Chapter 4 Financial Reporting and Analysis Skyline College Lecture Notes.

Chapter 4

Financial Reporting and Analysis

Skyline CollegeLecture Notes

Copyright © Houghton Mifflin Company. All rights reserved. 4–2

Investors use Financial Statements to

Analyze Financial Outlook and Performance

Will dividends be paid?

Will the stock price increase?

Are cash flows

adequate?

Financial Statements

Income Statement Balance Sheet

Statement of Retained EarningsStatement of Cash Flows

Can loans and interest be repaid?


Objectives of Financial Reporting

1. To furnish information useful in making investment and credit decisions

3. To provide information about business resources, claims to those resources, and changes in them

2. To provide information useful in assessing cash flow prospects


The Ideal and Actual Practice of Accounting

Accounting information:

Often does not adhere to all criteria

The Qualitative Characteristics of

Accounting

The Qualitative Characteristics of

Accounting

Is rarely simple or precise

Involves estimates and judgments

Standards for judging accounting information

Provided by the FASB


Qualitative Characteristics of Accounting Information

ReliabilityFaithful representationVerifiability Neutrality

RelevanceFeedback valuePredictive valueTimeliness

Accounting Conventions(rules of thumb used when preparing

financial statements)

Comparability and consistencyMaterialityConservatismFull disclosureCost-benefit

UsefulnessAccountants must provide

information that is useful in making decisions

UnderstandabilityDecision makers must be able to

interpret information


Understandability

Depends on both the accountant and the decision maker

Accountant Decision Maker

Prepares statements in accordance with GAAP

Must interpret the information and know how to use it


Usefulness

Relevance Reliability

Relies on two major qualitative characteristics…

Provide feedback Predictive value Be timely

A faithful representation verifiable Neutral


To obtain a loan

Why Do Some Companies Misrepresent Financial Results?

For personal gains like bonuses or promotions

To avoid penalties for poor

performance

To yield higher sales price if

company is sold

To meet the expectation

of stockholders


Certifying the Statements

Contributes to ethical financial reporting

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

The Sarbanes-Oxley Act:


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?


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.


Accounting Conventions (cont’d)

To help record transactions and prepare financial statements, accountants depend on five conventions or rules of thumb:

Comparability and consistency

Comparability and consistency

MaterialityMateriality

ConservatismConservatism

Full disclosureFull disclosure

Cost-benefitCost-benefit


Comparability and Consistency

Material is presented in such a way that a decision maker can recognize similarities, differences, and trends over time periods or between companies

Comparability Consistency

Requires that the same accounting procedure is used from one period to the next, unless users are informed of the change


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.


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.


Full Disclosure

Requires that statements and their notes present all information that is relevant to the users’ understanding

Disclosures required by the

FASB: Examples

Disclosures required by the

FASB: Examples

Accounting procedures Terms of company’s debt Commitments and contingencies Important events taking place after

the statement date

considered an integral part of the financials


Cost-Benefit

Underlies all qualitative characteristics and conventions

The benefits to be gained from providing accounting information should be greater than the costs of providing it


Classified Balance Sheet

Liabilities

Stockholders’ Equity

Assets

Current Assets InvestmentsProperty, Plant, & EquipmentIntangible Assets

Current Liabilities

Long-Term Liabilities

Contributed Capital

Retained Earnings

=


Assets

Long-term tangible assets like land and buildings used in continuing operations

Property, plant, & equipment

Long-term assets with no physical substance like copyrights, goodwill, and patents

Intangible assets

Assets not used in normal operations of business. Management does not plan to convert to cash in next year.

Investments

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

Current assets

4–20

Assets Section of Balance Sheet

Current AssetsCash $20,720Short-term investments 4,000Notes receivable 16,000Accounts receivable (net) 70,600Merchandise inventory 120,800Supplies 3,392Prepaid Insurance 13,200Total Current Assets

$248,712

InvestmentsLand held for future use 10,000


Property, Plant & EquipLand $9.000

Building $41,300

less accum depr 17,280 24,020

Equipment $54,000

less accum depr 28,900 25,100

Total property, plant & Equip 58,120

Intangible AssetsTrademark 1,000

Total Current Assets $317,832

Assets Section of Balance Sheet (cont)


Liabilities

Current liabilitiesObligations due to be paid or performed within one year or within the normal operating cycle, whichever is longer

Long-term liabilitiesDebts 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: Notes payable, accounts payable, salaries and wages payable, customer advances, current portion of long-term debt

Examples: Mortgages payable, long-term notes, bonds payable, employee pension obligations, long-term lease liabilities


Liabilities Section of Balance Sheet

Current liabilities

Notes payable $30,000

Accounts payable 51,366

Salaries payable 4,000

Total current liabilities $85,366

Long-term liabilities

Mortgage payable 35,600

Total liabilities $120,966

Will be paid from current assets

Will be paid from noncurrent assets


Stockholders’ Equity Section of Balance Sheet

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

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 76,866

Total stockholders’ equity 196,866


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 $43,332 Thomas Ling, Capital 71,448

Total partners’ equity $114,780


Income Statement Formats Single Step Multiple Step

Net Sales

Cost of Goods Sold

Gross Margin

Operating Expenses

Income from Operations

Other Revenues and Expenses

Income Before Income Taxes

Income Taxes Expense

Net Income

minus

minus

minus

equals

equals

equals

equals

plus or minus

Total Revenues

Costs and Expenses

Income Before Income Taxes

Income Taxes Expense

Net Income

minus

minus

equals

equals


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


Multiple Step Format

Net sales $579,312 Cost of goods sold 362,520Gross margin $216,792

Operating expenses Selling expenses $109,560 General and administrative expenses 69,008 Total operating expenses 178,568Income from operations $38,224

Other revenues and expenses Interest income $2,800 Less interest expense 5,262 Excess of other expenses over other revenues 2,462Income before income taxes $35,762 Income taxes expense 6,762Net income $29,000 Earnings per share $5.80

Ling Auto Supply CorporationIncome Statement

For the Year Ended December 31, 20xx


Net Sales

Sales

Less Sales Returns and Allowances

Less Sales Discounts

Net Sales

Gross Sales Total cash

salesTotal credit

sales

Revenue is recorded when earned under the revenue recognition rule


Cost of Goods Sold

Beginning Inventory

+ Net Purchases

Goods Available

Less Ending Inventory

Cost of Goods Sold

Amount a merchandiser paid for the merchandise it sold during an accounting period


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)


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


Income from Operations

Operating income is the difference between gross margin and operating expenses

Represents income from a company’s main business operations


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


Income Before and After Income Taxes

“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

Net income

Provision for income taxes, represent the expense for federal, state, and local taxes on corporate income

Less income taxes expense

Amount a company has earned from all activities—operating and nonoperating—before taking into account the amount of income taxes it incurred

Income before income taxes


Earnings Per Share

Net income earned on each share of common stock

Net Income Average Number of Shares of Common Stock Outstanding

= $5.80EPS = $29,0005,000 shares

For Ling Auto Supply Corporation:

EPS =


Single-Step Income Statement

All major categories of revenues

All major categories of expenses

Income taxes listed separately

RevenuesNet sales $579,312 Interest income 2,800Total revenues $582,112

Costs and expensesCost of goods sold $362,520 Selling expenses 109,560General and administrative 69,008Interest expense 5,262Total costs and expenses 546,350

Income before income taxes $35,762 Income taxes expense 6,762

Net income $29,000

Earnings per share $5.80

Income StatementFor the Year Ended December 31, 20xx

Ling Auto Supply Corporation


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?

Total Totalcurrent assets – current liabilities

Current assets Current liabilities

Measures of Liquidity

Working Capital Current Ratio

Ling Auto Supply:

$248,712 – $85,366 = $163,346 Ling Auto Supply:

$248,712 $85,366 = 2.9

Indicates ability to repay current obligations with current assets

Indicates ability to repay bills and outstanding loans


Profitability

Profit Margin Asset TurnoverReturn on Assets Debt to Equity Ratio Return on Equity

Measures of profitability:

The ability to earn a satisfactory income


Profit Margin

Percentage of each sales dollar that results in net income

On each dollar of sales, Ling made 5 cents

Net Income $29,000Net Sales $579,312

= = 0.05 or 5.0%



Comparing Profit Margins


Asset Turnover

Measures how efficiently assets are used to produce sales

Ling produces $1.90 in sales for each $1 invested in average total assets.

Net Sales $579,312Average Total Assets ($317,832 + $297,240) ÷ 2

= = 1.9 times



Comparing Asset Turnover


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 generates 9.4 cents of net income for each dollar invested in average total assets

Net Income $29,000Average Total Assets ($317,832 + $297,240) ÷ 2

= = 0.094 or 9.4%



Debt to Equity Ratio

Shows the proportion of the company financed by creditors in comparison with that financed by stockholders

Ling receives approximately 61% of financing from investors

Total Liabilities $120,966Stockholders’ Equity $196,866

= = 0.614 or 61.4%



Comparing Debt to Equity Ratios

Chapter 4 Financial Reporting and Analysis Skyline College Lecture Notes.

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