest, or equity, in a company.
– The first three terms are preferred to net worth because
many assets are recorded at their original cost rather
than at their current value.
 The equity section of the balance sheet differs
depending on whether the business is a sole
proprietorship, partnership, or corporation.
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Sole Proprietorship
 The owner’s equity section of a sole proprietorship
would be similar to the one shown for Bonali
Company:
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Partnership
 The equity section of a partnership’s balance sheet
is called partners’ equity.
 It is much like that in a sole proprietorship’s
balance sheet and might appear as follows:
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Corporation
(slide 1 of 2)
 The equity section of a balance sheet for a corporation is
called stockholders’ equity (or shareholders’ equity).
 It has two parts, contributed capital and retained earnings.
 The Contributed Capital (or Paid-in Capital) account
reflects the amount of assets invested by stockholders.
 It is generally shown on corporate balance sheets by two
amounts:
– the face, or par, value of issued stock
– the amounts paid in, or contributed, in excess of the par value per
share
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Corporation
(slide 2 of 2)
 The Retained Earnings account is sometimes
called Earned Capital because it represents the
stockholders’ claim to the assets that are earned
from operations and reinvested in corporate
operations.
 Distributions of assets to shareholders, which are
called dividends, reduce the Retained Earnings
account just as withdrawals of assets by the owner
of a business reduce the Capital account.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Overview of Classified Balance Sheet Accounts
 Similar accounts on the balance sheet and income
statement can be grouped, as shown below.
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Using Classified Financial Statements
 Ratios use the components of classified financial
statements to reflect how well a firm has
performed in terms of maintaining liquidity and
achieving profitability.
 Accounts must be classified correctly before the
ratios are computed, or the ratios will be incorrect.
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Evaluation of Liquidity
 Liquidity means having enough money on hand to
pay bills when they are due and to take care of
unexpected needs for cash. Two measures of
liquidity are working capital and current ratio.
 Working capital is the amount by which current
assets exceed current liabilities.
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Current Ratio
 The current ratio is the ratio of current assets to
current liabilities.
 To determine whether a current ratio is good or
bad, it must be compared with ratios for earlier
years and with similar measures for companies in
the same industry.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Evaluation of Profitability
 Profitability is the ability to earn a satisfactory
income.
– Profitability competes with liquidity because liquid
assets are not the best profit-producing resources.
– Ratios commonly used to evaluate a company’s ability
to earn income include:





Profit margin
Asset turnover
Return on assets
Debt to equity ratio
Return on equity
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Profit Margin
 The profit margin shows the percentage of each
sales dollar that results in net income.
– It is an indication of how well a company is controlling
its costs: the lower its costs, the higher its profit margin.
– To determine whether this is a satisfactory profit, it must
be compared with the profit margin of other companies
in the same industry.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Asset Turnover
 The asset turnover ratio measures how efficiently
assets are used to produce sales.
– A company with a high asset turnover uses its assets
more productively than one with a low asset turnover.
– Asset turnover is computed by dividing revenues by
average total assets. Average total assets are the sum
of assets at the beginning and the end of the period,
divided by 2.
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Return on Assets
 The return on assets ratio relates net income to
average total assets.
– This ratio combines the firm’s income-generating
strength (profit margin) and its revenue-generating
effectiveness (asset turnover).
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Debt to Equity Ratio
 The debt to equity ratio shows the proportion of a
company’s assets financed by creditors and the
proportion financed by the owner.
– This ratio is relevant to profitability, as well as liquidity,
because the more debt a company has, the more profit
it must earn to ensure payment of interest to creditors
and a return on the owner’s investment.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Return on Equity
 Return on equity is the ratio of net income to
average owner’s equity.
– Return on equity will always be greater than return on
assets because total equity will always be less than
total assets.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.