Financial Accounting:
Tools for Business Decision Making
Kimmel, Weygandt, Kieso
1
Chapter 2
Chapter 2
A Further Look at Financial Statements
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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.
Distinguish between a single-step and a multiple-step
income statement.
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Chapter 2
A Further Look at Financial Statements
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After studying Chapter 2, you should be
able to:
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 sections of a classified balance sheet.
Identify and compute ratios for analyzing a
company's liquidity and solvency.
Identify the sections of the statement of cash flows
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and the purpose of each.
General Guide for
Financial Accounting
 Generally
 Accepted
 Accounting
 Principles
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What is financial accounting
supposed to accomplish?
Provide Information useful 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
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within same company
Page 51 in Book
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
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Purpose of Income Statement
 An Income Statement is to report the
success or failure of the company’s
operations over a period of time.
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Two Forms Of
Income Statements
 Single-step income statement
 Multiple-step income statement
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Single-Step Income
Statement
One step… subtract total
expenses from total revenues
Revenues $10,000
Expenses
3,000
Net income $ 7,000
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Select Buy, Inc.
Single-step Income Statement
For the Year Ended December 31, 1998
Sales
Interest Revenue
Gain on Sale of equipment
Total Revenues
Expenses
Cost of goods sold
Selling expenses
Administrative expenses
Interest expense
Casualty Loss from vandalism
Income tax expense
Total expenses
Net income
$460,000
3,000
600
$463,600
$316,000
76,000
38,000
1,800
200
10,100
442,100
$ 21,500
Multiple-Step Income
Statement
Highlights the components of net income.
 Sales - Cost of Goods sold = Gross Profit
 Gross profit - operating expenses =
income from operations
 Other activities not related to operations are
added and/or subtracted to determine net
income or net loss.
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Multiple-Step Income
Statement
Operating expenses...
 Selling expenses--all of the expenses associated
with selling the merchandise from the
solicitation of the sale until the product is in the
hands of the buyer.
 Administrative expenses--general expenses
relating to general operating activities, human
resources, accounting, clerical, security, etc.
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Multiple-Step Income
Statement
 Nonoperating activities - unrelated to the
company's primary line of operations
 Other revenues and gains - interest, dividend,
rent revenue, and gain from sale of property
 Other expenses and losses - interest expense;
casualty losses; loss from sale or abandonment of
property, plant, and equipment; and loss from
strikes by employees and suppliers
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Select Buy, Inc.
Multi-step Income Statement
For the Year Ended December 31, 1998
Sales
Cost of goods sold
Gross profit
Operating expenses
Selling expenses
Administrative expenses
Total operating expenses
Income from operations
Other revenues and gains
Other expenses and losses
Income before income taxes
Income tax expense
Net income
$460,000
316,000
$144,000
$ 76,000
38,000
114,000
$ 30,000
$ 3,600
2,000
1,600
$ 31,600
10,100
$ 21,500
Remember...
The basic objective for financial
reporting is to provide information...
Useful For ?
Decision Making
Profitability Ratios...
measure operating success of a
company over a period of time.
 Return on Assets
 Profit Margin
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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.
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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.
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Statement of
Returned Earnings
Describes the events that caused changes in
the retained earnings account for the
period.
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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.
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Operating cycle of a
company is...
the average time it takes to
go from cash to cash in
producing revenues.
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Operating cycle of a
company is...
less than one year, so they
use a one year cut off;
except where noted that’s
what we’ll do.
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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
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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
 Marketable Securities
 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 of stocks and bonds of other
corporations.
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Property, Plant, and
Equipment
 Assets with relatively long
useful lives.
 Assets used in the business.
 Examples:
 land
 buildings
 machinery
 delivery equipment
 furniture and fixtures
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Intangible Assets
 Non current assets
 Have no physical substance
 Examples:
 patents
 copyrights
 trademarks or trade names
 franchiseIntangible Assets
have value because of
the exclusive rights or
privileges they possess.
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Current Liabilities
Obligations that are supposed to be paid
within the coming year...
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accounts payable
wages payable
bank loans payable
interest payable
taxes payable
interest payable
current maturities of
bank loans payable
long-term
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Long-Term Liabilities
Debts expected to be paid after
one year
Examples…
 include bonds payable
 mortgages payable
 long-term notes payable
 lease liabilities and
 obligations under employee pension plans
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Stockholders' Equity
 Capital stock - investments in the
business by the stockholders
 Retained earnings - earnings retained
for use in the business
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HUMANA CORPORATION
Page in book 176
Balance Sheet
December 31, 1994
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
Liquidity and Solvency
 Liquidity - The ability to
pay obligations as they come
due
 Solvency - The ability of the
enterprise to survive over a
long period of time
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Liquidity Ratios
 Working capital
 Current ratio
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Working Capital
Measures short-term ability to
pay liabilities
Current Assets - Current Liabilities = Working Capital
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Current Ratio
Measure of short term ability to
pay obligations
Current Ratio =
Current Assets
Current Liabilities
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Solvency Ratio
Debt to Total Assets Ratio
measures % of assets financed by
creditors.
Total Assets
Debt to Total Asset Ratio =
Total Debts
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Purpose of
Statement Of Cash Flows
To provide information about
 cash receipts
 cash payments
 net changes in cash
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Changes Result From
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 Stock/ Payment of
Dividends
 Issuing Debt/Repaying Debt
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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
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