Financial Accounting:
Tools for Business Decision Making, 2nd Ed.
Kimmel, Weygandt, Kieso
1
Chapter 2
Chapter 2
A Further Look at Financial Statements
After studying Chapter 2, you should be
able to:
 Explain the meaning of generally accepted
accounting principles and describe the
basic objective of financial reporting.
 Discuss the qualitative characteristics of
accounting information.
 Identify two constraints in accounting.
 Identify sections of a classified balance
sheet.
3
Chapter 2
A Further Look at Financial Statements
 Identify and compute ratios for analyzing a
company's profitability.
 Explain the relationship between a retained
earnings statement and a statement of
stockholders' equity.
 Identify and compute ratios for analyzing a
company's liquidity and solvency using a
balance sheet.
 Identify and compute ratios for analyzing a
company’s liquidity and solvency using a
statement of cash flows.
4
General Guide for
Financial Accounting
 Generally
 Accepted
 Accounting
 Principles
5
What is financial accounting
supposed to accomplish?
Provide the the most useful
financial information for…
Decision Making
6
Primary Accounting
Setting Body in the U.S.
 Financial
 Accounting
 Standards
 Board
7
Remember…
GAAP Are the Rules
The FASB makes the rules.
Basic Terms
 Relevance - information makes a difference
in decisions
 Reliability - information must be free of
error and bias
 Comparability - ability to compare
information of different companies because
they use same accounting principles
 Consistency - use of same accounting
principles and methods from year to year
9
within same company
Characteristics of Useful Information
Constraints in Accounting
Permits companies to modify GAAP
without hurting the usefulness of
information
 Materiality - if item doesn’t make a
difference, GAAP doesn’t have to be
followed
 Conservatism - in “gray” areas choose
guide which does not overstate assets or
income
11
A Classified Balance Sheet...
Generally contains the following
standard classifications:
 Current Assets
 Long-Term Investments
 Property, Plant, and Equipment
 Intangible Assets
 Current Liabilities
 Long-Term Liabilities
 Stockholders' Equity
12
Current Assets
 Assets that are expected to be converted to cash or
used in the business within a short period of time,
usually one year.
 Current assets are listed in order of liquidity.
 Examples:
 Cash
 Short-term investments
 Receivables
 Inventories
 Prepaid expenses
13
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 of stocks and bonds of other
corporations.
14
Property, Plant, and
Equipment
 Assets with relatively long
useful lives.
 Assets used in operating
the business.
 Examples:
 land
 buildings
 machinery
 delivery equipment
 furniture and fixtures15
Depreciation is...
 Practice of allocating an asset’s full
purchase price to a number of years
instead of expensing full cost in year
of purchase.
16
Accumulated
Depreciation account ...
 Shows the total amount of
depreciation taken over the life of
the asset.
17
CSU
CORPORATION
Assets
That
A Company
Balance Sheet
Depreciates...
December 31, 2001
Should be shown at cost less
accumulated depreciation
Assets
Cash
Accounts receivable
Supplies
Equipment
Less: Accumulated Depreciation
Total assets
$ 2,000
4,000
1,800
24,000
8,000
16,000
$23,800
18
Intangible Assets
 Noncurrent assets
 Have no physical substance
 Examples:
 patents
 copyrights
 trademarks or trade names
 franchise
Intangible Assets have value
because of the exclusive
rights or privileges they possess.
19
Current Liabilities
Obligations that are supposed to be paid
within the coming year...






accounts payable
wages payable
bank loans payable
interest payable
taxes payable
current maturities of
long-term bank
loans payable
20
Long-Term Liabilities
Debts expected to be paid after
one year
Examples…
 bonds payable
 mortgages payable
 long-term notes payable
 lease liabilities and
 obligations under employee pension plans
21
Stockholders' Equity
 Capital stock - investments in the
business by the stockholders
 Retained earnings - earnings kept for
use in the business
22
HUMANA CORPORATION
Balance Sheet
December 31, 19XX
Current
Current
(in millions)
Assets
Current Assets
Cash
Marketable securities (current)
Receivables
Other current assets
Total current assets
Property and equipment (net)
Marketable securities (long-term)
Other long-term assets
Total Assets
Liabilities and Stockholders’ Equity
Liabilities
Current Liabilities
Medical costs payable
Accounts payable
Income taxes payable
Total current liabilities
Long-term debt
Total liabilities
Stockholders’ equity
Common stock
Retained earnings
Total Liabilities and stockholders’ equity
$ 272
609
74
83
1,038
317
322
280
$1,957
$
527
233
56
816
83
899
830
228
$1,957
Ratios Analysis...
Expresses the relationship
among selected items of
financial statement data
Relationship can be expressed in
term of…
percentage
rate
proportion
24
Profitability Ratios...
measure operating success of a
company over a period of time.
 Return on Assets
 Profit Margin
25
Profitability Ratios...
measure operating success of a
company over a period of time.
 Return on Assets
 Profit Margin
26
Profitability Ratios...
measure operating success of a
company over a period of time.
 Return on Assets
 Profit Margin
27
Return On Assets Ratio
Reveals the amount of net income
generated by each dollar invested
Net Income
Return on Assets Ratio =
Average Assets
Higher value suggests favorable
efficiency.
28
Profit Margin Ratio
Measures the percentage of each dollar of
sales that results in net income
Profit Margin Ratio =
Net Income
Net Sales
Higher value suggests favorable
return on each dollar of sales.
29
Statement of
Retained Earnings
Describes the events that caused changes in
the retained earnings account for the
period.
30
CSU CORPORATION
Retained Earnings Statement
For the Year Ended December 31, 1998
Retained earnings, January 1
Add: Net Income
Less: Dividends
Retained earnings, December 31
$
0
6,800
6,800
0
$ 6,800
Statement of Retained
Earnings and Statement of
Stockholders Equity
Stockholders’ Equity:
 Retained Earning
 Common Stock
Since both of these parts affect
stockholders’ equity…
a statement of stockholders’ equity
provides better information than a
statement of retained earnings.
32
Financial Ratio Classifications
 Liquidity Ratios - measures of shortterm ability of the company to pay its
maturing obligations and to meet
unexpected needs for cash
 Profitability Ratios -measures of the
income or operating success of a
company for a given period of time
 Solvency Ratios - measures of the
ability of a company to survive over a
long period of time
33
Liquidity Ratios
 Working capital
 Current ratio
34
Working Capital
Measures short-term ability to
pay liabilities
Current Assets - Current Liabilities = Working Capital
35
Current Ratio
Measure of short term ability to
pay obligations
Current Ratio =
Current Assets
Current Liabilities
36
Solvency Ratio
Debt to Total Assets Ratio
measures % of assets financed by
creditors.
Total Debts
Debt to Total Asset Ratio =
Total Assets
37
Purpose of
Statement Of Cash Flows
To provide information about
 cash receipts
 cash payments
 net changes in cash
38
Changes Result From
Operating activities
Financing activities
Investing activities
39
Operating Activities
Cash inflows
and cash
outflows
associated with
the primary
operations of the
business.
40
Financing Activities
Cash inflows/ outflows come from
sources funding the business…
 Sale of Stock/ Payment of
Dividends
 Issuing Debt/Repaying Debt
41
Investing Activities
Cash inflows/ outflows result from
changes in investments and longterm assets…
 purchasing/disposing of investment
and long-lived assets using cash
 lending money and collecting the
loans
42
Current Cash Debt Coverage Ratio
=
Cash Provided by Operating Activities
Average Current Liabilities
43
Cash Debt Coverage Ratio
=
Cash Provided by Operating Activities
Average Total Liabilities
44
COPYRIGHT
Copyright ©2000 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility
for errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.