Financial Accounting:
Tools for Business Decision Making
Kimmel, Weygandt, Kieso, Trenholm
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Chapter 2
A Further Look at Financial Statements
After studying Chapter 2, you should
be able to:
1. Describe the basic objective of financial reporting,
and explain the meaning of generally accepted
accounting principles.
2. Discuss the qualitative characteristics of
accounting information.
3. Identify two constraints in accounting.
4. Identify the sections of a classified balance sheet.
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Chapter 2
A Further Look at Financial Statements
After studying Chapter 2, you should
be able to:
5. Identify and compute ratios for analysing a
company's profitability.
6. Explain the relationship between a statement of
retained earnings, a statement of earnings, and a
balance sheet.
7. Identify and compute ratios for analysing a
company's liquidity and solvency.
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Objective of Financial
Reporting
Provide the most useful financial
information for decision making
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General Guide for
Financial Reporting
Generally
Accepted
Accounting
Principles
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Characteristics of Useful
Information
Understandability
Relevance
Reliability
Comparability and consistency
6
Illustration 2-1
Characteristics of Useful Information
Constraints in Accounting
Modify GAAP without hurting the
usefulness of information
Cost-benefit
Materiality
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Classified Balance Sheet
Generally contains the following standard classifications:
Assets
Current assets
Long-term
investments
Capital assets
Liabilities
Current liabilities
Long-term
liabilities
Shareholders’ Equity
Share capital
Retained earnings
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Current Assets
Assets expected to be converted to
cash or used in the business within
the year
Listed in order of liquidity
Examples
Cash
Short-term investments
Receivables
Inventories
Prepaid expenses
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Long-Term Investments
Assets that can be converted into
cash, but whose conversion is not
expected within one year
Assets not intended for use within
the business
Example

Investments in shares
and bonds of other
corporations
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Capital Assets
Assets with relatively long useful
lives
Assets used in operating the
business
Two categories of capital assets
Tangible (with physical substance)
Intangible (with no physical substance)
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Tangible Capital Assets
Examples
Property, plant, and equipment
Land
Buildings
Machinery and equipment
Furniture and fixtures
Natural resources
Mineral deposits
Timber
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Intangible Capital Assets
Examples
Patents
Copyrights
Trademarks or trade names
Franchise
Intangible assets have value
because of the exclusive
rights or privileges they possess
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Amortization
Allocation of an asset’s full purchase
price to match cost to revenues over
entire estimated useful life instead of
expensing full cost in year of
purchase
Amortization is allocated for all
capital assets except land
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AMORTIZATION
Accumulated amortization account
shows the total amount of
amortization taken to date
The difference between the cost of
the asset and its accumulated
amortization is referred to as the net
book value of the asset
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CSU CORPORATION
Balance Sheet
December 31, 2001
Capital assets should be shown at net
book value (cost less accumulated
amortization)
Assets
Cash
Accounts receivable
Supplies
Equipment
Less: Accumulated amortization
Total assets
$ 2,000
4,000
1,800
24,000
8,000
16,000
$23,800
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Current Liabilities
Obligations that are
supposed to be paid
within the coming year
Accounts payable
Wages payable
Notes (bank loans) payable
Interest payable
Taxes payable
Current maturities of
long-term liabilities
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Long-Term Liabilities
Debts expected to be paid after one
year
Bonds payable
Mortgages payable
Long-term notes payable
Capital lease liabilities
Obligations under employee pension
plans
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Shareholders' Equity
Share capital
Investments in the business by the
shareholders
Retained earnings
Earnings kept for use in the business
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Current
Current
ANY CORPORATION
Balance Sheet (Sample Presentation)
December 31, 2001 (in millions)
Assets
Current assets
Cash
Short-term investments (current)
Receivables
Other current assets
Total current assets
Investments (long-term)
Capital assets
Other long-term assets
Total assets
Liabilities and Shareholders’ Equity
Liabilities
Current liabilities
Notes payable
Accounts payable
Income taxes payable
Total current liabilities
Long-term debt
Total liabilities
Shareholders’ equity
Share capital
Retained earnings
Total shareholders’ equity
Total liabilities and shareholders’ equity
$
272
609
74
83
1,038
317
322
280
$ 1,957
$
527
233
56
816
83
899
830
228
1,058
$ 1,957
Ratio Analysis
Mathematical relationship
Relationship can be expressed in
terms of
Percentage
Rate
Proportion
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Comparisons
Intracompany (prior years of your
company)
Intercompany (between companies)
Industry averages
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Financial Ratio Classifications
Profitability ratios
Measures of the earnings or operating success
of a company for a given period of time
Liquidity ratios
Measures of short-term ability of the company
to pay its maturing obligations and to meet
unexpected needs for cash
Solvency ratios
Measures of the ability of a company to
survive over a long period of time
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Using the Statement of
Earnings
With profitability ratios
Return on assets
Profit margin
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Profitability
Return On Assets Ratio
Reveals the amount of net earnings
generated by each dollar invested
Return on assets =
Net earnings
Average total assets
Higher value suggests
favourable efficiency
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Profitability
Profit Margin Ratio
Measures the percentage of each
dollar of sales that results in net
earnings
Profit margin =
Net earnings
Net sales
Higher value suggests
favourable return on each
dollar of sales
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Using the Statement of
Retained Earnings
Describes the events that caused
changes in the retained earnings
account for the period
Increased by earnings
Decreased by losses and dividends
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CSU CORPORATION
Statement of Retained Earnings
For the Year Ended December 31, 2001
Retained earnings, January 1
Add: Net earnings
Less: Dividends
Retained earnings, December 31
$
0 (1)
6,800 (2)
6,800
0
$ 6,800 (3)
Statement interrelationships:
(1) Opening retained earnings comes from, and agrees to,
ending retained earnings on prior period balance sheet
(2) Net earnings comes from, and agrees to, net earnings on
statement of earnings
(3) Ending retained earnings goes to, and agrees to, ending
retained earnings on current period balance sheet
Using the Balance Sheet
With liquidity ratios
Working capital
Current ratio
With solvency ratios
Debt to total assets
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Liquidity
Working Capital
Measures short-term ability to pay
liabilities
Current assets - current liabilities
= Working capital
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Liquidity
Current Ratio
Measure of short term ability to pay
obligations
Current ratio =
Current assets
Current liabilities
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Solvency
Debt to Total Assets
Measures % of assets financed by
creditors
Debt to total assets =
Total liabilities
Total assets
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Using the
Statement of Cash Flows
To provide information about
Cash receipts
Cash payments
Changes in cash (and cash equivalents)
From changes in
Operating activities
Financing activities
Investing activities
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Operating Activities
Cash inflows
and cash
outflows
associated with
the primary
operations of
the business
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Financing Activities
Cash inflows / outflows come from
sources funding the business
Sale of shares / payment of dividends
Issuing debt / repaying debt
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Investing Activities
Cash inflows/ outflows result from
changes in investments and capital
assets
Purchasing/disposing of investments
and long-lived assets using cash
Lending money and collecting the loans
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Liquidity
Cash Current Debt Coverage
Measures ability to generate
sufficient cash to satisfy short-term
needs
Cash current debt coverage ratio =
Cash provided by operating activities
Average current liabilities
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Solvency
Cash Total Debt Coverage
Measures ability to generate
sufficient cash to meet long-term
needs
Cash total debt coverage ratio =
Cash provided by operating activities
Average total liabilities
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Decision Checkpoints
Is the company using
its assets effectively?
Is the company
maintaining an
adequate margin
between sales and
expenses?
Can the company
meet its short-term
obligations?
Can the company
meet its long-term
obligations?
Return on assets ratio
Profit margin ratio
Working capital,
current ratio, cash
current debt coverage
ratio
Debt to total assets
ratio, cash total debt
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coverage ratio
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Copyright © 2001 John Wiley & Sons Canada, Ltd. All
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these programs or from the use of the information
contained herein.
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