Chapter 4
Financial
Reporting and
Analysis
Skyline College
Lecture Notes
Investors use Financial Statements to
Analyze Financial Outlook and Performance
Financial Statements
Income Statement
Balance Sheet
Statement of Retained Earnings
Statement of Cash Flows
Can loans and
interest be repaid?
Will dividends
be paid?
Will the stock
price increase?
Are cash flows
adequate?
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4–2
Objectives of Financial Reporting
1. To furnish information useful in making
investment and credit decisions
2. To provide information useful in
assessing cash flow prospects
3. To provide information about business
resources, claims to those resources, and
changes in them
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4–3
The Ideal and Actual Practice of
Accounting
Accounting information:
 Involves estimates and judgments
 Is rarely simple or precise
 Often does not adhere to all criteria
The Qualitative
Characteristics of
Accounting
 Standards for judging
accounting information
 Provided by the FASB
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4–4
Qualitative Characteristics of
Accounting Information
Understandability
Usefulness
Decision makers must be able to
interpret information
Accountants must provide
information that is useful in
making decisions
Accounting Conventions
(rules of thumb used when preparing
financial statements)
Comparability and consistency
Materiality
Conservatism
Full disclosure
Cost-benefit
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Relevance
Feedback
value
Predictive
value
Timeliness
Reliability
Faithful
representation
Verifiability
Neutrality
4–5
Understandability
Depends on both the accountant and the
decision maker
Accountant
 Prepares
statements in
accordance
with GAAP
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Decision Maker
 Must interpret the
information and
know how to use it
4–6
Usefulness
Relies on two major qualitative characteristics…
Relevance
Reliability
 Provide feedback
 Predictive value
 Be timely
 A faithful representation
 verifiable
 Neutral
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4–7
Why Do Some Companies Misrepresent
Financial Results?
To meet the
expectation
of stockholders
To yield higher
sales price if
company is sold
To avoid penalties
for poor
performance
For personal
gains like
bonuses or
promotions
To obtain a loan
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4–8
Certifying the Statements
Contributes to ethical financial reporting
The Sarbanes-Oxley Act:
 Requires CEOs and CFOs to swear that,
based on their knowledge, their company’s
quarterly and annual financial statements
filed with the SEC are accurate and complete
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4–9
Discussion: Ethics
Johanna Keller invested $400,000 in a
company based on her review of the
company’s financial statements. Management
states its revenue recognition method in the
annual report. The company is later asked to
restate the financial statements as a result of
an SEC investigation into its revenue
recognition practices.
Q. What responsibility do you think the CFO
holds in this situation?
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4–10
Ethics at Dell
Dell is committed to the achievement of
business success and the enhancement of
long-term stockholder value with the highest
standards of integrity and ethics.
The Board and management are jointly responsible for managing and
operating Dell's business with the highest standards of responsibility,
ethics and integrity. In that regard, the Board expects each director, as
well as each member of senior management, to lead by example in a
culture that emphasizes trust, integrity, honesty, judgment, respect,
managerial courage and responsibility.
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4–11
Accounting Conventions (cont’d)
To help record transactions and prepare financial
statements, accountants depend on five conventions
or rules of thumb:
Comparability
and consistency
Materiality
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Conservatism
Full disclosure
Cost-benefit
4–12
Comparability and Consistency
Comparability
Consistency
 Material is presented in  Requires that the same
such a way that a
accounting procedure is
decision maker can
used from one period to
recognize similarities,
the next, unless users
differences, and trends
are informed of the
over time periods or
change
between companies
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4–13
Materiality
 Is the information relevant to users?
 Would users do something different if they had not
known about an item?
 Is the nature of the item important to users?
Does the number change by 10% or more?
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.
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4–14
Conservatism
In the face of uncertainty…
accountants look to the convention of conservatism.
Choosing the option that is least likely to
overstate assets and income
Warning: The abuse of the convention of conservatism can
lead to misleading financial statements.
Example: If an accountant expensed a long-term asset of material
cost in the period of purchase, instead of capitalizing it, income
and assets for the current period would be understated. Income in
future periods would be overstated. There was no uncertainty, so
conservatism should not have been applied.
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4–15
Full Disclosure
Requires that statements and their notes
present all information that is relevant to
the users’ understanding
 considered an integral part of the financials
Disclosures
required by the
FASB: Examples




Accounting procedures
Terms of company’s debt
Commitments and contingencies
Important events taking place after
the statement date
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4–16
Cost-Benefit
 The benefits to be gained from providing
accounting information should be greater than
the costs of providing it
 Underlies all qualitative characteristics and
conventions
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4–17
Classified Balance Sheet
Assets
Current Assets
Investments
Property, Plant, & Equipment
Intangible Assets
Liabilities
=
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Current Liabilities
Long-Term Liabilities
Stockholders’ Equity
Contributed Capital
Retained Earnings
4–18
Assets
Current assets
Cash and other assets reasonably expected to be
converted to cash, consumed, or sold within one
year or its normal operating cycle, whichever is
longer
Investments
Assets not used in normal operations of business.
Management does not plan to convert to cash in
next year.
Property, plant, Long-term tangible assets like land and buildings
& equipment
used in continuing operations
Intangible
assets
Long-term assets with no physical substance like
copyrights, goodwill, and patents
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4–19
Assets Section of Balance Sheet
Current Assets
Cash
Short-term investments
Notes receivable
Accounts receivable (net)
Merchandise inventory
Supplies
Prepaid Insurance
Total Current Assets
$20,720
4,000
16,000
70,600
120,800
3,392
13,200
$248,712
Investments
Land held for future use
10,000
4–20
Assets Section of Balance Sheet (cont)
Property, Plant & Equip
Land
Building
$41,300
less accum depr
17,280
Equipment
$54,000
less accum depr
28,900
Total property, plant & Equip
$9.000
24,020
25,100
58,120
Intangible Assets
Trademark
Total Current Assets
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1,000
$317,832
4–21
Liabilities
Current liabilities
Obligations due to be paid or performed within one year or
within the normal operating cycle, whichever is longer
Examples: Notes payable, accounts payable, salaries and wages
payable, customer advances, current portion of long-term debt
Long-term liabilities
Debts of a business that fall due more than one year in the
future or beyond the normal operating cycle, which will be
paid out of noncurrent assets
Examples: Mortgages payable, long-term notes, bonds payable,
employee pension obligations, long-term lease liabilities
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4–22
Liabilities Section of Balance Sheet
Will be paid from Current liabilities
Notes payable
current assets
Accounts payable
Salaries payable
Total current liabilities
Will be paid from Long-term liabilities
noncurrent assets Mortgage payable
Total liabilities
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$30,000
51,366
4,000
$85,366
35,600
$120,966
4–23
Stockholders’ Equity Section of
Balance Sheet
Contributed capital
Common stock, $20 par value, 5,000 shares
authorized, issued, and outstanding
$100,000
Additional paid-in capital
20,000
Total contributed capital
$120,000
Retained earnings
Total stockholders’ equity
76,866
196,866
Contributed capital is generally shown as two amounts:
the par value of the issued stock and the additional
paid-in capital in excess of par
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4–24
Other Forms of
Business Organization
The equity section is different depending on the
form of business organization
For the sole proprietorship:
Owner’s Equity
Thomas Ling, Capital
$114,780
For the partnership:
Partners’ Equity
A.J. Martin, Capital
Thomas Ling, Capital
Total partners’ equity
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$43,332
71,448
$114,780
4–25
Income Statement Formats
Single Step
Total Revenues
Multiple Step
Net Sales
minus
minus
Cost of Goods Sold
equals
Gross Margin
minus
Costs and Expenses
Operating Expenses
equals
equals
Income from Operations
plus or minus
Other Revenues and Expenses
equals
Income Before Income Taxes
Income Before Income Taxes
minus
minus
Income Taxes Expense
Income Taxes Expense
equals
Net Income
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equals
Net Income
4–26
Multistep Income Statement
 Presents a series of steps, or subtotals, to arrive at
net income
 Used by firms operating in a single industry
 Valuable analytical tool
 Separates operating income from nonoperating
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4–27
Multiple Step Format
Ling Auto Supply Corporation
Income Statement
For the Year Ended December 31, 20xx
Net sales
Cost of goods sold
Gross margin
Operating expenses
Selling expenses
General and administrative expenses
Total operating expenses
Income from operations
Other revenues and expenses
Interest income
Less interest expense
Excess of other expenses over other revenues
Income before income taxes
Income taxes expense
Net income
Earnings per share
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$579,312
362,520
$216,792
$109,560
69,008
178,568
$38,224
$2,800
5,262
2,462
$35,762
6,762
$29,000
$5.80
4–28
Net Sales
Sales
Less Sales Returns and Allowances
Less Sales Discounts
Net Sales
Total cash
sales
Gross Sales
Total credit
sales
 Revenue is recorded when earned under the
revenue recognition rule
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4–29
Cost of Goods Sold
 Amount a merchandiser paid for
the merchandise it sold during an
accounting period
Beginning Inventory
+ Net Purchases
Goods Available
Less Ending Inventory
Cost of Goods Sold
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4–30
Gross Margin
Difference between net sales and cost of goods sold;
also called gross profit
Management is interested in:
 The amount of gross margin
 The percentage of gross margin
Ling Auto Supply Corp.
 Amount: $216,792 (Net sales minus cost of goods
sold)
 Percentage: 37.4 percent ($216,792 ÷ $579,312)
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4–31
Operating Expenses
Expenses other than cost of goods sold
that are incurred in running a business
Selling Expenses
Gen & Admin Expenses
• Cost of storing goods and
preparing them for sale
• Costs of preparing displays
• Advertising
• Promoting sales
•Sales Salaries & Commissions
•Depreciation on store Equip
• Accounting
• Personnel
• Credit checking
• Collections
•CEO’s Salary
•Office Salaries
•Depreciation on office Equip
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4–32
Income from Operations
Operating income is the difference
between gross margin and operating
expenses
Represents income from a company’s
main business operations
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4–33
Other Revenues and Expenses
Due to how a company finances (debt vs equity)
and whether there are idle assets
Examples:
 Rental Revenue
 Interest Income
 Interest expense
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4–34
Income Before and After Income Taxes
Income before
income taxes
Amount a company has earned from all
activities—operating and nonoperating—
before taking into account the amount of
income taxes it incurred
Less income taxes
expense
Provision for income taxes, represent the
expense for federal, state, and local taxes
on corporate income
Net income
“Bottom line” is what remains of the gross
margin after operating expenses are
deducted, other revenues and expenses are
added or deducted, and income taxes
expense are deducted
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4–35
Earnings Per Share
Net income earned on each share
of common stock
EPS =
Net Income
Average Number of Shares of Common Stock Outstanding
For Ling Auto Supply Corporation:
EPS =
$29,000
= $5.80
5,000 shares
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4–36
Single-Step Income Statement
Ling Auto Supply Corporation
Income Statement
For the Year Ended December 31, 20xx
All major categories
of revenues
All major categories
of expenses
Income taxes listed separately
Revenues
Net sales
Interest income
Total revenues
Costs and expenses
Cost of goods sold
Selling expenses
General and administrative
Interest expense
Total costs and expenses
$579,312
2,800
$582,112
$362,520
109,560
69,008
5,262
546,350
Income before income taxes
Income taxes expense
$35,762
6,762
Net income
$29,000
Earnings per share
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$5.80
4–37
Evaluating Liquidity
Does a company have enough money on hand to pay bills when
they are due and to take care of unexpected needs for cash?
Measures of Liquidity
Working Capital
Total
Total
current assets – current liabilities
Current Ratio
Current assets
Current liabilities
Ling Auto Supply:
Ling Auto Supply:
$248,712 – $85,366 = $163,346
$248,712  $85,366 = 2.9
Indicates ability to repay current
obligations with current assets
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Indicates ability to repay bills
and outstanding loans
4–38
Profitability
The ability to earn a satisfactory income
Measures of profitability:
 Profit Margin
 Asset Turnover
 Return on Assets
 Debt to Equity Ratio
 Return on Equity
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4–39
Profit Margin
Percentage of each sales dollar that
results in net income
Ling Auto Supply Corporation
Net Income
$29,000
=
Net Sales
$579,312
= 0.05 or 5.0%
On each dollar of sales, Ling made 5 cents
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4–40
Comparing Profit Margins
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4–41
Asset Turnover
Measures how efficiently assets are
used to produce sales
Ling Auto Supply Corporation
Net Sales
Average Total Assets
=
$579,312
= 1.9 times
($317,832 + $297,240) ÷ 2
Ling produces $1.90 in sales for each $1
invested in average total assets.
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4–42
Comparing Asset Turnover
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4–43
Return on Assets
Indicates the income-generating strength (profit
margin) of the company’s resources and how efficiently
the company is using all its assets (asset turnover)
Ling Auto Supply Corporation
Net Income
$29,000
=
= 0.094 or 9.4%
Average Total Assets
($317,832 + $297,240) ÷ 2
Ling generates 9.4 cents of net income for
each dollar invested in average total assets
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4–44
Debt to Equity Ratio
Shows the proportion of the company financed by
creditors in comparison with that financed by
stockholders
Ling Auto Supply Corporation
Total Liabilities
Stockholders’ Equity
=
$120,966
$196,866
= 0.614 or 61.4%
Ling receives approximately 61% of
financing from investors
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4–45
Comparing Debt to Equity Ratios
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4–46