Chapter
2-1
A Further Look at
Financial Statements
Chapter
2-2
Financial Accounting, Fifth Edition
Study Objectives
1.
Identify the sections of a classified balance sheet.
2.
Identify and compute ratios for analyzing a company’s
profitability.
3.
Explain the relationship between a retained earnings
statement and a statement of stockholders’ equity.
4.
Identify and compute ratios for analyzing a company’s
liquidity and solvency using a balance sheet.
5.
Use the statement of cash flows to evaluate solvency.
6.
Explain the meaning of generally accepted accounting
principles.
7.
Discuss financial reporting concepts.
Chapter
2-3
A Further Look At Financial Statements
The Classified
Balance Sheet
Current assets
Ratio analysis
Long-term
investments
Using the income
statement
Property, plant, and
equipment
Using the statement of
stockholders’ equity
Intangible assets
Using a classified
balance sheet
Current liabilities
Long-term liabilities
Stockholders’ equity
Chapter
2-4
Using the Financial
Statements
Using the statement of
cash flows
Financial Reporting
Concepts
The standard-setting
environment
Characteristics of
useful information
Assumptions and
principles
Constraints
The Classified Balance Sheet
Presents a snapshot at a point in time.
To improve understanding, companies group
similar assets and similar liabilities together.
Standard Classifications
Assets
Liabilities and Owner’s Equity
Current assets
Long-term investments
Property, plant, and equipment
Intangible assets
Chapter
2-5
Illustration 2-1
Current liabilities
Long-term liabilities
Stockholders’ equity
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Illustration 2-2
Chapter
2-6
The Classified Balance Sheet
Illustration 2-2
Chapter
2-7
The Classified Balance Sheet
Current Assets
Assets that a company expects to convert to cash
or use up within one year or the operating cycle,
whichever is longer.
Operating cycle is the average time it takes from
the purchase of inventory to the collection of
cash from customers.
Chapter
2-8
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Current Assets
Illustration 2-3
Companies usually list current asset accounts in the order
they expect to convert them into cash.
Chapter
2-9
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Review Question
Cash, and other resources that are reasonably
expected to be realized in cash or sold or consumed
in the business within one year or the operating
cycle, are called:
a. Current assets.
b. Intangible assets.
c. Long-term investments.
d. Property, plant, and equipment.
Chapter
2-10
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Long-Term Investments
Investments in stocks and bonds of other companies.
Investments in long-term assets such as land or
buildings that a company is not currently using in its
operating activities.
Illustration 2-4
Chapter
2-11
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Property, Plant, and Equipment
Long useful lives.
Currently used in operations.
Depreciation - allocating the cost of assets to a
number of years.
Accumulated depreciation - total amount of
depreciation expensed thus far in the asset’s life.
Chapter
2-12
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Property, Plant, and Equipment
Illustration 2-5
Chapter
2-13
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Intangible Assets
Assets that do not have physical substance.
Illustration 2-6
Chapter
2-14
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Review Question
Patents and copyrights are
a. Current assets.
b. Intangible assets.
c. Long-term investments.
d. Property, plant, and equipment.
Chapter
2-15
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Current Liabilities
Obligations the company is to pay within the
coming year.
Usually list notes payable first, followed by
accounts payable. Other items follow in order of
magnitude.
Liquidity - ability to pay obligations expected to
be due within the next year.
Chapter
2-16
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Current Liabilities
Illustration 2-7
Chapter
2-17
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Long-Term Liabilities
Obligations a company expects to pay after one
year.
Illustration 2-8
Chapter
2-18
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Review Question
Which of the following is not a long-term liability?
a. Bonds payable
b. Current maturities of long-term obligations
c. Long-term notes payable
d. Mortgages payable
Chapter
2-19
SO 1 Identify the sections of a classified balance sheet.
The Classified Balance Sheet
Stockholders’ Equity
Illustration 2-2
Common stock - investments of assets into the business by the
stockholders.
Retained earnings - income retained for use in the business.
Chapter
2-20
SO 1 Identify the sections of a classified balance sheet.
Using the Financial Statements
Ratio Analysis
Expresses relationship among selected items of
financial statement data.
Relationship expressed in terms of either a
percentage, a rate, or a simple proportion.
Chapter
2-21
Using the Financial Statements
Illustration: Best Buy has current assets of $9,081 million
and current liabilities of $6,301 million. We can determine
a relationship between these accounts by dividing current
assets by current liabilities, to get 1.44. The alternative
means of expression are:
Percentage:
Current assets are 144% of current
liabilities.
Rate:
Current assets are 1.44 times as great as
current liabilities.
Proportion:
The relationship of current assets to current
liabilities is 1.44:1.
Chapter
2-22
Using the Financial Statements
Chapter
2-23
Using the Financial Statements
Using the Income Statement
Illustration 2-10
Circuit City reported a net loss of $10.2 million for the year ended Feb. 28, 2007.
Chapter
2-24
SO 2 Identify and compute ratios for analyzing a company’s profitability.
Using the Financial Statements
Profitability
Ratio
Illustration: Earnings per share (EPS) measures the net
income earned on each share of common stock.
Best Buy
Illustration 2-11
Chapter
2-25
$1,377 - $0
=
(481 + 485) 2
$1,140 - $0
=
(485 + 493) 2
$2.85
$2.33
Using the Financial Statements
Review Question
For 2010 Stoneland Corporation reported net
income $26,000; net sales $400,000; and average
shares outstanding 6,000. There were preferred
stock dividends of $2,000. What was the 2010
earnings per share?
a. $4.00
b. $0.06
c. $16.67
$26,000 - $2,000
6,000
= $4.00
d. $66.67
Chapter
2-26
SO 2 Identify and compute ratios for analyzing a company’s profitability.
Using the Financial Statements
Using the Statement of Stockholders’ Equity
Illustration 2-12
Most companies
use a statement of
stockholders’
equity, rather than
a retained earnings
statement, so that
they can report all
changes in
stockholders’
equity accounts.
Chapter
2-27
SO 3 Explain the relationship between a retained earnings
statement and a statement of stockholders’ equity.
Using the Financial Statements
Using the Statement of Stockholders’ Equity
Observations from this financial statement of Best Buy:

Common stock increased during the first year as the
result of issuance of common stock.

Common stock declined in the second and third years as
the result of repurchasing shares of stock.

Best Buy paid an increasing amount of dividends each
year.

Prior to 2003, Best Buy did not pay dividends, even
though it was profitable and could do so.
Why didn’t Best Buy pay dividends prior to 2003?
Chapter
2-28
SO 3 Explain the relationship between a retained earnings
statement and a statement of stockholders’ equity.
Using the Financial Statements
Review Question
The balance in retained earnings is not affected by:
a. net income
b. net loss
c. issuance of common stock
d. dividends
Chapter
2-29
SO 3 Explain the relationship between a retained earnings
statement and a statement of stockholders’ equity.
Illustration 2-13
Using the
Financial
Statements
Using a
Classified
Balance Sheet
Chapter
2-30
Using the Financial Statements
Using a Classified Balance Sheet
Liquidity—the ability to pay obligations expected to
become due within the next year or operating cycle.
Illustration 2-14
When working capital is positive, there is greater likelihood
that the company will pay its liabilities.
Best Buy had working capital in 2007 of $2,780 million.
Chapter
2-31
SO 4 Identify and compute ratios for analyzing a company’s
liquidity and solvency using a balance sheet.
Using the Financial Statements
Liquidity
Ratio
Liquidity ratios measure the short-term ability of the
company to pay its maturing obligations and to meet
unexpected needs for cash.
Illustration 2-15
$9,081
$6,301
= 1.44:1
$7,985
$6,056
= 1.32:1
1.68:1
1.75:1
1.21:1
NA
For every dollar of current liabilities, Best Buy has $1.44 of current assets
Chapter
2-32
SO 4 Identify and compute ratios for analyzing a company’s
liquidity and solvency using a balance sheet.
Chapter
2-33
Using the Financial Statements
Using a Classified Balance Sheet
Solvency—the ability to pay interest as it comes due and
to repay the balance of a debt due at its maturity.
Solvency ratios measure the ability of the company to
survive over a long period of time.
Chapter
2-34
SO 4 Identify and compute ratios for analyzing a company’s
liquidity and solvency using a balance sheet.
Using the Financial Statements
Solvency
Ratio
Debt to total assets ratio measures the percentage of
total financing provided by creditors rather than
stockholders.
Illustration 2-16
$7,369
$13,570
= 54%
$6,607
$11,864
= 56%
55%
52%
21%
NA
The 2007 ratio means that every dollar of assets was financed by 54 cents of debt.
Chapter
2-35
SO 4 Identify and compute ratios for analyzing a company’s
liquidity and solvency using a balance sheet.
Using the Financial Statements
Review Question
The following ratios are available for Leer Inc. and Stable Inc.
Compared to Stable Inc., Leer Inc. has:
a.
higher liquidity, higher solvency, and higher profitability.
b. lower liquidity, higher solvency, and higher profitability.
c.
higher liquidity, lower solvency, and higher profitability.
d. higher liquidity and lower solvency, but profitability cannot be
compared based on information provided.
Chapter
2-36
SO 4 Identify and compute ratios for analyzing a company’s
liquidity and solvency using a balance sheet.
Chapter
2-37
Using the Financial Statements
Using the Statement of Cash Flows
To aid in the analysis of cash, the statement of cash flows
reports the cash effects of
1. a company’s operating activities,
2. its investing activities, and
3. its financing activities.
Chapter
2-38
SO 5 Use the statement of cash flows to evaluate solvency.
Using the Financial Statements
Illustration 2-17
Using the
Statement
of Cash
Flows
Would you feel
better about a
company’s health if
you knew that most
of its cash was
generated by
operating its
business rather than
by borrowing cash
from lenders?
Chapter
2-39
(
)
(
)
SO 5 Use the statement of cash flows to evaluate solvency.
Using the Financial Statements
Cash provided by operating activities fails to
take into account that a company must invest
in new PP&E and must maintain dividends at
current levels to satisfy investors.
Chapter
2-40
Answers on notes page.
SO 5 Use the statement of cash flows to evaluate solvency.
Financial Reports Concepts
The Standard-Setting Environment
Generally Accepted Accounting Principles (GAAP) - A set
of rules and practices, having substantial authoritative
support, that the accounting profession recognizes as a
general guide for financial reporting purposes.
Various standard-setting bodies determine these guidelines:
Chapter
2-41

Securities and Exchange Commission (SEC)

Public Company Accounting Oversight Board (PCAOB)

Financial Accounting Standards Board (FASB)

International Accounting Standards Board (IASB)
SO 6 Explain the meaning of generally accepted accounting principles.
Financial Reports Concepts
Review Question
Generally accepted accounting principles are:
a. a set of standards and rules that are recognized
as a general guide for financial reporting.
b. usually established by the Internal Revenue
Service.
c. the guidelines used to resolve ethical dilemmas.
d. fundamental truths that can be derived from
the laws of nature.
Chapter
2-42
SO 6 Explain the meaning of generally accepted accounting principles.
Chapter
2-43
Financial Reports Concepts
Characteristics of Useful Information
Illustration 2-18
Chapter
2-44
SO 7 Discuss financial reporting concepts.
Chapter
2-45
Financial Reports Concepts
Assumptions in Financial Reporting
Illustration 2-19
Monetary Unit
Time Period
Chapter
2-46
Economic Entity
Going Concern
SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
Principles in Financial Reporting
Illustration 2-20
Cost
Chapter
2-47
Full Disclosure
SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
Constraints in Financial Reporting
Illustration 2-20
Materiality
Chapter
2-48
Conservatism
SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
1.
Ability to easily evaluate one company’s results
relative to another’s.
Comparability
2.
Belief that a company will continue to operate for
the foreseeable future.
Going concern
3.
The judgment concerning whether an item is large
enough to matter to decision makers.
Materiality
Chapter
2-49
SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
4.
The reporting of all information that would make a
difference to financial statement users.
Full disclosure
5.
The practice of preparing financial statements at
regular intervals.
Time period
6.
The quality of information that indicates the
information makes a difference in a decision.
Relevance
Chapter
2-50
SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
7.
A belief that items should be reported on the
balance sheet at the price that was paid to acquire
the item.
Cost
8.
A company’s use of the same accounting principles
and methods from year to year.
Consistency
9.
The use of accounting methods that do not
overstate assets or income.
Conservatism
Chapter
2-51
SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
10. Tracing accounting events to particular companies.
Economic entity
11. The desire to minimize errors and bias in financial
statements.
Reliability
12. Reporting only those things that can be measured
in dollars.
Monetary unit
Chapter
2-52
SO 7 Discuss financial reporting concepts.
Financial Reports Concepts
Review Question
What is the primary criterion by which accounting
information can be judged?
a. Consistency.
b. Predictive value.
c. Usefulness for decision making.
d. Comparability.
Chapter
2-53
SO 7 Discuss financial reporting concepts.
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Chapter
2-54