CHAPTER
2
A Further Look at Financial
Statements
Objective of Financial Reporting
• To provide the most useful financial
information for decision making
General Guide for Financial
Reporting
• Generally
• Accepted
• Accounting
• Principles
Characteristics of Useful
Information
• Understandability
• Relevance
• Reliability
• Comparability and consistency
Constraints in Accounting
• Cost-benefit
• Materiality
Classified Balance Sheet
A classified balance sheet generally contains the
following standard classifications:
Liabilities
Assets
• Current liabilities
• Current assets
• Long-term investments • Long-term liabilities
Shareholders’ Equity
• Property, plant, and
equipment
• Share capital
• Intangible assets
• Retained earnings
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
Accounts receivable
Inventories
Prepaid expenses
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
Property, Plant, and Equipment
• Tangible assets with relatively long useful
lives
• Assets used in operating the business
Property, Plant, and Equipment
Examples
– Land
– Land improvements
– Buildings
– Machinery and
equipment
– Furniture and fixtures
Intangible Assets
• Intangible assets with relatively long
useful lives
• Future value because of the exclusive
rights or privileges they possess
Intangible Assets
Examples
–Patents
–Copyrights
–Trademarks or
trade names
–Franchises
–Goodwill
©®
™
Amortization
• Allocation of an asset’s full purchase price to
match cost to revenues over the entire
estimated useful life instead of expensing full
cost in the year of purchase
• The cost of long-lived assets with indefinite
lives (e.g., land) is not amortized
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
CSU CORPORATION
Balance Sheet
December 31, 2004
Amortizable long-lived 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
Current Liabilities
Obligations that are supposed to be paid
within the coming year
–
–
–
–
–
–
Accounts payable
Wages payable
Notes (bank loans) payable
Interest payable
Income taxes payable
Current maturities of long-term liabilities
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
Shareholders' Equity
• Share capital
– Investments in the business by the
shareholders
• Retained earnings
– Earnings kept for use in the business
Ratio Analysis
• Mathematical relationship
• Relationship can be expressed in terms of
– Percentage
– Rate
– Proportion
Comparisons
• Intracompany (between prior years of the
company)
• Intercompany (between companies)
• Industry averages (based on average ratios
for particular industries)
Financial Ratio Classifications
• Profitability ratios
– Measure the earnings or operating success of a
company for a given period of time
• Liquidity ratios
– Measure the short-term ability of the company to
pay its maturing obligations and to meet
unexpected needs for cash
• Solvency ratios
– Measure the ability of a company to survive over
a long period of time
Using the Statement of Earnings
• Many stakeholders in a company are
concerned with profitability. Two ratios can be
used to assess profitability.
• Earnings per share: measures the net
earnings for each common share.
• Price-earnings ratio: measures the ratio of the
market price of each common share to its
earnings per share.
Profitability Ratios
• EPS = Net Income - Preferred Dividends
Number of Shares
• P-E Ratio = Market Price Per Share
Earnings Per Share
Using the Classified Balance
Sheet
• The classified balance sheet can be used to
evaluate a company’s financial health
• Liquidity ratios measure the short term ability
of the company to pay its maturing
obligations (e.g. working capital, current ratio)
• Solvency ratios measure the company’s
ability to survive over a long period of time
(e.g. debt to total assets)
Liquidity Ratios
• Working Capital =
Current Assets - Current Liabilities
•
Current Ratio = Current Assets
Current Liabilities
Solvency Ratios
• Debt to Total Assets = Total Liabilities
Total Assets
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
CSU CORPORATION
Statement of Retained Earnings
Year Ended December 31, 2004
Retained earnings, January 1
Add: Net earnings
Less: Dividends
Retained earnings, December 31
$
0 (1)
6,800 (2)
6,800
0
$6,800 (3)
Using the Statement of
Retained Earnings
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
Cash Flow Statement
• To provide information about
– Cash receipts
– Cash payments
– Changes in cash (and cash equivalents)
• From changes in
– Operating activities
– Financing activities
– Investing activities
Operating Activities
• Cash inflows and cash outflows
associated with the primary operations of
the business
Financing Activities
• Cash inflows / outflows that come from
sources funding the business
– Sale of shares / payment of dividends
– Issuing debt / repaying debt
Investing Activities
• Cash inflows / outflows that result from
changes in investments, property, plant and
equipment and intangible assets
– Purchasing / disposing of investments and
long-lived assets using cash
– Lending money and collecting the loans
Using the Cash Flow Statement
Cash Current Debt Coverage =
Cash Provided by Operating Activities
Average Current Liabilities
Using the Cash Flow Statement
Cash Total Debt Coverage =
Cash Provided by Operating Activities
Average Total Liabilities