A Further Look at
Financial Statements
Chapter 2
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1 Generally Accepted
Accounting Principles
•
•
•
•
GAAP
Agreed-upon accounting rules
Most U.S. companies use
Promulgated by Financial Accounting
Standards Board - FASB
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1 Basic Objective of
Financial Reporting
Provide information useful for
decision making
Recall Content and Purpose of
Financial Statements
•
Income Statement
•
Retained Earnings Statement
•
Balance Sheet
•
Statement of Cash Flows
Recall Users of Financial
Statements
• Internal Users
• External Users
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2 Qualitative Characteristics of
Accounting Information
•
•
•
•
Relevance
Reliability
Comparability
Consistency
Relevance
• Makes a difference to the decision
• Confirms or corrects prior expectations,
feedback value
• Helps predict future events
• It is timely
Reliability
•
•
•
•
Can be depended upon
Verifiable – free of error
Faithful representation - factual
Neutral – does not favor anyone
Comparability & Consistency
• Comparability – different companies use
similar accounting policies
• Comparability – a firm uses similar
accounting policies year to year
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3 Constraints in Accounting
• Materiality
• Conservatism
Materiality
• Will it influence the
decision?
– MATERIAL
• No impact on
decision?
– IMMATERIAL
© PhotoDisc/Getty Images
© PhotoDisc/Getty Images
Conservatism
• When in doubt,
choose method
least likely to
overstate assets and
income
• Do not intentionally
understate!
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4 Identify the Sections of a
Classified Balance Sheet
• Helps users see if company has
enough assets to pay debts
• Can determine the short-term
and long-term claims on total
assets
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
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, or
how quickly they will convert to cash or be used
up . . .
Current Assets
• Examples:
– Cash
– Short-term investments
– Receivables
– Inventories
– Supplies
– 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.
Long-Term Investments
• Example:
– Investments of stocks and bonds of other
corporations.
Property, Plant, and Equipment
• Assets with relatively long useful lives.
• Assets used in operating the business.
• Examples:
– land
– buildings
– machinery
– delivery equipment
– furniture and fixtures
Digital Vision
Property, Plant, and
Equipment - Depreciation
• Depreciation expense allocates asset’s full
purchase price to a number of years (on
Income Statement)
• Balance sheet shows total amount of
depreciation taken over the life of the asset
in the Accumulated Depreciation account
Property, Plant, and
Equipment - Depreciation
Intangible Assets
• Non-current assets
• No physical substance
Current Liabilities
Obligations that are supposed to be paid within
the coming year...
Current Liabilities
•
•
•
•
•
•
accounts payable
wages payable
bank loans payable
interest payable
taxes payable
current maturities of long-term loans payable
Long-Term Liabilities
• Debts expected to be paid after one year
• Examples…
– bonds payable
– mortgages payable
– long-term notes payable
– lease liabilities
– obligations under employee pension plans
Stockholders' Equity
• Capital (Common) stock investments in the business by the
stockholders
• Retained earnings – net income
retained for use in the business
Ratio Analysis
• Expresses relationship among selected
items of financial statement data
• Relationship can be expressed in terms of…
– Percentage
– Rate
– Proportion
Ratio Analysis - Classifications
• Liquidity Ratios - measure short-term ability
of company to pay maturing obligations and
meet unexpected needs for cash
Ratio Analysis - Classifications
• Profitability Ratios - Measures of the
income or operating success of a company for a
given period of time
Ratio Analysis - Classifications
• Solvency Ratios - Measures of the ability of
the company to survive over a long period of
time
Ratio Analysis –
Use Multiple Measures!
• 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
Profitability Ratios
• Measures operating success (income) of a
company for a given period of time
• Two examples:
– Earnings Per Share (EPS)
– Price- Earnings Ratio (P-E)
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
Price-Earnings Ratio
How does the market perceive the company’s
prospect for future earnings?
Price-Earnings Ratio
=
Stock price per share
Earnings per share
High ratio suggests market has
favorable expectations
Ratio Examples
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7 Identify and Compute Ratios
for Analyzing a Company’s
Liquidity and Solvency Using a
Balance Sheet
Financial Ratio Classifications
• Liquidity Ratios - measures of short-term
ability to pay maturing obligations and to
meet unexpected needs for cash
•Working capital
•Current ratio
Working Capital
•Measure of short-term ability to pay
obligations
•Difference between current assets and
current liabilities
Working Capital = Current Assets - Current Liabilities
Positive working capital is favorable!
Current Ratio
•Another measure of short-term ability to pay
obligations
•Divide current assets by current liabilities
Current Ratio
=
Current Assets
Current Liabilities
•More dependable indicator
•Does not consider composition of current
assets
Current Ratio
Industry
average
means?
Current Ratio
Industry
average
means?
$1.49 of current
assets for every $1
of current debt
Financial Ratio Classifications
• Solvency Ratios - measures of the
ability of a company to survive over
a long period of time
•Debt to Total Assets Ratio
Debt to Total Assets Ratio
• Divide total debt (current and long-term
liabilities) by total assets
Total
Debts
Debt to Total Asset Ratio =
Total Assets
•Measures percentage of assets financed by
creditors rather than stockholders
Let’s Review
Selected financial information for
Drummond Company at 12/31/2005:
Cash
Receivables (net)
Inventory
Long-term assets
Total Assets
$60,000
$80,000
$70,000
$330,000
$540,000
Current Liabilities
Long-term debt
Total Liabilities
$140,000
$130,000
$270,000
Let’s compute current ratio . . .
Let’s Review –
Compute Current Ratio
Cash
Receivables (net)
Inventory
Long-term assets
Total Assets
$60,000
$80,000
$70,000
$330,000
$540,000
Current Liabilities
Long-term debt
Total Liabilities
$140,000
$130,000
$270,000
$210,000

$140,000
=
1.5 : 1
Let’s Review
Selected financial information for
Drummond Company at 12/31/2005:
Cash
Receivables (net)
Inventory
Long-term assets
Total Assets
$60,000
$80,000
$70,000
$330,000
$540,000
Current Liabilities
Long-term debt
Total Liabilities
$140,000
$130,000
$270,000
Now, let’s compute debt to total assets . . .
Let’s Review –
Compute Debt to Total Assets
Cash
Receivables (net)
Inventory
Long-term assets
Total Assets
$60,000
$80,000
$70,000
$330,000
$540,000
Current Liabilities
Long-term debt
Total Liabilities
$140,000
$130,000
$270,000
$270,000  $540,000 = 50%