Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. A Further Look at Financial...

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

A Further Look atA Further Look at Financial Statements Financial Statements

Chapter 2Chapter 2

Prepared by Carol A. HartleyPrepared by Carol A. Hartley

Providence CollegeProvidence College

Principles of AccountingPrinciples of AccountingKimmel • Weygandt • KiesoKimmel • Weygandt • Kieso


Study ObjectivesStudy Objectives1.1. Explain the meaning of generally accepted Explain the meaning of generally accepted

accounting principles and describe the basic accounting principles and describe the basic objective of financial reporting.objective of financial reporting.

2.2. Discuss the qualitative characteristics of Discuss the qualitative characteristics of accounting information.accounting information.

3.3. Identify two constraints in accounting.Identify two constraints in accounting.

4.4. Identify the sections of a classified balance Identify the sections of a classified balance sheet. sheet.


Study ObjectivesStudy Objectives5.5. Identify and compute ratios for analyzing a Identify and compute ratios for analyzing a

company’s profitability.company’s profitability.6.6. Explain the relationship between a retained earnings Explain the relationship between a retained earnings

statement and a statement of stockholders’ equity.statement and a statement of stockholders’ equity.7.7. Identify and compute ratios for analyzing a Identify and compute ratios for analyzing a

company’s liquidity and solvency using a balance company’s liquidity and solvency using a balance sheet.sheet.

8.8. Identify and compute ratios for analyzing a Identify and compute ratios for analyzing a company’s liquidity and solvency using a statement company’s liquidity and solvency using a statement of cash flows.of cash flows.


##11 Generally Accepted Generally Accepted Accounting PrinciplesAccounting Principles

• GAAPGAAP• Agreed-upon accounting rulesAgreed-upon accounting rules• Most U.S. companies useMost U.S. companies use• Promulgated by Financial Accounting Promulgated by Financial Accounting

Standards Board - FASBStandards Board - FASB


##11 Basic Objective of Basic Objective of Financial ReportingFinancial Reporting

Provide information useful for Provide information useful for decision makingdecision making


Recall Recall Content and Purpose of Content and Purpose of Financial StatementsFinancial Statements

• Income StatementIncome Statement

• Retained Earnings StatementRetained Earnings Statement

• Balance SheetBalance Sheet

• Statement of Cash FlowsStatement of Cash Flows


Recall Recall Users of Financial Users of Financial StatementsStatements

• Internal UsersInternal Users

• External UsersExternal Users


##22 Qualitative Characteristics of Qualitative Characteristics of

Accounting InformationAccounting Information

• RelevanceRelevance

• ReliabilityReliability

• ComparabilityComparability

• ConsistencyConsistency


RelevanceRelevance• Makes a difference to the decisionMakes a difference to the decision

• Confirms or corrects prior expectations, Confirms or corrects prior expectations, feedback value feedback value

• Helps predict future eventsHelps predict future events

• It is timelyIt is timely


ReliabilityReliability

• Can be depended uponCan be depended upon

• Verifiable – free of errorVerifiable – free of error

• Faithful representation - factualFaithful representation - factual

• Neutral – does not favor anyoneNeutral – does not favor anyone


Comparability & ConsistencyComparability & Consistency

• Comparability – different companies use Comparability – different companies use similar accounting policiessimilar accounting policies

• Comparability – a firm uses similar Comparability – a firm uses similar accounting policies year to yearaccounting policies year to year


##33 Constraints in Accounting Constraints in Accounting

• MaterialityMateriality

• ConservatismConservatism


MaterialityMateriality

• Will it influence the Will it influence the decision? decision? – MATERIALMATERIAL

• No impact on No impact on decision?decision?– IMMATERIALIMMATERIAL

© PhotoDisc/Getty Images© PhotoDisc/Getty Images© PhotoDisc/Getty Images© PhotoDisc/Getty Images


ConservatismConservatism

• When in doubt, choose method least likely to overstate assets and income

• Do not intentionally understate!


Let’s ReviewLet’s ReviewWhat organization issues United States What organization issues United States

accounting standards?accounting standards?

a.a. Financial Accounting Standards Board.Financial Accounting Standards Board.

d.d. None of the above. None of the above.

c.c. Internal Auditing Standards Committee. Internal Auditing Standards Committee.

b.b. Internal Accounting Standards Committee.Internal Accounting Standards Committee.


Let’s ReviewLet’s ReviewWhat organization issues United States What organization issues United States

accounting standards?accounting standards?

a.a. Financial Accounting Standards BoardFinancial Accounting Standards Board

d.d. None of the above.None of the above.

c.c. Internal Auditing Standards CommitteeInternal Auditing Standards Committee

b.b. Internal Accounting Standards Committee.Internal Accounting Standards Committee.


Let’s ReviewLet’s ReviewWhat is the primary criterion by which What is the primary criterion by which accounting information can be judged?accounting information can be judged?

a.a. Consistency.Consistency.

d.d. Comparability.Comparability.

c.c. Usefulness for decision making.Usefulness for decision making.

b.b. Predictive value.Predictive value.


Let’s ReviewLet’s ReviewWhat accounting constraint refers to the tendency What accounting constraint refers to the tendency

of accountants to resolve uncertainty in a way of accountants to resolve uncertainty in a way least likely to overstate assets and revenues?least likely to overstate assets and revenues?

a.a. Comparability.Comparability.

d. d. Consistency.Consistency.c.c. Conservatism.Conservatism.

b.b. Materiality.Materiality.


Let’s ReviewLet’s Review

a.a. Comparability.Comparability.

d. d. Consistency.Consistency.c.c. ConservatismConservatism

b.b. Materiality.Materiality.

What accounting constraint refers to the tendency What accounting constraint refers to the tendency of accountants to resolve uncertainty in a way of accountants to resolve uncertainty in a way least likely to overstate assets and revenues?least likely to overstate assets and revenues?


##44 Identify the Sections of a Identify the Sections of a Classified Balance SheetClassified Balance Sheet

• Helps users see if company has Helps users see if company has enough assets to pay debtsenough assets to pay debts

• Can determine the short-term Can determine the short-term and long-term claims on total and long-term claims on total assetsassets


Classified Balance SheetClassified Balance Sheet Generally contains the following standard Generally contains the following standard

classifications:classifications:– Current Assets Current Assets – Long-Term InvestmentsLong-Term Investments– Property, Plant, and EquipmentProperty, Plant, and Equipment– Intangible AssetsIntangible Assets– Current LiabilitiesCurrent Liabilities– Long-Term LiabilitiesLong-Term Liabilities– Stockholders' EquityStockholders' Equity


Current AssetsCurrent 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 AssetsCurrent Assets• Examples:

– Cash

– Short-term investments

– Receivables

– Inventories

– Supplies

– Prepaid expenses


Long-Term InvestmentsLong-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 InvestmentsLong-Term Investments

• Example:

– Investments of stocks and bonds of other corporations.


Property, Plant, and EquipmentProperty, 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 VisionDigital Vision


Property, Plant, and Property, Plant, and Equipment - DepreciationEquipment - 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 Property, Plant, and Equipment - DepreciationEquipment - Depreciation


Intangible AssetsIntangible Assets

• Non-current assets

• No physical substance


Current LiabilitiesCurrent LiabilitiesObligations that are supposed to be paid within

the coming year...


Current LiabilitiesCurrent Liabilities• accounts payable

• wages payable

• bank loans payable

• interest payable

• taxes payable

• current maturities of long-term loans payable


Long-Term LiabilitiesLong-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' EquityStockholders' Equity

• Capital (Common) stock - investments in the business by the stockholders

• Retained earnings – net income retained for use in the business


Let’s Put It All Together . . .Let’s Put It All Together . . .



How are current assets listed on the How are current assets listed on the balance sheet?balance sheet?

a.a. by liquidity.by liquidity.

d.d. alphabetically.alphabetically.

c.c. by longevity.by longevity.

b.b. by importance.by importance.


Let’s ReviewLet’s ReviewMany companies have valuable long-term Many companies have valuable long-term

assets that cannot be seen. assets that cannot be seen. These assets are referred to as?These assets are referred to as?

a.a. Fixed assets.Fixed assets.

d.d. Notes payable.Notes payable.

c.c. Intangible assets.Intangible assets.

b.b. Accounts receivable.Accounts receivable.


Let’s extend the discussion and Let’s extend the discussion and learn about some tools to analyze learn about some tools to analyze

financial statements. . .financial statements. . .


Ratio AnalysisRatio Analysis

• Expresses relationship among selected items of financial statement data

• Relationship can be expressed in terms of…

– Percentage

– Rate

– Proportion


Ratio Analysis - ClassificationsRatio Analysis - Classifications

• Liquidity RatiosLiquidity Ratios - measure short-term ability of company to pay maturing obligations and meet unexpected needs for cash



• Profitability RatiosProfitability Ratios - Measures of the income or operating success of a company for a given period of time



• Solvency RatiosSolvency Ratios - Measures of the ability of the company to survive over a long period of time


Ratio Analysis – Ratio Analysis – Use Multiple Measures!Use Multiple Measures!

• Intracompany comparisonsIntracompany comparisons - covering two years of the same company

• Industry average comparisonsIndustry average comparisons - based on average ratios for a particular industry

• Intercompany comparisonsIntercompany comparisons - based on comparisons with a competitor in the same industry


##55 Identify and Compute Ratios Identify and Compute Ratios for Analyzing a Company’s for Analyzing a Company’s

ProfitabilityProfitability


Profitability RatiosProfitability Ratios

• Measures operating success (income) of a company for a given period of time

• Two examples:

– Earnings Per Share (EPS)Earnings Per Share (EPS)

– Price- Earnings Ratio (P-E)Price- Earnings Ratio (P-E)


Earnings Per ShareEarnings Per Share

How does the company’s earning performance compare with that of previous years?

Higher value = improved performance

Net income-Preferred stock dividendsNet income-Preferred stock dividends Average common shares outstandingAverage common shares outstandingEPS=EPS=


Price-Earnings Ratio Price-Earnings Ratio

How does the market perceive the company’s prospect for future earnings?

High ratio suggests market has favorable expectations

Price-Earnings Ratio = Price-Earnings Ratio = Stock price per shareStock price per shareEarnings per shareEarnings per share


Ratio ExamplesRatio Examples


##66 Explain the Relationship Explain the Relationship

Between a Retained Earnings Between a Retained Earnings Statement and a Statement of Statement and a Statement of

Stockholders’ EquityStockholders’ Equity


Statement of Retained EarningsStatement of Retained Earnings

Recall from Chapter 1: Recall from Chapter 1: The Statement The Statement of Retained Earnings of Retained Earnings describes the changes in the retained earnings for the period . . .


RecallRecall from Chapter 1 - from Chapter 1 -Statement of Retained EarningsStatement of Retained Earnings

CSU CorporationCSU CorporationRetained Earnings StatementRetained Earnings Statement

For the Year Ended December 31, 2005For the Year Ended December 31, 2005

Retained earnings, January 1Retained earnings, January 1 $ 0$ 0

Add: Net incomeAdd: Net income 6,800 6,800 6,8006,800

Less: DividendsLess: Dividends 600 600Retained earnings, Dec. 31 Retained earnings, Dec. 31 $ 6,800$ 6,800


Statement of Statement of Stockholders’ EquityStockholders’ Equity

Recall earlier we said that stockholders’ equity has two Recall earlier we said that stockholders’ equity has two parts:parts:

Common StockCommon Stock andand

Retained Earnings,Retained Earnings,

Thus, The Statement of Stockholders’ Equity reports ALL Thus, The Statement of Stockholders’ Equity reports ALL CHANGES in all of the stock accounts and retained CHANGES in all of the stock accounts and retained earnings . . .earnings . . .


Statement of Statement of Stockholders’ EquityStockholders’ Equity



Which is Which is notnot an indicator of profitability? an indicator of profitability?

a.a. Current ratio.Current ratio.

d.d. Price-earnings ratio.Price-earnings ratio.

c.c. Net income.Net income.

b.b. Earnings per share.Earnings per share.


Let’s ReviewLet’s ReviewFor 2005 Stoneland Corporation reported net For 2005 Stoneland Corporation reported net

income $24,000; net sales $400,000; and average income $24,000; net sales $400,000; and average shares outstanding 6,000. There were no shares outstanding 6,000. There were no

preferred stock dividends. What was 2005 preferred stock dividends. What was 2005 earnings per share?earnings per share?

a.a. $4.00$4.00

d.d. $66.67$66.67

c.c. $16.67$16.67

b.b. $0.06$0.06



The balance in retained earnings is The balance in retained earnings is notnot affected by:affected by:

a.a. Net income.Net income.

d.d. Dividends.Dividends.

c.c. Issuance of common stock.Issuance of common stock.

b.b. Net loss.Net loss.



Liquidity and Solvency Using a Liquidity and Solvency Using a Balance SheetBalance Sheet


Financial Ratio ClassificationsFinancial Ratio Classifications

• Liquidity RatiosLiquidity Ratios - measures of short-term ability to pay maturing obligations and to meet unexpected needs for cash

•Working capitalWorking capital

•Current ratioCurrent ratio


Working CapitalWorking Capital

Working Capital = Current Assets - Current Liabilities Working Capital = Current Assets - Current Liabilities

•Measure of short-term ability to pay obligations

•Difference between current assets and current liabilities

Positive working capital is favorable!Positive working capital is favorable!


Current RatioCurrent Ratio

CurrentCurrent Ratio =Ratio =Current AssetsCurrent AssetsCurrent LiabilitiesCurrent Liabilities

•Another measure of short-term ability to pay obligations

•Divide current assets by current liabilities

•More dependable indicatorMore dependable indicator

•Does not consider composition of current Does not consider composition of current assetsassets



Industry Industry average average means? means?



Industry Industry average means? means?

$1.49 of current $1.49 of current assets for every $1 assets for every $1 of current debtof current debt


Financial Ratio ClassificationsFinancial Ratio Classifications

• Solvency RatiosSolvency Ratios - measures of the ability of a company to survive over a long period of time

•Debt to Total Assets RatioDebt to Total Assets Ratio


Debt to Total Assets RatioDebt to Total Assets Ratio

• Divide total debt (current and long-term liabilities) by total assets

Total DebtsTotal DebtsTotal AssetsTotal Assets

Debt to Total Asset Ratio Debt to Total Asset Ratio ==

•Measures percentage of assets financed by Measures percentage of assets financed by creditors rather than stockholderscreditors rather than stockholders



Selected financial information for Selected financial information for Drummond Company at 12/31/2005:Drummond Company at 12/31/2005:

Cash $60,000Receivables (net) $80,000Inventory $70,000Long-term assets $330,000Total Assets $540,000

Current Liabilities $140,000Long-term debt $130,000Total Liabilities $270,000

Let’s compute current ratio . . .Let’s compute current ratio . . .


Let’s Review – Let’s Review – Compute Current RatioCompute Current Ratio



$210,000$210,000

$140,000$140,000

==1.5 : 11.5 : 1



Selected financial information for Selected financial information for Drummond Company at 12/31/2005:Drummond Company at 12/31/2005:



Now, let’s compute debt to total assets . . .Now, let’s compute debt to total assets . . .


Let’s Review – Let’s Review – Compute Debt to Total AssetsCompute Debt to Total Assets



$270,000 $270,000 $540,000 = 50% $540,000 = 50%



Liquidity and Solvency Using a Liquidity and Solvency Using a Statement of Cash FlowsStatement of Cash Flows


RecallRecall from Chapter 1 - from Chapter 1 -Statement of Cash FlowsStatement of Cash Flows

• Provides information about sources and uses of cash, organized as . . .

• Operating Activities

• Investing Activities

• Financing Activities


Statement of Cash FlowsStatement of Cash Flows


Current Cash Debt Coverage RatioCurrent Cash Debt Coverage Ratio

Cash Provided by Operating ActivitiesCash Provided by Operating Activities

Average Current LiabilitiesAverage Current Liabilities

• Another measure of liquidityAnother measure of liquidity

•Indicates ability to generate cash to Indicates ability to generate cash to meet short-term needsmeet short-term needs


Cash Debt Coverage RatioCash Debt Coverage Ratio

Cash Provided by Operating ActivitiesCash Provided by Operating Activities

Average Total LiabilitiesAverage Total Liabilities

• Another measure of solvencyAnother measure of solvency

•Indicates ability to generate cash to Indicates ability to generate cash to meet long-term needsmeet long-term needs


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Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. A Further Look at Financial...

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