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 the sections of a classified balance
sheet.
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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.
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General Guide for
Financial Accounting
Generally
Accepted
Accounting
Principles
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What is financial accounting
supposed to accomplish?
Provide the the most useful
financial information for…
Decision Making
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Primary Accounting
Setting Body in the U.S.
Financial
Accounting
Standards
Board
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U.S. Government Agency That
Oversees Financial Markets
Securities
Exchange
Commission
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Remember…
GAAP Are the Rules
The FASB makes the rules.
The SEC enforces 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 the same accounting principles
Consistency - use of same accounting
principles and methods from year to year
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within the same company
Relevance
Reliability
Comparability
Consistency
1. Provides a basis
for forecasts
1. Is verifiable
Different
companies use
similar
accounting
PRINCIPLES
Company
uses
same accounting
METHODS from
year to year
2.Confirms/corrects
prior expectations
2. Is a faithful
representation
3. Is neutral
3. Is timely
Characteristics of Useful Information
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Constraints in Accounting
Permits companies to apply GAAP without
hurting the usefulness of information
Materiality - The constraint of determining
whether an item is large enough to likely
influence a decision.
Conservatism - The approach of choosing an
accounting method, when in doubt, that will be
least likely to overstate assets and net income.
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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 one year.
Current assets are listed in order of liquidity.
Examples:
Cash
Short-term investments
Receivables
Inventories
Supplies
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.
Investments in long-term assets
such as land or buildings that are
not currently being used in the
company’s operating activities.
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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.
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Accumulated Depreciation...
Shows the total amount of
depreciation taken over the life of
the asset.
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CSU
CORPORATION
Assets
That
A Company
Balance Sheet
Depreciates...
December 31, 2004
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
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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.
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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
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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
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Stockholders' Equity
Capital stock - investments in the
business by the stockholders
Retained earnings - earnings kept for
use in the business
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HUMANA CORPORATION
Balance Sheet
December 31, 200X
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
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Ratio Analysis...
Expresses relationship among
selected items of financial statement
data
Relationship can be expressed in
term of…
percentage
rate
proportion
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Ratio Analysis Classifications...
Liquidity Ratios - measures of short-term
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 the company to survive over a long
period of time
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Ratio Analysis
Intracompany comparisons - covering two
years of the same company
Industry average comparisons - based on
average ratios for a particular industry
Intercompany comparisons - based on
comparisons with a competitor in the
same industry
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Profitability Ratios...
Measures of the income or operating
success of a company for a given period of
time
Two Examples…
 Earnings Per Share
 Price-Earnings Ratio
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Earnings Per Share
How does the company’s earning
performance compare with that
of previous years?
EPS=
Net income-Preferred stock dividends
Average common shares outstanding
Higher value = improved performance
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Price-Earnings Ratio
Stock price per share
Price-Earnings Ratio =
Earnings per share
How does the market perceive the
company’s prospect for future
earnings?
High ratio suggests market has
favorable expectations
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Statement of
Retained 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, 200X
Retained earnings, January 1
Add: Net Income
Less: Dividends
Retained earnings, December 31
$
0
6,800
6,800
0
$ 6,800
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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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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
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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 Debts
Debt to Total Asset Ratio =
Total Assets
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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
investments and long-lived assets
using cash
lending money and collecting the
loans
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